SFAS 133 also allows the use of cash flow hedge accounting for foreign currency derivatives used to hedge the cash flow risk associated with a forecasted foreign currency transaction. For hedge accounting to apply, the forecasted transaction must be probable (likely to occur), the hedge must be highly effective in offsetting fluctuations in the cash flow associated with the foreign currency risk, and the hedging relationship must be properly documented.
Accounting for a hedge of a forecasted transaction differs from accounting for a hedge of a foreign currency firm commitment in two ways:
1. Unlike the accounting for a firm commitment, there is no recognition of the forecasted transaction or gains and losses on the forecasted transaction.
2. The company reports the hedging instrument (forward contract or option) at fair value, but because no gain or loss occurs on the forecasted transaction to offset against, the company does not report changes in the fair value of the hedging instrument as gains and losses in net income. Instead, it reports them in other comprehensive income. On the projected date of the forecasted transaction, the company transfers the cumulative change in the fair value of the hedging instrument from other comprehensive income (balance sheet) to net income (income statement).
Forward Contract Cash Flow Hedge of a Forecasted Transaction:
ADVERTISEMENTS:
To demonstrate the accounting for a hedge of a forecasted foreign currency transaction, assume that Amerco has a long-term relationship with its German customer and can reliably forecast that the customer will require delivery of goods costing 1 million euros in March 2010. Confident that it will receive 1 million euros on March 1, 2010, Amerco enters into a forward contract on December 1, 2009, to sell 1 million euros on March 1, 2010, at a rate of $1.30.
The facts are essentially the same as those for the hedge of a firm commitment except that Amerco does not receive a sales order from the German customer until late February 2010.
Relevant exchange rates and the fair value of the forward contract are as follows:
Over the two accounting periods, the net impact on net income is $1,305,000, which equals the amount of net cash inflow realized from the sale.
Option Designated as a Cash Flow Hedge of a Forecasted Transaction:
Now assume that Amerco hedges its forecasted foreign currency transaction by purchasing a 1 million euro put option on December 1, 2009. The option, which expires on March 1, 2010, has a strike price of $1.32 and a premium of $0,009 per euro.
The fair value of the option at relevant dates is as follows:
Over two periods, net income increases by $1,311,000, equal to the net cash inflow realized from the export sale (Sales of $1,320,000 – Option purchase price of $9,000).
Use of Hedging Instruments:
There are probably as many different corporate strategies regarding hedging foreign exchange risk as there are companies exposed to that risk. Some companies simply require hedges of all foreign currency transactions. Others require the use of a forward contract hedge when the forward rate results in a larger cash inflow or smaller cash outflow than with the spot rate. Still other companies have proportional hedging policies that require hedging on some predetermined percentage (e.g., 50 percent, 60 percent, or 70 percent) of transaction exposure.
Companies are required to provide information on the use of derivative financial instruments to hedge foreign exchange risk in the notes to financial statements. Exhibit 9.3 presents disclosures made by Abbott Laboratories in its 2005 annual report. Abbott Labs uses forward contracts to hedge foreign exchange risk associated with anticipated foreign currency transactions, foreign currency denominated payables and receivables, and foreign currency borrowings.
Much of its hedging activity relates to intercompany transactions involving foreign subsidiaries. The table in Exhibit 9.3 discloses that- (1) Abbott’s forward contracts primarily are to sell foreign currencies for U.S. dollars, (2) 37 percent of Abbott’s $4,092 billion in forward contracts at December 31, 2005, was in euros, and (3) with the exception of contracts in British pounds, all of Abbott’s forward contracts had a negative fair value and it reported these on the balance sheet as liabilities.
Abbott Labs uses forward contracts exclusively to manage its foreign exchange risk. In contrast, the Coca-Cola Company reported using a combination of forward contracts and currency options in its foreign exchange risk hedging strategy. In its 2005 annual report, Coca-Cola reported recording an increase (decrease) to AOCI of approximately $55 million, $6 million, and $(31) million, respectively, in 2005, 2004, and 2003, on foreign currency cash flow hedges. The company had forward contracts and options with a fair value of $39 million at December 31, 2005, which it reflected in the prepaid expenses and other assets section on the consolidated balance sheet.
The Euro:
The introduction of the euro as a common currency throughout much of Europe reduced the need for hedging in that region of the world. For example, a German company purchasing goods from a Spanish supplier no longer has an exposure to foreign exchange risk because both countries use a common currency. This is also true for German subsidiaries of U.S. parent companies. However, any euro-denominated transactions between the U.S. parent and its German (or other euro zone) subsidiary continue to be exposed to foreign exchange risk.
One advantage of the euro for U.S. companies is that a euro account receivable from sales to a customer in, say, the Netherlands, acts as a natural hedge of a euro account payable on purchases from, say, a supplier in Italy. Assuming that similar amounts and time periods are involved, any foreign exchange loss (gain) arising from the euro payable is offset by a foreign exchange gain (loss) on the euro receivable. A company does not need to hedge the euro account payable with a hedging instrument such as a foreign currency option.