Foreign Currency Forward Contract Hedges of Exposed Assets/Liabilities
Robert G Rambo. The CPA Journal. New York: Apr 2005.Vol.75, Iss. 4; pg. 30, 4 pgs
http://proquest.umi.com/pqdweb?did=822126781&sid=13&Fmt=4&clientId=68814&RQT
=309&VName=PQD
Abstract (Document Summary)
The proper treatment of foreign currency forward contract hedges of assets and liabilities
denominated in a foreign currency is not easily discernible from the examples provided
in the relevant statements (SFAS 133, SFAS 52, SFAS 138, SFAS 149) or from the
implementation guides from the FASB Derivatives Implementation Group (DIG).
Management has the option of designating forward contracts as either cash flow hedges
or fair value hedges of assets or liabilities denominated in a foreign currency (AJLFC).
To illustrate the similarities and differences in the accounting for cash flow hedges and
for fair value hedges, this article addresses the hedging of a foreign currency receivable
from the sale of inventory. An example would be a long-term purchase contract with a
net-settlement-on default clause.
Full Text (1397 words)
Copyright New York State Society of Certified Public Accountants Apr 2005
The proper treatment of foreign currency forward contract hedges of assets and liabilities
denominated in a foreign currency is not easily discernible from the examples provided
in the relevant statements (SFAS 52, Foreign Currency Translation; SFAS 133,
Accounting for Derivative Instruments and Hedging Activities; SFAS 138, Accounting for
Certain Derivative Instruments and Certain Hedging Activitiesan amendment of SFAS
133; and SFAS 149, Amendment of Statement 133 on Derivative Instruments and
Hedging Activities) or from the implementation guides from the FASB Derivatives
Implementation Group (DIG). Management has the option of designating forward
contracts as either cash flow hedges or fair value hedges of assets or liabilities
denominated in a foreign currency (AJLFC).
Cash Flow or Fair Value Treatment?
To illustrate the similarities and differences in the accounting for cash flow hedges and
for fair value hedges, this article addresses the hedging of a foreign currency receivable
from the sale of inventory. The normal purchases and sales exclusions of SFAS 133
(amended by SFAS 138) refer to contracts that technically meet the definition of a
derivative. An example would be a long-term purchase contract with a net-settlement-on
default clause. DIG Implementation Issue E17 (2001) states that a contract that qualifies
for the normal purchases and sales exception may be designated as the hedged item in
a fair value or cash flow hedge. SFAS 138 states that recognized A/LFCs may be the
hedged item in fair value or cash flow hedges.
SFAS 52 requires companies to measure A/LFCs at their dollar equivalent using the
current spot rate. Exchange risk is the change in the dollar value of exposed assets or
liabilities resulting from changes in the spot rate during a given period. These foreign
currency exchange gains and losses are recognized in net income.
One method of managing exposure to the exchange risk of an A/LFC is to enter into a
foreign exchange forward contract (FXFC) to lock in the dollar amount of the transaction
at maturity. Management can designate the forward contract as either a cash flow hedge
or a fair value hedge of the exposed A/LFC, because changes in spot rates affect both
the fair value and the cash flows of foreign currency receivables or payables.
The total gain or loss on the FXFC can be segregated into two components. The first
corresponds to the change in fair value of the FXFC resulting from changes in the spot
rate, and offsets the gain or loss on the underlying A/LFC. The second component
represents the initial premium or discount on the forward contract. Thus, the net gain or
loss will be the initial premium or discount. The accounting for the two components is
based on whether the FXFC is a cash flow hedge or a fair value hedge.
EXHIBIT 1
Spot Rates, Forward Rates, Valuations, Gains and Losses, and Discount Amortizations
over Contract Period
Accounting for cash flow hedges of A/LFC under SFAS 138 is different from the usual
accounting for cash flow hedges. Mark A. Trombley, in Accounting for Derivatives and
Hedging (McGrawHill/Irwin, 2003), summarizes the procedure as follows:
* Hedge effectiveness is assessed by comparing the change in the value of the
derivative attributable to changes in spot rates, excluding any changes in forward
discount or premium, with the change in the value of the hedged item. Because A/LFCs
are also measured using spot rates, this satisfies the highly effective hedge criteria.
* The hedged A/LFC is adjusted to fair value based on current spot rates, and a gain or
loss due to a change in fair value is recognized in earnings.
* The entire change in the fair value of the derivative (both the spot rate change and the
change in forward discount or premium) is reported in other comprehensive income
(OCI). This differs from the normal accounting for cash flow hedges in that the change in
the forward discount or premium, which is excluded in determining hedge effectiveness,
is not recognized in earnings.
* An amount equal to the gain or loss on the hedged item is then reclassed from CXZI
and recognized in earnings.
* The allocation of the original forward discount or premium is amortized using an
effective rate method, and reclassed from OCI to earnings.
Changes in the total value of fair value hedges are recognized as gains and losses in
earnings at the same time changes in the AJLFC are recognized and will offset each
other, except for the change in the forward discount or premium.
Example
The following example illustrates the accounting for the sale of inventory denominated in
euros, uses a 6% annual discount rate, and amortizes the forward contract premium
using an effective interest rate method. The journal entries illus(rate the fundamental
accounting for an FXFC designated as a hedge of a foreign currency receivable.
EXHIBIT 2
Journal Entries: Sale of Inventory for euro100,000
On November 2, 2003, an American company sold inventory to a German company for
euro100,000, with remittance due in 90 days. The spot rate on November 2, 2003, was
euro1 = $1.1584. On that same day, the American company entered into a forward
contract to sell euro100,000 in 90 days at euro 1 =$1.1576. Because the forward
contract completely eliminates the cash flow variability from exchange risk, the company
can designate the FXFC as a cash flow hedge of the receivable. Regardless of the
exchange rate of the euro on January 30, 2004, the company is guaranteed to receive
$115,760. The company can also designate the FXFC as a fair value hedge, because
the forward contract guarantees the fair value of the receivable will be $115,760.
Because the settlement date, currency type, and currency amount of the FXFC match
the corresponding terms of the receivable, the hedge is expected to be highly effective.
Actual hedge effectiveness is evaluated at each date by comparing the change in the
spot rate component of the forward price to the change in the value of the receivable.
Because the receivable is also measured using the spot rate, the hedge is considered to
be highly effective. Exhibit 1 provides a summary of spot rates, forward rates, valuations,
gains and losses, and discount amortizations over the contract period.
Enlarge 200%
Enlarge 400%
EXHIBIT 3
Partial Income Statements: Sale of Inventory for euro100,000
Journal entries for fair value hedges and cash flow hedges are provided in Exhibit 2. On
November 2, 2003, the company recognizes the sale and related receivable at $115,840
using the current spot rate. The forward contract requires no initial payment, so no
accounting is required on November 2. On December 31, 2003, the receivable is
adjusted to fair value based on the current spot rate (1.2597), and the corresponding
gain is recognized in net income. The loss on the forward contract, based on the change
in forward rates during the period (0.1015), is discounted at a 6% annual rate and
recognized in net income for the fair value hedge, and in OCI for the cash flow hedge
($100,000 × 0.1015 × 0.99502). The loss on the cash flow hedge is reclassed out of OCI
and into net income in two parts. First, the foreign exchange gain on the receivable
($10,130) is offset, and then the amortized discount on the forward contract ($54) is
recognized in net income.
On January 30, 2004, the receivable is adjusted to fair value based on the current spot
rate ( 1.2456), and the corresponding loss is recognized in net income. The fair value of
the forward contract is based on the cumulative change in the forward rate (0.0880). The
gain on the forward contract is the change in the fair value during the period, and is
recognized in net income for the fair value hedge, and in OCI for the cash flow hedge.
The gain on the cash flow hedge is reclassed into net income to offset the foreign
exchange loss on the receivable ($1,410), and the amortized discount on the forward
contract ($26) is reclassed into net income. The company settles the receivable and the
forward contract net, receiving $115,760.
Exhibit 3 presents the comprehensive income statements. OCI is shown in the single
statement format consistent with SFAS 130; it can also be shown in a separate income
statement beginning with net income, or in a statement of changes in owners' equity.
[Author Affiliation]
Robert G. Rambo, PhD, CPA, is cm assistant professor of accounting at the University
of Southern Mississippi-Gulf Coast, Long Beach, Miss.