Download Chapter 09 PowerPoint Presentation

Chapter Nine
Foreign
Currency
Transactions and
Hedging Foreign
Exchange Risk
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Learning Objective 9-1
Understand concepts related
to foreign currency, exchange
rates, and foreign exchange risk.
9-2
Exchange Rate Mechanisms
Between 1945 and 1973, countries fixed the
par value of their currency in terms of the
U.S. dollar.
The U.S. dollar was based on the Gold
Standard until 1971.
Since 1973, exchange rates have been
allowed to float in value.
Several currency arrangements exist.
9-3
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 multiple countries. Its value floats
against other world currencies.
9-4
Foreign Exchange Rates
 An Exchange Rate is the cost of one currency in terms of
another.
 Rates published daily in the Wall Street Journal are as of
4:00pm Eastern time on the day prior to publication. Rates
are also available on line at: www.oanda.com and
http://www.x-rates.com
 The published rates are wholesale rates that banks use with
each other – retail rates to consumers are higher.
 The difference between the rates at which a bank is willing
to buy and sell currency is known as the “spread.”
 Rates change constantly!
9-5
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.
 A forward contract requires the purchase (or sale)
of currency units at a future date at the contracted
exchange rate.
9-6
Foreign Exchange –
Option Contracts
An options contract gives the holder the option of
buying (or selling) currency units at a future date at
the contracted “strike” price.
 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.
 An option gives the holder “the right but not the
obligation” to trade the foreign currency in the
future.
9-7
Option values
Value is derived from :
 A function of 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
An option premium is a function of Intrinsic Value
and Time Value
9-8
Learning Objective 9-2
Account for foreign currency
transactions using the two
transaction perspective, accrual
approach.
9-9
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.
How do we account for the changes in the
value of the foreign currency?
9-10
Transaction Exposure
Export sale:
Exposure exists when the exporter allows
buyer to pay in a foreign currency sometime
after the sale has been made. The exporter is
exposed to the risk that the foreign currency
might depreciate between the date of sale and
the date payment is received, decreasing the
U.S. dollars collected.
9-11
Transaction Exposure
Import purchase:
Exposure exists when the importer is required
to pay in foreign currency sometime after the
purchase has been made. The importer is
exposed to the risk that the foreign currency
might appreciate between the date of purchase
and the date of payment, increasing the U.S.
dollars that have to be paid for the imported
goods.
9-12
Foreign Currency Transactions
There are two methods of accounting for changes in
the value of a foreign currency transaction, the onetransaction perspective and the two-transaction
perspective.
The one-transaction perspective assumes:
1. the export sale is not complete until the foreign
currency receivable has been collected .
2. Changes in the U.S. dollar value of the foreign
currency is accounted for as an adjustment to
Accounts Receivable and Sales.
9-13
Foreign Currency Transactions
GAAP requires the two-transaction approach and
treats the sale and collection of cash as two separate
transactions.
1. Account for the original sale in US Dollars at
date of sale. No subsequent adjustments are
required.
2. Changes in the U.S. dollar value of the foreign
currency are accounted for as gains/losses from
exchange rate fluctuations reported separately
from sales in the income statement.
9-14
Foreign Exchange Transaction Example
Summary of the relationship between fluctuations in
exchange rates and foreign exchange gains and losses:
 Foreign currency receivables from an export sale
creates an asset exposure to foreign exchange risk.
 Foreign currency payables from an import purchase
creates a liability exposure to foreign exchange risk.
9-15
Accounting for Unrealized Gains and Losses
Under the two-transaction perspective, a foreign
exchange gain or loss arises at the balance sheet date
that has not yet been realized in cash.
Two approaches exist to account for unrealized
foreign exchange gains and losses:
1. Deferral approach:
Gains and losses are deferred on the balance sheet
until cash is paid or received and a realized foreign
exchange gain or loss is included in income when paid.
9-16
Accounting for Unrealized Gains and Losses
2. Accrual approach (required by U.S. GAAP):
Unrealized foreign exchange gains and losses are
reported in net income in the period in which the
exchange rate changes.
Change in the exchange rate from the balance sheet
date to date of payment results in a second foreign
exchange gain or loss that is reported in the second
accounting period.
9-17
Learning Objective 9-3
Understand how foreign currency
forward contracts and foreign
currency options can be used to
hedge foreign exchange risk.
9-18
Hedging Foreign Exchange Risk
Companies will avoid uncertainty associated
with the effect of unfavorable changes in the
value of foreign currencies using foreign
currency derivatives.
The two most common derivatives used to
hedge foreign exchange risk are foreign
currency forward contracts and foreign
currency options.
9-19
Hedging Foreign Exchange Risk
Two foreign currency derivatives often used :
 Foreign currency forward contracts lock in
the price for which the currency will sell at
contract’s maturity.
 Foreign currency options establish a price
for which the currency can be sold, but is not
required to be sold at maturity.
9-20
Accounting for Derivatives
ASC Topic 815 provides guidance for hedges of four
types of foreign exchange risk.
1. Recognized foreign currency denominated
assets & liabilities.
2. Unrecognized foreign currency firm
commitments.
3. Forecasted foreign currency denominated
transactions.
4. Net investments in foreign operations
9-21
Accounting for Derivatives
The fair value of the derivative is recorded at the
same time as the transaction to be hedged, based on:
 The forward rate when the forward contract was
entered into.
 The current forward rate for a contract that
matures on the same date as the forward contract.
 A discount rate (the company’s incremental
borrowing rate).
9-22
Accounting for Derivatives
In accordance with U.S. GAAP, gains and losses
arising from changes in the fair value of derivatives
are recognized initially either
 on the income statement as a part of net income or
 on the balance sheet in accumulated other
comprehensive income.
Recognition treatment depends partly on whether the
company uses derivatives for hedging purposes or for
speculation.
9-23
Accounting for Derivatives
U.S. GAAP allows hedge accounting for foreign
currency derivatives only if three conditions are
satisfied:
1. The derivative is used to hedge either a cash
flow exposure or fair-value exposure to
foreign exchange risk.
2. The derivative is highly effective in offsetting
changes in the cash flows or fair value
related to the hedged item.
3. The derivative is properly documented as a
hedge.
9-24
Learning Objective 9-4
Account for forward contracts
and options used as hedges of
foreign currency denominated
assets and liabilities.
9-25
Accounting for Hedges
Two ways to account for hedges of foreign currency
denominated assets and liabilities:
1. Cash Flow Hedge
 The hedging instrument must completely offset the
variability in the cash flows associated with the foreign
currency receivable or payable.
 Gains/losses are recorded in Accumulated Other
Comprehensive Income.
2. Fair Value Hedge.
 Any other hedging instrument.
 Gains/losses are recognized immediately in net income.
9-26
Accounting for Hedges
Cash Flow Hedge
At the balance sheet date:
1. The hedged asset or liability is adjusted to fair value
based on changes in the spot exchange rate, and a
foreign exchange gain or loss is recognized in net
income.
2. The derivative hedging instrument is adjusted to fair
value (an asset or liability on the balance sheet) with
the counterpart recognized as a change in
Accumulated Other Comprehensive Income
(AOCI).
9-27
Accounting for Hedges
Cash Flow Hedge continued . . .
At the balance sheet date:
3. An amount equal to the foreign exchange gain or loss on
the hedged asset or liability is then transferred from AOCI
to net income to offset any gain or loss on the hedged asset or
liability.
4. An additional amount is removed from AOCI and
recognized in net income to reflect (a) the current period’s
amortization of the original discount or premium on the
forward contract (if it is the hedging instrument) or (b) the
change in the time value of the option (if it is the hedging
instrument).
9-28
Accounting for Hedges
Fair Value Hedge
At the balance sheet date:
1. Adjust the hedged asset or liability to fair value
based on changes in the spot exchange rate and
recognize a foreign exchange gain or loss in net
income.
2. Adjust the derivative hedging instrument to fair
value (resulting in an asset or liability reported on
the balance sheet) and recognize the counterpart as a
gain or loss in net income.
9-29
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.
As with forward contracts, options can be designated
as cash flow hedges or fair value hedges.
Option prices are determined using the BlackScholes Option Pricing Model covered in most
finance texts.
9-30
Learning Objective 9-5
Account for forward contracts
and options used as hedges
of foreign currency firm
commitments.
9-31
Foreign Currency
Firm Commitment Hedge
A firm commitment is an executory contract not
normally recognized in financial statements; the
company has not delivered goods nor has the customer
paid for them.
When a firm commitment is hedged using a derivative
financial instrument, hedge accounting requires
explicit recognition on the balance sheet at fair value
of both the derivative financial instrument and the
firm commitment.
9-32
Foreign Currency
Firm Commitment Hedge
Changes in the spot exchange rate are used to
determine the fair value of the firm
commitment when a foreign currency option
is the hedging instrument.
U.S. GAAP allows hedges of firm
commitments to be designated either as cash
flow or fair value hedges.
9-33
Foreign Currency
Firm Commitment Hedge
Options are carried at fair value on the balance sheet of
both the derivative financial instrument (forward
contract or option) and the firm commitment.
The change in value of the firm commitment gain/loss
offsets the gain or loss on the hedging instrument.
Gain/loss is recognized currently in net income, as is the
gain/loss on the firm commitment attributable to the
hedged risk.
9-34
Learning Objective 9-6
Account for forward contracts
and options used as hedges
of forecasted foreign currency
transactions.
9-35
Hedge of a Forecasted Foreign Currency
Denominated Transaction
Cash flow hedge accounting may be used for foreign
currency derivatives associated with a forecasted
foreign currency transaction.
The forecasted transaction must be probable, highly
effective, and the hedging relationship must be
properly documented.
There is no recognition of the forecasted transaction
or gains and losses on the forecasted transaction.
9-36
Hedge of a Forecasted Foreign Currency
Denominated Transaction
The company reports the hedging
instrument (forward contract or option) at
fair value, but changes in the fair value of
are not reported in net income.
Gains and losses on the hedging instrument
are recorded in Other Comprehensive
Income until the date of the forecasted
transaction then transferred to net income
on the projected transaction date.
9-37
Learning Objective 9-7
Prepare journal entries to
account for foreign currency
borrowings.
9-38
Foreign Currency Borrowings
Companies often must account for foreign
currency borrowings, another type of foreign
currency transaction.
Companies borrow foreign currency from foreign
lenders to finance foreign operations or to take
advantage of more favorable interest rates.
The facts that the principal and interest are
denominated in foreign currency and create an
exposure to foreign exchange risk complicate
accounting for a foreign currency borrowing.
9-39
Journal Entries
9-40
Foreign Currency Borrowings
Companies also lend foreign currency to related
parties, creating the opposite situation from a
foreign currency borrowing.
The company must keep track of a note receivable
and interest receivable, both of which are
denominated in foreign currency.
Fluctuations in the U.S. dollar value of the
principal and interest generally give rise to foreign
exchange gains and losses that would be included
in income.
9-41
IFRS—Foreign Currency Transactions and
Hedges
There are no substantive differences between U.S.
GAAP and IFRS in accounting for foreign
currency transactions.
Similar to U.S. GAAP, IAS 21, “The Effects of
Changes in Foreign Exchange Rates,” requires the
use of a two-transaction perspective in accounting
for foreign currency transactions with unrealized
foreign exchange gains and losses accrued in net
income in the period of exchange rate change.
9-42
IFRS—Foreign Currency Transactions and
Hedges
IAS 39, “Financial Instruments: Recognition and
Measurement,” governs accounting for hedging instruments
including those used to hedge foreign exchange risk.
One difference between the two sets of standards relates to
the type of financial instrument designated as a foreign
currency cash flow hedge.
U.S. GAAP allows only derivative financial instruments to
be used as a cash flow hedge.
IFRS allows nonderivative financial instruments.
9-43
IFRS—Foreign Currency Transactions and
Hedges
In 2010, the IASB proposed a new hedge accounting
model that would result in significant differences
between IFRS and U.S. GAAP.
In 2012, the IASB issued a draft of a forthcoming
statement that would move hedge accounting from IAS
39 to IFRS 9, “Financial Instruments,” to implement
the new model which would go into effect in 2015.
IFRS 9 is intended to more closely align accounting
with a company’s risk management activities.
9-44