Accounting for Foreign Currency Transactions and Hedging Foreign Exchange Risk

2. 12 Accounting for Foreign Currency Transactions and Hedging Foreign Exchange Risk Advanced Accounting, Third Edition

3. 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.

4. 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.

5. 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.

6. Foreign Currency Transactions • Recording and reporting problems with foreign currency transactions: • Transactions in a foreign currency must be translated before they can be aggregated with domestic transactions. • Receivables or payables denominated in foreign currencies are subject to gains and losses. • Companies use hedging strategies with derivatives to minimize the impact of exchange rate changes.

7. Exchange Rates—Means of Translation Translation - process of expressing amounts stated 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.

8. Exchange Rates—Means of Translation Direct Exchange Rate • Units of domestic currency that can be converted into one unit of foreign currency. • Direct rate = 1.517 ($1.517 U.S. for 1 British pound) Indirect Exchange Rate • 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)

9. 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).

10. Exchange Rates—Means of Translation • In both the spot and forward markets, a foreign exchange trader provides a quotation for buying (the bid rate) and a quotation for selling (the offer rate) foreign currency. • The trader’s buying rate will be lower than the quoted selling rate, and the spread between the two rates is profit for the trader.

11. 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

12. Measured Versus Denominated The selection of an exchange rate to be used in the translation process is complicated by the fact that some countries maintain multiple exchange rates. The government of a country may maintain official rates that differ from the market –determined rate, depending on the nature of the transaction. LO 1 Measured versus denominated.

13. Measured Versus Denominated Transactions are normally measured and recorded in terms of the currency where the company is located. • Reporting Currency - usually the currency where the company 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 1 Measured versus denominated.

14. Foreign Currency Transactions Foreign Currency Transaction - requires payment or receipt (settlement) in a foreign currency. • U.S. firm exposed to risk of unfavorable changes in the exchange rate. Direct exchange rate increasing, or foreign currency unit strengthening. More dollars needed to acquire the foreign currency units. = Direct exchange rate decreasing, or foreign currency unit weakening. Fewer dollars needed to acquire the foreign currency units. = LO 2 Foreign Currency Transactions.

15. Measured Versus Denominated Direct exchange rates Yen Strengthens Yen Weakens $ Weakens $ Strengthens Beginning of the year $1 = 1 Yen $1 = 1 Yen End of the year $2 = 1 Yen $0.5 = 1 Yen LO 1 Measured versus denominated.

16. Measured Versus Denominated Foreign currency transaction A transaction that require payment or receipt (settlement) in a foreign currency . LO 1 Measured versus denominated.

17. Foreign Currency Transactions Importing or Exporting of Goods or Services Translating Accounts Denominated in Foreign Currency Balance sheet date Settlement date Transaction date Units of foreign currency x Current direct exchange rate Increase or decrease is generally reported as a foreign currency transaction gain or loss, sometimes referred to as an exchange gain or loss, in determining net income for the current period. LO 3 Common transactions. LO 4 Three stages of concern.

18. Measured Versus Denominated (1) At the transaction date: Each asset, liability, revenue, expense, gain, or loss arising from the transaction is measured and recorded in reporting currency by: Units of foreign currency × current direct exchange rate Current exchange rate is the spot rate in effect on a given date. LO 1 Measured versus denominated.

19. Measured Versus Denominated (2) At the balance sheet date: Is date is occur between the transaction date and the settlement date. Recorded balances that are denominated in a foreign currency are adjusted using the spot rate in effect of the balance sheet date, and the transaction gain or loss is recognized currently in earnings. LO 1 Measured versus denominated.

20. Measured Versus Denominated (3) At the settlement date: In the case of a foreign currency payable, the Egyptian firm must convert Egyptian L.E. into foreign currency units to settle the account, whereas foreign currency units received to settle a foreign currency receivable will be converted into Egyptian L.E. LO 1 Measured versus denominated.

21. Measured Versus Denominated (3) At the settlement date: Although translation is not required, a transaction gain or loss is recognized if the number of Egyptian L.E. paid or received upon conversion does not equal the carrying value of the related payable or receivables. LO 1 Measured versus denominated.