FOREIGN CURRENCY TRANSACTION EXAMPLE EXERCISE
(TWO-TRANSACTION APPROACH)
(Shortened URL: bit.ly/FCtransaction)
Assume the following exchange rates between the US dollar ($ or USD) and the British pound (£ or BP) sterling:
(USDs to 1 BP)
Spot April 1 2.00
Three-month forward April 1 1.90
Spot April 30 1.80
Spot May 31 1.70
Spot June 30 1.65
1. On April 1, a US manufacturer enters into a commitment to sell equipment to a British importer with the sale denominated in £100. The goods are to be delivered the same day and paid for on June 30.
a. Assuming that no forward contract is entered into, what would be the journal entries for the US exporter, on April 1, April 30, May 31, and June 30? Assume the books are closed each month.
b. Assuming that a forward contract is entered into on April 1, what would be the journal entries for the US exporter on April 1, April 30, May 31, and June 30?
1-Apr Accounts Receivable (£) $200
Accounts Receivable (£) $165
To record receipt of customer payment.
Part b. - Entries for Forward Contract:
(These are additional entries; all entries in Part a would still be recorded.)
As shown, under the two-transaction approach, the foreign exchange effects (foreign currency receivable or payable) of the transaction are regarded as and accounted for as a distinct ‘second’ transaction from the original transaction to buy or sell goods or services.
Foreign Exchange Gain $20
To record change in exchange rates 1-Apr - 30-Apr £100 x (2.0-1.8)
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(ONE-TRANSACTION APPROACH)
1-Apr Accounts Receivable (£) $200
Sales $ 35
Accounts Receivable (£) $200
To record receipt of customer payment.
As shown, under the one-transaction approach, the foreign exchange effects (foreign currency receivable or payable) of the transaction are not recorded; they are assumed to be an integral part of the economic transaction to buy or sell goods or services.
Part b. - Entries for Forward Contract:
(These are additional entries; all entries in Part a would still be recorded.)
By using the one-transaction approach, an entity is not recording the foreign exchange effects (foreign currency receivable or payable) of the transaction and therefore would be unlikely to purchase a forward contract to offset FX gains or losses which are not recorded in the first place. If a forward contract is purchased, it would be accounted for as shown in the two-transaction approach.
Basic Terms Associated with Foreign Currency Exchange and Foreign Currency Transactions:
1. Currency option: The right, but not requirement, to trade a foreign currency at a set exchange rate on or before a given date in the future.
2. Spot currency: a currency designated for delivery within two business days. It is available at large banks.
3. Forward contract: a binding contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of a currency, at a specified price, at a future date. A forward contract can be used to offset foreign exchange gains and losses associated with changes in the value of the accounts receivable, resulting from changes in exchange rates.
4. Currency swap: a transaction in which two parties exchange an equivalent amount of money with each other but in different currencies.
5. Derivative: a contract between two parties which derives its value/price from an underlying asset. The most common types of derivatives are futures, options, forwards and swaps. According to SFAS 133, all derivatives must be carried on the balance sheet at fair value.
6. Hedge: a transaction implemented to protect an existing or anticipated position from an unwanted move in exchange rates. Foreign exchange hedges are implemented by a wide range of market participants, such as investors, traders and businesses.
7. Trade agreement: a contractual arrangement between nations regarding their trade relationships.