CH 12

Advanced
Accounting
Jeter ● Chaney
Accounting for Foreign

Currency Transactions
and Hedging Foreign
Exchange Risk
1
Prepared by Sheila Ammons, Austin Community College
Learning Objectives
• Distinguish between the terms “measured” and
“denominated.”
• Describe what is meant by a foreign currency transaction.
• Understand some of the more common foreign currency
transactions.
• Identify three stages of concern to accountants for foreign
currency transactions, and explain the steps used to translate
foreign currency transactions for each stage.
• Describe a forward exchange contract.
2
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Learning Objectives
• Explain the use of forward contracts as a hedge of an
unrecognized firm commitment.
• Identify some of the common situations in which a
forward exchange contract can be used as a hedge.
• Describe a derivative instrument and understand how it
may be used as a hedge.
• Explain how exchange gains and losses are reported for
fair value hedges and cash flow hedges.
3
Foreign Currency Transactions
• Many U.S. companies engage in international activities
such as:
– Exporting or importing goods,
– Establishing a foreign branch, or
– Holding an equity investment in a foreign company.
4
• Recording and reporting problems with foreign currency
transactions:
– Transactions to be settled in a foreign currency must be
translated (expressed in dollars) before they can be
aggregated with domestic transactions of the U.S. firm.
– Receivables or payables denominated in foreign
currencies are subject to gains and losses.
• Due to the changes in exchange rates.
– Companies use hedging strategies with derivatives to
minimize the impact of exchange rate changes on their
financial statements.
5
Exchange Rates—Means of Translation
• Translation - process of expressing amounts stated in
terms in a foreign currency in the currency of the
reporting entity by using an appropriate exchange rate.
• Exchange rate - ratio between a unit of one currency
and another currency for which that unit can be
exchanged at a particular time.
6
• Direct Exchange Quotation
– Units of domestic currency that can be converted
into one unit of foreign currency.
– Direct rate = 1.517 ($1.517 U.S. for 1 British pound)
• Indirect Exchange Quotation

– Units of foreign currency that can be converted into
one unit of domestic currency.
– Indirect rate = 1.00/1.517 = .6592 ($1 U.S. for .6592
British pound)
7
• Spot Rate
– Rate at which currencies can be exchanged today.
• Forward or Future Rate
– Rate at which currencies can be exchanged at some
future date.
• Forward Exchange Contract
– Contract to exchange currencies of different
countries on a stipulated future date, at a specified
rate (the forward rate).
8
• Floating Rates
– Relationship between major currencies is determined
by supply and demand factors.
– Increase risk to companies doing business with a
foreign company.
Example – Payable to be settled in 100,000 yen
Transaction Change Settlement
Date in Rate Date
Yen 100,000 100,000
Direct rate $ 0.00434 $ 0.00625
Payable $ 434.00 $ 625.00
An increase in in the value of the yen to $.00625 would result in an increase in the payable to $625.
Measured Versus Denominated
• Transactions are normally measured and recorded in terms
of the currency in which the reporting entity prepares its
financial statements.
– Reporting Currency - usually the currency where the
company is located.
• Transaction between a U.S. firm and a foreign company:
– Companies negotiate whether settlement is to be made in
dollars or in the foreign currency.
– If settled by foreign currency, U.S. firm measures the
receivable or payable in dollars, but the transaction is
denominated in the foreign currency.
LO 1 Measured versus denominated.

10
• Foreign Currency Transaction - requires payment or
receipt (settlement) in a foreign currency.
– U.S. firm exposed to risk of unfavorable changes in
the exchange rate.
Direct exchange rate increasing,
More dollars needed to acquire
or foreign currency unit = the foreign currency units.
strengthening.
Direct exchange rate

= Fewer dollars needed to acquire
decreasing, or foreign currency
the foreign currency units.
unit weakening.
LO 2 Foreign currency transaction.

11
Importing or Exporting of Goods or Services
Translating Accounts Denominated in Foreign Currency
Balance sheet
Transaction date Settlement date
date
Units of foreign currency x Current direct exchange rate (spot 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.
LO 3 Common transactions. LO 4 Three stages of concern.

12
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/Year 1
U.S. firm
Columbia firm
(Teletex)
8,541,000 pesos
received on 1/10/Year 2

13
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. (periodic method)
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

14
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
15
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

16
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 spot rate on this date was $.0391.
Inventory received
12/12/Year 1
U.S. firm
Taiwan firm
(Teletex)
500,000 Taiwan dollars
paid on 1/10/Year 2
17
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

18
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.
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
19
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

20
Importing or Exporting of Goods or Services: Two-transaction
approach:
– Sale or purchase is viewed as a transaction separate and distinct
from the financing arrangement.
– Dollar amount recorded (in Sales or in Purchases) is determined
by the exchange rate on the transaction date.
– Adjustments to the foreign-currency-denominated receivable or
payable are recorded directly to the transaction gain or loss
and included in net income.
• Transaction gain or loss
» Does not result from an operating decision to buy or
sell goods or services in a foreign market.
» But from a decision to delay the payment or receipt
of foreign currency and not to hedge the exposed
receivable or payable.
21
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
balance sheet at their fair value,
• Forward-based resulting in a payable position for one
• Option-based party and a receivable position for the
other.
LO 8 Derivatives as a hedge.
22
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.

23
Which Kind of Forward Contract to Choose?
• Forward Contract used as a
1. Hedge of a(n):
– Foreign currency transaction.
– Unrecognized firm commitment (a fair value hedge).
– Foreign-currency-denominated “forecasted” transaction
(a cash flow hedge).
– Net investment in foreign operations.
2. Speculation:
– Forward contracts used to speculate changes in foreign
currency.
LO 6 Hedging with forward contracts.

24
Using Forward Contracts as a Hedge
Hedge of a Foreign Currency Exposed Liability
• Problem 12-2: Crystal 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 Crystal 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, Crystal Exporting acquired a forward contract to
buy 210,000 Hong Kong dollars on April 1 for $.1314.

25
Problem 12-2: (additional facts)
April 1 Crystal 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 4/1 Delivery
Dec. 1 $.1265 $.1314
Dec. 29 .1240 .1305
Dec. 31 .1259 .1308
April 1 .1430
26
Problem 12-2: Prepare journal entries for the transactions including the
necessary adjustments on December 31.
Dec 1 Purchases 26,565

Hong Kong dollars 210,000

Dec. 1 Direct Spot Rate $ .1265

27
Dec 1 FC Receivable from Exch. Dealer 27,594

Dollars Payable to Exch. Dealer 27,594

Dec. 1 Forward Rate $ .1314

28
Dec 31 Accounts Payable 126

Transaction Gain 126

Dec. 31 Spot Rate $ .1259
Payable recorded on Dec. 1 26,565
Transaction gain $ 126

29
Dec 31 Transaction Loss 126
FC Receivable from Exchange Dealer 126

Dec. 31 Forward Rate $ .1308
Payable recorded on Dec. 1 27,594
Transaction loss $ (126)

30
Using Forward Contracts as a
Hedge
Apr 1 Transaction Loss 3,591


Apr. 1 Spot Rate $ .1430
Payable established on Dec. 31 26,439
Transaction loss $ (3,591)
LO 7 Forward contracts as a hedge.

31
Apr 1 FC Receivable from Exch. Dealer 2,562


Apr. 1 Spot Rate $ .1430
Payable established on Dec. 31 27,468
Transaction loss $ 2,562

32
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)

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

33
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.

34
Hedge
Hedge of a Foreign Currency Exposed Asset
• Accounting for a forward contract entered into as a
hedge of an exposed receivable position is similar to an
exposed liability position.
• Because the U.S. firm will be receiving foreign
currency in settlement of the exposed receivable
balance, it will enter into a forward contract to sell
foreign currency for U.S. dollars.

35
Hedge
Fair Value Hedge—Hedging an Unrecognized Foreign
Currency Commitment
• A U.S. 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 U.S. firm may enter a forward contract to hedge its
commitment.

36
Hedge
Exercise 12-14: Consider the following information:
1. On December 1, 2014, 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, 2015.
2. On December 1, 2014, the company enters into a forward contract to sell
10,000 pesos for $9.48 on March 1, 2015.
3. Spot rates and the forward rates for March 1, 2015, settlement were as
follows (dollars per peso):
Spot Rate Forward Rate
December 1, 2014 $9.54 $9.48
Balance sheet date (12/31/14) 9.49 9.44
March 1, 2015 9.47
4. On March 1, the equipment was sold for 10,000 pesos. The cost of the
equipment was $40,000. LO 6 Hedging with forward contracts. 37
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 Dollars 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
38
Hedge
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

39
Hedge
Mar 1 Cash 94,800
FC Payable to Exchange Dealer 94,700
Dollars Receivable from Exchange Dealer 94,800
Cost of Goods Sold 40,000

Inventory 40,000

40
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 9 Fair value hedge vs. cash flow hedge.

41
Cash Flow Hedge Illustration
Exercise 12-13: Consider the following information:
1. On December 1, 2014, a U.S. firm plans to purchase a piece of equipment (with an
asking price of 100,000 francs) in Switzerland during January of 2015. The
transaction is probable, and the transaction is to be denominated in euros.
2. On December 1, 2014, the company enters into a forward contract to buy 100,000
francs for $1.01 on January 31, 2015.
3. Spot rates and the forward rates for January 31, 2015, settlement were as follows
(dollars per francs):
Spot Rate Forward Rate for 1/31/15
December 1, 2014 $0.99 $1.01
Balance sheet date (12/31/14) 1.01 1.02
Jan. 31 and Feb. 1, 2015 1.04
4. On Feb. 1, the equipment was purchased for 100,000 francs.

42
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

43
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)]
Dollars Payable to Exchange Dealer 101,000
Cash 101,000
FC Receivable from Exchange Dealer 104,000
Feb. 1 Equipment 104,000

44
Hedge
Economic Hedge of a Net Investment in a Foreign Entity
– A U.S. firm that maintains an equity investment in a
foreign company 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.
– The gain or loss on the hedging instrument is reported in
the same manner as the translation adjustment
• reported in the cumulative translation adjustment
section under comprehensive income. FASB ASC
paragraph 815-35-35-1
LO 3 Common transactions.
45
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
– FASB ASC Section 815-20-50 specifies certain
minimal disclosures for derivative instruments and
nonderivative instruments designated as qualifying
hedging instruments.
LO 3 Common transactions.
46
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.
– Call Option:
• An option to purchase the foreign currency at a
specified rate, referred to as the exercise price.
– Put Option:
• An option to sell the foreign currency at a specified
rate.
LO 8 Derivatives used as a hedge.
47

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Advanced

Accounting for Foreign

• Indirect Exchange Quotation

LO 1 Measured versus denominated.

Direct exchange rate

LO 2 Foreign currency transaction.

Units of foreign currency x Current direct exchange rate (spot rate)

Increase or decrease is generally reported as a foreign currency transaction gain

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

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

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

Sales price in pesos 8,541,000

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

Receivable in pesos 8,541,000

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

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

Purchase price in Taiwan dollars 500,000

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

Payable in pesos 500,000

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

LO 5 Forward exchange contracts.

LO 6 Hedging with forward contracts.

LO 6 Hedging with forward contracts.

April 1 Crystal Exporting submitted full payment of 210,000 Hong

Dec 1 Purchases 26,565

Hong Kong dollars 210,000

LO 6 Hedging with forward contracts.

Dec 1 FC Receivable from Exch. Dealer 27,594

Hong Kong dollars 210,000

LO 6 Hedging with forward contracts.

Dec 31 Accounts Payable 126

Hong Kong dollars 210,000

LO 6 Hedging with forward contracts.

Hong Kong dollars 210,000

LO 6 Hedging with forward contracts.

Apr 1 Transaction Loss 3,591

Hong Kong dollars 210,000

LO 7 Forward contracts as a hedge.

Apr 1 FC Receivable from Exch. Dealer 2,562

Hong Kong dollars 210,000

LO 6 Hedging with forward contracts.

Accounts Payable 30,030

LO 6 Hedging with forward contracts.

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

LO 6 Hedging with forward contracts.

LO 7 Forward contracts as a hedge.

LO 7 Forward contracts as a hedge.

Dec 31 FC Payable from Exchange Dealer** 400

Foreign Exchange Loss 400

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

Firm Commitment* 300

* [(10,000 ´ ($9.44 - $9.47)] =$300

LO 6 Hedging with forward contracts.

Cost of Goods Sold 40,000

LO 6 Hedging with forward contracts.

LO 9 Fair value hedge vs. cash flow hedge.

LO 9 Fair value hedge vs. cash flow hedge.

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

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

LO 9 Fair value hedge vs. cash flow hedge.

LO 9 Fair value hedge vs. cash flow hedge.

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