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.

Click Here to View the Answer for the Initial Case.

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.

 

Hedging a Firm Commitment HK$ Purchase with a
:HK$ Forward--Main Scenario
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)    

 

Income Statement--Quarter ending 12-31-X1   
Other Income
   Gain on Forward Contract
   Loss on Firm Commitment

 676,145
 (676,145)
      Total Other Income            0

 

Balance Sheet At 12-31-X1
Forward Contract

676,145

Firm Commitment

676,145

 

:HK$ Forward--Main Scenario
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)
   

 

:HK$ Forward--Main Scenario
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)

 

Income Statement--Quarter Ending 3-31-X2
Other Income
   Loss on Forward Contract
   Gain on Firm Commitment

 (119,594)
 119,594
      Total Other Income             0

 

Balance Sheet At 3-31-X2
Cash
Equipment

 (7,356,783)
 7,356,783

 

 

Hedging a Forecasted HK$ Purchase with a
:HK$ Forward--Alternative Scenario A
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)    

 

 

Income Statement--Quarter Ending 12-31-X1
Net Income 0
Other Comprehensive Income
  Gain on Forward Contract
    Total Comprehensive Income

676,145
676,145

 

 

Balance sheet At 12-31-X1
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)    

 

 

Income Statement--Quarter Ending 3-31-X2
Net Income 0
Other Comprehensive Income
  Loss on Forward Contract
    Total Comprehensive Income

(119,594
 (119,594)

 

 

Balance Sheet At 3-31-X2   
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

:US$ Forward--Alternative Scenario B Firm Commitment
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

 

:US$ Forward--Alternative Scenario B Firm Commitment
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

:US$ Forward--Alternative Scenario B Firm Commitment
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 )    

 

:US$ Forward--Alternative Scenario B
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)    

 

Income Statement--Quarter Ending 3-31-X2
Other Income
   Loss on Forward Contract
   Gain on Firm Commitment

(116,698)
119,594
       Total Other Income     2,896

 

 

Balance Sheet At 3-31-X2
Cash (7,341,366) Retained Earnings 15,417
Equipment 7,356,783    

 

 

Hedging a Forecasted HK$ Purchase with a
:US$ Forward--Alternative Scenario C

 

:US$ Forward--Alternative Scenario C Forecasted Transaction
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)    

 

:US$ Forward--Alternative Scenario C Forecasted Transaction
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

 

Balance Sheet At 12-31-X1
Forward

688,666

AOCI

676,145

    Retained Earnings

  12,521

 

:US$ Forward--Alternative Scenario C Forecasted Transaction
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$60,780 x 121.03954:US$))
   

 

 

:US$ Forward--Alternative Scenario C Forecasted Transaction
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)    

 

 

Income Statement--Quarter Ending 3-31-X2
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)

 

 

Balance Sheet At 3-31-X2
Cash (7,341,366) AOCI 556,551
Equipment 7,913,334 Retained Earnings   15,417