Foreign Currency Transactions and Hedging

Foreign Exchange Risk

and
Translation of Foreign Currency Financial
Statements

Oleh:
Muhammad Fachreza 120110070
Roy Ronald A 120110070080
Bramantyo S A 120110070
Muhammad Graito H 120110070
Darmawansyah 120110070166

Jurusan Akuntansi Fakultas Ekonomi

Universitas Padjadjaran
2011
Foreign Currency Transactions and Hedging Foreign Exchange Risk

Foreign Exchange Rates

Exchange rates, to the U.S. dollar, are published in many places on the internet
and in newspapers. The Wall Street Journal publishes these daily, both as US$
equivalent (direct quotes) and currency per US$ (indirect quotes). A direct quote is the
reciprocal of an indirect quote and vice-versa. For example, if the direct quote for a Euro
was 1.3420, the indirect quote was 0.7452 (its inverse).

Terminology of Exchange Rates and Foreign Exchange Risk

 Export sale – a company sells to a foreign customer and receives payment in the
customer’s currency.
 Import purchase – a company purchases from a foreign supplier and pays in the
supplier’s currency.
 Foreign exchange risk – the chance that the exporter will receive less, or the
importer pay more, than anticipated as a result of change in exchange rate.

Accounting for Foreign Currency Transactions

Accounting – sale transaction One transaction perspective
 Treats sale and collection as one transaction.
 Transaction is complete when foreign currency is received and converted, sale is
measured at converted amount.
 This approach is not allowed under IAS or U.S. GAAP.
Two transaction perspective
 Treats sale and collection as two transactions.
 Sale is one transaction, collection is second transaction.
 Sale is based on current exchange rate.
 If exchange rate changes, collection is for different amount.
 Difference is considered foreign exchange gain or loss.
 Concepts are identical for purchase transaction.
Transaction types, exposure type and gain or loss – export sales
 Export sale  asset exposure, if foreign currency appreciates  foreign
exchange gain.
  Export sale  asset exposure, if foreign currency depreciates  foreign
exchange loss.
Transaction types, exposure type and gain or loss – import purchases
 Import purchase  liability exposure, if foreign currency appreciates  foreign
exchange loss.
 Import purchase  liability exposure, if foreign currency depreciates  foreign
exchange gain.

Hedging Foreign Exchange Risk

Hedging protecting against losses from exchange rate fluctuations. It allows firm
to focus on what it does best, i.e., the business operation. Hedging also reduces earnings
and cash flow volatility then removes a noncontrollable element of risk that is not well
understood or predictable.
Firms hedge the foreign currency risk they carry by buy or sell the foreign
currency, counterbalance the position by holding the opposite position within the
balance sheet structure (e.g., receivables, notes, etc.) and set up a foreign operation that
incurs expenses (sales) in the foreign currency. Firms can also hedge the foreign
currency risk they carry by use derivatives.
The objectives of hedge accounting:
 Marking assets and liabilities to market.
 Amortizing, in some fashion, the costs of the hedge instrument.
 Matching gains/losses of the exposure with the hedge, thus causing them to offset
each other
Hedges as designated in GAAP divide on 2 types. First, there are Cash flow
hedge, an accounting designation for hedges that offset variability in cash flows of
hedged items. The second, there are Fair value hedge, an accounting designation for
hedges that offset the variability in fair value of hedged assets and liabilities. Hedging
instrument is considered to be a cash flow (flow) or fair value (stock) hedge
decide by management does or In other words, the choice is entirely arbitrary
except for forecasted transactions (must be designated as a cash flow hedge).
The objectives of hedge accounting is Marking assets and liabilities to
market, amortizing, in some fashion, the costs of the hedge instrument, matching
gains/losses of the exposure with the hedge, thus causing them to offset each
other.
In general, For instruments designated as fair value hedges, gains and
losses go directly to income, For instruments designated as cash flow hedges,
gains and losses are matched to the underlying exposure, with the rest going to
“other comprehensive income”. Designation as a fair value hedge is essentially
meaningless for exposed positions (and such designation creates lots of
paperwork). For exposed positions, cash flow hedge treatment is thus preferred
because losses are exactly matched to gains in the underlying exposure. As a
result, earnings is better smoothed.
Foreign Exchange Markets
Factors that drive the existence and level of discounts or premiums is Inflation
differences across nations, Occurence of transaction costs, opportunity costs, and also
the Expectations.
Foreign Exchange exist When a transaction occurs and exchange of goods and
services is made. (An exposed asset/liability position). It also occur when goods and
services are ordered and the firm is committed to sell or buy them (A firm commitment)
and also when it is known that goods and services will likely be sold or purchased in the
future (a forecasted FC transaction).

Translation of Foreign Currency Financial Statements

The Conceptual Issues of Translating Foreign Currency Financial Statements

consist of Foreign country operations usually prepare financial statements using local
currency as the monetary unit, these financial statements must be translated into home
country currency, these operations also typically use local GAAP. Financial statements
must be translated into home country GAAP.
The primary conceptual issues are Each financial statement item must be
translated using some, hopefully relevant, exchange rate. So, What rate should be used?
In the current exchange rate, the average exchange rate, or
the historical exchange rate. Given that any adjustment is, at the point of translation,
unrealized, how should the resulting adjustment be recognized? in current income or in
an equity account on the balance sheet.
Balance Sheet Exposure
Assets and liabilities translated at the current exchange rate are exposed to risk
of a translation adjustment. When foreign currency appreciates, a net asset exposure
results in a positive translation adjustment. When foreign currency appreciates, a net
liability exposure results in a negative translation adjustment. Assets and liabilities
translated at the historical exchange rate are not exposed to a translation adjustment.
Inflation differences caused the decline in the value of the euro if the inflation
differential was 10%, then Before, 1,000,000E = 1,000,000$ and now, 1,000,000E
=1,100,000$;
 Thus the direct exchange rate would be .9091 (1,000,000/1,100,000).
 Thus the TRUE value of the land, in euros, is now 1,100,000E. The valuation should
be 1100000*.9091 = 1,000,000$, i.e., no change.
The difference between these two examples was the receivable is a monetary
asset and the land is a non-monetary asset. If inflation drives foreign exchange rate
movements, and monetary/non-monetary assets are affected differently, how should FC
effects be accounted for? in the first case, the land is reported at current cost instead of
historical cost.

Methods devised to sort all this out:

 Current/noncurrent
 Monetary/non-monetary
 Temporal
 Current rate

Current/Noncurrent Method
Current assets and liabilities are translated at the current exchange rate.
Noncurrent assets and liabilities and stockholders’ equity accounts are translated at
historical exchange rates. There is no theoretical basis for this method. Method is
seldom used in any countries and is not allowed by U.S. GAAP or IFRSs. The receivable
would be classified as current and translated using the current rate. The land would be
classified as noncurrent and translated at the historical rate. The advantages simplistic.
Requires no more characterization of assets/liabilities than is already provided by the
financial statements. And the disadvantages can mismatch exchange rate with valuation
basis. Example: inventories, noncurrent marketable equity securities.

Monetary/Nonmonetary Method
Monetary assets and liabilities are translated at the current exchange rate.
Nonmonetary assets and liabilities and stockholders’ equity accounts are translated at
historical exchange rates. The translation adjustment measures the net foreign
exchange gain or loss on current assets and liabilities as if these items were carried on
the parent’s books. The receivable would be translated using the current rate. The land
would be translated at the historical rate, even is it were considered impaired and thus
reported at fair value. The advantages are easy to understand, makes intuitive sense.
And usually not difficult to classify assets and liabilities. The disadvantages are
valuation basis in accounting doesn’t always line up right with classification, producing
meaningless values. Examples: impaired assets, fixed assets revalued upwards, long
term liabilities such as bonds.

Temporal Method
Objective is to translate financial statements as if the subsidiary had been using
the parent’s currency. Items carried on subsidiary’s books at historical cost, including all
stockholders’ equity items are translated at historical exchange rates. Items carried on
subsidiary’s books at current value are translated at current exchange rates. Income
statement items are translated at the exchange rate in effect at the time of the
transaction. The receivable translated using the current rate. If reported at historical
cost, the land would be translated at the historical rate. If reported at fair value, the land
would be translated at the current rate. The advantages are lines up with valuation
basis used in accounting, thus the numbers have most meaning. The disadvantages are
lots of volatility in financial statements and possibility of disappearing assets in
inflationary economies.

Current Rate Method

Objective is to reflect that the parent’s entire investment in a foreign subsidiary is
expose to exchange risk. All assets and liabilities are translated at the current exchange
rate. Stockholders’ equity accounts are translated at historical exchange rates. Income
statement items are translated at the exchange rate in effect at the time of the
transaction. The receivable would be translated using the current rate. The land would
be translated at the current rate. The advantages are simple to do and the ratios are not
distorted. The disadvantages are can produce disparate results that are not consistent
with the economics that are really going on, and the Foreign Currency adjustment.

Hedging Balance Sheet Exposure

Companies that have foreign subsidiaries with highly integrated operations use
the temporal method. The temporal method requires translation gains and losses to be
recognized in income. Losses negatively affect earnings, and both gains and losses
increase earnings volatility. These gains and losses result from the combination of
balance sheet exposure and exchange rate fluctuations. Companies can also hedge to
offset the effects of the translation adjustment to equity under the current rate method.
Companies can hedge against gains and losses by using foreign currency forward
contracts, options, and borrowings.

For example, company has a large subsidiary in the EU. The subsidiary has a
large net asset position. The Euro depreciates more than 40%. Huge losses are reported.
The subsidiary’s sales and profits skyrocket, since they now seem more competitive to
customers than ever. How do we interpret reported FC gains and losses, irrespective of
where they show up? In a world of “floating rate” currency, sometimes a weak currency
is good, and a strong currency is bad! This explains why, when markets are tight or
declining, nations compete with each other in a race to devalue their money the most!
All kinds of problems arise when the value of money changes and is uncertain.
The economic impact of these changes vary as a function of the inherent cause of the FC
movement and the type of holding (asset/liability; monetary/non-monetary;
current/noncurrent). Accounting limitations (e.g., historical cost) mix with this
uncertainty, making financial reporting difficult at best. The current paradigm is SFAS
52. This could easily change at any time, as it has several times before.