13 ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS AND HEDGING FOREIGN EXCHANGE RISK

Learning Objectives

1. Distinguish between the terms measured and denominated. 2. Describe a foreign currency transaction. 3. Understand some of the more common foreign currency transactions. . !dentify three stages of concern to accountants for foreign currency transactions and e"#$ain the ste#s used to trans$ate foreign currency transactions for each stage. %. Describe a forward e"change contract. &. '"#$ain the use of forward contracts as a hedge of an unrecogni(ed firm commitment. ). !dentify some of the common situations in which a forward e"change contract can be used as a hedge. *. Describe a derivative instrument and understand how it may be used as a hedge. +. '"#$ain how e"change gains and $osses are re#orted for fair va$ue hedges and cash f$ow hedges.

In the News: Lands, 'nd re#orted ho$ding net outstanding foreign currency forward contracts tota$ing -)) mi$$ion and o#tions tota$ing -1& mi$$ion. !n addition. based on antici#ated cash f$ows and outf$ows over the ne"t 12 months. if the U/ currency strengthens 101 re$ative to a$$ other currencies. Lands, 'nd,s fisca$ 2002 cash f$ows cou$d be adverse$y affected by -0.) mi$$ion. 1

2any com#anies in the United /tates engage in internationa$ activities such as e"#orting or im#orting goods. estab$ishing a foreign branch. or ho$ding an e3uity investment in a foreign com#any. 4ecording and re#orting #rob$ems are encountered when transactions with a foreign com#any or the financia$ statements of a foreign branch or investee are measured in a currency other than U./. currency. 5ransactions to be sett$ed in a foreign currency must be trans$ated 6 that is. e"#ressed in do$$ars 6 before they can be aggregated with the domestic transactions of the U./. firm. 7hen a foreign branch or investee maintains its accounts and #re#ares its financia$ statements in terms of the currency of the country in which it is domici$ed. the accounts must be trans$ated from the foreign currency into do$$ars before financia$ statements for the combined entity are #re#ared.
1

Lands, 'nd fisca$ 2001 8nnua$ 4e#ort.

5rans$ation is necessary because usefu$ financia$ re#orts cannot be #re#ared unti$ a$$ transactions and account ba$ances are stated in a common unit of currency. !n addition. the receivab$es or #ayab$es denominated in foreign currencies are subject to gains and $osses because of changes in e"change rates. 8$so. firms ma9e commitments or have budgeted forecasted transactions denominated in foreign currencies that are a$so subject to gains and $osses from changes in e"change rates. 2any com#anies resort to hedging strategies using derivatives to minimi(e the im#act of these e"change rate changes on their financia$ statements. Derivative instruments can be characteri(ed by vo$ati$e mar9et va$ues and the firm,s e"#osure to ris9 is usua$$y not ade3uate$y re#resented by the amount re#orted in the boo9s :carrying va$ue; because of the great #otentia$ for future $osses :and gains;. 5hus. the accounting for these instruments is im#ortant but not an easy one. <ecause of the wides#read invo$vement of U./. com#anies in foreign activities. accountants must be fami$iar with the #rob$ems associated with accounting for those activities. 5he e"#ansion of internationa$ business has been of #articu$ar concern to accountants because of deve$o#ments in the wor$dwide monetary system. 5hese deve$o#ments. cou#$ed with the e"istence of a number of acce#tab$e methods of trans$ating foreign financia$ statements and re#orting

gains or $osses on foreign currency f$uctuations. have drawn the attention of the =8/< at various #oints in time. 2 5his cha#ter inc$udes a discussion of the nature and use of e"change rates in the trans$ation #rocess. as we$$ as the accounting standards a##$ied in the trans$ation of transactions measured in a foreign currency. 8$so. an introduction to hedge accounting is #rovided. 5he trans$ation of accounts maintained in terms of a foreign currency is discussed in the ne"t cha#ter.

EXCHANGE RATES - MEANS OF TRANSLATION

5ransactions that are to be sett$ed in a foreign currency and financia$ statements of an affi$iate maintained in terms of a foreign currency are trans$ated :converted; into do$$ars by mu$ti#$ying the number of units of the foreign currency by a direct e"change rate. 5hus. translation is the #rocess of e"#ressing monetary amounts that are stated in terms of a foreign currency in the currency of the re#orting entity by using an a##ro#riate e"change rate. 8n exchange rate is the ratio between a unit of one currency and the amount of another currency for which that unit can be e"changed at a #articu$ar time.

5he discussion in this cha#ter is based #rimari$y on the accounting #rescribed in both SFAS No. 52, =oreign >urrency 5rans$ation :?orwa$9. >onn.@ =8/<. 1+*1;. and SFAS No. 133 . 8ccounting for Derivative !nstruments and Aedging 8ctivities :?orwa$9. >onn.@ =8/<. 1++*;.

8 direct exchange quotation is one in which the e"change rate is 3uoted in terms of how many units of the domestic currency can be converted into one unit of foreign currency . =or e"am#$e. a direct 3uotation of U./. do$$ars for one <ritish #ound of 1.%1) means that -1.%1) cou$d be e"changed for one <ritish #ound. 5o trans$ate #ounds into do$$ars. the number of #ounds is mu$ti#$ied by the direct e"change rate e"#ressed in do$$ars #er #ound. '"change rates are a$so stated in terms of converting one unit of the domestic currency into units of a foreign currency. which is ca$$ed an indirect quotation. !n the e"am#$e above. one U./. do$$ar cou$d be converted into .&%+2 #ounds :1.00B1.%1);. 5o trans$ate #ounds into do$$ars. the number of #ounds cou$d a$so be divided by the indirect e"change rate. '"change rates may be 3uoted either as a s#ot rate or a forward rate. 5he spot rate is the rate currencies can be e"changed today. 5he forward or future rate is the rate the currencies can be e"changes at some future date. 5he forward rate is an e"change rate estab$ished at the time a forward e"change contract is negotiated. 8 forward exchange contract is a contract to e"change at a s#ecified rate :the forward rate; currencies of different countries on a sti#u$ated future date. <efore the currencies are e"changed. the s#ot rate may move above or be$ow the contracted forward e"change rate. but this has no effect on the forward rate estab$ished when the forward e"change contract was negotiated. !n both the s#ot and

forward mar9ets. a foreign e"change trader #rovides a 3uotation for buying :the bid rate; and a 3uotation for se$$ing :the offer rate; foreign currency. 5he traderCs buying rate wi$$ be $ower than the 3uoted se$$ing rate. and the s#read between the two rates is #rofit for the trader. '"change rates are re#orted dai$y in terms of both direct and indirect 3uotations :see !$$ustration 1361; in the financia$ section of many news#a#ers.

!?/'45 !LLU/5485!O? 1361 A'4'

<efore the 1+)0s. rates of e"change of free mar9et countries were contro$$ed to some e"tent by member countries of the !nternationa$ 2onetary =und. 2ost of the member countries agreed to estab$ish e"change rates in terms of U./. do$$ars and go$d. 8$though the actua$ rate was free to f$uctuate. the countries that estab$ished official or fixed rates agreed to maintain the actua$ rate within 11 :21 after 1+)1; of the officia$ rate by buying or se$$ing U./. do$$ars or go$d. <ecause of #ressure on the do$$ar. the United /tates in 1+)1 sus#ended its commitment to convert do$$ars into go$d at -3% #er ounce. 5he re$ationshi# between major currencies is now determined $arge$y by su##$y and demand factors. ca$$ed floating rates. 8s a resu$t. significant rea$ignments have occurred between the currencies of various countries over a re$ative$y short #eriod of time.

&

=$oating rates increase the ris9 to com#anies doing business with a foreign com#any.3 8fter a rate change occurs. a$$ transactions are conducted at the new rate unti$ the ne"t change occurs. <ecause the amount to be received or #aid is affected by a change in e"change rates. there is a direct economic im#act on a com#anyCs o#erations. =or e"am#$e. a #ayab$e to be sett$ed in 100.000 yen has a do$$ar e3uiva$ent va$ue of - 3 when the direct e"change rate is -.00 3 . 8n increase in the va$ue of the yen to -.00&2% wou$d resu$t in an increase in the #ayab$e to -&2%. 5he se$ection of an e"change rate to be used in the trans$ation #rocess is com#$icated by the fact that some countries maintain mu$ti#$e e"change rates. 5he government of a country may maintain officia$ rates that differ from the mar9et6determined rate. de#ending on the nature of the transaction. =or e"am#$e. a government may estab$ish a set e"change rate for DDessentia$ goods and servicesCC and a$$ow the e"change rate for nonessentia$ goods and services to f$oat.

5he conce#ts of economic e"#osure and accounting e"#osure are not identica$. 8 com#any,s economic e"#osure may be broad$y defined as the uncertainty associated with the effect of e"change rate changes on the e"#ected cash f$ows of the re#orting entity. 8ccounting e"#osure. in contrast. is direct$y re$ated to accounts that are trans$ated at the current e"change rate.

In the News: 5he do$$ars strength is giving U./. industry headaches. 5he strengthening of the U./. do$$ar as com#ared to the currency of other countries is #ricing U./. goods out of the foreign mar9et and is ma9ing com#etition at home from im#orters fierce. Eenera$ 2oters chief financia$ officer states that the strong do$$ar is fran9$y destroying the manufacturing ca#abi$ity of the country. Over -1 tri$$ion worth of 8merican greenbac9. Fa#anese yen. and 'uro#ean euros and other currencies change hands dai$y. 5he do$$ar was hitting a 1%6year high in Fu$y 2001 against a mar9et bas9et of various currencies.

MEASURED VERSUS DENOMINATED

5ransactions are norma$$y measured and recorded in terms of the currency in which the re#orting entity #re#ares its financia$ statements. 5his currency is usua$$y the domestic currency of the country in which the com#any is domici$ed and is ca$$ed the reporting currency . !n subse3uent i$$ustrations the U./. do$$ar is assumed to be the re#orting currency of U./.6 based firms. 8ssets and $iabi$ities are denominated in a currency if their amounts are fi"ed in terms of that
Leaf-Chronicle . *B2)B01. Do$$ars strength giving U./. industry. <ush team headaches. by 2artin >rutsinger. #. 83.

currency. 5hus. a transaction between two U./. com#anies re3uiring #ayment of a fi"ed number of do$$ars is both measured and denominated in do$$ars. !n a transaction between a U./. firm and a foreign com#any. the two #arties usua$$y negotiate whether the sett$ement is to be made in do$$ars or in the domestic currency of the foreign com#any. !f the transaction is to be sett$ed by the #ayment of a fi"ed amount of foreign currency. the U./. firm measures the receivab$e or #ayab$e in do$$ars. but the transaction is denominated in the s#ecified foreign currency. 5o the foreign com#any. the transaction is both measured and denominated in its domestic currency.

FOREIGN CURRENCY TRANSACTIONS

8 transaction that re3uires #ayment or recei#t :sett$ement; in a foreign currency is ca$$ed a foreign currency transaction . 8 transaction with a foreign com#any that is to be sett$ed in do$$ars is not a foreign currency transaction to a U./. firm because the number of do$$ars to be received or #aid to sett$e the account is fi"ed and remains unaffected by subse3uent changes in the e"change rate. 5hus. a transaction of a U./. firm with a foreign entity to be sett$ed in do$$ars is accounted for in the same manner as if the transaction had been with a U./. com#any.

8 foreign currency transaction wi$$ be sett$ed in a foreign currency. and the U./. firm is e"#osed to the ris9 of unfavorab$e changes in the e"change rate that may occur between the date the transaction is entered into and the date the account is sett$ed. =or e"am#$e. assume that a U./. firm #urchased goods from a =rench firm and the U./. firm is to sett$e the $iabi$ity by the #ayment of 20.000 francs. 5he =rench firm wou$d measure and record the transaction as norma$ because the bi$$ing is in its re#orting currency. <ecause the bi$$ing is in a foreign currency :denominated in francs;. the U./. firm must trans$ate the amount of the foreign currency #ayab$e into do$$ars before the transaction is entered in its accounts. 8n increase :decrease; in the direct e"change rate wi$$ increase :decrease; the number of do$$ars re3uired to buy the fi"ed number of francs needed to sett$e the foreign currency $iabi$ity. 5he !re"t e#"$a%&e rate is often said to be increasing. or the

foreign currency unit to be strengthening. if more do$$ars are needed to ac3uire the foreign currency units. !f fewer do$$ars are needed. then the foreign currency is wea9ening or de#reciating in re$ation to the do$$ar :the direct e"change rate is decreasing;. >onsider the fo$$owing information. Direct '"change 4ates Gen /trengthens <eginning of year Gen 7ea9ens -1 H 1 Gen

-1 H 1 Gen

10

'nd of year

-2 H 1 Gen

-.% H 1 Gen

7ou$d a U/ com#any ho$ding a -10.000 receivable denominated in Gen #refer the Gen to strengthen or wea9enI !n this case. the com#any #refers a strengthened Gen because more do$$ars wou$d be received and an e"change gain wou$d be incurred. !f the transaction invo$ved a a!able denominated in Gen. the firm wou$d have incurred an e"change rate $oss because more do$$ars wou$d have to be #aid. 8s wi$$ be shown $ater. because firms cannot #erfect$y #redict changes in e"change rates. the U./. firm may hedge. that is. #rotect itse$f against an unfavorab$e change in the e"change rate by using derivatives. !n this cha#ter. we discuss the accounting for im#orting or e"#orting of goods. 5hen we #rovide an introduction to hedging the ris9 of foreign currency rate changes.

In the News: /ome currencies have undergone major changes in com#arison to the U/ do$$ar. >onsider the changes in the fo$$owing direct e"change rates between the U/ do$$ar and the <ra(i$ian 4ea$ and the 8ustra$ian do$$ar@ U/ Do$$ars to >onvert to =oreign >urrency

11

Fanuary . 20008ugust 2*. 2001 >hange 8ustra$ian Do$$ar <ra(i$ian 4ea$ -0.&%&% -0.% 3% -0.%2+3 -0.3+0)

Jercent

1+1 2*1

!n both cases. the U/ do$$ar has strengthened re$ative to the other currencies. One way to consider whether a currency has strengthened or wea9ened is to consider the direct e"change rate as the cost of the foreign currency. =or instance. when the direct e"change rate increases. the currency is chea#er so the currency has wea9ened re$ative to the U/ do$$ar.

I'port!%& or E#port!%& o( Goo s or Ser)!"es

Jrobab$y the most common form of foreign currency transaction is the e"#orting or im#orting of goods or services. !n each unsett$ed foreign currency transaction. there are three stages of concern to the accountant. 5hese stages and the a##ro#riate e"change rate to use in trans$ating accounts denominated in units of foreign currency :e"ce#t for forward e"change contracts; are as fo$$ows@

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1. At the date the transaction is first recognized in conformity with GAAP. 'ach asset. $iabi$ity. revenue. e"#ense. gain. or $oss arising from the transaction is measured and recorded in do$$ars by mu$ti#$ying the units of foreign currency by the current e"change rate. :5he current exchange rate is the s#ot rate in effect on a given date.; 2. At each balance sheet date that occurs between the transaction date and the settlement date . 4ecorded ba$ances that are denominated in a foreign currency are adjusted using the s#ot rate in effect at the ba$ance sheet date and the transaction gain or $oss is recogni(ed current$y in earnings. 3. At the settlement date. !n the case of a foreign currency #ayab$e. a U./. firm must convert U./. do$$ars into foreign currency units to sett$e the account. whereas foreign currency units received to sett$e a foreign currency receivab$e wi$$ be converted into do$$ars. 8$though trans$ation is not re3uired. a transaction gain or $oss is recogni(ed if the number of do$$ars #aid or received u#on conversion does not e3ua$ the carrying va$ue of the re$ated #ayab$e or receivab$e.

Using the s#ot rate to trans$ate foreign currency receivab$es and #ayab$es at each measurement date provides an estimate of the number of dollars to be received or to be paid to settle the

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account. ?ote that both gains and $osses are resu$t in adjustments to the receivab$e or #ayab$e. a##ro"imating a form of current va$ue accounting. 5he increase or decrease in the e"#ected cash f$ow is genera$$y re#orted as a foreign currency transaction gain or loss. sometimes referred to as an exchange gain or loss. in determining net income for the current #eriod. %

Importing Transaction* 5o i$$ustrate an im#orting transaction. assume that on December 1. 2003. a U./. firm #urchased 100 units of inventory from a =rench firm for %00.000 euros to be #aid on 2arch 1. 200 . 5he firmCs fisca$ year6end is December 31. 8ssume further that the U./. firm did not engage in any form of hedging activity. 5he s#ot rate for euros :-Beuro; at various times is as fo$$ows@

/#ot 5ransaction date 6 December 1. 2003 <a$ance sheet date 6 December 31. 2003 /ett$ement date 6 2arch 1. 200 4ate -1.0% 1.0* 1.0)

5he U./. firm wou$d #re#are the fo$$owing journa$ entry on December 1. 2003@

One e"ce#tion to this treatment of transaction gains and $osses wou$d invo$ve intercom#any transactions that are of a $ong6term financing or ca#ita$ nature between an investor and an investee that is conso$idated. combined. or accounted for by the e3uity method. 5here are accounted for as a com#onent of stoc9ho$ders, e3uity.
%

Dec. 1

Jurchases 8ccounts Jayab$e :%00.000 euros "

%2%.000

%2%.000

-1.0%Beuro; 8t the ba$ance sheet date. the accounts #ayab$e denominated in foreign currency is adjusted using the e"change rate :s#ot rate; in effect at the ba$ance sheet date. 5he entry is

Dec. 31

5ransaction Loss 8ccounts Jayab$e

1%.000

1%.000 -% 0.0 00 %2%.00 0 1%.000

8ccounts #ayab$e va$ued at 12B31 :%00.000 euros " -1.0*Beuro; 8ccounts #ayab$e va$ued at 12B1 :%00.000 euros " -1.0%Beuro; 8djustment to accounts #ayab$e needed or K%00.000 euros " :-1.0* 6 -1.0%; H -1%.000L

!f the e"change rate had dec$ined be$ow -1.0%. & for e"am#$e to -1.03. the U./. firm wou$d have recogni(ed a gain of -10.000 since it wou$d have ta9en on$y -%1%.000 :%00.000 euros " -1.03; to sett$e the -%2%.000 recorded $iabi$ity. <efore the sett$ement date. the U./. firm must buy euros in order to satisfy the $iabi$ity. 7ith a change in the e"change rate to -1.0).
&

5hroughout this cha#ter. we often state the e"change rate sim#$y in do$$arsM thus a rate of -1.0% means -1.0% #er unit of foreign currency :euro in this case;.

1%

the firm must #ay -%3%.000 on 2arch 1. 200 . to ac3uire the %00.000 euros. 5he journa$ entry to record the sett$ement is@

2ar. 1 8ccounts Jayab$e 5ransaction Eain >ash :%00.000 euros " -1.0)Beuro;

% 0.000

%.000 %3%.000

Over the three6month #eriod. the decision to de$ay ma9ing #ayment cost the firm -10.000 :the -%3%.000 cash #aid $ess the origina$ #ayab$e amount of -%2%.000;. 5his net amount was recogni(ed as a $oss of -1%.000 in 2003 and a gain of -%.000 in 200 .

?ote in the e"am#$e above that at December 31. the ba$ance sheet date. a transaction $oss was recogni(ed on the o#en account #ayab$e. /uch a $oss is considered unrea$i(ed because the account has not yet been sett$ed or c$osed. 7hen an account #ayab$e :or receivab$e; is sett$ed or c$osed. a transaction gain or $oss on the sett$ement is considered rea$i(ed. 5he =8/< reasoned that users of financia$ statements are best served by re#orting the effects of e"change rate changes on a firmCs financia$ #osition in the accounting #eriod in which they occur. even though they are unrea$i(ed and may reverse or #artia$$y reverse in a subse3uent #eriod. as in the i$$ustration above. 5his #rocedure is critici(ed. however. because under E88J. gains are

1&

not ordinari$y re#orted unti$ rea$i(ed and because the recognition of unrea$i(ed gains and $osses resu$ts in increased earnings vo$ati$ity.

Exporting Transaction

?ow assume that the U./. firm so$d 100

units of inventory for %00.000 euros to a =rench firm. 8$$ other facts are the same as those for the im#orting transaction. 5he journa$ entries to record this e"#orting transaction on the boo9s of the U./. >om#any are@

De"e'+er 1, -..3 - Date o( Tra%sa"t!o%

8ccounts 4eceivab$e :%00.000 euros " -1.0%; /a$es

%2%.000

%2%.000

De"e'+er 31, -..3 - /a0a%"e S$eet Date

8ccounts 4eceivab$e :-% 0.0006-%2%.000; 1%.000 5ransaction Eain 1%.000 5he receivab$e va$ued at 12B1. %00.000 euros " -1.0* H -% 0.000 5he receivab$e va$ued at 12B31. %00.000 euros " -1.0% H -%2%.000 >hange in the va$ue of the receivab$e - 1%.000

1)

Mar"$ 1, -..1 - Sett0e'e%t Date

>ash :%00.000 euros " -1.0); 5ransaction Loss 8ccounts 4eceivab$e

%3%.000 %.000

% 0.000

8 com#arison of the entries to record the e"#orting transaction with those #re#ared to record an im#orting transaction revea$s that a movement in the e"change rate has an o##osite effect on the com#anyCs re#orted income. 5hat is. the increase in the e"change rate from -1.0% to -1.0* resu$ted in a transaction gain in the case of a foreign currency receivab$e. whereas a transaction $oss was re#orted in the case of a foreign currency #ayab$e. 7hen the e"change rate decreased from -1.0* to -1.0). a transaction $oss was re#orted on the e"#osed receivab$e. whereas a transaction gain was re#orted on the e"#osed #ayab$e. 5hus. one too$ avai$ab$e to management to hedge a #otentia$ $oss on a foreign currency receivab$e is to enter into a transaction to estab$ish a $iabi$ity to be sett$ed in the same foreign currency. /imi$ar$y. a $iabi$ity to be sett$ed in units of a foreign currency can be hedged by entering into a receivab$e transaction denominated in the same foreign currency.

5hese re$ationshi#s are summari(ed be$ow.

1*

<a$ance /heet '"#osed 8ccount !ncrease in direct e"change rate !m#orting transaction Jayab$e '"#orting transaction 4eceivab$ 'ffect on <a$ance 4e#orted !ncrease !ncrease !ncome /tatement 'ffect 5ransaction $oss 5ransaction gain Decrease Decrease 5ransaction gain 5ransaction $oss

e Decrease in direct e"change rate !m#orting transaction Jayab$e '"#orting transaction 4eceivab$ e

Aow shou$d a transaction gain or $oss be re#ortedI !n the #revious e"am#$es. the do$$ar amount recorded in the /a$es account and the Jurchases account was determined by the e"change rate #revai$ing at the transaction date. 8djustments to the foreign currency denominated receivab$e or #ayab$e were recorded direct$y to transaction gain or $oss. Under this a##roach. referred to as the two! transaction approach . the sa$e or #urchase is viewed as a transaction se#arate and distinct from the financing arrangement. 5hus. the transaction gain or $oss does not resu$t from an o#erating decision to buy or se$$ goods or services in a foreign mar9et. but from a financia$ decision to de$ay the #ayment or recei#t of foreign

1+

currency and not to hedge the e"#osed receivab$e or #ayab$e against #ossib$e unfavorab$e currency rate changes. 8n a$ternative view that was rejected by the =8/< considers the initia$ transaction and sett$ement to be one transaction. /u##orters of this method contend that the initia$ transaction is incom#$ete and the amounts recorded are estimates unti$ such time as the tota$ sacrifice from the #urchase :units of domestic currency #aid; or the tota$ benefits from the sa$e :units of domestic currency received; are 9nown. Under this view. transaction gains or $osses shou$d be accounted for as an adjustment to the cost of the asset #urchased or to the revenue recorded in a sa$es transaction. 5here is an obvious im#$ementation #rob$em with this method when the sa$e or #urchase is recorded in one fisca$ #eriod and the recei#t or #ayment occurs in another #eriod.

In the News: Lands, 'nd re#orted in its fisca$ 2000 annua$ re#ort that foreign currency transaction gains and $osses are re#orted in Nother income and e"#enses., 5hey a$so stated that -3.* mi$$ion of $osses were re#orted as Nother e"#ense, on the income statement in fisca$ 1++* whi$e the amounts of $osses in fisca$ years 1+++ and 2000 were -1.+ mi$$ion and -0.* mi$$ion res#ective$y.

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He &!%& Fore!&% E#"$a%&e Rate R!s2

"erivative Instruments 8fter the issuance of SFAS No. 52 on foreign currency trans$ation. the =8/< became aware that firms were using creative instruments with increasing fre3uency to accom#$ish their desired hedging. many of which were not inc$uded in the sco#e of SFAS No. 52. >onse3uent$y. the =8/< issued another standard. SFAS No. 133, which e"#anded the sco#e of accounting for hedges. Under these new guide$ines. certain designated hedges are accounted for using $e &e a""o3%t!%& . 5his wi$$ be e$aborated u#on $ater. 8 derivative instrument may be defined as a financia$ instrument that by its terms at ince#tion or u#on occurrence of a s#ecified event. #rovides the ho$der :or writer; with the right :or ob$igation; to #artici#ate in some or a$$ of the #rice changes of another "n#erl!in$ va$ue of measure. but does not re3uire the ho$der to own or de$iver the under$ying va$ue of measure. 5hus its va$ue is #erive# from the under$ying va$ue of measure. 5he under$ying va$ue of measure may be one or more referenced financia$ instruments. commodities. or other assets. or other s#ecific items to which a rate. an inde" of #rices. or another mar9et indicator is a##$ied. !n most cases. derivatives differ from traditiona$ instruments :stoc9s and bonds. for e"am#$e; in that

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the eventua$ do$$ar amount of the #erformance is de#endent u#on subse3uent va$ue changes. rather than u#on a static measure. and the eventua$ outcome is necessari$y favorab$e to one of the #arties invo$ved and unfavorab$e to the other. 5he cash #ayments invo$ved are made at the end of the contract rather than at its ince#tion for the most #art. and the instruments have conse3uent$y been treated in the #ast in many cases as a ty#e of off6ba$ance sheet agreement. !n SFAS No. 133. the =8/< identified the fo$$owing as 9eystones for the accounting for derivative instruments@

O Derivative instruments re#resent rights or ob$igations that meet the definitions of assets or $iabi$ities and shou$d be re#orted in financia$ statements. O =air va$ue is the most re$evant measure for financia$ instruments and the on$y re$evant measure for derivative instruments. O On$y items that are assets or $iabi$ities shou$d be re#orted as such in the ba$ance sheet. O /#ecia$ accounting for items designated as being hedged shou$d be #rovided on$y for 3ua$ifying items. as demonstrated by an assessment of the e"#ectation of effective offsetting changes in fair va$ues or cash f$ows during the term of the hedge for the ris9 being hedged.

22

8$though over a thousand different ty#es of derivative instruments have been created. they are sometimes se#arated into the fo$$owing two broad categories@ =orward6based derivatives. such as forwards. futures. and swa#s. in which either #arty can otentiall! have a favorab$e or unfavorab$e outcome. but not both simu$taneous$y :e.g.. both wi$$ not simu$taneous$y have favorab$e outcomes;. O#tion6based derivatives. such as interest rate ca#s. o#tion contracts. and interest rate f$oors. in which on$y one #arty can #otentia$$y have a favorab$e outcome and it agrees to a #remium at ince#tion for this #otentia$ityM the other #arty is #aid the #remium. and can #otentia$$y have on$y an unfavorab$e outcome. Derivatives are recogni(ed the in the ba$ance sheet at their fair va$ue. Determination of that va$ue is based u#on the changes in the under$ying va$ue of measure :commodity. financia$ instrument. inde". etc.; and assessment of the e"#ected future cash f$ows. 5he resu$t is a #ayab$e #osition for one of the invo$ved #arties and a receivab$e #osition for the other.

For4ar

E#"$a%&e Co%tra"ts

23

7hi$e hedging can be accom#$ished with many different ty#es of derivatives. in this cha#ter we focus main$y on hedging with the use of forward contracts. Later in this cha#ter. we i$$ustrate the use of o#tions as a hedging device.

8 forward e"change contract :forward contract; is an agreement to e"change currencies of two different countries at a s#ecified rate :the forward rate; on a sti#u$ated future date. 8t the ince#tion of the contract. the forward rate norma$$y varies from the s#ot rate. The difference between the two rates is referred to as a discount 5premium6 if the forward rate is less than 5greater than6 the spot rate. as shown here.

'"chan ge =orward rate 4ate -.1)%

.00) #remium .00& discount

/#ot rate

.1&*

=orward rate 7$!"$ 2!% o( (or4ar

.1&2

"o%tra"t to "$oose8

!f the item being hedged is a foreign currency acco"nt a!able. the firm shou$d use a (or4ar "o%tra"t to p3r"$ase t$e (ore!&%

"3rre%"9 on the date the #ayab$e becomes due. 5his im#$ies that the firm can $oc9 in the cost of ac3uiring the foreign currency on the date the forward contract is ac3uired and subse3uent changes in the e"change rate wi$$ not affect the amount the firm has to #ay. One the other hand. if the item being hedged is a foreign currency acco"nts receivable. the firm shou$d use a (or4ar "o%tra"t to se00 t$e

(ore!&% "3rre%"9 on the date the receivab$e is e"#ected to be co$$ected.

T$e )a03at!o% o( a (or4ar

"o%tra"t 5!%tr!%s!" )ers3s t!'e

)a03e6: =orward contracts are va$ued on a net basis. =or e"am#$e. consider the fo$$owing. /u##ose on Fanuary 1. 200%. you obtain a one6 year forward contract to se$$ 10.000 >anadian do$$ars using the December 31. 200% forward rate of -1.%0. 5his forward rate is the best guess to estimate what the s#ot rate wi$$ be on December 31. 200%. 5herefore on Fanuary 1. 200%. you be$ieve that 10.000 >anadian do$$ars wi$$ be worth -1%.000. 5he forward contract $oc9s in the amount of cash you wi$$ receive. -1%.000. <ut since on Fanuary 1 this is a$so the e"#ected cost to obtain >anadian do$$ars. the va$ue of the forward contract is (ero on this date and it wi$$ remain (ero unti$ the

2%

forward rate for December 31. 200% sett$ement changes. 8ssume the fo$$owing additiona$ information@

=orward 4ate Date 1B1B200% )B1B200% 12B31B200% /#ot 4ate -1. 0 -1. 3 ;1*11 =or 12B31B0% /ett$ement Jremium ;1*<. -1. * -1. -0.10 -0.0% -0.00

7ith this forward contract. the amount of do$$ars to be received is fi"ed at -1%.000. but the amount #aid to ac3uire the foreign currency a$ters with changes in the e"change rate. 7hat conditions wi$$ cause the contract to be beneficia$ to the firmI !f the future s#ot rate fa$$s be$ow the forward rate on the forward contract. the firm wi$$ benefit. Loo9ing at the data in retros#ect. this is a va$uab$e forward contract for the firm because the forward contract $oc9s in the cash received at the -1.%0 rate but the firm can #urchase the currency on the sett$ement date at a s#ot rate of -1. other words. the firm #ays -1. :see the numbers in bo$d;. !n

to get -1.%0. <ut on the date the

forward contract is ac3uired. there is no guarantee that the firm wi$$ benefit from the contract :i.e. the s#ot rate on the sett$ement date might increase above -1.%0;.

2&

?ote that as the sett$ement date for the forward contract a##roaches. the forward rate converges to the settle%ent #ate s#ot rate. 8$so. note that the #remium changes over time but eventua$$y wi$$ become (ero on the sett$ement date. 7hat is the )a03e o( t$e (or4ar on Fu$y 1. 200%I 5he amount of cash received from the

forward is fi"ed at -1%.000. but now the forward rate for December 31 sett$ement has changed to -1. *. 5his im#$ies that we cou$d enter into a contract to #urchase the 10.000 >anadian do$$ars for -1 .*00. 5hus the va$ue of the forward has increased by -200 :the change in the forward rate;. /imi$ar$y. on the sett$ement date. the forward rate dro#s to -1. . ?ow the 10.000 >anadian do$$ars can be #urchased for

-1 . 00 and the forward contract has increased in va$ue by another - 00. 5he tota0 "$a%&e !% )a03e o( t$e (or4ar "o%tra"t from the

ince#tion to the sett$ement date can be com#uted by ta9ing the difference between the origina$ forward rate of -1.%0 and the s#ot rate on the sett$ement date :-1. ;. !n this e"am#$e the forward ;:10.000;L.

contract increased in va$ue by -&00 or K:-1.%06-1.

?otice that the initia$ #remium is -0.10 and that the s#ot rate increased over the year by -0.0 . 5he difference between these two e3ua$s the change in the va$ue of the forward contract over the forward contract :in this case the #remium re#resents a gain and the change in the s#ot rate is a $oss;. /ince the #remium wi$$ eventua$$y be (ero on the sett$ement date. the change in the #remium :or discount;

2)

is 9nown as the ti%e ele%ent of the change in va$ue of the forward contract. 5he change in the s#ot rate is considered the change in the intrinsic val"e of the forward. 5hus the tota$ change in va$ue is e3ua$ to the sum of the intrinsic va$ue and the time va$ue :9ee# in mind that each of these changes in va$ue can be #ositive or negative;. 5his is summari(ed be$ow.

=orward 4ate =or 12B31B0% Date /#ot 4ate 1B1B200% -1. 0 )B1B200% -1. 3 12B31B200%-1. /ett$ement -1.%0 -1. * -1. Jremium -0.10 -0.0% -0.00

>hange in Pa$ue:a; 5ota$ !ntrinsic 5ime Pa$ue Pa$ue Pa$ue

-0.02 :-0.03; -0.0% -0.0 :-0.01; -0.0%

5ota$ change in rates and #remium =oreign currency :>anadian do$$ars; 5ota$ change in va$ue in do$$ars :a;

-0.0& :-0.0 ; -0.10 10.000 -&00 10.000 10.000 :- 00; -1.000

:a; Definitions 5he tota$ change in the va$ue of the forward contract H the change in the forward rates mu$ti#$ied by the foreign currency. 5he change in the intrinsic va$ue of the forward contract H the change in the s#ot rate mu$ti#$ied by the foreign currency. and

2*

5he change in the time va$ue of the forward contract H the change in the #remium mu$ti#$ied by the foreign currency.

7$9

o (or4ar

rates

!((er (ro' spot rates8

=orward rates for the #urchase or sa$e of foreign currency. on some future date. can be higher. $ower. or e3ua$ to the current s#ot rate on that currency. =or instance. if the current s#ot rate for the e"change of #esos and do$$ars is -0.+%. the forward rate to e"change #esos for do$$ars in one year might be higher or $ower than -0.+% :it is un$i9e$y to be e3ua$;. 7hy do these rates differI 5he answer to this 3uestion invo$ves differences in interest rates between the two countries. /u##ose that the one6year forward rate and the current s#ot rate are e3ua$ but that in the U/ the cost of borrowing money for one year is %1 whi$e in 2e"ico the cost of borrowing is 101. 8 U/ com#any cou$d ta9e -+.%00 and convert this amount into 10.000 #esos :at today,s s#ot rate; and invest this amount in 2e"ico at 101 for one year. 5his wou$d accumu$ate to 11.000 #esos. 8t the same time. the firm cou$d buy a forward contract to se$$ 11.000 #esos at the forward rate of -0.+% for -10. %0. 8ssuming investments in the U/ and 2e"ico had e3ua$ ris9s and ta" characteristics. this wou$d amount to a ris96free %1 return :a 101 return in 2e"ico $ess %1 that cou$d have been earned in the U/;. !nvestors wou$d commit $arge sums of money to

2+

this investment. !n our e"am#$e. this #rocess wou$d tend to drive u# U/ interest rates. drive down 2e"ican interest rates. and $ower the forward rate. 5he e3ui$ibrium is 9nown as interest rate parity. 5herefore.

#orward rate H

(1 + i Mexico ) ( spot rate )

(1 + iUS )

where i re#resents the interest rate and the su#erscri#t re#resents the country. 5herefore. the forward rate that guarantees interest rate #arity is -0.+0&*. or

=orward rate H :1.0%B1.10;:-0.+%; H -0.+0&*.

5hen in the e"am#$e above. the 11.000 #esos cou$d on$y be converted into -+.+)% enab$ing the U/ com#any to earn on$y %1 interest. 5herefore. if the interest rate in the foreign country is higher than the rates in the U/. the forward rate wi$$ be below the current s#ot rate. !f the interest rate in the foreign country is lower than the rates in the U/. the forward rate wi$$ be above the current s#ot rate.

30

5here are a number of business situations in which a firm may desire to ac3uire a forward e"change contract. 5he uses of forward contracts inc$ude the fo$$owing@

1* He &es a. For4ar "o%tra"ts 3se as a $e &e o( a (ore!&% "3rre%"9

tra%sa"t!o%. 5hese inc$ude im#orting and e"#orting transactions denominated in foreign currency. 5hese hedges do not 3ua$ify for hedge accounting under =8/< 133 because the foreign e"change gains and $osses are a$ready re#orted in earnings under =8/< %2. and the #ayab$es and receivab$es are re#orted at mar9et va$ue on the ba$ance sheet. b. For4ar "o%tra"ts 3se as a $e &e o( a% unrecognized

firm commitment :a (a!r-)a03e $e &e;. 8n e"am#$e of an unrecogni(ed firm commitment wou$d be when the firm enters into a contract to #urchase an asset in two months for a fi"ed amount of foreign currency. /ince the e"change rate may change over the ne"t two months. the firm might use a forward contract to hedge the #otentia$ change in va$ue of the #urchased asset. Aedge accounting ru$es a##$y. <oth the change in va$ue of the hedge and the va$ue of the hedged item are re#orted in earnings :before the contract is re#orted on the boo9s;. 5his is i$$ustrated $ater.

31

c. For4ar

"o%tra"t 3se

as a $e &e o( a foreign currency

denominated $forecasted% transaction :a "as$ (0o4 $e &e;. 8 forecasted transaction is a situation where the firm has #$anned sa$es recei#ts :e"#ected to occur in the near future;. and uses the forward contract as a means to hedge the cash f$ow ris9. !nitia$$y. foreign e"change gains and $osses are re#orted in com#rehensive income whi$e no offsetting amount is re#orted for the hedged item. 'ventua$$y. the e"change gains and $osses wi$$ be re#orted in earnings in the #eriod the hedged item affects earnings :i.e. if the item being hedged is a forecasted #urchase of inventory. the gains and $osses on the hedge wi$$ be rec$assified into earnings when the inventory is so$d;. d. For4ar "o%tra"ts as a $e &e o( a net investment in

foreign operations. -* Spe"30at!o% For4ar "3rre%"9 . "o%tra"ts 3se to spe"30ate "$a%&es !% (ore!&%

5he c$assifications above are im#ortant because the accounting for a #articu$ar ty#e of forward contract de#ends on the #ur#ose for which it was obtained. 5he difference in accounting re$ates #rimari$y to two 3uestions.

32

1. Aow is a transaction gain or $oss on the forward contract com#uted and when shou$d the gain or $oss be re#ortedI 2. 7hat va$ue shou$d be re#orted for the forward contract in the financia$ statements over the $ife of the contractI

Aedges of forecasted foreign currency transaction may inc$ude some intercom#any transactions. 5he hedging of foreign currency intercom#any cash f$ows with foreign currency o#tions is not uncommon. <ecause of its be$ief that the accounting for a$$ derivative instruments shou$d be the same. the =8/< broadened the sco#e of hedges that are e$igib$e for hedge accounting :as s#ecified in FAS& 13';. !f an interco% an! foreign currency derivative is created. it can on$y be a hedging instrument in the consoli#ate# financia$ statements if the other member enters an offsetting contract with an outside :unaffi$iated; #arty to hedge its e"#osureM this restriction a##$ies because the standards re3uire that some com#onent with foreign currency e"#osure must be a #arty to the hedging transaction. !n the stand6a$one statements of the subsidiary. however. the intercom#any derivative cou$d be designated as a hedge in the absence of third6 #arty invo$vement. 5herefore intercom#any derivatives can be c$assified as either fair va$ue or cash f$ow hedges if they meet the definition for that #articu$ar hedge and if the member of the

33

conso$idated grou# not "sin$ the interco% an! #erivative as a hedge enters into a derivative with an unre$ated #arty to offset the origina$ e"#osure from the intercom#any hedge.

USING FOR7ARD CONTRACTS AS A HEDGE

He &e o( a (ore!&% "3rre%"9 e#pose

0!a+!0!t9

>onsider the im#orting e"am#$e used ear$ier in the cha#ter.

!m#orting 5ransaction with a =orward >ontract Used as a Aedge 1. On December 1. 2003. a U./. firm #urchased inventory for %00.000 euros #ayab$e on 2arch 1. 200 :i.e. the transaction is denominated in euros;. 2. 5he firmCs fisca$ year6end is December 31. 3. 5he s#ot rate for euros :-Beuro; and the forward rates for euros on 2arch 1. 200 at various times is as fo$$ows@

/#ot 5ransaction date 6 December 1. 2003 <a$ance sheet date 6 December 31. 2003 /ett$ement date 6 2arch 1. 200 4ate -1.0% 1.0& 1.0)

=orward 4ate :for 3B1B200 'uros; 1.0%2 1.0%+

. On December 1. 2003. the U./. firm entered into a forward contract to b"! %00.000 euros on 2arch 1. 200 . for -1.0%2.

On December 1. 2003. the firm entered into a contract to #urchase inventory for -%2%.000 :the s#ot rate was -1.0% on that date;. !f the e"change rate did not change over the #ayment #eriod. the firm wou$d owe -%2%.000 to sett$e the #ayab$e. Aowever. if the e"change rate increased to -1.0). the firm wou$d have to #ay -%3%.000 to sett$e the debt :%00.000 " -1.0);. On the other hand. if the e"change rate dro##ed to -1.02. the firm wou$d on$y need to #ay -%10.000. :or %00.000 " -1.02;. <ecause the firm cannot #erfect$y estimate the change in the e"change rate. the com#any might #refer to e$iminate this ris9 by entering into a forward contract to b"! e"ros on 2arch 1. 200 . /ince the forward rate on December 1. 2003 to #urchase euros on 2arch 1. 200 is -1.0%2. the com#any can buy %00.000 euros on 2arch 1 for a guaranteed #rice of -%2&.000. 5his fi"ed #rice means that the firm has determined in advance the ma"imum amount of $oss it wi$$ suffer. in this case -1.000. 5hus the firm is #rotected from future increases in the e"change rate above -1.0%2. <y $oc9ing into a set #rice. the firm gains if the s#ot rate on 2arch 1. 200 increases above -1.0%2 and $oses if the s#ot rate decreases be$ow -1.0%2. 5he im#ortant #oint to note about the hedge is that the firm 9nows with

3%

certainty on December 1. 2003. the amount of cash needed to #urchase the asset. 5he entries to record the #urchase and forward e"change contract are@

De"e'+er 1, -..3 - Tra%sa"t!o% Date

:1 ;

Jurchases 8ccounts Jayab$e :%00.000 euros " -1.0%; 5o record #urchase of goods on account using the s#ot rate on December 1. 2003.

%2%.00 0 %2%.000

5he accounts #ayab$e for the inventory #urchase is recorded using the s#ot rate on the transaction date :on December 1. 2003;

:2 ;

=oreign >urrency :=>; 4eceivab$e from '"change Dea$er %2&.00

3&

Do$$ars Jayab$e to '"change Dea$er :%00.000 euros " -1.0%2; 5o record forward contract to buy %00.000 euros using the forward rate.

%2&.000

8t the date of the transaction. the U./. firm records the forward contract by recogni(ing a #ayab$e and a receivab$e of -%2&.000 for the number of do$$ars to be #aid :units of foreign currency to be #urchased mu$ti#$ied by forward rate; to the e"change dea$er when the forward contract matures. ) 5he net va$ue of the forward contract is (ero since the #ayab$e and the receivab$e are e"act$y offset. 5he va$ue of the receivab$e from the dea$er and the accounts #ayab$e for the #urchase of inventory are subject to changes in e"change rate. but the gains and $osses genera$$y offset each other to a $arge e"tent since the terms and the amounts are e3ua$. On December 31. 2003. the s#ot rate increases from -1.0% to -1.0& resu$ting in an increase of -%.000 to accounts #ayab$e. 5he s#ot rate is used for accounts #ayab$e since that is the amount needed to sett$e the $iabi$ity.

De"e'+er 31, -..3 - /a0a%"e S$eet Date

!n #ractice. a journa$ entry may not be made to record a forward contract when the contract was negotiated because it re#resents an e"ecutory contract. 8$though arguments can be made either for or against recording such contracts. in this cha#ter forward contracts are recorded because it is easier to ana$y(e the subse3uent adjustments re3uired to re#ort the effects of a forward contract on the firm,s re#orted income.

3)

:3 ;

5ransaction Loss

%.000

8ccounts Jayab$e %.000 5o record a $oss on the $iabi$ity denominated in foreign currency

>urrent va$ue of accounts #ayab$e :%00.000 euros " -1.0&; H -%30.000 Less@ 4ecorded va$ue of accounts #ayab$e H -%2%.000 8djustment needed to accounts #ayab$e -%.000 or K%00.000 euros " :-1.0& 6 -1.0%;L H -%.000

On the other hand. the va$ue of the forward contract is determined using the change in the forward rates. 5he forward rate increased to -1.0%+ from -1.0%2. 5his resu$ts in an increase of -3.%00 to the receivab$e from the e"change dea$er. 4eca$$ that the #ayab$e to the foreign e"change dea$er is fi"ed by the forward contract. 5hus the forward contract has a #ositive -3.%00 va$ue at this #oint :December 31;.

: ;

=> 4eceivab$e from '"change Dea$er 5ransaction Eain

3.%00 3.%00

3*

5o record a gain on foreign currency to be received from e"change dea$er K:%00.000 euros " -1.0%+ H -%2+.%00; 6 -%2&.000;L. !f the financia$ statements are #re#ared on December 31. 2003. the va$ue of the forward contract is as fo$$ows@

=> 4eceivab$e from '"change Dea$er -%2+.%00 Do$$ars Jayab$e to '"change Dea$er ?et 4eceivab$e from '"change Dea$er %2&.000 -3.%00

5his net va$ue wou$d be re#orted on the ba$ance sheet. !n addition. accounts #ayab$e wou$d be recorded at the s#ot rate. or -%30.000. 5he income statement wou$d re#ort an e"change $oss of -%.000 and an e"change gain of -3.%00.

?ote that even though the forward contract and the accounts #ayab$e cover simi$ar terms :December 1 to 2arch 1; and amounts :%00.000 euros;. the amount of the transaction $oss on the #ayab$e does not e3ua$ the transaction gain on the => receivab$e. 5hey are not e3ua$ because accounts #ayab$e is va$ued using changes in the s#ot rate whi$e the va$ue of the forward contract is determined using changes in the forward rates. On the sett$ement date. the forward rate and the s#ot rate become e3ua$. 5hus the tota$ transaction gain or

3+

$oss on the contract wi$$ eventua$$y e3ua$ the guaranteed gain or $oss determined on the date the forward contract is ac3uired.

On 2arch 1. 200 . the s#ot rate increases to -1.0) from -1.0& resu$ting in an increase in accounts #ayab$e of -%.000. ::-1.0)6-1.0&; " %00.000;. /ince on the sett$ement date. the forward rate on this date and the s#ot rate are identica$. the change in the 2arch 1 forward rate on December 31 to the s#ot rate on 2arch 1. 2003 is -.011. or :-1.0%+ to -1.0);. 5his resu$ts in an increase to the => receivab$e of -%.%00. or ::-1.0)6-1.0%+; " %00.000;. 5he journa$ entries to record these events are as fo$$ows@

Mar"$ 1, -..1 - Sett0e'e%t Date :% ; 5ransaction Loss 8ccounts Jayab$e 5o record a $oss from 12B31B03 to 3B1B0 on $iabi$ity denominated in foreign currency. 5he current va$ue of the #ayab$e -%3%.000. :%00.000 euros " -1.0); $ess the recorded va$ue of the #ayab$e on December 31 of -%30.000 is -%.000. or K:%00.000 euros " -1.0) H -%3%.000; 6 -%30.000;L. %.000 %.00 0

:&;

=> 4eceivab$e from '"change Dea$er 5ransaction gain 0

%.%00

%.%00

5o record a gain from 12B31B03 to 3B1B0 on currency to be

foreign

received from e"change dea$er :5he change in

the 12B31 forward rate to the s#ot rate on 2arch 1. 200 times %00.000 euros. or K:%00.000 euros " -1.0) H -%3%.000; 6 -%2+.%00;L.;. 5he recorded ba$ances in both accounts #ayab$e and the => receivab$e are -%3%.000 ref$ecting the s#ot rate on 2arch 1. 2003. 5he do$$ars #ayab$e to the dea$er remains fi"ed at -%2&.000 the origina$ contracted amount. 'ntry :); records the cash #ayment of -%2&.000 and the reduction of the => #ayab$e. 8$so. the receivab$e is converted to the !nvestment in => re#resenting the %00.000 euros ac3uired in the forward contract. !n entry :*;. the euros are used to sett$e the accounts #ayab$e.

:);

Do$$ars Jayab$e to '"change Dea$er %2&.000 !nvestment in => :%00.000 euros; %3%.000 => 4eceivab$e from '"change Dea$er %3%.000 >ash %2&.000 5o record #ayment to e"change dea$er and recei#t of %00.000 euros :%00.000 euros " -1.0) H -%3%.000;. 8ccounts Jayab$e %3%.000 !nvestment in => %3%.000 5o record #ayment of $iabi$ity u#on transfer of %00.000 euros. <y obtaining the forward contract. the firm was ab$e to estab$ish at

:*;

the transaction date the amount of do$$ars :-%2&.000; that it wou$d ta9e to ac3uire the %00.000 euros needed to sett$e the account with

the foreign firm. ?ote. however. that the cost of the inventory of -%2%.000 was estab$ished on December 1 Kentry :1;L. !f the forward contract had not been obtained. the firm wou$d have had to #ay -%3%.000 to sett$e the account and wou$d have re#orted a net $oss of -10.000 on the e"#osed $iabi$ity #osition. 5he net gain from entering into the forward contract. however. $arge$y cance$ed out the net $oss on the e"#osed $iabi$ity #osition. 5hese transactions can be summari(ed in the fo$$owing tab$e.

5ransaction Aedged !tem <a$anceEainB:$oss; Aedge

5ransaction <a$anceEainB:$oss;

A""o3%ts =a9a+0e 12B1B2003 12B31B2003 3B1B2003 - %2%.000 %30.000 %3%.000 :%.000; :%.000; :10.000;

FC Re"e!)a+0e 12B1B2003 - %2&.000 12B31B2003 %2+.%00 3B1B2003 %3%.000 3.%00 %.%00 +.000

5ota$ gainB:$oss;

5hus the net effect is a -1.000 $oss when the forward contract is used.

He &e o( a (ore!&% "3rre%"9 e#pose

asset

!n the e"am#$e above. the U./. firm entered into a forward #urchase contract to hedge an e"#osed $iabi$ity #osition at a time when the forward rate was at a #remium. 8ccounting for a forward contract entered into as a hedge of an e"#osed receivab$e #osition is based on simi$ar ana$ysis. Aowever. because the U./. firm wi$$ be receiving foreign currency in sett$ement of the e"#osed receivab$e ba$ance. it wou$d enter into a forward contract to sell foreign currency for U./. do$$ars. !n this case. the receivab$e from the dea$er is denominated in a fi"ed number of do$$ars. the amount of which is

based on the contracted forward rate. whereas the ob$igation to the dea$er is denominated in a foreign currency. which is trans$ated into do$$ars using the current s#ot rate.

Fa!r Va03e He &e - He &!%& a% U%re"o&%!>e Co''!t'e%t

Fore!&% C3rre%"9

!n the #receding discussion of the im#orting and e"#orting of goods. the #urchase or sa$e of an asset was recorded on the transaction date. 5his date is considered the #oint at which tit$e to the goods is transferred. which is consistent with the recording of a transaction with another domestic com#any. Aowever. if the U./. firm at a date ear$ier than the transaction date made a commitment to a foreign com#any to se$$ goods or buy goods. and the #rice was estab$ished in foreign currency at the commitment date. changes in the e"change rate between the commitment date and transaction date wou$d be ref$ected in the cost or sa$es #rice of the asset. =or e"am#$e. assume that a U./. firm made an agreement on Fune 1 to buy goods from a =rench com#any for %00.000 francs. 8t this date. the s#ot rate was -.20. but on the transaction date. when tit$e to the goods transferred and a journa$ entry was recorded. the s#ot rate was -.22. 5he entry to record the #urchase is

Jurchases :%00.000 francs " -.22; 8ccounts Jayab$e

110.000

110.000

5hus. the change in the e"change rate that occurred between the commitment and the transaction date becomes a #art of the cost of inventory. rather than being re#orted as a se#arate gain or $oss item. 5he com#any. however. may sti$$ ac3uire a forward contract to hedge against the unfavorab$e change in the fair va$ue of the asset that may occur after the commitment date. 8 forward contract is considered a hedge of an identifiab$e foreign currency commitment if the forward contract is designated as. and is effective as. a hedge of a foreign currency commitment. 5he foreign currency commitment must s#ecify a$$ significant terms :such as 3uantity and #rice; and #erformance must be #robab$e. A &a!% or 0oss o% a (or4ar o% t$e $e &e "o%tra"t as 4e00 as t$e o((sett!%& &a!% or 0oss "3rre%t09 !% ear%!%&s* 5he

!te' are re"o&%!>e

gain or $oss :the change in the fair va$ue of the forward contract; is an adjustment of the carrying va$ue of the forward contract. /imi$ar$y. the change in va$ue of the firm commitment is recorded as such on the ba$ance sheet :even though the commitment has not yet been recorded;. 5he measurement of hedge effectiveness is beyond the sco#e of this cha#ter. but since the forward contracts are for simi$ar terms and amounts. they are assumed to be high$y effective.

Fa!r Va03e He &e I003strat!o% @ 5o i$$ustrate the accounting for a forward contract ac3uired to hedge an identifiab$e foreign currency commitment :a fair6va$ue hedge;. the fo$$owing facts are assumed@

=air Pa$ue Aedge '"am#$e 1. On 2arch 1. 2003. a U./. firm contracts to se$$ e3ui#ment to a foreign customer for 200.000 Eerman mar9s. 5he e3ui#ment is e"#ected to cost -&0.000 to manufacture and is to be de$ivered and the account is to be sett$ed one year $ater on 2arch 1. 200 . 5hus the transaction date and the sett$ement date are both 2arch 1. 200 .

2. On 2arch 1. 2003. the U./. firm enters into a forward contract to se$$ 200.000 Eerman mar9s in 12 months at the forward rate of -.3+.

3. /#ot rates and the forward rates for Eerman mar9s on se$ected dates are

/#ot '"chan QQQQQQDateQQQQQQ 2arch 1. 2003 ge 4ate -. 0

3B1B200 =orwar d 4ate -.3+0

&

December 31. 2003 2arch 1. 200

.3+% .3*

-.3*%

5he journa$ entry to record the forward contract on 2arch 1. 2003 is@

Mar"$ 1, -..3 :1 ; Do$$ars 4eceivab$e from '"change Dea$er :200.000 mar9s " -.3+; )*.000 => Jayab$e to '"change Dea$er )*.000 5o record the forward contract to se$$ 200.000 Eerman mar9s. ?ine months $ater. on the ba$ance sheet date :12B31B03;. the => #ayab$e needs to be adjusted to fair va$ue using the chan$e in the forwar# rates. 8$so. since this is a fair6va$ue hedge. the change in the fair va$ue of the hedged item must a$so be recorded. 5his is com#uted using the change in the forward rate. 5hese entries are as fo$$ows@

De"e'+er 31, -..3 :2 ; => Jayab$e to '"change Dea$er 1.000

'"change gain 1.000 5o record gain on foreign currency to be de$ivered to e"change dea$er using the change in forward rates :200.000 mar9s " :-.3+6-.3*%;;.

:3

'"change $oss

1.000

=irm commitment 1.000 5o record $oss on firm commitment using the change using the change in the forward rate :200.000 mar9s " :-.3+6-.3*%;;.

?ote that the firm commitment has not been recorded on the boo9s as of December 31. 2003. On the December 31. 2003 ba$ance sheet. the va$ue of the forward contract is as fo$$ows@

Do$$ars 4eceivab$e from '"change Dea$er :fi"ed; => Jayab$e to '"change Dea$er ?et 4eceivab$e )).000 -1.000

-)*.000

On the <a$ance /heet. the firm commitment wou$d be re#orted as a -1.000 $iabi$ity. On the !ncome /tatement. the e"change gain of -1.000 is re#orted. as we$$ as an e"change $oss of -1.000.

On 2arch 1. 200 :the transaction date and the sett$ement date;. the journa$ entries are@

Mar"$ 1, -..1 : ; => Jayab$e to '"change Dea$er 1.000

'"change gain 1.000 5o record gain on forward contract from 12B31B03 to

3B1B0 :200.000 mar9s " :-.3*%6-.3*;;H -1.000. :% ; '"change $oss 1.000

=irm commitment 1.000 5o record gain on forward contract from 12B31B03 to 3B1B0

:200.000 mar9s " :-.3+6-.3*%;;H -1.000 'ntries : ; and :%; adjust the va$ues of the => #ayab$e and the change in the fair va$ue of the firm commitment. ?ote that since the transaction date occurs on the sett$ement date. the change in va$ue is com#uted as the change in the forward rate on 12B31B2003 to the s#ot rate on 2arch 1. 200 :i.e. .3*% to .3*;.

:& ;

!nvestment in => =irm commitment /a$es :200.000 mar9s " -.3+; 5o record sa$e of e3ui#ment to foreign customer. >ost of Eoods /o$d !nventory 5o record cost of e3ui#ment so$d. >ash :200.000 " -.3+; => Jayab$e to '"change Dea$er :200.000 "

)&.000 2.000

)*.000

:) ; :* ;

&0.000 &0.000 )*.000 )&.000

-.3*; !nvestment in => Do$$ars 4eceivab$e from '"change Dea$er 5o record sett$ement of forward contract.

)&.000 )*.000

<ecause of the forward contract. the amount of sa$es recorded in entry :&; is e3ua$ to the forward rate on the forward contract mu$ti#$ied by 200.000 mar9s. or -)*.000 :i.e. 200.000 " -.3+;. 5he firm commitment account is e$iminated on this date. !n entry :*;. the firm se$$s 200.000 Eerman mar9s for -)*.000.

5he effect of these transactions on the firmCs #rofitabi$ity is as fo$$ows@

/a$es :-)&.000 R -2.000; >ost of goods so$d Eross #rofit

-)*.00 0 &0.000 -1*.00 0

5he number of do$$ars to be received was $oc9ed in by the forward contract at -)*.000 and the e3ui#ment was e"#ected to cost -&0.000. 5hus. the forward contract #ermitted the U./. firm to $oc9 in an e"#ected #rofit of -1*.000 on the sa$es contract. !f the forward contract had not been obtained. the #rofit earned on the contract

%0

wou$d de#end on the e"change rate in effect when #ayment was received from the Eerman customer. 7ithout the hedge. the amount of sa$es recorded wou$d have been -)&.000 :200.000 mar9s " -.3*; and the gross #rofit wou$d have been -1&.000. 8nd if the e"change rate had dro##ed be$ow -.3*. the amount of sa$es recorded wou$d have been even be $owerM for e"am#$e at an e"change rate of -.30. the amount of sa$es recorded wou$d have e3ua$ed the amount of cost of goods so$d. thus e$iminating any gross #rofit on the contract.

D!s"o3%t!%& t$e Fa!r Va03e o( t$e For4ar

Co%tra"t

8s stated ear$ier. the change in the forward contract was com#uted using the change in the forward rate. 8ccording to SFAS 133. these amounts shou$d be discounted to a #resent va$ue basis. =or e"am#$e. in entry :2;. the e"change gain on the => Jayab$e was com#uted to be -1.000 by ta9ing the change in the forward rates and mu$ti#$ying by the amount of foreign currency in the forward contract :200.000 mar9s " :-.3+6-.3*%;;. !f this amount were discounted using an interest rate of 121 for two months :unti$ the sett$ement date;. the -1.000 wou$d be recorded on the boo9s at -1.000 $ess -20. or -+*0. /imi$ar$y. the firm commitment in entry :3; wou$d be recorded on the boo9s at its discounted amount of -+*0. 5hese entries are re#eated as entries :3a; and : a;.

%1

:2a ;

=> Jayab$e to '"change Dea$er

+*0

'"change gain +*0 5o record gain on forward contract from 12B31B03 to 3B1B0 :200.000 mar9s " :-.3*%6-.3*;; H Less@ :-1.000;:2B12;:121; 5ota$ Discounted Eain H - +*0 +*0 +*0 -1.000 20

:3a ;

'"change $oss

=irm commitment 5o record gain on forward contract from 12B31B03 to 3B1B0 :200.000 mar9s " :-.3+6-.3*%;; $ess -20 H -+*0

5hen on 2arch 1. 200 . the tota$ gain over the $ife of the forward contract is -2.000 :or 200.000 " :-.3+6-.3*;;. <ut since -+*0 was a$ready recogni(ed. entry :3; wou$d be for -1.020 rather than sim#$y the change since December 31.

: a ;

=> Jayab$e to '"change Dea$er

1.020

'"change gain 1.020 5o record gain on forward contract from 12B31B03 to 3B1B0 #$us the discount a$ready recogni(ed :-20;

%2

:%b ;

:200.000 mar9s " :-.3*%6-.3*;;H -1.000R-20 H -1.020 '"change $oss 1.020 =irm commitment 1.020 5o record gain on forward contract from 12B31B03 to 3B1B0 #$us the discount a$ready recogni(ed :-20; :200.000 mar9s " :-.3+6-.3*%;;H -1.000 R 20 H -1.020 !n the remainder of this cha#ter. we ignore the com#$ication of

discounting to sim#$ify the a$ready com#$e" accounting for derivatives. 7e note a$so that. in many cases. the im#act of discounting is not materia$.

Cas$ F0o4 He &e - He &e o( a (ore"aste

tra%sa"t!o%

=irms may a$so be concerned about future transactions that have not yet occurred or for which there are no firm commitments. =or instance. on Fanuary 2&. 2003. Lands, 'nd re#orted carrying -)) mi$$ion of forward contracts and -1& mi$$ion of o#tions on the <a$ance /heet. Lands, 'nd antici#ated se$$ing #roducts to subsidiaries in the United Singdom. Fa#an. and Eermany over the ne"t year and #$anned to #urchase various inventory items from 'uro#ean su##$iers. 'ven though they might not have any firm contracts. Lands, 'nd may decide because of the high #robabi$ity of occurrence of these transactions to use derivatives to hedge this foreign currency

%3

e"change ris9. 5hese ty#es of hedges are 9nown as hedges of forecasted transactions. Un$i9e the treatment of fair va$ue hedges. the =8/< a$$ows deferra$ of the income statement recognition of the gains and $osses on forecasted transactions if certain criteria are met. Li9e other gains and $osses that are e"c$uded from the income statement. they must be inc$uded as com#onents of other com#rehensive income and re#orted in the stoc9ho$ders, e3uity section of the ba$ance sheet. 5he criteria for this treatment inc$ude@ 5he forecasted transaction is s#ecifica$$y identifiab$e at the time of the designation as a sing$e transaction or a grou# of individua$ transactions. 5he forecasted transaction is #robab$e and it #resents e"#osure to #rice changes that are e"#ected to affect earnings and cause variabi$ity in cash f$ows. 5he forecasted transaction invo$ves an e"change with an outside :unre$ated; #arty. :8n e"ce#tion is a$$owed for inter6 com#any foreign e"change transactions. /ee the #revious discussion in this cha#ter.; 5he forecasted transaction does not invo$ve a business combination. 8mounts in accumu$ated other com#rehensive income are rec$assified into earnings in the same #eriod or #eriods during which the hedged

forecasted transaction affects earnings. =or e"am#$e. if the forecasted hedged item is inventory. the rec$assification from accumu$ated other com#rehensive income into earnings occurs when the inventory is so$d. !f the forecasted hedged item is the #urchase of a fi"ed asset. the rec$assification occurs when the e3ui#ment is de#reciated.

In the News: 5he !nternationa$ 8ccounting /tandards <oard issued IAS No. 3(@ =inancia$ !nstruments@ 4ecognition and 2easurement in December 1++*. with some revision in October 2000. 7hi$e the !8/ <oard a$$ows both fair va$ue and cash f$ow hedges. the #rimary difference between IAS No. 3( and SFAS 133 is the treatment of unrecogni(ed firm commitments. Under SFAS 133. these hedges are considered fair va$ue hedges whi$e under IAS No. 3(. unrecogni(ed firm commitments are treated as cash f$ow hedges.

7e ne"t #resent an i$$ustration of the accounting for a forecasted transaction meeting the criteria identified by the =8/< for deferra$ of the gains or $osses into com#rehensive income.

%%

&ash #low 'edge Illustration! #orward &ontracts . 5o i$$ustrate the hedge of a forecasted foreign currency transaction with the use of an option, assume the following:

1. On December 1, 2003, a U. . firm estimates that at least !,000 units of in"entory will be purchased from a company in the United #ingdom during $anuary of 200% for !00,000 euros. &he transaction is probable and the transaction is to be denominated in euros. /a$es of the inventory are e"#ected to occur in the si" months fo$$owing the #urchase.

2. 5he com#any enters into a forward contract to #urchase %00.000 euros on Fanuary 31. 200 . for -1.01.

3. pot rates and the forward rates at $anuary 31, 200%, settlement were as follows 'dollars per euro(: )orward *ate pot *ate December 1, 2003 ,1.03 )or 1+31+0% ,1.01 -0.++

<a$ance sheet date :12B31B03;-1.00 Fanuary 31. 200 -0.+*

-y using the forward contract, the firm is assured of paying ,!0!,000 regardless of changes in the e.change rate. /f the e.change rate were to drop below ,1.01 the firm

%&

would lose, but if the e.change rate were to e.ceed ,1.01, the firm would be better off using the forward contract.

5he entry on December 1. 2003 to record the forward e"change contract to #urchase %00.000 euros on Fanuary 31. 200 . for -1.01 is@

December 1, 2003

:1 ;

=> 4eceivab$e from '"change Dea$er :%00.000 euros " -1.01; Do$$ars Jayab$e to '"change Dea$er %0%.00 0 %0%.000

One month later on the balance sheet date 'December 31, 2003(, the change in the "alue of the forward contract is ,10,000, '!00,000 . ',1.010,0.11((. &herefore, on December 31, 2003, the following entry is made:

December 31, 2003 - Balance Sheet Date

:2 ;

=oreign e"change $oss T Other >om#rehensive

10.000

!ncome :<a$ance /heet; => 4eceivab$e to '"change Dea$er 10.000 5o record a gain on the change in forward contract :%00.000 " :-1.016-0.++;;

%)

?otice that un$i9e the fair va$ue hedge. there is no offsetting firm commitment entry since this is a forecasted transaction. 5he e"change gain or $oss is re#orted in com#rehensive income and wi$$ affect the income statement when the inventory is eventua$$y so$d. On the <a$ance /heet. the forward contract is re#orted as a $iabi$ity at its fair va$ue of -10.000. and the offsetting amount is re#orted in stoc9ho$ders, e3uity in accumu$ated other com#rehensive income :as a $oss;.

January 31, 2004 transaction and settlement date

:3;

=oreign e"change $oss T Other >om#rehensive

%.000

!ncome :<a$ance /heet; => 4eceivab$e to '"change Dea$er 5o adjust the forward contract to its mar9et va$ue of -20.000.

%.000

5he change in va$ue of the forward contract K:-.++ 12B31 s#ot rate $ess -0.+* Fanuary 31. 200 s#ot rate; " %00.000 eurosL is -%.000. ?ote that the ba$ance in the => 4eceivab$e account is - +0.000 after entry :3;. 5he entry to record the sett$ement of the forward contract is as fo$$ows@

%*

: ;

!nvestment in => :%00.000 euros; +0.000 Do$$ars Jayab$e to '"change Dea$er %0%.000 => 4eceivab$e from '"change Dea$er >ash 5o sett$e with the trader.

+0.000 %0%.000

?ow su##ose that the forecasted transaction occurs and the %.000 units of inventory are #urchased on Fanuary 31. 200 for %00.000 euros. 5he journa$ entry to record the #urchase is@

:%;

!nventory :at the 12B31B0 s#ot rate; !nvestment in => :%00.000 euros;

+0.000

+0.000

/u##ose that in =ebruary. the inventory is so$d for -&00.000. 5he entries to record the sa$e and to rec$assify the amounts from Other >om#rehensive !ncome :a -1%.000 $oss. inc$uding -10.000 $oss at December 31. 2003 #$us the -%.000 additiona$ $oss at Fanuary 31. 200 ; into earnings are as fo$$ows@

February 2004 In entory Sales date

:&;

>ash >ost of goods so$d /a$es !nventory >ost of goods so$d :!ncome /tatement; =oreign e"change $oss T Other >om#rehensive

&00.000 +0.000

&00.000 +0.000 1%.000

:);

1%.000

%+

!ncome :<a$ance /heet; 5o rec$assify the amounts from accumu$ated other com#rehensive income into earnings :cost of goods so$d;. !n entry :);. the amounts recorded in accumu$ated other com#rehensive income is rec$assified into earnings. 5he =8/< does not s#ecify where on the income statement this amount shou$d be re#orted. 2any com#anies inc$ude this gain or $oss as #art of cost of goods so$d. as shown above.

E"o%o'!" He &e o( a Net I%)est'e%t !% a Fore!&% E%t!t9

8 U./. firm that maintains an e3uity investment in a foreign com#any may enter into a foreign currency transaction or a nonderivative financia$ instrument in an effort to minimi(e or offset the effects of currency f$uctuations on the net investment. 8 foreign currency transaction is considered a hedge of a net investment in a foreign entity if the forward contract is designated as. and is effective as. a hedge of the net investment. 5he gain or $oss on the hedging instrument is re#orted in the same manner as the trans$ation adjustment :under SFAS no. 52;. =or e"am#$e. assume that a U./. firm ho$ds an investment in the net assets of a =rench com#any that conducts its business #rimari$y in francs and accounts for the investment using the current rate method.

&0

8s wi$$ be shown in >ha#ter 1 . the investor com#any a##$ying the e3uity method to a $ess than %01 owned investee wi$$ record its share of the effect of a change in the e"change rate on the net assets of the foreign investee. 5o hedge against the e"#osure to e"change rate changes. the U./. firm may enter into an agreement to borrow francs from a =rench ban9. 8ssume further that the $oan is designated as. and is effective as. a hedge of the net investment in the =rench com#any. On subse3uent ba$ance sheet dates. both the net assets of the foreign com#any and the $oan denominated in francs are adjusted to ref$ect the current e"change rate. 8 gain :$oss; from the adjustment of the $iabi$ity wi$$ offset a $oss :gain; from the adjustment of the net investment in the foreign com#any. and a hedge resu$ts. <oth adjustments are re#orted as a com#onent of stoc9ho$dersC e3uity :accumu$ated other com#rehensive income; rather than re#orted current$y in income. Aowever. if the adjustment to the $oan ba$ance e"ceeds the adjustment of the ba$ance of the net investment. the e"cess is re#orted in the determination of net income as a transaction gain or $oss. 5he gains or $osses accumu$ated in a se#arate com#onent of stoc9ho$dersC e3uity remain there unti$ #art or a$$ of the investment in the foreign com#any is so$d.

For4ar

Co%tra"ts A"?3!re

to Spe"30ate !% t$e Mo)e'e%t o(

Fore!&% C3rre%"!es

&1

8 forward contract may be ac3uired for s#ecu$ative #ur#oses in antici#ation of rea$i(ing a gain. =or e"am#$e. assume that on December 1. 2003. the s#ot rate for the <ritish #ound is -2.3% and that the +06day futures rate is -2.3&. =urther assume that a com#any e"#ecting the e"change rate to increase to. say. -2. 3. enters into a contract on December 1 to ac3uire U100.000 on 2arch 1. 200 . :8 forward contract to se$$ foreign currency wou$d be negotiated if the firm e"#ected the future s#ot rate to be $ower than the forward rate.; 5he firmCs fisca$ year ends on December 31. and on that date the futures rate for #ounds to be #urchased on 2arch 1. 200 is -2.3). 5he s#ot rate is -2. 2 on 2arch 1. 200 . 5he journa$ entries to record the transactions are@

De"e'+er 1, -..3 :1 ; => 4eceivab$e from the '"change 23&.000

Dea$er Do$$ars Jayab$e to '"change Dea$er 23&.000 5o record the forward contract :U100.000 " -2.3&;.

5his entry recogni(es that the U./. firm has contracted to buy U100.000 in +0 days when the #ayment of -23&.000 is made to the e"change dea$er. <oth the debit and credit re$ated to a forward contract are measured by mu$ti#$ying the U100.000 by the forward

&2

rate of -2.3&. 5he =8/< reasoned that the forward rate shou$d be used because a firm s#ecu$ating in foreign currency changes is e"#osed to the ris9 of movements in the forward rate. /ince both accounts are based on the forward rate. there is no se#arate accounting for any discount or #remium on the forward contract.

De"e'+er 31, -..3 :2 ; => 4eceivab$e from '"change Dea$er 5ransaction Eain 1.00 0 1.00

0 5o record gain on foreign currency to be received from e"change dea$er :U100.000 " -2.3) H -23).000 6 -23&.000; or KU100.000 " :-2.3) 6 -2.3&;L.

5he foreign currency receivab$e is adjusted at the financia$ statement date since it is denominated in foreign currency units. 5he amount of the adjustment is com#uted by mu$ti#$ying the units of foreign currency to be received by the difference between the forward rate avai$ab$e for the remaining $ife of the forward contract and the rate $ast used to va$ue the contract. 5he transaction gain :or $oss; is re#orted current$y in income.

&3

Mar"$ 1, -..1 :3 ; => 4eceivab$e from '"change Dea$er %.000

5ransaction Eain %.000 5o record gain on foreign currency to be received from e"change dea$er :U100.000 " -2. 2 H -2 2.000 6 -23).000;. Do$$ars Jayab$e to '"change Dea$er 23&.000 !nvestment in => 2 2.000 >ash 23&.000 => 4eceivab$e from '"change Dea$er 2 2.000 5o record #ayment to e"change dea$er and recei#t of foreign >ash currency. 2 2.000 2 2.000

: ;

:% ;

!nvestment in => 5o record conversion of #ounds into cash.

On 2arch 1. the firm records any gain or $oss as a resu$t of changes in the e"change rate from the $ast va$uation date to the date of the transaction. U#on #ayment of -23&.000 to the e"change dea$er. the firm wi$$ receive U100.000. which can be converted into -2 2.000. 5he tota$ gain of -&.000 recogni(ed over the $ife of the contract is the difference between the va$ue of the foreign currency received

&

:-2 2.000; when the forward contract was e"ercised and the amount #aid :-23&.000; to the e"change dea$er. !f the firm had entered into a forward contract to se$$ foreign currency. the accounting wou$d be simi$ar to that above. e"ce#t the debit in entry :1; is for a fi"ed amount of do$$ars to be receivedM the credit records the ob$igation to buy foreign currency units for de$ivery to the e"change dea$er. 5he estimated cost of units to be de$ivered wi$$ vary as the e"change rate f$uctuates.

D!s"0os3re Re?3!re'e%ts o( t$e Var!o3s He &es SFAS No. 133 s#ecifies certain minima$ disc$osures for derivative instruments and nonderivative instruments designated as 3ua$ifying hedging instruments. 5he disc$osures inc$ude@ the objectives of the instruments. the strategies for achieving those objectives. the conte"t needed for understanding them. and the ris9 management #o$icy. !n addition. a descri#tion of transactions or items that are hedged must be disc$osed for each category. 8$so the fo$$owing s#ecific disc$osures are re3uired@

1. Fa!r )a03e $e &es :such as hedges of the foreign currency e"#osure of unrecogni(ed firm commitments; a. 8 descri#tion of where the amount of the gain or $oss is re#orted on the income statement.

&%

b. 5he amount of the gain or $oss recogni(ed in earnings when the hedged item no $onger 3ua$ifies as a fair va$ue hedge. 2. Cas$ (0o4 $e &es :inc$udes forecasted transactions; a. 8 descri#tion of where the amount of the gain or $oss is re#orted on the income statement. b. 8 descri#tion of the transactions or other events that wi$$ resu$t in the rec$assification into earnings of gains and $osses that are re#orted in accumu$ated other com#rehensive income. and the estimation of the net amount of the e"isting gains or $osses at the re#orting date e"#ected to be rec$assified into earnings within the ne"t 12 months. c. 5he ma"imum $ength of time over which the firm is hedging its e"#osure to the variabi$ity in future cash f$ows for forecasted transactions. d. 5he amount of the gain or $oss rec$assified into earnings as a resu$t of the discontinuance of cash f$ow hedges because it is #robab$y that the transaction wi$$ not occur. 3. He &es o( t$e %et !%)est'e%t in a foreign o#eration 5he net amount of gains or $osses inc$uded in the cumu$ative trans$ation adjustment during the re#orting #eriod.

&&

8$$ derivative instruments not designated as hedges must be identified as to their #ur#ose. and 3ua$itative disc$osures about the use of derivatives are encouraged. =ina$$y. the amount of net gains or $osses from cash f$ow hedges on derivative instruments that is inc$uded in other com#rehensive income must be shown as a se#arate c$assification. 5he disc$osures shou$d inc$ude@ beginning and ending accumu$ated gains or $osses from derivative instrumentsM the net change during the #eriod from hedging activitiesM and the net amount rec$assified to earnings.

Us!%& Opt!o%s to He &e Fore!&% C3rre%"9 C$a%&es

/o far in this cha#ter. forward contracts have been used as hedging items. 7ith the use of a forward contract. the firm wi$$ either gain or $ose. =or e"am#$e. if an accounts #ayab$e of 10.000 euros is hedged using a forward rate of -1.0%. the firm is guaranteed to #ay on$y -10.%00. !f the s#ot rate on the date of sett$ement is higher than -1.0%. the firm gains. but if the s#ot rate fa$$s be$ow -1.0%. the firm wou$d have been better off not using the forward contract. One advantage of the forward contract is that it is cost$ess to ac3uire. /u##ose the firm wanted to #rotect on$y the down side ris9 from changes in the e"change rate. 5o accom#$ish this. the firm may

&)

ac3uire a foreign currency ca$$ o#tion. 8 "a00 opt!o% is an o#tion to #urchase the foreign currency at a s#ecified rate. referred to as the e"ercise #rice. 8 p3t opt!o% is an o#tion to se$$ the foreign currency at a s#ecified rate. 5he advantage of using o#tions is that the o#tion gives the ho$der the ri$ht to buy or se$$ the currency. but if the e"change rate changes in a negative manner. the firm can sim#$y $et the o#tion $a#se. !n other words. the ho$der of the o#tion does not have to e"ercise the o#tion. 5he disadvantage of the o#tion is that there is an initia$ cost :i.e. a #remium; to ac3uire the o#tion. =or instance. in the e"am#$e above. the firm cou$d #urchase an o#tion for -&00* that wou$d a$$ow the firm to #urchase 10.000 euros at an e"ercise #rice of -1.0 %. !f the s#ot rate on the sett$ement date e"ceeds -1.0 % the firm wi$$ e"ercise the o#tionM if the s#ot rate is $ess than -1.0 %. the firm wi$$ $et the o#tion e"#ire. 8n Nin the money, o#tion is an o#tion where the firm benefits if the o#tion is e"ercised. !f on the date the ca$$ o#tion was #urchased. the s#ot rate of -1.0 % was e3ua$ to the e"ercise #rice of -1.0 %. the o#tion is out of the money at that #oint. 5his means that the entire va$ue of the o#tion is due to the Ntime va$ue, of the o#tion. 5he o#tion has va$ue because. over time. the s#ot rate may e"ceed the e"ercise #rice of the ca$$ o#tion :or the s#ot rate may be $ess than the e"ercise #rice for a #ut o#tion;.
*

5he se$$er of the o#tion wou$d use some o#tion #ricing mode$. such as <$ac96 /cho$es. for determining the amount of the #remium #aid.

&*

>ontinuing our e"am#$e. su##ose that one month $ater the s#ot rate increased to -1.0&. =or a ca$$ o#tion. this means that the firm can e"ercise the o#tion and obtain 10.000 euros for -1.0 % when the current e"change rate is -1.0&. 5hus the o#tion has an intrinsic va$ue of -1%0 Kthe difference between the s#ot rate and e"ercise #rice mu$ti#$ied by the amount of currency :-1.0&6-1.0 %;:10.000 euros;L. 5hus if the ca$$ o#tion had a current mar9et #rice of -)00. -1%0 wou$d be treated as the intrinsic va$ue and -%%0 wou$d be treated as the time va$ue of the o#tion. 5hus Nin the money, o#tions contain both an intrinsic and time va$ue e$ement. !f the s#ot rate dro#s to -1.03 :after the o#tion was ac3uired;. the firm wou$d be better off not e"ercising the o#tion and #urchase the needed euros on the mar9et at -1.03. 5he fo$$owing chart he$#s i$$ustrate when a ca$$ or a #ut o#tion might be used and when the o#tion is in the money.

!tem Less Aedged 4ate Jayab$e 4eceivab$e

O#tion

'"ercise Jrice

'"ercise Jrice is

Used

'"ceeds /#ot 4ate

than the /#ot

>a$$ O#tion Jut O#tion

N!n the 2oney, NOut of the 2oney, NOut of the 2oney, N!n the 2oney,

&+

5hus a ca$$ o#tion is used when a foreign currency is needed to #ay a $iabi$ity in the future. and a #ut o#tion is used when foreign currency received in the future needs to be so$d and converted into do$$ars.

&ash #low 'edge using (ptions) An Illustration. 5o i$$ustrate the hedge of a forecasted foreign currency transaction with the use of an option, assume the following:

1. On December 1, 2003, a U. . firm estimates that in"entory will be sold to a company in the United #ingdom during $anuary of 200% for !00,000 euros. &he cost of the in"entory sold is estimated to be ,300,000.

2. pot rates were as follows 'dollars per euro(:

December 1, 2003

,1.03

<a$ance sheet date :12B31B03; -1.00 =ebruary 1. 200 -0.+*

3. 5he transaction is to be denominated in euros.

. On December 1. 2003. the com#any #urchases a #ut o#tion for -%.000 to hedge any changes that may occur in the receivab$e denominated in euros. 5his o#tion a$$ows the firm to se$$ %00.000 euros at -1.02 with an e"#iration date of =ebruary 1. 200 . 5he )0

s#ot rate was -1.03 on this date so the o#tion is out of the money. 8t year6end :the ba$ance sheet date;. the va$ue of the o#tion increased to -1 .000. On the o#tion e"#iration date. the o#tion on$y has an intrinsic va$ue :the difference between the e"ercise #rice and the s#ot rate;. 5herefore on =ebruary 1. the va$ue of the o#tion is -20.000.

&he rationale for the use of the option is as follows. -ecause the sale is e.pected to occur in the future 'ne.t $anuary( and because the e.change rate may change unfa"orably, the company buys an option to sell !00,000 euros at ,1.02 or ,!10,000. 2hen the sale of in"entory occurs and the company recei"es the euros, the firm is sub3ect to any e.change losses. 4owe"er, because the firm now has an option to sell euros, the company can use the euros that it recei"es from the sale to deli"er on the option. &herefore, if the e.change rate drops below the e.ercise rate ',1.02(, the firm is co"ered 'i.e. the firm e.ercises the option and sells the !00,000 euros for ,!10,000(. /f the e.change rate e.ceeds the e.ercise rate, the option will not be e.ercised. 5he entries to record the #urchase and forward e"change contract are@

December 1, 2003 - !ransaction Date

:1 ;

O#tion to se$$ euros >ash 5o record #urchase of a #ut o#tion. )1

%.000 %.000

On the balance sheet date 'December 31, 2003(, the option is ad3usted to its mar5et "alue of ,1%,000. &herefore on December 31, 2003, the following entry is made.

December 31, 2003 - Balance Sheet Date

:2 ;

O#tion to se$$ euros =oreign e"change gain T Other >om#rehensive

+.000

+.000

!ncome :ba$ance sheet e3uity; 5o record a gain on the change in o#tion va$ue :-1 .0006 -%.000;

5he recognition of the gain is re#orted in com#rehensive income because it 3ua$ifies under the criteria designated in SFAS No. 133M for e"am#$e. the forecasted transaction is #robab$e and it #resents e"#osure to #rice changes that are e"#ected to affect earnings and cause variabi$ity in cash f$ows. 8mounts deferred from earnings are re#orted in other com#rehensive income. and are rec$assified into earnings in the #eriod during which the hedged forecasted transaction

)2

affects earnings :for e"am#$e. when a forecasted sa$e actua$$y occurs;.+

SFAS No. 133 . #ara. 31. 8ccounting for Derivative !nstruments and Aedging 8ctivities :?orwa$9. >onn.@ =8/<. 1++*;.

)3

February 1, 2004 "#tion $%#iration Date

:3;

O#tion to se$$ euros =oreign e"change gain T Other >om#rehensive

&.000 &.000

!ncome :ba$ance sheet e3uity; 5o adjust the o#tion va$ue to its mar9et va$ue of -20.000. 5he va$ue of the o#tion K:-1.02 e"ercise #rice $ess -0.+* s#ot rate; " %00.000 eurosL is -20.000 $ess the carrying va$ue of the o#tion :-1 .000;. 5echnica$$y since the forecasted transaction occurred on this date. the gain recorded in entry :3; cou$d a$so be re#orted in earnings immediate$y. 7e chose to initia$$y record the gain using the ba$ance sheet account :other com#rehensive income; and then immediate$y rec$assify the tota$ e"change gain into earnings :see entry :&; be$ow;. : ; !nvestment in => :%00.000 euros; +0.000 4evenues >ost of goods so$d 300.000 !nventory 5o se$$ the inventory :com#$ete the forecasted transaction;. :%; >ash :e"ercise #rice -1.02 " %00.000 euros; O#tion to se$$ euros :intrinsic va$ue on o#tion date; !nvestment in => :%00.000 euros V %10.000 20.000 +0.000

+0.000 300.000

-0.+*; 5o e"ercise the o#tion and sett$e with the trader. :&; =oreign e"change gain T Other >om#rehensive !ncome 4evenue :-+.000 from entry :2; and -&.000 from entry :3;. 5o rec$assify the tota$ e"change gains into earnings ?ote that in entry : ;. revenue is recorded at the s#ot rate. Aowever. entry :&; adjusts revenue to recogni(e the benefit of the o#tion. 'ntry :&; is re3uired because the amount recogni(ed in other accumu$ated income is rec$assified into earnings in the #eriod the hedged item affects earnings. 5hus the tota$ amount of revenue recogni(ed is -%1%.000. which re#resents the revenue recogni(ed at the s#ot rate :- +0.000; #$us the net benefit of the o#tion -1%.000 :-1.02 e"ercise rate over the s#ot rate -0.+* mu$ti#$ied by %00.000 euros $ess the initia$ cost of the o#tion of -%.000;. 1%.000 1%.000

Split Accounting Intrinsic and Time Value Elements : /n order to 6ualify for 7hedge accounting8 under SFAS No. 133, the hedges must be effecti"e. )irms are re6uired to measure the effecti"eness of their hedges 6uarterly. /f the hedge is not highly effect, hedge accounting can no longer be used. &herefore, firms must determine how they measure hedge effecti"eness. &his usually means that the changes in "alue of the hedge 'e.g. the forward contract or option( should be appro.imately e6ual to the changes in "alue of the

)%

hedged item. /n the e.amples used in this chapter, we ha"e used the change in the forward rate to measure the change in "alue of the forward contracts and the total change in the "alue of the option to measure the change in "alue of the option. &he )9 - allows split accounting for deri"ati"es. &his means that the intrinsic "alue of the deri"ati"e and the part of the option "alue related to time can be separated and accounted for differently. )or instance, firms can use the total change in "alue of the option to measure gains and losses or the change in the intrinsic "alue to measure the change in "alue of the deri"ati"e. &he change in the time "alue element would be ta5en immediately into earnings. 2hile it is important to 5now that these complicating factors e.ist, in this chapter we measure the change in "alue of the deri"ati"e using the total "alue of the deri"ati"e. 9lso, we assume that all hedges are highly effecti"e.

Ot$er For's o( Fore!&% /orro4!%& or Le% !%&

'ar$ier in the cha#ter. the e"#orting or im#orting of inventory was i$$ustrated. 8ccounting for other ty#es of foreign borrowing or $ending transactions is simi$arM that is. the two6transaction a##roach is fo$$owed in which the cost of an asset ac3uired or revenue recogni(ed is accounted for inde#endent$y from the method of sett$ement. =or e"am#$e. if a fi"ed asset is ac3uired from a foreign com#any on credit. the cost of the asset is the number of foreign currency units that wou$d be #aid in a cash transaction mu$ti#$ied by the e"change rate at the transaction date. 5he cost of the asset is not adjusted for )&

subse3uent changes in the e"change rate. but the $iabi$ity is adjusted at each ba$ance sheet date on the basis of the e"change rate in effect at that date. 5he adjustment to the $iabi$ity is re#orted current$y in income. 5he amount recorded for interest e"#ense is the e3uiva$ent number of U./. do$$ars needed to ma9e the interest #ayment.

))

/ummary

1. )istin$"ish between the ter%s *%eas"re#+ an# *#eno%inate#.+ 5ransactions are norma$$y measured and recorded in terms of the currency in which the re#orting entity #re#ares its financia$ statements. 8ssets and $iabi$ities are denominated in a currency if their amounts are fi"ed in terms of that currency 2. )escribe a forei$n c"rrenc! transaction. 8 foreign currency transaction is a transaction that re3uires sett$ement in a foreign currency. not in U. /. do$$ars :for a U. /. firm;. 3. ,n#erstan# so%e of the %ore co%%on forei$n c"rrenc! transactions. /ome common transactions inc$ude@ 1; im#orting or e"#orting goods or services on credit with the receivab$e or #ayab$e denominated in a foreign currencyM 2; borrowing from or $ending to a foreign com#any with the amount #ayab$e or receivab$e denominated in the foreign currencyM 3; engaging in a transaction with the intention of hedging a net investment in a foreign entityM and ; entering into a forward contract to by or se$$ foreign currency. . I#entif! three sta$es of concern to acco"ntants for forei$n c"rrenc! transactions an# e- lain the ste s "se# to translate forei$n c"rrenc! transactions for each sta$e. 8t the initia$ date the transaction is recogni(ed :in conformity with E88J;. the

)*

account :ba$ance sheet or income statement; arising from the transaction is measured and recorded in do$$ars by mu$ti#$ying the foreign currency unity by the current e"change rate. 8t each subse3uent ba$ance sheet date unti$ sett$ement. recorded ba$ances that are denominated in a foreign currency are adjusted to ref$ect the current e"change rate in effect at the ba$ance sheet date. 8t the sett$ement date. the treatment de#ends on whether the ba$ance to be sett$ed is a foreign currency #ayab$e or receivab$e. !f a foreign currency #ayab$e is being sett$ed. a U. /. firm must convert U. /. do$$ars into foreign currency units to sett$e the account. 8t the sett$ement of a foreign currency receivab$e. the foreign currency units received are converted into do$$ars. %. )escribe a forwar# e-chan$e contract. 8 forward e"change contract is an agreement to e"change currencies of two different countries at a s#ecified rate :the forward rate; on a sti#u$ated future date. 8t the ince#tion of the contract. the forward rate is usua$$y different from the s#ot rate. &. .- lain the "se of forwar# contracts as a he#$e of an "nreco$ni/e# fir% co%%it%ent. !n many cases. the firm enters into an agreement to #urchase or se$$ goods where the transaction is denominated in a foreign currency. <ecause the e"change rate might change before the #ayab$e is #aid or the

)+

receivab$e is co$$ected. a firm can use a forward contract to $oc9 in the amount of cash #aid or the amount of cash received. ). I#entif! so%e of the co%%on sit"ations in which a forwar# e-chan$e contract can be "se# as a he#$e. Aedges may be used to hedge a foreign currency e"#osed receivab$e or #ayab$e #osition. to hedge a net investment in a foreign subsidiary. o to hedge an identifiab$e foreign currency commitment. or to hedge a forecasted. *. )escribe a #erivative instr"%ent an# "n#erstan# how it %a! be "se# as a he#$e. 8 derivative is an e"ecutory contract between two #arties to be e"ecuted at a $ater date. with the resu$ting future cash f$ows de#endent u#on the change in some other under$ying measure of va$ue. 5he eventua$ do$$ar amount of the #erformance is determined by subse3uent va$ue changes. and the eventua$ outcome is necessari$y favorab$e to one of the #arties invo$ved and unfavorab$e to the other. +. .- lain how e-chan$e $ains an# losses are re orte# for fair val"e he#$es an# cash flow he#$es. 5he =8/< a$$ows deferra$ of the e"change gain and $oss on cash f$ow hedges :a forecasted transaction;. Li9e other gains and $osses that are e"c$uded from the income statement. they are inc$uded as com#onents of other com#rehensive income and re#orted in the stoc9ho$ders, e3uity section of the ba$ance sheet. On the other hand.

*0

e"change gains and $osses on fair va$ue hedges :unrecogni(ed firm commitments; are re#orted in current #eriods earnings a$ong with the e"change gain or $oss on the hedged item.

*1