Advanced Accounting Test 3
An option with a positive intrinsic value is said to be
"in-the-money."
Two major translation methods are currently used:
(1) the current rate method and (2) the temporal method.
Fair value of a forward contract at balance sheet date
(Initial forward rate - current forward rate)dollar value * present value factor for two months
Fair value of a forward contract at the end date
(initial forward rate - current forward rate[current forward rate is equal to the spot rate at that date by definition])*initial value
The following rule is consistent with the temporal method's underlying objective:
1.Assets and liabilities carried on the foreign operation's balance sheet at historical cost are translated at historical exchange rates to yield an equivalent historical cost in U.S. dollars. 2.Conversely, assets and liabilities carried at a current or future value are translated at the current exchange rate to yield an equivalent current value in U.S. dollars.
foreign currency options
A foreign currency option gives the holder of the option the right but not the obligation to trade foreign currency in the future
Export sale Transaction Exposure
A transaction exposure exists when the exporter allows the buyer to pay in a foreign currency and allows the buyer to pay sometime after the sale has been made. (Note that there is no exposure to foreign exchange risk if the exporter requires the foreign customer to make payment on the date of sale)
Export sale Asset (receivable) What happens if Foreign Currency appreciates/Depreciates?
Appreciates: Gain Depreciates: Loss
Import purchase Liability (payable) What happens if Foreign Currency appreciates/Depreciates?
Appreciates: Loss Depreciates: Gain
The fair value of a foreign currency option can be determined by applying an adaptation of the
Black-Scholes option pricing formula
other foreign entities are relatively self-contained and integrated with the local economy; primarily, they use a foreign currency in their daily operations.
Current Rate Method; translation adjustments should be reported as a separate component in accumulated other comprehensive income on the balance sheet.
If functional Currency is Foreign currency
Current rate method Separate component of Other Comprehensive Income (Stockholders' Equity)
Different Currency arrangements
Independent float Pegged to another currency European Monetary System (euro)
the translation adjustment
Net asset balance, 1/1/17 H Net income, 2017 A Dividends Declared H Net asset balance, 12/31/17 Net asset balance, 12/31/17 at current exchange rate C Translation Adjustment
Current Rate Method: Total assets > Total liabilities →
Net asset exposure
Temporal Method: Cash + Marketable securities + Receivables < Liabilities →
Net liability exposure
some foreign entities are so closely integrated with their parents that they conduct much of their business in U.S. dollars.
Temporal Method
If functional Currency is U.S. dollar
Temporal method Gain (loss) in Net Income
option premium
a function of two components: intrinsic value and time value
fair value exposure
exists if changes in exchange rates can affect the fair value of an asset or liability reported on the balance sheet.
The temporal method generates either a ___ balance sheet exposure, depending on whether cash plus marketable securities plus receivables are more than or less than liabilities.
net asset or a net liability
foreign currency firm commitment
noncancelable order that specifies the foreign currency price and date of delivery
intrinsic value
of an option: equal to the gain that could be realized by exercising the option immediately.
options must actually be purchased by paying an
option premium
Exhibit 10.1
page 479
U.S. GAAP requires unrealized foreign exchange gains and losses to be
reported in net income in the period in which the exchange rate changes
Authoritative accounting literature requires foreign currency balances such as a foreign currency receivable or a foreign currency payable to be
revalued at the balance sheet date to account for the change in exchange rates. Under the two-transaction perspective, this means that a foreign exchange gain or loss arises at the balance sheet date.
reporting currency
the currency in which the entity prepares its financial statements.
The balance sheet exposure under the current rate method is equal to
the foreign operation's net asset (total assets minus total liabilities) position
discount
the forward rate can be less than the spot rate
functional currency
the primary currency of the foreign entity's operating environment. It can be either the parent's currency (U.S.$ for a U.S.-based company) or a foreign currency (generally the local currency).
Application of the temporal method requires the inventory's foreign currency cost to be
translated into U.S. dollars at the historical exchange rate and foreign currency net realizable value to be translated into U.S. dollars at the current exchange rate.
When a foreign currency is the functional currency, foreign currency balances are
translated using the current rate method and a translation adjustment is reported in the stockholders' equity section of the balance sheet.
when the spot rate for the euro is $1.00, a put option (to sell euros) with a strike price of $0.97 has an intrinsic value of
zero
Even though a call option with a strike price of $1.00 has ____intrinsic value when the spot rate is $1.00, it will have a ___ time value
zero; positive time value because there is a chance that the spot rate could increase over the next 90 days and bring the option into the money.
At each balance sheet date, the following procedures are required for a Fair Value Hedge
1. Adjust the hedged asset or liability to fair value based on changes in the spot exchange rate and recognize a foreign exchange gain or loss in net income 2.Adjust the derivative hedging instrument to fair value (resulting in an asset or liability reported on the balance sheet) and recognize the counterpart as a gain or loss in net income
Three pieces of information are needed to determine the fair value of a forward contract at any point in time:
1. The forward rate when the forward contract was entered into. 2. The current forward rate for a contract that matures on the same date as the forward contract entered into. 3. A discount rate—typically, the company's incremental borrowing rate.
sources of foreign exchange risk
1.Recognized foreign currency denominated assets and liabilities. 2.Unrecognized foreign currency firm commitments. 3.Forecasted foreign currency denominated transactions. 4.Net investments in foreign operations.
where to report the resulting translation adjustment in the consolidated financial statements
1.Translation gain or loss: 2.Cumulative translation adjustment in other comprehensive income
Import purchase Transaction Exposure
A transaction exposure exists when the importer is required to pay in foreign currency and is allowed to pay sometime after the purchase has been made (Note that there is no exposure to foreign exchange risk if the importer makes payment in foreign currency on the date of purchase)
Cash Flow Hedge Fourth Requirement at Each Balance Sheet date
An additional amount is removed from AOCI and recognized in net income to reflect (a) the current period's amortization of the original discount or premium on the forward contract (if a forward contract is the hedging instrument) or (b) the change in the time value of the option (if an option is the hedging instrument)
Cash Flow Hedge Third Requirement at Each Balance Sheet date
An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability
Under the current rate method, the account Cost of Goods Sold (COGS)
COGS in FC × Average ER = COGS in $
Just Print off 9.7 and 9.9
DO IT NOW!
two-transaction perspective journal entries for an export sale
Date of Sale: AR --Sales Date of Collection (if loss) Foreign Exchange Loss --AR Cash --AR
Companies engaged in foreign currency activities often enter into hedging arrangements
as soon as they receive a noncancelable sales order or place a noncancelable purchase order.
Derivatives are reported on the balance sheet as ____ when they have a positive fair value and as ____ when they have a negative fair value
assets; liabilities
The temporal method requires translating property, plant, and equipment acquired at different times
at different (historical) exchange rates
foreign currency forward contract
can be negotiated by a firm with its bank to exchange foreign currency for U.S. dollars, or vice versa, on a specified future date at a predetermined exchange rate.
For many companies, the uncertainty of not knowing exactly how many U.S. dollars an export sale will generate is of great concern. To avoid this uncertainty, companies often use
derivative financial instruments to hedge against the effect of unfavorable changes in the value of foreign currencies.
fair value of a foreign currency forward contract
determined by reference to changes in the forward rate over the life of the contract, discounted to the present value
In accordance with U.S. GAAP, gains and losses arising from changes in the fair value of derivatives are recognized initially
either (1) in net income or (2) in other comprehensive income (reflected on the balance sheet in accumulated other comprehensive income).
call option
for the purchase of foreign currency by the holder of the option
Other comprehensive income consists of
income items that current authoritative accounting literature require to be deferred in stockholders' equity such as unrealized gains and losses on available-for-sale debt securities. Other comprehensive income is accumulated and reported as a separate line in the stockholders' equity section of the balance sheet.
The temporal method cannot translate the gain on the sale of land directly. Instead,
it requires translating the cash received and the cost of the land sold into U.S. dollars separately, with the difference being the U.S. dollar value of the gain. In accordance with the rules of the temporal method, the Cash account is translated at the exchange rate on the date of sale, and the Land account is translated at the historical rate
Accounting for the Translation of Foreign Currency Transactions and Foreign Currency Financial Statements."
mandated use of the temporal method with all companies reporting translation gains or losses in net income for all foreign operations.
time value
of an option: relates to the fact that the spot rate can change over time and cause the option's intrinsic value to increase
ompanies engaged in international trade need to keep ____ receivable and payable accounts in each of the currencies in which they have transactions.
separate; Each foreign currency receivable and payable should have a separate account number in the company's chart of accounts.
The lower of ___is reported on the consolidated balance sheet.
the dollar cost and dollar net realizable value
strike price
the exchange rate at which the option will be executed if the option holder decides to exercise the option
The current rate method requires translation of all income statement items at
the exchange rate in effect at the date of accounting recognition. For example, January 1 sales revenue should be translated at the January 1 exchange rate, January 2 sales at the January 2 exchange rate, and so on. Thus, in many cases, an assumption can be made that the revenue or expense is incurred evenly throughout the accounting period and a weighted average-for-the-period exchange rate can be used for translation. However, when an income account, such as a gain or loss, occurs at a specific point in time, the exchange rate at that date should be used for translation.
The current rate method translates the gain on sale of land at
the exchange rate in effect at the date of sale
Current Rate Method:A positive translation adjustment arises when
the foreign currency appreciates, and a negative translation adjustment arises when the foreign currency depreciates.
Import purchase Transaction Exposure Risk
the foreign currency might appreciate (increase in price) between the date of purchase and the date of payment, thereby increasing the U.S. dollars that have to be paid for the imported goods
Export sale Transaction Exposure Risk
the foreign currency might depreciate (decrease in value) between the date of sale and the date payment is received, thereby decreasing the U.S. dollars ultimately collected
When the interest rate in the foreign country exceeds the domestic interest rate
the foreign currency sells at a discount in the forward market
if the foreign interest rate is less than the domestic rate
the foreign currency sells at a premium
If the hedging instrument does not qualify as a cash flow hedge or if the company elects not to designate the hedging instrument as a cash flow hedge,
the hedge is designated as a fair value hedge.
he fundamental requirement of FASB ASC 815 is that companies carry all derivatives on the balance sheet at
their fair value.
The basic objective underlying the temporal method of translation is
to produce a set of U.S. dollar-translated financial statements as if the foreign subsidiary had actually used U.S. dollars in conducting its operations.
if the spot rate for the euro is $1.00, a call option (to purchase euros) with a strike price of $0.97 has an intrinsic value of
$0.03 per euro.
two-transaction perspective
This perspective treats the export sale and the subsequent collection of cash as two separate transactions. Because management has made two decisions—(1) to make the export sale and (2) to extend credit in foreign currency to the customer—the company should report the income effect from each of these decisions separately. The U.S. dollar value of the sale is recorded at the date the sale occurs. At that point, the sale has been completed; there are no subsequent adjustments to the Sales account. Any difference between the number of U.S. dollars that could have been received at the date of sale and the number of U.S. dollars actually received at the date of collection due to fluctuations in the exchange rate is a result of the decision to extend foreign currency credit to the customer. This difference is treated as a foreign exchange gain or loss that is reported separately from Sales in the income statement.
Current Exchange Method: a foreign operation represents a foreign currency net asset and if the foreign currency decreases in value against the U.S. dollar,
a decrease in the U.S. dollar value of the foreign currency net asset occurs.
Assume that on October 1, Amerco forecasts that it will make a purchase from the Hong Kong supplier in one month. To hedge against a possible increase in the price of the Hong Kong dollar, Amerco acquires a call option on October 1 to purchase Hong Kong dollars in one month. The foreign currency option represents
a hedge of a forecasted foreign currency denominated transaction.
Assume that on June 1, Amerco accepts an order to sell parts to a customer in South Korea at a price of 5 million Korean won. The parts will be delivered and payment will be received on August 15. On June 1, before the sale has been made, Amerco enters into a forward contract to sell 5 million Korean won on August 15. In this case, Amerco is using a foreign currency derivative as
a hedge of an unrecognized foreign currency firm commitment.
Because the amount of liabilities (current plus long term) translated at the current exchange rate usually exceeds the amount of assets translated at the current exchange rate,
a net liability exposure generally exists when the temporal method is used.
Current Method: To measure the net investment's exposure to foreign exchange risk,
all assets and all liabilities of the foreign operation are translated at the current exchange rate. Stockholders'
To qualify as a cash flow hedge, the hedging instrument must
completely offset the variability in the cash flows associated with the foreign currency receivable or payable
Changes in the fair value of derivatives must be included in
comprehensive income,
comprehensive income,
consists of two components: net income and other comprehensive income.
Under the current rate method, the ending inventory reported on the foreign currency balance sheet is translated at the
current exchange rate regardless of whether it is carried at cost or a lower net realizable value.
under the temporal method Cash, marketable securities, receivables, and most liabilities are carried at
current or future value and translated at the current exchange rate
Hedges of foreign currency denominated assets and liabilities, such as accounts receivable and accounts payable, can qualify as
either cash flow hedges or fair value hedges
cash flow exposure
exists if changes in exchange rates can affect the amount of cash flow to be realized from a foreign currency transaction with changes in cash flow reflected in net income.
put option
for the sale of foreign currency by the holder of the option
The two most common derivatives used to hedge foreign exchange risk are
foreign currency forward contracts and foreign currency options
If a company enters into a forward contract or purchases a put option on the date the sale is made, the derivative is being used as a
hedge of a recognized foreign currency denominated asset (the euro account receivable).
Temporal Method: Stockholders' equity accounts are translated at
historical exchange rates.
Current Method: Stockholders' equity items are translated at
historical rates.
The major issue in accounting for foreign currency transactions
how to deal with the change in U.S. dollar value of the sales revenue and account receivable resulting from the export when the foreign currency changes in value.
The corollary issue in accounting for foreign currency transactions
how to deal with the change in the U.S. dollar value of the account payable and goods being acquired in an import purchase
The call option establishes
the maximum amount that would have to be paid for euros but does not lock in a disadvantageous price should the spot rate fall below the option strike price.
direct quotes
the number of U.S. dollars needed to purchase one unit of foreign currency
spot rate
the price at which a foreign currency can be purchased or sold today.
forward rate
the price available today at which foreign currency can be purchased or sold sometime in the future.
The fair value of a foreign currency option on a specific date is
the sum of its intrinsic and time values on that date
Temporal Method:Application of this rule maintains
the underlying valuation method (current value or historical cost) that the foreign subsidiary uses in accounting for its assets and liabilities.
European Monetary System (euro)
In 1998, the countries comprising the European Monetary System adopted a common currency called the euro and established a European Central Bank.2 Until 2002, local currencies such as the German mark and French franc continued to exist but were fixed in value in terms of the euro. On January 1, 2002, local currencies disappeared, and the euro became the currency in 12 European countries. Today, 19 countries are part of the euro zone. The value of the euro floats against other currencies such as the Swiss franc, British pound, and U.S. dollar.
Under the temporal method, no single exchange rate can be used to directly translate COGS in FC into COGS in dollars.
Instead, COGS must be decomposed into beginning inventory, purchases, and ending inventory, and each component of COGS must then be translated at its appropriate historical rate.
Temporal Method: Cash + Marketable securities + Receivables > Liabilities →
Net asset exposure
Many U.S. companies report foreign exchange gains and losses on the income statement in a line item often titled
Other income (expense).
Foreign currency options can be purchased on the
Philadelphia Stock Exchange or the Chicago Mercantile Exchange, but most foreign currency options are purchased directly from a bank in the so-called over-the-counter (OTC) market. Options purchased in the OTC market usually have a strike price that is equal to the spot rate on that date. These options are said to be "at-the-money."
Can the forward exchange rate change?
The forward exchange rate for a specific future settlement date will change over time due to changes in the spot exchange rate and/or changes in the differential interest rates between two countries
premium
The forward rate can exceed the spot rate on a given date
Cash Flow Hedge First Requirement at Each Balance Sheet date
The hedged asset (foreign currency account receivable) or liability (foreign currency account payable) is adjusted to fair value based on changes in the spot exchange rate, and a foreign exchange gain or loss is recognized in net income
Independent Float
The value of the currency is allowed to fluctuate freely according to market forces with little or no intervention from the central bank (example countries include Australia, Brazil, Canada, Japan, Sweden, Switzerland, the United Kingdom, and the United States)
Pegged to another currency
The value of the currency is fixed (pegged) in terms of a particular foreign currency and the central bank intervenes as necessary to maintain the fixed value. For example, Bahrain, Panama, and Saudi Arabia peg their currency to the U.S. dollar. China has pegged its currency, the yuan (or Renminbi), to the U.S. dollar since 1994, while allowing a revaluation in 2005 and again in 2015.
Cash Flow Hedge Second Requirement at Each Balance Sheet date
To comply with the fundamental requirement of derivatives accounting, the derivative hedging instrument (forward contract or option) is adjusted to fair value (resulting in an asset or liability reported on the balance sheet) with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI)
The basic assumption underlying the current rate method
a company's net investment in a foreign operation is exposed to foreign exchange risk. In other words, a foreign operation represents a foreign currency net asset and if the foreign currency decreases in value against the U.S. dollar, a decrease in the U.S. dollar value of the foreign currency net asset occurs
