Chapter 9

Shandra Corporation (a U.S.-based company) expects to order goods from a foreign supplier at a price of 139,000 pounds, with delivery and payment to be made on April 20. On February 20, when the spot rate is $1.29 per pound, Shandra purchases a two-month call option on 139,000 pounds and designates this option as a cash flow hedge of a forecasted foreign currency transaction. The time value of the option is excluded in assessing hedge effectiveness; the change in time value is recognized in net income over the life of the option. The option has a strike price of $1.29 per pound and costs $1,390. The goods are received and paid for on April 20. Shandra sells the imported goods in the local market by May 31. The spot rate for pounds is $1.34 on April 20. What amount will Shandra Corporation report as foreign exchange gain or loss in net income for the quarter ended June 30? $0. $3,950. $1,390. $6,950.

$0. This is a cash flow hedge of a forecasted transaction. The original cost of the option of $1,390 is recognized as an adjustment to Cost of Goods Sold over the life of the option. There is no foreign exchange gain or loss recognized in a hedge of a forecasted transaction.

Brief, Inc., had a receivable from a foreign customer that is payable in the customer's local currency. On December 31, 2020, Brief correctly included this receivable for 280,000 local currency units (LCU) in its balance sheet at $220,000. When Brief collected the receivable on February 15, 2021, the U.S. dollar equivalent was $233,000. In Brief's 2021 consolidated income statement, how much should it report as a foreign exchange gain? $31,000 $18,000 $13,000 $0

$13,000 The dollar value of the LCU receivable has increased from $220,000 at December 31, 2020 to $233,000 at February 15, 2021. This increase of $13,000 should be reported as a foreign exchange gain in 2021.

On July 1, 2020, Mifflin Company borrowed 390,000 euros from a foreign lender evidenced by an interest-bearing note due on July 1, 2021. The note is denominated in euros. The U.S. dollar equivalent of the note principal is as follows: Date Amount July 1, 2020 borrowed) $320,000 12,31, 2020 (Mifflin's YE) 311,400 July 1, 2021 (date repaid) 297,800 In its 2021 income statement, what amount should Mifflin include as a foreign exchange gain or loss on the note? $13,600 loss $22,200 loss $13,600 gain $22,200 gain

$13,600 gain The decrease in the dollar value of the euro note payable represents a foreign exchange gain. In this case a $8,600 gain would have been accrued in 2020 and a $13,600 gain will be reported in 2021.

Monument Company (a U.S.-based company) ordered a machine costing €200,000 from a foreign supplier on January 15, when the spot rate was $1.20 per €. A one-month forward contract was signed on that date to purchase €200,000 at a forward rate of $1.22. The forward contract is properly designated as a fair value hedge of the €200,000 firm commitment. On February 15, when the company receives the machine, the spot rate is $1.21. At what amount should Monument Company capitalize the machine on its books? $41,000 $240,000 $242,000 $244,000

$244,000 Machinery should be capitalized at the forward rate on the date of receipt (FC200,000 × $1.22 = $244,000), which is equal to the actual amount of cash paid for its purchase.

Matthias Corp. had the following foreign currency transactions during 2020: Purchased merchandise from a foreign supplier on January 20 for the U.S. dollar equivalent of $64,600 and paid the invoice on April 20 at the U.S. dollar equivalent of $51,300. On September 1, borrowed the U.S. dollar equivalent of $308,000 evidenced by a note that is payable in the lender's local currency in one year. On December 31, the U.S. dollar equivalent of the principal amount was $325,000. In Matthias's 2020 income statement, what amount should be included as a net foreign exchange gain or loss? $3,700 loss $30,300 loss $13,300 gain $17,000 gain

$3,700 loss Calculate foreign exchange gain/loss. The merchandise purchase results in a foreign exchange gain of $13,300, 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 $17,000. The net foreign exchange loss is $3,700 ($13,300 gain − $17,000 loss).

On September 1, 2020, Stone Company received an order to sell a machine to a customer in Australia at a price of 100,000 Australian dollars. Stone shipped the machine and received payment on March 1, 2021. On September 1, 2020, Stone purchased a put option giving it the right to sell 100,000 Australian dollars on March 1, 2021, at a price of $80,000. Stone properly designated the option as a fair value hedge of the Australian dollar firm commitment. The option's time value is excluded in assessing hedge effectiveness, and the change in time value is recognized in net income over the life of the option. The option cost $2,000 and had a fair value of $2,300 on December 31, 2020. The fair value of the firm commitment was measured by referring to changes in the spot rate (discounting to present value is ignored). The following spot exchange rates apply: Date U.S. Dollar per Australian Dollar September 1, 2020$0.80 December 31, 2020 0.79 March 1, 2021 0.77 What was the net impact on Stone Company's 2020 income as a result of this fair value hedge of a firm commitment? $700 increase in income $300 increase in income $700 decrease in income $0

$700 decrease in income The easiest way to solve this problem is to prepare journal entries for the option fair value hedge and the firm commitment. The journal entries are as follows: DateGeneral JournalDebitCredit9/1/20Foreign currency option2,000 Cash 2,000 12/31/20Foreign currency option300 Foreign Exchange Gain or Loss 300 Foreign Exchange Gain or Loss1,000 Firm commitment 1,000 12/31/20 Firm commitment: [($0.79 − $0.80) × 100,000 = $1,000] Net impact on 2020 net income: Net foreign exchange gain (loss)$(700)Total decrease in net income$(700)

On September 1, 2020, Stone Company received an order to sell a machine to a customer in Australia at a price of 100,000 Australian dollars. Stone shipped the machine and received payment on March 1, 2021. On September 1, 2020, Stone purchased a put option giving it the right to sell 100,000 Australian dollars on March 1, 2021, at a price of $80,000. Stone properly designated the option as a fair value hedge of the Australian dollar firm commitment. The option's time value is excluded in assessing hedge effectiveness, and the change in time value is recognized in net income over the life of the option. The option cost $2,000 and had a fair value of $2,300 on December 31, 2020. The fair value of the firm commitment was measured by referring to changes in the spot rate (discounting to present value is ignored). The following spot exchange rates apply: Date U.S. Dollar per Australian Dollar September 1, 2020$0.80 December 31, 2020 0.79 March 1, 2021 0.77 What was the net impact on Stone Company's 2021 income as a result of this fair value hedge of a firm commitment and export sale? $78,000 increase in income $78,700 increase in income $1,300 decrease in income $0

$78,700 increase in income The easiest way to solve this problem is to prepare journal entries for the option fair value hedge and the firm commitment. The journal entries are as follows: DateGeneral JournalDebitCredit3/1/21Foreign currency option700 Foreign Exchange Gain or Loss 700 Foreign Exchange Gain or Loss2,000 Firm commitment 2,000 Foreign currency (AUD)77,000 Sales 77,000 Cash80,000 Foreign currency (AUD) Foreign currency option 77,000 3,000 Firm commitment3,000 Sales 3,000 12/31/20 Firm commitment: [($0.79 - $0.80) × 100,000 = $1,000] 3/1/21 Firm commitment: [($0.77 - $0.80) × 100,000 = $3,000 - $1,000 = $2,000] Net impact on 2021 net income: Sales$80,000 Net foreign exchange gain (loss) (1,300)Total increase in net income$78,700

Forward contracts

- executed on spot or forward basis - negotiated by a firm with a bank to exchange foreign for US or vice versa on specified future date at predetermined rate - written for whatever currency and date - no up front cost

accounting for changes in FV of derivatives

- included in comprehensive income US GAAP gains and losses arising form changes in FV are recognized either: 1. NI closed in RE 2. OCI reflected on BS ACOI

foreign currency options

- provide flexibility - put option = sale of foreign currency by holder call = purchase of foreign currency by holder of option - options purchased by paying option premium which is a function of the intrinsic and time value - intrinsic = equal to gain that could be realized by exercising option immediately - time value = spot rate can change over time and cause the options intrinsic value to increase

FV hedge

1. adjust the hedged asset or liability to FV based on changes in spot rate and recoinage a FEGL in NI 2. adjust derivative heeding instrument to FV and recognize counterpart as FEGL in NI 3. Adjust the net FEGL thus far recognized to properly reflect (A) current period amortization of original discount or premium on forward contract () change in the time value of the option

A spot rate may be defined as A. The price a foreign currency can be purchased or sold today. B. The price today at which a foreign currency can be purchased or sold in the future. C. The forecasted future value of a foreign currency. D. The U.S. dollar value of a foreign currency. E. The Euro value of a foreign currency.

A. The price a foreign currency can be purchased or sold today.

On December 1, 2020, Venice Company (a U.S.-based company) entered into a three-month forward contract to purchase 1,420,000 pesos on March 1, 2021. The following U.S. dollar per peso exchange rates apply: Date Spot Rate Forward Rate(to March 1, 2021) 12 1, 2020 $0.009 $0.012 12 31, 2020 0.011 0.014 3 1, 2021 0.015 N/A Ignoring present values, Which of the following correctly describes the manner in which Venice Company will report the forward contract on its December 31, 2020, balance sheet? As a liability in the amount of $2,840 As an asset in the amount of $2,840 As a liability in the amount of $1,420 As an asset in the amount of $1,420

As an asset in the amount of $2,840 The forward contract is reported on the December 31 balance sheet as an asset. The company has contracted to purchase pesos at $0.012 per peso. If it had waited until December 31 to enter into the forward contract it would have contracted to purchase pesos at $0.014 per peso. Therefore, the forward contract has a positive fair value and is an asset. The undiscounted fair value of the forward contract on December 31 is $2,840 [($0.014 - $0.012) × 1,420,000].

On October 1, Tile Co., a U.S. company, purchased products from Azulejo, a Portuguese company, with payment due on December 1. If Tile's operating income included no foreign exchange gain or loss, the transaction could have Been denominated in U.S. dollars. Resulted in an unusual gain. Generated a foreign exchange loss to be reported as a separate component of stockholders' equity. Generated a foreign exchange gain to be reported in accumulated other comprehensive income on the balance sheet.

Been denominated in U.S. dollars. 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, 2020.

On March 1, Derby Corporation (a U.S.-based company) expects to order merchandise from a supplier in Norway in three months. On March 1, when the spot rate is $0.15 per Norwegian krone, Derby enters into a forward contract to purchase 557,500 Norwegian kroner at a three-month forward rate of $0.170. Forward points are excluded in assessing the forward contract's effectiveness as a hedge, and are amortized to net income on a straight-line basis. At the end of three months, when the spot rate is $0.164 per Norwegian krone, Derby orders and receives the merchandise, paying 557,500 kroner. The merchandise is sold within 30 days. What amount(s) does Derby report in net income as a result of this cash flow hedge of a forecasted transaction and the related purchase and sale of merchandise? Cost of goods sold of $94,775 less foreign exchange gain of $11,150 Cost of goods sold of $91,430 plus foreign exchange loss of $3,345 Cost of goods sold of $83,625 plus foreign exchange loss of $11,150 Cost of goods sold of $94,775

Cost of goods sold of $94,775 The impact on net income is through Cost of Goods Sold, which is recognized at the forward rate. The total is $94,775 [$0.17 × 557,500 kroner]. Alternatively, the correct answer can be determined by preparing journal entries. The forward contract includes a premium of $11,150 [($0.170 - $0.15) × 557,500 kroner] that will be recognized in net income as an adjustment to Cost of Goods Sold. Date General Journal Debit Credit 3/1No journal entries 5/31Other Comprehensive Income (OCI)3,345 Forward Contract 3,345 [($0.17 − $0.164) × 557,500 kroner] Cost of Goods Sold11,150 Other Comprehensive Income (OCI) 11,150 (To recognize the forward contractdiscount in net income as anadjustment to COGS) Foreign Currency (NOK)91,430 Forward Contract3,345 Cash 94,775 Inventory91,430 Foreign Currency (NOK) 91,430 Cost of Goods Sold91,430 Inventory 91,430 Accumulated Other Comprehensive Income (AOCI)7,805 Cost of Goods Sold 7,805 Cost of Goods Sold = $94,775 ($11,150 + $91,430 − $7,805)

U.S. GAAP provides guidance for hedges of all the following sources of foreign exchange risk except A. Recognized foreign currency denominated assets and liabilities. B. Unrecognized foreign currency firm commitments. C. Forecasted foreign currency denominated transactions. D. Net investment in foreign operations. E. Deferred foreign currency gains and losses.

E. Deferred foreign currency gains and losses.

foreign currency option

FV compsoed of intrinsic and time value - manner in whcih FV is dtermiend dpeonds on wehthe rthe option is trade don an echange or has been acquired OTC. Market = current marke tprice quoted on echange. OTC = dtermined by obtianing price quote form option dealer

foreign currency forward contract

FV determined by reference to changes in forward rate over life of the recontract three things needed to determine FV of forward contract 1. forward rate when the forward contract was entered into 2. current forward rate for a contract that matures on the same date as the forward contract entered into 3. discount rate = company's incremental borrowing rate

A U.S. exporter has a Thai baht account receivable resulting from an export sale on June 1 to a customer in Thailand. The exporter signed a forward contract on June 1 to sell Thai baht and designated it as a cash flow hedge of a recognized Thai baht receivable. The spot rate was $0.022 on that date, and the forward rate was $0.021. Forward points are excluded from the assessment of hedge effectiveness. Which of the following is true with respect to the forward points on this contract? The forward points are a Forward contract discount that is recognized in net income as a foreign exchange gain. Forward contract premium that is recognized in net income as a foreign exchange loss. Forward contract premium that is recognized in net income as a foreign exchange gain. Forward contract discount that is recognized in net income as a foreign exchange loss

Forward contract discount that is recognized in net income as a foreign exchange loss The Thai baht is selling at a discount (spot rate exceeds forward rate). The exporter will receive fewer dollars as a result of selling the baht forward than if the baht had been received and converted into dollars on June 1. Thus, the discount results in a foreign exchange loss for the exporter.

hedge accounting

GAAP allows it when three conditions are met: 1. derivative used to hedge either cash flow exposure or a FV exposure to foreign exchange risk 2. derivative highly effective in offsetting changes in cash flows or FV 3. derivative is properly documented as a hedge

Spot rate

The price at which a foreign currency can be purchased or sold today

Grace Co. had a Chinese yuan payable resulting from imports from China and a Mexican peso receivable resulting from exports to Mexico. Grace recorded foreign exchange losses related to both its yuan payable and peso receivable. Did the foreign currencies increase or decrease in dollar value from the date of the transaction to the settlement date? Yuan Peso a.Increase Increase b.Increase Decrease c.Decrease Increase d.Decrease Decrease

Option B A foreign currency payable will generate a foreign exchange loss when the foreign currency increases in dollar value. A foreign currency receivable will generate a foreign exchange loss when the foreign currency decreases in dollar value. Hence, the correct combination is yuan (increase) and peso (decrease).

In accounting for foreign currency transactions, which of the following approaches is used in the United States? one-transaction perspective; defer foreign exchange gains and losses One-transaction perspective; accrue foreign exchange gains and losses Two-transaction perspective; defer foreign exchange gains and losses Two-transaction perspective; accrue foreign exchange gains and losses

Two-transaction perspective; accrue foreign exchange gains and losses Current accounting standards require a two-transaction perspective, accrual approach.

cash flow hedge

at each balance sheet date, following required 1. hedged asset is adjusted to FV based on changes in spot rate and FEGL recognized in NI 2. derivative hedging instrument is adjusted to FV with counter part recognized as a change in OCI 3. to achieve hedge, accounting, a FEGL related to the hedging to the hedging instrument is recognized to offset the Foreign exchange loses or gain on the hedge asset or liability with counterpart record in OCI 4. Additional foreign enchase loss is recognized in NI to reflect (A) current periods amortization of the original discount or premium on the forward contract or (B) change in the time value of the option

which is a true statement regarding the fundamental requirement of accounting for derivatives a. derivates are reported on the BS only as an asset b. derivatives are reported on the BS as a liability c. changes in derivative cost basis are recorded in the asset value d. changes in derivative FV are included in comprehensive income e. changes in derivative cost basis are recorded in the liability value

d. changes in derivative FV are included in comprehensive income

which statement is true regarding a foreign currency option? a. foreign currency gives the holder the obligation to buy or sell foreign currency in the future b. Foreign currency option gives the obligation to only sell foreign currency in the future c. foreign currency option gives the holder the obligation d. foreign currency gives the holder the right but not the obligation to buy or sell foreign current in the future e. foreign currency option gives the holder the obligation to buy or sell foreign currency in the future at the spot rate on the future date.

d. foreign currency gives the holder the right but not the obligation to buy or sell foreign current in the future

forward points

difference between forward rate and spot rate for currency on given date premium = forward > spot discount = spot < forward or when interest rate in foreign > domestic

a forward contract may be used for which of the following? 1. a FV hedge of an asset 2. cash flow hedge of an asset 3. FV hedge of a liability 4. cash flow hedge of a liability a. 1 and 3 b. 2 and 4 c. 1 and 2 d. 1,3,4 e, 1,2,3,4

e, 1,2,3,4

strike price

echange rate at which option will be executed if the holder decides to exerise it

Understand the different types of foreign exchange risk that can be hedged and how foreign currency forward contracts and foreign currency options can be used to hedge those risks.

exposure to foreign exchange risk transaction exposure: - Export sale - allows buyer to pay in foreign currency and allow buyer to pay sometime after sale exposed = risk that foreign currency might depreciate between date of sale and payment - import purchase = importer pay in forieng and allowed to pay after pruchase has been made epxosed = risk that foring currency might appreciate between the date fo pruchase and date of payment

Describe the relationship between foreign currency transactions, exchange rate changes, and foreign exchange gains and losses.

forward exchange rate will change over time due to changes in spot and/or changes in the differential interest rates between two countries

Which of the following combinations correctly describes the relationship between foreign currency transactions, exchange rate changes, and foreign exchange gains and losses? Type of Transaction Foreign Currency Foreign Exchange Gain or Loss a. Export sale Appreciates Loss b. Import purchase Appreciates Gain c. Import purchase Depreciates Gain d. Export sale Depreciates Gain

option 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.

Forward Rate

price available today at which foreign currency can be purchased or sold sometime in the future

FV of a option

sum of the intrinsic and time value on that date, and the time value of the option decreases to zero over the life of the option

Hedge

two most common derivates used to hedge risk are: 1. foreign currency forward contracts 2. foreign currency options three points in time company choose to hedge 1. edge of recognized foreign currency - denominated asset or liability = CF and FV 2. hedge of an unrecognized foreign currency firm commitment = CF and FV 3. hedge of a forecasted foreign currency transaction = FV only hedge accounting must be designated as cash flow hedge or FV hedge gains and loss on CF hedge = OCI and deferred on BS in AOCI Gains and loss on FV hedge = recognized immediately in NI and closed in RE FV exposure = exist if changes in rates affect the FV of the assert or liability reported on the BS CF exposure = exist if changes in rates can affect the amount of CF to be realized from foreign currency transaction with changes reflected in NI