CHAPTER 7
SOLUTIONS TO EXERCISES AND PROBLEMS
EXERCISES
E7.1
Recording Import Transactions
Purchases
Inventories
Accounts payable
Payments
Foreign currency
Cash
Accounts payable
Exchange loss
Exchange gain
Foreign currency
E7.2
Australia
Dr.
Cr.
91,500
91,500
Thailand
Dr.
Cr.
14,000
14,000
Indonesia
Dr.
Cr.
1,610
1,610
Dr.
140,000
92,250
10,000
1,050
140,000
92,250
91,500
750
10,000
14,000
--
-92,250
Jordan
140,000
1,050
1,610
--
4,000
10,000
Cr.
140,000
140,000
--
560
1,050
-140,000
Recording Export Transactions
Sales
Accounts receivable
Sales
Collection
Foreign currency
Exchange loss
Exchange gain
Accounts receivable
Cash
Foreign currency
Argentina
Dr.
Cr.
87,500
87,500
Canada
Dr.
Cr.
260,400
260,400
India
Dr.
Cr.
7,200
7,200
South Africa
Dr.
Cr.
16,900
16,900
90,500
--
256,800
3,600
9,000
--
15,800
1,100
3,000
87,500
90,500
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-260,400
256,800
90,500
1,800
7,200
9,000
256,800
-16,900
15,800
9,000
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15,800
E7.3
Recording Import and Export Transactions
Import Transactions
Transaction 1
Transaction date:
Inventory
3,300
Accounts payable
Payment date:
Accounts payable
Exchange loss
3,300
3,300
500
Cash
3,800
Transaction 2
Transaction date:
Inventory
180,000
Accounts payable
Payment date:
Accounts payable
180,000
180,000
Exchange gain
Cash
9,000
171,000
Export Transactions
Transaction 3
Transaction date:
Accounts receivable
118,400
Sales
Payment date:
Cash
Exchange loss
118,400
105,200
13,200
Accounts receivable
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Transaction 4
Transaction date:
Accounts receivable
712,500
Sales
712,500
Payment date:
Cash
746,700
Exchange gain
Accounts receivable
E7.4
Item
1
2
3
4
34,200
712,500
Adjusting Entry at Balance Sheet Date
Book Balance ($)
Dr. (Cr.)
$ 100,000
180,000
(500,000)
(50,000)
Dollar Equivalent, 12/31
Dr. (Cr.)
$ 90,000 = $.09 x 1,000,000
184,500 = $.82 x 225,000
(520,000) = $1.30 x 400,000
(48,000) = $.24 x 200,000
Adjustment Needed
Dr. (Cr.)
$ (10,000) Loss
4,500 Gain
(20,000) Loss
2,000 Gain
Adjusting Entry
Exchange loss
23,500
Accounts receivable
($10,000 - $4,500)
5,500
Accounts payable
($20,000 - $2,000)
18,000
To record the net transaction loss on the receivables and payables at December 31;
($23,500) = ($10,000) + $4,500 + ($20,000) + $2,000.
E7.5
Hedging Exposed Liability
a.
March 15, 2012
Inventory
18,100
Accounts payable
To record goods purchased; $18,100 = $.000905 x 20,000,000.
April 14, 2012
Exchange loss
18,100
60
Accounts payable
To restate payable at current spot rate; $60 = ($.000908 - $.000905) x 20,000,000.
60
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Investment in forward contract
160
Exchange gain
To restate forward contract to current fair value; $160 = ($.000908 - $.000900) x
20,000,000.
Foreign currency
160
18,160
Investment in forward
contract
160
Cash
18,000
To record payment to the dealer, receipt of 20,000,000 won, valued at the current spot rate
of $.000908/W, and fulfillment of the forward purchase contract.
Accounts payable
18,160
Foreign currency
18,160
b.
Dollars paid (to broker) with the hedge:
Dollars that would have been paid at the current spot rate to purchase
foreign currency for the supplier; (.000908 x 20,000,000):
Cash gain (amount saved) from hedging:
E7.6
$18,000
-18,160
$ 160
Hedging Exposed Asset
a.
September 1, 2011
Accounts receivable
14,000,000
Sales
To record sales made; $14,000,000 = $.35 x 40,000,000.
14,000,000
September 30, 2011
Exchange loss
400,000
Accounts receivable
400,000
To restate receivable at current spot rate; $400,000 = ($.35 - $.34) x 40,000,000.
Investment in forward contract
480,000
Exchange gain
480,000
To restate the forward contract to its current fair value; $480,000 = ($.352 - $.34) x
40,000,000.
Foreign currency
13,600,000
Accounts receivable
13,600,000
To record receipt of currency from Brazilian customer; $13,600,000 = $.34 x 40,000,000.
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Cash
14,080,000
Foreign currency
13,600,000
Investment in forward
contract
480,000
To record delivery of currency to the dealer, receipt of $14,080,000 as specified in the
contract, and settlement of the forward contract.
b.
Dollars received (from broker) with the hedge:
Dollars that would have been received from the
customer's foreign currency at the current
spot rate (.34 x 40,000,000):
Cash gain (increased proceeds) from hedging:
E7.7
$14,080,000
- 13,600,000
$ 480,000
Hedged Purchase Commitment and Exposed Liability
September 15, 2012
No entry
November 15, 2012
Investment in forward contract
15,000
Exchange gain
15,000
To record change in fair value of the forward contract; $15,000 = ($.105 - $.104) x
15,000,000.
Exchange loss
15,000
Firm commitment
To record the loss on the firm purchase commitment.
15,000
Inventories
1,545,000
Accounts payable
To record delivery of the goods at the current spot rate of $.103.
Firm commitment
1,545,000
15,000
Inventories
15,000
To adjust the carrying value of the goods for the accumulated loss on the firm commitment
during the commitment period.
December 31, 2012
Exchange loss
30,000
Accounts payable
30,000
To record loss due to increase in dollar value of accounts payable; $30,000 = ($.105 $.103) x 15,000,000.
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Investment in forward contract
30,000
Exchange gain
30,000
To record increase in value of forward purchase contract; $30,000 = ($.107 - $.105) x
15,000,000.
January 15, 2013
Exchange loss
45,000
Accounts payable
To record loss on accounts payable; $45,000 = ($.108 - $.105) x 15,000,000.
Investment in forward contract
45,000
15,000
Exchange gain
15,000
To record increase in fair value of forward purchase contract; $15,000 = ($.108 - $.107) x
15,000,000.
Foreign currency
1,620,000
Investment in forward
contract
Cash
To record fulfillment of the forward contract.
Accounts payable
60,000
1,560,000
1,620,000
Foreign currency
To record payment to the Mexican supplier.
E7.8
1,620,000
Hedged Sale Commitment and Exposed Asset
April 15, 2011
No entry
April 30, 2011
Investment in forward
Contract
75
Exchange gain
75
To record increase in fair value of the forward contract; $75 = ($.174 - $.173) x 75,000.
Exchange loss
Firm commitment
To record loss on U.S. dollar value of the firm sale commitment.
75
75
Accounts receivable
12,825
Sales revenue
12,825
To record delivery of goods to the South African customer; $12,825 = $.171 x 75,000.
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Firm commitment
75
Sales revenue
To adjust the sales revenue for the change in value of the firm sales commitment.
May 15, 2011
Accounts receivable
75
150
Exchange gain
To record gain on accounts receivable; $150 = ($.173 - $.171) x 75,000.
150
No entry is needed to revalue the investment in the forward contract since its fair value
remains at $75 [= ($.174 - $.173) x 75,000].
Foreign currency
12,975
Accounts receivable
12,975
To record receipt of rands from the South African customer, valued at the current spot rate
of $.173.
Cash
13,050
Foreign currency
12,975
Investment in forward
contract
75
To record delivery of the rands to the dealer, and settlement of the forward contract.
E7.9
Hedged Forecasted Purchase
June 30, 2011
Investment in forward contract
574
Other comprehensive
income
To record increase in fair value of forward purchase contract;
$574 = ($1.24 - $1.199) x 14,000.
Foreign currency
574
17,360
Investment in forward
contract
Cash
To record settlement of forward contract.
Inventory
574
16,786
17,360
Foreign currency
17,360
To record delivery of merchandise and payment to supplier; $17,360 = $1.24 x 14,000.
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July 12, 2011
Cash
19,000
Sales
19,000
To record merchandise sale.
Other comprehensive income
Cost of goods sold
574
16,786
Inventory
17,360
To record cost of sale, including release of gain on forward contract to cost of goods sold.
E7.10
Hedged Forecasted Sale
November 30, 2012
Other comprehensive income
500
Investment in forward
contract
To record decrease in value of forward contract; $500 = ($.651 - $.646) x 100,000.
Foreign currency
65,100
Sales
To record merchandise sale; $65,100 = $.651 x 100,000.
Sales
65,100
500
Other comprehensive
income
To transfer the loss on the hedge to current earnings.
Cash
Investment in forward contract
500
64,600
500
Foreign currency
To record settlement of forward contract.
E7.11
500
65,100
Recording Foreign Investment
a.
October 1, 2012
Short-term Investments
124,500
Cash
124,500
To record the purchase of a 6-month certificate of deposit, face value 1,000,000 krona,
from a Swedish bank; implied spot rate = $.1245 = $124,500/1,000,000.
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December 31, 2012
Short-term investments
20,000
Exchange gain
To accrue the transaction gain on the certificate of deposit;
$20,000 = ($.1445 - $.1245) x 1,000,000.
Interest receivable
20,000
5,418.75
Interest income
5,418.75
To accrue interest income to December 31, 2012 based on the December 31 exchange rate;
$5,418.75 = $.1445(3/12)(.15) x 1,000,000.
March 31, 2013
Exchange loss
21,700
Short-term investments
21,700
To accrue the transaction loss on the certificate of deposit since December 31, 2012;
$21,700 = ($.1445 - $.1228) x 1,000,000.
Exchange loss
813.75
Interest receivable
813.75
To accrue the transaction loss on the interest receivable; $813.75 = ($.1445-$.1228) x
37,500; 37,500 = .15(3/12)1,000,000, the interest (in krona) accrued on December 31,
2012.
Interest receivable
4,605
Interest income
4,605
To record interest income for the period January 1, 2013 to March 31, 2013 based on the
March 31exchange rate; $4,605 = $.1228 x 37,500 [(= (3/12).15 x 1,000,000)].
Foreign currency
132,010
Short-term investments
122,800
Interest receivable
9,210
To record the receipt of foreign currency for principal and interest at maturity of the
certificate of deposit; $132,010 = $.1228 x 1,075,000.
Cash
Foreign currency
To record conversion of 1,075,000 krona into dollars.
132,010
132,010
b.
This investment returned $7,510, the difference between the $124,500 paid to acquire the
certificate and the $132,010 received at maturity, in six months. The effective annual
interest rate on this investment is ($7,510/$124,500) x 2 = 12.06%. The company should
compare this return with that obtainable on alternative investments.
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E7.12
Speculative Foreign Contracts
a.
Forward purchase contract:
(.$.13 - $.128) x 10,000,000 = $20,000 current liability
Forward sale contract:
($.64 - $.634) x 10,000,000 = $60,000 current asset
b.
December 31, 2011
Exchange loss
30,000
Investment in forward
contract
30,000
To record loss accrued since December 16 on speculative forward purchase contract;
$30,000 = ($.125 - $.128) x 10,000,000.
Exchange loss
80,000
Investment in forward
contract
80,000
To record loss accrued since December 16 on speculative forward sale contract; $80,000 =
($.642 - $.634) x 10,000,000.
January 15, 2012
Investment in forward contract
60,000
Exchange gain
60,000
To record gain accrued since December 31 on speculative forward purchase contract;
$60,000 = ($.131 - $.125) x 10,000,000.
Foreign currency
1,310,000
Investment in forward
contract
10,000
Cash
1,300,000
To record settlement of the forward purchase contract; $10,000 = ($20,000) + ($30,000) +
$60,000.
Cash
Foreign currency
To record conversion of $H10,000,000 into dollars.
1,310,000
1,310,000
Note to instructor: The speculation in $H produced a net cash gain of $10,000 (=
$1,310,000 - $1,300,000).
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Investment in forward contract
60,000
Exchange gain
60,000
To record gain accrued since December 31 on speculative forward sale contract; $60,000 =
($.636- $.642) x 10,000,000.
Foreign currency
6,360,000
Cash
6,360,000
To record acquisition of $S on the spot market to settle the forward sale contract.
Cash
6,400,000
Investment in forward
contract
40,000
Foreign currency
6,360,000
To record settlement of the forward sale contract; $40,000 = $60,000 + ($80,000) +
$60,000.
Note to instructor: The speculation in $S produced a net cash gain of $40,000
(= 6,400,000 - 6,360,000).
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PROBLEMS
P7.1
Computation of Exchange Gain or Loss
a.
Computation of Exchange Adjustment on Receivables
Foreign Currency
Exchange Rate
Country
Amount
(12/31/12)
Belgium
300,000
$ 1.256
India
1,200,000
.0235
Saudi Arabia
90,000
.2666
Dollar amount of foreign currency receivables at 12/31/12
Less amount per books ($355,000 + $23,950 + $24,000)
Exchange gain on receivables
Amount ($)
$ 376,800
28,200
23,994
$ 428,994
(402,950)
$ 26,044
Computation of Exchange Adjustment on Payables
Foreign Currency
Exchange Rate
Country
Amount
(12/31/12)
Japan
(1,000,000)
$ .00911
Mexico
(500,000)
.10210
Dollar amount of foreign currency payables at 12/31/12
Less amount per books ($10,000 + $50,000)
Exchange loss on payables
Amount ($)
$ (9,110)
(51,050)
$(60,160)
(60,000)
$ (160)
Computation of Exchange Adjustment on Other Assets (Liabilities)
(1)
Amount ($)
Foreign Currency
Forward Rate
(Contract rate
Item
Dr. (Cr.)
(12/31/12)
minus current
forward rate) x
(1)
Forward purchase
contract (pesos)
500,000
$ .10235
$
(75)
Forward sale
contract (euros)
(300,000)
1.26200
( 3,600)
Dollar amount of other assets (liabilities)
denominated in foreign currencies at 12/31/12
$ (3,675)
Less amount per books [$(1,125) + $18,200]
(17,075)
Exchange loss on other assets (liabilities)
$ (20,750)
Net exchange gain (loss) in 2012;
$26,044 + $(160) + ($20,750).
$ 5,134
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Adjusting Entry - Books of Wheelstick Corporation
Accounts receivable
26,044
Investment in forward purchase contract
1,050
Accounts payable
Investment in forward sale
contract
Exchange gain
To record the exchange adjustments on accounts receivable, accounts payable, and the
forward purchase and sale contracts at December 31, 2012; $1,050 = ($75) – ($1,125);
($21,800) = ($3,600) - $18,200.
160
21,800
5,134
b.
The forward purchase contract is a hedge of the accounts payable to Mexican suppliers.
Following is an analysis of the exchange gains and losses on the exposure and the hedge
investment:
Accounts payable
Investment in forward purchase contract
Net exchange gain (loss)
Book
Value
$50,000
(1,125)
12/31/12
Value
$51,050
(75)
Exchange
Gain (Loss)
$(1,050)
1,050
$
0
The forward sale contract is a hedge of the accounts receivable from Belgian customers.
Following is an analysis of the exchange gains and losses on the exposure and the hedge
investment:
Accounts receivable
Investment in forward purchase contract
Net exchange gain (loss)
Book
Value
$355,000
18,200
12/31/12
Value
$376,800
(3,600)
Exchange
Gain (Loss)
$ 21,800
(21,800)
$
0
Both forward contracts are 100 percent effective in hedging Wheelstick’s exposure to
foreign exchange risk on the receivables from Belgian customers and the payables to
Mexican suppliers.
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P7.2
Import and Export Transactions and Hedged Commitment
August 14, 2011
Exchange loss
80,000
Investment in forward
contract
80,000
To record decline in fair value of forward contract; $80,000 = ($1.25 - $1.23) x 4,000,000.
Firm commitment
80,000
Exchange gain
To record reduction in cost of firm commitment.
Foreign currency
Investment in forward contract
80,000
4,920,000
80,000
Cash
To record settlement of forward purchase contract.
Inventory
5,000,000
4,920,000
Foreign currency
To record delivery of merchandise and payment to supplier;
$4,920,000 = $1.23 x 4,000,000.
Inventory
4,920,000
80,000
Firm commitment
To adjust inventory balance for value of firm commitment.
September 1, 2011
Accounts receivable
80,000
840,000
Sales revenue
To record sales to concern in Poland; $840,000 = $.28 x 3,000,000.
November 3, 2011
Exchange loss
840,000
60,000
Accounts receivable
To record decline in value of receivable; $60,000 = ($.28 - $.26) x 3,000,000.
Foreign currency
780,000
Accounts receivable
To record receipt of payment from customer.
Cash
Foreign currency
To record exchange of zloty into dollars.
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60,000
780,000
780,000
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P7.3
Accounting for Forward Contracts—Hedging and Speculation
a.
December 31, 2012
Exchange loss
120,000
Investment in forward contract
To record decline in value of forward sale contract #1;
$120,000 = ($.165 - $.105) x 2,000,000.
Firm commitment
120,000
120,000
Exchange gain
To record increase in sales value of firm commitment related to contract #1.
Investment in forward contract
180,000
Other comprehensive income
To record increase in value of forward purchase contract #2;
$60,000 = ($.165 - $.105) x 3,000,000.
Exchange loss
120,000
180,000
60,000
Investment in forward contract
60,000
To record loss on speculative contract #3; $60,000 = ($.165 - $.105) x 1,000,000.
January 29, 2013
Exchange loss
54,000
Investment in forward contract
54,000
To record decline in value of forward sale contract #1 since December 31; $54,000 =
($.192 - $.165) x 2,000,000.
Firm commitment
54,000
Exchange gain
To record increase in sales value of firm commitment related to contract #1.
384,000
Sales revenue
To record sale to South African customer; $384,000 = $.192 X 2,000,000.
54,000
Foreign currency
Sales revenue
384,000
174,000
Firm commitment
174,000
To adjust sales revenue for the accumulated balance in the firm commitment account.
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Cash
Investment in forward contract
210,000
174,000
Foreign currency
To record the settlement of forward sale contract #1.
Investment in forward contract
384,000
81,000
Other comprehensive income
To record increase in value of forward purchase contract #2;
$81,000 = ($.192 - $.165) x 3,000,000.
Foreign currency
81,000
576,000
Investment in forward contract
Cash
To record settlement of forward purchase contract #2.
Inventory
261,000
315,000
576,000
Foreign currency
To record purchase #2 at the current spot rate of $.192.
Exchange loss
576,000
27,000
Investment in forward contract
27,000
To record loss on forward sale contract #3; $27,000 = ($.192 - $.165) x 1,000,000.
Foreign currency
192,000
Cash
192,000
To record purchase of rands in the spot market, in anticipation of settlement of forward sale
contract #3.
Cash
Investment in forward contract
105,000
87,000
Foreign currency
To record settlement of forward sale contract #3.
192,000
b.
December 31, 2012 Balance Sheet:
Investment in forward contracts has a net balance of zero.
Firm commitment has a net debit balance of $120,000 (current asset).
Other comprehensive income is increased by $180,000 (stockholders= equity).
2012 Income Statement:
Net exchange loss on speculative activity is $60,000.
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c.
Observe that the forward contracts entered into by Futura represented a perfect
hedge. That is, forward sale contracts #1 and #3 were hedged by forward purchase
contract #2. One could argue that these forward exchange contracts were
unnecessary, and whatever transaction costs were incurred by Futura in connection
with the contracts represent an unnecessary loss to the firm.
P7.4
Hedging, Leverage, Return on Assets
a.
Note that the December 31, 2012 spot rate is $.80 (= $400 million/C$500 million) and the
forward rate in the contract is $88 (= $440 million/C$500 million). If the exchange rate is
$.83/C$ at the end of the first quarter, Cheesecake Factory incurs a net loss on the forward
contract of $25 million, since the C$ could be bought for $.83 instead of the $.88 forward
rate; ($25 million) = ($.83 - $.88) x 500 million. The contract requires purchase of C$ for
$440 million when the expected prevailing market price is $415 million. Concurrently
there is a $15 million [= ($.83- $.80) x 500 million] exchange loss on the payable that
increases liabilities.
Without the hedge, Cheesecake Factory's payable to the foreign supplier increases by $15
million and the $15 million exchange loss decreases equity. There is no change in total
assets. Using the data in the problem, measured leverage rises to .715 [= ($700 +
$15)/$1,000].
With the hedge, the payable still increases by $15 million. The forward contract is shown
as a current liability of $25 million. Using the data in the problem, measured leverage
becomes .74 [= ($700 + $15 + $25)/$1,000].
b.
If Cheesecake Factory did not use the forward contract, it could borrow $400 million now
and buy the needed foreign currency. This would cost $412 million, including 12% interest
for 3 months. The forward contract costs $440 million. In addition, if the company
borrows, it could invest the C$ in short-term foreign investments until required by the
foreign supplier. This alternative seems to dominate the forward contract.
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c.
As above, there is a $15 million exchange loss on the payable which decreases operating
income. The forward rate implied by the contract is $.81 (= $405 million/$500 million).
Thus there is a $10 million gain on the forward purchase contract that increases assets,
since the exchange rate increases from $.81 to $.83 at the end of the quarter.
Without the hedge, and assuming an annual ROA of .16 (.04 quarterly), at current
exchange rates projected operating income for the first quarter is $44 million [= .04
($1,000 + $1,200)/2]. Without the hedge, the $15 million exchange loss due to the
increasing exchange rate reduces operating income to $29 million and the quarterly ROA
to .026 [ = $29/($1,000 + $1,200/2)].
With the hedge, operating income is again reduced by the $15 million loss on the payable,
but increases by the $10 million gain on the forward purchase contract. Operating income
is $39 million = ($44 million - $5 million) and the quarterly ROA is .035 [= $39/($1,000 +
$1,200 + $10)/2].
P7.5
Transaction Exposure and Credit Analysis
a.
Using the information given, we can compute Poole's cash flow from operations as follows
(in millions):
Net income
$ 150
+ Depreciation expense
50
- Increase in noncash working capital
(40)
- Unrealized transaction gains on long-term debt
(22)
Cash flow from operations
$ 138
Because earnings overstate cash from operations by $12 million, "nearness to cash" could
be improved.
b.
Sales generate cash flows. When sales are denominated in a foreign currency, however,
the amount of cash ultimately collected is affected by changes in the exchange rate, as well
as by the general risk of default. Although we do not know Poole's 2012 projected sales to
these foreign customers, we do know that one-third of the ending inventory is designated to
be sold to them. Wide variations in the exchange rate will likely have material effects on
dollar cash flows from these sales.
The suggested analysis involves calculating the dollars lost on sale of the designated
inventory if customers pay Poole when the dollar strengthens and the exchange rate falls to
$.20/peso. In this case, the 500 million pesos will produce $75 million (= $175 - $.20 x
500) less, more than half of Poole's 2011 operating cash flow.
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c.
Poole seems to have considerable exposure to exchange rate risk, with foreign currency
denominated claims in receivables, payables and long-term debt, and susceptible revenuedriven cash flow streams. First, you would like more information on the extent of this
exposure and whether any of it represents natural hedges. Second, you want to know
management's plans to minimize this risk and the relative cost of different strategies, such
as forward contracts, foreign loans and investments, and accelerated payment and
collection policies.
P7.6
Hedging a Foreign Currency Commitment—Effects on Income
a.
November 30, 2012
Exchange loss
21,000
Investment in forward contract
21,000
To record decline in value of forward sale contract; $21,000 = ($.840 - $.798) x 500,000.
Firm commitment
21,000
Exchange gain
To record increase in sales value of the agreement with the Swiss customer.
21,000
Accounts receivable
390,000
Sales revenue
390,000
To record delivery of the motors to the Swiss customer; $390,000 = $.78 x 500,000.
Sales revenue
21,000
Firm commitment
21,000
To adjust sales revenue for the accumulated balance in the firm commitment account.
December 31, 2012
Exchange loss
5,000
Accounts receivable
To adjust accounts receivable balance to the new spot rate;
$5,000 = ($.78 - $.77) x 500,000.
Investment in forward
contract
5,000
10,000
Exchange gain
10,000
To record increase in value of forward sale contract; $10,000 = ($.84 - $.82) x 500,000.
©Cambridge Business Publishers, 2010
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181
January 31, 2013
Accounts receivable
20,000
Exchange gain
To adjust accounts receivable balance to the new spot rate;
$20,000 = ($.81 - $.77) x 500,000.
20,000
Investment in forward
contract
5,000
Exchange gain
5,000
To record increase in value of forward sale contract; $5,000 = ($.82 - $.81) x 500,000.
Foreign currency
405,000
Accounts receivable
405,000
To record payment by Swiss customer to Ellis Corporation; $405,000 = $390,000 - $5,000
+ $20,000.
Cash
Investment in forward
contract
399,000
6,000
Foreign currency
To record settlement of the forward sale contract.
405,000
b.
Exchange loss
Exchange gain
Sales revenue
Net effect on income
2012
$ ( 5,000)
10,000
369,000
$ 374,000
2013
$
-25,000
-$ 25,000
Note that the income effects for the two years sum to $399,000, the U.S. dollar amount
received from the sale and forward contract.
c.
With the forward contract, Ellis received $399,000 from the sale. Without the contract,
CHF500,000 would have been exchanged for $405,000 = $.81 x 500,000. Therefore Ellis
lost $6,000 due to hedging. However, Ellis did gain peace of mind in knowing the
$399,000 was locked in.
©Cambridge Business Publishers, 2010
182
Advanced Accounting, 1st Edition
P7.7
Hedging a Forecasted Transaction
December 31, 2011
Investment in forward contract
21,000
Other comprehensive income
To record increase in value of forward purchase contract;
$21,000 = (1.441 - $1.420) x 1,000,000.
January 29, 2012
Inventory
21,000
1,450,000
Accounts payable
To record delivery of merchandise at current spot rate of $1.45.
March 1, 2012
Exchange loss
1,450,000
10,000
Accounts payable
To adjust the account payable to the current spot rate;
$10,000 = ($1.46 - $1.45) x 1,000,000.
10,000
Investment in forward contract
19,000
Other comprehensive income
To record increase in value of forward purchase contract;
$19,000 = ($1.46 - $1.441) x 1,000,000.
Other comprehensive income
19,000
10,000
Exchange gain
To reclassify OCI to earnings to offset loss on accounts payable.
Foreign currency
10,000
1,460,000
Investment in forward contract
Cash
To record settlement of the forward contract.
Accounts payable
40,000
1,420,000
1,460,000
Foreign currency
1,460,000
To record payment to the supplier.
April 8, 2012
Cash
1,600,000
Sales revenue
1,600,000
To record sale to U.S. customer.
©Cambridge Business Publishers, 2010
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183
Cost of goods sold
1,450,000
Inventory
To record cost of merchandise sold.
1,450,000
Other comprehensive income
30,000
Cost of goods sold
To transfer remaining gain in OCI on forward purchase contract to current income.
P7.8
30,000
Analyzing the Performance of an Import/Export Department
a.
This problem is approached by evaluating the profit contributions of the import and export
departments separately and then by reviewing the reasonableness of the forward contracts.
Although the ultimate measure of profitability is cash received minus cash paid out, we are
also interested in the change in the dollar equivalents of Bush's overseas purchases and
sales between the transaction dates and the payment/collection dates. This may have some
implications for credit and payment policies.
Profit Contribution of the Import Transactions
(1)
(2)
(3)
(4)=(3)-(1)
(5)=(1)-(2)
(6)=(4)+(5)
Part #
$ Cost
When
Purchased
$ Cost
When
Paid
Total Net
Revenue
Gross
Contribution
Exchange
Gain (Loss)
Total
Contribution
K14
KR08
L16
M29Q
Total
$ 10,624
83,300
46,330
93,240
$233,494
Part #
A24
DD2
A27
B23
Total
$10,240 $ 15,500
$ 4,876
$
384
98,600
102,000
18,700
(15,300)
50,020
50,000
3,670
(3,690)
80,640
92,000
(1,240)
12,600
$239,500 $259,500
$26,006
$ (6,006)
Profit Contribution of the Export Transactions
$ 5,260
3,400
(20)
11,360
$20,000
(1)
(2)
(3)
(4)=(1)-(3)
(5)=(2)-(1)
(6)=(4)+(5)
$ Revenue
When
Sold
$ Revenue
When
Collected
Total Cost
Gross
Contribution
Exchange
Gain (Loss)
Total
Contribution
$ 31,752
150,000
220,000
9,198
$410,950
$ 34,104
144,000
232,000
8,468
$418,572
$ 27,720
144,000
178,000
8,500
$358,220
©Cambridge Business Publishers, 2010
184
$ 4,032
6,000
42,000
698
$52,730
$ 2,352
(6,000)
12,000
(730)
$ 7,622
$ 6,384
0
54,000
(32)
$ 60,352
Advanced Accounting, 1st Edition
Review of Forward Contracts
Overall, the contracts entered for hedging purposes produced a net gain of $2,700. The
forward purchase contract cost $130,200 (= 210,000 x $.62) while at maturity the foreign
currency could have been purchased for $123,900 (= 210,000 x $.59), yielding a loss of
$6,300 (= $130,200 - $123,900). The forward sale contract produced revenue of $270,000
(= 300,000 x $.90) while at maturity the same amount of foreign currency could have been
sold on the spot market for $261,000 (= 300,000 x $.87), yielding a gain of $9,000 (=
$270,000 - $261,000). The net gain amounted to $2,700 (= $9,000 - $6,300).
Note that had the hedging not been undertaken, exchange rate movements would have
produced losses on both the purchase and sale transactions. Ignoring interest rate effects,
and considering spot rates only, the cost of the foreign currency to be purchased increased
by $4,200 (=($.59 - $.57) x 210,000) between inception and maturity while the value of the
foreign currency to be sold decreased by $3,000 (= ($.88 - $.87)300,000) between
inception and maturity.
In contrast, the speculative contracts were mistakes. The foreign currency acquired for
$250,000 (= 1,000,000 x $.25) in the purchase contract could be sold for only $220,000 (=
1,000,000 x $.22) in the spot market at maturity, generating a loss of $30,000. Likewise,
the currency sold for $740,000 (= 1,000,000 x $.74) in the sale contract had to be
purchased in the spot market at maturity for $850,000 (= 1,000,000 x $.85) and a loss of
$110,000 resulted.
b.
Memorandum
TO:
FROM:
SUBJECT:
Top Management, Bush Specialty Products
Mr. X, Consultant
Review of William Johnston's Import/Export Department
Mr. Johnston is doing a reasonable job in the import/export business. Both import and
export transactions provided positive contributions toward fixed costs and profits of Bush.
The export business has been the most successful with a much higher ratio of profit
contribution to sales.
Unfortunately, these reasonably satisfactory results have been wiped out by Mr. Johnston's
activities in the forward markets for foreign exchange. Johnston entered into two
speculative forward contracts which produced losses of $140,000, almost $60,000 more
than the total profit contribution provided by the import/export transactions. I do not know
whether he has been cautioned against speculating with the firm's capital and cannot
recommend outright that Johnston be fired. At a minimum, he should be prohibited from
entering into speculative forward contracts on behalf of the import/export department.
©Cambridge Business Publishers, 2010
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185
Mr. Johnston's credit and payment policies should be reviewed. Several of the import and
export transactions resulted in large exchange gains and losses. Although there was a net
exchange gain, several of the currencies Mr. Johnston transacts in seem to be quite volatile.
Hence the timing of payments and collections should be closely monitored along with
movements in the exchange rates. While hedging in the forward market eliminates this
risk, there may be a more cost-effective solution.
P7.9
Recording a Hedged Foreign Loan
December 16, 2012
Cash
84,000,000
Loan payable
84,000,000
To record the dollar equivalent of £50 million borrowed from a London bank; $84,000,000
= $1.68 x 50,000,000.
December 31, 2012
Loan payable
1,000,000
Exchange gain
To accrue the exchange gain on the loan payable;
$1,000,000 = ($1.68 - $1.66) x 50,000,000.
Exchange loss
1,000,000
1,010,000
Investment in forward
contract
To accrue the loss on the forward purchase contract;
$1,010,000 = ($1.71 - $1.69) x 50,500,000.
1,010,000
Interest expense
415,000
Interest payable
415,000
To accrue interest expense on the loan payable from December 16 - December 31, 2012;
$415,000 = $1.66 x 250,000.
January 15, 2013
Loan payable
Exchange gain
To accrue the exchange gain on the loan payable;
$1,500,000 = ($1.66 - $1.63) x 50,000,000.
©Cambridge Business Publishers, 2010
186
1,500,000
1,500,000
Advanced Accounting, 1st Edition
Exchange loss
3,030,000
Investment in forward
contract
To accrue the exchange loss on the forward purchase contract;
$3,030,000 =($1.69 - $1.63) x 50,500,000.
3,030,000
Interest payable
7,500
Exchange gain
To accrue the gain on the interest payable; $7,500 = ($1.66 - $1.63) x 250,000.
Interest expense
7,500
407,500
Interest payable
407,500
To accrue interest expense on the loan payable from January 1 - January 15, 2013;
$407,500 = $1.63 x 250,000.
Foreign currency
Investment in forward
contract
82,315,000
4,040,000
Cash
To record settlement of the forward purchase contract.
86,355,000
Loan payable
Interest payable
81,500,000
815,000
Foreign currency
82,315,000
To record repayment of the loan and interest to the London Bank with the foreign currency.
P7.10
Interpretation of Financial Statement Disclosures
a.
Accumulated other comprehensive income
b.
Forward sales hedge foreign currency inflows. Therefore if the hedges are effective, the
anticipated foreign currency royalty and cost transactions involve a net inflow of currency
to IBM, locking in the future selling price of the currency to be received.
c.
Because IBM incurred gains on the hedges, the U.S. dollar must have strengthened with
respect to the hedged currencies (the $/FC rate declined). The hedge investments lock in
the future selling price of the currency. Gains occur when the market selling price
declines, since the company is able sell the currency at the higher forward rate.
©Cambridge Business Publishers, 2010
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187
d.
When the royalties are received, related losses on the hedge investments are reclassified
from AOCI to offset the royalty revenue. The journal entry debits royalty revenue and
credits AOCI.
P7.11 Hedge of Forecasted Transaction, Firm Commitment, and Exposed Position
December 31, 2010
Investment in forward
100,000
Other comprehensive income
To record gain on forward; $100,000 = ($1.12 - $1.11) x 10,000,000.
January 15, 2011
Investment in forward
100,000
100,000
Other comprehensive income
To record gain on forward; $100,000 = ($1.13 - $1.12) x 10,000,000.
100,000
February 1, 2011
Investment in forward
200,000
Other comprehensive income
To record gain on forward; $200,000 = ($1.15 - $1.13) x 10,000,000.
Exchange loss
200,000
Firm commitment
To record loss on firm commitment established on January 15.
Other comprehensive
income
200,000
200,000
Exchange gain
To reclassify OCI to income to exactly offset the loss on the firm commitment.
Inventory
Firm commitment
200,000
200,000
11,100,000
200,000
Accounts payable
11,300,000
To record delivery of the merchandise and the payable at the spot rate, and close the firm
commitment against the inventory balance.
March 1, 2011
Exchange loss
200,000
Accounts payable
To record loss on payable; $200,000 = ($1.15 - $1.13) x 10,000,000.
©Cambridge Business Publishers, 2010
188
200,000
Advanced Accounting, 1st Edition
NOTE: No adjustment is needed for the forward, since the forward rate did not change
between February 1 and March 1.
Other comprehensive
income
200,000
Exchange gain
To reclassify OCI to income to exactly offset the loss on the payable.
Foreign currency
200,000
11,500,000
Investment in forward
Cash
To close the forward contract.
Accounts payable
400,000
11,100,000
11,500,000
Foreign currency
11,500,000
To pay the supplier.
March 15, 2011
Cash
15,000,000
Sales revenue
To record the sale of the merchandise.
Cost of sales
15,000,000
11,100,000
Inventory
11,100,000
To record cost of sales.
©Cambridge Business Publishers, 2010
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189
P7.12
Evaluation of Domestic and Foreign Investments
Domestic Investment
$1,000,000 (1.03) = $1,030,000, for an effective annual yield of 6%.
U.K. Investment
$1,000,000 can be invested in a CD worth £588,235.29 [=$1,000,000/$1.70]. The value of
the CD at the end of 6 months is (£588,235.29) x 1.035 = £608,823.53. To avoid exchange
risk, the company would enter into a forward contract locking in the sale of £608,823.53 at
$1.73, which will yield $1,053,264.71. The annual effective yield is
($53,264.71/$1,000,000) x 2 = 10.65%.
German Investment
$1,000,000 can be invested in a CD worth €869,565.22 [=$1,000,000/$1.15]. The value of
the CD at the end of 6 months is (€869,565.22) x 1.025 = €891,304.35. To avoid exchange
risk, the company would enter into a forward contract locking in the sale of €891,304.35 at
$1.20, which will yield $1,069,565.20. The annual effective yield is
($69,565.20/$1,000,000) x 2 = 13.91%.
Recommendation: Purchase the German certificate as it has the highest effective annual
yield.
©Cambridge Business Publishers, 2010
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Advanced Accounting, 1st Edition