Foreign Currency Transactions and Hedging Foreign Exchange Risk Chapter Seven Foreign Currency Transactions and Hedging Foreign Exchange Risk Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Exchange Rate Mechanisms Learning Objective 7-1: Understand concepts related to foreign currency, exchange rates, and foreign exchange risk. Between 1945 and 1973, countries fixed the par value of their currency in terms of the U.S. dollar. The U.S. dollar was based on the Gold Standard until 1971. Since 1973, exchange rates have been allowed to float in value. Several currency arrangements exist. Exchange rates have not always fluctuated. During the period 1945–1973, countries fixed the par value of their currency in terms of the U.S. dollar, and the value of the U.S. dollar was fixed in terms of gold. Countries agreed to maintain the value of their currency within 1 percent of the par value. If the exchange rate for a particular currency began to move outside this 1 percent range, the country’s central bank was required to intervene by buying or selling its currency in the foreign exchange market. Because of the law of supply and demand, a central bank’s purchase of currency would cause the price of the currency to stop falling, and its sale of currency would cause the price to stop rising. The integrity of the system hinged on the U.S. dollar maintaining its value in gold and the ability of foreign countries to convert their U.S. dollar holdings into gold at the fixed rate of $35 per ounce. As the United States began to incur balance of payment deficits in the 1960s, a glut of U.S. dollars arose worldwide, and foreign countries began converting their U.S. dollars into gold. This resulted in a decline in the U.S. government’s gold reserve from a high of $24.6 billion in 1949 to a low of $10.2 billion in 1971. In that year, the United States suspended the convertibility of the U.S. dollar into gold, signaling the beginning of the end for the fixed exchange rate system. In March 1973, most currencies were allowed to float in value. Today, several different currency arrangements exist.

Foreign Exchange Mechanisms and Rates Independent float: currency fluctuates according to market forces. Pegged to another currency: currency’s value is fixed in terms of a particular foreign currency, and the central bank will intervene to maintain the fixed value. European Monetary System: the euro is used in multiple countries. Its value floats against other world currencies. Exchange Rate: cost of one currency in terms of another. Published rates are wholesale rates that banks charge each other – retail rates to consumers are higher. Exchange rate is the difference between the rates a bank is willing to buy and sell currency. Foreign Exchange Rates An Exchange Rate is the cost of one currency in terms of another. Rates published daily in the Wall Street Journal are as of 4:00pm Eastern time on the day prior to publication. The published rates are wholesale rates that banks use with each other – retail rates to consumers are higher. Rates are also available on line at: www.oanda.com and http://www.x-rates.com The difference between the rates at which a bank is willing to buy and sell currency is known as the “spread.” Rates change constantly!

Foreign Exchange – Option Contracts Options contracts give the holder the option (the right but not the obligation) of buying/ selling currency units at a future date at a contracted “strike” price. Put options allow sales of foreign currency by the holder. Call options allow purchases of foreign currency by the holder. Value is derived from : The difference between current spot rate and strike price. The difference between foreign and domestic interest rates. The length of time to option expiration. The potential volatility of changes in the spot rate. Option premium - a function of Intrinsic Value and Time Value An options contract gives the holder the option of buying (or selling) currency units at a future date at the contracted “strike” price. A “put” option allows for the sale of foreign currency by the option holder. A “call” option allows for the purchase of foreign currency by the option holder. An option gives the holder “the right but not the obligation” to trade the foreign currency in the future. Option values Value is derived from: a function of the difference between current spot rate and strike price The difference between foreign and domestic interest rates The length of time to option expiration The potential volatility of changes in the spot rate An option premium is a function of Intrinsic Value and Time Value

Foreign Currency Transactions Learning Objective 7-2: Account for foreign currency transactions using the two transaction perspective, accrual approach. A U.S. company buys or sells goods or services to a party in another country. This is often called foreign trade. The transaction is often denominated in the currency of the foreign party. How do we account for the changes in the value of the foreign currency? A U.S. company buys or sells goods or services to a party in another country. This is often called foreign trade. The transaction is often denominated in the currency of the foreign party. How do we account for the changes in the value of the foreign currency?

Foreign Currency Transactions Two methods of accounting for changes in the value of a foreign currency transaction exist. The one-transaction perspective assumes the export sale is not complete until the foreign currency receivable has been collected. Changes in the U.S. dollar value of the foreign currency is accounted for as an adjustment to Accounts Receivable and Sales. GAAP requires the two-transaction approach that accounts for the original sale in US Dollars at date of sale. No subsequent adjustments are required. Changes in the U.S. dollar value of the foreign currency are accounted for as gains/losses from exchange rate fluctuations reported separately from sales in the income statement. Conceptually, the two methods of accounting for changes in the value of a foreign currency transaction are the one-transaction perspective and the two-transaction perspective. The one-transaction perspective assumes that an export sale is not complete until the foreign currency receivable has been collected and converted into U.S. dollars. Any change in the U.S. dollar value of the foreign currency is accounted for as an adjustment to Accounts Receivable and to Sales. GAAP requires the two-transaction approach that accounts for the original sale in US Dollars at date of sale. No subsequent adjustments are required. Changes in the U.S. dollar value of the foreign currency are accounted for as gains/losses from exchange rate fluctuations reported separately from sales in the income statement.

Hedging Foreign Exchange Risk Learning Objective 7-3: Understand how foreign currency forward contracts and foreign currency options can be used to hedge foreign exchange risk. Companies will avoid uncertainty associated with the effect of unfavorable changes in the value of foreign currencies using foreign currency derivatives. Learning Objective 9-3: Understand how foreign currency forward contracts and foreign currency options can be used to hedge foreign exchange risk. Companies will avoid uncertainty associated with the effect of unfavorable changes in the value of foreign currencies using foreign currency derivatives.

Hedging Foreign Exchange Risk Two foreign currency derivatives that are often used to hedge foreign currency transactions: Foreign currency forward contracts. Foreign currency options. ASC Topic 815 provides guidance for hedges of four types of foreign exchange risk: Recognized foreign currency denominated assets & liabilities. Unrecognized foreign currency firm commitments. Forecasted foreign currency denominated transactions. Net investments in foreign operations. Hedging Foreign Exchange Risk Two foreign currency derivatives that are often used to hedge foreign currency transactions: Foreign currency forward contracts lock in the price for which the currency will sell at contract’s maturity. Foreign currency options establish a price for which the currency can be sold, but is not required to be sold at maturity. ASC Topic 815 provides guidance for hedges of four types of foreign exchange risk. Recognized foreign currency denominated assets & liabilities. Unrecognized foreign currency firm commitments. Forecasted foreign currency denominated transactions. Net investments in foreign operations

Accounting for Hedges Learning Objective 7-4: Account for forward contracts and options used as hedges of foreign currency denominated assets and liabilities. Two ways to account for a foreign currency hedge: Cash Flow Hedge The hedging instrument must completely offset the variability in the cash flows associated with the foreign currency receivable or payable. Gains/losses are recorded in Accumulated Other Comprehensive Income. Hedges of foreign currency denominated assets and liabilities, such as accounts receivable and accounts payable, can qualify as either cash flow hedges or fair value hedges. To qualify as a cash flow hedge, the hedging instrument must completely offset the vari- ability in the cash flows associated with the foreign currency receivable or payable. If the hedging instrument does not qualify as a cash flow hedge or if the company elects not to designate the hedging instrument as a cash flow hedge, the hedge is designated as a fair value hedge. The following summarizes the basic accounting for the two types of hedges of foreign currency denominated assets and liabilities. Fair Value Hedge. Any other hedging instrument. Gains/losses are recognized immediately in net income.

Foreign Currency Firm Commitment Hedge Learning Objective 7-5: Account for forward contracts and options used as hedges of foreign currency firm commitments. A firm commitment is an executory contract not normally recognized in financial statements; the company has not delivered goods nor has the customer paid for them. When a firm commitment is hedged using a derivative financial instrument, hedge accounting requires explicit recognition on the balance sheet at fair value of both the derivative financial instrument and the firm commitment. A firm commitment is an executory contract; the company has not delivered goods nor has the customer paid for them. Normally, executory contracts are not recognized in financial statements. However, when a firm commitment is hedged using a derivative financial instrument, hedge accounting requires explicit recognition on the balance sheet at fair value of both the derivative financial instrument (forward contract or option) and the firm commitment. The change in fair value of the firm commitment results in a gain or loss that offsets the loss or gain on the hedging instrument (forward contract or option), thus achieving the goal of hedge accounting

Hedge of a Forecasted Foreign Currency Denominated Transaction Learning Objective 7-6: Account for forward contracts and options used as hedges of forecasted foreign currency transactions. Cash flow hedge accounting may be used for foreign currency derivatives associated with a forecasted foreign currency transaction. The forecasted transaction must be probable, highly effective, and the hedging relationship must be properly documented. Hedge of a Forecasted Foreign Currency Denominated Transaction Cash flow hedge accounting may be used for foreign currency derivatives associated with a forecasted foreign currency transaction. The forecasted transaction must be probable, highly effective, and the hedging relationship must be properly documented. There is no recognition of the forecasted transaction or gains and losses on the forecasted transaction.

Foreign Currency Borrowings Learning Objective 7-7: Prepare journal entries to account for foreign currency borrowings. Companies often must account for foreign currency borrowings, another type of foreign currency transaction. Companies borrow foreign currency from foreign lenders to finance foreign operations or to take advantage of more favorable interest rates. Because the principal and interest are denominated in foreign currency and create an exposure to foreign exchange risk complicate accounting for a foreign currency borrowing. In addition to the receivables and payables that arise from import and export activities, companies often must account for foreign currency borrowings, another type of foreign currency transaction. Companies borrow foreign currency from foreign lenders either to finance foreign operations or perhaps to take advantage of more favorable interest rates. The facts that both the principal and interest are denominated in foreign currency and both create an exposure to foreign exchange risk complicate accounting for a foreign currency borrowing.

Journal Entries

IFRS—Foreign Currency Transactions and Hedges There are no substantive differences between U.S. GAAP and IFRS in accounting for foreign currency transactions. Similar to U.S. GAAP, IAS 21, “The Effects of Changes in Foreign Exchange Rates,” requires the use of a two-transaction perspective in accounting for foreign currency transactions with unrealized foreign exchange gains and losses accrued in net income in the period of exchange rate change. Similar to U.S. GAAP, IAS 21, “The Effects of Changes in Foreign Exchange Rates,” also requires the use of a two-transaction perspective in accounting for foreign currency transactions with unrealized foreign exchange gains and losses accrued in net income in the period of exchange rate change. There are no substantive differences between IFRS and U.S. GAAP in the accounting for foreign currency transactions.

IFRS—Foreign Currency Transactions and Hedges IAS 39, “Financial Instruments: Recognition and Measurement,” governs accounting for hedging instruments including those used to hedge foreign exchange risk. One difference between the two sets of standards relates to the type of financial instrument designated as a foreign currency cash flow hedge. U.S. GAAP allows only derivative financial instruments to be used as a cash flow hedge IFRS allows nonderivative financial instruments. IAS 39, “Financial Instruments: Recognition and Measurement,” governs the accounting for hedging instruments including those used to hedge foreign exchange risk. Rules and procedures in IAS 39 related to foreign currency hedge accounting generally are consistent with U.S. GAAP. Similar to current U.S. standards, IAS 39 allows hedge accounting for recognized assets and liabilities, firm commitments, and forecasted transactions when documentation requirements and effectiveness tests are met, and requires hedges to be designated as cash flow or fair value hedges. One difference between the two sets of standards relates to the type of financial instrument that can be designated as a foreign currency cash flow hedge. Under U.S. GAAP, only derivative financial instruments can be used as a cash flow hedge, whereas IFRS also allows nonderivative financial instruments, such as foreign currency loans, to be designated as hedging instruments in a foreign currency cash flow hedge.

IFRS—Foreign Currency Transactions and Hedges In 2010, the IASB proposed a new hedge accounting model that would result in significant differences between IFRS and U.S. GAAP. In 2012, the IASB issued a draft of a forthcoming statement that would move hedge accounting from IAS 39 to IFRS 9, “Financial Instruments,” to implement the new model which would go into effect in 2015. IFRS 9 is intended to more closely align accounting with a company’s risk management activities. In 2010, the IASB proposed a new hedge accounting model that would result in significant differences between IFRS and U.S. GAAP. In 2012, the IASB issued a draft of a forthcoming statement that would move hedge accounting from IAS 39, “Financial Instruments: Recognition and Measurement,” to IFRS 9, “Financial Instruments,” to implement the new model. The new model would go into effect in 2015. The forthcoming new hedging model will replace the rules-based hedge accounting requirements in IAS 39 and is intended to more closely align accounting with a company’s risk management activities. To improve transparency, the new hedging model will require several value changes to be included in AOCI rather than net income. As examples, the change in fair value of both the hedged item and the hedging instrument in a fair value hedge will be reflected in AOCI (similar to a cash flow) and the change in time value of options will be reflected in AOCI rather than net income.