Currency Types

Accounting Currency Types

Functional Currency is used to record the transactions and report their financial results for the company. Typically, the company conducts a majority of its business activities in the functional currency (often it’s the local currency where the company operates).

For example, a Japanese company operating in Japan would likely use the Japanese Yen as its functional currency.

Reporting Currency is the functional currency of the parent organization. We have introduced this term to clarify which functional currency is ultimately being used for the financial reporting of the parent company.

Foreign Currency is recorded for specific transactions that are not in the functional currency. For example, if a Japanese company purchases computer chips from a Singapore supplier priced in Singapore dollars, the foreign currency would be Singapore dollars.

Risks

Hedging Risks: Accounting standards outline a number of risks that may be hedged. For example, market price risk, credit risk, foreign currency risk, and interest rate risk. Foreign Currency Risk: This type of risk arises from the change in price of one currency against another. When companies have foreign currency assets (for example, cross-border sales or business operations across national borders) or foreign currency liabilities (for example, imports), they face currency risk if their foreign currency exposures or positions are not hedged.

Transaction Risk includes the current and prospective risk to earnings that exchange rates will change unfavourably over time for transactions already entered into (but not completed), or for future transactions in which the firm is likely to have a commitment in a foreign currency. The exchange rate risk increases proportionately with the length of time between entering into a contract and settling it (because there is more time for the exchange rate to fluctuate).

Translation Risk is proportional to the amount of assets held in foreign currencies. It is a form of currency risk associated with the valuation of balance sheet foreign currency assets and liabilities between financial reporting dates. At each reporting date, the balance sheet and income statement reflect the change in value of the foreign currency assets and liabilities due to the change in foreign exchange rates.

Courtesy: OANDA’s FXConsulting for Corporations

Pip Booker
Chairman & Founder
Booker and Cropper Capital Group

Hedge Accounting

Hedge accounting is not an automatic right; it must be earned. Once you have gathered your foreign currency exposure data, you then have to determine what forex hedge product will be used and whether the forex hedge will be designated for special accounting treatment. For our discussion, we will use a carry spot forex hedge; however, a forex forward contract could have been used as well. (In the two case studies at the end of this document, we detail the various accounting entries for a recorded foreign asset and a future firm commitment.)

To recap, the following hedges can be designated for special accounting treatment: A cash flow hedge may be designated for a highly probable forecasted transaction, a firm commitment (not recorded on the balance sheet), foreign currency cash flows of a recognized asset or liability, or a forecasted intercompany transaction. A fair value hedge may be designated for a firm commitment (not recorded) or foreign currency cash flows of a recognized asset or liability. A net investment hedge may be designated for the net investment in a foreign operation.

An economic forex hedge is not designated for special accounting treatment. The economic hedge would protect your economic position over time, but it may create earnings volatility. An economic forex hedge may be used to hedge any item; however, all the gains/losses on the hedge are immediately recorded into earnings.

Courtesy: OANDA’s FXConsulting for Corporations

Pip Booker
Chairman & Founder
Booker and Cropper Capital Group

Special Hedge - Forex

Before a company can designate a forex hedge as one that qualifies for the special hedge accounting, specific criteria must be met and documented. While each forex accounting hedge (cash flow, fair value, or investment) has unique accounting treatment, the guiding principle is the recognition of the gain/loss of the hedged items and the gain/loss of the forex hedge into earnings at the same time. That is, the effective portion of the forex hedge’s gain/loss is recognized simultaneously on the income

statement as the gains/losses from the hedged foreign currency item. The ineffective portion of a forex hedge’s change in value (for example, over-hedged amounts or interest carrying costs) must be recognized immediately in earnings. Similarly, any forex hedge that does not meet the criteria for designation or is not designated as a cash flow, fair value, or net investment hedge has its change in fair market value recognized immediately in earnings. Proper documentation is critical to achieving hedge accounting treatment and must be supplied up front before a hedge is initiated. Further, prospective and retrospective assessments of a forex hedge must take place over its lifetime to ensure the hedge is effective. As noted previously, any ineffective portion of a forex hedge is recorded directly to the income statement. The right to perform special hedge accounting for designated forex hedges must be

Courtesy: OANDA’s FXConsulting for Corporations

Pip Booker
Chairman & Founder
Booker and Cropper Capital Group

Forex Hedges

Types of Forex Hedges

All economic hedges aim to manage foreign currency exposure, meaning they are undertaken for the economic aim of reducing potential loss from fluctuations in foreign exchange rates. However, not all hedges are designated for special accounting treatment. Accounting standards enable hedge accounting for three different designated forex hedges: A cash flow hedge may be designated for a highly probable forecasted transaction, a firm commitment (not recorded on the balance sheet), foreign currency cash flows of a recognized asset or liability, or a forecasted intercompany transaction. A fair value hedge may be designated for a firm commitment (not recorded) or foreign currency cash flows of a recognized asset or liability. A net investment hedge may be designated for the net investment in a foreign operation.

Types of Hedged Exposures

Prior to initiating a forex hedge and designating the hedge for special accounting treatment, you will need to capture and evaluate data on the foreign currency exposure, which typically falls into the following categories: foreign currency cash flows of a recognized asset or liability (recorded on the balance sheet), a firm commitment (not recorded on the balance sheet), a highly probable forecasted foreign currency transaction, a forecasted foreign currency intercompany transaction, or the net investment in a foreign operation.

Pip Booker
Chairman & Founder
Booker and Cropper Capital Group

Foreign Exchange Rates

How can I trade foreign currency exchange rates?

As you can see from the London vacation example, currency exchange rates fluctuate. As the value of one currency rises or falls relative to another, traders decide to buy or sell currencies to make profits. Retail customers also participate in the forex market, generally as speculators who are hoping to profit from changes in currency rates.

Foreign currency exchange rates may be traded in one of three ways:

On an exchange that is regulated by the Commodity Futures Trading Commission (CFTC). For example, the Chicago Mercantile Exchange offers currency futures and options on futures products.
Exchange-traded currency futures and options provide their users with a liquid, secondary market for contracts with a set unit size, a fixed expiration date and centralized clearing.

 On an exchange that is regulated by the Securities and Exchange Commission (SEC). For example, the Philadelphia Stock Exchange offers options on currencies (i.e., the right but not the obligation to buy or sell a currency at a specific rate within a specified time). Exchange-traded options on currencies have characteristics similar to exchangetraded futures and options (e.g.,a liquid, secondary market with a set size, a fixed expiration date and centralized clearing).

 In the off-exchange, also called the over-the-counter (OTC) market. A retail customer trades directly with a counterparty and there is no exchange or central clearinghouse to support the transaction.

Courtesy: National Futures Assoc

Pip Booker
Chairman & Founder
Booker and Cropper Capital Group

Exchange Rate Consideration

Foreign currency exchange rates are what it costs to exchange one country’s currency for another country’s currency. For example, if you go to England on vacation, you will have to pay for your hotel, meals, admissions fees, souvenirs,and other expenses in British pounds. Since your money is all in US dollars,you will have to use (sell) some of your dollars to buy British pounds.

Assume you go to your bank before you leave and buy $1,000 worth of British pounds. If you get 565.83 British pounds (£565.83) for your $1,000, each dollar is worth .56583 British pounds.This is the exchange rate for converting dollars to pounds.

If £565.83 isn’t enough cash for your trip, you will have to exchange more US dollars for pounds while in England. Assume you buy another $1,000 worth of British pounds from a bank in England and get only
£557.02 for your $1,000. The exchange rate for converting dollars to pounds has dropped from .56583 to .55702. This means that US dollars are worth less compared to the British pound than they were before you left on vacation.

Assume that you have £100 left when you return home.You go to your bank and use the pounds to buy US dollars. If the bank gives you $179.31, each British pound is worth 1.7931 dollars.This is the exchange rate for converting pounds to dollars.

Pip Booker
Chairman & Founder
Booker and Cropper Capital Group

London and Europe Forex

About midway through the Asian trading day, European financial centers begin to open up and the market gets into its full swing. European financial centers and London account for over 50 percent of total daily global trading volume, with London alone accounting for about one-third of total daily
global volume, according to the 2004 survey.

The European session overlaps with half of the Asian trading day and half of the North American trading session, which means that market interest and liquidity is at its absolute peak during this session.

News and data events from the Eurozone (and individual countries like Germany and France), Switzerland, and the United Kingdom are typically released in the early-morning hours of the European session. As a result, some of the biggest moves and most active trading takes place in the European currencies (EUR, GBP, and CHF) and the euro crosscurrency pairs (EUR/CHF and EUR/GBP). Asian trading centers begin to wind down in the late-morning hours of the European session, and North American financial centers come in a few hours later, around 7 a.m. ET.

Pip Booker
Chairman & Founder
Booker and Cropper Capital Group