FOREIGN CURRENCY TRANSACTIONS

FOREX TRANSACTIONS IN GENERAL

In a strict sense, foreign exchange transactions are those that are to be

settled in foreign currency, regardless of the location of either party. These are
accounted for by the domestic company by converting the amounts in foreign
currency with BSP-set exchange rates

For conversion purposes, the exchange rates must be quoted directly,

where the Peso is expressed as the equivalent of one foreign currency. Rates
displayed on news are usually on indirect quotation. To convert, 1 ÷ (FC
equivalent of Php 1). Converting from direct quotation to indirect quotation
also follows the same format

If the given exchange rates in a particular problem are not in Peso, conversion is
necessary

How to determine a Foreign Currency Transaction?

TRANSACTION SETTLED IN Is it a foreign Is it a foreign

BETWEEN currency transaction currency transaction
to Domestic to Foreign
Corporation? Corporation?
1. DC & DC DO-Curr NO NO
2. DC & FC DO-Curr NO YES
3. DC & FC Fo-Curr YES NO
4. FC & FC Fo-Curr NO NO
*DC – Domestic Corporation
**FC – Foreign Corporation
***DO-Curr – Domestic Currency (Ex. PESO – for Philippines; US Dollar for USA)
****Fo-Curr – Foreign Currency (Ex. US Dollar for Philippines; PESO for USA)
 Important Dates to Consider in Foreign Exchange (Forex) Transactions

DATES IMPORTANCE RATE USED

Transaction Date (TD) The date when the purchase or SPOT/HISTORICAL
sale of goods or services or
currency takes place
Balance Sheet Date (BD) The date when closing rates SPOT/CLOSING
will be applied in computing
for the FOREX gain or loss
Settlement Date (SD) The date when payment or SPOT/ACTUAL
receipt shall be made and the
FOREX gain or loss computed
Different rates in FOREX

EXCHANGE RATES SYMBOL SIGNIFICANCE

SPOT RATE SR Rate TODAY and applicable TODAY
FUTURE RATE FR Rate TODAY applicable in the
FUTURE; also known as FORWARD
RATE
HISTORICAL RATE HR Spot rate in the Transaction date
CLOSING RATE CR Spot rate in the Balance Sheet date
ACTUAL RATE AR Spot rate in the Settlement date

Items to consider and their treatment of FOREX gain or (loss):

ITEMS FOREX gain/(loss) EXAMPLE OF MONETARY

reported in ITEMS
MONETARY P/L Accounts Receivable, Accounts
Payable

IMPORT AND EXPORT

(UNHEDGED) TRANSACTIONS

In an unhedged import and export transaction, the only relevant exchange

rate would be the spot rate as of the date of the transaction, balance sheet date,
and the date of settlement

Spot rates are classified as either buying or selling (also called bid and offer
rates, respectively). If the domestic entity exports, the buying rate is used since
this would be the price that the foreign buyer would pay for the goods. If the
domestic entity imports, the selling rate is used

Suppose the domestic company exports goods on F.O.B. destination freight

terms. On the date of transaction, the spot rate to be used will be as of the date
when the goods reached the buyer
– the point when legal title is passed under the freight term. Of course, if on
F.O.B. shipping point, it will be when shipped
 The domestic entity recognizes forex gain or loss as the spot rate changes
during the aforementioned dates only. For instance, if the domestic entity is an
exporter (thus it has outstanding accounts receivable) and the buying spot rate
increases, the entity recognizes forex gains to be recorded in profit/loss (together
with an increase in accounts receivable)

The foreign entity does not record any forex gains or losses since the transaction
is denominated in their currency

The final cash payment during the date of settlement shall of course still
be at the spot rate, so is the cost at which the asset purchased is recorded

FOREIGN DEBT TRANSACTIONS

❏ Just like purchase of commodities, forex gains/losses are also recognized in

foreign debt borrowings/grants. Also, the purchase of the goods might have
been made through issuance of promissory notes and other debt instrument

❏ If the domestic entity is a borrower, it must use the selling spot rate, and
the buying spot rate if it lends

ILLUSTRATION

Pa Rong Co. signed a two-year promissory note bearing 12% on December 1,

2020 for $10,000. Interest is to be paid monthly. Assume the selling spot rates are
the following: Php 2 (December 1), Php 3 (December 31), and Php 1.5 (December
31, 2021). On December 31, 2020, any forex gains/losses on the loan is based on
the principal alone. Thus, there is a forex loss of Php 10,000 with a credit to Notes
Payable for 2020 ($10,000 × [Php 3 – Php 2])

The actual interest expense is based on the current spot rate of the principal amount.
DERIVATIVE INSTRUMENTS

A financial instrument or other contract that meets the following criteria: Its value
changes in response to a change in an underlying ; it requires little or no initial net
investment and it is settled at a future date.

FORWARD CONTRACTS

An agreement between two parties whereby one party agrees to buy and the other party
agrees to sell at a specified amount of an item at a fixed price for delivery at a
specified future date.

FIRM (PURCHASE/SALE) COMMITMENTS

There is no actual transaction taking place in a firm commitment, which

can be to sell or purchase something at a future date. This means that the
purchase/the asset is not recorded until the date of settlement, unlike the previous
transaction in which the asset is already recognized at the date of transaction. Only
a memo entry is made for the asset during the transaction date
 Only forward rates are relevant in this case. At the date of settlement, the
purchase is recorded using the forward rate at the date of transaction. In a firm
commitment, the buyer (or seller) contracts that he will pay (receive) an amount
at the agreed rate no matter if it changes

There is zero net forex gain/loss in a firm commitment. Suppose the domestic
entity enters in a purchase commitment, and that the forward rate increases. They
would record a forex gain on the forward contract (debit FC-Receivable, credit
Forex Gain) and a forex loss on the item (debit Forex Loss, credit Firm
Commitment) at the same amount. ‘Firm Commitment’ in this case is a liability
account

At the date of settlement, the domestic entity pays/receives an amount equal

to the forward rate at the date of settlement which coincides with the spot
rate. The cost of the asset, as mentioned, is at the forward rate at the date of
transaction. Any difference is debited/credited to Firm Commitment account

HEDGED FOREX
TRANSACTIONS: GENERAL
CONCEPTS

Entities engage in hedging transactions to mitigate potential losses arising

from volatile exchange rates. To hedge is to take the position opposite that of the
transaction. This means that if the hedged item (the asset) records a forex loss,
the hedging instrument records a forex gain to even out things

Hedging instruments are usually in the form of derivatives, financial

instruments that derive their value from another instrument. They are classified
as either option-based (offers one-sided protection against exchange rate risks,
such as options and swaps) and forward-based (offers two-sided protection,
such as forward and futures contracts)
 Just like in a firm commitment, there are two sets of entries to be made in a
hedged transaction – one for the hedged item (the asset/liability) and one for the
hedging instrument. Suppose that the domestic entity buys, and the exchange rate
increases. The hedged item would record a forex loss (debit FOREX loss, credit
Accounts Payable), and the hedging instrument would record a forex gain (debit
Forward Contract, credit FOREX gain)

The net forex gain/loss from the hedged item and hedging instrument is
referred to as the forex gain/loss from hedging activity

Of course, on the hedging instrument’s side, the Forward Contract Receivable

account absorbs any change in exchange rate if the domestic entity purchases,
and Forward Contract Payable if it sells. On the other side, Accounts Payable
and Accounts Receivable absorbs the changes, respectively
 Note that the liability/receivable to third person is based on the entries on the
hedged item, not the hedging instrument

Forward rates are used for the hedging instrument until the date of
settlement, when the spot rate is used. Of course, if the selling spot rate is used on
the hedged item, the selling forward rate is used for the hedging instrument

Problems usually present forward rates classified as per a particular number of

days. The rate to be used is the number of days remaining until the date of
settlement

On settlement date, the domestic entity either receives (debits) or pays

(credits) cash equal to the difference of the spot rate at settlement and the forward
rate at the date of transaction. This is because the agreed upon rate (the forward
rate at the date of transaction) is the amount that the parties agreed to be paid
regardless of the change in the rates. A bank or other speculators usually handle
the difference

HEDGED FOREX TRANSACTIONS:

ACCOUNTING FOR HEDGING
INSTRUMENTS

Hedging instruments are also classified as either fair value hedges (used in
transactions with recognized assets and liabilities, such as in actual
purchases/sales), cash flow hedges (used in forecasted and anticipated
transactions), and net investment hedges (similar in treatment as to cash flow
hedges, used between a domestic and a foreign entity)

If silent, the hedge is assumed to be one of fair value hedge

Recording exchange rate changes as they affect the hedging instrument

can be made in two ways – split and non-split accounting. Under split
accounting, gains/losses of the instrument is divided into the effective portion
(or the intrinsic value), and the ineffective portion (or the time value gains and
losses)

In fair value hedges, both the effective and ineffective portion of the gains/losses
go to profit/loss. In cash flow/net investment hedges, the effective portion is a
component of other comprehensive income, while the ineffective portion goes to
profit/loss

Split and non-split accounting is best illustrated with options

 HEDGED FOREX
TRANSACTIONS OPTION
CONTRACTS

Options are contracts that grant holders the right to either buy (call) or sell
(put) goods at the future date at a predetermined price, called the strike/exercise
price. This is recorded as an investment in the balance sheet. The amount paid
for an option is referred to as the option premium

They may be classified as to the likeability of their exercise. If the option is

at the money (strike price equals current market prices), the option is likely to be
exercised, bearing no loss on the holder. If the option is in the money, it is also
likely to be exercised, bearing gains on the holder. In a put option, this is when the
strike price is greater than market prices; in a call option, this is when the strike
price is less than market prices. If out of the money, the option is likely not to be
exercised, since it would bring losses to the holder

The option contact is the hedging instrument. However, it is different

from forward contracts, since it has its own cost (the option premium). Also, it
is not affected by changes in the forward rate, since its value depends on its
current fair value

The change in the fair value is the fair value is total gains/losses on the hedging
instrument, to be recorded on profit/loss (if fair value hedge) or other
comprehensive income (if cash flow hedge) if the company uses non-split
accounting

If problems mention that “the effect of time value gains/losses are excluded in the
assessment of hedge effectiveness”, the company uses split accounting, wherein
the fair value change is divided into the effective and ineffective portions. Option
contracts are usually classified as cash flow hedges

Date #1 (difference) Date #2

Fair value of option xx Total gains/losses xx xx
LESS: Intrinsic value xx LESS: Intrinsic value g/l xx xx
Time value xx Time value g/l xx xx
 The intrinsic value is computed by multiplying the notional amount (the
amount of the foreign currency) by the difference of the strike price and the
market price per item. The change in the intrinsic value is the effective portion
of the total gains/losses. Note that the intrinsic value itself is not the effective
portion to be sent to OCI. The same goes for the time value gains/losses
There is only intrinsic value if the option is in the money, otherwise it shall be
zero. At the settlement date, the intrinsic value should always match the fair
value of the option, resulting to a zero time value gains/losses

The effective portion is among the components of OCI that gets transferred to
profit/loss. The amount is transferred if the asset purchased is sold or
depreciated, whichever is applicable

The forex gain/loss from the hedging activity in this case is equal only to
the time value gains/losses, since the effective portion goes to other
comprehensive income