Impact of accounting for derivatives on other comprehensive income.
The FASB intends to issue "Accounting for Derivative and Similar Financial Instruments and Hedging Activities" by the end of the first quarter of 1998. These new requirements will result in the reporting of some unrealized derivative gains and losses as other comprehensive income items. This article will illustrate how accounting for derivatives will impact other comprehensive income and how these unrealized gains or losses will be displayed in the Statement of Comprehensive Income.
BASIC ACCOUNTING FOR DERIVATIVES
The new accounting will require all derivatives to be measured at fair value and reported in the balance sheet as assets or liabilities. Accounting for the change in fair value of the derivative will depend on the reason for holding it, and whether it has been designated and qualifies for hedge accounting. A derivative designated and qualifying as a hedge of the exposure to changes in the fair value of a recognized asset or liability or a firm commitment is referred to as a fair value hedge. The gain or loss on a derivative designated as a fair value hedge will be recognized in current earnings. The gain or loss attributable to the risk being hedged on the hedged item will also be included in current earnings. This results in the carrying amount of the hedged item being adjusted for this change in fair value attributable to the hedged risk and the offsetting of the derivative gain or loss with the hedged item loss or gain to the extent the hedge is effective.
A derivative designated and qualifying as a hedge of the exposure to variable cash flows associated with a recognized asset or liability or with a forecasted transaction is referred to as a cash flow hedge. The gain or loss on a derivative designated as a cash flow hedge will be reported in other comprehensive income or earnings, as necessary, to adjust the balance in other comprehensive income to an amount that equals the lesser of (a) the cumulative gain or loss on the derivative or (b) the cumulative change in expected future cash flows on the hedged transaction. The result is that the excess cumulative gain or loss on the derivative would be considered to be ineffective and recognized in earnings.
ILLUSTRATION OF HEDGES AND REPORTING COMPREHENSIVE INCOME
The accounting for derivatives will result in another comprehensive income item when a derivative qualifies and is designated as a cash flow hedge. All or part of the change in derivative fair value will be reported in other comprehensive income and accumulated as a separate component of stockholders' equity. Two examples are provided which illustrate the accounting for cash flow hedges and how the unrealized gains or losses are displayed in a Statement of Comprehensive Income.
ILLUSTRATION 1: Cash Flow Hedge of an Existing Liability
On January 1, 1998, Company X is holding $10,000,000 of a 3-year debt tied to London Interbank Offer Rate (LIBOR) with payment and reset annually on December 31. Company X would rather be holding fixed-rate debt, so on January 1, 1998, they simultaneously enter into a 3-year interest rate swap to receive LIBOR and pay 8% on a notional $10,000,000 with settlement and reset annually on December 31. This swap effectively converts the variable-rate debt to a fixed rate.
The debt is a recognized liability that is exposed to variable cash outflows as LIBOR changes. The swap effectively hedges this cash flow exposure by synthetically converting the debt to a fixed-rate pay of 8 percent. Since the debt is variable-rate and the swap has a variable leg and the notional amounts, payments dates, reset dates, and remaining term of the swap are the same as the debt, the cumulative cash flows on the swap and the cumulative changes in cash flows on the debt are expected to completely offset. Therefore, the hedge ineffectiveness is zero and the entire change in derivative fair value will be reported in other comprehensive income.
Exhibit 1 includes LIBOR, swap settlements, fair values, and income before consideration of the unrealized gain/loss on the swap for 1998 and 1999. Illustration 1 includes the journal entries to account for the hedging transaction and the corresponding Statement of Comprehensive Income for the two years.
Referring to Illustration 1, Interest Expense of $800,000 is paid on the debt for 1998 since LIBOR was 8% on January 1, 1998. There is no swap settlement at the end of 1998 since LIBOR and the fixed-rate pay on the swap were both 8% at the beginning of the year. An adjusting entry is necessary at December 31, 1998, to mark the swap to its fair value of $175,000. The swap is recorded as an asset because LIBOR is reset at that date to 9% which means the company will receive 9% and pay 8% on the notional $10,000,000, resulting in a net receive position in the future. The entire $175,000 of unrealized gain is included as other comprehensive income since there was no hedge ineffectiveness. This unrealized gain is added to net income to determine total comprehensive income.
EXHIBIT 1 Given Information for ILLUSTRATION 1 SWAP DATE LIBOR SETTLEMENT FAIR VALUE Jan. 1, 1998 8.0% - - Dec. 31, 1998 9.0% $0 $175,000 Dec. 31, 1999 8.5% $100,000 $ 45,000 FOR YEAR INCOME BEFORE UNREALIZED ENDED GAIN/LOSS ON SWAP Dec. 31, 1998 $1,500,000 Dec. 31, 1999 $1,700,000
[TABULAR DATA FOR ILLUSTRATION 1 OMITTED]
Interest Expense of $900,000 is paid on the debt at the end of 1999 because LIBOR was reset to 9% on December 31, 1998. The swap settlement at the end of 1999 is $100,000 which is the difference between the LIBOR received (9%) and the fixed-rate pay (8%) on the notional $10,000,000. An amount equal to this settlement is removed from the accumulated unrealized gain of $175,000 and reported in earnings since the earnings impact of the hedged item (interest expense from the debt) is now occurring. The standard does not specifically prescribe the classification of gains or losses on the income statement; therefore the change is classified as an adjustment to Interest Expense since cash flow for interest is the risk being hedged.
An adjusting entry at December 31, 1999 is needed to adjust the swap to its fair value of $45,000. This fair value still represents an asset since the LIBOR of 8.5% remains higher than the 8% to be paid on the notional swap. However, the fair value has declined since LIBOR has declined. The swap account has a $75,000 asset balance before adjustment ($175,000 less than $100,000 settlement). The fair value of the swap is now only $45,000; therefore, the entry reduces the swap account by $30,000.
This decrease in fair value is reported in [TABULAR DATA FOR ILLUSTRATION 2 OMITTED] other comprehensive income for 1999, as well as the $100,000 reclassification. The entire $175,000 of swap gain was included in other comprehensive income for the year ended December 31, 1998. Then, $100,000 of this amount was included in net income for the year ended December 31, 1999 as a reduction of interest expense. In order to avoid double-counting this gain in comprehensive income (once in other comprehensive income and once in net income), the $100,000 is removed from other comprehensive income in the year it is included in net income.
The swap account, which now has a balance of $30,000 is reported as an asset. The unrealized gain account, which also has a $30,000 balance, represents the accumulated other comprehensive income which is reported as a separate component of stockholders' equity.
ILLUSTRATION 2: Cash Flow Hedge of a Forecasted Transaction
On October 15, 1998, Company X determines it will need 100,000 bushels of corn the latter part of February 1999. Company X uses corn as a raw material for its corn-based product. To hedge against price fluctuations (and therefore cash outflow fluctuations), Company X acquires March, 1999 futures contracts to purchase 100,000 bushels of corn at $2.70 per bushel. On December 31, 1998, the closing price of the March, 1999 contract is $2.80 per bushel. On February 21, 1999, the company purchases 100,000 bushels of corn through its normal commercial channels and closes out the futures contracts at $2.85 per bushel. The corn-based product was sold in July of 1999.
The journal entries for 1998 and 1999 as a result of the above cash flow hedge and the corresponding display in the Statement of Comprehensive Income are included in Illustration 2. An adjusting entry is made at year end for 1998 to adjust the futures contracts to fair value based on the closing price for that date. Since the company bought futures at a lower price than what they can now sell them for, the fair value represents a receivable and will be reported as an asset. The unrealized gain is included in other comprehensive income and accumulated as a separate component of stockholders' equity.
By the time the company is ready to purchase the corn, futures contracts have increased in value by $5,000. This unrealized gain also flows through other comprehensive income. The futures contracts are settled with Company X receiving $15,000. The corn is purchased at the current price of $2.85 per bushel. The $15,000 accumulated unrealized gain remains in equity until the earnings impact of the purchased corn. The earnings impact occurs when the final product is sold and the raw material becomes cost of goods sold. At this time the unrealized gain is removed from other comprehensive income and included in earnings as a reduction of cost of goods sold. The cost of goods sold related to the corn is now only $270,000 ($285,000-$15,000) which represents the price (outflow) locked in on October 15. The gain of $5,000 is included in other comprehensive income for 1999, and the $15,000 is reclassified when it reduces cost of goods sold and increases net income. Since the entire $15,000 was included in other comprehensive income during 1998 and 1999, the $15,000 needs to be removed when it is included in earnings.
SUMMARY OF EFFECTS OF ACCOUNTING FOR DERIVATIVES ON OTHER COMPREHENSIVE INCOME
Some believe it is inappropriate to record changes in value of derivatives that are cash flow hedges in other comprehensive income. They believe the resulting volatility in other comprehensive income and shareholders' equity is unwarranted. These fluctuations are created as a result of changes in market value of derivatives and the reclassification of these unrealized gains or losses when earnings impact of the hedged item occurs.
Previous accounting allowed many instruments to be recorded and subsequently carried at historical cost which was "zero" for several types of derivatives since no initial cost was involved in the contract. Those instruments, such as the swap in Illustration 1, which previously had no impact on other comprehensive income, must now be reported at fair value with the unrealized gain or loss included in other comprehensive income. This gain or loss is then removed from other comprehensive income when the hedged item impacts earnings.
Those instruments which were previously required to be marked to fair value, such as the futures contracts in Illustration 2, will continue to be marked to fair value. However, the unrealized gains <losses> which were deferred and reported as liabilities <assets> will now flow through other comprehensive income with removal at a later date when the hedged item impacts income.
In addition to fluctuations in other comprehensive income, hedge ineffectiveness will also affect earnings fluctuations. Excess cumulative change in derivative fair value over cumulative change in expected future cash flows of the hedged item will be included in earnings.
Gary L. Waters is the Director of Business/Student Partnerships in the Auburn University College of Business. Gary earned his BS degree from Auburn University, his MA degree from the University of Alabama, and his DBA degree from the University of Tennessee. Gary's primary research areas are financial accounting and accounting education. His research has appeared in The CPA Journal, The Woman CPA, The Journal of American Taxation Association, The EDP Auditor, The Accounting Educators' Journal, National Public Accountant, and Today's CPA.
Arlette C. Wilson is the KPMG Peat Marwick Professor of Accounting at Auburn University. Arlette earned her BA in Statistics and MBA in Accounting from the University of Mississippi and her PhD degree from the University of Arkansas. She has been published in numerous journals on various financial, accounting and auditing topics including derivatives.
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|Author:||Waters, Gary L.; Wilson, Arlette C.|
|Publication:||The National Public Accountant|
|Date:||Oct 1, 1998|
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