Foreign Exchange Forward Contract Accounting

A foreign exchange forward contract can be used by a business to reduce its risk to foreign currency losses when it exports goods to overseas customers and receives payment in the customers currency.

The basic concept of a foreign exchange forward contract is that its value should move in the opposite direction to the value of the expected receipt from the customer. In the case of a business receiving payment in a foreign currency the foreign exchange forward contract should be an agreement under which the business agrees to sell the foreign currency in return for a fixed amount of its own currency.

By entering into such a contract any fall in value of the customer receipt due to exchange rate changes is compensated by an increase in value of the foreign currency forward contract.

Foreign Exchange Forward Contract Example

Suppose a business operating and reporting in US Dollars makes a sale to a customer in Europe for 100,000 Euros. Since the customer will pay in Euros the business is subject to the risks resulting from fluctuations in the EUR/USD exchange rate. The business seeks to minimize its foreign currency exposure by entering into a foreign exchange forward contract.

Accounting for the transaction needs to be considered at three different dates.

  1. The sale date when the product is sold to the customer and the foreign exchange forward contract is entered into.
  2. The balance sheet date when the value for the accounts receivable and forward contract liability needs to be restated.
  3. The settlement date when the customer makes payment in Euros and the foreign exchange forward contract must be settled.

Sale and Foreign Exchange Forward Contract Date

The business makes a sale to the customer for the amount 100,000 Euros on December 2, 2016. At the date of the sale the EUR/USD spot rate was 1.23 and when converted to USD the export sale is worth USD 123,000 (EUR 100,000 x 1.23). The customer is expected to settle the account in 60 days on February 2, 2017.

The initial posting is to record the sale to the customer in the usual manner.

Goods are sold to the customer
Account Debit Credit
Accounts receivable 123,000
Revenue 123,000
Total 123,000 123,000

To reduce its exposure to foreign exchange risk the business enters into a 60 day foreign exchange forward contract.

The contract agrees that the business will sell 100,000 Euros in 60 days time (February 2, 2017) at a EUR/USD forward rate of 1.25 and will therefore receive/pay the difference between this rate and the rate on the settlement date. The effect of this contract is to fix the value of the EUR 100,000 the business will receive at USD 125,000.

Balance Sheet Date

At the balance sheet date of December 31, 2016 the exchange rate has changed. The EUR/USD spot rate is now 1.20 and the forward rate is 1.24. The business must now record the changes in fair value of the asset (in this case the accounts receivable) and the foreign exchange forward contract.

Effect on Accounts Receivable

The EUR/USD spot rate has changed from 1.23 to 1.20. The business is still due to receive EUR 100,000 however, at the new rate of 1.20 the accounts receivable now has a fair value of only USD 120,000 (100,000 x 1.20). Since the accounts receivable is currently recorded at USD 123,000 the business must record a foreign exchange loss of USD 3,000 calculated as follows.

EUR/USD spot rate at date of sale = 1.23
EUR/USD spot rate at balance sheet date = 1.20
Amount = EUR 100,000
Exchange loss = 100,000 x (1.23 - 1.20)
Exchange loss = 3,000

The foreign exchange loss is recorded as follows.

Foreign exchange loss at balance sheet date
Account Debit Credit
Foreign exchange 3,000
Accounts receivable 3,000
Total 3,000 3,000

The debit entry is recorded as an expense in the income statement under the heading of foreign exchange loss. The credit entry reduces accounts receivable to its fair value at the balance sheet date of 120,000.

Effect on Foreign Exchange Forward Contract

The EUR/USD forward rate has also moved from 1.25 to 1.24. Under the contract the business is owed the difference between the two rates and records a gain calculated as follows.

EUR/USD forward rate at date of sale = 1.25
EUR/USD forward rate at balance sheet date = 1.24
Amount = EUR 100,000
Exchange gain = 100,000 x (1.25 - 1.24)
Exchange gain = 1,000

The exchange gain is recorded with the following foreign exchange forward contract accounting entries.

Foreign exchange forward contract gain
Account Debit Credit
Forward contract 1,000
Foreign exchange 1,000
Total 1,000 1,000

The foreign exchange gain is posted to the income statement and a forward contract asset is established representing the net amount due to the business under the contract at the balance sheet date. It should be noted that under a foreign exchange forward contract only the difference resulting from changes in exchange rates is accounted for not the principal amount.

The effect of this gain is to offset the loss recorded above in relation to the accounts receivable amount.

Settlement Date

Assume for the sake of simplicity the customers pays on the due date (February 2, 2017) which is also the settlement date for the foreign exchange forward contract. On this date the EUR/USD spot rate is 1.18.

Effect on Accounts Receivable

The business receives EUR 100,000 from the customer which converted at the current spot rate represents USD 118,000 (100,000 x 1.18). The business must now use this to clear the accounts receivable balance of USD 120,000 and record a further foreign exchange loss calculated as follows.

EUR/USD spot rate at balance sheet date = 1.20
EUR/USD spot rate at settlement date = 1.18
Amount = EUR 100,000
Exchange loss = 100,000 x (1.20 - 1.18)
Exchange loss = 2,000

The foreign exchange loss is recorded as follows.

Foreign exchange loss on settlement
Account Debit Credit
Cash 118,000
Foreign exchange 2,000
Accounts receivable 120,000
Total 120,000 120,000

Effect on Foreign Exchange Forward Contract Liability

At the settlement date the spot rate is 1.18 and the business is owed the difference between this rate and the contract rate of 1.25.

The total gain on the contract is calculated as follows.

EUR/USD forward rate at contract date = 1.25
EUR/USD forward rate at settlement date = 1.18
Amount = EUR 100,000
Exchange gain = 100,000 x (1.25 - 1.18)
Exchange gain = USD 7,000

Since the business has already recorded the gain up to the balance sheet date of USD 1,000 the additional gain to be recorded is USD 6,000 (7,000 – 1,000) calculated as follows.

EUR/USD forward rate at balance sheet date = 1.24
EUR/USD forward rate at settlement date = 1.18
Amount = EUR 100,000
Exchange gain = 100,000 x (1.24 - 1.18)
Exchange gain = USD 6,000

The additional exchange gain is recorded with the following foreign exchange forward contract accounting entries.

Foreign exchange forward contract gain
Account Debit Credit
Forward contract 6,000
Foreign exchange gain 6,000
Total 6,000 6,000

Again the exchange gain is included in the income statement and the net amount due to the business under the foreign exchange forward contract is increased by 6,000.

Summary of Movements

The effect of foreign exchange rate movements on both the accounts receivable balance and the foreign exchange forward contract are shown in the summary tables below.

Accounts Receivable

Accounts receivable
Date Sale Year end Settle
EUR 100,000 100,000 100,000
Rate 1.23 1.20 1.18
USD 123,000 120,000 118,000
Loss -3,000 -2,000

The sale to the customer is for EUR 100,000 which at the date of the sale is worth USD 123,000. When the customer settles the account the exchange rate has changed, the business receives EUR 100,000 which is now only worth USD 118,000. In total the business has made a USD 5,000 (3,000 + 2,000) foreign exchange loss.

Foreign Exchange Forward Contract

Foreign exchange forward contract
Date Sale Year end Settle
EUR 100,000 100,000 100,000
Rate 1.25 1.24 1.18
USD 125,000 124,000 118,000
Gain 1,000 6,000

The foreign exchange forward contract is entered into to try and mitigate the effect of fluctuations in the exchange rate. The business sells EUR 100,000 it expects to receive from the customer at the rate of 1.25 and under the contract will receive the difference between this rate and the rate at the settlement date of 1.18 amounting to USD 7,000 (1,000 + 6,000).

In summary at the settlement date the business received EUR 100,000 cash from the customer which converted to USD 118,000. In addition cash of USD 7,000 is received from the forward exchange contract giving total cash receipts of USD 125,000 (118,000 + 7,000). The difference between the value of the original sales contract of USD 123,000 and the cash received of USD 125,000 is the foreign exchange gain of USD 2,000.

Foreign Exchange Forward Contract Accounting October 5th, 2017Team

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