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 Understand the definition of a derivative and the types of risks that derivatives can reduce Understand the structure, benefits, and costs of options, futures, and forward contracts Understand the most common approaches to determining hedge effectiveness and the criteria used to judge whether a hedge is or is not effective 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.) Understand the definition of a fair value hedge and the circumstances in which a derivative is accounted for as a fair value hedge Account for a cash flow hedge situation from inception through settlement and for a fair value hedge situation from inception through settlement Explain the difference between receivable or payable measurement and denomination 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.) 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 Sale on Account - Entries Adjust receivable to current rate Collect from customer, recognizing additional gain 11/1 Accounts receivable (euros)   Sales 12/31 Accounts receivable (euros)   Exchange gain 1/30 Cash (euros)   Accounts receivable   Exchange gain 1/30 Cash ($)   Cash (euros) 775     775     790       780 10 790     790 Convert funds © 2009 Pearson Education, Inc publishing as Prentice 12-38 Derivatives and Foreign Currency Transactions 10: Accounting for Foreign Currency Hedges © 2009 Pearson Education, Inc publishing as Prentice 12-39 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 12/2 12/31 1/30 Spot rate $0.0094 $0.0092 $0.0098 Acct Pay Forward rate $1,880 $0.0095 $1,840 $0.0093 $1,960 $0.0098 © 2009 Pearson Education, Inc publishing as Prentice Cont Rec $1,900 $1,860 $1,960 12-40 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 = ($20) • Spread between the spot and forward rate on 12/2 determines the total loss, e.g., cost of hedging © 2009 Pearson Education, Inc publishing as Prentice 12-41 Hedge: Liability - Entries 12/2: Buy equipment and sign forward contract 12/2 Equipment     12/2 Contract receivable (¥)   12/31: Adjust foreign monetary accounts to current (year-end) rate Accounts payable (¥) 1,880   Contract payable ($) 1,900     12/31 Accounts payable (¥)   Exchange gain Contract receivable (¥) © 2009 Pearson Education, Inc publishing as Prentice 1,900 40     12/31 Exchange loss   1,880 40 40     40 12-42 Hedge: Liability – Entries (cont.) 1/30: Pay promised $1,900 on forward contract and receive yen in exchange 1/30 Contract payable ($)   Cash ($) 1/30 Cash (¥)   Contract receivable (¥)   Exchange gain 1/30 Accounts payable (¥)   Exchange loss   Cash (¥) 1,900     1,900 1,960       1,860 100 1,840   120     1,960 Use the yen to pay the supplier © 2009 Pearson Education, Inc publishing as Prentice 12-43 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 = months • Monthly rate using Excel =rate(nper,pmt,pv,fv) =rate(3,0,850000,-840000) Result: 0.003937 © 2009 Pearson Education, Inc publishing as Prentice 12-44 Hedge: Anticipated Outflow • Forward rates and fair value of contract:  Date 12/2 12/31 3/1 Forward rate $1.68 $1.69 $1.72 Notional Amount £500,000 840,000 845,000 860,000 Contract Discounted Fair value Fair value     5,000 4,901 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 © 2009 Pearson Education, Inc publishing as Prentice 12-45 Hedge: Anticipated Outflow Entries 12/2 12/31     12/31     no entry for forward contract - no cash exchanged Forward contract 4,901   OCI   4,901 Bring forward contract to discounted fair value 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 unrealized gain put into OCI The discount on the contract is amortized over the months of the contract © 2009 Pearson Education, Inc publishing as Prentice 12-46 Hedge: Entries (cont.) The final balance in OCI is $10,000 CR This will reduce the equipment's depreciation over its life 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 for net settlement of contract: 860,000 current   840,000 contract 3/1 Equipment 860,000     Cash   860,000   Purchase equipment from supplier 3/1 OCI 6,654     Exchange gain   6,654   remaining amortization: 10,000 - 3,346 © 2009 Pearson Education, Inc publishing as Prentice 12-47 Derivatives and Foreign Currency Transactions 11: IASB Standards © 2009 Pearson Education, Inc publishing as Prentice 12-48 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 © 2009 Pearson Education, Inc publishing as Prentice 12-49 Derivatives and Foreign Currency Transactions 12: Disclosures © 2009 Pearson Education, Inc publishing as Prentice 12-50 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 © 2009 Pearson Education, Inc publishing as Prentice 12-51 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 Copyright © 2009 Pearson Education, Inc   Publishing as Prentice Hall © 2009 Pearson Education, Inc publishing as Prentice 12-52 ... 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... of a fair value hedge and the circumstances in which a derivative is accounted for as a fair value hedge Account for a cash flow hedge situation from inception through settlement and for a fair... denominated receivables and payables 11 Understand the International Accounting Standards Board accounting for derivatives 12 Comprehend the footnote disclosure requirements for derivatives ©