1. Advanced Accounting Chapter 12
Thirteenth Edition
Chapter 12
Derivatives and Foreign Currency: Concepts and Common Transactions
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2. Derivatives and Foreign Currency – Concepts and Common Transactions: Objectives
12.1 Understand the definition of a derivative and the types of risks that derivatives can manage Understand the structure, benefits and costs of options, futures contracts, forward contracts, and swaps 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 Explain the difference between receivable or payable measurement and denomination Record foreign currency-denominated sales/receivables and purchases/payables at the initial transaction date, period-end, and the receivable or payable settlement date.

3. Derivatives
Derivatives and Foreign Currency: Concepts and Common Transactions

4. Derivative (definition)
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.
A derivative can be used to offset (“hedge”) the potential fluctuation in
Interest rates
Commodity prices
Foreign currency exchange rates
Stock prices

5. Using Derivatives as Hedges
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

6. Types of Derivatives
Derivatives and Foreign Currency: Concepts and Common Transactions

7. Derivatives The four basic types of derivatives are: Forward Contracts
Futures Contracts
Options
Swaps

8. Forward Contracts 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

9. Futures Contracts
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.

10. Example: Forward Contract
Sun 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, Sun has determined their selling price regardless of the market, and Irene has locked in her purchase price. Sun 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.

11. Forward Contract Impact
If Sun’s fixed costs are $50,000, and the variable cost is $3 per unit, Sun will lock in a 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, Sun 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, Sun has profit of $20,000.

12. Options Options are the 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.

13. Swaps
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.

14. Swap
A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments. Most swaps involve cash flows based on a notional principal amount such as a loan or bond, although the instrument can be almost anything. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate or index price.
The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the- counter contracts primarily between businesses or financial institutions that are customized to the needs of both parties.

15. Interest Rate Swaps
In an interest rate swap, the parties exchange cash flows based on a notional principal amount (this amount is not actually exchanged) in order to hedge against interest rate risk or to speculate. For example, imagine ABC Co. has just issued $1 million in five- year bonds with a variable annual interest rate defined as the London Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis points). Also assume that LIBOR is at 2.5% and ABC management is anxious about an interest rate rise.

16. Interest Rate Swaps
The management team finds another company, XYZ Inc., that is willing to pay ABC an annual rate of LIBOR​ plus 1.3% on a notional principal of $1 million for five years. In other words, XYZ will fund ABC's interest payments on its latest bond issue. In exchange, ABC pays XYZ a fixed annual rate of 5% on a notional value of $1 million for five years. ABC benefits from the swap if rates rise significantly over the next five years. XYZ benefits if rates fall, stay flat or rise only gradually. 
Below are two scenarios for this interest rate swap: 1) LIBOR rises 0.75% per year; and 2) LIBOR rises 0.25% per year. 

17. Foreign Currency Exchange
Derivatives and Foreign Currency: Concepts and Common Transactions

18. 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 U.S. firms
U.S. dollar is the measurement currency.
Payables and receivables may be denominated in U.S. dollars or other currencies.

19. Quoting Exchange Rates
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

20. Establishing Exchange Rates
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.

21. Various Exchange Rates
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

22. Sales and Purchases Denominated in Foreign Currency
Derivatives and Foreign Currency: Concepts and Common Transactions

23. Currency Denomination
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 Currency Transactions

25. Foreign Exchange Risk
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.

26. Foreign Currency Transactions
The distinguishing feature of a foreign currency transaction is that settlement is effected in a foreign currency. Thus, foreign currency transactions occur whenever an enterprise purchases or sells goods for which payment is made in a foreign currency or when it borrows or lends foreign currency. As an example, a company purchasing inventories in Saudi Arabian riyals on account suffers an exchange loss should the riyal gain in value before settlement.

27. Recording Foreign Currency Transactions
Derivatives and Foreign Currency: Concepts and Common Transactions

28. Foreign Currency Purchases
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.

29. Foreign Currency Sales
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; or
Decrease Accounts Receivable, resulting in an exchange loss.
Foreign currency Accounts Receivable is adjusted to fair value each period until collected.

30. Single-Transaction Perspective
Under a single-transaction perspective, exchange adjustments (both settled and unsettled) are treated as an adjustment to the original transaction accounts on the premise that a transaction and its settlement are a single event.

33. Two-Transaction Perspective
Under a two-transaction perspective, collection of the foreign currency receivable is considered a separate event from the sale that gave rise to it.

35. Example: Purchase on Account
On 11/1, Sun purchases inventory for 500 euros on account. Sun pays for these goods on 1/30. Pertinent rates:
Date
Spot rate
Acct Pay
Gain (Loss)
11/1
$1.35
$675
blank 
12/31
$1.36
$680
$(5)
1/30
$1.38
$690
$(10)

36. Purchase on Account - Entries
11/1
Inventory
675
 blank
Account Payable(euros)
12/31
Exchange loss 5
1/30
Cash (euros)
690
Cash ($)
  1/30
Account Payable (euros)
680
  10
Adjust payable to current rate.
Convert dollars to euros so proper funds are available for payment.
Make payment in euros, recognizing additional loss.

37. Example: Sale on Account
On 11/1, Sun 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
$1.35
$675
 blank
12/31
$1.36
$680 $5
1/30
$1.38
$690
$10

38. Sale on Account - Entries
Adjust receivable to current rate
11/1
Accounts receivable (euros)
675
 blank
Sales
12/31 5
Exchange gain
1/30
Cash (euros)
690
Acct receivable (euros)
680 10
Cash ($)
Collect from customer, recognizing additional gain
Convert funds

39. Exception
Major exceptions to this requirement occur whenever (1) exchange adjustments relate to certain long-term intercompany transactions and (2) transactions are intended and effective as hedges of net investments (i.e., hedges of foreign operations’ exposed net asset/liability positions) and foreign currency commitments. (The notion of an exposed asset or liability position is described shortly.)

40. Example 1
On September 1, 2015, Cormorant Company purchased merchandise from Osaka Company of Japan for 20,000,000 yen payable on October 1, The spot rate for yen was $ on September 1 and the spot rate was $ on October 1.
 Required:
Did the exchange rate strength or weaken from September to October and what are the implications for Cormorant’s business?
What journal entry did Cormorant record on September 1, 2015?
What journal entry did Cormorant record on October 1, 2015?

41. Example 2
On October 15, 2015, Ibis Corporation, a French company, ordered merchandise listed on the Internet for 20,000 Euros from Spoonbill Corporation, a US corporation, which immediately accepted the order. The Euro rate was $1.20 US on October On November 15, Spoonbill shipped the goods and billed Ibis the purchase price of 20,000 Euros when the Euro rate was $1.30 US. Ibis paid the bill on December 10, Three days later Spoonbill exchanged the 20,000 Euros for US dollars when the Euro rate was $1.28US.
Required:
Compute the foreign currency gains or losses on the December 31, financial statements and show your calculations.

42. Example 3
On November 1, 2013, the Penguin Corporation, a US corporation, purchased an extruding machine from Shearwater Corporation, a UK company. The purchase price was $10,000 and Penguin agreed to pay in pounds on February 1, Both corporations are on a calendar year accounting period. Assume that the spot rates for the British pound on November 1, 2013, December 31, 2013, and February 1, 2014, are $1.60, $1.62, and $1.66, respectively.
Required: 
Record the November 1, December 31, and February 1 transactions in the General Journals of Penguin Corporation and Shearwater Corporation. If no entry is required on a particular date, indicate “No entry” in the General Journal.

43. Copyright