Forwards and Futures Go To Bob Jensens Flow

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Forwards and Futures Go To Bob Jensen’s Flow Chart http: //www. trinity. edu/rjensen/acct 5341/speakers/133

Forwards and Futures Go To Bob Jensen’s Flow Chart http: //www. trinity. edu/rjensen/acct 5341/speakers/133 flow. htm 3 -1

TRANSACTION MARKETS 3 -2 • Spot or Cash: Immediate exchange of property for payment

TRANSACTION MARKETS 3 -2 • Spot or Cash: Immediate exchange of property for payment • Forward: Later exchange of property for payment, t terms fixed today • Futures: Like forwards, but. . .

FORWARD CONTRACTS 3 -3 • Price setting mechanisms for deferred value dates • Totally

FORWARD CONTRACTS 3 -3 • Price setting mechanisms for deferred value dates • Totally flexible in terms of timing and size of transactions • Negotiated on a principal-to-principal basis • Introduce credit risk exposure to counterparties for profitable positions

FUTURES CONTRACTS • Price setting mechanisms for deferred value dates • Designed with specific

FUTURES CONTRACTS • Price setting mechanisms for deferred value dates • Designed with specific value dates and fixed contract sizes • Exchange traded, with bids and offers provided by exchange members • Daily cash settlements insure against the risk of counter-party defaults 3 -4

FINANCIAL INTEGRITY 3 -5 • Variation Margin: • Initial Margin: Good faith deposit or

FINANCIAL INTEGRITY 3 -5 • Variation Margin: • Initial Margin: Good faith deposit or collateral • Maintenance Level: Minimum below which account cannot fall One day’s gain or loss of the futures position (#contracts price change multiplier)

CUSTOMER PERFORMANCE BONDS Alternative Qualifying Instruments • • 3 -6 U. S. currency and

CUSTOMER PERFORMANCE BONDS Alternative Qualifying Instruments • • 3 -6 U. S. currency and Government securities Bank letters of credit GNMA pass-throughs Selected Brady bonds Selected sovereign securities NYSE, AMEX, S&P 500 and S&PMid. Cap stocks Selected mutual funds

Forecasted Transactions Versus Firm Commitments Forecasted transactions that are highly probable with a known

Forecasted Transactions Versus Firm Commitments Forecasted transactions that are highly probable with a known notional and cash flow risk from an unknown spot price or rate Firm commitments that are contracted with a specified notional and transaction price that eliminates cash flow risk but creates value risk equal to the difference between spot versus contracted price or rate 3 -7

Accounting for Forecasted Transactions Versus Firm Commitments Forecasted transactions are not booked or even

Accounting for Forecasted Transactions Versus Firm Commitments Forecasted transactions are not booked or even disclosed under present accounting standards. Firm commitments (more generally known as purchase commitments in the case of purchases) are to be disclosed but are not to be booked unless a significant loss anticipated. Then conservatism in dictates booking an anticipated loss reserve that is much like an allowance for warranty or bad debt expense. 3 -8

Examples 1 and 4 FAS 133 Appendix B Fair Value vs. Cash Flow Hedges

Examples 1 and 4 FAS 133 Appendix B Fair Value vs. Cash Flow Hedges See 133 ex 01 a. xls at http: //www. cs. trinity. edu/~rjensen/ 3 -9

Delta Ratio Effectiveness Testing 80%<Delta<125% Bounds Paragraph 146 in IAS 39 A hedge is

Delta Ratio Effectiveness Testing 80%<Delta<125% Bounds Paragraph 146 in IAS 39 A hedge is normally regarded as highly effective if, at inception and throughout the life of the hedge, the enterprise can expect changes in the fair value or cash flows of the hedged item to be almost fully offset by the changes in the fair value or cash flows of the hedging instrument, and actual results are within a range of 80 per cent to 125 per cent. For example, if the loss on the hedging instrument is 120 and the gain on the cash instrument is 100, offset can be measured by 120/100, which is 120 per cent, or by 100/120, which is 83 per cent. The enterprise will conclude that the hedge is highly effective. 3 -10

Example 4 from FAS 133 Paragraph 128 With 100% Delta Effectiveness Forecasted Transaction Entry

Example 4 from FAS 133 Paragraph 128 With 100% Delta Effectiveness Forecasted Transaction Entry Date Value Jan. 01 $1, 000 Jan. 31 $1, 025, 000 Inventory Book Value $0 $0 Cash Flow Hedge Value $0 $25, 000 = Change in Hedged Item Value $25, 000 = Change in Hedge Contract Value Delta = 1. 00 or 100% 3 -11

Example 4 from FAS 133 Paragraph 128 With 100% Delta Effectiveness Forecasted Transaction Entry

Example 4 from FAS 133 Paragraph 128 With 100% Delta Effectiveness Forecasted Transaction Entry Date Value Jan. 01 $1, 000 Jan. 31 $1, 025, 000 Jan. 31 Inventory Book Value $0 $0 Forward Contract P&L OCI Cash Flow Hedge Value $0 $25, 000 Debit 25, 000 0 Credit 25, 000 For cash flow hedges, adjust hedging derivative to fair value and offset to OCI to the extent of hedge effectiveness. 3 -12

Example 4 from FAS 133 Paragraph 128 With 90% Delta Effectiveness Forecasted Transaction Entry

Example 4 from FAS 133 Paragraph 128 With 90% Delta Effectiveness Forecasted Transaction Entry Date Value Jan. 01 $1, 000 Jan. 31 $1, 025, 000 Inventory Book Value $0 $0 Cash Flow Hedge Value $0 $22, 500 $25, 000 = Change in Hedged Item Value $22, 500 = Change in Hedge Contract Value Delta = 0. 90 or 90% 3 -13

Example 4 from FAS 133 Paragraph 128 With 90% Delta Effectiveness Forecasted Transaction Entry

Example 4 from FAS 133 Paragraph 128 With 90% Delta Effectiveness Forecasted Transaction Entry Date Value Jan. 01 $1, 000 Jan. 31 $1, 025, 000 Jan. 31 Inventory Book Value $0 $0 Forward Contract P&L OCI Cash Flow Hedge Value $0 $22, 500 Debit 22, 500 Credit 25, 000 Hedge accounting is allowed only to the degree of effectiveness if Delta is within 80%-125% range. 3 -14

Example 4 from FAS 133 Paragraph 128 With 75% Delta Effectiveness Forecasted Transaction Entry

Example 4 from FAS 133 Paragraph 128 With 75% Delta Effectiveness Forecasted Transaction Entry Date Value Jan. 01 $1, 000 Jan. 31 $1, 025, 000 Inventory Book Value $0 $0 Cash Flow Hedge Value $0 $18, 750 $25, 000 = Change in Hedged Item Value $18, 750 = Change in Hedge Contract Value Delta = 0. 75 or 75% 3 -15

Example 4 from FAS 133 Paragraph 128 With 75% Delta Effectiveness Forecasted Transaction Entry

Example 4 from FAS 133 Paragraph 128 With 75% Delta Effectiveness Forecasted Transaction Entry Date Value Jan. 01 $1, 000 Jan. 31 $1, 025, 000 Jan. 31 Inventory Book Value $0 $0 Forward Contract P&L OCI Cash Flow Hedge Value $0 $18, 750 Debit 18, 750 Credit 18, 750 0 When the hedge effectiveness lies outside the 80%-125% range, hedge accounting is not allowed. 3 -16

Example 4 Modified As Follows Forecasted Transaction Entry Inventory Book Cash Flow Hedge Date

Example 4 Modified As Follows Forecasted Transaction Entry Inventory Book Cash Flow Hedge Date Jan. 01 Jan. 31 Feb. 28 Mar. 31 Value $0 $0 $0 $1, 050, 000 Value $0 $18, 750 $25, 000 $50, 000 Value $1, 000 $1, 025, 000 $1, 050, 000 Suppose the inventory is purchased on March 31. Suppose the inventory is sold on April 30 for $1, 100, 000. 3 -17

Example 4 Modified February 28 Adjustment of Forward Contract Forecasted Transaction Entry Date Value

Example 4 Modified February 28 Adjustment of Forward Contract Forecasted Transaction Entry Date Value Jan. 01 $1, 000 Jan. 31 $1, 025, 000 Feb. 28 $1, 025, 000 Inventory Book Value $0 $0 $0 Cash Flow Hedge Value $0 $18, 750 $25, 000 Debit Credit Feb. 28 Forward Contract 6, 250 P&L 18, 750 OCI 25, 000 Bal. 25, 000 0 25, 000 Hedge effectiveness can be initially designated as being tested on a cumulative basis. 3 -18

Example 4 Modified March 31 Adjustment of Forward Contract Forecasted Transaction Entry Date Value

Example 4 Modified March 31 Adjustment of Forward Contract Forecasted Transaction Entry Date Value Jan. 01 $1, 000 Feb. 28 $1, 025, 000 Mar. 31 $1, 050, 000 Inventory Book Value $0 $0 $1, 050, 000 Mar. 31 Forward Contract P&L OCI Cash Flow Hedge Value $0 $25, 000 $50, 000 Debit Credit 25, 000 0 25, 000 Bal. 50, 000 0 50, 000 The forward contract is settled for $50, 000 in cash to offset the increase to $1, 050, 000 of the hedged item’s price. FAS 133 says carry forward OCI balance until inventory is sold. IAS 39 has an OCI basis adjustment on March 31, unlike FAS 133. 3 -19

Example 4 Modified March 31 Purchase of Inventory Debit Credit Mar. 31 Cash 50,

Example 4 Modified March 31 Purchase of Inventory Debit Credit Mar. 31 Cash 50, 000 Forward contract 50, 000 Mar. 31 Inventory Cash Bal. 50, 000 0 1, 050, 000 (1, 000) Under IAS 39, there will also be an entry to close the $50, 000 in OCI to P&L. Under FAS 133, there will be no such basis adjustment until the inventory is sold. 3 -20

Example 4 from FAS 133 Paragraph 128 April 30 Basis Adjustment of OCI Forecasted

Example 4 from FAS 133 Paragraph 128 April 30 Basis Adjustment of OCI Forecasted Transaction Sales Date Jan. 01 Apr. 30 Amount $0 $1, 100, 000 OCI P&L Inventory Book Value $0 $1, 050, 000 Debit 50, 000 Cash Flow Hedge Value $0 $0 Credit Bal. 0 50, 000 (50, 000) The sales profit of $1. 1 million less $1. 05 million is $50, 000 without hedging. With a cash flow hedge, retained earnings is increased by another $50, 000 that locked in inventory value at $1 million. 3 -21

Basis Adjustment Alternatives The carrying value of a hedging offset account (OCI, Firm Commitment,

Basis Adjustment Alternatives The carrying value of a hedging offset account (OCI, Firm Commitment, or Balance Sheet Item) may be written off prematurely whenever the hedge becomes severely ineffective. Under IAS 39, the carrying value of an effective hedge is written off when the hedge expires or is dedesignated. See Paragraphs 162 and 163 of IAS 39. Under FAS 133, the carrying value of an effective hedge is carried forward until the ultimate disposition of the hedged item (e. g. inventory sale or depreciation of equipment). See Paragraph 31 of FAS 133. 3 -22

Example 4 Modified April 30 Sale of Inventory Apr. 30 P&L (CGS) Inventory Debit

Example 4 Modified April 30 Sale of Inventory Apr. 30 P&L (CGS) Inventory Debit Credit Bal. 1, 050, 000 1, 000 0 Apr. 30 Cash 1, 100, 000 P&L (Sales) 1, 100, 000 (100, 000) The sales profit of $1. 1 million less $1. 05 million is $50, 000 without hedging. With a cash flow hedge, retained earnings is increased by another $50, 000 that locked in inventory value at $1 million. 3 -23

Cash Flow Hedge of a Precious Metal or Any Hedged Item to be Carried

Cash Flow Hedge of a Precious Metal or Any Hedged Item to be Carried at Value Forecasted Transaction Entry Date Value Jan. 01 $1, 000 Jan. 31 $1, 025, 000 Gold Book Value $0 $0 Cash Flow Hedge Value $0 $22, 500 $25, 000 = Change in Hedged Item Value $22, 500 = Change in Hedge Contract Value Delta = 0. 90 or 90% 3 -24

Cash Flow Hedge of a Precious Metal or Any Hedged Item to be Carried

Cash Flow Hedge of a Precious Metal or Any Hedged Item to be Carried at Value Forecasted Transaction Entry Date Value Jan. 01 $1, 000 Jan. 31 $1, 025, 000 Jan. 31 Gold Book Value $0 $0 Forward Contract P&L OCI Cash Flow Hedge Value $0 $22, 500 Debit 22, 500 Credit 22, 500 0 Paragraph 29(d) of FAS 133 prohibits the hedged item to be any item that is or will be carried on the books at fair value after acquisition. 3 -25

New Example Coming Up 3 -26

New Example Coming Up 3 -26

Firm Commitment with Contracted Price With 100% Delta Effectiveness Firm Commitment Entry Date Jan.

Firm Commitment with Contracted Price With 100% Delta Effectiveness Firm Commitment Entry Date Jan. 01 Jan. 31 Value $1, 000 $975, 000 Inventory Book Value $0 $0 Fair Value Hedge Value $0 $25, 000 -$25, 000 = Change in Value of Hedged Item $25, 000 = Change in Value of Hedge Contract Delta = 1. 00 = 100% 3 -27

Firm Commitment with Contracted Price With 100% Delta Effectiveness Firm Commitment Entry Date Value

Firm Commitment with Contracted Price With 100% Delta Effectiveness Firm Commitment Entry Date Value Jan. 01 $1, 000 Jan. 31 $975, 000 Jan. 31 Inventory Book Value $0 $0 Fair Value Hedge Value $0 $25, 000 Debit Forward contract 25, 000 P&L 0 Firm commitment Credit 25, 000 For firm commitments, the fair value hedge is adjusted to full value with the effective portion to firm commitment. 3 -28

Firm Commitment with Contracted Price With 90% Delta Effectiveness Firm Commitment Entry Date Value

Firm Commitment with Contracted Price With 90% Delta Effectiveness Firm Commitment Entry Date Value Jan. 01 $1, 000 Jan. 31 $975, 000 Jan. 31 Inventory Book Value $0 $0 Fair Value Hedge Value $0 $22, 500 Debit Forward contract 22, 500 P&L 2, 500 Firm commitment Credit 25, 000 Hedge accounting is allowed only to the degree of effectiveness if Delta is within 80%-125% range. 3 -29

Firm Commitment with Contracted Price With 75% Delta Effectiveness Firm Commitment Entry Date Value

Firm Commitment with Contracted Price With 75% Delta Effectiveness Firm Commitment Entry Date Value Jan. 01 $1, 000 Jan. 31 $975, 000 Jan. 31 Inventory Book Value $0 $975, 000 Forward contract P&L Firm commitment Fair Value Hedge Value $0 $18, 750 Debit 18, 750 Credit 18, 750 0 When the hedge effectiveness lies outside the 80%-125% range, hedge accounting is not allowed. 3 -30

New Example Coming Up 3 -31

New Example Coming Up 3 -31

Example 1 from FAS 133 Paragraph 105 With 100% Delta Effectiveness Inventory on Hand

Example 1 from FAS 133 Paragraph 105 With 100% Delta Effectiveness Inventory on Hand Entry Date Value Jan. 01 $1, 000 Jan. 31 $975, 000 Jan. 31 Inventory Book Value $1, 000 $975, 000 Forward contract P&L Inventory Fair Value Hedge Value $0 $25, 000 Debit 25, 000 0 Credit 25, 000 When the hedged item is already booked at historical cost, change its accounting to fair value during hedging period. 3 -32

Example 1 from FAS 133 Paragraph 105 With 90% Delta Effectiveness Inventory on Hand

Example 1 from FAS 133 Paragraph 105 With 90% Delta Effectiveness Inventory on Hand Entry Date Value Jan. 01 $1, 000 Jan. 31 $ 975, 000 Jan. 31 Inventory Book Value $1, 000 $ 975, 000 Forward contract P&L Inventory Fair Value Hedge Value $0 $22, 500 Debit 22, 500 Credit 25, 000 Hedge accounting is allowed only to the degree of effectiveness if Delta is within 80%-125% range. 3 -33

Example 1 from FAS 133 Paragraph 105 With 75% Delta Effectiveness Inventory on Hand

Example 1 from FAS 133 Paragraph 105 With 75% Delta Effectiveness Inventory on Hand Entry Date Jan. 01 Jan. 31 Fair Value Hedge Value $1, 000 $0 1, 000 (no change) $18, 750 Debit Credit Jan. 31 Forward contract 18, 750 P&L 18, 750 When the hedge effectiveness lies outside the 80%-125% range, hedge accounting is not allowed. 3 -34 Value $1, 000 $975, 000 Inventory Book

Cumulative Dollar Offset Hedging Actually is More Complicated See 133 ex 07 a. xls

Cumulative Dollar Offset Hedging Actually is More Complicated See 133 ex 07 a. xls at http: //www. cs. trinity. edu/~rjensen/ 3 -35

Forward Versus Futures Contracts Quotations from Walter Teets September 7, 2000 email message to

Forward Versus Futures Contracts Quotations from Walter Teets September 7, 2000 email message to Bob Jensen The error in our case is simply that the futures values (due to changes in either spot or futures prices) shouldn't be present valued, since there is daily settling up. But the (change in) values of the anticipated cash flows of the hedged item should be present valued, because there is usually no periodic settling of the cash flows associated with the hedged item. The change to the case is minor; the major point of the futures case is to show exclusion of the change in the difference between future and spot price from the determination of effectiveness. Present valuing the cash flow associated with the anticipated transaction, while not present valuing the futures (change in) value adds additional ineffectiveness to the hedging relation. Walter Teets at Gonzaga University 3 -36

KPMG Example 4. 2 Cumulative Dollar Offset 3 -37

KPMG Example 4. 2 Cumulative Dollar Offset 3 -37

New Example Coming Up 3 -38

New Example Coming Up 3 -38

Fair Value FX Hedging Example 3 from FAS 133 Paragraph 121 Example 3 illustrates

Fair Value FX Hedging Example 3 from FAS 133 Paragraph 121 Example 3 illustrates a firm commitment to purchase a machine on May 2 for 270, 000 Dfl Dutch guilders which exposes the firm to both a fair value risk and a foreign exchange (FX) risk. MNO enters a forward contract FX fair value hedge in which this company enters elects to hedge the 270, 000 Dfl with equivalent 240, 000 DM in German marks that it apparently had on hand on February 3. Although the example hedges in German DM currency, the firm declares this a fair value hedge of the firm commitment in U. S. dollars. To the extent of hedge effectiveness, the account Firm Commitment is used to offset changes in the value of the forward contract during the 3 -39 hedging period.

Cash Flow FX Hedging Example 10 from FAS 133 Paragraph 165 Example 10 illustrates

Cash Flow FX Hedging Example 10 from FAS 133 Paragraph 165 Example 10 illustrates DEF Company’s hedging of foreign currency risk of on three expected installments of 1, 000 DM German marks. As a cash flow hedge, other comprehensive income is used to offset changes in the value of the hedging forward contract to the extent that the contract is effective in hedging FX risk. But the effectiveness tests are very complicated as explained in Paragraph 169 3 -40

Cash Flow FX Hedging Example 10 from FAS 133 Paragraph 169. As each royalty

Cash Flow FX Hedging Example 10 from FAS 133 Paragraph 169. As each royalty is earned, DEF recognizes a receivable and royalty income. The forecasted transaction (the earning of royalty income) has occurred. The receivable is an asset, not a forecasted transaction, and is not eligible for cash flow hedge accounting. Nor is it eligible for fair value hedge accounting of the foreign exchange risk because changes in the receivable's fair value due to exchange rate changes are recognized immediately in earnings. (paragraph 21(c) prohibits hedge accounting in that situation. ) Consequently, DEF will dedesignate a proportion of the forward contract corresponding to the earned royalty. As the royalty is recognized in earnings and each proportion of the derivative is dedesignated, the related derivative gain or loss in accumulated other comprehensive income is reclassified into earnings. After that date, any gain or loss on the dedesignated proportion of the derivative and any transaction loss or gain on the royalty receivable will be recognized in earnings and will substantially offset each other. 3 -41

Example 10 in FAS 133 Appendix B Cash Flow Hedging of FX Risk See

Example 10 in FAS 133 Appendix B Cash Flow Hedging of FX Risk See 133 ex 10. doc at http: //www. cs. trinity. edu/~rjensen/ See 133 ex 10 a. xls at http: //www. cs. trinity. edu/~rjensen/ 3 -42

FORWARD/FUTURES PRICING Spot Price + Cost of Carry Expense of holding (financing, storage, insurance,

FORWARD/FUTURES PRICING Spot Price + Cost of Carry Expense of holding (financing, storage, insurance, etc. ) less income generated from spot Futures/Forward Price Basis = +/-(Futures - Spot) 3 -43

BASIS AND CONVERGENCE Price F =S e e F O S O Time 3

BASIS AND CONVERGENCE Price F =S e e F O S O Time 3 -44

SPECULATIVE TRADES 3 -45 • Outright positions • Basis trades / arbitrage • Calendar

SPECULATIVE TRADES 3 -45 • Outright positions • Basis trades / arbitrage • Calendar spreads • Inter-market spreads - TEDs, LEDs, BEDs, NOBs, etc.

FUTURES HEDGING Sources of Uncertainty 3 -46 • Rounding error • Cross-market (spread) risk

FUTURES HEDGING Sources of Uncertainty 3 -46 • Rounding error • Cross-market (spread) risk • Mismatching value dates (basis risk) • Timing of variation settlement cashflows

TIMING CONSIDERATION Problem: Futures results are realized daily, the effect on the exposure occurs

TIMING CONSIDERATION Problem: Futures results are realized daily, the effect on the exposure occurs in a deferred period Daily Futures Results 0 . . . Hedge Value Date t Time Solution: Tail the hedge to generate the present value of the desired price effects 3 -47

Tailing Futures Hedges/Tailing Spreads http: //www. kawaller. com/pdf/tails. pdf An untailed hedge ignores the

Tailing Futures Hedges/Tailing Spreads http: //www. kawaller. com/pdf/tails. pdf An untailed hedge ignores the difference between the time futures gains or losses are realized and the time the price effects on the associated cash market exposures are realized. A tailed hedge, on the other hand, takes these timing considerations into consideration. Put another way, an untailed hedge ignores the effects of financing costs or investment returns associated with daily variation margin settlements of futures contracts; a tailed hedge these effects. 3 -48

Tailing Futures Hedges/Tailing Spreads http: //www. kawaller. com/pdf/tails. pdf While tailed hedges should be

Tailing Futures Hedges/Tailing Spreads http: //www. kawaller. com/pdf/tails. pdf While tailed hedges should be recognized as more perfect from an economic perspective, untailed hedges have the advantage of offering the appearance of a better offset from an accounting point of view when deferral accounting methods are employed. Moreover, maintaining a correctly tailed hedge position requires an ongoing adjustment of the hedge position, while untailed hedges need no analogous adjustments. 3 -49

Tailing Futures Hedges/Tailing Spreads http: //www. kawaller. com/pdf/tails. pdf Importantly, the correct number of

Tailing Futures Hedges/Tailing Spreads http: //www. kawaller. com/pdf/tails. pdf Importantly, the correct number of contracts for this latter case will tend to increase as the passage of time erodes the difference between present values and future values. Ultimately, by the time the hedge value date is reached, the discounted present value will converge to the $500 amount. Thus, over time the required hedge will gradually rise to twenty contracts. This second case is an example of a tailed hedge, where the tail is the number of contracts needed to adjust for this present valuing effect. 3 -50

MARK-TO-MARKET VALUATIONS Forward Contracts MV = F(t+1) - F(t) d (1+ r) 360 =

MARK-TO-MARKET VALUATIONS Forward Contracts MV = F(t+1) - F(t) d (1+ r) 360 = F(t+1) - F(t) (1+r)n MV = Market Value F(i) = Forward Price at time i r= Zero coupon rate (to forward value date) d = Days to the forward value date n = Compounding periods to forward value date 3 -51

Complexities of Paragraph 63(c) of FAS 133 See KPMG 1 A Sheet in 133

Complexities of Paragraph 63(c) of FAS 133 See KPMG 1 A Sheet in 133 ex 07 a. xls at http: //www. cs. trinity. edu/~rjensen/ 63(c). If the effectiveness of a hedge with a forward or futures contract is assessed based on changes in fair value attributable to changes in spot prices, the change in the fair value of the contract related to the changes in the difference between the spot price and the forward or futures price would be excluded from the assessment of hedge effectiveness. 3 -52

CASE 3 - Firm Commitment Hedged with Forward Contract • On 9/30/2001, Global. Tech.

CASE 3 - Firm Commitment Hedged with Forward Contract • On 9/30/2001, Global. Tech. Co, a U. S. company issues a purchase order to a foreign supplier for equipment to be delivered and paid for at 3/31/2002. The terms of the agreement meet the criteria for a firm commitment. • The price is denominated in the foreign currency— FC 10, 000. • The company simultaneously enters into a forwardexchange contract, which matures 3/31/2002, in order to receive FC 10, 000 and pay U. S. $6, 600, 000. 3 -53

CASE 3 - Firm Commitment Hedged with Forward Contract Forward Rates Spot Rates for

CASE 3 - Firm Commitment Hedged with Forward Contract Forward Rates Spot Rates for 3/31/2002 9/30/2001 FC 1 = $0. 65 FC 1 = $0. 66 12/31/2001 FC 1 = $0. 67 FC 1 = $0. 69 3/31/2002 FC 1 = $0. 69 3 -54

CASE 3 - Firm Commitment Hedged with Forward Contract The entity documents the following:

CASE 3 - Firm Commitment Hedged with Forward Contract The entity documents the following: – Effectiveness will be measured by (a) comparing the change in the fair value of the forward contract attributable to changes in spot rates with (b) the changes in the fair value of the firm commitment attributable to changes in the spot rates – The spot-forward difference will be excluded from the assessment of effectiveness and recorded through earnings 3 -55

CASE 3 - Firm Commitment Hedged with Forward Contract The following demonstrates the journal

CASE 3 - Firm Commitment Hedged with Forward Contract The following demonstrates the journal entries to record this hedge under Statement 133: At 9/30/2001, no entry is recorded under Statement 133 because a cash payment is not made and the contract has a zero value. 3 -56

CASE 3 - Firm Commitment Hedged with Forward Contract Entries recorded at 12/31/2001 Forward

CASE 3 - Firm Commitment Hedged with Forward Contract Entries recorded at 12/31/2001 Forward contract Earnings 295, 567 To record the forward contract fair value (present value at a 6% discount rate of ((. 69 –. 66) x FC 10 million); includes both effective portion of hedge and ineffectiveness due to changes in the forward rate. Earnings Firm commitment 197, 044 To record the change in the fair value of the foreign-currency component of the firm commitment attributable to the change in spot rates ((. 65 –. 67) x FC 10 million), discounted at 6%. 3 -57

CASE 3 - Firm Commitment Hedged with Forward Contract Entries recorded at 3/31/2002 Forward

CASE 3 - Firm Commitment Hedged with Forward Contract Entries recorded at 3/31/2002 Forward contract Earnings 4, 433 To record time value change as there was no change in the forward rate (assumption for illustrative purposes only). Earnings Firm commitment 202, 956 To record the change in the fair value of the foreign-currency component of the firm commitment attributable to the change in spot rates ((. 65 –. 69) x FC 10 million) – 197, 044 3 -58

CASE 3 - Firm Commitment Hedged with Forward Contract 3/31/2002 (continued) Cash 300, 000

CASE 3 - Firm Commitment Hedged with Forward Contract 3/31/2002 (continued) Cash 300, 000 Forward contract 300, 000 To record cash receipt upon maturity of forward contract Equipment Firm commitment Cash 6, 500, 000 400, 000 To record purchase of equipment 3 -59 6, 900, 000

CASE 4 – Example 7 from Appendix B of FASB Statement 133 • Designation

CASE 4 – Example 7 from Appendix B of FASB Statement 133 • Designation and Discontinuance of a Cash Flow of the Forecasted Purchase of Inventory 3 -60