2 types here There are 2 types of foreign exchange transactions envisaged by IFRS: - Uncovered = "NORMAL" = "EASY"
- Covered = "COMPLEX" = "DIFFICULT"
Uncovered Lets get easier one out the way first:
- record transaction at the spot rate taking following into account:
* the monetary item will always be recorded at the closing spot rate at year end => its this that gives rise to the foreign exchange differences
* the non-monetary item will forever be recorded at that spot rate Refer 1st two examples at the back
Covered Now lets look at the more complicated part of forex, hedging… But first a few definitions:
Firm commitment = binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date (s)
Forecast transaction = an uncomitted but anticipated future transaction
Hedging instrument = designated derivative (hedge of risk of changes in forex rates only) OR
= designated non-derivative financial asset OR
= a non-derivative financial liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item
Hedge criteria Note that a company can only apply hedge accounting, which is a voluntary accounting basis if ALL of the following conditions are met:
- at inception of the hedge there is formal designation and documentation of the hedging relationship - the hedge is expected to be highly effective
- for cash flow hedges, a forecast transaction must be highly probable and must present an exposure to variations in cash flows that ultimately effect profit/loss
- the effectiveness of the hedge can be reliably measured - the hedge is assessed on an ongoing basis
MY ADVISE ALWAYS remember that there are 2 parts to a forex item which is hedged => the inventory/creditor leg and then the actual FEC leg itself. Treat them separately
2 types of hedging There are 2 types of hedges:
STEPS / POINTERS STEPS / POINTERS
Refer 3rd example at back for overriding principle
(1) when entering into an FEC - no transaction is recorded (1) when entering into an FEC - no transaction is recorded (2) IF YEAR END IS AFTER SETTLEMENT then the gain or loss on (2) when the underlying transaction is recorded or the year end is
settlement of the forward exchange contract (FEC) is the reached, the FEC is valued by multiplying the foreign currency difference between the monetary item recorded at spot rate amount of the FEC by the difference between the contracted on the settlement date and the amount paid/received in terms forward rate and the forward rate of a similar FEC for the of the FEC on the same date remaining period with a corresponding forward exchange asset
or liability being raised (3) IF YEAR END IS BEFORE SETTLEMENT then the gain or loss on
the forward exchange contract (FEC) is the difference between (3) then decide on whether its one of the following: the contracted forward rate and the forward rate for a similar
FEC for the remaining period until maturity of the original contract and a corresponding forward exchange asset/liability is raised (4) IF THE FEC IS RENEWED OR ROLLED FORWARD then on maturity
date recognise the gain or loss on the FEC as that between the original forward rate and the spot rate at that date
Refer 4th example at back
recognise a financial asset/liability recognise a non-financial asset/liability or firm commitment * then the gain or loss recognised directly in reclassify the gain or loss previously *
equity is reclassified to the income statement recognised in equity into income in the same period that the asset/liability statement in same period that the affects income statement asset/liability affects income statement
* any unrecoverable amount is recognised in OR
the income statement if the entity expects
that all or a portion of a loss recognised in reclassify the gain or loss previously * equity will not be recovered in a future recognised into equity to the asset or
period liability so covered
^ ^ ^
Fair value hedge
Do we have an underlying transaction = NO (eg a forecast transaction) Do we have an underlying transaction = YES
Hedging
Cash flow hedge
NOW IF:
ABOVE DEPENDENT ON COMPANY'S POLICY
NB!!! Once the underlying asset/liability is recorded then a cash flow hedge reverts to a fair value hedge if hedge is effective, recognise the gain
or loss directly through statement of changes in equity
Examples
Example - Simple forex (same year)
GoW Ltd buys goods from the USA for $100 000 (FOB) on 1 March 2008. The goods are expected to be delivered on 1 June 2008, with payment on 30 June 2008. The year end is 31 December.
The fllowing exchange rates apply:
1 $ = x R
1 March 2008 1 June 2008 30 June 2008
Prepare the journals for this. Solution:
1 Mar 2008 Inventory
Trade creditor
(Recording inventory at spot rate on FOB date)
1 June 2008 No entry
30 June 2008 Trade creditor
Foreign exchange loss - I/S Bank
(Payment to the USA supplier)
NOTES:
1 The monetary asset, the trade creditor is the one that changes, whereas the non-monetary asset, inventory, stays the same throughout
Example - Simple forex (different year ends)
FM (Pty) Ltd purchases goods from USA for $100 000 (FOB). Delivery of the goods is expected on 1 June 2008 with payment due on 31 July 2008. At year end, 60% of the inventory was still on hand. The year end is 30 June.
1 $ = x R
1 March 2008 1 June 2008 30 June 2008 31 July 2008
Prepare the journals for this. Solution:
1 March 2008 Inventory
Trade creditor
(Recording inventory at spot rate on FOB date)
1 June 2008 No entry
30 June 2008 Foreign exchange loss - I/S Trade creditor
(Entry to bring liability up to amount owed in Rands at year end)
31 July 208 Trade creditor
Foreign exchange loss - I/S Bank
(Record the payment made to the USA supplier)
Example - FV hedge
GranT Ltd purchases an item of plant for $1m on 1 March 2009, payable in 90 days time. They decide to cover forward on the purchase, worried about the possible devaluation of the Rand. The relevant exchange rates are:
Spot rates Forward rates 1$ = R 1$ = R
1 March 2009 1 June 2009
Year end is 30 June 2009. Assume the hedge criteria are met, and prepare the journals. Solution:
1 Mar 2009 Inventory
Creditor
(Record the purchase from the USA supplier) 1 Mar 2009 FEC = no entry on date of entering into transaction
1 June 2009 Forex loss
Creditor
(Re-measure monetary item to FV using spot rate at payment date of 8.33 - 8.00)
1 June 2009 FEC asset
FEC gain
Example - Fair value hedge rolled forward/renewed
Sonic Ltd purchases $100 000 (FOB) worth of goods on 1 March 2008. Payment is to be made on 28 February 2009. In order to protect itself against currency fluctuations they enter into a 6 month forward exchange contract on 1 March 2008. Year end is 30 June.
Spot rates Forward rates 1$ = R 1$ = R
1 March 2008
30 June 2008 (3 month)
31 August 2008 (6 month)
28 February 2009
On 31 August 2008 the company rolls forward the FEC for a further 6 months. Assume hedging criteria are met.
Prepare the journal entries. Solution:
1 March 2008 Inventory
Trade creditor ($100 000 * R8)
30 June 2008 Foreign exchange loss - I/S Trade creditor ($100 000 * (8.33-8.00))
FEC Asset
Forex gain - I/S ($100 000 * (8.37 - 8.12))
31 August 2008 Bank
Forex gain - I/S FEC asset
(Pay $100 000 at R8.12 and then take out a further FEC at R8.41)
28 Feb 2009 Forex loss - I/S Trade creditor ($100 000 * (8.54-8.33))
FEC asset
Forex gain - I/S ($100 000 * (8.54-8.47))
Trade creditor FEC asset
Bank ($100 000 * 8.47 FEC rate) (Payment to creditor and FEC settled)
