1. Chapter Seven Foreign Currency Transactions and Hedging Foreign Exchange Risk McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 7-2 Exchange Rate Mechanisms  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 currency arrangements exist.

3. 7-3 Different Currency Mechanisms  Independent Float - the currency is allowed to fluctuate according to market forces  Pegged to another currency - the currency’s value is fixed in terms of a particular foreign currency, and the central bank will intervene to maintain the fixed value  European Monetary System - a common currency (the euro) is used in multiple countries. Its value floats against other world currencies.

4. 7-4 Foreign Exchange Rates  An Exchange Rate is the cost of one currency in terms of another.  Rates published daily in the Wall Street Journal are as of 4:00pm Eastern time on the day prior to publication.  The published rates are wholesale rates that banks use with each other – retail rates to consumers are higher.  The difference between the rates at which a bank is willing to buy and sell currency is known as the “spread.”  Rates change constantly! LO 1

5. 7-5 Foreign Exchange Rates Spot Rate  The exchange rate that is available today. Forward Rate  The exchange rate that can be locked in today for an expected future exchange transaction.  The actual spot rate at the future date may differ from today’s forward rate.

6. Foreign Exchange - Forward Contracts A forward contract requires the purchase (or sale) of currency units at a future date at the contracted exchange rate. This forward contract allows us to purchase 1,000,000 ¥ at a price of $.0080 US in 30 days. But if the spot rate is $.0069 US in 30 days, we still have to pay $.0080 US and we lose $1,100!! 7-6

7. An options contract gives the holder the option of buying (or selling) currency units at a future date at the contracted “strike” price. That way, if the spot rate is $.0069 in 30 days, we only lose the $20 cost of the option contract! Foreign Exchange – Option Contracts An options contract gives the holder the option of buying (or selling) currency units at a future date at the contracted “strike” price. 7-7

8. 7-8 Foreign Currency - Option Contracts  A “put” option allows for the sale of foreign currency by the option holder.  A “call” option allows for the purchase of foreign currency by the option holder. Remember: An option gives the holder “the right but not the obligation” to trade the foreign currency in the future.

9. 7-9 Foreign Currency Transactions  A U.S. company buys or sells goods or services to a party in another country. This is often called foreign trade.  The transaction is often denominated in the currency of the foreign party.  How do we account for the changes in the value of the foreign currency? LO 2

10. Foreign Currency Transactions GAAP requires a two-transaction perspective. (1)Account for the original sale in US Dollars. (2)Account for gains/losses from exchange rate fluctuations. 7-10

11. 7-11 Foreign Exchange Transaction - Example On 12/1/13, Amerco sells inventory to a German corporation for 1 million euros on credit. Amerco expects to be paid in euros in 90 days. The current exchange rate is $1 = 1.32 €. Amerco would first record the sale: Note that Amerco’s ledger is in US Dollars, but has a separate account for receivables expected to be collected in a foreign currency.

12. 7-12 Foreign Exchange Transaction - Example On 12/31/13, the exchange rate is $1 = 1.33 €. At the balance sheet date we have to remeasure the original A/R to the current exchange rate. When we increase A/R to the new value in US Dollars, we recognize a gain from foreign currency exchange.

13. 7-13 Foreign Exchange Transaction - Example On 3/1/14, Amerco is paid the 1 million euros. The exchange rate on 3/1/14, was $1 = 1.30 €. Amerco records this transaction in two steps. First, Amerco remeasures the A/R balance at the current exchange rate. Then, they can record the collection of cash and clear the A/R balance.

14. 7-14 Hedging Foreign Exchange Risk  Companies will seek to reduce the risks associated with foreign currency fluctuations by hedging…  This means they will give up a portion of the potential gains to offset the possible losses.  A company enters into a potential transaction whose exposure is the opposite of the one that has the associated risk. LO 3

15. 7-15 Hedging Foreign Exchange Risk Two foreign currency derivatives that are often used to hedge foreign currency transactions:  Foreign currency forward contracts lock in the price for which the currency will sell at contract’s maturity.  Foreign currency options establish a price for which the currency can be sold, but is not required to be sold at maturity.

16. Accounting for Derivatives ASC Topic 815 provides guidance for hedges of four types of foreign exchange risk. 1.Recognized foreign currency denominated assets & liabilities. 3.Forecasted foreign currency denominated transactions. 2.Unrecognized foreign currency firm commitments. 4.Net investments in foreign operations 7-16

17. Accounting for Derivatives The fair value of the derivative is recorded at the same time as the transaction to be hedged, based on:  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 (the company’s incremental borrowing rate). 7-17

18. Accounting for Hedges Two ways to account for a foreign currency hedge: 1.Cash Flow Hedge  Completely offsets variability of a foreign currency receivable or payable.  Gains/losses are recorded as Comprehensive Income. Any other hedging instrument is a 2. Fair Value Hedge.  Gains/losses are recognized immediately in net income. LO 4 7-18

19. 7-19 Cash Flow Hedge – Date of Transaction Example Amerco’s sale agreement on 12/1/13 left them with foreign currency risk. They take a 90- day forward contract to sell 1 million euros, at a forward rate of $1.305 = 1 euro.

20. 7-20 Cash Flow Hedge – Interim Reporting Date Example Amerco’s year-end is 12/31/13. The year-end spot rate is $1.33 per euro. In addition, at 12/31/13 the forward rate to 3/1/14 (now a 60-day forward rate), has changed.

21. 7-21 Cash Flow Hedge – Interim Reporting Date Example Also, on 12/31/13, $10,000 is transferred from AOCI to a Loss on Forward Contract. Finally, we have to amortize the discount from the original transaction.

22. 7-22 Cash Flow Hedge – Date of Collection Example On 3/1/14, both the receivable and the exchange contract come due. Assume the spot rate at that date is $1.3 = 1 euro.

23. 7-23 Cash Flow Hedge – Date of Collection Example As at year-end, Amerco records an entry to offset the foreign exchange loss, and amortizes the rest of the discount. As a result of these entries, the balance in AOCI is zero: $4,236 + $15,783 - $30,000 + $9,981 = $0.

24. 7-24 Cash Flow Hedge – Date of Collection Example The amount due from the customer is received in euros, and Amerco completes the forward contract by selling the 1 million euros received.

25. 7-25 Fair Value Hedge – Date of Transaction Example In the same example with Amerco, assume that they designate the forward contract as a Fair Value Hedge, instead of a cash flow hedge. The entry on the date of sale will be the same. The forward contract requires no formal entry

26. 7-26 Fair Value Hedge - Interim Reporting Date Example Amerco’s year-end is 12/31/13. The year- end spot rate is $1.33 per euro. At 12/31/13, the forward rate to 3/1/14 (now a 60-day forward rate), has changed.

27. 7-27 Fair Value Hedge – Date of Collection Example On 3/1/14, both the receivable and the exchange contract come due. Assume the spot rate at that date is $1.3 = 1 euro.

28. 7-28 Fair Value Hedge – Date of Collection Example The amount due from the customer is received in euros, and Amerco completes the forward contract by selling the 1 million euros received.

29. 7-29 Using a Foreign Currency Option as a Hedge An option is a contract that allows you to exercise a predetermined exchange rate if it is to your advantage. 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 covered in most finance texts.

30. 7-30 Option values Value is 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 Fair values are determined by:  Intrinsic Value & Time Value

31. Foreign Currency Firm Commitment Hedge Options are carried at fair value on the balance sheet of both the derivative financial instrument (forward contract or option) and the firm commitment. The change in value of the firm commitment gain/loss offsets the gain or loss on the hedging instrument. Gain/loss is recognized currently in net income, as is the gain/loss on the firm commitment attributable to the hedged risk. LO 5 7-31

32. 7-32 Foreign Currency Firm Commitment - Example On December 1, 2013, Amerco received an order from a German customer. The delivery date is March 1, 2014, and Amerco is to receive immediate payment. Amerco has a firm commitment to make a sale and receive payment of 1,000,000 € three months later. Amerco decides to hedge this commitment with a forward contract of $1.305 = 1 €. No journal entry is made on this date.

33. 7-33 Foreign Currency Firm Commitment - Example On 12/31/13, the currently available forward rate to 3/1/14 is $1.316 = 1 €. The fair value of the forward contract and firm commitment are calculated below:

34. 7-34 Foreign Currency Firm Commitment - Example On 12/31/13, the gain on the firm commitment offsets the loss on the forward contract:

35. Foreign Currency Transactions Firm Commitment - Example On 3/1/14, the spot rate is $1.30 = 1 €. LO 6 7-35

36. On March 1, 2014, Amerco receives 1,000,000 € from the German customer upon delivery of the order, when the spot rate is $1.30 = 1 €. Amerco also sells the 1 million euros under the forward contract for US$1,305,000. Foreign Currency Transactions Firm Commitment - Example 7-36

37. The firm commitment is then closed as an adjustment to net income. Foreign Currency Transactions Firm Commitment - Example 7-37

38. 7-38 Hedge of a Forecasted Foreign Currency Denominated Transaction Cash flow hedge accounting may be used for foreign currency derivatives associated with a forecasted foreign currency transaction. The forecasted transaction must be probable, highly effective, and the hedging relationship must be properly documented. Gains and losses on the hedging instrument are recorded in Other Comprehensive Income until the date of the forecasted transaction. LO 6

39. On July 1, 2013, Multicorp borrows ¥ 1 billion and converts it into $9,210,000 in the spot market. On December 31, 2013, Mulitcorp must revalue the Japanese yen note payable with an offsetting foreign exchange gain or loss reported in income and must accrue interest expense and interest payable. Interest is calculated by multiplying the loan principal in yen by the relevant interest rate. The amount of interest payable in yen is then translated to U.S. dollars at the spot rate to record the accrual journal entry. On July 1, 2014, differences between the amount of interest accrued at year-end and the actual U.S. dollar amount that must be spent to pay the accrued interest are recognized as foreign exchange gains/ losses. LO 7 Foreign Currency Borrowings Example 7-39

40. Exchange rates in table above apply. Journal entries are recorded as follows: Foreign Currency Borrowings Example 7-40

41. Foreign Currency Borrowings Example Journal entries at end of accounting period: 7-41

42. 7-42 Summary Transactions may be denominated in currencies different from those used to keep accounting records. FASB has adopted a “two-transaction” approach, separating the actual sale or purchase transaction from the currency exchange “speculation.” A variety of hedging practices may be used to reduce foreign currency exchange risk. The two most popular hedging instruments are foreign currency options and foreign currency forward contracts.