McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Topics
Foreign exchange markets
Foreign exchange risk
Accounting for foreign currency transactions
Hedging
Foreign currency forward contracts and options
Accounting for hedges
Cash flow hedges and fair value hedges
7-2

Learning Objectives
1. Provide an overview of the foreign exchange market.
2. Explain how fluctuations in exchange rates give rise
to foreign exchange risk.
3. Demonstrate the accounting for foreign currency
transactions.
4. Describe how foreign currency forward contracts and
foreign currency options can be used to hedge
foreign exchange risk.
5. Describe the concepts of cash flow hedges, fair
value hedges, and hedge accounting.
6. Demonstrate the accounting for forward contracts
and options used as cash flow hedges and fair value
hedges to hedge foreign currency assets and
liabilities, foreign currency firm commitments, and
forecasted foreign currency transactions.

7-3

Foreign exchange rate

Purchase price of a foreign currency-- e.g., in

February 2010 it cost about 0.08 U.S. dollars
(eight cents) to purchase one Mexican peso.

From 1945 to 1973 countries had exchange rates

fixed to the U.S. dollar.

U.S. dollar was fixed to gold at $35 per ounce.

Balance-of-payments deficits in the U.S. during

the 1960s doomed this system, so, by March
1973 most currencies were allowed to float in
value.

Learning Objective 1

7-4

Exchange Rate Mechanisms

Independent float currency value allowed to

move freely with little government intervention.

Pegged to another currency currency value

fixed (pegged) in terms of a particular foreign
currency (e.g., U.S. dollar), and central bank
intervenes to maintain the exchange rate.

European Monetary System (Euro) twelve

countries use a single currency, which floats
against other currencies such as the U.S. dollar.

Learning Objective 1

7-5

Foreign Exchange Rates

Exchange rates, to the U.S. dollar, are published in

many places on the internet and in newspapers.

Exchange rates are reflected both as US $ equivalent

(direct quotes) and currency per US $ (indirect quotes).

For example, on February 16, 2010 the direct quote for

a Euro was $1.3605 and the indirect quote was
$0.7350. As a point of comparison, the direct quote
when the Euro first appeared in 1998 was
approximately $1.17 and the indirect quote was
approximately $0.85.

A direct quote is the reciprocal of an indirect quote and

vice-versa.

Learning Objective 1

7-6

Spot rates and Forward rates

Spot rate todays price for purchasing or

selling a foreign currency.

Forward rate todays price for purchasing or

selling a foreign currency for some future date.

Premium -- when the forward rate is greater

than the spot rate for a particular day.

Discount -- when the forward rate is less than

the spot rate for a particular day.

Learning Objective 1

7-7

Option contracts
Foreign currency option gives the right, but not
the obligation, to trade foreign currency for some
period.

Put

option the option to sell the foreign currency.

Call

option the option to buy the foreign currency.

Strike

price the exchange rate at which currency

will be exchanged when option is exercised.

Learning Objective 1

7-8

Option contracts

Option premium cost of purchasing the

option, which is a function of the options intrinsic
value and time value.

Intrinsic value is the gain that could be made

by immediate exercise of the option.

Time value the value that derives from the

fact that the currency value could increase
during the remainder of the option period.

Learning Objective 1

7-9

Terminology

Export sale a company sells to a foreign

customer and later receives payment in the
customers currency.

Import purchase a company purchases from a

foreign supplier and later pays in the suppliers
currency.

Foreign exchange risk the chance that the

exporter will receive less or that the importer will
pay more than anticipated as a result of a change
in the exchange rate.

Learning Objective 2

7-10

Example

Joe Inc., a U.S. company, makes a sale and ships

goods to Jose, SA, a Mexican customer.

Sales price is $100,000 (U.S.) and Joe allows Jose

to pay in pesos in 30 days.

The current exchange rate is $0.10 per 1 peso.

Joe plans to receive 1,000,000 pesos

($100,000/$0.10).

Learning Objective 2

7-11

Joe has foreign exchange risk exposure because

he may receive less than $100,000.

Suppose the peso decreases such that in 30 days

the exchange rate is $0.09 per 1 peso.

Joe will receive 1,000,000 pesos which will be

worth $90,000 (1,000,000 x $0.09) and Joe
receives $10,000 less due to exchange rate
fluctuation.

Learning Objective 2

7-12

Accounting sale transaction

One transaction perspective

Treats sale and collection as one transaction.

Transaction is complete when foreign currency is received

and converted, and sale is measured at converted amount.

This approach is not allowed under IAS or U.S. GAAP.

Learning Objective 3

7-13

Two transaction perspective

Treats sale and collection as two transactions

Sale is one transaction and collection is a second

transaction.

Sale is based on current exchange rate.

If exchange rate changes, collection is for different

amount.

Difference is considered foreign exchange gain or

loss.

Concepts are identical for purchase transaction.

Learning Objective 3

7-14

Transaction types, exposure type and

gain or loss export sales
Export

sale asset exposure--if foreign currency

appreciates
foreign exchange gain.
Export

sale asset exposure--if foreign currency

depreciates
foreign exchange loss.

Learning Objective 3

7-15

Transaction types, exposure type and

gain or loss import purchases

Import purchase liability exposure -- if foreign currency

appreciates foreign exchange loss.

Import purchase liability exposure -- if foreign currency

depreciates foreign exchange gain.

Learning Objective 3

7-16

Export sale example 1

February 1, 2011, Joe Inc., a U.S. company,

makes a sale and ships goods to Jose, SA, a
Mexican customer.

Sales price is $100,000 (U.S.).

Jose agrees to pay in pesos on March 2, 2011.

Assume spot rate as of February 1, 2011 is $0.10

per peso.

Learning Objective 3

7-17

Export sale example 1

Joe, Inc. records the sale (in U.S. $) on February 1,
2011 as follows:
Accounts Receivable
Sales

Learning Objective 3

100,000
100,000

7-18

Export sale example 1

On March 2, 2011, the spot rate is $0.09 per peso.
Joe Inc. will receive 1,000,000 pesos, which are now
worth $90,000. Joe makes the following journal
entry:
Cash
90,000
Foreign Exchange Loss 10,000
Accounts Receivable

Learning Objective 3

100,000

7-19

Export sale example 2

Assume the following facts are added or
changed:

Joe Inc., makes sale and ships goods on December 1,

2010 rather than February 1, 2011.

Spot rate as of December 1, 2010 is $0.11 per peso.

Spot rate as of December 31, 2010 is $0.105 per

peso.

Joe Inc. has a December 31 year end .

Learning Objective 3

7-20

Export sale example 2

Joe, Inc. records the sale (in U.S. $) on December 1,
2010 and the foreign exchange loss on December
31, 2010 as follows:
Accounts Receivable
Sales
Foreign Exchange Loss
Accounts Receivable

Learning Objective 3

110,000
110,000
5,000
5,000

7-21

Export sale example 2

Joe, Inc. records the receivable collection and an
additional foreign exchange loss on March 2, 2011:
Cash
Foreign Exchange Loss
Accounts Receivable
105,000

Learning Objective 3

90,000
15,000

7-22

Hedging -- protecting against losses from

exchange rate fluctuations. Companies often use
foreign currency forward contracts and foreign
currency options.

Foreign currency forward contract an

agreement to buy or sell foreign currency at a
future date.

Foreign currency option the right to buy or

sell foreign currency for a period of time.

Learning Objective 4

7-23

Hedging risk on an export sale example

1

Previously, Joe Inc. lost $20,000 without hedging

as the peso fell from $0.11 to $0.09.

The loss was ($0.11 - $0.09) x 1,000,000 pesos.

Joe could have purchased a foreign currency

forward contract on December 1, 2010.

Learning Objective 4

7-24

Hedging risk on an export sale example

1

Under the contract, Joe would have agreed to sell

1,000,000 pesos for $0.105 on March 2, 2011.

In this case, Joe would have collected $105,000

rather than $90,000.

Instead of a $20,000 foreign exchange loss, Joe

would have paid a $5,000 premium on the
forward contract.

Learning Objective 4

7-25

Hedging risk on an export sale example

2

Previously, Joe Inc. lost $20,000 without hedging

as the peso fell from $0.11 to $0.09.

The loss was ($0.11 - $0.09) x 1,000,000 pesos.

Joe could have purchased a foreign currency

option on December 1, 2010.

The option premium is $4,000.

Learning Objective 4

7-26

Hedging risk on an export sale

example 2

Joe would now have the option sell 1,000,000

pesos for $0.11 on March 2, 2011.

In this case Joe would have collected $110,000

rather than $90,000.

Instead of a $20,000 foreign exchange loss, Joe

would have paid $4,000 for the option.

Learning Objective 4

7-27

Hedge accounting an offsetting gain or loss

from the hedge is recognized in net income
during the same period as the gain or loss from
the hedged item.

Cash flow hedge an accounting designation

for hedges that offset variability in cash flows of
hedged items.

Fair value hedge an accounting designation

for hedges that offset the variability in fair value
of hedged assets and liabilities.

Learning Objective 5

7-28

Hedge accounting examples

1.

FC asset/forward contract/cash flow hedge.

2.

FC asset/forward contract/fair value hedge.

3.

FC asset/option/cash flow hedge.

4.

FC firm commitment/forward contract/fair value

hedge.

5.

FC firm commitment/option/fair value hedge.

6.

Forecasted FC transaction/option/cash flow hedge.

Learning Objective 6

7-29

Assumptions for examples 1 and 2

December 1, 2010, Joe Inc., a U.S. company, makes a

sale and ships goods to Jose, SA, a Mexican customer.

Sales price is $110,000 (U.S.).

Jose agrees to pay 1,000,000 pesos on March 2,

2011.

Spot rates per peso are: December 1, 2010, $0.11,

December 31, 2010, $0.10, and March 2, 2011,
$0.095.

The annual interest rate is 6% (0.5% per month).

Learning Objective 6

7-30

Joe enters a foreign currency forward contract on

December 1, 2010.

The contract calls for Joe to sell 1,000,000 pesos

at a forward rate of $0.105, on March 2, 2011.

The forward rate on December 31, 2010 for

March 2, 2011 delivery is $0.096.

Learning Objective 6

7-31

Example 1, FC asset/forward/cash flow

hedge
12/01/10
Accounts receivable
Sales
12/31/10
Foreign exchange loss
Accounts receivable
10,000

110,000
110,000
10,000

Accumulated Other Comprehensive Income 10,000

Gain on forward contract

10,000

Learning Objective 6

7-32

Example 1, FC asset/forward/cash flow

hedge
12/31/10
Forward contract
8,911
Accumulated Other Comprehensive Income
8,911
Discount expense*
1,667
Accumulated Other Comprehensive Income
1,667
(*discount expense is amortized using the straight-line
method)

Learning Objective 6

7-33

Example 1, FC asset/forward/cash flow

hedge
3/02/11
Foreign exchange loss
5,000
Accounts receivable
5,000
Accumulated Other Comprehensive Income
Gain on forward contract
5,000

5,000

Forward contract
1,089
Accumulated Other Comprehensive Income
1,089

Learning Objective 6

7-34

Example 1, FC asset/forward/cash flow

hedge
3/02/11
Discount expense
3,333
Accumulated Other Comprehensive Income
3,333
Foreign currency
95,000
Accounts receivable
95,000
Cash

Foreign currency
95,000
Forward contract
10,000

Learning Objective 6

105,000

7-35

Example 2, FC asset/forward/fair value

hedge
12/01/10
Accounts receivable
Sales

110,000

12/31/10
Foreign exchange loss
Accounts receivable
Forward contract
Gain on forward contract
8,911

Learning Objective 6

110,000
10,000
10,000

8,911

7-36

Example 2, FC asset/forward/fair value

hedge
3/02/11
Foreign exchange loss
5,000
Accounts receivable
5,000
Forward contract
Gain on forward contract
1,089

Learning Objective 6

1,089

7-37

Example 2, FC asset/forward/fair value

hedge
3/02/11
Foreign currency
Accounts receivable
95,000
Cash
95,000
10,000

Foreign currency

95,000

105,000

Forward contract

Learning Objective 6

7-38