In the examples thus far, Amerco does not enter into a hedge of its export sale until it actually makes the sale. Assume now that on December 1, 2011, Amerco receives and accepts an order from a German customer to deliver goods on March 1, 2012, at a price of 1 million euros.
Assume further that under the terms of the sales agreement, Amerco will ship the goods to the German customer on March 1, 2012, and will receive immediate payment on delivery. In other words, Amerco will not allow the German customer time to pay. Although Amerco will not make the sale until March 1, 2012, it has a firm commitment to make the sale and receive 1 million euros in three months. This creates a euro asset exposure to foreign exchange risk as of December 1, 2011. On that date, Amerco wants to hedge against an adverse change in the
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Account for forward contracts and options used as hedges of foreign currency firm commitments.
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Foreign Currency Transactions and Hedging Foreign Exchange Risk 401
value of the euro over the next three months. This is known as a hedge of a foreign currency firm commitment. Although prior U.S. GAAP originally indicated that only fair value hedge accounting is appropriate for hedges of foreign currency firm commitments, cash flow hedge accounting also now can be used. However, because the results of fair value hedge account- ing are intuitively more appealing, we do not cover cash flow hedge accounting for firm commitments.
A firm commitment is an executory contract; the company has not delivered goods nor has the customer paid for them. Normally, executory contracts are not recognized in financial statements. However, when a firm commitment is hedged using a derivative financial instru- ment, hedge accounting requires explicit recognition on the balance sheet at fair value of both the derivative financial instrument (forward contract or option) and the firm commitment. The change in fair value of the firm commitment results in a gain or loss that offsets the loss or gain on the hedging instrument (forward contract or option), thus achieving the goal of hedge accounting. This raises the conceptual question of how to measure the fair value of the firm commitment. When a forward contract is used as the hedging instrument, the fair value of the firm commitment is determined through reference to changes in the forward exchange rate.
Changes in the spot exchange rate are used to determine the fair value of the firm commitment when a foreign currency option is the hedging instrument.
Forward Contract Used as Fair Value Hedge of a Firm Commitment
To hedge its firm commitment exposure to a decline in the U.S. dollar value of the euro, Amerco decides to enter into a forward contract on December 1, 2011. Assume that on that date, the three-month forward rate for euros is $1.305 and Amerco signs a contract with New Manhattan Bank to deliver 1 million euros in three months in exchange for $1,305,000. No cash changes hands on December 1, 2011. Amerco measures the fair value of the firm com- mitment through changes in the forward rate. Because the fair value of the forward contract is also measured using changes in the forward rate, the gains and losses on the firm commitment and forward contract exactly offset. The fair value of the forward contract and firm commit- ment are determined as follows:
Forward Contract Firm Commitment Forward
Rate to Change in Change in
Date 3/1/12 Fair Value Fair Value Fair Value Fair Value
12/1/11 $1.305 –0– –0– –0– –0–
12/31/11 1.316 $(10,783)* $10,783 $10,783* $10,783
3/1/12 1.30 (spot) 5,000† 15,783 (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.
†($1,305,000 $1,300,000) $5,000.
Amerco pays nothing to enter into the forward contract at December 1, 2011. Both the forward contract and the firm commitment have a fair value of zero on that date. At Decem- ber 31, 2011, the forward rate for a contract to deliver euros on March 1, 2012, is $1.316.
A forward contract could be entered into on December 31, 2011, to sell 1 million euros for
$1,316,000 on March 1, 2012. Because Amerco is committed to sell 1 million euros for
$1,305,000, the value of the forward contract is $(11,000); present value is $(10,783), a liability. The fair value of the firm commitment is also measured through reference to changes in the forward rate. As a result, the fair value of the firm commitment is equal in amount but of opposite sign to the fair value of the forward contract. At December 31, 2011, the firm com- mitment is an asset of $10,783.
On March 1, 2012, the forward rate to sell euros on that date, by definition, is the spot rate,
$1.30. At that rate, Amerco could sell 1 million euros for $1,300,000. Because Amerco has a contract to sell euros for $1,305,000, the fair value of the forward contract on March 1, 2012, is $5,000 (an asset). The firm commitment has a value of $(5,000), a liability. The journal
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entries to account for the forward contract fair value hedge of a foreign currency firm com- mitment are as follows:
2011 Journal Entries—Forward Contract Fair Value Hedge of Firm Commitment
12/1/11 There is no entry to record either the sales agreement or the forward contract because both are executory contracts. A memorandum designates the forward contract as a hedge of the risk of changes in the fair value of the firm commitment resulting from changes in the U.S. dollar–euro forward exchange rate.
12/31/11 Loss on Forward Contract . . . . 10,783
Forward Contract . . . . 10,783 To record the forward contract as a liability at its fair value
of $(10,783) and record a forward contract loss for the change in the fair value of the forward contract since December 1.
Firm Commitment . . . . 10,783
Gain on Firm Commitment . . . . 10,783 To record the firm commitment as an asset at its fair value of
$10,783 and record a firm commitment gain for the change in the fair value of the firm commitment since December 1.
Consistent with the objective of hedge accounting, the gain on the firm commitment off- sets the loss on the forward contract, and the impact on 2011 net income is zero. Amerco re- ports the forward contract as a liability and reports the firm commitment as an asset on the December 31, 2011, balance sheet. This achieves the objective of making sure that derivatives are reported on the balance sheet and ensures that there is no impact on net income.
On March 1, 2012, Amerco first recognizes changes in the fair value of the forward con- tract and firm commitment since December 31. The company then records the sale and the set- tlement of the forward contract. Finally, the $5,000 balance in the firm commitment account is closed as an adjustment to net income. The required journal entries are as follows:
2012 Journal Entries—Forward Contract Fair Value Hedge of Firm Commitment
3/1/12 Forward Contract . . . . 15,783
Gain on Forward Contract . . . . 15,783 To adjust the fair value of the forward contract from
$(10,783) to $5,000 and record a forward contract gain for the change in fair value since December 31.
Loss on Firm Commitment . . . . 15,783
Firm Commitment . . . . 15,783 To adjust the fair value of the firm commitment from
$10,783 to $(5,000) and record a firm commitment loss for the change in fair value since December 31.
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.
Firm Commitment . . . . 5,000
Adjustment to Net Income–Firm Commitment . . . . 5,000 To close the firm commitment as an adjustment to net income.
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Foreign Currency Transactions and Hedging Foreign Exchange Risk 403
Once again, the gain on forward contract and the loss on firm commitment offset. As a result of the last entry, the export sale increases 2012 net income by $1,305,000 ($1,300,000 in sales plus a $5,000 adjustment to net income). This exactly equals the amount of cash re- ceived. In practice, companies use a variety of account titles for the adjustment to net income that results from closing the firm commitment account.
The net gain on forward contract of $5,000 ($10,783 loss in 2011 plus $15,783 gain in 2012) measures the net benefit to the company from hedging its firm commitment. Without the forward contract, Amerco would have sold the 1 million euros received on March 1, 2012, at the spot rate of $1.30 generating cash flow of $1,300,000. Through the forward contract, Amerco is able to sell the euros for $1,305,000, a net gain of $5,000.
Option Used as Fair Value Hedge of Firm Commitment
Now assume that to hedge its exposure to a decline in the U.S. dollar value of the euro, Amerco purchases a put option to sell 1 million euros on March 1, 2012, at a strike price of
$1.32. The premium for such an option on December 1, 2011, is $0.009 per euro. With this option, Amerco is guaranteed a minimum cash flow from the export sale of $1,311,000 ($1,320,000 from option exercise less $9,000 cost of the option).
Amerco measures the fair value of the firm commitment by referring to changes in the U.S.
dollar–euro spot rate. In this case, Amerco must discount the fair value of the firm commit- ment to its present value. The fair value and changes in fair value for the firm commitment and foreign currency option are summarized here:
Foreign Currency Option Firm Commitment Option
Premium Change in Spot Change in
Date for 3/1/12 Fair Value Fair Value Rate Fair Value Fair Value
12/1/11 $0.009 $ 9,000 –0– $1.32 –0– –0–
12/31/11 0.006 6,000 $3,000 1.33 $ 9,803* $ 9,803
3/1/12 0.020 20,000 14,000 1.30 (20,000)† 29,803
*$1,330,000 $1,320,000 $10,000 0.9803 $9,803, 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.
†$1,300,000 $1,320,000 $(20,000).
At December 1, 2011, given the spot rate of $1.32, the firm commitment to receive 1 mil- lion euros in three months would generate a cash flow of $1,320,000. At December 31, 2011, the cash flow that the firm commitment could generate increases by $10,000 to $1,330,000.
The fair value of the firm commitment at December 31, 2011, is the present value of $10,000 discounted at 1 percent per month for two months. Amerco determines the fair value of the firm commitment on March 1, 2012, by referring to the change in the spot rate from December 1, 2011, to March 1, 2012. Because the spot rate declines by $0.02 over that period, the firm commitment to receive 1 million euros has a fair value of $(20,000) on March 1, 2012. The journal entries to account for the foreign currency option and related foreign currency firm commitment are discussed next:
2011 Journal Entries—Option Fair Value Hedge of Firm Commitment
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 sales agreement because it is an executory contract. Amerco prepares a memorandum to designate the option as a hedge of the risk of changes in the fair value of the firm commitment resulting from changes in the spot exchange rate.
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12/31/11 Loss on Foreign Currency Option . . . . 3,000
Foreign Currency Option . . . . 3,000 To adjust the fair value of the option from $9,000 to $6,000
and record the change in the value of the option as a loss.
Firm Commitment . . . . 9,803
Gain on Firm Commitment . . . . 9,803 To record the firm commitment as an asset at its fair value of
$9,803 and record a firm commitment gain for the change in the fair value of the firm commitment since December 1.
Because the fair value of the firm commitment is based on changes in the spot rate whereas the fair value of the option is based on a variety of factors, the gain on the firm commitment and loss on the option do not exactly offset.
The impact on net income for the year 2011 is as follows:
Gain on firm commitment . . . $ 9,803 Loss on foreign currency option . . . (3,000) Impact on net income . . . $ 6,803 The effect on the December 31, 2011, balance sheet follows:
Assets Liabilities and Stockholders’ Equity Cash . . . $(9,000) Retained earnings . . . $6,803 Foreign currency option . . . 6,000
Firm commitment . . . 9,803
$ 6,803
On March 1, 2012, Amerco first recognizes changes in the fair value of the option and of the firm commitment since December 31. The company then records the sale and the exercise of the option. Finally, the $20,000 balance in the firm commitment account is closed as an adjustment to net income. The required journal entries are as follows:
2012 Journal Entries—Option Fair Value Hedge of Firm Commitment
3/1/12 Foreign Currency Option . . . . 14,000
Gain on Foreign Currency Option . . . . 14,000 To adjust the fair value of the foreign currency option from
$6,000 to $20,000 and record a gain on foreign currency option for the change in fair value since December 31.
Loss on Firm Commitment . . . . 29,803
Firm Commitment . . . . 29,803 To adjust the fair value of the firm commitment from $9,803
to $(20,000) and record a firm commitment loss for the change in fair value since December 31.
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 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.
Firm Commitment . . . . 20,000
Adjustment to Net Income . . . . 20,000 To close the firm commitment as an adjustment to net income.
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Foreign Currency Transactions and Hedging Foreign Exchange Risk 405
The following is the impact on net income for the year 2012:
Sales . . . $1,300,000 Loss on firm commitment . . . (29,803) Gain on foreign currency option . . . 14,000 Adjustment to net income–firm commitment . . . . 20,000 Impact on net income . . . $1,304,197
The net increase in net income over the two accounting periods is $1,311,000 ($6,803 in 2011 plus $1,304,197 in 2012), which exactly equals the net cash flow realized on the export sale ($1,320,000 from exercising the option less $9,000 to purchase the option). The net gain on the option of $11,000 (loss of $3,000 in 2011 plus gain of $14,000 in 2012) reflects the net benefit from having entered into the hedge. Without the option, Amerco would have sold the 1 million euros received on March 1, 2012, at the spot rate of $1.30 for $1,300,000.