1 Advanced Accounting Autumn 2015 Chapter 12 Part I Bill Myer – Autumn 2015.

1

Advanced Accounting

Autumn 2015

• Chapter 12• Part I

Bill Myer – Autumn 2015

2

Agenda

• Homework

• Chapter 12: Derivatives and Foreign Currency Transactions


3Bill Myer – Autumn 2015

Homework

• You should have already read Chapters 1-5, 8, 12

• Read Chapter 13: Foreign Currency Financial Statements

• Exercises E12-5 (1, 2, 3); E12-6; E12-7; E12-8; E12-9

4

Agenda

• Homework

• Chapter 12: Derivatives and Foreign Currency Transactions Derivatives Types of Derivatives Foreign Currency Exchange Sales and Purchases Denominated in Foreign Currency Recording Foreign Currency Transactions



• Vocabulary related to derivatives Derivative Option / Put option / Call option Future Forward Swap Hedge Commodity Net settlement

Vocabulary – Important Vocabulary for Chapter 12


• Vocabulary related to foreign currency Direct quote / indirect quote Reciprocal Spot rate / forward rate Current rate Functional currency Foreign currency transaction “Denominated”

Vocabulary – Important Vocabulary for Chapter 12

7

Derivatives and Foreign Currency – Focus Questions


• What are the four main types of derivatives?

• How can derivatives be used as a hedge?

• What is a company’s functional currency?

• What is a foreign currency transaction?

• What is foreign exchange risk?

• How do you adjust foreign currency accounts payable and foreign currency accounts receivable?

8

Derivatives and Foreign Currency – 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

9

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

10

Derivative (definition)


• A derivative can be used to offset (“hedge”) the potential fluctuation in

Interest rates

Commodity prices

Foreign currency exchange rates

Stock prices

11

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

12

Derivatives


• The four basic types of derivatives are:

Forward contracts

Futures contracts

Options

Swaps

13

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

14

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

15

Options


• 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

16

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

17

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

18

Forward Contract Impact


• If 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

19

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 generally the measurement currency

Payables and receivables may be denominated in U.S. dollars or other currencies

20

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

21

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

22

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

23

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

24

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

25

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

26

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

Decrease Accounts Receivable, resulting in an exchange loss

• Foreign currency Accounts Receivable is adjusted to fair value each period until collected.

27

Exercises

• E 12-5 (1, 2, 3) (page 465)


28

Example: Purchase on Account


• 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)

29

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

30

Exercises

• E 12-6 (page 466)

• E 12-7 (page 466)


31

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

32

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

33

Exercises

• E 12-8 (page 466)

• E 12-9 (page 466)


34

Derivatives and Foreign Currency – Review Questions


• What are the four main types of derivatives?

• How can derivatives be used as a hedge?

• What is a company’s functional currency?

• What is a foreign currency transaction?

• What is foreign exchange risk?

• How do you adjust foreign currency accounts payable and foreign currency accounts receivable?

1 Advanced Accounting Autumn 2015 Chapter 12 Part I Bill Myer – Autumn 2015.

Documents

Transcript of 1 Advanced Accounting Autumn 2015 Chapter 12 Part I Bill Myer – Autumn 2015.