Advanced accounting 10th by a beams athony ch12

publishing as Prentice Hall 12-5 1: Derivatives and Risk Management Derivatives and Foreign Currency Transactions... publishing as Prentice Hall 12-19 Cash Flow Hedge • Hedges – Anticipa

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by Floyd A Beams, Robin P Clement, Joseph H Anthony, and Suzanne Lowensohn

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

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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12-5

1: Derivatives and Risk Management

Derivatives and Foreign Currency Transactions

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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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

• With options, only one party is obligated to perform

• The other party has

– Ability,

– But not obligation to perform

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– Help manage costs

– Reduce risks to improve financial position

– Produce tax benefits

– Help avoid bankruptcy

Hedge Accounting

• At inception, document the hedge

– Relationship between hedged item and

• Nature of risk being hedged

• Means of assessing effectiveness

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– Item being hedged

– Delivery date of derivative

– Settlement date of the underlying

• If critical terms are identical, effectiveness is assumed

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

4: Cash Flow Hedges

Derivatives and Foreign Currency Transactions

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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

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.

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:

• 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.

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

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Hedge: Fuel – Example (cont.)

The last entry reclassifies the loss on the

contract from OCI into Cost of sales The

effect is to increase Cost of sales to

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5: Fair Value Hedges

Derivatives and Foreign Currency Transactions

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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6: Accounting for Hedges

Derivatives and Foreign Currency Transactions

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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Measurement and Denomination

– US dollar is the measurement currency

– Payables and receivables may be denominated in

US dollars or other currencies

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8: Foreign Currency Exchange Rates

Derivatives and Foreign Currency Transactions

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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– 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

9: Sales and Purchases Denominated

in Foreign Currency

Derivatives and Foreign Currency Transactions

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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

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)

Sale on Account - Entries

11/1 Accounts receivable (euros) 775  

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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

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• 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.

Hedge: Liability - Entries

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Cash Flow Hedge: Anticipated

• 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:

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Hedge: Anticipated Outflow

• Forward rates and fair value of contract:

• 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

 Date Forward rate

Notional Amount

£500,000 Fair value Contract Discounted Fair value

Hedge: Anticipated Outflow Entries

12/2 no entry for forward contract - no cash exchanged

  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

The discount on the contract is amortized

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11: IASB Standards

Derivatives and Foreign Currency Transactions

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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

12: Disclosures

Derivatives and Foreign Currency Transactions

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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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