Lecture 9 RSM321
Lecture 9 RSM321
Lecture 9 RSM321
1
Introduction
2
Introduction
n When the agreement calls for the transaction to be settled (paid) in a foreign
currency, this means one of two things:
q If the transaction is a purchase, the Canadian company will have to
acquire foreign currency in order to discharge the obligations resulting
from its imports.
q If the transaction is a sale, the Canadian company will receive foreign
currency as a result of its exports, and will have to sell the foreign
currency in order to receive Canadian dollars.
n These are foreign currency denominated transactions requiring conversion
to Canadian dollars.
3
Introduction
q the date at which the financial statements are reported with the foreign-
currency-denominated receivable or payable; AND
q the date of receipt or payment (“settlement”) of the foreign-currency-
denominated receivable or payable.
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Exchange Rate Quotations
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Exchange Rate Quotations
6
Exchange Rate Perspectives
n The denominated currency is the currency in which a transaction is
receivable or payable.
q A different currency may be used to record the transaction in the internal
accounting records.
n The functional currency is the currency of the primary economic
environment in which the entity operates.
q A foreign currency is a currency other than the functional currency.
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Exchange Rate Perspectives
n For accounting purposes there are basically three rates used in translating
foreign currency into the reporting currency:
q Closing rate is the spot rate on the reporting date of the financial
statements.
q Historical rate is the spot rate on the date of the transaction.
n The average rate for a period can be used as a proxy for the
historical rate for a series of transactions (e.g. purchases, sales,
interest income or expense) if they occur evenly throughout the
period.
q Forward rate is the agreed rate for exchange of currencies at a
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Accounting for Foreign Currency Transactions
11
Accounting for Foreign Currency Transactions
DR Inventory 980
CR Accounts payable 980
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Accounting for Foreign Currency Transactions
n By the end of its fiscal year (February 28th), the firm has incurred a $10 loss,
as the firm now has a monetary liability for USD1,000 x 0.99 = CAD990,
rather than the CAD980 at which the transaction was initially recorded. The
following entry is recorded for this loss reflecting the closing rate, since the
loss occurred as a separate event from the original purchase transaction.
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Accounting for Foreign Currency Transactions
n On March 30th (the final payment date), the following entry is made to clear
accounts payable, record the additional $20 foreign currency loss at the
settlement date spot rate, and record the cash payment:
DR Accounts payable 990
DR Foreign exchange loss 20
CR Cash 1,010
n This further loss of $20 is recognized in the period in which it occurs.
q The foreign currency loss is a period cost, recognized in the period in
which the change in exchange rates took place.
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Speculative Forward Exchange Contracts: Hedges
15
Hedges
16
Hedges
Hedged Item Example of Hedging Item
* “FC” = “Foreign Currency”
Note that exposure can arise earlier than the transaction date i.e. the date you enter into
a sale OR issue a purchase order (committed) OR even earlier when the transaction
is first anticipated.
Committed means a firm order with a customer or supplier. For anticipated transactions,
a firm order does not yet exist. 17
Hedges
accounting if it wishes and if the conditions for its use are present, but
does not necessarily have to use it.
q In some cases, the differential accounting impact between using/not
using hedge accounting is minimal. Because hedge accounting
requires extensive documentation, firms may decide to not apply hedge
accounting.
n Under hedge accounting, the exchange gains or losses on the hedged
items will be recognized in the income statement in the same period as the
exchange gains or losses on the hedging item. Without hedge accounting,
the exchange gains or losses on the hedged and hedging items would be
recognized in different periods.
n Note that hedge accounting implies an economic hedge is in place BUT an
economic hedge does not imply hedge accounting is being applied (e.g.,
offsetting FCU-denominated A/R, A/P require no special hedge accounting).
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Hedges
n The following items can be used to hedge currency fluctuations:
q A derivative financial instrument. For example, a forward exchange
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Hedges
n Anticipated future transactions, such as a future revenue stream or
purchase, cannot be used to hedge an existing foreign currency position
BUT can be the hedged item.
n The hedging instrument must be a firm commitment involving an
independent third party. Otherwise, a manager could just walk away from
the hedging instrument if it was in an unfavorable position. This would leave
GAAP earnings open to manipulation and they would lose the “hardness”
property (i.e., earnings can’t be what you want them to be-an idea we have
seen many times in the course).
n For example, with an anticipated FCU purchase, I can hedge by:
q 1) enter into a forward contract to receive FCU.
q 3) denote existing FCU A/R as a hedge if the terms are the same.
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Hedges
n Hedged items:
q Can be a recognized asset or liability, an unrecognized firm commitment,
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Hedges
22
Hedges
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Hedges
n If a hedge is truly effective; that is, all risks are transferred by the hedging
party, there should be no overall exchange gain or loss recorded on the
income statement over the life of the hedge, other than the cost of
establishing the hedge itself.
q The cost of an effective hedge is the difference between the forward rate
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Speculative Forward Contract Example
EXAMPLE —page 587 in text
On December 1, Year 1, Raven Co. enters into forward contract to sell 1 million
pesos (PP) to its bank on March 1, Year 2, at the market rate for a 90 day
forward contract of PP1 = $0.027. The Fixed leg of the forward is the A/R in
Cdn$ from the bank, while the Floating leg is the FC delivery obligation. On
December 31, Year 1, Raven’s year-end, the 60-day forward rate to sell
pesos on March 1 has changed to PP1 = $0.025. On March 1, Year 2, the
currencies are exchanged when the spot rate is PP1 = $0.022.
We will stress the gross method, which requires that the forward be recorded
initially. Hence, ignore the the term “memorandum entry” on page 588 of the
text, which only applies to the net method.
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Journal Entries for Speculative Forward Contract
At December 31,
due from bank $27,000
due to bank (at year-end
forward rate) $25,000
net due from bank (=gain)
$2,000
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Hedges
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Hedges
q Record the forward contract at the forward rate and the corresponding
payable to OR receivable from the bank.
q At financial statement reporting dates:
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Hedges
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Hedges
FU 200,000
1 forward rate ALWAYS converges to spot rate on f/x contract maturity date
2 forward rate and spot rate generally move in the same direction i.e. if spot rate appreciates,
forward rate appreciates; if spot rate depreciates, forward rate depreciates.
3 For our lecture notes, year 10 = year 1, and year 11 = year 2, in the Vulcan example in the text.
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Hedges
“Long”: receive FC. Vulcan loses if FCU “Short”: enter into obligation to deliver FC.
spot decreases. Vulcan gains if FCU spot decreases.
Cash $ 168,400
F/X loss before hedge $ 1,000
F/X loss = discount on hedge $ 4,600
Sales $ 174,000
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Hedging a Recognized Monetary Item
(journal entries, using the gross method)
01-Nov-10
November 1, Year 1
JOURNAL ENTRY # 2:
JOURNAL ENTRY # 3:
Memo Entry only
15-Nov-10
November 15, Year 1
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Hedging a Recognized Monetary Item
(journal entries)
JOURNAL ENTRY # 4:
31-Dec-10
December 31, Year 1
DR Accounts Receivable (FCU) $ 800
CR F/X gain $ 800
JOURNAL ENTRY # 5:
JOURNAL ENTRY # 6:
February 15, Year 2
15-Feb-11
15-Feb-1115, Year 2
February
JOURNAL ENTRY # 8:
15-Feb-11
February 15, Year 2
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Hedging a Recognized Monetary Item
(journal entries)
JOURNAL ENTRY # 9:
15-Feb-11
February 15, Year 2
DR Cash $ 168,400
CR Receivable from bank $ 168,400
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Hedges
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LO
Hedges
q For the final assessment, you are not responsible for the discussion in
the text (p. 597) of the option for FV Hedges under IFRS 9.6.2.4 to
segregate the forward contract into the intrinsic and insurance portions.
This option involves “smoothing” out the P&L impact of the amortization
of the hedged discount or premium, using the OCI account and drawing
just enough out of the OCI account to offset to zero the loss on marking
the natural position to the changing spot. The rest is straight line
amortized.
q Very few companies do this, as the costs outweigh the benefits of this
added complexity.
q Remember: for the final assessment, for FV hedges mark the natural
position to the changing spot rate and the floating leg of the forward
contract to the changing forward rate. The amortization of the hedge
discount or premium will occur automatically.
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Hedges
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Hedges
n Accounting for a cash flow hedge of an unrecognized firm commitment
q Record the forward contract and the corresponding payable to or receivable from
the bank.
q At each reporting date prior to purchase or sale:
n Revalue the forward contract at the forward rate (gain/loss to OCI).
q Later, when the purchase or sale transaction occurs:
n Record the purchase or sale transaction at the spot rate.
n Clear the balance in OCI with a corresponding debit or credit to the purchase
or sale transaction.
q Manning’s natural position is that of an importer, and is obliged to deliver FCU
(“short”). It is exposed if the FCU spot price increases. To hedge, it enters into
an obligation to purchase FCU from the bank at a fixed forward rate, a “long”
position which gains if the FCU spot price increases. The premium on the forward
contract at hedge inception is $7,000 = US $350,000 x (1.28-1.26). Manning is
willing to pay this premium at the order date in order to lock in the purchase cost
of the inventory at $448,000 = US $350,000 x 1.26 + $7,000.
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Hedges
June-02-10
June 2, Year 2 June-30-10
June 30, Year 2 August-01-10
August 1, Year 2
Receive goods,
Order goods settle forward
and hedge contract, and pay
order Year-end supplier
FCU 350,000
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Hedging an Unrecognized Firm Commitment –
Cash Flow Hedge (journal entries):
JOURNAL ENTRY # 1:
June 2, Year 2
02-Jun-10
JOURNAL ENTRY # 2:
30-Jun-10
June 30, Year 2
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Hedging an Unrecognized Firm Commitment –
Cash Flow Hedge (journal entries):
JOURNAL ENTRY # 3:
01-Aug-10
August 1, Year 2
JOURNAL ENTRY # 4:
01-Aug-10
August 1, Year 2
DR Inventory $ 2,800
CR OCI - cash flow hedge $ 2,800
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Hedging an Unrecognized Firm Commitment –
Cash Flow Hedge (journal entries):
JOURNAL ENTRY # 5:
01-Aug-10
August 1, Year 2
DR Inventory $ 445,200
CR Cash - FCU $ 445,200
JOURNAL ENTRY # 6:
01-Aug-10
August 1, Year 2
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Hedges
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LO
Hedging an Unrecognized Firm Commitment –
Cash Flow Hedge (journal entries):
JOURNAL ENTRY # 7:
01-Aug-10
August 1, Year 2
n Summary:
q All of the above journal entries can be condensed into one entry:
n DR Inventory $448,000
q CR Cash $448,000
q In the end, inventory is recorded at $448,000, the amount fixed by the forward
contract.
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Hedges
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Entering into a Forward To Hedge Both the Commitment
and the Accounts Payable when Settlement Date Falls After
the Delivery Date
n In the Manning example, the accounts payable was settled at the delivery
date. If settlement was later (say one month – September 1), Manning
could enter into a forward contract (at June 2) to hedge both the
commitment to buy inventory and the amount required to settle the accounts
payable. This is called a “straddle”, ie, it is a cash flow hedge until delivery,
then becomes a FV hedge until settlement. This is illustrated in P 10-15
(Carleton Ltd.)
n For a “straddle”, the basic principles for cash flow hedge accounting remain
the same. The unrealized foreign exchange gain or loss in OCI gets
recycled out and added to the purchased asset (in this case, inventory) at
the date of delivery.
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Entering into a Forward To Hedge Both the Commitment and the
Accounts Payable when Settlement Date Falls After the Delivery Date
n Thereafter, the forward becomes a fair value hedge of the balance sheet
monetary accounts payable from August 1st (receipt of goods) to September
1st (payment date). The forward and the accounts payable get marked
using the forward rate and the spot rate, respectively, with any re-
measurement amounts going directly to income. In this way, the pro ration
of the $7,000 premium between the cost of the inventory and the hedge of
the accounts payable arises as a natural consequence of the above journal
entries.
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Using Long Term Debt as a Hedge of a Future Revenue Stream
(a highly probable forecasted transaction)
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Foreign-currency transactions
q For each type of hedge, disclose a description of the hedge, the hedging
items and their fair values, and the risks being hedged.
q For cash flow hedges, disclose the periods when the cash flows are
expected to occur and incur a profit or loss, the amount recognized in
OCI during the period, the amount reclassified from OCI to income
during the period, and the amount reclassified in the period from OCI to
a non-financial asset or liability.
q Separate disclosure is required of gains or losses on fair value hedges,
and gains and losses from the ineffective portion of cash flow hedges
and of hedges of net investments in foreign operations recognized in
profit and loss in the period.
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Problem 10-
15
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