Natural (Economic) Hedge/ Hedging forecasted transactions and Firm Commitments

Question 1

What is the difference between natural (economic) hedge and hedge accounting?

Answer 1

Natural (economic) hedge: A derivative contract is used to offset uncertainty associated with another transaction or balance.

The hedged risk and derivative contract are marked to market and gains and losses flow to income.

Hedged Accounting: When certain criteria are met, there is “special” accounting for the hedged item and hedging contract. Cash flow or fair value hedge accounting is used.

Question 2

When you have a forward contract to mitigate risk on a payable, what is the journal entry that is booked on the date of initiation?

Answer 2

A/R (FC) XX
A/P (USD) (XX)

*NOTE THE A/P ACCOUNT DOES NOT CHANGE OVER TIME, IT REMAINS THE EXACT SAME!!

Question 3

When you have a forward contract to mitigate risk on a receivable in FX, what is the journal entry that is booked on the date of initiation?

Answer 3

A/R (USD) XX
A/P (FC) (XX)

*NOTE THE A/R ACCOUNT DOES NOT CHANGE OVER TIME, IT REMAINS THE SAME!

Question 4

T/F: Foreign currency dominated firm commitment can be either a fair value hedge or a cash flow hedge?

Answer 4

True

Question 5

T/F: Foreign currency denominated forecasted transactions only apply to cash flow hedges

Answer 5

True– this is not applicable to fair value hedge

Question 6

Gains and losses for a fair value hedge are recorded where?

Answer 6

net income

Question 7

Gains and losses for a cash flow hedge are recorded where?

Answer 7

Ineffective portion- Net Income

Effective portion- OCI

Question 8

What is a forecasted transaction?

Answer 8

A transaction that is probable to occur. Because there is no contract, you have to use cash flow hedge. You would use a futures contract/forward contract to hedge