1. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-1 Chapter 12: Derivatives and Foreign Currency Transactions by Jeanne M. David, Ph.D., Univ. of Detroit Mercy to accompany Advanced Accounting, 10 th edition by Floyd A. Beams, Robin P. Clement, Joseph H. Anthony, and Suzanne Lowensohn

2. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-2 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.

3. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-3 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.

4. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-4 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.

5. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-5 1: Derivatives and Risk Management Derivatives and Foreign Currency Transactions

6. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-6 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

7. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-7 2: Types of Derivatives Derivatives and Foreign Currency Transactions

8. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-8 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

9. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-9 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

10. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-10 Options With options, only one party is obligated to perform The other party has –Ability, –But not obligation to perform

11. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-11 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

12. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-12 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

13. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-13 3: Hedge Effectiveness Derivatives and Foreign Currency Transactions

14. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-14 Effectiveness To qualify for hedge accounting, the derivative instrument must be –Highly effective in offsetting –Gains or losses –In the item being hedged

15. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-15 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

16. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-16 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

17. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-17 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

18. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-18 4: Cash Flow Hedges Derivatives and Foreign Currency Transactions

19. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-19 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

20. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-20 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

21. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-21 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.

22. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-22 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 = $18.06 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. 12/112/311/31 Futures rate, for 1/31$1.4007$1.4050$1.3995 Cost of 4,200 barrels$5,882.94$5,901.00$5,877.90

23. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-23 Hedge: Fuel - Entries 12/1Futures contract10.00 Cash 10.00 12/31Futures contract18.06 OCI 18.06 1/31OCI23.10 Futures contract 23.10 1/31Cash4.96 Futures contract 4.96 1/31Inventory5,877.90 Cash 5,877.90 Adjust to fair value Settle contract; collect balance on margin. Purchase inventory. Sign contract

24. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-24 Hedge: Fuel – Example (cont.) Feb.Cash8,400.00 Sales 8,400.00 Feb.Cost of sales5,877.90 Inventory 5,877.90 Feb.Cost of sales5.04 OCI 5.04 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.

25. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-25 5: Fair Value Hedges Derivatives and Foreign Currency Transactions

26. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-26 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

27. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-27 6: Accounting for Hedges Derivatives and Foreign Currency Transactions

28. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-28 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

29. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-29 7: Foreign Currencies: Measurement versus Denomination Derivatives and Foreign Currency Transactions

30. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-30 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

31. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-31 8: Foreign Currency Exchange Rates Derivatives and Foreign Currency Transactions

32. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-32 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

33. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-33 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

34. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-34 9: Sales and Purchases Denominated in Foreign Currency Derivatives and Foreign Currency Transactions

35. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-35 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

36. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-36 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.

37. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-37 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: DateSpot rateAcct RecGain (Loss) 11/1$1.55$775 12/31$1.56$780$5 1/30$1.58$790$10

38. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-38 Sale on Account - Entries 11/1Accounts receivable (euros)775 Sales 775 12/31Accounts receivable (euros)5 Exchange gain 5 1/30Cash (euros)790 Accounts receivable 780 Exchange gain 10 1/30Cash ($)790 Cash (euros) 790 Adjust receivable to current rate. Collect from customer, recognizing additional gain Convert funds.

39. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-39 10: Accounting for Foreign Currency Hedges Derivatives and Foreign Currency Transactions

40. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-40 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. DateSpot rateAcct PayForward rateCont 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

41. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-41 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.

42. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-42 Hedge: Liability - Entries 12/2Equipment1,880 Accounts payable (¥ ) 1,880 12/2Contract receivable (¥)1,900 Contract payable ($) 1,900 12/31Accounts payable (¥)40 Exchange gain 40 12/31Exchange loss40 Contract receivable (¥) 40 12/31: Adjust foreign monetary accounts to current (year-end) rate. 12/2: Buy equipment and sign forward contract.

43. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-43 Hedge: Liability – Entries (cont.) 1/30Contract payable ($)1,900 Cash ($) 1,900 1/30Cash (¥)1,960 Contract receivable (¥) 1,860 Exchange gain 100 1/30Accounts payable (¥)1,840 Exchange loss120 Cash (¥) 1,960 1/30: Pay promised $1,900 on forward contract and receive yen in exchange Use the yen to pay the supplier

44. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-44 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

45. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-45 Hedge: Anticipated Outflow Forward rates and fair value of contract: The contract will be adjusted to its discounted 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 DateForward rate Notional Amount £500,000 Contract Fair value Discounted Fair value 12/2$1.68840,000 12/31$1.69845,0005,0004,901 3/1$1.72860,00020,00015,099

46. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-46 Hedge: Anticipated Outflow Entries 12/2no entry for forward contract - no cash exchanged 12/31Forward contract4,901 OCI 4,901 Bring forward contract to discounted fair value. 12/31OCI3,346 Exchange gain 3,346 Effective interest method amortization of the 10,000 discount. 850,000 x.003937 The change in value for the forward contract is an unrealized gain put into OCI. The discount on the contract is amortized over the 3 months of the contract.

47. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-47 Hedge: Entries (cont.) The final balance in OCI is $10,000 CR. This will reduce the equipment's depreciation over its life. 3/1Forward contract15,099 OCI 15,099 Bring forward contract to fair value, $20,000 3/1Cash20,000 Forward contract 20,000 for net settlement of contract: 860,000 current - 840,000 contract 3/1Equipment860,000 Cash 860,000 Purchase equipment from supplier 3/1OCI6,654 Exchange gain 6,654 remaining amortization: 10,000 - 3,346

48. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-48 11: IASB Standards Derivatives and Foreign Currency Transactions

49. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-49 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

50. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-50 12: Disclosures Derivatives and Foreign Currency Transactions

51. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-51 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

52. © 2009 Pearson Education, Inc. publishing as Prentice Hall12-52 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.