Hedge documentation is important in both financial reporting and income taxation.For financial accounting purposes, on the date of the hedge, an entity must identify the hedged item, the instrument used, the type of risk hedged, the means of assessing hedge effectiveness, and the risk management objective and strategy.
Gains and losses of different types of derivatives for fair value hedges are reflected in the income statement, offsetting losses and gains on transactions being hedged.
Gains and losses on cash flow hedges are “parked” in accumulated other comprehensive income until the transactions occur and then transferred to the income statement to offset the losses and gains on these transactions.
Foreign currency transactions record the dollar equivalent of the sale at the time of sale. Any unrealized foreign exchange gains or losses are accrued in net income during the period in which the exchange rate changes.
Mark-to-market rules do not apply to hedging transactions for tax purposes. An entity must treat an investment in regulated futures or foreign currency contracts that is not a hedging event as though it were sold on the last day of the year for tax purposes.
Robert Bloom, Ph.D., is a professorof accountancy at John Carroll University in University Heights, Ohio.His e-mail address is firstname.lastname@example.org. William J. Cenker, CPA,Ph.D., was also a professor of accountancy at John Carroll University. He died in March.
A derivative is a financial instrument that derives its value based on its relationship to another financial instrument such as a stock or bond, to an index or to an exchange rate.
With derivatives, mutual funds manage risk in their portfolios. Banks use them to guard against losses. Oil companies use them to hedge against or counteract the prospect of future price changes. Airlines use them to try to lock in more favorable fuel prices. And above all on our shrinking planet, cross-border transactions depend upon them to ameliorate the risk of currency exchange rate fluctuations. Because derivatives used in hedging are more likely than ever to crop up in companies’ financial statements, CPAs need to be conversant in the accounting requirements for them and especially how to manage the temporary differences between financial accounting and tax reporting.
This article focuses on two types of derivatives—options and forward contracts. Options are rights to engage in futures contracts, which are contracts to exchange goods of a particular quantity at a designated price and date. Forward contracts are the same as future contracts but are not regulated by organized exchanges. Whereas in accounting, derivatives are marked to market, that is not the case in income taxation. CPAs should be familiar not only with the accounting requirements of derivatives but also the income tax regulations governing them, since the differing treatments produce deferred tax consequences. This article contrasts gains and losses using those derivatives and in so doing reconciles the accounting and tax differences in deferred tax accounts.
Financial accounting for derivatives takes a fair value approach. The gain or loss on the derivative generally offsets the loss or gain on the risk exposure. The accounting treatment depends on whether it qualifies as a hedging instrument and, if so, on the designated reason for holding it (FASB Statement no. 133, Accounting for Derivative Instruments and Hedging Activities, paragraph 18).
a. No hedging designation. The gain or loss on a derivative instrument not designated a hedging instrument appears in current income.
b. Fair value hedge. This is a hedge of the fair value of an asset or liability in a purchase, sale transaction or firm commitment at a definite price. The gain or loss on a fair value derivative as well as the offsetting loss or gain on the hedged item appear in current earnings in the same period.
c. Cash flow hedge. This hedge is concerned with variable cash flows stemming from forecasted transactions or cash flows from assets and liabilities already incurred.
Effectiveness in hedging is the degree to which the value change in a hedge offsets the value change in what is being hedged—such as using a forward contract to offset exchange rate fluctuations in the euro on a sale of inventory in that currency to a foreign buyer. The effective portion of the gain or loss on a cash flow derivative is a component of other comprehensive income and reclassified to income in the same period or periods in which the hedged forecasted transaction affects income. Any remaining gain or loss on the derivative appears in current income.
The types and uses of derivatives are as varied as the number of financial instruments in which a company may invest. While the accounting for all derivatives follows the above general rules, this discussion considers derivatives used to manage the risk of currency fluctuations on transactions denominated in a foreign currency.
Foreign currency hedging transactions involve risk management associated with assets and liabilities denominated in a foreign currency. In such events a corporation buys or sells goods with a foreign corporation, and the transaction is to be settled in a foreign currency. With foreign currency firm commitments, a contract agreement to engage in a future foreign currency purchase or sale has occurred—such as a purchase order. With forecasts of foreign currency transactions, predictions of foreign currency transactions are made, but contractual obligations are not incurred. Net investments in foreign operations involve purchases of shares of stock in a foreign corporation. Hence, the “net investment” reflects the equity in this foreign entity (FASB Statement no. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities—an amendment of FASB Statement No. 133).
An entity may account for assets and liabilities hedges as well as hedges of foreign currency firm commitments either as fair value hedges or as cash flow hedges. Hedges of forecasts of foreign currency transactions may only be accounted for as cash flow hedges (FASB Statement no. 138). An entity reports hedges of net investments in foreign operations in the same way that the hedged translation adjustments are reported (FASB Statement no. 133).
For financial accounting purposes, an entity must use a two-transaction perspective to account for foreign currency transactions: the export sale itself and the extension of credit denominated in a foreign currency (FASB Statement no. 52, Foreign Currency Translation). The dollar equivalent of the sale is recorded at the time of sale, and any unrealized foreign exchange gains and losses are accrued in net income in the period in which the exchange rate changes (FASB Statement no. 52, paragraph 124).
Hedge documentation is imperative for financial accounting as well as income taxation. For financial accounting purposes, on the date of the hedge, an entity must identify the hedged item, the instrument used, the type of risk hedged, the means of assessing hedge effectiveness, and the risk management objective and strategy (FASB Statement no. 133).
INCOME TAX TREATMENT
For income taxation, there is an exception to the general requirement for a sale or other disposition to occur prior to gain or loss recognition. An entity treats an investment in regulated futures (that is, future contracts for the exchange of goods, which in contrast to forward contracts are exchange traded) that is not a hedging transaction as if it were sold at its fair market value on the last business day of the taxable year (IRC § 1256(a)(1)). Forty percent of any such gain or loss is treated as short term, 60% as long term (IRC §§ 1256(a)(3)(A) and (B)).
The mark-to-market rules do not, however, apply to hedging transactions, so gains and losses are not recognized on such events (IRC § 1256(e)). In taxation, an entity must clearly identify the hedging transaction as such on the day entered (Treas. Reg. § 1.1221-2(f)(1)). The item hedged must be similarly incurred (Treas. Reg. § 1.1221-2(f)(2)). The time of identification is defined as “contemporaneous,” or within 35 days (see Treas. Reg. § 1.1221-2(f)(2)(ii)). Further, for tax purposes such identification must be unambiguous. Identification for financial accounting or regulatory purposes is not sufficient unless the books and records indicate that the identification is also being made for income tax purposes (Treas. Reg. § 1.1221-2(f)(4)(ii)).
A corporation will normally enter into such contracts to hedge a future purchase commitment or to lock in a sales price denominated in a foreign currency. The gain or loss is then ordinary, serving to offset any gain or loss in the underlying contract. Sometimes, a corporation will need to generate a capital gain or loss, so the above hedging rules conceivably may be important for tax planning purposes.
Suppose that BC Corp. sells goods with a value of €2 million to Dugas Corp. in France. BC delivers the goods on 11-01- X1. The terms of the agreement require Dugas to pay the euros on 2-01-X2. BC investigates four alternatives with respect to hedging the euro-denominated receivable:
a. Purchase a put option to sell €2 million on 2-01-X2, designating the transaction as a fair value (asset exposure) hedge.
b. Purchase a put option to sell €2 million on 2-01-X2, designating the transaction as a cash flow hedge, or hedge of variable cash flows. As this example will show, a cash flow hedge generates less variable income effects.
c. Enter into a foreign currency forward exchange contract, designating the transaction as a fair value (asset exposure) hedge.
d. Enter into a foreign currency forward exchange contract, designating the transaction as a cash flow hedge.
Exhibit 1 summarizes financial information with respect to the €2 million receivable and the various alternatives. See this spreadsheet for illustrations.
Put option—fair value hedge. On the date of sale, BC Corp. prepares the journal entry for the foreign-currency denominated sale, assuming a periodic inventory system and the purchase of the option. If BC Corp. were to satisfy the criteria for hedge accounting and account for the purchase of the put option as a fair value hedge, it would adjust the carrying value of the receivable and put option to fair values at the balance sheet dates and recognize such adjustments to income. Assuming the option is a hedge for tax purposes, BC would not recognize as income (loss) the adjustment to the fair value of the option or the receivable at 12-31-X1. Accordingly, a temporary difference between accounting and income taxation occurs, having deferred tax consequences, at an assumed tax rate of 35%.
At 2-01-X2, BC adjusts the receivable and option to their current values, collects the receivable, and exercises the option. For financial accounting purposes, BC recognized income of $56,000 in X1 and a net loss of $80,000 in X2 with respect to its foreign currency transactions. The difference of $24,000 represents the cost of the option. For income tax purposes, BC recognizes the entire option cost of $24,000 as a deduction in X2. The balance in the asset and liability accounts is now zero, and, assuming no further hedging transactions at 12-31- X2, BC reverses the 12-31-X1 deferred tax adjustment.
Put option—cash flow hedge. BC Corp. prepares the same journal entries for the sale and option purchase as those for the fair value hedge. Since BC has an exposed asset position that will lead to a future cash flow, BC may account for the transaction either as a fair value or cash flow hedge. If BC accounts for the transaction as a cash flow hedge, the company reports fair value adjustments in other comprehensive income, not in the income statement. The balance of the accounting is similar to that accorded the fair value hedge. BC would adjust the receivable and option to fair value at balance sheet dates. As with the fair value hedge, a temporary difference between accounting and income taxation occurs, having deferred tax consequences, at an assumed tax rate of 35%.
The net effect of the above entries is to recognize $4,000 of option expense, which represents the decline in value of the option caused by the passage of time, starting at 12-31-X1, when the option has no intrinsic value. BC does not recognize a deduction for tax purposes, and hence the net temporary difference is $4,000.
At 2-01-X2, BC adjusts the receivable and option to their current values, adjusts accumulated other comprehensive income (AOCI) to reflect the decline in time value of the options, collects the receivable, and exercises the option. By 2-01-X2, the balance in AOCI is zero. BC recognized a $4,000 expense in X1 and a $20,000 expense in X2. The fair value option previously produced far more variable results—$56,000 of income in X1 and $80,000 of loss in X2. Assuming no further hedging activities at the end of X2, BC reverses the 12-31-X1 deferred tax accrual.
Forward contract—fair value hedge. Unlike the purchase of a put option, there is no value recorded for a forward contract at the time of execution since this is a fully executory contract, involving no exchange of assets or other action between the parties. Accordingly, no asset is recorded at that time. BC records the sale at the current spot rate.
BC Corp. knows the cost of extending credit to Dugas at the outset. This cost or discount equals the difference between the spot rate of $1.32 and the forward rate of $1.30 times €2 million [(1.32 × 1.30) × €2 million = $40,000]. The change in the forward rate from the time of the contract is entered until the balance sheet date is a reflection of the value or liability associated with the contract. The value is discounted or given a present value and recorded on the balance sheet along with the adjustment to the fair value of the asset. In this case, since the forward rate has increased to an amount above the forward rate at the time the contract was entered, the contract represents a liability to BC. With fair value hedges, the fair value adjustments appear in income rather than other comprehensive income. As was true with options, a temporary difference between accounting and income taxation occurs, with deferred tax consequences, at an assumed tax rate of 35%.
In X2, the accounts receivable and the forward contract are adjusted to fair value, the euros are received and delivered to the purchaser and, at year-end, the above deferred tax entry is reversed.
Forward contract—cash flow hedge. In X1, BC records the sale, but again makes no entry for the fully executory, forward currency exchange contract, involving no exchange of cash, and having a value of zero. At 12-31-X1, BC adjusts the value of the receivable using the new spot rate and offsets the resulting gain with an adjustment to AOCI. The forward contract is recorded, BC amortizes the cost of the forward contract, and recognizes deferred taxes on the difference between the accounting and taxable base in the balance sheet accounts. While the effective interest method is preferred for purposes of amortizing the discount, FASB’s Derivatives Implementation Group permits straight-line amortization of premiums and discounts.
At 2-01-X2, BC again adjusts the receivable and forward contracts to fair value, offsetting gains and losses against AOCI. The foreign currency received is exchanged for cash at the initial contracted forward rate. During X2, BC recognizes the $40,000 cost of the contract for tax purposes and, assuming no further hedging transactions, reverses the 12-31-X1 deferred tax accrual.
Again notice the appeal of cash flow hedge accounting versus fair value hedge accounting. Fair value accounting reported a $299 gain in X1 and a $40,299 loss in X2. Cash flow hedge accounting recognized $26,667 (two months amortization) in X1 and $13,333 in X2. Income effects, especially for hedges involving forward contracts, are determinable at the outset.
Internal Control Issues in Derivatives Usage and Internal Control—Integrated Framework (#990011)
Internal Control Issues in Derivatives Usage: An Information Tool (#990010)
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FASB Statement no. 52, Foreign Currency Translation
FASB Statement no. 133, Accounting for Derivative Instruments and Hedging Activities
FASB Statement no. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities—an amendment of FASB Statement No. 133, www.fasb.org
PCAOB study, Observations on Auditors’ Implementation of PCAOB Standards Relating to Auditors’ Responsibilities With Respect to Fraud, www.pcaobus.org/Inspections/Other/2007/01-22_Release_2007-001.pdf.