1. Foreign Currency Transactions and
Chapter Ten
Foreign Currency Transactions and
Hedging

2. 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.

3. Trading Foreign Currencies3
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

4. 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

5. Exchange Rate Mechanisms
Independent
Float
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.
EURO
Dollars
Pegged to
Another Currency

6. 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
These are
wholesale
prices.
Retail prices
are higher.

7. Foreign Exchange Rates7
Foreign Exchange Rates
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
Direct rate is reciprocal of indirect rate. 7

8. Foreign Exchange Rates
As the relative strength of a country’s economy changes . . .
. . . the exchange rate of the local currency relative to other currencies also fluctuates.
¥ = $?

9. Currency Exchange Terminology
Conversion: Going to the bank and physically exchanging currencies.
for

10. Currency Exchange Terminology
Translation: Process of applying an exchange rate to a foreign currency amount so that an amount can be expressed in dollars.
100 x $ = $145.30

11. Currency Exchange Terminology
Directly:  (Domestic for Foreign) $ =
$ = FC
Indirectly: (Foreign for Domestic) = $ 1
4 FC = $ 1

12. Currency Exchange Terminology
CUSTOM to express certain currencies directly (British Pound):
CUSTOM to express certain currencies indirectly (Japanese Yen): 1
= $
$1 =

13. Currency Exchange Terminology
FOREIGN CURRENCY STRENGTHENS (Gains):
Direct exchange rate goes UP.
Before: = $ After: = $1.64
Indirect exchange rate goes DOWN.
Before: $1 = After: $1 =

14. Currency Exchange Terminology
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.

15. Foreign Exchange Rates
Spot Rate
Exchange rate that is available today
Forward Rate
Exchange rate that can be locked in today for an expected future exchange transaction.

16. Forward Exchange Rates
Exchange 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) 1 1

17. Foreign Currency Transaction
….transaction that requires settlement in a foreign currency

18. 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.

19. Exposure to Foreign Exchange Risk19
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

20. Impact of Financial Risk due to Changes in Exchange Rates20
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

21. 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

22. Exchange Gains/Losses22
Exchange Gains/Losses
Reported on the income statement
Generated from two situations
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
AND
Exchange gain or loss is generated
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 22

23. 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.

24. Foreign Currency Transactions
The major accounting issue:
How do we account for the changes in the value of the foreign currency?

25. Foreign Currency Transactions
FASB No. 52
Requires a two-transaction perspective.
Account for the original sale in US $
Account for gains/losses from exchange rate fluctuations.

26. Accounting Procedures for Import/Export Transactions26
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

27. Accounting for Import/Export Transactions Example27
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.
To record the purchase of sweaters from New Zealand: $0.62 x 17,000 = $10,540
2012
Oct. 16
Inventories
10,540
Accounts payable
Initially recorded in U.S. Dollars 27

28. Accounting for Import/Export Transactions Example28
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.
Revalue the accounts payable to relect current exchange rate: ($0.63 – $0.62) × 17,000 = $170
2012
Dec. 16
Exchange loss
170
Accounts payable
Invest in sufficient foreign currency to pay the New Zealand manufacturer: $0.63 × 17,000 = $10,710
Dec. 16
Foreign currency
10,710
Cash
Record payment of the liability to the New Zealand manufacturer:
Dec. 16
Accounts payable
10,710
Foreign currency 28

29. Accounting for Import/Export Transactions Example29
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.
To record the purchase of scarves from the U.K.:
₤40,000 × 2 = $80,000
2012
Dec. 20
Inventories
80,000
Accounts payable
On December 22, 2012, Gap Inc., sold wool coats to a Canadian company for 9,800 Canadian dollars (C$). The exchange rate was $0.67/C$. Gap’s terms are 90 days, net.
To record the sale of coats to Canada:
$0.67 × 9,800 = $6,566
Dec. 22
Accounts receivable
6,566
Sales 29

30. Accounting for Import/Export Transactions Example30
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.
To record the cash purchase of buttons from Mexico:
$0.05 x 10,000 = $500
2012
Dec. 29
Inventories
500
Cash 30

31. Accounting for Import/Export Transactions Year-End Adjustments Example31
Accounting for Import/Export Transactions Year-End Adjustments Example
On January 31, 2012, Gap Inc. made adjusting entries. Exchange rates were $1.96/₤ and $0.685/C$.
To revalue the liability to the British mill to the current exchange rates: ($2.00 – $1.96) × 40,000 = $1,600:
2012
Jan. 31
Accounts payable
1,600
Exchange gain
U.S. dollar strengthened
To revalue the receivable from Canada to the current exchange rate: ($0.685 – $0.67) × 9,800 = $147
Jan. 31
Accounts receivable
147
Exchange gain
U.S. dollar weakened 31

32. Accounting for Import/Export Transactions Example32
On February 20, 2012, Gap Inc. paid its obligation to the British mill. The exchange rate was $1.93/₤.
To revalue the liability to the British mill to the current exchange rates: ($1.96 – $1.93) × 40,000 = $1,200:
2012
Feb. 20
Accounts payable
1,200
Exchange gain
To purchase sufficient foreign currency to pay the British mill: $1.93 × 40,000 = $77,200
Feb. 20
Foreign currency
77,200
Cash
To record payment of the liability to the British mill:
Feb. 20
Accounts payable
77,200
Foreign currency 32

33. Accounting for Import/Export Transactions Example33
On March 20, 2012, payment was received from the Canadian customer on the sale of the coats. The exchange rate was $0.65/C$.
To revalue the receivable to the current exchange rates: ($0.685 – $0.65) × 9,800 = $343
2012
Mar. 20
Exchange loss
343
Accounts receivable
To record receipt of foreign currency from Canada for receivable: $0.65 × 9,800 = $6,370
Mar. 20
Foreign currency
6,370
Accounts receivable
To record exchange of the Canadian currency for U.S. dollars:
Mar. 20
Cash
6,370
Foreign currency 33

34. Exchange Gains and Losses Due to Changes in Direct Exchange Rate34
Effects of Changing Exchange Rates on Receivables and Payables Denominated in Foreign Currencies
Exchange Gains and Losses Due to Changes in Direct Exchange Rate
Exposed Account
Increase
($ 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. 34

35. Essence of Hedging
Reducing exposure by offsetting foreign currency gains on assets/liabilities with foreign currency losses and visa versa

36. Hedging Foreign Exchange Exposures36
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
Rates could also move in the company’s favor. 36

37. Types of Foreign Exchange Risk37
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

38. Investments Used to Hedge
Forward Contracts
Foreign Currency Options
Buy (call)
Sell (put)
Foreign Currency Swaps 1 1

39. Accounting for Derivatives
SFAS 133/138 provides guidance for hedges of four types of foreign exchange risk.
Recognized foreign currency denominated assets & liabilities.
Forecasted foreign currency denominated transactions.
Net investments in foreign operations
Unrecognized foreign currency firm commitments.

40. Derivative Instruments Used in Hedging40
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

41. Determining the Value of Derivatives
9-41
Determining the Value of Derivatives
To determine the value of foreign currency derivatives, the company needs 3 basic pieces of information:
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.

42. Accounting for Hedges
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 ¥ = $1.
Bob uses a discount rate of 6%. What is the value of the forward contract on 12/31/11 ?

43. Accounting for Hedges
There are two ways that a foreign currency hedge can be accounted for.
Cash Flow Hedge
Fair Value Hedge
Gains/losses are recorded to Other Comprehensive Income
Gains/losses are recorded to the Income Statement

44. Now, let’s try a Fair Value Hedge.

45. 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.

46. 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 €.
This is an executory contract, so no entry is made on the contract date.

47. 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:

48. 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:

49. 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:

50. 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 Forward Contract Payable:

51. 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 €.
Collect the 20,000 € in settlement of the Account Receivable:

52. 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 €.
Complete the Forward Contract:

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

54. 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 alternative is an option contract to purchase 1,000,000 ¥ at $.0080 US in 30 days. But it costs $ per ¥.
That way, if the spot rate is $.0069 in 30 days, we only lose the $20 cost of the option contract!

55. 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

56. Option values Derived from a function combining:
9-56
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

57. 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

58. Hedge of a Foreign Currency Firm Commitment
Occurs when a company hedges a transaction that has yet to take place.
Example
Ruff 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.
Under fair value hedge accounting:
The gain/loss on the hedge is recognized currently in net income.
The gain/loss on the firm commitment attributable to the hedged risk is also recognized currently in net income.

59. 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.

60. Foreign Currency Firm Commitment - Example
Amerco will receive 1,000,000 € on March 1, 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 €.
Record the forward contract.

61. Foreign Currency Firm Commitment

62. Foreign Currency Firm Commitment
Amerco will receive 1,000,000 € on March 1, 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 €.
Record the firm commitment.

63. Foreign Currency 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 €.
Adjust the forward contract to its current value of $5,000.

64. Foreign Currency 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 €.
Record an offsetting loss associated with the Firm Commitment.

65. Foreign Currency 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 €.
Record the receipt of the foreign currency.

66. Foreign Currency 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 €.
Record the fulfilling of the forward contract.

67. Foreign Currency 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 €.
Close the Firm Commitment to Net Income.

68. Let’s try a Cash Flow Hedge Example

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

70. Cash Flow Hedge - Date of Transaction
Assume that MPG takes a 180-day forward contract to buy 100,000 pesos. Forward Contract rate is pesos = $1.
This is an executory contract, so no entry is made on the contract date.

71. 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 = pesos.
Remeasure the original payable:

72. Cash Flow Hedge - Interim Reporting Date
In addition, we record an entry to Other Comprehensive Income (OCI) to offset the exchange gain/loss associated with the original transaction.

73. Cash Flow Hedge - Interim Reporting Date
Also, on 6/30/12, the forward contract must be recorded. The available forward rate to October 8, 2012 is $1 = pesos. MPG uses a 6% discount rate.
Record the forward contract:

74. Cash Flow Hedge - Date of Collection Example
9-74
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.

75. 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 = pesos.
Remeasure the Accounts Payable:

76. Cash Flow Hedge - Date of Collection
As at year-end, MPG must record an entry to offset the foreign exchange loss of $139.

77. Cash Flow Hedge - Date of Collection Example
On 10/8/12, both the original payable and the exchange contract come due. The 10/8/12 exchange rate is $1 = pesos. .
Adjust the Forward Contract:

78. Cash Flow Hedge - Date of Collection Example
9-78
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.

79. 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 = pesos.
Purchase the 100,000 pesos:

80. 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 = pesos.
Complete the Forward Contract Payable:

81. The End . . .
. . . sort of