Solution Manual Advanced Accounting 11th Edition Joe Ben Hoyle Chap009

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CHAPTER 9 FOREIGN CURRENCY TRANSACTIONS AND

HEDGING FOREIGN EXCHANGE RISK

Chapter Outline

I. In today’s global economy, a great many companies deal in currencies other than their reporting currencies.

A. Merchandise may be imported or exported with prices stated in a foreign currency. B. For reporting purposes, foreign currency balances must be stated in terms of the

company’s reporting currency by multiplying it by an exchange rate. C. Accountants face two questions in restating foreign currency balances.

1. What is the appropriate exchange rate for restating foreign currency balances? 2. How are changes in the exchange rate accounted for?

D. Companies often engage in foreign currency hedging activities to avoid the adverse impact of exchange rate changes.

E. Accountants must determine how to properly account for these hedging activities.

II. Foreign exchange rates are determined in the foreign exchange market under a variety of different currency arrangements.

A. Exchange rates can be expressed in terms of the number of U.S. dollars to purchase one foreign currency unit (direct quotes) or the number of foreign currency units that can be obtained with one U.S. dollar (indirect quotes).

B. Foreign currency trades can be executed on a spot or forward basis.

1. The spot rate is the price at which a foreign currency can be purchased or sold today. 2. The forward rate is the price today at which foreign currency can be purchased or sold

sometime in the future.

3. Forward exchange contracts provide companies with the ability to “lock in” a price today for purchasing or selling currency at a specific future date.

C. Foreign currency options provide the right but not the obligation to buy or sell foreign currency in the future, and therefore are more flexible than forward contracts.

III. FASB Accounting Standards Codification Topic 830, Foreign Currency Matters (FASB ASC 830) prescribes accounting rules for foreign currency transactions.

A. Export sales denominated in foreign currency are reported in U.S. dollars at the spot exchange rate at the date of the transaction. Subsequent changes in the exchange rate until collection of the receivable are reflected through a restatement of the foreign currency account receivable with an offsetting foreign exchange gain or loss reported in income. This is known as a two-transaction perspective, accrual approach.

B. The two-transaction perspective, accrual approach also is used in accounting for foreign currency payables. Receivables and payables denominated in foreign currency create an exposure to foreign exchange risk; this is the risk that changes in the exchange rate over time will result in a foreign exchange loss.

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A. The fundamental requirement is that all derivatives must be carried on the balance sheet at their fair value. Derivatives are reported on the balance sheet as assets when they have a positive fair value and as liabilities when they have a negative fair value.

B. U.S. GAAP provides guidance for hedges of the following sources of foreign exchange risk: 1. foreign currency denominated assets and liabilities.

2. unrecognized foreign currency firm commitments. 3. forecasted foreign denominated currency transactions.

4. net investments in foreign operations (covered in Chapter 10).

C. Companies prefer to account for hedges in such a way that the gain or loss from the hedge is recognized in net income in the same period as the loss or gain on the risk being hedged. This approach is known as hedge accounting. Hedge accounting for foreign currency derivatives may be applied only if three conditions are satisfied:

1. the derivative is used to hedge either a cash flow exposure or fair value exposure to foreign exchange risk,

2. the derivative is highly effective in offsetting changes in the cash flows or fair value related to the hedged item, and

3. the derivative is properly documented as a hedge.

D. Hedge accounting is allowed for hedges of two different types of exposure: cash flow exposure and fair value exposure. Hedges of (1) foreign currency denominated assets and liabilities, (2) foreign currency firm commitments, and (3) forecasted foreign currency transactions can be designated as cash flow hedges. Hedges of (1) and (2) also can be designated as fair value hedges. Accounting procedures differ for the two types of hedges. E. For cash flow hedges of foreign currency denominated assets and liabilities, at each

balance sheet date:

1. The hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate, and a foreign exchange gain or loss is recognized in net income. 2. The derivative hedging instrument is adjusted to fair value (resulting in an asset or

liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI).

3. An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability.

4. An additional amount is removed from AOCI and recognized in net income to reflect (a) the current period’s amortization of the original discount or premium on the forward contract (if a forward contract is the hedging instrument) or (b) the change in the time value of the option (if an option is the hedging instrument).

F. For fair value hedges of foreign currency denominated assets and liabilities, at each balance sheet date:

1. The hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate, and a foreign exchange gain or loss is recognized in net income. 2. The derivative hedging instrument is adjusted to fair value (resulting in an asset or

liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income.

G. Under fair value hedge accounting for hedges of foreign currency firm commitments: 1. the gain or loss on the hedging instrument is recognized currently in net income, and 2. the change in fair value of the firm commitment is also recognized currently in net

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3.

This accounting treatment requires (1) measuring the fair value of the firm commitment, (2) recognizing the change in fair value in net income, and (3) reporting the firm commitment on the balance sheet as an asset or liability. A decision must be made whether to measure the fair value of the firm commitment through reference to (a) changes in the spot exchange rate or (b) changes in the forward rate.

H. Cash flow hedge accounting is allowed for hedges of forecasted foreign currency transactions. For hedge accounting to apply, the forecasted transaction must be probable (likely to occur). The accounting for a hedge of a forecasted transaction differs from the accounting for a hedge of a foreign currency firm commitment in two ways:

1. Unlike the accounting for a firm commitment, there is no recognition of the forecasted transaction or gains and losses on the forecasted transaction.

2. The hedging instrument (forward contract or option) is reported at fair value, but because there is no gain or loss on the forecasted transaction to offset against, changes in the fair value of the hedging instrument are not reported as gains and losses in net income. Instead they are reported in other comprehensive income. On the projected date of the forecasted transaction, the cumulative change in the fair value of the hedging instrument is transferred from other comprehensive income (balance sheet) to net income (income statement).

V. IFRS is very similar to U.S. GAAP with respect to the accounting for foreign currency transactions and hedging of foreign exchange risk.

A. IAS 21 requires the use of a two-transaction perspective in accounting for foreign currency transactions with unrealized foreign exchange gains and losses accrued in net income in the period of exchange rate change.

B. IAS 39 allows hedge accounting for foreign currency hedges of recognized assets and liabilities, firm commitments, and forecasted transactions when documentation requirements and effectiveness tests are met. Hedges are designated as cash flow or fair value hedges.

C. One difference between IFRS and U.S. GAAP relates to the type of financial instrument that can be designated as a foreign currency cash flow hedge. Under U.S. GAAP, only derivative financial instruments can be used as a cash flow hedge, whereas IFRS also allows non-derivative financial instruments, such as foreign currency loans, to be designated as hedging instruments in a foreign currency cash flow hedge.

Answer to Discussion Question: Do We Have a Gain or What?

This case demonstrates the differing kinds of information provided through application of current accounting rules for foreign currency transactions and derivative financial instruments.

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However, rather than leaving the tcheck receivable unhedged, Ahnuld sells tchecks forward at a price of $180,000. Because the future spot rate turns out to be only $1.70, the forward contract provides a benefit, increasing the amount of cash received from the export sale by $10,000. In accordance with current accounting standards, the change in the fair value of the forward contract (from zero initially to $10,000 at maturity) is recognized as a gain on the forward contract of $10,000. This gain reflects the cash flow benefit from having entered into the forward contract, and is the appropriate basis for evaluating the performance of the foreign exchange risk manager. (Students should be reminded that the forward contract will not always improve cash inflow. For example, if the future spot rate were $1.85, the forward contract would result in $5,000 less cash inflow than if the transaction were left unhedged.)

The net impact on income resulting from the fluctuation in the value of the tcheck is a loss of $20,000. Clearly, Ahnuld forgoes $20,000 in cash inflow by allowing the customer time to pay for the purchase, and the net loss reported in income correctly measures this. The $20,000 loss is useful to management in assessing whether the sale to Tcheckia generated an adequate profit margin, but it is not useful in assessing the performance of the foreign exchange risk manager. The net loss must be decomposed into its component parts to fairly evaluate the risk manager’s performance.

Gains and losses on forward contracts designated as fair value hedges of foreign currency assets and liabilities are relevant measures for evaluating the performance of foreign exchange risk managers. (The same is not true for cash flow hedges. For this type of hedge, performance should be evaluated by considering the net gain or loss on the forward contract plus or minus the forward contract premium or discount.)

Answers to Questions

1. Under the two-transaction perspective, an export sale (import purchase) and the subsequent collection (payment) of cash are treated as two separate transactions to be accounted for separately. The idea is that management has made two decisions: (1) to make the export sale (import purchase), and (2) to extend credit in foreign currency to the foreign customer (obtain credit from the foreign supplier). The income effect from each of these decisions should be reported separately.

2. Foreign currency receivables resulting from export sales are revalued at the end of accounting periods using the current spot rate. An increase in the value of a receivable will be offset by reporting a foreign exchange gain in net income, and a decrease will be offset by a foreign exchange loss. Foreign exchange gains and losses are accrued even though they have not yet been realized.

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4. Hedging is the process of eliminating exposure to foreign exchange risk so as to avoid potential losses from fluctuations in exchange rates. In addition to avoiding possible losses, companies hedge foreign currency transactions and commitments to introduce an element of certainty into the future cash flows resulting from foreign currency activities. Hedging involves establishing a price today at which foreign currency can be sold or purchased at a future date.

5. A party to a foreign currency forward contract is obligated to deliver one currency in exchange for another at a specified future date, whereas the owner of a foreign currency option can choose whether to exercise the option and exchange one currency for another or not.

6. Hedges of foreign currency denominated assets and liabilities are not entered into until a foreign currency transaction (import purchase or export sale) has taken place. Hedges of firm commitments are made when a purchase order is placed or a sales order is received, before a transaction has taken place. Hedges of forecasted transactions are made at the time a future foreign currency purchase or sale can be anticipated, even before an order has been placed or received.

7. Foreign currency options have an advantage over forward contracts in that the holder of the option can choose not to exercise if the future spot rate turns out to be more advantageous. Forward contracts, on the other hand, can lock a company into an unnecessary loss (or a reduced gain). The disadvantage associated with foreign currency options is that a premium must be paid up front even though the option might never be exercised.

8. An enterprise is required to recognize all derivative financial instruments as assets or liabilities on the balance sheet and measure them at fair value.

9. The fair value of a foreign currency forward contract is determined by reference to changes in the forward rate over the life of the contract, discounted to the present value. Three pieces of information are needed to determine the fair value of a forward contract at any point in time during its life: (a) the contracted forward rate when the forward contract is entered into, (b) the current forward rate for a contract that matures on the same date as the forward contract entered into, and (c) a discount rate; typically, the company’s incremental borrowing rate.

The manner in which the fair value of a foreign currency option is determined depends on whether the option is traded on an exchange or has been acquired in the over the counter market. The fair value of an exchange-traded foreign currency option is its current market price quoted on the exchange. For over the counter options, fair value can be determined by obtaining a price quote from an option dealer (such as a bank). If dealer price quotes are unavailable, the company can estimate the value of an option using the modified Black-Scholes option pricing model. Regardless of who does the calculation, principles similar to those in the Black-Scholes pricing model will be used in determining the value of the option.

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11. For hedge accounting to apply, the forecasted transaction must be probable (likely to occur), the hedge must be highly effective in offsetting fluctuations in the cash flow associated with the foreign currency risk, and the hedging relationship must be properly documented.

12. In both cases, (1) sales revenue (or the cost of the item purchased) is determined using the spot rate at the date of sale (or purchase), and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income.

For a cash flow hedge, the derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability. An additional amount is removed from AOCI and recognized in net income to reflect (a) the current period’s amortization of the original discount or premium on the forward contract (if a forward contract is the hedging instrument) or (b) the change in the time value_{of the option (if an option is the} hedging instrument).

For a fair value hedge, the derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income. The discount or premium on a forward contract is not allocated to net income. The change in the time value of an option is not recognized in net income.

13. For a fair value hedge of a foreign currency asset or liability (1) sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income. The forward contract is adjusted to fair value based on changes in the forward rate (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income. The foreign exchange gain (loss) and the forward contract loss (gain) are likely to be of different amounts resulting in a net gain or loss reported in net income.

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14. For a cash flow hedge of a foreign currency asset or liability (1) sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income. The forward contract is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability. An additional amount is removed from AOCI and recognized in net income to reflect the current period’s allocation of the discount or premium on the forward contract.

For a hedge of a forecasted transaction, the forward contract is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). Because there is no foreign currency asset or liability, there is no transfer from AOCI to net income to offset any gain or loss on the asset or liability. The current period’s allocation of the forward contract discount or premium is recognized in net income with the counterpart reflected in AOCI. Sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase). The amount accumulated in AOCI related to the hedge is closed as an adjustment to net income in the period in which the forecasted transaction was anticipated to occur.

15. In accounting for a fair value hedge, the change in the fair value of the foreign currency option is reported as a gain or loss in net income. In accounting for a cash flow hedge, the change in the entire fair value of the option is first reported in other comprehensive income, and then the change in the time value of the option is reported as an expense in net income.

16. The accounting for a foreign currency borrowing involves keeping track of two foreign currency payables—the note payable and interest payable. As both the face value of the borrowing and accrued interest represent foreign currency liabilities, both are exposed to foreign exchange risk and can give rise to foreign currency gains and losses.

Answers to Problems

1. C (Foreign exchange gain/loss on foreign currency transaction)

An import purchase causes a foreign currency payable to be carried on the books. If the foreign currency depreciates, the dollar value of the foreign currency payable decreases, yielding a foreign exchange gain.

2. D (Method of accounting for foreign currency transactions)

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3. B (Foreign exchange gain/loss on foreign currency transaction)

Foreign exchange gains related to foreign currency import purchases are treated as a component of income before income taxes. If there is no foreign exchange gain in operating income, then the purchase must have been denominated in U.S. dollars or there was no change in the value of the foreign currency from October 1 to December 1, 2013.

4. C (Calculate foreign exchange gain/loss on foreign currency transaction)

The dollar value of the LCU receivable has decreased from $110,000 at December 31, 2013 to $95,000 at February 15, 2014. This decrease of $15,000 should be reported as a foreign exchange loss in 2014.

5. D (Calculate foreign exchange gain/loss on foreign currency borrowing)

The increase in the dollar value of the euro note payable represents a foreign exchange loss. In this case a $25,000 loss would have been accrued in 2013 and a $10,000 loss will be reported in 2014.

6. D (Foreign exchange gain/loss on foreign currency transaction)

A foreign currency receivable will generate a foreign exchange gain when the foreign currency increases in dollar value. A foreign currency payable will generate a foreign exchange gain when the foreign currency decreases in dollar value. Hence, the correct combination is franc (increase) and peso (decrease).

7. D (Calculate foreign exchange gain/loss)

The merchandise purchase results in a foreign exchange loss of $8,000, the difference between the U.S. dollar equivalent at the date of purchase and at the date of settlement.

The increase in the dollar equivalent of the note’s principal results in a foreign exchange loss of $20,000.

The total foreign exchange loss is $28,000 ($8,000 + $20,000).

8. D (Forward contract cash flow hedge of foreign currency denominated asset/liability)

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9. D (Forward contract fair value hedge of foreign currency firm commitment)

The parts inventory will be recognized at the spot rate at the date of purchase (FC100,000 x $.23 = $23,000).

10. D (Determine the fair value of a forward contract)

The forward contract must be reported on the December 31, 2013 balance sheet as a liability. Barnum has locked-in to purchase ringgits at $0.042 per ringgit but could have locked-in to purchase ringgits at $0.037 per ringgit if it had waited until December 31 to enter into the forward contract. The forward contract must be reported at its fair value discounted for two months at 12% [($.042 – $.037) x 1,000,000 = $5,000 x .9803 = $4,901.50].

11. C (Calculate foreign exchange gain/loss on foreign currency transaction)

The 10 million won receivable has changed in dollar value from $35,000 at 12/1/13 to $33,000 at 12/31/13. The won receivable will be written down by $2,000 and a foreign exchange loss will be reported in 2013 income.

12. B (Forward contract fair value hedge of foreign currency denominated asset/liability)

The nominal value of the forward contract on December 31, 2013 is a positive $2,000, the difference between the amount to be received from the forward contract actually entered into, $34,000 ($.0034 x 10 million), and the amount that could be received by entering into a forward contract on December 31, 2013 that matures on March 31, 2014, $32,000 ($.0032 x 10 million). The fair value of the forward contract is the present value of $2,000 discounted for two months ($2,000 x .9706 = $1,941.20). On December 31, 2013, MNC Corp. will recognize a $1,941.20 gain on the forward contract and a foreign exchange loss of $2,000 on the won receivable. The net impact on 2013 income is –$58.80.

13. A (Forward contract cash flow hedge of forecasted foreign currency transaction)

The krona is selling at a premium in the forward market, causing Pimlico to pay more dollars to acquire kroner than if the kroner were purchased at the spot rate on March 1. Therefore, the premium results in an expense of $10,000 [($.12 – $.10) x 500,000].

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3/1 no journal entries

6/1 Premium Expense $10,000

AOCI $10,000

AOCI $2,500

Forward Contract $2,500

Foreign Currency $57,500

Forward Contract 2,500

Cash $60,000

AOCI $7,500

Adjustment to Net Income $7,500

14. C (Option cash flow hedge of forecasted foreign currency transaction)

This is a cash flow hedge of a forecasted transaction. The original cost of the option is recognized as an Option Expense over the life of the option.

15-17. (Option fair value hedge of a foreign currency firm commitment)

The easiest way to solve problems 15 and 16 is to prepare journal entries for the option fair value hedge and the firm commitment. The journal entries are as follows:

9/1/13

Foreign Currency Option $2,000

Cash $2,000

12/31/13

Foreign Currency Option $300

Gain on Foreign Currency Option $300

Loss on Firm Commitment $980.30

Firm Commitment $980.30

[($.79 – $.80) x 100,000 = $1,000 x .9803 = $980.30]

Net impact on 2013 net income:

Gain on Foreign Currency Option $300.00

Loss on Firm Commitment (980.30)

$(680.30) 3/1/14

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Loss on Firm Commitment $2,019.70

Firm Commitment $2,019.70

[($.77 – $.80) x 100,000 = $3,000 – $980.30 = $2,019.70]

Foreign Currency (C$) $77,000

Sales $77,000

Cash $80,000

Foreign Currency (C$) $77,000

Foreign Currency Option 3,000

Firm Commitment $3,000

15-17. (continued)

Gain on Foreign Currency Option $ 700.00

Loss on Firm Commitment (2,019.70)

Sales 77,000.00

Adjustment to Net Income 3,000.00

$78,680.30 15. B

16. D

17. B Net cash inflow with option ($80,000 – $2,000) $78,000 Cash inflow without option (at spot rate of $.77) 77,000

Net increase in cash inflow $ 1,000

18-20. (Forward contract fair value hedge of a foreign currency firm commitment)

The easiest way to solve problems 18 and 19 is to prepare journal entries for the forward contract fair value hedge of a firm commitment. The journal entries are as follows:

3/1 no journal entries

3/31 Forward Contract $1,250

Gain on Forward Contract $1,250

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Loss on Firm Commitment $1,250

Net impact on first quarter net income is $0.

4/30 Loss on Forward Contract $250

Forward Contract $250

[Fair value of Forward Contract is ($.120 – $.118) x 500,000 = $1,000; $1,000 – $1,250 = $250]

Firm Commitment $250

Gain on Firm Commitment $250

Foreign Currency (pesos) $59,000

Sales [500,000 pesos x $.118] $59,000

Cash [500,000 x $.120] $60,000

Foreign Currency (pesos) $59,000

Net impact on second quarter net income is: Sales $59,000 – Loss on Forward Contract $250 + Gain on Firm Commitment $250 + Adjustment to Net Income $1,000 = $60,000.

18. A

19. C

20. B Cash inflow with forward contract [500,000 pesos x $.12] $60,000 Cash inflow without forward contract [500,000 pesos x $.118] 59,000

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21-22. (Option cash flow hedge of a forecasted foreign currency transaction)

The easiest way to solve problems 21 and 22 is to prepare journal entries for the option cash flow hedge of a forecasted transaction. The journal entries are as follows:

11/1/13

Cash $1,500

12/31/13

Option Expense $400

(The option has no intrinsic value at 12/31/13 so the entire change in fair value is due to a change in time value; $1,500 – $1,100 = $400 decrease in time value. The decrease in time value of the option is recognized as an expense in net income.)

Option Expense decreases net income by $400.

2/1/14

Option Expense $1,100

Foreign Currency Option 900

Accumulated Other Comprehensive Income (AOCI) $2,000

(Record expense for the decrease in time value of the option; $1,100 – $0 = $1,100; and write-up option to fair value ($.40 – $.41) x 200,000 = $2,000 – $1,100 = $900.)

Foreign Currency (BRL) [200,000 x $.41] $82,000

Cash [200,000 x $.40] $80,000

Parts Inventory (Cost-of-goods-sold) $82,000

Foreign Currency (BRL) $82,000

Accumulated Other Comprehensive Income (AOCI) $2,000

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Option Expense $ (1,100)

Cost-of-Goods-Sold (82,000)

Adjustment to Net Income 2,000 Decrease in Net Income $ (81,100)

21. B

22. C

23. (10 minutes) (Foreign currency payable -- import purchase)

a. The decrease in the dollar value of the LCU payable from November 1 (60,000 x .345 = $20,700) to December 31 (60,000 x .333 = $19,980) is recorded as a $720 foreign exchange gain in 2013.

b. The increase in the dollar value of the LCU payable from December 31 ($19,980) to January 15 (60,000 x .359 = $21,540) is recorded as a $1,560 foreign exchange loss in 2014.

24. (10 minutes) (Foreign currency receivable – export sale)

a. The ostra receivable decreases in dollar value from (50,000 x $1.05) $52,500 at December 20 to $51,000 (50,000 x $1.02) at December 31, resulting in a foreign exchange loss of $1,500 in 2013.

b. The further decrease in dollar value of the ostra receivable from $51,000 at December 31 to $49,000 (50,000 x $.98) at January 10 results in an additional $2,000 foreign exchange loss in 2014.

25. (10 minutes) (Foreign currency receivable – export sale)

9/15 Accounts Receivable (FCU) [100,000 x $.40] $40,000

Sales $40,000

9/30 Accounts Receivable (FCU) $2,000

Foreign Exchange Gain $2,000

[100,000 x ($.42 – $.40)]

10/15 Foreign Exchange Loss $5,000

Accounts Receivable (FCU)

[100,000 x ($.37 – $.42)] $5,000

Cash $37,000

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26. (10 minutes) (Foreign currency payable -- import purchase)

12/1/13 Inventory $52,800

Accounts Payable (LCU) [60,000 x $.88] $52,800

12/31/13 Accounts Payable (LCU) [60,000 x ($.82 – $.88)] $3,600

1/28/14 Foreign Exchange Loss $4,800

Accounts Payable (LCU) [60,000 x ($.90 – $.82)] $4,800

Accounts Payable (LCU) $54,000

Cash $54,000

27. (15 minutes) (Determine U.S. dollar balance for foreign currency transactions)

Inventory and Cost of Goods Sold are reported at the spot rate at the date the inventory was purchased. Sales are reported at the spot rate at the date of sale. Accounts Receivable and Accounts Payable are reported at the spot rate at the balance sheet date. Cash is reported at the spot rate when collected and the spot rate when paid.

a. Inventory [50,000 pesos x 40% x $.17] ... $3,400 b. COGS [50,000 pesos x 60% x $.17] ... $5,100 c. Sales [45,000 pesos x $.18]... $8,100 d. Accounts Receivable [45,000 – 40,000 = 5,000 pesos x $.21] ... $1,050 e. Accounts Payable [50,000 – 30,000 = 20,000 pesos x $.21] ... $4,200 f. Cash [(40,000 x $.19) – (30,000 x $.20)] ... $1,600

28. (25 minutes) (Prepare journal entries for foreign currency transactions)

2/1/13 Equipment $17,600

Accounts Payable (L) [40,000 x $.44] $17,600

4/1/13 Accounts Payable (L) $17,600

Foreign Exchange Loss 400

Cash [40,000 x $.45] $18,000

6/1/13 Inventory $14,100

Accounts Payable (L) [30,000 x $.47] $14,100

8/1/13 Accounts Receivable (L) [40,000 x $.48] $19,200

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Cost-of-Goods Sold $9,870

Inventory [$14,100 x 70%] $9,870

10/1/13 Cash [30,000 x $.49] $14,700

Accounts Receivable (L) [$19,200 x 3/4] $14,400

Foreign Exchange Gain 300

11/1/13 Accounts Payable (L) [$14,100 x 2/3] $9,400

Foreign Exchange Loss [20,000 x ($.50 – $.47)] 600

Cash [20,000 x $.50] $10,000

12/31/13 Foreign Exchange Loss $500

Accounts Payable (L) [10,000 x ($.52 – $.47)] $500

Accounts Receivable (L) [10,000 x ($.52 – $.48)] $400

Foreign Exchange Gain $400

2/1/14 Cash [10,000 x $.54] $5,400

Accounts Receivable (L) [10,000 x $.52] $5,200

Foreign Exchange Gain 200

3/1/14 Accounts Payable (L) [10,000 x $.52] $5,200

Foreign Exchange Loss 300

Cash [10,000 x $.55] $5,500

29. (20 minutes) (Determine income effect of foreign currency payable – import purchase)

a. Benjamin, Inc. has a liability of AL 160,000. On the date that this liability was created (December 1, 2013), the liability had a dollar value of $70,400 (AL 160,000 x $.44). On December 31, 2013, the dollar value has risen to $76,800 (AL 160,000 x $.48). The increase in the dollar value of the liability creates a foreign exchange loss of $6,400 ($76,800 – $70,400) in 2013.

By March 1, 2014, when the liability is paid, the dollar value has dropped to $72,000 (AL 160,000 x $.45) creating a foreign exchange gain of $4,800 ($72,000 – $76,800) to be reported in 2014.

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c. Benjamin, Inc. has a liability of AL 160,000. On the date that this liability was created (September 1, 2013), the liability had a dollar value of $73,600 (AL 160,000 x $.46). On December 31, 2013, the dollar value has risen to $76,800 (AL 160,000 x $.48). The increase in the dollar value of the liability creates a foreign exchange loss of $3,200 ($76,800 – $73,600) in 2013. By March 1, 2014, when the liability is paid, the dollar value has dropped to $72,000 (AL 160,000 x $.45) creating a foreign exchange gain of $4,800 ($72,000 – $76,800) to be reported in 2014.

30. (30 minutes) (Foreign currency borrowing)

a. 9/30/13 Cash $100,000

Note payable (dudek) [1,000,000 x $.10] $100,000

(To record the note and conversion of 1 million dudeks into $ at the spot rate.)

12/31/13 Interest Expense $525

Interest Payable (dudek) $525

[1,000,000 x 2% x 3/12 = 5,000 dudeks x $.105 spot rate]

(To accrue interest for the period 9/30 – 12/31/13.)

Foreign Exchange Loss $5,000

Note Payable (dudek) [1 m x ($.105 – $.10)] $5,000

(To revalue the note payable at the spot rate of $.105 and record a foreign exchange loss.)

9/30/14 Interest Expense [15,000 dudeks x $.12] $1,800

Interest Payable (dudek) 525

Foreign Exchange Loss [5,000 dudeks x

($.12 – $.105)] 75

Cash [20,000 dudeks x $.12] $2,400

(To record the first annual interest payment,

record interest expense for the period 1/1 – 9/30/14, and record a foreign exchange loss on the

interest payable accrued at 12/31/13.)

12/31/14 Interest Expense $625

Interest Payable (dudek) [5,000 dudeks x $.125] $625

(To accrue interest for the period 9/30 – 12/31/14.)

Foreign Exchange Loss $20,000

Note Payable (dudek) [1 m x ($.125 – $.105)] $20,000 (To revalue the note payable at the spot rate of

(18)

30. (continued)

9/30/15 Interest Expense [15,000 dudeks x $.15] $2,250

Interest Payable (dudek) 625

Foreign Exchange Loss [5,000 dudeks x

($.15 – $.125)] 125

Cash [20,000 dudeks x $.15] $3,000

(To record the second annual interest payment, record interest expense for the period 1/1 – 9/30/15, and record a foreign exchange loss on the interest payable accrued at 12/31/14.)

Note Payable (dudek) $125,000

Foreign Exchange Loss 25,000

Cash [1 m dudeks x $.15] $150,000

(To record payment of the 1 million dudek note.)

b. The effective cost of borrowing can be determined by considering the total interest expense and foreign exchange losses related to the loan and comparing this with the amount borrowed:

2013

Interest expense $525

Foreign exchange loss 5,000

Total $5,525 / $100,000 = 5.525% for 3 months =

= 22.1% for 12 months 2014

Interest expense $2,425

Foreign exchange losses 20,075

Total $22,500 / $100,000 = 22.5% for 12 months

2015

Interest expense $2,250

Foreign exchange losses 25,125

Total $27,375 / $100,000 = 27.38% for 9 months

= 36.5% for 12 months

(19)

30. (continued)

The net cash flow from this borrowing is:

Cash outflows:

Interest ($2,400 + $3,000) $5,400

Principal 150,000

$155,400

Cash inflow:

Borrowing (100,000)

Net cash outflow $ 55,400

Ignoring compounding, this results in an effective borrowing cost of approximately 27.7% per year [$55,400 / $100,000 = 55.4% over two years / 2 years = 27.7% per year].

31. (40 minutes) (Forward contract hedge of foreign currency receivable)

a. Cash Flow Hedge

12/1/13 Accounts Receivable (K) [20,000 x $2.00] $40,000

Sales $40,000

No entry for the forward contract.

12/31/13 Accounts Receivable (K) $2,000

[20,000 x ($2.10-$2.00)]

AOCI $2,450.75

Forward Contract $2,450.75

[20,000 x ($2.075 – $2.20) = $2,500 x .9803 = $2,450.75]

Loss on Forward Contract $2,000

AOCI $2,000

AOCI $500

Premium revenue $500

(20)

31. (continued)

Impact on 2013 income:

Sales $40,000

Foreign Exchange Gain 2,000

Loss on Forward Contract (2,000)

Premium Revenue 500

Total $40,500

3/1/14 Accounts Receivable (K) $3,000

[20,000 x ($2.25 – $2.10)]

AOCI $1,049.25

[20,000 x ($2.25 – $2.075) = $3,500 – 2,450.75] = $1,049.25

AOCI $3,000

AOCI $1,000

Premium revenue $1,000

[$1,500 x 2/3 = $1,000]

Foreign Currency (K) [20,000 x $2.25] $45,000

Accounts Receivable (K) $45,000

Cash [20,000 x $2.075] $41,500

Foreign Currency (K) $45,000

Premium revenue 1,000

Total $1,000

(21)

31. (continued)

b. Fair Value Hedge

12/1/13 Accounts Receivable (K) [20,000 x $2.00] $40,000

Sales $40,000

12/31/13 Accounts Receivable (K) $2,000

[20,000 x ($2.10 – $2.00)]

Loss on Forward Contract $2,450.75

[20,000 x ($2.075 – $2.20) = $2,500 x .9803 = $2,450.75]

Sales $40,000.00

Foreign Exchange Gain 2,000.00

Loss on Forward Contract (2,450.75)

Total $39,549.25

3/1/14 Accounts Receivable (K) $3,000

[20,000 x ($2.25 – $2.10)]

[20,000 x (2.25 – $2.075) = $3,500 – 2,450.75 = $1,049.25]

Accounts Receivable (K) $45,000

Cash [20,000 x $2.075] $41,500

Foreign Exchange Gain $3,000.00

Total $1,950.75

(22)

32. (40 minutes) (Forward contract hedge of foreign currency payable)

12/1/13 Parts Inventory (COGS) $40,000

Accounts Payable (K) $40,000

[20,000 x $2.00]

12/31/13 Foreign Exchange Loss $2,000

[20,000 x ($2.10 – $2.00)]

AOCI $2,450.75

[20,000 x ($2.075 – $2.20) = $2,500 x .9803 = $2,450.75]

AOCI $2,000

Premium Expense $500

AOCI $500

[20,000 x ($2.075 – $2.00) = $1,500 x 1/3 = $500]

Parts inventory (COGS) $(40,000)

Foreign Exchange Loss (2,000)

Gain on Forward Contract 2,000

Premium Expense (500)

Total $(40,500)

32. (continued)

[20,000 x ($2.25 – $2.10)]

AOCI $1,049.25

[20,000 x ($2.25 – $2.075) = $3,500 – 2,450.75 = $1,049.25]

AOCI $3,000

(23)

Premium Expense $1,000

AOCI $1,000

[$1,500 x 2/3 = $1,000]

Cash $41,500

Foreign Exchange Loss $(3,000)

Loss on Forward Contract 3,000

Premium revenue (1,000)

Total $(1,000)

Impact on net income over both periods: $(40,500) + $(1,000) = $(41,500); equal to cash outflow.

32. (continued)

12/1/13 Parts inventory (COGS) $40,000

[20,000 x $2.00]

[20,000 x ($2.10 – $2.00)]

Gain on Forward Contract $2,450.75

[20,000 x ($2.075 – $2.20) = $2,500 x .9803 = $2,450.75]

Parts inventory (COGS) $(40,000.00)

Foreign Exchange Loss (2,000.00)

Gain on Forward Contract 2,450.75

(24)

[20,000 x ($2.25 – $2.10)]

[20,000 x ($2.25 – $2.075) = $3,500 – 2,450.75 = $1,049.25]

Cash $41,500

32. (continued)

Foreign Exchange Loss $(3,000.00)

Total $(1,950.75)

Impact on net income over both periods: $(39,549.25) + $(1,950.75) = $(41,500.00); equal to cash outflow.

33. (30 minutes) (Option hedge of foreign currency receivable)

6/1 Accounts Receivable (P) $45,000

Sales [$.045 x 1,000,000 pesos] $45,000

Cash $2,000

Foreign Exchange Gain

[($.048 – $.045) x 1,000,000] $3,000

AOCI $200

(25)

Loss on Foreign Currency Option $3,000

AOCI $3,000

Option Expense $200

AOCI $200

Date Fair Value Intrinsic Value Time Value Change in Time Value

6/1 $2,000 $0 $2,000 –

6/30 $1,800 $0 $1,800 –$ 200

9/1 $1,000 $1,000 $0 –$1,800

33. (continued)

Accounts Receivable (P) $4,000

[($.044 – $.048) x 1,000,000]

AOCI $800

[$1,800 – $1,000]

AOCI $4,000

Gain on Foreign Currency Option $4,000

Option Expense $1,800

AOCI $1,800

(Change in time value of option is recognized as expense)

Foreign Currency (P) $44,000

Cash $45,000

Impact on Net Income over the Two Accounting Periods:

Sales $45,000

Foreign currency option expense (2,000)

Impact on net income $43,000 = Net cash inflow

(26)

Cash $2,000

[($.048 – $.045) x 1,000,000]

Loss on Foreign Currency Option $200

33. (continued)

[($.044 – $.048) x 1,000,000]

Loss on Foreign Currency Option $800

Cash $45,000

Impact on Net Income over the Two Accounting Periods:

Sales $45,000

Foreign Exchange Gain 3,000

Foreign Exchange Loss (4,000)

Loss on Foreign Currency Option (1,000)

Impact on net income $43,000 = Net cash inflow 34. (30 minutes) (Option hedge of foreign currency payable)

6/1 Inventory [$.085 x 1,000,000] $85,000

Accounts Payable (M) $85,000

Cash $2,000

(27)

AOCI $2,000

[$4,000 – $2,000]

AOCI $3,000

Option Expense $1,000*

AOCI $1,000

Date Fair Value Intrinsic Value Time Value Change in Time Value

6/1 $2,000 $0 $2,000 -

6/30 $4,000 $3,000 $1,000 -$1,000*

9/1 $5,000 $5,000 $0 -$1,000**

34. (continued)

[($.09 – $.088) x 1,000,000]

AOCI $1,000

[$5,000 – $4,000]

AOCI $2,000

Option Expense $1,000**

AOCI $1,000

Foreign Currency (M) $90,000

Cash $85,000

Impact on net income:

(28)

34. (continued)

6/1 Inventory $85,000

[$.085 x 1,000,000]

Cash $2,000

[($.088 – $.085) x 1,000,000]

[$4,000 – $2,000]

[($.09 – $.088) x 1,000,000]

[$5,000 – $4,000]

Cash $85,000

Impact on net income:

Foreign Exchange Loss ($5,000)

Gain on Foreign Currency Option 3,000

(29)

35. (30 minutes) (Forward contract cash flow hedge of foreign currency denominated asset)

Account Receivable (FCU) Forward Forward Contract Spot U.S. Dollar Change in U.S. Rate to Change in Date Rate Value Dollar Value 4/30/14 Fair Value Fair Value

11/01/13 $.53 $53,000 - $.52 $0 -

12/31/13 $.50 $50,000 -$3,000 $.48 $3,8441 _+$3,844

4/30/14 $.49 $49,000 -$1,000 $.49 $3,0002 _{- $ 844}

1_$52,000–_{$48,000 = $(4,000) x .961 = $3,844; where .961 is the present value factor for}

four months at an annual interest rate of 12% (1% per month) calculated as 1/1.014_. 2_$52,000–_{$49,000 = $3,000.}

2013 Journal Entries

11/01/13 Accounts Receivable (FCU) $53,000

Sales $53,000

There is no entry for the forward contract.

Accounts Receivable (FCU) $3,000

AOCI $3,000

AOCI $3,844

Discount expense $333.33

AOCI $333.33

[100,000 x ($.53 – $.52) = $1,000 x 2/6 = $333.33]

The impact on net income for the year 2013 is:

Sales $53,000.00

Foreign Exchange Loss (3,000.00)

Gain on Forward Contract 3,000.00

Net Gain (Loss) 0.00

Discount Expense (333.33)

(30)

35. (continued)

AOCI $1,000

AOCI $844

Forward Contract $844

Discount expense $666.67

AOCI $666.67

Foreign Currency (FCU) $49,000

Cash $52,000

Foreign Currency (FCU) $49,000

Foreign Exchange Loss $(1,000.00)

Net Gain (Loss) 0.00

Discount Expense (666.67)

Impact on net income $(666.67)

36. (30 minutes) (Forward contract fair value hedge of net foreign currency denominated asset)

Account Receivable (Payable) (mongs) Forward Forward Contract Change in U.S. Rate to Change in Date U.S. Dollar Value Dollar Value 1/31/14 Fair Value Fair Value

11/30/13 $265,000 ($159,000) - $.52 $0 -

12/31/13 $250,000 ($150,000) -$15,000 (-$9,000) $.48 $7,9211 _+$7,921

1/31/14 $245,000 ($147,000) -$ 5,000 (-$3,000) $.49 $6,0002 _{- $1,921}

1_$104,000–_{$96,000 = $(8,000) x .9901 = $7,921; where .9901 is the present value factor}

for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01.

(31)

11/30 Accounts Receivable (mongs) $265,000

Sales $265,000

[$.53 x 500,000 mongs]

Inventory $159,000

Accounts Payable $159,000

[$.53 x 300,000 mongs]

There is no formal entry for the forward contract.

Accounts Receivable (mongs) $15,000

Accounts Payable (mongs) $9,000

Sales $265,000

Net Foreign Exchange Loss $ (6,000) Gain on Forward Contract 7,921

Net Gain (Loss) 1,921

Impact on net income $266,921

36. (continued)

Accounts Receivable (mongs) $5,000

Foreign Currency (mongs) $245,000

(32)

Cash $104,000

Net Foreign Exchange Loss $(2,000)

Impact on net income $(3,921)

The net effect on the balance sheet is an increase in cash of $104,000 and an increase in inventory of $159,000 with a corresponding increase in retained earnings of $263,000 ($266,921 – $3,921).

37. (40 minutes) (Forward contract fair value hedge – foreign currency receivable and firm commitment (sale))

a. Foreign Currency Receivable

10/01 Accounts Receivable (LCU) $69,000

Sales (100,000 LCUs x $.69) $69,000

There is no formal entry for the forward contract.

[($.71 – $.69) x 100,000]

[($.74 – $.65) x 100,000 = $ 9,000 x .9901 = $ 8,910.90]

[($.72 – $.71) x 100,000]

Forward Contract $ 1,910.90

Gain on Forward Contract $ 1,910.90

(33)

Foreign Currency (LCU) $72,000

Accounts Receivable (LCU) $72,000

Cash $65,000

The impact on net income:

Sale $69,000.00

Foreign Exchange Gain 3,000.00

Impact on net income $65,000.00 = Cash Inflow

37. (continued)

b. Foreign Currency Firm Commitment (Sale)

10/01 There is no entry to record either the sales agreement or the forward contract as both are executory contracts.

12/31 Loss on Forward Contract $8,910.90

Gain on Firm Commitment $8,910.90

1/31 Forward Contract $1,910.90

Sales $72,000

Cash $65,000

(34)

Impact on Net Income:

Sales $72,000

Net Loss on Forward Contract (7,000)

Net Gain on Firm Commitment 7,000

Adjustment to Net Income (7,000)

$65,000 = Cash Inflow

38. (30 minutes) (Forward contract fair value hedge of a foreign currency firm commitment (purchase))

Forward Forward Contract Firm Commitment

Rate to Change in Change in

Date 10/31 Fair Value Fair Value Fair Value Fair Value

8/1 $.30 $0 - $0 $0 -

9/30 $.325 $4,950.501 _{+ $4,950.50 $(4,950.50)}1 _–_$4,950.50

10/31 $.320 (spot) $4,0002 –_{$ 950.50 $(4,000)}2 _{+ $ 950.50}

1_($65,000–_{$60,000) = $5,000 x .9901 = $4,950.5; where .9901 is the present value factor}

for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01.

2 _($64,000–_{$60,000) = $4,000.}

a. Journal entries

8/1 There is no entry to record either the purchase agreement or the forward contract as both are executory contracts.

9/30 Forward Contract $4,950.50

10/31 Loss on Forward Contract $950.50

Forward Contract $950.50

Firm Commitment $950.50

Gain on Firm Commitment $950.50

Foreign Currency (rupees) $64,000

Cash $60,000

Inventories (Cost-of-Goods-Sold) $64,000

Foreign Currency (rupees) $64,000

(35)

b. Assuming the inventory is sold in the fourth quarter, the net impact on net income is negative $60,000:

Cost-of-Goods-Sold $(64,000)

Adjustment to Net Income 4,000 Net impact on net income $(60,000)

c. The net cash outflow is $60,000.

39. (30 minutes) (Option fair value hedge of a foreign currency firm commitment (sale))

Firm Commitment Option Option

Spot Change in Premium Change in

Date Rate Fair Value Fair Value for 9/1 Fair Value Fair Value

6/1 $1.00 - - $0.010 $5,000 -

6/30 $0.99 $(4,901.50)1 –_{$ 4,901.50} _$0.016 _$8,000 _{+ $3,000}

9/1 $0.97 $(15,000)2 –_$10,098.50 _$0.030 _$15,000 _{+ $7,000}

1_$495,000_–_{$500,000 = $(5,000) x .9803 = $(4,901.5), where .9803 is the present value}

factor for two months at an annual interest rate of 12% (1% per month) calculated as 1/1.012_.

2_$485,000_–_{$500,000 = $(15,000).}

a. Journal Entries

6/1 Foreign Currency Option $5,000

Cash $5,000

There is no entry to record the sales agreement because it is an executory contract.

6/30 Loss on Firm Commitment $4,901.50

9/1 Loss on Firm Commitment $10,098.50

(36)

Sales $485,000

Cash $500,000

Foreign Currency (lek) $485,000

39. (continued)

b. Impact on Net Income

The impact on net income for the second quarter is:

Loss on Firm Commitment $(4,901.50)

Gain on Foreign Currency Option 3,000.00

Impact on net income $(1,901.50)

The impact on net income for the third quarter is:

Sales $485,000.00

Loss on Firm Commitment (10,098.50)

Gain on Foreign Currency option 7,000.00

Adjustment to Net Income 15,000.00

Impact on net income $496,901.50

The impact on net income over the second and third quarters is: $495,000 ($496,901.50 – $1,901.50)

c. Net Cash Inflow

The net cash inflow resulting from the sale is: $500,000 – $5,000 = $495,000

40. (20 minutes) (Option fair value hedge of a foreign currency firm commitment (purchase))

Firm Commitment Option Option

Spot Change in Premium Change in

Date Rate Fair Value Fair Value for 12/20 Fair Value Fair Value

11/20 $.20 - - $.008 $400 -

(37)

1_$10,000–_{$10,500 = $(500).} 2_$10,000–_{$9,000 = $1,000.}

3 The premium on 12/20 for an option that expires on that date is equal to the option’s

intrinsic value. Given the spot rate on 12/20 of $.21, a call option with a strike price of $.20 has an intrinsic value of $.01 per mark.

4 The premium on 12/20 for an option that expires on that date is equal to the option’s

intrinsic value. Given the spot rate on 12/20 of $.18, a call option with a strike price of $.20 has no intrinsic value – the premium on 12/20 is $.000.

a. The option strike price ($.20) is less than the spot rate ($.21) on December 20, the date the parts are to be paid for. Therefore, Big Arber will exercise its option. The journal entries are as follows:

11/20 Foreign Currency Option $400

Cash $400

There is no entry to record the purchase agreement because it is an executory contract.

12/20 Loss on Firm Commitment $500

Gain on Foreign Currency Option $100

Foreign Currency (pijio) $10,500

Cash $10,000

Foreign Currency Option 500

Parts inventory $10,500

Foreign Currency (pijio) $10,500

The following entry is made in the period when the inventory affects net income through cost-of-goods-sold:

Adjustment to Net Income $500

40. (continued)