Chapter Nine

Foreign
Currency
Transactions and
Hedging Foreign
Exchange Risk

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Learning Objective 9-1

Understand concepts related

to foreign currency, exchange
rates, and foreign exchange risk.

9-2

Exchange Rate Mechanisms

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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Different Currency Mechanisms

Independent Float - the currency is allowed to
fluctuate according to market forces
Pegged to another currency - the currencys value is
fixed in terms of a particular foreign currency, and the
central bank will intervene 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.

9-4

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
4:00pm Eastern time on the day prior to publication. Rates
are also available on line at: www.oanda.com and
http://www.x-rates.com
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.

Rates change constantly!

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Foreign Exchange Rates

Spot Rate
The exchange rate that is available today.
Forward Rate
The exchange rate that can be locked in today for
an expected future exchange transaction.
The actual spot rate at the future date may differ
from todays forward rate.
A forward contract requires the purchase (or sale)
of currency units at a future date at the contracted
exchange rate.
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Foreign Exchange
Option Contracts
An options contract gives the holder the option of
buying (or selling) currency units at a future date at
the contracted strike price.
A put option allows for the sale of foreign
currency by the option holder.
A call option allows for the purchase of foreign
currency by the option holder.
An option gives the holder the right but not the
obligation to trade the foreign currency in the
future.
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Option values
Value is derived from :
A function of the difference between current spot
rate and strike price
The difference between foreign and domestic
interest rates
The length of time to option expiration
The potential volatility of changes in the spot rate
An option premium is a function of Intrinsic Value
and Time Value
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Learning Objective 9-2

Account for foreign currency

transactions using the two
transaction perspective, accrual
approach.

9-9

Foreign Currency Transactions

A U.S. company buys or sells goods or
services to a party in another country. This
is often called foreign trade.
The transaction is often denominated in the
currency of the foreign party.
How do we account for the changes in the
value of the foreign currency?

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Transaction Exposure
Export sale:
Exposure exists when the exporter allows
buyer to pay in a foreign currency sometime
after the sale has been made. The exporter is
exposed to the risk that the foreign currency
might depreciate between the date of sale and
the date payment is received, decreasing the
U.S. dollars collected.
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Transaction Exposure
Import purchase:
Exposure exists when the importer is required
to pay in foreign currency sometime after the
purchase has been made. The importer is
exposed to the risk that the foreign currency
might appreciate between the date of purchase
and the date of payment, increasing the U.S.
dollars that have to be paid for the imported
goods.
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Foreign Currency Transactions

There are two methods of accounting for changes in
the value of a foreign currency transaction, the onetransaction perspective and the two-transaction
perspective.
The one-transaction perspective assumes:
1. the export sale is not complete until the foreign
currency receivable has been collected .
2. Changes in the U.S. dollar value of the foreign
currency is accounted for as an adjustment to
Accounts Receivable and Sales.
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Foreign Currency Transactions

GAAP requires the two-transaction approach and
treats the sale and collection of cash as two separate
transactions.
1. Account for the original sale in US Dollars at
date of sale. No subsequent adjustments are
required.
2. 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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Foreign Exchange Transaction Example

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

Foreign currency receivables from an export sale

creates an asset exposure to foreign exchange risk.

Foreign currency payables from an import purchase

creates a liability exposure to foreign exchange risk.
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Accounting for Unrealized Gains and Losses

Under the two-transaction perspective, a foreign
exchange gain or loss arises at the balance sheet date
that has not yet been realized in cash.
Two approaches exist to account for unrealized
foreign exchange gains and losses:
1. Deferral approach:
Gains and losses are deferred on the balance sheet
until cash is paid or received and a realized foreign
exchange gain or loss is included in income when paid.
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Accounting for Unrealized Gains and Losses

2. 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.

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Learning Objective 9-3

Understand how foreign currency

forward contracts and foreign
currency options can be used to
hedge foreign exchange risk.

9-18

Hedging Foreign Exchange Risk

Companies will avoid uncertainty associated
with the effect of unfavorable changes in the
value of foreign currencies using foreign
currency derivatives.
The two most common derivatives used to
hedge foreign exchange risk are foreign
currency forward contracts and foreign
currency options.

9-19

Hedging Foreign Exchange Risk

Two foreign currency derivatives often used :
Foreign currency forward contracts lock in
the price for which the currency will sell at
contracts maturity.
Foreign currency options establish a price
for which the currency can be sold, but is not
required to be sold at maturity.

9-20

Accounting for Derivatives

ASC Topic 815 provides guidance for hedges of four
types of foreign exchange risk.
1. Recognized foreign currency denominated assets &
liabilities (e.g., euro receivable/payable).
2. Unrecognized foreign currency firm commitments
(e.g., noncancellable SO/PO).
3. Forecasted foreign currency denominated
transactions (e.g., occurring regularly & reliably
forecasted).
4. Net investments in foreign operations.
9-21

Accounting for Derivatives

The fair value of the derivative is recorded at the
same time as the transaction to be hedged, based on:
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.
A discount rate (the companys incremental
borrowing rate).
9-22

Accounting for Derivatives

In accordance with U.S. GAAP, gains and losses
arising from changes in the fair value of derivatives
are recognized initially either
on the income statement as a part of net income or
on the balance sheet in accumulated other
comprehensive income.
Recognition treatment depends partly on whether the
company uses derivatives for hedging purposes or for
speculation.
9-23

Accounting for Derivatives

U.S. GAAP allows hedge accounting for foreign
currency derivatives only if three conditions are
satisfied:
1. The derivative is used to hedge either a cash
flow exposure or fair-value exposure to
foreign exchange risk.
2. The derivative is highly effective in offsetting
changes in the cash flows or fair value
related to the hedged item.
3. The derivative is properly documented as a
hedge.
9-24

Learning Objective 9-4

Account for forward contracts

and options used as hedges of
foreign currency denominated
assets and liabilities.

9-25

Accounting for Hedges

Two ways to account for hedges of foreign currency
denominated assets and liabilities:
1. Cash Flow Hedge
The hedging instrument must completely offset the
variability in the cash flows associated with the foreign
currency receivable or payable.
Gains/losses are recorded in Accumulated Other
Comprehensive Income.
2. Fair Value Hedge.
Any other hedging instrument.
Gains/losses are recognized immediately in net income.
9-26

Accounting for Hedges

Cash Flow Hedge
At the balance sheet date:
1. The hedged asset or liability 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.
2. The derivative hedging instrument is adjusted to fair
value (an asset or liability on the balance sheet) with
the counterpart recognized as a change in
Accumulated Other Comprehensive Income
(AOCI).
9-27

Accounting for Hedges

Cash Flow Hedge continued . . .
At the balance sheet date:
3. An amount equal to the foreign exchange gain or loss on
the hedged asset or liability is then transferred from AOCI
to net income to offset any gain or loss on the hedged asset or
liability.
4. An additional amount is removed from AOCI and
recognized in net income to reflect (a) the current periods
amortization of the original discount or premium on the
forward contract (if it is the hedging instrument) or (b) the
change in the time value of the option (if it is the hedging
instrument).
9-28

Cash Flow Hedge - Example

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9-29

Cash Flow Hedge - Example

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9-30

Cash Flow Hedge - Example

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9-31

Cash Flow Hedge - Example

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9-32

Cash Flow Hedge - Example

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9-33

Accounting for Hedges

Fair Value Hedge
At the balance sheet date:
1. 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.
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.
9-34

Fair Value Hedge - Example

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9-35

Fair Value Hedge - Example

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9-36

Cash Flow vs. Fair Value Hedge

The total impact on income is the same regardless of
whether the forward contract is designated as a fair
value hedge or as a cash flow hedge. In our example,
Amerco recognized an expense (or loss) of $15,000 in
both cases, and the company knew what the total
expense was going to be as soon as the contract was
signed.

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9-37

Cash Flow vs. Fair Value Hedge

A benefit to designating a forward contract as a cash flow hedge is that
the company knows the forward contract's effect on net income each
year as soon as the contract is signed. The net impact on income is the
periodic amortization of the forward contract discount or premium.
In our example, Amerco knew on December 1, 2015, that it would
recognize a discount expense of $5,000 in 2015 and $10,000 in 2016.
The impact on each year's income is not as systematic when the forward
contract is designated as a fair value hedgeloss of $783 in 2015 and
$14,217 in 2016. Moreover, the company does not know what the net
impact on 2015 income will be until December 31, 2015, when the euro
account receivable and the forward contract are revalued.
Because of the potential for greater volatility in periodic net income that
results from a fair value hedge, companies may prefer to designate
forward contracts used to hedge a foreign currency denominated asset or
liability as cash flow hedges.
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9-38

Foreign Currency Option as a Hedge

An option is a contract that allows you to exercise a
predetermined exchange rate if it is to your
advantage.
As with forward contracts, options can be designated
as cash flow hedges or fair value hedges.
Option prices are determined using the BlackScholes Option Pricing Model covered in most
finance texts.
9-39

Learning Objective 9-5

Account for forward contracts

and options used as hedges
of foreign currency firm
commitments.

9-40

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.
9-41

Foreign Currency
Firm Commitment Hedge
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.
U.S. GAAP allows hedges of firm
commitments to be designated either as cash
flow or fair value hedges.

9-42

Foreign Currency
Firm Commitment Hedge
Options are carried at fair value on the balance sheet of
both the derivative financial instrument (forward
contract or option) and the firm commitment.
The change in value of the firm commitment gain/loss
offsets the gain or loss on the hedging instrument.
Gain/loss is recognized currently in net income, as is
the gain/loss on the firm commitment attributable to
the hedged risk.
9-43

Option Used as FV Hedge - Example

Assume now that on December 1, 2015, Amerco receives and
accepts an order from a German customer to deliver goods on
March 1, 2016, at a price of 1 million euros. Assume further that
under the terms of the sales agreement, Amerco will ship the
goods to the German customer on March 1, 2016, and will
receive immediate payment on delivery. Assume that to hedge its
exposure to a decline in the U.S. dollar value of the euro, Amerco
purchases a put option to sell 1 million euros on March 1, 2016,
at a strike price of $1.32. The premium for such an option on
December 1, 2015, is $0.009 per euro. With this option, Amerco is
guaranteed a minimum cash flow from the export sale of
$1,311,000 ($1,320,000 from option exercise less $9,000 cost of
the option).
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9-44

Option Used as FV Hedge - Example

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9-45

Option Used as FV Hedge - Example

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9-46

Option Used as FV Hedge - Example

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9-47

Option Used as FV Hedge - Example

The net increase in net income over the two accounting
periods is $1,311,000 ($6,803 in 2015 plus $1,304,197 in
2016), which exactly equals the net cash flow realized
on the export sale ($1,320,000 from exercising the
option less $9,000 to purchase the option). The net gain
on the option of $11,000 (loss of $3,000 in 2015 plus
gain of $14,000 in 2016) reflects the net benefit from
having entered into the hedge. Without the option,
Amerco would have sold the 1 million euros received on
March 1, 2016, at the spot rate of $1.30 for $1,300,000.
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9-48

Learning Objective 9-6

Account for forward contracts

and options used as hedges
of forecasted foreign currency
transactions.

9-49

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 (likely
to occur), 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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Hedge of a Forecasted Foreign Currency

Denominated Transaction
The company reports the hedging
instrument (forward contract or option) at
fair value, but changes in the fair value of
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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Learning Objective 9-7

Prepare journal entries to

account for foreign currency
borrowings.

9-52

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 facts that the principal and interest are
denominated in foreign currency and create an
exposure to foreign exchange risk complicate
accounting for a foreign currency borrowing.
9-53

Foreign Currency Borrowings Example

To demonstrate the accounting for foreign currency
debt, assume that on July 1, 2015, Multicorp
International borrowed 1 billion Japanese yen () on a
1-year note at a per annum interest rate of 5 percent.
Interest is payable and the note comes due on July 1,
2016. The following exchange rates apply:.

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9-54

Journal Entries

9-55

Foreign Currency Borrowings

Companies also 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.
9-56

IFRSForeign Currency Transactions and

Hedges
There are no substantive differences between U.S.
GAAP and IFRS in accounting for foreign
currency transactions.
Similar to U.S. GAAP, IAS 21, The Effects of
Changes in Foreign Exchange Rates, 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.

9-57

IFRSForeign Currency Transactions and

Hedges
IAS 39, Financial Instruments: Recognition and
Measurement, governs accounting for hedging instruments
including those used to hedge foreign exchange risk.
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.
U.S. GAAP allows only derivative financial instruments to
be used as a cash flow hedge.
IFRS allows nonderivative financial instruments (e.g.,
foreign currency loans).
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IFRSForeign Currency Transactions and

Hedges
In 2010, the IASB proposed a new hedge accounting
model that would result in significant differences
between IFRS and U.S. GAAP.
In 2012, the IASB issued a draft of a forthcoming
statement that would move hedge accounting from IAS
39 to IFRS 9, Financial Instruments, to implement
the new model which would go into effect in 2015.
IFRS 9 is intended to more closely align accounting
with a companys risk management activities.

9-59