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Accounting for Foreign Currency
Transactions and Hedging
Foreign Currency Transactions
Foreign Currency Transaction vs. Foreign Currency
Translation
Foreign Currency Transaction : Transactions to be settled in a foreign currency and financial statements of an affiliate maintained in a foreign currency are translated into pesos by multiplying the number of units of the foreign currency by direct exchange rates. Foreign Currency Translation : The process of expressing monetary amounts that are stated in terms of a foreign currency into the currency of the reporting entity by using an appropriate exchange rate.
Exchange Rate
The ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged at a particular time. Direct Exchange Quotation : Exchange rate is quoted in terms of how many units of the domestic currency can be converted into one unit of foreign currency. To translate dollars into pesos, the number of dollars is MULTIPLIED by the direct exchange rate expressed in PESO PER DOLLAR. Indirect Exchange Quotation : Exchange rate is quoted in terms of converting one unit of domestic currency into units of foreign currency. To translate dollars into pesos, the number of dollars could also be DIVIDED by the indirect exchange rate expressed in DOLLAR PER PESO.
Kinds of Exchange Rates
Spot Rate (SR) : Rate TODAY and applicable TODAY Selling Spot Rate: Charged by the bank for current sales of the foreign currency. Buying Spot Rate: Rate at which money dealers will buy foreign currency. Spread: The difference between the selling and buying spot rate represents the gross profit of the trader in foreign currency. Future Rate (FR) : Rate TODAY applicable in the FUTURE; also known as FORWARD RATE. Historical Rate (HR) : Spot rate in the Transaction date. Closing Rate (CR) : Spot rate in the Balance Sheet date. Actual Rate (AR) : Spot rate in the Settlement date.
Functional Currency
PAS 21: It is the currency of the primary economic environment in which the entity operates. It is the currency that influences the sales prices of goods and services and the currency in which a firm receives most of its cash receipts and expends cash outlays. A transaction that requires settlement or payment in foreign currency is called a foreign currency transaction.
Important Dates to be Considered in Foreign Exchange
Transactions
Transaction Date (TD) : The date when the purchase or sale of goods or services or currency takes place. Rate used: SPOT/HISTORICAL. Balance Sheet Date (BD) : The date when closing rates will be applied in computing for the FOREX gain or loss. Rate used: SPOT/CLOSING. Settlement Date (SD) : The date when payment or receipt shall be made and the FOREX gain or loss computed. Rate Used: SPOT/ ACTUAL.
Transaction Exposure
It is the level of risk that currency change rates will change after a company has entered into, for example, a financial obligation. Transaction exposure measures gain or loss arising from financial obligations stated in terms of foreign currency.
Foreign Exchange (Forex) Losses
Increases in the selling spot rate for a foreign currency required by a Philippine Company to settle a liability denominated in that currency. Decreases in the buying spot rate.
Foreign Exchange (Forex) Gains
Decreases in the selling spot rate. Increases in the buying spot rate.
Purchase of Merchandise from Foreign Supplier
On November 15, 2020, VVL Corporation purchased merchandise from a U.S. firm for US$ 10,000 and opened a letter of credit with Bank of Philippine Island (BPI) to cover the importation. Bank service charge amounted to P1,500. The selling spot rate issued by BPI for US$ at various dates: Date of arrival of goods – December 15, 2020: P50. Balance Sheet Date – December 31, 2020: P50. Date of Receipt of importation documents and the required payment of the Letter of Credit to BPI – January 10, 2021: P50.
Types of Derivatives
Option-based derivatives : Have a one-sided exposure where one party can potentially have a favorable outcome for which it pays a premium at inception, while the other party can potentially have only an unfavorable outcome for which it is paid the premium at inception. Non-option-based derivatives : The downside risk and the upside potential on the hedged item are counterbalanced. Examples include forwards, futures, and swaps.
Hedging
Hedging is a risk management technique done by making an investment or acquiring some derivative instruments or even non- derivative instruments in order to offset potential losses or gains that may be incurred on some items as a result of a particular risk. A hedging relationship has two components: Hedge item : An asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that exposes the entity to risk of changes in fair value or future cash flows and is designated as being hedged. Hedge instrument : A designated derivative or (for a hedge of the risk of changes in foreign currency exchange rates only) a designated non- derivative financial asset or non-derivative financial liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item.
Fair Value Hedge
This hedges against the risk of changes in the fair value of a recognized asset or liability or an unrecognized firm commitment (or a portion of such asset, liability, or firm commitment) attributable to a particular risk, such as the fair value of fixed-rate debt changing as a result of changes in interest rates.
Cash Flow Hedge
A cash flow hedge is a hedge against the risk of changes in the expected cash flows. It is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with:
i. A recognized asset or a liability such as future interest payment or variable-interest debt; or ii. A highly probable forecasted transaction such as a forecasted sale or purchase that will affect future reported profit or loss.
Hedge of Net Investment in Foreign
Operations
This is a hedge of the exposure to foreign currency exchange gains or losses on an entity's net investment in a foreign operation (which is the amount of the entity's interest in the net asset of that operation).
Hedge Accounting
Hedge accounting refers to the designation of one or more hedging instruments so that their change in fair value offsets the change in fair value or the change in cash flows of a hedged item. It attempts to reduce the volatility created by the repeated adjustments of a financial instrument's value, known as marking to market. This reduced volatility is done by combining the instrument and the hedge as one entry, which offsets the opposing movements.
The following are the situations that require hedge accounting:
Hedged item and the hedging instruments are measured using different bases. Hedged item has yet to be recognized in the financial statements. Different treatments are applied to changes in fair value of the hedged item and the hedging instrument.
Hedging vs. Hedge Accounting
| Hedging | Hedge Accounting | | --- | --- | | A general term which means minimizing risks | Recognizes proportionately the offsetting effects on net profit or loss of changes in the fair values of the hedging instrument and the related item being hedged | | Changes risks | Changes the accounting for gains or losses | | Business decision | Accounting decision |
Fair Value Hedge
A fair value hedge is a hedge of the exposure to changes in fair value of:
A recognized asset or liability; or An unrecognized firm commitment; or A component of any such item, that is attributable to a particular risk and could affect profit or loss.
According to PFRS 9 Paragraph 6.5.8, the hedging relationship shall be accounted for as follows:
The gain or loss on the hedging instrument shall be recognized in profit or loss. The hedging gain or loss on the hedged item shall adjust the carrying amount of the hedged item (if applicable) and be recognized in profit or loss.
At the date of maturity, the forward rate converges to the spot rate on that date since there is no further period remaining on the contract.
Accounting for Recording Forward Contracts
There are two methods for accounting for forward contracts:
Gross or Broad Position Accounting: Forward contracts are recorded at the date of inception of the contract, reflecting the contractual obligations of both parties. Net Position Accounting: There is no journal entry at the inception date. At each subsequent reporting date, adjustments are made to reflect any change in the forward rate.
The following sections provide illustrations of fair value hedges using the net position accounting method.
A. Fair Value Hedge of a Recognized Asset
On December 15, 2020, VVL Co. sold goods to a Japanese firm for 1,000, yen on account. VVL Co. was concerned about the fluctuation in the Japanese yen, so on this date, VVL Co. entered into a 30-day forward contract to sell 1,000,000 yen for P470,000 to a bank at a forward rate of 0.47.
B. Fair Value Hedge of Recognized Liability
On December 15, 2020, VVL Co. purchased goods from a Korean firm for 10,000 won on account. VVL Co. was concerned about the fluctuation in the Korean won, so on this date, VVL Co. entered into a 60-day forward contract to buy 10,000 won for P12,400 from a bank at a forward rate of 1.24.
C. Fair Value Hedge of a Firm Purchase Commitment
On December 1, 2020, VVL Co. ordered inventory from a U.S. Firm. The purchase order is non-cancellable. The purchase price is 1,000 US dollars with delivery and payment to be made on March 1, 2021. VVL Co. entered into a forward contract to buy 1,000 US dollars on March 1, 2021 at a forward rate of P40.15.
D. Fair Value Hedge of a Firm Sales Commitment
On December 15, 2020, VVL Co. received a sales order from a Japanese firm in the amount of 500,000 yen. The goods are to be delivered on January 15,
- Due to the fluctuation in the Japanese yen, VVL Co. entered into a 30- day forward contract to sell 500,000 yen for P280,000 to a bank at the forward rate of P0.56.
E. Fair Value Hedge of a Firm Purchase Commitment
(Present Value)
On December 1, 2020, VVL Co. ordered inventory from a U.S. Firm. The purchase order is non-cancellable. The purchase price is 1,000 US dollars with delivery and payment to be made on March 1, 2021. VVL Co. entered into a forward contract to buy 1,000 US dollars on March 1, 2021 at a forward rate of P40.15. Assuming the relevant discount rate is 12%.
Exchange Rates and Journal Entries
Spot Rates and Forward Rates
The exchange rates available on various dates are as follows:
| Date | Spot Rate | 30-Day Forward Rate | 60-Day Forward Rate | 90-Day Forward Rate | |------------|-----------|---------------------|---------------------|---------------------| | 12/01/20 | 40.00 | 40.05 | 40.10 | 40.15 | | 12/31/20 | 40.30 | 40.45 | 40.40 | 40.45 | | 03/01/21 | 40.20 | 40.40 | 40.50 | 40.60 |
Journal Entries
Hedge Item - Unrecognized Firm Commitment
Hedging Instruments - FC Receivable
12/01/20 * FC Receivable: 40,150 * Pesos Payable: 40,
12/31/20 * Loss on FC: 245 * FC Receivable: 245 * Firm Commitment: 245 * FC Gain: 245 (1,000 x .25) - (250 x 12% x 2/12)
03/01/21 * Firm Commitment: 195 * Loss on FC Receivable: 195 (1,000 x.
- 245 * FC Gain: 195 * FC Receivable: 195 * Inventory: 40,200 * Cash FC: 40,200 * Cash-FC: 40,200 * FC Receivable: 40,200 * Firm Commitment: 50 * Pesos Payable: 40,150 * Inventory: 50 * Cash FC: 40,
Summary of Balances and Gains/Losses
| Hedged Item | Balance | Gain (Loss) | |-------------|---------|-------------| | 12/15/ | - | - | | 12/31/20 | 245 | (245) | | 03/01/21 | 50 | 195 | | Total Gain (Loss) | (50) | 50 |
| Hedging Instruments | Balance | Gain (Loss) | |---------------------|---------|-------------| | 12/15/20 | 40,150 | - | | 12/30/20 | 40,400 | 245 | | 03/01/21 | 40,200 | (195) |
not a reclassification adjustment and hence it does not affect other comprehensive income. ii. For cash flow hedges other than those covered by (i), that amount shall be reclassified from the cash flow hedge reserve to profit or loss as a reclassification adjustment in the same period or periods during which the hedged expected future cash flows affect profit or loss (e.g., in the periods that interest income or interest expense is recognized or when a forecast sale occurs). However, if that amount is a loss and an entity expects that all or a portion of that loss will not be recovered in one or more future periods, it shall immediately reclassify the amount that is not expected to be recovered into profit or loss as a reclassification adjustment.
Hedge Effectiveness and Ineffectiveness
Hedge effectiveness is the extent to which changes in the fair value or the cash flows of the hedging instrument offset changes in the fair value or the cash flows of the hedged item.
Hedge ineffectiveness is the extent to which the changes in the fair value or the cash flows of the hedging instrument are greater or less than those on the hedged item.
Discontinuation of Cash Flow Hedge
An entity shall discontinue prospectively the cash flow hedge in the following circumstances: - The hedging instrument expires or is sold, terminated, or exercised. - The hedge no longer meets the criteria for hedge accounting. - The forecast transaction is no longer expected to occur.
Illustration: Cash Flow Hedge (Hedge Effectiveness)
On July 1, 2020, VVL Co., a vegetable dealer, forecasts the purchase of 1, kilograms of broccoli in 6 months. To hedge the exposure, VVL Co. enters into 10 long cauliflower future contracts on July 1, 2020, each based on the purchase of 100 kilograms of cauliflower at P92.98 per kilogram.
The relevant information and calculations are as follows:
March 31, 2020 * Hedged Item (Broccoli) Current Price: P95.18, Previous Price: P93.76, Increase: P1.42, Changes: P1,420 * Hedging Instruments (Cauliflower) Current Price: P94.52, Previous Price: P92.98, Increase: P1.54, Changes: P1,540 * Cumulative Changes: Hedged Item (P1,420), Hedging Instruments P1,540 * Effectiveness Ratio: 92%
June 30, 2020 * Hedged Item (Broccoli) Current Price: P96.20, Previous Price: P95.18, Increase: P1.02, Changes: P1,020 * Hedging Instruments (Cauliflower) Current Price: P95.36, Previous Price: P94.52, Increase: P0.84, Changes: P840 * Cumulative Changes: Hedged Item (P2,440), Hedging Instruments P2,380 * Effectiveness Ratio: 102%
The assessment is that the hedge is HIGHLY EFFECTIVE.
Journal Entries
01/01/20 * Accumulated OCI: P1,420 * Gain on Futures Contract: P
06/30/20 * Inventory: P96,200 * Futures Contract: P840 * Cash: P96,200 * Loss on Futures Contract: P120 * Accumulated OCI: P
Cash Flow Hedge (Forecasted Transaction)
On December 1, 2020, VVL Co. expects to purchase a machine for $1,000 on March 2021. VVL Co. enters into a forward contract to purchase $1,000 on March 1, 2021 for P40.15, designating it as a cash flow hedge.
Journal Entries
12/01/20 * FC Receivable: P40,150 * Pesos Payable: P40,
12/31/20 * FC Receivable: P250 * OCI - Exchange Gain: P
03/01/21 * Machinery: P40,200 * OCI - Exchange Loss: P200 * Cash: P40,200 * FC Receivable: P200 * OCI - Exchange Gain: P50 * Pesos Payable: P40,150 * Machinery: P50 * Cash: P40,150 * Investment in FC: P40,200 * FC Receivable: P40,200 * Cash: P40,200 * Investment in FC: P40,
Balance Sheet Presentation
Dec. 1, 2020 * OCI: P0 * FC Receivable: P40,
12/31/20 * OCI: P250 * FC Receivable: P40,400 * Pesos Payable: P40,150 * Forward Contract: P
3/1/21 * OCI: P50 * Pesos Payable: P40,150 * Forward Contract: P
Synthesis/Generalization
Summary of the Effects of Foreign Exchange Gains (Losses)
in Import and Export Transactions
Statement of Financial Position (FP) Account Affected : - Importing Transaction: Payable account increases with an increase in exchange rate, and decreases with a decrease in exchange rate. - Exporting Transaction: Receivable account increases with an increase in exchange rate, and increases with a decrease in exchange rate.
Effect on Statement of Comprehensive Income (CI) : - Increase in Exchange Rate: - Importing Transaction: Loss is reported. - Exporting Transaction: Gain is reported. - Decrease in Exchange Rate: - Importing Transaction: Gain is reported. - Exporting Transaction: Loss is reported.
