Hedge of a Foreign Currency Exposed Liability
Consider the importing example used earlier in the page. Importing Transaction with a Forward Contract Used as a Hedge1. On December 1, 2003, a U.S. firm purchased inventory for 500,000 euros payable on March 1, 2004 (i.e. the transaction is denominated in euros).
2. The firm's fiscal year-end is December 31.
3. The spot rate for euros ($/euro) and the forward rates for euros on March 1, 2004 at various times is as follows:
| Spot Rate | Forward Rate (for 3/1/2004 Euros) |
|
| Transaction date - December 1, 2003 | $1.05 | 1.052 |
| Balance sheet date - December 31, 2003 | 1.06 | 1.059 |
| Settlement date - March 1, 2004 | 1.07 |
On December 1, 2003, the firm entered into a contract to purchase inventory for $525,000 (the spot rate was $1.05 on that date). If the exchange rate did not change over the payment period, the firm would owe $525,000 to settle the payable. However, if the exchange rate increased to $1.07, the firm would have to pay $535,000 to settle the debt (500,000 x $1.07). On the other hand, if the exchange rate dropped to $1.02, the firm would only need to pay $510,000, (or 500,000 x $1.02). Because the firm cannot perfectly estimate the change in the exchange rate, the company might prefer to eliminate this risk by entering into a forward contract to buy euros on March 1, 2004. Since the forward rate on December 1, 2003 to purchase euros on March 1, 2004 is $1.052, the company can buy 500,000 euros on March 1 for a guaranteed price of $526,000. This fixed price means that the firm has determined in advance the maximum amount of loss it will suffer, in this case $1,000. Thus the firm is protected from future increases in the exchange rate above $1.052. By locking into a set price, the firm gains if the spot rate on March 1, 2004 increases above $1.052 and loses if the spot rate decreases below $1.052. The important point to note about the hedge is that the firm knows with certainty on December 1, 2003, the amount of cash needed to purchase the asset.
The entries to record the purchase and forward exchange contract are: December 1, 2003 - Transaction Date
(1)
|
Purchases
|
525,000
|
|
Accounts Payable (500,000 euros x
$1.05)
|
525,000
|
||
To
record purchase of goods on account
using the spot rate on December 1, 2003. |
The accounts payable for the inventory purchase is recorded using the spot rate on the transaction date (on December 1, 2003)
(2)
|
Foreign Currency (FC) Receivable
from Exchange
|
||
Dealer
|
526,000
|
||
Dollars Payable to Exchange Dealer
|
526,000
|
||
(500,000
euros x $1.052)
| |||
To
record forward contract to buy 500,000 euros
using the forward rate.
|
At the date of the transaction, the U.S. firm records the forward contract by recognizing a payable and a receivable of $526,000 for the number of dollars to be paid (units of foreign currency to be purchased multiplied by forward rate) to the exchange dealer when the forward contract matures. The net value of the forward contract is zero since the payable and the receivable are exactly offset. The value of the receivable from the dealer and the accounts payable for the purchase of inventory are subject to changes in exchange rate, but the gains and losses generally offset each other to a large extent since the terms and the amounts are equal.
On December 31, 2003, the spot rate increases from $1.05 to $1.06 resulting in an increase of $5,000 to accounts payable. The spot rate is used for accounts payable since that is the amount needed to settle the liability.
December 31, 2003 - Balance Sheet Date
(3)
|
Transaction Loss
|
5,000
|
|
Accounts Payable
|
5,000
|
||
To record a loss on the liability
denominated in foreign currency
Current value of accounts payable (500,000 euros x $1.06) = $530,000
Less: Recorded value of accounts
payable = $525,000
Adjustment needed to accounts
payable
$5,000
or [500,000 euros x ($1.06 -
$1.05)] = $5,000
|
|||
(4)
|
FC Receivable from Exchange
Dealer
|
3,500
|
|
Transaction Gain
|
3,500
|
To record a gain
on foreign currency to be received from exchange dealer
[(500,000 euros x $1.059 = $529,500) -
$526,000)].
If the financial
statements are prepared on December 31, 2003, the value of the forward contract
is as follows:
FC Receivable from Exchange Dealer $529,500
Dollars Payable to Exchange Dealer 526,000
Net Receivable from Exchange Dealer $3,500
This
net value would be reported on the balance sheet. In addition, accounts payable
would be recorded at the spot rate, or $530,000. The income statement would
report an exchange loss of $5,000 and an exchange gain of $3,500.
Note that even though the forward
contract and the accounts payable cover similar terms (December 1 to March 1)
and amounts (500,000 euros), the amount of the transaction loss on the payable
does not equal the transaction gain on the FC receivable. They are not equal
because accounts payable is valued using changes in the spot rate while the
value of the forward contract is determined using changes in the forward rates.
On the settlement date, the forward rate and the spot rate become equal. Thus
the total transaction gain or loss on the contract will eventually equal the
guaranteed gain or loss determined on the date the forward contract is
acquired.
On March 1, 2004, the spot rate increases to $1.07 from $1.06 resulting in an increase in accounts payable of $5,000, (($1.07-$1.06) x 500,000). Since on the settlement date, the forward rate on this date and the spot rate are identical, the change in the March 1 forward rate on December 31 to the spot rate on March 1, 2003 is $.011, or ($1.059 to $1.07). This results in an increase to the FC receivable of $5,500, or (($1.07-$1.059) x 500,000). The journal entries to record these events are as follows:
March 1, 2004 - Settlement Date
(5)
|
Transaction Loss
|
5,000
|
|
Accounts Payable
|
5,000
|
(6)
|
FC Receivable from Exchange
Dealer
|
5,500
|
|
Transaction gain
|
5,500
|
||
| To record a gain from 12/31/03 to 3/1/04 on foreign currency to be received from exchange dealer (The change in the 12/31 forward rate to the spot rate on March 1, 2004 times 500,000 euros, or [(500,000 euros x $1.07 = $535,000) - $529,500)].). | |||
The recorded balances in both accounts payable and the FC receivable are $535,000 reflecting the spot rate on March 1, 2003. The dollars payable to the dealer remains fixed at $526,000 the original contracted amount. Entry (7) records the cash payment of $526,000 and the reduction of the FC payable. Also, the receivable is converted to the Investment in FC representing the 500,000 euros acquired in the forward contract. In entry (8), the euros are used to settle the accounts payable.
(7)
|
Dollars Payable to Exchange
Dealer
|
526,000
|
|
Investment in FC (500,000 euros)
|
535,000
|
||
FC Receivable from Exchange Dealer
|
535,000
|
||
Cash
|
526,000
|
||
| To record payment to exchange dealer and receipt of 500,000 euros (500,000 euros x $1.07 = $535,000). | |||
(8)
|
Accounts Payable
|
535,000
|
|
Investment in FC
|
535,000
|
||
| To record payment of liability upon transfer of 500,000 euros. | |||
By obtaining the forward contract, the firm was able to establish at the transaction date the amount of dollars ($526,000) that it would take to acquire the 500,000 euros needed to settle the account with the foreign firm. Note, however, that the cost of the inventory of $525,000 was established on December 1 [entry (1)]. If the forward contract had not been obtained, the firm would have had to pay $535,000 to settle the account and would have reported a net loss of $10,000 on the exposed liability position. The net gain from entering into the forward contract, however, largely canceled out the net loss on the exposed liability position.
These transactions can be summarized in the following table.
Transaction Transaction
Hedged
Item Balance Gain/(loss) Hedge Balance Gain/(loss)
Accounts Payable FC Receivable
12/1/2003 $ 525,000 12/1/2003 $
526,000
12/31/2003 530,000 (5,000) 12/31/2003 529,500 3,500
3/1/2003 535,000 (5,000) 3/1/2003 535,000 5,500
Total gain/(loss) (10,000) 9,000
Thus
the net effect is a $1,000 loss when the forward contract is used.
In practice, a journal entry may not be made to record a forward contract when the contract was negotiated because it represents an executory contract. Although arguments can be made either for or against recording such contracts, in this chapter forward contracts are recorded because it is easier to analyze the subsequent adjustments required to report the effects of a forward contract on the firm’s reported income.