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Accounting for risk, hedging and complex contracts

“The accounting for derivatives and complex contracts has been and is a great challenge for executives,
accountants, and auditors. The need for better explication and clarification of the labyrinthine derivative
and hedge accounting rules has never been greater, and Professor Abdel-khalik has risen to this challenge
in great splendor. This book is not only a tour de force in making a confusing maze of accounting
treatments clear and transparent, but it also delves into basic explorations of the nature of risk and
uncertainty, as well as an exposition of the many types of derivatives that accounting needs to describe and
quantify. I highly recommend this book to students who wish to make sense of the accounting for the 21st
century’s complex risk transactions.”
—Joshua Ronen, Professor, Stern School of Business, New York University, USA
“Derivatives complicate the life of accountants enormously, for they make it possible to do one thing in many
different ways. Sometimes the alternatives are clear, and at other times, they are not. Accountants can easily
find themselves in a quagmire of partially offsetting positions, the risks of which are unclear. This book helps
enormously. It puts accounting for derivatives in a broad context—explaining first the nature of the risks
facing individuals and firms, showing next how derivatives can be used to modify risks, and finally explaining
accounting rules for disclosing derivatives positions. Professor Abdel-khalik writes clearly and provides many
interesting examples of the use and abuse of derivatives. The book is important for accountants but also for
broader audiences wishing to understand the use of derivatives in risk management.”
—Hans Stoll, Professor, Owen Graduate School of Management, Vanderbilt University, USA
“While existing books devote attention to how practically to report risks, relatively little attention has been
given to the new accounting model (the accounting for risk), which the US and IFRS accounting standards
‘for risk’ have helped create. Abdel-khalik’s much-needed new book covers this gap. What is impressive

about this book is its ability not only to increase our knowledge of hedge accounting and accounting
for financial instruments but also to provide a robust framework to understand financial instruments,
contracts and related issues in order to better comprehend the logic and the use of accounting standards.”
—Saverio Bozzolan, Professor of Accounting, University of Padova, Italy

A. Rashad Abdel-khalik is a Professor of Accountancy and Director at the V.K. Zimmerman Center for
International Education and Research of Accounting at the University of Illinois, USA.
ISBN 978-0-415-80893-4

9 780415 808934

www.routledge.com

Cover image: © Lydia Jiang

Routledge titles are available as eBook editions in a range of digital formats

A. Rashad
Abdel-khalik

With the exponential growth in financial derivatives, accounting standards setters have had to keep pace
and devise new ways of accounting for transactions involving these instruments, especially hedging
activities. This book addresses the essential elements of these developments. The early chapters provide a
basic foundation by discussing the concepts of risk, risk types and measurement, and risk management.
This is followed by an introduction to the nature and valuation of free standing options, swaps, forward
and futures as well as of embedded derivatives. Discussion and illustrations of the cash flow hedge
and fair value hedge accounting treatments are offered in both single currency and multiple currency
environments, including hedging net investment in foreign operations. A final chapter is devoted to the
disclosure of financial instruments and hedging activities. The combination of these topics makes the
book an essential, self-contained source for upper level students looking to develop an understanding of
accounting for today’s financial realities.

Accounting for risk, hedging, &
complex contracts

Accounting


ACCOUNTING FOR RISK, HEDGING, AND
COMPLEX CONTRACTS



With the exponential growth in financial derivatives, accounting standards setters have had to
keep pace and devise new ways of accounting for transactions involving these instruments, especially hedging activities. This book addresses the essential elements of these developments. The
early chapters provide a basic foundation by discussing the concepts of risk, risk types and measurement, and risk management. This is followed by an introduction to the nature and valuation
of free standing options, swaps, forward and futures as well as of embedded derivatives. Discussion
and illustrations of the cash flow hedge and fair value hedge accounting treatments are offered in
both single-currency and multiple-currency environments, including hedging net investment in
foreign operations. A final chapter is devoted to the disclosure of financial instruments and hedging activities. The combination of these topics makes the book an essential, self-contained source
for upper level students looking to develop an understanding of accounting for today’s financial
realities.
A. Rashad Abdel-khalik is a Professor of Accountancy and Director at the V.K. Zimmerman Center
for International Education and Research in Accounting.


Page Intentionally Left Blank


ACCOUNTING FOR RISK,
HEDGING, AND COMPLEX
CONTRACTS
A. Rashad Abdel-khalik


First published 2014
by Routledge
711 Third Avenue, New York, NY 10017
Simultaneously published in the UK
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
Routledge is an imprint of the Taylor & Francis Group, an informa business
© 2014 Taylor & Francis
Typeset in Stone Serif by Swales & Willis, Exeter, Devon
Printed and bound
The right of A. Rashad Abdel-khalik to be identified as author of this work
has been asserted by him in accordance with sections 77 and 78 of the
Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this book may be reprinted or reproduced
or utilized in any form or by any electronic, mechanical, or other means,
now known or hereafter invented, including photocopying and recording,
or in any information storage or retrieval system, without permission in
writing from the publishers.
Trademark notice: Product or corporate names may be trademarks or
registered trademarks, and are used only for identification and
explanation without intent to infringe.
Library of Congress Cataloging in Publication Data
ISBN 13: 978–0–415–80893–4 (hbk)
ISBN 13: 978–0–203–13753–6 (ebk)
The FASB material is copyrighted by the Financial Accounting Foundation,
401 Merritt 7, PO Box 5116, Norwalk, CT 06856-5116, USA,
and is reproduced with permission.
The author/editor and publisher gratefully acknowledge the permission
granted to reproduce the copyright material in this book. Every effort
has been made to trace copyright holders and to obtain their permission
for the use of copyright material. The publisher apologizes for any errors
or omissions and would be grateful if notified of any corrections that
should be incorporated in future reprints or editions of this book.


To the memories of my parents, Mohamed and Gamilah, and
E. J. Demaris, Nicholas Dopuch and Leon E. Hay, American educators
who had significant influence on my life


Page Intentionally Left Blank


BRIEF CONTENTS

List of Illustrations
Preface

xvii
xxiii

PART I FOUNDATION

1

CHAPTER 1

Definitions of Risk and Risk Appetite

3

CHAPTER 2

Types of Risk

15

CHAPTER 3

Measurement of Risk

51

CHAPTER 4

Basics of Risk Management

93

PART II INSTRUMENTS

127

CHAPTER 5

129

An Introduction to Derivative Financial Instruments (Freestanding Derivatives)

PART III ACCOUNTING

183

CHAPTER 6

Qualifications for Hedge Accounting

185

CHAPTER 7

Hedge Accounting I (Single Currency)

226

CHAPTER 8

Hedge Accounting II (Single Currency)

291

CHAPTER 9

Hybrid Securities and Embedded Derivatives

333

CHAPTER 10

Currency Types and Risk: Hedging Transaction Settlement Risk

380

CHAPTER 11

Operating and Accounting Currency Risk

424

CHAPTER 12

Risk Disclosure in Financial Statements

428

Appendix to Chapter 1: The Gambler Who Does Not Lose
Appendix to Chapter 7: Proposed Changes in the Classification of Financial Instruments
Appendix to Chapter 9: The Significance of Embedded Derivatives (The Case of
Landsvirkjun, Iceland)

541

Bibliography
Index

543
551

512
516


Page Intentionally Left Blank


DETAILED CONTENTS

List of Illustrations
Preface

xvii
xxiii

PART I FOUNDATION


CHAPTER 1

Definitions of Risk and Risk Appetite

1
3

1.1 Risk and Open Systems

3

1.2 Risk and Uncertainty

4

1.3 Risk-Taking Types of Decision Makers: Three Schools of Thought

6

1.3.1
1.3.2
1.3.3
1.3.4

The Intrinsic School
The Extrinsic (Situational) School
Comparing the Two Theories
The Pragmatic School

1.4 Internal Controls and Risk-Seeking Behavior
1.5 A Summary and Transition



CHAPTER 2

Types of Risk

6
8
9
9
10
12

15

2.1 Open Systems and Different Risk Exposures

15

2.2 Qualitative Classification of Risk
2.2.1 Insurability
2.2.2 Diversifiability
2.3 Functional Classification of Risk
2.3.1 Operational Risk and Accounting Controls
2.3.2 Accounting Reporting Risk Exposures
2.3.3 Market (Price) Risk
2.3.4 Credit Risk
2.3.5 Liquidity Risk
2.4 Summary of Key Points

17
17
18
19
19
21
34
45
47
48


x

Contents



CHAPTER 3

Measurement of Risk

51

3.1 Risk and Ambiguity

51

3.2 Measurement of Risk with Limited Observations
3.2.1 Using Two Observations
3.2.2 Risk Measures Using Three Observations
3.2.3 Measurement of Risk for Multiple Observations
3.3 Value-at-Risk
3.3.1 Meaning and Estimation of VaR
3.3.2 The Effect of Diversification on VaR
3.3.3 Limitations of VaR
3.3.4 Illustrations of VaR in Annual Reports
3.3.5 Comparison of VaR Disclosures
3.3.6 Quasi Value-at-Risk in Accounting
3.3.7 Earnings at Risk
3.4 Interest-Rate-Gap and Duration-Gap as Measures of Interest Rate Risk
3.4.1 Interest-Rate-Gap Measures
3.4.2 Duration Measures
3.4.3 Same Present Values for Assets with Different Durations
3.5 Other Liquidity Risk Measures
3.5.1 Fixed Charge Ratio
3.6 Measurement of Credit Risk
3.6.1 Using Financial Analysis Ratios
3.6.2 Multivariate Analysis of Default Risk Using Financial Ratios
3.6.3 Merton’s and KMV Models
3.6.4 Morningstar’s Comparison of Models
3.6.5 Credit Scoring
3.7 Summary of Key Points
3.7.1 Generic Measures of Risk
3.7.2 Functional Measures of Risk

51
51
54
57
60
61
64
68
68
71
71
72
72
73
76
78
80
81
82
82
84
85
87
88
89
90
90



CHAPTER 4

Basics of Risk Management

93

4.1 Enterprise Risk Management (ERM)

93

4.2 Definition of ERM

93

4.3 The COSO Cube
4.3.1 An Example of Implementing a COSO-Like System
4.4 Event Severity and Likelihood

94
95
96

4.5 Approaches to Managing Risk
4.5.1 Risk Avoidance
4.5.2 Self-Insuring
4.5.3 Second Party Insurance
4.5.4 Diversification
4.6 Alliances and Interlocking Ownership (Keiretsu & Chaebol)

97
98
99
99
102
108


Contents

4.7 Hedging
4.7.1 Definition of Hedging
4.7.2 Natural Hedging
4.7.3 Financial Hedging
4.7.4 Factors to Consider in Hedging
4.8 Asset/Liability Management
4.8.1 Factoring
4.8.2 Securitization
4.9 Managing Credit Risk
4.9.1 Debt Covenants
4.10 Summary of Key Points

PART II INSTRUMENTS


CHAPTER 5

An Introduction to Derivative Financial Instruments
(Freestanding Derivatives)

xi

109
109
109
111
112
115
116
116
120
120
124

127

129

5.1 Fundamental and Derivative Financial Instruments
5.1.1 Fundamental Securities
5.1.2 Derivative Instruments
5.2 Options
5.2.1 Types of Options
5.2.2 Basic Features
5.2.3 Market Price versus Strike Price
5.2.4 Payoff Functions of Call and Put Options
5.2.5 Option Premium and Other Values
5.2.6 Valuation of Options
5.2.7 Options Greeks
5.3 Warrants
5.3.1 Nature of Warrants
5.3.2 Valuation of Warrants
5.3.3 Examples of Annual Report Disclosures of Warrants
5.4 Swap Contracts
5.4.1 Interest Rate Swaps
5.4.2 Commodity Swaps
5.5 Forward Contracts
5.5.1 Definition and Concepts
5.5.2 Valuation of Forward Contracts
5.5.3 An Illustration of a Commodity Forward Contract
5.6 Futures

129
129
130
131
131
131
133
134
135
136
145
148
148
153
154
155
156
167
170
170
171
173
176

5.7 Credit Default Swaps
5.7.1 Two Important Qualifications
5.7.2 The Implications
5.8 Summary of Key Points

178
178
179
180


xii

Contents

PART III ACCOUNTING


CHAPTER 6

Qualifications for Hedge Accounting

183
185

6.1 A Brief Recap of Financial Derivatives

185

6.2 Accounting for Financial Derivatives under Ordinary GAAP
6.2.1 Fair Value Is Mandatory
6.2.2 The Changes in Fair Values Flow through Earnings
6.3 Uses of Financial Derivatives
6.3.1 Using Derivatives as Investments
6.3.2 Using Derivatives to Hedge Risk
6.4 What Is Hedge Accounting?
6.4.1 Basic Features
6.4.2 Ultimate Goals of Hedge Accounting
6.5 Fundamental Premises

185
185
186
186
186
188
192
192
193
193

6.6 Hedge Accounting Qualifying Criteria
6.6.1 An Outline of Qualifying Criteria
6.6.2 Necessary Requisites
6.7 How Important Are Derivative Instruments?

195
195
196
213

6.8 Sources of Complexity in Hedge Accounting

216

6.9 Summary of Key Points
6.9.1 Previous Chapter
6.9.2 Key Issues

221
221
222



CHAPTER 7

Hedge Accounting I (Single Currency)

226

7.1 The Two Types of Accounting Standards

226

7.2 Ordinary GAAP versus Hedge Accounting
7.2.1 Financial Assets
7.2.2 Financial Liabilities
7.3 Risk and Hedge Accounting
7.3.1 Two Main Types of Risk Exposure
7.3.2 Hedging Objectives
7.3.3 Hedgeable Risks
7.4 Why Hedge Accounting?
7.4.1 Similar Risk Exposure but Different Accounting Treatment
7.4.2 Mismatching Flows and Value Changes
7.4.3 Mismatching Timing of Flows and Earnings Recognition
7.4.4 Centrality of Management Intent
7.4.5 Special Issues about Cash Flow Hedge (Overhedge and Underhedge)
7.5 Hedging Inventory
7.5.1 Fair Value Hedge of Inventory (1)
7.5.2 Cash Flow Hedge of Forecasted Sale of Inventory (2)
7.5.3 Fair Value Hedge of Inventory (3)
7.5.4 Fair Value Hedge of Inventory (4)

226
227
228
228
228
229
231
238
238
240
244
248
249
250
251
260
265
272


Contents

7.6 Cash Flow Hedge
7.6.1 Hedging a Prospective Transaction (A Case of Underhedge Followed by Overhedge)
7.6.2 Cash Flow Hedge of Prospective Transaction (Recapturing Overhedge Charges)
7.7 Summary of Key Points



CHAPTER 8

Hedge Accounting II (Single Currency)

8.1 Hedging Interest Rate Risk
8.1.1 Types of Interest Rate Risk Exposure
8.1.2 Interest Rate Swaps
8.2 Illustrations of Accounting for Hedging Using Interest Rate Swaps
8.2.1 Hedging a Fixed-Rate Debt
8.2.2 Determination of Swap Rates
8.2.3 Determination of the Fixed-Leg Rate
8.2.4 Some Financial Considerations
8.3 The Accounting Processes and Analysis
8.3.1 Hedge Designation
8.3.2 Conclusion of Prospective (Ex-Ante) Assessment of Hedge Effectiveness
8.3.3 Performance of the Hedge
8.3.4 Hedge Ineffectiveness and Termination
8.3.5 The Management Decision
8.4 Hedging Interest Rate Risk in a Cash Flow Hedge
8.4.1 Management Decision on the Accounting
8.5 Hedging Securities Valued at Fair Value through Other Comprehensive Income
(Available for Sale)
8.5.1 Fair Value Hedge of Interest Rate Risk (For Marketable Securities (AFS) in
Absence or Presence of Credit Default Risk)
8.5.2 Hedging Cash Flow Risk Using Interest Rate Floors
8.6 Summary of Key Points
8.6.1 Accounting for Interest Rate Swaps



CHAPTER 9

Hybrid Instruments and Embedded Derivatives

xiii

277
277
283
287

291
291
292
293
298
298
299
301
302
302
303
304
307
314
315
317
318
322
322
325
330
330

333

9.1 Basic Features of Hybrids

333

9.2 Examples of Hybrid Securities
9.2.1 Bonds with Detachable Warrants
9.2.2 Bonds with Non-Detachable Warrants
9.2.3 Convertible Bonds
9.2.4 Callable and Puttable Debt
9.2.5 Convertible Callable and Puttable Bonds
9.2.6 Debt Exchangeable for Common Stock (DECS)
9.2.7 Equity-Linked Notes
9.2.8 Adjustable, Step-up, Callable Financial Instruments
9.2.9 Preferred Stock

334
335
336
336
338
340
343
348
349
350


xiv

Contents

9.3 Accounting for Hybrid Instruments
9.3.1 The Challenge for Accounting
9.3.2 Definitions from Master Glossary of Accounting Standards Codification
9.4 Three Building Blocks
9.4.1 Distinction between Liabilities and Equity
9.4.2 Bifurcation of Hybrid Instruments
9.4.3 Multiple Embedded Derivatives
9.5 Embedded Derivatives Not Subject to Hedge Accounting
9.5.1 Contracts Classified in their Entirety as Liabilities
9.5.2 Contracts that Are Equity Derivatives
9.5.3 Extreme Risk Interest Rate-Linked Derivatives
9.6 Summary of Key Points
9.6.1 Types of Derivatives
9.6.2 Accounting for Embedded Derivatives

352
352
353
354
354
357
361
363
363
366
375
376
376
377



CHAPTER 10

10.1

An Overview of Currency Matters

380

10.2

Changing Currency Exchange Rates
10.2.1 The Gold Standard
10.2.2 The Currency-Floating Regime: Causes of Changing Rates
Consequences of Changing Currency Exchange Rates

381
381
382
385

10.3
10.4

Currency Types and Risk: Hedging Transaction
Settlement Risk

Types of Exchange Rate Changes
10.4.1 Currency Changes
10.5 Types of Currency Prices
10.5.1 Currency Prices by Reference to Time
10.5.2 Currency Type by Reference to Function
10.6 Currency Risk Exposure
10.6.1 Definition and Types of Currency Risk
10.7 Currency Transaction-Settlement Risk
10.7.1 Sources of Currency Transaction-Settlement Risk
10.7.2 Examples of Currency Transaction-Settlement Risk
10.8 Mitigating Currency Transaction-Settlement Risk
10.8.1 Parallel (or Back-to-Back) Loans
10.8.2 Matching Inflows and Outflows in the Same Currency
10.8.3 Money Market Hedge
10.9 Hedging Using Financial Derivatives
10.9.1 Accounting Qualifying Criteria for Hedging Currency Risk
10.9.2 Other Unique Features
10.9.3 Examples of Hedging Currency in some Enterprises
10.10 Currency Hedge Accounting Illustrations
10.10.1 Using Forward Contracts to Hedge Foreign-Currency-Denominated Debt
10.10.2 Processing and Accounting Documentation
10.11 Summary of Key Points

380

385
385
387
387
388
391
391
393
394
394
400
400
402
403
407
407
409
411
413
413
415
422


Contents

■ CHAPTER 11

Operating and Accounting Currency Risk

xv

424

11.1

A Brief Review

424

11.2

Volume of Currency Derivatives

424

11.3

Currency Operating Risk
11.3.1 Hedging Forecasted Sales and Purchases
An Illustration of Hedging a Forecasted Foreign Purchase (Using Currency Options)
11.4.1 Accounting for the Hedging Relationship
11.4.2 Consequences of Hedge Effectiveness
11.4.3 What if the Options Were Out-of-the-Money?
Hedging a Firm (Binding) Commitment
11.5.1 Using Forward Contracts to Hedge Firm Commitment
11.5.2 An Illustration of Hedging Currency Risk of a Firm Commitment
11.5.3 Analysis of the of the Fair Value Hedge Illustration
Accounting for Currency Swaps
11.6.1 Design and Valuation of Currency Swaps
11.6.2 An Illustration: Fixed-for-Fixed Currency Swap
Translation (Accounting) Risk
11.7.1 Relevant Types of Currency Exchange Rates
11.7.2 Relevance of Organizational Influence
11.7.3 Risk Exposure of Net Investment
11.7.4 An Illustration of the Translation Adjustment Account and Hedging
Summary of Key Points

425
426
428
429
435
436
436
437
438
444
444
445
446
458
459
460
465
466
475

11.4

11.5

11.6

11.7

11.8

■ CHAPTER 12

Risk Disclosure in Financial Statements

478

12.1

Disclosure and Geography

478

12.2

General Disclosures

478

12.3

Disclosure Related to Strategic Risk

479

12.4

Market Risk Disclosures
12.4.1 Disclosure of Financial Instruments and Hedging
12.4.2 Illustrations
Liquidity Risk
12.5.1 Basic Definitions Related to Financial Instruments
12.5.2 A Summary of the Proposed ASU Disclosures
12.5.3 Related Disclosures
Credit Risk
12.6.1 Measurement and Management of Credit Risk: Illustrations
Disclosures about Operational Risk
12.7.1 Disclosures about Internal Control and Information System
12.7.2 Disclosure about Employees’ Compensation and Risk Governance
Concentration Risk
12.8.1 Categories of Concentration Risk
Summary of Key Points

482
483
485
491
492
492
495
496
498
501
501
504
505
505
509

12.5

12.6
12.7

12.8
12.9


xvi

Contents

Appendix to Chapter 1: The Gambler Who Does Not Lose

512

Appendix to Chapter 7: Proposed Changes in the Classification of Financial Instruments

516

Appendix to Chapter 9: The Significance of Embedded Derivatives (The Case of
Landsvirkjun, Iceland)

541

Bibliography
Index

543
551


LIST OF ILLUSTRATIONS

Exhibits
1.1
1.2
2.1
2.2

Combinations of Probability, Outcome and Knowledge
An Example of the Classification of Decision Makers’ Attitudes toward Risk
Strategic Risk Management at the Bank of America
The Federal Deposit Insurance Corporation Statement on the Use of Estimation
in Financial Statements
2.3
Currency Risk Exposure
2.4
The 2×2 Combinations of Fixed-Rate and Floating-Rate Instruments
2.5
Impact of Changes in Market Interest Rate on Cash Flows of Floating-Rate Assets
and Floating-Rate Liabilities
2.6
The Impact of Change in Market Interest Rate on the Values of Fixed-Rate Instruments
2.7
Impact of Change in Market Yield on the Fair Value of Fixed-Rate Financial
Instruments
3.1
Advertisements for an Employment Position
3.2
An Illustration for Measuring Effect of Diversification on VaR
3.3
VaR Disclosure Examples, The Coca-Cola Company and Dell, Inc.
3.4
Corporate Reporting VaR Diversification Effect
3.5
Comparison of VaR Disclosure by Four Companies (2009 & 2010)
3.6
The Directional Impact of Change in Interest-Rate-Gap on Cash Flow
3.7
An Illustration of Using Interest-Rate-Gap
3.8
A Comparison of Duration and Modified Duration for 9% Fixed-Rate Bonds
Having Different Cash Flow Patterns
3.9
Two Measures of Financial Leverage for Five Corporations
3.10 Correspondence of Default Spread and Credit Rating Scores
4.1
Risk Management at Intercontinental Hotel Group, plc
4.2
Examples of Concern about Consideration of both Severity of Impact and
Probability of Event Occurrence
4.3
Hedging Fuel Cost at Airlines
4.4
Hedging at Public Utilities
4.5
Hedging Oil Revenues by the Government of Mexico
4.6
Managing Liquidity Risk
4.7
Liquidity Risk Management at Landsvirkjun (Iceland)
4.8
Disclosure of Debt Covenants of Seagate Technology Holdings

4
7
16
22
37
38
39
41
43
52
65
68
69
70
74
75
79
83
89
95
98
113
114
114
115
116
122


xviii

List of Illustrations

4.9
5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
5.9
5.10
5.11

Cases of Debt Covenant Violations
Spot vs. Strike Prices of Options
Determination of Option Premium Based on the Black-Scholes Model
An Illustration of Valuation of a Call Option Using the Two-Period Binomial Model
The Options Greeks
An Example of Privately Written Option Contracts
Options and Warrants: Similarities and Differences
Flexible (Unstandardized) Options
Two Examples of Selling Warrants
A News Report about the SEC’s Preference for the Binomial Option Valuation Model
Valuation of Detachable Warrants—MidSouth Bank
The Two Possible Paths if One Firm Borrows at Fixed Interest Rate and the
Other Borrows at Floating Interest Rates
Deriving the Floating Rate for the Term of the Swap Using Data of the Illustration
of BB Enterprises
Deriving the Fixed Rate for the Fixed Leg
Commodity Swaps—Wool Swaps Written by Commonwealth Bank of Australia
Impact of Forward Price Deviation from Efficient Pricing
An Illustration of a Forward Contract
Differences between Forwards and Futures Contracts
An Example of NYMEX “Net Settled” Futures Contract
Examples of Corporate Disclosures of Trading Derivatives
IBM Cash Flow Hedging of Forecasted Issuance of Debt
Using Regression in Testing Effectiveness
Description of Hedge Accounting at IBM
Cases Describing the Volume of Derivatives in Financial and Non-Financial
Institutions
Two Examples of Seemingly Simple Contracts from the FASB Derivatives
Implementation Group
Relationship of Risk, Values, and Cash Flow in Response to Changes in Interest Rate
Hedgeable Fair Value Risks Acceptable for Accounting
Effects of Mismatching the Valuation of Financial Assets and Financial Liabilities
Different Effects of Changing Interest Rate for Fixed-Rate Financial Assets and
Fixed-Rate Financial Liabilities
Different Effects of Changing Interest Rate for Floating-Rate Financial Assets and
Floating-Rate Financial Liabilities
Different Effects of Changing Interest Rate for Fixed-Rate Financial Assets and
Floating-Rate Financial Liabilities
Different Effects of Changing Interest Rate for Floating-Rate Financial Assets
and Fixed-Rate Financial Liabilities
Effects of Hedge Accounting on Applying Ordinary GAAP
Hedging Documentation for Milsom Farms, Inc.
Cash Flow Hedging Documentation for Milsom Farms, Inc.
Hedge Documentation: Cherokee, Inc.
Interest Rate Swaps as Affecting Risk Substitution
Deriving the Floating Rates for the Term of the Swap

5.12
5.13
5.14
5.15
5.16
5.17
5.18
6.1
6.2
6.3
6.4
6.5
6.6
7.1
7.2
7.3
7.4
7.5
7.6
7.7
7.8
7.9
7.10
7.11
8.1
8.2

123
134
137
143
145
147
149
149
151
153
154
159
165
166
168
172
173
176
177
188
190
209
212
214
217
229
237
239
240
241
242
242
248
252
260
278
298
300


8.3
8.4
8.5
8.6
8.7
8.8
9.1
9.2
9.3
9.4
9.5
9.6
9.7
10.1
10.2
10.3
10.4
10.5
10.6
10.7
11.1
11.2
11.3
11.4
11.5
11.6
12.1
12.2
12.3
12.4
12.5
12.6
12.7
12.8
12.9
12.10
12.11
A1.1
A1.2
A1.3

List of Illustrations

xix

Deriving the Coupon Rates for the Fixed Leg of the Swap
BetaCo Initial Hedge Documentation
For Swap Contract W215 to hedge Debt Contract KA50T
Prospective Assessment of Hedge Effectiveness
Assessment of Ex-Ante (Prospective) Hedge Effectiveness with a Downward
Shift of Zero-Coupon Rate by 50 Basis Points
La Sierra Initial Hedge Documentation (Interest Rate Swap Contract H3A7)
The Composition of Hybrid Instruments
Embedded Options—Callable Bonds Case of Time Warner Cable, Inc. Public
Offering Prospectus on 9/8/2011
Characteristics of Adding a Put or a Call Option to Convertible Securities
Deutsche Telekom AG Issuance of Debt Exchangeable for Common Stock (DECS)
Examples of Perpetual Preferred Stock Issues
Disclosure of Convertible and Puttable Notes with Embedded Derivatives
Examples of Hybrids with Embedded Derivatives
Comparison of Direct and Indirect Quotes
Impact of Type of Change in Currency Exchange Rates
Determinants of Functional Currency
Examples of Determining Functional Currency
An Outline of the Risks Created by Changing Currency Rates
Hedgeable Currency Risk and Hedging Approaches
Excerpts from General Electric 2011 Form 10-K
American Flooring Distributor, Inc., Initial Hedge Documentation
USKitchen Company: Initial Hedge Documentation
The Intersection of Cross-Currency Type and Accounting Treatment
FlowinWaters Enterprises Hedge Documentation
An Outline of Currency Conversion Guides
Pharma-R-US Incorporated Hedge Documentation (For FX Forward Contract
FX44-INR)
An Illustration of the Scope of MD&A (Intel Corporation)
MD&A Qualification about Forward-Looking Information (E. I. Du Pont De Nemours
and Company)
All-in-One Required Quantitative Disclosures about All Financial Instruments
Value at Risk for Investment Banking and Credit Portfolios
The Volume of Financial Derivatives at JPMorgan Chase
Disclosure of Liquidity Risk and Interest Rate Risk
An Illustration of Disclosing Exposure to Credit Risk
The Boeing Corporation’s Disclosure of Exposure to Credit Risk
DineEquity CEO Certification about Internal Controls
An Excerpt from the Management Report on Internal Control at General Motors
An Illustration Regarding Allocations Made for Segment Reporting
Reservation Price for Travel on Tuesday April 10
TLC Reporting Strategy 1
TLC Reporting Strategy 2

301
303
304
309
313
318
334
339
342
346
351
362
362
381
386
389
390
392
411
412
430
439
446
449
464
470
480
481
484
486
488
494
498
499
502
504
509
513
514
515


xx

List of Illustrations

Figures
1.1
2.1
2.2
2.3

Prospect Theory Payoff Function
Linkage of Different Risk Exposures
The Impact of Restatement of Financial Statements on Stock Prices of Aurora Company
Impact of Changing Market Interest Rate on the Market Value of a Fixed-Rate
Instrument (Bond)
3.1
Three Different Triangular Distributions
3.2
The Standard Normal Z (Units of Standard Deviation) Probability Distribution
3.3
Measurement of VaR for Prices of a Hypothetical Stock
4.1
Probability/Impact Matrix
4.2
Risk (Payoff) Profiles of Oil Company and Airline Company in Face of Changing
Oil Prices
4.3
Hedging Profiles of Different Downside Risks
4.4
The Process of Factoring Receivables Under Two Different Options
5.1
Payoff of a Call Option for a Hypothetical Stock
5.2
Payoff of a Put Option for a Hypothetical Stock
5.3
The Behavior of Option Values to the Holder of AZIZA, Inc. Stock Option
5.4
A Two-Period Binomial Model
5.5
A Two-Period Binomial Tree
5.6
Basic Plain Vanilla Interest Rate Swap
5.7
Interest Rate Swap to Hedge Two Different Types of Debt
5.8
U.S. Zero-Coupon 10-Year Yield Curve (European Central Bank)
5.9
Zero-Coupon Rates of the U.S. Treasury Month by Month for 2011
5.10 BB Enterprises, Inc. Swap Contract to Hedge Fixed-Rate Debt
5.11 Payoff Profiles of Two Forward Contracts
6.1
Derivatives Categories in Accounting
6.2
Regression Relationships for Price Changes of Two Derivative Instruments and
Two Hedged Items
6.3
A Flowchart Summary for Eligibility for Hedge Accounting
6.4
OTC Derivative Notional Accounts by Type of User
6.5
Volume of National Amounts of OTC Derivatives as Reported by ISDA
7.1
Fair Value Change Mismatching Due to the Mixed-Attribute Accounting Model
7.2
Mismatching Due to the Accounting Mixed-Attribute Model in the Presence
of Hedging but in Absence of Hedge Accounting
7.3
Overhedge and Underhedge in Cash Flow Hedging
7.4
Two Approaches to Measuring CGS
7.5
Calculation of the Cost of Goods Sold for Malthus Farms, Inc.
7.6
Calculation of the Cost of Goods Sold for Cecil Pigou Enterprises, Inc. (A Different
Scenario)
8.1
Hedging A Liability: Fixed for Floating Interest-Rate Swaps
8.2
Hedging Value and Cash Flow Risk of an Asset: Fixed for Floating Interest-Rate Swaps
9.1
A Typical Payoff Profile of Debt Exchangeable for Common Stock
9.2 The Varying Conversion Ratios of the Deutsche Telekom AG Issue Debt
Exchangeable for Common Stock (DECS)

8
17
29
41
57
59
63
97
110
112
117
134
135
138
141
143
156
160
162
163
164
171
191
210
212
213
214
244
247
250
257
270
276
296
297
345
347


List of Illustrations

9.3
9.4
9.5

The Decision on Bifurcating Embedded Derivatives
A Flowchart for Accounting Decisions Related to Convertible Debt
A Flowchart for Bifurcation of Embedded Derivatives in the Presence of
Conventional Convertible Debt
9.6 Flowchart of the Decision on the Clearly and Closely Related Criterion for
Extreme Risk Interest Rate-Linked Instruments (The Double-Double Test)
10.1 An Illustration of Interest Rate Parity and Exchange Rate
10.2 Relationships between Different Currency Risk Exposures
10.3 An Illustration of Parallel Loans
10.4 The Flow of Funds for a Money Market Hedge
11.1 Using Options to Hedge FX Downside Risk
11.2 Flow of Funds for Swap Contract No. FX7Euro
11.3 General Remeasurement/Translation Rules
11.4 The Process of Currency Translation to Consolidate Financial Statements of
Parent and Subsidiaries
11.5 An Interpretation of the Relationship between Net Assets as Investment at Risk
and as Translated for Consolidation
12.1 Daily Revenues at Risk with 95% Confidence
A9.1 Hedging Fixed-Rate Debt Using Interest Rate Swap

xxi

361
370
371
376
384
393
401
405
427
447
463
463
467
487
542

Tables
2.1
2.2
2.3
2.4
3.1
3.2
4.1
4.2
5.1
5.2
5.3
7.1
7.2
7.3
7.4
7.5
7.6

Restatement of Earnings at Freddie Mac
Exchange Rates between the Chinese Renminbi and Five other Currencies
Impact of Interest Rate Changes on Cash Flow for Floating-Rate Assets and
Floating-Rate Liabilities
Market Value (Present Value) of a Fixed-Rate Instrument for Scenarios of Different
Market Yield
Probabilities of Different States of a Triangular Distribution
VaR Calculation for Portfolio ZK7
An Illustration of Rates of Return for the Investment Asset i Given Three States of
Nature
Comparison of Individual Stocks and Portfolios Assuming Different Correlations
The Behavior of Changes in Option Values to the Holder of a Call Stock Option of
AZIZA, Inc.
Reported Statistics on Derivatives Activities for Three Companies
Borrowing Rates Available to XYZ Unlimited, Inc. and ABC, Inc.
Cataloging Different Timing of Cash Flow and Accruals
The Impact of Applying Cash Flow Hedge Accounting on Cash Flow and Earnings
Soybean Spot and Future Price Movements (Fair Value Hedge No Ineffectiveness)
A Comparison of Different Conditions of Using Financial Derivatives
Soybean Spot and Future Price Movements (Fair Value Hedge No Ineffectiveness)
Soybean Spot and Future Price Movements (Fair Value Hedge Presence of
Ineffectiveness)

27
35
39
43
55
63
105
107
138
156
159
245
247
252
258
261
266


xxii

7.7
7.8
7.9
7.10
7.11
8.1
8.2
8.3
9.1
10.1
11.1
11.2
11.3
11.4
11.5
11.6
A9.1

List of Illustrations

Comparisons of Conditions and Scenarios Related to Presence or Absence of
Hedge Effectiveness
Soybean Spot and Future Price Movements for Cecil Pigou Enterprises (Fair Value
Hedge when Prices Are Increasing)
A Comparison of Conditions With and Without Hedging Cecil Pigou Enterprises,
Inc. (Inventory Prices Follow Increasing Forward Prices Condition)
Measurement of the Amount of Overhedge
Assumption and Information Related to Hedging Forecasted Purchase of Soybean
for Crushing
Interest Expense and Accreting Book Value of Debt for the Remaining Term of
Bond Contract TA50T
Assumptions about Movements of the Zero-Coupon Curve and Time Value of
Options
Calculation of Intrinsic Values of Interest Rate Floors
Two Examples of Structured Equity-Linked Notes
Price Behavior of Currency Exchange Rate between the Brazilian Real and the
U.S. Dollar
Volume of Currency Trade in North America
The Effect of Currency Exchange Rates of BRL to USD on Time Value and Intrinsic
Value of Options (Contract OP17BR)
Measurement of the Fair Value of the Forward Contract and Change in Firm
Commitment
The Present Value of Swap Contract No. FX7Euro
The Balance Sheets of Pharma-R-US and Pharma-R-IN on December 31, 20x1
Measurement of the Fair Value of the Forward Contract Change in Net Investment
in Pharma-R-IN and Hedge Effectiveness
Impact of Embedded Derivatives on Reported Profits (The Case of Landsvirkjun)

271
273
277
279
283
315
326
327
348
414
425
431
440
448
468
471
542


PREFACE

Those of you who have read the standard on financial instruments and understood it have not read
it properly.
Sir David Tweedy, Former Chairman, International Accounting Standards Board
I think that given you are breaking new ground; you are putting forward thoughts and ideas for
debate.
Anonymous
Derivatives and hedging represent one of the more complex and nuanced topical areas within both
US GAAP and IFRS.
IFRS and US GAAP: similarities and differences. PwC October 2011

Starting in the early 1990s, concern about matters related to the economics of information, risk and
uncertainty in financial reporting has overtaken almost all the efforts devoted to financial reporting and the standard setting process. Awareness of these issues is not new, however. Informed
accountants and interested financial analysts have known all along that every number on the
balance sheet is an estimate from a distribution of values and no single number can adequately
describe an asset or a liability. The unprecedented development of complex financial instruments,
financial derivatives and complex contracts since early 2000 has brought this awareness to the
forefront. The resulting equally complex accounting rules have undoubtedly created a final resting
place for any view of accounting as a cut and dried subject matter.
Viewing the development in accounting, it is fair to note that accounting standards and
thought have come of age; analysis of contracts and exposure to risk has led to establishing a new
accounting model. After decades of debate and argumentation, accounting standard setters and
academics have come to agree that (a) reporting current values would be informative and that (b)
the elements of compound contracts should be sorted out and accounted for in accordance with
their economic substance.
This shift in focus and analysis is not the result of a master plan. It is, rather, an outcome of
intensive engagement by standard setters in responding to significant shifts in the sectors that run
the economic engine in our society; it is the financial sector accompanied by the astronomical
growth in the volume and transactions involving financial derivative instruments. Typically, the
historical cost of these derivatives is negligible, if any at all, but they create rights and obligations as
the conditions underlying their formation change. In this setting, only current value could describe
the rights and obligations of counterparties to a contract. These instruments have been growing
at an exponential rate since December 21, 2000 when Congress and the Clinton administration


xxiv

Preface

pre-empted the States’ anti-bucket shop laws1 following the 1999 repeal of critical terms of the 1933
Glass-Steagall Act, thereby allowing commercial banks to also undertake investment banking.2 Both
actions have handed banks and financial institutions a significant unguarded free playing field.
According to a survey by the International Swap Dealers Association (ISDA), the volume (notional
amounts) of trade in over-the-counter financial derivatives in 2011 has exceeded $540 trillion and,
according to the Bank for International Settlements, the notional (face) amount of over-the-counter
financial derivatives has grown from about $20 trillion in 2000 to over $638.9 trillion at the end of June
2012.3 Unfortunately for the public and public interest, all of these trades are carried out in “dark”
markets—no transparency of any kind and it has never been made clear how markets could operate efficiently without information! What does this mean for accountants? It signifies the absence
of observable prices creating the need to develop knowledge and expertise on how to estimate
the fair values of these derivatives for the purposes of preparing and auditing financial reports.4
Additionally, the structure of the contracts of these derivatives and their wide-spread use created
the need to develop a special set of accounting rules that are both new and alien—this is the new
accounting.
During the same period of time, claims were made regarding the flight of capital out of the
U.S. financial markets to the London Stock Exchange which reportedly had less arduous listing
and reporting requirements than the exchanges in the USA. Adding these developments to the
high rate of growth in global commerce has led both the U.S. Financial Accounting Standards
Board (FASB) and the International Accounting Standards Board (IASB) to recognize the necessity
of cooperation and collaboration for the development and convergence of accounting standards.
The efforts on both sides have led to very similar structures and content of Generally Accepted
Accounting Principles (GAAP) of the USA and international GAAP (IFRS for International Financial
Reporting Standards) with respect to accounting for financial instruments and hedging. Furthermore, contrary to folk tales, both systems are detailed, complex and approach accounting to contracts and transactions in an equally convoluted manner. Indeed, the assertion that one system is
more rule-based than the other does not appear to be founded in reality because, in my judgment,
both systems are essentially rule-based and laborious.
It is also worth noting that the thought processes of accounting standards, setters and regulators have come a long way over the past few decades. In the early 1970s, for example, the American
Institute of Certified Public Accountants (AICPA) objected to two research monographs authored
by Maurice Moonitz and Robert Sprouse (and published by the Research Division of the AICPA)
that had espoused the then new-on-the-scene views such as discounting long-term receivables and
reporting their present values. Thirty years later we find accounting standards and guidance aim
at incorporating the economic substance of complex transactions and making use of the necessary
economic tools such as option valuation models, Macaulay’s Duration, risk transfer and risk sharing
and judgment about what constitutes thin or broad (liquid) markets so as to decide on which path
to take in estimating fair values.
These developments have created a new accounting model that continues to be missed by
many financial accounting courses and textbooks. For example, typical financial reporting presentations never entertain the notion that the enterprise could earn or lose profits by trading on its
inventory while it is still in stock. It is true that we need to teach our students about inventory cost
flow assumptions, but when the value or cash flow related to inventory is hedged and the hedge
meets certain criteria, the book value of inventories may be written up or down in keeping with the
changes in market values. Furthermore, the new accounting considers management actions while
holding inventory: the management could hedge the funds that are forecasted to be collected


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