Accounting Standards Update 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities,modifies the accounting and reporting of foreign currency forward contract hedges of recognized assets and liabilities denominated in a foreign currency. Management has the option of designating foreign currency forward contracts as fair value hedges, as cash flow hedges with hedge effectiveness based on changes in spot rates, or as cash flow hedges with hedge effectiveness based on changes in forward rates of recognized assets or liabilities denominated in a foreign currency. To illustrate the similarities and differences in the accounting for the three hedge designations, this article addresses the hedging of a foreign currency receivable from the purchase of inventory.
Accounting for Foreign Currency Hedges under ASU 2017-12
Accounting Standards Codification (ASC) Topic 830, “Foreign Currency Matters,” requires companies to measure assets and liabilities denominated in a foreign currency 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 gains and losses are recognized and reported in earnings.
One method of managing the exposure to the exchange risk of an asset or liability denominated in a foreign currency is to enter into a foreign exchange forward contract to lock in the dollar amount of the transaction at maturity. Management can designate the forward contract as either a fair value or cash flow hedge of the foreign currency–denominated asset or liability because changes in spot rates affect both its fair value and its cash flows.
ASC Topic 815, “Derivatives and Hedging,” requires companies to measure foreign currency forward contracts at fair value, derived by discounting the difference between the contract rate and the current forward rate to the settlement date. The total gain or loss on the forward contract has two components. The first corresponds to the change in the forward contract resulting from changes in the spot rate and offsets the overall gain or loss on the underlying asset or liability. The second is the initial premium or discount on the forward contract; that is, the net gain or loss equals the initial premium or discount. The accounting for the two components is based on management’s forward contract hedge designation.
The change in fair value of a foreign currency forward contract designated as a fair value hedge is recognized currently in earnings in the same line of the income statement as the foreign currency exchange gain or loss on the underlying asset or liability. The net effect on earnings is the difference between the foreign exchange gain or loss on the asset or liability and the change in the fair value of the forward contract.
The change in fair value resulting from changes in spot rates of a foreign currency forward contract designated as a cash flow hedge with hedge effectiveness based on changes in spot rates is currently recognized in other comprehensive income. Changes in the forward contract’s fair value related to changes in the difference between forward and spot rates is recognized in earnings in the same line of the income statement as the foreign currency exchange gain or loss on the underlying asset or liability. An amount that will offset the related foreign currency exchange gain or loss is reclassified from other comprehensive income to earnings and reported in the same line of the income statement as the foreign currency exchange gain or loss on the underlying asset or liability. The net effect on earnings is the difference between the foreign exchange gain or loss on the asset or liability and the change in the fair value of the forward contract, identical to the earnings effect of the fair value hedge designation.
The change in fair value of a foreign currency forward contract designated as a cash flow hedge with hedge effectiveness based on changes in forward rates is currently recognized in other comprehensive income. An amount that will offset the related foreign currency exchange gain or loss is reclassified from other comprehensive income to earnings and reported in the same line of the income statement as the foreign currency exchange gain or loss on the underlying asset or liability. The period’s amortization of the initial premium or discount on the foreign currency forward contract is reclassified from other comprehensive income to earnings and reported in the same line of the income statement as the foreign currency exchange gain or loss on the underlying asset or liability. The net effect on earnings is the period’s amortization of the initial premium or discount on the foreign currency forward contract.
Example
The following example illustrates the accounting for the purchase of inventory denominated in euros (€), uses a 6% annual discount rate, and amortizes the forward contract premium using the straight-line method. The journal entries illustrate the fundamental accounting for a foreign currency forward contract designated as a hedge of a foreign currency payable.
On May 1, 2017, an American company purchased inventory from a German company for €100,000, with remittance due in three months. The spot rate on May 1, 2017, was €1=$1.0899. On the same date, the American company entered into a forward contract to buy €100,000 in three months at €1=$1.0929. Because the forward contract completely eliminates the cash flow variability from exchange rate risk, the company can designate the forward contract as a cash flow hedge of the payable. Regardless of the exchange rate of the euro on July 31, 2017, the company is guaranteed to pay $109,290. The company can also designate the forward contract as a fair value hedge because it guarantees the fair value of the payable will be $109,290. Because the settlement date, currency type, and currency amount of the forward contract match the corresponding terms of the payable, the hedge is expected to be highly effective. Actual hedge effectiveness is evaluated at each date by comparing the change in the value of the receivable to the change in the value of the forward contract. Exhibit 1 provides a summary of spot rates, forward rates, valuations, gains and losses, and premium amortizations over the contract period.
Exhibit 1
Account Payable from Purchase of Inventory for €100,000 on 05/1/2017 and Forward Contract to Purchase €100,000 on 07/31/2017
Journal entries for fair value hedge and cash flow hedge designations are provided in Exhibit 2. On May 1, 2017, the company recognizes the purchase and related payable at $108,990 using the current spot rate. The forward contract requires no initial payment, so no accounting is required on May 1, 2017.
Exhibit 2
Journal Entries: Purchase of Inventory for €100,000 and Forward Contract Hedges of Accounts Payable Credit Entries Shown in (Parentheses)
The net effect on earnings is the period’s amortization of the initial premium or discount on the foreign currency forward contract.
Fair value hedge.
On June 30, 2017, the payable is adjusted to fair value based on the current spot rate (1.1426), and the corresponding foreign currency exchange loss of $5,270 is recognized in earnings. The gain on the forward contract ($5,075) is based on the change in forward rates during the period (0.0510), discounted at a 6% annual rate to July 31, 2017. The gain is recognized in earnings on the same line of the income statement as the foreign currency exchange loss on the underlying foreign currency denominated payable.
On July 31, 2017, the payable is adjusted to fair value based on the current spot rate (1.1842), and the corresponding $4,160 exchange loss is recognized in earnings. The fair value of the forward contract is based on the cumulative change in the forward rate (0.0913). The $4,055 gain on the forward contract is the change in the fair value of the contract during the period and is recognized in earnings in the same line of the income statement as the foreign currency exchange loss on the payable. The company settles the payable and the forward contract net, paying $109,290.
Cash flow hedge with effectiveness based on changes in spot rates.
On June 30, 2017, the payable is adjusted to fair value based on the current spot rate (1.1426), and the corresponding foreign currency exchange loss of $5,270 is recognized in earnings. The gain on the forward contract ($5,075) is based on the change in forward rates during the period (0.0510), discounted at a 6% annual rate to July 31, 2017. A gain of $5,270 is recognized in other comprehensive income, and a loss of $195 ($5,270 − $5,075) is recognized in earnings in the same line of the income statement as the foreign currency exchange loss on the underlying payable. The portion of the gain on the forward contract equal to the $5,270 loss on the payable is reclassified out of other comprehensive income into earnings in the same line of the income statement as the foreign currency exchange loss on the payable.
On July 31, 2017, the payable is adjusted to fair value based on the current spot rate (1.1842), and the corresponding $4,160 exchange loss is recognized in earnings. The fair value of the forward contract is based on the cumulative change in the forward rate (0.0913). The $4,055 gain on the forward contract is the change in the fair value of the contract during the period. A gain of $4,160 is recognized in other comprehensive income, and a loss of $105 ($4,160 − $4,055) is recognized in earnings in the same line of the income statement as the foreign currency exchange loss on the payable. The portion of the gain on the forward contract equal to the $4,160 loss on the payable is reclassified out of other comprehensive income into earnings in the same line of the income statement as the foreign currency exchange loss on the payable. The company settles the payable and the forward contract net, paying $109,290.
Cash flow hedge with effectiveness based on changes in forward rates.
On June 30, 2017, the payable is adjusted to fair value based on the current spot rate (1.1426), and the corresponding foreign currency exchange loss of $5,270 is recognized in earnings. The gain on the forward contract ($5,075) is based on the change in forward rates during the period (0.0510), discounted at a 6% annual rate to July 31, 2017, and is recognized in other comprehensive income. The portion of the gain on the forward contract equal to the $5,270 loss on the payable is reclassified out of other comprehensive income into earnings in the same line of the income statement as the foreign currency exchange loss on the underlying payable. The two-month amortization of the premium on the forward contract ($200) is reclassified out of other comprehensive income into earnings in the same line of the income statement as the foreign currency exchange loss on the payable.
On July 31, 2017, the payable is adjusted to fair value based on the current spot rate (1.1842), and the corresponding $4,160 exchange loss is recognized in earnings. The fair value of the forward contract is based on the cumulative change in the forward rate (0.0913). The $4,055 gain on the forward contract is the change in the fair value of the contract during the period, and is recognized in other comprehensive income. The portion of the gain on the forward contract equal to the $4,160 loss on the payable is reclassified out of other comprehensive income into earnings in the same line of the income statement as the foreign currency exchange loss on the payable. The one-month amortization of the premium on the forward contract ($100) is reclassified out of other comprehensive income into earnings in the same line of the income statement as the foreign currency exchange loss on the payable. The company settles the payable and the forward contract net, paying $109,290.
Exhibit 3 presents the comprehensive income statements. Other comprehensive income is shown in the single statement format. It can also be shown in a separate income statement beginning with net income, or in a statement of changes in owners’ equity.
Exhibit 3
Partial Comprehensive Income Statements: Purchase of Inventory for €100,000 and Forward Contract Hedges on Accounts Payable
