Cash Flow Hedge Example

12/1/Y1
Inventory
$20,000.00
To record purchase and A/P of 20000C
A/P
$20,000.00
12/31/Y1
Foreign Exchange Loss
$1,000.00
To adjust value for spot of $1.05
A/P
$1,000.00
AOCI
$1,000.00
To record a gain on the forward contract
Gain on Forward Contract
$1,000.00
Forward Contract
$1,176.36
To record the forward contract as an asset
AOCI
$1,176.36
Premium Expense
$266.67
Allocate the fwd contract discount
AOCI
$266.67
3/1/Y2
Foreign Exchange Loss
$1,400.00
To adjust value for spot of $1.12
A/P
$1,400.00
AOCI
$1,400.00
To record a gain on the forward cont.
Gain on Forward Contract
$1,400.00
Forward Contract
$423.64
To adjust the fwd. cont. to its FV of $1600
AOCI
$423.64
Premium Expense
$533.33
To allocate the remaining fwd. cont. discount
AOCI
$533.33
Foreign Currency
$22,400.00
To record the settlement of the fwd. cont.
Forward Contract
$1,600.00
Cash
$20,800.00
A/P
$22,400.00
To record the payment of the A/P
Foreign Currency
$22,400.00
Notice how in year 2 when the payable is paid off, the amount of cash paid is equal to the forward rate of exchange back in year 1. Any change in the forward rate, however, changes the value of the forward contract. In this example, the exchange rate climbed in both years, increasing the value of the forward contract. Since the derivative instruments are required to be recorded at fair value, these adjustments must be made to the forward contract listed on the books. The offsetting account is other comprehensive income. This process allows the gain and loss on the position to be shown in Net income.
The second is a fair value hedge. Again, according to IAS 39 this is “a hedge of the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss” [3]. More simply, this type of hedge would eliminate the fair value risk of assets and liabilities reported on the Balance sheet. Since Accounts receivable and payable are recorded here, a fair value hedge may be used for these items. The following are the journal entries that would be made if the previous example were a fair value hedge