Consider the following Importing Transaction with a Forward Contract Used as a Hedge

On December 1, 2015, a U.S. firm purchased inventory for 500,000 Euros payable on March 1, 2016 (i.e. the transaction is denominated in Euros). The firm's fiscal year-end is December 31. The spot rate for Euros ($/Euro) and the forward rates for Euros on March 1, 2016 at various times are as follows:

	Spot Rate	Forward Rate (for 3/1/2016 Euros)
Transaction date - December 1, 2015	$1.05	1.052
Balance sheet date - December 31, 2015	1.06	1.059
Settlement date - March 1, 2015	1.07

On December 1, 2015, the U.S. firm entered into a forward contract to buy 500,000 Euros on March 1, 2016, for $1.052.

On December 1, 2015, the firm entered into a contract to purchase inventory for $525,000 (the spot rate was $1.05 on that date). If the exchange rate did not change over the payment period, the firm would owe $525,000 to settle the payable. However, if the exchange rate increased to $1.07, the firm would have to pay $535,000 to settle the debt (500,000 x $1.07). On the other hand, if the exchange rate dropped to $1.02, the firm would only need to pay $510,000, (or 500,000 x $1.02). Because the firm cannot perfectly estimate the change in the exchange rate, the company might prefer to eliminate this risk by entering into a forward contract to buy Euros on March 1, 2016. Since the forward rate on December 1, 2015 to purchase Euros on March 1, 2016 is $1.052, the company can buy 500,000 Euros on March 1 for a guaranteed price of $526,000. This fixed price means that the firm has determined in advance the maximum amount of loss it will suffer, in this case $1,000. Thus the firm is protected from future increases in the exchange rate above $1.052. By locking into a set price, the firm gains if the spot rate on March 1, 2016 increases above $1.052 and loses if the spot rate decreases below $1.052. The important point to note about the hedge is that the firm knows with certainty on December 1, 2015, the amount of cash needed to purchase the asset.

a.Prepare the entries to record the purchase and forward exchange contracts at the following dates:

December 1, 2015 - Transaction Date

December 31, 2015 - Balance Sheet Date

March 1, 2016 - Settlement Date

b.Explain the net effect of the forward contract on net income over the life of the contract.

Fair Value Hedge - Hedging an Unrecognized Foreign Currency Firm Commitment

In the preceding discussion of the importing and exporting of goods, the purchase or sale of an asset was recorded on the transaction date. This date is considered the point at which title to the goods is transferred, which is consistent with the recording of a transaction with another domestic company. However, if the U.S. firm at a date earlier than the transaction date made a commitment to a foreign company to sell goods or buy goods, and the price was established in foreign currency at the commitment date, changes in the exchange rate between the commitment date and transaction date would be reflected in the cost or sales price of the asset. For example, assume that a U.S. firm made an agreement on June 1 to buy goods from a Turkish company for 500,000 Lira. At this date, the spot rate was $.20, but on the transaction date, when title to the goods transferred and a journal entry was recorded, the spot rate was $.22. The entry to record the purchase is

Purchases (500,000 Lira x $.22)	110,000
Accounts Payable		110,000

Thus, the change in the exchange rate that occurred between the commitment and the transaction date becomes a part of the cost of inventory, rather than being reported as a separate gain or loss item. The company, however, may still acquire a forward contract to hedge against the unfavorable change in the fair value of the asset that may occur after the commitment date.

A forward contract is considered a hedge of an identifiable foreign currency commitment if the forward contract is designated as, and is effective as, a hedge of a foreign currency commitment. The foreign currency commitment must specify all significant terms (such as quantity and price) and performance must be probable. A gain or loss on a forward contract as well as the offsetting gain or loss on the hedged item are recognized currently in earnings. The gain or loss (the change in the fair value of the forward contract) is an adjustment of the carrying value of the forward contract. Similarly, the change in value of the firm commitment is recorded as such on the balance sheet (even though the commitment has not yet been recorded). The measurement of hedge effectiveness is beyond the scope of this chapter, but since the forward contracts are for similar terms and amounts, they are assumed to be highly effective.

Fair Value Hedge Problem: Answer the following related to a forward contract acquired to hedge an identifiable foreign currency commitment (a fair-value hedge):

Homework question #2

Consider the following Fair Value Hedge

On March 1, 2015, a U.S. firm contracts to sell equipment to a foreign customer for 200,000 Lira. The equipment is expected to cost $60,000 to manufacture and is to be delivered and the account is to be settled one year later on March 1, 2016. Thus the transaction date and the settlement date are both March 1, 2016. On March 1, 2015, the U.S. firm enters into a forward contract to sell 200,000 Lira in 12 months at the forward rate of $.39. Spot rates and the forward rates for Lira on selected dates are:

	Spot	3/1/2016
	Exchange	Forward
______Date______	Rate	Rate
March 1, 2015	$.40	$.390
December 31, 2015	.395	$.385
March 1, 2016	.38

a. Make the journal entries at the following dates.

March 1, 2015

December 31, 2015

March 1, 2016

b.Explain the effect of the above transactions on the firms profitability.