Derivative Report: Testing and Accounting for Hedge Ineffectiveness Under FAS 133, Paragraph 168

By Angela L.J. Hwang and Robert E. Jensen

EXAMPLE

On 10/01/01, USC Co., a U.S. company, issues a purchase order to a German supplier, GMI Inc., for a machine to be
paid for on 03/31/02. The price is denominated in German marks (Deutsche Marks or DM) DM10,000,000. Althou
not make the purchase until 03/31/02, it has a firm commitment to do so and to pay 10 million DM in six months. Th
liability exposure to foreign exchange risk if DM appreciates over the next six months. To mitigate this uncertainty, U
fix the purchase cost in US$ by entering into a 6-month forward contract to purchase DM when the purchase order is
accepted by the German supplier, GMI. The spot rate on 10/01/01 is $0.65 per DM and the forward rate is $0.66 per
03/31/02 settlement. Therefore, USC enters into a forward contract on 10/01/01 with the Bank of Globe to pay US$6
exchange for the receipt of DM10,000,000 on 03/31/02, which can then be used to pay GMI. On entering into the co
neither receives nor pays a premium. Assuming the transaction meets the firm commitment criteria to record as a fair
accounting, how would USC address the following questions?
QUESTIONS

1. Discuss the expected results of entering into the forward contract and prepare required journal entries on 10/01/0
explicit regarding what is the hedged item and what is the hedging instrument.

2. On 12/31/01, the spot rate has changed to $0.67 per DM and forward exchange rate for settlement on 03/31/02 is
What is the impact of the change in exchange rates on journal entries, closing entries, and summary financial stateme

3. On 03/31/02, the spot rate has changed to $0.71 per DM. What are the journal entries to record: (1) the impact o
exchange rates, (2) the purchase of the new machine, (3) the settlement of the forward contract. In addition, evaluate
these events on financial statements.

4. Explain how Paragraph 168 has relevance in the transactions of this example. What is the reason we exclude fr
assessment of effectiveness the portion of the fair value of the forward contract attributable to the spot-forwa
(the difference between the spot exchange rate and the forward exchange rate)?

EXHIBIT 1
Supporting Calculations for Fair Value FX Hedge
Panel One: Input Data
Machine's Price in DM: 10,000,000
I
II
Spot Rate
Forward Rate
t
(0)
(1)
(2)

10/01/01
12/31/01
03/31/02

$/DM
Exchange Ratio
$0.65
$0.67
$0.71

$/DM
Exchange Ratio
$0.66
$0.69
N/A

Panel Two: Firm Commitment-- based on $/DM Spot Rate

At = It X DM10,000,000
*Bt = A0 - At

t
(0)
(1)
(2)

FX Adjusted Price
in US$
10/01/01
$6,500,000
12/31/01
$6,700,000
03/31/02
$7,100,000

III
Spot Rate

IV
Forward Rate
Yearly
Yearly
Discount
Discount Rate
Rate
6%
6%
6%
6%
6%
6%

Ct = IIIt / 12

Cumulative Change in
Monthly
FX Adjusted Price
Discount Rate
$0
0.5%
($200,000)
0.5%
($600,000)
0.5%

Panel Three: Forward Contract-- based on $/DM Forward Rate

Ft = IIt X DM10,000,000
*Gt = Ft - F0

Ht = IVt / 12

*Dt = PV of Bt
*Et = Dt - Dt-1
Present Value
Firm
Commitment
$0
($197,030)
($600,000)

Period Change in
Firm Commitment

*Jt = PV of Gt

*Kt = Jt - Jt-1

($197,030)
($402,970)

Present Value
t
(0)
(1)
(2)

FX Adjusted Price
in US$
10/01/01
$6,600,000
12/31/01
$6,900,000
03/31/02
$7,100,000

Cumulative Change in
Monthly
FX Adjusted Price
Discount Rate
$0
0.5%
$300,000
0.5%
$500,000
0.5%

*Columns with numbers in parentheses indicate a loss.

Column Purpose (To calculate)
Panel One: Input Data
I
Spot rate of US$/DM exchange ratio
II
Forward rate of US$/DM exchange ratio for the 03/31/02 forward contract
III
Yearly discount rate for spot rates
IV
Yearly discount rate for forward rates
Panel Two: Firm Commitment
A
Conversion of DM10,000,000 firm commitment to US$
B
Cumulative change in the value of the firm commitment in US$
C
Monthly discount rate for spot rates
D
Fair value of the firm commitment
E
Period change in the fair value of the firm commitment
Panel Three: Forward Contract
F
Conversion of DM10,000,000 forward contract to US$
G
Cumulative change in the value of the forward contract in US$
H
Monthly discount rate for forward rates
J
Fair value of the forward contract
K
Period change in the fair value of the forward contract

Forward
Contract
$0
$295,545
$500,000

Period Change in
Forward Contract
$295,545
$204,455

EXHIBIT 2
Summary of Journal Entries
(Numbers in parentheses indicate a Credit balance in the Balance column.)
Balance
Entry

Date
Debit
Credit
10/01/01 Forward contract
Cash
This entry is required only if the forward contract has value on 10/01/01
10/01/01 Firm commitment
Cash
This entry is required only if the firm commitment has value on 10/01/01

Dr. (Cr.)
$0
$0

$0
$0

1-1

12/31/01 Forward contract

Loss/gain from forward contract
To adjust the value of the forward contract

295,545
-

295,545

$295,545
($295,545)

1-2

12/31/01 Firm commitment

Loss/gain from firm commitment
To adjust the value of the firm commitment

197,030

197,030
-

($197,030)
$197,030

1-3

12/31/01 Loss/gain from firm commitment

Loss/gain from forward contract
Retained earnings
To close nominal accounts

295,545
-

197,030
98,515

$0
$0
($98,515)

2-1

03/31/02 Forward contract

Loss/gain from forward contract
To adjust the value of the forward contract

204,455
-

204,455

$500,000
($204,455)

2-2

03/31/02 Firm commitment

Loss/gain from firm commitment
To adjust the value of the firm commitment

402,970

402,970
-

($600,000)
$402,970

2-3

03/31/02 Loss/gain from firm commitment

Loss/gain from forward contract
Retained earnings
To close nominal accounts

204,455
198,515

402,970
-

$0
$0
$100,000

2-4

03/31/02 Cash
Firm commitment
Machinery and equipment
To record the purchase of the machine

2-5

03/31/02 Forward contract

Cash
To record the settlement of the forward contract

600,000
6,500,000

7,100,000 ($7,100,000)
$0
- $6,500,000

500,000

500,000
$0
- ($6,600,000)

EXHIBIT 3
Summary of Simplified Financial Statements
(Numbers in parentheses indicate a Credit balance.)
Summary Financial Statement Dr. (Cr.)
12/31/01
Loss (gain) from firm commitment
Loss (gain) from forward contract
Total Other Income

Income Statement

Balance Sheet
Assets
Liabilities & Equity

$197,030
($295,545)
($98,515)

Cash
Firm commitment
Forward contract
Machinery and equipment
Retained earnings

($197,030)
$295,545

$295,545
03/31/02
Loss (gain) from firm commitment
Loss (gain) from forward contract
Total Other Income

Cash
Firm commitment
Forward contract
Machinery and equipment
Retained earnings

($98,515)
($295,545)

$402,970
($204,455)
$198,515

($6,600,000)
$0
$0
$6,500,000
($100,000)

$100,000
$100,000