Dr. Mohammad S.

Bazaz

Foreign Currency Transaction

Factors cause foreign currency exchange rates to change: The price of a foreign currency (the exchange rate) is governed by the laws of supply and demand. The following factors affect supply and demand: o Relative domestic inflation rates Foreign inflation pushes the direct exchange rate down omestic inflation pushes the direct exchange rate up. o !nterest Rates "ountries may increase their interest rates to attract capital# thereby creating demand for their currencies. o Trade deficit or trade surplus !n recent years# $% has approximately &'(( billion annual trade deficit. o %ervice deficit or service surplus $% has roughly &)( billion service surplus a year *ver +((#((( foreign students attending $% colleges# which brings about &,- billion. .early +( million foreigners visit the $nited %tates annually# spending over &-- billion. o !nvestment deficit or investment surplus. The $% has had si/able annual investment surpluses $0# 1apan# the .etherlands# and "anada are primary investors in the $%. o Federal deficits o 2overnment3imposed restrictions on currency transfers. o "ivil disorders and wars. The interrelationship between foreign trade and foreign investment o 1apanese dealers (for example) can use their accumulated dollars from their trade surplus in various ways such as: 4c5uire $.%. 6roducts. 4c5uire $% services 4c5uire $% real estate 4c5uire $% companies 4c5uire $% treasury securities Trade and investment relationship can be formuli/ed as: Trade deficit - Service surp us ! "nvestment Surp us

#ccounting for Foreign Currency

'787 '7-8

#$B %&. '99:#$B %o. )((

'7)8 '( 99:SF#S

'7)-

'7,'

'77,

%o. )99: SF#S %o. *99: SF#S %o. +,!!-SF#S %o.

Trans ation Methods:

3"urrent 3 "on3current method 3;onetary3 .on monetary ;ethod 3Temporal ;ethod 3"urrent Rate method

&./ective of Trans ation ($nder %F4% .o. -<):

6roviding information that is generally compatible with the expected economic effects of a rate change on an enterprise=s cash flows and e5uity. Reflecting in consolidated statements the financial results and relationships of the individual consolidated entities as measured in their functional currencies in conformity with $% generally accepted accounting principles.

Termino ogies:
Foreign currency >ocal (recording) currency Reporting (parent) currency Functional currency

Functiona Currency:
decision of management).

is the currency of the primary environment in which it operates# (sub?ect to

Factors 0hen functiona currency is not o.vious:

3%ales 6rice 33 >ocal ". 3%ales mar@et 33 6arent ". 3Axpenses 33 >ocal ". 3Financing 33 >ocal ". 3Bigh volume of trade 33 6arent ".

1xchange $ates:
%pot Rate Bistorical Rate "urrent (Calance sheet) Rate Forward Rate 2S$3 24$3 2C$3 2F$3

Floating# Fixed# and ;ultiple Axchange rates

The 1uro:
1anuary '# '777# the Auro became the common currency for most of the counties (4ustria# Celgium# Finland# France# 2ermany# !reland# !taly# >uxembourg# the .etherlands# 6ortugal# %pain# and more). 1anuary '# <((<# all non3cash transactions were denominated in the Auro. 1anuary '# <((<# the conversion schedule called for the issuance of paper currency. 1une 8(# <((<# the conversion to the Auro for all business and consumer transactions was scheduled to be complete and the old national currencies of the participating countries will no longer be used.

Foreign Currency Transaction:

&ne-transaction perspective o "onsider the original amount recorded for a foreign merchandise purchase as an estimate# sub?ect to ad?ustment when the exact cash outlay re5uired for the purchase is @nown. Thus# this perspective emphasi/es the cash-payment aspect# rather than the bargain-price aspect# of the transaction. o F4%C re?ected this approach T0o-transaction perspective o %upporters argue that an importer=s or exporter=s assumption of a ris@ of fluctuations in the exchange rate for a foreign currency is a financing decision# not a merchandising decision. o This approach was sanctioned by the F4%C# %F4% .o. -<.

SF#S %o. +,:

3

.o forward contract:
34t the date of Transaction 3 record at %R 34t each balance sheet date. 3ad?ust to the "R 34ny gainsDlosses recogni/ed in the current income.

1xamp es: '. *n .ov. '# <((( a $%. firm sold merchandise for ".&'((#((( to a "anadian firm. *n 1an <-# <((' collected ".&'((#(((. *n 1an 8' converted the ".&'((#((( into $%& #ssuming: %pot Rate 1ournal entries: ''D'D(( 4ccount Receivable (fc) %ales Rev. 4ccount Receivable Axchange 2ain "ash (fc) Axchange >oss 4ccount Receivable "ash "ash (fc) 2ain on Axchange &)-#((( &)-#((( & -#((( & -#((( &),#((( & <#((( (fc) &,<#((( &),#((( & +#((( .ov. ' &(.)ec. 8' &(.,( 1an. <&(.), 1an 8' &(.,<

'<D8'D((

'D<-D('

&,(#(((

'D8'D('

Foreign Currency Derivatives and 4edging #ctivities $nder F#SB Statement %o. )((# E4ccounting for erivative !nstruments and Bedging 4ctivities#F %uch contracts are considered derivative instruments. Cased on %F4% '88# derivative instruments represent rights or obligations and should be reported on the financial statements. Fair value is considered the only relevant measure for derivative instruments. Three situations in which forward exchange contacts are used (%F4% '88): '. To speculate in foreign currency exchange price movements <. 4 fair value hedge: a. To hedge an exposed foreign currency assets or liability b. To hedge a firm commitment c. To hedge a net investment in a foreign entity. 8. 4 cash flow hedge: To hedge a foreign currency forecasted transaction.

Specu ation:
3a forward contract is valued at F$ throughout the life of the contract. FR is considered as fair value of the contract at any time. 3Axchange gains or osses on forward contracts are included in the income statement of the period in which the forward exchange rate changes. 1xamp e: *n .ov. '# <(('a $% firm entered into a contract to purchase ".&'((#((( at a ',(3days forward exchange rate. #ssuming: %pot Rate '<(3days future ',(3days future ''D'D(' .ov. '# <((' &(.)&(.)G 56.7* ec. 8'#<((' &(.,( 56.77 &(.,' &),#((( &),#((( & '#((( & '#((( &,+#((( "ontract Receivable (fc) Axchange 2ains "ontract 6ayable (&) "ash &),#((( &),#((( &))#((( & )#((( 4pril 8(#<((< 56.*' &(.,8 &(.,)

"ontract Receivable (fc) "ontract 6ayable (&) Axchange >oss "ontract Receivable (fc) "ash (fc)

'<D8'D(' +D8(D(<

4edging an exposed %et #ssets or %et 8ia.i ity 9osition:

Business Axporters !mporters %et 9osition 4ccount Receivable 4ccount 6ayable For0ard Contract To sell Foreign "urrency To buy Foreign "urrency

Forward Rate to sell

%pot Rate

Forward Rate to purchase

H3333333333333x33333333333333333333333333x3333333333333333333333333333x333333333333333: iscount 6remium

4 forward contract is recorded at the forward rate ( F$) while the underlying assets or liability is recorded at the spot rate (S$) (and ad?usted to these respective rates and values at the financial statement date). *ver the life of the contract# the initial difference between the S$ and the F$ is the cost of hedging the exchange rate ris@. Forward contract (denominated in foreign currency) is always recorded at its fair value# F$. $nder %F4%'88# both the exchange gain and the offsetting loss must be reported in current earnings. 6erfect Bedging 6artial Bedging

1xamp e: *n .ov. '# '777 a $% firm %old ".&'((#((( to a "anadian company to receive in 7( days. #ssuming: .ov. '# '77%pot Rate 56.*6 8(3days future &(.), G(3days future &(.)) 7(3days future 56.7+ ''D'D77 4ccount Receivable (fc) %ales Revenue "ontract Receivable (&) "ontract 6ayable '<D8'D77 Axchange >oss 4ccount Receivable Axchange >oss "ontract 6ayable (fc) 1an 8'# <((( "ash (fc) Axchange >oss 4ccount Receivable "ontract 6ayable (fc) "ash (fc) Axchange 2ain "ash "ontract Receivable ec. 8' 56.7* 56.7: &(.)8 &(.)+ &,(#((( &,(#((( &)-#((( (fc) & <#((( (fc) & '#((( & '#((( &)+#((( & +#((( (fc) &)G#((( &)+#((( & <#((( &)-#((( &)-#((( &),#((( & <#((( &)-#((( 1an 8'# <((( 56.7' &(.)&(.)8&(.)+-

4edging an "dentifia. e Foreign Currency Commitment

 F" commitment is a contract or agreement denominated in F" that will result in foreign currency transaction at a later date. 4n identifiable foreign currency commitment differs from an exposed assets or liability position because the commitment does not meet the accounting tests for recording the related asset or liability in the accounts. 4 forward contract that is a hedge of a firm commitment is based on the forward rate# not the spot rate. There is no re5uirement that the life of the forward contract has to be at the foreign currency commitment dateI however# the re5uired accounting for the forward contract must begin at the designation date. 1xamp e: *n *ctober <# '777 a $% firm contracts with a "anadian firm for delivery of '#((( cases of bourbon at a price of ".& '((#(((. The bourbon is to be delivered in ;arch and payment made in "anadian dollars on ;arch 8'# <(((. !n order to hedge this future commitment# the $%. firm purchases '((#((( "anadian dollars for delivery in ',( days at a forward exchange rate of &.))-. #ssume: "onditions of %F4% .o. '88 are met and: &ct. ,; )<<< Dec. () %pot Rate 56.7+ &(.)+ 7(3days future &(.), 56.7: ',(3days future 56.77+ &(.)8 '(D<D77 "ontract Receivable (fc) "ontract 6ayable (&) Axchange loss "ontract Receivable (fc) &))#-(( &))#-(( & '#-(( & '#-(( March ();66 56.7( &(.)&(.)8-

'<D8'D77

This loss is offset by the increase in the value of the underlying firm commitment shown below: '<D8'D77 "hange in value of firm commitment in ".& Axchange gain (".&'((#((( x (&.))- 3 &.)G)) &'#-(( &'#-((

4ssuming that the discount factor of annual interest rate of '(J and remaining life of three month is materia # then the discounted loss that per %F4% '88 should be calculated as the present value of &'-(( discounted for three month: &'#-((('K.(<-) 3' 9 &'#+G8. The entry of '<D8'D77 should be: '<D8'D77 Axchange loss & '#+G8

"ontract Receivable

(fc)

& '#+G8

This loss is offset by the increase in the value of the underlying firm commitment shown below: '<D8'D77 "hange in value of firm commitment in ".& Axchange gain &'#+G8 &'#+G8

8D8'D(( '.

"ontract 6ayable (&) "ash "ash (fc) Axchange loss "ontract Receivable (fc) "hange in value of firm "ommitment in ".& Axchange gain 6urchases "hange in value of firm "ommitment in ".& 4ccounts 6ayable (fc) 4ccounts 6ayable "ash (fc) (fc)

&))#-(( &))#-(( &)8#((( 8#((( &)G#(((

<.

8.

&8#((( &8#((( &))#-(( & +#-(( &)8#((( )8#((( &)8#(((

+.

-.

4edging a net investment in a foreign entity:

2ains and losses are recorded as translation ad?ustments of stoc@holders= e5uity This is necessary because Translation gains and losses also reported as translation ad?ustments to stoc@holders= e5uity. Bedges of investment in foreign subsidiary with $% dollar functional currency is considered as specu ation.

1xamp e: %uppose a $% firm has investment in +(J of $0 firm. *n ecember 8'# '777 the balance of investment is &'#<,(#(((# e5ual to +(J of <#(((#((( pounds# boo@ value of e5uity (net assets) of the $0 firm at the exchange rate of &'.G(. The $% firm to hedge its investment in the $0 firm against foreign currency exchange ris@ may borrow ,((#((( pounds for one year at '<J interest on 1an. '# <((( at the %R of &'.G(. The loan is denominated in pounds with interest and principle payable on 1an. '# <(('. The records are: 1an '# <((( "ash >oan 6ayable (fc) &'#<,(#((( &'#<,(#(((

*n .ov. '# <((( the $0 firm declared and paid '((#((( pounds dividend (6R9&'.)-). .ov. '# <((( "ash !nvestment in $0 firm &)(#((( &)(#(((

*n ec. <((( the $0 firm reported net income +((#((( pounds (avg. rate 9&'.)( and the "R9&'.,().

%ummary of $0 firm=s A5uity: *wners= A5uity on 1an '# <((( .et income ividends A5uity 4d?ustment currency change .et 4ssets on ec. 8'# <((( British 9ounds <#(((#((( +((#((( ('((#((() 33 <#8((#((( L&'.G( L&'.)( L&'.)=S Do ar &8#<((#((( G,(#((( (')-#((() +8-#((( &+#'+(#(((

ec. 8'#<((( !nvestment in $0 !ncome from $0 firm A5uity ad?ustmentM A5uity 4d?ustmentM >oan 6ayable (fc) !nterest Axpense Axchange >oss !nterest payable 1an '# <((' !nterest 6ayable >oan 6ayable "ash

&++G#((( &<)<#((( &')+#((( &'G(#((( &'G(#((( &'G8#<(( 7#G(( &')<#,(( & ')<#,(( '#++(#((( &'#G'<#,((

The balance of e5uity ad?ustment in the boo@ of $% firm would be only &'+#((( (&')+#((( 3 &'G(#(((). EA5uity 4d?ustmentF is also called as E*ther "omprehensive incomeF as it is re5uired per %F4% .o. '8( to be reported at comprehensive income.

Cash F o0 4edge of an #nticipated Foreign Currency Trans ation 4 committed transaction 5ualifies as a foreign currency fair value hedge# where as an anticipated foreign currency transaction is considered a foreign currency cash f o0 hedge. 4 cash flow hedge Eapplies to a derivative designated as a hedge of the foreign currency exposure of a foreign3currency3denominated forecasted transactionF (%F4% .o. '88) Nith an anticipated foreign currency transaction# there is no basis for ad?usting the EvalueF of underlying transaction as was done with the committed transaction. Therefore# the offset to the change in the value of the derivative contract (which still must be carried at fair value (F$)# per %F4% .o. '88) is to other comprehensive income (e5uity ad?ustment). 4ny EinefficiencyF in the derivative contract will show up in the current income# as with any other derivative contract.

1xamp e: $sing the data under the example of foreign currency commitment above but assuming an anticipated; rather committed# transaction re5uires the following ?ournal entries. '(D<D77 "ontract Receivable (fc) "ontract 6ayable (&) *ther comprehensive income "ontract Receivable (fc) &))#-(( &))#-(( & '#-(( & '#-((

'<D8'D77

1ournal entries on ;arch 8'# <((( to account for foreign currency transaction and related forward contract are as follows: 8D8'D(( '. "ontract 6ayable "ash "ash (fc) *ther comprehensive income "ontract Receivable (fc) &))#-(( &))#-(( &)8#((( 8#((( &)G#(((

<.

8.

6urchases &))#-(( *ther comprehensive income 4ccounts 6ayable (fc)

& +#-(( &)8#(((

Nith this entry# the gain or loss would effectively become part of regular income when the underlying purchases are sold or used. +. 4ccounts 6ayable "ash (fc) (fc) )8#((( &)8#(((

$eferences Ca@er# R.# O. >emb@e# and T. 0ing# 4dvanced Financial 4ccounting# -th edition# <((<# ;c2raw3 Bill "ompany# "hapters '' P'<# pp.-,)3)'G.
Ca/a/# ;.# . %enteney# and R. %harp# '77). "urrency Axchange Rate Axposure of $.%.3Cased ;ultinational "orporations: The $sefulness of %F4% .o. '+# 2eographic %egment isclosures. Advances in International Accounting# Oolume '(# pp.'3<G. Ca/a/ and %enteney# QThe !mpact of 4ccounting Regulatory Avents $pon Aarning Response "oefficients: The "ase of %F4% .o. , and %F4% .o. '+#Q 4sia36acific 1ournal of 4ccounting# ecember '77G# Ool. 8# .o. <# pp. <'73<8,. Ca/a/# ;. and R. 6arameswaran# Q4 .ew 4pproach to the 6roblem of Barmoni/ing !nternational 4ccounting reports#Q 2lobal Financial 1ournal# Fall '77-#Ool. G# .o<# pp.'--3')+. Ca/a/ and %enteney# QThe !mpact of %F4% .o. ,# Translation 6rocedures upon the A5uity %ecurity 6rice Response to $.%. Cased ;.ARs Aarnings .ewsQ# 4dvances in !nternational 4ccounting# '77-# Ool. ,# pp.-'3G-. Ceams# F.# 1. Cro/ovs@y# and ". %houlders# 4dvanced 4ccounting # ) th Adition# <(((# 6rentice Ball# $pper %addle River# .ew 1ersey# ()+-,. "allaghan and Ca/a/# Q"omprehensive ;easurement of Foreign !ncome: The "ase of %F4% .o. -<Q# The !nternational 1ournal of 4ccounting# '77<# Ool. <)# .o. 8# pp. ,(3,).

>arson# A. 1ohn# ;odern 4dvanced 4ccounting# 7th edition# <((8# ;c2raw3Bill Bigher Aducation# "hapters ''3'8# pp.+7(3G'7.
Financial 4ccounting %tandards Coard. '7)8. %tatement of Financial 4ccounting %tandards .o.'. Foreign "urrency Translation !nformation. %tanford# "onn. isclosure of

SSSSSSS. '7)-. %tatement of Financial 4ccounting %tandards .o. ,. 4ccounting for the Translation of Foreign "urrency Transactions and Foreign "urrency Financial %tatements. %tanford# "onn. SSSSSSS. '7,'. %tatement of Financial 4ccounting %tandard .o.-<. Foreign "urrency Translation. %tanford# "onn. SSSSSSS. '77,. %tatement of Financial 4ccounting %tandard .o. '88. 4ccounting for erivative !nstruments and Bedging 4ctivities. %tanford# "onn. %enteney# avid# ;ohammad s. Ca/a/# and 4li 6eyvandy# E4ssessing "urrency Axchange Rate Axposure $sing 2eographic %egment isclosures: The !mpact of "urrency %pecific Type and egree of AxposureF# 4dvances in !nternational 4ccounting# <G pages# <((8# Forthcoming.

9ro. em >) Transactions 0ith Foreign Companies Barris !nc. had the following transactions: '. *n %eptember '# Barris !nc. purchased parts from a 1apanese company for a $.%. dollar e5uivalent value of &,#(((# to be paid on February <(. The exchange rates were: %eptember ' ecember 8' February <( 'yen 9 &.(()( 'yen 9 &.(()'yen 9 &.((,'

<. *n .ovember '# Barris !nc. sold products to a %wiss customer for a $.%. dollar e5uivalent of &'(#(((# to be received on ;arch '(. The exchange rates were: .ovember ' ecember 8' ;arch '( ' %. franc 9 &.)( ' %. franc 9 &.GG ' %. franc 9 &.G,

$e?uired: a. 4ssume the two transactions are denominated in $% dollars. 6repare the entries re5uired for the dates of the transactions and their settlement in $% dollar. b. 4ssume the two transactions are denominated in the applicable local currency units of the foreign entities. 6repare the entries re5uired for the dates of the transactions and their settlement in the local currency units of the 1apanese company (yen) and the %wiss customer (%. franc).

9ro. em >, @ain or oss on Specu ative For0ard 1xchange Contract *n ecember '# <(x'# %ycamore "ompany ac5uired a 7(3day speculative forward contract to sell '<(#((( Critish pound at a forward rate of ' 9 & '.G'. The rates are as follows: ate ecember '# <(x' ecember 8'# <(x' ;arch '# <(x< %pot rate ' 9 & '.G' ' 9 & '.G' 9 & '.-,Forward Rate For ;arch ' ' 9 & '.-7 ' 9 & '.G< ' 9 & '.-,-

$e?uired: a. 6repare appropriate ?ournal entries for the period of ecember '# <(x' through ;arch '# <(x<. b. %how the effects of this speculation on both <(x' and <(x< incomes before taxes.

9ro. em > ( 9urchase 0ith For0ard 1xchange Contract and "ntervening Fisca Aear-1nd. 6umped $p "ompany 6urchased e5uipment from %wit/erland for '+(#((( francs on ecember 'G# <(x'# with payment due on February '+# <(x<. *n ecember 'G# <(x'# 6umped $p also ac5uired a G(3day forward contract to purchase francs at a forward rate of %Fr ' 9 &.G). *n ecember 8'# <(x'# the forward rate for an exchange on February '+# <(x<# is %Fr ' 9 &.G7-. The spot rates were: ecember 'G# <(x' ecember 8'# <(x' February '+# <(x, ' %Fr 9 &.G, ' %Fr 9 .)( ' %Fr 9 .G7

$e?uired: a. 6repare ?ournal entries for 6umped $p "ompany to record the purchase of e5uipment# all entries associated with the forward contract# the ad?usting entries on ecember 8'# <(x'# and entries to record the payment on February '+# <(x<. b. Nhat was the effect on the income statement of the hedged transaction for the year ended ecember 8'# <(x'T c. Nhat was the overall effect on the income statement of this transaction from ecember 'G# <(x' to February '+# <(x<T

9ro. em >' 4edge of a purchase 2Commitment 0ithout and 0ith Time Ba ue of Money Considerations3: *n .ovember '# <(xG# %mith !mports !nc. contracted to purchase teacups from Angland for 8(#((( pounds (U). The teacup were to be delivered on 1anuary 8(# <(x)# and payment would be due on ;arch '# <(x). *n .ovember '# <(xG# %mith !mports entered into a '<(3 day forward contract to receive 8(#((( pounds at a forward rate of ' 9 &'.-7. The forward contract was ac5uired to hedge the financial component of the foreign currency commitment. 4dditional information and data for the exchange rate is: '. 4ssume the company uses the forward rate in measuring the forward exchange contract and for measuring hedge effectiveness. <. %pot and exchange rates are: Forward Rate ate .ovember '# <(xG ecember 8'# <(xG 1anuary 8(# <(x) ;arch '# <(x) %pot Rate ' 9 &'.G' ' 9 &'.G' 9 &'.-7 ' 9 &'.-,For ;arch '# <(x) ' 9 &'.-7 ' 9 &'.G< ' 9 &'.G( ' 9 &'.-,-

Re5uired: a. Nhat is %mith=s net exposure to changes in the exchange rate of pounds for dollars between .ovember '# <(xG# and ;arch '# <(x)T b. 6repare all ?ournal entries from .ovember '# <(xG# through ;arch '# <(x)# for the purchase of the subassemblies# the forward exchange contract# and the foreign currency transaction. 4ssume %mith=s fiscal year ends on ecember 8'# <(xG. c. 4ssume interest is significant and the time value of money is considered in valuing the forward contract and hedged commitment. $se a '< percent annual interest rate. 6repare all ?ournal entries from .ovember '# <(xG# through ;arch '# <(x)# for the purchase of the subassemblies# the forward exchange contract# and the foreign currency transaction. 4ssume %mith=s fiscal year ends on ecember 8'# <(x).