After studying this chapter, you should be able to do the following:

1. Translate foreign currency transactions and balances into the functional currency.
2. Prepare journal entries and subsequent financial statement presentation for forward exchange contracts that are entered into for speculative purposes.
3. Describe the concept of hedging, and prepare a list of items that could be used as a hedge against foreign currency risk.
4. Prepare journal entries and subsequent financial statement presentation for forward exchange contracts that hedge existing monetary positions.
5. Prepare journal entries and subsequent financial statement presentation for forward exchange contracts that hedge firm commitments.
6. Prepare journal entries and subsequent financial statement presentation for forward exchange contracts that hedge highly probable future transactions.
7. Analyze and interpret financial statements involving foreign currency transactions and forward contracts.
8. Identify some of the differences between IFRSs and ASPE involving foreign currency transactions and hedging.
9. Incorporate the time value of money when determining the fair value of a forward contract.

Currency Exchange Rates
Many Canadian companies conduct business in foreign countries as well as in Canada. No specific accounting issues arise when the parties involved in an import or export transaction agree that the settlement will be in Canadian dollars. Because it is a Canadian-dollar-denominated transaction, the company will record the foreign purchase or sale in exactly the same manner as any domestic purchase or sale. In many situations, however, the agreement calls for the transaction to be settled in a foreign currency. This means one of two things: (a) the Canadian company will have to acquire foreign currency in order to discharge the obligations resulting from its imports, or (b) the Canadian company will receive foreign currency as a result of its exports and will have to sell the foreign currency in order to receive Canadian dollars. Transactions such as these are called foreign-currency-denominated transactions.

Both the recording of foreign-currency-denominated transactions and the translation of foreign-currency financial statements require the use of currency exchange rates. An exchange rate is simply the price of one currency in terms of another currency. Exchange rates fluctuate on a daily basis.

Transactions denominated in foreign-currency are recorded in Canadian dollars at the spot rate in effect on the date of the transaction. At the date of the balance sheet, foreign-currency assets and liabilities are translated into Canadian dollars to preserve the normal measurement at either historical cost or current value. Any gains or losses arising from changes in exchange rates on the exposed items are reflected in profit for the period.

Some points to remember about foreign-currency transactions:

• Exchange rates fluctuate over time due primarily to differences in inflation rates, interest rates, and trading practices between the two countries.



• Exchange rates can be quoted directly or indirectly. The direct method is the reciprocal of the indirect method.



• The spot rate is the rate to exchange currency today, whereas the forward rate is the rate agreed to today for exchanging currency at a future date.



• A forward exchange contract is an agreement between a bank and a customer to exchange currencies on a specified future date at a specified rate.



• It is important to note that currency issues can be discussed and analyzed from many different perspectives. There are four main perspectives: (1) denominated currency (the currency in which the transaction is denominated); (2) recording currency or internal record-keeping currency (the currency in which the transaction is recorded in the internal accounting records); (3) functional currency (the currency of the primary economic environment in which the entity operates); and (4) presentation or reporting currency (the currency in which the financial statements are presented by the reporting entity).



• IAS 21 requires that individual transactions be translated into the functional currency of the reporting entity. In turn, IAS 21 states that an entity can present or report its financial statements in any currency it wants to use. IAS 21 defines functional currency as the currency of the primary economic environment in which the entity operates and foreign currency as any currency other than the functional currency of the entity. The primary economic environment is normally the one in which the entity primarily generates and expends cash.



• A monetary item is converted into cash at a fixed and predetermined amount of currency.



• For accounting purposes, there are basically three rates used in translating foreign currency into the reporting currency: the closing rate, the historical rate, and the forward rate. The spot rate at the end of the reporting period of the financial statements is called the closing rate. The spot rate on the date of a transaction is called the historical rate for that transaction. The agreed rate for exchange of currencies at a future date is called the forward rate.



• The average rate is the weighted average of the historical rates for the period. Individual transactions must be translated into the functional currency at the historical rate.



• According to IAS 21, a foreign-currency transaction must be recorded, on initial recognition in the functional currency, by applying to the foreign-currency amount the spot exchange rate between the functional currency and the foreign currency at the date of the transaction. At the end of each reporting period, (a) foreign-currency monetary items must be translated using the closing rate; (b) non-monetary items that are measured in terms of historical cost in a foreign currency must be translated using the historical rate; and (c) non-monetary items that are measured at fair value in a foreign currency must be translated using the exchange rates at the date when the fair value was determined. We will refer to this method of translation as the temporal method. The translation method should ideally produce either historical cost in dollars or fair value in dollars consistent with normal measurement rules for the financial statement items. Recall that according to Canadian GAAP, monetary assets and monetary liabilities are typically valued at fair value, non-monetary assets are usually valued at the lower of historical cost and market value, and non-monetary liabilities and shareholders’ equity are usually valued at historical amounts. Revenues and expenses are usually measured at historical amounts.



• Any exchange adjustments arising on the settlement of monetary items or on the translation of monetary items at rates different from those at which they were translated on initial recognition during the period or in previous financial statements must be recognized in profit or loss in the period in which they arise, with two exceptions. First, when a gain or loss on a non-monetary item is recognized in other comprehensive income, any exchange adjustment pertaining to that item must also be recognized in other comprehensive income (for example, IAS 16 revaluation model for property, plant, and equipment). Second, a monetary available-for-sale financial asset (such as an investment in bonds) is treated as if it were carried at amortized cost in the foreign currency. Exchange differences resulting from changes in the amortized cost of this asset are recognized in profit or loss, and other changes in carrying amount are recognized in other comprehensive income.

Import/Export Transactions Denominated in Foreign Currency

• Foreign-exchange adjustments are included in profit in the period in which they occur.
• The sale is translated at the historical rate to produce a historical price in Canadian dollars. This is consistent with normal measurement rules to record sales at historical values.
• The accounts receivable (or accounts payable) is translated at the closing rate to produce a current value in Canadian dollars. This is consistent with normal measurement rules to record monetary items at current values.
• Exchange gains are reported in profit even though they are unrealized.

Transaction Gains and Losses from Non-current Monetary Items

• Interest expense is translated at the average of the historical rates to produce a historical price in Canadian dollars. This is consistent with normal measurement rules to record interest expense at historical values.
• Loans payable (or loans receivable) are translated at the closing rate to produce a current value in Canadian dollars. This is consistent with normal measurement rules to record monetary items at current values.
• Exchange gains and losses occur on items translated at the closing rate but not on items translated at historical rates.

Speculative Forward Exchange Contracts

• A forward exchange contract is one in which an exchange broker (usually a bank) and its customer agree to exchange currencies at a set price on a future date. Forward contracts can be either fixed dated or option dated. A fixed-dated contract specifies a fixed date such as June 18, for example. An option-dated contract specifies a certain period such as the month of June. A company may enter into a forward exchange contract purely to speculate on future exchange movements.



• In a forward exchange contract, two parties agree to exchange currencies at a future date at a specified exchange rate.



• According to IAS 39 and IFRS 9, a forward contract is considered to be a financial instrument. It must be recorded at fair value on the date the contract is entered into and be revalued at fair value throughout its life, with any gains or losses reflected in income as they occur. There are two methods of recording this forward contract: the gross method and the net method. Under the gross method, the receivable from the bank and the payable to the bank are each recorded separately at fair value. Under the net method, the receivable and payable are netted against each other and only the net receivable or net payable is recorded. Either method is acceptable for internal recording-keeping purposes. The gross and net methods produce the same overall result in the end and both methods are presented the same way on the financial statements.



• A forward contract is a financial instrument which must be valued at fair value throughout its life.



• When the forward rate changes, the fair value of the forward contract changes.



• While forward exchange contracts are certainly executory, they are also firm commitments, and once entered cannot be cancelled. For this reason, IFRSs require that the forward contract be recorded in the financial statements. (An executory contract is one in which neither party has performed its obligation to the other. Most contracts trigger accounting recognition only when one of the parties fulfills the obligation as agreed.)

Hedges
The use of hedging instruments, such as forward exchange contracts, removes the risks associated with exchange rate changes. If all risks are removed, the hedge is “perfect.” It also is possible to have a situation in which only a portion of a position is hedged and the balance is at risk, or in which, as was illustrated, a portion of the hedging instrument ceases to act as a hedge and becomes exposed to foreign-currency risk.

In a fair value hedge and in a speculative forward exchange contract, exchange gains and losses are recognized in profit in the period of the change in exchange rates. In a cash flow hedge, the exchange gains and losses on the hedging instrument are initially reported in other comprehensive income and subsequently reclassified to profit when the hedged item affects profit.

Some points to remember about hedges and accounting for hedges:

• A hedging instrument is the item used to offset the risk exposure. The hedged item is the item with the risk exposure that the entity has taken steps to modify.



• IFRS 9 (which supersedes IAS 39 effective January 1, 2015) states that an anticipated future transaction can be a hedged instrument but it cannot be a hedging instrument. Therefore, it is not possible to designate a future revenue stream as a hedge of an existing monetary liability for accounting purposes. A derivative can be a hedging instrument but would not typically be a hedged item.



• Under hedge accounting, the exchange gains or losses on the hedging instrument will be reported in income in the same period as the exchange gains or losses on the hedged item.



• Hedge accounting is optional. The entity can choose to apply hedge accounting and thereby ensure that gains and losses on the hedged item are reported in income in the same period as the gains and losses on the hedging instrument. Alternatively, it could choose to not apply hedge accounting and account for the hedged item and the hedging instrument in isolation of each other.



• To qualify for hedge accounting, the following four conditions must be met: (1) at the inception of the hedge, there is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge; (2) the hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk, consistently with the originally documented risk management strategy for that particular hedging relationship; (3) the effectiveness of the hedge can be reliably measured; and (4) the hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the financial reporting periods for which the hedge was designated.



• Hedges can be designated for accounting purposes as fair value hedges, cash flow hedges, or hedges of a net investment in a foreign operation. In a fair value hedge, the entity uses a hedging instrument to hedge against the fluctuation in the fair value of the hedged item. In a cash flow hedge, the entity uses a hedging instrument (such as a derivative) to hedge against the fluctuation in the Canadian dollar value of future cash flows (such as future sales). The gain or loss on the hedging instrument is initially reported in other comprehensive income and subsequently reclassified to profit when the hedged item affects profit.



• The closing rate is used when the financial statement item can be settled at any time (i.e. accounts receivable, accounts payable, etc), whereas the forward rate is used when the item must be settled at a future date (i.e., the forward contract payable to, or receivable from, the bank or broker).



• The executory contract items should be shown at their net amount in the balance sheet because they will be settled simultaneously and on a net basis. For example, the receivable from and payable to the bank for the foreign currency are offset against each other and only the net difference is reported as either an asset or a liability.



• Disclosure requirements – There are many disclosure requirements listed in IAS 21 for the effects of changes in foreign-exchange rates and IFRS 9 (IAS 39) related to hedges. For instance, the entity must disclose the type of hedge and the risks being hedged. In addition, the entity must disclose the flow into and out of other comprehensive income during the year relating to cash flow hedges.

ASPE Differences

• Hedge accounting is permitted only when the critical terms of the hedging instrument match those of the hedge item.



• An entity may designate only the following hedging relationships (all under the assumption to mitigate the effect of future price changes of the commodity/foreign-currency exchange rates): (a) an anticipated purchase or sale of a commodity hedged with a forward contract; (b) an anticipated transaction denominated in a foreign currency hedged with a forward contract; (c) a foreign-currency-denominated interest-bearing asset or liability hedged with a cross-currency interest rate swap; (d) the net investment in a self-sustaining foreign operation hedged with a derivative or a non-derivative financial instrument.



• Hedge accounting for private companies follows an accrual-based model and is more restrictive and much simpler than hedge accounting for public companies.



• Disclosure is minimal compared to the disclosure required for public companies.