Chapter 11, Problem 11.16AE

a

To determine

Introduction:

Derivatives designed as hedge: To reduce risks, ASC 815 provides specific requirements for classifying derivative as a hedge. Hedge accounting offsets the gain or loss on the hedged instrument. Hedges can be used to offset foreign currency exchange rate risk, interest rate risk and commodity risk. A derivative instrument in order to qualify as a hedge must have sufficient documentation at the beginning of the hedge term to identify the objective of the hedge. The hedge must be highly effective throughout its term. The effectiveness must be tested every three months and each time the financial instrument is prepared.

The net exposure to changes in exchange rate of pounds for dollars between November 1, 20X6 and March 1, 20X7.

Answer to Problem 11.16AE

No net exposure from November 1, 20X6 and March 1, 20X7.

Explanation of Solution

Earning from Forward contract $\pounds 30,000\times (\$1.61-\$1.59)$	$600
Less adjustment when inventory sold $\pounds 30,000\times (\$1.59-\$1.60)$	($300)
Earning through revaluation $\pounds 30,000\times (\$1.59-\$1.60)$	($300)
Net exposure	0

b

To determine

Introduction:

Derivatives designed as hedge: To reduce risks, ASC 815 provides specific requirements for classifying derivative as a hedge. Hedge accounting offsets the gain or loss on the hedged instrument. Hedges can be used to offset foreign currency exchange rate risk, interest rate risk and commodity risk. A derivative instrument in order to qualify as a hedge must have sufficient documentation at the beginning of the hedge term to identify the objective of the hedge. The hedge must be highly effective throughout its term. The effectiveness must be tested every three months and each time the financial instrument is prepared.

The entries for the purchase of inventory and forward contract during November 1, 20X6 through March 1, 20X7 Assuming fiscal year ends on December 31, 20X6

Explanation of Solution

Date	Particulars	Debit $	Credit $
11/1/20X6	Foreign currency receivable from exchange broker	47,700
	Dollars payable to exchange broker		47,700
	(Entered into foreign exchange contract to manage foreign currency exposer)
12/31/20X6	Foreign currency receivable from exchange broker	900
	Foreign currency transaction gain		900
	(Revaluation of foreign currency receivable to end of period fair value)
12/31/X6	Foreign currency transaction loss	900
	Firm commitment		900
	(Record the loss on the financial instrument aspect of the firm commitment)
1/30/20X7	Foreign currency transaction loss	600
	Foreign currency receivable from exchange broker		600
	(Revaluation of foreign currency receivable to U.S. dollar equivalent)
	Firm commitment	600
	Foreign currency transaction gain		600
	(Recording of gain on the financial instrument aspect of the firm commitment)
	Purchases	47,400
	Firm commitment	300
	Accounts payable		47,700
	(Purchased and recognized foreign currency payable)
03/1/20X7	Foreign currency transaction loss	450
	Foreign currency receivable from exchange broker		450
	(Revaluation of foreign currency receivable)
	Accounts payable	150
	Foreign currency transaction gain		150
	(Revaluation of foreign currency payable)
	Dollars payable to exchange broker	47,700
	Cash		47,700
	(Delivery of dollars to exchange broker as per the exchange contract)
	Foreign currency unit (A$)	47,550
	Foreign currency receivable from exchange broker		47,550
	(Received £30,000 from exchange broker in accordance with contract)

1. Signed forward contract to manage foreign currency exposer

$47,700 = $\pounds 30,000\times \$1.59$

2. Foreign currency transaction gain of revaluation of receivable

  $\$900=\pounds 30,000\times (\$1.62-\$1.59)$

3. Loss on firm commitment recognized

  $\$900=\pounds 30,000\times (\$1.62-\$1.59)$

4. Revaluation of foreign currency receivable to current U.S. dollar

  $\$600=\pounds 30,000\times (\$1.60-\$1.62)$

5. Recognized gain on the financial instrument aspect of firm commitment.

  $\$600=\pounds 30,000\times (\$1.60-\$1.62)$

6. Purchase of inventory committed

  $\$47,700=\pounds 30,000\times \$1.59Jan30Spot$

7. Revaluation of foreign currency receivable to fair value

  $\$450=\pounds 30,000\times (\$1.585-\$1.60)$

8. Revaluation of foreign currency payable with change in spot from $1.59 to $1.585

  $\$150=\pounds 30,000\times (\$1.585-\$1.59)$

9. Received £30,000 in exchange of U.S. dollar

  $\$47,700=\pounds 30,000\times \$1.59Jan30Spot$

10. Received £30,000 in exchange of U.S. dollar from exchange broker

  $\$47,700=\pounds 30,000\times \$1.585Mar1Spot$

11. £30,000 delivered to creditor.

c

To determine

Introduction:

Derivatives designed as hedge: To reduce risks, ASC 815 provides specific requirements for classifying derivative as a hedge. Hedge accounting offsets the gain or loss on the hedged instrument. Hedges can be used to offset foreign currency exchange rate risk, interest rate risk and commodity risk. A derivative instrument in order to qualify as a hedge must have sufficient documentation at the beginning of the hedge term to identify the objective of the hedge. The hedge must be highly effective throughout its term. The effectiveness must be tested every three months and each time the financial instrument is prepared.

The entries assuming that interest is significant and the time value of money is considered in valuing forward contract.

Explanation of Solution

Date	Particulars	Debit $	Credit $
11/1/20X6	Foreign currency receivable from exchange broker	47,700
	Dollars payable to exchange broker		47,700
	(Entered into foreign exchange contract to manage foreign currency exposer)
12/31/X6	Foreign currency receivable from exchange broker	882
	Foreign currency transaction gain		882
	(Revaluation of foreign currency receivable)
	Foreign currency transaction loss	882
	Accounts payable		882
	(Revaluation of foreign currency payable)
01/30/20X7	Foreign currency transaction loss	585
	Foreign currency receivable from exchange broker		585
	(Revaluation of foreign currency receivable recognized )
	Firm commitment	585
	Foreign currency transaction gain		585
	(Gain on financial instrument aspect of the firm commitment recognized)
	Purchases	47,403
	Firm commitment	297
	Accounts payable		47,700
	(Accounts payable in foreign currency recognized)
3/1/20X7	Foreign currency transaction loss	447
	Foreign currency receivable from exchange broker		447
	(Revaluation of foreign currency receivable to fair value)
	Accounts payable	150
	Foreign currency transaction gain		150
	(Revaluation of foreign currency payable to equivalent U.S. dollars)
	Dollars payable to exchange broker	47,700
	Cash		47,700
	(Delivery of dollars to exchange broker as per the exchange contract)
	Foreign currency unit (A$)	47,550
	Foreign currency receivable from exchange broker		47,550
	(Received £30,000 from exchange broker in accordance with contract)
	Accounts payable	47,550
	Foreign currency Units		47,550
	(Foreign currency unit paid to creditor)

1. Signed forward contract to manage foreign currency exposer

$60,900 = $\pounds 30,000\times \$1.59$

2. Revaluation of foreign currency receivable to discounted end of period fair value:

Gain on foreign currency transaction $\pounds 30,000\times (\$1.62-\$1.59)$	$900
Adjustment of discount $(\$900\times .12)\times \frac{2}{12}$	($18)
Discounted gains	$882

3. Revaluation of foreign currency receivable to current U.S. dollar equivalent:

Gain on foreign currency receivable $\pounds 30,000\times (\$1.60-\$1.59)$	$300
Adjustment of discount $(\$300\times .12)\times \frac{1}{12}$	($3)
Discounted gains	$297
Less: gain recognized previously	(882)
Net change in fair value	($585)

4. Purchase of inventory valued at spot rate $\$47,700=\pounds 30,000\times \$1.59$
5. Revaluation of foreign currency receivable to current U.S. dollar and recognized:

Undiscounted loss on forward contract $\pounds 30,000\times (\$1.585-\$1.59)$	($150)
Less: previously recognized net gain	($297)
Loss for the period	$447

6. Revaluation of foreign currency payable equivalent to U.S. dollars

$150 = $\pounds 30,000\times (\$1.585-\$1.59)$

7. Purchase of inventory commitment met

  $\$47,700=\pounds 30,000\times \$1.59$

8. Received £30,000 from exchange broker in accordance with forward contract

  $\$47,550=\pounds 30,000\times \$1.585Mar1Spotrate$

9. £30,000 delivered to creditor.