FOREIGN CURRENCY TRANSACTIONS

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FOREIGN CURRENCY TRANSACTIONS

• Chapter 5

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Foreign Currency Transaction

• Foreign currency transaction a transaction in a
  currency other than the one in which the
  financial records are maintained
• Currency to be exchanged generally a negotiated
  term
• Denominated currency expressed currency in
  which a transaction is to be completed

3
Exchange Rates

• Ratio at which one currency can be converted into
  another currency
• Rates may be determined by government issuing the
  currency (fixed rate) or by market conditions
  (floating rate)

4
Fixed Exchange Rates

• May be established to accomplish specific
  objectives such as encouraging export trade
• Official exchange rate ay differ for different
  types of transactions

5
Floating Exchange Rates

• Values of currencies fluctuate based on supply
  and demand
• Supply and demand for a currency depend partially
  on
• Interest rate differences between economies
• Balance of trade differences
• Political stability
• Anticipated inflation

6
Direct / Indirect Exchange Rates

• Relationship between two currencies is stated in
  terms of either currency
• Indirect number of foreign currency units to
  acquire one unit of domestic currency
• 1.00 1.55 Swiss francs
• Direct number of domestic currency units
  required to acquire one unit of the foreign
  currency 1 Swiss franc 0.645
• The reciprocal of one rate is the other rate

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Spot Rate

• Exchange rate that exists for an immediate
  exchange of currency

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Recording a Purchase or Sale Denominated in a
Foreign Currency

• Transaction recorded at SPOT RATE even if
  currency wont be exchanged until later date
• Spot rate currencys value at transaction date
  best estimate of currencys future value
• Potential future changes in value not recognized
  because direction and amount are not predictable

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Payment After Transaction Date (No Balance Sheet
Date)

• Economic value of currency to be exchanged may
  change subsequent to the initial transaction date
• Any change in value is recognized as a gain or
  loss in the period in which the exchange of
  currency occurs

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Settlement Date

• Date on which the foreign currency transaction is
  satisfied through transfer of currency

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Monetary Accounts

• Accounts fixed in units of currency. Examples
• Accounts Receivable
• Accounts Payable
• Notes Payable

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Payment After Transaction Date (Balance Sheet
Date)

• Monetary account balance is an estimate of
  economic value to be exchanged
• Monetary account balance is adjusted to reflect
  change in estimated value

13
Hedging

• The use of a financial instrument contract to
  eliminate exchange rate fluctuation risk
• Two common ways to hedge
• Forward contract
• Option contract

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Forward Contract

• Agreement to exchange currency at a future date
  at a guaranteed exchange rate (Forward Rate)
• Eliminates risk associated with exchange rate
  fluctuations
• Cost of entering contract often negligible
• Contract can be for any number of currency units
  settlement on any date

15
Option Contract

• Two parties to the agreement
• Writer guarantees an exchange of currencies at
  agreed price (strike price)
• Holder has the right, but not obligation, to
  exchange currencies
• Writer exchanges currencies with holder at a
  predetermined rate only if holder chooses to
  exercise the option

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Option Contract

• Holder avoids unfavorable exchange rate movement
• Option contracts are offered in fixed sizes
  (e.g., 62,500 euros)
• Two types of options
• Call holder has the right to purchase currency
• Put holder has the right to sell currency

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Option Contract

• Holder pays premium to writer premium size
  depends on strike price and contract length
• More favorable strike price to holder demands
  higher premium
• Potential gain to holder is infinite loss
  limited to premium
• Amount of premium sets the writers maximum gain,
  possible loss is infinite

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Accounting for Forward Contract Hedge

• Two series of entries
• Underlying transaction
• Forward contract (hedge)
• Transaction date
• Entry for underlying transaction
• No entry for forward contract, executory contract

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Forward Contract Accounting

• Balance sheet date
• Revalue payable or receivable on underlying
  transaction to new spot rate, gain or loss to
  income statement
• Revalue forward contract to fair value to new
  forward exchange rate, gain or loss to income
  statement

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Forward Contract Accounting

• Settlement date
• Revalue transaction payable or receivable and
  forward contract
• Settle obligation
• Write off both payable or receivable, and
  forward contract
• Pay or receive cash to/from foreign currency
  exchange broker

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Accounting for Option Hedge

• Two series of entries
• Underlying transaction
• Option contract (hedge)
• Transaction date
• Entry for underlying transaction
• Entry for option contract for premium paid to
  writer (initial option contract market value)

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Option Hedge Accounting

• Balance sheet date
• Revalue payable or receivable on underlying
  transaction to new spot rate, gain or loss to the
  income statement
• Revalue option contract to new fair value, gain
  or loss to the income statement

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Option Hedge Accounting

• Settlement date
• Revalue payable or receivable and option contract
  
• Settle obligation
• Write off both payable or receivable and option
  contract
• Pay or receive cash to/from foreign currency
  exchange broker

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Foreign Currency Commitment

• Agreement to buy or sell goods denominated in a
  fixed number of foreign currency units at some
  time in the future
• Foreign currency commitment period
• Begins date of the agreement to buy or sell ends
  when the item is purchased or sold

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Foreign Currency Commitment

• Hedging a commitment eliminates the currency risk
  resulting from a transaction that has not
  occurred
• Key issue offsetting gains and losses on
  forward or option contract and purchase or sales
  commitment

26
Foreign Currency Commitment

• Accounting issue
• Gain or loss on hedging instrument (forward or
  option contract) is recognized at balance sheet
  date(s) and transaction date
• Offsetting loss or gain on purchase or sales
  commitment is recognized
• No impact on net income

27
Forward Contract Hedge of Foreign Currency
Commitment

• Two series of entries
• Underlying transaction
• Forward contract (hedge)
• Commitment date
• No entry for purchase or sales commitment,
  executory contract
• No entry for forward contract, executory contract

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Forward Contract Hedge of Foreign Currency
Commitment

• Balance sheet date
• Revalue forward contract and commitment in same
  manner as on balance sheet date forward exchange
  rate, gain or loss to the income statement
• Recognize loss or gain on purchase or sales
  commitment in same dollar amount as the forward
  contract adjustment

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Forward Contract Hedge of Foreign Currency
Commitment

• Transaction date
• Revalue forward contract and commitment in same
  manner as on a balance sheet date
• Recognize sale at spot rate
• Close purchase or sales commitment to sales or
  asset acquired

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Option Contract Hedge of Foreign Currency
Commitment

• Two series of entries
• Underlying transaction
• Option contract (hedge)
• Commitment date
• No entry for purchase or sales commitment,
  executory contract
• Entry for option contract for premium paid to
  writer (initial option contract market value)

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Option Contract Hedge of Foreign Currency
Commitment

• Balance sheet date
• Revalue option contract to fair value, gain or
  loss to the income statement
• Recognize loss or gain on purchase or sales
  commitment in same dollar amount as the option
  contract adjustment

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Option Contract Hedge of Foreign Currency
Commitment

• Transaction date
• Revalue option contract and sales commitment in
  same manner as on a balance sheet date
• Recognize sale at spot rate
• Close purchase or sales commitment to sales or
  asset acquired

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Forecasted Transaction

• A transaction that is EXPECTED TO OCCUR based on
  a continuing relationship between the entities
• Key concept gains and losses on forward or
  option contract purchased to hedge a forecasted
  transaction reported in other comprehensive
  income until item is purchased or sold AND item
  impacts the income statement

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Forward Contract Hedge of Forecasted Transaction

• Hedge initiation
• No journal entry, executory contract
• Balance sheet date
• Revalue forward contract to fair value based on
  change in forward exchange rate, gain or loss to
  other comprehensive income

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Forward Contract Hedge of Forecasted Transaction

• Transaction date
• Revalue forward contract for change in forward
  exchange rate, gain/loss to other comprehensive
  income
• Recognize sale or purchase at spot rate

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Forward Contract Hedge of Forecasted Transaction

• Transaction date
• Sales transactions close other comprehensive
  income as adjustment to Sales when forecasted
  sale occurs
• Inventory purchases close other comprehensive
  income as adjustment to cost of good sold when
  forecasted inventory purchase is sold

37
Option Contract Hedge of Forecasted Transaction

• Hedge initiation
• Entry for option contract for premium paid to
  writer (initial option contract market value)
• Balance sheet date
• Revalue option contract to fair value, gain or
  loss to other comprehensive income

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Option Contract Hedge of Forecasted Transaction

• Transaction date
• Revalue option contract to fair value, gain or
  loss to other comprehensive income
• Recognize sale at spot rate

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Option Contract Hedge of Forecasted Transaction

• Transaction date
• Sales transactions close other comprehensive
  income as adjustment to Sales when forecasted
  sale occurs
• Inventory purchases close other comprehensive
  income as adjustment to cost of good sold when
  forecasted inventory purchase is sold

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Speculative Contracts

• Foreign currency contracts entered into without
  intent to hedge an underlying transaction,
  commitment to a future transaction, or forecasted
  transaction

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Speculative Contracts (contd)

• Initiation
• Forward contract, no entry
• Option contract, entry for option contract for
  premium paid to writer (initial option contract
  market value)

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Speculative Contracts

• Balance sheet date revalue contract to fair
  value, gain or loss to income statement
• Settlement date
• Revalue contract to fair value (spot rate at
  maturity date)
• Settle obligation
• Write off on contract
• Exchange cash with foreign currency exchange
  broker