Electronic
Presentations
in Microsoft®
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Prepared by
James Myers,
C.A.
University of
Toronto
© 2010 McGraw-Hill
Ryerson Limited
Chapter 10, Slide 1
© 2010 McGraw-Hill Ryerson Limited
Chapter 10
Foreign Currency
Transactions
Chapter 10, Slide 2
© 2010 McGraw-Hill Ryerson Limited
Learning Objectives
1.
2.
3.
Translate foreign currency transactions and balances
into the presentation currency.
Describe when to use the closing rate and when to use
the historical rate when translating assets and liabilities
denominated in a foreign currency. Evaluate whether
this practice produces results consistent with the
normal measurement and valuation of assets and
liabilities for domestic transactions and operations.
Describe the concept of hedging, and prepare a list of
items that could be used as a hedge
Chapter 10, Slide 3
© 2010 McGraw-Hill Ryerson Limited
Learning Objectives
4.
5.
6.
Prepare journal entries and subsequent financial
statement presentation for forward exchange contracts
that hedge existing monetary positions, firm
commitments, or are entered into for speculative
purposes
Apply the concept of hedge accounting to long-term
debt acting as a hedge of a future revenue stream
Differentiate between the accounting for a fair value
hedge and a cash flow hedge
Chapter 10, Slide 4
© 2010 McGraw-Hill Ryerson Limited
Introduction

Many Canadian companies conduct business in foreign
countries as well as in Canada

No specific accounting issues arise when the parties
involved in an import or export transaction agree that the
payment will be in Canadian dollars

LO 1
Since it is a Canadian dollar denominated transaction, the
company will record the foreign purchase or sale in exactly the
same manner as any domestic purchase or sale
Chapter 10, Slide 5
© 2010 McGraw-Hill Ryerson Limited
Introduction

When the agreement calls for the transaction to be
settled (paid) in a foreign currency, this means one of the
two things:



If the transaction is a purchase, the Canadian company will have
to acquire foreign currency in order to discharge the obligations
resulting from its imports
If the transaction is a sale, the Canadian company will receive
foreign currency as a result of its exports, and will have to sell the
foreign currency in order to receive Canadian dollars
These are foreign currency denominated transactions
requiring conversion to Canadian dollars
LO 1
Chapter 10, Slide 6
© 2010 McGraw-Hill Ryerson Limited
Introduction

In a foreign-currency-denominated transaction,
accounting issues arise when the value of the Canadian
dollar has changed relative to the value of the foreign
currency between:



the time the transaction occurs and
the date at which the financial statements are reported with the
foreign-currency-denominated receivable or payable, and
the date of receipt or payment (“settlement”) of the foreigncurrency-denominated receivable or payable
Transaction
LO 1
Report
Settle
Chapter 10, Slide 7
© 2010 McGraw-Hill Ryerson Limited
Exchange Rate Quotations

Recording foreign currency denominated transactions
requires the use of exchange rates


Foreign currency exchange rates fluctuate because of the relative
inflation rate, interest rate, and trade surplus/deficit of a country
An exchange rate can be expressed one of two ways:

The direct rate represents the cost in Canadian dollars to
purchase one unit of foreign currency, e.g. $1 U.S. (USD) = $0.98
Canadian (CAD) means it takes $0.98 CAD to purchase 1 USD
The indirect rate represents the cost in a foreign currency to
purchase 1 Canadian dollar, e.g. $1.02 USD = $1 CAD. The
indirect rate is the reciprocal of the direct rate, i.e. divide the
direct rate into 1 (1/0.98 = 1.02)
LO 1
Chapter 10, Slide 8
© 2010 McGraw-Hill Ryerson Limited

Exchange Rate Quotations

The spot rate is the rate to exchange currency at a
particular moment in time




There are in fact separate spot rates for purchases and sales of
foreign currency; the purchase rate is higher than the sell rate in
order to provide a profit to the currency dealer. To simplify for our
purposes, we assume one single spot rate
Rates are quoted in newspapers and on the Internet (e.g. Bank of
Canada website at http://bankofcanada.ca/en/rates/exchange.html)
The forward rate is the rate agreed today in a forward
exchange contract to exchange a specific amount of
currency at a specified future date
Forward exchange contracts are often used to hedge
foreign currency transactions.
LO 1
Chapter 10, Slide 9
© 2010 McGraw-Hill Ryerson Limited
Exchange Rate Quotations - Example
This exhibit shows both spot and forward rates
LO 1
Chapter 10, Slide 10
© 2010 McGraw-Hill Ryerson Limited
Exchange Rate Perspectives

The denominated currency is the currency in which a
transaction is receivable or payable


The functional currency is the currency of the primary
economic environment in which the entity operates


A different currency may be used to record the transaction in the
internal accounting records
A foreign currency is a currency other than the functional
currency
The presentation currency or reporting currency is
the currency in which the financial statements are
presented

LO 1
A number of Canadian companies present their financial
statements in U.S. dollars since many of their users are American
Chapter 10, Slide 11
© 2010 McGraw-Hill Ryerson Limited
Exchange Rate Perspectives

IAS 21 requires that individual transactions be translated
into the functional currency of the reporting entity

LO 1
The functional currency is that of the reporting entity’s primary
economic environment in which it generates or expends cash
Chapter 10, Slide 12
© 2010 McGraw-Hill Ryerson Limited
Accounting for Foreign Currency Transactions

For accounting purposes there are basically three rates
used in translating foreign currency into the reporting
currency:


Closing rate is the spot rate on the reporting date of the financial
statements
Historical rate is the spot rate on the date of transaction


LO 1
The average rate for a period can be used as a proxy for the
historical rate for a series of transactions (e.g. purchases, sales,
interest income or expense) if they occur evenly throughout the
period
Forward rate is the agreed rate for exchange of currencies at a
specified future date
Chapter 10, Slide 13
© 2010 McGraw-Hill Ryerson Limited
Accounting for Foreign Currency Transactions
Transaction
On transaction
date
Report
On reporting
date
Translate from foreign
currency to functional
currency at spot rate
Translate foreign
currency monetary
items at closing rate
If multiple transactions
occurred evenly
throughout a period,
use the average rate
Translate nonmonetary historical
cost items at
historical rate
Settle
On settlement
date
Translate receipt or
payment of foreign
currency at spot rate
Translate non-monetary fair value items at
rate in effect when fair
value was determined
LO 1, 2
Chapter 10, Slide 14
© 2010 McGraw-Hill Ryerson Limited
Accounting for Foreign Currency Transactions

Accounting for a foreign currency transaction is
illustrated using the following Canadian dollar (CAD) and
U.S. dollar (USD) rates:
Date
Jan 31
Feb 28
Mar 30
LO 1
Rate (CAD per USD)
0.98
0.99
1.01
Chapter 10, Slide 15
© 2010 McGraw-Hill Ryerson Limited
Accounting for Foreign Currency Transactions


A Canadian firm receives merchandise with an invoice
price of USD1,000 on January 31. The company’s year
end is February 28 and payment is due March 30. What
entries are necessary?
At the time of the purchase transaction, the following
entry would be made using the January 31 transaction
date spot rate:
Purchases
Accounts payable
LO 1
980
980
Chapter 10, Slide 16
© 2010 McGraw-Hill Ryerson Limited
Accounting for Foreign Currency Transactions

By the Feb. 28 end of its fiscal year, the firm has
incurred a $10 loss, as the firm is now has a monetary
liability for USD1,000 x 0.99 = CAD990, rather than the
CAD980 at which the transaction was initially recorded.
The following entry is recorded for this loss reflecting the
closing rate, since the loss occurred as a separate event
from the original purchase transaction:
Exchange Loss
Accounts payable
LO 1
10
10
Chapter 10, Slide 17
© 2010 McGraw-Hill Ryerson Limited
Accounting for Foreign Currency Transactions


On March 30 final payment, this entry is made to clear
accounts payable, record the additional $20 foreign
currency loss at the settlement date spot rate, and
record the cash payment:
Accounts payable
990
Exchange loss
20
Cash
1,010
This further loss of $20 is recognized in the period in
which it occurs

LO 1
the foreign currency loss is a period cost, recognized in the
period in which the change in exchange rates took place
Chapter 10, Slide 18
© 2010 McGraw-Hill Ryerson Limited
Accounting for Foreign Currency Transactions

Currency fluctuations are relevant to companies and to
users of their financial statements
 At each financial statement reporting date,



LO 2
Foreign currency-denominated monetary assets and liabilities
are restated to the current exchange rate
Other foreign currency-denominated balance sheet items that
are reported at historical cost are maintained at the historical
rate (i.e. the rate in effect on the date of the original
transaction)
Foreign currency gains and losses on monetary items must be
recorded and reported in the period in which they occur
Chapter 10, Slide 19
© 2010 McGraw-Hill Ryerson Limited
Accounting for Foreign Currency Transactions

The translation method should produce either historical
cost in functional currency or current value in functional
currency consistent with normal measurement rules for
the financial statement items


LO 2
GAAP requires income and expense to be measured at historical
amounts
GAAP requires monetary assets and liabilities to be measured at
current value, non-monetary assets are usually valued at the
lower of historical cost and market value, and non-monetary
liabilities and shareholders’ equity are usually valued at historical
amounts
Chapter 10, Slide 20
© 2010 McGraw-Hill Ryerson Limited
Hedges



Foreign currency losses can be significant, and prudent
management suggests that they should be guarded
against if possible
This type of protection is generally referred to as
“hedging” which can be defined as a means of
transferring risk arising from foreign exchange (or
interest rate, or price) fluctuations from those who wish
to avoid it to those who are willing to assume it
The hedged item is the item with the risk exposure that
the entity has taken steps to guard against. The hedging
item is the item used to offset that risk exposure
LO 3
Chapter 10, Slide 21
© 2010 McGraw-Hill Ryerson Limited
Hedges
Hedged Item
Example of Hedging Item
* “FC” = “Foreign Currency”
Completed sale
Forward contract (deliver FC)
Completed purchase
Forward contract (receive FC)
Accounts receivable
FCU-denominated A/P or forward
contract (deliver FC)
Accounts payable
FCU-denominated A/R or forward
contract (receive FC)
Committed sale
FCU-denominated loan or forward
contract (deliver FC)
Committed purchase
Forward contract (receive FC)
LO 3
Chapter 10, Slide 22
© 2010 McGraw-Hill Ryerson Limited
Hedges

Hedge accounting is defined and described in IAS 39


Hedge accounting is optional. An entity can choose to apply
hedge accounting if it wishes and if the conditions for its use are
present, but does not necessarily have to use it
Under hedge accounting, the exchange gains or losses
on the hedged items will be recognized in the income
statement in the same period as the exchange gains or
loses on the hedging item when they would otherwise be
recognized in different periods
LO 3
Chapter 10, Slide 23
© 2010 McGraw-Hill Ryerson Limited
Hedges

The following items can be used to hedge currency
fluctuations:



LO 3
A derivative financial instrument. For example, a forward
exchange contract, foreign currency option contract, or foreign
currency futures contract could be used to hedge a monetary
asset or liability commitment or anticipated future transaction.
 A forward contract is a financial instrument which must be
valued at fair value throughout its life.
A monetary item. For example, an existing foreign currencydenominated monetary asset or liability could be used to hedge a
foreign currency-denominated commitment or an anticipated
future transaction.
An anticipated future transaction, such as future revenue stream,
cannot be used to hedge an existing foreign currency position
Chapter 10, Slide 24
© 2010 McGraw-Hill Ryerson Limited
Hedges



Under a forward contract, a financial institution agrees to
exchange a foreign currency with its client at a future
date at a rate set at the time the contract is entered into
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
LO 3
Chapter 10, Slide 25
© 2010 McGraw-Hill Ryerson Limited
Hedges

To qualify for hedge accounting, the following conditions
must be met at the inception of the hedge:
 The entity has identified in writing the hedged and
hedging items, the risks, and management’s strategy


There is reasonable assurance that the hedge will be
effective at the inception and throughout its term



LO 3
Cannot use related party instruments as hedging items
An “effective” hedge is one in which the timing and amount of
the hedging item matches the hedged item.
The values of the hedged and hedging items can be
reliably measured
Hedge is assessed as effective throughout its life
Chapter 10, Slide 26
© 2010 McGraw-Hill Ryerson Limited
Hedges

If a hedge is truly effective, that is, all risks are
transferred by the hedging party, there should be no
overall exchange gain or loss recorded on the income
statement over the life of the hedge, other than the cost
of establishing the hedge itself


The cost of an effective hedge is the difference between the
forward rate and spot rate at the date of the hedged transaction
A forward exchange contract that is not a designated,
effective hedging item is a speculative financial
instrument required to be recorded at fair value with
gains or losses reported in profit and loss as they occur

Businesses may choose to enter into speculative forward
contracts in the hope of profiting from exchange rate changes
LO 3, 4
Chapter 10, Slide 27
© 2010 McGraw-Hill Ryerson Limited
Hedges

There are three types of hedges:



LO 3
Fair value hedge: the hedging item is used to hedge against the
fair value of the hedged item which is an existing monetary
position (e.g. accounts receivable or payable). Fair value hedges
are entered into at the same time or after the monetary item (A/R
or A/P) has arisen, or if the hedging item is in place before this
time and the company chooses to treat it as a fair value hedge.
Gains and losses are recorded in income
Cash flow hedge: the hedging item is used to hedge against the
fluctuation in the Canadian dollar value of future cash flows (e.g.
future sales or purchases). Cash flow hedges are entered into
before the transaction has occurred. Gains and losses are
recorded in other comprehensive income (OCI)
Hedge of a net investment in a foreign operation: The hedging
item is used to hedge against the effects of currency fluctuations
on these operations (discussed in Chapter 11)
Chapter 10, Slide 28
© 2010 McGraw-Hill Ryerson Limited
Hedges
Accounting for a fair value hedge of a recognized
monetary item
 In the following case the hedged item is either a
purchase or sale transaction that has already occurred
but not yet settled. The hedging item is a forward
contract



LO 6
Record the transaction (purchase/sale) at the transaction date
spot rate. The recorded value of the transaction remains
unchanged throughout the life of the hedge
Record the forward contract at the forward rate and the
corresponding payable to or receivable from bank
At financial statement reporting dates:
 Revalue the transaction payable/receivable at the closing rate
with gain/loss recorded in income
Chapter 10, Slide 29
© 2010 McGraw-Hill Ryerson Limited
Hedges
Accounting for a fair value hedge of a recognized
monetary item





Revalue the forward contract at the forward rate with gain/loss
to income. Payable to/receivable from bank does not change
On the balance sheet, report the forward contract
asset/liability net of the payable to or receivable from bank
At settlement, repeat the procedures of the financial statement
reporting date, and record all cash flows at the spot rate
In the above case, accounting for the hedge does not
result in a change to the value of the transaction which
occurred before the hedge was in place
Next, let’s look at a case in which hedge accounting
provides a different result
LO 6
Chapter 10, Slide 30
© 2010 McGraw-Hill Ryerson Limited
Hedges
Accounting for a cash flow hedge of an unrecognized
firm commitment
 In this case the hedged item is a committed purchase or
sale transaction that has not yet occurred, and the
hedging item is a forward contract


LO 6
Record the forward contract and the corresponding payable to or
receivable from bank
Later, when the purchase or sale transaction occurs:
 Revalue the forward contract at forward rate, recording the
gain/loss in Other Comprehensive Income (OCI)
 Record the purchase or sale transaction at spot rate
 Clear the forward contract revaluation balance in OCI with a
corresponding debit or credit to the purchase or sale
Chapter 10, Slide 31
© 2010 McGraw-Hill Ryerson Limited
Hedges
Accounting for a cash flow hedge of an unrecognized
firm commitment


Between the time the transaction occurs and settlement of the
resulting payable or receivable, follow the procedures for fair
value hedges of recognized monetary items (slides 29-30)
In the above case, the application of hedge accounting
has resulted in a purchase/sale transaction value that is
different (by the amount of the pre-transaction hedge
gain or loss transferred from OCI) than if hedge
accounting had not been applied

LO 6
A company may choose to treat a cash flow hedge as a fair value
hedge instead, recording hedge gains/losses in income before
the transaction occurs
Chapter 10, Slide 32
© 2010 McGraw-Hill Ryerson Limited
Hedges

Accounting for long term debt applied as a hedge of
future revenue stream

Record in OCI the exchange gains and losses on the portion of
the loan that is equal to the remaining expected future sales,
tracking the OCI entries separately by year in which they arose


As the sales revenue is earned:


LO 5
As a portion of revenue is earned, the same portion of the loan
becomes ineffective as a hedge and exchange gains and losses on
the ineffective portion of the loan should be recorded in income
In Year 1, reclassify from OCI-Year 1 to sales an amount equal to:
Year 1 sales / Total expected sales
In Year 2, (i) reclassify from OCI-Year 2 to sales an amount equal to:
Year 2 sales / Total remaining expected sales and (ii) reclassify from
OCI-Year 1 to sales an amount equal to Year 2 sales / Total
expected sales. Repeat this process until the sales are complete
Chapter 10, Slide 33
© 2010 McGraw-Hill Ryerson Limited
Foreign-currency transactions

Foreign currency disclosures required (IAS 21):





LO 1
The amount of exchange gain or loss recorded in profit and loss
The amount of exchange gain or loss recorded in OCI
For each type of hedge, disclose a description of the hedge, the
hedging items and their fair values, and the risks being hedged
For cash flow hedges, disclose the periods when the cash flows
are expected to occur and incur a profit or loss, the amount
recognized in OCI during the period, the amount reclassified from
OCI to income during the period, and the amount reclassified in
the period from OCI to a non-financial asset or liability
Separate disclosure is required of gains or losses on fair value
hedges, and gains and losses from the ineffective portion of cash
flow hedges and of hedges of net investments in foreign
operations recognized in profit and loss in the period
Chapter 10, Slide 34
© 2010 McGraw-Hill Ryerson Limited