Trans-America Corp. (TC) is a U.S. company which manufactures automotive components for GM and Chrysler but has never sold to Ford. TC has contracted with Ford to build a new component for an upcoming model, payment to be made in U.S. dollars. The contract specifies significant penalties for failure to deliver. TC has the manufacturing capacity to fulfill the contract. Use of these facilities will prevent it from entering into some other contracts to deliver components. The new component will require specialized subcomponents which can only be manufactured by Unique Products (UP). TC has discussed the planned transaction with UP. UP provided verbal assurances that although there is a backlog of orders at the moment, it is highly likely that it will able to deliver the subcomponents to TC in a timely manner. TC anticipates payment on Feb. 1, 2017. UP only accepts payments in Euros. TC plans to exchange dollars for Euros at the time of the anticipated payment. Because the Euro-Dollar exchange rate fluctuates, TC is uncertain about how many dollars it must use to satisfy its contract with UP. To protect itself from fluctuations in the exchange rate, TC enters into an option contract with World Bank on 7-13-16. The option allows TC the option, but not the obligation, to pay a specific dollar amount to World Bank and receive the expected number of Euros needed to pay UP on Feb. 1, 2017. TC would like to use specialized "hedge" accounting for its option contract with World Bank. The Accounting Standard Codification's (ASC) specifies that one of the requirements to use "hedge" accounting with an option is that it is probable that the hedged transaction will be consummated. In this case, the hedged transaction is TC's payment to UP resulting from the planned purchase.
Requirements:
Is TC's planned purchase of the subcomponents, along with the subsequent payment, "probable" to occur under the ASC's hedge accounting guidance? You are not evaluating the probability of the option will be exercised. You are only assessing the probability that the anticipated payments will be made to UP.