CHAPTER 5

Foreign Currency Hedges

About This Chapter

Foreign currency derivatives and hedging activities continues to illustrate the previous accounting guidance for fair value and cash flows hedges for companies that conduct business in more than one currency. The accounting guidance for derivative and hedge accounting on how to account for foreign currency transactions is limited to:

The previous illustrations on accounting for fair value and cash flow hedges will be applied to foreign currency hedges, including the hedge of a net investment in a foreign subsidiary. This chapter will focus on any differences of what derivative instruments qualify as hedges of a company’s price (market) risk due to changes in exchange rates between currencies. As usual we will use comprehensive illustrations to demonstrate the accounting and documentation requirements for foreign currency hedges. Special attention will be devoted to hedging the net investment of a foreign-controlled subsidiary.

Foreign Currency Hedges

Accounting guidance permits three major exceptions to the general principles to accounting for derivative instruments and hedging activities from our previous discussions in chapter 1. These exceptions are:

Accounting for Foreign Currency Transactions

The complexity of accounting for foreign currency transactions is that accounting standard setters, both U.S. GAAP and IFRS, had derivative and hedging guidance in place for foreign currency transactions that were not superseded by the issuance of the present accounting guidance for derivative instruments and hedging activities. This complicates the understanding of the derivative instruments, impact on financial statements by requiring adherence to two sets of reasonably complicated accounting standards. Let’s proceed with an explanation of accounting for foreign currency transactions and then dive into placing a hedge around the existing asset, liability, firm commitment, or forecasted future cash flows.

A foreign currency transaction is a transaction between (for our purposes) U.S. companies and foreign suppliers or customers in which the transaction is denominated in a foreign currency measured on the financial statements in dollars ($). In essence, every foreign currency transaction is two transactions; 1) operating transaction; and 2) financing transaction. The operating transaction component is normally the buying and selling of products or services. The operating portion does not result in a gain or loss due to price risk caused by the movement of the dollar against the foreign exchange currency. There will, however, be a transaction gain or loss due to changes in the currencies that are recorded as a finance gain or loss.

Foreign currency rates are determined by comparing the price of one country’s currency (U.S. dollar) with what that currency can purchase in foreign currency units (FC). The rates can be expressed directly—amount of currency needed to acquire one unit of foreign currency or indirectly—amount of foreign currency that can be acquired per unit of domestic currency. For example, at present (exchange rates change every business day) the Great Britain Pound (GBP) is trading at $1: GPB 1.50272. To determine the United States Dollar (USD) we would divide the value of the GPB into 1 USD and arrive at $0.66546. This translates to the USD is worth $0.66546 when compared to the GPB.

Currency rates of foreign countries when compared to the USD are generally floating rates. That is, based on the particular relative economic conditions for that country (or the European Union which has the Euro) their currency floats against the dollar. China is the exception as they peg their currency to be relatively constant against the dollar as a component of governmental policy. These floating exchange rates against the USD causes the financial gain or loss when companys get paid in foreign currencies (FC) for sales made or when making purchases of goods and services that occur on a date other than the operating transaction date. This is what is meant by the strengthening of the USD or the weakness of the USD when compared to FCs. For example, if the GPB goes to 1.6025 as measured against the USD, the USD equivalent would be $0.62. The dollar weakened against the GBP. This is the risk of foreign currency transactions, the FC strengthens against the dollar, making the USD less valuable or the USD rises against the FC making the FC less valuable. The management of these risks, by using derivative instruments, depends on whether the company is receiving assets (cash) or paying off liabilities.

When companies are receiving assets they would prefer that the foreign currency strengthen against the dollar. Since foreign currency (FC) business transactions are settled in the local foreign currency then remeasured to U.S. dollars, the rising FC will be worth more dollars and result in an exchange gain being recorded. When the company is paying liabilities, it wants the opposite, the USD rising against the FC. In that case, the USD buys more FCs to settle the transaction.

The accounting framework used account for import and export transactions is as follows:

The following examples¹ will illustrate the accounting for foreign currency transactions.

On October 16, X1, a Retailer purchased sweaters at an invoice price of 17,000 New Zealand dollars (NZ$) from a New Zealand manufacturer. The exchange rate was $.0.62: NZ$. Payment was due on December 16, X1.

Financial Statement Template

Assets =	Liabilities +	Stockholder’s equity
		+ Exchange gain – Exchange loss

To record the purchase of sweater inventory on October 16

Assets =	Liabilities +	Stockholder’s equity
+ Inventory + 10,540	+ Accounts payable + 10,540

Note: The calculation is NZ$ 17,000 X $0.62 = $10,540. The transaction is denominated in NZ$, but measured in USD. The accounts payable will be settled in NZ$ based on their $ equivalent on the settlement date.

On December 16, the Retailer purchases 17,000 NZ$ at an exchange rate of $0.63: NZ$ and transmits to manufacturers bank in New Zealand.

Assets =	Liabilities +	Stockholder’s equity
	+ Accounts payable + 710	– Exchange loss – 710

Note: Accounts payable amount is now NZ$17,000 X $0.63 = $17,710, which is $710 greater than the amount recorded on October 16.

Assets =	Liabilities +	Stockholder’s equity
+ Foreign Currency + 10,710 – Cash – 710,000

Assets =	Liabilities +	Stockholder’s equity
– Foreign currency – 10,710	– Accounts payable – 10,710

Note: The strengthening of the NZ$ against the USD and the company is a liability position caused by the foreign currency loss. Also, note that the inventory account, the operating aspect of the transaction, is not changed due to currency changes, instead the balance sheet account is changed.

The following illustration will involve accounting for a sale and making the adjustment on the balance sheet reporting date.

On November 20, X1, the Retailer sold wool coats to a Canadian company for 9,800 Canadian dollars (C$) when the spot exchange rate was $0.95: C$. Payment was due on January 20, X2. The company’s fiscal year ended on December 31, X1. The exchange rate on December 31, X1, was $0.985: C$ and the exchange rate on January 20, X2 was $.995: C$.

Assets =	Liabilities +	Stockholder’s equity
		+ Exchange gain – Exchange loss + Revenue

To record the sale wool coats to a Canadian company on November 20:

Assets =	Liabilities +	Shareholder’s equity
+ Accounts receivable + 9,310		+ Revenue + 9,310

Calculations to derive the asset and revenue amounts recorded are 9,800C $ × $0.95 =$9,310

January 31 entry to record the appropriate adjustment on the financial statements:

Assets =	Liabilities +	Shareholder’s equity
+ Accounts receivable + 343		+ Exchange gain + 343

Calculations to derive increased asset value at the reporting date are C$ (9,800 x $0.985) – 9,310 = $343. The USD weakened against the C$ leading the foreign currency buying more dollars.

On January 20, X2, the company received payment from the Canadian company at the spot rate of $0.995, and exchanged the Canadian currency for USD, after adjustment for the movement of the C$ against the USD. To record changes due to a strengthened C$:

Assets =	Liabilities +	Shareholder’s equity
+ Accounts receivable + 98		+ Exchange gain + 98

To record the collection of the account receivable from the Canadian company:

Assets =	Liabilities +	Shareholder’s equity
+ Foreign currency + 9,751 – Accounts receivable – 9,751

To record the exchange of C$ to USD:

Assets =	Liabilities +	Shareholder’s equity
+ Cash + 9,751 – Foreign currency – 9,751

Note: The foreign currency strengthened against the USD, resulting in the foreign currency buying more dollars.

The illustrations above demonstrate the exchange (price) risk that companies have to take when selling and purchasing products and services in international markets. The company challenge in managing the price risk is two-fold: (a) Will the USD rise or fall against the particular foreign currency in which the company has economic transactions? and (b) Is the company in a net asset position or a net liability position with regard to its current operations? The combination of the company’s perspective of the answers to the two questions above will determine its risk management strategy. Derivative instruments that can be used as hedges of the financial risk (each foreign currency transaction has an operating and financial risk) can be a very effective way for companies to manage those risks. The following simplified example will illustrate the accounting for a hedge of exposed assets using a forwards sale contract.

The Retailer sold goods for 2,000 GBP to a British customer on Oct 1, X1, when the spot rate was $2.10: GBP. Payment in pounds is due on March 1, X2. On the same date as the operating transaction was entered into, Retailer enters into a forward sale contract to deliver 2,000 GBP on March 1, X2, at a forward rate of $2.11/GBP.

Assets =	Liabilities +	Stockholder’s equity
		+ Revenue + Exchange gain – Exchange loss

Retailer records the sale of goods to the British Customer on October 1:

Assets =	Liabilities +	Shareholder’s equity
+ Accounts receivable + 4,200		+ Revenue + 4,200

Calculation to record revenue is $2.10 × 2,000 = $4,200

Note: No entry is required for the forward contract since its fair value is zero because the contract price and the forward price are the same at contract inception. When the forward price moves over the life of the hedge, then a gain or loss will be recorded.

Retailer records a year-end adjustment for both the changes in the spot rate (financial component of the sales transaction) and an adjustment for the changes in the forward rate on the derivative instrument. On December 31, X1, the spot rate for GBP has moved to $2.15/GBP and the forward rate for delivery is now $2.16/GBP.

To record the changing value of exchange spot rates on the financial statements:

Assets =	Liabilities +	Shareholder’s equity
+ Accounts receivables + 100		+ Exchange gain + 100

Calculation is ($2.15 – $2.10) × 2,000 = $100

To record the change in fair value of the forward contract:

Assets =	Liabilities +	Shareholder’s equity
	+ Forward contract + 100	– Exchange loss – 100

Calculation is ($2.16 – $2.11) × 2,000 = 100

On March 1, X2, the British customer pays the Retailer and the company settles the forward contract. The spot rate and the forward rate have converged to $2.18/GBP.

To record the changing value of the exchange spot rates on the financial statements:

Assets =	Liabilities +	Shareholder’s equity
+ Accounts receivable + 60		+ Exchange gain + 60

Calculation is ($2.18 – $2.15) × 2,000 = $60

To record the changing fair value of the derivative instrument:

Assets =	Liabilities +	Shareholder’s equity
	+ Forward contract + 40	– Exchange loss – 40

Assets =	Liabilities +	Shareholder’s equity
		– Exchange loss – 40

Calculation is ($2.18 – $2.16) x 2,000 = $40

To record payment to the British customer on March 1, X2:

Assets =	Liabilities +	Shareholder’s equity
+ Foreign currency + 4,360 – Accounts receivable – 4,360

Calculation is $4,200 + $100 +$60 = $4,360

To record the delivery of the foreign currency and settlement of the forward contract on March 1, X1:

Assets =	Liabilities +	Shareholder’s equity
+ Cash + 4,220 – Foregin currency – 4,360	– Forward contract – 140

Analysis: the company receives foreign currency (GBP) based on the forward contract of 2,000 × $2.11 = $4,220 and closed out the forward contract liability account and the foreign currency account.

The remainder of this chapter will demonstrate through comprehensive illustrations the most popular foreign currency hedges used by companies.

Use of a Forward Exchange Contract to Hedge a Firm Commitment to Pay Foreign Currency

A U.S. company enters into a firm commitment with a foreign supplier on September 30, X1, to purchase equipment for foreign currency (FC) 10,000,000. The equipment is deliverable on March 31, X2, and is payable on June 30, X2. In order to hedge the commitment to pay foreign currency of 10,000,000, the company enters into a forward exchange contract on September 30, X1, to receive FC 10,000,000 on June 30, X2 at an exchange rate of FC1=U.S.$0.72.

The company assesses hedge effectiveness based on the measurement of the difference between changes in the value of the forward exchange contract and the USD equivalent of the firm commitment. Since both of the fair value changes are calculated based on changes in the forward rates from inception to June 30, X2, the company determines there will be no hedge ineffectiveness.

Foreign Currency (FC)/U.S. Exchange Rates

Date	Spot rates	Forward rates for June 30, X2
September 30,X1	FC 1 = $0.65	FC 1 = $0.72
December 31, X1	FC 1 = $0.66	FC 1 = $0.71
March 31, X2	FC 1 = $0.69	FC 1 = $0.71
June 30, X2	FC 1 = $0.70	Spot and forward rates converge

As the basis for determining the impact on the financial statements over the term of the hedging relationship the company prepares the following fair value analysis assuming zero hedge ineffectiveness. The fair value analysis is based on changes in the forward rates for both the derivative instrument (forward contract) and the firm commitment discounted at 6.00% to determine the net present value.

Date	Fair value of forward contract discounted at 6.00%	Change in fair value of forward contract gain (loss)
September 30, X1	$–	$–
December 31, X1	(97,066)*	(97,066)
March 31, X2	(98,522)**	(1,456)
June 30, X2	(200,000)***	(101,478)
Total		($200,000)

^*[FC 10,000,000 × (0.71 – 0.72)/[1.06/4)]^2 = (97,066)

^**[FC 10,000,000 × (0.71 – 0.72)]/1.06/4 = 98,522

^***[FC 10,000,000 × (0.70 – 0.72)] = 200,000

Hedge Documentation

a. Risk Management Strategy

The objective of the transaction is to hedge the changes in the fair value of the equipment purchase (fair value hedge) firm commitment attributable to changes in foreign currency forward rates between the foreign currency (FC) and the USD. The company entered into a forward contract to purchase FC 10,000,000 on September 30, XI, to receive FC 10,000,000 on June 30, X2 to reduce the risk in the variability of foreign currency exchange rates.

b. Hedging Instrument

A forward contract to buy FC 10,000,000 at an exchange rate of FC 1 = U. S. $0.72 on June 30, X2.

c. Hedged Item

The firm commitment to purchase equipment from foreign supplier at foreign currency 10,000,000 on March 30, X2.

d. Assessing Hedge Effectiveness

The company has performed a critical terms assessment of the derivative instrument and the hedged item and concluded that the changes in fair value attributable to the changes in foreign currency and the USD are expected to be completely offset by the forward contract. The company will perform ongoing effectiveness tests by verifying and documenting that the critical terms of the firm commitment and the forward contract (derivative instrument) match.

The company documented that the critical terms match was as follows.

The following illustrates the financial statement impact over the term of the derivative instrument as well as the firm commitment.

Assets =	Liabilities +	Shareholder’s equity
		+ Foreign exchange gain – Foreign exchange loss

September 30, X1

No impact on financial statements as the forward contract has zero value at inception

December 31,X1

To record the change in fair value of the forward exchange contract

Assets =	Liabilities +	Stockholder’s equity
	+ Forward contract payable + 97,066	– Foreign exchange loss – 97,066

Note: fair value changes are taken from the fair value table above.

To record change in the fair value of the firm commitment that is due to changes in the exchange rate:

Assets =	Liabilities +	Stockholder’s Equity
+ Firm commitment + 97,066		+ Foreign exchange gain + 97,066

Note: for a fair value hedge if the derivative instrument (forward contract) goes out of the money then the accounting rules require that the firm commitment offset the liability recorded that is equal to the loss on foreign exchange, be offset by a gain on foreign exchange with the offset being to an asset account firm commitment.

March 31, X2

To record the change in fair value of the forward exchange contract

Assets =	Liabilities +	Stockholder’s Equity
	+ Forward contract payable + 1,456	– Foreign exchange loss – 1,456

Note: the amount recorded on March 31 increase the balance sheet account forward contract payable to $98,522

To record the change in fair value of the firm commitment due to changes in foreign exchange rates:

Assets =	Liabilities +	Stockholder’s Equity
+ Firm commitment + 1,456		+ Foreign exchange gain + 1,456

Note: the amount recorded on March 31 for the asset account firm commitment will now be equal to the account balance for the forward contract payable.

To record receipt of the equipment on March 31, X2 at the forward contract rate established by the hedging transaction:

Assets =	Liabilities +	Stockholder’s Equity
+ Equipment + 6,998,522 – Firm commitment – 98,522	+ Equipment payable + 6,900,000

Note: the equipment is recorded at the spot price on March 31, X2, of $0.69 × FC 10,000,000 = $6,900,000. The firm commitment asset is written off at its carrying value of $98,522. The equipment then is recorded at the combination of the two amounts. Also, note that the equipment will not be placed in service until the payment date of June 30, X2, so no depreciation would be recorded on June 30, X2.

June 30, X2

To recognize the change in fair value of the forward contract:

Assets =	Liabilities +	Stockholder’s Equity
	+ Forward contract payable + 101,478	– Foreign exchange loss – 101,478

Note: The company has a natural hedge on the derivative instrument since it settled the firm commitment hedge transaction on March 31, X2. The foreign-currency-denominated payable is remeasured to the company’s reporting currency (USD) using the reporting period and changes in the spot rate. For the remainder of the transaction (converting FC to cash to pay the account payable) the change in fair value of the forward contract consists of these components:

This will cause some recorded income statement mismatch in the forward contract the accounts payable owned due to the implicit interest cost of the forward. In the journal entry above, I assumed $98, 522 × (6.00%/4) = $1,478.

To recognize the transaction loss on the foreign currency account payable:

Assets =	Liabilities +	Stockholder’s Equity
	+ Accounts payable + 100,000	– Foreign exchange loss – 100,000

Note: the change in the fair value of accounts payable is based solely on the changes in spot rates. FC 10,000,000 × ($0.69 – $0.70) = $100,000

To record settlement of the forward contract and the accounts payable:

Assets =	Liabilities +	Stockholder’s Equity
– Cash – 7,200,000	– Forward contract payable – 200,000 – Accounts payable – 7,000,000

Note: Settlement of the forward contract at FC 10,000,000 × $0.72 = $7,200,000. Accounts payable is FC 10,000,000 × $0.70 (spot price) = $7,000,000. The forward contract payable is written off when the derivative instrument is settled.

Analysis of the Hedged Transaction

The firm commitment was recorded $6,998,522, which consisted of the accounts payable at the spot price of $0.69 x FC 10,000,000 plus the fair value of the firm commitment. If the company which was very close to the accounts payable of $7,000,000 that was recorded. In addition, gains and losses on the firm commitment were offset, with just a small amount of earnings mismatch when we settled the forward contract. However, the movement of forward rates caused a $200,000 loss on the derivative instrument.

For the next illustration, let’s examine a cash flow using foreign-currency option.

Use of Foreign-Currency Options to Hedge Forecasted Foreign Sales

Company is a U.S. reporting company with sales to foreign customers. The company’s sales are denominated in foreign currencies (FC) but do not meet the accounting guidance for classification as a firm commitment. The company forecasts that as of September 30, X1, foreign currency sales of FC 10,000,000 will occur in 6 months on March 31, X2. The company has historical experience with its customers that the sales are probable of occurring. The company’s risk management policy uses foreign currency put options to hedge the exchange (price) risk when selling to foreign customers. Because this is a hedge of a forecasted transaction, the company will designate as a cash flow hedge of forecasted sales.

The contractual terms and conditions of the foreign currency put are as follows:

Contract items	Put option contract terms
Contract amount	FC 10,000,000
Trade date	September 30, X1
Expiration date	March 31, X2
Foreign currency exercise rate (price)	FC 1 = $0.50
Spot rate	FC 1 = $0.50
Premium	$20,000

The premium paid for the option represents the time value only. Option premiums generally represent the time value only when purchased because the interaction between the foreign currency exercise rate of FC 1 = $0.50 and the spot rate of FC 1 = $0.50 has not moved. The difference in the spot rate from September 30, X1 and March 31, X2 will put the option in the money (spot rate rises above the exercise rate) or out of the money (spot rate falls below the exercise rate). This movement between the two rates is called the intrinsic value of the option. The foreign-currency put option is designated as hedge of the company’s forecasted cash flows, and the company expects the hedge to be perfectly effective because the critical terms of the derivative instrument match the hedged item (forecasted future cash flows from sales). The company will assess hedge effectiveness at inception and over the life of the hedge on the basis of changes in the options intrinsic value—amount of positive value for the difference between the option’s spot exchange rate and the exercise exchange rate. Changes in the time value (premium of $20,000) will not be hedged and will instead be written off to earnings over the term of the contract.

Risk Management Strategy

The objective of the hedged transaction is to eliminate the currency (price) risk associated with the forecasted foreign-currency denominated sales for the company which is a USD reporting currency due to changes in the FC:USD exchange rate. The derivative instrument purchase takes place on September 30, X1.

Hedging Instrument

This is a cash flow hedge in which the hedging instrument is a purchased put option to sell FC 10,000,000 with an exercise price of FC 1: $0.50 USD. The risk exposure being hedged is the variability of the future expected cash flows attributable to a specific change is exchange rates.

Hedged Item

The foreign exchange put option is designated as a foreign currency cash flow hedge of FC 10,000,000 of forecasted foreign currency sales on March 31, X2. The company has determined that the forecasted transaction is probable of occurring based on historical transactions of a similar nature and will update this assessment for each reporting period of the hedged transaction.

Assessing Hedge Effectiveness

The company assessed the critical terms of the derivative instrument and the hedged item (forecasted cash flows) and found a match such that changes in the put options intrinsic value will completely offset the changes in the forecasted cash flows based on changes in the spot rate. The company used the following accounting guidance in determining whether the critical terms of the derivative instrument and the hedged item matched in concluding hedging effectiveness.

The company will assess the critical terms of the hedged transaction to determine if there are any changes that would cause some ineffectiveness. The company will record in other comprehensive income (OCI) changes in the derivative instrument that are effective in offsetting changes in the forecasted cash flows due to changes in the spot rate over the term of the hedged transaction. Any change in the critical terms that cause hedging ineffectiveness between the derivative instrument and the hedged transaction will be recorded in earnings.

Prior to recording the financial statement effects of the hedged transaction, we will examine the valuation of the derivative instrument (put option) over the term of the hedged transaction.

Valuation of the Derivative Instrument

FC/U.S. $ March Contract	9/30/X1	12/31/X1	3/31/X2
Contract rate	2.00	2.00	2.00
Spot rate	2.00	2.10	2.30

Given the information above, we then perform a fair value analysis that will become the basis for recording the financial statement effects and determining hedge effectiveness.

Fair Value Analysis of Derivative Instrument

Date	Time Value	Intrinsic Value	Total Value
9/30/X1	$20,000	$—	$20,000
12/31/X1	9,000	238,0951	247,095
3/31/X1	——	652,1742	652,174

(FC 10,000,000/2.00 = $5,000,000) less (FC 10,000,000/2.10) = $4,761,905 which equals $238,095.

Taking the same $5,000,000 contract rate, we subtract the sport rate of (FC 10,000,000/2.30 = $4,347,826) = $414,079. This is the amount of the increase in intrinsic value for the March 31, X2 reporting period. In the table above, the $414,079 is added to the $238,095 to produce the reported asset value of $652,174.

Note that the time value goes to zero on settlement date. The decreasing value in time value component of the put option will go directly to earnings. However, since we are hedging the forecasted cash flows with the changes in spot rates (intrinsic value) of the derivative instrument, this produces no hedge ineffectiveness.

The following transaction history is an analysis of the financial statement effects of the hedged transaction.

Assets =	Liabilities +	Stockholder’s Equity
		– Loss on hedge + OCI—deferred gain – OCI -deferred loss + Revenue

September 30, X1

To record the foreign currency option at the premium paid:

Assets =	Liabilities +	Stockholder’s Equity
+ Foreign currency option + 20,000 – Cash – 20,000

Note: The option is recorded as an asset when paid and represents the time value of option. Over the term of the hedged transaction, the time value will converge to zero, so we will write this amount off against earnings over the term of the hedged transaction.

December 31, X1

To record the change in time value of the foreign currency option;

Assets =	Liabilities +	Stockholder’s Equity
– Foreign currency option – 11,000		Loss on hedge 11.000

Note: The computation of the time value decrease is a present value calculation using the risk-free rate and the time remaining on the option. For our purposes, they are given values.

To record the change in the intrinsic value of the option;

Assets =	Liabilities +	Stockholder’s Equity
+ Foreign currency option + 238,095		+ OCI + 238,095

Note: The option goes in the money and is recorded as a deferred gain in OCI in Shareholder’s equity.

March 31, X2

To record the change in the time value of the option:

Assets =	Liabilities +	Stockholder’s Equity
– Foreign currency option – 9,000		– Loss on Hedge – 9,000

Note: Time value goes to zero on settlement so we remove the remaining value from the asset account foreign currency option.

To record the change in the intrinsic value of the option:

Assets =	Liabilities +	Stockholder’s Equity
+ Foreign currency option + 414,079		+ OCI + 414,079

Note: Record the increase in the foreign currency option account to reflect changes in the spot rate from 2.10 to 2.30 on March 31, X2.

To record FC 10,000,000 in sales at the current spot rate of 2.30 FC/U.S.$:

Assets =	Liabilities +	Stockholder’s Equity
	+ Cash + 4,347,826	+ Revenue + 4,347,826

Note: The company records the sales of FC 10,000,000 and records the U.S. dollar equivalent in revenue.

To record settlement of the derivative instrument (put option):

Assets =	Liabilities +	Stockholder’s Equity
+ Cash + 652,174 + Foreign currency option + 652,174

Note: The company settles the foreign currency option and receives cash equivalent to its intrinsic value, which is the result of the spot rates moving from 2.00 to 2.30 over the term of the hedged transaction of FC 10,000,000 as compared to the contract rate of 2.00.

To transfer the deferred gains in OCI to earnings:

Assets =	Liabilities +	Stockholder’s Equity
		– OCI – 652,174 + Revenue + 652,174

Note: The hedge was done to assure that the company received at least $5,000,000 from its FC 10,000,000 sales. The transaction above when we cashed out the derivative instrument for $652,174 combined with the spot sales of $4,347,826 accomplishes our objective. The cost of the option contract of $20,000 was the cost of predictability that assured the company of revenue of $5,000,000.

The next two illustrations both involve hedging the net investment in a foreign subsidiary. Subsidiary will be used to describe the relationship when a U.S Company controls the operating and financial policies of a foreign company. The first illustration will use a forward exchange contract and the second illustration will use a non derivative contract to hedge the net investment in a foreign subsidiary. The use of a non-derivative contract in a hedged transaction is one of the exceptions to accounting guidance for hedging activities that is allowed under accounting guidance for foreign operations.

Prior to illustrating a hedge of the net investment in a subsidiary some accounting background is necessary to understand why a company would do the hedged transaction. The risk management strategy for this type of hedge is to protect the net carrying value (assets minus liabilities) of the subsidiary from adverse changes in the local foreign currency that the subsidiary uses during the year to record and report its changes in assets and liabilities. The adverse effect of foreign exchange rates is magnified by the accounting guidance that generally requires assets and liabilities to translated by the U.S. company at the spot rate for the foreign exchange equivalent using the fiscal reporting date at the end of the year.

This arbitrary accounting rule mandates that companys generally use the spot exchange rates of Foreign Currency (FC) USD in the year-end reporting date. However, during the operating year the company has been reporting changes based on exchange rates that were in effect when the transactions were originated and settled. Since exchange rates fluctuate every business day, the translation of foreign controlled companies, balance sheets and income statements to be combined with the U.S. company would never equal and would the accounting equation would be out of balance.

Accounting guidance then rectifies this imbalance by requiring the offset amount needed to balance the combined financial statements by using an account called cumulative translation adjustment (CTA) in shareholder’s equity. For example, if the CTA amount needed to balance the financial statements is a credit (think gain) then the amount is added to shareholder’s equity. If the amount needed to balance the financial statements is a debit (think loss) the CTA is reduced by that amount. The CTA account is a permanent balance sheet account that is carried on the financial statements of the U.S. company until they would divest the foreign subsidiary or sell a large enough interest in the subsidiary that the U.S. company would no longer control the foreign subsidiary.

The risk management strategy is to protect against a large debit CTA (loss from foreign exchange translation) because of the adverse effect on the company’s shareholder equity amount as reported in the combined financial statements. Changes in shareholder equity from one balance sheet date to the next are generally viewed by financial statement users as the amount of earnings retained by the company from its earned income. The amount retained for the current year is net income earned minus the dividends paid. When companies are required by accounting rules to add in other components of shareholder equity the financial analysis of the company can be difficult to assess.

In the previous chapter on accounting for cash flow hedges, the use of the offset account other comprehensive income (OCI) can make this the analysis of changes in assets and liabilities from one year to the next or over time more difficult. In my view, that is why I look at changes to OCI over the term of the hedge as deferred gains or losses. That view does not hold for the cumulative translation adjustment because it is a purely arbitrary rule that allows combined financial statements to be in balance. They are not deferred gains and losses because normally the company has no intention of realizing the CTA amounts by immediate sale of the operating subsidiary. The way to mitigate the adverse changes or to smooth out changes to the reported amount of a foreign subsidiary on the U.S. company’s financial statements is to engage in hedges of the net investment (assets minus liabilities). Since assets minus liabilities is equal to shareholder equity you are hedging the adverse change in arbitrary changes to shareholder equity not due to income earned and dividends paid.

Use of a Forward-Exchange Contract to Hedge a Net Investment in a Foreign Subsidiary

A U.S. Company has a net investment of FC 50,000,000 in a foreign subsidiary. On October 1, X1, the company enters into a six-month forward contract to sell FC 50,000,000 at FC 1 = $1.70, when the spot rate is FC 1 = $1.72 to hedge its entire net investment in foreign subsidiary of FC 50,000,000 as of the beginning of the reporting year.

The company will measure effectiveness based on the changes in the forward rates and on the beginning balance of the net investment in foreign subsidiary at the beginning of the hedging period. This will allow the company to record all changes in the fair value of the derivative instrument (forward contract) to be reported in the cumulative translation adjustment (CTA) account in shareholder’s equity. The company documents that the notional of the forward contract and the hedged item match and the currency of the forward matches the currency of the foreign subsidiary.

Exchange Rates

Date	Spot	Forward
October 1, X1	FC 1 = $1.72	FC 1 = $1.70
December 31, X1	FC 1 = $1.65	FC 1 = $1.63
March 31, X2	FC 1 = $1.60	FC 1 = $1.60

We can take the hypothesized changes in exchange rates and construct our fair value analysis of the derivative instrument and the hedged item.

Fair Value Analysis of Derivative Instrument and Hedged Item

Date	Change in fair value of forward contract (discount rate used is 8%)	Change in fair value of net investment due to changes in the spot rate ( ) represents liability
October 1, X1	$—	$—
December 31, X1	3,431,3731	(3,500,000)3
March 31, X2	1,586,627	(2,500,000)
Cumulative	$5,000,0002	($6,000,000)4

¹Fair value change on December 31, X1, is calculated as [FC 50,000,000X (1.70–1.63)]/[1 +(.08/4)] = $3,431,627. Note: the change in the derivative instrument is calculated using the change in forward rates.

²The $5,000,000 is derived from the calculation FC 50,000,000 X (1.70 –1.60). The change in fair value for March 31, X2, is the difference between the cumulative total and the December 31, X1, change in fair value.

³The $3,500,000 is derived from the calculation FC 50,000,000 X (1.72 – 1.65). Note the changes in the net investment account are computed using the changes in the spot rate, and with no discount attached.

⁴The $6,000,000 is derived from the calculation FC 50,000,000 X (1.72 – 1.60). The $2,500,000 fair value change is the difference between the cumulative change in fair and the change in fair value of the hedged item on December 31, X1.

Hedge Documentation

Risk Management Strategy

The objective of the hedged transaction is to hedge the net investment in foreign subsidiary of the company, against adverse changes in exchange rates. The Company uses the USD for reporting while the foreign subsidiary uses FC in their financial reporting. The hedge is to protect the net investment (Shareholder’s equity) from movements of the FC when translated into the reporting currency U.S. dollar.

Hedging Instrument

Company will use a forward contract to sell FC 50,000,000 at FC 1 = U.S. $ 1.70. The derivative instrument is entered into on October 1, X1, and will be settled on March 31, X2.

Hedged Item

The foreign forward exchange contract is designated as a hedge of the net investment of the foreign subsidiary’s beginning balance of FC 50,000,000 on October 1, X2.

Assessing Hedge Effectiveness

Hedge effectiveness will be assessed at the inception of the hedged term and over the term of the hedged transaction. Effectiveness will be based on overall changes in the fair value of the foreign forward contract. The fair value changes will be based on changes in the forward rate. The critical terms of the hedged transaction including notional, currency, and underlying for the forward contract match the same critical terms of the net investment in foreign subsidiary as of October 1, X1. As a result, the company expects the hedge to be highly effective.

The company will measure effectiveness of the forward contract on the foreign exchange risk of the net investment in subsidiary by using a hypothetical derivative. The changes in the value of the foreign forward contract will be compared to changes in the hypothetic derivative, which will be changes in the net investment in foreign subsidiary over the term of the hedge. The net investment in foreign subsidiary will be hypothetically calculated beginning at October 1, X1, and on required reporting and settlement dates over the term of the hedged transaction. The hypothetical derivatives (net investment in foreign subsidiary) changes in fair value will use the spot rates in effect over the term of the hedged transaction.

The following transaction history of the hedged transaction will demonstrate the financial statement effects.

Assets =	Liabilities +	Stockholder’s Equity
		+Cumulative Translation Adjustment (CTA)

October 1, X1

No entry at inception since the FC forward equals the contract rate

December 31, X1

To record the change in fair value of the forward contract from October 1, X1 as a CTA:

Assets =	Liabilities +	Stockholder’s Equity
+ Forward contract receivable + 3,431,473		+ CTA + 3,431,473

Note: the forward contract receivable goes in the money because the forward rate for the October contract for March settlement decreases on December 31, X1. The offset entry is to increase shareholder equity by increasing the cumulative translation adjustment account for the same amount.

To record the change in the foreign subsidiaries assets and liabilities (net investment in foreign subsidiary) based on changes in the spot rate from October 1, X1 to December 31, X1:

Assets =	Liabilities +	Stockholder’s Equity
– Net investment in foreign subsidiary – 3,500,000		– CTA – 3,500,000

Note: The net investment decrease is calculated as per the table above based on changes in the spot rates from October 1, X1, to December 31, X1. The offset entry to CTA will represent some ineffectiveness due to the derivative instrument using the forward rate to record fair value changes and the hypothetical derivative net investment in foreign subsidiary is using the spot rate. The net investment in foreign subsidiary is carried on the controlling company’s books as a single-line item in their financial statements.

March 31, X2

To record the change in the fair value of the forward contract from December 31, X2, to the settlement date:

Assets =	Liabilities +	Stockholder’s Equity
+ Forward contract receivable + 1,586,627		+ CTA + 1,586,627

Note: Change in the fair value on the forward contract from inception to the settlement date is $5,000,000.

To record the cash settlement of the forward contract:

Assets =	Liabilities +	Stockholder’s Equity
+ Cash + 5,000,000 – Forward contract Receivable – 5,000,000

Note: The forward contract is turned into cash on the settlement date. The $5,000,000 represents the gain from entering into the forward contract on October 1, X1.

To record the cumulative translation adjustment:

Assets =	Liabilities +	Stockholder’s Equity
– Net Investment in foreign subsidiary – 2,500,000		– CTA – 2,500,000

Note: The forward contract went in the money by $5,000,000 while the net investment went out of the money by $6,000,000. However, for these types of hedges there is no ineffectiveness that goes to earnings. From the analysis above, note that all the adjustments are made on the balance sheet accounts of the controlling company. What appears to be ineffectiveness will not be recorded over the term of the hedged transaction.

Analysis

The controlling company will increase cash by $5,000,000 by settling the forward contract. The company will also maintain the cumulative translation adjustment account, which results in a net change of minus $1,000,000 over the term of the hedged transactions and also carry the net investment in foreign subsidiary account at $6,000,000 less than its beginning balance of FC 50,000,000, which would be carried on the company’s books at FC 50,000,000 × 1.72 (spot rate) = $86,000,000.

The mathematical result of the hedged transaction was to record debits for the asset cash (forward contract receivable) and a debit net change of $1,000,000 in the cumulative translation adjustment account, which equals $6,000,000. This amount is offset by the decrease in the net investment in subsidiary account of $6,000,000, which would be the credit change in the account. The total changes when translating the FC into USD for the March 31, X2 reporting date would offset to zero. No ineffectiveness in the hedge.