Chapter 12: Derivatives and

Foreign Currency Transactions

by Jeanne M. David, Ph.D., Univ. of Detroit Mercy

to accompany
Advanced Accounting, 10th edition
by Floyd A. Beams, Robin P. Clement,
Joseph H. Anthony, and Suzanne Lowensohn

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 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.

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 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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Derivatives and Foreign Currency Transactions
1: Derivatives and Risk Management

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 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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Derivatives and Foreign Currency Transactions
2: Types of Derivatives

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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

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 Options
• With options, only one party is obligated to
perform
• The other party has
– Ability,
– But not obligation to perform

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 Using Derivatives as Hedges
• A hedge can
– Shift risk of fluctuations in sales prices, costs,
interest rates, currency exchange rates
– Help manage costs
– Reduce risks to improve financial position
– Produce tax benefits
– Help avoid bankruptcy

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 Hedge Accounting
• At inception, document the hedge
– Relationship between hedged item and
derivative instrument
– Risk management objective and strategy for
hedge
• Hedged instrument
• Hedged item
• Nature of risk being hedged
• Means of assessing effectiveness

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Derivatives and Foreign Currency Transactions
3: Hedge Effectiveness

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 Effectiveness
To qualify for hedge accounting, the derivative
instrument must be
– Highly effective in offsetting
– Gains or losses
– In the item being hedged

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 Critical Term Analysis
• Effectiveness considers
– Nature of the underlying variable
– Notional amount
– Item being hedged
– Delivery date of derivative
– Settlement date of the underlying
• If critical terms are identical, effectiveness is
assumed

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 Example of Effectiveness
• Item to be hedged
– Accounts payable
– Due January 1, 2019
– 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, 2019

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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
– Regression analysis
– Correlation analysis
• Example
– Using derivatives based on heating oil or
crude oil to hedge jet fuel costs

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Derivatives and Foreign Currency Transactions
4: Cash Flow Hedges

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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

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 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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Derivatives and Foreign Currency Transactions
5: Fair Value Hedges

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 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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Derivatives and Foreign Currency Transactions
6: Accounting for Hedges

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 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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Derivatives and Foreign Currency Transactions
7: Foreign Currencies: Measurement
versus Denomination

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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 US firms
– US dollar is the measurement currency
– Payables and receivables may be denominated in
US dollars or other currencies

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Derivatives and Foreign Currency Transactions
8: Foreign Currency Exchange Rates

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 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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 Rates
• Spot rate
– Exchange rate for immediate delivery
• Current rate
– 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

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Derivatives and Foreign Currency Transactions
9: Sales and Purchases Denominated
in Foreign Currency

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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

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 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: Purchases on Account
ATC, a U.S. corporation, purchased merchandise
from Paris Company on December 1, 2011, for
10,000 euros, when the spot rate for euros was
$0.6600. ATC closed its books at December 31,
2011, when the spot rate for euros was $0.6550, and
it settled the account on January 30, 2012,when the
spot rate was $0.6650. These transactions and events
are recorded by ATC as follows:

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 Example: Purchases on Account

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 Example: Purchases on Account

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 Example: Sale on Account
On December 15, 2011, ATC sold merchandise to
Rome Company for 20,000 euros, when the spot rate
for euros was $0.6625. ATC closed its books on
December 31, when the spot rate was $0.6550,
collected the account on January 15, 2012, when the
spot rate was $0.6700, and held the euros until
January 20, when it converted the euros into U.S.
dollars at the $0.6725 spot rate in effect on that date.
ATC records the transactions as follows:

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 Example: Sale on Account

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 Example: Sale on Account

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 Example: Sale on Account

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Publishing as Prentice Hall

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