Chapter Six: Accounting and Reporting for Foreign Currency Transaction

Accounting Issues
Accountants must be able to record and report transactions involving exchanges of domestic
currencies and foreign currencies. Foreign currency transactions of a company include sales,
purchases, and other transactions giving rise to a transfer of foreign currency or the recording of
receivables or payables that are denominated —that is, numerically specified to be settled—in a
foreign currency. Because financial statements of virtually all companies are prepared using a
specific reporting currency, transactions denominated in other currencies must be restated to
their reporting currency equivalents before they can be recorded in the company’s books and
included in its financial statements. This process of restating foreign currency transactions to
their reporting currency–equivalent values is termed translation.
In addition, many large corporations have multinational operations such as foreign based
subsidiaries or branches. The foreign subsidiaries prepare their financial statements in their home
currencies. The foreign currency amounts in the financial statements of these subsidiaries have to
be translated, that is, restated, into their parent company currency equivalents before they can be
consolidated with the financial statements of the parent company's reporting currency unit.
When parties from two different nations transact business, they must settle on which currency
will be used to specify the payment amount. The currency used to settle the transaction is the
“denominated currency”. For example, if an American retailer purchases wine from a French
company. Will the amount paid be in Euros or U.S. dollars?
The decision as to which currency will be used as the denominated currency sets up whether the
seller or the buyer will bear the risk (or receive the benefit) as to changes in currency exchange
rates. For example, if the wine shipment will be paid for in U.S. dollars, and if the US dollar
drops in value vis-à-vis the Euro, then the US buyer will pay the amount anticipated in US
dollars. The French seller will get the agreed upon price in US dollars, but when the French
seller converts them into Euros, the French seller will get a lesser amount than was anticipated
when the contract was signed. Correspondingly, if the US dollar goes up in value vis-à-vis the
Euro, then the US buyer will still pay the amount anticipated in US dollars, but the French seller
converts those US dollars into Euros, the French seller will receive a greater amount of Euros
than was anticipated when the contract was signed. Because the contract is specified in a foreign
currency as far as the French company is concerned, the French company bears the burden and
receive the benefit of exchange rate fluctuations.
Foreign Currency Exchange Rates
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. The foreign currency exchange rates between currencies
are established daily by foreign exchange brokers serve as agents for individuals or countries
wishing to deal in foreign currencies. Some countries, such as China, maintain an official fixed
rate of currency exchange and have established fixed exchange rates for dividends remitted
outside the country.

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The Determination of Exchange Rates
A country’s currency is much like any other commodity, and exchange rates change because of a
number of economic factors affecting the supply of and demand for a nation’s currency. For
example, if a nation is experiencing high levels of inflation, the purchasing power of its currency
decreases. This reduction in the value of a currency is reflected by a decrease in the positioning
of that country’s currency relative to other nations’ currencies. Other factors causing exchange
rate fluctuations are a nation’s balance of payments, changes in a country’s interest rate and
investment levels, and the stability and process of governance.
Direct versus Indirect Exchange Rates
There are two ways to quote a foreign currency exchange rate.
 A “direct quote” specifies how many units of the domestic currency will be received for
one unit of the foreign currency.
 An “indirect quote” specifies how many units of the foreign currency will be received
for one unit of the domestic or “base” currency.
From the viewpoint of a Ethiopian entity:
Direct Exchange Rate Indirect Exchange Rate
Dollar to Birr Birr to Dollar
$1 = Br. 21.051 Br. 1 = $0.048
Spot Rates versus Current Rates
ASC 830 refers to the use of both spot rates and current rates for measuring the currency used in
international transactions. The spot rate is the exchange rate for immediate delivery of
currencies. The current rate is defined simply as the spot rate on the entity’s balance sheet date.
Forward Exchange Rates
The “forward rate” refers to an exchange of currency that will occur at a future point in time. An
agreement to exchange currencies at a specified price at a specified future point in time is a
“Forward Contract”. Active dealer markets in forward exchange contracts are maintained for
companies wishing to either receive or deliver major international currencies. The forward rate
on a given date is not the same as the spot rate on the same date. Expectations about the relative
value of currencies are built into the forward rate. The difference between the forward rate and
the spot rate on a given date is called the spread . The spread gives information about the
perceived strengths or weaknesses of currencies.
Foreign Currency Transactions
Foreign currency transactions are economic activities denominated in a currency other than the
entity’s recording currency. These include:
Purchases or sales of goods or services (imports or exports), the prices of which are stated
in a foreign currency
Loans payable or receivable in a foreign currency
Purchase or sale of foreign currency forward exchange contracts
Purchase or sale of foreign currency units

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If a domestic Company deals with a foreign Company and the contract is denominated in
domestic currency, then the domestic Company is not exposed to any foreign currency risks. If,
however, the contract is denominated in the foreign currency, then the domestic Company is
exposed to a foreign currency risk. The change in the domestic currency determines if there is an
exchange gain or loss.
For financial statement purposes, transactions denominated in a foreign currency must be
translated into the currency the reporting company uses. At each balance sheet date, account
balances denominated in a currency other than the entity’s reporting currency must be adjusted to
reflect changes in exchange rates during the period. The adjustment in equivalent domestic
currency values is a foreign currency transaction gain or loss for the entity when exchange rates
have changed.
Illustration: Assume that a US Company sells mining equipment to a British Company on June
1, 2004 with the corresponding receivable to be paid or settled on July 1, 2004. The equipment
has a selling price of US$306,000 and a cost of US$250,000. On June 1, 2004, the British pound
is worth US$1.70, and on July 1, 2004, the pound is worth US$1.60. Record the transaction in
the books of US Company and British Company assume the payment is to be made:
In US dollars, and
In British Pounds
Assume the payment is to be made in US dollars, and the British company bears the foreign
currency risk.
June 1, 2004:
US Company British Company
Accounts receivable ……. $306,000 Plant, pro. & equ ….. £180,000
Sales …........................... $306,000 Accounts Payable .... £180,000
($306,000/1.70 = £180,000)
Cost of goods sold ……. $250,000
Inventory …........................... $250,000
July 1, 2004:
US Company British Company
Cash ……..................... $306,000 Accounts Payable ….. £180,000
Accounts receivable....... $306,000 Exchange loss ............ 11,250
Cash ..................... £191,250
($306,000/1.60 = £191,250)
Assume the payment is to be made in British pounds, and the US company bears the foreign
currency risk.
June 1, 2004:
US Company British Company
Accounts receivable ……. $306,000 Plant, pro. & equ ….. £180,000
Sales …........................... $306,000 Accounts Payable .... £180,000
($306,000/1.70 = £180,000)
Cost of goods sold ……. $250,000

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 Inventory …........................... $250,000
July 1, 2004:
US Company British Company
Cash ……..................... $288,000 Accounts Payable ….. £180,000
Exchange loss ............ 18,000 Cash .....................
£180,000
Accounts receivable....... $306,000
(£180,000 x 1.60 = $288,000)
Foreign currency import and export transactions – Required accounting overview (assuming the
company does not use forward contracts):
Transaction date: Record the purchase or sale transaction at the domestic currency
equivalent value using the spot direct exchange rate on this date.
Balance sheet date: Adjust the payable or receivable to its domestic currency
equivalent, end-of-period value using the current direct exchange rate and recognize any
exchange gain or loss for the change in rates between the transaction and balance sheet
dates.
Settlement date: Adjust the foreign currency payable or receivable for any changes in
the exchange rate between the balance sheet date (or transaction date) and the settlement
date, recording any exchange gain or loss as required and record the settlement of the
foreign currency payable or receivable
The FASB established that foreign currency exchange gains or losses resulting from the
revaluation of assets or liabilities denominated in a foreign currency must be recognized
currently in the income statement of the period in which the exchange rate changes.
Illustration: On December 16, 2014, Motor Corporation, an Ethiopian firm, purchased
merchandise from Wing Company, US Company for $30,000 to be paid on January 15, 2015.
Relevant exchange rates for US dollar are as follows:
December 16, 2014: Br. 20.50
December 31, 2014: Br. 20.90
January 15, 2015: Br. 20.75
Required: Prepare all journal entries on Motor Corporation’s books to account for the above
transaction.
December 16:
Purchase inventory on account:
Inventory ………………. Br. 615,000
Accounts Payable ....……… Br. 615,000
Accounts payable = Br. 615,000 = 30,000 × Br. 20.50 Dec. 16 spot rate.

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December 31:
Adjust payable denominated in dollar to current Birr–equivalent value using the spot rate:
Exchange Loss …................ Br. 12,000
Accounts Payable ……..…… Br. 12,000
Exchange loss = Br. 12,000 = (Br. 20.90 – Br. 20.50) x $30,000
January 15:
Pay $30,000 to US Company, in settlement of liability denominated in dollar.
Accounts Payable ……………Br. 627,000
Cash ……....................…… Br. 622,500
Exchange gain .................... Br. 4,500
Cash paid = Br. 622,500 = Br. 20.75 x $30,000 Jan. 15 spot rate
Exchange gain = Br. 12,000 = (Br. 20.75 – Br. 20.90) x $30,000

Managing International Currency Risk with Foreign Currency Forward Exchange

Financial Instruments
Companies operating internationally are subject not only to normal business risks but also to
additional risks from changes in currency exchange rates. Therefore, multinational enterprises
(MNEs) often use derivative instruments, including foreign currency–denominated forward
exchange contracts, foreign currency options, and foreign currency futures, to manage risk
associated with foreign currency transactions.
The accounting for derivatives and hedging activities is guided by ASC 815. A financial
instrument is cash, evidence of ownership, or a contract that both (1) imposes on one entity a
contractual obligation to deliver cash or another instrument and (2) conveys to the second entity
that contractual right to receive cash or another financial instrument. Examples include cash,
stock, notes payable and receivable, and many financial contracts.
A derivative is a financial instrument or other contract whose value is “derived from” some other
item that has a variable value over time. An example of a derivative is a foreign currency
forward exchange contract whose value is derived from changes in the foreign currency
exchange rate over the contract’s term.
Derivatives Designated as Hedges
Derivatives may be designated to hedge or reduce risks. Some companies obtain derivatives that
are not designated as hedges but as speculative financial instruments. For example, a company
may enter into a forward exchange contract that does not have any offsetting intent. In this case,
the gain or loss on the derivative is recorded in periodic earnings.
Hedge accounting offsets the gain (loss) on the hedged item with the loss (gain) on the hedging
instrument. Hedges are applicable to (1) foreign currency exchange risk in which currency
exchange rates change over time; (2) interest-rate risks, particularly for companies owing
variable-rate debt instruments; and (3) commodity risks whose future commodity prices may be
quite different from spot prices.

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Forward Contracts
As noted above, Forward Contract is a contract to buy or sell a specified amount of an asset at a
specified price at a specified future date. The current price for the asset is the spot price, and the
price specified in the Forward Contract is the forward price. The initial value of a forward
contract is zero and it does not usually require an initial outlay of cash. This is because a
Forward Contract is a fair deal. The values assigned to the currencies reflect what everyone
agrees are today’s market prices for those currencies.
Options
An Option represents the right (not the obligation) to either buy (Call Option) or sell (Put
Option) a specified amount of an asset at a specified price at a specified future date. This price
specified in the option is referred to as the strike price or the exercise price. You have to pay
something for the Option. This is because this is not a fair deal on its face. You are being given
the right to buy/sell something. With the Forward Contract, you had the obligation to buy/sell
something at an agreed upon price. You had to do the deal. Here, you don’t have to do the deal.
You have the right to do the deal if it makes sense, or you can walk away.
Types of Hedges
Derivatives can be used to avoid the exposure to risk by hedging against an unfavorable outcome
associated with rate/price changes. Hedges are classified as either “fair value hedges” or “cash
flow hedges”.
A fair value hedge is used to offset changes in the fair market value of items with fixed prices or
rates. It designated to hedge the exposure to potential changes in the fair value of:
a. A recognized asset or liability such as available-for-sale investments or
b. an unrecognized firm commitment for which a binding agreement exists, such as to buy
or sell inventory.
The net gains and losses on the hedged asset or liability and the hedging instrument are
recognized in current earnings on the income statement.
A cash flow hedge is used to establish fixed prices or rates when future cash flows could vary
due to changes in prices or rates. It designated to hedge the exposure to potential changes in the
anticipated cash flows, either into or out of the company, for
a. A recognized asset or liability such as future interest payments on variable-interest debt
or
b. A forecasted cash transaction such as a forecasted purchase or sale.
A forecasted cash transaction is a transaction that is expected to occur but for which there is not
yet a firm commitment. Thus, a forecasted transaction has no present rights to future benefits or a
present liability for future obligations.

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Fair Value Hedge – Using a Forward Contract
Companies entering into business transactions involving foreign currency exchange risks could
eliminate that risk by settling the transaction immediately (e.g., paying immediately or requiring
immediate payment).
If immediate settlement is not practical, then a company can hedge against the exchange risk by
purchasing a Forward Contract to acquire the needed foreign currency. The reason why the
hedge works is that you started with an asset (or a liability) that is tied to foreign currency (e.g.,
an account payable). You then buy a liability (or an asset) that is tied to the same amount of
foreign currency (e.g., an account receivable). Since you now have both an asset and a liability
that are both tied to the same amount of foreign currency. If the value of that foreign currency
goes up, you owe more (the liability) but you have more (the asset). The net difference in your
position is zero; hence a hedge.
Illustration: Assume that on November 1, 2012, a US company purchases inventory from a
Canadian vendor with subsequent payment due in Canadian dollars. Payment of CAN $ 100,000
is required on February 1, 2013. The US company is willing to pay the account payable to the
Canadian company at today’s exchange rates, but it afraid that the Candian dollar will go up vis-
à-vis the US dollar, and it doesn’t want to take a chance that this may happen. To protect itself
from foreign currency exchange risk, the US company purchased a Forward Contract to purchase
Canadian dollars. On November 1, 2012, the US company purchased a forward contract to buy
CAN $ 100,000 at a forward rate of 1 CAN $ = US$0.506.
Selected spot and forward rates are as follows:
Forward Rate for remaining
Date Spot Rate Term of Contract
Nov. 1, 2012 CAN $ = U.S $0.50 CAN $ = U.S $0.506
Dec. 31, 2012 CAN $ = U.S $0.52 CAN $ = U.S $0.530
Feb. 1, 2013 CAN $ = U.S $0.55 CAN $ = U.S $0.550
If the US company had not hedged its position, it would have lost $5,000. This is because the US
company has to pay CAN$100,000 on February 1, 2013. The US company has to buy the needed
Canadian dollars at that time. On February 1, 2013, the exchange rate is 1 CAN$ = U.S. $0.55.
The US company will have to pay the equivalent of US $55,000 (100,000 x 0.55). Since the
original payable was for US$ 50,000, the US company had a Exchange Loss of US$ 5,000 on the
payable. This loss will still be reflected on the books of the US company despite the hedge.
With the hedge, the US company has purchased an asset, which is the receivable under the
Forward Contract. That receivable represents the value of CAN $100,000. On February 1, 2013,
the Forward Contract receivable will be worth US$55,000 (100,000 x 0.55). The US company
bought this asset for US$50,600. Therefore, it has a gain of US$4,400 on the Forward Contract.
When you net the Exchange Loss ($5,000) and Forward Contract Gain ($4,400), you have a loss
of $600. This loss represents the cost of the hedging transaction (US$ 600).

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Forward Contract Fair Value Hedge – Straddling 2 Years
When the business transaction straddles two years, the cost of the hedge is split between the two
years. At the end of the year, we will book the Exchange Loss and we will book a Forward
Contract Gain (or an Exchange Gain coupled with a Forward Contract Loss). At the end of the
year, the amount of the Forward Contract Gain (or loss) is the difference between: (i) the price
(specified in the Forward Contract) that you locked in, and (ii) the price others would have to
agree to at the end of the year if they executed a new Forward Contract (for delivery of CAN
$100,000 at the same date as the original contract). Since the prices in the Forward Contracts are
paid in the future, the difference represents a gain that is in future dollars. You need to take the
present value of that gain in order to calculate the Forward Contract Gain at the end of the year.
Continue with the previous illustration. We will discount the changes in the value of the forward
contract at a 6% rate. The Forward Contract Gain is calculated as follows:
Buying FC December 31
Price Others Would Pay at end of year for Forward Contract........................ $53,000
(100,000 x 0.53)
Less: Price Locked in on Original Forward Contract ..................................... (50,600)
(100,000 x 0.506)
Difference in Forward Rates: .......................................................................... $2,400
Forward Contract Gain using 6% discount rate .............................................. $2,388
(PVIF = 0.995025)
Less: Matching Forward Contract Gain Tied To The Exchange ..................... (2,000)
Loss ($0.52 - $0.50) x 100,000
Cost of the Hedge in 2012(Remaining Gain) ................................................... $388

We are going to do the same calculation at the settlement date (February 1, 2013).

Buying FC February 1
Value of Foreign Currency at end of Forward Contract .............................. $55,000
(0.55 x 100,000)
Price You have to Pay for Foreign Currency under the Forward ................ ($50,600)
Contract (100,000 x 0.506)
Total Forward Contract Gain ........................................................................ $4,400
Less: Forward Contract Gain Booked in 2012 .............................................. (2,388)
Forward Contract Gain Applicable to 2013 ................................................... $2,012
Less: Matching Forward Contract Gain Tied To Exchange Loss in ............. (3,000)
2013 ($0.55 - $0.52) x 100,000]
Cost of Hedge in 2013 ................................................................................... ($988)

The gain for 2012 ($388) plus the loss for 2013 (-$988) equals the $600 cost of the hedging
transaction

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The journal entries relating to this transaction are as follows:
November 1, 2012:
To record purchase inventory on account:
Inventory ………...………. 50,000
Accounts Payable …….....… 50,000
$50,000 = CAN$100,000 × $0.50 November 1 spot rate.
To record purchase forward contract:
Forward contract Receivable ….......... 50,600
Forward contract Payable($) ……………….. 50,600
$50,600 = CAN$100,000 × $0.506 forward rate.
The required adjusting entries on December 31, 2012
Record the Exchange Loss from the increase in the Canadian dollar:
Exchange Loss …...................... 2,000
Accounts Payable ……………… 2,000
$2,000 = ($0.52 – $0.50) x CAN$100,000
Record a matching Forward Contract “Gain” (exactly equal to the Exchange Loss) on the
Forward Contract:
Forward contract Receivable …....……… 2,000
Unrealized gain on forward contract …...… 2,000
$2,000 = ($0.52 – $0.50) x CAN$100,000
First, we book a Forward Contract Gain exactly equal to the Exchange Loss. This
represents the hedging portion of the Forward Contract. Whatever is left of the Forward
Contract Gain is then recognized as a cost of the hedge in 2012.
Forward contract Receivable …....……… 388
Unrealized gain on forward contract …...… 388
February 1, 2013:
Record the Matching Forward Contract “Gain”:
Forward Contract Receivable ............................ $3,000
Unrealized Gain on Forward Contract ............... $3,000
$3,000 = ($0.55 – $0.52) x CAN$100,000
Record the receipt of the Foreign Currency under the Forward Contract:
Foreign Currency .................................... $55,000
Forward Contract Receivable ................. $55,000
Record the payment of the Forward Contract payable:
Foreign Contract Payable ........... $50,600
Cash ................................................ $50,600

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 Record the Payment of the Account Payable with the Foreign Currency. Also, recognize
the Exchange Loss from the increase in the Canadian dollar:
Accounts Payable ...................................... $52,000
Exchange Loss [(0.55 - 0.52) x 1,000] ...... 3,000
Foreign Currency ........................................ $55,000
In 2013, the Forward Contract Gain is $2,012, but we created a matching Forward Contract
“Gain” of $3,000. This creates a greater gain than we really had, we have to book a loss now to
bring the Forward Contract Gain down to the actual gain of $2,012. This requires booking a loss
of $988 ($3,000 - $2,012). This is the cost of the hedge in 2013:
Loss on Forward Contract (Cost of Hedge) ......... $988
Forward Contract Receivable ........................... $988

The net effect of all the gains and losses for this transaction is the US$ 600 cost of the hedging
transaction:
Exchange Loss - 2012 ................................................. ($2,000)
Unrealized Gain on Forward Contract - 2012 ............. 2,000
Exchange Loss - 2013 .................................................. (3,000)
Unrealized Gain on Forward Contract - 2013 .............. 3,000
Cost of Hedge - 2012 .................................................... 388
Cost of Hedge - 2013 .................................................... (988)
Net Effect (Net Cost of Hedge) .................................... ($600)

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