Decoding of Corporate Financial Communications: Derivative Instruments, Pensions, Forecasting

• Report rights infringement
• published: 19 Nov 2013
• views: 600

Decoding of Corporate Financial Communications Derivative Instruments, Retirement Benefits / Pensions Forecasting Financial Statements Professor Cooperberg June 12th, 2013 To hedge the risk of adverse changes (foreign exchange and interest rates changing, stock prices, etc), derivative instruments are used. It is essentially locking in to an acceptable level (for example a good interest rate). Forward contracts lock into a price that you will owe on a specific day in the future while swaps contracts trade off a fixed interest rate for a variable rate. There are many unique and complex derivatives to meet specific customer needs. Every derivative has certain characteristics (underlying prices, notional amounts, whether or not an initial investment is required). They are recognized on the balance sheet as either an asset or liability, depending on the contract and are revalued to market value (mark to market) each period. The gain or loss sustained on the revaluation immediately goes to either net income or OCI (other comprehensive income). The accumulated amount in other comprehensive income is then transferred to net income periodically. There are three types of derivatives covered. A speculative instrument is made for the purpose of a gain (and is revalued each period and recognized in net income). Fair value hedges are used to protect the value of an asset. Cash flow hedges are used to protect cash flows from the sale of an asset. Fair value hedges and cash flow hedges differ based upon purpose. If not specified as fair value or cash flow hedge, it must be considered a speculative investment. FASB requires disclosures concerning derivatives. For cash flow hedges, the transaction that will cause a gain or loss must be reclassified in net income and that amount must be estimated in the next 12 months. The net amount of gain (or loss) should be included in net income if the hedged commitment no longer qualifies as a fair value or cash flow hedge. Derivatives should be marked to market each period. However, some derivatives won't have active markets and therefore have unreliable valuation (such as ENRON and AIG). Many derivatives can be classified as fair value or cash flow hedges at the firm's discretion. Gains and losses on cash flow hedges effect earnings later than fair market hedges. Effectively hedged firms should have relatively small gains and losses. If a firm has large or highly variable gains / losses, it may be using derivatives ineffectively. Regarding retirement benefits, they accrue during the life of employment and become useful upon retirement. The employer recognizes the cost of these benefits as an expense while the employees work and contribute to revenues. This is usually based on assumptions about employee turnover, future compensation and health care costs, and future interest rates. Pension plans also have separate accounting records. There are two types - defined benefit and defined contribution plans. Defined contribution plans are plans where the employer agrees to contribute a certain amount to a pension fund each period and the amount the employee eventually receives depends on the performance of the fund. A defined benefit plan is one where the employer agrees to make benefits payments upon retirement based upon a formula of wages earned and years of service. Employer should contribute enough to ensure that the benefit plan is funded (invested by a trustee). As assets accumulate, they appear on the pension fund balance sheet (not the firm's balance sheet). Under a defined contribution plan, an employer's obligation is satisfied upon contribution. A defined benefit plan, on the other hand, increases each period. It increases as the employee's salary increases, as the employee moves closer to actually receiving the benefit (the PV increases), and as payments are made to employees, the assets and liabilities of the plan decrease in the amount of the payment. There are several key terms pertaining to pensions, such as VBOs (vested benefit obligations), ABOs (accumulated benefit obligation), PBOs (projected benefit obligation), and actuarial gains / losses. Derivative Instruments: 0:19 Characteristics of Derivative Instruments: 3:02 Accounting for Derivatives: 4:10 Class of Derivatives: 5:08 Fair Value Hedges: 6:17 Cash Flow Hedges: 8:31 FASB required disclosures: 10:26 Accounting Quality Issues: 14:32 Retirement Benefits: 17:11 Pensions (defined benefit plan): 19:15 Pensions (employer's obligation): 22:36 Key Pension Terms: 23:54 Funded Status of Pension Plan: 26:21 Other Post Retirement Benefits: 30:09 Analysts Treatment of Pensions: 30:48 Chapter 10 Begins - Forecasting Financial Statements: 35:28 Forecasting Financial Statements: 43:31 Difficulty of Forecasting: 45:05 Benefits / Results of Forecasting: 46:04 Seven Step of the Forecasting Sequence: 47:04 Practical Tips: 48:00 Step 1 - Projecting Revenues: 52:38