Investment Accounting: Hedges and Derivatives | Bisk CPA Review FAR

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Last Updated: May 2015

Disclaimer: Some of this FAR CPA Review content is outdated. Always use an updated CPA Review course when studying.



Welcome back in this CPA Review class, we're going to continue our discussion on how to account for a company's investments. And you know, in our last class we spoke about how to account for held to maturity, securities trading securities available for sale securities. Let's do a couple of problems in that area.

Number one says the following information pertains to smoke companies, investments in marketable equity securities. Classified as available for sale. So these are all available for sale securities on December 31 of the current year smoke has a security with a $70,000 cost and a $50,000 fair value at year-end.

No market adjustment account currently exists. A marketable equity security costing. 50,000 has a $60,000 fair value. December 31 of the current year smoke believes that the recovery from an earlier lower fair value is permanent, and I don't think that would throw you off. We do care if a decline in the market is permanent.

How can recovery be permanent? It really doesn't make a lot of sense. Does it? How could you say our recovery? Is permanent. You mean that investment could never go down again for the rest of eternity? That doesn't, that's really nonsense. Again, you would have to worry, as we said in our last class if a decline in the market is permanent, a company going bankrupt like Enron, that's a that is something you'd have to worry about, but saying a recovery is permanent is really nonsensical, so we're not worried about that.

What is the net effect? Of the above. Two items on the balances of smokes market adjustment account for available for sale securities at December 31 of the current year. Well, as you know, when they got to year-end, they use fair value accounting with avail for sale, but they don't adjust available for sale securities, security by security.

They do it in aggregate. So let's think about this. They have the first security costs 70,000 with a market of 50,000 the second security costs 50,000 with a market of 60,000 so what is the aggregate cost of. The available for sale securities, 70 plus 50 120,000 what is the aggregate market at year-end?

60 plus 50 110,000 so here's the point, because the aggregate cost is 120,000 the aggregate market's 110,000 what's the adjusting entry that we make at year-end? We're going to debit OCI 10,000 and we're going to credit market adjustment 10,000 so the answer is D. What this creates is a $10,000 credit balance in market adjustment cause that's the adjusting entry.

We would make it your rent. We would debit OCI 10,000 and we would credit market adjustment. 10,000 let's do a set. Let's do two and three. It says son had investments in equity securities classified as trading costing 650,000. On June 30th of the year, two sons decided to hold the investment indefinitely and reclassified the investment from trading to avail for sale on that date, the investment fair value was 575,000 December 31 year one at June 30th year two it was 530,004 to 90,000 December 31 year two.

So we know the market prices. The micro price of the investment was 575,000 December 31 year one 490,000 December 31 year two and on the day they transferred the investment to available for sale. June 30th's market price was 530,000 now let's go through this together. What would have, first of all, what would have happened at the end of year one, just back up a little bit here?

When they got to December 31 year one remember it was classified as trading. And trading is accounted for at fair value, and we adjust trading security by security. Remember, we do trading security by security, so let's just think it through. When they got to December 31 year one the cost of the trading securities was 650,000 the market price December 31 year one was 575,000 so what adjusting entry did they make?

Didn't they debit an unrealized holding loss? 75,000 and credit the investment. 75,000 in other words, at the end of year one, they would have literally written the trading securities from the cost 650,000 down to the market price. 575,000 they would have debited and unrealized holding loss. 75,000 and that loss would have gone to the income statement cause its trading.

And they would have credited the investment 75,000 so they would have literally written these investments down to the market price. December 31 year one 575,000. So they've written it down, down to market price. 575,000 now what happens on June 30th year two they transfer this investment from trading to avail for sale when the market price is 530,000 and that's why I wanted to get into this problem with you.

How do we handle transferring investments from one portfolio to another? Well, what you're dealing with here is a rule. It's not a difficult rule. But it's a rule you have to be aware of. Listen carefully when you transfer investment from one portfolio to another, I don't care what port portfolios are involved, anytime you transfer on investment from one portfolio to another on the day of the transfer, right?

That individual security to its fair market value. That's the rule on the day of the transfer. You always write that individual security to its fair market value because the effect they want, they always want security to enter its new portfolio at fair value. That is the effect that they want. They always want it security to go into its new portfolio at fair value.

So let's, let's just apply the rule. When they got to June 30th year two. The securities in the portfolio. Now at 575,000 if it was written to 575,000 but on the day of the transfer, the market price, June 30th was 530,000 so what would they, would they have done? They would have debited and unrealized holding loss, 45,000 see, their job would have been to bring that security from the carrying value 575,000 down to its fair value on the day of the transfer, 530,000 so they would have debited on unrealized holding loss.

45,000 credit, the investment 45,000 that way the investment goes into its new portfolio at its fair value, 530,000 so now we can answer question number two. What amount of loss from investments with some report, and it's the year to the income statement. What's on the year to income statement would be that 45,000 answer a and how do I know what's on the income statement?

Because trading's involved. Make sure it's clear in your notes that that's the adjusting entry I would make. If I'm transferring to or from trading, any time trading is involved, that's the entry I'd make. I would debit an unrealized holding loss. 45,000 credit. The investment, 45,000 that loss would go to the income statement.

That's why it's the answer because trading's involved. That is the entry I would make if I'm going to or from trading. I just want to show you every possibility. What if I'm going. What if I'm going from avail for sale to held to maturity? I'm the same problem. What if instead, we were going from available for sale to held to maturity or held to maturity to available for sale?

Well, if trading's not involved, the rule is the same. The rule doesn't change. I have to write the individual security to what's fair market value because they always want security to go to its new portfolio at fair value. So notice I would still credit. I would still credit the investment. 45,000 I have to write the security to its fair value.

I still have to write the security from 575,000 down to 530,000 so notice I would still credit the investment 45,000 but now I would debit OCI. So if trading's not involved, the rule is the same. But if I go held to maturity to available for sale or available for sale to held to maturity. I credit the investment for 45,000 but now I would debit OCI.

Now that unrealized loss wouldn't go to the income statement. Because trading is not involved, but here trading is involved and that's why the answer is a, and that's the main reason I wanted to do this problem with you, to talk about how you transfer investments from one portfolio to another. All right, now let's get to December 31 year to what happens at December 31 year two.

Well, now it's in the available for sale portfolio, and I do avail for sale in aggregate, of course. So when I got to December 31 year two I would look at the aggregate cost of. The available for sale securities, which will be now 530,000 once it's an aggregate market at year end 490,000 so what would I do?

I would debit OCI 40,000 and credit market adjustment, 40,000 doesn't that make sense? Because when I get to December 31 year two now it's is available for sale, which I do in aggregate. So I would look at the aggregate cost. Of my available for sale portfolio, which is the 530,000 but the aggregate market on December 31 year two is 490,000 so I would debit OCI 40,000 because now it's available for sale credit market adjustment, 40,000 so now we can answer question number three.

What amount with some report as unrealized loss from these investments in equity securities in OCI at the end of the year. To answer a, again, 40,000. Now we're going to continue our discussion of how to account for the company's investments by getting into derivatives and hedging activities. Let me give you a couple of definitions because mostly what this area is about is definitions.

What is a derivative? A derivative is an investment that derives its value. This is where the word comes from derivative because the investment derives its value from another security. Or another commodity. It's an investment that derives its value from another security or another commodity. For example, if you invest in foreign currency options, well that is a derivative investment because the total value that investment is derived from whether the Euro got more expensive today or cheaper today if you invest in grain futures, that is a derivative investment because of the total value that investment is derived.

From whether the price of wheat went up or down today. These are derivative investments. Now, something I want to mention cause this drives students crazy. Don't forget a derivative investment can be an asset or a liability. Now, why? Because with a derivative investment, if I'm in a gain position, clearly I'm in an asset position.

But with a derivative investment, if I'm in a loss position and it's big enough. It could be a liability position. So keep that in mind. Derivative investments can be assets or liabilities because again, with a derivative investment, if I'm in a gain position, clearly I'm in an asset position, but at them, if I'm in a lie, if I'm in a loss position and it's big enough, could be a liability position.

It is possible. Now, what's hedging? Hedging is a strategy. Hedging is a strategy where a company invests in a derivative for the purpose of counterbalancing a potential loss somewhere else. They're trying to counterbalance a potential loss in another security or another transaction. That's what hedging is.

You've heard the phrase hedging your bets. That's what hedging is. It's a strategy where a company invests in a derivative for the purpose. It's for the purpose of counterbalancing. A potential loss in another security or another transaction. In other words, you're hoping you make enough profit on this investment that will counterbalance a loss that you could incur somewhere else.

You're hedging your bets. Now let's get to the most important part of this. How do we account for derivatives and hedging activities? Now I'm going to start with how we account. For a derivative that's not being used as a hedge. So we're going to start with how we account for a derivative that's not being used as a hedge.

It's really very simple. If a company has a derivative investment that is not being used as a hedge, then that derivative will be on the company's balance sheet as either an asset or a liability. It'll be on the company's balance sheet. As either an asset or liability, and it's accounted for at fair market value.

It's fair value accounting. So if a company has a derivative investment that is not being used as a hedge, it's not being used as a hedge. It's a non-hedge derivative. It's going to be on the company's balance sheet as either an asset or a liability. It's a distinct asset or liability, and it's a pounded for at fair market value.

So you know what's coming. If I'm going to write a non-hedge derivative up to fair value will, then I would have an unrealized holding gain. If I'm going to write a non-hedge derivative down to fair value, we'll then I'm going to have an unrealized holding loss and you have to remember, and he unrealized holding gains or losses.

Any unrealized holding gains or losses from a non-hedge derivative belong on the income statement. These gains and losses are included in earning. Now let's talk about it. How you account for derivative that is being used as a hedge. Now listen carefully. How you account for a derivative that is being used as a hedge.

Depends on what kind of hedge that it is. There are two broad types of hedges. Here we go. The first type of hedge is called a fair value hedge. A fair value hedge. Is a hedge against potential losses from the change in the fair market value of something. Again, a fair value hedge is a hedge against potential losses.

That's what they all are. It's a hedge against potential losses from the change in the fair market value of an asset or liability. You're hedging against potential losses from the change in the fair market value of an asset or liability. Now, once you know what a fair value had is, how do you account for it?

Well, a fair value hedge. Will be on the company's balance sheet as either an asset or a liability. And yes, it is accounted for at fair market value. So once again, what's being required here is fair value accounting. So again, a fair value hedge will be on the company's balance sheet as either an asset or a liability.

And yes, it is accounted for at fair value. So you know what's coming up. If I'm going to use fair value accounting, I'm going to have unrealized holding gains and losses and let me say it, and he unrealized holding gains or losses from a fair value hedge belong on the income statement. These gains and losses are included in earnings, and if you're really listening to me, and I know you are.

What you've noticed is that a fair value hedge is accounted for exactly the same way. We account for a derivative that's not being used as a hedge. It's identical. You're going to account for fair value hedge exactly the same way you account for a derivative that's not being used as a hedge at all. Now let's talk about a cash flow hedge.

Now, what is a cash flow hedge? A cash flow hedge is a hedge against potential losses. It is a hedge against potential losses. In the future, cash flows from an asset or a liability. Again, a cash flow hedge is a hedge against potential losses from the future. Cash flows from an asset or a liability. That's a cash flow hedge.

Now, once again, once you know what it is, how do we account for it? Well, a cash flow hedge will be on the company's balance sheet. As either an asset or a liability. And yes, a cash flow hedge is accounted for at fair market value. So we need to say that a cash flow hedge will be on the company's balance sheet as either an asset or a liability.

It is accounted for at fair value. So once again, what is required here is fair value accounting. So you know what? We have to deal with. Unrealized holding gains and losses. Now listen carefully. How you account for the unrealized holding gains and losses from a cash flow hedge depends on whether the hedge is effective or not.

I'll say it again. This is really the only tricky part of this because how do we account, how do we account for the unrealized holding gains and losses from a cash flow hedge? Depends on whether the hedge is effective or not. Now, if you have an effective cash flow hedge, and I think you know what that means.

What is an effective cash flow hedge? I'm making a profit from this investment that counterbalances, counterbalancing, and loss somewhere else. That's an effective cash flow hedge. I have an effective cash flow hedge if I'm making a profit on this investment that is counter balancing a loss somewhere else.

If you have an effective cash flow hedge, that gain does not go to the income statement. That gain goes directly to stockholder's equity as an item of other comprehensive income. It's an item of OCI. If you have an effective cash flow hedge, that game does not go to the income statement. That game goes directly to stockholder's equity as an item of OCI.

Now what if it's ineffective? How could a cash flow hedge be ineffective? What if it drops in value. What if you take a bath on this investment? Who said it had to be effective? If you have an ineffective cash flow hedge, that if it drops in value, that loss goes directly to the income statement. If you have an ineffective cashflow hedge, that loss would go directly to the income statement.

Now let's do a couple of entries. Want to illustrate what we've just said. Let's say a company has an investment in a. All right. And let's say it is a cash flow hedge. So a company has an investment in egg, it is a cash flow hedge, and let's say it is effective. Well, if investment in a is a cash flow hedge and it is effective, is it rising or falling in value?

It's rising. So you're going to debit investment in a, you're going to write it up to fair value. And what are your credit OCI? It makes sense. It's an effective cash flow hedge. It's rising in value, so you're going to debit investment in a, you're going to write it up to fair value and you're going to credit OCI.

Now, here's what's a little tricky when the loss that you were hedging against finally gets on the income statement again, when the loss that you were trying to counterbalance when the loss that you were hedging against finally does get on the income statement, that could be two years from now, then you would debit OCI.

Take that gain out of stockholder's equity and credit gain on derivatives, you'd credit an income statement account gain on derivatives because the effect they're trying to have here is that on your income statement, you're going to show the loss and how you counterbalanced it. That's what we're trying to do here.

So again, later when the loss that you were hedging against finally gets on the income statement, and as I say, that could be, you know, three years from now, then you'll debit OCI. Take that gain out of stockholder's equity and credit gain on derivatives. That way on your income statement, you can show the loss and how you counterbalanced it.

Now, let's say the company also has an investment in B. It is also a cash flow hedge, but let's say it's ineffective. If a company also has an investment in B to cash flow hedge, it's ineffective. It's dropping in value. You would simply debit loss on investments, loss on derivatives, take it to take the loss right to the income statement, and credit investment in B.

Write it down for fair value. If you have an ineffective cash flow hedge, that loss goes directly to the income statement and you write the security down to fair value. Now, also in the area of derivatives and hedging activities, you get into the foreign currency. Derivatives. So what you'll want to watch out for these, if the exam mentions a foreign currency-denominated from commitment hedge, again, you gotta be careful if the CPA Exam were to mention a foreign currency denominated, in other words, it's nominated, it's the nominated in a foreign currency.

If the exam mentions a foreign currency-denominated from a commitment hedge or a. Foreign currency-denominated available for sale securities hedge. So either one of those, either a foreign currency-denominated from commitment hedge or foreign currency-denominated available for sale securities hedge.

Those you treat those as fair value hedges. Just remember they are fair value hedges, so just go right back to my notes on fair value hedges. We don't, we won't go through them again, but though, just so you know what, they are a foreign currency-denominated from commitment hedge or foreign currency-denominated avail Fidel securities hedge, either one of those.

Those are, those are fair value hedges. Just account for them as fair value hedges. Now if on the other hand, they mentioned a foreign currency denominated forecasted transaction hedge, I think you'd get it anyway. Because now you're talking about cash. If they mentioned the foreign currency denominated forecasted transaction hedge or foreign currency denominated net investment in foreign operations hedge, again, I think you'd get it sounds like cash.

Either a foreign currency denominated forecasted transaction hedge or foreign currency denominated net investment in foreign operations hedge. Those are cash flow hedges. So you just go right back to my notes on cash flow hedges because those are treated of course as cash flow hedges because they are cash flow hedges.

So make sure you go over these definitions and how to account for derivatives and hedging activities. And I will look to see you in the next class. Keep studying.


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