CHAPTER 7

ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS

Introduction
The continuing growth in world trade and the significance of foreign operations in Philippine
companies have resulted in increasing attention being paid to international accounting practices
and problems.These problems are generally subdivided into two broad areas:
1) Problems related to transactions which give rise to receivables and payables denominated
in foreign currencies must be measured and recorded in Philippine currency; and
2) Problems arising from the translation of foreign currency statements into Phillipine
currency.

Basis: International Accounting Standards (IAS) No.21-Accounting for the effects of changes
foreign exchange rate

IAS No. 39- Financial Instrument: Recognition and Measuremen

Specific Objectives
At the end of the lesson, the students should be able to:
Account for foreign currency transactions.
Translate the financial statements of a foreign operation.

Duration: 6 hours (Lecture/Discussion/Problem Solving)

LESSON PROPER

Definition of exchange rate:

An exchange rate is a measure of how much one currency may be exchanged for another
currency. The following terms are used to describe exchange rate:

1) A direct quote measures how much of the domestic currency must be exchanged to
receive one unit of a foreign currency (i.e. Peso : Foreign currency). An indirect quote
measures how many units of a foreign currency will be received for one unit of domestic
currency (i.e. Foreign currency : peso).
2) A currency may either strengthen (gain) or weaken (lose) relative to another currency.
A strengthening of a currency means that the directly quoted amount decreases and the
indirectly quoted amount increases. The opposite should be true for a weakening
currency.
3) Buying and selling rates of exchange respectively represent what a currency broker is
willing to pay to acquire or sell a currency.
4) A spot rate indicates the number of units of a currency that would be exchanged for one
unit of another currency on a given date.
5) A forward rate establishes, at one point in time, the number of units of one currency to
be exchanged for one unit of another currency at a specified future date. On a given date,
different forward rates may exist for the same currency, depending on how far in the
future an exchange is to take place.
 a) The agreement to exchange currencies on a future date is called a forward contract.
b) A premium or discount refers to when the forward rate is greater than or less than
the spot rate, respectively.

Accounting for Foreign Currency Transactions – PAS no.21 Revised

A transaction that requires settlement or payment in a foreign currency is called a foreign

currency transaction.

Some of the more common foreign currency transactions are:

1) Importing and exporting goods on credit with the receivable or payable denominated
in foreign currency;
2) Borrowing or lending denominated in foreign currency;
3) Entering into a forward exchange contract to buy or sell foreign currency.

In each unsettled foreign currency transactions (i.e. a receivable or a payable exists),

there are three issues of concern. These issues and the appropriate exchange rate to be used in
translating accounts denominated in units of foreign currency (except for forward exchange
contracts), are as follows:

1) At the date the transaction is first recorded – each asset, liability, revenue, gain or
loss arising from the transaction is measured and recorded in Phil. Pesos by
multiplying the units of FC by the closing exchange rate, that is, the spot rate in effect
on a given date.

2) At each balance sheet date that occurs between the transaction date and
settlement date- Recorded balances that are denominated in foreign currency are
adjusted to reflect the closing exchange rate in effect at the date of the SFP. Foreign
exchange gain (or loss) is recognized for the difference in exchange rate between the
transaction date and the balance sheet date.

3) At the settlement date- in the case of a FC payable, a Philippine company must

convert Phil. Pesos into FC units to settle the account, while FC units received to
settle a FC receivable will be converted into pesos. Although translation is not
required, a FC gain (or loss) is recognized if the amount of pesos paid or received
upon conversion does not equal the carrying value of the related payable or
receivable.

Translation of Financial Statements of Foreign Operations (IAS 21)

Only one translation method is described for foreign operations, the closing or current rate
method that was applied to foreign entities under the original IAS 21.

The following procedures are prescribed by IAS 21 to translate foreign entity’s statements
from its functional currency into the presentation currency:
 1) Translate all items of financial position, including the allocated goodwill, at the
closing rate, except for share capital and pre-acquisition surplus which should be
translated at their historical rate. Post acquisition profits are derived based on the
balances in their year-to-year translation. Exchange surplus are derived as the
balancing figure.

2) Translate all items of income and expense at the average rate or as the accounting
policy requires. Translate items of other comprehensive income at the average rate

3) Retained earnings brought forward should be based on the prior year’s post
acquisition profits in the presentation currency (e.g. in local pesos) . Interim dividend
paid is translated at the actual rate ruling on the date of payment while dividend
payable, if any, is translated at the closing rate.

4) Prepare the consolidated financial statements using the normal consolidation

procedures,

5) Prove the total exchange difference as follows:

a) Net assets and goodwill at acquisition date translated at closing rate minus net
assets and goodwill at acquisition date translated at their historical rate.
b) Year-to-year increase in net assets (i.e. retained earnings for each year)
translated at closing rate minus their year-to-year reported amounts in Phil.
Peso, and
c) Any revaluation surplus arising during the year translated at the closing rate
minus the amount translated at the date of revaluation.

PROBLEM SOLVING:

On December 31, 2020, a branch in Singapore submitted the following financial statements stated in
Singapore Dollar:
Statement of Financial Position
Monetary Assets $ 20,000
Non Monetary Assets 15,000
Monetary Liabilities 18,000
Common Stock 12,000
Retained Earnings, Dec.31 5,000

Income Statement and Retained Earnings

Sales $ 27,000
Expenses (including depreciation of $1,000) 25,000
Net income 2,000
Retained Earnings, Jan.1 3,000
Retained Earnings, Dec. 31 5,000
 Current rate- 1 Singapore Dollar =
The exchange rates are: P37
Historical rate- 1 Singapore Dollar = P34
Average rate- 1 Singapore Dollar = P35

Assuming the Retained Earnings on Jan.1, 2020 of the Singapore Branch in Phil. Pesos is P128,100.

Translate the above statements into Phil. Peso. Your answer must start with the Statement of
Income and Retained Earnings, followed by the Statement of Financial Position.

Functional Currency is the Currency of a Hyperinflationary Economy

Determining whether an economy is hyperinflationary in accordance with IAS 29 requires

judgement. The standard does not establish an absolute rule at which hyperinflation is deemed to
arise. However, when cumulative inflation over three years approaches or exceeds 100%, it
must be conceded that the economy is suffering from hyperinflation.

Financial statements of entities whose functional currency is that of a hyperinflationary economy

first have to be restated and then translated under IAS 21 if the parent has a different
presentation currency, in order that they can be incorporated in the consolidated financial
statements of the parent company.

Restatement of Statement of Financial Position (sample problem)

Before Historical Year-end After
Restatement GP Index* GP Index Restatement***
(HC) (HC)
Cash 200 200
Inventory 500 500 600 600
Property, Plant & Eqt. 450 150 600 1,800
Total Assets 1,150 2,600

Accounts Payable 360 360

Long term debt 500 500
Equity** 290 1,740
Total Liabilities & Equity 1,150 2,600

*General price index at the date of purchase

**Equity is restated as follows:

(1)the components of the equity , except retained earnings and any revaluation
surplus, are restated by applying a general price index from the dates the
components were contributed or otherwise arose;

(2) any revaluation surplus that arose from previous periods is eliminated;
 (3) restated RE are derived from all the other amounts in the restated SFP.

*** Historical cost x General price index at the end of the reporting period
General price index at the date of acquisition

Activity:
Exercises/problems on foreign exchange transactions will be uploaded in LMS for
discussion.

CHAPTER 8
ACCOUNTING FOR DERIVATIVES
Introduction
Derivative accounting is becoming more and more important. Some companies even employ
accountants whose sole responsibility is to account for derivative transactions. The audit
profession also regard derivatives as risk areas. Because of the risks inherent in engaging in
derivatives transactions and their potential for abusive use, reporting standards now require
proper accounting and disclosure of derivatives.

Specific objectives
At the end of the lesson, the students should be able to:

 Identity the characteristics of a derivative.

 State the purposes of acquiring derivatives.

Duration: 6 hours (Lecture/Discussion/Problem Solving)

LESSON PROPER

 Derivatives are secondary securities whose value is solely based (derived) on the value of
the primary security that they are linked to–called the underlying. Typically, derivatives are
considered advanced investing.

 A derivative has all of the following characteristics:

1) Its value changes in response to the change in the underlying
2) It requires no initial net investment or a very minimal initial net investment
3) It is settled at a future date.

 The purpose of obtaining derivatives are:

1) To speculate (incur risk); or
2) To hedge (avoid or manage risk)

While a derivative's value is based on an asset, ownership of a derivative doesn't mean

ownership of the asset.
Common types of derivatives are:

1) Forward contract-agreement between two parties to exchange ( buy or sell) a specified

amount of a commodity , security or foreign currency at a specified date in the future at a
pre-agreed price.
2) Futures contract- a contract traded on an exchange that allows an entity to buy or sell a
specified quantity of commodity or a financial security at a specified price on a specified
future date.

Forwards
Forwards are private contracts
which are most likely over-the-
counter transactions
Forwards are customized contracts
Forwards are private contracts
between two private parties who
interact directly with each other
Forwards may be settled by the
actual delivery of the agreed-upon
commodity or net cash payment
Futures
Futures are traded in a market
Futures are standardized contracts
A party in a futures contract may never
know the other contracting party because
they interact indirectly through a broker
Futures are normally settled thru net cash
payment

3) Option- An option is a financial derivative contract that provides the holder the right to
buy or sell an underlying in the future for a price set today. The price of the option is
separate from the price of the underlying. The following terms are usually associated on
option contracts:

Premium -the option price. This is the sum of money that the option buyer pays the option
seller to obtain the “right” being sold in the option. This money is paid when the option
contract is initiated.
Time value of the option- this is the difference between the option's market price and its intrinsic
value. Changes in the time value of the option are taken to current earnings.

Intrinsic value of the option- this is the difference between the current market price and the option
price of the hedged item. This is also the value of the option if it is exercised today.

Strike price- the price at which the holder has the option to buy or sell the item.

Option to buy "in the money"-- this exists when the market price is more than the strike price.
(opposite if Option to sell)

Option to buy "out of the money"- this exists when the market price is less than the strike price.
(opposite if option to sell)

TWO BASIC TYPES OR OPTIONS

1) Call option- an option granting the right to buy an underlying. (Also called “CALLS”)

ILLUSTRATION FOR A CALL OPTION

Power Corporation shares are currently traded at P65. An option to buy 1,000 shares at P68 per
share three months from now is worth P2 per share. If the option is bought, the call buyer’s
positions are:

a) The option buyer will pay the option seller the premium of P2,000 (P2 x 1,000 sh)
b) If, at the end of three months, the stocks trade at P75:
1)the option buyer will exercise,and thus pay the option seller the amount of
P68,000 (1,000 sh x P68)
2) The buyer may either keep the stocks or sell them:
a)if he holds the stocks, he'll record the investment in his books
at P75,000 (market value)
b) if he sells the stocks, he'll receive P75,000 from the sale.

c) if,at the end of 3 months, the stocks traded at P66;

1)The option buyer will not exercise the option. His loss will be the premium
payment of P2,000 only.
2) If he exercises the option, he'll pay the seller P68,000 and own 1,000 shares
that he can sell for only P66,000. He will lose P2,000 (P68K-P66K) plus the
P2,000 option premium for a total loss of P4,000.
3)If, at the end of 3 months, the stocks traded at P68 (the strike price), the
option buyer will not realize any gain or loss from the exercise of the option.

ILLUSTRATION FOR A PUT OPTION

Shoemart, Inc. currently trades at P15 per share. An option to sell 1,000 shares for P17 per share
three months from now is worth P2. If the option is bought, the option buyer’s position are:
a) The option buyer will pay the option seller the premium of P2,000
b) If, at the end of 3 months, the stock is traded at P11:
1) The option buyer will exercise, buy 1,000 shares from the market and sell the stocks
to the option seller for P17,000.
2) The buyer gained P6,000 (P17K-P11K) and netted P4,000 from transaction (gain
of P6,000 – P2,000 option premium).

c) If,at the end of 3 months, the stock is traded at P20, the buyer will not exercise the option.
He will lose only the premium of P2,000.

d) If, at the end of 3 months, the stock is traded at P17 (the strike price), the option buyer
will generally not exercise the option (no gain from the effort).

Accounting for derivatives is a balance sheet item in which the derivatives held by a company are
shown in the financial statement in a method approved by GAAP..
.
Derivatives can generally be categorized into two:

1) Option based derivatives (examples are option contracts, interest rate caps, interest rate
floors). Under this contract, it has a “one-sided exposure” wherein only one party can
potentially have a favorable outcome for which it pays a premium at inception; the
other party can potentially have only an unfavorable outcome for which it is paid
the premium at inception. Consequently, only the downside risk on the
hedged item is counterbalanced.

2) Forward based derivatives (examples are forwards, futures and swaps). Under these
contracts, it has a two sided exposure wherein either party (but not both simultaneously)
can potentially have a favorable outcome and either party (but not both simultaneously)
can have an unfavorable outcome. Consequently, the downside risk and the upside
potential on the hedged item are counterbalanced.

Activity
Exercises/problems for discussion will be uploaded in the LMS.

CHAPTER 9
HEDGE ACCOUNTING

Introduction
Hedge accounting is a practice of accountancy that attempts to reduce any volatility created by
the repeated adjustment of a financial instrument’s value. Every business, regardless of its size
or sector, is inherently exposed to risks.

Specific objectives
At the end of the lesson, the students should be able to:
 Enumerate the qualifying hedged items.
 Differentiate fair value hedge from cash flow hedge

Duration: 6 hours (Lecture/Discussion/Problem Solving)

LESSON PROPER
HEDGING- a risk management technique that involves using one or more derivatives or other
hedging instruments to offset changes in fair value or cash flows of hedged items. The general
provisions on hedging and hedge accounting are contained in PAS 9. A hedging relationship
has two components:

 Hedged item- it is an asset, liability, firm commitment, a highly probable forecast

transaction, or net investment in a foreign operation. To be designated as a hedged item,
it should expose the entity to risk of changes in fair value or future cash flows.
 Hedging instrument- it is a designated derivative or a designated non-derivative financial asset
or designated non derivative financial liability whose fair value or cash flows are expected to
offset changes in fair value or cash flows of a designated hedged item. Examples of hedging
instruments are foreign exchange forward contracts, interest rate swaps and commodity futures
contracts.

Three types of hedging relationships:

1) Fair value hedge- this is a hedge of the exposure to changes in fair value of a recognized asset
or liability or an unrecognized firm commitment that is attributable to a particular risk, and that
could affect profit or loss. Under fair value accounting, changes in the fair value of the hedging
instrument and of the hedged item are recognized in profit or loss at the same time.

2) Cash flow hedge -this is the hedge of the exposure to variability in cash flows that is attributable
to particular risk associated with a recognized asset or liability or a highly probable forecast
transactions and could affect profit or loss. Under cash flow hedge accounting, changes in the
fair value of the hedging instruments attributable to the hedged risk are deferred (rather than
being recognized immediately in profit or loss). The accounting for the hedged item is not
adjusted.

3) Foreign currency hedge – this is the hedge to exposure to foreign currency exchange gains
or losses on an entity’s net investment in a foreign operation (which is the amount of the entity’s
interest in the net assets of that operation). Hedges of net investment in foreign operations are
accounted for like cash flow hedges.

The Notional Value

The notional value is the total underlying amount on which a derivatives trade is based. For example,
if an options contract is for 1,000 shares of common stock and the shares are valued at P20 each,
then the notional value of the arrangement is P20,000. The notional value concept is commonly
included in the terms of stock options, interest rate swaps, foreign currency derivatives and similar
arrangements.

Notional value is much larger than the market value of a trade, which is the price at which a position
can be bought or sold in the market. The amount of leverage associated in the trade is the notional
value divided by the market value of the trade.

Example: Notional value vs. market value

A call option for 100 shares of XYZ stock with a strike price of P40 may trade in the market for
P1.20 per contract.
Market value (P1.20 x 100) = P120
Notional value (P40 x 100) = P4,000

Summary of Hedge Accounting for Foreign Exchange Gains and Effectiveness

Purpose of the Type of Hedge Hedge Accounting Accounting
Foreign Exchange Accounting Treatment Result
Derivative Applies?
 To hedge a foreign “Undesignated” No Recognize Concurrent
exchange receivable hedge immediately in P & L recognition in P & L
or a foreign exchange (same treatment for
payable foreign exchange
gain or loss on
hedged item)
To hedge a firm Fair value hedge Yes Recognize Concurrent
commitment immediately in P & L recognition in P & L
(same treatment for
foreign exchange
gain or loss on
hedged item)
To hedge a forecasted Cash flow hedge Yes To the extent the Concurrent
foreign transaction hedge is effective, recognition in P & L
recognized in OCI. on a delayed basis.
The ineffective
portion of the gain or
loss will be reported
immediately in P &
L.
To hedge an Net investment Yes Recognized in OCI. Concurrent
investment in hedge Remove and recognition in P &L
subsidiary recognize in P & L on a delayed basis
upon disposal of the
investment.
To speculate Not applicable No Recognize Recognition in P &L
immediately in P & L currently.

Comparison: Fair Value Hedge Vs. Cash Flow Hedge

Hedging Instrument
(Forward Contract)
Gain or Loss on Hedging
Instrument
Gain or loss on the hedged
item due to hedged risk
Gain or loss in OCI section is
transferred to P & L
Fair Value Hedge Cash Flow Hedge
On balance sheet, carried at Fair On balance sheet, carried at Fair Value
Value
Recognized immediately in P & To the extent the hedge is effective,
L recognized in OCI.
The ineffective portion of the gain or
loss will be reported immediately in P
& L.
Recognized immediately in P & Not applicable (forecasted transactions
L: are not recognized)
Not applicable If the item hedged is a forecasted
purchase of inventory, the gains or
losses on the hedge will be reclassified
to earnings when inventory is sold. If
the hedged item is a forecasted
purchase of equipment, the gains or
losses on the hedge will be reclassified
to earnings as the equipment is
depreciated.