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1 Christensen, Advanced Financial Accounting (2025 edition)

Chapter 11 – Multinational Accounting: Foreign Currency Transactions and Financial Instruments

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I. Multinational Accounting: An Overview II. Accounting for Foreign Currency Transactions

III. Hedging and Hedge Accounting: Overview, Hedging, Hedge Accounting for Foreign Currency

I. Multinational Accounting: An Overview A. Multinational Enterprise (MNE) and Foreign Currency Risk

MNE (Page 544): a U.S. company doing business in a global market with different economic and

currency environments

a. (normal) business or operational risks, and

b. foreign currency (FC) exposure or risk: because non-US dollars (USD) might be involved

(1) MNE transacts (does import/export or lending/borrowing) with a foreign entity directly

e.g. (“Case 1”) On 10/1/20X1, AmeriCo, a U.S. company, buys inventories from a supplier in Japan for ¥2,000,000 with the payment due on 4/1/20X2. The fiscal year- end for AmeriCo is December 31. The direct foreign exchange (FX) rates between USD and ¥ are as follows:

Date

Spot Rate

Forward Rate for 4/1/X2 Delivery of ¥

8/1/20X1 $0.0065 $0.0073

10/1/20X1 $0.0070 $0.0075

12/31/20X1 $0.0080 $0.0077

4/1/20X2 $0.0076

Note: AmeriCo is an ☐importer ☐exporter and need to pay off a liability, A/P.

Terminology: (Pages 546-551)

• “direct” FX rate: Home currency/Foreign currency

e.g. For AmeriCo, a US company, home currency is USD

$0.0070 is 0.0070 USD ¥  , i.e. 0.0070 USD needed to exchange for one ¥

So, ¥2,000,000 = ________ USD (= _____________ × ________, direct exchange rate)

Question: Do FX rates change? Ans: ☐Yes ☐No (Of course!)

If, direct exchange rate ↑↑↑↑ , ☐ more ☐ fewer USD are needed to exchange for

one FC, So, relative to USD, FC has ☐appreciated ☐depreciated in value,

i.e. USD has ☐strengthened ☐weakened in value.

If, direct exchange rate ↓↓↓↓ , ☐more ☐fewer USD are needed to exchange for

one FC, So, relative to USD, FC has ☐appreciated ☐depreciated in value,

i.e. USD has ☐strengthened ☐weakened in value.

Note: indirect exchange rate is FC per USD, e.g., ¥ USD  , from the perspective of a

person in foreign country  direct exchange rate = 1 ÷ indirect exchange rate

So, if indirect exchange rate ↑, direct exchange rate ☐↑ ☐↓

Clue: If the FX rate provided is in “$”, it is direct!

For “firm commitment” and “forecasted FC transaction” discussion on pages 8- 9.

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• “spot rate”: the FX rate for immediate delivery of FC (page 551)

“current rate”: the spot rate on the ___________ date (More on this in chapter 12.)

• “forward (FW) rate” (page 551): the predetermined (“locked in”) FX rate for delivery of

FC on a given date in the future. FW rate = > < ≠ spot rate 🡪 difference is “spread”

⇨ (page 561) forward premium: forward rate > spot rate forward discount: forward rate < spot rate

So, on 10/1/20X1, it is forward ☐premium ☐discount of $_________________

Scenario 1 : The Japan company requires payment (i.e. settlement) in ¥, i.e. the

transaction (TX) is “denominated” (i.e. to be settled) in ☐¥ ☐USD

🡪 Foreign currency transactions (pages 551-556)

Implication: To make the payment in ¥, AmeriCo must use a FC broker or

dealer to exchange USD for ¥ (i.e. to ☐buy (receive) ☐sell (deliver) ¥).

So, for AmeriCo, how much USD to _______ ¥ is the _________.

Question: On 10/1/X1, does AmeriCo know what will be the FX rate on 4/1/20X2?

Ans: ☐Yes ☐No So, AmeriCo is exposed to fluctuations in the FX rate.

Implication: (Figure 11-2 on page 550 and Figure 11-8 on page 577)

If, On 4/1/X2, (direct) FX rate is $0.0076, FX rate ↑ ↓ ; i.e. ¥ has appreciated depreciated,

USD equivalent payment = _________________________. ☹

Because the cost to purchase ¥2,000,000 is ☐more ☐less, this is a ☐gain ☐loss.

But, ☐gain ☐loss if AmeriCo is an exporter!

If, On 4/1/X2, (direct) FX rate is $0.0066, FX rate ↑ ↓ ; i.e. ¥ has appreciated depreciated,

USD equivalent payment = _________________________. ☺

Because the cost to purchase ¥2,000,000 is ☐more ☐less, this is a ☐gain ☐loss.

But, ☐gain ☐loss if AmeriCo is an exporter!

Scenario 2 : The Japan company requires payment in USD

Question: Is there any FX risk? Ans: ☐Yes ☐ No

Observation: FX risk exists only when the transaction is denominated, i.e. to be

settled, in ☐USD ☐FC Practice: E11-3, b (revised) The Hi-Stakes Company in the U.S. has a number of importing and exporting transactions that result in payables and receivables, respectively. Indicate in the following table whether Hi-Stakes will have a foreign currency transaction gain (G), loss (L), or not be affected (NA) by changes in the direct exchange rates for each of the four situations presented.

Settlement

Currency

Direct Exchange Rate

Transaction Increases Decreases

Import FC

Export FC

Import USD

Export USD

Question: Where to find the foreign currency exchange rates? (C11-3)

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(2) MNE has a foreign subsidiary to transact with a foreign entity

Q: Is the transaction denominated in FC or USD? Ans: most likely ☐ FC ☐ USD

Note: The F/S of the foreign subsidiary (in FC) must be translated (restated) to USD

 FC ☐transaction risk ☐translation risk (Chapter 12)

B. Manage FX risk by Using Hedging (“Risk Management”) (page 557 and Appendix 11B)

Note: Most companies do not want the uncertainty of not knowing exactly how many USD to

pay or collect  use derivatives to “neutralize” FX risk; do ____________

Review: Derivatives are financial instruments that “derive” their values from changes in the

value of an underlying such as stock price, interest rate, FX rate, commodity price, etc.

Derivatives for FC include options, futures, forwards, and swaps (a series of forwards).

Future and Forward Contracts for FC: An agreement between a seller and a buyer that

requires the seller to deliver FC (and receive USD) at a designated future date

(“expiration date”) and at a predetermined FX rate to the buyer. No initial investment is

required.

*Futures are standardized contracts traded in the market, regulated by clearinghouse, and

require daily settlement; forward contracts are negotiated with dealers, i.e. “over-the-

counter.” Forwards have more flexible terms than futures, but are subject to credit risk of

the counterparty. For foreign currency, forwards are used more for its flexibility.

a. “hedging”: take the opposite position to offset (neutralize) the risk the company is exposed to

Review: fixed rate loan vs floating rate loan

e.g. $1,000, 10%, 1-year loan with interest payment fixed at 10%

Next Int. Payment Fair Value (present value)

If mkt rate = 12%

If mkt rate = 8%

This is ☐fair value risk ☐cash flow risk; G/L reported on I/S? ☐Yes ☐No

e.g. $1,000, 1-year loan with interest payment floating (variable) with market rate

Next Int. Payment Fair Value (present value)

If mkt rate = 12%

If mkt rate = 8%

This is ☐fair value risk ☐cash flow risk; G/L reported on I/S? ☐Yes ☐No

b. “hedge accounting”: a special accounting for financial instruments designated to hedge risk

* G/L on the hedging instrument (e.g. forward contract) are recognized in NI when the L/G

on the item to be hedged, i.e. “hedged item” (e.g. A/P in FC) is recognized in NI.

G/L from Changes in Fair Value

Hedged Item Hedging Instrument

Fair value hedge

Cash flow hedge  _____________

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Review: CI = _________ (in I/S) ± __________ (in Statement of CI); So OCI bypass I/S

↓ ↓

Σ NI 🡪 _______ ΣOCI 🡪 ________

∆ in AOCI is reported in Statement of SE and both R/EEB and AOCIEB are in B/S.

II. Accounting for Foreign Currency Import/Export Transactions (“Case 1”) GAAP is ASC830: Foreign Currency Matters

1. transaction date: the date the import/export transaction is initially recorded on the books

GAAP: The FC transaction, asset/liability, revenue/expense, gain/loss

must be recorded in USD using the _______ rate on the transaction date

__________ (spot rate = ____________)

.............. ........

Note: A/P (or A/R for sales) in FC should be separated from A/P (or A/R) in USD

Question: How about changes in the FX rate after the transaction date?

Issue: Should both Inventory and A/P (¥) be adjusted to reflect the changes in FX rates?

GAAP: “two-transaction approach” (page 554) to separate “operating” (import

purchase/export sale) and the “financing” (immediate or delayed payment, i.e.

monetary assets/liabilities) as two separate decision making

 The purchase (sale) transaction is complete on the transaction date; no

more adjustment is to be made to the initially recorded cost of goods purchased

or revenues for goods sold.

But, the receivables/payables, including lending/borrowing, (i.e. monetary A/L

to receive/pay a fixed amount) must be adjusted to its fair value.

2. financial reporting date, i.e. balance sheet date

GAAP: A/P (A/R) in FC must be revalued using the _______ rate on the B/S date (“current rate”)

Review: If FX rate ↑, gains for ☐ payables ☐ receivables,

because FC ☐ appreciated ☐ depreciated, ☐ pay ☐ receive more.

So, loss for ____________

If FX rate ↓, gains for ☐ payables ☐ receivables,

because FC ☐ appreciated ☐ depreciated, ☐ pay ☐ receive less.

So, loss for ____________

__________ (spot rate = ____________)

.............. ........

Issue: How to report the FC transaction (TX) gains or losses in the F/S?

GAAP: FC TX G/L are to be ☐included in current NI (as other income/loss) ☐deferred in

OCI even though these G/L are unrealized

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Summary for 20X1:

I/S: FC TX gain loss = $__________ in NI

B/S: Inventory = $___________ A/P (¥) = $__________

R/E = $ _____________

3. settlement date: the date payment is made

__________ (spot rate = ____________)

..............

........

(Recognize G/L on A/P (¥))

..............

........

(Purchase ¥)

..............

........

(Pay A/P (¥))

Assume that inventory is sold for $20,000 cash on April 30, 20X2

Cash............................ $20,000

Sales....................... $20,000 COGS ......................... $______

Inventory ............... $______

Summary for 20X2 I/S:

Gross profit

FC TX gain loss

Net income

Practice: E11-11, #1 Dale Inc., a U.S. company, bought machine parts from a German company on March 1, 20X1, for €30,000, when the spot rate for euros was $0.4895. Dale’s year-end was March 31, when the spot rate was $0.4845. On April 20, 20X1, Dale paid the liability with €30,000 acquired at a rate of $0.4945. Dale’s income statements should report a foreign exchange gain or loss for years ended March 31:

20X1: __________________________; 20X2: __________________________

III. Hedging and Hedge Accounting (pages 557-578) A. An Overview

Question: How to hedge the FX risk (i.e. foreign currency risk) using forward contracts?

Ans: For forward contract, the “underlying” is the FX rate; e.g. AmeriCo needs to pay

 A/P (¥) = $___________

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¥2,000,000 in five months after purchase. If ¥ appreciates (i.e. USD weakened),

AmeriCo needs more USD to buy ¥ (pay more). To avoid this unfavorable risk,

AmeriCo could enter a forward contract to buy (receive) ¥2,000,000 in five months.

So, If FX rate ↑, ☐ gain ☐ loss for the FW contract because receive ☐ more ☐ less

But, ☐ gain ☐ loss for A/P because pay ______  G/L cancelled out, risk is hedged

If FX rate ↓, ☐ gain ☐ loss for the FW contract because receive ☐ more ☐ less

But, ☐ gain ☐ loss for A/P because pay ______  G/L cancelled out, risk is hedged

Note: G/L might not be completely cancelled out (not fully hedged)! (to be discussed later)

Question: Now there are two items related to each other: (1) Hedged item: A/P and (2)

Hedging Instrument: forward contract. …☹! (Not that bad!)

GAAP is ASC815:

1. All derivatives (e.g. forward contracts) are reported on the B/S as either asset (gain) or liability (loss) at fair value, e.g. forward rate for forward contracts Note: The forward rate “should be” discounted to present value if interest is significant.

2. Accounting for G/L (i.e. changes in fair value) on a derivative depends on how it is intended to be used: (1) “hedging”: G/L on a derivative not designated as a hedging instrument or not

qualified as one are recognized in current NI Note: This rule applies to derivatives used for speculation purposes too, i.e. no hedged item

(“Case 4”) (2) “hedge accounting”: G/L on a derivate designated as a hedging instrument are

recognized in NI in the same period as the L/G on hedged items (i.e. matching!)

 neutralizes (offsets) G/L and helps company reduces income volatility, “… more closely reflects an entity’s risk management activities.” (ASC815)

a. criteria to use hedge accounting (ASC 815-20-25-3) (page 558) (a) The derivative is designated as a hedging instrument for fair value risk or cash

flow risk. (b) The hedge must be “highly effective” (high correlation) in achieving offsetting

changes (in practice, within 80% to 125% range) in the fair value or cash flows of the item being hedged, evaluated at inception (currency type, currency amount, settlement date), at least every 3 months, and each of the subsequent B/S date.

(c) Sufficient documentation must be provided at the beginning of the hedge term.

b. general rules for hedge accounting (a) fair value hedge: G/L are recognized in current earnings to offset G/L on the

item being hedged (Hint: Hedged item is like a fixed rate loan) (b) cash flow hedge:

- G/L (effective portion) are deferred in OCI (Hint: Hedged item is like a floating rate loan) until the earnings process is complete, e.g. when the inventory is sold.

- G/L (ineffective portion) are recognized in current earnings

c. disclosure <ASC 815-10-50> (1) how and why an entity uses derivatives, (2) how the derivatives and related hedged items are accounted for and (3) how the derivatives affect financial position, financial performance and cash flows.

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B. Hedging: Manage exposed FC asset/liability position from FC TX (“Case 1”)

On 10/1/20X1, to hedge its exposure to a possible ↑ in FX rate (i.e. appreciation of ¥ or depreciation of USD), AmeriCo entered into a FW contract to purchase (receive) ¥2,000,000 (and to deliver USD) on 4/1/20X2. (Note: ¥2,000,000 is the “notional amount” of the FW contract.)

(1) forward Initiation Date, 10/1/20X1 (also the transaction date to purchase inventory)

FC Transaction (ASC 830) Forward (ASC 815)

Inventory .......................... $14,000

A/P (¥) ......................... $14,000

*

(spot = $0.0070) (forward = $0.0075)

* No formal entry for the FW contract because it is an “executory contract” and has a net fair

value of $0: ¥ Receivable from dealer = $________ = USD payable to dealer = $_________

Textbook does make an entry, but I think it makes it more complicated as GAAP requires hedging instruments be reported using the “net approach” (page 564, footnote #3 and page 567)

(2) B/S Date: 12/31/20X1 (to recognize G/L on A/P (¥) and the forward contract)

ASC 815: G/L for the forward contract is changes in its fair value, forward rate.

FC Transaction (ASC 830) Forward (ASC 815)

FC TX G/L-NI ................. $2,000

A/P (¥) ......................... $2,000

(spot = $0.0080) (forward = $0.0077)

Summary for 20X1:

I/S: FC TX gain loss = $__________ in NI

✶FC TX loss on FC transaction does not cancel out with FC TX gain on forward because to measure fair value, ASC830 (for FC TX) uses the spot rate, but ASC815 (for derivatives) uses the forward rate.

B/S: Inventory = $___________ A/P (¥) = $__________

Forward = $____________ R/E = $ _____________

(3) Forward Expiration Date, 4/1/20X2 (also the settlement date to pay off A/P (¥))

(a) to recognize G/L on A/P (¥) and the forward contract

FC Transaction (ASC 830) Forward (ASC 815)

A/P (¥) ............................. $800

FC TX G/L-NI ............. $800

(spot = $0.0076) (“forward” = $0.0076)

(b) to deliver USD, receive ¥, and to pay off A/P (¥)

A/P (¥) ............................. _______

FC units (¥) ................. _______

Assume inventory is sold for $20,000 on April 30, 20X2

Cash............................ $20,000

Sales....................... $20,000 COGS ......................... $14,000

Inventory ............... $14,000

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Summary for 20X2 I/S:

Gross profit

FC TX gain loss

Net income

Observations:

(1) Gross profit = _____________________; NOT affected by hedging

(2) Σ FC TX G/L over two years = ___________, a ☐gain ☐ loss = $Forward premium

Note: The FW premium is like an “insurance” that AmeriCo pays to avoid the risk that ¥ would appreciate. Compared to uncertainty if without hedging, AmeriCo knows exactly the amount of loss at the date of purchase. The “insurance” is amortized over the hedge term. (page 567)

(3) Compared to no hedging, income variability is ☐ more ☐ less

Note: How to find the forward rate to use? E.g. E11-19, #1

The following information applies to Denton Inc.’s sale of 10,000 foreign currency units

(i.e. to _________ 10,000 FC) under a forward contract dated November 1, 20X5, for

delivery on January 31, 20X6:

FX Rate 11/1/20X5 12/31/20X5

Spot rates $0.80 $0.83

30-day rate 0.79 0.82

90-day rate 0.78 0.81

11/1/20X5 12/31/20X5 1/31/20X6

If Denton entered into the forward contract to speculate in the foreign currency,

FC TX ☐ gain ☐ loss to report for 20X5 is: $____________

C. Hedge Accounting for Foreign Currency

1. Fair Value Hedge: Hedge an unrecognized foreign currency firm commitment (“Case 2”)

On 8/1/20X1, AmeriCo (1) signs a noncancelable (binding, legally enforceable) order to

purchase goods from a Japanese company on 10/1/20X1 and (2) to hedge its exposure to a

possible ↑ in FX rate (i.e. appreciation of ¥ or depreciation of USD) for the firm commitment (the obligation to pay ¥), AmeriCo enters into a forward contract to purchase ¥2,000,000 on 4/1/20X2. (I.e. This FW to receive ¥2,000,000, asset, is to hedge the firm commitment to purchase ¥2,000,000 of goods, a liability.)

8/1/20X1 10/1/20X1 4/1/20X2

GAAP: This is a fair value hedge because the hedged item is a firm commitment with

amount in FC ________ (like a fixed rate loan)

 G/L on the hedging instrument in ☐current NI ☐ OCI

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Note: Don’t worry about the financial recording for the firm commitment on page 570-571.

: No recording of firm commitment on 8/1/20X1, but G/L for the firm commitment is

to be recorded on 10/1/20X1 based on changes in FW rates from 8/1/20X to

10/1/20X

2. Cash Flow Hedge: Hedge a forecasted foreign currency transaction (“Case 3”)

- planned, anticipated, possible purchases or sales, but not committed or guaranteed yet, i.e. there is no firm commitment

- e.g. some companies have FC purchase/sale transactions that occur on a regular basis

e.g. On 8/1/20X1, AmeriCo (1) anticipates that it will purchase goods from a Japanese

company on 10/1/20X1 and (2) to hedge its exposure to a possible ↑ in FX rate (i.e. appreciation of ¥ or depreciation of USD) that will affect its future cash flows in buying the inventory, AmeriCo enters into a forward contract to purchase ¥2,000,000 on 4/1/20X2.

GAAP: Can qualify only as a cash flow hedge because the hedged item is a forecasted

purchase with amount ____________ (like a floating rate loan)

 G/L on the hedging instrument, effective portion, are deferred in OCI until the

hedged forecasted transaction impacts NI, e.g. when inventory is sold

*After the actual purchase (or sale), companies can continue to use cash flow

hedge or change to a fair value hedge

Example: E11-10 (revised)

On 10/1/20X1, to hedge its exposure a possible ↑ in FX rate (i.e. appreciation of ¥ or depreciation of USD), AmeriCo entered into a FW contract to purchase (receive) ¥2,000,000 (and to deliver USD) on 4/1/20X2. (Note: To be correct, AmeriCo should have entered the FW contract on 8/1, not 10/1.)

a. AmeriCo designated this forward contract as a fair value hedge

Note: Compared the recording and reporting to “hedging” without using “hedge

accounting” (Case 1 on LN pages 7-8).

(1) Forward Initiation Date, 10/1/20X1 (also the transaction date to purchase inventory)

Hedged Item (ASC 830) Hedging Instrument (ASC 815)

Inventory .......................... $14,000

A/P (¥) ......................... $14,000

(memo)

(spot = $0.0070) (forward = $0.0075)

(2) B/S Date: 12/31/20X1

FC Transaction (ASC 830) Hedging Instrument (ASC 815)

FC TX G/L-NI ................. $2,000

A/P (¥) ......................... $2,000

FW .......................... $400

FC TX G/L-NI . $400

(spot = $0.0080) (forward = $0.0077)

Summary for 20X1:

I/S: FC TX gain loss = $1,600 in NI

B/S: Inventory = $14,000 A/P (¥) = $16,000

FW = $400 R/E = ($1,600)

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(3) Forward Expiration Date, 4/1/20X2 (also the settlement date to pay off A/P (¥))

FC Transaction (ASC 830) Forward (ASC 815)

(a) to recognize G/L on A/P (¥) and the forward contract

A/P (¥) ............................. $800

FC TX G/L-NI ............. $800

FC TX G/L-NI ....... $200

FW .................... $200

(b) to deliver USD, receive ¥, and to pay off A/P (¥)

A/P (¥) ............................. $15,200

FC units (¥) .................. $15,200

FC units (¥) ............ $15,200

FW .................... $200

Cash .................. $15,000

(spot = $0.0076) (“forward” = $0.0076)

Assume inventory is sold for $20,000 on April 30, 20X2

Cash............................ $20,000

Sales....................... $20,000 COGS ......................... $14,000

Inventory ............... $14,000

Summary for 20X2 I/S:

Gross profit $6,000

FC TX gain loss $600

Net income $6,600

Observation: The accounting recording is exactly the same as if no hedge accounting has been applied! (Note, disclosures would be different, but don’t worry!)

Observation: Overall effect on net income from 20X1 to 20X2 = $____________

b. AmeriCo designated this forward contract as a cash flow hedge

(1) Forward Initiation Date, 10/1/20X1 (also the transaction date to purchase inventory)

Hedged Item (ASC 830) Hedging Instrument (ASC 815)

Inventory .......................... $14,000

A/P (¥) ......................... $14,000

(memo)

(spot = $0.0070) (forward = $0.0075)

(2) B/S Date: 12/31/20X1

FC Transaction (ASC 830) Hedging Instrument (ASC 815)

FC TX G/L-NI ................. $2,000

A/P (¥) ......................... $2,000

FW .......................... $400

.............. $400

(spot = $0.0080) (forward = $0.0077)

GAAP: An amount equal to the transaction gain or loss on the hedged item is transferred from OCI to earnings to offset the transaction gain or loss recorded in earnings

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Summary for 20X1:

I/S: FC TX gain loss = ________ in NI

B/S: Inventory = $ A/P (¥) = $___________

FW = $ R/E = $______________

AOCI = $____________

(3) Forward Expiration Date, 4/1/20X2 (also the settlement date to pay off A/P (¥))

FC Transaction (ASC 830) Forward (ASC 815)

(a) to recognize G/L on A/P (¥) and the forward contract

A/P (¥) ............................. $800

FC TX G/L-NI ............. $800

.............. $200

FW .................... $200

(b) to deliver USD, receive ¥, and to pay off A/P (¥)

A/P (¥) ............................. $15,200

FC units (¥) .................. $15,200

FC units (¥) ............ $15,200

Cash .................. $15,000

FW .................... $200

(spot = $0.0076) (“forward” = $0.0076)

Assume inventory is sold for $20,000 on April 30, 20X2

Cash............................ $20,000

Sales....................... $20,000 COGS .........................

Inventory ...............

Summary for 20X2 I/S:

Gross profit

FC TX gain loss

Net income

Observation: G/L on hedging instruments are recognized in earnings (through ↑ in COGS for

this example) when the item being hedged affects earnings.

Observation: Overall effect on net income from 20X1 to 20X2 = $____________

Same as if designated as a fair value hedge!