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Foreign Currency Concepts and Transactions. Chapter 12. Learning Objective 1. Introduce foreign currency and definitions. Foreign Exchange Concepts and Definitions. Currencies provide…. a standard of value,. a medium of exchange,. and a unit of measure. for economic transactions.

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Foreign Currency Concepts and Transactions

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## Foreign Currency Conceptsand Transactions

Chapter 12

### Learning Objective 1

Introduce foreign currency

and definitions.

### Foreign Exchange Conceptsand Definitions

Currencies provide…

a standard

of value,

a medium

of exchange,

and a unit

of measure

for economic transactions.

### Foreign Exchange Conceptsand Definitions

In the case of transactions between

the amounts receivable and payable

are denominated in local currency of

either the buying or the selling entity.

### Foreign Exchange Conceptsand Definitions

Exchange rates are essentially prices for

currencies expressed in units of

other currencies.

=

.0082

### Learning Objective 2

Understand quotation conventions

for foreign currency and

exchange rates.

\$1.60

1

=

\$1.60

1

\$1.60

=

£0.625

### Direct and Indirect Quotationof Exchange Rates

Assume that \$1.60 can be exchanged for £1.

Direct quotation (U.S. dollar equivalent):

Indirect quotation (foreign currency per U.S. dollar):

Weakens

Strengthens

Floating

Fixed

Multiple

### The Euro

Twelve member states of the European

Union chose to participate in the transition

to a single currency for Europe, the Euro.

The euro currency is

managed by the European

Central Bank.

### Spot, Current, and HistoricalExchange Rates

Spot rate– the exchange rate for immediate

delivery of currencies exchanged

Current rate– the exchange rate at the

balance sheet date or the transaction date

Historical rate– the rate in effect at the

date a specific transaction or event occurred

### Learning Objective 3

Learn foreign-currency-

denominated transactions

accounting.

### Foreign Currency TransactionsOther Than Forward Contracts

Local

transactions

Foreign

transactions

An entity’s functional currencyis the

currency of an entity’s primary

economic environment.

### Foreign Currency TransactionsOther Than Forward Contracts

Foreign currency transactionsare stated

(denominated) in a currency other than

an entity’s functional currency.

The provisions of FASB Statement No. 52

apply only to foreign currency transactions

and foreign currency financial statements.

### Translation at the Spot Rate

A U.S. corporation imports inventory

from a Canadian firm when the spot

rate for Canadian dollars is \$.70

The invoice calls for payment of 10,000

How does the U.S. importer record the transaction?

### Translation at the Spot Rate

Inventory7,000

Accounts Payable (fc)7,000

(Translation 10,000 Canadian dollars × .70 spot rate)

If the account payable is settled when the

spot rate is \$.69, how is it recorded?

### Translation at the Spot Rate

Accounts payable (fc)7,000

Exchange Gain 100

Cash6,900

(Cash required equals 10,000 Canadian dollars

× the \$0.69 spot rate)

### Purchases Denominatedin Foreign Currency

American Trading Company purchased goods from

Kimetz Company on December 1, 2008, for 10,000

euros when the spot rate for euros was \$0.6600.

AT closed its books at December 31, 2008,

when the spot rate for euros was \$0.6550,

and settled the account on January 30, 2009,

when the spot rate was \$0.6650.

### Purchases Denominatedin Foreign Currency

December 1, 2008

Inventory6,600

Accounts Payable (fc)6,600

To record purchase of merchandise from Kimetz

Company (10,000 euros × \$0.6600 rate)

December 31, 2008

Accounts Payable (fc) 50

Exchange Gain 50

To adjust accounts payable to exchange rate at

year end [10,000 euros × (\$0.6600 – \$0.6550)]

### Purchases Denominatedin Foreign Currency

January 30, 2009

Accounts Payable (fc)5,550

Exchange Loss 100

Cash6,650

To record payment in full to Kimetz Company

(10,000 euros × \$0.6650 spot rate)

### Sales Denominatedin Foreign Currency

On December 16, 2008, American Trading sold

merchandise to Kimetz for 20,000 euros when

the spot rate for euros was \$0.6600.

AT closed its books at December 31, when the

spot rate was \$0.6550, collected the account on

January 15, 2009, when the spot rate was \$0.6700,

and held the cash until January 20, when it

converted the euros into USD at a \$0.6725 rate.

### Sales Denominatedin Foreign Currency

December 15, 2008

Accounts Receivable (fc)13,200

Sales13,200

To record sales to Kimetz

(20,000 euros × \$0.6600 spot rate)

December 31, 2008

Accounts Receivable (fc) 100

Exchange Gain 100

To adjust accounts receivable year end

[20,000 euros × (\$0.6650 – \$0.6600)]

### Sales Denominatedin Foreign Currency

January 15, 2009

Cash13,400

Accounts Receivable (fc)13,300

Exchange Gain 100

To record collection in full from Kimetz

(20,000 euros × \$0.6700) and recognize exchange gain

for 2009 [20,000 euros × (\$0.6700 – \$0.6650)]

January 20, 2009

Cash13,450

Exchange Gain 50

Cash (fc)13,400

To convert 20,000 euros into U.S. dollars

(20,000 euros × \$0.6725)

### Learning Objective 4

Comprehend cash flow hedge

accounting and fair value

hedge accounting.

### Foreign Currency Derivativesand Hedging Activities

Derivative is the name given to a

The derivative contract’s value to the investor

is directly related to the fluctuations in price,

rate, or some other variable that underlies it.

Forward contracts

Future contracts

### Derivative Instruments

Options contracts

### Derivative Instruments

Options are rights to take an action,

but the holder is not obligated to do so.

A forward contract is negotiated between

the parties and not through an exchange.

### Derivative Instruments

Futures contracts bind both parties

(the writer and the holder) to perform.

A cash flow hedge is designed to limit

the company’s exposure to price

changes in forecasted purchases.

### Derivative Instruments

A company signs an option contract on

January 15, 2003, at a cost of \$1,000.

The company can exercise its option

to purchase 100,000 gallons of

fuel at \$1 per gallon.

The option expires on May 31, 2003.

### Derivative Instruments

January 15, 2003

Fuel Contract Option1,000

Cash1,000

The company prepares its quarterly

report on March 31, 2003.

Market price of fuel is \$1.25.

The company could exercise the

option on this date.

### Derivative Instruments

March 31, 2003

Fuel Contract Option24,000

Other Comprehensive

Income – Unrealized Holding

Gains on Fuel Option Contract24,000

On May 31, 2003, the fuel price is \$1.30.

The writer of the option must pay the

company \$0.30 per gallon, or \$30,000.

### Derivative Instruments

May 31, 2003

Fuel Inventory130,000

Cash130,000

Cash 30,000

Fuel Contract Option 25,000

Other Comprehensive Income 5,000

### Derivative Instruments

The fuel inventory is used on June 15, 2003.

June 15, 2003

Cost of Goods Sold130,000

Fuel Inventory130,000

Other Comprehensive Income 30,000

Cost of Goods Sold 30,000

### Fair Value Hedges

A fair value hedge is a derivative contract that

attempts to reduce the price risk of an existing

asset or firm purchase commitment.

### Summary of Forward Contracts(Speculation)

Purpose

To speculate in exchange rate changes

Recognition

Exchange gains and losses are recognized currently,

based on forward exchange rate changes.

Expected Effect of Hedge and Related

Foreign Currency Item

Income effect equals exchange

gains and losses recognized.

### Summary of Forward Contracts(Hedge of a Net Asset or Liability Position)

Purpose

To offset exposure to existing net asset

or liability position

Recognition

Exchange gains and losses are recognized currently,

but they are offset by related gains or losses

on net asset or liability position.

Expected Effect of Hedge and Related

Foreign Currency Item

Income effect equals the amortization of premium

or discount (gains and losses offset.)

### Summary of Forward Contracts(Hedge of an Identifiable Commitment)

Purpose

To offset exposure to a future purchase or sale and

thereby lock in the price of an existing contract

Recognition

Exchange gains and losses are recognized

currently, but are offset by related

gains or losses in the firm commitment.

Expected Effect of Hedge and Related

Foreign Currency Item

Income effect equals the difference in the change in

value of the instrument versus the firm commitment.

### Summary of Forward Contracts(Hedge of an Anticipated Transaction)

Purpose

To offset exposure of possible

future purchase or sale

Recognition

Exchange gains or losses on the hedge counted

in other comprehensive income until the

underlying transaction is complete.

Expected Effect of Hedge and Related

Foreign Currency Item

No immediate income effect.

### Summary of Forward Contracts(Hedge of a Net Investment in a Foreign Entity)

Purpose

To offset exposure to an existing net

investment in a foreign entity

Recognition

Exchange gains and losses are recognized as other

comprehensive income and will offset translation

adjustments recorded on the net investment.

Expected Effect of Hedge and Related

Foreign Currency Item

Income effect equals the change in the future value

of the hedge versus the value of the net investment.

1

Derivative instruments represent

rights or obligations.

2

Fair value is the most relevant measurement.

### The Four Fundamental Decisions

3

Only items that are assets or

liabilities should be reported.

4

Special accounting should be provided

only for qualifying items.

### Learning Objective 5

Apply foreign-currency-

denominated derivative

accounting.

### Speculation

Exchange gains or losses on derivative

instruments that speculate in foreign

currency price movements are included

in income in the period in which the

forward exchange rates change.

### Speculation

On November 2, 2007, U.S. International

enters into a 90-day forward contract

(future) to purchase 10,000 euros (€).

The current quotation for 90-day futures is €5,400.

The spot rate for euros on November 2 is \$0.5440.

December 31, 2007January 30, 2008

30-day futures\$0.5450\$0.5480

Spot rate\$0.5500\$0.5530

### Speculation

What are the journal entries of U.S. International

to account for the speculation?

### Speculation

November 2, 2007

Contract Receivable (fc)5,400

Contract Payable5,400

To record contract for 10,000 euros × \$0.5400

exchange rate for 90-day futures

### Speculation

December 31, 2007

Contract Receivable (fc)50

Exchange Gain50

To adjust receivable from exchange broker

and recognize exchange gain

10,000 euros × (\$0.5450 forward exchange rate

for 30-day futures – \$0.5400 per books)