IAR1.0117 Derivatives-Hedging-Instruments STUDENTS-copy.pdf...

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INTERMEDIATE ACCOUNTING 1
IAR1.0117-Accounting for Derivatives and Hedging Instruments
LECTURE NOTES
Nature of Derivative
A derivative is a financial instrument or other contract within the scope of PAS 39
with all three of the following characteristics:
a) its value changes in response to the change in a specified interest rate, financial
instrument price, commodity price, foreign exchange rate, index of prices or
rates, credit rating or credit index, or other variable, provided in the case of a
non-financial variable that the variable is not specific to a party to the contract
(sometimes called the ‘underlying’);
b) it requires no initial net investment or an initial net investment that is smaller
than would be required for other types of contracts that would be expected to
have a similar response to changes in market factors; and
c) it is settled at a future date.
Examples of Derivatives
Interest Rate Swaps : Contracts to exchange cash flows as of a specified date or a
series of specified dates based on a notional amount and fixed and floating rates.
Forwards : Contracts to purchase or sell a specific quantity of a financial instrument,
a commodity, or a foreign currency at a specified price determined at the outset,
with delivery or settlement at a specified future date. Settlement is at maturity by
actual delivery of the item specified in the contract, or by a net cash settlement.
The party that buys the underlying asset in the contract is said to have a long
position and the party that sells has a short position .
Futures : Contracts similar to forwards but with the following differences: Futures
are generic exchange-traded, whereas forwards are individually tailored. Futures
are generally settled through an offsetting (reversing) trade, whereas forwards are
generally settled by delivery of the underlying item or cash settlement.
Options : Contracts that give the purchaser the right, but not the obligation, to buy
(call option) or sell (put option) a specified quantity of a particular financial
instrument, commodity, or foreign currency, at a specified price (strike price),
during or at a specified period of time. These can be individually written or
exchange-traded. The purchaser of the option pays the seller (writer) of the option
a fee (premium) to compensate the seller for the risk of payments under the option.
Caps and Floors : These are contracts sometimes referred to as interest rate
options. An interest rate cap will compensate the purchaser of the cap if interest
rates rise above a predetermined rate (strike rate) while an interest rate floor will
compensate the purchaser if rates fall below a predetermined rate.

PRISM CPA REVIEW
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Recognition of Derivatives
Derivatives are recognized when, and only when, the entity becomes a party to the
contractual provisions of the instrument .