Accounting for Foreign Currency Transactions. Chapter 10 Foreign Currency Transactions Topic 2: Accounting Fair Value and Cash Flow Hedges

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1 Chapter 10 Foreign Currency Transactions Topic 2: Accounting Fair Value and Cash Flow Hedges Advanced Accounting Dr. Chula King 1 Student Learning Outcomes Account for foreign currency transactions Account for fair value foreign currency hedges on existing transactions with a forward contract Account for cash flow hedges 2 Accounting for Foreign Currency Transactions Transactions both denominated and measured in the reporting entity s currency are not affected by changes in exchange rates Transactions are denominated in FC and measured in domestic currency Changes in exchange rates between the transaction date and the settlement date result in exchange gain or loss to reporting entity If a FC transaction is unsettled at the end of the period, exchange gains/losses should be accrued on the FC payable or receivable 3

2 Foreign Currency Unsettled Transaction Example US Company which operates on a calendar year, purchases inventory from a foreign company on 11/1/20X1 for 1,000 Foreign Currency (FC). 1,000 FC to be paid on 2/1/20X2 Spot Rate 11/1/X1 1FC = $ /31/X1 1FC = $0.52 2/1/X2 1FC = $0.55 US Company Purchases Inventory Pays 1,000 FC Foreign Company 4 Foreign Currency Unsettled Transaction Example 11/1 Inventory 500 FC Payable 500 (1,000 FC x $0.50) 12/31 Exchange Loss 20 FC Payable 20 1,000 FC x ($0.52 $0.50) 2/1 FC Payable (500+20) 520 Exchange Loss* 30 Cash FC(1,000 FC x $0.55) 550 *1,000 FC x ($0.55 $0.52) 5 Exposure to Foreign Currency Risk Actual existing foreign currency transactions resulting in a FC payable/fc receivable Firm commitment to enter into a foreign currency transaction Forecasted foreign currency transaction with a high probability of occurrence Investment in a foreign subsidiary Forecasted transaction Firm Commitment Transaction Settlement 6

3 Characteristics of Derivatives Underlyings The rates or prices that relate to the asset or liability Notional Amount The number of units or quantity specified in the instrument Minimal Initial Investment A derivative requires little or no investment upon inception No Required Delivery The contract can be settled for cash without buying or selling the related asset/liability Both the underlying price/rate AND the notional amounts are required to determine total value of the derivative at any point in time 7 Common Types of Derivatives To hedge against FC Exchange risk Forward contracts Option contracts 8 Foreign Currency (FC) Forward s A contract to buy or sell a specified amount of FC Specified fixed rate Delivery at a specified future point in time Seller is in the short position Buyer is in the long position Specified, fixed rate is the forward rate Specified future date is the forward date The value of the contract at inception is zero Total change in value of forward contract is measured as the difference between the forward rate and the spot rate at the forward date 9

4 Example FC Forward On April 1, seller agrees to provide buyer with 1,000,000 FC in 90 days, on June 29 at a forward rate of 1 FC = $0.16 Assume a spot rate on June 29 of 1 FC = $0.18 Writer of the (Seller) Sells 1,000,000 FC in 90 days Pays $160,000 in 90 days Holder of the (Buyer) Inception: FC at the forward rate in 90 days $ 160,000 Settlement: FC at spot rate in 180,000 Gain in value to buyer/loss in value to seller $ 20, Value Changes of a Forward Over Time Cumulative change in forward value of a contract Difference between the original forward value and the remaining forward value The present value of the cumulative change in forward value is determined by discounting the cumulative change in forward value from the settlement date to the present time at the appropriate discount rate. 11 The Forward Rate A function of variables As variables change, the value of the forward contract changes Current value of the forward contract is determined by present value of future rates 12

5 Example: Change in Value of Forward Remaining Term of Forward Rate Notional Amount Total Forward Value Cumulative Change in Forward Value 90 days $ ,000,000 $160, days $ ,000,000 $170,000 $10, days $ ,000,000 $170,000 $10,000 0 days $ ,000,000 $180,000 $20,000 Assume a 6% discount rate calculations on next slide Discounting occurs from the date of settlement back to the valuation date, with the discount rate equal to 1 (1 + discount rate for the period of time) n. For example, if the discount rate was 6%, and the date of settlement was March 1, two months of discounting back to December 31 would be required. 13 Change in Value of Forward 60 Days 30 Days Total Life Cumulative change in forward value $10,000 $10,000 $20,000 Present value of cumulative change: 60 days at 6% (10,000 (1.005) 2 * $9, days at 6% (10, ) 1 ** $9,950 0 days at 6% $20,000 Previously recognized gain/loss 0 (9,901) (9,950) Current period gain/loss $9,901 $49 $10,050 * 6% annual rate is.5%per month; = 9, = 9,901 PV, n=2, i= 0.5% ** = 9,950 PV, n = 1, i= 0.5% 14 Derivatives Designated as a Hedge Fair value hedge Recognized foreign currency denominated asset or liability; or Unrecognized foreign currency firm commitment Cash flow hedge A forecasted foreign currency transaction; The forecasted functional currency equivalent cash flows associated with a recognized asset or liability; or Unrecognized foreign currency firm commitment 15

6 Fair Value Hedges Used to offset changes in fair value of items with fixed exchange price or rates Recognized FC asset or liability Unrecognized FC firm commitment Prices or rates are fixed Subsequent changes in the price or rates affect the fair value The derivative instrument can be used as a hedge against exchange risk 16 Fair Value Hedges (continued) Fair value hedges receive special accounting treatment if certain criteria are satisfied Formal documentation of the hedging relationship Ongoing assessment of hedge effectiveness Other criteria must also be satisfied 17 Special Accounting Treatment for Fair Value Hedges The gain or loss on the derivative instrument is recognized currently in earnings The gain or loss on the hedged item is also recognized currently in earnings Recognizing both changes in value in current earnings gives recognition to the offsetting nature of the hedge Changes in the time value of a derivative may be excluded from assessment of hedge effectiveness and recognized in current earnings 18

7 Accounting for a Fair Value Hedge Illustrated Calendar year US Company purchases inventory from foreign vendor for 100,000 FC on 11/1/X1. The 100,000 FC is due the foreign vendor on 2/1/X2. On 11/1/X1, the US Company acquires FC forward contract to acquire 100,000 FC on 2/1/X2. Changes in value are discounted at 6%. Forward Rate for Date Spot Rate Remaining Term of November 1, 20X1 1 FC = $ FC = $0.506 December 31, 20X1 1 FC = $ FC = $0.530 February 1, 20X2 1 FC = $ FC = $ What is Occurring FC Broker $ US Company Purchases Inventory Pays 100,000 FC Foreign Company Date Spot Rate Forward Rate for Remaining Term of November 1, 20X1 1 FC = $ FC = $0.506 December 31, 20X1 1 FC = $ FC = $0.530 February 1, 20X2 1 FC = $ FC = $ Journal entries 11/1/20X1 Inventory 50,000 FC Payable 50,000 (100,000 x $0.50 spot rate) US company and Foreign company FC Receivable 50,600 $ Payable 50,600 (100,000 x $0.506 forward rate) US company and Broker 21

8 Journal entries 12/31/20X1 Exchange Loss 2,000 FC Payable 2,000 (($0.52 $0.50) x 100,000) (difference in spot rates) FC Receivable 2,388 Gain on contract 2,388 (($0.53 $0.506) x 100,000) (difference in forward rates, discounted from 2/1 to 12/31) 22 What Happens on Settlement Date? FC Broker $ US Company Purchases Inventory Pays 100,000 FC Foreign Company 23 Journal entries 2/1/20X2 $ Payable 50,600 Cash 50,600 (Pay the broker fixed amount of cash, established on 11/1/X1) Cash FC(100,000 FC x $0.55) 55,000 Gain on 2,012 FC Receivable (50, ,388) 52,988 (Receive 100,000 FC in satisfaction of FC Receivable) FC Payable (50, ,000) 52,000 Exchange Loss 3,000 Cash FC 55,000 (Pay the foreign company 100,000 FC) 24

9 Cash Flow Hedges Used to hedge against changes in the cash flows of forecasted foreign currency transaction Special accounting treatment Effective portion of gain/loss reported in OCI If time value is excluded, changes in time value recognized currently in earnings rather than OCI, as the amortization of a premium or discount Premium: Forward rate > spot rate Discount: Forward rate < spot rate Amounts reported in OCI reclassified into recognized earnings in the same period in which the hedge item affect earnings 25 Accounting for a Cash Flow Hedge Illustrated June 1, US Company with June 30 FYE forecasted the purchase of 5,000 units of inventory from a foreign vendor, with the purchase of the inventory forecasted to occur on September 1 and require the payment of 100,000 FC. On June 1, the US Company acquires FC forward contract to acquire 100,000 FC on September 1. Changes in value are discounted at 6%. 26 Relevant Spot and Forward Rates Date Spot Rate Forward Rate for Remaining Term of June 1 1 FC = $ FC = $0.542 June 30 1 FC = $ FC = $0.560 September 1 1 FC = $ FC = $0.575 Premium: Forward rate > Spot rate Discount: Forward rate < Spot rate Premium = ($0.542 $0.53) x 100,000 = $1,200 Amortized over the life of the contract 27

10 What is Occurring? FC Broker $ US Company 28 Journal Entries 6/1 FC Receivable 54,200 $ Payable 54,200 (100,000 x $0.542) 6/30 FC Receivable* 1,782 Premium Expense** 400 OCI 2,182 *[( ) x 100,000] x [1 (1.005) 2 ] **1,200 3 = 400/month x 1 month 9/1 $ Payable 54,200 Cash 54,200 Cash FC(100,000 x.575) 57,500 Premium expense (400 x 2) 800 OCI 2,318 FC Receivable (54, ,782) 55, Concluding Comments Accounting for foreign currency transactions Explained the accounting treatment related to fair value foreign currency hedges on existing transactions and cash flow hedges on forecasted transactions 30

11 The Next Step Exercises 10 4, 10 6, 10 7 Problems 10 1 (omit Transactions C and D), 10 2, 10 3 Supplemental Problems 31