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 unrecognized firm commitments denominated in a foreign currency. Forward contracts reduce the foreign exchange risk of the change in the dollar value of firm commitments resulting from changes in foreign exchange rates during a period. Management has the choice of designating foreign currency forward contracts as fair value hedges or cash flow hedges of unrecognized firm commitments denominated in a foreign currency, and of assessing hedge effectiveness based on changes in spot rates or changes in forward rates. This article addresses the similarities and differences in the accounting for different hedge designations and hedge effectiveness bases for foreign currency forward contract hedges of unrecognized foreign currency–denominated firm commitments for the purchase of inventory.

Foreign Currency Contracts: The Basics

ASC Topic 815 requires companies to measure foreign currency forward contracts at fair value, derived by discounting to the settlement date the difference between the contract rate and the current forward rate. The total gain or loss on the forward contract has two components. The first is the change in the value of the forward contract resulting from changes in the spot rate; the second is the change in the value of the forward contract resulting from changes in the difference between the forward rate and the spot rate. The accounting for the two components is based on management’s forward contract hedge designation and the basis for assessing hedge effectiveness.

Firm commitments are executor contracts that are only recognized when they are the hedged item in a qualifying fair value hedge. The carrying amount of the firm commitment depends upon the basis for assessing hedge effectiveness. For a fair value hedge with effectiveness based on changes in spot rates, the firm commitment is adjusted to fair value based on the change in the spot rate, with the resulting gain or loss recognized in earnings. The forward contract is adjusted to fair value based on the change in the forward rate, and the resulting gain or loss is recognized in earnings in the same line of the income statement as the gain or loss on the underlying foreign currency–denominated firm commitment. The net effect on earnings each period is the difference between the gain or loss from the change in the spot rate and the gain or loss from the change in the forward rate.

For a fair value hedge with effectiveness based on changes in forward rates, the firm commitment is adjusted to fair value based on changes in the forward rate, with the resulting gain or loss recognized in earnings. The forward contract is adjusted to fair value based on changes in the forward rate, with the resulting gain or loss recognized in earnings in the same line of the income statement as the gain or loss on the underlying foreign currency–denominated firm commitment. The net effect on earnings each period is zero, because the changes in both the firm commitment and the forward contract are based on changes in forward rates.

There is no recognition of the firm commitment when the forward contract is designated as a cash flow hedge. When hedge effectiveness is based on changes in the spot rate, the component of the change in fair value of the foreign currency forward contract from the changes in the spot rate is recognized currently in other comprehensive income. The change in the forward contract’s fair value related to changes in the difference between the forward rate and the spot rate is recognized in earnings. The net effect on earnings for each period is the difference between the gain or loss from the change in the spot rate and the gain or loss from the change in the forward rate. The resulting balance in cumulative other comprehensive income represents the change in the spot rate from the initial contract date to the settlement date, and will be reclassified out of other comprehensive income into earnings in the period that the hedged item affects income.

Management has the choice of designating foreign currency forward contacts as fair value hedges or cash flow hedges of unrecognized firm commitments denominated in a foreign currency, and of assessing hedge effectiveness based on changes in spot rates or changes in forward rates.

The change in fair value of a foreign currency forward contract designated as a cash flow hedge with effectiveness based on changes in forward rates is currently recognized in other comprehensive income. The period’s amortization of the initial premium or discount on the foreign currency forward contract is reclassified from other comprehensive income to earnings. The net effect on earnings each period is the amortization of the premium or discount. The resulting balance in cumulative other comprehensive income represents the change in the forward rate from the initial contract date to the settlement date, and will be reclassified out of other comprehensive income into earnings in the period that the hedged item affects income.

Example

The following example illustrates the accounting for the purchase of inventory denominated in euros using a 6% annual discount rate and amortizing the forward contract premium using the straight-line method. The journal entries illustrate the fundamental accounting for a foreign currency–denominated firm commitment and a corresponding foreign currency forward contract designated as—

  • a fair value hedge with effectiveness based on changes in spot rates;
  • a fair value hedge with effectiveness based on changes in forward rates,
  • a cash flow value hedge with effectiveness based on changes in spot rates; and
  • a cash flow value hedge with effectiveness based on changes in forward rates.

On May 1, 2019, an American company with a December 31 year-end enters into a binding contract to purchase inventory from a German company for €100,000, with delivery and remittance due on July 31, 2019. The spot rate on May 1, 2019, was €1 = $1.0899. On the same date, the American company entered into a forward contract to buy €100,000 on July 31, 2019, at €1 = $1.0929. Regardless of the exchange rate on July 31, 2019, the company is guaranteed to pay $109,290. The company can designate the forward contract as a fair value hedge or a cash flow hedge of the firm commitment. The accounting for the resulting $300 forward contract premium [(1.0929 −1.0899) × 100,000] depends upon the hedge designation of the forward contract. Because the settlement date, currency type, and currency amount of the forward contract match the corresponding terms of the firm commitment, the hedge is expected to be highly effective. The company prepares financial statements on a quarterly basis.

The net effect on earnings each period is the difference between the gain or loss from the change in the spot rate and the gain or loss from the change in the forward rate.

Exhibit 1 provides a summary of spot rates, forward rates, valuations, gains and losses, and premium amortizations over the contract period. Journal entries for fair value hedge designations are provided in Exhibit 2, and for cash flow hedge designations in Exhibit 3. Neither the firm commitment nor the forward contract require an initial payment, so no accounting recognition is required on May 1, 2019.

Exhibit 1

Summary of Example

Firm Commitment on 05/1/2019 for Purchase of Inventory for €100,000 on 07/31/2019 and Forward Contract to Purchase €100,000 on 07/31/2019 Date; USD/€ Spot Rate; €/USD Forward Rate to 07/31/19; Total Spot Rate Change1; Present Value of Total Spot Rate Change2; Change In Spot Rate (Gain) Loss3; Total Forward Rate Change4; Forward Contract Fair Value Dr (Cr)5; Forward Contract (Gain) Loss6; Spot Rate Effectiveness Excluded Component (Gain) Loss7; Straight-Line Amortization of Premium8 05/01/19; 1.0899; 1.0929; 0; 0; 0; 0; 0; 0; 0; 0 06/30/19; 1.1426; 1.1439; 0.0527; $ 5,244; $ 5,244; 0.0510; $ 5,075; ($ 5,075); $ 169; $ 200 07/31/19; 1.1842; 1.1842; 0.0943; $ 9,430; $ 4,186; 0.0913; $ 9,130; ($ 4,055); $ 131; $ 100 1 Current spot rate minus 05/01/19 spot rate. 2 Spot rate change times €100,000 discounted to 07/31/19 at 6% annual rate. 3 Current present value of spot rate change minus previous present value of spot rate change. 4 Current forward rate minus 05/01/19 forward rate. 5 Forward rate difference times €100,000 discounted to 07/31/19 at 6% annual rate. 6 Current forward contract fair value minus previous forward contract fair value. 7 Change in spot rate gain (loss) plus forward contract gain (loss). 8 Monthly rate equals €100,000 times (05/01/19 forward rate minus 05/01/19 spot rate) divided by 3 months. OCI=other comprehensive income

Exhibit 2

Journal Entries: Fair Value Hedge

Firm Commitment on 05/1/2019 for Purchase of Inventory for €100,000 on 07/31/2019, and Forward Contract Designated as Fair Value Hedge to Purchase €100,000 on 07/31/2019 Fair Value Hedge: Spot Rate; Fair Value Hedge: Forward Rate 05/01/2019; 05/01/2019 No entry; No entry 6/30/2019; 6/30/2019 Foreign exchange (FX) loss; 5,244; Foreign exchange loss; 5,075 Firm commitment; 5,244; Firm commitment; 5,270 To recognize FX loss on firm commitment in earnings based on changes in spot rates; To recognize FX loss on firm commitment in earnings based on changes in forward rate Forward contract; 5,075; Forward contract; 5,075 Forward contract gain; 5,075; Forward contract gain: OCI; 5,075 To recognize gain on forward contract in earnings; To recognize gain on forward contract in earnings 07/31/2019; 07/31/2019 Foreign exchange loss; 4,186 Foreign exchange loss; 4,055 Firm commitment 4,186; Firm commitment 4,055 To recognize FX loss on firm commitment in earnings based on changes in spot rates; To recognize FX loss on firm commitment in earnings based on changes in forward rate Forward contract 4,055; Forward contract 4,055 Forward contract gain 4,055; Forward contract gain: OCI 4,055 To recognize gain on forward contact in earnings; To recognize gain on forward contract in earnings Inventory; 108,990; Inventory; 109,290 Firm commitment; 9,430; Firm commitment; 9,130 Forward contract; 9,130; Forward contract; 9,130 Cash; 109,290; Cash; 109,290 To purchase inventory and settle forward contract net; To purchase inventory and settle forward contract net OCI=other comprehensive income

Exhibit 3

Journal Entries: Cash Flow Hedge

Firm Commitment on 05/1/2019 for Purchase of Inventory for €100,000 on 07/31/2019, and Forward Contract Designated as Cash Flow Hedge to Purchase €100,000 on 07/31/2019 Cash Flow Hedge: Spot Rate; Cash Flow Hedge: Forward Rate 05/01/2019; 05/01/2019 No entry; No entry 06/30/2019; 06/30/2019 Forward contract; 5,075; Forward contract; 5,075 Forward contract loss; 169; Forward contract gain: OCI; 5,075 Forward contract gain: OCI; 5,244 To recognize gain on forward contract from changes in spot rates in OCI and loss from change in forward rates in earnings; To recognize gain on forward contract in OCI Forward contract loss; 200 Reclassify amortization: OCI; 200 To reclassify two-month amortization of initial forward contract premium from other comprehensive income to earnings 07/31/2019; 07/31/2019 Forward contract; 4,055; Forward contract; 4,055 Forward contract loss; 131; Forward contract gain: OCI; 4,055 Forward contract gain: OCI; 4,186 To recognize gain on forward contract from changes in spot rates in OCI and loss from change in forward rates in earnings; To recognize gain on forward contract in OCI Forward contract loss; 100 Reclassify amortization: OCI; 100 To reclassify one-month amortization of initial forward contract premium from other comprehensive income to earnings Inventory; 118,420; Inventory; 118,420 Forward contract; 9,130; Forward contract; 9,130 Cash; 109,290; Cash; 109,290 To purchase inventory and settle forward contract, net; To purchase inventory and settle forward contract, net OCI=other comprehensive income

Fair Value Hedge with Effectiveness Based on Changes in Spot Rates

On June 30, 2019, the firm commitment is adjusted to fair value based on the total change in spot rates discounted at a 6% annual rate to July 31, 2019, and the corresponding foreign exchange loss of $5,244 for the period is recognized in earnings. The forward contract is adjusted to fair value based on the total change in forward rates discounted at a 6% annual rate to July 31, 2019, and the corresponding gain of $5,075 for the period is recognized in earnings in the same line of the income statement as the foreign exchange loss on the foreign currency–denominated firm commitment. The net loss of $169 is the period’s allocation of the $300 forward contract premium.

On July 31, 2019, the firm commitment is adjusted to fair value based on the total change in spot rates, and the corresponding $4,186 foreign exchange loss from the change in value over the period is recognized in earnings. The forward contract is adjusted to fair value based on the total change in forward rates, and the corresponding gain of $4,055 for the period is recognized in earnings in the same line of the income statement as the foreign exchange loss on the foreign currency–denominated firm commitment. The net loss of $131 is the period’s allocation of the $300 forward contract premium. The inventory is recorded at $108,990: the current spot rate of $118,420 less the $9,430 firm commitment balance. The recorded inventory amount reflects the initial spot rate on May 1, 2019. The company settles the forward contract net, paying $109,290 for the inventory.

Fair Value Hedge with Effectiveness Based on Changes in Forward Rates

On June 30, 2019, the firm commitment is adjusted to fair value based on the total change in forward rates discounted at a 6% annual rate to July 31, 2019, and the corresponding foreign exchange loss of $5,075 for the period is recognized in earnings. The forward contract is adjusted to fair value, and the corresponding gain of $5,075 for the period is recognized in earnings in the same line of the income statement as the foreign exchange loss on the foreign currency–denominated firm commitment.

On July 31, 2019, the firm commitment is adjusted to fair value based on the total change in forward rates, and the corresponding $4,055 foreign exchange loss from the change in value over the period is recognized in earnings. The forward contract is adjusted to fair value, and the corresponding gain of $4,055 for the period is recognized in earnings in the same line of the income statement as the foreign exchange loss on the foreign currency–denominated firm commitment. The inventory is recorded at $109,290: the current spot rate of $118,420 less the $9,130 firm commitment balance. The recorded inventory amount reflects the initial forward rate on May 1, 2019. The company settles the forward contract net, paying $109,290 for the inventory. The $300 forward contract premium is a component of the recorded inventory cost and will be recognized in earnings in the period the inventory is sold.

Cash Flow Hedge with Effectiveness Based on Changes in Spot Rates

On June 30, 2019, the forward contract is adjusted to fair value, resulting in a $5,075 gain. The portion of the gain from changes in spot rates, $5,244, is recognized in other comprehensive income, and a loss of $169 (the difference between the total gain of $5,075 and the portion of the gain from the change in spot rates, $5,244) is recognized in earnings. The $169 loss is the period’s allocation of the $300 forward contract premium.

On July 31, 2019, the forward contract is adjusted to fair value based on the total change in forward rates, resulting in a $4,055 gain. The portion of the gain from changes in spot rates, $4,186, is recognized in other comprehensive income, and a loss of $131 (the difference between the total gain of $4,055 and the portion of the gain from the change in spot rates, $4,186) is recognized in earnings. The $131 loss is the period’s allocation of the $300 forward contract premium. The inventory is recorded at $118,420, reflecting the current spot rate. The company settles the forward contract net, paying $109,290 for the inventory. The resulting $9,430 balance in accumulated other comprehensive income will be reclassified to earnings and will reduce cost of goods sold in the period the inventory is sold, making the net inventory cost $108,990, reflecting the initial spot rate on May 1, 2019.

Cash Flow Hedge with Effectiveness Based on Changes in Forward Rates

On June 30, 2019, the forward contract is adjusted to fair value, resulting in a $5,075 gain recognized in other comprehensive income. The two-month amortization of the premium on the forward contract ($200) is reclassified from other comprehensive income into earnings.

On July 31, 2019, the forward contract is adjusted to fair value, resulting in a $4,055 gain recognized in other comprehensive income. The one-month amortization of the premium on the forward contract ($100) is reclassified from other comprehensive income into earnings. The inventory is recorded at $118,420, reflecting the current spot rate. The company settles the forward contract net, paying $109,290 for the inventory. The resulting $9,430 balance in accumulated other comprehensive income will be reclassified to earnings and reduce cost of goods sold in the period the inventory is sold, reducing the net inventory cost to $108,990, reflecting the initial spot rate on May 1, 2019.

The first option is to recognize the resulting purchase or sale at the spot rate at the initial contract date. The second option is to recognize the resulting purchase or sale at the forward rate on the initial contract date.

Exhibit 4 presents partial comprehensive quarterly income statements for fair value hedges, and Exhibit 5 presents partial comprehensive quarterly income statements for cash flow hedges. 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. While there is no income statement effect of a firm commitment and a forward contract designated as a fair value hedge with effectiveness based on changes in the forward rate, it is provided in Exhibit 4 to demonstrate the difference between the reporting for the two hedge effectiveness options.

Exhibit 4

Partial Quarterly Comprehensive Income Statements: Fair Value Hedge

Firm Commitment on 05/1/2019 for Purchase of Inventory for €100,000 on 06/30/2019, and Forward Contract Designated as Fair Value Hedge to Purchase €100,000 on 07/31/2019 Fair Value Hedge: Spot Rate; Fair Value Hedge: Forward Rate 6/30/2019; 6/30/2019 Foreign exchange loss; $ (169); Foreign exchange loss; $ — Net income; (169); Net income; — OCI; —; OCI; — Comprehensive income; $ (169); Comprehensive income; $ — 9/30/2019; 9/30/2019 Foreign exchange loss; $ (131); Foreign exchange loss; $ — Net income; $ (131); Net income; — OCI; $ —; OCI; -— Comprehensive income; $ (131); Comprehensive income; $ -— OCI=other comprehensive income

Exhibit 5

Partial Quarterly Comprehensive Income Statements: Cash Flow Hedge

Firm Commitment on 05/01/2019 for Purchase of Inventory for €100,000 on 07/31/2019, and Forward Contract Designated as Cash Flow Hedge to Purchase €100,000 on 07/31/2019 Cash Flow Hedge: Spot Rate; Cash Flow Hedge: Forward Rate 6/30/2019; 6/30/2019 Forward contract loss; $ (169); Forward contract loss; $ (200) Net income; (169); Net income; (200) OCI; OCI Gain on forward contract; 5,244; Gain on forward contract; 5,075 Reclassification of premium amortization; 200 Total OCI; 5,244; Total OCI; 5,275 Comprehensive income; $ 5,075; Comprehensive income; $ 5,075 9/30/2019; 9/30/2019 Forward contract loss; $ (131); Forward contract loss; $ (100) Net income; (131); Net income; (100) OCI; OCI Gain on forward contract; 4,186; Gain on forward contract; 4,055 Reclassification of premium amortization; 100 Total OCI; 4,186; Total OCI; 4,155 Comprehensive income; $ 4,055; Comprehensive income; $ 4,055 Note: $9,430 balance in accumulated other comprehensive income will be reclassified to earnings and reduce cost of goods sold in the period(s) the inventory is sold. Net inventory cost is $108,990, reflecting initial spot rate on 5/01/19. OCI=other comprehensive income

Accounting Standards Update 2017-12 allows entities utilizing foreign currency forward contracts to hedge unrecognized firm commitments denominated in a foreign currency two options for recognizing the resulting purchase or sale. The first option is to recognize the resulting purchase or sale at the spot rate at the initial contract date. The initial premium or discount on the forward contract is recognized in earnings over the term of the contract. The second option is to recognize the resulting purchase or sale at the forward rate on the initial contract date. The initial premium or discount on the forward contract is recognized as a component of the cost of the inventory purchased or the resulting sale.

Robert G. Rambo, PhD, CPA is an assistant professor of accounting at Loyola University New Orleans, New Orleans, La.