Chapter 9, Problem 34P

On June 1, Cairns Corporation purchased goods front a foreign supplier at a price of 1,000,000 francs and will make payment in three months on September 1. On June 1, Cairns acquired an option to purchase 1,000,000 francs in three months at a strike price of $0.852. Relevant exchange rates and option premiums for the franc are as follows:

Date	Spot Rate	Call Option Premium for September 1 (strike price $0.852)
June 1	$0.852	$0.002
June 30	0.858	0.007
September 1	0.872	N/A

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

1. a. Assuming that Cairns designates the foreign currency option as a cash flow hedge of a foreign currency payable, 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 Cairns designates the foreign currency option as a fair value hedge of a foreign currency payable, 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 payable. Identify be the impact on net income over the two accounting periods.

Explanation of Solution

The journal entries read to be passed in year (June month) (Cash flow hedge):

Date	Particulars	Post Ref.	Debit($)	Credit($)
06/01/2017	Goods Purchase		852,000
	Account Payable ( francs)			852,000
	( To record purchase of goods and 1000,000 francs at the spot rate @ $0.852 )
	Foreign currency option		2,000
	Cash			2,000
	( To record the purchase of the foreign currency option at fair value at the rate of $0.002)
30/6/2017	Foreign exchange loss		6,000
	Account payable			6,000
	( To adjust the value of the fracas at spot rate @ $0.858 and record the loss resulting from appreciation in francs since June 1)
09/11/2017	Foreign currency option		5,000
	AOCI ( Accumulated other comprehensive Income)			5,000
	(To adjust the fair value of the option from  $0.002 to $0.007 with corresponding credit to AOCI ( Accumulated other comprehensive Income) )
	AOCI ( Accumulated other comprehensive Income)		6,000
	Gain on foreign currency option			6,000
	(To record gain on foreign currency option to affect the loss an account payable)
	AOCI ( Accumulated other comprehensive Income)		5,000
	Option Income			5,000
	(To recognized the change in the time value of the option as an increase in net income)

Table: (1)

Impact on the net income for quarter ending on 30^th June:

Particulars	Amount($)	Amount($)
Purchase		852,000
Foreign exchange loss	(6,000)
Gain on foreign currency option	6,000
Net gain / ( loss)	-
Option income		5,000
Impact on net income		857,000

Table: (2)

Journal Entries as on 1^st September:

Date	Particulars	Post Ref.	Debit($)	Credit($)
9/1/2017	Account Payable ( francs)		14,000
	Foreign exchange gain			14,000
	( To adjust the value of the fracas payable to new spot rate of $0.872)
	AOCI ( Accumulated other comprehensive Income)		20,000
	Foreign exchange option			20,000
	(To adjust the fair value of the option from  $0.852 to $0.872 with corresponding credit to AOCI ( Accumulated other comprehensive Income) )
30/6/2017	Loss on foreign currency option		14,000
	AOCI ( Accumulated other comprehensive Income)			14,000
	(To record gain on foreign currency option to affect the foreign currency loss an account payable with corresponding credit to AOCI ( Accumulated other comprehensive Income) )
9/1/2017	Account payable		872,000
	foreign currency			872,000
	(To record payment of francs 1000,000 so supplied at the spot rate)
	Foreign currency		872,000
	Cash			852,000
	foreign currency option			20,000
	( To record exercise of option @ $0.852 and remove foreign currency from accounts)

Table: (3)

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

Particulars	Amount($)	Amount($)
Foreign exchange gain	14,000
Gain on foreign currency option	( 14,000)
Net gain / ( loss)	0
Option income		0
Impact on net income		0

Table: (4)

To determine

Prepare journal entries for foreign currency option as a fair value hedge of a foreign currency payable. Identify the impact on net income over the two accounting periods.

Explanation of Solution

The following entries need to be passed in year (June month) (Fair value hedge):

Date	Particulars	Post Ref.	Debit($)	Credit($)
6/1/2017	Goods Purchase		852,000
	Account Payable ( francs)			852,000
	( To record purchase of goods and 1000,000 francs at the spot rate @ $0.852 )
	Foreign currency option		2,000
	Cash			2,000
	( To record the purchase of the foreign currency option at fair value @ $0.888)
30/6/2017	Foreign exchange loss		6,000
	Account payable (francs)			6,000
	( To adjust the value of the fracas at new spot rate @ $0.858)
	Foreign currency option		5,000
	Gain on foreign currency option			5,000
	(To adjust the fair value of the option from $0.007 and record the gain an foreign currency option)

Table: (5)

Impact on net income as on 30^th June:

Particulars	Amount($)	Amount($)
Purchase		852,000
Foreign exchange loss	(6,000)
Gain on foreign currency option	5,000
Net gain / ( loss)		(1,000)
Option income		0
Impact on net income		851,000

Table: (6)

Journal entries on 1^st September:

Date	Particulars	Post Ref.	Debit($)	Credit($)
9/1/year	Account Payable ( francs)		14,000
	Foreign exchange gain			14,000
	( To adjust the value of the fracas payable at new spot rate of $0.872)
	Account Payable ( francs)		872,000
	Foreign currency			872,000
	( To record payment of francs 1000,000 to supplies at spot rate @ $0.872 )
	Foreign currency (francs)		872,000
	Cash			852,000
	Foreign currency option			20,000
	( To record exercise of the option and remove foreign currency option from the accounts)

Table: (7)

Impact on net income on 30^th September:

Particulars	Amount($)
Foreign exchange gain	14,000
Net impact	14,000

Table: (8)