Chapter Seven

Foreign
Currency
Transactions and
Hedging Foreign
Exchange Risk

McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Exchange Rate Mechanisms

Prior to 1973, currency values were
generally fixed.
The US $ was based on the Gold
Standard.
Since 1973, exchange rates have been
allowed to fluctuate.
Several currency arrangements exist.

7-2

Different Currency Mechanisms

Independent Float - the currency is allowed to
fluctuate according to market forces
Pegged to another currency - the currencys
value is fixed in terms of a particular foreign
currency, and the central bank will intervene
to maintain the fixed value
European Monetary System - a common
currency (the euro) is used in multiple
countries. Its value floats against other world
currencies.
7-3

LO 1

Foreign Exchange Rates

An Exchange rate is the cost of one currency in
terms of another.
The exchange rate can be quoted in two ways, e.g.,
as USD/EUR or EUR/USD. Be careful that you
apply the correct version and not its reciprocal.
Published exchange rates are wholesale rates that
banks use with each other retail rates to
consumers are less favorable.
The difference between the rates at which a bank
is willing to buy and sell currency is
known as the spread.
Rates change every business day.
7-4

Foreign Exchange Rates

Spot Rate
The exchange rate that is available today.
Forward Rate
The exchange rate that can be locked in
today for an expected future exchange
transaction.
The actual spot rate at the future date may
differ from todays forward rate.
7-5

LO 1

Why exchange rates matter

The financial accounting system records
everything the same way, in terms of a specific
base currency.
A fundamental principle is the monetary unit
assumption.
If a company engages in transactions in multiple
currencies, this assumption is violated.
Accountants need to force all reporting into a
single currency so that accounts are additive.
Any method of imposing one currency accounting
will be arbitrary. This will create messiness
whenever exchange rates change.
7-6

Foreign Exchange Forward Contracts

A forward contract requires the exchanging of
currencies at a future date at the contracted
exchange rate.
This forward contract
allows us to purchase
1,000,000 at a price of
$.0080 US in 30 days.

But if the spot rate is

$.0069 US in 30 days,
we still have to pay
$.0080 US and we lose
$1,100!!

7-7

Foreign Exchange
Option Contracts
An options contract gives the holder the option
of exchanging currencies at a future date at the
contracted strike price.

An options contract gives

the holder the option of
buying (or selling) currency
units at a future date at the
contracted strike price.

That way, if the spot

rate is $.0069 in 30 days,
we only lose the $20 cost
of the option contract!

7-8

LO 2

Foreign Currency Transactions

A U.S. company buys or sells goods or
services to a party in another country.
This is often called foreign trade.
The transaction is often denominated
in the currency of the foreign party.
How do we account for the changes in
the value of the foreign currency?

7-9

Foreign Currency Transactions

GAAP requires a two-transaction
perspective.
(1)Account for the original sale in
your currency.
(2)Account for gains/losses from
exchange rate fluctuations until
the receivable/payable is settled.
7-10

Foreign Exchange Transaction Example

On 12/1/13, Amerco sells inventory to a German
corporation for 1 million euros on credit. Amerco
expects to be paid in euros in 90 days.
The current exchange rate is $1.32 = 1 .
Amerco would first record the sale:

Note that Amercos ledger is in US Dollars, but has a

separate account for receivables expected to be
collected in a foreign currency.
7-11

Foreign Exchange Transaction Example

On 12/31/13, the exchange rate is $1.33 = 1 .
At the balance sheet date we have to remeasure the
original A/R to the current exchange rate.

When we increase A/R to the new value in

US Dollars, we recognize a gain from foreign
currency exchange.
7-12

Foreign Exchange Transaction Example

On 3/1/14, Amerco is paid the 1 million euros.
The exchange rate on 3/1/14, was $1.30 = 1 .
Amerco records this transaction in two steps.

First, Amerco remeasures the A/R balance at the

current exchange rate. Then, they can record the
collection of cash and clear the A/R balance.
7-13

LO 3

Hedging Foreign Exchange Risk

Companies will seek to reduce the risks
associated with foreign currency fluctuations
by hedging
This means they will give up a portion of the
potential gains to offset the possible losses.
A company enters into a potential transaction
whose exposure is the opposite of the one that
has the associated risk.

7-14

Hedging Foreign Exchange Risk

Two foreign currency derivatives that are
often used to hedge foreign currency
transactions:
Foreign currency forward contracts lock in the
price for which the currency will sell at
contracts maturity.
Foreign currency options establish a price for
which the currency can be sold, but is not
required to be sold at maturity.

7-15

Accounting for Derivatives

ASC Topic 815 provides guidance for hedges
of four types of foreign exchange risk.
1. Recognized foreign currency
denominated assets & liabilities.
2. Unrecognized foreign currency firm
commitments.
3. Forecasted foreign currency denominated
transactions.
4. Net investments in foreign operations
7-16

Accounting for Derivatives

The fair value of the derivative is recorded
at all points in time. For a forward
contract., it is zero when initiated and can
be an asset or liability after that. Factors
involved in this include:
The forward rate when the forward
contract was entered into.
The current forward rate for a
contract that matures on the same date
as the forward contract.
A discount rate (the companys
incremental borrowing rate).

7-17

LO 4

Accounting for Hedges

Two ways to account for a foreign currency hedge:
1. Cash Flow Hedge
. Completely offsets variability of a foreign
currency receivable or payable.
. Gains/losses are recorded as OCI.
. The anticipated gain/loss is amortized as
revenue/expense
2. Fair
Value Hedge.over the life of the position.
Gains/losses are recognized immediately in
net income.
For a receivable/payable, this is no special
accounting at all. The two positions are both
fair valued over time regardless.
7-18

Cash Flow Hedge

Date of Transaction Example
Amercos sale agreement on 12/1/13 left them
with foreign currency risk. They take a 90day forward contract to sell 1 million euros,
at a forward rate of $1.305 = 1 euro.

7-19

Cash Flow Hedge

Interim Reporting Date Example
Amercos year-end is 12/31/13. The year-end
spot rate is $1.33 per euro.

In addition, at 12/31/13 the forward rate to 3/1/14

(now a 60-day forward rate), has changed.

7-20

Cash Flow Hedge

Interim Reporting Date Example
Also, on 12/31/13, $10,000 is transferred from
AOCI to a Loss on Forward Contract.

Finally, we have to amortize the discount from the

original transaction.

7-21

Cash Flow Hedge

Date of Collection Example
On 3/1/14, both the receivable and the exchange
contract come due. Assume the spot rate at
that date is $1.3 = 1 euro.

7-22

Cash Flow Hedge

Date of Collection Example
As at year-end, Amerco records an entry to
offset the foreign exchange loss, and amortizes
the rest of the discount.

As a result of these entries, the balance in AOCI

is zero: $4,236 + $15,783 - $30,000 + $9,981 = $0.
7-23

Cash Flow Hedge

Date of Collection Example
The amount due from the customer is received
in euros, and Amerco completes the forward
contract by selling the 1 million euros received.

7-24

Fair Value Hedge

Date of Transaction Example
In the same example with Amerco, assume
that they designate the forward contract as a
Fair Value Hedge, instead of a cash flow
hedge. The entry on the date of sale will be
the same.

The forward contract requires no formal entry

7-25

Fair Value Hedge Interim Reporting Date Example

Amercos year-end is 12/31/13. The year-end
spot rate is $1.33 per euro.

At 12/31/13, the forward rate to 3/1/14 (now a

60-day forward rate), has changed.
7-26

Fair Value Hedge

Date of Collection Example
On 3/1/14, both the receivable and the
exchange contract come due. Assume the spot
rate at that date is $1.3 = 1 euro.

7-27

Fair Value Hedge

Date of Collection Example
The amount due from the customer is
received in euros, and Amerco completes the
forward contract by selling the 1 million
euros received.

7-28

LO 7

Foreign Currency
Borrowings Example
On July 1, 2013, Multicorp borrows 1 billion and converts it
into $9,210,000 in the spot market. On December 31, 2013,
Mulitcorp must revalue the Japanese yen note payable with an
offsetting foreign exchange gain or loss reported in income and
must accrue interest expense and interest payable.

Interest is calculated by multiplying the loan principal in yen by

the relevant interest rate. The amount of interest payable in yen is
then translated to U.S. dollars at the spot rate to record the
accrual journal entry. On July 1, 2014, differences between the
amount of interest accrued at year-end and the actual U.S. dollar
amount that must be spent to pay the accrued interest are
recognized as foreign exchange gains/ losses.

7-29

Foreign Currency
Borrowings Example

Exchange rates in table above apply. Journal

entries are recorded as follows:

7-30

Foreign Currency
Borrowings Example
Journal entries at end of accounting period:

7-31

Summary
Transactions may be denominated in currencies
different from those used to keep accounting
records.
FASB has adopted a two-transaction approach,
separating the actual sale or purchase transaction
from the currency exchange speculation.
A variety of hedging practices may be used to
reduce foreign currency exchange risk. The two
most popular hedging instruments are foreign
currency options and foreign currency forward
contracts.
7-32