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Wiley CPAexcel Exam Review 2014 Focus Notes: Financial Accounting and Reporting by Ray Whittington

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Focus on: Derivative Instruments—Module 19

Investments in Derivative Securities

Derivatives—Derive their value from other assets. Examples:

  • Stock option—Value based on underlying stock price
  • Commodity futures contract—Value based on underlying commodity price

Initially recorded at cost (or allocated amount)—Reported on balance sheet at fair value

  • Trading security—Unrealized gains and losses on income statement
  • Available-for-sale security—Unrealized gains and losses reported as other comprehensive income in stockholders’ equity

Characteristics of Derivatives

Settlement in cash or assets easily convertible to cash (such as marketable securities)

Underlying index on which value of derivative is based (usually the price of some asset)

No or little net investment at time of creation:

  • Futures-based derivative involves no payments at all when derivative created
    • Such a derivative must be settled on settlement date in all cases
  • Options-based derivative involves small premium payment when derivative created
    • Option holder has right not to settle derivative if results would be unfavorable
    • Payment of premium when derivative created is price of this option

Use of Derivatives

Speculative—Attempt to profit from favorable change in underlying index

  • Gain or loss on change in fair value reported in ordinary income

Certain derivatives qualify as hedge instruments and must meet the following criteria:

  • Sufficient documentation must be provided at designation
  • The hedge must be highly effective ...

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