BU416 Page 1 of 9. Accounting Treatment of Transactions Exposure Dr. J. A. Schnabel

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1 BU416 Page 1 of 9 Accounting Treatment of Transactions Exposure Dr. J. A. Schnabel Transactions exposure deals with a situation where a contractually specified amount of foreign currency is paid or received. The two cases of a Canadian importer from China and a Canadian exporter to China are considered. The import and exports contract are denominated in RMB, i.e. renminbi the Chinese currency. The contracts are signed and three months after signing, payment or receipt occurs. During the indicated 3-month time interval between contract signing and receipt or payment of the RMB amount, the RMB appreciates/depreciates vis-à-vis the loonie (AKA Canadian dollar). This article discusses the accounting treatment of transactions exposure, i.e. the journal entries that describe transactions exposure, from the point of view of the Canadian entity. The financial amounts calculated in this document reflect some rounding. Recall that, in the jargon of accounting, left-hand journal entries are known as debits and right-hand entries are known as credits. The exchange rate at contract signing equals RMB 6.5/C$ or C$ /RMB. Note that the second number is the reciprocal or inverse of the first number. After 3 months, when payment or receipt occurs, two scenarios are envisioned. In one scenario, the exchange rate becomes RMB 6 or C$ , i.e. the RMB appreciates or the loonie depreciates. In a second scenario, the exchange rate becomes RMB 7 or C$ , i.e. the RMB depreciates or the loonie appreciates. Note that in this document, the possibility of Canadian firm hedging its exposure is not considered, i.e. the Canadian firm does not mitigate its exposure to foreign exchange risk.

2 BU416 Page 2 of 9 Case of a Canadian Importer, contract amount is RMB 1 million: When the import contract is signed, the following journal entries are recorded: Purchases C$153,846 Accounts Payable C$153,846 Note that C$153,846 = RMB 1 million / (RMB 6.5/C$) = RMB 1 million X C$ /RMB. Scenario 1: After 3 months, if the RMB appreciates to C$ , the following journal entries are recorded: Accounts Payable C$153,846 Cash FX Loss C$12,821 C$166,667 Note that C$166,667 = RMB 1 million X CS / RMB; this is the C$ value of the cash that is paid. Observe that C$ 12,821 = C$ 166,667 C$ 153,846, i.e. the FX loss is the difference between the C$ value of the Canadian firm s eventual payment of C$166,667 and the original C$ value of the Canadian firm s liability of C$ 153,846. The FX loss is the increase in the Canadian dollar value of the payable. The FX loss always appears as a debit entry. Scenario 2: After 3 months, if the RMB depreciates to C$ , the following journal entries are recorded: Accounts Payable C$153,846 Cash FX Gain C$142,857 C$10,989 Note that C$ 142,857 = RMB 1 million X C$ / RMB; this is the C$ value of the cash that is paid. Observe that C$ 10,989 = C$ 153,846 C$ 142,857, i.e. the FX gain is the difference between the C$ value of the Canadian firm s original liability and the C$ value of the amount that the Canadian firm eventually pays. The FX gain is the reduction in the Canadian dollar value of the payable. The FX gain always appears as a credit entry.

3 BU416 Page 3 of 9 The following graphical depiction of the case of Canadian importer, who faces a contractually specified foreign currency liability, provides a succinct and intuitive summary of the numerical example just considered. On the X axis is measured the value of the RMB in C$s (i.e. C$s per RMB), whereas on the Y axis is measured the value of the cash flow in C$s. Following convention, a cash outflow, such as the payment of the Canadian importer, is represented by a negative cash flow. Scenario 1: The RMB appreciation, represented by movement away from the origin on the X axis, causes the C$ value of the RMB-denominated liability to increase, resulting an FX loss. Scenario 2: The RMB depreciation, represented by movement towards the origin on the X axis, causes the C$ value of the RMB-denominated liability to shrink, resulting an FX gain.

4 BU416 Page 4 of 9 Case of a Canadian Exporter, contract amount is RMB 2 million: When the import contract is signed, the following journal entries are recorded: Accounts Receivable Sales C$307,692 C$307,692 Note that C$ 307,692 = RMB 2 million X C$ / RMB. Scenario 1: After 3 months, if the RMB appreciates to C$ , the following journal entries are recorded: Accounts Receivable C$307,692 Cash C$333,334 FX Gain C$25,642 Note that C$ 333,334 = RMB 2 million X C$ / RMB; this is the C$ value of the cash received. Observe that C$ 25,642 = C$ 333,334 C$ 307,692, i.e. the FX gain is the difference in the eventual C$ value of the RMB receipt versus the original C$ value of the RMB receipt. The FX gain is the increase in the Canadian dollar value of the receivable. The FX gain always appears as a credit entry. Scenario 2: After 3 months, if the RMB depreciates to C$ / RMB, the following journal entries are recorded: Cash FX Loss C$285,714 C$21,978 Accounts Receivable C$307,692 Note that C$ 285,714 = RMB 2 million X C$ / RMB; this is the C$ value of the cash received. Observe that C$ 21,978 = C$ 307,692 C$ 285,714, i.e. the FX loss equals the difference between the original C$ value of the RMB receipt and the eventual C$ value of the RMB receipt. The FX loss is the decrease in the Canadian dollar value of the receivable. The FX loss always appears as a debit entry.

5 BU416 Page 5 of 9 The following graphical depiction of the case of Canadian exporter, who projects a contractually specified foreign currency receivable, provides a succinct and intuitive summary of the numerical example just considered. On the X axis is measured the value of the RMB in C$s (i.e. C$s per RMB), whereas on the Y axis is measured the value of the cash flow in C$s. Note that, as the Canadian exporter is receiving a cash flow, the Y variable is uniformly positive Scenario 1: The RMB appreciation, represented by movement away from the origin on the X axis, causes the C$ value of the RMB-denominated receivable to increase, resulting an FX gain. Scenario 2: The RMB depreciation, represented by movement towards the origin on the X axis, causes the C$ value of the RMB-denominated receivable to shrink, resulting an FX loss.

6 BU416 Page 6 of 9 Transactions exposure is reflected in the firm s financial (accounting) statements. Accounting exposure refers to the effects of exchange rate changes reflected in the firm s financial (accounting) statements Thus, transactions exposure is a component of accounting exposure. The following table summarizes the effects of exchange rate changes on foreign currency denominated export and import contracts. The entries refer to whether an FX (or foreign currency) gain or loss eventuates. FX appreciates FX depreciates Exports Gain Loss Imports Loss Gain

7 BU416 Page 7 of 9 Practice Questions on the Accounting Treatment of Transactions Exposure In the quiz, all questions will be of the multiple-choice type, where you will be provided with four alternatives. For questions that involve numerical calculations, the None of the above alternative will not be provided to avoid rounding error problems. Take note that the answers provided in the following problems do involve rounding. An explanation is provided for question 1. However, no explanation is provided for the subsequent questions as the solution format is the same. 1. A US firm signs an import contract for the amount of RMB 10 million when the exchange rate is RMB 6.3/U$. After 3 months, when the exchange rate is RMB 5.9/U$, the amount is paid. Does the US firm experience an FX gain or loss? What is the amount of the FX gain or loss? Does the FX gain or loss appear as a debit or a credit in the journal entries? Answer: An FX loss of U$107,613 occurs, which appears as a debit. Explanation: When the import contract is struck or signed, the U$ value of the liability equals U$ 1,587,302 = RMB 10 million / RMB 6.3. However, when the contract is settled or paid off, the U$ value of the liability equals U$ 1,694,915 = RMB 10 million / RMB 5.8. Thus, the FX loss incurred by the US firm equals U$ 107,613. An FX loss is always reflected as a debit entry. 2. A US firm signs an import contract for the amount of RMB 10 million when the exchange rate is RMB 6.3/U$. After 3 months, when the exchange rate is RMB 6.5/U$, the amount is paid. Does the US firm experience an FX gain or loss? What is the amount of the FX gain or loss? Does the FX gain or loss appear as a debit or a credit in the journal entries? Answer: An FX gain of U$48,840 occurs, which appears as a credit. 3. A US firm signs an export contract for the amount of RMB 10 million when the exchange rate is RMB 6.3/U$. After 3 months, when the exchange rate is RMB 5.9/U$, the amount is paid. Does the US firm experience an FX gain or loss? What is the amount of the FX gain or loss? Does the FX gain or loss appear as a debit or a credit in the journal entries? Answer: An FX gain of U$107,613 occurs, which appears as a credit.

8 BU416 Page 8 of 9 4. A US firm signs an export contract for the amount of RMB 10 million when the exchange rate is RMB 6.3/U$. After 3 months, when the exchange rate is RMB 6.5/U$, the amount is paid. Does the US firm experience an FX gain or loss? What is the amount of the FX gain or loss? Does the FX gain or loss appear as a debit or a credit in the journal entries? Answer: An FX loss of U$48,840 occurs, which appears as a debit.

9 BU416 Page 9 of 9 Addendum: A Diagrammatic Exposition of Accounting via T-Accounts Debits Credits Assets Liabilities Expenses Revenues Increases Decreases Decreases Increases