Brandlin company of anaheim california sells parts

407

hoy44953_ch09_407-472.indd 407 10/27/16 09:15 PM

chapter

Today, international business transactions are a regular occurrence. In its 2015 annual report, Lockheed Martin Corporation reported export sales of $9.5 billion, representing 21 percent of total sales. Some businesses are very significantly involved in transactions occurring through-

out the world as evidenced by this excerpt from Cirrus Logic, Inc.’s fiscal year

2015 annual report: “Export sales, principally to Asia, including sales to U.S.-

based customers that manufacture at plants overseas, were approximately

$869.9 million in fiscal year 2015, $673.7 million in fiscal year 2014, and

$764.9 million in fiscal year 2013. Export sales to customers located in Asia

were 92 percent of net sales in fiscal years 2015 and 2014 and 91 percent in

fiscal year 2013. All other export sales represented 3 percent of net sales in

each of fiscal years 2015, 2014, and 2013.”

Collections from export sales or payments for imported items might be

made not in U.S. dollars but in pesos, pounds, yen, and the like depending on

the negotiated terms of the transaction. As foreign currency exchange rates

fluctuate, so does the U.S. dollar value of these export sales and import pur-

chases. Companies often find it necessary to engage in some form of hedg-

ing activity to reduce losses arising from fluctuating exchange rates. At the

end of fiscal year 2015, in conjunction with its foreign currency hedging activi-

ties, Apple, Inc., reported having outstanding foreign exchange contracts with

a notional value of $119.2 billion.

This chapter covers accounting issues related to foreign currency trans-

actions and foreign currency hedging activities. To provide background for

subsequent discussions of the accounting issues, the chapter begins by

describing foreign exchange markets. The chapter then discusses account-

ing for import and export transactions, followed by coverage of various hedg-

ing techniques. Because they are most popular, the discussion concentrates

on foreign currency forward contracts and options. Understanding how to

account for these items is important for any company engaged in inter-

national transactions.

9 Foreign Currency Transactions and Hedging Foreign Exchange Risk Learning Objectives

After studying this chapter, you should be able to:

LO 9-1 Understand concepts related to foreign currency, exchange rates, and foreign exchange risk.

LO 9-2 Account for foreign currency transactions using the two- transaction perspective, accrual approach.

LO 9-3 Account for foreign currency borrowings.

LO 9-4 Understand the different types of foreign exchange risk that can be hedged and how foreign currency forward contracts and foreign currency options can be used to hedge those risks.

LO 9-5 Understand the accounting guidelines for derivative financial instruments.

LO 9-6 Understand the basic concepts of hedge accounting.

LO 9-7 Account for forward contracts and options used as hedges of foreign currency denominated assets and liabilities.

LO 9-8 Account for forward contracts and options used as hedges of foreign currency firm commitments.

LO 9-9 Account for forward contracts and options used as hedges of forecasted foreign currency transactions.

Final PDF to printer

408 Chapter 9

hoy44953_ch09_407-472.indd 408 10/27/16 09:15 PM

Foreign Exchange Markets Each country (or group of countries) uses its own currency as the unit of value for the purchase and sale of goods and services. The currency used in the United States is the U.S. dollar, the currency used in Mexico is the Mexican peso, the currency used by a subset of European Union countries is the euro, and so on. If a U.S. citizen travels to Mexico and wishes to purchase local goods, Mexican merchants require payment to be made in Mexican pesos. To make a purchase in Mexico, a U.S. citizen would need to acquire pesos using U.S. dollars. The foreign currency exchange rate is the price at which the foreign currency can be acquired (or sold). A variety of factors determine the exchange rate between two currencies; unfortunately for those engaged in international business, the exchange rate can fluctuate over time.1

Exchange Rate Mechanisms Exchange rates have not always fluctuated. During the period 1945–1973, countries fixed the value of their currency in terms of the U.S. dollar, and the value of the U.S. dollar was fixed in terms of gold. In March 1973, most countries allowed their currencies to float in value. Today, several different currency arrangements exist. Some of the more important ones and the countries affected follow:

1. 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).

2. 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. By managing the value of its currency (downward) rather than allowing it to float freely, the Chinese government has made it easier for Chinese companies to export their products overseas.

3. European Monetary System (euro): In 1998, the countries comprising the European Mon- etary 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.

Foreign Exchange Rates Exchange rates between the U.S. dollar and many foreign currencies are published on a daily basis in The Wall Street Journal and major U.S. newspapers. Exchange rates also are avail- able online at websites such as www.oanda.com and www.x-rates.com. To illustrate exchange rates and the foreign currency market, next we examine exchange rates for selected currencies reported for December 1-2, 2015, as shown in Exhibit 9.1.

The exchange rates shown in Exhibit 9.1 are for trades between banks; that is, these are interbank or wholesale prices. Prices charged by banks to retail customers, such as companies engaged in international business, are higher. These are selling rates at which banks will sell currency to one another. The prices that banks are willing to pay to buy foreign currency are

LO 9-1

Understand concepts related to foreign currency, exchange rates, and foreign exchange risk.

1 Several theories attempt to explain exchange rate fluctuations but with little success, at least in the short term. An understanding of the causes of exchange rate changes is not necessary to comprehend the con- cepts underlying the accounting for changes in exchange rates. 2 Most longtime members of the European Union (EU) are “euro zone” countries. The major exception is the United Kingdom, which elected not to participate. Switzerland is another important European country not part of the euro zone because it is not a member of the EU.

Final PDF to printer

Foreign Currency Transactions and Hedging Foreign Exchange Risk 409

hoy44953_ch09_407-472.indd 409 10/27/16 09:15 PM

somewhat less than the selling rates. The difference between the buying and selling rates is the spread through which the banks earn a profit on foreign exchange trades. For example, the December 1, 2015, selling rate for the euro was $1.0607, while the the buying rate was $1.0596. On that date, banks were willing to buy euros for $1.0596 and sell them for $1.0607, earning a profit of $0.0011 per euro.

Two columns of information are shown for each day’s exchange rates. The first col- umn reports direct quotes, which indicate the number of U.S. dollars needed to purchase one unit of foreign currency. The direct quote for the Brazilian real on December 1 was $0.2584; in other words, 1.0 Brazilian real (BRL) could be purchased for $0.2584. The second column reports indirect quotes, which indicate the number of foreign currency units that could be purchased with one U.S. dollar. These rates are simply the inverse of direct quotes (indirect quote = 1 ÷ direct quote). If one BRL can be purchased with $0.2584, then 3.87 BRL can be purchased with $1.00. To avoid confusion, direct quotes are used exclusively in this chapter.

The third and fourth columns in Exhibit 9.1 show exchange rates for December 2, 2015. Two of the currencies shown increased in U.S. dollar price (appreciated) from December 1 to December 2, namely the euro and Brazilian real. For example, the euro increased in price by $0.0078 from one day to the next. As a result, the purchase of 100,000 euros on December 2, 2015, would have cost $780 more than on the previous day. In contrast, the U.S. dollar price for two currencies decreased (depreciated) from one day to the next, namely the British pound and Canadian dollar. The Chinese yuan did not change in U.S. dollar value because this cur- rency was effectively pegged to the U.S. dollar.

Foreign Currency Forward Contracts Foreign currency trades can be executed on a spot or forward basis. The spot rate is the price at which a foreign currency can be purchased or sold today. In contrast, the forward rate is the price available today at which foreign currency can be purchased or sold sometime in the future. Because many international business transactions take some time to be completed, the ability to lock in a price today at which foreign currency can be purchased or sold at some future date has definite advantages.

A 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. A forward contract can be written for whatever currency and for whatever future date is required. Entering into a forward contract has no up-front cost; the firm and its bank simply agree today to exchange foreign currency for U.S. dollars at the forward rate on a future date. Similar to how banks make a profit in the spot market, there is a spread between the buying and selling rates in the forward market. For example, on Febru- ary 1 a bank might agree to buy 500,000 British pounds in three months from one customer at a forward rate of $1.50 and simultaneously agree to sell 500,000 British pounds (GBP) in three months to another customer at a rate of $1.51. In this way, the bank generates a profit of $5,000 (500,000 GBP x $0.01) from entering into these two forward contracts.

The forward rate can exceed the spot rate on a given date, in which case the foreign cur- rency is said to be selling at a premium in the forward market, or the forward rate can be less than the spot rate, in which case the currency is selling at a discount. Currencies sell at a pre- mium or a discount because of differences in interest rates between two countries. When the interest rate in the foreign country exceeds the domestic interest rate, the foreign currency

December 1, 2015 December 2, 2015

Country/Currency Direct* Indirect† Direct* Indirect†

Euro zone euro . . . . . . . . . . . . . . . . . 1.0607 0.9428 1.0685 0.9359 UK pound . . . . . . . . . . . . . . . . . . . . . 1.5078 0.6632 1.5027 0.6655 Canada dollar . . . . . . . . . . . . . . . . . . 0.7491 1.3349 0.7480 1.3369 Brazil real . . . . . . . . . . . . . . . . . . . . . . 0.2584 3.8700 0.2595 3.8536 China yuan . . . . . . . . . . . . . . . . . . . . 0.1560 6.4103 0.1560 6.4103

EXHIBIT 9.1 Exchange Rates for Selected Currencies (December 1-2, 2015)

Source: http://www.oanda.com/currency/historical-rates. *www.oanda.com/currency/historical-rates. †Indirect quotes have been calculated by the author.

Final PDF to printer

410 Chapter 9

hoy44953_ch09_407-472.indd 410 10/27/16 09:15 PM

sells at a discount in the forward market. Conversely, if the foreign interest rate is less than the domestic rate, the foreign currency sells at a premium.3

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. For example, assume on April 15 the U.S. dollar (USD) per Mexi- can peso (MXN) spot rate is $0.11 and the forward rate for a forward contract to be settled on June 15 is $0.105. The peso is selling at a discount of $0.005 in the two-month forward market due to a higher interest rate in Mexico than in the United States. If the USD/MXN spot rate decreases to $0.08 on May 15, the forward rate for a June 15 settlement-date forward contract also will decrease, to an amount less than $0.08. The peso will continue to sell at a discount in the one-month forward market because of the higher interest rate in Mexico.

Until December 2014, The Wall Street Journal published forward rates offered by New York banks for several major currencies on a daily basis. Since then, it has been difficult for third parties to obtain data on foreign currency forward rates. The spot rate for Swiss francs (CHF) on December 8, 2014, was reported to be $1.0245. On the same day, the one-month forward rate was reported as $1.0250, so the CHF was selling at a premium in the forward market. By entering into a forward contract on December 8, 2014, it would have been possible for a firm to guarantee that CHF could be purchased on January 8, 2015, at a price of $1.0250, regardless of what the spot rate turned out to be on January 8. Entering into the forward con- tract to purchase CHF would have been beneficial if the spot rate on January 8 was more than $1.0250. On the other hand, such a forward contract would have been detrimental if the spot rate was less than $1.0250. In either case, the firm must execute the forward contract and pur- chase CHF on January 8 at $1.0250.

As it turned out, the spot rate for CHF on January 8, 2015, was $0.9819, so entering into a one-month forward contract on December 8, 2014, to purchase CHF at $1.0250 on January 8, 2015, would have resulted in a loss because CHF could have been purchased at a lower price using the spot rate on that date.

Foreign Currency Options To provide companies more flexibility than exists with a forward contract, a market for foreign currency options has developed. A foreign currency option gives the holder of the option the right but not the obligation to trade foreign currency in the future. A put option is for the sale of foreign currency by the holder of the option; a call option is for the purchase of foreign cur- rency by the holder of the option. The strike price is the exchange rate at which the option will be executed if the option holder decides to exercise the option. The strike price is similar to a forward rate. There are generally several strike prices to choose from at any particular time. 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 usu- ally have a strike price that is equal to the spot rate on that date. These options are said to be “at-the-money.”

Unlike a forward contract, for which banks earn their profit through the spread between buying and selling rates, options must actually be purchased by paying an option premium, which is a function of two components: intrinsic value and time value. An option’s intrinsic value is equal to the gain that could be realized by exercising the option immediately. For example, 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. Euros can be purchased for $0.97 and sold for $1.00, generating a gain of $0.03 per euro. On the other hand, 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

3 This relationship is based on the theory of interest rate parity that indicates the difference in national inter- est rates should be equal to, but opposite in sign to, the forward rate discount or premium. This topic is cov- ered in detail in international finance textbooks.

Final PDF to printer

Foreign Currency Transactions and Hedging Foreign Exchange Risk 411

hoy44953_ch09_407-472.indd 411 10/27/16 09:15 PM

value of zero. An option with a positive intrinsic value is said to be “in-the-money.” The 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. Even though a call option with a strike price of $1.00 has zero intrinsic value when the spot rate is $1.00, it will have a 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. As time passes, the time value of an option decreases because there is less time remaining for the option to increase in intrinsic value. The fair value of a foreign currency option on a specific date is the sum of its intrinsic and time values on that date.

The fair value of a foreign currency option can be determined by applying an adaptation of the Black-Scholes option pricing formula. This formula is discussed in detail in international finance books. In very general terms, the value of an option is a function of the difference between the current spot rate and strike price, the difference between domestic and foreign interest rates, the length of time to expiration, and the potential volatility of changes in the spot rate. For purposes of this book, the premium originally paid for a foreign currency option and its subsequent fair value up to the date of expiration derived from applying the pricing formula will be given.

On December 17, 2015, when the USD spot rate for euros was $1.09, the Chicago Mer- cantile Exchange indicated that a January 2016 call option in euros with a strike price of $1.09 could have been purchased by paying a premium of $0.0068 per euro. Thus, the right to purchase a standard contract of 125,000 euros in December 2016 at a price of $1.09 per euro could have been acquired by paying $850 ($0.0068 × 125,000 euros). Because the spot rate and the strike price were both $1.09, the euro call option had zero intrinsic value and a time value of $850. If the spot rate for euros on January 17, 2016, is more than $1.09, the option will be exercised and euros purchased at the strike price of $1.09. If, on the other hand, the January 17, 2016, spot rate is less than $1.09, the option will not be exercised; instead, euros will be purchased at the lower spot rate. The call option establishes the maxi- mum 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. The actual spot rate for euros on January 17, 2016, turned out to be $1.091, so the option would have been exercised and euros purchased for $1.09.

Foreign Currency Transactions Export sales and import purchases are international transactions; they are components of what is called trade. When two parties from different countries enter into a transaction, they must decide which of the two countries’ currencies to use to settle the transaction. For exam- ple, if a U.S. computer manufacturer sells to a customer in Japan, the parties must decide whether the transaction will be denominated (payment will be made) in U.S. dollars or in Japanese yen.

Assume that a U.S. exporter (Amerco) sells goods to a German importer that will pay in euros (€). In this situation, Amerco has entered into a foreign currency transaction. It must restate the euro amount that it actually will receive into U.S. dollars to account for this trans- action. This happens because Amerco keeps its books and prepares financial statements in U.S. dollars. Although the German importer has entered into an international transaction, it does not have a foreign currency transaction (payment will be made in its currency) and no restatement is necessary.

Assume that, as is customary in its industry, Amerco does not require immediate pay- ment and allows its German customer 30 days to pay for its purchases. By doing this, Amerco runs the risk that the euro might depreciate against the U.S. dollar between the sale date and the date of payment. If so, the sale would generate fewer U.S. dollars than it would have had the euro not decreased in value, and the sale is less profitable because it was made on a credit basis. In this situation Amerco is said to have an exposure to foreign

LO 9-2

Account for foreign currency transactions using the two- transaction perspective, accrual approach.

Final PDF to printer

412 Chapter 9

hoy44953_ch09_407-472.indd 412 10/27/16 09:15 PM

exchange risk. Specifically, Amerco has a transaction exposure that can be summarized as follows:

∙ Export sale: 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. The exporter is exposed to the risk that 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.

∙ Note that there is no exposure to foreign exchange risk if the exporter requires the for- eign customer to make payment on the date of sale. In that case, the exporter would receive foreign currency and immediately convert it into U.S. dollars at the spot rate on the date of sale.

∙ Import purchase: 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. The importer is exposed to the risk that 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.

∙ Note that there is no exposure to foreign exchange risk if the importer makes payment in foreign currency on the date of purchase. In that case, the importer converts U.S. dollars into foreign currency at the spot rate on the date of purchase and immediately makes payment.

Accounting Issue The major issue in accounting for foreign currency transactions is 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 is how to deal with the change in the U.S. dollar value of the account payable and goods being acquired in an import purchase.) For example, assume that Amerco, a U.S. company, sells goods to a German cus- tomer at the price of 1 million euros when the spot exchange rate is $1.32 per euro. If payment were received at the sale date, Amerco could have converted 1 million euros into $1,320,000; this amount clearly would be the amount at which the sales revenue would be recognized. Instead, Amerco allows the German customer 30 days to pay for its purchase. At the end of 30 days, the euro has depreciated to $1.30 and Amerco is able to convert the 1 million euros received on that date into only $1,300,000. How should Amerco account for this $20,000 decrease in value?

FASB ASC 830-20 Foreign Currency Matters–Foreign Currency Transactions requires companies to use what can be referred to as a two-transaction perspective in accounting for foreign currency transactions. This perspective treats the export sale and the subsequent col- lection 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.

Similarly, an import purchase denominated in a foreign currency and the subsequent pay- ment of cash must be accounted for separately. The U.S. dollar value of the goods purchased is recorded at the date of purchase, with no subsequent adjustments to the cost of the goods. Any difference between the number of U.S. dollars that could have been paid on the date of purchase and the actual number of U.S. dollars that is paid on the payment date due to a change in the exchange rate is treated as a foreign exchange gain or loss.

Using the two-transaction perspective to account for its export sale to the German cus- tomer, Amerco would make the following journal entries:

Final PDF to printer

Foreign Currency Transactions and Hedging Foreign Exchange Risk 413

hoy44953_ch09_407-472.indd 413 10/27/16 09:15 PM

Date of Sale: Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . 1,320,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000 To record the sale and euro receivable at

the spot rate of $1.32. Date of Collection: Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . 20,000

Accounts Receivable (€) . . . . . . . . . . . . . . . . . . 20,000 To adjust the value of the euro receivable to the new

spot rate of $1.30 and record a foreign exchange loss resulting from the depreciation in the euro.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . 1,300,000 To record the receipt of 1 million euros and conver-

sion into U.S. dollars at the spot rate of $1.30.

Foreign Currency (FC)

Transaction Type of Exposure Appreciates Depreciates

Export sale Asset (receivable) Gain Loss Import purchase Liability (payable) Loss Gain

Sales are reported in income at the amount that would have been received if the customer had not been given 30 days to pay the 1 million euros—that is, $1,320,000. A separate Foreign Exchange Loss of $20,000 is reported in net income to indicate that because of the decision to extend foreign currency credit to the German customer and because the euro decreased in value, Amerco actually received fewer U.S. dollars.4

Note that Amerco keeps its Account Receivable (€) account separate from its U.S. dollar receivables. Companies engaged in international trade need to keep separate receivable and payable accounts in each of the currencies in which they have transactions. Each foreign cur- rency receivable and payable should have a separate account number in the company’s chart of accounts.

We can summarize the relationship between fluctuations in exchange rates and foreign exchange gains and losses as follows:

4 Note that the foreign exchange loss results because the customer is allowed to pay in euros and is given 30 days to pay. If the transaction were denominated in U.S. dollars, no loss would result, nor would there be a loss if the euros had been received at the date the sale was made.

A foreign currency receivable arising from an export sale creates an asset exposure to foreign exchange risk. If the foreign currency appreciates, the foreign currency asset increases in U.S. dollar value and a foreign exchange gain arises; depreciation of the foreign currency causes a foreign exchange loss. A foreign currency payable arising from an import purchase creates a liability exposure to foreign exchange risk. If the foreign currency appreciates, the foreign currency liability increases in U.S. dollar value and a foreign exchange loss results; deprecia- tion of the currency results in a foreign exchange gain.

Balance Sheet Date before Date of Payment The question arises as to what adjustments should be made if a balance sheet date falls between the date of sale (or purchase) and the date of collection (or payment). For example, assume that Amerco shipped goods to its German customer on December 1, 2017, with pay- ment to be received on March 1, 2018. Assume that at December 1, the spot rate for the euro was $1.32, but by December 31, the euro has appreciated to $1.33. Is any adjustment needed at December 31, 2017, when the books are closed to account for the fact that the foreign cur- rency receivable has changed in U.S. dollar value since December 1?