Foreign Currency Hedging and Forward Exchange Contracts

Foreign Currency Hedging and Forward ExchangeCompanies often use hedging and forward exchange contract strategies to attempt to manage their risk and minimize their exposure to fluctuations in the exchange rates of foreign currencies. Foreign currency transaction gains and losses on assets and liabilities that are denominated in a currency other than the functional currency can be hedged if a US company enters into a forward exchange contract which will be discussed on the later section of this post.  Case example presented in the section shows how a forward exchange contract can be used as a hedge, first against a firm commitment and then, following delivery date, as a hedge against a recognized liability. Read on…

 

Foreign Currency Hedging

ASC 815, Derivatives and Hedging, provides complex hedging rules that permit the reporting entity to elect to obtain special accounting treatment relative to foreign currency risks with respect to the following items:

  • Recognized assets or liabilities
  • Available-for-sale debt and equity securities
  • Unrecognized firm commitments
  • Foreign-currency-denominated forecasted cash flows
  • Net investment in a foreign operation

 

Measuring Hedge Effectiveness

While any entity may utilize hedging strategies, under the provisions of ASC 815 the transaction must meet a number of important conditions in order to qualify for hedge accounting. Among these conditions are the establishment, at inception, of criteria for measuring hedge effectiveness and ineffectiveness.

Periodically, each hedge must be evaluated for effectiveness, using the pre-established criteria, and the gains or losses associated with hedge ineffectiveness must be reported currently in earnings, and not deferred to future periods. In the instance of foreign currency hedges, ASC 815 states that reporting entities must exclude from their assessments of hedge effectiveness the portions of the fair value of forward contracts attributable to spotforward differences (i.e., differences between the spot exchange rate and the forward exchange rate).

In practice, this means that reporting entities engaging in foreign currency hedging will recognize changes in the above-described portion of the derivative’s fair value in earnings, in the same manner that changes representing hedge ineffectiveness are reported, but these are not considered to represent ineffectiveness. These entities must estimate the cash flows on forecasted transactions based on the current spot exchange rate, appropriately discounted for time value. Effectiveness is then assessed by comparing the changes in fair values of the forward contracts attributable to changes in the dollar spot price of the pertinent foreign currency to the changes in the present values of the forecasted cash flows based on the current spot exchange rate(s).

 

Foreign Currency Hedging Case Example

On October 1, 2009, Lie Dharma Co. (a US company) orders from its European supplier, Grunefunkt GmbH, a machine that is to be delivered and paid for on March 31, 2010. The price, denominated in euros, is €4,000,000. Although Lie Dharma will not make the payment until the planned delivery date, it has immediately entered into a firm commitment to make this purchase and to pay €4,000,000 upon delivery. This creates a euro liability exposure to foreign exchange risk; thus, if the euro appreciates over the intervening six months, the dollar cost of the equipment will increase.

To reduce or eliminate this uncertainty, Lie Dharma desires to lock in the purchase cost in euros by entering into a six-month forward contract to purchase euros on the date when the purchase order is issued to and accepted by Grunefunkt. The spot rate on October 1, 2009, is $1.40 per euro and the forward rate for March 31, 2010 settlement is $1.44 per euro. Lie Dharma enters into a forward contract on October 1, 2009, with the First Intergalactic Bank to pay US $5,760,000 in exchange for the receipt of €4,000,000 on March 31, 2010, which can then be used to pay Grunefunkt. No premium is received nor paid at the inception of this forward contract. The transaction is a firm commitment consistent with the requirements of ASC 815, and fair value hedge accounting is used in accounting for the forward contract.

Assume the relevant time value of money is measured at 1/2% per month (a nominal 6% annual rate). The spot rate for euros at December 31, 2009, is $1.45, and at March 31, 2010, it is $1.48. The forward rate as of December 31 for March 31 settlement is $1.46. Entries to reflect the foregoing scenario are as follows:

 

Journal entries per 10/1/09:

No entries, since neither the forward contract nor the firm commitment have value on this date

 

Journal entries per 12/31/09:

(1) To record present value (at 1/2% monthly rate) of change in value of forward contract [= change in forward rate (1.46 – 1.44) × €4,000,000 = $80,000 to be received in three months, discounted at 6% per annum]:
 
[Debit]. Forward currency contract = 78,818
[Credit]. Gain on forward contract = 78,818

 

(2) To record present value (at 1/2% monthly rate) of change in amount of firm commitment [= change in spot rate (1.45 – 1.40) × €4,000,000 = $200,000 to be paid in three months, discounted at 6% per annum]:

[Debit]. Loss on firm purchase commitment = 197,044
[Credit]. Firm commitment obligation = $197,044

 

(3) To close the gain and loss accounts to net income and thus to retained earnings:

[Debit]. Gain on forward contract = 78,818
[Debit]. P&L summary (then to retained earnings) =118,226
[Credit]. Loss on firm purchase commitment = 197,044

 

Journal entries per 3/31/10:
 
(1) To record change in value of forward contract {[= (1.48 – 1.44) × €4,000,000 =
$160,000] – gain previously recognized ($78,818)}:
 
[Debit]. Forward currency contract = 81,182
[Credit]. Gain on forward contract = 81,182

 

(2) To record change in amount of firm commitment {[= (1.48 – 1.40) × €4,000,000] less loss previously recognized ($197,044)}:

[Debit]. Loss on firm commitment = 122,956
[Credit]. Firm commitment obligation 122,956

 

(3) To record purchase of machinery based on spot exchange rate as of date of contractual commitment (1.40) and close out the firm commitment obligation (representing effect of change in spot rate during commitment period):
 
[Debit]. Firm commitment obligation = 320,000
[Debit]. Machinery and equipment = 5,600,000
[Credit]. Cash = 5,920,000

 

(4) To record collection of cash on net settlement of forward contract [= (1.48 – 1.44) × €4,000,000]:
 
[Debit]. Cash = 160,000
[Credit]. Forward contract = 160,000

 

(5) To close the gain and loss accounts to net income and thus to retained earnings:

[Debit]. Gain on forward contract = 81,182
[Debit]. P&L summary (then to retained earnings) 41,774
[Credit]. Loss on firm purchase commitment 122,956

 

Observe that in the foregoing example the gain on the forward contract did not precisely offset the loss incurred from the firm commitment. Since a hedge of an unrecognized foreign currency denominated firm commitment is accounted for as a fair value hedge, with gains and losses on hedging positions and on the hedged item both being recorded in current earnings, it may appear that the matter of hedge effectiveness is of academic interest only.

However, according to ASC 815, even if both components (that is, the net gain or loss representing hedge ineffectiveness, and the amount charged to earnings which was excluded from the measurement of ineffectiveness) are reported in current period earnings, the distinction between them is still of importance.

With respect to fair value hedges of firm purchase commitments denominated in a foreign currency, ASC 815 directs that “the change in value of the contract related to the changes in the differences between the spot price and the forward or futures price would be excluded from the assessment of hedge effectiveness.”

As applied to the foregoing example, therefore, the net credit to income in 2009 ($118,226) can be further analyzed into two constituent elements: the amount arising from the change in the difference between the spot price and the forward price, and the amount resulting from hedge ineffectiveness.

The former item, not attributed to ineffectiveness, arose because the spread between spot and forward price at hedge inception, (1.44 – 1.40 =) .04, fell to (1.46 – 1.45 =) .01 by December 31, for an impact amounting to (.04 – .01 =) .03 × €4,000,000 = $120,000, which, reduced to present value terms, equaled $118,227. The net credit to earnings in December 2009, ($78,818 + 118,226 =) $197,044, relates to the spread between the spot and forward rates on December 31 and is identifiable with hedge ineffectiveness.

 

Forward Exchange Contracts

A general rule for estimating the fair value of forward exchange rates under ASC 815 is to use the changes in the forward exchange rates, and discount those estimated future cash flows to a present-value basis. An entity will need to consider the time value of money if significant in the circumstances for these contracts.

The following example does not apply discounting of the future cash flows from the forward contracts in order to focus on the relationships between the forward contract and the foreign currency denominated payable.

Forward Exchange Contracts Case Example

Dharma Putra, Inc. enters into a firm commitment with Robot Ing., Inc. of Germany, on October 1, 2009, to purchase a computerized robotic system for €6,000,000. The system will be delivered on March 1, 2010, with payment due sixty days after delivery (April 30, 2010). Dharma Putra, Inc. decides to hedge this foreign currency firm commitment and enters into a forward exchange contract on the firm commitment date to receive €6,000,000 on the payment date. The applicable exchange rates are shown in the table below:

Date                           Spot rates      Forward rates for April 30, 2009
October 1, 2009         €1 = $1.55     €1 = $ 1.57
December 31, 2009    €1 = $1.58     €1 = $1.589
March 1, 2010            €1 = $1.58     €1 = $1.585
April 30, 2010            €1 = $1.60

 

A. Forward contract entries Hedge against firm commitment entries

(1) Journal entry per 10/1/08 (forward rate for 4/30/09 €1 = $1.57):

[Debit]. Forward contract receivable = 9,420,000
[Credit]. Dollars payable = 9,420,000

Note:

This entry recognizes the existence of the forward exchange contract using the gross method. Under the net method, this entry would not appear at all, since the fair value of the forward contract is zero when the contract is initiated. The amount is calculated using the 10/1/08 forward rate for 4/30/09 (€6,000,000 × $1.57 = $9,420,000).

Net fair value of the forward contract = $0

Note that the net fair value of the forward exchange contact on 10/1/08 is zero because there is an exact amount offset of the forward contract receivable of $9,420,000 with the dollars payable liability of $9,420,000. Many companies present only the net fair value of the forward contract on their balance sheets, and therefore, they would have no net amount reported for the forward contract at its inception.

 

(2) Journal entry per 12/31/08 (forward rate for 4/30/09 €1 = $1.589)

[Debit]. Forward contract receivable = 114,000
[Credit]. Gain on hedge activity = 114,000

Note:

The dollar values for this entry reflect, among other things, the change in the forward rate from 10/1/08 to 12/31/08. However, the actual amount recorded as gain or loss (gain in this case) is determined by all market factors.

Net increase in fair value of the forward contract = (1.589 – 1.57 = .019 × €6,000,000 = $114,000).

The increase in the net fair value of the forward exchange contract on 12/31/08 is $114,000 for the difference between the $7,134,000 ($7,020,000 plus $114,000) in the forward contract receivable and the $7,020,000 for the dollars payable liability. Many companies present only the net fair value on their balance sheet, in this case as an asset. And, this $114,000 is the amount that would be discounted to present value, if interest is significant, to recognize the time value of the future cash flow from the forward contract.

 

(3) Journal entry per 12/31/08:

[Debit]. Loss on hedge activity = 114,000
[Credit]. Firm commitment = 114,000

Note:

The dollar values for this entry are identical to those in entry (2), reflecting the fact that the hedge is highly effective (100%) and also the fact that the market recognizes the same factors in this transaction as for entry (2). This entry reflects the first use of the firm commitment account, a temporary liability account pending the receipt of the asset against which the firm commitment has been hedged.

 

(4) Journal entries per 3/1/09 (forward rate for 4/30/09 €1 = $1.585):

[Debit]. Loss on hedge activity = 24,000
[Credit]. Forward contract receivable = 24,000

 

(5) Journal entry per 3/1/09:

[Debit]. Firm commitment = 24,000
[Credit]. Gain on hedge activity 24,000

Note:

These entries again will be driven by market factors, and they are calculated the same way as entries (2) and (3) above. Note that the decline in the forward rate from 12/31/08 to 3/1/09 resulted in a loss against the forward contract receivable and a gain against the firm commitment [1.585 – 1.589 = (.004) × €6,000,000 = ($24,000)].

 

B. Hedge against a recognized liability entries

(6) Journal entry per 3/1/09 (spot rate €1 = $1.58):

[Debit]. Equipment = 9,390,000
[Debit]. Firm commitment = 90,000
[Credit]. Accounts payable (€) = 9,480,000

Note:

This entry records the receipt of the equipment, the elimination of the temporary liability account (firm commitment), and the recognition of the payable, calculated using the spot rate on the date of receipt (€6,000,000 × $1.58 = $9,480,000).

Net fair value of the forward contract = $90,000

The net fair value of the forward exchange contract on 3/1/09 is $90,000 for the difference between the $9,510,000 ($9,420,000 plus 114,000 minus $24,000) in the forward contract receivable and the $9,420,000 for the dollars payable liability. Another way of computing the net fair value is to determine the change in the forward contract rate from the initial date of the contract, 10/1/08, which is $1.585 – $1.57 = $.015 × €6,000,000 = $90,000.

Also note that the amount in the firm commitment temporary liability account is equal to the net fair value of the forward contract on the date the equipment is received.

 

(7) Journal entry per 4/30/09 (spot rate €1 = $1.60):

[Debit]. Forward contract receivable = 90,000
[Credit]. Gain on forward contract = 90,000

Note:

The gain or loss (gain in this case) on the forward contract is calculated using the change in the forward to the spot rate from 3/1/09 to 4/30/09 [€6,000,000 × ($1.60 – $1.585) = $90,000]

Net fair value of the forward contract = $180,000

The net fair value of the forward exchange contract on 4/30/09 is $180,000 for the difference between the $9,600,000 ($9,510,000 plus $90,000) in the forward contract receivable and the $9,420,000 for the dollars payable liability. The net fair value of the forward contract at its terminal date of 4/30/09 is based on the difference between the contract forward rate of €1 = $1.57 and the spot rate on 4/30/09 of €1 = $1.60. The forward contract receivable has reached its maturity and the contract is completed on this date at the forward rate of €1 = $1.57 as contracted on 10/1/08. If the entity recognizes an interest factor in the forward contract over the life of the contract, then interest is recognized at this time on the forward contract, but no separate accrual of interest is required for the accounts payable in euros.

 

(8) Journal entry per 4/30/09:

[Debit]. Transaction loss = 120,000
[Credit]. Accounts payable (€) = 120,000

Note:

The transaction loss related to the accounts payable reflects only the change in the spot rates and ignores the accrual of interest. [€6,000,000 × ($1.60 – $1.58) = $120,000]

 

(9) Journal entry per 4/30/09:

[Debit]. Dollars payable = 9,420,000
[Credit]. Cash = 9,420,000
[Debit]. Foreign currency units (€) = 9,600,000
[Credit]. Forward contract receivable = 9,600,000

Note:

This entry reflects the settlement of the forward contract at the 10/1/08 contracted forward rate (€6,000,000 × $1.17 = $7,020,000) and the receipt of foreign currency units valued at the spot rate (€6,000,000 × $1.20 = $7,200,000).

 

(10) Journal entry per 4/30/09:

[Debit]. Accounts payable (€) = 9,600,000
[Credit]. Foreign currency units (€) = 9,600,000

Note:This entry reflects the use of the foreign currency units to retire the account payable.

 

The example presents both the forward contract receivable and the dollars payable liability in order to show all aspects of the forward contract.

For financial reporting purposes, most companies present just the net fair value of the forward contract that would be the difference between the current value of the forward contract receivable and the dollars payable liability. Note that the foreign currency hedges in the illustration are not perfectly effective. However, for this example, the degree of ineffectiveness is not deemed to be sufficient to trigger income statement recognition per ASC 815.

The transactions that reflect the forward exchange contract, the firm commitment and the acquisition of the asset and retirement of the related liability appear below. The net fair value of the forward contract is shown below each set of entries for the forward exchange contract.

In the case of using a forward exchange contract to speculate in a specific foreign currency, the general rule to estimate the fair value of the forward contract is to use the forward exchange rate for the remainder of the term of the forward contract.