Simple Forward Contracts
On 1-July-2017, when the forward contract is formed, the seller makes the following accounting entry.
On 1-July-2017, when the forward contract is formed, the buyer makes the following accounting entry.
Again here, I have shown the entries for two scenarios.
Please read my blog on the mechanics of futures https://finaccfundas.blogspot.in/2018/01/very-basic-tutorial-for-futures.html
Let us take the same example that we used in hedging of currency sing forward contracts. For ease, I will reproduce the example
Since the company shorted EURUSD, in both CASE 1 and CASE 2, there is going to be a Gain/Loss in derivative transactions and a Gain/Loss in foreign exchange on sales. Though it is a non cash gain/loss, it has to be reported on the balance sheet date.
Since the company sold 120000 dollars (the product is manufactured by spending dollars and the mark up for the effort also is in dollars) to purchase 100000 Euros ( Customer pays in Euros). And we converted the accounts receivable entry from 100000 Euros to 120000 dollars. Now on Jun 30th, the dollar changed .
So we need to re translate the accounts receivables to changed dollar value.
The calculations for these gains and losses are shown in the table below
The re translation entries are
This profit/loss, though in paper, the company can claim any time, by closing the positions or at expiry. So it can always create a receivable, if its a profit in the trade, or a payable, if its a loss in the trade. We call these receivables as derivative assets and payables as derivative liabilities. Once the company takes the payout, if it's a profit or pays in if its a loss, after it either closes the account or at expiry, we settle the cash payout/pay ins against these assets/liabilities respectively. This can be seen as you read on.
Derivative Gain/Loss entries are
The calculations are as follows
For re translation of accounts receivable.
For recording derivatives Gain/Loss
These are the steps we have taken till now.
1. We record the sale of the product priced EUR 100000 in dollars $120000 using the spot rate of 1.20 EURUSD on Jun 1st.
2. On Jun 30th, since it is the balance sheet date, we record foreign currency gain on the accounts receivable (cash receivable for sale in Euros expressed in dollars). This is done by re translating the accounts recievables, using the spot rates on Jun 30th, for the four different cases.
3. We create a derivative asset/ liability, which is a receivables/ payables entry for the paper gain/loss in the trading account, and record a derivative gain loss using the existing futures rates for the four different cases on June 30th.
4. At the time of expiry we again re traslate the accounts receivable using the then spot/futures rate as both will be the same, and also again update the derivative assets. liabilities for the paper gain/loss on the expiry close.
Also let us check what the company can take out for profit in trade or what the company needs to compensate if it's a loss once futures expired.
Final Settlement Entries
Now once the cash is received from the customer in Euros on Sept 1, it is converted to dollars @ the spot rate and closed against Accounts Receivables. Then the cash is transferred between the trading account and the bank account, and is closed against the derivative assets and liabilities
Gain/Loss Comparison between hedging using a bespoke currency forward contract and Currency Futures
Now let us see the net Gain/Loss in hedging using Currency Futures
Now let us compare it with Gain/Loss in hedging by using a bespoke currency forward contract, I am reproducing the chart here.
The net result is the same.
A company can choose to hedge it's transactions using bespoke forward contracts or by using Currency Futures. Either way the results will be similar. The choice really depends upon other ancillary charges such as brokerage, taxes etc.