Professional Documents
Culture Documents
Foreign currency transactions occur when a company buys or sells in a currency other
than its reporting currency.
The objectives of translating foreign currency transactions are to accurately measure
the impact of the transaction on the firm and to allow it to be integrated with the
firms other financial information.
Market forces determine long-term exchange rates.
Factors that result in changing a countrys currency price are: inflation (higher
inflation weakens currency decreases purchasing power); interest rates differential
(higher interest rates strengthens currency); trade surplus/deficit (when exports are
greater than imports, currency increases).
A direct quotation provides the number of units of the Canadian dollar required to
purchase one unit of foreign currency (Ex: CDN$1.12 = US$1.00)
A indirect quotation provides the number of foreign currency units required to
purchase one unit of the Canadian dollar (Ex: US$0.8929 = CDN$1.00)
Part 2:
Class example 1:
Sam Ltd., a Canadian company, purchased supplies totalling 3,000,000 Euros from Ernie
Co. on June 1, 2002. Payment is due in 6 months (no hedges). On December 1, 2002,
Sam paid half of the accounts payable with cash and Ernie Co. agreed to accept a noninterest bearing note payable for the other half. The note payable is due December 1,
2004. Sams year-end is December 31. Prepare the journal entries for 2002 for the
accounts payable and note payable.
June 1, 2002
December 1, 2002
December 31, 2002
C$1 = Euros1.5
C$1 = Euros 2
C$1 = Euros 2.3
2,000,000
2,000,000
2,000,000
750,000
750,000
500,000
97,826
97,826
Part 3:
Class example 2:
On January 1, 2002, a Canadian firm borrowed 100,000 marks from a bank in Germany.
Annual interest rate is 10% and due each Dec 31 for the next five years. Principal is due
Dec. 31, 2006. Foreign exchange rates are: Jan. 1, 2002 C$0.60 = DM1.0; Dec 31, 2002
C$0.67 = DM1.0; Dec 31, 2003 C$0.59 = DM1.0.
In accordance with current GAAP, determine the exchange gain/loss for the loan on the
financial statements for Dec. 31, 2002 and 2003. Record all the related journal entries.
Journal entries:
Jan 1, 2002:
Cash
Foreign currency loan
Dec 31, 2002:
Foreign exchange loss
Foreign currency loan [DM100,000 (0.67-0.60)]
Interest expense [DM10,000 (.67+.60)/2]
Foreign exchange loss
Cash (DM100,000 x 10% = 10,000 x .67)
Dec 31, 2003:
Foreign currency loan [DM100,000 (0.67-0.59)]
Foreign exchange gain
Interest expense [DM10,000 (.67+.59)/2]
Foreign exchange gain
Cash (DM100,000 x 10% = 10,000 x .59)
60,000
60,000
7,000
7,000
6,350
350
6,700
8,000
8,000
6,300
400
5,900
Balance Sheet:
Foreign currency loan (100,000 x 0.67)
(100,000 x 0.59)
2002
$67,000
2003
$59,000
6,350
7,350
6,300
8,400
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Part 4:
Hedges:
The purpose of a hedge is to modify a firms exposure to risk (credit risk, interest rate
risk, foreign currency risk, and liquidity risk). It fixes the amount required to settle an
asset/liability that is denominated in a foreign currency. Guarantee a more secure and
predictable return.
A hedge can be an equal but opposite foreign currency item which fixes (and partially
offsets) the gains or losses on the item that is hedged (also reduces potential gains).
The most common form of hedge is a forward exchange contract (derivative). The
forward exchange contract is between an exchange broker (i.e. bank) and a customer
who agree to exchange currencies at a set price on a future date (fixed or option).
For example, if a company holds a receivable (payable) denominated in a foreign
currency, it could hedge this with a forward contract to sell (buy) the foreign currency
it will receive (need) at a fixed forward exchange rate.
Forward exchange contracts are executory contracts (neither party has fulfilled their
obligation) and are firm commitments and thus they can be recorded in the books
(optional). However, for reporting purposes, the receivable and payable will be offset
against each other and only the net amount will be reported on the balance sheet as a
forward contract. Hence, the Forward contract will be valued at its fair value.
Hedge accounting (optional) is not the same as hedging. Hedge accounting is an
accounting treatment that aims at matching the timing of income recognition on the
hedging item to the timing of income recognition of the related hedged item. Hedging
is designed to modify a firms exposure to risk.
Hedge accounting is applied only when gains, losses, revenues, and expenses on a
hedging item would otherwise be recognized in net income in a different period than
gains, losses, revenues, and expenses on the hedged item [3865.03].
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 [3865.07 (g)]. (This is addressed in more detail in Module 8.)
Handbook: To qualify for hedge accounting: 3 conditions must be met: 1. The
company must identify the risks and state that hedge accounting will be used, 2.
Formally document the hedge relationship and 3. Reasonable assurance that is will be
an effective hedge (i.e. will offset gains and losses).
Record hedges at a premium or at a discount:
Foreign currency transactions are hedged at a premium when the forward rate is
greater than the spot rate (asset = gain; liability = loss).
Example: $1US = $1.50 Forward; $1US = $1.00 Spot
Foreign currency transactions are hedged at a discount when the forward rate is less
than the spot rate (asset = loss; liability = gain).
Example: $1US = $1.00 Forward; $1US = $1.50 Spot
See text example page 509 to 513
Fair-value hedge:
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 [3865.07 (e)].
The hedged item and the hedging item are adjusted for the changes in fair value as a
result of changes in the foreign exchange rates. These changes in fair value result in
a loss or a gain, which is recognized in net income even when the hedged item has
been designated as available-for-sale [3865.47]. (Versus: gains and losses on
unhedged available-for-sale financial instruments are recognized in other
comprehensive income).
If the hedges were not perfect there would be a residual amount that would impact
net income (amortization of premium or discount).
The hedged item and the derivative hedging item are reported at fair value on the
balance sheet as required by section 3855.
For fair-value hedges of unrecognized firm commitments, the hedge price sets the
purchase price [3865.50].
Example: Buy goods for US$1,000 to be delivered in 2 months. Spot rate today
$1US = $1.10C. Immediately enters into a Forward contract at $1US = $1.08C. In 2
months will record the goods into their books at $1,080 (1,000 US x 1.08)
regardless of spot rate on the delivery / transaction date (1.06).
Part 5:
Class example 3: Chapter 11, Problem 8 (page 533)
En-Dur Corporation (EDC) is a Canadian company that exports computer software. On
December 1, 2005, EDC shipped software products to a customer in South Africa. The
selling price was established as 750,000 rand, with payment to be received on March 1,
2006.
On December 3, 2005, EDC entered into a fair value hedge with the Royal Bank at the
90-day forward rate of R1 = $0.781. The fiscal year-end of EDC is December 31. The
payment from the South Africa customer was received on March 1, 2006.
Exchange rates were as follows:
December 1, 2005
December 3, 2005
December 31, 2005
March 1, 2006
Required:
Part A:
Part B:
Spot Rates
R1 = $0.741
R1 = $0.741
R1 = $0.757
R1 = $0.738
Forward Rates
R1 = $0.781
R1 = $0.785
R1 = $0.738
Part A: (a)
December 1, 2005
Accounts receivable (R750,000 .741)
Sales
December 3, 2005
Receivable from bank (C$)
Payable to bank (R750,000 .781)
555,750
555,750
585,750
585,750
12,000
12,000
3,000
3,000
March 1, 2006
Exchange gain/loss
Accounts receivable (R750,000 [.738 .757])
Payable to bank (R750,000 [.738 .785])
Exchange gain/loss
14,250
14,250
35,250
35,250
553,500
553,500
Cash
585,750
553,500
553,500
585,750
(b)
En-Dur Corporation
Balance Sheet
As at December 31, 2005
Current assets
Accounts receivable
567,750
Current liabilities
Forward contract (1)
3,000
588,750
585,750
3,000
Note: Receivable and payable with the bank are usually recorded in the firms journals
(because they are a firm commitment and can not be cancelled) but are NOT reported on
the Balance Sheet (because they are executed contracts). However, the net amount of
these two executed contracts is reported on the Balance Sheet as Forward contract.
Recall an executed contract is when neither party has performed its obligation to the
other.
Part B:
March 1, 2006
Cash (R) (R750,000 .738 spot)
Exchange gain/loss
Accounts receivable (R750,000 .757 YE rate).......
553,500
14,250
567,750
At year end, $12,000 exchange gain recognized thru NI (R750,000 [.757 .741])
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Part 6:
Cash-flow hedge:
A cash-flow hedge is a hedge of the variability in cash flows of financial instruments,
forecasted future transactions (expected to occur in the future that has not yet given
rise to a recognized asset or liability) or unrecognized firm commitments [3865.07f].
Hedge future cash flows thus the risk is not yet incurred but the firm takes steps to
protect future cash flows against that potential variability.
To qualify for a cash-flow hedge, the hedged items must subsequently generate future
cash flows, which should be exposed to variability resulting from risk.
Gains and losses on the effective portion of the hedge are reported in other
comprehensive income [3865.52 (a)]. Gains and losses on the ineffective portion of
the hedge are reported in net income [3865.52 (b)].
The associated gains or losses recognized in other comprehensive income should be
reclassified into net income in the same period or periods during which the hedged
item (asset acquired, liability incurred, or anticipated transaction) affects net income.
If the company expects that all or a portion of a loss recognized in other
comprehensive income will not be recovered in one or more future periods, that
amount should be recognized into net income.
A company may elect to account for a hedge of the foreign currency risk in a firm
commitment as a cash-flow hedge [3865.51].
For cash-flow hedges of unrecognized firm commitments, the company may elect to
amortize to net income over the life of the asset acquired or liability assumed any
associated gains and losses previously included in other comprehensive income
[3865.56 (a)] or to have the hedge price set the purchase price [3865.56 (b)].
Summary of accounting treatment if adopt hedge accounting:
o Hedge date: Record the forward contract: set up Payable and Receivable
with the bank at forward rate. Calculate premium or discount and the cost
of sale or purchase based on the spot rate.
o If a year-end prior to transaction date: adjust forward contract to the
forward rate (unrealized gain/ loss held under OCI). Balance sheet: record
forward contract at fair value (CR = liability; DR = asset).
o On transaction date: record purchase/sale at spot rate and set up
payable/receivable. Adjust forward contract to the forward rate (unrealized
gain/loss held under OCI). Close OCI and AOCI (from year-end) to sale
or purchase (part of premium/discount).
o On settlement date: adjust payable or receivable to spot rate (gain or loss
thru NI) and forward contract to forward rate (gain or loss thru NI).
Net gain or loss is the balance of any amortization of the premium or
discount. Record cash as agreed, remove payable/receivable and remove
balance in forward contract (Payable and Receivable with the bank).
Premium/ discount is split between cost of hedging (thru NI) and value of sale/purchase
(value on hedge date final balance recorded in books).
If do NOT adopt Hedge accounting: Do not use OCI close to NI. No adjustment
to value of sale or purchase recorded at spot rate on transaction date.
480,000
480,000
4,000
4,000
468,000
468,000
4,000
4,000
16,000
16,000
4,000
4,000
10
Cash (SF)
Accounts receivable (SF400,000 1.19)
476,000
476,000
480,000
476,000
476,000
480,000
Premium of $8,000 (16,000 gain 8,000 loss) is split between the cost of hedging and
the value assigned to sales.
Premium assigned to cost of hedging: $16,000 gain: Dec 31: $12,000 gain (16,000
4,000) plus Jan. 31: $4,000 gain (12,000 8,000)
Premium assigned to sales: $8,000 loss: Sales value on October 1 $472,000 (400,000 x
1.18) less final balance of sales $464,000 (468,000-4,000)
(b) Trial balance, December 31, Yr 6
DR
CR
Accounts receivable
484,000
B/S
Sales
464,000 I/S
Exchange gain/loss
12,000 I/S
Receivable from bank*
480,000
Payable to bank*(400,000 x 1.22)
488,000
*A net amount of $8,000 Cr would appear on the BS: forward contract - current liability.
(c) If did not apply hedge accounting:
Dec. 1: Journal entry: do NOT use OCI
Loss
Payable to bank (SF 400,000 x (1.21-1.20)
4,000
4,000
Part 7:
Transnational financial reporting refers to reporting across national boundaries, that is,
reporting financial results to user groups located in a country other than the one where the
company is headquartered.
Some strategies to accommodate foreign users are:
1. Provide unchanged financial statements Do nothing.
3 reasons: little need for foreign capital, sophisticated users, and language and currency is
well understood around the world. This approach is cheap and easy for firm but increases
costs to users, which can discourage them from investing.
2. Prepare convenient translations: Prepare statements using a common language such
as English (or translate into the language of the foreign readers) but leave the figures in
the currency of the home country and accounting principles unchanged. Relatively easy
and inexpensive, foreign readers can read the financial statements which increase the
audience. But the figures and accounting principles are un-translated / unchanged.
3. Prepare convenient statements: Prepare statements using a common language such
as English and restate the figures to a common currency such as U.S. dollars. Foreign
readers can read them and monetary amounts are expressed in readers currency. But lose
foreign appearance and can be misleading if reader does not realize that foreign GAAP is
still used.
4. Restate financial statements on limited basis: Partially restate some figures or
provide reconciliations to the foreign countrys accounting policies in the notes to the
financial statements. More convenient for the foreign readers to analyze and decrease
penalties such as lower stock prices and higher interest rates related to the users when
effectively communicate financial information. But is more costly and inconvenient for
the company.
5. Prepare secondary financial statements: Issue new statements with the needs of the
potential user in mind. Translate to their language and their currency and restate to a
common GAAP such as IASC standards. Further reduce penalties, attract more
international investment as easier and cheaper for readers to analyze. But it is the most
expensive, requires two sets of books, and can disclose too much information to
competitors.
Criteria to consider to determine which approach to use:
: Decision should be based on cost-benefit analysis
: Who are the potential audience, what are the needs of the users and their level of
sophistication
: How well understood the local GAAP and international disclosure standards
: The amount of capital raised outside of the country
: How well the native language, currency and business environment is known
THE END
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