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?

Part a. - Entries for a Sale:

1-Apr Accounts Receivable (£) $200

Sales $200

Entries for a Change in FX Value

30-Apr Foreign Exchange Loss $20

Accounts Receivable (£) $20

To record change in exchange rates 1-Apr - 30-Apr £100 x (2.0 – 1.8)

31-May Foreign Exchange Loss $10

Accounts Receivable (£) $10

To record change in exchange rates 30-Apr- 31-May £100 x (1.8-1.7)

30-Jun Foreign Exchange Loss $5

Accounts Receivable (£) $5

To record change in exchange rates 31-May to 30-Jun - £100 x (1.7-1.65)

Entries for a Collection 30-Jun

30-June Cash (or Foreign Currency) $165

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.)

1-Apr Contract Receivable ($) $190

Foreign Exchange Loss $ 10

Contract Payable (£) $200

To record initial transaction, Contract Receivable: £100 x 1.90 forward rate=$190;

Contract Payable: £100 x 2.00 spot rate on April 1=$200.

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.

Entries for a Change in FX Value- Contract

30-Apr Contract Payable (£) $20

Foreign Exchange Gain $20

To record change in exchange rates 1-Apr - 30-Apr £100 x (2.0-1.8)

31-May Contract Payable (£) $10

Foreign Exchange Gain $10

To record change in exchange rates 30-Apr- 31-May £100x (1.8-1.7)

30-Jun Contract Payable (£) $5

Foreign Exchange Gain $5

To record change in exchange rates 31-May to 30-Jun - £100 x (1.7-1.65)

Final Settlement 30-Jun Contract

30-Jun Contract Payable (£) $165

Cash (£) $165

To record delivery of £100 to Bank. Note the £100, which is equal to $165 on June 30 is from the collection of the original Account Receivable.

30-Jun Cash $190

Contract Receivable ($) $190

To record receipt of $190 from bank per forward contract.

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(ONE-TRANSACTION APPROACH)

Part a. - Entries for a Sale:

1-Apr Accounts Receivable (£) $200

Sales $200

Entries for a Collection 30-Jun

30-June Cash (or Foreign Currency) $165

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.