392 Planning and Forecasting
of a der ivative contract be recognized as it occurs. However, GAAP does not
permit recognition of the loss from the decline in the dollar value of the fore-
casted DM cash f low.
Recognition of the $20,000 gain on the currency derivative as part of
earnings would present a problem. There would be no offsetting loss in the in-
come statement from the decline of the dollar value in the DM royalties.
Hedge accounting deals with this problem by providing that the $20,000 gain
on the derivative be included in other comprehensive income and not net in-
come. Then, when the DM royalties are received, the $20,000 gain is reclassi-
fied out of accumulated other comprehensive income and in to net income.
To illustrate the above fully, assume that the one million DM of royalties
are received, and that the value of the DM has not changed in value from
its previous year-end rate of $0.43. The hedge accounting is summarized in Ex-
hibit 12.24.
Notice that the total income recognized in the income statement in the
period in which the royalty is received is $450,000. This is equal to the original
value of the expected royalty cash f low. However, the $450,000 is made up of
only $430,000 in royalty value and the remainder is the product of the cash
f low hedge.
Hedges of Net Investments in Foreign Operations
Earlier discussion of statement translation revealed far less hedging of transla-
tion as opposed to transaction exposure. Most translation of the net investments
in foreign operations, typically foreign subsidiaries, employs the all-current
method. Under this translation procedure, all translation adjustments (transla-
tion gains and losses) are recorded in other comprehensive income. These trans-
lation adjustments are only included in the computation of net income if all or a
significant portion of the foreign operation is sold or other wise disposed of.
Some firms do hedge their translation exposure. Consistent with the trans-
lation adjustments being included in other comprehensive income, offsetting
gains and losses on currency derivatives used to hedge translation exposure are
EXHIBIT 12.24 Hedge accounting for expected cash f low.
Period of Receipt
Initial Period of RoyaltiesIncluded in net income
Gain on currency derivative 0 $ 20,000
Royalty cash inf low 0 430,000
$450,000
Included in other comprehensive income:
Gain on currency derivative $20,000 $ (20,000)