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FOREIGN CURRENCY TRANSACTIONS

FOREIGN CURRENCY TRANSACTIONS. Chapter 5. Foreign Currency Transaction. Foreign currency transaction: a transaction in a currency other than the one in which the financial records are maintained Currency to be exchanged generally a negotiated term

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FOREIGN CURRENCY TRANSACTIONS

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  1. FOREIGN CURRENCY TRANSACTIONS Chapter 5

  2. Foreign Currency Transaction • Foreign currency transaction: a transaction in a currency other than the one in which the financial records are maintained • Currency to be exchanged generally a negotiated term • Denominated currency: expressed currency in which a transaction is to be completed

  3. Exchange Rates • Ratio at which one currency can be converted into another currency • Rates may be determined by government issuing the currency (fixed rate) or by market conditions (floating rate)

  4. Fixed Exchange Rates • May be established to accomplish specific objectives such as encouraging export trade • Official exchange rate ay differ for different types of transactions

  5. Floating Exchange Rates • Values of currencies fluctuate based on supply and demand • Supply and demand for a currency depend partially on • Interest rate differences between economies • Balance of trade differences • Political stability • Anticipated inflation

  6. Direct / Indirect Exchange Rates • Relationship between two currencies is stated in terms of either currency • Indirect: number of foreign currency units to acquire one unit of domestic currency $1.00 = 1.55 Swiss francs • Direct: number of domestic currency units required to acquire one unit of the foreign currency 1 Swiss franc = $0.645 • The reciprocal of one rate is the other rate

  7. Spot Rate • Exchange rate that exists for an immediate exchange of currency

  8. Recording a Purchase or Sale Denominated in a Foreign Currency • Transaction recorded at SPOT RATE even if currency won’t be exchanged until later date • Spot rate: currency’s value at transaction date; best estimate of currency’s future value • Potential future changes in value not recognized because direction and amount are not predictable

  9. Payment After Transaction Date (No Balance Sheet Date) • Economic value of currency to be exchanged may change subsequent to the initial transaction date • Any change in value is recognized as a gain or loss in the period in which the exchange of currency occurs

  10. Settlement Date • Date on which the foreign currency transaction is satisfied through transfer of currency

  11. Monetary Accounts • Accounts fixed in units of currency. Examples: • Accounts Receivable • Accounts Payable • Notes Payable

  12. Payment After Transaction Date (Balance Sheet Date) • Monetary account balance is an estimate of economic value to be exchanged • Monetary account balance is adjusted to reflect change in estimated value

  13. Hedging • The use of a financial instrument contract to eliminate exchange rate fluctuation risk • Two common ways to hedge • Forward contract • Option contract

  14. Forward Contract • Agreement to exchange currency at a future date at a guaranteed exchange rate (Forward Rate) • Eliminates risk associated with exchange rate fluctuations • Cost of entering contract often negligible • Contract can be for any number of currency units; settlement on any date

  15. Option Contract • Two parties to the agreement • Writer – guarantees an exchange of currencies at agreed price (strike price) • Holder – has the right, but not obligation, to exchange currencies • Writer exchanges currencies with holder at a predetermined rate only if holder chooses to exercise the option

  16. Option Contract • Holder avoids unfavorable exchange rate movement • Option contracts are offered in fixed sizes (e.g., 62,500 euros) • Two types of options: • Call – holder has the right to purchase currency • Put – holder has the right to sell currency

  17. Option Contract • Holder pays premium to writer; premium size depends on strike price and contract length • More favorable strike price to holder demands higher premium • Potential gain to holder is infinite; loss limited to premium • Amount of premium sets the writer’s maximum gain, possible loss is infinite

  18. Accounting for Forward Contract Hedge • Two series of entries • Underlying transaction • Forward contract (hedge) • Transaction date • Entry for underlying transaction • No entry for forward contract, executory contract

  19. Forward Contract Accounting • Balance sheet date • Revalue payable or receivable on underlying transaction to new spot rate, gain or loss to income statement • Revalue forward contract to fair value to new forward exchange rate, gain or loss to income statement

  20. Forward Contract Accounting • Settlement date • Revalue transaction payable or receivable and forward contract • Settle obligation • Write off both payable or receivable, and forward contract • Pay or receive cash to/from foreign currency exchange broker

  21. Accounting for Option Hedge • Two series of entries • Underlying transaction • Option contract (hedge) • Transaction date • Entry for underlying transaction • Entry for option contract for premium paid to writer (initial option contract market value)

  22. Option Hedge Accounting • Balance sheet date • Revalue payable or receivable on underlying transaction to new spot rate, gain or loss to the income statement • Revalue option contract to new fair value, gain or loss to the income statement

  23. Option Hedge Accounting • Settlement date • Revalue payable or receivable and option contract • Settle obligation • Write off both payable or receivable and option contract • Pay or receive cash to/from foreign currency exchange broker

  24. Foreign Currency Commitment • Agreement to buy or sell goods denominated in a fixed number of foreign currency units at some time in the future • Foreign currency commitment period • Begins date of the agreement to buy or sell; ends when the item is purchased or sold

  25. Foreign Currency Commitment • Hedging a commitment eliminates the currency risk resulting from a transaction that has not occurred • Key issue – offsetting gains and losses on forward or option contract and purchase or sales commitment

  26. Foreign Currency Commitment • Accounting issue: • Gain or loss on hedging instrument (forward or option contract) is recognized at balance sheet date(s) and transaction date • Offsetting loss or gain on purchase or sales commitment is recognized • No impact on net income

  27. Forward Contract Hedge of Foreign Currency Commitment • Two series of entries • Underlying transaction • Forward contract (hedge) • Commitment date • No entry for purchase or sales commitment, executory contract • No entry for forward contract, executory contract

  28. Forward Contract Hedge of Foreign Currency Commitment • Balance sheet date • Revalue forward contract and commitment in same manner as on balance sheet date forward exchange rate, gain or loss to the income statement • Recognize loss or gain on purchase or sales commitment in same dollar amount as the forward contract adjustment

  29. Forward Contract Hedge of Foreign Currency Commitment • Transaction date • Revalue forward contract and commitment in same manner as on a balance sheet date • Recognize sale at spot rate • Close purchase or sales commitment to sales or asset acquired

  30. Option Contract Hedge of Foreign Currency Commitment • Two series of entries • Underlying transaction • Option contract (hedge) • Commitment date • No entry for purchase or sales commitment, executory contract • Entry for option contract for premium paid to writer (initial option contract market value)

  31. Option Contract Hedge of Foreign Currency Commitment • Balance sheet date • Revalue option contract to fair value, gain or loss to the income statement • Recognize loss or gain on purchase or sales commitment in same dollar amount as the option contract adjustment

  32. Option Contract Hedge of Foreign Currency Commitment • Transaction date • Revalue option contract and sales commitment in same manner as on a balance sheet date • Recognize sale at spot rate • Close purchase or sales commitment to sales or asset acquired

  33. Forecasted Transaction • A transaction that is EXPECTED TO OCCUR based on a continuing relationship between the entities • Key concept – gains and losses on forward or option contract purchased to hedge a forecasted transaction reported in other comprehensive income until item is purchased or sold AND item impacts the income statement

  34. Forward Contract Hedge of Forecasted Transaction • Hedge initiation • No journal entry, executory contract • Balance sheet date • Revalue forward contract to fair value based on change in forward exchange rate, gain or loss to other comprehensive income

  35. Forward Contract Hedge of Forecasted Transaction • Transaction date • Revalue forward contract for change in forward exchange rate, gain/loss to other comprehensive income • Recognize sale or purchase at spot rate

  36. Forward Contract Hedge of Forecasted Transaction • Transaction date • Sales transactions: close other comprehensive income as adjustment to Sales – when forecasted sale occurs • Inventory purchases: close other comprehensive income as adjustment to cost of good sold when forecasted inventory purchase is sold

  37. Option Contract Hedge of Forecasted Transaction • Hedge initiation • Entry for option contract for premium paid to writer (initial option contract market value) • Balance sheet date • Revalue option contract to fair value, gain or loss to other comprehensive income

  38. Option Contract Hedge of Forecasted Transaction • Transaction date • Revalue option contract to fair value, gain or loss to other comprehensive income • Recognize sale at spot rate

  39. Option Contract Hedge of Forecasted Transaction • Transaction date • Sales transactions: close other comprehensive income as adjustment to Sales – when forecasted sale occurs • Inventory purchases: close other comprehensive income as adjustment to cost of good sold when forecasted inventory purchase is sold

  40. Speculative Contracts • Foreign currency contracts entered into without intent to hedge an underlying transaction, commitment to a future transaction, or forecasted transaction

  41. Speculative Contracts (cont’d) • Initiation • Forward contract, no entry • Option contract, entry for option contract for premium paid to writer (initial option contract market value)

  42. Speculative Contracts • Balance sheet date: revalue contract to fair value, gain or loss to income statement • Settlement date • Revalue contract to fair value (spot rate at maturity date) • Settle obligation • Write off on contract • Exchange cash with foreign currency exchange broker

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