NON-PROFIT ACCOUNTING HW

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Chapter Seven

Foreign Currency Transactions and Hedging Foreign Exchange Risk

Learning Objective 7-1

Understand concepts related to foreign currency, exchange rates, and foreign exchange risk.

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LO 7-1: Understand concepts related to foreign currency, exchange rates, and foreign exchange risk.

Exchange Rate Mechanisms

Each country (or group of countries) uses its own currency as the unit of value for the purchase and sale of goods and services.

Between 1945 and 1973, countries fixed the par value of their currency in terms of the U.S. dollar.

The U.S. dollar was based on the gold standard until 1971.

Since 1973, exchange rates have been allowed to float in value.

Several currency arrangements exist.

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Each country (or group of countries) 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, the currency used by a subset of European Union countries is the Euro, and so on. If a U.S. citizen travels to Mexico and wishes to purchase local goods, Mexican merchants require payment to be made in Mexican pesos. To make a purchase in Mexico, a U.S. citizen would need to acquire pesos using U.S. dollars. The foreign currency exchange rate is the price at which the foreign currency can be acquired (or sold). A variety of factors determine the exchange 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 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. In March 1973, most countries allowed their currencies to float in value. Today, several different currency arrangements exist.

Different Currency Mechanisms

Independent float—the currency is allowed to fluctuate according to market forces.

Pegged to another currency—the currency’s value is fixed in terms of a particular foreign currency, and the central bank intervenes to maintain the fixed value.

European Monetary System—a common currency (the euro) is used in multiple countries. Its value floats against other world currencies.

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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 (example countries include Australia, Brazil, Canada, Japan, Sweden, Switzerland, the United Kingdom, and the United States).

Pegged to another currency: The value of the currency is fixed (pegged) in terms of a particular foreign currency and the central bank intervenes as necessary to maintain the fixed value. For example, Bahrain, Panama, and Saudi Arabia peg their currency to the U.S. dollar. China has pegged its currency, the yuan (or Renminbi), to the U.S. dollar since 1994, while allowing a revaluation in 2005 and again in 2015. By managing the value of its currency (downward) rather than allowing it to float freely, the Chinese government has made it easier for Chinese companies to export their products overseas.

European Monetary System (euro): In 1998, the countries comprising the European Monetary System adopted a common currency called the euro and established a European Central Bank.2 Until 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, 19 countries are part of the euro zone. The value of the euro floats against other currencies such as the Swiss franc, British pound, and U.S. dollar.

Foreign Exchange Rates

An exchange rate is the cost of one currency in terms of another.

Rates published daily in The Wall Street Journal are as of 4:00 p.m. eastern standard time on the day prior to publication. Rates are also available at the websites of OANDA and X-Rates.

The published rates are wholesale rates that banks use with each other; retail rates to consumers are higher.

The difference between the rates at which a bank is willing to buy and sell currency is known as the “spread.”

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Exchange rates between the U.S. dollar and many foreign currencies are published on a daily basis in The Wall Street Journal and major U.S. newspapers. Exchange rates also are available online at websites such as www.oanda.com and www.x-rates.com.

The exchange rates are for trades between banks; that is, these are interbank or wholesale prices. Prices charged by banks to retail customers, such as companies engaged in international business, are higher. These are selling rates at which banks will sell currency to one another. The prices that banks are willing to pay to buy foreign currency 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.

Foreign Currency Trades

Foreign currency trades can be executed on a spot or forward basis.

The spot rate is the price at which a foreign currency can be purchased or sold today.

The forward rate is the price available today at which foreign currency can be purchased or sold in the future.

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.

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Foreign currency trades can be executed on a spot or forward basis. The spot rate is the price at which a foreign currency can be purchased or sold today. In contrast, the forward rate is the price available today at which foreign currency can be purchased or sold sometime in the future. Because 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.

Foreign Currency Quotes

Information is reported for each day’s exchange rates as:

Direct quotes—indicate the number of domestic currency needed to purchase one unit of foreign currency, and

Indirect quotes—indicate the number of foreign currency units that could be purchased with one unit of domestic currency. These rates are simply the inverse of direct quotes.

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Two columns of information are shown for each day’s exchange rates. The first column reports direct quotes, which indicate the number of U.S. dollars needed to purchase one unit of foreign currency. The second column reports indirect quotes, which indicate the number of foreign currency units that could be purchased with one U.S. dollar. These rates are simply the inverse of direct quotes.

Forward Rates

Forward rates can fluctuate.

If forward rates exceed spot rates on any given date, the foreign currency is said to be selling at a premium in the forward market.

If forward rates are less than spot rates, the currency is said to be selling at a discount.

Currencies sell at a premium or a discount because of differences in interest rates between two countries.

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The forward rate can exceed the spot rate on a given date, in which case the foreign currency is said to be selling at a premium in the forward market, or the forward rate can be less than the spot rate, in which case the currency is selling at a discount. Currencies sell at a premium or a discount because 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.3

Foreign Exchange—Option Contracts

Foreign currency options give the holder of an option the right but not the obligation to trade foreign currency in the future.

“Put” options allow for the sale of foreign currency by the option holder.

“Call” options allow for the purchase of foreign currency by the option holder.

A strike price is the exchange rate at which options will be executed if option holders decide to exercise options.

Options purchased in the over-the-counter (OTC) market usually have a strike price equal to the spot rate on that date. These options are said to be “at-the-money.”

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To provide companies more flexibility than exists with a forward contract, a market for foreign currency options has developed. A foreign currency option gives the holder of the option the right but not the obligation to trade foreign currency in the future. A put option is for the sale of foreign currency by the holder of the option; a call option is for the purchase of foreign currency by the holder of the option. The strike price is the exchange rate at which the option will be executed if the option holder decides to exercise the option. The strike price is similar to a forward rate. There are generally several strike prices to choose from at any particular time. Foreign currency options can be purchased on the Philadelphia Stock Exchange or the Chicago Mercantile Exchange, but most foreign currency options are purchased directly from a bank in the so-called over-the-counter (OTC) market. Options purchased in the OTC market usually have a strike price that is equal to the spot rate on that date. These options are said to be “at-the-money.”

Option Values

Options are purchased by paying an option premium, a function of two components: intrinsic value and time value.

Intrinsic value is equal to the gain that could be realized by exercising the option immediately. An option with a positive intrinsic value is said to be “in-the-money.”

Time value relates to the spot rate which can change over time and cause the option’s intrinsic value to increase.

Time value of an option decreases over time because less time remains for the option to increase in intrinsic value.

The fair value of a foreign currency option on a specific date is the sum of its intrinsic and time values on that date.

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Options must be purchased by paying an option premium, which is a function of two components: intrinsic value and time value. An option’s intrinsic value is equal to the gain that could be realized by exercising the option immediately.

An option with a positive intrinsic value is said to be “in-the-money.” The time value of an option relates to the fact that the spot rate can change over time and cause the option’s intrinsic value to increase.

As time passes, the time value of an option decreases because there is less time remaining for the option to increase in intrinsic value. The fair value of a foreign currency option on a specific date is the sum of its intrinsic and time values on that date.

Learning Objective 7-2

Account for foreign currency transactions using the two- transaction perspective, accrual approach.

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LO 7-2: Account for foreign currency transactions using the two-transaction perspective, accrual approach.

Foreign Currency Transactions

Export sales and import purchases are international transactions; they are components of what is called trade.

The companies involved must decide which currency will be used to settle the transaction, and whether the transaction will be denominated (payment will be made) in domestic or foreign currency.

If a company receives foreign currency to settle the transaction, it must restate the amount of foreign currency received into domestic currency.

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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 in 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 transaction. 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.

Transaction Exposure

Assume an American company enters into a transaction and allows its foreign customer 30 days to pay for its purchases.

The American company runs the risk that the value of the foreign currency and domestic currency might change between the sale date and date of payment.

The sale could generate less or more domestic currency than it would have at the date of sale. If so, the American company has an exposure to foreign exchange risk.

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Assume that, as is customary in its industry, Amerco does not require immediate payment 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 exchange risk.

Export Sale

Export sale:

Exposure exists when an exporter allows a buyer to pay in a foreign currency after the sale has been made.

The exporter is exposed to the risk that the foreign currency might depreciate between the sale and payment dates.

No foreign exchange risk exposure exists if the exporter requires payment on the date of sale.

The foreign currency received would be immediately converted into domestic currency at the spot rate on the date of sale.

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Export sale: A transaction exposure exists when the exporter allows the buyer to pay in a foreign currency and allows the buyer to pay sometime after the sale has been made. The exporter is exposed to the risk that the foreign currency might depreciate (decrease in value) between the date of sale and the date payment is received, thereby decreasing the U.S. dollars ultimately collected.

Note that there is no exposure to foreign exchange risk if the exporter requires the foreign customer to make payment on the date of sale. In that case, the exporter would receive foreign currency and immediately convert it into U.S. dollars at the spot rate on the date of sale.

Import Purchase

Import purchase:

Exposure exists when the importer is required to pay in foreign currency sometime after the purchase.

The importer is exposed to the risk that the foreign currency might appreciate between the purchase and payment dates, increasing the domestic currency paid.

No foreign exchange risk exposure exists if the importer makes a payment on the date of purchase.

The domestic currency paid would be immediately converted into foreign currency at the spot rate on the date of purchase.

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Import purchase: A transaction exposure exists when the importer is required to pay in foreign currency and is allowed to pay sometime after the purchase has been made. The importer is exposed to the risk that the foreign currency might appreciate (increase in price) between the date of purchase and the date of payment, thereby increasing the U.S. dollars that have to be paid for the imported goods.

Note that there is no exposure to foreign exchange risk if the importer makes payment in foreign currency on the date of purchase. In that case, the importer converts U.S. dollars into foreign currency at the spot rate on the date of purchase and immediately makes payment.

Accounting for Foreign Currency Transactions

A major issue in accounting for foreign currency transactions is how to account for the:

Change in the domestic currency value of the sales revenue and account receivable resulting from the export when the foreign currency changes in value.

Change in the domestic currency value of the account payable and goods being acquired in an import purchase.

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The major issue in accounting for foreign currency transactions is how to deal with the change in U.S. dollar value of the sales revenue and account receivable resulting from the export when the foreign currency changes in value. (The corollary issue is how to deal with the change in the U.S. dollar value of the account payable and goods being acquired in an import purchase.)

Accounting for Foreign Currency—Sales

FASB ASC 830-20 Foreign Currency Matters - Foreign Currency Transactions requires the two-transaction perspective and treats the sale and collection of cash as two separate transactions.

Account for the original sale in U.S. dollars at date of sale. No subsequent adjustments are required.

Changes in the U.S. dollar value of the foreign currency are accounted for as gains/losses from exchange rate fluctuations reported separately from sales in the income statement.

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FASB ASC 830-20 Foreign Currency Matters - Foreign Currency Transactions requires companies to use what can be referred to as a two-transaction perspective in accounting for foreign currency transactions. This perspective treats the export sale and the subsequent collection of cash as two separate transactions. Because management has made two decisions—(1) to make the export sale and (2) to extend credit in foreign currency to the customer—the company should report the income effect from each of these decisions separately. The U.S. dollar value of the sale is recorded at the date the sale occurs. At that point, the sale has been completed; there are no subsequent adjustments to the Sales account. Any difference between the number of U.S. dollars that could have been received at the date of sale and the number of U.S. dollars actually received at the date of collection due to fluctuations in the exchange rate is a result of the decision to extend foreign currency credit to the customer. This difference is treated as a foreign exchange gain or loss that is reported separately from Sales in the income statement.

Accounting for Foreign Currency—Purchases

Import purchases denominated in a foreign currency and the subsequent cash payment must be accounted for separately.

The U.S. dollar value of the goods purchased is recorded at the date of purchase, with no subsequent adjustments to the cost of the goods.

Any difference between the number of U.S. dollars that could have been paid on the purchase date and the actual number of U.S. dollars paid on the payment date due to a change in the exchange rate is treated as a foreign exchange gain or loss.

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Similarly, an import purchase denominated in a foreign currency and the subsequent payment of cash must be accounted for separately. The U.S. dollar value of the goods purchased is recorded at the date of purchase, with no subsequent adjustments to the cost of the goods. Any difference between the number of U.S. dollars that could have been paid on the date of purchase and the actual number of U.S. dollars that is paid on the payment date due to a change in the exchange rate is treated as a foreign exchange gain or loss.

Summary of Exchange Rates and Foreign Exchange Gains and Losses

Summary of the relationship between fluctuations in exchange rates and foreign exchange gains and losses:

Foreign currency receivables from an export sale create an asset exposure to foreign exchange risk.

Foreign currency payables from an import purchase create a liability exposure to foreign exchange risk.

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A summary of the relationship between fluctuations in exchange rates and foreign exchange gains and losses is presented in the table. A foreign currency receivable arising from an export sale creates an asset exposure to foreign exchange risk. If the foreign currency appreciates, the foreign currency asset increases in U.S. dollar value and a foreign exchange gain arises; depreciation of the foreign currency causes a foreign exchange loss. A foreign currency payable arising from an import purchase creates a liability exposure to foreign exchange risk. If the foreign currency appreciates, the foreign currency liability increases in U.S. dollar value and a foreign exchange loss results; depreciation of the currency results in a foreign exchange gain.

Balance Sheet Date before Date of Payment

Authoritative accounting literature requires foreign currency balances—foreign currency receivables or foreign currency payables—to be revalued at the balance sheet date to account for change in exchange rates.

Consistent with accrual accounting, under the two-transaction perspective, a foreign exchange gain or loss arises at the balance sheet date.

U.S. GAAP requires the accrual accounting approach to be used to account for foreign exchange rate changes.

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Authoritative accounting literature requires foreign currency balances such as a foreign currency receivable or a foreign currency payable to be revalued at the balance sheet date to account for the change in exchange rates. Under the two-transaction perspective, this means that a foreign exchange gain or loss arises at the balance sheet date. The next question then is what should be done with these foreign exchange gains and losses that have not yet been realized in cash. Should they be included in net income?

Accrual approach (required by U.S. GAAP):

Unrealized foreign exchange gains and losses are reported in net income in the period in which the exchange rate changes.

Change in the exchange rate from the balance sheet date to date of payment results in a second foreign exchange gain or loss that is reported in the second accounting period.

Accounting for Unrealized Gains and Losses

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U.S. GAAP requires unrealized foreign exchange gains and losses to be reported in net income in the period in which the exchange rate changes. This is consistent with accrual accounting as it results in reporting the effect of a rate change that will have an impact on cash flow in the period when the event causing the impact takes place. Thus, any change in the exchange rate from the date of sale to the balance sheet date results in a foreign exchange gain or loss to be reported in income in that period. Any change in the exchange rate from the balance sheet date to the date of collection results in a second foreign exchange gain or loss that is reported in the net income in the second accounting period.

International Financial Accounting Standards (IFRS)

Similar to U.S. GAAP, IAS 21, “The Effects of Changes in Foreign Exchange Rates,” requires the use of a two-transaction perspective to account for foreign currency transactions with unrealized foreign exchange gains and losses accrued in net income in the period of exchange rate change.

There are no substantive differences between U.S. GAAP and IFRS in accounting for foreign currency transactions.

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International Accounting Standard 21—The Effects of Changes in Foreign Exchange Rates

Similar to U.S. GAAP, IAS 21, “The Effects of Changes in Foreign Exchange Rates,” also requires the use of a two-transaction perspective in accounting for foreign currency transactions with unrealized foreign exchange gains and losses accrued in net income in the period of exchange rate change. There are no substantive differences between IFRS and U.S. GAAP in the accounting for foreign currency transactions.

Learning Objective 7-3

Account for foreign currency borrowings.

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LO 7-3: Account for foreign currency borrowings.

Foreign Currency Borrowings

Companies often must account for foreign currency borrowings, another type of foreign currency transaction.

Companies borrow foreign currency from foreign lenders to finance foreign operations or to take advantage of more favorable interest rates.

The principal and interest are denominated in foreign currency and create an exposure to foreign exchange risk which complicate accounting for a foreign currency borrowing.

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In addition to the receivables and payables that arise from import and export activities, companies often must account for foreign currency borrowings, another type of foreign currency transaction. Companies borrow foreign currency from foreign lenders either to finance foreign operations or perhaps to take advantage of more favorable interest rates. The facts that both the principal and interest are denominated in foreign currency and both create an exposure to foreign exchange risk complicate accounting for a foreign currency borrowing.

Foreign Currency Loans

Companies lend foreign currency to related parties, creating the opposite situation from a foreign currency borrowing.

The company must keep track of a note receivable and interest receivable, both of which are denominated in foreign currency.

Fluctuations in the U.S. dollar value of the principal and interest generally give rise to foreign exchange gains and losses that would be included in income.

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At times companies lend foreign currency to related parties, creating the opposite situation from a foreign currency borrowing. The accounting involves keeping track of a note receivable and related interest receivable, both of which are denominated in foreign currency. Fluctuations in the U.S. dollar value of the principal and interest generally give rise to foreign exchange gains and losses that would be included in net income. An exception arises when the foreign currency loan is made on a long-term basis to a foreign branch, subsidiary, or equity method affiliate. Foreign exchange gains and losses on “intra-entity foreign currency transactions that are of a long-term investment nature (that is, settlement is not planned or anticipated in the foreseeable future)” are deferred in accumulated other comprehensive income until the loan is repaid. Only the foreign exchange gains and losses related to the interest receivable are recorded currently in net income.

Learning Objective 7-4

Understand the different types of foreign exchange risk that can be hedged and how foreign currency forward contracts and foreign currency options can be used to hedge those risks.

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LO 7-4: Understand the different types of foreign exchange risk that can be hedged and how foreign currency forward contracts and foreign currency options can be used to hedge those risks.

Hedging Foreign Exchange Risk

To avoid uncertainty of unfavorable changes in the value of foreign currencies in foreign transactions, companies often use derivative financial instruments to hedge against the effect of unfavorable changes in the value of foreign currencies.

A derivative financial instrument, or simply derivative, derives its value from some “underlying.” In this case, the underlying is the currency exchange rate.

The two most common derivatives used to hedge foreign exchange risk are:

Foreign currency forward contracts.

Foreign currency options.

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To avoid uncertainty of unfavorable changes in the value of foreign currencies, companies often use derivative financial instruments to hedge against the effect of unfavorable changes in the value of foreign currencies. A derivative financial instrument, or simply derivative, derives its value from some “underlying.” In the case of foreign currency derivatives, the underlying is the currency exchange rate. The two most common derivatives used to hedge foreign exchange risk are foreign currency forward contracts and foreign currency options.

Hedge of a Recognized Foreign Currency Denominated Asset

Foreign currency forward contracts lock in the price for which the currency will sell at contract’s maturity.

Foreign currency options establish a price for which the currency can be sold, but is not required to be sold at maturity.

If a company enters into a forward contract or purchases a put option on the date the sale is made, the derivative is used as a hedge of a recognized foreign currency denominated asset.

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Through a forward contract, a company can lock in the price at which it will sell foreign currency it receives in three months. An option establishes a price at which it will be able, but is not required, to sell the foreign currency it receives in three months. If the company enters into a forward contract or purchases a put option on the date the sale is made, the derivative is being used as a hedge of a recognized foreign currency denominated asset (the euro account receivable).

Accounting for Foreign Currency Firm Commitments

Companies engaged in foreign currency activities often enter into hedging arrangements as soon as they receive a noncancelable sales order or place a noncancelable purchase order.

A noncancelable order that specifies the foreign currency price and date of delivery is known as a foreign currency firm commitment.

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Companies engaged in foreign currency activities often enter into hedging arrangements as soon as they receive a noncancelable sales order or place a noncancelable purchase order. A noncancelable order that specifies the foreign currency price and date of delivery is known as a foreign currency firm commitment.

Hedge of a Forecasted Foreign Currency Denominated Transaction Example

Assume an American company, Amerco, accepts an order to sell parts to a customer in South Korea at a price of 5 million Korean won. The parts will be delivered and payment will be received on August 15.

On June 1, before the sale has been made, Amerco enters into a forward contract to sell 5 million Korean won on August 15. In this case, Amerco is using a foreign currency derivative as a hedge of an unrecognized foreign currency firm commitment.

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Assume that on October 1, Amerco forecasts that it will make a purchase from the Hong Kong supplier in one month. To hedge against a possible increase in the price of the Hong Kong dollar, Amerco acquires a call option on October 1 to purchase Hong Kong dollars in one month. The foreign currency option represents a hedge of a forecasted foreign currency denominated transaction.

Hedge of an Unrecognized Foreign Currency Firm Commitment

Some companies have foreign currency transactions that occur on a regular basis and can be reliably forecasted.

For example, Amerco regularly purchases materials from a supplier in Hong Kong for which it pays in Hong Kong dollars.

Even if Amerco has no contract to make future purchases, it has an exposure to foreign currency risk if it plans to continue making purchases from the Hong Kong supplier.

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Some companies have foreign currency transactions that occur on a regular basis and can be reliably forecasted. For example, Amerco regularly purchases materials from a supplier in Hong Kong for which it pays in Hong Kong dollars. Even if Amerco has no contract to make future purchases, it has an exposure to foreign currency risk if it plans to continue making purchases from the Hong Kong supplier. Assume that on October 1, Amerco forecasts that it will make a purchase from the Hong Kong supplier in one month. To hedge against a possible increase in the price of the Hong Kong dollar, Amerco acquires a call option on October 1 to purchase Hong Kong dollars in one month. The foreign currency option represents a hedge of a forecasted foreign currency denominated transaction.

Hedge of an Unrecognized Foreign Currency Firm Commitment (continued)

Assume on October 1, Amerco forecasts that it will make a purchase from the Hong Kong supplier in one month.

To hedge against a possible increase in the price of the Hong Kong dollar, Amerco acquires a call option on October 1 to purchase Hong Kong dollars in one month.

The foreign currency option represents a hedge of a forecasted foreign currency denominated transaction.

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Amerco regularly purchases materials from a supplier in Hong Kong for which it pays in Hong Kong dollars. Even if Amerco has no contract to make future purchases, it has an exposure to foreign currency risk if it plans to continue making purchases from the Hong Kong supplier. Assume that on October 1, Amerco forecasts that it will make a purchase from the Hong Kong supplier in one month. To hedge against a possible increase in the price of the Hong Kong dollar, Amerco acquires a call option on October 1 to purchase Hong Kong dollars in one month. The foreign currency option represents a hedge of a forecasted foreign currency denominated transaction.

Learning Objective 7-5

Understand the accounting guidelines for derivative financial instruments.

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LO 7-5: Understand the accounting guidelines for derivative financial instruments.

FASB ASC Topic 815, “Derivatives and Hedging”

ASC Topic 815 provides guidance for hedges of four types of foreign exchange risk:

Recognized foreign currency denominated assets and liabilities.

Unrecognized foreign currency firm commitments.

Forecasted foreign currency denominated transactions.

Net investments in foreign operations.

Different accounting applies to each type of foreign currency hedge.

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FASB ASC Topic 815, “Derivatives and Hedging,” governs the accounting for derivatives, including those used to hedge foreign exchange risk. This authoritative literature provides guidance for hedges of the following sources of foreign exchange risk:

1. Recognized foreign currency denominated assets and liabilities.

2. Unrecognized foreign currency firm commitments.

3. Forecasted foreign currency denominated transactions.

4. Net investments in foreign operations.

Different accounting applies to each type of foreign currency hedge. This chapter demonstrates the accounting for the first three types of hedges. The next chapter covers hedges of net investments in foreign operations.

Determination of Fair Value of a Foreign Currency Forward Contract

The fair value of a foreign currency forward contract is determined by reference to changes in the forward rate over the life of the contract, discounted to present value.

Three pieces of information determine the fair value of a forward contract at any point in time:

The forward rate when the forward contract was entered into.

The current forward rate for a contract that matures on the same date as the forward contract entered into.

A discount rate—typically, the company’s incremental borrowing rate.

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The fair value of a foreign currency forward contract is determined by reference to changes in the forward rate over the life of the contract, discounted to the present value. Three pieces of information are needed to determine the fair value of a forward contract at any point in time:

1. The forward rate when the forward contract was entered into.

2. The current forward rate for a contract that matures on the same date as the forward contract entered into.

3. A discount rate—typically, the company’s incremental borrowing rate.

Determination of Fair Value of a Foreign Currency Option

The manner in which fair value of a foreign currency option is determined depends on whether the option is traded on an exchange or acquired in the over-the-counter market.

The fair value of an exchange-traded foreign currency option is its current market price quoted on the exchange.

For over-the-counter options, fair value can be determined by obtaining a price quote from an option dealer.

If dealer price quotes are unavailable, the value of an option can be estimated using the modified Black-Scholes option pricing.

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The manner in which the fair value of a foreign currency option is determined depends on whether the option is traded on an exchange or has been acquired in the over-the-counter market. The fair value of an exchange-traded foreign currency option is its current market price quoted on the exchange. For over-the-counter options, fair value can be determined by obtaining a price quote from an option dealer (such as a bank). If dealer price quotes are unavailable, the company can estimate the value of an option using the modified Black-Scholes option pricing model (briefly mentioned earlier). Regardless of who does the calculation, principles similar to those of the Black-Scholes pricing model can be used to determine the fair value of the option.

Accounting for Changes in the Fair Value of Derivatives

For speculative derivatives, the change in the fair value of the derivative must be recognized immediately as a gain or loss in net income.

Accounting for changes in the fair value of derivatives used for hedging depends on the nature of the foreign exchange risk being hedged and on whether the derivative qualifies for hedge accounting.

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Although using derivatives for speculation is not commonly done by nonfinancial institutions, financial entities might acquire derivative financial instruments as investments for speculative purposes. For speculative derivatives, the change in the fair value of the derivative must be recognized immediately as a gain or loss in net income.

The accounting for changes in the fair value of derivatives used for hedging depends on the nature of the foreign exchange risk being hedged and on whether the derivative qualifies for hedge accounting.

Learning Objective 7-6

Understand the basic concepts of hedge accounting.

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LO 7-6: Understand the basic concepts of hedge accounting.

Hedge Accounting

Hedge accounting:

Minimizes the adverse effect that changes in exchange rates have on cash flows and net income.

Recognizes the gain or loss from the hedge in net income in the same period as the loss or gain on the risk being hedged. These three conditions must be met. The derivative is:

Used to hedge either a cash flow exposure or a fair value exposure to foreign exchange risk.

Highly effective in offsetting changes in the cash flows or fair value related to the hedged item.

Properly documented as a hedge.

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Companies enter into hedging relationships to minimize the adverse effect that changes in exchange rates have on cash flows and net income. As such, companies would like to account for hedges in a way that recognizes the gain or loss from the hedge in net income in the same period as the loss or gain on the risk being hedged. This approach is known as hedge accounting. U.S. GAAP allows hedge accounting for foreign currency derivatives only if three conditions are satisfied:

The derivative is used to hedge either a cash flow exposure or a fair value exposure to foreign exchange risk.

The derivative is highly effective in offsetting changes in the cash flows or fair value related to the hedged item.

The derivative is properly documented as a hedge.

Each of these conditions is discussed in turn.

Derivatives for which companies wish to use hedge accounting must be designated as either a cash flow hedge or a fair value hedge.

For hedges of recognized foreign currency assets and liabilities and hedges of foreign currency firm commitments, companies must choose between the two types of designation.

Hedges of forecasted foreign currency transactions can qualify only as cash flow hedges.

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Accounting for Derivatives

Derivatives for which companies wish to use hedge accounting must be designated as either a cash flow hedge or a fair value hedge. For hedges of recognized foreign currency assets and liabilities and hedges of foreign currency firm commitments, companies must choose between the two types of designation. Hedges of forecasted foreign currency transactions can qualify only as cash flow hedges.

Accounting Procedures for Hedges

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Accounting procedures differ for the two types of hedges.

In general, gains and losses on cash flow hedges are included in other comprehensive income (and therefore deferred on the balance sheet in accumulated other comprehensive income).

Gains and losses on fair value hedges are recognized immediately in net income.

Accounting procedures differ for the two types of hedges. In general, gains and losses on cash flow hedges are included in other comprehensive income (and therefore deferred on the balance sheet in accumulated other comprehensive income), and gains and losses on fair value hedges are recognized immediately in net income.

Accounting for Fair Value Hedges

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A fair value exposure exists if changes in exchange rates can affect the fair value of an asset or liability reported on the balance sheet.

To qualify for hedge accounting, the fair value risk must have the potential to affect net income if it is not hedged.

If the foreign currency depreciates for a foreign currency account receivable, the receivable must be written down with an offsetting loss recognized in net income.

The authoritative literature has determined that a fair value exposure also exists for foreign currency firm commitments.

A fair value exposure exists if changes in exchange rates can affect the fair value of an asset or liability reported on the balance sheet. To qualify for hedge accounting, the fair value risk must have the potential to affect net income if it is not hedged. For example, a fair value risk is associated with a foreign currency account receivable. If the foreign currency depreciates, the receivable must be written down with an offsetting loss recognized in net income. The authoritative literature has determined that a fair value exposure also exists for foreign currency firm commitments.

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Accounting for Cash Flow Hedges

A cash flow exposure exists if changes in exchange rates can affect the amount of cash flow to be realized from a foreign currency transaction with changes in cash flow reflected in net income.

A foreign currency account receivable, for example, has both a fair value exposure and a cash flow exposure.

A cash flow exposure exists for:

Recognized foreign currency assets and liabilities.

Foreign currency firm commitments.

Forecasted foreign currency transactions.

A cash flow exposure exists if changes in exchange rates can affect the amount of cash flow to be realized from a foreign currency transaction with changes in cash flow reflected in net income. A foreign currency account receivable, for example, has both a fair value exposure and a cash flow exposure. A cash flow exposure exists for (1) recognized foreign currency assets and liabilities, (2) foreign currency firm commitments, and (3) forecasted foreign currency transactions.

Hedging Documentation

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U.S. GAAP requires formal documentation of the hedging relationship at the inception date of the hedge.

Specific accounting procedures followed and journal entries needed to account for a foreign currency hedging relationship are determined by a combination of the following factors:

The type of foreign currency item being hedged:

Foreign currency denominated asset or liability.

Foreign currency firm commitment.

Forecasted foreign currency transaction.

For hedge accounting to be applied, U.S. GAAP requires formal documentation of the hedging relationship at the inception of the hedge (i.e., on the date a foreign currency forward contract is entered into or a foreign currency option is acquired).

The specific accounting procedures followed and journal entries needed to account for a foreign currency hedging relationship are determined by a combination of the following factors:

1. The type of foreign currency item being hedged:

a. Foreign currency denominated asset or liability.

b. Foreign currency firm commitment.

c. Forecasted foreign currency transaction.

2. The type of hedging instrument used:

a. Forward contract.

b. Option.

3. The nature of the hedged risk:

a. Cash flow exposure.

b. Fair value exposure.

4. The nature of the foreign currency item being hedged:

a. Asset (existing or future).

b. Liability (existing or future).

Hedging Documentation (continued)

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The type of hedging instrument used:

Forward contract.

Option.

The nature of the hedged risk:

Cash flow exposure.

Fair value exposure.

The nature of the foreign currency item being hedged:

Asset (existing or future).

Liability (existing or future).

2. The type of hedging instrument used:

a. Forward contract.

b. Option.

3. The nature of the hedged risk:

a. Cash flow exposure.

b. Fair value exposure.

4. The nature of the foreign currency item being hedged:

a. Asset (existing or future).

b. Liability (existing or future).

Learning Objective 7-7

Account for forward contracts and options used as hedges of foreign currency denominated assets and liabilities.

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LO 7-7: Account for forward contracts and options used as hedges of foreign currency denominated assets and liabilities.

Hedge of a Forecasted Foreign Currency Denominated Transaction—Cash Flow Hedges and Fair Value Hedges

Hedges of foreign currency denominated assets and liabilities, accounts receivable and accounts payable, can qualify as either cash flow hedges or fair value hedges.

To qualify as a cash flow hedge, the hedging instrument must completely offset the variability in the cash flows associated with the foreign currency receivable or payable.

If it does not qualify as a cash flow hedge or if the company elects not to designate it as a cash flow hedge, the hedge is designated as a fair value hedge.

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Hedges of foreign currency denominated assets and liabilities, such as accounts receivable and accounts payable, can qualify as either cash flow hedges or fair value hedges. To qualify as a cash flow hedge, the hedging instrument must completely offset the variability in the cash flows associated with the foreign currency receivable or payable. If the hedging instrument does not qualify as a cash flow hedge or if the company elects not to designate the hedging instrument as a cash flow hedge, the hedge is designated as a fair value hedge.

Cash Flow Hedge

At the balance sheet date:

Adjust the hedged asset or liability to fair value based on changes in the spot exchange rate and recognize a foreign exchange gain or loss in net income.

Adjust the derivative hedging instrument to fair value (resulting in an asset or liability reported on the balance sheet) with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI).

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At each balance sheet date, the following procedures are required:

The hedged asset (foreign currency account receivable) or liability (foreign currency account payable) is adjusted to fair value based on changes in the spot exchange rate, and a foreign exchange gain or loss is recognized in net income (Cash Flow Hedge Step B.1. in Exhibit 7.2).

To comply with the fundamental requirement of derivatives accounting, the derivative hedging instrument (forward contract or option) is adjusted to fair value (resulting in an asset or liability reported on the balance sheet) with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI) (Cash Flow Hedge Step B.2. in Exhibit 7.2).

Cash Flow Hedge (continued)

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An amount equal to the foreign exchange gain or loss on the hedged asset or liability is transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability.

An additional amount is removed from AOCI and recognized in net income to reflect:

the current period’s amortization of the original discount or premium on the forward contract or

the change in the time value of the option.

An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability (Cash Flow Hedge Step B.3. in Exhibit 7.2).

An additional amount is removed from AOCI and recognized in net income to reflect (a) the current period’s amortization of the original discount or premium on the forward contract (if a forward contract is the hedging instrument) or (b) the change in the time value of the option (if an option is the hedging instrument) (Cash Flow Hedge Step B.4. in Exhibit 7.2).

Fair Value Hedges

At the balance sheet date:

Adjust the hedged asset or liability to fair value based on changes in the spot exchange rate and recognize a foreign exchange gain or loss in net income.

Adjust the derivative hedging instrument to fair value (resulting in an asset or liability reported on the balance sheet) and recognize the counterpart as a gain or loss in net income.

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Fair Value Hedge

At each balance sheet date, the following procedures are required:

Adjust the hedged asset or liability to fair value based on changes in the spot exchange rate and recognize a foreign exchange gain or loss in net income (Fair Value Hedge Step B.1. in Exhibit 7.2).

Adjust the derivative hedging instrument to fair value (resulting in an asset or liability reported on the balance sheet) and recognize the counterpart as a gain or loss in net income (Fair Value Hedge Step B.2. in Exhibit 7.2).

Learning Objective 7-8

Account for forward contracts and options used as hedges of foreign currency firm commitments.

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LO 7-8: Account for forward contracts and options used as hedges of forecasted foreign currency transactions.

Unrecognized Foreign Currency Firm Commitment Hedge

A firm commitment is an executory contract not normally recognized in financial statements; the company has not delivered goods nor has the customer paid for them.

When a firm commitment is hedged using a derivative financial instrument, hedge accounting requires explicit recognition on the balance sheet at fair value of both the derivative financial instrument and the firm commitment.

The change in fair value of the firm commitment results in a gain or loss that offsets the loss or gain on the hedging instrument (forward contract or option).

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A firm commitment is an executory contract; the company has not delivered goods nor has the customer paid for them. Normally, executory contracts are not recognized in financial statements. However, when a firm commitment is hedged using a derivative financial instrument, hedge accounting requires explicit recognition on the balance sheet at fair value of both the derivative financial instrument (forward contract or option) and the firm commitment.

Foreign Currency Forward Contract and Spot Rate Hedges

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When a forward contract is used as the hedging instrument, the fair value of the firm commitment is determined through reference to changes in the forward exchange rate.

Changes in the spot exchange rate are used to determine the fair value of the firm commitment when a foreign currency option is the hedging instrument.

This raises the conceptual question of how to measure the fair value of the firm commitment. When a forward contract is used as the hedging instrument, the fair value of the firm commitment is determined through reference to changes in the forward exchange rate. Changes in the spot exchange rate are used to determine the fair value of the firm commitment when a foreign currency option is the hedging instrument.

Learning Objective 7-9

Account for forward contracts and options used as hedges of forecasted foreign currency transactions.

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LO 7-9: Account for forward contracts and options used as hedges of forecasted foreign currency transactions.

Hedge of a Forecasted Foreign Currency Denominated Transaction

Cash flow hedge accounting may be used for foreign currency derivatives associated with a forecasted foreign currency transaction.

The forecasted transaction must be probable, highly effective, and the hedging relationship must be properly documented.

There is no recognition of the forecasted transaction or gains and losses on the forecasted transaction.

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Cash flow hedge accounting also is used for foreign currency derivatives used to hedge the cash flow risk associated with a forecasted foreign currency transaction. For hedge accounting to apply, the forecasted transaction must be probable (likely to occur), the hedge must be highly effective in offsetting fluctuations in the cash flow associated with the foreign currency risk, and the hedging relationship must be properly documented.

Unlike the accounting for a firm commitment, there is no recognition of the forecasted transaction or gains and losses on the forecasted transaction. (Because there is no recognition of an asset or liability, there is no fair value exposure to foreign exchange risk. Thus, fair value hedge accounting is not appropriate for hedges of forecasted transactions.)

Reporting the Hedging Instrument

The company reports the hedging instrument (forward contract or option) at fair value, but changes in the fair value of the hedging instrument are not reported in net income.

Gains and losses on the hedging instrument are recorded in Other Comprehensive Income until the date of the forecasted transaction, then transferred to net income on the projected transaction date.

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The company reports the hedging instrument (forward contract or option) at fair value, but because no gain or loss occurs on the forecasted transaction to offset against, the company does not report changes in the fair value of the hedging instrument as gains and losses in net income. Instead, it reports them in other comprehensive income. On the projected date of the forecasted transaction, the company transfers the cumulative change in the fair value of the hedging instrument from accumulated other comprehensive income (balance sheet) to net income (income statement).

IFRS 9—Financial Instruments

IFRS 9, “Financial Instruments,” provides guidance on the accounting for hedging instruments including those used to hedge foreign exchange risk. IFRS 9 rules and procedures related to foreign currency hedge accounting generally are consistent with U.S. GAAP. It:

1) Allows hedge accounting for foreign currency-denominated assets and liabilities, firm commitments, and forecasted transactions that meet documentation requirements and effectiveness tests, and

2) Requires hedges to be designated as cash flow or fair value hedges.

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IFRS 9, “Financial Instruments,” provides guidance on the accounting for hedging instruments including those used to hedge foreign exchange risk. Rules and procedures in IFRS 9 related to foreign currency hedge accounting generally are consistent with U.S. GAAP. Similar to current U.S. standards, IFRS 9 allows hedge accounting for foreign currency-denominated assets and liabilities, firm commitments, and forecasted transactions when documentation requirements and effectiveness tests are met and requires hedges to be designated as cash flow or fair value hedges.

IFRS 9 and U.S. GAAP Designation Differences

One difference between the two sets of standards relates to the type of financial instrument that can be designated as a foreign currency cash flow hedge.

Under U.S. GAAP, only derivative financial instruments can be used as a cash flow hedge.

IFRS 9 also allows nonderivative financial instruments, such as foreign currency loans, to be designated as hedging instruments in a foreign currency cash flow hedge.

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One difference between the two sets of standards relates to the type of financial instrument that can be designated as a foreign currency cash flow hedge. Under U.S. GAAP, only derivative financial instruments can be used as a cash flow hedge, whereas IFRS 9 also allows nonderivative financial instruments, such as foreign currency loans, to be designated as hedging instruments in a foreign currency cash flow hedge.

IFRS 9 and U.S. GAAP Recognition of Changes in Fair Value Differences

The standards also differ with regard to the recognition of changes in fair value of forward contracts used as fair value hedges.

IFRS 9 allows companies to choose between recognizing fair value changes either in net income or in other comprehensive income.

U.S. GAAP requires recognition of changes in net income.

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The standards also differ with regard to the recognition of changes in fair value of forward contracts used as fair value hedges. IFRS 9 allows companies to choose between recognizing these changes either in net income (as is required under U.S. GAAP) or in other comprehensive income.

Another difference relates to the accounting for the time value of options. Under IFRS 9, the initial time value of an option must be amortized to net income on a systematic and rational (e.g., straight-line) basis. To achieve this, changes in time value are reflected initially in AOCI rather than in net income, with an amount equal to the current period’s amortization reclassified from AOCI to net income. The total amount recognized as option expense in net income will be the same under both IFRS and U.S. GAAP, but the timing of income statement recognition is likely to differ.

IFRS 9 and U.S. GAAP Recognition of Time Value Differences

IFRS 9 requires the initial time value of an option to be amortized to net income on a systematic and rational basis.

Changes in time value are reflected initially in AOCI, with an amount equal to the current period’s amortization reclassified from AOCI to net income.

The total amount recognized as option expense in net income will be the same under both IFRS and U.S. GAAP, but timing of income recognition may differ.

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