ACCT 352 - CHAPT 16 - COMPLEX FINANCIAL INSTRUMENTS
Financial instruments are contracts that create both a financial asset for one party and a financial
liability or equity instrument for the other party. Financial instruments can be primary or derivatives.
Primary financial instruments include most basic financial assets and financial liabilities such as
receivables and payables, as well as equity instruments such as shares.
Derivatives instruments, are more complex. They are called derivatives because they derive (get)
their value from an underlying primary instrument, index, or non financial item, such a commodity
(called the "underlying").
Derivatives are defined by the accounting standards as financial instruments that create rights and
obligations that have the effect of transferring, between parties to the instrument, one or more of
the financial risks that are inherent in an underlying primary instrument. They transfer risk that are
inherent in the underlying primary instrument without either party having to hold any investment
in the underlying.
They have three characteristics:
their value changes in response to the underlying instrument (the "underlying").
they require little or no initial investment
they are settled at a future date.
As a basic rule, derivatives are measure at fair value with hains and losses booked through net
Understanding Derivatives: Managing Risks
Derivatives exist to help companies manage risks.
There are different layers of cost relating to the use of derivatives. Three categories of costs are as
- Direct Costs: transaction costs like bank service charges, brokerage fees and insurance premiums.
Charged by an intermediary directly related to the derivative.
- Indirect Costs: activity of researching, analyzing and executing these transactions uses a significant
amount of employee time.
- Hidden or opportunity costs
Some of the financial risks that managers try to manage through derivatives are:
o Credit risk: risk that one party to a financial instrument will cause a financial loss for
the other party by failing to discharge (respect) its obligation.
o Liquidity risk: risk that an entity will have difficulty meeting obligations that are
associated with financial liabilities. Own risk of not meeting financial obligations.
o Market risk: risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market prices. There are three types of market risk:
currency risk, interest rate risk, and other price risk.
Currency risk: risk that the FV or future cash flows of a financial instrument
will fluctuate because of changes in foreign exchange rates.
Interest rate risk: risk that FV or future cash flows of a financial instrument
will fluctuate because of changes in market interest rates.
Other price risk: the risk that the fair value of future cash flows of a financial
instrument will fluctuate because of changes in market price (other than
price changes arising from interest rate risk or currency risk), whether those
changes are caused by factors that are specific to the individual financial
instrument or its issuer, or factors that affect all similar financial instruments
being traded in the market. ACCT 352 - CHAPT 16 - COMPLEX FINANCIAL INSTRUMENTS
Recognition and measurement of derivatives
The basic principles regarding accounting for derivatives are as follows:
Recognition and Measurement of
Basic principles of accounting for derivatives:
1. Financial instruments (including financial derivatives)
and certain non -financial derivatives that meet
definitions of assets or liabilities should be reported in
financial statements when entity becomes party to the
2. Derivatives should be reported at fair value (most
3. Gains and losses should be recorded through net
Special accounting is used for items that have been
designated as being part of a hedging relationship
o Non-Financial derivatives and executory contracts.
Accounting for purchase commitments:
o Options and Warrants
Options and warrants are derivative instruments. An option or warrant gives the holder the
contractual right to acquire or sell an underlying instrument at a fixed price (the exercise or strike
price - the agreed upon price at which the option may be settled) with a defined time (exercise
period). Good example is to buy shares of a company at a fixed price on a specified date. TheACCT 352 - CHAPT 16 - COMPLEX FINANCIAL INSTRUMENTS
underlying is the shares (i.e. this option derives its value from the share price of the underlying
The holder has the right to exercise the option but is not obliged to buy the sahres at the exercise
If a company purchases an option, it will pay a fee or premium to gain a right to do something. If a
company writes an option, it charges a fee or premium and gives the holder/purchaser the right to
do something. The rights in question may be either of the following:
- a right to buy the underlying (a call option)
- a right to sell the underlying (a put option)
Accounting for Derivatives
January 2 (acquisition date)
Derivatives Financial Assets 400
March 31 (to record change in value of option)
Derivatives Financial Assets 19,700*
Assume options are trading at $20,100