Ebook Advanced accounting (11th edition): Part 1

Ebook Advanced accounting (11th edition): Part 1 presents the following chapters: Chapter 1 business combinations; chapter 2 stock investments - investor accounting and reporting; chapter 3 an introduction to consolidated financial statements; chapter 4 consolidation techniques and procedures; chapter 5 intercompany profit transactions – inventories; chapter 6 intercompany profit transactions - plant assets; chapter 7 intercompany profit transactions – bonds; chapter 8 consolidations - changes in ownership interests; chapter 9 indirect and mutual holdings; chapter 10 subsidiary preferred stock, consolidated earnings per share, and consolidated income taxation; chapter 11 consolidation theories, push-down accounting, and corporate joint ventures; chapter 12 derivatives and foreign currency: concepts and common transactions.

This page intentionally left blank ADVANCED ACCOUNTING Editorial Director: Sally Yagan Editor in Chief: Donna Battista Director of Editorial Services: Ashley Santora Senior Editorial Project Manager: Karen Kirincich Editorial Assistant: Jane Avery Director of Marketing: Patrice Jones Marketing Assistant: Ian Gold Senior Managing Editor: Cindy Zonneveld Production Project Manager: Carol O’Rourke Senior Art Director: Jonathan Boylan Interior Design: Jonathan Boylan Cover Designer: Jonathan Boylan Composition: PreMediaGlobal Full-Service Project Management: Kristy Zamagni Senior Operations Specialist: Diane Peirano Printer/Binder: Edwards Brothers Cover Printer: Demand Production Center Typeface: 10/12 Times Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on appropriate page within text The GASB Statement No 33, Accounting for Financial Reporting for Nonexchange Transactions, Appendix C summary chart, “Classes and Timing of Recognition of Nonexchange Transactions,” copyright by the Governmental Accounting Standards Board, 401 Merritt 7, Norwalk, CT 06856-5116, U.S.A., is reprinted with permission Complete copies of this document are available from the GASB Copyright © 2012, 2009, 2006, 2003, 2000 by Pearson Education, Inc., Upper Saddle River, New Jersey, 07458 Pearson Prentice Hall All rights reserved Printed in the United States of America This publication is protected by copyright and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise For information regarding permission(s), write to: Rights and Permissions Department Pearson Prentice Hall™ is a trademark of Pearson Education, Inc Pearson® is a registered trademark of Pearson plc Prentice Hall® is a registered trademark of Pearson Education, Inc Pearson Education Ltd., London Pearson Education Singapore, Pte Ltd Pearson Education, Canada, Inc Pearson Education–Japan Pearson Education Australia PTY, Limited Pearson Education North Asia, Ltd., Hong Kong Pearson Education de Mexico, S.A de C.V Pearson Education Malaysia, Pte Ltd Pearson Education Upper Saddle River, New Jersey CIP data is on file at the Library of Congress 10 ISBN-13: 978-0-13-256896-8 ISBN-10: 0-13-256896-9 ELEVENTH EDITION ADVANCED ACCOUNTING Floyd A Beams Virginia Polytechnic Institute and State University Joseph H Anthony Michigan State University Bruce Bettinghaus Grand Valley State University Kenneth A Smith University of Washington This page intentionally left blank In memory of Madeline To Trish To Karen, Madelyn and AJ JOE ANTHONY BRUCE BETTINGHAUS KENNETH A SMITH This page intentionally left blank ABOUT THE AUTHORS FLOYD A BEAMS, PH.D., authored the first edition information in the securities markets He has published a number of Advanced Accounting in 1979 and actively revised his text through the next six revisions and twenty-one years while maintaining an active professional and academic career at Virginia Tech where he rose to the rank of Professor, retiring in 1995 Beams earned his B.S and M.A degrees from the University of Nebraska, and a Ph.D from the University of Illinois He published actively in journals including The Accounting Review, Journal of Accounting, Auditing and Finance, Journal of Accountancy, The Atlantic Economic Review, Management Accounting, and others He was a member of the American Accounting Association and the Institute of Management Accountants and served on committees for both organizations Beams was honored with the National Association of Accounts’ Lybrand Bronze Medal Award for outstanding contribution to accounting literature, the Distinguished Career in Accounting award from the Virginia Society of CPAs, and the Virginia Outstanding Accounting Educator award from the Carman G Blough student chapter of the Institute of Management Accountants Professor Beams passed away three years ago; however, we continue to honor his contribution to the field, and salute the impact he had on this volume of articles in leading accounting and finance journals, including The Journal of Accounting & Economics, The Journal of Finance, Contemporary Accounting Research, The Journal of Accounting, Auditing, & Finance, and Accounting Horizons BRUCE BETTINGHAUS, PH.D., is an Assistant Professor of Accounting in the School of Accounting in The Seidman College of Business at Grand Valley State University His teaching experience includes corporate governance and accounting ethics, as well as accounting theory and financial reporting for both undergraduates and graduate classes He earned his Ph.D at Penn State University and his B.B.A at Grand Valley State University Bruce has also served on the faculties of the University of Missouri and Michigan State University He has been recognized for high quality teaching at both Penn State and Michigan State universities His research interests focus on governance and financial reporting for public firms He has published articles in The International Journal of Accounting and The Journal of Corporate Accounting and Finance KENNETH A SMITH, PH.D., is a Senior Lecturer in JOSEPH H ANTHONY, PH.D., joined the Michigan the Evans School of Public Affairs at the University of WashState University faculty in 1983 and is an Associate Professor of Accounting at the Eli Broad College of Business He earned his B.A in 1971 and his M.S in 1974, both awarded by Pennsylvania State University, and he earned his Ph.D from The Ohio State University in 1984 He is a Certified Public Accountant, and is a member of the American Accounting Association, American Institute of Certified Public Accountants, American Finance Association, and Canadian Academic Accounting Association He has been recognized as a Lilly Foundation Faculty Teaching Fellow and as the MSU Accounting Department’s Outstanding Teacher in 1998–99 and in 2010–2011 Anthony teaches a variety of courses, including undergraduate introductory, intermediate, and advanced financial accounting He also teaches financial accounting theory and financial statement analysis at the master’s level, as well as financial accounting courses in Executive MBA programs, and a doctoral seminar in financial accounting and capital markets research He co-authored an introductory financial accounting textbook Anthony’s research interests include financial statement analysis, corporate reporting, and the impact of accounting ington He earned his Ph.D from the University of Missouri, his M.B.A from Ball State University and his B.A in Accounting from Anderson University (IN) He is a Certified Public Accountant Smith’s research interests include government accounting and budgeting, non-profit financial management, non-financial performance reporting and information systems in government and non-profit organizations He has published articles in such journals as Accounting Horizons, Journal of Government Financial Management, Public Performance & Management Review, Nonprofit and Voluntary Sector Quarterly, International Public Management Journal, Government Finance Review, and Strategic Finance Smith’s professional activities include membership in the American Accounting Association, the Association of Government Accountants, the Government Finance Officers Association, the Institute of Internal Auditors, and the Institute of Management Accountants He serves on the Steering Committee for the Public Performance Measurement Reporting Network and as the Executive Director for the Oregon Public Performance Measurement Association vii This page intentionally left blank 414 CHAPTER 12 LEARNING OBJECTIVE F OREIG N EXCHAN G E C O NC E P T S A ND DE FINIT IO NS Foreign business activity by U.S corporations has expanded rapidly over time In 2009, exports of U.S goods and services were $1.571 trillion, and imports of foreign goods and services totaled $1.946 trillion.2 These figures were down slightly from the record-setting year of 2008 when combined imports and exports of goods and services in and out of the U.S totaled $4.377 trillion The effect of international branch and subsidiary operations on U.S companies’ operating results is sizeable Almost 70 percent of the Coca-Cola Company’s operating revenues and 80 percent of its operating income came from operations outside of the United States in 2007 Also in 2007, 27 percent of Apple’s net sales came from Europe and Japan, and 18 percent of Starbucks’ revenues and 24 percent of Wal-Mart’s were earned outside the United States During 2004, nearly 63 percent of Nike’s revenues came from non-U.S sources In this section we discuss foreign currency concepts and foreign currency transaction accounting Chapter 13 demonstrates the accounting for hedging foreign currency risks, while Chapter 14 discusses foreign currency financial statement translation Currencies provide a standard of value, a medium of exchange, and a unit of measure for economic transactions Currencies of different countries perform the first two functions with varying degrees of efficiency, but essentially all currencies provide a unit of measure for the economic activities and resources of their respective countries For transactions to be included in financial records, they must be measured in a currency Typically, the currency in which a transaction is recorded and the currency needed to settle the transaction are the same For example, a Chicago pizza shop buys all its produce and other inputs and pays all of its employees and other bills using U.S dollars The pizza shop collects dollars from its customers If a receivable or payable arises, it will require receiving or spending dollars for settlement A receivable or payable is denominated in a currency when it must be paid in that currency A receivable or payable is measured in a currency when it is recorded in the financial records in that currency In this example, the pizza shop’s receivables and payables are denominated and measured in the same currency, the U.S dollar In the case of transactions between business entities of different countries, the amounts receivable and payable are ordinarily denominated in the local currency of either the buying entity or the selling entity.3 For example, if a U.S firm sells merchandise to a British firm, the transaction amount will be denominated (or paid) in either U.S dollars or British pounds, even though the U.S firm will measure and record its account receivable and sales in U.S dollars and the British firm will measure and record its purchase and account payable in British pounds, regardless of the currency in which the transaction is denominated If the transaction is denominated in British pounds, the U.S firm has to determine how many U.S dollars the transaction represents in order to record it If the transaction is denominated in U.S dollars, the British firm has to determine how many British pounds the transaction represents To measure transactions in their own currencies, businesses around the world rely on exchange rates negotiated on a continuous basis in world currency markets Exchange rates are essentially prices for currencies expressed in units of other currencies Direct and Indirect Quotation of Exchange Rates An exchange rate is the ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged at a particular time The exchange rate can be computed directly or indirectly Assume that $1.60 can be exchanged for British pound (£1) Direct quotation (U.S dollar per one foreign currency unit): $1.60 = $1.60 2U.S Department of Commerce, Bureau of Economic Analysis U.S International Trade in Goods and Services Report November 10, 2010 3Sometimes the amounts are denominated in the currency of a third country whose currency is relatively more stable than the currency of either the buyer or the seller Derivatives and Foreign Currency: Concepts and Common Transactions Indirect quotation (the number of foreign currency units per U.S dollar): = £0.625 $1.60 The first approach is a direct quotation (from a U.S viewpoint) because the rate is expressed in U.S dollars: $1.60 is equivalent to one British pound (one unit of the foreign currency) The second approach is an indirect quotation (from a U.S viewpoint) because the rate is expressed in British pounds (the foreign currency): £0.625 is equivalent to one U.S dollar The Foreign Exchange section of The Wall Street Journal shows both direct (U.S dollar equivalent) and indirect (currency per U.S dollar) exchange rates on a daily basis Floating, Fixed, and Multiple Exchange Rates Exchange rates may be fixed by a governmental unit or may be allowed to fluctuate (float) with changes in the currency markets Official, or fixed, exchange rates are set by a government and not change as a result of changes in world currency markets Free, or floating, exchange rates are those that reflect fluctuating market prices for a currency based on supply and demand and other factors in the world currency markets F LOATING E XCHANGE R ATES Theoretically, a currency’s value should reflect its buying power in world markets For example, an increase in a country’s inflation rate indicates that its currency’s purchasing power is decreasing The currency’s value should fall in relation to other currencies The technical term for this movement in currency value is weakening A currency falls, or weakens, relative to another currency if it takes more of the weakening currency to purchase one unit of the other currency A large trade surplus (when the amount of exports exceeds imports) usually results in an increased demand for a country’s currency because many of those export sales must be paid in the exporting country’s currency The exporting country’s currency becomes more valuable relative to the importing countries’ currencies, or it strengthens A currency strengthens relative to another currency if it takes fewer units of the strengthening currency to purchase one unit of the other currency A large trade deficit (when the amount of imports exceeds exports) should lead to a decrease, or weakening, of the currency’s value Although inflation and net trade position (trade surplus or trade deficit) are common causes of changes in floating exchange rates, other factors have occasionally been more influential Interest rate differences across countries influence supply and demand for a country’s currency because many investors buy securities in the international securities markets Speculative trading to take advantage of currency movements also affects exchange rates To reduce its trade deficit, the U.S government has occasionally asked other countries (Taiwan and South Korea, for example) to let their currencies strengthen against the U.S dollar A decline in value of the dollar in relation to other major currencies should increase the price of foreign products in the United States and lead to a reduction of imports to the United States Similarly, U.S goods can be sold in international markets for fewer foreign currency units when the dollar weakens against those currencies Even so, a weakening U.S dollar has often done little to abate U.S consumers’ demand for imported products, and changes in the exchange rates may have little effect on the trade deficit Other factors that may affect a country’s trade balance include interest rates and tax rates A mathematical example of strengthening and weakening of a currency relative to another currency follows Initially, assume that one British pound can be purchased for $1.50 If the quote is indirect, $1 can be purchased for 0.6667 pounds If the dollar weakens relative to the pound, each pound is more expensive in dollar terms If the dollar weakens by 10 percent, each pound will now cost $1.65 If the dollar weakens by 10 percent, it takes fewer pounds to buy $1, so now $1 can be purchased for 0.6061 pounds If the dollar strengthens relative to the pound, each pound is less expensive in dollar terms If the dollar strengthens by 10 percent, each pound will now cost $1.35 If the quote is indirect, $1 can now be purchased for 0.7407 pounds F IXED AND M ULTIPLE E XCHANGE R ATES When exchange rates are fixed, the issuing government is able to set (fix) different rates for different kinds of transactions For example, it may set a 415 416 CHAPTER 12 preferential rate for imports (or certain kinds of imports) and penalty rates for exports (or certain kinds of exports) in order to promote the economic objectives of the country Such rates are referred to as multiple exchange rates Spot, Current, and Historical Exchange Rates The exchange rates that are used in accounting for foreign operations and transactions (other than forward contracts) are spot rates, current exchange rates, and historical exchange rates Spot rate is a market term; current and historical rates are accounting terms These are defined as follows: Spot rate The exchange rate for immediate delivery of currencies exchanged Current rate The rate at which one unit of currency can be exchanged for another currency at the balance sheet date or the transaction date Historical rate The rate in effect at the date a specific transaction or event occurred Spot, current, and historical rates may be either fixed or floating rates, depending on the particular currency involved Spot rates for foreign transactions between the United States and a country with fixed exchange rates will normally change in that foreign country only as a result of government action (except for transactions in the black market in the foreign country’s currency) For example, the Argentine government can control the exchange rate in Buenos Aires, but not in New York Spot rates for foreign transactions with a country that has floating exchange rates may change daily, or several times in a single day, depending on factors that influence the currency markets However, only one spot rate exists for a given transaction The foreign currency transaction’s current rate is the spot rate in effect for immediate settlement of the amounts denominated in foreign currency at the transaction date or at the balance sheet date Historical rates are the spot rates that were in effect on the date that a particular event or transaction occurred Foreign Exchange Quotations Major U.S banks facilitate international trade by maintaining departments that provide bank transfer services between U.S and non-U.S companies, as well as currency exchange services Selected interbank transaction exchange rates on November 28, 2010, were:4 U.S $ Equivalent Britain (pound) Canada (dollars) Euro Japan (yen) Mexico (peso) $1.5588 $0.9786 $1.3242 $0.0119 $0.08 Currency per U.S $ 0.6413 pounds 1.0219 Canadian dollars 0.7552 euros 84.095 yen 12.495 pesos A payment of $1,558,800 to a U.S banker at p.m est on November 28, 2010, would have entitled a U.S corporation to purchase British goods selling for £1,000,000 or to settle an account payable denominated at £1,000,000 Similarly, a U.S company could have purchased merchandise selling for 1,000,000 Canadian dollars for $978,600 at that time The U.S bankers that provide foreign exchange services are, of course, paid for their services The payment is the difference between the amount that they receive from U.S corporations and the amount they pay out for the foreign currencies, or vice versa For example, a bank that trades foreign currency may offer to sell British pounds for $1.57 or to buy them for $1.55 when the quoted rate for British pounds is $1.56 Thus, a firm can buy 1,000,000 pounds from the bank for $1,570,000 or sell 1,000,000 pounds to the bank for $1,550,000, and the bank realizes a $10,000 gain in either case LEARNING OBJECTIVE F OREIG N CURRENC Y T R A NS A C T IO NS OT H E R T H A N FO R WA R D C O NT R A CT S Transactions within a country that are measured and recorded in the currency of that country are local transactions The transactions of a British subsidiary would be recorded in British pounds, and its financial statements would be stated in British pounds However, its financial statements 4Source: Yahoo Finance Web site, November 29, 2010 Derivatives and Foreign Currency: Concepts and Common Transactions must be converted into U.S dollars before consolidation with a U.S parent company Translation of foreign currency financial statements is covered in Chapter 14 This discussion of foreign currency transactions assumes the point of view of a U.S firm whose functional currency is the U.S dollar (which is also its local currency) An entity’s functional currency is the currency of its primary economic environment Normally, the predominant currency received or expended to complete transactions is the functional currency Chapter 14 contains a more extensive discussion of the functional currency concept Foreign transactions are transactions between countries or between enterprises in different countries Foreign currency transactions are transactions whose terms are stated (denominated) in a currency other than an entity’s functional currency Thus, a foreign transaction may or may not be a foreign currency transaction The most common types of foreign transactions are imports and exports of goods and services Import and export transactions are foreign transactions, but they are not foreign currency transactions unless their terms are denominated in a foreign currency—that is, a currency other than the entity’s functional currency An export sale by a U.S company to a Canadian company is a foreign currency transaction from the viewpoint of the U.S company only if the invoice is denominated (fixed) in Canadian dollars Translation is required if the transaction is denominated in a foreign currency, but not if it is denominated in the entity’s functional currency FASB Requirements Current GAAP [2] applies only to foreign currency transactions and to foreign currency financial statements GAAP stipulates the following requirements for foreign currency transactions other than derivatives: At the date the transaction is recognized, each asset, liability, revenue, expense, gain, or loss arising from the transaction shall be measured and recorded in the functional currency of the recording entity by use of the exchange rate in effect at that date At each balance sheet date, recorded balances that are denominated in a currency other than the functional currency of the recording entity shall be adjusted to reflect the current exchange rate TRANSLATION AT THE SPOT RATE The first requirement for recording foreign currency transactions is that they must be translated into U.S dollars at the spot rate in effect at the transaction date Each asset, liability, revenue, and expense account arising from the transaction is translated into dollars before it is recorded The unit of measurement is changed from the foreign currency to the U.S dollar Assume that a U.S corporation imports inventory from a Canadian firm when the spot rate for Canadian dollars is $0.7000 The invoice calls for payment of 10,000 Canadian dollars in 30 days (Note: The $ sign used for the spot rate indicates direct quotation—the U.S dollar equivalent of one unit of foreign currency.) The U.S importer records the transaction as follows: $7,000 Inventory (+A) Accounts payable (fc) (+L) (Translation: 10,000 Canadian dollars * $0.7000 spot rate.) $7,000 Except for the foreign currency (fc) notation, the entry is recorded in the usual manner The notation is used here to indicate that the account payable is denominated in foreign currency The inventory is measured in U.S dollars, and no subsequent adjustment is made to the inventory account for foreign currency rate fluctuations If the account payable is paid when the spot rate is $0.6900, the payment is recorded as follows: $7,000 Accounts payable (fc) (-L) Exchange gain (+Ga, +SE) Cash (-A) (Cash required equals 10,000 Canadian dollars * $0.6900 spot rate.) $ 100 6,900 417 418 CHAPTER 12 The $100 exchange gain results because a liability measured at $7,000 is settled for $6,900 This gain reflects a change in the exchange rate between the initial transaction date and the date of payment If the exchange rate had changed to $0.7200, a $200 exchange loss would have resulted Exhibit 12-1 illustrates the accounting differences that arise when foreign transactions are denominated in an entity’s functional currency (U.S dollars) as opposed to a foreign currency In examining the exhibit, keep in mind that a transaction must be denominated in a foreign currency to be a foreign currency transaction When the billing for a U.S company’s sale or purchase is denominated in U.S dollars, no translation is required EX H I BI T 2- C omparison of Purc hase and Sale Transact ions D enominat ed in U.S D o ll ars Ve rsus B rit is h Po unds SALES TRANSACTION Assumption: U.S Foods sells merchandise to London Industries Ltd for $16,500, or £10,000 when the exchange rate is $1.65, and receives payment when the exchange rate is $1.64 IF BILLING IS IN U.S DOLLARS (Date of sale) Accounts receivable (+A) Sales (+R, +SE) To record sale to London Industries; invoice is $16,500 $16,500 (Date of receipt) Cash (+A) Accounts receivable (-A) To record collection in full from London Industries $16,500 $16,500 $16,500 IF BILLING IS IN BRITISH POUNDS Accounts receivable (fc) (+A) Sales (+R, +SE) To record sale to London Industries; billing is for £10,000 (£10,000 * $1.65 = $16,500) Cash (fc) (+A) Exchange loss (+Lo, -SE) Accounts receivable (fc) (-A) To record collection in full from London Industries (£10,000 * $1.64 = $16,400) $16,500 $16,500 $16,400 100 $16,500 PURCHASE TRANSACTION Assumption: U.S Foods purchases merchandise from London Industries Ltd for $8,250, or £5,000 pounds when the exchange rate is $1.65 and pays the account when the exchange rate is $1.67 IF BILLING IS IN U.S DOLLARS (Date of purchase) Inventory (+A) Accounts payable (+L) To record purchase from London Industries; billing is $8,250 (Date of payment) Accounts payable (-L) Cash (-A) To record payment in full to London Industries $8,250 $8,250 $8,250 $8,250 IF BILLING IS IN BRITISH POUNDS Inventory (+A) Accounts payable (fc) (+L) To record purchase from London Industries; billing is for £5,000 (£5,000 * $1.65 = $8,250) Accounts payable (fc) (-L) Exchange loss (+Lo, -SE) Cash (fc) (-A) To record payment in full to London Industries (£5,000 * $1.67 = $8,350) $8,250 $8,250 $8,250 100 $8,350 Derivatives and Foreign Currency: Concepts and Common Transactions The potential for exchange gains and losses arises only when the receivable or payable is billed in the foreign currency However, no gain or loss on translation is recorded at the initial recording BALANCE SHEET DATE ADJUSTMENTS Gains and losses on foreign currency transactions cannot be deferred until foreign currency is converted into U.S dollars or until related receivables are collected or payables are settled Instead, these amounts are adjusted to reflect current exchange rates at the balance sheet date, and any exchange gains or losses that result from the adjustments are included in current-year income Purchases Denominated in Foreign Currency ATC, a U.S corporation, purchased merchandise from Paris Company on December 1, 2011, for 10,000 euros, when the spot rate for euros was $0.6600 ATC closed its books at December 31, 2011, when the spot rate for euros was $0.6550, and it settled the account on January 30, 2012, when the spot rate was $0.6650 These transactions and events are recorded by ATC as follows: December 1, 2011 Inventory (+A) Accounts payable (fc) (+L) To record purchase of merchandise from Paris Company (10,000 euros * $0.6600 rate) December 31, 2011 Accounts payable (fc) (-L) Exchange gain (+Ga, +SE) To adjust accounts payable to exchange rate at year-end [10,000 euros × ($0.6550 - $0.6600)] January 30, 2012 Accounts payable (fc) (-L) Exchange loss (+Lo, -SE) Cash (fc) (-A) To record payments in full to Paris Company (10,000 euros * 0.6650 spot rate) Date December 1, 2011 (initial transaction date) December 31, 2011 (financial statement date) January 30, 2012 (settled accounts payable by purchasing and distributing euros) Overall $6,600 $6,600 $ 50 $ 50 $6,550 100 $6,650 Spot Rate Inventory Accounts Payable (10,000 Euros) $0.6600 $6,600 $6,600 — $0.6550 $6,600 $6,550 $ 50 $0.6650 $6,600 $6,650 ($100) Gain (Loss) ($ 50) The example shows that on December 1, 2011, ATC incurred a liability of $6,600 denominated in euros On December 31, 2011, the liability was adjusted to reflect the current exchange rate, and a $50 exchange gain was included in ATC’s 2011 income statement The exchange gain is the product of multiplying 10,000 euros by the change in the spot rate for euros between December and December 31, 2011 By January 30, 2012, when the liability was settled, the spot rate for euros had increased to $0.6650, and ATC recorded a $100 exchange loss The actual total exchange loss is only $50 [10,000 euros × ($0.6650 − $0.6600)], but this loss is reported as a $50 exchange gain in 2011 and a $100 exchange loss in 2012 In summary, foreign currency–denominated purchases must be measured in dollars at the purchase date using the foreign currency spot rate on that date If a balance sheet date occurs before the liability is paid, the accounts payable must be remeasured to reflect the spot rate at the financial statement date A gain results if the dollar strengthens, LEARNING OBJECTIVE 419 420 CHAPTER 12 because more euros can be purchased by one dollar than when the liability was first recorded A loss results if the dollar weakens, because fewer euros can be purchased by one dollar than when the liability was first recorded When the liability is paid, a gain (when the liability is smaller since the last financial statement date) or loss (when the liability is larger than at the last financial statement date) is recorded because the liability is paid at the spot rate on the payment date Typically, companies arrange with banks to handle the conversion The bank charges the company’s bank account in dollars (including a transaction fee) and transfers foreign currency to the payee’s account Sales Denominated in Foreign Currency On December 15, 2011, ATC sold merchandise to Rome Company for 20,000 euros, when the spot rate for euros was $0.6625 ATC closed its books on December 31, when the spot rate was $0.6550, collected the account on January 15, 2012, when the spot rate was $0.6700, and held the euros until January 20, when it converted the euros into U.S dollars at the $0.6725 spot rate in effect on that date ATC records the transactions as follows: December 15, 2011 Accounts receivable (fc) (+A) Sales (+R, +SE) To record sales to Rome (20,000 euros * $0.6625 spot rate) $13,250 $13,250 December 31, 2011 Exchange loss (+Lo, -SE) Accounts receivable (fc) (-A) To adjust accounts receivable at year-end [20,000 euros * ($0.6550 - $0.6625)] $ $ January 15, 2012 Cash (fc) (+A) Accounts receivable (fc) (-A) Exchange gain (+Ga, +SE) To record collection in full from Rome (20,000 euros × $0.6700 ) and recognize exchange gain for 2012 [20,000 euros * ($0.6700 - $0.6550)] 12/15/11 (initial transaction date) 12/31/11* (financial statement date) 1/15/12 (collection of accounts receivable in euros) 1/20/12 (conversion of euros to dollars) Overall 150 $13,400 $13,100 300 January 20, 2012 Cash (+A) Exchange gain (+Ga, +SE) Cash (fc) (-A) To convert 20,000 euros into U.S dollars (20,000 euros * $0.6725) Date 150 $13,450 $ 50 13,400 Spot Rate Accounts Receivable 20,000 Euros Sales Gain (Loss) $0.6625 $0.6550 $0.6700 $13,250 $13,100 $13,400 $13,250 Unchanged Unchanged — ($150) $300 $0.6725 $13,450 Unchanged $ 50 $200 *Sales are closed at year-end into retained earnings The term unchanged here means that no further adjustment of the sales amount is necessary because the sales amount was “locked in” when the accounts receivable and related sales were first recorded In summary, foreign currency–denominated sales must be measured in dollars at the sales date using the foreign currency spot rate on that date Derivatives and Foreign Currency: Concepts and Common Transactions If a financial statement date occurs before the receivable is paid, the accounts receivable must be remeasured to reflect the spot rate at the financial statement date A gain results when the dollar has weakened because the foreign currency to be received is worth more dollars than when initially recorded A loss results when the dollar has strengthened because the foreign currency to be received is worth less in dollars than when it was originally recorded When the receivable is paid, a gain or loss is recorded because the receivable will be paid at the spot rate on the payment date If a company holds foreign currency for a period of time for speculative purposes after a receivable is paid instead of converting it into dollars, gains and losses continue to be reported at each financial statement date until the foreign currency is converted into dollars SUMMARY OF DIRECT RATE CHANGES ($ PER CURRENCY UNIT) ON THE CARRYING VALUE OF FOREIGN CURRENCY–DENOMINATED ACCOUNTS RECEIVABLE AND ACCOUNTS PAYABLE Spot Rate Change Effect on the Dollar Relative to the Foreign Currency Impact on Foreign Currency– Denominated Account Increases Dollar weaker Increases Dollar weaker Decreases Dollar stronger Decreases Dollar stronger Accounts receivable Accounts payable Accounts receivable Accounts payable Increases—Gain Increases—Loss Decreases—Loss Decreases—Gain International Accounting Standards IFRS [3] addresses how to include foreign currency transactions and foreign operations in the financial statements Like GAAP [2], IFRS requires that transactions be recorded initially at the rate of exchange at the date of the transaction At each subsequent balance sheet date, foreign currency monetary amounts (such as foreign currency–denominated accounts receivables and payables) should be marked to the spot rate at the balance sheet date Again, similar to GAAP, gains and losses from differences between the initial amount recorded and the year-end value for these monetary assets and liabilities are included in current year income SUMMARY Derivatives are a widely-used mechanism to manage various risks Because of their flexibility to isolate one type of risk, and manage risks with low costs, they have become very popular tools for hedging strategies This chapter explains the types and uses of derivatives, while Chapter 13 covers the accounting for derivatives and hedging activity International accounting is concerned with accounting for foreign currency transactions and operations An entity’s functional currency is the currency of the primary environment in which the entity operates Foreign currency transactions are denominated in a currency other than an entity’s functional currency Foreign currency transactions (other than forward contracts) are measured and recorded in U.S dollars at the spot rate in effect at the transaction date A change in the exchange rate between the date of the transaction and the settlement date results in an exchange gain or loss that is reflected in income for the period At the balance sheet date, any remaining balances that are denominated in a currency other than the functional currency are adjusted to reflect the current exchange rate, and the gain or loss is charged to income QUESTIONS Define the term derivative and provide examples of risks that derivative contracts are designed to reduce Explain the differences between forward contracts and futures contracts and the potential benefits and potential costs of each type of contract 421 422 CHAPTER 12 Explain the differences between options and swaps and the potential benefits and potential costs of each type of contract What does “Net Settlement” mean? Distinguish between measurement and denomination in a particular currency Assume that one euro can be exchanged for 1.20 U.S dollars What is the exchange rate if the exchange rate is quoted directly? Indirectly? What is the difference between official and floating foreign exchange rates? Does the United States have floating exchange rates? What is a spot rate with respect to foreign currency transactions? Could a spot rate ever be a historical rate? Could a spot rate ever be a fixed exchange rate? Discuss Assume that a U.S corporation imports electronic equipment from Japan in a transaction denominated in U.S dollars Is this transaction a foreign currency transaction? A foreign transaction? Explain the difference between these two concepts and their application here 10 How are assets and liabilities denominated in foreign currency measured and recorded at the transaction date? At the balance sheet date? 11 Criticize the following statement: “Exchange losses arise from foreign import activities, and exchange gains arise from foreign export activities.” 12 When are exchange gains and losses reflected in a business’s financial statements? 13 A U.S corporation imported merchandise from a British company for £1,000 when the spot rate was $1.45 It issued financial statements when the current rate was $1.47, and it paid for the merchandise when the spot rate was $1.46 What amount of exchange gain or loss will be included in the U.S corporation’s income statements in the period of purchase and in the period of settlement? EXERCISES E 12-1 What is a characteristic of a forward? a Traded on an exchange b Negotiated with a counterparty c Covers a stream of future payments d Must be settled daily What is a characteristic of a swap? a Traded on an exchange b Only interest rates can be the underlying c Covers a stream of future payments d Must be settled daily What is a characteristic of a future? a Gives the holder the right but not the obligation to buy or sell b Negotiated with a counterparty c Covers a stream of future payments d Must be settled daily What is a characteristic of a option? a Gives the holder the right but not the obligation to buy or sell b Negotiated with a counterparty c Covers a stream of future payments d Must be settled daily E 12-2 Which is true about the seller of a put option? a They have the right to buy the underlying b They have the right to sell the underlying c They have the obligation to buy the underlying d They have the obligation to sell the underlying Which is true about the holder of a call option? a They have the right to buy the underlying b They have the right to sell the underlying c They have the obligation to buy the underlying d They have the obligation to sell the underlying Derivatives and Foreign Currency: Concepts and Common Transactions Which is true about the seller of a call option? a They have the right to buy the underlying b They have the right to sell the underlying c They have the obligation to buy the underlying d They have the obligation to sell the underlying Which is true about the holder of a put option? a They have the right to buy the underlying b They have the right to sell the underlying c They have the obligation to buy the underlying d They have the obligation to sell the underlying E 12-3 Quotation conventions, measurement versus denomination If $1.5625 can be exchanged for British pound, the direct and indirect exchange rate quotations are: a $1.5625 and British pound, respectively b $1.5625 and 0.64 British pounds, respectively c $1.00 and 1.5625 British pounds, respectively d $1.00 and 0.64 British pounds, respectively A U.S firm purchases merchandise from a Canadian firm with payment due in 60 days and denominated in Canadian dollars The U.S firm will report an exchange gain or loss on settlement if the transaction is: a Recorded in U.S dollars b Measured in U.S dollars c Not hedged through a forward contract d Settled after an exchange rate change has occurred Exchange gains and losses on accounts receivable and payable that are denominated in a foreign currency are: a Accumulated and reported upon settlement b Deferred and treated as transaction price adjustments c Reported as equity adjustments from translation d Recognized in the periods in which exchange rates change E 12-4 Accounting for foreign currency–denominated purchases Zimmer Corporation, a U.S firm, purchased merchandise from Taisho Company of Japan on November 1, 2011, for 10,000,000 yen, payable on December 1, 2011 The spot rate for yen on November was $0.0075, and on December the spot rate was $0.0076 REQUIRED Did the dollar weaken or strengthen against the yen between November and December 1, 2011? Explain On November 1, 2011, at what amount did Zimmer record the account payable to Taisho? On December 1, 2011, Zimmer paid the 10,000,000 yen to Taisho Prepare the journal entry to record settlement of the account on Zimmer’s books If Zimmer had chosen to hedge its exposed net liability position on November 1, would it have entered a forward contract to purchase yen for future receipt or to sell yen for future delivery? Explain E 12-5 Accounting for foreign currency–denominated purchases settled in subsequent year On December 16, 2011, Aviator Corporation, a U.S firm, purchased merchandise from Wing Company for 30,000 euros to be paid on January 15, 2012 Relevant exchange rates for euros are as follows: December 16, 2011 December 31, 2011 January 15, 2012 $1.20 $1.25 $1.24 R E Q U I R E D : Prepare all journal entries on Aviator Corporation’s books to account for the purchase on December 16, adjustment of the books on December 31, and payment of the account payable on January 15 423 424 CHAPTER 12 E 12-6 Accounting for foreign currency–denominated sales settled in subsequent year On November 16, 2011, Wick Corporation of the United States sold inventory items to Candle Ltd of Canada for 90,000 Canadian dollars, to be paid on February 14, 2012 Exchange rates for Canadian dollars on selected dates are as follows: November 16, 2011 December 31, 2011 February 14, 2012 $0.80 $0.84 $0.83 R E Q U I R E D : Determine the exchange gain or loss on the sale to Candle Ltd to be included in Wick’s income statement for the years 2011 and 2012 E 12-7 Accounting for foreign currency–denominated sales Door Corporation, a U.S company, sold inventory items to Royal Cabinets Ltd of Great Britain for £200,000 on May 1, 2011, when the spot rate was 0.6000 pounds The invoice was paid by Royal on May 30, 2011, when the spot rate was 0.6050 pounds R E Q U I R E D : Prepare Door’s journal entries for the sale to Royal on May and receipt of the £200,000 on May 30 E 12-8 [Based on AICPA] Various foreign currency–denominated transactions On September 1, 2011, Bain Corporation received an order for equipment from a foreign customer for 300,000 euros, when the U.S dollar equivalent was $400,000 Bain shipped the equipment on October 15, 2011, and billed the customer for 300,000 euros when the U.S dollar equivalent was $420,000 Bain received the customer’s remittance in full on November 16, 2011, and sold the 300,000 euros for $415,000 In its income statement for the year ended December 31, 2011, what should Bain report as a foreign exchange gain or loss? On September 22, 2011, Yumi Corporation purchased merchandise from an unaffiliated foreign company for 10,000 euros On that date, the spot rate was $1.20 Yumi paid the bill in full on March 20, 2012, when the spot rate was $1.30 The spot rate was $1.24 on December 31, 2011 What amount should Yumi report as a foreign currency transaction gain or loss in its income statement for the year ended December 31, 2011? On July 1, 2011, Clark Company borrowed 1,680,000 pesos from a foreign lender by signing an interest-bearing note due on July 1, 2012, which is denominated in pesos The U.S dollar equivalent of the note principal was as follows: July 1, 2011 (date borrowed) December 31, 2011 (Clark’s year-end) July 1, 2012 (date paid) $210,000 240,000 280,000 In its income statement for 2012, what amount should Clark include as a foreign exchange gain or loss? On July 1, 2011, Stone Company lent $120,000 to a foreign supplier by accepting an interest-bearing note due on July 1, 2012 The note is denominated in the currency of the borrower and was equivalent to 840,000 pesos on the loan date The note principal was appropriately included at $140,000 in the receivables section of Stone’s December 31, 2011, balance sheet The note principal was repaid to Stone on the July 1, 2012, due date, when the exchange rate was pesos to $1 In its income statement for the year ended December 31, 2012, what amount should Stone include as a foreign currency transaction gain or loss? E 12-9 Various foreign currency–denominated transactions settled in subsequent year Monroe Corporation imports merchandise from some Canadian companies and exports its own products to other Canadian companies The unadjusted accounts denominated in Canadian dollars at December 31, 2011, are as follows: Account receivable from the sale of merchandise on December 16 to Carver Corporation Billing is for 150,000 Canadian dollars and due January 15, 2012 Account payable to Forest Corporation for merchandise received December and payable on January 30, 2012 Billing is for 275,000 Canadian dollars $103,500 $195,250 Derivatives and Foreign Currency: Concepts and Common Transactions Exchange rates on selected dates are as follows: December 31, 2011 January 15, 2012 January 30, 2012 $0.68 $0.675 $0.685 REQUIRED Determine the net exchange gain or loss from the two transactions that will be included in Monroe’s income statement for 2011 Determine the exchange gain or loss from settlement of the two transactions that will be included in Monroe’s 2012 income statement E 12-1 Various foreign currency–denominated transactions settled in subsequent year American TV Corporation had two foreign currency transactions during December 2011, as follows: December 12 December 15 Purchased electronic parts from Toko Company of Japan at an invoice price of 50,000,000 yen when the spot rate for yen was $0.00750 Payment is due on January 11, 2012 Sold television sets to British Products Ltd for 40,000 pounds when the spot rate for British pounds was $1.65 The invoice is denominated in pounds and is due on January 14, 2012 REQUIRED Prepare journal entries to record the foregoing transactions Prepare journal entries to adjust the accounts of American TV Corporation at December 31, 2011, if the current exchange rates are $0.00760 and $1.60 for Japanese yen and British pounds, respectively Prepare journal entries to record payments to Toko Company on January 11, 2012, when the spot rate for Japanese yen is $0.00765, and to record receipt from British Products Ltd on January 14, 2012, when the spot rate for British pounds is $1.63 E 12-11 Accounting for speculative hedges Martin Corporation, a U.S import–export firm, enters into a forward contract on October 2, 2011, to speculate in euros The contract requires Martin to deliver 1,000,000 euros to the exchange broker on March 31, 2012 Quoted exchange rates for euros are as follows: Spot rate 30-day forward rate 90-day forward rate 180-day forward rate 10/2/11 12/31/11 3/31/12 $0.6590 0.6580 0.6560 0.6530 $0.6500 0.6450 0.6410 0.6360 $0.6550 0.6500 0.6460 0.6400 R E Q U I R E D : Prepare the journal entries on Martin’s books to account for the speculation throughout the life of the contract PROBLEMS P12-1 The Economics of derivatives On June 1, 2011, TCO enters into a forward agreement with XYZ to buy 100,000 gallons of fuel oil at $2.40 on December 31, 2011 At the time of inception of the forward, the price of fuel oil is $2.45 On December 31, 2011 the price of fuel oil is $2.48 The contract allows for net settlement REQUIRED What is the net settlement on the forward contract? 425 426 CHAPTER 12 P12-2 The Economics of derivatives In July of 2011, Sue enters into a forward agreement with Ann to lock in a sales price for wheat Sue anticipates selling 300,000 bushels of wheat at the market in March of 2012 Ann agrees to a forward with Sue to buy 300,000 bushels at $6.20 Sue’s cost for the wheat is $45.90 per bushel The contract allows for net settlement REQUIRED Determine the economic income of the sales transaction at various price levels at maturity for the forward Consider market prices of $6.00, $6.10, $6.20, $6.30, and $6.40 Make a table similar to the Gre copper example found in the chapter P12-3 The economics of derivatives Consider the same basic facts as in P12-2, but instead of a forward contract Sue purchases put options to sell 300,000 bushels at $6.20 per bushel The options cost $0.05 a bushel REQUIRED Determine the economic income of the sales transaction at various price levels at maturity for the forward Consider market prices of $6.00, $6.10, $6.20, $6.30, and $6.40 Make a table similar to the Gre copper example P 12-4 Accounting for foreign currency–denominated receivables and payables—multiple years The accounts of Lincoln International, a U.S corporation, show $81,300 accounts receivable and $38,900 accounts payable at December 31, 2011, before adjusting entries are made An analysis of the balances reveals the following: Accounts Receivable Receivable denominated in U.S dollars Receivable denominated in 20,000 Swedish krona Receivable denominated in 25,000 British pounds Total $28,500 11,800 41,000 $81,300 Accounts Payable Payable denominated in U.S dollars Payable denominated in 10,000 Canadian dollars Payable denominated in 15,000 British pounds Total $ 6,850 7,600 24,450 $38,900 Current exchange rates for Swedish krona, British pounds, and Canadian dollars at December 31, 2011, are $0.66, $1.65, and $0.70, respectively REQUIRED Determine the net exchange gain or loss that should be reflected in Lincoln’s income statement for 2011 from year-end exchange adjustments Determine the amounts at which the accounts receivable and accounts payable should be included in Lincoln’s December 31, 2011 balance sheet Prepare journal entries to record collection of the receivables in 2012 when the spot rates for Swedish krona and British pounds are $0.67 and $1.63, respectively Prepare journal entries to record settlement of accounts payable in 2012 when the spot rates for Canadian dollars and British pounds are $0.71 and $1.62, respectively P 12-5 Foreign currency–denominated receivables and payables—multiple years Shelton Corporation of New York is an international dealer in jewelry and engages in numerous import and export activities Shelton’s receivables and payables in foreign currency units before year-end adjustments on December 31, 2011, are summarized as follows: Derivatives and Foreign Currency: Concepts and Common Transactions Foreign Currency Currency Units Rate on Date of Transaction Per Books in U.S Dollars Current Rate on 12/31/11 $165,000 165,000 105,600 15,000 $450,600 $1.6600 0.6700 0.6400 0.0076 $105,000 28,600 33,300 $166,900 $0.6900 0.1350 0.0076 Accounts Receivable Denominated in Foreign Currency British pounds Euros Swedish krona Japanese yen 100,000 250,000 160,000 2,000,000 $1.6500 0.6600 0.6600 0.0075 Accounts Payable Denominated in Foreign Currency Canadian dollars 150,000 $0.7000 Mexican pesos 220,000 0.1300 Japanese yen 4,500,000 0.0074 REQUIRED Determine the amount at which the receivables and payables should be reported in Shelton’s December 31, 2011, balance sheet Calculate individual gains and losses on each of the receivables and payables and the net exchange gain that should appear in Shelton’s 2011 income statement Assume that Shelton wants to hedge its exposure to amounts denominated in euros Should it buy or sell euros for future delivery? In what amount or amounts? INTERNET EXERCISE Go to the CNBC.com Web site and navigate to the commodities page Click on a specific commodity link next to the “more contracts” label How many types of commodities are available for trading? How far into the future can you trade on the prices of these commodities? Which types of commodities are expected to have increasing (decreasing) prices in the future? R E F E R E N C E S T O T H E A U T H O R I TAT I V E L I T E R AT U R E [1] FASB ASC 815 “Derivatives and Hedging.” Originally Statement of Financial Accounting Standards No 133 “Accounting for Derivative Instruments and Hedging Activities.” Stamford, CT: Financial Accounting Standards Board, 1998 [2] FASB ASC 830 “Foreign Currency Matters.” Originally Statement of Financial Accounting Standards No 52 “Foreign Currency Translation.” Stamford, CT: Financial Accounting Standards Board, 1981 [3] IASC International Accounting Standard 21 “The Effects of Changes in Foreign Exchange Rates.” International Accounting Standards Committee, 2003 427 This page intentionally left blank ... 10 20 30 10 0 15 0 15 0 $460 $ 90 10 0 300 10 0 11 0 $700 $ 90 90 $ 30 60 10 0 80 30 $300 $ 30 70 On January 1, 2 011 , Pub Corporation acquired all of Sun’s outstanding stock for $300,000 Pub paid $10 0,000... Finance 50,622 67,008 66,3 01 Consumer & Industrial 9,703 11 ,737 12 ,663 Corporate items and eliminations 1, 414 1, 914 4,609 $15 6,783 $18 2, 515 $17 2,488 Total The note goes on to provide similar detailed... stock, $10 par Other paid-in capital Retained earnings Total equities Sun Corporation Fair Value Book Value Fair Value $11 5 40 12 0 45 200 18 0 $700 $11 5 40 15 0 10 0 300 245 $950 $ 10 20 50 30 10 0 90