Test 3 Flashcards
Spot rates
the exchange rate that is available today
Forward rate
- the exchange rate that can be locked in today for an expected future exchange transaction (for a fee)
- the actual spot rate at the future data may differ from today’s forward rate
Forward Contract
requires the purchase (or sale) of currency units at a future date at the contracted exchange rate
Option Contract
gives the holder the option of buying (or selling) currency units at a future date at the contracted “strike” price; the “right but not the obligation” to trade the foreign currency in the future
Put option
allows for the sale of foreign currency by the option holder
Call option
allows for the purchase of foreign currency by the option holder
Transaction is “denominated” (stated) in the currency of the foreign party
- buy in US $, no restaement; no foregin exchange gain or loss
- buy in foreign currency, needs restatement, creates a foregin exchange gain or loss
Export Sale - Asset Exposure (Accounts receivable)
Seller allows the buyer to pay in a foreign currency sometime after the sale has been made could result in the risk that the foreign currency might depreciate, decreasing the US dollars collected
Import Purchase - Liability Exposure (Accounts Payable)
Purchaser is required to pay in foreign currency sometime after the purchase has been made could result in the risk that the foreign currency might appreciate, increasing the US dollars that have to be paid for the imported goods
GAAP requires a two-transaction “accrual” approach:
- Account for the orignal sale in US dollars at the date of the sale
- Account for gains/losses from exchange rate fluctuations (at year end or date of receipt/payment), which are reported separately in the income statement as:
- foreign exchange gain
- foreign exchange loss
Accounting for unrealized gains and losses (under the accrual approach required by US GAAP)
– Unrealized foreign exchange gains and losses are reported in net income in the period in which the
exchange rate changes (i.e., at year end)
– Change in the exchange rate from the balance sheet date (year end) to date of receipt/payment results
in a second foreign exchange gain or loss that is reported in the second accounting period
Hedging foreign exchange risk:
– Companies seek to reduce the risks associated with foreign currency fluctuations by hedging.
– This means that they will give up a portion of the potential gains to offset the possible losses.
Two foreign currency derivatives that are often used to hedge foreign currency transactions:
– Foreign currency forward contracts – lock in the price for which the currency will sell at contract’s
maturity
– Foreign currency options – establishes a price for which the currency can be sold, but is not required to
be sold at maturity
To prepare worldwide consolidated financial statements, a US parent company must:
1) convert the foreign GAAP financial statements of its foreign operations into US GAAP, and
2) translate the financial statements from the foreign currency into US dollars
Need to determine the Functional Currency used
– Functional Currency – the primary currency of the foreign entity’s operating environment (eg., US
dollar or another foreign currency)
– Functional Currency determines how to convert financial statements
Possible Functional Currencies
➢ Recording currency – foreign entity’s local currency (eg., peso, British pound, Yen, etc.)
➢ Reporting currency – currency of the final reporting entity (eg., US dollar)
➢ Another foreign currency – foreign currency other than the recording currency (eg., Euros which
need to be converted/translated into British pound)
Functional Currency = local currency when:
➢ Foreign operations are relatively self-contained and integrated within the country in which it’s
located
➢ Operations and cash flows occur in country of location
Functional Currency = reporting currency (US dollar) when:
➢ Foreign operations are a direct and integral component or extension of a US entity’s operations
➢ Local economy is in hyperinflation – cumulative inflation rate of 100% or more over 3 year period
(local currency cannot be functional)
Two methods to translate financial statements;
1)Temporal Method
➢ Functional currency = US Dollar or hyper-inflationary economy
➢ Remeasurement process used
➢ Foreign exchange translation adjustment is a gain/loss in Net Income
2) Current Rate Method
➢ Functional currency = local foreign currency
➢ Translation process used
➢ Foreign exchange translation adjustment is a gain/loss to Other Comprehensive Income
(=>Stockholders’ Equity as Accumulated OCI)
Current Rate Method
Computation of Translation Adjustment: (Functional Currency = Foreign
Currency)
Temporal Method
Computation of Remeasurement Gain/Loss: (Functional Currency = U.S. $)
