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LEARNING OUTCOME
After studying this chapter, you should be able to:
• LO1 Understand concepts related to foreign
currency, exchange rates, and foreign exchange
risk.
• LO2 Account for foreign currency transactions
using the two-transaction perspective, accrual
approach.
• LO3 Understand how foreign currency forward
contracts and foreign currency options can be
used to hedge foreign exchange risk.
• LO4 Account for forward contracts and options
used as hedges of foreign currency denominated
assets and liabilities.
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Terms
• Foreign currency: is the currency other than
local currency.
• Transactions: exchange of goods or service
between two parties in monetary terms.
• Foreign currency transactions: are transaction
between two parties using foreign currency
• The foreign exchange rate is the price at which
the foreign currency can be acquired.
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Exchange Rate Mechanisms
• Independent float: The value of the currency is
allowed to fluctuate freely according to market
forces with little or no intervention from the central
bank
• Pegged to another currency: The value of the
currency is fixed (pegged) in terms of a particular
foreign currency and the central bank intervenes as
necessary to maintain the fixed value.
• European Monetary System (euro): In 1998, the
countries comprising the European Monetary
System adopted a common currency called the
euro and established a European Central Bank.
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Foreign Exchange Rates
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Types of exchange rates
Foreign currency trades can be executed on:
1. Spot rates
2. Forward rates
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Spot Rates
• The spot rate is the price at which a foreign
currency can be purchased or sold today. There
are two types of spot rates:
i. Buying spot rates
ii. Selling spot rates
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Forward Rate
• forward rate is the price today at which
foreign currency can be purchased or sold
sometime in the future.
• Because many international business
transactions take some time to be completed,
the ability to lock in a price today at which
foreign currency can be purchased or sold at
some future date has definite advantages.
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Option Contracts
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• a call is for the purchase of foreign currency
by the holder of the option.
• The strike price is the exchange rate at which
the option will be executed if the option
holder decides to exercise the option.
• The strike price is similar to a forward rate.
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Accounting Alternatives
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Example 1
• Assume that Amerco, a U.S. company, sells goods to a
German customer at the price of 1 million Euros on
December 1, 2016. n/30.
• The exchange rates were as follows:
• De e er , ………………….$ .
• De e er , …………………$ .
Instruction
Record the above transaction assume that Amerco is:
1. Exporter
2. Importer
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Importer
• December 1
Merchandise invesntory ……….. , ,
A/P…………………………………………… , ,
December 31
A/P……………… ,
Gai o foreig urre y tra s…... ,
A/P……….. , ,
ash …………….. , ,
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We can summarize the relationship between
fluctuations in exchange rates and foreign exchange
gains and losses as follows:
Foreign Currency (FC)
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Balance Sheet Date before Date of Payment
• Assume that Amerco, a U.S. company, sells goods to a
German customer at the price of 1 million euros on
December 1, 2015. n/90.
The exchange rates for 1 euro were as follows:
• De e er , ………………….$ .
• De e er , ………………… .
• Mar h , ………………………… .
Instruction: pass the necessary journal entries on the
book of Ameroc company on:
1. December 1, 2016
2. December 31, 2016 (financial statement date)
3. March 1, 2017
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HEDGES OF FOREIGN
EXCHANGE RISK
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• To avoid this uncertainty due to foreign
exchange rate fluactuation, companies often
use foreign currency derivatives to hedge
against the effect of unfavorable changes in
the value of foreign currencies.
• The two most common derivatives used to
hedge foreign exchange risk are:
• foreign currency forward contracts
• foreign currency options.
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DERIVATIVES ACCOUNTING
• Topic 815, Derivatives and Hedging, of the
FASB Accounting Standards Codification
governs the accounting for derivatives,
including those used to hedge foreign
exchange risk.
This authoritative literature provides guidance
for hedges of the following sources of foreign
exchange risk:
• Recognized foreign currency denominated
assets and liabilities.
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Fundamental Requirement of Derivatives Accounting
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• In accordance with U.S. GAAP, gains
and losses arising from changes in the
fair value of derivatives are recognized
initially either
(1) on the income statement as a part
of net income or
(2) (2) on the balance sheet in
accumulated other comprehensive
income.
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HEDGE ACCOUNTING
• Companies enter into hedging relationships to minimize
the adverse effect that changes in exchange rates have
on cash flows and net income.
• U.S. GAAP allows hedge accounting for foreign currency
derivatives only if three conditions are satisfied:
• The derivative is used to hedge either a fair-value
exposure or cash flow exposure to foreign exchange risk.
• The derivative is highly effective in offsetting changes in
the fair value or cash flows related to the hedged item.
• The derivative is properly documented as a hedge.
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Nature of the Hedged Risk
• A fair-value exposure exists if changes in
exchange rates can affect the fair value of an
asset or liability reported on the balance sheet.
• To qualify for hedge accounting, the fair-value risk
must have the potential to affect net income if it
is not hedged.
• A cash flow exposure exists if changes in
exchange rates can affect the amount of cash
flow to be realized from a transaction with
changes in cash flow reflected in net income.
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• Derivatives for which companies wish to
use hedge accounting must be designated
as either a fair value hedge or a cash flow
hedge.
• In general,
• gains and losses on fair value hedges are
recognized immediately in net income,
• gains and losses on cash flow hedges are
included in accumulated other
comprehensive income. /AOCI/
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• HEDGES OF FOREIGN CURRENCY
DENOMINATED ASSETS AND
LIABILITIES
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• Hedges of foreign currency denominated
assets and liabilities, such as accounts
receivable and accounts payable, can qualify
as either:
• cash flow hedges or
• fair value hedges.
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Comprehensive Exercise
Assume that Amerco, a U.S. company, sells
goods to a German customer at the price of 1
million Euros on December 1, 2015. n/90.
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The relevant exchange rates, forward rates and option
premium are as follows:
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INSTRUCTIONS
Pass the necessary journal entries on
decemeber1, December 31 and march 1, 2012
on the book of AMERCO company under:
1. Forward contract using:
A. Cash flow hedging
B. Fair value hedging
2. Option contract using:
A. Cash flow hedging
B. Fairvalue hedging
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Solution table
Account Receivable (€) Forward Forward Contract
U.S. Dollar Change in Rate to Change in Fair
Spot U.S. Value Dollar Value 3/1/12 Value Fair Value
Date Rate
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The company prepares the following journal entries on
December 31:
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• The impact on net income for the year 2011 follows:
• Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,320,000
Foreign exchange gain. . . . . . . . . . . . $ 10,000
• Loss on forward contract . . . . . . . . . . (10,000)
• Net gain (loss). . . . . . . . . . . . . . . . . . . . . . . . . . . . –0–
• Discount expense. . . . . . . . . . . . . . . . . . . . . . . . . (5,019)
• Impact on net income. . . . . . . . . . . . . . . . . $1,314,981
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The effect on the December 31, 2011, balance
sheet is as follows:
$1,330,000
Retained earnings . . .. . . . 1,314,981
AOCI . . . . . . . . .. . . . . . 4,236
…………………………..$1,330,000
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2012 Journal Entries—Forward Contract Designated as Cash
Flow Hedge
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The impact on net income for the year 2012 follows:
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END FOR TODAY
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