Advanced Accounting Jeter ● Chaney Accounting for Foreign Currency Transactions and Hedging Foreign Exchange Risk Prepared by Sheila Ammons, Austin Community College Learning Objectives • Distinguish between the terms “measured” and “denominated.” • Describe what is meant by a foreign currency transaction • Understand some of the more common foreign currency transactions • Identify three stages of concern to accountants for foreign currency transactions, and explain the steps used to translate foreign currency transactions for each stage • Describe a forward exchange contract Copyright © 2015 John Wiley & Sons, Inc All rights reserved Learning Objectives • Explain the use of forward contracts as a hedge of an unrecognized firm commitment • Identify some of the common situations in which a forward exchange contract can be used as a hedge • Describe a derivative instrument and understand how it may be used as a hedge • Explain how exchange gains and losses are reported for fair value hedges and cash flow hedges Copyright © 2015 John Wiley & Sons, Inc All rights reserved Foreign Currency Transactions • Many U.S companies engage in international activities such as: – Exporting or importing goods, – Establishing a foreign branch, or – Holding an equity investment in a foreign company Copyright © 2015 John Wiley & Sons, Inc All rights reserved Foreign Currency Transactions • Recording and reporting problems with foreign currency transactions: – Transactions to be settled in a foreign currency must be translated (expressed in dollars) before they can be aggregated with domestic transactions of the U.S firm – Receivables or payables denominated in foreign currencies are subject to gains and losses • Due to the changes in exchange rates – Companies use hedging strategies with derivatives to minimize the impact of exchange rate changes on their financial statements Copyright © 2015 John Wiley & Sons, Inc All rights reserved Exchange Rates—Means of Translation • Translation - process of expressing amounts stated in terms in a foreign currency in the currency of the reporting entity by using an appropriate exchange rate • Exchange rate - ratio between a unit of one currency and another currency for which that unit can be exchanged at a particular time Copyright © 2015 John Wiley & Sons, Inc All rights reserved Exchange Rates—Means of Translation • Direct Exchange Quotation – Units of domestic currency that can be converted into one unit of foreign currency – Direct rate = 1.517 ($1.517 U.S for British pound) • Indirect Exchange Quotation – Units of foreign currency that can be converted into one unit of domestic currency – Indirect rate = 1.00/1.517 = 6592 ($1 U.S for 6592 British pound) Copyright © 2015 John Wiley & Sons, Inc All rights reserved Exchange Rates—Means of Translation • Spot Rate – Rate at which currencies can be exchanged today • Forward or Future Rate – Rate at which currencies can be exchanged at some future date • Forward Exchange Contract – Contract to exchange currencies of different countries on a stipulated future date, at a specified rate (the forward rate) Copyright © 2015 John Wiley & Sons, Inc All rights reserved Exchange Rates—Means of Translation • Floating Rates – Relationship between major currencies is determined by supply and demand factors – Increase risk to companies doing business with a foreign company Example – Payable to be settled in 100,000 yen An increase in in the value of the yen to $.00625 would result in an increase in the payable to $625 Copyright © 2015 John Wiley & Sons, Inc All rights reserved Measured Versus Denominated • Transactions are normally measured and recorded in terms of the currency in which the reporting entity prepares its financial statements – Reporting Currency - usually the currency where the company is located • Transaction between a U.S firm and a foreign company: – Companies negotiate whether settlement is to be made in dollars or in the foreign currency – If settled by foreign currency, U.S firm measures the receivable or payable in dollars, but the transaction is denominated in the foreign currency LO Measured versus denominated Copyright © 2015 John Wiley & Sons, Inc All rights reserved Using Forward Contracts as a Hedge Problem 12-2: Prepare journal entries for the transactions including the necessary adjustments on December 31 Apr Investment in Foreign Currency 30,030 Dollars Payable to Exch Dealer 27,594 Cash 27,594 FC Receivable from Exch Dealer 30,030 (payment to dealer and receipt of 210,000 Hong Kong dollars) Accounts Payable 30,030 Investment in Foreign Currency 30,030 LO Hedging with forward contracts (payment of liability upon transfer of 210,000 Hong Kong dollars) Copyright © 2015 John Wiley & Sons, Inc All rights reserved Using Forward Contracts as a Hedge Problem 12-2: Transaction Summary Thus the net effect is a $1,029 loss when the forward contract is used LO Hedging with forward contracts Copyright © 2015 John Wiley & Sons, Inc All rights reserved Using Forward Contracts as a Hedge Hedge of a Foreign Currency Exposed Asset • Accounting for a forward contract entered into as a hedge of an exposed receivable position is similar to an exposed liability position • Because the U.S firm will be receiving foreign currency in settlement of the exposed receivable balance, it will enter into a forward contract to sell foreign currency for U.S dollars LO Forward contracts as a hedge Copyright © 2015 John Wiley & Sons, Inc All rights reserved Using Forward Contracts as a Hedge Fair Value Hedge—Hedging an Unrecognized Foreign Currency Commitment • A U.S firm, at a date earlier than the transaction date, may make a commitment to a foreign company to buy or sell goods at a price established in foreign currency • Changes in the exchange rate between the commitment date and transaction date would be reflected in the cost or sales price of the asset • The U.S firm may enter a forward contract to hedge its commitment LO Forward contracts as a hedge Copyright © 2015 John Wiley & Sons, Inc All rights reserved Using Forward Contracts as a Hedge Exercise 12-14: Consider the following information: On December 1, 2014, a U.S firm contracts to sell equipment (with an asking price of 10,000 pesos) in Mexico The firm will take delivery and will pay for the equipment on March 1, 2015 On December 1, 2014, the company enters into a forward contract to sell 10,000 pesos for $9.48 on March 1, 2015 Spot rates and the forward rates for March 1, 2015, settlement were as follows (dollars per peso): Spot Rate Forward Rate December 1, 2014 $9.54 $9.48 Balance sheet date (12/31/14) 9.49 9.44 March 1, 2015 9.47 LO Hedging with forward contracts Copyright © 2015 John Wiley All rights reserved On March 1, the equipment was sold& Sons, for Inc 10,000 pesos The cost of the Using Forward Contracts as a Hedge Exercise 12-14: Prepare all journal entries needed on December 1, December 31, and March to account for the forward contract, the firm commitment, and the transaction to sell the equipment Dec Dollars Receivable from Exchange Dealer* 94,800 FC Payable to Exchange Dealer 94,800 Dec 31 FC Payable from Exchange Dealer** 400 Foreign Exchange Gain 400 Foreign Exchange Loss 400 Firm= Commitment** * (10,000 x $9.48 $94,800) 400 x ($9.48 - $9.44)] = $400 ** [(10,000 LO Hedging with forward contracts Copyright © 2015 John Wiley & Sons, Inc All rights reserved Using Forward Contracts as a Hedge Exercise 12-14: Prepare all journal entries needed on December 1, December 31, and March to account for the forward contract, the firm commitment, and the transaction to sell the equipment Mar Foreign Exchange Loss 300 FC Payable from Exchange Dealer* 300 Firm Commitment* Foreign 300 Exchange Gain 300 Investment in FC 94,700 Commitment * [(10,000Firm ´ ($9.44 - $9.47)] =$300 Sales (10,000 100 x 9.48) LO Hedging with forward contracts Copyright © 2015 John Wiley & Sons, Inc All rights reserved Using Forward Contracts as a Hedge Exercise 12-14: Prepare all journal entries needed on December 1, December 31, and March to account for the forward contract, the firm commitment, and the transaction to sell the equipment Mar Cash 94,800 FC Payable to Exchange Dealer Investment in 94,700 FC 94,700 Dollars Receivable from Exchange Dealer 94,800 Cost of Goods Sold 40,000 Inventory 40,000 LO Hedging with forward contracts Copyright © 2015 John Wiley & Sons, Inc All rights reserved Using Forward Contracts as a Hedge Cash Flow Hedge-A Forecasted Transaction – Cash Flow Hedge - hedging cash flows for future transactions that have not yet occurred or for which there are no firm commitments – Cash flow hedges may defer the income statement recognition of gains and losses on forecasted transactions if certain criteria are met – Amounts in accumulated other comprehensive income are reclassified into earnings in the same period which the hedged forecasted transaction affects earnings LO Fair value hedge vs cash flow hedge Copyright © 2015 John Wiley & Sons, Inc All rights reserved Cash Flow Hedge Illustration Exercise 12-13: Consider the following information: On December 1, 2014, a U.S firm plans to purchase a piece of equipment (with an asking price of 100,000 francs) in Switzerland during January of 2015 The transaction is probable, and the transaction is to be denominated in euros On December 1, 2014, the company enters into a forward contract to buy 100,000 francs for $1.01 on January 31, 2015 Spot rates and the forward rates for January 31, 2015, settlement were as follows (dollars per francs): Spot Rate Forward Rate for 1/31/15 December 1, 2014 $0.99 $1.01 Balance sheet date (12/31/14) 1.01 1.02 Jan 31 and Feb 1, 2015 1.04 LO francs Fair value On Feb 1, the equipment was purchased for 100,000 hedge vs cash flow hedge Copyright © 2015 John Wiley & Sons, Inc All rights reserved Using Forward Contracts as a Hedge Exercise 12-13: Prepare all journal entries needed on Dec 1, Dec 31, Jan 31, and Feb to account for the forecasted transaction, the forward contract, and the transaction to buy the equipment Dec.1 FC Receivable from Exchange Dealer 101,000 Dollars Payable to Exchange Dealer* 101,000 Dec.31 FC Receivable from Exchange Dealer** 1,000 Foreign Exchange Gain – OCI 1,000 * (100,000 x $1.01) = $101,000 ** [(100,000 x ($1.01- $1.02)] = $1,000 LO Fair value hedge vs cash flow hedge Copyright © 2015 John Wiley & Sons, Inc All rights reserved Using Forward Contracts as a Hedge Exercise 12-13: Prepare all journal entries needed on Dec 1, Dec 31, Jan 31, and Feb to account for the forecasted transaction, the forward contract, and the transaction to buy the equipment Jan 31 FC Receivable from Exchange Dealer Foreign Exchange Gain – OCI 2,000 [(100,000 ´ ($1.02- $1.04)] 2,000 Investment in FC 104,000 Dollars Payable to Exchange Dealer 101,000 Cash 101,000 FC Receivable from Exchange Dealer 104,000 Feb Equipment 104,000 LO Fair value hedge vs cash flow hedge InvestmentCopyright in FC © 2015 John Wiley & Sons, Inc All rights reserved Using Forward Contracts as a Hedge Economic Hedge of a Net Investment in a Foreign Entity – A U.S firm that maintains an equity investment in a foreign company may enter into a foreign currency transaction or a nonderivative financial instrument • in an effort to minimize or offset the effects of currency fluctuations on an equity investment – The gain or loss on the hedging instrument is reported in the same manner as the translation adjustment • reported in the cumulative translation adjustment section under comprehensive income FASB ASC paragraph 815-35-35-1 LO Common transactions Copyright © 2015 John Wiley & Sons, Inc All rights reserved Using Forward Contracts as a Hedge Forward Contracts Acquired to Speculate in the Movement of Foreign Currencies – A forward contract may be acquired for speculative purposes in anticipation of realizing a gain Disclosure Requirements of the Various Hedges – FASB ASC Section 815-20-50 specifies certain minimal disclosures for derivative instruments and nonderivative instruments designated as qualifying hedging instruments LO Common transactions Copyright © 2015 John Wiley & Sons, Inc All rights reserved Using Forward Contracts as a Hedge Using Options to Hedge Foreign Currency Changes – Options, give the holder the advantage of right but not the obligation to buy or sell the currency – If the exchange rate changes in a negative manner, the firm can simply let the option lapse without a loss – Call Option: • An option to purchase the foreign currency at a specified rate, referred to as the exercise price – Put Option: • An option to sell the foreign currency at a specified rate LO Derivatives used as a hedge Copyright © 2015 John Wiley & Sons, Inc All rights reserved 47 ... Contracts as a Hedge Problem 12- 2: Prepare journal entries for the transactions including the necessary adjustments on December 31 Dec 31 Accounts Payable Transaction 126 Gain 126 Hong Kong dollars... Hedge Problem 12- 2: Prepare journal entries for the transactions including the necessary adjustments on December 31 Dec 31 Transaction Loss FC Receivable 126 from Exchange Dealer 126 Hong Kong... © 2015 John Wiley & Sons, Inc All rights reserved Foreign Currency Transactions Exercise 12- 2: Dec 12, Purchased computer chips from a company domiciled in Taiwan The contract was denominated