Advanced Accounting: Accounting For Foreign Currency Transactions

Advanced Accounting

Accounting for Foreign

Currency Transactions

13 - 0

Pretest no. 4 1. Which of the following combination correctly describes the relationship between foreign currency transactions, exchange rate changes and foreign exchanges gains and losses? Type of transactions

Foreign Currency

Forex

a. Export Sale

Appreciates

Loss

b. Import purchase

Appreciates

Gain

c. Import purchase

Depreciates

Gain

d. Export Sale

Depreciates

Gain

13 - 1

Pretest no. 4 2. When transactions is to be settles by the receipt or payment of a fixed amount of a specified currency, the receivables or payables is said to be: a. Converted in that currency b. Denominated in that currency c. Measured in that currency d. Translated in that currency

13 - 2

Pretest no. 4 Problem 19-1

Problem 19-2

13 - 3

Objectives: To be familiar with the standards of financial accounting and recording of foreign currency transactions To be familiar with the financial statements of foreign entity into presentation currency(Philippine Peso)

13 - 4

Foreign Currency Transaction These are transactions denominated in foreign currency, the settlement of which is to be made in foreign currency. Involves purchases or sales of goods

13 - 5

What is an Exchange Rate? This is the rate in which the currencies of two countries are exchange at a particular time. It may be quoted directly or indirectly.

13 - 6

Measured vs Denominated Measured

Denominated

Measured for financial reporting purposes in another currency.

Assets and Liabilities denominated in one currency if their amount is fixed in terms of that currency.

Regardless of the currency in which a transaction in which is denominated, the party to the transaction measures and records the transaction in currency (local currency) in which is locate

When transactions is to be settled by the receipt or payment of a specified currency, the Receivable or payable should be denominated in that currency

But measured and recorded by the Philippine Pesos.

The transaction is denominated in US dollar

However, The US exporter’s transactions is both denominated and measured in US dollar.

13 - 7

Exchange Rates Direct exchange rate  how

many units of the domestic currency can be converted into one unit of foreign currency

Philippine Pesos equivalent Value 1 FC

e.g., 42:

42 Pesos

1 Dollar

13 - 8

Exchange Rates Indirect exchange rate  how

many units of the foreign currency can be converted into one unit of domestic

currency

1 FC Philippine Pesos Equivalent Value  e.g.,

$1

.0238095 Philippine Peso 13 - 9

Exchange Rates Spot rate rate for immediate delivery of currencies exchanged

 exchange

Forward or future rate rate for future delivery of currencies exchanged

 exchange

13 - 10

Importing or Exporting Goods or Services

Transaction date

Record transaction as: units of foreign currency x current exchange rate on this Date (spot rate)

Balance sheet date

Settlement date

Record accounts denominated in foreign currency as: units of foreign currency x Closing exchange rate

Settle accounts denominated in foreign currency as: units of foreign currency x current exchange rate

Adjust payable or receivable Record gains or losses

Adjust payable or receivable Record gains or losses 13 - 11

Importing or Exporting Goods or Services Transaction date

Treatment of foreign currency transaction gain/loss

Balance sheet date Foreign currency transaction gain/loss = units of foreign currency x change in exchange rate

Net income

Settlement date

Foreign currency transaction gain/loss = units of foreign currency x change in exchange rate

Net income 13 - 12

Importing Transactions An Example 12/1/12 (Transaction date) Purchases Accounts payable

525,000 525,000

500,000 euros x $1.05/euro

12/31/12 (Balance sheet date) Foreign Exchange loss Accounts payable

15,000 15,000

500,000 euros x $(1.08-1.05)/euro

13 - 13

Importing Transactions An Example 3/1/13 (Settlement date) Accounts payable Foreign Exchange gain Cash

540,000 5,000 535,000

Gain = 500,000 euros x $(1.08-1.07)/euro

13 - 14

Importing Transactions An Example Inventory delivered 12/1/2012 U.S. firm

French firm

500,000 euros to be paid on 3/1/2013 Spot rates: Transaction date: $1.05 Balance sheet date: $1.08 Settlement date: $1.07 13 - 15

Exporting Transactions An Example 12/1 (Transaction date) Accounts receivable Sales

525,000 525,000

500,000 euros x $1.05/euro

12/31 (Balance sheet date) Accounts receivable Foreign Exchange gain

15,000 15,000

500,000 euros x $(1.08-1.05)/euro

13 - 16

Exporting Transactions An Example Inventory delivered 12/1/2001 U.S. firm

French firm

500,000 euros to be received on 3/1/2002 Spot rates: Transaction date: $1.05 Balance sheet date: $1.08 Settlement date: $1.07 13 - 17

Exporting Transactions An Example 3/1 (Settlement date) Cash Foreign Exchange loss Accounts receivable

535,000 5,000 540,000

Gain = 500,000 euros x $(1.08-1.07)/euro

13 - 18

Exercise: If P 56.50 can be exchange for 1 US Dollar, the direct and indirect exchange rate are:  Direct  Indirect

13 - 19

Exercise:  Gab, Inc., a Philippine company, bought inventory items from a supplier in Singapore on November 5, 2012 for 50,000 Sing Dollar, when the spot rate was 33.60. On December 31, 2012, the spot rate was P 33.10. On January 15, 2013, Gab bought 50,000 Sing Dollar at the spot rate of 33.20 and paid the invoice.  1. Prepare journal entries  2.How much should Gab report in its Statement of Comprehensive Income for 2012 and 2013 as forex gain or loss?

13 - 20

Answer:  How much should Gab report in its Statement of Comprehensive Income for 2012 and 2013 as forex gain or loss? 2012- Php 25,000

2013-Php (5,000)

13 - 21

Exercise: 19-1 19-2

13 - 22

Derivatives  Are financial contracts

 A security whose price is dependent upon or derived from one or more underlying assets.  The derivative itself is merely a contract between two or more parties.  Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, 13 - 23

Characteristics of Derivatives Value changes in response to changes in specified interest rate, commodity price, security price, foreign exchange rate, index of prices or rates(called underlying) Requires no initial investment or minimal initial investment It is settled at a future date. 13 - 24

Common Examples of Derivatives Forward Contracts Swaps Options  As general, changes in the FV of a derivatives are recognized in P/L.

 However, if it is used to offset risk and special hedge accounting conditions are met, some or all changes in FV are recognized as a separate component of equity. 13 - 25

HEDGING It is a risk management technique involves using one or more derivatives or other hedging instruments to offset changes in FV or cash flows of hedged items. (PAS 39) Two components are 1. Hedged item and 2. Hedging Instrument.

13 - 26

1. Hedged Item It is an asset, liability, firm commitment, highly probable forecast transaction, or net investment in a foreign operation. Designated hedged Item should be exposed the entity to RISK of Changes in FV or future cash inflows.

13 - 27

2. Hedging Instrument It is a designated derivative or a designated non-derivative financial liability whose fair value or cash flows are expected to offset changes in FV or cash flows of designated hedged item. Hedging instruments are foreign exchange forward contracts, interest rate swaps and commodity futures contracts. 13 - 28

Three Types of Hedging relationships Fair Value Hedge – a hedge of exposure to changes in FV of a recognized asset or liability or an unrecognized firm commitment that is attributable to a particular risk and it could affect profit and loss.(Fully effective and not 100 percent effective)

13 - 29

Three Types of Hedging relationships  Cash Flow Hedge– a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognized asset or liability or a high probable forecast transactions and could affect profit or loss.  Changes in FV of hedging instrument attributable to the hedged risk are deferred (rather being recodnized immediately in P/L). The accounting if the Hedged Item is NOT adjusted. 13 - 30

Three Types of Hedging relationships  Hedged of a net investment in foreign operation – This is a hedged of the exposure of foreign exchange gains or losses on an entity’s net investment in a foreign operation.

 Accounted for like as cash flow hedge.

13 - 31

Hedge Accounting Recognizes the offsetting effects on P/L of changes in FV of the hedging instrument and hedged item very accounting period.

13 - 32

Qualification for hedge accounting  There is formal designation and documentation of hedging relationship…  The hedge is expected to be highly effective in achieving offsetting changed in FV or cash flows  Effectiveness of the hedge can be measured reliably  Hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the financial reporting

 Cash flow hedge, a hedge forecast must be highly probable and must present an exposure to variations in cash flows 13 - 33

Forward Exchange Contracts Definition  An

agreement to exchange currencies of two different countries at a specified rate (the forward rate) on a stipulated future date

13 - 34

Economic Hedge of Foreign Investment Conditions  the

forward contract is designated as, and is effective as, a hedge of the net investment; and

 the

foreign currency commitment is firm

13 - 35

Purposes of Forward Contracts Fair Value Hedge  Recognized

foreign currency denominated asset and liability

 An

unrecognized foreign currency firm commitment

Cash Flow Hedge  Forecasted

foreign currency transaction

 Unrecognized

commitment

foreign currency firm 13 - 36

Fair Value of an Exposed Net Asset or Net Liability Exposed Net Asset Position – Excess of assets denominated over the liabilities denominated in the same foreign currency and translated at current rate. Exposed net Liability Position – excess of liabilities denominated in a foreign currency over assets denominated in the foreign currency and translated at the current rate. 13 - 37

Illustration of Hedging an Exposed Net Liability Kindly refer to the Book page 352

13 - 38

Hedge: Foreign Currency Exposed Liability Inventory delivered Dec/1/2010

Phil firm

Japan firm 500,000 yen to be paid on 1/30/2011

Forward contract Pesos to be received on 1/30/2011 Phil firm

PNB Bank

500,000 yen to be received on 1/30/2011 13 - 39

Hedging an Exposed Net Asset Accounting procedures are basically comparable on our prior illustration except the purpose is to hedge an asset denominated in foreign currency.

13 - 40

Hedge: Foreign Currency Exposed Asset Inventory delivered Dec/1/2010

Phil firm

Japan firm 500,000 yen to be paid on 1/30/2011

Forward contract Pesos to be received on 1/30/2011 Phil firm

PNB Bank

500,000 yen to be received on 1/30/2011 13 - 41

Summary for Foreign Currency Exposed Liability and Asset Result of Hedging- Usually, the rates for future contracts result in hedges that increase income. Forward contract is recorded at forward rate. Underlying Liability is recorder at spot rate.

13 - 42

Summary for Foreign Currency Exposed Liability and Asset  Over the life of the contract, the initial difference between spot and forward rat is the cost of hedging the exchange risk- which is also called as premium or discount.

 The net cost reported in the income statement is the change in the relative value of the spot and forward rates, since the gains and losses on both hedge and the underlying are recorded in current earnings

13 - 43

Summary for Foreign Currency Exposed Liability and Asset  Therefore, Changes in the Value of hedging instrument and hedged item both being reported in the income statement.

13 - 44

Exercise:  Gabriel Corp. purchases merchandise from Lowcost Company of France for 1,000,000 Franc. The merchandise is received on December 1, 2010 with payment due in 60 days on January 30, 2011. Also on December 1, 2010, Gabriel enters into a 60-day forward contract with the bank to purchase the necessary 1,000,000 Franc for delivery in Jan. 30, 2011 to hedge Lowcost transaction. Exchange rates are as follows:

12/1/2010

12/31/2010

1/30/2011

Spot rates

6.01

6.16

6.01

30-day futures

6.05

6.07

6.07

60-day futures

6.06

6.08

6.08

Required: Prepare the necessary journal entries of Gabriel Corp., for 2010 and 2011. 13 - 45

Exercise:  Gabriel Corp. purchases merchandise from Lowcost Company of France for 1,000,000 Franc. The merchandise is received on December 1, 2010 with payment due in 60 days on January 30, 2011. Also on December 1, 2010, Gabriel enters into a 60-day forward contract with the bank to purchase the necessary 1,000,000 Franc for delivery in Jan. 30, 2011 to hedge Lowcost transaction. Exchange rates are as follows:

12/1/2010

12/31/2010

1/30/2011

Spot rates

6.01

6.16

6.01

Forward Rates

6.06

6.08

6.01

Remaining term of The contract Required: Prepare the necessary journal entries of Gabriel Corp., for 2010 and 2011. 13 - 46

Foreign Currency Commitment  It is a contract or agreement to purchase or sell of goods to a foreign entity in the future. To be settled in the foreign currency.  Settlement will not be made until after the delivery of goods, therefore it is exposed to changed in currency exchange rates before the transaction date.

13 - 47

Hedge of an Identifiable Foreign Currency Commitment  Conditions: 

the forward contract is designated as, and is effective as, a hedge of the

foreign currency commitment 

the foreign currency

commitment is firm

13 - 48

Illustration: Refer to page 356 of your book.

13 - 49

Cash Flow Hedge of a Foreign Currency Forecasted Transaction Anticipated but not guaranteed. Treatment – Deferred and recognized as OCI.

This is accumulated and reported as a separate line in the stockholder’s equity section.

13 - 50

Illustration: Refer to page 358 of your book.

13 - 51

Question. Differences of Forecasted Transaction, Identifiable Firm Commitment and Hedge of Denominated Asset or Liability  Basic

Purpose

 Recognition

13 - 52

Forward Contracts for Speculation

The forward contract  is

carried at forward rate at balance sheet date over remaining life of the contract

Transaction gain/loss  reported

in net income of current year 13 - 53

Option A financial derivative contract that provides the holder the right to buy or sell an underlying in the future, for a price set today. A price of the option is separate from the price of the underlying.

13 - 54

Option Premium- the option price. Strike price- the price at which the holder has the option to buy or sell the item. Option to buy “in the money” – market price > strike price

Option to buy “out of the money” – market price < strike price 13 - 55

Option Time Value of the Option – difference between option market price and intrinsic value Intrinsic Value of the Option – difference between the current market price and the option price of the hedge item.

13 - 56

Option Two types of Options  Call

Option – Calls – option granting the right to buy the underlying

 Put

Option – Put – option granting the right to sell the underlying

13 - 57

Illustration:  ABC

Corp. shares are currently traded at P 65. An option to buy 1,000 shares at P 68 per share three month from now is worth P 2 per share. If the option is bought, the option buyer’s position are: Traded at P 75 after 3 months Traded at 66 after 3 months Traded at 68 after 3 months

13 - 58

Swaps

An agreement whereby two counter parties contractually agree to swap or exchange one stream of cash flows for another, over period of time. 13 - 59

Swaps

It can be interest rate swaps and cross currency swaps.

13 - 60

Swaps

Interest rate swap  Value

changes in response to changes in underlying variable

 Little

or no investment

 Settlement

will occur at future dates

13 - 61

Swaps

Interest rate swap  Value

changes in response to changes in underlying variable

 Little

or no investment

 Settlement

will occur at future dates

13 - 62

Advanced Accounting by Debra Jeter and Paul Chaney Pedro Guerrero and Jose Peralta Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

13 - 63