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Foreign Currency Forward Contracts and Cash Flow Hedging Navigating Accounting and Disclosure Requirements

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Foreign Currency Forward Contracts and Cash Flow Hedging Navigating Accounting and Disclosure Requirements A CCOUNTING & AUDITING accounting Foreign Currency Forward Contracts and Cash Flow Hedging Navigating Accounting and Disclosure Requirements By Josef Rashty and John O'Shaughnessy ompanies use futures contracts (i.e., derivative instru- wish to trade a contract payment provision calling for fixed ments) to manage exposure to various risks, such as inter- interest payment to another company for a variable interest pay- est rate risk, foreign exchange risk, acquisition of invento- ment. The instrument achieves the objectives of both: One com- C ry or capital equipment price risk, and credit risk. Because pany locks in a fixed cash flow and the other speculates on of the great variety of these types of contracts, “instruments” gen- interest changes. The accounting literature uses the “derivative” erally refer to any such contracts that trade in markets such as to further describe such contracts. the Chicago Mercantile Exchange as well as agreements devel- Hedge accounting generally requires that companies recog- oped strictly between companies. For example, one company may nize derivatives as assets and liabilities and subsequently measure 24 OCTOBER 2010 / THE CPA JOURNAL them at fair value. A derivative must a company creates a derivative instrument notional amount or a payment provision, qualify to be able to use hedge accounting. by engaging in a cash flow hedge trans- determines the settlement amount. A The alternative is to use nonhedge deriva- action. Before proceeding, it is necessary notional amount (ASC 815-10-15-92) is tive accounting, which reflects derivative to explain some of the technical concepts the number of currency units specified in fair value changes in earnings rather than behind derivatives. a derivative contract, and it determines on the balance sheet. Nonhedge account- Derivative instruments represent rights or the settlement amount under a derivative ing is generally unappealing to companies obligations and thus, should be shown as instrument. In summary, the settlement of because it creates volatility in earnings. If assets or liabilities. Because of the complex- a derivative instrument is determined by items initially qualify for hedge account- ity and quick evolution of derivative instru- the interaction of the notional amount and ing but subsequently lose their eligibility, ments, they were not required to be report- the underlying. they must revert back to nonhedge account- ed in financial statements until 1998, when Companies must recognize derivative ing and the unrealized gains and losses will FASB issued SFAS 133, Accounting for instruments as assets or liabilities in their be reflected in current earnings. Derivative Instruments and Hedging Activities statement of financial position at fair value The breadth and complexity of deriva- (Accounting Standards Codification [ASC] and remeasure their fair values in subse- tive accounting have created significant Topic 815). quent periods. challenges for companies that use them. FASB defines a derivative as a financial Futures and forwards are contracts to Many companies have failed to account for instrument or other contract with the fol- buy or sell a defined amount of a specif- them properly, resulting in a significant lowing characteristics (ASC 815-10-15-83): ic underlying asset at a specified price number of restatements. Companies must (a) It has (1) one or more underlyings agreed to at origination, with delivery and understand the economics of the transac- and (2) one or more notional amounts settlement at a specified future date. tion from a risk management perspective, or payment provisions or both. Those Companies use foreign currency forward and be versed in its accounting complexi- terms determine the amount of the set- contracts to hedge against changes in cur- ties. The determination that a transaction tlement or settlements, and, in some rency exchange rates of an existing asset qualifies for hedge accounting is subject to cases, whether or not a settlement is or liability, a firm commitment, or a fore- interpretation. Different conclusions can be required. (b) It requires no initial net casted transaction. Cash flow hedges, on reached as to whether a contract should investment or an initial net investment the other hand, protect against the risk be accounted for as a derivative instrument. that is smaller than would be required that variable prices, costs, rates, or terms There have been many examples of com- for other types of contracts that would will make future cash flows uncertain. panies restating their financial statements be expected to have a similar response A cash flow hedge is a hedge of the vari- because their initial judgment that called to changes in market factors. (c) Its able cash flow of an anticipated or fore- for derivative accounting subsequently terms require or permit net settlement, it casted transaction that will probably occur, proved to be incorrect. can readily be settled net by a means but the amount of which has not been fixed outside the contract, or it provides for at the time of initiation of the hedge Background delivery of an asset that puts the recip- transaction. Forecasted transactions must Derivatives are financial instruments ient in a position not substantially dif- be probable future transactions that do not whose value stems from fluctuations of their ferent from net settlement. meet the definition of a firm commitment underlying assets, liabilities, interest rates, Generally Accepted Accounting under GAAP. Forecasted transactions foreign currency exchange rates, or indices. Principles (GAAP) requires that if a hedge can be contractually established or merely Companies must recognize derivatives as transaction meets the criteria that permit probable because of a company’s past or assets or liabilities on the balance sheet at the use of hedge accounting, an entity may expected business practices. In other words, fair value and periodically remeasure them. elect to designate a derivative as one of the unlike firm commitment transactions, either If a derivative qualifies as a hedge instru- following hedges: some terms of the transaction are variable ment, it can decrease the volatility on a com- I Fair value—a hedge of the exposure to or the transaction itself is not contractual- pany’s statement of operations or income. changes in the fair value of a recognized ly certain. An example of this type of trans- For example, if a derivative qualifies as a asset or liability or of an unrecognized firm action is illustrated below. cash flow hedge, a company can report the commitment that are attributable to a par- Effectiveness. A transaction must be effective portion of the gain or loss on the ticular risk. effective to qualify for hedge accounting derivative instrument as a component of I Cash flow—a hedge of the exposure to under ASC 815. Hedge effectiveness refers other comprehensive income (loss), rather variability in the cash flows of a recog- to the extent that the changes in the fair than on the income statement, and reclassi- nized asset or liability, or of a forecasted value of hedging instrument offset the fy it into earnings in the same period or peri- transaction. changes in the fair value of the hedged item ods during which the hedged transaction I Net investment—a hedge of the foreign (the underlying). Although there is no spe- affects earnings. currency exposure of a net investment in cific guidance to determine that a hedge The accounting rules for derivatives are a foreign operation. is highly effective, FASB staff has stated the most complex ever issued by FASB. An underlying or a hedged item (ASC informally that in order for a hedge to be The discussion below will examine the 815-10-15-88) is a variable within a deriva- highly effective, the cumulative change in accounting and disclosures required when tive instrument that, along with either a the value of the derivative instrument OCTOBER 2010 / THE CPA JOURNAL 25 expressed as a ratio of the cumulative ment may be excluded from the effective- liability (ASC 815-35-55-2). The follow- change in the fair value of the hedged item ness assessment. When entities exclude the ing table reflects the monthly statement of (the underlying) must fall within the time value for the effectiveness testing pur- operations of Entity S: range of 80% to 120%. poses, the excluded time value will be Revenues 2,000 LCU If the hedge is highly effective, then reflected in the income statement. Expenditures 12,000 the treatment of the difference in the In order to maintain the advantages of Net loss 10,000 LCU changes in fair value of the derivative hedge accounting treatment, an entity must In this illustration, the hedged item (the instrument and the hedged item (the under- comply with rigorous GAAP documenta- underlying) is the exchange rate or the lying) depends upon the type of hedge. For tion requirements for its hedging transac- exchange rate index, and the notional amount example, for derivative instruments that tions. This must be performed at the incep- is the fixed number of currency units (20,000 qualify as cash flow hedges, the effective tion of the hedging relationship and on an LCU) which is the payment provision for the portion of the gain or loss on the deriva- ongoing basis (at least quarterly). The settlement of derivative instrument. tive instrument is reported as a compo- assessment must include an evaluation of According to ASC 830, Foreign nent of other comprehensive income (loss) whether the relationship between the Currency Matters, companies should reflect and is reclassified into earnings in the same derivative instrument and the hedged item the foreign currency fluctuation on the period or periods during which the hedged (the underlying) is considered highly effec- intercompany accounts that are not hedged forecasted transaction affects earnings. tive. In the absence of such documentation, or are de-designated (i.e., discontinued as Therefore, an entity can eliminate volatil- an instrument might not qualify for hedge a hedge) (ASC 830-20).
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