A

APPENDIX

Derivatives

OVERVIEW A complex class of financial instruments exists in financial markets in response

to the desire of firms to manage risks. In fact, these financial instruments have
been created solely to hedge against risks created by other financial instru-
ments or by forecasted transactions that have yet to occur. These financial
instruments often are called derivatives because they “derive” their values
or contractually required cash flows from the value of some underlying secu-
rity or index. Accounting for derivatives is the focus of this Appendix.

LEARNING After studying this Appendix, you should be able to:

OBJECTIVES ● LOA–1 Identify the major derivative securities used to hedge against risk. (p. A-3)
● LOA–2 Understand the way we account for fair value hedges. (p. A-8)
● LOA–3 Understand the way we account for cash flow hedges. (p. A-12)
● LOA–4 Understand the way we account for foreign currency hedges. (p. A-16)
● LOA–5 Describe disclosure requirements for derivatives and risk. (p. A-18)
● LOA–6 Understand the extended method for interest rate swap accounting. (p. A-18)

“. . . derivatives are financial weapons of mass destruction . . .”

— Warren Buffett, Berkshire Hathaway CEO

“. . . the growing use of complex financial instruments known as derivatives does not pose a
threat to the country’s financial system . . .”
— Alan Greenspan, Federal Reserve Chair

“Used properly, derivative instruments don’t create surprises. They help minimize them.”
— David Weinberger, PAAMCO, Managing Director

In today’s global economy and evolving financial markets, businesses are increasingly
exposed to a variety of risks, which, unmanaged, can have major impacts on earnings. Risk
management, then, has become critical. Derivative financial instruments have become the
key tools of risk management.1

1
Almost all financial institutions and over half of all nonfinancial companies use derivatives.

A-2
 APPENDIX A Derivatives A-3

Derivatives are financial instruments that “derive” their values or contractually required Derivatives are financial
cash flows from some other security or index. For instance, a contract allowing a company instruments that “derive”
to buy a particular asset (for example, steel, gold, or wheat) at a designated future date at a their values from some
other security or index.
predetermined price is a financial instrument that derives its value from expected and actual
changes in the price of the underlying asset. Financial futures, forward contracts, options,
and interest rate swaps are the most frequently used derivatives. We discuss each of these in
the paragraphs that follow. Derivatives are valued as tools to manage or hedge companies’
increasing exposures to risk, including interest rate risk, price risk, and foreign exchange
risk. Companies may enter into derivatives to entirely or partially offset these risk expo-
sures. The variety, complexity, and magnitude of derivatives have grown rapidly in recent
years. Accounting standard-setters have scrambled to keep pace.
Multimillion-dollar losses by a number of high profile companies and the financial col- Derivatives serve as a form
lapse of Bear Stearns and AIG2 makes it tempting to conclude that derivatives are risky of “insurance” against risk.
business indeed. Certainly they can be quite risky if misused, but the fact is, these financial
instruments exist to lessen, not increase, risk. Properly used, they serve as a form of “insur-
ance” against risk. In fact, if a company is exposed to a substantial risk and does not hedge
that risk, it is taking a gamble. On the other hand, if a derivative is used improperly, it can
be a huge gamble itself.
Many observers are fearful that the size of the derivatives market poses significant risk
to the economy. Some caution that the vast derivatives market could even cause the entire
global financial system to crash, particularly if a large portion of the derivatives contracts
are held for speculative purposes or are poorly conceived positions. Why? If interest rates
rise, then many speculative interest rate swaps would incur losses. But it’s also the size of
the interest rate swap market and the size of the resultant losses that prompts the anxiety. At
the end of June 2020, the over-the-counter derivatives market was $607 trillion. Yes, that’s
607 with twelve zeroes ($607,000,000,000,000). And, that’s nearly over 31 times the U.S.
gross domestic product. Eighty-two percent of those derivatives ($495 trillion) are interest
rate contracts.3 Our focus here, though, is not on the risk posed by the speculative use of
derivatives, but instead on the use of derivatives to reduce company risk.

Derivatives Used to Hedge Risk

Hedging means taking an action that is expected to produce exposure to a particular type Hedging means taking
of risk that is opposite of a risk to which the company already is exposed. For instance, a risk position that is
the volatility of interest rates creates exposure to interest-rate risk for companies that issue opposite to an actual
position that is exposed
debt—which, of course, includes most companies. A company that arranges loans with to risk.
floating (variable) interest rates is exposed to the risk that interest rates might increase and
adversely affect borrowing costs. Similarly, a company that regularly reissues commercial
paper (short-term notes) as it matures faces the possibility that new rates will be higher and ● LOA–1
cut into forecasted income. When borrowings are large, the potential cost can be substantial.
So, the firm might choose to hedge its position by entering into a transaction that would
produce a gain of roughly the same amount as the potential loss if interest rates do, in fact,
increase. A way to do this is to enter into a contract that exchanges (swaps) floating rate pay-
ments for fixed interest payments, or vice versa, without exchanging the underlying notes.
Hedging is most commonly used to manage three areas of risk exposure: fair value risk,
cash flow risk, and foreign currency risk. Hedging against fair value risk protects the exist-
ing financial instrument against changes in its fair value. Hedging against cash flow risk
protects against market related fluctuations in the cash to be paid or cash to be received for
items such as interest receivable and payable. Hedging against foreign currency risk pro-
tects against exchange rate fluctuations that would change the dollar equivalent that must
be repaid or will be received on a contract denominated in a foreign currency. Let’s look at
some of the more common derivatives.

2
Bear Sterns was sold to JPMorgan Chase, and AIG worked with regulators, reduced its risk, and has since recovered from its
difficulties.
3
Bank for International Settlements, BIS Quarterly Review, November 2020.
A-4 APPENDIX A Derivatives

A futures contract allows FUTURES A futures contract is an agreement between a seller and a buyer that requires
a firm to sell (or buy) a the seller to deliver a particular commodity (a nonfinancial asset such as corn, gold, or cattle)
commodity or a financial at a designated future date, at a predetermined price. When the contract involves a financial
instrument at a designated
future date, at today’s
instrument, such as a Treasury bond, Treasury bill, commercial paper, or a certificate of
price. deposit, the agreement is referred to as a financial futures contract.4 These contracts are
actively traded on regulated futures exchanges.
To appreciate the way these hedges work, let’s think about a financial instrument. Recall
that when interest rates rise, the market price of interest-bearing securities goes down. For
instance, if you have an investment in a 10% bond and market interest rates go up to, say,
12%, your 10% bond is less valuable relative to other bonds paying the higher rate. Con-
versely, when interest rates decline, the market price of interest-bearing securities goes up.
This risk that the investment’s value might change is referred to as fair value risk. The com-
pany that issued the securities is faced with fair value risk also. If interest rates decline, the
fair value of that company’s debt would rise, a risk the borrower may want to hedge against.
Later in this section, we’ll look at an illustration of how the borrower would account for and
report such a hedge.
Now let’s look at the effect on a contract to sell or buy securities (or any asset for that mat-
ter) at preset prices. A party who contracts to sell securities at a preset price benefits when
interest rates rise and the market price of those securities falls. Consequently, the value of the
The seller in a financial contract that gives one the right to sell securities at a preset price goes up as the market price
futures contract realizes a declines. Thus, the seller in a futures contract derives a gain (loss) when interest rates rise
gain (loss) when interest (decline).5 Conversely, the party obligated to buy securities at a preset price experiences a
rates rise (decline).
loss. This risk of having to pay more cash or receive less cash is referred to as cash flow risk.
A common example of cash flow risk is borrowing money by issuing a variable (float-
ing) rate note. If market interest rates rise, the borrower has to pay more interest. Similarly,
the lender (investor) in the variable (floating) rate note transaction faces cash flow risk that
interest rates will decline, resulting in lower cash interest receipts.
Let’s look closer at how a financial futures contract can mitigate risk. Consider a company
in April that will replace the $10 million of 3.5% notes it owes to its bank with a new issuance
of bonds to the public when the notes mature in June. The company is exposed to the risk that
interest rates in June will rise, increasing borrowing costs. To counteract that possibility, the
firm might enter a contract in April to deliver (sell) bonds in June at their current price.
Here’s what happens then. If interest rates rise, borrowing costs will go up for our exam-
ple company because it will have to issue debt securities (like notes payable or bonds pay-
able) at a higher interest cost (or lower price). But that loss will be offset (approximately)
by the gain produced by being in the opposite position on Treasury bond futures. Take note,
though, this works both ways. If interest rates go down causing debt security prices to rise,
the potential benefit of being able to issue debt at that lower interest rate (higher price) will
be offset by a loss on the futures position.
Since there are no corporate bond futures contracts, the company trades Treasury bond
futures, which will accomplish essentially the same purpose. In essence, the firm agrees to
sell Treasury bonds in June at a price established now (April). Let’s say it’s April 6 and the
price of Treasury bond futures on the Chicago Mercantile Exchange is quoted as 153.66.6
Since the trading unit of Treasury bond futures is a 15-year, $100,000, 6% Treasury bond,
the company might sell 65 Treasury bond futures to hedge the June issuance of debt. This
would effectively provide a hedge of 65 × $100,000 × 153.66% = $9,987,900.7
A very important point about futures contracts is that the seller does not need to have
actual possession of the commodity or financial instrument (the Treasury bonds, in this
case), nor is the purchaser of the contract required to take possession of the commodity. In
fact, virtually all financial futures contracts are “netted out” before the actual transaction is

4
Note that a financial futures contract meets the definition of a financial instrument because it entails the exchange of financial
i­nstruments (cash for Treasury bonds, for instance). But, a futures contract for the sale or purchase of a nonfinancial commodity like
corn or gold does not meet the definition because one of the items to be exchanged is not a financial instrument.
5
The seller of a futures contract is obligated to sell the bonds at a future date. The buyer of a futures contract is obligated to buy the
bonds at a future date. The company in our example, then, is the seller of the futures contract.
6
Price quotes are expressed as a percentage of par.
7
This is a simplification of the more sophisticated way financial managers determine the optimal number of futures.
 APPENDIX A Derivatives A-5

to take place. This is simply a matter of reversing the original position through an offset-
ting transaction. A seller closes out his transaction with a purchase. Likewise, a purchaser
would close out her transaction with a sale. After all, the objective is not to actually buy or
sell Treasury bonds (or whatever the commodity or financial instrument might be), but to
incur the financial impact of movements in interest rates as reflected in changes in Treasury
bond prices. Specifically, it will buy treasury bonds contracts at the lower price (to reverse
its original position) at the same time it’s issuing (selling) its new corporate bond issue at
that same lower price. The financial futures market is an “artificial” exchange in that its rea-
son for existing is to provide a mechanism to transfer risk from those exposed to it to those
willing to accept the risk, not to actually buy and sell the underlying financial instruments.
If the impending debt issue being hedged is a short-term issue, the company may attain a The effectiveness of a
more effective hedge by selling short-term futures, such as those based on Eurodollars or the hedge is influenced by the
secured overnight financing rate (SOFR), that also are traded in futures markets. The object closeness of the match
between the designated
is to get the closest association between the financial effects of interest rate movements on risk being hedged and
the actual transaction and the effects on the financial instrument used as a hedge. the financial instrument
chosen as a hedge.
FORWARD CONTRACTS A forward contract is similar to a futures contract, but a for-
ward contract is a customized contract between two parties that calls for either physical
delivery or cash settlement on a designated date, whereas a futures contract permits the seller
to decide later which specific day within the specified month will be the delivery date (if it
gets as far as actual delivery before it is closed out). Also, unlike a futures contract, a forward
contract usually is not traded on a market exchange. Instead, a forward contract usually is
traded in an over-the-counter market using an “intermediary” that will find a seller for a
buyer or a buyer for a seller (and who will customize the contract for the exact day, etc.)
To illustrate a nonfinancial forward contract, let’s say a large restaurant chain uses
500,000 pounds of avocados each year during the week of Cinco de Mayo to satisfy demand
for its famous guacamole. In recent years, the price of avocados has fluctuated significantly.
To reduce the cash flow risk associated with price volatility, the restaurant chain enters into
a forward contract with an intermediary on October 31 to buy 500,000 pounds of avocados
at a set price of $2.80/lb, with delivery in six months (April 30). The hedged transaction is
the forecasted purchase of avocados from suppliers. The hedging instrument is the forward
contract arranged with an intermediary, and the hedged risk is the change in purchase price.
As we saw with the financial futures contract, the seller and purchaser do not need to
exchange possession of the underlying commodity or financial instrument. Rather, the forward
contract will settle by an exchange of cash between the restaurant chain and the intermediary
based on the current market price for avocados on the date the contract is settled (April 30).
How does this impact the restaurant chain? If avocado prices rise and the restaurant chain
pays more to suppliers of avocados, this increased cost will be offset by the gain from being
in the opposite position in the forward contract. For example, assume the current market
price on April 30 is $3.00/lb. The company would receive cash from the settlement of the
forward contract of $100,000 ([$3.00 – $2.80] × 500,000 pounds). At the same time, if
avocado prices fall and the restaurant pays less to purchase avocados, this decrease in cost
will be offset by the loss on the settlement of the forward position. In either scenario, how-
ever, the restaurant chain achieves its goal of reducing the cash flow risk related to price
volatility—­when considering the purchase of avocados from suppliers and the settlement
of the forward contract with the intermediary, the restaurant ends up paying $2.80/lb for
avocados on April 30, regardless of the actual price movement.

OPTIONS Options frequently are purchased to hedge exposure to the effects of changing
interest rates. In that respect, options serve the same purpose as futures but are fundamen-
tally different. An option on a financial instrument—such as a U.S. Treasury bond—gives
its holder the right either to buy (call option) or to sell (put option) the Treasury bond at a
specified price and within a given time period. Importantly, though, the option holder has
no obligation to exercise the option. In contrast, the holder of a futures contract must buy
or sell within a specified period unless the contract is closed out before delivery comes due.
To illustrate a nonfinancial option contract, let’s reconsider the example of the restaurant
chain that wants to protect itself from rising avocado prices. Let’s say the restaurant chain is
A-6 APPENDIX A Derivatives

able to enter into a contract that gives it the option to purchase 500,000 pounds of avocados
in six months at the price of $2.80/lb. Assume this option contract has an initial premium of
$0.02 per avocado, or $10,000. That is, the restaurant pays a premium for the right (but not
the obligation) to buy avocados in the future at the current market price. If the price of avo-
cados increases to $3.00/lb, then the outcome of an option contract will be similar to what
we saw with the forward contract: the restaurant chain will exercise its option and receive
$100,000 ([$3.00 – $2.80] × 500,000 pounds) upon settlement of the option. Because the
restaurant chain paid an initial premium, the net cash effect of the option contract ($90,000
= $100,000 cash settlement − $10,000 premium) would be less than in the forward con-
tract example ($100,000 cash settlement). Unlike the forward contract, however, if avocado
prices fall, then the restaurant chain does not have to pay to settle the option contract. Rather,
it will let the option expire, and the restaurant chain will only be “out” the option premium.

FOREIGN CURRENCY FUTURES Foreign loans frequently are denominated in the cur-
rency of the lender (Japanese yen, Mexican peso, Euro, and so on). When loans must be
repaid in foreign currencies, a new element of risk is introduced. This exposure occurs
because when exchange rates change, the U.S. dollar equivalent of the foreign currency that
must be repaid differs from the U.S. dollar equivalent of the foreign currency borrowed.
Foreign exchange risk To hedge against “foreign exchange risk” exposure, some firms buy or sell foreign
often is hedged in the currency futures contracts. These are similar to financial futures except specific foreign
same manner as interest currencies are specified as the underlying in the futures contracts rather than specific debt
rate risk.
instruments. They work the same way to protect against foreign exchange risk as financial
futures protect against fair value or cash flow risk.

Interest rate swaps INTEREST RATE SWAPS Over 82% of derivatives are interest rate contracts, of which
exchange fixed interest 75% are interest rate swaps. These contracts exchange (swap) fixed interest payments
payments for floating for floating rate payments, or vice versa, without exchanging the underlying debt instru-
rate payments, or vice
versa, without exchanging
ments. For example, suppose you owe $100,000 on a 10% fixed rate home loan. You envy
the underlying notional your neighbor who also is paying 10% on her $100,000 mortgage, but hers is a floating
(principal) amounts. rate loan, so if market rates fall, so will her loan rate. To the contrary, she is envious of
your fixed rate, fearful that rates will rise, increasing her payments. A solution would be
for the two of you to effectively swap interest payments using an interest rate swap agree-
ment. The way a swap works, you both would continue to actually make your own interest
payments to your respective lenders, but you would exchange with each other the net cash
difference between payments at specified intervals. In this case, if market rates (and thus
floating payments) increase, you would pay your neighbor; if rates fall, she pays you. The
net effect is to exchange the consequences of rate changes: you have effectively converted
your fixed rate debt to floating rate debt, and your neighbor has done the opposite.
Of course, this technique is not dependent on happening into such a fortuitous pairing of
two borrowers with opposite philosophies on interest rate risk. Instead, banks or other inter-
mediaries (such as hedge funds) offer, for a fee, one-sided swap agreements to companies
desiring to be either fixed-rate payers or variable-rate payers. Intermediaries usually strive
to maintain a balanced portfolio of matched, offsetting swap agreements.
Theoretically, the two parties in a swap transaction exchange principal amounts, like the
$100,000 amount above, in addition to the interest on those amounts. However, it makes no
practical sense for the companies to send each other $100,000. Instead, the principal amount
is not actually exchanged but serves merely as the computational base for interest calcula-
tions and is called the notional amount. Similarly, the two parties typically do not send each
other the full interest payments being swapped. Rather, only the net amount is exchanged.
For example, Illustration A–1 provides a visualization of an interest rate swap. In this exam-
ple, Company A pays its lender a fixed rate of 10%, and Company B pays its lender a float-
ing rate that is currently 9%. The two companies enter into an interest rate swap. Company
A will receive a fixed rate payment from Company B and will pay Company B the floating
rate (and Company B will receive and pay the opposite). However, Company A and Com-
pany B don’t actually send each other the notional amounts, nor will they exchange full
interest payments. Instead, on the payment date, only the net amount (in this case, a $1,000
net payment from Company B to Company A) is exchanged.
 APPENDIX A Derivatives A-7

Illustration A–1 Interest Rate Swap

Swap of annual payments on $100,000 notional amount. Fixed interest rate: 10% ($10,000)

Swap Floating
10% Floating % %
Lender A Company A Company B Lender B
Fixed 10%

At the time of the settlement date, assume the floating rate is 9% ($9,000). Company B pays Company A $1,000.
The result of the swap:
Company A: Pays $10,000 to lender − $1,000 net cash settlement on swap = $9,000 floating amount
Company B: Pays $9,000 to lender + $1,000 net cash settlement on swap = $10,000 fixed amount

From an accounting standpoint, however, the central issue is not the operational differ-
ences among various hedge instruments. Instead, the accounting focuses on their similarities
in functioning as hedges against risk.

Accounting for Derivatives

A key to accounting for derivatives is knowing the purpose for which a company holds them
and whether the company is effective in serving that purpose. When derivatives are held
for risk management (hedging activities), the intended effect is a reduction in risk. On the
other hand, derivatives sometimes are held for speculative position taking, hoping for large
profits. The effect of speculative activity often increases risk.
It’s important to understand that, serving as investments rather than as hedges, deriva- Derivatives not serving
tives are extremely speculative. This is due to the high leverage inherent in derivatives. as hedges are extremely
While the investment outlay usually is negligible, the potential gain or loss on the invest- speculative due to the high
leverage inherent in such
ment can be quite high. A small change in interest rates or another underlying event can investments.
trigger a large change in the fair value of the derivative. Because the initial investment was
minimal, the change in value relative to the investment itself represents a huge percentage
gain or loss. The extraordinarily risky nature of derivative investments prompted Warren
Buffett, one of the country’s most celebrated financiers, to refer to derivatives as “financial
weapons of mass destruction.” To better reflect differences in underlying economics and
risks, accounting for derivatives is designed to treat differently (a) derivatives designated
as hedges and those not designated as hedges, as well as (b) intended hedges that are highly
effective and those that are not.8
The basic approach to accounting for derivatives is fairly straightforward, although Each derivative contract
implementation can be quite cumbersome. All derivatives, no exceptions, are carried on the has a “fair value,” which
balance sheet as either assets or liabilities at fair (or market) value.9 The reasoning is that is an amount that one
side owes the other at a
(a) derivatives create either rights or obligations that meet the definition of assets or liabili- particular moment.
ties, and (b) fair value is the most meaningful measurement.
Accounting for the gain or loss on a derivative depends on how it is used. Specifically, if
the derivative is not designated as a hedging instrument or doesn’t qualify as one, any gain
or loss from fair value changes is recognized immediately in earnings. On the other hand,
if a derivative is used to hedge against exposure to risk, any gain or loss from fair value
changes is either (a) recognized immediately in earnings along with an offsetting loss or
gain on the item being hedged or (b) deferred in comprehensive income until it can be rec-
ognized in earnings at the same time as earnings are affected by a hedged transaction. Which
way depends on whether the derivative is designated as a (a) fair value hedge, (b) cash flow
hedge, or (c) foreign currency hedge. Let’s look now at each of the three hedge designations.

8
Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging
Activities (Norwalk, CT: FASB, January 2017).
9
FASB ASC 815–10: Derivatives and Hedging—Overall.
A-8 APPENDIX A Derivatives

● LOA–2 FAIR VALUE HEDGES A company can be adversely affected when a change in either
prices or interest rates causes a change in the fair value of one of its assets, its liabilities,
A gain or loss from a fair or a commitment to buy or sell assets or liabilities. If a derivative is used to hedge against
value hedge is recognized the exposure to changes in the fair value of an asset, liability, or a firm commitment, it can
immediately in earnings, be designated as a fair value hedge. In that case, when the derivative is adjusted to reflect
along with the loss or
gain from the item being
changes in fair value, the other side of the entry recognizes a gain or loss to be included cur-
hedged. rently in earnings. At the same time, though, the loss or gain from changes in the fair value
of the hedged item due to the specific risk being hedged10 also is included currently in earnings.
This means that to the extent the hedge is effective in serving its purpose, the gain or loss
on the derivative will be offset by the loss or gain on the item being hedged. In fact, this is
precisely the concept behind the procedure, and offsetting effects of the derivative and the
hedged item are reported in the same line item in the income statement.
The income effects of Hedge accounting rules require that changes in the fair value of the hedged item be rec-
the hedge instrument ognized in income, even if that item (say, notes payable) is typically measured at amortized
and the income effects cost. This offsetting allows for a better reflection of the intent and effect of having the hedging
of the item being hedged
should affect earnings at
instrument. Without these special hedge accounting rules, measuring the derivative at fair
the same time and in the value with changes going into earnings would result in a mismatch between the gains and
same income statement losses on the hedging instrument and the timing of gains and losses on the hedged item.
line item. Some of the more common uses of fair value hedges are:
∙ An interest rate swap to synthetically convert fixed-rate debt (for which interest rate
changes could change the fair value of the debt) into floating-rate debt.
∙ A futures contract to hedge changes in the fair value (due to price changes) of alumi-
num, sugar, or some other type of inventory.
∙ A futures contract to hedge the fair value (due to price changes) of a firm commitment
to sell natural gas or some other asset.

ILLUSTRATION OF FAIR VALUE HEDGE Because interest rate swaps comprise the
majority of derivatives in use, we will use swaps to illustrate accounting for derivatives.
Let’s look at the example in Illustration A–2, which illustrates the shortcut method. The
shortcut method can be used only for an interest-bearing asset or liability that meets certain
criteria. Under the shortcut method, the hedge is assumed to be perfectly effective and,
therefore, the change in the fair value of the hedged item due to interest rate risk is assumed
to be the same as the change in the fair value of the interest rate swap.

Illustration A–2 Summer Semiconductors issued $1 million of 18-month, 10% notes payable to Third Bank
Interest Rate Swap— on January 1, 2024. Summer is exposed to the risk that general interest rates will decline,
Shortcut Method
causing the fair value of its debt to rise. (If the fair value of Summer’s debt increases, its
effective borrowing cost is higher relative to the market.)
• To hedge against this fair value risk, the firm also enters into an 18-month interest rate
swap agreement and designated the swap as a hedge against changes in the fair value of
the note. The fair value of the swap at inception is zero.
• Summer will pay the 10% fixed rate to the bank on its notes payable obligation. The swap
calls for the company to receive payment from the intermediary based on a 10% fixed
interest rate on a notional (principal) amount of $1 million and to make payment based on
a floating interest rate tied to changes in general rates.* The actual cash settlement on the
swap will be a net payment to the appropriate party.
As the Illustration shows, this effectively converts Summer’s fixed-rate debt to floating-rate
debt. Cash settlement of the net interest amount is made semiannually at June 30 and
December 31 of each year, with the net interest being the difference between the $50,000
(continued)

10
The fair value of a hedged item might also change for reasons other than from effects of the risk being hedged. For instance, the hedged
risk may be that a change in interest rates will cause the fair value of a bond to change. The bond price might also change, though, if the
market perceives that the bond’s default risk has changed.
 APPENDIX A Derivatives A-9

fixed interest [$1 million × (10% × ½)] and the floating interest rate at the beginning of the Illustration A–2
period. (concluded)
Floating (market) settlement rates were 9% at June 30, 2024, 8% at December 31, 2024,
and 9% at June 30, 2025. Net interest receipts can be calculated as shown below. Fair values
of the derivative resulting from those market rate changes are assumed to be quotes obtained
from securities dealers. For simplicity, this example also assumes a flat yield curve and that the
change in the benchmark rate and the change in the benchmark swap rate are the same.

1/1/24 6/30/24 12/31/24 6/30/25

Fixed rate – notes payable 10% 10% 10% 10%
Receive fixed rate – swap 10% 10% 10% 10%
Pay floating rate – swap 10% 9% 8% 9%
Fixed-rate receipts $ 50,000 $ 50,000 $ 50,000
[$1 million × (10% × ½)]
Floating-rate payments 50,000 45,000 40,000
[$1 million × ½ floating rate at
beginning of period]
Net interest receipts on swap $ 0 $ 5,000 $ 10,000
Fair value of interest rate swap $0 $ 9,363 $ 9,615 $ 0
*A common measure for benchmarking variable interest rates is SOFR, the Secured Overnight Financing Rate, a base rate
at which large financial institutions lend funds to each other. Prior to 2021, LIBOR (the London Interbank Offered Rate) was
a commonly used benchmark in contracts. However, it was recently phased out due to concerns about its reliability.

When the floating rate declined from 10% to 9%, the fair values of both the derivative (swap)
and the note increased. The shortcut method allows the company to assume that the carrying
amount of its debt increased by the same amount as the fair value of the swap. This created an
offsetting holding gain on the derivative and a holding loss on the note. Both are recognized in
earnings at the same time (at June 30, 2024). The changes in fair value are presented in the same
line item as the earnings effect of the underlying hedged item. In this example, then, we record
these holding gains and losses as decreases or increases in interest expense.

January 1, 2024 The interest rate swap is

Cash............................................................................................................................ 1,000,000 designated as a fair value
Notes payable.................................................................................................... 1,000,000 hedge on this note at
To record the issuance of the note. issuance.
June 30, 2024
Interest expense (10% × ½ × $1 million).......................................................... 50,000
Cash...................................................................................................................... 50,000
To record interest on the note.
The fair value of
Interest rate swap* ($9,363 − $0)...................................................................... 9,363 derivatives is recognized
interest expense.................................................................................................. 9,363 in the balance sheet.
To record change in fair value of the derivative.
Interest expense...................................................................................................... 9,363 The change in fair value
Notes payable (same as swap adjustment)................................................ 9,363 of the derivative and of
To record change in fair value of the note due to interest rate changes. the hedged liability are
reported in the same
*This would be a liability rather than an investment (asset) if the fair value had declined. income statement line
item as the earnings
effect of the hedged item.

In a typical swap agreement, the rates are determined or “reset” at the beginning of the
settlement period, but the net cash settlement occurs at the end of the period based on those
beginning-of-period rates. Therefore, at June 30, 2024, the net interest settlement is $0
because the fixed rate and the floating rate are both 5% (half of the 10% annual rate) at the
beginning of the period (at January 1, 2024).
A-10 APPENDIX A Derivatives

As with any debt, interest December 31, 2024

expense is the effective Interest expense...................................................................................................... 50,000
rate times the outstanding Cash (10% × ½ × $1,000,000)...................................................................... 50,000
balance. To record interest on the note.
The swap settlement is Cash [$50,000 − (9% × ½ × $1 million)].......................................................... 5,000
the difference between Interest expense................................................................................................ 5,000
the fixed interest (5%) and To record the net cash settlement on the swap.
variable interest (4.5%).
Interest rate swap ($9,615 − $9,363)............................................................... 252
The derivative is Interest expense................................................................................................ 252
increased by the change To record the change in fair value of the derivative.
in fair value. The note is
increased by the same
Interest expense...................................................................................................... 252
change in fair value. Notes payable (same as swap adjustment)................................................ 252
To record the change in fair value of the note due to interest rate changes.

On December 31, 2024, the net interest settlement (receipts) is $5,000 because the fixed rate
is 5% (half of the 10% annual rate) and the floating rate is 4.5% (half of the 9% annual rate) at the
beginning of the period. The fair value of the swap increased by $252 (from $9,363 to $9,615).
Similarly, we adjust the note’s carrying value by that same change under the shortcut method.
In other words, we assume there is a holding loss on the note that exactly offsets the gain
on the swap. This result is the hedging effect that motivated Summer to enter the fair value
hedging arrangement in the first place.
At June 30, 2025, Summer repeats the process of adjusting to fair value both the deriva-
tive investment and the note being hedged.

June 30, 2025

Interest expense...................................................................................................... 50,000
Cash (10% × ½ × $1,000,000)...................................................................... 50,000
To record interest on the note.
The net interest received Cash [$50,000 – (8% × ½ × $1 million)].......................................................... 10,000
is the difference between Interest expense................................................................................................ 10,000
the fixed interest (5%) and To record the change in fair value of the derivative.
floating interest (4%).
Interest expense...................................................................................................... 9,615
Interest rate swap ($0 − $9,615).................................................................. 9,615
The swap’s fair value now To record the change in fair value of the derivative.
is zero. Notes payable (same as swap adjustment)...................................................... 9,615
Interest expense................................................................................................ 9,615
To record the change in fair value of the note due to interest rate changes.
Notes payable.......................................................................................................... 1,000,000
Cash...................................................................................................................... 1,000,000
To repay the loan.

The net interest received is the difference between the fixed rate (5%) and floating rate
(4%) times $1 million. The fair value of the swap decreased by $9,615 (from $9,615 to
zero).11 That decline represents a holding loss that we recognize in earnings. Again, under
the shortcut method, we record a perfectly offsetting holding gain on the note for the change
in fair value due to changes in interest rates.
Here is an illustration of how the carrying values changed for the swap account and the note:
Swap Note
Jan. 1, 2024 1,000,000
June 30, 2024 9,363 9,363
Dec. 31, 2024 252 252
June 30, 2025 9,615 9,615
1,000,000
0 0

11
Because there are no future cash receipts from the swap arrangement at this point, the fair value of the swap is zero.
 APPENDIX A Derivatives A-11

The income statement is affected as follows:

Income Statement + (−)
June 30, 2024 $(50,000) Interest expense—fixed payment to lender
9,363 Interest expense—gain on interest rate swap
(9,363) Interest expense—loss on hedged note
$(50,000) Net effect—same as floating interest payment
Dec. 31, 2024 $(50,000) Interest expense—fixed payment to lender
5,000 Interest expense—net cash settlement on swap
252 Interest expense—gain on interest rate swap
(252) Interest expense—loss on hedged note
$(45,000) Net effect—same as floating interest payment
June 30, 2025 $(50,000) Interest expense—fixed payment to lender
10,000 Interest expense—net cash settlement on swap
(9,615) Interest expense—loss on interest rate swap
9,615 Interest expense—gain on hedged note
$(40,000) Net effect—same as floating interest payment

As this demonstrates, the swap effectively converts fixed-interest debt to floating-interest

debt. More importantly, the swap allows the company to hedge against changes in the fair
value of its debt due to changing interest rates with offsetting changes in the fair value of the
interest rate swap.

Additional Consideration
Fair Value of the Swap
The fair value of a derivative typically is based on a quote obtained from a derivatives dealer.
That fair value will approximate the present value of the expected net interest settlement
receipts for the remaining term of the swap. In fact, we can actually calculate the fair value of
the swap that we accepted as given in our illustration.
Since the June 30, 2024, floating rate of 9% caused the cash settlement on that date
to be $5,000, it’s reasonable to look at 9% as the best estimate of future floating rates and
therefore assume the remaining two cash settlements also will be $5,000 each. We can
then calculate at June 30, 2024, the present value of those expected net interest settlement
receipts for the remaining term of the swap.
Fixed interest 10% × ½ × $1 million $ 50,000
Expected floating interest 9% × ½ × $1 million 45,000
Expected cash receipts for both Dec. 31, 2024 and June 30, 2025 $ 5,000
× 1.87267*
 resent value of expected net interest settlement receipts for the
P $ 9,363
­remaining term
*Present value of an ordinary annuity of $1: n = 2, i = 4.5% (½ of 9%) (from Table 4)

Fair Value of the Notes

The fair value of the note payable will be the present value of principal and remaining
interest payments discounted at the market rate. The market rate will vary with the
designated floating rate. Under the shortcut method, we assume a perfect hedge and that
the market rate only varies with the floating rate. (We ignore variations due to changes in
default risk and/or interest rate term structure.) Assuming it’s 9% at June 30, 2024, we can
calculate the fair value (present value) of the notes.
Interest $50,000* × 1.87267† = $ 93,633
Principal $1,000,000 × 0.91573‡ = 915,730
Present value of remaining principal and interest payments $1,009,363
*½ of 10% × $1,000,000
†Present value of an ordinary annuity of $1: n = 2, i = 4.5% (from Table 4)
‡Present value of $1: n = 2, i = 4.5% (from Table 2) (continued)
A-12 APPENDIX A Derivatives

(concluded)
Note: This illustration featured a “plain-vanilla” interest rate swap, where the swap’s variable
interest rate is determined (reset) at the beginning of the period, and payment occurs at the
end of the period. However, there also can be interest rate swap-in-arrears, where the swap’s
variable interest rate is determined at the end of the period and is applied retroactively to
calculate the swap settlement. Had this arrangement been in effect in the current illustration,
the first cash settlement would have been received on June 30, 2024, and there would have
been a total of three cash settlements. It would not have affected the changes in the fair
value of the hedge or the assumptions of the shortcut method. Also, in this example, all terms
of the swap exactly match the terms of the underlying hedged item, including the interest
rate. Thus, the calculated change in the fair value of the debt exactly matches the change in
the fair value of the hedging instrument. However, this does not have to be true to qualify for
the shortcut method. For instance, the interest rate on the hedged item and the interest rate
on the swap can differ, as long as it’s by a constant amount throughout the contract.

● LOA–3 CASH FLOW HEDGES The risk in some transactions or events is the risk of a change in
cash flows, rather than a change in fair values. We noted earlier that fixed-rate debt subjects
A gain or loss from a cash a company to the risk that interest rate changes could change the fair value of the debt. If
flow hedge is deferred the obligation is floating-rate debt, the fair value of the debt will not change when interest
as other comprehensive rates do, but cash flows will change. If a derivative is used to hedge against the exposure to
income until it can be
recognized in earnings
changes in cash inflows or cash outflows of an asset or liability or a forecasted transaction
along with the earnings (like a future purchase or sale), it can be designated as a cash flow hedge. In a cash flow
effect of the item being hedge, when the derivative is adjusted to reflect changes in fair value, the gain or loss on
hedged. the derivative instrument is deferred as a component of other comprehensive income. It’s
included in earnings later, at the same time as earnings are affected by the hedged transac-
tion. At that date, it’s reported in the same income statement line item as the effects of the
hedged item.
Let’s consider a cash flow hedge of a commodity purchase. Assume we purchase and
hold an inventory of oats for use in our manufacturing process. Any changes in the price of
oats will affect cost of goods sold when we sell our food items produced with oats. Thus,
we would enter into a derivative contract to hedge against the risk of rising oats prices. As
prices increase between the inception of the contract and the sale of inventory, we will defer
(with a credit to Other comprehensive income) any increase in the value of the hedging
contract. Then, when the product is sold, we debit Other comprehensive income and reduce
(credit) cost of goods sold. Once again, the effect of hedging to match the earnings effect
of the derivative (reduce cost of goods sold, increasing earnings) with the earnings effect of
the item being hedged (increase cost of goods sold, decreasing earnings). Stated differently,
when it’s time for income statement recognition of the item being hedged, the accumulated
change in the hedging contract that’s been reflected in accumulated other comprehensive
income will be reclassified out of that account and into the income statement along with
effect of the item being hedged.
To understand the deferral of the gain or loss, we need to revisit the concept of compre-
hensive income. Comprehensive income, as you may recall from Chapters 4, 12, 17, and 18,
is a more expansive view of the change in shareholders’ equity than traditional net income.
It encompasses all changes in equity other than from transactions with owners.12 In addi-
tion to net income itself, comprehensive income includes up to four other changes in equity
that don’t (yet) belong in net income, namely, net holding gains (losses) on investments in
debt securities (Chapter 12), gains (losses) from, and amendments to, postretirement ben-
efit plans (Chapter 17), gains (losses) from foreign currency translation, and deferred gains
(losses) from derivatives designated as cash flow hedges and those designated as qualifying
hedging relationships.13

12
Transactions with owners primarily include dividends and the sale or purchase of shares of the company’s stock.
13
FASB ASC 220–10–55: Comprehensive Income—Overall—Implementation Guidance and Illustrations and Accounting Standards
Update No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, (Norwalk,
CT: FASB, January 2017).
 APPENDIX A Derivatives A-13

Some of the more commonly used cash flow hedges are

∙ An interest rate swap to synthetically convert floating-rate debt (for which interest rate
changes could change the cash interest payments) into fixed-rate debt.
∙ A futures contract to hedge a forecasted sale (for which price changes could change the
cash receipts) of natural gas, crude oil, or some other asset.
∙ A forward contract to hedge a forecasted purchase (for which price changes could
change the cash payments) of a commodity.
A company can designate the hedged risk as the overall change in cash flows of a hedged
item or the change in cash flows attributable to a contractually specified component of a
forecasted purchase or sale or a contractually specified interest rate in floating-rate debt.
ILLUSTRATION OF CASH FLOW HEDGE—INTEREST RATE SWAP Let’s assume once
again that we have a company that enters into an interest rate swap. However, in Illustration A–3,
the company seeks to hedge exposure to cash flow risk from interest rate volatility.

On January 1, 2024, Desai Company issues $2 million of floating-rate debt based on SOFR, Illustration A–3
with interest paid annually. Cash Flow Hedge; Interest
Rate Swap (Floating Rate
• The debt has 3 years to maturity, and the SOFR rate is 5% at issuance. to Fixed Rate)—Shortcut
• Interest payments on the debt, based on beginning-of-year rates, are due on December 31 Method
of each year, and the variable rate is reset after the payment is made.
• Desai is exposed to the risk that interest rates will rise, which will increase its periodic
interest payments.
• To hedge against this cash flow risk, the firm entered into a 3-year interest rate swap
agreement on January 1 and designated the swap as a cash flow hedge because it
protects Desai from having to make higher cash outflows for interest if interest rates do
rise. At inception, the fair value of the hedge is zero.
• The swap calls for the company to pay a fixed interest rate of 5% and receive SOFR based
on a notional amount of $2 million.
• Settlements on the interest rate swap will be made annually on December 31, with
interest rate resets after settlement at beginning-of-year rates.
• Assume that SOFR rates are reset to 5.5% at December 31, 2024, 4.75% at December
31, 2025, and 6.5% at December 31, 2026.
• The market value of the note in this case does not change as interest rate fluctuates,
because the note carries a variable interest rate.
• Fair values of the interest rate swap at the end of each accounting period are assumed to
be quotes by securities dealers.
• Net cash settlements for the swap are calculated as shown below:

1/1/24 12/31/24 12/31/25 12/31/26

Floating rate – $2 million debt to lender 5% 5.5% 4.75% 6.5%
Pay fixed rate – swap 5% 5% 5% 5%
Receive floating rate – swap 5% 5.5% 4.75% 6.5%
Fixed-rate payments
Fixed-rate payments ($2 million × 5%) $ 100,000 $ 100,000 $ 100,000
Floating-rate receipts ($2 million × 100,000 110,000 95,000
floating rate at beginning of period)
Net interest receipts (payments) on swap $ 0 $ 10,000 $ (5,000)
Fair value of interest rate swap $0 $ 18,463 $ (4,773) $ 0

As the illustration shows, this swap effectively converts Desai’s variable-rate debt to fixed-rate
debt. Assume that Desai qualifies to apply the shortcut method to assess hedge effectiveness.

January 1, 2024
Cash............................................................................................................................ 2,000,000
Notes payable.................................................................................................... 2,000,000
To record the issuance of the floating-rate debt.
A-14 APPENDIX A Derivatives

December 31, 2024

Interest expense (5% × $2 million)..................................................................... 100,000
Cash...................................................................................................................... 100,000
To record interest on the note.
Interest rate swap................................................................................................... 18,463
Other comprehensive income (OCI)—gain................................................. 18,463
To record the change in the fair value of the derivative.

At December 31, 2024, there is no cash exchanged for settlement of the interest rate
swap, because the cash settlement is based on beginning-of-year rates (when both the fixed
and floating rates were 5%). Desai does recognize an increase in the fair value of the interest
rate swap, related to the rising interest rates in the upcoming year. This increase in fair value
is recognized in other comprehensive income.

December 31, 2025

Interest expense (5.5% × $2 million).................................................................. 110,000
Cash...................................................................................................................... 110,000
To record interest on the note.
Cash [(5.5% × $2 million) – $100,000].............................................................. 10,000
Interest expense................................................................................................ 10,000
To record the net cash settlement on the swap.
Other comprehensive income (OCI)—loss....................................................... 23,236
Interest rate swap.............................................................................................. 23,236
To record the change in the fair value of the derivative
from an asset of $18,463 to a liability of $4,773.

The net cash settlement received on the swap is the difference between the floating rate at
the beginning of (5.5%) and the fixed rate (5%) times $2 million notional amount. The effect
of the net cash settlement is to set total cash outflows related to interest at $100,000, which
is equivalent to paying the fixed rate of 5%. This result is the cash flow hedging effect that
motivated Desai to enter the derivative arrangement.
At December 31, 2025, Desai repeats the process of adjusting the derivative to fair value.
Because interest rates have decreased and Desai anticipates a future net cash payment, the
swap represents a liability to the company. Once again, the change in the fair value of the
derivative (from an asset to a liability) is recognized into other comprehensive income.

December 31, 2026

Interest expense (4.75% × $2 million)............................................................... 95,000
Cash...................................................................................................................... 95,000
To record interest on the note.
Interest expense...................................................................................................... 5,000
Cash [(4.75% × $2 million) – $100,000]..................................................... 5,000
To record the net cash settlement on the swap.
Notes payable.......................................................................................................... 2,000,000
Cash...................................................................................................................... 2,000,000
To repay the debt.
Interest rate swap................................................................................................... 4,773
Other comprehensive income....................................................................... 4,773
To close out the swap contract account; the swap contract
was a liability of $4,773 and now has a fair value of zero.

At December 31, 2026, the fair value of the interest rate swap has decreased to zero
because there are no additional cash settlements expected, and the debt and the swap have
now matured. All earnings effects of the hedged item and derivative instrument have been
recorded in the income statement as interest expense.
 APPENDIX A Derivatives A-15

Total cash flows are affected as follows:

December 31, 2024 Payment on floating rate debt (5%) ($100,000)

Net settlement on interest rate swap 0
Total cash outflow ($100,000)
December 31, 2025 Payment on floating rate debt (5.5%) ($110,000)
Net settlement on interest rate swap 10,000
Total cash outflow ($100,000)
December 31, 2026 Payment on floating rate debt (4.75%) ($ 95,000)
Net settlement on interest rate swap (5,000)
Total cash outflow ($100,000)

This demonstrates that the interest rate swap designated as a cash flow hedge effectively
converts the floating-rate debt to fixed-rate debt.
A company also can use a forward contract to hedge the risk of change in cash flows
attributable to a component of a forecasted purchase of a commodity.

ILLUSTRATION OF CASH FLOW HEDGE—FORWARD CONTRACT Let’s assume that

we have a company that seeks to hedge exposure to cash flow risk, this time from a forecasted
purchase of a commodity. We see this scenario in Illustration A–4. The shortcut method is not
available because that can only be used for hedging relationships involving an interest-bearing
asset or liability. A forecasted transaction of a nonfinancial commodity does not fit that category.
However, the company can assume the hedge is perfectly effective using the critical-terms match.

Cavalier Bicycles uses carbon fiber to produce its high-performance road and mountain Illustration A–4
bikes. Cavalier anticipates it will need to purchase 45,000 pounds of carbon fiber in July Cash Flow Hedge; Forward
Contract
2025 to make enough bikes to meet its fourth quarter sales demand. However, if the price
of carbon fiber increases, the cost to produce the bikes will increase and, in turn, lower
Cavalier’s profit margins.
To hedge against the risk of rising carbon fiber prices, on June 1, 2025, Cavalier enters into
a forward contract with a third-party intermediary to buy 45,000 pounds of carbon fiber at
the current spot price of $10 per pound. It designates the contract as a cash flow hedge of
the anticipated carbon fiber purchase because the hedged risk is attributable to the volatility
in carbon fiber prices.
The price in the contract expires on July 31, 2025, and the contract will settle by an
exchange of cash with the intermediary based on the spot price on the settlement date. As
the illustration will show, Cavalier uses this forward contract to lock in the cost of its inventory
at the prevailing market price of $450,000 (45,000 pounds × $10 per pound).

June 1, 2025 No entry is required, because the current spot price equals the contract
price. Thus, the forward contract has no value.

June 30, 2025

Forward contract [($10.50 – $10.00) × 45,000]............................................ 22,500
Other comprehensive income (OCI)—gain................................................. 22,500
To record the change in the fair value of the derivative.

At June 30, 2025, the spot price of carbon fiber has increased. Therefore, the value of
the forward contract to Cavalier Bicycles has increased, as Cavalier is able to buy carbon
fiber at a lower price than current market prices. Thus, Cavalier reports the forward contract
in the balance sheet as an asset, with the gain on the derivative deferred as a component of
other comprehensive income. Cavalier will recognize this gain in current earnings when
the hedged item—in this case the cost of carbon fiber—is recognized in earnings (when the
produced inventory is sold).
A-16 APPENDIX A Derivatives

If Cavalier purchases 45,000 pounds of carbon fiber on July 2, 2025, for $10.50, it would
make the following entries to record the purchase of inventory and the settlement of the
forward contract:

July 2, 2025
Inventory—Carbon Fiber....................................................................................... 472,500
Cash ($10.50 × 45,000 pounds).................................................................. 472,500
To record purchase of inventory.
Cash [($10.50 – $10.00) × 45,000]................................................................... 22,500
Forward contract............................................................................................... 22,500
To record settlement of the forward contract.

The $22,500 forward contract settlement offsets the amount paid to purchase the inven-
tory at the prevailing market price of $472,500. The result is a net cash outflow of $10 per
pound, and an effective hedge of the cash flow for the purchase of inventory.
Cavalier defers the income effects of the forward contract in other comprehensive income
until the period in which it sells the inventory, affecting earnings through the same line item
as the hedged item—cost of goods sold. That is, the higher purchase price ($472,500) is
reflected in cost of goods sold as the inventory is sold, but that higher price is offset by the
previously deferred gain on the forward contract ($22,500) as Cavalier debits other compre-
hensive income and credits (decreases) cost of goods sold to recognize the gain into income.
For example, let’s say that Cavalier manufactures the carbon fiber into bicycles and sells
those bikes during the fourth quarter of 2025 for $1,200,000. The total value of the inven-
tory, which includes the cost of the carbon fiber purchase made on July 2, 2025, is $650,000.
The sale is recorded as follows:

Fourth Quarter 2022

Cash............................................................................................................................ 1,200,000
Sales revenue..................................................................................................... 1,200,000
To record sales.
Cost of goods sold.................................................................................................. 650,000
Inventory—Bikes................................................................................................ 650,000
To record cost of goods sold.
Accumulated other comprehensive
income (AOCI)—gain on forward contract.................................................... 22,500
Cost of goods sold............................................................................................ 22,500
To match the earnings effect of the hedged item (cost of carbon fiber)
and the forward contract.

Because the hedged purchase of carbon fiber has now affected earnings, Cavalier also
recognizes the previously deferred gain on the value of the forward contract into earnings.

● LOA–4 FOREIGN CURRENCY HEDGES Today’s economy is increasingly a global one. The
majority of large “U.S.” companies are, in truth, multinational companies that receive a
The possibility that foreign significant portion of their revenues from non-U.S. operations. Foreign operations often are
currency exchange rates denominated in the currency of the foreign country (the Euro, Japanese yen, Emirati dirham,
might change exposes
and so on). Even companies without foreign operations sometimes hold investments, issue
many companies to
foreign currency risk. debt, or conduct other transactions denominated in foreign currencies. As exchange rates
change, the dollar equivalent of the foreign currency changes. The possibility of currency
rate changes exposes these companies to the risk that some transactions require settlement
in a currency other than the entities’ functional currency or that foreign operations will
require translation adjustments to reported amounts.
 APPENDIX A Derivatives A-17

A foreign currency hedge is a hedge of foreign currency exposure of the following:

∙ A fair value hedge of a firm commitment or a recognized asset or liability (including an
available-for-sale debt security).
∙ A cash flow hedge of a forecasted transaction or a firm commitment.
∙ A hedge of a net investment in a foreign operation—the gain or loss is reported in other com-
prehensive income as part of unrealized gains and losses from foreign currency translation.14

HEDGE EFFECTIVENESS When a company elects to apply hedge accounting, it must To qualify as a hedge,
establish at the inception of the hedge the method it will use to assess the effectiveness of the hedging relationship
the hedging derivative.15 Hedge accounting is only permitted if the hedging relationship is must be highly effective
in achieving offsetting
“highly effective” in achieving offsetting changes in fair values or cash flows based on the
changes in fair values or
hedging company’s specified risk management objective and strategy. cash flows.
An assessment of this effectiveness must be made prospectively and retrospectively at least
every three months and whenever financial statements are issued or earnings are reported. There
are no precise guidelines for assessing effectiveness, but it generally means a high correlation
between changes in the fair value or cash flows of the derivative and of the item being hedged.
Initial hedge effectiveness assessments are performed quantitatively unless certain conditions
apply. The conditions include whether the company applies the shortcut method or determines
that the critical terms of the hedged item and the hedging instrument match (and can assume a
perfect hedge). At hedge inception, the company must also document the qualitative or quanti-
tative methods that will be used to assess effectiveness in the future. Hedge accounting must be
terminated for hedging relationships that no longer are highly effective.
In Illustration A–2 (and Illustration A–3), the loss on the hedged note exactly offset the gain Imperfect hedges result in
on the swap. This is because the swap in this instance was perfectly effective in hedging the part of the derivative gain
risk due to interest rate changes. However, the loss and gain would not have exactly offset each or loss being included in
other if there were differences in critical terms of the swap and the hedged note. For instance, current earnings.
suppose the swap’s term had been different from that of the note (say, a three-year swap term
compared with the 18-month term of the note) or if the notional amount of the swap differed
from that of the note (say, $500,000 rather than $1 million). In that case, changes in the fair
value of the swap and changes in the fair value of the note would not be the same. The result
would be a greater (or lesser) amount recognized in earnings for the swap than for the note.
Because there would not be an exact offset, earnings would be affected. As long as the hedge is
still considered “highly effective,” the company may still use hedge accounting.
Hedge accounting also allows a company to exclude certain components of the change in the
value of the derivative from the calculation of hedge effectiveness, including components of the
change in time value, as well as differences in spot and forward or futures prices. If a company
has excluded components, it recognizes the initial value in earnings over the life of the hedg-
ing instrument with subsequent changes in fair value included in other comprehensive income.
Alternatively, it might elect to recognize all fair value changes in the excluded component in
earnings immediately. Regardless of the option chosen, amounts related to the excluded compo-
nents that are recognized in income are included in the same line item on the income statement
as the earnings effect of the hedged item (for example, interest expense or cost of goods sold).

FAIR VALUE CHANGES UNRELATED TO THE RISK BEING HEDGED In ­Illustration A–2, Fair value changes
the fair value of the hedged note and the fair value of the swap changed by the same amounts unrelated to the risk being
each year because we assumed the fair values changed only due to interest rate changes. It’s hedged are ignored.
also possible, though, that the note’s fair value would change by an amount different from
that of the swap for reasons unrelated to interest rates. For instance, the market’s perception
of a company’s creditworthiness, and thus its ability to pay interest and principal when due,
also can affect the value of debt whether interest rates change or not. In hedge accounting, we
ignore those changes. We recognize only the fair value changes in the hedged item that we can
attribute to the risk being hedged (interest rate risk in this case). For example, if a changing

14
This is the same treatment previously prescribed for these translation adjustments by FASB ASC 830: Foreign Currency Matters.
15
Remember, if a derivative is not designated as a hedge, any gains or losses from changes in its fair value are recognized immediately in
earnings.
A-18 APPENDIX A Derivatives

perception of default risk had caused the note’s fair value to increase by an additional, say
$5,000, our journal entries in Illustration A–2 would have been unaffected. Notice, then, that
although we always mark a derivative to fair value, the reported amount of the item being
hedged (e.g., the notes payable in Illustration A-2) may not be its fair value. We mark a hedged
item to fair value only to the extent that its fair value changed due to the risk being hedged.

COVID-19: Accounting and Reporting Implications

The COVID-19 pandemic disrupted the normal operations of a variety of businesses through
its dramatic impact on consumer behavior and supply chains. As a result, many businesses
had to cancel or delay expected purchases and sales that were part of designated cash flow
hedge transactions. Topic 815, Derivatives and Hedging, requires that hedge accounting
be discontinued prospectively if forecasted transactions, such as commodity purchases and
sales, are no longer probable to occur within the time frame specified at hedge inception.
Moreover, if it is probable that the transactions will not occur within the specified time frame
or an additional period thereafter, then the company must reclassify deferred gains and
losses on the related hedging derivatives from AOCI to earnings immediately.
Typically, the “additional period” is two months. However, in April 2020, the FASB
deemed the COVID-19 pandemic to be a rare and extenuating circumstance. This
determination allows companies to extend the two-month window when evaluating the
deferred amounts in AOCI (ASC 815-30). In other words, for a discontinued cash flow
hedge, where the forecasted transaction is delayed due to COVID-19 but is still probable of
occurring, the net derivative gain or loss may remain in AOCI until the transaction actually
occurs (e.g., the commodity purchase is made).

● LOA–5 Disclosure of Derivatives and Risk

To be adequately informed about the effectiveness of a company’s risk management, inves-
tors and creditors need information about (a) how and why the company uses derivatives,
(b) how derivatives and related hedging items are accounted for, and (c) how derivatives and
related hedging activities affect the company’s financial position, financial performance,
and cash flows. Toward that end, extensive disclosure requirements provide information
that includes the following:
∙ Objectives and strategies for holding and issuing derivatives by risk exposure (interest
rate, price change, etc.).
∙ The accounting designations of derivative instruments (cash flow hedge, fair value
hedge, net investment hedge, or non-hedge).
∙ The volume of derivative activity.
∙ The location and fair values of derivative instruments in the balance sheet, the location
and amount of gains and losses on derivative instruments and related hedged items
reported in the income statement and in other comprehensive income, and the total
amount of each income and expense line item presented in the income statement that
includes gains or losses on fair value or cash flow hedges by type of contract—interest
rate contracts, foreign exchange contract, commodity contract, etc. This information
must be presented in a quantitative tabular format.
∙ The recognition policy for excluded components and changes in the fair value of
excluded components.

● LOA–6 Extended Method for Interest Rate Swap Accounting

A shortcut method for assessing the effectiveness of and accounting for an interest rate
swap is permitted when a hedge meets certain criteria. In general, the criteria are designed
to see if the hedge supports the assumption of “perfect effectiveness.” Illustration A–2 of
 APPENDIX A Derivatives A-19

a fair value hedge met those criteria, in particular, (a) the swap’s notional amount matches
the note’s principal amount, (b) the swap’s expiration date matches the note’s maturity
date, (c) the fair value of the swap is zero at inception, and (d) the floating payment is at
the market rate.16 Because Summer qualifies for the shortcut method, it can assume that
the swap will be perfectly effective in offsetting changes in the fair value of the debt, it
can use the changes in the fair value of the swap to measure the offsetting changes in the
fair value of the debt. That’s the essence of the shortcut method used in Illustration A–2.
The extended or “long-haul” method of assessing hedge effectiveness required when the
criteria are not met for the shortcut method (or critical-terms match) is described in this
section (Illustration A–5 begins by describing the same scenario as in ­Illustration A–2). It
produces the same effect on earnings and in the balance sheet as does the procedure shown
in Illustration A–2.

Summer Semiconductors issued $1 million of 18-month, 10% notes payable to Third Bank Illustration A–5
on January 1, 2024. Summer is exposed to the risk that general interest rates will decline, Interest Rate Swap
(Fixed Rate to Variable
­causing the fair value of its debt to rise. (If the fair value of Summer’s debt increases, its effec-
Rate)—Extended Method
tive ­borrowing cost is higher relative to the market.)
• To hedge against this fair value risk, the firm also enters into into an 18-month interest rate
swap agreement through an intermediary and designated the swap as a hedge against
changes in the fair value of the note. The fair value of the swap at inception is zero.
• Summer will pay the 10% fixed rate to the bank on its notes payable obligation. The swap
calls for the company to receive payment from the intermediary based on a 10% fixed
interest rate on a notional (principal) amount of $1 million and to make payment based on
a floating interest rate tied to changes in general rates.
• Cash settlement of the net interest amount is made semiannually at June 30 and
December 31 of each year, with the net interest being the difference between the
$50,000 fixed interest [$1 million × (10% × ½)] and the floating interest rate the beginning
of the period. That is, if the floating rate is less than the fixed rate, Summer will collect
cash. If the floating rate is more than the fixed rate, Summer will pay cash.
• Floating (market) settlement rates were 9% at June 30, 2024, 8% at December 31, 2024,
and 9% at June 30, 2025.
Net interest receipts can be calculated as shown below. Fair values of both the derivative
and the note resulting from those market rate changes are assumed to be quotes obtained
from securities dealers. The example assumes a flat yield curve and a parallel change in
interest rates between the market rate and the swap rate.

1/1/24 6/30/24 12/31/24 6/30/25

Fixed rate—notes payable 10% 10% 10% 10%
Fixed rate—swap 10% 10% 10% 10%
Floating rate—swap 10% 9% 8% 9%
Fixed-rate receipts [$1 million × $ 50,000 $ 50,000 $ 50,000
(10% × ½)]
Floating-rate payments [$1 million 50,000 45,000 40,000
× ½ floating rate at beginning of
period]
Net interest receipts on swap $ 0 $ 5,000 $ 10,000
Fair value of interest rate swap $ 0 $ 9,363 $ 9,615 $ 0
Fair value of notes payable $ 1,000,000 $1,009,363 $1,009,615 $ 0

When the floating rate declined in Illustration A–5 from 10% to 9% at the end of the
period, the fair values of both the derivative (swap) and the note increased.

16
There is no precise minimum interval, though it generally is three to six months or less. Other criteria are specified by FASB ASC
815–20–25–104: Derivatives and Hedging—Hedging—General—Recognition—Shortcut Method, SFAS No. 133 (para. 68), in addition
to the key conditions listed here.
A-20 APPENDIX A Derivatives

Because the shortcut method is not applied, Summer must determine the change in the
fair value of the notes payable resulting from the change in the benchmark (SOFR) swap
rate to assess the effectiveness of the hedge. Here, we assume Summer receives dealer
quotes for the fair value of the notes payable (in addition to the swap). The fair value of the
notes payable also can be calculated as the present value of the cash flows remaining at the
end of the period, discounted at the end of period rates. As long as the hedge is determined
to be highly effective, we record gains and losses in the fair value of the note as increases or
decreases to interest expense, and they will substantially offset the changes in the fair value
of the hedging instrument.

The interest rate swap is

designated as a fair value January 1, 2024
hedge on this note at Cash............................................................................................................................ 1,000,000
issuance. Notes payable.................................................................................................... 1,000,000
To record the issuance of the note.
The fair value of
derivatives is recognized June 30, 2024
in the balance sheet. All Interest expense (10% × ½ × $1 million).......................................................... 50,000
changes in fair value are
Cash...................................................................................................................... 50,000
presented in the same
To record interest to Third Bank.
line item as the earnings
effect of the hedged item. Interest rate swap ($9,363 – $0)......................................................................... 9,363
The hedged liability (or Interest expense change in fair value.......................................................... 9,363
asset) is adjusted to fair To record the change in the fair value of the derivative.
value for changes in the
Interest expense...................................................................................................... 9,363
benchmark interest rate.
Notes payable ($1,009,363 – $1,000,000)............................................... 9,363
To record change in fair value of the note due to interest rate changes.

No net interest settlement is received or paid on June 30, 2021 because the fixed and floating
rates at the beginning of the period were both 5% (half of the 10% annual rate). The decline in
rates at the end of the period, however, increase the value of the derivative security. We record
that holding gain, or increases in fair value, in earnings.
We also have a holding loss of the same amount. because the terms of the debt and the
swap match. In other words, our hedge is 100% effective. A holding loss occurs because
the interest rate change caused the debt’s fair value to increase as well. The changes in fair
value (holding gains and losses) are presented in the same line item as the earnings effect of
the underlying hedged item (interest expense).

Interest expense is the December 31, 2024

effective rate times the Interest expense (9% × ½ × $1,009,363)........................................................ 45,421
outstanding balance. Notes payable (difference)*.................................................................................. 4,579
Cash (10% × ½ × $1,000,000)...................................................................... 50,000
To record interest to Third Bank.

The cash settlement is Cash [$50,000 − (9% × ½ × $1 million)].......................................................... 5,000

the difference between Interest rate swap ($9,615 − $9,363)............................................................... 252
the fixed interest (5%) and Interest expense (interest on swap: 9% × ½ × $9,363).......................... 421
variable interest (4.5%). Interest expense (change in fair value)........................................................ 4,831
To record the net cash settlement, accrued interest on the swap,
Interest ($421) accrues on and change in the fair value of the derivative.
the derivative asset.
Interest expense...................................................................................................... 4,831
The note is increased by Notes payable [$1,009,615 − ($1,009,363 − $4,579)]......................... 4,831
the change in fair value. To record the change in fair value of the note due to interest rate changes.
 APPENDIX A Derivatives A-21

We determine interest on the note the same way we do for any liability, as you learned
earlier—at the effective rate (9% × ½) times the outstanding balance ($1,009,363). This
results in reducing the note’s carrying value for the cash interest paid in excess of the inter-
est expense.
The fair value of the swap increased by $252 (from $9,363 to $9,615). That increase
in fair value consists of (a) an increase of $4,831 due to the change in interest rates, (b)
a decrease of $5,000 due to the net cash settlement received, and (c) the $421 increase
that results from interest accruing on the asset.17 Similarly, we adjust the note’s carrying
value by the amount necessary to increase it to fair value. Again, all amounts recognized
in earnings are presented as interest expense.
At June 30, 2025, Summer repeats the process of adjusting to fair value both the deriva-
tive investment and the note being hedged.

June 30, 2025

Interest expense (8% × ½ × $1,009,615)........................................................ 40,385
Notes payable (difference)................................................................................... 9,615
Cash (10% × ½ × $1,000,000)...................................................................... 50,000
To record interest to Third Bank.
Cash [$50,000 − (8% × ½ × $1 million)].......................................................... 10,000 The net interest received
Interest rate swap ($0 − $9,615).................................................................. 9,615 is the difference between
Interest expense (interest on swap: 8% × ½ × $9,615).......................... 385 the fixed interest (5%) and
To record the net cash settlement, accrued interest on the swap, floating interest (4%).
and change in the fair value of the derivative.
Note payable............................................................................................................ 1,000,000
Cash...................................................................................................................... 1,000,000
To repay the loan from Third Bank.

The net interest settlement received is the difference between the fixed rate (5%) and
floating rate (4%), times $1 million. The fair value of the swap decreased by $9,615 (from
$9,615 to zero).18 That decrease in fair value consists of (a) a decrease of $10,000 due to the
net cash settlement received, and (b) an increase of $385 that results from interest accruing
on the asset.
Here’s how the book values changed for the swap account and the note.

Swap Note
Jan. 1, 2024 1,000,000
June 30, 2024 9,363 9,363
Dec. 31, 2024 252 4,579 4,831
June 30, 2025 9,615 9,615
1,000,000
0 0

17
The investment in the interest rate swap represents the present value of expected future net interest receipts. As with other such assets,
interest accrues at the effective rate times the outstanding balance. You also can think of the accrued interest mathematically as the
increase in present value of the future cash flows as we get one period nearer to the dates when the cash will be received.
18
Because there are no future cash receipts or payments from the swap arrangement at this point, the fair value of the swap is zero.
A-22 APPENDIX A Derivatives

The income statement is affected as follows:

Income Statement + (−)

June 30, 2024 $(50,000) Interest expense
0 Interest expense (no time has passed)
9,363 Interest expense—gain on interest rate swap
(9,363) Interest expense—loss on hedged note
$(50,000) Net effect—same as floating interest payment
Dec. 31, 2024 $(45,421) Interest expense
421 Interest expense (passage of time on swap)
4,831 Interest expense—gain on interest rate swap
(4,831) Interest expense—loss on hedged note
$(45,000) Net effect—same as floating interest payment
June 30, 2025 $(40,385) Interest expense
385 Interest expense (passage of time on swap)
Interest expense—hedged note
$(40,000) Net effect—same as floating interest payment

This demonstrates that swap effectively converts Summer’s fixed-interest debt to float-
ing interest debt and hedges changes in the fair value of the notes payable against offsetting
changes in the fair value of the hedging instrument.

Additional Consideration
Private Company GAAP—Derivatives and Hedging. The Private Company Council (PCC)
sought feedback from private company stakeholders and found that most users of private
company financial statements find it difficult to obtain fixed-rate borrowing and often
enter into an interest rate swap to economically convert their variable-rate borrowing into
a fixed-rate borrowing. However, this arrangement caused significant variability in the
income statements. The PCC concluded that the cost and complexity of hedge accounting
outweighed the benefits for private companies.
In response to the PCC’s conclusion, the FASB issued an Accounting Standards Update
in 2014 that allows a simplified approach to make it easier for certain interest rate swaps
to qualify for hedge accounting for private companies that is quite different from what is
required for public companies.19 This alternative allows a nonpublic company (that’s not
a financial institution) to apply hedge accounting to its interest rate swaps as long as the
terms of the swap and the related debt are aligned. If the conditions are met, the company
can assume the cash flow hedge is fully effective. Those applying the simplified hedge
accounting approach will be able to recognize the swap at its settlement value instead of at
its fair value. As a result, the amount of interest expense recorded in the income statement
approximates the amount that would have been recognized if the private company had
borrowed at a fixed rate.
This alternative should significantly reduce the cost and complexity of accounting for
derivatives and hedging transactions of private companies.

19
Accounting Standards Update No. 2014-03, “Derivatives and Hedging (Topic 815): Accounting for Certain Receive-Variable, Pay-
Fixed Interest Rate Swaps—Simplified Hedge Accounting Approach (a consensus of the Private Company Council)” (Norwalk, CT:
FASB, January 2014).
 APPENDIX A Derivatives A-23

The Bottom Line

● LOA–1 A variety of derivative securities are used to hedge against risk. These include futures contracts, forward
contracts, and options.
● LOA–2 A fair value hedge is used to hedge against the exposure to changes in the fair value of an asset, liability,
or a firm commitment.
● LOA–3 A cash flow hedge is used to hedge against the exposure to changes in cash inflows or cash outflows of an
asset or liability or a forecasted transaction (like a future purchase or sale).
● LOA–4 A foreign currency hedge is used to hedge against the possibility that movements in foreign currency exchange
rates could affect the entity’s financial statements because it has transactions, assets or liabilities, or a net
investment in a foreign operation that is denominated in a currency other than the entity’s functional currency.
● LOA–5 Ample disclosures about derivatives are essential to maintain awareness of potential opportunities and
problems with risk management.
● LOA–6 The extended method of assessing hedge effectiveness and hedge accounting for an interest rate swap
must be used unless (a) the swap’s notional amount matches the note’s principal amount, (b) the swap’s
expiration date matches the note’s maturity date, (c) the fair value of the swap is zero at inception, and (d)
the swap’s floating payment is at a market rate and its index matches the benchmark interest rate desig-
nated as the hedged interest rate. ●

Questions For Review of Key Topics

Q A–1 Some financial instruments are called derivatives. Why?
Q A–2 Should gains and losses on a fair value hedge be recorded as they occur, or should they be recorded to coincide
with losses and gains on the item being hedged?
Q A–3 Hines Moving Company held a fixed-rate debt of $2 million. The company wanted to hedge its fair value
exposure with an interest rate swap. However, the only notional available at the time, on the type of swap it
desired, was $2.5 million. What will be the effect of any gain or loss on the $500,000 notional difference?
Q A–4 What is a futures contract?
Q A–5 What is the effect on interest of an interest rate swap?
Q A–6 How are derivatives reported on the balance sheet? Why?
Q A–7 When is a gain or a loss from a cash flow hedge reported in earnings?

Exercises ®

E A–1 Indicate (by abbreviation) the type of hedge each activity described below would represent.
Derivatives; Hedge Type
hedge
FV Fair value hedge
classification CF Cash flow hedge
● LOA–1 FC Foreign currency hedge
N Would not qualify as a hedge
Activity
_____ 1. An options contract to hedge possible future price changes of inventory.
_____ 2. A futures contract to hedge exposure to interest rate changes prior to replacing bank notes when they
mature.
_____ 3. An interest rate swap to synthetically convert floating rate debt into fixed rate debt.
_____ 4. An interest rate swap to synthetically convert fixed rate debt into floating rate debt.
_____ 5. A futures contract to hedge possible future price changes of timber covered by a firm commitment to sell.
_____ 6. A futures contract to hedge possible future price changes of a forecasted sale of aluminum.
_____ 7. ExxonMobil’s net investment in offshore drilling operations in Brazil.
_____ 8. An interest rate swap to synthetically convert floating rate interest on an available-for-sale debt
investment into fixed rate interest.
_____ 9. An interest rate swap to synthetically convert fixed rate interest on a held-to-maturity debt investment
into floating rate interest.
_____10. An interest rate swap to synthetically convert fixed rate interest on an available-for-sale debt
investment into floating rate interest.
A-24 APPENDIX A Derivatives

E A–2 On January 1, 2024, LLB Industries borrowed $200,000 from Trust Bank by issuing a two-year, 10% note, with
Derivatives; interest payable quarterly.
interest rate
∙ LLB entered into a two-year interest rate swap agreement on January 1, 2024, and designated the swap as a
swap; fixed rate
fair value hedge. Its intent was to hedge the risk that general interest rates will decline, causing the fair value
debt
of its debt to increase.
● LOA–2
∙ The agreement called for the company to receive payment based on a 10% fixed interest rate on a notional
amount of $200,000 and to pay interest based on a floating interest rate. The contract called for cash settle-
ment of the net interest amount quarterly and rates reset at the beginning of each period.
∙ Floating (SOFR) settlement rates were 10% at January 1, 8% at March 31, and 6% at June 30 and September
30, 2024. The fair values of the swap are quotes obtained from a derivatives dealer. Those quotes and the fair
values of the note are as indicated below. Assume LLB uses the shortcut method.

January 1 March 31 June 30 September 30

Fair value of interest rate swap $ 0 $ 6,472 $ 11,394 $ 9,565
Fair value of notes payable $200,000 $206,472 $211,394 $209,565

Required:
1. Calculate the net cash settlement at March 31, June 30, and September 30, 2024.
2. Prepare the journal entries through September 30, 2024, to record the issuance of the note, interest, and nec-
essary adjustments for changes in fair value.
3. Repeat requirements 1 and 2 through June 30, 2024, assuming that rates reset in arrears.

E A–3 [This is a variation of E A–2, modified to consider fair value change unrelated to hedged risk.]
Derivatives; LLB Industries borrowed $200,000 from Trust Bank by issuing a two-year, 10% note, with interest payable
interest rate quarterly.
swap; fixed rate
∙ LLB entered into a two-year interest rate swap agreement on January 1, 2024, and designated the swap as a
debt; fair value
fair value hedge. Its intent was to hedge the risk that general interest rates will decline, causing the fair value
change unrelated
of its debt to increase.
to hedged risk
∙ The agreement called for the company to receive payment based on a 10% fixed interest rate on a notional
● LOA–2
amount of $200,000 and to pay interest based on a floating interest rate and rates reset at the beginning of
each period.
∙ Floating (SOFR) settlement rates were 10% at January 1, 8% at March 31, and 6% at June 30, 2024. The fair
values of the swap are quotes obtained from a derivatives dealer. Those quotes and the fair values of the note
are as indicated below. The additional rise in the fair value of the note (higher than that of the swap) on June
30 was due to investors’ perceptions that the creditworthiness of LLB was improving. Assume LLB uses the
shortcut method.

January 1 March 31 June 30 September 30

Fair value of interest rate swap $ 0 $ 6,472 $ 11,394 $ 9,565
Fair value of notes payable $200,000 $206,472 $220,000 $209,565

Required:
1. Calculate the net cash settlement at June 30, 2024.
2. Prepare the journal entries on June 30, 2024, to record the interest and necessary adjustments for changes in
fair value.

E A–4 [This is a variation of E A–2, modified to consider the extended method.]

Derivatives; On January 1, 2024, LLB Industries borrowed $200,000 from Trust Bank by issuing a two-year, 10% note, with
interest rate interest payable quarterly.
swap; fixed rate
∙ LLB entered into a two-year interest rate swap agreement on January 1, 2024, and designated the swap as a
debt; extended
fair value hedge. Its intent was to hedge the risk that general interest rates will decline, causing the fair value
method
of its debt to increase.
● LOA–6
∙ The agreement called for the company to receive payment based on a 10% fixed interest rate on a notional
amount of $200,000 and to pay interest based on a floating interest rate. The contract called for cash settle-
ment of the net interest amount quarterly and rates reset at the beginning of each period.
 APPENDIX A Derivatives A-25

∙ Floating (SOFR) settlement rates were 10% at January 1, 8% at March 31, and 6% at June 30 and September
30, 2024. The fair values of the swap are quotes obtained from a derivatives dealer. Assume that LLB does
not elect to use the shortcut method. The swap is deemed highly effective, but it is not assumed to be per-
fectly effective. Those quotes and the fair values of the note are as follows:

January 1 March 31 June 30 September 30

Fair value of interest rate swap $ 0 $ 6,472 $ 11,394 $ 9,565
Fair value of notes payable $200,000 $206,472 $211,394 $209,565

Required:
Prepare the journal entries through September 30, 2024, to record the issuance of the note, interest, and necessary
adjustments for changes in fair value. Use the extended method demonstrated in Illustration A–5.

E A–5 [This is a variation of E A–5, modified to consider fair value change unrelated to hedged risk.]
Derivatives; On January 1, 2024, LLB Industries borrowed $200,000 from Trust Bank by issuing a two-year, 10% note, with
interest rate interest payable quarterly.
swap; fixed-rate
∙ LLB entered into a two-year interest rate swap agreement on January 1, 2021, and designated the swap as a
debt; fair value
fair value hedge. Its intent was to hedge the risk that general interest rates will decline, causing the fair value
change unrelated
of its debt to increase.
to hedged
∙ The agreement called for the company to receive payment based on a 10% fixed interest rate on a notional
● LOA–6
amount of $200,000 and to pay interest based on a floating interest rate. The contract called for cash settle-
ment of the net interest amount quarterly and rates reset at the beginning of each period.
∙ Floating (SOFR) settlement rates were 10% at January 1, 8% at March 31, and 6% at June 30 and September 30,
2024. The fair values of the swap are quotes obtained from a derivatives dealer. Those quotes and the fair values
of the note are as indicated below. The additional rise in the fair value of the note (higher than that of the swap)

January 1 March 31 June 30 September 30

Fair value of interest rate swap $ 0 $ 6,472 $ 11,394 $ 9,565
Fair value of note payable $200,000 206,472 220,000 $209,565

on June 30 was due to investors’ perceptions that the creditworthiness of LLB was improving. Assume that LLB
does not elect to use the shortcut method. The swap is deemed highly effective, but it is not assumed to be per-
fectly effective.
Required:
1. Calculate the net cash settlement at June 30, 2024.
2. Prepare the journal entries on June 30, 2024, to record the interest and necessary adjustments for changes in
fair value. Use the extended method demonstrated in Illustration A–5.

E A–6 On January 1, 2024, Oriole Company purchased $500,000 of Nest Corporation’s five-year, 4% notes at par, with
Derivatives; interest receivable semiannually. The company classified the investment as available-for-sale.
interest rate
∙ To hedge the risk that general interest rates will increase and the fair market value of its investment in AFS
swap; fixed rate
debt securities will decrease, Oriole entered into a five-year plain vanilla interest rate swap agreement on Jan-
investment
uary 1, 2024, and designated the swap as a fair value hedge.
● LOA–2
∙ The agreement called for the company to make payments based on a 4% fixed interest rate on a notional
amount of $500,000 and to receive interest based on a floating interest rate (SOFR). The contract called
for cash settlement of the net interest amount semiannually on June 30 and December 31, based on begin-
ning-of-period rates.
∙ Oriole qualifies for and elects to use the shortcut method.
∙ Floating (market) settlement rates were 3% at June 30, 2024, 5% at December 31, 2024, and 5.5% at June 30, 2025.
The fair values of the swap on those dates are quotes obtained from a derivatives dealer and are listed below.
1/1/24 6/30/24 12/31/24 6/30/25
Interest revenue—AFS security $ 10,000 $ 10,000 $10,000
Fixed rate—swap 4% 4% 4% 4%
Floating rate—swap 4% 3% 5% 5.5%
Fair value of interest rate swap $0 $ (20,901) $ 17,925 $23,585
A-26 APPENDIX A Derivatives

Required:
1. Calculate the net cash settlement at June 30 and December 31, 2024, and June 30, 2025.
2. Prepare the journal entries through June 30, 2025, to record the investment in available-for-sale debt securi-
ties, interest, and necessary adjustments for changes in fair value.

E A–7 Arlington Steel Company is a producer of raw steel and steel-related products.
Derivatives; fair
∙ On January 3, 2025, Arlington enters into a firm commitment to purchase 10,000 tons of iron ore pellets from
value hedge;
a supplier to satisfy spring production demands. The purchase is to be at a fixed price of $63 per ton on April
futures contract;
30, 2025.
firm commitment
∙ To protect against the risk of changes in the fair value of the commitment contract, Arlington enters into a
● LOA–2
futures contract to sell 10,000 tons of iron ore on April 30 for $63/ton (the current price).
∙ The contract calls for net cash settlement, and the company must report changes in the fair values of its hedging
instruments each quarter. On March 31, the price of iron ore fell to $61/ton, and then to $60/ton on April 30.
Required:
1. Calculate the net cash settlement at April 30, 2025.
2. Prepare the journal entries for the period January 3 to April 30, 2025, to record the firm commitment, neces-
sary adjustments for changes in fair value, and settlement of the futures contract.

E A–8 Snackums, Inc., purchases wheat for use in its food manufacturing process. Snackums operates in a highly com-
Derivatives; cash petitive industry and is rarely able to increase its sales price.
flow hedge;
∙ On January 1, 2024, Snackums estimates that it only has enough wheat inventory to meet its manufacturing
futures contract;
needs for the first half of 2024, and forecasts the purchase of 20,000 bushels of wheat on June 30, 2024, from
forecasted
its supplier, Trigo Farms.
purchase
∙ Because Snackums is concerned that the price of wheat will increase during the coming months it enters into
● LOA–3
four June wheat futures contracts on January 1, 2024, to purchase wheat.
∙ Each futures contract is based on the purchase of 5,000 bushels of wheat at $6.73 per bushel on June 30,
2024, and will settle in cash at maturity. (For purposes of this problem, the daily margin accounts with the
clearinghouse are ignored.)
∙ The company must report changes in the fair value of its hedging instruments each quarter. The fair value of
the futures contract at inception is zero.
∙ Snackums designates the futures contract as a hedge of the variability of cash flows attributed to changes in
the spot price of wheat for its forecasted purchase of wheat.
∙ Since the critical terms of the forward contract and the forecasted purchase are exactly the same, Snackums
concludes that the hedging relationship is expected to be 100% effective.
The spot and forward prices per bushel of wheat and the fair value of the forward contract are as follows:

Date Spot Price (per bushel) Futures Price (per bushel)

January 1, 2024 $6.68 $6.73
March 31, 2024 $6.72 $6.77
June 30, 2024 $6.90 n/a

Required:
1. Calculate the net cash settlement at June 30, 2024.
2. Prepare the journal entries for the period January 1 to June 30, 2024, to record the forecasted purchase
transaction, necessary adjustment for changes in the fair value of the futures contract, and settlement of the
contract. Assume that Snackums purchases the wheat inventory from Trigo Farms on June 30, 2024, as
anticipated.
3. During the third quarter, Snackums uses all of the wheat it purchases in production and sells the related
inventory. What entry would Snackums make during the quarter ended September 30, 2024, related to the
hedged transaction?

E A–9 Cleveland Company is a U.S. firm with a U.S. dollar functional currency that manufactures copper-related
Derivatives; products. It forecasts that it will sell 5,000 feet of copper tubing to one of its largest customers at a price of
foreign currency; ¥50,000,000. Although this sale has not been firmly committed, Cleveland expects that the sale will occur in six
cash flow hedge months on June 30, 2024. Thus, Cleveland is exposed to changes in foreign currency exchange rates. To reduce
● LOA–4
 APPENDIX A Derivatives A-27

this exposure, Cleveland enters into a six-month foreign currency exchange forward contract with a third-party
dealer on January 1, 2024, to deliver ¥ and receive US$. The foreign exchange contract has the following terms:

Contract amount: ¥50,000,000

Maturity date: June 30, 2024
Forward contract rate: ¥105.00 = US $1.00

Yen / US$ Exchange rates:

Date Spot Rate Forward Rate for June 30

January 1 ¥100.00/US $1.00 ¥105.00/US $1.00
March 31 ¥102.00/US $1.00 ¥108.00/US $1.00
June 30 ¥110.00/US $1.00

Cleveland obtains the fair values of the forward exchange contract from the third-party dealer.

January 1 March 31 June 30

Swap fair value $0 $13,227 $21,645

Required:
1. Calculate the net settlement on June 30, 2024.
2. Prepare the journal entries for the period January 1 to June 30, 2024, to record the forward contract, n­ ecessary
adjustments for changes in fair value, and settlement.

E A–10 On January 1, 2024, JPS Industries borrowed $300,000 from Austin Bank by issuing a three-year, floating rate note
Derivatives; cash based on SOFR, with interest payable semiannually on June 30 and December of each year.
flow hedge;
∙ JPS entered into a three-year interest rate swap agreement on January 1, 2024, and designated the swap as a
interest rate
cash flow hedge. The intent was to hedge the risk that interest rates will rise, increasing its semi-annual inter-
swap; shortcut
est payments.
method
∙ The swap agreement called for the company to receive payment based on a floating interest rate on a notional
● LOA–3
amount of $300,000 and to pay a 6% fixed interest rate.
∙ The contract called for cash settlement of the net interest amount semiannually, and the rate on each reset date
(June 30 and December 31) determines the variable interest rate for the following six months. In other words,
the net cash settlement is based on beginning-of-period rates.
SOFR rates in 2024 were 6% at January 1, 5.5% at June 30, and 7% at December 31. The fair values of the swap
on those dates, obtained by dealer quotes, were as follows:

January 1 June 30 December 31

Swap fair value $0 $(3,459) $5,510

Required:
1. Calculate the net settlement on June 30 and December 31, 2024.
2. Prepare journal entries for the period January 1 to December 31, 2024, to record the note payable and ­hedging
instrument, necessary adjustments for changes in fair value, and settlement of the swap contract.

Problems
®

P A–1 On January 1, 2024, Avalanche Corporation borrowed $100,000 from First Bank by issuing a two-year, 8%
Derivatives; fixed-rate note with annual interest payments. The principal of the note is due on December 31, 2025.
interest rate swap
∙ Avalanche wanted to hedge against declines in general interest rates, so it also entered into a two-year SOFR-
● LOA–2
based interest rate swap agreement on January 1, 2024, and designates it as a fair value hedge. Because the
swap is entered at market rates, the fair value of the swap is zero at inception.
∙ The agreement called for the company to receive fixed interest at the current SOFR swap rate of 5% and pay
floating interest tied to SOFR. This arrangement results in an effective variable rate on the note of SOFR + 3%.
A-28 APPENDIX A Derivatives

∙ The contract specifies that the floating rate resets each year on June 30 and December 31 for the net set-
tlement that is due the following period. In other words, the net cash settlement is calculated using begin-
ning-of-period rates.
The SOFR rates on the swap reset dates and the fair values of the swap obtained from a derivatives dealer are as
follows:

1/1/24 6/30/24 12/31/24 6/30/25 12/31/25

Floating rate (SOFR) 5% 6% 4% 3% 3%
Fair value of interest rate swap $ 0 $ (1,414) $ 971 $ 985 $ 0

Avalanche meets all criteria for hedge accounting using the shortcut method.

Required:
1. What does the shortcut method allow Avalanche to assume? How does this assumption affect the application
of hedge accounting?
2. Calculate the net cash settlement at each settlement date during 2024 and 2025.
3. Prepare the journal entries during 2024 to record the issuance of the note, interest, net cash settlement for the
interest rate swap, and necessary adjustments for changes in fair value under the shortcut method.
4. Prepare the journal entries during 2025 to record interest, net cash settlement for the interest rate swap, neces-
sary adjustments for changes in fair value, and repayment of the debt.
5. Rollforward both the swap account and the notes payable account at each settlement/interest payment date.
6. Calculate the net effect on earnings of the hedging arrangement for the six-month periods ending June 30 and
December 31, 2024, and June 30 and December 31, 2025.

P A–2 [This is a variation of PA-1, modified to consider the extended method demonstrated in Illustration A–5.]
Derivatives; On January 1, 2024, Avalanche Corporation borrowed $100,000 from First Bank by issuing a two-year, 8% fixed-
interest rate rate note with annual interest payments. The principal of the note is due on December 31, 2025.
swap; fair value
∙ Avalanche wanted to hedge against declines in general interest rates, so it also entered into a two-year SOFR-
hedge; extended
based interest rate swap agreement on January 1, 2024, and designates it as a fair value hedge. Because the
method
swap is entered at market rates, the fair value of the swap is zero at inception.
● LOA–2; LOA–6
∙ The agreement called for the company to receive fixed interest at the current SOFR swap rate of 5% and pay
floating interest tied to SOFR. This arrangement results in an effective variable rate on the note of SOFR + 3%.
∙ The contract specifies that the floating rate resets each year on June 30 and December 31 for the net set-
tlement that is due the following period. In other words, the net cash settlement is calculated using begin-
ning-of-period rates.
The SOFR rates on the swap reset dates and the fair values of the swap obtained from a derivatives dealer are as
follows:

1/1/24 6/30/24 12/31/24 6/30/25 12/31/25

Floating rate (SOFR)—swap 5% 6% 4% 3% n/a
Fair value of interest rate swap $ 0 $ (1,414) $ 971 $ 985 $ 0
Cumulative change in the fair value of $ 0 $ 1,374 $ (950) $ (971) $ 0
debt due to changes in SOFR—gain (loss)

Avalanche will assess hedge effectiveness by comparing the cumulative change in the fair value of the swap to
the cumulative change in the fair value of the debt due to changes in the benchmark interest rate. It will consider
a ratio between 80–120% to be highly effective.

Required:
Use the extended or “long-haul” method demonstrated in Illustration A–5.
1. Calculate the effectiveness of the hedging relationship each period. Is the hedge highly effective?
2. Calculate the net cash settlement at each settlement date during 2024 and 2025.
3. Prepare the journal entries during 2024 to record the issuance of the note, interest, net cash settlement for the
interest rate swap, and necessary adjustments for changes in fair value.
4. Prepare the journal entries during 2025 to record interest, net cash settlement for the interest rate swap, neces-
sary adjustments for changes in fair value, and repayment of the debt.
5. Rollforward both the swap account and the notes payable account at each settlement/interest payment date.
6. Calculate the net effect on earnings of the hedging arrangement for the six-month periods ending June 30 and
December 31, 2024, and June 30 and December 31, 2025.
 APPENDIX A Derivatives A-29

P A–3 CMOS Chips is hedging a 20-year, $10 million, 7% bond payable with a 20-year interest rate swap and has des-
Derivatives; ignated the swap as a fair value hedge. The agreement called for CMOS to receive payment based on a 7% fixed
interest rate swap; interest rate on a notional amount of $10 million and to pay interest based on a floating interest rate tied to SOFR.
comprehensive The contract calls for cash settlement of the net interest amount on December 31 of each year.
● LOA–3 At December 31, 2024, the fair value of the derivative and of the hedged bonds has increased by $100,000
because interest rates declined during the reporting period.
Required:
1. Does CMOS have an unrealized gain or loss on the derivative for the period? On the bonds? Will earnings
increase or decrease due to the hedging arrangement? Why?
2. Suppose interest rates increased, rather than decreased, causing the fair value of both the derivative and of the
hedged bonds to decrease by $100,000. Would CMOS have an unrealized gain or loss on the derivative for
the period? On the bonds? Would earnings increase or decrease due to the hedging arrangement? Why?
3. Suppose the fair value of the bonds at December 31, 2024, had increased by $110,000 rather than $100,000,
with the additional increase in fair value due to investors’ perceptions that the creditworthiness of CMOS was
improving. Would CMOS have an unrealized gain or loss on the derivative for the period? On the bonds?
Would earnings increase or decrease due to the hedging arrangement? Why?
4. Suppose the notional amount of the swap had been $10.5 million, rather than the $10 million principal
amount of the bonds. As a result, at December 31, 2024, the swap’s fair value increased by $105,000 rather
than $100,000. Would CMOS have an unrealized gain or loss on the derivative for the period? On the bonds?
Would earnings increase or decrease due to the hedging arrangement? Why?
5. Suppose BIOS Corporation is an investor, having purchased all $10 million of the bonds issued by CMOS as
described in the original situation above. BIOS is hedging its investment, classified as available-for-sale, with
a 20-year interest rate swap and has designated the swap as a fair value hedge. The agreement called for BIOS
to make payment based on a 7% fixed interest rate on a notional amount of $10 million and to receive interest
based on a floating interest rate tied to SOFR. Would BIOS have an unrealized gain or loss on the derivative
for the period due to interest rates having declined? On the bonds? Would earnings increase or decrease due
to the hedging arrangement? Why?

Decision Makers’ Perspective

Apply your critical-thinking ability to the knowledge you’ve gained. These cases will provide you an opportunity to
develop your research, analysis, judgment, and communication skills. You also will work with other students, integrate
what you’ve learned, apply it in real-world situations, and consider its global and ethical ramifications. This practice will
broaden your knowledge and further develop your decision-making abilities.
©ImageGap/Getty Images

Real World The following is an excerpt from a disclosure note of Johnson & Johnson:
Case A–1
Derivative losses;
recognition in 6. Fair Value Measurements (in part)
earnings As of January 3, 2021, the balance of deferred net gains on derivatives included in accumulated other compre-
● LOA–4 hensive income was $652 million after-tax. The Company expects that substantially all of the amounts related to
forward foreign exchange contracts will be reclassified into earnings over the next 12 months as a result of trans-
actions that are expected to occur over that period.

Required:
1. Johnson & Johnson indicates that it expects that substantially all of the balance of deferred net gains on
­derivatives will be reclassified into earnings over the next 12 months as a result of transactions that are
expected to occur over that period. What is meant by “reclassified into earnings”?
2. What type(s) of hedging transaction might be accounted for in this way?

Communication A conceptual question in accounting for derivatives is this: Should gains and losses on a hedge instrument be
Case A–2 recorded as they occur, or should they be recorded to coincide (match) with income effects of the item being
Derivatives; hedged?
hedge accounting ABI Wholesalers plans to issue long-term notes in May that will replace its $20 million of 5% bonds when they
● LOA–3 mature in July. ABI is exposed to the risk that interest rates in July will rise, increasing borrowing costs (reducing
the selling price of its notes). To hedge that possibility, ABI entered a (Treasury bond) futures contract in May to
deliver (sell) bonds in July at their current price.
A-30 APPENDIX A Derivatives

As a result, if interest rates rise, borrowing costs will go up for ABI because it will issue notes at a higher inter-
est cost (or a lower price to increase the yield.) But that loss will be offset (approximately) by the gain produced
by being in the opposite position on Treasury bond futures.
Two opposing viewpoints are:
View 1: Gains and losses on derivative instruments designed to hedge anticipated transactions should be
recorded as they occur.
View 2: Gains and losses on derivative instruments designed to hedge anticipated transactions should be
recorded to coincide (match) with income effects of the item being hedged.
In considering this question, focus on conceptual issues regarding the practicable and theoretically appropriate
treatment, unconstrained by GAAP. Your instructor will divide the class into two to six groups, depending on the
size of the class. The mission of your group is to reach consensus on the appropriate accounting for the gains and
losses on instruments designed to hedge anticipated transactions.
Required:
1. Each group member should deliberate the situation independently and draft a tentative argument prior to the
class session for which the case is assigned.
2. In class, each group will meet for 10 to 15 minutes in different areas of the classroom. During that ­meeting,
group members will take turns sharing their suggestions for the purpose of arriving at a single group
treatment.
3. After the allotted time, a spokesperson for each group (selected during the group meetings) will share
the group’s solution with the class. The goal of the class is to incorporate the views of each group into a
­consensus approach to the situation.

Continuing Cases
Target Case Target Corporation prepares its financial statements according to U.S. GAAP. Target’s financial statements
● LOA-1, LOA-2, and disclosure notes for the year ended February 1, 2020, are available in Connect. This material is also available
LOA-5 under the Investor Relations link at the company’s website ([Link]).
Required:
1. Note 16 indicates that Target has derivative instruments consisting of interest rate swaps that are designated
as fair value hedges. The total notional amount of the existing swap agreements is $1,500 million. According
to the note, how is the net settlement determined under these agreements?
2. Target has designated its interest rate swaps as fair value hedges. What interest rate risk is Target concerned
about?
3. Does Target have a gain or a loss on its interest rate swaps for the fiscal year ended February 1, 2020, and
where in the financial statements was the gain or loss recorded? On the bond? Did earnings increase or
decrease due to the hedging arrangement? Why?
4. Based on information in Note 6 and Note 15, what are the balance sheet effects of the hedging relationships
described in Note 16 at February 1, 2020?

Air France–KLM Air France–KLM (AF), a Franco-Dutch company, prepares its financial statements according to International
Case Financial Reporting Standards. AF’s financial statements and disclosure notes for the year ended December 31,
● LOA-1, LOA-5 2019, are available in Connect. This material is also available under the Finance link at the company’s website
([Link].)
Required:
1. In Note 36.1: Risk management and Note 36.2: Derivative instruments, AF discusses its various risk expo-
sures and strategies to reduce its exposure to such risks. Based on the detailed disclosures in Note 36.2, what
are the three largest risk exposures (based on the fair value of its derivative instruments)? For each risk expo-
sure, list one derivative instrument it uses to hedge that risk.
2. Per Note 36.2, what is the fair value of AF’s derivative instruments on the balance sheet? (Hint: This informa-
tion is also provided in Notes 26 and 35.)