Foreign Currency Firm Commitment - Example On December 1, 2008, Mawr receives an order from a German customer. The delivery date is March 1, 2009, when Mawr will receive immediate payment. The sale is three months away, Mawr has a firm commitment to make the sale and receive payment of 1,000,000 €. Mawr decides to hedge this commitment. These are executory contracts, so no entries are made on this date. 9-1

Foreign Currency Firm Commitment - Example Mawr will receive 1,000,000 € on March 1, A forward contract was entered into to sell the euros at a price of $.905 = 1 €. Mawr’s discount rate is 12%. On 12/31/08, the currently available forward rate is $.916 = 1 €. 1.Record the forward contract. Mawr will receive 1,000,000 € on March 1, A forward contract was entered into to sell the euros at a price of $.905 = 1 €. Mawr’s discount rate is 12%. On 12/31/08, the currently available forward rate is $.916 = 1 €. 1.Record the forward contract. 9-2

Foreign Currency Firm Commitment - Example 9-3

Mawr will receive 1,000,000 € on March 1, A forward contract was entered into to sell the euros at a price of $.905 = 1 €. Mawr’s discount rate is 12%. On 12/31/08, the currently available forward rate is $.916 = 1 €. 2.Record the firm commitment. Mawr will receive 1,000,000 € on March 1, A forward contract was entered into to sell the euros at a price of $.905 = 1 €. Mawr’s discount rate is 12%. On 12/31/08, the currently available forward rate is $.916 = 1 €. 2.Record the firm commitment. Foreign Currency Firm Commitment - Example 9-4

Foreign Currency Firm Commitment - Example On March 1, 2009, Mawr receives 1,000,000 € from the German customer upon delivery of the order. On 3/1/09, the spot rate is $.900 = 1 €. 1.Adjust the forward contract to its current value of $5,000. On March 1, 2009, Mawr receives 1,000,000 € from the German customer upon delivery of the order. On 3/1/09, the spot rate is $.900 = 1 €. 1.Adjust the forward contract to its current value of $5,

Foreign Currency Firm Commitment - Example On March 1, 2009, Mawr receives 1,000,000 € from the German customer upon delivery of the order. On 3/1/09, the spot rate is $.900 = 1 €. 2.Record an offsetting loss associated with the Firm Commitment. On March 1, 2009, Mawr receives 1,000,000 € from the German customer upon delivery of the order. On 3/1/09, the spot rate is $.900 = 1 €. 2.Record an offsetting loss associated with the Firm Commitment. 9-6

Foreign Currency Firm Commitment - Example On March 1, 2009, Mawr receives 1,000,000 € from the German customer upon delivery of the order. On 3/1/09, the spot rate is $.900 = 1 €. 3.Record the receipt of the foreign currency. On March 1, 2009, Mawr receives 1,000,000 € from the German customer upon delivery of the order. On 3/1/09, the spot rate is $.900 = 1 €. 3.Record the receipt of the foreign currency. 9-7

Foreign Currency Firm Commitment - Example On March 1, 2009, Mawr receives 1,000,000 € from the German customer upon delivery of the order. On 3/1/09, the spot rate is $.900 = 1 €. 4.Record the fulfillment of the forward contract. On March 1, 2009, Mawr receives 1,000,000 € from the German customer upon delivery of the order. On 3/1/09, the spot rate is $.900 = 1 €. 4.Record the fulfillment of the forward contract. 9-8

Foreign Currency Firm Commitment - Example On March 1, 2009, Mawr receives 1,000,000 € from the German customer upon delivery of the order. On 3/1/09, the spot rate is $.900 = 1 €. 5.Close the Firm Commitment to Net Income. On March 1, 2009, Mawr receives 1,000,000 € from the German customer upon delivery of the order. On 3/1/09, the spot rate is $.900 = 1 €. 5.Close the Firm Commitment to Net Income. 9-9

Hedge of a Forecasted Foreign Currency Denominated Transaction SFAS 133 allows the use of cash flow hedge accounting for foreign currency derivatives associated with a forecasted foreign currency transaction  The forecasted transaction must be probable  The hedge must be highly effective  The hedging relationship must be properly documented 9-10

Hedge of a Forecasted Foreign Currency Denominated Transaction Accounting for a hedge of a forecasted transaction differs from that for a foreign currency firm commitment:  There is no recognition of the forecasted transaction or gains and losses on it.  The company reports the hedging instrument at fair value, but does not report changes in the fair value of the hedging instrument as gains and losses in net income. Instead, they are recorded in other comprehensive income. On the projected date of the forecasted transaction, the cumulative change in the fair value of the hedging instrument is transferred from other comprehensive income to net income. 9-11

An Interesting Footnote When foreign currency loans are made on a long-term basis to a foreign branch, subsidiary or equity method affiliate, SFAS 52 requires that foreign exchange gains and losses be deferred in other comprehensive income until the loan is repaid. Only the forex gains and losses related to the interest receivable are currently recorded in net income. 9-12

Summary The existence of different currencies creates an accounting challenge when transactions are denominated in currencies different from those used to keep accounting records FASB has adopted a “two-transaction” approach, separating the actual sale or purchase transaction from the currency exchange “speculation” A variety of hedging practices may be used to reduce foreign currency exchange risk. The two most popular hedging instruments are foreign currency options and foreign currency forward contracts 9-13

Possible Criticisms Some critics deride the “two transaction” approach adopted by the FASB, arguing that a single transaction has actually occurred. Some financial experts feel that the FASB’s definition of what constitutes a hedge is far too narrow. There is considerable controversy concerning the appropriate means of valuing options. WHAT DO YOU THINK??? 9-14