How Will The U.S. Company Report The Forward Contract

How will the U.S. company report the forward contract on its December 31, 2009, balance sheet?

On December 1, 2009, a U.S.-based company entered into a three-month forward contract to purchase 1 million Mexican pesos on March 1, 2010. The purchase rates for US dollar per peso are provided for December 1, 2009, December 31, 2009, and March 1, 2010, along with the company's borrowing rate of 12 percent and the present value factor for two months at this rate. The question focuses on how the company will report the forward contract in its December 31, 2009, balance sheet.

Introduction

Forward contracts are standardized agreements between two parties to buy or sell an asset at a specified future date and price. For companies involved in international transactions, forward contracts act as hedging tools to mitigate exchange rate risks. Proper accounting for such derivatives ensures accurate financial statement reporting, aligning with standards set by the Financial Accounting Standards Board (FASB), particularly ASC Topic 815, Derivatives and Hedging. This paper analyzes how a U.S. company should report its forward contract as of December 31, 2009, considering the relevant data and accounting principles.

Background and Key Data

The contract's initiation date is December 1, 2009, with a three-month duration, set to settle on March 1, 2010. The relevant exchange rates are:

  • December 1, 2009: Spot rate = $0.088 per peso, Forward rate = $0.084 per peso
  • December 31, 2009: Spot rate = $0.080 per peso, Forward rate = $0.074 per peso
  • March 1, 2010: Spot rate = $0.076 per peso

The company's borrowing rate is 12% annually. The present value factor for two months at the monthly rate (1%) is 0.9803, which will be used to discount future amounts.

Accounting for Forward Contracts

ASC 815 mandates that derivatives, including forward contracts, should be recognized as assets or liabilities at fair value on the balance sheet. Changes in fair value during the reporting period are generally recorded in earnings unless the derivative qualifies for hedge accounting. For a forward contract to qualify as a cash flow hedge, it must effectively hedge a forecasted transaction, and documentation must support the hedge relationship. If the forward contract does not meet hedge criteria, it is accounted for as a trading instrument, with gains or losses recognized immediately in earnings.

Determining the Forward Contract’s Fair Value as of December 31, 2009

To determine the fair value of the forward contract at the end of December 2009, the company compares the contracted forward rate with the current forward rate for the same period. The fair value represents the net position of the contract, considering the difference between the contracted rate and the prevailing market forward rate.

Calculating the Fair Value

As of December 31, 2009, the forward rate for three months is given as $0.074 per peso, while the implied forward rate based on current spot rates might differ. The fair value is essentially the difference between the contractual forward rate and the current forward rate, discounted back to December 31, 2009, using the present value factor.

The contractual forward rate is $0.084, and the current forward rate is $0.074 as of December 31, 2009. The difference per peso is:

Difference per peso = Contracted forward rate - Current forward rate


= $0.084 - $0.074


= $0.010

Since the company is purchasing pesos, a higher contractual rate than the current rate indicates a payable position. The total fair value of the forward contract is then:

Fair value = Difference per peso × Quantity of pesos


= $0.010 × 1,000,000


= $10,000

This amount represents the net liability if the forward rate is unfavorable at the balance sheet date.

Discounting to Balance Sheet Date

Because the contract matures in three months, but we are reporting smaller than that (as of December 31, 2009), we discount the fair value to the balance sheet date using the present value factor for two months (since two months remain from December 31, 2009, to the settlement date on March 1, 2010): 0.9803.

Present value of fair value = Fair value × PV factor


= $10,000 × 0.9803


= $9,803

Given the negative difference (the company is exposed to a potential loss if the forward rate moves unfavorably), the company should recognize this as a liability of approximately $9,803 on its balance sheet as of December 31, 2009.

Accounting Treatment and Disclosure

The firm should record the fair value of the forward contract as a liability of around $9,803 in its December 31, 2009, balance sheet, reflecting the unrealized loss due to the decline in the forward rate. If the company had designated the forward as a hedge of a forecasted transaction that is highly probable, it might consider hedge accounting. However, absent such designation, the fair value change is recognized immediately in earnings.

Furthermore, disclosures should include the amount of the derivative liability, the nature of the derivative, and how fair value was determined in accordance with ASC 820, Fair Value Measurement. This transparency ensures accurate portrayal of the company’s risk management strategies and financial position.

Conclusion

In summary, as of December 31, 2009, the U.S.-based company should recognize the fair value of its forward contract as a liability of approximately $9,803 on its balance sheet. This reflects the unfavorable position arising from the decline in the forward rate versus the contracted rate, discounted to the balance sheet date. Proper recognition and disclosure of derivative instruments are essential to adherence to accounting standards and providing stakeholders with an accurate picture of the company's financial health and risk management practices.

References

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  • FASB. (2020). ASC 820 – Fair Value Measurement. FASB.
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