Solution manual advanced accounting 11th edition joe ben hoyle chap009

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk CHAPTER 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 What is the appropriate exchange rate for restating foreign currency balances? 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 The spot rate is the price at which a foreign currency can be purchased or sold today The forward rate is the price today at which foreign currency can be purchased or sold sometime in the future 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 IV FASB Accounting Standards Codification Topic 815, Derivatives and Hedging (FASB ASC 815) governs the accounting for derivative financial instruments and hedging activities including the use of foreign currency forward contracts and foreign currency options 9-1 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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: foreign currency denominated assets and liabilities unrecognized foreign currency firm commitments forecasted foreign denominated currency transactions 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: the derivative is used to hedge either a cash flow exposure or fair value exposure to foreign exchange risk, the derivative is highly effective in offsetting changes in the cash flows or fair value related to the hedged item, and 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: 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 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) F For fair value hedges of foreign currency denominated assets and liabilities, at each balance sheet date: 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 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: the gain or loss on the hedging instrument is recognized currently in net income, and the change in fair value of the firm commitment is also recognized currently in net income 9-2 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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: Unlike the accounting for a firm commitment, there is no recognition of the forecasted transaction or gains and losses on the forecasted transaction 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 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 current accounting standards, 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 9-3 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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 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 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 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 9-4 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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 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 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 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 An enterprise is required to recognize all derivative financial instruments as assets or liabilities on the balance sheet and measure them at fair value 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 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) 9-5 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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 9-6 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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 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 D (Method of accounting for foreign currency transactions) Current accounting standards require a two-transaction perspective, accrual approach 9-7 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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 to December 1, 2013 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 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 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) 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) D (Forward contract cash flow hedge of foreign currency denominated asset/liability) 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 Thus, the premium results in additional revenue for the exporter 9-8 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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 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 be as follows: 9-9 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 3/1 no journal entries 6/1 Premium Expense AOCI $10,000 $10,000 AOCI Forward Contract $2,500 $2,500 Foreign Currency Forward Contract Cash $57,500 2,500 $60,000 AOCI Adjustment to Net Income $7,500 $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 Cash $2,000 $2,000 12/31/13 Foreign Currency Option Gain on Foreign Currency Option Loss on Firm Commitment Firm Commitment [($.79 – $.80) x 100,000 = $1,000 x 9803 = $980.30] Net impact on 2013 net income: Gain on Foreign Currency Option Loss on Firm Commitment 3/1/14 Foreign Currency Option Gain on Foreign Currency Option 9-10 $300 $300 $980.30 $980.30 $300.00 (980 30) $(680 30) $700 $700 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Sales $485,000 Cash Foreign Currency (lek) Foreign Currency Option $500,000 $485,000 15,000 Firm Commitment Adjustment to Net Income $15,000 $15,000 39 (continued) b Impact on Net Income The impact on net income for the second quarter is: Loss on Firm Commitment Gain on Foreign Currency Option Impact on net income $(4,901.50) 3,000.00 $(1,901.50) The impact on net income for the third quarter is: Sales Loss on Firm Commitment Gain on Foreign Currency option Adjustment to Net Income Impact on net income $485,000.00 (10,098.50) 7,000.00 15,000.00 $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 Spot Date Rate Fair Value 11/20 $.20 a) 12/20 $.21 b) 12/20 $.18 $(500)1 $1,0002 Option Change in Premium Fair Value for 12/20 Fair Value – $500 + $1,000 9-36 $.008 $.0103 $.0004 Option Change in Fair Value $400 $500 $0 + $100 – $400 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk $10,000 – $10,500 = $(500) $10,000 – $9,000 = $1,000 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 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 Cash $400 $400 There is no entry to record the purchase agreement because it is an executory contract 12/20 Loss on Firm Commitment Firm Commitment $500 Foreign Currency Option Gain on Foreign Currency Option $100 $500 $100 Foreign Currency (pijio) Cash Foreign Currency Option $10,500 Parts inventory Foreign Currency (pijio) $10,500 $10,000 500 $10,500 The following entry is made in the period when the inventory affects net income through cost-of-goods-sold: Firm Commitment Adjustment to Net Income $500 $500 40 (continued) b The option strike price ($.20) is greater than the spot rate ($.18) on December 20, the date the parts are to be paid for Therefore, Big Arber will allow the option to expire unexercised Foreign currency will be acquired at the spot rate on December 20 The journal entries are as follows: 9-37 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 11/20 Foreign Currency Option Cash $400 $400 There is no entry to record the purchase agreement because it is an executory contract 12/20 Firm Commitment Gain on Firm Commitment Loss on Foreign Currency Option Foreign Currency Option $1,000 $1,000 $400 $400 Foreign Currency (pijio) Cash $9,000 Parts Inventory Foreign Currency (pijio) $9,000 $9,000 $9,000 The following entry is made in the period when the inventory affects net income through cost-of-goods-sold: Adjustment to Net Income Firm Commitment $1,000 $1,000 41 (20 minutes) (Option cash flow hedge of a forecasted transaction) a 12/15/13 Foreign Currency Option Cash [1 million marks x $.005] $5,000 $5,000 No journal entry related to the forecasted transaction 12/31/13 Foreign Currency Option AOCI To recognize the increase in the value of the foreign currency option with the counterpart recorded in AOCI $3,000 Option Expense $1,000 AOCI To recognize the decrease in the time value of the option as expense [($.584 – $.58) x 1,000,000 = $4,000 – $3,000 = $1,000] 9-38 $3,000 $1,000 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 3/15/14 Foreign Currency Option AOCI To recognize the increase in the value of the Foreign Currency Option with the counterpart recorded in AOCI Option Expense AOCI To recognize the decrease in the time value of the option as expense Foreign Currency (marks) Cash Foreign Currency Option To record exercise of the foreign currency option at the strike price of $.58 and close out the foreign currency option account $2,000 $2,000 $4,000 $4,000 $590,000 $580,000 10,000 Parts Inventory $590,000 Foreign Currency (marks) To record the purchase of parts and payment of million marks to the supplier $590,000 41 (continued) AOCI Adjustment to Net Income To transfer the amount accumulated in AOCI as an adjustment to net income in the period in which the forecasted transaction occurs b Impact on net income: 2013 – $10,000 Option Expense 2014 – Cost-of-goods-sold Option Expense Adjustment to Net Income $10,000 $(1,000) $(590,000) (4,000) 10,000 $(584,000) The impact on net income over the two periods is $(585,000) c Net cash outflow for parts: $585,000 = ($5,000 + $580,000) 42 (60 minutes) (Unhedged foreign currency transaction; forward contract and option hedge of foreign currency liability; forward contract and option hedge of foreign currency firm commitment (purchase)) 9-39 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Part a Foreign Currency Liability (Unhedged) 9/15 9/30 10/31 Inventory Accounts Payable (euro) $200,000 Foreign Exchange Loss Accounts Payable (euro) $10,000 Foreign Exchange Loss Accounts Payable (euro) $10,000 $200,000 $10,000 $10,000 Foreign Currency (euro) Cash $220,000 Accounts Payable (euro) Foreign Currency (euro) $220,000 $220,000 $220,000 42 (continued) Part b Forward Contract Fair Value Hedge of a Foreign Currency Liability Spot Date Rate Value 9/15 $1.00 9/30 $1.05 10/31 $1.10 Accounts U.S Dollar Dollar Value $200,000 $210,000 $220,000 Payable (C) Forward Change in U.S Rate to 10/31 Fair Value $1.06 +$10,000 $1.09 +$10,000 $1.10 Forward Contract Change in Fair Value $0 $5,940.60 +$5,940.60 $8,000.00 +$2,059.40 $218,000 – $212,000 = $6,000 x 9901 = $5,940.60; 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 $220,000 – $212,000 = $8,000 9/15 Inventory Accounts Payable (euro) $200,000 $200,000 There is no formal entry for the forward contract 9/30 Foreign Exchange Loss Accounts Payable (euro) $10,000 $10,000 Forward Contract Gain on Forward Contract $5,940.60 $5,940.60 9-40 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 10/31 Foreign Exchange Loss Accounts Payable (euro) $10,000 $10,000 Forward Contract Gain on Forward Contract $2,059.40 $2,059.40 Foreign Currency (euro) Cash Forward Contract $220,000 Accounts Payable (euro) Foreign Currency (euro) $220,000 $212,000 8,000 $220,000 42 (continued) Part c Forward Contract Fair Value Hedge of a Foreign Currency Firm Commitment (Purchase) 9/15 There is no formal entry for the forward contract or the purchase order 9/30 Forward Contract Gain on Forward Contract $5,940.60 Loss on Firm Commitment Firm Commitment $5,940.60 Forward Contract Gain on Forward Contract $2,059.40 Loss on Firm Commitment Firm Commitment $2,059.40 10/31 $5,940.60 $5,940.60 $2,059.40 $2,059.40 Foreign Currency (euro) Cash Forward Contract $220,000 Inventory Foreign Currency (euro) $220,000 $212,000 8,000 $220,000 The following entry is made in the period when the inventory affects net income through cost-of-goods-sold: Firm Commitment Adjustment to Net Income $8,000 $8,000 9-41 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 42 (continued) Part d Option Cash Flow Hedge of a Foreign Currency Liability The following schedule summarizes the changes in the components of the fair value of the euro call option with a strike price of $1.00 for October 31 Spot Date Rate 09/15 $1.00 09/30 $1.05 10/31 $1.10 Option Fair Premium Value $.035 $7,000 $.070 $14,000 $.100 $20,000 Change in Fair Value + $7,000 + $6,000 Intrinsic Value $0 $10,0002 $20,000 Time Value $7,0001 $4,0002 $03 Change in Time Value - $3,000 - $4,000 Because the strike price and spot rate are the same, the option has no intrinsic value Fair value is attributable solely to the time value of the option With a spot rate of $1.05 and a strike price of $1.00, the option has an intrinsic value of $10,000 The remaining $4,000 of fair value is attributable to time value The time value of the option at maturity is zero 9/15 Inventory Accounts Payable (euro) $200,000 $200,000 Foreign Currency Option Cash 9/30 $7,000 $7,000 Foreign Exchange Loss Accounts Payable (euro) $10,000 $10,000 Foreign Currency Option AOCI $7,000 $7,000 AOCI Gain on Foreign Currency Option Option Expense AOCI $10,000 $10,000 $3,000 $3,000 42 (continued) 10/31 Foreign Exchange Loss Accounts Payable (euro) $10,000 $10,000 Foreign Currency Option AOCI $6,000 $6,000 9-42 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk AOCI Gain on Foreign Currency Option Option Expense AOCI $10,000 $10,000 $4,000 $4,000 Foreign Currency (euro) Cash Foreign Currency Option $220,000 Accounts Payable (euro) Foreign Currency (euro) $220,000 $200,000 $20,000 $220,000 42 (continued) Part e Option Fair Value Hedge of a Foreign Currency Firm Commitment (Purchase) Firm Commitment Option Spot Change in Premium Date Rate Fair Value Fair Value for 10/31 9/15 $1.00 $0 $.035 9/30 $1.05 $ (9,901) –$ 9,9011 $.070 10/31 $1.10 $(20,000) –$10,099 $.100 Foreign Currency Option Fair Value $ 7,000 $14,000 $20,000 Change in Fair Value +$7,000 +$6,000 $210,000 – $200,000 = $(10,000) x 9901 = $(9,901), 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 9/15 9/30 10/31 Foreign Currency Option Cash $7,000 Foreign Currency Option Gain on Foreign Currency Option $7,000 Loss on Firm Commitment Firm Commitment $9,901 Foreign Currency Option Gain on Foreign Currency Option $6,000 $7,000 $7,000 $9,901 Loss on Firm Commitment Firm Commitment $6,000 $10,099 $10,099 Foreign Currency (euro) Cash $220,000 $200,000 9-43 Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Foreign Currency Option 20,000 Inventory Foreign Currency (euro) $220,000 $220,000 The following entry is made in the period when the inventory affects net income through cost-of-goods-sold: Firm Commitment Adjustment to Net Income $20,000 $20,000 Chapter Develop Your Skills Research Case—International Flavors and Fragrances The responses to this assignment might change over time as the company changes its use of foreign currency derivatives or changes the manner in which it discloses its foreign currency hedging activities in the annual report The following responses are based on IFF’s 2010 annual report In 2010, IFF provided information in the annual report related to its management of foreign exchange risk in the following locations: a Item 1A Risk Factors “impact of currency fluctuation or devaluation” b Item 7A Quantitative and Qualitative Disclosures about Market Risk c Note 14 Financial Instruments – “derivatives” IFF uses foreign currency forward contracts to reduce exposure to cash flow volatility arising from foreign currency fluctuations associated with intercompany loans, certain foreign currency receivables and payables (hedges of foreign currency denominated assets and liabilities), and anticipated purchases of raw materials used in operations (hedges of forecasted transactions) The company uses a Japanese Yen- U.S Dollar swap to hedge monthly sale and purchase transactions between the U.S and Japan The company also uses forward contracts to hedge net investments in foreign operations (This topic is discussed in more detail in Chapter 10.) In Item 7a., IFF indicates that “the notional amount and maturity dates of such (i.e., forward) contracts match those of the underlying transactions.” Toward the end of Note 14, the company also indicates that “no ineffectiveness was experienced in the above noted cash flow hedges during the year ended December 31, 2010.” 9-44 ... 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. .. 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... a hedge of a forecasted transaction differs from the accounting for a hedge of a foreign currency firm commitment in two ways: Unlike the accounting for a firm commitment, there is no recognition