Advanced Accounting Lecturer : Ahalik, SE, Ak, M.Si, M.

Ak, CMA, CPMA, CPSAK FOREIGN CURRENCY CONCEPT AND TRANSACTION Distinguish between measurement and denomination in a particular currency A receivable or payable is denominated in a currency when it must be paid in that currency. A receivable or payable is measured in a currency when it is recorded in the financial records in that currency A transaction is measured in a particular currency if its magnitude is expressed in that currency. Assets and liabilities are denominated in a currency if their amounts are fixed in terms of that currency. Assume that one Canadian Dollar can be exchanged for $.72 U.S. dollar. What is the exchange rate if the exchange rate is quoted directly? Indirectly? Direct quotation: .72/1 = $.72 (from viewpoint of American Company) Indirect quotation: 1/.72 = 1.3889 Canadian dollars (from viewpoint of American Company) What is the difference between official and floating foreign exchange rate? Official or fixed rates are set by a government and do not change as a result of changes in world currency markets. Free or floating exchange rates are those that reflect fluctuating market prices for currency based on supply and demand factors in world currency markets. Spot rates are the exchange rates for immediate delivery of currencies exchanged. The current rate for foreign currency transactions is the spot rate in effect for immediate settlement of the amounts denominated in foreign currency at the balance sheet date. Historical rates are the rates that were in effect on the date that a particular event or transaction occurred. When are exchange gains and Losses reflected in a businesss financial statement? Exchange gains and losses occur because of changes in the exchange rates between the transaction date and the date of settlement. Both exchange gains and exchange losses can occur in either foreign import activities or foreign export activities.

Purchases Denominated in Foreign Currency American Trading Company, a U.S corporation, purchased merchandise from Paris Company on December 1, 2006, for 10.000 euro, when the spot rate for euros was $0.6600. American Trading closed it books at December 31, 2006, when the spot rate for euros was $0.6550, and it settled the account on January 30, 2007, when the spot rate was $0.6650.

Sales Denominated in Foreign Currency On December 16, 2006, American Trading Company sold merchandise to Rome company for 20.000 euros, when the spot rate for euros was $0.6625. American trading closed its book on December 31,2006 when the spot rate was $0.6550, collected the account on January 15, 2007, when the spot rate was $0.6700, and held the cash until January 20, when it converted the euros into U.S dollars at the $0.6725 spot rate.
Define the term of forward contract and the objective of hedge accounting? A forward exchange contract (or futures contract) is an agreement to exchange at a specified future date, currencies of different countries at a specified rate (the forward rate). Futures contracts (derivative instruments) are used to speculate in foreign currency exchange price movements, to hedge an exposed foreign currency net asset or net liability position, to hedge an anticipated or actual foreign currency commitment, or to hedge a net investment in a foreign entity. The purpose of the derivative contract is to mitigate or eliminate potential foreign exchange gains or losses. The derivative contract is carried at the forward rate (fair value) while the underlying liability is carried at the spot rate. If these two rates do not move exactly in tandem a recognized gain or loss would be the result. A hedge against an identifiable foreign currency commitment fixes the price of the commitment at the future rate. Any gains or losses on the hedge are exactly offset by changes in the value of the underlying firm commitment. No gain or loss would need to be recognized.

Forward & Hedging Case I (Forward) Managing an Exposed Foreign Currency Net Asset or Liability Position : Not a Designated Hedging Instrument 1. On October 1, 2006, President Co. purchases goods on account from Tokyo Industries in the amount of 2.000.000 Yen. 2. This transaction is denominated in Yen, and President offsets its exposed foreign currency liabilities with a forward exchange contract for the receipt of 2.000.000 Yen from Citibank 3. The term of the forward exchange contract equals the six-month credit period extended by Tokyo Industries. 4. December 31 is the year-end of President Co., and the payable is settled on April 1, 2007. Date U.S Dollar equivalent Value of 1 Yen Spot Forward Rate Exchange Rate October $.0070 1, 2006 Dec 31, $0.0080 2006 April 1, $0.0076 2007 $.0075 (180 days) $0.0077 (90 days)

Case II (Forward & Hedging) Hedging an Unrecognized Foreign Currency Firm Commitment : A Foreign Currency Fair Value Hedge 1. On August 1, 2006, President Co. contracts to purchase special-order goods from Tokyo Industries. Their manufacture and delivery will take place in 60 days (on October 1, 2006). The contract price is 2.000.000 Yen, to be paid by April 1, 2007, which is 180 days after delivery. 2. On August 1, President hedges its foreign currency payable commitment with a forward exchange contract to receive 2.000.000 Yen in 240 days (the 60 days until delivery plus 180 days of credit period). The future rate for a 240 day forward contract is $.0073 to 1 Yen. The purpose of this 240 day forward exchange contract is twofold. First, for the 60 days from August 1, 2006, until October 1, 2006, the forward exchange contract is a hedge of an identifiable foreign currency commitment. For the 180 day period from October 1, 2006 , until April 1, 2007, the forward exchange contract is a hedge of a Foreign currency exposed net liability position. The relevant exchange rates for this example are as follows :

U.S Dollar equivalent Value of 1 Yen Spot Forward Rate Exchange Rate August 1, $.0065 $.0073 (240 days) 2006 October 1, $.0070 $.0075 (180 days) 2006 Dec 31, $0.0080 $0.0077 (90 days) 2006 April 1, $0.0076 2007

Date

Derivative : is the name given to a broad of financial securities. Characteristics : fluctuations in price, rate, or some other variable. The party trying to control its economic rate or price change risk is engaging in a derivative, or hedge contract such as interest rates, commodity prices, foreign currency exchange rates, and stock prices. Typical forms of derivative instruments are option contracts, forward contracts, and future contracts. Hedge Structures Forward contracts : are negotiated contract between two parties for the delivery or purchase of a

commodity or foreign currency at a pre-agreed price, quantity, and delivery date. The agreement may require actual physical delivery of goods or may allow a net settlement.
Future contracts = forward contracts, differ from forward contracts in ways that allow them to be traded easily in market. A contractual agreement to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. Futures are contract between two parties, a buyer and a seller, to buy or sell something at a specified future date, which is termed the expiration date. Futures contract are actively traded in a number of commmodities including grains and oilseeds, livestock and meat, food and fiber, and metal and energy. Companies trading in futures contract are normally required to place cash in their margin accounts held by the brokerage exchange or a clearing house, and the gain (loss) on the future contract is then added (subtracted) from the companys margin account. This margin account is settled daily for the changes in contract value. Margin accounts are maintained at some percentage (typically 2 to 5 percent) of contract amount. If the company is the purchaser of a futures contract, it is said to go long in a position. If a company contract to sell with a future contract, it is said to go short. The accounting for future contract is quite similar to accounting for foreign currency forward contract. Forward contracts delivery quantities, prices, product quality, and delivery dates can all be negotiated. Under a future contract, the quantities, delivery dates, and product quality of each contract are defined by the exchange. The future price is a market-determined amount. Options : another commonly used hedging instrument structure. Only one side of the option contract is required to perform at the begest of the other. The other party to the option has the ability but not the obligation to perform. Example : option cost $1.000 to purchase 100.000 gallons of fuels at $1 per gallon. If market fuel price $1,1, company will exercise the option. If the market value is $0,90, the company will allow the option to expire. Types of Hedge Accounting Fair value hedge accounting The item being hedges is an existing asset or liability position or firm purchase or sale commitment. In this case, both the item being hedged and the derivative are marked to fair value at the end of the quarter or year-end on the books. The gain or loss on these items is reflected immediately in earnings. The risk being hedged is the variability in the fair value of the asset or liability. Cash flow hedge accounting The derivative hedges the exposure to the variability in expected future cash flows associated with risk. The gain or loss is included as a component of accumulated other comprehensive income (AOCI). Hedge of net investment in a foreign subsidiary

Illustration : Green company mines copper. It will mine and sell 100.000 pounds of copper during the next four quarter. Total costs is $28.900.000 or $289 per pounds. Green decides to sell its future production by entering into forward contract on 1 october 2008 with Brown for delivery to Brown 100.000 pounds of copper in one year at a price of $300 per pound. 1 oct 2008 - no journal entries The company has entered into a cash flow hedge because it is attempting to control the impact of price fluctuations its future cash flows and its sales. 31 dec 2008, market price of copper $310 Suppose that interest rate is 1% per month $10 x 100.000 = $1.000.000 $1.000.000 X PVIF, 1%, 9=$914.340 Other comprehensive income (OCI)(SE) Forward contract (L) 914.340 914.340