ISSUES IN ACCOUNTING EDUCATION Vol. 23, No. 1 February 2008 pp. 103-117 Accounting for Derivatives and Hedging Activities: Comparison of Cash Flow versus Fair Value Hedge Accounting Pamela A. Smith and Mark J. Kohlbeck ABSTRACT: Warfield Company is considering hedging the risk associated with (1) an available-for-sale (AFS) security portfolio and (2) an anticipated purchase of oil. Warfield's Board of Directors has limited experience in this area and has requested that you summarize the accounting and reporting implications if these items are hedged. The hedged risk in these two transactions can be either the risk associated with the cash flow or the risk associated with changes in the fair value. The two risks are discussed in separate parts of the case. In Part A, you will complete the accounting entries required for both cash flow and fair value hedges of the AFS security portfolio and summarize the financial statement impact to help you understand the mechanics and implications of hedge accounting. In Part B, you will complete the accounting entries required for both cash flow and fair value hedges, based on the structure of the transaction to purchase the oil, and summarize the financial statement impact of the accounting entries. You will then use the summary to draft a memo to the Board in which you articulate your understanding of the transaction structures, hedge accounting treatment, the financial statement impact, and documentation requirements for hedge accounting. CASE INSTRUCTIONS You have recently been employed by Warfield Company (the Company) and were approached by Mr. Clinton, the corporate treasurer, to assist in a project to help the Board of Directors understand the accounting and reporting implications of hedge accounting. Clinton is currently evaluating how to designate a put option that was purchased as a hedge of an available-for-sale (AFS) security portfolio. Clinton is also evaluating a hedge of an anticipated purchase of oil. He is evaluating the cash flow and fair value risks associated with each item. Mr. Young, the Chairman of the Board, has read about the potential devastating effects of derivatives and is wary about the proposed use of derivatives to hedge these items. Therefore, the Board wants an analysis of the proposed hedge structures' impact on the Pamela A. Smith is a Professor at Northern Illinois University and Mark J. Kohlbeck is an Assistant Professor at Florida Atlantic University. Professor Smith is indebted to numerous graduate and undergraduate students enrolled in classes at Northern Illinois University for their contributions to the development of this instructional case. We are indebted to Terry Warfield for helpful insights on earlier drafts and class-testing this case. We also thank Sue Ravenscroft (editor) and two anonymous reviewers for their helpful comments. The fact patterns in this case are based on actual corporate hedging scenarios. The names of the companies and individuals are fictitious. The fact patterns have been modified and simplified for instructional purposes. See the Teaching Notes for access to classroom ready tables. These tables are also available from the authors upon request. 104 Smith and Kohlbeck Issues in Accounting Education, February 2008 financial statements to help its members understand the financial reporting implications of hedging. Mr. Clinton has provided you with the facts for each hedge item. Part A provides the information about hedging the AFS security portfolio, and Part B provides the information related to the anticipated purchase of oil. Read the facts for each part and complete the tasks requested by Mr. Clinton. When completing these tasks, please ignore tax effects. Part A: Hedge the Cash Flow versus Fair Value of Available-for-Sale Security Portfolio On October 31, Warfield Company purchased 100,000 shares of Smith Company stock for $40 a share and classified the purchase as an AFS security according to Statement of Financial Accounting Standard No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS No. 115, FASB 1993). On November 30, the market price of Smith was $45 a share. On this date, the SFAS No. 115 adjustment to fair market value was recorded. Mr. Clinton believes that the market value of Smith has peaked. He has identified risks associated with the ultimate cash flow and the fair value of the AFS security portfolio and wants to hedge one of these risks. Therefore, the Company purchased a 60-day at-themoney put option for $3 a share to hedge the AFS security on November 30. The put option gives Warfield the right to sell Smith at $45 a share. Because the intrinsic value is zero upon its purchase (the put option is at-the-money), the $3 price represents the time value of the put option. The time value relates to the time to maturity and the likelihood that option will end up being in-the-money. Mr. Clinton must designate and document which risk is being hedged. He is considering two alternative risks to hedge and has asked you to complete the accounting and summarize the reporting implications related to each of the following hedge designations for this hedging instrument. Hedged Item: Cash Flows from AFS Security Portfolio Assume Mr. Clinton is interested in hedging the future cash flows generated from the AFS security portfolio because the cash flows will be used to satisfy a bond sinking fund requirement due on January 31. Therefore, the ultimate cash flows from this securities portfolio are designated as the hedged item. The put option gives Warfield the right to sell Smith at $45 a share, allowing Warfield to lock in the future cash flows from this portfolio. Hedged Item: Fair Value of AFS Security Portfolio Assume Mr. Clinton is interested in hedging the fair value of this AFS security portfolio. The fair value of the portfolio is designated as the hedged item because Warfield has to maintain certain asset levels to maintain a current ratio required by a lender. The put option will help accomplish the fair value hedge because the intrinsic value of the put option plus the spot price of the stock equals $45 a share. Therefore, with the put option, Warfield can lock in a minimum $4.5 million fair value of this portfolio. Required (1) Using Table 1, complete the journal entries for the AFS securities and the put option, assuming the designated hedge item is the ultimate cash flow from the p Accounting for Derivatives and Hedging Activities 105 Issues in Accounting Education, February 2008 boxes in the Tables indicate that an answer is expected. If no entry is necessary, indicate with ''none.'' (2) Using Table 2, complete the journal entries for the AFS securities and the put option, assuming the designated hedge item is the fair value of the portfolio. (3) Using Table 3, complete the summary of the financial statement impact for the cash flow and fair value hedge. Compare the impact of the two hedging scenarios and be prepared to discuss the following: How does the financial statement impact differ between the two hedges of the AFS security portfolio? How is the cash flow ''hedged?'' How is the fair value ''hedged?'' How does the accounting under SFAS No. 133 (FASB 1998) differ from the accounting under SFAS No. 115 once the AFS securities are designated as the hedged item? Part B: Hedge of Anticipated Purchase of Oil On October 31, Warfield Company is anticipating the purchase of 100,000 barrels of oil on January 31st of next year. The oil will be resold on March 31 at the spot price. However, recent turmoil in the world's oil-producing regions has negatively affected the supply of oil. These conditions are expected to continue into the foreseeable future. Mr. Clinton, the corporate treasurer, asked you to assist in the analysis of structuring the anticipated oil purchase transaction and the use of a futures contract to hedge this transaction. The Company can structure the transaction with the counterparty as either a forecasted transaction or a firm commitment. In anticipation of this transaction, the treasurer has determined that Warfield will purchase a futures contract at $39 per barrel (bbl) for 100,000 bbls with a maturity of January 31.2 The critical terms of the futures contract will match the anticipated transaction so the hedge is 100 percent effective. The futures contract is at market rates, and the company maintains a margin account with the broker; therefore, no cash will be exchanged at the inception of the contract. The futures contract settles in cash for the difference between the price stated on the contract and the spot price on January 31 (maturity). If the oil purchase is structured as a forecasted transaction, then Warfield will enter a futures contract for the right to buy oil on January 31 at $39/bbl. In a forecasted transaction, the price of oil is uncertain because the price will depend on the spot rate for oil on January 31 (this is referred to as a floating price). However, the futures contract provides a specific price ($39) for the oil on January 31 (this is referred to as a fixed price). Hedging the forecasted transaction with a futures contract converts uncertain future cash flows into fixed future cash flows by locking in the future cash flows related to this transaction. Therefore, this hedge converts a floating exposure into a fixed amount (floating to fixed). Under this scenario, cumulative gains or losses on the futures contract (assumed to be a 100 percent effective hedge) will offset the cumulative changes in forecasted cash flows of the purchase of oil. If the oil purchase is structured as a firm commitment for 100,000 bbls to be delivered on January 31 at a price of $39/bbl, then Warfield will enter a futures contract for the right 2 The hedge structure is set by the Treasury Department. You are not responsible for determining what derivative to use, whether to buy or sell the derivative, or when to enact the hedge terms. The hedge structure created in this case is purposefully simplified (assumes no time value, no processing cost, etc.) so that the impact of the hedge accounting is clear. 106 Smith and Kohlbeck Issues in Accounting Education, February 2008 to sell the oil on January 31 at $39/bbl. In a firm commitment, the price of oil is a specific price without regard to what happens in the market (a fixed price). The futures contract in this scenario is a commitment to sell the oil for $39. However, in order to settle the futures contract, the oil will be purchased at the spot rate on January 31 (an unknown or floating price). Hedging the firm commitment with the sale of a futures contract converts a fixed firm commitment into an uncertain future value (fixed to floating). Since the hedge is assumed to be 100 percent effective, cumulative gains or losses on the futures contract will offset the cumulative changes in the fair value of the firm commitment. The Board of Directors is concerned about the robustness of either hedge structure because of the uncertainty of oil prices increasing or decreasing during the hedge period. Therefore, Mr. Clinton created two pricing scenarios (price-increasing and price-decreasing) and asked you to complete the accounting entries and a summary of the financial statement impact for both pricing scenarios. Analysis of the hedge accounting under these different pricing assumptions will help evaluate the robustness of the hedge. Required (1) Price-Increasing Assuming a price-increasing scenario, use Tables 4, 5, and 8 to complete the following (clearly label each account, i.e., futures, firm commitment, Gain/LossIncome Statement (IS), Gain/LossOther Comprehensive Income (OCI)). The boxes in the Tables indicate that an answer is expected. If an entry is not applicable, indicate ''none.'' Journal entries for the hedge if it is structured as a forecasted transaction; Journal entries for the hedge if it is structured as a firm commitment; Financial statement summaries for each of the above. (2) Price-Decreasing Assuming a price-decreasing scenario, use Tables 6, 7, and 9 to complete the following (clearly label each account, i.e., futures, firm commitment, Gain/LossIncome Statement (IS), Gain/LossOther Comprehensive Income (OCI)). Journal entries for the hedge if it is structured as a forecasted transaction; Journal entries for the hedge if it is structured as a firm commitment; Financial statement summaries for each of the above. (3) Evaluate the two transaction structures and hedging strategies discussed above and prepare a memo to the Board of Directors clearly explaining the following (use Table 10 to compare the two transaction structures): a. The difference between the forecasted transaction and the firm commitment and pros/cons of structuring the transaction with the supplier as one or the other; b. The concepts behind cash flow and fair value hedging and the accounting treatment of each as it relates to these transactions; c. The documentation requirements (including the timing of any required documentation) in order to qualify for hedge accounting treatment under SFAS No. 133; d. The overall impact on the financial statements if the hedge is a cash flow hedge versus a fair value hedge and whether oil prices are increasing or decreasing (use the tables and summaries completed in Requirements 1 and 2 above); e. The circumstances under which you would recommend one transaction structure versus the other. Accounting for Derivatives and Hedging Activities 107 Issues in Accounting Education, February 2008 TABLE 1 Cash Flow Hedge of Available-for-Sale Security Portfolio (in 000s) October 31 November 30 December 31 January 31 Stock Price $40 $45 $44 $43 Option Value: Time Value (TV) $3 $1.6 $0 Intrinsic Value (IV) $0 $1.0a $2b $3 $2.6 $2 ($45 Strike Price) Entries for AFS Securities Entries for Put OptionTV Entries for Put OptionIV Entries for Settlement a (IV $45 strike $44 spot) b (IV $45 strike $43 spot) TABLE 2 Fair Value Hedge of Available-for-Sale Security Portfolio (in 000s) October 31 November 30 December 31 January 31 Stock Price $40 $45 $44 $43 Option Value: Time Value (TV) $3 $1.6 $0 Intrinsic Value (IV) $0 $1.0a $2b $3 $2.6 $2 ($45 Strike Price) Entries for AFS Securities Entries for Put OptionTV Entries for Put OptionIV Entries for Settlement a (IV $45 strike $44 spot) b (IV $45 strike $43 spot) 108 Smith and Kohlbeck Issues in Accounting Education, February 2008 TABLE 3 Summary of Financial Statement Impact October 31 November 30 December 31 January 31 Panel A: Hedge of Cash Flows from Available-for-Sale Security Portfolio (in 000s) Changes in Balance Sheet: Assets Liabilities EquityOCI EquityNI Cash flows Stock Value Put Option Total Investment Value Panel B: Hedge of Fair Value of Available-for-Sale Security Portfolio (in 000s) Changes in Balance Sheet: Assets Liabilities EquityOCI EquityNI Cash flows Stock Value IV of Put Option Hedged Fair Value TV of Put Option Total Investment Value Accounting for Derivatives and Hedging Activities 109 Issues in Accounting Education, February 2008 TABLE 4 Price-Increasing Scenario Cash Flow Hedge of Forecasted Transaction October 31 Nov 30 Dec 31 Jan 31 March 31 Oil Price $35 $40 $37 $44 $46 Futures Rate $39 $41 $38 $44 Entries for the Futures Contract (Contract to BUY) Entries for the Forecasted Transaction TABLE 5 Price-Increasing Scenario Fair Value Hedge of Firm Commitment October 31 Nov 30 Dec 31 Jan 31 March 31 Oil Price $35 $40 $37 $44 $46 Futures Rate $39 $41 $38 $44 Entries for the Futures Contract (Contract to SELL) Entries for the Firm Commitment (Contract to BUY) TABLE 6 Price-Decreasing Scenario Cash Flow Hedge of Forecasted Transaction October 31 Nov 30 Dec 31 Jan 31 March 31 Oil Price $35 $32 $34 $30 $29 Futures Rate $39 $34 $35 $30 Entries for the Futures Contract (Contract to BUY) Entries for the Forecasted Transaction 110 Smith and Kohlbeck Issues in Accounting Education, February 2008 TABLE 7 Price-Decreasing Scenario Fair Value Hedge of Firm Commitment October 31 Nov 30 Dec 31 Jan 31 March 31 Oil Price $35 $32 $34 $30 $29 Futures Rate $39 $34 $35 $30 Entries for the Futures Contract (Contract to SELL) Entries for the Firm Commitment (Contract to BUY) TABLE 8 Summary of Financial Statement Impact Price-Increasing Scenarios Oct 31 Nov 30 Dec 31 Jan 31 Mar 31 Cash Flow Hedge (Converting Floating to Fixed) Changes in Balance Sheet: Assets Liabilities EquityOCI EquityNI Cash Flows Value of Futures Contract Inventory value Fair Value Hedge (Converting Fixed to Floating) Changes in Balance Sheet: Assets Liabilities EquityOCI EquityNI Cash Flows Value of Futures Contract Value of Firm Commitment Inventory Value Accounting for Derivatives and Hedging Activities 111 Issues in Accounting Education, February 2008 TABLE 9 Summary of Financial Statement Impact Price-Decreasing Scenarios Oct 31 Nov 30 Dec 31 Jan 31 Mar 31 Cash Flow Hedge (Converting Floating to Fixed) Changes in Balance Sheet: Assets Liabilities EquityOCI EquityNI Cash Flows Value of Futures Contract Inventory Value Fair Value Hedge (Converting Fixed to Floating) Changes in Balance Sheet: Assets Liabilities EquityOCI EquityNI Cash Flows Value of Futures Contract Value of Firm Commitment Inventory Value 112 Smith and Kohlbeck Issues in Accounting Education, February 2008 TABLE 10 Summary of All Hedging Scenarios Cash Flow Hedge: Floating to Fixed Balance Sheet Volatility? (Yes or No) Cash Flow (Fixed) Inventory Value (Floating) Cost of Goods Sold (Fixed) Profit (Loss) Prices Increasing Prices Decreasing Fair Value Hedge: Fixed to Floating Balance Sheet Volatility? (Yes or No) Cash Flow (Floating) Inventory Value (Floating) Cost of Goods Sold (Floating) Profit (Loss) Prices Increasing Prices Decreasing REFERENCES Financial Accounting Standards Board (FASB). 1993. Accounting for Certain Investments in Debt and Equity Securities. Statement No. 115. Norwalk, CT: FASB. . 1998. Accounting for Derivative Instruments and Hedging Activities. Statement No. 133. Norwalk, CT: FASB