Foreign Currency Transactions and Hedging: CPA Exam Examples

Foreign Currency Transaction Basics

When a U.S. company enters into a transaction denominated in a foreign currency, it faces exchange rate risk between the transaction date and the settlement date. Under ASC 830, foreign currency transactions are recorded at the spot rate on the transaction date, and receivables and payables are remeasured at the spot rate on each subsequent balance sheet date and the settlement date. Exchange gains and losses from remeasurement are recognized in net income in the period they occur.

Import Transaction Example

On November 1, a U.S. company purchases inventory from a German supplier for 100,000 euros, payable on January 31. Exchange rates:

• November 1 (transaction date): 1 EUR = $1.10
• December 31 (balance sheet date): 1 EUR = $1.13
• January 31 (settlement date): 1 EUR = $1.15

November 1 entry:

• Debit: Inventory $110,000 (100,000 x $1.10)
• Credit: Accounts Payable $110,000

December 31 adjustment: The payable has increased to $113,000 (100,000 x $1.13).

• Debit: Foreign Currency Transaction Loss $3,000
• Credit: Accounts Payable $3,000

January 31 settlement: The payable is now $115,000 (100,000 x $1.15).

• Debit: Foreign Currency Transaction Loss $2,000
• Debit: Accounts Payable $113,000
• Credit: Cash $115,000

The inventory remains at its original $110,000. Only the monetary item (A/P) is remeasured.

Foreign Currency Translation (ASC 830)

When consolidating a foreign subsidiary, the subsidiary's financial statements must be translated into the parent's reporting currency. The method depends on the subsidiary's functional currency:

Current Rate Method (functional currency = local currency)

• Assets and liabilities: translated at the current (closing) rate
• Equity: translated at historical rates
• Revenues and expenses: translated at average rate for the period
• Translation adjustment: reported in OCI as cumulative translation adjustment (CTA)

Temporal (Remeasurement) Method (functional currency = parent's currency)

• Monetary assets/liabilities: current rate
• Nonmonetary assets/liabilities: historical rates
• Revenues/expenses related to nonmonetary items (depreciation, COGS): historical rates
• Other revenues/expenses: average rate
• Remeasurement gain/loss: recognized in net income

Hedging Foreign Currency Risk

Companies can use derivative instruments, most commonly forward contracts, to hedge foreign currency exposures. ASC 815 provides hedge accounting treatment that aligns the timing of gains and losses on the hedging instrument with the hedged item.

Fair Value Hedge of a Foreign Currency Receivable

A U.S. company sells goods to a British customer for 200,000 GBP on October 1, receivable December 31. To hedge, it enters a forward contract to sell 200,000 GBP on December 31 at a forward rate of $1.28. Spot rates: October 1: $1.30; December 31: $1.25.

October 1:

• Record sale: Debit A/R $260,000 (200,000 x $1.30); Credit Revenue $260,000
• Forward contract: No entry needed (fair value is zero at inception)

December 31:

• Remeasure receivable: A/R decreases from $260,000 to $250,000 (200,000 x $1.25). Debit: Foreign Currency Loss $10,000; Credit: A/R $10,000.
• Forward contract gain: The right to sell at $1.28 when the spot is $1.25 creates a gain. Forward contract fair value: 200,000 x ($1.28 - $1.25) = $6,000. Debit: Forward Contract Asset $6,000; Credit: Gain on Forward Contract $6,000.

The net impact on income is a $4,000 loss ($10,000 loss minus $6,000 gain). The hedge offsets most but not all of the exposure because the forward rate differs from the original spot rate (the difference reflects the forward premium/discount).

Cash Flow Hedge of a Forecasted Transaction

When hedging a forecasted foreign currency transaction (such as a planned purchase), the effective portion of the hedge gain or loss is recorded in OCI and reclassified to earnings when the forecasted transaction affects earnings. The ineffective portion goes immediately to earnings.

Net Investment Hedges

A hedge of a net investment in a foreign operation designates a derivative or a foreign-currency-denominated liability as the hedging instrument. The effective portion of the hedge gain or loss is recorded in the CTA within OCI, offsetting the translation adjustment on the net investment. This type of hedge is commonly tested in the context of consolidation questions.

Key Exam Tips

• Foreign currency transaction gains and losses on monetary items go to net income; translation adjustments on foreign subsidiaries using the current rate method go to OCI.
• The temporal method produces remeasurement gains/losses in net income; the current rate method produces CTA in OCI.
• Forward contracts are the most commonly tested hedging instrument; know the journal entries for both fair value and cash flow hedges.
• Inventory stays at the historical rate under both the purchase transaction and the temporal method.
• On the exam, always check whether the company has a payable (short foreign currency) or receivable (long foreign currency) to determine the direction of the exchange gain or loss.