N10 - Foreign Currentcy Transactions

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CHAPTER 10: Foreign Currency Transactions

Introduction

When parties from two different nations transact business, they must settle on

which currency will be used to specify the payment amount. The currency usedto settle the transaction is the denominated currency. For example, if anAmerican retailer purchases wine from a French company. Will the amount paidbe in Euros or U.S. dollars?

The decision as to which currency will be used as the denominated currency setsup whether the seller or the buyer will bear the risk (or receive the benefit) as tochanges in currency exchange rates. For example, if the wine shipment will bepaid for in U.S. dollars, and if the US dollar drops in value vis--vis the Euro, thenthe US buyer will pay the amount anticipated in US dollars. The French sellerwill get the agreed upon price in US dollars, but when the French seller converts

them into Euros, the French seller will get a lesser amount than was anticipatedwhen the contract was signed.

Correspondingly, if the US dollar goes up in value vis--vis the Euro, then the USbuyer will still pay the amount anticipated in US dollars, but the French sellerconverts those US dollars into Euros, the French seller will receive a greateramount of Euros than was anticipated when the contract was signed. Becausethe contract is specified in a foreign currency as far as the French company isconcerned, the French company bears the burden and receive the benefit ofexchange rate fluctuations.

If the contract specified that the purchase price was 100,000 Euros (100,000),then the US buyer will be bearing the burden (and receiving the benefit) from thechanges in exchange rates. Now, the French seller always receives the amountanticipated when the contract was signed (100,000 ), and the US buyer payswhatever is necessary in US dollars to get the 100,000 contract price.

When a party to the contract does not use the denominated currency to keep itsbooks (e.g., the US company in a contract denominated in Euros), it has aproblem, its books are kept using its domestic currency (US dollars). A companyis not allowed to introduce foreign currency into its bookkeeping system. Forexample, a US company can put down that it has an account payable of

100,000. How could it give a total liabilities figure if some of payables are inEuros. Every foreign currency figure has to be converted into its domesticcurrency (US dollars). This process is called foreign currency translation.


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The Mechanics of Exchange Rates

There are two ways to quote a foreign currency exchange rate. An indirectquote (also known as European terms) specifies how many units of the foreign

currency will be received for one unit of the domestic or base currency. This isthe way most foreign currency exchange rates are quoted in the United States.Specifying the exchange rate for Japanese yen as 121 yen ( 121) to the USdollar is an example of an indirect exchange rate.

A direct quote specifies how many units of the domestic currency will bereceived for one unit of the foreign currency. Specifying the exchange rate forthe British pound () as U.S. $1.50 per British pound is an example for a directexchange rate. In the United States, a direct quote is used for the British pound.

Direct Exchange Rate

Euro to Dollar

Indirect Exchange Rate

Dollar to Euros

1 = $1.05303 $1 = 0.949639

The way that you can remember the difference is that a direct quote tells youdirectly (without any calculation) what one unit of the foreign currency is worth indollars. An indirect quote tells you what one unit of the foreign currency is worthafter you do some calculations (indirectly):

$1 = 0.949639 [Indirect Quote]

$1/.949639 = 0.949639/.949639

1 = $1.05303 [Direct Quote]

Exchange rates often are quoted in terms of the buying rate (the price paid whenyou are buying) and the selling rate (the price paid when you are selling). Thedifference or spread between these two rates represents the brokerscommission is often referred to as the points. We will not talk about the spread inthis class, but you should be aware of it.

There are two groups of exchange rates. The spot rate refers to the amountpaid for the immediate delivery of the currency (if the exchange will occur withintwo business days). For example, you are in Paris and you go up to theAmerican Express office and ask, I have ten dollars here in my hand. Howmany Euros will you give me, you blood sucker? The forward rate refers to anexchange of currency that will occur at a future point in time, such as in 30 to 180days. For example, you write to American Express and ask, I am planning on atrip to Paris in three months. Can we make an agreement today in which Ipromise to come into your office in three months and give you $10, and you


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promise that you will give me a specified amount of Euros that we agree upontoday, you bloodsucker.

An agreement to exchange currencies at a specified price at a specified futurepoint in time is a Forward Contract (e.g., the 3-month agreement described

above). A Forward Contract can be used to hedge against the risk associatedwith changing exchange rates. They can be used to cover any number of dayseven though forward rates are usually quoted in terms of 30-day intervals.

For example, if the contract between the US retailer and the French wine seller isdenominated in Euros. The US retailer may be afraid that the US dollar will dropin value. Rather than bear that risk, the US retailer may purchase a ForwardContract and lock in the exchange rate that will be used when the accountpayable to the French seller will be paid.

The difference between the forward rate and the spot rate represents a premium

or discount. When the forward rate is greater than the spot rate at inception ofthe contract, the contract is said to be at a premium. The opposite situationresults in a discount. We will not discuss the concepts of discounts andpremiums in this class, but you should be aware of it.

The forward rate is affected by the interest rate differences between the twocountries, as well as other factors (e.g., the foreign currency brokerscommission, volatility of spot rates, the time period covered by the contract,expectations of future exchange rate changes, and the political and economicenvironments of a given country).

Interest Rate Differential

As noted above, one of the reasons for the difference between the forward rateand the spot rate is the interest rate differential between the holding aninvestment in foreign currency and holding an investment in domestic currencyover a period of time. For example, the spot rate for the Canadian dollar isCAN$ .6531 to US$ 1. The 90-day forward rate is $.6506. This can be calculatedusing a simple formula.

Example 1

If you assume that you can get 1 percent in the US (.25 percent per quarter) and2.55 percent in Canada (.6375 percent per quarter):

Forward Rate ofFC (CAN $)

Spot Rate of FC(CAN $)

Domestic (U.S.)Interest Rate

Foreign (Canadian)Interest Rate

.6506 = .6531 x (1.0025 / 1.006375)


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If the interest yield on the foreign currency (the Canadian dollar) is greater thanthe yield on the US dollar, the forward rate will be less than the spot rate(contract sells at a discount). This is true in Example 1.

Accounting For Foreign Currency Transactions

If a US company deals with a foreign company and the contract is denominatedin dollars, then the U.S. company is not exposed to any foreign currency risks.This transaction does not require and special accounting treatment.

If, however, the contract is denominated in the foreign currency, then the UScompany is exposed to a foreign currency risk. The accounting treatment forthese transactions divides the transaction into two parts. The first part is theunderlying business transaction. The second part is the settlement of theaccount payable/receivable.

The change in the buyers domestic currency determines if there is an exchangegain or loss.

Example 2

Assume that a US company sells mining equipment to a British company onJune 1, 2004 with the corresponding receivable to be paid or settled on July 1,2004. The equipment has a selling price of US$ 305,000 and a cost of US$250,000. On June 1, 2004, the British pound is worth US$ 1.70, and on July 1,2004, the pound is worth US$ 1.60. The payment is to be made in US dollars,and the British company bears the foreign currency risk.

June 1, 2004:

US Company British CompanyD. A/R $306,000 D. Equipment 180,000

C. Sales $306,000 C. A/P $180,000

US Company British CompanyD. COGS $250,000

C. Inventory $250,000(No Entry)

July 1, 2004:

US Company British CompanyD. Cash $306,000 D. A/P 180,000

C. A/R $306,000 ExchangeLoss 11,250C. Cash 191,250


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Example 3

Assume the same facts as in Example 2, but this time the payment is to be madein British pounds, and the US company bears the foreign currency risk.

June 1, 2004:


C. Sales $306,000 C. A/P $180,000



July 1, 2004:


ExchangeLoss

18,000 C. Cash 180,000

C. A/R $306,000

Example 3

Assume the same facts as Example 2 (contract denominated in US dollars),

except that the exchange on July 1, 2004, the British pound is worth $1.80.Because the payment is to be made in US dollars, the British company receivesthe benefit from the rise in the British Pound.

June 1, 2004:


C. Sales $306,000 C. A/P $180,000

US Company British Company

D. COGS $250,000C. Inventory $250,000

(No Entry)


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July 1, 2004:


C. A/R $306,000 C. Exch.

Gain

10,000

Cash 170,000

Example 5

Assume the same facts as in Example 4, but this time the payment is to be madein British pounds, and the US company receives the gain from the rise in theBritish pound.

June 1, 2004:


C. Sales $306,000 C. A/P $180,000



July 1, 2004:

US Company British Company

D. Cash $324,000 D. A/P 180,000C. Exch.

Gain $18,000C. Cash 180,000

A/R 306,000

The foreign currency exchange gain or loss is not an extraordinary item, and isincluded in income from continuing operations. If it is material, it should bedisclosed in the financial statements or in a note to the financial statements.

Unsettled Foreign Currency Transactions at Year End

The prior discussion assumed that that account receivable/payable was settledbefore the fiscal-year end of the company in question. It is possible that theaccount receivable/payable is outstanding at the year end. The rule is that aforeign currency asset should be revalued at the end of the year, and its value onthe balance sheet should reflect the value on that date. Think of this like whatyou do for marketable securities. When you change the value of something onthe balance sheet, you have to book a corresponding gain or loss in order to


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keep the balance sheet in balance. The gain or loss that comes from markingyour asset/liability to market appears in the income statement.

Example 6

Assume that a US company purchases goods from a foreign company onNovember 1, 2001. The purchase, in the amount of 1,000 Canadian Dollars, isdenominated in Canadian dollars. The exchange rate is CAN $ = US $.50. Theaccount payable is to be paid on February 1, 2002. The US company wouldmake the following journal entries:

November 1, 2001:

D. Inventory $500C. Accounts Payable $500

Assume that the US company uses a calendar year and that the exchange rate isCAN $ = US$ .052 on December 31, 2001. The US company would make thefollowing journal entry on December 31, 2001:

D. Exchange Loss [(.52 - .50) x 1,000] $20C. Accounts Payable $20

Assume that the exchange rate on February 1, 2002 is CAN $ = US$ .55. OnFebruary 1, 2002, the US company would make the following journal entry:

D. Accounts Payable $520

Exchange Loss [(.55 - .52) x 1,000] 30C. Cash $550

Hedging

Hedging involves the use of Derivatives. Derivatives are financial instrumentsthat derive their value from changes in the value of a related asset (e.g., foreigncurrency). We will use two derivatives in this class, a Forward Contract tobuy/sell foreign currency and an Option to buy/sell foreign currency.

Forward Contracts

As noted above, Forward Contract is a contract to buy or sell a specified amountof an asset at a specified price at a specified future date. The current price forthe asset is the spot price, and the price specified in the Forward Contract is theforward price. The initial value of a forward contract is zero and it does notusually require an initial outlay of cash. This is because a Forward Contract is afair deal. The values assigned to the currencies reflect what everyone agreesare todays market prices for those currencies.


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As the values of foreign currencies change, you may find that you locked in agood/bad price. This change in currency values then causes your ForwardContract to have a value other than zero.

For example, consider a non-currency situation. You make a contract to buy 1barrel of oil for $40 at a time when oil trades for $40 per barrel. The contractcalls for delivery in one year. After one year, the price of oil is $60 per barrel.Your contract to buy a barrel of oil for $40 is now worth $20. You could fairly askyour friend, Hi friend, I am sick today. Would you please do me a favor and giveme $20 for this piece of paper? You can take the paper down to the oil seller,and give them $40, you will then have a barrel of oil. You can now take thebarrel down to the oil market and sell it for $60 and break even. Ignoring thework involved, your friend would not lose any money because he paid you a fairprice for your piece of paper.

Options

An Option represents the right (not the obligation) to either buy (Call Option) orsell (Put Option) a specified amount of an asset at a specified price at a specifiedfuture date. This price specified in the option is referred to as the strike price orthe exercise price. You have to pay something for the Option. This is becausethis is not a fair deal on its face. You are being given the right to buy/sellsomething. With the Forward Contract, you had the obligation to buy/sellsomething at an agreed upon price. You had to do the deal. Here, you donthave to do the deal. You have the right to do the deal if it makes sense, or youcan walk away. Have a one-way right for a given time period is probably worth

something.

Assume that you have the right to buy your neighbors house for $600,000 for thenext year. Right now it is worth $600,000, so that it doesnt look like you got aparticularly good deal right now. That is true and the right to purchase the houseat that price today isnt worth anything right now. There is a second force herethat is worth something. You have locked in the $600,000 price for a year. In ayear, the price of the house may skyrocket way up, and you could make afortune. The potential for gain is worth something. So, you have to pay for it.

The price paid for an Option can be divided into these two parts. The first part is

called the intrinsic value of the Option. You could turn around today and use theOption and you would make so much money. For example you get an Option tobuy a barrel of oil for $30 for the next year. The current price for the barrel is$40. You could turn in your Option today and make $10. That is the intrinsicvalue of the Option. Would such an Option sell for less than $10? NO! Would itsell for more than $10? YES! Why? Because you have the right to buy a barrelof oil for $30 for the next year, and you could make even more money in thefuture. The potential for making more money means that the Option will sell for


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more than $10. The extra value of the Option over the intrinsic value is called thetime-value of the Option.

Types of Hedges

Derivatives can be used to avoid the exposure to risk by hedging against anunfavorable outcome associated with rate/price changes. Hedges are classifiedas either fair value hedges or cash flow hedges.

A fair value hedge is used to offset changes in the fair market value of items withfixed prices or rates. Fair value hedges include hedges against a change in thefair market value of:

A recognized asset or liability; or

An unrecognized firm commitment

Many accounting principles do not allow for the recognition in current earnings ofboth increases and decrease in the value of recognized assets, liabilities, or firmcommitments (e.g., historical cost). However, if the risk of such changes in valueis covered by a fair value hedge, special accounting treatment is allowed thatprovides for the recognition of such changes in earnings. These criteria arebeyond the scope of this chapter.

A cash flow hedge is used to establish fixed prices or rates when future cashflows could vary due to changes in prices or rates. Cash flow hedges includehedges against changes in cash flows associated with:

A forecasted transaction; or An existing asset or liability with variable future cash flows.

The purpose of the cash flow hedge is to allow the entity to fix the price or rateand reduce the variability of the cash flows. As was true with fair value hedges,special accounting treatment is only available if the hedge satisfies specifiedcriteria, which are beyond the scope of this chapter. With a cash flow hedge, thegain or loss on the derivative instrument will be reported in Other ComprehensiveIncome (OCI). OCI does not appear on the income statement. It is shown aspart of equity on the balance sheet. When the forecasted transaction occurs theamount in OCI will be reclassified into earnings (e.g., closed to Cost of Goods

Sold).


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Fair Value Hedge Using a Forward Contract

Companies entering into business transactions involving foreign currencyexchange risks could eliminate that risk by settling the transaction immediately

(e.g., paying immediately or requiring immediate payment). This may not bepractical.

If immediate settlement is not practical, then a company can hedge against theexchange risk by purchasing a Forward Contract to acquire the needed foreigncurrency. The purchase of the foreign currency contract involves the acquisitionof an asset that involves its own set of journal entries. In practice, mostcompanies do not make the extensive journal entries noted below. In order tounderstand the relationship between the Forward Contract and the underlyingbusiness transaction, we will make the extensive journal entries.

The reason why the hedge works is that you started with an asset (or a liability)that is tied to foreign currency (e.g., an account payable for CAN $100,000). Youthen buy a liability (or an asset) that is tied to the same amount of foreigncurrency (e.g., an account receivable for CAN $100,000). Since you now haveboth an asset and a liability that are both tied to the same amount of foreigncurrency. If the value of that foreign currency goes up, you owe more (theliability) but you have more (the asset). The net difference in your position iszero; hence a hedge.

Example 7

Assume that on November 1, 2001, a US company purchases inventory from aCanadian vendor with subsequent payment due in Canadian dollars. Paymentof CAN $ 100,000 is required on February 1, 2002. The US company is willing topay the account payable to the Canadian company at todays exchange rates,but it afraid that the Candian dollar will go up vis--vis the US dollar, and itdoesnt want to take a chance that this may happen.

To protect itself from foreign currency exchange risk, the US company purchaseda Forward Contract to purchase Canadian dollars. On November 1, 2001, theUS company purchased a forward contract to buy CAN $ 100,000 at a forwardrate of 1 CAN $ = US$ .506.

Selected spot and forward rates are as follows:

Date Spot RateForward Rate forRemaining Term of Contract

November 1, 2001 1 CAN $ = U.S. $ .50 1 CAN $ = U.S. $ .506December 31, 2001 1 CAN $ = U.S. $ .52 1 CAN $ = U.S. $ .530February 1, 2002 1 CAN $ = U.S. $ .55 1 CAN $ = U.S. $ .550


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If the US company had not hedged its position, it would have lost $5,000. This isbecause the US company has to pay CAN $100,000 on February 1, 2002. TheUS company has to buy the needed Canadian dollars at that time. On February1, 2002, the exchange rate is 1 CAN $ = U.S. $ .55. The US company will have

to pay the equivalent of US $55,000 (100,000 x .55). Since the original payablewas for US$ 50,000, the US company had a Exchange Loss of US$ 5,000 on thepayable. This loss will still be reflected on the books of the US company despitethe hedge.

With the hedge, the US company has purchased an asset, which is thereceivable under the Forward Contract. That receivable represents the value ofCAN $100,000. On February 1, 2002, the Forward Contract receivable will beworth US$ 55,000 (100,000 x .55). The US company bought this asset for US$50,600. Therefore, it has a gain of US$ 4,400 on the Forward Contract.

When you net the Exchange Loss ($5,000) and Forward Contract Gain ($4,400),you have a loss of $600. This loss represents the cost of the hedging transaction(US$ 600).

Forward Contract Fair Value Hedge Straddling 2 Years

When the business transaction straddles two years, the cost of the hedge is splitbetween the two years. At the end of the year, we will book the Exchange Lossand we will book a Forward Contract Gain (or an Exchange Gain coupled with aForward Contract Loss). At the end of the year, the amount of the ForwardContract Gain (or loss) is the difference between: (i) the price (specified in the

Forward Contract) that you locked in, and (ii) the price others would have toagree to at the end of the year if they executed a new Forward Contract (fordelivery of CAN $100,000 at the same date as the original contract). Since theprices in the Forward Contracts are paid in the future, the difference represents again that is in future dollars. You need to take the present value of that gain inorder to calculate the Forward Contract Gain at the end of the year.


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Example 8

Continue with the facts of Example 7. We will discount the changes in the valueof the forward contract at a 6% rate. The Forward Contract Gain is calculated as

follows:

Buying FC Dec. 31

Price Others Would Pay at end of year for Forward Contract(100,000 x .53)

$53,000

Less: Price Locked in on Original Forward Contract(100,000 x .506) -50,600Difference in Forward Rates: $2,400

Forward Contract Gain using 6% discount rate

(PVIF = .995025)

$2,388

Less: Matching Forward Contract Gain Tied To The ExchangeLoss [11/1 to 12/31 ($.52 - $.50) x 100,000] -2,000Cost of the Hedge in 2001(Remaining Gain) $388

Remember that we saw in Example 7 that the total cost of the hedge is $600.Why is it a gain in the first year? The gain tells you that if you abandoned thehedge at the end of the year (and took your chances with the account payable inCanadian dollars), you would make $388.

We are going to do the same calculation at the settlement date (February 1,

2002). We dont need to take a present value on the Forward Contract Gain,because we are no longer dealing with future dollars. It is February 21, 2002.

Also, we have to take out the Forward Contract Gain booked in the prior year($2,333). You cant count the same gain twice:

Buying FC Feb. 1Value of Foreign Currency at end of Forward Contract(.55 x 100,000) $55,000Price You have to Pay for Foreign Currency under the ForwardContract (100,000 x .506) -$50,600

Total Forward Contract Gain $4,400Less: Forward Contract Gain Booked in 2001 -2,388Forward Contract Gain Applicable to 2002 $2,012Less: Matching Forward Contract Gain Tied To Exchange Loss in2002 [Change In Spot Rates from 12/31 to 2/1 ($.55 - $.52) x100,000]

-3,000

Cost of Hedge in 2002 -$988


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The gain for 2001 ($388) plus the loss for 2002 (-$988) equals the $600 cost ofthe hedging transaction that we saw in Example 7.

The journal entries relating to this transaction are as follows:

November 1, 2001:

Record the Purchase of Inventory:

D. Inventory $50,000C. Accounts Payable $50,000

Record the Purchase of the Forward Contract:

D. Forward Contract Receivable $50,600C. Forward Contract Payable $50,600

December 31, 2001:

Record the Exchange Loss from the increase in the Canadian dollar:

D. Exchange Loss [(.52 - .50) x 100,000] $2,000C. Accounts Payable $2,000

Record a matching Forward Contract Gain (exactly equal to the ExchangeLoss) on the Forward Contract:

D. Forward Contract Receivable [(.52 - .50) x 100,000] $2,000C. Unrealized Gain on Forward Contract $2,000

First, we book a Forward Contract Gain exactly equal to the Exchange Loss.This represents the hedging portion of the Forward Contract. Whatever is left ofthe Forward Contract Gain is then recognized as a cost of the hedge in 2001.The book refers to this as the change in time value excluded from hedgeeffectiveness

If the matching Forward Contract Gain had been greater than the actualForward Contract Gain, you would have booked a loss for the cost of the hedgein 2001. We will see this in 2002.

D. Forward Contract Receivable $388C. Unrealized Gain on Forward Contract (Cost of Hedge) $388


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February 1, 2002:

Record the Matching Forward Contract Gain:

D. Forward Contract Receivable [(.55 - .52) x 100,000] $3,000

Cr. Unrealized Gain on Forward Contract $3,000

Record the receipt of the Foreign Currency under the Forward Contract:

D. Foreign Currency $55,000Cr. Forward Contract Receivable $55,000

Record the payment of the Forward Contract payable:

D. Foreign Contract Payable $50,600Cr. Cash $50,600

Record the Payment of the Account Payable with the Foreign Currency. Also,recognize the Exchange Loss from the increase in the Canadian dollar:

D. Accounts Payable $52,000Exchange Loss [(.55 - .52) x 1,000] 3,000Cr. Foreign Currency $55,000

In 2002, the Forward Contract Gain is $2,012, but we created a matchingForward Contract Gain of $3,000. This creates a greater gain than we reallyhad, we have to book a loss now to bring the Forward Contract Gain down to theactual gain of $2,012. This requires booking a loss of $988 ($3,000 - $2,012).This is the cost of the hedge in 2002:

D. Loss on Forward Contract (Cost of Hedge) $988C. Forward Contract Receivable $988

The net effect of all the gains and losses for this transaction is the US$ 600 costof the hedging transaction:

Exchange Loss - 2001 -$2,000Unrealized Gain on Forward Contract - 2001 2,000Exchange Loss - 2002 -3,000Unrealized Gain on Forward Contract - 2002 3,000Cost of Hedge - 2001 388Cost of Hedge - 2002 -988Net Effect (Net Cost of Hedge) -$ 600

In an effective hedge, the respective gains and losses should offset each otherexcept to the extent of the original premium or discount on the Forward Contract.


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Remember that the original premium in this transaction is the difference betweenthe forward price paid and the spot price [($ .506 - $ .50) x 100,000 = $ 600].

Financial statements on December 31 would look as follows:

Income Statement Balance SheetAssets:Exchange Loss$2,000 Inventory $50,000

Unrealized Gain onForward Contract -2,388

Forward Contract Receivable 52,988

Liabilities:Accounts Payable -$52,000Forward Contract Payable -50,600

The Exchange Loss and the Unrealized gain on the Forward Contract are netted.The Forward Contract Receivable and the Forward Contract Payable are also

netted.

If there had been no hedge, then the US company would have had an ExchangeLoss of $ 5,000.

Remember, that the hedge removes the uncertainty associated with exchangerate risk. The hedge eliminates exchange gains, as well as, losses. If theCanadian dollar drops (instead of rising), then the US company would have hadan exchange gain, which would have been eliminated by the Forward Contract.

Example 9

Continue with the facts of Examples 7&8. Assume that the Forward Contract stillcosts US$ 600, but that the spot prices for the Canadian dollar are as follows:

Date Spot RateNovember 1, 2001 1 CAN $ = U.S. $ .50December 31, 2001 1 CAN $ = U.S. $ .49February 1, 2002 1 CAN $ = U.S. $ .48

Without theForward

Contract

With theForward

ContractExchange gain (loss) on foreign currency transaction[100,000 x ( $ .48 - $ .50)] $2,000 $2,000Loss on forward contract due to changes in spotrates ---- -2,000

Subtotal $2,000 $ 0Cost of Hedge (Loss on forward contract excludedfrom assessment of hedge effectiveness) ---- -$600Net income effect $2,000 -$600


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A Forward Contract can also be used by the seller of the inventory to eliminateforeign currency exchange risks.

Forward Contract Amount Different from Transaction Amount

If a company purchases a Forward Contract for less than the amount of thecontract, then the company has only partially hedged the risk from changes inforeign exchange rates. An exchange loss or gain will occur for the unhedgedportion.

If a company purchases a Forward Contract for more than the amount of thecontract, then the company has an investment in the Forward Contract which willresult in a gain or loss.

Forward Contract for a Different Period than the Underlying

Business Transaction

If a company purchases a Forward Contract for a period shorter than theunderlying business transaction, then the company needs to extend theprotection of the hedge for the remaining period. This could happen if the holderof the Forward Contract exercises his or her right to close the Forward Contractearly:

The company could roll over the Forward Contract for the additionalperiod.

The company could cash in the Forward Contract and purchase another

Forward Contract to cover the exchange risk for the remaining period. The company could satisfy the underlying business obligation at the time

that the Forward Contract ends.

If a company purchases a Forward Contract for a period longer than theunderlying business transaction, then the company needs to extend theprotection of the hedge for the remaining period. This could happen if thecompany holding an account receivable receives the foreign currency paymentearly:

The company could roll back the Forward Contract to the shorter date.

The company could sell its interest in the Forward Contract. The company could hold the foreign currency payment and satisfy the

Forward Contract at its termination.


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Hedging an Identifiable Foreign Currency Commitment Using aForward Contract (A Fair Value Hedge)

In this situation, the US company makes a binding contract. It is an executory

contract because a sale has not occurred or a service has not been rendered yet.If you recall, the accounting treatment of such a contract is to ignore it until theproduct or service is delivered. When do you book a profit when you sellmerchandise? You book your profit when you deliver it. Until then, it doesntshow up in the books of the seller.

You are still on the hook with a binding contract. You are bound. You may haveto pay more than you thought if you have an account payable denominated inforeign currency. You may receive less than you thought if you if you have anaccount receivable denominated in foreign currency. You can still lose the sameamount of money.

There is an additional concern here. Before, you gain or loss was labeled as anExchange Gain/Loss. Here, because you dont book the transaction untildelivery, the gain or loss that you suffer will not be booked as an Exchange Gainor Loss. The transaction will be originally booked at the higher cost or lowerprice. The Exchange Loss will be in the lower price or higher cost, but it wont belabeled as an Exchange Loss. It will look like you made a bad deal.

For example, assuming a foreign account receivable, instead of showing anormal sale price coupled with an Exchange Loss, you will now show a low salesprice. If you assume a foreign account payable, instead of showing a normal

purchase price coupled with an Exchange Loss, you will now show a highpurchase price. Either way, you look like you are a bad business person.

The hedge allows you to create a Firm Commitment asset/liability thatpreserves the exchange rate for purposes of booking the Sales Revenue or Costof Goods Sold.

Example 10

Assume that on March 31, a US company commits to selling specialty equipmentto a Canadian customer with delivery and payment in 90 days. The equipment

costs $55,000. The firm commitment calls for payment in Canadian dollars at aselling price of CAN$ 100,000. Assume that the spot rate on March 31 is1 CAN$ = US$ .85. If the spot rate were to remain constant over time, the UScompany will receive $85,000 (100,000 x $ .85) and realize a gross profit on thesale of $30,000.


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Management fears that the Canadian dollar may weaken relative to the USdollar. Therefore, they wish to establish the dollar basis of the transaction at thecommitment date rather than the later transaction date.

Management acquires a Forward Contract to sell Canadian dollars in 90 days.

We will use a 6% discount rate.

Selected spot and forward rates are as follows:

Date Spot Rate Forward Rate forRemaining Term ofContract

March 31 1 CAN $ = U.S. $ .850 1 CAN $ = U.S. $ .845+ 30 days 1 CAN $ = U.S. $ .840 1 CAN $ = U.S. $ .838+ 60 days 1 CAN $ = U.S. $ .820 1 CAN $ = U.S. $ .814+ 90 days (transaction date) 1 CAN $ = U.S. $ .800 1 CAN $ = U.S. $ .800

The cost of the hedge protection here is $500 [($ .850 - $ .845) x 100,000]. Thiscost locks in the amount to be received under the contract. The cost of the hedgeis not calculated every 30 days. It is just given here for demonstration purposes.

The cost of this hedge for each 30 day period is as follows:

+30 days:

(Contract To Sell FC) + 30 daysPurchase Price Locked in by Forward Contract (100,000 x .845) $84,500Less: Price you could lock in today (100,000 x .838) -83,800

Difference in Forward Rates $700

Present Value of Difference with 6% discount (PVIF = .990075) $693Less: Matching Forward Contract Gain Tied To Exchange LossThe Change In Spot Rates in last 30 days ($ .85 - $ .84) x 100,000 -1,000Cost of Hedge for first 30 days -$307


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+60 days:

(Contract To Sell FC) + 60 daysPurchase Price Locked in by Forward Contract (100,000 x .845) $84,500Less: Price you can lock in today (100,000 x .814) -81,400

Difference in Forward Rates $3,100

Present Value of Difference with 6% discount (PVIF = .995025) $3,085Less: Present Value of Difference at +30 days -693

$2,392Less: Matching Forward Contract Gain Tied To The Change InSpot Rates in last 30 days ($.84 - $.82) x 100,000 -2,000Cost of Hedge for second 30 days (Remaining Gain) $392

+90 days:

(Contract To Sell FC) + 90 daysPurchase Price Locked in Forward Contract (100,000 x .845) $84,500Less: Value of Currency at maturity (100,000 x .800) -80,000Forward Contract Gain $4,500Less: Present Value of FMV at +60 days -3,085

$1,415Less: Matching Forward Contract Gain Tied To The Change InSpot Rates in last 30 days ($.82 - $.80) x 100,000 -2,000Cost of Hedge for last 30 days -$585

The total cost of the hedge transaction is $500 (the difference between theforward and spot prices x 100,000):

Change in first 30-day period -$307Change in second 30-day period 392Change in last 30-day period -585

-$500

The journal entries relating to this transaction are as follows:

March 31:

Record the Purchase of the Forward Contract:

D. Forward Contract Receivable $84,500C. Forward Contract Payable $84,500


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+30 Days:

Record the loss on the Firm Commitment from the decrease in the Canadiandollar (this takes the place of the exchange loss):

D. Loss on Firm Commitment [(.85 - .84) x 100,000] $1,000C. Firm Commitment $1,000

Record the Gain on the Forward Contract:

D. Forward Contract Payable [(.85 - .84) x 100,000] $1,000C. Unrealized Gain on Forward Contract $1,000

Recognize the portion of the US$ 500 cost of the hedging transaction allocable tothe first 30 days. The book refers to this as the change in time value excludedfrom hedge effectiveness:

D. Unrealized Loss on Forward Contract (Cost ofHedge) $307C. Forward Contract Payable $307

+60 days:

Record the Loss on the Firm Commitment:




Recognize the portion of the US$ 500 cost of the hedging transaction allocable tothe second 30 days. The book refers to this as the change in time valueexcluded from hedge effectiveness:

D. Forward Contract Payable $392C. Unrealized Gain on Forward Contract (Cost of

Hedge) $392


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+90 days:

Record the Loss on the Firm Commitment:




Recognize the portion of the US$ 500 cost of the hedging transaction allocable tothe last 30 days. The book refers to this as the change in time value excludedfrom hedge effectiveness:

D. Unrealized Loss on Forward Contract (Cost ofHedge) $585C. Forward Contract Payable $585

Record the receipt of the Foreign Currency from the underlying businesstransaction:

D. Foreign Currency $80,000Firm Commitment 5,000C. Sales Revenue $85,000

Record the Cost of Goods Sold:

D. Cost of Goods Sold $55,000C. Inventory $55,000

Sell the Foreign Currency under the Forward Contract and satisfy the ForwardContract payable:

D. Foreign Contract Payable $80,000C. Foreign Currency $80,000

Record the receipt of payment under the Forward Contract satisfying the ForwardContract Receivable:

D. Cash $84,500C. Forward Contract Receivable $84,500


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The effect of the fair value hedge can be summarized as follows:

TargetedPosition

Without theHedge

With theHedge

Sales price $85,000 $80,000 $85,000

Cost of Sales -55,000 -55,000 -55,000Gross Profit $30,000 $25,000 $30,000Loss on Commitment -5,000Gain on Forward Contract ________ ________ 5,000Subtotal $30,000 $25,000 $30,000Derivative loss excluded from assessmentof effectiveness (the time value) Cost ofHedge ________ ________ -$500Net Income Effect $30,000 $25,000 $29,500

The fair value hedge was effective in maintaining the targeted gross profit. It was

accomplished at a cost of $500. Remember that the hedge could haveprevented an increase in the gross profit.

If financial statements were prepared on April 30 (+30 days), with sixty dayremaining the hedge, the sale and hedge would be reported as follows:

Income Statement Balance SheetLoss on FirmCommitment -$1,000

Assets:

Unrealized Gain onForward Contract 1,000

Forward Contract Receivable $84,500

Unrealized Loss onForward Contract -307

Liabilities:

Firm Commitment -$1,000Forward Contract Payable -$83,807

The Loss on the Firm Commitment and the Unrealized gain on the ForwardContract offset each other. The Forward Contract Receivable and the ForwardContract Payable are netted.

Hedging a Forecasted Transaction Using an Option (Cash FlowHedge)

As noted above, with a cash flow hedge, the transaction hasnt occurred (ExistingForeign Currency Transaction) and no contract has been signed (IdentifiableForeign Currency Commitment). Here, the US company projects that it will needforeign currency in the future for a planned transaction. It would like to limit thevariability in the exchange rate (future cash flows) that will be used when theplanned transaction occurs. Because the terms of the transaction are not fixed, ifspecified requirements are met, this hedge can qualify for cash flow hedgetreatment.


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As noted above, the income earned on the foreign currency derivative investmentused in a cash flow hedge will create Other Comprehensive Income (OCI). In thecase of the option, the change in the intrinsic value of the hedge is the OCI. TheOCI will offset any exchange losses. The change in the time-value of the option

is the cost of the hedge.

Example 11

Assume that on June 1, a US company thought that it might purchase of 5,000units of inventory from a foreign vendor. The purchase would probably occur onSeptember 1, and require the payment of 100,000 FC. It is anticipated that theinventory will be processed further and delivered to customers by early October.On June 1, the US company purchased a call option to buy 100,000 FC at astrike price of 1 FC = $ .55 during September. The US company paid $900 forthe option. On September 1, the US company purchased 5,000 units of inventory

at a cost of 103,000 FC. The option was settled/sold on September 1 at its fairmarket value of $2,600. After incurring further processing costs of $20,000, theinventory was sold for $95,000 on October 5.

Spot rates, option values, and changes in value over time are as follows:

6/1 6/30 7/31 9/1Spot Rate of FC $ .530 $ .552 $ .57 $ .575Fair Value of Option $900 $1,350 $2,400 $2,600Less: Intrinsic Value of Option [(CurrentSpot Rate - $.55) x 100,000] (zero if

negative) (OCI) -0 -200 -2,000 -2,500Time Value of Option $900 $1,150 $400 $100Change in Time Value of Option (Cost ofHedge) 250 -750 -300

The Cost of the Hedge (the Change in the Time Value of the Option) is $800($250 750 350 = $800) or ($900 - $100 = $800).

The existence of the cash flow hedge using the call option to buy limits theexposure of rises in the foreign currency to $2,000, which is the differencebetween the exercise price and the current spot rate of the foreign currency

[($.55 - $53) x 100,000]:

June 30 July 31 Sept.1Intrinsic Value of Option (OCI): $200 $2,000 $2,500Less: Value of Expected Cash Flows[(Change in Spot Rates) x 100,000]: -2,200 -4,000 -4,500Currency fluctuation not protected by Hedge: -$2,000 -$2,000 -$2,000


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With the use of the call option, the US company can walk away from the hedge ifthe foreign currency exchange rate stays below the option or strike price ($.55).Thus, the call option allows the US company to benefit from drops in the foreigncurrency exchange rate. It just loses the option price ($900). If the U.S.Company had used a Forward Contract, the US company would have been

obligated to purchase the foreign currency or settle the contract when the foreigncurrency exchange rate drops.

Without theOption

With theOption

Cost of Sales - Raw Materials -$59,225 -$59,225Cost of Sales Processing Costs -20,000 -20,000

-$79,225 -$79,225Adjustment to sales due to change in the intrinsicvalue of the option (OCI): _______ $2,500COGS -$79,225 -$76,725

Sales Price of Inventory 95,000 95,000Gross Profit $15,775 $18,275(Cost of Hedge = $900 - $100 = $800) _________ -$800Net Income Effect: $15,775 $17,475

The company adjusted gross profit is $1,700 higher than it would have beenwithout an option [the intrinsic value of the option ($2,500) less the cost of theoption ($800)]. The adjusted gross profit resulting from the use of a hedgeresults from the following:

Sales Revenue $95,000Locked in cost of goods sold on 100,000 FC at the strike price of$ . 55 (55,000)No hedge on the additional cost of 3,000 FC at the transactiondate spot rate of $ .575 (1,725)Processing costs (20,000)Adjusted gross profit $18,275

June 1:

Invest in the Call Option:

D. Investment in Call Option $900C. Cash $900


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June 30:

Record change in value of Call Option:

D. Investment in Call Option ($1,350 - $900) $450

C. Unrealized Gain on Call Option $250Other Comprehensive Income (OCI) (Increase inIntrinsic Value of Call Option 200

July 31:


D. Investment in Call Option ($2,400 - $1,350) $1,050Unrealized Loss on Call Option $750C. Other Comprehensive Income (OCI) (Increase in

Intrinsic Value of Call Option $1800

September 1:


D. Investment in Call Option ($2,600 - $2,400) $200Unrealized Loss on Call Option $300C. Other Comprehensive Income (OCI) (Increase in

Intrinsic Value of Call Option $500

Settle the Call Option:

D. Cash $2,600C. Investment in Call Option $2,600

Purchase Inventory:

D. Inventory $59,225C. Cash $59,225

Process Inventory further:

D. Inventory $20,000C. Cash $20,000

Sell Inventory:

D. Cash $95,000C. Sales Revenue $95,000


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Recognize Cost of Goods Sold:

D. Cost of Goods Sold $79,225C. Inventory $79,225

Close Other Comprehensive Income (OCI) to Cost of Goods Sold:

D. Other Comprehensive Income (OCI) $2,500C. Cost of Goods Sold $2,500

If financial statements were presented at June 30, the hedge would be reportedas follows:

Income Statement Balance SheetUnrealized Gain onOption -$250

Assets:

Investment in Options $1,350Stockholders Equity:Other Comprehensive Income

Gain On Option-$200

The FASB specifies disclosure requirements for hedging transaction. There arefour basic disclosures:

The objectives of using hedging instruments and the strategies forachieving the objective.

A description of the various types of hedges such as fair value hedges and

cash flow hedges. A description of the entity's risk management policy for hedging types

along with a description of the types of transactions which are hedged.

Detailed information regarding: the amount of gains/losses on hedges, wheregains/losses are recognized-earnings or other comprehensive income, whengains/losses appearing in other comprehensive income will be recognized inearnings, where gains/losses recognized in earnings appear in the incomestatement, and gains/losses recognized due to a hedge no longer qualifyingfor hedge accounting.


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Comparison of Valuation of Forward Contract and Options:

Forward Contract Option1 Fair Market Value of

Hedge Instrument

Present Value of

Changes in ForwardPrice of Currency

Market Price of Option

2 Gain/Loss Shown ForHedge Instrument

Change in SpotRates

Change in IntrinsicValue of Option(Current Spot Rate Strike Price)

Cost of the Hedge Change in 1-2 overinvestment period(Initial Investment =$0)

Change in 1-2 overinvestment period(Initial Investment =price paid for option)

Documents

N10 - Foreign Currentcy Transactions