Example DH 8-6 and Example DH 8-7illustrate the accounting for foreign currency fair value hedges.
EXAMPLE DH 8-6
Fair value hedge of a firm commitment to pay foreign currency using a nonderivative instrument as the hedging instrument
USA Corp is a US dollar (USD) functional currency reporting entity.
In connection with the renovation of one of its plants, USA Corp enters into a firm commitment with a foreign supplier to purchase equipment for 10 million euro (EUR). The equipment is deliverable on March 31, 20X2; payment is due on June 30, 20X2.
USA Corp has a EUR 10 million receivable from a customer due June 30, 20X2.
On September 30, 20X1, USA Corp documents its designation of the receivable as the hedging instrument in a fair value hedge of foreign currency risk resulting from the firm commitment to purchase equipment in euro.
USA Corp assesses the criteria in ASC 815-20-25-84 and concludes that the hedging relationship is expected to be perfectly effective under the critical terms match method of assessing effectiveness because the critical terms of the hedging instrument (receivable) and the hedged transaction are identical (i.e., same notional, same date, same currency).
The following table summarizes the exchange rates during the hedging relationship.
Date | Spot exchange rate | ||
September 30, 20X1 | USD 0.84 = EUR 1 | ||
December 31, 20X1 | USD 0.81 = EUR 1 | ||
March 31, 20X2 | USD 0.79 = EUR 1 | ||
June 30, 20X2 | USD 0.78 = EUR 1 |
The following table shows the change in the USD value of the receivable and the firm commitment.
Date | Change in value of the receivable | Change in value of the firm commitment |
September 30, 20X1 | — | — |
December 31, 20X1 | USD 300,000 | USD 300,000 |
March 31, 20X2 | USD 200,000 | USD 200,000 |
June 30, 20X2 | USD 100,000 | USD 100,000 |
The equipment is placed in service on June 30, 20X2.
How should USA Corp account for this hedging relationship?
Analysis
There is no entry required to record the change in fair value of the firm commitment during the period ended September 30, 20X1 because there was no change in spot rates from the time of designation.
Since the hedging relationship meets the requirements for the critical terms match method of assessing effectiveness, and assuming USA Corp has monitored the hedging relationship each quarter and noted no changes, USA Corp can assume that the hedging relationship is perfectly effective.
USA Corp would record the following entries on December 31, 20X1.
Dr. Foreign currency transaction gain or loss | USD 300,000 | |
Cr. Euro-denominated customer receivable | USD 300,000 | |
To record the change in the value of the foreign currency-denominated customer receivable (hedging instrument) | ||
Dr. Firm commitment to buy equipment | USD 300,000 | |
Cr. Foreign currency transaction gain or loss | USD 300,000 | |
To recognize the change in the firm commitment (hedged item) due to a change in the spot exchange rate |
USA Corp would record the following entries when the equipment is delivered on March 31, 20X2.
Dr. Foreign currency transaction gain or loss | USD 200,000 | |
Cr. Euro-denominated customer receivable | USD 200,000 | |
To record the change in the value of the foreign currency-denominated customerreceivable (hedging instrument) in the same line item as hedged item | ||
Dr. Firm commitment to buy equipment | USD 200,000 | |
Cr. Foreign currency transaction gain or loss | USD 200,000 | |
To recognize the change in the firm commitment (hedged item) due to a change in the spot exchange rate | ||
Dr. Equipment | USD 8,400,000 | |
Cr. Firm commitment to buy equipment | USD 500,000 | |
Cr. Account payable | USD 7,900,000 | |
To record the receipt of the equipment on March 31, 20X2 and the related payable at the March 31, 20X2 spot rate |
USA Corp would record the following entries when the account payable is settled on June 30, 20X2.
Dr. Foreign currency transaction gain or loss | USD 100,000 | |
Cr. Euro-denominated customer receivable | USD 100,000 | |
To record the change in the value of the foreign currency-denominated customer receivable in the same line item as the hedged item | ||
Dr. Accounts payable | USD 100,000 | |
Cr. Foreign currency transaction gain or loss | USD 100,000 | |
To recognize the transaction loss on the foreign currency accounts payable | ||
Dr. Accounts payable | USD 7,800,000 | |
Dr. Cash | USD 7,800,000 | |
Cr. Cash | USD 7,800,000 | |
Cr. Euro-denominated customer receivable | USD 7,800,000 | |
To record the settlement of the account payable and customer receivable on June 30, 20X2 | ||
EXAMPLE DH 8-7
Fair value hedge of the foreign currency risk in an available-for-sale debt security
USA Corp is a US dollar (USD) functional currency reporting entity.
On September 30, 20X1, USA Corp purchases a British pound sterling (GBP)-denominated debt security for GBP 100,000 and classifies it as available for sale. On that same date, USA Corp enters into a forward contract to sell GBP 100,000 on December 31, 20X1, at the current exchange rate of USD 1.49 = GBP 1 to hedge the impact of currency fluctuations on the available-for-sale security over the next three months.
On September 30, 20X1, USA Corp designates the forward contract as a fair value hedge of the GBP-denominated debt security and decides to assess the effectiveness of the hedge based on changes in the spot exchange rate. Therefore, changes in the fair value of the available-for-sale debt security due to changes in the spot exchange rate will be recorded in earnings, along with the entire change in the fair value of the forward contract.
USA Corp assesses the criteria in ASC 815-20-25-84 and concludes that the hedging relationship is expected to be perfectly effective under the critical terms match method of assessing effectiveness as follows:
- The critical terms of the forward and the hedged transaction are identical (i.e., notional, date, currency)
- The fair value of the forward is zero at inception
- Hedge effectiveness will be assessed based on changes in the spot rate
USA Corp elects to exclude the changes in the difference between the forward rate and the spot rate from the effectiveness assessment and decides to record this change in earnings.
The following table summarizes the exchange rates and fair values of the forward contract at inception and conclusion of the hedging relationship.
Date | Spot exchange rate | Forward exchange rate to December 31, 20X1 | Fair value of forward contract |
September 30, 20X1 | USD 1.50 = GBP 1 | USD 1.49 = GBP 1 | — |
December 31, 20X1 | USD 1.30 = GBP 1 | USD 1.30 = GBP 1 | USD 19,000* |
* GBP 100,000 × (USD 1.49 – USD 1.30)
The following table shows the change in the fair value of the available-for-sale debt security.
Date | Spot exchange rate | Fair value of the security (GBP) | Fair value of the security (USD) |
September 30, 20X1 | USD 1.50 = GBP 1 | GBP 100,000 | USD 150,000 |
December 31, 20X1 | USD 1.30 = GBP 1 | GBP 110,000 | USD 143,000 |
USA Corp has a policy of segregating the impact of foreign currency risk by multiplying the opening fair value of the foreign currency-denominated security by the change in exchange rates. The purpose of this calculation is to determine what portion of any increase (or decrease) in the fair value of the security is related to change in the security price and what portion is related to changes in exchange rates. USA Corp performs this calculation as follows:
GBP 100,000 × (USD 1.30 – USD 1.50) = USD 20,000 loss
To calculate the change in the fair value of the available-for-sale security attributable to risks that are not hedged, USA Corp performs the following calculation:
(GBP 110,000 – GBP 100,000) × USD 1.30 = USD 13,000 gain
The total change in the fair value of the GBP-denominated security is USD (7,000), which comprises a USD 20,000 foreign currency loss and a USD 13,000 gain from other sources (e.g., interest rates and credit).
How should USA Corp account for this hedging relationship?
Analysis
There is no entry to record the forward contract because it is an at-market forward with a fair value of zero.
Since the hedging relationship meets the requirements for the critical terms match method of assessing effectiveness, and assuming USA Corp has monitored the hedging relationship each quarter and noted no changes, USA Corp can assume that the hedging relationship is perfectly effective.
To record the purchase of the available-for-sale debt security on September 30, 20X1, USA Corp would record the following entry.
Dr. Investment in available-for-sale security | USD 150,000 | |
Cr. Cash | USD 150,000 | |
To record the purchase of the available-for-sale security at the spot rate of USD 1.50 = GBP 1 |
USA Corp would record the following entries on December 31, 20X1.
Dr. Forward contract receivable | USD 19,000 | |
Cr. Gain or loss on available-for-sale securities | USD 19,000 | |
To record the change in the fair value of the forward contract in the same line item as the hedged item | ||
Dr. Gain or loss on available-for-sale securities | USD 20,000 | |
Cr. Investment in available-for-sale security | USD 20,000 | |
To record the change in the fair value of the available-for-sale security attributable to the spot foreign currency risk being hedged | ||
Dr. Investment in available-for-sale security | USD 13,000 | |
Cr. Other comprehensive income | USD 13,000 | |
To record the change in the fair value of the available-for-sale security attributable to risks that are not hedged | ||
Dr. Cash | USD 19,000 | |
Cr. Forward contract receivable | USD 19,000 | |
To record the settlement of the forward contract at its maturity | ||
If USA Corp had hedged the available-for-sale security for a longer period and used the critical terms match method of assessing hedge effectiveness, it would have to rebalance the hedge ratio given its policy of measuring the foreign currency gain/loss component based on the foreign currency fair value as of the beginning of each reporting period.
Some reporting entities choose to determine the gain or loss attributable to foreign currency risk based on the foreign currency cost basis. Under this approach, the foreign currency gain or loss attributable to the unrealized holding gain or loss would not be considered to be a part of the hedging relationship, which would allow the hedging relationship to be designated on a static basis.
