Foreign Currency Hedging Case Example

On October 1, 2009, Lie Dharma Co. (a US company) orders from its European supplier, Grunefunkt GmbH, a machine that is to be delivered and paid for on March 31, 2010. The price, denominated in euros, is 4,000,000. Although Lie Dharma will not make the payment until the planned delivery date, it has immediately entered into a firm commitment to make this purchase and to pay 4,000,000 upon delivery. This creates a euro liability exposure to foreign exchange risk; thus, if the euro appreciates over the intervening six months, the dollar cost of the equipment will increase. To reduce or eliminate this uncertainty, Lie Dharma desires to lock in the purchase cost in euros by entering into a six-month forward contract to purchase euros on the date when the purchase order is issued to and accepted by Grunefunkt. The spot rate on October 1, 2009, is $1.40 per euro and the forward rate for March 31, 2010 settlement is $1.44 per euro. Lie Dharma enters into a forward contract on October 1, 2009, with the First Intergalactic Bank to pay US $5,760,000 in exchange for the receipt of 4,000,000 on March 31, 2010, which can then be used to pay Grunefunkt. No premium is received nor paid at the inception of this forward contract. The transaction is a firm commitment consistent with the requirements of ASC 815, and fair value hedge accounting is used in accounting for the forward contract. Assume the relevant time value of money is measured at 1/2% per month (a nominal 6% annual rate). The spot rate for euros at December 31, 2009, is $1.45, and at March 31, 2010, it is $1.48. The forward rate as of December 31 for March 31 settlement is $1.46. Entries to reflect the foregoing scenario are as follows:

Journal entries per 10/1/09: No entries, since neither the forward contract nor the firm commitment have value on this date

Journal entries per 12/31/09: (1) To record present value (at 1/2% monthly rate) of change in value of forward contract [= change in forward rate (1.46 1.44) 4,000,000 = $80,000 to be received in three months, discounted at 6% per annum]: [Debit]. Forward currency contract = 78,818 [Credit]. Gain on forward contract = 78,818

(2) To record present value (at 1/2% monthly rate) of change in amount of firm commitment [= change in spot rate (1.45 1.40) 4,000,000 = $200,000 to be paid in three months, discounted at 6% per annum]: [Debit]. Loss on firm purchase commitment = 197,044 [Credit]. Firm commitment obligation = $197,044

(3) To close the gain and loss accounts to net income and thus to retained earnings: [Debit]. Gain on forward contract = 78,818 [Debit]. P&L summary (then to retained earnings) =118,226 [Credit]. Loss on firm purchase commitment = 197,044

Journal entries per 3/31/10: (1) To record change in value of forward contract {[= (1.48 1.44) 4,000,000 = $160,000] gain previously recognized ($78,818)}: [Debit]. Forward currency contract = 81,182 [Credit]. Gain on forward contract = 81,182

(2) To record change in amount of firm commitment {[= (1.48 1.40) 4,000,000] less loss previously recognized ($197,044)}: [Debit]. Loss on firm commitment = 122,956 [Credit]. Firm commitment obligation 122,956

(3) To record purchase of machinery based on spot exchange rate as of date of contractual commitment (1.40) and close out the firm commitment obligation (representing effect of change in spot rate during commitment period): [Debit]. Firm commitment obligation = 320,000 [Debit]. Machinery and equipment = 5,600,000 [Credit]. Cash = 5,920,000

(4) To record collection of cash on net settlement of forward contract [= (1.48 1.44) 4,000,000]: [Debit]. Cash = 160,000 [Credit]. Forward contract = 160,000

(5) To close the gain and loss accounts to net income and thus to retained earnings: [Debit]. Gain on forward contract = 81,182 [Debit]. P&L summary (then to retained earnings) 41,774 [Credit]. Loss on firm purchase commitment 122,956

Observe that in the foregoing example the gain on the forward contract did not precisely offset the loss incurred from the firm commitment. Since a hedge of an unrecognized foreign currency denominated firm commitment is accounted for as a fair value hedge, with gains and losses on hedging positions and on the hedged item both being recorded in current earnings, it may appear that the matter of hedge effectiveness is of academic interest only.