1. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-1 Chapter 35 Accounting for foreign currency transactions

2. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-2 Objectives of this lecture Understand why it is necessary to translate foreign currency transactions into Australian dollars Understand that all transactions denominated in overseas currencies must initially be translated at the exchange rate in place as at the date of the transaction (the transaction date’s spot rate) using the entity’s ‘functional currency’

3. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-3 Objectives (cont.) Understand that at the end of the reporting period all foreign currency monetary items must be translated at the reporting date spot rate Understand the difference between a functional currency and a presentation currency

4. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-4 Objectives (cont.) Understand what a qualifying asset is and be able to provide the appropriate accounting entries relating to a qualifying asset Understand the difference between a fair value hedge and a cash flow hedge, and be able to provide the appropriate accounting entries in respect of both

5. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-5 Objectives (cont.) Understand what a foreign currency swap is and why it might be undertaken, and be able to provide the relevant journal entries to account for a foreign currency swap

6. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-6 Introduction to accounting for foreign currency transactions Accounting for foreign currency transactions is governed by AASB 121 The Effect of Changes in Foreign Exchange Rates Australian companies now allowed to use a ‘presentation currency’ (currency in which the financial statements are prepared) in other than Australian dollars, but must disclose the reason and justification for its choice of presentation currency

7. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-7 Introduction to accounting for foreign currency transactions (cont.) Two general issues to be considered in foreign currency translations 1.Where debts, receivables or other monetary items are denominated in currencies other than domestic currency there is a need to convert them into a single currency (not necessarily Australian dollars) –unless transactions converted into a common currency, financial statements would include account balances in different currencies—the aggregate would not make sense 2.Where an entity controls a foreign subsidiary, the financial statements of that subsidiary need to be translated into a common currency before the consolidation process (addressed in Chapter 36)

8. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-8 Foreign currency transactions Exchange rate defined as (AASB 121): –the ratio of exchange for two currencies Exchange rates frequently change (daily) and this results in the need for the translation of transactions. This involves transactions: –denominated in a foreign currency, or –requiring settlement in a currency other than the functional currency of the entity

9. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-9 Foreign currency transactions (cont.) Examples of foreign currency transactions Acquisition of goods from a foreign supplier where the transaction is denominated in a foreign currency Sale of goods to a foreign customer where the transaction is denominated in a foreign currency Loan from foreign lender denominated in a foreign currency Refer to Worked Example 35.1 on page 1126—Acquisition of goods from a foreign supplier where the transaction is denominated in a foreign currency

10. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-10 Foreign currency transactions (cont.) Accounting entry at date of original transaction AASB 121 (par. 21) A foreign currency transaction shall be recorded, on initial recognition in the functional currency, by applying to the foreign currency amount the spot exchange rate between the functional currency and the foreign currency at the date of the transaction Key terms Spot exchange rate: the exchange rate for immediate delivery Functional currency: the currency of the primary economic environment in which the entity operates—important as this identifies what currency the transactions will be converted into

11. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-11 Foreign currency transactions (cont.) Key terms (cont.) Functional currency—note AASB 121 (par. 9) The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. An entity considers the following factors in determining functional currency: (a)The currency (i) that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled), and (ii) of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services (b) The currency that mainly influences labour, material and other costs of providing goods and services (this will often be the currency in which such costs are denominated and settled)

12. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-12 Foreign currency transactions (cont.) Key terms (cont.) Presentation currency—the currency in which the financial statements are presented—note AASB 121 (par. 38) An entity may present its financial statements in any currency (or currencies). If the presentation currency differs from the entity’s functional currency, it translates it results and financial position into the presentation currency. For example, when a group contains individual entities with different functional currencies (perhaps there are a number of different subsidiaries operating within different countries and with different functional currencies), the results and financial position of each entity are expressed in a single common currency so that consolidated financial statements may be presented

13. . Foreign currency transactions (cont.) Key terms (cont.) Presentation currency—the currency in which the financial statements are presented—note AASB 121 (par. 38) (cont.) Therefore, where consolidated financial statements are prepared, transactions will first be translated into a particular functional currency, and then prior to consolidation, the subsidiaries’ financial statements will all be translated into the group’s single presentation currency Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-13

14. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-14 Illustration 1 On 1 June 2011, XYZ Ltd acquired goods on credit from a UK supplier. The goods were shipped FOB London on 1 June 2011. The cost of the goods was £200 000, and remained unpaid at 30 June 2011 On 1 June 2011 the exchange rate was $1.00 = £0.50. On 30 June 2011 it was $1.00 = £0.55

15. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-15 Illustration 1 — Solution As at 1 June, the debt would be equal to $400 000 (which is 200 000/0.50). It is converted at the spot rate As at 30 June, the debt would be equal to $363 636 (which is 200 000/0.55 using the reporting date spot rate) AASB 121 requires that: A foreign currency transaction shall be recorded, on initial recognition in the functional currency, by applying to the foreign currency amount the spot exchange rate between the functional currency and the foreign currency at the date of the transaction Hence, the initial entry on 1 June 2011 would be: DrInventory400 000 CrAccounts payable400 000

16. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-16 Reporting date adjustments AASB 121 requires that foreign currency monetary items (which includes payables and receivables) outstanding at reporting date shall be translated at the spot rate at reporting date (referred to as the ‘closing rate’) AASB 121 requires that the exchange differences relating to monetary items shall be brought to account as part of profit or loss in the financial year in which the exchange rates change Hence, the entry on 30 June 2011 would be: DrAccounts payable36 363 CrExchange gain 36 363 Note that the adjustment goes to profit or loss, and not to inventory

17. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-17 Presentation currency Although a previously referred to requirement does state that any presentation currency may be used, AASB 121 has been amended by the insertion of paragraph Aus38.1. Paragraph Aus38.1 states: Notwithstanding paragraph 38, for the purpose of reporting under the Corporations Act, entities are only permitted to present financial statements which purport to be drawn up in accordance with the Corporations Act in one presentation currency The currency generally required for presentation in Australia is Australian dollars. However, relief from this requirement is given to some entities For example, BHP Billiton Ltd presents its financial statements using US dollars rather than Australian dollars as its presentation currency

18. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-18 Foreign currency transactions: reporting date adjustments Foreign currency monetary items outstanding at the reporting date must be translated using the closing rate –Closing rate—the spot exchange rate at the reporting date –Foreign currency monetary items—include accounts payable and receivable; cash; interest, notes, loans and dividends receivable; bank overdraft; income taxes, wages, notes and/or debentures payable Any exchange differences (foreign exchange gains or losses) are generally then brought to account as part of profit or loss in the reporting period in which the exchange rates change

19. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-19 Foreign currency transactions: reporting date adjustments (cont.) Exception to rule that foreign currency monetary items outstanding at reporting date must be translated at spot rate at reporting date: –instances of contractual arrangement—the exchange rate has been fixed for a particular transaction General principle applied, however, is that exchange differences relating to monetary items are to be recognised as income or expenses in reporting period in which the exchange rates change –Exceptions to this rule (addressed later):  qualifying assets  certain types of hedging arrangements (cash-flow hedges)

20. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-20 Determining functional currency and presentation currency Number of issues to consider in determining functional currency (AASB 121, par. 9) –Consideration needs to be given to the currency in which the general purpose financial statements are prepared  If the entity’s shareholders reside primarily within Australia the expectation is that the presentation currency would be Australian dollars

21. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-21 Determining functional currency and presentation currency (cont.) Number of issues to consider in determining functional currency (AASB 121, par. 9) (cont.) –Presentation currency may not be the same as functional currency, e.g. parent company residing in Australia controls a subsidiary company residing in a foreign country (e.g. South Africa)  If subsidiary operates within South Africa and sells its goods and purchases its raw materials in Rand, the functional currency is South African rands  For the purposes of translating the results for Australian purposes, the presentation currency would be Australian dollars Refer to Worked Example 35.2 on p.1129—Determination of functional currency and presentation currency

22. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-22 Long-term receivables and payables At reporting date all monetary items must be translated using the reporting date spot rates Exchange gain or loss that results from translating both current and non-current receivables and payables must be included in the profit or loss for the financial period –Unpopular with Australian companies as fluctuations mean there is doubt as to whether unrealised profit/loss will actually be realised, particularly in relation to non- current monetary items –Argued that recognition of a profit or loss at reporting date is inappropriate, since the exchange rate fluctuates in the long term and there is significant doubt whether the unrealised profit or loss will ever be realised Refer to Worked Example 35.3 on pp. 1131–2—Translation of a non-current liability

23. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-23 Worked Example 35.3—Translation of a non-current liability On 1 July 2011 Noosa Ltd enters into an agreement to borrow £500 000 from Fistral plc (UK) Fistral plc sends the loan money to Noosa Ltd’s Australian bank account The loan is for five years and requires the payment of interest at the rate of 10% on 30 June each year. Noosa Ltd’s reporting date is 30 June. The relevant exchange rates are: 1 July 2011 A$1.00 = £0.50 30 June 2012 A$1.00 = £0.40 REQUIRED Provide the journal entries in the books of Noosa Ltd for the year ending 30 June 2012 to account for the above transaction

24. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-24 Worked Example 35.3—Solution 1 July 2011 Dr Cash 1 000 000 Cr Loan payable 1 000 000 (to recognise the foreign currency loan at the 1 July 2011 spot rate: 1 000 000 = 500 000 ÷ 0.50. Again, remember that throughout the period the transactions are recorded in the entity’s functional currency) 30 June 2012 Dr Interest expense 125 000 Cr Cash 125 000 (to recognise year-end interest payment 125 000 = (500 000 × 10%) ÷ 0.40) Dr Foreign exchange loss 250 000 Cr Loan payable 250 000 (to recognise the effect of retranslation of the loan at the 30 June 2012 spot rates; the increase in the amount of the loan payable is to be treated as an expense in the period in which the exchange rate moves) Balance of payable at 1 July 2011: $500 000 ÷ 0.50 $1 000 000 Balance of payable at 30 June 2012: $500 000 ÷ 0.40 $1 250 000 Increase in loan payable $250 000

25. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-25 Translation of other monetary assets such as cash deposits The same principles apply to translation of other monetary items such as cash and money market deposits Refer to Worked Example 35.4 on page 1131— Translation of cash denominated in a foreign currency

26. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-26 Qualifying assets Exception to the general rule that exchange differences relating to monetary items (current and non-current) are to be brought to account as expenses or revenues in the period in which the exchange rate changes Defined in AASB 123 Borrowing Costs as an asset that necessarily takes a substantial period of time (considered to be greater than 12 months) to get ready for its intended use or sale

27. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-27 Qualifying assets (cont.) Examples (AASB 123, par. 6) –Inventories that require a substantial period of time to bring them to a saleable condition, manufacturing plants, power generation facilities and investment properties –Other investments and those inventories that are routinely manufactured or otherwise produced in large quantities on a repetitive basis over a short period of time are not qualifying assets. Assets that are ready for their intended use or sale when acquired are also not qualifying assets

28. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-28 Qualifying assets (cont.) Exchange differences that lead to an increase in the cost of an asset are considered to be borrowing costs under AASB 123 For qualifying assets, AASB 123 requires the borrowing costs to be capitalised as part of the cost of the asset (borrowing costs that are directly attributable to acquisition, construction or production of a qualifying asset shall be capitalised as part of the cost of that asset, par. 11)

29. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-29 Qualifying assets (cont.) Exchange differences included in cost of qualifying assets for the financial year are the amounts that would otherwise have been credited/debited to profit or loss Amount capitalised as the cost of the asset not to exceed its recoverable amount If exchange differences cause the recoverable amount of a qualifying asset to be exceeded, the excess should be written off to the income statement (AASB 123, par. 19) Refer to Worked Example 35.5 on page 1133—Foreign currency transaction relating to a qualifying asset

30. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-30 Illustration 2 — Foreign currency transaction relating to a qualifying asset On 1 July, 2010 AB Ltd entered into a binding agreement with a Singapore Company to construct an item of plant. The cost of the plant was $500 000 Singapore. The plant was completed on 1 June 2011 and shipped FOB Singapore on that date. The debt was unpaid at 30 June 2011 The exchange rates at the relevant dates were: 1 July 2010:$1 Aus = $1.20 Singapore 1 June 2011 :$1 Aus = $1.12 Singapore 30 June 2011: $1 Aus = $1.10 Singapore

31. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-31 Illustration 2—Solution Being under construction, the item would appear to be a ‘qualifying asset’ for the period from 1 July 2010 to 1 June 2011. Therefore, the movement in exchange rates to 1 June 2011 would be incorporated in the cost of the asset. Any subsequent movements would be included with profit or loss.

32. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-32 Illustration 2—Solution (cont.) 1 July 2010 Dr Plant416 667 CrAccounts payable 416 667 (500 000/1.20) 1 June 2011 Dr Plant29 762 CrAccounts payable 29 762 (500 000/1.12) – 416 667 30 June 2011 DrExchange loss 8 116 CrAccounts payable 8 116 (500 000/1.10) – (416 667 + 29 762)

33. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-33 Hedging transactions Where amounts are owed to, or owed by, entities in foreign currencies, entities are exposed to the risk of losses, which might be generated by movements in exchange rates To minimise the risk associated with foreign currency monetary items, an entity may enter a hedging contract

34. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-34 Hedging transactions (cont.) Hedging –Action taken, whether by entering a foreign currency contract or otherwise, with the objective of avoiding or mitigating possible adverse financial effects of movements in exchange rates –Agreement entered into that takes a position opposite to the original transaction AASB 121 does not address foreign currency hedges Need to refer to AASB 139 Financial Instruments: Recognition and Measurement

35. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-35 Hedging transactions (cont.) ‘Buy hedge’ Involves a situation where a third party (e.g. a bank) agrees to sell a fixed amount of a particular overseas currency on a fixed future date at the rate of exchange quoted in the contract (the forward rate) Useful to entities that buy goods with the purchase price denominated in a foreign currency Forward rate—the exchange rate for delivery of a currency at a specified date in the future, i.e. a guaranteed rate of exchange that will be provided in the future

36. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-36 Hedging transactions (cont.) ‘Sell hedge’ Arrangement to sell an overseas currency to another entity, on or before a particular date, at an agreed rate Useful to an entity that sells goods overseas with the sales price denominated in a foreign currency An Australian entity can fix at the outset the amount of Australian dollars it will ultimately receive from a sale

37. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-37 Hedging transactions (cont.) When there is a hedge, the foreign exchange gains or losses on one transaction (e.g. hedge contract, also referred to as the hedging instrument ) will be offset by gains or losses on another (e.g. transaction with a purchaser of the entity’s inventory, also referred to as the hedged item) If the exchange rate falls, a gain will be made on the sale to overseas purchaser (hedged item) but a loss will be made on the contract with the bank (hedging instrument) because the overseas currency has increased in value—the entity had already agreed to a forward rate with the bank If the exchange rate rises (in the same scenario) the opposite will hold Perfectly hedged—hedge agreement completely eliminates the consequences of adverse exchange rate fluctuations— otherwise, partially hedged

38. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-38 Hedging transactions (cont.) Accounting for hedge transactions Hedge accounting Recognises the offsetting effects on profit or loss of changes in the fair values of the hedging instrument and the hedged item (AASB 139, par. 85) Hedge instrument A designated derivative or (for a hedge of the risk of changes in foreign currency exchange rates only) a designated non- derivative financial asset or non-derivative financial liability whose fair value or cash flows are expected to offset changes in the fair value of cash flows of a designated hedge item (pars 72–7 and Appendix A, pars AG94–AG97, elaborate on the definition of a hedging instrument)

39. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-39 Hedging transactions (cont.) Accounting for hedge transactions (cont.) Hedge item An asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that (a) exposes the entity to risk in changes of fair value or future cash flows and (b) is designated a hedge (pars 78–84 and Appendix A, pars AG98–AG101, elaborate on the definition of hedged items) Hedge accounting Attempts to match the timing of the profit or loss recognition on the hedging instrument with the profit and loss on the hedged item—only when the hedging instrument meets specific requirements To classify an arrangement as a hedge and to apply ‘hedge accounting’ AASB 139 strictly requires five conditions to be met

40. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-40 Hedging transactions (cont.) Five conditions to be met to apply ‘hedge accounting’ (AASB 139, par. 88) 1.At the inception of the hedge there is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge 2.The hedge is expected to be highly effective (Appendix A, pars AG105–AG113) in achieving offsetting changes in fair values or cash flows attributable to the hedge risk 3.For cash flow hedges, a forecast transaction that is the subject of the hedge must be highly probable and must present an exposure to variations in cash flows that could ultimately affect profit or loss

41. . Hedging transactions (cont.) Five conditions to be met to apply ‘hedge accounting’ (AASB 139, par. 88) (cont.) 4.The effectiveness of the hedge can be reliably measured, i.e. the fair value or cash flows of the hedged item that are attributable to the hedged risk and the fair value of the hedging instrument can be reliably measured 5.The hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the reporting periods for which the hedge was designated Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-41

42. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-42 Hedging transactions (cont.) Accounting for hedge transactions (cont.) Five conditions summarised in Figure 35.1 (p. 1137) If the conditions are not satisfied hedge accounting is not to be applied (and gains and losses of the hedging instrument associated with the hedge would simply go to profit or loss as such gains and losses occur)

43. . Hedging transactions (cont.) Two tests to be applied concerning ‘hedge effectiveness’ 1.Prospectively, at the inception of the hedge and throughout the life of the hedge, the hedge must be ‘highly effective’, i.e. the changes in the fair value or the cash flows of a hedged item (e.g. payable related to the purchase of inventory) must ‘almost fully’ offset the changes in the fair value or cash flows of the hedging instrument (e.g. forward- rate commitment with a bank) 2.Retrospectively, and as measured each financial period, the hedge is deemed to be highly effective so that the actual results are in a range of between 80 and 125%, e.g. if there is a gain on a hedging instrument of $100 and the loss on the hedged item is $110 the effectiveness of the hedge in terms of offsetting the loss on the hedged item is 100/110 (90.01%)—if the loss on the hedge item was $200 the test would not have been met Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-43

44. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-44 Hedging transactions (cont.) Accounting for hedge transactions (cont.) Three types of hedges identified in AASB 139 1.Fair value hedges (addressed in this chapter) 2.Cash-flow hedges (addressed in this chapter) 3.Hedges of net investments of foreign operations (not addressed in this chapter) Need to account separately for: the hedging transaction (that is, the ‘hedging instrument’), e.g. forward rate agreement with a bank, and the transaction that led to the need for the hedge, e.g. original purchase or sales arrangement with an overseas entity (that is, the hedged item)

45. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-45 Fair value hedge For a fair-value hedge (which might be undertaken to mitigate the risks associated with changes in the fair values of particular assets, such as an entity’s share portfolio), paragraph 89 of AASB 139 requires both the hedged item and the hedging instrument to be valued at fair value, with any gains or losses owing to fair value adjustments to be treated as part of the period’s profit or loss If the gains or losses on the hedged item are ‘perfectly hedged’ the gains or losses on the hedging instrument will offset the gains or losses on the hedged item so that the net effect on the period’s profit or loss could be $nil

46. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-46 Accounting for fair value hedges Provided a fair-value hedge meets the conditions set out in AASB 139, paragraph 89, during the period, the general accounting rule is that any gain or loss from remeasuring the hedging instrument at fair value and the gain or loss on the hedged item attributable to the hedged risk are recognised in profit or loss For example, if there is a gain of $110 on a hedging instrument (say, a forward contract to buy foreign currency) and a loss of $100 on the hedged item (say, accounts payable denominated in foreign currency), the accounting entries for a fair-value hedge would be: Dr Forward contract 110 Cr Profit and loss 110 Dr Profit and loss 100 Cr Accounts payable100

47. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-47 Cash-flow hedge In a cash-flow hedge, the risk being hedged is potential volatility in future cash flows The cash flows might relate to a particular asset or liability, for example, future expected sales in a foreign currency or future floating interest payments on a recognised liability Any gain or loss that is determined to be associated with an effective cash-flow hedge (i.e. the gain or loss on the hedging instrument) is initially recognised in equity. This ensures that any volatility in the profit or loss is avoided in the period during which the gains or losses on the hedged item (e.g. an amount payable on an overseas purchase of inventory) are not yet recognised in the entity’s profit or loss

48. . Cash-flow hedge (cont.) The ineffective part of the hedge is recognised in profit or loss In order to match the gains or losses of the hedged item and the hedging instrument, the changes in the fair value of the hedging instrument recognised in equity are removed from equity and recognised in the entity’s profit or loss (a ‘reclassification adjustment) at the same time as the cash flows from the hedged item are recognised in profit or loss Clearly the main distinction between a fair-value hedge and a cash-flow hedge is the fact that the former deals with changes in fair value while the latter deals with changes in cash flows Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-48

49. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-49 Worked Example 35.7—Cash-flow hedge where hedging arrangement is organised after the purchase of inventory On 1 March 2012 Koala Ltd, an Australian entity, purchases UK£1.2 million of inventory from Nigel Incorporated, a UK entity The amount is payable on 1 August 2012 A forward exchange contract for the delivery of UK£1.2 million is taken out with ABC Bank on 1 May 2012. ABC Bank requires delivery of the foreign currency on 1 August 2012 Koala Limited has a 30 June end of reporting period Additional information The relevant exchange rates are as follows: Spot Forward Date rate rate 1 March 2012 0.40 1 May 2012 0.37 0.35 30 June 2012 0.36 0.34 1 August 2012 0.32 0.32 REQUIRED Prepare the journal entries for Koala Ltd to account for the hedge and provide evidence of whether or not hedge accounting in the above situation was beneficial

50. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-50 Worked Example 35.7—Solution Receivable Amount payable Fair value Gain/(loss) Spot Forward on forward on forward of forward on forward Date rate rate contract contract contract contract 1 March 2012 0.40 – 1 May 2012 0.37 0.35 3 428 571 3 428 571 0 30 June 2012 0.36 0.34 3 529 412 3 428 571 100 840 100 840 1 August 2012 0.32 0.32 3 750 000 3 428 571 321 429 220 589 It is a requirement of AASB 139 that a fair value be attributed to the hedging instrument. In this situation, the fair value will change as the available forward rate being offered by the bank changes. For example, when the contract is originally negotiated, the bank is assumed to be offering the forward rate of A$1.00 = £0.35 for the delivery of UK£ on 30 June 2012 to any interested parties. Therefore, the contract itself has no fair value. However, if on 31 December the bank is only prepared to offer a forward rate for delivery of UK£ of A$1.00 = £0.34 if Koala Ltd was able to transfer its contract to another party needing UK£ on that date, then given the other options available to that other party, that party would be prepared to pay up to $100 840 for the contract, which equates to ($1 200,000 ÷ 0.35) - ($1 200,000 ÷ 0.34). The fair value of the contract would be deemed to be $100 840

51. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-51 Worked Example 35.7—Solution (cont.) 1 March 2012 Dr Inventory3 000 000 Cr Accounts payable 3 000 000 1 May 2012 Dr Foreign exchange loss 243 243 Cr Accounts payable 243 243 [(UK£1 200 000 ÷ 0.37) – (UK£1 200 000 ÷ 0.40) = $243 243]

52. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-52 Worked Example 35.7—Solution (cont.) 30 June 2012 Dr Forward contract 100 840 Cr Gain on forward contract 100 840 [because the entity is recognising the gains or losses on the accounts payable then the gain or loss on the forward contract will also be taken to profit or loss at the same time to offset the gains or losses on the inventory purchase] Dr Foreign exchange loss 90 090 Cr Accounts payable 90 090 [(UK£1 200 000 ÷ 0.37) – (UK£1 200 000 ÷ 0.36) = $90,090; Test $90 090 ÷ $100 840 = 89%]

53. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-53 Worked Example 35.7—Solution (cont.) 1 August 2012 Dr Forward contract 220 589 Cr Gain on forward contract 220 589 Dr Foreign exchange loss 416 667 Cr Accounts payable 416 667 [(UK£1 200 000 ÷ 0.36) – (UK£1 200 000 ÷ 0.32) = $416 667] Dr Accounts payable 3 750 000 Cr Forward contract 321 429 Cr Cash 3 428 571 Settlement of forward rate contract and accounts payable

54. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-54 Worked Example 35.7—Solution (cont.) Foreign exchange loss incurred $ Amount paid on 1 August 2012 3 428 571 Accounts payable as at 1 March 2012 (date of purchase) 3 000 000 Total foreign exchange loss (428 571) Foreign exchange loss recorded For reporting period ending 30 June 2012 Foreign exchange loss on accounts payable on 1 May 2012 (243 243) Foreign exchange gain on forward contract on 30 June 2012 100 840 Foreign exchange loss on accounts payable on 30 June 2012 (90 090) (232 493) For year ending 30 June 2013 Foreign exchange gain on forward contract on 1 August 2012 220 589 Foreign exchange loss on accounts payable on 1 August 2012 (416 667) (196 078) Total foreign exchange loss recorded (428 571) If the purchased was not hedged Amount paid on 1 August 2012 ($1 200 000 ÷ 0.32) 3 750 000 Accounts payable as at 1 March 2012 (date of purchase) 3 000 000 Total foreign exchange loss 750 000

55. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-55 Worked Example 35.8—Cash-flow hedge where hedging arrangement is organised before the purchase of inventory Cornish Ltd exports surfboards to Newquay (UK) plc. Newquay (UK) plc placed the order on 1 April 2012. The consignment of surfboards was sold FOB Byron Bay (NSW) on 1 May 2012. The sales price was UK£1 million payable on 1 August 2012 A sell hedge forward-rate contract was entered into on 1 April 2012 (before the date of the sale) with ABC Bank for the delivery of Australian dollars in exchange for £UK1 million on 1 August 2012. The forward rate of the contract is $AUS1.00 = UK£0.40 on 1 April 2012. Cornish Ltd uses cash-flow hedge accounting Additional information Spot Forward Date rate rate 1 April 2012 0.35 0.40 1 May 2012 0.30 0.36 30 June 2012 0.25 0.29 1 August 2012 0.37 0.37 Cornish Ltd’s end of reporting period is 30 June REQUIRED Prepare the journal entries for Cornish Ltd

56. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-56 Worked Example 35.8—Solution Receivable Amount payable Fair valueGain/(loss) Spot Forward on forward on forward of forward on forward Date rate rate contract contract contract contract 1 April 2012 0.35 0.40 2 500 000 2 500 000 – – 1 May 2012 0.30 0.36 2 500 000 2 777 778 (277 778) (277 778) 30 June 2012 0.25 0.29 2 500 000 3 448 276 (948 276) (670 498) 1 Aug 2012 0.37 0.37 2 500 000 2 702 702 (202 702) 745 574 1 April 2012 No journal entries because right and obligation are the same 1 May 2012 Dr Accounts receivable 3 333 333 Cr Sales 3 333 333 Recording sales (UK£1 000 000 ÷ 0.30) Dr Hedging reserve 277 778 Cr Forward contract 277 778 Recording loss on accounts receivable. The forward contract would represent a liability rather than an asset. Once the overseas sale is made the gains or losses on the hedging instrument would thereafter be taken directly to profit or loss (not to a reserve) to offset the gains or losses on the account receivable that is denominated in a foreign currency Dr Sales 277 778 Cr Hedging reserve 277 778 Transferring hedge reserve to sales account

57. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-57 Worked Example 35.8—Solution (cont.) 30 June 2012 Dr Accounts receivable 666 667 Cr Foreign exchange gain 666 667 [(UK£1 000 000 ÷ 0.30 = $3 333 333) – (UK£1 000 000 ÷ 0.25 = $4 000 000) = $666 667] Dr Loss of forward contract 670 498 Cr Forward contract 670 498 1 August 2012 Dr Foreign exchange loss 1 297 297 Cr Accounts receivable 1 297 297 [(UK£1 000 000 ÷ 0.37 = $2 702 702) – (UK£1 000 000 ÷ 0.25 = $4 000 000) = $1 297 297] Dr Forward contract 745 574 Cr Gain from forward contract 745 574 Dr Cash 2 500 000 Dr Forward contract 202 702 Cr Accounts receivable 2 702 702 Receiving payments and fulfilling forward contract

58. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-58 Worked Example 35.8—Solution (cont.) In this example, the sales proceeds of UK£1.0 million have been fully hedged. As the forward-rate contract was entered into before the date of the sale, any costs or gains associated with the hedge contract are adjusted against the sales price It is assumed that all five conditions necessary for hedge accounting are satisfied. Further, any exchange gains or losses on the forward-rate contract, after the date of sale, will be recognised in profit and loss Ultimately, the entity receives the amount it had locked in with the bank, this being $2 500 000. Effectively, the entity is receiving $2 702 702 from the overseas customer of which $202 702 goes to the bank for the amount owing on the hedging instrument The amount that is paid to the bank at the end of the contract represents the difference between UK£1.0 million divided by the negotiated forward rate (1 000 000 ÷ 0.40) and UK£1.0 million divided by the spot rate on 1 August 2012 (1 000 000 ÷ 0.37)

59. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-59 Foreign currency swaps Commonly used swaps are: –interest rate swaps, e.g. where a fixed-interest-rate obligation is swapped for a variable-rate obligation (refer to Chapter 15) –foreign currency swaps—where the obligation related to a loan denominated in one currency is swapped for a loan denominated in another currency

60. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-60 Foreign currency swaps (cont.) Reasons for foreign currency swaps If an organisation has a number of receivables denominated in a foreign currency, to hedge against exchange fluctuations it may convert some domestic loans into foreign currency loans, in the same denomination as that of the receivables For example, if an organisation has some receivables that are denominated in US dollars and a loan in Australian dollars then it is exposed to foreign currency risks. However, if it swaps its domestic loan for a loan denominated in US dollars then it will have both receivables and payables in the same currency and gains on one will offset losses on the other Need to find another entity that is prepared to swap its foreign currency loans for the organisation’s domestic currency loans

61. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-61 Contractual obligations of foreign currency swaps The other parties to the loans may not know about the swap arrangements Contractual relationship between entity and lending institution remains unchanged Should one party to the swap default on the arrangement, the obligation for repayment vests with the primary borrower Refer to Worked Example 35.10 on pp.1148–9— Example of a foreign currency swap

62. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-62 Worked Example 35.10—Foreign currency swap On 1 July 2011 Lennox Ltd, an Australian company, borrows US$1 million from a US corporation at a rate of 10%, repayable in US dollars. The loan is for a period of three years and is on more favourable terms than Lennox Ltd is able to obtain within Australia Lennox Ltd trades predominantly within Australia and therefore does not have any receivables that are denominated in US dollars At the same time Angourie Ltd, also an Australian company, borrows A$1.25 million from an Australian bank at a fixed rate of 10%. The loan is also for a period of three years. Angourie Ltd also has a number of receivables denominated in US dollars To insulate itself from foreign currency movements, it would prefer to have some payables denominated in US dollars As a result of perceived benefits to both parties, Lennox Ltd and Angourie Ltd decide to swap their interest and principal obligations on the same date that they take out the loans, this being 1 July 2011 Under the swap terms, each party agrees to take control of the other party’s principal and interest obligations The relevant exchange rates are: 01 July 2011 A$1.00 = US$0.80 30 June 2012 A$1.00 = US$0.70 30 June 2013 A$1.00 = US$0.68 30 June 2014 A$1.00 = US$0.76 We will assume that the required market rates on both loans are equal to the coupon rates, that is, they are also 10% (meaning there is no discount or premium on the loans), and we will further assume that the market rates remain at 10% throughout the terms of the loans. Cash payments related to each loan are to be made on 30 June of each year REQUIRED Provide the journal entries in the books of Lennox Ltd to account for the above swap for the year ending 30 June 2012

63. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-63 Worked Example 35.10—Solution Date Fair value of foreign Fair value of the Fair value Gain/(loss) currency receivable Australian payable of swapon hedge component of swapcomponent of swap* 1 July 20111 250 000** 1 250 000– – 30 June 20121 428 571***1 250 000178 571 178 571 30 June 20131 470 588****1 250 000 220 588 42 017 30 June 2014 1 333 333*****1 250 000 83 333 (137 255) *Because the interest paid on the Australian loan (the coupon rate) is 10%, which also matches the required market rate, the face value of the loan also equates to the present value—that is, there is no premium or discount on the loan **[(1 000 000 ÷ 0.80) × 0.10 × 2.4868518 + [(1 000 000 ÷ 0.8) × 0.7513147] = 1 250 000 *** [(1 000 000 ÷ 0.70) × 0.10 × 1.7355371] + [(1 000 000 ÷ 0.70) × 0.8264462] = 1 428 571 **** [(1 000 000 ÷ 0.68) × 0.10 × 0.9090909] + [(1 000 000 ÷ 0.68) x 0.9090909] = 1 470 588 ***** 1 000 000 ÷ 0.75 = 1 333 333

64. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-64 Worked Example 35.10—Solution (cont.) Accounting entries in the books of Lennox Ltd 01 July 2011 Dr Cash 1 250 000 Cr Foreign loan 1 250 000 [to recognise, at the 1 July 2011 spot rate, the initial loan received from the US company (1 250 000 = 1 000 000 ÷ 0.80)] There is no entry to recognise the swap as the fair value of the swap agreement is deemed to be zero on 1 July 2011 as shown in the table on previous slide The effect of the entering the swap means that Lennox Ltd is insulated from any foreign currency gains or losses that might result from changes in the exchange rates 30 June 2012 Dr Foreign exchange loss 178 571 Cr Foreign loan 178 571 Value of loan as at 1 July 2011 (1 000 000 ÷ 0.80) 1 250 000 Value of loan as at 30 June 2012 (1 000 000 ÷ 0.70) 1 428 571 Increase in the value of the loan 178 571

65. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-65 Worked Example 35.10—Solution (cont.) Dr Swap 178 571 Cr Gain on swap contract 178 571 (to recognise the gain on the swap contract negotiated with Angourie Ltd—see table. The swap would be considered to represent a financial asset) Dr Interest expense 142 857 Cr Cash 142 857 [142 857 = (1 000 000 × 0.10) ÷ 0.7] Dr Cash 17 857 Cr Interest expense 17 857 (142 857 – (1 250 000 × 10 per cent) = 17 857) Lennox initially has to make the payment to the US company for the funds it borrows. That is, even in the presence of the agreement with Angourie, Lennox will still comply with its contractual commitment with the overseas capital supplier. However, Angourie has agreed to take responsibility for the overseas loan, while Lennox Ltd has agreed to take responsibility for Angourie Ltd’s domestic loan. The interest payment on the domestic loan is $125 000 (that is $1 250 000 × 10%). Lennox Ltd will receive $17 857 from Angourie Ltd, so that Lennox Ltd’s total interest expense ($142 857 – $17 857) is that payable on the domestic loan ($125 000)—the loan for which it has agreed to take responsibility

66. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-66 Summary The lecture deals with various issues associated with the translation of transactions that are denominated in a foreign currency To account for transactions in a foreign currency, three accounting standards need to be considered 1.AASB 121 The Effects of Changes in Foreign Currency Rates 2.AASB 123 Borrowing Costs 3.AASB 139 Financial Instruments: Recognition and Measurement

67. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-67 Summary (cont.) Key issues –Foreign currency transactions should initially be translated at the spot rate in place at the date of the transaction using the functional currency as the basis for the translation –The functional currency might be different from the presentation currency –Any changes in the Australian dollar equivalents of foreign currency monetary amounts (e.g. foreign currency receivables, foreign currency payables, and foreign currency monetary deposits) are, with limited exceptions, to be recognised as part of profit or loss, whether or not the gains have been realised

68. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-68 Summary (cont.) Any gains or losses on foreign currency receivables and payables are not to be offset against related purchases or sales amounts If the movement relates to a ‘qualifying asset’ AASB 123 requires the movement to be adjusted against the cost of the asset—foreign currency movements will be adjusted against the cost of the asset only as long as the asset’s adjusted book value does not exceed its recoverable amount Once an asset ceases to be a ‘qualifying asset’ all movements in related monetary terms are to go to profit or loss

69. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-69 Summary (cont.) Where hedge contracts have been entered into, the forward-rate contracts and purchase or sales transactions must be accounted for separately Where hedge transactions satisfy the five conditions necessary for applying hedge accounting, AASB 139 requires any costs associated with entering a cash-flow hedge, as they pertain to the hedging instrument, to be deferred to equity and subsequently included in the costs or sales price of the goods or services Any changes in the value of the hedging instrument are to be deferred in equity and subsequently included as part of the costs of the goods or services to the extent they occur up until the purchase or sale date

70. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 35-70 Summary (cont.) If a hedge transaction is taken out subsequent to the purchase or sale date, any changes in the value of the hedging instrument are to be transferred to profit or loss to offset the gains or losses on the hedged item Foreign currency swaps may be undertaken as a form of hedging: – where a swap occurs the primary borrower will still have a commitment to the primary lender should the other party to the swap default on the swap arrangement It is not correct practice to eliminate a particular loan from the accounts when a swap arrangement has been negotiated