SUBJECT: Accounting 18 (

DESCIPTIVE TITLE: Auditing & Assurance –Specialized Industries

Instructor: Alfredo R. Cabiso

This course covers essential issues on advanced courses dealing with financial accounting and
reporting in various topical areas. Included in this course are topics on foreign currency Page | 1
transactions, hedging foreign currency exchange risks, foreign currency translation, and home
office and branch accounting.

The materials in this learning module are from the following:

1. Main reference Textbook: Advanced Financial Accounting:2021 edition by
Antonio Dayag.
2. Other references:
 Advanced Financial Accounting Volume 2: by Pedro Guerrero & Jose
Peralta
 CPA Reviewer in Practical Accounting 2: by Antonio Dayag
 CPA Reviewer in Practical Accounting 2: by Pedro Guerrero & Jose Peralta

LESSON No. 2
Hedging Foreign Currency Exchange Rate Risk
(Forward Contract)

Learning Objectives:
The students should be able:
 To understand the concept of hedging;
 To be able to understand the reasons why an enterprise resort to hedging;
 To understand what derivatives are;
 To know the accounting of hedging foreign currency

DERIVATIVES
A derivative instrument may be defined as a financial instrument that by, its terms of inception
or upon occurrence of a specific even, provides the holder (or writer) with the right (or
obligation) to participate in some or all of the price changes of another underlying value of
measure, but does not require the holder to own or deliver the underlying value of measure.
Thus, its value is derived from it.

The underlying value of measure may be one or more referenced:

 financial instrument
 foreign currencies, or
 commodities, or
 other assets, or
 other specific items to which a rate such as interest rates, foreign exchange rates, an
index of prices, or another market indicator is applied. In most cases, derivatives differ
from traditional instruments (stocks and bonds, for example)

HEDGING
Hedging is a risk management technique that involves using one or more derivatives or other
hedging instruments to offset changes in fair value or cash flows of hedged items. The general
provisions on hedging and hedged accounting are contained in PAS 39. A hedging relationship
had two components, namely:

1. Hedged item. A hedged item is an asset, liability, firm commitment, highly probable forecast
transaction, or net investment in a foreign operation. To be designated as a hedged item, the
designated hedged item should expose the entity to risk of changes in fair value or future
cash flows.

2. Hedging instrument. A hedging instrument is a designated derivative or a designated non-

derivative financial asset or non-derivative financial liability whose fair value or cash flows are
expected to offset changes in fair value or cash flows of a designated hedged item.
Examples of hedging instruments are foreign exchange forward contracts, interest rate
swaps and commodity futures contracts.
Page | 2
Three types of hedging relationships:
a. Fair value hedge. This is a hedge of the exposure to changes in fair value of a recognized
asset or liability or an unrecognized firm commitment that is attributable to a particular risk,
and that could affect profit or loss. Under fair value accounting, changes in the fair value of
the hedging instrument and of the hedged item are recognized in profit or loss at the same
time. The result is that there will be no (net) impact on profit or loss of the hedging
instrument and the hedge is fully effective, because changes in fair value will offset each Page | 3
other.
b. Cash flow hedge. This is a hedge of the exposure to variability in cash flows that is
attributable to particular risk associated with recognized asset or liability or a highly probable
forecast transactions and could affect profit or loss. Under cash flow hedge accounting,
changes in fair value of the hedging instruments attributable to the hedge risk are
deferred( rather that being recognized immediately in profit or loss). The accounting for the
hedged item is not adjusted.
c. Hedge of a net investment in foreign operation. This is a hedge of the exposure to
foreign currency exchange gains or losses on an entity’s net investment in a foreign
operation (which is the amount of the entity’s interest in the net asset of that operation).
Hedges of net investments in foreign operations are accounted for like cash flow edges.

Hedge Accounting
Hedge accounting recognizes the offsetting effects on profit or loss of changes in the fair value
of the hedging instrument and the hedge item every accounting period

Foreign Currency Forward Contract

A foreign currency forward contract is an agreement to exchange currencies of different
countries on a specified future date at the specified rate (the forward rate)

The fair value of a foreign currency forward contract is determined by reference to changes in
the forward rate over the life of the contract. The changes in the forward rate may be
discounted to the present value.

Foreign currency forward contracts are usually entered into for the following purposes:
1. A fair value hedge – this includes hedges against a change in the fair value of:
 A recognized foreign currency denominated asset or liability
 An unrecognized foreign currency firm commitment

2. A cash flow hedge – this includes hedges against the change in cash flows associated with:
 A forecasted foreign currency transaction.
 An unrecognized foreign currency firm commitment.

Illustrative Problems:

Refer to the comprehensive problem No. I, Chapter 7 of your book “Advanced Financial
Accounting” 2021 Edition by: Antonio Dayag. Solutions to this problems will be
discussed in online classes