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

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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

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Learning Objectives1. 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.

7-4Learning Objective 1

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.

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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

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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

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Spot rates and Forward rates Spot rate – today’s price for purchasing or

selling a foreign currency.

Forward rate – today’s 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

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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

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Option contracts Option premium – cost of purchasing the

option, which is a function of the option’s 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

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Terminology Export sale – a company sells to a foreign customer

and later receives payment in the customer’s currency.

Import purchase – a company purchases from a foreign supplier and later pays in the supplier’s 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

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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

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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

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Accounting – sale transactionOne 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

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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

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Transaction types, exposure type and gain or loss – export salesExport sale asset exposure--if foreign currency appreciates foreign exchange gain.

Export sale asset exposure--if foreign currency depreciates foreign exchange loss.

Learning Objective 3

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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

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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

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Export sale – example 1

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

Accounts Receivable 100,000Sales 100,000

Learning Objective 3

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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 90,000Foreign Exchange Loss 10,000

Accounts Receivable 100,000

Learning Objective 3

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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

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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 110,000Sales 110,000

Foreign Exchange Loss 5,000Accounts Receivable 5,000

Learning Objective 3

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Export sale – example 2

Joe, Inc. records the receivable collection and an additional foreign exchange loss on March 2, 2011:

Cash 90,000Foreign Exchange Loss 15,000

Accounts Receivable 105,000

Learning Objective 3

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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

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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

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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

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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

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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

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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

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Hedge accounting examples1. 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

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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

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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

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Example 1, FC asset/forward/cash flow hedge12/01/10Accounts receivable 110,000

Sales 110,00012/31/10Foreign exchange loss 10,000

Accounts receivable 10,000Accumulated Other Comprehensive Income 10,000

Gain on forward contract 10,000

Learning Objective 6

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Example 1, FC asset/forward/cash flow hedge12/31/10Forward contract 8,911

Accumulated Other Comprehensive Income 8,911Discount expense*

1,667Accumulated Other Comprehensive Income

1,667(*discount expense is amortized using the straight-line method)

Learning Objective 6

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Example 1, FC asset/forward/cash flow hedge3/02/11Foreign exchange loss

5,000Accounts receivable

5,000Accumulated Other Comprehensive Income 5,000

Gain on forward contract 5,000Forward contract

1,089Accumulated Other Comprehensive Income

1,089

Learning Objective 6

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Example 1, FC asset/forward/cash flow hedge3/02/11Discount expense 3,333 Accumulated Other Comprehensive Income 3,333Foreign currency 95,000 Accounts receivable 95,000Cash 105,000 Foreign currency 95,000 Forward contract 10,000

Learning Objective 6

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Example 2, FC asset/forward/fair value hedge12/01/10Accounts receivable 110,000

Sales 110,00012/31/10Foreign exchange loss 10,000

Accounts receivable 10,000 Forward contract 8,911

Gain on forward contract 8,911

Learning Objective 6

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Example 2, FC asset/forward/fair value hedge3/02/11Foreign exchange loss 5,000

Accounts receivable 5,000

Forward contract 1,089 Gain on forward contract

1,089

Learning Objective 6

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Example 2, FC asset/forward/fair value hedge3/02/11Foreign currency 95,000

Accounts receivable 95,000Cash 105,000

Foreign currency 95,000

Forward contract 10,000

Learning Objective 6