Chapter Nine Foreign Currency Transactions and Hedging Foreign Exchange Risk Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Foreign Exchange Rates  An Exchange Rate is the cost of one currency in terms of another.  Rates published daily in the Wall Street Journal are as of 4:00pm Eastern time on the day prior to publication.  The published rates are wholesale rates that banks use with each other – retail rates to consumers are higher.  The difference between the rates at which a bank is willing to buy and sell currency is known as the “spread.”  Rates change constantly! LO 1 9-2

Foreign Exchange Rates Spot Rate  The exchange rate that is available today. Forward Rate  The exchange rate that can be locked in today for an expected future exchange transaction.  The actual spot rate at the future date may differ from today’s forward rate. 9-3

Foreign Currency - Option Contracts  A “put” option allows for the sale of foreign currency by the option holder.  A “call” option allows for the purchase of foreign currency by the option holder. Remember: An option gives the holder “the right but not the obligation” to trade the foreign currency in the future. 9-4

Foreign Currency Transactions GAAP requires a two- transaction perspective. (1)Account for the original sale in US Dollars. (2)Account for gains/losses from exchange rate fluctuations. LO 2 9-5

Hedging Foreign Exchange Risk Two foreign currency derivatives that are often used to hedge foreign currency transactions:  Foreign currency forward contracts lock in the price for which the currency will sell at contract’s maturity.  Foreign currency options establish a price for which the currency can be sold, but is not required to be sold at maturity. LO 3 9-6

Accounting for Derivatives ASC Topic 815 provides guidance for hedges of four types of foreign exchange risk. 1.Recognized foreign currency denominated assets & liabilities. 3.Forecasted foreign currency denominated transactions. 2.Unrecognized foreign currency firm commitments. 4.Net investments in foreign operations 9-7

Accounting for Derivatives The fair value of the derivative is recorded at the same time as the transaction to be hedged, based on:  The forward rate when the forward contract was entered into.  The current forward rate for a contract that matures on the same date as the forward contract.  A discount rate (the company’s incremental borrowing rate). 9-8

Accounting for Hedges Two ways to account for a foreign currency hedge: 1. Cash Flow Hedge  Completely offsets variability of a foreign currency receivable or payable.  Gains/losses are recorded as Comprehensive Income. Any other hedging instrument is a 2.Fair Value Hedge.  Gains/losses are recognized immediately in net income. LO 4 9-9

Using a Foreign Currency Option as a Hedge An option is a contract that allows you to exercise a predetermined exchange rate if it is to your advantage. As with forward contracts, options can be designed as cash flow hedges or fair value hedges. Option prices are determined using the Black-Scholes Option Pricing Model covered in most finance texts. 9-10

Option values Value is derived from a function combining:  The difference between current spot rate and strike price  The difference between foreign and domestic interest rates  The length of time to option expiration  The potential volatility of changes in the spot rate  Fair values are determined by: Intrinsic Value & Time Value 9-11

Foreign Currency Firm Commitment Hedge Options are carried at fair value on the balance sheet of both the derivative financial instrument (forward contract or option) and the firm commitment. The change in value of the firm commitment gain/loss offsets the gain or loss on the hedging instrument. Gain/loss is recognized currently in net income, as is the gain/loss on the firm commitment attributable to the hedged risk. LO

Hedge of a Forecasted Foreign Currency Denominated Transaction Accounting for a hedge of a forecasted transaction differs from accounting for a hedge of a foreign currency firm commitment in two ways: 1. Unlike the accounting for a firm commitment, the forecasted transaction and related gains and losses are not recognized. 2. The company reports the hedging instrument (forward contract or option) at fair value, but because no gain or loss occurs, the company does not report changes in the fair value of the hedging instrument as gains and losses in net income. Instead, it reports the changes in other comprehensive income. LO

Foreign Currency Borrowings Example On July 1, 2013, Multicorp borrows ¥ 1 billion and converts it into $9,210,000 in the spot market. On December 31, 2013, Mulitcorp must revalue the Japanese yen note payable with an offsetting foreign exchange gain or loss reported in income and must accrue interest expense and interest payable. Interest is calculated by multiplying the loan principal in yen by the relevant interest rate. The amount of interest payable in yen is then translated to U.S. dollars at the spot rate to record the accrual journal entry. On July 1, 2014, differences between the amount of interest accrued at year- end and the actual U.S. dollar amount that must be spent to pay the accrued interest are recognized as foreign exchange gains/ losses. LO

Foreign Currency Borrowings Example Exchange rates in table above apply. Journal entries are recorded as follows: 9-15

Foreign Currency Borrowings Example Journal entries at end of accounting period: 9-16