PPT

WEEK 4 LECTURE NOTES PART I

FOREIGN CURRENCY EXPOSURE

FOREIGN EXCHANGE

Country → currency → unit of value for purchases and sales of goods and services

For example, United States dollar

United Kingdom pound

Japan yen

Switzerland franc

There are several currency arrangements

1. Pegged to another country’s currency, often the US dollar

2. Independent float – value fluctuates based on market forces

3. European Monetary System (euro) – currency established by the European Central Bank

Foreign exchange rates

· Rates are available daily not only in newspapers but on the web

· These rates are the ones banks and foreign exchange brokers charge each other to exchange currencies

· Typically…

· Rates to buy are lower than selling rates, which are higher

· Resulting in profits on foreign exchange trades

·

Trades can occur on a spot or a forward basis

SPOT RATE is the price at which a foreign currency can be purchased or sold today

FORWARD RATE is the price that can be locked-in today at which foreign currency can be purchased or sold at a predetermined date in the future.

FORWARD	SPOT	CURRENCY SELLING @
0.0916	0.0902	Premium in forward market
0.0811	0.0902	Discount

Companies enter into forward contracts with their banks to fix the price at which they can buy or sell foreign currency at a specified future date.

Note: There is no upfront cost to enter into a forward contract.

When the contract matures, the forward contract must be honored, with the company buying or selling foreign currency at the predetermined forward rate.

Companies can also purchase a foreign currency option that gives them the right, but not the obligation, to buy or sell foreign currency at a specified future date at a predetermined price; known as the strike price.

Note: The company purchases the option by paying an option premium

Upon maturity, the company can choose to exercise the option and buy or sell currency at the strike price or allow the option to expire unexercised.

FOREIGN EXCHANGE RISK

Export sales and import purchases are international transactions that are denominated in a foreign currency create exposure to risk

· An increase in the value of a foreign currency will result in a foreign exchange gain on a foreign currency receivable and a loss on a payable

· A decrease in the value of a foreign currency will result in a foreign exchange loss on a foreign currency receivable and a gain on the payable.

FINANCIAL STATEMENT PREPARATION

· Foreign currency balances must be revalued to their current domestic currency equivalent using current exchange rates when the financials are prepared.

· Gains and losses on foreign currency balances are recognized in income in the period in which the exchange rate change occurs; referred to as the two-transaction perspective, accrual approach.

HEDGING

Exposure to foreign exchange risk can be eliminated through hedging...

Establishing a price today at which a foreign currency to be received in the future can be sold in the future or at which a foreign currency to be paid in the future can be purchased in the future.

The two most used instruments for hedging foreign exchange risk are

1. Foreign currency forward contracts*

2. Foreign currency options*

*See above notes under the spot and forward rate for definitions.

Guidance for Hedging

There are two International Accounting Standards (IAS) that apply - IAS32 and IAS39; also, IFRS 9 and 7 are applicable.

According to the Deloitte website….

Overview:

IAS 32 Financial Instruments: Presentation outlines the accounting requirements for the presentation of financial instruments, particularly as to the classification of such instruments into financial assets, financial liabilities and equity instruments. The standard also provides guidance on the classification of related interest, dividends and gains/losses, and when financial assets and financial liabilities can be offset.

IAS 32 was reissued in December 2003 and applies to annual periods beginning on or after 1 January 2005.

Objective of IAS 32

The stated objective of IAS 32 is to establish principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and liabilities. [IAS 32.1]

IAS 32 addresses this in a number of ways:

· clarifying the classification of a financial instrument issued by an entity as a liability or as equity

· prescribing the accounting for treasury shares (an entity's own repurchased shares)

· prescribing strict conditions under which assets and liabilities may be offset in the balance sheet

IAS 32 is a companion to IAS 39 Financial Instruments: Recognition and Measurement and IFRS 9 Financial Instruments. IAS 39 deals with, among other things, initial recognition of financial assets and liabilities, measurement subsequent to initial recognition, impairment, derecognition, and hedge accounting. IAS 39 is progressively being replaced by IFRS 9 as the IASB completes the various phases of its financial instruments project.

For more details use the following link below or reference the lecture notes from Week 3.

http://www.iasplus.com/en/standards/ias/ias32

In January 2014 IASB finalized a new hedge accounting model. According to KPMG The IASB’s recently issued general hedge accounting standard, which aligns hedge accounting more closely with risk management, will result in additional risk management strategies qualifying for hedge accounting under International Financial Reporting Standards.

The new standard does not fundamentally change the three types of hedging relationships or the requirement to measure and recognize ineffectiveness.

Assessing the effectiveness of a hedging relationship will require more judgment and applying the new guidance in some areas remains complex.

Key Facts

The new IASB standard:

· Allows fair value elections for certain credit exposures and own-use contracts;

· Allows cash instruments to be used as hedging instruments in additional circumstances;

· Allows the time value of purchased options, the forward element of forward contracts, and foreign currency basis spreads to be deferred or amortized as a cost of hedging;

· Extends the availability of hedge accounting to additional risk exposures;

· Removes bright lines from hedge effectiveness testing; and

· Requires rebalancing hedging relationships without terminating hedge accounting in certain situations and prohibits voluntary termination of otherwise qualifying hedging relationships.

Key Impacts

For entities following IFRS:

· The new IASB standard will enable them to better reflect in their financial statements how they manage risks with financial instruments.

· If they have significant commodity price exposures, they could benefit because hedge accounting will be allowed for risk components of nonfinancial items.

DERIVATIVES

According to Investopedia.com…

A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index or security. Common underlying instruments include: bonds, commodities, currencies, interest rates, market indexes and stocks. Futures contracts, forward contracts, options, swaps and warrants are common derivatives.

Derivatives are used for speculating and hedging purposes. Speculators seek to profit from changing prices in the underlying asset, index or security.

A derivative is a financial instrument or other contract within the scope of IAS 32 and IFRS 9

For our purpose, derivative contracts are used to hedge foreign exchange prices.

Most common derivatives are

· Foreign currency forward contracts

· Foreign currency options

Hedge accounting is appropriate if the derivative is

(a) used to hedge an exposure to foreign exchange risk,

(b) highly effective in offsetting changes in the fair value or cash flows related to the hedged item, and

(c) properly documented as a hedge.

Under hedge accounting gains and losses on the hedging instruments are reported in net income in the same period as gains and losses on the item being hedged.

Fundamental Requirement

· All derivatives are carried on the balance sheet at fair value

· Positive value = asset

· Negative value = liability

As a result, another accounting issue is the treatment of unrealized gains and losses, which are recognized in net income.

Homework Assignment

Research your MNC and report on any accounting issues covered in this chapter related to foreign currency transactions and hedging activities. Post your report in this week’s discussion area by nlt Saturday evening. By the end of Week 4, you are required to also respond to at least one other post. If someone asks a question of you, please take the time to also respond to those questions.