to accompany

Advanced Accounting, 11th edition

by Beams, Anthony, Bettinghaus, and Smith
Chapter 12
Derivatives and Foreign
Currency: Concepts
and Common
Transactions
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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.
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1: DERIVATIVES
Derivatives and Foreign Currency:
Concepts and Common Transactions
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
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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
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2: TYPES OF DERIVATIVES
Derivatives and Foreign Currency:
Concepts and Common Transactions
Derivatives
The four basic types of
derivatives are:

Forward Contracts
Futures Contracts
Options
Swaps
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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

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Futures Contracts
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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.
Options
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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.
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.





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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.
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Forward Contract Impact
If Sams 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.
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3: FOREIGN CURRENCY
EXCHANGE
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Derivatives and Foreign Currency:
Concepts and Common Transactions
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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
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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

Establishing Exchange Rates
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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.
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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
4: SALES AND PURCHASES
DENOMINATED IN FOREIGN
CURRENCY
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Derivatives and Foreign Currency:
Concepts and Common Transactions
Currency Denomination
A companys 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 companys
functional currency.


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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.
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5: RECORDING FOREIGN
CURRENCY TRANSACTIONS
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Derivatives and Foreign Currency:
Concepts and Common Transactions
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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.
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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.
Example: Purchase on Account
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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 $(10)
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Purchase on Account - Entries
11/1 Inventory 675
Account Payable(euros) 675
12/31 Exchange loss 5
Account Payable(euros) 5
1/30 Cash (euros) 690
Cash ($) 690
1/30 Account 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.
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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)
11/1 $1.35 $675
12/31 $1.36 $680 $5
1/30 $1.38 $690 $10
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Sale on Account - Entries
11/1 Accounts receivable (euros) 675
Sales 675
12/31 Accounts receivable (euros) 5
Exchange gain 5
1/30 Cash (euros) 690
Acct receivable (euros) 680
Exchange gain 10
1/30 Cash ($) 690
Cash (euros) 690
Adjust
receivable
to current
rate.
Collect
from
customer,
recognizing
additional
gain
Convert funds.
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