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Chapter 12: Derivatives and

Foreign Currency Transactions


by Jeanne M. David, Ph.D., Univ. of Detroit Mercy

to accompany
Advanced Accounting, 10th edition
by Floyd A. Beams, Robin P. Clement,
Joseph H. Anthony, and Suzanne Lowensohn

2009 Pearson Education, Inc. publishing as Prentice 12-1


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

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Objectives (cont.)
5. Understand the definition of a fair value hedge and the
circumstances in which a derivative is accounted for as a fair value
hedge.
6. Account for a cash flow hedge situation from inception through
settlement and for a fair value hedge situation from inception
through settlement.
7. Explain the difference between receivable or payable measurement
and denomination.
8. 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.

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

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Derivatives and Foreign Currency Transactions
1: Derivatives and Risk Management

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Derivatives (def.)
Derivative is a name given to a broad range of
financial securities.
The derivative contract's value to the investor is
Directly related to fluctuations in price, rate or
some other variable
That underlies it.
Typical derivative instruments
Option contracts
Forward contracts
Futures contracts

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Derivatives and Foreign Currency Transactions
2: Types of Derivatives

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Forward Contracts
Forward contracts
Negotiated contracts between two parties
For the delivery or purchase of
A commodity or
A foreign currency
At an agreed upon price, quantity, and delivery
date.
Settlement of the forward contract may be
Physical delivery of the good, or
Net settlement

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Futures Contracts
Futures contracts are specific type of forward
contracts
Characteristics are standardized
Characteristics are set by futures exchanges
Rather than by the contracting parties
Exchange guarantees performance
Settlement may also be made by entering
another futures contract in the opposite direction

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Options
With options, only one party is obligated to
perform
The other party has
Ability,
But not obligation to perform

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Using Derivatives as Hedges
A hedge can
Shift risk of fluctuations in sales prices, costs,
interest rates, currency exchange rates
Help manage costs
Reduce risks to improve financial position
Produce tax benefits
Help avoid bankruptcy

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Hedge Accounting
At inception, document the hedge
Relationship between hedged item and
derivative instrument
Risk management objective and strategy for
hedge
Hedged instrument
Hedged item
Nature of risk being hedged
Means of assessing effectiveness

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Derivatives and Foreign Currency Transactions
3: Hedge Effectiveness

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Effectiveness
To qualify for hedge accounting, the derivative
instrument must be
Highly effective in offsetting
Gains or losses
In the item being hedged

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Critical Term Analysis
Effectiveness considers
Nature of the underlying variable
Notional amount
Item being hedged
Delivery date of derivative
Settlement date of the underlying
If critical terms are identical, effectiveness is
assumed

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Example of Effectiveness
Item to be hedged
Accounts payable
Due January 1, 2007
For delivery of 10,000 euros
Variable is the changing value of euros
Hedge instrument
Forward contract
To accept delivery of 10,000 euros
On January 1, 2007

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Statistical Analysis
If critical terms of item to be hedged and hedge
instrument do not match
Statistical analysis can determine effectiveness
Regression analysis
Correlation analysis
Example
Using derivatives based on heating oil or
crude oil to hedge jet fuel costs

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Derivatives and Foreign Currency Transactions
4: Cash Flow Hedges

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Cash Flow Hedge
Hedges
Anticipated or forecasted transactions

Hedges exposure to variability in expected


future cash flows associated with a risk.

Hedged risk
Variability in expected future cash flows

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Accounting for Cash Flow Hedge
Hedge instrument is recorded at cost
Adjust to fair value
Change in fair value is recorded as Other
Comprehensive Income (OCI)
When the forecasted transaction impacts the
income statement
Reclassify OCI to the hedged revenue or
expense account

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Cash Flow Hedge Example: Fuel
Utility 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.

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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:
12/1 12/31 1/31
Futures rate, for 1/31 $1.4007 $1.4050 $1.3995
Cost of 4,200
Change barrelscontract
in futures $5,882.94 $5,901.00
to Dec. $5,877.90
31 = $18.06
Change 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.

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Hedge: Fuel - Entries
Sign 12/1 Futures contract 10.00
contract
Cash 10.00
Adjust to 12/31 Futures contract 18.06
fair value OCI 18.06
1/31 OCI 23.10
Settle Futures contract 23.10
contract;
collect 1/31 Cash 4.96
balance on Futures contract 4.96
margin.
1/31 Inventory
Purchase inventory. 5,877.90
Cash 5,877.90
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Hedge: Fuel Example (cont.)
Record Feb. Cash 8,400.00
the sale
and cost Sales 8,400.00
of sales. Feb. Cost of sales 5,877.90
Inventory 5,877.90
Feb. Cost of sales 5.04
The last entry reclassifiesOCI
the loss on the 5.04
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.
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Derivatives and Foreign Currency Transactions
5: Fair Value Hedges

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Fair Value Hedge
Hedges
An existing asset or liability position, or
A firm purchase or sales commitment

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

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Derivatives and Foreign Currency Transactions
6: Accounting for Hedges

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Accounting for a Fair Value Hedge
Exchange gains and losses are recognized
immediately in income
Exchange gain or loss

Offset by related losses and gains on the hedged


item

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Derivatives and Foreign Currency Transactions
7: Foreign Currencies: Measurement
versus Denomination

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Measurement and Denomination
Measured in a currency
Recorded in the financial records in that currency
Denominated in a currency
Requires settlement (payment or receipt) in that
currency
For US firms
US dollar is the measurement currency
Payables and receivables may be denominated in
US dollars or other currencies

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Derivatives and Foreign Currency Transactions
8: Foreign Currency Exchange Rates

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Quoting Exchange Rates
Direct 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

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Rates
Spot rate
Exchange rate for immediate delivery
Current rate
Exchange rate at balance sheet date, or
Exchange rate at the income statement
transaction date
Historical rate
Exchange rate existed when a specific
transaction or event occurred

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Derivatives and Foreign Currency Transactions
9: Sales and Purchases Denominated
in Foreign Currency

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Foreign Currency Purchases
Purchases on account
Denominated in a foreign currency
Subject to foreign exchange risk
Changes in the foreign exchange rate
Rate increases result in exchange losses
Increases to payables
Rate decreases result in exchange gains
Foreign currency accounts payable is adjusted to
fair value each period until paid

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Foreign Currency Sales
Sales on account
Denominated in a foreign currency
Subject to foreign exchange risk
Changes in the foreign exchange rate
Rate increases result in exchange gains
Increases to receivables
Rate decreases result in exchange losses
Foreign currency accounts receivable is adjusted
to fair value each period until collected.

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Example: Sale on Account
On 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:
Date Spot rate Acct Rec Gain (Loss)
11/1 $1.55 $775
12/31 $1.56 $780 $5
1/30 $1.58 $790 $10

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Sale on Account - Entries
11/1 Accounts receivable (euros) 775
Adjust Sales 775
receivable
to current 12/31 Accounts receivable (euros) 5
rate.
Exchange gain 5
Collect 1/30 Cash (euros) 790
from
customer, Accounts receivable 780
recognizing Exchange gain 10
additional
gain 1/30 Cash ($) 790
Convert Cash
funds.(euros) 790

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Derivatives and Foreign Currency Transactions
10: Accounting for Foreign Currency
Hedges

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Fair Value Hedge: Liability
Cary purchases equipment costing 200,000 yen
on 12/2/09 with payment due on 1/30/10.
On 12/2/09 Cary enters a forward contract to
purchase 200,000 yen on 1/30/10 at the forward
contract rate of $0.0095.
Date Spot rate Acct Pay Forward rate Cont Rec
12/2 $0.0094 $1,880 $0.0095 $1,900
12/31 $0.0092 $1,840 $0.0093 $1,860
1/30 $0.0098 $1,960 $0.0098 $1,960

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Hedge: Liability Effect (cont.)
Accounts payable:
Gain of $40 for December
Loss of $120 for January
Contract receivable:
Loss of $40 for December
Gain of $100 for January
The net gain/loss for December = $0.
The net loss for January = ($20)
Total exchange loss on the transaction = ($20)
Spread between the spot and forward rate on
12/2 determines the total loss, e.g., cost of
hedging.
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Hedge: Liability - Entries
12/2: Buy 12/2 Equipment 1,880
equipment
and sign Accounts payable () 1,880
forward 12/2 Contract receivable () 1,900
contract.
Contract payable ($) 1,900
12/31 Accounts payable () 40
12/31:
Adjust Exchange gain 40
foreign 12/31 Exchange loss 40
monetary
accounts Contract receivable () 40
to current
(year-end)
rate.
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Hedge: Liability Entries (cont.)
1/30: Pay 1/30 Contract payable ($) 1,900
promised
$1,900 on Cash ($) 1,900
forward 1/30 Cash () 1,960
contract
and Contract receivable () 1,860
receive
yen in Exchange gain 100
exchange 1/30 Accounts payable () 1,840
Exchange loss 120
Use the yen to pay()
Cash the supplier 1,960

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Cash Flow Hedge: Anticipated
Cash Outflow
On 12/2/08, Winkler anticipates purchasing equipment on
3/1/09 with payment on that date of 500,000.
On 12/2/08, Winkler signs a 90-day forward contract to
buy 500,000 for $1.68 (the spot rate is $1.70)
The contract discount is (1.70-1.68)x500,000=10,000
Amortized to exchange gain over life of contract
Use effective interest method
Implied interest is:
PV = 1.70(500,000) = 850,000
FV = 1.68(500,000) = 840,000
Period = 3 months
Monthly rate using Excel =rate(nper,pmt,pv,fv)
=rate(3,0,850000,-840000)
Result: 0.003937
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Hedge: Anticipated Outflow
Forward rates and fair value of contract:

Notional
Amount Contract Discounted
Date Forward rate 500,000 Fair value Fair value
12/2 $1.68 840,000
12/31 $1.69 845,000 5,000 4,901
The3/1
contract $1.72 860,000
will be adjusted 20,000
to its discounted 15,099
fair value. Use the
incremental borrowing rate (12%, or 1% monthly), discounting
for the remaining contract life.
12/31: 5,000 / (1.01)2
3/1 (end of contract): 15,000
Note: 1/31 would be equal to fair value / (1.01)1

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Hedge: Anticipated Outflow Entries
12/2 no entry for forward contract - no cash exchanged
12/31 Forward contract 4,901
OCI 4,901
Bring forward contract to discounted fair value.
12/31 OCI 3,346
Exchange gain 3,346
The change in value for the
Effective interest method amortization of the 10,000
discount.
forward contract is an 850,000 x .003937 The discount on the
unrealized gain put into contract is amortized
OCI. over the 3 months of
the contract.
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Hedge: Entries (cont.)
3/1 Forward contract 15,099
OCI 15,099
Bring forward contract to fair value, $20,000
3/1 Cash 20,000
The final
balance in Forward contract 20,000
OCI is
$10,000 CR. for net settlement of contract: 860,000 current -
This will 840,000 contract
reduce the 3/1 Equipment 860,000
equipment's
depreciation Cash 860,000
over its life.
Purchase equipment from supplier
3/1 Education,
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12-47
Derivatives and Foreign Currency Transactions
11: IASB Standards

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IASB Similar to US GAAP
IAS 21 foreign exchange rates
foreign denominated monetary amounts adjusted to
current rate at balance sheet date
Translation of foreign currency statements
IAS 32 financial instruments
Debt and equity instruments
IAS 39 derivatives and hedges
Cash flow and fair value hedges
Difference: hedges of firm commitments can be
either cash flow or fair value hedge

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Derivatives and Foreign Currency Transactions
12: Disclosures

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Footnote Disclosures
Focus on risk management objectives and
strategies
Fair value hedges
Net gain or loss in earnings, placement on
statements, effectiveness and ineffectiveness
Cash flow hedges
Hedge ineffectiveness gain or loss, placement on
statements, types of situations hedged, expected
length of time, effect of discontinuance of hedge

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Publishing as Prentice Hall

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