Accounting for Derivatives
Financial derivatives are contracts whose value is derived from the performance of an underlying asset, index, rate, or other financial instruments. Major kinds of derivatives include futures, i.e., contracts to buy or sell an asset at a predetermined future date and price that are standardized and traded on exchanges; options which are contracts that give the holder the right, but not the obligation, to buy or sell an asset at a specific price on or before a certain date; swaps that are agreements to exchange cash flows or other financial instruments between two parties; forward contracts that are customized agreements between two parties to buy or sell an asset at a specified future date for a price agreed upon today; credit default swaps are insurance-like contracts where the buyer pays a premium to the seller in exchange for compensation if a specified credit event (such as a default) occurs; and currency swaps, which are agreements to exchange principal and interest payments in different currencies.
[Derivatives Explained in One Minute: https://youtu.be/gCHiLLgO55o]
Derivatives are used for a variety of purposes, including hedging risk, speculating on price movements, and gaining access to otherwise hard-to-trade assets or markets. They are used to hedge against the risk of price changes in commodities, raw materials, stocks, or currencies or as a defence against the risk of fluctuating interest rates on loans or investments. They can be used to speculate for profit based on the movement of an asset’s price or to gain exposure to an asset’s price movement with a smaller initial investment. As a tool to manage liquidity that is to say to manage cash flows more efficiently, particularly when immediate cash is tied up in other areas of the business or, as hinted before, to gain exposure to markets or assets that may be difficult or expensive to access directly. As a means to manage foreign exchange, derivatives can be used to manage risks associated with changes in exchange rates for businesses dealing in multiple currencies or to hedge against fluctuations in currency values that could impact the cost of imports or the value of exports. As a tool to manage interest rates swaps between fixed and variable interest rates depending on their preferences and market conditions and to manage the interest rate exposure of existing or planned debt. Other uses include meeting regulatory requirements and internal compliance strategies, as well as part of strategic business decisions.
Role of the Accountant
In a small business, an accountant plays a crucial role in managing and accounting for derivatives. He/she must identify them and classify all the derivative instruments the business is involved in, such as options, futures, forward contracts, and swaps. He has to value and record the derivatives which involve determining the fair value (the price at which the option can reasonably be expected to trade in the market, a value influenced by several factors, its intrinsic value (the difference between the option strike price and the value of the underlying asset) and extrinsic value (determined by the option’s time to expiration, underlying asset volatility, interest rates, and expected dividend payments for stocks.)) of derivatives using market data and appropriate valuation techniques and accurately record derivatives as assets or liabilities on the balance sheet based on fair value.
His duties include hedge accounting requiring him to prepare and maintain documentation specifying hedging relationships, risk management objectives, and strategies, and regularly testing and documenting the effectiveness of hedges to ensure their qualification for hedge accounting treatment.
As usual, financial reporting is a facet of the responsibilities of the accountant, and he must treat derivatives in the same manner. He must record realized and unrealized gains or losses from derivatives in the income statement and include detailed disclosures in the financial statements about the nature and extent of derivatives, the risks they pose, and how those risks are managed.
The accountant must ensure that the firm remains compliant and follows regulations. Particularly he must ensure that their option portfolio is compliant with International Financial Reporting Standards (IFRS 9) or Accounting Standards Codification (ASC 815,) a standard, part of the US GAAP, and prepare any necessary regulatory reports related to derivatives.
The accountant must engage in risk management, i.e., he must assess the risks associated with derivatives, including market, credit, and liquidity risks, and implement and maintain internal controls to monitor and manage derivative activities effectively.
Finally, the accountant must have a communication plan that enables him to inform management, investors, and other stakeholders about the financial impact and risks of derivatives. He must advise on strategic decisions involving derivatives, such as hedging strategies or speculative investments.
Tools & Techniques
Accountants have a variety of tools and techniques at their disposal to effectively account for derivatives. Firstly, they have valuation models which include the Black-Scholes Model used for pricing options, this model helps in determining the fair value of options based on factors like the underlying asset’s price, strike price, volatility, and time to expiration. The Binomial Tree Model is used for valuing options and other derivatives by simulating different possible paths the price of the underlying asset can take over time. And, Monte Carlo Simulation is a technique used to model the probability of different outcomes in a process that cannot easily be predicted due to the intervention of random variables.
There are software solutions for accounting for derivatives for example Enterprise Resource Planning (ERP) systems, like SAP, often have modules specifically designed for financial instruments and derivatives, helping in recording, valuing, and reporting derivatives. But there is software solutions specifically designed for derivatives accounting, such as hedge management systems focused on the operational aspects of hedging and hedge accounting tools specifically designed to handle the accounting and financial reporting of hedging activities, which can handle complex calculations and ensure compliance with accounting standards.
There are risk management tools that help in assessing and managing risks associated with derivatives, including market risk, credit risk, and liquidity risk; and scenario analysis tools that allow accountants to perform scenario analysis to understand the potential impact of different market conditions on the value of derivatives.
Now, not least, there are compliant management systems that help in ensuring that the accounting for derivatives complies with relevant regulations and standards, such as IFRS 9 or ASC 815.
[The Easiest Way to Derive the Black-Scholes Model: https://youtu.be/NHvQ5CSSgw0]
Regulations And Regulatory Institutions
For small businesses, the accounting for derivatives is primarily governed by the International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP). IFRS 9 covers the recognition, measurement, presentation, and disclosure of financial instruments, including derivatives. It applies to all entities, including small businesses, and provides guidance on hedge accounting and the classification of financial assets and liabilities. Accounting Standards Codification (ASC 815) for derivatives and hedging, part of the US GAAP, provides detailed guidance on accounting for derivatives and hedging activities. It includes requirements for recognizing and measuring derivatives, as well as hedge accounting rules.
[ASC 815: Introduction to Hedge Accounting: https://youtu.be/LpB5FnnwPKI]
Records on Financial Statements
Accounting for derivatives can be complex due to their nature and the various ways they can impact a company’s financial position and performance.
Realized gains or losses from the settlement of derivative contracts and unrealized gains or losses, i.e., changes in the fair value of derivatives that are not settled by the end of the reporting period are also recorded on the income statement.
Derivatives are reported as either assets or liabilities, depending on their fair value at the balance sheet date. Derivatives with a positive fair value are assets, while those with a negative fair value are liabilities. If a derivative qualifies for hedge accounting, it affects how changes in its fair value are recorded. For example, in a cash flow hedge, the effective portion of gains or losses is reported in other comprehensive income (OCI,) presented in the equity section of the balance sheet, rather than net income.
Cash flows related to derivatives used for hedging operating activities are included in operating, investing, and financing activities on cash flow statements.
Conclusion
Financial derivatives are contracts whose value is derived from the performance of an underlying asset, index, rate, or other financial instruments. Major types of derivatives include futures, options, swaps, forward contracts, and credit default swaps. These instruments can be complex and carry significant risks, making it essential to fully understand them and their implications before engaging in any transactions.
While trading in derivatives can offer substantial benefits, it is equally important to acknowledge the inherent risks and complexities. Small businesses should seek appropriate advice and ensure they have the necessary expertise and systems in place to manage these instruments effectively.
Accountants in small businesses often wear multiple hats, and these responsibilities may be shared with other financial roles or advisors. However, their expertise and diligence in derivative accounting are crucial for the business’s financial health and compliance. Accountants must identify and classify all the derivative instruments the business is involved in, such as options, futures, forward contracts, and swaps. Their duties also include hedge accounting, financial reporting, compliance, risk management, and communication.
To support their responsibilities, accountants have various tools and techniques at their disposal to effectively account for derivatives. These tools enable accountants to accurately value, record, and report derivatives, ensuring transparency and compliance with accounting standards.
For small businesses, the accounting for derivatives is primarily governed by the International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP). Remember, accounting specifics can vary based on the type of derivative and the company’s accounting policies.
Other Resources
Derivatives
Financial Derivatives Explained: https://youtu.be/nf9ByTdX0aY
Derivatives and Hedging: https://kpmg.com/us/en/frv/reference-library/2023/handbook-derivatives-hedging-accounting.html
Derivatives and Hedging Handbook: https://kpmg.com/kpmg-us/content/dam/kpmg/frv/pdf/2023/handbook-derivatives-hedging-accounting-2.pdf
Accounting for Derivatives
A Guide to Accounting for Derivatives: https://rsmus.com/insights/financial-reporting/a-guide-to-accounting-for-derivatives.html
A Guide to Accounting for Derivatives: https://rsmus.com/content/dam/rsm/insights/financial-reporting/1pdf/a-guide-to-accounting-for-derivatives.inline.pdf
ASC 815: Introduction to Hedge Accounting: https://youtu.be/LpB5FnnwPKI
The Accounting Standards Codification (ASC) U.S. GAAP: https://youtu.be/VIONQVhIEa8
International Financial Reporting Standard for Small and Medium-sized Entities (IFRS for SMEs): https://www.ifrs.org/content/dam/ifrs/publications/ifrs-for-smes/english/2015/ifrs-for-smes-standard-part-a.pdf?bypass=on
Financial Instruments: Overview of IFRS 9: https://youtu.be/GKqWIMYig0s
IFRS 9 Financial Instruments summary – still applies in 2024: https://youtu.be/qFOyyP_po3I
FASB Investor Podcast: Hedging: https://youtu.be/smBQmapQFRg?list=PLzlPBq5-q5kifB4gh_nEwxCVQPVVzY1f0
Basics of Hedge Accounting: https://youtu.be/u6WLTDYfTjA
Valuation Models
Black Scholes Explained – A Mathematical Breakdown: https://youtu.be/EEM2YBzH-2U
The Black-Scholes Model: https://www.columbia.edu/~mh2078/FoundationsFE/BlackScholes.pdf
Black Scholes Model: https://www.wallstreetmojo.com/black-scholes-model/
One-Step Binomial Tree made EASY: https://youtu.be/be3eAn0kZ4g?list=PLWOwTjItERc7lFHz0ERMWsZLvTdjsJlk4
CFA Level I Derivatives – Binomial Model for Pricing Options: https://youtu.be/JeY4Bq1F-8Q
Binomial Tree: Overview, Examples, and Formulas: https://www.investopedia.com/terms/b/binomial_tree.asp
What is Monte Carlo Simulation? https://youtu.be/7TqhmX92P6U
What is Monte Carlo Simulation? https://www.ibm.com/topics/monte-carlo-simulation
Monte Carlo Simulation: https://corporatefinanceinstitute.com/resources/financial-modeling/monte-carlo-simulation/
Options
Put Options Explained: Options Trading For Beginners: https://youtu.be/tlcCPX4t9y0
Call Options Explained: Options Trading For Beginners: https://youtu.be/kC28MuQPyu8
Futures Contracts
Introduction To Futures Trading (Beginners Guide): https://youtu.be/lcBNWiCn1Uo
FULL Futures Trading Guide for Beginners in 10 Minutes: https://youtu.be/l6CaHkTARx4
Forward Contracts
Forward Contracts Explained in 3 Minutes! https://youtu.be/KbtjRtbdlhU
CFA Level I Derivatives – Forward Contracts vs Futures Contracts: https://youtu.be/423QLJo2-Jo
Swaps
How swaps work – the basics: https://youtu.be/-aXRZ6xN3bk
Currency Swaps: https://youtu.be/MPQMm8JxpDE
Interest Rate Swaps Explained | Example Calculation: https://youtu.be/DrlKjSG1V6s
Credit Default Swaps (CDS): https://youtu.be/QTXn_FRRcnI
Credit default swaps illustrated with toys: https://youtu.be/uoF6c2BFAXo
Crypto Hedges
Bitcoin Options: Overview & TOP Trading Tips: https://youtu.be/yDXB1jafqg4
Learn How To Trade Crypto Options In 4 MINUTES! https://youtu.be/N13qWwvL89E
