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

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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

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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

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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

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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

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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:
Futures rate, for 1/31
Cost of 4,200 barrels

12/1

12/31

1/31

$1.4007

$1.4050

$1.3995

$5,882.94 $5,901.00 $5,877.90

Change in futures contract to Dec. 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
contract
Adjust to
fair value
Settle
contract;
collect
balance on
margin.

12/1 Futures contract

10.00

Cash
12/31 Futures contract

10.00
18.06

OCI
1/31 OCI

18.06
23.10

Futures contract
1/31 Cash

23.10
4.96

Futures contract
Purchase
inventory.
1/31 Inventory
5,877.90
Cash

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4.96
5,877.90
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Hedge: Fuel Example (cont.)

Record
the sale
and cost
of sales.

Feb. Cash

8,400.00

Sales
Feb. Cost of sales

8,400.00
5,877.90

Inventory
Feb. Cost of sales
5.04
The last entry reclassifiesOCI
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.
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5,877.90
5.04

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Derivatives and Foreign Currency Transactions

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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

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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

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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

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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

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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

11/1

$1.55

$775

12/31

$1.56

$780

$5

1/30

$1.58

$790

$10

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Gain (Loss)

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Sale on Account - Entries

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

11/1 Accounts receivable (euros)

775

Sales
12/31 Accounts receivable (euros)

775
5

Exchange gain
1/30 Cash (euros)

5
790

Accounts receivable

780

Exchange gain
1/30 Cash ($)
Convert funds.
Cash (euros)

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10
790
790
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Derivatives and Foreign Currency Transactions

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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

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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Cont Rec

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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
equipment
and sign
forward
contract.

12/2 Equipment

1,880

Accounts payable ()
12/2 Contract receivable ()

1,880
1,900

Contract payable ($)

12/31:
Adjust
foreign
monetary
accounts
to current
(year-end)
rate.

12/31 Accounts payable ()

1,900
40

Exchange gain
12/31 Exchange loss
Contract receivable ()

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40
40
40
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Hedge: Liability Entries (cont.)

1/30: Pay
promised
$1,900 on
forward
contract
and
receive
yen in
exchange

1/30 Contract payable ($)

1,900

Cash ($)
1/30 Cash ()

1,900
1,960

Contract receivable ()

1,860

Exchange gain

100

1/30 Accounts payable ()

1,840

Exchange loss
Use the yen to pay the supplier
Cash ()

120

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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:
Date

Forward rate

Notional
Amount
500,000

12/2

$1.68

840,000

12/31

$1.69

845,000

Contract Discounted
Fair value Fair value
5,000

4,901

3/1contract
$1.72
860,000 to its20,000
The
will be adjusted
discounted15,099
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
Exchange gain

3,346
3,346

The change in value for the

The discount
the
Effective
method amortization
of theon
10,000
forward contract
is an interest
discount. 850,000 x .003937
contract is amortized
unrealized gain put into
over the 3 months of
OCI.
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

The final
balance in
OCI is
$10,000 CR.
This will
reduce the
equipment's
depreciation
over its life.

3/1 Cash

20,000

Forward contract

20,000

for net settlement of contract: 860,000 current 840,000 contract

3/1 Equipment
860,000
Cash

860,000

Purchase equipment from supplier

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3/1 OCI

Exchange gain

6,654

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6,654

Derivatives and Foreign Currency Transactions

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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

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 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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