Solution Manual Advanced Accounting 11th Edition Joe Ben Hoyle Chap009

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(1)Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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. 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

(2) 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: 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 income. 9-2

(3) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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. 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

(4) 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 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. 9-4

(5) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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 BlackScholes 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

(6) 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

(7) 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 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) Current accounting standards require a two-transaction perspective, accrual approach. 9-7

(8) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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) 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. 9-8

(9) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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]. 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

(10) 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

(11) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Loss on Firm Commitment $2,019.70 Firm Commitment [($.77 – $.80) x 100,000 = $3,000 – $980.30 = $2,019.70] Foreign Currency (C$) Sales $77,000 Cash Foreign Currency (C$) Foreign Currency Option $80,000 Firm Commitment Adjustment to Net Income $3,000 $2,019.70 $77,000 $77,000 3,000 $3,000 15-17. (continued) Net impact on 2014 net income: Gain on Foreign Currency Option Loss on Firm Commitment Sales Adjustment to Net Income $ 700.00 (2,019.70) 77,000.00 3,000.00 $78,680.30 15. B 16. D 17. B Net cash inflow with option ($80,000 – $2,000) Cash inflow without option (at spot rate of $.77) Net increase in cash inflow $78,000 77,000 $ 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 Gain on Forward Contract ($1,250 – $0) 9-11 $1,250 $1,250

(12) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Loss on Firm Commitment Firm Commitment $1,250 $1,250 Net impact on first quarter net income is $0. 18-20. (continued) 4/30 Loss on Forward Contract Forward Contract [Fair value of Forward Contract is ($.120 – $.118) x 500,000 = $1,000; $1,000 – $1,250 = $250] $250 Firm Commitment Gain on Firm Commitment $250 $250 $250 Foreign Currency (pesos) Sales [500,000 pesos x $.118] $59,000 Cash [500,000 x $.120] Foreign Currency (pesos) Forward Contract $60,000 Firm Commitment Adjustment to Net Income $1,000 $59,000 $59,000 1,000 $1,000 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 Net increase in cash flow from forward contract $ 1,000 9-12

(13) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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 Foreign Currency Option Cash $1,500 $1,500 12/31/13 Option Expense $400 Foreign Currency Option $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) (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] Cash [200,000 x $.40] Foreign Currency Option $82,000 Parts Inventory (Cost-of-goods-sold) Foreign Currency (BRL) $82,000 Accumulated Other Comprehensive Income (AOCI) Adjustment to Net Income 9-13 $2,000 $80,000 2,000 $82,000 $2,000 $2,000

(14) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 21-22. (continued) Net impact on 2014 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 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 9/30 10/15 Accounts Receivable (FCU) [100,000 x $.40] Sales $40,000 $40,000 Accounts Receivable (FCU) Foreign Exchange Gain [100,000 x ($.42 – $.40)] $2,000 Foreign Exchange Loss Accounts Receivable (FCU) [100,000 x ($.37 – $.42)] $5,000 Cash Accounts Receivable (FCU) $37,000 9-14 $2,000 $5,000 $37,000

(15) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 26. (10 minutes) (Foreign currency payable -- import purchase) 12/1/13 Inventory Accounts Payable (LCU) [60,000 x $.88] $52,800 $52,800 12/31/13 Accounts Payable (LCU) [60,000 x ($.82 – $.88)] $3,600 Foreign Exchange Gain 1/28/14 $3,600 Foreign Exchange Loss $4,800 Accounts Payable (LCU) [60,000 x ($.90 – $.82)] Accounts Payable (LCU) Cash $4,800 $54,000 $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 4/1/13 6/1/13 8/1/13 Equipment Accounts Payable (L) [40,000 x $.44] $17,600 Accounts Payable (L) Foreign Exchange Loss Cash [40,000 x $.45] $17,600 400 Inventory Accounts Payable (L) [30,000 x $.47] $14,100 Accounts Receivable (L) [40,000 x $.48] Sales $19,200 $17,600 $18,000 9-15 $14,100 $19,200

(16) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Cost-of-Goods Sold Inventory [$14,100 x 70%] 10/1/13 11/1/13 Cash [30,000 x $.49] Accounts Receivable (L) [$19,200 x 3/4] Foreign Exchange Gain Accounts Payable (L) [$14,100 x 2/3] Foreign Exchange Loss [20,000 x ($.50 – $.47)] Cash [20,000 x $.50] $9,870 $9,870 $14,700 $14,400 300 $9,400 600 $10,000 12/31/13 Foreign Exchange Loss Accounts Payable (L) [10,000 x ($.52 – $.47)] $500 Accounts Receivable (L) [10,000 x ($.52 – $.48)] Foreign Exchange Gain $400 2/1/14 3/1/14 $500 $400 Cash [10,000 x $.54] Accounts Receivable (L) [10,000 x $.52] Foreign Exchange Gain $5,400 Accounts Payable (L) [10,000 x $.52] Foreign Exchange Loss Cash [10,000 x $.55] $5,200 300 $5,200 200 $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. b. 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 1, 2013, 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 2013. 9-16

(17) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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] (To record the note and conversion of 1 million dudeks into $ at the spot rate.) 12/31/13 Interest Expense $525 Interest Payable (dudek) [1,000,000 x 2% x 3/12 = 5,000 dudeks x $.105 spot rate] (To accrue interest for the period 9/30 – 12/31/13.) Foreign Exchange Loss Note Payable (dudek) [1 m x ($.105 – $.10)] (To revalue the note payable at the spot rate of $.105 and record a foreign exchange loss.) 9/30/14 $100,000 $525 $5,000 $5,000 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] (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.) $2,400 12/31/14 Interest Expense $625 Interest Payable (dudek) [5,000 dudeks x $.125] (To accrue interest for the period 9/30 – 12/31/14.) $625 Foreign Exchange Loss $20,000 Note Payable (dudek) [1 m x ($.125 – $.105)] (To revalue the note payable at the spot rate of $.125 and record a foreign exchange loss.) 9-17 $20,000

(18) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 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] (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] (To record payment of the 1 million dudek note.) $3,000 $150,000 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 Foreign exchange loss Total 2014 Interest expense Foreign exchange losses Total 2015 Interest expense Foreign exchange losses Total $525 5,000 $5,525 / $100,000 = 5.525% for 3 months = = 22.1% for 12 months $2,425 20,075 $22,500 / $100,000 = 22.5% for 12 months $2,250 25,125 $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%. 9-18

(19) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 30. (continued) The net cash flow from this borrowing is: Cash outflows: Interest ($2,400 + $3,000) Principal Cash inflow: Borrowing Net cash outflow $5,400 150,000 $155,400 (100,000) $ 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] Sales $40,000 $40,000 No entry for the forward contract. 12/31/13 Accounts Receivable (K) Foreign Exchange Gain [20,000 x ($2.10-$2.00)] $2,000 $2,000 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 AOCI $2,000 AOCI $500 Premium revenue [20,000 x ($2.075 – $2.00) = $1,500 x 1/3 = $500] 9-19 $2,000 $500

(20) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 31. (continued) Impact on 2013 income: Sales Foreign Exchange Gain Loss on Forward Contract Premium Revenue Total 3/1/14 $40,000 2,000 (2,000) 500 $40,500 Accounts Receivable (K) Foreign Exchange Gain [20,000 x ($2.25 – $2.10)] $3,000 $3,000 AOCI $1,049.25 Forward Contract $1,049.25 [20,000 x ($2.25 – $2.075) = $3,500 – 2,450.75] = $1,049.25 Loss on Forward Contract AOCI $3,000 AOCI Premium revenue [$1,500 x 2/3 = $1,000] $1,000 $3,000 $1,000 Foreign Currency (K) [20,000 x $2.25] Accounts Receivable (K) $45,000 Cash [20,000 x $2.075] Forward Contract Foreign Currency (K) $41,500 3,500 Impact on 2014 income: Foreign Exchange Gain Loss on Forward Contract Premium revenue Total $45,000 $45,000 $3,000 (3,000) 1,000 $1,000 Impact on net income over both periods: $40,500 + $1,000 = $(41,500); equal to cash inflow. 9-20

(21) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 31. (continued) b. Fair Value Hedge 12/1/13 Accounts Receivable (K) [20,000 x $2.00] Sales $40,000 $40,000 No entry for the forward contract. 12/31/13 Accounts Receivable (K) Foreign Exchange Gain [20,000 x ($2.10 – $2.00)] $2,000 $2,000 Loss on Forward Contract $2,450.75 Forward Contract [20,000 x ($2.075 – $2.20) = $2,500 x .9803 = $2,450.75] Impact on 2013 income: Sales Foreign Exchange Gain Loss on Forward Contract Total 3/1/14 $2,450.75 $40,000.00 2,000.00 (2,450.75) $39,549.25 Accounts Receivable (K) Foreign Exchange Gain [20,000 x ($2.25 – $2.10)] $3,000 $3,000 Loss on Forward Contract $1,049.25 Forward Contract $1,049.25 [20,000 x (2.25 – $2.075) = $3,500 – 2,450.75 = $1,049.25] Foreign Currency (K) [20,000 x $2.25] Accounts Receivable (K) $45,000 Cash [20,000 x $2.075] Forward Contract Foreign Currency (K) $41,500 3,500 Impact on 2014 income: Foreign Exchange Gain Loss on Forward Contract Total $45,000 $45,000 $3,000.00 (1,049.25) $1,950.75 Impact on net income over both periods: $39,549.25 + $1,950.75 = $41,500; equal to cash inflow. 9-21

(22) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 32. (40 minutes) (Forward contract hedge of foreign currency payable) a. Cash Flow Hedge 12/1/13Parts Inventory (COGS) Accounts Payable (K) [20,000 x $2.00] $40,000 $40,000 No entry for the forward contract. 12/31/13 Foreign Exchange Loss Accounts Payable (K) [20,000 x ($2.10 – $2.00)] $2,000 $2,000 Forward Contract $2,450.75 AOCI $2,450.75 [20,000 x ($2.075 – $2.20) = $2,500 x .9803 = $2,450.75] AOCI Gain on Forward Contract $2,000 $2,000 Premium Expense $500 AOCI [20,000 x ($2.075 – $2.00) = $1,500 x 1/3 = $500] Impact on 2013 income: Parts inventory (COGS) Foreign Exchange Loss Gain on Forward Contract Premium Expense Total $500 $(40,000) (2,000) 2,000 (500) $(40,500) 32. (continued) 3/1/14 Foreign Exchange Loss Accounts Payable (K) [20,000 x ($2.25 – $2.10)] $3,000 $3,000 Forward Contract $1,049.25 AOCI $1,049.25 [20,000 x ($2.25 – $2.075) = $3,500 – 2,450.75 = $1,049.25] AOCI Gain on Forward Contract 9-22 $3,000 $3,000

(23) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Premium Expense AOCI [$1,500 x 2/3 = $1,000] $1,000 $1,000 Foreign Currency (K) [20,000 x $2.25] Cash Forward Contract $45,000 Accounts Payable (K) Foreign Currency (K) $45,000 Impact on 2014 income: Foreign Exchange Loss Loss on Forward Contract Premium revenue Total $41,500 3,500 $45,000 $(3,000) 3,000 (1,000) $(1,000) Impact on net income over both periods: $(40,500) + $(1,000) = $(41,500); equal to cash outflow. 32. (continued) b. Fair Value Hedge 12/1/13Parts inventory (COGS) Accounts Payable (K) [20,000 x $2.00] $40,000 $40,000 No entry for the forward contract. 12/31/13 Foreign Exchange Loss Accounts Payable (K) [20,000 x ($2.10 – $2.00)] $2,000 $2,000 Forward Contract $2,450.75 Gain on Forward Contract $2,450.75 [20,000 x ($2.075 – $2.20) = $2,500 x .9803 = $2,450.75] Impact on 2013 income: Parts inventory (COGS) Foreign Exchange Loss Gain on Forward Contract Total $(40,000.00) (2,000.00) 2,450.75 $(39,549.25) 9-23

(24) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 3/1/14 Foreign Exchange Loss Accounts Payable (K) [20,000 x ($2.25 – $2.10)] $3,000 $3,000 Forward Contract $1,049.25 Gain on Forward Contract $1,049.25 [20,000 x ($2.25 – $2.075) = $3,500 – 2,450.75 = $1,049.25] Foreign Currency (K) [20,000 x $2.25] Cash Forward Contract $45,000 Accounts Payable (K) Foreign Currency (K) $45,000 $41,500 3,500 $45,000 32. (continued) Impact on 2014 income: Foreign Exchange Loss Gain on Forward Contract Total $(3,000.00) 1,049.25 $(1,950.75) Impact on net income over both periods: $(39,549.25) + $(1,950.75) = $(41,500.00); equal to cash outflow. 33. (30 minutes) (Option hedge of foreign currency receivable) a. Cash Flow Hedge 6/1 6/30 Accounts Receivable (P) Sales [$.045 x 1,000,000 pesos] $45,000 $45,000 Foreign Currency Option Cash $2,000 Accounts Receivable (P) Foreign Exchange Gain [($.048 – $.045) x 1,000,000] $3,000 $2,000 AOCI Foreign Currency Option [($.0018 – $.0020) x 1,000,000] 9-24 $3,000 $200 $200

(25) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Loss on Foreign Currency Option AOCI Option Expense AOCI Date 6/1 6/30 9/1 Fair Value $2,000 $1,800 $1,000 $3,000 $3,000 $200 $200 Intrinsic Value $0 $0 $1,000 Time Value $2,000 $1,800 $0 Change in Time Value – –$ 200 –$1,800 33. (continued) 9/1 Foreign Exchange Loss Accounts Receivable (P) [($.044 – $.048) x 1,000,000] $4,000 AOCI Foreign Currency Option [$1,800 – $1,000] $800 AOCI Gain on Foreign Currency Option $4,000 $800 $4,000 $4,000 Option Expense $1,800 AOCI (Change in time value of option is recognized as expense) Foreign Currency (P) Accounts Receivable (P) $44,000 Cash Foreign Currency (P) Foreign Currency Option $45,000 $1,800 $44,000 $44,000 $1,000 Impact on Net Income over the Two Accounting Periods: Sales $45,000 Foreign currency option expense (2,000) Impact on net income $43,000 = Net cash inflow b. Fair Value Hedge 6/1 Accounts Receivable (P) Sales [$.045 x 1,000,000] 9-25 $45,000 $45,000

(26) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 6/30 Foreign Currency Option Cash $2,000 Accounts Receivable (P) Foreign Exchange Gain [($.048 – $.045) x 1,000,000] $3,000 $2,000 Loss on Foreign Currency Option Foreign Currency Option 33. (continued) 9/1 Foreign Exchange Loss Accounts Receivable (P) [($.044 – $.048) x 1,000,000] Loss on Foreign Currency Option Foreign Currency Option $3,000 $200 $200 $4,000 $4,000 $800 $800 Foreign Currency (P) Accounts Receivable (P) $44,000 Cash Foreign Currency (P) Foreign Currency Option $45,000 $44,000 $44,000 $1,000 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 $43,000 = Net cash inflow 34. (30 minutes) (Option hedge of foreign currency payable) a. Cash Flow Hedge 6/1 6/30 Inventory [$.085 x 1,000,000] Accounts Payable (M) $85,000 $85,000 Foreign Currency Option Cash $2,000 Foreign Exchange Loss Accounts Payable (M) [($.088 – .085) x 1,000,000] $3,000 $2,000 9-26 $3,000

(27) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Date 6/1 6/30 9/1 Foreign Currency Option AOCI [$4,000 – $2,000] $2,000 AOCI Gain on Foreign Currency Option $3,000 Option Expense AOCI $1,000* Fair Value $2,000 $4,000 $5,000 $2,000 $3,000 $1,000 Intrinsic Value $0 $3,000 $5,000 Time Value $2,000 $1,000 $0 Change in Time Value -$1,000* -$1,000** 34. (continued) 9/1 Foreign Exchange Loss Accounts Payable (M) [($.09 – $.088) x 1,000,000] $2,000 Foreign Currency Option AOCI [$5,000 – $4,000] $1,000 AOCI Gain on Foreign Currency Option $2,000 Option Expense AOCI $1,000** $2,000 $1,000 $2,000 $1,000 Foreign Currency (M) Cash Foreign Currency Option $90,000 Accounts Payable (M) Foreign Currency (M) $90,000 $85,000 $5,000 $90,000 Impact on net income: Option Expense ($2,000) 9-27

(28) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 34. (continued) b. Fair Value Hedge 6/1 6/30 9/1 Inventory Accounts Payable (M) [$.085 x 1,000,000] $85,000 Foreign Currency Option Cash $2,000 Foreign Exchange Loss Accounts Payable (M) [($.088 – $.085) x 1,000,000] $3,000 Foreign Currency Option Gain on Foreign Currency Option [$4,000 – $2,000] $2,000 Foreign Exchange Loss Accounts Payable (M) [($.09 – $.088) x 1,000,000] $2,000 Foreign Currency Option Gain on Foreign Currency Option [$5,000 – $4,000] $1,000 $85,000 $2,000 $3,000 $2,000 $2,000 $1,000 Foreign Currency (M) Cash Foreign Currency Option $90,000 Accounts Payable (M) Foreign Currency (M) $90,000 $85,000 5,000 $90,000 Impact on net income: Foreign Exchange Loss Gain on Foreign Currency Option Impact on net income ($5,000) 3,000 ($2,000) 9-28

(29) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 35. (30 minutes) (Forward contract cash flow hedge of foreign currency denominated asset) Date 11/01/13 12/31/13 4/30/14 Spot Rate $.53 $.50 $.49 Account Receivable (FCU) Forward U.S. Dollar Change in U.S. Rate to Value Dollar Value 4/30/14 $53,000 $.52 $50,000 -$3,000 $.48 $49,000 -$1,000 $.49 Forward Contract Change in Fair Value Fair Value $0 $3,8441 +$3,844 $3,0002 - $ 844 $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 1/1.01 4. 2 $52,000 – $49,000 = $3,000. 1 2013 Journal Entries 11/01/13 Accounts Receivable (FCU) Sales $53,000 $53,000 There is no entry for the forward contract. 12/31/13 Foreign Exchange Loss Accounts Receivable (FCU) $3,000 $3,000 AOCI Gain on Forward Contract $3,000 Forward Contract AOCI $3,844 $3,000 $3,844 Discount expense AOCI [100,000 x ($.53 – $.52) = $1,000 x 2/6 = $333.33] The impact on net income for the year 2013 is: Sales Foreign Exchange Loss Gain on Forward Contract Net Gain (Loss) Discount Expense Impact on net income $53,000.00 (3,000.00) 3,000.00 0.00 (333.33) $52,666.67 9-29 $333.33 $333.33

(30) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 35. (continued) 2014 Journal Entries 4/30/14 Foreign Exchange Loss Accounts Receivable (FCU) $1,000 AOCI Gain on Forward Contract $1,000 $1,000 $1,000 AOCI Forward Contract $844 $844 Discount expense AOCI $666.67 Foreign Currency (FCU) Accounts Receivable (FCU) $49,000 Cash Foreign Currency (FCU) Forward Contract $52,000 $666.67 $49,000 $49,000 3,000 The impact on net income for the year 2014 is: Foreign Exchange Loss Gain on Forward Contract Net Gain (Loss) Discount Expense Impact on net income $(1,000.00) 1,000.00 0.00 (666.67) $(666.67) 36. (30 minutes) (Forward contract fair value hedge of net foreign currency denominated asset) Account Receivable (Payable) (mongs) Forward Change in U.S. Rate to Date U.S. Dollar Value Dollar Value 1/31/14 11/30/13 $265,000 ($159,000) $.52 12/31/13 $250,000 ($150,000) -$15,000 (-$9,000) $.48 1/31/14 $245,000 ($147,000) -$ 5,000 (-$3,000) $.49 Forward Contract Change in Fair Value Fair Value $0 1 $7,921 +$7,921 $6,0002 - $1,921 $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. 2 $104,000 – $98,000 = $6,000. 1 9-30

(31) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 2013 Journal Entries 11/30 Accounts Receivable (mongs) Sales [$.53 x 500,000 mongs] $265,000 Inventory Accounts Payable [$.53 x 300,000 mongs] $159,000 $265,000 $159,000 There is no formal entry for the forward contract. 12/31 Foreign Exchange Loss Accounts Receivable (mongs) $15,000 $15,000 Accounts Payable (mongs) Foreign Exchange Gain $9,000 Forward Contract Gain on Forward Contract $7,921 $9,000 $7,921 The impact on net income for the year 2013 is: Sales Net Foreign Exchange Loss $ (6,000) Gain on Forward Contract 7,921 Net Gain (Loss) Impact on net income $265,000 1,921 $266,921 36. (continued) 2014 Journal Entries 1/31 Foreign Exchange Loss Accounts Receivable (mongs) $5,000 Accounts Payable (mongs) Foreign Exchange Gain $3,000 Loss on Forward Contract Forward Contract $1,921 $5,000 $3,000 $1,921 Foreign Currency (mongs) Accounts Receivable (mongs) 9-31 $245,000 $245,000

(32) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Accounts Payable (mongs) Foreign Currency (mongs) $147,000 Cash Foreign Currency (mongs) Forward Contract $104,000 $147,000 $98,000 $6,000 The impact on net income for the year 2014 is: Net Foreign Exchange Loss Loss on Forward Contract Impact on net income $(2,000) (1,921) $(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) Sales (100,000 LCUs x $.69) $69,000 $69,000 There is no formal entry for the forward contract. 12/31 Accounts Receivable (LCU) Foreign Exchange Gain [($.71 – $.69) x 100,000] $2,000 $2,000 Loss on Forward Contract $8,910.90 Forward Contract [($.74 – $.65) x 100,000 = $ 9,000 x .9901 = $ 8,910.90] 1/31 Accounts Receivable (LCU) Foreign Exchange Gain [($.72 – $.71) x 100,000] $8,910.90 $1,000 $1,000 Forward Contract $ 1,910.90 Gain on Forward Contract $ 1,910.90 [($.72 – $.65) x 100,000 = $ 7,000 loss – 8,910.90 = $ 1,910.90 gain] 9-32

(33) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Foreign Currency (LCU) Accounts Receivable (LCU) $72,000 Cash Forward Contract Foreign Currency (LCU) $65,000 $7,000 $72,000 $72,000 The impact on net income: Sale Foreign Exchange Gain Loss on Forward Contract Gain on Forward Contract Impact on net income $69,000.00 3,000.00 (8,910.90) 1,910.90 $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 Forward Contract $8,910.90 Firm Commitment Gain on Firm Commitment $8,910.90 Forward Contract Gain on Forward Contract $1,910.90 Loss on Firm Commitment Firm Commitment $1,910.90 1/31 $8,910.90 $8,910.90 $1,910.90 $1,910.90 Foreign Currency (LCU) Sales $72,000 Cash Forward Contract Foreign Currency (LCU) $65,000 $7,000 Adjustment to Net Income Firm Commitment $7,000 $72,000 9-33 $72,000 $7,000

(34) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Impact on Net Income: Sales Net Loss on Forward Contract Net Gain on Firm Commitment Adjustment to Net Income $72,000 (7,000) 7,000 (7,000) $65,000 = Cash Inflow 38. (30 minutes) (Forward contract fair value hedge of a foreign currency firm commitment (purchase)) Date 8/1 9/30 10/31 Forward Rate to 10/31 $.30 $.325 $.320 (spot) Forward Contract Change in Fair Value Fair Value $0 $4,950.501 + $4,950.50 $4,0002 – $ 950.50 Firm Commitment Change in Fair Value Fair Value $0 $0 $(4,950.50)1 – $4,950.50 $(4,000)2 + $ 950.50 ($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. 1 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 Gain on Forward Contract $4,950.50 Loss on Firm Commitment Firm Commitment $4,950.50 Loss on Forward Contract Forward Contract $950.50 Firm Commitment Gain on Firm Commitment $950.50 Foreign Currency (rupees) Cash Forward Contract $64,000 Inventories (Cost-of-Goods-Sold) Foreign Currency (rupees) $64,000 10/31 $4,950.50 $4,950.50 $950.50 $950.50 $60,000 4,000 Firm Commitment Adjustment to Net Income $64,000 $4,000 $4,000 9-34

(35) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk b. Assuming the inventory is sold in the fourth quarter, the net impact on net income is negative $60,000: Cost-of-Goods-Sold Adjustment to Net Income Net impact on net income $(64,000) 4,000 $(60,000) c. The net cash outflow is $60,000. 39. (30 minutes) (Option fair value hedge of a foreign currency firm commitment (sale)) Date Spot Rate Firm Commitment Change in Fair Value Fair Value Option Premium for 9/1 Option Change in Fair Value Fair Value 6/1 6/30 9/1 $1.00 $0.99 $0.97 $(4,901.50)1 $(15,000)2 $0.010 $0.016 $0.030 $5,000 $8,000 $15,000 – $ 4,901.50 – $10,098.50 + $3,000 + $7,000 $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). 1 a. Journal Entries 6/1 Foreign Currency Option Cash $5,000 $5,000 There is no entry to record the sales agreement because it is an executory contract. 6/30 Loss on Firm Commitment Firm Commitment $4,901.50 $4,901.50 Foreign Currency Option Gain on Foreign Currency Option 9/1 Loss on Firm Commitment Firm Commitment $3,000 $3,000 $10,098.50 $10,098.50 Foreign Currency Option Gain on Foreign Currency Option Foreign Currency (lek) $7,000 $7,000 $485,000 9-35

(36) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Sales $485,000 Cash Foreign Currency (lek) Foreign Currency Option $500,000 Firm Commitment Adjustment to Net Income $15,000 $485,000 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)) Date Spot Rate 11/20 $.20 a) 12/20 $.21 b) 12/20 $.18 Firm Commitment Change in Fair Value Fair Value Option Premium for 12/20 $(500)1 $1,0002 $.008 $.0103 $.0004 – $500 + $1,000 9-36 Option Change in Fair Value Fair Value $400 $500 $0 + $100 – $400

(37) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk $10,000 – $10,500 = $(500). $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 $.000. 1 2 a. The option strike price ($.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

(38) 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 $3,000 AOCI To recognize the increase in the value of the foreign currency option with the counterpart recorded in AOCI. 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

(39) 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. $2,000 Option Expense AOCI To recognize the decrease in the time value of the option as expense. $4,000 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 $4,000 $590,000 $580,000 10,000 Parts Inventory $590,000 Foreign Currency (marks) To record the purchase of parts and payment of 1 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. $10,000 b. Impact on net income: 2013 – 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

(40) 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 Date 9/15 9/30 10/31 Spot Rate $1.00 $1.05 $1.10 Accounts Payable (C) U.S. Dollar Change in U.S. Value Dollar Value $200,000 $210,000 +$10,000 $220,000 +$10,000 Forward Rate to 10/31 $1.06 $1.09 $1.10 Forward Contract Change in Fair Value Fair Value $0 1 $5,940.60 +$5,940.60 $8,000.002 +$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. 2 $220,000 – $212,000 = $8,000. 1 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

(41) 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 Foreign Currency (euro) Cash Forward Contract $220,000 Accounts Payable (euro) Foreign Currency (euro) $220,000 $2,059.40 $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 Foreign Currency (euro) Cash Forward Contract $220,000 Inventory Foreign Currency (euro) $220,000 10/31 $5,940.60 $5,940.60 $2,059.40 $2,059.40 $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

(42) 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 1 2 3 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

(43) 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) Date 9/15 9/30 10/31 Spot Rate $1.00 $1.05 $1.10 Firm Commitment Change in Fair Value Fair Value $0 $ (9,901) –$ 9,9011 $(20,000) –$10,099 Option Premium for 10/31 $.035 $.070 $.100 Foreign Currency Option Change in Fair Value Fair Value $ 7,000 $14,000 +$7,000 $20,000 +$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. 1 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

(44) 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 9 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. 1. 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” 2. 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.) 3. 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

(45) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Accounting Standards Case—Forecasted Transactions Questions asked in the case are: • Is management’s intent sufficient to assess that a forecasted transaction is likely to occur? • If not, what additional evidence must be considered? Source of guidance: FASB ASC 815-20-55-24 Derivatives and Hedging; HedgingGeneral; Implementation Guidance and Illustrations; Probability of a Forecasted Transaction ASC 815-20-55-24 states: “An assessment of the likelihood that a forecasted transaction will take place should not be based solely on management's intent because intent is not verifiable. The transaction's probability should be supported by observable facts and the attendant circumstances. Consideration should be given to all of the following circumstances in assessing the likelihood that a transaction will occur. a. The frequency of similar past transactions b. The financial and operational ability of the entity to carry out the transaction c. Substantial commitments of resources to a particular activity (for example, a manufacturing facility that can be used in the short run only to process a particular type of commodity) d. The extent of loss or disruption of operations that could result if the transaction does not occur e. The likelihood that transactions with substantially different characteristics might be used to achieve the same business purpose (for example, an entity that intends to raise cash may have several ways of doing so, ranging from a short-term bank loan to a common stock offering).” The answers to the specific questions asked in the case are: • Management’s intent is not sufficient to assess whether a forecasted transaction is likely to occur. • Additional evidence listed in items a. – e. in ASC 815-20-55-24 must be considered in assessing that likelihood. 9-45

(46) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Excel Case—Determine Foreign Exchange Gains and Losses 1., 2. and 3. Spreadsheet for the calculation of the foreign exchange gains (losses) related to Import/Export Company’s foreign currency transactions for the year 2010. Foreign Currency Brazilian real (BRL) Swiss franc (CHF) Swiss franc (CHF) Euro Euro Chinese yuan (CNY) South Korean won (KRW) Total Net Foreign Exchange Gain (Loss) Type of Transaction Import purchase (payable) Export sale (receivable) Import purchase (payable) Export sale (receivable) Export sale (receivable) Import purchase (payable) Import purchase (payable) Amount in Foreign Currency Transaction Date Exchange Rate at Transaction Date $ Value on Transaction Date Settlement Date Exchange Rate at Settlemen t Date $ Value on Settlement Date Foreign Exchange Gain (Loss) (87,000) 1/4/2010 0.577477 (50,240.50) 5/4/2010 0.57428 (49,962.36) 278.14 51,700 1/4/2010 0.967455 50,017.42 5/4/2010 0.913718 47,239.22 (2,778.20) (55,000) 5/4/2010 0.913718 (50,254.49) 10/4/2010 1.02836 (56,559.80) (6,305.31) 37,200 4/1/2010 1.3468 50,100.96 9/1/2010 1.28 47,616.00 (2,484.96) 37,200 4/1/2010 1.3468 50,100.96 10/1/2010 1.3726 51,060.72 959.76 (342,000) 1/4/2010 0.146471 (50,093.08) 10/4/2010 0.14945 (51,111.90) (1,018.82) (55,600,000) 1/4/2010 0.00086557 (48,125.69) 10/4/2010 0.0008892 (49,439.52) (1,313.83) (12,663.22) Source of exchange rates: www.x-rates.com, Historical Lookup Import/Export Company reported a net foreign exchange loss of $12,663.22 in 2010 income. Possible discussion points for instructors: Note that all transactions had a $ value on transaction date of approximately $50,000. The size of the foreign exchange gains and losses reported in the last column differs substantially across transactions because of different rates and directions of change in the exchange rates across the currencies in which Import/Export Company had exposures. At one extreme, the large depreciation in value of the CHF from 1/4/10 to 5/4/10 coupled with an asset exposure resulted in a large foreign exchange loss. The large appreciation in value of the CHF from 5/4/10 to 10/4/10 coupled with the CHF liability exposure also generated a large foreign exchange loss. The depreciation in value of the Euro from 4/1/10 to 9/1/10 resulted in a foreign exchange loss on one of the company’s Euro receivables; the overall appreciation in value of the Euro from 4/1/10 to 10/1/10 resulted in a foreign exchange gain on a second Euro receivable. 9-46

(47) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Analysis Case—Cash Flow Hedge 1. Given the $6,000 total Premium Expense, the forward rate on 2/1/13 must have been $1.06 [($1.06 – $1.00 spot) x 100,000 euros = $6,000]. 2. Given that the forward contract is reported as a liability of $1,980 ($2,000 x .9901), the forward rate at 3/31/13 must have been $1.04 [($1.04 – $1.06) x 100,000 euros = $2,000]. The fact that the forward contract is a liability signals that the forward rate at 3/31 is less than the forward rate on 2/1. 3. Given that the cost of goods sold is $103,000, the spot rate on 5/1/13 must have been $1.03. Linber must pay $1.06 per euro under the forward contract, so the forward contract results in an economic loss of $3,000 [($1.06 – $1.03) x 100,00 euros]. The negative adjustment to net income reflects this economic loss. 4. The Premium Expense of $6,000 reflects the increase in cost for the parts from the date the transaction was forecasted until the date of purchase. If Linber had purchased 100,000 euros on 2/1/13 at the spot rate of $1.00, it could have saved $6,000. Internet Case—Historical Exchange Rates 1. Spreadsheets for the calculation of the foreign exchange gains (losses) related to Pier Ten Company’s foreign currency account receivables. Currency Code Foreign Currency Account Receivabl e Exchange Rate on 12/14/10 U.S. Dollar Value on 12/14/10 Indian rupee INR 898,000 0.0222781 $20,005.73 Philippine peso PHP 874,000 0.0228883 20,004.37 Japanese yen JPY 1,662,500 0.0120353 20,008.69 Malaysian ringgit MYR 62,550 0.319881 20,008.56 $80,027.35 Currency Code Foreign Currency Account Receivabl e Exchange Rate on 12/31/10 U.S. Dollar Value on 12/31/10 Indian rupee INR 898,000 0.0223602 $20,079.46 Philippine peso PHP 874,000 0.0229194 20,031.56 9-47 Foreign Exchange Gain (Loss) on 12/31/10 $ 73.73 27.19

(48) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Japanese yen JPY 1,662,500 0.0122982 20,445.76 437.07 Malaysian ringgit MYR 62,550 0.3263 20,410.07 401.51 $80,966.85 Currency Code Foreign Currency Account Receivabl e Exchange Rate on 1/14/11 U.S. Dollar Value on 1/14/11 $ 939.50 Foreign Exchange Gain (Loss) on 1/14/11 Indian rupee INR 898,000 0.0220214 $19,775.22 $ (304.24) Philippine peso PHP 874,000 0.0225666 19,723.21 (308.35) Japanese yen JPY 1,662,500 0.0120456 20,025.81 (419.95) Malaysian ringgit MYR 62,550 0.326938 20,449.97 39.90 $79,974.21 Currency Code Foreign Currency Account Receivabl e U.S. Dollar Value on 12/14/10 U.S. Dollar Value on 1/14/11 $ (992.64) Net Foreign Exchange Gain (Loss) Indian rupee INR 898,000 $20,005.73 $19,775.22 $ (230.51) Philippine peso PHP 874,000 20,004.37 19,723.21 (281.16) Japanese yen JPY 1,662,500 20,008.69 20,025.81 17.12 Malaysian ringgit MYR 62,550 20,008.56 20,449.97 441.41 $80,027.35 $79,974.21 $ (53.14) Source of exchange rates: www.x-rates.com, Historical Lookup 2. Pier Ten would have reported a net foreign exchange gain of $939.50 in 2010 and a net foreign exchange loss of $992.64 in 2011 related to these foreign currency receivables. The transactions denominated in Indian rupees and Philippine pesos resulted in a net foreign exchange loss of $230.51 and $281.16, respectively. The PHP receivable would have been the most important to hedge. 9-48

(49) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk 3. Assuming a strike price equal to the December 14, 2010 spot rate, the only foreign currency transactions for which the purchase of a put option costing $100 would have been beneficial are the transactions in Indian rupees and Philippine pesos. Net cash inflow from the INR receivable would have been $130.51 greater ($230.51 FX loss avoided less $100.00 cost of option) if a put option had been acquired and the net cash flow from the PHP receivable would have been $181.16 greater ($281.16 FX loss avoided less $100.00 cost of option) if a put option had been acquired. Put options in JPY and MYR would have had no value at 1/14/11. The purchase of JPY and MYR options would have resulted in a decrease in net cash inflow to Pier Ten of $200.00 (the cost of the options). Communication Case—Forward Contracts and Options To: Mr. Dewey Nukem, CEO, Palmetto Bug Extermination Company (PBEC) The primary advantage of using forward contracts to hedge foreign exchange risk is that there is no cost to enter into them. The disadvantage is that the company is obligated to exchange foreign currency for dollars at the contracted forward rate. Depending upon the future spot rate, this may or may not be advantageous for the company. In contrast, the primary disadvantage of using foreign currency options to hedge foreign exchange risk is that there is an upfront cost incurred to purchase them. The primary advantage is that the company is not required to exchange foreign currency for dollars at the option strike price if it is disadvantageous to do so. The company can simply allow the option to expire unexercised and the only cost is the initial premium that was paid to acquire the option. Exporters sometimes use forward contracts to hedge export sales (import purchases) when the foreign currency is selling at a forward premium (discount) as this locks in premium revenue (discount revenue). The risk associated with this strategy is that the customer may or may not pay on time. If an exporter enters into a forward contract to sell foreign currency, and the customer does not pay on time, the exporter will need to purchase foreign currency at the spot rate to settle the forward contract. This is essentially the same as speculation; a gain or loss could arise. In this case, the exporter might be better off by purchasing a foreign currency put option. The exporter can simply allow the option to exercise if it has not received foreign currency from the customer by the expiration date. 9-49

(50) Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk Since PBEC is making import purchases, it has more control over the timing of when it will need foreign currency. In that case, it should be safe to enter into a forward contract to purchase foreign currency on the date when PBEC plans to pay for its purchases. However, there is always the risk that the supplier does not deliver on time, in which case the forward contract provides PBEC with foreign currency for which it has no current use. The bottom line is that there is no right or wrong answer to the question which hedging instrument should be used to hedge the Swiss franc exposure to foreign exchange risk. Both forward contracts and option have the advantages and disadvantages. 9-50

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