EMBA Module 8
Foreign Currency
Transactions and Hedging
Foreign Exchange Risk
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7-2
Exchange Rate Mechanisms
• Prior to 1973, currency
values were generally
fixed. The US $ was
based on the Gold
Standard.
• Since 1973, exchange
rates have been allowed
to fluctuate.
• Several valuation models
exist.
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Different Currency Mechanisms
• Independent Float (the currency is allowed to fluctuate
according to market forces)
• Pegged to another currency (the currency’s value is fixed in
terms of a particular foreign currency, and the central bank
will intervene to maintain the fixed value)
• European Monetary System – A common currency (the euro)
is used in different countries. Its value floats against other
world currencies.
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7-4
Foreign Exchange Markets
• Countries use currencies for
internal economic transactions.
• To make transactions in
another country, units of that
country’s currency may need to
be acquired.
• The price at which a currency
can be acquired is known as the
“exchange rate.”
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7-5
Foreign Exchange Rates
• Exchange rates are
published daily in the
Wall Street Journal.
– These are “end-of-day”
rates, as of 4:00pm
Eastern time on the
day prior to publication
• Remember – Rates
change constantly
• The difference between
the rates at which a bank
is willing to buy and sell
currency is known as the
“spread.”
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Foreign Exchange Rates
As the relative strength
of a country’s economy
changes . . .
. . . the exchange rate of
the local currency
relative to other
currencies also
fluctuates.
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?¥ = $?
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7-7
Foreign Exchange Rates
Spot Rate
• The exchange rate that is
available today.
Forward Rate
• The exchange rate that can be
locked in today for an expected
future exchange transaction.
• The actual spot rate at the
future date may differ from
today’s forward rate.
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7-8
Foreign Exchange Forward Contracts
A forward contract requires the purchase (or
sale) of currency units at a future date at the
contracted exchange rate.
This forward
contract allows us
to purchase
1,000,000 ¥ at a
price of $.0080 US
in 30 days.
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But if the spot rate is
$.0069 US in 30 days,
we still have to pay
$.0080 US and we
lose $1,100!!
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7-9
Foreign Exchange Options Contracts
An options contract gives the holder the option
of buying (or selling) the currency units at a
future date at the contracted “strike” price.
An alternative is
an option contract
to purchase
1,000,000 ¥ at
$.0080 US in 30
days. But it costs
$.00002 per ¥.
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That way, if the spot
rate is $.0069 in 30
days, we only lose
the $20 cost of the
option contract!
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7-10
Foreign Currency Option Contracts
• A “put” option allows for the sale of foreign
currency by the option holder.
• A “call” option allows for the purchase of
foreign currency by the option holder.
(Remember: An option gives the holder “the right but not
the obligation” to trade the foreign currency in the
future.)
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Insuring Against Foreign Exchange Risk
• Attempt to reduce the risk of adverse consequences
on the firm due to unpredicted changes in future
exchange rates
Hedging
when a firm insures itself against
foreign exchange risk
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Spot Exchange Rate
Exchange rate of one currency into
currency on a particular day
another
• Spot exchange rates are reported on a real-time basis
– on a minute-by-minute basis
– determined by the interaction between the demand and supply
of that currency relative to the demand and supply of other
currencies
• Quoted as the
– amount of foreign currency one U.S. dollar will buy
– value of U.S. dollar for a one unit of foreign currency
Forward Exchange
Two parties agree to exchange currency and execute the
deal at some specific date in the future
• Used by firms to insure or hedge against foreign exchange
risk that can make a transaction unprofitable
• Exchange rates governing such future transactions are
referred to forward exchange rates
• Forward exchange rates can be quoted for 30 days, 60
days, 90 days, 180 days or longer into the future
Forward Exchange Rates
Selling at a Premium
Expectation that the dollar will appreciate
the yen over the next 30 days
– Spot Rate:
– 30 days Forward:
$1 = Y120
$1 = Y130
against
Forward Exchange Rates
Selling at a Discount
Expectation that the dollar will depreciate
the yen over the next 30 days
– Spot Rate:
– 30 days Forward:
$1 = Y120
$1 = Y110
against
Reducing Risk
Forward Exchange
When two parties agree to exchange currency and
execute the deal at some specific future date
• Insures against foreign exchange risk for a limited period
• US firm imports laptops (at the price of Y200,000) from a Japanese supplier and
must pay the supplier in 30 days after arrival in Yen
• Current dollar/yen spot exchange rate is $1 = Y120
• Importer’s cost is $1,667 (200,000/120)
• Importer can sell the laptop at $2,000 at a gross profit of $333 (2,000-1,667)
• Importer does not have the funds to pay the supplier until laptops are sold
• To hedge against the risk of exchange rate movements between the $ and Yen,
the importer can engage in a forward exchange
• Assume the dollar is selling at a 30-day discount at $1 = Y110
• Importer is guaranteed to not pay more than $1,818 (200,000/110)
• Importer guaranteed $182 gross profit and insures against a loss
• If the dollar is selling at a 30-day premium at $1 =Y130
• Importer guaranteed to not pay more than $1,538 (200,000/130)
• Importer guaranteed $462 gross profit and insures against a loss
Reducing Risk
Currency Swap
Simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates
• Insures against foreign exchange risk for a limited period
• Swaps are transacted between:
– international firms and their banks
– between banks
– between governments
Today
Apple needs to pay $1 M account payable to Japanese supplier
90 Days
Apple collects Y120 M account receivable from Japanese customer
Spot Rate Today
$1 = Y120
90 Day Forward Rate
$1 = Y110
Swap
• Apple sells $1 M to its bank in return for Y120 M and can pay its accounts payable
today
• At the same time, Apple enters into a 90-day forward exchange deal with its bank
for converting Y120 M into US dollars
• Thus, in 90 days, Apple will receive $1.09 M (Y120/110 = 1.09)
• Since the Yen is selling at 90-day premium, Apple receives more dollars than it
started with….but the opposite could also occur….but Apple knows today!
7-20
Foreign Currency Transactions
• A U.S. company buys or
sells goods or services
to a party in another
country. This is often
called “foreign trade.”
• The transaction is often
denominated in the
currency of the foreign
party.
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The major
accounting issue:
How do we account
for the changes in
the value of the
foreign currency?
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7-21
Foreign Currency Transactions
FASB No. 52
Requires a two-transaction
perspective.
(1) Account for the original
sale in US $
(2) Account for gains/losses
from exchange rate
fluctuations.
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Foreign Currency Transactions
When a
transaction
occurs on one
date (for example
a credit sale) . . .
. . . but the cash
flow is at a later
date . . .
. . . fluctuating
exchange rates
can result in
exchange rate
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gains or losses.
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1/23/07 1 £ = $1.9818 US
2/23/07 1 £ = $1.9635 US
?
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7-23
Foreign Currency Transactions
When the rate is
expressed as the
US $ equivalent
of 1 unit of
foreign currency,
the rate is called
a
“DIRECT
QUOTE”
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1/23/07 1 £ = $1.9818 US
2/23/07 1 £ = $1.9635 US
?
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7-24
Foreign Currency Transactions
When the rate is
expressed as the
US $ equivalent of
1 unit of foreign
currency, the rate
is called a
“DIRECT QUOTE”
When the rate is
expressed as the
number of foreign
currency units that
$1 will buy, the rate
is called an
“INDIRECT QUOTE”
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1/23/07 1 £ = $1.9818 US
2/23/07 1 £ = $1.9635 US
1/23/07 .5046 £ = $1 US
2/23/07 .5093 £ = $1 US
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7-25
Foreign Exchange Transaction Example
On 12/1/08, Nuuk sells inventory to Coventry Corp. on
credit. Coventry will pay Nuuk 10,000 British pounds
in 90 days.
The current exchange rate is $1 = .6425 £.
Prepare Nuuk’s journal entry.
Nuuk's
General
Journal
BOBCO's
GENERAL
JOURNAL
Date
Date
Description
Description
Dec 1 A/R (to be collected in £)
Sales
10,000£ ÷ .6425 = $15,564
amounts rounded
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Page
Debit
Debit
34
Credit
15,564
15,564
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Foreign Exchange Transaction Example
On 12/31/08, the exchange rate is $1 = .6400 £.
At the balance sheet date we have to “re-measure”, or
adjust, the original A/R to the current exchange rate.
Nuuk's General
Journal
BOBCO's
GENERAL
JOURNAL
Date
Description
Dec 31 A/R
Foreign Exchange Gain
$15,564 - (10,000£ ÷ .6400)
amounts rounded
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Page
Debit
34
Credit
61
61
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7-27
Foreign Exchange Transaction Example
On 3/1/09, Coventry Corp. pays Nuuk the 10,000 £ for
the 12/1/08 sale.
The exchange rate on 3/1/09, was $1 = .6500 £.
On 3/1/09, we have to do TWO things.
First, we must “re-measure” the A/R.
Nuuk's General
Journal
BOBCO's
GENERAL
JOURNAL
Date
Description
Mar 1 Foreign Exchange Loss
A/R
$15,625 - (10,000£ ÷ .6500)
amounts rounded
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Page
Debit
34
Credit
240
240
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7-28
Foreign Exchange Transaction Example
On 3/1/09, Coventry Corp. pays Nuuk the 10,000 £ for
the 12/1/08 sale.
The exchange rate on 3/1/09, was $1 = .6500 £.
On 3/1/09, we have to do TWO things.
Second, we must record receipt of the £.
Nuuk's
General
Journal
BOBCO's
GENERAL
JOURNAL
Date
Date
Mar 1 Cash
A/R
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Description
Description
Page
Debit
34
Credit
15,385
15,385
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7-29
Hedging Foreign Exchange Risk
• Companies will seek to reduce the risks
associated with foreign currency fluctuations
by “hedging” their exposure
• This means surrendering a portion of potential
gains to offset possible losses by entering into
a potential transaction whose exposure is the
opposite of that for the existing transaction.
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Hedging Foreign Exchange Risk
To control for the
risk of exchange rate
fluctuation, a
forward contract for
currency can be
purchased.
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Hedging
effectively reduces
the uncertainty
associated with
fluctuating
exchange rates.
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7-31
Hedging Foreign Exchange Risk
• To hedge a foreign
currency
transaction,
companies may use
foreign currency
derivatives
• Two common tools:
– Foreign currency
forward contracts
– Foreign currency
options
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Accounting for Derivatives
SFAS 133 provides guidance for hedges of
four types of foreign exchange risk.
Recognized
foreign currency
denominated
assets &
liabilities.
Unrecognized
foreign currency
firm
commitments.
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Forecasted
foreign currency
denominated
transactions.
Net investments
in foreign
operations
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7-33
Accounting for Derivatives
• Often a transaction involving a credit
sale/purchase is denominated in a
foreign currency.
• On the transaction date, the foreign
currency receivable/payable is
recorded.
• If a forward contract is entered into
to hedge the transaction, SFAS No.
133 requires the forward contract be
carried at FAIR VALUE.
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?
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7-34
Determining the Value of Derivatives
To determine the value of
foreign currency derivatives,
the company needs 3 basic
pieces of information:
(1) The forward rate when the
forward contract was entered
into.
(2) The current forward rate for a
contract that matures on the
same date as the forward
contract.
(3) A discount rate.
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Accounting for Hedges
As the Fair Value of a forward contract changes, gains
or losses are recorded.
On 12/31/08, Chan has a
forward contract to deliver $-value of the
500,000¥ at the
500,000¥ to Inuwashi
currently available
Company on 1/31/09 at
forward rate
$
4,082
120¥ = $1. The available
$-value of the
500,000¥ at the
31-day forward rate on
contracted rate
4,167
12/31/08 is 122.50¥ = $1.
Loss on Forward
Chan uses a discount rate
Contract
$
85
of 6%. What is the value of
the forward contract on
The present value
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7-36
Accounting for Hedges
There are two ways that a foreign currency
hedge can be accounted for.
Cash
Flow
Hedge
Fair
Value
Hedge
Gains/losses are
recorded as
Comprehensive Income
Gains/losses are
recorded on the Income
Statement
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7-37
Cash Flow Hedge - Date of Transaction
Example
On 4/1/08, Madh, Inc., a U.S. maker of auto parts,
purchases parts from Caracol Company in Mexico for
100,000 Pesos on credit. Payment is due in 180 days
(October 8, 2008).
The current exchange rate is $1 = 9.5000 pesos.
Prepare Madh’s journal entry on 4/1/08.
MPG, Inc.
General
Journal
Madh's
General
Journal
Date
Date
Apr
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Description
Description
1 Purchases
A/P
Amounts rounded
Page
Debit
Debit
18
Credit
10,526
10,526
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7-38
Cash Flow Hedge - Date of Transaction
Example
Assume that Madh takes a 180-day
forward contract to buy 100,000 pesos.
The forward contract rate is 9.7400
pesos = $1.
Madh's General Journal
Date
Description
Page 18
Debit
Credit
This is an executory contract, so
no entry is made on the contract
date.
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7-39
Cash Flow Hedge - Interim Reporting
Date Example
At Madh’s year-end, 6/30/08, the value of the foreign
currency payable must be re-measured, or
adjusted, based on the 6/30/08 spot rate of $1 =
9.5250 pesos.
1. re-measure the original payable:
Madh's
General
Journal
MPG,
Inc.
General
Journal
Date
Description
Jun 30 A/P (pesos)
Foreign Exchange Gain
100,000 ÷ 9.525 = $10,499
$10,526 - $10,499 = 27
Amounts rounded
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Debit
Credit
27.00
27.00
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7-40
Cash Flow Hedge - Interim Reporting
Date Example
2. In addition, we record an entry to Accumulated
Other Comprehensive Income (AOCI) to offset the
exchange gain/loss associated with the original
transaction.
MPG,
MPG,Inc.
Inc.General
GeneralJournal
Journal
Date
Date
Description
Description
Jun 30 Foreign Exchange Loss
AOCI
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Debit
Credit
27.00
27.00
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7-41
Cash Flow Hedge - Interim Reporting
Date Example
Also, on 6/30/08, the forward contract must be
recorded. The available forward rate to October
8, 2008 is $1 = 9.6200 pesos. Madh uses a 6%
discount rate.
3. Record the forward contract:
Madh's
General
Journal
MPG,
Inc.
General
Journal
Date
Description
Jun 30 Forward Contract
AOCI
at the 90-Day Rate = $10,395
at the Contract Rate = $10,267
PV factor = .9851
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Page 25
Debit
Credit
126.09
126.09
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7-42
Cash Flow Hedge - Interim Reporting
Date Example
4. Finally, we have to amortize the discount from the
original transaction date.
In the original transaction, we had a discount of $11
($10,267 - $10,256). Amortize the discount using
the straight-line method.
MPG, Inc. General Journal
Date
Description
Jun 30 Discount Expense
AOCI
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Debit
Credit
5.50
5.50
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7-43
Cash Flow Hedge - Date of Collection
Example
On 10/8/08, both the original receivable and the
exchange contract come due. Assume the 10/8/08
exchange rate is $1 = 9.4000 pesos.
1. re-measure the Accounts Payable:
MPG, Inc. General Journal
Date
Description
Oct 8 Foreign Exchange Loss
Accounts Payable
100,000 ÷ 9.4000 = $10,638
$10,638 - $10,499 = $139
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Debit
Credit
139
139
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7-44
Cash Flow Hedge - Date of Collection
Example
2. As at year-end, Madh must
record an entry to offset the
foreign exchange loss of $139.
Madh's
MPG,
Inc.General
GeneralJournal
Journal
Date
Date
Description
Description
Oct 8 AOCI
Foreign Exchange Gain
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Debit
Credit
139
139
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7-45
Cash Flow Hedge - Date of Collection
Example
On 10/8/08, both the original payable and the
exchange contract come due. The 10/8/08
exchange rate is $1 = 9.4000 pesos. .
3. Adjust the Forward Contract:
MPG,
MPG,Inc.
Inc.General
GeneralJournal
Journal
Date
Date
Description
Description
Page 25
Debit
Credit
Oct 8 Forward Contract
244.91
AOCI
244.91
at the Current Rate = $10,638
at the Contract Rate = $10,267
Current Forward Contract = $126.09
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7-46
Cash Flow Hedge - Date of Collection
Example
4. Finally, Madh must amortize the rest of the
discount from the original transaction date.
In the original transaction, Madh had a discount of
$11 ($10,267 - $10,256). The discount is
amortized using the straight-line method.
Madh's
MPG,
Inc.General
GeneralJournal
Journal
Date
Date
Description
Description
Oct 8 Discount Expense
AOCI
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Page 25
Debit
Credit
5.50
5.50
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7-47
Cash Flow Hedge - Date of Collection
Example
On 10/8/08, both the original payable and the
exchange contract come due. The 10/8/08
exchange rate is $1 = 9.4000 pesos.
5. Purchase the 100,000 pesos:
MPG,
MPG,Inc.
Inc.General
GeneralJournal
Journal
Date
Date
Description
Description
Oct 8 Foreign Currency (pesos)
Cash
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Page 40
Debit
Credit
10,267
10,267
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7-48
Cash Flow Hedge - Date of Collection
Example
On 10/8/08, both the original payable and the
exchange contract come due. The 10/8/08
exchange rate is $1 = 9.4000 pesos.
6. Complete the Forward Contract Payable:
Madh's General Journal
Date
Oct
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Description
Page
Debit
8 A/P (pesos)
10,638
Forward Contract
Foreign Currency (pesos)
40
Credit
371
10,267
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7-49
Fair Value Hedge - Date of
Transaction Example
On 12/1/08, Castor Co., a U.S. confectioner sells cookies
to L’Orignal, a French company, for 20,000 Euro’s (€)
on credit. Payment is due in 90 days (March 1,
2009).
Assume the current exchange rate is $.9700 = 1 €.
Prepare Castor Co.’s journal entry.
Castor's
General
Journal
BALLOON
CO. GEN'L
JOURNAL
Date
Date
Description
Description
Dec 1 A/R (€) (rounded)
Sales
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Page
Debit
Debit
18
Credit
19,400
19,400
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7-50
Fair Value Hedge - Date of
Transaction Example
Castor Co. buys a 90-day forward contract
to pay 20,000 €. Castor contracts for
the 90-day forward rate on 12/1/08 at
$.9500 = 1 €.
Castor's General Journal
Date
Description
Page 18
Debit
Credit
This is an executory contract, so
no entry is made on the contract
date.
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7-51
Fair Value Hedge - Interim
Reporting Date Example
On 12/31/08, the value of the foreign currency
receivable must be adjusted based on the 12/31/08
spot rate of $.9650 = 1 €.
 Adjust the original receivable:
BALLOON CO. GEN'L JOURNAL
Date
Description
Dec. 31 Foreign Exchange Loss
Accounts Receivable (€)
20,000 x .9650 = $19,300
$19,400 - $19,300 = 100
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Debit
Credit
100.00
100.00
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7-52
Fair Value Hedge - Interim
Reporting Date Example
Also, on 12/31/08, the forward contract
must be recorded. The available
forward rate to March 1, 2009 is $.9520
= 1 €. Castor uses a 6% discount rate.
Record the forward contract:
Castor's General
Journal
BALLOON
CO. GEN'L
JOURNAL
Date
Date
Description
Description
Dec. 31 Loss on Forward Contract
Forward Contract
at the 60-Day Rate = $19,040
at the Contract Rate = $19,000
PV factor = .9901
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Debit
Credit
40
40
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7-53
Fair Value Hedge - Date of
Collection Example
On 3/1/09, both the original receivable and the forward
contract come due. The 3/1/09 exchange rate is
$.9540 = 1 €.
1. Adjust the Accounts Receivable:
Castor's General
Journal
BALLOON
CO. GEN'L
JOURNAL
Date
Description
Mar 1 Foreign Exchange Loss
Accounts Receivable
20,000 x .9540 = $19,080
$19,300 - $19,080 = $220
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Page 40
Debit
Credit
220
220
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7-54
Fair Value Hedge - Date of
Collection Example
On 3/1/09, both the original receivable and the forward
contract come due. The 3/1/09 exchange rate is
$.9540 = 1 €.
 Adjust the Forward Contract Payable:
Castor's
General
Journal
BALLOON
CO. GEN'L
JOURNAL
Date
Date
Description
Description
Mar 1 Loss on Forward Contract
Forward Contract
at the Spot Rate = $19,080
at the Contract Rate = $19,000
Forward Contract on 12/31 = 39.60
McGraw-Hill/Irwin
International Business, 5/e
Page 40
Debit
Credit
40.40
40.40
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-55
Fair Value Hedge - Date of
Collection Example
On 3/1/09, both the original receivable and the forward
contract come due. The 3/1/09 exchange rate is
$.9540 = 1 €.
3. Collect the 20,000 € in settlement of the Account
Receivable:
Castor's General
Journal
BALLOON
CO. GEN'L
JOURNAL
Date
Date
Description
Description
Mar 1 Foreign Currency (€)
Accounts Receivable (€)
McGraw-Hill/Irwin
International Business, 5/e
Page 40
Debit
Credit
19,080
19,080
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-56
Fair Value Hedge - Date of Collection
Example
On 3/1/09, both the original receivable and the forward
contract come due. The 3/1/09 exchange rate is
$.9540 = 1 €.
4. Complete the Forward Contract:
Castor's General
Journal
BALLOON
CO. GEN'L
JOURNAL
Date
Date
Description
Description
Mar 1 Cash ($)
Forward Contract
Foreign Currency (€)
McGraw-Hill/Irwin
International Business, 5/e
Page 40
Debit
Credit
19,000
80
19,080
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-57
Using a Foreign Currency Option as a
Hedge
• An option is a
contract that
allows you to
exercise a
predetermined
exchange rate if
it is to your
advantage.
• Options carry a
cost.
McGraw-Hill/Irwin
International Business, 5/e
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-58
Using a Foreign Currency Option as a
Hedge
As with forward
contracts, options can
be designed as cash
flow hedges or fair
value hedges.
Option prices are
determined using the
Black-Scholes Option
Pricing Model covered
in most finance texts.
McGraw-Hill/Irwin
International Business, 5/e
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-59
Option values
• Derived from a function combining:
– The difference between current spot rate and
strike price
– The difference between foreign and domestic
interest rates
– The length of time to option expiration
– The potential volatility of changes in the spot rate
McGraw-Hill/Irwin
International Business, 5/e
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-60
Using a Foreign Currency Option as a
Hedge
SFAS 133 requires that the
option be carried at fair
value on the balance sheet.
Option fair values are
determined by examining
the current quotes for
similar options and
breaking the fair value into
two components:
Intrinsic Value & Time
Value
McGraw-Hill/Irwin
International Business, 5/e
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-61
Hedge of a Foreign Currency Firm
Commitment
Occurs when a company hedges a
transaction that has yet to take place.
Example
Ruff Wood orders
1,000,000 board
feet of lumber from
Brazil. Ruff Wood
enters the hedge
contract on the
same day as the
order is placed.
McGraw-Hill/Irwin
International Business, 5/e
Under fair value hedge
accounting:
(1) The gain/loss on the hedge is
recognized currently in net
income.
(2) The gain/loss on the firm
commitment attributable to
the hedged risk is also
recognized currently in net
© 2005 The McGraw-Hill Companies,
Inc., All Rights Reserved.
income.
7-62
Foreign Currency Firm Commitment Example
On December 1, 2008, Mawr receives an order from
a German customer. The delivery date is March
1, 2009, when Mawr will receive immediate
payment.
The sale is three months away, Mawr has a firm
commitment to make the sale and receive
payment of 1,000,000 €.
Mawr decides to hedge this commitment.
Mawr's General Journal
Date
Page
Description
Debit
18
Credit
These are executory contracts, so
no entries are made on this date.
McGraw-Hill/Irwin
International Business, 5/e
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-63
Foreign Currency Firm Commitment Example
Mawr will receive 1,000,000 € on March 1, 2009. A
forward contract was entered into to sell the
euros at a price of $.905 = 1 €. Mawr’s discount
rate is 12%.
On 12/31/08, the currently available forward rate is
$.916 = 1 €.
1. Record the forward contract.
Mawr's General Journal
Date
McGraw-Hill/Irwin
International Business, 5/e
Page
Description
Debit
18
Credit
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-64
Foreign Currency Firm Commitment Example
1,000,000 € @ the contract rate of $.905
$
905,000
1,000,000 € @ the currently available forward rate
of $.916
$
916,000
Difference attributed to loss on forward contract
$
(11,000)
Time value factor at the discount rate of 12%
12/31/08 fair value of the forward contract.
Mawr's General
Amerco
GeneralJournal
Journal
Date
Description
Dec 31 Loss on Forward Contract
Forward Contract
McGraw-Hill/Irwin
International Business, 5/e
0.9803
$
(10,783)
Page
Debit
18
Credit
10,783
10,783
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-65
Foreign Currency Firm Commitment Example
Mawr will receive 1,000,000 € on March 1, 2009. A
forward contract was entered into to sell the
euros at a price of $.905 = 1 €. Mawr’s discount
rate is 12%.
On 12/31/08, the currently available forward rate is
$.916 = 1 €.
2. Record the firm commitment.
Mawr's General Journal
Amerco
Journal
Date
Date
Page
Page
Description
Description
Dec 31 Firm Commitment
Gain on Firm Commitment
Note that this entry effectively
offsets the loss on the forward
contract.
McGraw-Hill/Irwin
International Business, 5/e
Debit
Debit
18
Credit
10,783
10,783
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-66
Foreign Currency Firm Commitment Example
On March 1, 2009, Mawr receives 1,000,000
€ from the German customer upon
delivery of the order. On 3/1/09, the spot
rate is $.900 = 1 €.
1. Adjust the forward contract to its
current value of $5,000.
Mawr's General
Amerco
GeneralJournal
Journal
Date
Mar
McGraw-Hill/Irwin
International Business, 5/e
Description
1 Forward Contract
Gain on Forward Contract
Page
Debit
18
Credit
15,783
15,783
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-67
Foreign Currency Firm Commitment Example
On March 1, 2009, Mawr receives 1,000,000
€ from the German customer upon
delivery of the order. On 3/1/09, the spot
rate is $.900 = 1 €.
2. Record an offsetting loss associated
with the Firm Commitment.
Mawr's General
Amerco
GeneralJournal
Journal
Date
Date
Mar
McGraw-Hill/Irwin
International Business, 5/e
Page
Page
Description
Description
1 Loss on Firm Commitment
Firm
Commitment
Note
that
the balance in the
Firm Commitment is now
$5,000 CR.
Debit
Debit
18
18
Credit
Credit
15,783
15,783
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-68
Foreign Currency Firm
Commitment - Example
On March 1, 2009, Mawr receives 1,000,000
€ from the German customer upon
delivery of the order. On 3/1/09, the spot
rate is $.900 = 1 €.
3. Record the receipt of the foreign
currency.
Mawr's General
Amerco
GeneralJournal
Journal
Date
Mar
McGraw-Hill/Irwin
International Business, 5/e
Description
1 Foreign Currency (€)
Sales
Page
Debit
18
Credit
900,000
900,000
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-69
Foreign Currency Firm Commitment Example
On March 1, 2009, Mawr receives 1,000,000
€ from the German customer upon
delivery of the order. On 3/1/09, the spot
rate is $.900 = 1 €.
4. Record the fulfillment of the forward
contract.
Mawr's General
Amerco
GeneralJournal
Journal
Date
Mar
McGraw-Hill/Irwin
International Business, 5/e
Description
1 Cash
Forward Contract
Foreign Currency
Page
Debit
18
Credit
905,000
5,000
900,000
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-70
Foreign Currency Firm Commitment Example
On March 1, 2009, Mawr receives 1,000,000
€ from the German customer upon
delivery of the order. On 3/1/09, the spot
rate is $.900 = 1 €.
5. Close the Firm Commitment to Net
Income.
Mawr's General
Amerco
GeneralJournal
Journal
Date
Mar
McGraw-Hill/Irwin
International Business, 5/e
Page
Description
1 Firm Commitment
Adjustment to Net Income
Debit
18
Credit
5,000
5,000
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-71
Hedge of a Forecasted Foreign Currency
Denominated Transaction
• SFAS 133 allows the use of cash flow hedge
accounting for foreign currency derivatives
associated with a forecasted foreign currency
transaction
– The forecasted transaction must be probable
– The hedge must be highly effective
– The hedging relationship must be properly
documented
McGraw-Hill/Irwin
International Business, 5/e
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-72
Hedge of a Forecasted Foreign Currency
Denominated Transaction
• Accounting for a hedge of a forecasted transaction differs
from that for a foreign currency firm commitment:
– There is no recognition of the forecasted transaction or gains and
losses on it.
– The company reports the hedging instrument at fair value, but does
not report changes in the fair value of the hedging instrument as gains
and losses in net income. Instead, they are recorded in other
comprehensive income. On the projected date of the forecasted
transaction, the cumulative change in the fair value of the hedging
instrument is transferred from other comprehensive income to net
income.
McGraw-Hill/Irwin
International Business, 5/e
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-73
An Interesting Footnote
When foreign currency loans are made on a
long-term basis to a foreign branch, subsidiary
or equity method affiliate, SFAS 52 requires
that foreign exchange gains and losses be
deferred in other comprehensive income until
the loan is repaid. Only the forex gains and
losses related to the interest receivable are
currently recorded in net income.
McGraw-Hill/Irwin
International Business, 5/e
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-74
Summary
• The existence of different currencies creates an accounting
challenge when transactions are denominated in currencies
different from those used to keep accounting records
• FASB has adopted a “two-transaction” approach, separating
the actual sale or purchase transaction from the currency
exchange “speculation”
• A variety of hedging practices may be used to reduce foreign
currency exchange risk. The two most popular hedging
instruments are foreign currency options and foreign currency
forward contracts
McGraw-Hill/Irwin
International Business, 5/e
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-75
Possible Criticisms
• Some critics deride the “two transaction” approach adopted
by the FASB, arguing that a single transaction has actually
occurred.
• Some financial experts feel that the FASB’s definition of what
constitutes a hedge is far too narrow.
• There is considerable controversy concerning the appropriate
means of valuing options.
McGraw-Hill/Irwin
International Business, 5/e
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.