FRM Notes 2011 Unit IVA Accounting and Disclosure of Risk Management Activity

FRM Notes 2011 Unit IVA Accounting and Disclosure of Risk Management Activity

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Version: January 3, 2011 Fin 7400: Financial Risk Management IV. IMPLEMENTING A RISK MANAGEMENT PROGRAM A. 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. Derivatives Accounting Note: An excellent source, which was used extensively in developing these notes, is Risk Management, Derivatives, and Financial Analysis Under SFAS No.133 by Gary L. Gastineau, Donald J. Smith, and Rebecca Todd. Charlottesville, Virginia: The Research 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, FAS 133: Accounting 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 hedge accounting 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 was over. 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. Under 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 inventory. 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. It sells 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 Unit IVA Page 1 of 11 D. M. Chance, LSU
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Version: January 3, 2011 Fin 7400: Financial Risk Management contract expires and it delivers the gold, receiving a price of $392. At that time, the spot price of gold is $385/oz. There are two key questions:
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This note was uploaded on 02/28/2012 for the course FIN 7400 taught by Professor Donchance during the Fall '11 term at LSU.

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FRM Notes 2011 Unit IVA Accounting and Disclosure of Risk Management Activity

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