Discuss the effects of transactions involving derivatives and the fair value option on the statements of cash flows

Answer 1

THE EFFECTS OF TRANSACTIONS INVOLVING DERIVATIVES AND THE FAIR VALUE OPTION ON THE STATEMENT OF CASH FLOWS

Firms engage in transactions involving derivatives. For the most part, the complex parts of these transactions occur after the firm has acquired the derivative, but those subsequent transactions do not affect cash flows until, possibly, their settlement. The following discussion refers to a statement of cash flows that uses the indirect method for presenting cash flows from operations.

The firm acquires a derivative for cash. Most such derivative acquisitions represent marketable securities held as current assets. The cash flow from operations section shows a subtraction for the increase in the current asset accounts in an amount equal to the firm's expenditure to acquire the derivative. If the firm classifies the derivative as a nonoperating asset, then the cash outflow appears in the investing section of the statement of cash flows. Subsequent to acquisition, the firm may report changes in the fair value of the derivative in income. Those changes do not affect cash flow. A subtraction in the operating section of cash flows from operations offsets the amount of any gain reported in income. An addition in the operating section offsets the amount of any loss reported in income.

Subsequent to acquisition, the firm may report changes in fair value of derivatives in Other Comprehensive Income. These changes have no effect on any lines of the statement of cash flows.

As the derivative transaction settles, there can be various effects. Some of these settlements involve net cash flow, such as for a derivative that is not a hedge. Derivatives with cash settlement can involve cash flows even when the firm uses them as a hedge; often, however, the cash inflow or outflow from the derivative usually offsets another cash outflow or inflow from the other side of the hedge. Other settlements involve the receipt of assets such as inventory or equipment, which do not involve cash.

There is a fair value option for marketable securities and derivatives. Firms using the fair value option mark the carrying value of the asset to fair value each period.

If the change in fair value increases carrying value, then the firm reports a gain in income equal to the amount of the increase in carrying value during the current period. The cash flow from operations section starts with the resulting higher income. That higher income does not, however, result in increased cash inflows during the current period, so the cash flow from operations sections shows a subtraction for the amount of the gain.

If the change in fair value of the derivative decreases carrying value, then the firm reports the amount of that decrease as a loss during the current period. The cash flow from operations section shows lower income as a result. The loss does not, however, result in outflows or in decreased cash inflows during the current period, so the cash flow from operations sections shows an addback for the loss.