7. Issues at Entity Level

Question 1

What are 3 types of foreign currency exchange risks faced by an entity?

Answer 1

Transaction risk.
Translation risk.
Economic risk.

Question 2

What is transaction risks? Examples?

Answer 2

The possible unfavorable impact of changes in currency exchange rates on transactions denominated in a foreign currency.
*Change in exchange rate will decrease dollars collected or increase dollars needed.
A/R, A/P, etc

Question 3

How can a firm mitigate transaction risks?

Answer 3

1. Matching: Incur equal payables and receivables in the same currency for offsetting effects; loss on one would be offset by a gain on the other
2. Leading/lagging pmts and collection: paying obligations or collecting receivables earlier or later to avoid the risk
3. Hedging: Using offsetting or contra transactions so that a loss on one would be offset by a gain on the other

Question 4

Hedging: how does it work with A/R that is denominated in foreign currency?

Answer 4

The firm can enter into a contract now (called forward contract) to sell the foreign currency when it is received at a price or rate set now.

Question 5

What are other 2 examples of transaction risks?

Answer 5

• Forecasted foreign currency-denominated transactions

* Unrecognized firm commitments

Question 6

What is translation risk?

Answer 6

The possible unfavorable impact of changes in currency exchange rates on the financial statements of an entity when those statements are converted from one currency to another.

Question 7

When does translation risk occur?

Answer 7

When a domestic entity has foreign operations which prepares its FS in a foreign currency.

Question 8

Why the translation of foreign FS may be needed?

Answer 8

• Apply equity method accounting
• Combine with other entities
• Consolidate with domestic parent

Question 9

How can a firm mitigate translation risk?

Answer 9

1. Reduce the amount of assets/liabilities converted using the current (spot) exchange rate
2. Create offsetting assets/liabilities so that a gain on one is offset by a loss on the other
3. Borrow in the foreign currency in an amount approximating the net asset exposure so that a gain/loss on translation is offset by a loss or gain on the borrowing

Question 10

What is economic risk?

Answer 10

The possible unfavorable impact of changes in currency exchange rates on a firm’s future international earning power.
Exchange rate changes affect the price competitiveness of entities in countries for which the exchange rate changes.

Question 11

How can a firm mitigate economic risks?

Answer 11

1. Distribute productive assets in different countries with different currencies
2. Shift sources of revenues and expenses to different locations with different currencies

Question 12

What is a major foreign currency hedging instrument?

Answer 12

Forward contracts.

Question 13

What are 2 types of forward contracts?

Answer 13

1. A foreign currency forward exchange contract: to buy or sell a specified amount of a foreign currency at a specified date at a specified rate
2. A foreign currency option contract: gives the right (option) to buy or sell a specified amount of a foreign currency at a specified date at a specified rate

Question 14

What is call options? Put options?

Answer 14

Call: buy
Put: sell

Question 15

What is transfer pricing?

Answer 15

Amount at which goods and services are transferred between affiliated entities, which determines profit/loss and taxes owed.

Question 16

Can company manipulate the transfer price?

Answer 16

Yes to have lower tax rate in one country and over all higher after tax profit.

Question 17

Can companies set whatever transfer pricing they want?

Answer 17

No, in the US, appropriate allocation of income between entities under common control is provided in IRS code.

Question 18

How does IRS code instruct entities to set transfer pricing?

Answer 18

Income allocation based on functions performed and risks assumed by each party.

Question 19

In practice, how is the transfer price determined?

Answer 19

Based on;

• Cost to the selling unit - either variable or full cost
• Market price - the price of such goods or services in the market, if available
• Negotiated price - between buying and selling units