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THE

CPA
BOARD EXAMS
OUTLINES
by John Mahatma Agripa, CPA

#5

ADVANCED FINANCIAL ACCOUNTING AND REPORTING

FOREIGN
EXCHANGE
TRANSACTIONS
Based on lectures and materials by Rodiel C. Ferrer, CPA, Ph.D. and
Brian Lim, CPA (CPAR)

FOREX TRANSACTIONS IN GENERAL

In a strict sense, foreign exchange transactions are those that are


to be settled in foreign currency, regardless of the location of either
party. These are accounted for by the domestic company by
translating the amounts in foreign currency with BSP-set exchange
rates
For translation purposes, the exchange rates must be quoted
directly, where the Peso is expressed as the equivalent of one
foreign currency. Rates displayed on news are usually on indirect
quotation. To convert, 1 (FC equivalent of Php 1). Converting
from direct quotation to indirect quotation also follows the same
format
If the given exchange rates in a particular problem are not in Peso,
conversion is necessary

IMPORT AND EXPORT (UNHEDGED)


TRANSACTIONS

In an unhedged import and export transaction, the only relevant


exchange rate would be the spot rate as of the date of the
transaction, balance sheet date, and the date of settlement
Spot rates are classified as either buying or selling (also called bid
and offer rates, respectively). If the domestic entity exports, the
buying rate is used since this would be the price that the foreign
buyer would pay for the goods. If the domestic entity imports, the
selling rate is used
Suppose the domestic company exports goods on F.O.B.
destination freight terms. On the date of transaction, the spot rate
to be used will be as of the date when the goods reached the buyer
the point when legal title is passed under the freight term. Of
course, if on F.O.B. shipping point, it will be when shipped

The domestic entity recognizes forex gains or losses as the spot


rate changes during the aforementioned dates only. For instance,
if the domestic entity is an exporter (thus it has outstanding
accounts receivable) and the buying spot rate increases, the entity
recognizes forex gains to be recorded in profit/loss (together with
an increase in accounts receivable)
The foreign entity does not record any forex gains or losses since
the transaction is denominated in their currency
The final cash payment during the date of settlement shall of
course still be at the spot rate, so is the cost at which the asset
purchased is recorded

FOREIGN DEBT TRANSACTIONS

Just like purchase of commodities, forex gains/losses are also


recognized in foreign debt borrowings/grants. Also, the purchase
of the goods might have been made through issuance of
promissory notes and other debt instrument
If the domestic entity is a borrower, it must use the selling spot
rate, and the buying spot rate if it lends
Pa Rong Co. signed a two-year promissory note
bearing 12% on December 1, 2016 for $10,000. Interest is to be
paid monthly. Assume the selling spot rates are the following: Php
2 (December 1), Php 3 (December 31), and Php 1.5 (December
31, 2017)
o On December 31, 2016, any forex gains/losses on the loan is
based on the principal alone. Thus, there is a forex loss of Php
10,000 with a credit to Notes Payable for 2016 ($10,000
[Php 3 Php 2])
o The actual interest expense is based on the current spot rate
of the principal amount
o On December 31, 2017, forex gains/losses are now based on
ILLUSTRATION

both the principal and the interest. The forex gains/losses


from the interest is based on the forex gains/losses
computed on the principal. There is a forex gain on the
principal amounting to Php 15,000 ($10,000 [Php 3 Php
1.5]). Thus, there is also a forex gain on the interest,
amounting to Php 1,800 (Php 15,000 .12)

FIRM (PURCHASE/SALE) COMMITMENTS

There is no actual transaction taking place in a firm commitment,


which can be to sell or purchase something at a future date. This
means that the purchase/the asset is not recorded until the date
of settlement, unlike the previous transaction in which the asset is
already recognized at the date of transaction. Only a memo entry is
made for the asset during the transaction date
Only forward rates are relevant in this case. At the date of
settlement, the purchase is recorded using the forward rate at the
date of settlement. In a firm commitment, the buyer (or seller)
contracts that he will pay (receive) an amount at the agreed rate no
matter if it changes
There is zero net forex gain/loss in a firm commitment. Suppose
the domestic entity enters in a purchase commitment, and that the
forward rate increases. They would record a forex gain on the
commitment (debit Accounts Payable, credit Forex Gain) and a
forex loss on the item (debit Firm Commitment, credit Forex Loss)
at the same amount. Firm Commitment in this case is an asset
account
At the date of settlement, the domestic entity pays/receives an
amount equal to the forward rate at the date of settlement. The
cost of the asset, as mentioned, is at the forward rate at the date of
transaction. Any difference is debited/credited to Firm
Commitment account

HEDGED FOREX TRANSACTIONS:


GENERAL CONCEPTS

Entities engage in hedging transactions to mitigate potential


losses arising from volatile exchange rates. To hedge is to take the
position opposite that of the transaction. This means that if the
hedged item (the asset) records a forex gain, the hedge records a
forex loss to even out things
Hedging instruments are usually in the form of derivatives,
financial instruments that derive their value from another
instrument. They are classified as either option-based (offers onesided protection against exchange rate risks, such as options and
swaps) and forward-based (offers two-sided protection, such as
forward and futures contracts)
Just like in a firm commitment, there are two sets of entries to be
made in a hedged transaction one for the hedged item (the
asset) and one for the hedging instrument. Suppose that the
domestic entity sells, and the exchange rate increases. The hedged
item would record a forex gain (debit Accounts Receivable, credit
Forex Gain), and the hedging instrument would record a forex loss
(debit Forex Loss, credit Forward Contract Payable)
The net forex gain/loss from the hedged item and hedging
instrument is referred to as the forex gain/loss from hedging
activity
Of course, on the hedging instruments side, the Forward Contract
Receivable account absorbs any change in exchange rate if the
domestic entity purchases, and Forward Contract Payable if it
sells. On the other side, Accounts Payable and Accounts
Receivable absorbs the changes, respectively
Note that the liability/receivable to third person is based on the
entries on the hedged item, not the hedging instrument
Forward rates are used for the hedging instrument until the date of

settlement, when the spot rate is used. Of course, if the selling


spot rate is used on the hedged item, the selling forward rate is
used for the hedging instrument
Problems usually present forward rates classified as per a
particular number of days. The rate to be used is the number of
days remaining until the date of settlement
On settlement date, the domestic entity either receives (debits) or
pays (credits) cash equal to the difference of the spot rate at
settlement and the forward rate at the date of transaction. This is
because the agreed upon rate (the forward rate at the date of
transaction) is the amount that the parties agreed to be paid
regardless of the change in the rates. A bank or other speculators
usually handle the difference

HEDGED FOREX TRANSACTIONS:


ACCOUNTING FOR HEDGING INSTRUMENTS

Hedging instruments are also classified as either fair value hedges


(used in transactions with recognized assets and liabilities, such
as in actual purchases/sales), cash flow hedges (used in
forecasted and anticipated transactions), and net investment
hedges (similar in treatment as to cash flow hedges, used between
a domestic and a foreign entity)
If silent, the hedge is assumed to be one of fair value hedge
Recording exchange rate changes as they affect the hedging
instrument can be made in two ways split and non-split
accounting. Under split accounting, gains/losses of the instrument
is divided into the effective portion (or the intrinsic value), and the
ineffective portion (or the time value gains and losses)
In fair value hedges, both the effective and ineffective portion of
the gains/losses go to profit/loss. In cash flow/net investment

hedges, the effective portion is a component of other


comprehensive income, while the ineffective portion goes to
profit/loss
Split and non-split accounting is best illustrated with options

HEDGED FOREX TRANSACTIONS:


OPTION CONTRACTS

Options are contracts that grant holders the right to either buy
(call) or sell (put) goods at the future date at a predetermined
price, called the strike/exercise price. This is recorded as an
investment in the balance sheet. The amount paid for an option is
referred to as the option premium
They may be classified as to the likeability of their exercise. If the
option is at the money (strike price equals current market prices),
the option is likely to be exercised, bearing no loss on the holder. If
the option is in the money, it is also likely to be exercised, bearing
gains on the holder. In a put option, this is when the strike price is
greater than market prices; in a call option, this is when the strike
price is less than market prices. If out of the money, the option is
likely not to be exercised, since it would bring losses to the holder
The option contact is the hedging instrument. However, it is not a
derivative like forward contracts, since it has its own cost (the
option premium). Also, it is not affected by changes in the forward
rate, since its value depends on its current fair value
The change in the fair value is the fair value is total gains/losses
on the hedging instrument, to be recorded on profit/loss (if fair
value hedge) or other comprehensive income (if cash flow hedge) if
the company uses non-split accounting
If problems mention that the effect of time value gains/losses are
excluded in the assessment of hedge effectiveness, the company

uses split accounting, wherein the fair value change is divided into
the effective and ineffective portions. Option contracts are usually
classified as cash flow hedges
The following format is used for split accounting:
Fair value of option
LESS: Intrinsic value
Time value

Date #1
xx
xx
xx

(difference)
Date #2
Total gains/losses
xx
xx
LESS: Intrinsic value g/l xx
xx
Time value g/l
xx
xx

The intrinsic value is computed by multiplying the notional amount


(the amount of the foreign currency) by the difference of the strike
price and the market price per item. The change in the intrinsic
value is the effective portion of the total gains/losses. Note that
the intrinsic value itself is not the effective portion to be sent to
OCI. The same goes for the time value gains/losses
There is only intrinsic value if the option is in the money, otherwise
it shall be zero. At the settlement date, the intrinsic value should
always match the fair value of the option, resulting to a zero time
value gains/losses
The effective portion is among the components of OCI that gets
transferred to profit/loss. The amount is transferred if the asset
purchased is sold or depreciated, whichever is applicable
The forex gain/loss from the hedging activity in this case is equal
only to the time value gains/losses, since the effective portion
goes to other comprehensive income

FOREIGN CURRENCY TRANSLATION

The presentation currency to be used in the financial statements is


the functional currency, which is the one used in the economic
environment in which the entity operates. Sales dictate the entitys
functional currency

Translation of financial statements also give rise to gains/losses to


be recorded in other comprehensive income. This is to be
transferred to profit/loss when the foreign branch is sold
Translation gain/loss to be entered in statement of comprehensive
income can be computed as follows:
Net assets @ current/year-end rate
LESS: Net assets @ roll-forward
Beg net assets @ rate of prev. year-end
xx
ADD: Net income @ average rate
xx
ADD: Dividends @ rate at declaration
xx
Translation gain/loss, balance in OCI in equity current year
LESS: Translation gain/loss, beginning
Translation gain/loss, current year (to SCI)

xx

xx
xx
xx
xx

For instance, the domestic entity owns not a business but just a
single asset overseas thats measured at fair value, such as
investment property. That items value shall be its fair value
overseas at foreign currency, to be translated with the exchange
rate as of when the fair value was determined. No forex
gains/losses are recorded, but only unrealized gains/losses. This
is because forex gains/losses only emerge from monetary assets,
such as accounts receivable/payable
If the item is measured at cost, it remains to be measured at its
historical cost, using the exchange rate when purchased

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