Chapter 10 Accounting for Foreign Currency Transactions SUMMARY OF ASSIGNMENT MATERIAL Item Q10.

1 Topics Covered Compare single-transaction approach and twotransaction approach regarding the amount, timing and character of reported income. Define foreign exchange risk and its major sources. Explanation of the risks faced by a company dealing in overseas markets and discussion of important information needed in establishing credit and payment policies for foreign customers. Explanation of the nature of forward and option contracts and how they are used to neutralize foreign exchange risk. Explain why a foreign currency forward contract is known as a derivative financial instrument. Explain the SFAS 133 accounting for hedges of firm commitments and forecasted transactions. Discussion of whether or not an intended hedging transaction will be an effective hedge. Discussion of whether or not an intended hedging transaction will be an effective hedge. Explain balance sheet reporting of forward contracts. Lev el Mod Time 10-15

Q10.2 Q10.3

Low Low

10-15 10-15

Q10.4

Med

10-15

Q10.5

Low

5-10

Q10.6 Q10.7 Q10.8 Q10.9

Med Low Low Mod

10-15 5-10 5-10 10-15

SUMMARY OF ASSIGNMENT MATERIAL (cont=d.) 10-1

Item Q10.10

Topics Covered Describe two foreign currency transactions other than forward contracts that could be used as hedges. Explanation of forward contracts used as an economic hedge of a net investment in a foreign entity, and the required accounting for these contracts. Explanation of whether the forward exchange rate for the foreign currency will be above or below the spot rate if U.S. interest rates exceed a foreign country=s interest rates (Appendix 1) Journal entries for various import transactions. Journal entries for various export transactions. Journal entries to record four import/export transactions and related cash settlement. Adjusting entry to restate receivables and payables denominated in foreign currencies at balance sheet date. Journal entries for hedged import transaction; calculate gain/loss from hedging. Journal entries for hedged export transaction; calculate gain/loss from hedging. Journal entries for a hedged purchase commitment and exposed liability. Journal entries for hedged sale commitment and exposed asset.

Lev el Low

Time 10-15

Q10.11

Mod

10-15

Q10.12

High

15-20

E10.1 E10.2 E10.3 E10.4

Low Low Low Low

15-20 15-20 15-20 10-15

E10.5 E10.6 E10.7 E10.8

Low Low Mod Mod

10-15 10-15 15-20 15-20

SUMMARY OF ASSIGNMENT MATERIAL (cont=d.) 10-2

Item E10.9

Topics Covered Journal entries for a hedged forecasted purchase.

Lev el Mod Mod Mod Mod

Time 15-20 15-20 20-30 15-20

E10.10 Journal entries for a hedged forecasted sale. E10.11 Journal entries for a short-term foreign investment; evaluation of the investment. E10.12 Economic hedge of a net investment in a foreign entity; entries to record forward contract serving as an effective hedge; calculation of transaction adjustment and indicate its accounting treatment. E10.13 Journal entries for speculative forward purchase and sale contracts spanning two accounting periods. E10.14 Covered interest arbitrage; calculate U.S. interest rate, expected forward rate and maturity value of foreign investment (Appendix 1). E10.15 Reporting a currency swap used as a hedge of a forecasted transaction (Appendix 2). P10.1 Computation of transaction gains and losses based on a list of the firm=s receivables, payables, and other assets (liabilities); evaluation of forward contracts. Journal entries for hedged import commitment; import and export transactions. Journal entries and disclosure for forward contracts entered for various hedging and speculative reasons; evaluation of the company=s use of the forward market.

Mod

15-20

High

15-20

Mod Mod

15-20 25-35

P10.2 P10.3

Mod Mod

15-25 40-50

10-3

SUMMARY OF ASSIGNMENT MATERIAL (cont=d.) Item P10.4 Topics Covered Approaches to hedging an import transaction; effects on total liabilities/total assets and return on assets. Calculate cash flow from operations to assess earnings quality and effect of changing exchange rate on cash flow in a credit analysis setting. Journal entries for hedged export commitment spanning two accounting periods; income effects for each period and analysis of hedge effectiveness. Journal entries for a hedged forecasted transaction that becomes a firm commitment and then an exposed position. Evaluation of performance of an import/export department with forward contracts; managerial use of accounting data produced in foreign currency transactions. Journal entries for a hedged foreign loan. Evaluation of foreign and domestic investments. Adjusting entry at balance sheet date requiring computation of transaction adjustment on receivables, payables, and other assets (liabilities), including forward contracts. This is a more complex version of P10.1 using different data. Lev el High Time 30-40

P10.5

Mod

30-40

P10.6

Mod

20-30

P10.7

Mod

40-45

P10.8

High

50-60

P10.9 P10.10 P10.11

Mod Mod Mod

25-35 25-35 30-40

SUMMARY OF ASSIGNMENT MATERIAL (cont=d.)

Item P10.12

Topics Covered Transfer prices and taxes in an intercompany setting involving a foreign subsidiary; impact of expected exchange rate movement on hedging decision; criteria for determining whether forward contract qualifies as a hedge.

Lev el High

Time 30-40

P10.13

Evaluate alternative ways of paying for an import Mod transaction; covered interest arbitrage used; effect of payment scenarios on earnings volatility (Appendix 1). Calculate the forward rate; report a currency swap used as a hedge of a firm sale commitment (Appendix 1, 2). Mod

25-35

P10.14

20-30

CARRYBACK TABLE The carryback table identifies the assignment items which are new in this edition and those which are carried over from the seventh edition. For the latter, the problem number in the seventh edition is shown. New Problem Number New Problem Number New Proble m Numbe r P10.1 P10.2 P10.3 P10.4 P10.5 P10.6 P10.7 P10.8 P10.9 P10.10 P10.11 P10.12 P10.13 P10.14

Source

Source

Source

Q10.1 Q10.2 Q10.3 Q10.4 Q10.5 Q10.6 Q10.7 Q10.8 Q10.9 Q10.10 Q10.11 Q10.12

Q10.1 Q10.2 Q10.3 Q10.4 Q10.5 Q10.6 Q10.7 Q10.8 Q10.9 Q10.10 Q10.11 Q10.12

E10.1 E10.2 E10.3 E10.4 E10.5 E10.6 E10.7 E10.8 E10.9 E10.10 E10.11 E10.12 E10.13 E10.14

E10.1 E10.2 E10.3 E10.4 E10.5 E10.6 E10.7 E10.8 E10.9 E10.10 E10.11 E10.12 E10.13 E10.14

P10.1 P10.2 P10.3 P10.4 P10.5 P10.6 P10.7 P10.8 P10.9 P10.10 P10.1 1 P10.1 2 P10.1 3 new

E10.15 new Carryforward tables for all chapters, identifying the disposition of seventh edition assignment items, appear at the beginning of the solutions manual. ANSWERS TO QUESTIONS Q10.1 Under the two-transaction approach, the transaction adjustment accruing to the payable or receivable is viewed as a separately reportable income statement item, not as part of the related purchase or sale. In contrast, the single-transaction approach treats the transaction adjustment as part of the purchase or sale on the grounds that the dollar measured purchase or sale is not fully complete until the payable or receivable is settled. Under both approaches, the receivable or payable is adjusted to its current spot rate. Under the single-transaction approach, transaction adjustments affect gross margin through their effects on reported sales and purchases (or cost of good sold). The two-transaction approach does not affect gross margin as it reports the transaction adjustments as "other income/expense" in the period the spot rate changes. Q10.2 A company is exposed to foreign exchange risk if changes in exchange rates result in gains or losses to the company, either currently or in the future. The major sources of foreign exchange risk are: 1. Foreign-currency-denominated receivables and payables. 2. Foreign-currency-denominated long-term loans, notes payable, or notes
receivable. 3. Net investment in a foreign subsidiary or division.

4.

Firm commitment to purchase or sell, where the invoice price is denominated in foreign currency. 5. Forecasted purchase or sale transactions, where the invoice price is denominated in foreign currency. 6. Speculative forward or futures contracts in foreign currency.

Q10.3

Aside from the credit-worthiness of specific overseas customers, Barber should be very concerned about the extension of credit or the acceptance of purchase orders for sales denominated in units of the foreign currency. If prices are quoted in terms of the foreign currency, any lapse of time between acceptance of a purchase order from overseas and the time for payment adds foreign exchange risk to whatever other risks Barber is bearing. Thus, to the extent possible, Barber should negotiate for prices in terms of U.S. dollars if it wishes to avoid this risk. However, the foreign customer would then bear the risk of changes in the exchange rate. If Barber=s competition offers prices denominated in the currency of the customer, Barber may not be able to require payments in U.S. dollars. The following kinds of information would be relevant to Barber's overseas credit and payment policies. 1. 2. 3. 4. Volatility and direction of movements in exchange rates. Interest rates in the U.S. and in the foreign countries. Availability of a forward market if needed. Typical spread between spot and forward rates to assess the cost of hedging. Credit and payment policies of competitors.

5.

Q10.4 A foreign exchange forward contract locks in the future buying or selling price of a foreign currency. Foreign exchange risk is neutralized because there is no uncertainty concerning the U.S. dollar value of the future purchase or sale, even though exchange rates may fluctuate. Forward contracts are typically structured to fit the individual needs of the company. For example, a company expecting to receive 10 million yen from a customer in Japan in two months may enter a forward sale contract specifying the exchange rate for exactly 10 million yen at the date the customer payment is expected. Similarly, a company expecting to make a foreign currency payment to a foreign supplier may use a forward contract to lock in the U.S. dollar equivalent of this currency purchase. A forward contract requires the company to follow through on the contract. Therefore it must buy (sell) currency at the contracted price no matter what the current market price is. A foreign currency option contract sets a strike price for the currency. The contract gives the company the option of purchasing or selling the currency at this strike price, or letting the contract expire. Option contracts are typically standardized and traded in organized markets, and are therefore not structured to meet the individual needs of a company. The company will instead select from a menu of contracts to neutralize its exposure. Unlike forward contracts, option contracts usually require an initial investment (margin deposit). A call option provides the opportunity to buy currency at the strike price. At the time the company must purchase currency to pay a supplier, if the spot rate is above the strike price the company will purchase the currency at the strike price. Otherwise the company will let the option expire and purchase the currency at the current market price. A put option provides the opportunity to sell currency at the strike price. At the time the company receives foreign currency from a customer, if the spot rate is below the strike price the company will exercise the option and sell the currency at the strike price. Otherwise, the company will sell the currency at the market price.

Q10.5 A derivative financial instrument is one whose value is tied to or derived from the value of some underlying or reference item. The value of a foreign currency forward contract--the value of the foreign currency to be received or sold pursuant to the contract--is therefore based on the market price for the currency referenced in the contract. Q10.6 When a company uses a forward contract to hedge a firm commitment involving a foreign-currency-denominated purchase or sale, both the forward contract and the firm commitment are marked to market as the market rate changes. Thus the forward contract is reported at its fair market value, and the offsetting gain and loss from the hedged commitment and the hedge investment appear on the same income statement. When a company uses a forward contract to hedge a forecasted transaction involving a foreign-currency-denominated purchase or sale, the forward contract is marked to market and the resulting gain or loss is accumulated in other comprehensive income until the forecasted transaction impacts the income statement. Thus the forward contract is reported at its fair market value, and the gain or loss on the forward contract is reported in the same income statement as the loss or gain on the hedged transaction. Q10.7 Yes, this will be an effective hedge. Any transaction adjustment accruing to the hedge offsets the transaction adjustment accruing to the receivables. For example, if both the spot and forward exchange rates, $/,, rise by $.10, a transaction loss of $100,000 (= $.10 x 1,000,000) accrues on the hedge and a transaction gain of $100,000 accrues on the receivables. Q10.8 No, this is not an effective hedge. Put options allow the holder to sell currency at the strike price. The cost of the forecasted transaction increases, in U.S. dollars, as the exchange rate for the peso increases. But Balboa will

show a loss on the put option, since it fixes the selling price of pesos and has value only when the rate declines. Therefore the loss on the put option only adds to the loss on the forecasted transaction. Balboa should invest in a call option, fixing the price at which it may buy the currency required to pay the supplier. Q10.9 Forward contracts are valued on the balance sheet at fair market value, calculated as the difference between the current forward rate for delivery at the contracted date and the contracted rate for delivery at the contracted date. A forward purchase contract will have a debit (credit) balance and be shown as a current asset (liability) if the contracted forward rate is less (greater) than the current forward rate. A forward sale contract will have a debit (credit) balance and be shown as a current asset (liability) if the contracted forward rate is greater (less) than the current forward rate. Q10.10 Virtually any foreign currency investment that effectively reduces exchange rate risk can serve as a hedge. Two examples are: 1. An investment in a foreign bond or note denominated in the same currency (or one that moves in tandem with that currency) with amounts and due dates coinciding with those exposing the company to exchange risk. Receivables and payables denominated in the same currency, or in currencies that move in tandem, can likewise serve as hedges of each other.

2.

Q10.11 If an American company has a net investment in a foreign branch, investee, or subsidiary whose functional currency is its local currency, the subsidiary's net assets expose the American company to risk of exchange rate movements, since these amounts are translated at the current exchange rate. This risk is normally a debit balance. To hedge this risk, the American company may borrow in the foreign currency or sell the currency forward so that transaction adjustments accruing to the hedge (a credit balance) offset the translation adjustments accruing to the foreign investment, thereby neutralizing the exchange rate risk. This is similar to a transaction designed to hedge foreign denominated receivables. If the American company has a net investment in a foreign subsidiary whose functional currency is the U.S. dollar, the risk typically comes from the subsidiary's cash, receivables, and debt, since these accounts are translated at the current exchange rate. The net exposure is usually a credit balance, which is hedged with an offsetting receivable or forward purchase contract denominated in the foreign currency. If the functional currency (the currency in which the foreign entity generates most of its net cash flows) is the U.S. dollar, transaction adjustments to the forward contract are included in current income. In contrast, if the functional currency is a foreign currency, transaction adjustments are accumulated in other comprehensive income, a component of stockholders= equity, thereby bypassing current income. Q10.12 (appendix) Pounds sterling futures would sell at a premium over the spot rate. The reason is that a dollar invested in the U.S. is worth more in six months than that same dollar invested in the U.K. Investors will sell pounds sterling for dollars today and purchase pounds sterling with dollars for delivery in six months. If the dollar does not decrease in value relative to the pound--the foreign exchange rate rises--conversion of pounds sterling into dollars in order to take advantage of higher interest rates in the U.S. will continue unabated. If interest rates were higher in the U.K., the situation would reverse because dollars would be converted today into the pounds needed to make investments in the U.K.

SOLUTIONS TO EXERCISES E10.1 RECORDING IMPORT TRANSACTIONS Australia Dr. Cr. 91,500 91,500 Thailand Dr. Cr. 14,000 14,000 Indonesia Dr. Cr. 1,610 1,610 Jordan Dr. Cr. 140,000 140,000

Purchase Transactions Purchases Accounts Payable Payment Transactions Foreign Currency Cash Accounts Payable Transaction Loss Transaction Gain Foreign Currency

92,250 92,250 91,500 750 C 92,250

10,000 10,000 14,000 C 4,000 10,000

1,050 1,050 1,610 C 560 1,050

140,000 140,000 140,000 C C 140,000

E10.2

RECORDING EXPORT TRANSACTIONS Argentina Dr. Cr. 250,000 250,000 Canada Dr. Cr. 260,400 260,400 India Dr. Cr. 7,200 7,200 South Africa Dr. Cr. 16,900 16,900

Sales Transactions Accounts Receivable Sales Collection Transactions Foreign Currency Transaction Loss Transaction Gain Accounts Receivable Cash Foreign Currency

253,000 C 253,000

256,800 3,600 3,000 250,000 256,800 253,000

C 260,400 256,800

9,000 C 9,000

15,800 1,100 1,800 7,200 15,800 9,000

C 16,900 15,800

E10.3

RECORDING IMPORT AND EXPORT TRANSACTIONS

IMPORT TRANSACTIONS Transaction 1 Transaction date: Inventory Accounts Payable Payment date: Accounts Payable Transaction Loss Cash Transaction 2 Transaction date: Inventory Accounts Payable Payment date: Accounts Payable Transaction Gain Cash EXPORT TRANSACTIONS Transaction 3 Transaction date: Accounts Receivable Sales 342,400 342,400 180,000 9,000 171,000 180,000 180,000 3,300 500 3,800 3,300 3,300

E10.3 (cont=d.) Payment date: Cash Transaction Loss Accounts Receivable Transaction 4 Transaction date: Accounts Receivable Sales Payment date: Cash Transaction Gain Accounts Receivable E10.4 ADJUSTING ENTRY AT BALANCE SHEET DATE Adjustment Needed Dr. (Cr.) (10,000) (Loss) 4,500 (Gain) (20,000) (Loss) 2,000 (Gain) 746,700 34,200 712,500 712,500 712,500 329,200 13,200 342,400

Book Balance ($) Dollar Equivalent, 12/31 Item Dr. (Cr.) Dr. (Cr.) 1 $100,000 90,000 = $.09 x 1,000,000 2 180,000 184,500 = $.82 x 225,000 3 (500,000) (520,000) = $1.30 x 400,000 4 (50,000) (48,000) = $.24 x 200,000

E10.4 (cont=d.) Adjusting Entry Transaction Loss Accounts Receivable ($10,000 - $4,500) Accounts Payable ($20,000 - $2,000) To record the net transaction loss on the receivables and payables at December 31; ($23,500) = ($10,000) + $4,500 + ($20,000) + $2,000. E10.5 HEDGING EXPOSED LIABILITY 23,500 5,500 18,000

Requirement 1: March 15, 20X3 Inventory Accounts Payable To record goods purchased; $18,100 = $.000905 X 20,000,000. April 14, 20X3 Transaction Loss Accounts Payable To restate payable at current spot rate; $60 = ($.000908 - $.000905) X 20,000,000. Investment in Forward Contract Transaction Gain To restate forward contract to current fair value; $160 = ($.000908 - $.000900) X 20,000,000. 160 160 60 60 18,100 18,100

E10.5 (cont=d.) Foreign Currency Investment in Forward Contract Cash To record payment to the dealer, receipt of 20,000,000 won, valued at the current spot rate of $.000908/W, and fulfillment of the forward purchase contract. Accounts Payable Foreign Currency Requirement 2: Dollars paid (to broker) with the hedge: Dollars that would have been paid at the current spot rate to purchase foreign currency for the supplier; (.000908 X 20,000,000): Cash gain (amount saved) from hedging: E10.6 HEDGING EXPOSED ASSET $18,000 -18,160 $ 160 18,160 18,160 18,160 160 18,000

Requirement 1: September 1, 20X6 Accounts Receivable Sales To record sales made; $33,200,000 = $.83 X 40,000,000. September 30, 20X6 Transaction Loss Accounts Receivable To restate receivable at current spot rate; $400,000 = ($.83 - $.82) X 40,000,000. 400,000 400,000 33,200,000 33,200,000

E10.6 (cont=d.) Investment in Forward Contract Transaction Gain To restate the forward contract to its current fair value; $480,000 = ($.832 - $.82) X 40,000,000. Foreign Currency Accounts Receivable To record receipt of currency from Brazilian customer; $32,800,000 = $.82 X 40,000,000. Cash Foreign Currency Investment in Forward Contract To record delivery of currency to the dealer, receipt of $33,280,000 as specified in the contract, and settlement of the forward contract. Requirement 2: Dollars received (from broker) with the hedge: Dollars that would have been received from the customer's foreign currency at the current spot rate (.82 X 40,000,000): Cash gain (increased proceeds) from hedging: $33,280,000 - 32,800,000 $ 480,000 33,280,000 32,800,000 480,000 32,800,000 32,800,000 480,000 480,000

E10.7

HEDGED PURCHASE COMMITMENT AND EXPOSED LIABILITY No entry

September 15, 20X3

November 15, 20X3 Investment in Forward Contract Gain on Hedge Activity To record change in fair value of the forward contract; $15,000 = ($.105 - $.104) X 15,000,000. Loss on Hedge Activity Firm Commitment To record the loss on the firm purchase commitment. Purchases Accounts Payable To record delivery of the goods at the current spot rate of $.103. Firm Commitment Purchases To adjust the carrying value of the goods for the accumulated loss on the firm commitment during the commitment period. December 31, 20X3 Transaction Loss Accounts Payable To record loss due to increase in dollar value of accounts payable; $30,000 = ($.105 - $.103) X 15,000,000.

15,000 15,000

15,000 15,000 1,545,000 1,545,000

15,000 15,000

30,000 30,000

E10.7 (cont=d.) Investment in Forward Contract Transaction Gain To record increase in value of forward purchase contract; $30,000 = ($.107 - $.105) X 15,000,000. January 15, 20X4 Transaction Loss Accounts Payable To record loss on accounts payable; $45,000 = ($.108 - $.105) X 15,000,000. Investment in Forward Contract Transaction Gain To record increase in fair value of forward purchase contract; $15,000 = ($.108 - $.107) X 15,000,000. Foreign Currency Investment in Forward Contract Cash To record fulfillment of the forward contract. Accounts Payable Foreign Currency To record payment to the Mexican supplier. 1,620,000 1,620,000 1,620,000 60,000 1,560,000 15,000 15,000 45,000 45,000 30,000 30,000

E10.8

HEDGED SALE COMMITMENT AND EXPOSED ASSET

April 15, 20X4 No entry April 30, 20X4 Investment in Forward Contract Gain on Hedge Activity To record increase in fair value of the forward contract; $75 = ($.174 - $.173) X 75,000. Loss on Hedge Activity Firm Commitment To record loss on U.S. dollar value of the firm sale commitment. Accounts Receivable Sales Revenue To record delivery of goods to the South African customer; $12,825 = $.171 X 75,000. Firm Commitment Sales Revenue To adjust the sales revenue for the change in value of the firm sales commitment. May 15, 20X4 Accounts Receivable Transaction Gain To record gain on accounts receivable; $150 = ($.173 - $.171) X 75,000. 150 150 75 75 12,825 12,825 75 75 75 75

No entry is needed to revalue the investment in the forward contract since its fair value remains at $75 [= ($.174 - $.173) X 75,000].

E10.8 (cont=d.) Foreign Currency Accounts Receivable To record receipt of rands from the South African customer, valued at the current spot rate of $.173. Cash Foreign Currency Investment in Forward Contract To record delivery of the rands to the dealer, and settlement of the forward contract. E10.9 HEDGED FORECASTED PURCHASE 13,050 12,975 75 12,975 12,975

June 30, 20X0 Investment in Forward Contract Other Comprehensive Income To record increase in fair value of forward purchase contract; $574 = ($1.24 - $1.199) X 14,000. Foreign Currency Investment in Forward Contract Cash To record settlement of forward contract. Inventory Foreign Currency To record delivery of merchandise and payment to supplier; $17,360 = $1.24 X 14,000. 17,360

574 574

17,360 574 16,786

17,360

E10.9 (cont=d.) July 12, 20X0 Cash Sales To record merchandise sale. Other Comprehensive Income Cost of Goods Sold Inventory To record cost of sale, including release of gain on forward contract to cost of goods sold. E10.10 HEDGED FORECASTED SALE 574 16,786 17,360 19,000 19,000

November 30, 20X1 Other Comprehensive Income Investment in Forward Contract To record decrease in value of forward contract; $500 = ($.651 - $.646) X 100,000. Foreign Currency Sales To record merchandise sale; $65,100 = $.651 X 100,000. Sales Other Comprehensive Income To transfer the loss on the hedge to current earnings. Cash Investment in Forward Contract Foreign Currency To record settlement of forward contract. E10.11 RECORDING FOREIGN INVESTMENT

500 500

65,100 65,100 500 500 64,600 500 65,100

Requirement 1:

October 1, 20X0 Short-term Investments Cash To record the purchase of a 6-month certificate of deposit, face value 1,000,000 krona, from a Swedish bank. December 31, 20X8 Short-term Investments Transaction Gain To accrue the transaction gain on the certificate of deposit; $20,000 = ($.1445 - $.1245) X 1,000,000. Interest Receivable Interest Income To accrue interest income to December 31, 20X0 based on the December 31 exchange rate; $5,418.75= $.1445(3/12)(.15) x 1,000,000. March 31, 20X1 Transaction Loss Short-term Investments To accrue the transaction loss on the certificate of deposit since December 31, 20X0; $21,700 = ($.1445 - $.1228)X1,000,000. Transaction Loss Interest Receivable To accrue the transaction loss on the interest receivable; $813.75= ($.1445-$.1228)X 37,500; 37,500 = .15(3/12)1,000,000, the interest (in krona) accrued on December 31,20X0.

124,500 124,500

20,000 20,000

5,418.75 5,418.75

21,700 21,700

813.75 813.75

E10.11 (cont=d.) Interest Receivable Interest Income To record interest income for the period January 1, 20X1 to March 31, 20X1 based on the March 31exchange rate; $4,605 = $.1228 X 37,500 [(= (3/12).15 X 1,000,000)]. Foreign Currency ($.1228 x 1,075,000) Short-term Investments Interest Receivable To record the receipt of foreign currency for principal and interest at maturity of the certificate of deposit. Cash Foreign Currency To record conversion of 1,075,000 krona into dollars. Requirement 2: This investment returned $7,510, the difference between the $124,500 paid to acquire the certificate and the $132,010 received at maturity. The effective annual interest rate on this investment is $7,510/$124,500 X 2 = 3.016%. If this company could have obtained alternative investments for a higher rate of interest, this was a poor investment. 132,010 132,010 132,010 122,800 9,210 4,605 4,605

E10.12

HEDGE OF NET INVESTMENT

Requirement 1: Williams has a net investment (debit balance) in its foreign subsidiary. Translation of this net investment was discussed in Chapter 9 and need not be considered here. The dollar equivalent of both the parent's net investment and, by implication, the net assets of the subsidiary, is affected by changes in the exchange rate. To hedge this debit balance, Williams must generate a foreign currency credit balance which will produce a transaction adjustment of opposite sign. Either taking out a loan denominated in NP or selling NP forward (the Forward Sale Contract has a credit balance) will lead to the desired result. Requirement 2: The transaction adjustment on the forward sale contract is a gain of $21,000 [= ($.02 - $.0194) 35,000,000]. The accounting treatment of the gain depends upon the functional currency of the foreign subsidiary. Since the functional currency is the foreign currency (NP), the transaction gain bypasses current income and is entered directly into other comprehensive income. E10.13 SPECULATIVE FORWARD CONTRACTS

Requirement 1: Forward Purchase Contract: (.$.13 - $.128) X 10,000,000 = $20,000 current liability Forward Sale Contract: ($.64 - $.634) X 10,000,000 = $60,000 current asset

E10.13 (cont=d.) Requirement 2: December 31, 20X0 Transaction Loss Investment in Forward Contract To record transaction loss accrued since December 16 on speculative forward purchase contract; $30,000 = ($.125 - $.128)10,000,000. Transaction Loss Investment in Forward Contract To record transaction loss accrued since December 16 on speculative forward sale contract; $80,000 = ($.642 - $.634)10,000,000. January 15, 20X1 Investment in Forward Contract Transaction Gain To record transaction gain accrued since December 31 on speculative forward purchase contract; $60,000 = ($.131 - $.125)10,000,000. Foreign Currency Investment in Forward Contract Cash To record settlement of the forward purchase contract. 1,310,000 10,000 1,300,000 60,000 60,000 80,000 80,000 30,000 30,000

E10.13 (cont=d.) Cash Foreign Currency To record conversion of $H10,000,000 into dollars. 1,310,000 1,310,000

Note to instructor: The speculation in $H produced a net cash gain of $10,000 (= 1,310,000 - 1,300,000). Investment in Forward Contract Transaction Gain To record transaction gain accrued since December 31 on speculative forward sale contract; $60,000 = ($.636- $.642)10,000,000. Foreign Currency Cash To record acquisition of $S on the spot market to settle the forward sale contract. Cash Investment in Forward Contract Foreign Currency To record settlement of the forward purchase contract. 6,400,000 40,000 6,360,000 6,360,000 6,360,000 60,000 60,000

Note to instructor: The speculation in $S produced a net cash gain of $40,000 (= 6,400,000 - 6,360,000).

E10.14

COVERED INTEREST ARBITRAGE (APPENDIX 1)

Requirement 1: Recall that: RF = RS(1 + IUS)/(1 + IFN) Manipulating gives us: RF(1 + IFN) = RS(1 + IUS) RF + RFIFN = RS + RSIUS IUS = (RF + RFIFN - RS)/RS Now we enter the problem data: IUS = [.63 + (.63 X .06) - .60]/.60 IUS = .0678/.60 IUS = .113 Check: (1.113) X 120,000 = .63 X (1.06 X 200,000) 133,560 = 133,560 Requirement 2: The total number of dollars received at maturity consists of the hedged principal and the unhedged interest. At the $.60 spot rate, the $120,000 becomes a LC200,000 investment; 200,000 = 120,000/.60. $126,000 7,320 $133,320 The difference between $133,560 and $133,320 is $240 [= ($.63 - $.61) X (.06 X 200,000), the cash lost because the interest was not hedged. Note to Instructor: The LC is selling forward at a premium of 5% [= (.63 - . 60)/.60]; thus the US interest rate is about 5% higher. Hedged principal: $.63 X 200,000 Unhedged interest: $.61 X (.06 X 200,000)

E10.14 (cont=d.) Requirement 3: Recall that: RF = RS(1 + IUS)/(1 + IFN) RF = .60(1.04)/1.06 RF = .5887

Check: E10.15

(1.04) X 120,000 = .5887 X (1.06 X 200,000) 124,800 = 124,800 CURRENCY SWAP (APPENDIX 2)

October 1, 20X2 No entry as the swap has no value at this time. December 31, 20X2 Investment in Swap Other Comprehensive Income To recognize the transaction gain accrued on the swap; $53,000 = ($.603 - $.55) X 1,000,000. Foreign Currency Sales Revenue To record the sale to customers in Australia at the current spot rate; $550,000 = $A1,000,000 X $.55. Other Comprehensive Income Sales Revenue To reclassify the swap gain to income. Cash Investment in Swap Foreign Currency To record settlement of the swap. SOLUTIONS TO PROBLEMS P10.1 COMPUTATION OF EXCHANGE GAIN OR LOSS 603,000 53,000 550,000 53,000 53,000 550,000 550,000 53,000 53,000

Requirement 1:
Computation of Transaction Adjustment on Receivables

Foreign Currency E.R. Country Amount (12/31/X2) Belgium 300,000 1.256 India 1,200,000 .0235 Saudi Arabia 90,000 .2666 Dollar amount of foreign currency receivables at 12/31/X2 Less amount per books ($355,000 + $23,950 + $24,000) Transaction gain on receivables

Amount ($) $376,800 28,200 23,994 $428,994 (402,950) $ 26,044

Computation of Transaction Adjustment on Payables Foreign Currency E.R. Country Amount (12/31/X2) Ecuador (60,000,000) $.00015 Mexico (500,000) .10210 Dollar amount of foreign currency payables at 12/31/X2 Less amount per books ($10,000 + $50,000) Transaction loss on payables Amount ($) $ (9,000) (51,050) $(60,050) (60,000) $ 50

P10.1 (cont=d.)
Computation of Transaction Adjustment on Other Assets (Liabilities)

Foreign Currency Forward Rate Item Dr. (Cr.) (12/31/X2) Forward purchase contract (pesos) 500,000 $.10235 Forward sale contract (euros) (300,000) 1.26200 Dollar amount of other assets (liabilities) denominated in foreign currencies at 12/31/X2 Amount per books [$(1,125) + $18,200] Transaction loss on other assets (liabilities) Net transaction gain (loss) in 20X2; $26,044 + $(50)+ ($20,750).

Amount ($) (Contract Rate minus Current Forward Rate) $ (75)

( 3,600) $ (3,675) 17,075 $ 20,750 $ 5,244

Adjusting Entry - Books of Wheelstick Corporation Accounts Receivable 26,044 Investment in Forward Purchase Contract 1,050 Accounts Payable Investment in Forward Sale Contract Transaction Gain To record the transaction adjustments on accounts receivable, accounts payable, and the forward purchase and sale contracts at December 31, 20X2.

50 21,800 5,244

P10.1 (cont=d.) Requirement 2: The forward purchase contract is a hedge of the accounts payable to Mexican suppliers. Following is an analysis of the transaction gains and losses on the exposure and the hedge investment: Book 12/31/X2 Transaction Value Value Gain (Loss) $50,000 $51,050 $(1,050) (1,125) (75) 1,050 -0-

Accounts Payable Investment in Forward Purchase Contract Net Transaction Gain (Loss)

The forward sale contract is a hedge of the accounts receivable from Belgian customers. Following is an analysis of the transaction gains and losses on the exposure and the hedge investment: Book 12/31/X2 Transaction Value Value Gain (Loss) $355,000 $376,800 $21,800 18,200 (3,600) (21,800) -0-

Accounts Receivable Investment in Forward Purchase Contract Net Transaction Gain (Loss)

Both forward contracts are 100 percent effective in hedging Wheelstick=s exposure to foreign exchange risk on the receivables from Belgian customers and the payables to Mexican suppliers.

P10.2 IMPORT AND EXPORT TRANSACTIONS AND HEDGED COMMITMENT August 14, 20X5 Loss on Hedge Activity Investment in Forward Contract To record decline in fair value of forward contract; $80,000 = ($1.25 - $1.23) X 4,000,000. Firm Commitment Gain on Hedge Activity To record reduction in cost of firm commitment. Foreign Currency Investment in Forward Contract Cash To record settlement of forward purchase contract. Inventory Foreign Currency To record delivery of merchandise and payment to supplier; $4,920,000 = $1.23 X 4,000,000. Inventory Firm Commitment To adjust inventory balance for value of firm commitment. September 1, 20X5 Accounts Receivable Sales Revenue To record sales to concern in Poland; $840,000 = $.28 X 3,000,000. 840,000 840,000 80,000 80,000 4,920,000 4,920,000 4,920,000 80,000 5,000,000 80,000 80,000

80,000 80,000

P10.2 (cont=d.) November 3, 20X5 Transaction Loss Accounts Receivable To record decline in value of receivable; $60,000 = ($.28 - $.26) X 3,000,000. Foreign Currency Accounts Receivable To record receipt of payment from customer. Cash Foreign Currency To record exchange of zloty into dollars. 780,000 780,000 780,000 780,000 60,000 60,000

P10.3 ACCOUNTING FOR FORWARD CONTRACTS--HEDGING AND SPECULATION Requirement 1: December 31, 20X7 Loss on Hedge Activity Investment in Forward Contract To record decline in value of forward sale contract #1; $120,000 = ($.165 - $.105) X 2,000,000. Firm Commitment Gain on Hedge Activity To record increase in sales value of firm commitment. 120,000 120,000 120,000 120,000

P10.3 (cont=d.) Investment in Forward Contract Other Comprehensive Income To record increase in value of forward purchase contract #2; $60,000 = ($.165 - $.105) X 1,000,000. Investment in Forward Contract Gain on Hedge Activity To record increase in value of forward purchase contract #3; $60,000 = ($.165 - $.105) X 2,000,000. Loss on Speculative Activity Investment in Forward Contract To record loss on speculative contract #4; $60,000 = ($.165 - $.105) X 1,000,000. January 29, 20X8 Loss on Hedge Activity Investment in Forward Contract To record decline in value of forward sale contract #1 since December 31; $54,000 = ($.192 - $.165) X 2,000,000. Firm Commitment Gain on Hedge Activity To record increase in sales value of firm commitment. Foreign Currency Sales Revenue To record sale to South African customer; $384,000 = $.192 X 2,000,000. 384,000 384,000 54,000 54,000 54,000 54,000 60,000 60,000 120,000 120,000 60,000 60,000

P10.3 (cont=d.) Sales Revenue Firm Commitment To adjust sales revenue for the accumulated balance in the firm commitment account. Cash Investment in Forward Contract Foreign Currency To record the settlement of forward sale contract #1. Investment in Forward Contract Other Comprehensive Income To record increase in value of forward purchase contract #2; $27,000 = ($.192 - $.165) X 1,000,000. Foreign Currency Investment in Forward Contract Cash To record settlement of forward purchase contract #2. Inventory Foreign Currency To record purchase #2 at the current spot rate of $.192. Investment in Forward Contract Gain on Hedge Activity To record increase in value of forward purchase contract #3; $54,000 = ($.192 - $.165) X 2,000,000. 54,000 54,000 192,000 192,000 192,000 87,000 105,000 27,000 27,000 210,000 174,000 384,000 174,000 174,000

P10.3 (cont=d.) Foreign Currency Investment in Forward Contract Cash To record settlement of forward purchase contract #3. Loss on Speculative Activity Investment in Forward Contract To record loss on forward sale contract #4; $27,000 = ($.192 - $.165) X 1,000,000. Foreign Currency Cash To record purchase of rands in the spot market, in anticipation of settlement of forward sale contract #4. Cash Investment in Forward Contract Foreign Currency To record settlement of forward sale contract #4. Requirement 2: December 31, 20X7 Balance Sheet: Investment in Forward Contracts has a net balance of zero. Firm Commitment has a net debit balance of $120,000 (current asset). Other Comprehensive Income is increased by $60,000 (stockholders= equity). P10.3 (cont=d.) December 31, 20X7 Income Statement: Net gain on hedge activity is $120,000 (presumably offset by a net loss on the net liability position of the branch). Net loss on speculative activity is $60,000. 105,000 87,000 192,000 192,000 192,000 27,000 27,000 384,000 174,000 210,000

Requirement 3: Observe that the forward contracts entered into by Futura represented a perfect hedge. That is, forward sale contracts #1 and #4 were hedged by forward purchase contracts #2 and #3. One could argue that these forward exchange contracts were unnecessary. Whatever transaction costs were incurred by Futura in connection with the contracts represent an unnecessary loss to the firm. P10.4 HEDGING, LEVERAGE, RETURN ON ASSETS Requirement 1: If the exchange rate rises to $.43/FC, ABC incurs a net loss on the forward contract of $10,000, since the forward rate declines from $.44 to $.43 on a forward contract of 1,000,000 FC units. In other words, the contract requires purchase of FC for $440,000 when the prevailing market price is $430,000. Without the forward contract, only $430,000 would need to be paid to satisfy the payable. Without the hedge, ABC's payable to the foreign supplier increases by $30,000 [ = ($.43 - $.40) 1,000,000] and the $30,000 exchange loss decreases equity. There is no change in total assets. Using the data in the problem, measured leverage rises to .73 [ = ($700,000 + $30,000)/$1,000,000]. With the hedge, the payable still increases by $30,000. The forward contract is shown as a current liability of $10,000. Using the data in the problem, measured leverage becomes .74 [ = (700,000 + 30,000 + 10,000)/1,000,000].

P10.4 (cont=d.) Requirement 2: If ABC did not use the forward contract, it could borrow $400,000 now and buy the needed foreign currency. This would cost $412,000, including 12% interest for 3 months. The forward contract costs $440,000. In addition, if the company borrows, it could invest the FC in short-term foreign investments until required by the foreign supplier. This alternative seems to dominate the forward contract. Requirement 3: As above, there is a $30,000 transaction loss on the payable which decreases operating income. There is a $25,000 gain on the forward purchase contract since the forward rate increases from $.405 to $.43. Without the hedge, and assuming an annual ROA of .16 (.04 quarterly), at current exchange rates projected operating income for the first quarter is $44,000 [ = .04 ($1,000,000 + $1,200,000)/2]. Without the hedge, the $30,000 transaction loss due to the increasing exchange rate reduces operating income to $14,000 and the quarterly ROA to .013 [ = $14,000/($1,000,000 + $1,200,0000/2)] With the hedge, operating income is again reduced by the $30,000 loss on the payable, but increases by the $25,000 gain on the forward purchase contract. Operating income is $39,000 = ($44,000 - $5,000) and the quarterly ROA is . 035 [ = $39,000/($1,000,000 + $1,200,000 + $25,000)/2].

P10.5 TRANSACTION EXPOSURE AND CREDIT ANALYSIS Requirement 1: Using the information given, we can compute Poole's cash flow from operations as follows: Net income $150,000 + Depreciation expense 50,000 - Increase in noncash working capital (40,000) - Unrealized transaction gains on long-term debt (22,000) Cash flow from operations $138,000 Because earnings are "overstated" by noncash items ($150,000 > $138,000), "nearness to cash" could be improved. Requirement 2: Sales generate cash flows. When sales are denominated in a foreign currency, however, the amount of cash ultimately collected is affected by changes in the exchange rate, as well as by the general risk of default. Although we do not know Poole's 20X5 projected sales to these foreign customers, we do know that one-third of the ending inventory is designated to be sold to them. Wide variations in the exchange rate will likely have material effects on dollar cash flows from these sales. The suggested analysis involves calculating the dollars lost on sale of the designated inventory if customers pay Poole when the dollar strengthens and the exchange rate falls to $.20/FC. In this case, the FC500,000 will produce $75,000 (= $175,000 - $.20 X 500,000) less, more than half of Poole's 20X4 operating cash flow.

P10.5 (cont=d.) Requirement 3: Poole seems to have considerable exposure to exchange rate risk, with foreign currency denominated claims in receivables, payables and long-term debt, and susceptible revenue-driven cash flow streams. First, you would like more information on the extent of this exposure and whether any of it represents natural hedges. Second, you want to know management's plans to minimize this risk and the relative cost of different strategies, such as forward contracts, foreign loans and investments, and accelerated payment and collection policies. P10.6 HEDGING A FOREIGN CURRENCY COMMITMENT-EFFECTS ON INCOME Requirement 1: November 30, 20X2 Loss on Hedge Activity Investment in Forward Contract To record decline in value of forward sale contract; $21,000 = ($.840 - $.798) X 500,000. Firm Commitment Gain on Hedge Activity To record increase in sales value of the agreement with the Swiss customer. Accounts Receivable Sales Revenue To record delivery of the motors to the Swiss customer; $390,000 = $.78 X 500,000. 390,000 390,000 21,000 21,000 21,000 21,000

P10.6 (cont=d.) Sales Revenue Firm Commitment To adjust Sales Revenue for the accumulated balance in the Firm Commitment account. December 31, 20X2 Transaction Loss Accounts Receivable To adjust accounts receivable balance to the new spot rate; $5,000 = ($.78 - $.77) X 500,000. Investment in Forward Contract Transaction Gain To record increase in value of forward sale contract; $10,000 = ($.84 - $.82) X 500,000. January 31, 20X3 Accounts Receivable Transaction Gain To adjust accounts receivable balance to the new spot rate: $20,000 = ($.81 - $.77) X 500,000. Investment in Forward Contract 5,000 Transaction Gain To record increase in value of forward sale contract; $5,000 = ($.82 - $.81) X 500,000. Foreign Currency 405,000 405,000 Accounts Receivable To record payment by Swiss customer to Ellis Corporation. 5,000 20,000 20,000 10,000 10,000 5,000 5,000 21,000 21,000

P10.6 (cont=d.) Cash Investment in Forward Contract Foreign Currency To record settlement of the forward sale contract. Requirement 2: Transaction Loss Transaction Gain Sales Revenue Net Effect on Income 20X2 $ ( 5,000) 10,000 369,000 $374,000 20X3 $ B 25,000 B $ 25,000 399,000 6,000 405,000

Note that the sum of the income effects for the two years equals $399,000, which is the U.S. dollar amount received from the sale and forward contract. Requirement 3. With the forward contract, Ellis received $399,000 from the sale. Without the contract, SF500,000 would have been exchanged for $405,000 = $.81 X 500,000. Therefore Ellis lost $6,000 due to hedging. However, Ellis did gain peace of mind in knowing the $399,000 was locked in.

P10.7 HEDGING A FORECASTED TRANSACTION The forward contract in this problem is a hedge of a forecasted transaction from September 1, 20X1 to November 1, 20X1; it is a hedge of a firm commitment from November 1, 20X1 to January 29, 20X2, and a hedge of an existing exposure from January 29, 20X2 to March 1, 20X2. November 1, 20X1 Investment in Forward Contract Other Comprehensive Income To record increase in value of forward purchase contract; $5,000 = (1.425 - $1.420) X 1,000,000. December 31, 20X1 Investment in Forward Contract Gain on Hedge Activity To record increase in value of forward purchase contract; $16,000 = (1.441 - $1.425) X 1,000,000. Loss on Hedge Activity Firm Commitment To record increase in value of purchase commitment. January 29, 20X2 Investment in Forward Contract Gain on Hedge Activity To record increase in value of forward purchase contract; $17,000 = ($1.458 - $1.441) X 1,000,000. Loss on Hedge Activity Firm Commitment To record increase in value of firm purchase commitment. 17,000 17,000 16,000 16,000

5,000 5,000

16,000 16,000

17,000 17,000

P10.7 (cont=d.) Inventory Accounts Payable To record delivery of merchandise at current spot rate of $1.45. Firm Commitment Inventory To adjust the inventory balance for the accumulated balance in the firm commitment account. March 1, 20X2 Transaction Loss Accounts Payable To adjust the account payable to the current spot rate; $10,000 = ($1.46 - $1.45) X 1,000,000. Investment in Forward Contract Transaction Gain To record increase in value of forward purchase contract; $2,000 = ($1.46 - $1.458) X 1,000,000. Foreign Currency Investment in Forward Contract Cash To record settlement of the forward contract. Accounts Payable Foreign Currency To record payment to the supplier. 1,460,000 1,460,000 1,460,000 40,000 1,420,000 2,000 2,000 10,000 10,000 33,000 33,000 1,450,000 1,450,000

P10.7 (cont=d.) April 8, 20X2 Cash Sales Revenue To record sale to U.S. customer. Cost of Goods Sold Inventory To record cost of merchandise sold. Other Comprehensive Income Cost of Goods Sold To transfer gain on forward purchase contract during the forecast period to current income. P10.8 ANALYZING THE PERFORMANCE OF AN IMPORT/EXPORT DEPARTMENT Requirement 1: This problem is approached by evaluating the profit contributions of the import and export departments separately and then by reviewing the reasonableness of the forward contract. Although the ultimate measure of profitability is cash received minus cash paid out, we will also be interested in the change in the dollar equivalents of Bush's overseas purchases and sales between the transaction dates and the payment/collection dates. This may have some implications for credit and payment policies. 1,417,000 1,417,000 5,000 5,000 1,600,000 1,600,000

P10.8 (cont=d.) Profit Contribution of the Import Transactions

(1) Part # K14 KR08 L16 M29Q Total Cost When Purchased $ 10,624 83,300 46,330 93,240 $233,494

(2) $ Cost When Paid $10,240 98,600 50,020 80,640 $239,500

(3) Total Net Revenue $ 15,500 102,000 50,000 92,000 $259,500

(4)=(3)-(1) Gross Contribution $ 4,876 18,700 3,670 (1,240) $26,006

(5)=(1)-(2) Exchange Gain (Loss) $ 384 (15,300) (3,690) 12,600 $ (6,006)

(6)=(4)+(5) Total Contribution $ 5,260 3,400 (20) 11,360 $20,000

P10.8 (cont=d.) Profit Contribution of the Export Transactions

(1) Part # A24 DD2 A27 B23 Total $ Revenue When Sold $ 31,752 150,000 220,000 9,198 $410,950

(2) $ Revenue When Collected $ 34,104 144,000 232,000 8,468 $418,572

(3) Total Cost $ 27,720 144,000 178,000 8,500 $358,220

(4)=(1)-(3) Gross Contribution $ 4,032 6,000 42,000 698 $52,730

(5)=(2)-(1) Exchange Gain (Loss) $ 2,352 (6,000) 12,000 (730) $ 7,622

(6)=(4)+(5) Total Contribution $ 6,384 0 54,000 (32) $ 60,352

P10.8 (cont=d.) Review of Forward Contracts Overall, the contracts entered for hedging purposes produced a net gain of $2,700. The forward purchase contract cost $130,200 (= 210,000 x $.62) while at maturity the foreign currency could have been purchased for $123,900 (= 210,000 x $.59), yielding a loss of $6,300 (= $130,200 $123,900). The forward sale contract produced revenue of $270,000 (= 300,000 x $.90) while at maturity the same amount of foreign currency could have been sold on the spot market for $261,000 (= 300,000 x $.87), yielding a gain of $9,000 (= $270,000 - $261,000). The net gain amounted to $2,700 (= $9,000 - $6,300). Note that had the hedging not been undertaken, exchange rate movements would have produced losses on both the purchase and sale transactions. Ignoring interest rate effects, the cost of the foreign currency to be purchased increased by $4,200 (=($.59 - $.57)210,000) between inception and maturity while the value of the foreign currency to be sold decreased by $3,000 (= ($.88 - $.87)300,000) between inception and maturity. In contrast, the speculative contracts were mistakes. The foreign currency acquired for $250,000 (= 1,000,000 x $.25) in the purchase contract could be sold for only $220,000 (= 1,000,000 x $.22) in the spot market at maturity, generating a loss of $30,000. Likewise, the currency sold for $740,000 (= 1,000,000 x $.74) in the sale contract had to be purchased in the spot market at maturity for $850,000 (= 1,000,000 x $.85) and a loss of $110,000 resulted.

P10.8 (cont=d.) Requirement 2: Memorandum TO: Top Management, Bush Specialty Products FROM: Mr. X, Consultant SUBJECT: Review of William Johnston's Import/Export Department Mr. Johnston is doing a reasonable job in the import/export business. Both import and export transactions provided positive contributions toward fixed costs and profits of Bush. The export business has been the most successful with a much higher ratio of profit contribution to sales. Unfortunately, these reasonably satisfactory results have been wiped out by Mr. Johnston's activities in the forward markets for foreign exchange. Johnston entered into two speculative forward contracts which produced losses of $140,000, almost $60,000 more than the total profit contribution provided by the import/export transactions. I do not know whether he has been cautioned against speculating with the firm's capital and cannot recommend outright that Johnston be fired. At a minimum, he should be prohibited from entering into speculative forward contracts on behalf of the import/export department. Mr. Johnston's credit and payment policies should be reviewed. Several of the import and export transactions resulted in large exchange gains and losses. Although there was a net exchange gain, several of the currencies Mr. Johnston transacts in seem to be quite volatile. Hence the timing of payments and collections should be closely monitored along with movements in the exchange rates. While hedging in the forward market eliminates this risk, it does so for a price which may not represent the most cost-effective solution.

P10.9 RECORDING A HEDGED FOREIGN LOAN December 16, 20X1 Cash Loan Payable To record the dollar equivalent of ,50,000 borrowed from a London bank; $84,000 = $1.68 x 50,000. December 31, 20X1 Loan Payable Transaction Gain To accrue the transaction gain on the loan payable; $1,000 = ($1.68 - $1.66) X 50,000. Transaction Loss Investment in Forward Contract To accrue the loss on the forward purchase contract; $1,010 = ($1.71 - $1.69) X 50,500. Interest Expense Interest Payable To accrue interest expense on the loan payable from December 16 - December 31, 20X1; $415 = $1.66 x 250. The interest accrual reflects the spot rate in effect when the interest is accrued. January 15, 20X2 Loan Payable Transaction Gain To accrue the transaction gain on the loan payable; $1,500 = ($1.66-$1.63) X 50,000. Transaction Loss Investment in Forward Contract To accrue the transaction loss on the forward purchase contract; $3,030 =($1.69 - $1.63) X 50,500. 3,030 3,030 1,500 1,500 415 415 1,010 1,010 1,000 1,000 84,000 84,000

P10.9 (cont=d.) Interest Payable Transaction Gain To accrue the gain on the interest payable; $7.50 = ($1.66 - $1.63) X 250. Interest Expense Interest Payable To accrue interest expense on the loan payable from January 1 - January 15, 20X2; $407.50 = $1.63 x 250. Foreign Currency Investment in Forward Contract Cash To record settlement of the forward purchase contract. Loan Payable Interest Payable Foreign Currency To record repayment of the loan and interest to the London Bank with the foreign currency. 81,500 815 82,315 82,315 4,040 86,355 407.50 407.50 7.50 7.50

P10.10 EVALUATION OF DOMESTIC AND FOREIGN INVESTMENTS Domestic Investment $1,000,000 (1.06) = $1,060,000, for an effective annual yield of 12%. U.K. Investment $1,000,000 can be invested in a CD worth ,588,235.29 [=$1,000,000/$1.70]. The value of the CD at the end of 6 months is (,588,235.29) X 1.07 = , 629,411.76. To avoid exchange risk, the company would enter into a forward contract locking in the sale of ,629,411.76 at $1.73, which will yield $1,088,882.30. The annual effective yield is ($88,882.30/$1,000,000) X 2 = 17.78%. German Investment $1,000,000 can be invested in a CD worth _869,565.21 [=$1,000,000/$1.15]. The value of the CD at the end of 6 months is (_869,565.21) X 1.05 = _913,043.47. To avoid exchange risk, the company would enter into a forward contract locking in the sale of _913,043.47 at $1.20, which will yield $1,095,652.10. The annual effective yield is ($95,652.10/$1,000,000) X 2 = 19.13%. Recommendation: Purchase the German certificate as it has the highest effective annual yield.

P10.11 ADJUSTING ENTRIES AT BALANCE SHEET DATE Computation of Transaction Adjustment on Receivables Foreign Currency E.R. Country Amount (December 31, 20X7) Australia 2,000,000 $ .62 Norway 5,000,000 .19 Spain 10,000,000 .007 Dollar amount of foreign currency receivables at December 31, 20X7 Less amount per books ($1,200,000 + $1,000,000 + $80,000) Transaction loss on receivables Note: Accounts due from Peruvian customers are denominated in dollars. Computation of Transaction Adjustment on Payables Foreign Currency E.R. Amount (December 31, 20X7) Brazil 4,000,000 $.83000 Columbia 6,000,000 .00065 Netherlands 10,000,000 1.25000 Dollar amount of foreign currency payables at December 31, 20X7 Less amount per books ($3,100,000 + $4,200 + $12,700,000) Transaction loss on payables Country Note: Accounts due to Swedish suppliers are denominated in dollars. Amount ($) $ (3,320,000) (3,900) (12,500,000) $(15,823,900) (15,804,200) $ 19,700 Amount ($) $1,240,000 950,000 70,000 $2,260,000 (2,280,000) $ 20,000

P10.11 (cont=d.) Computation of Transaction Adjustment on Other Assets (Liabilities) Foreign Currency E.R. Dr. (Cr.) (12/31/X7) (200,000,000) $.008 (5,000,000) $.0234 - $.025 10,000,000 $1.24 - $1.21 (10,000,000) $.27 - $.23 (1,000,000) $.284 - $.2867 Current Required Adjustment Valuation ($) Dr. (Cr.) $(1,600,000) $(100,000) (8,000) (6,000) 300,000 (300,000) 400,000 600,000 (2,700) (11,700)

Item Note payable Forward purchase contract (rupees) Forward purchase contract (euros) Forward sale contract (riyal) Forward sales contract (pesetas)

P10.11 (cont=d.) Adjusting Entries - Books of Warner Corporation Transaction Loss Accounts Receivable Accounts Payable To adjust accounts receivable and payable denominated in foreign currencies to their dollar equivalents at December 31, 20X7 and recognize the related transaction loss. Transaction Loss Note Payable To adjust note payable denominated in yen to its current dollar equivalent at December 31, 20X7. Loss on Speculative Activity Investment in Forward Purchase Contract To adjust speculative forward purchase contract denominated in rupees to its current value. Transaction Loss Investment in Forward Contract To adjust forward purchase contract for euros, held as a hedge of an existing account payable, to its current value. Investment in Forward Sale Contract Gain on Hedge Activity To adjust forward sale contract for riyal, held as a hedge of a firm sale commitment, to its current value. P10.11 (cont=d.) 600,000 600,000 200,000 200,000 6,000 6,000 100,000 100,000 39,700 20,000 19,700

Loss on Hedge Activity Firm Commitment To recognize decrease in value of firm commitment to sell to a Saudi Arabian customer. Other Comprehensive Income Investment in Forward Sale Contract To adjust forward sale contract for zloty, held as a hedge of a forecasted sale to a Polish customer.

600,000 600,000

11,700 11,700

P10.12 TAXES, HEDGING AND PRICING INTERNATIONAL TRANSFERS Requirement 1: The transfer price that minimizes the worldwide income tax liability is the price that assigns as much of the income as possible to the foreign subsidiary. Because the parent company must report a gross margin of at least 20% over cost, the transfer price cannot be less than $90, determined as follows: .2 = .2P = 1.2P = P= P= (108 - P)/P 108 - P 108 108/1.2 90

P10.12 (cont=d.) At a transfer price of $90, the worldwide tax liability on gross margin is $16.95, calculated as follows. All foreign items are expressed in dollars at the prevailing exchange rate, $.10/N. Foreign tax = .15(90 - 25) = 9.75 U.S. tax = .40(108 - 90) = 7.20 For each dollar the transfer price is reduced, total income tax rises by $.25 (= . 4 - .15). Requirement 2: The requirement that transfer prices should reflect arm's length transactions between unrelated parties does constrain companies' flexibility somewhat. Certainly if a company sells identical products on identical terms to unrelated parties, abuse might be easy to spot. But there may be a variety of arrangements whereby similar products are sold to unrelated parties, none of which exactly parallels the parent/subsidiary transaction. As a result, companies are still likely to have considerable latitude in setting defensible transfer prices. Even if transfer prices are constrained, cost allocations may facilitate the desired profit allocation between controlling and minority interests or between foreign and domestic income.

P10.12 (cont=d.) Requirement 3: If the dollar strengthens as predicted, the dollar transfer price will fall and the amount of income taxed at the high U.S. rate increases. A 20% drop in the direct exchange rate will increase the total tax by $4.50 (=.25 X .2 X 90) per unit. To avoid this tax impact, the U.S. parent could try to enter into a forward purchase contract to hedge against an increase in the value of the dollar. Unfortunately, if foreign exchange market participants share the "experts" opinion that the dollar will strengthen, the forward rate will be below the spot rate and the currency will be bought at a discount. Thus the high dollar equivalent of the transfer price cannot be sustained in this way. Even if a forward contract could be entered to sustain the high exchange rate, if the dollar does strengthen and the exchange rate falls, the U.S. parent suffers an opportunity loss by purchasing the currency at the higher forward rate. Using the problem data, if the rate falls by 20% after a forward contract at $.10/N is entered, the U.S. parent will pay $90 for the nahks needed to purchase a unit of product, not $72 [= (1 - .2).10 X 900]. Thus the parent would pay $18 (= 90 - 72) to save $4.50 in taxes, not a good idea. Requirement 4: Per SFAS 133, in order for a foreign currency forward contract to qualify as a hedge of a foreign currency commitment, (1) the contract must be designated as, and effective as, a hedge and (2) the commitment must be firm (all significant terms are specified, performance is probable). In order for the foreign currency forward contract to qualify as a hedge of a forecasted transaction, the forecasted transaction must be identified, there must be formal documentation of the hedging relationship, and the hedging relationship must be effective and assessed on a regular basis. P10.13 PURCHASE ALTERNATIVES AND CASH FLOW ANALYSIS (APPENDIX 1) Requirement 1:

a. Paying in full on April 1 amounts to $823,200 [= (.98 X 600,000) X 1.40]. b. Hedging with a forward contract produces a total payment of $864,000 (= 1.44 X 600,000) on September 1. The present value on April 1 of this payment is $830,769 (= 864,000/1.04). c. Using the "covered interest arbitrage" formula enables us to solve for the 6-month U.K. interest rate. Rf = Rs(1 + IUS)/(1 + IUK) (1 + IUK) = Rs(1 + IUS)/Rf IUK = Rs(1 + IUS)/Rf - 1 IUK = 1.40(1.04)/1.44 - 1 IUK = 1.011 - 1 = .011 If ,600,000 is invested, the temporary investment produces ,606,600 (= 1.011 X 600,000) in six months. Of this amount at maturity, the ,600,000 principal is used to pay the British supplier. Depending on the spot rate at September 30, the present value on April 1 of the ,6,600 interest could range between $7,996 [= (1.26 X 6,600)/1.04] and $9,773 [= (1.54 X 6,600/1.04)]. Because $840,000 (= 1.40 X 600,000) must be converted on April 1 to obtain the ,600,000 investment, the net cost as of April 1 ranges between $830,227 (= 840,000 - 9,773) and $832,004 (= 840,000 - 7,996).

P10.13 (cont=d.) An alternative approach involves determining the amount of UK investment needed today (4/1/X3) to produce ,600,000 in six months. 600,000/1.011 = 593,472 At the current spot rate of $1.40/,, Wyatt would have to convert $830,860 (= 1.40 X 593,472) into the UK investment for a cash cost of $830,860 on April 1, 20X3. d. Purchase from the domestic firm requires cash with a present value on April 1 of $815,527 [= 769,231 (= 800,000/1.04) + 46,296 (= 50,000/1.08)]. Requirement 2: Purchase from the domestic firm involves the smallest cash outlay in present value. However, the additional warranty costs and the potential nonquantifiable loss in goodwill are of concern. The next best alternative is immediate purchase, taking advantage of the 2% cash discount. The risk here is that the supplier might not perform. Only the investment in the ,-denominated security will affect earnings volatility during the next 6 months. By not being designated a hedge, transaction adjustments are recognized currently in earnings. Although the potential transaction adjustments due to swings in the spot rate could be large, we cannot determine if such effects would be material. Transaction adjustments on the forward contract are either offset by other transaction adjustments (firm commitments) or are temporarily reported in other comprehensive income (forecasted transactions).

P10.14

CURRENCY SWAP: COMPUTATION OF FORWARD RATE AND ENTRIES (APPENDIX 1 AND 2)

Requirement 1: The direct forward rate equals the current spot rate multiplied by (1 + the yield on U.S. government securities) and divided by (1 + the yield on foreign government securities). This problem calls for the 6-month forward rate and uses 6-month interest rates in the calculations (e.g., the 12-month U.S. interest rate is .07; for 6 months the rate is .07/2 or .035). In equation form, Rf,6 = Rs(1 + Ius,6)/(1 + If,6) = 1.6(1.035)/(1.051) = 1.576 Requirement 2: July 1, 20X1 No entry as the swap has no net value. December 31, 20X1 Loss on Hedge Activity Investment in Swap To recognize the loss accrued on the swap; $434,000 = ($1.70 - $1.576) X 3,500,000. Firm Commitment Gain on Hedge Activity To recognize the gain on the construction contract firm commitment. 434,000 434,000 434,000 434,000

P10.14 (cont=d.) Foreign Currency Sales Revenue To recognize payment received on the construction contract; $5,950,000 = $1.70 X 3,500,000. This entry assumes the payment is earned. Sales Revenue Firm Commitment To adjust sales revenue for the change in value of the firm commitment. Cash Investment in Swap Foreign Currency To record settlement of the swap. 5,516,000 434,000 5,950,000 434,000 434,000 5,950,000 5,950,000