Advanced Accounting Ch9
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Foreign Exchange Rate
The price at which the foreign currency can be acquired
the number of U.S. dollars needed to purchase one unit of foreign currency
the number of foreign currency units that could be purchased with one U.S. dollar
the price at which a foreign currency can be purchased or sold today
the price today at which foreign currency can be purchased or sold sometime in the future
forward rate exceeds spot rate
foreign interest rate is less than the domestic rate - the foreign currency sells at a premium
forward rate less that spot rate
foreign interest rate exceeds domestic interest rate - foreign currency sells at a discount
Foreign Currency Option
gives the holder of the option the right but not the obligation to trade foreign currency in the future
for the sale of foreign currency by the holder of the option
for the purchase of foreign currency by the holder of the option
the exchange rate at which the option will be executed if the option holder decides to exercise the option
two components of option premium
- intrinsic value
- time value
Option premium - option must actually be purchased by paying an option premium
equal to the gain that could be realized by exercising the option immediately
Postitive intrinsic value - "in the money"
relates to the fact that the spot rate can change over time and cause the option to become in the money.
Black - Scholes option pricing formula
the value of a foreign currency option can be determined by applying an adaptation of the Black - Scholes option pricing formula.
The value of an option is a function of the difference between teh current spot rate and strike price, the difference between domestic and foreign interest rates, the length of time to expiration, and the potential volatility of changes in the spot rate.
export sales and import purchases are internation transaction - components of trade.
one-transaction perspective (not GAAP)
- assumes export sale is not complete until the foreign currency receivable has been collected and converted into U.S. dolllars.
- criticized because it hides the fact that the company could have received more that other company had been required to pay at the date of sale
- loss is buried in an adjustment to sales.
Two-transaction perspective (GAAP)
treats the export sale and teh subsequent collection of cash as two separate transactions.
- Because management has made two decisions
- 1. to make the export sale
- 2. to extend credit in foreign currency to the customer
- the company should report the income effect from each of these decisions separately.
Accrual approach to account for unrealized foreign exchange gains and losses (GAAP)
a firm reports unrealized foreign gains and losses in net income in the period in which the exchange rate changes.
- criticism - leads to a violation of conservatism
- one of only two situation in which it is acceptable to recognize an unrealized gain in income.
Two most common derivaties used to hedge foreign exchange risk (to hedge against the efeect of unfavorable changes in the value of foreign currencies)
- foreign currency forward contracts
- foreign currency options
Foreign currency forward contract
a company can lock in the price at which it will sell the euros
foreign currency option
establishes a price at which a company will be able, but is not required, to sell the euros
Foreign currency firm commitment
noncancelable order that specifies the foreign currency price and date of delivery
Sources of foreign exhange risk (hedged)
- 1. Recognized foreign currency denominated assets and liabilities
- 2. Unrecognized foreign currency firm commitments
- 3. Forcasted foreign currency denominated transactions
- 4. Net investments in foreign operations
Fundamental requirement of Derivatives Accounting
- carry on balance sheet at fair value
- assets when positive fair value
- liabilities when negative fair value
- FV change over time - adjustments to carrying values of assets and liabilities
- treatment of gains and losses arise from these adjustments
The fair value of a foreign currency forward contract is determined by reference to changes in the forward rate over the life of the contract.
- 3 pieces of information needed to determine fair value of forwary contract:
- 1. The forward rate when the forward contract was entered into
- 2. The current forward rate for a contract that matures on the same date as the forward contract entered into
- 3. A discount rate - typically, the company's incremental borrowing rate
Changes in fair value must be included in comprehensive income (all changs in equity from nonowner sources)
- Net income
- Other Comprehensive Income
Gains and losses arising from changes in the fair value of derivatives are recognized initially either
- 1. on the income statement as a part of net income
- 2. on the balance sheet as a component of other comprehensive income.
account for hedges in such a way to recognize the gain or loss from the hedge in net incom in the same period as the loss or gain on risk being hedged
3 conditions to allow hedge accounting for foreign currency derivatives
- 1. The derivative is used to hedge either a fair-value exposure or cash flow exposure to foreign exchange risk
- 2. The dervative is highly effective in offsetting changes in the fair value or cash flows related to the hedged item
- 3. the derivative is properly documented as a hedge
exists if changes in exchange rates can affect the fair value of an asset or liability reported on the balance sheet
must have the potential to affect net income if it is not hedged
Cash flow exposure
exists if changs in exchange rates can affect the amount of cash flow to be relaized from a transaction with changes in cash flow reflected in net income
A Cash flow exposure exists for
- 1. recognized foreign currency assets and liabilities (Fair value or cash flow hedge)
- 2. foreign currency firm commitments (Fair value or cash flow hedge)
- 3. forcasted foreign currency transactions (only cash flow hedge)
Gains and losses on fair value hedges are recognized immediately in net income
Gains and losses on cash flow hedges are included in other comprehensive income.
if critical terms of the hedging instrument match those of the hedged item
Critical terms: currency type, currency amount, and settlement date
ongoing assessment: cumulative dollar offset method
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