CHAPTER THREE

Accounting for Foreign Currency

Transactions and Hedging Foreign
Exchange Risk
Exchange Rate Mechanisms

• Prior to 1991 in Ethiopia, currency value was

fixed.
• The Ethiopian Birr exchange value was based
on the US $, like Br 2.07 = US $ 1
• Since 1991, exchange rates have been allowed
to fluctuate.
• Several valuation models exist in general.
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 different countries.
Its value floats against other world currencies.
Foreign Exchange Rates

• The price at which a currency can be acquired

is known as the “exchange rate.”
• Exchange rates are published daily by NBE
• Remember –Rates change constantly
• The difference between the rates at which a
bank is willing to buy and sell currency is
known as the “spread.”
Foreign Exchange Rates

• As the relative strength of a country’s

economy changes . . .
• . . . the exchange rate of the local currency
relative to other currencies also fluctuates.
• Br = $?
• Foreign Exchange Rates:
[1] Spot Rates
[2] Forward Rates
Cont….
• Spot Rate: The exchange rate that is available
today.
• Exchange Rate: It is an amount of Ethiopian Birr
required to purchase one unit of a foreign
currency on a given date.
• Direct Exchange Rate: Units of domestic currency that can be
converted into one unit of foreign currency.
August 08/2015 1 USD = Br 20.79
August 08/2015 1 Euro = Br23.17
When the rate is expressed as the Et
Br equivalent of 1 unit of foreign
currency, the rate is called a “DIRECT
QUOTE”
Cont….
Indirect Exchange Rate
Units of foreign currency that can be converted into one unit of
domestic currency.

Floating Rates
Relationship between major currencies is determined by supply
and demand factors.

Translation - process of expressing amounts stated in a foreign

currency in the currency of the reporting entity by using
an appropriate exchange rate.
Cont….
• A cross rate is an exchange rate between the
currencies of two countries that are not
quoted against each other, but are quoted
against one common currency.
Foreign Currency Transactions

• An Ethiopian 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.
• Transactions involving foreign currencies: ™
Purchase of merchandise from a foreign supplier
Sale of merchandise to a foreign customer
Loan payable in a foreign currency
L
™oan receivable in a foreign currency
Foreign Currency Transactions

FASB No. 52
• Requires a two-transaction perspective.
(1)Account for sale
(2)Account for gains/losses from exchange rate
fluctuations
Foreign Currency Transactions

• When a transaction occurs on one date (for

example a credit sale) . . ..

• . . . but the cash flow is at a later date . . . . . .

• . . . fluctuating exchange rates can result in
exchange rate gains or losses.
Foreign Exchange Transaction Example
• On 12/1/08, Nuuk sells inventory to Coventry
Corp. on credit. Coventry will pay Nuuk
10,000 British pounds in 90 days. The current
exchange rate is $1 = .6425 £. Prepare Nuuk’s
journal entry.
Nuuk General Journal Page 34
Date Description Debit Credit
Dec 1 A/R (to be collected in £) 15,564
Sales 15,564
10,000£ ÷ .6425 = $15,564
amounts rounded
Foreign Exchange Transaction Example

• On 12/31/08, the exchange rate is $1 = .6400

£. At the balance sheet date we have to
“remeasure”, or adjust, the original A/R to the
current exchange rate.
• Nuuk General Journal Page 34
Date Description Debit Credit
Dec 31 A/R 61
Foreign Exchange Gain 61
$15,564 - (10,000£ ÷ .6400)
amounts rounded
Foreign Exchange Transaction Example
• On 3/1/09, Coventry Corp. pays Nuuk the
10,000 £for the 12/1/08 sale. The exchange
rate on 3/1/09, was $1 = .6500 £. On 3/1/09,
we have to do TWO things.
• First, we must “remeasure”the A/R.
Nuuk General Journal Page 34
Date Description Debit Credit
Mar 1 Foreign Exchange Loss 240
A/R 240
$15,625 - (10,000£ ÷ .6500)
amounts rounded
Foreign Exchange Transaction Example

• On 3/1/09, Coventry Corp. pays Nuuk the

10,000 £for the 12/1/08 sale.
• The exchange rate on 3/1/09, was $1 = .6500 £.
On 3/1/09, we have to do TWO things.
• Second, we must record receipt of the £.
• Nuuk General Journal Page 34
Date Description Debit Credit
Mar 1 Cash 15,385
A/R 15,385
Foreign Currency Transactions

Importing or Exporting of Goods or Services

Translating Accounts Denominated in Foreign Currency

Balance sheet Settlement

Transaction date date date

Units of foreign currency x Current direct exchange rate

Increase or decrease is generally reported as a foreign currency transaction

gain or loss, sometimes referred to as an exchange gain or loss, in determining
net income for the current period.

.
Importing and Exporting Transactions

Exercise 12-2: During December of the current year, Teletex Systems,

Inc., a company based in Seattle,
Washington, entered into the following transactions:

Dec. 10 Sold seven office computers to a company located in

Colombia for 8,541,000 pesos. On this date, the spot rate was
365 pesos per U.S. dollar.

Inventory delivered
12/10/2009
U.S. firm
Columbia firm
(Teletex)
8,541,000 pesos
received on 1/10/2010
LO 3 Common transactions.
LO 4 Three stages of concern.
Importing and Exporting Transactions

Exercise 12-2: Dec. 10, Sold seven office computers to a company

located in Colombia for 8,541,000 pesos. On this date, the spot rate
was 365 pesos per U.S. dollar. Prepare the journal entry on the books of
Teletex Systems, Inc.

Accounts receivable 23,400

Sales 23,400

Sales price in pesos 8,541,000

Pesos per U.S. dollar / 365
Sales price in U.S. dollars $ 23,400
Importing and Exporting Transactions

Exercise 12-2: Prepare journal entry necessary to adjust the accounts

as of December 31. Assume that on December 31 the direct exchange
rates was Colombia peso $.00268.

Transaction loss 510

Accounts receivable 510

Receivable in pesos 8,541,000

Direct exchange rate to U.S. dollar $ .00268
Receivable in U.S. dollars $ 22,890
Balance in receivable 23,400
Transaction loss $ 510

LO 3 Common transactions. LO 4 Three stages of concern.

Importing and Exporting Transactions

Exercise 12-2: Prepare journal entry to record settlement of the account

on January 10. Assume that the direct exchange rate on the settlement
date was Colombia peso $.00320.

Cash (8,541,000 x $.00320) 27,331

Accounts receivable ($23,400 - $510) 22,890
Transaction gain 4,441
Importing and Exporting Transactions

Exercise 12-2: During December of the current year, Teletex Systems,

Inc., a company based in Seattle, Washington, entered into the following
transactions:
Dec. 12 Purchased computer chips from a Taiwan company.
Contract was denominated in 500,000 Taiwan dollars. Direct
exchange rate on this date was $.0391.

Inventory received
12/12/2009
U.S. firm
Taiwan firm
(Teletex)
500,000 Taiwan dollars
paid on 1/10/2010
Importing and Exporting Transactions

Exercise 12-2: Dec. 12, Purchased computer chips from a company

domiciled in Taiwan. The contract was denominated in 500,000 Taiwan
dollars. The direct exchange spot rate on this date was $.0391. Prepare
the journal entry on the books of Teletex Systems, Inc.

Purchases 19,550
Accounts payable 19,550

Purchase price in Taiwan dollars 500,000

Direct exchange rate to U.S. dollar x $.0391
Purchase price in U.S. dollars $ 19,550
Importing and Exporting Transactions

Exercise 12-2: Prepare journal entry necessary to adjust the account as

of December 31. Assume that on December 31 the direct exchange
rates was Taiwan dollar $.0351.

Accounts payable 2,000

Transaction gain 2,000

Payable in pesos 500,000

Direct exchange rate to U.S. dollar $ .0351
Payable in U.S. dollars $ 17,550
Balance in payable 19,550
Transaction gain $ 2,000
Importing and Exporting Transactions

Exercise 12-2: Prepare journal entry to record settlement of account

on January 10. Assume that the direct exchange rate on the settlement
date was Taiwan dollar $.0398.

Transaction loss 2,350

Accounts payable ($19,550 - $2,000) 17,550
Cash (500,000 x $.0398) 19,900
Importing and Exporting Transactions

Importing or Exporting of Goods or Services

Foreign currency transaction gains and losses

are included in net income.
Hedging Foreign Exchange Risk

• To control for the risk of exchange rate

fluctuation, a forward contract for currency can
be purchased.
• Hedging effectively reduces the uncertainty
associated with fluctuating exchange rates.
• To hedge a foreign currency transaction,
companies may use foreign currency derivatives.
• Two common tools: ™
1. Foreign currency forward contracts ™
2. Foreign currency options
Accounting for Derivatives

• Often a transaction involving a credit

sale/purchase is denominated in a foreign
currency.
• On the transaction date, the foreign currency
receivable/payable is recorded.
• If a forward contract is entered into to hedge
the transaction, SFAS No. 133 requires the
forward contract be carried at FAIR VALUE.
Accounting for Hedges

• There are two ways that a foreign currency

hedge can be accounted for.
1. Cash Flow Hedge: Gains/losses are recorded
as Comprehensive Income
2. Fair Value Hedge: Gains/losses are recorded
on the Income Statement
Cash Flow Hedge -Date of Transaction
Example
• On 4/1/08, Madh, Inc., a U.S. maker of auto
parts, purchases parts from Caracol
Company in Mexico for 100,000 Pesoson
credit. Payment is due in 180 days (October
8, 2008). The current exchange rate is $1 =
9.5000 pesos. Prepare Madh’s journal entry on
4/1/08.
Date Description Debit Credit
Apr 1 Purchases 10,526
A/P 10,526
Amounts rounded
Cash Flow Hedge -Date of Transaction
Example

• At Madh’s year-end, 6/30/08, the value of the

foreign currency payable must be re-
measured, or adjusted, based on the 6/30/08
spot rate of $1 = 9.5250 pesos.
.Remeasure the original payable:
Date Description Debit Credit
Jun 30 A/P (pesos) 27.00
Foreign Exchange Gain 27.00
100,000 ÷ 9.525 = $10,499
$10,526 - $10,499 = 27
Amounts rounded
Importing and Exporting Transactions

Hedging Foreign Exchange Rate Risk

Derivative Instrument - a financial instrument that provides the holder
(or writer) with the right (or obligation) to participate in some or all of
the price changes of another underlying value of measure, but does
not require the holder to own or deliver the underlying value of
measure.

Two broad categories: Derivatives are recognized in the

Forward-based balance sheet at their fair value,
Option-based resulting in a payable position for one
party and a receivable position for the
other.
Importing and Exporting Transactions

Forward Exchange Contracts

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

LO 5 Forward exchange contracts.

Importing and Exporting Transactions

Which Kind of Forward Contract to Choose?

1. Forward Contract used as a Hedge of a(n):
a. Foreign currency transaction.
b. Unrecognized firm commitment (a fair value hedge).
c. Foreign-currency-denominated “forecasted” transaction (a
cash flow hedge).
d. Net investment in foreign operations.

2. Speculation
Forward contracts used to speculate changes in foreign currency.

LO 5 Forward exchange contracts.

Using Forward Contracts as a Hedge

Hedge of a Foreign Currency Exposed Liability

Problem 12-2: Christel Exporting Co. is a U.S. wholesaler engaged in
foreign trade. The following transaction is representative of its
business dealings. The company uses a periodic inventory system and
is on a calendar-year basis. All exchange rates are direct quotations.

Dec. 1 Christel Exporting purchased merchandise from Chang’s Ltd., a

Hong Kong manufacturer. The invoice was for 210,000 Hong Kong
dollars, payable on April 1. On this same date, Christel Exporting
acquired a forward contract to buy 210,000 Hong Kong dollars on April
1 for $.1314.
Using Forward Contracts as a Hedge

Problem 12-2: (additional facts)

April 1 Christel Exporting submitted full payment of 210,000 Hong Kong
dollars to Chang’s, Ltd., after obtaining the 210,000 Hong Kong dollars
on its forward contract.
Spot rates and the forward rates for the Hong Kong dollar were as
follows:
Forward Rate for
Spot Rate ($) April 1 Delivery ($)
Dec. 1 .1265 .1314
Dec. 29 .1240 .1305
Dec. 31 .1259 .1308
April 1 .1430
Using Forward Contracts as a Hedge

Problem 12-2: Prepare journal entries for the transactions including

the necessary adjustments on December 31.

Dec 1 Purchases 26,565

Accounts Payable 26,565

Hong Kong dollars 210,000

Dec. 1 Direct Spot Rate $ .1265
Payable in U.S. dollars $ 26,565

LO 7 Forward contracts as a hedge.

Using Forward Contracts as a Hedge

Problem 12-2: Prepare journal entries for the transactions including

the necessary adjustments on December 31.

Dec 1 FC Receivable from Exch. Dealer 27,594

Dollars Payable to Exch. Dealer 27,594

Hong Kong dollars 210,000

Dec. 1 Forward Rate $ .1314
Payable in U.S. dollars $ 27,594

LO 7 Forward contracts as a hedge.

Using Forward Contracts as a Hedge

Problem 12-2: Prepare journal entries for the transactions including

the necessary adjustments on December 31.

Dec 31 Accounts Payable 126

Transaction Gain 126

Hong Kong dollars 210,000

Dec. 31 Spot Rate $ .1259
Payable in U.S. dollars $ 26,439
Payable recorded on Dec. 1 26,565
Transaction gain $ 126

LO 7 Forward contracts as a hedge.

Using Forward Contracts as a Hedge

Problem 12-2: Prepare journal entries for the transactions including

the necessary adjustments on December 31.

Dec 31 Transaction Loss 126

FC Receivable from Exchange Dealer 126

Hong Kong dollars 210,000

Dec. 31 Forward Rate $ .1308
Payable in U.S. dollars $ 27,468
Payable recorded on Dec. 1 27,594
Transaction loss $ (126)

LO 7 Forward contracts as a hedge.

Using Forward Contracts as a Hedge

Problem 12-2: Prepare journal entries for the transactions including

the necessary adjustments on December 31.

Dec 31 Transaction Loss 3,591

Accounts payable 3,591

Hong Kong dollars 210,000

Apr. 1 Spot Rate $ .1430
Payable in U.S. dollars $ 30,030
Payable established on Dec. 31 26,439
Transaction loss $ (3,591)

LO 7 Forward contracts as a hedge.

Using Forward Contracts as a Hedge

Problem 12-2: Prepare journal entries for the transactions including

the necessary adjustments on December 31.

Dec 31 FC Receivable from Exch. Dealer 2,562

Transaction Gain 2,562

Hong Kong dollars 210,000

Apr. 1 Spot Rate $ .1430
Payable in U.S. dollars $ 30,030
Payable established on Dec. 31 27,468
Transaction loss $ 2,562

LO 7 Forward contracts as a hedge.

Using Forward Contracts as a Hedge

Problem 12-2: Prepare journal entries for the transactions including

the necessary adjustments on December 31.

Apr 1 Investment in Foreign Currency 30,030

Dollars Payable to Exch. Dealer 27,594
Cash 27,594
FC Receivable from Exch. Dealer 30,030
(payment to dealer and receipt of 210,000 Hong Kong dollars)

Accounts Payable 30,030

Investment in Foreign Currency 30,030
(payment of liability upon transfer of 210,000 Hong Kong dollars)

LO 7 Forward contracts as a hedge.

Using Forward Contracts as a Hedge

Problem 12-2: Transaction Summary

Transaction Transaction
Hedged Item Balance Gain/(Loss) Hedge Balance Gain/(Loss)
Accounts Payable FC Receivable
Dec. 1 $ 26,565 Dec. 1 $ 27,594
Dec. 31 26,439 $ 126 Dec. 31 27,468 $ (126)
Apr. 1 30,030 (3,591) Apr. 1 30,030 2,562
Total gain/(loss) $ (3,465) $ 2,436

Thus the net effect is a $1,029 loss when the forward

contract is used.

LO 7 Forward contracts as a hedge.

Using Forward Contracts as a Hedge

Fair Value Hedge—Hedging an Unrecognized Foreign

Currency Commitment

 A Ethiopian firm, at a date earlier than the transaction date, may

make a commitment to a foreign company to buy or sell goods at a
price established in foreign currency.

 Changes in the exchange rate between the commitment date and

transaction date would be reflected in the cost or sales price of the
asset.

 The Ethiopian firm may enter a forward contract to hedge its

commitment.

LO 7 Forward contracts as a hedge.

Using Forward Contracts as a Hedge
Exercise 12-14: Consider the following information:
1. On December 1, 2008, a U.S. firm contracts to sell equipment (with an
asking price of 10,000 pesos) in Mexico. The firm will take delivery and
will pay for the equipment on March 1, 2009.
2. On December 1, 2008, the company enters into a forward contract to sell
10,000 pesos for $9.48 on March 1, 2009.
3. Spot rates and the forward rates for March 1, 2009, settlement were as
follows (dollars per peso):
Spot Rate Forward Rate
December 1, 2008 $9.54 $9.48
Balance sheet date (12/31/08) 9.49 9.44
March 1, 2009 9.47
4. On March 1, the equipment was sold for 10,000 pesos. The cost of the
equipment was $40,000.
LO 7 Forward contracts as a hedge.
Using Forward Contracts as a Hedge
Exercise 12-14: Prepare all journal entries needed on December 1, December
31, and March 1 to account for the forward contract, the firm commitment,
and the transaction to sell the equipment.

Dec 1 Receivable from Exchange Dealer* 94,800

FC Payable to Exchange Dealer 94,800

Dec 31 FC Payable from Exchange Dealer** 400

Foreign Exchange Gain 400

Foreign Exchange Loss 400

Firm Commitment** 400

* (10,000 x $9.48 = $94,800)

** [(10,000 x ($9.48 - $9.44)] = $400

LO 7 Forward contracts as a hedge.

Using Forward Contracts as a Hedge
Exercise 12-14: Prepare all journal entries needed on December 1, December
31, and March 1 to account for the forward contract, the firm commitment,
and the transaction to sell the equipment.

Mar 1 Foreign Exchange Loss 300

FC Payable from Exchange Dealer* 300

Firm Commitment* 300

Foreign Exchange Gain 300

Investment in FC 94,700
Firm Commitment 100
Sales (10,000 x 9.48) 94,800

* [(10,000 ´ ($9.44 - $9.47)] =$300

LO 7 Forward contracts as a hedge.

Using Forward Contracts as a Hedge
Exercise 12-14: Prepare all journal entries needed on December 1, December
31, and March 1 to account for the forward contract, the firm commitment,
and the transaction to sell the equipment.

Mar 1 Cash 94,800

FC Payable to Exchange Dealer 94,700
Investment in FC 94,700
Dollars Receivable from Exchange Dealer 94,800

Cost of Goods Sold 40,000

Inventory 40,000

LO 7 Forward contracts as a hedge.

Using Forward Contracts as a Hedge

Cash Flow Hedge-A Forecasted Transaction

 Cash Flow Hedge - hedging cash flows for future transactions that
have not yet occurred or for which there are no firm
commitments.

 Cash flow hedges may defer the Income statement recognition of

gains and losses on forecasted transactions if certain criteria are
met.

 Amounts in accumulated other comprehensive income are

reclassified into earnings in the same period which the hedged
forecasted transaction affects earnings.

LO 7 Fair value hedge vs. cash flow hedge.

Using Forward Contracts as a Hedge
Exercise 12-13: Consider the following information:
1. On December 1, 2008, a U.S. firm plans to purchase a piece of equipment
(with an asking price of 100,000 francs) in Switzerland during January of
2009. The transaction is probable, and the transaction is to be
denominated in euros.
2. On December 1, 2008, the company enters into a forward contract to buy
100,000 francs for $1.01 on January 31, 2009.
3. Spot rates and the forward rates for January 31, 2009, settlement were as
follows (dollars per francs):
Spot Rate Forward Rate
December 1, 2008 $0.99 $1.01
Balance sheet date (12/31/08) 1.01 1.02
Jan. 31 and Feb. 1, 2009 1.04
4. On Feb. 1, the equipment was purchased for 100,000 francs.
LO 7 Fair value hedge vs. cash flow hedge.
Using Forward Contracts as a Hedge
Exercise 12-13: Prepare all journal entries needed on Dec. 1, Dec. 31, Jan. 31,
and Feb. 1 to account for the forecasted transaction, the forward contract, and
the transaction to buy the equipment.

Dec.1 FC Receivable from Exchange Dealer 101,000

Dollars Payable to Exchange Dealer* 101,000

Dec.31 FC Receivable from Exchange Dealer** 1,000

Foreign Exchange Gain – OCI 1,000

* (100,000 x $1.01) = $101,000

** [(100,000 x ($1.01- $1.02)] = $1,000

LO 7 Fair value hedge vs. cash flow hedge.

Using Forward Contracts as a Hedge
Exercise 12-13: Prepare all journal entries needed on Dec. 1, Dec. 31, Jan. 31,
and Feb. 1 to account for the forecasted transaction, the forward contract, and
the transaction to buy the equipment.

Jan.31 FC Receivable from Exchange Dealer 2,000

Foreign Exchange Gain – OCI 2,000
[(100,000 ´ ($1.02- $1.04)]

Investment in FC 104,000
Dollars Payable to Exchange Dealer 101,000
Cash 101,000
FC Receivable from Exchange Dealer 104,000
Feb. 1 Equipment 104,000
Investment in FC 104,000

LO 7 Fair value hedge vs. cash flow hedge.

Using Forward Contracts as a Hedge

Economic Hedge of a Net Investment in a Foreign Entity

 A U.S. firm may enter into a foreign currency transaction or a

nonderivative financial instrument in an effort to minimize or
offset the effects of currency fluctuations on an equity investment
in a foreign company.

 The gain or loss on the hedging instrument is reported in the same

manner as the translation adjustment (under SFAS No. 52).

LO 7 Fair value hedge vs. cash flow hedge.

Using Forward Contracts as a Hedge

Forward Contracts Acquired to Speculate in the

Movement of Foreign Currencies
A forward contract may be acquired for speculative purposes in
anticipation of realizing a gain.

Disclosure Requirements of the Various Hedges

SFAS No. 133 specifies certain minimal disclosures for derivative
instruments and nonderivative instruments designated as qualifying
hedging instruments.

LO 7 Fair value hedge vs. cash flow hedge.

LO 3 Common transactions.
Using Forward Contracts as a Hedge

Using Options to Hedge Foreign Currency Changes

 Options, give the holder the advantage of right but not the
obligation to buy or sell the currency.

 If the exchange rate changes in a negative manner, the firm can

simply let the option lapse without a loss.

LO 8 Derivatives used as a hedge.