Currency Forward Contract –

Imports
A currency forward contract can be used by a business to reduce its risk
to foreign currency losses when it imports goods from overseas suppliers and
makes payment in the suppliers currency.
The basic concept of a currency forward contract is that its value should move
in the opposite direction to the value of the expected payment to the supplier.
In the case of a business making a payment in a foreign currency the currency
forward contract should be an agreement under which the business agrees to
buy the foreign currency in return for a fixed amount of its own currency.

By entering into such a contract any increase in value of the supplier payment
due to exchange rate changes is compensated by a decrease in value of the
foreign currency forward contract.

Currency Forward Contract Example

Suppose a business operating and reporting in US Dollars makes a purchase
from a supplier in Europe for 35,000 Euros. Since the supplier wants payment
in Euros the business is subject to the risks resulting from fluctuations in the
EUR/USD exchange rate. The business seeks to minimize its foreign currency
exposure by entering into a currency forward contract.

Accounting for the transaction needs to be considered at three different dates.

1. The purchase date when the product is purchased from the supplier and
the currency forward contract is entered into.
2. The balance sheet date when the value for the accounts payable and the
currency forward contract needs to be restated.
3. The settlement date when the business makes payment in Euros and the
currency forward contract must be settled.
Purchase and Currency Forward Contract
Date
The business makes a purchase from the supplier for the amount of 35,000
Euros on December 5, 2016. At the date of the purchase the
EUR/USD spot rate was 1.17 and when converted to USD the import purchase
is worth USD 40,950 (EUR 35,000 x 1.17). The supplier expects the business
to settle the account in 60 days on February 5, 2017.
The initial posting is to record the purchase from the supplier in the usual
manner.
Account Debit Credit
Purchases 40,950
Accounts payable 40,950
Total 40,950 40,950
Goods are purchased from the supplier

To reduce its exposure to foreign exchange risk the business enters into a 60
day currency forward contract.
The contract agrees that the business will buy 35,000 Euros in 60 days time
(February 5, 2017) at a EUR/USD forward rate of 1.22 and will therefore
receive/pay the difference between this rate and the rate on the settlement
date. The effect of this contract is to fix the value of the EUR 35,000 the
business will pay at USD 42,700 (35,000 x 1.22).
Balance Sheet Date
At the balance sheet date of December 31, 2016 the exchange rate has
changed. The EUR/USD spot rate is now 1.23 and the forward rate is 1.29. The
business must now record the changes in fair value of the liability (in this case
the accounts payable) and the currency forward contract.

Effect on Accounts Payable

The EUR/USD spot rate has changed from 1.17 to 1.23. The business is due to
pay the supplier EUR 35,000 equivalent to USD 43,050 (35,000 x 1.23) at the
balance sheet date. The liability currently shown in the accounting records is
USD 40,950 (35,000 x 1.17) and therefore the business has a foreign exchange
loss of USD 2,100 (43,050 – 40,950) calculated as follows.
EUR/USD spot rate at date of sale = 1.17

EUR/USD spot rate at balance sheet date = 1.23

Amount = EUR 35,000

Exchange loss = USD 35,000 x (1.23 - 1.17)

Exchange loss = USD 2,100

The foreign exchange loss is recorded as follows.

Account Debit Credit
Foreign exchange 2,100
Accounts payable 2,100
Total 2,100 2,100
Foreign exchange loss at balance sheet date

The debit entry is recorded as an expense in the income statement under the
heading of foreign exchange loss. The credit entry increases accounts payable
to its fair value at the balance sheet date of 43,050.

Effect on Currency Forward Contract

The EUR/USD forward rate has also moved from 1.22 to 1.29. Under the
currency forward contract the business is owed the difference between the
two rates and records a gain calculated as follows.
EUR/USD forward rate at date of sale = 1.22

EUR/USD forward rate at balance sheet date = 1.29

Amount = EUR 35,000

Exchange gain = USD 35,000 x (1.29 - 1.22)

Exchange gain = USD 2,450

The exchange gain is recorded with the following currency forward contract
accounting entries.

Account Debit Credit

Forward contract 2,450
Foreign exchange gain 2,450
Total 2,450 2,450
Currency forward contract gain

The foreign exchange gain is posted to the income statement and a forward
contract asset is established representing the net amount due to the business
under the contract at the balance sheet date. It should be noted that under a
currency forward contract only the difference resulting from changes in
exchange rates is accounted for not the principal amount.
The effect of this gain is to offset the loss recorded above in relation to the
accounts payable amount.
Settlement Date
Assume for the sake of simplicity the business pays on the due date (February
5, 2017) which is also the settlement date for the currency forward contract.
On this date the EUR/USD spot rate is 1.31.

Effect on Accounts Payable

The business pays EUR 35,000 to the supplier which converted at the current
spot rate represents USD 45,850 (35,000 x 1.31). The business must now clear
the accounts payable balance of USD 43,050 and record a further foreign
exchange loss of USD 2,800 (45,850 – 43,050) calculated as follows.
EUR/USD spot rate at balance sheet date = 1.23

EUR/USD spot rate at settlement date = 1.31

Amount = EUR 35,000

Exchange loss = 35,000 x (1.31 - 1.23)

Exchange loss = 2,800

The foreign exchange loss is recorded as follows.

Account Debit Credit

Accounts payable 43,050
Foreign exchange 2,800
Cash 45,850
Total 45,850 45,850
Foreign exchange loss on settlement

Effect on Currency Forward Contract

Under the contract the business has agreed to buy EUR 35,000 for USD 42,700
(35,000 x 1.22). At the settlement date the spot rate is 1.31 and the business is
owed the difference between this rate and the contract rate of 1.22.

The total gain on the contract is calculated as follows.

EUR/USD forward rate at contract date = 1.22

EUR/USD forward rate at settlement date = 1.31

Amount = EUR 35,000

Exchange gain = 35,000 x (1.31 - 1.22)

Exchange gain = USD 3,150

Since the business has already recorded the gain up to the balance sheet date
of USD 2,450 the additional gain to be recorded is USD 700 (3,150 – 2,450)
calculated as follows.
EUR/USD forward rate at balance sheet date = 1.29

EUR/USD forward rate at settlement date = 1.31

Amount = EUR 35,000

Exchange gain = USD 35,000 x (1.31 - 1.29)

Exchange gain = USD 700

The additional exchange gain is recorded with the following currency forward
contract accounting entries.

Account Debit Credit

Forward contract 700
Foreign exchange 700
Total 700 700
Currency forward contract gain

Again the exchange gain is included in the income statement and the net
amount due to the business under the currency forward contract is increased
by 700

Summary of Movements
The effect of foreign exchange rate movements on both the accounts payable
balance and the currency forward contract are shown in the summary tables
below.

Accounts Payable
Date Purchase Year end Settle
EUR 35,000 35,000 35,000
Rate 1.17 1.23 1.31
USD 40,950 43,050 45,850
Loss -2,100 -2,800
Accounts payable

The purchase from the supplier is for EUR 35,000 which at the date of the
purchase is worth USD 40,950. When the business pays the supplier account
the exchange rate has changed, the business pays EUR 35,000 which is now
costs USD 45,850. In total the business has made a USD 4,900 (2,100 + 2,800)
foreign exchange loss.

Currency Forward Contract

Date Purchase Year end Settle
EUR 35,000 35,000 35,000
Rate 1.22 1.29 1.31
USD 42,700 45,150 45,850
Gain 2,450 700
Currency forward contract

The currency forward contract is entered into to try and mitigate the effect of
fluctuations in the exchange rate. The business buys the EUR 35,000 it expects
to pay to the supplier at the rate of 1.22 and under the contract will receive
the difference between this rate and the rate at the settlement date of 1.31
amounting to USD 3,150 (2,450 + 700).
In summary at the settlement date the business pays EUR 35,000 cash to the
supplier which converts to USD 45,850. In addition cash of USD 3,150 is
received from the currency forward contract giving a net cash payment of USD
42,700 (45,850 – 3,150). The difference between the value of the original
purchase contract of USD 40,950 and the cash paid of USD 42,700 is the
foreign exchange loss of USD 1,750.