3. Foreign Exchange Concepts and Definitions Currencies provide… a standard of value, a medium of exchange, and a unit of measure for economic transactions.
4. Foreign Exchange Concepts and Definitions In the case of transactions between business entities of different countries, the amounts receivable and payable are denominated in local currency of either the buying or the selling entity.
5. Foreign Exchange Concepts and Definitions Exchange rates are essentially prices for currencies expressed in units of other currencies. = .0082
6. Learning Objective 2 Understand quotation conventions for foreign currency and exchange rates.
7. Direct and Indirect Quotation of Exchange Rates Direct quotation (U.S. dollar equivalent): Assume that $1.60 can be exchanged for £ 1. Indirect quotation (foreign currency per U.S. dollar): $1.60 1 = $1.60 = £0.625 1 $1.60
9. The Euro Twelve member states of the European Union chose to participate in the transition to a single currency for Europe, the Euro. € The euro currency is managed by the European Central Bank.
10. Spot, Current, and Historical Exchange Rates Spot rate – the exchange rate for immediate delivery of currencies exchanged Current rate – the exchange rate at the balance sheet date or the transaction date Historical rate – the rate in effect at the date a specific transaction or event occurred
12. Foreign Currency Transactions Other Than Forward Contracts Local transactions Foreign transactions An entity’s functional currency is the currency of an entity’s primary economic environment.
13. Foreign Currency Transactions Other Than Forward Contracts Foreign currency transactions are stated (denominated) in a currency other than an entity’s functional currency. The provisions of FASB Statement No. 52 apply only to foreign currency transactions and foreign currency financial statements.
14. Translation at the Spot Rate A U.S. corporation imports inventory from a Canadian firm when the spot rate for Canadian dollars is $.70 The invoice calls for payment of 10,000 Canadian dollars in 30 days. How does the U.S. importer record the transaction?
15. Translation at the Spot Rate Inventory 7,000 Accounts Payable (fc) 7,000 (Translation 10,000 Canadian dollars × .70 spot rate) If the account payable is settled when the spot rate is $.69, how is it recorded?
16. Translation at the Spot Rate Accounts payable (fc) 7,000 Exchange Gain 100 Cash 6,900 (Cash required equals 10,000 Canadian dollars × the $0.69 spot rate)
17. Purchases Denominated in Foreign Currency American Trading Company purchased goods from Kimetz Company on December 1, 2008, for 10,000 euros when the spot rate for euros was $0.6600. AT closed its books at December 31, 2008, when the spot rate for euros was $0.6550, and settled the account on January 30, 2009, when the spot rate was $0.6650.
18. Purchases Denominated in Foreign Currency December 1, 2008 Inventory 6,600 Accounts Payable (fc) 6,600 To record purchase of merchandise from Kimetz Company (10,000 euros × $0.6600 rate) December 31, 2008 Accounts Payable (fc) 50 Exchange Gain 50 To adjust accounts payable to exchange rate at year end [10,000 euros × ($0.6600 – $0.6550)]
19. Purchases Denominated in Foreign Currency January 30, 2009 Accounts Payable (fc) 5,550 Exchange Loss 100 Cash 6,650 To record payment in full to Kimetz Company (10,000 euros × $0.6650 spot rate)
20. Sales Denominated in Foreign Currency On December 16, 2008, American Trading sold merchandise to Kimetz for 20,000 euros when the spot rate for euros was $0.6600. AT closed its books at December 31, when the spot rate was $0.6550, collected the account on January 15, 2009, when the spot rate was $0.6700, and held the cash until January 20, when it converted the euros into USD at a $0.6725 rate.
21. Sales Denominated in Foreign Currency December 15, 2008 Accounts Receivable (fc) 13,200 Sales 13,200 To record sales to Kimetz (20,000 euros × $0.6600 spot rate) December 31, 2008 Accounts Receivable (fc) 100 Exchange Gain 100 To adjust accounts receivable year end [20,000 euros × ($0.6650 – $0.6600)]
22. Sales Denominated in Foreign Currency January 15, 2009 Cash 13,400 Accounts Receivable (fc) 13,300 Exchange Gain 100 To record collection in full from Kimetz (20,000 euros × $0.6700) and recognize exchange gain for 2009 [20,000 euros × ($0.6700 – $0.6650)] January 20, 2009 Cash 13,450 Exchange Gain 50 Cash (fc) 13,400 To convert 20,000 euros into U.S. dollars (20,000 euros × $0.6725)
23. Learning Objective 4 Comprehend cash flow hedge accounting and fair value hedge accounting.
24. Foreign Currency Derivatives and Hedging Activities Derivative is the name given to a broad range of financial securities. The derivative contract’s value to the investor is directly related to the fluctuations in price, rate, or some other variable that underlies it.
26. Derivative Instruments Options are rights to take an action, but the holder is not obligated to do so. A forward contract is negotiated between the parties and not through an exchange.
27. Derivative Instruments Futures contracts bind both parties (the writer and the holder) to perform. A cash flow hedge is designed to limit the company’s exposure to price changes in forecasted purchases.
28. Derivative Instruments A company signs an option contract on January 15, 2003, at a cost of $1,000. The company can exercise its option to purchase 100,000 gallons of fuel at $1 per gallon. The option expires on May 31, 2003.
29. Derivative Instruments January 15, 2003 Fuel Contract Option 1,000 Cash 1,000 The company prepares its quarterly report on March 31, 2003. Market price of fuel is $1.25. The company could exercise the option on this date.
30. Derivative Instruments March 31, 2003 Fuel Contract Option 24,000 Other Comprehensive Income – Unrealized Holding Gains on Fuel Option Contract 24,000 On May 31, 2003, the fuel price is $1.30. The writer of the option must pay the company $0.30 per gallon, or $30,000.
31. Derivative Instruments May 31, 2003 Fuel Inventory 130,000 Cash 130,000 Cash 30,000 Fuel Contract Option 25,000 Other Comprehensive Income 5,000
32. Derivative Instruments June 15, 2003 Cost of Goods Sold 130,000 Fuel Inventory 130,000 Other Comprehensive Income 30,000 Cost of Goods Sold 30,000 The fuel inventory is used on June 15, 2003.
33. Fair Value Hedges A fair value hedge is a derivative contract that attempts to reduce the price risk of an existing asset or firm purchase commitment.
34. Summary of Forward Contracts (Speculation) Purpose To speculate in exchange rate changes Recognition Exchange gains and losses are recognized currently, based on forward exchange rate changes. Expected Effect of Hedge and Related Foreign Currency Item Income effect equals exchange gains and losses recognized.
35. Summary of Forward Contracts (Hedge of a Net Asset or Liability Position) Purpose To offset exposure to existing net asset or liability position Recognition Exchange gains and losses are recognized currently, but they are offset by related gains or losses on net asset or liability position. Expected Effect of Hedge and Related Foreign Currency Item Income effect equals the amortization of premium or discount (gains and losses offset.)
36. Summary of Forward Contracts (Hedge of an Identifiable Commitment) Purpose To offset exposure to a future purchase or sale and thereby lock in the price of an existing contract Recognition Exchange gains and losses are recognized currently, but are offset by related gains or losses in the firm commitment. Expected Effect of Hedge and Related Foreign Currency Item Income effect equals the difference in the change in value of the instrument versus the firm commitment.
37. Summary of Forward Contracts (Hedge of an Anticipated Transaction) Purpose To offset exposure of possible future purchase or sale Recognition Exchange gains or losses on the hedge counted in other comprehensive income until the underlying transaction is complete. Expected Effect of Hedge and Related Foreign Currency Item No immediate income effect. Adjusts underlying transaction.
38. Summary of Forward Contracts (Hedge of a Net Investment in a Foreign Entity) Purpose To offset exposure to an existing net investment in a foreign entity Recognition Exchange gains and losses are recognized as other comprehensive income and will offset translation adjustments recorded on the net investment. Expected Effect of Hedge and Related Foreign Currency Item Income effect equals the change in the future value of the hedge versus the value of the net investment.
39. The Four Fundamental Decisions 1 Derivative instruments represent rights or obligations. 2 Fair value is the most relevant measurement.
40. The Four Fundamental Decisions 3 Only items that are assets or liabilities should be reported. 4 Special accounting should be provided only for qualifying items.
42. Speculation Exchange gains or losses on derivative instruments that speculate in foreign currency price movements are included in income in the period in which the forward exchange rates change.
43. Speculation On November 2, 2007, U.S. International enters into a 90-day forward contract (future) to purchase 10,000 euros (€). The current quotation for 90-day futures is €5,400. The spot rate for euros on November 2 is $0.5440.
44. Speculation What are the journal entries of U.S. International to account for the speculation? December 31, 2007 January 30, 2008 30-day futures $0.5450 $0.5480 Spot rate $0.5500 $0.5530
45. Speculation November 2, 2007 Contract Receivable (fc) 5,400 Contract Payable 5,400 To record contract for 10,000 euros × $0.5400 exchange rate for 90-day futures
46. Speculation December 31, 2007 Contract Receivable (fc) 50 Exchange Gain 50 To adjust receivable from exchange broker and recognize exchange gain 10,000 euros × ($0.5450 forward exchange rate for 30-day futures – $0.5400 per books)
