Derivatives and Foreign Currency: Concepts and Common Transactions

Chapter 12
Derivatives and Foreign

Currency: Concepts
and Common
Transactions
to accompany
Advanced Accounting, 11th edition
by Beams, Anthony, Bettinghaus, and Smith
Copyright ©2012 Pearson Education,

12-1
Inc. Publishing as Prentice Hall
Derivatives and Foreign Currency – Concepts
and Common Transactions: Objectives
1. 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.
12-2
Derivatives and Foreign Currency:
Concepts and Common Transactions
1: DERIVATIVES

12-3
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
12-4
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
12-5
2: TYPES OF DERIVATIVES

12-6
Derivatives
The four basic types of
derivatives are:
 Forward Contracts
 Futures Contracts
 Options
 Swaps
12-7
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
12-8
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. Copyright ©2012 Pearson Education,
12-9
Options
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.
12-10
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.

12-11
Example: Forward Contract
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. Copyright ©2012 Pearson Education,
12-12
Forward Contract Impact
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.
12-13
3: FOREIGN CURRENCY
EXCHANGE

12-14
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
12-15
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

12-16
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.
12-17
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
12-18
4: SALES AND PURCHASES

DENOMINATED IN FOREIGN
CURRENCY

12-19
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.
12-20
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.
12-21
5: RECORDING FOREIGN
CURRENCY TRANSACTIONS

12-22
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.
12-23
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. Copyright ©2012 Pearson Education,
12-24
Example: Purchase on Account
On 11/1, Sam purchases inventory for 500
euros on account. Sam pays for these goods
on 1/30. Pertinent rates:
Date Spot rate Acct Pay Gain (Loss)

11/1 $1.35 $675
12/31 $1.36 $680 $(5)
1/30 $1.38 $690 $(10)

12-25
Purchase on Account - Entries
11/1 Inventory 675

Adjust Account Payable(euros) 675
payable to 12/31 Exchange loss 5
current Account Payable(euros) 5
rate.
1/30 Cash (euros) 690
Convert Cash ($) 690
dollars to 1/30 Account Payable (euros) 680
euros so Exchange loss 10
proper funds Cash (euros) 690
are available
for payment. Make payment in
euros, recognizing
additional loss.
12-26
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)

11/1 $1.35 $675
12/31 $1.36 $680 $5
1/30 $1.38 $690 $10

12-27
Sale on Account - Entries
11/1 Accounts receivable (euros) 675

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

12-28
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12-29

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Chapter 12

Derivatives and Foreign

Copyright ©2012 Pearson Education,

Copyright ©2012 Pearson Education,

Copyright ©2012 Pearson Education,

Settlement may also be made by entering

Swaps are commonly negotiated on an

Copyright ©2012 Pearson Education,

Sam risks loss of potential revenue if the

If the market price for the item increases, Sam

Copyright ©2012 Pearson Education,

Direct and indirect quotes are reciprocals

Copyright ©2012 Pearson Education,

4: SALES AND PURCHASES

Copyright ©2012 Pearson Education,

A foreign currency transaction is

Foreign Exchange Risk is the

Copyright ©2012 Pearson Education,

Date Spot rate Acct Pay Gain (Loss)

Copyright ©2012 Pearson Education,

11/1 Inventory 675

Date Spot rate Acct Rec Gain (Loss)

Copyright ©2012 Pearson Education,

11/1 Accounts receivable (euros) 675

Copyright ©2012 Pearson Education,

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