CHAPTER 12
ANSWERS TO QUESTIONS
1. An exchange rate is the ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged at a particular time. A direct quotation is one in which the exchange rate is quoted in terms of how many units of the domestic currency can be converted into one unit of foreign currency. An indirect quotation is stated in terms of converting one unit of domestic currency into units of foreign currency.
2. When a transaction is to be settled in a foreign currency, a change in the exchange rate increases or decreases the expected cash flow to be received or paid when the account is settled.
3. (1) Transaction Date -- at this date, the transaction is recorded. If the transaction is stated in foreign currency units, the exchange rate prevailing at this date is used to convert the foreign currency units to domestic units.
(2) Balance Sheet Date -- at this date, recorded dollar balances (or other domestic currency, if applicable) representing receivables or payables that are to be settled in foreign currency units are revalued at the exchange rate on this date. The adjustment is recorded as a transaction gain or loss.
(3) Settlement Date -- the foreign currency received or paid is converted into domestic currency at the spot rate. A difference between the conversion and the carrying value of the receivable or payable is a transaction gain or loss.
4. A transaction gain (loss) related to an unsettled receivable should be included in the determination of net income for the current period.
5. Receivable recorded at the transaction date 100,000 ´ $.009 $900
Receivable recorded at the balance sheet date 100,000 ´ $.006 600
Transaction loss $300
Receivable is reported at $600 in the balance sheet.
6. A purchase (sale) is viewed as a transaction separate from the method of settlement. Once the purchase (sale) is made, a firm has the choice of settling at the transaction date, thus incurring no gain or loss from subsequent changes in the exchange rate; or purchasing a forward contract, and also avoiding a gain or loss from holding foreign currency commitments. The choice of settlement rests with management, and their decision should have no effect on the valuation of a purchase or sales transaction.
7. A forward exchange contract is an agreement to buy or sell foreign currency units at a particular time for an agreed upon exchange rate. This rate will usually be the forward rate at the time the contract is entered into and any difference between the forward rate and the spot rate is amortized to income over the life of the contract.
8. A forward contract to buy (sell) foreign currency has an opposite effect on income compared to the gain or loss associated with translation of a payable (receivable) to be settled in the foreign currency units.
In other words, as the exchange rate fluctuates, the forward contract will gain or lose the same amount as the payable or receivable will lose or gain. Therefore, no net transaction gain or loss will be incurred.
9. The transaction must be designated as, and is effective as, a hedge of a foreign currency commitment, and the foreign currency commitment is firm.
10. Forward contracts are valued using changes in forward rates and generally any gains or losses are recognized in the same period as changes in value of hedged item (Fair Value hedges). Gains or losses in Cash Flow hedges are deferred until the hedged item is included in income. A forward contract held for speculation is recorded at the transaction date using the forward rate. There is no separate accounting for a discount or premium. Subsequent valuations (at balance sheet dates) are based on the forward rate available for the remaining life of the forward contract.
11. Foreign currency exchange gains (losses) from hedging a forecasted transaction are deferred and included in the determination of the foreign currency transaction at transaction date.
12. A put option is a contract that gives the holder the right to sell an asset (such as a unit of foreign currency) at a specified price within a specified time period. Firms use these options to protect against expected unfavorable changes in exchange rates. If a company has a contract to sell inventory and is expected to receive a foreign currency, the company can use the option to sell the foreign currency received from the sale to deliver on the option, thus locking into a foreign exchange rate.
13. A derivative instrument may be defined as a financial instrument that by its terms at inception or upon occurrence of a specified event, provides the holder (or writer) with the right (or obligation) to participate in some or all of the price changes of another underlying value of measure, but does not require the holder to own or deliver the underlying value of measure. Thus its value is derived from the underlying value of measure. In SFAS No. 133, the FASB identified the following as keystones for the accounting for derivative instruments:
* Derivative instruments represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements.
* Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments.
* Only items that are assets or liabilities should be reported as such in the balance sheet.
* Special accounting for items designated as being hedged should be provided only for qualifying items, as demonstrated by an assessment of the expectation of effective offsetting changes in fair values or cash flows during the term of the hedge for the risk being hedged.
14. Deivative instruments can be divided into two broad categories:
a) Forward-based derivatives, such as forwards, futures, and swaps, in which either party can potentially have a favorable or unfavorable outcome, but not both simultaneously (e.g., both will not simultaneously have favorable outcomes).
b) Option-based derivatives, such as interest rate caps, option contracts, and interest rate floors, in which only one party can potentially have a favorable outcome and it agrees to a premium at inception for this potentiality; the other party is paid the premium, and can potentially have only an unfavorable outcome.
15. The FASB allows deferral of the income statement recognition of the gains and losses on forecasted transactions if certain criteria are met. Like other gains and losses that are excluded from the income statement, they must be included as components of “other comprehensive income” and reported in the stockholders’ equity section of the balance sheet. The criteria for this treatment include:
· The forecasted transaction is specifically identifiable at the time of the designation as a single transaction or a group of individual transactions.
· The forecasted transaction is probable and it presents exposure to price changes that are expected to affect earnings and cause variability in cash flows.
· The forecasted transaction involves an exchange with an outside (unrelated) party (intercompany foreign currency transactions are excluded)
· The forecasted transaction does not involve a business combination.
They are reclassified into earnings when the forecasted transaction occurs and the item is recorded in earning.
Business Ethics
Business ethics solutions are merely suggestions of points to address. The objective is to raise the students' awareness of the topics, and to invite discussion. In most cases, there is clear room for disagreement or conflicting viewpoints.
1. Stock options, in theory, are used to create incentives for the firm’s executives to increase operating performance. The practice of backdating options defeats this purpose. The point of backdating options is to avoid issuing ‘in the money’ stock options which would have had both accounting and tax consequences not favorable to the firm. Backdating avoids accounting recognition.
2. Executives always have the right not to exercise options if they feel that there is an ethical issue. However, if the proper disclosures are followed (which is rarely the case), then back-dating options is not illegal under current laws.
ANSWERS TO EXERCISES
Exercise 12-1
Apr. 3 Purchases 11,520
Accounts Payable (1,600,000 ´ $.0072) 11,520
5 Accounts Receivable 2,800
Sales 2,800
9 Accounts Receivable 16,800
Sales 16,800
11 Purchases 25,000
Accounts Payable (801,282 ´ $.0312) 25,000
16 Accounts Payable (1,000,000 ´ $.0072) 7,200
Transaction Gain 500
Cash (1,000,000 ´ $.0067) 6,700
18 Accounts Payable 25,000
Transaction Loss 4,487
Cash (801,282 ´ $.0368) 29,487
22 Cash 16,800
Accounts Receivable 16,800
30 Accounts Payable (600,000 ´ $.0072) 4,320
Transaction Loss 360
Cash (600,000 ´ $.0078) 4,680
Exercise 12-2
Part A Dec 10 Accounts Receivable (8,541,000/365) 23,400
Sales 23,400
12 Raw Materials Inventory (Purchases) 19,550
Accounts Payable (500,000 ´ $.0391) 19,550
Part B Dec 31 Transaction Loss 510
Accounts Receivable 510
[(8,541,000 ´ $.00268 = $22,890) – $23,400]
31 Accounts Payable 2,000
Transaction Gain [(500,000 ´ $.0351 = $17,550) - $19,550] 2,000
Exercise 12-2 (continued)
Part C Jan 10 Cash (8,541,000 ´ $.00320) 27,331
Accounts Receivable ($23,400 - $510) 22,890
Transaction Gain 4,441
10 Transaction Loss 2,350
Accounts Payable ($19,550 - $2,000) 17,550
Cash (500,000 ´ $.0398) 19,900
Part D Dec 10 Accounts Receivable 23,400
Sales 23,400
31 No entry required.
Jan 10 Cash 23,400
Accounts Receivable 23,400
Exercise 12-3 / Exercise 12-4 / Exercise 12-51.d 2.d 3.d 4.a 5.b / 1.d 2.b 3.c 4.a / 1.b 2.b 3.d 4.c
Exercise 12-6
Part A Accounts Receivable Amount
SLS, Inc. (denominated in $) $200,000
TNT, Ltd. (130,000 ´ $1.482) 192,660
Accounts Payable
AGT (600,000 ´ $.460) 276,000
SDS, Ltd. (denominated in $) $160,000
Part B Receivable Payable
SLS, Inc. TNT, Ltd. AGT SDS, Ltd.
Transaction date $200,000 $195,780* $294,000** $160,000
Balance sheet date 200,000 192,660 276,000 160,000
Transaction gain (loss) $ 0 $ ( 3,120) $18,000 $ 0
* 130,000 ´ $1.506 = $195,780
** 600,000 ´ $0.490 = $294,000
Exercise 12-7
Part A Oct. 2 Accounts Receivable (300,000 ´ $.4737) 142,110
Service Revenue 142,110
2 Dollars Receivable from Exchange Dealer 141,900
FC Payable to Exchange Dealer 141,900
(300,000 ´ $.473= $141,900)
Dec 31 Accounts Receivable 4,740
Transaction Gain [(300,000 ´ $.4895 = 146,850) - 142,110] 4,740
31 Transaction Loss [(300,000 ´ $.4810 = $144,300) - $141,900] 2,400
FC Payable to Exchange Dealer 2,400
Feb 1 Accounts Receivable 1,650
Transaction Gain [(300,000 ´ $.4950 = $148,500) - $146,850] 1,650
1 Transaction Loss [(300,000 ´ $.4950 = $148,500) - $144,300] 4,200
FC Payable to Exchange Dealer 4,200
Feb. 1 Investment in FC 148,500
Accounts Receivable (300,000 ´ $.4950) 148,500
Feb. 1 Cash 141,900
FC Payable to Exchange Dealer 148,500
Investment in FC 148,500
Dollars Receivable from Exchange Dealer 141,900
2008 2009
Part B 1. Revenue $142,110 $ 0
Transaction gain (loss) related to the exposed receivable balance 4,740 1,650
Transaction gain (loss) related to the forward contract (2,400) (4,200)
Effect on net income $144,450 $(2,550)
2. Cumulative effect on net income: $144,450 - $2,550 = $141,900
3. Cash received = $141,900
Exercise 12-8
Nov. 1 FC Receivable from Exchange Dealer 131,700
Dollars Payable to Exchange Dealer 131,700
(5,000,000 ´ $.02634 = $131,700)
Dec 31 FC Receivable from Exchange Dealer 5,050
Exchange Gain 5,050
[(5,000,000 ´ $.02735 = $136,750) - $131,700]
31 Exchange loss 5,050
Firm Commitment 5,050
May 1 Exchange loss 7,200
FC Receivable from Exchange Dealer 7,200
[(5,000,000 ´ $.02591 = $129,550)- $136,750]
1 Firm Commitment 7,200
Exchange Gain 7,200
1 Dollars Payable to Exchange Dealer 131,700
Investment in FC 129,550
FC Receivable from Exchange Dealer 129,550
Cash 131,700
1 Merchandise Inventory 131,700
Investment in FC 129,550
Firm commitment 2,150
Alternative entries
Nov. 1 No Entry is made
Dec 31 FC contract 5,050
Exchange Gain 5,050
[(5,000,000 ´ $.02735 = $136,750) - $131,700]
31 Exchange loss 5,050
Firm Commitment 5,050
May 1 Exchange loss 7,200
FC Contract 7,200
[(5,000,000 ´ $.02591 = $129,550)- $136,750]
1 Firm Commitment 7,200
Exchange Gain 7,200
FC Contract 2,150
Cash 2,150
1 Investment in FC 129,550
Cash 129,550
1 Merchandise Inventory 131,700
Investment in FC 129,550
Firm Commitment 2,150
Exercise 12-9
Nov. 1 Dollars Receivable from Exchange Dealer 457,650
FC Payable to Exchange Dealer (900,000 ´ $.5085) 457,650
Dec. 31 FC Payable to Exchange Dealer 8,010
Transaction Gain [(900,000 ´ $.4996 = $449,640) - $457,650] 8,010
Jan. 30 FC Payable to Exchange Dealer 15,300
Transaction Gain [(900,000 ´ $.4826 = $434,340) - $449,640] 15,300
30 Investment in FC 434,340
Cash 434,340
30 Cash 457,650
FC Payable to Exchange Dealer 434,340
Dollars Receivable from Exchange Dealer 457,650
Investment in FC 434,340
Exercise 12-10
Nov. 1 FC Receivable from Exchange Dealer 457,650
Dollars Payable to Exchange Dealer (900,000 ´ $.5085) 457,650
Dec. 31 Transaction Loss 8,010
FC Receivable from Exchange Dealer 8,010
[(900,000 ´ $.4996 = $449,640) - $457,650]
Jan. 30 Transaction Loss 15,300
FC Receivable from Exchange Dealer 15,300
[(900,000 ´ $.4826 = $434,340) - $449,640]
30 Investment in FC 434,340
Dollars Payable to Exchange Dealer 457,650
Cash 457,650
FC Receivable from Exchange Dealer 434,340
30 Cash 434,340
Investment in FC 434,340
Exercise 12-11
April 1 Equipment 188,880
Notes Payable (120,000 ´ $1.574) 188,880
June 30 Interest Expense 5,616
Cash (3,600 ´ $1.560) 5,616
Sept. 30 Interest Expense 5,494
Cash (3,600 ´ $1.526) 5,494
Dec. 31 Interest Expense 5,393
Cash (3,600 ´ $1.498) 5,393
31 Notes Payable 9,120
Transaction Gain [(120,000 ´ $1.498 = $179,760) - $188,880] 9,120
Mar. 31 Transaction Loss 4,800
Notes Payable [(120,000 ´ $1.538 = $184,560) - $179,760] 4,800
31 Interest Expense (3,600 ´ $1.538) 5,537
Notes Payable 184,560
Cash (123,600 ´ $1.538) 190,097
Exercise 12-12
1. 50,000,000 ´ $.0269 = $1,345,000
2. 50,000,000 ´ $.0291 = $1,455,000
3. 50,000,000 ´ ($.0269 - $.0239) = 150,000 premium (forward rate is greater than spot rate)
4. Valuation - 11/15/2008 50,000,000 ´ $.0239 = $1,195,000
12/31/2008 50,000,000 ´ $.0224 = 1,120,000
Transaction gain - 2008 $ 75,000