Foreign Currency Concepts
and Transactions
Chapter 12
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Learning Objective 1
Introduce foreign currency
and definitions.
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Foreign Exchange Concepts
and Definitions
Currencies provide…
a standard
of value,
a medium
of exchange,
and a unit
of measure
for economic transactions.
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Foreign Exchange Concepts
and Definitions
In the case of transactions between
business entities of different countries,
the amounts receivable and payable
are denominated in local currency of
either the buying or the selling entity.
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Foreign Exchange Concepts
and Definitions
Exchange rates are essentially prices for
currencies expressed in units of
other currencies.
=
.0082
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Learning Objective 2
Understand quotation conventions
for foreign currency and
exchange rates.
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Direct and Indirect Quotation
of Exchange Rates
Assume that $1.60 can be exchanged for £1.
Direct quotation (U.S. dollar equivalent):
$1.60
= $1.60
1
Indirect quotation (foreign currency per U.S. dollar):
1
= £0.625
$1.60
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Floating, Fixed, and Multiple
Exchange Rates.
Weakens
Floating
Strengthens
Fixed
Multiple
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The Euro
Twelve member states of the European
Union chose to participate in the transition
to a single currency for Europe, the Euro.
€
The euro currency is
managed by the European
Central Bank.
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Spot, Current, and Historical
Exchange Rates
Spot rate – the exchange rate for immediate
delivery of currencies exchanged
Current rate – the exchange rate at the
balance sheet date or the transaction date
Historical rate – the rate in effect at the
date a specific transaction or event occurred
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Learning Objective 3
Learn foreign-currencydenominated transactions
accounting.
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Foreign Currency Transactions
Other Than Forward Contracts
Local
transactions
Foreign
transactions
An entity’s functional currency is the
currency of an entity’s primary
economic environment.
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Foreign Currency Transactions
Other Than Forward Contracts
Foreign currency transactions are stated
(denominated) in a currency other than
an entity’s functional currency.
The provisions of FASB Statement No. 52
apply only to foreign currency transactions
and foreign currency financial statements.
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Translation at the Spot Rate
A U.S. corporation imports inventory
from a Canadian firm when the spot
rate for Canadian dollars is $.70
The invoice calls for payment of 10,000
Canadian dollars in 30 days.
How does the U.S. importer record the transaction?
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Translation at the Spot Rate
Inventory
7,000
Accounts Payable (fc)
7,000
(Translation 10,000 Canadian dollars × .70 spot rate)
If the account payable is settled when the
spot rate is $.69, how is it recorded?
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Translation at the Spot Rate
Accounts payable (fc)
7,000
Exchange Gain
100
Cash
6,900
(Cash required equals 10,000 Canadian dollars
× the $0.69 spot rate)
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Purchases Denominated
in Foreign Currency
American Trading Company purchased goods from
Kimetz Company on December 1, 2008, for 10,000
euros when the spot rate for euros was $0.6600.
AT closed its books at December 31, 2008,
when the spot rate for euros was $0.6550,
and settled the account on January 30, 2009,
when the spot rate was $0.6650.
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Purchases Denominated
in Foreign Currency
December 1, 2008
Inventory
6,600
Accounts Payable (fc)
6,600
To record purchase of merchandise from Kimetz
Company (10,000 euros × $0.6600 rate)
December 31, 2008
Accounts Payable (fc)
50
Exchange Gain
50
To adjust accounts payable to exchange rate at
year end [10,000 euros × ($0.6600 – $0.6550)]
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Purchases Denominated
in Foreign Currency
January 30, 2009
Accounts Payable (fc)
5,550
Exchange Loss
100
Cash
6,650
To record payment in full to Kimetz Company
(10,000 euros × $0.6650 spot rate)
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Sales Denominated
in Foreign Currency
On December 16, 2008, American Trading sold
merchandise to Kimetz for 20,000 euros when
the spot rate for euros was $0.6600.
AT closed its books at December 31, when the
spot rate was $0.6550, collected the account on
January 15, 2009, when the spot rate was $0.6700,
and held the cash until January 20, when it
converted the euros into USD at a $0.6725 rate.
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Sales Denominated
in Foreign Currency
December 15, 2008
Accounts Receivable (fc) 13,200
Sales
13,200
To record sales to Kimetz
(20,000 euros × $0.6600 spot rate)
December 31, 2008
Accounts Receivable (fc)
100
Exchange Gain
100
To adjust accounts receivable year end
[20,000 euros × ($0.6650 – $0.6600)]
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Sales Denominated
in Foreign Currency
January 15, 2009
Cash
13,400
Accounts Receivable (fc)
Exchange Gain
13,300
100
To record collection in full from Kimetz
(20,000 euros × $0.6700) and recognize exchange gain
for 2009 [20,000 euros × ($0.6700 – $0.6650)]
January 20, 2009
Cash
Exchange Gain
Cash (fc)
13,450
50
13,400
To convert 20,000 euros into U.S. dollars
(20,000 euros × $0.6725)
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Learning Objective 4
Comprehend cash flow hedge
accounting and fair value
hedge accounting.
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Foreign Currency Derivatives
and Hedging Activities
Derivative is the name given to a
broad range of financial securities.
The derivative contract’s value to the investor
is directly related to the fluctuations in price,
rate, or some other variable that underlies it.
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Derivative Instruments
Options contracts
Forward contracts
Future contracts
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Derivative Instruments
Options are rights to take an action,
but the holder is not obligated to do so.
A forward contract is negotiated between
the parties and not through an exchange.
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Derivative Instruments
Futures contracts bind both parties
(the writer and the holder) to perform.
A cash flow hedge is designed to limit
the company’s exposure to price
changes in forecasted purchases.
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Derivative Instruments
A company signs an option contract on
January 15, 2003, at a cost of $1,000.
The company can exercise its option
to purchase 100,000 gallons of
fuel at $1 per gallon.
The option expires on May 31, 2003.
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Derivative Instruments
January 15, 2003
Fuel Contract Option
1,000
Cash
1,000
The company prepares its quarterly
report on March 31, 2003.
Market price of fuel is $1.25.
The company could exercise the
option on this date.
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Derivative Instruments
March 31, 2003
Fuel Contract Option
Other Comprehensive
Income – Unrealized Holding
Gains on Fuel Option Contract
24,000
24,000
On May 31, 2003, the fuel price is $1.30.
The writer of the option must pay the
company $0.30 per gallon, or $30,000.
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Derivative Instruments
May 31, 2003
Fuel Inventory
Cash
130,000
Cash
30,000
Fuel Contract Option
Other Comprehensive Income
130,000
25,000
5,000
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Derivative Instruments
The fuel inventory is used on June 15, 2003.
June 15, 2003
Cost of Goods Sold
Fuel Inventory
Other Comprehensive Income
Cost of Goods Sold
130,000
130,000
30,000
30,000
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Fair Value Hedges
A fair value hedge is a derivative contract that
attempts to reduce the price risk of an existing
asset or firm purchase commitment.
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Summary of Forward Contracts
(Speculation)
Purpose
To speculate in exchange rate changes
Recognition
Exchange gains and losses are recognized currently,
based on forward exchange rate changes.
Expected Effect of Hedge and Related
Foreign Currency Item
Income effect equals exchange
gains and losses recognized.
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Summary of Forward Contracts
(Hedge of a Net Asset or Liability Position)
Purpose
To offset exposure to existing net asset
or liability position
Recognition
Exchange gains and losses are recognized currently,
but they are offset by related gains or losses
on net asset or liability position.
Expected Effect of Hedge and Related
Foreign Currency Item
Income effect equals the amortization of premium
or discount (gains and losses offset.)
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Summary of Forward Contracts
(Hedge of an Identifiable Commitment)
Purpose
To offset exposure to a future purchase or sale and
thereby lock in the price of an existing contract
Recognition
Exchange gains and losses are recognized
currently, but are offset by related
gains or losses in the firm commitment.
Expected Effect of Hedge and Related
Foreign Currency Item
Income effect equals the difference in the change in
value of the instrument versus the firm commitment.
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Summary of Forward Contracts
(Hedge of an Anticipated Transaction)
Purpose
To offset exposure of possible
future purchase or sale
Recognition
Exchange gains or losses on the hedge counted
in other comprehensive income until the
underlying transaction is complete.
Expected Effect of Hedge and Related
Foreign Currency Item
No immediate income effect.
Adjusts underlying transaction.
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Summary of Forward Contracts
(Hedge of a Net Investment in a Foreign Entity)
Purpose
To offset exposure to an existing net
investment in a foreign entity
Recognition
Exchange gains and losses are recognized as other
comprehensive income and will offset translation
adjustments recorded on the net investment.
Expected Effect of Hedge and Related
Foreign Currency Item
Income effect equals the change in the future value
of the hedge versus the value of the net investment.
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The Four Fundamental Decisions
Derivative instruments represent
rights or obligations.
Fair value is the most relevant measurement.
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The Four Fundamental Decisions
Only items that are assets or
liabilities should be reported.
Special accounting should be provided
only for qualifying items.
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Learning Objective 5
Apply foreign-currencydenominated derivative
accounting.
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Speculation
Exchange gains or losses on derivative
instruments that speculate in foreign
currency price movements are included
in income in the period in which the
forward exchange rates change.
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Speculation
On November 2, 2007, U.S. International
enters into a 90-day forward contract
(future) to purchase 10,000 euros (€).
The current quotation for 90-day futures is €5,400.
The spot rate for euros on November 2 is $0.5440.
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Speculation
December 31, 2007 January 30, 2008
30-day futures
Spot rate
$0.5450
$0.5500
$0.5480
$0.5530
What are the journal entries of U.S. International
to account for the speculation?
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Speculation
November 2, 2007
Contract Receivable (fc)
5,400
Contract Payable
5,400
To record contract for 10,000 euros × $0.5400
exchange rate for 90-day futures
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Speculation
December 31, 2007
Contract Receivable (fc)
50
Exchange Gain
50
To adjust receivable from exchange broker
and recognize exchange gain
10,000 euros × ($0.5450 forward exchange rate
for 30-day futures – $0.5400 per books)
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End of Chapter 12
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