Advanced Accounting 12Th Edition By Hoyle Schaefer and Doupnik

Advanced Accounting 12Th Edition By Hoyle Schaefer and Doupnik

CHAPTER 9
FOREIGN CURRENCY TRANSACTIONS AND
HEDGING FOREIGN EXCHANGE RISK
Chapter Outline

I. In today’s global economy, a great many companies deal in currencies other than their reporting currencies.
A. Merchandise may be imported or exported with prices stated in a foreign currency.
B. For reporting purposes, foreign currency balances must be stated in terms of the company’s reporting currency by multiplying it by an exchange rate.
C. Accountants face two questions in restating foreign currency balances.
1. What is the appropriate exchange rate for restating foreign currency balances?
2. How are changes in the exchange rate accounted for?
D. Companies often engage in foreign currency hedging activities to avoid the adverse impact of exchange rate changes.
E. Accountants must determine how to properly account for these hedging activities.

II. Foreign exchange rates are determined in the foreign exchange market under a variety of different currency arrangements.
A. Exchange rates can be expressed in terms of the number of U.S. dollars to purchase one foreign currency unit (direct quotes) or the number of foreign currency units that can be obtained with one U.S. dollar (indirect quotes).
B. Foreign currency trades can be executed on a spot or forward basis.
1. The spot rate is the price at which a foreign currency can be purchased or sold today.
2. The forward rate is the price today at which foreign currency can be purchased or sold sometime in the future.
3. Forward exchange contracts provide companies with the ability to “lock in” a price today for purchasing or selling currency at a specific future date.
C. Foreign currency options provide the right but not the obligation to buy or sell foreign currency in the future, and therefore are more flexible than forward contracts.

III. FASB Accounting Standards Codification Topic 830, Foreign Currency Matters (FASB ASC 830) prescribes accounting rules for foreign currency transactions.
A. Export sales denominated in foreign currency are reported in U.S. dollars at the spot exchange rate at the date of the transaction. Subsequent changes in the exchange rate until collection of the receivable are reflected through a restatement of the foreign currency account receivable with an offsetting foreign exchange gain or loss reported in income. This is known as a two-transaction perspective, accrual approach.
B. The two-transaction perspective, accrual approach also is used in accounting for foreign currency payables. Receivables and payables denominated in foreign currency create an exposure to foreign exchange risk; this is the risk that changes in the exchange rate over time will result in a foreign exchange loss.

IV. FASB Accounting Standards Codification Topic 815, Derivatives and Hedging (FASB ASC 815) governs the accounting for derivative financial instruments and hedging activities including the use of foreign currency forward contracts and foreign currency options.
A. The fundamental requirement is that all derivatives must be carried on the balance sheet at their fair value. Derivatives are reported on the balance sheet as assets when they have a positive fair value and as liabilities when they have a negative fair value.
B. U.S. GAAP provides guidance for hedges of the following sources of foreign exchange risk:
1. foreign currency denominated assets and liabilities.
2. unrecognized foreign currency firm commitments.
3. forecasted foreign denominated currency transactions.
4. net investments in foreign operations (covered in Chapter 10).
C. Companies prefer to account for hedges in such a way that the gain or loss from the hedge is recognized in net income in the same period as the loss or gain on the risk being hedged. This approach is known as hedge accounting. Hedge accounting for foreign currency derivatives may be applied only if three conditions are satisfied:
1. the derivative is used to hedge either a cash flow exposure or fair value exposure to foreign exchange risk,
2. the derivative is highly effective in offsetting changes in the cash flows or fair value related to the hedged item, and
3. the derivative is properly documented as a hedge.
D. Hedge accounting is allowed for hedges of two different types of exposure: cash flow exposure and fair value exposure. Hedges of (1) foreign currency denominated assets and liabilities, (2) foreign currency firm commitments, and (3) forecasted foreign currency transactions can be designated as cash flow hedges. Hedges of (1) and (2) also can be designated as fair value hedges. Accounting procedures differ for the two types of hedges.
E. For cash flow hedges of foreign currency denominated assets and liabilities, at each balance sheet date:
1. The hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate, and a foreign exchange gain or loss is recognized in net income.
2. The derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI).
3. An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability.
4. An additional amount is removed from AOCI and recognized in net income to reflect (a) the current period’s amortization of the original discount or premium on the forward contract (if a forward contract is the hedging instrument) or (b) the change in the time value of the option (if an option is the hedging instrument).
F. For fair value hedges of foreign currency denominated assets and liabilities, at each balance sheet date:
1. The hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate, and a foreign exchange gain or loss is recognized in net income.
2. The derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income.