Hedge of a Foreign Currency Exposed Asset
In the example above, the U.S. firm entered into a forward purchase contract to hedge an exposed liability position at a time when the forward rate was at a premium. Accounting for a forward contract entered into as a hedge of an exposed receivable position is based on similar analysis. However, because the U.S. firm will be receiving foreign currency in settlement of the exposed receivable balance, it would enter into a forward contract to sell foreign currency for U.S. dollars. In this case, the receivable from the dealer is denominated in a fixed number of dollars, the amount of which is based on the contracted forward rate, whereas the obligation to the dealer is denominated in a foreign currency, which is translated into dollars using the current spot rate.
Fair Value Hedge - Hedging an Unrecognized Foreign Currency Commitment
In the preceding discussion of the importing and exporting of goods, the purchase or sale of an asset was recorded on the transaction date. This date is considered the point at which title to the goods is transferred, which is consistent with the recording of a transaction with another domestic company. However, if the U.S. firm at a date earlier than the transaction date made a commitment to a foreign company to sell goods or buy goods, and the price was established in foreign currency at the commitment date, changes in the exchange rate between the commitment date and transaction date would be reflected in the cost or sales price of the asset. For example, assume that a U.S. firm made an agreement on June 1 to buy goods from a French company for 500,000 francs. At this date, the spot rate was $.20, but on the transaction date, when title to the goods transferred and a journal entry was recorded, the spot rate was $.22. The entry to record the purchase is Purchases (500,000 francs x $.22) 110,000 Accounts Payable 110,000
In the preceding discussion of the importing and exporting of goods, the purchase or sale of an asset was recorded on the transaction date. This date is considered the point at which title to the goods is transferred, which is consistent with the recording of a transaction with another domestic company. However, if the U.S. firm at a date earlier than the transaction date made a commitment to a foreign company to sell goods or buy goods, and the price was established in foreign currency at the commitment date, changes in the exchange rate between the commitment date and transaction date would be reflected in the cost or sales price of the asset. For example, assume that a U.S. firm made an agreement on June 1 to buy goods from a French company for 500,000 francs. At this date, the spot rate was $.20, but on the transaction date, when title to the goods transferred and a journal entry was recorded, the spot rate was $.22. The entry to record the purchase is Purchases (500,000 francs x $.22) 110,000 Accounts Payable 110,000
Thus, the change in the exchange rate that occurred between the commitment and the transaction date becomes a part of the cost of inventory, rather than being reported as a separate gain or loss item. The company, however, may still acquire a forward contract to hedge against the unfavorable change in the fair value of the asset that may occur after the commitment date.
A forward contract is considered a hedge of an identifiable foreign currency commitment if the forward contract is designated as, and is effective as, a hedge of a foreign currency commitment. The foreign currency commitment must specify all significant terms (such as quantity and price) and performance must be probable. A gain or loss on a forward contract as well as the offsetting gain or loss on the hedged item are recognized currently in earnings. The gain or loss (the change in the fair value of the forward contract) is an adjustment of the carrying value of the forward contract. Similarly, the change in value of the firm commitment is recorded as such on the balance sheet (even though the commitment has not yet been recorded). The measurement of hedge effectiveness is beyond the scope of this chapter, but since the forward contracts are for similar terms and amounts, they are assumed to be highly effective.
Fair Value Hedge Illustration: To illustrate the accounting for a forward contract acquired to hedge an identifiable foreign currency commitment (a fair-value hedge), the following facts are assumed:
Fair Value Hedge Example
1. On March 1, 2003, a U.S. firm contracts to sell equipment to a foreign customer for 200,000 German marks. The equipment is expected to cost $60,000 to manufacture and is to be delivered and the account is to be settled one year later on March 1, 2004. Thus the transaction date and the settlement date are both March 1, 2004.
2. On March 1, 2003, the U.S. firm enters into a forward contract to sell 200,000 German marks in 12 months at the forward rate of $.39.
3. Spot rates and the forward rates for German marks on selected dates are
Spot
|
3/1/2004
|
|
Exchange
|
Forward
|
|
______Date______
|
Rate |
Rate |
March 1, 2003
|
$.40
|
$.390
|
December 31, 2003
|
.395
|
$.385
|
March 1, 2004
|
.38
|
The journal entry to record the
forward contract on March 1, 2003 is: March 1, 2003
(1)
|
Dollars Receivable from Exchange
Dealer
|
||
(200,000 marks x $.39)
|
78,000
|
||
FC
Payable to Exchange Dealer
|
78,000
|
||
To record the forward contract to
sell 200,000 German marks.
|
|||
(2)
|
FC Payable to Exchange Dealer
|
1,000
|
|
Exchange gain
|
1,000
|
||
To
record gain on foreign currency to be delivered to exchange dealer using the change in forward
rates
|
|||
(200,000
marks x ($.39-$.385)).
|
|||
(3)
|
Exchange loss
|
1,000
|
|
Firm commitment
|
1,000
|
||
To
record loss on firm commitment using the change
using the change in the forward rate |
|||
(200,000
marks x ($.39-$.385)).
|
|||
Dollars Receivable from Exchange
Dealer (fixed) $78,000
FC Payable to Exchange Dealer 77,000
Net Receivable $1,000
On March 1, 2004 (the transaction date and the settlement date), the journal entries are: March 1, 2004
(4)
|
FC Payable to Exchange Dealer
|
1,000
|
|
Exchange gain
|
1,000
|
||
To
record gain on forward contract from 12/31/03 to 3/1/04
(200,000 marks x ($.385-$.38))= $1,000. | |||
(5)
|
Exchange loss
|
1,000
|
|
Firm commitment
|
1,000
|
||
To
record gain on forward contract from 12/31/03 to 3/1/04
(200,000 marks x ($.39-$.385))= $1,000 |
|||
(6)
|
Investment in FC
|
76,000
|
|
Firm commitment
|
2,000
|
||
Sales (200,000 marks x $.39)
|
78,000
|
||
To
record sale of equipment to foreign customer.
|
|||
(7)
|
Cost of Goods Sold
|
60,000
|
|
Inventory
|
60,000
|
||
To
record cost of equipment sold.
|
|||
(8)
|
Cash (200,000 x $.39)
|
78,000
|
|
FC Payable to Exchange Dealer
(200,000 x $.38)
|
76,000
|
||
Investment in FC
|
76,000
|
||
Dollars Receivable from Exchange Dealer
|
78,000
|
||
To
record settlement of forward contract.
|
The effect of these transactions on the firm's profitability is as follows:
Sales ($76,000 + $2,000)
|
$78,000
|
Cost of goods sold
|
60,000
|
Gross profit
|
$18,000
|
The number of dollars to be received was locked in by the forward contract at $78,000 and the equipment was expected to cost $60,000. Thus, the forward contract permitted the U.S. firm to lock in an expected profit of $18,000 on the sales contract. If the forward contract had not been obtained, the profit earned on the contract would depend on the exchange rate in effect when payment was received from the German customer. Without the hedge, the amount of sales recorded would have been $76,000 (200,000 marks x $.38) and the gross profit would have been $16,000. And if the exchange rate had dropped below $.38, the amount of sales recorded would have been even be lower; for example at an exchange rate of $.30, the amount of sales recorded would have equaled the amount of cost of goods sold, thus eliminating any gross profit on the contract.