Chapter 10

Foreign

Currency

Transactions

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Foreign currency exchange rates A number of factors may influence the rate of

exchange between currencies Exchange rates may be quoted direct (1 FC =

$0.25) or indirect ($1 = 4 FC) Exchange rates also may differ depending on

whether they are a buying (bid price) or selling (offered price) rate

Present and future rates are known as spot and forward rates respectively

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Forward exchange rates Apply to the exchange of currencies at a

future (forward) point in time The agreement to exchange currencies at a

future date is generally a forward contract

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Forward exchange rates (con’t) The forward contract specifies the forward rate

of exchange and the forward date The difference between a forward rate and the

current spot rate represents– a premium (forward > spot) or – a discount (forward < spot)

and is explained in part by interest differentials

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FactsSpot Rate 1 FC = $1.50Amount of FC to be sold 10,000 FCForward Date 60 days forwardInterest rate on FC 6.0%Interest rate on $ 7.2%

Interest differentials affect forward rates

Calculation of Forward Rate$ FC

Value Today 15,000 10,000Interest for 60 days 180 100Value in 60 days 15,180 10,100Forward Rate = $15,180 10,100 FC; 1FC = $1.503

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Accounting for foreign currency transactions

Transactions are denominated in FC and measured in dollars (domestic currency)

Changes in exchange rates between the transaction date and the settlement date expose the domestic company to exchange gains or losses

If a FC transaction is unsettled at the end of the period, exchange gains/losses should be accrued

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Foreign currency transactions demonstrated

-A-Transaction

Date

Spot Rate: 1 FC = $1.50 1 FC = $1.53 1 FC = $1.52

-C-Settlement

Date

-B-YearEnd

Journal entries for these dates follow . . .

Transaction: Purchase inventory for 100,000 FC

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Foreign currency transactions demonstrated (con’t)

A) Inventory 150,000Accounts Payable 150,000

purchase inventory; rate = $1.50

B) Exchange Loss 3,000Accounts Payable 3,000

fiscal year-end; rate = $1.53

C) Accounts Payable 153,000Exchange Gain 1,000Cash 152,000

settlement date; rate = $1.52

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Hedging against foreign currency exchange risk

hedge a FC transaction hedge a FC commitment hedge a forecasted FC transaction

Hedging is designed to manage the risk or uncertainty associated with possible changes in exchange rates.

In the context of foreign currency transactions, hedging may be used to:

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Investments used to hedge Derivative instruments Forward contracts FC options

– buy (call)– sell (put)

FC swaps

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-A-Transaction

Date

Spot Rate: 1 FC = $1.50 1 FC = $1.53 1 FC = $1.52

-C-Settlement

Date

-B-YearEnd

Fwd Rate: 1 FC = $1.505 1 FC = $1.529 n/a

Transaction: Buy inventory for 100,000 FC. A forward contract to buy FC on settlement date was acquired on transaction date.

Hedging a foreign currency transaction with a fwd contract

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Hedging a foreign currency transaction with a fwd contract (con’t)

Without Withoutthe hedge the hedge

Exchange gain (loss) onforeign currency transactions ($2,000) ($2,000)

Gain (loss) on fwd contract 2,000 Subtotal ($2,000) -0- Gain (loss) on forward

contract excluded fromassessment of hedge effectiveness_______ (500)

Net Income effect ($2,000) ($500)

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Hedging complications Forward contract expires before or after contract date - rollover

contract Forward contract amount different than transaction amount

– if less than transaction amount = partial hedge

– if greater than transaction amount = part speculative hedge

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Hedge on identifiable foreign currency commitment Used to fix or establish the basis of a FC transaction based on

exchange rates at the commitment date versus the transaction date Involves market prices which have been previously determined at the

time of the commitment Is a fair value hedge and must meet specific criteria for special

accounting treatment

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Special accounting treatment - recognize in earnings

– gain or loss on hedge (forward contract) prior to transaction date

– gain or loss on the commitment (with an appropriate adjustment to the basis of the committed item)

Hedge on identifiable foreign currency commitment (con’t)

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-A-Commitment

Date

Spot Rate: 1 FC = $1.50 1 FC = $1.53 1 FC = $1.54

-C-Settlement

Date

-B-Transaction

Date

Fwd Rate: 1 FC = $1.505 1 FC = $1.531 n/a

Hedging an identifiable foreign currency commitment

Transaction: Commit to buy inventory for 100,000 FC which will be sold for $200,000. A forward contract to buy FC at the settlement date was acquired on the commitment date.

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Hedging an identifiable foreign currency commitment (cont’d)

Targeted Without the With thePosition Hedge Hedge

Selling Price $200,000 $200,000 $200,000Cost of Sales (150,000) (153,000) (150,000)

Gross Profit 50,000 47,000 50,000Gain (Loss) on Commitment 3,000Gain (Loss) on Forward contract

During commitment period (3,000)Subsequent to transaction (1,000) (1,000)

Gain (loss) on forward contract excluded from hedge effectiveness (500)

Net Income Effect $50,000 $46,000 $48,500

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Hedging a foreign denominated forecasted transaction Involves a transaction which is expected to (versus committed to)

occur in the future Designed to reduce the risk associated with exchange rate

changes which could affect the forecasted transaction Is a cash flow hedge and must meet specific criteria for special

accounting treatment

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Hedging a foreign denominated forecasted transaction (con’t) Special accounting treatment The gain or loss on the hedge prior to the transaction date is:

– recognized outside of earnings as a component of other comprehensive income (OCI) and then

– recognized in earnings, after the forecasted transaction has occurred, in the same period in which the transaction affects earnings

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-A-Forecasted

Date

Spot Rate: 1 FC = $1.50 1 FC = $1.46

n/a

-B-Transaction

Date

Forward Rate: 1 FC = 1.495

Transaction: Forecasted sale of goods (which cost $110,000) for 100,000 FC on the transaction date. A forward contract to sell FC at the transaction date was acquired when the sale was forecasted.

Hedging a foreign denominated forecasted transaction

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Without the With theHedge Hedge

Sales price of inventory 146,000$ 146,000$ Cost of sales (110,000) (110,000) Gross profit 36,000 36,000 Adjustment to cost of sales due to gain (loss) on forward contract 4,000 Adjusted gross profit 36,000 40,000 Gain (loss) on forward contract excluded from assessment of hedge effectiveness (500) Net income effect 36,000$ 39,500$

Hedging a foreign denominated forecasted transaction