Advanced accounting 10th by a beams athony ch12

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.

© 2009 Pearson Education, Inc. publishing as Prentice

12-2

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.

© 2009 Pearson Education, Inc. publishing as Prentice

12-3


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.

© 2009 Pearson Education, Inc. publishing as Prentice

12-4


Derivatives and Foreign Currency Transactions

1: Derivatives and Risk Management

© 2009 Pearson Education, Inc. publishing as Prentice

12-5


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
© 2009 Pearson Education, Inc. publishing as Prentice

12-6

Derivatives and Foreign Currency Transactions

2: Types of Derivatives

© 2009 Pearson Education, Inc. publishing as Prentice

12-7


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

© 2009 Pearson Education, Inc. publishing as Prentice

12-8


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

© 2009 Pearson Education, Inc. publishing as Prentice

12-9


Options
• With options, only one party is obligated to perform
• The other party has

– Ability,
– But not obligation to perform

© 2009 Pearson Education, Inc. publishing as Prentice

12-10


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

© 2009 Pearson Education, Inc. publishing as Prentice

12-11


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
© 2009 Pearson Education, Inc. publishing as Prentice

12-12


Derivatives and Foreign Currency Transactions

3: Hedge Effectiveness

© 2009 Pearson Education, Inc. publishing as Prentice

12-13


Effectiveness
To qualify for hedge accounting, the derivative instrument
must be

– Highly effective in offsetting
– Gains or losses
– In the item being hedged

© 2009 Pearson Education, Inc. publishing as Prentice

12-14


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

© 2009 Pearson Education, Inc. publishing as Prentice

12-15


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
© 2009 Pearson Education, Inc. publishing as Prentice

12-16


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

© 2009 Pearson Education, Inc. publishing as Prentice

12-17


Derivatives and Foreign Currency Transactions

4: Cash Flow Hedges

© 2009 Pearson Education, Inc. publishing as Prentice

12-18

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

© 2009 Pearson Education, Inc. publishing as Prentice

12-19


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

© 2009 Pearson Education, Inc. publishing as Prentice

12-20

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.

© 2009 Pearson Education, Inc. publishing as Prentice

12-21


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.

© 2009 Pearson Education, Inc. publishing as Prentice

12-22


Hedge: Fuel - Entries
Sign
contract
Adjust to
fair value
Settle
contract;
collect
balance on
margin.

12/1 Futures contract
 
Cash
12/31 Futures contract
 
OCI
1/31 OCI
 
Futures contract
1/31 Cash

 
Futures contract
1/31 Inventory
 
Cash

10.00  
 

10.00
18.06  

 

18.06
23.10  

 

23.10
4.96  

 
4.96
5,877.90  
 
5,877.90

Purchase inventory.
© 2009 Pearson Education, Inc. publishing as Prentice

12-23


Hedge: Fuel – Example (cont.)
Record
the sale
and cost
of sales.

Feb. Cash
 
Sales
Feb. Cost of sales
 
Inventory
Feb. Cost of sales
 
OCI

8,400.00
 
5,877.90
 
5.04
 

 
8,400.00
 

5,877.90
 
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.
© 2009 Pearson Education, Inc. publishing as Prentice

12-24


Derivatives and Foreign Currency Transactions

5: Fair Value Hedges

© 2009 Pearson Education, Inc. publishing as Prentice

12-25