chapter ten foreign currency transactions and hedging

Chapter Ten

Foreign Currency Foreign Currency Transactions andTransactions and

HedgingHedging

Foreign Exchange Market: The Biggest Market of All

An OTC market--not an organized exchange such as the NYSE.

Open 24/7

$1.5 Trillion per day.

Market-makers: Several hundred banks located throughout the world.

Trading Foreign Currencies

Spot Markets Transactions requiring immediate delivery of

foreign currency

Forward Markets Transactions involving delivery of the foreign

currency at a later date

Futures Markets Standardized contracts for future delivery trade

at futures rates

3

Foreign Exchange Markets

Each country uses its own currency for internal economic transactions.

To make transactions in another country, units of that country’s currency must be acquired.

Exchange Rate --- cost of obtaining other currencies

Measure of how much of one currency can be exchanged for another currency

Each country uses its own currency for internal economic transactions.

To make transactions in another country, units of that country’s currency must be acquired.

Exchange Rate --- cost of obtaining other currencies

Measure of how much of one currency can be exchanged for another currency

Exchange Rate Mechanisms

Prior 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 valuation models exist.

Prior 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 valuation models exist.

Foreign Exchange Rates

Published daily in the Wall Street Journal. These are “end-of-day”

rates. As of 4:00pm Eastern time

Change constantly during the day

Spread --- difference between the rates at which a bank is willing to buy and sell a currency

Published daily in the Wall Street Journal. These are “end-of-day”

rates. As of 4:00pm Eastern time

Change constantly during the day

Spread --- difference between the rates at which a bank is willing to buy and sell a currency


Price of one unit of country’s currency expressed in units of another country’s currency

Expressed in two ways Indirect rate

Amount of foreign currency that can be acquired per unit of domestic currency

Direct rate Amount of domestic currency needed to acquire one unit

of foreign currency

7

Direct rate is reciprocal of indirect rate.


As the relative strength of a country’s economy

changes . . .

. . . the exchange rate of the local currency relative to other currencies also

fluctuates.

¥ = $?

Currency ExchangeTerminology

Conversion: Going to the bank and physically exchanging currencies.

for


Translation: Process of applying an exchange rate to a foreign currency amount so that an amount can be expressed in dollars.

100 x $1.45296 = $145.30

Currency Exchange Terminology

Directly: (Domestic for Foreign)

$1.45296 = 1

$ .25 = 1 FC

Indirectly: (Foreign for Domestic)

.68825 = $ 1 4 FC = $ 1


CUSTOM to express certain currencies directly (British Pound):

CUSTOM to express certain currencies indirectly (Japanese Yen):

1

$1 = 89.9841

= $1.45296


FOREIGN CURRENCY STRENGTHENS (Gains):

Direct exchange rate goes UP.

Before: 1 = $1.60 After: 1 = $1.64

Indirect exchange rate goes DOWN.

Before: $1 = .625 After: $1 = .610


Foreign Currency-- Strengthens:It becomes more expensive to buy.

• Imports cost more.• Exports cost foreign customers less.

Foreign Currency-- Weakens :It becomes less expensive to buy.

• Imports cost less.• Exports cost foreign customers more.


Spot Rate

Exchange rate that is available today

Forward Rate

Exchange rate that can be locked in today for an expected future exchange transaction.

Spot Rate

Exchange rate that is available today

Forward Rate

Exchange rate that can be locked in today for an expected future exchange transaction.

Forward Exchange RatesExchange of currencies at a future (forward) point in time

Forward Contract--- agreement to exchange currencies at a future date

Contract specifies the forward rate of exchange and the forward date

Difference between a forward rate and the current spot rate represents

Premium (Forward > Spot) or Discount (Forward < Spot)

Foreign Currency Transaction

….transaction that requires settlement in a foreign

currency

Translation Terminology

Denominated --- Currency in which an foreign exchange transaction is to be settled.

Measured --- Currency in which an foreign exchange transaction is recorded in the books and records.

Exposure to Foreign Exchange Risk

Occurs with purchases and sales:

When a U.S. exporter sells to a foreign customer on credit A risk that the dollar equivalent of the future cash

receipt will change due to changes in the foreign exchange rate

When a U.S. importer purchases goods from a foreign supplier on credit A risk that the dollar equivalent of the future cash

payment varies as the foreign exchange rate changes

19

Impact of Financial Risk due to Changes in Exchange Rates

Can significantly impact the stability of a company’s financial results

U.S. Dollars per unit of Foreign Currency:

20

Gains/Losses for Domestic Company

No gain/loss for domestic company that bills or has itself billed in its domestic currency

Gain/Loss is possible if domestic company bills or has itself billed in foreign currency

Exchange Gains/Losses Reported on the income statement Generated from two situations

22

U.S. Company makes a credit sale abroad, at a price

denominated in foreign currency units

Dollar value of the receivable changes

before the payment is received and

converted into dollars

U.S. Company purchases goods from abroad on account at a price denominated in foreign currency units

Dollar value owed changes before the

U.S. company converts dollars into

foreign currency

AND

AND

Exchange gain or loss

is generated

Transactions --- Relevant Dates

Order/Commitment Date: Date the purchase or sales order is issued.

Transaction Date: Date that title passes and the parties record the sale and purchase.

Intervening (F/R or B/S) Date: Dates between the transaction date and the settlement date.

Settlement Date: Date that the debtor pays the creditor.

Foreign Currency Transactions

The major accounting issue:How do we account for the changes in the value of the foreign currency?

The major accounting issue:How do we account for the changes in the value of the foreign currency?

Foreign Currency Transactions

FASB No. 52Requires a two-transaction

perspective.

(1) Account for the original sale in US $

(2) Account for gains/losses from exchange rate

fluctuations.

FASB No. 52Requires a two-transaction

perspective.

(1) Account for the original sale in US $

(2) Account for gains/losses from exchange rate

fluctuations.

Accounting Procedures for Import/Export Transactions

Restate foreign current invoice price into dollars using the appropriate foreign exchange spot rate Record the transaction in dollars.

Record an exchange gain or loss if exchange rate changes cause dollars to differ from original transaction

If the transaction is not settled at balance sheet date, record an exchange gain/loss by adjusting the receivable/payable to its dollar equivalent using the spot rate at the balance sheet date

26

Accounting for Import/Export Transactions Example

On October 16, 2012, Gap Inc., purchased sweaters at an invoice price of 17,000 New Zealand dollars (NZ$) from a New Zealand manufacturer. The exchange rate was $0.62/NZ$. Payment was to be made on December 16, 2012.

27

To record the purchase of sweaters from New Zealand: $0.62 x 17,000 = $10,540

2012

Oct. 16 Inventories 10,540 Accounts payable 10,540

Initially recorded in U.S. Dollars


On December 16, 2012, Gap Inc. purchased NZ$17,000 at an exchange rate of $0.63/NZ$ and transmitted the NZ$ to the manufacturer’s bank in New Zealand.

28

Revalue the accounts payable to relect current exchange rate: ($0.63 – $0.62) × 17,000 = $170

2012

Dec. 16 Exchange loss 170 Accounts payable 170

Invest in sufficient foreign currency to pay the New Zealand manufacturer: $0.63 × 17,000 = $10,710

Dec. 16 Foreign currency 10,710 Cash 10,710

Dec. 16 Accounts payable 10,710 Foreign currency 10,710

Record payment of the liability to the New Zealand manufacturer:


On December 20, 2012, Gap Inc., purchased scarves from a British mill for ₤40,000 when the exchange rate was $2/₤. Payment is due on February 20, 2013.

29

2012

Dec. 20 Inventories 80,000 Accounts payable 80,000

To record the purchase of scarves from the U.K.:₤40,000 × 2 = $80,000

To record the sale of coats to Canada: $0.67 × 9,800 = $6,566

Dec. 22 Accounts receivable 6,566 Sales 6,566

On December 22, 2012, Gap Inc., sold wool coats to a Canadian company for 9,800 Canadian dollars (C$). The exchange rate was $0.67/C$. Gap’s terms are 90 days, net.


On December 29, 2012, Gap Inc., purchased buttons from a Mexican supplier for 10,000 pesos (P) when the exchange rate was $0.05/P. A check was mailed immediately.

30

To record the cash purchase of buttons from Mexico: $0.05 x 10,000 = $500

2012

Dec. 29 Inventories 500

Cash 500

Accounting for Import/Export Transactions Year-End Adjustments Example

31

To revalue the liability to the British mill to the current exchange rates: ($2.00 – $1.96) × 40,000 = $1,600:

On January 31, 2012, Gap Inc. made adjusting entries. Exchange rates were $1.96/₤ and $0.685/C$.

2012

Jan. 31 Accounts payable 1,600 Exchange gain 1,600

To revalue the receivable from Canada to the current exchange rate: ($0.685 – $0.67) × 9,800 = $147Jan. 31 Accounts receivable 147 Exchange gain 147

U.S. dollar weakened

U.S. dollar strengthened


32

To revalue the liability to the British mill to the current exchange rates: ($1.96 – $1.93) × 40,000 = $1,200:

On February 20, 2012, Gap Inc. paid its obligation to the British mill. The exchange rate was $1.93/₤.

2012

Feb. 20 Accounts payable 1,200 Exchange gain 1,200

To purchase sufficient foreign currency to pay the British mill: $1.93 × 40,000 = $77,200

Feb. 20 Foreign currency 77,200 Cash 77,200

Feb. 20 Accounts payable 77,200 Foreign currency 77,200

To record payment of the liability to the British mill:


33

To revalue the receivable to the current exchange rates: ($0.685 – $0.65) × 9,800 = $343

On March 20, 2012, payment was received from the Canadian customer on the sale of the coats. The exchange rate was $0.65/C$.

2012

Mar. 20 Exchange loss 343 Accounts receivable 343

To record receipt of foreign currency from Canada for receivable: $0.65 × 9,800 = $6,370

Mar. 20 Foreign currency 6,370 Accounts receivable 6,370

Mar. 20 Cash 6,370 Foreign currency 6,370

To record exchange of the Canadian currency for U.S. dollars:

Effects of Changing Exchange Rates on Receivables and Payables

Denominated in Foreign Currencies

34

Exchange Gains and Losses Due to Changes in Direct Exchange Rate

Exposed AccountIncrease

($ Weakens)Decrease

($ Strengthens)

Accounts Receivable (AR) AR increases; gain AR decreases; loss

Accounts Payable (AP) AP increases; loss AP decreases; gain

Dollar values of sales revenue and inventory purchase costs are not affected by changes

in the foreign exchange rate.

Dollar values of sales revenue and inventory purchase costs are not affected by changes

in the foreign exchange rate.

Essence of Hedging

Reducing exposure by offsetting foreign currency

gains on assets/liabilities with foreign currency losses and

visa versa

Hedging Foreign Exchange Exposures

Importers and Borrowers Face risk that the direct exchange rate will rise

Requires more dollars to purchase the foreign currency to pay obligation

Exporters and Lenders Face risk that the direct exchange rate will fall

Causing the receipt of fewer dollars on conversion than the amount owed

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Rates could also move in the company’s favor.

Types of Foreign Exchange Risk

Exposed Position Holding a receivable or payable

Firm Commitment Agreement to buy or sell merchandise in the future

Forecasted Transactions Buying or selling from/to foreign customers on a

recurring basis

Speculative Investments Deliberate exposures through forward contracts or

other instruments

37

Investments Used to Hedge

Forward Contracts

Foreign Currency OptionsBuy (call)Sell (put)

Foreign Currency Swaps

Accounting for Derivatives

SFAS 133/138 provides guidance for hedges of four types of foreign exchange risk.

SFAS 133/138 provides guidance for hedges of four types of foreign exchange risk.

Recognized foreign currency

denominated assets & liabilities.

Recognized foreign currency

denominated assets & liabilities.

Forecasted foreign currency

denominated transactions.

Forecasted foreign currency

denominated transactions.

Unrecognized foreign currency

firm commitments.

Unrecognized foreign currency

firm commitments.

Net investments in foreign

operations

Net investments in foreign

operations

Derivative Instruments Used in Hedging

Hedging A method of neutralizing risk by trading in the

forward, futures, or options markets Involves covering a foreign currency exposure by

contracting in the forward market to purchase or sell foreign currency at a specified time in the future for a fixed price

Removes the uncertainty involved in not knowing how many dollars will be paid or received

40

Determining the Value of Derivatives

To determine the value of foreign currency derivatives, the company

needs 3 basic pieces of information:

(1) The forward rate when the forward contract was entered into.

(2) The current forward rate for a contract that matures on the same

date as the forward contract.(3) A discount rate.

To determine the value of foreign currency derivatives, the company

needs 3 basic pieces of information:

(1) The forward rate when the forward contract was entered into.

(2) The current forward rate for a contract that matures on the same

date as the forward contract.(3) A discount rate.

9-41

Accounting for Hedges

As the Fair Value of a Forward Contract changes, gains or losses are recorded.

As the Fair Value of a Forward Contract changes, gains or losses are recorded.

On 12/31/11, Bob has a forward contract to deliver 500,000 ¥ to Inuwashi Company on 1/31/12

at 120 ¥ = $1. The available 31-day forward rate on 12/31/11 is

122.50 ¥ = $1. Bob uses a discount rate of 6%.

What is the value of the forward contract on 12/31/11

On 12/31/11, Bob has a forward contract to deliver 500,000 ¥ to Inuwashi Company on 1/31/12

at 120 ¥ = $1. The available 31-day forward rate on 12/31/11 is

122.50 ¥ = $1. Bob uses a discount rate of 6%.

What is the value of the forward contract on 12/31/11

?

Accounting for Hedges

There are two ways that a foreign currency hedge can be accounted for.

There are two ways that a foreign currency hedge can be accounted for.

Cash Flow

Hedge

Cash Flow

Hedge

Fair Value Hedge

Fair Value Hedge

Gains/losses are recorded to Other

Comprehensive Income

Gains/losses are recorded to the Income

Statement

Now, let’s try a Fair Value

Hedge.

Fair Value Hedge - Date of Transaction

On 12/1/11, Balloon Co., a U.S. balloon manufacturer sells balloons to Maison Rue., a French company, for 20,000 Euro’s (€) on credit. Payment is due in

90 days (March 1, 2012).

The current exchange rate is $.9700 = 1 €.

Prepare Balloon Co.’s journal entry.

Fair Value Hedge - Date of Transaction

Balloon Co buys a 90-day forward contract to pay 20,000 €. Balloon

contracts for the 90-day forward rate on 12/1/11 of $.9500 = 1 €.

Balloon Co buys a 90-day forward contract to pay 20,000 €. Balloon

contracts for the 90-day forward rate on 12/1/11 of $.9500 = 1 €.

This is an executory contract, so no entry is made on the contract

date.


date.

Fair Value Hedge - Interim Reporting Date

On 12/31/11, the value of the foreign currency receivable must be adjusted based on the

12/31/11 spot rate of $.9650 = 1 €. Adjust the original receivable:

On 12/31/11, the value of the foreign currency receivable must be adjusted based on the

12/31/11 spot rate of $.9650 = 1 €. Adjust the original receivable:

Fair Value Hedge - Interim Reporting Date

Also, on 12/31/11, the forward contract must be recorded. The available forward rate to

March 1, 2012 is $.9520 = 1 €. Balloon uses a 6% discount rate.

Record the forward contract:

Fair Value Hedge - Date of Collection

On 3/1/12, both the original receivable and the forward contract come due.

The 3/1/12 exchange rate is $.9540 = 1 €.

Adjust the Accounts Receivable:

On 3/1/12, both the original receivable and the forward contract come due.

The 3/1/12 exchange rate is $.9540 = 1 €.

Adjust the Accounts Receivable:


On 3/1/12, both the original receivable and the forward contract come due. The 3/1/12

exchange rate is $.9540 = 1 €. Adjust the Forward Contract Payable:


exchange rate is $.9540 = 1 €. Adjust the Forward Contract Payable:


exchange rate is $.9540 = 1 €.

Collect the 20,000 € in settlement of the Account Receivable:



Collect the 20,000 € in settlement of the Account Receivable:





Complete the Forward Contract:



Complete the Forward Contract:

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!

Foreign Exchange Forward Contracts

A forward contract requires the purchase of currency units at a future date at the contracted exchange rate.

A forward contract requires the purchase of currency units at a future date at the contracted exchange rate.

An alternative is an option contract to

purchase 1,000,000 ¥ at $.0080 US in 30 days. But it costs

$.00002 per ¥.

That way, if the spot rate is $.0069 in 30 days, we only lose the $20 cost of the

option contract!

Foreign Exchange Options Contracts

An options contract gives the holder the option of buying the currency units at a future date at the

contracted “strike” price.

An options contract gives the holder the option of buying the currency units at a future date at the

contracted “strike” price.

Using a Foreign Currency Option as a Hedge

As with forward contracts, options can be designed

as cash flow hedges or fair value hedges.

Option prices are determined using the Black-Scholes Option

Pricing Model

Option values

Derived from a function combining: The difference between current spot rate

and strike price The difference between foreign and

domestic interest rates The length of time to option expiration The potential volatility of changes in the

spot rate

9-56

Using a Foreign Currency Option as a Hedge

SFAS 133 requires options be carried at fair value on

the balance sheet.

Option fair values are determined by examining

the current quotes for similar options and

breaking the fair value into two components:

Intrinsic Value & Time Value

Under fair value hedge accounting:

(1) The gain/loss on the hedge is recognized currently in net income.

(2) The gain/loss on the firm commitment attributable to the hedged risk is also recognized

currently in net income.

Under fair value hedge accounting:

(1) The gain/loss on the hedge is recognized currently in net income.

(2) The gain/loss on the firm commitment attributable to the hedged risk is also recognized

currently in net income.

Hedge of a Foreign Currency Firm Commitment

Occurs when a company hedges a transaction that has yet to take place.

Occurs when a company hedges a transaction that has yet to take place.

ExampleRuff Wood orders

1,000,000 board feet of lumber from Brazil. Ruff Wood enters the hedge contract on the same day as the order

is placed.

ExampleRuff Wood orders

1,000,000 board feet of lumber from Brazil. Ruff Wood enters the hedge contract on the same day as the order

is placed.

Foreign Currency Firm Commitment

On December 1, 2011, Amerco receives an order from a German customer. The delivery date is March 1, 2012, when

Amerco will receive immediate payment.The sale is three months away, Amerco has

a firm commitment to make the sale and receive payment of 1,000,000 €.

Amerco decides to hedge this commitment.

These are executory contracts, so no entries are made on this date.

These are executory contracts, so no entries are made on this date.

Foreign Currency Firm Commitment - Example

Amerco will receive 1,000,000 € on March 1, 2012. A forward contract was entered

into to sell the euros at a price of $.905 = 1 €. Amerco’s discount rate is 12%.

On 12/31/11, the currently available forward rate is $.916 = 1 €.

1. Record the forward contract.




1. Record the forward contract.




2. Record the firm commitment.




2. Record the firm commitment.



On March 1, 2012, Amerco receives 1,000,000 € from the German customer upon deliver of the order. On 3/1/12, the

spot rate is $.900 = 1 €.1. Adjust the forward contract to its

current value of $5,000.


spot rate is $.900 = 1 €.1. Adjust the forward contract to its

current value of $5,000.



spot rate is $.900 = 1 €. Record an offsetting loss associated

with the Firm Commitment.


spot rate is $.900 = 1 €. Record an offsetting loss associated

with the Firm Commitment.



spot rate is $.900 = 1 €. Record the receipt of the foreign

currency.


spot rate is $.900 = 1 €. Record the receipt of the foreign

currency.



spot rate is $.900 = 1 €. Record the fulfilling of the forward

contract.


spot rate is $.900 = 1 €. Record the fulfilling of the forward

contract.


On March 1, 2012, Amerco receives 1,000,000 € from the German customer upon deliver

of the order. On 3/1/12, the spot rate is $.900 = 1 €.

Close the Firm Commitment to Net Income.

On March 1, 2012, Amerco receives 1,000,000 € from the German customer upon deliver

of the order. On 3/1/12, the spot rate is $.900 = 1 €.

Close the Firm Commitment to Net Income.

Let’s try a Cash Flow Hedge

Example

Cash Flow Hedge - Date of Transaction

On 4/1/12, MPG, Inc., a U.S. maker of auto parts, purchases parts from Aguila Company in Mexico 100,000 Pesos on

credit. Payment is due in 180 days (October 8, 2012).

The current exchange rate is $1 = 9.5000 pesos.

Prepare MPG’s journal entry on 4/1/12.

Cash Flow Hedge - Date of Transaction

Assume that MPG takes a 180-day forward contract to buy 100,000 pesos. Forward

Contract rate is 9.7400 pesos = $1.

Assume that MPG takes a 180-day forward contract to buy 100,000 pesos. Forward

Contract rate is 9.7400 pesos = $1.


date.


date.

Cash Flow Hedge - Interim Reporting Date

At MPG’s year-end, 6/30/12, the value of the foreign currency payable must be re-measured, or

adjusted, based on the 6/30/12 spot rate of $1 = 9.5250 pesos.

Remeasure the original payable:

At MPG’s year-end, 6/30/12, the value of the foreign currency payable must be re-measured, or

adjusted, based on the 6/30/12 spot rate of $1 = 9.5250 pesos.

Remeasure the original payable:


In addition, we record an entry to Other Comprehensive Income (OCI) to offset the exchange gain/loss associated with

the original transaction.

In addition, we record an entry to Other Comprehensive Income (OCI) to offset the exchange gain/loss associated with

the original transaction.


Also, on 6/30/12, the forward contract must be recorded. The available forward rate to October 8,

2012 is $1 = 9.6200 pesos. MPG uses a 6% discount rate.

Record the forward contract:

Cash Flow Hedge - Date of Collection Example

Finally, MPG must amortize the rest of the discount from the original transaction date.

In the original transaction, MPG had a discount of $259 ($10,526 - $10,267). The discount is amortized using the straight-

line method.



line method.

9-74

Cash Flow Hedge - Date of Collection

On 10/8/12, both the original payable and the exchange contract come due. The 10/8/12 exchange rate is $1

= 9.4000 pesos.

Remeasure the Accounts Payable:


= 9.4000 pesos.

Remeasure the Accounts Payable:


As at year-end, MPG must record an entry to offset the foreign exchange

loss of $139.

As at year-end, MPG must record an entry to offset the foreign exchange

loss of $139.


On 10/8/12, both the original payable and the exchange contract come due. The 10/8/12 exchange rate is $1 =

9.4000 pesos. .

Adjust the Forward Contract:

On 10/8/12, both the original payable and the exchange contract come due. The 10/8/12 exchange rate is $1 =

9.4000 pesos. .

Adjust the Forward Contract:




line method.



line method.

9-78

On 10/8/12, both the original payable and the exchange contract come due. The 10/8/12

exchange rate is $1 = 9.4000 pesos.

Purchase the 100,000 pesos:

On 10/8/12, both the original payable and the exchange contract come due. The 10/8/12

exchange rate is $1 = 9.4000 pesos.

Purchase the 100,000 pesos:




= 9.4000 pesos.

Complete the Forward Contract Payable:


= 9.4000 pesos.

Complete the Forward Contract Payable:

The End . . .

. . . sort of

chapter ten foreign currency transactions and hedging

Documents

unit of foreign currency

foreign exchange ratesas

forward rate of exchange

currency values

organized exchange

indirect exchange rate

unit of countrys currency

foreign customers