Chapter 09 - Guide to Accounting for Foreign Currency Transactions and Hedging Exchange Risk

Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
CHAPTER 9
FOREIGN CURRENCY TRANSACTIONS AND
HEDGING FOREIGN EXCHANGE RISK
Chapter Outline
I. In today’s global economy, a great many companies deal in currencies other than their
reporting currencies.
A. Merchandise may be imported or exported with prices stated in a foreign currency.
B. For reporting purposes, foreign currency balances must be stated in terms of the
company’s reporting currency by multiplying it by an exchange rate.
C. Accountants face two questions in restating foreign currency balances.
1. What is the appropriate exchange rate for restating foreign currency balances?
2. How are changes in the exchange rate accounted for?
D. Companies often engage in foreign currency hedging activities to avoid the adverse impact
of exchange rate changes.
E. Accountants must determine how to properly account for these hedging activities.
II. Foreign exchange rates are determined in the foreign exchange market under a variety of
different currency arrangements.
A. Exchange rates can be expressed in terms of the number of U.S. dollars to purchase one
foreign currency unit (direct quotes) or the number of foreign currency units that can be
obtained with one U.S. dollar (indirect quotes).
B. Foreign currency trades can be executed on a spot or forward basis.
1. The spot rate is the price at which a foreign currency can be purchased or sold today.
2. The forward rate is the price today at which foreign currency can be purchased or sold
sometime in the future.
3. Forward exchange contracts provide companies with the ability to “lock in” a price
today for purchasing or selling currency at a specific future date.
C. Foreign currency options provide the right but not the obligation to buy or sell foreign
currency in the future, and therefore are more flexible than forward contracts.
III. FASB Accounting Standards Codification Topic 830, Foreign Currency Matters (FASB ASC
830) prescribes accounting rules for foreign currency transactions.
A. Export sales denominated in foreign currency are reported in U.S. dollars at the spot
exchange rate at the date of the transaction. Subsequent changes in the exchange rate
until collection of the receivable are reflected through a restatement of the foreign currency
account receivable with an offsetting foreign exchange gain or loss reported in income.
This is known as a two-transaction perspective, accrual approach.
B. The two-transaction perspective, accrual approach also is used in accounting for foreign
currency payables. Receivables and payables denominated in foreign currency create an
exposure to foreign exchange risk; this is the risk that changes in the exchange rate over
time will result in a foreign exchange loss.
IV. FASB Accounting Standards Codification Topic 815, Derivatives and Hedging (FASB ASC
815) governs the accounting for derivative financial instruments and hedging activities
including the use of foreign currency forward contracts and foreign currency options.
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A. The fundamental requirement is that all derivatives must be carried on the balance sheet at
their fair value. Derivatives are reported on the balance sheet as assets when they have a
positive fair value and as liabilities when they have a negative fair value.
B. U.S. GAAP provides guidance for hedges of the following sources of foreign exchange risk:
1. foreign currency denominated assets and liabilities.
2. unrecognized foreign currency firm commitments.
3. forecasted foreign denominated currency transactions.
4. net investments in foreign operations (covered in Chapter 10).
C. Companies prefer to account for hedges in such a way that the gain or loss from the hedge
is recognized in net income in the same period as the loss or gain on the risk being
hedged. This approach is known as hedge accounting. Hedge accounting for foreign
currency derivatives may be applied only if three conditions are satisfied:
1. the derivative is used to hedge either a cash flow exposure or fair value exposure to
foreign exchange risk,
2. the derivative is highly effective in offsetting changes in the cash flows or fair value
related to the hedged item, and
3. the derivative is properly documented as a hedge.
D. Hedge accounting is allowed for hedges of two different types of exposure: cash flow
exposure and fair value exposure. Hedges of (1) foreign currency denominated assets and
liabilities, (2) foreign currency firm commitments, and (3) forecasted foreign currency
transactions can be designated as cash flow hedges. Hedges of (1) and (2) also can be
designated as fair value hedges. Accounting procedures differ for the two types of hedges.
E. For cash flow hedges of foreign currency denominated assets and liabilities, at each
balance sheet date:
1. The hedged asset or liability is adjusted to fair value based on changes in the spot
exchange rate, and a foreign exchange gain or loss is recognized in net income.
2. The derivative hedging instrument is adjusted to fair value (resulting in an asset or
liability reported on the balance sheet), with the counterpart recognized as a change in
Accumulated Other Comprehensive Income (AOCI).
3. An amount equal to the foreign exchange gain or loss on the hedged asset or liability is
then transferred from AOCI to net income; the net effect is to offset any gain or loss on
the hedged asset or liability.
4. An additional amount is removed from AOCI and recognized in net income to reflect (a)
the current 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).
F. For fair value hedges of foreign currency denominated assets and liabilities, at each
balance sheet date:
1. The hedged asset or liability is adjusted to fair value based on changes in the spot
exchange rate, and a foreign exchange gain or loss is recognized in net income.
2. The derivative hedging instrument is adjusted to fair value (resulting in an asset or
liability reported on the balance sheet), with the counterpart recognized as a gain or
loss in net income.
G. Under fair value hedge accounting for hedges of foreign currency firm commitments:
1. the gain or loss on the hedging instrument is recognized currently in net income, and
2. the change in fair value of the firm commitment is also recognized currently in net
income.
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3.
This accounting treatment requires (1) measuring the fair value of the firm commitment, (2)
recognizing the change in fair value in net income, and (3) reporting the firm commitment
on the balance sheet as an asset or liability. A decision must be made whether to
measure the fair value of the firm commitment through reference to (a) changes in the spot
exchange rate or (b) changes in the forward rate.
H. Cash flow hedge accounting is allowed for hedges of forecasted foreign currency
transactions. For hedge accounting to apply, the forecasted transaction must be probable
(likely to occur). The accounting for a hedge of a forecasted transaction differs from the
accounting for a hedge of a foreign currency firm commitment in two ways:
1. Unlike the accounting for a firm commitment, there is no recognition of the forecasted
transaction or gains and losses on the forecasted transaction.
2. The hedging instrument (forward contract or option) is reported at fair value, but
because there is no gain or loss on the forecasted transaction to offset against,
changes in the fair value of the hedging instrument are not reported as gains and
losses in net income. Instead they are reported in other comprehensive income. On
the projected date of the forecasted transaction, the cumulative change in the fair value
of the hedging instrument is transferred from other comprehensive income (balance
sheet) to net income (income statement).
V. IFRS is very similar to U.S. GAAP with respect to the accounting for foreign currency
transactions and hedging of foreign exchange risk.
A. IAS 21 requires the use of a two-transaction perspective in accounting for foreign currency
transactions with unrealized foreign exchange gains and losses accrued in net income in
the period of exchange rate change.
B. IAS 39 allows hedge accounting for foreign currency hedges of recognized assets and
liabilities, firm commitments, and forecasted transactions when documentation
requirements and effectiveness tests are met. Hedges are designated as cash flow or fair
value hedges.
C. One difference between IFRS and U.S. GAAP relates to the type of financial instrument
that can be designated as a foreign currency cash flow hedge. Under U.S. GAAP, only
derivative financial instruments can be used as a cash flow hedge, whereas IFRS also
allows non-derivative financial instruments, such as foreign currency loans, to be
designated as hedging instruments in a foreign currency cash flow hedge.
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 current accounting standards, the decrease in the value of the tcheck receivable is
recognized as a foreign exchange loss of $30,000. This loss represents the cost of extending credit
to the foreign customer if the tcheck receivable is left unhedged.
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However, rather than leaving the tcheck receivable unhedged, Ahnuld sells tchecks forward at a
price of $180,000. Because the future spot rate turns out to be only $1.70, the forward contract
provides a benefit, increasing the amount of cash received from the export sale by $10,000. In
accordance with current accounting standards, the change in the fair value of the forward contract
(from zero initially to $10,000 at maturity) is recognized as a gain on the forward contract of
$10,000. This gain reflects the cash flow benefit from having entered into the forward contract, and
is the appropriate basis for evaluating the performance of the foreign exchange risk manager.
(Students should be reminded that the forward contract will not always improve cash inflow. For
example, if the future spot rate were $1.85, the forward contract would result in $5,000 less cash
inflow than if the transaction were left unhedged.)
The net impact on income resulting from the fluctuation in the value of the tcheck is a loss of
$20,000. Clearly, Ahnuld forgoes $20,000 in cash inflow by allowing the customer time to pay for
the purchase, and the net loss reported in income correctly measures this. The $20,000 loss is
useful to management in assessing whether the sale to Tcheckia generated an adequate profit
margin, but it is not useful in assessing the performance of the foreign exchange risk manager. The
net loss must be decomposed into its component parts to fairly evaluate the risk 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.
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4. Hedging is the process of eliminating exposure to foreign exchange risk so as to avoid

potential losses from fluctuations in exchange rates. In addition to avoiding possible losses,
companies hedge foreign currency transactions and commitments to introduce an element of
certainty into the future cash flows resulting from foreign currency activities. Hedging involves
establishing a price today at which foreign currency can be sold or purchased at a future date.
5. A party to a foreign currency forward contract is obligated to deliver one currency in exchange
for another at a specified future date, whereas the owner of a foreign currency option can
choose whether to exercise the option and exchange one currency for another or not.
6. Hedges of foreign currency denominated assets and liabilities are not entered into until a
foreign currency transaction (import purchase or export sale) has taken place. Hedges of firm
commitments are made when a purchase order is placed or a sales order is received, before a
transaction has taken place. Hedges of forecasted transactions are made at the time a future
foreign currency purchase or sale can be anticipated, even before an order has been placed or
received.
7. Foreign currency options have an advantage over forward contracts in that the holder of the
option can choose not to exercise if the future spot rate turns out to be more advantageous.
Forward contracts, on the other hand, can lock a company into an unnecessary loss (or a
reduced gain). The disadvantage associated with foreign currency options is that a premium
must be paid up front even though the option might never be exercised.
8. An enterprise is required to recognize all derivative financial instruments as assets or liabilities

on the balance sheet and measure them at fair value.
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).
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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.
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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 (Foreign exchange gain/loss on foreign currency transaction)
An import purchase causes a foreign currency payable to be carried on the

books. If the foreign currency depreciates, the dollar value of the foreign
currency payable decreases, yielding a foreign exchange gain.
2. D (Method of accounting for foreign currency transactions)
Current accounting standards require a two-transaction perspective, accrual

approach.
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3. B (Foreign exchange gain/loss on foreign currency transaction)
Foreign exchange gains related to foreign currency import purchases are

treated as a component of income before income taxes. If there is no foreign
exchange gain in operating income, then the purchase must have been
denominated in U.S. dollars or there was no change in the value of the
foreign currency from October 1 to December 1, 2013.
4. C (Calculate foreign exchange gain/loss on foreign currency transaction)
The dollar value of the LCU receivable has decreased from $110,000 at
December 31, 2013 to $95,000 at February 15, 2014. This decrease of $15,000
should be reported as a foreign exchange loss in 2014.
5. D (Calculate foreign exchange gain/loss on foreign currency borrowing)
The increase in the dollar value of the euro note payable represents a foreign
exchange loss. In this case a $25,000 loss would have been accrued in 2013
and a $10,000 loss will be reported in 2014.
6. D (Foreign exchange gain/loss on foreign currency transaction)
A foreign currency receivable will generate a foreign exchange gain when the
foreign currency increases in dollar value. A foreign currency payable will
generate a foreign exchange gain when the foreign currency decreases in
dollar value. Hence, the correct combination is franc (increase) and peso
(decrease).
7. D (Calculate foreign exchange gain/loss)
The merchandise purchase results in a foreign exchange loss of $8,000, the

difference between the U.S. dollar equivalent at the date of purchase and at
the date of settlement.
The increase in the dollar equivalent of the 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 (Forward contract cash flow hedge of foreign currency denominated

asset/liability)
The Thai baht is selling at a premium (forward rate exceeds spot rate). The
exporter will receive more dollars as a result of selling the baht forward than
if the baht had been received and converted into dollars on April 1. Thus, the
premium results in additional revenue for the exporter.
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9. D (Forward contract fair value hedge of foreign currency firm commitment)
The parts inventory will be recognized at the spot rate at the date of purchase
(FC100,000 x $.23 = $23,000).
10. D (Determine the fair value of a forward contract)
The forward contract must be reported on the December 31, 2013 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 (Calculate foreign exchange gain/loss on foreign currency transaction)
The 10 million won receivable has changed in dollar value from $35,000 at
12/1/13 to $33,000 at 12/31/13. The won receivable will be written down by
$2,000 and a foreign exchange loss will be reported in 2013 income.
12. B (Forward contract fair value hedge of foreign currency denominated

asset/liability)
The nominal value of the forward contract on December 31, 2013 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,
2013 that matures on March 31, 2014, $32,000 ($.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, 2013, 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 2013
income is –$58.80.
13. A (Forward contract cash flow hedge of forecasted foreign currency

transaction)
The krona is selling at a premium in the forward market, causing Pimlico to

pay more dollars to acquire kroner than if the kroner were purchased at the
spot rate on March 1. Therefore, the premium results in an expense of
$10,000 [($.12 – $.10) x 500,000].
The Adjustment to Net Income is the amount accumulated in Accumulated
Other Comprehensive Income (AOCI) as a result of recognizing the Premium
Expense and the fair value of the forward contract. The journal entries would
be as follows:
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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 (Option cash flow hedge of forecasted foreign currency transaction)
This is a cash flow hedge of a forecasted transaction. The original cost of the
option is recognized as an Option Expense over the life of the option.
15-17. (Option fair value hedge of a foreign currency firm commitment)
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:
9/1/13
Foreign Currency Option $2,000
Cash $2,000
12/31/13
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 2013 net income:
Gain on Foreign Currency Option $300.00
Loss on Firm Commitment (980.30)
$(680.30)
3/1/14
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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

15-17. (continued)

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
15. B
16. D
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
18-20. (Forward contract fair value hedge of a foreign currency firm commitment)
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)
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Loss on Firm Commitment $1,250

Net impact on first quarter net income is $0.
18-20. (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
Net impact on second quarter net income is: Sales $59,000 – Loss on Forward
Contract $250 + Gain on Firm Commitment $250 + Adjustment to Net Income
$1,000 = $60,000.
18. A
19. C
20. B Cash inflow with forward contract [500,000 pesos x $.12] $60,000
Cash inflow without forward contract [500,000 pesos x $.118] 59,000
Net increase in cash flow from forward contract $ 1,000
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21-22. (Option cash flow hedge of a forecasted foreign currency transaction)
the option cash flow hedge of a forecasted transaction. The journal entries
are as follows:
11/1/13
Cash $1,500
12/31/13
Option Expense $400
(The option has no intrinsic value at 12/31/13 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.
2/1/14
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
Parts Inventory (Cost-of-goods-sold) $82,000

Foreign Currency (BRL) $82,000
Accumulated Other Comprehensive Income (AOCI) $2,000

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21-22. (continued)

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 payable -- import purchase)
a. The decrease in the dollar value of the LCU payable from November 1 (60,000
x .345 = $20,700) to December 31 (60,000 x .333 = $19,980) is recorded as a
$720 foreign exchange gain in 2013.
b. The increase in the dollar value of the LCU payable from December 31
($19,980) to January 15 (60,000 x .359 = $21,540) is recorded as a $1,560
foreign exchange loss in 2014.
24. (10 minutes) (Foreign currency receivable – export sale)
a. The ostra receivable decreases in dollar value from (50,000 x $1.05) $52,500
at December 20 to $51,000 (50,000 x $1.02) at December 31, resulting in a
foreign exchange loss of $1,500 in 2013.
b. The further decrease in dollar value of the ostra receivable from $51,000 at
December 31 to $49,000 (50,000 x $.98) at January 10 results in an additional
$2,000 foreign exchange loss in 2014.
25. (10 minutes) (Foreign currency receivable – export sale)
9/15 Accounts Receivable (FCU) [100,000 x $.40] $40,000

Sales $40,000
9/30 Accounts Receivable (FCU) $2,000

Foreign Exchange Gain $2,000
[100,000 x ($.42 – $.40)]
10/15 Foreign Exchange Loss $5,000

Accounts Receivable (FCU)
[100,000 x ($.37 – $.42)] $5,000
Cash $37,000
Accounts Receivable (FCU) $37,000
9-14
26. (10 minutes) (Foreign currency payable -- import purchase)
12/1/13 Inventory $52,800

Accounts Payable (LCU) [60,000 x $.88] $52,800
12/31/13 Accounts Payable (LCU) [60,000 x ($.82 – $.88)] $3,600

1/28/14 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.
a. Inventory [50,000 pesos x 40% x $.17] ..................................................... $3,400

b. COGS [50,000 pesos x 60% x $.17] .......................................................... $5,100
c. Sales [45,000 pesos x $.18]....................................................................... $8,100
d. Accounts Receivable [45,000 – 40,000 = 5,000 pesos x $.21] ................ $1,050
e. Accounts Payable [50,000 – 30,000 = 20,000 pesos x $.21] ................... $4,200
f. Cash [(40,000 x $.19) – (30,000 x $.20)] .................................................... $1,600
28. (25 minutes) (Prepare journal entries for foreign currency transactions)
2/1/13 Equipment $17,600

Accounts Payable (L) [40,000 x $.44] $17,600
4/1/13 Accounts Payable (L) $17,600

Foreign Exchange Loss 400
Cash [40,000 x $.45] $18,000
6/1/13 Inventory $14,100

Accounts Payable (L) [30,000 x $.47] $14,100
8/1/13 Accounts Receivable (L) [40,000 x $.48] $19,200

Sales $19,200
9-15
Cost-of-Goods Sold $9,870

Inventory [$14,100 x 70%] $9,870
10/1/13 Cash [30,000 x $.49] $14,700

Accounts Receivable (L) [$19,200 x 3/4] $14,400
Foreign Exchange Gain 300
11/1/13 Accounts Payable (L) [$14,100 x 2/3] $9,400

Foreign Exchange Loss [20,000 x ($.50 – $.47)] 600
Cash [20,000 x $.50] $10,000
12/31/13 Foreign Exchange Loss $500

Accounts Payable (L) [10,000 x ($.52 – $.47)] $500
Accounts Receivable (L) [10,000 x ($.52 – $.48)] $400

Foreign Exchange Gain $400
2/1/14 Cash [10,000 x $.54] $5,400

Accounts Receivable (L) [10,000 x $.52] $5,200
Foreign Exchange Gain 200
3/1/14 Accounts Payable (L) [10,000 x $.52] $5,200

Foreign Exchange Loss 300
Cash [10,000 x $.55] $5,500
29. (20 minutes) (Determine income effect of foreign currency payable – import
purchase)
a. Benjamin, Inc. has a liability of AL 160,000. On the date that this liability
was created (December 1, 2013), the liability had a dollar value of $70,400
(AL 160,000 x $.44). On December 31, 2013, 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 2013.
By March 1, 2014, 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 2014.
b. Benjamin, Inc. has a liability of AL 160,000. On the date that this liability
was created (September 1, 2013), the liability had a dollar value of $73,600
(AL 160,000 x $.46). On December 1, 2013, 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 2013.
9-16
c. Benjamin, Inc. has a liability of AL 160,000. On the date that this liability
was created (September 1, 2013), the liability had a dollar value of $73,600
(AL 160,000 x $.46). On December 31, 2013, 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 2013.
By March 1, 2014, 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 2014.
30. (30 minutes) (Foreign currency borrowing)
a. 9/30/13 Cash $100,000

Note payable (dudek) [1,000,000 x $.10] $100,000
(To record the note and conversion of 1 million
dudeks into $ at the spot rate.)
12/31/13 Interest Expense $525

Interest Payable (dudek) $525
[1,000,000 x 2% x 3/12 = 5,000 dudeks x
$.105 spot rate]
(To accrue interest for the period 9/30 – 12/31/13.)
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.)
9/30/14 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 – 9/30/14,
and record a foreign exchange loss on the
interest payable accrued at 12/31/13.)
12/31/14 Interest Expense $625

Interest Payable (dudek) [5,000 dudeks x $.125] $625
(To accrue interest for the period 9/30 – 12/31/14.)
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.)
9-17
30. (continued)
9/30/15 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 – 9/30/15,
and record a foreign exchange loss on the interest
payable accrued at 12/31/14.)
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:
2013
Interest expense $525
Foreign exchange loss 5,000
Total $5,525 / $100,000 = 5.525% for 3 months =
= 22.1% for 12 months
2014
Interest expense $2,425
Foreign exchange losses 20,075
Total $22,500 / $100,000 = 22.5% for 12 months
2015
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%.
9-18
30. (continued)
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
12/1/13 Accounts Receivable (K) [20,000 x $2.00] $40,000

Sales $40,000
No entry for the forward contract.
12/31/13 Accounts Receivable (K) $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]
9-19
31. (continued)
Impact on 2013 income:

Sales $40,000
Foreign Exchange Gain 2,000
Loss on Forward Contract (2,000)
Premium Revenue 500
Total $40,500

[20,000 x ($2.25 – $2.10)]
AOCI $1,049.25
[20,000 x ($2.25 – $2.075) = $3,500 – 2,450.75] = $1,049.25

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

Foreign Currency (K) $45,000

Premium revenue 1,000
Total $1,000
Impact on net income over both periods: $40,500 + $1,000 = $(41,500); equal to
cash inflow.
9-20
31. (continued)
b. Fair Value Hedge
12/1/13 Accounts Receivable (K) [20,000 x $2.00] $40,000

Sales $40,000

[20,000 x ($2.10 – $2.00)]
Loss on Forward Contract $2,450.75

[20,000 x ($2.075 – $2.20) = $2,500 x .9803 = $2,450.75]

Sales $40,000.00
Foreign Exchange Gain 2,000.00
Loss on Forward Contract (2,450.75)
Total $39,549.25

[20,000 x ($2.25 – $2.10)]

[20,000 x (2.25 – $2.075) = $3,500 – 2,450.75 = $1,049.25]

Accounts Receivable (K) $45,000
Cash [20,000 x $2.075] $41,500


Foreign Exchange Gain $3,000.00
Total $1,950.75
Impact on net income over both periods: $39,549.25 + $1,950.75 = $41,500;

equal to cash inflow.
9-21
32. (40 minutes) (Forward contract hedge of foreign currency payable)
a. Cash Flow Hedge
12/1/13Parts Inventory (COGS) $40,000

Accounts Payable (K) $40,000
[20,000 x $2.00]

[20,000 x ($2.10 – $2.00)]

AOCI $2,450.75
[20,000 x ($2.075 – $2.20) = $2,500 x .9803 = $2,450.75]
AOCI $2,000
Premium Expense $500

AOCI $500
[20,000 x ($2.075 – $2.00) = $1,500 x 1/3 = $500]

Parts inventory (COGS) $(40,000)
Foreign Exchange Loss (2,000)
Gain on Forward Contract 2,000
Premium Expense (500)
Total $(40,500)
32. (continued)

[20,000 x ($2.25 – $2.10)]

AOCI $1,049.25
[20,000 x ($2.25 – $2.075) = $3,500 – 2,450.75 = $1,049.25]
AOCI $3,000
9-22
Premium Expense $1,000

AOCI $1,000
[$1,500 x 2/3 = $1,000]

Cash $41,500


Foreign Exchange Loss $(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 outflow.
32. (continued)
b. Fair Value Hedge
12/1/13Parts inventory (COGS) $40,000

[20,000 x $2.00]

[20,000 x ($2.10 – $2.00)]

Gain on Forward Contract $2,450.75
[20,000 x ($2.075 – $2.20) = $2,500 x .9803 = $2,450.75]

Parts inventory (COGS) $(40,000.00)
Foreign Exchange Loss (2,000.00)
Gain on Forward Contract 2,450.75
Total $(39,549.25)
9-23

[20,000 x ($2.25 – $2.10)]

[20,000 x ($2.25 – $2.075) = $3,500 – 2,450.75 = $1,049.25]

Cash $41,500

32. (continued)

Foreign Exchange Loss $(3,000.00)
Total $(1,950.75)
Impact on net income over both periods: $(39,549.25) + $(1,950.75) =

$(41,500.00); equal to cash outflow.
33. (30 minutes) (Option hedge of foreign currency receivable)
a. Cash Flow Hedge
6/1 Accounts Receivable (P) $45,000

Sales [$.045 x 1,000,000 pesos] $45,000

Cash $2,000

Foreign Exchange Gain
[($.048 – $.045) x 1,000,000] $3,000
AOCI $200
[($.0018 – $.0020) x 1,000,000]
9-24
Loss on Foreign Currency Option $3,000

AOCI $3,000
Option Expense $200

AOCI $200
Date Fair Value Intrinsic Value Time Value Change in Time Value
6/1 $2,000 $0 $2,000 –
6/30 $1,800 $0 $1,800 –$ 200
9/1 $1,000 $1,000 $0 –$1,800
33. (continued)

Accounts Receivable (P) $4,000
[($.044 – $.048) x 1,000,000]
AOCI $800
[$1,800 – $1,000]
AOCI $4,000
Gain on Foreign Currency Option $4,000

AOCI $1,800
(Change in time value of option is recognized as expense)
Foreign Currency (P) $44,000

Cash $45,000
Impact on Net Income over the Two Accounting Periods:

Sales $45,000
Foreign currency option expense (2,000)
Impact on net income $43,000 = Net cash inflow
b. Fair Value Hedge

Sales [$.045 x 1,000,000] $45,000
9-25

Cash $2,000

[($.048 – $.045) x 1,000,000]
Loss on Foreign Currency Option $200

33. (continued)

[($.044 – $.048) x 1,000,000]


Cash $45,000
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

Cash $2,000

[($.088 – .085) x 1,000,000]
9-26

AOCI $2,000
[$4,000 – $2,000]
AOCI $3,000
Option Expense $1,000*

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**
34. (continued)

[($.09 – $.088) x 1,000,000]

AOCI $1,000
[$5,000 – $4,000]
AOCI $2,000
Option Expense $1,000**

AOCI $1,000
Foreign Currency (M) $90,000

Cash $85,000

Impact on net income:

Option Expense ($2,000)
9-27
34. (continued)
b. Fair Value Hedge
6/1 Inventory $85,000

[$.085 x 1,000,000]

Cash $2,000

[($.088 – $.085) x 1,000,000]

[$4,000 – $2,000]

[($.09 – $.088) x 1,000,000]

[$5,000 – $4,000]

Cash $85,000

Impact on net income:

Foreign Exchange Loss ($5,000)
Gain on Foreign Currency Option 3,000
Impact on net income ($2,000)
9-28
35. (30 minutes) (Forward contract cash flow hedge of foreign currency
denominated asset)
Account Receivable (FCU) Forward Forward Contract

Spot U.S. Dollar Change in U.S. Rate to Change in
Date Rate Value Dollar Value 4/30/14 Fair Value Fair Value
11/01/13 $.53 $53,000 - $.52 $0 -
12/31/13 $.50 $50,000 -$3,000 $.48 $3,8441 +$3,844
4/30/14 $.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 1/1.01 4.
2
$52,000 – $49,000 = $3,000.
2013 Journal Entries
11/01/13 Accounts Receivable (FCU) $53,000

Sales $53,000
There is no entry for the forward contract.

AOCI $3,000

AOCI $3,844
Discount expense $333.33

AOCI $333.33
[100,000 x ($.53 – $.52) = $1,000 x 2/6 = $333.33]
The impact on net income for the year 2013 is:

Sales $53,000.00
Foreign Exchange Loss (3,000.00)
Net Gain (Loss) 0.00
Discount Expense (333.33)
Impact on net income $52,666.67
9-29
35. (continued)

AOCI $1,000
AOCI $844
Forward Contract $844
Discount expense $666.67

AOCI $666.67
Foreign Currency (FCU) $49,000

Cash $52,000
Foreign Currency (FCU) $49,000

Foreign Exchange Loss $(1,000.00)
Net Gain (Loss) 0.00
Discount Expense (666.67)
Impact on net income $(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 1/31/14 Fair Value Fair Value
11/30/13 $265,000 ($159,000) - $.52 $0 -
1
12/31/13 $250,000 ($150,000) -$15,000 (-$9,000) $.48 $7,921 +$7,921
1/31/14 $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.
9-30
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.

Accounts Receivable (mongs) $15,000
Accounts Payable (mongs) $9,000



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
36. (continued)



Foreign Currency (mongs) $245,000

9-31

Cash $104,000

Net Foreign Exchange Loss $(2,000)
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 – foreign currency receivable
and firm commitment (sale))
a. Foreign Currency Receivable
10/01 Accounts Receivable (LCU) $69,000

Sales (100,000 LCUs x $.69) $69,000

[($.71 – $.69) x 100,000]

[($.74 – $.65) x 100,000 = $ 9,000 x .9901 = $ 8,910.90]

[($.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]
9-32
Foreign Currency (LCU) $72,000

Accounts Receivable (LCU) $72,000
Cash $65,000
The impact on net income:

Sale $69,000.00
Foreign Exchange Gain 3,000.00
Impact on net income $65,000.00 = Cash Inflow
37. (continued)
b. Foreign Currency Firm Commitment (Sale)
10/01 There is no entry to record either the sales agreement or the

forward contract as both are executory contracts.
12/31 Loss on Forward Contract $8,910.90


Gain on Firm Commitment $8,910.90
1/31 Forward Contract $1,910.90



Sales $72,000
Cash $65,000

9-33
Impact on Net Income:

Sales $72,000
Net Loss on Forward Contract (7,000)
Net Gain on Firm Commitment 7,000
Adjustment to Net Income (7,000)
$65,000 = Cash Inflow
38. (30 minutes) (Forward contract fair value hedge of a foreign currency firm
commitment (purchase))
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
2
($64,000 – $60,000) = $4,000.
a. Journal entries
8/1 There is no entry to record either the purchase agreement or the
forward contract as both are executory contracts.

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
Inventories (Cost-of-Goods-Sold) $64,000
Foreign Currency (rupees) $64,000
9-34
b. 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)
Net impact on net income $(60,000)
c. The net cash outflow is $60,000.
39. (30 minutes) (Option fair value hedge of a foreign currency firm commitment
(sale))
Firm Commitment Option Option

Spot Change in Premium Change in
Date Rate Fair Value Fair Value for 9/1 Fair Value Fair Value
6/1 $1.00 - - $0.010 $5,000 -
6/30 $0.99 $(4,901.50)1 – $ 4,901.50 $0.016 $8,000 + $3,000
9/1 $0.97 $(15,000)2 – $10,098.50 $0.030 $15,000 + $7,000
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).
a. Journal Entries
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


9/1 Loss on Firm Commitment $10,098.50


Foreign Currency (lek) $485,000
9-35
Sales $485,000
Cash $500,000
Foreign Currency (lek) $485,000

39. (continued)
b. Impact on Net Income
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)
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)
c. Net Cash Inflow
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 commitment
(purchase))
Firm Commitment Option Option

11/20 $.20 - - $.008 $400 -
a) 12/20 $.21 $(500)1 – $500 $.0103 $500 + $100
b) 12/20 $.18 $1,0002 + $1,000 $.0004 $0 – $400
9-36
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
12/20 Loss on Firm Commitment $500

Foreign Currency (pijio) $10,500
Cash $10,000
Foreign Currency Option 500
Parts inventory $10,500
The following entry is made in the period when the inventory affects net
income through cost-of-goods-sold:

Adjustment to Net Income $500
40. (continued)
b. The option strike price ($.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:
9-37
11/20 Foreign Currency Option $400

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

12/20 Firm Commitment $1,000

Gain on Firm Commitment $1,000
Cash $9,000
Parts Inventory $9,000
The following entry is made in the period when the inventory affects net
income through cost-of-goods-sold:

41. (20 minutes) (Option cash flow hedge of a forecasted transaction)
a.
12/15/13 Foreign Currency Option $5,000

Cash [1 million marks x $.005] $5,000
No journal entry related to the forecasted

transaction.

AOCI $3,000
To recognize the increase in the value of
the foreign currency option with the counterpart
recorded in AOCI.

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]
9-38

AOCI $2,000
To recognize the increase in the value of the
Foreign Currency Option with the counterpart
recorded in AOCI.

AOCI $4,000
To recognize the decrease in the time value of
the option as expense.
Foreign Currency (marks) $590,000

Cash $580,000
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.
41. (continued)
AOCI $10,000
To transfer the amount accumulated in AOCI
as an adjustment to net income in the period
in which the forecasted transaction occurs.
b. Impact on net income: 2013 – Option Expense $(1,000)
2014 – Cost-of-goods-sold $(590,000)

Option Expense (4,000)
$(584,000)
The impact on net income over the two periods is $(585,000).
c. Net cash outflow for parts: $585,000 = ($5,000 + $580,000)
42. (60 minutes) (Unhedged foreign currency transaction; forward contract and
option hedge of foreign currency liability; forward contract and option hedge of
foreign currency firm commitment (purchase))
9-39
Part a. Foreign Currency Liability (Unhedged)
9/15 Inventory $200,000

Accounts Payable (euro) $200,000


Foreign Currency (euro) $220,000

Cash $220,000

42. (continued)
Part b. Forward Contract Fair Value Hedge of a 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 -
1
9/30 $1.05 $210,000 +$10,000 $1.09 $5,940.60 +$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
2
$220,000 – $212,000 = $8,000.
9/15 Inventory $200,000



9-40



Cash $212,000

42. (continued)
Part c. Forward Contract Fair Value Hedge of a Foreign Currency Firm

Commitment (Purchase)
9/15 There is no formal entry for the forward contract or the purchase order.





Cash $212,000
Inventory $220,000
The following entry is made in the period when the inventory affects net income
through cost-of-goods-sold:

9-41
42. (continued)
Part d. Option Cash Flow Hedge of a Foreign Currency Liability
The following schedule summarizes the changes in the components of the fair
value of the euro call option with a strike price of $1.00 for October 31.
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 $7,0001 -
09/30 $1.05 $.070 $14,000 + $7,000 $10,0002 $4,0002 - $3,000
10/31 $1.10 $.100 $20,000 + $6,000 $20,000 $03 - $4,000
1
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


Cash $7,000


AOCI $7,000
AOCI $10,000

AOCI $3,000
42. (continued)


AOCI $6,000
9-42
AOCI $10,000

AOCI $4,000

Cash $200,000

42. (continued)
Part e. Option Fair Value Hedge of a Foreign Currency Firm Commitment

(Purchase)
Firm Commitment Option Foreign Currency Option

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.

Cash $7,000





Cash $200,000
9-43
Inventory $220,000
The following entry is made in the period when the inventory affects net income
through cost-of-goods-sold:

Chapter 9 Develop Your Skills
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 2010 annual report.
1. In 2010, IFF provided information in the annual report related to its

management of foreign exchange risk in the following locations:
a. Item 1A. Risk Factors. -- “impact of currency fluctuation or devaluation”
b. Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
c. Note 14. Financial Instruments. – “derivatives”
2. IFF uses foreign currency forward contracts to reduce exposure to cash flow
volatility arising from foreign currency fluctuations associated with
intercompany loans, certain foreign currency receivables and payables
(hedges of foreign currency denominated assets and liabilities), and
anticipated purchases of raw materials used in operations (hedges of
forecasted transactions).
The company uses a Japanese Yen- U.S. Dollar swap to hedge monthly sale
and purchase transactions between the U.S. and Japan.
The company also uses forward contracts to hedge net investments in
foreign operations. (This topic is discussed in more detail in Chapter 10.)
3. In Item 7a., IFF indicates that “the notional amount and maturity dates of such
(i.e., forward) contracts match those of the underlying transactions.” Toward
the end of Note 14, the company also indicates that “no ineffectiveness was
experienced in the above noted cash flow hedges during the year ended
December 31, 2010.”
9-44
Accounting Standards Case—Forecasted Transactions
Questions asked in the case are:

• Is management’s intent sufficient to assess that a forecasted transaction is
likely to occur?
• If not, what additional evidence must be considered?
Source of guidance: FASB ASC 815-20-55-24 Derivatives and Hedging; Hedging-

General; Implementation Guidance and Illustrations; Probability of a
Forecasted Transaction
ASC 815-20-55-24 states: “An assessment of the likelihood that a forecasted

transaction will take place should not be based solely on management's intent
because intent is not verifiable. The transaction's probability should be supported
by observable facts and the attendant circumstances. Consideration should be
given to all of the following circumstances in assessing the likelihood that a
transaction will occur.
a. The frequency of similar past transactions
b. The financial and operational ability of the entity to carry out the transaction
c. Substantial commitments of resources to a particular activity (for example, a

manufacturing facility that can be used in the short run only to process a
particular type of commodity)
d. The extent of loss or disruption of operations that could result if the

transaction does not occur
e. The likelihood that transactions with substantially different characteristics

might be used to achieve the same business purpose (for example, an entity
that intends to raise cash may have several ways of doing so, ranging from a
short-term bank loan to a common stock offering).”
The answers to the specific questions asked in the case are:

• Management’s intent is not sufficient to assess whether a forecasted
transaction is likely to occur.
• Additional evidence listed in items a. – e. in ASC 815-20-55-24 must be
considered in assessing that likelihood.
9-45
Excel Case—Determine Foreign Exchange Gains and Losses
1., 2. and 3. Spreadsheet for the calculation of the foreign exchange gains (losses)
related to Import/Export Company’s foreign currency transactions for
the year 2010.
Exchange Exchange Foreign

Amount in Trans- Rate at $ Value on Settle- Rate at $ Value on Exchange
Foreign Type of Foreign action Transaction Transaction ment Settlemen Settlement Gain
Currency Transaction Currency Date Date Date Date t Date Date (Loss)
Brazilian Import
real purchase
(BRL) (payable) (87,000) 1/4/2010 0.577477 (50,240.50) 5/4/2010 0.57428 (49,962.36) 278.14
Swiss
franc Export sale
(CHF) (receivable) 51,700 1/4/2010 0.967455 50,017.42 5/4/2010 0.913718 47,239.22 (2,778.20)
Swiss Import
franc purchase
(CHF) (payable) (55,000) 5/4/2010 0.913718 (50,254.49) 10/4/2010 1.02836 (56,559.80) (6,305.31)
Export sale
Euro (receivable) 37,200 4/1/2010 1.3468 50,100.96 9/1/2010 1.28 47,616.00 (2,484.96)
Export sale
Euro (receivable) 37,200 4/1/2010 1.3468 50,100.96 10/1/2010 1.3726 51,060.72 959.76
Chinese Import
yuan purchase
(CNY) (payable) (342,000) 1/4/2010 0.146471 (50,093.08) 10/4/2010 0.14945 (51,111.90) (1,018.82)
South
Korean Import
won purchase
(KRW) (payable) (55,600,000) 1/4/2010 0.00086557 (48,125.69) 10/4/2010 0.0008892 (49,439.52) (1,313.83)
Total Net
Foreign
Exchange
Gain
(Loss) (12,663.22)
Source of exchange rates: www.x-rates.com, Historical Lookup
Import/Export Company reported a net foreign exchange loss of $12,663.22 in

2010 income.
Possible discussion points for instructors: 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 and directions of change in the
exchange rates across the currencies in which Import/Export Company had
exposures. At one extreme, the large depreciation in value of the CHF from
1/4/10 to 5/4/10 coupled with an asset exposure resulted in a large foreign
exchange loss. The large appreciation in value of the CHF from 5/4/10 to 10/4/10
coupled with the CHF liability exposure also generated a large foreign exchange
loss. The depreciation in value of the Euro from 4/1/10 to 9/1/10 resulted in a
foreign exchange loss on one of the company’s Euro receivables; the overall
appreciation in value of the Euro from 4/1/10 to 10/1/10 resulted in a foreign
exchange gain on a second Euro receivable.
9-46
Analysis Case—Cash Flow Hedge
1. Given the $6,000 total Premium Expense, the forward rate on 2/1/13 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 3/31/13 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 5/1/13 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 2/1/13 at the spot rate of $1.00, it
could have saved $6,000.
Internet Case—Historical Exchange Rates
1. Spreadsheets for the calculation of the foreign exchange gains (losses)

related to Pier Ten Company’s foreign currency account receivables.
Foreign
Currency
Account Exchange U.S. Dollar
Receivabl Rate on Value on
Currency Code e 12/14/10 12/14/10
Indian rupee INR 898,000 0.0222781 $20,005.73
Philippine peso PHP 874,000 0.0228883 20,004.37
Japanese yen JPY 1,662,500 0.0120353 20,008.69
Malaysian ringgit MYR 62,550 0.319881 20,008.56

$80,027.35
Foreign
Currency Foreign
Account Exchange U.S. Dollar Exchange
Receivabl Rate on Value on Gain (Loss)
Currency Code e 12/31/10 12/31/10 on 12/31/10
Indian rupee INR 898,000 0.0223602 $20,079.46 $ 73.73
Philippine peso PHP 874,000 0.0229194 20,031.56 27.19
9-47
Japanese yen JPY 1,662,500 0.0122982 20,445.76 437.07
Malaysian ringgit MYR 62,550 0.3263 20,410.07 401.51

$80,966.85 $ 939.50
Foreign
Currency Foreign
Account Exchange U.S. Dollar Exchange
Receivabl Rate on Value on Gain (Loss)
Currency Code e 1/14/11 1/14/11 on 1/14/11
Indian rupee INR 898,000 0.0220214 $19,775.22 $ (304.24)
Philippine peso PHP 874,000 0.0225666 19,723.21 (308.35)
Japanese yen JPY 1,662,500 0.0120456 20,025.81 (419.95)
Malaysian ringgit MYR 62,550 0.326938 20,449.97 39.90

$79,974.21 $ (992.64)
Foreign
Currency
Account U.S. Dollar U.S. Dollar Net Foreign
Receivabl Value on Value on Exchange
Currency Code e 12/14/10 1/14/11 Gain (Loss)
Indian rupee INR 898,000 $20,005.73 $19,775.22 $ (230.51)
Philippine peso PHP 874,000 20,004.37 19,723.21 (281.16)
Japanese yen JPY 1,662,500 20,008.69 20,025.81 17.12
Malaysian ringgit MYR 62,550 20,008.56 20,449.97 441.41
$80,027.35 $79,974.21 $ (53.14)
Source of exchange rates: www.x-rates.com, Historical Lookup
2. Pier Ten would have reported a net foreign exchange gain of $939.50 in 2010
and a net foreign exchange loss of $992.64 in 2011 related to these foreign
currency receivables. The transactions denominated in Indian rupees and
Philippine pesos resulted in a net foreign exchange loss of $230.51 and
$281.16, respectively. The PHP receivable would have been the most
important to hedge.
9-48
3. Assuming a strike price equal to the December 14, 2010 spot rate, the only
foreign currency transactions for which the purchase of a put option costing
$100 would have been beneficial are the transactions in Indian rupees and
Philippine pesos. Net cash inflow from the INR receivable would have been
$130.51 greater ($230.51 FX loss avoided less $100.00 cost of option) if a put
option had been acquired and the net cash flow from the PHP receivable
would have been $181.16 greater ($281.16 FX loss avoided less $100.00 cost
of option) if a put option had been acquired. Put options in JPY and MYR
would have had no value at 1/14/11. The purchase of JPY and MYR options
would have resulted in a decrease in net cash inflow to Pier Ten of $200.00
(the cost of the options).
Communication Case—Forward Contracts and Options
To: Mr. Dewey Nukem, CEO, Palmetto Bug Extermination Company (PBEC)
The primary advantage of using forward contracts to hedge foreign exchange

risk is that there is no cost to enter into them. The disadvantage is that the
company is obligated to exchange foreign currency for dollars at the contracted
forward rate. Depending upon the future spot rate, this may or may not be
advantageous for the company. In contrast, the primary disadvantage of using
foreign currency options to hedge foreign exchange risk is that there is an up-
front cost incurred to purchase them. The primary advantage is that the
company is not required to exchange foreign currency for dollars at the option
strike price if it is disadvantageous to do so. The company can simply allow the
option to expire unexercised and the only cost is the initial premium that was
paid to acquire the option.
Exporters sometimes use forward contracts to hedge export sales (import

purchases) when the foreign currency is selling at a forward premium (discount)
as this locks in premium revenue (discount revenue). The risk associated with
this strategy is that the customer may or may not pay on time. If an exporter
enters into a forward contract to sell foreign currency, and the customer does
not pay on time, the exporter will need to purchase foreign currency at the spot
rate to settle the forward contract. This is essentially the same as speculation; a
gain or loss could arise. In this case, the exporter might be better off by
purchasing a foreign currency put option. The exporter can simply allow the
option to exercise if it has not received foreign currency from the customer by
the expiration date.
9-49
Since PBEC is making import purchases, it has more control over the timing of
when it will need foreign currency. In that case, it should be safe to enter into a
forward contract to purchase foreign currency on the date when PBEC plans to
pay for its purchases. However, there is always the risk that the supplier does
not deliver on time, in which case the forward contract provides PBEC with
foreign currency for which it has no current use.
The bottom line is that there is no right or wrong answer to the question which
hedging instrument should be used to hedge the Swiss franc exposure to
foreign exchange risk. Both forward contracts and option have the advantages
and disadvantages.
9-50

Chapter 09 - Guide to Accounting for Foreign Currency Transactions and Hedging Exchange Risk

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Chapter 09 - Guide to Accounting for Foreign Currency Transactions and Hedging Exchange Risk

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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

Answer to Discussion Question: Do We Have a Gain or What?

4. Hedging is the process of eliminating exposure to foreign exchange risk so as to avoid

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

1. C (Foreign exchange gain/loss on foreign currency transaction)

An import purchase causes a foreign currency payable to be carried on the

2. D (Method of accounting for foreign currency transactions)

Current accounting standards require a two-transaction perspective, accrual

3. B (Foreign exchange gain/loss on foreign currency transaction)

Foreign exchange gains related to foreign currency import purchases are

4. C (Calculate foreign exchange gain/loss on foreign currency transaction)

5. D (Calculate foreign exchange gain/loss on foreign currency borrowing)

6. D (Foreign exchange gain/loss on foreign currency transaction)

7. D (Calculate foreign exchange gain/loss)

The merchandise purchase results in a foreign exchange loss of $8,000, the

8. D (Forward contract cash flow hedge of foreign currency denominated

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

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

11. C (Calculate foreign exchange gain/loss on foreign currency transaction)

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

13. A (Forward contract cash flow hedge of forecasted foreign currency

The krona is selling at a premium in the forward market, causing Pimlico to

3/1 no journal entries

6/1 Premium Expense $10,000

Foreign Currency $57,500

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

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

Loss on Firm Commitment $2,019.70

Foreign Currency (C$) $77,000

Firm Commitment $3,000

Net impact on 2014 net income:

17. B Net cash inflow with option ($80,000 – $2,000) $78,000

3/1 no journal entries

3/31 Forward Contract $1,250

Loss on Firm Commitment $1,250

Net impact on first quarter net income is $0.

4/30 Loss on Forward Contract $250

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

Option Expense decreases net income by $400.

Foreign Currency (BRL) [200,000 x $.41] $82,000

Parts Inventory (Cost-of-goods-sold) $82,000

Accumulated Other Comprehensive Income (AOCI) $2,000

Net impact on 2014 net income:

24. (10 minutes) (Foreign currency receivable – export sale)

25. (10 minutes) (Foreign currency receivable – export sale)

9/15 Accounts Receivable (FCU) [100,000 x $.40] $40,000

9/30 Accounts Receivable (FCU) $2,000

10/15 Foreign Exchange Loss $5,000

26. (10 minutes) (Foreign currency payable -- import purchase)

12/1/13 Inventory $52,800

12/31/13 Accounts Payable (LCU) [60,000 x ($.82 – $.88)] $3,600

1/28/14 Foreign Exchange Loss $4,800

Accounts Payable (LCU) $54,000

a. Inventory [50,000 pesos x 40% x $.17] ..................................................... $3,400

2/1/13 Equipment $17,600

4/1/13 Accounts Payable (L) $17,600

6/1/13 Inventory $14,100

8/1/13 Accounts Receivable (L) [40,000 x $.48] $19,200

Cost-of-Goods Sold $9,870

10/1/13 Cash [30,000 x $.49] $14,700

11/1/13 Accounts Payable (L) [$14,100 x 2/3] $9,400

12/31/13 Foreign Exchange Loss $500