Cash Flow Hedge Accounting and AOCI

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  • #198442
    Lan76214
    Member

    I’m reviewing cash flow hedge accounting and I am really confused. My book tells me that if you make a sale in a foreign currency, and create an AR in a foreign currency, you can use a hedge to counteract the volatility of the exchange rate. Great makes sense.

    Scenario is: American company sells to German company product worth $1,000,000 on 12/1/15 with the receivable due on 03/01/16 and enters into a forward contract on the date of sale. The Spot rate on the date of sale is $1.32 and the forward rate on 12/01 for 03/01/16 is $1.305. On December 31 (balance sheet date) the spot rate is $1.33 and the forward rate is $1.316.

    The following entries are then provided:

    12/1

    Dr. AR $1,320,000

    Cr. Sales $1,320,000

    12/31/15

    Dr. AR 10,000

    Cr. Foreign Exchange Gain 10,000

    Dr. Accumulated Other Comprehensive Income 10,783 (discounted)

    Cr. Forward Contract 10,783 (discounted)

    Dr. Loss on forward contract 10,000

    Cr. Accumulated Other Comprehensive Income 10,000

    Dr. Discount Expense 5,019

    Cr. Accumulated Other Comprehensive Income 5,019

    My questions are (I haven’t touched FAR in a while, so many of these questions may sound inexperienced) I thought you couldn’t debit or credit AOCI directly unless closing the balance of OCI to AOCI when preparing the financial statements. Is it possible to debit or credit AOCI like this without going through OCI? If so, in what circumstances? or is the book just skipping the step of going through OCI and just debiting and crediting OCI directly? If this is the case wouldn’t entry 3 on 12/31/2015 really just be a debit and credit to OCI?

    The loss on the forward contract is really 11,000. Why is it discounted? My book states that it is discounted using the company’s incremental borrowing rate. What is this rate, and why is it used to discount the forward contract?

    Entries 2 and 3 on 12/31 seem intertwined, but I am still confused as to why on entry 3 a loss is reported, yet AOCI is increased by the amount of the loss.

    Entry 4 is a complete mess to me. It calculates the effective interest rate by taking the difference between the spot and forward rate on 12/1 to get $15,000, which makes sense. However, it calculates the entry by doing [1 – the cubed root of (1305000/1320000)] = .0038023 then multiplying that by $1320000 to get $5,019. I haven’t seen the effective interest rate calculated this way. What is going on here?

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