AFAR - Foreign Exchange Transactions

THE CPA BOARD EXAMS OUTLINES by John Mahatma Agripa, CPA

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ADVANCED FINANCIAL ACCOUNTING AND REPORTING

FOREIGN EXCHANGE TRANSACTIONS Based on lectures and materials by Rodiel C. Ferrer, CPA, Ph.D. and Brian Lim, CPA (CPAR)

FOREX TRANSACTIONS IN GENERAL

 In a strict sense, foreign exchange transactions are those that are to be settled in foreign currency, regardless of the location of either party. These are accounted for by the domestic company by translating the amounts in foreign currency with BSP-set exchange rates  For translation purposes, the exchange rates must be quoted directly, where the Peso is expressed as the equivalent of one foreign currency. Rates displayed on news are usually on indirect quotation. To convert, 1 ÷ (FC equivalent of Php 1). Converting from direct quotation to indirect quotation also follows the same format If the given exchange rates in a particular problem are not in Peso, conversion is necessary

IMPORT AND EXPORT (UNHEDGED) TRANSACTIONS

 In an unhedged import and export transaction, the only relevant exchange rate would be the spot rate as of the date of the transaction, balance sheet date, and the date of settlement  Spot rates are classified as either buying or selling (also called bid and offer rates, respectively). If the domestic entity exports, the buying rate is used since this would be the price that the foreign buyer would pay for the goods. If the domestic entity imports, the selling rate is used Suppose the domestic company exports goods on F.O.B. destination freight terms. On the date of transaction, the spot rate to be used will be as of the date when the goods reached the buyer – the point when legal title is passed under the freight term. Of course, if on F.O.B. shipping point, it will be when shipped

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 The domestic entity recognizes forex gains or losses as the spot rate changes during the aforementioned dates only. For instance, if the domestic entity is an exporter (thus it has outstanding accounts receivable) and the buying spot rate increases, the entity recognizes forex gains to be recorded in profit/loss (together with an increase in accounts receivable) The foreign entity does not record any forex gains or losses since the transaction is denominated in their currency  The final cash payment during the date of settlement shall of course still be at the spot rate, so is the cost at which the asset purchased is recorded

FOREIGN DEBT TRANSACTIONS

 Just like purchase of commodities, forex gains/losses are also recognized in foreign debt borrowings/grants. Also, the purchase of the goods might have been made through issuance of promissory notes and other debt instrument  If the domestic entity is a borrower, it must use the selling spot rate, and the buying spot rate if it lends Pa Rong Co. signed a two-year promissory note bearing 12% on December 1, 2016 for $10,000. Interest is to be paid monthly. Assume the selling spot rates are the following: Php 2 (December 1), Php 3 (December 31), and Php 1.5 (December 31, 2017) o On December 31, 2016, any forex gains/losses on the loan is based on the principal alone. Thus, there is a forex loss of Php 10,000 with a credit to Notes Payable for 2016 ($10,000 × [Php 3 – Php 2]) o The actual interest expense is based on the current spot rate of the principal amount o On December 31, 2017, forex gains/losses are now based on ILLUSTRATION

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both the principal and the interest. The forex gains/losses from the interest is based on the forex gains/losses computed on the principal. There is a forex gain on the principal amounting to Php 15,000 ($10,000 × [Php 3 – Php 1.5]). Thus, there is also a forex gain on the interest, amounting to Php 1,800 (Php 15,000 × .12)

FIRM (PURCHASE/SALE) COMMITMENTS

 There is no actual transaction taking place in a firm commitment, which can be to sell or purchase something at a future date. This means that the purchase/the asset is not recorded until the date of settlement, unlike the previous transaction in which the asset is already recognized at the date of transaction. Only a memo entry is made for the asset during the transaction date  Only forward rates are relevant in this case. At the date of settlement, the purchase is recorded using the forward rate at the date of settlement. In a firm commitment, the buyer (or seller) contracts that he will pay (receive) an amount at the agreed rate no matter if it changes  There is zero net forex gain/loss in a firm commitment. Suppose the domestic entity enters in a purchase commitment, and that the forward rate increases. They would record a forex gain on the commitment (debit Accounts Payable, credit Forex Gain) and a forex loss on the item (debit Firm Commitment, credit Forex Loss) at the same amount. ‘Firm Commitment’ in this case is an asset account  At the date of settlement, the domestic entity pays/receives an amount equal to the forward rate at the date of settlement. The cost of the asset, as mentioned, is at the forward rate at the date of transaction. Any difference is debited/credited to Firm Commitment account

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HEDGED FOREX TRANSACTIONS: GENERAL CONCEPTS

 Entities engage in hedging transactions to mitigate potential losses arising from volatile exchange rates. To hedge is to take the position opposite that of the transaction. This means that if the hedged item (the asset) records a forex gain, the hedge records a forex loss to even out things  Hedging instruments are usually in the form of derivatives, financial instruments that derive their value from another instrument. They are classified as either option-based (offers onesided protection against exchange rate risks, such as options and swaps) and forward-based (offers two-sided protection, such as forward and futures contracts)  Just like in a firm commitment, there are two sets of entries to be made in a hedged transaction – one for the hedged item (the asset) and one for the hedging instrument. Suppose that the domestic entity sells, and the exchange rate increases. The hedged item would record a forex gain (debit Accounts Receivable, credit Forex Gain), and the hedging instrument would record a forex loss (debit Forex Loss, credit Forward Contract Payable) The net forex gain/loss from the hedged item and hedging instrument is referred to as the forex gain/loss from hedging activity Of course, on the hedging instrument’s side, the Forward Contract Receivable account absorbs any change in exchange rate if the domestic entity purchases, and Forward Contract Payable if it sells. On the other side, Accounts Payable and Accounts Receivable absorbs the changes, respectively Note that the liability/receivable to third person is based on the entries on the hedged item, not the hedging instrument  Forward rates are used for the hedging instrument until the date of

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settlement, when the spot rate is used. Of course, if the selling spot rate is used on the hedged item, the selling forward rate is used for the hedging instrument Problems usually present forward rates classified as per a particular number of days. The rate to be used is the number of days remaining until the date of settlement  On settlement date, the domestic entity either receives (debits) or pays (credits) cash equal to the difference of the spot rate at settlement and the forward rate at the date of transaction. This is because the agreed upon rate (the forward rate at the date of transaction) is the amount that the parties agreed to be paid regardless of the change in the rates. A bank or other speculators usually handle the difference

HEDGED FOREX TRANSACTIONS: ACCOUNTING FOR HEDGING INSTRUMENTS

 Hedging instruments are also classified as either fair value hedges (used in transactions with recognized assets and liabilities, such as in actual purchases/sales), cash flow hedges (used in forecasted and anticipated transactions), and net investment hedges (similar in treatment as to cash flow hedges, used between a domestic and a foreign entity) If silent, the hedge is assumed to be one of fair value hedge  Recording exchange rate changes as they affect the hedging instrument can be made in two ways – split and non-split accounting. Under split accounting, gains/losses of the instrument is divided into the effective portion (or the intrinsic value), and the ineffective portion (or the time value gains and losses) In fair value hedges, both the effective and ineffective portion of the gains/losses go to profit/loss. In cash flow/net investment

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hedges, the effective portion is a component of other comprehensive income, while the ineffective portion goes to profit/loss Split and non-split accounting is best illustrated with options

HEDGED FOREX TRANSACTIONS: OPTION CONTRACTS

 Options are contracts that grant holders the right to either buy (call) or sell (put) goods at the future date at a predetermined price, called the strike/exercise price. This is recorded as an investment in the balance sheet. The amount paid for an option is referred to as the option premium  They may be classified as to the likeability of their exercise. If the option is at the money (strike price equals current market prices), the option is likely to be exercised, bearing no loss on the holder. If the option is in the money, it is also likely to be exercised, bearing gains on the holder. In a put option, this is when the strike price is greater than market prices; in a call option, this is when the strike price is less than market prices. If out of the money, the option is likely not to be exercised, since it would bring losses to the holder  The option contact is the hedging instrument. However, it is not a derivative like forward contracts, since it has its own cost (the option premium). Also, it is not affected by changes in the forward rate, since its value depends on its current fair value The change in the fair value is the fair value is total gains/losses on the hedging instrument, to be recorded on profit/loss (if fair value hedge) or other comprehensive income (if cash flow hedge) if the company uses non-split accounting If problems mention that “the effect of time value gains/losses are excluded in the assessment of hedge effectiveness”, the company

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uses split accounting, wherein the fair value change is divided into the effective and ineffective portions. Option contracts are usually classified as cash flow hedges  The following format is used for split accounting: Fair value of option LESS: Intrinsic value Time value

Date #1 xx xx xx

(difference) Date #2 Total gains/losses xx xx LESS: Intrinsic value g/l xx xx Time value g/l xx xx

 The intrinsic value is computed by multiplying the notional amount (the amount of the foreign currency) by the difference of the strike price and the market price per item. The change in the intrinsic value is the effective portion of the total gains/losses. Note that the intrinsic value itself is not the effective portion to be sent to OCI. The same goes for the time value gains/losses There is only intrinsic value if the option is in the money, otherwise it shall be zero. At the settlement date, the intrinsic value should always match the fair value of the option, resulting to a zero time value gains/losses The effective portion is among the components of OCI that gets transferred to profit/loss. The amount is transferred if the asset purchased is sold or depreciated, whichever is applicable  The forex gain/loss from the hedging activity in this case is equal only to the time value gains/losses, since the effective portion goes to other comprehensive income

FOREIGN CURRENCY TRANSLATION

 The presentation currency to be used in the financial statements is the functional currency, which is the one used in the economic environment in which the entity operates. Sales dictate the entity’s functional currency

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 Translation of financial statements also give rise to gains/losses to be recorded in other comprehensive income. This is to be transferred to profit/loss when the foreign branch is sold  Translation gain/loss to be entered in statement of comprehensive income can be computed as follows: Net assets @ current/year-end rate LESS: Net assets @ roll-forward Beg net assets @ rate of prev. year-end xx ADD: Net income @ average rate xx ADD: Dividends @ rate at declaration xx Translation gain/loss, balance in OCI in equity current year LESS: Translation gain/loss, beginning Translation gain/loss, current year (to SCI)

xx

xx xx xx xx

 For instance, the domestic entity owns not a business but just a single asset overseas that’s measured at fair value, such as investment property. That item’s value shall be its fair value overseas at foreign currency, to be translated with the exchange rate as of when the fair value was determined. No forex gains/losses are recorded, but only unrealized gains/losses. This is because forex gains/losses only emerge from monetary assets, such as accounts receivable/payable If the item is measured at cost, it remains to be measured at its historical cost, using the exchange rate when purchased

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