beams11_ppt12

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

to accompanyAdvanced Accounting, 11th edition

by Beams, Anthony, Bettinghaus, and Smith

Chapter 12Derivatives 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 pricesCopyright ©2012 Pearson Education,

Inc. Publishing as Prentice Hall 12-4


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Using Derivatives as HedgesA hedge can

Shift risk of fluctuations in sales prices, costs, interest rates, or currency exchange rates

Help manage costsReduce risks to improve financial

positionProduce tax benefitsHelp avoid bankruptcy


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2: TYPES OF DERIVATIVES


Derivatives

The four basic types of derivatives are:

Forward Contracts Futures Contracts Options Swaps

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 12-7


Forward ContractsForward 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), orPut (sell)

With options, only one party is obligated to perform depending on the election of the other party to exercise their option.


SwapsSwaps 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 ContractSam 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. 12-12


Forward Contract ImpactIf 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.

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3: FOREIGN CURRENCY EXCHANGE

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Measurement and Denomination

Measured in a currencyRecorded in the financial records in that

currencyDenominated in a currency

Requires settlement (payment or receipt) in that currency

For U.S. firmsU.S. dollar is the measurement currencyPayables and receivables may be denominated

in U.S. dollars or other currencies


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Quoting Exchange RatesDirect 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 deliveryCurrent rate

Exchange rate at balance sheet date, orExchange rate at the time a transaction

takes placeHistorical rate

Exchange rate that existed when a specific transaction or event occurred


4: SALES AND PURCHASES DENOMINATED IN FOREIGN CURRENCY

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Currency DenominationA 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.

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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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Foreign Currency PurchasesPurchases 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 gainForeign currency Accounts Payable is adjusted to fair value each period until paid.


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Foreign Currency SalesSales 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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