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Chapter 13: Problem 45

In each of the following examples, determine the gain or loss resulting from foreign exchange transactions.All exchange rates are shown as the number of U.S. dollars required to obtain one unit of foreign currency. a. Shipley Company purchases supplies and records an account payable of 82,000 Japanese yen. The exchange rate on the purchase date is 0.009 dollar When the account payable is paid, the exchange rate has risen to 0.006 dollar b. Cameron Enterprises sells services and records an account receivable of 38,200 British pounds when the exchange rate is 1.38 dollar. Vaughan receives payment in pounds from the British buyer when the exchange rate is 1.44 dollar c. Bishop Chess Company records an account payable of 82,000 French francs when the exchange rate is 0.56 dollar. At payment date, the exchange rate has fallen to 0.51 dollar d. Describe how the firm might have hedged its foreign currency exposure by transactions to buy or sell foreign currencies in futures markets.

Short Answer

Expert verified
Shipley Company experienced a loss of 246 dollars, Cameron Enterprises gained 2,292 dollars, and Bishop Chess Company experienced a loss of 4,100 dollars due to foreign exchange rate fluctuations. A firm can hedge its foreign currency exposure via transactions in futures markets to buy or sell foreign currencies at a future date at a predetermined rate.

Step by step solution

01

Calculate the foreign exchange transactions for Shipley Company

On transaction date, value in dollars of Japanese yen payable = 82,000 yen * 0.009 dollar/yen = 738 dollars. On settlement date, value in dollars of yen paid = 82,000 yen * 0.006 dollar/yen = 492 dollars. Difference (gain or loss) = 738 dollars - 492 dollars = 246 dollars (loss).
02

Calculate the foreign exchange transactions for Cameron Enterprises

On transaction date, value in dollars of British pound receivable = 38,200 pounds * 1.38 dollar/pound = 52,716 dollars. On settlement date, value in dollars of pounds received = 38,200 pounds * 1.44 dollar/pound = 55,008 dollars. Difference (gain or loss) = 55,008 dollars - 52,716 dollars = 2,292 dollars (gain).
03

Calculate the foreign exchange transactions for Bishop Chess Company

On transaction date, value in dollars of French francs payable = 82,000 francs * 0.56 dollar/franc = 45,920 dollars. On settlement date, value in dollars of francs paid = 82,000 francs * 0.51 dollar/franc = 41,820 dollars. Difference(gain or loss) = 45,920 dollars - 41,820 dollars = 4,100 dollars (loss).
04

Describe hedging techniques for foreign currency exposure

A firm can use futures markets to hedge against foreign currency exposure. A futures contract allows the firm to buy or sell a currency at a future date at a predetermined rate. If the firm anticipates that the foreign currency value will rise (resulting in a loss when settling payables), it can enter into a futures contract to sell the foreign currency at today鈥檚 rate at a future date. This effectively locks in the current rate and would avoid losses from future rate increases. Or if the firm expects the foreign currency value to fall (resulting in a loss when settling receivables), it can enter into a futures contract to buy the foreign currency at today鈥檚 rate at a future date. This would lock in the current rate and avoid losses from future rate decreases. The cost of the futures contract is offset by the gain or saving in the foreign currency exchange rate movements.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Currency Exchange Rates
Currency exchange rates defy borders by dictating how much of one currency is needed to purchase a unit of another currency. These rates influence the cost of imports and exports, determining whether a transaction yields a gain or a loss. For example, if a U.S. company owes money in foreign currency such as yen, and the exchange rate changes in their favor between the time of purchase and payment, they may pay less in U.S. dollars than initially expected, and thus, save money. On the flip side, if the rate shifts adversely, they might end up paying more.
Knowing these rates is crucial when doing business internationally because they can fluctuate due to changes in the market. Some possible reasons for these changes include economic indicators, geopolitical events, and market speculation. These fluctuations can have a significant impact on a company's financial health, especially if these transactions are not insulated from rate changes.
Hedging Strategies
Hedging is like wearing a raincoat on a cloudy day鈥攜ou might not need it, but it's good to be prepared. Companies use hedging strategies to protect themselves against unfavorable movements in currency exchange rates. A popular tool for this purpose is the futures contract, which locks in an exchange rate for a future date.
Imagine a company knows it will receive payments in a foreign currency in a few months. If they suspect that the value of this currency might decrease, making their receivables worth less in their home currency, they can enter into a futures contract to buy the foreign currency at the current favorable rate. This move effectively "locks" the rate and secures them against any adverse future changes. Conversely, if they expect a foreign currency payable to increase in value, they can sell that currency through futures beforehand to avoid paying extra later. By using such strategies, businesses can secure themselves against the unpredictable nature of foreign exchange markets, ensuring more predictable financial outcomes.
Accounting for Foreign Transactions
Accounting for foreign transactions involves translating amounts from foreign currencies into the company's reporting currency. This step is necessary to reflect accurate financial statements. Exchange rate fluctuations must be calculated to determine either gains or losses when those transactions are settled.
Take Shipley Company, from the exercise mentioned, which recorded an account payable in yen. The amount changed between the time of purchase and payment due to exchange rate fluctuations, resulting in a recognized loss. Conversely, Cameron Enterprises recorded an account receivable in pounds and later realized a gain when the rate changed in their favor.
These gains and losses need to be documented in the financial records to provide a true view of the company鈥檚 financial standing. Doing so enables companies to make informed decisions based on current financial data, and it is a critical practice for transparency and compliance with accounting standards.

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Most popular questions from this chapter

Explain whether a U.S. firm would experience a gain or a loss related to its unhedged accounts receivable or payable in each of the following cases: a. A U.S. firm has accounts receivable in British pounds, and the pound strengthens relative to the U.S. dollar b. A U.S. firm has accounts payable in Mexican pesos, and the peso weakens relative to the U.S. dollar. c. A U.S. firm has accounts receivable in French francs, and the franc weakens relative to the U.S. dollar. d. A U.S. firm has accounts payable in Canadian dollars, and the Canadian dollar strengthens relative to the U.S. dollar.

Kimberly-Clark is a global corporation whose primary product is diapers and tissues.Access the EDGAR archives (www.gov.sec/edaux/searches.htm) to locate Kimberly-Clark's 1995 10-K.Answer the following questions based on its Note on Foreign Currency Related Issues. a. What is the dollar impact of foreign currency transactions included in consolidated net income? b. How does the company translate the financial statements of foreign operations other than those in hyper-inflationary economies? c. How does the company translate monetary assets (accounts receivable and cash) of subsidiaries located in hyper-inflationary economies? d. Determine the dollar impact on the company of the Mexican peso devaluation in 1995

Foreign companies whose shares are registered on U.S. security exchanges must file a description of significant differences between U.S. and domestic accounting principles with the SEC, as well as a reconciliation of net income and shareholders' equity under domestic and U.S. GAAP Antic Knights, plc, a British firm, included the following information in its SEC filings for 2000 1\. Summary of Differences Between United Kingdom and United States Generally Accepted Accounting Principles: (a) Acquisition cost Under United Kingdom GAAP, certain acquisition-related costs can be immediately charged to retained earnings. Under United States GAAP, these costs are charged to the statement of earnings as incurred. Examples of such items include certain costs related to the closure of facilities and severances of terminated employees. (b) Deferred Taxation United Kingdom GAAP allows for no provision for deferred taxation to be made if there is reasonable evidence that such taxation will not be payable in the foreseeable future. United States GAAP requires provisions for deferred taxation be made for all differences between the tax basis and book basis of assets and liabilities. (c) Goodwill and Otber Intangibles The Company writes off certain intangible assets, including goodwill, covenants not to compete, and favorable lease rights, directly to retained earnings in the year of acquisition. Under U.S. GAAP these intangible assets would be capitalized as assets and amortized over their estimated useful lives. 2\. Reconciliations of Net Income and Shareholders' Equity: a. For each of the indicated differences between U.S. and U.K. GAAP, indicate which method of accounting you consider to be more suitable to the needs of investor analysts. Explain your reasoning. b. Based on the information provided, do you consider U.K. or U.S.GAAP to be more conservative? Explain. c. Based on the explanations of differences between U.K. and U.S. GAAP, explain why each of the individual reconciling items is added (or subtracted) to convert to U.S. GAAP. (For example, why is goodwill subtracted in the income reconciliation and added in the shareholders' equity reconciliation?)

In each of the following cases, determine the amount of gain or loss to be reported in 1999 due to unhedged accounts receivable or payable that are denominated in foreign currencies.All exchange rates are stated as the number of U.S. dollars required to obtain one unit of foreign currency. a. Asebrook Company recorded an account receivable of 10,000 British pounds in 1999 when the exchange rate was 1.50 dollar.At year-end, the exchange rate had risen to 1.60 dollar b. Baker Company recorded an account payable of 1,000,000 New Taiwan dollars in 1999 when the exchange rate was 0.04 dollar.At year-end, the exchange rate had risen to 0.05 dollar c. Hanno Company recorded an account receivable of 100,000 Canadian dollars in 1999 when the exchange rate was 0.75 dollar. At year-end, the exchange rate had fallen to 0.68 dollar d. Pfeiffer Company recorded an account payable of 50,000 Swiss francs in 1999 when the exchange rate was 0.60 dollar.At year-end, the exchange rate had fallen to 0.57 dollar e. In each of these cases (a through \(\mathrm{d}\) ), describe how the U.S. firm might have insulated itself from foreign exchange gains and losses by transactions in the foreign exchange forward market.

Respond to the following remarks: I just read in the financial pages that Whale company owns 60 percent of Minnow Inc.'s shares. Whale Company includes all of Minnow's assets and liabilities and all of Minnow's revenues and expenses in its consolidated financial statements. It seems to me that this is a misrepresentation. If Whale owns 60 percent of Minnow, then it should only reflect 60 percent of Minnow in its financial statements.
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