Chapter Nine
Foreign
Currency
Transactions and
Hedging Foreign
Exchange Risk
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
LO 1
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.
 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!
9-2
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 today’s forward rate.
9-3
Foreign Currency Option Contracts
 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.
Remember: An option gives the holder “the
right but not the obligation” to trade the
foreign currency in the future.
9-4
LO 2
Foreign Currency Transactions
GAAP requires a twotransaction perspective.
(1) Account for the original sale
in US Dollars.
(2) Account for gains/losses from
exchange rate fluctuations.
9-5
LO 3
Hedging Foreign Exchange Risk
Two foreign currency derivatives that are
often used to hedge foreign currency
transactions:
 Foreign currency forward contracts lock in
the price for which the currency will sell at
contract’s maturity.
 Foreign currency options establish a price
for which the currency can be sold, but is not
required to be sold at maturity.
9-6
Accounting for Derivatives
ASC Topic 815 provides guidance for hedges
of four types of foreign exchange risk.
1. Recognized foreign currency denominated
assets & liabilities.
2. Unrecognized foreign currency firm
commitments.
3. Forecasted foreign currency denominated
transactions.
4. Net investments in foreign operations
9-7
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 company’s
incremental borrowing rate).
9-8
LO 4
Accounting for Hedges
Two ways to account for a foreign currency hedge:
1. Cash Flow Hedge
 Completely offsets variability of a foreign
currency receivable or payable.
 Gains/losses are recorded as Comprehensive
Income.
Any other hedging instrument is a
2. Fair Value Hedge.
 Gains/losses are recognized immediately in net
income.
9-9
Using a 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
designed as cash flow hedges or fair value
hedges.
Option prices are determined using the
Black-Scholes Option Pricing Model covered
in most finance texts.
9-10
Option values
Value is derived from a function combining:
 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
 Fair values are determined by:
Intrinsic Value & Time Value
9-11
LO 5
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.
9-12
LO 6
Hedge of a Forecasted Foreign Currency
Denominated Transaction
Accounting for a hedge of a forecasted transaction
differs from accounting for a hedge of a foreign
currency firm commitment in two ways:
1. Unlike the accounting for a firm commitment, the
forecasted transaction and related gains and losses
are not recognized.
2. The company reports the hedging instrument
(forward contract or option) at fair value, but
because no gain or loss occurs, the company does
not report changes in the fair value of the hedging
instrument as gains and losses in net income.
Instead, it reports the changes in other
comprehensive income.
9-13
LO 7
Foreign Currency
Borrowings Example
On July 1, 2013, Multicorp borrows ¥ 1 billion and
converts it into $9,210,000 in the spot market. On
December 31, 2013, Mulitcorp must revalue the Japanese
yen note payable with an offsetting foreign exchange gain
or loss reported in income and must accrue interest
expense and interest payable.
Interest is calculated by multiplying the loan principal in
yen by the relevant interest rate. The amount of interest
payable in yen is then translated to U.S. dollars at the spot
rate to record the accrual journal entry. On July 1, 2014,
differences between the amount of interest accrued at yearend and the actual U.S. dollar amount that must be spent to
pay the accrued interest are recognized as foreign exchange
gains/ losses.
9-14
Foreign Currency
Borrowings Example
Exchange rates in table above apply. Journal
entries are recorded as follows:
9-15
Foreign Currency
Borrowings Example
Journal entries at end of accounting period:
9-16