Module 001 Accounting For Liabilities-Current Part 4

FINANCIAL ACCOUNTING & REPORTING 2
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Accounting for Liabilities – Current Liabilities
Module 001 Accounting for liabilities-Current

Liabilities (Part 4)
Understanding derivatives starts with understanding one simple concept:

risk. If you buy everyday products, own property, run a business or manage
money for investors, risk is all around you every day. For some, risk stands
between them and progress. For others, risk represents an opportunity to
invest. If you’ve bought or sold a home, a car or shares of stock, you know
that there is always a risk that the price of what you buy or sell today could
shift depending on market movement. Derivative financial instruments are
recorded at fair value as either assets or liabilities on the balance sheet.
At the end of this module, you will be able to:
1. Explain the definition of a derivative and when the definition is met
2. Know the reasons for using derivatives
3. Identify common types of derivatives
4. Know the accounting rules pertaining to derivatives
Derivatives
Basic Financial Concepts
Recognized common financial product terminology and how these terms are applied
Long position vs. Short position
Long position
 An asset that is purchased with the anticipation that it will appreciate in
value.
 Expectation that underlying asset will increase in price
 Asset cost= purchase price x quantity
 Example: A purchase of a security with outright ownership
Short position
 Sale of a security that is not owned by the seller, or that the seller has
borrowed. This is the liability negative position on the market
 Borrowing or selling a security with intentions to buy back at a future date
and return the security to the lending party
 Expecting the underlying asset to decrease in price
 Liability= current price x quantity
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 Proceeds= selling price x quantity
An exchange is an organized market where buyers and sellers meet to trade
securities. Exchanges help to regulate the type of securities purchased and sold. This
concept is especially important in regard to a listed security and an over-the-
counter (OTC) security. A listed security can be traded through the exchange while
an OTC security is not traded through the exchange. Common example is the New
York Stock Exchange, which is a formalized regulatory organization.
Examples of securities that are exchanged traded or OTC
Exchange traded:
 Equities
 Options
 Futures
OTC:
 Options
 Forward
 Swaps
 Debt instruments
 Debt and equity placements
 Repurchase agreements
Exchange traded securities characteristics
 Standardized contracts
 Regulated by such associations such as the securities exchange
commissions, National Futures Associations and the Commodity Futures
Trading Commission
 Open to all investors
 Subject to registration requirements
 Considered interchangeable
OTC Traded securities characteristics
 Non-standardized and can be customized or tailored
 Traded outside of exchanges
 Traded in unregulated or ‘self’ regulated markets as:
- Inter-bank markets
- Negotiated contracts between counterparties/dealers
- Private placements
Trade date and settlement date are two important points in time when trading
securities.
Trade date is the date of a contractual obligation to buy or sell a security.
Settlement date is the date that cash transfers to settle a buy or sell transaction-the
actual da on which the transfer of cash or assets is completed.
A broker is a firm or an agent that purchases or sells securities on behalf of another.
Brokers may also provide a series of different services to their clients.
When buyers and sellers consider selling price or purchasing securities, there are
three pricing terms that apply.
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Bid price is the price that buyers are willing to pay for a particular financial
instrument
Mid price is the price between the bid and ask price. When parties agree to the mid
price there typically is a trade.
Ask price is the price that sellers are willing to sell a particular financial instrument.
A derivative instrument (type of financial instrument) is a contract whose value is

based on the performance of an underlying financial asset, index or other
investment. (Baron’s Dictionary of finance and investment terms)
A derivative is defined as a financial instrument or other contract within the scope

of IAS 39 if it has 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.
The term “underlying” is used in derivatives trading. A derivative is a financial

instrument whose price is based on or derived from another asset. The underlying
asset is the financial instrument from which a derivative’s price is based. Common
underlying instruments include bonds, commodities, currencies, interest rates,
market indexes and stocks.
Examples of underlying and notional amount:
Derivative Underlying Notional

Foreign currency forward Exchange rate Number of currency units
Interest rate swap Interest index Stated reference amount
Currency swap Exchange rate Specified currency amount
Interest rate cap Interest index Stated reference amount
Commodity future Commodity price Number of commodity units
Stock option Stock price Number of shares
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Reasons for using derivative
There are several different kinds of derivatives that have a variety of functions and
applications based on the particular type of derivative. As often is in the case in
trading, the more risk that is assumed, the more rewards that stand to be gained.
Derivatives can be used on both sides of the equation, to either reduce risk or
assume risk with the possibility of commensurate reward.
 Speculation is the assumption of risk in hopes of achieving gains. It is the act

of trading an asset that may have a significant risk of losing money and
hoping a profit from fluctuations in the market. With speculation, the risk of
loss is offset by the possibility of a huge gain.
 Hedging is an investment technique used to offset a potential loss on one
investment by purchasing a second investment with the expectations that it
will perform in the opposite way. Simply put, a hedge is used to reduce any
substantial losses or gains suffered by an investor. This strategy offsets a
given risk such as interest rate or foreign currency. A perfect hedge is one
that eliminates the possibility of a future gain or loss. Hedging is often used
as a risk management tool.
 Arbitrage is the attempt to profit from the differences (including
inefficiencies) between different markets. It is basically buying in one
market and simultaneously selling in another to profit from the temporary
difference. This type of trade profits by exploiting price differences of
identical or similar financial instruments on different markets.
 Leverage is obtaining economic exposure to securities or markets through
the use of borrowed funds with the hope that the income from the asset or
asset price appreciation will be more than the cost of borrowing.
Common derivatives
1. Future contracts
A contract to purchase or sell a specified commodity at some future date at a
specified price. These are traded in a future exchange market in much the same
manner as debt and equity securities being traded in the stock market.
2. Forward contracts
An agreement between two parties to exchange a specified amount of
commodity, security or foreign currency on a specified date in the future at a
specified price or exchange rate.
3. Options
A contract that gives the holder the right to purchase or sell an asset at specified
price during a definite period at some future time.
There are two options, namely call options on the part of the buyer, and put
option on the part of seller. A call option gives the holder the right to purchase
an asset, and a put option gives the right to sell an asset.
4. Swaps
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A derivative contract through which two parties exchange financial instruments.

These instruments can be almost anything, but most swaps involve cash flows
based on a notional principal amount that both parties agree to.
5. Warrants
Derivative that confers the right, but not the obligation, to buy or sell a security –
normally an equity – at a certain price before expiration. The price at which the
underlying security can be bought or sold is referred to as the exercise price or
strike price.
References and Supplementary Materials

Books and Journals
1. Valix, C. T., Peralta, J. F., & Valix, C. M. (2017). Financial Accounting (2017 ed., Vol. 2).
Manila, Philippines: GIC Enterprises & Co., Inc.
2. Cabrera, M. B., & Ocampo, R. R. (n.d.). Financial Accounting & Reporting - Standards &
Application (2014-2015 ed., Vol. 2). Manila, Philippines: GIC Enterprises & Co., Inc.
3. IAS 39 - Financial Instruments: Recognition and Measurement
Online Supplementary Reading Materials
1. Classifying and measuring financial instruments;
https://www.grantthornton.global/globalassets/1.-member-
firms/global/insights/article-pdfs/ifrs/gti-get-ready-ifrs-9-issue-1-classifying-and-
measuring-financial-instruments-upd.pdf; October 20, 2017
2. IFRS 9 Financial Instruments; http://www.ifrs.org/issued-standards/list-of-
standards/ifrs-9-financial-instruments/; October 20, 2017
3. Options, swaps, futures, MBSs, CDOs, and other derivatives;
https://www.khanacademy.org/economics-finance-domain/core-finance/derivative-
securities; October 20, 2017
4. OPTIONS, FUTURES, AND OTHER DERIVATIVES; http://polymer.bu.edu/hes/rp-
hull12.pdf; October 20, 2017
Online Instructional Videos
1. Options, swaps, futures, MBSs, CDOs, and other derivatives;
https://www.khanacademy.org/economics-finance-domain/core-finance/derivative-
securities; October 20, 2017
2. Derivative;
http://www.investopedia.com/terms/d/derivative.asp?ad=dirN&qo=investopediaSit
eSearch&qsrc=0&o=40186; October 20, 2017
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FINANCIAL ACCOUNTING & REPORTING 2

Module 001 Accounting for liabilities-Current

Understanding derivatives starts with understanding one simple concept:

A derivative instrument (type of financial instrument) is a contract whose value is

A derivative is defined as a financial instrument or other contract within the scope

The term “underlying” is used in derivatives trading. A derivative is a financial

Derivative Underlying Notional

 Speculation is the assumption of risk in hopes of achieving gains. It is the act

A derivative contract through which two parties exchange financial instruments.

References and Supplementary Materials

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