©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Foreign Currency Concepts and Transactions Chapter 12

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 1 Introduce foreign currency and definitions.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Foreign Exchange Concepts and Definitions Currencies provide… a standard of value, a medium of exchange, and a unit of measure for economic transactions.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Foreign Exchange Concepts and Definitions In the case of transactions between business entities of different countries, the amounts receivable and payable are denominated in local currency of either the buying or the selling entity.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Foreign Exchange Concepts and Definitions Exchange rates are essentially prices for currencies expressed in units of other currencies. =.0082

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 2 Understand quotation conventions for foreign currency and exchange rates.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Direct and Indirect Quotation of Exchange Rates Direct quotation (U.S. dollar equivalent): Assume that $1.60 can be exchanged for £1. Indirect quotation (foreign currency per U.S. dollar): $ =$1.60 =£ $1.60

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Floating, Fixed, and Multiple Exchange Rates. Floating Fixed Multiple Weakens Strengthens

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn The Euro Twelve member states of the European Union chose to participate in the transition to a single currency for Europe, the Euro. € The euro currency is managed by the European Central Bank.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Spot, Current, and Historical Exchange Rates Spot rate – the exchange rate for immediate delivery of currencies exchanged Current rate – the exchange rate at the balance sheet date or the transaction date Historical rate – the rate in effect at the date a specific transaction or event occurred

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 3 Learn foreign-currency- denominated transactions accounting.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Foreign Currency Transactions Other Than Forward Contracts Local transactions Foreign transactions An entity’s functional currency is the currency of an entity’s primary economic environment.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Foreign Currency Transactions Other Than Forward Contracts Foreign currency transactions are stated (denominated) in a currency other than an entity’s functional currency. The provisions of FASB Statement No. 52 apply only to foreign currency transactions and foreign currency financial statements.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Translation at the Spot Rate A U.S. corporation imports inventory from a Canadian firm when the spot rate for Canadian dollars is $.70 The invoice calls for payment of 10,000 Canadian dollars in 30 days. How does the U.S. importer record the transaction?

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Translation at the Spot Rate Inventory7,000 Accounts Payable (fc)7,000 (Translation 10,000 Canadian dollars ×.70 spot rate) If the account payable is settled when the spot rate is $.69, how is it recorded?

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Translation at the Spot Rate Accounts payable (fc)7,000 Exchange Gain 100 Cash6,900 (Cash required equals 10,000 Canadian dollars × the $0.69 spot rate)

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Purchases Denominated in Foreign Currency American Trading Company purchased goods from Kimetz Company on December 1, 2008, for 10,000 euros when the spot rate for euros was $ AT closed its books at December 31, 2008, when the spot rate for euros was $0.6550, and settled the account on January 30, 2009, when the spot rate was $

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Purchases Denominated in Foreign Currency December 1, 2008 Inventory6,600 Accounts Payable (fc)6,600 To record purchase of merchandise from Kimetz Company (10,000 euros × $ rate) December 31, 2008 Accounts Payable (fc) 50 Exchange Gain 50 To adjust accounts payable to exchange rate at year end [10,000 euros × ($ – $0.6550)]

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Purchases Denominated in Foreign Currency January 30, 2009 Accounts Payable (fc)5,550 Exchange Loss 100 Cash6,650 To record payment in full to Kimetz Company (10,000 euros × $ spot rate)

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Sales Denominated in Foreign Currency On December 16, 2008, American Trading sold merchandise to Kimetz for 20,000 euros when the spot rate for euros was $ AT closed its books at December 31, when the spot rate was $0.6550, collected the account on January 15, 2009, when the spot rate was $0.6700, and held the cash until January 20, when it converted the euros into USD at a $ rate.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Sales Denominated in Foreign Currency December 15, 2008 Accounts Receivable (fc)13,200 Sales13,200 To record sales to Kimetz (20,000 euros × $ spot rate) December 31, 2008 Accounts Receivable (fc) 100 Exchange Gain 100 To adjust accounts receivable year end [20,000 euros × ($ – $0.6600)]

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Sales Denominated in Foreign Currency January 15, 2009 Cash13,400 Accounts Receivable (fc)13,300 Exchange Gain 100 To record collection in full from Kimetz (20,000 euros × $0.6700) and recognize exchange gain for 2009 [20,000 euros × ($ – $0.6650)] January 20, 2009 Cash13,450 Exchange Gain 50 Cash (fc)13,400 To convert 20,000 euros into U.S. dollars (20,000 euros × $0.6725)

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 4 Comprehend cash flow hedge accounting and fair value hedge accounting.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Foreign Currency Derivatives and Hedging Activities Derivative is the name given to a broad range of financial securities. The derivative contract’s value to the investor is directly related to the fluctuations in price, rate, or some other variable that underlies it.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Options contracts Derivative Instruments Forward contracts Future contracts

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Derivative Instruments Options are rights to take an action, but the holder is not obligated to do so. A forward contract is negotiated between the parties and not through an exchange.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Derivative Instruments Futures contracts bind both parties (the writer and the holder) to perform. A cash flow hedge is designed to limit the company’s exposure to price changes in forecasted purchases.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Derivative Instruments A company signs an option contract on January 15, 2003, at a cost of $1,000. The company can exercise its option to purchase 100,000 gallons of fuel at $1 per gallon. The option expires on May 31, 2003.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Derivative Instruments January 15, 2003 Fuel Contract Option1,000 Cash1,000 The company prepares its quarterly report on March 31, Market price of fuel is $1.25. The company could exercise the option on this date.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Derivative Instruments March 31, 2003 Fuel Contract Option24,000 Other Comprehensive Income – Unrealized Holding Gains on Fuel Option Contract24,000 On May 31, 2003, the fuel price is $1.30. The writer of the option must pay the company $0.30 per gallon, or $30,000.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Derivative Instruments May 31, 2003 Fuel Inventory130,000 Cash130,000 Cash 30,000 Fuel Contract Option 25,000 Other Comprehensive Income 5,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Derivative Instruments June 15, 2003 Cost of Goods Sold130,000 Fuel Inventory130,000 Other Comprehensive Income 30,000 Cost of Goods Sold 30,000 The fuel inventory is used on June 15, 2003.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Fair Value Hedges A fair value hedge is a derivative contract that attempts to reduce the price risk of an existing asset or firm purchase commitment.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Summary of Forward Contracts (Speculation) Purpose To speculate in exchange rate changes Recognition Exchange gains and losses are recognized currently, based on forward exchange rate changes. Expected Effect of Hedge and Related Foreign Currency Item Income effect equals exchange gains and losses recognized.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Summary of Forward Contracts (Hedge of a Net Asset or Liability Position) Purpose To offset exposure to existing net asset or liability position Recognition Exchange gains and losses are recognized currently, but they are offset by related gains or losses on net asset or liability position. Expected Effect of Hedge and Related Foreign Currency Item Income effect equals the amortization of premium or discount (gains and losses offset.)

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Summary of Forward Contracts (Hedge of an Identifiable Commitment) Purpose To offset exposure to a future purchase or sale and thereby lock in the price of an existing contract Recognition Exchange gains and losses are recognized currently, but are offset by related gains or losses in the firm commitment. Expected Effect of Hedge and Related Foreign Currency Item Income effect equals the difference in the change in value of the instrument versus the firm commitment.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Summary of Forward Contracts (Hedge of an Anticipated Transaction) Purpose To offset exposure of possible future purchase or sale Recognition Exchange gains or losses on the hedge counted in other comprehensive income until the underlying transaction is complete. Expected Effect of Hedge and Related Foreign Currency Item No immediate income effect. Adjusts underlying transaction.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Summary of Forward Contracts (Hedge of a Net Investment in a Foreign Entity) Purpose To offset exposure to an existing net investment in a foreign entity Recognition Exchange gains and losses are recognized as other comprehensive income and will offset translation adjustments recorded on the net investment. Expected Effect of Hedge and Related Foreign Currency Item Income effect equals the change in the future value of the hedge versus the value of the net investment.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn The Four Fundamental Decisions Derivative instruments represent rights or obligations. Fair value is the most relevant measurement.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn The Four Fundamental Decisions Only items that are assets or liabilities should be reported. Special accounting should be provided only for qualifying items.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 5 Apply foreign-currency- denominated derivative accounting.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Speculation Exchange gains or losses on derivative instruments that speculate in foreign currency price movements are included in income in the period in which the forward exchange rates change.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Speculation On November 2, 2007, U.S. International enters into a 90-day forward contract (future) to purchase 10,000 euros (€). The current quotation for 90-day futures is €5,400. The spot rate for euros on November 2 is $

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Speculation What are the journal entries of U.S. International to account for the speculation? December 31, 2007January 30, day futures$0.5450$ Spot rate$0.5500$0.5530

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Speculation November 2, 2007 Contract Receivable (fc)5,400 Contract Payable5,400 To record contract for 10,000 euros × $ exchange rate for 90-day futures

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Speculation December 31, 2007 Contract Receivable (fc)50 Exchange Gain50 To adjust receivable from exchange broker and recognize exchange gain 10,000 euros × ($ forward exchange rate for 30-day futures – $ per books)

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn End of Chapter 12