McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6 Foreign Currency Transactions and Hedging Foreign Exchange Risk

6-2 Foreign Currency Transactions and Hedging Foreign Exchange Risk Chapter Topics Foreign exchange market. Foreign exchange risk. Accounting for foreign currency transactions. Hedging. Foreign currency forward contracts and options. Accounting for hedges. Cash flow hedges and fair value hedges.

6-3 Learning Objectives 1. Provide and overview of the foreign exchange market. 2. Explain how fluctuations in exchange rates give rise to foreign exchange risk. 3.Demonstrate the accounting for foreign currency transactions. 4. Describe how foreign currency forward contracts and foreign currency options can be used to hedge foreign exchange risk. Foreign Currency Transactions and Hedging Foreign Exchange Risk

6-4 Learning Objectives 5. Describe the concepts of cash flow hedges, fair value hedges, and hedge accounting. 6. Demonstrate the accounting for forward contracts and options used as cash flow hedges and fair value hedges to hedge foreign currency assets and liabilities, foreign currency firm commitments, and forecasted foreign currency transactions. Foreign Currency Transactions and Hedging Foreign Exchange Risk

6-5 Exchange Rates and Foreign Exchange Risk Terminology  Export sale – a company sells to a foreign customer and receives payment in the customer’s currency.  Import purchase – a company purchases from a foreign supplier and pays in the supplier’s currency.  Foreign exchange risk – the chance that the exporter will receive less, or the importer pay more, than anticipated as a result of change in exchange rate. Learning Objective 2

6-6 Accounting for Foreign Currency Transactions  Transactions are denominated in FC and measured in domestic currency  Changes in exchange rates between the transaction date and the settlement date results in exchange gain or loss to reporting entity  Transactions both denominated and measured in the reporting entity’s currency are not affected by changes in exchange rates  If a FC transaction is unsettled at the end of the period, exchange gains/losses should be accrued

6-7 Example  Joe Inc., a U.S. company, makes a sale and ships goods to Jose, SA, a Mexican customer.  Sales price is $100,000 (U.S.) and Joe allows Jose to pay in pesos in 30 days.  The current exchange rate is $0.10 per 1 peso.  Joe plans to receive 1,000,000 pesos ($100,000/$0.10). Learning Objective 2 Exchange Rates and Foreign Exchange Risk

6-8  Joe has foreign exchange risk exposure because he may receive less than $100,000.  Suppose the peso decreases such that in 30 days the exchange rate is $0.09 per 1 peso.  Joe will receive 1,000,000 pesos which will be worth $90,000 (1,000,000 x $0.09), Joe receives $10,000 less due to exchange rate fluctuation. Learning Objective 2 Exchange Rates and Foreign Exchange Risk

6-9 Accounting for Foreign Currency Transactions Accounting – sale transaction One transaction perspective  Treats sale and collection as one transaction.  Transaction is complete when foreign currency is received and converted, sale is measured at converted amount.  This approach is not allowed under IAS or U.S. GAAP. Learning Objective 3

6-10 Two transaction perspective  Treats sale and collection as two transactions:  Sale is one transaction  Collection is second transaction.  Sale is based on current exchange rate.  If exchange rate changes, collection is for different amount.  Difference is considered foreign exchange gain or loss.  Concepts are identical for purchase transaction. Learning Objective 3 Accounting for Foreign Currency Transactions

6-11 Transaction types, exposure type and gain or loss – export sales  Export sale  asset exposure, if foreign currency appreciates  foreign exchange gain.  Export sale  asset exposure, if foreign currency depreciates  foreign exchange loss. Learning Objective 3 Accounting for Foreign Currency Transactions

6-12 Transaction types, exposure type and gain or loss – import purchases  Import purchase  liability exposure, if foreign currency appreciates  foreign exchange loss.  Import purchase  liability exposure, if foreign currency depreciates  foreign exchange gain. ــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ Learning Objective 3 Accounting for Foreign Currency Transactions

6-13 Export sale – example 1  February 1, 2006, Joe Inc., a U.S. company, makes a sale and ships goods to Jose, SA, a Mexican customer.  Sales price is $100,000 (U.S.).  Jose agrees to pay in pesos on March 2,  Spot rate as of February 1, 2006 is $0.10 per peso. Learning Objective 3 Accounting for Foreign Currency Transactions

6-14 Export sale – example 1 Joe, Inc. records the sale (in U.S. $) on February 1, 2006 as follows: Accounts Receivable 100,000 Sales 100,000 Learning Objective 3 Accounting for Foreign Currency Transactions

6-15 Export sale – example 1 On March 2, 2006, the spot rate is $0.09 per peso. Joe Inc. will receive 1,000,000 pesos, which are now worth $90,000. Joe makes the following journal entry: Cash 90,000 Foreign Exchange Loss 10,000 Accounts Receivable 100,000 Learning Objective 3 Accounting for Foreign Currency Transactions

6-16 Export sale – example 2 Assume the following facts are added or change:  Joe Inc., makes sale and ships goods on December 1, 2005 rather than February 1,  Sales price is 1000,000 peso  Spot rate as of December 1, 2005 is $0.11 per peso.  Spot rate as of December 31, 2005 is $0.105 per peso.  Spot rate as of March 2, 2006 is $0.9 per peso.  Joe Inc. has a December 31 year end. Learning Objective 3 Accounting for Foreign Currency Transactions

6-17 Export sale – example 2 Joe, Inc. records the sale (in U.S. $) on December 1, 2005 and the foreign exchange loss on December 31, 2005 as follows: Accounts Receivable 110,000 Sales 110,000 (Sale (in U.S. $) on December 1, 2005) Foreign Exchange Loss 5,000 Accounts Receivable 5,000 (Foreign exchange loss on December 31, 2005 ) Learning Objective 3 Accounting for Foreign Currency Transactions

6-18 Export sale – example 2 Joe, Inc. records the receivable collection and an additional foreign exchange loss on March 2, 2006: Cash 90,000 Foreign Exchange Loss 15,000 Accounts Receivable 105,000 Learning Objective 3 Accounting for Foreign Currency Transactions

Export sale – example 3 During December of the current year, Teletex Systems, Inc., a company based in Seattle, Washington, entered into the following transactions: Dec. 10Sold seven office computers to a company located in Colombia for 8,541,000 pesos. On this date, the spot rate was 365 pesos per U.S. dollar. Assume that on December 31 the direct exchange rates was Colombia peso $ January 10. Assume that the direct exchange rate on the settlement date was Colombia peso $ Accounting for Foreign Currency Transactions

Export sale – example 3 During December of the current year, Teletex Systems, Inc., a company based in Seattle, Washington, entered into the following transactions: Dec. 10Sold seven office computers to a company located in Colombia for 8,541,000 pesos. On this date, the spot rate was 365 pesos per U.S. dollar. U.S. firm (Teletex) Inventory delivered 12/10/2006 8,541,000 pesos received on 1/10/2007 Columbia firm Accounting for Foreign Currency Transactions

Export sale – example 3, Dec. 10 Sold seven office computers to a company located in Colombia for 8,541,000 pesos. On this date, the spot rate was 365 pesos per U.S. dollar. Prepare the journal entry on the books of Teletex Systems, Inc. Accounts receivable 23,400 Sales23,400 Sales price in pesos8,541,000 Pesos per U.S. dollar/ 365 Sales price in U.S. dollars$ 23,400 Accounting for Foreign Currency Transactions

Export sale – example 3 Prepare journal entry necessary to adjust the accounts as of December 31. Assume that on December 31 the direct exchange rates was Colombia peso $ Transaction loss 510 Accounts receivable 510 Receivable in pesos8,541,000 Direct exchange rate to U.S. dollar$ Receivable in U.S. dollars$ 22,890 Balance in receivable 23,400 Transaction loss$ 510 Accounting for Foreign Currency Transactions

Export sale – example 3 Prepare journal entry to record settlement of the account on January 10. Assume that the direct exchange rate on the settlement date was Colombia peso $ Cash (8,541,000 x $.00320) 27,331 Accounts receivable ($23,400 - $510) 22,890 Transaction gain 4,441 Accounting for Foreign Currency Transactions

Emport sale – example 4 During December of the current year, Teletex Systems, Inc., a company based in Seattle, Washington, entered into the following transactions: Dec. 12 Purchased computer chips from a Taiwan company. Contract was denominated in 500,000 Taiwan dollars. Direct exchange rate on this date was $ U.S. firm (Teletex) Inventory received 12/12/ ,000 Taiwan dollars paid on 10/1/2007 Taiwan firm Accounting for Foreign Currency Transactions

Emport sale – example 4 Dec. 12, Purchased computer chips from a company domiciled in Taiwan. The contract was denominated in 500,000 Taiwan dollars. The direct exchange spot rate on this date was $ Prepare the journal entry on the books of Teletex Systems, Inc. Purchases 19,550 Accounts payable19,550 Purchase price in Taiwan dollars500,000 Direct exchange rate to U.S. dollarx $.0391 Purchase price in U.S. dollars$ 19,550 Accounting for Foreign Currency Transactions

Emport sale – example 4 Prepare journal entry necessary to adjust the account as of December 31. Assume that on December 31 the direct exchange rates was Taiwan dollar $ Accounts payable2,000 Transaction gain2,000 Payable in pesos500,000 Direct exchange rate to U.S. dollar$.0351 Payable in U.S. dollars$ 17,550 Balance in payable 19,550 Transaction gain$ 2,000 Accounting for Foreign Currency Transactions

Emport sale – example 4 Prepare journal entry to record settlement of account on January 10. Assume that the direct exchange rate on the settlement date was Taiwan dollar $ Transaction loss 2,350 Accounts payable ($19,550 - $2,000) 17,550 Cash (500,000 x $.0398) 19,900 Accounting for Foreign Currency Transactions