Lu Sales 71,000 (71,000) 12/31/20X1 offset: FX Loss

Lu Chen

Heidi Blakeway-Phillips

ACCT 404

November 20, 2017

Foreign Currency Hedges

I.
Introduction

In
the 1970s, after the collapse of the Bretton Woods system, more and more
companies were exposed to global market risks, which includes fluctuations of
interest rates, foreign currency exchange rates, commodities prices etc.  Under this circumstance, derivative
instruments have been developed rapidly. Foreign currency hedge is one of the
derivative instruments to help companies reduce the risk of fluctuation in
foreign currency exchange rates. There are three types of foreign currency
hedges: a fair value hedge, a cash flow hedge and a hedge of a net investment
in a foreign operation. A cash flow hedge is a hedge of the variability in cash
flows that is attributable to a future transaction (Pirchegger). A fair value hedge
may be designated for a firm commitment (not recorded) or foreign currency cash
flows of a recognized asset/liability (OANDA FX Consulting for
Corporations).

 Under the U.S. GAAP, companies are given an
opportunity to opt for or against hedge accounting. If companies do not elect
hedge accounting, the entries would have been the same as the entities made
under the Fair Value Hedge. This paper focuses on analyzing the differences
between Fair Value Hedge and Cash Flow Hedge and why companies want to choose
one method over another in some situations.

II.
Case Study

A U.S.
company (ABC Company) enters into a forward contract with a foreign supplier on
December 1, 20X1, to sale an equipment for foreign currency 100,000 to be receivable
on March 31, 20X2. The following exchange rate applies:

 

 

The
following table shows the entities used in cash flow hedge and Fair value hedge:

 

CASH FLOW HEDGE

FAIR VALUE HEDGE

 

Account

 Debit (Credit)

Account

Debit (Credit)

12/1/20X1
 

A/R
Sales

71,000
(71,000)

A/R
Sales

71,000
(71,000)

12/31/20X1
 
 
 
 
offset:
 
 
 

FX Loss
A/R

2,000
(2,000)

FX Loss
A/R

2,000
(2,000)

Forward Contract
AOCI

1,941
(1,941)

Forward Contract
FX Gain

1,941
(1,941)

AOCI
FX Gain

1,000
(1,000)

Discount Expense
AOCI

500
(500)

3/31/20X2
 
 
 
 
offset:
 
 
 
 
settlement
 
 
 
 

A/R
FX Gain

3,000
(3,000)

A/R
FX Gain

3,000
(3,000)

AOCI
Forward

4,941
(4,941)

FX Loss
Forward

4,941
(4,941)

FX loss
AOCI

3,000
(3,000)

Discount Expense
AOCI

1,500
(1,500)

Foreign Currency
A/R

72,000
(72,000)

Foreign Currency
A/R

72,000
(72,000)

Cash
Forward
Foreign Currency

69,000
3,000
(72,000)

Cash
Forward
Foreign Currency

69,000
3,000
(72,000)

 

Analysis Based on Cash Flow Hedge:

Cash
flow hedge is a perfect hedge because the changes in the cash flow from the
hedged item (the Accounts Receivable) are perfectly offset by the changes in
the cash flow from the hedged instruments. As shown in the above accounting
entities table, under a cash flow hedge, the impact to earnings is recorded in
the Other Comprehensive Income account and transferred to net earnings when the
inventory is sold to the third parties (not when it is sold to a subsidiary) (OANDA FX Consulting for Corporations).

On
December 31, the influence of foreign exchange transaction perfectly offset the
gains and losses resulting from this transaction. A foreign exchange loss of
$2,000 from the movement of spot rate on hedging item (the accounts receivable)
is perfectly offset by the $2,000 gain from hedging instrument (the forward
contract). The gain from hedging instrument is recorded in Accumulated Other
Comprehensive Income (AOCI). Therefore, the influence on net income is $500,
which is the one month’s amortization amount of the differences between the
spot rate and forward rate on the first day of entering the forward contract.
On the other hand, if the company did not enter the forward contract, the
foreign exchange loss on the account receivable in foreign currency would not
have been offset, and thus the net income would have been reduced by $2,000
instead of $500.

On
March 31, the foreign exchange gain of $3,000 from the movement of spot rate on
the foreign currency receivables is perfectly offset by the $3,000 foreign
exchange loss from the forward market. The loss from hedging instrument is
recorded in AOCI.  Therefore, the
influence on the net income is $1,500, which is the three months’ remaining of
forward contract discount amortization. If the company did not enter the
forward contract, the foreign exchange gain on the foreign currency receivables
would not have been offset, and thus the net income would have been increased
by $3,000 instead of being reduced by $1,500.

Analysis Based on Fair Value Hedge:

Fair
Value Hedge treats the net gains and losses on both hedged item and hedging
instrument to current earnings in the reporting period. The tracking process
and the accounting treatments under fair value hedge are relatively easier than
the cash flow hedge because it records the differences directly in the income
statement for the current reporting period.

On
December 31, the influence of foreign exchange transaction nearly offset the
gains and losses resulting from this transaction. A foreign exchange loss of
$2,000 from the movement of spot rate on the foreign currency receivables is
nearly offset by the $1,941 gain from the forward contract. Therefore, the
impact on net income is about $59.  If
the company did not enter the forward contract, the foreign exchange gain on
the foreign currency receivables would have not been offset, and thus the net
income would have been decreased by $2,000 instead of $59.

On
March 31 the foreign exchange gain of $3,000 from the movement of spot rate on
the foreign currency receivables is nearly offset by the $4,941 forward
exchange loss from forward contract. Therefore, the impact on net income is
$1,941. If the company did not enter the forward contract, the foreign exchange
gain on the foreign currency receivables would not have been offset, and thus
the net income would have been increased by $3,000 instead of being reduced by
$1,941.

Summary

Because
of the two different currency exchange rates used—the spot and the forward—a
difference normally exists between the amount of gain or loss. This difference
should not be large but does create some volatility in the income statement (Theodore E.Christensen). As shown in the
above analyses, to protect itself from the fluctuations in the foreign exchange
rate, the company can enter into a forward contract to lock the exchange rate
currently for an expected future transaction.  Since cash flow hedge can perfectly offset the
gain or loss from foreign exchange movement,

Under
fair value hedge, the differences between spot rate and forward rate can impact
the income statement directly in the current period. If the fluctuation or the
amount of the hedged item is huge, the net earnings of the company would be
affected relatively more than cash flow hedge.

III.
Conclusion

This
paper firstly introduces the background in which the hedging instruments
arrives and some basic concepts about the foreign currency hedges and then
involves a case study to compare the cash flow hedge and fair value hedge in
detail. By analyzing the case, we conclude that the difference exists between
these two methods and have some but not huge impact on the net earnings. If the
derivative instrument is recorded as a cash flow hedge the differences would be
recorded in the equity section under AOCI, instead of recording directly on the
income statement for each reporting period for fair value hedge. Management
should base on their hedging strategies to choose the optimal hedging method
and optimal accounting method to record foreign currency transactions.

Foreign
currency hedges can help companies reduce earnings volatility and accurately
represent the entity’s risk management activities in the financial statements (Jeff Craft). However, the hedge
accounting process is very complicated for many companies to deal with and
increase the difficulties of accounting treatments and auditing. Companies are
allowed to designate the forward contract as a cash flow hedge from the time
the contract is initially made until the final settlement of the hedged items (Financial Accounting Standards Board). But the hedging
accounting is complex. If a company have a three-year hedge, it has to keep
running the calculations and making the accounting adjustment every quarter to
match the criteria. As a result, the foreign currency hedges can be very
complicated and a tricky area for accountants. However, the tracking process of
the impact of the hedged items would be easier when using a fair value hedge.

In
conclusion, the foreign currency hedging is a very challenging part for both
accountants and auditors. Fair value hedge method is a good choice for
corporations that involves many foreign transactions but has less capability to
tracking the accounting treatments of certain hedges. For multinational
corporations, which equip with professional accounting departments, they should
base on their accurate forecasting and hedging strategies to choose the method
that benefit them most. There is still a long way for FASB to come up with more
adaptable and less complex accounting standards in terms of foreign currency
hedges.

 

 

Works Cited
Financial Accounting Standards Board.
“Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate
Swaps–Simplified Hedge Accounting Approach.” Derivatives and Hedging
(Topic 815) January 2014.
Jeff Craft, Jason Weaver. “Using Hedge
Accounting to Better Reflect Risk Mitigation Strategies.” Deloitte
(2014).
L. D. Meyer, S. M. Dabney, W. C. Harmon. ”
Transactions of the ASAE.” (1995): 809.
OANDA FX Consulting for Corporations. “Forex
Hedge Accounting Treatment.” Foreign Exchange Management (2015).
Pirchegger, Barbara. “Hedge accounting
incentives for cash flow hedges of forecasted transactions.” European
Accounting Review (2006).
Theodore E.Christensen, David M. Cottrell, Cassy
Budd. ADVANCED FINANCIAL ACCOUNTING, ELEVENTH EDITION. New York:
McGraw-Hill Education, 2016.
 

 

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