Foreign Currency Transactions and Hedges

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Foreign Currency Transactions and Hedges

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Amortized Cost. Held-to-maturity financial assets. Net Income. Not Applicable. Historical Cost ... Amortize the premium on the forward contract ... – PowerPoint PPT presentation

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Title: Foreign Currency Transactions and Hedges


1
Chapter 8
  • Foreign Currency Transactions and Hedges

2
Overview of Chapter 8
  • 2 Major Accounting Issues
  • Accounting for foreign currency transactions
  • Accounting for currency hedging activities

3
Definitions
  • Foreign currency transaction
  • Transactions that are denominated in a foreign
    currency.
  • Denominated
  • When the monetary value of a transaction is
    specified in a currency that is not the companys
    reporting currency.

4
Why do currency fluctuations occur?
  • Like all prices, currency exchange rates are a
    function of supply and demand
  • As with the determination of the price of a share
    in the stock market, the amounts that traders are
    willing to bid or ask for a currency are
    indicative of not only current supply and demand,
    but expectations as to future events
  • As economic conditions evolve, and expectations
    change, inevitably, fluctuations will occur
  • Long run effects inflation rates and interest
    rates

5
Foreign Currency Transactions
  • Example
  • On December 5, 2005, Domestic Corp sells 100
    units of its product in the US for US100,000.
    The exchange rate on the date of the transaction
    was US1 CDN1.25, then the Canadian equivalent
    is 127,000
  • Dr Accounts receivable 125,000
  • Cr Sales 125,000
  • What if the exchange rate changes to US1
    CDN1.27 at the time of settlement (payment)?

6
Foreign Currency Transactions
  • Alternatives
  • Increase the amount of revenue recorded or
  • Recognize the gain in a separate account

7
2 Different Approaches
  • One-Transaction
  • Views the accrual and the cash settlement as one
    single economic event
  • Two-Transaction
  • The accrual is viewed as one event and the cash
    settlement is treated as a separate financing
    activity
  • Recommended by the CICA

8
Foreign Currency Transactions
  • Journal entry on settlement would be
  • Dr Cash 127,000
  • Cr Accounts receivable 125,000
  • Cr Foreign currency exchange gain 2,000
  • 3 important dates transaction date, balance
    sheet date, and settlement date

9
Foreign Currency Transactions
  • Current Practice
  • Monetary items are
  • Restated at each BS date to current rate
  • Gains/losses are recorded in income
  • Non-monetary items are recorded at historical
    cost
  • therefore are not revalued for changes in
    exchange rates
  • New Standard Oct/06
  • The treatment of exchange gains/losses varies,
    depending on the type of asset or liability
  • i.e. different for held to maturity, available
    for sale and held for trading assets and
    liabilities

10
New Standards
  • Effective for fiscal years beginning on or after
    October 1, 2006
  • Until then, financial statements will be based on
    existing standards, which essentially do NOT use
    fair values for any financial instruments
  • Most significant difference in this new standard
    is as it relates to financial instruments that
    are recorded at fair values at each balance sheet
    date (i.e. available for sale and held for
    trading assets and liabilities)

11
Summary
  • 2 Alternatives for reporting carrying value at BS
    date
  • Cost
  • Fair Value
  • 2 Alternatives for reporting the gain/loss from
    changes in fair values
  • Recognize in income immediately
  • Defer it in other comprehensive income until
    realized

12
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13
Hedging
  • Foreign currency losses can be significant, and
    many companies protect themselves against this
    exposure through HEDGING transactions
  • Hedging is the creation of an offsetting balance
    in the same foreign currency
  • Hedging may be accomplished in several ways
  • Through offsetting amounts arising in the normal
    course of business
  • Through cash or revenue flows expected in the
    foreign currency
  • Through holding of assets in the foreign location
  • Through swaps, options, and futures contracts
  • Through forward contracts MOST COMMON

14
Forward Contracts
  • Under a forward contract, a financial institution
    agrees to exchange currencies at a future date at
    a rate set when the contract is entered
  • A forward contract is in some respects an
    executory contract and so some firms make no
    formal entries
  • Generally, however, the binding nature of the
    forward relationship leads to journal entries
    which take a prescribed sequence

15
Forward Contracts
  • The costs of forward contracts include the direct
    costs of the forward premium and the costs of
    administration of the foreign currency
    denominated items by the company
  • The principal benefit is the alleviation of risk
  • Known future cash flows enable better planning
  • Not all risks are eliminated by forward contracts
  • A significant risk is the opportunity cost of
    favorable exchange fluctuations having been
    foregone - that is, the firm has lost
    opportunities for gains

16
Hedging
  • There is one important distinction to make before
    getting into how to account for hedges what are
    we hedging
  • an EXISTING transaction, or
  • an EXPECTED transaction

17
Hedging - Existing Transaction
  • When an existing monetary position is hedged
  • Record the transaction (purchase/sale)
  • Set up the forward contract vs. the payable or
    receivable to/from bank
  • At balance sheet dates
  • Revalue the original payable/receivable
  • Revalue the forward contract
  • Value of payable/receivable to bank not changed
  • Amortize the premium on the forward contract
  • At settlement, repeat the procedures of the
    statement date, and record all cash flows executed

18
Hedging - Expected Transaction
  • When a purchase or sale of goods or services in a
    foreign currency is hedged before the
    transaction, the Canadian dollar price of such
    goods or services is established by the terms of
    the hedge.

19
Requirements for Hedge Accounting
  • In order to qualify for hedge accounting, a
    specific currency risk must be identified and
    designated as a hedged item. A specific hedging
    item must also be designated.
  • There must also be reasonable assurance that the
    hedging relationship will be effective at
    negating or substantially reducing the currency
    risk.
  • Hedges must also be tested for effectiveness in
    order to maintain hedge accounting.
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