Forward contracts is a type of derivative financial instrument that occurs between 2 parties. The first party agrees to buy an asset from the second at a specified future date for a price specified immediately. These types of Forward contracts, unlike futures contracts, are not traded over any exchanges; they take place over-the-counter between 2 private parties. The mechanics of a forward contract are fairly simple, which is why these types of derivatives are popular as a hedge against risk and as speculative opportunities. Knowing how to account for forward contracts requires a basic understanding of the underlying mechanics and a few simple journal entries. Here's Tips On How to Account for Forward Contracts :
- Determine the terms of the forward contract. A forward contract is a simple agreement that has 3 key characteristics. These characteristics are the spot rate, the forward rate, and the asset to be exchanged. The spot rate is the current market value for the asset in question. For example, consider a forward contract through which a farmer agrees to sell a quantity of grain to a wholesaler in the future at a price specified now. The spot rate is the price of that grain if it were to be sold immediately, rather than in the future. The forward rate is the agreed-upon future price in the contract. In the example above, imagine the grain is currently worth $10,000 (the spot rate). The contract may specify that the grain will be sold for $12,000 a year from now. This future price - $12,000 - is the forward rate. The third aspect of any forward contract is the asset to be exchanged. In the example above, the asset is a specified quantity of grain.
- Record the journal entry for the establishment of the currency forward contract. When the contract is signed, no physical exchange takes place, but a journal entry must be made to recognize the signing. In the example above, the farmer debits Contract Receivable for $12,000 to recognize the amount of money collectible at the forward rate. The farmer credits Grain Obligation (or a similarly-named account) for $10,000 and Premium on Forward Contract ("PFC") for $2000. PFC is a contra-asset account that is associated with the Contract Receivable account. The wholesaler debits Grain Receivable for $10,000 (the spot rate) and PFC for $2000, and credits Contract Payable for $12,000. PFC represents a contra-liability account for the wholesaler.
- Determine the market value of the asset as of the future and forward contracts maturation date. The journal entries needed upon maturation will vary based on the current market value of the asset in question. In this example, assume that after 1 year, the market value of the grain has risen to $11,000.
- Record the journal entries upon the exchange of the asset. When the foreign exchange forward contracts matures, the asset is exchanged; in this case, the farmer sells the grain to the wholesaler at the forward rate ($12,000). Journal entries are needed to recognize this transaction. The farmer debits Cash for $12,000 (the actual amount received), and debits PFC for $2000 and Grain Obligation for $10,000 to close the account balances. The farmer credits Contract Receivable for $12,000 to close the account balance, credits Grain for $11,000 (the current market value), and credits Gain on Forward Contract for $1000 to record the $1000 gain recognized over the grain's market value. The wholesaler debits Contract Payable for $12,000 to close the balance, debits Grain for $11,000 (the market value), and debits Loss on Forward Contract for $1000. The wholesaler credits Cash for $12,000, and then credits Grain Receivable for $10,000 and PFC for $2000 to close the forward contracts.
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