Futures [forward] contracts are used by multinational firms to protect their trade [buy and sell] various commodities that are traded on various exchanges around the world. These commodities include metals, meats, grains, unique items, and financial instruments such as: bonds and notes, commercial paper, treasury bills, GNMA mortgages. 

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By definition, a futures contract is an exchange-traded contract between a futures exchange clearinghouse and a buyer and a seller for the future delivery of a standardized quantity of an item at a specified future date and at a specified price.  Accounting for futures contracts needs to account for all its characteristic and the complexities associated with them.

This post examines the accounting treatments associated with the phenomena affecting the activities of trading protected by “futures [forward] contracts”. Future contract case examples and journal entries required for each transactions are presented for easier understanding on the concept. Enjoy!

 

Characteristic Of Future [Forward] Contract with Exchange Broker

All forward [future] contracts with an exchange broker have the following common characteristics:

  • The need for an initial margin deposit, paid to the broker that represents a small portion of the futures contracts.
  • The need to readjust the deposit as the market value of the futures contract changes.
  • The need to close out the account by either receiving or delivering the item, paying out receiving cash, or entering into an offsetting contract.

 

A depiction of these characteristics follows:

When an enterprise enters into a futures contract with an exchange broker, an initial margin deposit is paid to the broker. The margin deposit usually represents a small fraction of the value of the futures contract. The deposit is recorded as an asset on the enterprise’s books, but the value of the futures contract is recorded.

As the market value of the futures contract changes, the change is reflected in the enterprise’s account with the broker on a regular basis. When market changes increase the broker account, the enterprise may be able to withdraw cash from the account, and when market changes decrease the amount, the company may be required to pay additional cash to the broker to maintain a specified minimum balance in the broker’s account.

The futures contract may be closed out [canceled or settled] by either delivering or receiving, paying or receiving cash, or by entering into an offsetting contract. When the futures contract is closed out, the margin deposit is returned to the enterprise with the cash from the gains on the futures contract. If the enterprise suffers a loss on the futures contract, the margin deposit is offset against amounts to be paid by the enterprise to the broker.

Accounting for futures contracts differs depending on whether or not the contract is accounted for as a hedge and, if it is a hedge, whether the hedged item is carried at market value, whether it is a hedge of an existing asset or liability position or a firm commitment, or if the contract is a hedge of an anticipated transaction. Let’s discuss each of them in more details. Read on…

 

Futures Contracts Not Accounted for as a Hedge [a Speculation]

If the transaction does not qualify as a hedge because it does not relate to a hedged item [such as an asset or liability position, or firm commitment or an anticipated transaction], it is accounted for as a speculation in futures contracts. In the case of a futures contract not accounted for as a hedge:

  • the provisions of the Accounting Principles Board (APB) Opinion No. 30 are followed, and the gain or loss on the contract that is equal to the change in contract market price times the contract size is charged to income periods of change in value of the contract; and
  • the payables to a futures broker are classified as a current asset until the closing of the contract.

 

Case Example

On October 1, 2009, the Lie Dharma Futures Company purchases 100 February 1, 2010, soybean futures contracts. The quoted market prices at the date of purchases is $5.80 a bushel; each contract covers 5,000 bushels. The initial margin deposit is $240,000. At the end of Year 1, the quoted market price of the soybean contract is $5.60 a bushel. The contract is closed on February 1, 2010, when the quoted market price is $5.30 a bushel.

 

At the inception of the contract on October 1, 2009

[Debit]. Deposit with Futures Broker = $240,000
[Credit]. Cash = $240,000
[This is to record the initial margin deposit when the contract is executed].

 

At the end of Year 2009

[Debit]. Loss of Futures Contracts = $100,000
[Credit]. Payable to Futures Broker = $100,000
[This is to recognize losses on futures contracts of $0.20 per bushel ($5.80 – $5.60) on 500,000 bushel (500 x 100)].

 

At the expiration of the contract on February 1, 2010

[Debit]. Payables to Futures Broker = $100,000
[Debit]. Loss on Futures Contract = $150,000
[Credit]. Cash = $250,000
[This is to record the total loss on the contract, which is equal to ($5.60 – $5.30) x 500,000) and the $100,000 payment to the broker]

[Debit]. Cash = $240,000
[Credit]. Deposit with Futures Broker = $240,000
[This is to record the return of the margin deposit by the broker].

 

Futures Contracts Accounted for as a Hedge

The accounting for futures contracts that qualify as hedges is different from the accounting for futures contracts that do not qualify as hedges.

To qualify as a hedge according to SFAS 80, the contract must meet the following criteria:

  • The contract must be related to and designated as a hedge of identifiable assets, liabilities, firm commitments or anticipated transactions.
  • The hedged item must expose the firm to the risks of exchanges in price or interest rates. The determination of price risk is to be done on a decentralized basis when the firm is unable to do so at the firm level.
  • The changes in the market value of a futures contract must be highly correlated during the life of the contract with changes in a fair value of the hedged item. The correlation must last if changes in the market value for the futures contract essentially offset changes in the fair value for the hedged item of the hedged item’s interest expense or interest income. 

After qualifying as a hedge by meeting these criteria, the accounting for futures contracts for each type of hedge item depends on whether the hedge item is reported at market value, whether it is a hedge of an existing asset or liability position or firm commitment, and whether it is a hedge of an anticipated transaction.

 

Futures Contracts Accounted for as a Hedged Item Is Carried at Market Value

In such a case, both the changes in the values of the hedged asset and the related futures contract must be recognized in the same accounting period. The unrealized change in the fair value of the item can be accounted for under one of two options: either (1) charge it to net income or (2) maintain it in a separate stockholders’ equity account until sale or disposition of the hedged item.

The treatment of the changes in the market value of the related futures contract follows the option chosen for the changes in the fair market value of the hedged item:

  • If the latter is charged to income, the changes in the market value of the related futures contract is also charged to income in which the market value changes.
  • If the changes in the fair market value are charged to stockholders’ equity account, the changes in the market value of the futures contract are also maintained in a stockholders’ equity account until disposition of the related item.

 
Case Example

The following example illustrates the accounting for futures contracts accounted for as a hedge when the hedged item is carried at market value:

On November 1, 2009, Lie Dharma Putra, Inc. has a gold inventory of 30,000 troy ounces, carried at a market value of $500 per ounce. The company expects to sell the gold in February 2010, and sells 300 futures contracts of 100 troy ounces of gold each at a price for $500 per ounce to be delivered at the time of sale. A $250,000 deposit is required by the broker. At the end of year 2009, the market price is $530. In February of 2010, the company sells the entire gold inventory at $550 per ounce and closes out the futures contract at the same price.

The entries for the futures contract transactions are as follows:

 

At the inception of the contract on November 1, 2009

[Debit]. Deposit with the Futures Broker = $250,000
[Credit]. Cash = $250,000
[This is to make record of the initial margin deposit when the contract is executed].

 

At the end of Year 2009

a. Recognize the changes in the fair market value of the gold inventory:

[Debit]. Gold Inventory = $900,000
[Credit]. Unrealized Gain on Market Increase of Gold = $900,000
[This is to recognize the changes in the fair market value of the gold inventory which equals ($530 – $500) x (30,000 troy ounces) = $900,000].

b. Recognize the loss on futures contracts:

[Debit]. Loss on Futures Contracts = $900,000
[Credit]. Payable to Futures Brokers = $900,000
[This is to recognize the loss on futures contracts which equals ($530 – $500) x (30,000 troy ounces) = $900,000].

 

At the expiration of the contract in February 2010

[Debit]. Cash = $16,500,000
[Credit]. Gold Inventory = $15,900,000
[Credit]. Gains on Market Increase in Gold = $600,000
[Thsi is to recognize the sale of gold at $550 and the realization of a gain in the market increase in gold of $600,000 which is computed as ($550 – $530) = (30,000 troy ounces)].

The loss on futures contracts from December 1 through February is the $600,000 computed as above, and it is journalized as follow:

[Debit]. Payable to Futures Broker = $900,000
[Credit]. Loss on Futures Contracts = $600,000
[Credit]. Cash = $1,250,000
[Credit]. Deposit with Futures Broker = $250,000

 

Futures Contracts Accounted for as a Hedge of an Existing Asset or Liability Position or a Firm Commitment

In such a case, any change in the market value of the futures contract is accounted for as an adjustment of the carrying value of the hedged item. If the contract is a hedge of a firm commitment, changes in the market value of the contract are included in the measurement of the transaction satisfying the commitment.

If there is a difference between the contract price value of the hedged item and two conditions are met, the difference between the contract and the fair value of the hedged item is accounted for as a discount or a premium to be amortized as income over the life of the contract.

The two conditions that need to be met are that:

  • the hedged item is deliverable under contract; and
  • the futures contract and the hedged item will be kept by the firm until the date of the delivery of the futures contract. If the two conditions are not met, then the difference between the contract price and the value of the hedged item is accounted for in the same manner as changes in contract value.

Case Example

The following example illustrates accounting for futures contracts accounted for as hedge of an existing asset or liability position:

On November 1, 2009, Lie Dharma Putra Inc. has a soybean inventory of 30,000 bushels carried at a cost of $6.00 a bushel. The firms intend to sell the whole inventory by February 2010. The firms sell six February 2010 futures contracts in November 2009 at a price of $6.50 per bushel. A $15,000 deposit is required by the broker. At the end of year A, the market price of soybeans is $7.10 per bushel. In February 2010, the company sells the whole inventory at $6.30 per bushel and closes out the six futures contracts at the same price.

The entries for the futures contracts transactions are as follows:

At the inception of the contract on November 1, 2009

[Debit]. Deposit with Futures Broker = $15,000
[Credit]. Cash = $15,000
[This to make a record of the initial margin deposit when the contract is executed].

 

At the end of year 2009

[Debit]. Deferred loss on Futures Contracts = $18,000
[Credit]. Payable to Futures Broker = $18,000
[This to recognize the change in the market value of the contracts, which is calculated as ($7.10 – $6.50) x 30,000 = $18,000, and carry the deferred loss on futures contracts as a current asset].

 

At the expiration of the contract in February 2010

[Debit]. Cash = $21,000
[Debit]. Payable to Futures Broker = $18,000
[Credit]. Deferred Gain on Futures Contract = $24,000
[Credit]. Deposit with Futures Broker = $15,000
[This is to recognize, at the expiration of the contract: (1) the deferred gain on futures contract, which is equal to ($7.10 – $6.30) x 30,000, and (2) the cash received from the broker ($15,000 deposit – $18,000 deferred loss to the broker + $24,000 gain on futures contract)].

[Debit]. Deferred Gain on Futures Contracts = $24,000
[Credit]. Deferred Loss on Futures Contracts = $18,000
[Credit]. Inventory = $6,000
[This is to make an adjustment in carrying value of the hedged item].

[Debit]. Cash = $189,000
[Debit]. Cost of Sales = $174,000
[Credit]. Sales = $189,000
[Credit]. Inventory = $174,000
[This is to recognize the sale of inventory (30,000 x $6.30) and the expending of the cost of inventory ($180,000 – $6,000)].

 

Futures Contracts Accounted for as a Hedge of an Anticipated Transaction

As stated above, when a futures contract is accounted for as a hedge, the hedge may be for an anticipated transaction that the Firm intends or expects to enter into, but is not legally required to do so. Therefore, in such a situation, the futures contract does not relate to a firm’s existing assets, liabilities or commitments.

To qualify as a hedge of an anticipated transaction, the following criteria need to be met: the terms and characteristics of the transactions are identifiable; and the anticipated transaction is possible:

If the two conditions are not met, the gain or loss on the contract is charged to income in the period of change in the market value of the contract.

If the two conditions are met, the hedge qualifies as a hedge of an anticipated transaction and the following situations are possible:

  • If it is probable that the quantity of the anticipated transaction is less than the hedge, then the gains and losses on the contract in excess of the anticipated transaction are charged to income.
  • If the hedge is closed prior to the completion of the transaction, the changes in value are accumulated, carried forward and included in the anticipated transaction.
  • If the hedge is not closed prior to the completion of the transaction, the change in market value of the contract is accounted for in the same manner as the anticipated transaction. 

Case Example

The following example illustrates the accounting for a futures contract accounted for as a hedge of an anticipated transaction:

The Lie Dharma Putra Company uses gold in its finishing process. In October 2009, it decides to acquire a contract of 30,000 ounces of gold at $500 per ounce. A $100,000 deposit is required by the broker. On February 1, 2010, the Lie Dharma Putra Company acquires 30,000 troy ounces for $520 per ounce and closes out the futures contract.

The end of the fiscal year for the company is March 30. The entries for the futures contract transaction are as follows:

At the inception of the contract on October 1, 2009

[Debit]. Deposit with Futures Broker = $100,000
[Credit]. Cash = $100,000

 

At the expiration of the contract on February 1, 2010

a. Recognize the deferred gain on the futures contract:

[Debit]. Cash = $700,000
[Credit]. Deposit with Futures Broker = $100,000
[Credit]. Deferred Gain on Futures Contract = $600,000
[This to recognize the deferred gain on the futures contract, which is equal to ($520 – $500) x (30,000), and the cash received from the broker ($100,000 + $600,000)].

b. Recognize the purchase of gold:

[Debit]. Deferred Gain on Futures Contract = $600,000
[Debit]. Raw Material Inventory (gold) = $15,000,000
[Credit]. Cash = $15,600,000
[This is to recognize the purchase of gold].