Question

1. Create your own specific and detailed example of foreign exchange options to hedge an anticipated purchase of inventory of these types of foreign exchange options from the beginning of the use of an option to the end of the use or the settlement of the option over a three-month period of time:   
2. Show the required journal entries required at each respective date during the three-month period, including an explanation of the basis of each of your journal entry calculations and the authoritative support for each entry following the US GAAP.
3. Make sure your journal entries are clear with regards to which financial statement account is affected by each of your journal entries (Balance Sheet, Income Statement, Other Comprehensive Income, etc.).

Answer 1

FOREIGN CURRENCY TRANSACTIONS

A transaction that requires payment or receipt (settlement) in a foreign currency is called a foreign currency transaction. A transaction with a foreign company that is to be settled in dollars is not a foreign currency transaction to a U.S. firm because the number of dollars to be received or paid to settle the account is fixed and remains unaffected by subsequent changes in the exchange rate. Thus, a transaction of a U.S. firm with a foreign entity to be settled in dollars is accounted for in the same manner as if the transaction had been with a U.S. company.

The direct exchange rate is often said to be increasing, or the foreign currency unit to be strengthening, if more dollars are needed to acquire the foreign currency units. If fewer dollars are needed, then the foreign currency is weakening or depreciating in relation to the dollar (the direct exchange rate is decreasing). Consider the following information.

                                                Direct Exchange Rates                 

                                Yen Strengthens                Yen Weakens

Beginning of year       $1 = 1 Yen                       $1 = 1 Yen

End of year                 $2 = 1 Yen                      $.5 = 1 Yen

In the News:

Some currencies have undergone major changes in comparison to the US dollar. Consider the changes in the following direct exchange rates between the US dollar and the Brazilian Real and the Australian dollar:

                                                   US Dollars to Convert to Foreign Currency

                                                    January 4, 2000      August 28, 2001       Percent Change

            Australian Dollar                  $0.6565                   $0.5293                        19%

            Brazilian Real                       $0.5435                   $0.3907                        28%

In both cases, the US dollar has strengthened relative to the other currencies. One way to consider whether a currency has strengthened or weakened is to consider the direct exchange rate as the cost of the foreign currency. For instance, when the direct exchange rate increases, the currency is cheaper so the currency has weakened relative to the US dollar.At the date the transaction is first recognized in conformity with GAAP. Each asset, liability, revenue, expense, gain, or loss arising from the transaction is measured and recorded in dollars by multiplying the units of foreign currency by the current exchange rate.

To illustrate an importing transaction, assume that on December 1, 2003, a U.S. firm purchased 100 units of inventory from a French firm for 500,000 euros to be paid on March 1, 2004. The firm's fiscal year-end is December 31. Assume further that the U.S. firm did not engage in any form of hedging activity. The spot rate for euros ($/euro) at various times is as follows:

	Spot Rate
Transaction date - December 1, 2003	$1.05
Balance sheet date - December 31, 2003	1.08
Settlement date - March 1, 2004	1.07

The U.S. firm would prepare the following journal entry on December 1, 2003:

Dec. 1        Purchases	525,000
Accounts Payable (500,000 euros x $1.05/euro)		525,000

At the balance sheet date, the accounts payable denominated in foreign currency is adjusted using the exchange rate (spot rate) in effect at the balance sheet date. The entry is

Dec. 31      Transaction Loss	15,000
Accounts Payable		15,000
Accounts payable valued at 12/31 (500,000 euros x $1.08/euro)		$540,000
Accounts payable valued at 12/1 (500,000 euros x $1.05/euro)		525,000
Adjustment to accounts payable needed		$ 15,000
or
[500,000 euros x ($1.08 - $1.05) = $15,000]

If the exchange rate had declined below $1.05,[1] for example to $1.03, the U.S. firm would have recognized a gain of $10,000 since it would have taken only $515,000 (500,000 euros x $1.03) to settle the $525,000 recorded liability.

Before the settlement date, the U.S. firm must buy euros in order to satisfy the liability. With a change in the exchange rate to $1.07, the firm must pay $535,000 on March 1, 2004, to acquire the 500,000 euros. The journal entry to record the settlement is:

Mar. 1     Accounts Payable	540,000
Transaction Gain		5,000
Cash (500,000 euros x $1.07/euro)		535,000

Over the three-month period, the decision to delay making payment cost the firm $10,000 (the $535,000 cash paid less the original payable amount of $525,000). This net amount was recognized as a loss of $15,000 in 2003 and a gain of $5,000 in 2004.

Note in the example above that at December 31, the balance sheet date, a transaction loss was recognized on the open account payable. Such a loss is considered unrealized because the account has not yet been settled or closed. When an account payable (or receivable) is settled or closed, a transaction gain or loss on the settlement is considered realized. The FASB reasoned that users of financial statements are best served by reporting the effects of exchange rate changes on a firm's financial position in the accounting period in which they occur, even though they are unrealized and may reverse or partially reverse in a subsequent period, as in the illustration above. This procedure is criticized, however, because under GAAP, gains are not ordinarily reported until realized and because the recognition of unrealized gains and losses results in increased earnings volatility.

2.

Now assume that the U.S. firm sold 100 units of inventory for 500,000 euros to a French firm. All other facts are the same as those for the importing transaction. The journal entries to record this exporting transaction on the books of the U.S. Company are:

December 1, 2003 - Date of Transaction

Accounts Receivable (500,000 euros x $1.05)	525,000
Sales		525,000

December 31, 2003 - Balance Sheet Date

Accounts Receivable ($540,000-$525,000)	15,000
Transaction Gain		15,000
The receivable valued at 12/1, 500,000 euros x $1.08 =   $540,000                      The receivable valued at 12/31, 500,000 euros x $1.05 = $525,000                      Change in the value of the receivable                                $ 15,000

March 1, 2004 - Settlement Date

Cash (500,000 euros x $1.07)	535,000
Transaction Loss	5,000
Accounts Receivable		540,000

A comparison of the entries to record the exporting transaction with those prepared to record an importing transaction reveals that a movement in the exchange rate has an opposite effect on the company's reported income. That is, the increase in the exchange rate from $1.05 to $1.08 resulted in a transaction gain in the case of a foreign currency receivable, whereas a transaction loss was reported in the case of a foreign currency payable. When the exchange rate decreased from $1.08 to $1.07, a transaction loss was reported on the exposed receivable, whereas a transaction gain was reported on the exposed payable. Thus, one tool available to management to hedge a potential loss on a foreign currency receivable is to enter into a transaction to establish a liability to be settled in the same foreign currency. Similarly, a liability to be settled in units of a foreign currency can be hedged by entering into a receivable transaction denominated in the same foreign currency.

These relationships are summarized below.

                       Balance Sheet

Exposed Account

Effect on Balance Reported

Income Statement Effect

Increase in direct exchange rate
Importing transaction	Payable	Increase	Transaction loss
Exporting transaction	Receivable	Increase	Transaction gain
Decrease in direct exchange rate
Importing transaction	Payable	Decrease	Transaction gain
Exporting transaction	Receivable	Decrease	Transaction loss

How should a transaction gain or loss be reported? In the previous examples, the dollar amount recorded in the Sales account and the Purchases account was determined by the exchange rate prevailing at the transaction date. Adjustments to the foreign currency denominated receivable or payable were recorded directly to transaction gain or loss. Under this approach, referred to as the two- transaction approach, the sale or purchase is viewed as a transaction separate and distinct from the financing arrangement. Thus, the transaction gain or loss does not result from an operating decision to buy or sell goods or services in a foreign market, but from a financial decision to delay the payment or receipt of foreign currency and not to hedge the exposed receivable or payable against possible unfavorable currency rate changes.

An alternative view that was rejected by the FASB considers the initial transaction and settlement to be one transaction. Supporters of this method contend that the initial transaction is incomplete and the amounts recorded are estimates until such time as the total sacrifice from the purchase (units of domestic currency paid) or the total benefits from the sale (units of domestic currency received) are known. Under this view, transaction gains or losses should be accounted for as an adjustment to the cost of the asset purchased or to the revenue recorded in a sales transaction. There is an obvious implementation problem with this method when the sale or purchase is recorded in one fiscal period and the receipt or payment occurs in another period.