Financial Accounting Level 4 Module 7

Transcription

1 Financial Accounting Level 4 Module 7 IMPORTANT Exchange rates can be stated in two different ways: 1. Canadian dollar equivalent method: This is when we are given how much it will cost in Canadian funds to buy one foreign fund. eg. US$1 = C$1.35 Thus if I purchase an item for US$20.00 it will cost me (20 x 1.35) C$ Foreign currency equivalent method: This is when we are given how much the Canadian dollar is worth in foreign funds. eg. C$1 = US$.74 Thus if I purchased an item for US$20.00 it would cost me (20 /.74) pay special attention to the method used to state the exchange rates!! Foreign Currency Transactions This topic deals with transactions in foreign currency (only dealing with transactions, not foreign operations or subsidiaries this is covered in Module 8). Basically, we as accountants are trying to find the best way to record a foreign business transaction. If a purchase is made by Domestic Corp. from Foreign Corp. at what value do we record the transaction, knowing that when the payment is made to Foreign Corp. the exchange rate will have changed and thus the amount of the payment may not correspond to the amount recorded at the time the transaction took place? Should be use the purchase date exchange rate or the payment date exchange rate to value the transaction? Whether the transaction is short term in nature or long term, the accounting treatment is the same. Transactions within one fiscal year: (assume a Dec. 31 year end) eg. D Co. purchases on account 100 units of inventory at US$5 on December 4 when the exchange rate is US$1 = C$1.40. D Co. then pays the supplier on December 30 when the exchange rate is US$1 = C$1.41. IFRS recommends the two transaction approach. This means that the purchase is viewed as one transaction and the payment is viewed as a second unrelated transaction. The payment transaction is a financing transaction not a purchasing transaction. This is the same reason why interest on a note payable for the purchase of machinery would not be capitalized to the machinery account but rather charged as interest expense. Purchase Transaction Dec 4: DR Inventory / Purchases (100u x US$5 x C$1.40) CR Accounts Payable ACCTG FA4 Module 7 Foreign Currency Transactions page 1

2 Payment Transaction Dec 30: DR Accounts Payable DR Foreign currency loss ( )x(100u x US$5) 5.00 CR Cash (100u x US$5 x C$1.41) The foreign currency loss is the difference between the purchase amount and the payment amount. This loss would show up on the income statement under "other gains and losses". Note the accounts payable could not be debited for because there was only in the account to begin with!! (the value an item enters the books at is the value it leaves at, ALWAYS) Transactions that cover two fiscal years: eg: D Co. purchases on account 100 units of inventory at US$5 on December 4 when the exchange rate is US$1 = C$1.40. D Co. then pays the supplier on Jan 5 when the exchange rate is US$1 = C$1.41. The December 31 exchange rate is C$1 = US$0.76. Dec 4 DR Inventory / Purchases CR A/P Dec 31 DR A/P CR foreign currency gain ( ((100u x US$5)/.76)) = = Jan 5 DR A/P ( ) DR Foreign currency loss CR Cash (100u x US$5 x C$1.41) We recognize that at Dec 31 we only owe $ Canadian to the supplier and that if we pay on Dec 31 we have saved (gained) $42.11 since the time of purchase. This information is seen as relevant to the user of the F/S because it shows how the business is positioned at Dec 31. This information can then be used to evaluate the company. This information is also seen as reliable due to the fact that the foreign exchange rates are an established rating system. However, it is up to the user to recognize that all foreign exchange transactions are risky, in that come payment time the amount payable may not be as listed on the Dec 31 balance sheet. ACCTG FA4 Module 7 Foreign Currency Transactions page 2

3 Hedging Hedging in general is the process of trying to protect the value of an item, ie protect it from risk of valuation change. Usually, the types of risks that are hedged include credit risk, interest rate risk, foreign currency risk, and liquidity risk. The idea is to enter in one or more contracts aimed at offsetting exposure to one or more risks. Hedged item the item that is being hedged. Hedging item the item that is acting to offset the risks of the hedged item (usually a derivative instrument, can be a non-derivative item, only if it is hedging a foreign currency risk). Hedge accounting may only be applied when gains, losses, revenues and expenses on a hedging item (a derivative such as a forward contract would be recognized in net income in a different accounting period than the gains, losses, revenues and expenses on the hedged item (a financial instrument such as accounts receivable). For example, the forward contract may not be settled until Jan 15 (assume a Dec 31 year end), however, the accounts payable or receivable it is hedging would need to be valued at fair market value at year end, Dec. 31. So this section allows the forward contract value to be included in the financial statements to offset the item it is hedging (ie to offset the A/R or A/P for example). Note that if the hedged item and hedging item s gains and losses are to be reported in the same period, only the net effect would impact the financial statement values, hence by applying hedge accounting the result is the same as if the items are in the same accounting period. Definitions A fair-value hedge is a hedge of all or part of the risk exposure to changes in the fair value of financial instruments or unrecognized firm commitment. A common example is the hedge of the foreign exchange risk associated with a foreign currency denominated accounts receivable. A cash-flow hedge is a hedge of the variability in cash flows of financial instruments or forecasted future transactions or unrecognized firm commitments. A common cash-flow hedge is an interest-rate swap that effectively converts a variable-rate bond payable into a fixed-rate bond payable, or vice versa, depending on management s outlook for future interest rates. Sometimes the derivative may qualify as a cash flow or fair value hedge, such as forward contract hedging an expected monetary position. A hedge of the net investment in a self-sustaining foreign operation or subsidiary is a hedge of the foreign currency exposure of the net investment (net assets) in the operation. (This is addressed in more detail in Module 8.) Hedge effectiveness is a measure of the extent to which a hedging item, such as a derivative forward contract, mimics in an equal and opposite direction the fair-value or cash-flow changes of the item being hedged, such as a foreign currency denominated accounts receivable financial instrument. An example of an 80% effective hedge would be one where the fair value of the accounts receivable had declined by $10,000 while the derivative forward contract had only increased by $8,000. If instead the derivative had increased by $10,000, then it would be a perfectly effective hedge. ACCTG FA4 Module 7 Foreign Currency Transactions page 3

4 Effectiveness is assessed for periods up to the current balance sheet date (retroactively) to measure the extent of any actual ineffectiveness and to determine whether hedge accounting remains appropriate for the current fiscal period. Effectiveness is assessed prospectively to justify the assessment that the relationship will be effective. Effectiveness is assessed, at a minimum, quarterly. Conditions for applying hedge accounting Because hedge accounting is optional, management must prepare a significant amount of documentation concerning the objective and strategy of specific risk being hedged, the hedged item, the hedging item, the term of the hedging relationship, and the method of assessing the hedge effectiveness. A hedge of an anticipated future transaction requires sufficient documentation so that when the transaction occurs it is clear that it has indeed hedged the transaction. Designation of a hedging relationship Because hedge accounting is optional, management must formally document when a hedging relationship occurs. The documentation includes identification of the specific items included in the hedging relationship, the period of the hedging relationship and management desire to employ hedge accounting. Management may at any time discontinue hedge accounting by terminating the hedging relationship and re-designate a new hedging relationship between the derivative and another financial instrument. Hedge accounting The hedged item and the derivative hedging item are reported at fair value as required by IAS 39, Financial instruments Recognition and measurement. For fair-value hedges, gains and losses are reported in net income even when the hedged item has been designated as available-for-sale. Recall from Module 1 that gains and losses on unhedged available-for-sale financial instruments are recognized in other comprehensive income. If hedged and for perfect hedges, these gains and losses on these financial instruments and the losses and gains associated with the hedging item would cancel each other out and therefore there would be no impact on the income statement. If the hedges were not perfect there would be a residual amount that would impact net income. For fair-value hedges of unrecognized firm commitments, the hedge price sets the purchase price. For example, assume a company enters into a firm commitment to buy C$10,000 (translated from the U.S. dollar exchange rate) worth of inventory in three months. The company immediately acquires at no cost a derivative forward contract to lock in the price at C$9,500. When the purchase commitment is executed in three month s time, the inventory is recorded at $9,500. A company may elect to account for a hedge of the foreign currency risk in a firm commitment as a cash-flow hedge. ACCTG FA4 Module 7 Foreign Currency Transactions page 4

5 For cash-flow hedges, gains and losses on the effective portion of the hedge are reported in other comprehensive income. For cash-flow hedges, gains and losses on the ineffective portion of the hedge are reported in net income. Disclosure Firms should disclose information concerning such hedging items as derivatives sufficient to enable users of financial statements to understand the objectives and strategy of the hedging arrangements categorized by fair-value hedges, cash-flow hedges, hedges of net investments in self-sustaining foreign operations, and other hedges. Fair Value Hedges A special accounting issue arises when a Canadian company enters into a transaction that requires the funds of the transaction to be in a currency other than Canadian dollars. If the agreement calls for the transaction to be settled in a foreign currency, then the Canadian company will have to acquire foreign currency in order to discharge an obligation resulting from a purchase or will receive foreign currency from its customer as a result of a sale and will then have to sell the foreign currency in order to receive Canadian dollars. Companies assume risks when dealing in foreign currencies. To guard against these risk companies engage in hedging. Hedging can be achieved in many ways. The basic idea behind hedging is to reduce the risks associated with foreign exchange rate fluctuations. It is up to management to decide if they will apply hedge accounting. Hedge accounting requires the hedged item and the item (derivative) hedging the hedged item to be reported at fair value in accordance with IAS 39. You would use the spot rate to value the hedged item (A/R or A/P for example) and the fair value of the hedging item to value it (for example, the forward rate, if the hedging item is a forward contract). Essentially, you simply are reporting both items at their fair market values. Forward contracts are one way hedging can take place. Example: Assume Co. A, a Canadian company, has a receivable for US$1,000 and payment is due 30 days from now. Co. A can enter into a contract NOW to sell the US$1,000 in 30 days time at a guaranteed exchange rate (forward rate). Thus, Co. A is eliminating the uncertainty of exchange rate fluctuations. The guaranteed rate may be different than the rate on the sale date (spot rate), creating a premium or discount on the hedging transaction. Also, come payment time (30 days), the guaranteed rate may be higher or lower than the actual exchange rate, creating a gain or loss at the time of payment. However, Co. A has hedged itself against a potentially large loss, but may have also limited a potentially large gain by agreeing to sell the US$1,000 at the guaranteed rate. Spot rate - exchange rate at date of transaction Forward rate - exchange rate bank has guaranteed Example: October 31, 20X0 -Canada Co. purchased computer chips from US Co. for US$150,000, payable ACCTG FA4 Module 7 Foreign Currency Transactions page 5

6 in three months. US$1 = C$1.37. October 31, 20X0 - Canada Co. entered into a forward contract at a rate of US$1 = C$1.39. December 31, 20X0 - year end. US$1 = C$1.40. This is also the forward contract rate. January 31, 20X1 - Received US$150,000 from the forward contract and paid US Co. US$1 = C$1.41. Journal Entries: Oct 31, 20X0 DR Computer Chips Inventory (150,000 x 1.37) 205,500 CR Accounts Payable 205,500 Receivable from Bank (150,000 x 1.39) 208,500 Payable to Bank 208,500 December 31, 20X0 To adjust payable to year end exchange rate: DR foreign exchange loss/gain (205,500 - (150,000 x 1.40)) 4,500 CR Accounts Payable 4,500 DR Receivable from Bank ( ) x 150,000 1,500 CR foreign exchange loss/gain 1,500 Effectively, by entering into the forward contract the company has guaranteed a foreign exchange loss of 3,000 = $150,000 x ( ) over the life of the contract (3 months). The net effect of the above amount is (4,500-1,500) = 3,000 loss reported in net income. If no hedging was done there would have been a 4,500 loss. B/S 20X0 Current Assets: Forward Contract (net Receivable and Payable to Bank) (208, ,500) 208,500)) 1,500 Current Liabilities: Accounts Payable 210,000 Note that 210,000-1,500 = 208,500 which is the amount of the receivable from the bank (150,000 x 1.39) for the forward contract. I/S 20X0 Other gains and losses: Foreign exchange loss (hedge expense) 3,000 ACCTG FA4 Module 7 Foreign Currency Transactions page 6

7 January 31, 20X1 To update accounts to spot rate DR foreign exchange loss/gain ( ) x 150,000 1,500 CR Accounts Payable 1,500 DR Receivable from Bank 1,500 CR foreign exchange loss/gain 1,500 To record payment: DR Payable to Bank 208,500 CR Cash 208,500 DR Cash (150,000 x 1.41) 211,500 CR Receivable from Bank 211,500 DR Accounts Payable 211,500 CR Cash 211,500 Note if the forward contract rates are different than the exchange rate at any given time, the forward rate should be used to record the forward contract. When the exchange rate and forward contract rates are different the hedge will not be perfect. Cash Flow Hedges Companies can hedge expected monetary positions by entering into a forward contract before the actual purchase of items takes place. In this case, the forward contract is still valued at its fair market value, as for fair value hedge, but the gain or loss is reported in other comprehensive income until the hedged item is recognized this assume hedge accounting is applied, if hedge accounting is not used the change in value of the forward contract is recognized in net income. Once the hedged item is recognized (transaction takes place) the cumulative gain/loss on the forward contract is applied against the value of the related asset purchased. What this does is it forces the asset purchased to be valued at the forward contract rate. From this point on, the accounting is the same as fair value hedges, you would fair value the forward contract and fair value the related payable. The gain or loss would be reported in net income. International reporting to attract investors As the capital markets become more global, companies must decide how to best attract investors given that investors come from different cultures, speak different languages, are familiar with different regulations and accounting policies. There are five strategies employed for this purpose. 1. Provide financial statements as prepared by the home country and let the investors deal with their own challenges in interpreting the information. 2. Prepare statements using a common language. 3. Prepare statements in a common language and translate dollar figures into the appropriate foreign currency. 4. Prepare statements in a common language and translate dollar figures into the appropriate foreign currency as well as translate the financial statements to reflect the appropriate countries GAAP requirements. 5. Issue statements tailored to the needs of the specific user group in a language and GAAP they understand. As we go down the list of option, each is more complicated than the next. We, as professional ACCTG FA4 Module 7 Foreign Currency Transactions page 7

8 accountants, have to be careful that the costs do not outweigh the benefits or that the task is not out of our range of expertise. Chapter 10 Problem 10 (a) August 1, Year 1 Inventory 180,000 Accounts payable (DM) 180,000 (DM450, ) November 1, Year 1 Exchange loss 34,286 Accounts payable (DM) 34,286 ([DM450, ] = 214, ,000) Due from bank (DM) 236,842 Payable to bank 236,842 (DM450, ) Note: The due from bank and due to bank would be offset against each other and only the net difference between the two will be reported on the balance sheet as either a current asset or current liability. December 31, Year 1 Exchange gains and losses 50,420 Accounts payable (DM) 50,420 ([DM450, ] = 264, ,286) Due from bank (DM) 13,158 Exchange gains and losses 13,158 ([DM450, ] = 250, ,842) ACCTG FA4 Module 7 Foreign Currency Transactions page 8

9 March 1, Year 2 Accounts payable (DM) 98,039 Exchange gains and losses 98,039 ([DM450, ] = 166, ,706) Exchange gains and losses 83,333 Due from bank (DM) 83,333 ([DM450, ] = 166, ,000) Payable to bank 236,842 Cash 236,842 Cash (DM) 166,667 Due from bank (DM) 166,667 (DM450, ) Accounts payable (DM) 166,667 Cash (DM) 166,667 (b) August 1, Year 1 Inventory 180,000 Notes payable (DM) 180,000 December 31, Year 1 Exchange loss 84,706 Notes payable (DM) 84,706 ([450, ] = 264, ,000) ACCTG FA4 Module 7 Foreign Currency Transactions page 9

10 (c) The exchange rate should be applied to produce a translated amount consistent with the way we normally measure assets and liabilities. If an item is to be measured at historical cost e.g., inventory, we should apply the historical rate to the historical value in foreign currency to derive the historical cost in Canadian dollars. If an item is to be measured at current value e.g., accounts payable, we should apply the closing rate to the current value in foreign currency to derive the current value in Canadian dollars. Chapter 10 Problem 13 (a) October 15, Year 4 Inventory 316,000 Accounts payable (RL) 316,000 (RL800, ) Receivable from bank (RL) 326,400 Payable to bank 326,400 (RL 800, ) December 1, Year 4 Accounts receivable (AP) 622,500 Sales 622,500 (AP2,500, ) Receivable from bank 565,000 Payable to bank (AP) 565,000 (AP2,500, = 565,000) December 15, Year 4 Accounts payable (RL) 6,400 Exchange gains and losses 6,400 (RL 800,000 [ ]) ACCTG FA4 Module 7 Foreign Currency Transactions page 10

11 Exchange gains and losses 16,800 Receivable from bank (RL) 16,800 (RL 800,000 [ ]) Payable to bank 326,400 Cash 326,400 Cash (RL) 309,600 Receivable from bank (RL) 309,600 (RL 800, ) Accounts payable (RL) 309,600 Cash (RL) 309,600 (RL 800, ) December 31, Year 4 Exchange gains and losses 40,000 Accounts receivable (AP) 40,000 (AP2,500,000 [ ]) Payable to bank (AP) 10,000 Exchange gains and losses 10,000 (AP2,500,000 [ ]) (b) Hull Manufacturing Corp. Balance Sheet as at December 31, Year 4 Assets Accounts receivable 582,500) Forward contract 10,000* * Receivable from bank 565,000 Less: payable to bank 555,000 Forward contract 10,000 ACCTG FA4 Module 7 Foreign Currency Transactions page 11

12 Problem 10-5 (note since the question states this is a contracted (ie committed) event rather than a forecasted event, the forward contract should be accounted for as a fair value hedge, however, the cash flow hedge accounting is also shown for demonstration purposes) Note: debits are without brackets and credits are with brackets. October 1, Year 6 CF Hedge FV Hedge Receivable from bank 480, ,000 Payable to bank (SF) (480,000) (480,000) (SF400, ) December 31, Year 6 Exchange loss/gain 8,000 Other comprehensive income 8,000 Payable to bank (SF) (8,000) (8,000) (SF400,000 [ ]) Commitment receivable 8,000 Exchange loss/gain (8,000) (SF400,000 [ ]) January 31, Year 7 Cash (SF) 476, ,000 Sales (476,000) (476,000) (SF400, ) Payable to bank (SF) 12,000 12,000 Other comprehensive income (12,000) Exchange gain/loss (12,000) (SF400,000 x [ ]) Exchange gain/loss 12,000 Commitment receivable (12,000) (SF400,000 [ ]) Commitment receivable 4,000 Other comprehensive income 4,000 Sales (4,000) (4,000) To clear other commitment receivable/other comprehensive income to sales account (a) (c) ACCTG FA4 Module 7 Foreign Currency Transactions page 12

13 Payable to bank (SF) 476, ,000 Cash (SF) (476,000) (476,000) Cash 480, ,000 Receivable from bank (480,000) (480,000) Trial balance, December 31, Year 6 CF Hedge FV Hedge (b) (d) Commitment receivable 8,000 B/S Receivable from bank* 480, ,000 B/S Payable to bank* (488,000) (488,000) B/S Exchange gains & losses 0 0 I/S Other comprehensive income 8,000 * A net amount of $8,000 cr. would appear on the balance sheet as a forward contract liability. (e) Under the fair value hedge, a current asset and current liability of $8,000 are reported whereas only an $8,000 current liability is reported under the cash flow hedge. Therefore, the fair value hedge shows a slightly better liquidity position. ACCTG FA4 Module 7 Foreign Currency Transactions page 13