Question

On 1.1.2020, Sub-1 entered into a contract to purchase gold (inventories) from a foreign supplier, to be delivered in twelve months’ time on 31.12.2020. On that date, €1,500,000 will be payable on delivery.

Sub-1 does not wish to be exposed to changes in exchange rates. Therefore, it takes out a forward contract to purchase €1,500,000 in twelve months’ time at $/€ 0.95 ($1 = €0.95).

On 30.6.2020, the forward rate for 31.12.2020 is $/€ 0.90.

On 31.12.2020, when the gold inventories are delivered, the exchange (spot) rate is at $/€ 0.90.

Questions

1. What is the economic hedge objective of the forward contract entered into by Sub-1?

2. What are Sub-1’s journal entries on 30.6.2020 and 31.12.2020 if hedge accounting is not applied? The forward contract is an asset or a liability on 30.6.2020 (how much is it worth)? Why?

3. What are Sub-1’s journal entries on 30.6.2020 and 31.12.2020 if hedge accounting is applied?

4. Compared the impact in Sub-1’s Profit & Loss statement of the transactions (inventory purchase and forward contract) with and without hedge accounting being applied (focus on cost of goods sold, gain/loss from derivative contract and net income/loss).

Answer 1

1. What is the economic hedge objective of the forward contract entered into by Sub-1? Objective is

Domestic Currency is USD

Foreign Currency is Euro

above is interpreted from the payment to be made in Euros and secondly purchase is from foreign supplier, it means i Sub 1 has to make payment in foreign currency. So he has to offer doemstic currency to purchase Euro and payment thereof. Here the objective of entering in to contract is to fix the rate that how much euro will be gathered over the offerring of 1 domestic currency. Hedge is being made to stop it from fluctuating or declining the value of Euro against 1 domestic currency offerrings.  

2.  

If Hedge accounting is not applied
Date	Accounting Descriptions	Debit	Credit
30.06.2020	Purchases A/c Dr.	1666667 USD
	To Creditors A/c		1666667 USD
31.12.2020	Creditors A/c	1666667 USD
	To Cash A/c		1666666 USD
	( Being Creditors Paid off)

Forward Contract is Liability because payment is to be purchased aginst Euros. It means Euro  is payment liability . On 30.06.2020 Worth is 1578947.36 USD worth.

3.

If Hedge accounting is applied
Date	Accounting Descriptions	Debit	Credit
01.01.2020	Purchases A/c Dr.	1578947.36 USD
	To Creditors A/c		1578947.36 USD
	( Being Purchases made )
30.06.2020	P and L A/c Dr.	87719.29 USD
	To Gain on Forward Purchase A/c		87719.29 USD
	( Being difference 0.95 -0.90 )
31.12.2020	Creditors A/c	1578947.36 USD
	Gain on Forward Purchase A/c	87719.29 USD
	To Cash A/c		1666666 USD
	( Being Creditors Paid off)

4. With Hedge Accouting Sub 1 is able to secure himself over the loss due to the flucuation in the exchange rate from 0.95 to 0.90 Euro. Because as Payment need to be made at 0.90 Euro as compared to  0.95 euro. It means at 1 USD offerring will able to get 0.95 Euro whereas with chnage in exchange rate to 0.90 euro it means will get only 0.90 Euro agianst 1 USD. With Forward exchange will able to cover the fluctuations in the payments to be made to Creditors.