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Chapter 10

Foreign Currency Transactions

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A brief description of the major points covered in each case and problem.
CASES
Case 10-1
This case discusses differing ways to measure gains and losses on foreign currency
transactions and forward contracts used to hedge these transactions.
Case 10-2 (prepared by Peter Secord, Saint Marys University)
This case requires a discussion of the risks that can occur as a result of import/export
transactions denominated in foreign currency and suggested solutions that the company can
use to cope with the problem.
Case 10-3
In this case, adapted from a CPA exam, students are asked to discuss accounting issues
related to the establishment of a manufacturing operation in Russia and the exporting and
importing of goods to and from Russia.
Case 10-4
In this case, adapted from a CPA exam, students are asked to discuss the accounting issues
and financial viability of a professional football team. The issues involve intercompany and
related party transactions, revenue recognition, push-down accounting, foreign currency
translation and provisions.
Case 10-5
In this case, adapted from a CPA exam, students are asked to discuss the accounting issues
for the high technology company that is planning to go public. The issues involve revenue
recognition, development costs, currency swap and warranty costs.

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PROBLEMS
Problem 10-1 (30 min.)
This problem requires journal entries and financial statement presentation of a foreign currency
sales transaction and a forward contract to hedge the monetary position both with and without
discounting for the time value of money.
Problem 10-2 (30 min.)
This problem requires journal entries for a forward contract to hedge an existing monetary
position using both a cash flow hedge and a fair value hedge.
Problem 10-3 (20 min.)
This problem requires journal entries required for a noncurrent monetary liability denominated
in a foreign currency.
Problem 10-4 (25 min.)
This problem requires journal entries and financial statement presentation for a forward
contract used to hedge a highly probable forecasted foreign transaction.
Problem 10-5 (20 min.)
This problem requires journal entries required for a foreign-denominated investment in bonds
assuming that the bonds are: a) held-to-maturity bonds, b) held-for-trading bonds, and c)
available-for-sale bonds.
Problem 10-6 (40 min.)
Journal entries are required to record the hedge of an expected credit sale assuming a cash
flow hedge and then assuming a fair value hedge. Analysis of the impact on the current ratio of
the two types of hedges is also required.
Problem 10-7 (35 min.)
This problem requires journal entries and financial statement presentation of a foreign currency
purchase transaction and a forward contract to hedge the monetary position both with and
without discounting for the time value of money.

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Problem 10-8 (40 min.)


This problem involves the purchase of equipment and a forward contract designated as a
hedge of a firm commitment. Journal entries are to be prepared under three different
scenarios: 1) the forward contract is a cash flow hedge; 2) the forward contract is a fair value
hedge; and 3) hedge accounting is not applied when accounting for the forward contract.
Problem 10-9 (40 min.)
This problem involves the sale of computer software and a forward contract designated as a
hedge of a firm commitment. Selected account balances are to be calculated under three
different scenarios: 1) the forward contract is a cash flow hedge; 2) the forward contract is a
fair value hedge; and 3) hedge accounting is not applied when accounting for the forward
contract.
Problem 10-10 (25 min.)
A company enters a foreign currency denominated sale and purchase, neither of which is
hedged. Journal entries are required.
Problem 10-11 (20 min.)
This problem requires journal entries for a forward contract to hedge a firm commitment to
purchase equipment. The forward contract is designated as a cash flow hedge.
Problem 10-12 (40 min.)
This problem requires journal entries and financial statement presentation of a foreign currency
purchase with no hedge, with a cash flow hedge, with a fair value hedge and using ASPE for a
cash flow hedge.
Problem 10-13 (35 min.)
This problem requires journal entries and financial statement presentation of foreign currency
purchase and sale transactions and forward contracts to hedge these transactions. Exchange
rates are stated using direct quotations.
Problem 10-14 (25 min.)

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In this problem, a foreign currency denominated loan is used to hedge a future revenue
stream. Journal entries are required for the cash flow hedge.
Problem 10-15 (10 min.)
This CGA-Canada-adapted problem requires a calculation of the amounts presented for
exchange gains or losses when a company has a long-term foreign currency denominated
liability.

SOLUTIONS TO REVIEW QUESTIONS


1.

Accounting issues arise when a Canadian company has receivables or payables


denominated in foreign currency, and the value of the Canadian dollar changes relative to
the foreign currency subsequent to the original recording of these items. The issues are
what dollar amount should be recorded for these foreign transactions and how should any
losses or gains be reflected in the financial statements. In a similar manner, problems
arise when a Canadian parent has to translate the foreign currency denominated financial
statements of its subsidiaries.

2.

A pegged exchange rate arises when governments of various countries agree in advance
to establish the rates at which their currencies will trade in terms of some single currency.
The price of a unit of foreign currency tends to stay stable in relation to other currencies
under such a system. Floating exchange rates arise when market forces determine the
prices of currencies. The price of a unit of foreign currency will increase or decrease in
relation to other currencies under a system of floating rates.

3.

"One U.S. dollar equals 1.15 Canadian dollars" is a direct quotation. The amount of an
indirect quotation can be obtained by taking the reciprocal of the direct quotation. In this
case, one Canadian dollar equals 0.8696 U.S. dollars.

4.

A spot rate is the rate at which a unit of foreign currency can be purchased on a particular
day. A forward rate on a particular day is the rate for exchange of currencies on a
particular future date.

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5.

On the transaction date, foreign currency denominated assets and liabilities are
measured in Canadian dollars by translating the foreign currency amount at the spot rate.
Nonmonetary assets remain at that amount on subsequent balance sheet dates even
though the currency rate has changed. (An exception would apply in the situation where
the assets are measured at market under the lower of cost and net realizable value
requirement, in which case the closing rate at the date of the balance sheet would be
used.) Monetary assets and liabilities are translated at the closing rate as at the date of
subsequent balance sheets. This results in the recording of unrealized gains or losses
when the exchange rate has changed.

6.

The exchange rate should be applied to produce a translated amount consistent with the
way we normally measure assets and liabilities. If an item is to be measured at historical
cost, we should apply the historical rate to the historical value in foreign currency to
derive the historical cost in Canadian dollars. If an item is to be measured at current
value, we should apply the closing rate to the current value in foreign currency to derive
the current value in Canadian dollars.

7.

The spot rate is the exchange rate in effect at a particular point in time. The closing rate
is the exchange rate in effect at the close of business at the end of the reporting period.

8.

A fair value hedge uses a hedging instrument to hedge the change in fair value of the
hedged item. Gains or losses are reported in profit in the period they occur for both the
hedged item and the hedging instrument. A cash flow hedge uses a hedging instrument
to hedge future cash flows. Gains or losses on the hedging instrument are reported in
other comprehensive income and are deferred as a component of shareholders equity
until the hedged item is reported in income.

9.

Generally speaking, in order to hedge against the effects of foreign currency exchange
fluctuations, one takes a foreign currency position opposite to the position that one
wishes to protect. For example, if you wish to protect an asset position, you hedge with a
liability position of the same amount. The following items could act as a hedge:

forward exchange contracts

foreign currency futures contracts

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foreign currency option contracts

10. A forward exchange contract may be acquired to act as a hedge for either an existing
monetary position or an expected future monetary position. Alternatively, a contract may
be acquired for speculative purposes.
11. Foreign currency denominated monetary assets or liabilities must be translated at the
closing rate on the date of the balance sheet regardless of whether the item has been
hedged. If the item has been hedged, offsetting gains or losses on the hedging
instrument will be reflected in the income statement to match against the gains or losses
on the hedged item.
12. The lower of cost and net realizable value requirement is applied by comparing the
Canadian dollar historical cost of the original items with the current foreign currency
denominated net realizable value for these items, translated at the closing rate and
valuing the inventory at the lower of the two numbers.
13. For the fair value hedge of an unrecognized firm commitment, the change in both the fair
value of the hedging instrument and the hedged item are recognized in profit as they
occur. For the cash flow hedge of an unrecognized firm commitment, the exchange gains
or losses are reported in other comprehensive income and deferred as a separate
component of shareholders equity until the committed transaction occurs. It will later be
transferred out of other comprehensive income and become part of the cost or selling
price of the item being hedged and reported in income when the hedged item is reported
in income.
14. Hedge accounts are netted for reporting purposes. The receivable from, and payable to,
the bank are offset against each other. The resultant debit or credit balance is reported as
a deferred charge or credit on the balance sheet. The reason for this is that these are
executory contracts, and because neither party has performed, no assets or liabilities
exist.
15. The term "hedge accounting" is used for a system of accounting that ensures that the
gains or losses from a hedged position are offset in the same accounting period by the
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losses or gains from the hedging instrument. Therefore, if gains or losses from one occur
before those from the other they are deferred until the matching can take place.
16. Hedge accounting would not be used in this situation because the gains and losses from
the hedging instrument and the hedged item occur will both be reported in the same
period and will offset each other. Hedge accounting comes into play when gains or losses
from one item would otherwise be recognized in a different period than the offsetting
losses or gains from the other item.
17. The long-term debt is usually equal to the expected amount of the future revenue stream
at the inception of the hedge. The amount of the debt remains constant while the amount
of future revenue that it hedges declines. In this manner, an increasing portion of debt
ceases to be a hedge each year and is therefore exposed to exchange rate changes.
18. If the inventory is being purchased for cash, the premium paid on a forward contract will
initially be reported in other comprehensive income and deferred as a separate
component of shareholders equity. The premium will be removed from other
comprehensive income and reported in regular income when the inventory is sold. If the
inventory is purchased on account and the forward contract is designated as both a
hedge of the item and the ensuing monetary liability, the portion of the premium
pertaining to the commitment will be reported as previously explained. The portion of the
premium relating to the monetary liability will also be deferred in other comprehensive
income and will be recognized in regular income over the term of the accounts payable,
i.e., from the purchase date of the inventory to the settlement date of the accounts
payable.

SOLUTIONS TO CASES
Case 10-1
Interfast Corporation could have received $1,600,000 from its export sale to Loznia if it had
required immediate payment. Instead, Interfast allows its customer six months to pay.
Interfast would have received only $1,360,000 (LR400,000 x 3.4) if it had not entered into the
forward contract. This would have resulted in a decrease in cash inflow of $240,000. The
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decrease in the value of the LR receivable would have been recognized as a foreign exchange
loss of $240,000. This loss represents the cost of extending credit to the foreign customer if
the LR receivable is left unhedged.
However, rather than leaving the LR receivable unhedged, Interfast sells LRs forward at a price
of $1,440,000 (LR400,000 x 3.60). Since the spot rate was $3.40 on the settlement date of
the contract, the forward contract provides a benefit, increasing the amount of cash received
from the export sale by $80,000. The $80,000 change in the fair value of the forward contract
(from zero initially to $80,000 at maturity) is recognized as a gain on the forward contract. 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 would not always improve cash inflow.
For example, if the future spot rate were $3.70, the forward contract would result in $40,000
less cash inflow than if the transaction were left unhedged.)
The net impact on income resulting from the fluctuation in the value of the LR is a loss of
$160,000. Clearly, Interfast forgoes $160,000 in cash inflow by allowing the customer time to
pay for the purchase, and the net loss reported in income correctly measures this. The
$160,000 loss is useful to management in assessing whether the sale to Loznia 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 are relevant measures for evaluating the performance
of foreign exchange risk managers.

Case 10-2
Long Life Enterprises*
Note to instructor: This case is intended only to raise awareness of the potential complexity
of foreign currency exposure for an importer/exporter, and to reinforce the notion that a
business has multiple flows and does not operate one transaction at a time, as many
conventional "problems" are structured. This is the element this case is meant to draw out in
class discussion; preparation of a detailed solution would be beyond the scope of the typical
accounting course, but the note below may be of interest.

* Case solution prepared by Peter Secord, Saint Mary's University. Used with permission.
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Losses on foreign currency positions only occur when there is an exposure that is, an
uncovered position in a foreign currency and the substantial losses of the firm are a
consequence of having an uncovered position at a time of currency fluctuation.
The complexity of the cash flow patterns suggests that this may require the use of
sophisticated computer software for tracking the balance (receivable or payable) outstanding
with respect to any particular foreign currency. The company could then follow the practice of
hedging net amounts to guard from uncovered losses. Such software can now be readily
incorporated into payables and receivables modules of most accounting packages.
Over the longer haul, maintenance of floats in foreign currency (and perhaps associated lines
of credit) can reduce the realized transaction gains and losses on actual currency conversion.
The idea, however, is to always have the foreign currency receivables and payables in balance
(provided that this is cost effective) in order to minimize the net exposure at any given time. In
this regard, terms can be modified for both receivables and payables in order that a closer
matching of flows can be attempted. Aggressive management of the net position is necessary
to ensure there are no surprises.

Case 10-3
Memo to:

Partner

From:

Staff accountant

Subject:

Canada Cola Inc. (CCI) Engagement

The establishment of accounting policies for this division is critical since future profit sharing
will be based on the division's financial statements. We must take into account CCI's financial
reporting objectives for these operations. CCI will want to maximize profits for the Russian
operations for two reasons: 1) Since CCI is a public company, it wants to maximize profits to
attract and retain investors in the company. 2) CCI wants to maximize the withdrawal of vodka
from Russia for sale in the Canadian market.
Given the unusual nature of the restrictions for operations in Russia, extensive disclosure will
be essential to allowing the readers of CCI's financial statements to understand these
operations. This disclosure could include the nature of the joint operations agreement, the type
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and quantity of assets (i.e., vodka) that were received, or other specific assets contributed.

Accounting for the division


The operations in Russia are a division of CCI, so it is necessary to include all the revenues,
expenses, assets, and liabilities of this division in the separate entity records of CCI. However,
we are faced with a significant measurement problem: at what amount should we record these
items in CCI's financial statements?

Machinery and working capital


The machinery and working capital provided by CCI should initially be recorded in CCI's
accounts at their historical cost, denominated in Canadian dollars. The machinery should be
amortized over its useful life. However, there is a fair amount of uncertainty as to the useful life
of the machinery. If things go well, the useful life could be the physical life of the machinery. On
the other hand, if things do not go well, the life of this venture may be very short. At the outset,
the term of the agreement should be used as the useful life. As further information becomes
available as to the likelihood for success, the useful life can either be lengthened or shortened.
In the meantime, we should be cognizant of the high potential for the assets to be impaired
and should expect to perform impairment tests on a regular basis. The working capital may not
be recoverable since it is only profits and not working capital that the Russian government will
translate to vodka. We should consider disclosing working capital as a noncurrent asset
because it is not a liquid asset (i.e., it cannot be converted to cash for CCI purposes).

Land and building


We must also consider whether any accounting recognition should be given to the assets (land
and building) contributed by the Russian government. In essence, this contribution is similar to
a government grant of a nonmonetary asset, which may or may not be reflected in the
accounts. Factors supporting the exclusion of these assets from CCI's accounts include the
fact that legal title has not been transferred and, therefore, to some extent neither have the
risks and rewards of ownership. The situation is similar to that of a rent-free lease being
provided: no recognition would be given in the accounts. Furthermore, the conservatism and
the objectivity concept support no recognition in the accounts. Even if there were to be any
recognition in the accounts, it would be very difficult to determine the fair value of these assets
in a country such as Russia, where real estate is not freely traded. We may consider as an

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alternative the recording in the accounts of an estimate of the future benefit to be derived from
this asset. However, this "value in use" will also be very difficult to estimate.

Measurement of revenue and expenses


There are significant measurement problems in trying to determine the revenues and
expenses of Russian operations to be included in CCI's financial statements. We cannot
simply use the exchange rate between rubles and Canadian dollars because although we can
convert Canadian dollars to rubles, we cannot directly convert our Russian profits,
denominated in rubles, to Canadian dollars. The substance of the transaction is similar to a
nonmonetary transaction CCI essentially receives vodka in return for its cola. Therefore, the
issue becomes this: when do we record the value of the vodka in the accounts? Alternatives
include:

recording all revenues and expenses at the time profit is determined in rubles at their
equivalent value in vodka, as determined by the prevailing export market price in
Russia and in Canada. The obvious problem with this alternative is that the ultimate
amount to be received, in Canadian dollars upon the sale of vodka, may change. The
prevailing export price in Russia (i.e., the price of vodka in rubles) may change, thereby
changing the profit previously recorded. Furthermore, the market value of vodka in
Canada may change. However, past history suggests that this is not a significant risk
since the government liquor boards in many provinces control prices, and there is little,
if any, past history of declines in liquor prices. In contrast, there is a strong possibility
that market prices may decline given the limited number of buyers in Canada and the
possibility that they may be confronted with too much supply (e.g., other joint venturers
may also have vodka to sell, or CCI's Russian profits may exceed Canadian demand
for vodka).

recording all revenues and expenses at the time the rubles are converted to vodka.
This alternative eliminates the risk that the price of vodka in rubles may change.
However, there is still the risk that the market value of vodka being sold to Canada may
change significantly, as discussed above.

recording revenues and expenses only when the vodka is sold to the Canadian market
and the exact profit in Canadian dollars is reliably measured. This would obviously be
the most conservative approach since the gains are recognized only when they are
realized.

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Valuation of vodka inventory


If Russian profits are recorded in CCI's accounts at any time before the vodka is actually sold
in Canada (i.e., either of the first two alternatives above), we must then determine how to treat
the gains and losses that arise because of fluctuations in the price of vodka. The realized
gains and losses would clearly be taken into income. The issue then becomes how to disclose
these amounts in the income statements. They can either be offset directly against Russian
revenues or disclosed separately as holding gains or losses.
The unrealized gains and losses could either be taken into income (as of the financial
statement date), or deferred until the final gain or loss is realized.
Alternative approach to transaction valuation
In trying to determine how to measure Russian operations for CCI's financial statements, we
could also seek guidance from the generally accepted accounting principles for foreign
operations. For example, we may be able to apply the principles inherent in the temporal
method, as many factors suggest that the Canadian dollar is the functional currency. CCI
must supply the raw materials, and it must use its processes in converting the syrup into cola.
CCI receives vodka as the output of the foreign operations. The vodka is brought to Canada
for sale in the Canadian market. These factors indicate that the Russian operations are
integrated with those of CCI and that CCI is wholly responsible for the management of
Russian operations.
On the other hand, several factors suggest that the operations are somewhat independent of
CCI and are therefore self-sustaining. The government can exert strong control over the
operations, and other assets, such as the machinery, cannot be removed. These factors
indicate that the Canadian dollar is not the functional currency.

Treatment of 50% payment to Russian government


We must consider how to disclose, in the income statement, the profits belonging to the
Russian government. One alternative is to record the payment as a one-line item, either as a
royalty charge or as the rental charge for the building provided by the Russian government.
Another approach is to consider the payment to the Russian government to be, in effect, a tax
cost. This approach may then affect the Canadian tax provision.

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Other reporting alternatives


We may want to consider reporting alternatives other than a 100% combination of revenues
and expenses because CCI may not have total control of these operations. Although CCl is
responsible for the management of Russian operations, Russia still has the power to
intervene. Given the real possibility of limitations on control, we should consider reporting
Russian operations using proportionate consolidation (50%).

Other issues
Since the operations in Russia may be significant to CCI, it may be necessary to disclose
segmented information on these operations.
We must also consider how to treat losses that may arise from these operations. For example,
it may be necessary to recover previous losses before any future profits are converted to
vodka.

Case 10-4
To: Marie Caisse
From: CPA
Subject: UFL Players Association (UFLPA) Engagements
The following items are those for which the accounting treatment adopted by Calgary Cowboys
Limited (CCL) is not or may not be in accordance with ASPE and therefore could distort the
analysis of CCLs financial viability.
1. Push-down accounting
CCL appears to have used push-down accounting to record the sale of CCL shares to
Crystal Roberts Management (CRM). However, under CPA Canada Handbook Section
1625, push-down accounting would not be applicable because it does not meet the
following criteria (Section 1625.4):
a. All or virtually all of the equity interests in the enterprise have been acquired, in one or
more transactions between non-related parties, by an acquirer who controls the
enterprise after the transaction or transactions; or
b. The enterprise has been subject to a financial reorganization, and the same party does
not control the enterprise both before and after the reorganization;
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and in either situation new costs are reasonably determinable.


Despite the sale of 100% of CCLs shares to CRM on January 1, Year 7, actual control of
CCL has not changed hands since Crystal controls CCL both before and after the
transaction. The transaction only affects the legal form of the relationship between Crystal
and CCL and not the economic substance.
As a result of the revaluation, the value of the non-competition clause was increased to
$100 million. This accounting treatment triggers a significant increase in the amortization
expense because the intangible was being amortized at the rate of $150,000 a year,
whereas in Year 7 and Year 8 the annual amortization expense related to this asset was
about $5 million. A major part of the $6 million net loss in each of the last two years is due
to this $4,850,000 yearly excess amount being charged to amortization.
2. Foreign currency translation
CCL capitalized as deferred gains the exchange gains related to current salaries payable
resulting from the decrease in value of the US dollar.
According to Handbook Section 1651.20, An exchange gain or loss of the reporting
enterprise that arises on translation or settlement of a foreign currencydenominated
monetary item or a non-monetary item carried at market should be included in the
determination of net income for the current period. Therefore, exchange gains resulting
from the translation of monetary items on foreign currencydenominated transactions
should be recognized in income during the period. Therefore the accounting treatment is
incorrect.
Because of the accounting error, CCLs net income for Year 8 is understated by $442,000
($566,000 $124,000). We do not have the information for Year 6, so I have assumed for
the time being that all the deferred exchange gains recognized on the Year 7 balance sheet
were realized in Year 7. Therefore, net income for Year 7 is understated by $124,000.
3. Salary expense and accrued liabilities for Jimmy Swagger
CCL charged the salary expense and recorded a liability in Year 8 for Jimmy Swaggers
salary for the years Year 9 and Year 10, since he will likely be traded to another club and
will no longer be playing for the Cowboys. The contract should be examined to determine
exactly what obligations the Cowboys and Jimmy have with regards to this situation. For
example, is Jimmy required to play until he is traded? What happens if CCL cant find
another team to pick up his contract? I suspect these questions have been directly
addressed in the contract. However, without access to the contract, I will use the general
accounting principles regarding liabilities to analyze the Cowboys accounting treatment.

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According to Section 1000.29,


Liabilities have three essential characteristics:
(a) They embody a duty or responsibility to others that entails settlement by future transfer
or use of assets, provision of services or other yielding of economic benefits, at a
specified or determinable date, on occurrence of a specified event, or on demand;
(b) The duty or responsibility obligates the entity leaving it little or no discretion to avoid it;
and
(c) The transaction or event obligating the entity has already occurred.
The first criterion is met as CCL does have a responsibility to transfer assets at a future
date. However, the second criterion is less straightforward. There is a way CCL can avoid
responsibility: if Swagger is traded, the contract with CCL will be terminated and the new
team will be responsible for any future salary. As for the third criterion, the event obligating
the entity has not occurred. While CCL has a legal obligation to pay Swagger, the amount
due is related to his performance in Year 9 and Year 10. Therefore, whether he is traded or
not, the $3 million liability should not be recognized on the balance sheet as at December
31, Year 8. Either he is traded and the Cowboys will not have to pay this amount at all, or
he will renew his contract with the Cowboys and this amount will represent compensation
for future services, and is therefore not a liability as at December 31, Year 8.
The $3 million liability and related expense should not be included in the Cowboys Year 8
financial statements. Income is therefore understated by $3 million.
4. Signing bonuses
CCL expenses the signing bonuses it pays to players. The question here is whether the
signing bonuses result in an asset. According to Section 1000.24, Assets are economic
resources controlled by an entity as a result of past transactions or events and from which
future economic benefits may be obtained. In addition, the item must be identifiable in
order to be considered an intangible asset. Therefore, the item must be four things:
1. controlled by the entity;
2. embodying a future benefit;
3. resulting from a past transaction; and
4. identifiable.
Signing bonuses are offered as incentives for players to sign a long-term employment
contract with CCL. Once the contract is accepted, it provides CCL with the exclusive use of
the player in question for the period agreed to. Presumably, if CCL is willing to offer the
player a signing bonus, it is because it believes the player will be a valuable contribution to

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the team and, as a result, will bring CCL identifiable future benefits that arise from a
contractual right in the way of wins or increased interest from fans.
According to Section 3064.18, an intangible asset should only be recognized if the item
meets the definition of an intangible asset and if the recognition criteria are met. Paragraph
21 contains the recognition criteria:
An intangible asset should be recognized if, and only if: a) it is probable that the expected
future economic benefits that are attributable to the asset will flow to the entity; and b) the
cost of the asset can be measured reliably.
I believe that both of these criteria have been met. We are told that the signing bonus is
refundable within the first year should the player decide to leave; therefore, the signing
bonus guarantees that the entity will derive a future benefit from having that player on the
team for a minimum of a year. Also, the cost of the signing bonus is known.
As a result, the signing bonus should be capitalized as an asset in the financial statements.
Because a recognized intangible asset should be amortized over its useful life, the next
step is determining the useful life of the asset. The contracts are, on average, for a period
of two to four years with an additional one-year renewal option. In addition, the bonus
becomes refundable should a player leave within the first year. Therefore, the signing
bonuses have a definite life that could be as short as one year or as long as five years,
assuming the renewable option is exercised. One could argue that the average life of a
contract, three years, should be used, but the argument for a useful life of one year is also
valid, seeing as there is no guarantee that the player will stay beyond the first year, as
demonstrated by Jimmy Swagger, the defensive tackle who has asked to be traded. For
purposes of the calculation, I have assumed a useful life of one year.
There were $5 million in signing bonuses expensed in Year 8. We know that $1 million of
this total relates to Jimmy Swagger and was paid at the start of the Year 8 season, which
would have been the beginning of July Year 8. As the statements are as at December 31,
Year 8, only six months have passed by year-end, and therefore only half of the signing
bonus related to Jimmy should have been amortized up to that point. While we know that
Jimmy asked to be traded after year-end, the contract requires him to stay with the team
for the full year or refund the bonus, so either way, his signing bonus still has value. With
regards to the remaining $4 million in bonuses expensed in Year 8, we do not know when
these contracts were signed and therefore cannot calculate the exact amount of
amortization. If we assume that the contracts and related signing bonuses were paid
evenly throughout the year, then we can assume that approximately half of the balance

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17

should be amortized by December 31, Year 8. Therefore, the Year 8 signing bonus
expense should be decreased by half ($500,000 for Jimmy and $2 million for the rest). This
adjustment increases the Year 8 net income figure by $2.5 million. If we make a similar
assumption for Year 7, then the Year 7 net income figure increases by $2 million [$4 million
50%]. This also means that the Year 8 net income figure should be reduced by $2 million
to recognize the second half of the Year 7 signing bonus expense.
5. Related party transactions (TV rights and interest) The contract CCL signed with the
Calgary Sports Channel is a related party transaction since the TV network is owned by
Crystals holding company. CCL billed the network for $1.5 million, even though an
unrelated entity was prepared to pay $8 million for these rights. The transfer price is
therefore significantly lower than the fair value of the service provided.
Per Section 3840.18-19, A monetary related party transaction, or a non-monetary related
party transaction that has commercial substance, should be measured at the exchange
amount when it is in the normal course of operations, unless paragraph 3840.22 applies.
The transaction between CCL and the Calgary Sports Channel is monetary.
One could argue that this transaction was not done in the normal course of business due to
the magnitude of the difference between the agreed-upon amount ($1.5 million) and the
fair value of the TV rights ($8 million). The fact that these contracts are negotiated only
once per year or every few years could also put the normal course of business concept in
question. On the other hand, this transaction appears to be in the normal course of
operations as it is not uncommon for a sports team to enter into a contract with a TV
network for the right to broadcast its games. I conclude that this transaction should be
measured at the exchange amount. Per Section 3840.23, The exchange amount reflects
the actual amount of the consideration given for the item transferred or service provided.
Therefore, it was appropriate for CCL to record the transaction at $1.5 million, the amount
paid by the Calgary Sports Channel.
As with the local TV revenue, interest on the advance from the parent company is a related
party transaction that should be measured at the exchange amount because it is a
monetary transaction conducted in the ordinary course of business. Therefore, it has been
recorded in accordance with ASPE. However, CCL should disclose the nature and amount
of the related party transaction in its financial statements.
These adjustments would result in the following revised income:
Income before income taxes per current statements

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Year 8

Year 7

(6,025,000)

(6,524,000)

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Modern Advanced Accounting in Canada, Eighth Edition

Adjustments:
Amortization non-competition clause

4,850,000

4,850,000

442,000

124,000

Salary expense for Jimmy Swagger

3,000,000

Year 8 signing bonuses ($500,000 + $2 million)

2,500,000

Year 7 signing bonuses

(2,000,000)

2,000,000

Adjusted income before income taxes per ASPE

$ 2,767,000

$ 450,000

Exchange gains

CCLs financial viability based on the restated statements


Billy Baker has asked us to evaluate the financial viability of the team. In order to do so, all
revenues directly associated with running the football team must be included in the income
statement. Due to the organizational structure used by CRM, various football revenues are in
related companies. This makes CCLs income statement less useful for evaluating the teams
viability. Therefore, the following adjustments are required.
1. Local television contract
While it was appropriate under ASPE for CCL to record the sale of local television rights at
$1.5 million, it underestimates the potential viability of the company since these rights could
have been sold for $8 million. Therefore, for purposes of evaluating the viability of CCL, I
believe the transaction should be valued at $8 million. If it is up to CCL to decide who to
sell the television rights to, then it is giving up that additional $6.5 million as a result of a
management decision, and the players should not be held responsible for that decision.
Therefore, a $6.5 million adjustment will be made to the Year 8 income statement.
2. Interest on advance from the parent company
It seems to me that the 20% interest rate is significantly higher than the market rate as it
currently stands. CCLs operations do not seem very risky revenues are stable and
foreseeable, the largest expense is at the discretion of the team, the other expenses are
fixed and easily foreseeable, and the debt/equity ratio is very low. I believe that a rate of
8% would be more reasonable for a long-term corporate loan. By using an interest rate of
8% instead of 20%, CCLs income for Year 8 increases by $206,400 ($344,000 12%
20%) and CCLs income for Year 7 increases by $330,600 ($551,000 12% 20%).
3. Parking revenue
In practical terms, since the team plays 10 home games per season and spectators fill the
15,000 parking spaces at $10 each every time, I estimate that $1.5 million in parking
revenue is earned each year. The parking lot is leased by CRM from the city for only one

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19

dollar per year. The parking lot is adjacent to the stadium, and we can assume that the only
reason the city leases the lot to CRM for such a low fee is because it was an incentive
offered to encourage Crystal to open the football franchise. CRM would not be able to
make such a profit off the parking lot if it did not own the Cowboys; the revenue is related
to spectators using the lot during games and the cost of the lot is next to nothing because
CRM owns the franchise. Therefore, this revenue should be included in the calculation of
the viability of the franchise.
4. Food and beverage revenue
It is not clear where the food and beverage revenue has been recognized, but it does not
appear to be on CCLs income statement. Since 40,000 spectators spend an average of
$25 per game each on food and beverages, I estimate gross revenue from this activity at
about $10 million. By conservatively estimating the contribution margin at 50% of sales,
this adds up to an additional $5 million in income taken out of CCL. Again, this revenue is
directly linked to owning the franchise since it is money earned during the games.
5. Travel expenses
Finally, the expenses related to Crystals private jet are entirely charged to CCL, even
though she uses the jet for other activities.
If CCL were to fly commercial, the travel expenses would total approximately $1 million per
year (50 people $2,000 10 trips) instead of the $2 million CCL is now paying. I estimate
that only $1 million should be charged to CCL for the purpose of evaluating its viability,
which means that its income increases by an additional $1 million.
As a result of these findings, the adjustment to CCLs net income for Year 7 and Year 8, when
applying ASPE and including all revenues generated by the Cowboys and only those expenses
relating specifically to the teams operations is as follows:
Year 8

Year 7

$ 2,767,000

$ 450,000

6,500,000

6,750,000

206,400

330,600

Parking revenue

1,500,000

1,500,000

Food and beverage revenue (net)

5,000,000

5,000,000

Travel expenses

1,000,000

1,000,000

16,973,400

15,030,600

150,000

150,000

Adjusted income before income taxes per ASPE


Adjustments:
Local TV broadcast rights
Interest on advance from parent company

Adjusted income before income taxes


Amortization non-competition clause

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Amortization signing bonuses


Signing bonus payments
Operating cash flow

4,500,000

2,000,000

(5,000,000)

(4,000,000)

$ 16,623,400 $ 13,180,600

Far from being in a loss position, CCLs operations generate adjusted income before income
taxes of $17 million in Year 8 and $15 million in Year 7.
Since the stadium is leased, capital investment is immaterial, and the investment in working
capital (inventories, accounts receivable) is negligible, CCLs operating cash flows can be used
as a cash cow for Crystals other investments.
Once the income is converted into cash flow, results are just as good. The amortization
expense for the non-competition clause ($150,000 per year) has no impact on cash flow, but
the signing bonuses do have a direct impact on them.
This cash flow is extremely attractive for Crystal. CCL has no outside debt, and the advance
from the parent company is completely offset when we include the revenues generated by the
Cowboys that are currently distributed to the parent company. The long-term debt/equity ratio
is therefore virtually nil.
Consequently, I feel it is wrong to claim that the current player compensation system
jeopardizes the survival of the Calgary Cowboys. This may not be the case for other teams, but
based on the information presented, my analysis shows that CCL appears to be a highly
profitable enterprise, very solvent, and in no way threatened with extinction.
Pervasive Qualities and Skills
My analysis indicates that CCL adopted several overly conservative accounting treatments. In
addition, the corporate structure of CCL, its parent company (CRM), and the other subsidiaries
of CRM is such that revenues directly related to the football teams operations are accounted
for in the parent company, while expenses relating to the parent company are recorded in
CCL.
As can be seen, each adjustment that I previously noted related to the choice of accounting
policy increases CCLs net income compared with the amount shown in the income statement
prepared by the teams management. This would suggest that CCL deliberately selected overly
conservative accounting policies to project a less rosy viability picture and add weight to the
owners argument at the negotiating table.
The organizational structure of Crystal Roberts companies means that some of the Cowboys
operating revenues are recognized outside CCL while expenses of the parent company are

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21

recognized in CCL. For example, the parking revenue is earned by the parent company, which
benefits from spectator attendance at the Cowboys games. In a similar vein, revenue from the
sale of food and beverages at the stadium during the games is not reported by CCL, so I
assume its reported by CRM. In addition, the travel expenses include the full operating costs
of the private jet owned by Crystal, even though CCL uses the jet for only 10 trips per year.
Clearly, the income statement shows a significantly understated income figure that is of little
use in evaluating the teams actual viability. Once the necessary adjustments are made to
show a net income that is more representative of the actual viability of the Calgary Cowboys
income before taxes for Year 8 goes from negative $6 million to positive $17 million.
This systemic bias is a result of the negotiation process with the UFLPA. The team owners
have an incentive to show a poor financial position so that the players will accept the newly
proposed compensation system. Since the Cowboys are one of the teams claiming to be
facing extinction because of financial difficulties resulting from the current player compensation
system, it is not surprising that CCLs accounting policies have an obvious bias.
The team owners claim that most of the teams have a negative bottom line and chose to
present CCLs financials as an example of a troubled team. Therefore, it is possible that what
is occurring at CCL is also occurring across the league: other teams may be manipulating their
results in the same fashion as CCL. The other teams financials may need to be reviewed
before the new compensation plan proposed by the owners can be properly evaluated and
before strike negotiations can be resolved.

Case 10-5
Memo to:

Partner

From:

CPA

Re:

ZIM Inc. Audit

Overview
There are a number of significant new issues pertaining to this years ZIM engagement,
particularly the pending initial public offering (IPO).

Financial statements are often an

important component in setting the offering price of an IPO. As a result, ZIMs management
will likely want to maximize net income by maximizing assets and minimizing liabilities in an
effort to positively influence the offering price of the IPO. For example, ZIMs preliminary
financial statements indicate that a significant portion of its sales was recorded in the last
month of the year. Given the circumstances, I have to wonder whether these are real sales or
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the result of managements efforts to maximize net income.


Capitalization/depreciation of software development costs
The software development costs represent a significant and large balance sheet item. We
must carefully review these costs to determine whether the associated products have future
earnings potential. If they do not, they must be written down or written off. The accounting for
these amounts may have a significant effect on the valuation of ZIM for purposes of the IPO,
as investors will associate the reported asset values with future revenue generating ability.
Under IAS 36, an asset is impaired when its carrying amount exceeds its recoverable amount.
Recoverable amount is the higher of an assets net selling price and value in use (i.e. the
present value of the assets expected future cash flows). When the carrying amount of an
asset exceeds it recoverable amount, the asset should be written down to its recoverable
amount. As discussed further in this memo, there appears to be impairment issues concerning
the photon phasing project, the Transact product and the ATM 4000 project.
In addition, the development costs must be amortized on a systematic basis over their useful
life (IAS 38 Intangible Assets). The formula used by ZIM to determine the annual amortization
rate seems reasonable as the formula seems to be estimating the useful life using units of
production. However, it is difficult to estimate total expected unit sales during the products life
(the denominator of the formula), especially in this industry, and the estimates may be subject
to manipulation by management. By using high estimates of total sales management could
reduce the amount amortized in a period, thereby increasing net income. This could have an
effect on the offering price of ZIM shares when the company goes public.
The photon-phasing project has been put on hold pending a decision on the direction the
project will take. This project has $691,000 of deferred development costs associated with it
on the balance sheet. Given the delay, we must assess whether these costs have future
benefits. That is, can these costs justifiably continue to be deferred given the uncertainty
surrounding the product? We must investigate managements intent regarding this project, its
technical feasibility, its marketability, etc.
I also have concerns about Dr. Alec Zimmers use of the technology developed when he was
with his previous employer. Does Dr. Zimmer have a legal right to use the technology, or are

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23

there prospective legal problems if the previous employer decides that it has a proprietary right
to the technology?
Transact revenue recognition
ZIM sells the Transact software at a loss but generates a profit overall on the product because
it sells training at a significant profit. The training is necessary if customers are to obtain
optimal benefits from Transact. This arrangement raises questions about revenue recognition
as well as the appropriate accounting for the deferred development costs associated with the
product.
ZIM appears to have recognized all the revenue associated with Transact training during July
Year 8, even though the actual training has not yet been purchased by the customers, and
customers are not likely to purchase the training until fiscal Year 9.

We must determine

whether some or all of the revenue from the training should be recognized when the
equipment is sold or whether the revenue from the two components should be recognized
separately. The issue at hand is whether management can offset the losses incurred on the
loss-leader Transact product with the profits earned on the connected profitable Transact
training sales transaction.
The issue to consider is whether or not, in substance, a single transaction, or separate
transactions, are involved.

An argument could be made that the software and training

represent components of a single transaction if one was always sold with the other, particularly
when considering that the company would likely not sell a product at a loss. However, the
products appear to be sold separately, and the customer does not appear to have an
obligation to purchase the training once it has purchased the software. These facts support
that the components represent separate transactions, as opposed to components of a single
transaction, such that revenue would be recognized separately for each component.
Nonetheless, if the software is not fully functional without the training, and historical experience
supports that customers almost always purchase the training subsequently then this might lend
support to the components being linked as a single transaction.
If it is determined that the facts support these transactions are separate, then, while it would be
appropriate to recognize revenue for the sale of the software component in July Year 8, it
would only be appropriate to recognize revenue for any subsequent sale of the training

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component as that service is provided in Year 9.


If it is determined that the facts support these transactions are linked such that they represent
components of a single transaction, further analysis would be required to determine the
appropriate accounting for a multiple element transaction.
The conclusion on the substance of the transaction also has implications for the deferred
development costs related to the Transact product. If considered a single transaction, then it
could be argued that the amortization rate for the deferred development costs should take into
account sales of both the Transact product and the related training.

This would result in

deferring some of these costs to Year 9, resulting in higher income in the current period and
potentially have a positive effect on the offering price of the IPO. If, however, the sale of
software and training are considered to be two separate transactions, then the deferred
development costs should be written off in Year 8 since the Transact software does not
generate profits. This would result in lower income in the current period.
My preliminary conclusion is that the transactions are separate since the customer has no
obligation to purchase the Transact training. Therefore, revenue for sale of the training should
only be recognized when such sale has been made and over the period that the training is
being provided. Consistent with this conclusion, deferred development costs related to the
Transact software should be written off in Year 8. We will need to carefully review the sales
contracts and sales histories to verify the particular facts and circumstances surrounding the
sale of the Transact software and training.
IDSL Software
The IDSL 600 product was delivered to customers in two parts, with the deliveries of the
components spanning the year-end. The hardware was sold and delivered in May Year 8 while
the custom software required to operate the equipment was delivered to customers via the
Internet in September Year 8.

ZIM recognized $2.104 million of revenue on IDSL 600,

representing about 8% of revenues for Year 8. This is a material amount. If we find that some
or all of the revenue from this product should not be recognized until fiscal Year 9, income for
Year 8 will decrease and the valuation of the shares for the IPO is likely to be negatively
affected.
There are three possible times when revenue can be reasonably recognized: first, when the

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25

equipment is shipped; second, proportionatelythat is, recognize part of the revenue when
the equipment was shipped and part when the software was shipped; and third, when the
product is operationalthat is, when the hardware and software have both been delivered to
and accepted by the customer. For full recognition in fiscal Year 8 to be allowable, the crucial
question is whether the earnings process can be considered complete before the customer
receives the software. From the information we have, the hardware is not operational without
the custom software provided by ZIM. (Since custom software is involved, software does not
appear to be available from other providers that could be used to operate the hardware.) This
situation would support not allowing full recognition during fiscal Year 8.
The earnings process could be considered complete if, for all intents and purposes, work on
the software was virtually complete, there were few uncertainties about the completion at the
date of shipment of the hardware (and certainly by the year end), and the software was
incidental to the functionality of the hardware. However, as this custom software is required to
operate the equipment, this does not appear to be a viable alternative.
As for recognizing part of the revenue when the equipment has been delivered and part when
the software has been delivered, this would be appropriate if the two components were
separately identifiable components of a single transaction, and the fair values of each
component could be separately determined.

However, as the equipment and the custom

software are not sold separately, and the custom software is essential to the functionality of the
hardware, it is difficult to view the equipment and the software as separately identifiable
components. Therefore, these facts would support delaying revenue recognition until both
components have been delivered.
We should determine whether there are any customer acceptance provisions. If the customer
can return the hardware and the software if the software does not meet the customers custom
design requirements, then revenue recognition should be delayed until such customer
acceptance has been obtained.
It is clear that ZIM has a strong incentive to recognize this revenue during fiscal Year 8
because of the effect on revenue and income and therefore on the IPO.

My preliminary

recommendation is to delay revenue recognition until the custom software has been delivered.
Revenue for both the hardware and software components should be recognized at that time,

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provided there are no further customer acceptance considerations.


ATM 4000 buy-back
ZIM has offered $467,500 to buy back all units of its failed ATM 4000 product. One customer
has launched a $4 million lawsuit for losses suffered as result of using the product. Clearly, a
minimum of $467,500 must be expensed and set up as a liability for fiscal Year 8. Since the
product is effectively being terminated, there is no justification for any treatment other than
immediate recognition of the costs and the liability. Management may prefer deferral because
of the IPO. This treatment is, however, inappropriate. In addition, the deferred development
costs associated with the ATM 4000 must be written off in fiscal Year 8 since these costs no
longer represent a future benefit. There has been impairment (IAS 36).
A crucial question that must be investigated is whether the $467,500 is a reasonable estimate
of the cost of repurchasing all of the units. The fact that ZIM has offered that amount does not
mean that it will ultimately pay that amount. The cost could end up being significantly higher.
Failure to include a higher estimate, if appropriate, would result in material misstatement of the
financial statements.
The lawsuit should be disclosed in the financial statements in accordance with IAS 37. At this
point we have no information to assess the likelihood of the outcome of the suit, or the final
amount that will have to be paid. Since a reasonable estimate cannot be made, disclosure
rather than accrual is therefore appropriate pending additional information.
Ransom
The ransom payment itself ($100,000) will likely have little effect on the valuation of the
company because the amount is small relative to the overall value of the company (sales
appear to be over $25 million). In addition, the payment is presumably a non-recurring item
that will therefore have no long-term effect on the earnings of the company.
There are implications, however. The ransom could be considered to be a bribe, which is an
illegal act. Zim could be fined if found guilty of participating in an illegal act. Furthermore, if the
bribe becomes public knowledge, it could negatively affect the reputation of the company. All of
these factors indicate a contingency. A liability will not have to be recognized at this stage
because it is not determinable whether anything will ever have to be paid. The contingency

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should be disclosed if there is a possibility that a material amount could have to be paid.
If the hacker discloses the flaws despite receiving the ransom payment, or if the flaws become
public knowledge by some other means, then the revenue generating ability of the product will
be impaired. Under these circumstances, it is appropriate to consider whether the deferred
development costs related to Firewall Plus should be written down.
We must still consider how to account for the ransom payment: whether it should be
capitalized or expensed. Capitalization can be justified because the payment protects the
design of the product and allows it to continue to be a marketable product, thereby protecting
revenues already earned. Without the payment, the value of the Firewall product would be
significantly impaired because of disclosure of the security flaw. That said, expensing seems
to make more sense. Even with the payment the hacker could still disclose the flaw, or the
flaw could become public knowledge in some other way, so future benefit is not assured. Also,
the payment does not enhance the service potential of the software; it merely maintains it.
Therefore, my preliminary recommendation is that the ransom payment should be expensed.

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Headhunter fee
ZIM incurred $178,000 in placement fees for new employees. The company has capitalized
the amount and is amortizing it over five years. Alec Zimmer may be motivated to defer the
fees to improve earnings because of the IPO. If capitalization can be justified, the five-year
amortization period would probably be too long because there is no guarantee that an
employee will stay five years, especially in view of the high turnover often seen in high-tech
industries. If capitalization was considered appropriate, a shorter amortization period should
be considered, for example a one-year period since some employees may not work out and
ZIM would receive a refund from the headhunter for anyone leaving the company within one
year of being hired.
On the other hand, since this outlay is an ordinary operating cost, it is likely more appropriate
to expense the amount in the current period. This is on the grounds that there is no future
economic benefit to be generated from the placement fee, and therefore, it does not meet the
definition of an asset. While ZIM may be entitled to a refund in the future of some of the
placement fees paid, this would represent at best a contingent asset, which is not recognized
under IFRS. ZIM would only recognize an asset for such a receivable when its realization is
virtually certain (i.e. when a termination/resignation within the one year hire period has
occurred such that ZIM becomes entitled to a refund of the placement fees).
My preliminary recommendation, therefore, is that the placement fees should be expensed in
the year incurred.
PC capitalization policy
The company has extended the write-off period for desktop computers from one year to two.
Either write-off period is reasonable, and both reflect the short lives of desktop computers.
The issue is that the amount involved is material, and the change in treatment will affect the
financial statements. Managements motivation for the change may be to lower current period
expenses for the IPO.
Consideration must be given to whether the change in write-off period is a change in
accounting policy or a change in estimate.

A change in estimate is accounted for

prospectively; a change in policy is accounted for retroactively. I suggest classifying this as a


change in estimate because the company appears to have been using a one year write-off

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policy (rather than an expensing policy), which means that extending the write-off period to two
years is simply a change in the estimate of the computers usefulness.
Swap
It must be determined whether the swap and settlement of the debt are two distinct
transactions or part of a single transaction. If they are two separate transactions, then the gain
can be recognized since it is no longer hedged. This approach can be supported since it can
be argued that the swap is now speculative and the full gain/loss should be brought into
income. If, however, the swap and settlement are really part of the same transaction, then the
gain should be deferred and the final gain or loss recognized when the swap ends.
The question remains of whether to account for the outstanding swap and, if so, how to
account for it. The treatment of the swap instrument that remains should correspond to the
treatment of the $3 million gain. (If the gain is recognized right away, then recognize future
gains/losses each year.) The details of the remaining swap and the accounting policy used
should be disclosed.
ACC problem
It appears that another firm in the industry may have stolen some of ZIMs computer programs.
The important issue is whether there is any impairment of the revenue generating ability of
ZIMs products as a result of its programs having fallen into the hands of competitors. If the
revenue generating ability of products has been impaired, then it might be necessary to write
down their balance sheet value.

SOLUTIONS TO PROBLEMS
Problem 10-1
(a)

(i)

December 1, Year 5
Accounts receivable (FC)
Sales

444,600
444,600

(FC600,000 .741)

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December 3, Year 5
Memorandum Entry
Company entered into forward contract to pay FC600,000 to the bank in exchange for
$468,600 (FC600,000 .781) to be received from the bank on April 1, Year 6. The payable to
the bank will offset the receivable from the customer.
(ii)
December 31, Year 5
Accounts receivable (FC)

9,600

Exchange gain

9,600

(FC600,000 [.757 .741])


Exchange loss

6,000

Forward contract

6,000

(FC600,000 [.791 .781])


(iii)
April 1, Year 6
Accounts receivable (FC)

27,000

Exchange gain

27,000

(FC600,000 [.802 .757])


Exchange loss

6,600

Forward contract

6,600

(FC600,000 [.802 .791])


Cash (FC)

481,200

Accounts receivable (FC)

481,200

(FC600,000 .802)
Cash

468,600

Forward contract

12,600
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Cash (FC)

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(b)
Manitoba Exporters Inc.
Balance Sheet
at December 31, Year 5
Assets
Accounts receivable

454,200

Liabilities
Forward contract
(c)

6,000

(i)

December 1, Year 5
Accounts receivable (FC)

444,600

Sales

444,600

(FC600,000 .741)
December 3, Year 5
Memorandum Entry
Company entered into forward contract to pay FC600,000 to the bank in exchange for
$468,600 to be received from the bank on April 1, Year 6. The payable to the bank will offset
the receivable from the customer.

(ii)
December 31, Year 5
Accounts receivable (FC)

9,600

Exchange gain

9,600

(FC600,000 [.757 .741])


Exchange loss

5,911

Forward contract

5,911

(FC600,000 [.791 .781] / 1.005 3)

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(iii)
April 1, Year 6
Accounts receivable (FC)

27,000

Exchange gain

27,000

(FC600,000 [.802 .757])


Exchange loss

6,689

Forward contract

6,689

(FC600,000 .802 (468,600 + 5,911])


Cash (FC)

481,200

Accounts receivable (FC)

481,200

(FC600,000 .802)
Cash

468,600

Forward contract

12,600

Cash (FC)

481,200

(FC600,000 .802)

Problem 10-2
Note: debits are without brackets and credits are with brackets.
(a)

(b)

444,600

444,600

(444,600)

(444,600)

December 1, Year 5
Accounts receivable (FC)
Sales
(FC600,000 .741)
December 3, Year 5
Memorandum Entry
Company entered into forward contract to pay FC600,000 to the bank in exchange for
$468,600 (FC600,000 .781) to be received from the bank on April 1, Year 6. The spot
element of the payable to the bank will offset the receivable from the customer. The forward

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element of the payable to the bank (i.e. the premium on the forward contract) will be accounted
for as a hedge expense.
December 31, Year 5
Accounts receivable (FC)
Exchange gain

9,600

9,600

(9,600)

(9,600)

(FC600,000 [.757 .741])


OCI - Exchange loss on cash flow hedge

9,600

Exchange loss

9,600

Forward contract

(9,600)

(9,600)

(FC600,000 [.757 .741])


Exchange loss

9,600

OCI - Exchange loss on cash flow hedge

(9,600)

Recycle OCI through net income to offset exchange gain


Hedge expense (FC600,000 x (.781 - .741) x )
Forward contract

6,000

6,000

(6,000)

(6,000)

27,000

27,000

(27,000)

(27,000)

Expense premium of forward contract over 4 months


April 1, Year 6
Accounts receivable (FC)
Exchange gain
(FC600,000 [.802 .757])
OCI - Exchange loss on cash flow hedge

27,000

Exchange loss

27,000

Forward contract

(27,000)

(27,000)

(FC600,000 [.802 .757])


Exchange loss

27,000

OCI - Exchange loss on cash flow hedge


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Recycle OCI through net income to offset exchange gain


Hedge expense (FC600,000 x (.781 - .741) x 3/4)

18,000

18,000

(18,000)

(18,000)

481,200

481,200

(481,200)

(481,200)

468,600

468,600

12,600

12,600

(481,200)

(481,200)

Forward contract
Expense premium of forward contract over 4 months
Cash (FC)
Accounts receivable (FC)
(FC600,000 .802)
Cash
Forward contract
Cash (FC)
(c)
The journal entries are exactly the same except for the following:

- the entry to adjust the forward contract to fair value is put through OCI for a cash flow hedge
but charged/credited directly to exchange gains/losses for a fair value hedge
- an extra entry is made for the cash flow hedge to reclassify the exchange adjustment from
OCI to net income to offset the exchange gain/loss on the hedged item
The net effect of all entries is exactly the same under the two methods.

Problem 10-3
(a)
January 1, Year 1
Cash

46,360,000

Loan payable

46,360,000

(40,000,000 1.159)
December 31, Year 1
Exchange loss
Loan payable

360,000
360,000

(40,000,000 [1.168 1.159])

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Interest expense (4,800,000 1.1635)

5,584,800

Exchange loss

21,600

Cash (4,800,000 1.168)

5,606,400

(b)
Exchange gains (losses) would appear on the yearly income statements of Moose Utilities as
shown below.
Date

Exchange Yearly gain (loss) on


Rate

Loan

Interest

Jan.1/1

1.159

Dec.31/1

1.168

(360,000)

(21,600)

Dec.31/2

1.160

320,000)

19,200

Dec.31/3

1.152

320,000

19,200

Dec.31/4

1.155

(120,000)

(7,200)

160,000

9,600)

Total (4 years)

Problem 10-4
October 31, Year 1
Memorandum entry
Company entered into forward contract to receive MP1,000,000 from the bank in exchange for
a payment of $750,000 (MP10,000,000 x 0.075) to the bank on March 1, Year 2. The
receivable from the bank will offset the payable to the supplier.
December 31, Year 1
Forward contract

10,000

Other comprehensive income cash flow hedge

10,000

(MP10,000,000 [0.077 0.076])


Value forward contract at fair value
March 1, Year 2
Forward contract

20,000

Other comprehensive income cash flow hedge

20,000

(MP10,000,000 [0.078 0.076])


Value forward contract at fair value
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Cash (MP) (MP10,000,000 0.078)

780,000

Forward contract

30,000

Cash

750,000

Inventory

780,000

Cash (TL)

780,000

(MP10,000,000 0.078)
Accumulated OCI cash flow hedge

30,000

Inventory

30,000

To clear accumulated other comprehensive income


(b)
Partial trial balance December 31, Year 1

DR

Forward contract *

CR

$10,000

Other comprehensive income cash flow hedge**

$10,000

$10,000

$10,000

* Forward contract is shown as a current asset


** Other comprehensive income is shown after net income on the statement of
comprehensive income. Accumulated other comprehensive income is shown as a separate
component of shareholders equity.

Problem 10-5
Note: debits are without brackets and credits are with brackets.
(a)

(b)

(c)

January 1, Year 5

HTM

HFT

AFS

3,062,400

3,062,400

3,062,400

(3,062,400)

(3,062,400)

(3,062,400)

Investment in bonds
Cash
(US$2,200,000 x 1.392)
December 31, Year 5
Exchange loss

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112,200

112,200

112,200

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Investment in bonds

(112,200)

(112,200)

(112,200)

59,004

59,004

(US$2,200,000 [1.392 1.341])


Investment in bonds
Unrealized gain

(59,004)

Other comprehensive income: unrealized gain

(59,004)

([US$2,200,000 1.02 x 1.341] [CDN$3,062,400 CDN$112,200]) = CDN$59,004 gain


Cash (US$264,000 x 1.341)
Exchange loss
Interest revenue (US$264,000 x 1.3665)

354,024

354,024

354,024

6,732

6,732

6,732

(360,756)

(360,756)

(360,756)

Problem 10-6
Note: debits are without brackets and credits are with brackets.

October 1, Year 6

(a)

(c)

CF Hedge

FV Hedge

Memorandum Entries
Company signed a contract to sell merchandise for SF400,000 for delivery on January 31,
Year 7.
Company entered into forward contract to pay SF400,000 to the bank in exchange for
$480,000 (SF400,000 1.20) to be received from the bank on January 31, Year 7. The
payable to the bank will offset the receivable from the customer.
December 31, Year 6
Exchange loss

8,000

Other comprehensive income

8,000

Forward contract

(8,000)

(8,000)

(SF400,000 [1.22 1.20])


Commitment receivable

8,000

Exchange gain

(8,000)

(SF400,000 [1.22 1.20])

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January 31, Year 7


Cash (SF)
Sales

476,000

476,000

(476,000)

(476,000)

12,000

12,000

(SF400,000 1.19)
Forward contract
Other comprehensive income

(12,000)

Exchange gain

(12,000)

(SF400,000 x [1.22 1.19])


Exchange loss

12,000

Commitment receivable

(12,000)

(SF400,000 [1.22 1.19])


Commitment receivable
Other comprehensive income
Sales

4,000
4,000
(4,000)

(4,000)

480,000

480,000

(4,000)

(4,000)

(476,000)

(476,000)

To clear other commitment receivable/other


comprehensive income to sales account
Cash
Forward contract
Cash (SF)

(b)
Trial balance, December 31, Year 6

CF Hedge

Commitment receivable
Forward contract liability
Exchange gains & losses
Other comprehensive income

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(d)
FV Hedge
8,000 B/S

(8,000)
0

(8,000) B/S
0 I/S

8,000

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(e) Under the fair value hedge, a current asset and current liability of $8,000 are reported
whereas only an $8,000 current liability is reported under the cash flow hedge. Therefore,
the fair value hedge shows a slightly better liquidity position.

Problem 10-7
(a) (i)
December 1, Year 3
Inventory

462,202

Accounts payable (DM)

462,202

(DM613,000 0.754)
December 3, Year 3
Memorandum Entry
Company entered into forward contract to receive DM613,000 from the bank in exchange for a
payment of $486,722 (DM613,000 x 0.794) to the bank on April 1, Year 4. The receivable from
the bank will offset the payable to the supplier.
(ii)
December 31, Year 3
Exchange loss

9,808

Accounts payable (DM)

9,808

(DM613,000 [0.770 - 0.754])


Forward contract

3,065

Exchange gain

3,065

(DM613,000 [0.799 - 0.794])


(iii)
April 1, Year 4
Exchange loss

27,585

Accounts payable (DM)

27,585

(DM613,000 [0.815 - 0.770])


Forward contract

9,808
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Exchange gain

9,808

(DM613,000 [0.815 - 0.799])


Cash (DM)

499,595*

Forward contract

12,873

Cash

486,722

*(DM613,000 0.815)
(b)
Hamilton Importing Corp.
Statement of Financial Position
at December 31, Year 3
Assets
Forward contract

$3,065

Liabilities
Accounts payable

$472,010

(c) (i)
December 1, Year 3
Inventory

462,202

Accounts payable (DM)

462,202

(DM613,000 x 0.754)
December 3, Year 3
Memorandum Entry
Company entered into forward contract to receive DM613,000 from the bank in exchange for a
payment of $486,722 (DM613,000 x 0.794) to the bank on April 1, Year 4. The receivable from
the bank will offset the payable to the supplier.
(ii)
December 31, Year 3
Exchange loss
Accounts payable (DM)
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9,808
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(DM613,000 [0.770 - 0.754])


Forward contract

2,997

Exchange gain

2,997

(DM613,000 [0.799 - 0.794] / 1.00750 3)


(iii)
April 1, Year 4
Exchange loss

27,585

Accounts payable (DM)

27,585

(DM613,000 [0.815 - 0.770])


Forward contract

9,876

Exchange gain

9,876

(DM613,000 0.815 [486,722 + 2,997])


Cash (DM)

499,595*

Forward contract

12,873

Cash

486,722

* (DM613,000 0.815)

Problem 10-8
August 1, Year 3
Memorandum Entry
Company signed a contract to purchase machinery for HK$500,000 for delivery on
December 31, Year 3 i.e. will pay HK$500,000
August 2, Year 3
Memorandum Entry
Company entered into forward contract to receive HK$500,000 from the bank in exchange for
a payment of $82,500 (HK$500,000 x 0.165) to the bank on December 31, Year 3. The
receivable from the bank will offset the payable to the supplier.
(a)
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October 1, Year 3
Machinery

82,000

Accounts payable (HK$)

82,000
82,000

82,000
82,000

82,000

(HK$500,000 x 0.164)
Forward contract

1,500

OCI

1,500

1,500

1,500

Exchange gains/losses

1,500

1,500

(HK$500,000 x [0.168 0.165])


Accumulated OCI

1,500

Machinery

1,500

(To transfer accumulated OCI to machinery)


Exchange gains/losses

1,500

Commitment liability

1,500

(Recognize change in value of notional accounts payable)


(HK$500,000 x [0.168 0.165])
Commitment liability

1,500

Machinery

1,500

(To transfer commitment liability to machinery)


December 31, Year 3
Forward contract

500

OCI

500

500

500

Exchange gains/losses

500

500

(HK$500,000 x [0.169 0.168])


Exchange gains/losses

2,500

Account payable

2,500
2,500

2,500
2,500

2,500

(HK$500,000 x [0.169 0.164])


OCI

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Exchange gains/losses

500

Clear OCI to exchange gains/losses as reclassification adjustment


Cash (HK$) (HK$500,000 x 0.169)

84,500

Forward contract
Cash

84,500

84,500

2,000

2,000

2,000

82,500

82,500

82,500

(Settle forward contract with bank)


Accounts payable (HK$)

84,500

Cash (HK$)

84,500
84,500

84,500
84,500

84,500

(Pay supplier)
Summary journal entry
Machinery

80,500

80,500

82,000

2,000

2,000

500

Exchange gains/losses
Cash

82,500

82,500

82,500

(d)
The cash outflow of $82,500 is the same under all three scenarios and is equal to the amount
paid to the bank to get the HK$ to be paid to the supplier. The difference between the three
parts is based on how the exchange adjustment on the forward contract is allocated. In parts
a) and b), the full exchange adjustment prior to delivery is allocated to the machinery due to
the special rules under hedge accounting. In part c), all of the exchange adjustments end up
in exchange gains/losses.

Problem 10-9
(i) Sale of software when delivered (600,000 / 5.09)

Parts a & b

Part c

117,878

117,878

(445)

117,433

117,878

Less: exchange adjustment to date of installation


600,000 / 5.20 600,000 / 5.18)
Net value of sale
(ii) Exchange loss to date of installation

445

Exchange gains/losses after installation


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45

on accounts receivable
[600,000 / 5.14 600,000 / 5.09)]

1,147 loss

1,147 loss

901 loss

901 loss

2,048 loss

2,493 loss

115,385

115,385

on forward contract
[600,000 / 5.18 600,000 / 5.14)]
Net exchange gains/losses
(iii) Cash flows for the period
(= amount received from bank through forward contract)
(c)
The cash inflow of $115,385 is the same under all three scenarios and is the amount received
from the bank in exchange for the Danish Krona as fulfilment of the forward contract. The
difference in the sales and exchange gains/losses is based on how the exchange adjustment
prior to the installation of the software was allocated. In parts a) and b), the full exchange
adjustment prior to installation was allocated to the sale. In the part c), it was allocated to
exchange gains/losses.

Problem 10-10
a)
January 10, Year 1
Cash

11,600

Deferred revenue (US$10,000 x 1.16)

11,600

March 17, Year 1


Accounts receivable (US$90,000 x 1.17)
Deferred revenue

105,300
11,600

Sales

116,900

May 1, Year 1
Land (US$200,000 x 1.19)

238,000

Cash (US$100,000 x 1.19)

119,000

Accounts payable (US$100,000 x 1.19)

119,000

June 30, Year 1


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Accounts receivable (US$90,000 x [1.23 1.17])

5,400

Exchange gain

5,400

Exchange loss

4,000

Accounts payable (US$100,000 x [1.23 1.19])

4,000

Interest expense (US$100,000 x 6% x 2/12 x [1.23 1.19] / 2)


Exchange loss

1,210
20

Interest payable (US$100,000 x 6% x 2/12 x 1.23)

1,230

July 31, Year 1


Accounts receivable (US$90,000 x [1.25 1.23])

1,800

Exchange gain

1,800

Cash (US$90,000 x 1.25)

112,500

Accounts receivable

112,500

b)
The market value of the land at June 30, Year 1 is C$258,300 (US$200,000 x 1.23).

Problem 10-11
May 1 & 2, Year 1
Memorandum Entries
JDH ordered equipment from a German supplier for payment of 100,000 on delivery on
October 1, Year 1.
Company entered into a forward contract to receive 100,000 from the bank in exchange for a
payment of $138,000 to the bank on October 1, Year 1. The receipt of 100,000 from the bank
will offset the payable to the supplier.
October 1, Year 1
Forward contract (100,000 [1.39 1.36])

1,000

Other comprehensive income exchange gains and losses

1,000

To adjust forward contract to October 1 forward rate

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Equipment (100,000 1.37)

137,000

Accounts payable ()

137,000

Other comprehensive income exchange gains and losses

1,000

Equipment

1,000

To clear other comprehensive income into equipment account


December 31, Year 1
Exchange gains and losses (100,000 [1.39 1.38])

3,000

Forward contract

3,000

To adjust forward contract to December 31 forward rate


Accounts payable (100,000 [1.37 1.36])

1,000

Exchange gains and losses

1,000

To adjust accounts payable to December 31 spot rate


Cash ()

136,000

Forward contract

2,000

Cash

138,000

To settle forward contract with bank


Accounts payable ()

136,000

Cash ()

136,000

To pay supplier with funds received from bank

Problem 10-12
Note: Debits without brackets and credits with brackets
(a) (i)

(c)

(d)

June 2, Year 3
Memorandum entry
Company entered into forward contract to receive TL217,000 from the bank in exchange for a
payment of $195,300 (TL217,000 x 0.90) to the bank on March 1, Year 2. The receivable from
the bank will offset the payable to the supplier.
June 30, Year 3
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Other comprehensive income cash flow hedge

1,085

Exchange gains and losses

1,085

Forward contract

(1,085)

(1,085)

(TL217,000 [0.895 0.90])


Commitment liability

1,085

Exchange gains and losses

(1,085)

To recognize gain on commitment liability


September 30, Year 3
Forward contract

3,255

Other comprehensive income cash flow hedge

3,255

(3,255)

Exchange gains and losses

(3,255)

(TL217,000 [0.91 0.895])


Exchange gains and losses

3,255

Commitment liability

(3,255)

To recognize loss on commitment liability


(TL217,000 [0.91 0.895])
Cash (TL)
Forward contract
Cash

197,470

197,470

197,470

(2,170)

(2,170)

(2,170)

(195,300)

(195,300)

(195,300)

(TL217,000 0.90)
Inventory
Cash (TL)

197,470

197,470

197,470

(197,470)

(197,470)

(197,470)

(TL217,000 0.91)
Commitment liability

2,170

Other comprehensive income cash flow hedge


Inventory

2,170
(2,170)

(2,170)

To clear other comprehensive income (3,255 1,085)

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Gain on forward contract

2,170

Inventory

(2,170)

To record gain on forward contract as adjustment to cost of inventory


(a) (ii)
Partial trial balance June 30, Year 3
Other comprehensive income cash flow hedge*

DR

CR

$1,085

Payable to bank**

$1,085
$1,085

$1,085

* Other comprehensive income is shown after net income on the statement of


comprehensive income. Accumulated other comprehensive income is shown as a separate
component of shareholders equity.
(b)
September 30, Year 3
Inventory (TL217,000 x 0.91)

197,470

Cash (TL)

197,470

(e)
Inventory is the only current asset that would be different under the four options. There would
be no differences for current liabilities. Inventory would be reported at $197,470 when no
forward contract was entered and at $195,300 for the other options. Therefore, the current
ratio would be higher under option b) where no forward contract was entered.

Problem 10-13
(a)
October 15, Year 4
Inventory

340,300

Accounts payable (RL)

340,300

(RL820,000 .415)
Memorandum entry

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Company entered into forward contract to receive RL820,000 from the bank in exchange for a
payment of $350,960 (RL 820,000 .428) to the bank on December 15, Year 4. The receivable
from the bank will offset the payable to the supplier.
December 1, Year 4
Accounts receivable (AP)

677,800

Sales

677,800

(AP2,520,000 .269)
Memorandum entry
Company entered into forward contract to pay AP2,520,000 to the bank in exchange for
$619,920 (AP2,520,000 .246) from the bank on January 31, Year 5. The payable to the bank
will offset the receivable from the customer.
December 15, Year 4
Accounts payable (RL)

6,560

Exchange gains and losses

6,560

(RL 820,000 [.407 .415])


Exchange gains and losses

17,220

Forward contract

17,220

(RL 820,000 [.407 .428])


Cash (RL) (RL 820,000 .407)

333,740

Forward contract

17,220

Cash

350,960

Accounts payable (RL)

333,740

Cash (RL)

333,740

(RL 820,000 .407)


December 31, Year 4
Exchange gains and losses

40,320

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Accounts receivable (AP)

40,320

(AP2,520,000 [.253 .269])


Forward contract

10,080

Exchange gains and losses

10,080

(AP2,520,000 [.242 .246])


(b)
Hull Manufacturing Corp.
Balance Sheet
as at December 31, Year 4
Assets
Accounts receivable

637,560

Forward contract

10,080

Problem 10-14
January 1, Year 1
Cash

1,470,000

Loan payable

1,470,000

(SF1,400,000 1.05)
During Year 1
Cash

616,000

Sales revenue

616,000

(SF560,000 1.10)
Interest expense (12% SF1,400,000 1.10)
Exchange loss
Cash (12% SF1,400,000 1.15)

184,800
8,400
193,200

December 31, Year 1

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Other comprehensive income (Yr. 1)

140,000

Loan payable

140,000

(SF1,400,000 [1.15 1.05])


Sales revenue

56,000

Other comprehensive income (Yr. 1)

56,000

(560/1,400 140,000)
During Year 2
Cash

588,000

Sales revenue

588,000

(SF490,000 1.20)
Interest expense (12% SF1,400,000 1.20)
Exchange loss

201,600
8,400

Cash (12% SF1,400,000 1.25)

210,000

December 31, Year 2


Other comprehensive income (Yr. 2)

84,000

Exchange loss*

56,000

Loan payable

140,000

(SF1,400,000 [1.25 1.15] = 140,000)


* (560/1,400 140,000 = 56,000)
Sales revenue

98,000

Other comprehensive income (Yr. 1)

49,000

Other comprehensive income (Yr. 2)

49,000

(490/1,400 140,000)
During Year 3
Cash

444,500

Sales revenue

444,500

(SF350,000 1.27)
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Interest expense (12% SF1,400,000 1.27)


Exchange loss

213,360
5,040

Cash (12% SF1,400,000 1.30)

218,400

December 31, Year 3


Other comprehensive income (Year 3)

17,500

Exchange loss ([560+490] /1,400 x 70,000)

52,500

Loan payable

70,000

(SF1,400,000 [1.30 1.25])


Sales revenue

87,500

Other comprehensive income Yr. 1 (25% x 140,000)

35,000

Other comprehensive income Yr. 2 (25% x 140,000)

35,000

Other comprehensive income Yr. 3 (25% x 70,000)

17,500

Loan payable

1,820,000

Cash

1,820,000

Problem 10-15
Year

Gain (loss)

Gain (loss)

Loan Payable

Interest Payment

Year 4

(6,240) *

(234) ***

Year 5

12,480 **

468 ****

208,000 (1.49 1.46) = (6,240)

**

208,000 (1.43 1.49) = 12,480

*** 208,000 .075 (1.475 1.49) = (234)


**** 208,000 .075 (1.46 1.43) = 468

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