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Accounting 610
Foreign Currency Transactions and Hedging
Financial Accounting
Dr. David L Senteney
California State University San Bernardino
John Simhachalam
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Abstract
In recent years especially with the advancement of modern technological expertise,
numerous multinational subsidiaries have sprouted off of many local US Corporations. To
mitigate foreign currency risk of exposure, many Financial Instruments like forward contracts,
swaps, and options have been used as foreign currency derivatives to hedge risks of income loss
due to the fluctuating currency markets. In this research paper, I will illustrate two types of
hedging instruments used in multinational corporations such as forward contracts and options. In
addition I will demonstrate how these hedging instruments are presented in the consolidated
financial statements and exactly where these accounting numbers a placed. As the world
constricts with the domination of large multinational corporations, accounting for foreign
currency risk mitigation through hedging derivatives, will signify that the information indicated
is vital for all consolidated financial statement users throughout the world, and especially in the
USA. The ability to properly read and understand reconciled financial statements is usually only
for those that have an accounting background, would make it difficult for the non-accounting
populace to comprehend and properly analyze the statements, especially if they had foreign
currency transaction information. This paper will attempt to educate and facilitate the
understanding of how foreign currency transactions are associated to hedging derivatives plus
their related Financial Instruments and why and where they go on the financial statements.
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Introduction
“International trade (imports and exports) constitutes a significant portion of the world
economy. According to the World Trade Organization, more than $18 trillion worth of
merchandise was exported (and imported) in 2011. Recent growth in trade has been phenomenal.
From 1990 to 2001, global exports increased by 75 percent while global gross domestic product
increased by only 27 percent.”(Timothy Doupnik, 2015) Foreign currency transactions are a vital
part of offshore and multinational corporations throughout the world. Many firms in the United
States presently, are actively importing and exporting goods and services have remarkably
increased by 70% +-5. These export sales and import purchases create a foreign currency
transaction exposure due to fluctuations in the foreign currency markets. These fluctuations arise
from market forces in conjunction to the supply and demand of foreign currencies. Inevitably,
this day to day fluctuation of currencies throughout the world creates specific situations which
unavoidably have to be protected by various hedging instruments.
“Raytheon Company is a U.S. based electronics and defense Systems Company with
more than $6.2 billion of annual export sales. In 2012, 25% of Raytheon’s sales were outside the
United States. Even small businesses are significantly more involved in exporting. Companies
with fewer than five hundred workers comprise a 97% of U.S. exporters”. (Timothy Doupnik,
2015) When a U.S. Company engages itself in foreign exports and imports, the denominated
currency is usually in foreign currency; hence, these companies use hedging derivatives to ensure
some kind protection against foreign currency losses. Commercial and International Banks
provides these services, the most common being foreign currency forward contracts and foreign
currency options. These hedging instruments, more commonly known as derivatives, would
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curb any material risk associated with foreign currency transactions. Before we engage into the
specifics of these hedging instruments and how they are related to the various assets and
liabilities associated with net income, accumulated other comprehensive income, and the balance
sheet we will have to briefly go over some financial and accounting terminology associated with
these topics. It is important to remember that the following jargon used in the accounting and
financial industries for foreign currency transactions are the fundamental foundation of how this
subject matter is taught and explained.
Literature Review including Terminology
Foreign currency transaction-a transaction with a foreign company, and paid with foreign
currency.
Foreign currency risks-risks associated with foreign currency transactions subjected to a
fluctuating currency market, thus being exposed to a foreign currency gain or loss.
Hedge-an investment to reduce the risk of adverse price movements in an asset, such as of
forward contract, or an options contract (Google dictionary).
Financial Instruments-tradeable assets of any kind, including derivatives like forward and
options contracts (Google dictionary)
Derivative-contract between two people or more parties based upon the asset or assets, and its
value is determined by fluctuations in the underlying asset, as in its fair value.
Forward contracts-an informal contract between two parties to buy or sell foreign currency at a
future date for a specific price quoted today and with a settlement date. (Timothy Doupnik,2015)
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Options contract-an agreement between the buyer and the seller that gives the purchaser of the
option the right but not the obligation to buy or sell a particular asset (foreign currency), at a later
date and on an agreed upon price. (Timothy Doupnik, 2015)
Foreign exchange rates-the rate at which one currency can be exchanged for another. (Google
Dictionary)
Foreign currency translation –the expression of amounts denominated in one currency in terms
of another currency by using the rate at which the two currencies are exchanged. When a parent-
subsidiary relationship exist between two companies in different countries using different
currencies, the act or practice of changing the financial statements of the subsidiary to conform
to the accounting standards of the parent’s country, as well as re-denominating the subsidiary’s
currency into the parents currency.(the free dictionary)
Spot rate-the price at which a foreign currency could be purchased or sold today. (Timothy
Doupnik, 2015)
Foreign exchange gains or loss-gains or loss associated with foreign currency transaction risk
due to fluctuations in the currency market.
Forward rates-the rate today at which foreign currency could be bought sometime in the future.
Foreign currency options-is a derivative financial instrument that gives the right but not the
obligation to exchange money denominated in one currency of the pre-agreed exchange rate on a
specified date (Timothy Doupnik, 2015).
Put option-this for the sale of foreign currency by the holder of the option. (Timothy Doupnik,
2015)
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Call option-an option to buy foreign currency at an agreement on price. (Timothy Doupnik,
2015)
Strike price-the exchange rate at which the option will be executed if the holder of the option
decides to exercise the option. (Google dictionary)
Option premium-is a function of two components, the intrinsic value at a time value.
Intrinsic value-a gain that can be a realized if the option is exercised immediately.
Time value-is related to the fact that over time the spot rate will change and bring the option into
the money.
Exports sale-A transaction exposure exists when the exporter allows the buyer to pay in a foreign
currency and also allows the buyer to pay sometime after the sale has been made. (John Bishop
2014)
Import purchase-A transaction exposure exists when the importer is required to pay in foreign
currency and is allowed to pay sometime after the purchase has been made. (John Bishop, 2014)
Balance sheet date-exchange rate as of the date of the balance sheet, terminology mostly used in
translation purposes.
Let’s start by explaining the various ways most foreign currency is assessed, according to
Doupnik and Perera, the 3 ways foreign currency are valued:-
“1. Independent float. The value of the currency is allowed to fluctuate freely according to
market forces, with little or no intervention from the central bank (Australia, Brazil, Canada,
Japan, Mexico, Sweden, Switzerland, and United States).
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2. Pegged to another currency. The value of the currency is fixed (pegged) in terms of a
particular foreign currency, and the central bank intervenes as necessary to maintain the fixed
value. For example, several countries peg their currency to the U.S. dollar (including the
Bahamas and Ecuador).
3. European Monetary System (euro). In 1998, the countries comprising the European Monetary
System adopted a common currency called the euro and established the European Central Bank.
6 Until 2002, local currencies such as the German mark and French franc continued to exist but
were fixed in value in terms of the euro. On January 1, 2002, local currencies disappeared and
the euro became the currency in 12 European countries. In 2013, 17 countries were members of
the “euro zone.” The value of the euro floats against other currencies such as the U.S. dollar.”
(Timothy Doupnik, 2015)
These 3 different methods of foreign currency systems give rise to fluctuations in the
currency markets thus; the rates change from day to day. When the rates change, it produces an
uncertainty in the future effects of transactions that are completed with foreign companies.
These fluctuations are mostly due to the market forces mainly in the supply and demand of these
various currencies. So we can ask ourselves, why these risks exist, how the domestic companies
(US firms) account for the risk, and what methods do the FASB and IASB require for these risks
and its related hedging activities. Taking into consideration the distortions that are created in
processing foreign transactions from its inception to its finality, could be ascertained only with
the correct use of specific derivatives, and its classification would then correspond to what
accounting methods are used and where the accounting information gets placed in the financial
statements.
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Let’s view some examples of how foreign currency risks are created, and how the FASB
wants these risks to be accounted for. We will start with the two instances where foreign
currencies risks could possibly be propagated. Firstly, in an export sale a US Company selling
products or services to a foreign company and will pay in the future with foreign currency. In
this instance when there is a fluctuation of the foreign currency rate the U.S. Company is
exposed to foreign currency gain or loss. Secondly, when a U.S. Company buys products or
services from a foreign company and the U.S. Company has to pay the foreign company with
foreign currency in the future. Due to the fluctuating market forces, again the U.S. Company is
exposed to foreign currency gain or loss; this is called an import purchase. As we know this can
get more complicated when the U.S. Company makes foreign transactions, in either export sale
or import purchases, contrary to the covenant of conservatism, at the balance sheet date all gains
losses have to be accounted for. When these foreign transactions extend past the balance sheet
date, to year two, the gains or losses at the balance sheet date have to be remunerated by the
gains or losses on the settlement date. We need to remind ourselves that these foreign currency
problems only arise when these sales or purchases are made on credit and settled in the future.
Notably, due to this very reason of adhering to FASB and IASB guidelines in foreign currency
transactions, most established foreign currencies have developed spot rates simultaneously with
forward and options rates. As a result, both frameworks allows special form of hedging these
losses and gains, in the practice of hedging derivatives which, if used as required, in most cases
will offset the differences in the Other Comprehensive Income section, or be included in Net
Income. The remaining hedging derivatives or related financial instruments hidden away in
equity in the balance sheet will turn out to be either an asset or liability.
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Forward Contracts
“Foreign currency trades can be executed on the spot and forward basis. The spot rate is
the price at which the foreign currency can be bought a sold today. In contrast, forward rate is
the price today at which the foreign currency can be sold or purchased sometime in the future.
Because many international transactions take some time to be completed, the ability to lock in a
price today at which a foreign currency can be bought or sold at a future date has certain
advantages.”(John Bishop, 2014) As a result these forward rates can determine the evaluation of
a premium or a discount. For example, when the forward rate is higher than the spot rate, then it
is a premium however, when the forward rate is lower than the spot rate, you have a discount.
Any U.S. firm can style forward contracts with banks to meet the needs of the firm, from one
time period to the next, and forward contracts have no up front cost. A firm can take advantage
of forward contracts; two protect it from future losses or otherwise make a valid explanation of
certain gains however, noting that when it comes to foreign currency transactions, one firm’s loss
is another firm’s gain.
“In the forward contract, two parties agree to the sale of some asset on some future date,
called a settlement date at the specific price today.”(Lawrence Revsine, 2015) The forward rate
is also known as being a good predictor of future spot rate. Although forward contracts do
protect certain exposure risks, and there’s still a chance of upside or downside dangers
depending on what the U.S. firm, wants to protect. If the forward rate is higher than the spot rate
at settlement date than you would have been better off to have not contracted forward. However,
for theoretical purposes, the gains and losses still offset the increase or decrease in the fair value
of the abovementioned financial instrument.
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Options contract
To generate more elasticity to the forward contract, the options market has been
developed, as the forward contract has to be honored despite what the spot rate turns out to be.
Considering, that options gives the purchaser the right but not the obligation to purchase the
foreign currency in the future does seem much more user friendly for U.S. firms to conduct
international transactions. There are call options, put options and the strike price. As you have
read in the terminology section of this paper, the significance of the verbiage is essential to the
workings of the options that have been purchased. “Most foreign currency options can be
purchased directly from a bank, the so called over the counter market, but they also may be
purchased on the Philadelphia stock exchange and the Chicago mercantile exchange.” (Lawrence
Revsine, 2015) Hence, although foreign currency options contracting may seem complex, it
however, may be much more user friendly for credit worthy foreign currency transactions.
Taking into consideration that the option premium is based on 2 components, the intrinsic and
time value, they validate how an option may become in the money at strike price. “Options do
not necessarily lock in a specified profit margin of price. Instead to provide a hedge it resembles
insurance. Options allow companies to hedge against downside risks-value losses-while
retaining the opportunity to benefit from favorable price movements”. (Lawrence Revsine, 2015)
As we can see a downside risk is eliminated in the upside potential is retained therefore, although
an option premium has to be paid at startup it certainly has greater benefits for the contract
holder.
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Regulating Hedging Derivatives
Due to the risk of fluctuations in the foreign exchange market, numerous multinational
companies have conducted various hedging techniques using mainly derivatives financial
instruments two of which have been clearly explained above. The Financial Accounting
Standards Board (FASB) and the International Accounting Standards Board (IASB) regulate
how these financial instruments are accounted for on the balance sheet and how their associated
numbers impact the income statement, balance sheet and their related line items. It is imperative
to know the proper accounting for the selected hedging derivatives and in their specific use in
relation to the asset or liability they are associated with in conjunction to how they are regulated
in their presentation on the user firm’s Financial Statements. As reiterated by Viswanathan and
Menon, “As of June 1990, the Financial Accounting Standards Board (FASB), had required
Multi-National Corporations to provide information regarding Foreign Exchange Derivatives. In
SFAS No. 105, the FASB requires companies to disclose the notional amounts of Foreign
Exchange Derivatives. Notional amounts are intended to measure the company’s involvement in
transactions that have off balance sheet risks”. (Viswanathan K.G. and Menon, 2015) To review
the various types of foreign currency hedging derivative financial instruments and how they are
used, it is indispensable to assess them independently to judge their regulatory relationship in
how they are being presented.
Successively, since the use of derivatives mostly has worldwide significance, the
International organization of Securities Commissions (IOSCO) placed the responsibility of
control upon the IASB which then promulgated two standards. The IAS 32, Financial
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Instruments, its Disclosure and Presentation, 1995 which did create a true guidance, and then the
IAS 39, Financial Statements, Recognition and Measurement, which was generated as an interim
guidance which states that:-
1) All derivatives should be reported on the balance sheet at fair value (off- balance sheet
treatment is not acceptable).
2) “Hedge accounting” is acceptable for those derivatives used for hedging purposes provided
the hedging relationship is clearly defined, measurable, and actually effective.
The FASB ASC 830 as well as the IAS 39 delivers some more assistance to the following
foreign currency altercation dangers.
1. Recognized foreign-currency-denominated assets and liabilities.
2. Unrecognized foreign currency firm commitments.
3. Forecast foreign-currency-denominated transactions.
These three forms of hedges have differing methods of accounting for with its related
information being assessed into either in net income or Other Comprehensive Income, which
items include unrealized gains and losses from currency translations (which is not discussed in
this paper) and unrealized gains and losses in derivative instruments. The fair value of the
restated assets and liabilities is shown in the Accumulated Other Comprehensive Income, which
is below the retained earnings, and in the equity section of the balance sheet.
Notably, most unhedged or hedged Fair Value foreign gains and losses, are included in
the line item on the Income Statement called Other Income (Expenses), since these items are
inclusive of other secondary gains or losses from sales of assets, and it is important to include the
specificities of the numbers in the Notes to the Income statement in how they were originated. In
most cases companies indicate the amounts of gains or losses derived from foreign currency
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transactions usually, only if they were material in nature. For example, in the Notes to Financial
Statements in “Its 2012 annual report, Merck & Company Inc. indicated that the income
statement item “Other (Income) Expense, Net” included exchange losses of $185 million in
2012, $143 million in 2011, and $214 million in 2010.” (Viswanathan K.G. and Menon, 2015)
In respect to the gains and losses of recognized foreign currency assets and liabilities
being hedged, specific derivatives instruments such as forward contracts and options mitigate
adverse effects on cash flow and earnings. These derivative financial instruments are carried at
fair value subject a company to conduct foreign transactions due to exchange rate movements
because the gains and losses on these derivatives are intended to offset the gains and losses on
the assets and liabilities that are being hedged. Comparatively, the two things to consider are; is
it a cash flow or a fair value hedge? The cash flow hedge will impact the other comprehensive
income and the fair value hedge will do so in net income. “The Fair Value Exposure-refers to the
change in fair value of an on-balance sheet asset, liability item or a yet-to-be recognized firm
commitment. In this situation, the derivative instrument must be marked to their fair value as if it
were a speculative or investment item. Likewise, the risk exposure is marked to its fair value.
Thus, the offsetting gains and losses are marked and recognized in current earnings
contemporaneously. Cash Flow Exposure-represents the changes in cash flow of an on balance
sheet item or an expected future transaction. The financial results associated with the derivative
instrument are categorized as either “effective” or “ineffective”. The ineffective portion of those
gains or losses is recognized in current earnings. The effective component is carried initially as
“other comprehensive income” (OCI) but subsequently reposted as income during the accounting
period in which forecasted cash flows are recognized.”(CME, 2014).
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Consequently, the gains and losses of a cash flow hedge, are accumulated in the equity section of
the balance sheet in an account titled Accumulated other comprehensive income and they are
unrecognized with respect to net income(i.e. They are not included in net income). As these
unrealized gains and losses are offset, previous accumulated gains or losses are removed from
other comprehensive income and are reclassified in net income, which has the impact of moving
the gain or loss in the equity section of the balance sheet (where each instrument is accounted for
at its fair value) from AOCI to retained earnings. As far as the Fair Value hedges are concerned,
all gains or losses whether realized or unrealized will flow through net income.
My Opinion
As reiterated, foreign currency transactions and accounting for its derivative instruments
appears to be somewhat interdisciplinary as it certainly requires an understanding of finance and
accounting. It’s Finance since it involves exchange rates and the economies of various countries,
foreign and domestic, as in their interest rates and its effect on inflation, as it impacts their
functional currency. Secondly, it is also an accounting endeavor since the diverse hedging
mechanisms selects the differing journal entries and the bearing that these journal entries might
have on the income statement and balance sheet. It is obvious that the only valid reasoning
behind the financial accounting for the constant analysis and remuneration of all related accounts
is to safeguard or streamline the volatility of foreign exchange rates in ones favor. This is mostly
due to the imperfections of capital markets. In this aspect, this very specialized field is not well
understood unless one makes remarkable entry into its complex structure. The movement of local
or parent’s currency units from one account to another to offset effective and ineffective losses
or gains appears to be subjective in nature taking into consideration the specific guidelines
attributable to the firm, their specific industry and materiality are mostly principles based except
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for US GAAP. As it is noted that firms with greater growth opportunities and tighter financial
constraints are more likely to use currency derivatives, however its use can also be connected to
how the hedging program is set, which is by a case to case basis. In certain cases the
management’s involvement in their own monetary compensation into the firm is derived from
their stock measurement, creates a need for its management. Stock options and bonuses thus
certainly influence use of certain foreign currency derivatives for upward growth to dampen
volatility by reducing cash flow variations. After all, one of the many goals of management is to
attain a standard of wealth. There is also the tax implication that can be arranged by the use, or
not use of specific hedging activity which may lead to the manipulation of earnings. In addition,
another vital reasoning behind the use of derivatives is the cost of the hedging program which
includes expertise, administration and the cost of the financial instruments. If the cost is low then
it will become much more available, contrary to if the cost is great, than is it worth offsetting
probable losses? Another complication that may arise is the use of the OCI account which can be
used for manipulating the bottom line. Many large multinational companies usually have no idea
of the specifics of losses and gains that get hidden away in OCI. Yes they are supposed to be
explained in the disclosures and footnotes but only if they are material, therefore creating a
cookie jar effect for earnings management. The empirical evidence for most derivatives on the
financial statements is somewhat limited, and difficult to understand taking into consideration
that most foreign subsidiary companies operate with a completely different set of rules. I believe
that all derivatives should be accounted for on the income statement and nothing placed in OCI
for more transparency toward the financial statement users. The topic of foreign currency
transactions and the use of hedging derivative is an ominous field to tread in, and it has to be
used very challengingly. It’s mostly catered for the larger firms and the more knowledgeable
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hedge managers who know how to use it efficiently and effectively in this global arena that we
call the capital market.
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References
CME. (2014). Deravities and Hedge Accounting. Unknown:Unknown.
free dictionary.(2015). Retrievedfromfree dictionary:thefreedictionary.com
googledictionary.(2015). Retrievedfromgoogle:google.com
JohnBishop,N.J. (2014). PWC Foreign Currency Guide. PWC.
Lawrence Revsine,D.W.(2015). Financial Reporting and Analysis. New York:McGraw Hill.
TimothyDoupnik,H.P.(2015). InternationalAccounting. New York:McGraw Hill.
ViswanathanK.G.andMenon,S.(2005). ForeignCurrencyandRiskManagementPracticesinUS
Multinationals. Journalof InternationalBusinessand Law,Volume 1Issue 1 Article 3.