Foreign Currency Transactions

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Foreign Currency Transactions

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1. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 1 Chapter 11 Foreign Currency Transactions

2. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 2 Learning Objectives To identify how to record a foreign currency transaction To describe when to use the current rate and when to use the historical rate when translating assets and liabilities denominated in a foreign currency. To describe the concept of hedging, and prepare a list of items that could be used as a hedge

3. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 3 Learning Objectives To prepare journal entries and subsequent financial statement presentation for forward exchange contracts that hedge existing monetary positions, firm commitments, or are entered into for speculative purposes To apply the concept of hedge accounting to long-term debt acting as a hedge to a future revenue stream To differentiate between the accounting for a fair value hedge and a cash flow hedge

4. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 4 Introduction Many Canadian companies conduct business in foreign countries as well as in Canada No specific accounting issues arise when the parties involved in an import or export transaction agree that the settlement will be in Canadian dollars Since it is a Canadian dollar denominated transaction, the company will record the foreign purchase or sale in exactly the same manner as any domestic purchase or sale

5. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 5 Introduction When the agreement calls for the transaction to be settled in a foreign currency, this means one of the two things: The Canadian company will have to acquire foreign currency in order to discharge the obligations resulting from it imports The Canadian company will receive foreign currency as a result of its exports, and will have to sell the foreign currency in order to receive Canadian dollars

6. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 6 Introduction Transactions such as these are called foreign currency denominated transactions Accounting issues arise when the value of the Canadian dollar has changed relative to the value of the foreign currency at the time financial statements need to be prepared or non the date of the subsequent settlement of the receivable or payable

7. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 7 Currency Exchange Rate Both the recording foreign currency denominated transactions and the translation of foreign currency financial statements require the use of currency exchange rates An exchange rate is simply the price of one currency in terms of another currency

8. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 8 Currency Exchange Rate The European Union – 11 of the 15 countries that make up the original membership of the European Union agreed to adopt a common currency called the euro January 1, 2002 Three of the founding members (Denmark, Britain, and Sweden) chose not to adopt the common currency and are using their own currencies

9. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 9 Currency Exchange Rate There are many reasons why a country’s currency price changes of which the major one are the following Inflation rates Interest rates Trade surplus and deficits Exchange rate showing the value of Canadian dollar in terms of other foreign currency are quoted daily in many Canadian newspapers

10. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 10 Currency Exchange Rate The amounts that usually appear are called direct quotations, which means that the amount represents the cost in Canadian dollar to purchase one unit of foreign currency For example a quotation of 1 pound = CDN$2.2972 means that it cost 2.2972 Canadian dollars An indirect quotation will state the cost in a foreign currency to purchase 1 Canadian dollar Examples of foreign exchange quotation on a particular day for 4 countries’ currencies are shown in Exhibit 11.1

11. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 11 Exhibit 11.1

12. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 12 Accounting for Foreign Currency Transactions For accounting purposes there are basically 3 rates used in translating foreign currency into the reporting currency: Current rate is the spot rate on the reporting date of the financial statements Historical rate is the spot rate on the date of transaction Forward rate is the agreed rate for exchange of currencies at a future date

13. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 13 Accounting for Foreign Currency Transactions Until Section 1650 of the Handbook was issued, accountants had 2 alternatives for recording currency denominated import and export transactions One transaction approach Two transaction approach The “Two transaction approach” was chosen by the Accounting Standard Committee as the preferred approach for use in Canada

14. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 14 Foreign Currency Transactions Accounting for a foreign currency transaction is illustrated using the following rates: Date Rate ( US$ / C$ ) Jan 31 1.53 Feb 28 1.55 Mar 30 1.56

15. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 15 Foreign Currency Transactions A Canadian firm purchases merchandise with an invoice price of $1,000 US on January 31, with payment due March 30, and a fiscal year end of February 28. What entries are necessary? At purchase, this entry would be made: Purchases 1,530 Accounts Payable 1,530

16. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 16 Foreign Currency Transactions By the end of the fiscal year, the firm has incurred a $20 loss, as the firm is now liable for C$1,550, rather than the C$1,530 at which the transaction was initially recorded

17. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 17 Foreign Currency Transactions At fiscal year end, the recognition of the loss is recorded in the following manner Foreign Currency Loss 20 Accounts Payable 20 At this time, the foreign currency liability is now reported at its Canadian dollar equivalent, and the loss is recognized in the period in which it has occurred

18. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 18 Foreign Currency Transactions At final payment, this entry is made: Accounts payable 1,550 Foreign Currency Loss 10 Cash 1,560 This further loss is also recognized in the period in which it occurs In all cases, the foreign currency loss is a period cost, recognized in the period in which the change in exchange rates took place

19. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 19 Foreign Currency Transactions Canadian companies have no particular advantage when dealing internationally, and must frequently accept that international transactions are to be denominated in a foreign currency rather than Canadian These foreign currency transactions must be recorded in the reporting currency of the company The assets and liabilities denominated in the foreign currency must be repaid in that currency, so the Canadian company will bear the risks and costs associated with the inevitable currency fluctuations

20. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 20 Foreign Currency Transactions Why do currency fluctuations occur? Currency exchange rates are the price of a currency, denominated in another currency Like all prices, currency exchange rates are a function of supply and demand As with the determination of the price of a share in the stock market, the amounts that traders are willing to bid or ask for a currency are indicative of not only current supply and demand, but expectations as to future events As economic conditions evolve, and expectations change, inevitably, fluctuations will occur

21. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 21 Foreign Currency Transactions Currency fluctuations are relevant to companies and to users of their financial statements At each statement date, monetary amounts are restated to the current exchange rate foreign currency gains and losses on current items must be recorded and reported in the period in which they occur although once subject to deferral and amortization, gains and losses arising on non-current items are now subject to immediate recognition in the period

22. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 22 Foreign Currency Transactions How does accounting for foreign currency transactions work? When the transaction is initially entered, the amounts are recorded in the reporting currency of the companies entering into the transaction At each statement date, the foreign currency amount is restated to the reporting currency equivalent, and a gain or loss is recognized At the time of settlement of the asset or liability, the amount is again restated to the reporting currency equivalent, and a further gain or loss is recognized

23. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 23 Hedge Accounting Foreign currency losses can be significant, and prudent management suggests that they should be guarded against if possible This type of protection is generally referred to as “hedging” which can be defined as a means of transferring risk arising from foreign exchange (or interest rate, or price) fluctuations from those who wish to avoid it to those who are willing to assume it

24. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 24 Hedge Accounting If a hedge is truly effective, that is, all risks are removed, there should be no overall exchange gain or loss hitting the income statement other than the cost of establishing the hedge It is also possible to have a situation in which only a portion of a position is hedged and the balance is at risk or in which a portion of the hedging instrument ceases to act as a hedge and becomes exposed to foreign currency risk

25. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 25 Hedge Accounting Section 3865 suggests that the following hedging items could be used to hedge against the risk of exchange fluctuations: A derivative financial instrument. For example, a forward exchange contract, a foreign currency option contract, or a foreign currency futures contract could be used to hedge a monetary asset or liability commitment, or an anticipated future transactions A monetary item. For example, an existing monetary asset or liability could be used to hedge a commitment or an anticipated future transaction

26. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 26 Hedge Accounting The solution is Hedge accounting is defined and described in Section 3865 of the CICA Handbook Under hedge accounting, the exchange gains or losses on the hedged items will be recognized in the income statement in the same period as the exchange gains or loses on the hedging item when they would otherwise be recognized in different periods

27. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 27 Hedge Accounting To qualify for hedge accounting, the following 3 conditions must be met At the inception of the hedging relationship, the entity has identified the risks being hedged and designated that hedge accounting will be applied At the inception of the hedging relationship, the entity has format documentation of the hedging relationship, its purpose and method of assessing its effectiveness, and the method of accounting for the hedging relationship The entity has reasonable assurance that the hedge will be effective at the inception and throughout its item

28. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 28 Forward Exchange Contracts Under a forward contract, a financial institution agrees to exchange currencies at a future date at a rate set when the contract is entered A forward contract is in some respects an executory contract and so some firms make no formal entries Generally, however, the binding nature of the forward relationship leads to journal entries which take a prescribed sequence

29. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 29 Forward Exchange Contracts When an existing monetary position is hedged: Record the transaction (purchase/sale) Set up the forward contract vs. the payable or receivable to/from bank At statement dates: Revalue the original payable/receivable Revalue the forward contract Value of payable/receivable to bank not changed Amortize the premium on the forward contract At settlement, repeat the procedures of the statement date, and record all cash flows executed

30. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 30 Forward Exchange Contracts The costs of forward contracts include the direct costs of the forward premium and the costs of administration of the foreign currency denominated items by the company The principal benefit is the alleviation of risk Known future cash flows enable better planning Not all risks are eliminated by forward contracts A significant risk is the opportunity cost of favourable exchange fluctuations having been foregone - that is, the firm has lost opportunities for gains

31. Chapter 11 © 2005 McGraw-Hill Ryerson Limited 31 Speculative Forward Exchange Contracts A speculative forward contract should be valued at forward rates throughout its life with any gains or loses reflected in income as they occur A company may enter into a foreign exchange contract purely to speculate on future exchange movements e.g. a company might enter into a contract to purchase foreign currency at a 60 day forward rate in anticipation that the spot rate in 60 days’ time will be greater that the original forward rate

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