Chapter 9, Problem 33P

On June 1, Alexander Corporation sold goods to a foreign customer at a price of 1,000,000 pesos and will receive payment in three months on September 1. On June 1, Alexander acquired an option to sell 1,000,000 pesos in three months at a strike price of $0,062. Relevant exchange rates and option premiums for the peso are as follows:

Date	Spot Rate	Put Option Premium for September 1 (strike price $0,062)
June 1	$0.062	$0.0025
June 30	0.066	0.0018
September 1	0.061	N/A

  Alexander must close its books and prepare its second-quarter financial statements on June 30.

1. a. Assuming that Alexander designates the foreign currency option as a cash flow hedge of a foreign currency receivable, prepare journal entries for these transactions in U.S. dollars. What is the impact on net income over the two accounting periods?
2. b. Assuming that Alexander designates the foreign currency option as a fair value hedge of a foreign currency receivable, prepare journal entries for these transactions in U.S. dollars. What is the impact on net income over the two accounting periods?

To determine

Prepare journal entries for foreign currency option as a cash flow hedge of a foreign currency receivable what will be the impact on net income over the two accounting period?

Explanation of Solution

The following entries need to be passed in year (June month) (Cash flow hedge):

Date	Particulars	Post Ref.	Debit($)	Credit($)
12/1/17	Account Receivable (peso)		62,000
	Sales			62,000
	( To record sale and pesos at the spot rate  $0.062)
12/3/17	Foreign currency option		2,500
	Cash			2,500
	( To record the purchase of the foreign currency option as on assets at the fair value @ $0.0025)
12/3/17	Account Receivable		4,000
	Foreign exchange gain			4,000
	( To adjust the value as the pesos receivable to the new spot rate @ $0.066 and record a foreign exchange gain resulting from appreciation of peso since June,1)
12/31/17	AOCI ( Accumulated other comprehensive Income)		700
	Foreign currency option			700
	To adjust the fair value of the option from $0.0025 to 0.0018 with the corresponding debit to AOCI ( Accumulated other comprehensive Income)
12/31/17	Loss on foreign currency option		4,000
	AOCI ( Accumulated other comprehensive Income)			4,000
	(To record a loss on foreign currency option to affect the foreign currency gain on the actual receivable with a corresponding audit to AOCI (Accumulated other comprehensive Income)
	Option Expense		700
	AOCI ( Accumulated other comprehensive Income)			700
	( To recognize the change in the time value of the option as a decrease in net income)

Table: (1)

Impact on the net income for quarter ending on 8^th June:

Particular	Amount($)	Amount($)
Sale		62,000
Foreign exchange gain	4,000
Loss on Foreign currency option	(4,000)
Net gain/(loss)	-	0
Option Expense		700
Impact on net income		61,300

Table: (2)

Journal entries as on 1^st September:

Date	Particulars	Post Ref.	Debit($)	Credit($)
3/1/18	Foreign exchange loss		5,000
	Account Receivable ( pesos)			5,000
	(To adjust the value of pesos receivable to the new spot rate of $0.061 and record foreign exchange loss resulting from the depreciation the peso since June 30)
12/3/17	Foreign currency option		1,000
	AOCI ( Accumulated other comprehensive Income)			1,000
	( To adjust the fair value as the option from $0.0018 to with a corresponding credit to AOCI ( Accumulated other comprehensive Income) $\left(\$0.062-\$0.061\right)\times \text{1000000pes}$
12/31/17	AOCI ( Accumulated other comprehensive Income)		5,000
	Gain on foreign currency option			5,000
	( To record the gain an foreign currency option to affect the foreign exchange gain on account receivable with a corresponding debit to AOCI ( Accumulated other comprehensive Income)
	Foreign currency		61,000
	Account Receivable			61,000
	(To record receipt of peso 1000,000 from customer as an assets at the spot rate)
	Cash		62,000
	Foreign currency			61,000
	Foreign currency option			1,000
	( To record exercise or the option @ $ 0.062 and remove Foreign currency option from accounts)

Table: (3)

Impact on the net income as on 1^st September:

Particular	Amount($)	Amount($)
Foreign exchange loss	(5,000)
Gain on Foreign currency option	5,000
Net gain/(loss)	-	0
Option Expense		0
Impact on net income		0

Table: (4)

Working note:

Balance of AOCI account:

$\begin{array}{c}\text{AOCI}=-700+4,000+700+1,000-5,000\\ =\text{Nil}\end{array}$

To determine

Prepare journal entries for foreign currency option as a fair value hedge of a foreign currency receivable and identify the impact on net income over the two accounting period?

Explanation of Solution

The following entries need to be passed in year (June month) (Cash flow hedge):

Date	Particular	Post Ref.	Debit($)	Credit($)
6/1/year	Account Receivable (peso)		62,000
	Sales			62,000
	( To record sale and pesos 1000,000 at the spot rate  $0.062)
	Foreign currency option		2,500
	Cash			2,500
	( To record the purchase of the foreign currency option as on assets at the fair value @ $0.0025)
6/30/year	Account Receivable ( pesos)		4,000
	Foreign exchange gain			4,000
	( To adjust the value as the pesos receivable to the new spot rate @ $0.066 and record a foreign exchange gain resulting from appreciation of peso since June,1)
12/31/17	Loss on foreign currency option		700
	foreign currency option			700
	(To adjust the fair value of the option from $0.0025 to $0.0018 with the corresponding debit to loss on foreign currency option)

Table: (5)

Impact on the net income as on 30^th June:

Particular	Amount($)	Amount($)
Sale		62,000
Foreign exchange gain	4,000
Loss on Foreign currency option	(700)
Net gain/(loss)	-	3,300
Option Expense		0
Impact on net income		65,300

Table: (6)

Journal entries as on 1^st December:

Date	Particular	Post Ref.	Debit($)	Credit($)
12/1/17	Foreign exchange loss		5,000
	Account Receivable ( pesos)			5,000
	(To adjust the value of pesos receivable to the new spot rate) $\left(@\$0.061-\$0.066\right)\times 1000,000\text{peso}$
12/3/17	Foreign currency		61,000
	Account Receivable			61,000
	( To Record receipt of peso 1000,000 from customer at spot rate $0.0061)
	Cash		62,000
	Foreign currency (Peso)			61,000
	Foreign currency option			1,000
	( To record exercise or the option and remove foreign currency option from the accounts) $\left(\$0.062\times 1000000\text{pesoes}\right)$

Table: (7)

Impact on net income 30^th September:

Particular	Amount($)	Amount($)
Foreign exchange loss		(5,000)
Impact on net income		(5000)

Table: (8)