A. Not a Hedge Accounting • Importing Transaction (Exposed Liability).

On December 1, 20x4, Dominador Company purchased inventory for US $1,000 payable on March 1
, 20x5 (i.e., the transaction is payable in dollars.

Also on December 1, 20x4, Dominador Company entered into the first forward contract to buy $l000
on March 1,20x5 for P40.15.

The journal entries to record the hedged item and hedging instrument are as follows:

Hedged Item - Importing Transaction Hedging Instrument – Forward Contracts

(Exposed Liability) (Broad Approach or Gross Position Accounting)
December 1, 20x4
Transaction Date Date of Inception/Hedging of 90 days Forwards
Inventory ($1,000 * ₱40) 40,000 FC Receivable from XD 40,000
Accounts Payable Pesos Payable to XD
40,000 (₱40.15 * $1,000)
To record purchase of goods 40,000
on account using the spot rate To record forward contract
on 12/1/x4. to buy $1,000 using forward
rate.
*XD-exchange dealer

At the date of the transaction, the Philippine firm records the forward con recognizing a pesos
payable and a foreign currency (FC) receivable of P40 number of pesos to be exchange dealer when
the forward contract matures. value of the forward contract is zero since the payable and the
receivable are offset. The value of the receivable from the dealer and the accounts purchase of
inventory are subject to changes in exchange rate, but the gains losses generally offset each other
since the terms and the amounts are equal.

If the financial statements are prepared on December l, 20x4, the value of the f contract is as follows:

Balance Sheet Presentation on 12/1/x4

FC Receivable from XD ₱40,150
Less: Pesos Payable to XD 40,150
Forward Contract (fair value) ₱ 0
December 31, 20x4
(Balance Sheet Date on intervening financial reporting date)
FC Transaction Loss 300 FC Receivable from XD 250
Accounts Payable FC Transaction Gain
[(₱40.30 - ₱40.00) * $1,000] 300 [(₱40.40 - ₱40.15) * $1,000] 250
To record a loss on the exposed To record a gain on foreign
liability denominated in foreign currency to be received from
currency. FC dealer .
*FC-foreign currency

The fair value of the forward contract is determined using the change in the rates. The forward rate
increased to P40,40 from P40.15. This results in an increase of P250 to the receivable from the
 exchange dealer. Recall that the payable tb the foreign exchange dealer is fixed by the foward
contract. Thus the forward contract hm a positive P250 value (asset) at this point (December 31 ). If
the financial statements are prepared on December 31, 20x4, the value of the forward contract is as
follows:

Balance Sheet Presentation on 12/1/x4

FC Receivable from XD (₱40.40 * $1,000) ₱40,400
Less: Pesos Payable to XD (fixed at ₱40.15) 40,150
Forward Contract (fair value – asset ) ₱ 250

This net value would be reported on the balance sheet. In addition, accounts payable would be
recorded at the spot rate, or P40,300. The income statement would report an exchange loss of P300
and an exchange gain of P250.

On March 1, 20x5 (the translation date and the settlement date), the journal entries are:

March 1, 20x5
Settlement Date Settlement Date/Date of Expiration of Contract
Accounts Payable 100 FC Transaction Loss 200
FC Transaction Gain FC Receivable from XD
[(₱40.30 - ₱40.20) * $1,000] [(₱40.40 - ₱40.20) * $1,000]
100 200
To record gain from 12/1/x4 to To record a loss on foreign
3/1/x5 on liability denominated currency to be received from
In FC. FC dealer.
Payable from XD 40,150
Cash
40,150
To record payment to
exchange dealer.
Investment in FC 40,200
FC Receivable from XD
40,200
To record receipt of foreign
currency.
Accounts Payable 40,200 Cash 40,200
Cash (refer to note below) Investment in FC
40,200 40,200
To record payment of accounts To record conversion of US
payable at spot rate. dollars into cash for payment
of accounts payable.
Note: This entry may be ignored and instead the
investment in FC will be outright credited in
payment of accounts payable. For succeeding
illustrations the conversion of FC to peso cash to
settle items acquired can be used.

The recorded balances in accounts payable and the FC receivable ore reflecting the spot rate on
March 1. 20x5. The pesos payable to the exchange dealer remain fixed at P40,150, the original
contracted amount. The entry above records the cash payment of P40, 150 and the reduction of the
pesos payable.

Also, the receivable is converted to the Investment in FC representing the $1,000 acquied in the
forward contract. Eventually, the dollars are converted to pesos to settle the accounts payable.

By obtaining the forward contract, the firm was able to establish at the transaction date the amount of
pesos (P40.150) that it would take to acquire the $1 ,000 needed to settle the account with the foreign
firm. Note, however. that the cost of the inventory of P40,000 was established on December 1.

If the forward contract had not been obtained. the firm would have had to pay P40.200 to settle the
account and would have reported a net loss of P200 on the exposed liability position. The net gain
from entering into the forward contract, however, largely canceled out the net loss on the exposed
liability position.

These transactions can be summarized in the following table.

Hedged Item (Exposed Liability) Hedging Instrument (Forward Contract)

Accounts Payable Balance Transaction FC Receivable Balance Transaction
gain (loss) gain (oss)
12/1/x4 ₱40,000 12/1/x4 ₱40,150
13/31/x4 40,300 (₱300) 13/31/x4 40,400 ₱250
3/1/x5 40,200 100 3/1/x5 40,200 (200)
Total gain (loss) (₱200) ₱50

Thus, the net effect is a P 150 loss when the forward contract is used.

Assume further that the inventory is sold to o third party at a price of P60,000 cash on March 1,
20x5, which was also the maturity date of the forward contract, It should be noted that the date is
coincidental and the sale of inventory is not settlement of the forward contract by physical delivery.
The journal entries to record the sale are as follows:

Cash 60,000
Sales
60,000
To record cash sales.
Cost of Goods Sold 40,000
Inventory
40,000
To record cost of sales.
Comparing the hedged position with one that is without the hedged (ignoring balance sheet date), the
hedged has achieved its objective as follows:

Without With Hedging

Hedging
Proceeds from sales ₱ 60,000 ₱ 60,000
Proceeds from contract [(₱40.20 - ₱40.15) * $1,000]*
 refer to the Net position accounting, the balance of the forward
- 50
contract of ₱50 on March 1, 20x5
Tote proceeds ₱ 60,000.00 ₱ 60,050.00

Sales ₱ 60,000 ₱ 60,000

Less: Cost of Goods Sold 40,000 40,000
Gross Profit ₱ 20,000 ₱ 20,000
Add(Deduct):
Foreign currency transaction gain (loss) - hedged item
(₱100-300) -200 -200
Foreign currency transaction gain (loss) – hedging instrument
(₱250-200) - 50
Net Income ₱ 19,800 ₱ 19,850

"Net" Position Accounting

The following illustrates the effects of "net" position accounting using the illustration above:
Hedged Item - Importing Transaction Hedging Instrument – Forward Contracts
(Exposed Liability) (Broad Approach or Gross Position Accounting)
December 1, 20x4
Transaction Date Date of Inception/Hedging of 90 days Forwards
Inventory ($1,000 * ₱40) 40,000 Memorandum Entry only.
Accounts Payable No formal journal entry as the fair value of forward
40,000 contract is zero.
To record purchase of goods
on account using the spot rate
on 12/1/x4.

On December l, the firm entered a contract to purchase inventory for $1,000 (the spot rate was P40
on that date). If the exchange rate did not change over the payment period, the firm would owe
P40.000 to settle the payable.

However, if the exchange rate increased to P40.20, the firm would have to pay P40,200 to settle the
debt ($1,000 * P40.20). On the other hand, if the exchange rate dropped to P39.80, the firm would
only need to pay P39,800 (or $1,000*P39.80).

Because the firm cannot perfectly estimate the change in the exchange rate. company might prefer to
eliminate this risk by entering into a forward contract dollars on March l, 20x5.

Since the forward rate on December 1, 20x4, to purchase dollars on March l, 20x5, is P40.15, the
company can buy $1,000 on March I for a guaranteed price of P40,150.

This fixed price means that .the firm has determined in advance the maximum (and exact) amount of
loss it will suffer—in this case P150 (P40.15, forward rate less P40, spot rate). Thus the firm is
protected from future increases in the exchange rate above P40.15. By locking into a set price, the
firm gains if the spot rate on March l, 20x5 increases above P40.15 and loses if the spot rate
decreases below P40.15.

The important point to note about the hedge is that the firm knows with certainty on December 1,
20x3, the amount of cash needed to purchase the asset.

It should be noted that the accounts payable for the inventory purchase ore using the spot rate on the
transaction date (on December 1, 20x3).

December 31, 20x4

(Balance Sheet Date on intervening financial reporting date)
FC Transaction Loss 300 FC Receivable from XD 250
Accounts Payable FC Transaction Gain
[(₱40.30 - ₱40.00) * $1,000] 300 [(₱40.40 - ₱40.15) * $1,000] 250
To record a loss on the exposed To record a gain on foreign
liability denominated in foreign currency to be received from
currency. FC dealer .

On December 31, 20x4, the spot rate increases from P40 to P40.30, resulting to an increase of P300
to accounts payable. The spot rate is used for accounts payable since that’s the amount needed to
settle the liability.

On the other hand, the fair value of the forward contract is determined using the change in the
forward rates. The forward rate increased to P40.40 from P40.15. This results in increase of P250
[(P40.40 P40.15) x $1.000] which is an asset since it arises because of a gain.

Thus the fair value forward contract has a debit balance of P250 value at this point (December 31,
20x4) an indication of an asset balance. In addition, accounts payable could be recorded at the spot
rate, or P40,300.

The financial statements are prepared on December 31, 20x4, the value of the trod contract is as
follows:

Forward Contract (debit balance – asset) ₱250

The income statement would report an exchange loss of P300 and an exchange gain of P250.

On March 1, 20x5 (the transaction date and the settlement date), the journal entries are:
March 1, 20x5
Settlement Date Settlement Date/Date of Expiration of Contract
Accounts Payable 100 FC Transaction Loss 200
FC Transaction Gain FC Receivable from XD
[(₱40.30 - ₱40.20) * $1,000] [(₱40.40 - ₱40.20) * $1,000]
100 200
To record gain from 12/1/x4 to To record a loss on foreign
3/1/x5 on liability denominated currency to be received from
In FC. FC dealer.
Accounts Payable 40,200 Cash 50
Cash (₱40.20 * $1,000) Forward Contract
40,200 50
 To record the payment of Net settlement received from the
exchange dealer. dealer on expiration or maturity
date of forward contract.

Hedging Instrument (Forward Contract)

FC Receivable Balance Transaction
On March 1, 20x5, the spot rate decreases to gain (oss)
P40.20 from P40.30, resulting to a decrease 12/1/x4 ₱40,150
in accounts payable of P100 [(₱40.30 - 13/31/x4 40,400 ₱250
₱40.20) * $1,000]. 3/1/x5 40,200 (200)
₱50
Once on the settlement date, the forward rate
on this date and the spot rate are identical, he change in the March 1 forward rate on December 31 to
the spot rate on March 1, 2010 is 0.20 or (P40.40 to P40.20). This results to a decrease to the fair
value of forward contract of P200, or [(₱40.40 - ₱40.20) * $1,000].