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
Exhibit 2
Journal Entries: Fair Value Hedge
Exhibit 3
Journal Entries: Cash Flow Hedge
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
Exhibit 5
Partial Quarterly Comprehensive Income Statements: Cash Flow Hedge
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.
