Foreign Currency Transactions,

Translation of Foreign Currency Financial

Statements, and the Future of Financial Statements

MIM 517Class 7

Fall 2010

Learning Objectives

Calculate transaction gains and losses on “assets/liabilities denominated in a foreign currency” (A/LFC)

Basic understanding of foreign currency hedges on A/LFC

Overview translation of foreign currency financial statements

Gain exposure to potential future financial statement format changes

Foreign Currency Transactions

Defined: Transactions denominated in a currency other than the reporting currency. These give rise to an asset or liability denominated in a foreign currency.

Exchange rate fluctuations between the time of purchase/sale and settlement gives rise to a foreign exchange gain or loss on the I/S. This should be properly recorded in the period in which it occurs.

Foreign Currency Definitions

Indirect Rate - Number of foreign currency units per US$ Direct Rate – Number of US$s per unit of foreign currency Spot Rate– Current exchange rate Forward Rate – Rate specifically contracted today for

future exchange of currency Future Rate – Rate used in standard contract for future

exchange of currency Spread – difference between current and forward rate. Can

be a premium or discount Forward Contract – Contract between 2 parties to buy or

sell a currency at specified rate at specified date Foreign Currency Swap – simultaneous spot and forward

transaction Currency Option –Right to sell (put) or buy (call) foreign

currency by a specified date in the future

How to Account for a Foreign Currency Transactions (U.S. & IASC)

1. Record the purchase/sale in $ using spot rate

2. Revalue A/P or A/R if open at period end (unrealized gain/loss) using period end spot rate

3. Settle A/P or A/R and record foreign exchange gain or loss using spot rate when settled

Foreign Currency Transaction Sale Example:

Ex: On 12/5/2009 Americo sells goods to German company for 1 million euros. German customer has 30 days to pay. Because Americo keeps its books in US$, it must restate the sale and receivable into US$. The (indirect) spot rate is $1.21 per euro on 12/5/2009.

At 12/5/2009 the following should be recorded:

AR $1,210,000 = Sales $1,210,000 (note: we’re ignoring the Inventory and COGS portion of the entry)

Foreign Currency Transaction Sale Example Continued:

At 12/31/2009 the new spot rate is $1.24 per euro. Does Americo have a foreign exchange gain or loss?

According to US and IASC GAAP, record unrealized gain at 12/31/2009. Note this is a “paper” gain.

A/R $30,000 = Foreign Exch Gain $30,000

Foreign Currency Transaction Sale Example Continued:

1/2/2010 the transaction is settled at a spot rate of $1.23. Does Americo have a foreign exchange gain or loss now?

Note this is a “real” loss, and is calc from 12/31/09.

A/R $10,000 = Foreign Exch Loss $10,000

When the cash is actually received:

Cash $1,230,000 A/R $1,230,000 =

Foreign Currency Transaction Sale Example and Summary:

2009 2010Foreign Exchange Gain (loss) $30,000 $(10,000)

Recall exchange rates: euro first appreciates, then depreciates12/05/09 $1.21 per euro12/31/09 $1.24 per euro => US$ weakens, FC strengthens01/02/10 $1.23 per euro => US$ strengthens, FC weakens

Thus foreign currency exposure is as follows:Transaction Exposure FC Appreciates FC DepreciatesExport Sale Asset Gain LossImport Purchase Liability Loss Gain

Foreign Borrowing and Lending

Investment in debt/equity securities of foreign entities

Why would a company do this? Accounting issues

Value at purchase using spot rate Value at year end using y/e spot rate record

exchange gain/loss on Income Statement Value any interest receivable/payable on debt

instruments using y/e spot rate record exchange gain/loss on Income Statement when interest received or paid

Types of Foreign Exchange Risk

Holding receivable/payable denominated in a foreign currency (previous slides)

Firm purchase/sale commitment denominated in foreign currency

Forecasted transactions in foreign currency

Deliberate exposure to exchange risk to generate a rate of return (speculative)

Hedge a Foreign Currency Transaction

Objective is to neutralize foreign exchange risk – you will know with 100% certainty how much a transaction will cost in your own currency.

Can do via: Forward or future contract (foreign currency

hedge) Options contract Other more complicated derivatives

Business decision is when and how much to do

Forward Contract Example:

Assume now that Americo wants to lock in a price at which it can sell the 1 million euros that it will receive on 1/2/10.

Americo enters into a 30 day forward contract to sell 1 million euros at a rate of $1.20 per euro. (Recall the spot rate is $1.21) Thus, Americo will need to deliver 1 million euros to Big Bank in 30 days in exchange for $1,200,000. Americo just “hedged” its euro asset exposure.

What is Americo’s gain or loss with vs. without hedging? Without hedging: $20,000 net gain for 2009 and 2010

combined With hedging: $10,000 loss

Business Issues with Forward Contracts

The Juice Co., a health juice producer recently has been expanding its sales through exports to foreign markets. Earlier this year, the company negotiated the sale of several thousand cases of turnip juice to a retailer in the country of Tcheckia. The customer is unwilling to assume the risk of having to make payment in U.S. $. Desperate to enter the Tcheckian market, the VP for international sales agrees to denominate the sale in tchecks, the national currency of Tcheckia. The currency exchange rate for tchecks is $2.00 per tcheck. In addition, the customer indicates that he can not make payment until all of the juice has been sold. Payment is scheduled for 6 months from the date of sale.

Business Issues with Forward Contracts

Fearful that the tcheck might depreciate in value over the next six months, the head of risk management department at Juice Co. enters into a forward contract to sell tchecks in 6 months at a forward rate of $1.80. Six months later, when payment is received from the Tcheckian customer, the spot rate for the tcheck is $1.70. The corporate treasurer calls the head of risk management into her office.

Treasurer: I see that your decision to hedge our foreign currency position on that sale to Tcheckia was a bad one.

Business Issues with Forward Contracts

Dept. Head: What do you mean? We have a gain on that forward contract. We’re $10,000 better off from having entered into that hedge.

Treasurer: That’s not what the books say. The accountants have recorded a net loss of $20,000 on that particular deal. I’m afraid I’m not going to be able to pay you a bonus this year.

Dept. Head: Those bean counters have messed up again. I told those guys in int’l sales that selling to customers in Tcheckia was risky, but at least by hedging our exposure, we managed to receive a reasonable amount of cash on that deal. In fact, we ended up with a gain of $10,000 on the hedge. Tell the Accountants to check their debits and credits again!

Options

Set (strike) price for obtaining a foreign currency in the future

There is a cost to “lock in” this exchange rate Premium related to future rate for currency Brokerage fee to obtain contract (sunk cost) Additional brokerage fee IF exercise contract

Do you want to exercise the contract? “At the money”: strike price = spot rate “Out of the money”: strike price < favorable than spot

rate “In the money”: strike price > favorable than spot rate

exercise!

Options ExampleAssume Americo hedges its exposure to euro foreign exchange risk by purchasing a foreign currency put option. Assume that on 12/08/09 Americo selects a strike price of $1.20 when the spot rate is $1.21 and pays a brokerage fee of $.009 per euro. What is Americo’s guaranteed minimum cash flow?

$9,000 cost to buy the option $1,200,000 inflow if the option is exercised Another $9,000 cost if the option is exercised

Option “in the money” if spot rate at 1/07/10 is < $1.191 What is Americo’s gain or loss if exercise option or not?

Exercise option: $10,000 loss & $9,000 brokerage costs for 2009 and $9,000 brokerage costs for 2010

Don’t exercise option: $9,000 brokerage costs for 2009. Gain/loss depends upon the spot rate at 1/07/10!!!

Accounting for Hedges Against Foreign Exchange Risk

Hold receivable/payable denominated in a foreign currency (Fair value hedge)

Firm purchase/sale commitment denominated in foreign currency (Fair value hedge)

Forecasted transactions in foreign currency (Cash Flow hedge)

Deliberate exposure to exchange risk to generate a rate of return (Speculative)

Accounting for Non-Speculative Hedges (US & IFRS)

Disclose hedging policies and activities in f/n Starbucks f/n 1, 4

Accounting depends on classification Rules are SFAS133 and 161 The fair value of the contract itself is calculated

and recorded with the corresponding asset or liability

Fair value hedge vs. Cash flow hedge Issue is where gain/loss gets recorded

Fair value hedge Income Statement Cash flow hedge Other comprehensive income

“Natural Hedge”

What is it? How does it work? Why would a company prefer this

to using forward contracts or options?

Translation of Foreign Currency Financial Statements

Background Companies operate in foreign countries In most countries, companies must prepare F/S

in the local currency using local accounting rules.

To do worldwide consolidation, companies must Convert to U.S. GAAP Translate F/S from local currency into U.S. dollars

Reporting currency: Parent company’s currency (U.S. $) Functional currency: Primary currency in local sub’s

operating environment

Translation of Foreign Currency Financial Statements

Translation gains/losses arise from converting foreign currency f/s into U.S.$ using different rates

Historical exchange rate Current exchange rate Average exchange rate

This is a “paper” gain/loss Equity Section of the Balance Sheet

(Accumulated Other Comprehensive Income) Income Statement

Methods of Translating Foreign Currency Financial Statements

Methods Commonly Used (U.S., IFRS) Current Rate (Closing Rate) Method

This is the most common method Use if “functional currency” = local

currency Temporal Method

Use if “functional currency” = U.S. dollar

Current Rate Method – Basic Idea

Translate assets and liabilities at year end spot rate

Translate equity (CS & APIC) using historical rate

Translate income statement using average rate

Translation adjustment recorded in equity section (other comprehensive income) as a “plug”

Look at Starbucks

Temporal Method

Specific rules exist for rates at which translate individual B/S and I/S items Rules very complicated

“Remeasurement” gain/loss gets recorded in the Income Statement Increases volatility of Income Statement

When to use Current vs. Temporal Rate Method

Decision is based upon the “functional currency” of the subsidiary

Functional Translation Translation

Currency Method AdjustmentU.S. Dollar Temporal Method Gain/Loss in N/IForeign currency Current rate Method Equity

Exception: Highly inflationary economy (> 100% over 3 years) must use temporal method.

Why should you care about translation?

Performance evaluation Understand other comprehensive

income

Now that you are comfortable with financial statements…

It may all change!