The Coca-Cola Company is organized geographically and defines reportable operating segments as regions of the world. The following information was extracted from Note 21 (Operating Segments) in the Coca-Cola Company 2008 Annual Report:
CPAskills
CPAskills
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Information about our Company’s operations by operating segment for the years ended December 31, 2008, 2007, and 2006, is as follows (in millions):
Eurasia Latin North Bottling
and Africa Europe America America Pacific Investments Corporate Eliminations Consolidated 2008
Net operating revenues:
Third party . . . . $2,135 $4,785 $3,623 $ 8,205 $4,358 $8,731 $ 107 $ — $31,944
Intersegment . . . . 192 1,016 212 75 337 200 — (2,032) —
Total net revenues . . . . 2,327 5,801 3,835 8,280 4,695 8,931 107 (2,032) 31,944
Operating income (loss) . . . . 834 3,175 2,099 1,584 1,858 264 (1,368) — 8,446
Interest income . . . . — — — — — — 333 — 333
Interest expense . . . . — — — — — — 438 — 438
Depreciation and amortization . . . . . 26 169 42 376 78 409 128 — 1,228
Equity income (loss)—net . . . . (14) (4) 6 (2) (19) (844) 3 — (874)
Income (loss) before income taxes . . 811 3,182 2,082 1,587 1,836 (625) (1,434) — 7,439
Identifiable operating assets . . . . 956 3,012 1,849 10,845 1,444 7,935 8,699 — 34,740
Investments . . . . 395 179 199 4 72 4,873 57 — 5,779
Capital expenditures . . . . 67 76 58 493 177 818 279 — 1,968
2007
Net operating revenues:
Third party . . . . $1,941 $4,447 $3,069 $ 7,761 $3,997 $7,570 $ 72 $ — $28,857
Intersegment . . . . 168 845 175 75 409 125 — (1,797) —
Total net revenues . . . . 2,109 5,292 3,244 7,836 4,406 7,695 72 (1,797) 28,857
Operating income (loss) . . . . 667 2,775 1,749 1,696 1,699 153 (1,487) — 7,252
Interest income . . . . — — — — — — 236 — 236
Interest expense . . . . — — — — — — 456 — 456
Depreciation and amortization . . . . . 23 141 41 359 82 388 129 — 1,163
Equity income (loss)—net . . . . 37 11 1 4 (14) 630 (1) — 668
Income (loss) before income taxes . . 696 2,796 1,752 1,700 1,665 761 (1,497) — 7,873
Identifiable operating assets . . . . 1,023 2,997 1,989 10,510 1,468 8,962 8,543 — 35,492
Investments . . . . 386 111 245 18 23 6,949 45 — 7,777
Capital expenditures . . . . 74 79 47 344 191 645 268 — 1,648
2006
Net operating revenues:
Third party . . . . $1,680 $3,874 $2,484 $ 7,013 $3,990 $4,954 $ 93 $ — $24,088
Intersegment . . . . 124 703 132 16 128 89 — (1,192) —
Total net revenues . . . . 1,804 4,577 2,616 7,029 4,118 5,043 93 (1,192) 24,088
Operating income (loss) . . . . 592 2,361 1,438 1,683 1,650 18 (1,434) — 6,308
Interest income . . . . — — — — — — 193 — 193
Interest expense . . . . — — — — — — 220 — 220
Depreciation and amortization . . . . . 23 101 25 361 60 278 90 — 938
Equity income (loss)—net . . . . 38 11 (2) 9 (10) 56 — — 102
Income (loss) before income taxes . . 619 2,380 1,433 1,690 1,633 67 (1,244) — 6,578
Identifiable operating assets . . . . 853 2,590 1,516 4,778 1,120 5,953 6,370 — 23,180
Investments . . . . 328 97 1 17 16 6,302 22 — 6,783
Capital expenditures . . . . 42 94 44 421 133 418 255 — 1,407
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374 Chapter 8
Required
1. Use an electronic spreadsheet to calculate the following measures for each of Coca-Cola’s reportable operating segments (excluding Bottling Investments and Corporate):
Percentage of total net revenues, 2007 and 2008.
Percentage change in total net revenues, 2006 to 2007 and 2007 to 2008.
Operating income as a percentage of total net revenues (profit margin), 2007 and 2008.
2. Determine whether you believe Coca-Cola should attempt to expand its operations in a particular region of the world to increase operating revenues and operating income.
3. List any additional information you would like to have to conduct your analysis.
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Today, international business transactions are a regular occurrence. In its 2008 annual report, Lockheed Martin Corporation reported export sales of $5.9 billion, representing 14 percent of total sales. Even small businesses are significantly involved in transactions occurring throughout the world as evidenced by this excerpt from Cirrus Logic, Inc.’s 2008 Annual Report: “Export sales, principally to Asia, include sales to U.S.-based customers with manufacturing plants overseas and represented 62 percent, 62 percent, and 66 percent of our net sales in fiscal years 2008, 2007, and 2006, respectively.” Collections from ex- port sales or payments for imported items may be made not in U.S.
dollars but in pesos, pounds, yen, and the like depending on the ne- gotiated terms of the transaction. As the foreign currency exchange rates fluctuate, so does the U.S. dollar value of these export sales and import purchases. Companies often find it necessary to engage in some form of hedging activity to reduce losses arising from fluctuat- ing exchange rates. At the end of fiscal year 2008 as part of its foreign currency hedging activities, Textron, Inc., reported having outstanding foreign currency forward contracts and options with a notional value of $1.0 billion.
This chapter covers accounting issues related to foreign currency transactions and foreign currency hedging activities. To provide back- ground for subsequent discussions of the accounting issues, the chapter begins by describing foreign exchange markets. The chapter then dis- cusses accounting for import and export transactions, followed by cov- erage of various hedging techniques. Because they are most popular, the discussion concentrates on forward contracts and options. Under- standing how to account for these items is important for any company engaged in international transactions.
375
chapter
9
Foreign Currency Transactions and Hedging Foreign
Exchange Risk LEARNING OBJECTIVES
After studying this chapter, you should be able to:
LO1 Understand concepts related to foreign currency, exchange rates, and foreign exchange risk.
LO2 Account for foreign currency transactions using the two-transaction perspective, accrual approach.
LO3 Understand how foreign currency forward contracts and foreign currency options can be used to hedge foreign exchange risk.
LO4 Account for forward contracts and options used as hedges of foreign currency denominated assets and liabilities.
LO5 Account for forward contracts and options used as hedges of foreign currency firm commitments.
LO6 Account for forward contracts and options used as hedges of forecasted foreign currency transactions.
LO7 Prepare journal entries to account for foreign currency borrowings.
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376 Chapter 9
FOREIGN EXCHANGE MARKETS
Each country uses its own currency as the unit of value for the purchase and sale of goods and services. The currency used in the United States is the U.S. dollar, the currency used in Mexico is the Mexican peso, and so on. If a U.S. citizen travels to Mexico and wishes to pur- chase local goods, Mexican merchants require payment to be made in Mexican pesos. To make a purchase, a U.S. citizen has to acquire pesos using U.S. dollars. The foreign exchange rateis the price at which the foreign currency can be acquired. A variety of factors determine the ex- change rate between two currencies; unfortunately for those engaged in international business, the exchange rate can fluctuate over time.1
Exchange Rate Mechanisms
Exchange rates have not always fluctuated. During the period 1945–1973, countries fixed the par value of their currency in terms of the U.S. dollar, and the value of the U.S. dollar was fixed in terms of gold. Countries agreed to maintain the value of their currency within 1 per- cent of the par value. If the exchange rate for a particular currency began to move outside this 1 percent range, the country’s central bank was required to intervene by buying or selling its currency in the foreign exchange market. Because of the law of supply and demand, a central bank’s purchase of currency would cause the price of the currency to stop falling, and its sale of currency would cause the price to stop rising.
The integrity of the system hinged on the U.S. dollar maintaining its value in gold and the ability of foreign countries to convert their U.S. dollar holdings into gold at the fixed rate of
$35 per ounce. As the United States began to incur balance of payment deficits in the 1960s, a glut of U.S. dollars arose worldwide, and foreign countries began converting their U.S. dol- lars into gold. This resulted in a decline in the U.S. government’s gold reserve from a high of
$24.6 billion in 1949 to a low of $10.2 billion in 1971. In that year, the United States sus- pended the convertibility of the U.S. dollar into gold, signaling the beginning of the end for the fixed exchange rate system. In March 1973, most currencies were allowed to float in value.
Today, several different currency arrangements exist. Some of the more important ones and the countries affected follow:
1. Independent float:The value of the currency is allowed to fluctuate freely according to market forces with little or no intervention from the central bank (Canada, Japan, Sweden, Switzerland, United States).
2. Pegged to another currency:The value of the currency is fixed (pegged) in terms of a partic- ular foreign currency and the central bank intervenes as necessary to maintain the fixed value.
For example, the Bahamas, Panama, and Saudi Arabia peg their currency to the U.S. dollar.
3. European Monetary System (euro): In 1998, the countries comprising the European Monetary System adopted a common currency called the euroand established a European Central Bank.2Until 2002, local currencies such as the German mark and French franc continued to exist but were fixed in value in terms of the euro. On January 1, 2002, local currencies disappeared, and the euro became the currency in 12 European countries. Today, 16 countries are part of the euro area. The value of the euro floats against other currencies such as the U.S. dollar.
Foreign Exchange Rates
Exchange rates between the U.S. dollar and many foreign currencies are published on a daily basis in The Wall Street Journaland major U.S. newspapers. Exchange rates also are available on the Internet at www.oanda.com and www.x-rates.com. To better illustrate exchange rates
LO1
Understand concepts related to foreign currency, exchange rates, and foreign exchange risk.
1Several theories attempt to explain exchange rate fluctuations but with little success, at least in the short term. An understanding of the causes of exchange rate changes is not necessary to comprehend the con- cepts underlying the accounting for changes in exchange rates.
2Most longtime members of the European Union (EU) are “euro zone” countries. The major exception is the United Kingdom, which elected not to participate. Switzerland is another important European country not part of the euro zone because it is not a member of the EU.
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EXHIBIT 9.1 The Wall Street Journal Foreign Exchange Quotes, Tuesday, March 31, 2009 US$ vs,
——–Tues––—— YTD chg Country/currency in US$ per US$ (%) Americas
Argentinapeso* . . . . .2694 3.7120 7.5 Brazilreal . . . . .4310 2.3202 0.3 Canadadollar . . . . .7931 1.2609 3.6
1-mos forward . . . . .7932 1.2607 3.6
3-mos forward . . . . .7941 1.2593 3.5
6-mos forward . . . . .7953 1.2574 3.5
Chilepeso . . . . .001716 582.75 ⴚ8.7 Colombiapeso . . . . .0003938 2539.36 12.9 EcuadorUS dollar . . . . . 1 1 unch Mexicopeso* . . . . .0706 14.1623 3.2 Perunew sol . . . . .3170 3.155 0.6 Uruguaypeso† . . . . .04150 24.10 ⴚ1.2 Venezuelab. fuerte . . . .465701 2.1473 unch Asia-Pacific
Australiandollar . . . . .6952 1.4384 2.3 Chinayuan . . . . .1463 6.8334 0.2 Hong Kongdollar . . . . . .1290 7.7504 unch Indiarupee . . . . .01977 50.582 4.0 Indonesiarupiah . . . . .0000865 11561 6.0 Japanyen . . . . .010106 98.95 9.1
1-mos forward . . . . .010110 98.91 9.1
3-mos forward . . . . .010121 98.80 9.1
6-mos forward . . . . .010142 98.60 9.2
Malaysiaringgits§ . . . . . .2743 3.6456 5.6 New Zealanddollar . . . .5696 1.7556 2.9 Pakistanrupee . . . . .01243 80.451 1.7 Philippinespeso . . . . .0207 48.239 1.6 Singaporedollar . . . . .6575 1.5209 6.2 South Koreawon . . . . . .0007278 1374.00 8.8 Taiwandollar . . . . .02947 33.933 3.5 Thailandbaht . . . . .02820 35.461 2.0 Vietnamdong . . . .00005622 17786 1.7
US$ vs,
——–Tues––––— YTD chg Country/currency in US$ per US$ (%) Europe
Czech Rep.koruna** . . .04855 20.597 7.2 Denmarkkrone . . . . .1784 5.6054 5.2 Euro areaeuro . . . . 1.3286 .7527 5.1 Hungaryforint . . . . .004314 231.80 21.9 Norwaykrone . . . . .1488 6.7204 ⴚ3.4 Polandzloty . . . . .2875 3.4783 17.1 Russiaruble‡ . . . . .02949 33.910 11.1 Swedenkrona . . . . .1217 8.2169 5.0 Switzerlandfranc . . . . . .8785 1.1383 6.7
1-mos forward . . . . .8790 1.1377 6.6
3-mos forward . . . . .8803 1.1360 6.6
6-mos forward . . . . .8824 1.1333 6.6
Turkeylira** . . . . .6014 1.6627 7.9 UK pound . . . . 1.4347 .6970 1.7
1-mos forward . . . . 1.4348 .6970 1.6
3-mos forward . . . . 1.4352 .6968 1.5
6-mos forward . . . . 1.4359 .6964 1.4
Middle East/Africa
Bahraindinar . . . . 2.6526 .3770 unch Egyptpound* . . . . .1775 5.6329 2.4 Israelshekel . . . . .2369 4.2212 11.7 Jordandinar . . . . 1.4129 .7078 ⴚ0.1 Kuwaitdinar . . . . 3.4305 .2915 5.5 Lebanonpound . . . . .0006634 1507.39 unch Saudi Arabiariyal . . . . . .2666 3.7509 ⴚ0.1 South Africarand . . . . . .1055 9.4787 0.9 UAEdirham . . . . .2722 3.6738 unch SDR†† . . . . 1.4951 .6689 3.0
*Floating rate.
†Financial.
§Government rate.
‡Russian Central Bank rate.
**Rebased as of Jan 1, 2005.
††Special Drawing Rights (SDR); from the International Monetary Fund; based on exchange rates for U.S., British, and Japanese currencies.
Note: Based on trading among banks of $1 million and more, as quoted at 4 p.m. ET by Reuters.
Source: The Wall Street Journal,April 1, 2009, p. C2. Reprinted with permission of The Wall Street Journal,copyright © Dow Jones & Company, Inc. All Rights Reserved Worldwide.
Foreign Currency Transactions and Hedging Foreign Exchange Risk 377
and the foreign currency market, next we examine the exchange rates published in The Wall Street Journalfor Tuesday, March 31, 2009, as shown in Exhibit 9.1.
These exchange rates were quoted in New York at 4:00 p.m. Eastern time (ET). The U.S. dol- lar price for one Argentinian peso on Tuesday, March 31, at 4:00 p.m. in New York was $0.2694.
The U.S. dollar price for a peso at 4:01 p.m. Eastern time in New York was probably something different, as was the U.S. dollar price for a peso in Buenos Aires at 4:00 p.m. ET. These exchange rates are for trades between banks in amounts of $1 million or more; that is, these are interbank or wholesale prices. Prices charged to retail customers, such as companies engaged in interna- tional business, are higher. These are selling rates at which banks in New York will sell currency to one another. The prices that banks are willing to pay to buy foreign currency (buying rates) are somewhat less than the selling rates. The difference between the buying and selling rates is the spread through which the banks earn a profit on foreign exchange trades.
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Two columns of information are published for each day’s exchange rates. The first column, in US$, indicates the number of U.S. dollars needed to purchase one unit of foreign currency.
These are known as direct quotes. The direct quote for the Swedish krona on March 31 was
$0.1217; in other words, 1.0 krona could be purchased with $0.1217. The second column, per US$, indicates the number of foreign currency units that could be purchased with one U.S. dollar. These are called indirect quotes,which are simply the inverse of direct quotes. If one krona can be purchased with $0.1217, then 8.2169 kroner can be purchased with $1.00.
(The arithmetic does not always work out perfectly because the direct quotes published in The Wall Street Journalare carried out to only four decimal points.) To avoid confusion, direct quotes are used exclusively in this chapter.
The third column indicates the year-to-date change in the value of each foreign currency. In the three months following January 1, 2009, the Canadian dollar increased in value relative to the U.S. dollar by 3.6 percent, whereas during the same time period, the Chilean peso de- creased in value by 8.7 percent. Several currencies, such as the Bahraini dinar and the Hong Kong dollar, did not change in value because they were pegged to the U.S. dollar.
Spot and Forward Rates
Foreign currency trades can be executed on a spot or forward basis. The spot rateis the price at which a foreign currency can be purchased or sold today. In contrast, the forward rateis the price today at which foreign currency can be purchased or sold sometime in the future. Be- cause many international business transactions take some time to be completed, the ability to lock in a price today at which foreign currency can be purchased or sold at some future date has definite advantages.
Most of the quotes published in The Wall Street Journalare spot rates. In addition, it publishes forward rates quoted by New York banks for several major currencies (British pound, Canadian dollar, Japanese yen, and Swiss franc) on a daily basis. This is only a partial listing of possible forward contracts. A firm and its bank can tailor forward contracts in other currencies and for other time periods to meet the firm’s needs. Entering into a forward contract has no up-front cost.
The forward rate can exceed the spot rate on a given date, in which case the foreign currency is said to be selling at apremiumin the forward market, or the forward rate can be less than the spot rate, in which case it is selling at adiscount. Currencies sell at a premium or a discount be- cause of differences in interest rates between two countries. When the interest rate in the foreign country exceeds the domestic interest rate, the foreign currency sells at a discount in the forward market. Conversely, if the foreign interest rate is less than the domestic rate, the foreign currency sells at a premium.3Forward rates are said to be unbiased predictors of the future spot rate.
The spot rate for British pounds on March 31, 2009, indicates that 1 pound could have been purchased on that date for $1.4347. On the same day, the one-month forward rate was $1.4348.
By entering into a forward contract on March 31, it was possible to guarantee that pounds could be purchased on April 30 at a price of $1.4348, regardless of what the spot rate turned out to be on April 30. Entering into the forward contract to purchase pounds would have been beneficial if the spot rate on April 30 was more than $1.4348. On the other hand, such a forward contract would have been detrimental if the spot rate was less than $1.4348. In either case, the forward contract must be honored and pounds must be purchased on April 30 at $1.4348.
As it turned out, the spot rate for pounds on April 30, 2009, was $1.4789, so entering into a one-month forward contract on March 31, 2009, to purchase pounds at $1.4348 would have resulted in a gain.
Option Contracts
To provide companies more flexibility than exists with a forward contract, a market for foreign currency optionshas developed. A foreign currency option gives the holder of the option the right but not the obligationto trade foreign currency in the future. A putoption is for the sale of foreign currency by the holder of the option; a callis for the purchase of foreign currency by the holder of the option. The strike priceis the exchange rate at which the option will be
378 Chapter 9
3This relationship is based on the theory of interest rate parity that indicates the difference in national interest rates should be equal to, but opposite in sign to, the forward rate discount or premium. This topic is covered in detail in international finance textbooks.
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Foreign Currency Transactions and Hedging Foreign Exchange Risk 379
executed if the option holder decides to exercise the option. The strike price is similar to a for- ward rate. There are generally several strike prices to choose from at any particular time. For- eign currency options can be purchased on the Philadelphia Stock Exchange, on the Chicago Mercantile Exchange, or directly from a bank in the so-called over-the-counter market.
Unlike a forward contract, for which banks earn their profit through the spread between buying and selling rates, options must actually be purchased by paying an option premium, which is a function of two components: intrinsic value and time value. An option’s intrinsic valueis equal to the gain that could be realized by exercising the option immediately. For ex- ample, if a spot rate for a foreign currency is $1.00, a calloption (to purchase foreign cur- rency) with a strike price of $0.97 has an intrinsic value of $0.03, whereas a putoption (to sell foreign currency) with a strike price of $0.97 has an intrinsic value of zero. An option with a positive intrinsic value is said to be “in the money.” The time valueof an option relates to the fact that the spot rate can change over time and cause the option to become in the money. Even though a 90-day call option with a strike price of $1.00 has zero intrinsic value when the spot rate is $1.00, it will still have a positive time value because there is a chance that the spot rate could increase over the next 90 days and bring the option into the money.
The value of a foreign currency option can be determined by applying an adaptation of the Black-Scholes option pricing formula. This formula is discussed in detail in international finance books. In very general terms, the value of an option is a function of the difference between the current spot rate and strike price, the difference between domestic and foreign interest rates, the length of time to expiration, and the potential volatility of changes in the spot rate. For purposes of this book, the premium originally paid for a foreign currency option and its subsequent fair value up to the date of expiration derived from applying the pricing formula will be given.
On June 9, 2009, the Chicago Mercantile Exchange indicated that a July 2009 call option in euros with a strike price of $1.39 could have been purchased by paying a premium of
$0.0197 per euro. Thus, the right to purchase a standard contract of 62,500 euros in June 2009 at a price of $1.39 per euro could have been acquired by paying $1,231.25 ($0.0197 62,500 euros). If the spot rate for euros in July 2009 turned out to be more than $1.39, the option would be exercised and euros purchased at the strike price of $1.39. If, on the other hand, the July spot rate is less than $1.39, the option would not be exercised; instead, euros would be purchased at the lower spot rate. The call option contract establishes the maximum amount that would have to be paid for euros but does not lock in a disadvantageous price should the spot rate fall below the option strike price.
FOREIGN CURRENCY TRANSACTIONS
Export sales and import purchases are international transactions; they are components of what is called trade. When two parties from different countries enter into a transaction, they must decide which of the two countries’ currencies to use to settle the transaction. For example, if a U.S. computer manufacturer sells to a customer in Japan, the parties must decide whether the transaction will be denominated (payment will be made) in U.S. dollars or Japanese yen.
Assume that a U.S. exporter (Amerco) sells goods to a German importer that will pay in euros (€). In this situation, Amerco has entered into a foreign currency transaction. It must restate the euro amount that it actually will receive into U.S. dollars to account for this trans- action. This happens because Amerco keeps its books and prepares financial statements in U.S. dollars. Although the German importer has entered into an international transaction, it does not have a foreign currency transaction (payment will be made in its currency) and no restatement is necessary.
Assume that, as is customary in its industry, Amerco does not require immediate pay- ment and allows its German customer 30 days to pay for its purchases. By doing this, Amerco runs the risk that the euro might depreciate against the U.S. dollar between the sale date and the date of payment. If so, the sale would generate fewer U.S. dollars than it would have had the euro not decreased in value, and the sale is less profitable because it was made on a credit basis. In this situation Amerco is said to have an exposure to foreign
LO2
Account for foreign currency transactions using the two- transaction perspective, accrual approach.
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