chapter 9 translation of foreign currency transactions
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Chapter 9Chapter 9
Translation OfTranslation Of
Foreign Currency TransactionsForeign Currency Transactions
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The Need For TranslationThe Need For Translation
Foreign Currency TransactionForeign Currency Transaction– Buying or selling goods or servicesBuying or selling goods or services– Borrowing or lending money Borrowing or lending money
denominated in a foreign currencydenominated in a foreign currency– Acquiring investments that must be paid Acquiring investments that must be paid
for in a foreign currencyfor in a foreign currency– Hedging transactionHedging transaction
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The Need For TranslationThe Need For Translation
Foreign Currency Financial Foreign Currency Financial StatementsStatements– Significantly influenced companiesSignificantly influenced companies– SubsidiariesSubsidiaries
IntegratedIntegrated Self-sustainingSelf-sustaining
– Joint venturesJoint ventures
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TerminologyTerminology SPOT RATESPOT RATE: The term spot rate is : The term spot rate is
used to refer to the exchange rate at a used to refer to the exchange rate at a particular point in time. particular point in time.
In accounting literature, the most In accounting literature, the most relevant spot rate is the one that relevant spot rate is the one that prevails at the Balance Sheet date and, prevails at the Balance Sheet date and, in this context, it is generally referred in this context, it is generally referred to as the to as the current ratecurrent rate..
There are at least two “spot” rates at There are at least two “spot” rates at any point in timeany point in time– Bid rateBid rate– Ask rateAsk rate
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TerminologyTerminology
HISTORIC RATEHISTORIC RATE: : This term is used to refer This term is used to refer to the exchange rate that to the exchange rate that prevailed at the time a prevailed at the time a particular Balance Sheet particular Balance Sheet item was:item was:
- acquired (asset) or- acquired (asset) or- incurred (liability).- incurred (liability).
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Alternative Methods of Alternative Methods of TranslationTranslation
Current / Non-Current MethodCurrent / Non-Current Method
Monetary / Non-Monetary MethodMonetary / Non-Monetary Method
Temporal MethodTemporal Method
Current Rate MethodCurrent Rate Method
CompletelyDiscredited
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The Temporal MethodThe Temporal Method
The ConceptThe Concept– Items valued at current Items valued at current
values are translated values are translated using current exchange using current exchange rates.rates.
– Items valued at historic Items valued at historic values are translated values are translated using historic exchange using historic exchange rates.rates.
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The Temporal MethodThe Temporal Method
ExampleExample– Inventories carried at cost Inventories carried at cost
would be translated at would be translated at historic rateshistoric rates
– Inventories carried at net Inventories carried at net realizable value would be realizable value would be translated at current ratestranslated at current rates
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Temporal As Per Temporal As Per CICA HandbookCICA Handbook
Paragraph 1651.03(c)(i) Paragraph 1651.03(c)(i) The temporal method is a The temporal method is a method of translation that translates assets, liabilities, method of translation that translates assets, liabilities, revenues and expenses in a manner that retains their bases revenues and expenses in a manner that retains their bases of measurement in terms of the Canadian dollar (i.e., it uses of measurement in terms of the Canadian dollar (i.e., it uses the Canadian dollar as the unit of measure). In particular:the Canadian dollar as the unit of measure). In particular:– monetary items are translated at the exchange rate in effect at monetary items are translated at the exchange rate in effect at
the balance sheet date;the balance sheet date;– non-monetary items are translated at historical exchange non-monetary items are translated at historical exchange
rates, unless such items are carried at market, in which case rates, unless such items are carried at market, in which case they are translated at the exchange rate in effect at the they are translated at the exchange rate in effect at the balance sheet date;balance sheet date;
– revenue and expense items are translated at the exchange revenue and expense items are translated at the exchange rate in effect on the dates they occur;rate in effect on the dates they occur;
– depreciation or amortization of assets translated at historical depreciation or amortization of assets translated at historical exchange rates is translated at the same exchange rates as exchange rates is translated at the same exchange rates as the assets to which it relates.the assets to which it relates.
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Temporal As Per Temporal As Per CICA HandbookCICA Handbook
Monetary Items DefinedMonetary Items DefinedParagraph 1651.03(b)Paragraph 1651.03(b) Monetary items are Monetary items are money and claims to money the value of which, money and claims to money the value of which, in terms of the monetary unit, whether foreign in terms of the monetary unit, whether foreign or domestic, is fixed by contract or otherwise. or domestic, is fixed by contract or otherwise. Future Income tax liabilities and assets are Future Income tax liabilities and assets are classified as monetary items.classified as monetary items.
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Temporal As Per Temporal As Per CICA HandbookCICA Handbook
Items specified as non-monetaryItems specified as non-monetary– Investments in equity instruments carried at costInvestments in equity instruments carried at cost– Inventories carried at costInventories carried at cost– Prepaid itemsPrepaid items– Property, plant and equipment and accumulated amortizationProperty, plant and equipment and accumulated amortization– Patents, trademarks, licenses and formulasPatents, trademarks, licenses and formulas– GoodwillGoodwill– Other intangible assets (including deferred charges)Other intangible assets (including deferred charges)– Deferred incomeDeferred income– Share capital (see Paragraph 9-31)Share capital (see Paragraph 9-31)– Revenue and expenses related to non-monetary items, Revenue and expenses related to non-monetary items,
including:including:– Cost of goods soldCost of goods sold– Depreciation and amortization (including amortization of Depreciation and amortization (including amortization of
deferred income)deferred income)
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Temporal As Per Temporal As Per CICA HandbookCICA Handbook
Other Guidance On Monetary ItemsOther Guidance On Monetary Items– Paragraph 1651.47Paragraph 1651.47 Preference shares of a Preference shares of a
foreign operation held by the reporting foreign operation held by the reporting enterprise are translated in the same enterprise are translated in the same manner as common shares (i.e., at historical manner as common shares (i.e., at historical rates) unless redemption is either required or rates) unless redemption is either required or imminent, in which case the current rate is imminent, in which case the current rate is used. ...used. ...
– Paragraph 1651.52Paragraph 1651.52 Future income tax Future income tax liabilities and assets are monetary items and, liabilities and assets are monetary items and, as such, are translated at the current rate.as such, are translated at the current rate.
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Conceptual Definition Vs. CICAConceptual Definition Vs. CICA
The two approaches The two approaches provide identical provide identical resultsresults
References to References to monetary confuse monetary confuse temporal with temporal with monetary vs. non-monetary vs. non-monetarymonetary
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Temporal Method and Temporal Method and FC TransactionsFC Transactions
Paragraph 1651.14Paragraph 1651.14 At the transaction At the transaction date, each asset, liability, revenue or date, each asset, liability, revenue or expense arising from a foreign currency expense arising from a foreign currency transaction of the reporting enterprise transaction of the reporting enterprise should be translated into Canadian dollars should be translated into Canadian dollars by the use of the exchange rate in effect at by the use of the exchange rate in effect at that date. [October, 2006]that date. [October, 2006]
Use Of Averages IfUse Of Averages If– Transactions occur uniformly over the periodTransactions occur uniformly over the period– Exchange rate changes uniformly over the Exchange rate changes uniformly over the
periodperiod
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Temporal Method and Temporal Method and FC TransactionsFC Transactions
Paragraph 1651.16Paragraph 1651.16 At each balance sheet date, At each balance sheet date, monetary items denominated in a foreign currency monetary items denominated in a foreign currency should be adjusted to reflect the exchange rate in should be adjusted to reflect the exchange rate in effect at the balance sheet date. (July, 1983)effect at the balance sheet date. (July, 1983)
Paragraph 1651.18Paragraph 1651.18 At each balance sheet date, At each balance sheet date, for non-monetary assets of the reporting enterprise for non-monetary assets of the reporting enterprise that are carried at market, the Canadian dollar that are carried at market, the Canadian dollar equivalent should be determined by applying the equivalent should be determined by applying the exchange rate in effect at the balance sheet date to exchange rate in effect at the balance sheet date to the foreign currency market price. (July, 1983)the foreign currency market price. (July, 1983)
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Exchange Gains And LossesExchange Gains And Losses
SourceSource– Some items are Some items are
translated at translated at current ratescurrent rates
– As the rate As the rate changes, gains and changes, gains and losses ariselosses arise
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Exchange Gains And LossesExchange Gains And Losses
Balance Balance Sheet ItemSheet Item
Exchange Exchange Rate Rate MovementMovement
Effect on Effect on IncomeIncome
AssetAsset IncreaseIncrease GainGain
AssetAsset DecreaseDecrease LossLoss
LiabilityLiability IncreaseIncrease LossLoss
LiabilityLiability DecreaseDecrease GainGain
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Required Treatment of Required Treatment of Gains and LossesGains and Losses
Paragraph 1651.120Paragraph 1651.120 An exchange gain An exchange gain or loss of the reporting enterprise that or loss of the reporting enterprise that arises on translation or settlement of a arises on translation or settlement of a foreign currency-denominated monetary foreign currency-denominated monetary item or a non-monetary item carried at item or a non-monetary item carried at market should be included in the market should be included in the determination of net income for the determination of net income for the current period. (January, 2002)current period. (January, 2002)
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Required Treatment of Required Treatment of Gains and LossesGains and Losses
An ExceptionAn Exception– Changes in fair value on available-for-Changes in fair value on available-for-
sale investments to Other sale investments to Other Comprehensive IncomeComprehensive Income
– Exchange gains and losses receive Exchange gains and losses receive comparable treatment comparable treatment
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Required Treatment of Required Treatment of Gains and LossesGains and Losses
Foreign Currency Foreign Currency Financial Financial Statements receive Statements receive different treatment different treatment (see Chapter 10)(see Chapter 10)
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DisclosureDisclosure Paragraph 1651.37Paragraph 1651.37 The amount of The amount of
exchange gain or loss included in net exchange gain or loss included in net income should be disclosed (see paragraphs income should be disclosed (see paragraphs 1651.20, 1651.24 and 1651.31). An entity 1651.20, 1651.24 and 1651.31). An entity may exclude from this amount those may exclude from this amount those exchange gains or losses arising on financial exchange gains or losses arising on financial instruments classified as held for trading in instruments classified as held for trading in accordance with "Financial Instruments — accordance with "Financial Instruments — Recognition And Measurement", Section Recognition And Measurement", Section 3855. 3855.
An entity may also exclude from this amount An entity may also exclude from this amount exchange gains or losses on available-for-exchange gains or losses on available-for-sale financial assets and cash flow hedges sale financial assets and cash flow hedges (see "Hedges", Section 3865) included in (see "Hedges", Section 3865) included in any gains or losses removed from any gains or losses removed from accumulated other comprehensive income accumulated other comprehensive income and included in net income for the period. and included in net income for the period. (October, 2006)(October, 2006)
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DisclosureDisclosure
Paragraph Paragraph 1520.031520.03 contains contains an identical an identical recommendationrecommendation
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Foreign Currency Foreign Currency Purchases and SalesPurchases and Sales
Two transaction approach Two transaction approach requiredrequired– Transaction recorded at Transaction recorded at
current ratecurrent rate
– Exchange gains and losses Exchange gains and losses into income as they ariseinto income as they arise
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Foreign Currency Foreign Currency Purchases and SalesPurchases and Sales
On December 12, 2007, a Canadian company purchases Inventory in Switzerland for 100,000 Swiss Francs (SF, hereafter). At this time SF1 = $0.94. When the company closes its books on December 31, 2007, the Inventory is still on hand and the Accounts Payable has not been paid. On this later date SF1 = $0.96.
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Foreign Currency Foreign Currency Purchases and SalesPurchases and Sales
December 12, 2007December 12, 2007
Inventory [(SF)($100,000)($0.94)]Inventory [(SF)($100,000)($0.94)] $94,000$94,000
Accounts PayableAccounts Payable $94,000$94,000
December 31, 2007December 31, 2007
Exchange LossExchange Loss
[(SF100,000)($0.96 - $0.94)][(SF100,000)($0.96 - $0.94)] $2,000$2,000
Accounts PayableAccounts Payable $2,000$2,000
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Foreign Currency Foreign Currency Capital TransactionCapital Transaction
Example
On December 31, 2008, a Canadian Company with a December 31 year end borrows €1,000,000. At this time €1 = $1.40.
On December 31, 2009, the rate for the Euro is €1 = $1.50 and on December 31, 2010, the rate is €1 - $1.55. On this latter date the loan is repaid.
Ignore interest payments.
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Foreign Currency Foreign Currency Capital TransactionCapital Transaction
December 31, 2008December 31, 2008
Cash [(€1,000,000)($1.40)]Cash [(€1,000,000)($1.40)]$1,400,00$1,400,00
00
LiabilitiesLiabilities$1,400,0$1,400,0
0000
December 31, 2009December 31, 2009
Exchange LossExchange Loss
[(€ 1,000,000)($1.50 - $1.40)[(€ 1,000,000)($1.50 - $1.40) $100,000$100,000
LiabilitiesLiabilities $100,000$100,000
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Foreign Currency Capital Foreign Currency Capital TransactionTransaction
December 31, 2010December 31, 2010
Exchange Loss Exchange Loss
[(€1,000,000)($1.55 - $1.50)][(€1,000,000)($1.55 - $1.50)] $50,000$50,000
LiabilitiesLiabilities $50,000$50,000
December 31, 2010December 31, 2010
Liabilities [Liabilities [€1,000,000)($1.55)]€1,000,000)($1.55)]$1,550,00$1,550,00
00
CashCash$1,550,00$1,550,00
00
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Held-To-Maturity Held-To-Maturity InvestmentsInvestments
Example
On January 1, 2008, Empire Inc. acquires £200,000 in long-term debt of a British company. At this time £1 = $2.15.
On December 31, 2008, when Empire Inc. closes its books, the exchange rate is £1 = $2.25.
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Held-To-Maturity Held-To-Maturity InvestmentsInvestments
January 1, 2008January 1, 2008
Bonds [(£200,000)($2.15)]Bonds [(£200,000)($2.15)] $430,000$430,000
CashCash $430,000$430,000
December 31, 2008December 31, 2008
Bonds [(£200,000)($2.25 - $2.15)]Bonds [(£200,000)($2.25 - $2.15)] $20,000$20,000
Exchange GainExchange Gain $20,000$20,000
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Available-For-Sale At Cost Available-For-Sale At Cost InvestmentsInvestments
ExampleOn January 1, 2008, Empire Inc. acquires £200,000 in equity securities of a British company.
At this time £1 = $2.15. The investment is classified as available for sale and the shares do not have a quoted market price.
On December 31, 2008, when Empire Inc. closes its books, the exchange rate is £1 = $2.25.
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Available-For-Sale At Cost Available-For-Sale At Cost InvestmentsInvestments
January 1, 2008January 1, 2008
Shares [(£200,000)($2.15)]Shares [(£200,000)($2.15)] $430,000$430,000
CashCash $430,000$430,000
December 31, 2008December 31, 2008
No Entry Is RequiredNo Entry Is Required
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Held-For-Trading Held-For-Trading InvestmentsInvestments
ExampleOn January 1, 2008, Empire Inc. acquires £200,000 in equity securities of a British company.
At this time £1 = $2.15. The investment is classified as held for trading.
On December 31, 2008, when Empire Inc. closes its books, the market value of the securities has increased to £215,000 and the exchange rate is £1 = $2.25.
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Held-For-Trading Held-For-Trading InvestmentsInvestments
January 1, 2008January 1, 2008
Shares [(£200,000)($2.15)]Shares [(£200,000)($2.15)] $430,000$430,000
CashCash$430,00$430,00
00
December 31, 2008December 31, 2008
Shares [(£215,000)($2.25) - $430,000]Shares [(£215,000)($2.25) - $430,000] $53,750 $53,750
Fair Value Gain – Net IncomeFair Value Gain – Net Income
[(£215,000 - £200,000)[(£215,000 - £200,000)($2.25)]($2.25)]
$33,75$33,7500
Exchange Gain – Net IncomeExchange Gain – Net Income
[(£200,000)($2.25 - $2.15)][(£200,000)($2.25 - $2.15)] 20,00020,000
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Available-For-Sale At Fair Value Available-For-Sale At Fair Value InvestmentsInvestments
ExampleOn January 1, 2008, Empire Inc. acquires £200,000 in equity securities of a British company.
At this time £1 = $2.15. The investment is classified as available for sale.
On December 31, 2008, when Empire Inc. closes its books, the market value of the securities has increased to £215,000 and the exchange rate is £1 = $2.25.
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Available-For-Sale At Fair Value Available-For-Sale At Fair Value InvestmentsInvestments
January 1, 2008January 1, 2008
Shares [(£200,000)($2.15)]Shares [(£200,000)($2.15)] $430,000$430,000
CashCash $430,000$430,000
December 31, 2008December 31, 2008
Shares [(£215,000)($2.25) - Shares [(£215,000)($2.25) - $430,000]$430,000] $53,750$53,750
Fair Value Gain – OCIFair Value Gain – OCI
[(£215,000 - £200,000)[(£215,000 - £200,000)($2.25)]($2.25)] $33,750$33,750
Exchange Gain - OCIExchange Gain - OCI
[(£200,000)($2.25 - $2.15)][(£200,000)($2.25 - $2.15)] 20,00020,000
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Available-For-Sale At Fair Value Available-For-Sale At Fair Value InvestmentsInvestments
ReclassificationReclassificationIf investments are sold, the If investments are sold, the
Other Comprehensive Other Comprehensive Income amounts will be Income amounts will be reclassified into Net reclassified into Net IncomeIncome
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HedgingHedging
An extremely complex An extremely complex areaarea
Our coverage is limited Our coverage is limited to simple applications to simple applications in the area of foreign in the area of foreign exchange riskexchange risk
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HedgingHedging Paragraph 3865.02Paragraph 3865.02
Hedging is an activity Hedging is an activity designed to modify an designed to modify an entity's exposure to one entity's exposure to one or more risks by creating or more risks by creating an offset between an offset between changes in the fair value changes in the fair value of, or the cash flows of, or the cash flows attributable to, the attributable to, the hedged item and the hedged item and the hedging item (or changes hedging item (or changes resulting from a resulting from a particular risk exposure particular risk exposure relating to those items).relating to those items).
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Hedged Items In GeneralHedged Items In General
Paragraph 3865.07(c)Paragraph 3865.07(c) A hedged item is all or a A hedged item is all or a specified portion of a recognized asset, a specified portion of a recognized asset, a recognized liability, an anticipated transaction, or recognized liability, an anticipated transaction, or a net investment in a self-sustaining foreign a net investment in a self-sustaining foreign operation, or a group of similar recognized assets, operation, or a group of similar recognized assets, recognized liabilities or anticipated transactions, recognized liabilities or anticipated transactions, having an identified risk exposure that an entity having an identified risk exposure that an entity has taken steps to modify.has taken steps to modify.
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Hedged Items: Hedged Items: Foreign Currency ApplicationsForeign Currency Applications
Foreign currency denominated Foreign currency denominated monetary assets or monetary monetary assets or monetary liabilitiesliabilities
Anticipated TransactionsAnticipated Transactions– Firm commitmentsFirm commitments– Forecasted transactionsForecasted transactions
Investments in self-sustaining foreign Investments in self-sustaining foreign operationsoperations
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Hedging Items In GeneralHedging Items In General
Paragraph 3065.07(d)Paragraph 3065.07(d) A hedging item is all A hedging item is all or a specified percentage of a derivative, or all or or a specified percentage of a derivative, or all or a specified percentage of a group of derivatives a specified percentage of a group of derivatives offsetting a risk exposure identified in the offsetting a risk exposure identified in the hedged item. All or a specified percentage of:hedged item. All or a specified percentage of:– (i) a non-derivative financial asset;(i) a non-derivative financial asset;– (ii) a non-derivative financial liability; or(ii) a non-derivative financial liability; or– (iii) a group of non-derivative financial assets or non-(iii) a group of non-derivative financial assets or non-
derivative financial liabilities, provided that all non-derivative financial liabilities, provided that all non-derivative items in a group are similar;derivative items in a group are similar;
may be designated as a hedging item only for a may be designated as a hedging item only for a hedge of a foreign currency risk exposure.hedge of a foreign currency risk exposure.
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Hedging Items: Hedging Items: Foreign Currency ApplicationsForeign Currency Applications
ExampleOn July 1, 2008, a Canadian company purchases merchandise in France for €200,000.
At this time €1 = $1.40.
The merchandise must be paid for on December 31, 2008.
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Hedging Items: Hedging Items: Foreign Currency ApplicationsForeign Currency Applications
Purchase Euros on July 1, 2008Purchase Euros on July 1, 2008– Effective but costly (no return on funds)Effective but costly (no return on funds)
Purchase financial asset Purchase financial asset denominated in Eurosdenominated in Euros– Some rate of returnSome rate of return– Low rates on short term investmentsLow rates on short term investments
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Hedging Items: Hedging Items: Foreign Currency ApplicationsForeign Currency Applications
Purchase non-financial assets Purchase non-financial assets denominated in Eurosdenominated in Euros– InconvenientInconvenient– May or may not be effectiveMay or may not be effective
Forward contract to take delivery of Forward contract to take delivery of Euros on December 31, 2008Euros on December 31, 2008– EffectiveEffective– Requires no investment of fundsRequires no investment of funds
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A Derivatives PrimerA Derivatives Primer Paragraph 3855.19(e)Paragraph 3855.19(e) A derivative is a financial A derivative is a financial
instrument or other contract within the scope of this instrument or other contract within the scope of this Section with all three of the following characteristics:Section with all three of the following characteristics:
(i) its value changes in response to the change in a (i) its value changes in response to the change in a specified interest rate, financial instrument price, specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or other variable rates, a credit rating or credit index, or other variable (sometimes called the "underlying"), provided in the case of (sometimes called the "underlying"), provided in the case of a non-financial variable that the variable is not specific to a a non-financial variable that the variable is not specific to a party to the contract;party to the contract;
(ii) it requires no initial net investment or an initial net (ii) it requires no initial net investment or an initial net investment that is smaller than would be required for other investment that is smaller than would be required for other types of contracts that would be expected to have a similar types of contracts that would be expected to have a similar response to changes in market factors; andresponse to changes in market factors; and
(iii) it is settled at a future date.(iii) it is settled at a future date.
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A Derivatives PrimerA Derivatives Primer
TypesTypes– ContractsContracts
ForwardsForwards FuturesFutures Both parties must performBoth parties must perform
– OptionsOptions Only one party required to performOnly one party required to perform
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A Derivatives PrimerA Derivatives Primer
Accounting proceduresAccounting procedures– Initial recognition at fair value (often nil)Initial recognition at fair value (often nil)– Subsequent measurement at fair valueSubsequent measurement at fair value– Gains and losses to Net Income (in general)Gains and losses to Net Income (in general)
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Forward Exchange ContractsForward Exchange Contracts
Example (From Text Paragraph 9-99)
On January 1, 2007, Sandor Inc., a Canadian public company, enters into a forward exchange contract to take delivery of £100,000 on December 31, 2007 at a rate of £1 = $2.30.
On January 1, 2007, the exchange rate is £1 = $2.26.
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Forward Exchange ContractsForward Exchange Contracts
Initial RecognitionInitial Recognition– No consideration for contractNo consideration for contract– Fair value = nilFair value = nil– No recognition in the financial No recognition in the financial
statementsstatements
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Forward Exchange ContractsForward Exchange Contracts
Settlement on December 31, 2007 when Settlement on December 31, 2007 when rate is £1 = $2.33.rate is £1 = $2.33.
December 31, 2007December 31, 2007
Cash [(£100,000)($2.33)]Cash [(£100,000)($2.33)] $233,000$233,000
Cash [(£100,000)($2.30)]Cash [(£100,000)($2.30)] $230,000$230,000
Gain On ContractGain On Contract 3,0003,000
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Forward Exchange ContractsForward Exchange Contracts
If Balance Sheet date occurred prior to settlement of the contract, the fair value of the contract would have to be recorded in the Balance Sheet. This would result in a gain or loss to be included in Net Income.
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Hedge AccountingHedge Accounting
Objective
Hedge accounting is a method for recognizing the gains, losses, revenues and expenses associated with the items in a hedging relationship such that those gains, losses, revenues and expenses are recognized in net income in the same period when they would otherwise be recognized in different periods.
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Hedge AccountingHedge Accounting
Its use is optionalIts use is optional– Often not necessary Often not necessary
(e.g., contract hedging a (e.g., contract hedging a monetary asset)monetary asset)
– Sometimes cannot qualifySometimes cannot qualify
– Management may decide not Management may decide not to useto use
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Hedge AccountingHedge Accounting
QualificationQualification– DesignationDesignation
– DocumentationDocumentation
– Evaluation for effectiveness Evaluation for effectiveness (Beyond the scope of this text)(Beyond the scope of this text)
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Fair Value HedgesFair Value Hedges
Under this approach, gains and Under this approach, gains and losses on the hedging item losses on the hedging item must be included in Net must be included in Net Income. Income.
Gains and losses on the Gains and losses on the hedged item that are hedged item that are attributable to the hedged risk attributable to the hedged risk must also be included in Net must also be included in Net Income. Income.
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5757
Fair Value HedgesFair Value Hedges
Fair value hedge accounting can be used Fair value hedge accounting can be used when the hedge is a hedge of the when the hedge is a hedge of the exposure to changes in the fair value of:exposure to changes in the fair value of:
– a recognized asset or liability;a recognized asset or liability;
– an unrecognized firm commitment; oran unrecognized firm commitment; or
– an identified portion of such an asset, an identified portion of such an asset, liability, or firm commitment. liability, or firm commitment.
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Cash Flow Hedge Cash Flow Hedge AccountingAccounting
Cash Flow Hedge AccountingCash Flow Hedge Accounting Under this approach, gains and Under this approach, gains and losses on the hedging item are losses on the hedging item are treated as items of Other treated as items of Other Comprehensive Income, rather than Comprehensive Income, rather than as items to be included in the as items to be included in the determination of Net Income. determination of Net Income.
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5959
Cash Flow Hedge Cash Flow Hedge AccountingAccounting
Cash flow hedge accounting can be Cash flow hedge accounting can be used when the hedge is a hedge of used when the hedge is a hedge of the exposure to variability in cash the exposure to variability in cash flows associated with:flows associated with:– a recognized asset or liability;a recognized asset or liability;
– a forecasted transaction; ora forecasted transaction; or
– the foreign currency risk in an the foreign currency risk in an unrecognized firm commitment.unrecognized firm commitment.
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Hedge Of Exposed Monetary BalanceHedge Of Exposed Monetary Balance
ExampleOn November 1, 2008, Torcan Ltd. a Canadian company with a December 31 year end, sells merchandise in Switzerland for 1,000,000 Swiss Francs (SF, hereafter). Assume that, at this time, the exchange rate is SF1 = $0.90.
On December 31, 2008, the exchange rate is SF1 = $0.92.
The merchandise is paid for on February 1, 2009 when the exchange rate is SF1 = $0.95.
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Example – No Hedge Example – No Hedge AccountingAccounting
November 1, 2008November 1, 2008
Receivable [(SF1,000,000)($0.90)]Receivable [(SF1,000,000)($0.90)] $900,000$900,000
SalesSales $900,000$900,000
December 31, 2008December 31, 2008
Receivable [(SF1,000,000)($0.92 - Receivable [(SF1,000,000)($0.92 - $0.90)]$0.90)] $20,000$20,000
Exchange GainExchange Gain $20,000$20,000
© 2008 Clarence Byrd In© 2008 Clarence Byrd Inc.c.
6262
Example – No Hedge Example – No Hedge AccountingAccounting
February 1, 2009February 1, 2009
Receivable [(SF1,000,000)($0.95 - Receivable [(SF1,000,000)($0.95 - $0.92)]$0.92)] $30,000$30,000
Exchange GainExchange Gain $30,000$30,000
CashCash $950,000$950,000
ReceivableReceivable $950,000$950,000
© 2008 Clarence Byrd In© 2008 Clarence Byrd Inc.c.
6363
Example – Example – Hedge With Forward ContractHedge With Forward Contract
ExampleOn November 1, 2008, Torcan Ltd. a Canadian company with a December 31 year end, sells merchandise in Switzerland for 1,000,000 Swiss Francs (SF, hereafter). Assume that, at this time, the exchange rate is SF1 = $0.90.
On December 31, 2008, the exchange rate is SF1 = $0.92.
The merchandise is paid for on February 1, 2009 when the exchange rate is SF1 = $0.95.
HedgeOn November 1, 2008, Torcan enters a contract to deliver SF1,000,000 on February 1, 2009 at a rate of SF1 = $0.92.
On December 31, 2008 the one month forward rate is SF1 = $0.93, resulting in a fair value for the contract of $9,950.
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6464
Example – Example – Hedge With Forward ContractHedge With Forward Contract
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6565
Example – Example – Hedge With Forward ContractHedge With Forward Contract
November 1, 2008November 1, 2008
Receivable [(SF1,000,000)($0.90)]Receivable [(SF1,000,000)($0.90)]$900,00$900,00
00
SalesSales $900,000$900,000
December 31, 2008December 31, 2008
Receivable [(SF1,000,000)($0.92 - Receivable [(SF1,000,000)($0.92 - $0.90)]$0.90)] $20,000$20,000
Exchange GainExchange Gain $20,000$20,000
Exchange LossExchange Loss $9,950$9,950
Forward Contract (Liability)Forward Contract (Liability) $9,950$9,950
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Example – Example – Hedge With Forward ContractHedge With Forward Contract
February 1, 2009February 1, 2009
Receivable [(SF1,000,000)($0.95 - Receivable [(SF1,000,000)($0.95 - $0.92)]$0.92)] $30,000$30,000
Exchange GainExchange Gain $30,000$30,000
Exchange Loss – Exchange Loss – [(SF1,000,000)($0.95 - $0.92) - [(SF1,000,000)($0.95 - $0.92) - $9,950)]$9,950)] $20,050$20,050
Forward ContractForward Contract $20,050$20,050
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6767
Example – Example – Hedge With Forward ContractHedge With Forward Contract
February 1, 2009February 1, 2009
CashCash $950,000$950,000
ReceivableReceivable $950,000$950,000
Cash [(SF1,000,000)($0.92)]Cash [(SF1,000,000)($0.92)] $920,000$920,000
Forward Contract ($9,950 + $20,050)Forward Contract ($9,950 + $20,050) 30,00030,000
Cash [(SF1,000,000)($0.95)]Cash [(SF1,000,000)($0.95)] $950,000$950,000
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6868
Hedge Of Exposed Monetary BalanceHedge Of Exposed Monetary Balance
ExampleOn October 1, 2008, Ardin Ltd. commits to purchasing merchandise in Germany at a cost of €500,000. At this time the spot rate for Euros is €1 = $1.57. The merchandise is to be delivered and paid for on May 1, 2009.
On October 1, 2008, Ardin also acquires a term deposit with a maturity value of €500,000 (ignore the interest that would accrue on this asset).
On December 31, 2008, when Ardin closes its books, the exchange rate has decreased to €1 = $1.55. On May 1, 2009, the rate is €1 = $1.52.
© 2008 Clarence Byrd In© 2008 Clarence Byrd Inc.c.
6969
Example – No Hedge Example – No Hedge AccountingAccounting
October 1, 2008October 1, 2008
Term Deposit [(€500,000)($1.57)]Term Deposit [(€500,000)($1.57)] $785,000$785,000
CashCash $785,000$785,000
December 31, 2008December 31, 2008
Exchange Loss [(€500,000)($1.55 - Exchange Loss [(€500,000)($1.55 - $1.57)]$1.57)] $10,000$10,000
Term DepositTerm Deposit $10,000$10,000
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Example – No Hedge Example – No Hedge AccountingAccounting
May 1, 2009May 1, 2009
Exchange Loss [(€500,000)($1.55 - Exchange Loss [(€500,000)($1.55 - $1.52)]$1.52)] $15,000$15,000
Term DepositTerm Deposit $15,000$15,000
Cash [(€500,000)($1.52)]Cash [(€500,000)($1.52)] $760,000$760,000
Term DepositTerm Deposit $760,000$760,000
Merchandise [(€500,000)($1.52)]Merchandise [(€500,000)($1.52)] $760,000$760,000
CashCash $760,000$760,000
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7171
Example – No Hedge Example – No Hedge AccountingAccounting
The economic gain on the commitment (i.e., the purchase will now cost less) cannot be recognized.
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7272
Hedge Of Exposed Monetary BalanceHedge Of Exposed Monetary Balance
ExampleOn October 1, 2008, Ardin Ltd. commits to purchasing merchandise in Germany at a cost of €500,000. At this time the spot rate for Euros is €1 = $1.57. The merchandise is to be delivered and paid for on May 1, 2009.
On October 1, 2008, Ardin also acquires a term deposit with a maturity value of €500,000 (ignore the interest that would accrue on this asset).
On December 31, 2008, when Ardin closes its books, the exchange rate has decreased to €1 = $1.55. On May 1, 2009, the rate is €1 = $1.52.
Document the hedging relationship and use Cash Flow Hedge Accounting.
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7373
Example – Example – Cash Flow Hedge AccountingCash Flow Hedge Accounting
October 1, 2008October 1, 2008
Term Deposit [(€500,000)($1.57)]Term Deposit [(€500,000)($1.57)] $785,000$785,000
CashCash$785,00$785,00
00
December 31, 2008December 31, 2008
OCI - Exchange Loss [(€500,000)($1.55 - OCI - Exchange Loss [(€500,000)($1.55 - $1.57)]$1.57)] $10,000$10,000
Term DepositTerm Deposit $10,000$10,000
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7474
Example – Example – Cash Flow Hedge AccountingCash Flow Hedge Accounting
May 1, 2009May 1, 2009
OCI - Exchange Loss [(€500,000)($1.55 - OCI - Exchange Loss [(€500,000)($1.55 - $1.52)]$1.52)] $15,000$15,000
Term DepositTerm Deposit $15,000$15,000
Cash [(€500,000)($1.52)]Cash [(€500,000)($1.52)]$760,00$760,00
00
Term DepositTerm Deposit$760,00$760,00
00
Merchandise [(€500,000)($1.52)]Merchandise [(€500,000)($1.52)]$760,00$760,00
00
CashCash$760,00$760,00
00
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Example – Example – Cash Flow Hedge AccountingCash Flow Hedge Accounting
Alternative 1 – Reclassify ImmediatelyAlternative 1 – Reclassify Immediately
May 1, 2009May 1, 2009
MerchandiseMerchandise $25,000$25,000
OCI – Reclassification AdjustmentOCI – Reclassification Adjustment $25,000$25,000
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7676
Example – Example – Cash Flow Hedge AccountingCash Flow Hedge Accounting
Alternative 2 – Reclassify When Merchandise SoldAlternative 2 – Reclassify When Merchandise Sold
January 1, 2010January 1, 2010
Cost Of Goods SoldCost Of Goods Sold $760,00$760,0000
MerchandiseMerchandise $760,00$760,0000
Cost Of Goods SoldCost Of Goods Sold $25,000$25,000
OCI – Reclassification AdjustmentOCI – Reclassification Adjustment $25,000$25,000
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7777
Hedge Of Net Investment Hedge Of Net Investment In Self-Sustaining OperationIn Self-Sustaining Operation
Paragraph 3865.58Paragraph 3865.58 A hedge of a net investment in a self- A hedge of a net investment in a self-sustaining foreign operation, including a hedge of a monetary item sustaining foreign operation, including a hedge of a monetary item that is accounted for as part of the net investment (see “Foreign that is accounted for as part of the net investment (see “Foreign Currency Translation”, Section 1651), should be accounted for as Currency Translation”, Section 1651), should be accounted for as follows:follows:– (a) the portion of the gain or loss on the hedging item that is (a) the portion of the gain or loss on the hedging item that is
determined to be an effective hedge (see paragraphs 3865.08 determined to be an effective hedge (see paragraphs 3865.08 -.45) should be recognized in other comprehensive income (see -.45) should be recognized in other comprehensive income (see “Comprehensive Income”, Section 1530); and“Comprehensive Income”, Section 1530); and
– (b) the ineffective portion of the gain or loss on the hedging (b) the ineffective portion of the gain or loss on the hedging item should be recognized in net income.item should be recognized in net income.
The gain or loss on the hedging item relating to the effective portion The gain or loss on the hedging item relating to the effective portion of the hedge that has been recognized in other comprehensive of the hedge that has been recognized in other comprehensive income should be recognized in net income in the same period income should be recognized in net income in the same period during which corresponding exchange gains or losses arising from during which corresponding exchange gains or losses arising from the translation of the financial statements of the self-sustaining the translation of the financial statements of the self-sustaining foreign operation are recognized in net income. (October, 2006)foreign operation are recognized in net income. (October, 2006)
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7878
Hedge Of Net Investment Hedge Of Net Investment In Self-Sustaining OperationIn Self-Sustaining Operation
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7979
Hedge Of Net Investment Hedge Of Net Investment In Self-Sustaining OperationIn Self-Sustaining Operation
Reduction In Net InvestmentReduction In Net Investment– Paragraph 1651.31Paragraph 1651.31 An appropriate An appropriate
portion of the exchange gains and losses portion of the exchange gains and losses accumulated in the separate component accumulated in the separate component of accumulated other comprehensive of accumulated other comprehensive income should be included in the income should be included in the determination of net income when there determination of net income when there is a reduction in the net investment. is a reduction in the net investment. (October, 2006)(October, 2006)
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Discontinuance Of Discontinuance Of Hedge AccountingHedge Accounting
Discontinue If:Discontinue If:– The hedging item ceases to existThe hedging item ceases to exist– The hedged item ceases to existThe hedged item ceases to exist– It becomes probable that an anticipated It becomes probable that an anticipated
transaction will not occurtransaction will not occur– The entity terminates the hedging designationThe entity terminates the hedging designation– The hedging relationship ceases to be effectiveThe hedging relationship ceases to be effective
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International ConvergenceInternational Convergence
Hedging covered in IAS Hedging covered in IAS No. 39, No. 39, Financial Financial InstrumentsInstruments– No differences that impact No differences that impact
on the material covered in on the material covered in this text this text
Other foreign currency Other foreign currency issues in Chapter 10 issues in Chapter 10
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