Question

Address the following, which cover the main objectives for this module:

1. Summarize the differences that exist, if any, between the US GAAP and IFRS on the accounting for derivatives designated as hedges at the current date you are answering this question.
2. Prepare an example of a U.S.-based firm managing an exposed foreign currency net liability position including the journal entries required from the date the U.S. firm purchases goods on account from a foreign-based supplier until the date the purchase is settled, including all journal entries required over a 3-month period of time.

Answer 1

1)Differences that may exist between US GAAP and IFRS on the accounting for derivetives as hedges are as follows:

Accounting for amounts excluded from the assessment of effectiveness US GAAP and IFRS diverge regarding how to account for a component excluded from the assessment of effectiveness.

US GAAP IFRS For Cash flow, fair value, and net investment hedges, an entity may choose between two methods to account for an excluded component: 1. Amortization approach The initial value of the excluded component is recognized in earnings using a systematic and rational method over the life of the hedging instrument, with any difference between the change in fair value of the excluded component and the amount in earnings recognized in OCI (CTA for net investment hedges). 2. Mark-to-market approach the changes in fair value of the excluded component are recognized in current earnings. Unlike IFRS, US GAAP does not have a specific concept of aligned time value (i.e. time value that only relates to the hedged item) or aligned forward element. When using the spot method, discounting of the spot rate is not required (and in the case of a net investment hedge, discounting is not permitted). IFRS 9 has specific guidance by type of derivative. Options For cash flow, fair value, and net investment hedges, if an entity elects to designate only the intrinsic value of the option as the hedging instrument, it must account for the changes in the “aligned time value” (i.e., when the critical terms of the option and hedged item are aligned) in OCI and hold those changes in a hedging reserve in equity. Recognition of the aligned time value in profit or loss will depend on whether the hedge is transaction-related (and recorded in profit or loss at the same time as the hedged item) or time–period-related (and recorded in profit or loss using a systematic and rational basis over the period of the hedge). Forwards points and currency basis spread An entity may recognize changes in value due to changes in forward points or foreign currency basis spread in profit or loss immediately or defer them using the recognition guidance for options. Aligned portion Recognition of the excluded component applies to the aligned portion, i.e., the portion for which the critical terms such as notional, price, term and underlying of the derivative and the hedged item are aligned. This is called the “aligned time value” or “aligned forward element.” IFRS 9 specifies a particular calculation methodology that can be complex to apply when the actual time value or forward element is lower than the aligned time value or forward element at inception of the hedge. National Professional Services Group When the change in spot rate is the designated hedged risk, entities still need to consider the time value of money and, when appropriate, measure the hedged item using the discounted spot rate. However, for a net investment hedge, we believe that an entity can choose not to impute a time period into the hedging relationship and designate the hedged risk without discounting.

EXAMPLE:

On December 1, 2017, the firm entered into a contract to purchase inventory for $525,000 (the spot rate was $1.05 on that date). If the exchange rate did not change over the payment period, the firm would owe $525,000 to settle the payable. However, if the exchange rate increased to $1.07, the firm would have to pay $535,000 to settle the debt (500,000 x $1.07). On the other hand, if the exchange rate dropped to $1.02, the firm would only need to pay $510,000, (or 500,000 x $1.02). Because the firm cannot perfectly estimate the change in the exchange rate, the company might prefer to eliminate this risk by entering into a forward contract to buy euros on March 1, 2018. Since the forward rate on December 1, 2017 to purchase euros on March 1, 2018 is $1.052, the company can buy 500,000 euros on March 1 for a guaranteed price of $526,000. This fixed price means that the firm has determined in advance the maximum amount of loss it will suffer, in this case $1,000. Thus the firm is protected from future increases in the exchange rate above $1.052. By locking into a set price, the firm gains if the spot rate on March 1, 2018 increases above $1.052 and loses if the spot rate decreases below $1.052. The important point to note about the hedge is that the firm knows with certainty on December 1, 2017, the amount of cash needed to purchase the asset.

The entries to record the purchase and forward exchange contract are:

December 1, 2017 - Transaction Date

(1)	Purchases	525,000
	Accounts Payable (500,000 euros x $1.05)		525,000
	To record purchase of goods on account               using the spot rate on December 1, 2017.

The accounts payable for the inventory purchase is recorded using the spot rate on the transaction date (on December 1, 2017)

(2)	Foreign Currency (FC) Receivable from Exchange
	Dealer	526,000
	Dollars Payable to Exchange Dealer		526,000
	(500,000 euros x $1.052)
	To record forward contract to buy 500,000 euro                   using the forward rate.

At the date of the transaction, the U.S. firm records the forward contract by recognizing a payable and a receivable of $526,000 for the number of dollars to be paid (units of foreign currency to be purchased multiplied by forward rate) to the exchange dealer when the forward contract matures. The net value of the forward contract is zero since the payable and the receivable are exactly offset. The value of the receivable from the dealer and the accounts payable for the purchase of inventory are subject to changes in exchange rate, but the gains and losses generally offset each other to a large extent since the terms and the amounts are equal.

On December 31, 2017, the spot rate increases from $1.05 to $1.06 resulting in an increase of $5,000 to accounts payable. The spot rate is used for accounts payable since that is the amount needed to settle the liability.

December 31, 2017 - Balance Sheet Date

(3)	Transaction Loss	5,000
	Accounts Payable		5,000
	To record a loss on the liability denominated in foreign currency Current value of accounts payable (500,000 euros x $1.06) = $530,000 Less: Recorded value of accounts payable   =                           $525,000 Adjustment needed to accounts payable                                      $5,000 On the other hand, the value of the forward contract is determined using the change in the forward rates. The forward rate increased to $1.059 from $1.052. This results in an increase of $3,500 to the receivable from the exchange dealer. Recall that the payable to the foreign exchange dealer is fixed by the forward contract. Thus the forward contract has a positive $3,500 value at this point (December 31). (4) FC Receivable from Exchange Dealer 3,500      Transaction Gain 3,500 To record a gain on foreign currency to be received from exchange dealer [(500,000 euros x $1.059 = $529,500) - $526,000)]. If the financial statements are prepared on December 31, 2017, the value of the forward contract is as follows:               FC Receivable from Exchange Dealer                                 $529,500               Dollars Payable to Exchange Dealer                                     526,000               Net Receivable from Exchange Dealer                                   $3,500 This net value would be reported on the balance sheet. In addition, accounts payable would be recorded at the spot rate, or $530,000. The income statement would report an exchange loss of $5,000 and an exchange gain of $3,500.               Note that even though the forward contract and the accounts payable cover similar terms (December 1 to March 1) and amounts (500,000 euros), the amount of the transaction loss on the payable does not equal the transaction gain on the FC receivable. They are not equal because accounts payable is valued using changes in the spot rate while the value of the forward contract is determined using changes in the forward rates. On the settlement date, the forward rate and the spot rate become equal. Thus the total transaction gain or loss on the contract will eventually equal the guaranteed gain or loss determined on the date the forward contract is acquired. On March 1, 2018, the spot rate increases to $1.07 from $1.06 resulting in an increase in accounts payable of $5,000, (($1.07-$1.06) x 500,000). Since on the settlement date, the forward rate on this date and the spot rate are identical, the change in the March 1 forward rate on December 31 to the spot rate on March 1, 2017 is $.011, or ($1.059 to $1.07). This results in an increase to the FC receivable of $5,500, or (($1.07-$1.059) x 500,000). The journal entries to record these events are as follows:

SETTELMENT DATE

(5)	Transaction Loss	5,000
	Accounts Payable		5,000

To record a loss from 12/31/17 to 3/1/18 on liability denominated in foreign currency. The current value of the payable $535,000, (500,000 euros x $1.07) less the recorded value of the payable on December 31 of $530,000 is $5,000, or [(500,000 euros x $1.07 = $535,000) - $530,000)].

(6)	FC Receivable from Exchange Dealer	5,500
	Transaction gain		5,500
	To record a gain from 12/31/17 to 3/1/18 on     foreign currency to be     received from exchange dealer (The change in the 12/31 forward rate to               the spot rate on March 1, 2018 times 500,000 euros, or               [(500,000 euros x $1.07 = $535,000) - $529,500)].).

The recorded balances in both accounts payable and the FC receivable are $535,000 reflecting the spot rate on March 1, 2017. The dollars payable to the dealer remains fixed at $526,000 the original contracted amount. Entry (7) records the cash payment of $526,000 and the reduction of the FC payable. Also, the receivable is converted to the Investment in FC representing the 500,000 euros acquired in the forward contract. In entry (8), the euros are used to settle the accounts payable.

(7)	Dollars Payable to Exchange Dealer	526,000
	Investment in FC (500,000 euros)	535,000
	FC Receivable from Exchange Dealer		535,000
	Cash		526,000
	To record payment to exchange dealer and receipt of 500,000 euros    (500,000 euros x $1.07 = $535,000).
(8)	Accounts Payable	535,000
	Investment in FC		535,000
	To record payment of liability upon transfer of 500,000 euros.

By obtaining the forward contract, the firm was able to establish at the transaction date the amount of dollars ($526,000) that it would take to acquire the 500,000 euros needed to settle the account with the foreign firm. Note, however, that the cost of the inventory of $525,000 was established on December 1 [entry (1)]. If the forward contract had not been obtained, the firm would have had to pay $535,000 to settle the account and would have reported a net loss of $10,000 on the exposed liability position. The net gain from entering into the forward contract, however, largely canceled out the net loss on the exposed liability position.