2 Accounting for Foreign Currency Transactions and Hedging Foreign Exchange Risk

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. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information)

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. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information)

Foreign Currency Transactions Many companies engage in international activities such as: Exporting or importing goods, Foreign Direct Investment (FDI) Greenfield investment – the establishment of a new operation in the foreign country (Establishing a foreign branch) Acquisition – investment in an existing operation in the foreign country., (Holding an equity investment in a foreign company).

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.

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.

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)

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. Premium -- when the forward rate is greater than the spot rate for a particular day. Discount -- when the forward rate is less than the spot rate for a particular day. Forward Exchange Contract Contract to exchange currencies of different countries on a stipulated future date, at a specified rate (the forward rate).

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

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.

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.

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.

Importing and Exporting Transactions Export sale – example 1 February 1, 2006, Joe Inc., a U.S. company, makes a sale and ships goods to Jose, SA, a Mexican customer. Sales price is $100,000 (U.S.). Jose agrees to pay in pesos on March 2, 2006. Spot rate as of February 1, 2006 is $0.10 per peso. On March 2, 2006, the spot rate is $0.09 per peso. Prepare the journal entry on the books of Joe Inc

Importing and Exporting Transactions Export sale – example 1 Joe, Inc. records the sale (in U.S. $) on February 1, 2006 as follows: Accounts Receivable 100,000 Sales 100,000

Importing and Exporting Transactions Export sale – example 1 On March 2, 2006, the spot rate is $0.09 per peso. Joe Inc. will receive 1,000,000 pesos, which are now worth $90,000. Joe makes the following journal entry: Cash 90,000 Transaction Foreign Exchange Loss 10,000 Accounts Receivable 100,000

Importing and Exporting Transactions Exercise 12-2 During December of the current year, Teletex Systems, Inc., a company based in Seattle, Washington, entered into the following transactions: Dec. 10 Sold seven office computers to a company located in Colombia for 8,541,000 pesos. On this date, the spot rate was 365 pesos per U.S. dollar. Inventory delivered 10/12/2006 U.S. firm (Teletex) Columbia firm 8,541,000 pesos received on 1/10/2007 LO 3 Common transactions. LO 4 Three stages of concern.

Importing and Exporting Transactions Exercise 12-2 Dec. 10, Sold seven office computers to a company located in Colombia for 8,541,000 pesos. On this date, the spot rate was 365 pesos per U.S. dollar. Prepare the journal entry on the books of Teletex Systems, Inc. Accounts receivable 23,400 Sales 23,400 Sales price in pesos 8,541,000 Pesos per U.S. dollar / 365 Sales price in U.S. dollars $ 23,400 LO 3 Common transactions. LO 4 Three stages of concern.

Importing and Exporting Transactions Exercise 12-2 Prepare journal entry necessary to adjust the accounts as of December 31. Assume that on December 31 the direct exchange rates was Colombia peso $.00268. Transaction loss 510 Accounts receivable 510 Receivable in pesos 8,541,000 Direct exchange rate to U.S. dollar $ .00268 Receivable in U.S. dollars $ 22,890 Balance in receivable 23,400 Transaction loss $ 510 LO 3 Common transactions. LO 4 Three stages of concern.

Importing and Exporting Transactions Exercise 12-2 Prepare journal entry to record settlement of the account on January 10. Assume that the direct exchange rate on the settlement date was Colombia peso $.00320. Cash (8,541,000 x $.00320) 27,331 Accounts receivable ($23,400 - $510) 22,890 Transaction gain 4,441 LO 3 Common transactions. LO 4 Three stages of concern.

Importing and Exporting Transactions Exercise 12-2 During December of the current year, Teletex Systems, Inc., a company based in Seattle, Washington, entered into the following transactions: Dec. 12 Purchased computer chips from a Taiwan company. Contract was denominated in 500,000 Taiwan dollars. Direct exchange rate on this date was $.0391. Inventory received 12/12/2006 U.S. firm (Teletex) Taiwan firm 500,000 Taiwan dollars paid on 10/1/2007 LO 3 Common transactions. LO 4 Three stages of concern.