13 ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS AND

HEDGING FOREIGN EXCHANGE RISK

Learning Objectives
1. Distingui sh bet ween the ter ms meas ur ed and denomi nat e d.
2. Describe a foreign currency trans act i on.
3. Underst and some of the mor e common foreign currency
trans act i ons.
. !dentify three st ages of concer n to account ant s for foreign
currency trans act i ons and e"#$ ai n the st e#s used to trans$ at e
foreign currency trans act i ons for each st age.
%. Describe a forward e"change cont r act .
&. '"#$ain the use of forward contr act s as a hedge of an
unrecogni(ed firm commi t me nt .
). !dentify some of the common situati ons in which a forward
e"change cont r act can be used as a hedge.
*. Describe a derivati ve instrument and under st and how it may be
used as a hedge.
+. '"#$ain how e"change gains and $osses are re#ort ed for fair
va$ue hedges and cash f$ow hedges .
In the News:
Lands, 'nd re#ort ed ho$ding net out st andi ng foreign currency forward
cont r act s tot a$ing -)) mi$$ion and o#tions tot a$ing -1& mi$$ion. !n
addition. based on antici#at ed cash f$ows and outf$ows over the ne"t
12 mont hs. if the U/ currency strengt hens 101 re$ative to a$$ other
currenci es. Lands, 'nd,s fisca$ 2002 cash f$ows cou$d be adver s e$ y
affect ed by -0. ) mi$$ion.
1
2any com#ani es in the United /tat es engage in int ernat i ona$
activiti es such as e"#orti ng or im#orti ng goods. est ab$ishi ng a foreign
branch. or ho$ding an e3uit y invest me nt in a foreign com#any.
4ecording and re#orti ng #rob$ ems are encount er e d when trans act i ons
with a foreign com#any or the financi a$ st at e me nt s of a foreign branch
or invest ee are meas ur ed in a currency other than U./. currency.
5rans acti ons to be set t$ ed in a foreign currency must be trans$ at ed 6
that is. e"#r es s ed in do$$ars 6 before they can be aggr egat e d with the
domes t i c trans act i ons of the U./. firm. 7hen a foreign branch or
invest e e mai nt ai ns its account s and #re#ar es its financi a$ st at e me nt s
in ter ms of the currency of the count r y in which it is domici$ed. the
account s must be trans$ at ed from the foreign currency into do$$ars
before financi a$ st at e me nt s for the combi ned entit y are #re#ar ed.
1
Lands, 'nd fisca$ 2001 8nnua$ 4e#ort.
2
5rans$ ati on is neces s ar y becaus e usefu$ financi a$ re#ort s cannot be
#re#ar ed unti$ a$$ trans act i ons and account ba$ ances are st at ed in a
common unit of currency.
!n addi tion. the receivab$ es or #ayab$ es denomi nat e d in foreign
currenci es are subj ect to gains and $osses becaus e of changes in
e"change rat es. 8$so. firms ma9e commi t me nt s or have budget ed
forecas t ed trans act i ons denomi nat e d in foreign currenci es that are
a$so subj ect to gains and $osses from changes in e"change rat es. 2any
com#ani es resort to hedgi ng strat egi es using derivatives to mini mi(e
the im#act of thes e e"change rat e changes on their financi a$
st at e me nt s . Derivative instrume nt s can be char act eri(ed by vo$ati$e
mar9et va$ues and the firm,s e"#osur e to ris9 is usua$$y not
ade3uat e$ y re#r es ent e d by the amount re#ort ed in the boo9s
:carryi ng va$ue; becaus e of the great #ot enti a$ for future $osses :and
gains;. 5hus. the account i ng for thes e instrument s is im#ort ant but
not an easy one.
<ecaus e of the wides#r ea d invo$vement of U./. com#ani es in
foreign activiti es. account ant s must be fami$iar with the #rob$ ems
associ at ed with account i ng for those activities. 5he e"#ansi on of
int ernat i ona$ busines s has been of #articu$ ar concer n to account ant s
becaus e of deve$ o#me nt s in the wor$dwide monet ar y syst em. 5hese
deve$ o#me nt s . cou#$ ed with the e"ist ence of a number of acce#t ab$ e
met hods of trans$ ati ng foreign financi a$ st at e me nt s and re#orti ng
3
gains or $osses on foreign currency f$uctuati ons. have drawn the
at t ent i on of the =8/< at various #oint s in time.
2
5his cha#t er inc$udes
a discussi on of the nat ur e and use of e"change rat es in the trans$ ati on
#roces s. as we$$ as the account i ng st andar ds a##$ied in the trans$ ati on
of trans act i ons meas ur ed in a foreign currency. 8$so. an introducti on
to hedge accounti ng is #rovided. 5he trans$ ati on of account s
mai nt ai ned in ter ms of a foreign currency is discuss ed in the ne"t
cha#t er.
EXCHANGE RATES - MEANS OF TRANSLATION
5rans acti ons that are to be set t$ ed in a foreign currency and
financi a$ st at e me nt s of an affi$iat e maint ai ned in ter ms of a foreign
currency are trans$ at ed :conver t ed; into do$$ars by mu$ti#$ying the
number of units of the foreign currency by a direct e"change rat e.
5hus. trans l at i on is the #roces s of e"#r es si ng monet ar y amount s
that are st at ed in ter ms of a foreign currency in the currency of the
re#orti ng entit y by using an a##ro#ri at e e"change rat e. 8n exchang e
rat e is the ratio bet ween a unit of one currency and the amount of
anot her currency for which that unit can be e"changed at a #articu$ ar
time.
2
5he discus si on in this cha#t er is bas ed #ri mari$y on the accounti ng #rescri bed in
bot h SFAS No. 52, =orei gn >urrency 5rans$ ati on :?orwa$9. >onn.@ =8/<. 1+*1;. and
SFAS No. 133 . 8ccounti ng for Derivative !nstrume nt s and Aedgi ng 8ctivities
:?orwa$9. >onn.@ =8/<. 1++*;.

8 dir ec t exchang e quot a t i on is one in which the e"change rat e is

3uot ed in ter ms of how many units of the domes t i c currency can be
conver t ed into one uni t of for ei gn curr e nc y . =or e"am#$ e. a direct
3uot ati on of U./. do$$ars for one <ritish #ound of 1.%1) means that
-1. %1) cou$d be e"change d for one <ritish #ound. 5o trans$ at e #ounds
into do$$ars. the number of #ounds is mu$ti#$ied by the direct
e"change rat e e"#r es s ed in do$$ars #er #ound. '"change rat es are
a$so st at ed in ter ms of conver ti ng one uni t of t he dome s t i c
curr enc y into units of a foreign currency. which is ca$$ed an indi r ec t
quot a t i on . !n the e"am#$ e above. one U./. do$$ar cou$d be conver t ed
into .&%+2 #ounds :1.00B 1. %1);. 5o trans$ at e #ounds into do$$ars. the
number of #ounds cou$d a$so be divided by the indirect e"change rat e.
'"change rat es may be 3uot ed either as a s#ot rat e or a forward
rat e. 5he spot rat e is the rat e currenci es can be e"change d today.
5he for war d or fut ur e rat e is the rat e the currenci es can be
e"changes at some futur e dat e. 5he forward rat e is an e"change rat e
est ab$ished at the time a forward e"change contr act is negoti at ed. 8
for war d exchan g e cont r ac t is a contr act to e"change at a s#ecified
rat e :the for war d rat e ; currenci es of different count ri es on a
sti#u$ at ed futur e dat e. <efore the currenci es are e"changed. the s#ot
rat e may move above or be$ow the cont r act ed forward e"change rat e.
but this has no effect on the forward rat e est ab$ished when the
forward e"change cont r act was negoti at ed. !n bot h the s#ot and
%
forward mar9et s. a foreign e"change trader #rovides a 3uot at i on for
buying :the bi d rat e ; and a 3uot at i on for se$$ing :the off er rat e ;
foreign currency. 5he trader C s buying rat e wi$$ be $ower than the
3uot ed se$$ing rat e. and the s#read bet ween the two rat es is #rofit for
the trader. '"change rat es are re#ort ed dai$y in ter ms of bot h direct
and indirect 3uot ati ons :see !$$ustr ati on 136 1; in the financi a$ section of
many news#a#er s .
!?/'45 !LLU/5485!O? 136 1 A'4'
<efore the 1+)0s. rat es of e"change of free mar9et count ri es were
cont ro$$ ed to some e"t ent by member count ri es of the !nternat i ona$
2onet ar y =und. 2ost of the member count ri es agreed to est ab$ish
e"change rat es in ter ms of U./. do$$ars and go$d. 8$though the act ua$
rat e was free to f$uctuat e. the count ri es that est ab$ished offi ci al or
fixe d rat es agr eed to mai nt ai n the act ua$ rat e within 11 :21 aft er
1+)1; of the officia$ rat e by buying or se$$ing U./. do$$ars or go$d.
<ecaus e of #ress ur e on the do$$ar. the United /tat es in 1+)1
sus#ende d its commi t me nt to conver t do$$ars into go$d at -3% #er
ounce. 5he re$ationshi # bet ween maj or currenci es is now det er mi ned
$arge$y by su##$y and demand fact ors. ca$$ed float i ng rat e s . 8s a
resu$t. significant rea$ignme nt s have occurr ed bet ween the currenci es
of various count ri es over a re$ative$y short #eriod of time.
&
=$oating rat es increas e the ris9 to com#ani es doing busines s with a
foreign com#any.
3
8fter a rat e change occurs. a$$ trans act i ons are
conduct ed at the new rat e unti$ the ne"t change occurs. <ecaus e the
amount to be received or #aid is affect ed by a change in e"change
rat es. ther e is a direct economi c im#act on a com#anyC s o#er at i ons.
=or e"am#$ e. a #ayab$ e to be set t$ ed in 100. 000 yen has a do$$ar
e3uiva$ ent va$ue of -3 when the direct e"change rat e is -.003.
8n increas e in the va$ue of the yen to -.00&2% wou$d resu$ t in an
increas e in the #ayab$ e to -&2%.
5he se$ ection of an e"change rat e to be used in the trans$ ati on
#roces s is com#$icat ed by the fact that some count ri es mai nt ai n
mu$ti#$ e e"change rat es. 5he gover nme nt of a count r y may maint ai n
officia$ rat es that differ from the mar9et 6 det er mi ned rat e. de#endi ng
on the nat ur e of the trans act i on. =or e"am#$ e. a gover nme nt may
est ab$ish a set e"change rat e for DDes s ent i a$ goods and servicesC C and
a$$ow the e"change rat e for nones s ent i a$ goods and services to f$oat.
3
5he conce#t s of economi c e"#os ur e and accounti ng e"#osur e are not identica$. 8
com#any, s economi c e"#osur e may be broad$ y defined as the uncert ai nt y
associ at ed with the effect of e"change rat e changes on the e"#ect ed cash f$ows of
the re#orti ng entit y. 8ccounti ng e"#os ur e. in cont r as t . is direct$y re$at ed to
account s that are trans$ at ed at the current e"change rat e.
)
In the News:
5he do$$ars strengt h is giving U./. indust r y headaches . 5he
strengt he ni ng of the U./. do$$ar as com#ar ed to the currency of other
count ri es is #ricing U./. goods out of the foreign mar9et and is ma9ing
com#et i tion at home from im#ort er s fierce. Eener a$ 2oters chief
financi a$ officer st at es that the strong do$$ar is fran9$y dest royi ng the
manuf act uri ng ca#abi$ity of the count r y. Over -1 tri$$ion wort h of
8merican greenbac9. Fa#anes e yen. and 'uro#ean euros and other
currenci es change hands dai$y. 5he do$$ar was hitting a 1%6 year high in
Fu$y 2001 agai nst a mar9et bas9et of various currenci es.

MEASURED VERSUS DENOMINATED

5rans acti ons are nor ma$$y meas ur e d and recorded in ter ms of the
currency in which the re#orti ng entit y #re#ar es its financi a$
st at e me nt s . 5his currency is usua$$y the domes t i c currency of the
count r y in which the com#any is domici$ed and is ca$$ed the repor t i ng
curr enc y . !n subs e3uent i$$ustr ati ons the U./. do$$ar is assume d to be
the re#orti ng currency of U./.6 bas ed firms. 8sset s and $iabi$ities are
deno mi na t e d in a currency if their amount s are fi"ed in ter ms of that

Leaf- Chronicl e . *B2)B 01. Do$$ars strengt h giving U./. indust r y. <ush team
headac he s . by 2artin >rutsinger. #. 83.
*
currency. 5hus. a trans act i on bet ween two U./. com#ani es re3uiring
#ayment of a fi"ed number of do$$ars is bot h meas ur ed and
denomi nat e d in do$$ars. !n a trans act i on bet ween a U./. firm and a
foreign com#any. the two #arti es usua$$y negoti at e whet her the
set t$ eme nt is to be made in do$$ars or in the domes t i c currency of the
foreign com#any. !f the trans act i on is to be set t$ ed by the #ayment of
a fi"ed amount of foreign currency. the U./. firm meas ur es the
receivab$ e or #ayab$ e in do$$ars. but the trans act i on is denomi nat e d in
the s#ecified foreign currency. 5o the foreign com#any. the
trans act i on is bot h meas ur ed and denomi nat ed in its domes t i c
currency.
FOREIGN CURRENCY TRANSACTIONS
8 trans act i on that re3uir es #ayment or recei #t :set t$ eme nt ; in a
foreign currency is ca$$ed a for ei gn curr e nc y trans ac t i on . 8
trans act i on with a foreign com#any that is to be set t$ ed in do$$ars is
not a foreign currency trans act i on to a U./. firm becaus e the number
of do$$ars to be received or #aid to set t$ e the account is fi"ed and
remai ns unaffect ed by subs e3ue nt changes in the e"change rat e.
5hus. a trans act i on of a U./. firm with a foreign entit y to be set t$ ed in
do$$ars is account ed for in the same manner as if the trans act i on had
been with a U./. com#any.
+
8 foreign currency trans act i on wi$$ be set t$ ed in a foreign currency.
and the U./. firm is e"#os ed to the ris9 of unfavor ab$ e changes in the
e"change rat e that may occur bet ween the dat e the trans act i on is
ent er ed into and the dat e the account is set t$ ed. =or e"am#$ e. assume
that a U./. firm #urchas ed goods from a =rench firm and the U./. firm
is to set t$ e the $iabi$ity by the #ayme nt of 20. 000 francs. 5he =rench
firm wou$d meas ur e and record the trans act i on as norma$ becaus e the
bi$$ing is in its re#orti ng currency. <ecaus e the bi$$ing is in a foreign
currency :denomi nat e d in francs;. the U./. firm must trans$ at e the
amount of the foreign currency #ayab$ e into do$$ars befor e the
trans act i on is ent er ed in its account s. 8n increas e :decr eas e; in the
direct e"change rat e wi$$ increas e :decr eas e; the number of do$$ars
re3uir ed to buy the fi"ed number of francs needed to set t$ e the
foreign currency $iabi$ity.
5he !re"t e#"$a%& e rat e is often said to be increasi ng. or the
foreign currency unit to be strengt he ni ng. if mor e do$$ars are needed
to ac3uir e the foreign currency units. !f fewer do$$ars are needed.
then the foreign currency is wea9eni ng or de#r eci ati ng in re$ation to
the do$$ar :the direct e"change rat e is decr easi ng;. >onsider the
fo$$owing informat i on.
Direct '"change 4at es
Gen /trengt hens Gen 7ea9ens
<eginni ng of year -1 H 1 Gen -1 H 1 Gen
10
'nd of year -2 H 1 Gen -.% H 1 Gen
7ou$d a U/ com#any ho$ding a -10. 000 recei vabl e denomi nat e d in
Gen #refer the Gen to strengt hen or wea9enI !n this case. the
com#any #refer s a strengt hene d Gen becaus e mor e do$$ars wou$d be
received and an e"change gain wou$d be incurred. !f the trans act i on
invo$ved a a!abl e denomi nat e d in Gen. the firm wou$d have incurr ed
an e"change rat e $oss becaus e mor e do$$ars wou$d have to be #aid. 8s
wi$$ be shown $at er. becaus e firms cannot #erfect$y #redict changes in
e"change rat es. the U./. firm may hedg e . that is. #rot ect itse$f
agai nst an unfavor ab$ e change in the e"change rat e by using
derivatives.
!n this cha#t er . we discuss the account i ng for im#orti ng or
e"#orti ng of goods. 5hen we #rovide an introducti on to hedgi ng the
ris9 of foreign currency rat e changes.
In the News:
/ome currenci es have under gone maj or changes in com#ari son to the
U/ do$$ar. >onsider the changes in the fo$$owing direct e"change rat es
bet ween the U/ do$$ar and the <ra(i$ian 4ea$ and the 8ustra$i an do$$ar@
U/ Do$$ars to >onver t to =oreign >urrency
11
Fanuary . 2000 8ugust 2*. 2001 Jercent
>hange
8ustra$i an Do$$ar -0. &%&% -0. %2+3 1+1
<ra(i$ian 4ea$ -0. %3% -0. 3+0) 2*1
!n bot h cases. the U/ do$$ar has strengt he ne d re$ative to the other
currenci es. One way to consider whet her a currency has strengt he ne d
or wea9ened is to consi der the direct e"change rat e as the cost of the
foreign currency. =or inst ance. when the direct e"change rat e
increas es . the currency is chea#er so the currency has wea9ened
re$ative to the U/ do$$ar.
I'port! %& or E#port! %& o( Goos or Ser)! " e s
Jrobab$ y the most common form of foreign currency trans act i on is
the e"#orti ng or im#orti ng of goods or services. !n each unset t $ ed
foreign currency trans act i on. ther e are three st ages of concer n to the
account ant . 5hese st ages and the a##ro#ri at e e"change rat e to use in
trans$ ati ng account s denomi nat e d in units of foreign currency :e"ce#t
for forward e"change contr act s; are as fo$$ows@
12
1. At t he dat e t he trans ac t i on is firs t recogni z e d in conf or mi t y
wi t h GAAP . 'ach ass et . $iabi$ity. revenue. e"#ens e. gain. or $oss
arising from the trans act i on is meas ur ed and recorded in do$$ars by
mu$ti#$ying the units of foreign currency by the current e"change
rat e. :5he curr ent exchan g e rat e is the s#ot rat e in effect on a
given dat e. ;
2. At each bal anc e she e t dat e t hat occur s bet we e n t he
trans ac t i on dat e and t he set t l e me n t dat e . 4ecorded ba$ ances
that are denomi nat ed in a foreign currency are adj ust ed using the
s#ot rat e in effect at the ba$ ance sheet dat e and the trans act i on
gain or $oss is recogni(ed current$ y in earni ngs.
3. At t he set t l e me n t dat e . !n the case of a foreign currency
#ayab$ e. a U./. firm must conver t U./. do$$ars into foreign currency
units to set t$ e the account . wher eas foreign currency units received
to set t$ e a foreign currency receivab$ e wi$$ be conver t ed into
do$$ars. 8$though trans$ ati on is not re3uired. a trans act i on gain or
$oss is recogni(ed if the number of do$$ars #aid or received u#on
conver si on does not e3ua$ the carrying va$ue of the re$at ed #ayab$ e
or receivab$ e.
Using the s#ot rat e to trans$ at e foreign currency receivab$ es and
#ayab$ es at each meas ur e me nt dat e provi d e s an es t i ma t e of t he
numb e r of doll ar s t o be rec ei v e d or t o be pai d t o set t l e t he
13
account . ?ot e that bot h gains and $osses are resu$t in adj ust me nt s to
the receivab$ e or #ayab$ e. a##ro"i mat i ng a form of current va$ue
account i ng. 5he increas e or decr eas e in the e"#ect ed cash f$ow is
gener a$$y re#ort ed as a foreign currency trans ac t i o n gai n or los s .
somet i mes referr ed to as an exchan g e gai n or los s . in det er mi ni ng
net income for the current #eriod.
%

Impor t i ng Trans ac t i on * 5o i$$ustrat e an im#orti ng trans act i on.
assume that on December 1. 2003. a U./. firm #urchas ed 100 units of
invent or y from a =rench firm for %00. 000 euros to be #aid on 2arch 1.
200. 5he firmC s fisca$ year6 end is December 31. 8ssume furt her that
the U./. firm did not engage in any form of hedgi ng activit y. 5he s#ot
rat e for euros :-Beuro; at various times is as fo$$ows@
/#ot
4at e
5rans acti on dat e 6 December 1. 2003 -1. 0%
<a$ance sheet dat e 6 December 31. 2003 1.0*
/et t$ ement dat e 6 2arch 1. 200 1.0)
5he U./. firm wou$d #re#ar e the fo$$owing journa$ ent ry on
December 1. 2003@
%
One e"ce#t i on to this treat me nt of trans act i on gains and $osses
wou$d invo$ve intercom#a ny trans act i ons that are of a $ong6 ter m
financi ng or ca#it a$ nat ur e bet ween an invest or and an invest ee that is
conso$idat ed. combi ned. or account ed for by the e3ui t y met hod. 5here
are account ed for as a com#onent of stoc9ho$ der s, e3uit y.
1
Dec. 1 Jurchas es %2%. 000
8ccount s Jayab$ e :%00. 000 euros "
-1. 0%B eur o;
%2%. 000
8t the ba$ ance sheet dat e. the account s #ayab$ e denomi nat ed in
foreign currency is adjust ed using the e"change rat e :s#ot rat e; in
effect at the ba$ance sheet dat e. 5he entry is
Dec. 31 5rans acti on Loss 1%. 000
8ccount s Jayab$ e 1%. 000
8ccount s #ayab$ e va$ued at 12B 31 :%00. 000 euros "
-1. 0*B eur o;
-%0. 0
00
8ccount s #ayab$ e va$ued at 12B 1 :%00. 000 euros "
-1. 0%B eur o;
%2%. 00
0
8djust ment to account s #ayab$ e needed -
1%. 000
or
K%00. 000 euros " :-1. 0* 6 -1. 0%; H -1%. 000L
!f the e"change rat e had dec$ined be$ow -1. 0%.
&
for e"am#$ e to
-1. 03. the U./. firm wou$d have recogni(ed a gain of -10. 000 since it
wou$d have ta9en on$y -%1%. 000 :%00. 000 euros " -1. 03; to set t$ e the
-%2%. 000 recorded $iabi$ity.
<efore the set t$ eme nt dat e. the U./. firm must buy euros in order
to satisfy the $iabi$ity. 7ith a change in the e"change rat e to -1. 0).
&
5hroughout this cha#t er. we oft en st at e the e"change rat e sim#$ y in do$$arsM thus a
rat e of -1. 0% means -1. 0% #er unit of foreign currency :euro in this cas e;.
1%
the firm must #ay -%3%. 000 on 2arch 1. 200. to ac3uir e the %00. 000
euros. 5he journa$ ent ry to record the set t$ eme nt is@
2ar. 1 8ccount s Jayab$ e %0. 000
5rans acti on Eain %.000
>ash :%00. 000 euros "
-1. 0)B eur o;
%3%. 000
Over the three6 mont h #eriod. the decision to de$ ay ma9i ng
#ayment cost the firm -10. 000 :the -%3%. 000 cash #aid $ess the
origina$ #ayab$ e amount of -%2%. 000;. 5his net amount was
recogni(ed as a $oss of -1%. 000 in 2003 and a gain of -%. 000 in 200.
?ote in the e"am#$ e above that at December 31. the ba$ ance sheet
dat e. a trans act i on $oss was recogni(ed on the o#en account #ayab$ e.
/uch a $oss is consi der ed unrea$i(ed becaus e the account has not yet
been set t$ ed or c$osed. 7hen an account #ayab$ e :or receivab$ e; is
set t$ ed or c$osed. a trans act i on gain or $oss on the set t$ eme nt is
consi der ed rea$i(ed. 5he =8/< reasoned that users of financi a$
st at e me nt s are best served by re#orti ng the effect s of e"change rat e
changes on a firmC s financi a$ #osition in the account i ng #eriod in which
they occur. even though they are unrea$i(ed and may rever s e or
#arti a$$y revers e in a subs e3uent #eriod. as in the i$$ustrati on above.
5his #rocedur e is critici(ed. however. becaus e under E88J. gains are
1&
not ordinari$y re#ort ed unti$ rea$i(ed and becaus e the recogni tion of
unrea$i(ed gains and $osses resu$t s in increas ed earni ngs vo$ati$ity.
Expor t i ng Trans ac t i on ?ow assume that the U./. firm so$d 100
units of invent or y for %00. 000 euros to a =rench firm. 8$$ other fact s
are the same as thos e for the im#orting trans act i on. 5he journa$
ent ri es to record this e"#orti ng trans act i on on the boo9s of the U./.
>om#any are@
De"e '+ e r 1, -..3 - Dat e o( Tra%s a" t ! o%
8ccount s 4eceivab$ e :%00. 000 euros " -1. 0%; %2%. 000
/a$es %2%. 000
De" e '+ e r 31, -..3 - /a0 a%" e S$e e t Dat e
8ccount s 4eceivab$ e :-%0. 0006 -%2%. 000; 1%. 000
5rans acti on Eain 1%. 000
5he receivab$ e va$ued at 12B1. %00. 000 euros " -1. 0* H
-%0. 000
5he receivab$ e va$ued at 12B31. %00. 000 euros " -1. 0% H
-%2%. 000
>hange in the va$ue of the receivab$ e - 1%. 000
1)
Mar"$ 1, -..1 - Set t0 e 'e % t Dat e
>ash :%00. 000 euros " -1. 0); %3%. 000
5rans acti on Loss %.000
8ccount s 4eceivab$ e %0. 000
8 com#ari son of the ent ri es to record the e"#orti ng trans act i on
with those #re#ar ed to record an im#orti ng trans act i on revea$ s that a
moveme nt in the e"change rat e has an o##osi t e effect on the
com#anyC s re#ort ed income. 5hat is. the increas e in the e"change rat e
from -1. 0% to -1. 0* resu$t ed in a trans act i on gain in the case of a
foreign currency receivab$ e. wher eas a trans act i on $oss was re#ort ed
in the case of a foreign currency #ayab$ e. 7hen the e"change rat e
decr eas e d from -1. 0* to -1. 0). a trans act i on $oss was re#ort ed on the
e"#os ed receivab$ e. wher eas a trans act i on gain was re#ort ed on the
e"#os ed #ayab$ e. 5hus. one too$ avai$ ab$ e to manage me nt to hedge a
#ot ent i a$ $oss on a foreign currency receivab$ e is to ent er into a
trans act i on to est ab$ish a $iabi$ity to be set t$ ed in the same foreign
currency. /imi$ar$y. a $iabi$ity to be set t$ ed in units of a foreign
currency can be hedged by ent eri ng into a receivab$ e trans act i on
denomi nat e d in the same foreign currency.
5hese re$ations hi #s are summari (ed be$ow.
1*
<a$ance /heet
'"#osed
8ccount
'ffect on
<a$ance
4e#ort ed
!ncome
/tat eme nt
'ffect
!ncreas e in direct e"change rat e
!m#orting trans act i on Jayab$ e !ncreas e 5rans acti on
$oss
'"#orting trans act i on 4eceivab$
e
!ncreas e 5rans acti on
gain
Decreas e in direct e"change rat e
!m#orting trans act i on Jayab$ e Decreas e 5rans acti on
gain
'"#orting trans act i on 4eceivab$
e
Decreas e 5rans acti on
$oss
Aow shou$ d a trans act i on gain or $oss be re#ort edI !n the #revious
e"am#$ es. the do$$ar amount recorded in the /a$es account and the
Jurchas es account was det er mi ned by the e"change rat e #revai$ing at
the trans act i on dat e. 8djust ment s to the foreign currency
denomi nat e d receivab$ e or #ayab$ e were recorded direct$ y to
trans act i on gain or $oss. Under this a##roach. referr ed to as the t wo!
trans ac t i on appr oac h . the sa$ e or #urchas e is viewed as a
trans act i on se#ar at e and distinct from the financing arrange me nt .
5hus. the trans act i on gain or $oss does not resu$ t from an o#er at i ng
decision to buy or se$$ goods or services in a foreign mar9et . but from
a financi a$ decision to de$ ay the #ayment or recei #t of foreign
1+
currency and not to hedge the e"#os ed receivab$ e or #ayab$ e agai nst
#ossib$ e unfavor ab$ e currency rat e changes.
8n a$t er nat i ve view that was reject ed by the =8/< consi der s the
initia$ trans act i on and set t$ eme nt to be one trans act i on. /u##or t er s of
this met hod cont end that the initia$ trans act i on is incom#$ et e and the
amount s recorded are esti mat es unti$ such time as the tot a$ sacrifice
from the #urchas e :unit s of domes t i c currency #aid; or the tot a$
benefit s from the sa$e :unit s of domes t i c currency received; are
9nown. Under this view. trans act i on gains or $osses shou$ d be
account ed for as an adjust me nt to the cost of the asset #urchas ed or
to the revenue recorded in a sa$es trans act i on. 5here is an obvious
im#$eme nt at i on #rob$ em with this met hod when the sa$ e or #urchas e
is recorded in one fisca$ #eriod and the recei #t or #ayme nt occurs in
anot her #eriod.
In the News:
Lands, 'nd re#ort ed in its fisca$ 2000 annua$ re#ort that foreign
currency trans act i on gains and $osses are re#ort ed in Nother income
and e"#ens es . , 5hey a$so st at ed that -3. * mi$$ion of $osses were
re#ort ed as Nother e"#ens e, on the income st at e me nt in fisca$ 1++*
whi$e the amount s of $osses in fisca$ years 1+++ and 2000 were -1. +
mi$$ion and -0. * mi$$ion res#ect i ve$ y.
20
He&! %& Fore! &% E#"$a%& e Rat e R!s2
"eri vat i v e Inst r ume n t s 8fter the issuance of SFAS No. 52 on
foreign currency trans$ ati on. the =8/< became awar e that firms were
using creative instrume nt s with increasi ng fre3uency to accom#$ish
their desired hedgi ng. many of which were not inc$uded in the sco#e
of SFAS No. 52 . >onse3ue nt $ y. the =8/< issued anot her st andar d.
SFAS No. 133, which e"#ande d the sco#e of account i ng for hedges .
Under thes e new guide$ines. cert ai n designat e d hedges are account ed
for using $e& e a""o3%t ! %& . 5his wi$$ be e$abor at ed u#on $at er.
8 deri v a t i v e ins t r ume n t may be defined as a financi a$ instrume nt
that by its ter ms at ince#ti on or u#on occurr ence of a s#ecified event .
#rovides the ho$der :or writ er; with the right :or ob$igati on; to
#artici#at e in some or a$$ of the #rice changes of anot her "n#erl !i n$
va$ue of meas ur e. but does not re3uire the ho$der to own or de$iver
the under$ ying va$ue of meas ur e. 5hus its va$ue is #erive# from the
under$ yi ng va$ue of meas ur e. 5he under$ yi ng va$ue of meas ur e may be
one or mor e refer enced financi a$ instrument s . commodi ti es. or other
asset s. or other s#ecific items to which a rat e. an inde" of #rices. or
anot her mar9et indicat or is a##$ied. !n most cases. derivatives differ
from traditiona$ instrument s :stoc9s and bonds. for e"am#$ e; in that
21
the event ua$ do$$ar amount of the #erfor mance is de#ende nt u#on
subs e3ue nt va$ue changes. rat her than u#on a st atic meas ur e. and
the event ua$ outcome is neces s ari$y favor ab$ e to one of the #arti es
invo$ved and unfavor ab$ e to the other. 5he cash #ayme nt s invo$ved
are made at the end of the contr act rat her than at its ince#ti on for the
most #art . and the instrume nt s have conse3uent $ y been treat ed in the
#ast in many cases as a ty#e of off6 ba$ance sheet agr ee me nt .
!n SFAS No. 133 . the =8/< identified the fo$$owing as 9eyst ones for
the accounti ng for derivati ve instrument s @
O Derivative instrume nt s re#r es ent right s or ob$igations that meet
the definitions of ass et s or $iabi$ities and shou$ d be re#ort ed in
financi a$ st at e me nt s .
O =air va$ue is the most re$evant meas ur e for financi a$ instrument s
and the on$y re$evant meas ur e for derivative instrume nt s .
O On$y items that are ass et s or $iabi$ities shou$d be re#ort ed as such
in the ba$ ance sheet .
O /#eci a$ account i ng for items designat e d as being hedged shou$ d
be #rovided on$y for 3ua$ifying items. as demons t r at e d by an
asses s me nt of the e"#ect at i on of effective offset ti ng changes in fair
va$ues or cash f$ows during the ter m of the hedge for the ris9 being
hedged.
22
8$though over a thous and different ty#es of derivati ve instrument s
have been creat ed. they are somet i mes se#ar at e d into the fo$$owing
two broad cat egori es@
=orward6 bas ed derivatives. such as forwards. futur es. and
swa#s. in which either #art y can ot ent i all! have a favorab$ e or
unfavor ab$ e outcome. but not bot h simu$t aneous$ y :e. g.. bot h
wi$$ not simu$t aneous$ y have favorab$ e outcomes ; .
O#tion6 bas ed derivati ves. such as int er es t rat e ca#s. o#tion
cont r act s. and int er es t rat e f$oors. in which on$y one #art y can
#ot ent i a$$y have a favor ab$ e outcome and it agr ees to a
#remi um at ince#ti on for this #ot enti a$it yM the other #art y is
#aid the #remi um. and can #ot enti a$$y have on$y an
unfavor ab$ e outcome.
Derivatives are recogni(ed the in the ba$ance sheet at their fair
va$ue. Det er mi nat i on of that va$ue is bas ed u#on the changes in the
under$ yi ng va$ue of meas ur e :commodi t y. financi a$ instrument . inde".
etc.; and ass es s me nt of the e"#ect ed future cash f$ows. 5he resu$ t is
a #ayab$ e #osition for one of the invo$ved #arti es and a receivab$ e
#osition for the other.
For4ar E#"$a%& e Co%tra"t s
23
7hi$e hedgi ng can be accom#$i shed with many different ty#es of
derivatives. in this cha#t er we focus mai n$y on hedgi ng with the use of
forward contr act s. Later in this cha#t er. we i$$ustr at e the use of
o#tions as a hedgi ng device.
8 forward e"change cont r act :forward contr act ; is an agree me nt to
e"change currenci es of two different count ri es at a s#ecified rat e :the
forward rat e; on a sti#u$ at ed future dat e. 8t the ince#ti on of the
cont r act . the forward rat e nor ma$$ y varies from the s#ot rat e. The
diff er e nc e bet we e n t he t wo rat e s is ref er r e d t o as a di s count
5 pr e mi u m 6 if t he for war d rat e is les s t han 5 gr ea t e r t han 6 t he
spot rat e . as shown her e.
'"chan
ge
4at e
=orward rat e -.1)%
.00)
#remi um
/#ot rat e .1&*
.00&
discount
=orward rat e .1&2
7$! "$ 2!% o( (or4ar "o%tra"t to "$oos e 8
2
!f the item being hedged is a foreign currency acco"nt a!abl e .
the firm shou$ d use a (or4ar "o%tra"t to p3r"$as e t$e (ore! &%
"3rre%"9 on the dat e the #ayab$ e becomes due. 5his im#$ies that the
firm can $oc9 in the cost of ac3uiring the foreign currency on the dat e
the forward cont r act is ac3uired and subs e3ue nt changes in the
e"change rat e wi$$ not affect the amount the firm has to #ay. One the
other hand. if the item being hedged is a foreign currency acco"nt s
recei vabl e . the firm shou$ d use a (or4ar "o%tra"t to se0 0 t$e
(ore! &% "3rre%" 9 on the dat e the receivab$ e is e"#ect ed to be
co$$ect ed.
T$e )a0 3at ! o% o( a (or4ar "o%tra"t 5!%tr! %s! " )ers 3s t! 'e
)a0 3e6 : =orwar d cont r act s are va$ued on a net basis. =or e"am#$ e.
consi der the fo$$owing. /u##os e on Fanuar y 1. 200%. you obt ai n a one6
year forward cont r act to se$$ 10. 000 >anadi an do$$ars using the
December 31. 200% forwar d rat e of -1. %0. 5his forwar d rat e is the
best gues s to esti mat e what the s#ot rat e wi$$ be on December 31.
200%. 5herefor e on Fanuary 1. 200%. you be$ieve that 10. 000 >anadi an
do$$ars wi$$ be wort h -1%. 000. 5he forward cont r act $oc9s in the
amount of cash you wi$$ receive. -1%. 000. <ut since on Fanuary 1 this
is a$so the e"#ect ed cost to obt ai n >anadi an do$$ars. the va$ue of the
forward contr act is (ero on this dat e and it wi$$ remai n (ero unti$ the
2%
forward rat e for December 31. 200% set t$ eme nt changes . 8ssume the
fo$$owing addi tiona$ informat i on@
=orward 4at e
Dat e /#ot 4at e =or 12B31B 0% /et t$ ement Jremi um
1B1B 200% -1. 0 ;1* <. -0. 10
)B1B 200% -1. 3 -1. * -0. 0%
12B 31B 200% ;1* 11 -1. -0. 00
7ith this forward cont r act . the amount of do$$ars to be received is
fi"ed at -1%. 000. but the amount #aid to ac3uir e the foreign currency
a$t ers with changes in the e"change rat e. 7hat conditions wi$$ caus e
the contr act to be beneficia$ to the firmI !f the future s#ot rat e fa$$s
be$ow the forward rat e on the forwar d cont r act . the firm wi$$ benefit.
Loo9ing at the dat a in retros#ect . this is a va$uab$ e forward contr act
for the firm becaus e the forward contr act $oc9s in the cash received at
the -1. %0 rat e but the firm can #urchas e the currency on the
set t$ eme nt dat e at a s#ot rat e of -1. :see the number s in bo$d;. !n
other words. the firm #ays -1. to get -1. %0. <ut on the dat e the
forward contr act is ac3uir ed. ther e is no guar ant e e that the firm wi$$
benefit from the cont r act :i.e. the s#ot rat e on the set t$ eme nt dat e
might increas e above -1. %0;.
2&
?ote that as the set t$ eme nt dat e for the forward cont r act
a##roaches . the forward rat e conver ges to the set tl e %e nt #at e s#ot
rat e. 8$so. not e that the #remi um changes over time but event ua$$y
wi$$ become (ero on the set t$ eme nt dat e. 7hat is the )a0 3e o( t$e
(or4ar on Fu$y 1. 200%I 5he amount of cash received from the
forward is fi"ed at -1%. 000. but now the forward rat e for December 31
set t$ eme nt has changed to -1. *. 5his im#$ies that we cou$d ent er into
a cont r act to #urchas e the 10. 000 >anadi an do$$ars for -1. *00. 5hus
the va$ue of the forwar d has increas ed by -200 :the change in the
forward rat e;. /imi$ar$y. on the set t$ eme nt dat e. the forward rat e
dro#s to -1. . ?ow the 10. 000 >anadi an do$$ars can be #urchas ed for
-1. 00 and the forward cont r act has increas ed in va$ue by anot her
-00. 5he tot a0 "$a%& e !% )a0 3e o( t$e (or4ar "o%tra"t from the
ince#ti on to the set t$ eme nt dat e can be com#ut ed by ta9ing the
difference bet ween the origina$ forward rat e of -1. %0 and the s#ot
rat e on the set t$ eme nt dat e :-1. ;. !n this e"am#$ e the forwar d
cont r act increas ed in va$ue by -&00 or K:-1. %06 -1. ;:10. 000;L.
?otice that the initia$ #remi um is -0. 10 and that the s#ot rat e
increas ed over the year by -0. 0. 5he difference bet ween thes e two
e3ua$ s the change in the va$ue of the forward cont r act over the
forward contr act :in this case the #remi um re#r es ent s a gain and the
change in the s#ot rat e is a $oss;. /ince the #remi um wi$$ event ua$$y be
(ero on the set t$ eme nt dat e. the change in the #remi um :or discount ;
2)
is 9nown as the ti %e ele%ent of the change in va$ue of the forwar d
cont r act . 5he change in the s#ot rat e is consi der ed the change in the
intrinsic val"e of the forward. 5hus the tot a$ change in va$ue is e3ua$
to the sum of the intrinsic va$ue and the time va$ue :9ee# in mind that
each of thes e changes in va$ue can be #ositive or negati ve;. 5his is
summari (ed be$ow.
=orwar d 4at e >hange in Pa$ue: a;
=or 12B31B 0% 5ota$ !ntrinsic 5ime
Dat e /#ot 4at e /et t$ ement Jremi um Pa$ue Pa$ue Pa$ue
1B1B 200% -1. 0 -1. %0 -0. 10
)B1B 200% -1. 3 -1. * -0. 0% -0. 02 :-0. 03; -0. 0%
12B 31B 200% -1. -1. -0. 00 -0. 0 :-0. 01; -0. 0%
5ota$ change in rat es and #remi um -0. 0& :-0. 0; -0. 10
=oreign currency :>anadi an do$$ars; 10. 000 10. 000 10. 000
5ota$ change in va$ue in do$$ars :a; -&00 :-00; -1. 000
:a; Definitions
5he tot a$ change in the va$ue of the forwar d cont r act H the change
in the forward rat es mu$ti#$ied by the foreign currency.
5he change in the intrinsic va$ue of the forward cont r act H the
change in the s#ot rat e mu$ti#$ied by the foreign currency. and
2*
5he change in the time va$ue of the forward contr act H the change
in the #remi um mu$ti#$ied by the foreign currency.
7$9 o (or4ar rat e s !(( er (ro' spot rat e s 8
=orward rat es for the #urchas e or sa$ e of foreign currency. on some
futur e dat e. can be higher. $ower. or e3ua$ to the current s#ot rat e on
that currency. =or inst ance. if the current s#ot rat e for the e"change
of #esos and do$$ars is -0. +%. the forward rat e to e"change #esos for
do$$ars in one year might be higher or $ower than -0. +% :it is un$i9e$y
to be e3ua$;. 7hy do thes e rat es differI 5he answer to this 3uesti on
invo$ves differences in int er es t rat es bet ween the two count ri es.
/u##os e that the one6 year forward rat e and the current s#ot rat e are
e3ua$ but that in the U/ the cost of borrowing money for one year is
%1 whi$e in 2e"ico the cost of borrowing is 101. 8 U/ com#any cou$d
ta9e -+. %00 and conver t this amount into 10. 000 #esos :at today,s
s#ot rat e; and invest this amount in 2e"ico at 101 for one year. 5his
wou$d accumu$ at e to 11. 000 #esos. 8t the same time. the firm cou$d
buy a forwar d cont r act to se$$ 11. 000 #esos at the forward rat e of
-0. +% for -10. %0. 8ssumi ng invest me nt s in the U/ and 2e"ico had
e3ua$ ris9s and ta" char act eri stics. this wou$d amount to a ris96 free
%1 ret ur n :a 101 ret urn in 2e"ico $ess %1 that cou$d have been
earned in the U/;. !nvest ors wou$d commi t $arge sums of money to
2+
this invest me nt . !n our e"am#$ e. this #rocess wou$d tend to drive u#
U/ int er es t rat es. drive down 2e"ican int er es t rat es. and $ower the
forward rat e. 5he e3ui$ibrium is 9nown as int er e s t rat e pari t y .
5herefor e.
#orwar d rat e H
( )
( )
( ) rate sot
&e'ico
i
(S
i
+
+
1
1
wher e i re#r es ent s the int er es t rat e and the su#er scri #t re#r es ent s the
count r y. 5herefor e. the forward rat e that guar ant e e s int er es t rat e
#arity is -0. +0&*. or
=orward rat e H :1.0%B 1. 10;:-0. +%; H -0. +0&*.
5hen in the e"am#$ e above. the 11. 000 #esos cou$d on$y be conver t ed
into -+. +)% enab$ing the U/ com#any to earn on$y %1 int er es t .
5herefor e. if the inter es t rat e in the foreign count r y is hi gher than the
rat es in the U/. the forward rat e wi$$ be bel ow the current s#ot rat e. !f
the inter es t rat e in the foreign count r y is lower than the rat es in the
U/. the forward rat e wi$$ be abov e the current s#ot rat e.
30
5here are a number of busines s situati ons in which a firm may
desire to ac3uir e a forward e"change cont r act . 5he uses of forward
cont r act s inc$ude the fo$$owing@
1* He& e s
a. For4ar "o%tra"t s 3s e as a $e& e o( a (ore! &% "3rre%"9
tra%s a" t ! o% . 5hese inc$ude im#orti ng and e"#orti ng trans act i ons
denomi nat e d in foreign currency. 5hese hedges do not 3ua$ify for
hedge accounti ng under =8/< 133 becaus e the foreign e"change
gains and $osses are a$ready re#ort ed in earni ngs under =8/< %2.
and the #ayab$ es and receivab$ es are re#ort ed at mar9et va$ue
on the ba$ ance sheet .
b. For4ar "o%tra"t s 3s e as a $e& e o( a% unr ec o g ni z e d
firm commi t me n t :a (a!r- )a0 3e $e& e ;. 8n e"am#$ e of an
unrecogni(ed firm commi t me nt wou$d be when the firm ent er s
into a cont r act to #urchas e an ass et in two mont hs for a fi"ed
amount of foreign currency. /ince the e"change rat e may change
over the ne"t two mont hs. the firm might use a forward cont r act
to hedge the #ot ent i a$ change in va$ue of the #urchas ed asset .
Aedge account i ng ru$es a##$y. <oth the change in va$ue of the
hedge and the va$ue of the hedged item are re#ort ed in earni ngs
:befor e the contr act is re#ort ed on the boo9s;. 5his is i$$ustr at ed
$at er.
31
c. For4ar "o%tra"t 3s e as a $e& e o( a for ei gn curr enc y
deno mi na t e d $for ec a s t e d % trans ac t i o n :a "as $ (0o4 $e& e ;.
8 forecas t ed trans act i on is a situati on wher e the firm has
#$anned sa$ es recei #t s :e"#ect ed to occur in the near futur e;. and
uses the forward contr act as a means to hedge the cash f$ow
ris9. !nitia$$y. foreign e"change gains and $osses are re#ort ed in
com#r ehe nsi ve income whi$e no offset ti ng amount is re#ort ed for
the hedged item. 'vent ua$$ y. the e"change gains and $osses wi$$
be re#ort ed in earni ngs in the #eriod the hedged item affect s
earni ngs :i.e. if the item being hedged is a forecas t ed #urchas e
of invent or y. the gains and $osses on the hedge wi$$ be
rec$ assified into earni ngs when the invent or y is so$d;.
d. For4ar "o%tra"t s as a $e& e o( a net inve s t me n t in
for ei gn oper at i ons .
-* Spe" 30 at ! o%
For4ar "o%tra"t s 3s e to spe" 30 at e "$a%& e s !% (ore! &%
"3rre%"9 .
5he c$assificati ons above are im#ort ant becaus e the account i ng for
a #articu$ ar ty#e of forward contr act de#ends on the #ur#os e for which
it was obt ai ned. 5he difference in account i ng re$at es #ri mari$y to two
3uesti ons.
32
1. Aow is a trans act i on gain or $oss on the forward contr act com#ut ed
and when shou$d the gain or $oss be re#ort edI
2. 7hat va$ue shou$ d be re#ort ed for the forward contr act in the
financi a$ st at e me nt s over the $ife of the contr act I
Aedges of forecas t ed foreign currency trans act i on may inc$ude
some int ercom#a ny trans act i ons. 5he hedgi ng of foreign currency
int ercom#a ny cash f$ows with foreign currency o#tions is not
uncommon. <ecaus e of its be$ief that the accounti ng for a$$ derivati ve
instrume nt s shou$ d be the same. the =8/< broadene d the sco#e of
hedges that are e$igib$e for hedge accounti ng :as s#ecified in FAS)
13* ;. !f an int erco%an! foreign currency derivative is creat ed. it can
on$y be a hedgi ng instrume nt in the consoli#at e# financi a$ st at e me nt s
if the other member ent er s an offset ti ng contr act with an out si de
:unaffi$iat ed; #art y to hedge its e"#osur eM this rest riction a##$ies
becaus e the st andar ds re3uire that some com#onent with foreign
currency e"#osur e must be a #art y to the hedgi ng trans act i on. !n the
st and6 a$one st at e me nt s of the subsi di ary. however. the int ercom#a ny
derivative cou$d be desi gnat ed as a hedge in the absence of third6
#art y invo$veme nt . 5herefor e intercom#a ny derivatives can be
c$assified as either fair va$ue or cash f$ow hedges if they meet the
definition for that #articu$ ar hedge and if the member of the
33
conso$idat ed grou# not "sin$ the interco%an! #erivati ve as a hedge
ent er s into a derivative with an unre$ at ed #art y to offset the origina$
e"#osur e from the intercom#a ny hedge.
USING FOR7ARD CONTRACTS AS A HEDGE
He&e o( a (ore! &% "3rre%" 9 e#pos e 0!a+!0! t 9
>onsider the im#orti ng e"am#$ e used ear$ier in the cha#t er .
!m#orting 5rans acti on with a =orward >ontract Used as a Aedge
1. On December 1. 2003. a U./. firm #urchas ed invent or y for %00. 000
euros #ayab$ e on 2arch 1. 200 :i.e. the trans act i on is denomi nat e d
in euros;.
2. 5he firmC s fisca$ year6 end is December 31.
3. 5he s#ot rat e for euros :-Beuro; and the forward rat es for euros on
2arch 1. 200 at various times is as fo$$ows@
/#ot
4at e
=orward 4at e
:for 3B1B 200 'uros;
5rans acti on dat e 6 December 1.
2003
-1. 0% 1.0%2
<a$ance sheet dat e 6 December
31. 2003
1.0& 1.0%+
/et t$ ement dat e 6 2arch 1. 200 1.0)
3
. On December 1. 2003. the U./. firm ent er ed into a forward contr act
to b"! %00. 000 euros on 2arch 1. 200. for -1. 0%2.
On December 1. 2003. the firm ent er ed into a contr act to #urchas e
invent or y for -%2%. 000 :the s#ot rat e was -1. 0% on that dat e;. !f the
e"change rat e did not change over the #ayme nt #eriod. the firm
wou$d owe -%2%. 000 to set t$ e the #ayab$ e. Aowever. if the e"change
rat e increas ed to -1. 0). the firm wou$d have to #ay -%3%. 000 to set t$ e
the debt :%00. 000 " -1. 0);. On the other hand. if the e"change rat e
dro##ed to -1. 02. the firm wou$d on$y need to #ay -%10. 000. :or
%00. 000 " -1. 02;. <ecaus e the firm cannot #erfect$ y esti mat e the
change in the e"change rat e. the com#any might #refer to e$iminat e
this ris9 by ent eri ng into a forward cont r act to b"! e"ros on 2arch 1.
200. /ince the forward rat e on December 1. 2003 to #urchas e euros
on 2arch 1. 200 is -1. 0%2. the com#any can buy %00. 000 euros on
2arch 1 for a guar ant e e d #rice of -%2&. 000. 5his fi"ed #rice means
that the firm has det er mi ned in advance the ma"i mum amount of $oss
it wi$$ suffer. in this case -1. 000. 5hus the firm is #rot ect ed from futur e
increas es in the e"change rat e above -1. 0%2. <y $oc9ing into a set
#rice. the firm gains if the s#ot rat e on 2arch 1. 200 increas es above
-1. 0%2 and $oses if the s#ot rat e decr eas e s be$ow -1. 0%2. 5he
im#ort ant #oint to not e about the hedge is that the firm 9nows with
3%
cert ai nt y on December 1. 2003. the amount of cash needed to
#urchas e the asset .
5he ent ri es to record the #urchas e and forward e"change
cont r act are@
De" e '+ e r 1, -..3 - Tra%s a" t ! o% Dat e
:1
;
Jurchas es %2%. 00
0
8ccount s Jayab$ e :%00. 000 euros "
-1. 0%;
%2%. 000
5o record #urchas e of goods on
account
using the s#ot rat e on December 1.
2003.
5he account s #ayab$ e for the invent or y #urchas e is recorded using the
s#ot rat e on the trans act i on dat e :on December 1. 2003;
:2
;
=oreign >urrency :=>; 4eceivab$ e from
'"change
Dea$ er %2&. 00
3&
0
Do$$ars Jayab$ e to '"change Dea$ er %2&. 000
:%00. 000 euros " -1. 0%2;
5o record forwar d cont r act to buy
%00. 000 euros using the forward rat e.
8t the dat e of the trans act i on. the U./. firm records the forward
cont r act by recogni(ing a #ayab$ e and a receivab$ e of -%2&. 000 for
the number of do$$ars to be #aid :units of foreign currency to be
#urchas ed mu$ti#$ied by forward rat e; to the e"change dea$ er when
the forward cont r act mat ur es .
)
5he net va$ue of the forward cont r act is
(ero since the #ayab$ e and the receivab$ e are e"act$ y offset. 5he va$ue
of the receivab$ e from the dea$ er and the account s #ayab$ e for the
#urchas e of invent or y are subj ect to changes in e"change rat e. but
the gains and $osses gener a$$ y offset each other to a $arge e"t ent
since the ter ms and the amount s are e3ua$.
On December 31. 2003. the s#ot rat e increas es from -1. 0% to -1. 0&
resu$ting in an increas e of -%. 000 to account s #ayab$ e. 5he s#ot rat e
is used for account s #ayab$ e since that is the amount needed to set t$ e
the $iabi$ity.
De" e '+ e r 31, -..3 - /a0 a%" e S$e e t Dat e
)
!n #ractice. a journa$ entry may not be made to record a forwar d cont r act when the
cont r act was negoti at ed becaus e it re#res e nt s an e"ecut or y contr act . 8$though
argume nt s can be made either for or agai nst recordi ng such cont r act s. in this
cha#t er forwar d cont r act s are recorded becaus e it is easi er to ana$ y(e the
subs e3ue nt adjust me nt s re3uired to re#ort the effect s of a forwar d cont r act on the
firm,s re#ort ed income.
3)
:3
;
5rans acti on Loss %.000
8ccount s Jayab$ e %.000
5o record a $oss on the $iabi$ity denomi nat e d in foreign currency
>urrent va$ue of account s #ayab$ e :%00. 000 euros " -1. 0&; H
-%30. 000
Less@ 4ecorded va$ue of account s #ayab$ e H
-%2%. 000
8djust ment needed to account s #ayab$ e
-%. 000
or K%00. 000 euros " :-1. 0& 6 -1. 0%;L H -%. 000
On the other hand. the va$ue of the forward contr act is det er mi ned
using the change in the forward rat es. 5he forward rat e increas ed to
-1. 0%+ from -1. 0%2. 5his resu$ t s in an increas e of -3. %00 to the
receivab$ e from the e"change dea$ er. 4eca$$ that the #ayab$ e to the
foreign e"change dea$ er is fi"ed by the forwar d cont r act . 5hus the
forward contr act has a #ositive -3. %00 va$ue at this #oint :December
31;.
:
;
=> 4eceivab$ e from '"change Dea$ er 3.%00
5rans acti on Eain 3.%00
3*
5o record a gain on foreign currency to be received from
e"change dea$ er
K:%00. 000 euros " -1. 0%+ H -%2+. %00; 6 -%2&. 000;L.
!f the financi a$ st at e me nt s are #re#ar ed on December 31. 2003. the
va$ue of the forward contr act is as fo$$ows@
=> 4eceivab$ e from '"change Dea$ er -%2+. %00
Do$$ars Jayab$ e to '"change Dea$ er %2&. 000
?et 4eceivab$ e from '"change Dea$ er -3. %00
5his net va$ue wou$d be re#ort ed on the ba$ance sheet . !n addition.
account s #ayab$ e wou$d be recorded at the s#ot rat e. or -%30. 000.
5he income st at e me nt wou$d re#ort an e"change $oss of -%. 000 and
an e"change gain of -3. %00.
?ote that even though the forward contr act and the account s
#ayab$ e cover simi$ar ter ms :December 1 to 2arch 1; and amount s
:%00. 000 euros;. the amount of the trans act i on $oss on the #ayab$ e
does not e3ua$ the trans act i on gain on the => receivab$ e. 5hey are not
e3ua$ becaus e account s #ayab$ e is va$ued using changes in the s#ot
rat e whi$e the va$ue of the forward cont r act is det er mi ned using
changes in the forward rat es. On the set t$ eme nt dat e. the forward rat e
and the s#ot rat e become e3ua$. 5hus the tot a$ trans act i on gain or
3+
$oss on the contr act wi$$ event ua$$y e3ua$ the guar ant e e d gain or $oss
det er mi ned on the dat e the forward cont r act is ac3uir ed.
On 2arch 1. 200. the s#ot rat e increas es to -1. 0) from -1. 0&
resu$ting in an increas e in account s #ayab$ e of -%. 000. ::-1. 0)6 -1. 0&;
" %00. 000;. /ince on the set t$ eme nt dat e. the forward rat e on this
dat e and the s#ot rat e are identica$. the change in the 2arch 1
forward rat e on December 31 to the s#ot rat e on 2arch 1. 2003 is
-.011. or :-1. 0%+ to -1. 0);. 5his resu$ t s in an increas e to the =>
receivab$ e of -%. %00. or ::-1. 0)6 -1. 0%+; " %00. 000;. 5he journa$
ent ri es to record thes e event s are as fo$$ows@
Mar"$ 1, -..1 - Set t0 e 'e % t Dat e
:%
;
5rans acti on Loss %.000
8ccount s Jayab$ e %.00
0
5o record a $oss from 12B 31B 03 to 3B1B0 on $iabi$ity
denomi nat e d in foreign currency. 5he current va$ue of the
#ayab$ e -%3%. 000. :%00. 000 euros " -1. 0); $ess the recorded
va$ue of the #ayab$ e on December 31 of -%30. 000 is -%. 000.
or K:%00. 000 euros " -1. 0) H -%3%. 000; 6 -%30. 000;L.
:&; => 4eceivab$ e from '"change Dea$ er %.%00
5rans acti on gain %.%00
0
5o record a gain from 12B31B 03 to 3B1B 0 on foreign
currency to be received from e"change dea$ er :5he change in
the 12B31 forward rat e to
the s#ot rat e on 2arch 1. 200 times %00. 000 euros. or
K:%00. 000 euros " -1. 0) H -%3%. 000; 6 -%2+. %00;L. ;.
5he recorded ba$ances in bot h account s #ayab$ e and the => receivab$ e
are -%3%. 000 ref$ecti ng the s#ot rat e on 2arch 1. 2003. 5he do$$ars
#ayab$ e to the dea$ er remai ns fi"ed at -%2&. 000 the origina$
cont r act ed amount . 'ntry :); records the cash #ayment of -%2&. 000
and the reducti on of the => #ayab$ e. 8$so. the receivab$ e is conver t ed
to the !nvest me nt in => re#r es ent i ng the %00. 000 euros ac3uired in
the forward cont r act . !n ent ry :*;. the euros are used to set t$ e the
account s #ayab$ e.
:); Do$$ars Jayab$ e to '"change Dea$ er %2&. 000
!nvest me nt in => :%00. 000 euros; %3%. 000
=> 4eceivab$ e from '"change Dea$ er %3%. 000
>ash %2&. 000
5o record #ayment to e"change dea$ er and recei #t of
%00. 000 euros :%00. 000 euros " -1. 0) H -%3%. 000;.
:*; 8ccount s Jayab$ e %3%. 000
!nvest me nt in => %3%. 000
5o record #ayme nt of $iabi$ity u#on transf er of %00. 000 euros.
<y obt ai ni ng the forward contr act . the firm was ab$ e to est ab$ish at
the trans act i on dat e the amount of do$$ars :-%2&. 000; that it wou$d
ta9e to ac3uire the %00. 000 euros needed to set t$ e the account with
1
the foreign firm. ?ote. however. that the cost of the invent or y of
-%2%. 000 was est ab$ished on December 1 Kent ry :1;L. !f the forward
cont r act had not been obt ai ned. the firm wou$d have had to #ay
-%3%. 000 to set t$ e the account and wou$d have re#ort ed a net $oss of
-10. 000 on the e"#os ed $iabi$ity #osition. 5he net gain from ent eri ng
into the forwar d cont r act . however. $arge$ y cance$ ed out the net $oss
on the e"#os ed $iabi$ity #osition.
5hese trans act i ons can be summari (ed in the fo$$owing tab$ e.
2
5rans act i on 5rans act i on
Aedged !tem <a$ance EainB:$oss; Aedge <a$ance EainB:$oss;
A""o3%t s =a9a+0 e FC Re"e! )a+0 e
12B 1B 2003 - %2%. 000 12B 1B 2003 - %2&. 000
12B 31B 2003 %30. 000 :%.000; 12B 31B 2003 %2+. %00 3.%00
3B1B 2003 %3%. 000 :%.000; 3B1B 2003 %3%. 000 %.%00
5ota$ gainB:$oss; :10. 000; +.000
5hus the net effect is a -1. 000 $oss when the forward contr act is
used.
He&e o( a (ore! &% "3rre%" 9 e#pos e as s e t
!n the e"am#$ e above. the U./. firm ent er ed into a forward
#urchas e cont r act to hedge an e"#os ed $iabi$ity #osition at a time
when the forward rat e was at a #remi um. 8ccounti ng for a forward
cont r act ent er ed into as a hedge of an e"#os ed receivab$ e #osition is
based on simi$ar ana$ysi s. Aowever. becaus e the U./. firm wi$$ be
receiving foreign currency in set t$ eme nt of the e"#os ed receivab$ e
ba$ance. it wou$d ent er into a forwar d cont r act to sell foreign currency
for U./. do$$ars. !n this case. the receivab$ e from the dea$ er is
denomi nat e d in a fi"ed number of do$$ars. the amount of which is
3
based on the contr act ed forward rat e. wher eas the ob$igati on to the
dea$ er is denomi nat e d in a foreign currency. which is trans$ at ed into
do$$ars using the current s#ot rat e.
Fa!r Va0 3e He&e - He&! %& a% U%re"o& %! > e Fore! &% C3rre%"9
Co''! t 'e %t
!n the #recedi ng discussi on of the im#orting and e"#orti ng of
goods. the #urchas e or sa$e of an ass et was recorded on the
trans act i on dat e. 5his dat e is consider ed the #oint at which tit$e to the
goods is transf err ed. which is consist ent with the recordi ng of a
trans act i on with anot her domes t i c com#any. Aowever. if the U./. firm
at a dat e ear$ier than the trans act i on dat e made a commi t me nt to a
foreign com#any to se$$ goods or buy goods. and the #rice was
est ab$ished in foreign currency at the commi t me nt dat e. changes in
the e"change rat e bet ween the commi t me nt dat e and trans act i on
dat e wou$d be ref$ect ed in the cost or sa$ es #rice of the ass et . =or
e"am#$ e. assume that a U./. firm made an agr ee me nt on Fune 1 to
buy goods from a =rench com#any for %00. 000 francs. 8t this dat e.
the s#ot rat e was -.20. but on the trans act i on dat e. when tit$e to the
goods transf err ed and a journa$ ent ry was recorded. the s#ot rat e was
-.22. 5he ent ry to record the #urchas e is

Jurchas es :%00. 000 francs " -.22; 110. 000

8ccount s Jayab$ e 110. 000
5hus. the change in the e"change rat e that occurr ed bet ween the
commi t me nt and the trans act i on dat e becomes a #art of the cost of
invent or y. rat her than being re#ort ed as a se#ar at e gain or $oss item.
5he com#any. however. may sti$$ ac3uir e a forward cont r act to hedge
agai nst the unfavor ab$ e change in the fair va$ue of the asset that may
occur aft er the commi t me nt dat e.
8 forward contr act is consider ed a hedge of an identifiab$ e foreign
currency commi t me nt if the forwar d cont r act is designat e d as. and is
effective as. a hedge of a foreign currency commi t me nt . 5he foreign
currency commi t me nt must s#ecify a$$ significant ter ms :such as
3uanti t y and #rice; and #erfor mance must be #robab$ e. A &a! % or
0os s o% a (or4ar "o%tra"t as 4e00 as t$e o(( s e t t ! %& &a! % or 0os s
o% t$e $e& e !te' are re"o&%! > e "3rre%t 0 9 !% ear%! %& s * 5he
gain or $oss :the change in the fair va$ue of the forward contr act ; is an
adjust me nt of the carryi ng va$ue of the forward cont r act . /imi$ar$y. the
change in va$ue of the firm commi t me nt is recorded as such on the
ba$ance sheet :even though the commi t me nt has not yet been
recorded;. 5he meas ur e me nt of hedge effectivenes s is beyond the
sco#e of this cha#t er . but since the forwar d cont r act s are for simi$ar
ter ms and amount s. they are assume d to be high$y effective.
%
Fa!r Va0 3e He&e I003strat ! o% @ 5o i$$ustr at e the account i ng for a
forward contr act ac3uired to hedge an identifiab$ e foreign currency
commi t me nt :a fair6 va$ue hedge;. the fo$$owing fact s are assume d@
=air Pa$ue Aedge '"am#$ e
1. On 2arch 1. 2003. a U./. firm cont r act s to se$$ e3ui #me nt to a
foreign cust omer for 200. 000 Eerman mar9s. 5he e3ui #me nt is
e"#ect ed to cost -&0. 000 to manuf act ur e and is to be de$iver ed
and the account is to be set t$ ed one year $at er on 2arch 1. 200.
5hus the trans act i on dat e and the set t$ eme nt dat e are bot h 2arch
1. 200.
2. On 2arch 1. 2003. the U./. firm ent er s into a forward cont r act to
se$$ 200. 000 Eerman mar9s in 12 mont hs at the forward rat e of
-.3+.
3. /#ot rat es and the forward rat es for Eerman mar9s on se$ ect ed
dat es are
/#ot 3B1B 200

'"chan
ge
=orwar
d
QQQQQQDat eQQQQQQ 4at e 4at e
2arch 1. 2003 -.0 -.3+0
&
December 31. 2003 .3+% -.3*%
2arch 1. 200 .3*
5he journa$ entry to record the forward cont r act on 2arch 1. 2003 is@
Mar"$ 1, -..3
:1
;
Do$$ars 4eceivab$ e from '"change Dea$ er
:200. 000 mar9s " -.3+; )*. 000
=> Jayab$ e to '"change Dea$ er )*. 000
5o record the forward cont r act to se$$ 200. 000 Eerman
mar9s.
?ine mont hs $at er. on the ba$ ance sheet dat e :12B31B 03;. the =>
#ayab$ e needs to be adj ust ed to fair va$ue using the chan$e in the
forwar# rates . 8$so. since this is a fair6 va$ue hedge. the change in the
fair va$ue of the hedged item must a$so be recorded. 5his is com#ut ed
using the change in the forward rat e. 5hese entri es are as fo$$ows@
De" e '+ e r 31, -..3
:2
;
=> Jayab$ e to '"change Dea$ er 1.000
'"change gain 1.000
5o record gain on foreign currency to be de$iver ed to
e"change dea$ er using the change in forward rat es
:200. 000 mar9s " :-.3+6 -.3*%;;.
:3 '"change $oss 1.000
)
;
=irm commi t me nt 1.000
5o record $oss on firm commi t me nt using the change
using the change in the forward rat e
:200. 000 mar9s " :-.3+6 -.3*%;;.
?ote that the firm commi t me nt has not been recorded on the boo9s as
of December 31. 2003. On the December 31. 2003 ba$ ance sheet . the
va$ue of the forward contr act is as fo$$ows@
Do$$ars 4eceivab$ e from '"change Dea$ er :fi"ed; -)*. 000
=> Jayab$ e to '"change Dea$ er )). 000
?et 4eceivab$ e -1. 000
On the <a$ance /heet . the firm commi t me nt wou$d be re#ort ed as a
-1. 000 $iabi$ity. On the !ncome /tat eme nt . the e"change gain of
-1. 000 is re#ort ed. as we$$ as an e"change $oss of -1. 000.
On 2arch 1. 200 :the trans act i on dat e and the set t$ eme nt dat e;. the
journa$ entri es are@
Mar"$ 1, -..1
:
;
=> Jayab$ e to '"change Dea$ er 1.000
'"change gain 1.000
5o record gain on forward cont r act from 12B 31B 03 to
*
3B1B 0
:200. 000 mar9s " :-.3*%6 -.3*;; H -1. 000.
:%
;
'"change $oss 1.000
=irm commi t me nt 1.000
5o record gain on forward cont r act from 12B 31B 03 to
3B1B 0
:200. 000 mar9s " :-.3+6 -.3*%;; H -1. 000
'ntries :; and :%; adj ust the va$ues of the => #ayab$ e and the change
in the fair va$ue of the firm commi t me nt . ?ot e that since the
trans act i on dat e occurs on the set t$ eme nt dat e. the change in va$ue is
com#ut ed as the change in the forward rat e on 12B31B 2003 to the s#ot
rat e on 2arch 1. 200 :i.e. .3*% to .3*;.
:&
;
!nvest me nt in => )&. 000
=irm commi t me nt 2.000
/a$es :200. 000 mar9s " -.3+; )*. 000
5o record sa$ e of e3ui #me nt to foreign
cust omer .
:)
;
>ost of Eoods /o$d &0. 000
!nvent or y &0. 000
5o record cost of e3ui #me nt so$d.
:*
;
>ash :200. 000 " -.3+; )*. 000
=> Jayab$ e to '"change Dea$ er :200. 000 " )&. 000
+
-.3*;
!nvest me nt in => )&. 000
Do$$ars 4eceivab$ e from '"change Dea$ er )*. 000
5o record set t$ eme nt of forwar d
cont r act .
<ecaus e of the forwar d cont r act . the amount of sa$es recorded in
ent ry :&; is e3ua$ to the forward rat e on the forward cont r act
mu$ti#$ied by 200. 000 mar9s. or -)*. 000 :i.e. 200. 000 " -.3+;. 5he
firm commi t me nt account is e$iminat ed on this dat e. !n ent ry :*;. the
firm se$$s 200. 000 Eerman mar9s for -)*. 000.
5he effect of thes e trans act i ons on the firmC s #rofit abi$ity is as
fo$$ows@
/a$es :-)&. 000 R
-2. 000;
-)*. 00
0
>ost of goods so$d
&0. 000
Eross #rofit -1*. 00
0
5he number of do$$ars to be received was $oc9ed in by the forward
cont r act at -)*. 000 and the e3ui#ment was e"#ect ed to cost -&0. 000.
5hus. the forwar d cont r act #er mi t t ed the U./. firm to $oc9 in an
e"#ect ed #rofit of -1*. 000 on the sa$es cont r act . !f the forwar d
cont r act had not been obt ai ned. the #rofit earned on the cont r act
%0
wou$d de#end on the e"change rat e in effect when #ayme nt was
received from the Eerman cust omer . 7ithout the hedge. the amount
of sa$ es recorded wou$d have been -)&. 000 :200. 000 mar9s " -.3*;
and the gross #rofit wou$d have been -1&. 000. 8nd if the e"change
rat e had dro##ed be$ow -.3*. the amount of sa$es recorded wou$d
have been even be $owerM for e"am#$ e at an e"change rat e of -.30.
the amount of sa$ es recorded wou$d have e3ua$ ed the amount of cost
of goods so$d. thus e$iminati ng any gross #rofit on the contr act .
D!s"o3%t ! %& t$e Fa!r Va0 3e o( t$e For4ar Co%tra"t
8s st at ed ear$ier. the change in the forward contr act was com#ut ed
using the change in the forward rat e. 8ccording to SFAS 133 . thes e
amount s shou$ d be discount ed to a #res ent va$ue basis. =or e"am#$ e.
in ent ry :2;. the e"change gain on the => Jayab$ e was com#ut ed to be
-1. 000 by ta9ing the change in the forward rat es and mu$ti#$ying by
the amount of foreign currency in the forward contr act :200. 000
mar9s " :-.3+6 -.3*%;;. !f this amount were discount ed using an
int er es t rat e of 121 for two mont hs :unti$ the set t$ eme nt dat e;. the
-1. 000 wou$d be recorded on the boo9s at -1. 000 $ess -20. or -+*0.
/imi$ar$y. the firm commi t me nt in entry :3; wou$d be recorded on the
boo9s at its discount ed amount of -+*0. 5hese ent ri es are re#eat ed
as entri es :3a; and :a;.
%1
:2a
;
=> Jayab$ e to '"change Dea$ er +*0
'"change gain +*0
5o record gain on forward cont r act from 12B 31B 03 to
3B1B 0
:200. 000 mar9s " :-.3*%6 -.3*;; H -1. 000
Less@ :-1. 000;: 2B 12;:121; H 20
5ota$ Discount ed Eain - +*0
:3a
;
'"change $oss +*0
=irm commi t me nt +*0
5o record gain on forward cont r act from 12B 31B 03 to
3B1B 0
:200. 000 mar9s " :-.3+6 -.3*%;; $ess -20 H -+*0
5hen on 2arch 1. 200. the tot a$ gain over the $ife of the forward
cont r act is -2. 000 :or 200. 000 " :-.3+6 -.3*;;. <ut since -+*0 was
a$ready recogni(ed. ent ry :3; wou$d be for -1. 020 rat her than sim#$y
the change since December 31.
:a
;
=> Jayab$ e to '"change Dea$ er 1.020
'"change gain 1.020
5o record gain on forward cont r act from 12B 31B 03 to
3B1B 0
#$us the discount a$ready recogni(ed :-20;
%2
:200. 000 mar9s " :-.3*%6 -.3*;; H -1. 000R-20 H -1. 020
:%b
;
'"change $oss 1.020
=irm commi t me nt 1.020
5o record gain on forward cont r act from 12B 31B 03 to
3B1B 0
#$us the discount a$ready recogni(ed :-20;
:200. 000 mar9s " :-.3+6 -.3*%;; H -1. 000 R 20 H -1. 020
!n the remai nder of this cha#t er. we ignor e the com#$icati on of
discounti ng to sim#$ify the a$ready com#$ e" account i ng for derivatives.
7e not e a$so that . in many cases. the im#act of discounti ng is not
mat eri a$.
Cas$ F0o4 He&e - He&e o( a (ore"a s t e tra%s a" t ! o%
=irms may a$so be concer ned about futur e trans act i ons that have
not yet occurr ed or for which ther e are no firm commi t me nt s . =or
inst ance. on Fanuar y 2&. 2003. Lands, 'nd re#ort ed carrying -))
mi$$ion of forward cont r act s and -1& mi$$ion of o#tions on the <a$ance
/heet . Lands, 'nd antici#at ed se$$ing #roduct s to subsi di ari es in the
United Singdom. Fa#an. and Eermany over the ne"t year and #$anned
to #urchas e various invent or y items from 'uro#ean su##$iers. 'ven
though they might not have any firm cont r act s. Lands, 'nd may
decide becaus e of the high #robabi$ity of occurr ence of thes e
trans act i ons to use derivati ves to hedge this foreign currency
%3
e"change ris9. 5hese ty#es of hedges are 9nown as hedges of
forecas t ed trans act i ons.
Un$i9e the treat me nt of fair va$ue hedges . the =8/< a$$ows deferr a$
of the income st at e me nt recogni tion of the gains and $osses on
forecas t ed trans act i ons if cert ai n crit eri a are met . Li9e other gains
and $osses that are e"c$uded from the income st at e me nt . they must
be inc$uded as com#onent s of other com#r ehensi ve income and
re#ort ed in the stoc9ho$ der s, e3ui t y section of the ba$ ance sheet . 5he
criteri a for this treat me nt inc$ude@
5he forecas t ed trans act i on is s#ecifica$$y identifiab$ e at the
time of the designat i on as a sing$ e trans act i on or a grou# of
individua$ trans act i ons.
5he forecas t ed trans act i on is #robab$ e and it #res ent s
e"#osur e to #rice changes that are e"#ect ed to affect earni ngs
and caus e vari abi$ity in cash f$ows.
5he forecas t ed trans act i on invo$ves an e"change with an
out side :unre$ at ed; #art y. :8n e"ce#ti on is a$$owed for inter6
com#any foreign e"change trans act i ons. /ee the #revious
discussi on in this cha#t er . ;
5he forecas t ed trans act i on does not invo$ve a busines s
combi nat i on.
8mount s in accumu$ at ed other com#r ehe nsi ve income are rec$ assified
into earni ngs in the same #eriod or #eriods during which the hedged
%
forecas t ed trans act i on affect s earni ngs. =or e"am#$ e. if the forecas t ed
hedged item is invent or y. the rec$ assification from accumu$ at ed other
com#r ehe nsi ve income into earni ngs occurs when the invent or y is
so$d. !f the forecas t ed hedged item is the #urchas e of a fi"ed ass et .
the rec$ assification occurs when the e3ui #me nt is de#r eci at ed.
In the News:
5he !nternat i ona$ 8ccounti ng /tandar ds <oard issued IAS No. 3+ @
=inanci a$ !nstrument s @ 4ecogni tion and 2easur e me nt in December
1++*. with some revision in October 2000. 7hi$e the !8/ <oard a$$ows
bot h fair va$ue and cash f$ow hedges . the #rimar y difference bet ween
IAS No. 3+ and SFAS 133 is the treat me nt of unrecogni(ed firm
commi t me nt s . Under SFAS 133 . thes e hedges are consider ed fair
va$ue hedges whi$e under IAS No. 3+ . unrecogni(ed firm commi t me nt s
are treat ed as cash f$ow hedges.
7e ne"t #res ent an i$$ustrati on of the account i ng for a forecas t ed
trans act i on meet i ng the criteri a identified by the =8/< for deferr a$ of
the gains or $osses into com#r ehensi ve income.
%%
&ash #low 'edg e Illus t r a t i on! #orwar d &ont r ac t s . 5o i$$ustrat e
the hedge of a forecasted foreign currency transaction with the use of an o#tion. assume
the fo$$owing@
1. On December 1. 2003. a U./. firm estimates that at $east %.000 units of inventory wi$$
be #urchased from a com#any in the United Singdom during Fanuary of 200 for
%00.000 euros. 5he transaction is #robab$e and the trans act i on is to be
denomi nat e d in euros. /a$es of the invent or y are e"#ect ed to occur
in the si" mont hs fo$$owing the #urchas e.
2. 5he com#any ent er s into a forward cont r act to #urchas e %00. 000
euros on Fanuar y 31. 200. for -1. 01.
3. /#ot rates and the forward rates at Fanuary 31. 200. sett$ement were as fo$$ows
:do$$ars #er euro;@
=orward 4ate
/#ot 4ate =or 1B31B0
December 1. 2003 -1.03 -1.01
<a$ance sheet dat e :12B 31B 03; -1. 00 -0. ++
Fanuary 31. 200 -0. +*
<y using the forward contract. the firm is assured of #aying -%0%.000 regard$ess of
changes in the e"change rate. !f the e"change rate were to dro# be$ow -1.01 the firm
%&
wou$d $ose. but if the e"change rate were to e"ceed -1.01. the firm wou$d be better off
using the forward contract.
5he ent ry on December 1. 2003 to record the forward e"change
cont r act to #urchas e %00. 000 euros on Fanuary 31. 200. for -1. 01 is@
De"e'+er 1, -..3
:1
;
=> 4eceivab$ e from '"change Dea$ er
:%00. 000 euros " -1. 01; %0%. 00
0
Do$$ars Jayab$ e to '"change Dea$ er %0%. 000
One month $ater on the ba$ance sheet date :December 31. 2003;. the change in the
va$ue of the forward contract is -10.000. :%00.000 " :-1.016-0.++;;. 5herefore. on
December 31. 2003. the fo$$owing entry is made@
De"e'+er 31, -..3 - /a0a%"e S$eet Date
:2
;
=oreign e"change $oss T Other
>om#r ehensi ve
!ncome :<a$ance /heet ;
10. 000
=> 4eceivab$ e to '"change Dea$ er 10. 000
5o record a gain on the change in forward contr act :%00. 000 "
:-1. 016 -0. ++;;
%)
?otice that un$i9e the fair va$ue hedge. ther e is no offset ti ng firm
commi t me nt entry since this is a forecas t ed trans act i on. 5he
e"change gain or $oss is re#ort ed in com#r ehensi ve income and wi$$
affect the income st at e me nt when the invent or y is event ua$$y so$d. On
the <a$ance /heet . the forwar d cont r act is re#ort ed as a $iabi$ity at its
fair va$ue of -10. 000. and the offset ti ng amount is re#ort ed in
stoc9ho$ der s, e3uit y in accumu$ at ed other com#r ehe nsi ve income :as
a $oss;.
?a%3ar9 31, -..1 @ tra%sa"t!o% a% sett0e'e%t ate
:3; =oreign e"change $oss T Other
>om#r ehensi ve
!ncome :<a$ance /heet ;
%.000
=> 4eceivab$ e to '"change Dea$ er %.000
5o adjust the forward contr act to its mar9et va$ue of
-20. 000.
5he change in va$ue of the forward cont r act K:-.++ 12B 31 s#ot
rat e $ess -0. +* Fanuary 31. 200 s#ot rat e; " %00. 000 eurosL is
-%. 000.
?ote that the ba$ ance in the => 4eceivab$ e account is -+0. 000 aft er
ent ry :3;. 5he ent ry to record the set t$ eme nt of the forward contr act is
as fo$$ows@
%*
:; !nvest me nt in => :%00. 000 euros; +0. 000
Do$$ars Jayab$ e to '"change Dea$ er %0%. 000
=> 4eceivab$ e from '"change Dea$ er +0. 000
>ash %0%. 000
5o set t$ e with the trader.
?ow su##os e that the forecas t ed trans act i on occurs and the %.000
units of invent or y are #urchas ed on Fanuary 31. 200 for %00. 000
euros. 5he journa$ ent ry to record the #urchas e is@
:%; !nvent or y :at the 12B31B 0 s#ot rat e; +0. 000
!nvest me nt in => :%00. 000 euros; +0. 000
/u##os e that in =ebruar y. the invent or y is so$d for -&00. 000. 5he
ent ri es to record the sa$e and to rec$ assify the amount s from Other
>om#r ehensi ve !ncome :a -1%. 000 $oss. inc$uding -10. 000 $oss at
December 31. 2003 #$us the -%. 000 addi tiona$ $oss at Fanuary 31.
200; into earni ngs are as fo$$ows@
Fe+r3ar9 -..1 @ I%)e%tor9 Sa0es ate
:&; >ash &00. 000
>ost of goods so$d +0. 000
/a$es &00. 000
!nvent or y +0. 000
:); >ost of goods so$d :!ncome /tat e me nt ; 1%. 000
=oreign e"change $oss T Other
>om#r ehensi ve
1%. 000
%+
!ncome :<a$ance /heet ;
5o rec$assify the amount s from accumu$ at ed other
com#r ehe nsi ve income into earni ngs :cost of goods so$d;.
!n entry :);. the amount s recorded in accumu$ at ed other
com#r ehe nsi ve income is rec$ assified into earni ngs. 5he =8/< does not
s#ecify wher e on the income st at e me nt this amount shou$ d be
re#ort ed. 2any com#ani es inc$ude this gain or $oss as #art of cost of
goods so$d. as shown above.
E"o%o'! " He&e o( a Net I%)es t 'e % t !% a Fore! &% E%t! t9
8 U./. firm that mai nt ai ns an e3ui t y invest me nt in a foreign
com#any may ent er into a foreign currency trans act i on or a
nonderi vati ve financi a$ instrument in an effort to mini mi(e or offset
the effect s of currency f$uct uat i ons on the net invest me nt . 8 foreign
currency trans act i on is consider ed a hedge of a net invest me nt in a
foreign entit y if the forward contr act is designat e d as. and is effective
as. a hedge of the net invest me nt . 5he gain or $oss on the hedgi ng
instrume nt is re#ort ed in the same manner as the trans$ ati on
adjust me nt :under SFAS no. 52 ;.
=or e"am#$ e. assume that a U./. firm ho$ds an invest me nt in the
net ass et s of a =rench com#any that conduct s its busines s #ri mari$y in
francs and account s for the invest me nt using the current rat e met hod.
&0
8s wi$$ be shown in >ha#t er 1. the invest or com#any a##$ying the
e3uit y met hod to a $ess than %01 owned invest e e wi$$ record its shar e
of the effect of a change in the e"change rat e on the net asset s of the
foreign invest e e. 5o hedge agai nst the e"#osur e to e"change rat e
changes . the U./. firm may ent er into an agree me nt to borrow francs
from a =rench ban9. 8ssume further that the $oan is designat e d as.
and is effective as. a hedge of the net invest me nt in the =rench
com#any. On subs e3ue nt ba$ ance sheet dat es. bot h the net asset s of
the foreign com#any and the $oan denomi nat e d in francs are adj ust ed
to ref$ect the current e"change rat e. 8 gain :$oss; from the adjust me nt
of the $iabi$ity wi$$ offset a $oss :gain; from the adj ust ment of the net
invest me nt in the foreign com#any. and a hedge resu$ t s. <oth
adjust me nt s are re#ort ed as a com#onent of stoc9ho$ der sC e3uit y
:accumu$ at ed other com#r ehe nsi ve income; rat her than re#ort ed
current$ y in income. Aowever. if the adj ust me nt to the $oan ba$ance
e"ceeds the adjust me nt of the ba$ance of the net invest me nt . the
e"ces s is re#ort ed in the det er mi nat i on of net income as a trans act i on
gain or $oss. 5he gains or $osses accumu$ at e d in a se#ar at e com#onent
of stoc9ho$ der sC e3uit y remai n ther e unti$ #art or a$$ of the invest me nt
in the foreign com#any is so$d.
For4ar Co%tra"t s A"A3!re to Spe" 30 at e !% t$e Mo)e 'e %t o(
Fore! &% C3rre%"! e s
&1
8 forward contr act may be ac3uired for s#ecu$ ati ve #ur#os es in
antici#ati on of rea$i(ing a gain. =or e"am#$ e. assume that on
December 1. 2003. the s#ot rat e for the <ritish #ound is -2. 3% and
that the +06 day futures rat e is -2. 3&. =urther assume that a com#any
e"#ecti ng the e"change rat e to increas e to. say. -2. 3. ent er s into a
cont r act on December 1 to ac3uire U100. 000 on 2arch 1. 200. :8
forward contr act to se$$ foreign currency wou$d be negoti at ed if the
firm e"#ect ed the futur e s#ot rat e to be $ower than the forward rat e. ;
5he firmC s fisca$ year ends on December 31. and on that dat e the
futur es rat e for #ounds to be #urchas e d on 2arch 1. 200 is -2. 3).
5he s#ot rat e is -2. 2 on 2arch 1. 200. 5he journa$ ent ri es to record
the trans act i ons are@
De" e '+ e r 1, -..3
:1
;
=> 4eceivab$ e from the '"change
Dea$ er
23&. 000
Do$$ars Jayab$ e to '"change Dea$ er 23&. 000
5o record the forward cont r act :U100. 000 " -2. 3&;.
5his ent ry recogni(es that the U./. firm has contr act ed to buy
U100. 000 in +0 days when the #ayment of -23&. 000 is made to the
e"change dea$ er. <oth the debit and credit re$at ed to a forward
cont r act are meas ur ed by mu$ti#$ying the U100. 000 by the forwar d
&2
rat e of -2. 3&. 5he =8/< reasoned that the forward rat e shou$ d be used
becaus e a firm s#ecu$ ati ng in foreign currency changes is e"#os ed to
the ris9 of moveme nt s in the forward rat e. /ince bot h account s are
based on the forward rat e. ther e is no se#ar at e account i ng for any
discount or #remi um on the forward contr act .
De" e '+ e r 31, -..3
:2
;
=> 4eceivab$ e from '"change Dea$ er 1.00
0
5rans acti on Eain 1.00
0
5o record gain on foreign currency to be received from
e"change
dea$ er :U100. 000 " -2. 3) H -23). 000 6 -23&. 000; or KU100. 000
"
:-2. 3) 6 -2. 3&;L.
5he foreign currency receivab$ e is adj ust ed at the financi a$
st at e me nt dat e since it is denomi nat ed in foreign currency units. 5he
amount of the adjust me nt is com#ut ed by mu$ti#$ying the units of
foreign currency to be received by the difference bet ween the forwar d
rat e avai$ab$ e for the remai ni ng $ife of the forwar d cont r act and the
rat e $ast used to va$ue the cont r act . 5he trans act i on gain :or $oss; is
re#ort ed current$ y in income.
&3
Mar"$ 1, -..1
:3
;
=> 4eceivab$ e from '"change Dea$ er %.000
5rans acti on Eain %.000
5o record gain on foreign currency to be received from
e"change dea$ er :U100. 000 " -2. 2 H -22. 000 6 -23). 000;.
:
;
Do$$ars Jayab$ e to '"change Dea$ er 23&. 000
!nvest me nt in => 22. 000
>ash 23&. 000
=> 4eceivab$ e from '"change Dea$ er 22. 000
5o record #ayment to e"change dea$ er and recei #t of
foreign currency.
:%
;
>ash 22. 000
!nvest me nt in => 22. 000
5o record conver si on of #ounds
into cash.
On 2arch 1. the firm records any gain or $oss as a resu$ t of changes
in the e"change rat e from the $ast va$uati on dat e to the dat e of the
trans act i on. U#on #ayment of -23&. 000 to the e"change dea$ er. the
firm wi$$ receive U100. 000. which can be conver t ed into -22. 000. 5he
tot a$ gain of -&. 000 recogni(ed over the $ife of the cont r act is the
difference bet ween the va$ue of the foreign currency received
&
:-22. 000; when the forwar d cont r act was e"ercised and the amount
#aid :-23&. 000; to the e"change dea$ er.
!f the firm had ent er ed into a forward cont r act to se$$ foreign currency.
the accounti ng wou$d be simi$ar to that above. e"ce#t the debit in
ent ry :1; is for a fi"ed amount of do$$ars to be receivedM the credit
records the ob$igation to buy foreign currency units for de$ivery to the
e"change dea$ er. 5he esti mat ed cost of units to be de$iver ed wi$$ vary
as the e"change rat e f$uct uat es .
D!s"0 os 3r e ReA3!re 'e %t s o( t$e Var! o3s He& e s
SFAS No. 133 s#ecifies cert ai n mini ma$ disc$osur es for derivative
instrume nt s and nonderi vati ve instrume nt s designat e d as 3ua$ifying
hedgi ng instrument s . 5he disc$osur es inc$ude@ the obj ectives of the
instrume nt s . the strat egi es for achi evi ng thos e obj ectives. the cont e"t
needed for under st andi ng them. and the ris9 manage me nt #o$icy. !n
addition. a descri #tion of trans act i ons or items that are hedged must
be disc$osed for each cat egor y.
8$so the fo$$owing s#ecific disc$osur es are re3uir ed@
1. Fa!r )a0 3e $e& e s :such as hedges of the foreign currency
e"#osur e of unrecogni(ed firm commi t me nt s ;
a. 8 descri #tion of wher e the amount of the gain or $oss is
re#ort ed on the income st at e me nt .
&%
b. 5he amount of the gain or $oss recogni(ed in earni ngs when
the hedged item no $onger 3ua$ifies as a fair va$ue hedge.
2. Cas$ (0o4 $e& e s :inc$udes forecas t ed trans act i ons;
a. 8 descri #tion of wher e the amount of the gain or $oss is
re#ort ed on the income st at e me nt .
b. 8 descri#tion of the trans act i ons or other event s that wi$$
resu$t in the rec$assification into earni ngs of gains and $osses
that are re#ort ed in accumu$ at ed other com#r ehe nsi ve
income. and the esti mat i on of the net amount of the e"isting
gains or $osses at the re#orti ng dat e e"#ect ed to be
rec$ assified into earni ngs within the ne"t 12 mont hs.
c. 5he ma"i mum $engt h of time over which the firm is hedgi ng
its e"#os ur e to the vari abi$ity in future cash f$ows for
forecas t ed trans act i ons.
d. 5he amount of the gain or $oss rec$ assified into earni ngs as a
resu$t of the disconti nuance of cash f$ow hedges becaus e it is
#robab$ y that the trans act i on wi$$ not occur.
3. He& e s o( t$e %et !%)e s t 'e % t in a foreign o#er at i on
5he net amount of gains or $osses inc$uded in the cumu$ ative
trans$ ati on adjust me nt during the re#orti ng #eriod.
&&
8$$ derivative instrume nt s not desi gnat ed as hedges must be
identified as to their #ur#os e. and 3ua$it ative disc$osur es about the
use of derivatives are encour age d.
=ina$$y. the amount of net gains or $osses from cash f$ow hedges on
derivative instrume nt s that is inc$uded in other com#r ehe nsi ve
income must be shown as a se#ar at e c$assificati on. 5he disc$osur es
shou$d inc$ude@ beginni ng and endi ng accumu$ at e d gains or $osses
from derivative instrume nt s M the net change during the #eriod from
hedgi ng activitiesM and the net amount rec$assified to earni ngs.
Us! %& Opt! o%s to He&e Fore! &% C3rre%"9 C$a%&e s
/o far in this cha#t er. forward cont r act s have been used as hedgi ng
items. 7ith the use of a forward cont r act . the firm wi$$ either gain or
$ose. =or e"am#$ e. if an account s #ayab$ e of 10. 000 euros is hedged
using a forward rat e of -1. 0%. the firm is guar ant e e d to #ay on$y
-10. %00. !f the s#ot rat e on the dat e of set t$ eme nt is higher than
-1. 0%. the firm gains. but if the s#ot rat e fa$$s be$ow -1. 0%. the firm
wou$d have been bet t er off not using the forwar d cont r act . One
advant age of the forward contr act is that it is cost$ ess to ac3uire.
/u##os e the firm want ed to #rot ect on$y the down side ris9 from
changes in the e"change rat e. 5o accom#$ish this. the firm may
&)
ac3uir e a foreign currency ca$$ o#tion. 8 "a00 opt! o% is an o#tion to
#urchas e the foreign currency at a s#ecified rat e. referr ed to as the
e"ercise #rice. 8 p3t opt! o% is an o#tion to se$$ the foreign currency
at a s#ecified rat e. 5he advant age of using o#tions is that the o#tion
gives the ho$der the ri$ht to buy or se$$ the currency. but if the
e"change rat e changes in a negat i ve manner . the firm can sim#$y $et
the o#tion $a#se. !n other words. the ho$der of the o#tion does not
have to e"ercise the o#tion. 5he disadvant a ge of the o#tion is that
ther e is an initia$ cost :i.e. a #remi um; to ac3uir e the o#tion. =or
inst ance. in the e"am#$ e above. the firm cou$d #urchas e an o#tion for
-&00
*
that wou$d a$$ow the firm to #urchas e 10. 000 euros at an
e"ercise #rice of -1. 0%. !f the s#ot rat e on the set t$ eme nt dat e
e"ceeds -1. 0% the firm wi$$ e"ercise the o#tionM if the s#ot rat e is $ess
than -1. 0%. the firm wi$$ $et the o#tion e"#ire.
8n Nin the money, o#tion is an o#tion wher e the firm benefit s if the
o#tion is e"ercised. !f on the dat e the ca$$ o#tion was #urchas ed. the
s#ot rat e of -1. 0% was e3ua$ to the e"ercise #rice of -1. 0%. the
o#tion is out of the money at that #oint. 5his means that the entire
va$ue of the o#tion is due to the Ntime va$ue, of the o#tion. 5he o#tion
has va$ue becaus e. over time. the s#ot rat e may e"ceed the e"ercise
#rice of the ca$$ o#tion :or the s#ot rat e may be $ess than the e"ercise
#rice for a #ut o#tion;.
*
5he se$$er of the o#tion wou$d use some o#tion #ricing mode$ . such as <$ac96
/cho$ es. for det er mi ni ng the amount of the #remi um #ai d.
&*
>ontinui ng our e"am#$ e. su##os e that one mont h $at er the s#ot
rat e increas ed to -1. 0&. =or a ca$$ o#tion. this means that the firm can
e"ercise the o#tion and obt ai n 10. 000 euros for -1. 0% when the
current e"change rat e is -1. 0&. 5hus the o#tion has an intrinsic va$ue
of -1%0 Kthe difference bet ween the s#ot rat e and e"ercise #rice
mu$ti#$ied by the amount of currency :-1. 0&6 -1. 0%;: 10. 000 euros;L.
5hus if the ca$$ o#tion had a current mar9et #rice of -)00. -1%0 wou$d
be treat ed as the intrinsic va$ue and -%%0 wou$d be treat ed as the
time va$ue of the o#tion. 5hus Nin the money, o#tions cont ai n bot h an
intrinsic and time va$ue e$ement . !f the s#ot rat e dro#s to -1. 03 :aft er
the o#tion was ac3uired;. the firm wou$d be bet t er off not e"erci sing
the o#tion and #urchas e the needed euros on the mar9et at -1. 03.
5he fo$$owing chart he$#s i$$ustrat e when a ca$$ or a #ut o#tion
might be used and when the o#tion is in the money.
!tem O#tion '"ercise Jrice '"ercise Jrice is
Less
Aedged Used '"ceeds /#ot 4at e than the /#ot
4at e
Jayab$ e >a$$ O#tion N!n the 2oney, NOut of the 2oney,
4eceivab$ e Jut O#tion NOut of the 2oney, N!n the 2oney,
&+
5hus a ca$$ o#tion is used when a foreign currency is needed to #ay a
$iabi$ity in the futur e. and a #ut o#tion is used when foreign currency
received in the future needs to be so$d and conver t ed into do$$ars.
&ash #low 'edg e usi ng (pt i ons ) An Illus t r at i on . 5o i$$ustrat e the
hedge of a forecasted foreign currency transaction with the use of an o#tion. assume the
fo$$owing@
1. On December 1. 2003. a U./. firm estimates that inventory wi$$ be so$d to a com#any in
the United Singdom during Fanuary of 200 for %00.000 euros. 5he cost of the
inventory so$d is estimated to be -300.000.
2. /#ot rates were as fo$$ows :do$$ars #er euro;@
December 1. 2003 -1.03
<a$ance sheet dat e :12B 31B 03; -1. 00
=ebruar y 1. 200 -0. +*
3. 5he trans act i on is to be denomi nat e d in euros.
. On December 1. 2003. the com#any #urchas es a #ut o#tion for
-%. 000 to hedge any changes that may occur in the receivab$ e
denomi nat e d in euros. 5his o#tion a$$ows the firm to se$$ %00. 000
euros at -1. 02 with an e"#irati on dat e of =ebruar y 1. 200. 5he
)0
s#ot rat e was -1. 03 on this dat e so the o#tion is out of the money.
8t year6 end :the ba$ ance sheet dat e;. the va$ue of the o#tion
increas ed to -1. 000. On the o#tion e"#irati on dat e. the o#tion
on$y has an intrinsic va$ue :the difference bet ween the e"ercise
#rice and the s#ot rat e;. 5herefor e on =ebruar y 1. the va$ue of the
o#tion is -20. 000.
5he rationa$e for the use of the o#tion is as fo$$ows. <ecause the sa$e is e"#ected to
occur in the future :ne"t Fanuary; and because the e"change rate may change unfavorab$y.
the com#any buys an o#tion to se$$ %00.000 euros at -1.02 or -%10.000. 7hen the sa$e of
inventory occurs and the com#any receives the euros. the firm is subject to any e"change
$osses. Aowever. because the firm now has an o#tion to se$$ euros. the com#any can use
the euros that it receives from the sa$e to de$iver on the o#tion. 5herefore. if the e"change
rate dro#s be$ow the e"ercise rate :-1.02;. the firm is covered :i.e. the firm e"ercises the
o#tion and se$$s the %00.000 euros for -%10.000;. !f the e"change rate e"ceeds the
e"ercise rate. the o#tion wi$$ not be e"ercised.
5he ent ri es to record the #urchas e and forward e"change cont r act
are@
De"e'+er 1, -..3 - Tra%sa"t!o% Date
:1
;
O#tion to se$$ euros %.000
>ash %.000
5o record #urchas e of a #ut o#tion.
)1
On the ba$ance sheet date :December 31. 2003;. the o#tion is adjusted to its mar9et
va$ue of -1.000. 5herefore on December 31. 2003. the fo$$owing entry is made.
De"e'+er 31, -..3 - /a0a%"e S$eet Date
:2
;
O#tion to se$$ euros +.000
=oreign e"change gain T Other
>om#r ehensi ve
!ncome :ba$ ance sheet e3uit y;
+.000
5o record a gain on the change in o#tion va$ue :-1. 0006
-%. 000;
5he recogni tion of the gain is re#ort ed in com#r ehe nsi ve income
becaus e it 3ua$ifies under the criteri a designat e d in SFAS No. 133 M for
e"am#$ e. the forecas t ed trans act i on is #robab$ e and it #res ent s
e"#osur e to #rice changes that are e"#ect ed to affect earni ngs and
caus e variabi$ity in cash f$ows. 8mount s deferr ed from earni ngs are
re#ort ed in other com#r ehe nsi ve income. and are rec$ assified into
earni ngs in the #eriod during which the hedged forecas t ed trans act i on
)2
affect s earni ngs :for e"am#$ e. when a forecas t ed sa$ e act ua$$y
occurs;.
+
+
SFAS No. 133 . #ar a. 31. 8ccounti ng for Derivative !nstrume nt s and Aedgi ng
8ctivities :?orwa$9. >onn.@ =8/<. 1++*;.
)3
Fe+r3ar9 1, -..1 @ Opt!o% E#p!rat!o% Date
:3; O#tion to se$$ euros &.000
=oreign e"change gain T Other
>om#r ehensi ve
!ncome :ba$ ance sheet e3uit y;
&.000
5o adjust the o#tion va$ue to its mar9et va$ue of -20. 000.
5he va$ue of the o#tion K:-1. 02 e"ercise #rice $ess -0. +* s#ot
rat e; " %00. 000 eurosL is -20. 000 $ess the carrying va$ue of the
o#tion :-1. 000;.
5echnica$$y since the forecas t ed trans act i on occurr ed on this dat e. the
gain recorded in ent ry :3; cou$d a$so be re#ort ed in earni ngs
immedi at e$ y. 7e chose to initia$$y record the gain using the ba$ ance
sheet account :other com#r ehe nsi ve income; and then immedi at e$ y
rec$ assify the tot a$ e"change gain into earni ngs :see ent ry :&; be$ow;.
:; !nvest me nt in => :%00. 000 euros; +0. 000
4evenues +0. 000
>ost of goods so$d 300. 000
!nvent or y 300. 000
5o se$$ the invent or y :com#$ et e the forecas t ed
trans act i on;.
:%; >ash :e"ercise #rice -1. 02 " %00. 000
euros;
%10. 000
O#tion to se$$ euros :intrinsic va$ue on
o#tion dat e;
20. 000
!nvest me nt in => :%00. 000 euros V +0. 000
)
-0. +*;
5o e"erci se the o#tion and set t$ e with the trader.
:&; =oreign e"change gain T Other
>om#r ehensi ve !ncome
1%. 000
4evenue :-+. 000 from ent ry :2; and
-&. 000 from
ent ry :3;.
1%. 000
5o rec$assify the tot a$ e"change gains into earni ngs
?ote that in entry :;. revenue is recorded at the s#ot rat e. Aowever.
ent ry :&; adjust s revenue to recogni(e the benefit of the o#tion. 'ntry
:&; is re3uired becaus e the amount recogni(ed in other accumu$ at e d
income is rec$assified into earni ngs in the #eriod the hedged item
affect s earni ngs. 5hus the tot a$ amount of revenue recogni(ed is
-%1%. 000. which re#r es ent s the revenue recogni(ed at the s#ot rat e
:-+0. 000; #$us the net benefit of the o#tion -1%. 000 :-1. 02 e"ercise
rat e over the s#ot rat e -0. +* mu$ti#$ied by %00. 000 euros $ess the
initia$ cost of the o#tion of -%. 000;.
*plit Accounting + Intrinsic and Time ,alue Elements: !n order to 3ua$ify for hedge
accounting under SFAS No. 133. the hedges must be effective. =irms are re3uired to
measure the effectiveness of their hedges 3uarter$y. !f the hedge is not high$y effect. hedge
accounting can no $onger be used. 5herefore. firms must determine how they measure
hedge effectiveness. 5his usua$$y means that the changes in va$ue of the hedge :e.g. the
forward contract or o#tion; shou$d be a##ro"imate$y e3ua$ to the changes in va$ue of the
)%
hedged item. !n the e"am#$es used in this cha#ter. we have used the change in the forward
rate to measure the change in va$ue of the forward contracts and the tota$ change in the
va$ue of the o#tion to measure the change in va$ue of the o#tion. 5he =8/< a$$ows s#$it
accounting for derivatives. 5his means that the intrinsic va$ue of the derivative and the
#art of the o#tion va$ue re$ated to time can be se#arated and accounted for different$y. =or
instance. firms can use the tota$ change in va$ue of the o#tion to measure gains and $osses
or the change in the intrinsic va$ue to measure the change in va$ue of the derivative. 5he
change in the time va$ue e$ement wou$d be ta9en immediate$y into earnings. 7hi$e it is
im#ortant to 9now that these com#$icating factors e"ist. in this cha#ter we measure the
change in va$ue of the derivative using the tota$ va$ue of the derivative. 8$so. we assume
that a$$ hedges are high$y effective.
Ot$er For's o( Fore! &% /orro4! %& or Le%! %&
'ar$ier in the cha#t er . the e"#orti ng or im#orti ng of invent or y was
i$$ustrat ed. 8ccounti ng for other ty#es of foreign borrowing or $ending
trans act i ons is simi$arM that is. the two6 trans act i on a##roach is
fo$$owed in which the cost of an asset ac3uir ed or revenue recogni(ed
is account ed for inde#ende nt $ y from the met hod of set t$ eme nt . =or
e"am#$ e. if a fi"ed ass et is ac3uir ed from a foreign com#any on credit.
the cost of the asset is the number of foreign currency units that
wou$d be #aid in a cash trans act i on mu$ti#$ied by the e"change rat e at
the trans act i on dat e. 5he cost of the asset is not adjust ed for
)&
subs e3ue nt changes in the e"change rat e. but the $iabi$ity is adj ust ed
at each ba$ ance sheet dat e on the basis of the e"change rat e in effect
at that dat e. 5he adjust me nt to the $iabi$ity is re#ort ed current$ y in
income. 5he amount recorded for int er es t e"#ens e is the e3uiva$ ent
number of U./. do$$ars needed to ma9e the int er es t #ayme nt .
))
/ummar y
1. ,istin$"i sh bet wee n the ter%s -%eas "re#. an# -#eno%i nat e#..
5rans acti ons are nor ma$$y meas ur e d and recorded in ter ms of
the currency in which the re#orti ng entit y #re#ar es its financi a$
st at e me nt s . 8sset s and $iabi$ities are deno mi na t e d in a
currency if their amount s are fi"ed in ter ms of that currency
2. ,escribe a forei$n c"rrenc! transacti on. 8 foreign currency
trans act i on is a trans act i on that re3uires set t$ eme nt in a foreign
currency. not in U. /. do$$ars :for a U. /. firm;.
3. (n#erst an# so%e of the %ore co%%on forei$n c"rrenc!
transacti ons. /ome common trans act i ons inc$ude@ 1; im#orti ng
or e"#orti ng goods or services on credit with the receivab$ e or
#ayab$ e denomi nat e d in a foreign currencyM 2; borrowi ng from
or $ending to a foreign com#any with the amount #ayab$ e or
receivab$ e denomi nat ed in the foreign currencyM 3; engagi ng in
a trans act i on with the int enti on of hedgi ng a net invest me nt in a
foreign entit yM and ; ent eri ng into a forward contr act to by or
se$$ foreign currency.
. I#entif ! three sta$es of concern to acco"nt ant s for forei$n
c"rrenc! transacti ons an# e'lain the st es "se# to translat e
forei$n c"rrenc! transacti ons for each sta$e. 8t the initia$ dat e
the trans act i on is recogni(ed :in confor mi t y with E88J;. the
)*
account :ba$ ance sheet or income st at e me nt ; arising from the
trans act i on is meas ur ed and recorded in do$$ars by mu$ti#$ying
the foreign currency unity by the current e"change rat e. 8t
each subs e3ue nt ba$ance sheet dat e unti$ set t$ eme nt . recorded
ba$ances that are denomi nat ed in a foreign currency are
adjust ed to ref$ect the current e"change rat e in effect at the
ba$ance sheet dat e. 8t the set t$ eme nt dat e. the treat me nt
de#ends on whet her the ba$ ance to be set t$ ed is a foreign
currency #ayab$ e or receivab$ e. !f a foreign currency #ayab$ e is
being set t$ ed. a U. /. firm must conver t U. /. do$$ars into foreign
currency units to set t$ e the account . 8t the set t$ eme nt of a
foreign currency receivab$ e. the foreign currency units received
are conver t ed into do$$ars.
%. ,escribe a forwar# e'chan$e contract . 8 forward e"change
cont r act is an agr ee me nt to e"change currenci es of two
different count ri es at a s#ecified rat e :the forward rat e; on a
sti#u$ at ed futur e dat e. 8t the ince#ti on of the contr act . the
forward rat e is usua$$y different from the s#ot rat e.
&. /'lain the "se of forwar# contract s as a he#$e of an
"nreco$ni 0 e# fir% co%%i t %e nt . !n many cases. the firm ent er s
into an agr ee me nt to #urchas e or se$$ goods wher e the
trans act i on is denomi nat e d in a foreign currency. <ecaus e the
e"change rat e might change before the #ayab$ e is #aid or the
)+
receivab$ e is co$$ect ed. a firm can use a forward cont r act to $oc9
in the amount of cash #aid or the amount of cash received.
). I#entif ! so%e of the co%%on sit"ations in which a forwar#
e'chan$e contract can be "se# as a he#$e. Aedges may be
used to hedge a foreign currency e"#os ed receivab$ e or #ayab$ e
#osition. to hedge a net invest me nt in a foreign subsi di ary. o to
hedge an identifiab$ e foreign currency commi t me nt . or to hedge
a forecas t ed.
*. ,escribe a #erivati ve instr"%e nt an# "n#erst an# how it %a! be
"se# as a he#$e. 8 derivative is an e"ecut or y contr act bet ween
two #arti es to be e"ecut ed at a $at er dat e. with the resu$ting
futur e cash f$ows de#ende nt u#on the change in some other
under$ yi ng meas ur e of va$ue. 5he event ua$ do$$ar amount of the
#erfor mance is det er mi ned by subs e3ue nt va$ue changes. and
the event ua$ outcome is neces s ari$y favor ab$ e to one of the
#arti es invo$ved and unfavor ab$ e to the other.
+. /'lain how e'chan$e $ains an# losses are reort e# for fair
val"e he#$es an# cash flow he#$es . 5he =8/< a$$ows deferr a$ of
the e"change gain and $oss on cash f$ow hedges :a forecas t ed
trans act i on;. Li9e other gains and $osses that are e"c$uded from
the income st at e me nt . they are inc$uded as com#onent s of
other com#r ehe nsi ve income and re#ort ed in the stoc9ho$ der s,
e3uit y section of the ba$ ance sheet . On the other hand.
*0
e"change gains and $osses on fair va$ue hedges :unrecogni(ed
firm commi t me nt s ; are re#ort ed in current #eriods earni ngs
a$ong with the e"change gain or $oss on the hedged item.

*1