Chapter 9 Lecture Slides

8/20/2019 Chapter 9 Lecture Slides

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Chapter Nine

Foreign

CurrencyTransactions and

Hedging Foreign

Exchange Risk

Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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Learning Objective 9-1

Understand concepts relatedto foreign currency, exchange

rates, and foreign exchange risk.

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Exchange Rate Mechanisms

Between 1945 and 1973, countries fixed the

par value of their currency in terms of the

U.S. dollar.The U.S. dollar was based on the Gold

Standard until 1971.

Since 1973, exchange rates have beenallowed to float in value.

Several currency arrangements exist.

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Different Currency Mechanisms

Independent Float - the currency is allowed to

fluctuate according to market forces

Pegged to another currency - the currency’s value is

fixed in terms of a particular foreign currency, and thecentral bank will intervene to maintain the fixed value

European Monetary System - a common currency (the

euro) is used in multiple countries. Its value floats

against other world currencies.

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Foreign Exchange Rates

An Exchange Rate is the cost of one currency in terms ofanother.

Rates published daily in the Wall Street Journal are as of

4:00pm Eastern time on the day prior to publication. Rates

are also available on line at: www.oanda.com andhttp://www.x-rates.com

The published rates are wholesale rates that banks use with

each other – retail rates to consumers are higher.

The difference between the rates at which a bank is willing

to buy and sell currency is known as the “spread.”

Rates change constantly!

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http://www.oanda.com/http://www.x-rates.com/http://www.x-rates.com/http://www.oanda.com/


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Foreign Exchange Rates

Spot Rate

The exchange rate that is available today.

Forward Rate

The exchange rate that can be locked in today for

an expected future exchange transaction.

The actual spot rate at the future date may differ

from today’s forward rate.A forward contract requires the purchase (or sale)

of currency units at a future date at the contracted

exchange rate.

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Foreign Exchange –

Option Contracts

An options contract gives the holder the option of

buying (or selling) currency units at a future date at

the contracted “strike ” price.

A “put” option allows for the sale of foreigncurrency by the option holder.

A “call” option allows for the purchase of foreign

currency by the option holder.

An option gives the holder “the right but not the

obligation” to trade the foreign currency in the

future.

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Option values

Value is derived from :

A function of the difference between current spot

rate and strike price

The difference between foreign and domestic

interest rates

The length of time to option expiration

The potential volatility of changes in the spot rateAn option premium is a function of Intrinsic Value

and Time Value

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Account for foreign currencytransactions using the two

transaction perspective, accrual

approach.

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Foreign Currency Transactions

A U.S. company buys or sells goods or

services to a party in another country. This

is often called foreign trade.The transaction is often denominated in the

currency of the foreign party.

How do we account for the changes in thevalue of the foreign currency?

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Transaction Exposure

Export sale:

Exposure exists when the exporter allows

buyer to pay in a foreign currency sometimeafter the sale has been made. The exporter is

exposed to the risk that the foreign currency

might depreciate between the date of sale and

the date payment is received, decreasing the

U.S. dollars collected.

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Transaction Exposure

Import purchase:

Exposure exists when the importer is required

to pay in foreign currency sometime after thepurchase has been made. The importer is

exposed to the risk that the foreign currency

might appreciate between the date of purchase

and the date of payment, increasing the U.S.

dollars that have to be paid for the imported

goods.

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There are two methods of accounting for changes in

the value of a foreign currency transaction, the one-

transaction perspective and the two-transaction

perspective.

The one-transaction perspective assumes:

1. the export sale is not complete until the foreign

currency receivable has been collected .

2. Changes in the U.S. dollar value of the foreign

currency is accounted for as an adjustment to

Accounts Receivable and Sales.

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GAAP requires the two-transaction approach and

treats the sale and collection of cash as two separate

transactions.

1. Account for the original sale in US Dollars atdate of sale. No subsequent adjustments are

required.

2. Changes in the U.S. dollar value of the foreigncurrency are accounted for as gains/losses from

exchange rate fluctuations reported separately

from sales in the income statement.

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Foreign Exchange Transaction -

Example

Summary of the relationship between fluctuations inexchange rates and foreign exchange gains and losses:

Foreign currency receivables from an export salecreates an asset exposure to foreign exchange risk.

Foreign currency payables from an import purchase

creates a l iabi l i ty exposure to foreign exchange risk.

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Accounting for Unrealized Gains and Losses

Under the two-transaction perspective, a foreign

exchange gain or loss arises at the balance sheet date

that has not yet been realized in cash.

Two approaches exist to account for unrealized

foreign exchange gains and losses:

1. Deferral approach:

Gains and losses are deferred on the balance sheetuntil cash is paid or received and a realized foreign

exchange gain or loss is included in income when paid.

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2. Accrual approach (required by U.S. GAAP):

Unrealized foreign exchange gains and losses are

reported in net income in the period in which the

exchange rate changes.

Change in the exchange rate from the balance sheet

date to date of payment results in a second foreign

exchange gain or loss that is reported in the secondaccounting period.

Accounting for Unrealized Gains and Losses

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Understand how foreign currency

forward contracts and foreign

currency options can be used to

hedge foreign exchange risk.

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Hedging Foreign Exchange Risk

Companies will avoid uncertainty associated

with the effect of unfavorable changes in the

value of foreign currencies using foreign

currency derivatives.

The two most common derivatives used to

hedge foreign exchange risk are foreign

currency forward contracts and foreigncurrency options .

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Hedging Foreign Exchange Risk

Two foreign currency derivatives often used :

Foreign currency forward contracts lock in

the price for which the currency will sell atcontract’s maturity.

Foreign currency options establish a price

for which the currency can be sold, but is not

required to be sold at maturity.

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Accounting for Derivatives

ASC Topic 815 provides guidance for hedges of four

types of foreign exchange risk.

1. Recognized foreign currency denominated assets &

liabilities (e.g., euro receivable/payable).

3. Forecasted foreign currency denominatedtransactions (e.g., occurring regularly & reliably

forecasted).

2. Unrecognized foreign currency firm commitments

(e.g., noncancellable SO/PO).

4. Net investments in foreign operations.

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The fair value of the derivative is recorded at the

same time as the transaction to be hedged, based on:

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. A discount rate (the company’s incremental

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

on the income statement as a part of net income or

on the balance sheet in accumulated other

comprehensive income.

Recognition treatment depends partly on whether the

company uses derivatives for hedging purposes or for

speculation.

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U.S. GAAP allows hedge accounting for foreign

currency derivatives only if three conditions are

satisfied:

1. The derivative is used to hedge either a cashflow exposure or fair-value exposure to

foreign exchange risk.

2. The derivative is highly effective in offsetting

changes in the cash flows or fair valuerelated to the hedged item.

3. The derivative is properly documented as a

hedge.

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Account for forward contracts

and options used as hedges of

foreign currency denominated

assets and liabilities.

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Accounting for Hedges

Two ways to account for hedges of foreign currencydenominated assets and liabilities:

1. Cash Flow Hedge

The hedging instrument must completely offset the

variability in the cash flows associated with the foreign

currency receivable or payable.

Gains/losses are recorded in Accumulated Other

Comprehensive Income.

2. Fair Value Hedge.

Any other hedging instrument.

Gains/losses are recognized immediately in net income.

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Cash Flow HedgeAt the balance sheet date:

1. The hedged asset or liability is adjusted to fair value

based on changes in the spot exchange rate, and a

foreign exchange gain or loss is recognized in net

income.

2. The derivative hedging instrument is adjusted to fair

value (an asset or liability on the balance sheet) withthe counterpart recognized as a change in

Accumulated Other Comprehensive Income

(AOCI).

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Cash Flow Hedge continued . . .At the balance sheet date:

3. An amount equal to the foreign exchange gain or loss on

the hedged asset or liability is then transferred from AOCI

to net income to offset any gain or loss on the hedged asset or

liability.

4. An additional amount is removed from AOCI and

recognized in net income to reflect (a) the current period’s

amortization of the original discount or premium on the

forward contract (if it is the hedging instrument) or (b) the

change in the time value of the option (if it is the hedging

instrument).

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Cash Flow Hedge - Example

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Fair Value Hedge

At the balance sheet date:

1. Adjust the hedged asset or liability to fair valuebased on changes in the spot exchange rate, and

recognize a foreign exchange gain or loss in net

income.

2. Adjust the derivative hedging instrument to fairvalue (resulting in an asset or liability reported on

the balance sheet) and recognize the counterpart as a

gain or loss in net income.

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Fair Value Hedge - Example



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Fair Value Hedge - Example



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Cash Flow vs. Fair Value Hedge


The total impact on income is the same regardless of

whether the forward contract is designated as a fair

value hedge or as a cash flow hedge. In our example,

Amerco recognized an expense (or loss) of $15,000 inboth cases, and the company knew what the total

expense was going to be as soon as the contract was

signed.


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Cash Flow vs. Fair Value Hedge


•

A benefit to designating a forward contract as a cash flow hedge is thatthe company knows the forward contract's effect on net income each

year as soon as the contract is signed. The net impact on income is the

periodic amortization of the forward contract discount or premium.

• In our example, Amerco knew on December 1, 2015, that it would

recognize a discount expense of $5,000 in 2015 and $10,000 in 2016.

• The impact on each year's income is not as systematic when the forward

contract is designated as a fair value hedge — loss of $783 in 2015 and

$14,217 in 2016. Moreover, the company does not know what the net

impact on 2015 income will be until December 31, 2015, when the euro

account receivable and the forward contract are revalued.

• Because of the potential for greater volatility in periodic net income that

results from a fair value hedge, companies may prefer to designate

forward contracts used to hedge a foreign currency denominated asset or

liability as cash flow hedges.


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Foreign Currency Option as a Hedge

An option is a contract that allows you to exercise a

predetermined exchange rate if it is to your

advantage.As with forward contracts, options can be designated

as cash flow hedges or fair value hedges.

Option prices are determined using the Black-

Scholes Option Pricing Model covered in most

finance texts.

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and options used as hedges

of foreign currency firm

commitments.

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Foreign Currency

Firm Commitment Hedge

A firm commitment is an executory contract not

normally recognized in financial statements; the

company has not delivered goods nor has the

customer paid for them.

When a firm commitment is hedged using a

derivative financial instrument, hedge accounting

requires explicit recognition on the balance sheet atfair value of both the derivative financial instrument

and the firm commitment.

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Foreign Currency


Changes in the spot exchange rate are used to

determine the fair value of the firm

commitment when a foreign currency optionis the hedging instrument.

U.S. GAAP allows hedges of firm

commitments to be designated either as cash

flow or fair value hedges.

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Foreign Currency


Options are carried at fair value on the balance sheet of

both the derivative financial instrument (forward

contract or option) and the firm commitment.

The change in value of the firm commitment gain/loss

offsets the gain or loss on the hedging instrument.

Gain/loss is recognized currently in net income, as isthe gain/loss on the firm commitment attributable to

the hedged risk.

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Option Used as FV Hedge - Example


Assume now that on December 1, 2015, Amerco receives andaccepts an order from a German customer to deliver goods on

March 1, 2016, at a price of 1 million euros. Assume further that

under the terms of the sales agreement, Amerco will ship the

goods to the German customer on March 1, 2016, and will

receive immediate payment on delivery. Assume that to hedge its

exposure to a decline in the U.S. dollar value of the euro, Amerco

purchases a put option to sell 1 million euros on March 1, 2016,

at a strike price of $1.32. The premium for such an option on

December 1, 2015, is $0.009 per euro. With this option, Amerco isguaranteed a minimum cash flow from the export sale of

$1,311,000 ($1,320,000 from option exercise less $9,000 cost of

the option).


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The net increase in net income over the two accounting

periods is $1,311,000 ($6,803 in 2015 plus $1,304,197 in

2016), which exactly equals the net cash flow realized

on the export sale ($1,320,000 from exercising theoption less $9,000 to purchase the option). The net gain

on the option of $11,000 (loss of $3,000 in 2015 plus

gain of $14,000 in 2016) reflects the net benefit from

having entered into the hedge. Without the option,Amerco would have sold the 1 million euros received on

March 1, 2016, at the spot rate of $1.30 for $1,300,000.


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and options used as hedges

of forecasted foreign currency

transactions.

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Hedge of a Forecasted Foreign Currency


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Denominated Transaction

Cash flow hedge accounting may be used for foreign

currency derivatives associated with a forecasted

foreign currency transaction.

The forecasted transaction must be probable (likelyto occur), highly effective, and the hedging

relationship must be properly documented.

There is no recognition of the forecasted transaction

or gains and losses on the forecasted transaction.

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Denominated Transaction

The company reports the hedging

instrument (forward contract or option) at

fair value, but changes in the fair value of

are not reported in net income.

Gains and losses on the hedging instrument

are recorded in Other Comprehensive

Income until the date of the forecastedtransaction, then transferred to net income

on the projected transaction date.

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Foreign Currency Borrowings

Companies often must account for foreign

currency borrowings, another type of foreign

currency transaction.

Companies borrow foreign currency from foreignlenders to finance foreign operations or to take

advantage of more favorable interest rates.

The facts that the principal and interest are

denominated in foreign currency and create an

exposure to foreign exchange risk complicate

accounting for a foreign currency borrowing.

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Foreign Currency Borrowings -


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Foreign Currency Borrowings -

Example

McGraw-Hi ll /I rwi n Copyright © 2015 by The McGraw-Hil l Companies, I nc. Al l ri ghts reserved. 9-54

To demonstrate the accounting for foreign currencydebt, assume that on July 1, 2015, Multicorp

International borrowed 1 billion Japanese yen (¥) on a

1-year note at a per annum interest rate of 5 percent.

Interest is payable and the note comes due on July 1,2016. The following exchange rates apply:.

Journal Entries


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Foreign Currency Borrowings

Companies also lend foreign currency to related

parties, creating the opposite situation from a

foreign currency borrowing.

The company must keep track of a note receivableand interest receivable, both of which are

denominated in foreign currency.

Fluctuations in the U.S. dollar value of the

principal and interest generally give rise to foreign

exchange gains and losses that would be included

in income.

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IFRS F i C T ti d


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IFRS — Foreign Currency Transactions and

Hedges

There are no substantive differences between U.S.

GAAP and IFRS in accounting for foreign

currency transactions.

Similar to U.S. GAAP, I AS 21, “The Effects ofChanges in Foreign Exchange Rates,” requires the

use of a two-transaction perspective in accounting

for foreign currency transactions with unrealized

foreign exchange gains and losses accrued in netincome in the period of exchange rate change.

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IFRS F i C T ti d


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Hedges

I AS 39, “Financial Instruments: Recognition and

Measurement,” governs accounting for hedging instruments

including those used to hedge foreign exchange risk.

One difference between the two sets of standards relates tothe type of financial instrument that can be designated as a

foreign currency cash flow hedge.

U.S. GAAP allows only derivative financial instruments to

be used as a cash flow hedge.

IFRS allows nonderivative financial instruments (e.g.,

foreign currency loans).

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IFRS F i C T ti d


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Hedges

In 2010, the IASB proposed a new hedge accounting

model that would result in significant differences

between IFRS and U.S. GAAP.

In 2012, the IASB issued a draft of a forthcomingstatement that would move hedge accounting from IAS

39 to I FRS 9 , “Financial Instruments,” to implement

the new model which would go into effect in 2015.

IFRS 9 is intended to more closely align accountingwith a company’s risk management activities.

Documents

Chapter 9 Lecture Slides