390 Planning and Forecasting
at their fair values. Whether or not these changes in fair value go immedi-
ately into the computation of net income will depend upon (1) whether or
not the derivative is used for hedging purposes and (2) the nature of the
hedge applications.
The accounting for changes in the fair value of a foreign-currency deriva-
tive depend upon its intended use. Possibilities include (1) the hedging of
exposure to changes in the fair value of a recognized asset, liability or an un-
recognized firm commitment, (2) the hedging of exposure to variable cash
f lows of a forecasted transaction, and (3) the hedging of a net investment in a
foreign operation. These three hedging applications are referred to as fair
value, cash f low and net-investment hedges, respectively.
Changes in the fair values of currency derivatives will either be reported
in the income statement as these changes take place or they will initially be re-
ported in other comprehensive income (OCI). The gains and losses that are ini-
tially included in OCI will subsequently be included in the income statement
when the hedged transaction affects net income.
Fair Value Hedges
A firm purchase commitment in a foreign currency is an example of a transac-
tion that could be a fair-value hedge candidate. Normally, there is no initial
recording on the books of the firm commitment. However, there is currency
risk and subsequent increases and decreases in the value of the foreign cur-
rency give rise to losses and gains, respectively. To illustrate how a hedge
would be accounted for in this case, assume a purchase commitment made for
100 million yen when the yen rate was $0.008976. By the end of the account-
ing period the yen has appreciated to $0.009000. This increase in the yen of
$0.000024 ($0.009000−$0.008976) creates a loss on the purchase commit-
ment of $2,400 ($0.000024×100 million yen). Also assume that the firm had
entered into a for ward contract to buy 100 million yen as a hedge of the firm
commitment. We will assume that the for ward contract (the currency deriva-
tive) also increased in value by $2,400.
Under SFAS No. 133, the $2,400 increase in the cost of the purchase
commitment would be recorded as a loss on the commitment. In addition, the
for ward contract would also be marked to market value, creating an offsetting
gain of $2,400. Each of these items would be reported in the income statement
where they will offset each other.
The special feature of the above accounting (i.e., hedge accounting), is
the recognition of the loss on the purchase commitment. Prior to SFAS No.
133, it would have been common not to recognize the loss on the purchase
commitment, but to recognize and defer the gain on the for ward contract.
Then the loss on the purchase commitment would not be recognized until the
purchase was made. At this time, the deferred gain on the currency derivative
would be deducted from the cost of the purchase. SFAS No. 133 basically
eliminates this type of gain or loss deferral on financial derivatives.