Lu ChenHeidi Blakeway-PhillipsACCT 404November 20, 2017 Foreign Currency HedgesI.
Introduction Inthe 1970s, after the collapse of the Bretton Woods system, more and morecompanies were exposed to global market risks, which includes fluctuations ofinterest rates, foreign currency exchange rates, commodities prices etc. Under this circumstance, derivativeinstruments have been developed rapidly. Foreign currency hedge is one of thederivative instruments to help companies reduce the risk of fluctuation inforeign currency exchange rates.
There are three types of foreign currencyhedges: a fair value hedge, a cash flow hedge and a hedge of a net investmentin a foreign operation. A cash flow hedge is a hedge of the variability in cashflows that is attributable to a future transaction (Pirchegger). A fair value hedgemay be designated for a firm commitment (not recorded) or foreign currency cashflows of a recognized asset/liability (OANDA FX Consulting for Corporations). Under the U.S. GAAP, companies are given anopportunity to opt for or against hedge accounting. If companies do not electhedge accounting, the entries would have been the same as the entities madeunder the Fair Value Hedge. This paper focuses on analyzing the differencesbetween Fair Value Hedge and Cash Flow Hedge and why companies want to chooseone method over another in some situations.
II.Case StudyA U.S.company (ABC Company) enters into a forward contract with a foreign supplier onDecember 1, 20X1, to sale an equipment for foreign currency 100,000 to be receivableon March 31, 20X2. The following exchange rate applies: Thefollowing 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:Cashflow hedge is a perfect hedge because the changes in the cash flow from thehedged item (the Accounts Receivable) are perfectly offset by the changes inthe cash flow from the hedged instruments. As shown in the above accountingentities table, under a cash flow hedge, the impact to earnings is recorded inthe Other Comprehensive Income account and transferred to net earnings when theinventory is sold to the third parties (not when it is sold to a subsidiary) (OANDA FX Consulting for Corporations).
OnDecember 31, the influence of foreign exchange transaction perfectly offset thegains 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 forwardcontract). The gain from hedging instrument is recorded in Accumulated OtherComprehensive Income (AOCI). Therefore, the influence on net income is $500,which is the one month’s amortization amount of the differences between thespot 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, theforeign exchange loss on the account receivable in foreign currency would nothave been offset, and thus the net income would have been reduced by $2,000instead of $500. OnMarch 31, the foreign exchange gain of $3,000 from the movement of spot rate onthe foreign currency receivables is perfectly offset by the $3,000 foreignexchange loss from the forward market. The loss from hedging instrument isrecorded in AOCI. Therefore, theinfluence on the net income is $1,500, which is the three months’ remaining offorward contract discount amortization. If the company did not enter theforward contract, the foreign exchange gain on the foreign currency receivableswould not have been offset, and thus the net income would have been increasedby $3,000 instead of being reduced by $1,500.
Analysis Based on Fair Value Hedge:FairValue Hedge treats the net gains and losses on both hedged item and hedginginstrument to current earnings in the reporting period. The tracking processand the accounting treatments under fair value hedge are relatively easier thanthe cash flow hedge because it records the differences directly in the incomestatement for the current reporting period.OnDecember 31, the influence of foreign exchange transaction nearly offset thegains and losses resulting from this transaction. A foreign exchange loss of$2,000 from the movement of spot rate on the foreign currency receivables isnearly offset by the $1,941 gain from the forward contract. Therefore, theimpact on net income is about $59. Ifthe company did not enter the forward contract, the foreign exchange gain onthe foreign currency receivables would have not been offset, and thus the netincome would have been decreased by $2,000 instead of $59.OnMarch 31 the foreign exchange gain of $3,000 from the movement of spot rate onthe foreign currency receivables is nearly offset by the $4,941 forwardexchange loss from forward contract. Therefore, the impact on net income is$1,941.
If the company did not enter the forward contract, the foreign exchangegain on the foreign currency receivables would not have been offset, and thusthe net income would have been increased by $3,000 instead of being reduced by$1,941. SummaryBecauseof the two different currency exchange rates used—the spot and the forward—adifference normally exists between the amount of gain or loss. This differenceshould not be large but does create some volatility in the income statement (Theodore E.Christensen). As shown in theabove analyses, to protect itself from the fluctuations in the foreign exchangerate, the company can enter into a forward contract to lock the exchange ratecurrently for an expected future transaction. Since cash flow hedge can perfectly offset thegain or loss from foreign exchange movement, Underfair value hedge, the differences between spot rate and forward rate can impactthe income statement directly in the current period.
If the fluctuation or theamount of the hedged item is huge, the net earnings of the company would beaffected relatively more than cash flow hedge. III.Conclusion Thispaper firstly introduces the background in which the hedging instrumentsarrives and some basic concepts about the foreign currency hedges and theninvolves a case study to compare the cash flow hedge and fair value hedge indetail. By analyzing the case, we conclude that the difference exists betweenthese two methods and have some but not huge impact on the net earnings.
If thederivative instrument is recorded as a cash flow hedge the differences would berecorded in the equity section under AOCI, instead of recording directly on theincome statement for each reporting period for fair value hedge. Managementshould base on their hedging strategies to choose the optimal hedging methodand optimal accounting method to record foreign currency transactions. Foreigncurrency hedges can help companies reduce earnings volatility and accuratelyrepresent the entity’s risk management activities in the financial statements (Jeff Craft).
However, the hedgeaccounting process is very complicated for many companies to deal with andincrease the difficulties of accounting treatments and auditing. Companies areallowed to designate the forward contract as a cash flow hedge from the timethe contract is initially made until the final settlement of the hedged items (Financial Accounting Standards Board). But the hedgingaccounting is complex. If a company have a three-year hedge, it has to keeprunning the calculations and making the accounting adjustment every quarter tomatch the criteria.
As a result, the foreign currency hedges can be verycomplicated and a tricky area for accountants. However, the tracking process ofthe impact of the hedged items would be easier when using a fair value hedge. Inconclusion, the foreign currency hedging is a very challenging part for bothaccountants and auditors. Fair value hedge method is a good choice forcorporations that involves many foreign transactions but has less capability totracking the accounting treatments of certain hedges.
For multinationalcorporations, which equip with professional accounting departments, they shouldbase on their accurate forecasting and hedging strategies to choose the methodthat benefit them most. There is still a long way for FASB to come up with moreadaptable and less complex accounting standards in terms of foreign currencyhedges. 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.