"J. Adams and Company: Accounting for Interest Rate Swaps in a Horizontal Yield Curve Environment" illustrates three of the four accounting treatments for derivatives and related hedged items. It should be covered by all users of these cases, as the three types of accounting are illustrated using a single instrument. This allows students to focus on differences in accounting treatments, holding other factors (types of derivatives, pricing mechanisms, and underlying transactions) constant. It requires a minimum of discussion of pricing issues, requiring only that students understand how fair values of fixed-rate bonds, and cash flows related to variable-rate investments, change as interest rates change.
Students are asked to prepare journal entries and summary financial statements for three years for four different scenarios. First, to provide a benchmark for comparisons of hedging results, journal entries and statements are required for fixed-rate debt and a variable-rate investment, assuming no interest rate swap is used as a hedge. Second, three sets of journal entries and statements are prepared, assuming the same basic financial instruments as well as an interest rate swap. For the first set, the interest rate swap is not designated as a hedge. For the second and third sets, the swap is designated as a fair value hedge, then a cash flow hedge. Based on the three years of incomes under the four different alternatives, students are asked to calculate the standard deviations of net income, other comprehensive income, and accumulated other comprehensive income. Comparisons of these standard deviations will highlight the effects of the different accounting treatments on resulting accounting reports.
"Gannonsan Micro-Brewery: Accounting for Forwards
Hedging Foreign Currency Transactions" illustrates
fair value and cash flow hedges, and introduces the concept of
The second and third alternatives incorporate ineffectiveness. In these scenarios, the firm commitment (second alternative) or anticipated transaction (third alternative) is denominated in Hong Kong dollars, while the foreign exchange forward is for the purchase of U.S. dollars. Since the Hong Kong dollar is pegged within a range of the U.S. dollar, the forward will be highly effective in hedging the purchase transaction. However, there will be some ineffectiveness, as there is some variation in the exchange rate between the U.S. dollar and the Hong Kong dollar. Again, students do not have to recalculate the effects of variation in the yen-Hong Kong dollar exchange rate - the calculations done for the basic scenario carry over to the last two alternatives. Calculation of the effects of the change in yen-U.S. dollar exchange rates has to be done only once as well; results are used in alternative two for accounting for a fair value hedge of a firm commitment, then in alternative three for a cash flow hedge of an anticipated transaction.
"Pimentel Cigar Company: Accounting for Options Hedging Equity
Securities" illustrates a third fair value hedge using stock options,
introduces more sophisticated derivatives pricing models (the
Black-Scholes options pricing model), illustrates derivative price
changes due to more than one factor (changes in underlying and
passage of time), and introduces the concept of excluding part of the
change in value of the derivative from assessment of hedge
effectiveness. Purchased put options are used to hedge an investment
in available for sale equity securities. Effectiveness is determined
based on changes in the
"C.L. Smith and Sons: Accounting for Futures Hedging Commodity Purchases and Sales" illustrates the accounting for futures designated as cash flow hedges of anticipated transactions, the purchase of soybeans and the sale of soybean oil and soybean meal by a soybean processing company. The case comes in two versions, "regular" and "lite." The "regular" version extends the treatment of accounting for cash flow hedges in several ways. First, futures on three different commodities (soybeans, soybean oil, and soybean meal) are used simultaneously. Second, futures relating to three different delivery months for each of the three commodities are used as hedges. Having a number of different hedges in effect at the same time significantly increases the difficulty of the case over the previous cases, but brings the case closer to the situation faced by companies who hedge extensively using futures (one company reports its hedging activities result in 60,000 futures transactions per year - close to 300 transactions per business day). Third, the company specifies that hedge effectiveness will be assessed based on changes in fair value attributable to changes in spot prices. Therefore, changes in fair value due to changes in the difference between futures and spot prices will be recognized in net income during the period of change.
In the main scenario, the portion of the change in fair value of the futures due to changes in spot prices is completely effective in offsetting the discounted change in expected cash flows related to the anticipated transactions (purchases and sales of soybeans, soybean oil, and soybean meal), because the processing plant is assumed to be located in Toledo, Ohio, at one of the delivery points specified in the futures contracts. Therefore, the futures prices and related spot prices are for exactly the same commodities as the commodities actually purchased and sold. The alternative scenario in the "regular" version alters this assumption, locating the processing plant in Atlanta. SFAS 133 does not allow the assumption that commodities in different locations have the same prices. Therefore, companies cannot assume the portion of the change in value of a futures contract due to changes in spot prices at the futures delivery point will perfectly offset the change in discounted expected cash flows based on spot prices in a different location. Ineffectiveness must be identified, and reflected in net income, along with the portion of the change in fair value of the future excluded from determination of hedge effectiveness. Only the effective portion of the change in the fair value of the future may be reflected in other comprehensive income.
The "lite" version of the case is the same as the "regular" version, except that hedging of only one month's purchases and sales is considered, rather than three. This reduces the computational difficulty considerably, at the expense of less appreciation of the complexity encountered by companies engaged in extensive hedging activities.
"J. Adams and Company Revisited: Accounting for Interest Rate Swaps in an Upward-Sloping Yield Curve Environment" is not primarily an accounting extension, but rather an illustration of pricing complexities. The opening interest rate swap case is amended slightly, by introducing an upward-sloping yield curve. This requires calculation of implied forward rates from the yield curve, the use of implied forward rates to calculate expected cash flows, and the use of different discount rates to discount expected cash flows occurring at different times. Certain accounting complications arise due to the upward-sloping yield curve underlying the interest rate swap. Rounding out the set of cases, this case again illustrates the accounting for a single derivative used as a speculative instrument, a fair value hedge, and finally as a cash flow hedge.
Back to Title Page |