Currency Forward Contract Hedges of Exposed Assets/Liabilities
Robert G. Rambo
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 Activities—an
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
Flow or Fair Value Treatment?
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.
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.
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.
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.
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
(McGraw-Hill/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 OCI 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.
in the total value of fair value hedges are recognized as
gains and losses in earnings at the same time changes in
the A/LFC are recognized and will offset each other, except
for the change in the forward discount or premium.
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 illustrate
the fundamental accounting for an FXFC designated as a hedge
of a foreign currency receivable.
November 2, 2003, an American company sold inventory to
a German company for €100,000, with remittance due
in 90 days. The spot rate on November 2, 2003, was €1
= $1.1584. On that same day, the American company entered
into a forward contract to sell €100,000 in 90 days
at €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
entries for fair value hedges and cash flow hedges are provided
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 x 0.1015 x 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
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.
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.
G. Rambo, PhD, CPA, is an assistant professor of
accounting at the University of Southern Mississippi–Gulf
Coast, Long Beach, Miss.