Advanced Accounting

Thirteenth Edition, Global Edition

Chapter 12
Derivatives and
Foreign Currency:
Concepts and Common
Transactions

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Derivatives and Foreign Currency –
Concepts and Common Transactions:
Objectives
12.1 Understand the definition of a derivative and the
types of risks that derivatives can manage.
12.2 Understand the structure, benefits and costs of
options, futures contracts, forward contracts, and
swaps.
12.3 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.

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Derivatives and Foreign Currency –
Concepts and Common Transactions:
Objectives (continued)
12.4 Explain the difference between receivable or
payable measurement and denomination.
12.5 Record foreign currency-denominated
sales/receivables and purchases/payables at the
initial transaction date, period-end, and the
receivable or payable settlement date.

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12.1: Derivatives
Derivatives and Foreign Currency: Concepts and Common
Transactions

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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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12.2: Types of Derivatives
Derivatives and Foreign Currency: Concepts and Common
Transactions

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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
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.

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Options
Options are the 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.

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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
Sun 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,
Sun has determined their selling price regardless of
the market, and Irene has locked in her purchase
price.

Sun 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 Sun’s fixed costs are $50,000, and the variable
cost is $3 per unit, Sun will lock in a 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, Sun 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, Sun has
profit of $20,000.

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12.3: Foreign Currency Exchange
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

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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.

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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

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12.4: Sales and Purchases Denominated
in Foreign Currency
Derivatives and Foreign Currency: Concepts and Common
Transactions

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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.

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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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12.5: Recording Foreign Currency
Transactions
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.

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Example: Purchase on Account
On 11/1, Sun purchases inventory for 500 euros on
account.
Sun pays for these goods on 1/30.

Pertinent rates:
Date Spot rate Acct Pay Gain (Loss)
11/1 $1.35 $675 blank 
12/31 $1.36 $680 $(5)
1/30 $1.38 $690 $(10)

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Purchase on Account - Entries
11/1 Inventory 675  blank
Adjust
payable to  blank Account Payable(euros)  blank 675
current 12/31 Exchange loss 5  blank
rate.  blank Account Payable(euros)  blank 5
1/30 Cash (euros) 690  
Convert
dollars to  blank Cash ($)  blank 690
euros so   1/30 Account Payable (euros) 680  blank
proper funds  blank Exchange loss   10  blank
are available
for payment.  blank Cash (euros)  blank 690

Make payment in euros,

recognizing additional
loss.

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Example: Sale on Account
On 11/1, Sun 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  blank
12/31 $1.36 $680 $5
1/30 $1.38 $690 $10

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Sale on Account - Entries
Adjust
receivable to 11/1 Accounts receivable (euros) 675  blank
current rate  blank Sales  blank 675
12/31 Accounts receivable (euros) 5  blank

Collect from  blank Exchange gain  blank 5

customer, 1/30 Cash (euros) 690  blank
recognizing  blank Acct receivable (euros)  blank 680
additional
gain  blank Exchange gain  blank 10
1/30 Cash ($) 690  blank
 blank Cash (euros)  blank 690

Convert funds

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