Advanced Accounting

Lecturer
:
Ahalik, SE, Ak, M.Si, M.Ak, CMA, CPMA, CPSAK, CPA, DipIFR, CA
FOREIGN CURRENCY CONCEPT AND TRANSACTION
Distinguish between measurement and denomination in a particular
currency
A receivable or payable is denominated in a currency when it must be paid
in that currency.
A receivable or payable is measured in a currency when it is recorded in
the financial records in that currency
A transaction is measured in a particular currency if its magnitude is
expressed in that currency. Assets and liabilities are denominated in a
currency if their amounts are fixed in terms of that currency.
Assume that one Canadian Dollar can be exchanged for $.72 U.S. dollar.
What is the exchange rate if the exchange rate is quoted directly?
Indirectly?
Direct quotation: .72/1 = $.72 (from viewpoint of American Company)
Indirect quotation: 1/.72 = 1.3889 Canadian dollars (from viewpoint of
American Company)
What is the difference between official and floating foreign exchange rate?
Official or fixed rates are set by a government and do not change as a
result of changes in world currency markets. Free or floating exchange
rates are those that reflect fluctuating market prices for currency based on
supply and demand factors in world currency markets.
Spot rates are the exchange rates for immediate delivery of currencies
exchanged. The current rate for foreign currency transactions is the spot
rate in effect for immediate settlement of the amounts denominated in
foreign currency at the balance sheet date. Historical rates are the rates
that were in effect on the date that a particular event or transaction
occurred.
When are exchange gains and Losses reflected in a businesss financial
statement?
Exchange gains and losses occur because of changes in the exchange
rates between the transaction date and the date of settlement. Both
exchange gains and exchange losses can occur in either foreign import
activities or foreign export activities.

Purchases Denominated in Foreign Currency

American Trading Company, a U.S corporation, purchased
merchandise from Paris Company on December 1, 2013, for
10.000 euro, when the spot rate for euros was $1.6600. American
Trading closed it books at December 31, 2013, when the spot
rate for euros was $1.6550, and it settled the account on January
30, 2014, when the spot rate was $1.6650.

Sales Denominated in Foreign Currency

On December 16, 2013, American Trading
Company sold merchandise to Rome company for
20.000 euros, when the spot rate for euros was
$0.6625. American trading closed its book on
December 31,2013 when the spot rate was
$0.6550, collected the account on January 15,
2014, when the spot rate was $0.6700, and held
the cash until January 20, when it converted the
euros into U.S dollars at the $0.6725 spot rate.
Define the term of forward contract and the objective of hedge accounting?
A forward exchange contract (or futures contract) is an agreement to
exchange at a specified future date, currencies of different countries at a
specified rate (the forward rate). Futures contracts (derivative instruments)
are used to speculate in foreign currency exchange price movements, to
hedge an exposed foreign currency net asset or net liability position, to
hedge an anticipated or actual foreign currency commitment, or to hedge a
net investment in a foreign entity.
The purpose of the derivative contract is to mitigate or eliminate potential
foreign exchange gains or losses. The derivative contract is carried at the
forward rate (fair value) while the underlying liability is carried at the spot
rate. If these two rates do not move exactly in tandem a recognized gain or
loss would be the result.
A hedge against an identifiable foreign currency commitment fixes the
price of the commitment at the future rate. Any gains or losses on the
hedge are exactly offset by changes in the value of the underlying firm
commitment. No gain or loss would need to be recognized.

Forward & Hedging

Case I (Forward)
Managing an Exposed Foreign Currency Net
Asset or Liability Position : Not a Designated
Hedging Instrument
1. On October 1, 2013, President Co. purchases
goods on account from Tokyo Industries in
the amount of 2.000.000 Yen.
2. This transaction is denominated in Yen, and
President offsets its exposed foreign
currency liabilities with a forward exchange
contract for the receipt of 2.000.000 Yen from
Citibank
3. The term of the forward exchange contract
equals the six-month credit period extended
by Tokyo Industries.
4. December 31 is the year-end of President Co.,
and the payable is settled on April 1, 2014.
Date
U.S Dollar equivalent Value
of 1 Yen
Spot
Forward
Rate
Exchange Rate
October
$.0070
1, 2013
Dec 31, $0.0080
2013
April
1, $0.0076

$.0075 (180 days)

$0.0077 (90 days)

2014
Case II (Forward & Hedging)
Hedging an Unrecognized Foreign Currency Firm
Commitment : A Foreign Currency Fair Value Hedge
1. On August 1, 2006, President Co. contracts to
purchase special-order goods from Tokyo
Industries. Their manufacture and delivery will
take place in 60 days (on October 1, 2006). The
contract price is 2.000.000 Yen, to be paid by
April 1, 2007, which is 180 days after delivery.
2. On August 1, President hedges its foreign
currency payable commitment with a forward
exchange contract to receive 2.000.000 Yen in
240 days (the 60 days until delivery plus 180
days of credit period). The future rate for a 240
day forward contract is $.0073 to 1 Yen. The
purpose of this 240 day forward exchange
contract is twofold. First, for the 60 days from
August 1, 2006, until October 1, 2006, the
forward exchange contract is a hedge of an
identifiable foreign currency commitment. For the
180 day period from October 1, 2006 , until April
1, 2007, the forward exchange contract is a
hedge of a Foreign currency exposed net liability
position.
The relevant exchange rates for this example are as
follows :

Date

U.S Dollar equivalent Value

of 1 Yen
Spot
Forward
Rate
Exchange Rate
August 1, $.0065 $.0073 (240 days)
2006
October 1, $.0070 $.0075 (180 days)
2006
Dec
31, $0.0080 $0.0077 (90 days)
2006
April
1, $0.0076
2007

Derivative : is the name given to a broad of financial

securities.
Characteristics : fluctuations in price, rate, or some
other variable.
The party trying to control its economic rate or price
change risk is engaging in a derivative, or hedge
contract such as interest rates, commodity prices,
foreign currency exchange rates, and stock prices.
Typical forms of derivative instruments are option
contracts, forward contracts, and future contracts.
Hedge Structures

Forward contracts : are negotiated contract between

two parties for the delivery or purchase of a
commodity or foreign currency at a pre-agreed price,
quantity, and delivery date. The agreement may
require actual physical delivery of goods or may allow
a net settlement.
Future contracts = forward contracts, differ from forward contracts in ways that allow them to be traded easily in market. A
contractual agreement to buy or sell a particular commodity or financial instrument at a pre-determined price in the future.
Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a
futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.
Futures are contract between two parties, a buyer and a seller, to buy or sell something at a specified future date, which is
termed the expiration date. Futures contract are actively traded in a number of commmodities including grains and
oilseeds, livestock and meat, food and fiber, and metal and energy.
Companies trading in futures contract are normally required to place cash in their margin accounts held by the brokerage
exchange or a clearing house, and the gain (loss) on the future contract is then added (subtracted) from the companys
margin account. This margin account is settled daily for the changes in contract value. Margin accounts are maintained at
some percentage (typically 2 to 5 percent) of contract amount.
If the company is the purchaser of a futures contract, it is said to go long in a position. If a company contract to sell with
a future contract, it is said to go short. The accounting for future contract is quite similar to accounting for foreign
currency forward contract.
Forward contracts delivery quantities, prices, product quality, and delivery dates can all be negotiated.
Under a future contract, the quantities, delivery dates, and product quality of each contract are defined by the exchange.
The future price is a market-determined amount.
Options : another commonly used hedging instrument structure. Only one side of the option contract is required to perform
at the begest of the other. The other party to the option has the ability but not the obligation to perform.
Example : option cost $1.000 to purchase 100.000 gallons of fuels at $1 per gallon. If market fuel price $1,1, company will
exercise the option. If the market value is $0,90, the company will allow the option to expire.
Types of Hedge Accounting
1. Fair value hedge accounting
The item being hedges is an existing asset or liability position or firm purchase or sale commitment. In this case, both
the item being hedged and the derivative are marked to fair value at the end of the quarter or year-end on the books.
The gain or loss on these items is reflected immediately in earnings. The risk being hedged is the variability in the fair
value of the asset or liability.
2. Cash flow hedge accounting
The derivative hedges the exposure to the variability in expected future cash flows associated with risk. The gain or
loss is included as a component of accumulated other comprehensive income (AOCI).
3. Hedge of net investment in a foreign subsidiary

Illustration :
Green company mines copper. It will mine and sell
100.000 pounds of copper during the next four
quarter. Total costs is $28.900.000 or $289 per
pounds. Green decides to sell its future production by
entering into forward contract on 1 october 2008 with
Brown for delivery to Brown 100.000 pounds of
copper in one year at a price of $300 per pound.
1 oct 2008 - no journal entries
The company has entered into a cash flow hedge
because it is attempting to control the impact of price
fluctuations its future cash flows and its sales.
31 dec 2008, market price of copper $310
Suppose that interest rate is 1% per month
$10 x 100.000 = $1.000.000
$1.000.000 X PVIF, 1%, 9=$914.340
Other comprehensive income (OCI)(SE)
Forward contract (L)

914.340
914.340