Ch6 IntAcct Sum24-Dropbbbox-updated.pptx

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1. Chapter 9 Foreign Currency Transactions and Hedging Foreign Exchange Risk

2. Foreign Exchange Markets In today’s global economy, many companies deal in currencies other than their reporting currencies. Merchandise may be imported or exported with prices stated in a foreign currency . For reporting purposes, foreign currency balances must be stated in terms of the company’s reporting currency (e.g. $US for US companies) by multiplying it by an exchange rate .

3. Exchange Rate Mechanisms Prior to 1973, currency values were generally fixed. The US $ was based on the Gold Standard. Since 1973, exchange rates have been allowed to fluctuate . Several currency arrangements exist.

4. 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 the central 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.

5. Foreign Exchange Rates Foreign exchange rates are determined in the foreign exchange market under a variety of different currency arrangements . Spot Rates : The exchange rate that is available today . Exchange rates can be expressed in terms of the number of U.S. dollars to purchase one foreign currency unit ( direct quotes – in US $ ) or the number of foreign currency units that can be obtained with one U.S. dollar ( indirect quotes – per US $ ).

6. Foreign Exchange Rates When the rate is expressed as the US $ equivalent of 1 unit of foreign currency , the rate is called a “DIRECT QUOTE”

7. Foreign Exchange Rates When the rate is expressed as the US $ equivalent of 1 unit of foreign currency, the rate is called a “DIRECT QUOTE” When the rate is expressed as the number of foreign currency units that $1 will buy , the rate is called an “ INDIRECT QUOTE ”

8. Foreign Exchange Markets Each country uses its own currency for internal economic transactions. To make transactions in another country, units of that country’s currency may need to be acquired. The cost of those currencies is called the exchange rate .

9. Foreign Exchange Markets As the relative strength of a country’s economy changes . . . . . . the exchange rate of the local currency relative to other currencies also fluctuates .

10. Foreign Exchange Rates An Exchange Rate is the cost of one currency in terms of another . Rates published daily in The Wall Street Journal are as of 4:00 p.m. eastern standard time on the day prior to publication. Rates are also available at the websites of OANDA and X-Rates. 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!!

11. Foreign Exchange Markets Accountants face two questions in restating foreign currency balances. How are changes in the exchange rate accounted for ? (Ch.9) What is the appropriate exchange rate for restating foreign currency balances ? (Ch.10)

12. Foreign Currency Transactions A U.S. company buys or sells goods or services to a party in another country. The transaction is often denominated in the currency of the foreign party . The major accounting issue : How do we account for the changes in the value of the foreign currency?

13. Foreign Currency Transactions ASC 830 Requires a two-transaction perspective. Account for the original sale in US $ Account for gains/losses from exchange rate fluctuations.

14. Foreign Currency Transactions ... but the cash flow is at a later date ... ... fluctuating exchange rates can result in exchange rate gains or losses . When a transaction occurs on one date (for example a credit sale ) . . .

15. Foreign Currency Transactions ASC 830 prescribes accounting rules for foreign currency transactions . Export sales denominated in foreign currency are reported in U.S. dollars at the spot exchange rate at the date of the transaction. Subsequent changes in the exchange rate are reflected through a restatement of the foreign currency account receivable with an offsetting foreign exchange gain or loss reported in income . This is known as a two-transaction perspective , accrual approach . The two-transaction perspective, accrual approach is also used in accounting for foreign currency payables . Receivables and payables denominated in foreign currency create an exposure to foreign exchange risk .

16. Summary of Exchange Rates and Foreign Exchange Gains and Losses Summary of the relationship between fluctuations in exchange rates and foreign exchange gains and losses : Foreign currency receivables from an export sale create an asset exposure to foreign exchange risk. Foreign currency payables from an import purchase create a liability exposure to foreign exchange risk.

17. Hedging Foreign Exchange Risk Companies will seek to reduce the risks associated with foreign currency fluctuations by foreign currency hedging activities to avoid the adverse impact of exchange rate changes. This means they will give up a portion of the potential gain s to offset the possible losses . Hedging effectively reduces the uncertainty associated with fluctuating exchange rates. A company enters into a potential transaction whose exposure is the opposite of the one that has the associated risk. Accountants must determine how to properly account for these hedging activities .

18. Hedging Foreign Exchange Risk Which of the following is the characteristic of a perfect hedge ? (AICPA 2008) a. No possibility of future gain or loss. b. No possibility of future gain only. c. No possibility of future loss only. d. The possibility of future gain and no future loss.

19. Hedging Foreign Exchange Risk Which of the following is the characteristic of a perfect hedge ? (AICPA 2008) a. No possibility of future gain or loss. b. No possibility of future gain only. c. No possibility of future loss only. d. The possibility of future gain and no future loss.

20. Hedging Foreign Exchange Risk Two foreign currency derivatives that are often used to hedge foreign currency transactions: Foreign currency forward contracts lock in the price for which the currency will sell at contract’s maturity. Foreign currency options establish a price for which the currency can be sold, but is not required to be sold at maturity.

21. Which of the following financial instruments may be considered a derivative financial instrument ? (AICPA 2019) A. Option contract. B. Municipal bond. C. Bank certificate of deposit. D. Money market fund.

22. Which of the following financial instruments may be considered a derivative financial instrument? (AICPA 2019) A. Option contract. B. Municipal bond. C. Bank certificate of deposit. D. Money market fund.

23. Hedging Foreign Exchange Risk Foreign currency trades can be executed on a spot or forward basis. The spot rate is the price at which a foreign currency can be purchased or sold today . The forward rate is the price today at which foreign currency can be purchased or sold sometime in the future . Forward exchange contracts provide companies with the ability to “lock in” a price today for purchasing or selling currency at a specific future date .

24. Foreign Exchange Rates Spot Rates The exchange rate that is available today . Forward Rates 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 .

25. This forward contract allows us to purchase 1,000,000 ¥ at a price of $.0080 US in 30 days.(=$8,000) But if the spot rate is $.0089 US in 30 days (=$8,900), we need to pay only $.0080 US and we gain $900 Foreign Exchange Forward Contracts A forward contract requires the purchase (or sale) of currency units at a future date at the contracted exchange rate.

26. This forward contract allows us to purchase 1,000,000 ¥ at a price of $.0080 US in 30 days.(=$8,000) But if the spot rate is $.0069 US in 30 days (=$6,900) !, we still have to pay $.0080 US and we lose $1,100 Foreign Exchange Forward Contracts

27. Foreign Exchange Options Contracts Foreign currency options provide the right but not the obligation to buy or sell foreign currency in the future, and therefore are more flexible than forward contracts. A “ put ” option allows for the sale of foreign currency by the option holder. A “ call ” option allows for the purchase of foreign currency by the option holder.

28. An alternative is an option contract to purchase ¥ 1,000,000 at $.0080 US in 30 days. But it costs $.00002 per ¥. That way, if the spot rate is $.0069 in 30 days, we only lose the $20 cost of the option contract! Foreign Exchange Options Contracts An options contract gives the holder the option of buying the currency units at a future date at the contracted “ strike ” price.

29. What is a " strike price ?" A. The exchange rate that is used to buy a foreign currency today B. The price that will be paid for goods in a forward contract C. The difference between the wholesale rate and the retail rate for foreign currency exchange D. The exchange rate that will be used if a foreign currency option is executed

30. What is a " strike price ?" A. The exchange rate that is used to buy a foreign currency today B. The price that will be paid for goods in a forward contract C. The difference between the wholesale rate and the retail rate for foreign currency exchange D. The exchange rate that will be used if a foreign currency option is executed