On December 12, 20X1, Imp Co. entered into three forward exchange contracts, each to purchase 100,000 francs in 90 days. The relevant exchange rates are as follows:
Forward Rate
Spot Rate (for March 12, 20X2)
——— ——————–
December 12, 20X1 $.88 $.90
December 31, 20X1 .98 .93
Imp entered into the second forward contract to hedge a commitment to purchase equipment being manufactured to Imp's specifications. At December 31, 20X1, what amount of net foreign currency transaction gain should Imp include in income from this forward contract?
A.
$0
B.
$3,000
C.
$5,000
D.
$10,000
answered B, and it's incorrect. The correct answer is A(?). I don't understand the explanation below. Anyone can re-explain it easily? Thank you.
The “second” forward contract was entered into to hedge a purchase commitment, therefore (assuming that all other conditions are met) it qualifies as a hedge of a purchase commitment. In that case, the forward contract qualifies as a fair value hedge (rather than a cash flow hedge). Therefore, the change in fair value of the derivative (the forward contract) should be included in net income, as should the change in fair value of the hedged commitment. Accordingly, the $3,000 gain (100,000 francs × ($.90-$.93)) would be included in income from continuing operations. If the hedge associated with the derivative qualified as a cash flow hedge, the unrealized gain would be included in other comprehensive income rather than in net income. However, the increase in the fair value of the hedged item, the purchase commitment, should be a $3,000 loss. The unrealized gain of $3,000 associated with the derivative (the hedging instrument) and the $3,000 unrealized loss associated with the hedged instrument (the purchase commitment) should result in a net unrealized gain/loss of $0. Thus, the net unrealized gain/loss included in income from continuing operations is $0.
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