SIMAD UNIVERSITY
Chapter 6
Foreign Currency Transactions
and Hedging Foreign
Exchange Risk
Faisal Abukar Haji Sufi
(Master of Science of International Accounting)
PREPARED FOR:
Dear Students
April, 2014
Learning Objectives
Provide an overview of the foreign exchange market.
Explain how fluctuations in exchange rates give rise to foreign exchange
risk.
Demonstrate the accounting for foreign currency transactions.
Describe how foreign currency forward contracts and foreign currency
options can be used to hedge foreign exchange risk.
Describe the concepts of cash flow hedges, fair value hedges, and hedge
accounting.
Demonstrate the accounting for forward contracts and options used as cash
flow hedges and fair value hedges to hedge foreign currency assets and
liabilities, foreign currency firm commitments, and forecasted foreign
currency transactions.
Foreign Exchange Markets
Foreign exchange rate – Each country uses its own currency as
the unit of value for the purchase and sale of goods and service
however, purchase price of a foreign currency is termed as foreign
exchange rate.
From 1945 to 1973 countries had exchange rates fixed to the
U.S. dollar.
U.S. dollar was fixed to gold at $35 per ounce.
Balance-of-payments deficits in the U.S. during the 1960s
doomed this system in March 1973.
Exchange Rate Mechanisms
There are several different currency arrangement exist. The
following are most important ones:
Independent float – currency value allowed moving freely with little
government intervention.
Pegged to another currency – currency value fixed (pegged) in terms
of a particular foreign currency (e.g., U.S. dollar), central bank
intervenes to maintain the exchange rate.
European Monetary System (Euro) – twelve countries use a single
currency.
Foreign Exchange Rates:
Exchange rates, to the U.S. dollar, are published in many
places on the internet and in newspapers.
The Wall Street Journal publishes these daily, both as US$
equivalent (direct quotes) and currency per US$ (indirect
quotes).
For example, on March 16, 2005 the direct quote for a Euro
was $1.3420 and the indirect quote was 0.7452
A direct quote is the reciprocal of an indirect quote and vice-
versa.
Spot rates and Forward rates
Spot rate – today’s price for purchasing or selling a foreign currency.
Forward rate – today’s price for purchasing or selling a foreign
currency for some future date.
Premium – when the forward rate is greater than the spot rate for a
particular day.
Discount –when the forward rate is less than the spot rate for a
particular day.
Option Contracts:
Foreign currency option – gives the right, but not the
obligation, to trade foreign currency for some period.
Put option –the option to sell the foreign currency.
Call option – the option to buy the foreign currency.
Strike price – the exchange rate at which currency will be
exchanged when option is exercised.
Option Contracts:
o Intrinsic value – is the gain that could be made by immediate
exercise of the option. For example if the spot rate for a foreign is
$1, a call option with strike price of 0.97 and intrinsic value is 0.03
o Time value – the value that derives from the fact that the currency
value could increase during the remainder of the option period, for
example although a 90-day call option with a strike price of $1
has zero intrinsic value when spot rate is $1. It will still have a
positive time value because there is a chance that spot rate would
increase over the 90 days and bring the option into the money.
Foreign Currency Transactions
Foreign Currency Transactions
Export sale: – a company sells to a foreign customer and later
receives payment in the customer’s currency.
Import purchase – a company purchases from a foreign supplier
and later pays in the supplier’s currency.
These above transactions are known as transactions
exposure.
Foreign exchange risk: – the chance that the exporter will
receive less or that the importer will pay more than anticipated as
a result of a change in the exchange rate.
Accounting – Sale Transaction
One transaction perspective
Treats sale and collection as one transaction.
Transaction is complete when foreign currency is received and
converted, and sale is measured at converted amount.
This approach is not allowed under IAS or U.S. GAAP.
Two transaction perspective
Treats sale and collection as two transactions
Sale is one transaction and collection is a second
transaction.
Sale is based on current exchange rate.
If exchange rate changes, collection is for different amount.
Difference is considered foreign exchange gain or loss.
Concepts are identical for purchase transaction.
Two transaction perspective
For example:
• Eximco Inc., a U.S. company, makes a sale and ships goods to
Spanish, customer with price of 1 million when the spot rate is $1.5
per euro.
• At the end of the three months the euro has depreciated to $1.48.
Account Title Debit Credit
Accounts receivable (+ Asset) 1500,000
Sales revenue 1500,000
Foreign Exchange Loss 20,000
Account Receivable 20,000
Cash 1,480,000
Account Receivable 1,480,000
Transaction types, exposure type and gain or loss
Export sale asset exposure - if foreign currency appreciates
foreign exchange gain.
Export sale asset exposure - if foreign currency depreciates
foreign exchange loss.
Import purchase liability exposure - if foreign currency appreciates
foreign exchange loss.
Import purchase liability exposure - if foreign currency depreciates
foreign exchange gain.
Balance Sheet Date before Date of Payment
On December 10 Year 1, Eximco Inc. shipped goods valued one
Million to its Spanish customer with payment to be received on March
1, Year 2. The spot rate 1.50
By December 31, Year 1. The euro appreciated to $1.51.
On March 1 Year 2, the spot rate depreciated with $1.48 per euro.
Question One:
Is there any adjustment needed at December 31 Yea foreign
currency changed in U. S dollar value since December 10?
Answer:
General consensus worldwide is that a foreign currency
receivable or foreign currency payable should be revaluated at the
balance sheet date to account for the change in exchange rate.
Balance Sheet Date before Date of Payment
Question two:
• 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?
Answer:
• The two approaches to accounting for unrealized foreign
exchange gains and losses are the Deferral approach and
accrual approach.
Deferral approach:
Unrealized gains and losses are deferred on the balance sheet until
cash is actually paid or received.
When cash is paid or received a realized foreign exchange gain or
loss would be included in income.
NB this approach is acceptable under neither IFRS nor U.S
GAAP.
Accrual approach:
A firm reports for unrealized foreign exchange gains and
losses in the net income in the period in which exchange rate
changes.
IAS 21 requires companies to use the accrual approach.
FASB justified this approach as accrual accounting.
Accrual approach – Illustrative Transaction:
Account Title Debit Credit
12//10/Y1 Accounts receivable 150,000
Sales 150,000
12//10/Y1 Accounts receivable 10,000
Foreign Exchange Gains 10,000
3/1/Y2 Foreign Exchange Loss 30,000
Accounts receivable 30,000
Cash 1,480,000
Accounts receivable 1,480,000
HEDGHING FOREIGN EXCHANGE RISK
Hedging - protecting against losses from exchange rate fluctuations.
Companies often use foreign currency forward contracts and
foreign currency options.
Foreign currency forward contract – an agreement to buy or sell foreign
currency at a future date.
Foreign currency option – the right to buy or sell foreign currency for a
period of time.
If the company enters into either of the above on the date of sales
is made, the derivative is known as a hedge of a recognized
foreign currency denominated asset.
HEDGHING FOREIGN EXCHANGE RISK
If the company accepts noncancelable purchase order that
specifies foreign currency price and date of delivery by
applying the above issue, this is known as a foreign currency
firm commitment.
If the company makes regular purchases in supplies outside the
country or regular sales to customers outside the country, this
is known as a hedge of a forecasted foreign currency-
denominated transaction.
Cash Flow Hedges, Fair Value Hedges, and
Hedge Accounting
Hedge accounting – an offsetting gain or loss from the hedge is
recognized in net income during the same period as the gain or loss
from the hedged item.
Cash flow hedge – an accounting designation for hedges that offset
variability in cash flows of hedged items.
Fair value hedge – an accounting designation for hedges that offset
the variability in fair value of hedged assets and liabilities.
HEDGING COMBINATIONS
The specific entries required to account for a foreign currency
hedging relationship are determined by a combinations of the
following factors:
The type of item being hedged:
Foreign currency – denominated asset/liability.
Foreign currency firm commitment.
Forecasted foreign currency transactions.
The nature of item being hedged:
Existing or future assets.
Existing or future liability.
HEDGING COMBINATIONS
The type of hedging instrument being used:
Forward contract.
Options contract.
The nature of the hedged risk:
Fair value exposure.
Cash flow exposure.
Hedge Accounting
FC asset/forward contract/cash flow hedge.
FC asset/forward contract/fair value hedge.
FC asset/option/cash flow hedge.
FC firm commitment/forward contract/fair value
hedge.
FC firm commitment/option/fair value hedge.
FC asset/forward contract/cash flow hedge.
Illustration
December 1, Year 1:
Eximco ships the goods to the Spanish customer, with selling price
of €1000,000.
Eximco sells €1000,000 to First National Bank by signing
executory contract with forward rate.
Changes of Spot Rate during the transaction period are
following:
Spot rate of $1.5 is for December 1 Year, 1.51 is for December 31
Year, and 1.48 is for March 1 Year 2.
Changes of Forward Rate during the transaction period are
following:
Forward rate of 1.485 is for December 1 Year, 1.496 is for
December 31 Year1, and 1.480 is for March 1 Year 2.
FC asset/forward contract/cash flow hedge.
Accounts Receivable (€) Forward Contract
Date Spot U.S Dollar Change in Forward Fair Value Change in
Rate Value U.S. Dollar Rate Value
Value To 3/1/Y2
12/1/Y1 $1.50 $1,500,000 $1.485 $0 -
12/31/Y1 $1.51 $1,510,000 +$10,000 $1.496 $(10,783) - $10,783
3/1/Y2 $1.48 $1,480,000 -$30,000 $1.480 $5,000 +$15,783
$1,485,000 – $1,496,000 = 11,000 X (1/1.01)² = $10,783
FC asset/forward contract/cash flow hedge.
Debit Credit
12/1/Y1 Account Receivable.............................................. $1,500,000
Sales................................................................. $1,500,000
12/1/Y1 Account Receivable.............................................. $10,000
Foreign Exchange $10,000
Gain....................................
12/31/Y1 Accumulated Other Comprehensive Income........ $10,783
Forward Contract............................................. $10,783
Loss on Forward $10,000
Contract.....................................
Accumulated Other Comprehensive Income. $10,000
Discount $4,967
Expense..................................................
Accumulated Other Comprehensive Income... $4,967
FC asset/forward contract/cash flow hedge (Cont’d)
Implicit Interest Rate Method
= 0.003345
1,485,000 X 0.003345 = $4,967
FC asset/forward contract/cash flow hedge (Cont’d)
The impact on Year 1 net income is as follows:
Sales 1,500,000
Foreign Exchange Gain……………………………………… $10,000
Loss on Forward Contract…………………………………… -$10,000
Net Gain (Loss) ……………………………………………… 0
Discount Expense…………………………………………… (4,967)
Impact on net income………………………………………… $1,495,033
The effect on the December 31, Year 1, balance sheet is as follows:
Assets Liabilities and Stockholder’s Equity
Accounts Receivable 1,510,000 Forward contract $10,783
Retained earnings 1,495,033
AOCI 4,184
1,510,000
FC asset/forward contract/cash flow hedge (Cont’d)
Debit Credit
2/1/Y2 Foreign Exchange Loss.................................................. $30,000
Account Receivable................................................ $30,000
Forward Contract........................................................... $15,783
Accumulated Other Comprehensive Income........... $15,783
Accumulated Other Comprehensive Income.................. $30,000
Gain on Forward Contract...................................... $30,000
Discount Expense.......................................................... $10,033
Accumulated Other Comprehensive Income.......... $10,033
Foreign Exchange Currency.......................................... $1,480,000
Account Receivable................................................ $1,480,000
Cash............................................................................... 1,485,000
Foreign Currency................................................... $1,480,000
Foreign Contract.................................................... 5,000
FC asset/forward contract/cash flow hedge (Cont’d)
The impact on Year 1 net income is as follows:
Foreign Exchange Loss……………………………………… $(30,000)
Gain on Forward Contract…………………………………… $30,000
Net Gain (Loss) ……………………………………………… 0
Discount Expense…………………………………………… (10,033)
Impact on net income……………………………………… (10,033)
FC asset/forward contract/fair value hedge.
Debit Credit
12/1/Y1 Account Receivable $1,500,000
Sales $1,500,000
12/1/Y1 Account Receivable $10,000
Foreign Exchange Gain $10,000
12/31/Y1 Loss on Forward Contract $10,783
Forward Contract $10,783
FC asset/forward contract/fair value hedge.
The impact on Year 1 net income is as follows:
Sales $1,500,000
Foreign Exchange Gain $10,000
Loss on Forward Contract ($10,783)
Net Gain (Loss) ($783)
Impact on net income $1,499,217
The effect on the December 31, Year 1, balance sheet is as follows:
Assets Liabilities and Stockholder’s Equity
Accounts Receivable 1,510,000 Forward contract $10,783
Retained earnings $1,499,217
1,510,000
FC asset/forward contract/fair value hedge.
Debit Credit
2/1/Y2 Foreign Exchange Loss $30,000
Account Receivable $30,000
Forward Contract $15,783
Gain on Forward Contract $15,783
Foreign Exchange Currency $1,480,000
Account Receivable $1,480,000
Cash 1,485,000
Foreign Currency $1,480,000
Foreign Contract 5,000
FC asset/forward contract/fair value hedge.
The impact on Year 1 net income is as follows:
Foreign Exchange Loss $(30,000)
Gain on Forward Contract $15,783
Impact on Net Income) ($14,217)
Under fair value hedge accounting, the original forward contract
discount is not amortized systematically over the life of the
contract. Instead, it is recognized in income as the difference the
Foreign Exchange Gain (Loss) on the account receivable and the
Gain (Loss) on the forward Contract, that is $(783) in Year 1
$(14,217) in the Year 2. The net impact on the income over the two
years is $(15,000).
FC asset/option/cash flow hedge
Eximco purchases an over the counter option from its bank
with a strike price of $1.5 when the spot rate is $1.50 and pays
premium of $0.009 per euro. Thus this purchase price for the
option is $9,000.
This time the strike price and spot rate are the same, there is no
intrinsic value associated with this option.
NB If the spot rate for euro in the future is greater the strike
price of 1.50, the Eximo will not exercise its option and will sell
euros at the higher spot rate.
FC asset/option/cash flow hedge
Illustration
December 1, Year 1:
Eximco ships the goods to the Spanish customer, with selling price
of €1000,000.
Eximco sells €1000,000 to First National Bank by signing executory
contract with forward rate.
Changes of Spot Rate during the transaction period are
following:
Spot rate of $1.5 is for December 1 Year, 1.51 is for December 31
Year, and 1.48 is for March 1 Year 2.
Changes of Option Premium during the transaction period are
following:
Option premium rate of 0.009 is for December 1 Year, 0.006 is for
December 31 Year1, and 0.020 is for March 1 Year 2.
FC asset/option/cash flow hedge
Accounts Receivable (€) Foreign Currency Option
Change in Option
Spot U.S Dollar U.S. Dollar Premium Change in
Date Rate Value Value To 3/1/Y2 Fair Value Value
12/1/Y1 $1.50 $1,500,000 $0.009 $9,000 -
12/31/Y1 $1.51 $1,510,000 +$10,000 $0.006 $6,000 - 3,000
3/1/Y2 $1.48 $1,480,000 -$30,000 $0.020 $20,000 +$14,000
Fair Intrinsic Time Value Change in
Date Value Value Value
12/1/Y1 $9,000 $0 $9,000
12/31/Y1 $6,000 $0 $6,000 - 3,000
3/1/Y2 $20,000 $20,000 $0 -$6000
FC asset/option/cash flow hedge
Debit Credit
12/1/Y1 Account Receivable $1,500,000
Sales $1,500,000
Foreign Currency Option 9,000
Cash 9,000
12/1/Y1 Account Receivable $10,000
Foreign Exchange Gain $10,000
12/31/Y1 Accumulated Other Comprehensive Income $3,000
Foreign Currency Option $3,000
Loss on Foreign Currency Option 10,000
Accumulated Other Comprehensive Income 10,000
Option expense $3,000
Accumulated Other Comprehensive Income $3,000
FC asset/option/cash flow hedge
The impact on Year 1 net income is as follows:
Sales 1,500,000
Foreign Exchange Gain $10,000
Loss on Forward Contract ($10,000)
Net Gain (Loss) 0
Discount Expense (3,000)
Impact on net income $ 1,497,000
The effect on the December 31, Year 1, balance sheet is as follows:
Assets Liabilities and Stockholder' Equity
Cash (9,000) Retained Earnings $1,497,000
Accounts Receivable 1,510,000 AOCI 10,000
Foreign Currency Option 6000
1,507,000 $1,507,000
FC asset/option/cash flow hedge
Debit Credit
Foreign Exchange Loss $30,000
Accounts Receivable $30,000
Foreign Currency Option $14,000
Accumulated Other Comprehensive Income $14,000
Accumulated Other Comprehensive Income $30,000
Gain on Foreign Currency Option $30,000
Option Expense $6,000
Accumulated Other Comprehensive Income $6,000
Foreign Currency $1,480,000
Accounts Receivable $1,480,000
Cash $1,500,000
Foreign Currency $1,480,000
Foreign Currency Option $20,000
FC asset/option/cash flow hedge
The impact on Year 1 net income is as follows:
Foreign Exchange Loss $(30,000)
Loss on Forward Contract $30,000
Net Gain (Loss) 0
Option Expense (6,000)
Impact on net income $ (6,000)
FC asset/option/cash flow hedge
If the spot rate at March 1, Year2 is greater than the strike price of
$1.50, Eximco would allow its option to expire unexercised.
The option would be reported as an asset on the December 31, Year
1 balance sheet at $6,000 and euro account receivable would have a
carrying value of $1,510,000.
However, spot rate on that date is $1.505 rather than $1.480 so the
following journal entries took place:
FC asset/option/cash flow hedge
Debit Credit
3/2/Y2 Foreign Exchange Loss $5,000
Accounts Receivable $5,000
Loss on Foreign Currency Option $6,000
Foreign Currency Option $6,000
Accumulated Other Comprehensive Income $5,000
Gain on Foreign Currency Option $5,000
Foreign Currency $1,505,000
Accounts Receivable 1,505,000
Cash $1,505,000
Foreign Currency $1,505,000
FC firm commitment/forward contract/fair value hedge.
Important Points:
SFAS 133 indicate that only fair value hedge accounting was
appropriate for hedges of foreign currency firm commitments.
FASB’s Derivatives Implementation Group subsequently
concluded cash flow hedge accounting also could be used.
However, because the results of fair value accounting are
intuitively more appealing.
FC firm commitment/forward contract/fair value hedge.
The fair value of the firm commitment is measured through
reference to changes in the forward contract. As the result, the fair
value of the firm commitment is equal in amount but of opposite
sing to the fair value of the forward contract.
Forward Contract Firm Commitment
Forward Fair Value Change in Change in
Date Rate Fair Value Fair Value Value
12/1/Y1 $1.485 $0 0 $0 -
12/31/Y1 $1.496 $(10,783) $-10,783 $10,783 10,783
3/1/Y2 $1.480 $5,000 +$15,783 $(5,000) $(15,783)
FC firm commitment/forward contract/fair value hedge.
Debit Credit
12/1/Y1 There is no entry because no sales took place
12/31/Y1 Loss on Forward Contract $10,783
Forward Contract $10,783
Firm Commitment $10,783
Gain on Firm Commitment $10,783
The impact on Year 1 December 31, net income is as follows:
Gain on Firm Commitment $(10,7830)
Loss on Forward Contract $10,7830
Net Gain (Loss) 0
Impact on net income 0
FC firm commitment/forward contract/fair value hedge.
The effect on the December 31, Year 1, balance sheet is as follows:
Assets Liabilities and Stockholder' Equity
Firm Commitment $10,783 Forward Contract $1,0783
3/1/Y2 Forward Contract $15,783
Gainn on Forward Contract $15,783
Loss on Firm Commitment $15,783
Firm Commitment $15,783
Foreign Currency $1,480,000
Sales $1,480,000
Cash $1,485,000
Foreign Currency $1,480,000
Forward Contract $5,000
Firm Commitment $5,000
Adjustment to Net Income $5,000
FC firm commitment/option/fair value hedge.
Eximco purchases a put option to sell € 1,000,000 on March 1,
Year 2, at a strike price of $1.50.
The premium for such an option on December 1, Year 1, is
$0.009 peer euro.
With this option, Eximco is guaranteed a minimum cash flows
from the export sale of $1,491,000 (1,500,000 – 9,000).
FC firm commitment/option/fair value hedge.
Option
Premium Change in Spot Change in
Date for 3/1/Y2 Fair Value Fair Value Rate Fair Value Fair Value
12/1/Y1 $0.009 $9,000 0 $1.50 0 0
12/31/Y1 $0.006 $6,000 ($3,000) $1.51 $9,803 $9,803
3/1/Y2 $0.020 $20,000 14,000 $1.48 (20,000) (29,803)
$1,510,000 - 1,500,000 = $10,000 x 0.9803 = $9,803 is the present value factor
for two months at annual interest rate of 12% (1% per month)
FC firm commitment/option/fair value hedge.
12/31/Y1 Foreign Currency option $9,000
Cash $9,000
Firm Commitment $9,803
Gain on Firm Commitment $9,803
Loss on Foreign Currency Option $3,000
Foreign
The impact on Year 1Currency
Decemberoption
31, net income is as follows: $3,000
Gain on firm commitment $9,803
Loss on foreign option (3000)
Impact on net income $6,803
FC firm commitment/option/fair value hedge.
The effect on the December 31, Year 1, balance sheet is as follows:
Assets Liabilities and Stockholder' Equity
Cash (9,000) Retained Earnings $6,803
Foreign Currency Option 6000
Firm commitment 9,803
$6,803 $6,803
FC firm commitment/option/fair value hedge.
3/1/Y2 Loss on firm commitment $29,803
Firm Commitment $29,803
Foreign Currency option $14,000
Gain on foreign currency option $14,000
Foreign Currency $1,480,000
Sales $1,480,000
Cash $1,500,000
Foreign Currency $1,480,000
Foreign Currency Option $20,000
Firm Commitment $20,000
Adjustment to Net Income $20,000
FC firm commitment/option/fair value hedge.
The impact on Year 1 December 31, net income is as follows:
Sales $1,480,000
Loss on Foreign Currency Option ($29,803)
Gain on Foreign Currency Option $14,000
Adjustment to Net Income $20,000
Impact on net income $1,484,197
END