January 3, 2011
Financial Risk Management
IMPLEMENTING A RISK MANAGEMENT
Accounting and Disclosure of Risk Management Activity
In this unit, we focus on two issues:
how derivatives are accounted for on financial
statements and how derivatives are disclosed on financial statements.
These are separate
but related issues.
An excellent source, which was used extensively in developing these notes, is
Management, Derivatives, and Financial Analysis Under SFAS No.133
by Gary L.
Gastineau, Donald J. Smith, and Rebecca Todd. Charlottesville, Virginia:
Foundation of AIMR and the Blackwell Series in Finance (2001).
This monograph is not
assigned but is highly recommended if you wish to obtain further details.
For the most
details, however, you should examine the authoritative document,
for Derivative Instruments and Hedging Activities
, which was released in 1998 and is
available at www.fasb.org.
Until the year 2000, derivatives accounting has, with a few exceptions, not been well-
covered in professional accounting guidelines.
Most firms tried to use
as much as possible.
A hedge is a combination of transactions in which the gains or
losses on one transaction offset, wholly or partially, the gains or losses on another.
Usually this involves a transaction in an asset in the spot market that is being hedged by a
transaction in a derivative. Hedge accounting is a method of accounting for derivatives
such that the gains and losses of the derivative do not significantly affect income.
Formerly, hedge accounting resulted in not accounting for the derivative until the hedge
When the hedge is terminated, the gain or loss on the derivative is accounted
for by combining it with the accounting for the transaction that is being hedged.
new accounting rules, hedge accounting means that the gains and losses on the derivative
are accounted for during the hedge but in such a manner that a hedge that works
reasonably well will not have a harmful effect on reported income.
Here is an example of a hedge that we will examine.
A company is engaged in the business of buying gold from mining
companies and selling it to jewelry manufacturers.
It holds gold in its
It hedges the risk of the holding of gold by selling forward
contracts on gold.
Suppose on January 15, it buys 10,000 ounces of gold
that it anticipates it will sell on May 15.
The gold costs $388/oz.
forward contracts at a price of $392/oz.
On March 31, its quarter ends and
it is required to publish its financial statements.
On May 15, the forward
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D. M. Chance, LSU