CHAPTER 4

ACCOUNTING FOR FOREIGN

CURRENCY TRANSACTION

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 LEARNING OUTCOME
After studying this chapter, you should be able to:
• LO1 Understand concepts related to foreign
currency, exchange rates, and foreign exchange
risk.
• LO2 Account for foreign currency transactions
using the two-transaction perspective, accrual
approach.
• LO3 Understand how foreign currency forward
contracts and foreign currency options can be
used to hedge foreign exchange risk.
• LO4 Account for forward contracts and options
used as hedges of foreign currency denominated
assets and liabilities.
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 Terms
• Foreign currency: is the currency other than
local currency.
• Transactions: exchange of goods or service
between two parties in monetary terms.
• Foreign currency transactions: are transaction
between two parties using foreign currency
• The foreign exchange rate is the price at which
the foreign currency can be acquired.

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 Exchange Rate Mechanisms
• Independent float: The value of the currency is
allowed to fluctuate freely according to market
forces with little or no intervention from the central
bank
• Pegged to another currency: The value of the
currency is fixed (pegged) in terms of a particular
foreign currency and the central bank intervenes as
necessary to maintain the fixed value.
• European Monetary System (euro): In 1998, the
countries comprising the European Monetary
System adopted a common currency called the
euro and established a European Central Bank.
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 Foreign Exchange Rates

• The foreign exchange rate is the price at which

the foreign currency can be acquired.
• direct quotes indicates the number of U.S.
dollars needed to purchase one unit of foreign
currency.
• indirect quotes indicates the number of
foreign currency units that could be purchased
with one U.S. dollar. which are simply the
inverse of direct quotes.

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 Types of exchange rates
Foreign currency trades can be executed on:
1. Spot rates
2. Forward rates

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 Spot Rates
• The spot rate is the price at which a foreign
currency can be purchased or sold today. There
are two types of spot rates:
i. Buying spot rates
ii. Selling spot rates

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 Forward Rate
• forward rate is the price today at which
foreign currency can be purchased or sold
sometime in the future.
• Because many international business
transactions take some time to be completed,
the ability to lock in a price today at which
foreign currency can be purchased or sold at
some future date has definite advantages.

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 Option Contracts

• To provide companies more flexibility than

exists with a forward contract, a market for
foreign currency options has developed.
• A foreign currency option gives the holder of
the option the right but not the obligation to
trade foreign currency in the future.
• A put option is for the sale of foreign currency
by the holder of the option;

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• a call is for the purchase of foreign currency
by the holder of the option.
• The strike price is the exchange rate at which
the option will be executed if the option
holder decides to exercise the option.
• The strike price is similar to a forward rate.

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 Accounting Alternatives

• Conceptually, the two methods of accounting

for changes in the value of a foreign currency
transaction are the
• one-transaction perspective and
• the two-transaction perspective.

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 Example 1
• Assume that Amerco, a U.S. company, sells goods to a
German customer at the price of 1 million Euros on
December 1, 2016. n/30.
• The exchange rates were as follows:
• De e er , ………………….$ .
• De e er , …………………$ .
Instruction
Record the above transaction assume that Amerco is:
1. Exporter
2. Importer

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 Importer
• December 1
Merchandise invesntory ……….. , ,
A/P…………………………………………… , ,
December 31
A/P……………… ,
Gai o foreig urre y tra s…... ,
A/P……….. , ,
ash …………….. , ,

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We can summarize the relationship between
fluctuations in exchange rates and foreign exchange
gains and losses as follows:
Foreign Currency (FC)

Transaction Type of Exposure Appreciates Depreciates

Export sale Asset Gain Loss

Import purchase Liability Loss Gain

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 Balance Sheet Date before Date of Payment
• Assume that Amerco, a U.S. company, sells goods to a
German customer at the price of 1 million euros on
December 1, 2015. n/90.
The exchange rates for 1 euro were as follows:
• De e er , ………………….$ .
• De e er , ………………… .
• Mar h , ………………………… .
Instruction: pass the necessary journal entries on the
book of Ameroc company on:
1. December 1, 2016
2. December 31, 2016 (financial statement date)
3. March 1, 2017

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 HEDGES OF FOREIGN
EXCHANGE RISK

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• To avoid this uncertainty due to foreign
exchange rate fluactuation, companies often
use foreign currency derivatives to hedge
against the effect of unfavorable changes in
the value of foreign currencies.
• The two most common derivatives used to
hedge foreign exchange risk are:
• foreign currency forward contracts
• foreign currency options.

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 DERIVATIVES ACCOUNTING
• Topic 815, Derivatives and Hedging, of the
FASB Accounting Standards Codification
governs the accounting for derivatives,
including those used to hedge foreign
exchange risk.
This authoritative literature provides guidance
for hedges of the following sources of foreign
exchange risk:
• Recognized foreign currency denominated
assets and liabilities.

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 Fundamental Requirement of Derivatives Accounting

• The fundamental requirement is that companies

carry all derivatives on the balance sheet at their
fair value.
• Derivatives are reported on the balance sheet as
assets when they have a positive fair value and as
liabilities when they have a negative fair value.
• The first issue in accounting for derivatives is the
determination of fair value.
• The second issue in accounting for derivatives is
the treatment of the gains and losses that arise
from these adjustments.
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 Determination of Fair Value of Derivatives
• The fair value of a foreign currency forward contract is
determined by reference to changes in the forward rate
over the life of the contract, discounted to the present
value.
• Three pieces of information are needed to determine
the fair value of a forward contract at any point in time:
• 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 entered into.
• A discount rate—typi ally, the o pa y’s i re e tal
borrowing rate.

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• In accordance with U.S. GAAP, gains
and losses arising from changes in the
fair value of derivatives are recognized
initially either
(1) on the income statement as a part
of net income or
(2) (2) on the balance sheet in
accumulated other comprehensive
income.
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 HEDGE ACCOUNTING
• Companies enter into hedging relationships to minimize
the adverse effect that changes in exchange rates have
on cash flows and net income.
• U.S. GAAP allows hedge accounting for foreign currency
derivatives only if three conditions are satisfied:
• The derivative is used to hedge either a fair-value
exposure or cash flow exposure to foreign exchange risk.
• The derivative is highly effective in offsetting changes in
the fair value or cash flows related to the hedged item.
• The derivative is properly documented as a hedge.

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 Nature of the Hedged Risk
• A fair-value exposure exists if changes in
exchange rates can affect the fair value of an
asset or liability reported on the balance sheet.
• To qualify for hedge accounting, the fair-value risk
must have the potential to affect net income if it
is not hedged.
• A cash flow exposure exists if changes in
exchange rates can affect the amount of cash
flow to be realized from a transaction with
changes in cash flow reflected in net income.
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• Derivatives for which companies wish to
use hedge accounting must be designated
as either a fair value hedge or a cash flow
hedge.
• In general,
• gains and losses on fair value hedges are
recognized immediately in net income,
• gains and losses on cash flow hedges are
included in accumulated other
comprehensive income. /AOCI/

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 • HEDGES OF FOREIGN CURRENCY
DENOMINATED ASSETS AND
LIABILITIES

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• Hedges of foreign currency denominated
assets and liabilities, such as accounts
receivable and accounts payable, can qualify
as either:
• cash flow hedges or
• fair value hedges.

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 Comprehensive Exercise
Assume that Amerco, a U.S. company, sells
goods to a German customer at the price of 1
million Euros on December 1, 2015. n/90.

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 The relevant exchange rates, forward rates and option
premium are as follows:

Date Spot rate Forward rate as Option premium

of 1 march

Dec 1,2011 $1.32 1.305 0.009

Dec 31,2011 1.33 1.316 0.006

March 1, 2012 1.30 N/A 0.20

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 INSTRUCTIONS
Pass the necessary journal entries on
decemeber1, December 31 and march 1, 2012
on the book of AMERCO company under:
1. Forward contract using:
A. Cash flow hedging
B. Fair value hedging
2. Option contract using:
A. Cash flow hedging
B. Fairvalue hedging

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 Solution table
Account Receivable (€) Forward Forward Contract
U.S. Dollar Change in Rate to Change in Fair
Spot U.S. Value Dollar Value 3/1/12 Value Fair Value
Date Rate

12/1/11 $1.32 $1,320,000 $1.305 –0– —

12/31/11 1.33 1,330,000 — $10,000 1.316 $(10,783)* $10,783
3/1/12 1.30 1,300,000 $30,000 1.30 5,000† 15,783

*$1,305,000 $1,316,000 $(11,000) 0.9803 $(10,783), where 0.9803 is the

present value factor for two months at an annual interest rate of 12 percent
(1 percent per month) calculated as 1/1.012.
†$1,305,000
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$1,300,000 $5,000. 32
 2011 Journal Entries—Forward Contract
Designated as a Cash Flow Hedge

• Memo- Amerco company entered into a

forward contract on December 1,2011.

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The company prepares the following journal entries on
December 31:

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• The impact on net income for the year 2011 follows:
• Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,320,000
Foreign exchange gain. . . . . . . . . . . . $ 10,000
• Loss on forward contract . . . . . . . . . . (10,000)
• Net gain (loss). . . . . . . . . . . . . . . . . . . . . . . . . . . . –0–
• Discount expense. . . . . . . . . . . . . . . . . . . . . . . . . (5,019)
• Impact on net income. . . . . . . . . . . . . . . . . $1,314,981

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 The effect on the December 31, 2011, balance
sheet is as follows:

Assets Accounts Liabilities and Stockholders’ Equity

receivable (€) . . . . Forward contract . . .$ 10,783
..

$1,330,000
Retained earnings . . .. . . . 1,314,981
AOCI . . . . . . . . .. . . . . . 4,236
…………………………..$1,330,000

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 2012 Journal Entries—Forward Contract Designated as Cash
Flow Hedge

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The impact on net income for the year 2012 follows:

Foreign exchange loss . . . . . . . . . . . . . $(30,000)

Gain on forward contract . . . . . . . . . . 30,000

Net gain (loss) . . . . . . . . . . . . . . . . . . . –0–

Discount expense . . . . . . . . . . . . . . . . $(9,981)
Impact on net income . . . . . . . . . . . $(9,981)

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 END FOR TODAY

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