Cash flow hedge accounting also is used for foreign currency derivatives used to hedge the cash flow risk associated with a forecasted foreign currency transaction. For hedge accounting to apply, the forecasted transaction must be probable (likely to occur), the hedge must be highly effective in offsetting fluctuations in the cash flow associated with the foreign currency risk, and the hedging relationship must be properly documented.
Accounting for a hedge of a forecasted transaction differs from accounting for a hedge of a foreign currency firm commitment in two ways:
1. Unlike the accounting for a firm commitment, there is no recognition of the forecasted transaction or gains and losses on the forecasted transaction.
2. The company reports the hedging instrument (forward contract or option) at fair value, but because no gain or loss occurs on the forecasted transaction to offset against, the company does not report changes in the fair value of the hedging instrument as gains and losses in net income. Instead, it reports them in other comprehensive income. On the projected date of the forecasted transaction, the company transfers the cumulative change in the fair value of the hedging instrument from other comprehensive income (balance sheet) to net income (income statement).
Forward Contract Cash Flow Hedge of a Forecasted Transaction
To demonstrate the accounting for a hedge of a forecasted foreign currency transaction, as- sume that Amerco has a long-term relationship with its German customer and can reliably forecast that the customer will require delivery of goods costing 1 million euros in March 2012. Confident that it will receive 1 million euros on March 1, 2012, Amerco enters into a forward contract on December 1, 2011, to sell 1 million euros on March 1, 2012, at a rate of
$1.30. The facts are essentially the same as those for the hedge of a firm commitment except that Amerco does not receive a sales order from the German customer until late February 2012. Relevant exchange rates and the fair value of the forward contract are as follows:
Forward Contract
Forward Rate Change in
Date to 3/31/12 Fair Value Fair Value
12/1/11 $1.305 –0– –0–
12/31/11 1.316 $(10,783)* $10,783
3/1/12 1.30 (spot) 5,000 15,783
* ($1,305,000 $1,316,000) $(11,000) 0.9803 $(10,783), where 0.9803 is the present value factor for two months at an annual interest rate of 12 percent (1 percent per month) calculated as 1/1.012. The original discount on the forward contract is determined by the difference in the €spot rate and the three-month forward rate on December 1, 2011: ($1.305 $1.32) €1 million $15,000.
LO6
Account for forward contracts and options used as hedges of forecasted foreign currency transactions.
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2011 Journal Entries—Forward Contract Hedge of a Forecasted Transaction
12/1/11 There is no entry to record either the forecasted sale or the forward contract. A memorandum designates the forward contract as a hedge of the risk of changes in the cash flows related to the forecasted sale resulting from changes in the spot rate.
12/31/11 Accumulated Other Comprehensive Income (AOCI) . . . . 10,783
Forward Contract . . . . 10,783 To record the forward contract as a liability at its fair value
of $10,783 with a corresponding debit to AOCI.
Discount Expense . . . . 5,000
Accumulated Other Comprehensive Income (AOCI) . . . . . 5,000
To record straight-line allocation of the forward contract discount: $15,000 1⁄3$5,000.
Discount expense reduces 2011 net income by $5,000. The impact on the December 31, 2011, balance sheet is as follows:
Assets Liabilities and Stockholders’ Equity
No effect Forward contract . . . $10,783
Retained earnings . . . (5,000) AOCI . . . (5,783)
$ 0
2012 Journal Entries—Forward Contract Hedge of a Forecasted Transaction
3/1/12 Forward Contract . . . . 15,783
Accumulated Other Comprehensive Income (AOCI) . . . . . 15,783
To adjust the carrying value of the forward contract to its current fair value of $5,000 with a corresponding credit to AOCI.
Discount Expense . . . . 10,000
Accumulated Other Comprehensive Income (AOCI) . . . . . 10,000
To record straight-line allocation of the forward contract discount: $15,000 2⁄3$10,000.
Foreign Currency (€) . . . . 1,300,000
Sales . . . . 1,300,000 To record the sale and the receipt of €1 million as
an asset at the spot rate of $1.30.
Cash . . . . 1,305,000
Foreign Currency (€) . . . . 1,300,000 Forward Contract . . . . 5,000 To record settlement of the forward contract (receipt of
$1,305,000 in exchange for delivery of €1 million) and remove the forward contract from the accounts.
Accumulated Other Comprehensive Income (AOCI) . . . . 20,000
Adjustment to Net Income–Forecasted Transaction . . . . 20,000 To close AOCI as an adjustment to net income.
The impact on net income for the year 2012 follows:
Sales . . . $1,300,000 Discount expense . . . (10,000) Adjustment to net income–forecasted transaction . . 20,000
Impact on net income . . . $1,310,000 406 Chapter 9
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Foreign Currency Transactions and Hedging Foreign Exchange Risk 407
Over the two accounting periods, the net impact on net income is $1,305,000, which equals the amount of net cash inflow realized from the sale.
Option Designated as a Cash Flow Hedge of a Forecasted Transaction
Now assume that Amerco hedges its forecasted foreign currency transaction by purchasing a 1 million euro put option on December 1, 2011. The option, which expires on March 1, 2012, has a strike price of $1.32 and a premium of $0.009 per euro. The fair value of the option at relevant dates is as follows (same as in previous examples):
Foreign Currency Option Option
Premium Fair Change in Intrinsic Time Change in Date for 3/1/12 Value Fair Value Value Value Time Value
12/1/11 $0.009 $ 9,000 –0– –0– $9,000 –0–
12/31/11 0.006 6,000 $ 3,000 –0– 6,000 $ 3,000
3/1/12 0.020 20,000 14,000 $20,000 –0– 6,000
2011 Journal Entries—Option Hedge of a Forecasted Transaction
12/1/11 Foreign Currency Option . . . . 9,000
Cash . . . . 9,000 To record the purchase of the foreign currency option as an asset.
There is no entry to record the forecasted sale. A memorandum designates the foreign cur- rency option as a hedge of the risk of changes in the cash flows related to the forecasted sale.
At December 31, the carrying value of the option is decreased for the change in fair value since December 1, and the change in the time value of the option is recognized as option ex- pense. The required journal entries are as follows:
12/31/11 Accumulated Other Comprehensive Income (AOCI) . . . . 3,000
Foreign Currency Option . . . . 3,000 To adjust the carrying value of the option to its fair value with
a corresponding debit to AOCI.
Option Expense . . . . 3,000
Accumulated Other Comprehensive Income (AOCI) . . . . . 3,000
To recognize the change in the time value of the option as a decrease in net income with a corresponding credit to AOCI.
The impact on net income for the year 2011 follows:
Option expense . . . $(3,000) Impact on net income . . . $(3,000)
A foreign currency option of $6,000 is reported as an asset on the December 31, 2011, balance sheet. Cash is decreased by $9,000, and Retained Earnings is decreased by $3,000.
On March 1, 2012, first the carrying value of the option is adjusted to fair value and the change in the time value of the option is recognized as option expense. Then, the sale and the exercise of the foreign currency option are recorded. Finally, the balance in AOCI related to
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the hedge of the forecasted transaction is closed as an adjustment to net income. The follow- ing entries are required:
2012 Journal Entries—Option Hedge of a Forecasted Transaction
3/1/12 Foreign Currency Option . . . . 14,000
Accumulated Other Comprehensive Income (AOCI) . . . . . 14,000
To adjust the carrying value of the option to its fair value with a corresponding credit to AOCI.
Option Expense . . . . 6,000
Accumulated Other Comprehensive Income (AOCI) . . . . . 6,000
To recognize the change in the time value of the option as a decrease in net income with a corresponding credit to AOCI.
Foreign Currency (€) . . . . 1,300,000
Sales . . . . 1,300,000 To record the sale and the receipt of €1 million as an
asset at the spot rate of $1.30.
Cash . . . . 1,320,000
Foreign Currency (€) . . . . 1,300,000 Foreign Currency Option . . . . 20,000 To record the exercise of the foreign currency option (receipt
of $1,320,000 in exchange for delivery of €1 million) and remove the foreign currency option from the accounts.
Accumulated Other Comprehensive Income (AOCI) . . . . 20,000
Adjustment to Net Income–Forecasted Transaction . . . . 20,000 To close AOCI as an adjustment to net income.
The following is the impact on net income for the year 2012:
Sales . . . $1,300,000 Option expense . . . (6,000) Adjustment to net income–forecasted transaction . . 20,000
Impact on net income . . . $1,314,000
Over the two periods, a total of $1,311,000 is recognized as net income, which is equal to the net cash inflow realized from the export sale ($1,320,000 from the sale less $9,000 for the option).