We now return to the Amerco example in which the company has a foreign currency account receivable to demonstrate the accounting for a hedge of a recognized foreign currency de- nominated asset.8In the preceding example, Amerco has an asset exposure in euros when it sells goods to the German customer and allows the customer three months to pay for its pur- chase. To hedge its exposure to a possible decline in the U.S. dollar value of the euro, Amerco enters into a forward contract.
Assume that on December 1, 2011, 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.
Because the spot rate on December 1 is $1.32, the euro (€) is selling at a discount in the three-month forward market (the forward rate is less than the spot rate). Because the euro is selling at a discount of $0.015 per euro, Amerco receives $15,000 less than it would had payment been received at the date the goods are delivered ($1,305,000 versus $1,320,000).
This $15,000 reduction in cash flow can be considered as an expense; it is the cost of ex- tending foreign currency credit to the foreign customer.9Conceptually, this expense is sim- ilar to the transaction loss that arises on the export sale. It exists only because the transaction is denominated in a foreign currency. The major difference is that Amerco knows the exact amount of the discount expense at the date of sale, whereas when it is left unhedged, Amerco does not know the size of the transaction loss until three months pass.
(In fact, it is possible that the unhedged receivable could result in a transaction gain rather than a transaction loss.)
Because the future spot rate turns out to be only $1.30, selling euros at a forward rate of
$1.305 is obviously better than leaving the euro receivable unhedged: Amerco will receive
$5,000 more as a result of the hedge. This can be viewed as a gain resulting from the use of the forward contract. Unlike the discount expense, the exact size of this gain is not known until three months pass. (In fact, it is possible that use of the forward contract could result in an additional loss. This would occur if the spot rate on March 1, 2012, is more than the forward rate of $1.305.)
Amerco must account for its foreign currency transaction and the related forward contract simultaneously but separately. The process can be better understood by referring to the steps involving the three parties—Amerco, the German customer, and New Manhattan Bank—
shown in Exhibit 9.2.
Because the settlement date, currency type, and currency amount of the forward contract match the corresponding terms of the account receivable, the hedge is expected to be highly effective. If Amerco properly designates the forward contract as a hedge of its euro account receivable position, it may apply hedge accounting. Because it completely offsets the variability in the cash flows related to the account receivable, Amerco may designate the forward contract as a cash flow hedge. Alternatively, because changes in the spot rate affect not only the cash
8The comprehensive illustration at the end of this chapter demonstrates the accounting for the hedge of a foreign currency denominated liability.
9This should not be confused with the cost associated with normal credit risk—that is, the risk that the cus- tomer will not pay for its purchase. That is a separate issue unrelated to the currency in which the transaction is denominated.
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flows but also the fair value of the foreign currency receivable, Amerco may elect to account for this forward contract as a fair value hedge.
In either case, Amerco determines the fair value of the forward contract by referring to the change in the forward rate for a contract maturing on March 1, 2012. The relevant exchange rates, U.S. dollar value of the euro receivable, and fair value of the forward contract are deter- mined as follows:
Account Receivable (€) Forward Forward Contract U.S. Dollar Change in U.S. Rate to Change in Date Spot Rate Value Dollar Value 3/1/12 Fair Value Fair Value
12/1/11 $1.32 $1,320,000 — $1.305 –0– —
12/31/11 1.33 1,330,000 $10,000 1.316 $(10,783)* $10,783
3/1/12 1.30 1,300,000 $30,000 1.30 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, and the forward contract has a fair value of zero on that date. At December 31, 2011, the forward rate for a contract to deliver euros on March 1, 2012, is $1.316. Amerco could enter into a forward contract 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 nominal value of the forward contract is $(11,000). The fair value of the forward contract is the pre- sent value of this amount. Assuming that Amerco has an incremental borrowing rate of 12 percent per year (1 percent per month) and discounting for two months (from Decem- ber 31, 2011, to March 1, 2012), the fair value of the forward contract at December 31, 2011, is $(10,783), a liability. On March 1, 2012, the forward rate to sell euros on that date is, by definition, 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. This represents an increase of $15,783 in
388 Chapter 9
EXHIBIT 9.2 Hedge of a Foreign Currency Account Receivable with a Forward Contract
Steps on December 1, 2011
1. Amerco ships goods to the German customer, thereby creating an Account Receivable 2.
Steps on March 1, 2012 3.
4.
5. New Manhattan Bank pays Amerco $1,305,000.
German customer Amerco New Manhattan Bank
5. 03/1/12 —$1,305,000 received executory contract
1. 12/1/11—goods shipped 11
12 12
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Foreign Currency Transactions and Hedging Foreign Exchange Risk 389
fair value from December 31, 2011. The original discount on the forward contract is deter- mined by the difference in the euro spot rate and three-month forward rate on December 1, 2011: ($1.305 $1.32) €1 million $15,000.
Forward Contract Designated as Cash Flow Hedge
Assume that Amerco designates the forward contract as a cash flow hedgeof a foreign cur- rency denominated asset. In this case, it allocates the original forward discount or premium to net income over the life of the forward contract using an effective interest method. The com- pany prepares the following journal entries to account for the foreign currency transaction and the related forward contract:
2011 Journal Entries—Forward Contract Designated as a Cash Flow Hedge
12/1/11 Accounts Receivable (€) . . . . 1,320,000
Sales . . . . 1,320,000 To record the sale and €1 million account receivable at
the spot rate of $1.32 (Step 1 in Exhibit 9.2).
12/31/11 Accounts Receivable (€) . . . . 10,000
Foreign Exchange Gain . . . . 10,000 To adjust the value of the €receivable to the new spot rate
of $1.33 and record a foreign exchange gain resulting from the appreciation of the €since December 1.
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.
Loss on Forward Contract . . . . 10,000
Accumulated Other Comprehensive Income (AOCI) . . . . . 10,000
To record a loss on forward contract to offset the foreign exchange gain on account receivable with a corresponding credit to AOCI.
Discount Expense . . . . 5,019
Accumulated Other Comprehensive Income (AOCI) . . . . . 5,019
To allocate the forward contract discount to net income over the life of the contract using the effective interest method with a corresponding credit to AOCI.
Amerco makes no formal entry for the forward contract because it is an executory contract (no cash changes hands) and has a fair value of zero (Step 2 in Exhibit 9.2).
Amerco prepares a memorandum designating the forward contract as a hedge of the risk of changes in the cash flow to be received on the foreign currency account receivable resulting from changes in the U.S. dollar–euro exchange rate. The company prepares the following journal entries on December 31:
The first entry at December 31, 2011, serves to revalue the foreign currency account re- ceivable and recognize a foreign exchange gain of $10,000 in net income. The second entry recognizes the forward contract as a liability of $10,783 on the balance sheet. Because the forward contract has been designated as a cash flow hedge, the debit of $10,783 in the second entry is made to AOCI, which decreases stockholders’ equity. The third entry achieves the objective of hedge accounting by transferring $10,000 from AOCI to a loss on forward contract. As a result of this entry, the loss on forward contract of $10,000 and the foreign exchange gain on the account receivable of $10,000 exactly offset one another, and the net impact on income is zero. As a result of the second and third entries, the forward contract is reported on the balance sheet as a liability at fair value of $(10,783); a loss on forward
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contract is recognized in the amount of $10,000 to offset the foreign exchange gain; and AOCI has a negative (debit) balance of $783. The second and third entries could be com- bined into one entry as follows:
The negative balance in AOCI of $783 can be viewed as that portion of the loss on the forward contract (decrease in fair value of the forward contract) that is not recognized in net income but instead is deferred in stockholders’ equity. Under cash flow hedge accounting, a loss on the hedging instrument (forward contract) is recognized only to the extent that it offsets a gain on the item being hedged (account receivable).
The last entry uses the effective interest method to allocate a portion of the $15,000 for- ward contract discount as an expense to net income. The company calculates the implicit interest rate associated with the forward contract by considering the fact that the forward con- tract will generate cash flow of $1,305,000 from a foreign currency asset with an initial value of $1,320,000. Because the discount of $15,000 accrues over a three-month period, the effec- tive interest rate is calculated as [1 冑3$1,305,000/$1,320,000] .0038023. The amount of discount to be allocated to net income for the month of December 2011 is $1,320,000 .0038023 $5,019.
The impact on net income for the year 2011 follows:
Sales. . . $1,320,000 Foreign exchange gain . . . $ 10,000
Loss on forward contract . . . (10,000)
Net gain (loss). . . –0–
Discount expense . . . (5,019) Impact on net income. . . $1,314,981 The effect on the December 31, 2011, balance sheet is as follows:
Assets Liabilities and Stockholders’ Equity Accounts receivable (€) . . . $1,330,000 Forward contract . . . $ 10,783
Retained earnings . . . 1,314,981 AOCI . . . 4,236
$1,330,000
2012 Journal Entries—Forward Contract Designated as Cash Flow Hedge
From December 31, 2011, to March 1, 2012, the euro account receivable decreases in value by
$30,000 and the forward contract increases in value by $15,873. In addition, on March 1, 2012, the remaining discount on forward contract must be amortized to expense. The company prepares the following journal entries on March 1 to reflect these changes:
390 Chapter 9
Loss on Forward Contract . . . . 10,000 Accumulated Other Comprehensive Income (AOCI) . . . . 783
Forward Contract . . . . 10,783
3/1/12 Foreign Exchange Loss . . . . 30,000
Accounts Receivable (€) . . . . 30,000 To adjust the value of the €receivable to the new spot rate
of $1.30 and record a foreign exchange loss resulting from the depreciation of the €since December 31.
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.
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Foreign Currency Transactions and Hedging Foreign Exchange Risk 391
As a result of these entries, the balance in AOCI is zero: $4,236 $15,783 $30,000
$9,981 $0.
The next two journal entries recognize the receipt of euros from the customer, close out the euro account receivable, and record the settlement of the forward contract.
The impact on net income for the year 2012 follows:
Foreign exchange loss . . . $(30,000) Gain on forward contract . . . 30,000
Net gain (loss) . . . –0–
Discount expense . . . $(9,981) Impact on net income . . . $(9,981)
The net effect on the balance sheet over the two years is a $1,305,000 increase in Cash with a corresponding increase in Retained Earnings of $1,305,000 ($1,314,981 $9,981). The cumulative amount recognized as Discount Expense of $15,000 reflects the cost of extending credit to the German customer.
The net benefit from entering into the forward contract is $5,000. This “gain” is not directly reflected in net income. However, it can be calculated as the difference between the net gain on the forward contract and the cumulative amount of discount expense ($20,000 $15,000
$5,000) recognized over the two periods.
Effective Interest versus Straight-Line Methods
Use of the effective interest method results in allocating the forward contract discount $5,019 at the end of the first month and $9,981 at the end of the next two months. Straight-line allo- cation of the $15,000 discount on a monthly basis results in a reasonable approximation of these amounts:
12/31/11 $15,000 1/3$5,000 3/1/12 $15,000 2/3$10,000
Accumulated Other Comprehensive Income (AOCI) . . . . 30,000
Gain on Forward Contract . . . . 30,000 To record a gain on forward contract to offset the foreign
exchange loss on account receivable with a corresponding debit to AOCI.
Discount Expense . . . . 9,981
Accumulated Other Comprehensive Income (AOCI) . . . . . 9,981
To allocate the remaining forward contract discount to net income ($15,000 5,019 $9,981) with a corresponding credit to AOCI.
Foreign Currency (€) . . . . 1,300,000
Accounts Receivable (€) . . . . 1,300,000 To record receipt of €1 million from the German customer as
an asset (Foreign Currency) at the spot rate of $1.30 (Step 3 in Exhibit 9.2).
Cash . . . . 1,305,000
Foreign Currency (€) . . . . 1,300,000 Forward Contract . . . . 5,000 To record settlement of the forward contract (i.e., record
receipt of $1,305,000 in exchange for delivery of €1 million) and remove the forward contract from the accounts (Steps 4 and 5 in Exhibit 9.2).
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Determining the effective interest rate is complex and provides no conceptual insights. For the remainder of this chapter, we use straight-line allocation of forward contract discounts and premiums. The important thing to keep in mind in this example is that with a cash flow hedge, an expense equal to the original forward contract discount is recognized in net income over the life of the contract.
What if the forward rate on December 1, 2011, had been $1.326 (i.e., the euro was sell- ing at a premium in the forward market)? In that case, Amerco would receive $6,000 more through the forward sale of euros ($1,326,000) than had it received the euros at the date of sale ($1,320,000). Amerco would allocate the forward contract premium as an increase in net income at the rate of $2,000 per month: $2,000 at December 31, 2011, and $4,000 at March 1, 2012.
Forward Contract Designated as Fair Value Hedge
Assume that Amerco decides to designate the forward contract not as a cash flow hedge but as a fair value hedge. In that case, it takes the gain or loss on the forward contract directly to net income and does not separately amortize the original discount on the forward contract.
2011 Journal Entries—Forward Contract Designated as a Fair Value Hedge
12/1/11 Accounts Receivable (€) . . . . 1,320,000
Sales . . . . 1,320,000 To record the sale and €1 million account receivable at the
spot rate of $1.32 (Step 1 in Exhibit 9.2).
The forward contract requires no formal entry (Step 2 in Exhibit 9.2). A memorandum desig- nates the forward contract as a hedge of the risk of changes in the fair value of the foreign cur- rency account receivable resulting from changes in the U.S. dollar–euro exchange rate.
The company prepares the following entries on December 31:
12/31/11 Accounts Receivable (€) . . . . 10,000
Foreign Exchange Gain . . . . 10,000 To adjust the value of the €receivable to the new
spot rate of $1.33 and record a foreign exchange gain resulting from the appreciation of the €since December 1.
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.
The first entry at December 31, 2011, serves to revalue the foreign currency account receiv- able and recognize a foreign exchange gain of $10,000. The second entry recognizes the for- ward contract as a liability of $10,783 on the balance sheet. Because the forward contract has been designated as a fair value hedge, the debit in the second entry recognizes the entire change in fair value of the forward contract as a loss in net income; there is no deferral of loss in stockholders’ equity. A net loss of $783 is reported in net income as a result of these two entries.
The impact on net income for the year 2011 is as follows:
Sales . . . $1,320,000 Foreign exchange gain . . . $ 10,000
Loss on forward contract . . . (10,783)
Net gain (loss) . . . (783) Impact on net income . . . $1,319,217 392 Chapter 9
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The effect on the December 31, 2011, balance sheet follows:
Assets Liabilities and Stockholders’ Equity Accounts receivable (€) . . . $1,330,000 Forward contract . . . .$ 10,783
Retained earnings . . . 1,319,217
$1,330,000
2012 Journal Entries—Forward Contract Designated as a Fair Value Hedge The company prepares the following entries on March 1:
3/1/12 Foreign Exchange Loss . . . . 30,000
Accounts Receivable (€) . . . . 30,000 To adjust the value of the €receivable to the new
spot rate of $1.30 and record a foreign exchange loss resulting from the depreciation of the €since December 31.
DO WE HAVE A GAIN OR WHAT?
Ahnuld Corporation, a health juice producer, recently expanded its sales through exports to foreign markets. Earlier this year, the company negotiated the sale of several thousand cases of turnip juice to a retailer in the country of Tcheckia. The customer is unwilling to assume the risk of having to pay in U.S. dollars. Desperate to enter the Tcheckian market, the vice president for international sales agrees to denominate the sale in tchecks, the na- tional currency of Tcheckia. The current exchange rate for 1 tcheck is $2.00. In addition, the customer indicates that it cannot pay until it sells all of the juice. Payment is scheduled for six months from the date of sale.
Fearful that the tcheck might depreciate in value over the next six months, the head of the risk management department at Ahnuld Corporation enters into a forward contract to sell tchecks in six months at a forward rate of $1.80. The forward contract is designated as a fair value hedge of the tcheck receivable. Six months later, when Ahnuld receives payment from the Tcheckian customer, the exchange rate for the tcheck is $1.70. The cor- porate treasurer calls the head of the risk management department into her office.
Treasurer: I see that your decision to hedge our foreign currency position on that sale to Tcheckia was a bad one.
Department head: What do you mean? We have a gain on that forward contract. We’re
$10,000 better off from having entered into that hedge.
Treasurer: That’s not what the books say. The accountants have recorded a net loss of
$20,000 on that particular deal. I’m afraid I’m not going to be able to pay you a bonus this year. Another bad deal like this one and I’m going to have to demote you back to the interest rate swap department.
Department head: Those bean counters have messed up again. I told those guys in inter- national sales that selling to customers in Tcheckia was risky, but at least by hedging our exposure, we managed to receive a reasonable amount of cash on that deal. In fact, we ended up with a gain of $10,000 on the hedge. Tell the accountants to check their debits and credits again. I’m sure they just put a debit in the wrong place or some accounting thing like that.
Have the accountants made a mistake? Does the company have a loss, a gain, or both from this forward contract?
Discussion Question
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