Foreign Currency Transactions and Hedging Foreign Exchange Risk

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
CHAPTER 9
FOREIGN CURRENCY TRANSACTIONS AND
HEDGING FOREIGN EXCHANGE RISK
Chapter Outline
I.
In todays 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
companys reporting currency by multiplying it by an exchange rate.
C. Accountants face two questions in restating foreign currency balances.
1. What is the appropriate exchange rate for restating foreign currency balances?
2. How are changes in the exchange rate accounted for?
D. Companies often engage in foreign currency hedging activities to avoid the adverse
impact of exchange rate changes.
E. Accountants must determine how to properly account for these hedging activities.
II.
Foreign exchange rates are determined in the foreign exchange market under a variety of
different currency arrangements.
A. Exchange rates can be expressed in terms of the number of U.S. dollars to purchase
one foreign currency unit (direct quotes) or the number of foreign currency units that
can be obtained with one U.S. dollar (indirect quotes).
B. Foreign currency trades can be executed on a spot or forward basis.
1. The spot rate is the price at which a foreign currency can be purchased or sold
today.
2. The forward rate is the price today at which foreign currency can be purchased or
sold sometime in the future.
3. Forward exchange contracts provide companies with the ability to lock in a price
today for purchasing or selling currency at a specific future date.
C. Foreign currency options provide the right but not the obligation to buy or sell foreign
currency in the future, and therefore are more flexible than forward contracts.
III. FASB Accounting Standards Codification Topic 830, Foreign Currency Matters (FASB ASC
830) prescribes accounting rules for foreign currency transactions.
A. Export sales denominated in foreign currency are reported in U.S. dollars at the spot
exchange rate at the date of the transaction. Subsequent changes in the exchange
rate until collection of the receivable are reflected through a restatement of the foreign
currency account receivable with an offsetting foreign exchange gain or loss reported
in income. This is known as a two-transaction perspective, accrual approach.
B. The two-transaction perspective, accrual approach also is used in accounting for
foreign currency payables. Receivables and payables denominated in foreign
currency create an exposure to foreign exchange risk; this is the risk that changes in
the exchange rate over time will result in a foreign exchange loss.
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Education.
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.
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 periods 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.
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G. Under fair value hedge accounting for hedges of foreign currency firm commitments:
1. the gain or loss on the hedging instrument is recognized currently in net income,
and
2. the change in fair value of the firm commitment is also recognized currently in net
income.
This accounting treatment requires (1) measuring the fair value of the firm
commitment, (2) recognizing the change in fair value in net income, and (3) reporting
the firm commitment on the balance sheet as an asset or liability. A decision must be
made whether to measure the fair value of the firm commitment through reference to
(a) changes in the spot exchange rate or (b) changes in the forward rate.
H. 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.
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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 [$2.00 x 100,000 tchecks] 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.
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 managers 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.)
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Answers to Questions
1.
Under the two-transaction perspective, an export sale (import purchase) and the
subsequent collection (payment) of cash are treated as two separate transactions to be
accounted for separately. The idea is that management has made two decisions: (1) to
make the export sale (import purchase), and (2) to extend credit in foreign currency to the
foreign customer (obtain credit from the foreign supplier). The income effect from each of
these decisions should be reported separately.
2.
Foreign currency receivables resulting from export sales are revalued at the end of
accounting periods using the current spot rate. An increase in the value of a receivable
will be offset by reporting a foreign exchange gain in net income, and a decrease will be
offset by a foreign exchange loss. Foreign exchange gains and losses are accrued even
though they have not yet been realized.
3.
Foreign exchange gains and losses are created by two factors: having foreign currency
exposures (foreign currency receivables and payables) and changes in exchange rates.
Appreciation of the foreign currency will generate foreign exchange gains on receivables
and foreign exchange losses on payables. Depreciation of the foreign currency will
generate foreign exchange losses on receivables and foreign exchange gains on
payables.
4.
Hedging is the process of eliminating exposure to foreign exchange risk so as to avoid

potential losses from fluctuations in exchange rates. In addition to avoiding possible
losses, companies hedge foreign currency transactions and commitments to introduce an
element of certainty into the future cash flows resulting from foreign currency activities.
Hedging involves establishing a price today at which foreign currency can be sold or
purchased at a future date.
5.
A party to a foreign currency forward contract is obligated to deliver one currency in

exchange for another at a specified future date, whereas the owner of a foreign currency
option can choose whether to exercise the option and exchange one currency for another
or not.
6.
Hedges of foreign currency denominated assets and liabilities are not entered into until a
foreign currency transaction (import purchase or export sale) has taken place. Hedges of
firm commitments are made when a purchase order is placed or a sales order is received,
before a transaction has taken place. Hedges of forecasted transactions are made at the
time a future foreign currency purchase or sale can be anticipated, even before an order
has been placed or received.
7.
Foreign currency options have an advantage over forward contracts in that the holder of
the option can choose not to exercise if the future spot rate turns out to be more
advantageous. Forward contracts, on the other hand, can lock a company into an
unnecessary loss (or a reduced gain). The disadvantage associated with foreign currency
options is that a premium must be paid up front even though the option might never be
exercised.
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.
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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 companys
incremental borrowing rate.
The manner in which the fair value of a foreign currency option is determined depends on
whether the option is traded on an exchange or has been acquired in the over the counter
market. The fair value of an exchange-traded foreign currency option is its current market
price quoted on the exchange. For over the counter options, fair value can be determined
by obtaining a price quote from an option dealer (such as a bank). If dealer price quotes
are unavailable, the company can estimate the value of an option using the modified
Black-Scholes option pricing model. Regardless of who does the calculation, principles
similar to those in the Black-Scholes pricing model will be used in determining the value of
the option.
10. Hedge accounting is defined as recognition of gains and losses on the hedging instrument
in the same period as the recognition of gains and losses on the underlying hedged asset
or liability (or firm commitment).
11. For hedge accounting to apply, the forecasted transaction must be probable (likely to
occur), the hedge must be highly effective in offsetting fluctuations in the cash flow
associated with the foreign currency risk, and the hedging relationship must be properly
documented.
12. In both cases, (1) sales revenue (or the cost of the item purchased) is determined using
the spot rate at the date of sale (or purchase), and (2) the hedged asset or liability is
adjusted to fair value based on changes in the spot exchange rate with a foreign
exchange gain or loss recognized in net income.
For a cash flow hedge, the derivative hedging instrument is adjusted to fair value
(resulting in an asset or liability reported on the balance sheet), with the counterpart
recognized as a change in Accumulated Other Comprehensive Income (AOCI). An
amount equal to the foreign exchange gain or loss on the hedged asset or liability is then
transferred from AOCI to net income; the net effect is to offset any gain or loss on the
hedged asset or liability. An additional amount is removed from AOCI and recognized in
net income to reflect (a) the current periods 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
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is adjusted to fair value based on changes in the forward rate (resulting in an asset or
liability reported on the balance sheet), with the counterpart recognized as a gain or loss
in net income. The foreign exchange gain (loss) and the forward contract loss (gain) are
likely to be of different amounts resulting in a net gain or loss reported in net income.
For a fair value hedge of a firm commitment, there is no hedged asset or liability to
account for. The forward contract is adjusted to fair value based on changes in the forward
rate (resulting in an asset or liability reported on the balance sheet), with a gain or loss
recognized in net income. The firm commitment is also adjusted to fair value based on
changes in the forward rate (resulting in a liability or asset reported on the balance sheet),
and a gain or loss on firm commitment is recognized in net income. The firm commitment
gain (loss) offsets the forward contract loss (gain) resulting in zero impact on net income.
Sales revenue (cost of purchases) is recognized at the spot rate at the date of sale
(purchase). The firm commitment account is closed as an adjustment to net income in the
period in which the hedged item affects net income.
14. For a cash flow hedge of a foreign currency asset or liability (1) sales revenue (cost of
purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the
hedged asset or liability is adjusted to fair value based on changes in the spot exchange
rate with a foreign exchange gain or loss recognized in net income. The forward contract
is adjusted to fair value (resulting in an asset or liability reported on the balance sheet),
with the counterpart recognized as a change in Accumulated Other Comprehensive
Income (AOCI). An amount equal to the foreign exchange gain or loss on the hedged
asset or liability is then transferred from AOCI to net income; the net effect is to offset any
gain or loss on the hedged asset or liability. An additional amount is removed from AOCI
and recognized in net income to reflect the current periods 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 periods 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 payablesthe 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.
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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.
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, 2015.
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, 2015 to $95,000 at February 15, 2016. This decrease of
$15,000 should be reported as a foreign exchange loss in 2016.
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 2015 and a $10,000 loss will be reported in 2016.
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).
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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 notes 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. 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
receipt (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, 2015 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%, which is $4,901.50 [($.042 $.037) x
1,000,000 x .9803].
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
12/1/15 to $33,000 at 12/31/15. The won receivable will be written down by
$2,000 and a foreign exchange loss will be reported in 2015 income.
12. B (Forward contract fair value hedge of foreign currency denominated

asset/liability)
The nominal value of the forward contract on December 31, 2015 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,
12. (continued)
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2015 that matures on March 31, 2016, $32,000 [$.0032 x 10 million]. The
fair value of the forward contract is the present value of $2,000 discounted
for three months, which is $1,941.20 [$2,000 x .9706]. On December 31,
2015, 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 2015 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:
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.
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15-17. (Option fair value hedge of a foreign currency firm commitment)

15. B
16. D
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:
9/1/15
Foreign Currency Option
Cash
$2,000
$2,000
12/31/15
Gain on Foreign Currency Option
Loss on Firm Commitment
Firm Commitment
[($.79 $.80) x 100,000 = $1,000 x .9803 = $980.30]
Net impact on 2015 net income:
3/1/16
$300
$300
$980.30
$980.30
$300.00
(980.30)
$(680.30)
$700
$700

$2,019.70
Firm Commitment
[($.77 $.80) x 100,000 = $3,000 $980.30 = $2,019.70]
Foreign Currency (C$)
Sales
$77,000
Cash
Foreign Currency (C$)
$80,000
Firm Commitment
$3,000
$2,019.70
$77,000
$77,000
3,000
$3,000
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15-17. (continued)
Sales
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
700.00
(2,019.70)
77,000.00
3,000.00
$78,680.30
$78,000
77,000
$ 1,000
18-20. (Forward contract fair value hedge of a foreign currency firm commitment)
for the forward contract fair value hedge of a firm commitment. The journal
3/1
no journal entries
3/31
Forward Contract
Gain on Forward Contract
($1,250 $0)
$1,250

Firm Commitment
$1,250
$1,250
$1,250
Net impact on first quarter net income is $0.
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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
$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
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21-22. (Option cash flow hedge of a forecasted foreign currency transaction)

for the option cash flow hedge of a forecasted transaction. The journal
11/1/15
Cash
$1,500
$1,500
12/31/15
Option Expense
$400
$400
(The option has no intrinsic value at 12/31/15 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.
2/1/16
Option Expense
$1,100
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]
$82,000
Parts Inventory
Foreign Currency (BRL)
$82,000
$2,000
$80,000
2,000
$82,000
Accumulated Other Comprehensive Income (AOCI)

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$2,000
$2,000
Education.
21-22. (continued)
Option Expense
$ (1,100)
Cost-of-Goods-Sold
(82,000)
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 2015.
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 2016.
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 2015.
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 2016.
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

[100,000 x ($.37 $.42)]
$5,000
$2,000
Cash
$37,000
26. (10 minutes) (Foreign currency payable -- import purchase)
9-15
$5,000
$37,000
Education.
12/1/15
Inventory
Accounts Payable (LCU) [60,000 x $.88]
$52,800
$52,800
12/31/15 Accounts Payable (LCU) [60,000 x ($.82 $.88)] $3,600

1/28/16

$4,800
Accounts Payable (LCU) [60,000 x ($.90 $.82)]
Accounts Payable (LCU)
Cash
$3,600
$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
9-16
Education.
28. (25 minutes) (Prepare journal entries for foreign currency transactions)
2/1/15
4/1/15
6/1/15
8/1/15
Equipment
Accounts Payable (L) [40,000 x $.44]
$17,600
Accounts Payable (L)

Cash [40,000 x $.45]
$17,600
400
Inventory
$14,100
Accounts Receivable (L) [40,000 x $.48]

Sales
$19,200
$18,000
Cost-of-Goods Sold
Inventory [$14,100 x 70%]
10/1/15
$17,600
Cash [30,000 x $.49]

Accounts Receivable (L) [$19,200 x 3/4]
$14,100
$19,200
$9,870
$9,870
$14,700
$14,400

11/1/15
Accounts Payable (L) [$14,100 x 2/3]

Foreign Exchange Loss [20,000 x ($.50 $.47)]
Cash [20,000 x $.50]
300
$9,400
600
$10,000
12/31/15 Foreign Exchange Loss

Accounts Payable (L) [10,000 x ($.52 $.47)]
$500
Accounts Receivable (L) [10,000 x ($.52 $.48)]

$400
2/1/16
3/1/16
$500
$400
Cash [10,000 x $.54]

Accounts Receivable (L) [10,000 x $.52]
$5,400

Cash [10,000 x $.55]
$5,200
300
9-17
$5,200
200
$5,500
Education.
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, 2015), the liability had a dollar value of
$70,400 (AL 160,000 x $.44). On December 31, 2015, 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 2015.
By March 1, 2016, 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 2016.
b. Benjamin, Inc. has a liability of AL 160,000. On the date that this liability
was created (September 1, 2015), the liability had a dollar value of
$73,600 (AL 160,000 x $.46). On December 1, 2015, 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 2015.
c.
Benjamin, Inc. has a liability of AL 160,000. On the date that this liability
was created (September 1, 2015), the liability had a dollar value of
$73,600 (AL 160,000 x $.46). On December 31, 2015, 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 2015.
By March 1, 2016, 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 2016.
9-18
Education.
30. (30 minutes) (Foreign currency borrowing)

a.
9/30/15
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.)
12/31/15 Interest Expense

$525
Interest Payable (dudek)
[1,000,000 x 2% x 3/12 = 5,000 dudeks x
$.105 spot rate]
(To accrue interest for the period 9/30 12/31/15.)
Note Payable (dudek) [1 m x ($.105 $.10)]
(To revalue the note payable at the spot rate of
$.105 and record a foreign exchange loss.)
$5,000
9/30/16
$1,800
525
Interest Expense [15,000 dudeks x $.12]

Foreign Exchange Loss [5,000 dudeks x
($.12 $.105)]
Cash [20,000 dudeks x $.12]
(To record the first annual interest payment,
record interest expense for the period 1/1 9/30/16,
and record a foreign exchange loss on the
interest payable accrued at 12/31/15.)
$525
$5,000
75
12/31/16 Interest Expense

$625
Interest Payable (dudek) [5,000 dudeks x $.125]
(To accrue interest for the period 9/30 12/31/16.)
$20,000
Note Payable (dudek) [1 m x ($.125 $.105)]
(To revalue the note payable at the spot rate of
$.125 and record a foreign exchange loss.)
9-19
$100,000
$2,400
$625
$20,000
Education.
30. (continued)
9/30/17
Interest Expense [15,000 dudeks x $.15]

Foreign Exchange Loss [5,000 dudeks x
($.15 $.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 12/31/16.)
Note Payable (dudek)
Cash [1 m dudeks x $.15]
(To record payment of the 1 million dudek note.)
$2,250
625
125
$3,000
$125,000
25,000
$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:
2015
Interest expense
Foreign exchange loss
Total
2016
Interest expense
Foreign exchange losses
Total
2017
Interest expense
Foreign exchange losses
Total
$525
5,000
$5,525 / $100,000 = 5.525% for 3 months
5.525% x 12/3 = 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
27.38% x 12/9 = 36.5% for 12 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%.
9-20
Education.
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;
55.4% / 2 years = 27.7% per year].
9-21
Education.
31. (40 minutes) (Forward contract hedge of foreign currency receivable)

a. Cash Flow Hedge
9-22
Education.
31. (continued)
a. Cash Flow Hedge (continued)
9-23
Education.
31. (continued)
b. Fair Value Hedge
9-24
Education.
31. (continued)
b. Fair Value Hedge (continued)
9-25
Education.
32. (40 minutes) (Forward contract hedge of foreign currency payable)

a. Cash Flow Hedge
9-26
Education.
32. (continued)
a. Cash Flow Hedge (continued)
9-27
Education.
32. (continued)
b. Fair Value Hedge
9-28
Education.
32. (continued)
b. Fair Value Hedge (continued)
9-29
Education.
33. (30 minutes) (Option hedge of foreign currency receivable)

a. Cash Flow Hedge
6/1
Accounts Receivable (P)

Sales [$.062 x 1,000,000]
$62,000
$62,000

$2,500
Cash
$2,500
6/30

[($.066 $.062) x 1,000,000]
$4,000
$4,000
AOCI
[($.0018 $.0025) x 1,000,000]
Loss on Foreign Currency Option
AOCI
Option Expense
AOCI
Date
6/1
6/30
9/1
Fair Value
$2,500
$1,800
$1,000
$700
$700
$4,000
$4,000
$700
$700
Intrinsic Value
$0
$0
$1,000
9-30
Time Value
$2,500
$1,800
$0
Change in Time Value
$ 700
$1,800
Education.
33. (continued)
9/1

[($.061 $.066) x 1,000,000]
AOCI
[$1,800 $1,000]
AOCI
$5,000
$5,000
$800
$800
$5,000
$5,000
Option Expense
$1,800
AOCI
(Change in time value of option is recognized as expense)
Foreign Currency (P)
$61,000
Cash
$62,000
$1,800
$61,000
$61,000
1,000
Impact on Net Income over the Two Accounting Periods:

Sales
$62,000
4,000
(4,000)
(5,000)
5,000
Foreign currency option expense
(2,500)
Impact on net income
$59,500 = Net cash inflow
9-31
Education.
33. (continued)
b. Fair Value Hedge
6/1
6/30

Sales [$.062 x 1,000,000]
$62,000

Cash
$2,500

[($.066 $.062) x 1,000,000]
$4,000
$2,500

9/1
$62,000

[($.061 $.066) x 1,000,000]
$4,000
$700
$700
$5,000
$5,000
$800
$800

$61,000
Cash
$62,000
$61,000
$61,000
1,000
Impact on Net Income over the Two Accounting Periods:

Sales
$62,000
4,000
(5,000)
(1,500)
$59,500
= Net cash inflow
9-32
Education.
34. (30 minutes) (Option hedge of foreign currency payable)

a. Cash Flow Hedge
6/1
6/30
Date
6/1
6/30
9/1
Inventory [$.085 x 1,000,000]

Accounts Payable (M)
$85,000
$85,000

Cash
$2,000

[($.088 .085) x 1,000,000]
$3,000

AOCI
[$4,000 $2,000]
$2,000
AOCI
$3,000
Option Expense
AOCI
$1,000*
Fair Value
$2,000
$4,000
$5,000
$2,000
$3,000
$2,000
$3,000
$1,000
Intrinsic Value
$0
$3,000
$5,000
9-33
Time Value
$2,000
$1,000
$0
Change in Time Value

-$1,000*
-$1,000**
Education.
34. (continued)
9/1

[($.09 $.088) x 1,000,000]
$2,000

AOCI
[$5,000 $4,000]
$1,000
AOCI
$2,000
Option Expense
AOCI
$1,000**
$2,000
$1,000
$2,000
$1,000
Foreign Currency (M)

Cash
$90,000

$90,000
$85,000
$5,000
$90,000
Impact on net income:

Option Expense
($2,000)
9-34
Education.
34. (continued)
b. Fair Value Hedge
6/1
6/30
9/1
Inventory
[$.085 x 1,000,000]
$85,000

Cash
$2,000

[($.088 $.085) x 1,000,000]
$3,000

[$4,000 $2,000]
$2,000

[($.09 $.088) x 1,000,000]
$2,000

[$5,000 $4,000]
$1,000
$85,000
$2,000
$3,000
$2,000
$2,000
$1,000

Cash
$90,000

$90,000
$85,000
5,000
$90,000
Impact on net income:

($5,000)
3,000
($2,000)
9-35
Education.
35. (30 minutes) (Forward contract cash flow hedge of foreign currency
denominated asset)
Date
11/01/15
12/31/15
4/30/16
Account Receivable (FCU) Forward

SpotU.S. DollarChange in U.S.Rate to
RateValue Dollar Value
4/30/16
Fair Value
$.53
$53,000
$.52
$.50
$50,000
-$3,000
$.48
$.49
$49,000
-$1,000
$.49
Forward Contract
Change in
Fair Value
$0
$3,8441
+$3,844
$3,0002
- $ 844
($52,000 $48,000) 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
2015 Journal Entries

11/01/15 Accounts Receivable (FCU)
Sales
$53,000
$53,000
There is no entry for the forward contract.

12/31/15 Foreign Exchange Loss
$3,000
$3,000
AOCI
$3,000
Forward Contract
AOCI
$3,844
$3,000
$3,844
Discount expense
AOCI
[100,000 x ($.53 $.52) x 2/6]
$333.33
$333.33
The impact on net income for the year 2015 is:

Sales
Net Gain (Loss)
Discount Expense
$53,000.00
(3,000.00)
3,000.00
0.00
(333.33)
$52,666.67
9-36
Education.
35. (continued)
4/30/16

$1,000
AOCI
$1,000
$1,000
$1,000
AOCI
Forward Contract
$844
$844
Discount expense
AOCI
$666.67
Foreign Currency (FCU)

$49,000
Cash
Foreign Currency (FCU)
Forward Contract
$52,000
$666.67
$49,000
$49,000
3,000

Net Gain (Loss)
Discount Expense
$(1,000.00)
1,000.00
0.00
(666.67)
$(666.67)
9-37
Education.
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
1/31/16
11/30/15 $265,000 ($159,000)
$.52
12/31/15 $250,000 ($150,000) -$15,000 (-$9,000)
$.48
1/31/16 $245,000 ($147,000) -$ 5,000 (-$3,000)
$.49
Forward Contract
Change in
Fair Value
Fair Value
$0
$7,9211
+$7,921
$6,0002
- $1,921
($104,000 $96,000) 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

11/30
Accounts Receivable (mongs)

Sales
[$.53 x 500,000]
$265,000
Inventory
Accounts Payable
[$.53 x 300,000]
$159,000
$265,000
$159,000
There is no formal entry for the forward contract.

12/31

$15,000
$15,000
Accounts Payable (mongs)

$9,000
Forward Contract
$7,921
$9,000
$7,921

Sales
Net Foreign Exchange Loss $ (6,000)
7,921
Net Gain (Loss)
9-38
$265,000
1,921
$266,921
Education.
36. (continued)
1/31

$5,000

$3,000

Forward Contract
$1,921
$5,000
$3,000
$1,921
Foreign Currency (mongs)

$245,000

$147,000
Cash
Forward Contract
$104,000
$245,000
$147,000
$98,000
$6,000

Net Foreign Exchange Loss
$(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).
9-39
Education.
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 x $.69]
$69,000
$69,000

12/31

[($.71 $.69) x 100,000]
Forward Contract
[($.74 $.65) x 100,000 x .9901]
1/31

[($.72 $.71) x 100,000]
Forward Contract
[(($.72 $.65) x 100,000) 8,910.90]
$2,000
$2,000
$8,910.90
$8,910.90
$1,000
$1,000
$ 1,910.90
$ 1,910.90
Foreign Currency (LCU)

$72,000
Cash
Forward Contract
$65,000
$7,000
$72,000
$72,000
The impact on net income:

Sale
$69,000.00
3,000.00
(8,910.90)
1,910.90
$65,000.00 = Cash Inflow
9-40
Education.
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

Forward Contract
$8,910.90
Firm Commitment
$8,910.90
Forward Contract
$1,910.90

Firm Commitment
$1,910.90
1/31
$8,910.90
$8,910.90
$1,910.90
$1,910.90

Sales
$72,000
Cash
Forward Contract
$65,000
$7,000

Firm Commitment
$7,000
$72,000
$72,000
$7,000
Impact on Net Income:

Sales
Net Loss on Forward Contract
Net Gain on Firm Commitment
$72,000
(7,000)
7,000
(7,000)
$65,000 = Cash Inflow
9-41
Education.
38. (30 minutes) (Forward contract fair value hedge of a foreign currency firm
commitment (purchase))
Forward
Date 10/31
8/1
9/30
10/31
Rate to
Fair Value
$.30
$.325
$.320 (spot)
Forward Contract
Fair Value
$0
$4,950.50 1
$4,0002
Change in
Fair Value
+ $4,950.50
$ 950.50
Firm Commitment
Change in
Fair Value
$0
$(4,950.50)1
$(4,000)2
$0
$4,950.50
+ $ 950.50
($65,000 $60,000) x .9901 = $4,950.5; where .9901 is the present value factor for one
2
($64,000 $60,000) = $4,000.
a. Journal entries
8/1
There is no entry to record either the purchase agreement or the

forward contract as both are executory contracts.
9/30
Forward Contract
$4,950.50

Firm Commitment
$4,950.50

Forward Contract
$950.50
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
$64,000
$4,000
$4,000
b. Assuming the inventory is sold in the fourth quarter, the net impact on net
income is negative $60,000:
Cost-of-Goods-Sold
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))
9-42
Education.
Firm Commitment
Spot
Date Rate Fair Value
6/1
6/30
9/1
$1.00
$0.94
$0.88
Option
Change in
Fair Value
for 9/1
$(5,881.80)1
$(12,000)2
$5,881.80
$6,118.20
Option
Premium
Fair Value
Fair Value
Change in
$0.020
$0.028
N/A
$2,000
$2,800
$12,000
+ $800
+ $9,200
($94,000 $100,000) x .9803 = $(5,881.80), where .9803 is the present value factor for
two months at an annual interest rate of 12% (1% per month) calculated as 1/1.01 2.
2
$88,000 $100,000 = $(12,000).
a. Journal Entries
6/1

Cash
$2,000.00
$2,000.00
There is no entry to record the sales agreement

because it is an executory contract.
6/30

Firm Commitment
$5,881.80
$5,881.80

9/1
$800.00
$800.00

Firm Commitment
$6,118.20

$9,200.00
$6,118.20
Foreign Currency (lek)

Sales
$9,200.00
$88,000.00
$88,000.00
Cash
Foreign Currency (lek)
$100,000.00
Firm Commitment
$12,000.00
$88,000.00
12,000.00
$12,000.00
39. (continued)
b. Impact on Net Income
9-43
Education.
The impact on net income for the second quarter is:

$(5,881.80)
800.00
$(5,081.80)
The impact on net income for the third quarter is:

Sales
Gain on Foreign Currency option
$88,000.00
(6,118.20)
9,200.00
12,000.00
$103,081.80
The impact on net income over the second and third quarters is:
$98,000 ($103,081.80 $5,801.80)
c. Net Cash Inflow
The net cash inflow resulting from the sale is:
$98,000 ($100,000 $2,000)
9-44
Education.
40. (20 minutes) (Option fair value hedge of a foreign currency firm commitment
(purchase))
Firm Commitment
Spot
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
$.008
$.0103
$.0004
Option
Change in
Fair Value
$400
$500
$0
+ $100
$400
$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 options
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 pijio.
4
The premium on 12/20 for an option that expires on that date is equal to the options
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 $.000.
2
a.
The option strike price ($.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

Cash
$400
$400
There is no entry to record the purchase agreement

12/20

Firm Commitment
$500

$100
$500
$100
Foreign Currency (pijio)

Cash
$10,500
Parts inventory
$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
9-45
$500
$500
Education.
40. (continued)
b. The option strike price ($.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:
11/20

Cash
$400
$400
There is no entry to record the purchase agreement

12/20
Firm Commitment
$1,000
$1,000
$400
$400

Cash
$9,000
Parts Inventory
$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:
Firm Commitment
9-46
$1,000
$1,000
Education.
41. (20 minutes) (Option cash flow hedge of a forecasted transaction)

a.
12/15/15 Foreign Currency Option
Cash [1 million marks x $.005]
$5,000
$5,000
No journal entry related to the forecasted

transaction.
12/31/15 Foreign Currency Option
AOCI
To recognize the increase in the value of
the foreign currency option with the counterpart
recorded in AOCI.
$3,000
$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]
3/15/16

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
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
Parts Inventory
$590,000
Foreign Currency (marks)
To record the purchase of parts and payment
of 1 million marks to the supplier.
9-47
$1,000
$580,000
10,000
$590,000
Education.
41. (continued)
AOCI
To transfer the amount accumulated in AOCI
as an adjustment to net income in the period
in which the forecasted transaction occurs.
$10,000
$10,000
b. Impact on net income: 2015 Option Expense
$(1,000)
2016 Cost-of-goods-sold
Option Expense
$(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))
Part a. Foreign Currency Liability (Unhedged)
9/15
9/30
10/31
Inventory
Accounts Payable (euro)
$200,000

$10,000

$10,000
$200,000
$10,000
$10,000
Foreign Currency (euro)

Cash
$220,000

$220,000
$220,000
9-48
$220,000
Education.
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 Payable (C)

Forward
U.S. Dollar
Change in U.S.
Rate to
Dollar Value 10/31 Fair Value
$200,000
$1.06
$210,000
+$10,000
$1.09
$220,000
+$10,000
$1.10
Forward Contract
Change in
Fair Value
$0
$5,940.60 1
+$5,940.60
$8,000.00 2
+$2,059.40
($218,000 $212,000) 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.
9/15
Inventory
$200,000
$200,000

9/30

$10,000
$10,000
Forward Contract
10/31
$5,940.60
$5,940.60

$10,000
$10,000
Forward Contract
$2,059.40

Cash
Forward Contract
$220,000

$220,000
$2,059.40
$212,000
8,000
$220,000
9-49
Education.
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
$5,940.60

Firm Commitment
$5,940.60
Forward Contract
$2,059.40

Firm Commitment
$2,059.40

Cash
Forward Contract
$220,000
Inventory
$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
$8,000
$8,000
9-50
Education.
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
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
$200,000
$200,000

Cash
9/30
$7,000
$7,000

$10,000
$10,000

AOCI
$7,000
$7,000
AOCI
Option Expense
AOCI
$10,000
$10,000
$3,000
$3,000
9-51
Education.
42. (continued)
10/31

$10,000
$10,000

AOCI
$6,000
$6,000
AOCI
Option Expense
AOCI
$10,000
$10,000
$4,000
$4,000

Cash
$220,000

$220,000
$200,000
$20,000
$220,000
9-52
Education.
42. (continued)
Part e. Option Fair Value Hedge of a Foreign Currency Firm Commitment
(Purchase)
Firm Commitment
Option
Spot
Change in
Premium
Fair Value
for 10/31
9/15
$1.00
$0
$.035
9/30
$1.05
$ (9,901)
$ 9,901 1
$.070
10/31
$1.10
$(20,000)
$10,099
$.100

Fair Value
$ 7,000
$14,000
$20,000
Change in
Fair Value
+$7,000
+$6,000
($200,000 $210,000) x .9901 = $(9,901), where .9901 is the present value factor for one
9/15
9/30
10/31

Cash
$7,000

$7,000

Firm Commitment
$9,901

$6,000
$7,000
$7,000
$9,901

Firm Commitment
$6,000
$10,099
$10,099

Cash
$220,000
Inventory
$220,000
$200,000
20,000
$220,000
The following entry is made in the period when the inventory affects net income
through cost-of-goods-sold:
Firm Commitment
$20,000
$20,000
9-53
Education.
Chapter 9 Develop Your Skills

Research CaseInternational 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 IFFs 2012 annual report.
1. In 2012, IFF provided information in the annual report related to its
management of foreign exchange risk in the following locations:
a. Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
c. Note 14. Financial Instruments, under derivatives.
2. Note 14 indicates that IFF uses foreign currency forward contracts to
reduce exposure to cash flow volatility arising from foreign currency
fluctuations associated with intercompany loans, 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 also uses forward contracts to hedge net investments in
foreign operations. (This topic is discussed in more detail in Chapter 10.)
3. Toward the end of Note 14, the company indicates that the ineffective
portion of the above noted cash flow hedges and net investment hedges
was not material for the years ended December 31, 2012 and 2011.
9-54
Education.
Accounting Standards CaseForecasted Transactions

Questions asked in the case are:
Is managements 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:
Managements 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.
9-55
Education.
Excel CaseDetermine Foreign Exchange Gains and Losses

Note to Instructors: At the time this case is assigned to students, please verify
that www.x-rates.com still reports the exchange rates used in the solution
below. These exchange rates were obtained from www.x-rates.com in
January 2013. For unexplained reasons, in the past, www.x-rates.com has
made changes over time to the historical exchange rates that it reports.
1., 2. and 3. Spreadsheet for the calculation of the foreign exchange gains
(losses) related to Import/Export Companys foreign currency
transactions for the year 2012.
Foreign
Currency
Brazilian
real (BRL)
Chilean
peso
(CLP)
Swiss
franc
(CHF)
Swiss
franc
(CHF)
Type of
Transaction
Import
purchase
Euro
Euro
Chinese
yuan
(CNY)
Total Net
Foreign
Exchange
Gain
(Loss)
Amount in
Foreign
Currency
Transaction
Date
Exchange
Rate at
Transaction
Date
$ Value on
Transaction
Date
Settlement Date
Exchange
Rate at
Settlement
Date
$ Value on
Settlement
Date
Foreign
Exchange
Gain
(Loss)
(100,000)
1/10/2012
0.553189
(55,318.90)
5/10/2012
0.511316
(51,131.60)
$4,187.30
(27,000,000)
1/10/2012
0.001968
(53,136.00)
5/10/2012
0.002056
(55,512.00)
(2,376.00)
50,000
1/10/2012
1.05384
52,692.00
4/10/2012
1.087158
54,357.90
1,665.90
(50,000)
4/10/2012
1.087158
(54,357.90)
7/10/2012
1.020427
(51,021.35)
3,336.55
Export sale
40,000
1/10/2012
1.278102
51,124.08
4/10/2012
1.306505
52,260.20
1,136.12
Export sale
40,000
4/10/2012
1.306505
52,260.20
7/10/2012
1.225452
49,018.08
(3,242.12)
(340,000)
1/10/2012
0.158353
(53,840.02)
10/10/2012
0.158893
(54,023.62)
(183.60)
Import
purchase
Export sale
Import
purchase
Import
purchase
$4,524.15
Source of exchange rates: www.x-rates.com, Historical Lookup

Import/Export Company reported a net foreign exchange gain of $4,524.15 in
2012 income.
Possible discussion points for instructors: Note that all transactions had a $
value on transaction date of approximately $53,000. 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 BRL from 1/10/12 to
5/10/12 coupled with the BRL liability exposure generated a large foreign
exchange gain.
Excel Case (continued)
9-56
Education.
On the other hand, the large appreciation in the value of the CLP over the
same time period resulted in a foreign exchange loss on a foreign currency
payable.
An appreciation in the Euro from 1/10/12 to 4/10/12 coupled with the Euro
asset exposure resulting from the export sale on 1/10/12 generated a foreign
exchange gain. The subsequent depreciation in value of the Euro from 4/10/12
to 7/10/12 coupled with an asset exposure resulting from the export sale on
4/10/12 created a large foreign exchange loss.
Analysis CaseCash Flow Hedge
1. Given the $6,000 total Premium Expense, the forward rate on 2/1/15 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 3/31/15 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 5/1/15 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 100,000 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 2/1/15 at the spot rate of $1.00, it
could have saved $6,000.
9-57
Education.
Internet CaseHistorical Exchange Rates

Note to Instructors: At the time this case is assigned to students, please verify
that www.x-rates.com still reports the exchange rates used in the solution
below. These exchange rates were obtained from www.x-rates.com in
January 2013. For unexplained reasons, in the past, www.x-rates.com has
made changes over time to the historical exchange rates that it reports.
1. Spreadsheets for the calculation of the foreign exchange gains (losses)
related to Pier Ten Companys foreign currency account receivables.
Currency
Code
Indian rupee
INR
Philippine peso
PHP
Japanese yen
JPY
Malaysian ringgit
MYR
Foreign
Currency
Account
Receivable
1,062,00
0
830,00
0
1,578,00
0
61,20
0
Exchange
Rate on
10/15/12
U.S. Dollar
Value on
10/15/12
0.018851
$ 20,019.76
0.024108
20,009.64
0.012687
20,020.09
0.32704
20,014.85
$ 80,064.34
Currency
Code
Indian rupee
INR
Philippine peso
PHP
Japanese yen
JPY
Malaysian ringgit
MYR
Foreign
Currency
Account
Receivable
1,062,00
0
830,00
0
1,578,00
0
61,20
0
U.S. Dollar
Value on
10/31/12
Foreign
Exchange
Gain (Loss)
on 10/31/12
0.018586
$ 19,738.33
0.024307
20,174.81
165.17
0.012512
19,743.94
(276.15)
0.328216
20,086.82
71.97
Exchange
Rate on
10/31/12
$ 79,743.90
9-58
(281.43)
(320.44)
Education.
Internet Case (continued)
Currency
Code
Indian rupee
INR
Philippine peso
PHP
Japanese yen
JPY
Malaysian ringgit
MYR
Currency
Code
Indian rupee
INR
Philippine peso
PHP
Japanese yen
JPY
Malaysian ringgit
MYR
Foreign
Currency
Account
Receivable
1,062,00
0
830,00
0
1,578,00
0
61,20
0
Foreign
Currency
Account
Receivable
1,062,00
0
830,00
0
1,578,00
0
61,20
0
U.S. Dollar
Value on
11/15/12
Foreign
Exchange
Gain (Loss)
on 11/15/12
0.018265
$ 19,397.43
0.024279
20,151.57
(23.24)
0.012319
19,439.38
(304.55)
0.326531
19,983.70
(103.12)
Exchange
Rate on
11/15/12
(340.90)
$ 78,972.08
(771.82)
U.S. Dollar
Value on
10/15/12
U.S. Dollar
Value on
11/15/12
Net Foreign
Exchange
Gain (Loss)
$ 20,019.76
$ 19,397.43
20,009.64
20,151.57
141.93
20,020.09
19,439.38
(580.70)
20,014.85
19,983.70
(31.15)
$ 80,064.34
$ 78,972.08
$ (1,092.26)
(622.33)
Source of exchange rates: www.x-rates.com, Historical Lookup

2. Pier Ten would have reported a net foreign exchange loss of $320.44 in the
fiscal year ended October 31, 2012 and a net foreign exchange loss of
$771.82 in the fiscal year ended October 31, 2013 related to these foreign
currency receivables. The transactions denominated in Indian rupees,
Japanese yen, and Malaysian ringgits resulted in foreign exchange losses
of $622.33, $580.70, and $31.15, respectively. The INR receivable, which
generated the largest loss, would have been the most important to hedge.
3. Assuming a strike price equal to the October 15, 2012 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 Japanese yen. Net cash inflow from the INR receivable would
have been $522.33 greater ($622.33 FX loss avoided less $100.00 cost of
the option) if a
9-59
Education.
Internet Case (continued)

put option in INR had been acquired, and the net cash flow from the JPY
receivable would have been $480.70 greater ($580.70 FX loss avoided less
$100.00 cost of the option) if a put option in JPY had been acquired.
Because the strike price is greater than the spot rate on 11/15/12, the put
option in MYR would be exercised, but it would result in a decrease in net
cash flow of $68.85 ($31.15 loss avoided less $100.00 cost of the option).
Because the strike price is less than the spot rate on 11/15/12 the put
option in PHP would be allowed to expire unexercised. The purchase of
the PHP option would result in a decrease in net cash inflow to Pier Ten of
$100.00 (the cost of the option).
9-60
Education.
Communication CaseForward 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 up-front 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.
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.
9-61
Education.

Foreign Currency Transactions and Hedging Foreign Exchange Risk

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Foreign Currency Transactions and Hedging Foreign Exchange Risk

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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

Answer to Discussion Question

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

A party to a foreign currency forward contract is obligated to deliver one currency in

An enterprise is required to recognize all derivative financial instruments as assets or

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

The fair value of a foreign currency forward contract is determined by reference to

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

(Calculate foreign exchange gain/loss on foreign currency transaction)

(Calculate foreign exchange gain/loss on foreign currency borrowing)

(Foreign exchange gain/loss on foreign currency transaction)

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

(Calculate foreign exchange gain/loss)

(Forward contract cash flow hedge of foreign currency denominated

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

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

(Calculate foreign exchange gain/loss on foreign currency transaction)

12. B (Forward contract fair value hedge of foreign currency denominated

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

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

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

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

Loss on Firm Commitment

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

Loss on Firm Commitment

Net impact on first quarter net income is $0.

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

Loss on Forward Contract

Foreign Currency (pesos)

Cash [500,000 x $.120]

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

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

Accumulated Other Comprehensive Income (AOCI)

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

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

Accounts Receivable (FCU)

Foreign Exchange Loss

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

12/31/15 Accounts Payable (LCU) [60,000 x ($.82 $.88)] $3,600

Foreign Exchange Loss

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

Accounts Payable (L)

Accounts Receivable (L) [40,000 x $.48]

Cash [30,000 x $.49]

Foreign Exchange Gain

Accounts Payable (L) [$14,100 x 2/3]

12/31/15 Foreign Exchange Loss

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

Cash [10,000 x $.54]

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

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

30. (30 minutes) (Foreign currency borrowing)

12/31/15 Interest Expense

Interest Expense [15,000 dudeks x $.12]

12/31/16 Interest Expense

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk