Solution manual advanced accounting 9e by hoyle ch09

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.. The hedged asset or

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

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 Statement 52 of the Financial Accounting Standards Board, issued in December 1981,

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 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 is also used in accounting for foreign currency payables Receivables and payables denominated in foreign currency create an exposure to foreign exchange risk

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 SFAS 133 (as amended by SFAS 138) provides guidance for hedges of the following

sources of foreign exchange risk:

1 foreign currency denominated assets and liabilities

2 foreign currency firm commitments

3 forecasted foreign 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 fair value exposure or cash flow exposure to foreign exchange risk,

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

3 the derivative is properly documented as a hedge

D SFAS 133 allows hedge accounting 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 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 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 income

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 SFAS 133 allows cash flow hedge accounting 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)

Learning Objectives

Having completed Chapter 9, “Foreign Currency Transactions and Hedging Foreign Exchange Risk,” students should be able to fulfill each of the following learning objectives:

1 Read and understand published foreign exchange quotes

2 Understand the one-transaction and two-transaction perspectives to accounting for foreign currency transactions

3 Account for foreign currency transactions using the two-transaction perspective

4 Explain the concept of exposure to foreign exchange risk that arises from foreign currency transactions

5 Explain how forward contracts and options can be used to hedge foreign exchange risk

6 Account for forward contracts and options used as hedges of

a foreign currency denominated assets and liabilities,

b foreign currency firm commitments, and

c forecasted foreign currency transactions

7 Account for foreign currency borrowings

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

The Ahnuld Corporation could have received $200,000 from its export sale to Tcheckia if it had required immediate payment Instead, Ahnuld allows its customer six months to pay Given the future exchange rate of $1.70, Ahnuld would have received only $170,000 if it had not entered into the forward contract This would have resulted in a decrease in cash inflow of $30,000 In accordance with SFAS 52, the decrease in the value of the tcheck receivable is recognized as a foreign exchange loss of $30,000 This loss represents the cost of extending credit to the foreign customer if the tcheck receivable is left unhedged

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 SFAS 133, 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

3 Foreign exchange gains and losses are created by two factors: having foreign currency exposures (foreign currency receivables and payables) and changes in exchange rates Appreciation of the foreign currency will generate foreign exchange gains on receivables and foreign exchange losses on payables Depreciation of the foreign currency will generate foreign exchange losses on receivables and foreign exchange gains on payables

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

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

10 Hedge accounting is defined as recognition of gains and losses on the hedging instrument in the same period as the recognition of gains and losses on the underlying hedged asset or liability (or firm commitment)

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

For a fair value hedge of a firm commitment, there is no hedged asset or liability to account for 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 a gain or loss recognized in net income The firm commitment is also adjusted to fair value based on changes in the forward rate (resulting in a liability or asset reported on the balance sheet), and a gain or loss on firm commitment is recognized in net income The firm commitment gain (loss) offsets the forward contract loss (gain) resulting in zero impact on net income Sales revenue (cost of purchases)

is recognized at the spot rate at the date of sale (purchase) The firm commitment account is closed as an adjustment to net income in the period in which the hedged item affects net income

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 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 SFAS 52 requires a two-transaction perspective, accrual approach

3 B 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, 2009

4 C The dollar value of the LCU receivable has decreased from $110,000 at

December 31, 2009 to $95,000 at February 15, 2010 This decrease of $15,000 should be reported as a foreign exchange loss in 2010

5 D 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 2009 and a $10,000 loss will be reported in 2010

6 D 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 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 The Thai baht is selling at a premium (forward rate exceeds spot rate) The

exporter will receive more dollars as a result of selling the baht forward than

if the baht had been received and converted into dollars on April 1 Thus, the premium results in additional revenue for the exporter

9 D The parts inventory will be recognized at the spot rate at the date of purchase

(FC100,000 x $.23 = $23,000)

10 D The forward contract must be reported on the December 31, 2009 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 The 10 million won receivable has changed in dollar value from $35,000 at

12/1/09 to $33,000 at 12/31/09 The won receivable will be written down by

$2,000 and a foreign exchange loss will be reported in 2009 income

12 B The nominal value of the forward contract on December 31, 2009 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,

2009 that matures on March 31, 2010, $32,000 ($.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, 2009, 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 2009 income is –$58.80

13 A 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]

The Adjustment to Net Income is the amount accumulated in Accumulated Other Comprehensive Income (AOCI) as a result of recognizing the premium expense and the fair value of the forward contract The journal entries would

14 C 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

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

Net impact on 2009 net income:

Gain on Foreign Currency Option $300.00

$(680.30)

3/1/10

16 (continued)

Net impact on 2010 net income:

Gain on Foreign Currency Option $ 700.00

Adjustment to Net Income 3,000.00

$78,680.30

17 B Net cash inflow with option ($80,000 – $2,000) $78,000

Cash inflow without option (at spot rate of $.77) 77,000

18 and 19

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:

$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

Net increase in cash flow from forward contract $ 1,000

21 and 22

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:

(The option has no intrinsic value at 12/31/09 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

2/1/10

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

Parts Inventory (Cost-of-Goods-Sold) $82,000

Accumulated Other Comprehensive Income (AOCI) $2,000

21 and 22 (continued)

Net impact on 2010 net income:

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 Purchase/Payable)

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 2009 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 2010

24 (10 minutes) (Foreign Currency Sale/Receivable)

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 2009 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 2010

25 (10 minutes) (Foreign Currency Sale/Receivable)

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

[100,000 x ($.42 – $.40)]

Accounts Receivable (FCU)

26 (10 minutes) (Foreign Currency Purchase/Payable)

Accounts Payable (LCU) [60,000 x $.88] $52,800 12/31/09 Accounts Payable (LCU) [60,000 x ($.82 – $.88)] $3,600

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

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

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

28 (25 minutes) (Prepare Journal Entries for Foreign Currency Transactions)

29 (20 minutes) (Determine Income Effect of Foreign Currency Purchase/Payable)

a Benjamin, Inc has a liability of AL 160,000 On the date that this liability was created (December 1, 2009), the liability had a dollar value of $70,400 (AL 160,000 x $.44) On December 31, 2009, 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 2009

By March 1, 2010, 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 2010

b Benjamin, Inc has a liability of AL 160,000 On the date that this liability was created (September 1, 2009), the liability had a dollar value of $73,600 (AL 160,000 x $.46) On December 1, 2009, when the liability is paid, the dollar value has decreased to $70,400 (AL 160,000 x $.44) The drop in the dollar value of the liability creates a foreign exchange gain of $3,200 ($70,400 – $73,600) in 2009

c Benjamin, Inc has a liability of AL 160,000 On the date that this liability was created (September 1, 2009), the liability had a dollar value of $73,600 (AL 160,000 x $.46) On December 31, 2009, 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 2009

By March 1, 2010, 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 2010

30 (30 minutes) (Foreign Currency Borrowing)

(To accrue interest for the period 9/30 – 12/31/09.)

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.)

9/30/10 Interest Expense [15,000 dudeks x $.12] $1,800

Foreign Exchange Loss [5,000 dudeks x

(To record the first annual interest payment, record interest expense for the period 1/1 – 9/30/10, and record a foreign exchange loss on the

interest payable accrued at 12/31/09.)

Interest Payable (dudek) [5,000 dudeks x $.125] $625 (To accrue interest for the period 9/30 – 12/31/10.)

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

$.125 and record a foreign exchange loss.)

30 (continued)

9/30/11 Interest Expense [15,000 dudeks x $.15] $2,250

Foreign Exchange Loss [5,000 dudeks x

(To record the second annual interest payment, record interest expense for the period 1/1 – 9/30/11, and record a foreign exchange loss on the interest payable accrued at 12/31/10.)

(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:

2009

Foreign exchange loss 5,000

= 22.1% for 12 months

2010

Foreign exchange losses 20,075

2011

Foreign exchange losses 25,125

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

= 36.5% for 12 months

Because of appreciation in the value of the dudek, the effective annual

borrowing costs range from 22.1% – 36.5%

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

31 (continued)

Impact on 2009 income:

Foreign Exchange Gain 2,000

Loss on Forward Contract (2,000)

Foreign Exchange Gain $3,000

Loss on Forward Contract (3,000)

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

cash inflow

Foreign exchange gain 2,000.00

Loss on forward contract (2,450.75)

32 (40 minutes) (Forward Contract Hedge of Foreign Currency Payable)

a Cash Flow Hedge

[20,000 x $2.00]

No entry for the Forward Contract

Parts Inventory (COGS) $(40,000)

Gain on forward contract 2,000

Premium Expense (500)

Foreign Exchange Loss $(3,000)

Loss on Forward Contract 3,000

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

to cash outflow

32 (continued)

b Fair Value Hedge

[20,000 x $2.00]

No entry for the forward contract

Parts Inventory (COGS) $(40,000.00)

Foreign Exchange Loss (2,000.00)

Gain on forward contract 2,450.75

32 (continued)

Impact on 2010 income:

Foreign Exchange Loss $(3,000.00)

Gain on Forward Contract 1,049.25

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)

a Cash Flow Hedge

Accumulated Other Comprehensive

Over the two accounting periods, Sales are $45,000 and Option Expense is

$2,000 Net increase in cash is $43,000

b Fair Value Hedge