A forward exchange contract is an agreement to exchange different currencies at a specified future date and at a given rate (forward rate). A forward contract is a foreign currency transaction. A gain or loss on a forward contract that does not satisfy the conditions described below is included in earnings.
Note: Currency swaps are accounted for in a similar way.
A gain or loss (whether deferred or not) on a forward contract, except a speculative forward contract, should be computed by multiplying the foreign currency amount of the forward contract by the difference between the spot rate at the balance sheet date and the spot rate at the date of inception of the forward contract.
The discount or premium on a forward contract (i.e., the foreign currency amount of the contract multiplied by the difference between the contracted forward rate and the spot rate at the date of inception of the contract) should be accounted for separately from the gain or loss on the contract and typically should be included in computing net income over the life of the forward contract.
A gain or loss on a speculative forward contract (a contract that does not hedge an exposure) should be computed by multiplying the foreign currency amount of the forward contract by the difference between the forward rate available from the remaining maturity of the contract and the contracted forward rate (or the forward rate last used to measure a gain or loss on that contract for an earlier period). No separate accounting recognition is given to the discount or premium on a speculative forward contract.
How To Hedge Foreign Currency Exposure To Reduce Risk?
Foreign currency transactions gains and losses on assets and liabilities, denominated in a currency other than the functional currency, can be hedged if the U.S. company engages into a forward exchange contract.
There can be a hedge even if there is not a forward exchange contract. For example: a foreign currency transaction can serve as an economic hedge offsetting a parent’s net investment in a foreign entity.
A U.S. parent owns 100 percent of a French subsidiary having net assets of $3 million in euros. The U.S. parent can borrow $3 million in euros to hedge its net investment in the French subsidiary. Assume the French franc is the functional currency and the $3 million obligation is denominated in euros. The variability in the exchange rate for euros does not have a net effect on the parent’s consolidated balance sheet because increases in the translation adjustments balance arising from translation of the net investment will be netted against decreases in this balance arising from the adjustment of the liability denominated in euros.
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