Solution manual Advanced Accounting 9e by Hoyle Ch09 PDF

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Find more slides, ebooks, solution manual and testbank on CHAPTER 9 FOREIGN CURRENCY TRANSACTIONS AND HEDGING FOREIGN EXCHANGE RISK Chapter Outline I. In global economy, a great many companies deal in currencies other than their reporting currencies. A. Merchandise may be imported or exported with p...

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CHAPTER 9 FOREIGN CURRENCY TRANSACTIONS AND HEDGING FOREIGN EXCHANGE RISK Chapter Outline I.

In today’s global economy, a great many companies deal in currencies other than their reporting currencies. A. Merchandise may be imported or exported with prices stated in a foreign currency. B. For reporting purposes, foreign currency balances must be stated in terms of the company’s reporting currency by multiplying it by an exchange rate. C. Accountants face two questions in restating foreign currency balance s. 1. What is the appropriate exchange rate for restating foreign currency balances? 2. How are changes in the exchange rate accounted for? D. Companies often engage in foreign currency hedging activities to avoid the adverse impact of exchange rate changes. E. Accountants must determine how to properly account for these hedging activities.

II.

Foreign exchange rates are determined in the foreign exchange market under a variety of different currency arrangements. A. Exchange rates can be expressed in terms of the number of U.S. dollars to purchase one foreign currency unit (direct quotes) or the number of foreign currency units that can be obtained with one U.S. dollar (indirect quotes). B. Foreign currency trades can be executed on a spot or forward basi s. 1. The spot rate is the price at which a foreign currency can be purchased or sold today. 2. The forward rate is the price today at which foreign currency can be purchased or sold sometime in the future. 3. Forward exchange contracts provide companies with the ability to “lock in” a price today for purchasing or selling currency at a specific future date. C. 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.

III. Statement 52 of the Financial Accounting Standards Board, issued in December 1981, prescribes accounting rules for foreign currency transactions. A. 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 twotransaction perspective, accrual approach. B. 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. IV. FASB Statement 133 (as amended by FASB Statement 138) governs the accounting for derivative financial instruments and hedging activities including the use of foreign currency forward contracts and foreign currency options. A. The fundamental requirement of SFAS 133 is that all derivatives must be carried on the McGraw-Hill/Irwin Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

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balance sheet at their fair value. Derivatives are reported on the balance sheet as assets when they have a positive fair value and as liabilities when they have a negative fair value. B. SFAS 133 (as amended by SFAS 138) provides guidance for hedges of the following sources of foreign exchange risk: 1. foreign currency denominated assets and liabilities. 2. foreign currency firm commitments. 3. forecasted foreign currency transactions. 4. net investments in foreign operations (covered in Chapter 10). C. Companies prefer to account for hedges in such a way that the gain or loss from the hedge is recognized in net income in the same period as the loss or gain on the risk being hedged. This approach is known as hedge accounting. Hedge accounting for foreign currency derivatives may be applied only if three conditions are satisfied: 1. the derivative is used to hedge either a fair value exposure or cash flow exposure to foreign exchange risk, 2. the derivative is highly effective in offsetting changes in the fair value or cash flows related to the hedged item, and 3. the derivative is properly documented as a hedge. D. SFAS 133 allows hedge accounting for hedges of two different types of exposure: cash flow exposure and fair value exposure. Hedges of (1) foreign currency denominated assets and liabilities, (2) foreign currency firm commitments, and (3) forecasted foreign currency transactions can be designated as cash flow hedges. Hedges of (1) and (2) also can be designated as fair value hedges. Accounting procedures differ for the two types of hedges. E. For cash flow hedges of foreign currency assets and liabilities, at each 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 (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). 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; the net effect is 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 a forward contract is the hedging instrument) or (b) the change in the time value of the option (if an option is the hedging instrument). F. For fair value hedges of foreign currency assets and liabilities, at each 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 (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income. G. Under fair value hedge accounting for hedges of foreign currency firm commitments: 1. the gain or loss on the hedging instrument is recognized currently in net income, and 2. the change in fair value of the firm commitment is also recognized currently in net income. This accounting treatment requires (1) measuring the fair value of the firm commitment, (2) recognizing the change in fair value in net income, and (3) reporting the firm commitment on the balance sheet as an asset or liability. A decision must be made whether to McGraw-Hill/Irwin 9-2

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measure the fair value of the firm commitment through reference to (a) changes in the spot exchange rate or (b) changes in the forward rate. H. SFAS 133 allows cash flow hedge accounting for hedges of forecasted foreign currency transactions. For hedge accounting to apply, the forecasted transaction must be probable (likely to occur). The accounting for a hedge of a forecasted transaction differs from the accounting for a hedge of a foreign currency firm commitment in two ways: 1. Unlike the accounting for a firm commitment, there is no recognition of the forecasted transaction or gains and losses on the forecasted transaction. 2. The hedging instrument (forward contract or option) is reported at fair value, but because there is no gain or loss on the forecasted transaction to offset against, changes in the fair value of the hedging instrument are not reported as gains and losses in net income. Instead they are reported in other comprehensive income. On the projected date of the forecasted transaction, the cumulative change in the fair value of the hedging instrument is transferred from other comprehensive income (balance sheet) to net income (income statement).

Learning Objectives Having completed Chapter 9, “Foreign Currency Transactions and Hedging Foreign Exchange Risk,” students should be able to fulfill each of the following learning objectives: 1. Read and understand published foreign exchange quotes. 2. Understand the one-transaction and two-transaction perspectives to accounting for foreign currency transactions. 3. Account for foreign currency transactions using the two-transaction perspective. 4. Explain the concept of exposure to foreign exchange risk that arises from foreign currency transactions. 5. Explain how forward contracts and options can be used to hedge foreign exchange risk. 6. Account for forward contracts and options used as hedges of a. foreign currency denominated assets and liabilities, b. foreign currency firm commitments, and c. forecasted foreign currency transactions. 7. Account for foreign currency borrowings.

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Answer to Discussion Question Do we have a gain or what? This case demonstrates the differing kinds of information provided through application of current accounting rules for foreign currency transactions and derivative financial instruments. The Ahnuld Corporation could have received $200,000 from its export sale to Tcheckia if it had required immediate payment. Instead, Ahnuld allows its customer six months to pay. Given the future exchange rate of $1.70, Ahnuld would have received only $170,000 if it had not entered into the forward contract. This would have resulted in a decrease in cash inflow of $30,000. In accordance with SFAS 52, the decrease in the value of the tcheck receivable is recognized as a foreign exchange loss of $30,000. This loss represents the cost of extending credit to the foreign customer if the tcheck receivable is left unhedged. However, rather than leaving the tcheck receivable unhedged, Ahnuld sells tchecks forward at a price of $180,000. Because the future spot rate turns out to be only $1.70, the forward contract provides a benefit, increasing the amount of cash received from the export sale by $10,000. In accordance with SFAS 133, the change in the fair value of the forward contract (from zero initially to $10,000 at maturity) is recognized as a gain on the forward contract of $10,000. This gain reflects the cash flow benefit from having entered into the forward contract, and is the appropriate basis for evaluating the performance of the foreign exchange risk manager. (Students should be reminded that the forward contract will not always improve cash inflow. For example, if the future spot rate were $1.85, the forward contract would result in $5,000 less cash inflow than if the transaction were left unhedged.) The net impact on income resulting from the fluctuation in the value of the tcheck is a loss of $20,000. Clearly, Ahnuld forgoes $20,000 in cash inflow by allowing the customer time to pay for the purchase, and the net loss reported in income correctly measures this. The $20,000 loss is useful to management in assessing whether the sale to Tcheckia generated an adequate profit margin, but it is not useful in assessing the performance of the foreign exchange risk manager. The net loss must be decomposed into its component parts to fairly evaluate the risk manager’s performance. Gains and losses on forward contracts designated as fair value hedges of foreign currency assets and liabilities are relevant measures for evaluating the performance of foreign exchange risk managers. (The same is not true for cash flow hedges. For this type of hedge, performance should be evaluated by considering the net gain or loss on the forward contract plus or minus the forward contract premium or discount.)

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Answers to Questions 1.

Under the two-transaction perspective, an export sale (import purchase) and the subsequent collection (payment) of cash are treated as two separate transactions to be accounted for separately. The idea is that management has made two decisions: (1) to make the export sale (import purchase), and (2) to extend credit in foreign currency to the foreign customer (obtain credit from the foreign supplier). The income effect from each of these decisions should be reported separately.

2.

Foreign currency receivables resulting from export sales are revalued at the end of accounting periods using the current spot rate. An increase in the value of a receivable will be offset by reporting a foreign exchange gain in net income, and a decrease will be offset by a foreign exchange loss. Foreign exchange gains and losses are accrued even though they have not yet been realized.

3.

Foreign exchange gains and losses are created by two factors: having foreign currency exposures (foreign currency receivables and payables) and changes in exchange rates. Appreciation of the foreign currency will generate foreign exchange gains on receivables and foreign exchange losses on payables. Depreciation of the foreign currency will generate foreign exchange losses on receivables and foreign exchange gains on payables.

4.

Hedging is the process of eliminating exposure to foreign exchange risk so as to avoid potential losses from fluctuations in exchange rates. In addition to avoiding possible losses, companies hedge foreign currency transactions and commitments to introduce an element of certainty into the future cash flows resulting from foreign currency activities. Hedging involves establishing a price today at which foreign currency can be sold or purchased at a future date.

5.

A party to a foreign currency forward contract is obligated to deliver one currency in exchange for another at a specified future date, whereas the owner of a foreign currency option can choose whether to exercise the option and exchange one currency for another or not.

6.

Hedges of foreign currency denominated assets and liabilities are not entered into until a foreign currency transaction (import purchase or export sale) has taken place. Hedges of firm commitments are made when a purchase order is placed or a sales order is received, before a transaction has taken place. Hedges of forecasted transactions are made at the time a future foreign currency purchase or sale can be anticipated, even before an order has been placed or received.

7.

Foreign currency options have an advantage over forward contracts in that the holder of the option can choose not to exercise if the future spot rate turns out to be more advantageous. Forward contracts, on the other hand, can lock a company into an unnecessary loss (or a reduced gain). The disadvantage associated with foreign currency options is that a premium must be paid up front even though the option might never be exercised.

8.

SFAS 133 requires an enterprise to recognize all derivative financial instruments as assets or liabilities on the balance sheet and measure them at fair value.

9.

The fair value of a foreign currency forward contract is determined by reference to changes in the forward rate over the life of the contract, discounted to the present value. Three pieces of

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information are needed to determine the fair value of a forward contract at any point in time during its life: (a) the contracted forward rate when the forward contract is entered into, (b) the current forward rate for a contract that matures on the same date as the forward contract entered into, and (c) a discount rate; typically, the company’s incremental borrowing rate. The manner in which the fair value of a foreign currency option is determined depends on whether the option is traded on an exchange or has been acquired in the over the counter market. The fair value of an exchange-traded foreign currency option is its current market price quoted on the exchange. For over the counter options, fair value can be determined by obtaining a price quote from an option dealer (such as a bank). If dealer price quotes are unavailable, the company can estimate the value of an option using the modified BlackScholes option pricing model. Regardless of who does the calculation, principles similar to those in the Black-Scholes pricing model will be used in determining the value of the option. 10. Hedge accounting is defined as recognition of gains and losses on the hedging instrument in the same period as the recognition of gains and losses on the underlying hedged asset or liability (or firm commitment). 11. For hedge accounting to apply, the forecasted transaction must be probable (likely to occur), the hedge must be highly effective in offsetting fluctuations in the cash flow associated with the foreign currency risk, and the hedging relationship must be properly documented. 12. In both cases, (1) sales revenue (or the cost of the item purchased) is determined using the spot rate at the date of sale (or purchase), and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income. For a cash flow hedge, the derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability. 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 a forward contract is the hedging instrument) or (b) the change in the time value of the option (if an option is the hedging instrument). For a fair value hedge, the derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income. The discount or premium on a forward contract is not allocated to net income. The change in the time value of an option is not recognized in net income. 13. For a fair value hedge of a foreign currency asset or liability (1) sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income. The forward contract is adjusted to fair value based on changes in the forward rate (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income. The foreign exchange gain (loss) and the forward contract loss (gain) are likely to be of different amounts McGraw-Hill/Irwin 9-6

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resulting in a net gain or loss reported in net income. For a fair value hedge of a firm commitment, there is no hedged asset or liability to account for. The forward contract is adjusted to fair value based on changes in the forward rate (resulting in an asset or liability reported on the balance sheet), with a gain or loss recognized in net income. The firm commitment is also adjusted to fair value based on changes in the forward rate (resulting in a liability or asset reported on the balance sheet), and a gain or loss on firm commitment is recognized in net income. The firm commitment gain (loss) offsets the forward contract loss (gain) resulting in zero impact on net income. Sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase). The firm commitment account is closed as an adjustment to net income in the period in which the hedged item affects net income. 14. For a cash flow hedge of a foreign currency asset or liability (1) sales revenue (cost of purchases) is rec...