Accounting Ch. 6 - 8

How is the fair value of a foreign currency forward contract determined? How is the fair value of an option determined?

The fair value of a foreign currency forward contract is determined by reference to changes in the forward rate over the life of the contract, discounted to the present value. Three pieces of information are needed to determine the fair value of a forward contract at any point in time during its life: (a) the contracted forward rate when the forward contract is entered into, (b) the current forward rate for a contract that matures on the same date as the forward contract entered into, and (c) a discount rate; typically, the company's incremental borrowing rate. The manner in which the fair value of a foreign currency option is determined depends on whether the option is traded on an exchange or has been acquired in the over the counter market. The fair value of an exchange-traded foreign currency option is its current market price quoted on the exchange. For over the counter options, fair value can be determined by obtaining a price quote from an option dealer (such as a bank). If dealer price quotes are unavailable, the company can estimate the value of an option using the modified Black-Scholes option pricing model. Regardless of who does the calculation, principles similar to those in the Black-Scholes pricing model will be used in determining the value of the option.

Article Hedging - Hedged Percentage

The percentage of a company's foreign currency exposure that is hedged will often be directly related to the predictability of its foreign currency cash flows. The greater the degree of predictability, the greater the percentage of exposure that is hedged. There is also a direct relationship between the degree to which foreign currency fluctuations can impact the bottom line and the percentage of exposures that are hedged. Typically low margin businesses hedge larger percentages of their exposures. Typically companies with predictable foreign cash flows hedge 50 percent or more of their exposures.

Article Hedging - Hedge Instrument

The two most common instruments used for hedging against unfavorable currency movements are forwards and options. A foreign exchange forward is an agreement to buy or sell a currency at a specified exchange rate on a future date or during a specified period of time. Foreign exchange forwards are obligations in which both parties to the contract deliver a specified currency to the other party on a known date for a known amount of another currency. This makes a foreign exchange forward a "deliverable forward."

What is the concept underlying the two-transaction perspective to accounting for foreign currency transactions?

Under the two-transaction perspective, an export sale (import purchase) and the subsequent collection (payment) of cash are treated as two separate transactions to be accounted for separately. The idea is that management has made two decisions: (1) to make the export sale, and (2) to extend credit in foreign currency to the foreign customer. The income effect from each of these decisions should be reported separately.

Article 5 things to know about Hedging

Volatility Currency Cash Flows Hedge Instrument Hedged Percentage Method of Hedge Execution

What are the two major issues related to the translation of foreign currency financial statements?

Which method should be used Where the resulting translation adjustment should be reported in the consolidated financial statements

How does a foreign currency option differ from a foreign currency forward contract?

A party to a foreign currency forward contract is obligated to deliver one currency in exchange for another at a specified future date, whereas the owner of a foreign currency option can choose whether to exercise the option and exchange one currency for another or not.

Under U.S. GAAP, where are changes in the fair value of derivatives reported? A. As part of "Accumulated Other Comprehensive Income" on the Balance Sheet B. They are not recognized until the options are exercised C. Retained Earnings D. None of the above

A. As part of "Accumulated Other Comprehensive Income" on the Balance Sheet

When accounting for forward contracts, what is meant by the term "executory contract"? A. No cash changes hands B. The CEO of the company is the only one authorized to engage in the contract C. There must be a price paid for the option D. The contract is valid if one of the parties sign it

A. No cash changes hands

What has occurred when one company purchases the right to buy a foreign currency sometime in the future at an exchange rate quoted today? A. The company has acquired a call option. B. The company has entered a forward contract. C. The currency has appreciated relative to the dollar. D. The company has acquired a put option.

A. The company has acquired a call option.

What is foreign exchange risk exposure? A. The possibility of a loss because of changes in the value of a foreign currency B. Losses caused by paying for purchased goods in a foreign currency C. Losses caused by receiving payment in a foreign currency for goods sold D. All of the above

A. The possibility of a loss because of changes in the value of a foreign currency

What is a "foreign exchange rate?" A. The price to buy a foreign currency B. The price to buy foreign goods C. The difference between the price of goods in a foreign currency and the price in a domestic currency D. The cost to hold all monetary assets in a single currency

A. The price to buy a foreign currency

Under U.S. GAAP, foreign exchange losses should be recorded by: A. debiting "Foreign Exchange Loss". B. crediting "Foreign Exchange Loss". C. debiting "Retained Earnings". D. debiting "Sales Revenue".

A. debiting "Foreign Exchange Loss".

The number of Japanese yen (¥) required today to buy one U.S. dollar ($) today is called: A. the spot rate. B. the exact rate. C. the forward rate. D. the retail rate.

A. the spot rate.

What was Chapter 6 about?

Accounting environment, profession, regulation, principles/ practices, and differences with IFRS in China Germany Japan Mexico United Kingdom

What happens under the current rate method?

All assets and liabilities are translated at the current exchange rate, giving rise to a net asset balance sheet exposure. Appreciation in the foreign currency will result in a positive translation adjustment. Depreciation in the foreign currency will result in a negative translation adjustment. By translating assets carried at historical cost at the current exchange rate, the current rate method maintains relationships that exist among account balances int he foreign currency financial statements but distorts the underlying valuation method used by the foreign operation.

How are foreign currency derivatives such as forward contracts and options reported on the balance sheet?

All derivative financial instruments must be recognized as assets or liabilities on the balance sheet, measured at fair value.

What happens under the temporal method?

Assets carried at current or future value (cash, marketable securities, receivables) and liabilities are translated (remeasured) at the current exchange rate. Assets carried at historical cost and stockholders' equity are translated (remeasured) at historical exchange rates. When liabilities are greater than the sum of cash, marketable securities, and receivables, a net liability balance sheet exposure exists. Appreciation in the foreign currency will result in a negative translation adjustment. Depreciation in the foreign currency will result in a positive translation adjustment. By translating assets carried at historical cost at historical exchange rates, the temporal method maintains the underlying valuation method used by the foreign operation but distorts relationships that exist among account balances in the foreign currency financial statements.

What kind of exposure exists for recognized foreign currency assets and liabilities? A. Fair value exposure B. Cash flow exposure C. Both fair value exposure and cash flow exposure D. Neither fair value exposure nor cash flow exposure

B. Cash flow exposure

The central bank of Country X buys and sells its own currency to ensure that the currency is always exchanged in a ratio of 2:1 with the currency of Country Y. What can we conclude about these two currencies? A. Country X is using the Euro. B. Country X has pegged its currency to the currency of Country Y. C. Country X has an undesirable currency. D. Country X allows its currency to float relative to the currency of Country Y.

B. Country X has pegged its currency to the currency of Country Y.

In hedge accounting, which of the following exposure should be hedged by foreign currency derivative? A. Temporal exposure B. Fair value exposure C. Derivative exposure D. Forward contract exposure

B. Fair value exposure

What term is used to describe the circumstances under which Amazing Corporation is entering the forward contract? A. Hedge of an unrecognized foreign currency firm commitment B. Hedge of a recognized foreign-currency-denominated asset C. Hedge of a forecast foreign-currency-denominated transaction D. Hedge of net investment in foreign operations

B. Hedge of a recognized foreign-currency-denominated asset

Which of the following statements is true about hedge accounting under U.S. GAAP? A. Companies may choose whether to account for derivatives as cash flow hedges or fair value hedges. B. If a derivative qualifies as a cash flow hedge, the hedging instrument is adjusted to fair value on each balance sheet date. C. If a derivative is elected by the company not to be designated as a cash flow hedge, it must be accounted for as such. D. Hedge accounting is only advantageous when a foreign currency depreciates between the transaction date and the payment date.

B. If a derivative qualifies as a cash flow hedge, the hedging instrument is adjusted to fair value on each balance sheet date.

King's Bank, a British company, purchases market research services from Harris Interactive, a U.S. company. As per the terms of the contract, payment is to be made three months later in U.S. dollars when the report is delivered. How would King's Bank like to see the exchange rate move, assuming it isn't hedging the transaction? A. It hopes that the U.S. dollar appreciates in value against the British pound. B. It hopes that the British pound appreciates in value against the U.S. dollar. C. It makes no difference, since they are the customer and the sale takes place in the U.K. D. It hopes that there is no change between the spot rate and the forward rate.

B. It hopes that the British pound appreciates in value against the U.S. dollar.

Why is the accrual method of accounting for unrealized foreign exchange gains sometimes criticized? A. Foreign exchange gains almost never occur, so there is no reason to have an accounting standard for it. B. It violates the principle of conservatism. C. It is not objective. D. There is no reliable method for measuring unrealized foreign exchange gains.

B. It violates the principle of conservatism.

Amazing Corporation, a U.S. enterprise, sold product to a customer in Wales on October 1, 20x1 for £100,000 with payment required on April 1, 20x2. Relevant exchange rates are: The discount factor corresponding to the company's incremental borrowing rate for 6 months is 0.95.Assuming that Amazing Corporation does not hedge this transaction, what is the amount of exchange gain or loss that it should show on its December 31, 20x1 income statement? A. Loss $1,000 B. Loss $2,000 C. Gain $1,000 D. Gain $1,900

B. Loss $2,000

What has occurred when one company arranges to buy a foreign currency sometime in the future, at an exchange rate quoted today? A. The company has purchased a foreign currency option. B. The company has entered a forward contract. C. The currency has been devalued. D. None of the above

B. The company has entered a forward contract.

What is the intrinsic value of a foreign currency option? A. he difference between the spot rate and the strike price B. The gain that could be realized if the option was exercised immediately C. The chance that a currency will rise over time to make the option in the money D. The difference between a call option and a put option

B. The gain that could be realized if the option was exercised immediately

What is "asset exposure" to foreign exchange risk? A. The possibility that an asset denominated in domestic currency will decline in value because of changes in the foreign exchange rate B. The possibility that an asset denominated in a foreign currency will change in value because of a change in the foreign exchange rate C. The loss resulting from an import purchase when a foreign currency appreciates D. The loss resulting from an import purchase when a foreign currency depreciates

B. The possibility that an asset denominated in a foreign currency will change in value because of a change in the foreign exchange rate

Under International Accounting Standards Board rules, what method is required to account for foreign currency transactions? A. A one-transaction perspective must be used. B. The two-transaction perspective must be used. C. A sale is not recorded until payment is received and converted to U.S. dollars. D. A sale is not recorded until payment is received in the foreign currency.

B. The two-transaction perspective must be used.

Under U.S. GAAP, what method is required to account for foreign currency transactions? A. A one-transaction perspective must be used. B. The two-transaction perspective must be used. C. A sale is not recorded until payment is received and converted to U.S. dollars. D. A sale is not recorded until payment is received in the foreign currency.

B. The two-transaction perspective must be used.

What is the requirement for reporting derivatives under international accounting standards and U.S. GAAP? A. They may be shown on the balance sheet or they may be treated as off-balance sheet investments. B. They must be shown on the balance sheet at fair value. C. They must be shown on the balance sheet at historical cost. D. They may be shown on the balance sheet at historical cost or at net realizable value.

B. They must be shown on the balance sheet at fair value

How is the fair value of a foreign currency option calculated? A. By using the Box-Jenkins technique B. Using the modified Black-Scholes pricing model C. Through an arms-length transaction D. Using quotes given daily in the Wall Street Journal

B. Using the modified Black-Scholes pricing model

A noncancelable sales order that specifies foreign currency price and date of delivery is known as a: A. hedge. B. foreign currency firm commitment. C. forward contract. D. put option.

B. foreign currency firm commitment.

For an upcoming trip, Pat wants to buy Euros at the local bank when the current exchange rate quoted on OANDA.com was $1.563 per 1. What should Pat plan to pay for 1,000? A. exactly $1,563 B. more than $1,563 C. about $640 D. less than $640

B. more than $1,563

Article Hedging - Currency Cash Flows

Banking industry data suggests that U.S. companies hedged approximately 50 percent of their expected foreign cash flows in 2011. Companies typically hedge their foreign cash flows to reduce translation exposures to their base currency, thereby providing a greater degree of certainty for their base currency cash flows. In addition, hedging allows companies to protect against unfavorable movements relative to their budget rate, allowing for more stable earnings.

How is the appropriate combination of translation method and disposition of translation adjustment is determined under both IFRS and US GAAP?

By identifying the functional currency of a foreign operation. The financial statements of foreign operations whose functional currency is different from the parent's reporting currency are translated using the current rate method, with the translation adjustment included in stockholders' equity. The financial statements of foreign operations whose functional currency is the same as the parent's reporting currency are translated using the temporal method, with the resulting translation gain or loss reported currently in net income.

What is a "strike price?" A. The exchange rate that is used to buy a foreign currency today B. The price that will be paid for goods in a forward contract C. The exchange rate that will be used if a foreign currency option is executed D. The difference between the wholesale rate and the retail rate for foreign currency exchange

C. The exchange rate that will be used if a foreign currency option is executed

How should discounts or premiums on forward contracts be treated if the derivative is hedging a foreign-currency-denominated asset? A. Carried on the balance sheet until the contract is completed B. Included in income in the period the derivative is acquired C. Amortized over the life of the forward contract D. None of the above

C. Amortized over the life of the forward contract

What kind of exposure exists for foreign currency firm commitments? A. Fair value exposure B. Cash flow exposure C. Both fair value exposure and cash flow exposure D. Neither fair value exposure nor cash flow exposure

C. Both fair value exposure and cash flow exposure

Why was there very little fluctuation in the foreign exchange rate in the period 1945-1973? A. This was a period when the world economy was very stable. B. There was very little growth in the world economy between 1945 and 1973. C. Countries linked their currency to the U.S. dollar, which was backed by gold reserves. D. Most currencies were pegged to the British pound, which could be converted to sterling silver.

C. Countries linked their currency to the U.S. dollar, which was backed by gold reserves.

Under U.S. GAAP, what method of amortizing discounts or premiums on forward contracts must be used? A. Weighted average method or accelerated method B. Sum of digit method only C. Effective interest rate method or straight line method D. Straight line method only

C. Effective interest rate method or straight line method

Which of the following is done when accounting for a cash flow hedge, but is not done when accounting for a fair value hedge? A. The hedged asset or liability is adjusted to fair value. B. Foreign exchange gains or losses on the hedged asset or liability are recorded in net income. C. Increases or decreases in a derivative's fair value are recorded in accumulated other comprehensive income. D. Gains or losses resulting from adjusting the fair value of a derivative are recorded in net income.

C. Increases or decreases in a derivative's fair value are recorded in accumulated other comprehensive income.

What is a foreign currency transaction? A. It is another name for an international transaction. B. It is a transaction that involves payment at a date sometime in the future. C. It is a business deal denominated in a currency other than a company's domestic currency. D. It is an economic event measured in a currency other than U.S. dollars.

C. It is a business deal denominated in a currency other than a company's domestic currency.

What is "hedge accounting?" A. Any record keeping related to purchase, sale, or valuation of derivatives. B. Recording options and other derivatives on the Balance Sheet. C. Matching gains or losses from hedging with losses or gains from the risk being hedged. D. Using multiple accounting methods to offset the effect of foreign currency exchange.

C. Matching gains or losses from hedging with losses or gains from the risk being hedged.

What is the primary difference between a cash flow hedge and a fair value hedge? A. The fair value hedge must completely offset the variability in the cash flow from the foreign currency receivable or payable. B. The cash flow hedge can only be used to offset potential foreign currency losses on accounts receivable. C. The cash flow hedge must completely offset the variability in cash flow from the foreign currency receivable or payable. D. The fair value hedge can only be used to offset the variability in cash flow from long-term fixed assets related to foreign currency fluctuations.

C. The cash flow hedge must completely offset the variability in cash flow from the foreign currency receivable or payable.

How should U.S. companies record receivables and payables from international trade that are denominated in foreign currencies? A. All assets and liabilities of U.S. companies must be recorded in U.S. dollars. B. Conservatism would dictate that liabilities should be recorded in the currency in which they are payable, but assets should be recorded in U.S. dollars, regardless of what currency will be received. C. There should be separate receivable and payable accounts for each currency that is used by the company. D. The company should choose any one currency to use for recording receivable and payables so that there is consistency in the accounts.

C. There should be separate receivable and payable accounts for each currency that is used by the company.

Under U.S. GAAP, what is the proper treatment of unrealized foreign exchange losses? A. They should be deferred on the Balance Sheet until the cash is paid. B. They should not be recognized until cash is received to complete the transaction. C. They should be recorded on the Income Statement in the period the exchange rate changes. D. They should be deferred on the Balance Sheet until an offsetting foreign exchange gain is realized.

C. They should be recorded on the Income Statement in the period the exchange rate changes.

Which of the following statements is true of intrinsic value of options? A. When the option strike price is more than the spot rate, the intrinsic value is zero. B. When the option strike price is equal to the spot rate, the intrinsic value is positive. C. When the option strike price is less than the spot rate, the intrinsic value is zero. D. When the option strike price is more than the spot rate, the intrinsic value is negative.

C. When the option strike price is less than the spot rate, the intrinsic value is zero.

When a currency is allowed to increase or decrease freely according to market forces, the currency is said to: A. be pegged to another currency. B. be less valuable. C. have independent float. D. devalue.

C. have independent float.

The number of U.S. dollars ($) today to buy one U.K. pound (£) six months from now is called: A. the spot rate. B. the exact rate. C. the forward rate. D. the prime rate.

C. the forward rate.

When two parties from different countries enter into a transaction: A. the currency to be used for settling the transaction is set by the government. B. a third country's currency must be used to denominate the transaction. C. the two parties are free to decide the currency that should be used to settle the transaction. D. the domestic currency of the buyer must be used to settle the transaction.

C. the two parties are free to decide the currency that should be used to settle the transaction.

Article Hedging - Volatility

Currency volatility is one of the biggest risks companies around the world face. In recent years, companies have increased their use of hedging strategies to protect against earnings volatility that can come about or occur as a result of large movements in the currency markets. A series of events has lead to this increase in hedging. It began with the sharp decline in emerging-market currencies during the financial crisis of 2008 and 2009. In that period, the USD and JPY strengthened as they were seen as safe havens. Now currency volatility is being driven by uncertainty over the health and stability of Europe, which has lead to significant gyrations in the Euro and emerging market currencies. For some companies, a 2 percent move in a currency can wipe out a bottom line, a move that can be exceeded in a single day.

What information is needed to determine the fair value of a foreign currency forward contract? A. The forward rate at the date the contract was entered B. The current forward rate for a contract that matures on the same dates as the forward contract that was entered into C. A discount rate to determine the present value of the contract D. All of the above information is needed

D. All of the above information is needed

Under U.S. GAAP, which of the following conditions must be met to qualify for hedge accounting? A. There must be formal documentation of the hedging relationship. B. A derivative must be used specifically to hedge fair value exposure or cash flow exposure. C. The hedge must be effective. D. All of the above must be met in order to qualify for hedge accounting.

D. All of the above must be met in order to qualify for hedge accounting.

Assume that Amazing Corporation enters a forward contract on October 1, 20x1 to sell £100,000 six months hence, on April 1, 20x2. How should Amazing Corporation report the forward contract on its December 31, 20x1 financial Statements? A. Asset $1,950 B. Liability $1,950 C. Asset $1,000 D. Asset $950

D. Asset $950

Which of the following statements is true of the relationship between foreign currency transactions, exchange rate changes, and foreign exchange gains and losses? A. In an export sales, depreciation of the foreign currency causes a foreign exchange gain. B. In an import purchase, appreciation of the foreign currency causes a foreign exchange gain. C. In an import purchase, depreciation of the foreign currency causes a foreign exchange loss. D. In an export sales, appreciation of the foreign currency causes a foreign exchange gain.

D. In an export sales, appreciation of the foreign currency causes a foreign exchange gain.

Why must the two-transaction perspective be used for recording foreign currency transactions under U.S. GAAP? A. The two-transaction perspective is required under IFRS. B. U.S. GAAP requires conservatism in financial reporting. C. All other methods are excessively complicated to use and therefore obscure the essence of the transaction. D. Management made two decisions: one to sell and another to extend credit in a foreign currency.

D. Management made two decisions: one to sell and another to extend credit in a foreign currency.

Which of the following statements is true about the Euro? A. It is the currency used by all countries in the European Union. B. It is pegged to the U.S. dollar. C. It is the currency required to be used in financial reporting under international accounting standards. D. None of the statements above is true.

D. None of the statements above is true.

A bank exchanging foreign currency makes its profit in what manner? A. On the difference between the spot rate and the foreign rate B. A bank is forbidden, by law, to charge a premium in foreign currency exchange C. On the present value of the forward rate discounted to the date an option is purchased D. On the difference between the buying and selling rates

D. On the difference between the buying and selling rates

Under U.S. GAAP, what is the proper treatment of unrealized foreign exchange gains? A. They should be deferred on the Balance Sheet until cash is received. B. The principle of conservatism requires that they should never be recognized. C. They should not be recorded until cash is received and the exchange transaction is completed. D. They should be recognized in income on the date the exchange rate changes.

D. They should be recognized in income on the date the exchange rate changes.

Northland Corporation recorded £1,000,000 in Accounts Receivable for sales to customers in the United Kingdom and recorded Accounts Payable of 2,000,000 Yuan for product purchased from China. If Northland recorded a foreign currency exchange loss on its receivables and a foreign currency gain on its payables, what must have happened to each currency? A. Yuan appreciated, Pound depreciated B. Yuan depreciated, Pound appreciated C. Yuan appreciated, Pound appreciated D. Yuan depreciated, Pound depreciated

D. Yuan depreciated, Pound depreciated

What do different account translation methods give rise to?

Different concepts of balance sheet exposure and translation adjustments of differing sign and magnitude

What does the word hedging mean? Why do companies hedge foreign exchange risk?

Hedging is the process of eliminating exposure to foreign exchange risk so as to avoid potential losses from fluctuations in exchange rates. In addition to avoiding possible losses, companies hedge foreign currency transactions and commitments so as to introduce an element of certainty into the future cash flows resulting from foreign currency activities. Hedging involves establishing a price today at which foreign currency can be sold or purchased at a future date.

What are the differences in accounting for a forward contract used as a cash flow hedge of (a) a foreign-currency-denominated asset or liability and (b) a forecasted foreign currency transaction?

For a cash flow hedge of a foreign currency asset or liability (1) sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income. The forward contract is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability. An additional amount is removed from AOCI and recognized in net income to reflect the current period's allocation of the discount or premium on the forward contract. For a hedge of a forecasted transaction, the forward contract is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). Because there is no foreign currency asset or liability, there is no transfer from AOCI to net income to offset any gain or loss on the asset or liability. The current period's allocation of the forward contract discount or premium is recognized in net income with the counterpart reflected in AOCI. Sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase). The amount accumulated in AOCI related to the hedge is closed as an adjustment to net income in the period in which the forecasted transaction was anticipated to occur.

What are the differences in accounting for a forward contract used as a fair value hedge of (a) a foreign-currency-denominated asset or liability and (b) a foreign currency firm commitment?

For a fair value hedge of a foreign currency asset or liability (1) sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income. The forward contract is adjusted to fair value based on changes in the forward rate (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income. The foreign exchange gain (loss) and the forward contract loss (gain) are likely to be of different amounts resulting in a net gain or loss reported in net income. For a fair value hedge of a firm commitment, there is no hedged asset or liability to account for. The forward contract is adjusted to fair value based on changes in the forward rate (resulting in an asset or liability reported on the balance sheet), with a gain or loss recognized in net income. The firm commitment is also adjusted to fair value based on changes in the forward rate (resulting in a liability or asset reported on the balance sheet), and a gain or loss on firm commitment is recognized in net income. The firm commitment gain (loss) offsets the forward contract loss (gain) resulting in zero impact on net income. Sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase). The firm commitment account is closed as an adjustment to net income in the period in which the hedged item affects net income.

Under what conditions can hedge accounting be used to account for a foreign currency option used to hedge a forecasted foreign currency transaction?

For hedge accounting to apply, the forecasted transaction must be probable (likely to occur), the hedge must be highly effective in offsetting fluctuations in the cash flow associated with the foreign currency risk, and the hedging relationship must be properly documented.

Why might a company prefer a foreign currency option rather than a forward contract in hedging a foreign currency firm commitment? Why might a company prefer a forward contract over an option in hedging a foreign currency asset or liability?

Foreign currency options have an advantage over forward contracts in that the holder of the option can choose not to exercise if the future spot rate turns out to be more advantageous. Forward contracts, on the other hand, can lock a company into an unnecessary loss (or a reduced gain). The disadvantage associated with foreign currency options is that a premium must be paid up front even though the option might never be exercised.

A company makes an export sale denominated in a foreign currency and allows the customer one month to pay. Under the two-transaction perspective, accrual approach, how does the company account for fluctuations in the exchange rate for the foreign currency?

Foreign currency receivables resulting from export sales are revalued at the end of accounting periods using the current spot rate. An increase in the value of a receivable will be offset by reporting a foreign exchange gain in net income, and a decrease will be offset by a foreign exchange loss. Foreign exchange gains and losses are accrued even though they have not yet been realized.

What factors create a foreign exchange gain on a foreign currency transaction? What factors create a foreign exchange loss?

Foreign exchange gains and losses are created by two factors: having foreign currency exposures (foreign currency receivables and payables) and changes in exchange rates. Appreciation of the foreign currency will generate foreign exchange gains on receivables and foreign exchange losses on payables. Depreciation of the foreign currency will generate foreign exchange losses on receivables and foreign exchange gains on payables.

What is hedge accounting?

Hedge accounting is defined as recognition of gains and losses on the hedging instrument in the same period as the recognition of gains and losses on the underlying hedged asset or liability (or firm commitment).

How does the timing of hedges of the following differ? a. Foreign-currency-denominated assets and liabilities. b. Foreign currency firm commitments c. Forecasted foreign currency transactions

Hedges of foreign currency denominated assets and liabilities are not entered into until a foreign currency transaction (import purchase or export sale) has taken place. Hedges of firm commitments are made when a purchase order is placed or a sales order is received, before a transaction has taken place. Hedges of forecasted transactions are made at the time a future foreign currency purchase or sale can be anticipated, even before an order has been placed or received.

How are changes in the fair value of an option accounted for in a cash flow hedge? In a fair value hedge?

In accounting for a fair value hedge, the change in the fair value of the foreign currency option is reported as a gain or loss in net income. In accounting for a cash flow hedge, the change in the entire fair value of the option is first reported in other comprehensive income, and then the change in the time value of the option is reported as an expense in net income.

What are the differences in accounting for a forward contract used as (a) a cash flow hedge and (b) a fair value hedge of a foreign-currency-denominated asset or liability?

In both cases, (1) sales revenue (or the cost of the item purchased) is determined using the spot rate at the date of sale (or purchase), and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss is recognized in net income. For a cash flow hedge, the derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability. An additional amount is removed from AOCI and recognized in net income to reflect (a) the current period's amortization of the original discount or premium on the forward contract (if a forward contract is the hedging instrument) or (b) the change in the time value of the option (if an option is the hedging instrument). For a fair value hedge, the derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income. The discount or premium on a forward contract is not allocated to net income. The change in the time value of an option is not recognized in net income.

What is the only substantive difference in translation rules between IFRS and US GAAP?

It relates to foreign operations that report in the currency of a hyper-inflationary economy. IAS 21 requires the parent first to restate the foreign financial statements for inflation using rules in IAS 29 and then to translate the statements into parent-company currency using the current rate method. FASB ASC 830 requires the financial statements of foreign operations that report in the currency of a highly inflationary economy to be translated using the temporal method, as if the US dollar were the functional currency. A country is considered highly inflationary if its cumulative three-year inflation rate exceeds 100 percent.

Article Hedging - Method of Hedge Execution

Most companies that hedge recurring exposures use one of two methods, rolling hedges or layered hedges. Under a rolling hedge program, a company maintains a constant percentage of its cash flow exposures hedged for a predetermined period of time. As one hedge comes to maturity, the next period is hedged. Under a layered hedge program, a company hedges a percentage of its future exposures and then adds to future period hedges over time to increase the percentage of coverage in those future periods. Some companies prefer to do opportunistic hedging, in which hedges are executed when market conditions appear optimal. Historically, layered hedging provides the most stable currency exchange rates over time.

Where do some companies hedge their balance sheet exposures to avoid reporting remeasurement losses in income and/or negative translation adjustments?

Stockholders' equity.

In what way is the accounting for a foreign currency borrowing more complicated than the accounting for a foreign currency account payable?

The accounting for a foreign currency borrowing involves keeping track of two foreign currency payables--the note payable and interest payable. As both the face value of the borrowing and accrued interest represent foreign currency liabilities, both are exposed to foreign exchange risk and can give rise to foreign currency gains and losses.