KW ch17 Derivatives.pptxVIP

C H A P T E R17INVESTMENTSIntermediate Accounting13th EditionKieso, Weygandt, and Warfield Defining DerivativesFinancial instruments that derive their value from values of other assets (e.g., stocks, bonds, or commodities). For example, the option (right) to buy a share of stock at a fixed price derives its value from the stock’s price. As this increases, the value of the option increases.Four different types of derivatives:Financial forwards Financial futures.Options.Swaps.Who Uses Derivatives, and Why?Producers and Consumers (forward contracts)Speculators and Arbitrageurs (futures and options)Corporations and Financial Institutions (swaps)LO 9 Explain who uses derivative and why.Basic Principles in Accounting for DerivativesRecognize derivatives in the financial statements as assets and liabilities.Report derivatives at fair value.Recognize gains and losses resulting from speculation in derivatives immediately in income.Report gains and losses resulting from hedge transactions differently, depending on the type of hedge.Example of Derivative Financial Instrument-SpeculationIllustration: Assume that a company purchases a call option contract from Baird Investment Co.,on January 2, 2010, when Laredo shares are trading at $100 per share. The contract gives it the option to purchase 1,000 shares (referred to as the notional amount) of Laredo stock at an option price of $100 per share. The option expires on April 30, 2010. The company purchases the call option for $400 and makes the following entry on January 2, 2010.Call Option 400 Cash 400Option PremiumExample of Derivative Financial Instrument-SpeculationThe option premium consists of two amounts.Illustration 17A-1Intrinsic value is the difference between the market price and the preset strike price at any point in time. It represents the amount realized by the option holder, if exercising the option immediately. On January 2, 2010, the intrinsic value is zero because the market price equals the preset strike