Advanced Financial Accounting

Class 10/Chapter 10: Foreign Currency Transactions

1
 Introduction

n Many Canadian companies conduct business in foreign countries as

well as in Canada.
n No specific accounting issues arise when the parties involved in an
import or export transaction agree that the payment will be in
Canadian dollars.
q Since it is a Canadian dollar denominated transaction, the

company will record the foreign purchase or sale in exactly the

same manner as any domestic purchase or sale.

2
 Introduction

n When the agreement calls for the transaction to be settled (paid) in a foreign
currency, this means one of two things:
q If the transaction is a purchase, the Canadian company will have to
acquire foreign currency in order to discharge the obligations resulting
from its imports.
q If the transaction is a sale, the Canadian company will receive foreign

currency as a result of its exports, and will have to sell the foreign
currency in order to receive Canadian dollars.
n These are foreign currency denominated transactions requiring conversion
to Canadian dollars.

3
 Introduction

n In a foreign-currency-denominated transaction, accounting issues arise

when the value of the Canadian dollar has changed relative to the value of
the foreign currency between:
q the time the transaction occurs; AND

q the date at which the financial statements are reported with the foreign-
currency-denominated receivable or payable; AND
q the date of receipt or payment (“settlement”) of the foreign-currency-
denominated receivable or payable.

Transaction Report Settle

4
 Exchange Rate Quotations

n Recording foreign currency denominated transactions requires the use of

exchange rates.
q Foreign currency exchange rates fluctuate because of the relative
inflation rate, interest rate, and trade surplus/deficit of a country.
n An exchange rate can be expressed one of two ways:
q The direct rate represents the cost in Canadian dollars to purchase one

unit of foreign currency, e.g. $1 U.S. (USD) = $0.98 Canadian (CAD)

means it takes $0.98 CAD to purchase 1 USD.
q The indirect rate represents the cost in a foreign currency to purchase 1
Canadian dollar, e.g. $1.02 USD = $1 CAD. The indirect rate is the
reciprocal of the direct rate, i.e. divide the direct rate into 1 (1/0.98 =
1.02).
q Note that either of these two methods may be used in an exam setting
so ensure you are comfortable with each approach.

5
 Exchange Rate Quotations

n The spot rate is the rate to exchange currency at a particular moment in

time.
q There are, in fact, separate spot rates for purchases and sales of foreign
currency; the sell rate is higher than the purchase rate in order to provide
a profit to the currency dealer. To simplify for our purposes, we assume
one single spot rate.
q Rates are quoted in newspapers and on the Internet (e.g. Bank of
Canada website at https://www.bankofcanada.ca/rates/exchange/daily-
exchange-rates-lookup/).
n The forward rate is the rate agreed today in a forward exchange contract to
exchange a specific amount of currency at a specified future date.
n Forward exchange contracts are used to hedge foreign currency
transactions.

6
 Exchange Rate Perspectives
n The denominated currency is the currency in which a transaction is
receivable or payable.
q A different currency may be used to record the transaction in the internal
accounting records.
n The functional currency is the currency of the primary economic
environment in which the entity operates.
q A foreign currency is a currency other than the functional currency.

n The presentation currency or reporting currency is the currency in which

the financial statements are presented.
q A number of Canadian companies present their financial statements in
U.S. dollars since many of their users are American.
n In this class we deal with transactions denominated in a foreign currency
and the Canadian dollar will be the recording, functional and presentation
currencies. We relax these assumptions in the next class.

7
 Exchange Rate Perspectives

n IAS 21 requires that individual transactions be translated into the functional

currency of the reporting entity.
q The functional currency is that of the reporting entity’s primary economic
environment in which it generates or expends cash.

n More on this in the next class.

8
Accounting for Foreign Currency Transactions

n For accounting purposes there are basically three rates used in translating
foreign currency into the reporting currency:
q Closing rate is the spot rate on the reporting date of the financial
statements.
q Historical rate is the spot rate on the date of the transaction.

n The average rate for a period can be used as a proxy for the
historical rate for a series of transactions (e.g. purchases, sales,
interest income or expense) if they occur evenly throughout the
period.
q Forward rate is the agreed rate for exchange of currencies at a

specified future date.

9
Accounting for Foreign Currency Transactions

Transaction Report Settle

On transaction date On reporting date On settlement date

Translate from foreign Translate foreign Translate receipt or

currency to functional currency monetary payment of foreign
currency at the spot items at the closing currency at the spot
rate. rate. rate.
If multiple transactions Translate non-
occurred evenly monetary historical
throughout a period, cost items at the
use the average rate. historical rate.
Translate non-
monetary fair value
items at the rate in
effect when fair value
was determined. 10
Accounting for Foreign Currency Transactions

n Accounting for a foreign currency transaction is illustrated using the

following Canadian dollar (CAD) and U.S. dollar (USD) rates:

Date Rate (CAD per USD)

Jan 31 0.98
Feb 28 0.99
Mar 30 1.01

11
Accounting for Foreign Currency Transactions

n A Canadian firm receives merchandise with an invoice price of

USD1,000 on January 31. The company’s year end is February 28
and payment is due March 30. What entries are necessary?
n At the time of the purchase transaction, the following entry would be
made using the January 31 transaction date spot rate:

DR Inventory 980
CR Accounts payable 980

12
Accounting for Foreign Currency Transactions

n By the end of its fiscal year (February 28th), the firm has incurred a $10 loss,
as the firm now has a monetary liability for USD1,000 x 0.99 = CAD990,
rather than the CAD980 at which the transaction was initially recorded. The
following entry is recorded for this loss reflecting the closing rate, since the
loss occurred as a separate event from the original purchase transaction.

DR Foreign exchange loss 10

CR Accounts payable 10

13
Accounting for Foreign Currency Transactions

n On March 30th (the final payment date), the following entry is made to clear
accounts payable, record the additional $20 foreign currency loss at the
settlement date spot rate, and record the cash payment:
DR Accounts payable 990
DR Foreign exchange loss 20
CR Cash 1,010
n This further loss of $20 is recognized in the period in which it occurs.
q The foreign currency loss is a period cost, recognized in the period in
which the change in exchange rates took place.

14
 Speculative Forward Exchange Contracts: Hedges

n Foreign currency losses can be significant, and prudent management

suggests that they should be guarded against if possible.
n This type of protection is generally referred to as “hedging” which can be
defined as a means of transferring risk arising from foreign exchange (or
interest rate, or price) fluctuations from those who wish to avoid it to those
who are willing to assume it.
n The hedged item is the item with the risk exposure that the entity has taken
steps to guard against. The hedging item is the item used to offset that risk
exposure.

15
 Hedges

Natural Exposure Hedge Strategy

“Long”: receive FC. Company loses if “Short”: enter into an obligation to

FCU spot decreases. deliver FC. Company gains if FCU
spot decreases.

“Short”: deliver FC. Company loses if “Long”: enter into an obligation to

FCU spot increases. receive FC. Company gains if FCU
spot increases.

16
 Hedges
Hedged Item Example of Hedging Item
* “FC” = “Foreign Currency”

Accounts receivable (receive FC) FCU-denominated A/P or forward contract (deliver

FC)

Accounts payable (deliver FC) FCU-denominated A/R or forward contract

(receive FC)

Committed sale (receive FC) FCU-denominated loan or forward contract

(deliver FC)

Committed purchase (deliver FC) Forward contract (receive FC)

Anticipated sale (receive FC) FCU-denominated loan or forward contract

(deliver FC)

Anticipated purchase (deliver FC) Forward contract (receive FC)

Note that exposure can arise earlier than the transaction date i.e. the date you enter into
a sale OR issue a purchase order (committed) OR even earlier when the transaction
is first anticipated.
Committed means a firm order with a customer or supplier. For anticipated transactions,
a firm order does not yet exist. 17
 Hedges

n Hedge accounting is defined and described in IFRS 9.

q Hedge accounting is optional. An entity can choose to apply hedge

accounting if it wishes and if the conditions for its use are present, but
does not necessarily have to use it.
q In some cases, the differential accounting impact between using/not
using hedge accounting is minimal. Because hedge accounting
requires extensive documentation, firms may decide to not apply hedge
accounting.
n Under hedge accounting, the exchange gains or losses on the hedged
items will be recognized in the income statement in the same period as the
exchange gains or losses on the hedging item. Without hedge accounting,
the exchange gains or losses on the hedged and hedging items would be
recognized in different periods.
n Note that hedge accounting implies an economic hedge is in place BUT an
economic hedge does not imply hedge accounting is being applied (e.g.,
offsetting FCU-denominated A/R, A/P require no special hedge accounting).

18
 Hedges
n The following items can be used to hedge currency fluctuations:
q A derivative financial instrument. For example, a forward exchange

contract, foreign currency option contract, or foreign currency futures

contract could be used to hedge a monetary asset or liability position, a
committed future transaction, or an anticipated future transaction.
n A forward contract is a financial instrument which must be valued at
fair value throughout its life (IFRS 9).
q A monetary item. For example, an existing foreign currency-
denominated monetary asset or liability could be used to hedge a foreign
currency-denominated position, a committed future transaction, or an
anticipated future transaction.

19
 Hedges
n Anticipated future transactions, such as a future revenue stream or
purchase, cannot be used to hedge an existing foreign currency position
BUT can be the hedged item.
n The hedging instrument must be a firm commitment involving an
independent third party. Otherwise, a manager could just walk away from
the hedging instrument if it was in an unfavorable position. This would leave
GAAP earnings open to manipulation and they would lose the “hardness”
property (i.e., earnings can’t be what you want them to be-an idea we have
seen many times in the course).
n For example, with an anticipated FCU purchase, I can hedge by:
q 1) enter into a forward contract to receive FCU.

q 2) buy FCU now. OR

q 3) denote existing FCU A/R as a hedge if the terms are the same.

20
 Hedges
n Hedged items:
q Can be a recognized asset or liability, an unrecognized firm commitment,

a highly probable forecast transaction, or a net investment in a foreign

operation.
q Can be a single item, a group of items, or a component of these items.

q Must be reliably measurable.

q If it is a forecast transaction (or a component thereof), that transaction

must be highly probable.

q Any item (both financial and non-financial) with currency risk that can be

identified and measured can be a hedged item.

q Net positions can be hedged i.e. a company can hedge a net foreign

exchange position of 20 that is made up of an asset of 100 and a liability

of 80.

21
 Hedges

n Under a forward contract, a financial institution agrees to exchange a

foreign currency with its client at a future date at a rate set at the time the
contract is entered into.
n If the natural position is “long” (receive FC at a future date), enter into a
“short” forward contract with the bank (obligation to deliver FC at a future
date). This dilemma typically faces exporters. The fixed leg of the forward is
the A/R in Cdn$ from the bank, while the Floating leg is the FC delivery
obligation, the latter marked to the changing forward rate.
n If the natural position is “short” (deliver FC at future date), enter into a “long”
forward contract with the bank (obligation to receive FC at future date). This
dilemma typically faces importers. The fixed leg of the forward is the A/P in
Cdn$ to the bank, while the Floating leg is the A/R from the bank, the latter
marked to the changing forward rate.

22
 Hedges

n To qualify for hedge accounting, the following conditions must be

met at the inception of the hedge:

q The hedging relationship consists only of eligible hedging

instruments and eligible hedged items.
q There is formal designation and documentation at the inception of
the hedge.
q The hedging relationship meets the hedge effectiveness
requirements.

23
 Hedges

n If a hedge is truly effective; that is, all risks are transferred by the hedging
party, there should be no overall exchange gain or loss recorded on the
income statement over the life of the hedge, other than the cost of
establishing the hedge itself.
q The cost of an effective hedge is the difference between the forward rate

and the spot rate at the date of the hedged transaction.

n A forward exchange contract that is not a designated, effective hedging item
is a speculative financial instrument required to be recorded at fair value
with gains or losses reported in profit and loss as they occur.
q Either the gross or the net method may be used for internal record
keeping purposes; however, for financial statement reporting purposes,
bank receivables and payables must be reported on a net basis.
q Businesses may choose to enter into speculative forward contracts in

the hope of profiting from exchange rate changes.

24
 Speculative Forward Contract Example
EXAMPLE —page 587 in text
On December 1, Year 1, Raven Co. enters into forward contract to sell 1 million
pesos (PP) to its bank on March 1, Year 2, at the market rate for a 90 day
forward contract of PP1 = $0.027. The Fixed leg of the forward is the A/R in
Cdn$ from the bank, while the Floating leg is the FC delivery obligation. On
December 31, Year 1, Raven’s year-end, the 60-day forward rate to sell
pesos on March 1 has changed to PP1 = $0.025. On March 1, Year 2, the
currencies are exchanged when the spot rate is PP1 = $0.022.

We will stress the gross method, which requires that the forward be recorded
initially. Hence, ignore the the term “memorandum entry” on page 588 of the
text, which only applies to the net method.

25
Journal Entries for Speculative Forward Contract

At December 31,
due from bank $27,000
due to bank (at year-end
forward rate) $25,000
net due from bank (=gain)
$2,000

26
 Hedges

n There are three types of hedges:

q Fair value hedge: the hedging item is used to hedge against the fair
value of the hedged item which is an existing monetary position (e.g.
accounts receivable or payable).
q Cash flow hedge: the hedging item is used to hedge against the
fluctuation in the Canadian dollar value of future cash flows (e.g.
committed or anticipated future sales or purchases). Cash flow hedges
are entered into before the transaction has occurred. Gains and losses
are recorded in other comprehensive income (OCI) and later recycled
out to income to achieve the concurrent income recognition objectives of
hedge accounting.
q Hedge of a net investment in a foreign operation: The hedging item is
used to hedge against the effects of currency fluctuations on these
operations (discussed in Chapter 11 – next class).

27
 Hedges

n Accounting for a fair value hedge of a recognized monetary item

q Record the transaction (purchase/sale) at the transaction date spot rate.

q Record the forward contract at the forward rate and the corresponding
payable to OR receivable from the bank.
q At financial statement reporting dates:

n Revalue the transaction payable/receivable at the closing spot rate

with gain/loss recorded in income (“mark the natural position to the
new spot rate”).
n Revalue the forward contract at the forward rate with the
corresponding gain/loss to income (“mark the floating leg of the
forward to the new forward rate”).
n On the balance sheet, report the forward contract asset/liability on a
net basis.
q At settlement, repeat the procedures noted above for the financial
statement reporting date, and record all cash flows at the spot rate.

28
 Hedges

n Accounting for a fair value hedge of a recognized monetary item.

In most cases, with a recognized monetary item, hedge accounting does
NOT need to be applied.
Why? Because both the monetary item i.e. A/R or A/P balance and the
forward contract are valued at fair value at each reporting date with the
exchange adjustments reported in profit. Since exchange adjustments
on both items are already being reported in profit in the same period, it is
not necessary to use hedge accounting.
Hedge accounting is only necessary when exchange adjustments would
otherwise be reported in profit in different periods.
In the example to follow, hedge accounting is not applied as there is no
reason to do so.

29
 Hedges

n Hedging a recognized monetary item

n (Vulcan example, p. 593 of text):
November-01-10
November 1 November-15-10
November 15 December-31-10 February-15-11
February 15
December 31
Year 1 Year 1 Year 1 Year 2

Collect receivable and settle

Sell goods on account Hedge receivable Year-end forward exchange contract

FU 200,000

SPOT RATE $ 0.8700 $ 0.8650 $ 0.8690 $ 0.8600

FORWARD RATE $ 0.8510 $ 0.8420 $ 0.8520 $ 0.8600

NOTE THE FOLLOWING:

1 forward rate ALWAYS converges to spot rate on f/x contract maturity date

2 forward rate and spot rate generally move in the same direction i.e. if spot rate appreciates,
forward rate appreciates; if spot rate depreciates, forward rate depreciates.

3 For our lecture notes, year 10 = year 1, and year 11 = year 2, in the Vulcan example in the text.

30
 Hedges

n As an exporter, Vulcan’s position is as follows:

Natural Exposure Hedge Strategy

“Long”: receive FC. Vulcan loses if FCU “Short”: enter into obligation to deliver FC.
spot decreases. Vulcan gains if FCU spot decreases.

n Vulcan waited until November 15 to hedge, so suffered an unhedged loss of $1,000

as the spot rate declined. At the date of the hedge, Vulcan’s receivable translated at
spot is $173,000. It is willing to lock in FCU 200,000 x 0.842 = $168,400; thus incurs
a discount of $4,600 ($173,000 - $168,400) to hedge against any further losses.
Since this is a perfect hedge, the only net income effect after November 15 is
expensing the discount (analogy: insurance premium) and the net effect can be
condensed into one entry, as follows:
DR CR

Cash $ 168,400
F/X loss before hedge $ 1,000
F/X loss = discount on hedge $ 4,600
Sales $ 174,000
31
 Hedging a Recognized Monetary Item
(journal entries, using the gross method)
01-Nov-10
November 1, Year 1

DR Accounts receivable (FCU) $ 174,000

CR Sales $ 174,000

FCU 200,000 x 0.870 = $174,000

Comment: note how initial sale booked at spot rate at date of sale

JOURNAL ENTRY # 2:

November 15, Year 1

15-Nov-10

DR. Exchange gains and losses $ 1,000

CR Accounts receivable (FCU) $ 1,000

FCU 200,000 x (0.870-0.865)

Comment: exchange loss prior to date of hege; note how equal to change in spot rates over this time period.

JOURNAL ENTRY # 3:
Memo Entry only
15-Nov-10
November 15, Year 1

DR Receivable from bank $ 168,400

CR Payable to bank (FCU) $ 168,400

FCU 200,000 x 0.842= $168,400

Comment: forward contract with bank at forward rate; note that receivable balance will not change
from now until contract maturity; however, payable will be revalued through time.

32
 Hedging a Recognized Monetary Item
(journal entries)
JOURNAL ENTRY # 4:

31-Dec-10
December 31, Year 1
DR Accounts Receivable (FCU) $ 800
CR F/X gain $ 800

FCU 200,000 x (0.869-0.865)

December 31,
Comment: to adjust A/R balance to December Year
31, 1 spot rate. Note how Cdn $ has depreciated,
2010
resulting in a F/X gain.

JOURNAL ENTRY # 5:

December 31, Year 1

31-Dec-10

DR F/X loss $ 2,000

CR Payable to bank (FCU) $ 2,000

FCU 200,000 x (0.852-0.842)

December 31,
Comment: to adjust forward contract to December 31,Year
20101 forward rate. Note how Cdn $ has depreciated,
resulting in a F/X loss. Note also how F/X loss here offsets to some extent F/X gain on underlying A/R
monetary balance. However, the offset is not perfect - still net $1,200 F/X loss exposure.
This is the portion of the $4,600 hedge discount expensed in 2010.Year 1.
For financial statement reporting purposes, receivable/payable to bank presented on net basis as "forward contract"
liability i.e. $168,400 - $168,400 + $2,000= $2,000 liability.

JOURNAL ENTRY # 6:
February 15, Year 2
15-Feb-11

DR F/X loss $ 1,800

CR Accounts receivable (FCU) $ 1,800

FCU 200,000 x (0.869-0.860) 33

February 15,
Comment: to adjust A/R balance to February 15,Year 2
2011 spot rate. Note how Cdn $ has appreciated,
resulting in a F/X loss.
 Hedging a Recognized Monetary Item
(journal entries)
JOURNAL ENTRY # 7:

15-Feb-1115, Year 2
February

DR F/X loss $ 1,600

CR Payable to bank (FCU) $ 1,600

FCU 200,000 x (0.860-0.852)

Comment: to adjust forward contract to February 15,Year
February 15, 20112 forward rate. Now how forward contract moved in
opposite direction as spot rate, resulting in F/X loss on forward contract as well (note that this is unusual but
can occur on occasion). Note that $3,400 ($1,800 + $1,600) is the remaining portion of the discount expensed in 2011.
Year 2.

JOURNAL ENTRY # 8:

15-Feb-11
February 15, Year 2

DR Cash (FCU) $ 172,000

CR Accounts receivable (FCU) $ 172,000

FCU 200,000 x 0.86

Comment: to record collection from foreign customer. Note how recorded at spot rate as of date of collection.
No consideration for forward contract in place. Note how A/R balance from customer now is nil balance.

34
 Hedging a Recognized Monetary Item
(journal entries)
JOURNAL ENTRY # 9:

15-Feb-11
February 15, Year 2

DR Payable to bank (FCU) $ 172,000

CR Cash (FCU) $ 172,000

FCU 200,000 x 0.86

Comment: to deliver FCU to bank in satisfaction of forward contract.
Note how payable balance to bank is now nil balance.

JOURNAL ENTRY # 10:

February 15, Year 2

15-Feb-11

DR Cash $ 168,400
CR Receivable from bank $ 168,400

FCU 200,000 x 0.842

Comment: to record receipt of Cdn from bank at contracted forward rate.
Note how receivable balance from bank is now nil balance.

35
 Hedges

Summary of Vulcan Example (Exporter)

Cash from customer $172,000
Net Cash to bank -3,600
Sales proceeds locked in by hedge $168,400

36
LO
 Hedges

q For the final assessment, you are not responsible for the discussion in
the text (p. 597) of the option for FV Hedges under IFRS 9.6.2.4 to
segregate the forward contract into the intrinsic and insurance portions.
This option involves “smoothing” out the P&L impact of the amortization
of the hedged discount or premium, using the OCI account and drawing
just enough out of the OCI account to offset to zero the loss on marking
the natural position to the changing spot. The rest is straight line
amortized.
q Very few companies do this, as the costs outweigh the benefits of this
added complexity.
q Remember: for the final assessment, for FV hedges mark the natural
position to the changing spot rate and the floating leg of the forward
contract to the changing forward rate. The amortization of the hedge
discount or premium will occur automatically.

37
 Hedges

n Accounting for an unrecognized firm commitment

q IFRS 9.6.5.4 states that a hedge of the foreign currency risk of a firm

commitment may be accounted for as a fair value hedge or a cash flow

hedge. However, in practice, cash flow hedge accounting is more
prevalent and will be the only method illustrated here (and testable).

38
 Hedges
n Accounting for a cash flow hedge of an unrecognized firm commitment
q Record the forward contract and the corresponding payable to or receivable from
the bank.
q At each reporting date prior to purchase or sale:
n Revalue the forward contract at the forward rate (gain/loss to OCI).
q Later, when the purchase or sale transaction occurs:
n Record the purchase or sale transaction at the spot rate.
n Clear the balance in OCI with a corresponding debit or credit to the purchase
or sale transaction.
q Manning’s natural position is that of an importer, and is obliged to deliver FCU
(“short”). It is exposed if the FCU spot price increases. To hedge, it enters into
an obligation to purchase FCU from the bank at a fixed forward rate, a “long”
position which gains if the FCU spot price increases. The premium on the forward
contract at hedge inception is $7,000 = US $350,000 x (1.28-1.26). Manning is
willing to pay this premium at the order date in order to lock in the purchase cost
of the inventory at $448,000 = US $350,000 x 1.26 + $7,000.

39
 Hedges

n Hedging an unrecognized firm commitment

n (Manning example, p. 598):

June-02-10
June 2, Year 2 June-30-10
June 30, Year 2 August-01-10
August 1, Year 2

Receive goods,
Order goods settle forward
and hedge contract, and pay
order Year-end supplier

FCU 350,000

SPOT RATE 1.26 1.268 1.272

FORWARD RATE 1.28 1.275 1.272

40
 Hedging an Unrecognized Firm Commitment –
Cash Flow Hedge (journal entries):
JOURNAL ENTRY # 1:

June 2, Year 2
02-Jun-10

DR Receivable from bank - FCU $ 448,000

CR Payable to bank $ 448,000

FCU 350,000 x 1.280 = $448,000

Comment: to record entry into f/x contract.
While receivable balance will change throughout life of contract, payable will not.

JOURNAL ENTRY # 2:

30-Jun-10
June 30, Year 2

DR OCI - cash flow hedge $ 1,750

CR Receivable from bank - FCU $ 1,750

FCU 350,000 x (1.280-1.275)

Comment: to adjust forward contract to June
June30, 2010
30, Year 2 forward rate.
note how only "receivable from bank" account is adjusted.

41
 Hedging an Unrecognized Firm Commitment –
Cash Flow Hedge (journal entries):
JOURNAL ENTRY # 3:

01-Aug-10
August 1, Year 2

DR OCI - cash flow hedge $ 1,050

CR Receivable from bank - FCU $ 1,050

FCU 350,000 x (1.275-1.272)

Comment: to adjust forward contract to August 1 forward rate.

JOURNAL ENTRY # 4:

01-Aug-10
August 1, Year 2

DR Inventory $ 2,800
CR OCI - cash flow hedge $ 2,800

Comment: to reallocate exchange adjustments from OCI to inventory.

This establishes the cost of inventory locked in by the hedge =
$448,000 ($2,800 + $445,200).

42
 Hedging an Unrecognized Firm Commitment –
Cash Flow Hedge (journal entries):

JOURNAL ENTRY # 5:

01-Aug-10
August 1, Year 2

DR Inventory $ 445,200
CR Cash - FCU $ 445,200

FCU 350,000 x 1.272

Comment: to record inventory purchase and payment at August 1st spot rate.

JOURNAL ENTRY # 6:

01-Aug-10
August 1, Year 2

DR Payable to bank $ 448,000

CR Cash $ 448,000

FCU 350,000 x 1.280

Comment: to record payment to bank at forward contract rate.

43
 Hedges

Summary of Manning Example (Importer)

Cash to supplier $445,200
Net Cash to bank 2,800
Purchase outlay locked in by hedge $448,000

44
LO
 Hedging an Unrecognized Firm Commitment –
Cash Flow Hedge (journal entries):

JOURNAL ENTRY # 7:

01-Aug-10
August 1, Year 2

DR Cash - FCU $ 445,200

CR Receivable from bank - FCU $ 445,200

FCU 350,000 x 1.272

Comment: to record receipt of 350,000 FCU from bank at August 1 spot rate.

n Summary:
q All of the above journal entries can be condensed into one entry:
n DR Inventory $448,000
q CR Cash $448,000
q In the end, inventory is recorded at $448,000, the amount fixed by the forward
contract.

45
 Hedges

n Accounting for a fair value hedge of an unrecognized firm commitment

(text, page 601)
q Record the forward contract and the corresponding payable to or
receivable from bank.
q At each reporting date prior to purchase or sale:

n Revalue the forward contract at forward rate (gain/loss to income)

n Create a “commitment” asset/liability for same dollar amount as
forward contract revaluation (noted above) but opposite sign i.e.
(loss/gain to income)
n I/S impact of above two journal entries is nil
q Later, when the purchase or sale transaction occurs:

n Record the purchase or sale transaction at spot rate, with

commitment asset/liability cleared out to purchase or sale transaction

46
 Entering into a Forward To Hedge Both the Commitment
and the Accounts Payable when Settlement Date Falls After
the Delivery Date
n In the Manning example, the accounts payable was settled at the delivery
date. If settlement was later (say one month – September 1), Manning
could enter into a forward contract (at June 2) to hedge both the
commitment to buy inventory and the amount required to settle the accounts
payable. This is called a “straddle”, ie, it is a cash flow hedge until delivery,
then becomes a FV hedge until settlement. This is illustrated in P 10-15
(Carleton Ltd.)
n For a “straddle”, the basic principles for cash flow hedge accounting remain
the same. The unrealized foreign exchange gain or loss in OCI gets
recycled out and added to the purchased asset (in this case, inventory) at
the date of delivery.

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 Entering into a Forward To Hedge Both the Commitment and the
Accounts Payable when Settlement Date Falls After the Delivery Date

n Thereafter, the forward becomes a fair value hedge of the balance sheet
monetary accounts payable from August 1st (receipt of goods) to September
1st (payment date). The forward and the accounts payable get marked
using the forward rate and the spot rate, respectively, with any re-
measurement amounts going directly to income. In this way, the pro ration
of the $7,000 premium between the cost of the inventory and the hedge of
the accounts payable arises as a natural consequence of the above journal
entries.

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 Using Long Term Debt as a Hedge of a Future Revenue Stream
(a highly probable forecasted transaction)

n We do want to make a remark on the text example used on pages 603-606,

which is a very ineffective hedge in years 2 and 3.
n The recycling out of OCI achieves matching of the gains and losses on each
side of the hedge.
n Basically, the company expects a revenue stream of 200,000 Singapore
dollars each year for three years and, to hedge, borrows SD 600,000,
payable in full at the end of three years. As the text explains, at the end of
the first year, since one- third of the revenue stream has been received,
one-third of the loan balance no longer qualifies as a hedge. Similarly, at
the end of the second year, two-thirds of the loan balance no longer
qualifies as a hedge.
n Class discussion: can anyone think of a more effective way to hedge the
revenue stream of SD 600,000 ?

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 Foreign-currency transactions

n Foreign currency disclosures required (IAS 21):

q The amount of exchange gain or loss recorded in profit and loss.

q The amount of exchange gain or loss recorded in OCI.

q For each type of hedge, disclose a description of the hedge, the hedging
items and their fair values, and the risks being hedged.
q For cash flow hedges, disclose the periods when the cash flows are
expected to occur and incur a profit or loss, the amount recognized in
OCI during the period, the amount reclassified from OCI to income
during the period, and the amount reclassified in the period from OCI to
a non-financial asset or liability.
q Separate disclosure is required of gains or losses on fair value hedges,

and gains and losses from the ineffective portion of cash flow hedges
and of hedges of net investments in foreign operations recognized in
profit and loss in the period.

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Problem 10-
15

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