chapter 12: derivatives and foreign currency transactions

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  • Chapter 12: Derivatives and Foreign Currency Transactionsby Jeanne M. David, Ph.D., Univ. of Detroit Mercy

    to accompanyAdvanced Accounting, 10th editionby Floyd A. Beams, Robin P. Clement, Joseph H. Anthony, and Suzanne Lowensohn


  • Derivative and Foreign Currency Transactions: ObjectivesUnderstand the definition of a derivative and the types of risks that derivatives can reduce.Understand the structure, benefits, and costs of options, futures, and forward contracts. Understand the most common approaches to determining hedge effectiveness and the criteria used to judge whether a hedge is or is not effective. Understand the definition of a cash flow hedge and the circumstances in which a derivative is accounted for as a cash flow hedge.

  • Objectives (cont.)Understand the definition of a fair value hedge and the circumstances in which a derivative is accounted for as a fair value hedge. Account for a cash flow hedge situation from inception through settlement and for a fair value hedge situation from inception through settlement. Explain the difference between receivable or payable measurement and denomination. Understand key concepts related to foreign currency exchange rates, such as indirect and direct quotes; floating, fixed, and multiple exchange rates; and spot, current, and historical exchange rates.

  • Objectives (cont.)Record foreign currency-denominated sales/receivables and purchases/payables at the initial transaction date, year-end, and the receivable or payable settlement date. Understand the special derivative accounting related to hedges of existing foreign currency denominated receivables and payables. Understand the International Accounting Standards Board accounting for derivatives. Comprehend the footnote disclosure requirements for derivatives.

  • 1: Derivatives and Risk ManagementDerivatives and Foreign Currency Transactions

  • Derivatives (def.)Derivative is a name given to a broad range of financial securities.The derivative contract's value to the investor isDirectly related to fluctuations in price, rate or some other variableThat underlies it.Typical derivative instrumentsOption contractsForward contractsFutures contracts

  • 2: Types of DerivativesDerivatives and Foreign Currency Transactions

  • Forward ContractsForward contracts Negotiated contracts between two partiesFor the delivery or purchase of A commodity orA foreign currencyAt an agreed upon price, quantity, and delivery date.Settlement of the forward contract may bePhysical delivery of the good, orNet settlement

  • Futures ContractsFutures contracts are specific type of forward contractsCharacteristics are standardizedCharacteristics are set by futures exchangesRather than by the contracting partiesExchange guarantees performanceSettlement may also be made by entering another futures contract in the opposite direction

  • OptionsWith options, only one party is obligated to performThe other party has Ability,But not obligation to perform

  • Using Derivatives as HedgesA hedge canShift risk of fluctuations in sales prices, costs, interest rates, currency exchange ratesHelp manage costsReduce risks to improve financial positionProduce tax benefitsHelp avoid bankruptcy

  • Hedge AccountingAt inception, document the hedgeRelationship between hedged item and derivative instrumentRisk management objective and strategy for hedgeHedged instrumentHedged itemNature of risk being hedgedMeans of assessing effectiveness

  • 3: Hedge EffectivenessDerivatives and Foreign Currency Transactions

  • EffectivenessTo qualify for hedge accounting, the derivative instrument must beHighly effective in offsettingGains or lossesIn the item being hedged

  • Critical Term AnalysisEffectiveness considersNature of the underlying variableNotional amountItem being hedgedDelivery date of derivativeSettlement date of the underlyingIf critical terms are identical, effectiveness is assumed

  • Example of EffectivenessItem to be hedgedAccounts payableDue January 1, 2007For delivery of 10,000 eurosVariable is the changing value of eurosHedge instrumentForward contractTo accept delivery of 10,000 eurosOn January 1, 2007

  • Statistical AnalysisIf critical terms of item to be hedged and hedge instrument do not matchStatistical analysis can determine effectivenessRegression analysisCorrelation analysisExampleUsing derivatives based on heating oil or crude oil to hedge jet fuel costs

  • 4: Cash Flow HedgesDerivatives and Foreign Currency Transactions

  • Cash Flow HedgeHedgesAnticipated or forecasted transactions

    Hedges exposure to variability in expected future cash flows associated with a risk.

    Hedged riskVariability in expected future cash flows

  • Accounting for Cash Flow HedgeHedge instrument is recorded at costAdjust to fair valueChange in fair value is recorded as Other Comprehensive Income (OCI)When the forecasted transaction impacts the income statementReclassify OCI to the hedged revenue or expense account

  • Cash Flow Hedge Example: FuelUtility anticipates purchasing oil for sale to its customers next February. On Dec. 1 Utility enters a futures contract to acquire 4,200 gallons of oil at $1.4007 per gallon for delivery on Jan. 31. A margin of $10 is to be paid up front.On Dec. 31, the price for delivery of oil on Jan. 31 is $1.4050. On Jan. 31, the spot rate for current delivery is $1.3995. Utility settles the contract, accepting delivery of 4,200 gallons of oil.

  • Hedge: Fuel (cont.)In Feb. Utility sells all the oil to its customers for $8,400 and reclassifies its OCI from the hedge as cost of sales. Pertinent rates:

    Change in futures contract to Dec. 31 = $18.06Change in futures contract to Jan. 31 = ($23.10)The loss on the contract is ($5.04) OCI, and this serves to increase the cost of sales.

    12/112/311/31Futures rate, for 1/31$1.4007 $1.4050 $1.3995 Cost of 4,200 barrels$5,882.94 $5,901.00 $5,877.90

  • Hedge: Fuel - Entries

    Adjust to fair valueSettle contract; collect balance on margin.Purchase inventory. Sign contract

    12/1Futures contract10.00 Cash10.00 12/31Futures contract18.06 OCI18.06 1/31OCI23.10 Futures contract23.10 1/31Cash4.96 Futures contract4.96 1/31Inventory5,877.90 Cash5,877.90

  • Hedge: Fuel Example (cont.)

    Record the sale and cost of sales.The last entry reclassifies the loss on the contract from OCI into Cost of sales. The effect is to increase Cost of sales to $5,882.94. This is the cost of the oil based on the futures contract signed on Dec. 1.

    Feb.Cash8,400.00 Sales8,400.00 Feb.Cost of sales5,877.90 Inventory5,877.90 Feb.Cost of sales5.04 OCI5.04

  • 5: Fair Value HedgesDerivatives and Foreign Currency Transactions

  • Fair Value HedgeHedges An existing asset or liability position, orA firm purchase or sales commitment

    Hedged risk Change in the value of the asset, liability, or commitment

  • 6: Accounting for HedgesDerivatives and Foreign Currency Transactions

  • Accounting for a Fair Value HedgeExchange gains and losses are recognized immediately in incomeExchange gain or loss

    Offset by related losses and gains on the hedged item

  • 7: Foreign Currencies: Measurement versus DenominationDerivatives and Foreign Currency Transactions

  • Measurement and DenominationMeasured in a currencyRecorded in the financial records in that currencyDenominated in a currencyRequires settlement (payment or receipt) in that currencyFor US firmsUS dollar is the measurement currencyPayables and receivables may be denominated in US dollars or other currencies

  • 8: Foreign Currency Exchange RatesDerivatives and Foreign Currency Transactions

  • Quoting Exchange RatesDirect quotation (US dollars per one foreign currency unit)$1.60 (US dollars) for 1 (British pound)Indirect quotation (foreign currency units per one US dollar)0.625 (British pounds) for $1 (US dollar)

    Direct and indirect quotes are reciprocals

    1 / $1.60 = 0.625$1 / 0.625 = $1.60

  • RatesSpot rateExchange rate for immediate deliveryCurrent rateExchange rate at balance sheet date, orExchange rate at the income statement transaction dateHistorical rateExchange rate existed when a specific transaction or event occurred

  • 9: Sales and Purchases Denominated in Foreign CurrencyDerivatives and Foreign Currency Transactions

  • Foreign Currency PurchasesPurchases on accountDenominated in a foreign currencySubject to foreign exchange riskChanges in the foreign exchange rateRate increases result in exchange lossesIncreases to payables Rate decreases result in exchange gainsForeign currency accounts payable is adjusted to fair value each period until paid

  • Foreign Currency SalesSales on accountDenominated in a foreign currencySubject to foreign exchange riskChanges in the foreign exchange rateRate increases result in exchange gainsIncreases to receivables Rate decreases result in exchange lossesForeign currency accounts receivable is adjusted to fair value each period until collected.

  • Example: Sale on AccountOn 11/1 Sam sells goods for 500 euros on account. The customer pays on 1/30 and cash is converted on that date. Pertinent rates:

    DateSpot rateAcct RecGain (Loss)11/1$1.55 $775 12/31$1.56 $780 $5 1/30$1.58 $790 $10

  • Sale on Account - Entries

    Adjust receivable to current rate.Collect from customer, recognizing additional gainConvert funds.

    11/1Accounts receivable (euros)775 Sales775 12/31Accounts receivable (euros)5 Exchange gain5 1/30Cash (euros)790 Accounts receivable780 Exchange gain10 1/30Cash ($)790 Cash (euros)790

  • 10: Ac