Balmoral Co.'s functional currency is the U.S. dollar.  On October 1, 20X0, Balmoral enters into a firm commitment to purchase equipment for delivery on March 31, 20X1.  The price of the equipment is fixed at £10,000 with payment due on delivery.

Also on October 1, 20X0, Balmoral enters into a foreign currency forward contract to buy £10,000 on March 31, 20X1.  Balmoral will pay $1.10 per £1, which is the current forward rate for an exchange on March 31, 20X1.  Balmoral designates the foreign currency forward contract as a hedge of its risk of changes in the fair value of the firm commitment resulting from changes in the U.S. dollar/£ exchange rate.  This hedging strategy should enable the equipment to be recorded at $11,000 (the forward price inherent in the foreign currency forward contract) at the time of purchase regardless of the then prevailing spot exchange rate.

Assumptions:

Spot rates, forward rates, and fair value of the foreign currency forward contract are as follows:

Balmoral will assess hedge effectiveness by comparing the overall changes in fair value of the forward contract to the changes in fair value of the firm commitment measured by reference to changes in the US$/£ forward exchange rates.  Changes in the fair value of the foreign currency forward contract related to changes in the £ forward price are expected to be 100 percent effective in offsetting the changes in fair value of the firm commitment because both are denominated in the same currency and have the same terms.

Changes in the fair value of the foreign currency forward contract are:

The fair value of the foreign currency forward contract at inception is zero.

The foreign currency forward contract settles on March 31, 20X1 with Balmoral receiving $500 (£10,000 x ($1.15 - $1.10)).

a)      There would be a memorandum entry made on October 1, 20X0 documenting the existence of the hedging relationship.  The financial records of Balmoral would not otherwise be impacted as of this date because the foreign currency forward contract was at market rates (i.e., fair value was zero).

b)      The journal entries as of December 31, 20X0 would be as follows:

1.  Dr.  Change in fair value of firm commitment (P&L)
     Cr.  Firm commitment (B/S)
(To record the change in fair value of the firm commitment to purchase the equipment)

2.  Dr.  Forward contract (B/S)
     Cr.  Unrealized gain on forward contract (P&L)
(To record the change in fair value of the foreign currency forward contract)

c)     The journal entries as of March 31, 20X1 would be as follows:

1.  Dr.  Firm commitment (B/S)
     Cr.  Change in fair value of firm commitment (P&L)
(To record the change in fair value of the firm commitment to purchase the equipment)

2.  Dr.  Unrealized loss on forward contract (P&L)
     Cr.  Forward contract (B/S)
(To record the change in fair value of the foreign currency forward contract)

3.  Dr.  Cash (B/S)
     Cr.  Forward contract (B/S)
(To record settlement of the foreign currency forward contract)

4.  Dr.  Plant and equipment (B/S)
     Dr.  Firm Commitment (B/S)
     Cr.  Cash (B/S)
(To record the purchase of the equipment from the UK supplier)

Observations:

Balmoral's hedging objective was to lock in the purchase price of the equipment at the U.S. dollar price based on the £ forward rate on October 1, 20X0.  During the period the hedge was in place, the U.S. dollar weakened against the pound sterling.  Without any hedge, the equipment would have cost $11,500 (£10,000 at the spot exchange rate of £1:$1.15).  However, with the hedge, Balmoral limited its net cash outflow to $11,000.

Because Balmoral chose to assess hedge effectiveness based on changes in the fair value of the firm commitment using forward rates, no hedge ineffectiveness was reflected in earnings.