Foreign currency transactions and hedging

Larkspur buys components from suppliers in the United States, pays some of them in US dollars and sells some products to American customers. Each of these transactions exposes it to changes in exchange rates between the date it agrees a price and the date cash changes hands. This lesson covers how such transactions are recorded under IAS 21, how exchange differences on receivables and payables are reported, and how forward contracts and hedge accounting under IFRS 9 can reduce the volatility those differences create. The next lesson takes up the related but distinct problem of translating the financial statements of a whole foreign operation.

Functional currency comes first

IAS 21 requires each entity to identify its functional currency, the currency of the primary economic environment in which it operates. The primary indicators are the currency that mainly influences sales prices for its goods and services, the currency of the country whose competitive forces and regulations mainly determine those prices, and the currency that mainly influences wages, materials and other costs. Secondary indicators include the currency in which financing is raised and in which receipts from operations are usually retained. A transaction is a foreign currency transaction when it is denominated in a currency other than the entity's functional currency. Larkspur's functional currency is the Canadian dollar, so a purchase invoiced in US dollars is a foreign currency transaction. The presentation currency, the currency in which statements are presented, can differ from the functional currency; that is the subject of the next lesson.

Recording transactions

A foreign currency transaction is recorded initially at the spot exchange rate on the date of the transaction; for practical reasons an average rate for a week or month may be used if rates do not fluctuate significantly. At each reporting date, monetary items such as cash, receivables, payables and loans, which are rights to receive or obligations to pay a fixed or determinable number of currency units, are retranslated at the closing rate. Non-monetary items measured at historical cost, such as inventory, equipment and prepayments, stay at the rate on the transaction date. Exchange differences on settling or retranslating monetary items are recognized in profit or loss in the period they arise. Where consideration is paid or received in advance, IFRIC 22 makes the transaction date the date the prepayment or deferred income is first recognized.

Because the exchange difference arises every time rates move, a payable that crosses a year end produces two exchange differences: one from the transaction date to the reporting date and another from the reporting date to settlement. The cost of the inventory or equipment acquired is fixed at the transaction-date rate; later rate changes affect profit, not the asset.

Forward contracts as economic hedges

A treasurer who does not want to bear the risk of a stronger US dollar can enter into a forward contract, an agreement to buy USD 500,000 on 31 January at a rate fixed today. Under IFRS 9 the forward is a derivative measured at fair value through profit or loss. Because the payable is also retranslated through profit or loss, the gain on the forward offsets most of the loss on the payable without any special hedge accounting. This natural offset is why entities rarely designate hedges of recognized monetary items: the accounting already matches.

# A foreign currency payable, with and without a forward contract (illustrative rates)
amount = 500_000                       # USD owed to the supplier
spot = {"1 Nov 2026": 1.36, "31 Dec 2026": 1.39, "31 Jan 2027": 1.38}   # CAD per USD
forward_rate = 1.365                    # contracted on 1 Nov for delivery 31 Jan
forward_31_dec = 1.392                  # forward rate for 31 Jan delivery, quoted on 31 Dec
payable = {d: round(amount * r) for d, r in spot.items()}
dates = list(spot)
fx_2026 = payable[dates[0]] - payable[dates[1]]          # gain (+) or loss (-) on the payable
fx_2027 = payable[dates[1]] - payable[dates[2]]
fwd_dec = round((forward_31_dec - forward_rate) * amount)    # fair value, ignoring discounting
fwd_jan = round((spot[dates[2]] - forward_rate) * amount)
print(f"Payable in CAD: " + ", ".join(f"{d} {v:,}" for d, v in payable.items()))
print(f"Exchange gain (loss) on payable: 2026 {fx_2026:,}; 2027 {fx_2027:,}")
print(f"Forward gain (loss):             2026 {fwd_dec:,}; 2027 {fwd_jan - fwd_dec:,}")
print(f"Net effect on profit:            2026 {fx_2026 + fwd_dec:,}; 2027 {fx_2027 + fwd_jan - fwd_dec:,}")
print(f"Total CAD cost of settling: {payable[dates[2]] - fwd_jan:,} = {amount:,} x {forward_rate}")

Payable in CAD: 1 Nov 2026 680,000, 31 Dec 2026 695,000, 31 Jan 2027 690,000
Exchange gain (loss) on payable: 2026 -15,000; 2027 5,000
Forward gain (loss):             2026 13,500; 2027 -6,000
Net effect on profit:            2026 -1,500; 2027 -1,000
Total CAD cost of settling: 682,500 = 500,000 x 1.365

The program shows the payable and a forward contracted on 1 November at 1.365 for 31 January delivery. In 2026 the forward gains 13,500, offsetting most of the 15,000 loss on the payable; in 2027 it loses 6,000 against the 5,000 gain. The net effect, a 1,500 loss and then a 1,000 loss, is the difference between the spot and forward rates (the forward points), and the total cost of settlement is locked at 682,500, the forward rate times USD 500,000. Fair values here ignore discounting and credit risk, which a real valuation would include.

Hedge accounting

When the hedged item is not yet recognized, such as a forecast purchase or a firm commitment, or is measured differently from the derivative, the gains and losses fall in different periods. Hedge accounting is an optional set of rules that fixes this mismatch. IFRS 9 recognizes three types of hedge. In a fair value hedge, of a recognized asset or liability or an unrecognized firm commitment, the hedged item is remeasured for the hedged risk through profit or loss, offsetting the derivative. In a cash flow hedge, of a highly probable forecast transaction or variable cash flows, the effective portion of the derivative's gain or loss goes to other comprehensive income and accumulates in a cash flow hedge reserve until the hedged cash flows affect profit. A hedge of a net investment in a foreign operation, covered in the next lesson, is accounted for like a cash flow hedge.

To qualify, IFRS 9 requires formal designation and documentation at inception of the risk management objective, the hedging instrument, the hedged item and the risk; an economic relationship between hedged item and instrument; that credit risk does not dominate the value changes; and a hedge ratio consistent with the quantities actually used for risk management. There is no bright-line effectiveness test. Ineffectiveness, for example when the cash flow hedge reserve would exceed the cumulative change in the hedged cash flows, is recognized in profit or loss. Entities may still elect to continue applying the IAS 39 hedge accounting rules until the IASB completes its project on dynamic risk management.

# Cash flow hedge of a forecast USD purchase of inventory (illustrative rates)
amount = 1_000_000                    # forecast purchase on 31 Mar 2027, in USD
forward_rate = 1.37                   # forward contracted 1 Oct 2026
forward_31_dec = 1.40                 # forward rate for 31 Mar delivery, quoted 31 Dec 2026
spot_31_mar = 1.42
fv_dec = round((forward_31_dec - forward_rate) * amount)
fv_mar = round((spot_31_mar - forward_rate) * amount)
purchase = round(spot_31_mar * amount)
print(f"Hedge reserve (OCI) at 31 Dec 2026: {fv_dec:,}")
print(f"Change in OCI to 31 Mar 2027:      {fv_mar - fv_dec:,}; cumulative {fv_mar:,}")
print(f"Inventory purchased at spot:       {purchase:,}")
print(f"IFRS 9 basis adjustment: inventory recorded at {purchase - fv_mar:,}; reserve cleared")
print("The hedged rate flows to cost of sales as the inventory is sold.")

Hedge reserve (OCI) at 31 Dec 2026: 30,000
Change in OCI to 31 Mar 2027:      20,000; cumulative 50,000
Inventory purchased at spot:       1,420,000
IFRS 9 basis adjustment: inventory recorded at 1,370,000; reserve cleared
The hedged rate flows to cost of sales as the inventory is sold.

The program reproduces the example. Without hedge accounting, the 30,000 gain on the forward would appear in 2026 profit while the inventory purchase it protects occurs in 2027, a mismatch that makes profit volatile for reasons unrelated to performance. Hedge accounting defers the gain in equity and releases it when the hedged purchase affects profit.

Private enterprises

ASPE Section 1651 records foreign currency transactions the same way: at the transaction-date rate, with monetary items retranslated at the closing rate and exchange gains and losses in net income. ASPE Section 3856 allows hedge accounting only for a limited set of relationships, such as a forward contract hedging an anticipated purchase or sale denominated in a foreign currency, when the critical terms match and the entity documents the relationship at inception. Under that approach the forward contract is not recognized until it matures; the hedged transaction is recorded at the forward rate when it occurs. The result is simpler than IFRS 9 but cannot be applied to most complex hedges.

IFRS 7 requires disclosure of the entity's risk management strategy, how hedging affects the amount, timing and uncertainty of future cash flows, and the effects of hedge accounting on financial position and performance, including a reconciliation of the cash flow hedge reserve. Canadian public companies also discuss currency exposure in management's discussion and analysis.

Choosing a strategy

Not every exposure needs hedging. A company with offsetting receivables and payables in the same currency has a natural hedge; one that can price its sales in its own currency may avoid exposure entirely. Forward contracts lock in a rate but give up the benefit of favourable moves; options cost a premium but preserve upside. Hedge accounting brings documentation and testing costs, so smaller companies often accept some volatility in reported results rather than designate hedges. Whatever the choice, the accounting should report the economics transparently, and users should be able to see how much of reported profit came from exchange movements.