SM Hoyle AdvAcc11e Ch09

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CHAPTER 9
FOREIGN CURRENCY TRANSACTIONS AND
HEDGING FOREIGN EXCHANGE RISK
Chapter Outline
I. In todays 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
companys 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. Statement 52 of the Financial Accounting Standards Board, issued in December 1981,
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
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 is also used in accounting for foreign
currency payables. Receivables and payables denominated in foreign currency create an
exposure to foreign exchange risk.
IV. FASB Statement 133 (as amended by FASB Statement 138) governs the accounting for
derivative financial instruments and hedging activities including the use of foreign currency
forward contracts and foreign currency options.
A. The fundamental requirement of SFAS 133 is that all derivatives must be carried on the
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Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e 9-1
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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. SFAS 133 (as amended by SFAS 138) provides guidance for hedges of the following
sources of foreign exchange risk:
1. foreign currency denominated assets and liabilities.
2. foreign currency firm commitments.
3. forecasted foreign 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 fair value exposure or cash flow exposure to
foreign exchange risk,
2. the derivative is highly effective in offsetting changes in the fair value or cash flows
related to the hedged item, and
3. the derivative is properly documented as a hedge.
D. SFAS 133 allows hedge accounting 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 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 periods 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 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.
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
9-2 Solutions Manual
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. SFAS 133 allows cash flow hedge accounting 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).
Learning Objectives
Having completed Chapter 9, Foreign Currency Transactions and Hedging Foreign Exchange
Risk, students should be able to fulfill each of the following learning objectives:
1. Read and understand published foreign exchange quotes.
2. Understand the one-transaction and two-transaction perspectives to accounting for foreign
currency transactions.
3. Account for foreign currency transactions using the two-transaction perspective.
4. Explain the concept of exposure to foreign exchange risk that arises from foreign currency
transactions.
5. Explain how forward contracts and options can be used to hedge foreign exchange risk.
6. Account for forward contracts and options used as hedges of
a. foreign currency denominated assets and liabilities,
b. foreign currency firm commitments, and
c. forecasted foreign currency transactions.
7. Account for foreign currency borrowings.

Answer to Discussion Question
Do we have a gain or what?

This case demonstrates the differing kinds of information provided through application of current
accounting rules for foreign currency transactions and derivative financial instruments.
The Ahnuld Corporation could have received $200,000 from its export sale to Tcheckia if it had
required immediate payment. Instead, Ahnuld allows its customer six months to pay. Given the
future exchange rate of $1.70, Ahnuld would have received only $170,000 if it had not entered into
the forward contract. This would have resulted in a decrease in cash inflow of $30,000. In
accordance with SFAS 52, the decrease in the value of the tcheck receivable is recognized as a
foreign exchange loss of $30,000. This loss represents the cost of extending credit to the foreign
customer if the tcheck receivable is left unhedged.
However, rather than leaving the tcheck receivable unhedged, Ahnuld sells tchecks forward at a
price of $180,000. Because the future spot rate turns out to be only $1.70, the forward contract
provides a benefit, increasing the amount of cash received from the export sale by $10,000. In
accordance with SFAS 133, the change in the fair value of the forward contract (from zero initially to
$10,000 at maturity) is recognized as a gain on the forward contract of $10,000. This gain reflects
the cash flow benefit from having entered into the forward contract, and is the appropriate basis for
evaluating the performance of the foreign exchange risk manager. (Students should be reminded
that the forward contract will not always improve cash inflow. For example, if the future spot rate
were $1.85, the forward contract would result in $5,000 less cash inflow than if the transaction were
left unhedged.)
The net impact on income resulting from the fluctuation in the value of the tcheck is a loss of
$20,000. Clearly, Ahnuld forgoes $20,000 in cash inflow by allowing the customer time to pay for
the purchase, and the net loss reported in income correctly measures this. The $20,000 loss is
useful to management in assessing whether the sale to Tcheckia generated an adequate profit
margin, but it is not useful in assessing the performance of the foreign exchange risk manager. The
net loss must be decomposed into its component parts to fairly evaluate the risk managers
performance.
Gains and losses on forward contracts designated as fair value hedges of foreign currency assets
and liabilities are relevant measures for evaluating the performance of foreign exchange risk
managers. (The same is not true for cash flow hedges. For this type of hedge, performance should
be evaluated by considering the net gain or loss on the forward contract plus or minus the forward
contract premium or discount.)

Answers to Questions
1. Under the two-transaction perspective, an export sale (import purchase) and the subsequent
collection (payment) of cash are treated as two separate transactions to be accounted for
separately. The idea is that management has made two decisions: (1) to make the export sale
(import purchase), and (2) to extend credit in foreign currency to the foreign customer (obtain
credit from the foreign supplier). The income effect from each of these decisions should be
reported separately.
2. Foreign currency receivables resulting from export sales are revalued at the end of accounting
periods using the current spot rate. An increase in the value of a receivable will be offset by
reporting a foreign exchange gain in net income, and a decrease will be offset by a foreign
exchange loss. Foreign exchange gains and losses are accrued even though they have not
yet been realized.
3. Foreign exchange gains and losses are created by two factors: having foreign currency
exposures (foreign currency receivables and payables) and changes in exchange rates.
Appreciation of the foreign currency will generate foreign exchange gains on receivables and
foreign exchange losses on payables. Depreciation of the foreign currency will generate
foreign exchange losses on receivables and foreign exchange gains on payables.
4. Hedging is the process of eliminating exposure to foreign exchange risk so as to avoid

potential losses from fluctuations in exchange rates. In addition to avoiding possible losses,
companies hedge foreign currency transactions and commitments to introduce an element of
certainty into the future cash flows resulting from foreign currency activities. Hedging involves
establishing a price today at which foreign currency can be sold or purchased at a future date.
5. A party to a foreign currency forward contract is obligated to deliver one currency in exchange
for another at a specified future date, whereas the owner of a foreign currency option can
choose whether to exercise the option and exchange one currency for another or not.
6. Hedges of foreign currency denominated assets and liabilities are not entered into until a
foreign currency transaction (import purchase or export sale) has taken place. Hedges of firm
commitments are made when a purchase order is placed or a sales order is received, before a
transaction has taken place. Hedges of forecasted transactions are made at the time a future
foreign currency purchase or sale can be anticipated, even before an order has been placed or
received.
7. Foreign currency options have an advantage over forward contracts in that the holder of the
option can choose not to exercise if the future spot rate turns out to be more advantageous.
Forward contracts, on the other hand, can lock a company into an unnecessary loss (or a
reduced gain). The disadvantage associated with foreign currency options is that a premium
must be paid up front even though the option might never be exercised.
8. SFAS 133 requires an enterprise to recognize all derivative financial instruments as assets or
liabilities on the balance sheet and measure them at fair value.
9. The fair value of a foreign currency forward contract is determined by reference to changes in
the forward rate over the life of the contract, discounted to the present value. Three pieces of

information are needed to determine the fair value of a forward contract at any point in time
during its life: (a) the contracted forward rate when the forward contract is entered into, (b) the
current forward rate for a contract that matures on the same date as the forward contract
entered into, and (c) a discount rate; typically, the companys incremental borrowing rate.
The manner in which the fair value of a foreign currency option is determined depends on
whether the option is traded on an exchange or has been acquired in the over the counter
market. The fair value of an exchange-traded foreign currency option is its current market price
quoted on the exchange. For over the counter options, fair value can be determined by
obtaining a price quote from an option dealer (such as a bank). If dealer price quotes are
unavailable, the company can estimate the value of an option using the modified Black-
Scholes option pricing model. Regardless of who does the calculation, principles similar to
those in the Black-Scholes pricing model will be used in determining the value of the option.
10. Hedge accounting is defined as recognition of gains and losses on the hedging instrument in
the same period as the recognition of gains and losses on the underlying hedged asset or
liability (or firm commitment).
11. For hedge accounting to apply, the forecasted transaction must be probable (likely to occur),
the hedge must be highly effective in offsetting fluctuations in the cash flow associated with the
foreign currency risk, and the hedging relationship must be properly documented.
12. In both cases, (1) sales revenue (or the cost of the item purchased) is determined using the
spot rate at the date of sale (or purchase), and (2) the hedged asset or liability is adjusted to
fair value based on changes in the spot exchange rate with a foreign exchange gain or loss
recognized in net income.
For a cash flow hedge, the derivative hedging instrument is adjusted to fair value (resulting in
an asset or liability reported on the balance sheet), with the counterpart recognized as a
change in Accumulated Other Comprehensive Income (AOCI). An amount equal to the
foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to
net income; the net effect is to offset any gain or loss on the hedged asset or liability. An
additional amount is removed from AOCI and recognized in net income to reflect (a) the
current periods amortization of the original discount or premium on the forward contract (if a
forward contract is the hedging instrument) or (b) the change in the time value of the option (if
an option is the hedging instrument).
For a fair value hedge, the derivative hedging instrument is adjusted to fair value (resulting in
an asset or liability reported on the balance sheet), with the counterpart recognized as a gain
or loss in net income. The discount or premium on a forward contract is not allocated to net
income. The change in the time value of an option is not recognized in net income.
13. For a fair value hedge of a foreign currency asset or liability (1) sales revenue (cost of
purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged
asset or liability is adjusted to fair value based on changes in the spot exchange rate with a
foreign exchange gain or loss recognized in net income. The forward contract is adjusted to
fair value based on changes in the forward rate (resulting in an asset or liability reported on the
balance sheet), with the counterpart recognized as a gain or loss in net income. The foreign
exchange gain (loss) and the forward contract loss (gain) are likely to be of different amounts
resulting in a net gain or loss reported in net income.
For a fair value hedge of a firm commitment, there is no hedged asset or liability to account for.
The forward contract is adjusted to fair value based on changes in the forward rate (resulting in
an asset or liability reported on the balance sheet), with a gain or loss recognized in net
income. The firm commitment is also adjusted to fair value based on changes in the forward
rate (resulting in a liability or asset reported on the balance sheet), and a gain or loss on firm
commitment is recognized in net income. The firm commitment gain (loss) offsets the forward
contract loss (gain) resulting in zero impact on net income. Sales revenue (cost of purchases)
is recognized at the spot rate at the date of sale (purchase). The firm commitment account is
closed as an adjustment to net income in the period in which the hedged item affects net
income.
14. For a cash flow hedge of a foreign currency asset or liability (1) sales revenue (cost of
purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged
asset or liability is adjusted to fair value based on changes in the spot exchange rate with a
foreign exchange gain or loss recognized in net income. The forward contract is adjusted to
fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart
recognized as a change in Accumulated Other Comprehensive Income (AOCI). An amount
equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred
from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or
liability. An additional amount is removed from AOCI and recognized in net income to reflect
the current periods 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 periods 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
payablesthe note payable and interest payable. As both the face value of the borrowing and
accrued interest represent foreign currency liabilities, both are exposed to foreign exchange
risk and can give rise to foreign currency gains and losses.

Answers to Problems
1. C An import purchase causes a foreign currency payable to be carried on the

books. If the foreign currency depreciates, the dollar value of the foreign
currency payable decreases, yielding a foreign exchange gain.
2. D SFAS 52 requires a two-transaction perspective, accrual approach.
3. B Foreign exchange gains related to foreign currency import purchases are

treated as a component of income before income taxes. If there is no foreign
exchange gain in operating income, then the purchase must have been
denominated in U.S. dollars or there was no change in the value of the
foreign currency from October 1 to December 1, 2009.
4. C The dollar value of the LCU receivable has decreased from $110,000 at
December 31, 2009 to $95,000 at February 15, 2010. This decrease of $15,000
should be reported as a foreign exchange loss in 2010.
5. D The increase in the dollar value of the euro note payable represents a foreign
exchange loss. In this case a $25,000 loss would have been accrued in 2009
and a $10,000 loss will be reported in 2010.
6. D A foreign currency receivable will generate a foreign exchange gain when the
foreign currency increases in dollar value. A foreign currency payable will
generate a foreign exchange gain when the foreign currency decreases in
dollar value. Hence, the correct combination is franc (increase) and peso
(decrease).
7. D The merchandise purchase results in a foreign exchange loss of $8,000, the

difference between the U.S. dollar equivalent at the date of purchase and at
the date of settlement.
The increase in the dollar equivalent of the 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 The Thai baht is selling at a premium (forward rate exceeds spot rate). The
exporter will receive more dollars as a result of selling the baht forward than
if the baht had been received and converted into dollars on April 1. Thus, the
premium results in additional revenue for the exporter.
9. D The parts inventory will be recognized at the spot rate at the date of purchase
(FC100,000 x $.23 = $23,000).

10. D The forward contract must be reported on the December 31, 2009 balance
sheet as a liability. Barnum has locked-in to purchase ringgits at $0.042 per
ringgit but could have locked-in to purchase ringgits at $0.037 per ringgit if it
had waited until December 31 to enter into the forward contract. The forward
contract must be reported at its fair value discounted for two months at 12%
[($.042 $.037) x 1,000,000 = $5,000 x .9803 = $4,901.50].
11. C The 10 million won receivable has changed in dollar value from $35,000 at
12/1/09 to $33,000 at 12/31/09. The won receivable will be written down by
$2,000 and a foreign exchange loss will be reported in 2009 income.
12. B The nominal value of the forward contract on December 31, 2009 is a positive
$2,000, the difference between the amount to be received from the forward
contract actually entered into, $34,000 ($.0034 x 10 million), and the amount
that could be received by entering into a forward contract on December 31,
2009 that matures on March 31, 2010, $32,000 ($.0032 x 10 million). The fair
value of the forward contract is the present value of $2,000 discounted for
two months ($2,000 x .9706 = $1,941.20). On December 31, 2009, MNC Corp.
will recognize a $1,941.20 gain on the forward contract and a foreign
exchange loss of $2,000 on the won receivable. The net impact on 2009
income is $58.80.
13. A The krona is selling at a premium in the forward market, causing Pimlico to
pay more dollars to acquire kroner than if the kroner were purchased at the
spot rate on March 1. Therefore, the premium results in an expense of
$10,000 [($.12 $.10) x 500,000].
The Adjustment to Net Income is the amount accumulated in Accumulated
Other Comprehensive Income (AOCI) as a result of recognizing the premium
expense and the fair value of the forward contract. The journal entries would
be as follows:
3/1 no journal entries
6/1 Premium Expense $10,000

AOCI $10,000
AOCI $2,500
Forward Contract $2,500
Foreign Currency $57,500

Forward Contract 2,500
Cash $60,000
AOCI $7,500
Adjustment to Net Income $7,500

14. C This is a cash flow hedge of a forecasted transaction. The original cost of the
option is recognized as an Option Expense over the life of the option.
15. B
16. D
The easiest way to solve problems 15 and 16 is to prepare journal entries for
the option fair value hedge and the firm commitment. The journal entries are
as follows:
9/1/09
Foreign Currency Option $2,000
Cash $2,000
12/31/09
Foreign Currency Option $300
Gain on Foreign Currency Option $300
Loss on Firm Commitment $980.30
Firm Commitment $980.30
[($.79 $.80) x 100,000 = $1,000 x .9803 = $980.30]
Net impact on 2009 net income:
Gain on Foreign Currency Option $300.00
Loss on Firm Commitment (980.30)
$(680.30)
3/1/10
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


16. (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
17. B Net cash inflow with option ($80,000 $2,000) $78,000

Cash inflow without option (at spot rate of $.77) 77,000
Net increase in cash inflow $ 1,000
18 and 19.
the forward contract fair value hedge of a firm commitment. The journal
entries are as follows:
3/1 no journal entries
3/31 Forward Contract $1,250

Gain on Forward Contract $1,250
($1,250 $0)
Loss on Firm Commitment $1,250

Net impact on first quarter net income is $0.

18 and 19. (continued)
4/30 Loss on Forward Contract $250

Forward Contract $250
[Fair value of forward contract is
($.120 $.118) x 500,000 = $1,000;
$1,000 $1,250 = $250]
Firm Commitment $250
Gain on Firm Commitment $250
Foreign Currency (pesos) $59,000
Sales [500,000 pesos x $.118] $59,000
Cash [500,000 x $.120] $60,000
Foreign Currency (pesos) $59,000
Net impact on second quarter net income is: Sales $59,000 Loss on Forward
Contract $250 + Gain on Firm Commitment $250 + Adjustment to Net Income
$1,000 = $60,000.
18. A
19. C
20. B Cash inflow with forward contract [500,000 pesos x $.12] $60,000
Cash inflow without forward contract [500,000 pesos x $.118] 59,000
Net increase in cash flow from forward contract $ 1,000

21 and 22.
the option cash flow hedge of a forecasted transaction. The journal entries
are as follows:
11/1/09
Cash $1,500
12/31/09
Option Expense $400
(The option has no intrinsic value at 12/31/09 so the entire change in fair
value is due to a change in time value; $1,500 $1,100 = $400 decrease in
time value. The decrease in time value of the option is recognized as an
expense in net income.)
Option Expense decreases net income by $400.
2/1/10
Option Expense $1,100
Foreign Currency Option 900
Accumulated Other Comprehensive Income (AOCI) $2,000
(Record expense for the decrease in time value of the
option; $1,100 $0 = $1,100; and write-up option to fair
value ($.40 $.41) x 200,000 = $2,000 $1,100 = $900.)
Foreign Currency (BRL) [200,000 x $.41] $82,000

Cash [200,000 x $.40] $80,000
Parts Inventory (Cost-of-Goods-Sold) $82,000

Foreign Currency (BRL) $82,000


21 and 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 Purchase/Payable)
The decrease in the dollar value of the LCU payable from November 1 (60,000 x
.345 = $20,700) to December 31 (60,000 x .333 = $19,980) is recorded as a $720
foreign exchange gain in 2009. The increase in the dollar value of the LCU
payable from December 31 ($19,980) to January 15 (60,000 x .359 = $21,540) is
recorded as a $1,560 foreign exchange loss in 2010.
24. (10 minutes) (Foreign Currency Sale/Receivable)
The ostra receivable decreases in dollar value from (50,000 x $1.05) $52,500 at
December 20 to $51,000 (50,000 x $1.02) at December 31, resulting in a foreign
exchange loss of $1,500 in 2009. The further decrease in dollar value of the
ostra receivable from $51,000 at December 31 to $49,000 (50,000 x $.98) at
January 10 results in an additional $2,000 foreign exchange loss in 2010.
25. (10 minutes) (Foreign Currency Sale/Receivable)
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


26. (10 minutes) (Foreign Currency Purchase/Payable)
12/1/09 Inventory $52,800

Accounts Payable (LCU) [60,000 x $.88] $52,800
12/31/09 Accounts Payable (LCU) [60,000 x ($.82 $.88)] $3,600

Foreign Exchange Gain $3,600
1/28/10 Foreign Exchange Loss $4,800

Accounts Payable (LCU) [60,000 x ($.90 $.82)] $4,800
Accounts payable (LCU) $54,000

Cash $54,000
27. (15 minutes) (Determine U.S. Dollar Balance for Foreign Currency Transactions)
Inventory and Cost of Goods Sold are reported at the spot rate at the date the
inventory was purchased. Sales are reported at the spot rate at the date of sale.
Accounts Receivable and Accounts Payable are reported at the spot rate at the
balance sheet date. Cash is reported at the spot rate when collected and the
spot rate when paid.
Inventory [50,000 pesos x 40% x $.17] ......................................................... $3,400

COGS [50,000 pesos x 60% x $.17] .............................................................. $5,100
Sales [45,000 pesos x $.18]........................................................................... $8,100
Accounts Receivable [45,000 40,000 = 5,000 pesos x $.21] ..................... $1,050
Accounts Payable [50,000 30,000 = 20,000 pesos x $.21] ........................ $4,200
Cash [(40,000 x $.19) (30,000 x $.20)] ........................................................ $1,600

28. (25 minutes) (Prepare Journal Entries for Foreign Currency Transactions)
2/1/09 Equipment $17,600

Accounts Payable (L) [40,000 x $.44] $17,600
4/1/09 Accounts Payable (L) $17,600

Foreign Exchange Loss 400
Cash [40,000 x $.45] $18,000
6/1/09 Inventory $14,100

Accounts Payable (L) [30,000 x $.47] $14,100
8/1/09 Accounts Receivable (L) [40,000 x $.48] $19,200

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

Inventory [$14,100 x 70%] $9,870
10/1/09 Cash [30,000 x $.49] $14,700

Accounts Receivable (L) [$19,200 x 3/4] $14,400
Foreign Exchange Gain 300
11/1/09 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
12/31/09 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
2/1/10 Cash [10,000 x $.54] $5,400

Accounts Receivable (L) [10,000 x $.52] $5,200
Foreign Exchange Gain 200
3/1/10 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 Purchase/Payable)
a. Benjamin, Inc. has a liability of AL 160,000. On the date that this liability
was created (December 1, 2009), the liability had a dollar value of $70,400
(AL 160,000 x $.44). On December 31, 2009, the dollar value has risen to
$76,800 (AL 160,000 x $.48). The increase in the dollar value of the liability
creates a foreign exchange loss of $6,400 ($76,800 $70,400) in 2009.
By March 1, 2010, when the liability is paid, the dollar value has dropped to
$72,000 (AL 160,000 x $.45) creating a foreign exchange gain of $4,800
($72,000 $76,800) to be reported in 2010.
b. Benjamin, Inc. has a liability of AL 160,000. On the date that this liability
was created (September 1, 2009), the liability had a dollar value of $73,600
(AL 160,000 x $.46). On December 1, 2009, when the liability is paid, the
dollar value has decreased to $70,400 (AL 160,000 x $.44). The drop in the
dollar value of the liability creates a foreign exchange gain of $3,200
($70,400 $73,600) in 2009.
c. Benjamin, Inc. has a liability of AL 160,000. On the date that this liability
was created (September 1, 2009), the liability had a dollar value of $73,600
(AL 160,000 x $.46). On December 31, 2009, the dollar value has risen to
$76,800 (AL 160,000 x $.48). The increase in the dollar value of the liability
creates a foreign exchange loss of $3,200 ($76,800 $73,600) in 2009.
By March 1, 2010, when the liability is paid, the dollar value has dropped to
$72,000 (AL 160,000 x $.45) creating a foreign exchange gain of $4,800
($72,000 $76,800) to be reported in 2010.

30. (30 minutes) (Foreign Currency Borrowing)
a. 9/30/09 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.)
12/31/09 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 12/31/09.)
Foreign Exchange Loss $5,000

Note payable (dudek) [1 m x ($.105 $.10)] $5,000
(To revalue the note payable at the spot rate of
$.105 and record a foreign exchange loss.)
9/30/10 Interest Expense [15,000 dudeks x $.12] $1,800

Interest Payable (dudek) 525
Foreign Exchange Loss [5,000 dudeks x
($.12 $.105)] 75
Cash [20,000 dudeks x $.12] $2,400
(To record the first annual interest payment,
record interest expense for the period 1/1 9/30/10,
and record a foreign exchange loss on the
interest payable accrued at 12/31/09.)
12/31/10 Interest Expense $625

Interest Payable (dudek) [5,000 dudeks x $.125] $625
(To accrue interest for the period 9/30 12/31/10.)
Foreign Exchange Loss $20,000

Note Payable (dudek) [1 m x ($.125 $.105)] $20,000
(To revalue the note payable at the spot rate of
$.125 and record a foreign exchange loss.)

30. (continued)
9/30/11 Interest Expense [15,000 dudeks x $.15] $2,250

Interest Payable (dudek) 625
Foreign Exchange Loss [5,000 dudeks x
($.15 $.125)] 125
Cash [20,000 dudeks x $.15] $3,000
(To record the second annual interest payment,
record interest expense for the period 1/1 9/30/11,
and record a foreign exchange loss on the interest
payable accrued at 12/31/10.)
Note Payable (dudek) $125,000

Foreign Exchange Loss 25,000
Cash [1 m dudeks x $.15] $150,000
(To record payment of the 1 million dudek note.)
b. The effective cost of borrowing can be determined by considering the total

interest expense and foreign exchange losses related to the loan and comparing
this with the amount borrowed:
2009
Interest expense $525
Foreign exchange loss 5,000
Total $5,525 / $100,000 = 5.525% for 3 months =
= 22.1% for 12 months
2010
Interest expense $2,425
Foreign exchange losses 20,075
Total $22,500 / $100,000 = 22.5% for 12 months
2011
Interest expense $2,250
Foreign exchange losses 25,125
Total $27,375 / $100,000 = 27.38% for 9 months
= 36.5% for 12 months
Because of appreciation in the value of the dudek, the effective annual

borrowing costs range from 22.1% 36.5%.

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
12/1/09 Accounts Receivable (K) [20,000 x $2.00] $40,000

Sales $40,000
No entry for the forward contract.
12/31/09 Accounts Receivable (K) $2,000

[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]

31. (continued)
Impact on 2009 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.

31. (continued)
b. Fair Value Hedge
12/1/09 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

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 Currency (K) $45,000

Foreign Exchange Gain $3,000.00
Loss on Forward Contract (1,049.25)
Total $1,950.75
Impact on net income over both periods: $39,549.25 + $1,950.75 = $41,500;

equal to cash inflow.

32. (40 minutes) (Forward Contract Hedge of Foreign Currency Payable)
a. Cash Flow Hedge
12/1/09 Parts Inventory (COGS) $40,000

Accounts Payable (K) $40,000
[20,000 x $2.00]
No entry for the Forward Contract.

[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
Premium Expense $1,000

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

Cash $41,500

Foreign currency (K) $45,000

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
12/1/09 Parts 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)

[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

Foreign currency (K) $45,000

32. (continued)

Foreign Exchange Loss $(3,000.00)
Gain on Forward Contract 1,049.25
Total $(1,950.75)
Impact on net income over both periods: $(39,549.25) + $(1,950.75) =

$(41,500.00); 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
Accumulated Other Comprehensive

Income (AOCI) $200
[($.0018 $.0020) x 1,000,000]
Loss on Foreign Currency Option $3,000

Income (AOCI) $3,000
Option Expense $200

Income (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]

Income (AOCI) $800
[$1,800 $1,000]

Gain on Foreign Currency Option $4,000

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

Cash $45,000
Over the two accounting periods, Sales are $45,000 and Option Expense is
$2,000. Net increase in cash is $43,000.
b. Fair Value Hedge

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

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]

[$4,000 $2,000]

Option Expense $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]

[$5,000 $4,000]

Option Expense $1,000**

Foreign Currency (M) $90,000

Cash $85,000

Impact on net income:

Option Expense $ 2,000
Inventory (Cost of Goods Sold) 85,000
Cash outflow $87,000

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

Foreign currency (M) $90,000
Impact on net income:

Foreign Exchange Loss ($5,000)
Gain on Foreign Currency Option 3,000
Impact on net income ($2,000)
Inventory 85,000
Cash Outflow $87,000

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 4/30/10 Fair Value Fair Value
11/01/09 $.53 $53,000 - $.52 $0 -
12/31/09 $.50 $50,000 -$3,000 $.48 $3,8441 +$3,844
4/30/10 $.49 $49,000 -$1,000 $.49 $3,0002 - $ 844
1
$52,000 $48,000 = $(4,000) x .961 = $3,844; where .961 is the present value factor for
four months at an annual interest rate of 12% (1% per month) calculated as 1/1.01 4.
2
$52,000 $49,000 = $3,000.
2009 Journal Entries
11/01/09 Accounts Receivable (FCU) $53,000

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



Discount Expense $333.33

Accumulated Other Comprehensive Income (AOCI) $333.33
[100,000 x ($.53 $.52) = $1,000 x 2/6 = $333.33]
The impact on net income for the year 2009 is:

Sales $53,000.00
Foreign Exchange Loss (3,000.00)
Net gain (loss) 0.00
Discount Expense (333.33)
Impact on net income $52,666.67

35. (continued)


Accumulated Other Comprehensive Income (AOCI) $844

Forward Contract $844
Discount Expense $666.67

Accumulated Other Comprehensive Income (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 1/31/10 Fair Value Fair Value
11/30/09 $265,000 ($159,000) - $.52 $0 -
12/31/09 $250,000 ($150,000) -$15,000 (-$9,000) $.48 $7,9211 +$7,921
1/31/10 $245,000 ($147,000) -$ 5,000 (-$3,000) $.49 $6,0002 - $1,921
1
$104,000 $96,000 = $(8,000) x .9901 = $7,921; where .9901 is the present value factor
for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01.
2
$104,000 $98,000 = $6,000.
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


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)
a. Foreign Currency Receivable
10/01 Accounts Receivable (LCU) $69,000

Sales (100,000 LCUs x $.69) $69,000
There is no formal entry for the forward contract.

[($.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]
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
Loss on Forward Contract (8,910.90)
Impact on net income $65,000.00 = Cash Inflow

37. (continued)
b. Foreign Currency Firm Sales Commitment
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

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
Purchase Commitment)
Forward Forward Contract Firm Commitment

Rate to Change in Change in
Date 10/31 Fair Value Fair Value Fair Value Fair Value
8/1 $.30 $0 - $0 $0 -
9/30 $.325 $4,950.501 + $4,950.50 $(4,950.50)1 $4,950.50
10/31 $.320 (spot) $4,0002 $ 950.50 $(4,000)2 + $ 950.50
1
($65,000 $60,000) = $5,000 x .9901 = $4,950.5; where .9901 is the present value factor
for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01.
2
($64,000 $60,000) = $4,000.
8/1 There is no entry to record either the purchase agreement or the

forward contract as both are executory contracts.


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

The net cash outflow is $60,000. Assuming the inventory is sold in the fourth
quarter, the net impact on net income is negative $60,000:
Cost of goods sold $(64,000)

Adjustment to net income 4,000
Net impact on net income $(60,000)
39. (30 minutes) (Option Fair Value Hedge of a Foreign Currency Firm Sale
Commitment)
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).
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


The impact on net income for the second quarter is:

Loss on Firm Commitment $(4,901.50)
Gain on Foreign Currency Option 3,000.00
Impact on net income $(1,901.50)

39. (continued)
9/1 Loss on Firm Commitment $10,098.50


Foreign Currency (lek) $485,000

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

The impact on net income for the third quarter is:

Sales $485,000.00
Loss on Firm Commitment (10,098.50)
Gain on Foreign Currency Option 7,000.00
Adjustment to Net Income 15,000.00
Impact on net income $496,901.50
The impact on net income over the second and third quarters is:
$495,000 ($496,901.50 $1,901.50)
The net cash inflow resulting from the sale is: $500,000 $5,000 = $495,000

40. (20 minutes) (Option Fair Value Hedge of a Foreign Currency Firm Purchase
Commitment)
Firm Commitment Option Option

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
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 options
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 options
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
Adjustment to Net Income $500
(Note that this last entry is not made until the
period when the parts inventory affects net income
through cost of goods sold.)


40. (continued)
b. The option strike price ($.20) is greater than the spot rate ($.18) on December 20,
the date the parts are to be paid for. Therefore, Big Arber will allow the option to
expire unexercised. Foreign currency will be acquired at the spot rate on
December 20. The journal entries are as follows:
11/20 Foreign Currency Option $400

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

12/20 Firm Commitment $1,000

Gain on Firm Commitment $1,000
Cash $9,000
(Note that this last entry is not made until the
period when the parts inventory affects net income
through cost of goods sold.)

41. (20 minutes) (Option Cash Flow Hedge of Forecasted Transaction)
12/15/09 Foreign Currency Option $5,000

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

transaction.

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]

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
Foreign Currency Options 10,000
To record exercise of the foreign currency
option at the strike price of $.58 and close
out the foreign currency option account.

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.
Impact on net income: 2009 Option expense $(1,000)
2010 Cost of Goods Sold $(590,000)

Option Expense (4,000)
Adjustment to Net Income 10,000
$(584,000)
Net cash outflow for parts: $585,000 = ($5,000 + $580,000)
42. (60 minutes) (Foreign Currency Transaction, Forward Contract and Option
Hedge of Foreign Currency Liability, Forward Contract and Option Hedge of
Foreign Currency Firm Commitment)
a. Unhedged Foreign Currency Liability
9/15 Inventory $200,000

Accounts Payable (euro) $200,000


Foreign Currency (euro) $220,000

Cash $220,000


42. (continued)
b. Forward Contract Fair Value Hedge of a Recognized Foreign Currency

Liability
Accounts Payable (C) Forward Forward Contract

Spot U.S. Dollar Change in U.S. Rate to Change in
Date Rate Value Dollar Value 10/31 Fair Value Fair Value
9/15 $1.00 $200,000 - $1.06 $0 -
9/30 $1.05 $210,000 +$10,000 $1.09 $5,940.601 +$5,940.60
10/31 $1.10 $220,000 +$10,000 $1.10 $8,000.002 +$2,059.40
1
$218,000 $212,000 = $6,000 x .9901 = $5,940.60; where .9901 is the present value
factor for one month at an annual interest rate of 12% (1% per month) calculated as
1/1.01.
2
$220,000 $212,000 = $8,000.
9/15 Inventory $200,000

There is no formal entry for the forward contract.





Cash $212,000


42. (continued)
c. Forward Contract Fair Value Hedge of a Foreign Currency Firm Commitment
9/15 There is no formal entry for the forward contract or the purchase order.





Cash $212,000
Inventory $220,000

(Note that this last entry is not made until the period when the inventory
affects net income through cost of goods sold.)

42. (continued)
d. Option Cash Flow Hedge of a Recognized Foreign Currency Liability
The following schedule summarizes the changes in the components of the fair
value of the euro call option with a strike price of $1.00 for October 31.
Change Change
Spot Option Fair in Fair Intrinsic Time in Time
Date Rate Premium Value Value Value Value Value
09/15 $1.00 $.035 $7,000 - $0 $7,0001 -
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





42. (continued)





Cash $200,000


42. (continued)
e. Option Fair Value Hedge of a Foreign Currency Firm Commitment
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
Inventory $220,000

(Note that this last entry is not made until the period when the inventory
affects net income through cost of goods sold.)

Answers to Develop Your Skills Cases
Research CaseInternational 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 IFFs 2005 annual report.
1. In 2005, IFF provided information in the annual report related to its

management of foreign exchange risk in the following locations:
a. Item 1A. Risk Factors.
b. Item 7. Management Discussion and Analysis of Financial Condition and
Results of Operations under Market Risk.
c. Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
b. Note 15. Financial Instruments (same disclosure as in MD&A).
2. IFF uses foreign currency forward contracts to reduce exposure to cash flow
volatility arising from foreign currency fluctuations associated with certain
foreign currency receivables and payables (hedges of foreign currency
denominated assets and liabilities) and anticipated purchases of raw
materials (hedges of forecasted transactions).
The company also uses a Japanese Yen- U.S. Dollar swap to hedge monthly
sale and purchase transactions between the U.S. and Japan.
3. In Note 15, IFF indicates that the notional amount and maturity dates of its
forward contracts match those of the underlying transactions.

FARS Case 1Hedge of Forecasted Foreign Currency Transaction
1. Using the advanced query function in FARS to search for the phrase
forecasted foreign currency transaction returns two hits: SFAS 131,
paragraphs 485 and 487. Paragraph 487 provides an answer to the question.
2. SFAS 131, paragraph 487 indicates that for a hedge of a forecasted foreign
currency transaction to qualify for hedge accounting, the component of the
entity that has the foreign currency exposure (i.e., the French subsidiary)
must be a party to the hedging transaction. In other words, the U.S. parent
cannot apply hedge accounting for the foreign currency option acquired to
hedge the French subsidiarys foreign exchange risk.
FARS Case 2Foreign Currency-Denominated Debt
1. Using the advanced query function in FARS to search for the phrase foreign
currency-denominated interest payments returns two hits. Note: Include the
hyphen between currency and denominated and the s in payments (plural).
Statement 133 Implementation Issue No. H4, Hedging Foreign-Currency-
Denominated Interest Payments, provides an answer to the question.
2. The DIGs response to Issue H4 is that a company may not treat foreign-
currency-denominated fixed-rate interest payments as an unrecognized firm
commitment that may be designated as a hedged item in a foreign currency
fair value hedge. However, those fixed-rate interest payments could be
designated as the hedged transaction in a cash flow hedge.

Excel CaseDetermine Foreign Exchange Gains and Losses
1., 2. and 3. Spreadsheet for the calculation of the foreign exchange gains (losses)
related to Import/Export Companys foreign currency transactions for
the year 2004.
Exchange Exchange
Type of Amount in Trans- Rate at $ Value at Rate at $ Value at Foreign
Trans- Foreign action Transaction Transaction Settlement Settlement Settlement Exchange
Foreign Currency action Currency Date Date Date Date Date Date Gain (Loss)
Brazilian real Import

(BRL) purchase (147,700) 2/2/2004 0.338696 (50,025.40) 8/2/2004 0.327815 (48,418.28) $1,607.12
Swiss franc Import

(CHF) purchase (63,600) 3/1/2004 0.787216 (50,066.94) 4/30/2004 0.770179 (48,983.38) 1,083.55
Euro
(EUR) Export sale 40,500 4/1/2004 1.2358 50,049.90 7/1/2004 1.2158 49,239.90 (810.00)
South African rand

(ZAR) Export sale 347,200 4/30/2004 0.144092 50,028.74 11/1/2004 0.163666 56,824.84 6,796.09
Chinese yuan
(CNY) Export sale 413,900 6/1/2004 0.120821 50,007.81 8/31/2004 0.120823 50,008.64 0.83
Thai baht Import

(THB) purchase (2,045,000) 7/1/2004 0.0244918 (50,085.73) 10/1/2004 0.0241779 (49,443.81) 641.93
British pound Import

(GBP) purchase (27,400) 8/2/2004 1.8273 (50,068.02) 11/1/2004 1.8323 (50,205.02) (137.00)
South Korean won Import

(KRW) purchase (57,700,000) 8/31/2004 0.000868056 (50,086.83) 12/1/2004 0.000956938 (55,215.32) (5,128.49)
Total Net
Foreign Exchange
Gain (Loss) $4,054.03
Import/Export Company reported a net foreign exchange gain of $4,054.03 in 2004

income.
Note that all transactions had a $ value on transaction date of approximately $50,000.
The size of the foreign exchange gains and losses reported in the last column
differs substantially across transactions because of different rates of change in the
exchange rates across the currencies in which Import/Export Company had
exposures. At one extreme, the large appreciation in value of the ZAR coupled with
the asset exposure in that currency generated a large foreign exchange gain. On the
other hand, a similar dollar value asset exposure in CNY resulted in a negligible gain
as a result of the very small change in the $/CNY exchange rate over the relevant
period.

Analysis CaseCash Flow Hedge
1. Given the $6,000 total premium expense, the forward rate must have been
$1.06 [($1.06 $1.00 spot) x 100,000 euros = $6,000].
2. Given that the forward contract is reported as a liability of $1,980 ($2,000 x
.9901), the forward rate at 3/31/09 must have been $1.04 [($1.04 $1.06) x
100,000 euros = $2,000]. The fact that the forward contract is a liability
signals that the forward rate at 3/31 is less than the forward rate on 2/1.
3. Given that the cost of goods sold is $103,000, the spot rate on 5/1/09 must
have been $1.03. Linber must pay $1.06 per euro under the forward contract,
so the forward contract results in an economic loss of $3,000 [($1.06 $1.03)
x 100,00 euros]. The negative adjustment to net income reflects this
economic loss.
4. The premium expense of $6,000 reflects the increase in cost for the parts
from the date the transaction was forecasted until the date of purchase. If
Linber had purchased 100,000 euros on 2/1/09 at the spot rate of $1.00, it
could have saved $6,000.

Internet CaseHistorical Exchange Rates
1. Spreadsheets for the calculation of the foreign exchange gains (losses)

related to Pier Ten Companys foreign currency account receivables.
Foreign
Currency Exchange U.S. Dollar
Account Rate on Value on
Currency Receivable 12/15/06 12/15/06
South Korean won (KRW) 30,000,000 0.001099 $32,970.00
Malaysian ringgit (MYR) 115,000 0.282 32,430.00
Singapore dollar (SGD) 50,000 0.6494 32,470.00
Thai baht (THB) 1,150,000 0.0284 32,660.00
Total $130,530.00
Foreign Foreign
Currency Exchange U.S. Dollar Exchange
Account Rate on Value on Gain (Loss)
Currency Receivable 12/31/06 12/31/06 on 12/31/06
South Korean won (KRW) 30,000,000 0.001091 $32,730.00 $(240.00)
Malaysian ringgit (MYR) 115,000 0.2835 32,602.50 172.50
Singapore dollar (SGD) 50,000 0.6521 32,605.00 135.00
Thai baht (THB) 1,150,000 0.02805 32,257.50 (402.50)
Total $130,195.00 $(335.00)
Foreign Foreign
Currency Exchange U.S. Dollar Exchange Net Foreign
Account Rate on Value on Gain (Loss) Exchange
Currency Receivable 1/15/07 1/15/07 on 1/15/07 Gain (Loss)
South Korean won (KRW) 30,000,000 0.001116 $33,480.00 $ 750.00 $ 510.00
Malaysian ringgit (MYR) 115,000 0.2982 34,293.00 1,690.50 1,863.00
Singapore dollar (SGD) 50,000 0.6483 32,415.00 (190.00) (55.00)
Thai baht (THB) 1,150,000 0.02797 32,165.50 (92.00) (494.50)
$132,353.50 $2,158.50 $1,823.50

2. Pier Ten would have reported a net foreign exchange loss of $335.00 in 2006
and a net foreign exchange gain of $2,158.50 in 2007 related to these foreign
currency receivables. The transaction denominated in Thai baht resulted in a
net foreign exchange loss of $494.50 and would have been the most
important to hedge.
3. Assuming a strike price equal to the December 15, 2006 spot rate, the only
foreign currency transaction for which the purchase of a put option would
have been beneficial is the transaction in Thai baht. Net cash inflow from the
THB receivable would have been $394.50 greater ($494.50 loss avoided less
$100.00 cost of option) if a put option had been acquired. Put options in
KRW and MYR would have had no value at 1/15/07, resulting in a decrease in
net cash inflow to Pier Ten of $200.00 (the cost of the options). The put
option in SGD would have had a value of $55.00 on 1/15/07 and would have
been exercised. However, there would have been a net loss on the SGD
option of $45.00 ($55.00 fair value less $100.00 cost of option), indicating that
it would not have been beneficial to acquire the SGD option.

Communication CaseForward Contracts and Options
The advantage of using forward contracts is that there is no cost to enter them.
The disadvantage is that the company is obligated to exchange foreign currency
for dollars at the contracted forward rate. Depending upon the future spot rate,
this may or may not be advantageous for the company. The disadvantage of
using options is that there is an up-front cost incurred. The advantage is that
the company is not required to exchange foreign currency for dollars at the
option strike price if it is disadvantageous to do so.
Exporters sometimes use forward contracts to hedge export sales (import

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


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McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2009

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Answer to Discussion Question

Do we have a gain or what?

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2009

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

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2009

resulting in a net gain or loss reported in net income.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2009

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

2. D SFAS 52 requires a two-transaction perspective, accrual approach.

3. B Foreign exchange gains related to foreign currency import purchases are

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

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2009

3/1 no journal entries

6/1 Premium Expense $10,000

Foreign Currency $57,500

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2009

Loss on Firm Commitment $2,019.70

Foreign Currency (C$) $77,000

Firm Commitment $3,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2009

Net impact on 2010 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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2009

18 and 19. (continued)

4/30 Loss on Forward Contract $250

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2009

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

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2009

21 and 22. (continued)

Net impact on 2010 net income:

23. (10 minutes) (Foreign Currency Purchase/Payable)

24. (10 minutes) (Foreign Currency Sale/Receivable)

25. (10 minutes) (Foreign Currency Sale/Receivable)

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

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2009

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2009

26. (10 minutes) (Foreign Currency Purchase/Payable)

12/1/09 Inventory $52,800

12/31/09 Accounts Payable (LCU) [60,000 x ($.82 $.88)] $3,600

1/28/10 Foreign Exchange Loss $4,800

Accounts payable (LCU) $54,000

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

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2009

2/1/09 Equipment $17,600

4/1/09 Accounts Payable (L) $17,600

6/1/09 Inventory $14,100

8/1/09 Accounts Receivable (L) [40,000 x $.48] $19,200

Cost of Goods Sold $9,870

10/1/09 Cash [30,000 x $.49] $14,700

11/1/09 Accounts Payable (L) [$14,100 x 2/3] $9,400

12/31/09 Foreign Exchange Loss $500

Accounts receivable (L) [10,000 x ($.52 $.48)] $400