Question

a) Explain 'hedging'.

b) Explain the financial reporting issue that arises when a company enters into foreign currency transactions. Provide examples of various foreign currency transactions and indicate whether each transaction involves the initial recognition of a monetary item or non-monetary item or both.

c) Describe the indicators used in determining the functional currency of an entity.

d) Explain what is meant by a spot exchange rate, closing exchange rate, and forward exchange rate.

e) What is meant by foreign exchange risk? How can forward exchange contracts be used to manage foreign exchange risk?

Answer 1

a)A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security.

Hedging is often considered an advanced investing strategy, but the principles of hedging are fairly simple.The aim of hedging is to reduce the losses from unexpected fluctuation arises in the market. Hedging is the processor to retain your profit from both sides of the row. When you plan to hedge that means you are trying to reduce the risk, you cannot prevent the event to occur but you can reduce the impact of losses.

The four key steps in the Hedging Process that are required for every firm are as follows:

1)Identifying Foreign Currency Risk

2)Setting Parameters

3)Choosing a Product

4)Evaluating Performance

b)Company Financial Statements must include the financial effects of all transactions during the Reporting period including effects of Foreign Currency transaction.

The Foreign currency transactions have to be recognised using Accrual Accounting .Accordingly,monetary assets and monetary liabilities may be recognised before there is a cash receipt or cash payments that conclude or settle the transactions.The need for the re-transition of monetary items creates the financial reporting issue of exchange differences and how such difference should be recognised in the financial statements.

Examples of various foreign currency transactions and indicate whether each transaction involves the initial recognition of a monetary item or non-monetary item or both.

TRANSACTIONS INITIAL RECOGNITION AND MEASUREMENT

MONETARY ITEMS NON-MONETARY ITEMS

1)Purchase of inventory on account Trade Creditors Inventory

2)Purchase of Plant on Account   Payable to Supplier Plant

3)Purchase of service on account   Payable to Supplier -

c)The functional currency is determined by looking at a number of relevant factors. This currency should be the currency in which an entity usually generates and spends cash. Functional currency should be the one in which the business transactions of an entity are normally denominated. All of the transactions which are not in the functional currency are treated as foreign transactions. Following five factors need to be considered when determining a functional currency. Functional currency is the currency that mainly affects the prices at which the goods or services are sold of the country whose regulations, market conditions and competitive forces mainly affect the pricing policy of the entity that influences the costs and expenses of the entity in which the funds are usually generated in which receipts from operating activities are retained.

d)Spot Exchange Rate: A spot exchange rate contract is a contract that involves the purchase or sale of a currency for immediate delivery and payment on the spot date, which is normally two business days after the trade date. The spot rate, or spot price, is the price quoted for the immediate settlement of the spot contract.

Closing Exchange Rate:The exchange rate for two currencies at the end of a period of time, such as a trading day or month.

Forward Exchange Rate:The forward exchange rate is the exchange rate at which a bank agrees to exchange one currency for another at a future date when it enters into a forward contract with an investor.

e) Foreign exchange risk is also known as FX risk, exchange rate risk or currency risk is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arises when there is a risk of an unfavourable change in exchange rate between the domestic currency and the denominated currency before the date when the transaction is completed.

Foreign Exchange Risk Management : Although businesses could not control the fluctuation of the exchange rates but they can manage the risk by using proper hedging tools e.g. Forward, Futures, and Options, in order to manage their revenues and costs more efficiently.