Chapter 6, Problem 14EP

a.

To determine

Record journal entries and determine effect on net income using cash flow hedge.

Explanation of Solution

Cash Flow Hedge:

Companies use cash flow hedge to minimize the variability in cash flows. It is used by the companies to minimize or eliminate the risk arising from change in the flow of cash.

To record sales:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/1/Y1	Accounts receivable		20,000
	Sales			20,000
	(to record sales)

Table (1)

• Since, accounts receivable is an asset and assets are increased. Hence, accounts receivable is debited.
• Since, sales are revenue and revenue is increased. Hence, sales are credited.

No entry for forward contract

To record foreign exchange gain:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Accounts receivable		1,000
	Foreign exchange gain			1,000
	(to record foreign exchange gain)

Table (2)

• Since, accounts receivable is an asset and assets are increased. Hence, accounts receivable are debited.
• Foreign exchange gain is a gain and gains are increased. Hence, foreign exchange gain is credited.

To record loss on forward contract:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Loss on forward contract		1,000
	AOCI			1,000
	(to record loss on forward contract)

Table (3)

• Since, loss on forward contract is a loss and losses are increased. Hence, loss on forward contract is debited.
• Since, AOCI is a liability and liabilities are increased. Hence, AOCI is credited.

To record AOCI:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	AOCI		1,176.36
	Forward contract			1,176.36
	(to record AOCI)

Table (4)

• Since, AOCI is a liability and liabilities are decreased. Hence, AOCI is debited.
• Since, forward contract is an asset and assets are decreased. Hence, forward contract is credited.

To record premium revenue:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	AOCI		266.67
	Premium revenue			266.67
	(to record premium revenue)

Table (5)

• Since, AOCI is a liability and liabilities are decreased. Hence, AOCI is debited.
• Since, premium revenue is revenue and revenue is increased. Hence, premium revenue is credited.

To record foreign exchange gain

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
3/1/Y2	Accounts receivable		1,400
	Foreign exchange gain			1,400
	(to record foreign exchange gain)

Table (6)

• Since, accounts receivable is an asset and assets are increased. Hence, accounts receivable are debited.
• Foreign exchange gain is a gain and gains are increased. Hence, foreign exchange gain is credited.

To record loss on forward contract:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
3/1/Y2	Loss on forward contract		1,400
	AOCI			1,400
	(to record loss on forward contract)

Table (7)

• Since, loss on forward contract is a loss and losses are increased. Hence, loss on forward contract is debited.
• Since, AOCI is a liability and liabilities are increased. Hence, AOCI is credited.

To record AOCI:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
3/1/Y2	AOCI		423.64
	Forward contract			423.64
	(to record AOCI)

Table (8)

• Since, AOCI is a liability and liabilities are decreased. Hence, AOCI is debited.
• Since, forward contract is an asset and assets are decreased. Hence, forward contract is credited.

To record premium revenue:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	AOCI		533.33
	Premium revenue			533.33
	(to record premium revenue)

Table (9)

• Since, AOCI is a liability and liabilities are decreased. Hence, AOCI is debited.
• Since, premium revenue is revenue and revenue is increased. Hence, premium revenue is credited.

To record account receivable:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Foreign currency		22,400
	Accounts receivable			22,400
	(to record accounts receivable)

Table (10)

• Since, foreign currency is an asset and assets are increased. Hence, foreign currency is debited.
• Since, accounts receivable is an asset and asset is decreased. Hence, accounts receivable is credited.

To record cash received:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Cash		20,800
	Forward contract		1,600
	Foreign currency			22,400
	(to record accounts receivable)

Table (11)

• Since, cash is an asset and assets are increased. Hence, cash account is debited.
• Since, forward contract is an asset and assets are increased. Hence, forward contract is debited.
• Since, foreign currency is an asset and assets are decreased. Hence, foreign currency is credited.

Impact on net income can be calculated as below:

For Year 1,

$\mathrm{Net}income=\mathrm{Sales}+\text{Income}+\text{Gain}-\text{Loss}$

Substitute $20,000 for sales, $1,000 for income, $266.67 for gain and $1,000 for loss in the formula,

$\begin{array}{c}\mathrm{Net}income=\$20,000+\$1,000+\$266.67-\$1,000\\ =\$20,266.67\end{array}$

For Year 2,

$\mathrm{Net}income=\mathrm{Sales}+\text{Income}+\text{Gain}-\text{Loss}$

Substitute $0 for sales, $1,400 for income, $533.33 for gain and $1,400 for loss in the formula,

$\begin{array}{c}\mathrm{Net}income=\$0+\$1,400+\$533.33-\$1,400\\ =\$533.33\end{array}$

Impact on income over both accounting period is $20,800 $\left(\$20,266.67+\$533.33\right)$

Working Note:

Conversion of sale from crown to USD

$\begin{array}{c}\mathrm{Sales}(inUSD)=\mathrm{Sale}value(incrown)\times \mathrm{USD}\text{}percrown\\ =20,000\times \$1\\ =\$20,000\end{array}$

Computation of foreign exchange gain in USD:

$\begin{array}{c}\mathrm{Foreign}exchangegain=\text{Difference}\times \mathrm{Sale}value\\ =(\$1.05-\$1.00)\times \$20,000\\ =\$1,000\end{array}$

Computation of net income of both accounting periods:

$\begin{array}{c}\mathrm{Net}income(Year1and2)=\mathrm{Net}income(Year1)+\mathrm{Net}income(Year2)\\ =\$20,266.67+\$533.33\\ =\$20,800\end{array}$

b.

To determine

Record journal entries and determine effect on net income using fair value hedge.

Explanation of Solution

Fair Value Hedge:

If the fair value of an asset or a liability is affected by the change in exchange rate than it is called fair value hedge. If the fair value is not hedged, the fair value risk must affect the net income to meet the requirements for hedge accounting.

To record sales:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/1/Y1	Accounts receivable		20,000
	Sales			20,000
	(to record sales)

Table (12)

• Since, accounts receivable is an asset and assets are increased. Hence, accounts receivable is debited.
• Since, sales are revenue and revenue is increased. Hence, sales are credited.

No entry for forward contract

To record foreign exchange gain:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Accounts receivable		1,000
	Foreign exchange gain			1,000
	(to record foreign exchange gain)

Table (13)

• Since, accounts receivable is an asset and assets are increased. Hence, accounts receivable are debited.
• Foreign exchange gain is a gain and gains are increased. Hence, foreign exchange gain is credited.

To record loss on forward contract:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Loss on forward contract		1176.36
	Forward contract			1176.36
	(to record loss on forward contract)

Table (14)

• Since, loss on forward contract is a loss and losses are increased. Hence, loss on forward contract is debited.
• Since, AOCI is a liability and liabilities are increased. Hence, AOCI is credited.

To record foreign exchange gain

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
3/1/Y2	Accounts receivable		1,400
	Foreign exchange gain			1,400
	(to record foreign exchange gain)

Table (15)

• Since, accounts receivable is an asset and assets are increased. Hence, accounts receivable are debited.
• Foreign exchange gain is a gain and gains are increased. Hence, foreign exchange gain is credited.

To record loss on forward contract:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
3/1/Y2	Loss on forward contract		423.64
	AOCI			423.64
	(to record loss on forward contract)

Table (16)

• Since, loss on forward contract is a loss and losses are increased. Hence, loss on forward contract is debited.
• Since, AOCI is a liability and liabilities are increased. Hence, AOCI is credited.

To record account receivable:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Foreign currency		22,400
	Accounts receivable			22,400
	(to record accounts receivable)

Table (17)

• Since, foreign currency is an asset and assets are increased. Hence, foreign currency is debited.
• Since, accounts receivable is an asset and assets are decreased. Hence, accounts receivable is credited.

To record cash received:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Cash		20,800
	Forward contract		1,600
	Foreign currency			22,400
	(to record accounts receivable)

Table (18)

• Since, cash is an asset and assets are increased. Hence, cash account is debited.
• Since, forward contract is an asset and assets are increased. Hence, forward contract is debited.
• Since, foreign currency is an asset and assets are decreased. Hence, foreign currency is credited.

Impact on net income can be calculated below:

For Year 1,

$\mathrm{Net}income=\text{Sales}+\text{Gain}-\text{Loss}$

Substitute $20,000 for sales, $1,000 for gain and 1,176.36 for loss in the above formula.

$\begin{array}{c}\mathrm{Net}income=\$20,000+\$1,000-\$1,176.36\\ =\$19,823.64\end{array}$

For Year 2,

$\mathrm{Net}income=\text{Sales}+\text{Gain}-\text{Loss}$

Substitute $0 for sales, $1400 for gain and $423.64 for loss in the above formula.

$\begin{array}{c}\mathrm{Net}income=\$0+\$1,400-\$423.64\\ =\$976.36\end{array}$

Impact on income over both accounting period is $20,800.

Working Note:

Conversion of sale from crown to USD

$\begin{array}{c}\mathrm{Sales}(inUSD)=\mathrm{Sale}value(incrown)\times \mathrm{USD}\text{}percrown\\ =20,000\times \$1\\ =\$20,000\end{array}$

Computation of foreign exchange gain in USD:

$\begin{array}{c}\mathrm{Foreign}exchangegain=\text{Difference}\times \mathrm{Sale}value\\ =(\$1.05-\$1.00)\times \$20,000\\ =\$1,000\end{array}$

Computation of net income of both accounting periods:

$\begin{array}{c}\mathrm{Net}income(Year1and2)=\mathrm{Net}income(Year1)+\mathrm{Net}income(Year2)\\ =\$19,823.64+\$976.36\\ =\$20,800\end{array}$