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Chapter 10

Accounting for Foreign Currency Transactions

SUMMARY OF ASSIGNMENT MATERIAL

Item Topics Covered Level

Time

Q10.1 Compare single-transaction approach and two-transaction approach regarding the amount,timing and character of reported income.

Mod 10-15

Q10.2 Define foreign exchange risk and its majorsources.

Low 10-15

Q10.3 Explanation of the risks faced by a companydealing in overseas markets and discussion ofimportant information needed in establishingcredit and payment policies for foreigncustomers.

Low 10-15

Q10.4 Explanation of the nature of forward and optioncontracts and how they are used to neutralizeforeign exchange risk.

Med 10-15

Q10.5 Explain why a foreign currency forwardcontract is known as a derivative financialinstrument.

Low 5-10

Q10.6 Explain the SFAS 133 accounting for hedges offirm commitments and forecasted transactions.

Med 10-15

Q10.7 Discussion of whether or not an intendedhedging transaction will be an effective hedge.

Low 5-10

Q10.8 Discussion of whether or not an intendedhedging transaction will be an effective hedge.

Low 5-10

Q10.9 Explain balance sheet reporting of forwardcontracts.

Mod 10-15

SUMMARY OF ASSIGNMENT MATERIAL (cont=d.)

10-1

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Time

Q10.10 Describe two foreign currency transactions otherthan forward contracts that could be used ashedges.

Low 10-15

Q10.11 Explanation of forward contracts used as aneconomic hedge of a net investment in a foreignentity, and the required accounting for thesecontracts.

Mod 10-15

Q10.12 Explanation of whether the forward exchangerate for the foreign currency will be above or

below the spot rate if U.S. interest rates exceed aforeign country=s interest rates (Appendix 1)

High 15-20

E10.1 Journal entries for various import transactions. Low 15-20

E10.2 Journal entries for various export transactions. Low 15-20

E10.3 Journal entries to record four import/exporttransactions and related cash settlement.

Low 15-20

E10.4 Adjusting entry to restate receivables and

payables denominated in foreign currencies atbalance sheet date.

Low 10-15

E10.5 Journal entries for hedged import transaction;calculate gain/loss from hedging.

Low 10-15

E10.6 Journal entries for hedged export transaction;calculate gain/loss from hedging.

Low 10-15

E10.7 Journal entries for a hedged purchasecommitment and exposed liability.

Mod 15-20

E10.8 Journal entries for hedged sale commitment andexposed asset.

Mod 15-20


10-2

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Time

E10.9 Journal entries for a hedged forecasted purchase. Mod 15-20

E10.10 Journal entries for a hedged forecasted sale. Mod 15-20

E10.11 Journal entries for a short-term foreigninvestment; evaluation of the investment.

Mod 20-30

E10.12 Economic hedge of a net investment in a foreignentity; entries to record forward contract servingas an effective hedge; calculation of transactionadjustment and indicate its accounting treatment.

Mod 15-20

E10.13 Journal entries for speculative forward purchase

and sale contracts spanning two accountingperiods.

Mod 15-20

E10.14 Covered interest arbitrage; calculate U.S. interestrate, expected forward rate and maturity value offoreign investment (Appendix 1).

High 15-20

E10.15 Reporting a currency swap used as a hedge of aforecasted transaction (Appendix 2).

Mod 15-20

P10.1 Computation of transaction gains and losses

based on a list of the firm=s receivables,payables, and other assets (liabilities); evaluationof forward contracts.

Mod 25-35

P10.2 Journal entries for hedged import commitment;import and export transactions.

Mod 15-25

P10.3 Journal entries and disclosure for forwardcontracts entered for various hedging andspeculative reasons; evaluation of the

company=s use of the forward market.

Mod 40-50

10-3

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Time

P10.4 Approaches to hedging an import transaction;effects on total liabilities/total assets and returnon assets.

High 30-40

P10.5 Calculate cash flow from operations to assessearnings quality and effect of changing exchangerate on cash flow in a credit analysis setting.

Mod 30-40

P10.6 Journal entries for hedged export commitmentspanning two accounting periods; income effects

for each period and analysis of hedgeeffectiveness.

Mod 20-30

P10.7 Journal entries for a hedged forecastedtransaction that becomes a firm commitment andthen an exposed position.

Mod 40-45

P10.8 Evaluation of performance of an import/exportdepartment with forward contracts; managerialuse of accounting data produced in foreigncurrency transactions.

High 50-60

P10.9 Journal entries for a hedged foreign loan. Mod 25-35

P10.10 Evaluation of foreign and domestic investments. Mod 25-35

P10.11 Adjusting entry at balance sheet date requiringcomputation of transaction adjustment onreceivables, payables, and other assets(liabilities), including forward contracts. This isa more complex version of P10.1 using differentdata.

Mod 30-40


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Time

P10.12 Transfer prices and taxes in an intercompanysetting involving a foreign subsidiary; impact ofexpected exchange rate movement on hedgingdecision; criteria for determining whetherforward contract qualifies as a hedge.

High 30-40

P10.13 Evaluate alternative ways of paying for an importtransaction; covered interest arbitrage used; effectof payment scenarios on earnings volatility(Appendix 1).

Mod 25-35

P10.14 Calculate the forward rate; report a currency

swap used as a hedge of a firm sale commitment(Appendix 1, 2).

Mod 20-30

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CARRYBACK TABLE

The carryback table identifies the assignment items which are new in thisedition and those which are carried over from the seventh edition. For thelatter, the problem number in the seventh edition is shown.

NewProblemNumber Source

NewProblemNumber Source

NewProble

mNumbe

r

Source

Q10.1 Q10.1 E10.1 E10.1 P10.1 P10.1

Q10.2 Q10.2 E10.2 E10.2 P10.2 P10.2

Q10.3 Q10.3 E10.3 E10.3 P10.3 P10.3

Q10.4 Q10.4 E10.4 E10.4 P10.4 P10.4

Q10.5 Q10.5 E10.5 E10.5 P10.5 P10.5

Q10.6 Q10.6 E10.6 E10.6 P10.6 P10.6

Q10.7 Q10.7 E10.7 E10.7 P10.7 P10.7

Q10.8 Q10.8 E10.8 E10.8 P10.8 P10.8

Q10.9 Q10.9 E10.9 E10.9 P10.9 P10.9

Q10.10 Q10.10 E10.10 E10.10 P10.10 P10.10

Q10.11 Q10.11 E10.11 E10.11 P10.11 P10.11

Q10.12 Q10.12 E10.12 E10.12 P10.12 P10.1

2E10.13 E10.13 P10.13 P10.1

3

E10.14 E10.14 P10.14 new

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E10.15 new

Carryforward tables for all chapters, identifying the disposition of seventhedition assignment items, appear at the beginning of the solutions manual.

ANSWERS TO QUESTIONS

Q10.1

Under the two-transaction approach, the transaction adjustment accruing tothe payable or receivable is viewed as a separately reportable incomestatement item, not as part of the related purchase or sale. In contrast, thesingle-transaction approach treats the transaction adjustment as part of the

purchase or sale on the grounds that the dollar measured purchase or sale isnot fully complete until the payable or receivable is settled.

Under both approaches, the receivable or payable is adjusted to its currentspot rate. Under the single-transaction approach, transaction adjustmentsaffect gross margin through their effects on reported sales and purchases (orcost of good sold). The two-transaction approach does not affect grossmargin as it reports the transaction adjustments as "other income/expense" inthe period the spot rate changes.

Q10.2

A company is exposed to foreign exchange risk if changes in exchange ratesresult 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 notesreceivable.

3. Net investment in a foreign subsidiary or division.4. Firm commitment to purchase or sell, where the invoice price is denominated inforeign currency.

5. Forecasted purchase or sale transactions, where the invoice price is denominatedin foreign currency.6. Speculative forward or futures contracts in foreign currency.

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Q10.3

Aside from the credit-worthiness of specific overseas customers, Barbershould be very concerned about the extension of credit or theacceptance of purchase orders for sales denominated in units of theforeign currency. If prices are quoted in terms of the foreign currency,any lapse of time between acceptance of a purchase order fromoverseas and the time for payment adds foreign exchange risk towhatever other risks Barber is bearing. Thus, to the extent possible,Barber should negotiate for prices in terms of U.S. dollars if it wishes toavoid this risk. However, the foreign customer would then bear the riskof changes in the exchange rate. If Barber=s competition offers pricesdenominated in the currency of the customer, Barber may not be ableto require payments in U.S. dollars.

The following kinds of information would be relevant to Barber'soverseas credit and payment policies.

1. Volatility and direction of movements in exchange rates.2. Interest rates in the U.S. and in the foreign countries.3. Availability of a forward market if needed.4. Typical spread between spot and forward rates to assess the

cost of hedging.

5. Credit and payment policies of competitors.

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Q10.4

A foreign exchange forward contract locks in the future buying orselling price of a foreign currency. Foreign exchange risk is neutralizedbecause 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 ofthe company. For example, a company expecting to receive 10 millionyen from a customer in Japan in two months may enter a forward salecontract specifying the exchange rate for exactly 10 million yen at thedate the customer payment is expected. Similarly, a companyexpecting to make a foreign currency payment to a foreign suppliermay use a forward contract to lock in the U.S. dollar equivalent of thiscurrency purchase. A forward contract requires the company to followthrough on the contract. Therefore it must buy (sell) currency at thecontracted 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 thecurrency at this strike price, or letting the contract expire. Optioncontracts are typically standardized and traded in organized markets,and are therefore not structured to meet the individual needs of acompany. The company will instead select from a menu of contracts toneutralize its exposure. Unlike forward contracts, option contractsusually require an initial investment (margin deposit). A call optionprovides the opportunity to buy currency at the strike price. At thetime the company must purchase currency to pay a supplier, if the spot

rate is above the strike price the company will purchase the currency atthe strike price. Otherwise the company will let the option expire andpurchase the currency at the current market price. Aputoptionprovides the opportunity to sell currency at the strike price. At the timethe company receives foreign currency from a customer, if the spotrate is below the strike price the company will exercise the option andsell the currency at the strike price. Otherwise, the company will sellthe currency at the market price.

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Q10.5

A derivative financial instrumentis one whose value is tied to or derived fromthe value of some underlying or reference item. The value of a foreigncurrency forward contract--the value of the foreign currency to be received orsold pursuant to the contract--is therefore based on the market price for thecurrency referenced in the contract.

Q10.6

When a company uses a forward contract to hedge a firm commitmentinvolving a foreign-currency-denominated purchase or sale, both the forwardcontract and the firm commitment are marked to market as the market rate

changes. Thus the forward contract is reported at its fair market value, andthe offsetting gain and loss from the hedged commitment and the hedgeinvestment appear on the same income statement.

When a company uses a forward contract to hedge a forecasted transactioninvolving a foreign-currency-denominated purchase or sale, the forwardcontract is marked to market and the resulting gain or loss is accumulated inother comprehensive income until the forecasted transaction impacts theincome statement. Thus the forward contract is reported at its fair marketvalue, 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 tothe hedge offsets the transaction adjustment accruing to the receivables. Forexample, if both the spot and forward exchange rates, $/,, rise by $.10, atransaction loss of $100,000 (= $.10 x 1,000,000) accrues on the hedge and atransaction gain of $100,000 accrues on the receivables.

Q10.8

No, this is not an effective hedge. Put options allow the holder to sellcurrency 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

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show a loss on the put option, since it fixes the selling price of pesos and hasvalue only when the rate declines. Therefore the loss on the put option onlyadds to the loss on the forecasted transaction. Balboa should invest in a calloption, fixing the price at which it may buy the currency required to pay thesupplier.

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 atthe contracted date and the contracted rate for delivery at the contracted date.A forward purchase contract will have a debit (credit) balance and be shownas a current asset (liability) if the contracted forward rate is less (greater) thanthe current forward rate. A forward sale contract will have a debit (credit)

balance and be shown as a current asset (liability) if the contracted forwardrate is greater (less) than the current forward rate.

Q10.10

Virtually any foreign currency investment that effectively reduces exchangerate risk can serve as a hedge. Two examples are:

1. An investment in a foreign bond or note denominated in the samecurrency (or one that moves in tandem with that currency) with

amounts and due dates coinciding with those exposing the companyto exchange risk.

2. Receivables and payables denominated in the same currency, or incurrencies that move in tandem, can likewise serve as hedges ofeach other.

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Q10.11If an American company has a net investment in a foreign branch, investee, orsubsidiary whose functional currency is its local currency, the subsidiary's netassets expose the American company to risk of exchange rate movements,since these amounts are translated at the current exchange rate. This risk isnormally a debit balance. To hedge this risk, the American company may

borrow in the foreign currency or sell the currency forward so that transactionadjustments accruing to the hedge (a credit balance) offset the translationadjustments accruing to the foreign investment, thereby neutralizing theexchange rate risk. This is similar to a transaction designed to hedge foreigndenominated receivables. If the American company has a net investment in aforeign subsidiary whose functional currency is the U.S. dollar, the risktypically comes from the subsidiary's cash, receivables, and debt, since theseaccounts are translated at the current exchange rate. The net exposure is

usually a credit balance, which is hedged with an offsetting receivable orforward purchase contract denominated in the foreign currency.

If the functional currency (the currency in which the foreign entity generatesmost of its net cash flows) is the U.S. dollar, transaction adjustments to theforward contract are included in current income. In contrast, if the functionalcurrency is a foreign currency, transaction adjustments are accumulated inother 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. Thereason is that a dollar invested in the U.S. is worth more in six months thanthat same dollar invested in the U.K. Investors will sell pounds sterling fordollars today and purchase pounds sterling with dollars for delivery in sixmonths. If the dollar does not decrease in value relative to the pound--theforeign exchange rate rises--conversion of pounds sterling into dollars in orderto 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 investmentsin the U.K.

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SOLUTIONS TO EXERCISES

E10.1 RECORDING IMPORT TRANSACTIONS

Australia Thailand Indonesia JordanPurchase Transactions

PurchasesAccounts Payable

Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.

91,50091,500

14,00014,000

1,6101,610

140,000140,000

Payment Transactions

Foreign CurrencyCash

92,25092,250

10,00010,000

1,0501,050

140,000140,000

Accounts PayableTransaction Loss

Transaction GainForeign Currency

91,500750

C92,250

14,000C

4,00010,000

1,610C

5601,050

140,000C

C140,000

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E10.2 RECORDING EXPORT TRANSACTIONS

Argentina Canada India South Africa

Sales Transactions

Accounts ReceivableSales

Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.250,000

250,000260,400

260,4007,200

7,20016,900

16,900

Collection Transactions

Foreign CurrencyTransaction Loss

Transaction GainAccounts Receivable

253,000C

3,000250,000

256,8003,600

C260,400

9,000C

1,8007,200

15,8001,100

C16,900

CashForeign Currency

253,000253,000

256,800256,800

9,0009,000

15,80015,800

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E10.3 RECORDING IMPORT AND EXPORT TRANSACTIONS

IMPORT TRANSACTIONS

Transaction 1

Transaction date:

Inventory 3,300Accounts Payable 3,300

Payment date:Accounts Payable 3,300Transaction Loss 500

Cash 3,800

Transaction 2

Transaction date:

Inventory 180,000Accounts Payable 180,000

Payment date:Accounts Payable 180,000

Transaction Gain 9,000

Cash 171,000

EXPORT TRANSACTIONS

Transaction 3

Transaction date:

Accounts Receivable 342,400Sales 342,400

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E10.3 (cont=d.)

Payment date:

Cash 329,200Transaction Loss 13,200

Accounts Receivable 342,400

Transaction 4

Transaction date:Accounts Receivable 712,500

Sales 712,500

Payment date:

Cash 746,700Transaction Gain 34,200Accounts Receivable 712,500

E10.4 ADJUSTING ENTRY AT BALANCE SHEET DATE

ItemBook Balance ($)

Dr. (Cr.)Dollar Equivalent, 12/31

Dr. (Cr.)Adjustment Needed

Dr. (Cr.)

1 $100,000 90,000 = $.09 x1,000,000

(10,000) (Loss)

2 180,000 184,500 = $.82 x225,000

4,500 (Gain)

3 (500,000) (520,000) = $1.30 x400,000

(20,000) (Loss)

4 (50,000) (48,000) = $.24 x200,000

2,000 (Gain)

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E10.4 (cont=d.)

Adjusting Entry

TransactionLoss

23,500

Accounts Receivable($10,000 - $4,500) 5,500Accounts Payable($20,000 - $2,000) 18,000

To record the net transaction loss on the receivables andpayables at December 31; ($23,500) = ($10,000) +$4,500 + ($20,000) + $2,000.

E10.5 HEDGING EXPOSED LIABILITY

Requirement 1:

March 15, 20X3Inventory 18,100

Accounts Payable 18,100

To record goods purchased;$18,100 = $.000905 X 20,000,000.

April 14, 20X3

Transaction Loss 60Accounts Payable 60

To restate payable at current spot rate;$60 = ($.000908 - $.000905) X 20,000,000.

Investment in Forward Contract 160Transaction Gain 160

To restate forward contract to current fair value;$160 = ($.000908 - $.000900) X 20,000,000.

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E10.5 (cont=d.)

Foreign Currency 18,160Investment in Forward Contract 160

Cash 18,000To record payment to the dealer, receipt of 20,000,000won, valued at the current spot rate of $.000908/W, andfulfillment of the forward purchase contract.

Accounts Payable 18,160Foreign Currency 18,160

Requirement 2:

Dollars paid (to broker) with the hedge: $18,000Dollars that would have been paid at the current spot rate to

purchase foreign currency for the supplier; (.000908 X20,000,000): -18,160Cash gain (amount saved) from hedging: $ 160

E10.6 HEDGING EXPOSED ASSET

Requirement 1:

September 1, 20X6Accounts Receivable 33,200,000

Sales 33,200,000

To record sales made;$33,200,000 = $.83 X 40,000,000.

September 30, 20X6Transaction Loss 400,000

Accounts Receivable 400,000To restate receivable at current spot rate;$400,000 = ($.83 - $.82) X 40,000,000.

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E10.6 (cont=d.)

Investment in Forward Contract 480,000Transaction Gain 480,000

To restate the forward contract to its current fair value;$480,000 = ($.832 - $.82) X 40,000,000.

Foreign Currency 32,800,000

Accounts Receivable 32,800,000To record receipt of currency from Braziliancustomer; $32,800,000 = $.82 X 40,000,000.

Cash 33,280,000Foreign Currency 32,800,000

Investment in Forward Contract 480,000To record delivery of currency to the dealer,receipt of $33,280,000 as specified in thecontract, and settlement of the forward contract.

Requirement 2:

Dollars received (from broker) with the hedge: $33,280,000Dollars that would have been received from thecustomer's foreign currency at the currentspot rate (.82 X 40,000,000): - 32,800,000

Cashgain (increased proceeds) from hedging: $ 480,000

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E10.7 HEDGED PURCHASE COMMITMENT AND EXPOSEDLIABILITY

September 15, 20X3 No entry

November 15, 20X3Investment in ForwardContract 15,000

Gain on Hedge Activity 15,000

To record change in fair value of the forwardcontract; $15,000 = ($.105 - $.104) X 15,000,000.

Loss on Hedge Activity 15,000Firm Commitment 15,000

To record the loss on the firm purchase commitment.

Purchases 1,545,000Accounts Payable 1,545,000

To record delivery of the goods at the current spotrate of $.103.

Firm Commitment 15,000

Purchases 15,000To adjust the carrying value of the goods for theaccumulated loss on the firm commitment during thecommitment period.

December 31, 20X3

Transaction Loss 30,000Accounts Payable 30,000

To record loss due to increase in dollar value of accountspayable; $30,000 = ($.105 - $.103) X 15,000,000.

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E10.7 (cont=d.)


To record increase in value of forward purchase contract;$30,000 = ($.107 - $.105) X 15,000,000.

January 15, 20X4Transaction Loss 45,000

Accounts Payable 45,000To record loss on accounts payable;$45,000 = ($.108 - $.105) X 15,000,000.

Investment in Forward Contract 15,000

Transaction Gain 15,000To record increase in fair value of forward purchasecontract; $15,000 = ($.108 - $.107) X 15,000,000.

Foreign Currency 1,620,000

Investment in ForwardContract 60,000Cash 1,560,000

To record fulfillment of the forward contract.

Accounts Payable 1,620,000

Foreign Currency 1,620,000To record payment to the Mexican supplier.

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E10.8 HEDGED SALE COMMITMENT AND EXPOSED ASSET

April 15, 20X4 No entry

April 30, 20X4

Investment in Forward Contract 75Gain on Hedge Activity 75

To record increase in fair value of the forward contract;$75 = ($.174 - $.173) X 75,000.

Loss on Hedge Activity 75Firm Commitment 75

To record loss on U.S. dollar value of the firm salecommitment.

Accounts Receivable 12,825Sales Revenue 12,825

To record delivery of goods to the South Africancustomer; $12,825 = $.171 X 75,000.

Firm Commitment 75

Sales Revenue 75To adjust the sales revenue for the change in valueof the firm sales commitment.

May 15, 20X4

Accounts Receivable 150Transaction Gain 150

To record gain on accounts receivable;$150 = ($.173 - $.171) X 75,000.

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

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E10.8 (cont=d.)

Foreign Currency 12,975Accounts Receivable 12,975

To record receipt of rands from the South Africancustomer, valued at the current spot rate of $.173.

Cash 13,050

Foreign Currency 12,975Investment in Forward Contract 75

To record delivery of the rands to the dealer, andsettlement of the forward contract.

E10.9 HEDGED FORECASTED PURCHASE

June 30, 20X0Investment in ForwardContract 574

Other Comprehensive Income 574To record increase in fair value of forward purchasecontract; $574 = ($1.24 - $1.199) X 14,000.

Foreign Currency 17,360Investment in Forward Contract 574Cash 16,786

To record settlement of forward contract.

Inventory 17,360Foreign Currency 17,360

To record delivery of merchandise and payment tosupplier; $17,360 = $1.24 X 14,000.

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E10.9 (cont=d.)

July 12, 20X0

Cash 19,000Sales 19,000

To record merchandise sale.

Other Comprehensive Income 574

Cost of Goods Sold 16,786Inventory 17,360

To record cost of sale, including releaseof gain on forward contract to cost of goods sold.

E10.10 HEDGED FORECASTED SALE

November 30, 20X1Other ComprehensiveIncome 500

Investment in ForwardContract 500

To record decrease in value of forward contract;$500 = ($.651 - $.646) X 100,000.

Foreign Currency 65,100Sales 65,100

To record merchandise sale; $65,100 = $.651 X 100,000.

Sales 500

Other Comprehensive Income 500To transfer the loss on the hedge to current earnings.

Cash 64,600Investment in Forward Contract 500

Foreign Currency 65,100To record settlement of forward contract.

E10.11 RECORDING FOREIGN INVESTMENT

Requirement 1:

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October 1, 20X0

Short-term Investments 124,500Cash 124,500

To record the purchase of a 6-month certificate ofdeposit, face value 1,000,000 krona, from a Swedish bank.

December 31, 20X8Short-term Investments 20,000

Transaction Gain 20,000To accrue the transaction gain on the certificate of deposit;$20,000 = ($.1445 - $.1245) X 1,000,000.

Interest Receivable 5,418.75

Interest Income 5,418.75To 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, 20X1Transaction Loss 21,700

Short-term Investments 21,700To accrue the transaction loss on the certificateof deposit since December 31, 20X0;$21,700 = ($.1445 - $.1228)X1,000,000.

Transaction Loss 813.75Interest Receivable 813.75

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.

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E10.11 (cont=d.)

Interest Receivable 4,605Interest Income 4,605

To record interest income for the period January 1, 20X1 toMarch 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) 132,010

Short-term Investments 122,800Interest Receivable 9,210

To record the receipt of foreign currency for principal andinterest at maturity of the certificate of deposit.

Cash 132,010Foreign Currency 132,010

To record conversion of 1,075,000 krona into dollars.

Requirement 2:

This investment returned $7,510, the difference between the $124,500 paid toacquire the certificate and the $132,010 received at maturity. The effectiveannual interest rate on this investment is $7,510/$124,500 X 2 = 3.016%. Ifthis company could have obtained alternative investments for a higher rate ofinterest, this was a poor investment.

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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 beconsidered here. The dollar equivalent of both the parent's net investmentand, by implication, the net assets of the subsidiary, is affected by changes inthe exchange rate. To hedge this debit balance, Williams must generate aforeign currency credit balance which will produce a transaction adjustment ofopposite sign. Either taking out a loan denominated in NP or selling NPforward (the Forward Sale Contract has a credit balance) will lead to thedesired 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 dependsupon the functional currency of the foreign subsidiary. Since the functionalcurrency is the foreign currency (NP), the transaction gain bypasses currentincome 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

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E10.13 (cont=d.)

Requirement 2:

December 31, 20X0

Transaction Loss 30,000Investment in Forward Contract 30,000

To record transaction loss accrued since December 16on speculative forward purchase contract;$30,000 = ($.125 - $.128)10,000,000.

Transaction Loss 80,000

Investment in Forward Contract 80,000To record transaction loss accrued since December 16

on speculative forward sale contract;$80,000 = ($.642 - $.634)10,000,000.

January 15, 20X1


To record transaction gain accrued since December 31on speculative forward purchase contract;$60,000 = ($.131 - $.125)10,000,000.

Foreign Currency 1,310,000Investment in ForwardContract 10,000Cash 1,300,000

To record settlement of the forward purchasecontract.

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E10.13 (cont=d.)

Cash 1,310,000Foreign Currency 1,310,000

To record conversion of $H10,000,000 into dollars.

Note to instructor: The speculation in $H produced a net cash gain of $10,000(= 1,310,000 - 1,300,000).


Transaction Gain 60,000To record transaction gain accrued since December 31on speculative forward sale contract;$60,000 = ($.636- $.642)10,000,000.

Foreign Currency 6,360,000Cash 6,360,000

To record acquisition of $S on the spot market tosettle the forward sale contract.

Cash 6,400,000

Investment in ForwardContract 40,000Foreign Currency 6,360,000

To record settlement of the forward purchasecontract.

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

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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 + RSIUSIUS = (RF + RFIFN - RS)/RS

Now we enter the problem data:

IUS = [.63 + (.63 X .06) - .60]/.60

IUS

= .0678/.60IUS = .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 hedgedprincipal and the unhedged interest. At the $.60 spot rate, the $120,000

becomes a LC200,000 investment; 200,000 = 120,000/.60.

Hedged principal: $.63 X 200,000 $126,000Unhedged interest: $.61 X (.06 X 200,000) 7,320

$133,320The difference between $133,560 and $133,320 is $240 [= ($.63 - $.61) X (.06X 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.

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E10.14 (cont=d.)

Requirement 3:

Recall that: R F = RS(1 + IUS)/(1 + IFN)RF = .60(1.04)/1.06RF = .5887

Check: (1.04) X 120,000 = .5887 X (1.06 X 200,000)124,800 = 124,800

E10.15 CURRENCY SWAP (APPENDIX 2)

October 1, 20X2

No entry as the swap has no value at this time.

December 31, 20X2Investment in Swap 53,000

Other Comprehensive Income 53,000

To recognize the transaction gain accrued on theswap; $53,000 = ($.603 - $.55) X 1,000,000.

Foreign Currency 550,000Sales Revenue 550,000

To record the sale to customers in Australia at thecurrent spot rate; $550,000 = $A1,000,000 X $.55.

Other Comprehensive Income 53,000Sales Revenue 53,000

To reclassify the swap gain to income.

Cash 603,000Investment in Swap 53,000

Foreign Currency 550,000To record settlement of the swap.

SOLUTIONS TO PROBLEMS

P10.1 COMPUTATION OF EXCHANGE GAIN OR LOSS

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Requirement 1:

Computation of Transaction Adjustment on Receivables

CountryForeign Currency

AmountE.R.

(12/31/X2) Amount ($)

BelgiumIndiaSaudi Arabia

300,0001,200,000

90,000

1.256.0235.2666

$376,80028,20023,994

Dollar amount of foreign currency receivables at 12/31/X2Less amount per books ($355,000 + $23,950 + $24,000)Transaction gain on receivables

$428,994(402,950)$ 26,044

Computation of Transaction Adjustment on Payables

Country Foreign CurrencyAmount E.R.(12/31/X2) Amount ($)EcuadorMexico

(60,000,000)(500,000)

$.00015.10210

$ (9,000)(51,050)

Dollar amount of foreign currency payables at 12/31/X2Less amount per books ($10,000 + $50,000)Transaction loss on payables

$(60,050)(60,000)

$ 50

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P10.1 (cont=d.)

Computation of Transaction Adjustment on Other Assets (Liabilities)

ItemForeign Currency

Dr. (Cr.)Forward Rate

(12/31/X2)

Amount ($)(Contract Rate

minus CurrentForward Rate)

Forward purchasecontract (pesos)Forward salecontract (euros)

500,000

(300,000)

$.10235

1.26200

$ (75)

( 3,600)Dollar amount of other assets (liabilities)denominated in foreign currencies at 12/31/X2Amount per books [$(1,125) + $18,200]Transaction loss on other assets (liabilities)

Net transaction gain (loss) in 20X2;$26,044 + $(50)+ ($20,750).

$ (3,675)17,075

$ 20,750

$ 5,244

Adjusting Entry - Books of Wheelstick CorporationAccounts Receivable 26,044Investment in ForwardPurchase Contract 1,050

Accounts Payable 50

Investment in Forward

Sale Contract 21,800Transaction Gain 5,244

To record the transaction adjustments on accountsreceivable, accounts payable, and the forward purchase andsale contracts at December 31, 20X2.

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P10.1 (cont=d.)

Requirement 2:

The forward purchase contract is a hedge of the accounts payable to Mexicansuppliers. Following is an analysis of the transaction gains and losses on theexposure and the hedge investment:

BookValue

12/31/X2Value

TransactionGain (Loss)

Accounts Payable $50,000 $51,050 $(1,050)

Investment in Forward PurchaseContract (1,125) (75) 1,050

Net Transaction Gain (Loss) -0-

The forward sale contract is a hedge of the accounts receivable from Belgiancustomers. Following is an analysis of the transaction gains and losses on theexposure and the hedge investment:

BookValue

12/31/X2Value

TransactionGain (Loss)

Accounts Receivable $355,000 $376,800 $21,800Investment in Forward PurchaseContract 18,200 (3,600) (21,800)

Net Transaction Gain (Loss) -0-

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

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P10.2 IMPORT AND EXPORT TRANSACTIONS AND HEDGEDCOMMITMENT

August 14, 20X5

Loss on HedgeActivity 80,000


To record decline in fair value of forward contract;$80,000 = ($1.25 - $1.23) X 4,000,000.

Firm Commitment 80,000Gain on Hedge Activity 80,000

To record reduction in cost of firm commitment.

Foreign Currency 4,920,000Investment in Forward Contract 80,000

Cash 5,000,000To record settlement of forward purchase contract.

Inventory 4,920,000Foreign Currency 4,920,000

To record delivery of merchandise and payment tosupplier; $4,920,000 = $1.23 X 4,000,000.

Inventory 80,000Firm Commitment 80,000

To adjust inventory balance for value of firm commitment.

September 1, 20X5


To record sales to concern in Poland;$840,000 = $.28 X 3,000,000.

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P10.2 (cont=d.)

November 3, 20X5

Transaction Loss 60,000Accounts Receivable 60,000

To record decline in value of receivable;$60,000 = ($.28 - $.26) X 3,000,000.

Foreign Currency 780,000

Accounts Receivable 780,000To record receipt of payment from customer.

Cash 780,000Foreign Currency 780,000

To record exchange of zloty into dollars.

P10.3 ACCOUNTING FOR FORWARD CONTRACTS--HEDGINGAND SPECULATION

Requirement 1:

December 31, 20X7Loss on Hedge Activity 120,000

Investment in ForwardContract 120,000

To record decline in value of forward sale contract #1;$120,000 = ($.165 - $.105) X 2,000,000.


To record increase in sales value of firm commitment.

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P10.3 (cont=d.)

Investment in ForwardContract

60,000

Other Comprehensive Income 60,000To record increase in value of forward purchase contract #2;$60,000 = ($.165 - $.105) X 1,000,000.


Gain on Hedge Activity 120,000To record increase in value of forward purchase contract#3; $60,000 = ($.165 - $.105) X 2,000,000.

Loss on SpeculativeActivity 60,000

Investment in Forward Contract 60,000To record loss on speculative contract #4;$60,000 = ($.165 - $.105) X 1,000,000.

January 29, 20X8Loss on Hedge Activity 54,000


To record decline in value of forward sale contract #1 sinceDecember 31; $54,000 = ($.192 - $.165) X 2,000,000.


To record increase in sales value of firm commitment.


Sales Revenue 384,000

To record sale to South African customer;$384,000 = $.192 X 2,000,000.

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P10.3 (cont=d.)

Sales Revenue 174,000Firm Commitment 174,000

To adjust sales revenue for the accumulated balance inthe firm commitment account.

Cash 210,000


Foreign Currency 384,000To record the settlement of forward sale contract #1.

Investment in Forward

Contract 27,000Other ComprehensiveIncome 27,000

To record increase in value of forward purchase contract#2; $27,000 = ($.192 - $.165) X 1,000,000.

Foreign Currency 192,000Investment in Forward Contract 87,000Cash 105,000

To record settlement of forward purchase contract #2.

Inventory 192,000Foreign Currency 192,000

To record purchase #2 at the current spot rate of $.192.


Gain on Hedge Activity 54,000To record increase in value of forward purchase contract

#3; $54,000 = ($.192 - $.165) X 2,000,000.

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P10.3 (cont=d.)

Foreign Currency 384,000Investment in ForwardContract 174,000Cash 210,000

To record settlement of forward purchase contract #3.

Loss on SpeculativeActivity 27,000


To record loss on forward sale contract #4; $27,000 =($.192 - $.165) X 1,000,000.

Foreign Currency 192,000Cash 192,000

To record purchase of rands in the spot market, inanticipation of settlement of forward sale contract #4.

Cash 105,000Investment in Forward Contract 87,000


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.

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Requirement 3:

Observe that the forward contracts entered into by Futura represented a perfecthedge. That is, forward sale contracts #1 and #4 were hedged by forward

purchase contracts #2 and #3. One could argue that these forward exchangecontracts were unnecessary. Whatever transaction costs were incurred byFutura in connection with the contracts represent an unnecessary loss to thefirm.

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 aforward contract of 1,000,000 FC units. In other words, the contract requirespurchase 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 satisfythe 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 decreasesequity. 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 contractis 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].

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P10.4 (cont=d.)

Requirement 2:

If ABC did not use the forward contract, it could borrow $400,000 now andbuy the needed foreign currency. This would cost $412,000, including 12%interest for 3 months. The forward contract costs $440,000. In addition, if thecompany borrows, it could invest the FC in short-term foreign investmentsuntil required by the foreign supplier. This alternative seems to dominate theforward 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 contractsince the forward rate increases from $.405 to $.43.

Without the hedge, and assuming an annual ROA of .16 (.04 quarterly), atcurrent 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 operatingincome 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 thepayable, 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].

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P10.5 TRANSACTION EXPOSURE AND CREDIT ANALYSIS

Requirement 1:

Using the information given, we can compute Poole's cash flow fromoperations 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 theexchange rate, as well as by the general risk of default. Although we do notknow Poole's 20X5 projected sales to these foreign customers, we do knowthat one-third of the ending inventory is designated to be sold to them. Widevariations in the exchange rate will likely have material effects on dollar cashflows from these sales.

The suggested analysis involves calculating the dollars lost on sale of thedesignated inventory if customers pay Poole when the dollar strengthens andthe 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 20X4operating cash flow.

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P10.5 (cont=d.)

Requirement 3:

Poole seems to have considerable exposure to exchange rate risk, with foreigncurrency denominated claims in receivables, payables and long-term debt, andsusceptible revenue-driven cash flow streams. First, you would like moreinformation on the extent of this exposure and whether any of it representsnatural hedges. Second, you want to know management's plans to minimizethis 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, 20X2Loss on HedgeActivity

21,000


To record decline in value of forward sale contract;

$21,000 = ($.840 - $.798) X 500,000.


Gain on Hedge Activity 21,000To record increase in sales value of the agreement withthe Swiss customer.


To record delivery of the motors to the Swiss customer;$390,000 = $.78 X 500,000.

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P10.6 (cont=d.)


To adjust Sales Revenue for the accumulated balancein the Firm Commitment account.

December 31, 20X2Transaction Loss 5,000

Accounts Receivable 5,000To adjust accounts receivable balance to the new spotrate; $5,000 = ($.78 - $.77) X 500,000.


Transaction Gain 10,000To record increase in value of forward sale contract;$10,000 = ($.84 - $.82) X 500,000.

January 31, 20X3Accounts Receivable 20,000

Transaction Gain 20,000To adjust accounts receivable balance to the new spotrate: $20,000 = ($.81 - $.77) X 500,000.

Investment in Forward Contract5,000

Transaction Gain 5,000

To record increase in value of forward sale contract;$5,000 = ($.82 - $.81) X 500,000.


Accounts Receivable 405,000To record payment by Swiss customer to Ellis Corporation.

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P10.6 (cont=d.)

Cash 399,000Investment in Forward Contract 6,000

Foreign Currency 405,000To record settlement of the forward sale contract.

Requirement 2:

20X2 20X3Transaction Loss $ ( 5,000) $ BTransaction Gain 10,000 25,000Sales Revenue 369,000 B

Net Effect on Income $374,000 $ 25,000

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 thecontract, SF500,000 would have been exchanged for $405,000 = $.81 X500,000. Therefore Ellis lost $6,000 due to hedging. However, Ellis did gain

peace of mind in knowing the $399,000 was locked in.

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P10.7 HEDGING A FORECASTED TRANSACTION

The forward contract in this problem is a hedge of a forecasted transactionfrom September 1, 20X1 to November 1, 20X1; it is a hedge of a firmcommitment from November 1, 20X1 to January 29, 20X2, and a hedge of anexisting exposure from January 29, 20X2 to March 1, 20X2.

November 1, 20X1Investment in ForwardContract 5,000


To record increase in value of forward purchase contract;$5,000 = (1.425 - $1.420) X 1,000,000.

December 31, 20X1Investment in ForwardContract 16,000

Gain on Hedge Activity 16,000To record increase in value of forward purchase contract;$16,000 = (1.441 - $1.425) X 1,000,000.


To record increase in value of purchase commitment.

January 29, 20X2Investment in ForwardContract 17,000

Gain on Hedge Activity 17,000To record increase in value of forward purchase contract;$17,000 = ($1.458 - $1.441) X 1,000,000.

Loss on Hedge Activity 17,000

Firm Commitment 17,000To record increase in value of firm purchase commitment.

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P10.7 (cont=d.)

Inventory 1,450,000Accounts Payable 1,450,000

To record delivery of merchandise at current spotrate of $1.45.


Inventory 33,000To adjust the inventory balance for the accumulated

balance in the firm commitment account.

March 1, 20X2


Accounts Payable 10,000To adjust the account payable to the current spot rate;$10,000 = ($1.46 - $1.45) X 1,000,000.


Transaction Gain 2,000To record increase in value of forward purchasecontract; $2,000 = ($1.46 - $1.458) X 1,000,000.

Foreign Currency 1,460,000Investment in ForwardContract 40,000

Cash 1,420,000To record settlement of the forward contract.

Accounts Payable 1,460,000Foreign Currency 1,460,000

To record payment to the supplier.

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P10.7 (cont=d.)

April 8, 20X2

Cash 1,600,000Sales Revenue 1,600,000

To record sale to U.S. customer.

Cost of Goods Sold 1,417,000

Inventory 1,417,000To record cost of merchandise sold.

Other Comprehensive Income 5,000Cost of Goods Sold 5,000

To transfer gain on forward purchase contract during the

forecast period to current income.

P10.8 ANALYZING THE PERFORMANCE OF ANIMPORT/EXPORT DEPARTMENT

Requirement 1:

This problem is approached by evaluating the profit contributions of theimport and export departments separately and then by reviewing the

reasonableness of the forward contract. Although the ultimate measure ofprofitability is cash received minus cash paid out, we will also be interested inthe change in the dollar equivalents of Bush's overseas purchases and sales

between the transaction dates and the payment/collection dates. This mayhave some implications for credit and payment policies.

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

(1) (2) (3) (4)=(3)-(1) (5)=(1)-(2) (6)=(4)+(5)

Part #

Cost

WhenPurchased

$ Cost

WhenPaid

Total Net

Revenue

Gross

Contribution

Exchange

Gain (Loss)

Total

Contribution

K14KR08L16M29QTotal

$ 10,62483,30046,33093,240

$233,494

$10,24098,60050,02080,640

$239,500

$ 15,500102,00050,00092,000

$259,500

$ 4,87618,7003,670

(1,240)$26,006

$ 384(15,300)(3,690)12,600

$ (6,006)

$ 5,2603,400

(20)11,360

$20,000

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P10.8 (cont=d.)

Profit Contribution of the Export Transactions

(1) (2) (3) (4)=(1)-(3) (5)=(2)-(1) (6)=(4)+(5)

Part # $ RevenueWhen Sold $ RevenueWhen Collected Total Cost GrossContribution ExchangeGain (Loss) TotalContribution

A24DD2A27B23Total

$ 31,752150,000220,000

9,198$410,950

$ 34,104144,000232,000

8,468$418,572

$ 27,720144,000178,000

8,500$358,220

$ 4,0326,000

42,000698

$52,730

$ 2,352(6,000)12,000

(730)$ 7,622

$ 6,3840

54,000(32)

$ 60,352

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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 couldhave been sold on the spot market for $261,000 (= 300,000 x $.87), yielding again 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 movementswould have produced losses on both the purchase and sale transactions.Ignoring interest rate effects, the cost of the foreign currency to be purchasedincreased by $4,200 (=($.59 - $.57)210,000) between inception and maturitywhile 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 currencyacquired for $250,000 (= 1,000,000 x $.25) in the purchase contract could besold 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 marketat maturity for $850,000 (= 1,000,000 x $.85) and a loss of $110,000 resulted.

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P10.8 (cont=d.)

Requirement 2:Memorandum

TO: Top Management, Bush Specialty ProductsFROM: Mr. X, ConsultantSUBJECT: Review of William Johnston's Import/Export Department

Mr. Johnston is doing a reasonable job in the import/export business. Bothimport and export transactions provided positive contributions toward fixedcosts and profits of Bush. The export business has been the most successfulwith a much higher ratio of profit contribution to sales.

Unfortunately, these reasonably satisfactory results have been wiped out byMr. Johnston's activities in the forward markets for foreign exchange.Johnston entered into two speculative forward contracts which producedlosses of $140,000, almost $60,000 more than the total profit contribution

provided by the import/export transactions. I do not know whether he hasbeen cautioned against speculating with the firm's capital and cannotrecommend outright that Johnston be fired. At a minimum, he should be

prohibited from entering into speculative forward contracts on behalf of theimport/export department.

Mr. Johnston's credit and payment policies should be reviewed. Several of theimport 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 paymentsand collections should be closely monitored along with movements in theexchange rates. While hedging in the forward market eliminates this risk, itdoes so for a price which may not represent the most cost-effective solution.

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P10.9 RECORDING A HEDGED FOREIGN LOAN

December 16, 20X1

Cash 84,000Loan Payable 84,000

To record the dollar equivalent of,50,000 borrowed froma London bank; $84,000 = $1.68 x 50,000.

December 31, 20X1Loan Payable 1,000

Transaction Gain 1,000To accrue the transaction gain on the loan

payable; $1,000 = ($1.68 - $1.66) X 50,000.

Transaction Loss 1,010Investment in Forward Contract 1,010

To accrue the loss on the forward purchase contract;$1,010 = ($1.71 - $1.69) X 50,500.

Interest Expense 415

Interest Payable 415To accrue interest expense on the loan payablefrom December 16 - December 31, 20X1;$415 = $1.66 x 250. The interest accrual reflectsthe spot rate in effect when the interest is accrued.

January 15, 20X2

Loan Payable 1,500Transaction Gain 1,500

To accrue the transaction gain on the loan payable;$1,500 = ($1.66-$1.63) X 50,000.


Investment in Forward Contract 3,030To accrue the transaction loss on the forward purchasecontract; $3,030 =($1.69 - $1.63) X 50,500.

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P10.9 (cont=d.)

Interest Payable 7.50Transaction Gain 7.50

To accrue the gain on the interest payable;$7.50 = ($1.66 - $1.63) X 250.

Interest Expense 407.50

Interest Payable 407.50To accrue interest expense on the loan payable fromJanuary 1 - January 15, 20X2; $407.50 = $1.63 x 250.

Foreign Currency 82,315Investment in Forward Contract 4,040

Cash 86,355To record settlement of the forward purchase contract.

Loan Payable 81,500Interest Payable 815

Foreign Currency 82,315To record repayment of the loan and interestto the London Bank with the foreign currency.

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P10.10 EVALUATION OF DOMESTIC AND FOREIGNINVESTMENTS

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 forwardcontract 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 aforward 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.

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P10.11 ADJUSTING ENTRIES AT BALANCE SHEET DATE

Computation of Transaction Adjustment on Receivables


AmountE.R.

(December 31, 20X7) Amount ($)AustraliaNorwaySpain

2,000,0005,000,000

10,000,000

$ .62.19.007

$1,240,000950,00070,000

Dollar amount of foreign currency receivablesat December 31, 20X7Less amount per books ($1,200,000 + $1,000,000 + $80,000)Transaction loss on receivables

$2,260,000(2,280,000)$ 20,000

Note: Accounts due from Peruvian customers are denominated in dollars.

Computation of Transaction Adjustment on Payables


AmountE.R.

(December 31, 20X7) Amount ($)BrazilColumbia

Netherlands

4,000,0006,000,000

10,000,000

$.83000.00065

1.25000

$ (3,320,000)(3,900)

(12,500,000)Dollar amount of foreign currency payables at December 31, 20X7Less amount per books ($3,100,000 + $4,200 + $12,700,000)Transaction loss on payables

$(15,823,900)(15,804,200)

$ 19,700

Note: Accounts due to Swedish suppliers are denominated in dollars.

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P10.11 (cont=d.)

Computation of Transaction Adjustment on Other Assets (Liabilities)

Item

ForeignCurrency

Dr. (Cr.)E.R.

(12/31/X7)Current

Valuation ($)Required Adjustment

Dr. (Cr.)

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

(200,000,000)(5,000,000)10,000,000

(10,000,000)(1,000,000)

$.008$.0234 - $.025$1.24 - $1.21

$.27 - $.23$.284 - $.2867

$(1,600,000)(8,000)

300,000400,000

(2,700)

$(100,000)(6,000)

(300,000)600,000(11,700)

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P10.11 (cont=d.)

Adjusting Entries - Books of Warner Corporation

Transaction Loss 39,700Accounts Receivable 20,000

Accounts Payable 19,700To adjust accounts receivable and payabledenominated in foreign currencies to their dollar

equivalents at December 31, 20X7 and recognizethe related transaction loss.


Note Payable 100,000To adjust note payable denominated in yen to itscurrent dollar equivalent at December 31, 20X7.

Loss on Speculative Activity 6,000

Investment in ForwardPurchase Contract 6,000

To adjust speculative forward purchase contractdenominated in rupees to its current value.

Transaction Loss 200,000Investment in ForwardContract 200,000

To adjust forward purchase contract for euros,held as a hedge of an existing account payable, toits current value.

Investment in Forward SaleContract 600,000

Gain on Hedge Activity 600,000To adjust forward sale contract for riyal, held as a hedgeof a firm sale commitment, to its current value.P10.11 (cont=d.)

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To recognize decrease in value of firm commitment to sellto a Saudi Arabian customer.


Investment in ForwardSale Contract 11,700

To adjust forward sale contract for zloty, held as a hedgeof a forecasted sale to a Polish customer.

P10.12 TAXES, HEDGING AND PRICING INTERNATIONAL

TRANSFERS

Requirement 1:

The transfer price that minimizes the worldwide income tax liability is theprice 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% overcost, the transfer price cannot be less than $90, determined as follows:

.2 = (108 - P)/P

.2P = 108 - P1.2P = 108

P = 108/1.2P = 90

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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) = 9.75U.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 transactionsbetween 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 ofarrangements whereby similar products are sold to unrelated parties, none ofwhich exactly parallels the parent/subsidiary transaction.

As a result, companies are still likely to have considerable latitude in settingdefensible transfer prices. Even if transfer prices are constrained, cost

allocations may facilitate the desired profit allocation between controlling andminority interests or between foreign and domestic income.

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P10.12 (cont=d.)

Requirement 3:

If the dollar strengthens as predicted, the dollar transfer price will fall and theamount of income taxed at the high U.S. rate increases. A 20% drop in thedirect exchange rate will increase the total tax by $4.50 (=.25 X .2 X 90) perunit. To avoid this tax impact, the U.S. parent could try to enter into aforward purchase contract to hedge against an increase in the value of thedollar. 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 thehigh 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. parentsuffers an opportunity loss by purchasing the currency at the higher forwardrate. Using the problem data, if the rate falls by 20% after a forward contractat $.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 parentwould pay $18 (= 90 - 72) to save $4.50 in taxes, not a good idea.

Requirement 4:

PerSFAS 133, in order for a foreign currency forward contract to qualify as ahedge of aforeign currency commitment, (1) the contract must be designatedas, and effective as, a hedge and (2) the commitment must be firm (allsignificant terms are specified, performance is probable).

In order for the foreign currency forward contract to qualify as a hedge of aforecasted transaction, the forecasted transaction must be identified, theremust be formal documentation of the hedging relationship, and the hedgingrelationship must be effective and assessed on a regular basis.

P10.13 PURCHASE ALTERNATIVES AND CASH FLOW ANALYSIS(APPENDIX 1)

Requirement 1:

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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 the6-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 atSeptember 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 X6,600/1.04)]. Because $840,000 (= 1.40 X 600,000) must be converted onApril 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).

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P10.13 (cont=d.)

An alternative approach involves determining the amount of UKinvestment 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 onApril 1, 20X3.

d. Purchase from the domestic firm requires cash with a present value onApril 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 presentvalue. However, the additional warranty costs and the potentialnonquantifiable loss in goodwill are of concern. The next best alternative isimmediate purchase, taking advantage of the 2% cash discount. The risk hereis that the supplier might not perform.

Only the investment in the ,-denominated security will affect earningsvolatility 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 othertransaction adjustments (firm commitments) or are temporarily reported inother comprehensive income (forecasted transactions).

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P10.14 CURRENCY SWAP: COMPUTATION OF FORWARD RATEAND ENTRIES (APPENDIX 1 AND 2)

Requirement 1:

The direct forward rate equals the current spot rate multiplied by (1 + the yieldon U.S. government securities) and divided by (1 + the yield on foreigngovernment securities). This problem calls for the 6-month forward rate anduses 6-month interest rates in the calculations (e.g., the 12-month U.S. interestrate 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, 20X1Loss on Hedge Activity 434,000

Investment in Swap 434,000To recognize the loss accrued on the swap;$434,000 = ($1.70 - $1.576) X 3,500,000.


To recognize the gain on the construction contractfirm commitment.

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P10.14 (cont=d.)

Foreign Currency 5,950,000Sales Revenue 5,950,000

To recognize payment received on the constructioncontract; $5,950,000 = $1.70 X 3,500,000. Thisentry assumes the payment is earned.


To adjust sales revenue for the change in value of thefirm commitment.

Cash 5,516,000Investment in Swap 434,000

Foreign Currency 5,950,000To record settlement of the swap.

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