Test 3

Question 1

Spot rates

Answer 1

the exchange rate that is available today

Question 2

Forward rate

Answer 2

• 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

Question 3

Forward Contract

Answer 3

requires the purchase (or sale) of currency units at a future date at the contracted exchange rate

Question 4

Option Contract

Answer 4

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

Question 5

Put option

Answer 5

allows for the sale of foreign currency by the option holder

Question 6

Call option

Answer 6

allows for the purchase of foreign currency by the option holder

Question 7

Transaction is “denominated” (stated) in the currency of the foreign party

Answer 7

• buy in US $, no restaement; no foregin exchange gain or loss
• buy in foreign currency, needs restatement, creates a foregin exchange gain or loss

Question 8

Export Sale - Asset Exposure (Accounts receivable)

Answer 8

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

Question 9

Import Purchase - Liability Exposure (Accounts Payable)

Answer 9

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

Question 10

GAAP requires a two-transaction “accrual” approach:

Answer 10

• 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

Question 11

Accounting for unrealized gains and losses (under the accrual approach required by US GAAP)

Answer 11

– 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

Question 12

Hedging foreign exchange risk:

Answer 12

– 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.

Question 13

Two foreign currency derivatives that are often used to hedge foreign currency transactions:

Answer 13

– 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

Question 14

To prepare worldwide consolidated financial statements, a US parent company must:

Answer 14

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

Question 15

Need to determine the Functional Currency used

Answer 15

– 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

Question 16

Possible Functional Currencies

Answer 16

➢ 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)

Question 17

Functional Currency = local currency when:

Answer 17

➢ 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

Question 18

Functional Currency = reporting currency (US dollar) when:

Answer 18

➢ 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)

Question 19

Two methods to translate financial statements;

Answer 19

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)

Question 20

Current Rate Method

Answer 20

Computation of Translation Adjustment: (Functional Currency = Foreign
Currency)

Question 21

Temporal Method

Answer 21

Computation of Remeasurement Gain/Loss: (Functional Currency = U.S. $)