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FA4 Class notes

Barbara Wyntjes, B.Sc., CGA

Module 7: Foreign Currency Transaction and Hedge Accounting:


Part 1:

Foreign currency transactions occur when a company buys or sells in a currency other
than its reporting currency.
The objectives of translating foreign currency transactions are to accurately measure
the impact of the transaction on the firm and to allow it to be integrated with the
firms other financial information.
Market forces determine long-term exchange rates.
Factors that result in changing a countrys currency price are: inflation (higher
inflation weakens currency decreases purchasing power); interest rates differential
(higher interest rates strengthens currency); trade surplus/deficit (when exports are
greater than imports, currency increases).
A direct quotation provides the number of units of the Canadian dollar required to
purchase one unit of foreign currency (Ex: CDN$1.12 = US$1.00)
A indirect quotation provides the number of foreign currency units required to
purchase one unit of the Canadian dollar (Ex: US$0.8929 = CDN$1.00)

Current transactions denominated in a foreign currency:


Recording current transactions:
One transaction approach: the foreign currency denominated purchase/sale and the
settlement of the resulting payable or receivable is considered a single
transaction/economic event. The initial amount recorded for the purchase or sale is
considered an estimate of the final amount, which is established on the settlement
date. Problem: if settlement is not received until after year-end, Year-end adjustments
must split inventory and COGS. Thus the amount recorded for purchase or sale is
depending on how it is financed (loss/gain from a change in exchange rate is added to
cost of inventory or sale price). Therefore AcSB rejected this approach.

Two-transaction approach: the foreign currency denominated purchase/sale and the


settlement of the resulting payable or receivable is considered two separate
transactions. The purchase/sale is an operating transaction that is completed and
recorded on the date of the transaction. The financing transaction is not complete until
the payable/receivable is settled. Thus any change in the amount to be paid as a result
of not settling on the day of sale is deemed to be a benefit/cost of financing and not
charged to the cost of inventory/sale.
CICA Handbook does not mention the two-transaction approach but it is the
foundation of many Handbook recommendations
Monetary assets and liabilities are fixed by contract in terms of a monetary unit.

FA4 Class notes

Barbara Wyntjes, B.Sc., CGA

Reporting short-term monetary balances:


3 alternatives for reporting short-term monetary balances at year end: historical rate;
year end rate but defer gain or loss until settlement; or year end rate but recognize the
gain or loss immediately.
CICA recommends the third alternative as the information provided by the foreign
exchange market is viewed as reliable and objective.
Reporting short-term and long-term non-monetary balances:
Examples of short-term non-monetary items: inventory, prepaid insurance, deferred
revenue.
Examples of long-term non-monetary items: capital assets, intangibles and share
capital.
Foreign currency transactions should be translated at the exchange rate in effect on
the date of the transaction.
Their translated amount becomes their historical cost.
Since non-monetary items are not tied to cash payments, they are not exposed to
changes in exchange rates and thus no further adjustments are needed.
However, non-monetary items that are reported at market value should be restated to
the year-end rate and gains and losses recognized immediately (similar treatment as
short-term monetary items).
Long-term monetary items:
Prior to 1983, long-term monetary balances were reported at historical rate, no further
adjustments were made.
In response to the demand for consistent standards, AcSB considered 3 alternatives to
historical cost for recording.
1. Adjust monetary assets and liabilities balances to year-end rate and defer any
gains/losses until realized. Rationale: gains and losses will even out, but studies show that
the trend in exchange rates tend to be increasing or decreasing and not even out. Thus this
option does not provide the best matching and thus was rejected by AcSB.
2. Adjust monetary assets and liabilities balances to YE rate and defer and amortize
gains/losses over the remaining life of the instrument. Rationale: some gains and losses
would net out over time resulting in smoothing some of the foreign exchange rate
fluctuations over the life of the instrument. Problem: out of sync with other countries;
smoothing might mask ineffective management of exchange risk; and management can
use hedging to manage foreign exchange rate risks.
Between 1983 to December 2001, CICA recommended this method.
3. Adjust monetary assets and liabilities balances to year-end rate and recognized any
gains/losses immediately. Rationale: Same treatment as short-term monetary balances,
the market value provides more relevant information to statement users and the new
treatment harmonizes Canadian GAAP with GAAP of other countries. Problem:
including gains and losses in income would cause fluctuations in income and the firm
would look more risky and less stable.
2

FA4 Class notes

Barbara Wyntjes, B.Sc., CGA

CICA recommends this alternative effective January 1, 2002.


Sum: At each reporting date, all monetary assets and liabilities should be translated
at the current rate. Foreign exchange gains/losses on monetary assets/liabilities
would be recognized in income immediately.

Part 2:
Class example 1:
Sam Ltd., a Canadian company, purchased supplies totalling 3,000,000 Euros from Ernie
Co. on June 1, 2002. Payment is due in 6 months (no hedges). On December 1, 2002,
Sam paid half of the accounts payable with cash and Ernie Co. agreed to accept a noninterest bearing note payable for the other half. The note payable is due December 1,
2004. Sams year-end is December 31. Prepare the journal entries for 2002 for the
accounts payable and note payable.
June 1, 2002
December 1, 2002
December 31, 2002

C$1 = Euros1.5
C$1 = Euros 2
C$1 = Euros 2.3

June 1, 2002 Transaction


Inventory .................................................................
Accounts payable .........................................

2,000,000
2,000,000

(Euros 3,000,000 1.5 = 2,000,000)


December 1, 2002 Partial settlement
Accounts payable.....................................................
Notes payable...............................................
Cash.............................................................
Exchange gain..............................................

2,000,000
750,000
750,000
500,000

(Euros 1,500,000 2 = 750,000)


(Euros 1,500,000 2 = 750,000)
December 31, 2002 Year end
Notes payable ..........................................................
Exchange gain..............................................

97,826
97,826

(Euros 1,500,000 2.3 = 652,174)

FA4 Class notes

Barbara Wyntjes, B.Sc., CGA

Part 3:
Class example 2:
On January 1, 2002, a Canadian firm borrowed 100,000 marks from a bank in Germany.
Annual interest rate is 10% and due each Dec 31 for the next five years. Principal is due
Dec. 31, 2006. Foreign exchange rates are: Jan. 1, 2002 C$0.60 = DM1.0; Dec 31, 2002
C$0.67 = DM1.0; Dec 31, 2003 C$0.59 = DM1.0.
In accordance with current GAAP, determine the exchange gain/loss for the loan on the
financial statements for Dec. 31, 2002 and 2003. Record all the related journal entries.
Journal entries:
Jan 1, 2002:
Cash
Foreign currency loan
Dec 31, 2002:
Foreign exchange loss
Foreign currency loan [DM100,000 (0.67-0.60)]
Interest expense [DM10,000 (.67+.60)/2]
Foreign exchange loss
Cash (DM100,000 x 10% = 10,000 x .67)
Dec 31, 2003:
Foreign currency loan [DM100,000 (0.67-0.59)]
Foreign exchange gain
Interest expense [DM10,000 (.67+.59)/2]
Foreign exchange gain
Cash (DM100,000 x 10% = 10,000 x .59)

60,000
60,000

7,000
7,000
6,350
350
6,700

8,000
8,000
6,300
400
5,900

Balance Sheet:
Foreign currency loan (100,000 x 0.67)
(100,000 x 0.59)

2002
$67,000

2003
$59,000

Income Statement 2002:


Interest expense
Foreign exchange currency loss (7,000 + 350)

6,350
7,350

Income Statement 2003:


Interest expense
Foreign exchange currency gain (8,000 + 400)

6,300
8,400
4

FA4 Class notes

Barbara Wyntjes, B.Sc., CGA

Part 4:
Hedges:
The purpose of a hedge is to modify a firms exposure to risk (credit risk, interest rate
risk, foreign currency risk, and liquidity risk). It fixes the amount required to settle an
asset/liability that is denominated in a foreign currency. Guarantee a more secure and
predictable return.
A hedge can be an equal but opposite foreign currency item which fixes (and partially
offsets) the gains or losses on the item that is hedged (also reduces potential gains).
The most common form of hedge is a forward exchange contract (derivative). The
forward exchange contract is between an exchange broker (i.e. bank) and a customer
who agree to exchange currencies at a set price on a future date (fixed or option).
For example, if a company holds a receivable (payable) denominated in a foreign
currency, it could hedge this with a forward contract to sell (buy) the foreign currency
it will receive (need) at a fixed forward exchange rate.
Forward exchange contracts are executory contracts (neither party has fulfilled their
obligation) and are firm commitments and thus they can be recorded in the books
(optional). However, for reporting purposes, the receivable and payable will be offset
against each other and only the net amount will be reported on the balance sheet as a
forward contract. Hence, the Forward contract will be valued at its fair value.
Hedge accounting (optional) is not the same as hedging. Hedge accounting is an
accounting treatment that aims at matching the timing of income recognition on the
hedging item to the timing of income recognition of the related hedged item. Hedging
is designed to modify a firms exposure to risk.
Hedge accounting is applied only when gains, losses, revenues, and expenses on a
hedging item would otherwise be recognized in net income in a different period than
gains, losses, revenues, and expenses on the hedged item [3865.03].
A hedge of the net investment in a self-sustaining foreign operation or subsidiary
is a hedge of the foreign currency exposure of the net investment (net assets) in the
operation [3865.07 (g)]. (This is addressed in more detail in Module 8.)
Handbook: To qualify for hedge accounting: 3 conditions must be met: 1. The
company must identify the risks and state that hedge accounting will be used, 2.
Formally document the hedge relationship and 3. Reasonable assurance that is will be
an effective hedge (i.e. will offset gains and losses).
Record hedges at a premium or at a discount:
Foreign currency transactions are hedged at a premium when the forward rate is
greater than the spot rate (asset = gain; liability = loss).
Example: $1US = $1.50 Forward; $1US = $1.00 Spot
Foreign currency transactions are hedged at a discount when the forward rate is less
than the spot rate (asset = loss; liability = gain).
Example: $1US = $1.00 Forward; $1US = $1.50 Spot
See text example page 509 to 513

FA4 Class notes

Barbara Wyntjes, B.Sc., CGA

Fair-value hedge:

Fair value hedge is a hedge of all or part of the risk exposure to changes in the fair
value of financial instruments or unrecognized firm commitment [3865.07 (e)].

The hedged item and the hedging item are adjusted for the changes in fair value as a
result of changes in the foreign exchange rates. These changes in fair value result in
a loss or a gain, which is recognized in net income even when the hedged item has
been designated as available-for-sale [3865.47]. (Versus: gains and losses on
unhedged available-for-sale financial instruments are recognized in other
comprehensive income).

If the hedges were not perfect there would be a residual amount that would impact
net income (amortization of premium or discount).

The hedged item and the derivative hedging item are reported at fair value on the
balance sheet as required by section 3855.

For fair-value hedges of unrecognized firm commitments, the hedge price sets the
purchase price [3865.50].

Example: Buy goods for US$1,000 to be delivered in 2 months. Spot rate today
$1US = $1.10C. Immediately enters into a Forward contract at $1US = $1.08C. In 2
months will record the goods into their books at $1,080 (1,000 US x 1.08)
regardless of spot rate on the delivery / transaction date (1.06).

Section 3865 - Review Exhibit 7.4-1.


Summary of accounting treatment:
o On the transaction date: Record the purchase/sale and A/P or A/R at the spot
rate.
o On the Hedge date: Adjust payable or receivable to spot rate (gain or loss thru
NI). Record the forward contract as a Payable and Receivable with the bank at
the forward rate. Calculate the discount or premium, which is the difference
between the spot rate and forward rate on the Hedge date. It is recognized
over the terms of the forward exchange contract, which ensures proper
matching
o At year-end: adjust payable or receivable to spot rate (gain or loss thru NI)
and forward contract to forward rate (gain or loss thru NI). Part of the
resulting foreign exchange gain/loss will offset each other and the other part
will be recognition of the discount or premium. Balance sheet: record
forward contract at fair value (CR = liability; DR = asset)
o On settlement date: adjust payable or receivable to spot rate (gain or loss thru
NI) and forward contract to forward rate (gain or loss thru NI).
Net gain or loss is the balance of any amortization of the premium or discount.
Record cash as agreed, remove payable/receivable and remove balance in
Payable and Receivable with the bank.

FA4 Class notes

Barbara Wyntjes, B.Sc., CGA

Part 5:
Class example 3: Chapter 11, Problem 8 (page 533)
En-Dur Corporation (EDC) is a Canadian company that exports computer software. On
December 1, 2005, EDC shipped software products to a customer in South Africa. The
selling price was established as 750,000 rand, with payment to be received on March 1,
2006.
On December 3, 2005, EDC entered into a fair value hedge with the Royal Bank at the
90-day forward rate of R1 = $0.781. The fiscal year-end of EDC is December 31. The
payment from the South Africa customer was received on March 1, 2006.
Exchange rates were as follows:
December 1, 2005
December 3, 2005
December 31, 2005
March 1, 2006
Required:
Part A:
Part B:

Spot Rates
R1 = $0.741
R1 = $0.741
R1 = $0.757
R1 = $0.738

Forward Rates
R1 = $0.781
R1 = $0.785
R1 = $0.738

a) Prepare the journal entries to record all the above events.


b) Prepare a partial balance sheet of EDC on December 31, 2005, that
presents the accounts associated with the hedge.
Assume that EDC did not enter into the hedge transaction on December 3,
2005. Prepare the journal entries to record the receipt of R750,000 on
March 1, 2006.

Part A: (a)
December 1, 2005
Accounts receivable (R750,000 .741)
Sales
December 3, 2005
Receivable from bank (C$)
Payable to bank (R750,000 .781)

555,750
555,750
585,750
585,750

Premium = .781-.741 = .04 (750,000) = $30,000 Gain.


December 31, 2005
Accounts receivable
Exchange gain/loss (R750,000 [.757 .741])
Exchange gain/loss
Payable to bank (R750,000 [.785 .781])

12,000
12,000
3,000
3,000

Net gain = $9,000


7

FA4 Class notes

Barbara Wyntjes, B.Sc., CGA

March 1, 2006
Exchange gain/loss
Accounts receivable (R750,000 [.738 .757])
Payable to bank (R750,000 [.738 .785])
Exchange gain/loss

14,250
14,250
35,250
35,250

Net gain = $21,000


Cash (R)
Accounts receivable (R)

553,500

Payable to bank (R)


Cash (R)

553,500

Cash

585,750

553,500
553,500

Receivable from bank

585,750

(b)
En-Dur Corporation
Balance Sheet
As at December 31, 2005
Current assets
Accounts receivable

567,750

Current liabilities
Forward contract (1)

3,000

(1) Payable to bank (750,000 x .785)


Less: receivable from bank
Forward contract

588,750
585,750
3,000

Note: Receivable and payable with the bank are usually recorded in the firms journals
(because they are a firm commitment and can not be cancelled) but are NOT reported on
the Balance Sheet (because they are executed contracts). However, the net amount of
these two executed contracts is reported on the Balance Sheet as Forward contract.
Recall an executed contract is when neither party has performed its obligation to the
other.
Part B:
March 1, 2006
Cash (R) (R750,000 .738 spot)
Exchange gain/loss
Accounts receivable (R750,000 .757 YE rate).......

553,500
14,250
567,750

At year end, $12,000 exchange gain recognized thru NI (R750,000 [.757 .741])
8

FA4 Class notes

Barbara Wyntjes, B.Sc., CGA

Part 6:
Cash-flow hedge:
A cash-flow hedge is a hedge of the variability in cash flows of financial instruments,
forecasted future transactions (expected to occur in the future that has not yet given
rise to a recognized asset or liability) or unrecognized firm commitments [3865.07f].
Hedge future cash flows thus the risk is not yet incurred but the firm takes steps to
protect future cash flows against that potential variability.
To qualify for a cash-flow hedge, the hedged items must subsequently generate future
cash flows, which should be exposed to variability resulting from risk.
Gains and losses on the effective portion of the hedge are reported in other
comprehensive income [3865.52 (a)]. Gains and losses on the ineffective portion of
the hedge are reported in net income [3865.52 (b)].
The associated gains or losses recognized in other comprehensive income should be
reclassified into net income in the same period or periods during which the hedged
item (asset acquired, liability incurred, or anticipated transaction) affects net income.
If the company expects that all or a portion of a loss recognized in other
comprehensive income will not be recovered in one or more future periods, that
amount should be recognized into net income.
A company may elect to account for a hedge of the foreign currency risk in a firm
commitment as a cash-flow hedge [3865.51].
For cash-flow hedges of unrecognized firm commitments, the company may elect to
amortize to net income over the life of the asset acquired or liability assumed any
associated gains and losses previously included in other comprehensive income
[3865.56 (a)] or to have the hedge price set the purchase price [3865.56 (b)].
Summary of accounting treatment if adopt hedge accounting:
o Hedge date: Record the forward contract: set up Payable and Receivable
with the bank at forward rate. Calculate premium or discount and the cost
of sale or purchase based on the spot rate.
o If a year-end prior to transaction date: adjust forward contract to the
forward rate (unrealized gain/ loss held under OCI). Balance sheet: record
forward contract at fair value (CR = liability; DR = asset).
o On transaction date: record purchase/sale at spot rate and set up
payable/receivable. Adjust forward contract to the forward rate (unrealized
gain/loss held under OCI). Close OCI and AOCI (from year-end) to sale
or purchase (part of premium/discount).
o On settlement date: adjust payable or receivable to spot rate (gain or loss
thru NI) and forward contract to forward rate (gain or loss thru NI).
Net gain or loss is the balance of any amortization of the premium or
discount. Record cash as agreed, remove payable/receivable and remove
balance in forward contract (Payable and Receivable with the bank).
Premium/ discount is split between cost of hedging (thru NI) and value of sale/purchase
(value on hedge date final balance recorded in books).
If do NOT adopt Hedge accounting: Do not use OCI close to NI. No adjustment
to value of sale or purchase recorded at spot rate on transaction date.

FA4 Class notes

Barbara Wyntjes, B.Sc., CGA

Class example 4: Chapter 11, Problem 5 (page 531)


On October 1, Year 6, Versatile Company (VC) contracted to sell merchandise to a
customer in Switzerland at a selling price of SF400,000. The contract called for the
merchandise to be delivered to the customer on December 1, Year 6, with payment to be
received in Swiss francs on January 31, Year 7. On October 1, Year 6, VC arranged a
forward contract to deliver SF400,000 on January 31, Year 7, at a rate of SF1 = $1.20.
VCs year-end is December 31. The merchandise was delivered on December 1, Year 6;
SF400,000 were received and delivered to the bank on January 31, Year 7.
Exchange rates were as follows:
Spot Rates
Forward Rates
October 1, Year 6
SF1 = $1.18
SF1 = $1.20
December 1, Year 6
SF1 = $1.17
SF1 = $1.21
December 31, Year 6
SF1 = $1.21
SF1 = $1.22
January 31, Year 7
SF1 = $1.19
SF1 = $1.19
a) Prepare the journal entries that VC should make to record the events described
assuming that the forward contract is designated as a cash flow hedge.
b) Prepare a partial trial balance of the accounts used as at December 31, Year 6 and
indicate how each would appear on the companys financial statements.
c) What would be the difference if they chose not to apply hedge accounting?
Solution: (a)
October 1, Yr 6
Receivable from bank (C$) agreed to receive
Payable to bank (SF400,000 1.20)

480,000
480,000

Premium = 1.2-1.18 = .02(400,000) = 8,000 gain.


Sales value on October 1 = $472,000 (400,000 x 1.18)
December 1, Yr 6
Other Comprehensive Income
Payable to bank (SF 400,000 x (1.21-1.20)
Accounts receivable (SF400,000 1.17)
Sales
Sales
Other Comprehensive Income (close to sales)
December 31, Yr 6
Accounts receivable
Exchange gain/loss (SF400,000 [1.21 1.17])
Exchange gain/loss
Payable to bank (SF400,000 [1.22 1.21])
Net gain = 12,000

4,000
4,000
468,000
468,000
4,000
4,000
16,000
16,000
4,000
4,000

10

FA4 Class notes


January 31, Yr 7
Exchange gains and losses
Accounts receivable (SF400,000 x (1.19-1.21)
Payable to Bank (SF400,000 x (1.19-1.22)
Exchange gains and losses
Net gain = 4,000

Barbara Wyntjes, B.Sc., CGA


8,000
8,000
12,000
12,000

Cash (SF)
Accounts receivable (SF400,000 1.19)

476,000

Payable to bank (SF400,000 1.19)


Cash (SF)

476,000

Cash (C$) agreed


Receivable from bank (C$)

480,000

476,000

476,000
480,000

Premium of $8,000 (16,000 gain 8,000 loss) is split between the cost of hedging and
the value assigned to sales.
Premium assigned to cost of hedging: $16,000 gain: Dec 31: $12,000 gain (16,000
4,000) plus Jan. 31: $4,000 gain (12,000 8,000)
Premium assigned to sales: $8,000 loss: Sales value on October 1 $472,000 (400,000 x
1.18) less final balance of sales $464,000 (468,000-4,000)
(b) Trial balance, December 31, Yr 6
DR
CR
Accounts receivable
484,000
B/S
Sales
464,000 I/S
Exchange gain/loss
12,000 I/S
Receivable from bank*
480,000
Payable to bank*(400,000 x 1.22)
488,000
*A net amount of $8,000 Cr would appear on the BS: forward contract - current liability.
(c) If did not apply hedge accounting:
Dec. 1: Journal entry: do NOT use OCI
Loss
Payable to bank (SF 400,000 x (1.21-1.20)

4,000
4,000

Sales would remain at 468,000


Premium assigned to cost of hedging: $12,000 gain: Dec. 1: $4,000 loss; Dec 31:
$12,000 net gain (16,000 4,000) plus Jan. 31: $4,000 net gain (12,000 8,000)
Premium assigned to sales: $4,000 loss: Sales value on October 1 $472,000 (400,000 x
1.18) less final balance of sales $468,000
Premium = net gain $8,000
11

FA4 Class notes

Barbara Wyntjes, B.Sc., CGA

Part 7:
Transnational financial reporting refers to reporting across national boundaries, that is,
reporting financial results to user groups located in a country other than the one where the
company is headquartered.
Some strategies to accommodate foreign users are:
1. Provide unchanged financial statements Do nothing.
3 reasons: little need for foreign capital, sophisticated users, and language and currency is
well understood around the world. This approach is cheap and easy for firm but increases
costs to users, which can discourage them from investing.
2. Prepare convenient translations: Prepare statements using a common language such
as English (or translate into the language of the foreign readers) but leave the figures in
the currency of the home country and accounting principles unchanged. Relatively easy
and inexpensive, foreign readers can read the financial statements which increase the
audience. But the figures and accounting principles are un-translated / unchanged.
3. Prepare convenient statements: Prepare statements using a common language such
as English and restate the figures to a common currency such as U.S. dollars. Foreign
readers can read them and monetary amounts are expressed in readers currency. But lose
foreign appearance and can be misleading if reader does not realize that foreign GAAP is
still used.
4. Restate financial statements on limited basis: Partially restate some figures or
provide reconciliations to the foreign countrys accounting policies in the notes to the
financial statements. More convenient for the foreign readers to analyze and decrease
penalties such as lower stock prices and higher interest rates related to the users when
effectively communicate financial information. But is more costly and inconvenient for
the company.
5. Prepare secondary financial statements: Issue new statements with the needs of the
potential user in mind. Translate to their language and their currency and restate to a
common GAAP such as IASC standards. Further reduce penalties, attract more
international investment as easier and cheaper for readers to analyze. But it is the most
expensive, requires two sets of books, and can disclose too much information to
competitors.
Criteria to consider to determine which approach to use:
: Decision should be based on cost-benefit analysis
: Who are the potential audience, what are the needs of the users and their level of
sophistication
: How well understood the local GAAP and international disclosure standards
: The amount of capital raised outside of the country
: How well the native language, currency and business environment is known
THE END
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