Chapter 6. Forgein Currency Transactions

INTERNATIONAL SCHOOL
Ha Noi National University

http://is.vnu.edu.vn/
CHAPTER 6:
FOREIGN CURRENCY
TRANSACTIONS AND HEDGING
FOREIGN EXCHANGE RISK
Hanoi, 2020
.VNU.EDU.VN - HTTP://IS.VNU.EDU.VN - HTTP://IS.VNU.EDU.VN
CHAPTER TOPICS
• Foreign exchange markets
• Foreign exchange risk
• Accounting for foreign currency transactions
• Hedging
• Foreign currency forward contracts and options
• Accounting for hedges
• Cash flow hedges and fair value hedges
LEARNING OBJECTIVES
1. Provide an overview of the foreign exchange market.

2. Explain how fluctuations in exchange rates give rise to
foreign exchange risk.
3. Demonstrate the accounting for foreign currency
transactions.
4. Describe how foreign currency forward contracts and
foreign currency options can be used to hedge foreign
exchange risk.
5. Describe the concepts of cash flow hedges, fair value
hedges, and hedge accounting.
6. Demonstrate the accounting for forward contracts and
options used as cash flow hedges and fair value hedges to
hedge foreign currency assets and liabilities, foreign
currency firm commitments, and forecasted foreign
currency transactions. INTERNATIONAL SCHOOL
FOREIGN EXCHANGE MARKETS
Foreign exchange markets
• Each country uses its own currency as the unit value for
purchase and sale of goods or services. E.g. USD, VND,…
• Purchase price of a foreign currency-- e.g., in February 2010

it cost about 0.08 U.S. dollars (eight cents) to purchase one
Mexican peso.
• From 1945 to 1973 countries had exchange rates fixed to

the U.S. dollar.
• Balance-of-payments deficits in the U.S. during the 1960s

doomed this system, so, by March 1973 most currencies
were allowed to float in value.
Learning Objective 1 INTERNATIONAL SCHOOL
 Exchange Rate Mechanisms

Today, several different currency arrangements exist. The following
are some of the more important ones and the countries they affect:
• Independent float – currency value allowed to move freely with

little government intervention.
• Pegged to another currency – currency value fixed (pegged)

in terms of a particular foreign currency (e.g., U.S. dollar), and
central bank intervenes to maintain the exchange rate.
• European Monetary System (Euro)- EU countries use a

single currency, which floats against other currencies such as
the U.S. dollar.
Foreign Exchange Rates
• Exchange rates between U.S. dollar and most foreign currencies,

are published in many places on the internet and in newspapers.
• Exchange rates are reflected both as US $ equivalent (direct
quotes) and currency per US $ (indirect quotes).
• For example, on February 16, 2010 the direct quote for a Euro
was $1.3605 and the indirect quote was €0.7350. As a point of
comparison, the direct quote when the Euro first appeared in
1998 was approximately $1.17 and the indirect quote was
approximately €0.85.
• A direct quote is the reciprocal of an indirect quote and vice-
versa.

EXHIBIT 7.1
Foreign Exchange Rates U.S. Dollar per
Foreign Currency
Spot rates and Forward rates
• Spot rate – today’s price for purchasing or selling a foreign

currency.
• Forward rate – today’s price for purchasing or selling a

foreign currency for some future date.
 Premium -- when the forward rate is greater than the spot

rate for a particular day.
 Discount -- when the forward rate is less than the spot rate
for a particular day.
Example:

Option contracts
Foreign currency option – gives the right, but not the

obligation, to trade foreign currency in the future. It includes:
• Put option – the option to sell the foreign currency.
• Call option – the option to buy the foreign currency.
• Strike price – the exchange rate at which currency will be

exchanged when option is exercised. The strike price is
similar to a forward rate.

Option contracts
• Option premium – cost of purchasing the option, which is a

function of the option’s intrinsic value and time value.
• Intrinsic value – is the gain that could be made by

immediate exercise of the option.
• Time value – the value that derives from the fact that the
currency value could increase during the remainder of the
option period.

FORGEIN CURRENCY TRANSACTIONS
The transaction exposure can be summary as follows:
• Export sale – a company sells to a foreign customer and

later receives payment in the customer’s currency.
• Import purchase – a company purchases from a foreign

supplier and later pays in the supplier’s currency.
 Foreign exchange risk – the chance that the exporter will

receive less or that the importer will pay more than anticipated
as a result of a change in the exchange rate.

Example
• A Inc., a U.S. company, makes a sale and ships goods to B,

SA, a Mexican customer.
• Sales price is $100,000 (U.S.) and A allows B to pay in pesos

in 30 days.
• The current exchange rate is $0.10 per 1 peso in day 1.
• Joe plans to receive 1,000,000 pesos ($100,000/$0.10).

• Joe has foreign exchange risk exposure because he may

receive less than $100,000.
• Suppose the peso decreases such that in 30 days the

exchange rate is $0.09 per 1 peso.
• Joe will receive 1,000,000 pesos which will be worth

$90,000 (1,000,000 x $0.09) and Joe receives $10,000 less
due to exchange rate fluctuation.

Accounting – sale transaction
One transaction perspective
• Treats sale and collection as one transaction.
• Transaction is complete when foreign currency is received

and converted, and sale is measured at converted amount.
• This approach is not allowed under IAS or U.S. GAAP.

Instead, IAS 21 require companies to use a two-transaction
perspective.

ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS
Two transaction perspective
• Treats sale and collection as two transactions
• Sale is one transaction and collection is a 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.

ACCOUNTING FOR FOREIGN CURRENCY
TRANSACTIONS
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.

• Day 1.
Dr Account Receivable $100.000
Cr Sales $ 100.000
Day 30
1) Dr Cash/bank $110.000
Cr Gain on ER $ 10.000
Cr A/R $100.000
2) Dr Cash/Bank $90.000
Dr Loss on ER $10.000
Cr A/R $100.000
TRANSACTIONS
Transaction types, exposure type and gain or loss – import
purchases
• Import purchase  liability exposure -- if foreign currency
appreciates  foreign exchange loss.(expense)
• Import purchase  liability exposure -- if foreign currency

depreciates  foreign exchange gain. (income)

TRANSACTIONS
Export sale – example 1
• February 1, 2011, Joe Inc., a U.S. company, makes a
sale and ships goods to Jose, SA, a Mexican customer.
• Sales price is $100,000 (U.S.).
• Jose agrees to pay in pesos on March 2, 2011.
• Assume spot rate as of February 1, 2011 is $0.10 per

peso.

Day 1.
Dr Goods $100.000
Cr Account Payable $100.000
Day 30.
Dr Account payable $100.000
Dr Loss on $10.000
Cr Cash/bank $110.000

TRANSACTIONS
Joe, Inc. records the sale (in U.S. $) on February 1, 2011 as

follows:
Accounts Receivable 100,000

Sales 100,000

TRANSACTIONS
On March 2, 2011, the spot rate is $0.09 per peso.

Joe Inc. will receive 1,000,000 pesos, which are now worth
$90,000. Joe makes the following journal entry:
Cash 90,000
Foreign Exchange Loss 10,000


TRANSACTIONS
Balance Sheet Date before Date of Payment
Example:
Company A sold and shipped goods to customer B on
December 1, Year 1, with payment to be received on March
1, Year 2. Assume that:
- Spot rate at Dec 1, Year 1 for euros: $1.50
- Sport rate at Dec 31, Year 1 for euros: $ 1.51
? ? Is any adjustment needed at Dec 31, Year 1 ?
Yes

TRANSACTIONS
Assume the following facts are added or changed:
• Joe Inc., makes sale and ships goods on December 1, 2010

with payment will be received on March 2, 2011 with rate
$0.09
• Spot rate as of December 1, 2010 is $0.11 per peso.
• Spot rate as of December 31, 2010 is $0.105 per peso.
• Joe Inc. has a December 31 year end.

? How is adjustment needed at Dec 31, 2010 ?

TRANSACTIONS
Joe, Inc. records the sale (in U.S. $ 100,000) on December

1, 2010 and the foreign exchange loss on December 31,
2010 as follows:
• December 1, 2010
Accounts Receivable $110,000
Sales $110,000
To record the sale and U.S received (1.000.000 peso) at
sport rate $0.11
• December 31, 2010
Foreign Exchange Loss $5,000
Accounts Receivable $5,000
To adjust the value of U.S received at the rate $0.105

TRANSACTIONS
Joe, Inc. records the receivable collection and an additional

foreign exchange loss on March 2, 2011:
Cash 90,000
Foreign Exchange Loss 15,000
To record the received U.S of 1000,000 peso at the rate

$0.09

HEDGING FOREIGN EXCHANGE RISK
• Hedging
– Protects from exchange rate fluctuations
– Foreign currency forward contracts
– Foreign currency options
• Foreign currency forward contract
– Buy or sell foreign currency
– Future date
• Foreign currency option
– Right to buy or sell foreign currency
– For a period of time

Hedging risk on an export sale – example 1
• Previously, Joe Inc. lost $20,000 without hedging as the

peso fell from $0.11 to $0.09.
• The loss was ($0.11 - $0.09) x 1,000,000 pesos.
• Joe could have purchased a foreign currency forward

contract on December 1, 2010.

• Under the contract, Joe would have agreed to sell 1,000,000

pesos for $0.105 on March 2, 2011.
• In this case, Joe would have collected $105,000 rather than

$90,000.
• Instead of a $20,000 foreign exchange loss, Joe would have

paid a $5,000 premium on the forward contract.

• Previously, Joe Inc. lost $20,000 without hedging as the

peso fell from $0.11 to $0.09.
• The loss was ($0.11 - $0.09) x 1,000,000 pesos.
• Joe could have purchased a foreign currency option on

December 1, 2010.
• The option premium is $4,000.

• Joe would now have the option sell 1,000,000 pesos for
$0.11 on March 2, 2011.
• In this case Joe would have collected $110,000 rather than

$90,000.
• Instead of a $20,000 foreign exchange loss, Joe would have

paid $4,000 for the option.

CASH FLOW HEDGES, FAIR VALUE HEDGES,
AND HEDGE ACCOUNTING
• Hedge accounting – an offsetting gain or loss from the
hedge is recognized in net income during the same period
as the gain or loss from the hedged item.
• Cash flow hedge – an accounting designation for hedges

that offset variability in cash flows of hedged items.
• Fair value hedge – an accounting designation for hedges

that offset the variability in fair value of hedged assets and
liabilities.

HEDGE ACCOUNTING
Hedge accounting examples

1. FC asset/forward contract/cash flow hedge.
2. FC asset/forward contract/fair value hedge.
3. FC asset/option/cash flow hedge.
4. FC firm commitment/forward contract/fair value hedge.
5. FC firm commitment/option/fair value hedge.
6. Forecasted FC transaction/option/cash flow hedge.

HEDGE ACCOUNTING
Assumptions for examples 1 and 2
• December 1, 2010, Joe Inc., a U.S. company, makes a sale

and ships goods to Jose, SA, a Mexican customer.
• Sales price is $110,000 (U.S.).
• Jose agrees to pay 1,000,000 pesos on March 2, 2011.
• Spot rates per peso are: December 1, 2010, $0.11,

December 31, 2010, $0.10, and March 2, 2011, $0.095.
• The annual interest rate is 6% (0.5% per month).

HEDGE ACCOUNTING
• Joe enters a foreign currency forward contract on

December 1, 2010.
• The contract calls for Joe to sell 1,000,000 pesos at a

forward rate of $0.105, on March 2, 2011.
• The forward rate on December 31, 2010 for March 2,

2011 delivery is $0.096.

HEDGE ACCOUNTING
Example 1, FC asset/forward/cash flow hedge

12/01/10
Accounts receivable 110,000
Sales 110,000
12/31/10
Foreign exchange loss 10,000
Accumulated Other Comprehensive Income 10,000
Gain on forward contract 10,000

HEDGE ACCOUNTING

12/31/10
Forward contract 8,911
Discount expense* 1,667
(*discount expense is amortized using the straight-line method)

HEDGE ACCOUNTING

3/02/11

HEDGE ACCOUNTING

3/02/11
Discount expense 3,333
Accumulated Other Comprehensive Income
3,333
Foreign currency 95,000
Cash 105,000

HEDGE ACCOUNTING
Example 2, FC asset/forward/fair value hedge

12/01/10
Sales 110,000
12/31/10

HEDGE ACCOUNTING

3/02/11


HEDGE ACCOUNTING

3/02/11
Cash 105,000

End of Chapter 6
Ha Noi National University
http://is.vnu.edu.vn/

Chapter 6. Forgein Currency Transactions

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INTERNATIONAL SCHOOL

Ha Noi National University

• Foreign exchange markets

• Foreign exchange risk

• Accounting for foreign currency transactions

• Foreign currency forward contracts and options

• Accounting for hedges

• Cash flow hedges and fair value hedges

1. Provide an overview of the foreign exchange market.

FOREIGN EXCHANGE MARKETS

Foreign exchange markets

• Purchase price of a foreign currency-- e.g., in February 2010

• From 1945 to 1973 countries had exchange rates fixed to

• Balance-of-payments deficits in the U.S. during the 1960s

FOREIGN EXCHANGE MARKETS

 Exchange Rate Mechanisms

• Independent float – currency value allowed to move freely with

• Pegged to another currency – currency value fixed (pegged)

• European Monetary System (Euro)- EU countries use a

FOREIGN EXCHANGE MARKETS

Foreign Exchange Rates

• Exchange rates between U.S. dollar and most foreign currencies,

Learning Objective 1 INTERNATIONAL SCHOOL

• Spot rate – today’s price for purchasing or selling a foreign

• Forward rate – today’s price for purchasing or selling a

 Premium -- when the forward rate is greater than the spot

Learning Objective 1 INTERNATIONAL SCHOOL

Foreign currency option – gives the right, but not the

• Put option – the option to sell the foreign currency.

• Call option – the option to buy the foreign currency.

• Strike price – the exchange rate at which currency will be

Learning Objective 1 INTERNATIONAL SCHOOL

FOREIGN EXCHANGE MARKETS

• Option premium – cost of purchasing the option, which is a

• Intrinsic value – is the gain that could be made by

Learning Objective 1 INTERNATIONAL SCHOOL

FORGEIN CURRENCY TRANSACTIONS

The transaction exposure can be summary as follows:

• Export sale – a company sells to a foreign customer and

• Import purchase – a company purchases from a foreign

 Foreign exchange risk – the chance that the exporter will

Learning Objective 2 INTERNATIONAL SCHOOL

FORGEIN CURRENCY TRANSACTIONS

• A Inc., a U.S. company, makes a sale and ships goods to B,

• Sales price is $100,000 (U.S.) and A allows B to pay in pesos

• The current exchange rate is $0.10 per 1 peso in day 1.

• Joe plans to receive 1,000,000 pesos ($100,000/$0.10).

Learning Objective 2 INTERNATIONAL SCHOOL

FORGEIN CURRENCY TRANSACTIONS

• Joe has foreign exchange risk exposure because he may

• Suppose the peso decreases such that in 30 days the

• Joe will receive 1,000,000 pesos which will be worth

Learning Objective 2 INTERNATIONAL SCHOOL

FORGEIN CURRENCY TRANSACTIONS

Accounting – sale transaction

One transaction perspective

• Treats sale and collection as one transaction.

• Transaction is complete when foreign currency is received

• This approach is not allowed under IAS or U.S. GAAP.

Learning Objective 3 INTERNATIONAL SCHOOL

ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS

Two transaction perspective

• Treats sale and collection as two transactions

• Sale is one transaction and collection is a second