Importing or Exporting of Goods or Services
Probably the most common form of foreign currency transaction is the exporting or importing of goods or services. In each unsettled foreign currency transaction, there are three stages of concern to the accountant. These stages and the appropriate exchange rate to use in translating accounts denominated in units of foreign currency (except for forward exchange contracts) are as follows:
1. At the date the transaction is first recognized in conformity with GAAP. Each asset, liability, revenue, expense, gain, or loss arising from the transaction is measured and recorded in dollars by multiplying the units of foreign currency by the current exchange rate. (The current exchange rate is the spot rate in effect on a given date.)
2. At each balance sheet date that occurs between the transaction date and the settlement date. Recorded balances that are denominated in a foreign currency are adjusted using the spot rate in effect at the balance sheet date and the transaction gain or loss is recognized currently in earnings.
3. At the settlement date. In the case of a foreign currency payable, a U.S. firm must convert U.S. dollars into foreign currency units to settle the account, whereas foreign currency units received to settle a foreign currency receivable will be converted into dollars. Although translation is not required, a transaction gain or loss is recognized if the number of dollars paid or received upon conversion does not equal the carrying value of the related payable or receivable.
Using the spot rate to translate foreign currency receivables and payables at each measurement date provides an estimate of the number of dollars to be received or to be paid to settle the account. Note that both gains and losses are result in adjustments to the receivable or payable, approximating a form of current value accounting. The increase or decrease in the expected cash flow is generally reported as a foreign currency transaction gain or loss, sometimes referred to as an exchange gain or loss, in determining net income for the current period.
Importing Transaction. To illustrate an importing transaction, assume that on December 1, 2003, a U.S. firm purchased 100 units of inventory from a French firm for 500,000 euros to be paid on March 1, 2004. The firm's fiscal year-end is December 31. Assume further that the U.S. firm did not engage in any form of hedging activity. The spot rate for euros ($/euro) at various times is as follows:
The U.S. firm would prepare the following journal entry on December 1, 2003:
At the balance sheet date, the accounts payable denominated in foreign currency is adjusted using the exchange rate (spot rate) in effect at the balance sheet date. The entry is
If the exchange rate had declined below $1.05, for example to $1.03, the U.S. firm would have recognized a gain of $10,000 since it would have taken only $515,000 (500,000 euros x $1.03) to settle the $525,000 recorded liability.
Before the settlement date, the U.S. firm must buy euros in order to satisfy the liability. With a change in the exchange rate to $1.07, the firm must pay $535,000 on March 1, 2004, to acquire the 500,000 euros. The journal entry to record the settlement is:
Over the three-month period, the decision to delay making payment cost the firm $10,000 (the $535,000 cash paid less the original payable amount of $525,000). This net amount was recognized as a loss of $15,000 in 2003 and a gain of $5,000 in 2004.
Note in the example above that at December 31, the balance sheet date, a transaction loss was recognized on the open account payable. Such a loss is considered unrealized because the account has not yet been settled or closed. When an account payable (or receivable) is settled or closed, a transaction gain or loss on the settlement is considered realized. The FASB reasoned that users of financial statements are best served by reporting the effects of exchange rate changes on a firm's financial position in the accounting period in which they occur, even though they are unrealized and may reverse or partially reverse in a subsequent period, as in the illustration above. This procedure is criticized, however, because under GAAP, gains are not ordinarily reported until realized and because the recognition of unrealized gains and losses results in increased earnings volatility.
Exporting Transaction. Now assume that the U.S. firm sold 100 units of inventory for 500,000 euros to a French firm. All other facts are the same as those for the importing transaction. The journal entries to record this exporting transaction on the books of the U.S. Company are:
December 1, 2003 - Date of Transaction
March 1, 2004 - Settlement Date
A comparison of the entries to record the exporting transaction with those prepared to record an importing transaction reveals that a movement in the exchange rate has an opposite effect on the company's reported income. That is, the increase in the exchange rate from $1.05 to $1.08 resulted in a transaction gain in the case of a foreign currency receivable, whereas a transaction loss was reported in the case of a foreign currency payable. When the exchange rate decreased from $1.08 to $1.07, a transaction loss was reported on the exposed receivable, whereas a transaction gain was reported on the exposed payable. Thus, one tool available to management to hedge a potential loss on a foreign currency receivable is to enter into a transaction to establish a liability to be settled in the same foreign currency. Similarly, a liability to be settled in units of a foreign currency can be hedged by entering into a receivable transaction denominated in the same foreign currency.
An alternative view that was rejected by the FASB considers the initial transaction and settlement to be one transaction. Supporters of this method contend that the initial transaction is incomplete and the amounts recorded are estimates until such time as the total sacrifice from the purchase (units of domestic currency paid) or the total benefits from the sale (units of domestic currency received) are known. Under this view, transaction gains or losses should be accounted for as an adjustment to the cost of the asset purchased or to the revenue recorded in a sales transaction. There is an obvious implementation problem with this method when the sale or purchase is recorded in one fiscal period and the receipt or payment occurs in another period.
In the News:
Probably the most common form of foreign currency transaction is the exporting or importing of goods or services. In each unsettled foreign currency transaction, there are three stages of concern to the accountant. These stages and the appropriate exchange rate to use in translating accounts denominated in units of foreign currency (except for forward exchange contracts) are as follows:
1. At the date the transaction is first recognized in conformity with GAAP. Each asset, liability, revenue, expense, gain, or loss arising from the transaction is measured and recorded in dollars by multiplying the units of foreign currency by the current exchange rate. (The current exchange rate is the spot rate in effect on a given date.)
2. At each balance sheet date that occurs between the transaction date and the settlement date. Recorded balances that are denominated in a foreign currency are adjusted using the spot rate in effect at the balance sheet date and the transaction gain or loss is recognized currently in earnings.
3. At the settlement date. In the case of a foreign currency payable, a U.S. firm must convert U.S. dollars into foreign currency units to settle the account, whereas foreign currency units received to settle a foreign currency receivable will be converted into dollars. Although translation is not required, a transaction gain or loss is recognized if the number of dollars paid or received upon conversion does not equal the carrying value of the related payable or receivable.
Using the spot rate to translate foreign currency receivables and payables at each measurement date provides an estimate of the number of dollars to be received or to be paid to settle the account. Note that both gains and losses are result in adjustments to the receivable or payable, approximating a form of current value accounting. The increase or decrease in the expected cash flow is generally reported as a foreign currency transaction gain or loss, sometimes referred to as an exchange gain or loss, in determining net income for the current period.
Importing Transaction. To illustrate an importing transaction, assume that on December 1, 2003, a U.S. firm purchased 100 units of inventory from a French firm for 500,000 euros to be paid on March 1, 2004. The firm's fiscal year-end is December 31. Assume further that the U.S. firm did not engage in any form of hedging activity. The spot rate for euros ($/euro) at various times is as follows:
|
|
Spot
Rate
|
| Transaction date - December 1, 2003 | $1.05 |
| Balance sheet date - December 31, 2003 | 1.08 |
| Settlement date - March 1, 2004 | 1.07 |
The U.S. firm would prepare the following journal entry on December 1, 2003:
|
525,000
|
|
|
|
Accounts Payable (500,000 euros x
$1.05/euro)
|
|
525,000
|
At the balance sheet date, the accounts payable denominated in foreign currency is adjusted using the exchange rate (spot rate) in effect at the balance sheet date. The entry is
15,000
| ||
Accounts Payable
|
15,000
| |
Accounts payable valued at 12/31 (500,000 euros x $1.08/euro) | $540,000 | |
Accounts
payable valued at 12/1 (500,000 euros x $1.05/euro)
|
525,000
| |
Adjustment
to accounts payable needed
|
$ 15,000
| |
or
| ||
[500,000
euros x ($1.08 - $1.05) = $15,000]
|
Before the settlement date, the U.S. firm must buy euros in order to satisfy the liability. With a change in the exchange rate to $1.07, the firm must pay $535,000 on March 1, 2004, to acquire the 500,000 euros. The journal entry to record the settlement is:
| Mar. 1 Accounts Payable | 540,000 |
|
|
Transaction Gain
|
|
5,000
|
|
Cash (500,000 euros x $1.07/euro)
|
|
535,000
|
Over the three-month period, the decision to delay making payment cost the firm $10,000 (the $535,000 cash paid less the original payable amount of $525,000). This net amount was recognized as a loss of $15,000 in 2003 and a gain of $5,000 in 2004.
Note in the example above that at December 31, the balance sheet date, a transaction loss was recognized on the open account payable. Such a loss is considered unrealized because the account has not yet been settled or closed. When an account payable (or receivable) is settled or closed, a transaction gain or loss on the settlement is considered realized. The FASB reasoned that users of financial statements are best served by reporting the effects of exchange rate changes on a firm's financial position in the accounting period in which they occur, even though they are unrealized and may reverse or partially reverse in a subsequent period, as in the illustration above. This procedure is criticized, however, because under GAAP, gains are not ordinarily reported until realized and because the recognition of unrealized gains and losses results in increased earnings volatility.
Exporting Transaction. Now assume that the U.S. firm sold 100 units of inventory for 500,000 euros to a French firm. All other facts are the same as those for the importing transaction. The journal entries to record this exporting transaction on the books of the U.S. Company are:
December 1, 2003 - Date of Transaction
|
525,000
|
|
|
|
Sales
|
525,000
|
|
| December 31, 2003 - Balance Sheet Date |
| Accounts Receivable ($540,000-$525,000) | 15,000 | |
|
Transaction Gain
|
15,000 | |
|
The receivable valued at
12/1, 500,000 euros x $1.08 =
$540,000
The receivable valued at
12/31, 500,000 euros x $1.05 = $525,000
Change in the value of the receivable $ 15,000
|
||
| Cash (500,000 euros x $1.07) |
535,000
|
|
|
Transaction Loss
|
5,000
|
|
|
Accounts Receivable
|
|
540,000 |
These relationships are summarized below.
| Increase in direct exchange rate | |||
|
Importing transaction
|
Payable
|
Increase
|
Transaction
loss
|
|
Exporting transaction
|
Receivable
|
Increase
|
Transaction
gain
|
| Decrease in direct exchange rate | |||
|
Importing transaction
|
Payable
|
Decrease
|
Transaction
gain
|
|
Exporting transaction
|
Receivable
|
Decrease
|
Transaction
loss
|
How should a transaction gain or loss be reported? In the previous examples, the dollar amount recorded in the Sales account and the Purchases account was determined by the exchange rate prevailing at the transaction date. Adjustments to the foreign currency denominated receivable or payable were recorded directly to transaction gain or loss. Under this approach, referred to as the two- transaction approach, the sale or purchase is viewed as a transaction separate and distinct from the financing arrangement. Thus, the transaction gain or loss does not result from an operating decision to buy or sell goods or services in a foreign market, but from a financial decision to delay the payment or receipt of foreign currency and not to hedge the exposed receivable or payable against possible unfavorable currency rate changes.
An alternative view that was rejected by the FASB considers the initial transaction and settlement to be one transaction. Supporters of this method contend that the initial transaction is incomplete and the amounts recorded are estimates until such time as the total sacrifice from the purchase (units of domestic currency paid) or the total benefits from the sale (units of domestic currency received) are known. Under this view, transaction gains or losses should be accounted for as an adjustment to the cost of the asset purchased or to the revenue recorded in a sales transaction. There is an obvious implementation problem with this method when the sale or purchase is recorded in one fiscal period and the receipt or payment occurs in another period.
In the News:
Lands’ End reported in its fiscal 2000 annual report that foreign currency transaction gains and losses are reported in ‘other income and expenses.’ They also stated that $3.8 million of losses were reported as ‘other expense’ on the income statement in fiscal 1998 while the amounts of losses in fiscal years 1999 and 2000 were $1.9 million and $0.8 million respectively.
Hedging Foreign Exchange Rate Risk
Derivative Instruments After the issuance of SFAS No. 52 on foreign currency translation, the FASB became aware that firms were using creative instruments with increasing frequency to accomplish their desired hedging, many of which were not included in the scope of SFAS No. 52. Consequently, the FASB issued another standard, SFAS No. 133, which expanded the scope of accounting for hedges. Under these new guidelines, certain designated hedges are accounted for using hedge accounting. This will be elaborated upon later.
A derivative instrument may be defined as a financial instrument that by its terms at inception or upon occurrence of a specified event, provides the holder (or writer) with the right (or obligation) to participate in some or all of the price changes of another underlying value of measure, but does not require the holder to own or deliver the underlying value of measure. Thus its value is derived from the underlying value of measure. The underlying value of measure may be one or more referenced financial instruments, commodities, or other assets, or other specific items to which a rate, an index of prices, or another market indicator is applied. In most cases, derivatives differ from traditional instruments (stocks and bonds, for example) in that the eventual dollar amount of the performance is dependent upon subsequent value changes, rather than upon a static measure, and the eventual outcome is necessarily favorable to one of the parties involved and unfavorable to the other. The cash payments involved are made at the end of the contract rather than at its inception for the most part, and the instruments have consequently been treated in the past in many cases as a type of “off-balance sheet” agreement.
In SFAS No. 133, the FASB identified the following as keystones for the accounting for derivative instruments:
One exception to this treatment of transaction gains and losses would involve intercompany transactions that are of a long-term financing or capital nature between an investor and an investee that is consolidated, combined, or accounted for by the equity method. There are accounted for as a component of stockholders’ equity.
Throughout this chapter, we often state the exchange rate simply in dollars; thus a rate of $1.05 means $1.05 per unit of foreign currency (euro in this case).
Hedging Foreign Exchange Rate Risk
Derivative Instruments After the issuance of SFAS No. 52 on foreign currency translation, the FASB became aware that firms were using creative instruments with increasing frequency to accomplish their desired hedging, many of which were not included in the scope of SFAS No. 52. Consequently, the FASB issued another standard, SFAS No. 133, which expanded the scope of accounting for hedges. Under these new guidelines, certain designated hedges are accounted for using hedge accounting. This will be elaborated upon later.
A derivative instrument may be defined as a financial instrument that by its terms at inception or upon occurrence of a specified event, provides the holder (or writer) with the right (or obligation) to participate in some or all of the price changes of another underlying value of measure, but does not require the holder to own or deliver the underlying value of measure. Thus its value is derived from the underlying value of measure. The underlying value of measure may be one or more referenced financial instruments, commodities, or other assets, or other specific items to which a rate, an index of prices, or another market indicator is applied. In most cases, derivatives differ from traditional instruments (stocks and bonds, for example) in that the eventual dollar amount of the performance is dependent upon subsequent value changes, rather than upon a static measure, and the eventual outcome is necessarily favorable to one of the parties involved and unfavorable to the other. The cash payments involved are made at the end of the contract rather than at its inception for the most part, and the instruments have consequently been treated in the past in many cases as a type of “off-balance sheet” agreement.
In SFAS No. 133, the FASB identified the following as keystones for the accounting for derivative instruments:
- Derivative instruments represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements.
- Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments.
- Only items that are assets or liabilities should be reported as such in the balance sheet.
- Special accounting for items designated as being hedged should be provided only for qualifying items, as demonstrated by an assessment of the expectation of effective offsetting changes in fair values or cash flows during the term of the hedge for the risk being hedged.
- Forward-based derivatives, such as forwards, futures, and swaps, in which either party can potentially have a favorable or unfavorable outcome, but not both simultaneously (e.g., both will not simultaneously have favorable outcomes).
- Option-based derivatives, such as interest rate caps, option contracts, and interest rate floors, in which only one party can potentially have a favorable outcome and it agrees to a premium at inception for this potentiality; the other party is paid the premium, and can potentially have only an unfavorable outcome.
One exception to this treatment of transaction gains and losses would involve intercompany transactions that are of a long-term financing or capital nature between an investor and an investee that is consolidated, combined, or accounted for by the equity method. There are accounted for as a component of stockholders’ equity.
Throughout this chapter, we often state the exchange rate simply in dollars; thus a rate of $1.05 means $1.05 per unit of foreign currency (euro in this case).