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ACCT 352 - CHAPT 16 - NOTES.pdf

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McGill University
ACCT 352
Ralph Cecere

ACCT 352 - CHAPT 16 - COMPLEX FINANCIAL INSTRUMENTS Derivatives. 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 income. 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 follows: - 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 Derivatives 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 contract 2. Derivatives should be reported at fair value (most relevant) 3. Gains and losses should be recorded through net income Special accounting is used for items that have been designated as being part of a hedging relationship 9 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 shares). The holder has the right to exercise the option but is not obliged to buy the sahres at the exercise price. 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 Cash 400 March 31 (to record change in value of option) Derivatives Financial Assets 19,700* Gain 19,700 Assume options are trading at $20,100 *(20,
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