5.3 Foreign Currency Cash Flow Hedges

Hedging Relationship Type	Possible Types of Foreign-Currency Denominated Hedged Items (See ASC 815-20-25-28)	Permitted Hedging Instruments
Foreign currency cash flow hedge	Forecasted transaction Unrecognized firm commitment Forecasted functional-currency-equivalent cash flows associated with a recognized asset or liability Forecasted intra-entity transaction	Derivative

As discussed in the ASC master glossary and Chapter 4, a cash flow hedge is “a hedge of the exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk.” The variability in that risk must have the potential to affect reported earnings. When an entity elects to hedge a recognized asset or liability for changes in cash flows attributable to changes in foreign currency exchange rates, additional guidance is needed because the hedged item in many cases is already subject to measurement under ASC 830-20.

5.3.1 Hedged Items in a Foreign Currency Cash Flow Hedge

To have exposure to changes in cash flows that are attributable to changes in foreign currency exchange rates, the hedged item must be either (1) an existing foreign-currency-denominated asset or liability or (2) a forecasted transaction that will be settled in a foreign currency, including certain intra-entity transactions.

ASC 815-20

25-38 The conditions in the following paragraph relate to a derivative instrument designated as hedging the foreign currency exposure to variability in the functional-currency-equivalent cash flows associated with any of the following:

A forecasted transaction (for example, a forecasted export sale to an unaffiliated entity with the price to be denominated in a foreign currency)
A recognized asset or liability
An unrecognized firm commitment
A forecasted intra-entity transaction (for example, a forecasted sale to a foreign subsidiary or a forecasted royalty from a foreign subsidiary).

In a manner consistent with ASC 815-20-25-38, if the relevant cash flow hedge accounting requirements are met, foreign currency exposures associated with any of the following may qualify as the hedged item in a cash flow hedge of foreign currency risk: (1) a forecasted transaction, including intra-entity transactions, (2) a recognized foreign-currency-denominated asset or liability, and (3) an unrecognized firm commitment.

5.3.1.1 Forecasted Transactions

Foreign currency exposures related to a forecasted transaction may qualify as the hedged item in a cash flow hedging relationship. Note that entities are permitted to hedge forecasted intra-entity foreign-currency-denominated transactions on a consolidated basis, which is unique to foreign currency cash flow hedging (see Section 5.3.1.1.1 for further discussion of hedging intra-entity transactions).

Forecasted transactions that will be denominated in a foreign currency may qualify as the hedged item in a cash flow hedging relationship if the hedging relationship meets the conditions to qualify for cash flow hedge accounting, as discussed in Chapter 4. However, there are some considerations that are unique to foreign currency cash flow hedges, which will be discussed in the remainder of this section.

5.3.1.1.1 Forecasted Intra-Entity Transactions

Generally, intra-entity transactions cannot be designated hedged items on a consolidated basis since such transactions would be eliminated upon consolidation and would therefore not expose the group to a risk that affects profit or loss. However, intra-entity foreign-currency-denominated transactions represent an exception to this rule in that foreign currency exposure from an intra-entity transaction may not be fully eliminated upon consolidation as a result of the application of ASC 830. In that way, the foreign currency exposure of a probable forecasted intra-entity transaction may qualify for cash flow hedge accounting provided that it gives rise to transaction gains or losses through earnings in accordance with ASC 830-20, resulting in an exposure that affects earnings on the reporting entity’s consolidated basis.

Example 5-8

Intercompany Sales

SimpleBand, a U.S. company, manufactures a product in a factory in the United States and sells the product to its affiliates in Europe under an intercompany sales agreement. The functional currency of each affiliate is the local currency, and all intercompany sales are denominated in the local currency of the affiliate.

SimpleBand enters into three foreign exchange forward contracts, each with a notional amount of EUR 50 million at the beginning of its fiscal year. Provided that all relevant criteria are met, SimpleBand may designate a hedge of the first EUR 150 million of its forecasted intercompany sales. As long as the hedge is highly effective, the fair value of the forward contracts will be recorded in OCI and reclassified into earnings when the sales are realized in the consolidated income statement (i.e., when the affiliate recognizes revenue from the sale to an unrelated third party).

The foreign currency risk of an intercompany dividend does not affect earnings until it is declared, at which time it becomes an intercompany receivable or payable. Thus, until it is declared, a forecasted dividend has no earnings impact and does not qualify as a forecasted exposure under ASC 815. In essence, a hedge of a forecasted intercompany dividend usually represents a hedge of expected future earnings. Forecasted net income is not a transaction; it results from many net transactions, which under ASC 815 cannot be hedged in aggregate.

Once the dividend is declared, the parent will remeasure the dividend receivable at prevailing spot rates until it is collected. However, the parent could designate a derivative contract as the hedging instrument to hedge the foreign currency risk of the foreign-currency-denominated receivable.

5.3.1.1.2 Hedging Forecasted Transaction Through Settlement Date

ASC 815-20

25-34 The provisions of this Section (including paragraph 815-20-25-28) that permit a recognized foreign-currency-denominated asset or liability to be the hedged item in a fair value or cash flow hedge of foreign currency exposure also pertain to a recognized foreign-currency-denominated receivable or payable that results from a hedged forecasted foreign-currency-denominated sale or purchase on credit. Specifically, an entity may choose to designate either of the following:

A single cash flow hedge that encompasses the variability of functional currency cash flows attributable to foreign exchange risk related to the settlement of the foreign-currency-denominated receivable or payable resulting from a forecasted sale or purchase on credit
Both of the following separate hedges:
1. A cash flow hedge of the variability of functional currency cash flows attributable to foreign exchange risk related to a forecasted foreign-currency-denominated sale or purchase on credit
2. A foreign currency fair value hedge of the resulting recognized foreign-currency-denominated receivable or payable.

25-35 If two separate hedges are designated, the cash flow hedge would terminate (that is, be dedesignated) when the hedged sale or purchase occurs and the foreign-currency-denominated receivable or payable is recognized.

25-36 The use of the same foreign currency derivative instrument for both the cash flow hedge and the fair value hedge is not prohibited.

In many cases, a forecasted transaction exposes an entity to changes in foreign currency exchange rates beyond the date the actual forecasted transaction occurs because that transaction may give rise to a foreign-currency-denominated receivable or payable that settles at a future date. ASC 815 provides a couple of alternatives for entities that want to hedge those forecasted transactions for foreign currency exposure all the way to the settlement date of the resulting receivable or payable. A hedge of the variability in cash flows related to a forecasted transaction is a cash flow hedging relationship; however, an entity hedging a recognized foreign-currency-denominated asset or liability for foreign currency risk may hedge that risk as either a fair value hedge (see Section 5.2.1.1) or a cash flow hedge (see Section 5.3.1.2). Therefore, if an entity wants to hedge both the forecasted transaction and the foreign-currency-denominated asset or liability resulting from that transaction, it may choose to designate that hedging relationship as either of the following:

A single hedging relationship of the variability in both (1) the cash flows related to the forecasted transaction and (2) the cash flows related to the recognized foreign-currency-denominated receivable or payable.
First, a cash flow hedge of the variability in the cash flows related to the forecasted transaction, and then a separate fair value hedge of the foreign-currency-denominated receivable or payable.

Example 5-9

Hedge of Forecasted Foreign-Currency-Denominated Sale Through Receivable Settlement Date

GoldenAge (a USD functional entity) expects to sell watches to a large customer on March 17, 20X1, in a sale denominated in EUR, with 90-day payment terms (due June 15, 20X1). To hedge its exposure to the foreign currency, GoldenAge enters into a forward contract to exchange EUR for USD that settles on June 15, 20X1. GoldenAge has two alternatives for hedging the exposure up to the expected collection date of the receivable (i.e., when it expects to receive the foreign currency).

Alternative 1 — Combined Cash Flow Hedge

GoldenAge designates the forward contract as a cash flow hedge of the variability in the USD cash flows attributable to changes in the EUR/USD exchange rate related to the settlement of the EUR-denominated receivable resulting from the forecasted sale of watches on March 17, 20X1. Thus, it is a combined hedge of both (1) the changes in the USD cash flows from a sale that will occur in a fixed amount of EUR and (2) the transaction gains and losses GoldenAge will incur on the receivable, once it is recognized. The hedge does not need to be dedesignated when the forecasted sale occurs.

Alternative 2 — Cash Flow Hedge of Forecasted Sale and Fair Value Hedge of EUR-Denominated Receivable

GoldenAge designates the derivative as a cash flow hedge of the variability in the USD cash flows attributable to changes in the EUR/USD exchange rate related to the forecasted EUR-denominated sale on credit. When the forecasted sale occurs, GoldenAge must discontinue the cash flow hedging relationship and could then redesignate the forward as the hedging instrument in a foreign currency fair value hedge of the EUR-denominated receivable.

See Example 5-15 for a detailed illustration of a hedge of the foreign currency risk related to a forecasted transaction through the settlement date of the receivable.

Connecting the Dots

If an entity uses a purchased option to hedge the foreign currency risk related to a forecasted purchase or sale through the settlement date of the payable or receivable and would like to assess the effectiveness of the hedge by evaluating the option’s terminal value (see Sections 2.5.2.1.2.2 and 4.1.3), it should consider that the terminal value method may only be applied to a cash flow hedging relationship. Accordingly, an entity that uses a purchased option that settles on the same date as the forecasted settlement of the payable or receivable resulting from a forecasted purchase or sale would be likely to prefer to document the hedging relationship as a single combined cash flow hedging relationship of the variability in the cash flows related to the forecasted settlement of the payable or receivable resulting from the forecasted purchase or sale (Alternative 1 in Example 5-9). In this case, as long as the four criteria noted in ASC 815-20-25-129 are met, the hedging relationship may be considered perfectly effective. See Example 5-16 for an illustration of the use of the terminal value method for a purchased option hedging the foreign currency risk related to the forecasted settlement of a payable resulting from a forecasted purchase of inventory.

Alternatively, an entity may choose to designate a cash flow hedge of the variability in functional currency cash flows attributable to foreign exchange risk related to a forecasted foreign-currency-denominated sale or purchase on credit and then separately designate a foreign currency fair value hedge of the resulting recognized foreign-currency-denominated receivable or payable (Alternative 2 in Example 5-9). In that case, the entity would terminate (dedesignate) the cash flow hedge when the hedged sale or purchase occurs and the foreign-currency-denominated receivable or payable is recognized. Such a strategy would not be considered perfectly effective because cash flow hedging is only applied until the date the forecasted purchase or sale occurs, which does not match the option’s settlement date. In this scenario, the “perfect” hypothetical option would have a maturity date matching the date of the forecasted purchase or sale, and hedge effectiveness would be assessed by comparing the change in fair value of (1) the actual option with (2) the hypothetical option. Under this hedging designation, once a foreign-currency-denominated receivable or payable exists, only fair value hedging may be applied. Even though this strategy cannot be considered perfectly effective, hedge accounting is not precluded.

5.3.1.1.3 Portfolio Hedging — Net Cash Flows

As discussed in Section 2.2.2.2, ASC 815-20-25-15(a)(2) allows an entity to hedge a group of individual transactions that have the same risk exposure. However, “[a] forecasted purchase and a forecasted sale shall not both be included in the same group of individual transactions that constitute the hedged transaction.” ASC 815-20-25-39(c) provides consistent guidance on foreign currency cash flow hedging relationships; it states that “[i]f the hedged transaction is a group of individual forecasted foreign-currency-denominated transactions, a forecasted inflow of a foreign currency and a forecasted outflow of the foreign currency cannot both be included in the same group.”

It is common for entities with significant operating activities in foreign environments to both generate sales and incur expenses in those environments. An entity is prohibited from designating the forecasted sales and expenditures as the hedged item in the same hedging relationship. However, it can determine its net forecasted cash inflows or outflows and designate a portfolio of either forecasted sales or forecasted expenses as the hedged item. For example, if an entity with a USD functional currency expects to have sales of EUR 100 million and expenses of EUR 80 million in the following month (i.e., a forecasted net cash inflow of EUR 20 million), it could not designate as the hedged item the forecasted net purchases and sales for the following month. However, it may designate as the hedged item the first EUR 20 million of sales in the following month.

Section 5.1.2.3 discusses the exception for the use of a central treasury function to offset the exposures arising from multiple internal derivatives on an aggregate or net basis. An entity’s ability to use the function to enter into derivatives with third parties that are related to the net exposure from multiple hedging relationships does not override the prohibition on hedging a portfolio of cash inflows and outflows in a single hedging relationship.

5.3.1.1.4 Foreign-Currency-Denominated Debt Acquisition or Issuance

An entity may expect to issue debt that will be denominated in a foreign currency. While this often occurs because the entity will be funding a significant purchase in that currency, in some cases the entity may simply want to take advantage of beneficial interest rates in a particular economic environment. In either case, the forecasted issuance of foreign-currency-denominated debt does not give rise to a foreign currency risk related to the principal amount of the debt before it is issued because there is no earnings exposure from the potential changes in cash flows attributable to changes in foreign currency exchange rates. However, forecasted interest payments related to the forecasted issuance of foreign-currency-denominated debt may be hedged for foreign currency risk. An entity may hedge the foreign currency risk related to the principal, interest payments, or both for recognized foreign-currency-denominated debt.

Foreign currency risk exposure related to the forecasted acquisition of a foreign-currency-denominated debt instrument does not qualify for hedge accounting for the same reason that the forecasted issuance of debt does not qualify (i.e., there is no earnings exposure). However, hedges of the interest receipts related to a forecasted acquisition of a debt instrument for changes in cash flows attributable to changes in foreign currency exchange rates may qualify for hedge accounting.

5.3.1.1.5 Hedges of Foreign Currency Exposure on Forecasted Business Acquisitions Prohibited

As noted in Section 2.2.1.3, ASC 815-20-25-15(g) prohibits the hedge of a forecasted transaction involving a business combination. In addition, even if an entity has entered into a firm commitment to acquire a business in which the purchase price is denominated in a foreign currency, it is prohibited from hedging the foreign currency exposure related to that firm commitment, as noted in Section 5.2.1.2.

Example 5-10

Forecasted Acquisition of a Foreign Business

On January 1, 20X0, Forbin, a company with a USD functional currency, announces a tender offer to acquire all of the common stock of Rutherford, a British company. Forbin offers GBP 6.90 for each share of Rutherford, GBP 3.5 billion in total. The transaction is expected to close sometime in the third quarter of 20X0. Forbin is exposed to foreign currency risk during the tender period because a strengthening of the pound will result in a higher cost to Forbin. Fluff, an investment banker, provides Forbin with a hedging proposal in which the currency exposure would be mitigated by using at-the-money call options on pounds. However, the forecasted business combination does not meet the criteria to qualify as the hedged item in a foreign currency cash flow hedge since ASC 815-20-25-15(g) prohibits hedges of forecasted transactions involving business combinations; in addition, ASC 815-20-25-43(c) states that a firm commitment to enter into a business combination cannot be the hedged item in a fair value hedge.

Connecting the Dots

In a June 19, 2018, agenda request, the ISDA’s Accounting Committee asked the FASB to consider an agenda topic that “extends the ability to designate a fair value or cash flow hedge of foreign currency exposure” related to either a firmly committed or forecasted acquisition of a business. As of the date of the publication of this Roadmap, the FASB has not added this topic to its agenda.

5.3.1.2 Recognized Foreign-Currency-Denominated Asset or Liability

An entity may hedge a foreign-currency-denominated asset or liability for changes in its cash flows that are attributable to changes in foreign currency exchange rates under ASC 815-20-25-38(b). As discussed in Section 5.2.1.1, entities have the choice of applying either fair value hedging (see ASC 815-20-25-37(a)) or cash flow hedging (see ASC 815-20-25-38(b)) to protect themselves from foreign currency risk for recognized foreign-currency-denominated assets and liabilities.

ASC 815-20

25-39 A hedging relationship of the type described in the preceding paragraph qualifies for hedge accounting if all the following criteria are met:

The criteria in paragraph 815-20-25-30(a) through (b) are met.
All of the cash flow hedge criteria in this Section otherwise are met, except for the criterion in paragraph 815-20-25-15(c) that requires that the forecasted transaction be with a party external to the reporting entity.
If the hedged transaction is a group of individual forecasted foreign-currency-denominated transactions, a forecasted inflow of a foreign currency and a forecasted outflow of the foreign currency cannot both be included in the same group.
If the hedged item is a recognized foreign-currency-denominated asset or liability, all the variability in the hedged item’s functional-currency-equivalent cash flows shall be eliminated by the effect of the hedge.

25-40 For purposes of item (d) in the preceding paragraph, an entity shall not specifically exclude a risk from the hedge that will affect the variability in cash flows. For example, a cash flow hedge cannot be used with a variable-rate foreign-currency-denominated asset or liability and a derivative instrument based solely on changes in exchange rates because the derivative instrument does not eliminate all the variability in the functional currency cash flows. As long as no element of risk that affects the variability in foreign-currency-equivalent cash flows has been specifically excluded from a foreign currency cash flow hedge and the hedging instrument is highly effective at providing the necessary offset in the variability of all cash flows, a less-than-perfect hedge would meet the requirement in (d) in the preceding paragraph. That criterion does not require that the derivative instrument used to hedge the foreign currency exposure of the forecasted foreign-currency-equivalent cash flows associated with a recognized asset or liability be perfectly effective, rather it is intended to ensure that the hedging relationship is highly effective at offsetting all risks that impact the variability of cash flows.

25-41 If all of the variability of the functional-currency-equivalent cash flows is eliminated as a result of the hedge (as required by paragraph 815-20-25-39(d)), an entity can use cash flow hedge accounting to hedge the variability in the functional-currency-equivalent cash flows associated with any of the following:

All of the payments of both principal and interest of a foreign-currency-denominated asset or liability
All of the payments of principal of a foreign-currency-denominated asset or liability
All or a fixed portion of selected payments of either principal or interest of a foreign-currency-denominated asset or liability
Selected payments of both principal and interest of a foreign-currency-denominated asset or liability (for example, principal and interest payments on December 31, 20X1, and December 31, 20X3).

Example 13: Eliminating All Variability in Cash Flows

55-132 The following Cases illustrate the application of paragraph 815-20-25-39(d) regarding whether all the variability in a hedged item’s functional-currency-equivalent cash flows are eliminated by the effect of the hedge:

Difference in optionality (Case A)
b. Difference in reset dates (Case B)
Difference in notional amounts (Case C).

Case A: Difference in Optionality

55-133 An entity has issued a fixed-rate foreign-currency-denominated debt obligation that is callable (that is, by that entity) and desires to hedge its foreign currency exposure related to that obligation with a fixed-to-fixed cross-currency swap. A fixed-to-fixed currency swap could be used to hedge the fixed-rate foreign-currency-denominated debt instrument that is callable even though the swap does not contain a mirror-image call option as long as the terms of the swap and the debt instrument are such that they would be highly effective at providing offsetting cash flows and as long as it was probable that the debt instrument would not be called and would remain outstanding.

Case B: Difference in Reset Dates

55-134 An entity has issued a variable-rate foreign-currency-denominated debt obligation and desires to hedge its foreign currency exposure related to that obligation. The entity uses a variable-to-fixed cross-currency interest rate swap in which it receives the same foreign currency based on the variable rate index contained in the debt obligation and pays a fixed amount in its functional currency. If the swap would otherwise meet this Subtopic’s definition of providing high effectiveness in hedging the foreign currency exposure of the debt instrument, but there is a one day difference between the reset dates in the debt obligation and the swap (that is, the one day difference in reset dates results in the hedge being highly effective, but not perfectly effective), the variable-to-fixed cross-currency interest rate swap could be used to hedge the variable-rate foreign-currency-denominated debt instrument even though there is a one-day difference between the reset dates or a slight difference in the notional amounts in the debt instrument and the swap. This would be true as long as the difference in reset dates or notional amounts is not significant enough to cause the hedge to fail to be highly effective at providing offsetting cash flows.

Case C: Difference in Notional Amounts

55-135 This Case involves the same facts as in Case B, except that there is no difference in the reset dates. However, there is a slight difference in the notional amount of the swap and the hedged item. If the swap would otherwise meet this Subtopic’s definition of providing high effectiveness in hedging the foreign currency exposure of the debt instrument, paragraph 815-20-25-39(d) does not preclude the swap from qualifying for hedge accounting simply because the notional amounts do not exactly match. The mismatch attributable to the slight difference in the notional amount of the swap and the hedged item could be eliminated by designating only a portion of the contract with the larger notional amount as either the hedging instrument or hedged item, as appropriate.

Under ASC 815-20-25-39(d), “[i]f the hedged item is a recognized foreign-currency-denominated asset or liability, all the variability in the hedged item’s functional-currency-equivalent cash flows shall be eliminated by the effect of the hedge.” If viewed in isolation, ASC 815-20-25-39(d) appears to require the hedging instrument to perfectly fix all variability in cash flows of the entire hedged foreign-currency-denominated asset or liability. However, ASC 815-20-25-40 and the examples in ASC 815-20-55-132 through 55-135 help illustrate that an entity must hedge all the different risks that result in variability in the cash flows of the designated hedged item. For example, to qualify for foreign currency cash flow hedge accounting, an entity that issues variable-rate foreign-currency-denominated debt needs to hedge the changes in cash flows that are attributable to both interest rate risk and foreign currency risk. Such a hedge could typically be achieved with a pay-fixed, receive-variable cross-currency interest rate swap. Note that the interest rate index and the stated currency for the variable leg of that cross currency interest rate swap do not need to match the interest rate and currency of the hedged debt; however, the cross-currency interest rate swap needs to be highly effective at offsetting the changes in cash flows of the hedged debt that are attributable to changes in interest rates and foreign currency exchange rates.

In addition, ASC 815-20-25-41 clarifies that an entity may still hedge selected contractual payments related to an existing foreign-currency-denominated asset or liability. Specifically, an entity may “hedge the variability in the functional-currency-equivalent cash flows associated with any of the following:

All of the payments of both principal and interest of a foreign-currency-denominated asset or liability
All of the payments of principal of a foreign-currency-denominated asset or liability
All or a fixed portion of selected payments of either principal or interest of a foreign-currency-denominated asset or liability
Selected payments of both principal and interest of a foreign-currency-denominated asset or liability.”

In other words, if an entity wants to hedge the variability in the cash flows of an existing foreign-currency-denominated asset or liability, it first needs to identify the selected cash flows from the asset or liability that it wishes to hedge. Those cash flows can be any or all the cash flows (interest or principal, or both). An entity may hedge a proportion of the cash flows selected, but if so, it must pick the same proportion of the asset’s cash flows for each of the contractual cash flows identified as the hedged item. Once the entity has identified the contractual cash flows (or portions thereof) to be hedged, it must hedge all of the risks that create variability in the functional-currency-equivalent cash flows related to those contractual cash flows.

Example 5-11

Hedging Foreign-Currency-Denominated Variable-Rate Debt

PiperPiper has a USD functional currency. On January 1, 20X1, it issues EUR 100 million of EURIBOR-based debt, with interest payable annually on December 31. The principal is due only at maturity on December 31, 20X5. Below are some examples of the different hedging instruments and designated hedged items that PiperPiper is considering.

Derivative	Hedged Item	Qualifies for Cash Flow Hedging?
Five-year pay-USD-fixed, receive-EUR EURIBOR swap with notional of EUR 100 million	All principal and interest cash flows of the debt	Yes. PiperPiper may identify all of the contractual cash flows of the debt as the hedged item. The derivative eliminates all of the variability in cash flows since it converts both the variable interest rate and the foreign currency into a fixed amount of functional currency.
Five-year pay-USD-fixed, receive-EUR-SOFR swap with notional of EUR 100 million	All principal and interest cash flows of the debt	Maybe. PiperPiper may identify all of the contractual cash flows of the debt as the hedged item. However, the interest rate underlying the variable leg of the swap (SOFR) is not the same as the interest rate index for the variable-rate debt (EURIBOR), so the swap would only qualify for hedge accounting if it is highly effective at offsetting the variability in functional-currency-equivalent cash flows. PiperPiper would not be prohibited from applying hedge accounting because the swap hedges the variability related to all risks that result in variability in cash flows (i.e., interest rate risk and foreign currency risk).
Pay USD, receive EUR forward with 70 million EUR notional; matures on December 31, 20X5	70 percent of the principal payment of the debt due on December 31, 20X5	Yes. PiperPiper may identify any individual contractual cash flow of the debt, or a portion thereof. In addition, the only source of variability in functional-currency-equivalent cash flows related to that principal payment due on December 31, 20X5, is changes in EUR/USD exchange rates (i.e., the changes in interest rates do not affect the amount of principal due on December 31, 20X5). The forward contract eliminates the variability attributable to that risk.
Five different pay USD, receive EUR forwards, each with a EUR 4 million notional (based on the EURIBOR rate at inception of the hedge multiplied by the principal amount of the debt); maturity dates are December 31 of 20X1, 20X2, 20X3, 20X4, and 20X5	The forecasted interest payments for each of the five years of the debt	No. While PiperPiper may identify the hedged item as only the interest payments associated with the debt (or a portion thereof) and not the principal, it must eliminate the variability in the functional-currency-equivalent cash flows. The forward contracts do not eliminate such variability because changes in EURIBOR will alter the amount of interest due on each of those dates. The forward contracts only hedge foreign currency risk, not interest rate risk.

Example 5-12

Hedging Foreign-Currency-Denominated Fixed-Rate Debt

PiperPiper has a USD functional currency. On January 1, 20X1, it issues EUR 100 million of fixed-rate debt, with interest of 5 percent payable annually on December 31. The principal is due only at maturity on December 31, 20X5. Below are some examples of the different hedging instruments and designated hedged items that PiperPiper is considering.

Derivative	Hedged Item	Qualifies for Cash Flow Hedging?
Five-year pay-USD-fixed, receive-EUR-fixed swap with notional of EUR 100 million	All principal and interest cash flows of the debt	Yes. PiperPiper may identify all the contractual cash flows of the debt as the hedged item. The derivative eliminates all the variability in cash flows since it converts all of the payments into a fixed amount of functional currency.
Pay USD, receive EUR forward with 70 million EUR notional; matures on December 31, 20X5	70 percent of the principal payment of the debt due on December 31, 20X5	Yes. PiperPiper may identify any individual contractual cash flow of the debt, or a portion thereof. In addition, the only source of variability in functional-currency-equivalent cash flows related to that principal payment due on December 31, 20X5, is changes in EUR/USD exchange rates (i.e., the changes in interest rates do not affect the amount of principal due on December 31, 20X5). The forward contract eliminates the variability attributable to that risk.
Five different pay-USD, receive-EUR forwards, each with a notional of EUR 5 million; maturity dates are on December 31 of 20X1, 20X2, 20X3, 20X4, and 20X5	The forecasted interest payments for each of the five years of the debt	Yes. PiperPiper may identify the hedged item as only the interest payments associated with the debt (or a portion thereof) and not the principal. In addition, because it is fixed-rate debt, the only source of variability in functional-currency-equivalent cash flows for those interest payments is the changes in the EUR/USD exchange rate. The forward contracts eliminate the variability attributable to that risk.
A pay-USD, receive-EUR forward with a notional of EUR 5 million; matures on December 31, 20X1	The forecasted interest payment due on December 31, 20X1	Yes. PiperPiper may identify the hedged item as any individual interest or principal payment associated with the debt (or a portion thereof). In addition, because it is fixed-rate debt, the only source of variability in functional-currency-equivalent cash flows related to that interest payment is changes in the EUR/USD exchange rate. The forward contract eliminates the variability attributable to that risk.

5.3.1.3 Firm Commitments

ASC 815-20

Foreign Exchange Risk of a Firm Commitment as Hedged Transaction in a Cash Flow Hedge

25-42 The reference in the definition of a forecasted transaction indicating that a forecasted transaction is not a firm commitment focuses on firm commitments that have no variability. The reference does not preclude a cash flow hedge of the variability in functional-currency-equivalent cash flows if the commitment’s fixed price is denominated in a foreign currency. Although that definition of a firm commitment requires a fixed price, it permits the fixed price to be denominated in a foreign currency. A firm commitment can expose the parties to variability in their functional-currency-equivalent cash flows. The definition of a forecasted transaction also indicates that the transaction or event will occur at the prevailing market price. From the perspective of the hedged risk (foreign exchange risk), the translation of the foreign currency proceeds from the sale of the nonfinancial assets will occur at the prevailing market price (that is, current exchange rate). Example 14 (see paragraph 815-20-55-136) illustrates the application of this guidance.

It may seem counterintuitive that there is exposure to changes in cash flows related to a firm commitment since the definition of a firm commitment requires the price of the item being bought or sold to be fixed. However, as noted in ASC 815-20-25-42, if that price is expressed as a fixed amount of a foreign currency, there is exposure to changes in functional-currency-equivalent cash flows attributable to changes in foreign currency exchange rates.

The following firm commitments are precluded from qualifying as the hedged item in a foreign-currency-related cash flow hedge:

Intercompany commitments — Such commitments do not meet the definition of a firm commitment because they are not with a third party (see Section 3.1.1). However, an entity may hedge forecasted transactions related to intercompany commitments that have foreign currency exposure in a cash flow hedging relationship (see Section 5.3.1.1.1).
Firm commitments to enter in a business combination — ASC 815-20-25-43(c) specifically prohibits such commitments from qualifying as the hedged item in a fair value hedge. ASC 815 is silent regarding whether such commitments are permissible as foreign currency cash flow hedges. We believe that it would be inappropriate to hedge a firm commitment to enter into a business combination for foreign currency risk under a cash flow hedging model for many of the same reasons that an entity is prohibited from hedging a forecasted transaction involving a business combination (see Section 2.2.1.3).

5.3.2 Hedging Instruments in a Foreign Currency Cash Flow Hedge

Derivative instruments are the only permissible hedging instruments in a foreign currency cash flow hedging relationship. Certain nonderivative instruments may qualify as the hedging instruments in some foreign currency fair value hedges and net investment hedges, but nonderivative instruments are not permitted as the hedging instrument in a foreign currency cash flow hedge.

5.3.3 Accounting for Foreign Currency Cash Flow Hedges

As noted in Chapter 4, in a typical qualifying cash flow hedging relationship, an entity records the change in the hedging instrument’s fair value in OCI, except for any changes in the fair value of components that are excluded from the effectiveness assessment if the entity elects to recognize such changes in current-period earnings (see Section 4.1.6). Amounts in AOCI are reclassified into earnings when the hedged item affects earnings or when it becomes probable that the forecasted transaction will not occur.

5.3.3.1 Unique Considerations for Foreign Currency Cash Flow Hedges

The accounting for a qualifying foreign currency cash flow hedge requires some slight modifications to the typical cash flow hedging model in a few circumstances:

If an entity is hedging the variability in the functional-currency-equivalent cash flows of a recognized foreign-currency-denominated asset or liability that is remeasured at spot exchange rates in accordance with ASC 830, the initial time value of the hedging instrument should be recognized in earnings over the life of the hedging instrument, even if the entity does not exclude any components of the hedging instrument from the effectiveness assessment. See Section 5.3.3.1.1 for further discussion.
If an entity is hedging a forecasted intra-entity transaction, amounts recognized in OCI should be reclassified out of AOCI when the forecasted transaction affects earnings, which depends on when the related transaction with an external third-party affects earnings. See Section 5.3.3.1.2 for further discussion.
If an entity has designated and documented that it will assess effectiveness on an after-tax basis (see Section 5.1.3), the portion of the gain or loss on the hedging instrument that exceeds the loss or gain, respectively, on the hedged item should be included as an offset to the related tax effects in the period in which such effects are recognized. See Section 5.3.3.1.3 for further discussion.

5.3.3.1.1 Hedging Variability in Functional-Currency-Equivalent Cash Flows of Recognized Foreign-Currency-Denominated Asset or Liability

ASC 815-30

35-3 When the relationship between the hedged item and hedging instrument is highly effective at achieving offsetting changes in cash flows attributable to the hedged risk, an entity shall record in other comprehensive income the entire change in the fair value of the designated hedging instrument that is included in the assessment of hedge effectiveness. More specifically, a qualifying cash flow hedge shall be accounted for as follows: . . .

d. If a non-option-based contract is the hedging instrument in a cash flow hedge of the variability of the functional-currency-equivalent cash flows for a recognized foreign-currency-denominated asset or liability that is remeasured at spot exchange rates under paragraph 830-20-35-1, an amount that will both offset the related transaction gain or loss arising from that remeasurement and adjust earnings for that period’s allocable portion of the initial spot-forward difference associated with the hedging instrument (cost to the purchaser or income to the seller of the hedging instrument) shall be reclassified each period from other comprehensive income to earnings if the assessment of effectiveness is based on total changes in the non-option-based instrument’s cash flows. If an option contract is used as the hedging instrument in a cash flow hedge of the variability of the functional-currency-equivalent cash flows for a recognized foreign-currency-denominated asset or liability that is remeasured at spot exchange rates under paragraph 830-20-35-1 to provide only one-sided offset against the hedged foreign exchange risk, an amount shall be reclassified each period to or from other comprehensive income with respect to the changes in the underlying that result in a change in the hedging option’s intrinsic value. In addition, if the assessment of effectiveness is based on total changes in the option’s cash flows (that is, the assessment will include the hedging instrument’s entire change in fair value — its entire gain or loss), an amount that adjusts earnings for the amortization of the cost of the option on a rational basis shall be reclassified each period from other comprehensive income to earnings. This guidance is limited to foreign currency hedging relationships because of their unique attributes and is an exception for foreign currency hedging relationships. . . .

35-6 Remeasurement of the hedged foreign-currency-denominated assets and liabilities is based on the guidance in Topic 830, which requires remeasurement based on spot exchange rates, regardless of whether a cash flow hedging relationship exists.

Under the cash flow hedging model, if a qualifying hedging relationship is highly effective, all changes in the derivative’s fair value that are included in the effectiveness assessment are recognized in OCI. However, in a foreign currency cash flow hedging relationship involving a foreign-currency-denominated asset or liability, the remeasurement of that asset or liability under ASC 830 is based only on changes in the spot exchange rate. ASC 815-30-35-3(d) requires an entity to reclassify amounts out of AOCI and into earnings if they are related to and offset the transaction gain or loss on the hedged asset or liability. If the entity includes the total changes in the hedging instrument’s fair value in the effectiveness assessment, there will be a mismatch between (1) the gains and losses on the derivative that are recognized in OCI and (2) the amounts that would be reclassified out of AOCI to offset the transaction gains and losses on the hedged asset or liability. As a result, ASC 815-30-35-3(d) also requires an entity to recognize the difference (referred to as the “cost or income” from the hedging instrument) in earnings over the life of the hedging relationship. The calculation of the “cost or income” and the method for recognizing that amount in earnings over the life of the hedging relationship depends on the nature of both the derivative and the hedged item. The table below summarizes the alternatives.

Derivative Type	Cost or Income	Hedged Item — Method of Recognition in Earnings
Forward	The initial difference between the spot and forward rates	Interest-bearing asset or liability — interest method Non-interest-bearing asset or liability — either interest method or pro rata method Combined hedge of forecasted transaction through settlement date — based on either initial forward rates or pro rata method
Option	Time value of option	All assets and liabilities — rational method of amortization

ASC 815-30-35-9 describes how to apply the guidance in ASC 815-30-35-3(d) to a single combined hedging relationship involving a forward contract hedging the change in cash flows attributable to foreign currency risk related to the settlement of a foreign-currency-denominated receivable or payable resulting from a forecasted sale or purchase on credit (see Section 5.3.1.1.2). However, ASC 815-30-35-9(b) provides broader guidance on how to recognize the initial spot-forward difference in earnings, depending on the nature of the hedged item. ASC 815-30-35-9(b) states:

The functional currency interest rate implicit in the hedging relationship as a result of entering into the forward contract is used to determine the amount of cost or income to be ascribed to each period of the hedging relationship. The cash flow hedging model for recognized foreign-currency-denominated assets and liabilities requires use of the interest method at the inception of the hedging relationship to determine the amount of cost or income to be ascribed to each relevant period of the hedging relationship. However, for simplicity, in hedging relationships in which the hedged item is a short-term non-interest-bearing account receivable or account payable, the amount of cost or income to be ascribed each period can also be determined using a pro rata method based on the number of days or months of the hedging relationship. In addition, in a short-term single cash flow hedging relationship that encompasses the variability of functional-currency-equivalent cash flows attributable to foreign exchange risk related to the settlement of a foreign-currency-denominated receivable or payable resulting from a forecasted sale or purchase on credit, the amount of cost or income to be ascribed each period can also be determined using a pro rata method or a method that uses two foreign currency forward exchange rates. The first foreign currency forward exchange rate would be based on the maturity date of the forecasted purchase or sale transaction. The second foreign currency forward exchange rate would be based on the settlement date of the resulting account receivable or account payable.

Example 18 in ASC 815-30-55-106 through 55-112 shows a detailed illustration of an entity hedging a forecasted purchase of inventory on credit through the settlement date of the payable. The example includes an illustration of how to allocate the “cost or income” under both the pro rata method and the method that uses two foreign currency forward rates. In our experience, most entities apply the pro rata method. See Examples 5-13 and 5-15 for detailed illustrations of entities applying a single hedging relationship to a forecasted transaction through the settlement date of the related receivable or payable under the pro rata method.

The guidance in ASC 815-30-35-3(a) does not apply to the components of the derivative that are excluded from the effectiveness assessment (see Section 4.1.6) or to any hedging relationship in which an entity is applying the terminal value method (see Section 4.1.3). See Example 5-14 for an illustration of an entity that hedges a forecasted purchase of inventory through the settlement date of the related payable and excludes the forward points of the derivative from the effectiveness assessment. See Example 5-16 for an illustration of an entity using the terminal value method for a hedge of a forecasted purchase of inventory with a purchased option.

5.3.3.1.2 Hedging Forecasted Intra-Entity Transactions

ASC 815-30

Example 14: Reclassifying Amounts From a Cash Flow Hedge of a Forecasted Foreign-Currency-Denominated Intra-Entity Sale

55-86 This Example illustrates the application of paragraphs 815-20-25-30 and 815-20-25-39 through 25-41. This Example has the following assumptions:

Parent A is a multinational corporation that has the U.S. dollar (USD) as its functional currency.
Parent A has the following two subsidiaries:
1. Subsidiary B, which has the Euro (EUR) as its functional currency
2. Subsidiary C, which has the Japanese yen (JPY) as its functional currency.
Subsidiary B manufactures a product and has a forecasted sale of the product to Subsidiary C that will be transacted in JPY.

55-87 Eventually, Subsidiary C will sell the product to an unrelated third party in JPY. Subsidiary B enters into a forward contract with an unrelated third party to hedge the cash flow exposure of its forecasted intra-entity sale in JPY to changes in the EUR-JPY exchange rate.

55-88 The transaction in this Example meets the hedge criteria of paragraphs 815-20-25-30 and 815-20-25-39 through 25-41, which permits a derivative instrument to be designated as a hedge of the foreign currency exposure of variability in the functional-currency-equivalent cash flows associated with a forecasted intra-entity foreign-currency-denominated transaction if certain criteria are met. Specifically, the operating unit having the foreign currency exposure (Subsidiary B) is a party to the hedging instrument; the hedged transaction is denominated in JPY, which is a currency other than Subsidiary B’s functional currency; and all other applicable criteria in Section 815-20-25 are satisfied.

55-89 Subsidiary B measures the derivative instrument at fair value and records the gain or loss on the derivative instrument in accumulated other comprehensive income. In the consolidated financial statements, the amount in other comprehensive income representing the gain or loss on a derivative instrument designated in a cash flow hedge of a forecasted foreign-currency-denominated intra-entity sale should be reclassified into earnings in the period that the revenue from the sale of the manufactured product to an unrelated third party is recognized and presented in earnings in the same income statement line item as the earnings effect of the hedged item. The reclassification into earnings in the consolidated financial statements should occur when the forecasted sale affects the earnings of Parent A. Because the consolidated earnings of Parent A will not be affected until the sale of the product by Subsidiary C to the unrelated third party occurs, the reclassification of the amount of derivative gain or loss from other comprehensive income into earnings in the consolidated financial statements should occur upon the sale by Subsidiary C to an unrelated third party.

55-90 This guidance is relevant only with respect to the consolidated financial statements. In Subsidiary B’s separate entity financial statements, the reclassification of the amount of the derivative instrument gain or loss from other comprehensive income into earnings should occur in the period the forecasted intra-entity sale is recorded because Subsidiary B’s earnings are affected by the change in the EUR-JPY exchange rate when the sale to Subsidiary C occurs.

As discussed in Section 5.3.1.1, an entity may hedge foreign-currency-denominated forecasted intra-entity transactions in a foreign currency cash flow hedge for changes in cash flows attributable to foreign currency risk as long as those transactions ultimately result in a transaction with an external third party. Example 14 in ASC 815-30-55-86 through 55-90 illustrates a few important concepts for hedging forecasted intra-entity transactions:

The forecasted transaction is the intra-entity transaction, so hedge accounting related to that transaction ceases when the intra-entity transaction occurs.
Amounts recognized in OCI related to that intra-entity transaction are reclassified out of AOCI when the transaction with the unrelated third party occurs (i.e., when the transaction affects earnings for the consolidated financial statements).
The timing of reclassification from AOCI in the stand-alone financial statements of individual subsidiaries may differ from the timing in the consolidated financial statements.

5.3.3.1.3 Hedging on an After-Tax Basis

ASC 815-30

35-5 If an entity has designated and documented that it will assess effectiveness and measure hedge results of a cash flow hedge of foreign currency risk on an after-tax basis as permitted by paragraph 815-20-25-3(b)(2)(vi), the portion of the gain or loss on the hedging instrument that exceeded the loss or gain on the hedged item shall be included as an offset to the related tax effects in the period in which those tax effects are recognized.

If an entity is hedging on an after-tax basis, as discussed in Section 5.1.3, the portion of the gain or loss on the hedging instrument that exceeds the loss or gain, respectively, on the hedged item should be included as an offset to the related tax effects in the period in which such effects are recognized. Only the amount necessary to offset the loss or gain on the hedged item is recognized in OCI as part of the hedging relationship.

5.3.3.2 Income Statement Classification

As discussed in Section 4.1, all amounts in AOCI for a qualifying cash flow hedging relationship (1) should be reclassified into earnings when the forecasted transaction affects earnings and (2) are presented in the same line item as the earnings effect of the hedged item. If the hedged item is a forecasted transaction and it becomes probable that the transaction will not occur within two months of the originally specified time period, amounts are generally immediately reclassified from AOCI (see Section 4.1.5.2 for further discussion of the accounting for discontinued cash flow hedges).

In a manner similar to the accounting for fair value hedging relationships (see discussion in Section 5.2.3.3), if an entity is hedging multiple risks, the earnings effect of the amounts reclassified out of AOCI will need to be allocated on the basis of how much each of the hedged risks affected the changes in the hedging instrument’s fair value that were recorded in OCI. For example, an entity hedging foreign-currency-denominated variable-rate debt for changes in cash flows that are attributable to both foreign currency risk and interest rate risk would need to allocate amounts reclassified out of AOCI to interest expense and transaction gains or losses.

In addition, if the entity is using an after-tax hedging strategy, as discussed in Section 5.1.3, the portion of the gain or loss on the hedging instrument that exceeded the loss or gain, respectively, on the hedged item should be included as an offset to the related tax effects in the period in which such effects are recognized.

5.3.4 Illustrative Examples

Example 5-13

Hedging Forecasted Foreign-Currency-Denominated Purchase of Inventory Through Payable Settlement Date

On January 1, 20X1, BeBop Co., an entity with a USD functional currency, forecasts the purchase of EUR 1 million of inventory on April 30, 20X1. The resulting EUR-denominated payable is expected to be settled on June 30, 20X1. BeBop Co. enters into a forward contract on January 1, 20X1, to sell USD 980,873 and buy EUR 1 million on June 30, 20X1, and designates it as a combined hedge of the variability in cash flows attributable to changes in the USD/EUR exchange rate from the forecasted settlement of a foreign-currency-denominated payable resulting from its forecasted purchase of inventory. BeBop Co. will assess the effectiveness of the hedge on the basis of the total changes in the forward contract’s fair value (i.e., it will not exclude any components of the forward contract from the effectiveness assessment). BeBop Co. elects to ascribe the initial difference between the forward rate and spot rate to each period by using the pro rata method, as allowed by ASC 815-30-35-9(b). The USD/EUR spot exchange rate on January 1, 20X1, was 1.0064. In other words, BeBop Co. could buy EUR 1 million for USD 993,641 on January 1, 20X1.

The allocation of the initial difference between the forward rate and spot rate under the pro rata method is as follows:

Assume that (1) the forecasted transactions remain probable throughout the entire hedging relationship and will occur when expected and (2) the inventory is sold on July 31, 20X1, for $1.3 million.

Note that for simplicity, it is assumed that the forward contract’s fair value is equal to the forward rate as of the date of valuation less the contractual exchange rate multiplied by the notional; discounting is ignored. The reclassification of amounts from AOCI into earnings is reported in the same income statement line item in which the hedged transaction is reported. In this example, since this strategy effectively combines two transactions (the purchase of inventory and the settlement of a payable) into one hedging relationship, (1) amounts related to hedging the changes in foreign currency risk associated with the inventory will be recognized in cost of goods sold and (2) amounts related to the recognized payable will be recognized in transaction gains and losses.

BeBop Co. records the following journal entries:

January 1, 20X1

No entry is required. The forward contract was entered into at-the-money.

March 31, 20X1

The rate for a USD/EUR forward settling on June 30, 20X1, is 0.9308. Therefore, the forward contract has a positive fair value of $93,472.

April 30, 20X1

The table below shows (1) the relevant spot and forward rates on April 30, 20X1, (2) the forward contract’s fair values on March 31, 20X1, and April 30, 20X1, and (3) the change in the forward contract’s fair value.

The journal entries are as follows:

June 30, 20X1

The table below shows (1) the spot rate on June 30, 20X1, (2) the forward contract’s fair values on April 30, 20X1, and June 30, 20X1, and (3) the change in the forward contract’s fair value.

The journal entries are as follows:

July 31, 20X1

BeBop Co. sells the inventory for $1.3 million. The journal entries are as follows:

Example 5-14

Hedging Forecasted Foreign-Currency-Denominated Purchase of Inventory Through Payable Settlement Date — Excluded Component

On January 1, 20X1, BeBop Co., an entity with a USD functional currency, forecasts the purchase of EUR 1 million of inventory on April 30, 20X1. The resulting EUR-denominated-payable is expected to be settled on June 30, 20X1. BeBop Co. enters into a forward contract on January 1, 20X1, to sell USD 980,873 and buy EUR 1 million on June 30, 20X1. It designates the contract as a combined hedge of the variability in cash flows attributable to changes in the USD/EUR exchange rate from the forecasted settlement of a foreign-currency-denominated payable resulting from its forecasted purchase of inventory. BeBop Co. will assess the effectiveness of the hedge on the basis of the changes in the spot exchange rate (i.e., it will exclude the forward/spot component of the forward contract from the effectiveness assessment). BeBop Co. elects to amortize the initial difference between the forward rate and spot rate evenly over the life of the hedging relationship. The USD/EUR spot exchange rate on January 1, 20X1, is 1.0064; therefore, BeBop Co. could buy EUR 1 million for USD 993,641 on that date.

The allocation of the initial difference between the forward rate and spot rate for amortization over the hedging period is as follows:

Assume that (1) the forecasted transactions remain probable throughout the entire hedging relationship and will occur when expected and (2) the inventory is sold on July 31, 20X1, for $1.3 million.

Note that for simplicity, it is assumed that the forward contract’s fair value is equal to the forward rate as of the date of valuation less the contractual exchange rate multiplied by the notional; discounting is ignored. The reclassification of amounts from AOCI into earnings is reported in the same income statement line item in which the hedged transaction is reported. In this example, since this strategy effectively combines two transactions (the purchase of inventory and the settlement of a payable) into one hedging relationship, (1) amounts related to hedging the changes in foreign-currency risk associated with the inventory will be recognized in cost of goods sold and (2) amounts related to the payable will be recognized in transaction gains and losses.

BeBop Co. records the following journal entries:

January 1, 20X1

No journal entry is required. The forward contract was entered into at-the-money.

March 31, 20X1

The rate for a USD/EUR forward settling on June 30, 20X1, is 0.9308. Therefore, the forward contract has a positive fair value of $93,472. The journal entry as of March 31, 20X1, is as follows:

April 30, 20X1

The table below shows (1) the relevant spot and forward rates on April 30, 20X1, and (2) the forward contract’s fair values on March 31, 20X1, and April 30, 20X1.

The journal entries are as follows:

June 30, 20X1

The table below shows (1) the spot rate on June 30, 20X1, (2) the forward contract’s fair values on April 30, 20X1, and June 30, 20X1, and (3) the change in the forward contract’s fair value.

The journal entries are as follows:

July 31, 20X1

BeBop Co. sells the inventory for $1.3 million. The journal entries are as follows:

Example 5-15

Hedging Forecasted Foreign-Currency-Denominated Sale of Inventory Through Receivable Settlement Date

On January 1, 20X1, Golden Age, an entity with a USD functional currency, forecasts the sale of EUR 1 million of inventory on April 30, 20X0. The resulting euro receivable is expected to be settled on June 30, 20X1. Golden Age enters into a forward contract on January 1, 20X1, to buy USD 980,873 and sell EUR 1 million on June 30, 20X1. It designates the contract as a combined hedge of the variability in cash flows attributable to changes in the USD/EUR exchange rate from the forecasted settlement of a foreign-currency-denominated receivable on June 30, 20X1, resulting from its forecasted sale of inventory on April 30, 20X0. Golden Age will assess the effectiveness of the hedge on the basis of the total changes in the forward contract’s fair value (i.e., it will not exclude any components of the forward contract from the effectiveness assessment). Golden Age elects to ascribe the initial difference between the forward rate and spot rate to each period by using the pro rata method, as allowed by ASC 815-30-35-9(b). The USD/EUR spot exchange rate on January 1, 20X1, is 1.0064; therefore, Golden Age could sell EUR 1 million for USD 993,641 on that date.

The allocation of the initial difference between the forward rate and spot rate for amortization over the hedging period is as follows:

Assume that the forecasted transactions remain probable throughout the entire hedging relationship and will occur when expected.

Note that for simplicity, it is assumed that the forward contract’s fair value is equal to the forward rate as of the date of valuation less the contractual exchange rate multiplied by the notional; discounting is ignored. The reclassification of amounts from AOCI into earnings is reported in the same income statement line item in which the hedged transaction is reported. In this example, since this strategy effectively combines two transactions (the sale of inventory and the settlement of a receivable) into one hedging relationship, (1) amounts related to hedging the changes in foreign-currency risk associated with the sale of inventory will be recognized in revenue and (2) amounts related to the receivable will be recognized in transaction gains and losses.

Golden Age records the following journal entries:

January 1, 20X1

No entry is required. The forward contract was entered into at-the-money.

March 31, 20X1

The rate for a USD/EUR forward settling on June 30, 20X1, is 0.9308. Therefore, the forward contract has a negative fair value of $93,472. The journal entry is as follows:

April 30, 20X1

The table below shows (1) the relevant spot and forward rates as of April 30, 20X1, (2) the forward contract’s fair values on March 31, 20X1, and April 30, 20X1, and (3) the change in the forward contract’s fair value.

The journal entries are as follows:

June 30, 20X1

The table below shows (1) the spot rate as of June 30, 20X1, (2) the fair values of the forward contract on April 30, 20X1, and June 30, 20X1, and (3) the change in the forward contract’s fair value:

The journal entries are as follows:

Example 5-16

Purchased Option Hedging Forecasted Foreign-Currency-Denominated Purchase of Inventory Through Settlement Date — Terminal Value Method

On January 1, 20X2, Golden Age, an entity with a USD functional currency, forecasts the purchase of EUR 1 million of inventory on March 31, 20X1. The resulting EUR payable is expected to be settled on June 30, 20X2. Golden Age enters into a European option contract on January 1, 20X2, to sell USD 942,300 and buy EUR 1 million on June 30, 20X2. It designates the contract as a combined hedge of the variability in cash flows attributable to changes in the USD/EUR exchange rate from the forecasted settlement of the euro-denominated payable on June 30, 20X2, resulting from its euro-denominated forecasted purchase on March 31, 20X2. Entering into this type of a purchased option is in compliance with Golden Age’s overall risk management policy. It pays a premium of $28,866 for the option.

Golden Age formally documents the hedging relationship at the inception of the hedge. In accordance with its policy, Golden Age will (1) assess effectiveness on the basis of the total changes in the option’s cash flows and (2) compare the option’s terminal value to the expected change in forecasted cash flows for USD/EUR spot exchange rates above 0.9423 (see ASC 815-20-25-126 through 25-129). Golden Age may assume perfect effectiveness because (1) the terms of the option perfectly match the forecasted purchase of EUR and (2) the option cannot be exercised before maturity (i.e., the criteria in ASC 815-20-25-129 are satisfied).

The table below shows the spot rates and fair values of the option as of January 1, March 31, and June 30, 20X2.

Assume that (1) the forecasted transactions remain probable throughout the entire hedging relationship and will occur when expected, (2) the payable is settled on June 30, 20X2, and (3) the inventory is sold on July 31, 20X2, for $1.3 million.

Golden Age records the following journal entries:

January 1, 20X2

March 31, 20X2

June 30, 20X2

No entry is necessary for the settlement of the option because it expires unexercised (out-of-the-money).

July 31, 20X2

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.