ACC803 Advanced Financial Reporting

Accounting for Foreign Currency Transactions – Hedge Accounting

Hedging is a risk management technique that involves using one or more derivatives or other
hedging instruments to offset changes in fair value or cash flows of one or more assets, liabilities,
or future transactions.

Example of a hedge

As an example, imagine your company that normally operates is USD. Recently, your company
has decided to spread its business to Europe and made a sale of some goods to European customer
for let’s say 20 million EUR. Invoice to EU customer is due after 9 months.

However, your company is afraid that due to movements in foreign currency rates it will get
significantly less USD after 9 months and therefore, it enters into offsetting foreign currency
forward contract with bank to sell 20 million EUR for some fixed rate after 9 months.

What’s the hedge here?

• Hedged risk is a foreign currency risk.

• Hedged item is a receivable in foreign currency.

Hedging instrument is a foreign currency forward contract to sell EUR for a fixed rate at a
fixed date.
Key Terms:

Exchange Rate: The rate at which one currency can be exchanged for another.
Translation of foreign currency transactions: Translation of transactions denominated or requiring
settlement in a currency other than the functional currency of the entity.
Functional currency: The currency of the primary economic environment in which the entity
operates.
Presentation currency: The currency in which the financial statements are presented.
Spot rate: The exchange rate for immediate delivery of currencies to be exchanged.
Hedge: Action taken to minimize possible adverse financial effects of movements in exchange
rates or other market values.

Practical Scenarios:

- Purchase of Goods
- Sale of Goods

Example 1: Adoption of a hedge contract after the date of the purchase of goods.

On 1 March 2012 Koala Limited, an Australian entity, purchases UK£1.2 million of inventory
from Nigel Incorporated, a UK entity. The amount is payable on 1 August 2012. A forward
exchange contract for the delivery of UK£1.2 million is taken out with ABC Bank on 1 May 2012.
ABC Bank requires a delivery of the foreign currency on 1 August 2012. Koala Limited has a 30
June end of reporting period. Assume a discount rate of 6 per cent per annum.

Additional information:
The relevant exchange rates are as follows:
Date Spot rate Forward rate
1 March 2012 0.40
1 May 2012 0.37 0.35
30 June 2012 0.36 0.34
1 August 2012 0.32 0.32

Required:

1. Prepare the journal entries for Koala Limited to account for the hedge.
2. Provide evidence of whether or not hedge accounting in the above situation was beneficial.
Work Sheet:

Date: Particulars: Debit ($): Credit ($):

Foreign exchange loss incurred:
Amount paid on 1 August 2012 $
Accounts payable as at 1 March 2012
(Date of purchase) $
Total foreign exchange loss $

If purchase was not hedged:

Amount paid on 1 August 2012 (1.2 million /0.32) $
Accounts payable as at 1 March 2012
(Date of purchase) $
Total foreign exchange loss $

Example 2: Adoption of a hedge contract before the date of a sale of goods

Conish Limited exports surfboards to Newquay (UK) plc. Newquay (UK) plc placed the order on
1 April 2012. The consignment of surfboards was sold FOB Byron Bay (NSW) on 1 May 2012.
The sales price was UK£1 million payable on 1 August 2012.

A sell hedge forward-rate contract was entered into on 1 April 2012 (before the date of the sale)
with ABC Bank for the delivery of Australian dollars in exchange for £UK 1 million on 1 August
2012. The forward rate of the contract is $AUS1.00 = UK£0.40 on 1 April 2012. Cornish Limited
uses cash-flow hedge accounting.

Additional Information:
The relevant exchange rates are as follows:

Date Spot rate Forward rate

1 April 2012 0.35 0.40
1 May 2012 0.30 0.36
30 June 2012 0.25 0.29
1 August 2012 0.37 0.37

Cornish Limited’s end of reporting period is 30 June.

Required:
Prepare the journal entries for Cornish Limited.
Worksheet:

Date: Particulars: Debit ($): Credit ($):