Chapter 7 Flashcards
What is the concept underlying the two-transaction perspective to accounting for foreign currency transactions?
Under the two-transaction perspective, an export sale (import purchase) and the subsequent collection (payment) of cash are treated as two separate transactions to be accounted for separately. The idea is that management has made two decisions: (1) to make the export sale, and (2) to extend credit in foreign currency to the foreign customer. The income effect from each of these decisions should be reported separately.
A company makes an export sale denominated in a foreign currency and allows the customer one month to pay. Under the two-transaction perspective, accrual approach, how does the company account for fluctuations in the exchange rate for the foreign currency?
Foreign currency receivables resulting from export sales are revalued at the end of accounting periods using the current spot rate. An increase in the value of a receivable will be offset by reporting a foreign exchange gain in net income, and a decrease will be offset by a foreign exchange loss. Foreign exchange gains and losses are accrued even though they have not yet been realized.
What factors create a foreign exchange gain on a foreign currency transaction? What factors create a foreign exchange loss?
Foreign exchange gains and losses are created by two factors: having foreign currency exposures (foreign currency receivables and payables) and changes in exchange rates. Appreciation of the foreign currency will generate foreign exchange gains on receivables and foreign exchange losses on payables. Depreciation of the foreign currency will generate foreign exchange losses on receivables and foreign exchange gains on payables.
What does the word “hedging” mean? Why do companies hedge foreign exchange risk?
Hedging is the process of eliminating exposure to foreign exchange risk so as to avoid potential losses from fluctuations in exchange rates. In addition to avoiding possible losses, companies hedge foreign currency transactions and commitments so as to introduce an element of certainty into the future cash flows resulting from foreign currency activities. Hedging involves establishing a price today at which foreign currency can be sold or purchased at a future date.
How does a foreign currency option differ from a foreign currency forward contract?
A party to a foreign currency forward contract is obligated to deliver one currency in exchange for another at a specified future date, whereas the owner of a foreign currency option can choose whether to exercise the option and exchange one currency for another or not.
How does the timing of hedges of the following differ? (a) Foreign currency denominated assets and liabilities. (b) Foreign currency firm commitments. (c) Forecasted foreign currency transactions.
Hedges of foreign currency denominated assets and liabilities are not entered into until a foreign currency transaction (import purchase or export sale) has taken place. Hedges of firm commitments are made when a purchase order is placed or a sales order is received, before a transaction has taken place. Hedges of forecasted transactions are made at the time a future foreign currency purchase or sale can be anticipated, even before an order has been placed or received.
Why might a company prefer a foreign currency option rather than a forward contract in hedging a foreign currency firm commitment? Why might a company prefer a forward contract over an option in hedging a foreign currency asset or liability?
Foreign currency options have an advantage over forward contracts in that the holder of the option can choose not to exercise if the future spot rate turns out to be more advantageous. Forward contracts, on the other hand, can lock a company into an unnecessary loss (or a reduced gain). The disadvantage associated with foreign currency options is that a premium must be paid up front even though the option might never be exercised.
How are foreign currency derivatives such as forward contracts and options reported on the balance sheet?
All derivative financial instruments must be recognized as assets or liabilities on the balance sheet, measured at fair value.
How is the fair value of a foreign currency forward contract determined? How is the fair value of an option determined?
The fair value of a foreign currency forward contract is determined by reference to changes in the forward rate over the life of the contract, discounted to the present value. Three pieces of information are needed to determine the fair value of a forward contract at any point in time during its life: (a) the contracted forward rate when the forward contract is entered into, (b) the current forward rate for a contract that matures on the same date as the forward contract entered into, and (c) a discount rate; typically, the company’s incremental borrowing rate.
The manner in which the fair value of a foreign currency option is determined depends on whether the option is traded on an exchange or has been acquired in the over the counter market. The fair value of an exchange-traded foreign currency option is its current market price quoted on the exchange. For over the counter options, fair value can be determined by obtaining a price quote from an option dealer (such as a bank). If dealer price quotes are unavailable, the company can estimate the value of an option using the modified Black-Scholes option pricing model. Regardless of who does the calculation, principles similar to those in the Black-Scholes pricing model will be used in determining the value of the option.
What is hedge accounting?
Hedge accounting is defined as recognition of gains and losses on the hedging instrument in the same period as the recognition of gains and losses on the underlying hedged asset or liability (or firm commitment).
Under what conditions can hedge accounting be used to account for a foreign currency option used to hedge a forecasted foreign currency transaction?
For hedge accounting to apply, the forecasted transaction must be probable (likely to occur), the hedge must be highly effective in offsetting fluctuations in the cash flow associated with the foreign currency risk, and the hedging relationship must be properly documented.
What are the differences in accounting for a forward contract used as ( a )a cash flow hedge and (b) a fair value hedge of a foreign-currency-denominated asset or liability?
In both cases, (1) sales revenue (or the cost of the item purchased) is determined using the spot rate at the date of sale (or purchase), and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss is recognized in net income.
For a cash flow hedge, the derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability. An additional amount is removed from AOCI and recognized in net income to reflect (a) the current period’s amortization of the original discount or premium on the forward contract (if a forward contract is the hedging instrument) or (b) the change in the time value of the option (if an option is the hedging instrument).
For a fair value hedge, the derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income. The discount or premium on a forward contract is not allocated to net income. The change in the time value of an option is not recognized in net income.
What are the differences in accounting for a forward contract used as a fair value hedge of (a) a foreign-currency-denominated asset or liability and (b) a foreign currency firm commitment?
- For a fair value hedge of a foreign currency asset or liability (1) sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income. The forward contract is adjusted to fair value based on changes in the forward rate (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income. The foreign exchange gain (loss) and the forward contract loss (gain) are likely to be of different amounts resulting in a net gain or loss reported in net income.
For a fair value hedge of a firm commitment, there is no hedged asset or liability to account for. The forward contract is adjusted to fair value based on changes in the forward rate (resulting in an asset or liability reported on the balance sheet), with a gain or loss recognized in net income. The firm commitment is also adjusted to fair value based on changes in the forward rate (resulting in a liability or asset reported on the balance sheet), and a gain or loss on firm commitment is recognized in net income. The firm commitment gain (loss) offsets the forward contract loss (gain) resulting in zero impact on net income. Sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase). The firm commitment account is closed as an adjustment to net income in the period in which the hedged item affects net income.
What are the differences in accounting for a forward contract used as a cash flow hedge of (a) a foreign-currency-denominated asset or liability and (b) a forecasted foreign currency transaction?
For a cash flow hedge of a foreign currency asset or liability (1) sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income. The forward contract is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability. An additional amount is removed from AOCI and recognized in net income to reflect the current period’s allocation of the discount or premium on the forward contract.
For a hedge of a forecasted transaction, the forward contract is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). Because there is no foreign currency asset or liability, there is no transfer from AOCI to net income to offset any gain or loss on the asset or liability. The current period’s allocation of the forward contract discount or premium is recognized in net income with the counterpart reflected in AOCI. Sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase). The amount accumulated in AOCI related to the hedge is closed as an adjustment to net income in the period in which the forecasted transaction was anticipated to occur.
How are changes in the fair value of an option accounted for in a cash flow hedge? In a fair value hedge?
In accounting for a fair value hedge, the change in the fair value of the foreign currency option is reported as a gain or loss in net income. In accounting for a cash flow hedge, the change in the entire fair value of the option is first reported in other comprehensive income, and then the change in the time value of the option is reported as an expense in net income.
