Forward Purchase Contract Accounting: A Guide for Businesses

Forward purchase contracts, also known as forward contracts, are agreements between two parties to purchase or sell a specified asset at a future date and at a predetermined price. This type of contract is commonly used in business transactions to secure a future supply or sale of goods, commodities, or financial instruments.

However, forward purchase contract accounting can be a complex and challenging area for businesses, especially for those unfamiliar with the accounting principles and standards governing these contracts. In this article, we’ll provide a comprehensive guide to forward purchase contract accounting, including its definition, calculation, and reporting requirements.

What is a Forward Purchase Contract?

A forward purchase contract is a legally binding agreement between two parties, where the buyer agrees to purchase a specified asset (such as raw materials, merchandise, or commodities) at a future date and at a predetermined price. The seller, in turn, agrees to deliver the asset on the specified date and at the agreed-upon price, regardless of the current market price at that time.

Forward purchase contracts are often used by businesses to reduce the risk of price fluctuations, secure a future supply of goods, or lock in a favorable price for a future sale. For example, a manufacturer may enter into a forward purchase contract with a supplier to purchase raw materials at a set price, thereby ensuring a steady supply of inputs for their production process.

Calculating the Value of a Forward Purchase Contract

The value of a forward purchase contract depends on several factors, including the current market price of the underlying asset, the contract price, and the time remaining until the contract’s expiration date. To calculate the value of a forward purchase contract, businesses use a formula called the forward price formula.

The forward price formula is as follows:

Forward Price = Spot Price + Financing Cost – Income from Asset

Where:

– Spot Price: The current market price of the underlying asset

– Financing Cost: The interest rate or financing cost required to hold the asset until the contract’s expiration date

– Income from Asset: The expected income generated by holding the asset until the contract’s expiration date

Reporting Requirements for Forward Purchase Contracts

Businesses that enter into forward purchase contracts must follow certain reporting requirements under generally accepted accounting principles (GAAP) and the International Financial Reporting Standards (IFRS). The specific rules and disclosures may vary depending on the accounting standard used by the business.

Under GAAP, forward purchase contracts are classified as derivatives and are subject to specific accounting rules outlined in Accounting Standards Codification (ASC) 815, Derivatives and Hedging. The standard requires businesses to recognize the fair value of the contract as either an asset or liability on their balance sheet, depending on whether the contract is in a net gain or net loss position.

Similarly, under IFRS 9, Financial Instruments, forward purchase contracts must be classified as either financial assets or financial liabilities. The standard also requires businesses to recognize the fair value of the contract on their balance sheet, with any changes in value being recorded in the income statement.

Conclusion

Forward purchase contract accounting is an important area for businesses that engage in these types of contracts. By understanding the definition, calculation, and reporting requirements for forward purchase contracts, businesses can ensure compliance with accounting standards and make informed decisions about their future supply or sale of goods. If you need help with forward purchase contract accounting, consider consulting with a certified public accountant or a financial expert.