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A foreign exchange hedge (also called a FOREX hedge) is a method used by companies to eliminate or hedge their foreign exchange risk resulting from transactions in foreign currencies (see foreign exchange derivative ). This is done using either the cash flow hedge or the fair value method. The accounting rules for this are addressed by both the International Financial Reporting Standards (IFRS) and by the US Generally Accepted Accounting Principles (US GAAP) as well as other national accounting standards.

A foreign exchange hedge transfers the foreign exchange risk from the trading or investing company to a business that carries the risk, such as a bank. There is cost to the company for setting up a hedge. By setting up a hedge, the company also forgoes any profit if the movement in the exchange rate would be favourable to it.

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Foreign exchange risk [ edit ]

When companies conduct business across borders, they must deal in foreign currencies. Companies must exchange foreign currencies for home currencies when dealing with receivables, and vice versa for payables. This is done at the current exchange rate between the two countries. Foreign exchange risk is the risk that the exchange rate will change unfavorably before payment is made or received in the currency. For example, if a United States company doing business in Japan is compensated in yen, that company has risk associated with fluctuations in the value of the yen versus the United States dollar. [ 1 ]

Hedge [ edit ]

A hedge is a type of derivative. or a financial instrument. that derives its value from an underlying asset. This concept is important and will be discussed later. Hedging is a way for a company to minimize or eliminate foreign exchange risk. Two common hedges are forward contracts and options .

A forward contract will lock in an exchange rate today at which the currency transaction will occur at the future date. [ 2 ]

An option sets an exchange rate at which the company may choose to exchange currencies. If the current exchange rate is more favorable, then the company will not exercise this option. [ 2 ]

The main difference between the hedge methods is who derives the benefit of a favourable movement in the exchange rate. With a forward contract the other party derives the benefit, while with an option the company retains the benefit by choosing not to exercise the option if the exchange rate moves in its favour.

Accounting for Derivatives [ edit ]

Under IFRS [ edit ]

Guidelines for accounting for financial derivatives are given under IFRS 7. Under this standard, “an entity shall group financial instruments into classes that are appropriate to the nature of the information disclosed and that take into account the characteristics of those financial instruments. An entity shall provide sufficient information to permit reconciliation to the line items presented in the balance sheet”. [ 3 ] Derivatives should be grouped together on the balance sheet and valuation information should be disclosed in the footnotes. This seems fairly straightforward, but IASB has issued two standards to help further explain this procedure.

The International Accounting Standards IAS 32 and 39 help to give further direction for the proper accounting of derivative financial instruments. IAS 32 defines a “financial instrument” as “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity”. [ 4 ] Therefore, a forward contract or option would create a financial asset for one entity and a financial liability for another. The entity required to pay the contract holds a liability, while the entity receiving the contract payment holds an asset. These would be recorded under the appropriate headings on the balance sheet of the respective companies. IAS 39 gives further instruction, stating that the financial derivatives be recorded at fair value on the balance sheet. IAS 39 defines two major types of hedges. The first is a cash flow hedge, defined as: “a hedge of the exposure to variability in cash flows that (i) is attributable to a particular risk associated with a recognized asset or liability or a highly probable forecast transaction, and (ii) could affect profit or loss”. [ 5 ] In other words, a cash flow hedge is designed to eliminate the risk associated with cash transactions that can affect the amounts recorded in net income.

Below is an example of a cash flow hedge for a company purchasing Inventory items in year 1 and making the payment for them in year 2, after the exchange rate has changed.