Explain how fluctuations in exchange rates give rise to foreign exchange risk
International Accounting Fifth Edition Timothy Doupnik | Mark Finn Giorgio Gotti | Hector Perera Chapter 6: Foreign Currency Transactions and Hedging Foreign Exchange Risk ©2020 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education. Learning Objectives 1 Provide an overview of the foreign exchange market. Explain how fluctuations in exchange rates give rise to foreign exchange risk. Demonstrate the accounting for foreign currency transactions. Describe how foreign currency forward contracts and foreign currency options can be used to hedge foreign exchange risk. Describe the concepts of cash flow hedges, fair value hedges, and hedge accounting. 6-2 ©2020 McGraw-Hill Education Learning Objectives 2 Demonstrate the accounting for forward contracts and options used as cash flow hedges and fair value hedges to hedge foreign currency assets and liabilities, foreign currency firm commitments, and forecasted foreign currency transactions. 6-3 ©2020 McGraw-Hill Education Foreign Exchange Markets 1 Foreign exchange rate. • Purchase price of a foreign currency. 1945 –1973. • Exchange rates fixed in U.S. dollar. • U.S. dollar was fixed in gold. • U.S. dollar was fixed to gold at $35 per ounce. 1960s Balance-of-payments deficits in the U.S. March 1973 most currencies float in value. 6-4 ©2020 McGraw-Hill Education Foreign Exchange Markets 2 Exchange Rate Mechanisms. • Independent float. • Currency value allowed to move freely. • Little government intervention. • Australia, Brazil, Canada, U.S., Japan, Switzerland. • Pegged to another currency. • • • • Currency value fixed in terms of a foreign currency. E.g., U.S. dollar. Central bank maintains the exchange rate. Countries pegged to U.S. dollar: Hong Kong, Panama, Saudi Arabia. European Monetary System (Euro). • Twelve countries use a single currency. • Floats against other currencies. • E.g., U.S. dollar. 6-5 ©2020 McGraw-Hill Education Foreign Exchange Markets 3 Foreign Exchange Rates. • • • • • Interbank rates. Wholesale prices. Banks charge one another. Exchange of currencies. Spread: difference between buying and selling rates. Published on the Internet and in newspapers. Reflected. • • • • Direct quotes (U.S. $ equivalent). Indirect quotes (currency per U.S. $). Direct quote reciprocal of indirect quote. Indirect quote reciprocal of direct quote. 6-6 ©2020 McGraw-Hill Education Foreign Exchange Markets 4 Spot rates. • Today’s price for purchasing or selling a foreign currency. Forward rate. • Today’s price for purchasing or selling a foreign currency sometime in the future. Premium. • Forward rate is greater than the spot rate. Discount. • Forward rate is less than the spot rate. Differences in interest rates cause premium/discount. • Interest rate foreign > interest rate local gives discount. 6-7 ©2020 McGraw-Hill Education Foreign Exchange Markets 5 Option contracts. • Foreign currency option. • Gives right, no obligation. • Trade foreign currency. • Trade in future. • Put option. • Option to sell the foreign currency. • Call option. • Option to buy the foreign currency. • Strike price. • Exchange rate at which currency will be exchanged if option is exercised. 6-8 ©2020 McGraw-Hill Education Foreign Exchange Markets 6 Option contracts. • Option premium. • Cost of purchasing the option. • Function of the option’s intrinsic value and time value. • Intrinsic value. • Immediate exercise of the option [either “in the money” or value of zero]. • Gain. • Time value. • Derived value. • Currency value increase. • During the remainder of the option period. Value from adaptation of Black-Scholes option pricing formula. 6-9 ©2020 McGraw-Hill Education Foreign Currency Transactions 1 Transaction exposure. • Exposure to foreign exchange risk. • Export sale [risk is foreign currency declines in value]. • Sale to foreign customer. • Later payment. • In customer’s currency. • Import purchase [risk is foreign currency increases in value]. • Purchases from foreign supplier. • Payment in the supplier’s currency. • Later payment. • Foreign exchange risk. • Change in the exchange rate results in. • Exporter will receive less. • Importer will pay more than anticipated. 6-10 ©2020 McGraw-Hill Education Foreign Currency Transactions 2 Example. • Joe Inc., a U.S. company, makes a sale and ships goods to Jose, SA, a Mexican customer. • Sales price is $100,000 (U.S.) and Joe allows Jose to pay in pesos in 30 days. • The current exchange rate is $0.10 per 1 peso. • Joe plans to receive 1,000,000 pesos ($100,000/$0.10). 6-11 ©2020 McGraw-Hill Education Foreign Currency Transactions 3 Joe has foreign exchange risk exposure because he may receive less than $100,000. Suppose the peso decreases such that in 30 days the exchange rate is $0.09 per 1 peso. Joe will receive 1,000,000 pesos which will be worth $90,000 (1,000,000 x $0.09) and Joe receives $10,000 less due to exchange rate fluctuation. 6-12 ©2020 McGraw-Hill Education Accounting for Foreign Currency Transactions 1 One transaction perspective. • Treats sale and collection as one transaction. • Transaction complete when. • Foreign currency received and converted. • Sale is measured at converted amount. • Not allowed under IFRS or U.S. GAAP. 6-13 ©2020 McGraw-Hill Education Accounting for Foreign Currency Transactions 2 Two transaction perspective. • Two transactions. • Sale. • Collection. • Sale based on current exchange rate. • Exchange rate changes. • Collection for different amount. • Difference considered. • Foreign exchange gain. • Foreign exchange loss. • Concepts are identical for purchase transaction. • IAS 21 and FASB ASC 830 require two-transaction perspective. 6-14 ©2020 McGraw-Hill Education Accounting for Foreign Currency Transactions 3 Transaction types, exposure type and gain or loss – export sales. Export sale → asset exposure–if foreign currency appreciates → foreign exchange gain. Export sale → asset exposure–if foreign currency depreciates →foreign exchange loss. 6-15 ©2020 McGraw-Hill Education Accounting for Foreign Currency Transactions 4 Transaction types, exposure type and gain or loss – import purchases. Import purchase → liability exposure — if foreign currency appreciates → foreign exchange loss. Import purchase → liability exposure — if foreign currency depreciates → foreign exchange gain. 6-16 ©2020 McGraw-Hill Education Accounting for Foreign Currency Transactions 5 Export sale – example 1. February 1, 2018, Eximco, a U.S. company, makes a sale and ships goods to Jose, a Spanish customer. Sales price is $1,500,000. Jose agrees to pay in Euros on March 2, 2018. Assume spot rate as of February 1, 2018, is $1.50 = 1Euro. 6-17 ©2020 McGraw-Hill Education Accounting for Foreign Currency Transactions 6 Export sale – example 1. Joe Inc. records the sale (in U.S. $) on February 1, 2018, as follows: Accounts Receivable Sales $1,500,000 $1,500,000 6-18 ©2020 McGraw-Hill Education Accounting for Foreign Currency Transactions 7 Export sale – example 1. On March 2, 2018, the spot rate is 1Euro = $1.48. Joe Inc. will receive 1,000,000 Euros, which are now worth $1,480,000. Joe makes the following journal entries: Dr. Foreign Exchange Loss 20,000 Cr. 20,000 Accounts Receivable Dr. Cash 1,480,000 Cr. 1,480,000 Accounts Receivable 6-19 ©2020 McGraw-Hill Education Accounting for Foreign Currency Transactions 8 Balance Sheet Date before Date of Payment. • Revalue foreign currency receivable or payable to spot rate on balance sheet date. • Accrual Approach: show gain or loss for change in value of receivable or payable. 6-20 ©2020 McGraw-Hill Education Accounting for Foreign Currency Transactions 9 Export sale – example 2. Assume the following facts are added or changed: Joe Inc., makes sale and ships goods on December 1, 2017 rather than February 1, 2018. Spot rate as of December 1, 2017, is $1.50 per Euro. Spot rate as of December 31, 2017, is $1.51 per Euro. Joe Inc. has a December 31 year-end. 6-21 ©2020 McGraw-Hill Education Accounting for Foreign Currency Transactions 10 Export sale – example 2. Joe, Inc. records the sale (in U.S. $) on December 1, 2017, and the foreign exchange gain on December 31, 2017, as follows: Accounts Receivable Sales Accounts Receivable Foreign Currency Gain 1,500,000 1,500,000 10,000 10,000 6-22 ©2020 McGraw-Hill Education Accounting for Foreign Currency Transactions 11 Export sale – example 2. Joe Inc. records the receivable collection and a foreign exchange loss on March 2, 2018: Dr. Foreign Exchange Loss 30,000 Cr. Accounts Receivable 30,000 Dr. Cash 1,480,000 Cr. Accounts Receivable 1,480,000 6-23 ©2020 McGraw-Hill Education Hedging Foreign Exchange Risk 1 Hedging. • Protects from exchange rate fluctuations. • Foreign currency forward contracts. • Foreign currency options. Foreign currency forward contract. • Buy or sell foreign currency. • Future date. Foreign currency option. • Right to buy or sell foreign currency. • For a period of time. 6-24 ©2020 McGraw-Hill Education Hedging Foreign Exchange Risk 2 Derivative. • Hedge accounting appropriate if derivative. • Used to hedge an exposure. • Highly effective In offsetting changes in. • Fair value. • Cash flows related to the hedged item. • Properly documented as a hedge. 6-25 ©2020 McGraw-Hill Education Accounting for Derivatives IAS 39 General Principles for Derivative Accounting. • All derivatives shown on balance sheet at fair value. • Asset if positive fair value; liability if negative fair value. • “Hedge Accounting” acceptable if hedging relationship is clearly defined, measurable and actually effective. • Three pieced need to get fair value of derivative. • Forward rate and date of forward contract. • Current forward rate for contract with same maturity date. • Discount rate (firm’s borrowing rate). 6-26 ©2020 McGraw-Hill Education Accounting for Changes in Fair Value of Derivative Change in Fair Value part of Comprehensive Income. Gain or loss in fair value either. • On income statement as part of net income or, • On balance sheet as component of other comprehensive income. • Usually income statement treatment if speculation and balance sheet treatment if hedge transaction. 6-27 ©2020 McGraw-Hill Education Hedge Accounting Must satisfy 3 conditions. • Derivative hedges either fair value exposure or cash flow exposure to foreign currency risk. • Derivative is highly effective in offsetting changes in fair value or cash flows related to hedged item. • Derivative properly documented as a hedge. 6-28 ©2020 McGraw-Hill Education Nature of Hedged Risk 1 Fair value exposure: change in exchange rates affects fair value of asset or liability with corresponding potential to affect net income if not hedged. Cash flow exposure: change in exchange rates affect the amount of cash flow to be realized with corresponding affect on net income. Hedge accounting requires derivatives be classified. • Fair value hedge: foreign currency assets, liabilities, firm commitments. • Cash flow hedge: forecasted foreign currency transactions. 6-29 ©2020 McGraw-Hill Education Nature of Hedged Risk 2 Gains/Losses Fair Value Hedges immediately to income. Gains/Losses Cash Value Hedge included other comprehensive income. Hedge Effectiveness Requirements. • Economic relationship between eligible hedged item and hedging instrument. • The effect of credit risk does not dominate the value changes that result from that economic relationship. • Equality of quantity of hedged item and quantity of hedging instrument. 6-30 ©2020 McGraw-Hill Education Nature of Hedged Risk 3 Hedge Documentation. • Hedging relationship formally documented at inception of hedge. • Hedging item. • Hedging instrument. • Nature of risk being hedged. • How hedge effectiveness will be assessed. • Risk management objective. • Strategy for undertaking the hedge. Cash Flow Statement Impact. • Classified on basis of cash flows arising from hedged item. 6-31 ©2020 McGraw-Hill Education Nature of Hedged Risk 4 Hedging Combinations. • Type being Hedged. • Foreign-currency-denominated asset/liability. • Foreign currency firm commitment. • Forecasted foreign currency transactions. • Nature of item being hedged. • Asset. • Liability. • Type of Hedging Instrument Used. • Forward Contract. • Option Contract. • Swap. • Futures. 6-32 ©2020 McGraw-Hill Education Nature of Hedged Risk 5 Hedging Combinations. • Nature of Hedged Risk. • Fair value hedge. • Cash flow hedge. • Hedge of net investment in foreign operations. 6-33 ©2020 McGraw-Hill Education Hedges of Foreign-CurrencyDenominated Assets and Liabilities 1 Cash Flow Hedge [at balance sheet date]. • Hedged asset/liability at fair market value. • Gain/loss shown in income. • Amount equal to gain/loss recognized transferred to AOCI to offset any gain/loss on hedged asset or liability. • Hedging instrument adjusted to fair value with counterpart in AOCI. • Additional amount removed from AOCI transferred to income to reflect. • Current period’s amortization of original discount/premium. • Change in time value of option. 6-34 ©2020 McGraw-Hill Education Hedges of Foreign-CurrencyDenominated Assets and Liabilities 2 Fair Value Hedge [balance sheet date]. • Hedged asset/liability adjusted to fair value. • Foreign exchange gain/loss to income statement. • Hedging instrument adjusted to fair value with counterpart recognized as gain/loss on income statement. 6-35 ©2020 McGraw-Hill Education Hedging Foreign Exchange Risk 3 Hedging risk on an export sale – example 1. Previously, Joe Inc. lost $10,000 without hedging as the Euro fell from $1.50 to $1.49. The loss was ($1.50 − 1.49) 1,000,000 Euros. Joe could have purchased a foreign currency forward contract on December 1, 2017. 6-36 ©2020 McGraw-Hill Education Hedge Accounting 2 Assumptions for examples 1 and 2. December 1, 2017, Joe Inc., a U.S. company, makes a sale and ships goods to Jose, SA, a Spanish customer. Sales price is $1,500,000 (U.S.). Jose agrees to pay 1,000,000 Euros on March 2, 2018. Spot rates per Euro are: December 1, 2017, $1.50; December 31, 2017, $1.51; and March 2, 2018, $1.48. The annual interest rate is 6% (0.5% per month). 6-37 ©2020 McGraw-Hill Education Hedge Accounting 3 Joe enters a foreign currency forward contract on December 1, 2017. The contract calls for Joe to sell 1,000,000 Euros at a forward rate of $1.485, on March 2, 2018. The forward rate on December 31, 2017, for March 2, 2018, delivery is $1.496. 6-38 ©2020 McGraw-Hill Education Hedge Accounting 4 Example 1, FC asset/forward/cash flow hedge. 12/01/17 Accounts Receivable 1,500,000 Sales 1,500,000 12/31/17 Accounts Receivable 10,000 Gain on Foreign Currency Loss on Forward Contract 10,000 10,000 AOCI 10,000 12/31/17 AOCI Forward Contract 10,783 10,783 6-39 ©2020 McGraw-Hill Education Hedge Accounting 5 Example 1, FC asset/forward/cash flow hedge. Discount Expense Accumulated Other Comprehensive Income 5,017 5,017 (Discount expense is amortized using the straight-line method.) 6-40 ©2020 McGraw-Hill Education Hedge Accounting 6 Example 1, FC asset/forward/cash flow hedge. 3/02/18 Foreign Exchange Loss Accounts Receivable Accumulated Other Comprehensive Income Gain on Forward Contract Forward Contract AOCI 30,000 30,000 30,000 30,000 15,783 15,783 6-41 ©2020 McGraw-Hill Education Hedge Accounting 7 Example 1, FC asset/forward/cash flow hedge. 3/02/18 Discount Expense 9,983 Accumulated Other Comprehensive Income Foreign Currency 9,983 1,480,000 Accounts Receivable Cash 1,480,000 1,485,000 Foreign Currency 1,480,000 Forward Contract 5,000 6-42 ©2020 McGraw-Hill Education Hedge Accounting 8 Example 2, FC asset/forward/fair value hedge. 12/01/17 Accounts Receivable Sales 12/31/17 Account Receivable Foreign Exchange Gain Loss on Forward Contract Forward Contract 1,500,000 1,500,000 10,000 10,000 10,783 10,783 6-43 ©2020 McGraw-Hill Education Hedge Accounting 9 Example 2, FC asset/forward/fair value hedge. 3/02/18 Foreign Exchange Loss 30,000 Accounts Receivable Forward Contract Gain on Forward Contract 30,000 15,783 15,783 6-44 ©2020 McGraw-Hill Education Hedge Accounting 10 Example 2, FC asset/forward/fair value hedge. 3/02/18 Foreign Currency 1,480,000 Accounts Receivable Cash 1,480,000 1,485,000 Foreign Currency 1,480,000 Forward Contract 5,000 6-45 ©2020 McGraw-Hill Education Foreign Currency Option used to Hedge a Recognized Foreign-Currency-Denominated Asset 1 Our Eximco Company purchases an OPTION to sell 1,000,000 Euros for $1.50 each. Option contract costs $9,000. Cash flow Hedge. Dr. Accounts Receivable $1,500,000 Cr. Sales Dr. Foreign Currency Option Cr. Cash $1,500,000 9,000 9,000 6-46 ©2020 McGraw-Hill Education Foreign Currency Option used to Hedge a Recognized Foreign-Currency-Denominated Asset 2 Cash Flow Hedge. • December 31, $1.51 per Euro. Dr. Accounts Receivable 10,000 Cr. Foreign Currency Gain Dr. Loss on Foreign Currency Option 10,000 10,000 Cr. AOCI Dr. AOCI 10,000 3,000 Cr. Foreign Currency Option Dr. Option Expense Cr. AOCI 3,000 3,000 3000 6-47 ©2020 McGraw-Hill Education Foreign Currency Option used to Hedge a Recognized Foreign-Currency-Denominated Asset 3 Cash Flow Hedge. • March 2, 2018 1Euro = $1.48. Dr. Foreign Exchange Loss 30,000 Cr. Accounts Receivable Dr. AOCI 30,000 30,000 Cr. Gain on Foreign Currency Option Dr. Foreign Currency Option 30,000 14,000 Cr. AOCI Dr. Option Expense 14,000 6,000 Cr. AOCI Dr. Foreign Currency 6,000 1,480,000 Cr. Accounts Receivable Dr. Cash Cr. Foreign Currency Cr. Foreign Currency Option 1,480,000 1,500,000 1,480,000 20,000 6-48 ©2020 McGraw-Hill Education Foreign Currency Option used to Hedge a Recognized Foreign-Currency-Denominated Asset 4 Cash Flow Hedge. • Ending spot rate $1.505 instead of $1.48 (hence option is worthless). • March 2, 2018. Dr. Foreign Exchange Loss 5,000 Cr. Accounts Receivable Dr. Loss on Foreign Currency Option 5,000 6,000 Cr. Foreign Currency Option Dr. AOCI 6,000 5,000 Cr. Gain on Foreign Currency Option Dr. Foreign Currency 5,000 1,505,000 Cr. Accounts Receivable Dr. Cash 1,505,000 1,505,000 Cr. Foreign Currency Dr. AOCI Cr. Gain ©2020 McGraw-Hill Education 1,505,000 5,000 5,000 6-49 Option Designated as Fair Value Hedge Gain or loss directly to net income. No recognition in change in time value of option. No difference in cash flows or net income recognized. 6-50 ©2020 McGraw-Hill Education Hedges of Unrecognized Foreign Currency Firm Commitments 1 Firm commitment: Company signs contract to deliver merchandise at future date with receivable in a foreign currency also at future date. No journal entry when contract signed. If Fair Value Hedge [taken when contract signed before any accounting record of future transaction]. • Gain/loss on hedge recognized in income. • Gain/loss on firm commitment attributable to hedged risk also recognized in income. • Accounting treatment. • Measure fair value of firm commitment. • Recognize change in fair value in net income. • Report firm commitment on balance sheet as asset or liability. 6-51 ©2020 McGraw-Hill Education Hedges of Unrecognized Foreign Currency Firm Commitments 2 How to measure fair value of firm commitment. • Changes in value of spot exchange rate or, • Changes in value of forward exchange rate. 6-52 ©2020 McGraw-Hill Education Hedges of Unrecognized Foreign Currency Firm Commitments 3 Forward Contract Used as Fair Value Hedge of Firm Commitment. • • • Using Eximco example: On December 1, Year 1 Eximco accepts order from Spanish customer to deliver goods March 1 Year 2 with payment of 1,000,000 Euros on March 1 Year 2. December 1 Year 1: Eximco enters into forward contract to sell 1,000,000 Euros at $1.485. December 31 forward rate is $1.496 …so “loss” of 11,000 or present value 10,783. • Debit: loss on forward contract 10783. • Credit: forward contract. • Debit: Firm commitment 10783. • Credit: Gain on Firm commitment 10783. 6-53 ©2020 McGraw-Hill Education Hedges of Unrecognized Foreign Currency Firm Commitments 4 March 1 Year 2 goods delivered, payment received, forward contract settled. Debit: Foreign Currency 1,480,000 Credit: Sales Debit: Cash 1,480,000 1,485,000 Credit: Foreign Currency 1,480,000 Credit: Forward Contract 5,000 Debit: Firm Commitment Credit: Adjustment to net income 5,000 5,000 6-54 ©2020 McGraw-Hill Education Hedges of Unrecognized Foreign Currency Firm Commitments 5 Option Used as Fair Value Hedge of Firm Commitment. Eximco purchases put option to sell 1,000,000 Euros at $1.50 instead of forward contract. Cost of option $9,000. December 1: Debit: Foreign Currency Option 9,000 Credit: Cash 9,000 December 31: Debit: Firm Commitment 9,803 Credit: Gain on Firm Commitment Debit: Loss on Foreign Currency Option Credit: Foreign Currency Option 9,083 3,000 3,000 6-55 ©2020 McGraw-Hill Education Hedges of Unrecognized Foreign Currency Firm Commitments 6 March 1st. Debit: Loss on Firm Commitment 29,803 Credit: Firm Commitment Debit: Foreign Currency Option 29,803 14,000 Credit: Gain on Foreign Currency Option Debit: Foreign Currency 14,000 1,480,000 Credit: Sales Debit: Cash 1,480,000 1,500,000 Credit: Foreign Currency 1,480,000 Credit: Foreign Currency Option Debit: Firm Commitment Credit: Adjustment to Net Income 20,000 20,000 20,000 6-56 ©2020 McGraw-Hill Education Hedge of Forecasted Foreign-CurrencyDenominated Transaction 1 Differs from accounting for a hedge of foreign currency commitment in 2 ways: • No recognition of the forecasted transaction gain/loss on the forecasted transaction. • Hedging instrument shown at fair value with changes in value going to Other Comprehensive Income. 6-57 ©2020 McGraw-Hill Education Hedge of Forecasted Foreign-CurrencyDenominated Transaction 2 Option Designated as Cash Flow Hedge of a Forecasted Transaction: • • Using Eximco: On December 1 Year 1 they purchase put option to sell 1,000,000 (at $1.50) Euros on March 1 expecting sale to Spanish Company. Put option costs $9,000. February 1, Year 2 get order from Spanish Company to deliver goods March 1 Year 2 for 1,000,000 Euros. December 1 Debit: Foreign Currency Option 9,000 Credit: Cash 9,000 December 31 Debit: Option Expense Credit: Foreign Currency Option 3,000 3,000 6-58 ©2020 McGraw-Hill Education Hedge of Forecasted Foreign-CurrencyDenominated Transaction 3 March 1. Debit: Foreign Currency Option 14,000 Debit: Option Expense 6,000 Credit: AOCI Debit: Foreign Currency 20,000 1,480,000 Credit: Sales Debit: Cash 1,480,000 1,500,000 Credit: Foreign Currency 1,480,000 Credit: Foreign Currency Option Debit: AOCI Credit: Adjustment to Income 20,000 20,000 20,000 6-59 ©2020 McGraw-Hill Education End of Chapter 6 6-60 ©2020 McGraw-Hill Education
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