Foreign currency transactions and hedging

Larkspur buys components from suppliers in Canada, pays some of them in Canadian dollars and sells some products to Canadian 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 ASC 830-20, how transaction gains and losses on receivables and payables are reported, and how forward contracts and hedge accounting under ASC 815 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 entity.

Functional currency comes first

ASC 830 requires each entity to identify its functional currency, the currency of the primary economic environment in which it operates, normally the environment in which it primarily generates and expends cash. The indicators include the currency of its cash flows, whether sales prices respond to local or worldwide markets, where its sales market is, the currency of its expenses, the currency of its financing and the extent of intercompany transactions with the parent. 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 US dollar, so a purchase invoiced in Canadian dollars is a foreign currency transaction. The reporting currency 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; an average rate may be used if it approximates the results. At each balance sheet date, monetary assets and liabilities denominated in a foreign currency, such as cash, receivables, payables and loans, are remeasured at the current rate. Nonmonetary items measured at historical cost, such as inventory, equipment and prepayments, stay at the historical rate. The resulting transaction gains and losses are generally included in net income for the period in which the exchange rate changes, with exceptions for certain hedges and intercompany balances of a long-term investment nature, which are covered in the next lesson.

Because the gain or loss arises every time rates move, a payable that crosses a year end produces two transaction gains or losses: one from the transaction date to the balance sheet date and another from the balance sheet date to settlement. The cost of the inventory or equipment acquired is fixed at the transaction-date rate; later rate changes affect earnings, not the asset.

Forward contracts as economic hedges

A treasurer who does not want to bear the risk of a stronger Canadian dollar can enter into a forward contract, an agreement to buy CAD 500,000 on 31 January at a rate fixed today. Under ASC 815 the forward is a derivative measured at fair value with changes in earnings. Because the payable is also remeasured through earnings, the change in the forward offsets most of the change in 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                       # CAD owed to the supplier
spot = {"1 Nov 2026": 0.735, "31 Dec 2026": 0.72, "31 Jan 2027": 0.725}   # USD per CAD
forward_rate = 0.738                    # contracted on 1 Nov for delivery 31 Jan
forward_31_dec = 0.722                  # 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 USD: " + ", ".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 USD cost of settling: {payable[dates[2]] - fwd_jan:,} = {amount:,} x {forward_rate}")

Payable in USD: 1 Nov 2026 367,500, 31 Dec 2026 360,000, 31 Jan 2027 362,500
Exchange gain (loss) on payable: 2026 7,500; 2027 -2,500
Forward gain (loss):             2026 -8,000; 2027 1,500
Net effect on profit:            2026 -500; 2027 -1,000
Total USD cost of settling: 369,000 = 500,000 x 0.738

The program shows the payable and a forward contracted on 1 November at 0.738 for 31 January delivery. In 2026 the forward loses 8,000, offsetting the 7,500 gain on the payable; in 2027 it gains 1,500 against the 2,500 loss. The net effect, a 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 369,000, the forward rate times CAD 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 forecasted 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. ASC 815 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 adjusted for changes in fair value attributable to the hedged risk through earnings, offsetting the derivative. In a cash flow hedge, of a forecasted transaction or variable cash flows, the change in the derivative's fair value included in the effectiveness assessment goes to other comprehensive income and accumulates in AOCI until the hedged transaction affects earnings. A hedge of a net investment in a foreign operation, covered in the next lesson, records gains and losses in the cumulative translation adjustment.

To qualify, ASC 815 requires formal documentation at inception, including how effectiveness will be assessed, and an expectation that the hedge will be highly effective, generally interpreted as offsetting 80 to 125 percent of changes in the hedged item. After ASU 2017-12, an initial quantitative test is often required, but later assessments may be qualitative, and the entire change in the fair value of the hedging instrument included in the assessment is recorded in the same income statement line as the hedged item; ineffectiveness is no longer measured and reported separately. Private companies have simplified options, including the simplified hedge accounting approach for certain interest rate swaps and later documentation deadlines.

# Cash flow hedge of a forecast CAD purchase of inventory (illustrative rates)
amount = 1_000_000                    # forecast purchase on 31 Mar 2027, in CAD
forward_rate = 0.74                   # forward contracted 1 Oct 2026
forward_31_dec = 0.725                 # forward rate for 31 Mar delivery, quoted 31 Dec 2026
spot_31_mar = 0.715
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"ASC 815: inventory stays at {purchase:,}; AOCI of {fv_mar:,} is reclassified to cost of sales")
print(f"as the inventory is sold, so cost of sales reflects {purchase - fv_mar:,} in total.")

Hedge reserve (OCI) at 31 Dec 2026: -15,000
Change in OCI to 31 Mar 2027:      -10,000; cumulative -25,000
Inventory purchased at spot:       715,000
ASC 815: inventory stays at 715,000; AOCI of -25,000 is reclassified to cost of sales
as the inventory is sold, so cost of sales reflects 740,000 in total.

The program reproduces the example. Without hedge accounting, the 15,000 loss on the forward would hit 2026 earnings while the inventory purchase it protects occurs in 2027, a mismatch that makes earnings volatile for reasons unrelated to performance. Hedge accounting defers the loss in AOCI and releases it when the hedged purchase affects earnings.

Disclosures and the SEC

SEC registrants disclose their exposure to market risk, including foreign currency risk, in a quantitative and qualitative section of Form 10-K (Regulation S-K Item 305), often using sensitivity analysis of the effect of a hypothetical 10 percent change in exchange rates. ASC 815 also requires tabular disclosure of the fair values of derivatives and the location and amounts of gains and losses in the income statement and OCI, and the objectives and strategies behind hedging activity.

Under IFRS, by contrast, a cash flow hedge of a forecast purchase of a non-financial item requires a basis adjustment to the asset's initial cost, and IFRS 9 has no bright-line effectiveness test. These differences matter when comparing a US filer with a foreign private issuer that reports under IFRS.

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 favorable 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.