Advanced Accounting by Debra Jeter and Paul Chaney Chapter 13: Accounting for Foreign Currency Transactions Slides Authored by Hannah Wong, Ph.D. Rutgers University

Exchange Rates lDirect exchange rate n how many units of the domestic currency can be converted into one unit of foreign currency n e.g., 1.517: $ British pound lIndirect exchange rate n how many units of the foreign currency can be converted into one unit of domestic currency n e.g.,.6592: $ British pound

Exchange Rates lSpot rate n exchange rate for immediate delivery of currencies exchanged lForward or future rate n exchange rate for future delivery of currencies exchanged

Exchange Rates lOfficial or fixed rates n the country maintains the actual exchange rate of its currency within 2% of the official rate n by buying or selling U.S. dollars or gold lFloating rates n the currency’s exchange rate is determined by supply and demand factors n increases risk to companies doing business with a foreign company

Measured VS Denominated n transactions are normally measured and recorded in the currency in which the reporting entity prepares its financial statements n Assets and liabilities are denominated in a currency if their amounts are fixed in terms of that currency

Foreign Currency Transactions lDefinition n A transaction that requires settlement in a foreign currency lExamples: n importing or exporting goods on credit n borrowing or lending to a foreign company n hedging a net investment in a foreign entity n forward contract

Importing or Exporting Goods or Services Transaction date Settlement date Balance sheet date Record transaction as: units of foreign currency x current exchange rate Record accounts denominated in foreign currency as: units of foreign currency x current exchange rate Settle accounts denominated in foreign currency as: units of foreign currency x current exchange rate

Importing or Exporting Goods or Services Transaction date Settlement date Balance sheet date Foreign currency transaction gain/loss = units of foreign currency x change in exchange rate Foreign currency transaction gain/loss = units of foreign currency x change in exchange rate Net income Treatment of foreign currency transaction gain/loss

lForeign currency transaction gain/loss is included in net income except n long-term financing or capital transactions with an investee consolidated or accounted for by the equity method (included in S/E) n economic hedges of a net foreign investment (included in S/E) n economic hedges of an identifiable foreign currency commitment (deferred) Importing or Exporting Goods or Services

Importing Transactions An Example U.S. firm French firm Inventory delivered 12/1/ ,000 euros to be paid on 3/1/2002 Spot rates: Transaction date: $1.05 Balance sheet date: $1.08 Settlement date: $1.07

Importing Transactions An Example 12/1 (Transaction date) Purchases525,000 Accounts payable 525, ,000 euros x $1.05/euro 12/31 (Balance sheet date) Transaction loss15,000 Accounts payable 525, ,000 euros x $( )/euro

Importing Transactions An Example 3/1 (Settlement date) Accounts payable 540,000 Transaction gain 5,000 Cash535,000 Gain = 500,000 euros x $( )/euro

Exporting Transactions An Example U.S. firm French firm Inventory delivered 12/1/ ,000 euros to be received on 3/1/2002 Spot rates: Transaction date: $1.05 Balance sheet date: $1.08 Settlement date: $1.07

Exporting Transactions An Example 12/1 (Transaction date) Accounts receivable525,000 Sales525, ,000 euros x $1.05/euro 12/31 (Balance sheet date) Accounts receivable15,000 Transaction gain15, ,000 euros x $( )/euro

Exporting Transactions An Example 3/1 (Settlement date) Cash 535,000 Transaction loss 5,000 Accounts receivable 540,000 Gain = 500,000 euros x $( )/euro

Economic Hedge of Foreign Investment lConditions n the forward contract is designated as, and is effective as, a hedge of the net investment; and n the foreign currency commitment is firm

Forward Exchange Contracts Definition n An agreement to exchange currencies of two different countries at a specified rate (the forward rate) on a stipulated future date

Uses of Forward Exchange Contracts lHedges n to hedge a foreign currency exposed receivable or payable n to hedge a net investment in a foreign entity n to hedge an identifiable foreign currency commitment lSpeculation n to speculate in foreign currency in anticipation of a gain

Hedge: Foreign Currency Exposed Liability U.S. firm French firm Inventory delivered 12/1/ ,000 euros to be paid on 3/1/2002 Spot rates: Transaction date: $1.05 Balance sheet date: $1.08 Settlement date: $1.07 U.S. firm Exchange dealer $ to be received on 3/1/ ,000 euros to be received on 3/1/2002 Forward contract

Hedge: Foreign Currency Exposed Liability 12/1 (Transaction date) Purchases525,000 Accounts payable 525,000 Foreign currency (FC) receivable 525,000 Premium on forward contract 2,500 Dollars payable 527, ,000 euros x $1.05 spot rate 500,000 euros x $1.055 forward rate

Hedge: Foreign Currency Exposed Liability 12/31 (Balance sheet date) Transaction loss15,000 Accounts payable15,000 Foreign currency (FC) receivable 15,000 Transaction gain15, ,000 euros x $( ) change in spot rate Amortization expense ($2,500/3)833 Premium of forward contract833 Amortization of premium of FC The transaction gain and loss offset each other

Hedge: Foreign Currency Exposed Liability 3/1 (settlement date) Accounts payable5,000 Transaction gain5,000 Transaction loss5,000 Foreign currency (FC) receivable 5, ,000 euros x $( ) change in spot rate Dollars payable 527,500 Investment in FC535,000 FC receivable 535,000 Cash 527,500 To record settlement of FC contract

Hedge: Foreign Currency Exposed Liability 3/1 (settlement date) Amortization of premium of FC Amortization expense ($2,500/3)833 Premium of forward contract833 Accounts payable535,000 Investment in FC 535,000 To record settlement of account payable

Hedge of a Forecasted Transaction 12/1/2001 Settlement date Balance sheet date U.S. firm purchased an option for $5,000, allowing the firm to sell 500,000 euros at $1.02 U.S. firm estimates sales to the U.K. in 1/2002 for 500,000 euros Spot rates: 12/1/2001: $ /31/2001: $1.00 2/1/2002: $0.98

Hedge of a Forecasted Transaction 12/1 (Transaction date) The deferred gain is reported in other comprehensive income, not as part of net income 12/31 (Balance sheet date) Options to sell euros9,000 Deferred gain on option9,000 Options to sell euros5,000 Cash5,000 To record purchase of options

Hedge of a Forecasted Transaction 2/1 (Option expiration date) To transfer the deferred gain from equity to net income Deferred gain on option9,000 Options to sell euros9,000 Options to sell euros6,000 Gain on options6,000 To adjust option to its realizable value of $20,000

Hedge of a Forecasted Transaction 2/1 (Option expiration date) Cash510,000 Options to sell euros 20,000 Payable to option trader 490,000 Exercise the option and settle with the trader

Foreign Currency Commitment lA U.S. firm may commit to a foreign firm to sell or buy goods, and the price is established in foreign currency lchange in exchange rate between the commitment date and transaction date is reflected in the cost or sale price, not a separate gain or loss lThe U.S. firm may enter a forward contract to hedge its commitment

Hedge of an Identifiable Foreign Currency Commitment lConditions: n the forward contract is designated as, and is effective as, a hedge of the foreign currency commitment n the foreign currency commitment is firm

Hedge of an Identifiable Foreign Currency Commitment lEffective hedging gain/loss on the forward contract n deferred and included in the measurement of the related foreign currency transaction when recorded n i.e., treat the forward contract as an integral part of the importing or exporting transaction lNon-hedging gain/loss on the forward contract n not deferred n included in net income in the current period

Forward Contracts for Speculation lThe forward contract n is carried at forward rate at balance sheet date over remaining life of the contract lTransaction gain/loss n reported in net income of current year

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