ACCT3321 Lecture Notes - Lecture 11: Cash Flow Hedge, Credit Risk, Book Value

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CHAPTER 23

Foreign currency transactions and forward exchange contracts

-Functional currency

oIs the currency of the primary economic environment in which the company

operates [the one in which the company primarily generates and expends

cash

-Types of foreign currency transactions

oA transaction that is denominated or requires settlement in a foreign

currency

oAny currency other than the company’s functional currency

EXCHANGE RATES

- The ratio of exchange for two currencies

-Spot exchange rate  the exchange rate for immediate delivery at a particular point

in time whereas the closing rate is the spot exchange rate at the end of the reporting

period

INITIAL MEASUREMENT AT THE TRANSACTION DATE

- Which exchange rates should be used to translate the foreign currency balances?

- The financial statement item that arise from a foreign currency transaction should be

measured on initial recognition using the historical exchange rate at the date of

transaction

- The acquisition or disposal of an asset – the date of the transaction depends on

when control of the future economic benefits embodied in the asset are obtained

from or transferred to another entity

- DR Purchase thing CR payable to foreign supplier (initial recognition)

MONETARY AND NON-MONETARY ITEMS

- Monetary – units of currency held and assets and liabilities to be received or paid in

a fixed or determinable amount of currency

oRefers to cash or another item that constitutes a claim to cash or an

obligation to pay cash

oShares held in ASX = financial asset but the shares do not constitute a

monetary item

- Non-monetary item – an asset or liability that is not a monetary item – inventory and

PPE

FOREIGN EXCHANGE DIFFERENCES FOR MONETARY ITEMS

- The difference resulting from translating a given number of units of one currency

into another currency at difference exchange rates

-Realised and unrealised gains or losses from exchange differences

oWhen there are differences in the exchange rate and you win out

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oWhen it occurs in more than one period – should the unrealised exchange

gain or losses be recognised?

oThere is a requirement that exchange gains and losses be immediately

recognised in the P&L as they arise

-The relationship between exchange rates and exchange differences

oExample p 10 – 11

oIf the change in exchange rate shows that the foreign currency increases in

value relative to the functional currency:

A monetary asset denominated in foreign currency will increase when

translated into the less valuable functional currency  giving rise to a

gain as the company is effectively entitles to receive more units of

functional currency

A monetary liability denominated in foreign currency will increase

when translated into the less valuable functional currency  giving rise

to a foreign exchange loss as the company is effectively asked to pay

more units of functional currency

oIf the change in the exchange rate shows that the foreign currency decreases

in value relative to the functional currency

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Document Summary

Functional currency: is the currency of the primary economic environment in which the company operates [the one in which the company primarily generates and expends cash. Types of foreign currency transactions: a transaction that is denominated or requires settlement in a foreign currency, any currency other than the company"s functional currency. Spot exchange rate the exchange rate for immediate delivery at a particular point in time whereas the closing rate is the spot exchange rate at the end of the reporting period. The financial statement item that arise from a foreign currency transaction should be measured on initial recognition using the historical exchange rate at the date of transaction. The acquisition or disposal of an asset the date of the transaction depends on when control of the future economic benefits embodied in the asset are obtained from or transferred to another entity. Dr purchase thing cr payable to foreign supplier (initial recognition)

Related Questions

Sendelbach Corporation is a U.S.-based organization with operations throughout the world. One of its subsidiaries is headquartered in Toronto. Although this wholly owned company operates primarily in Canada, it engages in some transactions through a branch in Mexico. Therefore, the subsidiary maintains a ledger denominated in Mexican pesos (Ps) and a general ledger in Canadian dollars (C$). As of December 31, 2017, the subsidiary is preparing financial statements in anticipation of consolidation with the U.S. parent corporation. Both ledgers for the subsidiary are as follows:

Main OperationâCanada
	Debit		Credit
Accounts payable			C$	41,555
Accumulated depreciation				42,000
Buildings and equipment	C$	182,000
Cash		41,000
Common stock				65,000
Cost of goods sold		218,000
Depreciation expense		8,400
Dividends, 4/1/17		34,000
Gain on sale of equipment, 6/1/17				6,500
Inventory		94,000
Notes payableâdue in 2020				84,000
Receivables		83,000
Retained earnings, 1/1/17				150,590
Salary expense		38,000
Sales				327,000
Utility expense		10,500
Branch operation		7,745
Totals	C$	716,645	C$	716,645

Branch OperationâMexico
	Debit		Credit
Accounts payable			Ps	67,500
Accumulated depreciation				40,000
Building and equipment	Ps	55,000
Cash		66,500
Depreciation expense		3,500
Inventory (beginningâincome statement)		38,000
Inventory (endingâincome statement)				35,500
Inventory (endingâbalance sheet)		35,500
Purchases		72,000
Receivables		36,000
Salary expense		10,500
Sales				139,000
Main office				35,000
Totals	Ps	317,000	Ps	317,000

Additional Information

The Canadian subsidiaryâs functional currency is the Canadian dollar, and Sendelbachâs reporting currency is the U.S. dollar. The Canadian and Mexican operations are not viewed as separate accounting entities.

The building and equipment used in the Mexican operation were acquired in 2007 when the currency exchange rate was C$0.21 = Ps 1.

Purchases of inventory were made evenly throughout the fiscal year.

Beginning inventory was acquired evenly throughout 2016; ending inventory was acquired evenly throughout 2017.

The Main Office account on the Mexican records should be considered an equity account. This balance was remeasured into C$7,745 on December 31, 2017.

Currency exchange rates for 1 Ps applicable to the Mexican operation follow:


Weighted average, 2016	C$	0.26
January 1, 2017		0.28
Weighted average rate for 2017		0.30
December 31, 2017		0.31

The December 31, 2016, consolidated balance sheet reported a cumulative translation adjustment with a $51,950 credit (positive) balance.

The subsidiaryâs common stock was issued in 2004 when the exchange rate was $0.44 = C$1.

The subsidiaryâs December 31, 2016, retained earnings balance was C$150,590, an amount that has been translated into U.S.$70,363.

The applicable currency exchange rates for 1 C$ for translation purposes are as follows:


January 1, 2017	US$	0.70
April 1, 2017		0.69
June 1, 2017		0.68
Weighted average rate for 2017		0.67
December 31, 2017		0.65

Remeasure the Mexican operationâs account balances into Canadian dollars. (Note: Back into the beginning net monetary asset or liability position.)

Prepare financial statements (income statement, statement of retained earnings, and balance sheet) for the Canadian subsidiary in its functional currency, Canadian dollars.

Translate the Canadian dollar functional currency financial statements into U.S. dollars so that Sendelbach can prepare consolidated financial statements.

Complete this question by entering your answers in the tabs below.

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Req A

Remeasure the Mexican operationâs account balances into Canadian dollars. (Note: Back into the beginning net monetary asset or liability position.) (Input all amounts as positive values.)

	Canadian Dollars
	Debit	Credit
Accounts payable
Accumulated depreciation
Building and equipment
Cash
Depreciation expense
Inventory (beginningâincome statement)
Inventory (endingâincome statement)
Inventory (endingâbalance sheet)
Purchases
Receivables
Salary expense
Sales
Main office

Total

b. Prepare financial statements (income statement, statement of retained earnings, and balance sheet) for the Canadian subsidiary in its functional currency, Canadian dollars.
c. Translate the Canadian dollar functional currency financial statements into U.S. dollars so that Sendelbach can prepare consolidated financial statements.

(Round U.S. Dollar values to 2 decimal places. Amounts to be deducted and losses should be indicated with a minus sign.)

Show less

SENDELBACH CORPORATION
Financial Statements
For the Year Ended December 31, 2017
	Canadian Dollar	U.S. Dollar
Income Statement:
	C$

	C$






	C$

Statement of Retained Earnings:
Retained earnings, 1/1/15	C$


Retained earnings, 12/31/15	C$

Balance Sheet:
Assets:
	C$





Total	C$
Liabilities and Equities:
	C$





Total	C$

blushleopard760

DOZIER INDUSTRIES (B)

Richard Rothschild, the chief financial officer of DozierIndustries, was still contemplating how best to manage the exchangerisk related to the company's new sales contract. The Â£1,057,500balance of the contract was due in three months on April 14, 1986,creating a long position in British pounds. Rothschild had spokenpreviously to John Gunn, an officer in the International Divisionof Southeastern National Bank, about hedging his long poundexposure. Gunn had explained two alternatives available to Dozierto reduce the exchange risk: a forward contract or a spottransaction. Either transaction would ensure that Dozier receive aset dollar value for its pound receivable, regardless of any changein the value of the pound. Given his previous analysis of theforeign exchange market, Rothschild was concerned that both ofthese hedging alternatives would lock in a profit margin below the6% he had originally anticipated for the contract. He wondered ifthere were some way to get the upside potential without all therisk.

The pound had weakened since his bid submission date on December3 (see Exhibit 1), but he was not entirelyconvinced it would continue to fall, or at least not as much as theforward rate indicated. If the future spot rate were greater thanthe current forward rate, an unhedged position could lead to again, whereas a hedged position would create an opportunity lost.Rothschild wondered if other alternatives were available, and heagain called John Gunn at the bank for advice.

Gunn explained that Rothschild could also use currency optionsto hedge against his uncertain foreign exchange exposure. Optionsprovide a means of hedging against volatility without taking aposition on expected future rates. Gunn explained that there aretwo basic varieties of options contracts: "puts" and "calls." A putgives the holder the right, but not the obligation, to sell foreigncurrency at a set exercise or "strike" price within a specifiedtime period. A call gives the holder the right to buy foreigncurrency at a set price. In comparison with a forward or futurescontract, the holder of an option does not have to transact at theagreed-upon price, but has the choice or option to do so. Gunn toldRothschild that options are complicated and increase the front endcost of hedging in comparison with a forward hedge. He saidRothschild could find the prevailing option contract prices in theWall Street Journal (see Exhibit 2).

EXHIBIT 1

HISTORICAL SPOT RATE AND FORWARD POUND IN U.S DOLLARS

DATE SPOT 3- MONTH FORWARD RATE

07/08/85 1.3640 1.3490

07/16 1.3880 1.3744

07/23 1.4090 1.3963

07/30 1.4170 1.4067

08/6 1.3405 1.3296

08/13 1.3940 1.3828

08/20 1.3900 1.3784

08/27 1.3940 1.3817

09/4 1.3665 1.3553

09/10 1.3065 1.2960

09/17 1.3330 1.3226

09/24 1.4200 1.4089

10/1 1.4120 1.4005

10/8 1.4155 1.4039

10/15 1.4120 1.4007

10/22 1.4290 1.4171

10/29 1.4390 1.4270

11/5 1.4315 1.4194

11/12 1.4158 1.4037

11/19 1.4320 1.4200

11/26 1.4750 1.4628

12/3 1.4820 1.4704

12/10 1.4338 1.4214

12/17 1.4380 1.4249

12/23 1.4245 1.4114

12/30 1.4390 1.4260

01/7/86 1.4420 1.4284

1/14/86 1.4370 1.4198

EXHIBIT 2

FOREIGN CURRENCY OPTIONS ON JANUARY 14,1986

OPTION& STRIKEPRICE CALLS-LAST PUTS-LAST

UNDERLYING CENT PERUNIT JAN. FEB.MAR. JAN. FEB. MAR.

Bpound 130 S R 13.50 S R R

144.41 135 S R 9.20 S 0.20 0.50

144.41 140 S 4.50 4.75 S 0.80 1.55

144.41 145 s 1.35 2.50 s 3.10 4.40

144.41 150 s 0.40 0.90 s r r

r- not traded s- no option offered. andLast is premium (purchase price)

Dozier Industries (B)

FOREIGN CURRENCY IPTIONS ON DECEMBER 3,1985

OPTIONS& STRIKEPRICE CALLS-LAST PUTS-LAST

UNDERLYING CENT PERUNIT DEC. JAN. MAR. DEC. JAN. MAR.

Bpound 120 29.00 S 28.95 R S R

148.86 130 19.10 R R R R R

148.86 135 13.80 R 14.60 0.05 R R

148.86 140 8.80 R 10.00 0.05 R S

148.86 145 4.00 4.50 5.70 0.20 1.05 3.20

148.86 150 0.65 1.65 3.35 R R 5.60

148.86 155 R 0.50 1.70 R R R

R- NOTTRADED S- NO OPTIONS OFFERED. LAST IS THE PREMIUM(PURCHASE PRICE)

Case B: Additional Information
1. You should treat January 14, 1986 as the date when you areperforming your analysis and acting on the analysis (hedging or nothedging).
2. To reduce risk, Dozier will take the 10% initial deposit(pounds) and sell the pounds in the spot market on Jan 14.
3. Any dollars that Dozier receives on Jan 14 are deposited in thebank for 90 days.
4. For the purpose of your calculations, you may ignore the factthat currency option contracts for the pound come in 12,500 poundincrements. However, you may discuss this limitation qualitativelyin making your recommendation (last discussion question)below.
5. None of the option contracts mature on Apr 14, 1986. Ideally,Dozier would want an option that matures on that date for thepurpose of hedging. In deciding which option maturity is best (Febor Mar), you should consider this problem and choose the maturitythat best meets Dozierâs hedging objective. First choose the optionmaturity that best meets Dozierâs objective. Then in yourcalculations below, you may treat the options as if they mature Apr14. Qualitatively, however, you should consider this maturitymismatch in making your recommendation (last discussion question)below.
6. In exhibit 2, 144.41 U.S. cents per pound refers to the spotrate for the pound on Jan 14. This is inconsistent with what isreported elsewhere in both the A and B parts of this case. Continueto use the spot rate given in part A of this case for 1/14/86. Forthe rest of the table the rows correspond to a strike price between130 cents and 150 cents per pound. The columns correspond to eithercall options or put options with either Jan, Feb, or Marchmaturities. Any entry in the table (for example 0.50 cents perpound) is the option premium. In this example, 0.50 cents per poundis the premium for a put option with a March maturity and a strikeprice of 135 cents per pound.

First read the âBâ case, and then address the followingquestions:
1. Do you recommend using a call or put option to hedge theexchange rate risk? Explain.
2. Do you recommend an option with expiration in Feb. orMarch?
3. Calculate the U.S. dollar profit or loss for each possibleoutcome; there will be more than one possible outcome for eachoption. Recall that with an option, the option does not have to beexercised; the holder may choose to trade in the future spotmarket. The holderâs choice depends on the future spot rate. Note:You will do these calculations for either all of the call optionsor all of the put options and for either all of the Feb or all ofthe March options, depending on your answer to the first twoquestions above. Hint: Since Dozierâs motive is hedging, you firstcalculate the revenue in dollars that Dozier will receive for thePound receivable. Then subtract Dozierâs Costs given in Case Aexhibit 3.
4. Which option do you recommend? Explain. Note: You must nowselect one of the options with a given maturity and strikeprice.
5. Compare the option hedge to the forward hedge (in the A case)and to remaining unhedged. Which do you recommend? Explain.

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ACCT3321 Lecture Notes - Lecture 11: Cash Flow Hedge, Credit Risk, Book Value

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