ACCOUNTING FOR

DERIVATIVES AND HEDGING

TRANSACTIONS

Chapter 11

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 1

 OBJECTIVES

Identify the characteristics of a derivative.

Give examples of derivatives.
State the purposes of acquiring derivatives.
Enumerate the qualifying hedged items.
Differentiate fair value hedge from cash flow
hedge

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 2

 Overview on the topic

Introduction to basic concepts

Accounting for forward contracts
Accounting for futures contracts, options
and swaps
Accounting for net investment hedges and
embedded derivatives

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 3

 RISKS

Financial Risk
Credit risk
Liquidity risk
Market risk
Interest rate risk
Currency risk
Other price risk

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 4

 Foreign Currency Derivatives
and Hedging Activities
Derivative is a financial instrument or other contract that
derives its value from the changes in value of some other
underlying asset or other instrument.
.

The derivative contract’s value to the investor

is directly related to the fluctuations in price,
rate, or some other variable that underlies it.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 5

 Characteristics of Derivatives
1. Whose value changes in response to
changes in a specified variable or underlying

2. It requires no initial investment or an initial

net investment that is smaller than would be
required for other types of contracts that
would be expected to have a similar response
to changes in market factors

3. It is settled at a future date.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 6
 Purpose of derivatives

The purpose of obtaining derivatives is either:

to speculate (incur risk); or
to hedge (avoid or manage risk).

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 7

On initial date of transaction, a derivative normally
entails no cost or an initial net investment that is
smaller than would be required for other types of
contracts that have a similar response to changes in
market factors.

After initial date of transaction, the value of a derivative

is determined by multiplying (or other arithmetical
interaction) the notional amount by the underlying.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 8

 Derivative Instruments

Option contracts

Forward contracts

Future contracts

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 9

 Option Contract
Option – is a contract giving the holder the right, but not the
obligation, to buy or sell an asset at a specified price any
time during a specified period in the future. When the holder
exercises his right, the writer of the option is obligated to
perform his obligation on the option contract.

Types of options as to right of holder:

1. Call option – an option to buy
2. Put option – and option to sell

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 10

 Option Contract

➢ At the money – holder may or may not exercise option; no gain

or loss in exercising
➢ In the money – holder should exercise; gain in exercising
➢ Out of the money – holder should not exercise; loss in exercising

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 11

 Derivative Instruments

Futures contract - is a contract traded on an exchange that

allows an entity to buy or sell a specified quantity of
commodity or a financial security at a specified price on a
specified future date.

A forward contract is negotiated between the parties. It

bind both parties (the writer and the holder) to perform.
It is an agreement to exchange currencies of different
countries on a specified future date at specified rate.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 12

 Forward vs. Future Contract

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 13

 Hedging and Hedge Accounting
Hedging
➢ It is a risk management technique that involves
using one or more derivatives or other hedging
instrument to offset changes in fair value or
cash flow of hedged items.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 14

 Hedging and Hedge Accounting
Hedged Item
It is an asset, liability, firm commitment, highly probable forecast
transaction, or net investment in a foreign operation. To be design-
ated as a hedged item, the designated hedge item should expose the
entity to risk of changes in fair value or future cash flows

Hedge Instrument
It is a designated derivative whose FV or cash flows are
expected to offset changes in FV or cash flows of a designated
hedge item.
©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 15
A hedged item can be a:
1. Recognized asset or liability (e.g., recorded
receivables or recorded payables)
2. Unrecognized firm commitment (e.g., receivable
not yet recorded on a future sale commitment or
payable not yet recorded on a future purchase
commitment)
3. Highly probable forecast transaction (e.g., a
planned but not committed future sale or future
purchase)
4. Net investment in a foreign operation (e.g., a
foreign subsidiary)
©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 16
 Firm commitment – is a binding agreement for the
exchange of a specified quantity of resources at a specified
price on a specified future date or dates.
Forecast transaction – is an uncommitted but anticipated
future transaction.
Foreign operation – is an entity that is a subsidiary,
associate, joint venture or branch of a reporting entity
whose activities are based or conducted in a country or
currency other than those of the reporting entity.
Net investment in a foreign operation – is the amount of
the reporting entity’s interest in the net assets of that
operation.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 17

 Measurement of derivatives

All derivatives are measured at fair value. The

accounting for fair value changes depends on
whether the derivative is:

1. Not designated as a hedging instrument;

2. Designated as fair value hedge; or
3. Designated as cash flow hedge.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 18

 Hedging Relationships

A fair value hedge is a derivative contract that

attempts to reduce the price risk of an existing
Asset/ liability or firm purchase commitment.

A cash flow hedge is designed to limit the company’s

exposure to price changes in forecasted transactions.

Hedge of a net investment in a foreign operation

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 19
 Distinction Fair Value Hedge Cash Flow Hedge
1. Certainty of transaction Transaction is certain Transaction is uncertain
2. Update to Fair Value Accounts are upfdated to Fair Value No Update
3. Recognition of change in FV of Change in Intrinsic Value - Other
Hedging Instrument using split Change in Intrinsic Value - Profit/ Loss Comp. Income
Accounting Change in Time Value- Profit/ Loss Change in Time Value- Profit/ Loss
©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 20
©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 21
©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 22
 Apply foreign-currency-
denominated derivative
accounting.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 23

 Speculation

Exchange gains or losses on derivative

instruments that speculate in foreign
currency price movements are included
in income in the period in which the
forward exchange rates change.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 24

 Speculation

On November 2, 2007, Phil Co.

enters into a 90-day forward contract
(future) to purchase 10,000 euros (€).
The current quotation for 90-day futures is P5,400.
The spot rate for euros on November 2 is P0.5440.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 25

 Speculation

December 31, 2007 January 30, 2008

day futures P0.5450 P0.5480

Spot rate P0.5500 P0.5530

What are the journal entries of Pinoy Co.

to account for the speculation?

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 26

 Speculation
November 2, 2007
Contract Receivable (fc) 5,400
Contract Payable 5,400
To record contract for 10,000 euros × P0.5400 exchange rate for 90-day futures

December 31, 2007

Contract Receivable (fc) 50
Exchange Gain 50
To adjust receivable from exchange broker
and recognize exchange gain
10,000 euros × (P0.5450 forward exchange rate for 30-day
futures – P0.5400 per books)

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 27

 Speculation

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 28

 Fair Value Hedge- Call Option
Illustration
On October 1, 2023, Phil Comp took a delivery from Bahrain
firm of inventory costing 1,140,000 dinar . Payment is due on
January 30, 2024. Concurrently, Phil Co paid P15,700 cash to
acquire at- the money option for 1,140,000 dinar. Strike price
is P12.40

10/1/23 12/31/23 1/30/24

Market Price P12.40 P12.423 P12.427
FV of Call Option P28,200 P30,780

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 29

 Hedged Item Hedging Instrument
10/1 Purchases 14,136,000 Call Option 15,700
Accounts Payable 14,136,000 Cash 15,700
12/31 ForEx Loss 26,220 Call Option 26,220
Accounts Payable 26,220 Gain on Derivatives (IV) 26,220
Loss on Derivatives (TV) 13,720
Call Option 13,720
1/30 Accounts Payable 14,162,220 Cash (FC) 14,166,780
ForEx Loss 4,560 Loss on Derivatives (TV) 1,980
Cash (FC) 14,166,780 Gain on Derivatives (IV) 4,560
Call Option 28,200
Cash (LC) 14,136,000
10/1 12/31 1/30
12.40 12.423 12.427
FV of Call Option 15,700 28,200 30,780
Intrinsic Value (Eff P) 0 26,220 30,780
Time Value (Ineff P) 15,700 1,980 0
©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 30
Notional Amount 1,140,000 dinar
 Fair Value Hedge- Put Option
Illustration
On December 1, 2023, F Comp acquired 4,600 shares of QRS
at a cost of P28 per share. F comp classifies them as AFS. On
the same date, F decides to hedge against a possible decline in
the value of securities by purchasing at a cost of P11,900 an at-
the-money option to sell the 4,600 shares. The option expires
on April 1, 2024

12/1/23 12/31/23 4/1/24

M shares (cost/share) P28.00 P26.50 P23.50
FV of Put Option P15,400 P20,700
©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 31
 Hedged Item Hedging Instrument
12/1 AFS 128,800 Put Option 11,900
Cash 128,800 Cash 11,900
12/31 Loss on Rev’n 6,900 Put Option 3,500
AFS 6,900 Gain on Derivatives 3,500

4/1 Loss on Rev’n 13,800 Cash 128,800

AFS 13,800 Gain on Derivatives 5,300
Put Option 15,400
AFS 108,100

12/1 12/31 4/1

28.00 26.50 23.50
FV of Put Option 11,900 15,400 20,700
Intrinsic Value (Eff P) 0 6,900 20,700
Time Value (Ineff P) 11,900 8,500 0
Notional
©2003 PrenticeAmount 4,600
Hall Business Publishing, shares
Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 32
 Hedged Item Hedging Instrument
11/2 AR 9,107,280 FC Receivable 8,962,720
Sales 9,107,280 FC Payable 8,962,720
12/31 ForEx Loss 133,440 FC Payable 22,240
AR 133,440 ForEx Gain 22,240

4/1 Cash (FC) 8,907,120 FC Payable 8,940,480

ForEx Loss 66,720 Cash (FC) 8,907,120
AR 8,973,840 ForEx Gain 33,360
Cash (FC) 8,962,720
FC Receivable 8,962,720
12/1 12/31 4/1
Bid Spot Rate 81.90 80.70 80.10
30-day futures P82.30 P80.40 P83.90
90-day futures P80.60 P81.60 P83.40
©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 33
 Cash Flow Hedge
Illustration
On August 1, 2013, EFG Co. forecasted to purchase of
60,000 units of inventory from Bangladesh Co. The purchase
would probably occur on Nov 2 and require the payment of
2,340,000 taka. It is anticipated that the inventory could be
further processed and delivered to customers by early
December. On august 1, the company purchased P8,850 call
option to buy 2,340,000 taka at strike price
of P7.95.
Aug 1 Aug 31 Sept 30 Nov 2
Spot rate P7.93 P7.952 P7.963 P7.97
FV of Call Option P15,690 P34,410 ?
On Nov 2, EFG purchased 60,000 units of inventory.
The option was exercise on that date.
©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 34
 Hedged Item Hedging Instrument
8/1 NO ENTRY Call Option 8,850
Cash 8,850
8/31 NO ENTRY Call Option (IV) 4,680
Gain on Derivatives (OCI) 4,680
Call Option (TV) 2,160
Gain on Derivatives (P/L) 2,160
9/30 NO ENTRY Call Option (IV) 25,740
Gain on Derivatives (OCI) 25,740
Loss on Derivatives (P/L) 7,020
Call Option (IV) 7,020
Cash (FC) 18,649,800
Loss on Derivatives (P/L) 3,990
11/2 Purchases 18,649,800 Gain on Derivatives 16,380
Cash 18,649,800 Call Option 34,410
Notional Amount 2,340,000 taka Cash (LC) 18,603,000
08/1 8/31 9/30 11/2
Strike price 7.95
Market price 7.93 7.952 7.963 7.97
FV of Call Option 8,850 15,690 34,410 46,800
Intrinsic Value (Eff P) 0 4,680 30,420 46,800
Time
©2003 Value
Prentice (Ineff
Hall P) Publishing,
Business 8,850
Advanced Accounting11,010 3,990 0 12 - 35
8/e, Beams/Anthony/Clement/Lowensohn
 Forward Contract
Illustration
M sold merchandise for 111,200 rupees to a customer in India on
Nov 2, 2023. Collection in Indian rupees was due on January 31,
2024. On the same date, to hedge this foreign currency exposure, M
Entered into futures contract to sell 111,200 rupees to a bank for
delivery on January 31, 2024. Exchange rate for rupees as follows:
Nov 2 Dec 31 Jan 31
Strike Price P81.70 P81.70 P81.70
Offer Spot Rate P81.70 P80.50 P80.30
Bid Spot rate P81.90 P80.70 P80.10
30-day futures P82.30 P80.40 P83.90
60-day futures 81.80 80.30 82.60
90-day futures P80.60 P81.60 P83.40
120-day futures 80.10 81.40 82.80
©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 36
 Forward Exchange Contract
Illustration
M sold merchandise for 111,200 rupees to a customer in India on
Nov 2, 2023. Collection in Indian rupees was due on January 31,
2024. On the same date, to hedge this foreign currency exposure, M
Entered into futures contract to sell 111,200 rupees to a bank for
delivery on January 31, 2024. Exchange rate for rupees as follows:
Nov 2 Dec 31 Jan 31

Offer Rate P81.70 P80.50 P80.30

Bid Spot rate P81.90 P80.70 P80.10
30-day futures P82.3 P80.4 P83.9
60-day futures 81.8 80.3 82.6
90-day futures P80.60 P81.60 P83.40
120-day futures 80.10 81.40 82.80
©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 37
 Forward Exchange Contract
Illustration
M sold merchandise for 111,200 rupees to a customer in India on
Nov 2, 2023. Collection in Indian rupees was due on January 31,
2024. On the same date, to hedge this foreign currency exposure, M
Entered into futures contract to sell 111,200 rupees to a bank for
delivery on January 31, 2024. Exchange rate for rupees as follows:
Nov 2 Dec 31 Jan 31

Bid Spot rate P81.90 P80.70 P80.10

30-day futures P82.3 P80.4 P83.9
60-day futures 81.8 80.3 82.6
90-day futures P80.60 P81.60 P83.40
120-day futures 80.10 81.40 82.80
©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 38
 Forward Exchange Contract
Illustration
M sold merchandise for 111,200 rupees to a customer in India
on Nov 2, 2023. Collection in Indian rupees was due on
January 31, 2024. On the same date, to hedge this foreign
currency exposure, M Entered into futures contract to sell
111,200 rupees to a bank for delivery on January 31, 2024.
Exchange rate for rupees as follows:
Nov 2 Dec 31 Jan 31

Bid Spot rate P81.90 P80.70 P80.10

Forward Rate P80.60 P80.4 P80.10

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 39

 Hedged Item Hedging Instrument
11/2 AR 9,107,280 FC Receivable 8,962,720
Sales 9,107,280 FC Payable 8,962,720
12/31 ForEx Loss 133,440 FC Payable 22,240
AR 133,440 Gain on Forward Cont. 22,240

4/1 Cash (FC) 8,907,120 FC Payable 8,940,480

ForEx Loss 66,720 Cash (FC) 8,907,120
AR 8,973,840 Gain on Forward Cont. 33,360
Cash (LC) 8,962,720
FC Receivable 8,962,720

11/2 12/31 4/1

Bid Spot rate P81.90 P80.70 P80.10
Forward Rate P80.60 P80.4 P80.10
Notional
©2003 Amount
Prentice Hall 111,200
Business Publishing, rupees 8/e, Beams/Anthony/Clement/Lowensohn
Advanced Accounting 12 - 40
 Hedging of a Foreign Currency
Purchase Commitment
Illustration
On October 1,2023, Pinoy Corp entered into a firm commitment
with a Japanese firm to acquire a machine, delivery and passage
of title on March 31, 2024, at a price of 37,800 dirhams. On the
same date, to hedge against unfavourable changes in the
exchange rate of the dirhams, Pinoy Corp entered into 180-day
forward contract with BPI for 37,800 dirhams. Exchange rate
Were as follows:
Spot Rate Forward Rate
10/1/23 P96.50 P94.30
12/31/23 97.25 96.50
3/31/24 99.70 99.70
©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 41
 Hedged Item Hedging Instrument
10/1 NO ENTRY FC Receivable 3,564,540
FC Payable 3,564,540
12/31 Loss on Firm Comm. 83,160 FC Receivable 83,160
Firm Commitment 83,160 Gain on Forward Cont. 83,160

3/31 Machinery 3,564,540 FC Payable 3,564,540

Firm Comm. 83,160 Cash 3,564,540
Loss on Firm Comm. 120,960
Cash (FC) 3,768,660
Cash 3,768,660 FC Receivable 3,647,700
Gain on Forward Cont. 120,960

10/1 12/31 3/31

Spot rate P96.50 P97.25 P99.70
Forward Rate P94.30 P96.50 P99.70
Notional
©2003 Amount
Prentice Hall 37,800
Business Publishing, Advanceddirhams
Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 42
 Hedging in Net Investment in a
Foreign Entity
Illustration
Pinoy Corp, a Philippine comp, has a 30% equity investment in Hong
Kong Comp, King Inc. On December 31,2013, the balance in Pinoy’s
investment in King account is P3,120,000 equal to 30% of King’s net
assets of 2,000,00 HKg$ times a P5.20 year-end exchange Rate. On this
date, Pinoy has no translation adjustment balance Relative to its investmen
in king. To hedge its net investment in King, Pinoy borrows 500,000 Hkg$
for one year at 12% interest on January 1,2014 at a spot rate of P5.20.
The loan is denominated in HKg$, with principal and interest payable on
January 1,2015. Assume that November 2,2014, King declares and pays
a 100,000 HKg$ Dividend when the spot rate is P5.35. On December 31,
King reports net income of 400,000 HKg$. Weighted average for the year
is P5.30 and the closing exchange rate on Dec 31 is P5.40.
©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 43
 Hedging in Net Investment in a
Foreign Entity
HK $ Exchange Rate Phil. P
Net Assets, Jan 1 2,000,000 5.20 10,400,000
Net Income, Dec 31 400,000 5.30 2,120,000
Dividends Paid (100,000) 5.35 (535,000)
Total 11,985,000
Translation Adj. 435,000
Net Assets, Dec 31 2,300,000 5.40 12,420,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 44

 Hedging in Net Investment in a
Foreign Entity
Date Hedged Item Hedging Instrument
Jan 1 Investment in King 3,120,000 Cash 2,600,000
Cash 3,120,000 Loan Payable 2,600,000

Nov 2 Cash 160,500

Investment in King 160,500

Dec 31 Investment in King 766,500 Translation Adjustment 100,000

Investment Income 636,000 Loan Payable 100,000
Translation Adjustment 130,500
Interest Expense 318,000
Forex Loss 6,000
Interest Payable 324,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 45

 End of Module 2

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 12 - 46