Module 7: Foreign Currency Transaction and Hedge Accounting:

Module 7: Foreign Currency Transaction and Hedge Accounting: Part 1: Foreign currency transactions occur when a company buys or sells in a currency other than its reporting currency. The objectives of translating foreign currency transactions are to accurately measure the impact of the transaction on the firm and to allow it to be integrated with the firm s other financial information. Market forces determine long-term exchange rates. Factors that result in changing a country s currency price are: inflation (higher inflation weakens currency decreases purchasing power); interest rates differential (higher interest rates strengthens currency); trade surplus/deficit (when exports are greater than imports, currency increases). A direct quotation provides the number of units of the Canadian dollar required to purchase one unit of foreign currency (Ex: CDN$1.12 = US$1.00) A indirect quotation provides the number of foreign currency units required to purchase one unit of the Canadian dollar (Ex: US$0.8929 = CDN$1.00) Current transactions denominated in a foreign currency: Recording current transactions: One transaction approach: the foreign currency denominated purchase/sale and the settlement of the resulting payable or receivable is considered a single transaction/economic event. The initial amount recorded for the purchase or sale is considered an estimate of the final amount, which is established on the settlement date. Problem: if settlement is not received until after year-end, Year-end adjustments must split inventory and COGS. Thus the amount recorded for purchase or sale is depending on how it is financed (loss/gain from a change in exchange rate is added to cost of inventory or sale price). Therefore AcSB rejected this approach. Two-transaction approach: the foreign currency denominated purchase/sale and the settlement of the resulting payable or receivable is considered two separate transactions. The purchase/sale is an operating transaction that is completed and recorded on the date of the transaction. The financing transaction is not complete until the payable/receivable is settled. Thus any change in the amount to be paid as a result of not settling on the day of sale is deemed to be a benefit/cost of financing and not charged to the cost of inventory/sale. CICA Handbook does not mention the two-transaction approach but it is the foundation of many Handbook recommendations Monetary assets and liabilities are fixed by contract in terms of a monetary unit. 1

Reporting short-term monetary balances: 3 alternatives for reporting short-term monetary balances at year end: historical rate; year end rate but defer gain or loss until settlement; or year end rate but recognize the gain or loss immediately. CICA recommends the third alternative as the information provided by the foreign exchange market is viewed as reliable and objective. Reporting short-term and long-term non-monetary balances: Examples of short-term non-monetary items: inventory, prepaid insurance, deferred revenue. Examples of long-term non-monetary items: capital assets, intangibles and share capital. Foreign currency transactions should be translated at the exchange rate in effect on the date of the transaction. Their translated amount becomes their historical cost. Since non-monetary items are not tied to cash payments, they are not exposed to changes in exchange rates and thus no further adjustments are needed. However, non-monetary items that are reported at market value should be restated to the year-end rate and gains and losses recognized immediately (similar treatment as short-term monetary items). Long-term monetary items: Prior to 1983, long-term monetary balances were reported at historical rate, no further adjustments were made. In response to the demand for consistent standards, AcSB considered 3 alternatives to historical cost for recording. 1. Adjust monetary assets and liabilities balances to year-end rate and defer any gains/losses until realized. Rationale: gains and losses will even out, but studies show that the trend in exchange rates tend to be increasing or decreasing and not even out. Thus this option does not provide the best matching and thus was rejected by AcSB. 2. Adjust monetary assets and liabilities balances to YE rate and defer and amortize gains/losses over the remaining life of the instrument. Rationale: some gains and losses would net out over time resulting in smoothing some of the foreign exchange rate fluctuations over the life of the instrument. Problem: out of sync with other countries; smoothing might mask ineffective management of exchange risk; and management can use hedging to manage foreign exchange rate risks. Between 1983 to December 2001, CICA recommended this method. 3. Adjust monetary assets and liabilities balances to year-end rate and recognized any gains/losses immediately. Rationale: Same treatment as short-term monetary balances, the market value provides more relevant information to statement users and the new treatment harmonizes Canadian GAAP with GAAP of other countries. Problem: including gains and losses in income would cause fluctuations in income and the firm would look more risky and less stable. 2

CICA recommends this alternative effective January 1, 2002. Sum: At each reporting date, all monetary assets and liabilities should be translated at the current rate. Foreign exchange gains/losses on monetary assets/liabilities would be recognized in income immediately. Part 2: Class example 1: Sam Ltd., a Canadian company, purchased supplies totalling 3,000,000 Euros from Ernie Co. on June 1, 2002. Payment is due in 6 months (no hedges). On December 1, 2002, Sam paid half of the accounts payable with cash and Ernie Co. agreed to accept a noninterest bearing note payable for the other half. The note payable is due December 1, 2004. Sam s year-end is December 31. Prepare the journal entries for 2002 for the accounts payable and note payable. June 1, 2002 C$1 = Euros1.5 December 1, 2002 C$1 = Euros 2 December 31, 2002 C$1 = Euros 2.3 June 1, 2002 Transaction Inventory... 2,000,000 Accounts payable... 2,000,000 (Euros 3,000,000 1.5 = 2,000,000) December 1, 2002 Partial settlement Accounts payable... 2,000,000 Notes payable... 750,000 Cash... 750,000 Exchange gain... 500,000 (Euros 1,500,000 2 = 750,000) (Euros 1,500,000 2 = 750,000) December 31, 2002 Year end Notes payable... 97,826 Exchange gain... 97,826 (Euros 1,500,000 2.3 = 652,174) 3

Part 3: Class example 2: On January 1, 2002, a Canadian firm borrowed 100,000 marks from a bank in Germany. Annual interest rate is 10% and due each Dec 31 for the next five years. Principal is due Dec. 31, 2006. Foreign exchange rates are: Jan. 1, 2002 C$0.60 = DM1.0; Dec 31, 2002 C$0.67 = DM1.0; Dec 31, 2003 C$0.59 = DM1.0. In accordance with current GAAP, determine the exchange gain/loss for the loan on the financial statements for Dec. 31, 2002 and 2003. Record all the related journal entries. Journal entries: Jan 1, 2002: Cash 60,000 Foreign currency loan 60,000 Dec 31, 2002: Foreign exchange loss 7,000 Foreign currency loan [DM100,000 (0.67-0.60)] 7,000 Interest expense [DM10,000 (.67+.60)/2] 6,350 Foreign exchange loss 350 Cash (DM100,000 x 10% = 10,000 x.67) 6,700 Dec 31, 2003: Foreign currency loan [DM100,000 (0.67-0.59)] 8,000 Foreign exchange gain 8,000 Interest expense [DM10,000 (.67+.59)/2] 6,300 Foreign exchange gain 400 Cash (DM100,000 x 10% = 10,000 x.59) 5,900 Balance Sheet: 2002 2003 Foreign currency loan (100,000 x 0.67) $67,000 (100,000 x 0.59) $59,000 Income Statement 2002: Interest expense 6,350 Foreign exchange currency loss (7,000 + 350) 7,350 Income Statement 2003: Interest expense 6,300 Foreign exchange currency gain (8,000 + 400) 8,400 4

Part 4: Hedges: The purpose of a hedge is to modify a firm s exposure to risk (credit risk, interest rate risk, foreign currency risk, and liquidity risk). It fixes the amount required to settle an asset/liability that is denominated in a foreign currency. Guarantee a more secure and predictable return. A hedge can be an equal but opposite foreign currency item which fixes (and partially offsets) the gains or losses on the item that is hedged (also reduces potential gains). The most common form of hedge is a forward exchange contract (derivative). The forward exchange contract is between an exchange broker (i.e. bank) and a customer who agree to exchange currencies at a set price on a future date (fixed or option). For example, if a company holds a receivable (payable) denominated in a foreign currency, it could hedge this with a forward contract to sell (buy) the foreign currency it will receive (need) at a fixed forward exchange rate. Forward exchange contracts are executory contracts (neither party has fulfilled their obligation) and are firm commitments and thus they can be recorded in the books (optional). However, for reporting purposes, the receivable and payable will be offset against each other and only the net amount will be reported on the balance sheet as a forward contract. Hence, the Forward contract will be valued at its fair value. Hedge accounting (optional) is not the same as hedging. Hedge accounting is an accounting treatment that aims at matching the timing of income recognition on the hedging item to the timing of income recognition of the related hedged item. Hedging is designed to modify a firm s exposure to risk. Hedge accounting is applied only when gains, losses, revenues, and expenses on a hedging item would otherwise be recognized in net income in a different period than gains, losses, revenues, and expenses on the hedged item [3865.03]. A hedge of the net investment in a self-sustaining foreign operation or subsidiary is a hedge of the foreign currency exposure of the net investment (net assets) in the operation [3865.07 (g)]. (This is addressed in more detail in Module 8.) Handbook: To qualify for hedge accounting: 3 conditions must be met: 1. The company must identify the risks and state that hedge accounting will be used, 2. Formally document the hedge relationship and 3. Reasonable assurance that is will be an effective hedge (i.e. will offset gains and losses). Record hedges at a premium or at a discount: Foreign currency transactions are hedged at a premium when the forward rate is greater than the spot rate (asset = gain; liability = loss). Example: $1US = $1.50 Forward; $1US = $1.00 Spot Foreign currency transactions are hedged at a discount when the forward rate is less than the spot rate (asset = loss; liability = gain). Example: $1US = $1.00 Forward; $1US = $1.50 Spot See text example page 509 to 513 5

Fair-value hedge: Fair value hedge is a hedge of all or part of the risk exposure to changes in the fair value of financial instruments or unrecognized firm commitment [3865.07 (e)]. The hedged item and the hedging item are adjusted for the changes in fair value as a result of changes in the foreign exchange rates. These changes in fair value result in a loss or a gain, which is recognized in net income even when the hedged item has been designated as available-for-sale [3865.47]. (Versus: gains and losses on unhedged available-for-sale financial instruments are recognized in other comprehensive income). If the hedges were not perfect there would be a residual amount that would impact net income (amortization of premium or discount). The hedged item and the derivative hedging item are reported at fair value on the balance sheet as required by section 3855. For fair-value hedges of unrecognized firm commitments, the hedge price sets the purchase price [3865.50]. Example: Buy goods for US$1,000 to be delivered in 2 months. Spot rate today $1US = $1.10C. Immediately enters into a Forward contract at $1US = $1.08C. In 2 months will record the goods into their books at $1,080 (1,000 US x 1.08) regardless of spot rate on the delivery / transaction date (1.06). Section 3865 - Review Exhibit 7.4-1. Summary of accounting treatment: o On the transaction date: Record the purchase/sale and A/P or A/R at the spot rate. o On the Hedge date: Adjust payable or receivable to spot rate (gain or loss thru NI). Record the forward contract as a Payable and Receivable with the bank at the forward rate. Calculate the discount or premium, which is the difference between the spot rate and forward rate on the Hedge date. It is recognized over the terms of the forward exchange contract, which ensures proper matching o At year-end: adjust payable or receivable to spot rate (gain or loss thru NI) and forward contract to forward rate (gain or loss thru NI). Part of the resulting foreign exchange gain/loss will offset each other and the other part will be recognition of the discount or premium. Balance sheet: record forward contract at fair value (CR = liability; DR = asset) o On settlement date: adjust payable or receivable to spot rate (gain or loss thru NI) and forward contract to forward rate (gain or loss thru NI). Net gain or loss is the balance of any amortization of the premium or discount. Record cash as agreed, remove payable/receivable and remove balance in Payable and Receivable with the bank. 6

Part 5: Class example 3: Chapter 11, Problem 8 (page 533) En-Dur Corporation (EDC) is a Canadian company that exports computer software. On December 1, 2005, EDC shipped software products to a customer in South Africa. The selling price was established as 750,000 rand, with payment to be received on March 1, 2006. On December 3, 2005, EDC entered into a fair value hedge with the Royal Bank at the 90-day forward rate of R1 = $0.781. The fiscal year-end of EDC is December 31. The payment from the South Africa customer was received on March 1, 2006. Exchange rates were as follows: Spot Rates Forward Rates December 1, 2005 R1 = $0.741 December 3, 2005 R1 = $0.741 R1 = $0.781 December 31, 2005 R1 = $0.757 R1 = $0.785 March 1, 2006 R1 = $0.738 R1 = $0.738 Required: Part A: a) Prepare the journal entries to record all the above events. b) Prepare a partial balance sheet of EDC on December 31, 2005, that presents the accounts associated with the hedge. Part B: Assume that EDC did not enter into the hedge transaction on December 3, 2005. Prepare the journal entries to record the receipt of R750,000 on March 1, 2006. Part A: (a) December 1, 2005 Accounts receivable (R750,000.741) 555,750 Sales 555,750 December 3, 2005 Receivable from bank (C$) 585,750 Payable to bank (R750,000.781) 585,750 Premium =.781-.741 =.04 (750,000) = $30,000 Gain. December 31, 2005 Accounts receivable 12,000 Exchange gain/loss (R750,000 [.757.741]) 12,000 Exchange gain/loss 3,000 Payable to bank (R750,000 [.785.781]) 3,000 Net gain = $9,000 7

March 1, 2006 Exchange gain/loss 14,250 Accounts receivable (R750,000 [.738.757]) 14,250 Payable to bank (R750,000 [.738.785]) 35,250 Exchange gain/loss 35,250 Net gain = $21,000 Cash (R) 553,500 Accounts receivable (R) 553,500 Payable to bank (R) 553,500 Cash (R) 553,500 Cash 585,750 Receivable from bank 585,750 (b) En-Dur Corporation Balance Sheet As at December 31, 2005 Current assets Accounts receivable 567,750 Current liabilities Forward contract (1) 3,000 (1) Payable to bank (750,000 x.785) 588,750 Less: receivable from bank 585,750 Forward contract 3,000 Note: Receivable and payable with the bank are usually recorded in the firm s journals (because they are a firm commitment and can not be cancelled) but are NOT reported on the Balance Sheet (because they are executed contracts). However, the net amount of these two executed contracts is reported on the Balance Sheet as Forward contract. Recall an executed contract is when neither party has performed its obligation to the other. Part B: March 1, 2006 Cash (R) (R750,000.738 spot) 553,500 Exchange gain/loss 14,250 Accounts receivable (R750,000.757 YE rate)... 567,750 At year end, $12,000 exchange gain recognized thru NI (R750,000 [.757.741]) 8

Part 6: Cash-flow hedge: A cash-flow hedge is a hedge of the variability in cash flows of financial instruments, forecasted future transactions (expected to occur in the future that has not yet given rise to a recognized asset or liability) or unrecognized firm commitments [3865.07f]. Hedge future cash flows thus the risk is not yet incurred but the firm takes steps to protect future cash flows against that potential variability. To qualify for a cash-flow hedge, the hedged items must subsequently generate future cash flows, which should be exposed to variability resulting from risk. Gains and losses on the effective portion of the hedge are reported in other comprehensive income [3865.52 (a)]. Gains and losses on the ineffective portion of the hedge are reported in net income [3865.52 (b)]. The associated gains or losses recognized in other comprehensive income should be reclassified into net income in the same period or periods during which the hedged item (asset acquired, liability incurred, or anticipated transaction) affects net income. If the company expects that all or a portion of a loss recognized in other comprehensive income will not be recovered in one or more future periods, that amount should be recognized into net income. A company may elect to account for a hedge of the foreign currency risk in a firm commitment as a cash-flow hedge [3865.51]. For cash-flow hedges of unrecognized firm commitments, the company may elect to amortize to net income over the life of the asset acquired or liability assumed any associated gains and losses previously included in other comprehensive income [3865.56 (a)] or to have the hedge price set the purchase price [3865.56 (b)]. Summary of accounting treatment if adopt hedge accounting: o Hedge date: Record the forward contract: set up Payable and Receivable with the bank at forward rate. Calculate premium or discount and the cost of sale or purchase based on the spot rate. o If a year-end prior to transaction date: adjust forward contract to the forward rate (unrealized gain/ loss held under OCI). Balance sheet: record forward contract at fair value (CR = liability; DR = asset). o On transaction date: record purchase/sale at spot rate and set up payable/receivable. Adjust forward contract to the forward rate (unrealized gain/loss held under OCI). Close OCI and AOCI (from year-end) to sale or purchase (part of premium/discount). o On settlement date: adjust payable or receivable to spot rate (gain or loss thru NI) and forward contract to forward rate (gain or loss thru NI). Net gain or loss is the balance of any amortization of the premium or discount. Record cash as agreed, remove payable/receivable and remove balance in forward contract (Payable and Receivable with the bank). Premium/ discount is split between cost of hedging (thru NI) and value of sale/purchase (value on hedge date final balance recorded in books). If do NOT adopt Hedge accounting: Do not use OCI close to NI. No adjustment to value of sale or purchase recorded at spot rate on transaction date. 9

Class example 4: Chapter 11, Problem 5 (page 531) On October 1, Year 6, Versatile Company (VC) contracted to sell merchandise to a customer in Switzerland at a selling price of SF400,000. The contract called for the merchandise to be delivered to the customer on December 1, Year 6, with payment to be received in Swiss francs on January 31, Year 7. On October 1, Year 6, VC arranged a forward contract to deliver SF400,000 on January 31, Year 7, at a rate of SF1 = $1.20. VC s year-end is December 31. The merchandise was delivered on December 1, Year 6; SF400,000 were received and delivered to the bank on January 31, Year 7. Exchange rates were as follows: Spot Rates Forward Rates October 1, Year 6 SF1 = $1.18 SF1 = $1.20 December 1, Year 6 SF1 = $1.17 SF1 = $1.21 December 31, Year 6 SF1 = $1.21 SF1 = $1.22 January 31, Year 7 SF1 = $1.19 SF1 = $1.19 a) Prepare the journal entries that VC should make to record the events described assuming that the forward contract is designated as a cash flow hedge. b) Prepare a partial trial balance of the accounts used as at December 31, Year 6 and indicate how each would appear on the company s financial statements. c) What would be the difference if they chose not to apply hedge accounting? Solution: (a) October 1, Yr 6 Receivable from bank (C$) agreed to receive 480,000 Payable to bank (SF400,000 1.20) 480,000 Premium = 1.2-1.18 =.02(400,000) = 8,000 gain. Sales value on October 1 = $472,000 (400,000 x 1.18) December 1, Yr 6 Other Comprehensive Income 4,000 Payable to bank (SF 400,000 x (1.21-1.20) 4,000 Accounts receivable (SF400,000 1.17) 468,000 Sales 468,000 Sales 4,000 Other Comprehensive Income (close to sales) 4,000 December 31, Yr 6 Accounts receivable 16,000 Exchange gain/loss (SF400,000 [1.21 1.17]) 16,000 Exchange gain/loss 4,000 Payable to bank (SF400,000 [1.22 1.21]) 4,000 Net gain = 12,000 10

January 31, Yr 7 Exchange gains and losses 8,000 Accounts receivable (SF400,000 x (1.19-1.21) 8,000 Payable to Bank (SF400,000 x (1.19-1.22) 12,000 Exchange gains and losses 12,000 Net gain = 4,000 Cash (SF) 476,000 Accounts receivable (SF400,000 1.19) 476,000 Payable to bank (SF400,000 1.19) 476,000 Cash (SF) 476,000 Cash (C$) agreed 480,000 Receivable from bank (C$) 480,000 Premium of $8,000 (16,000 gain 8,000 loss) is split between the cost of hedging and the value assigned to sales. Premium assigned to cost of hedging: $16,000 gain: Dec 31: $12,000 gain (16,000 4,000) plus Jan. 31: $4,000 gain (12,000 8,000) Premium assigned to sales: $8,000 loss: Sales value on October 1 $472,000 (400,000 x 1.18) less final balance of sales $464,000 (468,000-4,000) (b) Trial balance, December 31, Yr 6 DR CR Accounts receivable 484,000 B/S Sales 464,000 I/S Exchange gain/loss 12,000 I/S Receivable from bank* 480,000 Payable to bank*(400,000 x 1.22) 488,000 *A net amount of $8,000 Cr would appear on the BS: forward contract - current liability. (c) If did not apply hedge accounting: Dec. 1: Journal entry: do NOT use OCI Loss 4,000 Payable to bank (SF 400,000 x (1.21-1.20) 4,000 Sales would remain at 468,000 Premium assigned to cost of hedging: $12,000 gain: Dec. 1: $4,000 loss; Dec 31: $12,000 net gain (16,000 4,000) plus Jan. 31: $4,000 net gain (12,000 8,000) Premium assigned to sales: $4,000 loss: Sales value on October 1 $472,000 (400,000 x 1.18) less final balance of sales $468,000 Premium = net gain $8,000 11

Part 7: Transnational financial reporting refers to reporting across national boundaries, that is, reporting financial results to user groups located in a country other than the one where the company is headquartered. Some strategies to accommodate foreign users are: 1. Provide unchanged financial statements Do nothing. 3 reasons: little need for foreign capital, sophisticated users, and language and currency is well understood around the world. This approach is cheap and easy for firm but increases costs to users, which can discourage them from investing. 2. Prepare convenient translations: Prepare statements using a common language such as English (or translate into the language of the foreign readers) but leave the figures in the currency of the home country and accounting principles unchanged. Relatively easy and inexpensive, foreign readers can read the financial statements which increase the audience. But the figures and accounting principles are un-translated / unchanged. 3. Prepare convenient statements: Prepare statements using a common language such as English and restate the figures to a common currency such as U.S. dollars. Foreign readers can read them and monetary amounts are expressed in reader s currency. But lose foreign appearance and can be misleading if reader does not realize that foreign GAAP is still used. 4. Restate financial statements on limited basis: Partially restate some figures or provide reconciliations to the foreign country s accounting policies in the notes to the financial statements. More convenient for the foreign readers to analyze and decrease penalties such as lower stock prices and higher interest rates related to the users when effectively communicate financial information. But is more costly and inconvenient for the company. 5. Prepare secondary financial statements: Issue new statements with the needs of the potential user in mind. Translate to their language and their currency and restate to a common GAAP such as IASC standards. Further reduce penalties, attract more international investment as easier and cheaper for readers to analyze. But it is the most expensive, requires two sets of books, and can disclose too much information to competitors. Criteria to consider to determine which approach to use: : Decision should be based on cost-benefit analysis : Who are the potential audience, what are the needs of the users and their level of sophistication : How well understood the local GAAP and international disclosure standards : The amount of capital raised outside of the country : How well the native language, currency and business environment is known THE END 12