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Chapter 12
FOREIGN CURRENCY CONCEPTS AND TRANSACTIONS
Comprehensive Chapter Outline
SINCE 1981, FASB STATEMENT NO, 52, “FOREIGN CURRENCY TRANSLATION,”
HAS PROVIDED STANDARDS OF ACCOUNTING FOR FOREIGN EXCHANGE
TRANSACTIONS AND FOREIGN OPERATIONS.
A Definitions of currencies from FAS 52:
1 An entity’s functional currency is the currency of the primary environment in
which it operates. This is normally the currency in which it generates and
expends cash. Company management determines the functional currency.
2 Foreign currency is a currency other than the entity’s functional currency.
3 Local currency is the currency of a particular country being referred to.
4 Reporting currency is the currency in which an enterprise prepares its financial
statements.
B FAS 52 identifies the objectives of translation as:
1 Providing information that is generally compatible with the expected economic
effects of a rate change on an enterprise’s cash flows and equity, and
2 Reflecting in consolidated statements the financial results and relationships of the
individual consolidated entities as measured in their functional currencies in
conformity with U.S. GAAP.
C A transaction is measured in a particular currency if its magnitude is expressed in that
currency and included in the financial records in that currency. Assets and liabilities are
denominated in a currency if their amounts are fixed in terms of that currency and will
be settled in that currency. For example, US Company buys merchandise from a
Mexican firm for 500,000 pesos, payable in 10 days. The transaction is denominated in
pesos. US Company must measure the purchase in US dollars before it can be
recorded. This is done through the use of exchange rates.
D An exchange rate is the ratio between a unit of one currency and the amount of another
currency for which that unit can be exchanged. From the viewpoint of a U.S. company:
1 A direct quotation is expressed in U.S. dollars. It is the U.S. dollar equivalent
of 1 unit of a foreign currency. A direct quotation for Mexican pesos might be
$.1333. The purchase denominated at 500,000 pesos is measured at $66,650
U.S. dollars (500,000 pesos x $.1333).
2 An indirect quotation is expressed in the foreign currency. It is the foreign
currency equivalents to one U.S. dollar. An indirect quotation for Mexican
pesos is expressed as 7.5019 pesos. The 500,000 pesos purchase is measured at
$66,650 (500,000 pesos / 7.5019 pesos).
3 A spot rate is the exchange rate for immediate delivery of currencies
exchanged.
4 The current rate is the rate at which one unit of currency can be exchanged for
another currency at the balance sheet date or the transaction date.
5 The historical rate is the rate in effect at the date a specific transaction or event
occurred.
FOREIGN EXCHANGE TRANSACTIONS OTHER THAN FORWARD CONTRACTS
A Foreign exchange transactions are transactions whose terms are denominated in a
currency other than an entity’s functional currency.
1 A foreign transaction is a transaction between entities in different countries.
The transaction is a foreign currency transaction only if it is denominated in a
foreign currency from a U.S. firm’s viewpoint.
2 International transactions denominated in U.S. dollars are not foreign currency
transactions from a U.S. firm’s viewpoint.
B FAS 52 requirements for foreign currency transactions:
1 The transaction is translated into U.S. dollars (the functional exchange rate for
the U.S. firm) at the spot rate in effect at the transaction date.
a An exchange gain or loss results when the exchange rate changes
between the transaction date and the settlement date.
b An exchange gain or loss occurs only when the transaction is
denominated in a foreign currency.
2 At the balance sheet date, recorded balances that are denominated in a foreign
currency are adjusted to the current exchange rate. The difference between the
recorded balance and the adjusted balance at the balance sheet date is the
exchange gain or loss to be included in current income.
FOREIGN CURRENCY DERIVATIVES AND HEDGING ACTIVITIES
A A hedging operation is the purchase or sale of a foreign currency contract to offset the
risks of holding receivables and payables denominated in a foreign currency. These
contracts are considered derivative instruments and accounted for according to FASB
Statement No. 133 “Accounting for Derivative Instruments and Hedging Activities”.
B A forward exchange contract (or future) is an agreement to exchange different
currencies at a specified future date and at a specified rate (the forward rate). Forward
or future exchange rates for 30-, 90-, and 180-day delivery are quoted daily for the
world’s leading currencies.
1 The accounting for forward exchange contracts depends on the nature and
purpose of the hedge.
2 FASB Statement No. 133 identifies speculations, fair value hedges, and cash
flow hedges.
C Fair value hedges:
1 Hedge of an exposed net asset position or net liability position:
a An exposed net assets position is an excess of assets denominated in
foreign currency over liabilities denominated in that currency and
translated at the current rate. To hedge the exposed net asset position, a
firm enters into a forward contract with an exchange broker to sell
foreign currency for future delivery.
(1) The contract receivable with the exchange broker will be stated in
U.S. dollars at the forward rate. This part of the contract will not
change with changes in the exchange rate. The contract payable
to the exchange broker is denominated in the foreign currency
and it is measured and recorded at the forward rate throughout
the life of the contract. Under FAS 52 provisions, receivables and
payables denominated in foreign currency must be adjusted to the
current spot rate at the balance sheet date. Thus, the contract
payable is adjusted to the forward rate at the balance sheet date
and the original account receivable is adjusted to the spot rate at
the balance sheet date.
(2) A gain or loss on the net asset position will be offset by the gain
or loss on the forward contract.
(3) The income effect of the hedge is the amount of the change in the
spot rate that is not exactly offset by a corresponding change in
the forward rate.
(4) The change in the derivative instrument must also be discounted
back from the maturity date since that is when the gain or loss
will actually occur.
b An exposed net liability position is an excess of liabilities denominated
in a foreign currency over assets denominated in the same currency and
translated at the current rate. To hedge the exposed net liability position,
a firm enters into a forward contract with the exchange broker to
purchase foreign currency for future receipt.
(1) In this case the contract receivable is denominated in foreign
currency. The contract payable is stated in U.S. dollars and both
are measured at the forward rate.
(2) The gain or loss on the original liability offsets the opposite gain
or loss on the contract receivable. The income effect occurs
when the change in the forward rate (at which the contract is
recorded) is not the same as the change in the spot rate (at which
the underlying liability is recorded).
2 Hedging an identifiable foreign currency commitment:
a A foreign currency commitment is a contract or agreement that will
result in a foreign currency transaction at a later date. The U.S. firm has
an exposure to exchange rate changes, but a commitment has not been
entered in the accounts as an asset or liability.
b A forward exchange contract is a hedge of an identifiable foreign
currency commitment if it is both intended and effective as a hedge of
the commitment and the commitment is firm.
(1) The forward exchange contract with the exchange broker is
initially recorded the same as a hedge of an exposed net asset or
liability position, and the contract receivable or payable
denominated in foreign currency must be adjusted on the balance
sheet date to the future rate at the balance sheet date.
(2) The recorded gain or loss on the hedge needs to be offset by a
corresponding gain or loss on the underlying transaction. Since
the underlying transaction is not recorded, a new account must be
set up to record the change in value of the unrecorded underlying
transaction.
(3) When the underlying firm commitment is executed, the change in
value is incorporated in the amount of the purchase or sale that
the company was hedging.
D Cash flow hedge: To hedge a forecasted foreign currency transaction.
1 With a forecasted transaction there is no grounds for adjusting a non-existent
underlying transaction. Still the derivative contract must be carried at fair value.
The offset to the change in the fair value of the derivative is, therefore, other
comprehensive income.
2 When the anticipated transaction comes to fruition, the other comprehensive
income account is closed into the purchase or sales amount. If the anticipated
transaction fails to materialize, the gain or loss is recognized in net income.
E Speculation: A forward exchange contract that speculates in foreign currency exchange
price movements is valued at forward rates throughout the life of the contract. All gains and
losses on the contract are included in current income.
Description of assignment material Minutes
Questions (13)
Exercises (16)
E12-1 6 MC general questions (FASB Statement No. 52 concepts) 12
E12-2 [Zimmer] Short answer questions 12
E12-3 [Rubbick] Journal entries for a purchase denominated in foreign currency 12
E12-4 [Littel] Determine exchange gain or loss for two years from sale 10
denominated in foreign currency
E12-5 [Alliance] Journal entries for a sale transaction using indirect quotations 10
E12-6 AICPA 4 MC problem-type questions 16
E12-7 [Monroe] Calculate exchange gain or loss at year end and at settlement 12
E12-8 [American TV] Journal entries (purchase and sale transactions, year- 20
end adjustments, and payment and collection of accounts)
E12-9 [Hayes] Journal entries for purchase transaction and forward contract 20
to hedge net liability position
E12-10 [Trendy] Computations (hedge of net liability position) 10
E12-11 [Imp] AICPA 3 MC problem type questions (forward contracts) 12
E12-12 [Bradley] Compute exchange gain or loss and balance of receivables 20
denominated in foreign currency at year-end
E12-13 [Kelly] Journal entries for purchase and sale transactions; sale and 20
related hedge of net asset position
E12-14 [Ace Foundry/Windsor] Journal entries for hedge of sale commitment 25
and settlement
E12-15 [Import Bazaar] Journal entry to record hedge of a purchase 10
commitment; also a question on year-end adjustment
E12-16 [Martin] Journal entries for speculation in Swiss francs 16
Problems (13)
P12-1 [Lincoln International] Calculate year-end exchange gain or loss; calculate 30
receivables and payables in balance sheet; journal entries
P12-2 [Baylor/Rameau] Journal entries at year end and collection 20
P12-3 [Shelton] Calculate receivables, payables, exchange gains and losses, and 20
account for a hedge of a net asset or liability amount
P12-4 [Worldwide] Journal entries for hedge of a sales commitment and settlement 22
P12-5 [Mercer] Journal entries to record settlement of receivables and payables 25
P12-6 [Flex-American] Journal entries to hedge a purchase commitment and 22
settlement
P12-7 [Bateman/Ramsay] Journal entries to hedge a foreign currency sales 22
commitment and settlement
P12-8 [Marlington] Journal entries to hedge a net liability position 25
P12-9 [Richmond-Davis] Journal entries (sales transaction and hedge of net asset 25
position)
P12-10 [Stuart-American] Schedule and computations (balance sheet and income 50
statement effects of foreign currency transactions including hedge of sale
commitment, speculation, and a purchase and related hedge)
P12-11 [Grandview] Computations of balance sheet and income statement effects of 50
foreign currency transactions (sale and related hedge, purchase and related
hedge, and hedge of purchase commitment)
P12-12 [Phillip/Slusser] Journal entries for 40% equity investment at book value and 30
related hedge of a net investment by a loan
P12-13 [Pepperell/Spinoza] Journal entries to hedge a net investment in a foreign 35
entity and account for the foreign investee
Internet Assignment
Using Xerox Corporation’s 2001 annual report from their website, answer questions relating to
derivative and foreign currency transactions.
Illustration 12-1
Overview of FASB Statement No. 52 Provisions
Relating to Foreign Currency Concepts and Transactions
OBJECTIVES OF TRANSLATION
* To provide information compatible with the expected economic effects of a rate change
on the cash flows and equity of an entity, and
* To measure the financial results and relationships of individual consolidated entities in
their functional currencies and reflect them in consolidated financial statements in
accordance with U.S. GAAP.
FOREIGN CURRENCY CONCEPTS
Functional currency – The currency of the primary environment in which an entity operates.
Generally, this is the currency in which the entity generates and expends cash.
Foreign currency – A currency other than the functional currency of the entity to which
reference is made.
Local currency – Currency of the country in which the entity is located.
Recording currency – Currency of the country in which the accounting records are maintained.
Reporting currency – Currency in which an enterprise prepares its financial statements. [Note
that enterprise refers to the firm preparing the combined, consolidated, or equity method
financial statements, i.e., the parent/investor company.]
CURRENCY EXCHANGE RATES
Spot rate – The exchange rate for immediate delivery of currencies exchanged.
Current rate – The rate at which one unit of currency can be exchanged for another currency at
the balance sheet date or the transaction date.
Historical rate – The rate in effect at the date a specific transaction or event occurred.
FOREIGN CURRENCY TRANSACTIONS
A transaction is a foreign currency transaction if its terms are denominated in a foreign
currency; that is, if its terms are fixed in a currency other than the entity’s functional currency.
FOREIGN CURRENCY TRANSACTIONS OTHER THAN FORWARD CONTRACTS
* Measured at the spot rate on the transaction date
* Adjusted to the current rate at the balance sheet date and gain or loss is recognized
* Upon settlement, gain or loss is recognized for the difference between the settlement
amount and the book value of the receivable or payable
DERIVATIVE INSTRUMENTS (FORWARD CONTRACTS) (FASB Statement No. 133)
TREATED AS A SPECULATION
* Measured at forward exchange rates during the contract life
* Gains and losses (discounted) are recognized currently based on forward exchange rates
* Upon settlement, gain or loss is recognized for the difference between the settlement
amount and the book value of the contract receivable or payable
FORWARD CONTRACTS TO HEDGE A NET ASSET OR LIABILITY POSITION
* Measured at forward exchange rates throughout the contract life
* Gains and losses are recognized currently, but they offset the gains and losses on the
related assets or liabilities (to the extent that the spot and forward rates move in tandem)
* Upon settlement, gains and losses are recognized as the difference between the settlement
amount and the book value of the contract receivable or payable
FORWARD CONTRACTS TO HEDGE AN IDENTIFIABLE COMMITMENT
* Measured at forward exchange rates throughout the contract life
* Gains and losses are recognized but an offsetting gain or loss is set up as a change in the
value of the underlying firm commitment
* Upon settlement, the change in the value of the firm commitment is treated as an
adjustment of the transaction amount
FORWARD CONTRACT TO HEDGE AN ANTICIPATED TRANSACTION
* No basis to adjust an anticipated transaction, however the derivative must be carried at fair
value
* The offset to the change in value of the derivative is recorded as other comprehensive
income
At fruition the other comprehensive income adjusts the underlying transaction amount.
If the anticipated transaction is cancelled, the gain or loss is transferred to net income.
Illustration 12-2
DIRECT AND INDIRECT QUOTATIONS
Direct quotation is expressed in U.S. dollars. It is the U.S. dollar equivalent of 1 unit of
a foreign currency.
An indirect quotation is expressed in the foreign currency. It is the foreign currency
equivalent of 1 U.S. dollar.
A direct quotation for French francs on October 31, 20X6 is $.20. One French franc
can be purchased for $.20.
$.20/1 = $.20
The indirect quotation for French francs on October 31, 20X6 is 5 francs. One U.S.
dollar can be purchased with 5 francs.
1/$.20 = 5 francs
INTERPRETATION OF FOREIGN EXCHANGE RATE CHANGES
Case 1
The British pound is quoted at $1.50 against the U.S. dollar on January 15, 20X6 and at
$1.40 on March 15, 20X6. Is the U.S. dollar strengthening or weakening against the
British pound?
The U.S. dollar is strengthening. The cost to a U.S. company of 1 British pound on
January 15 was $1.50, but only $1.40 on March 15.
Case 2
The German mark is quoted at $.45 on April 10, 20X7 and at $.50 on May 10, 20X7.
Is the dollar strengthening or weakening against the German mark?
The U.S. dollar is weakening. The cost of 1 mark on April 10 was $.45, but on May
10, it was $.50. Alternatively, a U.S. firm could have obtained 222 marks for $100 on
April 10, but only 200 marks for $100 on May 10.
