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8.4 Foreign currency cash flow hedges

Publication date: 31 Mar 2024

us Derivatives & hedging guide

An unrecognized firm commitment, a forecasted transaction, or a recognized asset or liability (including intercompany receivables or payables) are all eligible exposures for a foreign currency cash flow hedge. Only a derivative can be designated as the hedging instrument in a cash flow hedge.

Common examples of foreign currency cash flow hedges include the hedge of the foreign currency risk:

In a forecasted intercompany or third-party purchase or sale of a foreign currency-denominated financial asset
In a forecasted intercompany or third-party purchase or sale of a nonfinancial asset (e.g., inventory or fixed asset)
In a forecasted receipt or payment of service-related revenues denominated in a foreign currency (e.g., royalties or franchise fees)
Related to a recognized asset or liability that is remeasured in income (e.g., receipt or payment of interest on a foreign-currency-denominated debt instrument)

The hedging of these risks is permitted only if all of the variability in functional currency-equivalent cash flows is eliminated, as required by ASC 815-20-25-39(d) and ASC 815-20-25-40.

8.4.1 Qualifying criteria

ASC 815-20-25-39 and ASC 815-20-25-40 specify qualifying criteria for foreign currency cash flow hedges in addition to the criteria applicable to all foreign currency hedges in ASC 815-20-25-30, discussed in DH 8.3.

ASC 815-20-25-39

A hedging relationship of the type described in the preceding paragraph qualifies for hedge accounting if all the following criteria are met:

The criteria in paragraph 815-20-25-30(a) through (b) are met.
All of the cash flow hedge criteria in this Section otherwise are met, except for the criterion in paragraph 815-20-25-15(c) that requires that the forecasted transaction be with a party external to the reporting entity.
If the hedged transaction is a group of individual forecasted foreign-currency-denominated transactions, a forecasted inflow of a foreign currency and a forecasted outflow of the foreign currency cannot both be included in the same group.
If the hedged item is a recognized foreign-currency-denominated asset or liability, all the variability in the hedged item’s functional-currency-equivalent cash flows shall be eliminated by the effect of the hedge.

ASC 815-20-25-40

For purposes of item (d) in the preceding paragraph, an entity shall not specifically exclude a risk from the hedge that will affect the variability in cash flows. For example, a cash flow hedge cannot be used with a variable-rate foreign-currency-denominated asset or liability and a derivative instrument based solely on changes in exchange rates because the derivative instrument does not eliminate all the variability in the functional currency cash flows. As long as no element of risk that affects the variability in foreign-currency-equivalent cash flows has been specifically excluded from a foreign currency cash flow hedge and the hedging instrument is highly effective at providing the necessary offset in the variability of all cash flows, a less-than-perfect hedge would meet the requirement in (d) in the preceding paragraph. That criterion does not require that the derivative instrument used to hedge the foreign currency exposure of the forecasted foreign-currency-equivalent cash flows associated with a recognized asset or liability be perfectly effective, rather it is intended to ensure that the hedging relationship is highly effective at offsetting all risks that impact the variability of cash flows.

As stated in ASC 815-20-25-39(b), a foreign currency cash flow hedge must also meet the criteria applicable to all cash flow hedges, except that the forecasted transaction does not need to be with a third party (i.e., intercompany transactions can be the hedged transaction in a foreign currency cash flow hedge). These requirements are discussed in DH 6 for hedges of financial items and DH 7 for hedges of nonfinancial items.

Question DH 8-4
Does the requirement in ASC 815-20-25-39(d) that a cash flow hedge of the foreign currency risk in a recognized foreign currency-denominated asset or liability must eliminate all of the variability in the functional currency-equivalent cash flows mean that the hedging relationship must be perfectly effective?

PwC response

No. A relationship qualifies for cash flow hedge accounting as long as it is designed to offset all relevant risks (e.g., interest rate, foreign currency) and is highly effective. This requirement is designed to prevent reporting entities from specifically excluding a risk that will affect the variability in cash flows from the hedging relationship. However, the hedging relationship does not have to be perfectly effective.

Question DH 8-5
Is the variability in functional currency-equivalent proceeds expected to be received from the forecasted issuance of foreign currency-denominated debt eligible for designation as the hedged transaction in a cash flow hedge of foreign currency risk?

PwC response

No. An anticipated foreign currency borrowing is not a transaction that qualifies for hedge accounting of foreign currency risk. The variation in functional currency-equivalent proceeds that a reporting entity will receive upon borrowing the funds at a future date does not present an earnings exposure because changes in exchange rates from hedge inception to the borrowing date will only impact the initial measurement of the liability. The repayment of this amount will not impact earnings.

Question DH 8-6
Can a reporting entity hedge the foreign currency risk in the forecasted earnings of a foreign subsidiary?

PwC response

No. The forecasted earnings (or net income) of a foreign subsidiary is not permitted to be the hedged item; ASC 815 prohibits hedge accounting for hedges of future earnings. A reporting entity may designate (1) a net investment in a foreign operation or (2) royalty payments that are to be received from a subsidiary as the hedged item. See DH 8.6 for information on net investment hedges.

Question DH 8-7
Can a reporting entity hedge the foreign currency risk associated with a forecasted intercompany dividend?

PwC response

No. The intercompany dividend does not present an earnings exposure so it is not eligible to be a hedged item.

Question DH 8-8
A parent company and foreign subsidiary both have a US dollar functional currency. The foreign subsidiary’s sales and cost of sales are denominated in US dollars, while all other operating costs are denominated in the local foreign currency. Can the foreign subsidiary hedge its forecasted foreign currency-denominated operating costs?

PwC response

Yes. The local-currency operating costs are considered denominated in a foreign currency since the functional currency of the foreign subsidiary is the US dollar. The forecasted operating costs may need to be segregated into specific forecasted transactions (e.g., payments of rent, salaries, and similar specific costs) to meet the qualifying criteria for cash flow hedge accounting (e.g., specific identification, probability, high effectiveness), but these forecasted foreign currency-denominated transactions are eligible to be hedged.

Question DH 8-9
Can a reporting entity hedge a specified amount of foreign currency-denominated sales (e.g., 10 million euro in sales)?

PwC response

Yes. A reporting entity can designate a specified amount of foreign currency-denominated sales as the hedged item in a cash flow hedge of the foreign currency risk in foreign currency-denominated sales. This differs from cash flow hedges of nonfinancial risks, which require that the hedged item be a specified number of units sold rather than a specified currency amount.

8.4.2 Cash flow hedge of a forecasted purchase or sale on credit

When a forecasted foreign currency purchase or sale will be made on credit (i.e., a payable or receivable will be created by the sale), a reporting entity can choose to hedge the foreign currency risk to the date the sale will occur or to the date the foreign currency payable or receivable will be settled.

Hedging to the settlement date of the payable or receivable allows a reporting entity to designate one overall cash flow hedging relationship rather than designating separate cash flow hedging relationships of (1) the forecasted purchase/sale and (2) payment of the payable/receivable (which would require dedesignating and redesignating the hedging instrument).

8.4.2.1 Hedge to the sale date

When a reporting entity chooses to hedge to the date the sale will occur, changes in the fair value of the hedging derivative should be recorded in OCI until the sales date; that amount should be reclassified into earnings as the hedged transaction impacts earnings (in the same income statement line item).

A reporting entity can decide to assess hedge effectiveness either (1) based on the forward price or (2) based on the spot price. If a reporting entity chooses the spot method, it would generally elect to amortize the spot-forward difference over the life of the hedge. See DH 8.3.1.1 for information on excluded components.

Example DH 8-1 in DH 8.4.4 illustrates the accounting for this type of a hedging relationship.

8.4.2.2 Hedge to the settlement date of the payable or receivable

A reporting entity may use a single forward contract to hedge the foreign currency risk associated with a forecasted foreign currency purchase or sale through to the settlement date of the payable or receivable. ASC 815-20-25-34 through ASC 815-20-25-36 permits a reporting entity to designate such a forward in a single cash flow hedging relationship of the variability attributable to foreign currency risk related to the settlement of a foreign currency-denominated receivable or payable resulting from a forecasted transaction on credit.

This type of hedging relationship may have been more beneficial before the issuance of the new hedging guidance because the longer hedge period together with a forward to forward hedge designation minimized earnings volatility when compared to recording the change in the spot-to-forward difference in earnings. It may not be applied as often now that a reporting entity can elect to amortize the spot-to-forward difference when the forward points are excluded from the assessment of hedge effectiveness.

ASC 815-30-35-9 provides guidance with respect to this type of hedging relationship.

Excerpt from ASC 815-30-35-9

For a single cash flow hedge that encompasses the variability of functional-currency-equivalent cash flows attributable to foreign exchange risk related to the settlement of a foreign-currency-denominated receivable or payable resulting from a forecasted sale or purchase on credit, the guidance in paragraph 815-30-35-3 is applied as follows:

The gain or loss on the derivative instrument that is included in the assessment of hedge effectiveness is reported in other comprehensive income during the period before the forecasted purchase or sale.
The functional currency interest rate implicit in the hedging relationship as a result of entering into the forward contract is used to determine the amount of cost or income to be ascribed to each period of the hedging relationship….
For forecasted sales on credit, the amount of cost or income ascribed to each forecasted period is reclassified from other comprehensive income to earnings on the date of the sale. For forecasted purchases on credit, the amount of cost or income ascribed to each forecasted period is reclassified from other comprehensive income to earnings in the same period or periods during which the asset acquired affects earnings. The reclassification from other comprehensive income to earnings of the amount of cost or income ascribed to each forecasted period is based on the guidance in paragraphs 815-30-35-38 through 35-41.
The income or cost ascribed to each period encompassed within the periods of the recognized foreign-currency-denominated receivable or payable is reclassified from other comprehensive income to earnings at the end of each reporting period.

Example 18 (see paragraph 815-30-55-106) illustrates such a transaction.

See examples in DH 8.4.4. Example DH 8-2 illustrates this strategy when hedge effectiveness is assessed based on forward rates and Example DH 8-3 illustrates this strategy when hedge effectiveness is assessed based on spot rates.

8.4.3 Accounting for cash flow hedges

Foreign currency cash flow hedges are accounted for in the same way as other cash flow hedges under ASC 815. The hedging derivative is recorded at fair value; changes in the fair value of the hedging derivative are recorded in OCI and reclassified into earnings as the hedged transaction impacts earnings (in the same income statement line item). If a reporting entity elects to exclude a component of the change in fair value of the hedging instrument (e.g., time value of an option) from the assessment of effectiveness, the fair value attributable to the excluded component may be recognized currently in earnings or included in OCI and amortized over the life of the hedging instrument. See DH 8.3.1.1 for information on excluding components.

8.4.3.1 Accounting for a cash flow hedge of foreign currency items

When the hedged item in a highly effective cash flow hedge is a recognized foreign-currency-denominated asset or liability, ASC 815 requires the following accounting at each reporting period:

The hedged item is measured based on the current spot rate, as required by ASC 830, and the resulting transaction gain or loss is recorded in earnings
The hedging instrument is measured at fair value and the entire gain or loss is initially recorded in OCI
An amount equal to the transaction gain or loss on the hedged item is transferred from OCI to earnings to offset the transaction gain or loss recorded in earnings

When a forward contract is designated as the hedging instrument in a cash flow hedge of a foreign currency-denominated asset or liability, the different bases for measuring the forward contract (based on forward rates) and the asset or liability (based on spot rates) give rise to a mismatch.

When noninterest-bearing assets or liabilities, such as trade receivables and payables, are hedged with a forward contract, the spot-forward difference should be amortized; how it is amortized depends on whether it is excluded from the assessment of hedge effectiveness. If the spot-forward difference is excluded, the difference should be recognized in earnings using a systematic and rational amortization method over the life of the hedging instrument. When the spot-forward difference is not treated as an excluded component, the difference should be recognized using the interest method. See DH 8.3.1.1 for information on excluding components from the effectiveness assessment of a foreign currency hedge.

Some reporting entities decide to forgo hedge accounting and elect to simply “economically hedge” noninterest-bearing assets or liabilities, particularly short-term trade payables and receivables (i.e., not designate the derivative as a hedge). In those cases, the derivative is measured at fair value each reporting period, with all changes in fair value recorded in earnings. The receivable or payable is measured at the spot exchange rate (as required by ASC 830) and the resulting transaction gain or loss is recorded in earnings.

8.4.4 Foreign currency cash flow hedging examples

Example DH 8-1, Example DH 8-2, Example DH 8-3, Example DH 8-4 and Example DH 8-5 illustrate the accounting for foreign currency cash flow hedges.

EXAMPLE DH 8-1

Cash flow hedge of foreign currency risk resulting from forecasted foreign currency sales

USA Corp is a US dollar (USD) functional currency manufacturing company.

USA Corp forecasts that it will sell 12 million euro (EUR) of its primary product to European customers in six months. Payment will be made at the date of sale. The sales are not firmly committed, but historical experience and current sales forecasts indicate that the sales are probable.

On September 30, 20X1, USA Corp enters into a six-month foreign currency forward contract to deliver EUR and receive USD to hedge a portion of its exposure to euro sales. The foreign exchange forward contract has the following terms:


Contract amount:	EUR 10 million
Maturity date:	March 31, 20X2
Forward contract rate:	USD 0.83 = EUR 1

On September 30, 20X1, USA Corp documents its designation of the forward contract as a cash flow hedge of foreign currency risk resulting from the forecasted euro sales.

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 forward is for the sale of the same quantity, the same currency, and at the same time as the hedged forecasted sale; the critical terms of the forward and the hedged item are identical
The fair value of the forward contract at inception is zero
Hedge effectiveness will be assessed based on changes in the forward price of the currency

The following table summarizes the exchange rates during the hedging relationship.

Date	Spot exchange rate	Forward exchange rate to March 31, 20X2
September 30, 20X1	USD 0.84 = EUR 1	USD 0.83 = EUR 1
December 31, 20X1	USD 0.81 = EUR 1	USD 0.805 = EUR 1
March 31, 20X2	USD 0.79 = EUR 1	—

The following table shows the fair values of the forward contract, which are based on the changes in forward rates (discounting to net present value has been ignored for simplicity).

Date	Fair value of forward contract	Gain (loss) on forward contract
September 30, 20X1	—	—
December 31, 20X1	USD 250,000	USD 250,000
March 31, 20X2	USD 400,000	USD 150,000

How should USA Corp account for this hedging relationship?

Analysis

There is no entry required to record the forward contract at inception of the hedge 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.

USA Corp would record the following entry on December 31, 20X1 to record the change in fair value of the forward contract in OCI.


Dr. Forward contract receivable	USD 250,000
Cr. Other comprehensive income		USD 250,000
To record the change in fair value of the forward contract

USA Corp would record the following entries when the forecasted sales occur and forward contract matures on March 31, 20X2.


Dr. Forward contract receivable	USD 150,000
Cr. Other comprehensive income		USD 150,000
To record the change in fair value of the forward contract
Dr. Cash	USD 400,000
Cr. Forward contract receivable		USD 400,000
To record the net settlement of the forward contract at its maturity
Dr. Cash	USD 7,900,000
Cr. Sales		USD 7,900,000
To record EUR 10 million in cash sales at the spot rate of USD 0.79 = EUR 1
Dr. Other comprehensive income	USD 400,000
Cr. Sales		USD 400,000
To transfer the gain on the hedge activity from other comprehensive income to sales (the same line item as the hedged item) when the forecasted transaction impacts earnings

Even though there was an unfavorable change in exchange rates that reduced the functional currency-equivalent sales proceeds received, USA Corp’s sales in US dollars were fixed at USD 8,300,000 (USD 7,900,000 sales + USD 400,000 gain on forward contract) equal to the EUR 10,000,000 converted to USD at the forward rate at inception through the hedge.

EXAMPLE DH 8-2
Cash flow hedge of foreign currency risk resulting from forecasted foreign currency sales on credit (hedge through payment of receivable, based on change in entire fair value)

USA Corp is a US dollar (USD) functional currency manufacturing company.

USA Corp forecasts that it will sell 12 million euro (EUR) of its primary product to European customers in six months. Instead of receiving cash for the sales on March 31, 20X2 (the sales date), USA Corp will record an account receivable for the sale, which it expects the customers to pay on April 30, 20X2. The sales are not firmly committed, but historical experience and current sales forecasts indicate that the sales are probable.

On September 30, 20X1, USA Corp enters into a seven-month foreign currency forward contract to deliver EUR and receive USD to hedge its foreign currency exposure resulting from the forecasted sale and the cash flows from the euro-denominated account receivable. The foreign exchange forward contract has the following terms:


Contract amount:	EUR 10 million
Maturity date:	April 30, 20X2
Forward contract rate:	USD 0.828 = EUR 1

On September 30, 20X1, USA Corp documents its designation of the forward contract as a cash flow hedge of foreign currency risk resulting from the forecasted euro sales that includes the variability of the functional currency-equivalent cash flow from collection of the euro-denominated account receivable. USA Corp decides to assess the effectiveness of the hedge based on changes in the entire fair value of the forward contract.

USA Corp elects to attribute the forward points to the forecasted sale portion and resulting receivable using the pro rata method described in ASC 815-30-35-9 and Example 18 in ASC 815-30-55-106 through ASC 815-30-55-112. To do this, USA Corp:

Calculates the forward points as USD 120,000, which is the difference between the functional currency-equivalent amount at (1) the spot rate at inception and (2) the derivative’s forward rate
Determines the number of days (1) between the inception of the derivative and the invoice date (182 days) and (2) between the invoice date and the payment date (30 days), a total of 212 days
Allocates the forward points to each period: (1) between the inception of the derivative and the invoice date (182 days/212 days × USD 120,000 = USD 103,019) and (2) between the invoice date and the payment date (30 days/212 days × USD 120,000 = USD 16,981)

The forward is for the purchase of the same quantity, the same currency, and at the same time as the hedged forecasted sale; the critical terms of the forward and the hedged item are identical
The fair value of the forward contract at inception is zero
Hedge effectiveness will be assessed based on changes in the forward price of the currency

The following table summarizes the exchange rates during the hedging relationship.

Date	Spot exchange rate	Forward exchange rate to April 30, 20X2
September 30, 20X1	USD 0.84 = EUR 1	USD 0.828 = 1 EUR
December 31, 20X1	USD 0.81 = EUR 1	USD 0.803 = 1 EUR
March 31, 20X2	USD 0.79 = EUR 1	USD 0.788 = 1 EUR
April 30, 20X2	USD 0.78 = EUR 1	—

The following table shows the fair values of the forward contract, which are based on the changes in forward rates (discounting to net present value has been ignored for simplicity).

Date	Fair value of forward contract	Gain (loss) on forward contract
September 30, 20X1	—	—
December 31, 20X1	USD 250,000	USD 250,000
March 31, 20X2	USD 400,000	USD 150,000
April 30, 20X2	USD 480,000	USD 80,000

How should USA Corp account for this hedging relationship?

Analysis

There is no entry required to record the forward contract at inception of the hedge 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, 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 entry on December 31, 20X1 to record the change in fair value of the forward contract.

Dr. Forward contract receivable	USD 250,000
Cr. Other comprehensive income		USD 250,000
To record the change in the fair value of the forward contract

USA Corp would record the following entries when the forecasted sale occurs on March 31, 20X2.

Dr. Forward contract receivable	USD 150,000
Cr. Other comprehensive income		USD 150,000
To record the change in the fair value of the forward contract
Dr. Accounts receivable (EUR 10 million)	USD 7,900,000
Cr. Sales		USD 7,900,000
To record EUR 10 million in cash sales at the spot rate of USD 0.79 = EUR 1
Dr. Accumulated other comprehensive income	USD 500,000
Cr. Sales		USD 500,000
To reclassify the portion of the change in fair value of the forward contract due to changes in undiscounted spot rates attributable to the forecasted sale recognized at the invoice date from accumulated other comprehensive income
Dr. Sales	USD 103,019
Cr. Accumulated other comprehensive income		USD 103,019
To reclassify the undiscounted allocable cost of the hedge from inception through the date of sale from accumulated comprehensive income into earnings

USD 8,400,000 sales (USD 7,900,000 sales + USD 500,000 gain on forward contract attributable to changes in the spot rate) equals the EUR 10,000,000 converted to USD at the spot rate at inception of the hedge. Further adjusting sales for USD 103,019 cost of the hedge results in sales of USD 8,296,981.

USA Corp would record the following entries on April 30, 20X2.

Dr. Forward contract receivable	USD 80,000
Cr. Other comprehensive income		USD 80,000
To record the change in the fair value of the forward contract
Dr. Foreign currency transaction loss	USD 100,000
Cr. Accounts receivable (EUR 10 million)		USD 100,000
To record the transaction loss for the period based on the change in the spot rate (EUR 10,000,000 × USD 0.78 = EUR 1) – (EUR 10,000,000 × USD 0.79 = EUR 1)
Dr. Accumulated other comprehensive income	USD 100,000
Cr. Foreign currency transaction gain or loss		USD 100,000
To reclassify an amount from accumulated other comprehensive income to earnings to offset all of the foreign currency transaction loss recorded for the receivable during the period
Dr. Foreign currency transaction gain or loss	USD 16,981
Cr. Accumulated other comprehensive income		USD 16,981
To reclassify the allocable cost of the forward contract from the sale date to the April cash receipt date from accumulated other comprehensive income into earnings
Dr. Cash	USD 7,800,000
Cr. Accounts receivable (EUR 10,000,000)		USD 7,800,000
To record the cash receipt for the settlement of the receivable
Dr. Cash	USD 480,000
Cr. Forward contract receivable		USD 480,000
To record the net settlement of the forward contract at its maturity

EXAMPLE DH 8-3
Cash flow hedge of foreign currency risk resulting from forecasted foreign-currency sales (hedge through payment of receivable, forward points excluded from assessment of effectiveness)

USA Corp is a US dollar (USD) functional currency manufacturing company.

On September 30, 20X1, USA Corp documents its designation of the forward contract as a cash flow hedge of foreign currency risk resulting from the forecasted euro sales through the collection date of the account receivable. However, for this hedging relationship, USA Corp decides to assess the effectiveness of the hedge based on changes in the spot exchange rate. Therefore, the change in fair value of the forward contract attributable to changes in the spot exchange rate is recorded in OCI through the date of sale. USA Corp quantifies the amount of forward points attributable to the forward contract between September 30, 20X1 and April 30, 20X2 and amortizes that amount to earnings using a systematic and rational method over the hedge period.

USA Corp assess 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 forward is for the purchase of the same quantity, the same currency, and at the same time as the hedged forecasted payment; the critical terms of the forward and the hedged item are identical
The fair value of the forward contract at inception is zero
Hedge effectiveness will be assessed based on changes in the spot price

The following table summarizes the exchange rates during the hedging relationship.

Date	Spot exchange rate	Forward exchange rate to April 30, 20X2
September 30, 20X1	USD 0.84 = EUR 1	USD 0.828 = EUR 1
December 31, 20X1	USD 0.81 = EUR 1	USD 0.803 = EUR 1
March 31, 20X2	USD 0.79 = EUR 1	USD 0.788 = EUR 1
April 30, 20X2	USD 0.78 = EUR 1	—

The following table shows the fair values of the forward contract, which are based on changes in forward rates (discounting to net present value has been ignored for simplicity).

Date	Fair value of forward contract	Change in spot value of the forward contract
September 30, 20X1	—	—
December 31, 20X1	USD 250,000	USD 300,000
March 31, 20X2	USD 400,000	USD 200,000
April 30, 20X2	USD 480,000	USD 100,000

How should USA Corp account for this hedging relationship?

Analysis

There is no entry required to record the forward contract at inception of the hedge because the forward contract is an at-market forward with a fair value of zero.

USA Corp would record the following entries on December 31, 20X1 to record the change in fair value of the forward contract and amortization of the forward points.

Dr. Forward contract receivable	USD 250,000
Cr. Other comprehensive income		USD 250,000
To record the change in fair value of the forward contract
Dr. Sales	USD 52,075
Cr. Accumulated other comprehensive income		USD 52,075
To record the amortization of the forward points (USD 120,000 × 92 days / 212 days)

USA Corp would record the following entries when the forecasted sale occurs on March 31, 20X2.

Dr. Forward contract receivable	USD 150,000
Cr. Other comprehensive income		USD 150,000
To record the change in fair value of the forward contract
Dr. Sales	USD 50,943
Cr. Accumulated other comprehensive income		USD 50,943
To record the amortization of the forward points (USD 120,000 × 90 days / 212 days)
Dr. Accounts receivable	USD 7,900,000
Cr. Sales		USD 7,900,000
To record EUR 10 million0 in cash sales at the spot rate of USD 0.79 = EUR 1
Dr. Accumulated other comprehensive income	USD 500,000
Cr. Sales		USD 500,000
To reclassify the change in fair value of the forward contract attributable to changes in spot rates through March 31,20X2 from accumulated other comprehensive income into sales (the same line item as the hedged item)

USA Corp would record the following entries on April 30, 20X2.

Dr. Forward contract receivable	USD 80,000
Cr. Other comprehensive income		USD 80,000
To record the change in the fair value of the forward contract
Dr. Foreign currency transaction gain or loss	USD 16,981
Cr. Accumulated other comprehensive income		USD 16,981
To record the amortization of the forward points
Dr. Foreign currency transaction gain or loss	USD 100,000
Cr. Accounts receivable		USD 100,000
To record the transaction loss for the period based on the change in the spot rate (EUR 10 million × USD 0.79 = EUR 1) – (EUR 10,000,000 × USD 0.78 = EUR 1)
Dr. Accumulated other comprehensive income	USD 100,000
Cr. Foreign currency transaction gain or loss		USD 100,000
To reclassify an amount from accumulated other comprehensive income to earnings to offset all of the foreign currency transaction loss recorded for the receivable during the period
Dr. Cash	USD 7,800,000
Cr. Accounts receivable (EUR 10 million)		USD 7,800,000
To record the cash receipt for the settlement of the receivable
Dr. Cash	USD 480,000
Cr. Forward contract receivable		USD 480,000
To record the net settlement of the forward contract at its maturity

EXAMPLE DH 8-4
Use of foreign currency option to hedge forecasted foreign sales

USA Corp is a US dollar (USD) functional currency manufacturing company.

USA Corp forecasts that it will sell 12 million euro (EUR) of its primary product to European customers in six months, on March 31, 20X1. Payment will be made at the date of sale. The sale is not firmly committed, but historical experience and sales forecasts indicate that the sales are probable.

On September 30, 20X1, USA Corp enters into a six-month foreign currency put option on EUR to hedge a portion of its exposure to euro sales.

The foreign exchange put option has the following terms:

Contract amount:	EUR 10 million
Maturity date:	March 31, 20X2
Strike price:	USD 0.84 = EUR 1
Option premium:	USD 20,000

The option has a strike price that is at the money and the option premium reflects only the option’s time value.

On September 30, 20X1, USA Corp documents its designation of the put option as a cash flow hedge of foreign currency risk in the forecasted euro sales below the strike price. It decides to exclude the time value of the option from the assessment of effectiveness; effectiveness will be assessed based on the option’s intrinsic value. USA Corp assesses hedge effectiveness at inception of the hedging relationship and on an ongoing basis and determines that the hedging relationship is highly effective.

The USD 20,000 of option time value will be systematically amortized and included in earnings.

The following table summarizes the exchange rates, intrinsic values, and fair values of the put option during the hedging relationship.

Since the spot exchange rate on the date the option expires (March 31, 20X2) is below the option’s strike price, USA Corp will exercise the put option.

How should USA Corp account for this hedging relationship?

Analysis

USA Corp would record the following entry on September 30, 20X1.

Dr. Foreign currency option	USD 20,000
Cr. Cash		USD 20,000
To record the premium paid to purchase the put option

USA Corp would record the following entries on December 31, 20X1.

Dr. Foreign currency option	USD 285,000
Cr. Other comprehensive income		USD 285,000
To record the change in the fair value of the put option
Dr. Sales	USD 10,110
Cr. Accumulated other comprehensive income		USD 10,110
To record the amortization of the put option’s time value (USD 20,000 × 92 days / 182 days)

USA Corp would record the following entries when the forecasted sales occur and the put option expires on March 31, 20X2.

Dr. Foreign currency option	USD 195,000
Cr. Other comprehensive income		USD 195,000
To record the change in the fair value of the put option
Dr. Sales	USD 9,890
Cr. Accumulated other comprehensive income		USD 9,890
To record the amortization of the put option’s time value (USD 20,000 × 90 days / 182 days)
Dr. Cash	USD 7,900,000
Cr. Sales		USD 7,900,000
To record EUR 10 million in cash sales at the spot rate of USD 0.79 = EUR 1
Dr. Accumulated other comprehensive income	USD 500,000
Cr. Sales		USD 500,000
To reclassify the change in fair value of the put option for changes in undiscounted spot rate rates from accumulated other comprehensive income into earnings.
Dr. Cash	USD 500,000
Cr. Foreign currency option		USD 500,000
To record the net cash settlement of the option upon exercise

USD 8,400,000 sales (USD 7,900,000 sales + USD 500,000 gain on put option attributable to changes in the spot rate) equals the EUR 10,000,000 converted to USD at the spot rate at inception of the hedge. Further adjusting sales for USD 20,000 cost of the hedge results in sales of USD 8,380,000 across all the reporting periods.

EXAMPLE DH 8-5
Cash flow hedge of foreign-currency-denominated debt with a fixed-for-fixed cross-currency swap

USA Corp is a US dollar (USD) functional currency manufacturing company.

On January 1, 20X1, USA Corp issues 1,000,000 in euro (EUR) denominated debt. The debt matures on December 31, 20X1 and bears interest at a fixed rate of 8% per year. Concurrent with the debt issuance, USA Corp enters into a cross-currency swap to hedge the foreign currency risk associated with the debt. The swap has the following terms:

Maturity date:	December 31, 20X1
Initial exchange:	USA Corp pays EUR 1,000,000 and receives USD 860,000
USA Corp pays:	7% fixed rate on a notional of USD 860,000
USA Corp receives:	8% fixed rate on a notional of EUR 1,000,000
Final exchange:	USA Corp pays USD 860,000 and receives EUR 1,000,000

All terms of the swap match those of the foreign currency debt, including the notional amount and interest payment dates. By entering into the fixed-for-fixed cross-currency interest rate swap, USA Corp fixed the USD interest expense throughout the life of the debt and the amount due in USD at maturity.

On January 1, 20X1, USA Corp documents its designation of the fixed-for-fixed cross-currency swap as a cash flow hedge of the changes in the cash flows of the foreign currency-denominated debt (both interest and principal) resulting from foreign exchange risk.

The critical terms of the debt and the cross-currency swap are identical (i.e., notional, interest rate, cash flow date)
The fair value of the swap at inception is zero
Hedge effectiveness will be assessed based on changes in the total fair value of the swap

The following table summarizes the spot exchange rate and the fair value of the fixed-for-fixed cross-currency swap (excluding the accrued swap interest).

For purposes of this example, assume USA Corp only issues annual financial statements. In addition, for simplicity, interest expense (on the debt and swap) is recorded at the period-end spot rate rather than the average rate over the reporting period.

How should USA Corp account for this hedging relationship?

Analysis

USA Corp would record the following entry upon the issuance of the debt on January 1,20X1. There is no entry required to record the swap at inception of the hedge because it has a fair value of zero.

Dr. Cash	USD 860,000
Cr. Foreign-currency-denominated debt		USD 860,000
To record the issuance of the foreign-currency-denominated debt at the spot exchange rate at issuance of USD 0.86 = EUR 1

USA Corp would record the following entries on December 31, 20X1.

Dr. Foreign-currency-denominated debt	USD 50,000
Cr. Foreign currency transaction gain or loss		USD 50,000
To record the transaction gain on remeasurement of the foreign currency-denominated debt (from spot exchange rate at issuance of USD 0.86 = EUR 1 to the spot exchange rate at December 31 of USD 0.81 = EUR 1)
Dr. Interest expense	USD 64,800
Cr. Cash		USD 64,800
To record 8% interest on foreign currency-denominated debt at the spot rate of USD 0.81 = EUR 1
Dr. Cash	USD 4,600
Cr. Interest expense		USD 4,600
To record the swap accrual (EUR 1,000,000 × 8% ÷ USD 0.081) - (USD 860,000 × 7%)
Dr. Other comprehensive income	USD 50,000
Cr. Currency-swap payable		USD 50,000
To record the change in the clean value of the currency swap
Dr. Foreign currency transaction gain or loss	USD 50,000
Cr. Other comprehensive income		USD 50,000
To reclassify an amount from accumulated other comprehensive income to earnings to offset the foreign currency transaction gain recorded on the debt during the period
Dr. Foreign currency-denominated debt	USD 810,000
Cr. Cash		USD 810,000
To record the repayment of the foreign-currency-denominated debt at the current spot rate of USD 0.81 = EUR 1
Dr. Currency swap payable	USD 50,000
Cr. Cash		USD 50,000
To record the principal net settlement on the currency swap at the spot rate on the settlement date

The USD 50,000 loss on the swap offsets the USD 50,000 transaction gain on the foreign currency-denominated debt. In addition, the swap accrual reduced the total interest expense on the foreign currency-denominated debt to USD 60,200 (USD 64,800 interest expense – USD 4,600 swap accrual), which is synthetically equal to paying 7% on USD 860,000 of debt.

PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

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8.4 Foreign currency cash flow hedges

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