lOMoARcPSD|21549393 Chapter 9 foreign currency transactions and risk Governmental and Not-for-Profit Accounting (Liberty University) Studocu is not sponsored or endorsed by any college or university Downloaded by Titus Tally (tallyatoror@gmail.com) lOMoARcPSD|21549393 ACCT 403 Chapter 9. Foreign Currency Transactions and Hedging Foreign Exchange Risk Foreign currency exchange rate – the price at which foreign currency is acquired/sold Common currency arrangements::: 1) independent float (value of currency is allowed to fluctuate freely according to market forces). 2) pegged to another currency (value of currency is fixed in terms of a particular foreign currency, bank intervenes to maintain fixed value). 3) European monetary system (the euro is the currency for several countries) Direct quote = number of US dollars needed to purchase 1 unit of foreign currency Spot rate = price at which foreign currency can be purchased/sold today Forward rate = price available today at which foreign currency can be purchased or sold sometime in the future Foreign currency forward contract – can be negotiated by a firm with its bank to exchange foreign currency for dollars on a specified future data at a predetermined rate Under a forward contract, banks earn their profit through the spread between buying and selling rates Options are purchased by paying an option premium which is a function of two components::: intrinsic value (equal to the gain that could be realized by exercising the option immediately) and time value (spot rate can change over time and cause intrinsic values to increase) Foreign currency transaction exposure summary::: export sale (exposure exists when the exporter allows the buyer to pay in a foreign currency and allows the buyer to pay sometime after a sale has been made) and import purchase (exposure exists when the importer is required to pay in foreign currency and is allowed to pay sometime after purchase has been made). Two transaction perspective is required to account for foreign currency transactions, treats the export sale and the subsequent collection of cash as two separate transactions The US dollar value of the sale is recorded at the date the sale occurs, a foreign exchange gain/loss is reported separately (for the amount the company could have received if they exchanged it immediately versus the amount they actually received) An import purchase in a foreign currency and the subsequent payment of cash are recorded separately (accounted in the same way *above*) Foreign currency balances need to be adjusted at the balance sheet date (even if the date of payment is not for another few weeks/months/etc)(*same entries as required above except no cash is yet collected*) IFRS and GAAP are largely unified about this topic Downloaded by Titus Tally (tallyatoror@gmail.com) lOMoARcPSD|21549393 If a company borrows money (loan, note) in a foreign currency, 1) convert it into US dollars. 2) revalue with a foreign exchange gain/loss when necessary or on balance sheet date. 3) interest is calculated (in order to accrue it every month) by multiplying loan principle * relevant interest rate and then translating it into US dollars. 4) any difference between the amount of interest accrued and the actual US dollar amount is a foreign exchange gain/loss at year end. Hedging – involves establishing a price today at which a foreign currency to be received in the future can be sold in the future OR at which a foreign currency to be paid in the future can be purchased in the future. Hedge of a recognized foreign currency – denominated asset – if a company enters into a forward contract or purchases a put option (to guarantee a set currency exchange rate to buy or sell) on the date the sale is made, the derivative qualifies as a hedge. Foreign currency firm commitment – a noncancelable order that specifies the foreign currency price and date of delivery Hedge of an unrecognized foreign currency firm commitment – when an order is accepted but before the sale is made, the company enters into a forward contract to sell the foreign currency on a specified date Hedge of a forecasted foreign currency, denominated transaction – company frequently buys from a foreign seller, forecasts it will buy in a few months, purchases a call option to purchase the foreign currency in a few months. Companies must carry all derivatives on the balance sheet at their FAIR VALUE Derivatives are reported on the balance sheet as assets when they have a positive FV and as liabilities when they have a negative FV 3 qualities are needed to know to assess FV of a foreign currency forward contract::: 1) forward rate when the forward contract was entered into. 2) current forward rate for a similar contract. 3) a discount rate Changes in the fair value of derivatives are included in comprehensive income For speculative derivatives (entered into in the hope they are going to appreciate), the change in the fair value of the derivative must be recognized immediately as a foreign exchange gain/loss in net income US GAAP allows hedge accounting for foreign currency derivatives if ALL three::: 1) derivative is used to hedge cash flow exposure or FV exposure to foreign exchange risk. 2) derivative is highly effective in offsetting changes in cash flows or FV related to the hedged item. 3) derivative is properly documented as a hedge Hedges of recognized foreign currency – denominated assets and liabilities and hedges of foreign currency – denominated firm commitments, companies can choose between cash flow hedge or FV hedge. Hedges of forecasted foreign currency – denominated transactions can ONLY be cash flow hedges. A derivative instruments effectiveness must be reevaluated at each balance sheet date Generally, the assessment of hedge effectiveness involves comparing the change in FV of the hedging instrument with the change in FV of the item being hedged Forward points (when a forward contract is the hedging instrument) and time value (when an option is the hedging instrument) can be excluded from hedge effectiveness Downloaded by Titus Tally (tallyatoror@gmail.com) lOMoARcPSD|21549393 An entity may choose to designate only the spot component of a forward contract as the hedging instrument and may choose to designate only the intrinsic value of an option as the hedging instrument GAAP requires formal documentation of the hedging relationship at the inception of the hedge Hedging company must prepare a document that IDs::: hedged item, hedging instrument, nature of the risk being hedged, how effectiveness will be assessed, risk management objective and strategy for undertaking the hedge For cash flow hedges, at each balance sheet date the following procedures are required::: 1) hedged asset/liability is adjusted to FV based on changes in spot exchange rate and a foreign exchange gain/loss is recognized in net income. 2) derivative hedging instrument is adjusted to FV with the counterpart recognized in OCI. 3) foreign exchange gain/loss related to the hedging instrument is recognized with the counterpart recognized in OCI. 4) an additional foreign exchange loss is recognized in net income to reflect the current periods amortization of OG discount/premium on the forward contract OR change in time value of the option. For fair value hedges, at each balance sheet date the following procedures are required::: 1) adjusted hedged asset/liability to FV based on changes in spot exchange rate and a foreign exchange gain/loss is recognized in net income. 2) adjust the derivative hedging instrument to FV and recognize counterpart as foreign exchange gain/loss in net income. 3) adjust the net foreign exchange gain/loss to properly recognize EITHER the current periods amortization of the OG discount/premium of the forward contract OR change in time value of the option. For a forward contract hedge of a foreign currency (denominated asset) - If there is a foreign contract premium, the company would receive MORE through the forward sale of foreign currency than if it had received foreign currency at the date of sale. The company would allocate the forward contract premium as an increase in net income. For an option hedge of a foreign currency (denominated asset) - If the spot rate had exceeded the strike price, the company would allow its option to expire unexercised. Instead it would sell the foreign currency at the spot rate on that date and the FV of the foreign currency option would be 0 For a hedge of a foreign currency (denominated firm commitment) – can be considered a cash flow hedge OR a FV hedge, however, FV is much more appealing. When a firm commitment is hedged using a derivative financial instrument, hedge accounting requires explicit recognition on the balance sheet at FV the derivative financial instrument AND the firm commitment. When a forward contract is used as the hedging instrument, the FV of the firm commitment is determined through reference to changes in the forward exchange rate. When a foreign currency option is the hedging instrument, changes in the spot exchange rate are used to determine FV of the firm commitment. Objective of hedge accounting is for the loss on the firm commitment (or the other two *above*) will offset the gain on the forward contract such that the impact on net income is zero. Downloaded by Titus Tally (tallyatoror@gmail.com) lOMoARcPSD|21549393 Accounting for a hedge of a forecasted transaction differs from accounting for a hedge of a foreign currency firm commitment in 2 ways:::: 1) no recognition of the forecasted transaction or gains/losses on forecasted transaction. 2) company reports the hedging instrument at FV and recognizes changes in OCI There are many different corporate strategies (corporate policies) regarding hedging foreign exchange risk IFRS and GAAP are largely converged on reporting hedging financial instruments GAAP generally does not permit a nonderivative financial instrument to be used as a hedging instrument. Under IFRS, nonderivative financial instruments classified at FV through profit/loss are permitted to be used as hedging instruments for all types of risks Downloaded by Titus Tally (tallyatoror@gmail.com)
