Gannonsan Micro-Brewery: Accounting for Forwards
Hedging Foreign Currency Transactions
Walter R. Teets Robert Uhl
Main Scenario: The Gannonsan Micro-Brewery (GMB), a Japanese company, is experimenting with a new brew Gannon Stoutas a local competitor to the famous Guinness. GMB's investigations have led to the determination that new equipment, including a stainless steel brewkettle, lauter tune, whirlpool, 6 fermenting and storage tanks, and a hot water tank, all of the highest quality, is needed. Such equipment has been located; it is produced by the German company Bierhaus GMBH, and is available through a distributor in Hong Kong. On November 1, 19X1, GMB signed a contract to purchase the equipment on March 31, 19X2, at a cost of 470,100 Hong Kong dollars (HK$), payable in HK$. GMB is concerned about foreign currency exchange rate movements over the contract period, and wishes to x the price in yen, its functional currency. Therefore, the company enters into a forward to purchase HK$470,100 for ¥ = 7,356,783, when the exchange rate for settlement on March 31, 19X2, is ¥ = 15.6494 per HK$.
When the contract is signed, and the forward entered into, there are no journal entries. At that time, the forward contract has a value of zero, as does the rm commitment.
1. On December 31, 19X1, the ¥:HK$ forward exchange rate for settlement on March 31, 19X2, has changed to ¥ = 17.0877 per HK$. Prepare required journal entries, and summary financial statements, showing the results of the change in exchange rates. Assume that GMB has determined that, in the long run, transparent financial statements will be beneficial, so will prepare statements in conformity with U.S. GAAP. (Ignore present value considerations in this case, both in the main scenario and the alternative scenarios.)
2. On March 31, 19X2, the spot exchange rate is ¥ = 16.8333 per HK$. Make the required journal entries to (1) record the fair values of the firm commitment and forward; (2) reflect the settlement of the forward; and (3) record the purchase of the new equipment. Also, prepare summary financial statements reflecting the results of these transactions.
Alternative Scenarios:
Scenario A:
Assume GMB has not entered into a firm commitment to purchase the
equipment, but only forecasts the purchase of the equipment. Repeat requirements
1 and 2 above, assuming GMB enters into the ¥:HK$ hedge. In addition, prepare
adjusting entries needed at 12/31/X2 to record depreciation and related items,
assuming a ten-year useful life, no salvage, straight-line depreciation, and use
of the half-year convention. Click Here to
View the Answer for Scenario A.
Scenario B:
Assume again GMB has entered into a firm commitment, but will instead
enter into a ¥-US$ forward in the amount of US$60,780 to hedge the HK$ firm
commitment. Repeat requirements 1 and 2 above, assuming that in addition to the ¥:HK$
rates given above the ¥-US$ rates on November 1, December 31, and March
31 are 121.03954, 132.37000, and 130.45000. (Do not calculate depreciation
expense.) Click Here to View the Answer for
Scenario B.
Scenario C:
Assume GMB has not entered into a firm commitment to purchase the
equipment, but only forecasts the purchase of the equipment. Repeat requirements
1 and 2 above, assuming that in addition to the ¥:HK$
rates given above the ¥-US$ rates on November 1, December 31, and March
31 are 121.03954, 132.37000, and 130.45000. (Do not calculate depreciation
expense.) Click Here to View the Answer for
Scenario C.
Journal Entries, 12-31-X1 (in ¥) | ||
Forward Contract | 676,145 | |
Gain on Forward Contract | 676,145 | |
(To record the change in value of the forward contract November 01, 19X1, ¥ = 15.6494 per HK$ December 31, 19X1, ¥ = 17.0877 per HK$ (HK$470,100 x 17.0877¥:HK$) - (HK$470,000 x 15.6494¥:HK$) (HK$470,100 x 01.4383¥:HK$) = 676,145HK$) |
||
Loss on Firm Commitment | 676,145 | |
Firm Commitment | 676,145 | |
(To record the change in value of the hedged item) |
||
Gain on Forward Contract | 676,145 | |
Loss on Firm Commitment | 676,145 | |
(To close nominal accounts) |
Other Income Gain on Forward Contract Loss on Firm Commitment |
676,145 (676,145) |
Total Other Income | 0 |
Forward Contract |
676,145 |
Firm Commitment |
676,145 |
Journal entries, 3-31-X2 (in ¥) | ||
Loss on Forward Contract | 119,594 | |
Forward Contract | 119,594 | |
(To record the change in value of the forward contract December 31, 19X1, ¥ = 17.0877 per HK$ March 31, 19X2, ¥ = 16.8333 per HK$ (HK$470,100 x 16.8333¥:HK$) - (HK$470,000 x 17.0877¥:HK$) (HK$470,100 x -00.2544¥:HK$) = -119,594HK$) |
||
Firm Commitment | 119,594 | |
Gain on Firm Commitment | 119,594 | |
(To record the change in value of the hedged item) |
Foreign Currency (HK$) | 7,913,334 | |
Forward Contract | 556,551 | |
Cash | 7,356,783 | |
(To record settlement of the forward contract November 01, 19X1, ¥ = 15.6494 per HK$ March 31, 19X2, ¥ = 16.8333 per HK$ (HK$470,100 x 16.8333¥:HK$) - (HK$470,000 x 15.6494¥:HK$) (HK$470,100 x 01.1839¥:HK$) = 556,551HK$) |
||
Equipment | 7,356,783 | |
Firm Commitment | 556,551 | |
Foreign Currency (HK$) | 7,913,334 | |
(To record the purchase of the machine and close the Firm Commitment account) |
||
Gain on Forward Contract | 119,594 | |
Loss on Firm Commitment | 119,594 | |
(To close nominal accounts) |
Other Income Loss on Forward Contract Gain on Firm Commitment |
(119,594) 119,594 |
Total Other Income | 0 |
Cash Equipment |
(7,356,783) |
Journal Entries, 12-31-X1 (in ¥) | ||
Forward Contract | 676,145 | |
OCI | 676,145 | |
(To record the change in value of the forward contract November 01, 19X1, ¥ = 15.6494 per HK$ December 31, 19X1, ¥ = 17.0877 per HK$ (HK$470,100 x 17.0877¥:HK$) - (HK$470,000 x 15.6494¥:HK$) (HK$470,100 x 01.4383¥:HK$) = 676,145HK$) |
||
OCI | 676,145 | |
Accum. OCI | 676,145 | |
(To close nominal accounts) |
Net Income | 0 |
Other Comprehensive Income Gain on Forward Contract Total Comprehensive Income |
676,145 676,145 |
Forward Contract |
676,145 |
AOCI |
676,145 |
Journal entries, 3-31-X2 (in ¥) | ||
OCI | 119,594 | |
Forward Contract | 119,594 | |
(To record the change in value of the forward contract December 31, 19X1, ¥ = 17.0877 per HK$ March 31, 19X2, ¥ = 16.8333 per HK$ (HK$470,100 x 16.8333¥:HK$) - (HK$470,000 x 17.0877¥:HK$) (HK$470,100 x -00.2544¥:HK$) = -119,594HK$) |
||
Foreign Currency (HK$) | 7,913,334 | |
Forward Contract | 556,551 | |
Cash | 7,356,783 | |
(To record settlement of the forward contract November 01, 19X1, ¥ = 15.6494 per HK$ March 31, 19X2, ¥ = 16.8333 per HK$ (HK$470,100 x 16.8333¥:HK$) - (HK$470,000 x 15.6494¥:HK$) (HK$470,100 x 01.1839¥:HK$) = 556,551HK$) |
||
Equipment | 7,913,334 | |
Foreign Currency (HK$) | 7,913,334 | |
(To record the purchase of the machine HK$470,100 x 16.8333¥:HK$) |
||
AOCI | 119,594 | |
OCI | 119,594 | |
(To close nominal accounts) |
Net Income | 0 |
Other Comprehensive Income Loss on Forward Contract Total Comprehensive Income |
(119,594 (119,594) |
Cash |
(7,356,783) |
AOCI |
556,551 |
Equipment |
7,913,334 |
Journal entries, 12-31-X2 | ||
Depreciation Expense | 395,667 | |
Accumulated Depreciation | 395,667 | |
(To record depreciation, (7,913,334 ÷ 10) x .5) |
||
Reclassification Adjustment (OCI) | 27,828 | |
Depreciation Expense | 27,828 | |
(Reclassify OCI recognized in
Earnings (556,551 ÷ 10) x .5) |
Hedging a Firm Commitment HK$ Purchase with a
¥:US$ Forward--Alternative Scenario B
Preliminary Calculations
Firm Commitment | 11-1-X1 | 12-31-X1 | 3-31-X2 |
Forward rate for settlement on 3-31-X2 |
15.6494 |
17.0877 |
16.8333 |
Firm commitment, HK$ | (470,100) | (470,100) | (470,100) |
¥ Value, current rate | (7,356,783) | (8,032,928) | (7,913,334) |
¥ Value, original rate | (7,356,783) | (7,356,783) | (7,356,783) |
Fair Value of FC | -0- | (676,145) | (556,551) |
Change in Fair Value, gain (loss) | (676,145) | 119,594 |
Forward Contract | |||
Firm Commitment | 11-1-X1 | 12-31-X1 | 3-31-X2 |
Forward rate for settlement on 3-31-X2 |
121.03954 |
132.37000 |
130.45000 |
Forward purchase, US$ | 60,780 | 60,780 | 60,780 |
¥ Value, current rates | 7,356,783 | 8,045,449 | 7,928,751 |
¥ to be paid | 7,356,783 | 7,356,783 | 7,356,783 |
Fair Value of Forward | -0- | 688,666 | 571,968 |
Change in Fair Value gain (loss) | 688,666 | (116,698) | |
Ineffectiveness | 12,521 | 2,896 |
Total Ineffectiveness = $12,521 + $2,896 = $15,417
Foreign Currency (US$) | 7,928,751 | |
Forward Contract | 571,968 | |
Cash | 7,356,783 | |
(To record the settlement of the forward contract (US$60,780 x 130.45000¥:US$) and (US$60,780 x 121.03954¥:US$)) |
||
Cash | 15,417 | |
Foreign Currency (HK$) | 7,913,334 | |
Foreign currency (US$) | 7,928,751 | |
(Convert US$ to HK$ needed: balance in ¥) |
Equipment | 7,356,783 | |
Firm Commitment | 556,551 | |
Foreign Currency (HK$) | 7,913,334 | |
(To record the purchase of the machine and close the Firm Commitment account) | ||
Gain on Firm Commitment | 119,594 | |
Retained Earnings | 2,896 | |
Loss on Forward Contract | 116,698 | |
(To close nominal accounts) |
Other Income Loss on Forward Contract Gain on Firm Commitment |
(116,698) 119,594 |
Total Other Income | 2,896 |
Cash | (7,341,366) | Retained Earnings | 15,417 |
Equipment | 7,356,783 |
Hedging a Forecasted HK$ Purchase with a
¥:US$ Forward--Alternative Scenario C
Journal Entries, 12-31-X1 (in ¥) | ||
Forward Contract | 688,666 | |
OCI | 676,145 | |
Gain on Forward Contract | 12,521 | |
(To record the change in value of the forward contract (US$60,780 x 121.03954¥:US$) - (US$60,780 x 132.37000¥:US$)) |
||
OCI | 676,145 | |
Gain on Forward Contract | 12,521 | |
Retained Earnings | 12,521 | |
Accum. OCI | 676,145 | |
(To close nominal accounts) |
Other Income Gain on Forward Contract |
12,521 |
Total Other Income | 12,521 |
Other Comprehensive Income Gain on Forward |
676,145 |
Total Comprehensive Income | 688,666 |
Forward |
688,666 |
AOCI |
676,145 |
Retained Earnings |
12,521 |
Journal entries, 3-31-X2 (in ¥) | ||
OCI | 119,594 | |
Forward Contract | 116,698 | |
Gain on Forward Contract | 2,896 | |
(To record the change in value of the forward (US$60,780 x 132.37000¥:US$)- (US$60,780 x 130.45000¥:US$) and reclassify to earnings the remaining cumulative hedge ineffectiveness) |
||
Foreign Currency (US$) | 7,928,751 | |
Forward Contract | 571,968 | |
Cash | 7,356,783 | |
(To record the settlement of the forward contract (US$60,780 x 130.45000¥:US$) and (US$60,780 x 121.03954¥:US$)) |
Cash | 15,417 | |
Foreign currency (HK$) | 7,913,334 | |
Foreign Currency (US$) | 7,928,751 | |
(Convert US$ to HK$ needed; balance in ¥ |
||
Equipment | 7,913,334 | |
Foreign Currency (HK$) | 7,913,334 | |
(To record the purchase of the machine) | ||
AOCI | 119,594 | |
Gain on Forward Contract | 2,896 | |
Retained Earnings | 2,896 | |
OCI | 119,594 | |
(To close nominal accounts) |
Other Income Gain on Forward Contract |
2,896 |
Total Other Income | 2,896 |
Other Comprehensive Income Loss on Forward |
(119,594) |
Total Comprehensive Income | (116,698) |
Cash | (7,341,366) | AOCI | 556,551 |
Equipment | 7,913,334 | Retained Earnings | 15,417 |