FASB Statement 133 Accounting for Derivative Instruments and

FASB Statement 133 Accounting for Derivative Instruments and Hedging Activities October 12 -13, 2000 Chicago, IL 1 -0

ACCOUNTING FOR DERIVATIVES FASB Statement No. 133 Presentation by Bavan Holloway Robert Jensen Ira G. Kawaller 1 -1

CASE 1 Cash Flow Hedge of Forecasted Inventory Sale n ABC is hedging the risk of changes in cash flows related to a forecasted sale of 100, 000 bushels of Commodity A to be sold at the end of period 1. The inventory carrying value is $1 million, and current market value is $1. 1 million n On the first day of period 1, ABC enters into Derivative Z to sell 100, 000 bushels at $1. 1 million at the end of period n At hedge inception, the derivative is at-the-money (fair value is 0) n All terms of the commodity and the derivative match (i. e. , no expected ineffectiveness) n On last day of Period 1, fair value of Derivative Z increased by $25, 000 and expected sales price of 100, 000 bushels of Commodity A decreased $25, 000 n From Example 4, Appendix B of Standard 1 -2

CASE 1 Cash Flow Hedge of Forecasted Inventory Sale Journal entries at end of period 1 Derivative Z 25, 000 OCI 25, 000 To record Derivative Z at fair value Cash Derivative Z 25, 000 To record settlement of Derivative Z 1 -3 25, 000

CASE 1 Cash Flow Hedge of Forecasted Inventory Sale Journal entries at end of period 1 Cash 1, 075, 000 CGS 1, 000 Revenue 1, 075, 000 Inventory 1, 000 To record inventory sale OCI 25, 000 Earnings 25, 000 To reclassify amount in OCI to earnings upon inventory sale 1 -4

CASE 1 Cash Flow Hedge of Forecasted Inventory Sale Forecasted cash flows: $1, 100, 000 Actual cash flows: Derivative $ Sale of inventory Total 25, 000 1, 075, 000 $1, 100, 000 The variability of cash flows related to the forecasted inventory sale is offset by change in value of derivative. 1 -5

CASE 2 Fair Value Hedge of Inventory n ABC has 1, 000 bushels of a Commodity with a fair value of $1. 1 million and a carrying value of $1. 0 million n ABC wants to hedge overall fair value of the Commodity n On 1/1/X 1, ABC enters into an at-the-money “matching” derivative to hedge the changes in fair value of the 1, 000 bushels of the Commodity 1 -6

CASE 2 (Cont’d) Fair Value Hedge of Inventory n Effectiveness will be assessed by comparing entire change in fair value of derivative to change in market price of inventory (time value will be ignored for illustration purposes only) n On 1/31/X 1, the fair value of the derivative has increased by $25, 000 and the fair value of the inventory has decreased by $25, 000 1 -7

CASE 2 Fair Value Hedge of Inventory Journal entries at end of period: Derivative 25, 000 Earnings 25, 000 To record derivative at fair value Earnings 25, 000 Inventory To record loss on hedged inventory 1 -8 25, 000