Answer to Discussion Question Do we have a gain or what? This case demonstrates the differing kinds of information provided through application of current accounting rules for foreign currency transactions and derivative financial instruments. The Ahnuld Corporation could have received $200,000 from its export sale to Tcheckia if it had required immediate payment. Instead, Ahnuld allows its customer six months to pay. Given the future exchange rate of $1.70, Ahnuld would have received only $170,000 if it had not entered into the forward contract. This would have resulted in a decrease in cash inflow of $30,000. In accordance with SFAS 52, the decrease in the value of the tcheck receivable is recognized as a foreign exchange loss of $30,000. This loss represents the cost of extending credit to the foreign customer if the tcheck receivable is left unhedged. However, rather than leaving the tcheck receivable unhedged, Ahnuld sells tchecks forward at a price of $180,000. Because the future spot rate turns out to be only $1.70, the forward contract provides a benefit, increasing the amount of cash received from the export sale by $10,000. In accordance with SFAS 133, the change in the fair value of the forward contract (from zero initially to $10,000 at maturity) is recognized as a gain on the forward contract of $10,000. This gain reflects the cash flow benefit from having entered into the forward contract, and is the appropriate basis for evaluating the performance of the foreign exchange risk manager. (Students should be reminded that the forward contract will not always improve cash inflow. For example, if the future spot rate were $1.85, the forward contract would result in $5,000 less cash inflow than if the transaction were left unhedged.) The net impact on income resulting from the fluctuation in the value of the tcheck is a loss of $20,000. Clearly, Ahnuld forgoes $20,000 in cash inflow by allowing the customer time to pay for the purchase, and the net loss reported in income correctly measures this. The $20,000 loss is useful to management in assessing whether the sale to Tcheckia generated an adequate profit margin, but it is not useful in assessing the performance of the foreign exchange risk manager. The net loss must be decomposed into its component parts to fairly evaluate the risk manager’s performance. Gains and losses on forward contracts designated as fair value hedges of foreign currency assets and liabilities are relevant measures for evaluating the performance of foreign exchange risk managers. (The same is not true for cash flow hedges. For this type of hedge, performance should be evaluated by considering the net gain or loss on the forward contract plus or minus the forward contract premium or discount.)
Answers to Questions 1. Under the two-transaction perspective, an export sale (import purchase) and the subsequent
collection (payment) of cash are treated as two separate transactions to be accounted for separately. The idea is that management has made two decisions: (1) to make the export sale (import purchase), and (2) to extend credit in foreign currency to the foreign customer (obtain credit from the foreign supplier). The income effect from each of these decisions should be reported separately.
2. Foreign currency receivables resulting from export sales are revalued at the end of accounting
periods using the current spot rate. An increase in the value of a receivable will be offset by reporting a foreign exchange gain in net income, and a decrease will be offset by a foreign exchange loss. Foreign exchange gains and losses are accrued even though they have not yet been realized.
3. Foreign exchange gains and losses are created by two factors: having foreign currency
exposures (foreign currency receivables and payables) and changes in exchange rates. Appreciation of the foreign currency will generate foreign exchange gains on receivables and foreign exchange losses on payables. Depreciation of the foreign currency will generate foreign exchange losses on receivables and foreign exchange gains on payables.
4. Hedging is the process of eliminating exposure to foreign exchange risk so as to avoid potential
losses from fluctuations in exchange rates. In addition to avoiding possible losses, companies hedge foreign currency transactions and commitments to introduce an element of certainty into the future cash flows resulting from foreign currency activities. Hedging involves establishing a price today at which foreign currency can be sold or purchased at a future date.
5. A party to a foreign currency forward contract is obligated to deliver one currency in exchange
for another at a specified future date, whereas the owner of a foreign currency option can choose whether to exercise the option and exchange one currency for another or not.
6. Hedges of foreign currency denominated assets and liabilities are not entered into until a foreign currency transaction (import purchase or export sale) has taken place. Hedges of firm commitments are made when a purchase order is placed or a sales order is received, before a transaction has taken place. Hedges of forecasted transactions are made at the time a future foreign currency purchase or sale can be anticipated, even before an order has been placed or received.
7. Foreign currency options have an advantage over forward contracts in that the holder of the
option can choose not to exercise if the future spot rate turns out to be more advantageous. Forward contracts, on the other hand, can lock a company into an unnecessary loss (or a reduced gain). The disadvantage associated with foreign currency options is that a premium must be paid up front even though the option might never be exercised.
8. SFAS 133 requires an enterprise to recognize all derivative financial instruments as assets or
liabilities on the balance sheet and measure them at fair value. 9. The fair value of a foreign currency forward contract is determined by reference to changes in
the forward rate over the life of the contract, discounted to the present value. Three pieces of information are needed to determine the fair value of a forward contract at any point in time during its life: (a) the contracted forward rate when the forward contract is entered into, (b) the
current forward rate for a contract that matures on the same date as the forward contract entered into, and (c) a discount rate; typically, the company’s incremental borrowing rate.
The manner in which the fair value of a foreign currency option is determined depends on whether the option is traded on an exchange or has been acquired in the over the counter market. The fair value of an exchange-traded foreign currency option is its current market price quoted on the exchange. For over the counter options, fair value can be determined by obtaining a price quote from an option dealer (such as a bank). If dealer price quotes are unavailable, the company can estimate the value of an option using the modified Black-Scholes option pricing model. Regardless of who does the calculation, principles similar to those in the Black-Scholes pricing model will be used in determining the value of the option.
10. Hedge accounting is defined as recognition of gains and losses on the hedging instrument in
the same period as the recognition of gains and losses on the underlying hedged asset or liability (or firm commitment).
11. For hedge accounting to apply, the forecasted transaction must be probable (likely to occur), the hedge must be highly effective in offsetting fluctuations in the cash flow associated with the foreign currency risk, and the hedging relationship must be properly documented.
12. In both cases, (1) sales revenue (or the cost of the item purchased) is determined using the
spot rate at the date of sale (or purchase), and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income.
For a cash flow hedge, the derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability. An additional amount is removed from AOCI and recognized in net income to reflect (a) the current period’s amortization of the original discount or premium on the forward contract (if a forward contract is the hedging instrument) or (b) the change in the time value of the option (if an option is the hedging instrument).
For a fair value hedge, the derivative hedging instrument is adjusted to fair value (resulting in
an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income. The discount or premium on a forward contract is not allocated to net income. The change in the time value of an option is not recognized in net income.
13. For a fair value hedge of a foreign currency asset or liability (1) sales revenue (cost of
purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income. The forward contract is adjusted to fair value based on changes in the forward rate (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income. The foreign exchange gain (loss) and the forward contract loss (gain) are likely to be of different amounts resulting in a net gain or loss reported in net income.
For a fair value hedge of a firm commitment, there is no hedged asset or liability to account for. The forward contract is adjusted to fair value based on changes in the forward rate (resulting in
an asset or liability reported on the balance sheet), with a gain or loss recognized in net income. The firm commitment is also adjusted to fair value based on changes in the forward rate (resulting in a liability or asset reported on the balance sheet), and a gain or loss on firm commitment is recognized in net income. The firm commitment gain (loss) offsets the forward contract loss (gain) resulting in zero impact on net income. Sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase). The firm commitment account is closed as an adjustment to net income in the period in which the hedged item affects net income.
14. For a cash flow hedge of a foreign currency asset or liability (1) sales revenue (cost of
purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income. The forward contract is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability. An additional amount is removed from AOCI and recognized in net income to reflect the current period’s allocation of the discount or premium on the forward contract.
For a hedge of a forecasted transaction, the forward contract is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). Because there is no foreign currency asset or liability, there is no transfer from AOCI to net income to offset any gain or loss on the asset or liability. The current period’s allocation of the forward contract discount or premium is recognized in net income with the counterpart reflected in AOCI. Sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase). The amount accumulated in AOCI related to the hedge is closed as an adjustment to net income in the period in which the forecasted transaction was anticipated to occur.
15. In accounting for a fair value hedge, the change in the fair value of the foreign currency option
is reported as a gain or loss in net income. In accounting for a cash flow hedge, the change in the entire fair value of the option is first reported in other comprehensive income, and then the change in the time value of the option is reported as an expense in net income.
16. The accounting for a foreign currency borrowing involves keeping track of two foreign currency
payables—the note payable and interest payable. As both the face value of the borrowing and accrued interest represent foreign currency liabilities, both are exposed to foreign exchange risk and can give rise to foreign currency gains and losses.
Answers to Problems 1. C An import purchase causes a foreign currency payable to be carried on the
books. If the foreign currency depreciates, the dollar value of the foreign currency payable decreases, yielding a foreign exchange gain.
2. D SFAS 52 requires a two-transaction perspective, accrual approach. 3. B Foreign exchange gains related to foreign currency import purchases are
treated as a component of income before income taxes. If there is no foreign exchange gain in operating income, then the purchase must have been denominated in U.S. dollars or there was no change in the value of the foreign currency from October 1 to December 1, 2009.
4. C The dollar value of the LCU receivable has decreased from $110,000 at
December 31, 2009 to $95,000 at February 15, 2010. This decrease of $15,000 should be reported as a foreign exchange loss in 2010.
5. D The increase in the dollar value of the euro note payable represents a foreign
exchange loss. In this case a $25,000 loss would have been accrued in 2009 and a $10,000 loss will be reported in 2010.
6. D A foreign currency receivable will generate a foreign exchange gain when the
foreign currency increases in dollar value. A foreign currency payable will generate a foreign exchange gain when the foreign currency decreases in dollar value. Hence, the correct combination is franc (increase) and peso (decrease).
7. D The merchandise purchase results in a foreign exchange loss of $8,000, the difference between the U.S. dollar equivalent at the date of purchase and at the date of settlement.
The increase in the dollar equivalent of the note’s principal results in a foreign exchange loss of $20,000.
The total foreign exchange loss is $28,000 ($8,000 + $20,000). 8. D The Thai baht is selling at a premium (forward rate exceeds spot rate). The
exporter will receive more dollars as a result of selling the baht forward than if the baht had been received and converted into dollars on April 1. Thus, the premium results in additional revenue for the exporter.
9. D The parts inventory will be recognized at the spot rate at the date of purchase
10. D The forward contract must be reported on the December 31, 2009 balance sheet as a liability. Barnum has locked-in to purchase ringgits at $0.042 per ringgit but could have locked-in to purchase ringgits at $0.037 per ringgit if it had waited until December 31 to enter into the forward contract. The forward contract must be reported at its fair value discounted for two months at 12% [($.042 – $.037) x 1,000,000 = $5,000 x .9803 = $4,901.50].
11. C The 10 million won receivable has changed in dollar value from $35,000 at
12/1/09 to $33,000 at 12/31/09. The won receivable will be written down by $2,000 and a foreign exchange loss will be reported in 2009 income.
12. B The nominal value of the forward contract on December 31, 2009 is a positive
$2,000, the difference between the amount to be received from the forward contract actually entered into, $34,000 ($.0034 x 10 million), and the amount that could be received by entering into a forward contract on December 31, 2009 that matures on March 31, 2010, $32,000 ($.0032 x 10 million). The fair value of the forward contract is the present value of $2,000 discounted for two months ($2,000 x .9706 = $1,941.20). On December 31, 2009, MNC Corp. will recognize a $1,941.20 gain on the forward contract and a foreign exchange loss of $2,000 on the won receivable. The net impact on 2009 income is –$58.80.
13. A The krona is selling at a premium in the forward market, causing Pimlico to
pay more dollars to acquire kroner than if the kroner were purchased at the spot rate on March 1. Therefore, the premium results in an expense of $10,000 [($.12 – $.10) x 500,000].
The Adjustment to Net Income is the amount accumulated in Accumulated Other Comprehensive Income (AOCI) as a result of recognizing the premium expense and the fair value of the forward contract. The journal entries would be as follows:
3/1 no journal entries 6/1 Premium Expense $10,000 AOCI $10,000 AOCI $2,500 Forward Contract $2,500 Foreign Currency $57,500 Forward Contract 2,500 Cash $60,000 AOCI $7,500 Adjustment to Net Income $7,500
14. C This is a cash flow hedge of a forecasted transaction. The original cost of the
option is recognized as an Option Expense over the life of the option. 15. B 16. D The easiest way to solve problems 15 and 16 is to prepare journal entries for
the option fair value hedge and the firm commitment. The journal entries are as follows:
9/1/09 Foreign Currency Option $2,000 Cash $2,000 12/31/09 Foreign Currency Option $300 Gain on Foreign Currency Option $300 Loss on Firm Commitment $980.30 Firm Commitment $980.30 [($.79 – $.80) x 100,000 = $1,000 x .9803 = $980.30] Net impact on 2009 net income: Gain on Foreign Currency Option $300.00 Loss on Firm Commitment (980.30) $(680.30) 3/1/10 Foreign Currency Option $700 Gain on Foreign Currency Option $700 Loss on Firm Commitment $2,019.70 Firm Commitment $2,019.70 [($.77 – $.80) x 100,000 = $3,000 – $980.30 = $2,019.70] Foreign Currency (C$) $77,000 Sales $77,000 Cash $80,000 Foreign Currency (C$) $77,000 Foreign Currency Option 3,000 Firm Commitment $3,000 Adjustment to Net Income $3,000
16. (continued) Net impact on 2010 net income: Gain on Foreign Currency Option $ 700.00 Loss on Firm Commitment (2,019.70) Sales 77,000.00
Adjustment to Net Income 3,000.00 $78,680.30 17. B Net cash inflow with option ($80,000 – $2,000) $78,000 Cash inflow without option (at spot rate of $.77) 77,000 Net increase in cash inflow $ 1,000 18 and 19. The easiest way to solve problems 18 and 19 is to prepare journal entries for
the forward contract fair value hedge of a firm commitment. The journal entries are as follows:
3/1 no journal entries 3/31 Forward Contract $1,250 Gain on Forward Contract $1,250 ($1,250 – $0) Loss on Firm Commitment $1,250 Firm Commitment $1,250 Net impact on first quarter net income is $0.
18 and 19. (continued) 4/30 Loss on Forward Contract $250 Forward Contract $250 [Fair value of forward contract is ($.120 – $.118) x 500,000 = $1,000; $1,000 – $1,250 = $250] Firm Commitment $250 Gain on Firm Commitment $250 Foreign Currency (pesos) $59,000 Sales [500,000 pesos x $.118] $59,000 Cash [500,000 x $.120] $60,000 Foreign Currency (pesos) $59,000 Forward Contract 1,000 Firm Commitment $1,000 Adjustment to Net Income $1,000
Net impact on second quarter net income is: Sales $59,000 – Loss on Forward
Contract $250 + Gain on Firm Commitment $250 + Adjustment to Net Income $1,000 = $60,000.
18. A 19. C 20. B Cash inflow with forward contract [500,000 pesos x $.12] $60,000 Cash inflow without forward contract [500,000 pesos x $.118] 59,000 Net increase in cash flow from forward contract $ 1,000
21 and 22. The easiest way to solve problems 21 and 22 is to prepare journal entries for
the option cash flow hedge of a forecasted transaction. The journal entries are as follows:
11/1/09 Foreign Currency Option $1,500 Cash $1,500 12/31/09 Option Expense $400 Foreign Currency Option $400 (The option has no intrinsic value at 12/31/09 so the entire change in fair
value is due to a change in time value; $1,500 – $1,100 = $400 decrease in time value. The decrease in time value of the option is recognized as an expense in net income.)
Option Expense decreases net income by $400. 2/1/10 Option Expense $1,100 Foreign Currency Option 900 Accumulated Other Comprehensive Income (AOCI) $2,000 (Record expense for the decrease in time value of the option; $1,100 – $0 = $1,100; and write-up option to fair value ($.40 – $.41) x 200,000 = $2,000 – $1,100 = $900.) Foreign Currency (BRL) [200,000 x $.41] $82,000 Cash [200,000 x $.40] $80,000 Foreign Currency Option 2,000 Parts Inventory (Cost-of-Goods-Sold) $82,000 Foreign Currency (BRL) $82,000 Accumulated Other Comprehensive Income (AOCI) $2,000 Adjustment to Net Income $2,000
21 and 22. (continued) Net impact on 2010 net income: Option Expense $ (1,100) Cost-of-Goods-Sold (82,000) Adjustment to Net Income 2,000 Decrease in Net Income $ (81,100) 21. B 22. C 23. (10 minutes) (Foreign Currency Purchase/Payable)
The decrease in the dollar value of the LCU payable from November 1 (60,000 x .345 = $20,700) to December 31 (60,000 x .333 = $19,980) is recorded as a $720 foreign exchange gain in 2009. The increase in the dollar value of the LCU payable from December 31 ($19,980) to January 15 (60,000 x .359 = $21,540) is recorded as a $1,560 foreign exchange loss in 2010.
The ostra receivable decreases in dollar value from (50,000 x $1.05) $52,500 at December 20 to $51,000 (50,000 x $1.02) at December 31, resulting in a foreign exchange loss of $1,500 in 2009. The further decrease in dollar value of the ostra receivable from $51,000 at December 31 to $49,000 (50,000 x $.98) at January 10 results in an additional $2,000 foreign exchange loss in 2010.
26. (10 minutes) (Foreign Currency Purchase/Payable) 12/1/09 Inventory $52,800 Accounts Payable (LCU) [60,000 x $.88] $52,800 12/31/09 Accounts Payable (LCU) [60,000 x ($.82 – $.88)] $3,600 Foreign Exchange Gain $3,600 1/28/10 Foreign Exchange Loss $4,800 Accounts Payable (LCU) [60,000 x ($.90 – $.82)] $4,800 Accounts payable (LCU) $54,000 Cash $54,000
27. (15 minutes) (Determine U.S. Dollar Balance for Foreign Currency Transactions)
Inventory and Cost of Goods Sold are reported at the spot rate at the date the inventory was purchased. Sales are reported at the spot rate at the date of sale. Accounts Receivable and Accounts Payable are reported at the spot rate at the balance sheet date. Cash is reported at the spot rate when collected and the spot rate when paid.
Inventory [50,000 pesos x 40% x $.17] ......................................................... $3,400 COGS [50,000 pesos x 60% x $.17] .............................................................. $5,100 Sales [45,000 pesos x $.18] .......................................................................... $8,100 Accounts Receivable [45,000 – 40,000 = 5,000 pesos x $.21] .................... $1,050 Accounts Payable [50,000 – 30,000 = 20,000 pesos x $.21] ....................... $4,200 Cash [(40,000 x $.19) – (30,000 x $.20)] ........................................................ $1,600
29. (20 minutes) (Determine Income Effect of Foreign Currency Purchase/Payable)
a. Benjamin, Inc. has a liability of AL 160,000. On the date that this liability was created (December 1, 2009), the liability had a dollar value of $70,400 (AL 160,000 x $.44). On December 31, 2009, the dollar value has risen to $76,800 (AL 160,000 x $.48). The increase in the dollar value of the liability creates a foreign exchange loss of $6,400 ($76,800 – $70,400) in 2009.
By March 1, 2010, when the liability is paid, the dollar value has dropped to $72,000 (AL 160,000 x $.45) creating a foreign exchange gain of $4,800 ($72,000 – $76,800) to be reported in 2010.
b. Benjamin, Inc. has a liability of AL 160,000. On the date that this liability was created (September 1, 2009), the liability had a dollar value of $73,600 (AL 160,000 x $.46). On December 1, 2009, when the liability is paid, the dollar value has decreased to $70,400 (AL 160,000 x $.44). The drop in the dollar value of the liability creates a foreign exchange gain of $3,200 ($70,400 – $73,600) in 2009.
c. Benjamin, Inc. has a liability of AL 160,000. On the date that this liability was created (September 1, 2009), the liability had a dollar value of $73,600 (AL 160,000 x $.46). On December 31, 2009, the dollar value has risen to $76,800 (AL 160,000 x $.48). The increase in the dollar value of the liability creates a foreign exchange loss of $3,200 ($76,800 – $73,600) in 2009. By March 1, 2010, when the liability is paid, the dollar value has dropped to $72,000 (AL 160,000 x $.45) creating a foreign exchange gain of $4,800 ($72,000 – $76,800) to be reported in 2010.
[1,000,000 x 2% x 3/12 = 5,000 dudeks x $.105 spot rate]
(To accrue interest for the period 9/30 – 12/31/09.) Foreign Exchange Loss $5,000 Note payable (dudek) [1 m x ($.105 – $.10)] $5,000
(To revalue the note payable at the spot rate of $.105 and record a foreign exchange loss.)
9/30/10 Interest Expense [15,000 dudeks x $.12] $1,800 Interest Payable (dudek) 525 Foreign Exchange Loss [5,000 dudeks x ($.12 – $.105)] 75 Cash [20,000 dudeks x $.12] $2,400
(To record the first annual interest payment, record interest expense for the period 1/1 – 9/30/10, and record a foreign exchange loss on the interest payable accrued at 12/31/09.)
12/31/10 Interest Expense $625 Interest Payable (dudek) [5,000 dudeks x $.125] $625 (To accrue interest for the period 9/30 – 12/31/10.) Foreign Exchange Loss $20,000 Note Payable (dudek) [1 m x ($.125 – $.105)] $20,000
(To revalue the note payable at the spot rate of $.125 and record a foreign exchange loss.)
9/30/11 Interest Expense [15,000 dudeks x $.15] $2,250 Interest Payable (dudek) 625 Foreign Exchange Loss [5,000 dudeks x ($.15 – $.125)] 125 Cash [20,000 dudeks x $.15] $3,000
(To record the second annual interest payment, record interest expense for the period 1/1 – 9/30/11, and record a foreign exchange loss on the interest payable accrued at 12/31/10.)
Note Payable (dudek) $125,000 Foreign Exchange Loss 25,000 Cash [1 m dudeks x $.15] $150,000
(To record payment of the 1 million dudek note.)
b. The effective cost of borrowing can be determined by considering the total interest expense and foreign exchange losses related to the loan and comparing this with the amount borrowed:
2009 Interest expense $525 Foreign exchange loss 5,000 Total $5,525 / $100,000 = 5.525% for 3 months = = 22.1% for 12 months 2010 Interest expense $2,425 Foreign exchange losses 20,075 Total $22,500 / $100,000 = 22.5% for 12 months 2011 Interest expense $2,250 Foreign exchange losses 25,125 Total $27,375 / $100,000 = 27.38% for 9 months = 36.5% for 12 months Because of appreciation in the value of the dudek, the effective annual borrowing costs range from 22.1% – 36.5%.
The net cash flow from this borrowing is: Cash outflows: Interest ($2,400 + $3,000) $5,400 Principal 150,000 $155,400 Cash inflow: Borrowing (100,000) Net cash outflow $ 55,400
Ignoring compounding, this results in an effective borrowing cost of approximately 27.7% per year [$55,400 / $100,000 = 55.4% over two years / 2 years = 27.7% per year].
31. (40 minutes) (Forward Contract Hedge of Foreign Currency Receivable) a. Cash Flow Hedge
12/1/09 Accounts Receivable (K) [20,000 x $2.00] $40,000 Sales $40,000 No entry for the forward contract. 12/31/09 Accounts Receivable (K) $2,000 Foreign Exchange Gain $2,000 [20,000 x ($2.10-$2.00)] AOCI $2,450.75 Forward Contract $2,450.75 [20,000 x ($2.075 – $2.20) = $2,500 x .9803 = $2,450.75] Loss on Forward Contract $2,000 AOCI $2,000 AOCI $500 Premium Revenue $500 [20,000 x ($2.075 – $2.00) = $1,500 x 1/3 = $500]
Impact on 2009 income: Sales $40,000 Foreign Exchange Gain 2,000 Loss on Forward Contract (2,000) Premium Revenue 500 Total $40,500
3/1/10 Accounts Receivable (K) $3,000 Foreign Exchange Gain $3,000 [20,000 x ($2.25 – $2.10)] AOCI $1,049.25 Forward Contract $1,049.25 [20,000 x ($2.25 – $2.075) = $3,500 – 2,450.75] = $1,049.25 Loss on Forward Contract $3,000 AOCI $3,000 AOCI $1,000 Premium Revenue $1,000 [$1,500 x 2/3 = $1,000] Foreign Currency (K) [20,000 x $2.25] $45,000 Accounts Receivable (K) $45,000 Cash [20,000 x $2.075] $41,500 Forward Contract 3,500 Foreign Currency (K) $45,000
Impact on 2010 income: Foreign Exchange Gain $3,000 Loss on Forward Contract (3,000) Premium Revenue 1,000 Total $1,000 Impact on net income over both periods: $40,500 + $1,000 = $(41,500); equal to cash inflow.
12/1/09 Accounts Receivable (K) [20,000 x $2.00] $40,000 Sales $40,000
No entry for the forward contract.
12/31/09 Accounts Receivable (K) $2,000 Foreign Exchange Gain $2,000
[20,000 x ($2.10 – $2.00)] Loss on Forward Contract $2,450.75 Forward contract $2,450.75 [20,000 x ($2.075 – $2.20) = $2,500 x .9803 = $2,450.75] Impact on 2009 income: Sales $40,000.00 Foreign exchange gain 2,000.00 Loss on forward contract (2,450.75) Total $39,549.25
3/1/10 Accounts Receivable (K) $3,000 Foreign Exchange Gain $3,000 [20,000 x ($2.25 – $2.10)] Loss on Forward Contract $1,049.25 Forward Contract $1,049.25 [20,000 x (2.25 – $2.075) = $3,500 – 2,450.75 = $1.049.25] Foreign Currency (K) [20,000 x $2.25] $45,000 Accounts Receivable (K) $45,000 Cash [20,000 x $2.075] $41,500 Forward Contract 3,500 Foreign Currency (K) $45,000
Impact on 2010 income: Foreign Exchange Gain $3,000.00 Loss on Forward Contract (1,049.25) Total $1,950.75 Impact on net income over both periods: $39,549.25 + $1,950.75 = $41,500; equal to cash inflow.
32. (40 minutes) (Forward Contract Hedge of Foreign Currency Payable) a. Cash Flow Hedge 12/1/09 Parts Inventory (COGS) $40,000 Accounts Payable (K) $40,000 [20,000 x $2.00]
No entry for the Forward Contract.
12/31/09 Foreign Exchange Loss $2,000 Accounts Payable (K) $2,000 [20,000 x ($2.10 – $2.00)] Forward Contract $2,450.75 AOCI $2,450.75 [20,000 x ($2.075 – $2.20) = $2,500 x .9803 = $2,450.75] AOCI $2,000 Gain on Forward Contract $2,000 Premium Expense $500 AOCI $500 [20,000 x ($2.075 – $2.00) = $1,500 x 1/3 = $500]
Impact on 2009 income: Parts Inventory (COGS) $(40,000) Foreign Exchange Loss (2,000) Gain on forward contract 2,000 Premium Expense (500) Total $(40,500)
b. Fair Value Hedge 12/1/09 Parts Inventory (COGS) $40,000 Accounts Payable (K) $40,000 [20,000 x $2.00] No entry for the forward contract. 12/31/09 Foreign Exchange Loss $2,000 Accounts Payable (K) $2,000 [20,000 x ($2.10 – $2.00)] Forward Contract $2,450.75 Gain on Forward Contract $2,450.75 [20,000 x ($2.075 – $2.20) = $2,500 x .9803 = $2,450.75]
Impact on 2009 income: Parts Inventory (COGS) $(40,000.00) Foreign Exchange Loss (2,000.00) Gain on forward contract 2,450.75 Total $(39,549.25)
3/1/10 Foreign Exchange Loss $3,000 Accounts Payable (K) $3,000 [20,000 x ($2.25 – $2.10)] Forward Contract $1,049.25 Gain on Forward Contract $1,049.25 [20,000 x ($2.25 – $2.075) = $3,500 – 2,450.75 = $1,049.25] Foreign Currency (K) [20,000 x $2.25] $45,000 Cash $41,500 Forward Contract 3,500 Accounts Payable (K) $45,000 Foreign currency (K) $45,000
9/1 Foreign Exchange Loss $4,000 Accounts Receivable (P) $4,000 [($.044 – $.048) x 1,000,000] Accumulated Other Comprehensive Income (AOCI) $800 Foreign Currency Option $800 [$1,800 – $1,000] Accumulated Other Comprehensive Income (AOCI) $4,000 Gain on Foreign Currency Option $4,000 Option Expense $1,800 Accumulated Other Comprehensive Income (AOCI) $1,800 (Change in time value of option recognized as expense) Foreign Currency (P) $44,000 Accounts Receivable (P) $44,000 Cash $45,000 Foreign Currency (P) $44,000 Foreign Currency Option $1,000
Over the two accounting periods, Sales are $45,000 and Option Expense is $2,000. Net increase in cash is $43,000.
b. Fair Value Hedge
6/1 Accounts Receivable (P) $45,000 Sales [$.045 x 1,000,000] $45,000 Foreign Currency Option $2,000 Cash $2,000 6/30 Accounts Receivable (P) $3,000 Foreign Exchange Gain $3,000 [($.048 – $.045) x 1,000,000] Loss on Foreign Currency Option $200 Foreign Currency Option $200
9/1 Foreign Exchange Loss $4,000 Accounts Receivable (P) $4,000 [($.044 – $.048) x 1,000,000] Loss on Foreign Currency Option $800 Foreign Currency Option $800 Foreign Currency (P) $44,000 Accounts Receivable (P) $44,000
Cash $45,000 Foreign Currency (P) $44,000 Foreign Currency Option $1,000 Impact on Net Income over the Two Accounting Periods: Sales $45,000 Foreign Exchange Gain 3,000 Foreign Exchange Loss (4,000) Loss on Foreign Currency Option (1,000) Impact on Net Income $43,000 = Net cash inflow
34. (30 minutes) (Option Hedge of Foreign Currency Payable) a. Cash Flow Hedge
6/1 Inventory [$.085 x 1,000,000] $85,000 Accounts Payable (M) $85,000 Foreign Currency Option $2,000 Cash $2,000 6/30 Foreign Exchange Loss $3,000 Accounts Payable (M) $3,000 [($.088 – .085) x 1,000,000] Foreign Currency Option $2,000 Accumulated Other Comprehensive Income (AOCI) $2,000 [$4,000 – $2,000] Accumulated Other Comprehensive Income (AOCI) $3,000 Gain on Foreign Currency Option $3,000 Option Expense $1,000* Accumulated Other Comprehensive Income (AOCI) $1,000
Date Fair Value Intrinsic Value Time Value Change in Time Value 6/1 $2,000 $0 $2,000 - 6/30 $4,000 $3,000 $1,000 -$1,000* 9/1 $5,000 $5,000 $0 -$1,000**
6/1 Inventory $85,000 Accounts Payable (M) $85,000 [$.085 x 1,000,000] Foreign Currency Option $2,000 Cash $2,000 6/30 Foreign Exchange Loss $3,000 Accounts Payable (M) $3,000 [($.088 – $.085) x 1,000,000] Foreign Currency Option $2,000 Gain on Foreign Currency Option $2,000 [$4,000 – $2,000] 9/1 Foreign Exchange Loss $2,000 Accounts Payable (M) $2,000 [($.09 – $.088) x 1,000,000] Foreign Currency Option $1,000 Gain on Foreign Currency Option $1,000 [$5,000 – $4,000] Foreign Currency (M) $90,000 Cash $85,000 Foreign Currency Option $5,000 Accounts Payable (M) $90,000 Foreign currency (M) $90,000
Impact on net income: Foreign Exchange Loss ($5,000) Gain on Foreign Currency Option 3,000 Impact on net income ($2,000) Inventory 85,000 Cash Outflow $87,000
Account Receivable (FCU) Forward Forward Contract Spot U.S. Dollar Change in U.S. Rate to Change in Date Rate Value Dollar Value 4/30/10 Fair Value Fair Value 11/01/09 $.53 $53,000 - $.52 $0 - 12/31/09 $.50 $50,000 -$3,000 $.48 $3,8441 +$3,844 4/30/10 $.49 $49,000 -$1,000 $.49 $3,0002 - $ 844 1 $52,000 – $48,000 = $(4,000) x .961 = $3,844; where .961 is the present value factor for four months at an annual interest rate of 12% (1% per month) calculated as 1/1.014. 2 $52,000 – $49,000 = $3,000.
2009 Journal Entries 11/01/09 Accounts Receivable (FCU) $53,000 Sales $53,000 There is no entry for the forward contract.
12/31/09 Foreign Exchange Loss $3,000 Accounts Receivable (FCU) $3,000 Accumulated Other Comprehensive Income (AOCI) $3,000 Gain on Forward Contract $3,000 Forward Contract $3,844 Accumulated Other Comprehensive Income (AOCI) $3,844 Discount Expense $333.33 Accumulated Other Comprehensive Income (AOCI) $333.33 [100,000 x ($.53 – $.52) = $1,000 x 2/6 = $333.33]
The impact on net income for the year 2009 is:
Sales $53,000.00 Foreign Exchange Loss (3,000.00) Gain on Forward Contract 3,000.00 Net gain (loss) 0.00 Discount Expense (333.33) Impact on net income $52,666.67
36. (30 minutes) (Forward Contract Fair Value Hedge of Net Foreign Currency Denominated Asset)
Account Receivable (Payable) (mongs) Forward Forward Contract Change in U.S. Rate to Change in Date U.S. Dollar Value Dollar Value 1/31/10 Fair Value Fair Value 11/30/09 $265,000 ($159,000) - $.52 $0 - 12/31/09 $250,000 ($150,000) -$15,000 (-$9,000) $.48 $7,9211 +$7,921 1/31/10 $245,000 ($147,000) -$ 5,000 (-$3,000) $.49 $6,0002 - $1,921
1 $104,000 – $96,000 = $(8,000) x .9901 = $7,921; where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01. 2 $104,000 – $98,000 = $6,000.
2009 Journal Entries 11/30 Accounts Receivable (mongs) $265,000 Sales $265,000 [$.53 x 500,000 mongs] Inventory $159,000 Accounts Payable $159,000 [$.53 x 300,000 mongs] There is no formal entry for the Forward Contract. 12/31 Foreign Exchange Loss $15,000 Accounts Receivable (mongs) $15,000 Accounts Payable (mongs) $9,000 Foreign Exchange Gain $9,000 Forward Contract $7,921 Gain on Forward Contract $7,921
The impact on net income for the year 2009 is:
Sales $265,000 Net Foreign Exchange Loss $ (6,000) Gain on Forward Contract 7,921 Net gain (loss) 1,921 Impact on net income $266,921
Net Foreign Exchange Loss $(2,000) Loss on Forward Contract (1,921) Impact on net income $(3,921)
The net effect on the balance sheet is an increase in cash of $104,000 and an increase in inventory of $159,000 with a corresponding increase in retained earnings of $263,000 ($266,921 – $3,921).
37. (40 minutes) (Forward Contract Fair Value Hedge) a. Foreign Currency Receivable
10/01 Accounts Receivable (LCU) $69,000 Sales (100,000 LCUs x $.69) $69,000 There is no formal entry for the forward contract. 12/31 Accounts Receivable (LCU) $2,000 Foreign Exchange Gain $2,000 [($.71 – $.69) x 100,000] Loss on Forward Contract $8,910.90 Forward Contract $8,910.90 [($.74 – $.65) x 100,000 = $ 9,000 x .9901 = $ 8,910.90] 1/31 Accounts Receivable (LCU) $1,000 Foreign Exchange Gain $1,000 [($.72 – $.71) x 100,000] Forward Contract $ 1,910.90 Gain on Forward Contract $ 1,910.90 [($.72 – $.65) x 100,000 = $ 7,000 loss – 8,910.90 = $ 1,910.90 gain] Foreign Currency (LCU) $72,000 Accounts Receivable (LCU) $72,000 Cash $65,000 Forward Contract $7,000 Foreign Currency (LCU) $72,000
The impact on net income:
Sale $69,000.00 Foreign Exchange Gain 3,000.00 Loss on Forward Contract (8,910.90) Gain on Forward Contract 1,910.90 Impact on net income $65,000.00 = Cash Inflow
38. (30 minutes) (Forward Contract Fair Value Hedge of a Foreign Currency Firm Purchase Commitment)
Forward Forward Contract Firm Commitment Rate to Change in Change in Date 10/31 Fair Value Fair Value Fair Value Fair Value 8/1 $.30 $0 - $0 $0 - 9/30 $.325 $4,950.501 + $4,950.50 $(4,950.50)1 – $4,950.50 10/31 $.320 (spot) $4,0002 – $ 950.50 $(4,000)2 + $ 950.50
1 ($65,000 – $60,000) = $5,000 x .9901 = $4,950.5; where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01. 2 ($64,000 – $60,000) = $4,000.
8/1 There is no entry to record either the purchase agreement or the
forward contract as both are executory contracts. 9/30 Forward Contract $4,950.50 Gain on Forward Contract $4,950.50 Loss on Firm Commitment $4,950.50 Firm Commitment $4,950.50 10/31 Loss on Forward Contract $950.50 Forward Contract $950.50 Firm Commitment $950.50 Gain on Firm Commitment $950.50 Foreign Currency (rupees) $64,000 Cash $60,000 Forward Contract 4,000 Inventories (Cost-of-goods-sold) $64,000 Foreign Currency (rupees) $64,000 Firm Commitment $4,000 Adjustment to Net Income $4,000 The net cash outflow is $60,000. Assuming the inventory is sold in the fourth quarter, the net impact on net income is negative $60,000: Cost of goods sold $(64,000) Adjustment to net income 4,000 Net impact on net income $(60,000)
1 $495,000 – $500,000 = $(5,000) x .9803 = $(4,901.5), where .9803 is the present value factor for two months at an annual interest rate of 12% (1% per month) calculated as 1/1.012. 2 $485,000 – $500,000 = $(15,000).
6/1 Foreign Currency Option $5,000 Cash $5,000 There is no entry to record the sales agreement because it is an executory contract. 6/30 Loss on Firm Commitment $4,901.50 Firm Commitment $4,901.50 Foreign Currency Option $3,000 Gain on Foreign Currency Option $3,000 The impact on net income for the second quarter is:
Loss on Firm Commitment $(4,901.50) Gain on Foreign Currency Option 3,000.00 Impact on net income $(1,901.50)
39. (continued) 9/1 Loss on Firm Commitment $10,098.50 Firm Commitment $10,098.50 Foreign Currency Option $7,000 Gain on Foreign Currency Option $7,000 Foreign Currency (lek) $485,000 Sales $485,000 Cash $500,000 Foreign Currency (lek) $485,000 Foreign Currency Option 15,000 Firm Commitment $15,000 Adjustment to Net Income $15,000 The impact on net income for the third quarter is:
Sales $485,000.00 Loss on Firm Commitment (10,098.50) Gain on Foreign Currency Option 7,000.00 Adjustment to Net Income 15,000.00 Impact on net income $496,901.50 The impact on net income over the second and third quarters is: $495,000 ($496,901.50 – $1,901.50) The net cash inflow resulting from the sale is: $500,000 – $5,000 = $495,000
40. (20 minutes) (Option Fair Value Hedge of a Foreign Currency Firm Purchase Commitment)
Firm Commitment Option Option Spot Change in Premium Change in Date Rate Fair Value Fair Value for 12/20 Fair Value Fair Value
11/20 $.20 - - $.008 $400 - a) 12/20 $.21 $(500)
1 – $500 $.010
3 $500 + $100
b) 12/20 $.18 $1,0002 + $1,000 $.000
4 $0 – $400
1 $10,000 – $10,500 = $(500). 2 $10,000 – $9,000 = $1,000. 3 The premium on 12/20 for an option that expires on that date is equal to the option’s
intrinsic value. Given the spot rate on 12/20 of $.21, a call option with a strike price of $.20 has an intrinsic value of $.01 per mark.
4 The premium on 12/20 for an option that expires on that date is equal to the option’s intrinsic value. Given the spot rate on 12/20 of $.18, a call option with a strike price of $.20 has no intrinsic value – the premium on 12/20 is $.000.
a. The option strike price ($.20) is less than the spot rate ($.21) on December 20,
the date the parts are to be paid for. Therefore, Big Arber will exercise its option. The journal entries are as follows:
11/20 Foreign Currency Option $400 Cash $400
There is no entry to record the purchase agreement because it is an executory contract. 12/20 Loss on Firm Commitment $500 Firm Commitment $500
Foreign Currency Option $100 Gain on Foreign Currency Option $100
40. (continued) b. The option strike price ($.20) is greater than the spot rate ($.18) on December 20,
the date the parts are to be paid for. Therefore, Big Arber will allow the option to expire unexercised. Foreign currency will be acquired at the spot rate on December 20. The journal entries are as follows:
11/20 Foreign Currency Option $400 Cash $400 There is no entry to record the purchase agreement because it is an executory contract. 12/20 Firm Commitment $1,000 Gain on Firm Commitment $1,000
Loss on Foreign Currency Option $400 Foreign Currency Option $400
Foreign Currency (pijio) $9,000 Cash $9,000
Parts Inventory $9,000 Foreign Currency (pijio) $9,000
Adjustment to Net Income $1,000 Firm Commitment $1,000
(Note that this last entry is not made until the period when the parts inventory affects net income through cost of goods sold.)
41. (20 minutes) (Option Cash Flow Hedge of Forecasted Transaction)
12/15/09 Foreign Currency Option $5,000 Cash [1 million marks x $.005] $5,000 No journal entry related to the forecasted transaction. 12/31/09 Foreign Currency Option $3,000 AOCI $3,000
To recognize the increase in the value of the foreign currency option with the counterpart recorded in AOCI.
Option Expense $1,000 AOCI $1,000 To recognize the decrease in the time value of the option as expense. [($.584 – $.58) x 1,000,000 = $4,000 – $3,000 = $1,000] 3/15/10 Foreign Currency Option $2,000 AOCI $2,000
To recognize the increase in the value of the foreign currency option with the counterpart recorded in AOCI.
Option Expense $4,000 AOCI $4,000 To recognize the decrease in the time value of the option as expense. Foreign Currency (marks) $590,000 Cash $580,000 Foreign Currency Options 10,000
To record exercise of the foreign currency option at the strike price of $.58 and close out the foreign currency option account.
Parts Inventory $590,000 Foreign Currency (marks) $590,000 To record the purchase of parts and payment of 1 million marks to the supplier.
To transfer the amount accumulated in AOCI as an adjustment to net income in the period in which the forecasted transaction occurs.
Impact on net income: 2009 – Option expense $(1,000) 2010 – Cost of Goods Sold $(590,000) Option Expense (4,000) Adjustment to Net Income 10,000 $(584,000)
Net cash outflow for parts: $585,000 = ($5,000 + $580,000)
42. (60 minutes) (Foreign Currency Transaction, Forward Contract and Option
Hedge of Foreign Currency Liability, Forward Contract and Option Hedge of Foreign Currency Firm Commitment)
b. Forward Contract Fair Value Hedge of a Recognized Foreign Currency Liability
Accounts Payable (C) Forward Forward Contract Spot U.S. Dollar Change in U.S. Rate to Change in Date Rate Value Dollar Value 10/31 Fair Value Fair Value 9/15 $1.00 $200,000 - $1.06 $0 - 9/30 $1.05 $210,000 +$10,000 $1.09 $5,940.601 +$5,940.60 10/31 $1.10 $220,000 +$10,000 $1.10 $8,000.002 +$2,059.40
1 $218,000 – $212,000 = $6,000 x .9901 = $5,940.60; where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01. 2 $220,000 – $212,000 = $8,000.
9/15 Inventory $200,000 Accounts Payable (euro) $200,000 There is no formal entry for the forward contract. 9/30 Foreign Exchange Loss $10,000 Accounts Payable (euro) $10,000 Forward Contract $5,940.60 Gain on Forward Contract $5,940.60 10/31 Foreign Exchange Loss $10,000 Accounts Payable (euro) $10,000 Forward Contract $2,059.40 Gain on Forward Contract $2,059.40 Foreign Currency (euro) $220,000 Cash $212,000 Forward Contract $8,000 Accounts Payable (euro) $220,000 Foreign Currency (euro) $220,000
42. (continued) c. Forward Contract Fair Value Hedge of a Foreign Currency Firm Commitment 9/15 There is no formal entry for the forward contract or the purchase order. 9/30 Forward Contract $5,940.60 Gain on Forward Contract $5,940.60 Loss on Firm Commitment $5,940.60 Firm Commitment $5,940.60 10/31 Forward Contract $2,059.40 Gain on Forward Contract $2,059.40 Loss on Firm Commitment $2,059.40 Firm Commitment $2,059.40 Foreign Currency (euro) $220,000 Cash $212,000 Forward Contract $8,000 Inventory $220,000 Foreign Currency (euro) $220,000 Firm Commitment $8,000 Adjustment to Net Income $8,000 (Note that this last entry is not made until the period when the inventory
42. (continued) d. Option Cash Flow Hedge of a Recognized Foreign Currency Liability The following schedule summarizes the changes in the components of the fair value of the euro call option with a strike price of $1.00 for October 31. Change Change Spot Option Fair in Fair Intrinsic Time in Time Date Rate Premium Value Value Value Value Value 09/15 $1.00 $.035 $7,000 - $0 $7,000
Because the strike price and spot rate are the same, the option has no intrinsic value. Fair value is attributable solely to the time value of the option.
2 With a spot rate of $1.05 and a strike price of $1.00, the option has an intrinsic value of $10,000. The remaining $4,000 of fair value is attributable to time value.
3 The time value of the option at maturity is zero.
9/15 Inventory $200,000 Accounts Payable (euro) $200,000 Foreign Currency Option $7,000 Cash $7,000 9/30 Foreign Exchange Loss $10,000 Accounts Payable (euro) $10,000 Foreign Currency Option $7,000 Accumulated Other Comprehensive Income (AOCI) $7,000 Accumulated Other Comprehensive Income (AOCI) $10,000 Gain on Foreign Currency Option $10,000 Option Expense $3,000 Accumulated Other Comprehensive Income (AOCI) $3,000
42. (continued) e. Option Fair Value Hedge of a Foreign Currency Firm Commitment Firm Commitment Option Foreign Currency Option Spot Change in Premium Change in Date Rate Fair Value Fair Value for 10/31 Fair Value Fair Value 9/15 $1.00 $0 - $.035 $ 7,000 - 9/30 $1.05 $ (9,901) –$ 9,9011 $.070 $14,000 +$7,000 10/31 $1.10 $(20,000) –$10,099 $.100 $20,000 +$6,000
1 $210,000 – $200,000 = $(10,000) x .9901 = $(9,901), where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01.
9/15 Foreign Currency Option $7,000 Cash $7,000 9/30 Foreign Currency Option $7,000 Gain on Foreign Currency Option $7,000 Loss on Firm Commitment $9,901 Firm Commitment $9,901 10/31 Foreign Currency Option $6,000 Gain on Foreign Currency Option $6,000 Loss on Firm Commitment $10,099 Firm Commitment $10,099 Foreign Currency (euro) $220,000 Cash $200,000 Foreign Currency Option 20,000 Inventory $220,000 Foreign Currency (euro) $220,000 Firm Commitment $20,000 Adjustment to Net Income $20,000 (Note that this last entry is not made until the period when the inventory
Answers to Develop Your Skills Cases Research Case—International Flavors and Fragrances The responses to this assignment might change over time as the company
changes its use of foreign currency derivatives or changes the manner in which it discloses its foreign currency hedging activities in the annual report. The following responses are based on IFF’s 2005 annual report.
1. In 2005, IFF provided information in the annual report related to its
management of foreign exchange risk in the following locations: a. Item 1A. Risk Factors. b. Item 7. Management Discussion and Analysis of Financial Condition and
Results of Operations under “Market Risk.” c. Item 7A. Quantitative and Qualitative Disclosures about Market Risk. b. Note 15. Financial Instruments (same disclosure as in MD&A). 2. IFF uses foreign currency forward contracts to reduce exposure to cash flow
volatility arising from foreign currency fluctuations associated with certain foreign currency receivables and payables (hedges of foreign currency denominated assets and liabilities) and anticipated purchases of raw materials (hedges of forecasted transactions).
The company also uses a Japanese Yen- U.S. Dollar swap to hedge monthly sale and purchase transactions between the U.S. and Japan.
3. In Note 15, IFF indicates that the notional amount and maturity dates of its forward contracts match those of the underlying transactions.
FARS Case 1—Hedge of Forecasted Foreign Currency Transaction 1. Using the advanced query function in FARS to search for the phrase
“forecasted foreign currency transaction” returns two hits: SFAS 131, paragraphs 485 and 487. Paragraph 487 provides an answer to the question.
2. SFAS 131, paragraph 487 indicates that for a hedge of a forecasted foreign
currency transaction to qualify for hedge accounting, the component of the entity that has the foreign currency exposure (i.e., the French subsidiary) must be a party to the hedging transaction. In other words, the U.S. parent cannot apply hedge accounting for the foreign currency option acquired to hedge the French subsidiary’s foreign exchange risk.
FARS Case 2—Foreign Currency-Denominated Debt 1. Using the advanced query function in FARS to search for the phrase “foreign
currency-denominated interest payments” returns two hits. Note: Include the hyphen between currency and denominated and the “s” in payments (plural). Statement 133 Implementation Issue No. H4, “Hedging Foreign-Currency-Denominated Interest Payments,” provides an answer to the question.
2. The DIG’s response to Issue H4 is that a company may not treat foreign-
currency-denominated fixed-rate interest payments as an unrecognized firm commitment that may be designated as a hedged item in a foreign currency fair value hedge. However, those fixed-rate interest payments could be designated as the hedged transaction in a cash flow hedge.
Import/Export Company reported a net foreign exchange gain of $4,054.03 in 2004 income.
Note that all transactions had a $ value on transaction date of approximately $50,000. The size of the foreign exchange gains and losses reported in the last column differs substantially across transactions because of different rates of change in the exchange rates across the currencies in which Import/Export Company had exposures. At one extreme, the large appreciation in value of the ZAR coupled with the asset exposure in that currency generated a large foreign exchange gain. On the other hand, a similar dollar value asset exposure in CNY resulted in a negligible gain as a result of the very small change in the $/CNY exchange rate over the relevant period.
Analysis Case—Cash Flow Hedge 1. Given the $6,000 total premium expense, the forward rate must have been
$1.06 [($1.06 – $1.00 spot) x 100,000 euros = $6,000]. 2. Given that the forward contract is reported as a liability of $1,980 ($2,000 x
.9901), the forward rate at 3/31/09 must have been $1.04 [($1.04 – $1.06) x 100,000 euros = $2,000]. The fact that the forward contract is a liability signals that the forward rate at 3/31 is less than the forward rate on 2/1.
3. Given that the cost of goods sold is $103,000, the spot rate on 5/1/09 must have been $1.03. Linber must pay $1.06 per euro under the forward contract, so the forward contract results in an economic loss of $3,000 [($1.06 – $1.03) x 100,00 euros]. The negative adjustment to net income reflects this economic loss.
4. The premium expense of $6,000 reflects the increase in cost for the parts from the date the transaction was forecasted until the date of purchase. If Linber had purchased 100,000 euros on 2/1/09 at the spot rate of $1.00, it could have saved $6,000.
2. Pier Ten would have reported a net foreign exchange loss of $335.00 in 2006 and a net foreign exchange gain of $2,158.50 in 2007 related to these foreign currency receivables. The transaction denominated in Thai baht resulted in a net foreign exchange loss of $494.50 and would have been the most important to hedge.
3. Assuming a strike price equal to the December 15, 2006 spot rate, the only
foreign currency transaction for which the purchase of a put option would have been beneficial is the transaction in Thai baht. Net cash inflow from the THB receivable would have been $394.50 greater ($494.50 loss avoided less $100.00 cost of option) if a put option had been acquired. Put options in KRW and MYR would have had no value at 1/15/07, resulting in a decrease in net cash inflow to Pier Ten of $200.00 (the cost of the options). The put option in SGD would have had a value of $55.00 on 1/15/07 and would have been exercised. However, there would have been a net loss on the SGD option of $45.00 ($55.00 fair value less $100.00 cost of option), indicating that it would not have been beneficial to acquire the SGD option.
Communication Case—Forward Contracts and Options The advantage of using forward contracts is that there is no cost to enter them.
The disadvantage is that the company is obligated to exchange foreign currency for dollars at the contracted forward rate. Depending upon the future spot rate, this may or may not be advantageous for the company. The disadvantage of using options is that there is an up-front cost incurred. The advantage is that the company is not required to exchange foreign currency for dollars at the option strike price if it is disadvantageous to do so.
Exporters sometimes use forward contracts to hedge export sales (import
purchases) when the foreign currency is selling at a forward premium (discount) as this locks in premium revenue (discount revenue). The risk associated with this strategy is that the customer may or may not pay on time. If an exporter enters into a forward contract to sell foreign currency, and the customer does not pay on time, the exporter will need to purchase foreign currency at the spot rate to settle the forward contract. This is essentially the same as speculation; a gain or loss could arise. In this case, the exporter might be better off by purchasing a foreign currency put option. The exporter can simply allow the option to exercise if it has not received foreign currency from the customer by the expiration date.
Since PBEC is making import purchases, it has more control over the timing of
when it will need foreign currency. In that case, it should be safe to enter into a forward contract to purchase foreign currency on the date when PBEC plans to pay for its purchases. However, there is always the risk that the supplier does not deliver on time, it which case the forward contract provides PBEC with foreign currency for which it has no current use.
The bottom line is that there is no right or wrong answer to the question which
hedging instrument should be used to hedge the Swiss franc exposure to foreign exchange risk.
