In the News:
Lands’ End reported holding net outstanding foreign currency forward contracts totaling $77 million and options totaling $16 million. In addition, based on anticipated cash flows and outflows over the next 12 months, if the US currency strengthens 10% relative to all other currencies, Lands’ End’s fiscal 2002 cash flows could be adversely affected by $0.7 million.
Many companies in the United States engage in international activities such as exporting or importing goods, establishing a foreign branch, or holding an equity investment in a foreign company. Recording and reporting problems are encountered when transactions with a foreign company or the financial statements of a foreign branch or investee are measured in a currency other than U.S. currency. Transactions to be settled in a foreign currency must be translated - that is, expressed in dollars - before they can be aggregated with the domestic transactions of the U.S. firm. When a foreign branch or investee maintains its accounts and prepares its financial statements in terms of the currency of the country in which it is domiciled, the accounts must be translated from the foreign currency into dollars before financial statements for the combined entity are prepared. Translation is necessary because useful financial reports cannot be prepared until all transactions and account balances are stated in a common unit of currency.
In addition, the receivables or payables denominated in foreign currencies are subject to gains and losses because of changes in exchange rates. Also, firms make commitments or have budgeted forecasted transactions denominated in foreign currencies that are also subject to gains and losses from changes in exchange rates. Many companies resort to hedging strategies using derivatives to minimize the impact of these exchange rate changes on their financial statements. Derivative instruments can be characterized by volatile market values and the firm’s exposure to risk is usually not adequately represented by the amount reported in the books (carrying value) because of the great potential for future losses (and gains). Thus, the accounting for these instruments is important but not an easy one.
Because of the widespread involvement of U.S. companies in foreign activities, accountants must be familiar with the problems associated with accounting for those activities. The expansion of international business has been of particular concern to accountants because of developments in the worldwide monetary system. These developments, coupled with the existence of a number of acceptable methods of translating foreign financial statements and reporting gains or losses on foreign currency fluctuations, have drawn the attention of the FASB at various points in time.[2] This chapter includes a discussion of the nature and use of exchange rates in the translation process, as well as the accounting standards applied in the translation of transactions measured in a foreign currency. Also, an introduction to hedge accounting is provided. The translation of accounts maintained in terms of a foreign currency is discussed in the next chapter.
EXCHANGE RATES - MEANS OF TRANSLATION
Transactions that are to be settled in a foreign currency and financial statements of an affiliate maintained in terms of a foreign currency are translated (converted) into dollars by multiplying the number of units of the foreign currency by a direct exchange rate. Thus, translation is the process of expressing monetary amounts that are stated in terms of a foreign currency in the currency of the reporting entity by using an appropriate exchange rate. An exchange rate “is the ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged at a particular time.”
A direct exchange quotation is one in which the exchange rate is quoted in terms of how many units of the domestic currency can be converted into one unit of foreign currency. For example, a direct quotation of U.S. dollars for one British pound of 1.517 means that $1.517 could be exchanged for one British pound. To translate pounds into dollars, the number of pounds is multiplied by the direct exchange rate expressed in dollars per pound. Exchange rates are also stated in terms of converting one unit of the domestic currency into units of a foreign currency, which is called an indirect quotation. In the example above, one U.S. dollar could be converted into .6592 pounds (1.00/1.517). To translate pounds into dollars, the number of pounds could also be divided by the indirect exchange rate.
Exchange rates may be quoted either as a spot rate or a forward rate. The spot rate is the rate currencies can be exchanged today. The forward or future rate is the rate the currencies can be exchanges at some future date. The forward rate is an exchange rate established at the time a forward exchange contract is negotiated. A forward exchange contract is a contract to exchange at a specified rate (the forward rate) currencies of different countries on a stipulated future date. Before the currencies are exchanged, the spot rate may move above or below the contracted forward exchange rate, but this has no effect on the forward rate established when the forward exchange contract was negotiated. In both the spot and forward markets, a foreign exchange trader provides a quotation for buying (the bid rate) and a quotation for selling (the offer rate) foreign currency. The trader's buying rate will be lower than the quoted selling rate, and the spread between the two rates is profit for the trader. Exchange rates are reported daily in terms of both direct and indirect quotations (see Illustration 13-1) in the financial section of many newspapers.
Lands’ End reported holding net outstanding foreign currency forward contracts totaling $77 million and options totaling $16 million. In addition, based on anticipated cash flows and outflows over the next 12 months, if the US currency strengthens 10% relative to all other currencies, Lands’ End’s fiscal 2002 cash flows could be adversely affected by $0.7 million.
Many companies in the United States engage in international activities such as exporting or importing goods, establishing a foreign branch, or holding an equity investment in a foreign company. Recording and reporting problems are encountered when transactions with a foreign company or the financial statements of a foreign branch or investee are measured in a currency other than U.S. currency. Transactions to be settled in a foreign currency must be translated - that is, expressed in dollars - before they can be aggregated with the domestic transactions of the U.S. firm. When a foreign branch or investee maintains its accounts and prepares its financial statements in terms of the currency of the country in which it is domiciled, the accounts must be translated from the foreign currency into dollars before financial statements for the combined entity are prepared. Translation is necessary because useful financial reports cannot be prepared until all transactions and account balances are stated in a common unit of currency.
In addition, the receivables or payables denominated in foreign currencies are subject to gains and losses because of changes in exchange rates. Also, firms make commitments or have budgeted forecasted transactions denominated in foreign currencies that are also subject to gains and losses from changes in exchange rates. Many companies resort to hedging strategies using derivatives to minimize the impact of these exchange rate changes on their financial statements. Derivative instruments can be characterized by volatile market values and the firm’s exposure to risk is usually not adequately represented by the amount reported in the books (carrying value) because of the great potential for future losses (and gains). Thus, the accounting for these instruments is important but not an easy one.
Because of the widespread involvement of U.S. companies in foreign activities, accountants must be familiar with the problems associated with accounting for those activities. The expansion of international business has been of particular concern to accountants because of developments in the worldwide monetary system. These developments, coupled with the existence of a number of acceptable methods of translating foreign financial statements and reporting gains or losses on foreign currency fluctuations, have drawn the attention of the FASB at various points in time.[2] This chapter includes a discussion of the nature and use of exchange rates in the translation process, as well as the accounting standards applied in the translation of transactions measured in a foreign currency. Also, an introduction to hedge accounting is provided. The translation of accounts maintained in terms of a foreign currency is discussed in the next chapter.
EXCHANGE RATES - MEANS OF TRANSLATION
Transactions that are to be settled in a foreign currency and financial statements of an affiliate maintained in terms of a foreign currency are translated (converted) into dollars by multiplying the number of units of the foreign currency by a direct exchange rate. Thus, translation is the process of expressing monetary amounts that are stated in terms of a foreign currency in the currency of the reporting entity by using an appropriate exchange rate. An exchange rate “is the ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged at a particular time.”
A direct exchange quotation is one in which the exchange rate is quoted in terms of how many units of the domestic currency can be converted into one unit of foreign currency. For example, a direct quotation of U.S. dollars for one British pound of 1.517 means that $1.517 could be exchanged for one British pound. To translate pounds into dollars, the number of pounds is multiplied by the direct exchange rate expressed in dollars per pound. Exchange rates are also stated in terms of converting one unit of the domestic currency into units of a foreign currency, which is called an indirect quotation. In the example above, one U.S. dollar could be converted into .6592 pounds (1.00/1.517). To translate pounds into dollars, the number of pounds could also be divided by the indirect exchange rate.
Exchange rates may be quoted either as a spot rate or a forward rate. The spot rate is the rate currencies can be exchanged today. The forward or future rate is the rate the currencies can be exchanges at some future date. The forward rate is an exchange rate established at the time a forward exchange contract is negotiated. A forward exchange contract is a contract to exchange at a specified rate (the forward rate) currencies of different countries on a stipulated future date. Before the currencies are exchanged, the spot rate may move above or below the contracted forward exchange rate, but this has no effect on the forward rate established when the forward exchange contract was negotiated. In both the spot and forward markets, a foreign exchange trader provides a quotation for buying (the bid rate) and a quotation for selling (the offer rate) foreign currency. The trader's buying rate will be lower than the quoted selling rate, and the spread between the two rates is profit for the trader. Exchange rates are reported daily in terms of both direct and indirect quotations (see Illustration 13-1) in the financial section of many newspapers.
INSERT ILLUSTRATION 13-1 HERE
Before the 1970s, rates of exchange of free market countries were controlled to some extent by member countries of the International Monetary Fund. Most of the member countries agreed to establish exchange rates in terms of U.S. dollars and gold. Although the actual rate was free to fluctuate, the countries that established official or fixed rates agreed to maintain the actual rate within 1% (2% after 1971) of the official rate by buying or selling U.S. dollars or gold. Because of pressure on the dollar, the United States in 1971 suspended its commitment to convert dollars into gold at $35 per ounce. The relationship between major currencies is now determined largely by supply and demand factors, called floating rates. As a result, significant realignments have occurred between the currencies of various countries over a relatively short period of time.
Floating rates increase the risk to companies doing business with a foreign company.[3] After a rate change occurs, all transactions are conducted at the new rate until the next change occurs. Because the amount to be received or paid is affected by a change in exchange rates, there is a direct economic impact on a company's operations. For example, a payable to be settled in 100,000 yen has a dollar equivalent value of $434 when the direct exchange rate is $.00434. An increase in the value of the yen to $.00625 would result in an increase in the payable to $625.
The selection of an exchange rate to be used in the translation process is complicated by the fact that some countries maintain multiple exchange rates. The government of a country may maintain official rates that differ from the market-determined rate, depending on the nature of the transaction. For example, a government may establish a set exchange rate for ``essential goods and services'' and allow the exchange rate for nonessential goods and services to float.
In the News:
The dollars strength is giving U.S. industry headaches. The strengthening of the U.S. dollar as compared to the currency of other countries is pricing U.S. goods out of the foreign market and is making competition at home from importers fierce. General Moters chief financial officer states that “the strong dollar is frankly destroying the manufacturing capability of the country. Over $1 trillion worth of American greenback, Japanese yen, and European euros and other currencies change hands daily. The dollar was hitting a 15-year high in July 2001 against a market basket of various currencies.
MEASURED VERSUS DENOMINATED
Transactions are normally measured and recorded in terms of the currency in which the reporting entity prepares its financial statements. This currency is usually the domestic currency of the country in which the company is domiciled and is called the reporting currency. In subsequent illustrations the U.S. dollar is assumed to be the reporting currency of U.S.- based firms. Assets and liabilities are denominated in a currency if their amounts are fixed in terms of that currency. Thus, a transaction between two U.S. companies requiring payment of a fixed number of dollars is both measured and denominated in dollars. In a transaction between a U.S. firm and a foreign company, the two parties usually negotiate whether the settlement is to be made in dollars or in the domestic currency of the foreign company. If the transaction is to be settled by the payment of a fixed amount of foreign currency, the U.S. firm measures the receivable or payable in dollars, but the transaction is denominated in the specified foreign currency. To the foreign company, the transaction is both measured and denominated in its domestic currency.
FOREIGN CURRENCY TRANSACTIONSA
A foreign currency transaction will be settled in a foreign currency, and the U.S. firm is exposed to the risk of unfavorable changes in the exchange rate that may occur between the date the transaction is entered into and the date the account is settled. For example, assume that a U.S. firm purchased goods from a French firm and the U.S. firm is to settle the liability by the payment of 20,000 francs. The French firm would measure and record the transaction as normal because the billing is in its reporting currency. Because the billing is in a foreign currency (denominated in francs), the U.S. firm must translate the amount of the foreign currency payable into dollars before the transaction is entered in its accounts. An increase (decrease) in the direct exchange rate will increase (decrease) the number of dollars required to buy the fixed number of francs needed to settle the foreign currency liability.
The direct exchange rate is often said to be increasing, or the foreign currency unit to be strengthening, if more dollars are needed to acquire the foreign currency units. If fewer dollars are needed, then the foreign currency is weakening or depreciating in relation to the dollar (the direct exchange rate is decreasing). Consider the following information.
Would a US company holding a $10,000 receivable denominated in Yen prefer the Yen to strengthen or weaken? In this case, the company prefers a strengthened Yen because more dollars would be received and an exchange gain would be incurred. If the transaction involved a payable denominated in Yen, the firm would have incurred an exchange rate loss because more dollars would have to be paid. As will be shown later, because firms cannot perfectly predict changes in exchange rates, the U.S. firm may hedge, that is, protect itself against an unfavorable change in the exchange rate by using derivatives.
In this chapter, we discuss the accounting for importing or exporting of goods. Then we provide an introduction to hedging the risk of foreign currency rate changes.
Before the 1970s, rates of exchange of free market countries were controlled to some extent by member countries of the International Monetary Fund. Most of the member countries agreed to establish exchange rates in terms of U.S. dollars and gold. Although the actual rate was free to fluctuate, the countries that established official or fixed rates agreed to maintain the actual rate within 1% (2% after 1971) of the official rate by buying or selling U.S. dollars or gold. Because of pressure on the dollar, the United States in 1971 suspended its commitment to convert dollars into gold at $35 per ounce. The relationship between major currencies is now determined largely by supply and demand factors, called floating rates. As a result, significant realignments have occurred between the currencies of various countries over a relatively short period of time.
Floating rates increase the risk to companies doing business with a foreign company.[3] After a rate change occurs, all transactions are conducted at the new rate until the next change occurs. Because the amount to be received or paid is affected by a change in exchange rates, there is a direct economic impact on a company's operations. For example, a payable to be settled in 100,000 yen has a dollar equivalent value of $434 when the direct exchange rate is $.00434. An increase in the value of the yen to $.00625 would result in an increase in the payable to $625.
The selection of an exchange rate to be used in the translation process is complicated by the fact that some countries maintain multiple exchange rates. The government of a country may maintain official rates that differ from the market-determined rate, depending on the nature of the transaction. For example, a government may establish a set exchange rate for ``essential goods and services'' and allow the exchange rate for nonessential goods and services to float.
In the News:
The dollars strength is giving U.S. industry headaches. The strengthening of the U.S. dollar as compared to the currency of other countries is pricing U.S. goods out of the foreign market and is making competition at home from importers fierce. General Moters chief financial officer states that “the strong dollar is frankly destroying the manufacturing capability of the country. Over $1 trillion worth of American greenback, Japanese yen, and European euros and other currencies change hands daily. The dollar was hitting a 15-year high in July 2001 against a market basket of various currencies.
MEASURED VERSUS DENOMINATED
Transactions are normally measured and recorded in terms of the currency in which the reporting entity prepares its financial statements. This currency is usually the domestic currency of the country in which the company is domiciled and is called the reporting currency. In subsequent illustrations the U.S. dollar is assumed to be the reporting currency of U.S.- based firms. Assets and liabilities are denominated in a currency if their amounts are fixed in terms of that currency. Thus, a transaction between two U.S. companies requiring payment of a fixed number of dollars is both measured and denominated in dollars. In a transaction between a U.S. firm and a foreign company, the two parties usually negotiate whether the settlement is to be made in dollars or in the domestic currency of the foreign company. If the transaction is to be settled by the payment of a fixed amount of foreign currency, the U.S. firm measures the receivable or payable in dollars, but the transaction is denominated in the specified foreign currency. To the foreign company, the transaction is both measured and denominated in its domestic currency.
FOREIGN CURRENCY TRANSACTIONSA
Transaction that requires payment or receipt (settlement) in a foreign currency is called a foreign currency transaction. A transaction with a foreign company that is to be settled in dollars is not a foreign currency transaction to a U.S. firm because the number of dollars to be received or paid to settle the account is fixed and remains unaffected by subsequent changes in the exchange rate. Thus, a transaction of a U.S. firm with a foreign entity to be settled in dollars is accounted for in the same manner as if the transaction had been with a U.S. company.
A foreign currency transaction will be settled in a foreign currency, and the U.S. firm is exposed to the risk of unfavorable changes in the exchange rate that may occur between the date the transaction is entered into and the date the account is settled. For example, assume that a U.S. firm purchased goods from a French firm and the U.S. firm is to settle the liability by the payment of 20,000 francs. The French firm would measure and record the transaction as normal because the billing is in its reporting currency. Because the billing is in a foreign currency (denominated in francs), the U.S. firm must translate the amount of the foreign currency payable into dollars before the transaction is entered in its accounts. An increase (decrease) in the direct exchange rate will increase (decrease) the number of dollars required to buy the fixed number of francs needed to settle the foreign currency liability.
The direct exchange rate is often said to be increasing, or the foreign currency unit to be strengthening, if more dollars are needed to acquire the foreign currency units. If fewer dollars are needed, then the foreign currency is weakening or depreciating in relation to the dollar (the direct exchange rate is decreasing). Consider the following information.
Direct Exchange Rates
Yen Strengthens Yen Weakens
Beginning
of year $1 = 1 Yen $1 = 1 Yen
End
of year $2 = 1 Yen $.5 = 1 Yen
Would a US company holding a $10,000 receivable denominated in Yen prefer the Yen to strengthen or weaken? In this case, the company prefers a strengthened Yen because more dollars would be received and an exchange gain would be incurred. If the transaction involved a payable denominated in Yen, the firm would have incurred an exchange rate loss because more dollars would have to be paid. As will be shown later, because firms cannot perfectly predict changes in exchange rates, the U.S. firm may hedge, that is, protect itself against an unfavorable change in the exchange rate by using derivatives.
In this chapter, we discuss the accounting for importing or exporting of goods. Then we provide an introduction to hedging the risk of foreign currency rate changes.
In the News:
Some currencies have undergone major changes in comparison to the US dollar. Consider the changes in the following direct exchange rates between the US dollar and the Brazilian Real and the Australian dollar:
In both cases, the US dollar has strengthened relative to the other currencies. One way to consider whether a currency has strengthened or weakened is to consider the direct exchange rate as the cost of the foreign currency. For instance, when the direct exchange rate increases, the currency is cheaper so the currency has weakened relative to the US dollar.
US Dollars to Convert to Foreign Currency
January
4, 2000 August 28, 2001 Percent Change
Australian
Dollar $0.6565 $0.5293 19%
Brazilian
Real $0.5435 $0.3907 28%