ADVANCE ACCOUNTING Ch12

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Accounting for Foreign Currency Accounting for Foreign Currency Transactions and Hedging Foreign Transactions and Hedging Foreign Exchange RiskExchange Risk

Advanced Accounting, Fifth Edition

1212

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1. Distinguish between the terms “measured” and “denominated.”

2. Describe what is meant by a foreign currency transaction.

3. Understand some of the more common foreign currency transactions.

4. Identify three stages of concern to accountants for foreign currency transactions, and explain the steps used to translate foreign currency transactions for each stage.

5. Describe a forward exchange contract.

Learning ObjectivesLearning Objectives

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6. Explain the use of forward contracts as a hedge of an unrecognized firm commitment.

7. Identify some of the common situations in which a forward exchange contract can be used as a hedge.

8. Describe a derivative instrument and understand how it may be used as a hedge.

9. Explain how exchange gains and losses are reported for fair value hedges and cash flow hedges.

Learning ObjectivesLearning Objectives

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Many U.S. companies engage in international activities such as:

Exporting or importing goods,

Establishing a foreign branch, or

Holding an equity investment in a foreign company.

Foreign Currency TransactionsForeign Currency Transactions

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Recording and reporting problems with foreign currency transactions:

Transactions in a foreign currency must be translated (expressed in dollars) before they can be aggregated with domestic transactions.Receivables or payables denominated in foreign currencies are subject to gains and losses.Companies use hedging strategies with derivatives to minimize the impact of exchange rate changes.

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Exchange Rates—Means of TranslationExchange Rates—Means of Translation

Translation - process of expressing amounts stated in a foreign currency in the currency of the reporting entity by using an appropriate exchange rate.

Exchange rate - ratio between a unit of one currency and another currency for which that unit can be exchanged at a particular time.

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Direct Exchange RateUnits of domestic currency that can be converted Units of domestic currency that can be converted into into one unit of foreign currencyone unit of foreign currency..Direct rate =Direct rate = 1.517 ($1.517 U.S. for 1 British 1.517 ($1.517 U.S. for 1 British pound)pound)

Indirect Exchange RateUnits of foreign currency that can be converted Units of foreign currency that can be converted into into one unit of domestic currencyone unit of domestic currency..Indirect rate = 1.00/1.517 = .6592 Indirect rate = 1.00/1.517 = .6592 ($1 U.S. for .6592 British pound)($1 U.S. for .6592 British pound)


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Spot RateRate at which currencies can be exchanged today.Rate at which currencies can be exchanged today.

Forward or Future RateRate at which currencies can be exchanged at Rate at which currencies can be exchanged at some future date.some future date.

Forward Exchange ContractContract to exchange currencies of different Contract to exchange currencies of different countries on a stipulated future date, at a countries on a stipulated future date, at a specified rate (the forward rate). specified rate (the forward rate).


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Floating RatesRelationship between major currencies is Relationship between major currencies is determined by supply and demand factors.determined by supply and demand factors.Increase risk to companies doing business with a Increase risk to companies doing business with a foreign company.foreign company.


Transaction Change SettlementDate in Rate Date

Yen 100,000 100,000 Direct rate 0.00434$ 0.00625$ Payable 434.00$ 625.00$

Example – Payable to be settled in 100,000 yen

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Transactions are normally measured and recorded in terms of the currency in which the reporting entity prepares its financial statements.

Reporting Currency - usually the currency where the company is located.

Measured Versus DenominatedMeasured Versus Denominated

LO 1 Measured versus denominated.LO 1 Measured versus denominated.

Transaction between a U.S. firm and a foreign company:

Companies negotiate whether settlement is to be made in dollars or in the foreign currency. If settled by foreign currency, U.S. firm measures the receivable or payable in dollars, but the transaction is denominated in the foreign currency.

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Foreign Currency Transaction - requires payment or receipt (settlement) in a foreign currency.

U.S. firm exposed to risk of unfavorable changes in the exchange rate.


LO 2 Foreign Currency Transactions.LO 2 Foreign Currency Transactions.

Direct exchange rate increasing, or foreign

currency unit strengthening.

More dollars needed to acquire the foreign

currency units.

Direct exchange rate decreasing, or foreign

currency unit weakening.

Fewer dollars needed to acquire the foreign

currency units.

=

=

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LO 3 Common transactions.LO 3 Common transactions.LO 4 Three stages of concern.LO 4 Three stages of concern.

Translating Accounts Denominated in Foreign Currency

Importing or Exporting of Goods or Services

Transaction date

Settlement date

Balance sheet date

Units of foreign currency x Current direct exchange rate

Increase or decrease is generally reported as a foreign currency transaction gain or loss, sometimes referred to as an

exchange gain or loss, in determining net income for the current period.

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Importing and Exporting TransactionsImporting and Exporting Transactions


Exercise 12-2: During December of the current year, Teletex Systems, Inc., a company based in Seattle,Washington, entered into the following transactions:

Dec. 10 Sold seven office computers to a company located in Colombia for 8,541,000 pesos. On this date,

the spot rate was 365 pesos per U.S. dollar.

U.S. firm (Teletex)

Inventory delivered 12/10/Year 1

8,541,000 pesos received on 1/10/Year 2

Columbia firm

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Exercise 12-2: Dec. 10, Sold seven office computers to a company located in Colombia for 8,541,000 pesos. On this date, the spot rate was 365 pesos per U.S. dollar. Prepare the journal entry on the books of Teletex Systems, Inc. (periodic method)

Accounts receivable 23,400Sales23,400

Sales price in pesos 8,541,000

Pesos per U.S. dollar / 365Sales price in U.S. dollars $ 23,400

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LO 3 Common transactions. LO 4 Three stages of concern.LO 3 Common transactions. LO 4 Three stages of concern.

Exercise 12-2: Prepare journal entry necessary to adjust the accounts as of December 31. Assume that on December 31 the direct exchange rates was Colombia peso $.00268.

Transaction loss 510 Accounts receivable 510

Receivable in pesos 8,541,000

Direct exchange rate to U.S. dollar$ .00268Receivable in U.S. dollars $ 22,890Balance in receivable 23,400Transaction loss $ 510

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Exercise 12-2: Prepare journal entry to record settlement of the account on January 10. Assume that the direct exchange rate on the settlement date was Colombia peso $.00320.

Cash (8,541,000 x $.00320) 27,331 Accounts receivable ($23,400 - $510) 22,890Transaction gain 4,441

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Exercise 12-2: During December of the current year, Teletex Systems, Inc., a company based in Seattle, Washington, entered into the following transactions:Dec. 12 Purchased computer chips from a Taiwan company. Contract was denominated in 500,000 Taiwan dollars. Direct exchange rate on this date was $.0391.

U.S. firm (Teletex)

Inventory received 12/12/Year 1

500,000 Taiwan dollars paid on 1/10/Year 2

Taiwan firm

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Exercise 12-2: Dec. 12, Purchased computer chips from a company domiciled in Taiwan. The contract was denominated in 500,000 Taiwan dollars. The direct exchange spot rate on this date was $.0391. Prepare the journal entry on the books of Teletex Systems, Inc.

Purchases 19,550Accounts payable19,550

Purchase price in Taiwan dollars 500,000

Direct exchange rate to U.S. dollar x $.0391Purchase price in U.S. dollars $ 19,550

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Exercise 12-2: Prepare journal entry necessary to adjust the account as of December 31. Assume that on December 31 the direct exchange rates was Taiwan dollar $.0351.

Accounts payable 2,000 Transaction gain 2,000

Payable in pesos 500,000

Direct exchange rate to U.S. dollar$ .0351Payable in U.S. dollars $ 17,550Balance in payable 19,550Transaction gain $ 2,000

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Exercise 12-2: Prepare journal entry to record settlement of account on January 10. Assume that the direct exchange rate on the settlement date was Taiwan dollar $.0398.

Transaction loss 2,350 Accounts payable ($19,550 - $2,000)17,550

Cash (500,000 x $.0398) 19,900

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Foreign currency transaction gains and losses are included in net income.Two-transaction approach:

The sale or purchase is viewed as a transaction separate from the financing arrangement.The dollar amount recorded (in Sales or in Purchases) is determined by the exchange rate on the transaction date.Adjustments to the foreign-currency-denominated receivable or payable are recorded directly to the transaction gain or loss and included in net income.

Importing or Exporting of Goods or Services

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Derivative Instrument - a financial instrument that provides the holder (or writer) with the right (or obligation) to participate in some or all of the price changes of another underlying value of measure, but does not require the holder to own or deliver the underlying value of measure.

Two broad categories:Forward-basedOption-based

Hedging Foreign Exchange Rate Risk

Derivatives are recognized in the balance sheet at their fair value, resulting in a payable position for one party and a receivable position for the

other.LO 8 Derivatives as a hedge.LO 8 Derivatives as a hedge.

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A forward exchange contract (forward contract) is an agreement to exchange currencies of two different countries at a specified rate (the forward rate) on a stipulatedfuture date.

Forward Exchange Contracts

LO 5 Forward exchange contracts.LO 5 Forward exchange contracts.

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1. Forward Contract used as a Hedge of a(n):a. Foreign currency transaction.b. Unrecognized firm commitment (a fair value

hedge).c. Foreign-currency-denominated “forecasted”

transaction (a cash flow hedge).d. Net investment in foreign operations.

Which Kind of Forward Contract to Choose?

LO 5 Forward exchange contracts.LO 5 Forward exchange contracts.

2. SpeculationForward contracts used to speculate changes in foreign currency.

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Using Forward Contracts as a HedgeUsing Forward Contracts as a Hedge

Problem 12-2: Christel Exporting Co. is a U.S. wholesaler engaged in foreign trade. The following transaction is representative of its business dealings. The company uses a periodic inventory system and is on a calendar-year basis. All exchange rates are direct quotations.

Dec. 1 Christel Exporting purchased merchandise from Chang’s Ltd., a Hong Kong manufacturer. The invoice was for 210,000 Hong Kong dollars, payable on April 1. On this same date, Christel Exporting acquired a forward contract to buy 210,000 Hong Kong dollars on April 1 for $.1314.

Hedge of a Foreign Currency Exposed Liability

LO 7 Forward contracts as a hedge.LO 7 Forward contracts as a hedge.

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Problem 12-2: (additional facts) April 1 Christel Exporting submitted full payment of 210,000 Hong Kong dollars to Chang’s, Ltd., after obtaining the 210,000 Hong Kong dollars on its forward contract.Spot rates and the forward rates for the Hong Kong dollar were as follows:

Forward Rate for

Spot Rate ($) April 1 Delivery ($)Dec. 1 .1265 .1314Dec. 29 .1240 .1305Dec. 31 .1259 .1308April 1 .1430


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Problem 12-2: Prepare journal entries for the transactions including the necessary adjustments on December 31.


Dec 1 Purchases 26,565Accounts Payable

26,565

Hong Kong dollars 210,000

Dec. 1 Direct Spot Rate $ .1265Payable in U.S. dollars $ 26,565

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Problem 12-2: Prepare journal entries for the transactions including the necessary adjustments on December 31.Dec 1 FC Receivable from Exch. Dealer 27,594

Dollars Payable to Exch. Dealer27,594


Dec. 1 Forward Rate $ .1314Payable in U.S. dollars $ 27,594


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Problem 12-2: Prepare journal entries for the transactions including the necessary adjustments on December 31.Dec 31 Accounts Payable

126 Transaction Gain126


Dec. 31 Spot Rate $ .1259Payable in U.S. dollars $ 26,439Payable recorded on Dec. 1 26,565Transaction gain $ 126


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Problem 12-2: Prepare journal entries for the transactions including the necessary adjustments on December 31.Dec 31 Transaction Loss

126 FC Receivable from Exchange Dealer 126


Dec. 31 Forward Rate $ .1308Payable in U.S. dollars $ 27,468Payable recorded on Dec. 1 27,594Transaction loss $ (126)


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Problem 12-2: Prepare journal entries for the transactions including the necessary adjustments on December 31.Dec 31 Transaction Loss

3,591Accounts payable 3,591


Apr. 1 Spot Rate $ .1430Payable in U.S. dollars $ 30,030Payable established on Dec. 31 26,439Transaction loss $ (3,591)


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Problem 12-2: Prepare journal entries for the transactions including the necessary adjustments on December 31.Dec 31 FC Receivable from Exch. Dealer

2,562 Transaction Gain 2,562


Apr. 1 Spot Rate $ .1430Payable in U.S. dollars $ 30,030Payable established on Dec. 31 27,468Transaction loss $ 2,562


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Problem 12-2: Prepare journal entries for the transactions including the necessary adjustments on December 31.Apr 1 Investment in Foreign Currency30,030

Dollars Payable to Exch. Dealer 27,594Cash

27,594FC Receivable from Exch. Dealer

30,030(payment to dealer and receipt of 210,000 Hong Kong

dollars)

Accounts Payable 30,030Investment in Foreign Currency

30,030(payment of liability upon transfer of 210,000 Hong Kong

dollars)


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Problem 12-2: Transaction Summary


Transaction TransactionHedged I tem Balance Gain/ (Loss) Hedge Balance Gain/ (Loss)

Accounts Payable FC ReceivableDec. 1 26,565$ Dec. 1 27,594$ Dec. 31 26,439 126$ Dec. 31 27,468 (126)$ Apr. 1 30,030 (3,591) Apr. 1 30,030 2,562 Total gain/ (loss) (3,465)$ 2,436$

Thus the net effect is a $1,029 loss when the forward contract is used.

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Accounting for a forward contract entered into as a hedge of an exposed receivable position is similar to an exposed liability position.

Because the U.S. firm will be receiving foreign currency in settlement of the exposed receivable balance, it will enter into a forward contract to sell foreign currency for U.S. dollars.

Hedge of a Foreign Currency Exposed Asset



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A U.S. firm, at a date earlier than the transaction date, may make a commitment to a foreign company to buy or sell goods at a price established in foreign currency.

Changes in the exchange rate between the commitment date and transaction date would be reflected in the cost or sales price of the asset.

The U.S. firm may enter a forward contract to hedge its commitment.

Fair Value Hedge—Hedging an Unrecognized Foreign Currency Commitment



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Using Forward Contracts as a HedgeUsing Forward Contracts as a HedgeExercise 12-14: Consider the following information:1. On December 1, 2008, a U.S. firm contracts to sell

equipment (with an asking price of 10,000 pesos) in Mexico. The firm will take delivery and will pay for the equipment on March 1, 2009.

2. On December 1, 2008, the company enters into a forward contract to sell 10,000 pesos for $9.48 on March 1, 2009.

3. Spot rates and the forward rates for March 1, 2009, settlement were as follows (dollars per peso):

Spot Rate Forward Rate

December 1, 2008 $9.54 $9.48Balance sheet date (12/31/08) 9.49 9.44March 1, 2009 9.474. On March 1, the equipment was sold for 10,000 pesos. The

cost of the equipment was $40,000.LO 7 Forward contracts as a hedge.LO 7 Forward contracts as a hedge.

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Using Forward Contracts as a HedgeUsing Forward Contracts as a HedgeExercise 12-14: Prepare all journal entries needed on December 1, December 31, and March 1 to account for the forward contract, the firm commitment, and the transaction to sell the equipment.


Dec1 Receivable from Exchange Dealer* 94,800FC Payable to Exchange Dealer

94,800

* (10,000 x $9.48 = $94,800)** [(10,000 x ($9.48 - $9.44)] = $400

Dec31 FC Payable from Exchange Dealer** 400Foreign Exchange Gain

400Foreign Exchange Loss 400

Firm Commitment** 400

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Mar 1 Foreign Exchange Loss 300FC Payable from Exchange Dealer*

300Firm Commitment* 300

Foreign Exchange Gain300

Investment in FC 94,700Firm Commitment 100

Sales (10,000 x 9.48)94,800

* [(10,000 ´ ($9.44 - $9.47)] =$300

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Mar 1 Cash 94,800FC Payable to Exchange Dealer 94,700

Investment in FC94,700

Dollars Receivable from Exchange Dealer94,800

Cost of Goods Sold 40,000

Inventory40,000

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Cash Flow Hedge - hedging cash flows for future transactions that have not yet occurred or for which there are no firm commitments.

Cash flow hedges may defer the Income statement recognition of gains and losses on forecasted transactions if certain criteria are met.

Amounts in accumulated other comprehensive income are reclassified into earnings in the same period which the hedged forecasted transaction affects earnings.

Cash Flow Hedge-A Forecasted Transaction

LO 7 Fair value hedge vs. cash flow hedge.LO 7 Fair value hedge vs. cash flow hedge.


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Using Forward Contracts as a HedgeUsing Forward Contracts as a HedgeExercise 12-13: Consider the following information:1. On December 1, 2008, a U.S. firm plans to purchase a piece

of equipment (with an asking price of 100,000 francs) in Switzerland during January of 2009. The transaction is probable, and the transaction is to be denominated in euros.

2. On December 1, 2008, the company enters into a forward contract to buy 100,000 francs for $1.01 on January 31, 2009.

3. Spot rates and the forward rates for January 31, 2009, settlement were as follows (dollars per francs):

Spot Rate Forward Rate

December 1, 2008 $0.99 $1.01Balance sheet date (12/31/08) 1.01 1.02Jan. 31 and Feb. 1, 2009 1.044. On Feb. 1, the equipment was purchased for 100,000

francs.


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Using Forward Contracts as a HedgeUsing Forward Contracts as a HedgeExercise 12-13: Prepare all journal entries needed on Dec. 1, Dec. 31, Jan. 31, and Feb. 1 to account for the forecasted transaction, the forward contract, and the transaction to buy the equipment.


Dec.1 FC Receivable from Exchange Dealer101,000Dollars Payable to Exchange Dealer*

101,000

Dec.31FC Receivable from Exchange Dealer** 1,000Foreign Exchange Gain – OCI

1,000* (100,000 x $1.01) = $101,000** [(100,000 x ($1.01- $1.02)] = $1,000

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Using Forward Contracts as a HedgeUsing Forward Contracts as a HedgeExercise 12-13: Prepare all journal entries needed on Dec. 1, Dec. 31, Jan. 31, and Feb. 1 to account for the forecasted transaction, the forward contract, and the transaction to buy the equipment.


Jan.31 FC Receivable from Exchange Dealer 2,000Foreign Exchange Gain – OCI

2,000[(100,000 ´ ($1.02- $1.04)]

Investment in FC 104,000Dollars Payable to Exchange Dealer 101,000

Cash101,000

FC Receivable from Exchange Dealer104,000

Feb. 1 Equipment 104,000Investment in FC

104,000

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A U.S. firm may enter into a foreign currency transaction or a nonderivative financial instrument in an effort to minimize or offset the effects of currency fluctuations on an equity investment in a foreign company.

The gain or loss on the hedging instrument is reported in the same manner as the translation adjustment, that is, reported in the cumulative translation adjustment section under comprehensive income. FASB ASC paragraph 815-35-35-1

Economic Hedge of a Net Investment in a Foreign Entity



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A forward contract may be acquired for speculative purposes in anticipation of realizing a gain.

Forward Contracts Acquired to Speculate in the Movement of Foreign Currencies

LO 7 Fair value hedge vs. cash flow hedge.LO 7 Fair value hedge vs. cash flow hedge.LO 3 Common transactions.LO 3 Common transactions.


FASB ASC Section 815-20-50 specifies certain minimal disclosures for derivative instruments and nonderivative instruments designated as qualifying hedging instruments.

Disclosure Requirements of the Various Hedges

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Options, give the holder the advantage of right but not the obligation to buy or sell the currency.

If the exchange rate changes in a negative manner, the firm can simply let the option lapse without a loss.

Using Options to Hedge Foreign Currency Changes

LO 8 Derivatives used as a hedge.LO 8 Derivatives used as a hedge.


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ADVANCE ACCOUNTING Ch12

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