CHAPTER 10: Foreign Currency Transactions Introduction

When parties from two different nations transact business, they must settle on which currency will be used to specify the payment amount. The currency used to settle the transaction is the denominated currency. For example, if an American retailer purchases wine from a French company. Will the amount paid be in Euros or U.S. dollars? The decision as to which currency will be used as the denominated currency sets up whether the seller or the buyer will bear the risk (or receive the benefit) as to changes in currency exchange rates. For example, if the wine shipment will be paid for in U.S. dollars, and if the US dollar drops in value vis--vis the Euro, then the US buyer will pay the amount anticipated in US dollars. The French seller will get the agreed upon price in US dollars, but when the French seller converts them into Euros, the French seller will get a lesser amount than was anticipated when the contract was signed. Correspondingly, if the US dollar goes up in value vis--vis the Euro, then the US buyer will still pay the amount anticipated in US dollars, but the French seller converts those US dollars into Euros, the French seller will receive a greater amount of Euros than was anticipated when the contract was signed. Because the contract is specified in a foreign currency as far as the French company is concerned, the French company bears the burden and receive the benefit of exchange rate fluctuations. If the contract specified that the purchase price was 100,000 Euros ( 100,000), then the US buyer will be bearing the burden (and receiving the benefit) from the changes in exchange rates. Now, the French seller always receives the amount anticipated when the contract was signed ( 100,000 ), and the US buyer pays whatever is necessary in US dollars to get the 100,000 contract price. When a party to the contract does not use the denominated currency to keep its books (e.g., the US company in a contract denominated in Euros), it has a problem, its books are kept using its domestic currency (US dollars). A company is not allowed to introduce foreign currency into its bookkeeping system. For example, a US company can put down that it has an account payable of 100,000. How could it give a total liabilities figure if some of payables are in Euros. Every foreign currency figure has to be converted into its domestic currency (US dollars). This process is called foreign currency translation.

The Mechanics of Exchange Rates

There are two ways to quote a foreign currency exchange rate. An indirect quote (also known as European terms) specifies how many units of the foreign currency will be received for one unit of the domestic or base currency. This is the way most foreign currency exchange rates are quoted in the United States. Specifying the exchange rate for Japanese yen as 121 yen ( 121) to the US dollar is an example of an indirect exchange rate. A direct quote specifies how many units of the domestic currency will be received for one unit of the foreign currency. Specifying the exchange rate for the British pound () as U.S. $1.50 per British pound is an example for a direct exchange rate. In the United States, a direct quote is used for the British pound. Direct Exchange Rate Euro to Dollar 1 = $1.05303 Indirect Exchange Rate Dollar to Euros $1 = 0.949639

The way that you can remember the difference is that a direct quote tells you directly (without any calculation) what one unit of the foreign currency is worth in dollars. An indirect quote tells you what one unit of the foreign currency is worth after you do some calculations (indirectly): $1 = $1/.949639 = 0.949639 0.949639/.949639 [Direct Quote] [Indirect Quote]

1 = $1.05303

Exchange rates often are quoted in terms of the buying rate (the price paid when you are buying) and the selling rate (the price paid when you are selling). The difference or spread between these two rates represents the brokers commission is often referred to as the points. We will not talk about the spread in this class, but you should be aware of it. There are two groups of exchange rates. The spot rate refers to the amount paid for the immediate delivery of the currency (if the exchange will occur within two business days). For example, you are in Paris and you go up to the American Express office and ask, I have ten dollars here in my hand. How many Euros will you give me, you blood sucker? The forward rate refers to an exchange of currency that will occur at a future point in time, such as in 30 to 180 days. For example, you write to American Express and ask, I am planning on a trip to Paris in three months. Can we make an agreement today in which I promise to come into your office in three months and give you $10, and you

promise that you will give me a specified amount of Euros that we agree upon today, you bloodsucker. An agreement to exchange currencies at a specified price at a specified future point in time is a Forward Contract (e.g., the 3-month agreement described above). A Forward Contract can be used to hedge against the risk associated with changing exchange rates. They can be used to cover any number of days even though forward rates are usually quoted in terms of 30-day intervals. For example, if the contract between the US retailer and the French wine seller is denominated in Euros. The US retailer may be afraid that the US dollar will drop in value. Rather than bear that risk, the US retailer may purchase a Forward Contract and lock in the exchange rate that will be used when the account payable to the French seller will be paid. The difference between the forward rate and the spot rate represents a premium or discount. When the forward rate is greater than the spot rate at inception of the contract, the contract is said to be at a premium. The opposite situation results in a discount. We will not discuss the concepts of discounts and premiums in this class, but you should be aware of it. The forward rate is affected by the interest rate differences between the two countries, as well as other factors (e.g., the foreign currency brokers commission, volatility of spot rates, the time period covered by the contract, expectations of future exchange rate changes, and the political and economic environments of a given country).

Interest Rate Differential

As noted above, one of the reasons for the difference between the forward rate and the spot rate is the interest rate differential between the holding an investment in foreign currency and holding an investment in domestic currency over a period of time. For example, the spot rate for the Canadian dollar is CAN$ .6531 to US$ 1. The 90-day forward rate is $.6506. This can be calculated using a simple formula.

Example 1
If you assume that you can get 1 percent in the US (.25 percent per quarter) and 2.55 percent in Canada (.6375 percent per quarter): Forward Rate of FC (CAN $) .6506 = Spot Rate of FC (CAN $) .6531 x Domestic (U.S.) Foreign (Canadian) Interest Rate Interest Rate (1.0025 / 1.006375)

If the interest yield on the foreign currency (the Canadian dollar) is greater than the yield on the US dollar, the forward rate will be less than the spot rate (contract sells at a discount). This is true in Example 1.

Accounting For Foreign Currency Transactions

If a US company deals with a foreign company and the contract is denominated in dollars, then the U.S. company is not exposed to any foreign currency risks. This transaction does not require and special accounting treatment. If, however, the contract is denominated in the foreign currency, then the US company is exposed to a foreign currency risk. The accounting treatment for these transactions divides the transaction into two parts. The first part is the underlying business transaction. The second part is the settlement of the account payable/receivable. The change in the buyers domestic currency determines if there is an exchange gain or loss.

Example 2
Assume that a US company sells mining equipment to a British company on June 1, 2004 with the corresponding receivable to be paid or settled on July 1, 2004. The equipment has a selling price of US$ 305,000 and a cost of US$ 250,000. On June 1, 2004, the British pound is worth US$ 1.70, and on July 1, 2004, the pound is worth US$ 1.60. The payment is to be made in US dollars, and the British company bears the foreign currency risk. June 1, 2004: US Company British Company D. A/R $306,000 D. Equipment 180,000 C. Sales $306,000 C. A/P $180,000 US Company D. COGS $250,000 C. Inventory $250,000 July 1, 2004: D. Cash C. A/R US Company $306,000 British Company D. A/P 180,000 $306,000 Exchange Loss 11,250 C. Cash 191,250 British Company (No Entry)

Example 3
Assume the same facts as in Example 2, but this time the payment is to be made in British pounds, and the US company bears the foreign currency risk. June 1, 2004: US Company British Company D. A/R $306,000 D. Equipment 180,000 C. Sales $306,000 C. A/P $180,000 US Company D. COGS $250,000 C. Inventory $250,000 July 1, 2004: D. Cash Exchange Loss C. A/R US Company $288,000 18,000 $306,000 D. British Company A/P 180,000 C. Cash British Company (No Entry)

180,000

Example 3
Assume the same facts as Example 2 (contract denominated in US dollars), except that the exchange on July 1, 2004, the British pound is worth $1.80. Because the payment is to be made in US dollars, the British company receives the benefit from the rise in the British Pound. June 1, 2004: US Company British Company D. A/R $306,000 D. Equipment 180,000 C. Sales $306,000 C. A/P $180,000 US Company D. COGS $250,000 C. Inventory $250,000 British Company (No Entry)

July 1, 2004: D. Cash C. A/R US Company $306,000 British Company D. A/P 180,000 $306,000 C. Exch. Gain Cash

10,000 170,000

Example 5
Assume the same facts as in Example 4, but this time the payment is to be made in British pounds, and the US company receives the gain from the rise in the British pound. June 1, 2004: British Company US Company D. A/R $306,000 D. Equipment 180,000 C. Sales $306,000 C. A/P $180,000 US Company D. COGS $250,000 C. Inventory $250,000 July 1, 2004: D. Cash C. Exch. Gain A/R US Company $324,000 $18,000 306,000 D. British Company A/P 180,000 C. Cash British Company (No Entry)

180,000

The foreign currency exchange gain or loss is not an extraordinary item, and is included in income from continuing operations. If it is material, it should be disclosed in the financial statements or in a note to the financial statements.

Unsettled Foreign Currency Transactions at Year End

The prior discussion assumed that that account receivable/payable was settled before the fiscal-year end of the company in question. It is possible that the account receivable/payable is outstanding at the year end. The rule is that a foreign currency asset should be revalued at the end of the year, and its value on the balance sheet should reflect the value on that date. Think of this like what you do for marketable securities. When you change the value of something on the balance sheet, you have to book a corresponding gain or loss in order to

keep the balance sheet in balance. The gain or loss that comes from marking your asset/liability to market appears in the income statement.

Example 6
Assume that a US company purchases goods from a foreign company on November 1, 2001. The purchase, in the amount of 1,000 Canadian Dollars, is denominated in Canadian dollars. The exchange rate is CAN $ = US $.50. The account payable is to be paid on February 1, 2002. The US company would make the following journal entries: November 1, 2001: D. Inventory C. Accounts Payable $500 $500

Assume that the US company uses a calendar year and that the exchange rate is CAN $ = US$ .052 on December 31, 2001. The US company would make the following journal entry on December 31, 2001: D. Exchange Loss [(.52 - .50) x 1,000] C. Accounts Payable $20 $20

Assume that the exchange rate on February 1, 2002 is CAN $ = US$ .55. On February 1, 2002, the US company would make the following journal entry: D. Accounts Payable Exchange Loss [(.55 - .52) x 1,000] C. Cash $520 30

$550

Hedging
Hedging involves the use of Derivatives. Derivatives are financial instruments that derive their value from changes in the value of a related asset (e.g., foreign currency). We will use two derivatives in this class, a Forward Contract to buy/sell foreign currency and an Option to buy/sell foreign currency.

Forward Contracts
As noted above, Forward Contract is a contract to buy or sell a specified amount of an asset at a specified price at a specified future date. The current price for the asset is the spot price, and the price specified in the Forward Contract is the forward price. The initial value of a forward contract is zero and it does not usually require an initial outlay of cash. This is because a Forward Contract is a fair deal. The values assigned to the currencies reflect what everyone agrees are todays market prices for those currencies.

As the values of foreign currencies change, you may find that you locked in a good/bad price. This change in currency values then causes your Forward Contract to have a value other than zero. For example, consider a non-currency situation. You make a contract to buy 1 barrel of oil for $40 at a time when oil trades for $40 per barrel. The contract calls for delivery in one year. After one year, the price of oil is $60 per barrel. Your contract to buy a barrel of oil for $40 is now worth $20. You could fairly ask your friend, Hi friend, I am sick today. Would you please do me a favor and give me $20 for this piece of paper? You can take the paper down to the oil seller, and give them $40, you will then have a barrel of oil. You can now take the barrel down to the oil market and sell it for $60 and break even. Ignoring the work involved, your friend would not lose any money because he paid you a fair price for your piece of paper.

Options
An Option represents the right (not the obligation) to either buy (Call Option) or sell (Put Option) a specified amount of an asset at a specified price at a specified future date. This price specified in the option is referred to as the strike price or the exercise price. You have to pay something for the Option. This is because this is not a fair deal on its face. You are being given the right to buy/sell something. With the Forward Contract, you had the obligation to buy/sell something at an agreed upon price. You had to do the deal. Here, you dont have to do the deal. You have the right to do the deal if it makes sense, or you can walk away. Have a one-way right for a given time period is probably worth something. Assume that you have the right to buy your neighbors house for $600,000 for the next year. Right now it is worth $600,000, so that it doesnt look like you got a particularly good deal right now. That is true and the right to purchase the house at that price today isnt worth anything right now. There is a second force here that is worth something. You have locked in the $600,000 price for a year. In a year, the price of the house may skyrocket way up, and you could make a fortune. The potential for gain is worth something. So, you have to pay for it. The price paid for an Option can be divided into these two parts. The first part is called the intrinsic value of the Option. You could turn around today and use the Option and you would make so much money. For example you get an Option to buy a barrel of oil for $30 for the next year. The current price for the barrel is $40. You could turn in your Option today and make $10. That is the intrinsic value of the Option. Would such an Option sell for less than $10? NO! Would it sell for more than $10? YES! Why? Because you have the right to buy a barrel of oil for $30 for the next year, and you could make even more money in the future. The potential for making more money means that the Option will sell for

more than $10. The extra value of the Option over the intrinsic value is called the time-value of the Option.

Types of Hedges
Derivatives can be used to avoid the exposure to risk by hedging against an unfavorable outcome associated with rate/price changes. Hedges are classified as either fair value hedges or cash flow hedges. A fair value hedge is used to offset changes in the fair market value of items with fixed prices or rates. Fair value hedges include hedges against a change in the fair market value of: A recognized asset or liability; or An unrecognized firm commitment

Many accounting principles do not allow for the recognition in current earnings of both increases and decrease in the value of recognized assets, liabilities, or firm commitments (e.g., historical cost). However, if the risk of such changes in value is covered by a fair value hedge, special accounting treatment is allowed that provides for the recognition of such changes in earnings. These criteria are beyond the scope of this chapter. A cash flow hedge is used to establish fixed prices or rates when future cash flows could vary due to changes in prices or rates. Cash flow hedges include hedges against changes in cash flows associated with: A forecasted transaction; or An existing asset or liability with variable future cash flows.

The purpose of the cash flow hedge is to allow the entity to fix the price or rate and reduce the variability of the cash flows. As was true with fair value hedges, special accounting treatment is only available if the hedge satisfies specified criteria, which are beyond the scope of this chapter. With a cash flow hedge, the gain or loss on the derivative instrument will be reported in Other Comprehensive Income (OCI). OCI does not appear on the income statement. It is shown as part of equity on the balance sheet. When the forecasted transaction occurs the amount in OCI will be reclassified into earnings (e.g., closed to Cost of Goods Sold).

Fair Value Hedge Using a Forward Contract

Companies entering into business transactions involving foreign currency exchange risks could eliminate that risk by settling the transaction immediately (e.g., paying immediately or requiring immediate payment). This may not be practical. If immediate settlement is not practical, then a company can hedge against the exchange risk by purchasing a Forward Contract to acquire the needed foreign currency. The purchase of the foreign currency contract involves the acquisition of an asset that involves its own set of journal entries. In practice, most companies do not make the extensive journal entries noted below. In order to understand the relationship between the Forward Contract and the underlying business transaction, we will make the extensive journal entries. The reason why the hedge works is that you started with an asset (or a liability) that is tied to foreign currency (e.g., an account payable for CAN $100,000). You then buy a liability (or an asset) that is tied to the same amount of foreign currency (e.g., an account receivable for CAN $100,000). Since you now have both an asset and a liability that are both tied to the same amount of foreign currency. If the value of that foreign currency goes up, you owe more (the liability) but you have more (the asset). The net difference in your position is zero; hence a hedge.

Example 7
Assume that on November 1, 2001, a US company purchases inventory from a Canadian vendor with subsequent payment due in Canadian dollars. Payment of CAN $ 100,000 is required on February 1, 2002. The US company is willing to pay the account payable to the Canadian company at todays exchange rates, but it afraid that the Candian dollar will go up vis--vis the US dollar, and it doesnt want to take a chance that this may happen. To protect itself from foreign currency exchange risk, the US company purchased a Forward Contract to purchase Canadian dollars. On November 1, 2001, the US company purchased a forward contract to buy CAN $ 100,000 at a forward rate of 1 CAN $ = US$ .506. Selected spot and forward rates are as follows: Date November 1, 2001 December 31, 2001 February 1, 2002 Spot Rate 1 CAN $ = U.S. $ .50 1 CAN $ = U.S. $ .52 1 CAN $ = U.S. $ .55 Forward Rate for Remaining Term of Contract 1 CAN $ = U.S. $ .506 1 CAN $ = U.S. $ .530 1 CAN $ = U.S. $ .550

If the US company had not hedged its position, it would have lost $5,000. This is because the US company has to pay CAN $100,000 on February 1, 2002. The US company has to buy the needed Canadian dollars at that time. On February 1, 2002, the exchange rate is 1 CAN $ = U.S. $ .55. The US company will have to pay the equivalent of US $55,000 (100,000 x .55). Since the original payable was for US$ 50,000, the US company had a Exchange Loss of US$ 5,000 on the payable. This loss will still be reflected on the books of the US company despite the hedge. With the hedge, the US company has purchased an asset, which is the receivable under the Forward Contract. That receivable represents the value of CAN $100,000. On February 1, 2002, the Forward Contract receivable will be worth US$ 55,000 (100,000 x .55). The US company bought this asset for US$ 50,600. Therefore, it has a gain of US$ 4,400 on the Forward Contract. When you net the Exchange Loss ($5,000) and Forward Contract Gain ($4,400), you have a loss of $600. This loss represents the cost of the hedging transaction (US$ 600).

Forward Contract Fair Value Hedge Straddling 2 Years

When the business transaction straddles two years, the cost of the hedge is split between the two years. At the end of the year, we will book the Exchange Loss and we will book a Forward Contract Gain (or an Exchange Gain coupled with a Forward Contract Loss). At the end of the year, the amount of the Forward Contract Gain (or loss) is the difference between: (i) the price (specified in the Forward Contract) that you locked in, and (ii) the price others would have to agree to at the end of the year if they executed a new Forward Contract (for delivery of CAN $100,000 at the same date as the original contract). Since the prices in the Forward Contracts are paid in the future, the difference represents a gain that is in future dollars. You need to take the present value of that gain in order to calculate the Forward Contract Gain at the end of the year.

Example 8
Continue with the facts of Example 7. We will discount the changes in the value of the forward contract at a 6% rate. The Forward Contract Gain is calculated as follows: Buying FC Price Others Would Pay at end of year for Forward Contract (100,000 x .53) Less: Price Locked in on Original Forward Contract (100,000 x .506) Difference in Forward Rates: Forward Contract Gain using 6% discount rate (PVIF = .995025) Less: Matching Forward Contract Gain Tied To The Exchange Loss [11/1 to 12/31 ($.52 - $.50) x 100,000] Cost of the Hedge in 2001(Remaining Gain) Dec. 31 $53,000 -50,600 $2,400 $2,388 -2,000 $388

Remember that we saw in Example 7 that the total cost of the hedge is $600. Why is it a gain in the first year? The gain tells you that if you abandoned the hedge at the end of the year (and took your chances with the account payable in Canadian dollars), you would make $388. We are going to do the same calculation at the settlement date (February 1, 2002). We dont need to take a present value on the Forward Contract Gain, because we are no longer dealing with future dollars. It is February 21, 2002. Also, we have to take out the Forward Contract Gain booked in the prior year ($2,333). You cant count the same gain twice: Buying FC Value of Foreign Currency at end of Forward Contract (.55 x 100,000) Price You have to Pay for Foreign Currency under the Forward Contract (100,000 x .506) Total Forward Contract Gain Less: Forward Contract Gain Booked in 2001 Forward Contract Gain Applicable to 2002 Less: Matching Forward Contract Gain Tied To Exchange Loss in 2002 [Change In Spot Rates from 12/31 to 2/1 ($.55 - $.52) x 100,000] Cost of Hedge in 2002 Feb. 1 $55,000 -$50,600 $4,400 -2,388 $2,012 -3,000 -$988

The gain for 2001 ($388) plus the loss for 2002 (-$988) equals the $600 cost of the hedging transaction that we saw in Example 7. The journal entries relating to this transaction are as follows: November 1, 2001: Record the Purchase of Inventory: D. Inventory C. Accounts Payable Record the Purchase of the Forward Contract: D. Forward Contract Receivable C. Forward Contract Payable December 31, 2001: Record the Exchange Loss from the increase in the Canadian dollar: D. Exchange Loss [(.52 - .50) x 100,000] C. Accounts Payable $2,000 $2,000 $50,600 $50,600 $50,000 $50,000

Record a matching Forward Contract Gain (exactly equal to the Exchange Loss) on the Forward Contract: D. Forward Contract Receivable [(.52 - .50) x 100,000] C. Unrealized Gain on Forward Contract $2,000 $2,000

First, we book a Forward Contract Gain exactly equal to the Exchange Loss. This represents the hedging portion of the Forward Contract. Whatever is left of the Forward Contract Gain is then recognized as a cost of the hedge in 2001. The book refers to this as the change in time value excluded from hedge effectiveness If the matching Forward Contract Gain had been greater than the actual Forward Contract Gain, you would have booked a loss for the cost of the hedge in 2001. We will see this in 2002. D. Forward Contract Receivable C. Unrealized Gain on Forward Contract (Cost of Hedge) $388 $388

February 1, 2002: Record the Matching Forward Contract Gain: D. Forward Contract Receivable [(.55 - .52) x 100,000] Cr. Unrealized Gain on Forward Contract $3,000 $3,000

Record the receipt of the Foreign Currency under the Forward Contract: D. Foreign Currency Cr. Forward Contract Receivable Record the payment of the Forward Contract payable: D. Foreign Contract Payable Cr. Cash $50,600 $50,600 $55,000 $55,000

Record the Payment of the Account Payable with the Foreign Currency. Also, recognize the Exchange Loss from the increase in the Canadian dollar: D. Accounts Payable Exchange Loss [(.55 - .52) x 1,000] Cr. Foreign Currency $52,000 3,000

$55,000

In 2002, the Forward Contract Gain is $2,012, but we created a matching Forward Contract Gain of $3,000. This creates a greater gain than we really had, we have to book a loss now to bring the Forward Contract Gain down to the actual gain of $2,012. This requires booking a loss of $988 ($3,000 - $2,012). This is the cost of the hedge in 2002: D. Loss on Forward Contract (Cost of Hedge) C. Forward Contract Receivable $988 $988

The net effect of all the gains and losses for this transaction is the US$ 600 cost of the hedging transaction: Exchange Loss - 2001 Unrealized Gain on Forward Contract - 2001 Exchange Loss - 2002 Unrealized Gain on Forward Contract - 2002 Cost of Hedge - 2001 Cost of Hedge - 2002 Net Effect (Net Cost of Hedge) -$2,000 2,000 -3,000 3,000 388 -988 -$ 600

In an effective hedge, the respective gains and losses should offset each other except to the extent of the original premium or discount on the Forward Contract.

Remember that the original premium in this transaction is the difference between the forward price paid and the spot price [($ .506 - $ .50) x 100,000 = $ 600]. Financial statements on December 31 would look as follows: Income Statement Exchange Loss Unrealized Gain on Forward Contract Balance Sheet Assets: $2,000 Inventory Forward Contract Receivable -2,388 Liabilities: Accounts Payable Forward Contract Payable

$50,000 52,988 -$52,000 -50,600

The Exchange Loss and the Unrealized gain on the Forward Contract are netted. The Forward Contract Receivable and the Forward Contract Payable are also netted. If there had been no hedge, then the US company would have had an Exchange Loss of $ 5,000. Remember, that the hedge removes the uncertainty associated with exchange rate risk. The hedge eliminates exchange gains, as well as, losses. If the Canadian dollar drops (instead of rising), then the US company would have had an exchange gain, which would have been eliminated by the Forward Contract.

Example 9
Continue with the facts of Examples 7&8. Assume that the Forward Contract still costs US$ 600, but that the spot prices for the Canadian dollar are as follows: Date November 1, 2001 December 31, 2001 February 1, 2002 Spot Rate 1 CAN $ = U.S. $ .50 1 CAN $ = U.S. $ .49 1 CAN $ = U.S. $ .48 Without the Forward Contract $2,000 ---$2,000 ---$2,000 With the Forward Contract $2,000 -2,000 $0 -$600 -$600

Exchange gain (loss) on foreign currency transaction [100,000 x ( $ .48 - $ .50)] Loss on forward contract due to changes in spot rates Subtotal Cost of Hedge (Loss on forward contract excluded from assessment of hedge effectiveness) Net income effect

A Forward Contract can also be used by the seller of the inventory to eliminate foreign currency exchange risks.

Forward Contract Amount Different from Transaction Amount

If a company purchases a Forward Contract for less than the amount of the contract, then the company has only partially hedged the risk from changes in foreign exchange rates. An exchange loss or gain will occur for the unhedged portion. If a company purchases a Forward Contract for more than the amount of the contract, then the company has an investment in the Forward Contract which will result in a gain or loss.

Forward Contract for a Different Period than the Underlying Business Transaction
If a company purchases a Forward Contract for a period shorter than the underlying business transaction, then the company needs to extend the protection of the hedge for the remaining period. This could happen if the holder of the Forward Contract exercises his or her right to close the Forward Contract early: The company could roll over the Forward Contract for the additional period. The company could cash in the Forward Contract and purchase another Forward Contract to cover the exchange risk for the remaining period. The company could satisfy the underlying business obligation at the time that the Forward Contract ends.

If a company purchases a Forward Contract for a period longer than the underlying business transaction, then the company needs to extend the protection of the hedge for the remaining period. This could happen if the company holding an account receivable receives the foreign currency payment early: The company could roll back the Forward Contract to the shorter date. The company could sell its interest in the Forward Contract. The company could hold the foreign currency payment and satisfy the Forward Contract at its termination.

Hedging an Identifiable Foreign Currency Commitment Using a Forward Contract (A Fair Value Hedge)
In this situation, the US company makes a binding contract. It is an executory contract because a sale has not occurred or a service has not been rendered yet. If you recall, the accounting treatment of such a contract is to ignore it until the product or service is delivered. When do you book a profit when you sell merchandise? You book your profit when you deliver it. Until then, it doesnt show up in the books of the seller. You are still on the hook with a binding contract. You are bound. You may have to pay more than you thought if you have an account payable denominated in foreign currency. You may receive less than you thought if you if you have an account receivable denominated in foreign currency. You can still lose the same amount of money. There is an additional concern here. Before, you gain or loss was labeled as an Exchange Gain/Loss. Here, because you dont book the transaction until delivery, the gain or loss that you suffer will not be booked as an Exchange Gain or Loss. The transaction will be originally booked at the higher cost or lower price. The Exchange Loss will be in the lower price or higher cost, but it wont be labeled as an Exchange Loss. It will look like you made a bad deal. For example, assuming a foreign account receivable, instead of showing a normal sale price coupled with an Exchange Loss, you will now show a low sales price. If you assume a foreign account payable, instead of showing a normal purchase price coupled with an Exchange Loss, you will now show a high purchase price. Either way, you look like you are a bad business person. The hedge allows you to create a Firm Commitment asset/liability that preserves the exchange rate for purposes of booking the Sales Revenue or Cost of Goods Sold.

Example 10
Assume that on March 31, a US company commits to selling specialty equipment to a Canadian customer with delivery and payment in 90 days. The equipment costs $55,000. The firm commitment calls for payment in Canadian dollars at a selling price of CAN$ 100,000. Assume that the spot rate on March 31 is 1 CAN$ = US$ .85. If the spot rate were to remain constant over time, the US company will receive $85,000 (100,000 x $ .85) and realize a gross profit on the sale of $30,000.

Management fears that the Canadian dollar may weaken relative to the US dollar. Therefore, they wish to establish the dollar basis of the transaction at the commitment date rather than the later transaction date. Management acquires a Forward Contract to sell Canadian dollars in 90 days. We will use a 6% discount rate. Selected spot and forward rates are as follows: Date March 31 + 30 days + 60 days + 90 days (transaction date) Spot Rate 1 CAN $ = U.S. $ .850 1 CAN $ = U.S. $ .840 1 CAN $ = U.S. $ .820 1 CAN $ = U.S. $ .800 Forward Rate for Remaining Term of Contract 1 CAN $ = U.S. $ .845 1 CAN $ = U.S. $ .838 1 CAN $ = U.S. $ .814 1 CAN $ = U.S. $ .800

The cost of the hedge protection here is $500 [($ .850 - $ .845) x 100,000]. This cost locks in the amount to be received under the contract. The cost of the hedge is not calculated every 30 days. It is just given here for demonstration purposes. The cost of this hedge for each 30 day period is as follows: +30 days: (Contract To Sell FC) Purchase Price Locked in by Forward Contract (100,000 x .845) Less: Price you could lock in today (100,000 x .838) Difference in Forward Rates Present Value of Difference with 6% discount (PVIF = .990075) Less: Matching Forward Contract Gain Tied To Exchange Loss The Change In Spot Rates in last 30 days ($ .85 - $ .84) x 100,000 Cost of Hedge for first 30 days + 30 days $84,500 -83,800 $700 $693 -1,000 -$307

+60 days: (Contract To Sell FC) Purchase Price Locked in by Forward Contract (100,000 x .845) Less: Price you can lock in today (100,000 x .814) Difference in Forward Rates Present Value of Difference with 6% discount (PVIF = .995025) Less: Present Value of Difference at +30 days Less: Matching Forward Contract Gain Tied To The Change In Spot Rates in last 30 days ($.84 - $.82) x 100,000 Cost of Hedge for second 30 days (Remaining Gain) +90 days: (Contract To Sell FC) Purchase Price Locked in Forward Contract (100,000 x .845) Less: Value of Currency at maturity (100,000 x .800) Forward Contract Gain Less: Present Value of FMV at +60 days Less: Matching Forward Contract Gain Tied To The Change In Spot Rates in last 30 days ($.82 - $.80) x 100,000 Cost of Hedge for last 30 days + 90 days $84,500 -80,000 $4,500 -3,085 $1,415 -2,000 -$585 + 60 days $84,500 -81,400 $3,100 $3,085 -693 $2,392 -2,000 $392

The total cost of the hedge transaction is $500 (the difference between the forward and spot prices x 100,000): Change in first 30-day period Change in second 30-day period Change in last 30-day period The journal entries relating to this transaction are as follows: March 31: Record the Purchase of the Forward Contract: D. Forward Contract Receivable C. Forward Contract Payable $84,500 $84,500 -$307 392 -585 -$500

+30 Days: Record the loss on the Firm Commitment from the decrease in the Canadian dollar (this takes the place of the exchange loss): D. Loss on Firm Commitment [(.85 - .84) x 100,000] C. Firm Commitment Record the Gain on the Forward Contract: D. Forward Contract Payable [(.85 - .84) x 100,000] C. Unrealized Gain on Forward Contract $1,000 $1,000 $1,000 $1,000

Recognize the portion of the US$ 500 cost of the hedging transaction allocable to the first 30 days. The book refers to this as the change in time value excluded from hedge effectiveness: D. Unrealized Loss on Forward Contract (Cost of Hedge) C. Forward Contract Payable +60 days: Record the Loss on the Firm Commitment: D. Loss on Firm Commitment [(.84 - .82) x 100,000] C. Firm Commitment Record the Gain on the Forward Contract: D. Forward Contract Payable [(.84 - .82) x 100,000] C. Unrealized Gain on Forward Contract $2,000 $2,000 $2,000 $2,000 $307

$307

Recognize the portion of the US$ 500 cost of the hedging transaction allocable to the second 30 days. The book refers to this as the change in time value excluded from hedge effectiveness: D. Forward Contract Payable C. Unrealized Gain on Forward Contract (Cost of Hedge) $392 $392

+90 days: Record the Loss on the Firm Commitment: D. Loss on Firm Commitment [(.82 - .80) x 100,000] C. Firm Commitment Record the Gain on the Forward Contract: D. Forward Contract Payable [(.82 - .80) x 100,000] C. Unrealized Gain on Forward Contract $2,000 $2,000 $2,000 $2,000

Recognize the portion of the US$ 500 cost of the hedging transaction allocable to the last 30 days. The book refers to this as the change in time value excluded from hedge effectiveness: D. Unrealized Loss on Forward Contract (Cost of Hedge) C. Forward Contract Payable $585

$585

Record the receipt of the Foreign Currency from the underlying business transaction: D. Foreign Currency Firm Commitment C. Sales Revenue Record the Cost of Goods Sold: D. Cost of Goods Sold C. Inventory $55,000 $55,000 $80,000 5,000

$85,000

Sell the Foreign Currency under the Forward Contract and satisfy the Forward Contract payable: D. Foreign Contract Payable C. Foreign Currency $80,000 $80,000

Record the receipt of payment under the Forward Contract satisfying the Forward Contract Receivable: D. Cash C. Forward Contract Receivable $84,500 $84,500

The effect of the fair value hedge can be summarized as follows: Targeted Without the With the Position Hedge Hedge $80,000 $85,000 $85,000 -55,000 -55,000 -55,000 $30,000 $25,000 $30,000 -5,000 ________ ________ 5,000 $30,000 $25,000 $30,000 ________ $30,000 ________ $25,000 -$500 $29,500

Sales price Cost of Sales Gross Profit Loss on Commitment Gain on Forward Contract Subtotal Derivative loss excluded from assessment of effectiveness (the time value) Cost of Hedge Net Income Effect

The fair value hedge was effective in maintaining the targeted gross profit. It was accomplished at a cost of $500. Remember that the hedge could have prevented an increase in the gross profit. If financial statements were prepared on April 30 (+30 days), with sixty day remaining the hedge, the sale and hedge would be reported as follows: Income Statement Balance Sheet Loss on Firm Assets: Commitment -$1,000 Unrealized Gain on Forward Contract Receivable 1,000 Forward Contract Unrealized Loss on Liabilities: Forward Contract -307 Firm Commitment Forward Contract Payable

$84,500

-$1,000 -$83,807

The Loss on the Firm Commitment and the Unrealized gain on the Forward Contract offset each other. The Forward Contract Receivable and the Forward Contract Payable are netted.

Hedging a Forecasted Transaction Using an Option (Cash Flow Hedge)

As noted above, with a cash flow hedge, the transaction hasnt occurred (Existing Foreign Currency Transaction) and no contract has been signed (Identifiable Foreign Currency Commitment). Here, the US company projects that it will need foreign currency in the future for a planned transaction. It would like to limit the variability in the exchange rate (future cash flows) that will be used when the planned transaction occurs. Because the terms of the transaction are not fixed, if specified requirements are met, this hedge can qualify for cash flow hedge treatment.

As noted above, the income earned on the foreign currency derivative investment used in a cash flow hedge will create Other Comprehensive Income (OCI). In the case of the option, the change in the intrinsic value of the hedge is the OCI. The OCI will offset any exchange losses. The change in the time-value of the option is the cost of the hedge.

Example 11
Assume that on June 1, a US company thought that it might purchase of 5,000 units of inventory from a foreign vendor. The purchase would probably occur on September 1, and require the payment of 100,000 FC. It is anticipated that the inventory will be processed further and delivered to customers by early October. On June 1, the US company purchased a call option to buy 100,000 FC at a strike price of 1 FC = $ .55 during September. The US company paid $900 for the option. On September 1, the US company purchased 5,000 units of inventory at a cost of 103,000 FC. The option was settled/sold on September 1 at its fair market value of $2,600. After incurring further processing costs of $20,000, the inventory was sold for $95,000 on October 5. Spot rates, option values, and changes in value over time are as follows: Spot Rate of FC Fair Value of Option Less: Intrinsic Value of Option [(Current Spot Rate - $.55) x 100,000] (zero if negative) (OCI) Time Value of Option Change in Time Value of Option (Cost of Hedge) 6/1 $ .530 $900 -0 $900 6/30 7/31 $ .552 $ .57 $1,350 $2,400 -200 $1,150 250 -2,000 $400 -750 9/1 $ .575 $2,600 -2,500 $100 -300

The Cost of the Hedge (the Change in the Time Value of the Option) is $800 ($250 750 350 = $800) or ($900 - $100 = $800). The existence of the cash flow hedge using the call option to buy limits the exposure of rises in the foreign currency to $2,000, which is the difference between the exercise price and the current spot rate of the foreign currency [($.55 - $53) x 100,000]: Intrinsic Value of Option (OCI): Less: Value of Expected Cash Flows [(Change in Spot Rates) x 100,000]: Currency fluctuation not protected by Hedge: June 30 $200 -2,200 -$2,000 July 31 $2,000 -4,000 -$2,000 Sept.1 $2,500 -4,500 -$2,000

With the use of the call option, the US company can walk away from the hedge if the foreign currency exchange rate stays below the option or strike price ($.55). Thus, the call option allows the US company to benefit from drops in the foreign currency exchange rate. It just loses the option price ($900). If the U.S. Company had used a Forward Contract, the US company would have been obligated to purchase the foreign currency or settle the contract when the foreign currency exchange rate drops. Without the With the Option Option -$59,225 -$59,225 -20,000 -20,000 -$79,225 -$79,225 _______ -$79,225 95,000 $15,775 _________ $15,775 $2,500 -$76,725 95,000 $18,275 -$800 $17,475

Cost of Sales - Raw Materials Cost of Sales Processing Costs Adjustment to sales due to change in the intrinsic value of the option (OCI): COGS Sales Price of Inventory Gross Profit (Cost of Hedge = $900 - $100 = $800) Net Income Effect:

The company adjusted gross profit is $1,700 higher than it would have been without an option [the intrinsic value of the option ($2,500) less the cost of the option ($800)]. The adjusted gross profit resulting from the use of a hedge results from the following: Sales Revenue Locked in cost of goods sold on 100,000 FC at the strike price of $ . 55 No hedge on the additional cost of 3,000 FC at the transaction date spot rate of $ .575 Processing costs Adjusted gross profit June 1: Invest in the Call Option: D. Investment in Call Option C. Cash $900 $900 $95,000 (55,000) (1,725) (20,000) $18,275

June 30: Record change in value of Call Option: D. Investment in Call Option ($1,350 - $900) C. Unrealized Gain on Call Option Other Comprehensive Income (OCI) (Increase in Intrinsic Value of Call Option July 31: Record change in value of Call Option: D. Investment in Call Option ($2,400 - $1,350) Unrealized Loss on Call Option C. Other Comprehensive Income (OCI) (Increase in Intrinsic Value of Call Option September 1: Record change in value of Call Option: D. Investment in Call Option ($2,600 - $2,400) Unrealized Loss on Call Option C. Other Comprehensive Income (OCI) (Increase in Intrinsic Value of Call Option Settle the Call Option: D. Cash C. Investment in Call Option Purchase Inventory: D. Inventory C. Cash Process Inventory further: D. Inventory C. Cash Sell Inventory: D. Cash C. Sales Revenue $95,000 $95,000 $20,000 $20,000 $59,225 $59,225 $2,600 $2,600 $200 $300 $500 $1,050 $750 $1800 $450 $250 200

Recognize Cost of Goods Sold: D. Cost of Goods Sold C. Inventory $79,225 $79,225

Close Other Comprehensive Income (OCI) to Cost of Goods Sold: D. Other Comprehensive Income (OCI) C. Cost of Goods Sold $2,500 $2,500

If financial statements were presented at June 30, the hedge would be reported as follows: Income Statement Unrealized Gain on Option Assets: Balance Sheet $1,350 -$200

-$250

Investment in Options Stockholders Equity: Other Comprehensive Income Gain On Option

The FASB specifies disclosure requirements for hedging transaction. There are four basic disclosures: The objectives of using hedging instruments and the strategies for achieving the objective. A description of the various types of hedges such as fair value hedges and cash flow hedges. A description of the entity' risk management policy for hedging types s along with a description of the types of transactions which are hedged.

Detailed information regarding: the amount of gains/losses on hedges, where gains/losses are recognized-earnings or other comprehensive income, when gains/losses appearing in other comprehensive income will be recognized in earnings, where gains/losses recognized in earnings appear in the income statement, and gains/losses recognized due to a hedge no longer qualifying for hedge accounting.

Comparison of Valuation of Forward Contract and Options: 1 2 Fair Market Value of Hedge Instrument Gain/Loss Shown For Hedge Instrument Cost of the Hedge Forward Contract Present Value of Changes in Forward Price of Currency Change in Spot Rates Change in 1-2 over investment period (Initial Investment = $0) Option Market Price of Option Change in Intrinsic Value of Option (Current Spot Rate Strike Price) Change in 1-2 over investment period (Initial Investment = price paid for option)