Title: Foreign Currency Transactions and Hedges
1Chapter 8
- Foreign Currency Transactions and Hedges
2Overview of Chapter 8
- 2 Major Accounting Issues
- Accounting for foreign currency transactions
- Accounting for currency hedging activities
3Definitions
- 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.
4Why 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
5Foreign 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)?
6Foreign Currency Transactions
- Alternatives
- Increase the amount of revenue recorded or
- Recognize the gain in a separate account
72 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
8Foreign 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
9Foreign 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
10New 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)
11Summary
- 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(No Transcript)
13Hedging
- 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
14Forward 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
15Forward 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
16Hedging
- 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
17Hedging - 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
18Hedging - 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.
19Requirements 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.