Advanced accounting, 5th edition international student version ch12

12 12 Accounting for Foreign Currency Transactions and Hedging Foreign Exchange Risk Advanced Accounting, Fifth Edition Slide 12-1 Learning Learning Objectives 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 Slide 12-2 Describe a forward exchange contract Learning Learning Objectives Objectives Slide 12-3 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 Foreign Foreign Currency Currency Transactions Transactions Many U.S companies engage in international activities such as: Exporting or importing goods, Establishing a foreign branch, or Holding an equity investment in a foreign company Slide 12-4 Foreign Foreign Currency Currency Transactions Transactions 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 Slide 12-5 Exchange Exchange Rates—Means Rates—Means of of Translation 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 Slide 12-6 Exchange Exchange Rates—Means Rates—Means of of Translation 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 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) Slide 12-7 Exchange Exchange Rates—Means Rates—Means of of Translation 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 Forward Exchange Contract Contract to exchange currencies of different countries on a stipulated future date, at a specified rate (the forward rate) Slide 12-8 Exchange Exchange Rates—Means Rates—Means of of Translation 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 Yen Direct rate Payable Slide 12-9 Transaction Date 100,000 $ 0.00434 $ 434.00 Change in Rate Settlement Date 100,000 $ 0.00625 $ 625.00 Measured Measured Versus Versus Denominated Denominated 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 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 Slide 12-10 LO Measured versus denominated Using Using Forward Forward Contracts Contracts as as aa Hedge Hedge Problem 12-2: Transaction Summary Transaction Hedged I tem Balance Gain/ (Loss) Accounts Payable Dec Hedge Balance Gain/ (Loss) FC Receivable $ 26,565 Dec 31 26,439 Apr 30,030 Total gain/ (loss) Transaction Dec $ 126 (3,591) $ (3,465) $ 27,594 Dec 31 27,468 Apr 30,030 $ (126) 2,562 $ 2,436 Thus the net effect is a $1,029 loss when the forward contract is used Slide 12-34 LO Forward contracts as a hedge Using Using Forward Forward Contracts Contracts as as aa Hedge Hedge Hedge of a Foreign Currency Exposed Asset 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 Slide 12-35 LO Forward contracts as a hedge Using Using Forward Forward Contracts Contracts as as aa Hedge Hedge Fair Value Hedge—Hedging an Unrecognized Foreign Currency Commitment  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 Slide 12-36 LO Forward contracts as a hedge Using Using Forward Forward Contracts Contracts as as aa Hedge Hedge Exercise 12-14: Consider the following information: 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 On December 1, 2008, the company enters into a forward contract to sell 10,000 pesos for $9.48 on March 1, 2009 Spot rates and the forward rates for March 1, 2009, settlement were as follows (dollars per peso): December 1, 2008 Balance sheet date (12/31/08) March 1, 2009 Spot Rate $9.54 9.49 9.47 Forward Rate $9.48 9.44 On March 1, the equipment was sold for 10,000 pesos The Slide cost of the equipment was $40,000 LO Forward contracts as a hedge 12-37 Using Using Forward Forward Contracts Contracts as as aa Hedge Hedge Exercise 12-14: Prepare all journal entries needed on December 1, December 31, and March 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 Dec31 FC Payable from Exchange Dealer** 400 Foreign Exchange Gain 400 Foreign Exchange Loss 400 Firm Commitment** * (10,000 x $9.48 = $94,800) 400 ** [(10,000 x ($9.48 - $9.44)] = $400 Slide 12-38 LO Forward contracts as a hedge Using Using Forward Forward Contracts Contracts as as aa Hedge Hedge Exercise 12-14: Prepare all journal entries needed on December 1, December 31, and March to account for the forward contract, the firm commitment, and the transaction to sell the equipment Mar Foreign Exchange Loss 300 FC Payable from Exchange Dealer* 300 Firm Commitment* Foreign 300 Exchange Gain 300 Investment in FC 94,700 Firm Commitment * [(10,000 ´ ($9.44 - $9.47)] =$300 Sales (10,000 x Slide 12-39 94,800 100 9.48) LO Forward contracts as a hedge Using Using Forward Forward Contracts Contracts as as aa Hedge Hedge Exercise 12-14: Prepare all journal entries needed on December 1, December 31, and March to account for the forward contract, the firm commitment, and the transaction to sell the equipment Mar Cash 94,800 FC Payable to Exchange Dealer Investment in 94,700 FC 94,700 Dollars Receivable from Exchange Dealer 94,800   Cost of Goods Sold 40,000 Inventory Slide 12-40 40,000 LO Forward contracts as a hedge Using Using Forward Forward Contracts Contracts as as aa Hedge Hedge Cash Flow Hedge-A Forecasted Transaction  Cash Flow Hedge - hedging cash flows for future transactions that have not yet occurred or for which there are no firm commitments  Cash flow hedges may defer the Income statement recognition of gains and losses on forecasted transactions if certain criteria are met  Amounts in accumulated other comprehensive income are reclassified into earnings in the same period which the hedged forecasted transaction affects earnings Slide 12-41 LO Fair value hedge vs cash flow hedge Using Using Forward Forward Contracts Contracts as as aa Hedge Hedge Exercise 12-13: Consider the following information: On December 1, 2008, a U.S firm plans to purchase a piece of equipment (with an asking price of 100,000 francs) in Switzerland during January of 2009 The transaction is probable, and the transaction is to be denominated in euros On December 1, 2008, the company enters into a forward contract to buy 100,000 francs for $1.01 on January 31, 2009 Spot rates and the forward rates for January 31, 2009, settlement were as follows (dollars per francs): December 1, 2008 Balance sheet date (12/31/08) Slide Jan 31 and Feb 1, 2009 12-42 Spot Rate $0.99 1.01 1.04 Forward Rate $1.01 1.02 LO Fair value hedge vs cash flow hedge Using Using Forward Forward Contracts Contracts as as aa Hedge Hedge Exercise 12-13: Prepare all journal entries needed on Dec 1, Dec 31, Jan 31, and Feb to account for the forecasted transaction, the forward contract, and the transaction to buy the equipment Dec.1 FC Receivable from Exchange Dealer 101,000 Dollars Payable to Exchange Dealer* 101,000 Dec.31 FC Receivable from Exchange Dealer** 1,000 Foreign Exchange Gain – OCI 1,000 * (100,000 x $1.01) = $101,000 ** [(100,000 x ($1.01- $1.02)] = $1,000 Slide 12-43 LO Fair value hedge vs cash flow hedge Using Using Forward Forward Contracts Contracts as as aa Hedge Hedge Exercise 12-13: Prepare all journal entries needed on Dec 1, Dec 31, Jan 31, and Feb to account for the forecasted transaction, the forward contract, and the transaction to buy the equipment Jan.31 FC Receivable from Exchange Dealer 2,000 Foreign Exchange Gain – OCI 2,000 [(100,000 ´ ($1.02- $1.04)]   Slide 12-44 Investment in FC 104,000 Dollars Payable to Exchange Dealer 101,000 Cash 101,000 FC Receivable from Exchange Dealer 104,000  Feb Equipment LO Fair value hedge vs cash flow hedge 104,000 Using Using Forward Forward Contracts Contracts as as aa Hedge Hedge Economic Hedge of a Net Investment in a Foreign Entity  A U.S firm may enter into a foreign currency transaction or a nonderivative financial instrument in an effort to minimize or offset the effects of currency fluctuations on an equity investment in a foreign company  The gain or loss on the hedging instrument is reported in the same manner as the translation adjustment, that is, reported in the cumulative translation adjustment section under comprehensive Slide income FASB ASC paragraph 815-35-35-1 LO Fair value hedge vs cash flow hedge 12-45 LO Fair value hedge vs cash flow hedge Using Using Forward Forward Contracts Contracts as as aa Hedge Hedge Forward Contracts Acquired to Speculate in the Movement of Foreign Currencies A forward contract may be acquired for speculative purposes in anticipation of realizing a gain Disclosure Requirements of the Various Hedges FASB ASC Section 815-20-50 specifies certain minimal disclosures for derivative instruments and nonderivative instruments designated as qualifying hedging instruments Slide 12-46 LO Fair value hedge vs cash flow hedge LO Common transactions Using Using Forward Forward Contracts Contracts as as aa Hedge Hedge Using Options to Hedge Foreign Currency Changes  Options, give the holder the advantage of right but not the obligation to buy or sell the currency  If the exchange rate changes in a negative manner, the firm can simply let the option lapse without a loss Slide 12-47 LO Derivatives used as a hedge Copyright Copyright Copyright © 2011 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein Slide 12-48 ... hedges Foreign Foreign Currency Currency Transactions Transactions Many U.S companies engage in international activities such as: Exporting or importing goods, Establishing a foreign branch, or