Advanced accounting, 5th edition international student version ch12

Slide 12-25 Using Forward Contracts as a Hedge Using Forward Contracts as a Hedge Problem 12-2: Christel Exporting Co.. Slide 12-26 Using Forward Contracts as a Hedge Using Forward Contr

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Accounting for Foreign Currency Transactions and Hedging Foreign Exchange Risk

Advanced Accounting, Fifth Edition12

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12-2

1 Distinguish between the terms “measured” and

“denominated.”

2 Describe what is meant by a foreign currency transaction.

3 Understand some of the more common foreign currency

transactions.

4 Identify three stages of concern to accountants for foreign

currency transactions, and explain the steps used to translate foreign currency transactions for each stage.

5 Describe a forward exchange contract.

Learning Objectives

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6 Explain the use of forward contracts as a hedge of an

unrecognized firm commitment.

7 Identify some of the common situations in which a

forward exchange contract can be used as a hedge.

8 Describe a derivative instrument and understand how

it may be used as a hedge.

9 Explain how exchange gains and losses are reported

for fair value hedges and cash flow hedges.

Learning Objectives

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Foreign Currency Transactions

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Recording and reporting problems with foreign

currency transactions:

Transactions in a foreign currency must be

translated (expressed in dollars) 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

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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.

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Direct Exchange Rate

Units of domestic currency that can be converted into

into one unit of foreign currency 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

into one unit of domestic currency one unit of domestic currency

Indirect rate = 1.00/1.517 = 6592 ($1 U.S for 6592 British pound)

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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)

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Transaction Change Settlement

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Transactions are normally measured and recorded in

terms of the currency in which the reporting entity

prepares its financial statements

Reporting Currency - usually the currency where the company is located.

Measured Versus Denominated

LO 1 Measured versus denominated.

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

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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

LO 2 Foreign Currency Transactions.

Direct exchange rate

=

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LO 3 Common transactions.

LO 4 Three stages of concern.

Translating Accounts Denominated in Foreign

Balance sheet 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.

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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

Columbia firm

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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 (periodic method)

Sales23,400

Sales price in U.S dollars $ 23,400

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LO 3 Common transactions LO 4 Three stages of concern.

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

Accounts receivable 510

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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

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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

Taiwan firm

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Exercise 12-2: Dec 12, Purchased computer chips

from a company domiciled in Taiwan The contract was

denominated in 500,000 Taiwan dollars The direct

exchange spot rate on this date was $.0391 Prepare the journal entry on the books of Teletex Systems, Inc

Accounts payable19,550

Purchase price in Taiwan dollars 500,000 Direct exchange rate to U.S dollar x $.0391Purchase price in U.S dollars $ 19,550

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Exercise 12-2: Prepare journal entry necessary to

adjust the account as of December 31 Assume that on December 31 the direct exchange rates was Taiwan dollar

$.0351

Direct exchange rate to U.S dollar$ 0351

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Exercise 12-2: Prepare journal entry to record

settlement of account on January 10 Assume that the

direct exchange rate on the settlement date was Taiwan dollar $.0398

Accounts payable ($19,550 - $2,000)17,550

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 Foreign currency transaction gains and losses are included in net income.

 Two-transaction approach:

 The sale or purchase is viewed as a transaction separate from the financing arrangement.

 The dollar amount recorded (in Sales or in Purchases)

is determined by the exchange rate on the transaction date.

receivable or payable are recorded directly to the

transaction gain or loss and included in net income

Importing or Exporting of Goods or

Services

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Derivative Instrument - a financial instrument that

provides the holder (or writer) with the right (or

obligation) to participate in some or all of the price

changes of another underlying value of measure, but

does not require the holder to own or deliver the

underlying value of measure

Two broad categories:

Forward-basedOption-based

Hedging Foreign Exchange Rate Risk

Derivatives are recognized in the balance sheet at their fair value, resulting in a payable

position for one party and a

receivable position for the

other.

LO 8 Derivatives as a hedge.

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A forward exchange contract (forward contract) is an

agreement to exchange currencies of two different

countries at a specified rate (the forward rate) on a

stipulated

future date.

Forward Exchange Contracts

LO 5 Forward exchange contracts.

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1 Forward Contract used as a Hedge of a(n):

a Foreign currency transaction

b Unrecognized firm commitment (a fair value

hedge)

c Foreign-currency-denominated “forecasted”

transaction (a cash flow hedge)

d Net investment in foreign operations

Which Kind of Forward Contract to

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Using Forward Contracts as a Hedge

Problem 12-2: Christel Exporting Co is a U.S

wholesaler engaged in foreign trade The following

transaction is representative of its business dealings

The company uses a periodic inventory system and is on

a calendar-year basis All exchange rates are direct

quotations

Dec 1 Christel Exporting purchased merchandise from Chang’s Ltd., a Hong Kong manufacturer The invoice

was for 210,000 Hong Kong dollars, payable on April 1

On this same date, Christel Exporting acquired a forward contract to buy 210,000 Hong Kong dollars on April 1 for

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Problem 12-2: (additional facts)

April 1 Christel Exporting submitted full payment of

210,000 Hong Kong dollars to Chang’s, Ltd., after

obtaining the 210,000 Hong Kong dollars on its forward

contract

Spot rates and the forward rates for the Hong Kong

dollar were as follows:

Forward Rate for

Spot Rate ($) April 1 Delivery ($)

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Problem 12-2: Prepare journal entries for the

transactions including the necessary adjustments on

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December 31

Dec 1 FC Receivable from Exch Dealer 27,594

Dollars Payable to Exch Dealer27,594

LO 7 Forward contracts as a hedge.

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December 31

126

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December 31

126 FC Receivable from Exchange Dealer 126

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December 31

3,591

Payable established on Dec 31 26,439

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December 31

2,562 Transaction Gain 2,562

Payable established on Dec 31 27,468

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December 31

Apr 1 Investment in Foreign Currency30,030

Dollars Payable to Exch Dealer 27,594

Cash27,594

FC Receivable from Exch Dealer30,030

(payment to dealer and receipt of 210,000 Hong Kong dollars)

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Problem 12-2: Transaction Summary

Thus the net effect is a $1,029 loss when

the forward contract is used

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Accounting for a forward contract entered into as a

hedge of an exposed receivable position is similar to an exposed liability position

Because the U.S firm will be receiving foreign currency

in settlement of the exposed receivable balance, it will

enter into a forward contract to sell foreign currency for

U.S dollars

Hedge of a Foreign Currency Exposed

Asset

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 A U.S firm, at a date earlier than the transaction

date, may make a commitment to a foreign company

to buy or sell goods at a price established in foreign currency

 Changes in the exchange rate between the

commitment date and transaction date would be reflected in the cost or sales price of the asset

 The U.S firm may enter a forward contract to hedge

its commitment

Fair Value Hedge—Hedging an Unrecognized

Foreign Currency Commitment

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Exercise 12-14: Consider the following information:

1 On December 1, 2008, a U.S firm contracts to sell

equipment (with an asking price of 10,000 pesos) in

Mexico The firm will take delivery and will pay for the

equipment on March 1, 2009.

2 On December 1, 2008, the company enters into a forward

contract to sell 10,000 pesos for $9.48 on March 1, 2009.

3 Spot rates and the forward rates for March 1, 2009,

settlement were as follows (dollars per peso):

4 On March 1, the equipment was sold for 10,000 pesos The

cost of the equipment was $40,000.LO 7 Forward contracts as a hedge.

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Exercise 12-14: Prepare all journal entries needed on

December 1, December 31, and March 1 to account for the

forward contract, the firm commitment, and the transaction to sell the equipment.

Dec1 Receivable from Exchange Dealer * 94,800

FC Payable to Exchange Dealer 94,800

* (10,000 x $9.48 = $94,800)

** [(10,000 x ($9.48 - $9.44)] = $400

Dec31 FC Payable from Exchange Dealer ** 400

Foreign Exchange Gain 400

400

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