The following is an excerpt from a disclosure note of Johnson & Johnson: 6. Fair Value Measurements (in part) As of January 2, 2011, the balance of deferred net gains on derivatives included in accumulated other comprehensive income was $100 million after-tax. The Company expects that substantially all the amount related to foreign exchange contracts will be reclassified into earnings over the next 12 months as a result of transactions that are expected to occur over that period. Required: 1. Johnson & Johnson indicates that it expects that substantially all of the balance of deferred net gains on derivatives will be reclassified into earnings over the next 12 months as a result of transactions that are expected to occur over that period. What is meant by “reclassified into earnings”? 2. What type(s) of hedging transaction might be accounted for in this way?

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Asked Jan 23, 2020
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The following is an excerpt from a disclosure note of Johnson & Johnson: 6. Fair Value Measurements (in part) As of January 2, 2011, the balance of deferred net gains on derivatives included in accumulated other comprehensive income was $100 million after-tax. The Company expects that substantially all the amount related to foreign exchange contracts will be reclassified into earnings over the next 12 months as a result of transactions that are expected to occur over that period. Required: 1. Johnson & Johnson indicates that it expects that substantially all of the balance of deferred net gains on derivatives will be reclassified into earnings over the next 12 months as a result of transactions that are expected to occur over that period. What is meant by “reclassified into earnings”? 2. What type(s) of hedging transaction might be accounted for in this way?

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Expert Answer

Step 1

Derivatives: Derivatives are some financial instruments which are meant for managing risk and safeguard the risk created by other financial instruments. These financial instruments derive the values from the future value of underlying security or index. Some examples of derivatives are forward contracts, interest rate swaps, futures, and options.

Step 2

(1)

To explain: The meaning of the declaration “deferred net losses on derivatives would be reclassified into earnings”.

Reclassification into earnings:

  • Company J declares that the unrecognized net losses which are “anticipated to occur over the next 12 months” would be included as other comprehensive income in net income.
  • This anticipated net losses from forward contracts which would be reclassified into net income is referred to as reclassification of earnings.
Step 3

(2)

Fair value hedge: If the company uses any derivative to cover the risk due to fair value changes of asset, liability, or a commitment, the derivative is classified as fair value hedge. This type of hedge focusses to control the risk due to future price changes.

Cash flow hedge: If a company uses any derivative to co...

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