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12-1
12-2
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.
12-3
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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12-5
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
12-6
2: Types of Derivatives
12-7
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
12-8
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
12-9
Options
With options, only one party is obligated to
perform
The other party has
Ability,
But not obligation to perform
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12-11
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
2009 Pearson Education, Inc. publishing as Prentice
12-12
3: Hedge Effectiveness
12-13
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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12-15
Example of Effectiveness
Item to be hedged
Accounts payable
Due January 1, 2007
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, 2007
2009 Pearson Education, Inc. publishing as Prentice
12-16
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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12/1
12/31
1/31
$1.4007
$1.4050
$1.3995
Cost
of 4,200
barrelscontract
$5,882.94
$5,901.00
$5,877.90
Change
in futures
to Dec.
31 = $18.06
Change in futures contract to Jan. 31 = ($23.10)
The loss on the contract is ($5.04) OCI, and this serves
to increase the cost of sales.
12-22
10.00
18.06
OCI
1/31 OCI
Settle
contract;
collect
balance on
margin.
10.00
18.06
23.10
Futures contract
1/31 Cash
23.10
4.96
Futures contract
1/31 Inventory
Purchase
inventory.
Cash
4.96
5,877.90
5,877.90
12-23
Feb. Cash
8,400.00
Sales
Feb. Cost of sales
8,400.00
5,877.90
Inventory
Feb. Cost of sales
The last entry reclassifiesOCI
the loss on the
contract from OCI into Cost of sales. The
effect is to increase Cost of sales to
$5,882.94. This is the cost of the oil based
on the futures contract signed on Dec. 1.
2009 Pearson Education, Inc. publishing as Prentice
5,877.90
5.04
5.04
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12-25
12-26
12-27
12-28
12-29
12-30
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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
2009 Pearson Education, Inc. publishing as Prentice
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Spot rate
Acct Rec
11/1
$1.55
$775
12/31
$1.56
$780
$5
1/30
$1.58
$790
$10
Gain (Loss)
12-37
775
Sales
12/31 Accounts receivable (euros)
775
5
Exchange gain
1/30 Cash (euros)
5
790
Accounts receivable
780
Exchange gain
1/30 Cash ($)
Convert Cash
funds.(euros)
10
790
790
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12-39
Spot rate
12/2
$0.0094
$1,880
$0.0095
$1,900
12/31
$0.0092
$1,840
$0.0093
$1,860
1/30
$0.0098
$1,960
$0.0098
$1,960
Cont Rec
12-40
12-41
12/2 Equipment
1,880
Accounts payable ()
12/2 Contract receivable ()
1,880
1,900
1,900
40
Exchange gain
12/31 Exchange loss
Contract receivable ()
40
40
40
12-42
1,900
Cash ($)
1/30 Cash ()
1,900
1,960
Contract receivable ()
1,860
Exchange gain
100
1,840
Exchange loss
Use the yen to
pay()
the supplier
Cash
120
1,960
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12-44
Date
Forward rate
Notional
Amount
500,000
12/2
$1.68
840,000
12/31
$1.69
845,000
Contract Discounted
Fair value Fair value
5,000
4,901
The
3/1
860,000
20,000
15,099
contract $1.72
will be adjusted
to its discounted
fair value.
Use the
incremental borrowing rate (12%, or 1% monthly), discounting
for the remaining contract life.
12/31: 5,000 / (1.01)2
3/1 (end of contract): 15,000
Note: 1/31 would be equal to fair value / (1.01)1
12-45
4,901
OCI
4,901
3,346
3,346
12-46
15,099
OCI
15,099
3/1 Cash
20,000
Forward contract
20,000
860,000
Cash
860,000
3/1 OCI
2009 Pearson
Education, Inc. publishing as Prentice
6,654
12-47
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12-49
12: Disclosures
12-50
Footnote Disclosures
Focus on risk management objectives and
strategies
Fair value hedges
Net gain or loss in earnings, placement on
statements, effectiveness and ineffectiveness
Cash flow hedges
Hedge ineffectiveness gain or loss, placement on
statements, types of situations hedged, expected
length of time, effect of discontinuance of hedge
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