1. Foreign Currency Transactions
Chapter 10
Foreign
Currency
Transactions

2. 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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3. 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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4. 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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5. Interest differentials affect forward rates
Facts
Spot Rate 1 FC = $1.50
Amount of FC to be sold 10,000 FC
Forward Date 60 days forward
Interest rate on FC 6.0%
Interest rate on $ 7.2%
Calculation of Forward Rate
$ FC
Value Today 15,000 10,000
Interest for 60 days
Value in 60 days 15,180 10,100
Forward Rate = $15,180  10,100 FC; 1FC = $1.503
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6. 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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7. Foreign currency transactions demonstrated
Transaction: Purchase inventory for 100,000 FC
-A-
Transaction
Date
Spot Rate:
1 FC = $1.50
1 FC = $1.53
1 FC = $1.52
-C-
Settlement
-B-
Year
End
Journal entries for these dates follow . . .
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8. Foreign currency transactions demonstrated (con’t)
A) Inventory 150,000
Accounts Payable 150,000
purchase inventory; rate = $1.50
B) Exchange Loss 3,000
Accounts Payable 3,000
fiscal year-end; rate = $1.53
C) Accounts Payable 153,000
Exchange Gain 1,000
Cash 152,000
settlement date; rate = $1.52
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9. Hedging against foreign currency exchange risk
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:
hedge a FC transaction
hedge a FC commitment
hedge a forecasted FC transaction
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10. Investments used to hedge
Derivative instruments
Forward contracts
FC options
buy (call)
sell (put)
FC swaps
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11. Hedging a foreign currency transaction with a fwd contract
Transaction: Buy inventory for 100,000 FC. A forward contract to buy FC on settlement date was acquired on transaction date.
-A-
Transaction
Date
-B-
Year
End
-C-
Settlement
Date
Spot Rate:
1 FC = $1.50
1 FC = $1.53
1 FC = $1.52
Fwd Rate:
1 FC = $1.505
1 FC = $1.529
n/a
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12. Hedging a foreign currency transaction with a fwd contract (con’t)
Without Without
the hedge the hedge
Exchange gain (loss) on
foreign currency transactions ($2,000) ($2,000)
Gain (loss) on fwd contract ,000
Subtotal ($2,000) -0-
Gain (loss) on forward
contract excluded from
assessment of hedge effectiveness _______ (500)
Net Income effect ($2,000) ($500)
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13. 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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14. 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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15. Hedge on identifiable foreign currency commitment (con’t)
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)
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16. 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.
-A-
Commitment
Date
Spot Rate:
1 FC = $1.50
1 FC = $1.53
1 FC = $1.54
-C-
Settlement
-B-
Transaction Date
Fwd Rate:
1 FC = $1.505
1 FC = $1.531
n/a
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17. Hedging an identifiable foreign currency commitment (cont’d)1 1

18. 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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19. 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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20. Hedging a foreign denominated forecasted transaction
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.
-A-
Forecasted
Date
Spot Rate:
1 FC = $1.50
1 FC = $1.46
n/a
-B-
Transaction
Forward Rate:
1 FC = 1.495
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21. Hedging a foreign denominated forecasted transaction