Answers to Questions

1              A transaction is measured in a particular currency if its magnitude is expressed in that currency. Assets and liabilities are denominated in a currency if their amounts are fixed in terms of that currency.

2              Direct quotation: 1.20/1 = $1.20
Indirect quotation: 1/1.20 = .83 euros per dollar

3              Official or fixed rates are set by a government and do not change as a result of changes in world currency markets. Free or floating exchange rates are those that reflect fluctuating market prices for currency based on supply and demand factors in world currency markets. The United States changed from fixed to floating (free) exchange rates in 1971. But the U.S. dollar is sometimes described as a “filthy float” because the United States has frequently engaged in currency transactions to support or weaken the dollar against other currencies. Such action is taken for economic reasons, such as to make U.S. goods more competitive in world markets. Both Japan and Germany have engaged in currency transactions in an attempt to support the U.S. dollar. In February 1987, the United States and six other industrial nations (the Group of 7 or G-7) entered the Louvre accord to cooperate on economic and monetary policies in support of agreed upon exchange rate levels.

4              Spot rates are the exchange rates for immediate delivery of currencies exchanged. The current rate for foreign currency transactions is the spot rate in effect for immediate settlement of the amounts denominated in foreign currency at the balance sheet date. Historical rates are the rates that were in effect on the date that a particular event or transaction occurred.  Spot rates could be fixed rates if the currency was a fixed rate currency as determined by the government issuing the currency.

5              The transaction is a foreign transaction because it involves import activities, but it is not a foreign currency transaction for the U.S. firm because it is denominated in local currency. It is a foreign currency transaction for the Japanese company.

6              At the transaction date, assets and liabilities denominated in foreign currency are translated into dollars by use of the exchange rate in effect at that date, and they are recorded at that amount.
At the balance sheet date, cash and amounts owed by or to the enterprise that are denominated in foreign currency are adjusted to reflect the current rate. Assets carried at market whose current market price is stated in a foreign currency are adjusted to the equivalent dollar market price at the balance sheet date.

7              Exchange gains and losses occur because of changes in the exchange rates between the transaction date and the date of settlement. Both exchange gains and exchange losses can occur in either foreign import activities or foreign export activities. The statement is erroneous.

8              Exchange gains and losses on foreign currency transactions are reflected in income in the period in which the exchange rate changes except for hedges of an identifiable foreign currency commitment where deferral is possible if certain requirements are met. Also hedges of a net investment in a foreign entity are treated as equity adjustments from translation. Intercompany foreign currency transactions of a long-term nature are also treated as equity adjustments.

9              There will be a $20 exchange loss in the period of purchase and a $10 exchange gain in the period of settlement:

Billing date
Purchases	$1,450
Accounts payable (fc)		$1,450
Year-end adjustment
Exchange loss	$   20
Accounts payable (fc)		$   20
Settlement date
Accounts payable (fc)	$1,470
Cash		$1,460
Exchange gain		10

 

Derivative is the name given to a broad range of financial securities.  Their common characteristic is that the derivative contract’s value to the investor is directly related to fluctuations in price, rate, or some other variable that underlies it.  Interest rate, foreign currency exchange rate, commodity prices and stock prices are common types of prices and rate risks that companies hedge.
               
11           Hedge accounting refers to accounting designed to record changes in the value of the hedged item and the hedging instrument in the same accounting period.  This enhances transparency because the hedged item and hedging instrument accounting are linked.  Prior to hedge accounting, the financial statement effect of the hedged item and hedging instrument were not linked.  Since companies enter into hedges to mitigate risks, the accounting should reflect the effect of this strategy and should clearly communicate the strategy.  The accounting and footnote disclosures required for derivatives attempt to do this.

12    An option is a contract that allows the holder to buy or sell a security at a particular date.  The holder is not obligated to buy or sell the security. They may allow the contract to expire.  Typically, the holder must pay an upfront fee to the writer of the option.

A forward contract and futures contract are similar because both sides of the contract are obligated to perform.   A forward contract is negotiated between two parties, they agree upon delivering a certain quantity of goods or currency at a specific date in the future.  Many allow net settlement which means the “winner” of the contract receives cash consideration for the difference between the market price of the commodity and the contracted amount on the date the contract expires.   The initial amount exchanged at the date the contract is entered into is negligible.

A futures contract is traded on a market.  The amount of commodity to be exchanged and the date of delivery are standardized.  The futures rate is determined by the market at the date the contract is entered into.  These contracts are settled daily. 

13           Hedge effectiveness involves assessing how well the hedge mitigates the gains or losses of the asset, liability and/or anticipated transaction that it is entered into to mitigate.

The most common approaches to determining hedge effectiveness are critical term analysis and statistical analysis.

Under critical term analysis, the nature of the underlying variable, the notional amount of the derivative and the item being hedged, the delivery date of the derivative and the settlement date for the item being hedged are examined.  If the critical terms of the derivative and the hedged item are identical, then an effective hedge is assumed.

A statistical approach is used if critical terms don’t match.  One such approach involves comparing the correlation between changes in the price of the item being hedged and the derivative.  While the FASB does not specify a specific benchmark correlation coefficient, correlations of between 80% and 125% are considered to be highly effective.  Outside of these ranges, the hedge would not be considered highly effective.

14             Under a firm purchase or sales commitment, if the hedge is considered to be effective, then it would    qualify as a fair value hedge. 

15           A company that has an existing loan that involves a variable or floating interest rate enters into a pay-fixed, receive variable swap.  The company is swapping its variable interest rate payments for fixed ones.  These contracts are typically settled net.  For example, if the fixed rate agreed upon is 10% for the term of the swap agreement and in one year the variable rate is 9%, then the company with the variable rate loan must pay the difference in rates multiplied by the notional amount of the loan to the other party.  If the variable rate is 12%, then the company will receive the difference in rates multiplied by the notional amount of the loan.  Regardless of the movement in interest rates over the term of the swap, the company will pay the fixed rate, net.  This type of swap is aimed at reducing the variability in cash flows related to the debt therefore it is designated as a cash flow hedge.

16           A receive fixed, pay variable swap is entered into if a company has an existing loan that involves a fixed interest rate and desires to swap those fixed payments for variable payments.  For example, a company has a loan with an 8% fixed rate and enters into a swap arrangement so that it will pay LIBOR + 1%.   If the variable rate for a year is 9%, then the company will pay 1% multiplied by the notional amount as well as the 8% for the loan.  Thus, the company has paid 9%, the floating rate. 

 If the variable rate is 6% (5% LIBOR + 1%), then the company will pay 8% on the loan, but will receive 2% related to the swap.  Thus, the company will pay 6%, the floating rate.

This type of swap is aimed at reducing the variability in the fair value of the underlying loan therefore it is designated as a fair value hedge.

17           Fair value hedge accounting is used when the company is attempting to reduce the price risk of an existing asset/liability or firm purchase/sale commitment.  Cash flow hedge accounting is appropriate when the company is attempting to reduce the variability in cash flows thus it is appropriate when hedging anticipated purchases and sales. 

                Under certain circumstances, hedges of existing foreign currency denominated receivables and payables are accounted for as cash flow hedges instead of fair value hedges.  See question 18’s solution for these cases.

18           Cash flow hedge accounting can be used when hedging recognized currency denominated assets and liabilities if the variability of cash flows is completely eliminated by the hedge.  This criterion is generally met if all of the critical terms of the hedged item and the hedge match such as the settlement date, currency type and currency amounts.  If these don’t match then it must be accounted for as a fair value hedge.

                The key difference between this situation and the more general cash flow hedge case is that an existing asset or liability is being accounted for here.  Under the more general case, the recognition of gains and losses is deferred because an anticipated transaction is being hedged. 
The foreign currency asset or liability is marked to fair value at year-end and the resulting gain or loss account is recognized, however, the gain or loss is offset by reclassifying an equal amount from other comprehensive income.  Thus, the asset and liability are marked to fair value, but no gain or loss related to that adjustment is included in current period income.

                The premium or discount related to the hedge contract is amortized to income over the length of the contract using the effective interest method.  For example, if  a 100,000 euro foreign currency receivable due in 60 days is recorded at the spot rate of $1.20/euro or $120,000 and at the same date, a forward contract is entered into to deliver 100,000 euros in 60 days at a forward rate of $1.18, the company knows that it will lose $2,000.  This $2,000 must be amortized to income over the 60 day period. 

19           International Accounting Standards No. 32 and 39 prescribe the accounting for derivatives.  Their requirements are similar to SFAS No. 133 and 138 in terms of determining when hedge accounting can be used.  The requirements for determining hedge effectiveness are very similar.  Both fair value and cash flow hedge definitions and general requirements are similar.  However, under IAS 39, firm sale or purchase commitments can be accounted for as either fair value or cash flow hedges which differs from the FASB requirement that they must be accounted for as fair value hedges.

20           A forward contract of an anticipated foreign currency transaction is accounted for as a cash flow hedge.  The contract is marked to fair value at each financial date and the corresponding gain or loss is included in other comprehensive income.  Any premium or discount must be amortized to income over the contract term using an effective interest rate method.  The gain (loss) credit (debit) is offset by a debit (credit) from other comprehensive income.

                When the anticipated transaction occurs and the forward contract is settled, the resulting other comprehensive income balance is amortized to income in the same period as the underlying transaction is recognized in income. 

SOLUTIONS TO EXERCISES

 

Solution E12-1

 

1     b    

2     d    

3     d    

 

 

Solution E12-2

 

1     The dollar has weakened against the yen because it now costs more dollars to buy one yen.

 

2     10,000,000 yen ´ $.0075 = $75,000

 

3	Accounts payable	$75,000
	Exchange loss	1,000
	Cash		$76,000

 

4     Zimmer would have entered a contract to purchase yen for future receipt.

 

 

Solution E12-3

 

December 16, 2006

	Inventory	$36,000
	Accounts payable (euros)		$36,000

To record purchase of merchandise from Wing Corporation for 30,000 euros at $1.20 spot rate.

 

December 31, 2006

	Exchange loss	$   1,500
	Accounts payable (euros)		$   1,500

To adjust accounts payable to Wing: ($1.25 - $1.20) ´ 30,000 euros.

 

January 15, 2007

	Accounts payable (euros)	$37,500
	Exchange gain		$   300
	Cash		37,200

To record payment of 30,000 euros at $1.24 spot rate in settlement of account payable and to recognize gain.

 

 

Solution E12-4

 

Adjustment in value of account receivable for 2006:

      ($.84 - $.80) ´ 90,000 C$ = $3,600 exchange gain

 

Adjustment in value of account receivable at settlement in 2007:

      ($.83 - $.84) ´ 90,000 C$ = $900 exchange loss

 

Solution E12-5

 

May 1, 2006

	Accounts receivable (fc)	$333,333
	Sales		$333,333

To record sale of inventory items to Royal for 200,000 pounds: 200,000 pounds/.6000 pounds (indirect quotation).

 

May 30, 2006

	Cash (fc)	$330,579
	Exchange loss	2,754
	Accounts receivable (fc)		$333,333

To record receipt of 200,000 pounds from Royal in settlement of accounts receivable: 200,000 pounds/.6050 pounds.

 

Solution E12-6 [AICPA adapted]

 

1    

Receivable at 10/15/06	$420,000
Euros received and sold for U.S. dollars on 11/16/06	415,000
Foreign exchange loss 2006	5,000

 

2     On December 31, 2006 Yumi Corp. adjusts its account payable denominated in euros from $12,000 (10,000*.$1.20) to $12,400 (10,000 ´ $1.24) and recognizes a loss of $400 [10,000 LCU ´ ($1.24 - $1.20)]

 

3
		December 31, 2006 note payable	$240,000
		July 1, 2007 note payable	280,000
		2007 exchange loss	$(40,000)
4
		Note receivable December 31, 2006	$140,000
		Amount collected July 1, 2007
		(840,000 LCU ¸ 8)	105,000
		2007 exchange loss	$ 35,000

 

Solution E12-7

 

1	Exchange gain or loss in 2006:		Gain or (Loss)
	Account receivable December 16	$103,500
	December 31 adjusted balance
	150,000 C$ ´ $0.68	102,000	$(1,500)
	Account payable December 2	$195,250
	December 31 adjusted balance
	275,000 C$ ´ $0.68	187,000	8,250
	Net exchange gain for 2006		$ 6,750
2	Exchange gain or loss in 2007:
	Account receivable adjusted 12/31	$102,000
	Account receivable 1/15/07	101,250	$  (750)
	Account payable adjusted 12/31	$187,000
	Account payable 1/30/07	188,375	(1,375)
	Net exchange loss for 2007		$(2,125)

 

Solution E12-8

 

1     December 12, 2006

	Inventory	$375,000
	Accounts payable (yen)		$375,000

Purchase from Toko Company (50,000,000 yen ´ $.00750).

 

      December 15, 2006

	Accounts receivable (pounds)	$ 66,000
	Sales		$ 66,000

Sale to British Products Company (40,000 pounds ´ $1.65).

 

2     December 31, 2006

	Exchange loss	$  5,000
	Accounts payable (yen)		$  5,000

To adjust accounts payable denominated in yen for exchange rate change: 50,000,000 yen ´ ($.00760 - $.00750).

	Exchange loss	$  2,000
	Accounts receivable (pounds)		$  2,000

To adjust accounts receivable denominated in pounds for exchange rate change: 40,000 pounds ´ ($1.65 - $1.60).

 

3     January 11, 2007

	Accounts payable (yen)	$380,000
	Exchange loss	2,500
	Cash		$382,500

To record payment to Toko Company (50,000,000 yen ´ $.00765).

 

      January 14, 2007

	Cash	$ 65,200
	Accounts receivable (pounds)		$ 64,000
	Exchange gain		1,200

To record receipt from British Products Company: 40,000 pounds ´ $1.63.

 

E12-9

 

1     a.  December 1, 2006  No entry is necessary

 

      b.  December 31, 2006

	Other Comprehensive Income (-SE)	$9,901
	Forward Contract (+L)		$9,901

Forward contract value at 12/31/06($1,000 - $980)*500 = $10,000/(1.005)²= $9,901 liability

 

      c.  Settlement date February 28, 2007

	Forward Contract (-L)	$9,901
	Forward Contract (+A)	2,500
	Other Comprehensive Income (+SE)		$12,401

Forward contract value at 2/28/07($1,000 - $1,005)*500 = $2,500 asset.  The forward contract liability at 12/31/06 is eliminated and the asset established.  Accordingly, the corresponding credit to other comprehensive income, $12,401, will result in an ending balance of $2,500 credit in other comprehensive income.

 

	Rice Inventory ($1,005 * 500)	$502,500
	Cash		$502,500

    To record the rice purchase at market price

 

 

	Cash	$2,500
	Forward Contract (-A)		$2,500

    To record the forward contract settlement

 

2 

	Cash	$600,000
	Sales		$600,000
	Cost of Goods Sold	$500,000
	Other Comprehensive Income	2,500
	Inventory		$502,500

 

 

E12-10

 

1     a.  December 1, 2006

     No entry is necessary

 

      b.  December 31, 2006

	Loss on forward contract	$9,901
	Forward Contract		$9,901

Forward contract value at 12/31/06($1,000 - $980)*500 = $10,000/(1.005)²= $9,901 liability

 

	Firm Purchase Commitment	$9,901
	Gain on firm purchase commitment		$9,901

 

 

      c.  Settlement date February 28, 2007

	Forward Contract	$9,901
	Forward Contract	2,500
	Gain on forward contract		$12,401

Forward contract value at 2/28/07($1,000 - $1,005)*500 = $2,500 asset. 

 

 

	Loss on firm purchase commitment	$12,401
	Firm purchase commitment (-A)		$9,901
	Firm purchase commitment (+L)		2,500

 

 

 

	Rice Inventory	$500,000
	Firm purchase commitment	2,500
	Cash		$502,500

To record the rice purchase at market price

 

 

 

 

	Cash	$2,500
	Forward Contract (-A)		$2,500

To record the forward contract settlement

 

2. 

	Cash	$600,000
	Sales		$600,000
	Cost of Goods Sold	$500,000
	Inventory		$500,000

 

 

Solution E12-11

 

March 1, 2006

	Inventory	$16,300
	Accounts payable (pesos)		$16,300

To record purchase of inventory items denominated in pesos:

100,000 pesos ´ $.1630.

 

Forward contract—no entry is necessary

 

May 30, 2006

	Cash (pesos)	$16,000
	Exchange loss	500
	Cash		$16,500

To record receipt of 100,000 pesos from the exchange broker when the exchange rate is $.1600. Exchange loss: 100,000 pesos ´ ($.1650 - $.1600).

 

 

	Accounts payable (pesos)	$16,300
	Cash (pesos)		$16,000
	Exchange gain		300

To record payment to Cavilier of 100,000 pesos. Gain: 100,000 pesos ´ ($.1630 - $.1600).

 

 

 

Solution E12-12

1     December 1, 2006

	Inventory	$5,500
	Accounts Payable (yen)		$5,500

      Spot rate is $.00055*10,000,000 = $5,500

 

No entry is necessary related to the forward contract is necessary at this date.

 

      December 31, 2006

	Exchange Loss	$100
	Accounts Payable (yen)		$100

Entry to mark the accounts payable to the spot rate at year-end.

 

 

	Other Comprehensive Income	$100
	Exchange gain		$100

Amount reclassified out of other comprehensive income in order to offset the exchange loss since this is a cash flow hedge situation.

 

	Exchange Loss	$99.10
	Other comprehensive income		$99.10

The discount resulting from the forward contract is amortized to income over the contract’s term.  To solve for the effective interest rate $5,500*(1+r)²= $5,700. $5,700 = the forward rate .00057*10,000,000 = $5,700.  Solving for r= 1.80195%.  The discount amortization for this is .0180195*$5,500 = $99.10.

 

Summary:  A loss of $99.10 is reflected in 2006 income.

 

 

2    

 

      January 30, 2007

	Exchange Loss	$100
	Accounts Payable		$100

To mark Accounts Payable to spot rate

 

	Cash (yen)	$5,700
	Cash		$5,700

To record receipt of 10,000,000 pesos from the exchange broker.

 

	Other Comprehensive Income	$100
	Exchange Gain		$100

To record payment of cash to the exchange broker.

 

	Exchange Loss	$100.90
	Other Comprehensive Income		$100.90

To record amortization of discount for the last portion of the forward contract’s term. 

 

Summary:  A loss of $100.90 is reflected in 2007 income.  Notice that the balance in Other Comprehensive Income is now $0.  (12/31/06 $100 debit – $99.10 credit = $.90 debit 12/31/06.  $.90 debit + 100 debit - $100.90 credit = $0 balance at 1/30/07).

 

Solution E12-13 [AICPA adapted]

 

1     Assuming that this is a fair value hedge.  At 12/31/06, $3,000 is the forward contract fair value [100,000*($.90 forward rate contracted - $.93 Forward contract rate at 12/31/06) = $3,000].

 

Since this contract will not be settled for 72 days, the present value of the contract is $2,929 using .03288%  [i=12%/365 days] , n=72 and future value of $3,000.  The exchange gain related to this contract is recorded at 12/31/06 and the forward contract asset account is debited.

 

      December 31, 2006

	Forward Contract	$2,929
	Exchange Gain		$2,929

      To record forward contract at market

 

	Exchange Loss	$10,000
	Accounts Payable		$10,000

      To mark accounts payable to fair value at 12/31/06 (this assumes that the accounts payable was marked to market on 12/12/06, the date the forward contract was entered into)

 

 

 

2     This firm purchase commitment would be accounted for as a fair value hedge. 

      December 31, 2006

	Forward Contract	$2,929
	Exchange Gain		$2,929

 

	Exchange Loss	$2,929
	Firm purchase commitment		$2,929

 

3     The forward contract would again be recorded at fair value throughout the life of the contract.  Therefore, a $2,929 gain would be reported at 12/31/06.

 

Solution E12-14

 

April 1, 2006

	Contract receivable	$35,250
	Contract payable (fc)		$35,250

To record forward contract to sell 50,000 Canadian dollars to the exchange broker at the forward rate of .705 for delivery on May 31 for $35,250.

 

May 31, 2006

	Cash (fc)	$36,250
	Sales		$36,250

To record sale of fittings to Windsor for 50,000 Canadian dollars: ($.725 ´ 50,000 Canadian)

 

	Contract payable (fc)	$35,250
	Exchange loss on forward contract	1,000
	Cash (fc)		$36,250

To record payment of the contract denominated in Canadian dollars to the exchange broker.

 

	Cash	$35,250
	Contract receivable		$35,250

To record receipt of the $35,250 from the exchange broker to settle the account receivable denominated in U.S. dollars.

 

	Sales	$ 1,000
	Exchange loss		$ 1,000

To reclassify exchange loss on forward contract as an adjustment of the selling price.

 

Alternative solution:

On April 1, 2006, no entry is necessary if the forward contract allowed net settlement.  If this is the case, the May 31, 2006 entries would be:

 

May 31, 2006

	Cash	$36,250
	Sales		$36,250

To record sale of fittings to Windsor for 50,000 Canadian dollars: ($.725 ´ 50,000 Canadian).  Assuming immediate conversion of the Canadian dollars to U.S. dollars at the current exchange rate.

 

 

	Exchange loss on forward contract	1,000
	Cash		$1,000

To record net settlement of the exchange contract.

 

 

	Sales	$ 1,000
	Exchange loss		$ 1,000

To reclassify exchange loss on forward contract as an adjustment of the selling price.

 

 

 

Solution E12-15

 

1     Entry on November 2 for contract with the exchange broker:

 

	Contract receivable (fc)	$ 7,800
	Contract payable		$ 7,800

To record contract to purchase 1,000,000 yen in 90 days at the future rate.

 

If this contract allowed for net settlement, then no entry would be necessary on November 2.

 

2     No journal entry needed as the 30-day future rate at the end of the year is at $.0078 which was the same rate as the 90-day rate on November 2.

 

Solution E12-16

Comment: The contract receivable and payable are both recorded instead of recording the contract net because Martin must deliver the euros to the exchange broker, net settlement is not allowed.

 

October 2, 2006

	Contract receivable	$653,000
	Contract payable (fc)		$653,000

To record contract to sell 1,000,000 euros to exchange broker in 180 days for the forward rate of $.6530.

 

December 31, 2006

	Contract payable (fc)	$ 12,000
	Exchange gain		$ 12,000

To adjust contract payable in euros to the 90-day forward rate of $.6410.

 

March 31, 2007

	Contract payable (fc)	$641,000
	Exchange loss	14,000
	Cash (fc)		$655,000

To record payment of 1,000,000 euros to exchange broker when spot rate is $.6550.

 

	Cash	$653,000
	Contract receivable		$653,000

To record receipt of U.S. dollars from exchange broker in settlement of account.

 

SOLUTIONS TO PROBLEMS

 

Solution P12-1

 

1, 2		Per	Balance	Exchange Gain
		Books	Sheet	or (Loss)
	Accounts receivable
	U.S. dollars	$28,500	$28,500
	Swedish Krona (20,000 ´ $.66)	11,800	13,200	$1,400
	British pounds(25,000 ´ $1.65)	41,000	41,250	250
		$81,300	$82,950	1,650
	Accounts payable
	U.S. dollars	$ 6,850	$ 6,850
	Canadian dollars (10,000 ´ $.70)	7,600	7,000	$  600
	British pounds (15,000 ´ $1.65)	24,450	24,750	(300)
		$38,900	$38,600	300
	Net exchange gain			$1,950

 

3     Collect receivables:

 

	Cash	$28,500
	Accounts receivable		$28,500

To record collection of accounts receivable.

 

	Cash	$13,400
	Accounts receivable (Krona)		$13,200
	Exchange gain		200

To collect 20,000 Krona at $.67 spot rate.

 

	Cash	$40,750
	Exchange loss	500
	Accounts receivable (pounds)		$41,250

To collect 25,000 pounds at $1.63 spot rate.

 

4     Settlement of accounts payable:

 

	Accounts payable	$ 6,850
	Cash		$ 6,850

To record payment of accounts denominated in dollars.

 

	Accounts payable (Canadian $)	$ 7,000
	Exchange loss		100
	Cash		$ 7,100

To record payment of account denominated in Canadian dollars at $.71 spot rate.

 

	Accounts payable (pounds)	$24,750
	Cash		$24,300
	Exchange gain		450

To record payment of 15,000 pounds at $1.62 spot rate.

 

 Solution P12-2

 

1, 2			Balance	Exchange Gain
		Per Books	Sheet	or (Loss)
	Accounts receivable
	British pounds (100,000 ´ 1.660)	$165,000	$166,000	$1,000
	Euros (250,000 ´ $.670)	165,000	167,500	2,500
	Swedish krona (160,000 ´ $.640)	105,600	102,400	(3,200)
	Japanese yen (2,000,000 ´ $.0076)	15,000	15,200	200
		$450,600	$451,100	500
	Accounts payable
	Canadian dollars(150,000 ´ $.69)	$105,000	$103,500	$1,500
	Swedish krona (220,000 ´ $.135)	28,600	29,700	(1,100)
	Japanese yen (4,500,000 ´ $.0076)	33,300	34,200	(900)
		$166,900	$167,400	(500)
	Net exchange gain			$    0

 

3     The company would need to enter into a contract to deliver 250,000 euros (sell them) since it would be receiving euros and would need to convert them into US dollars.

 

Solution P12-3

 

1     The purpose of this hedge is to reduce variability in cash flows in the future since the firm entered into a variable interest loan and is swapping that for a fixed interest rate.  This is therefore a cash flow hedge.

 

2     One would expect that this is a highly effective hedge because the notional amount, $400,000 and the length of the term of the swap agreement agree. 

 

3     a.  The LIBOR rate at 12/31/06 is 5%, thus 2007’s interest rate on the variable loan will be 5% + 2% = 7%.  The swap fixed rate is 8%.  Campion will pay .01 percent more than the variable rate.  The fair value of the swap is the present value of the estimated future net payments.

 

Date of payment	Estimated payment based on 12/31/06 LIBOR rate	Factor	Present Value
12/31/07	.01*$400,000	1/(1.07)	$ 3,738
12/31/08	.01*$400,000	1/(1.07)2	3,493
12/31/09	.01*$400,000	1/(1.07)3	3,265
12/31/10	.01*$400,000	1/(1.07)4	3,051
Total			$13,547

 

      b.

      December 31, 2006 

	Other Comprehensive Income (-SE)	$13,547
	Interest Rate Swap (+L)		$13,547

To record the fair value of interest rate swap, cash flow hedge at 12/31/06.

 

 

	Interest Expense	$32,000
	Cash		$32,000

To record interest payment.

 

4. 

      December 31, 2007

	Interest Expense	$28,000
	Cash		$ 28,000

To record payment to Veneta Bank of the interest expense for the year under the variable rate loan.  The rate set on the loan at 1/1/07 was 7%.

 

	Interest Expense	$ 4,000
	Cash		$ 4,000

To record the payment due on the interest rate swap because the fixed rate is 8%.  This represents the net settlement amount.

 

	Interest rate swap (-L)	$ 8,347
	Other Comprehensive Income (+SE)		$ 8,347

To record the change in fair value of the interest rate swap.

 

The new variable rate for 2008 which is set at 12/31/07 is 5.5% + 2%.  As a result, the estimated amount that Campion would pay is reduced from 1% to .5%.

 

Date of payment	Estimated payment based on 12/31/06 LIBOR rate	Factor	Present Value
12/31/08	.005*$400,000	1/(1.075)	$ 1,860
12/31/09	.005*$400,000	1/(1.075)2	1,731
12/31/10	.005*$400,000	1/(1.075)3	1,610
Total			$ 5,200

 

     

The unadjusted Interest Rate Swap liability is $13,547 credit, the adjusted is $5,200 credit, the Interest Rate Swap Liability must be reduced by $8,347.

 

 

Solution P12-4

1.    This is a fair value hedge because the fixed rate loan’s fair value fluctuates over time as market interest rates change.  By entering into this swap agreement that fluctuation is eliminated.  So while the interest rate fluctuates, the loan’s fair value remains constant reflecting the fixed rate in the swap.

 

2.    Like P12-3, the terms match, thus this is considered to be a highly effective hedge.

 

 

 

 

 

 

 

 

3. 

      a.

Date of payment	Estimated payment based on 12/31/06 LIBOR rate	Factor	Present Value
12/31/07	.01*$400,000	1/(1.09)	$ 3,670
12/31/08	.01*$400,000	1/(1.09)2	3,367
12/31/09	.01*$400,000	1/(1.09)3	3,089
12/31/10	.01*$400,000	1/(1.09)4	2,834
Total			$12,960

 

 

 

 

b.    December 31, 2006

	Interest Expense	$32,000
	Cash		$32,000

To record interest due on fixed rate loan at 12/31/06

 

	Loan Payable (-L)	$12,960
	Interest Rate Swap		$12,960

      To record the interest rate swap at fair value, computations below.

 

Notice that the carrying value of the loan is now $387,040 ($400,000 - $12,960).  This agrees with the present value of the loan at the market rate of 9%.

Proof:  $400,000/(1.09)⁴ = $283,370 <= the present value of the maturity value.  The present value of the interest payments is $32,000*PVIFA(i=9,n=4)= $103,670. 

The total market value of the loan is $283,370 + $103,670 = $387,041.

 

4.

Date of payment	Estimated payment based on 12/31/06 LIBOR rate	Factor	Present Value
12/31/08	.005*$400,000	1/(1.085)	1,843
12/31/09	.005*$400,000	1/(1.085)2	1,699
12/31/10	.005*$400,000	1/(1.085)3	1,566
Total			$ 5,108

 

     

 

 

 

 

 

December 31, 2007

	Interest Expense			$32,000
	Cash				$32,000

To record interest due on fixed rate mortgage

 

	Interest Expense	$4,000
	Cash		$4,000

To record swap payment

 

 

	Interest Rate Swap	$7,852
	Loan Payable		$7,852

            To adjust interest rate swap to fair value, $5,108.

 

 

 

Notice that now the loan payable carrying value is:

$400,000 – 12,960 + 7,852 = $394,892.  This amount agrees with the present value of the loan at the market rate on this date, 8.5%. 

Proof:  $400,000/(1.085)³ = $313,163—Present value of the maturity value of the loan. 

The present value of the interest payments = $32,000*PVIFA(i=8.5,n=3)= $81,729.

The present value of the loan at a market rate of 8.5% is therefore $313,163 + $81,729 = $394,892.

 

Solution P12-5

 

1.    This hedge is designed to mitigate the impact of price changes on natural gas.  Since one would expect that natural gas price changes and futures market prices of natural gas to be highly correlated, this is likely to be a highly effective hedge.

 

2.    This would be accounted for as a cash flow hedge since this is a hedge of an anticipated transaction.

 

3.    November 2, 2006

	Futures contract	$100,000
	Cash		$100,000

Deposit is $5,000 * 20 contracts = $100,000

 

     

December 31,2006

	Other Comprehensive Income	$50,000
	Futures Contract		$50,000

      At 12/31/06, the futures contract price for delivery on the same date as our contract is $6.75 - $7.00 = $.25 loss per MMBtu * 10,000 * 20 contracts = $50,000 loss.

 

      February 2, 2007

	Futures contract	$20,000
	Other Comprehensive Income		$20,000

$6.85 - $6.75 = $.10 * 10,000 * 20 contract = $20,000 gain

 

	Cash	$70,000
	Futures contract		$70,000

      To record final settlement of futures contract.

     

 

	Gas Inventory	$1,370,000
	Cash		$1,370,000

      To record the purchase of natural gas at market rates.

 

      February 3, 2007

	Cash	$1,600,000
	Gas Revenue		$1,600,000

To record gas sale at $8.00 per MMBtu

 

 

	Cost of Goods Sold	$1,370,000
	Gas Inventory		$1,370,000

           

 

	Cost of Goods Sold	$30,000
	Other Comprehensive Income		$30,000

To record cost of goods sold so that it reflects the futures contract rate per the hedging contract, $7.00 per MMBtu.

 

 

Solution P12-6

NOTE: Parts 4 and 5 below are computed using the corrected market prices of $9 per troy ounce on December 31, 2006 (part 4) and $9.50 on February 1, 2007 (part 5). The market prices listed in the problem are incorrect.

 

1.    Yes, because the terms of the purchase commitment and the hedge instrument match. 

 

2.    This is a fair value hedge because a firm purchase commitment is being hedged instead of a an anticipated purchase.

 

3.   

	Silver options	$1,000
	Cash		$1,000

 

4.    December 31, 2006

	Loss on firm purchase commitment	$1,194,030
	Change in value of firm purchase commitment		$1,194,030

 

	Silver options	$1,193,030
	Gain		$1,193,030

1,200,000 * $1 change  ($10-$9) = $1,200,000 which will occur in 1 month (purchase and option expiration).  $1,200,000/1.005 = $1,194,030.  This is the present value of the firm purchase commitment and the option at 12/31/06 assuming 6% annual interest. 

 

Since the option already has a $1,000 balance, $1,193,030 will need to be recorded.

     

5.

	Change in value of firm purchase commitment	$594,030
	Gain		$594,030

To record the change in the firm purchase commitment.  ($9 - $9.50)* 1,200,000.  The ending balance is $600,000 after this adjustment.

 

	Loss	$594,030
	Silver option		$594,030

The silver options value has also declined.  However, the company will still exercise the option.

 

	Cash	$600,000
	Silver option		$600,000

      To record exercise of option.

 

	Silver inventory	$11,400,000
	Change in value of firm purchase commitment	600,000
	Cash		$12,000,000

      To record purchase of silver inventory.

 

 

 

Solution P12-7

 

1	Entries on April 1
	Accounts receivable (pesos)	$33,060
	Sales		$33,060

To record sales on account denominated in pesos: 200,000 pesos / 6.0496 LCUs

 

No entry to record the contract is necessary

 

2	Entries on May 30
	Cash (pesos)	$33,378
	Accounts receivable (pesos)		$33,060
	Exchange gain		318

To record collection of receivable in LCUs: 200,000 LCUs / 5.992 LCUs

 

	Cash	$33,228
	Exchange loss	150
	Cash (pesos)		$33,378

To record delivery of 200,000 pesos to the exchange broker.

 

     

 

 

 

 

Solution P12-8

 

1     Entry on October 2, 2006

	Contract receivable (euros)	$31,750
	Contract payable		$31,750

To record forward contract to purchase 50,000 euros at $.6350 as a hedge of a firm commitment.

 

2     December 31, 2006 adjustment

	Contract receivable (euros)	$   350
	Exchange gain		$   350

To adjust the contract receivable for 50,000 euros to the $.6420 future exchange rate at December 31, 2006: 50,000 euros ´ ($.6420 - $.6350).

 

	Exchange loss	$   350
	Change in value of firm commitment		$   350

To record the change in the value of the underlying firm commitment hedged.

 

3     Entries on March 31, 2007

	Contract payable	$31,750
	Cash		$31,750

To pay exchange broker for 50,000 euros at the forward rate of $.6350 established on October 2, 2003.

 

	Cash (euros)	$32,800
	Contract receivable (euros)		$32,100
	Exchange gain		700

To record receipt of 50,000 euros from exchange broker when spot rate is $.6560.

 

	Exchange Loss	$   700
	Change in value of firm commitment		$   700

To record the change in the value of the underlying firm commitment hedged.

 

	Purchases	$32,800
	Cash (euros)		$32,800

To record purchase and payment in euros at $.6560 spot rate.

 

	Change in value of firm commitment	$ 1,050
	Purchases		1,050

To record the adjustment of purchases for the change in the value of the firm commitment. This effectively fixes the purchase at the original forward rate.

 

 

Solution P12-9

We will assume that the hedge contract is to be settled net.

 

December 2, 2006

No entry

 

December 31, 2006

	Other comprehensive income: exchange loss	$ 4,950
	Forward contract		$ 4,950

Forward contract, 12/31/06, $1.69 – contract rate $1.68 = $.01 * 500,000 = $5,000.  This is to be paid in two months so the present value assuming 6% annual interest rate is:  $5,000/(1.005)² = $4,950.

 

	Exchange Loss	$ 3,346
	Other comprehensive income		$ 3,346

            To record discount amortization. See table below

 

March 1, 2007

	Cash (fc)	$855,000
	Sales		$855,000

To record delivery of equipment to Ramsay Ltd. and collection of 500,000 pounds at the $1.71 spot rate.

 

	Other comprehensive income: exchange loss	$10,050
	Forward contract		$10,050

To increase the forward contract to the final liability amount: $1.71-$1.68 = $.03*500,000 = $15,000 - $4,950 = $10,050 adjustment.

 

	Exchange Loss	$6,653
	Other comprehensive income		$6,653

            To record discount amortization. (See table below)

 

	Forward contract	$15,000
	Cash		$15,000

To record forward contract payment.

 

 

	Sales	$10,000
	Other comprehensive income		$10,000

 

 

      Discount amortization:

The spot rate at the date the forward contract was entered into $1.70*500,000 = $850,000. $1.68 * 500,000 = $840,000.  The discount of $10,000 must be amortized over the contract period.  The effective interest rate equates these two amounts using a 3 month time period, that rate is .3937%. 

 

Date	Discount amortization	Balance
		$ 850,000
December 31, 2006	$  3,346	846,654
January 31, 2007	3,333	843,320
March 1, 2007	3,320	840,000

 

Solution P12-10

 

1     December 16, 2006

	Equipment	$668,000
	Accounts payable (fc)		$668,000

To record purchase of equipment (400,000 pounds ´ $1.67).

 

2     December 31, 2006

	Accounts payable (fc)	$  8,000
	Exchange gain		$  8,000

To adjust accounts payable for currency exchange rate change: 400,000 pounds ´ ($1.67 - $1.65).

 

	Other Comprehensive Income	$  7,980
	Forward Contract		$  7,980

To record the forward contract loss at 12/31/06

 

 

	Exchange loss	$  8,000
	Other Comprehensive Income		$  8,000

To reclassify an amount from Other Comprehensive Income to offset the gain on the accounts payable

 

	Exchange Loss	$  1,994
	Other Comprehensive Income		$  1,994

To amortize the premium.  The premium is the difference between the $668,000 spot price for pounds at the date the contract was entered into and $672,000, the contracted amount.  This difference must be amortized to income over the 30 day period.  The effective interest rate is computed as follows:

$672,000 = $668,000* (1+r)³⁰, solving for r (the daily interest rate) = .0199025%.  $668,000*.000199025*15= $1,994.

 

December 31, 2006 account balances:

Accounts Payable                   $660,000

Forward Contract                      7,980 credit

Other comprehensive income            2,014 credit

 

Exchange loss (net)                   1,994

 

 

3     January 15, 2007

 

	Accounts payable (fc)	$4,000
	Exchange gain		$  4,000

To mark the accounts payable to fair value.

 

	Other comprehensive income	$8,020
	Forward contract		$   8,020

            To mark the forward contract to fair value.

 

	Exchange loss	$4,000
	Other Comprehensive Income		$  4,000

To record the reclassification from OCI to offset the exchange gain on the accounts payable

 

	Exchange loss	$2,006
	Other Comprehensive Income		$2,006

            To record the amortization of the premium

The total premium is $4,000 ($672,000 - $668,000), the portion left to be amortized is $4,000 - $1,994 = $2,006.

 

     

	Cash (fc)	$656,000
	Forward contract	16,000
	Cash		$672,000

      To record the settlement of the forward contract.

 

 

	Accounts payable (fc)	$656,000
	Cash (fc)		$656,000

To record payment of accounts payable in pounds.

 

January 15, 2007 account balances:

Accounts Payable:            $0

Forward Contract:

$7,980 credit + $8,020 – $16,000 = $0

Other Comprehensive Income:

$2,014 credit - $8,020 dr + $4,000 cr + $2,006 cr =  $0

 

Exchange Loss (net):         $2,006