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.
G. Under fair value hedge accounting for hedges of foreign currency firm commitments:
1. the gain or loss on the hedging instrument is recognized currently in net income,
and
2. the change in fair value of the firm commitment is also recognized currently in net
income.
This accounting treatment requires (1) measuring the fair value of the firm commitment,
(2) recognizing the change in fair value in net income, and (3) reporting the firm
commitment on the balance sheet as an asset or liability. A decision must be made
whether to measure the fair value of the firm commitment through reference to (a)
changes in the spot exchange rate or (b) changes in the forward rate.
H. Cash flow hedge accounting is allowed for hedges of forecasted foreign currency
transactions. For hedge accounting to apply, the forecasted transaction must be
probable (likely to occur). The accounting for a hedge of a forecasted transaction
differs from the accounting for a hedge of a foreign currency firm commitment in two
ways:
1. Unlike the accounting for a firm commitment, there is no recognition of the
forecasted transaction or gains and losses on the forecasted transaction.
2. The hedging instrument (forward contract or option) is reported at fair value, but
because there is no gain or loss on the forecasted transaction to offset against,
changes in the fair value of the hedging instrument are not reported as gains and
losses in net income. Instead they are reported in other comprehensive income.
On the projected date of the forecasted transaction, the cumulative change in the
fair value of the hedging instrument is transferred from other comprehensive income
(balance sheet) to net income (income statement).
V. IFRS is very similar to U.S. GAAP with respect to the accounting for foreign currency
transactions and hedging of foreign exchange risk.
A. IAS 21 requires the use of a two-transaction perspective in accounting for foreign
currency transactions with unrealized foreign exchange gains and losses accrued in net
income in the period of exchange rate change.
B. IAS 39 allows hedge accounting for foreign currency hedges of recognized assets and
liabilities, firm commitments, and forecasted transactions when documentation
requirements and effectiveness tests are met. Hedges are designated as cash flow or
fair value hedges.
C. One difference between IFRS and U.S. GAAP relates to the type of financial instrument
that can be designated as a foreign currency cash flow hedge. Under U.S. GAAP, only
derivative financial instruments can be used as a cash flow hedge, whereas IFRS also
allows non-derivative financial instruments, such as foreign currency loans, to be
designated as hedging instruments in a foreign currency cash flow hedge.
Answer to Discussion Question
Do we have a gain or what?
This case demonstrates the differing kinds of information provided through application of current
accounting rules for foreign currency transactions and derivative financial instruments.
The Ahnuld Corporation could have received $200,000 [$2.00 x 100,000 tchecks] from its export
sale to Tcheckia if it had required immediate payment. Instead, Ahnuld allows its customer six
However, rather than leaving the tcheck receivable unhedged, Ahnuld sells tchecks forward at a
price of $180,000. Because the future spot rate turns out to be only $1.70, the forward contract
provides a benefit, increasing the amount of cash received from the export sale by $10,000. In
The net impact on income resulting from the fluctuation in the value of the tcheck is a loss of
$20,000. Clearly, Ahnuld forgoes $20,000 in cash inflow by allowing the customer time to pay
for the purchase, and the net loss reported in income correctly measures this. The $20,000 loss
Gains and losses on forward contracts designated as fair value hedges of foreign currency
Answers to Questions
1. Under the two-transaction perspective, an export sale (import purchase) and the
subsequent collection (payment) of cash are treated as two separate transactions to be
2. Foreign currency receivables resulting from export sales are revalued at the end of
accounting periods using the current spot rate. An increase in the value of a receivable will
3. Foreign exchange gains and losses are created by two factors: having foreign currency
exposures (foreign currency receivables and payables) and changes in exchange rates.
4. Hedging is the process of eliminating exposure to foreign exchange risk so as to avoid
potential losses from fluctuations in exchange rates. In addition to avoiding possible
5. A party to a foreign currency forward contract is obligated to deliver one currency in
6. Hedges of foreign currency denominated assets and liabilities are not entered into until a
foreign currency transaction (import purchase or export sale) has taken place. Hedges of
has been placed or received.
7. Foreign currency options have an advantage over forward contracts in that the holder of the
option can choose not to exercise if the future spot rate turns out to be more advantageous.
8. An enterprise is required to recognize all derivative financial instruments as assets or
liabilities on the balance sheet and measure them at fair value.
9. The fair value of a foreign currency forward contract is determined by reference to changes
in the forward rate over the life of the contract, discounted to the present value. Three
The manner in which the fair value of a foreign currency option is determined depends on
whether the option is traded on an exchange or has been acquired in the over the counter
market. The fair value of an exchange-traded foreign currency option is its current market
10. Hedge accounting is defined as recognition of gains and losses on the hedging instrument
11. For hedge accounting to apply, the forecasted transaction must be probable (likely to
12. In both cases, (1) sales revenue (or the cost of the item purchased) is determined using the
loss recognized in net income.
For a cash flow hedge, 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). An amount equal to the
For a fair value hedge, 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
13. For a fair value hedge of a foreign currency asset or liability (1) sales revenue (cost of
purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged
asset or liability is adjusted to fair value based on changes in the spot exchange rate with a
For a fair value hedge of a firm commitment, there is no hedged asset or liability to account
for. The forward contract is adjusted to fair value based on changes in the forward rate
(resulting in an asset or liability reported on the balance sheet), with a gain or loss
recognized in net income. The firm commitment is also adjusted to fair value based on
period in which the hedged item affects net income.
14. For a cash flow hedge of a foreign currency asset or liability (1) sales revenue (cost of
purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged
asset or liability is adjusted to fair value based on changes in the spot exchange rate with a
foreign exchange gain or loss recognized in net income. The forward contract is adjusted
to fair value (resulting in an asset or liability reported on the balance sheet), with the
For a hedge of a forecasted transaction, the forward contract 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). Because
there is no foreign currency asset or liability, there is no transfer from AOCI to net income to
15. In accounting for a fair value hedge, the change in the fair value of the foreign currency
option is reported as a gain or loss in net income. In accounting for a cash flow hedge, the
16. The accounting for a foreign currency borrowing involves keeping track of two foreign
currency payables—the note payable and interest payable. As both the face value of the
Answers to Problems
1. C (Foreign exchange gain/loss on foreign currency transaction)
2. D (Method of accounting for foreign currency transactions)
Current accounting standards require a two-transaction perspective, accrual
approach.
5. D (Calculate foreign exchange gain/loss on foreign currency borrowing)
6. D (Foreign exchange gain/loss on foreign currency transaction)
7. D (Calculate foreign exchange gain/loss)
The merchandise purchase results in a foreign exchange loss of $8,000, the
difference between the U.S. dollar equivalent at the date of purchase and at the
date of settlement.
The total foreign exchange loss is $28,000 ($8,000 + $20,000).
8. D (Forward contract cash flow hedge of foreign currency denominated
asset/liability)
The Thai baht is selling at a premium (forward rate exceeds spot rate). The
exporter will receive more dollars as a result of selling the baht forward than if
the baht had been received and converted into dollars on April 1. Thus, the
premium results in additional revenue for the exporter.
11. C (Calculate foreign exchange gain/loss on foreign currency transaction)
12. B (Forward contract fair value hedge of foreign currency denominated
asset/liability)
12. (continued)
2015 that matures on March 31, 2016, $32,000 [$.0032 x 10 million]. The fair value
of the forward contract is the present value of $2,000 discounted for three
13. A (Forward contract cash flow hedge of forecasted foreign currency transaction)
The krona is selling at a premium in the forward market, causing Pimlico to pay
more dollars to acquire kroner than if the kroner were purchased at the spot rate
on March 1. Therefore, the premium results in an expense of $10,000 [($.12 – $.10)
x 500,000].
to Net Income $7,500
14. C (Option cash flow hedge of forecasted foreign currency transaction)
15-17. (Option fair value hedge of a foreign currency firm commitment)
15. B
16. D
The easiest way to solve problems 15 and 16 is to prepare journal entries for the
option fair value hedge and the firm commitment. The journal entries are as
follows:
9/1/15
Foreign Currency Option $2,000
Cash $2,000
12/31/15
Foreign Currency Option $700
Loss on Firm Commitment $2,019.70
Firm
Commitment $2,019.70
[($.77 – $.80) x 100,000 = $3,000 – $980.30 = $2,019.70]
Foreign Currency (C$) $77,000
Sales
$77,000
Cash $80,000
Foreign
15-17. (continued)
Net impact on 2016 net income:
Gain on Foreign Currency Option $ 700.00
Loss on Firm Commitment (2,019.70)
17. B Net cash inflow with option ($80,000 – $2,000) $78,000
Cash inflow without option (at spot rate of $.77) 77 ,000
Net increase in cash inflow $ 1,000
18-20. (Forward contract fair value hedge of a foreign currency firm commitment)
The easiest way to solve problems 18 and 19 is to prepare journal entries for the
forward contract fair value hedge of a firm commitment. The journal entries are as
follows:
3/1 no journal entries
Net impact on first quarter net income is $0.
18-20. (continued)
4/30 Loss on Forward Contract $250
Forward Contract $250
[Fair value of Forward Contract is
(($.120 – $.118) x 500,000) = $1,000;
$1,000 – $1,250 = $250]
18. A