Foreign Currency Forward Contracts and Hedging

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Foreign Currency Forward Contracts and Hedging

• ACCT 70053
• Spring 2008

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Cash flow hedge designation

• Cash flow hedge designation may be used for
  recognized assets or liabilities denominated in a
  foreign currency when all of the variability in
  the functional-equivalent cash flows are
  eliminated by the effects of the hedge.

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Example

• On December 1, 2007, US Co., Inc (USCI) sells
  merchandise to a European customer for
  1,000,000, payable on March 1, 2008. As a hedge
  against a possible decline in the value of the
  Euro, USCI enters into a forward contract with
  CitiChase Bank to sell 1,000,000 on March 1,
  2008 for 1,480,000.

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CF hedge procedures

• Hedge effectiveness is assessed by comparing the
  change in the value of the derivative
  attributable to changes in the spot rate with the
  change in the value of the hedged item.
• The hedged asset or liability is adjusted to fair
  value based on the change in spot rates, and a
  gain or loss is recognized in earnings.

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CF hedge procedures

• The entire change in the value of the derivative
  (including both the spot rate change and the
  change in forward discount or premium) is
  recorded in other comprehensive income.
• An amount equal to the gain or loss on the hedged
  item is removed from OCI and recognized in
  earnings.

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CF hedge procedures

• An additional amount is removed from OCI and
  recognized in earnings to reflect the
  amortization of the initial discount or premium
  by the effective rate method.

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Example
Fair value of forward contracts was determined
by dealer quotes. When dealer quotes are
unavailable, fair value may be estimated as the
estimated settlement cash flow, discounted at the
companys incremental borrowing rate. For
example, at 12/31/07, the estimated settlement
amount was 1,000,000 (1.465-1.476)
11,000. Assuming an incremental borrowing rate
of 1 per month, the present value of 11,000 to
be paid in 2 months is 11,000/(1.01)2
10,783.26
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CF hedge entries
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FV hedge procedures

• Recognize change in the fair value of the
  derivative at the same time as the change in the
  value of the hedged item.
• Both changes are recognized in earnings
  immediately and will offset each other except for
  the change in discount or premium.
• Note this is the same accounting that would
  apply without any hedge designation.

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FV hedge entries