Advanced Accounting by Hoyle et al, 6th Edition

Chapter SevenForeign Currency Transactions and Hedging Foreign Exchange Risk

McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Exchange Rate MechanismsPrior to 1973, currency values were generally fixed. The US $ was based on the Gold Standard. Since 1973, exchange rates have been allowed to fluctuate.Several currency arrangements exist.

7-#Exchange Rate MechanismsPrior to 1973, currency values were generally fixed. The US $ was based on the Gold Standard. Since 1973, exchange rates have been allowed to fluctuate.Several currency arrangements exist.

Different Currency MechanismsIndependent Float - the currency is allowed to fluctuate according to market forcesPegged to another currency - the currencys value is fixed in terms of a particular foreign currency, and the central bank will intervene to maintain the fixed valueEuropean Monetary System - a common currency (the euro) is used in multiple countries. Its value floats against other world currencies.7-#Different Currency MechanismsIndependent Float - the currency is allowed to fluctuate according to market forcesPegged to another currency - the currencys value is fixed in terms of a particular foreign currency, and the central bank will intervene to maintain the fixed valueEuropean Monetary System - a common currency (the euro) is used in multiple countries. Its value floats against other world currencies.

Foreign Exchange RatesAn Exchange rate is the cost of one currency in terms of another.The exchange rate can be quoted in two ways, e.g., as USD/EUR or EUR/USD. Be careful that you apply the correct version and not its reciprocal.Published exchange rates are wholesale rates that banks use with each other retail rates to consumers are less favorable.The difference between the rates at which a bank is willing to buy and sell currency is known as the spread.Rates change every business day.LO 17-#Foreign Exchange RatesAn Exchange Rate is the cost of one currency in terms of another.Rates published daily in the Wall Street Journal are as of 4:00pm Eastern time on the day prior to publication.The published rates are wholesale rates that banks use with each other retail rates to consumers are higher.The difference between the rates at which a bank is willing to buy and sell currency is known as the spread.Rates change constantly!

Foreign Exchange RatesSpot RateThe exchange rate that is available today.

Forward RateThe exchange rate that can be locked in today for an expected future exchange transaction.The actual spot rate at the future date may differ from todays forward rate.7-#Foreign Exchange RatesSpot RateThe exchange rate that is available today.Forward RateThe exchange rate that can be locked in today for an expected future exchange transaction.The actual spot rate at the future date may differ from todays forward rate.

Why exchange rates matterThe financial accounting system records everything the same way, in terms of a specific base currency.A fundamental principle is the monetary unit assumption.If a company engages in transactions in multiple currencies, this assumption is violated.Accountants need to force all reporting into a single currency so that accounts are additive.Any method of imposing one currency accounting will be arbitrary. This will create messiness whenever exchange rates change.LO 17-#Foreign Exchange RatesAn Exchange Rate is the cost of one currency in terms of another.Rates published daily in the Wall Street Journal are as of 4:00pm Eastern time on the day prior to publication.The published rates are wholesale rates that banks use with each other retail rates to consumers are higher.The difference between the rates at which a bank is willing to buy and sell currency is known as the spread.Rates change constantly!

Foreign Exchange - Forward ContractsA forward contract requires the exchanging of currencies at a future date at the contracted exchange rate.This forward contract allows us to purchase 1,000,000 at a price of $.0080 US in 30 days. But if the spot rate is $.0069 US in 30 days, we still have to pay $.0080 US and we lose $1,100!!

7-7A forward contract requires the purchase (or sale) of currency units at a future date at the contracted exchange rate. This forward contract allows us to purchase 1,000,000 at a price of $.0080 US in 30 days. But if the spot rate is $.0069 US in 30 days, we still have to pay $.0080 US and we lose $1,100!!

An options contract gives the holder the option of buying (or selling) currency units at a future date at the contracted strike price.That way, if the spot rate is $.0069 in 30 days, we only lose the $20 cost of the option contract!Foreign Exchange Option ContractsAn options contract gives the holder the option of exchanging currencies at a future date at the contracted strike price.7-8An options contract gives the holder the option of buying (or selling) currency units at a future date at the contracted strike price.An options contract gives the holder the option of buying (or selling) currency units at a future date at the contracted strike price. That way, if the spot rate is $.0069 in 30 days, we only lose the $20 cost of the option contract!

Foreign Currency TransactionsA U.S. company buys or sells goods or services to a party in another country. This is often called foreign trade.The transaction is often denominated in the currency of the foreign party. How do we account for the changes in the value of the foreign currency?

LO 27-#A U.S. company buys or sells goods or services to a party in another country. This is often called foreign trade.The transaction is often denominated in the currency of the foreign party. How do we account for the changes in the value of the foreign currency?

Foreign Currency TransactionsGAAP requires a two-transaction perspective.

Account for the original sale in your currency.

Account for gains/losses from exchange rate fluctuations until the receivable/payable is settled.7-10GAAP requires a two-transaction perspective.

Account for the original sale in US Dollars.

Account for gains/losses from exchange rate fluctuations.

Foreign Exchange Transaction - ExampleOn 12/1/13, Amerco sells inventory to a German corporation for 1 million euros on credit. Amerco expects to be paid in euros in 90 days.The current exchange rate is $1.32 = 1 .Amerco would first record the sale:Note that Amercos ledger is in US Dollars, but has a separate account for receivables expected to be collected in a foreign currency.

7-#On 12/1/13, Amerco sells inventory to a German corporation for 1 million euros on credit. Amerco expects to be paid in euros in 90 days.The current exchange rate is $1 = 1.32 .Amerco would first record the sale:Note that Amercos ledger is in US Dollars, but has a separate account for receivables expected to be collected in a foreign currency.

Foreign Exchange Transaction - ExampleOn 12/31/13, the exchange rate is $1.33 = 1 .At the balance sheet date we have to remeasure the original A/R to the current exchange rate.When we increase A/R to the new value in US Dollars, we recognize a gain from foreign currency exchange.

7-#On 12/31/13, the exchange rate is $1 = 1.33 .At the balance sheet date we have to remeasure the original A/R to the current exchange rate. When we increase A/R to the new value in US Dollars, we recognize a gain from foreign currency exchange.

Foreign Exchange Transaction - ExampleOn 3/1/14, Amerco is paid the 1 million euros.The exchange rate on 3/1/14, was $1.30 = 1 .Amerco records this transaction in two steps.First, Amerco remeasures the A/R balance at the current exchange rate. Then, they can record the collection of cash and clear the A/R balance.

7-#On 3/1/14, Amerco is paid the 1 million euros. The exchange rate on 3/1/14, was $1 = 1.30 . Amerco records this transaction in two steps. First, Amerco remeasures the A/R balance at the current exchange rate. Then, they can record the collection of cash and clear the A/R balance.

Hedging Foreign Exchange RiskCompanies will seek to reduce the risks associated with foreign currency fluctuations by hedgingThis means they will give up a portion of the potential gains to offset the possible losses. A company enters into a potential transaction whose exposure is the opposite of the one that has the associated risk.LO 37-#Hedging Foreign Exchange RiskCompanies will seek to reduce the risks associated with foreign currency fluctuations by hedgingThis means they will give up a portion of the potential gains to offset the possible losses. A company enters into a potential transaction whose exposure is the opposite of the one that has the associated risk.

Hedging Foreign Exchange Risk Two foreign currency derivatives that are often used to hedge foreign currency transactions:Foreign currency forward contracts lock in the price for which the currency will sell at contracts maturity.Foreign currency options establish a price for which the currency can be sold, but is not required to be sold at maturity.7-#Hedging Foreign Exchange Risk Two foreign currency derivatives that are often used to hedge foreign currency transactions:Foreign currency forward contracts lock in the price for which the currency will sell at contracts maturity.Foreign currency options establish a price for which the currency can be sold, but is not required to be sold at maturity.

Accounting for DerivativesASC Topic 815 provides guidance for hedges of four types of foreign exchange risk.Recognized foreign currency denominated assets & liabilities.Forecasted foreign currency denominated transactions.Unrecognized foreign currency firm commitments.Net investments in foreign operations7-16ASC Topic 815 provides guidance for hedges of four types of foreign exchange risk. Recognized foreign currency denominated assets & liabilities. Unrecognized foreign currency firm commitments. Forecasted foreign currency denominated transactions.Net investments in foreign operations

Accounting for DerivativesThe fair value of the derivative is recorded at all points in time. For a forward contract., it is zero when initiated and can be an asset or liability after that. Factors involved in this include:The forward rate when the forward contract was entered into.The current forward rate for a contract that matures on the same date as the forward contract.A discount rate (the companys incremental borrowing rate).7-17The fair value of the derivative is recorded at the same time as the transaction to be hedged, based on:The forward rate when the forward contract was entered into.The current forward rate for a contract that matures on the same date as the forward contract.A discount rate (the companys incremental borrowing rate).

Accounting for HedgesTwo ways to account for a foreign currency hedge:Cash Flow Hedge Completely offsets variability of a foreign currency receivable or payable. Gains/losses are recorded as OCI.The anticipated gain/loss is amortized as revenue/expense over the life of the position.

2. Fair Value Hedge. Gains/losses are recognized immediately in net income.For a receivable/payable, this is no special accounting at all. The two positions are both fair valued over time regardless.

LO 47-18Two ways to account for a foreign currency hedge:Cash Flow Hedge Completely offsets variability of a foreign currency receivable or payable. Gains/losses are recorded as Comprehensive Income.Any other hedging instrument is a Fair Value Hedge. Gains/losses are recognized immediately in net income.

Cash Flow Hedge Date of Transaction ExampleAmercos sale agreement on 12/1/13 left them with foreign currency risk. They take a 90-day forward contract to sell 1 million euros, at a forward rate of $1.305 = 1 euro.

7-#Cash Flow Hedge Date of Transaction ExampleAmercos sale agreement on 12/1/13 left them with foreign currency risk. They take a 90-day forward contract to sell 1 million euros, at a forward rate of $1.305 = 1 euro.

Cash Flow Hedge Interim Reporting Date ExampleAmercos year-end is 12/31/13. The year-end spot rate is $1.33 per euro.In addition, at 12/31/13 the forward rate to 3/1/14 (now a 60-day forward rate), has changed.

7-#Amercos year-end is 12/31/13. The year-end spot rate is $1.33 per euro.In addition, at 12/31/13 the forward rate to 3/1/14 (now a 60-day forward rate), has changed.

Cash Flow Hedge Interim Reporting Date ExampleAlso, on 12/31/13, $10,000 is transferred from AOCI to a Loss on Forward Contract. Finally, we have to amortize the discount from the original transaction.

7-#Also, on 12/31/13, $10,000 is transferred from AOCI to a Loss on Forward Contract. Finally, we have to amortize the discount from the original transaction.

Cash Flow Hedge Date of Collection ExampleOn 3/1/14, both the receivable and the exchange contract come due. Assume the spot rate at that date is $1.3 = 1 euro.

7-#On 3/1/14, both the receivable and the exchange contract come due. Assume the spot rate at that date is $1.3 = 1 euro.

Cash Flow Hedge Date of Collection ExampleAs at year-end, Amerco records an entry to offset the foreign exchange loss, and amortizes the rest of the discount.As a result of these entries, the balance in AOCI is zero: $4,236 + $15,783 - $30,000 + $9,981 = $0.

7-#As at year-end, Amerco records an entry to offset the foreign exchange loss, and amortizes the rest of the discount.As a result of these entries, the balance in AOCI is zero: $4,236 + $15,783 - $30,000 + $9,981 = $0.

Cash Flow Hedge Date of Collection ExampleThe amount due from the customer is received in euros, and Amerco completes the forward contract by selling the 1 million euros received.

7-#The amount due from the customer is received in euros, and Amerco completes the forward contract by selling the 1 million euros received.Fair Value Hedge Date of Transaction ExampleIn the same example with Amerco, assume that they designate the forward contract as a Fair Value Hedge, instead of a cash flow hedge. The entry on the date of sale will be the same.The forward contract requires no formal entry

7-#In the same example with Amerco, assume that they designate the forward contract as a Fair Value Hedge, instead of a cash flow hedge. The entry on the date of sale will be the same. The forward contract requires no formal entry.

Fair Value Hedge - Interim Reporting Date ExampleAmercos year-end is 12/31/13. The year-end spot rate is $1.33 per euro.At 12/31/13, the forward rate to 3/1/14 (now a 60-day forward rate), has changed.

7-#Amercos year-end is 12/31/13. The year-end spot rate is $1.33 per euro.At 12/31/13, the forward rate to 3/1/14 (now a 60-day forward rate), has changed.

Fair Value Hedge Date of Collection ExampleOn 3/1/14, both the receivable and the exchange contract come due. Assume the spot rate at that date is $1.3 = 1 euro.

7-#On 3/1/14, both the receivable and the exchange contract come due. Assume the spot rate at that date is $1.3 = 1 euro.

Fair Value Hedge Date of Collection ExampleThe amount due from the customer is received in euros, and Amerco completes the forward contract by selling the 1 million euros received.

7-#The amount due from the customer is received in euros, and Amerco completes the forward contract by selling the 1 million euros received.

On July 1, 2013, Multicorp borrows 1 billion and converts it into $9,210,000 in the spot market. On December 31, 2013, Mulitcorp must revalue the Japanese yen note payable with an offsetting foreign exchange gain or loss reported in income and must accrue interest expense and interest payable.Interest is calculated by multiplying the loan principal in yen by the relevant interest rate. The amount of interest payable in yen is then translated to U.S. dollars at the spot rate to record the accrual journal entry. On July 1, 2014, differences between the amount of interest accrued at year-end and the actual U.S. dollar amount that must be spent to pay the accrued interest are recognized as foreign exchange gains/ losses.LO 7Foreign Currency Borrowings Example7-29On July 1, 2013, Multicorp borrows 1 billion and converts it into $9,210,000 inthe spot market. On December 31, 2013, Mulitcorp must revalue the Japanese yen notepayable with an offsetting foreign exchange gain or loss reported in income and must accrueinterest expense and interest payable. Interest is calculated by multiplying the loanprincipal in yen by the relevant interest rate. The amount of interest payable in yen isthen translated to U.S. dollars at the spot rate to record the accrual journal entry. OnJuly 1, 2014, any difference between the amount of interest accrued at year-end and theactual U.S. dollar amount that must be spent to pay the accrued interest is recognized asa foreign exchange gain or loss.Exchange rates in table above apply. Journal entries are recorded as follows:

Foreign Currency Borrowings Example7-30Exchange rates and journal entries:Foreign Currency Borrowings ExampleJournal entries at end of accounting period:

7-31SummaryTransactions may be denominated in currencies different from those used to keep accounting records.FASB has adopted a two-transaction approach, separating the actual sale or purchase transaction from the currency exchange speculation.A variety of hedging practices may be used to reduce foreign currency exchange risk. The two most popular hedging instruments are foreign currency options and foreign currency forward contracts.7-#SummaryTransactions may be denominated in currencies different from those used to keep accounting records.FASB has adopted a two-transaction approach, separating the actual sale or purchase transaction from the currency exchange speculation.A variety of hedging practices may be used to reduce foreign currency exchange risk. The two most popular hedging instruments are foreign currency options and foreign currency forward contracts.