Foreign Currency Transactions Chapter 10 Foreign Currency Transactions

Foreign currency exchange rates A number of factors may influence the rate of exchange between currencies Exchange rates may be quoted direct (1 FC = $0.25) or indirect ($1 = 4 FC) Exchange rates also may differ depending on whether they are a buying (bid price) or selling (offered price) rate Present and future rates are known as spot and forward rates respectively C10 1 1

Forward exchange rates Apply to the exchange of currencies at a future (forward) point in time The agreement to exchange currencies at a future date is generally a forward contract C10 1 1

Forward exchange rates (con’t) The forward contract specifies the forward rate of exchange and the forward date The difference between a forward rate and the current spot rate represents a premium (forward > spot) or a discount (forward < spot) and is explained in part by interest differentials C10 1 1

Interest differentials affect forward rates Facts Spot Rate 1 FC = $1.50 Amount of FC to be sold 10,000 FC Forward Date 60 days forward Interest rate on FC 6.0% Interest rate on $ 7.2% Calculation of Forward Rate $ FC Value Today 15,000 10,000 Interest for 60 days 180 100 Value in 60 days 15,180 10,100 Forward Rate = $15,180  10,100 FC; 1FC = $1.503 C10

Accounting for foreign currency transactions Transactions are denominated in FC and measured in dollars (domestic currency) Changes in exchange rates between the transaction date and the settlement date expose the domestic company to exchange gains or losses If a FC transaction is unsettled at the end of the period, exchange gains/losses should be accrued C10 1 1

Foreign currency transactions demonstrated Transaction: Purchase inventory for 100,000 FC -A- Transaction Date Spot Rate: 1 FC = $1.50 1 FC = $1.53 1 FC = $1.52 -C- Settlement -B- Year End Journal entries for these dates follow . . . C10 1 1

Foreign currency transactions demonstrated (con’t) A) Inventory 150,000 Accounts Payable 150,000 purchase inventory; rate = $1.50 B) Exchange Loss 3,000 Accounts Payable 3,000 fiscal year-end; rate = $1.53 C) Accounts Payable 153,000 Exchange Gain 1,000 Cash 152,000 settlement date; rate = $1.52 C10 1 1

Hedging against foreign currency exchange risk Hedging is designed to manage the risk or uncertainty associated with possible changes in exchange rates. In the context of foreign currency transactions, hedging may be used to: hedge a FC transaction hedge a FC commitment hedge a forecasted FC transaction C10 1 1

Investments used to hedge Derivative instruments Forward contracts FC options buy (call) sell (put) FC swaps C10 1 1

Hedging a foreign currency transaction with a fwd contract Transaction: Buy inventory for 100,000 FC. A forward contract to buy FC on settlement date was acquired on transaction date. -A- Transaction Date -B- Year End -C- Settlement Date Spot Rate: 1 FC = $1.50 1 FC = $1.53 1 FC = $1.52 Fwd Rate: 1 FC = $1.505 1 FC = $1.529 n/a C10 1 1

Hedging a foreign currency transaction with a fwd contract (con’t) Without Without the hedge the hedge Exchange gain (loss) on foreign currency transactions ($2,000) ($2,000) Gain (loss) on fwd contract 2,000 Subtotal ($2,000) -0- Gain (loss) on forward contract excluded from assessment of hedge effectiveness _______ (500) Net Income effect ($2,000) ($500) C10

Hedging complications Forward contract expires before or after contract date - rollover contract Forward contract amount different than transaction amount if less than transaction amount = partial hedge if greater than transaction amount = part speculative hedge C10 1 1

Hedge on identifiable foreign currency commitment Used to fix or establish the basis of a FC transaction based on exchange rates at the commitment date versus the transaction date Involves market prices which have been previously determined at the time of the commitment Is a fair value hedge and must meet specific criteria for special accounting treatment C10 1 1

Hedge on identifiable foreign currency commitment (con’t) Special accounting treatment - recognize in earnings gain or loss on hedge (forward contract) prior to transaction date gain or loss on the commitment (with an appropriate adjustment to the basis of the committed item) C10 1 1

Hedging an identifiable foreign currency commitment Transaction: Commit to buy inventory for 100,000 FC which will be sold for $200,000. A forward contract to buy FC at the settlement date was acquired on the commitment date. -A- Commitment Date Spot Rate: 1 FC = $1.50 1 FC = $1.53 1 FC = $1.54 -C- Settlement -B- Transaction Date Fwd Rate: 1 FC = $1.505 1 FC = $1.531 n/a C10 1 1

Hedging an identifiable foreign currency commitment (cont’d) 1 1

Hedging a foreign denominated forecasted transaction Involves a transaction which is expected to (versus committed to) occur in the future Designed to reduce the risk associated with exchange rate changes which could affect the forecasted transaction Is a cash flow hedge and must meet specific criteria for special accounting treatment C10 1 1

Hedging a foreign denominated forecasted transaction (con’t) Special accounting treatment The gain or loss on the hedge prior to the transaction date is: recognized outside of earnings as a component of other comprehensive income (OCI) and then recognized in earnings, after the forecasted transaction has occurred, in the same period in which the transaction affects earnings C10 1 1

Hedging a foreign denominated forecasted transaction Transaction: Forecasted sale of goods (which cost $110,000) for 100,000 FC on the transaction date. A forward contract to sell FC at the transaction date was acquired when the sale was forecasted. -A- Forecasted Date Spot Rate: 1 FC = $1.50 1 FC = $1.46 n/a -B- Transaction Forward Rate: 1 FC = 1.495 C10 1 1

Hedging a foreign denominated forecasted transaction