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
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 barrels $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 12/1 Futures contract 10.00
contract Cash 10.00
12/31 Futures contract 18.06
Adjust to OCI 18.06
fair value 1/31 OCI 23.10
Futures contract 23.10
1/31 Cash 4.96
Settle
contract; Futures contract 4.96
collect 1/31 Inventory 5,877.90
balance on Cash 5,877.90
margin.
Purchase inventory.

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 Hedge: Fuel – Example (cont.)
Record Feb. Cash 8,400.00
the sale Sales 8,400.00
and cost Feb. Cost of sales 5,877.90
of sales.
Inventory 5,877.90
Feb. Cost of sales 5.04
OCI 5.04

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.
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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 12/31 Accounts receivable (euros) 5
to current Exchange gain 5
rate.
1/30 Cash (euros) 790
Collect Accounts receivable 780
from Exchange gain 10
customer, 1/30 Cash ($) 790
recognizing Cash (euros) 790
additional
gain
Convert funds.

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

Use the yen to pay the supplier

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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
3/1 $1.72 860,000 20,000 15,099
• 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

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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
Effective interest method amortization of the 10,000
discount. 850,000 x .003937
The change in value for the
forward contract is an 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
Forward contract 20,000
The final for net settlement of contract: 860,000 current -
balance in 840,000 contract
OCI is
$10,000 CR. 3/1 Equipment 860,000
This will Cash 860,000
reduce the Purchase equipment from supplier
equipment's
depreciation 3/1 OCI 6,654
over its life. Exchange gain 6,654
remaining amortization: 10,000 - 3,346
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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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