Prepared by: HAZEL JADE E.

VILLAMAR__
E-mail Address: [email protected]________

Central Luzon State University

Science City of Muñoz 3120
Nueva Ecija, Philippines

Instructional Module for the Course

ACCTG 2215 / Accounting for Business Combinations

Module 3
Topic 1
(Accounting for Currency Transactions)
Overview

This course covers the concepts and application of the different

standards related to accounting for business combination. It involves
techniques and methodologies on how to deal properly with issues and
problems involving business combination that are likely to be encountered
in practice and in the National CPA Licensure Examination.

I. Objectives
At the end of the module, the following are expected to:

A. Differentiate measured from denominated;

B. Differentiate Conversion and Translation; and

C. Understand the accounting for foreign currency transactions.

 ACCTG 2215 / Accounting for Business Combinations

ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS

DENOMINATED VS. MEASURED

Denominated – when a transaction is to be settled by the receipt or payment of a specified

currency, the receivable or payable is said to be denominated in that currency.

Measured – regardless of the currency in which a transaction is denominated, the party to

the transaction measures and records the transaction in the currency in which the party is
located.

CONVERSION VS. TRANSLATION

Conversion – On transactions involving foreign currency, the measured amount should be

converted into the local currency at the prevailing rate of exchange on the date of payment.

Translation – the assets, liabilities, and operating items of a foreign branch or subsidiary
are translated into Philippine pesos to consolidate them into the financial statements of the
Philippine home office or parent company. No actual exchange of currencies is involved,
only a translation into a single currency.

CURRENCY EXCHANGE RATE

Exchange rate – the rate in which the currencies of two countries are exchanged at a
particular time. The buying and selling of foreign currencies as though they were
commodities result in variation in the exchange rate between the currencies of two
countries. For example, the following are the exchange rates for the US dollars:

US Dollars in Pesos Pesos in US Dollars

United States of America (US Dollar) 48.60 0.020576

The $1.00 could be exchanged for approximately P48.60 (direct quotation). On the other
hand, P1.00 could be exchange for approximately $0.020576 (indirect quotation). The two
exchange rate are reciprocals.

Selling Spot Rate – charged by the bank for current sales of the foreign currency.
Buying Spot Rate – usually less than the selling spot rate.
Spread – the difference between the selling and buying spot rates which represents the
gross profit to a trader in foreign currency.
Forward Exchange Rate – applies to foreign currency transactions to be consummated
on a future date.
Forward Exchange Contracts – derivative instruments where the forward exchange
rates are used.

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Factors influencing fluctuations in the nation’s exchange rates includes differing

global rates of inflation, capital investment levels, money market variations, and monetary
actions of the central banks.

ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS

Foreign Currency Transaction – a transaction that requires settlement or payment in a

foreign currency. A transaction with a foreign company that is to be paid in Philippine peso
is not a foreign currency transaction to a Philippine company, because the amount of pesos
to be received or paid to settle the account is fixed and is not affected by subsequent
changes in the exchange rate.

Foreign Currency Translation – when the transaction is negotiated and settled in terms
of the foreign company’s local currency unit, the Philippine company must account for the
transactions denominated in foreign currency in terms of Philippine pesos by applying the
appropriate exchange rate between the foreign currency and the Philippine pesos.

Some of the more common foreign currency transactions are:

a. Importing and exporting goods on credit with the receivable or payable denominated in
foreign currency;
b. Borrowing or lending denominated in foreign currency; and
c. Entering into a forward exchange contract to buy or sell foreign currency.

Importing and Exporting of Goods

It is the most common form of foreign currency transaction. In each unsettled foreign
currency transaction, the following are to be considered:

a. At the date of transaction is first recognized, each asset, liability, revenue, gain
or loss arising from the transaction is measured and recorded in Philippine pesos
by multiplying the units of foreign currency by the closing exchange rate, that is,
the spot rate in effect on a given date.
b. At each balance sheet date that occurs between the transaction date and the
settlement date, recorded balances that are denominated in a foreign currency
are adjusted to reflect the closing exchange rate in effect at the date of the
statement of financial position. Foreign exchange (forex) gain or loss is to be
recognized for the difference in the exchange rate between the transaction date
and the balance sheet date.
c. At the settlement date, in the case of a foreign currency payable, a Philippine
company must convert Philippine pesos into foreign currency units to settle the
account, while foreign currency units received to settle a foreign currency

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receivable will be converted into pesos. Although translation is not required, a

foreign exchange (forex) gain or loss is to be recognized if the amount of pesos
paid or received upon conversion does not equal the carrying value of the related
payable or receivable.

Foreign Currency (Forex) Gains and Losses

The increase in the selling spot rate for a foreign currency required by a Philippine
company to settle a liability denominated in that currency generate foreign exchange (forex)
losses to the company because more Philippine peso are required to obtain the foreign
currency. The increases in the buying spot rate for a foreign currency to be received by a
Philippine company in settlement of a receivable denominated in that currency generate
foreign exchange (forex) gains to the company.
The decreases in the selling spot rate produce foreign exchange (forex) gains to the
company because fewer Philippine peso are required to obtain the foreign currency. The
decreases in the buying spot rate produce foreign exchange (forex) losses.

Balance Sheet Effect on balance Income

account affected reported Statement effect
Increase in exchange rate
Importing transaction Payable Increase Loss
Exporting transaction Receivable Increase Gain
Decrease in exchange rate
Importing transaction Payable Decrease Gain
Exporting transaction Receivable Decrease Loss

Foreign exchange gains and losses are included in the measurement of net income
for the accounting period in which the exchange rate (spot rate) changes (PAS 21).

DERIVATIVES

Derivatives are financial contracts or other contract with all three of the following
characteristics (PAS 39):
1. Whose value changes in response to changes in a specified interest rate, security price,
commodity price, foreign exchange rate, index of prices or rates, a credit rating or
credit index or other variable (sometimes called the “underlying”);
2. It requires no initial net investment or an initial net investment that is smaller than
what would be required for other types of contracts that would be expected to have a
similar response to changes in market factors.
3. It is settled at a future date.

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In the statement of financial position, derivatives are measured at fair values. As a

general rule, the changes in the fair value of a derivative are recognized in profit or loss.
However, when the derivative is used to offset risk and special hedge accounting conditions
are met, some or all changes in fair value are recognized as a separate component of equity.

HEDGING

It is a risk management technique that involves using one or more derivatives or

other hedging instruments to offset changes in fair value or cash flows of hedged items.
PAS 39 explains the general provisions on hedging and hedge accounting.

Two Components of a Hedging Relationship

a. Hedging Instrument – a designated derivative or a designated non-derivative financial

asset or non-derivative financial liability whose fair value or cash flows are expected to offset
changes in fair value or cash flows of a designated hedged item. Examples are interest rate
swaps, commodity futures contracts and foreign exchange forward contracts.

b. Hedged Item – an asset, liability, firm commitment, highly probable forecast transaction,
or net investment in a foreign operation. To be designated as a hedged item, the designated
hedged item should expose the entity to risk of changes in fair value or future cash flows.

Three Types of Hedging

a. Fair Value Hedge – a hedge of the exposure to changes in fair value of a recognized asset
or liability or an unrecognized firm commitment that is attributable to a particular risk, and
that could affect profit or loss. Under fair value accounting, changes in the fair value of the
hedging instrument and of the hedged item are recognized in profit or loss at the same
time. The result is that there will be no net impact on profit or loss of the hedging instrument
and the hedged item if the hedge is fully effective, because changes in fair value will offset
each other. If the hedge is not 100 percent effective, such ineffectiveness is automatically
reflected in profit or loss.

b. Cash Flow Hedge – a hedge of the exposure to variability in cash flows that is attributable
to particular risk associated with a recognized asset or liability or a highly probable forecast
transactions and could affect profit or loss. Under cash flow hedge accounting, changes in
the fair value of the hedging instruments attributable to the hedge risk are deferred rather
than being recognized immediately in profit or loss. The accounting for the hedged item is
not adjusted.

c. Hedge of a net investment in foreign operation – a hedge of the exposure to foreign

currency exchange gains or losses on an entity’s net investment in a foreign operation which

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is the amount of the entity’s interest in the net asset of that operation. Hedges of net
investments in foreign operations are accounted for like cash flow hedges.

Hedge Accounting

To qualify for hedge accounting, the hedging relationship should meet the following
conditions:
a. There is a formal designation and documentation of the hedging relationship and the
entity’s risk management objective and strategy for undertaking the hedge. Hedge
accounting is permitted only from the date such designation and documentation is in
place.
b. The hedge is expected to be highly effective in achieving offsetting changes in fair value
or cash flows attributable to the hedged risk.
c. The effectiveness of the hedge can be measured reliably.
d. The hedge is assessed on an ongoing basis and determined actually to have been highly
effective throughout the financial reporting periods for which the hedge was designated.
e. For cash flows hedges, a hedged forecast transaction must be highly probable and must
present an exposure to variations in cash flows that could ultimately affect profit or loss.

FOREIGN CURRENCY FORWARD CONTRACT

It is an agreement to exchange currencies of different countries on a specified future

date at the specified rate, the forward rate. The fair value of a foreign currency forward
contract is determined by reference to changes in the forward rate over the life of the
contract. The changes in the rate may be discounted to the present value.

Purposes of Foreign Currency Forward Contracts

a. Fair Value Hedge – includes hedges against a change in the fair value of a recognized
foreign currency denominated asset or liability and an unrecognized foreign currency
firm commitment.
b. Cash flow Hedge – includes hedges against the change in cash flows associated with a
forecasted foreign currency transactions and an unrecognized foreign currency firm
commitment.

Fair Value Hedge of an Exposed Net Asset or Net Liability Position

Foreign Currency Exposed Net Asset Position – the excess of assets denominated in
foreign currency over the liabilities denominated in the same foreign currency and
translated at the current rate.

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Foreign Currency Exposed Net Liability Position – the excess of liabilities

denominated in a foreign currency over assets denominated in that foreign currency and
translated at the current rate.

When the exposed asset or liability position is completely hedged, no net forex gains
or losses is to be recognized. Forex gains and the offsetting losses are to be recognized in
the computation of net income and of the carrying value of the hedge items. Normally,
banks set the forward rate at an amount different from the spot rate on the contract date.
The difference between these rates represents the cost of avoiding the risk of exchange
rate fluctuations.

Example of Hedging an Exposed Net Liability Position

Assume that on August 1, 2019, Purple Corporation purchases goods on account

from Violet Company of Japan for 500,000 yen. No letter of credit is required by Violet
Company. The billing date for the sale is December 1, 2019, and the payment is due in 60
days on January 30, 2020. In view of the sale, Purple Corporation enters into a forward
contract to buy 500,000 yen from the Bank of the Philippine Islands (BPI) in 60 days. The
relevant exchange rates are as follows:

Forward Rate for Remaining

Date Spot Rate
Term of Contract
December 1, 2019 1 Yen = P0.45 1 Yen = P0.50
December 31, 2019 1 Yen = P0.48 1 Yen = P0.51
January 30, 2020 1 Yen = P0.49 1 Yen = P0.49

The change in the value of the forward contract is not discounted. Assuming a perpetual
inventory system, the following are the journal entries on the books of Purple Corporation
to record the purchase (importation), the forward contract, year-end adjusting entries, and
the final settlement:

Relating to Importing Transactions:

December 1, 2019 Inventory 225,000
Accounts Payable – FC 225,000
To record the purchase of inventory.
(500,000 yen * P0.45)

December 31, 2019 Forex loss 15,000

Accounts Payable – FC 15,000
To adjust the accounts payable to year-end spot rate.
(500,000 yen * P0.03)

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January 30, 2020 Accounts payable – FC 240,000

Forex loss 5,000
Foreign currency 245,000
To record the settlement of the accounts payable at P0.49.

Relating to Forward Contract:

December 1, 2019 Forward Contract Receivable – FC 250,000
Forward Contract Payable 250,000
To record the purchase of forward contract.
(500,000 Yen * P0.50) A1

December 31, 2019 Forward Contract Receivable – FC 5,000

Gain on forward contract 5,000
To record the increase in the value of the forward contract.
(500,000 Yen * P0.01)

January 30, 2020 Foreign currency A2 245,000

Loss on forward contract 10,000
Forward contract receivable – FC 255,000
To record receipt of 500,000 yen according to forward contract.

Forward contract payable 250,000

Cash 250,000
To record the settlement.

Alternative entries:
A1 – An alternative for this entry would be a memo entry to describe the executory contract.
This treatment is acceptable since the forward contract has a fair value of zero on that
date. However, recognizing the forward contract with entries helps in understanding the
relationships in using forward contracts. If no entry were made at inception, subsequent
changes in the value of the forward contract (hedging instrument) would still be
recognized by either debiting or crediting the forward contract receivable in the case of
unrealized gain or loss, respectively.

A2 – If a memo entry was initially used to record the forward contract, the settlement of
the contract would be recorded as follows:
Foreign currency 245,000
Forward contract receivable – FC 5,000
Cash 250,000

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Example of Hedging an Exposed Net Asset Position

Accounting procedures for hedging an exposed asset position are basically

comparable to those illustrated for Purple Corporation except that the purpose is to hedge
an asset denominated in foreign currency, rather than a liability. Usually, the forward rate
for selling foreign currency for future delivery is normally less than the spot rate. For
example, a forward contract is entered to sell 100,000 Hongkong Dollar for delivery in 45
days might have a forward rate of P5.50 when the spot rate is P5.70. The forward contract
is recorded as:
Forward contract receivable 550,000
Forward contract payable 550,000
To record forward contract to deliver
100,000 HK dollars at forward rate of P5.50

The contract hedges any effect of changes in the exchange rate so that the net cost
over the life of the contract will be the P20,000 difference between the forward and spot
rates.

Results of Hedging

Forward rates are ordinarily set so that a cost is incurred related to the hedge.
Usually, the rates for future contracts result in hedges that increase income. A forward
contract is recorded at the forward rate, while the underlying asset or liability is recorded
at the spot rate and adjusted to the changes in rates and values at the financial statement
date). Over the life of the contract, the initial difference between the spot and forward rate
is the cost of hedging the exchange risk, which is sometimes called premium or discount.
Since the gains or losses on both the hedge and the underlying are recorded in current
earnings, the net cost reported in the net income statement is the change in the relative
value of the spot and forward rates.

If a company enters a forward contract for foreign currency units in excess of the
foreign currency units recognized in its exposed net asset or net liability position (a
speculation in the currency), the difference ends up either as a gain or loss. This is due to
the difference in the change in the value of the derivative and the change in the value of
the underlying item hedged both being reported in the income statement.

Fair Value Hedge of a Foreign Currency Denominated Commitment

Foreign Currency Commitment – a contract or agreement to purchase or sell goods to

a foreign entity in the future, to be settled for in the foreign currency. The settlement will
not be made until after delivery of the goods; therefore, it is exposed to changes in currency
exchange rates before the transaction date (the date of the delivery of the goods). The

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accounting for the forward contract must begin when the forward contract is designated as
a hedge of a foreign currency commitment.

Example:
On October 1, 2019, Luntian Corporation entered into a firm commitment with a Japanese
firm to acquire a machine, delivery, and passage of title on March 31, 2020, at a price of
1,000,000 yen. On the same date, to hedge against unfavorable changes in the exchange
rate of the yen, Luntian Corporation entered into a 180-day forward contract with Philippine
National Bank (PNB) for 1,000,000 yen. The relevant exchange rates for this example are
as follows:
October 1, 2019 December 31, 2019 March 31, 2020
Spot rate P0.40 P0.41 P0.38
Forward rate 0.425 0.41 0.38

Luntian Corporation’s journal entries to record the forward contracts transactions and the
purchase of the machine are:

October 1, 2019 Forward contract receivable 425,000

Forward contract payable 425,000
To record forward contract for 1,000,000 yen
for delivery in 180 days at forward rate of P0.425.

December 31, 2019 Loss on forward contract 15,000

Forward contract receivable 15,000
To record forex loss for the decrease in the
forward rate, (1,000,000 yen * (0.425-0.41)).

Firm commitment for machinery 15,000

Gain on firm commitment 15,000
To record the increase in fair value of the
purchase commitment, and resulted gain or the
decrease in the forward rate. Payment of Japanese
yen will cost smaller Philippine pesos.

March 31, 2020 Forward contract payable 425,000

Cash 425,000
To record settlement of forward contract.

Cash (foreign currency) 380,000

Loss on forward contract 80,000
Forward contract receivable 410,000
To record receipt of 1,000,000 yen from
PNB when the exchange rate is P0.38.

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Firm commitment for machinery 30,000

Gain on firm commitment 30,000
To record the change in the value of the
underlying firm commitment.
(1,000,000 yen * (P0.41-P0.38))

Purchases 425,000
Firm commitment for machinery 45,000
Cash (foreign currency) 380,000
To record purchases of machinery.

Cash flow Hedge of a Foreign Currency Forecasted Transaction

It is important to different accounting treatment of a hedge of a forecasted

transaction as a cash flow hedge versus that of an identifiable foreign currency commitment
as a fair value hedge. Unlike a foreign currency commitment as a fair value hedge. Unlike a
foreign currency commitment, a forecasted transaction is anticipated but not guaranteed.
Under the cash flow hedge, the changes in fair value of the hedging instrument is
deferred and recognized as other comprehensive income. This is accumulated and reported
as a separate line in the stockholders’ equity section of the statement in financial position.

Summary of Hedging Transactions

When transactions are denominated in one currency and measured in another,

changes in currency exchange rates can expose the transacting party to potential exchange
gains or losses. In order to reduce the uncertainty associated with exchange rate changes,
forward contracts and other derivatives are often used to hedge against this exposure.

Hedge of a Hedge of an Hedge of

Forecasted Identifiable Firm Denominated Asset or
Transaction Commitment Liability
Type of hedge Cash flow hedge Fair value hedge or Fair value hedge or
cash flow hedge. Most cash flow hedge. Most
often fair value. often fair value.
Basic purpose of Hedge against Hedging against Hedge the exchange
hedge changes in the cash exchange rate risk rate risk between the
flows due to exchange occurring between the transaction date and
risk occurring commitment date and the
between the rime of the transaction date payment/settlement
the probable date
forecasted transaction
and the resulting
actual transaction

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Recognition over time Changes in value are Changes in value are Changes in value are
of changes in the recognized as a recognized currently recognized currently
value of derivative component of other as a component of as a component of
comprehensive income income
income

SWAPS

It is an arrangement whereby two counter parties contractually agree to swap or

exchange one stream of cash flows for another, over a period of time. There are two major
types of swaps, namely, interest rate swaps and cross currency swaps.

Interest rate and currency swaps have become widely used financial arrangements.
Swaps are always derivatives. Regardless of how the arrangement is to be settled, the
following are the three key defining characteristics are present in all interest rate swaps:
a. the value changes are in response to changes in an underlying variable (interest rates or
an index of rates);
b. there is little or no initial net investment; and
c. settlement will occur at future dates.

OPTION CONTRACTS

It is a financial derivative contract that provides the holder the right to buy or sell an
underlying in the future, for a price set today. The price of the option is separate from the
price of the underlying. The following terms are usually associated on options contracts:

Premium – the option price. This is the sum of money that the option buyer pays the
option seller to obtain the right being sold in the option. This money is paid when the option
contract is initiated.

Time value of the option – is the difference between the options market price and its
intrinsic value. Changes in the time value of the option are taken to current earnings.

Intrinsic value of option – is the difference between the current market price and the
option price of the hedged item. This is also the value of the option if it were exercised
today.

Strike price – the price at which the holder has the option to buy or sell the item.

Option to buy “in the money” – exists when the market price is more than the strike
price.

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Option to buy “out of the money” – exists when the market price is less than the strike
price.

Underlying – the asset, financial instrument or any other basis to which the option is
linked, and from where its value is derived. the underlying can be a stock, bond, interest
rate, foreign currency or commodity.

Two Basic Types of Option

a. Call Option – an option granting the right to buy the underlying. Options of this type
may simply be called “calls”.

b. Put Option – an option granting the right to sell the underlying. Options of this type
may simply be called “put”.

Foreign Currency Option

It gives the holder of the option the right but not the obligation to trade foreign
currency in the future. A put option is for the sale of foreign currency by the holder of the
option; a call option is for the purchase of foreign currency by the holder of the option.
Foreign currency option can be purchased directly from a bank.

Hedging Disclosures

Hedge accounting is one of the more complex aspects of financial instruments

accounting under PAS 39. An entity engaged in hedging must disclose, separately for each
type of hedge.

a. a description of each type of hedge;

b. a description of the financial instrument designated as hedging instruments and their fair
values at the reporting date; and
c. the nature of the risks being hedged.

In the case of cash flow hedges, the reporting entity is to disclose:

a. the periods when the cash flows are expected to occur and when they are expected to
affect profit or loss;
b. a description of any forecasted transaction for which hedge accounting had previously
been used, but which is no longer expected to occur;
c. the amount that was recognized in equity during the period;

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d. the amount that was removed from equity and included in profit or loss for the period,
showing the amount included in each line item in the income statement; and
e. the amount that was removed from equity during the period and included in the initial
cost or other carrying amount of a non-financial asset or non-financial liability whose
acquisition or incurrence was a hedged highly probable forecast transaction.

The reporting entity is to disclose separately:

a. For fair value hedges, gains and losses from the hedging instrument and from the hedged
item attributable to the hedged risk;
b. The ineffectiveness recognized in profit or loss that arises from cash flow hedges; and
c. the ineffectiveness recognized in profit or loss that arises from hedges of net investments
in foreign operations.

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REFERENCES:

Advanced Accounting Principles and Procedural Applications Volume 2 by Pedro P. Guerrero

and Jose F. Peralta

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