Jade S.

Casayas, CPA
A transaction that requires payment or receipt (settlement) in a foreign currency is
called a foreign currency transaction.

An exchange rate “is the ratio between a unit of one currency and the amount of
another currency for which that unit can be exchanged at a particular time.”
A direct exchange quotation is one in which the exchange rate is quoted in terms of
how many units of the domestic currency can be converted into one unit of foreign
currency.

For example, a direct quotation of U.S. dollars for one British pound of 1.517 means
that $1.517 could be exchanged for one British pound
An indirect exchange quotations means that exchange rates are also stated in terms
of converting one unit of the domestic currency into units of a foreign currency

For example one U.S. dollar could be converted into .6592 pounds (1.00/1.517).
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 Rate

Contract to exchange currencies of different countries on a stipulated future date, at
a specified rate (the forward rate).
The direct exchange rate is often said to be increasing, or the foreign currency unit
to be strengthening, if more dollars are needed to acquire the foreign currency units.
If fewer dollars are needed, then the foreign currency is weakening or depreciating
in relation to the dollar (the direct exchange rate is decreasing).

Direct Exchange Rates

Yen Strengthens Yen Weakens
Beginning of year $1 = 1 Yen $1 = 1 Yen
End of year $2 = 1 Yen $.5 = 1 Yen
 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.
Three stages:
1. Date of transaction
2. Balance sheet date
3. Settlement date
At the date the transaction is first recognized in conformity with GAAP.

Rule:
Each asset, liability, revenue, expense, gain, or loss arising from the transaction is
measured and recorded in dollars by multiplying the units of foreign currency by the
current exchange rate. (The current exchange rate is the spot rate in effect on a
given date.)
At each balance sheet date that occurs between the transaction date and the
settlement date.

Rule:
Recorded balances that are denominated in a foreign currency are adjusted using
the spot rate in effect at the balance sheet date and the transaction gain or loss is
recognized currently in earnings.
Rule:
In the case of a foreign currency payable, a U.S. firm must convert U.S. dollars into
foreign currency units to settle the account, whereas foreign currency units received
to settle a foreign currency receivable will be converted into dollars. Although
translation is not required, a transaction gain or loss is recognized if the number of
dollars paid or received upon conversion does not equal the carrying value of the
related payable or receivable.
 To illustrate an importing transaction, assume that on December 1, 2003, a U.S. firm
purchased 100 units of inventory from a French firm for 500,000 euros to be paid on
March 1, 2004. The firm's fiscal year-end is December 31. Assume further that the U.S.
firm did not engage in any form of hedging activity. The spot rate for euros ($/euro)
at various times is as follows:

Spot Rate

Transaction date - December 1, 2003 $1.05

Balance sheet date - December 31, 2003 1.08

Settlement date - March 1, 2004 1.07

The U.S. firm would prepare the following journal entry on December 1, 2003:

Date of Transaction:

Dec. 1 Purchases 525,000

Accounts Payable (500,000 euros x 525,000

$1.05/euro)
Balance sheet date
At the balance sheet date, the accounts payable denominated in foreign currency is
adjusted using the exchange rate (spot rate) in effect at the balance sheet date. The
entry is

Dec. 31 Transaction Loss 15,000

Accounts Payable 15,000

Accounts payable valued at 12/31 (500,000 euros x $1.08/euro) $540,000

Accounts payable valued at 12/1 (500,000 euros x $1.05/euro) 525,000

Adjustment to accounts payable needed $ 15,000

or

[500,000 euros x ($1.08 - $1.05) = $15,000]

Settlement Date
Before the settlement date, the U.S. firm must buy euros in order to satisfy the
liability. With a change in the exchange rate to $1.07, the firm must pay $535,000 on
March 1, 2004, to acquire the 500,000 euros. The journal entry to record the
settlement is:

Mar. 1 Accounts Payable 540,000

Transaction Gain 5,000

Cash (500,000 euros x 535,000

$1.07/euro)
 Now assume that the U.S. firm sold 100 units of inventory for 500,000 euros to a
French firm. All other facts are the same as those for the importing transaction.

Date of transaction:

Accounts Receivable (500,000 euros x $1.05) 525,000

Sales 525,000
Balance sheet date:

Accounts Receivable ($540,000-$525,000) 15,000

Transaction Gain 15,000

The receivable valued at 12/1, 500,000 euros x $1.08 = $540,000

The receivable valued at 12/31, 500,000 euros x $1.05 = $525,000

Change in the value of the receivable $ 15,000

Settlement Date:

Cash (500,000 euros x $1.07) 535,000

Transaction Loss 5,000

Accounts Receivable 540,000

A derivative instrument may be defined as a financial instrument that by its terms at
inception or upon occurrence of a specified event, 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.
 Derivative instruments represent rights or obligations that meet the
definitions of assets or liabilities and should be reported in financial
statements.
 Fair value is the most relevant measure for financial instruments and
the only relevant measure for derivative instruments.
 Only items that are assets or liabilities should be reported as such in
the balance sheet.
 Special accounting for items designated as being hedged should be
provided only for qualifying items, as demonstrated by an
assessment of the expectation of effective offsetting changes in fair
values or cash flows during the term of the hedge for the risk being
hedged.
 Forward-based derivatives, such as forwards, futures, and swaps, in
which either party can potentially have a favorable or unfavorable
outcome, but not both simultaneously (e.g., both will not
simultaneously have favorable outcomes).

 Option-based derivatives, such as interest rate caps, option

contracts, and interest rate floors, in which only one party can
potentially have a favorable outcome and it agrees to a premium at
inception for this potentiality; the other party is paid the premium,
and can potentially have only an unfavorable outcome.
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. At the inception of the
contract, the forward rate normally varies from the spot rate. The
difference between the two rates is referred to as a discount
(premium) if the forward rate is less than (greater than) the spot
rate.
If the item being hedged is a foreign currency account payable, the
firm should use a forward contract to purchase the foreign
currency on the date the payable becomes due. This implies that the
firm can lock in the cost of acquiring the foreign currency on the date
the forward contract is acquired and subsequent changes in the
exchange rate will not affect the amount the firm has to pay. One the
other hand, if the item being hedged is a foreign currency accounts
receivable, the firm should use a forward contract to sell the foreign
currency on the date the receivable is expected to be collected.
We use the idea INTRINSIC VALUE vs. TIME VALUE

Forward Rate
Date Spot Rate For 12/31/18 Settlement Premium
1/1/2018 $1.40 $1.50 $0.10
7/1/2018 $1.43 $1.48 $0.05
12/31/2018 $1.44 $1.44 $0.00
 Forward Rate Change in Value(a)
For 12/31/18 Total Intrinsic Time
Date Spot Rate Settlement Premium Value Value Value
1/1/2018 $1.40 $1.50 $0.10
7/1/2018 $1.43 $1.48 $0.05 $0.02 ($0.03) $0.05
12/31/2018 $1.44 $1.44 $0.00 $0.04 ($0.01) $0.05
Total change in rates and premium $0.06 ($0.04) $0.10
Foreign currency (Canadian dollars) 10,000 10,000 10,000
Total change in value in dollars (a) $600 ($400) $1,000
 The total change in the value of the forward contract = the
change in the forward rates multiplied by the foreign
currency,
 The change in the intrinsic value of the forward contract =
the change in the spot rate multiplied by the foreign
currency, and
 The change in the time value of the forward contract = the
change in the premium multiplied by the foreign currency.
 HEDGES
a. Forward contracts used as a hedge of a foreign currency transaction
b. Forward contracts used as a hedge of an unrecognized firm commitment
c. Forward contract used as a hedge of a foreign currency denominated
‘forecasted’ transaction
d. Forward contracts as a hedge of a net investment in foreign operations

 SPECULATIONS
Forward contracts used to speculate changes in foreign currency.
Consider the importing example used earlier in the chapter.

Importing Transaction with a Forward Contract Used as a

Hedge
1. On December 1, 2018, a U.S. firm purchased inventory for
500,000 euros payable on March 1, 2019 (i.e. the transaction
is denominated in euros).
2. The firm's fiscal year-end is December 31.
3. The spot rate for euros ($/euro) and the forward rates for euros on
March 1, 2019 at various times is as follows:
Spot Forward Rate

Rate (for 3/1/2019 Euros)

Transaction date - December 1, 2018 $1.05 1.052

Balance sheet date - December 31, 2018 1.06 1.059

Settlement date - March 1, 2019 1.07

4. On December 1, 2018, the U.S. firm entered into a forward
contract to buy 500,000 euros on March 1, 2019, for $1.052.
 TRANSACTION DATE

(1) Purchases 525,000

Accounts Payable (500,000 euros x $1.05) 525,000

(2) Foreign Currency (FC) Receivable from Exchange Dealer 526,000

Dollars Payable to Exchange Dealer 526,000

(500,000 euros x $1.052)

 BALANCE SHEET DATE

(3) Transaction Loss 5,000

Accounts Payable 5,000

To record a loss on the liability denominated in foreign currency

Current value of accounts payable (500,000 euros x $1.06) = $530,000

Less: Recorded value of accounts payable = $525,000

Adjustment needed to accounts payable $5,000

or [500,000 euros x ($1.06 - $1.05)] = $5,000

(4) FC Receivable from Exchange Dealer 3,500

Transaction Gain 3,500

 SETTLEMENT DATE

(5) Transaction Loss 5,000

Accounts Payable 5,000

(6) FC Receivable from Exchange Dealer 5,500

Transaction gain 5,500

(7) Dollars Payable to Exchange Dealer 526,000

Investment in FC (500,000 euros) 535,000

FC Receivable from Exchange Dealer 535,000

Cash 526,000

To record payment to exchange dealer and receipt of 500,000 euros

(500,000 euros x $1.07 = $535,000).

(8) Accounts Payable 535,000

Investment in FC 535,000

To record payment of liability upon transfer of 500,000 euros.

Assume that a U.S. firm made an agreement on June 1 to buy goods from a French
company for 500,000 francs. At this date, the spot rate was $.20, but on the
transaction date, when title to the goods transferred and a journal entry was
recorded, the spot rate was $.22.

Purchases (500,000 francs x $.22) 110,000

Accounts Payable 110,000

A forward contract is considered a hedge of an identifiable foreign currency
commitment if the forward contract is designated as, and is effective as, a hedge of a
foreign currency commitment. The foreign currency commitment must specify all
significant terms (such as quantity and price) and performance must be probable. A
gain or loss on a forward contract as well as the offsetting gain or loss on the
hedged item are recognized currently in earnings.
 On March 1, 2003, a U.S. firm contracts to sell equipment to a foreign
customer for 200,000 German marks. The equipment is expected to
cost $60,000 to manufacture and is to be delivered and the account is
to be settled one year later on March 1, 2004. Thus the transaction
date and the settlement date are both March 1, 2004.
 On March 1, 2003, the U.S. firm enters into a forward contract to sell
200,000 German marks in 12 months at the forward rate of $.39.
 Spot rates and the forward rates for German marks on selected dates are:

Spot 3/1/2004

Exchange Forward

Rate Rate
______Date______

March 1, 2003 $.40 $.390

December 31, 2003 .395 $.385

March 1, 2004 .38

 MARCH 1, 2003

(1) Dollars Receivable from Exchange Dealer

(200,000 marks x $.39) 78,000

FC Payable to Exchange Dealer 78,000

 DECEMBER 31, 2003

FC Payable to Exchange Dealer 1,000

Exchange gain 1,000

Exchange loss 1,000

Firm commitment 1,000

 MARCH 1, 2004

FC Payable to Exchange Dealer 1,000

Exchange gain 1,000

Exchange loss 1,000

Firm commitment 1,000

TO RECORD THE SALE OF EQUIPMENT

Investment in FC 76,000

Firm commitment 2,000

Sales (200,000 marks x $.39) 78,000

Cost of Goods Sold 60,000

Inventory 60,000
Cash (200,000 x $.39) 78,000

FC Payable to Exchange Dealer (200,000 x $.38) 76,000

Investment in FC 76,000

Dollars Receivable from Exchange Dealer 78,000

1. On December 1, 2003, a U.S. firm estimates that at least
5,000 units of inventory will be purchased from a
company in the United Kingdom during January of 2004
for 500,000 euros. The transaction is probable and the
transaction is to be denominated in euros. Sales of the
inventory are expected to occur in the six months
following the purchase.
2. The company enters into a forward contract to purchase
500,000 euros on January 31, 2004, for $1.01.
3. Spot rates and the forward rates at January 31, 2004, settlement were as follows
(dollars per euro):
Forward Rate
Spot Rate For 1/31/04
December 1, 2003 $1.03 $1.01
Balance sheet date (12/31/03) $1.00 $0.99
January 31, 2004 $0.98
 DECEMBER 1, 2003

FC Receivable from Exchange Dealer

(500,000 euros x $1.01) 505,000

Dollars Payable to Exchange Dealer 505,000

 DECEMBER 31, 2003

Foreign exchange loss – Other Comprehensive 10,000

Income (Balance Sheet)

FC Receivable to Exchange Dealer 10,000

Investment in FC (500,000 euros) 490,000

Dollars Payable to Exchange Dealer 505,000

FC Receivable from Exchange Dealer 490,000

Cash 505,000
Now suppose that the forecasted transaction occurs and the 5,000 units of inventory
are purchased on January 31, 2004 for 500,000 euros. The journal entry to record the
purchase is:

Inventory (at the 12/31/04 spot rate) 490,000

Investment in FC (500,000 euros) 490,000

Suppose that in February, the inventory is sold for $600,000. The
entries to record the sale and to reclassify the amounts from Other
Comprehensive Income (a $15,000 loss, including $10,000 loss at
December 31, 2003 plus the $5,000 additional loss at January 31, 2004)
into earnings are as follows:

Cash 600,000

Cost of goods sold 490,000

Sales 600,000

Inventory 490,000
Cost of goods sold (Income Statement) 15,000

Foreign exchange loss – Other 15,000

Comprehensive Income (Balance Sheet)

A forward contract may be acquired for speculative purposes in
anticipation of realizing a gain.

For example, assume that on December 1, 2003, the spot rate for the
British pound is $2.35 and that the 90-day futures rate is $2.36. Further
assume that a company expecting the exchange rate to increase to,
say, $2.43, enters into a contract on December 1 to acquire £100,000 on
March 1, 2004. (A forward contract to sell foreign currency would be
negotiated if the firm expected the future spot rate to be lower than the
forward rate.) The firm's fiscal year ends on December 31, and on that
date the futures rate for pounds to be purchased on March 1, 2004 is
$2.37. The spot rate is $2.42 on March 1, 2004.
 DECEMBER 1, 2003

FC Receivable from the Exchange Dealer 236,000

Dollars Payable to Exchange Dealer 236,000

 DECEMBER 31, 2003

FC Receivable from Exchange Dealer 1,000

Transaction Gain 1,000

To record gain on foreign currency to be received from exchange

dealer (£100,000 x $2.37 = $237,000 - $236,000) or [£100,000 x
($2.37 - $2.36)].
 MARCH 1, 2004

FC Receivable from Exchange Dealer 5,000

Transaction Gain 5,000

To record gain on foreign currency to be received from exchange

dealer (£100,000 x $2.42 = $242,000 - $237,000).
Dollars Payable to Exchange Dealer 236,000

Investment in FC 242,000

Cash 236,000

FC Receivable from Exchange Dealer 242,000

To record payment to exchange dealer and receipt of foreign
currency.
Cash 242,000

Investment in FC 242,000

To record conversion of pounds into cash