CHAPTER Foreign Currency Transactions Fundamentals of Advanced Accounting 1 st Edition Fischer, Taylor, and Cheng 6 6

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #2 Foreign Currency Exchange Rates International monetary systems establish rates of exchange between currencies Exchange rate – a measure of how much of one currency can be exchanged for another Exchange rates may be quoted direct or indirect

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #3 Direct and Indirect quotes Quoted by a foreign currency trader Direct quote –How much domestic currency must be exchanged to receive 1 unit of foreign currency (FC) –Example: 1 FC = $.25 Indirect quote –The reciprocal of a direct quote –Example: $1 = 4FC

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #4 Currency Strengthens or Weakens Currency can “strengthen” or “weaken” against other currency Strengthens: –Reduction in a direct quote –Increase in an indirect quote –Domestic unit of currency demands more FC Weakens: opposite –Domestic unit of currency will buy less FC

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #5 Buying and Selling Rates Exchange rates may differ depending on whether they are a buying (bid price) or selling (offered price) rate Buying/selling rates – what a broker will pay to buy a currency Difference between buy/sell rate is a “spread” –Broker’s commission

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #6 Two Primary Groups of Exchange Rates Spot rate – currency delivered, bought, sold within 2 business days Forward rate – exchange of currencies at a future point in time –Forward Contract: Agreement to exchange currencies at a specific price at a specific time in the future

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #7 Forward and Spot Rates (continued) Both rates change constantly Spot rates are revised daily Changes in spot rates change forward rates At the end of a forward contract, the current forward rate becomes the spot rate –The value of a forward contract changes over the forward period

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #8 Forward and Spot Rates (continued) At inception of a forward contract, the difference between a forward rate and the current spot rate represents: –A premium (forward > spot) –A discount (forward < spot) The difference also represents contract expense or income to the contract purchaser

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #9 Interest Differentials Affect Forward Rates Interest differential - The difference between the interest you can earn holding an investment in a foreign currency versus a domestic currency Interest yield on FC > interest yield US$ –Forward rate less than spot rate –Forward contract at discount Interest yield on FC < interest yield US$ –Forward rate higher than spot rate –Forward contract at premium

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #10 Interest Differentials Affect Forward Rates Facts Spot rate1 FC = $.60 Amount of FC to be sold1,000 FC Forward date6 months forward Interest rate on FC7.25% Interest rate on $4.5% Calculation of forward rate US $ FC Value today$600.00FC 1, Interest for 6 months $ FC Value in 6 months $613.50FC 1, Forward rate = $  FC = 1 FC = $0.592

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #11 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

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #12 Foreign Currency Unsettled Transaction Example 11/1/X1 Transaction date Spot Rate: 1 FC = $ FC = $0.521 FC = $0.55 2/1/X2 Settlement date Year-end 12/31/X1 Journal entries for these dates follow... US Company purchases inventory on 11/1/20X1 for 1,000 FC. Purchase to be paid on 2/1/20X2

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #13 Foreign Currency Unsettled Transaction Example (continued) 11/1Inventory500 Accounts Payable500 Purchase inventory; rate = $ /31Exchange Loss20 Accounts Payable - FC20 Fiscal year-end; rate = $0.52 2/1Accounts Payable500 Exchange Loss30 Cash550 Settlement date; rate = $0.55

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #14 Exposure to FC Exchange Risk Certain situations expose domestic companies to FC exchange risk –An existing FC transaction resulting in recognition of assets or liabilities –A firm commitment to enter into a FC transaction –A forecasted FC transaction that has a high probability of occurrence –Investment in a foreign subsidiary Strategies to hedge risk include derivatives

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #15 Derivatives Defined Financial instruments that derive their value from changes in the value of a related asset or liability

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #16 Characteristics of Derivatives Underlyings – The rates or prices that relate to the asset or liability related to the derivative instrument Not the asset/liability, but its rate or price Notional amount – The number of units or quantity specified in the derivative instrument Minimal initial investment – A derivative requires little or no initial investment upon inception No required delivery – Contract can be settled for cash, without buying or selling related asset/liability Both the underlying price/rate AND the notional amounts are required to determine total value of the derivative at any point in time!

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #17 Common Types of Derivatives To hedge against FC Exchange risk –Forward contracts –Option contracts

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #18 Foreign Currency (FC) Forward Contracts A contract to buy or sell a specified amount of FC –Specified fixed rate –Delivery at a specified future point in time –Seller is in the “short” position –Buyer is in the “long” position Specified, fixed rate is the forward rate Specified future date is the forward date The value of the contract at inception is zero Total change in value of forward contract is measured as the difference between the forward rate and the asset’s spot rate at the forward date

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #19 Example - FC Forward Contract Writer of the Contract (Seller) Holder of the Contract (Buyer) Convey 1,000,000 FC in 90 days Pay $160,000 in 90 days FC at the forward rate in 90 days$ 160,000 Assumed spot rate in 90 days 180,000 Gain in value to holder$ 20,000 On 4/1, seller agrees to provide buyer with 1,000,000 FC on 6/29 for $0.16 per FC. Assume a spot rate on 6/29 of $0.18

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #20 Measuring Changes in the Value of a Forward Contract Over Time Measure cumulative change in forward value of a contract Difference between the original forward value and the remaining forward value The net present value of the change in forward value consists of two components: The change in the spot rates over time The change in the time value of the contract (spot – forward differences)

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #21 The Forward Rate A function of variables As variables change, the value of the forward contract changes Current value of the forward contract is determined by present value of future rates

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #22 Example: Change in Value of Forward Contract Assume a 6% discount rate – calculations on next slide

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #23 Example (continued): Change in Value of Forward Contract

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #24 FC Option Contracts Represent a right (not an obligation) to either buy or sell FC Valid for a specified period of time Specified buy/sell price –Referred to as the strike or exercise price –Strike price generally different from FC current value Call option – right to buy FC Put option – right to sell FC Holder pays nonrefundable cash outlay: premium –Writer has more risk than holder

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #25 FC Option Contracts (continued) Holder will not exercise the option if strike price is greater than fair value –Loss is limited to premium paid at inception –Gain is unlimited Options traded on an organized exchange Current value quoted in terms of present value

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #26 Example of a Put FC Option Option Writer Option Holder Sell 100,000 per FC Intrinsic value is the difference between the strike price and the market price Time value is the value of the option less the intrinsic value Calculations on next slide…. in 60 days

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #27 Example (continued): Put FC Option

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #28 Derivatives Designated as a Hedge Derivatives designated as a hedge are classified as –fair value hedge –cash flow hedge

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #29 Fair Value Hedges Used to offset changes in fair value of items with fixed exchange price or rates –Recognized FC asset or liability –Unrecognized FC firm commitment Prices or rates are fixed –Subsequent changes in the price or rates affect the fair value The derivative instrument can be used as a hedge against exchange risk

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #30 Fair Value Hedges (continued) Fair value hedges receive special accounting treatment if certain criteria are satisfied –Formal documentation of the hedging relationship –Ongoing assessment of hedge effectiveness –Other criteria must also be satisfied

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #31 Special Accounting Treatment for Fair Value Hedges Special accounting treatment: The gain or loss on the derivative instrument is recognized currently in earnings The gain or loss on the hedged item is also recognized currently in earnings Recognizing both changes in value in current earnings gives recognition to the offsetting nature of the hedge

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #32 Special Accounting Treatment for Fair Value Hedges (continued) Changes in the time value of a derivative are may be excluded from assessment of hedge effectiveness and recognized in current earnings

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #33 Cash Flow Hedges Used to establish fixed prices when future cash flows can vary due to changes in prices and rates. Include hedges against change in cash flows from: –Forecasted FC transaction –Forecasted functional-currency-equivalent cash flows associated with recognized asset/liability –Unrecognized FC firm commitment

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #34 Cash Flow Hedges (continued) Receive special accounting treatment if certain criteria are met – Formal documentation of the hedging relationship –Ongoing assessment of hedge effectiveness –Other criteria must also be satisfied Effective portion of gain/loss recognized in other comprehensive income (OCI). Ineffective portion recognized in current earnings Amounts reported in OCI will be transferred to current earnings in the same period that the hedged item affects earnings

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #35 Accounting for a Fair Value Hedge Illustrated US Company purchases inventory from foreign vendor Purchase date – 11/1/20X1 Due date – 2/1/20X2 Amount due – 100,000 FC Company acquires FC forward contract Changes in value discounted at 6%

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #36 Accounting for a Fair Value Hedge Illustrated (continued)

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #37 Assessing the Effectiveness of a Fair Value Hedge

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #38 Journal entries – 11/1/20X1 Inventory50,000 Accounts payable – FC50,000 (to record purchase of inventory) Forward contract receivable - FC50,000 Forward contract payable - $50,600 (to record purchase of FC forward contract)

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #39 Journal entries – 12/31/20X1 Exchange Loss2,000 Accounts payable – FC2,000 (to record exchange loss to spot rate) Forward contract receivable - FC2,388 Gain on contract2,388 (to record change in value of FC forward contract)

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #40 Journal entries – 2/1/20X2 Accounts payable52,000 Exchange Loss3,000 FC55,000 (to record payment) Forward contract receivable - FC2,012 Gain on contract2,012 (to record change in value of FC forward contract) FC55,000 FC receivable55,000 FC payable50,600 Cash50,600 (to record settlement of FC forward contract)

Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #41 Additional Illustrations The previous example was hedging with an FC forward contract Additional fair value examples are similar and detailed in the text –Hedging with an FC option –Hedging an FC firm commitment Cash flow hedges are also detailed in the text