1. Advanced Accounting by Debra Jeter and Paul Chaney
Chapter 12: Accounting for
Foreign Currency Transactions
and Hedging Foreign
Exchange Risk
Slides Authored by Hannah Wong, Ph.D.
Rutgers University

2. Indirect exchange rate
Exchange Rates
Direct exchange rate
how many units of the domestic currency can be converted into one unit of foreign currency
e.g., 1.517: $ British pound
Indirect exchange rate
how many units of the foreign currency can be converted into one unit of domestic currency
e.g., .6592: $ British pound
obj 1

3. Exchange Rates Spot rate Forward or future rate
exchange rate for immediate
delivery of currencies exchanged
Forward or future rate
exchange rate for future
delivery of currencies
exchanged
obj 1

4. Official or fixed rates
Exchange Rates
Official or fixed rates
the country maintains the actual exchange rate of its currency within 2% of the official rate
by buying or selling U.S. dollars or gold
Floating rates
the currency’s exchange rate is determined by supply and demand factors
increases risk to companies doing business with a foreign company
obj 1

5. Measured VS Denominated
transactions are normally measured and recorded in the currency in which the reporting entity prepares its financial statements
Assets and liabilities are denominated in a currency if their amounts are fixed in terms of that currency
obj 1

6. Foreign Currency Transactions
Definition
A transaction that requires settlement in a foreign currency
Examples:
importing or exporting goods on credit
borrowing or lending to a foreign company
hedging a net investment in a foreign entity
forward contract
obj 2,3

7. Importing or Exporting Goods or Services
Transaction date
Balance sheet date
Settlement date
Record transaction as:
units of foreign currency x
current exchange rate
Settle accounts denominated in foreign currency as:
units of foreign currency x
current exchange rate
Record accounts denominated in foreign currency as:
units of foreign currency x
current exchange rate
obj 3,4

8. Importing or Exporting Goods or Services
Transaction date
Balance sheet date
Settlement 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
Treatment of foreign currency transaction gain/loss
Income Statement
Income Statement
obj 3,4

9. Importing or Exporting Goods or Services
Foreign currency transaction gain/loss is included in net income except
long-term financing or capital transactions with an investee consolidated or accounted for by the equity method (included in S/E)
economic hedges of a net foreign investment (included in S/E)
economic hedges of an identifiable foreign currency commitment (deferred)
obj 3

10. Importing Transactions An Example
Inventory delivered
12/1/2001
French firm
U.S. firm
500,000 euros to
be paid on 3/1/2002
Spot rates:
Transaction date: $1.05
Balance sheet date: $1.08
Settlement date: $1.07
obj 3

11. Importing Transactions An Example
12/1 (Transaction date)
Purchases ,000
Accounts payable ,000
500,000 euros x $1.05/euro
12/31 (Balance sheet date)
Transaction loss 15,000
Accounts payable ,000
500,000 euros x $( )/euro
obj 3

12. Importing Transactions An Example
3/1 (Settlement date)
Accounts payable ,000
Transaction gain ,000
Cash ,000
Gain = 500,000 euros x $( )/euro
obj 3

13. Exporting Transactions An Example
Inventory delivered
12/1/2001
French firm
U.S. firm
500,000 euros to
be received on 3/1/2002
Spot rates:
Transaction date: $1.05
Balance sheet date: $1.08
Settlement date: $1.07
obj 3

14. Exporting Transactions An Example
12/1 (Transaction date)
Accounts receivable 525,000
Sales ,000
500,000 euros x $1.05/euro
12/31 (Balance sheet date)
Accounts receivable 15,000
Transaction gain 15,000
500,000 euros x $( )/euro
obj 3

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

16. Forward Exchange Contracts
Definition
An agreement to exchange currencies of two different countries at a specified rate (the forward rate) on a stipulated future date
obj 5

17. Uses of Forward Exchange Contracts
Hedges
to hedge a foreign currency exposed receivable or payable
to hedge a net investment in a foreign entity
to hedge an identifiable foreign currency commitment
Speculation
to speculate in foreign currency in anticipation of a gain
obj 5

18. Foreign Currency Commitment
A U.S. firm may commit to a foreign firm to sell or buy goods, and the price is established in foreign currency
change in exchange rate between the commitment date and transaction date is reflected in the cost or sale price, not a separate gain or loss
The U.S. firm may enter a forward contract to hedge its commitment
obj 6

19. Hedge of an Identifiable Foreign Currency Commitment
Conditions:
the forward contract is designated as, and is effective as, a hedge of the foreign currency commitment
the foreign currency commitment is firm
obj 6

20. Hedge of an Identifiable Foreign Currency Commitment
Effective hedging gain/loss on the forward contract
deferred and included in the measurement of the related foreign currency transaction when recorded
i.e., treat the forward contract as an integral part of the importing or exporting transaction
Non-hedging gain/loss on the forward contract
not deferred
included in net income in the current period
obj 6

21. Economic Hedge of Foreign Investment
Conditions
the forward contract is designated as, and is effective as, a hedge of the net investment; and
the foreign currency commitment is firm
obj 7

22. Hedge: Foreign Currency Exposed Liability
Inventory delivered
12/1/2001
French firm
U.S. firm
500,000 euros to
be paid on 3/1/2002
Forward contract
$ to be paid
on 3/1/2002
Exchange
dealer
U.S. firm
500,000 euros to
be received on 3/1/2002
Spot rates:
Transaction date: $1.05
Balance sheet date: $1.08
Settlement date: $1.07
obj 7

23. Hedge: Foreign Currency Exposed Liability
12/1 (Transaction date)
Purchases ,000
Accounts payable ,000
500,000 euros x $1.05 spot rate
Foreign currency (FC) receivable 525,000
Premium on forward contract 2,500
Dollars payable ,500
500,000 euros
x $1.055 forward rate
obj 7

24. Hedge: Foreign Currency Exposed Liability
12/31 (Balance sheet date)
Transaction loss 15,000
Accounts payable 15,000
The transaction
gain and loss
offset each other
500,000 euros x $( ) change in spot rate
Foreign currency (FC) receivable 15,000
Transaction gain 15,000
Amortization expense ($2,500/3)
Premium of forward contract
Amortization of premium of FC
obj 7

25. Hedge: Foreign Currency Exposed Liability
3/1 (settlement date)
Accounts payable ,000
Transaction gain ,000
Transaction loss ,000
Foreign currency (FC) receivable ,000
500,000 euros x $( ) change in spot rate
Dollars payable ,500
Investment in FC ,000
FC receivable ,000
Cash ,500
To record settlement of FC contract
obj 7

26. Hedge: Foreign Currency Exposed Liability
3/1 (settlement date)
Accounts payable ,000
Investment in FC ,000
To record settlement of account payable
Amortization expense ($2,500/3 x 2) 1,666
Premium of forward contract ,666
Amortization of premium of FC (1/1 – 3/1)
obj 7

27. Hedge of a Forecasted Transaction
Balance sheet date
Settlement date
12/1/2001
U.S. firm estimates sales to the U.K. in 1/2002 for 500,000 euros
Spot rates:
12/1/2001: $1.03
12/31/2001: $1.00
2/1/2002: $0.98
U.S. firm purchased an option for $5,000, allowing the firm to sell 500,000 euros at $1.02
obj 7

28. Hedge of a Forecasted Transaction
12/1 (Transaction date)
Options to sell euros 5,000
Cash ,000
To record purchase of options
12/31 (Balance sheet date)
Options to sell euros 9,000
Deferred gain on option 9,000
The deferred gain is reported in other comprehensive income,
not as part of net income
obj 7

29. Hedge of a Forecasted Transaction
2/1 (Option expiration date)
Options to sell euros 6,000
Gain on options 6,000
To adjust option to its realizable value of $20,000
Deferred gain on option 9,000
Options to sell euros 9,000
To transfer the deferred gain from equity to net income
obj 7

30. Hedge of a Forecasted Transaction
2/1 (Option expiration date)
Cash ,000
Options to sell euros ,000
Payable to option trader ,000
Exercise the option and settle with the trader
obj 7

31. Derivative Instruments
Contract between 2 parties.
To be executed at a later date.
Resulting cash flows dependent on change in underlying measure of value.
Zero sum – one party loses; one party gains.
obj 8

32. Reporting Hedge Gains & Losses
Fair Value
Reported in
Current Period
Income Statement
Cash Flow
Defer
Include as
“Other Comprehensive Income”
Exchange
Gains & Losses
Owners’ Equity
obj 9

33. Advanced Accounting by Debra Jeter and Paul Chaney
Copyright © 2003 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.