The Portable MBA in Finance and Accounting, 3rd Edition

(Greg DeLong) #1
Global Finance 391

Many of the hedging examples disclosed in Exhibits 12.5 and 12.8 in-
volved balances that were already recorded on the balance sheet of the
hedging firms. The use of hedges in these cases requires no special hedge ac-
counting.For example, consider the case of a one million pound sterling ac-
count receivable recorded when the sterling rate was $1.50. By the end of the
year, but before the pound receivable was collected, the pound depreciated to
$1.45. Assume that the U.S. firm hedged the full amount of the pound sterling
account receivable by entering a forward contract to sell the one million
pounds at the expected collection date.
Under current GAAP, the pound receivable must be revalued to the new
rate of $1.45, and a foreign currency transaction loss of $50,000 would be rec-
ognized. Moreover, the currency derivative would be marked to its new market
value, which is assumed to be $50,000, a perfect hedge.^38 This activity is sum-
marized below:


£ Account Receivable
Initial value of £1,000,000 at $1.50 equals $1,500,000
Value at year-end: £1,000,000 at $1.45 equals 1,450,000
Foreign-currency transaction loss 50,000
Currency Derivative
End-of-period value of the currency derivative $ 50,000
Initial value of the forward contract 0
Gain on the currency derivative (50,000)
Net effect on earnings $ 0

No special hedge accounting is required in the above case to cause the loss on
the receivable and the gain on the currency derivative to offset each other in
the income statement.


Cash Flow Hedges


Hedges of forecasted transactions, cash f low hedges,are distinguished from
hedges of firm commitments, which are classified as fair value hedges.As an
example, a forecasted transaction might involve the future receipt of royalty
payments in a foreign currency. There is currency exposure here because a de-
cline in the value of the foreign currency will reduce the dollar value of the
royalty, a cash f low, when it is received. A hedge of this exposure could be
achieved by selling a futures contract, investing in a put option, or selling the
foreign currency through a for ward contract.
In order to illustrate hedge accounting for a cash-f low hedge, assume
that a firm forecasts the receipt of one million German marks (DM) from roy-
alties. A currency derivative is acquired to hedge all of this exposure. At the
date that the derivative contract is entered into, the DM rate is $0.45. At the
end of the accounting period, but before the royalties are received, the DM
depreciates to $0.43. The value of the derivative contract increases by
$20,000. SFAS No. 133 requires that a gain from the increase in the fair value

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