Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

CHAPTER 9
FOREIGN CURRENCY TRANSACTIONS AND
HEDGING FOREIGN EXCHANGE RISK
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.
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, 2015.
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, 2015 to $95,000 at February 15, 2016. This decrease of
$15,000 should be reported as a foreign exchange loss in 2016.

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 2015 and a $10,000 loss will be reported in 2016.

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).
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

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 notes 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.

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
receipt (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, 2015 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%, which is $4,901.50 [($.042 $.037) x
1,000,000 x .9803].
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
12/1/15 to $33,000 at 12/31/15. The won receivable will be written down by
$2,000 and a foreign exchange loss will be reported in 2015 income.

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

asset/liability)
The nominal value of the forward contract on December 31, 2015 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,
12. (continued)
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

2015 that matures on March 31, 2016, $32,000 [$.0032 x 10 million]. The
fair value of the forward contract is the present value of $2,000 discounted
for three months, which is $1,941.20 [$2,000 x .9706]. On December 31,
2015, 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 2015 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:
3/1

no journal entries

6/1

Premium Expense
AOCI

$10,000
$10,000

AOCI
Forward Contract

$2,500
$2,500

Foreign Currency
Forward Contract
Cash

$57,500
2,500
$60,000

AOCI
Adjustment to Net Income

$7,500
$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.

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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

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

15. B
16. D
The easiest way to solve problems 15 and 16 is to prepare journal entries
for the option fair value hedge and the firm commitment. The journal
entries are as follows:
9/1/15
Foreign Currency Option
Cash

$2,000
$2,000

12/31/15
Foreign Currency Option
Gain on Foreign Currency Option
Loss on Firm Commitment
Firm Commitment
[($.79 $.80) x 100,000 = $1,000 x .9803 = $980.30]
Net impact on 2015 net income:
Gain on Foreign Currency Option
Loss on Firm Commitment
3/1/16
Foreign Currency Option
Gain on Foreign Currency Option

$300
$300
$980.30
$980.30

$300.00
(980.30)
$(680.30)
$700
$700

Loss on Firm Commitment

$2,019.70
Firm Commitment
[($.77 $.80) x 100,000 = $3,000 $980.30 = $2,019.70]
Foreign Currency (C$)
Sales

$77,000

Cash
Foreign Currency (C$)
Foreign Currency Option

$80,000

Firm Commitment
Adjustment to Net Income

$3,000

$2,019.70

$77,000
$77,000
3,000
$3,000

9-4

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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

15-17. (continued)
Net impact on 2016 net income:
Gain on Foreign Currency Option
Loss on Firm Commitment
Sales
Adjustment to Net Income
17. B Net cash inflow with option ($80,000 $2,000)
Cash inflow without option (at spot rate of $.77)
Net increase in cash inflow

700.00
(2,019.70)
77,000.00
3,000.00
$78,680.30
$78,000
77,000
$ 1,000

18-20. (Forward contract fair value hedge of a foreign currency firm commitment)
The easiest way to solve problems 18 and 19 is to prepare journal entries
for the forward contract fair value hedge of a firm commitment. The journal
entries are as follows:
3/1

no journal entries

3/31

Forward Contract
Gain on Forward Contract
($1,250 $0)

$1,250

Loss on Firm Commitment

Firm Commitment

$1,250

$1,250

$1,250

Net impact on first quarter net income is $0.

9-5

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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

18-20. (continued)
4/30

Loss on Forward Contract

Forward Contract
[Fair value of Forward Contract is
(($.120 $.118) x 500,000) = $1,000;
$1,000 $1,250 = $250]

$250

Firm Commitment
Gain on Firm Commitment

$250

$250

$250

Foreign Currency (pesos)

Sales [500,000 pesos x $.118]

$59,000

Cash [500,000 x $.120]

Foreign Currency (pesos)
Forward Contract

$60,000

Firm Commitment
Adjustment to Net Income

$1,000

$59,000
$59,000
1,000
$1,000

Net impact on second quarter net income is: Sales $59,000 Loss on
Forward Contract $250 + Gain on Firm Commitment $250 + Adjustment to
Net Income $1,000 = $60,000.
18. A
19. C
20. B Cash inflow with forward contract [500,000 pesos x $.12]
$60,000
Cash inflow without forward contract [500,000 pesos x $.118] 59,000
Net increase in cash flow from forward contract
$ 1,000

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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

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

The easiest way to solve problems 21 and 22 is to prepare journal entries
for the option cash flow hedge of a forecasted transaction. The journal
entries are as follows:
11/1/15
Foreign Currency Option
Cash

$1,500
$1,500

12/31/15
Option Expense
$400
Foreign Currency Option
$400
(The option has no intrinsic value at 12/31/15 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.
2/1/16
Option Expense
$1,100
Foreign Currency Option
900
Accumulated Other Comprehensive Income (AOCI)
(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]
Cash [200,000 x $.40]
Foreign Currency Option

$82,000

Parts Inventory
Foreign Currency (BRL)

$82,000

$2,000

$80,000
2,000
$82,000

Accumulated Other Comprehensive Income (AOCI)

Adjustment to Net Income

9-7

$2,000
$2,000

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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

21-22. (continued)
Net impact on 2016 net income:
Option Expense
$ (1,100)
Cost-of-Goods-Sold
(82,000)
Adjustment to Net Income
2,000
Decrease in Net Income $ (81,100)
21. B
22. C
31. (40 minutes) (Forward contract hedge of foreign currency receivable)
a. Cash Flow Hedge
Date
Journal entry
12/1/2015 Accounts receivable (K)
Sales
To record sales and foreign currency A/R

Debit
43200

Credit
43200

No entry needed for the forward contract on 12/1/15

12/31/2015 Accounts receivable (K)
AOCI

1600
1600

to revalue the foreign currency A/R account

AOCI

1960.6

Forward contract
to update the value of forward contract as of 12/31/15

1960.6

AOCI

400
Gain from forward contract premium amortization
400
allocate the forward contract premium over the life of the contract
and recognize the gain from the savings with forward contract in December

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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

31. (continued)
a. Cash Flow Hedge (continued)
Date
3/1/2016

Journal entry
Accounts receivable (K)
AOCI

Debit
2400

Credit
2400

to revalue the foreign currency A/R account

AOCI

839.4

Forward contract
to update the value of forward contract as of 12/31/15
AOCI

839.4

800
Gain from forward contract premium amortization

Foreign currency (K)

47200
Accounts receivable (K)
record the receipt of Korunas from the foreign customer
Cash
Forward contract
Foreign currency
record the settlement of the forward contract

9-9

800

47200

44400
2800
47200

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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

31. (continued)
b. Fair Value Hedge

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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk

31. (continued)
b. Fair Value Hedge (continued)

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