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Christensen_Advanced_Financial_Accounting_2025R_Ch11_PPT_Accessible.pptx

Chapter 11

Multinational Accounting: Foreign Currency Transactions and Financial Instruments

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Learning Objective 11.1

Understand how to make calculations using foreign currency exchange rates.

The Accounting Issues 1

Foreign currency transactions of a U S company include sales, purchases, and other transactions giving rise to a transfer of foreign currency or the recording of receivables or payables that are denominated in a foreign currency.

Translation is the process of restating foreign currency transactions to their U S dollar–equivalent values.

The Accounting Issues 2

Many U S corporations have multinational operations.

The foreign subsidiaries prepare their financial statements in their home currencies.

The foreign currency amounts in these financial statements have to be translated into their U S dollar equivalents before they can be consolidated with the U S parent’s financial statements that use the U S dollar as their reporting currency unit.

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Foreign Currency Exchange Rates 1

Foreign currency exchange rates between currencies are established daily by foreign exchange brokers who serve as agents for individuals or countries wishing to deal in foreign currencies.

Some countries maintain an official fixed rate of currency exchange and have established fixed exchange rates for dividends remitted outside the country.

Foreign Currency Exchange Rates 2

The determination of exchange rates.

Exchange rates change because of a number of economic factors affecting the supply of and demand for a nation’s currency.

Factors causing fluctuations in exchange rates include:

Level of inflation.

Balance of payments.

Changes in interest rate.

Changes in investment levels.

Stability and process of governance.

Direct versus Indirect Exchange Rates 1

The direct exchange rate (D E R) is the number of local currency units (L C U’s) needed to acquire one foreign currency unit (F C U).

From the viewpoint of a U S entity, the direct exchange rate ratio is expressed as follows.

Example: Assume that $1.20 can acquire 1 euro.

Direct versus Indirect Exchange Rates 2

The indirect exchange rate (I E R) is the reciprocal of the direct exchange rate.

From the viewpoint of a U S entity:

Example: Assume a U S-based company can purchase one euro for $1.20.

Direct versus Indirect Exchange Rates 3

D E R is identified as American terms.

To indicate that it is U S dollar–based and represents an exchange rate quote from the perspective of a person in the United States.

I E R is identified as European terms.

To indicate the direct exchange rate from the perspective of a person in Europe, which means the exchange rate shows the number of units of the European country’s local currency units per one U S dollar.

The terms currency is the numerator and the base currency is the denominator in the exchange rate ratio.

Changes in Exchange Rates 1

Weakening of the U S dollar—direct exchange rate increases.

Strengthening of the U S dollar—direct exchange rate decreases.

Changes in Exchange Rates 2

Weakening of the U S dollar—direct exchange rate increases, implies:

Taking more U S currency to acquire one foreign currency unit.

One U S dollar acquiring fewer foreign currency units.

Example: D E R increases from $1.33 per € to $1.45 per €.

Changes in Exchange Rates 3

Strengthening of the U S dollar—direct exchange rate decreases, implies:

Taking less U S currency to acquire one foreign currency unit.

One U S dollar acquiring more foreign currency units.

Example: D E R decreases from $1.45 per € to $1.26 per €.

Relationships between Currencies and Exchange Rates 1

Figure 11.2

	October 2015	April 2016	April 2017
Direct exchange rate ($/€)	$1.12	$1.14	$1.07
Indirect exchange rate (€/$)	€0.89	€0.88	€0.94

Between October 1, 2015, and April 1, 2016—weakening of the U S dollar:

Direct rate increases.

Dollar weakens (takes more U S currency to acquire 1 euro).

Indirect rate decreases.

Euro strengthens (takes fewer euros to acquire 1 U S dollar).

Imports into United States normally decrease in quantity.

Foreign goods imported into United States more expensive in dollars.

Exports from United States normally increase in quantity.

U S-made exports less expensive in euros.

Relationships between Currencies and Exchange Rates 2

Between April 1, 2016, and April 1, 2017—strengthening of the U S dollar:

Direct rate decreases.

Dollar strengthens (takes less U S currency to acquire 1 euro).

Indirect rate increases.

Euro weakens (takes more euros to acquire 1 U S dollar).

Imports into United States normally increase in quantity.

Foreign goods imported into United States less expensive in dollars ($1 can acquire more).

Exports from United States normally decrease in quantity.

U S-made exports more expensive (takes more euros to acquire goods).

Spot Rates versus Current Rates

The spot rate is the exchange rate for immediate delivery of currencies.

The current rate is defined simply as the spot rate on the entity’s balance sheet date.

Forward Exchange Rates 1

The forward rate on a given date is not the same as the spot rate on the same date.

Expectations about the relative value of currencies are built into the forward rate.

The spread:

The difference between the forward rate and the spot rate on a given date.

Gives information about the perceived strengths or weaknesses of currencies.

Forward Exchange Rates 2

Example:

Assume a U S-based company purchases inventory for €1,000 on 3/31 and the contract requires payment on 9/30.

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Practice Quiz Question #1

Which of the following statements is false?

a. Most currency exchange rates are determined by brokers on a daily basis.

b. Economic factors rarely affect exchange rates.

c. Some countries maintain control over their exchange rates.

d. When the U S dollar strengthens, it has greater buying power overseas and can buy more units of foreign currencies.

e. A spot rate is the exchange rate for immediate delivery of a currency.

Practice Quiz Question #1 Solution

Which of the following statements is false?

a. Most currency exchange rates are determined by brokers on a daily basis.

Answer: b. Economic factors rarely affect exchange rates.

c. Some countries maintain control over their exchange rates.

d. When the U S dollar strengthens, it has greater buying power overseas and can buy more units of foreign currencies.

e. A spot rate is the exchange rate for immediate delivery of a currency.

Learning Objective 11.2

Understand the accounting implications of and be able to make calculations related to foreign currency transactions.

Foreign Currency Transactions 1

Foreign currency transactions are economic activities denominated in a currency other than the entity’s recording currency.

These transactions include the following:

Purchases or sales of goods or services (imports or exports), the prices of which are stated in a foreign currency.

Loans payable or receivable in a foreign currency.

Purchase or sale of foreign currency forward exchange contracts.

Purchase or sale of foreign currency units.

Foreign Currency Transactions 2

For financial statement purposes, transactions denominated in a foreign currency must be translated into the currency the reporting company uses.

At each balance sheet date, account balances denominated in a currency other than the entity’s reporting currency must be adjusted to reflect changes in exchange rates during the period.

The adjustment in equivalent U S dollar values is a foreign currency transaction gain or loss for the entity when exchange rates have changed.

Foreign Currency Transactions 3

Assume that a U S company acquires €5,000 from its bank on January 1, 20X1, for use in future purchases from German companies. The direct exchange rate is $1.20 = €1; thus, the company pays the bank $6,000 for €5,000, as follows:

U S dollar–equivalent value of F C U	=	Foreign currency units	×	Direct exchange rate
$6,000	=	€5,000	×	$1.20

The following entry records this exchange of currencies:

January 1, 20X1
Foreign Currency Units (€ )	6,000
Cash		6,000

On July 1, 20X1, the exchange rate is $1.10 = €1. The following adjusting entry is required in preparing financial statements on July 1:

July 1, 20X1
Foreign Currency Transaction Loss	500
Foreign Currency Units (€ )		500

Foreign Currency Import and Export Transactions 1

An overview of the required accounting for an import or export transaction denominated in a foreign currency, assuming the company does not use forward contracts, is as follows:

Transaction date:

Record the purchase or sale transaction at the U S dollar–equivalent value using the spot direct exchange rate on this date.

Foreign Currency Import and Export Transactions 2

An overview of the required accounting for an import or export transaction denominated in a foreign currency, assuming the company does not use forward contracts, is as follows:

Balance sheet date:

Adjust the payable or receivable to its U S dollar–equivalent, end-of-period value using the current direct exchange rate.

Recognize any exchange gain or loss for the change in rates between the transaction and balance sheet dates.

Foreign Currency Import and Export Transactions 3

An overview of the required accounting for an import or export transaction denominated in a foreign currency, assuming the company does not use forward contracts, is as follows:

Settlement date:

Adjust the foreign currency payable or receivable for any changes in the exchange rate between the balance sheet date (or transaction date if transaction occurs after the balance sheet date) and the settlement date, recording any exchange gain or loss as required.

Record the settlement of the foreign currency payable or receivable.

Foreign Currency Import and Export Transactions 4

The two-transaction approach:

Views the purchase or sale of an item as a separate transaction from the foreign currency commitment.

The F A S B established that foreign currency exchange gains or losses resulting from the revaluation of assets or liabilities denominated in a foreign currency must be recognized currently in the income statement of the period in which the exchange rate changes.

There are a few exceptions to this general rule.

Illustration of Foreign Purchase Transaction 1

Assume the following information:

On October 1, 20X1, Peerless Products, a U S company, acquired goods on account from Tokyo Industries, a Japanese company, for $14,000, or 2,000,000 yen.

Peerless Products prepared financial statements at its year-end of December 31, 20X1.

Settlement of the payable was made on April 1, 20X2.

Illustration of Foreign Purchase Transaction 2

Assume the following information:

The direct spot exchange rates of the U S dollar–equivalent value of 1 yen were as follows:

Date	Direct Exchange Rate
October 1, 20X1 (transaction date)	$0.0070
December 31, 20X1 (balance sheet date)	0.0080
April 1, 20X2 (settlement date)	0.0076

Comparative U S Company Journal Entries for Foreign Purchase Transaction Denominated in U.S Dollars versus Foreign Currency Units

Figure 11.3

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Practice Quiz Question #2

Which of the following statements is false?

a. Foreign currency transactions of a U S firm involve the exchange of goods from a foreign country denominated in $ U S.

b. The purchase or sale of an item is a separate transaction from the foreign currency commitment under the two-transaction approach.

c. Foreign currency exchange gains or losses from the revaluation of assets or liabilities denominated in a foreign currency must be recognized in the period when the exchange rate changes.

Practice Quiz Question #2 Solution

Which of the following statements is false?

Answer: a. Foreign currency transactions of a U S firm involve the exchange of goods from a foreign country denominated in $ U S.

b. The purchase or sale of an item is a separate transaction from the foreign currency commitment under the two-transaction approach.

c. Foreign currency exchange gains or losses from the revaluation of assets or liabilities denominated in a foreign currency must be recognized in the period when the exchange rate changes.

Learning Objective 11.3

Understand how to hedge international currency risk using foreign currency forward exchange financial instruments.

Managing International Currency Risk with Foreign Currency Forward Exchange Financial Instruments 1

A financial instrument is cash, evidence of ownership, or a contract that both:

Imposes on one entity a contractual obligation to deliver cash or another instrument, and,

Conveys to the second entity that contractual right to receive cash or another financial instrument.

A derivative is a financial instrument or other contract whose value is “derived from” some other item that has a variable value over time.

Managing International Currency Risk with Foreign Currency Forward Exchange Financial Instruments 2

Characteristics of derivatives:

The financial instrument must contain one or more underlyings and one or more notional amounts, which specify the terms of the financial instrument.

Underlying: any financial or physical variable that has observable or objectively verifiable changes.

Notional amount: the number of currency units, shares, bushels, pounds, or other units specified in the financial instrument.

The financial instrument/contract requires no initial net investment or an initial net investment that is smaller than required for other types of contracts expected to have a similar response to changes in market factors.

Managing International Currency Risk with Foreign Currency Forward Exchange Financial Instruments 3

Characteristics of derivatives:

The contract terms:

Require or permit net settlement,

Provide for the delivery of an asset that puts the recipient in an economic position not substantially different from net settlement, or,

Allow for the contract to be readily settled net by a market or other mechanism outside the contract.

Derivatives Designated as Hedges 1

Two criteria must be met for a derivative instrument to qualify as a hedging instrument:

Sufficient documentation must be provided at the beginning of the hedge term to identify the objective and strategy of the hedge, the hedging instrument, and the hedged item, and how the hedge’s effectiveness will be assessed on an ongoing basis.

The hedge must be highly effective throughout its term.

Effectiveness is measured by evaluating the hedging instrument’s ability to generate changes in fair value that offset the changes in value of the hedged item.

Derivatives Designated as Hedges 2

Fair value hedges are designated to hedge the exposure to potential changes in the fair value of,

a) A recognized asset or liability such as available-for-sale investments, or,

b) An unrecognized firm commitment for which a binding agreement exists.

The net gains and losses on the hedged asset or liability and the hedging instrument are recognized in current earnings, and since they are always offsetting, there will be no net impact on earnings.

Fair Value Hedge

Scenario	Hedged Item: Asset, Liability, or Firm Commitment (reported at fair value)	Derivative Instrument (reported at fair value)	Net Impact on Current Earnings
Initial Valuation	Zero	Zero	Zero
Decrease in Fair Value	Decrease	Increase	Zero
Increase in Fair Value	Increase	Decrease	Zero

Derivatives Designated as Hedges 3

Cash flow hedges are designated to hedge the exposure to potential changes in the anticipated cash flows, either into or out of the company, for,

a) A recognized asset or liability such as future interest payments on variable-interest debt, or,

b) A forecasted cash transaction such as a forecasted purchase or sale.

A forecasted cash transaction is a transaction that is expected to occur but for which there is not yet a firm commitment.

Derivatives Designated as Hedges 4

Cash flow hedges:

Changes in the fair market value are separated into an effective portion and an ineffective portion.

The net gain or loss on the effective portion of the hedging instrument should be reported in other comprehensive income.

The gain or loss on the ineffective portion is reported in current earnings on the income statement.

Cash Flow Hedge

Prior to Settlement:

Scenario	Change in Anticipated Cash Flow (not reported)	Derivative Instrument (reported at fair value)	Other Comprehensive Income	Net Impact on Current Earnings
Initial Valuation	No change	Zero	Zero	Zero
Increase in Fair Value	Increase	Decrease	Loss	Zero
Decrease in Fair Value	Decrease	Increase	Gain	Zero

Settlement:

Scenario	Actual Cash Flow	Other Comprehensive Income	Net Impact on Current Earnings
Increase in Cash Flow	Increase (gain or revenue)	Reverse Prior Loss to O C I (a loss in current earnings)	Zero
Decrease in Cash Flow	Decrease (loss or expense)	Reverse Prior Gain in O C I (a gain in current earnings)	Zero

Derivatives Designated as Hedges 5

Foreign currency hedges are hedges in which the hedged item is denominated in a foreign currency.

The following types of hedges of foreign currency risk may be designated by the entity:

A fair value hedge of a firm commitment to enter into a foreign currency transaction.

A cash flow hedge of a forecasted foreign currency transaction.

A hedge of a net investment in a foreign operation.

Forward Exchange Contracts 1

Contracted through a dealer, usually a bank.

Possibly customized to meet contracting company’s terms and needs.

Typically, no margin deposit required.

Must be completed either with the underlying’s future delivery or net cash settlement.

Forward Exchange Contracts 2

A S C 815 establishes a basic rule of fair value for accounting for forward exchange contracts,

Changes in the fair value are recognized in the accounts, but the specific accounting for the change depends on the purpose of the hedge.

For forward exchange contracts, the basic rule is to use the forward exchange rate to value the forward contract.

Preview of Cases 1 through 3

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Case 1: Forward Exchange Contracts

Managing an exposed foreign currency net asset or liability position: not a designated hedging instrument.

This case presents the most common use of foreign currency forward contracts, which is to manage a part of the foreign currency exposure from accounts payable or accounts receivable denominated in a foreign currency.

Note that the company has entered into a foreign currency forward contract but that the contract does not qualify for or the company does not designate the forward contract as a hedging instrument.

Case 1: Timeline

Incur liability denominated in yen.

Sign 180-day forward exchange contract to receive yen.

Obtain yen by settling forward exchange contract.

Pay yen to settle account payable.

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Case 1: Rates Summary

The relevant direct exchange rates are as follows:

Date	U S Dollar–Equivalent Value of 1 Yen Spot Rate	U S Dollar–Equivalent Value of 1 Yen Forward Exchange Rate
October 1, 20X1 (transaction date)	$0.0070	$0.0075 (180 days)
December 31, 20X1 (balance sheet date)	0.0080	0.0077 (90 days)
April 1, 20X2 (settlement date)	0.0076

Case 1: Entries—October 1, 20X1

Entry to record the Account Payable:

Inventory	14,000
Accounts Payable (¥)		14,000

Purchase inventory on account:

$14,000 = ¥2,000,000 × $0.0070 Oct. 1 spot rate.

Entry to record the Forward Contract:

Foreign Currency Receivable from Exchange Broker (¥)	15,000
Dollars Payable to Exchange Broker ($)		15,000

Purchase forward contract to receive 2,000,000 yen:

$15,000 = ¥2,000,000 × $0.0075 forward rate.

Case 1: October 1

Figure 11.4

Foreign Currency Receivable from Broker (¥)

(6)	15,000
(7)	400
Bal. 12/31	15,400
		(9)	200
		(12)	15,200
Bal. 4/1	0

Accounts Payable (¥)

		(5)	14,000
		(8)	2,000
		Bal. 12/31	16,000
(10)	800
(13)	15,200
		Bal. 4/1	0

Foreign Currency Units (¥)


(12)	15,200	(13)	15,200
Bal. 4/1	0

Dollars Payable to Exchange Broker ($)

		(6)	15,000
		Bal. 12/31	15,000
(11)	15,000
		Bal. 4/1	0

Case 1: Entries—December 31, 20X1

Entry to Revalue the Forward Contract:

Foreign Currency Receivable from Exchange Broker (¥)	400
Foreign Currency Transaction Gain		400

Adjust receivable denominated in yen to current U S dollar–equivalent value using the forward rate:

$ 15,400	= ¥2,000,000 × $0.0077 Dec. 31 90-day forward rate
−15,000	= ¥2,000,000 × $0.0075 Oct. 1 180-day forward rate
$ 400	= ¥2,000,000 × ($0.0077 − $0.0075).

Entry to Revalue the Account Payable:

Foreign Currency Transaction loss	2,000
Accounts Payable (¥)		2,000

Adjust payable denominated in yen to current U S dollar–equivalent value using the spot rate:

$ 16,000	= ¥2,000,000 × $0.0080 Dec. 31, spot rate
− 14,000	= ¥2,000,000 × $0.0070 Oct. 1, spot rate
$ 2,000	= ¥2,000,000 × ($0.0080 − $0.0070).

Case 1: Entries—April 1, 20X2 1

Entry to Revalue the Forward Contract:

Foreign Currency Transaction Loss	200
Foreign Currency Receivable from Exchange Broker (¥)		200

Adjust receivable to spot rate on the settlement date:

$15,200	= ¥2,000,000 × $0.0076 Apr. 1, 20X2, spot rate
−15,400	= ¥2,000,000 × $0.0077 Dec. 31, 20X1, 90-day forward rate
$ 200	= ¥2,000,000 × ($0.0076 − $0.0077).

Entry to Revalue the Account Payable

Accounts Payable (¥)	800
Foreign Currency Transaction Gain		800

Adjust payable denominated in yen to spot rate on settlement date:

¥2,000,000 × ($0.0076 − $0.0080).

Case 1: Summary

F C Rec. from Broker (¥)

15,000
400
	200
15,200

Accounts Payable (¥)

	14,000
	2,000
800
	15,200

Case 1: Entries—April 1, 20X2 2

Dollars Payable to Exchange Broker ($)	15,000
Cash		15,000

Deliver U S dollars to currency broker as specified in the forward contract.

Foreign Currency Units (¥)	15,200
Foreign Currency Receivable from Exchange Broker (¥)		15,200

Receive ¥2,000,000 from exchange broker valued at the April 1, 20X2, spot rate:

$15,200 = ¥2,000,000 × $0.0076.

Accounts Payable ($)	15,200
Foreign Currency Units (¥)		15,200

Pay 2,000,000 yen to Tokyo Industries Inc. in settlement of liability denominated in yen.

Case 2: Forward Exchange Contracts

Hedging an unrecognized foreign currency firm commitment: a foreign currency fair value hedge.

This case presents the accounting for an unrecognized firm commitment to enter into a foreign currency transaction, which is accounted for as a fair value hedge.

A firm commitment exists because of a binding agreement for the future transaction that meets all requirements for a firm commitment.

The hedge is against the possible changes in fair value of the firm commitment from changes in the foreign currency exchange rates.

Case 2: Illustration of Hedging an Unrecognized Foreign Currency Firm Commitment 1

An import transaction between Peerless Products and Tokyo Industries is extended with the following information:

On August 1, 20X1, Peerless contracts to purchase special-order goods from Tokyo Industries. Their manufacture and delivery will take place in 60 days (on October 1, 20X1). The contract price is 2,000,000 yen, to be paid by April 1, 20X2, which is 180 days after delivery.

On August 1, Peerless hedges its foreign currency payable commitment with a forward exchange contract to receive 2,000,000 yen in 240 days (the 60 days until delivery plus 180 days of credit period). The future rate for a 240-day forward contract is $0.0073 to 1 yen. The purpose of this 240-day forward exchange contract is twofold. First, for the 60 days from August 1, 20X1, until October 1, 20X1, the forward exchange contract is a hedge of an identifiable foreign currency commitment. For the 180-day period from October 1, 20X1, until April 1, 20X2, the forward exchange contract is a hedge of a foreign currency exposed net liability position.

Case 2: Illustration of Hedging an Unrecognized Foreign Currency Firm Commitment 2

The relevant exchange rates for this example are as follows:

Date	U S Dollar–Equivalent Value of 1 Yen Spot Rate	U S Dollar–Equivalent Value of 1 Yen Forward Exchange Rate
August 1, 20X1	$0.0065	$0.0073 (240 days)
October 1, 20X1	0.0070	0.0075 (180 days)

Case 2: Illustration of Hedging an Unrecognized Foreign Currency Firm Commitment 3

A time line for the transactions follows:

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Case 2: Entries—August 1, 20X1

Entry to Record the Forward Contract:

Foreign Currency Receivable from Exchange Broker (¥)	14,600
Dollars Payable to Exchange Broker ($)		14,600

Sign forward exchange contract for receipt of 2,000,000 yen in 240 days:

$14,600 = ¥2,000,000 × $0.0073 Aug. 1, 240-day forward rate.

Entry for the Firm Commitment:

No Entry

Case 2: Entries—October 1, 20X1 1

Entry to Revalue the Forward Contract:

Foreign Currency Receivable from Exchange Broker (¥)	400
Foreign Currency Transaction Gain		400

Adjust forward contract to fair value, using the forward rate at this date, and recognize gain:

$ 15,000	= ¥2,000,000 × $0.0075 Oct. 1, 180-day forward rate
− 14,600	= ¥2,000,000 × $0.0073 Aug. 1, 240-day forward rate
$ 400	= ¥2,000,000 × ($0.0075 − $0.0073).

Case 2: Entries—October 1, 20X1 2

Entry to Record the Firm Commitment:

Foreign Currency Transaction Loss	400
Firm Commitment		400

To record the loss on the financial instrument aspect of the firm commitment:

$ 15,000	= ¥2,000,000 × $0.0075 Oct. 1, 180-day forward rate
− 14,600	= ¥2,000,000 × $0.0073 Aug. 1, 240-day forward rate
$ 400	= ¥2,000,000 × ($0.0075 − $0.0073).

Entry to Record the Account Payable:

Inventory	13,600
Firm Commitment	400
Accounts Payable (¥)		14,000

Record account payable at the spot rate and record the inventory purchase:

$14,000 = ¥2,000,000 × $0.0070 Oct. 1, spot rate.

Case 2: Summary 1

F C Rec. from Broker (¥)

14,600
400

October 1, 20X1

Accounts Payable (¥)


	14,000

Notice that these entries bring these two accounts to the same balances as Case #1 at October 1, 20X1.

Case 2: Entries—December 31, 20X1

Figure 11.5B

Forward Exchange Contract

(Use forward exchange rate).

Exposed Foreign Currency Position

(Use spot rate).

December 31, 20X1. Revalue forward contract using forward rate, and accounts payable in yen using spot rate.

(7)

Foreign Currency Receivable (¥)	400
Foreign Currency Transaction Gain		400

(8)

Foreign Currency Transaction Loss	2,000
Accounts Payable (¥)		2,000

Case 2: Entries—April 1, 20X2 1

Figure 11.5B

Forward Exchange Contract

(Use forward exchange rate).

Exposed Foreign Currency Position

(Use spot rate).

April 1, 20X2. Revalue forward contract at its termination to spot rate, and accounts payable in yen to spot rate.

(9)

Foreign Currency Transaction Loss	200
Foreign Currency Receivable (¥)		200

(10)

Accounts Payable (¥)	800
Foreign Currency Transaction Gain		800

Case 2: Summary 2

F C Rec. from Broker (¥)

14,600
400

400
	200
15,200

October 1, 20X1

Accounts Payable (¥)


	14,000
	2,000
800

	15,200

Case 2: Entries—April 1, 20X2 2

Figure 11.5B

Forward Exchange Contract (Use forward exchange rate).

Exposed Foreign Currency Position (Use spot rate).

April 1, 20X2. Deliver $14,600 in U.S dollars to exchange broker, receiving yen. Use yen to settle accounts payable.

(11)

Dollars Payable to Exchange Broker	14,600
Cash		14,600

(12)

Foreign Currency Units (¥)	15,200
Foreign Currency Receivable (¥)		15,200

(13)

Accounts Payable (¥)	15,200
Foreign Currency Units (¥)		15,200

Case 3: Forward Exchange Contracts 1

Hedging a forecasted foreign currency transaction: a foreign currency cash flow hedge.

This case presents the accounting for a forecasted foreign currency–denominated transaction, which is accounted for as a cash flow hedge of the possible changes in future cash flows.

The forecasted transaction is probable but not a firm commitment. Thus, the transaction has not yet occurred nor is it assured; the company is anticipating a possible future foreign currency transaction.

Because the foreign currency hedge is against the impact of changes in the foreign currency exchange rates used to predict the possible future foreign currency–denominated cash flows, it is accounted for as a cash flow hedge.

Case 3: Timeline

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Case 3: Forward Exchange Contracts 2

Case 3 is based on the data in Case 2 but adds the following assumption:

The purchase of inventory is forecasted in August, but there is not a binding agreement for this purchase.

Peerless Products Corporation enters into the 240-day forward exchange contract as a designated hedge against the future cash flows from the forecasted transaction, including the foreign currency-denominated accounts payable that would result from the purchase.

Case 3: Redesignate as Fair Value Hedge

A S C 815 allows a cash flow hedge to be redesignated as fair value hedge as follows:

Initially designate a forward foreign currency contract as a cash flow hedge if the contract’s purpose was offsetting forecasted cash flows, including transactions such as forecasted purchases or sales. Changes in the fair value of the cash flow hedge would be recognized as part of other comprehensive income. When the forecasted transaction becomes a firm commitment, the forward contract would be redesignated as a fair value hedge, and changes in the fair value contract would then be recognized in earnings.

The following slide presents the entries for this Case 3 alternative. The entries are compared to the entries for Case 1 by noting the entries that would change with a C after the entry number.

Case 3: Redesignate Alternative

Figure 11.6

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Case 3: Cash Flow Hedge Until Settlement

A S C 815 allows management the additional option of designating the forward contract as a cash flow hedge from the time the contract is initially made until final settlement as follows:

Designating the forward contract as a cash flow hedge from the time the contract is initially made until the final settlement of the payable or receivable. Changes in the value of the forward contract are measured using the forward exchange rate whereas changes in the account payable or receivable are measured using the spot exchange rate.

A S C 815 requires that other comprehensive income from the forward contract revaluation be offset for any foreign exchange gain or loss on the account receivable or payable. Any remaining component of other comprehensive income is taken into the earnings stream only on final completion of the earnings process.

The following slide presents the entries for this Case 3 alternative. The entries are compared to the entries for Case 1 by noting the entries that would change with a C after the entry number.

Case 3: Cash Flow Hedge Alternative

Figure 11.7

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Summary of Cases 1 through 3

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Case 4: Forward Exchange Contracts

Speculation in foreign currency markets:

This case presents the accounting for foreign currency forward contracts used to speculate in foreign currency markets. These transactions are not hedging transactions.

The foreign currency forward contract is revalued periodically to its fair value using the forward exchange rate for the remainder of the contract term.

The gain or loss on the revaluation is recognized currently in earnings on the income statement.

Case 4: Timeline

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Case 4: Rates Summary

The relevant direct exchange rates are as follows:

Date	U S Dollar–Equivalent Value of 1 Franc Spot Rate	U S Dollar–Equivalent Value of 1 Franc Forward Exchange Rate
October 1, 20X1	$0.73	$0.74 (180 days)
December 31, 20X1	0.75	0.78 (90 days)
April 1, 20X2	0.77

Case 4: Entry—October 1, 20X1

Entry to record the Forward Contract:

Dollars Receivable from Exchange Broker ($)	2,960
Foreign Currency Payable to Exchange Broker (SFr)		2,960

Enter into speculative forward exchange contract:

$2,960 = S F r 4,000 × $0.74, the 180-day forward rate.

Case 4: Entry—December 31, 20X1

Entry to Revalue the Forward Contract:

Foreign Currency Transaction Loss	160
Foreign Currency Payable to Exchange Broker (SFr)		160

Recognize speculation loss on forward contract for difference between initial 180-day forward rate and forward rate for remaining term to maturity of contract of 90 days:

$160 = S F r 4,000 × ($0.78 − $0.74)

Case 4: Entry—April 1, 20X2

Entry to Revalue the Forward Contract:

Foreign Currency Payable to Exchange Broker (SFr)	40
Foreign Currency Transaction Gain		40

Revalue foreign currency payable to spot rate at end of term of forward contract:

$40 = S F r 4,000 × ($0.78 − $0.77).

Case 4: Entries—April 1, 20X2

Foreign Currency Units (SFr)	3,080
Cash		3,080

Acquire foreign currency units (S F r) in open market when spot rate is $0.77 = S F r1:

$3,080 = S F r 4,000 × $0.77 spot rate.

FC Payable to Exchange Broker (SFr)	3,080
Foreign Currency Units (SFr)		3,080

Deliver foreign currency units to exchange broker in settlement of forward contract:

$3,080 = S F r 4,000 × $0.77 spot rate.

Cash	2,960
Dollars Receivable from Exchange Broker ($)		2,960

Receive U S dollars from exchange broker as contracted.

Practice Quiz Question #3

Which of the following is NOT one of the criteria for a hedge to be considered effective?

a. The hedge is based on an effective interest rate.

b. Documentation of the objective, strategy, and effectiveness of the hedge.

c. The hedge must be highly effective through its term.

d. The effectiveness of the hedge is assessed on an ongoing basis.

Practice Quiz Question #3 Solution

Which of the following is NOT one of the criteria for a hedge to be considered effective?

Answer: a. The hedge is based on an effective interest rate.

b. Documentation of the objective, strategy, and effectiveness of the hedge.

c. The hedge must be highly effective through its term.

d. The effectiveness of the hedge is assessed on an ongoing basis.

Learning Objective 11.4

Know how to measure hedge effectiveness, make interperiod tax allocations for foreign currency transactions, and hedge net investments in a foreign entity.

Additional Considerations 1

A note on measuring hedge effectiveness:

Effectiveness: there will be an approximate offset, within the range of 80 to 125 percent, of the changes in the fair value of the cash flows or changes in fair value to the risk being hedged.

Must be assessed at least every three months and when the company reports financial statements or earnings.

Intrinsic value and time value.

Additional Considerations 2

Interperiod tax allocation for foreign currency gains (losses).

Temporary differences in the recognition of foreign currency gains or losses between tax accounting and G A A P accounting require interperiod tax allocation.

The tax effect of the temporary difference is recognized in accordance with A S C 740 as a deferred tax asset or liability.

Additional Considerations 3

Hedges of a net investment in a foreign entity.

A number of balance sheet management tools are available for a U S company to hedge its net investment in a foreign affiliate.

A S C 815 specifies the following for derivative financial instruments designated as a hedge of the foreign currency exposure of a net investment in a foreign operation:

The portion of the change in fair value equivalent to a foreign currency transaction gain or loss should be reported in other comprehensive income.

The part of other comprehensive income resulting from a hedge of a net investment in a foreign operation then becomes part of the cumulative translation adjustment in other comprehensive income.

Practice Quiz Question #4

Which of the following is the appropriate test of hedge effectiveness?

a. The hedge offsets between 80–100% of the cash flows or risk of the item hedged.

b. The hedge offsets between 100–125% of the cash flows or risk of the item hedged.

c. The hedge offsets between 80–125% of the cash flows or risk of the item hedged.

d. The hedge offsets between 80–150% of the cash flows or risk of the item hedged.

Practice Quiz Question #4 Solution

Which of the following is the appropriate test of hedge effectiveness?

a. The hedge offsets between 80–100% of the cash flows or risk of the item hedged.

b. The hedge offsets between 100–125% of the cash flows or risk of the item hedged.

Answer: c. The hedge offsets between 80–125% of the cash flows or risk of the item hedged.

d. The hedge offsets between 80–150% of the cash flows or risk of the item hedged.

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The Accounting Issues 2 – Text Alternative

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The square on top is labeled P, with U S on the side. The square below is labeled S, with foreign on the side. The squares are connected with a vertical line.

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Forward Exchange Rates 2 – Text Alternative

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180-day forward rate = $1.40 per Euro. On 3 31, Sport rate = $1.36 per Euro. Spread = $0.05 per Euro, on 9 30.

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Comparative U S Company Journal Entries for Foreign Purchase Transaction Denominated in U.S Dollars versus Foreign Currency Units – Text Alternative

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If denominated in U S dollars. October 1, 20X1 date of purchase. Inventory, 14000. Accounts payable, 14000. December 31, 20X1, balance sheet date. No entry. April 31, 20X2, settlement date. Accounts payable, 14000. Cash, 14000. If denominated in Japanese Yen. October 1, 20X1 date of purchase. Inventory, 14000. Accounts payable, 14000. $14000 = 2000000 Yens multiplied by 0.0070 spot rate. December 31, 20X1, balance sheet date. Foreign currency transaction loss, 2000. Accounts payable in Yens, 2000. Adjustable payable denominated in foreign currency to current U S dollar equivalent and recognize exchange loss. $16000 = 2000000 Yens times 0.0080 December 31 spot rate. minus 14000 = 2000000 Yens times 0.0070 October 1 spot rate. Equals 42000 = 2000000 yens times 0.0080 minus 0.0070. April 1 20X2 settlement date. Accounts payable in Yens 800. Foreign currency transaction gain, 800. Adjust payable denominated in foreign currency to current U S dollar equivalent and recognize exchange gain. $15200 = 2000000 Yens times 0.0076 April 1 spot rate. Minus 16000 = 200000 Yens times 0.0080 December 31 spot rate. Equals $800 = 2000000 Yens times $0.0076 minus 0.0080. Foreign currency units in Yens 15200. Cash 15200. Acquire F C U to settle debt. $15200 = 2000000Yens times $0.0076 April 1 spot rate. Accounts payable 15200 Yens. Foreign currency units 15200 Yens.

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Preview of Cases 1 through 3 – Text Alternative

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Case 3: Forecast expected future transaction; enter into designated foreign currency forward contract; cash flow hedge of possible future foreign currency cash flow. Case 2: Sign binding agreement for transaction; enter into designated foreign currency forward contract; fair value hedge of changes in value of goods or services due to possible changes in exchange rates. Case 1: Receive goods or services from transaction; enter into undesignated foreign currency forward contract; manage exposed position by entering into foreign currency forward contract. Settlement of foreign currency denominated payable or receivable; settle foreign currency payable or receivable.

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Case 1: Timeline – Text Alternative

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The timeline has Transaction date of 10 1 X1, Balance sheet date of 12 31 X1, and Settlement date of 4 1 X2.

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Case 2: Illustration of Hedging an Unrecognized Foreign Currency Firm Commitment 3 – Text Alternative

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The first 2 dates represent firm commitment. The remaining part of the timeline is labeled exposed foreign currency payable. 8 1 X1. Sign contract for goods and enter into a 240-day forward exchange contract to hedge foreign currency payable commitment. 10 1 X1. Receive goods. 12 31 X1. Balance sheet date. 4 1 X2. Pay account payable, yen, with foreign currency units received from completion of forward exchange contract.

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Case 3: Timeline – Text Alternative

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The first 2 dates represent forecasted transaction. The remaining part of the timeline is labeled exposed foreign currency payable. 8 1 X1. Forecast the purchase of goods and enter into a 240-day forward exchange contract to hedge foreign currency purchase. 10 1 X1. Receive goods. 12 31 X1. Balance sheet date. 4 1 X2. Pay account payable, yen, with foreign currency units received from completion of forward exchange contract.

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Case 3: Redesignate Alternative – Text Alternative

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The sheet has 2 columns and 6 rows. The column