How to Account for Forward Contracts

Three Parts:Understanding Forward Contracts Negotiating a Forward Contract Accounting for a Forward Contract Questions and Answers

A forward contract is a type of derivative financial instrument that occurs between two 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 contracts, unlike futures contracts, are not traded over any exchanges; they take place over-the-counter between two 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.

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EditPart 1 of 3: Understanding Forward Contracts

1
Understand the definition of a forward contract. A forward contract is an agreement between a buyer and a seller to deliver a commodity on a future date for a specified price. The value of the commodity on that future date is calculated using rational assumptions about rates of exchange. Farmers use forward contracts to eliminate risk for falling grain prices. Forward contracts are also used in transactions using foreign exchange in an effort to reduce the risk of losses due to changes in the exchange rates.^[1]

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2
Learn the meaning of derivatives. A derivative is a security with a price that is based upon, or derived, from something else. Forward contracts are considered derivative financial instruments because the future value of the commodity is derived from other information about the commodity.^[2]
- The future value of the commodity for the forward contract is derived from the current market value, or spot price, and the risk-free rate of return.
3
Learn the meaning of hedging. In investing, hedging means minimizing risk. In forward contracts, buyers and sellers attempt to minimize risk of losses by locking in prices for commodities in advance. Buyers lock in a price in hopes that they will end up paying less than the current market value of a commodity. Sellers hedge their risks with forward contracts in an attempt to protect themselves from falling prices.^[3]

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EditPart 2 of 3: Negotiating a Forward Contract

1
Know the difference between the long position and the short position. The party agreeing to purchase the commodity assumes the long position. The party agreeing to sell the commodity is assuming the short position.^[4]
- The buyer, who is in the long position, is the person who stands to benefit if the price of the commodity rises higher than expected.
- The seller, who is in the short position, stands to lose if the price of the commodity rises.
2
Know the difference between the spot value and the forward value. The spot value and the forward value are both quotes for the rate at which the commodity will be bought or sold. The difference between the two has to do with the timing of the settlement and delivery of the commodity. Both parties in a forward contract need to know both values in order to accurately account for the forward contract.^[5][Image:Account for Forward Contracts Step 1 Version 2.jpg|center]]
- The spot rate is the current market value for the asset in question. It is the value of the commodity if it were sold today. For example, a farmer selling grain for the spot value agrees to sell it immediately for the current price.^[6]
- The forward rate is the agreed-upon future price in the contract. For example, suppose the farmer in the above example wants to enter into a forward contract in an effort to hedge against falling grain prices. He can agree to sell his grain to another party in six months at agreed-upon forward rate. When the time comes to sell, the grain will be sold for the agreed-upon forward rate, despite fluctuations that occur in the spot rate during the intervening six months.^[7]
3
Understand the relationship between the spot value and the forward value. The spot rate can be used to determine the forward rate. This is because a commodity’s future value is based in part on its current value. The other factor that is used to determine the forward value is the risk-free rate.^[8]
- The risk-free rate is the rate at which the commodity is expected to change in value with zero risk. It is usually based on the current interest rate of a three-month U.S. Treasury bill, which is considered the safest investment you can make.^[9]
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EditPart 3 of 3: Accounting for a Forward Contract

1
Record the journal entry for the establishment of the forward contract. When the contract is signed, no physical exchange takes place, but a journal entry must be made to recognize the signing.^[10]
- In the example above, suppose the spot rate is $10,000 and the farmer agrees to sell in one year for $12,000.
- 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 $2,000. 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 $2,000, and credits Contract Payable for $12,000. PFC represents a contra-liability account for the wholesaler.
2
Determine the market value of the asset as of the contract's 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.^[11]
3
Record the journal entries upon the exchange of the asset. When the contract 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.^[12]
- The farmer debits Cash for $12,000 (the actual amount received), and debits PFC for $2,000 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 $1,000 to record the $1,000 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 $2,000 to close the account balances.
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