1 Advanced Accounting Autumn 2015 Chapter 12 Part I Bill Myer – Autumn 2015

2 Agenda Homework Chapter 12: Derivatives and Foreign Currency Transactions Bill Myer – Autumn 2015

3 Homework You should have already read Chapters 1-5, 8, 12 Read Chapter 13: Foreign Currency Financial Statements Exercises E12-5 (1, 2, 3); E12-6; E12-7; E12-8; E12-9

4 Agenda Homework  Chapter 12: Derivatives and Foreign Currency Transactions  Derivatives  Types of Derivatives  Foreign Currency Exchange  Sales and Purchases Denominated in Foreign Currency  Recording Foreign Currency Transactions Bill Myer – Autumn 2015

5 Vocabulary related to derivatives  Derivative  Option / Put option / Call option  Future  Forward  Swap  Hedge  Commodity  Net settlement Vocabulary – Important Vocabulary for Chapter 12

6Bill Myer – Autumn 2015 Vocabulary related to foreign currency  Direct quote / indirect quote  Reciprocal  Spot rate / forward rate  Current rate  Functional currency  Foreign currency transaction  “Denominated” Vocabulary – Important Vocabulary for Chapter 12

7 Derivatives and Foreign Currency – Focus Questions Bill Myer – Autumn 2015 What are the four main types of derivatives? How can derivatives be used as a hedge? What is a company’s functional currency? What is a foreign currency transaction? What is foreign exchange risk? How do you adjust foreign currency accounts payable and foreign currency accounts receivable?

8 Derivatives and Foreign Currency – Objectives Bill Myer – Autumn Understand the definition of a derivative and the types of risks that derivatives can manage 2.Understand the structure, benefits and costs of options, futures, forward contracts and swaps 3.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.Explain the difference between receivable or payable measurement and denomination 5.Record foreign currency-denominated sales/receivables and purchases/payables at the initial transaction date, year-end, and the receivable or payable settlement date

9 Derivative (definition) Bill Myer – Autumn 2015 The name given to a broad range of financial securities  The derivative's value to the investor is directly related to fluctuations in price, rate or some other variable that underlies it

10 Derivative (definition) Bill Myer – Autumn 2015 A derivative can be used to offset (“hedge”) the potential fluctuation in  Interest rates  Commodity prices  Foreign currency exchange rates  Stock prices

11 Using Derivatives as Hedges Bill Myer – Autumn 2015 A hedge can:  Shift risk of fluctuations in sales prices, costs, interest rates, or currency exchange rates  Help manage costs  Reduce risks to improve financial position  Produce tax benefits  Help avoid bankruptcy

12 Derivatives Bill Myer – Autumn 2015 The four basic types of derivatives are:  Forward contracts  Futures contracts  Options  Swaps

13 Forward Contracts Bill Myer – Autumn 2015 Forward contracts are  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

14 Futures Contracts Bill Myer – Autumn 2015 Futures contracts are a specific type of forward contract  Characteristics are standardized  Characteristics are set by futures exchanges (rather than by the contracting parties) so performance risk is eliminated  Exchange guarantees performance Settlement may also be made by entering another futures contract in the opposite direction

15 Options Bill Myer – Autumn 2015 Options are right (but not the obligation) to either  Call (buy), or  Put (sell) With options, only one party is obligated to perform depending on the election of the other party to exercise their option

16 Swaps Bill Myer – Autumn 2015 Swaps are contracts to exchange an ongoing stream of cash flows, commonly swapping interest rates  Swap variable- for fixed-rate debt, or  Swap fixed- for variable-rate debt Swaps are commonly negotiated on an individual basis like forward contracts, but may be standardized and exchange-traded like futures

17 Example: Forward Contract Bill Myer – Autumn 2015 Sam decides to sell future production by entering into a forward contract with Irene for delivery of 10,000 items in one year at a price of $10 per item Thus, Sam has determined their selling price regardless of the market, and Irene has locked in her purchase price Sam risks loss of potential revenue if the market price for the items increases in the next year Irene risks loss of potential savings if the market price for the items decreases in the next year

18 Forward Contract Impact Bill Myer – Autumn 2015 If Sam’s fixed costs are $50,000, and the variable cost is $3 per unit, Sam will lock in profit of $20,000 ($100,000 revenue less $50,000 fixed costs less $30,000 variable costs) If the market price for the item increases, Sam can sell at the higher market price and settle with Irene by paying her the difference, or simply sell the items to Irene at the contracted price Either way, Sam has profit of $20,000

19 Measurement and Denomination Bill Myer – Autumn 2015 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 U.S. firms  U.S. dollar is generally the measurement currency  Payables and receivables may be denominated in U.S. dollars or other currencies

20 Quoting Exchange Rates Bill Myer – Autumn 2015 Direct quotation (U.S. dollars per one foreign currency unit)  $1.60 (U.S. dollars) for £1 (British pound) Indirect quotation (foreign currency units per one U.S. dollar)  £0.625 (British pounds) for $1 (U.S. dollar) Direct and indirect quotes are reciprocals  £1 / $1.60 = £0.625  $1 / £0.625 = $1.60

21 Establishing Exchange Rates Bill Myer – Autumn 2015 Exchange rates may be fixed by a governmental unit or may be allowed to fluctuate (float) with changes in the currency markets  Official (fixed) exchange rates are set by a government and do not fluctuate with the changes in the world currency markets  Free (floating) exchange rates reflect the fluctuating market prices for a currency based on supply and demand and other factors in the world currency markets

22 Various Exchange Rates Bill Myer – Autumn 2015 Spot rate  Exchange rate for immediate delivery Current rate  Exchange rate at balance sheet date, or  Exchange rate at the time a transaction takes place Historical rate  Exchange rate that existed when a specific transaction or event occurred

23 Currency Denomination Bill Myer – Autumn 2015 A company’s functional currency is the currency in which they transact the majority of their business A foreign currency transaction is any transaction that is measured and settled (“denominated”) in a currency other than the company’s functional currency

24 Foreign Exchange Risk Bill Myer – Autumn 2015 Foreign exchange risk is the risk that the functional currency and the currency used in the transaction will change in value compared to each other, and the company will lose money as a result

25 Foreign Currency Purchases Bill Myer – Autumn 2015 Purchases on account denominated in a foreign currency are subject to risk Changes in the foreign exchange rate may  Increase Accounts Payable, resulting in an exchange loss, or  Decrease Accounts Payable, resulting in an exchange gain Foreign currency Accounts Payable is adjusted to fair value each period until paid

26 Foreign Currency Sales Bill Myer – Autumn 2015 Sales on account denominated in a foreign currency are subject to risk Changes in the foreign exchange rate may  Increase Accounts Receivable, resulting in an exchange gain  Decrease Accounts Receivable, resulting in an exchange loss Foreign currency Accounts Receivable is adjusted to fair value each period until collected.

27 Exercises E 12-5 (1, 2, 3) (page 465) Bill Myer – Autumn 2015

28 Example: Purchase on Account Bill Myer – Autumn 2015 On 11/1, Sam purchases inventory for 500 euros on account Sam pays for these goods on 1/30 Pertinent rates: DateSpot rateAcct PayGain (Loss) 11/1$1.35$675 12/31$1.36$680$(5) 1/30$1.38$690$(10)

29 Purchase on Account - Entries Bill Myer – Autumn /1Inventory675 Account Payable(euros) /31Exchange loss5 Account Payable(euros) 5 1/30Cash (euros)690 Cash ($) 690 1/30Account Payable (euros)680 Exchange loss 10 Cash (euros) 690 Adjust payable to current rate Convert dollars to euros so proper funds are available for payment Make payment in euros, recognizing additional loss

30 Exercises E 12-6 (page 466) E 12-7 (page 466) Bill Myer – Autumn 2015

31 Example: Sale on Account Bill Myer – Autumn 2015 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$1.35$675 12/31$1.36$680$5 1/30$1.38$690$10

32 Sale on Account - Entries Bill Myer – Autumn /1Accounts receivable (euros)675 Sales /31Accounts receivable (euros)5 Exchange gain 5 1/30Cash (euros)690 Acct receivable (euros) 680 Exchange gain 10 1/30Cash ($)690 Cash (euros) 690 Adjust receivable to current rate Collect from customer, recognizing additional gain Convert funds

33 Exercises E 12-8 (page 466) E 12-9 (page 466) Bill Myer – Autumn 2015

34 Derivatives and Foreign Currency – Review Questions Bill Myer – Autumn 2015 What are the four main types of derivatives? How can derivatives be used as a hedge? What is a company’s functional currency? What is a foreign currency transaction? What is foreign exchange risk? How do you adjust foreign currency accounts payable and foreign currency accounts receivable?