Ch08 beechy ism

CHAPTER 8

Foreign Currency Transactionsand Hedges

This chapter addresses the principal issues of accounting for, and the reporting of, foreign currency transactions. The translation of foreign operations is covered in the following chapter, Chapter 9.

The first section discusses the translation of transactions and the balances that arise therefrom, both monetary and non-monetary. The alternative approaches to recognizing the exchange rate change in monetary balances are presented.

The second section provides an introduction to hedging and hedge accounting. The discussion on hedging emphasizes the fact that a hedge locks the hedger into a known gain or loss and thus insulates the transaction from future changes in the exchange rate. The discussion on hedge accounting focuses on its use when normal accounting does not match exchange gains and losses on the hedged item and the hedging instrument well. Both fair value and cash flow hedges are examined.

Instructors should note that the authors did not include the time value of money (i.e., the numbers are not discounted) in the solutions to the examples and problems in this chapter. The reason for this is to reduce the confusion students experience when learning the basic principles of accounting for foreign currency transactions and hedges. We believe that it is much easier for students to follow the accounting without including discounting.

Copyright © 2014 Pearson Canada Inc. 389

SUMMARY OF ASSIGNMENT MATERIAL

Case 8-1: Graham Enterprises LimitedThis case provides a simple situation wherein a parent establishes a new foreign subsidiary and negotiates a loan to buy a building for the sub. Students are asked to consider two things: the implicit hedge between the building and the loan and alternative parent-subsidiary structures that could lead to different impacts on consolidated reporting. This case looks forward to Chapter 9, and it could be assigned along with the reading of Chapter 9.

Case 8-2: Video Displays, Inc.The case deals with a Canadian manufacturer of video display units (VDUs) that undertakes a series of moves to establish itself in the US market. The company obtains debt financing in the US, and also arranges for a US distributor to act as sales agent. The transactions with the agent are denominated in US dollars, and the agent receives an accountable advance, also in US dollars. This case deals exclusively with foreign currency transactions and balances.

Case 8-3: Canada Cola Inc.This case provides a unique non-monetary transaction (exchange of vodka for cola syrup) as well as issues involving accounting for a subsidiary. It is a short but complicated case due to a restricted currency at that time. The auditing part of the required could be excluded.

Case 8-4: SpringForth Inc.This case deals with a fast growing company that finds itself having to address the management of and accounting for foreign currency exposures for the first time. The case requires students to address the use of hedging and the requirements to use hedge accounting. In addition, students are directed to explore how to account for the hedging of a commitment to purchase a company and how to structure hedging activities and accounting at the consolidated level. While the last two activities are not directly addressed in the chapter, using their knowledge from earlier in the text and from earlier courses, students should be able to handle the requirements.

P8-1 (10 minutes, easy)This problem requires the calculation of the exchange gain or loss on a four-year loan for two years.

P8-2 (15 minutes, easy) Translation of a foreign currency sale, recording of a partial payment from the customer, adjustment of the balance at year-end, and recording of the final payment.

P8-3 (15 minutes, easy)Gain and loss on a current receivable, and gain and loss on a long-term receivable.

P8-4 (20 minutes, easy)Preparation of journal entries in year of purchase of equipment is required in part 1. Part 2. requires the preparation of the journal entries for the sale of inventory in a foreign currency for that year and the subsequent year.


Chapter 8 – Foreign Currency Transactions and Hedges

P8-5 (15 minutes, easy)Preparation of relevant journal entries for purchases of equipment and calculation of specific balances on the year end balance sheet.

P8-6 (25 minutes, medium)This problem follows from P8-5 and requires all the journal entries for a two-year period for the equipment. A hedge is added in this problem.

P8-7 (30 minutes, medium)This problem includes a hedge of an anticipated transaction. Journal entries over a two-year period are required.

P8-8 (20 minutes, medium)This problem requires the preparation of journal entries for translation of the purchase of machine parts inventory. A forward contract is entered into after the receipt of the inventory.

P8-9 (20 minutes, medium) Reporting the financial statement impacts of (1) a sale (and current receivable) denominated in euros, and of (2) a 4-year loan payable in US dollars. The problem also requires students to think about the impacts of exchange gains and losses on the statement of cash flows.

P8-10 (20 minutes, easy)This problem requires entries to record the purchase of a machine assuming (1) that the liability is not hedged, and then (2) that the liability is hedged. Both year’s entries are required.

P8-11 (20 minutes, easy) This is an illustration of the fact that a hedge locks the hedger into a known gain or loss, thereby insulating the transaction from all future changes in the exchange rate. Four different spot rates at the settlement date are hypothesized. There are no complications in the problem, such as an intervening year-end.

P8-12 (25 minutes, medium)There are three simple scenarios in this question: (1) a current receivable, hedged, (2) the same receivable, unhedged, and (3) a long-term receivable, unhedged. Scenario (1) includes settlement of the receivable and the forward contract.

P8-13 (25 minutes, medium)An illustration of a hedge of an existing monetary position.

P8-14 (40 minutes, hard)Accounting for a hedge of a firm commitment. Part l. examines accounting for the transaction without the use of hedge accounting. Parts 2. and 3. examine the use of hedge accounting. Solutions for both a cash-flow hedge and a fair-value hedge are given.

P8-15 (30 minutes, medium)



Three purchase transactions are featured, resulting in two current and one long-term payable. First year entries are required, assuming no hedging, and then hedging.

P8-16 (30 minutes, medium)Preparation of journal entries for the hedge of an existing accounts payable.

P8-17 (40 minutes, hard)Preparation of journal entries for a firm commitment. Part1. does not use hedge accounting. Parts 2. and 3. use hedge accounting (solutions for both cash-flow and fair-value hedges are provided).

P8-18 (30 minutes, medium) A Canadian manufacturer enters into a commitment to produce a product for delivery over a specified period in the future. The commitment is hedged. The question requires the student to describe the financial statement impact of the transactions, assuming first that there is no intervening year-end, then that there is a year-end, and then that hedge accounting is used.

P8-19 (30 minutes, medium) In this problem, there are two transactions that result in current balances denominated in a foreign currency. One of the transactions is hedged, while the other is not. The problem requires initial recording, year-end adjustments, and final settlement. This is a good review problem.

P8-20 (30 minutes, medium) Preparation of journal entries for the hedge of a commitment by a non-derivative. Hedge accounting is used and solutions for both cash-flow and fair-value hedges are provided.

P8-21 (20 minutes, medium) Preparation of journal entries for the hedge of a highly probable future transaction.

ANSWERS TO REVIEW QUESTIONS

Q8-1: A transaction that is denominated in a foreign currency is a foreign currency transaction.

Q8-2: The primary cause of exchange rates over the long-term is differential inflation rates. Short-term changes may be due to speculation on the money markets.

Q8-3: (1) The machine would be recorded at $125,000, the eventual cash outflow that arose from purchasing the machine. (2) The machine would be recorded at $120,000, reflecting the exchange rate in effect when the machine was acquired.

Q8-4: At year-end, the liability should be reported at its current equivalent in Canadian dollars, or ₤5,000 @ $1.70 = $8,500. The decline in the value of the liability from $9,000 to $8,500 should be reported as an exchange gain on the statement of comprehensive income for the year.



Q8-5: Monetary balances are those that are fixed in a given currency, e.g. cash, receivables and payables. Non-monetary balances are amounts that are not fixed in terms of a currency, e.g. inventories, and do not represent a claim against monetary resources.

Q8-6: Some companies use an average weekly or monthly rate for translating foreign currencies as an expedient way of handling a large volume of foreign currency transactions. Minor differences between the actual spot rate and the rate used for translation of the transactions will be adjusted when the accounts are settled, or when still-outstanding monetary account balances are adjusted to the current rate on the reporting date

Q8-7: The purpose of hedging is to create a foreign-currency monetary position that is in opposition to a balance created through a foreign currency transaction. By creating an offsetting balance, any gains or losses realized on the transaction balance will be offset by losses or gains on the hedging balance.

Q8-8: A derivative possesses three characteristics:- its value changes in response to the change in a specified interest rate, financial

instrument price, commodity price, foreign exchange rate … (sometimes called the ‘underlying’);

- it requires little or no initial net investment- it is settled at a future date

[IAS 39.9]

Q8-9: If an exposed liability position is being hedged, then the hedge must create an offsetting asset position. Therefore, the hedging contract must be to receive or buy euros.

Q8-10: There is a cost to hedging (other than transaction costs) that is equal to the spread between the spot rate and the forward rate at the date of entering into the hedge. This cost (or income) is the known loss or gain that will be unavoidable. Losses and gains in excess of this spread are eliminated, however, regardless of the size and direction of movements in the exchange rate.

Q8-11: A forward contract is an executory contract because neither party will execute the contract until the settlement date.

Q8-12: Hedge accounting is a formal accounting designation wherein a hedging relationship qualifies for special accounting rules only if it meets all of the following five conditions:

1. the hedging relationship is formally designated and documented at inception within the company’s overall risk management strategy;2. the hedge is expected to be highly effective;3. for cash flow hedges, a forecast transaction is highly probable;4. the effectiveness of the hedge can be reliably measured;5. the hedge is assessed on an ongoing basis and has been highly effective in the past [IAS 39.88].



Hedge accounting gives companies the ability to change the timing of recognition in net income of certain unrealized foreign currency gains and losses. To match the gains and losses between a hedging instrument and a hedged item, hedge accounting gives a company two choices. It could speed up recognition of the offsetting loss or gain on the hedged item into the current period to match it with the hedging instrument. Alternatively, it could defer recognition on the loss or gain on the hedging instrument to correspond with the hedged item. This is essentially what occurs under hedge accounting.

Q8-13: When an anticipated transaction is hedged, there is no transaction balance yet recorded on the books; thus, a hedge of an anticipated future transaction is a hedge of an unrecorded executory contract rather than of an existing balance.

Q8-14: Cash-flow hedge: the hedging of the variability in cash flows that results from changes in foreign exchange rates and that affects profit or loss. Cash flow hedges can be for the exposure to changes in exchange rates that affect recognized assets or liabilities and highly probable forecast transactions.

Q8-15: A hedged item is a recognized asset or liability or an anticipated transaction. A hedging instrument is normally a derivative. For currency hedges only, it can also be a non-derivative financial asset or liability.

Q8-16: A fair-value hedge is a hedge of the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss.

Q8-17: For hedge accounting to be applied, a company must formally designate the hedging relationship and meet the criteria for hedge accounting.

Q8-18: An effective hedge is one where the changes in the fair value or cash flows of the hedging instrument offset the changes in the fair value or cash flows of the hedged item.

Q8-19: The conditions that must be met for a hedge to be deemed highly effective are:

1. An economic relationship exists between the hedging instrument and the hedged item;2. The designation is based on the relative quantities of the hedged item and hedging

instrument;3. The designation does not deliberately create hedge ineffectiveness by mismatching the

relative quantities of the hedged item and the hedging instrument so as to attain an inappropriate accounting outcome; and

4. The value change in the hedging relationship is not dominated by the effect of credit risk.

CASE NOTES



Case 8-1: Graham Enterprises Limited

Objectives of the Case

This case is intended to highlight the reporting implications for the parent of a parent-founded foreign operation. Students should consider how the subsidiary’s building and its related debt should be reported on the parent’s consolidated statements. The translation of foreign operations will not be discussed until Chapter 9, but this case should help to sensitize students to the problems inherent in consolidating foreign operations. Students should be able to recognize the presence of an implicit hedge.

Part 1:

Implicit hedge

Students should recognize that since the loan was used to buy the building, and since the building will be used to generate revenue in pounds sterling, the building is an implicit hedge of the loan liability. Can the building be used as a hedge of the loan payable using “hedge accounting”? The fair value of the loan will be affected by interest rates, credit risk and exchange rates. If the goal is to hedge against changes in the fair value of the loan then the building cannot be used as a hedging item for two reasons:

1. As a general rule, only derivatives can be used as hedging items for fair-value risk. Since the building is not a derivative, then it cannot be used as a hedging instrument.

2. In addition, if the loan is carried at “amortized cost”, its carrying value will not reflect the effect of changes in interest rates and therefore is would not be appropriate to use the loan as a hedged item.

The loan is subject to foreign exchange risk and therefore this qualifies the loan (regardless of its classification as a financial instrument) as a possible hedged item for foreign exchange risk only, to the extent that its fair value changes due to changes in the exchange rate. In addition, for foreign exchange risk, the hedging instrument does not have to be a derivative; it can also be a non-derivative financial asset or liability. The building, however, is also not a “non-financial asset or liability,” therefore it is not possible to use the building as a hedge of the foreign exchange risk present in the loan.

An alternative approach would be to ask if the loan could be the hedging item and the future revenue stream of the building could be the hedged item? Under this scenario, it could be argued that the company is trying to hedge the foreign exchange risk for a forecasted transaction, that is the future revenue stream (i.e., it would be a cash-flow hedge). This approach is also unlikely to be successful for two reasons:

1. The accounting guidelines require that the forecasted transaction be highly probable. Unless the company has a contract that indicates that it has pre-sold its future production, it is unlikely that it will meet the highly probable criterion.



2. The hedge may not meet the definition of an effective hedge. The hedge has to meet the 80-125% guideline and it is likely that the cash in-flows from the building would not match well with the cash out-flows for the debt.

Part 2:

Students should be able to see two possible approaches. First, they can use what they learned on how to account for foreign currency transactions in the chapter to address these transactions. Second, using the discussion in Part 1, students should be able to theorize that there should be an alternative approach that acknowledges the relationship between the building and the associated debt. A discussion could be used to tease out the conditions under which you would allow either method. This would serve as a useful introduction to the concept of functional currency and the idea of an integrated or independent subsidiary.

Foreign currency transactions approach

After studying Chapter 8, students should be able to see the consequences for Graham of treating the transactions in London as foreign currency transactions. This is equivalent to using the Canadian dollar as the functional currency for translation, as discussed in Chapter 9. If a transactions approach is taken, the results will be as follows:

1. The building will be translated at the historical rate of $2.00 and consolidated at $40 million.

2. Depreciation will be reported at the historical rate, amounting to $2.0 million/year.

3. The loan will be shown in the consolidated balance sheet at the year-end rate of $1.50, or $30 million.

4. An exchange gain of $10 million arising from the change in the dollar-equivalent loan balance will be reported in net income.

5. The interest expense will be translated at the rate that existed when it accrued, which would be the average for the year. An average rate of $1.75 may be assumed.

In summary, the loan and its interest expense would be reported at current rates while the building and its depreciation expense would be reported at the historical rate.

Functional currency approach

Students should recognize that since the building and the loan are related and are directly offsetting in the subsidiary’s balance sheet, it makes sense simply to translate both (and the related revenues and expenses) at the current rate and consolidate. This is the method of translation that uses a foreign currency as the functional currency, of course, although students have not yet been introduced to it by that name. The logic of the approach should be apparent, however.

The parent-subsidiary relationship



The required asks students to discuss the options available to the parent in structuring its relationship to the subsidiary. This requirement looks ahead to Chapter 9 and the concept of functional currency (previously known as self-sustaining and integrated foreign operations). A discussion can be generated prior to the next chapter which draws out the circumstances in which each of the reporting approaches might be appropriate. The discussion can also point out that the parent may be motivated to establish certain relationships with its foreign operations not just for operational reasons, but for financial reporting reasons as well.

Case 8-2: Video Displays, Inc.


To require students to consider the reporting issues for foreign currency transactions, including the appropriate reporting in a specific situation.

Objectives of Financial Reporting

The only specified users of VDI’s financial statements are (1) the owner-managers and (2) the US bank. There may be other significant creditors not mentioned in the case, or there may be other sources of debt financing in the future. Therefore, creditors (bankers) and the private owners are likely to be the primary users of the statements.

For these users, the needs probably are for (a) cash flow prediction and (b) performance evaluation. The owner-managers will be concerned with their ability to generate funds from operations for debt service and further investment, as will the bankers. Revenue and expense recognition policies will tend to favour alternatives that result in the highest quality of earnings, and will discourage the use of allocations. Nevertheless, accounting policies should reflect the economic events affecting the enterprise in order to enable the users to evaluate performance, even if allocations are required to do so. Tax minimization would likely be an important consideration for revenue recognition, but is irrelevant for the issues raised in this case. Exchange gains and losses affect taxes only when realized, and their taxation is unaffected by accounting policies.

Discussion of the issues

1. Reporting of the term loan: The US$3,000,000 term loan will be reported on the balance sheet, as will accrued interest. Interest is payable only annually, on March 1, and thus 10 months of interest at 12% per annum (US$300,000) will be accrued on December 31, 20X5. The 20X5 income statement will include interest expense of US$360,000, and will include the impact of exchange rate changes on the interest payable and the principal amount.

The interest is the easiest sub-issue to deal with. At December 31, 20X4, there would have been US$300,000 in accrued interest payable, translated at the then-current rate of $1.06, or Cdn$318,000. On March 1, 20X5 interest of US$360,000 was paid, at an assumed exchange rate of $1.05 (derived from Exhibit A as exchange rates on Feb.1 and April 1 were both $1.05) or



Cdn$378,000. The amount charged to 20X5 income from this payment therefore was $60,000 ($378,000 - $318,000). The $60,000 consists of two components: interest expense and foreign exchange gains or losses. Interest expense would have been $63,300 ($60,000 × 1.055).

The foreign exchange gain would be $3,300 consisting of the gain on accrued interest payable from 20X4 of $3,000 ($300,000 × [1.05 – 1.06]), and the gain on the interest accrued for January and February 20X5 of $300 ($60,000 × [1.05 -1.055]). In addition, the December 31, 20X5 accrual of US$300,000 is reported at its year-end Canadian equivalent of $345,000 (@ $1.15). The total expense on the income statement is the sum of two amounts, the interest expense of $330,000 ($300,000 × [1.15 + 1.05]/2) and the foreign exchange loss of $15,000 ($300,000 × [1.15 – (1.15+1.05)/2]), or $345,000. The total impact on the income statement for 20X5 is $405,000 (60,000 + 345,000).

The US$3,000,000 principal amount is to be reported at its year-end 20X5 current rate of $1.15 (or $3,450,000). For predicting cash flow and for assessing the liquidity position of VDI, this rate is appropriate. Then the question becomes how to report the change in value of $270,000 since December 31, 20X4. As discussed in the text, the only alternative acceptable under GAAP is to recognize the change in value in net income immediately as a foreign exchange loss.

The exchange rate change does reflect an economic event of the period, and charging the outcome to income does reflect in income the impact of changing exchange rates on the performance of the enterprise. As long as the charge is clearly identified on the income statement, readers can still see the results of operations independent of the impact of foreign financing on the net income.

2. Current account with the US distributor: The current account of the distributor is simply a current account receivable, and should be reported on VDI’s balance sheet at the current exchange rate. The account details that are shown in Exhibit A of the case indicate that both shipments and cash receipts have been entered into the account at the exchange rate in effect at the time of the transaction. In the case of shipments, this practice is fine. For the cash receipts, however, the cash account should have been debited for the current equivalent in Canadian funds while the receivable should have been credited for the historical amount of the invoice, with the difference going into the exchange gains and losses account. The practice as demonstrated in Exhibit A is satisfactory for efficient bookkeeping, however, in that the net amount of the exchange gains/losses for the period can be quickly determined by adjusting the balance of the account at the end of the accounting period. When the shipments (in US dollars) are netted against the payments (also in US dollars), the balance of the account can be determined to be US$430,000. At the year-end exchange rate of $1.15, the correct balance of the receivable is Cdn$494,500. The difference between the recorded balance of $449,000 and the correct balance of $494,500 is adjusted by simply debiting the receivable and crediting exchange gains/losses for $45,500.

Students may perceive the account as being “incorrectly” maintained by VDI, in that there is no attempt at the time of cash receipt to credit the receivable with the recorded amount of the invoice being paid. But to adjust for gains/losses on each transaction would be quite time-



consuming; it is far more efficient to make all entries at the current rate and then adjust the balance whenever financial statements are to be prepared.

3. Accountable advance: Of the US$60,000 accountable advance, US$40,000 has been accounted for by the distributor while the remaining US$20,000 is still outstanding. The advance was granted on April 4, 20X5, when the exchange rate apparently was about $1.05 as indicated by the recording of the April 1 shipment in Exhibit A. The $40,000 that has been spent by the distributor clearly should be charged to expense, but at what exchange rate? Two alternatives exist: the rate when the advance was granted or the rates in effect when the distributor spent the money. Since the distributor was, in effect, acting as agent for VDI in spending the money for promotional purposes, an argument could be made for recording the expenses at the rate in effect when the distributor made the expenditures. However, changes in the exchange rate between April 4 and the date of expenditure by the distributor would have to be determined and the difference between that rate and the rate of $1.05 would be charged or credited to exchange gains/losses. Therefore it certainly would be more expedient to simply charge the US$40,000 to expense at the April 4 rate (Cdn. $42,000) without attempting to estimate the dates of expenditure by the distributor and the exchange rates in effect on those dates.

The US$20,000 still outstanding can be viewed either as a receivable or as a prepaid expense. If it is viewed as a receivable (or financial asset), then the balance would be restated from Cdn$21,000 (@ $1.05) to Cdn$23,000 (@ $1.15) at year-end, the $2,000 adjustment being credited to exchange gains/losses. The effect of the adjustment of the receivable is to shift income from 20X6 to 20X5, since 20X5 is being credited with the increased value of the advance. The advance is really an expense in nature, however, it is doubtful whether income should be recognized from an expenditure rather than from revenue. If the remaining US$20,000 is viewed as a prepaid expense (not a financial asset), on the other hand, then the debit balance will remain at Cdn$21,000, and will be charged to operations in 2006.

A third alternative treatment for the US$20,000 balance would be to charge it to expense in 20X5. This approach could be defended with the argument that the entire US$60,000 was out of VDI’s control as soon as it was granted, and that the exact timing of expenditure by the distributor is essentially irrelevant to evaluation of VDI’s performance. This argument may seem persuasive when the cash flow objective is considered, since the cash flow did occur in 20X5. On the other hand, the matching concept suggests that the expenditure should be charged to operations in the periods in which the benefit is obtained, and matching can improve both cash flow prediction and performance appraisal. The US$20,000 would also meet the definition of an asset as it is expected to result in a future benefit.

Summary

There is no real issue in reporting the US term loan or the current account with the US distributor. The balance must be restated to the current year-end exchange rate.

For the accountable advance, the portion expended should be charged to income at the rate in effect when the advance was given due to the doubtful cost-benefit ratio of charging expense at the rates in effect when the distributor actually spent the money. The remaining balance of the



advance should probably be reported as a prepaid expense at the $1.05 rate in order to avoid recognizing income from an expenditure and to improve cash flow prediction and performance evaluation by relating the expenditure to the period in which the benefits are received.

Case 8-3: Canada Cola Inc.


This case provides a unique non-monetary transaction (exchange of vodka for cola syrup) as well as issues involving accounting for a subsidiary. It is a short but complicated case due to a restricted currency at that time in Russia. The students are asked to consider the accounting and auditing issues. The following suggested response is from the 1990 UFE Report, Paper II-Question 3.

Suggested Response

Memo to: PartnerFrom: CASubject: Canada Cola Inc. (CCI) Engagement

The establishment of accounting policies for this division is critical since future profit-sharing will be based on the division’s financial statements. We must take into account CCI’s reporting objectives for these operations, which may differ from the objectives of financial reporting for CCI’s Canadian statements. For example, CCI may want to maximize profits in the Russian operations in order to maximize its asset withdrawal from the country.

Given the unusual nature of the operations in Russia, extensive disclosure will be essential to allow the readers of CCI’s financial statements to understand these operations. This disclosure could include the nature of the joint venture agreement, the type and quantity of assets (i.e. vodka) which were received, or other specific assets contributed.

Accounting for the divisionThe operations in Russia are a division of CCI, so it is necessary to include all the revenues, expenses, assets and liabilities of this division. However, we are faced with a significant measurement problem: at what amount should we record the items in CCI’s financial statements?

Machinery and working capitalThe machinery and working capital provided by CCI should initially be recorded in CCI’s amounts at their historic cost, denominated in Canadian dollars. However, some valuation problems may be associated with these assets. CCI is entering an unproven market, and little or no information is available that could be used in assessing whether Canada Cola will do well in Russia. Furthermore, the Russian government, given its uncertain future direction, could decide to cancel the agreement at any time.



In light of this potential valuation problem, we should consider whether the assets should be expensed in the current year or, taking a somewhat less conservative approach, recorded on the cost-recovery basis.

If these assets are left on the accounts of CCI, then we must consider how they will be expensed over time. The machinery will wear over time, and the working capital may not be recoverable, since it is only profits and net working capital that the Russian government will translate to vodka. Alternatives include:

- amortizing the costs over the expected life of the agreement. or- amortizing the costs over a period of benefit that is less than the life of the agreement in

order to be conservative. This period will be difficult to determine.

We should consider disclosing working capital as a noncurrent asset because it is not a liquid asset (i.e., it cannot be converted to cash for CCI’s purposes).

Land and buildingWe must also consider whether any accounting recognition should be given to the assets (land and building) contributed by Russia. In essence, this contribution is similar to a government grant of a nonmonetary asset, which may or may not be reflected in the accounts. (The value of the assets would be offset by the value of the grants.) Factors supporting the exclusion of these assets from CCI’s accounts include the fact that legal title has not been transferred and, therefore, to some extent neither have the risks and rewards of ownership. The situation is similar to a rent-free lease being provided: no recognition would be given in the accounts. Furthermore, the conservatism and the objectivity concept support no recognition in the accounts. Even if there were to be any recognition in the accounts, it would be very difficult to determine the fair market value of these assets in a country such as Russia, where real estate is not freely traded. We may consider as an alternative the recording in the accounts of an estimate of the future benefit to be derived from the asset. However, this “value in use” will also be very difficult to estimate.

Measurement of revenues and expensesThere are significant measurement problems in trying to determine the revenues and expenses of the Russian operations to be included in CCI’s financial statements. We cannot simply use the exchange rate between rubles and Canadian dollars because although we can convert Canadian dollars to rubles, we cannot directly convert our Russian profits, denominated in rubles, to Canadian dollars. The substance of the transaction is similar to a nonmonetary transaction - CCI essentially receives vodka in return for its cola. Therefore, the issue becomes this: when do we record the value of the vodka in the accounts? Alternatives include:

- recording all revenues and expenses at the time they are recognized in rubles (e.g. at the time the profit is determined in rubles) at their equivalent value in vodka, as determined by the prevailing export market in Russia and Canada. The obvious problem with this alternative is the ultimate amount to be received, in Canadian dollars upon the sale of the vodka, may change. The prevailing export price in Russia (i.e. the price of vodka in rubles) may change, thereby changing the profit previously recorded. Furthermore, the market value



of vodka in Canada may change. However, past history suggests that this is not a significant risk since prices are controlled by the government liquor boards in many provinces, and there is little, if any, past history of declines in liquor prices. In contrast, there is a strong possibility that market prices may decline given the limited number of buyers in Canada and the possibility that they may be confronted with too much supply (e.g. other joint-ventures may also have vodka to sell, or CCI’s Russian profits may exceed Canadian demand for vodka).

- recording all revenues and expenses at the time the rubles are converted to vodka. This alternative eliminates the risk that the price of vodka in rubles may change. However, there is still the risk that the market value of vodka being sold to the Canadian market may change significantly, as discussed above.

- recording revenues and expenses only when the vodka is sold to the Canadian market, and the exact profit in Canadian dollars is reliably measured. This would obviously be the most conservative approach since the gains are recognized only when they are realized.

Valuation of vodka inventoryIf the Russian profits are recorded in CCI’s accounts at any time before the vodka is actually sold in Canada (i.e., either of the first two alternatives above), we must then determine how to treat the gains and losses that arise because of fluctuations in the price of vodka. The realized gains and losses would clearly be taken into income. The issue then becomes how to disclose these amounts in the income statements. They can either be offset directly against Russian revenues or disclosed separately as holding gains or losses.

The unrealized gains and losses would be taken into income (as of the financial statement date).

Alternative approach to transaction valuationIn trying to determine how to measure Russian operations for CCI’s financial statements, we could seek guidance from the generally accepted accounting principles for foreign operations. For example, we may be able to apply the principles inherent in the view that the functional currency is the Canadian dollar, as many factors suggest that Russian operations are integrated with those of CCI. CCI is wholly responsible for the management of the Russian operations. It must supply the raw materials, and it must use its processes in converting the syrup into cola.

On the other hand, several factors suggest that the functional currency may be the ruble as the operations are somewhat independent of CCI. The government can exert strong control over the operations, and other assets, such as the machinery, cannot be removed.

Treatment of the 50% payment to the Russian governmentWe must consider how to disclose, in the income statement, the profits belonging to the Russian government. One alternative is to record the payment as a one-time item, either as a royalty charge or as the rental charge for the building provided by the Russian government. Another approach is to consider the payment to the Russian government to be, in effect, a tax cost. This approach may then affect the Canadian tax provision.



Other reporting alternativesWe may want to consider reporting alternatives other than 100% combination of revenues and expenses because CCI may not have total control of these operations. Although CCI is responsible for the management of the Russian operations, Russia still has the power to intervene. Given the real possibilities of limitations on control, we should consider reporting the Russian operations under the equity basis. We should also consider reporting these operations on the cost basis in view of volatility of the government (which may seize operations), and the inability to retrieve assets.

Other issuesFuture tax implications may arise with the temporary differences between depreciation policies for financial statement purposes and tax purposes.

Since the operations in Russia may be significant to CCI, it may be necessary to disclose segmented information on these operations.

We must also consider how to treat losses that may arise from these operations. For example, it may be necessary to recover previous losses before any future profits are converted to vodka.

Auditing issuesThe extent of audit work to be performed by our firm will depend primarily on how we decide to account for the operations in Russia. For example, a 100% combination of revenues and expenses will involve considerably more work than if we account for this investment on the cost basis.

We will need to assess whether we can rely on auditors in Russia, or whether we will have to perform the investigations ourselves. Assessing whether we can rely on the Russian auditors may be difficult given the need to evaluate their professional competence and standards (i.e. very little information may be available regarding their training, standards, etc.).

It is necessary to obtain assurance that the profits in Russia are properly measured (to the satisfaction of the Russian government), in order to ensure the CCI liability is properly measured. We should determine whether a separate audit report will be needed for the statement of profit for the Russian operations. It will also be necessary to ensure that the Russian operations are converted to Canadian GAAP for inclusion in CCI’s financial statements.

The risk on this engagement is increased because of the significant valuation problems associated with these assets. These issues must be resolved. A qualified opinion will not be acceptable to CCI, as it is a public company.

[CICA]

Case 8-4: SpringForth Inc.




This case is intended to provide students with the opportunity to discuss the merits of hedging as good business practice and the issues surrounding the accounting for hedges. In particular, students have the opportunity to describe to a client the accounting issues that are likely to arise in any hedging program and their potential impact on reported results. Students are directed to two specific issues: a commitment to purchase another company and the existence of potentially offsetting exposures to the US dollar in different subsidiaries..

Assessment

The Company is a newly listed, publicly traded company that is experiencing rapid growth. It could potentially have to raise capital to finance growth/acquisitions especially if it becomes a consolidator in its industry. Management also appears to be inexperienced with respect to handling foreign currency issues.Management likely wants a healthy stock price to reduce dilution on any equity financings. Therefore it is necessary to establish a good reputation with analysts. This requires the ability to guide as to expected results. The company may also want to access the debt markets. To reduce the costs of debt, management will want to reduce the perceived risk of the firm.Conclusion: Management should reduce their exposure to foreign currency risks to the extent possible to reduce unnecessary volatility. Given their lack of experience, it may involve hiring the expertise.

Recommendations

1. The company should institute a hedging program to mitigate foreign currency risk – Instructors should try to tease out the details of any such program from students as most of them will likely arrive at this recommendation but few will have actually thought about what such a program will look like. The following issues could be discussed with students:- At what level will the hedging program operate? Should each subsidiary run their own hedging program? (Discuss the relationship between the subsidiary and parent. Is the subsidiary operated independently of the parent? If yes, should the hedging decisions also be independent?) - Why are subsidiaries likely to want to hedge? (Subsidiary management likely also want to reduce volatility as they are evaluated by head office)- Why should the parent (i.e., head office or a central treasury) manage foreign exchange exposures? (Several reasons can be given including better control as expertise can be centralized, it could also be cheaper as exposures in one subsidiary may naturally offset exposures in another subsidiary, better information available on overall exposure, may be easier to get information necessary to implement “hedge accounting” at the consolidated level)- In this case, it is probably best to recommend a “central treasury” approach in this situation given the apparent lack of expertise. Students could also be asked to think about how such a program would work. For example, guidelines could be issued requiring all transactions or balances in excess of a defined amount to be hedged through the central treasury. The central treasury, in turn, could just hedge its net exposure with external parties to reduce costs.

2. The company’s management should consult with its public accountants in setting up any central treasury in order to understand the reporting implications for different hedging decisions.



This is an opportunity for students to describe how the accounting for hedges normally works well when the gains and losses on the hedged item and the hedging instrument are recognized in the same period. It also provides an opportunity for students to describe circumstances when it may not work well and when “hedge accounting” should be used. Again students should be pushed to make sure that they understand the implications of adopting “hedge accounting”. An example of the type of documentation required can be found online in the following PWC document:http://www.pwc.com/en_MY/my/assets/publications/ias39.pdfIn addition, the question should be posed as to who/where the necessary documentation will take place. Students should be reminded that the documentation can’t be done after the fact. Further, the documentation will have to be done for each entity (i.e. each subsidiary and the parent’s separate statements as well as at the consolidated level …it is important that the implications for the consolidated statements are considered on an ongoing basis as “hedge accounting” cannot be done retroactively at the consolidated level).

3. Purchase of SummerBreeze – Student should be able to identify that SpringForth has a foreign currency exposure related to the purchase of SummerBreeze and that it should likely be hedged given the above analysis. Student should be guided to recognize that it is a “firm commitment” in the same way that a purchase order is a “firm commitment” (see definition of firm commitment on page xxx of the text) and as such “hedge accounting” can be used. Given that it is a firm commitment, if the fx exposure is hedged, the hedge can be designated as either a cash flow hedge or a fair value hedge. Students should be guided to understand the implications for accounting for the acquisition of SummerBreeze. If it is a cash flow hedge, the gain or loss will be deferred in OCI. On acquiring the business on February 1, 20X5, the gain or loss can be used to adjust the carrying value of the business (i.e., it will affect the goodwill recognized on acquisition). It will only impact income if there is an impairment of goodwill. If it is a fair value hedge, the gains and losses on the forward contract will be recognized in income but will be offset by the losses and gains related to the “commitment”. Any balance in the commitment account will be removed on February 1 and used to adjust the goodwill on acquisition (similar to the above adjustment for cash flow hedges). While most students will not recognize these accounting implications immediately, they should be guided so that they can discover it through class discussion. [Note that hedging the net investment in a foreign subsidiary could also be introduced here although it is not covered till the next chapter]

4. Offsetting foreign currency balances – these items can be used to help trigger some of the items discussed above. For example, should SpringUp and EverSpring both hedge externally given that they have offsetting balances? An alternative would be to have the both subsidiaries hedge the balances with the central treasury and then have the central treasury just hedge the net balance (this should result in lower overall costs of hedging for the consolidated entity). The “costs” of hedging can be further explored at this point. The purchase orders can also be used to trigger a discussion about the need for “hedge accounting” and its rather onerous requirements and subsequent costs. In addition, it can also be used to discuss the use of non-derivatives such as the receivable as a means of hedging the purchase order. Many students may automatically assume that it would be hedged by a forward contract but they should be reminded that it may not be necessary and further it may be less expensive to hedge them with the receivable. (see


http://www.pwc.com/en_MY/my/assets/publications/ias39.pdf


Reality Check 8-3 regarding the costs of hedging). These items can also be used to trigger a discussion of where the hedging and hedge accounting should occur. In addition to the designations made at the company level, designations will also have to be made at the consolidated level. Finally, with the new proposals in the recent ED, the hedging of net positions should be easier as all the items in the position no longer have to affect cash flows in the same period.

SOLUTIONS TO PROBLEMS

P8-1

For the year-ended December 31, 20X1, an exchange loss of $9,000 [(1.10–1.13) × $300,000] is reported on the income statement.

For the year-ended December 31, 20X2, an exchange gain of $18,000 [(1.13–1.07) × $300,000] is reported on the income statement.

P8-2

November 14, 20X1: Accounts receivable (₤100,000 × $1.51) 151,000Sales 151,000

Cost of goods sold 65,000Inventory 65,000

December 20, 20X1: Cash (₤40,000 × $1.56) 62,400Accounts receivable (₤40,000 × $1.51) 60,400Exchange gains and losses 2,000

December 31, 20X1: Accounts receivable (₤60,000 × $0.07) 4,200Exchange gains and losses 4,200

[₤60,000 × (1.58 – 1.51) = 4,200]

February 12, 20X2: Cash (₤60,000 × $1.55) 93,000Exchange gains and losses 1,800

Accounts receivable (₤60,000 × $1.58) 94,800 [₤60,000 × (1.55 – 1.58) = –1,800]

P8-3

December 31, 20X2: Exchange gains and losses 6,944Accounts receivable (current) 6,944

[(1,000,000 × 1/16) – (1,000,000 × 1/18)]

Exchange gains and losses 6,536Accounts receivable (long-term) 6,536



[2,000,000 × (1/17 – 1/18)]

December 1, 20X3: Cash (1,000,000 × 1/11) 90,909Accounts receivable (1,000,000 × 1/18) 55,556Exchange gains and losses 35,353

[1,000,000 × (1/18 – 1/11)]

December 31, 20X3: Accounts receivable (long-term) 111,111Exchange gains and losses 111,111

[2,000,000 × (1/18 – 1/9)]

P8-4

1.

July 1, 20X4 Equipment 769,231 Notes payable 769,231[€500,000 / 0.65]

December 31, 20X4 Interest expense 19,481 [(€500,000 × 6% × ½ ) / 0.77]

Exchange gain 731Cash (€15,000 / 0.80) 18,750

Notes payable 144,231 Exchange gain 144,231 [(€500,000/0.800) – $769,231 = $144,231]

2.

October 1,20X4 Accounts receivable 116,667 Sales 116,667[To record sale to Wein (€87,500 / 0.750)]

Cost of goods sold 100,000Inventory 100,000

[To remove sold goods from inventory]

December 31, 20X4 Exchange loss 7,292Accounts receivable 7,292

[To adjust accounts receivable to year-end exchange rate: (€87,500/0.800) – $116,667 = $7,292]

March 1, 20X5 Exchange loss 6,434Accounts receivable 6,434

[To adjust accounts receivable to



March 1, 20X5 exchange rate: (€87,500/0.85 – €87,500/0.80)]

Cash (€87,500/0.850) 102,941Accounts receivable 102,941

[To record receipt of funds from Wein]

P8-5

1.

July 1, 20X8 — No entry

October 31, 20X8

Equipment 52,083 Accounts Payable 52,083

[US$50,000 / 0.96 = 52,083]

December 1, 20X8

Accounts Payable (30,000 / 0.96) 31,250 Exchange Gain 947 Cash (30,000 / 0.99) 30,303

[Gain is 30,000 × (1/0.96 – 1/0.99) = 947]

December 31, 20X8

Accounts Payable 833 Exchange Gain 833

[Gain is (20,000 / 1.00) – (20,000 / 0.96)]

Depreciation Expense 1736 Accumulated Depreciation 1736

[$52,083 × 1/5 × 2/12]

2.

Equipment: US$50,000 / 0.96 = $52,083Accumulated Depreciation: $1,736Accounts Payable: US$20,000 / 1.00 = $20,000

P8-6



1. Hedge accounting is not necessary because the gains and losses on the accounts payable and forward contract receivable are recognized and offset against one another under normal accounting so there is likely little need to incur the additional expense of using hedge accounting.

2.

July 1, 20X8 — No entry

October 31, 20X8Equipment 52,083 Accounts Payable 52,083

(US$50,000 / 0.96 = 52,083)

December 1, 20X8Accounts Payable (30,000 / 0.96) 31,250 Exchange Gain 947 Cash (30,000 / 0.99) 30,303

Gain is 30,000 × (1/0.96 – 1/0.99) = 947

Both methods of accounting for the hedge are presented:

Gross Method Net Method

December 1, 20X8Forward contract receivable (US$) 20,101 Forward contract payable (C$) 20,101[US$20,000 / 0.995]

December 31, 20X8Accounts Payable 833 833 Exchange gains 833 833[Gain is (20,000 / 1.00) – (20,000 / 0.96)]

Exchange losses 101 101 Forward contract receivable 101 101[Loss is (20,000 / 1.000) – (20,000 / 0.995)]

January 1, 20X9Forward contract payable 20,101 Cash (C$) 20,101

Cash (US$) 20,000 20,000 Forward contract receivable 20,000 101 Cash (C$) 20,101



Accounts Payable 20,000 20,000 Cash (US$) 20,000 20,000



P8-7

The hedge is treated as first, a fair-value hedge and second, a cash-flow hedge. Suggested solutions are given below.

1. Fair-value hedge


September 7, 20X5Deposit on equipment (100,000 / 0.92) 108,696 108,696 Cash 108,696 108,696

Forward contract receivable (US$) 439,560 Forward contract payable (C$) 439,560[US$400,000 / 0.91]

December 31, 20X5Exchange losses 9,662 9,662 Commitment Liability 9,662 9,662[Loss is (400,000 / 0.92) – (400,000 / 0.90)]

Forward contract receivable 8,368 8,368 Exchange gains 8,368 8,368[Gain is (400,000 / 0.91) – (400,000 / 0.893)]

January 15, 20X6Exchange losses 10,101 10,101 Commitment Liability 10,101 10,101[Loss is (400,000 / 0.90) – (400,000 / 0.88)]

Forward contract receivable 9,215 9,215 Exchange gains 9,215 9,215[Loss is (400,000 / 0.893) – (400,000 / 0.875)]

Equipment 543,478 543,478Commitment liability (9,662 + 10,101) 19,763 19,763 Deposit on equipment 108,696 108,696 Accounts Payable (400,000 / 0.88) 454,545 454,545

February 15, 20X6Forward contract payable 439,560 Cash (C$) 439,560



Cash (US$) (400,000 / 0.85) 470,588 470,588 Forward contract receivable 457,143 17,583 Exchange gains 13445 13,445 Cash (C$) 439,560

Accounts Payable 454,545 454,545Exchange losses 16,043 16,043 Cash (US$) 470,588 470,588

Notes:

On delivery, accounts payable are recorded at the spot rate ($454,545 = US$400,000/0.88) to reflect the value of the obligation to pay US$400,000 to the supplier. The P.O. commitment liability is reversed as the increase in the liability is now captured in the accounts payable. Finally, the equipment is recorded at $543,478 to balance the journal entry. This results in the equipment being recorded at the spot rate (0.92) that was in effect when the purchase order was issued (500,000 / .92 = 543,478).

The cost of the hedge was $4,778 [(400,000 / 0.92) – (400,000 / 0.91)]. Of this amount, $1,294 (9,662 – 8,368) was charged to operations in 20X5 while $886 was charged to operations for the period from January 1 to January 15 and $2,598 was charged to operations for the period from January 15 to February 15.

2. Cash-flow hedge


September 7, 20X5Deposit on equipment (100,000 / 0.92) 108,696 108,696 Cash 108,696 108,696

Forward contract receivable (US$) 439,560 Forward contract payable (C$) 439,560[US$400,000 / 0.91]

December 31, 20X5Forward contract receivable 8,368 8,368 OCI 8,368 8,368[Gain is (400,000 / 0.91) – (400,000 / 0.893)]

January 15, 20X6Forward contract receivable 9,215 9,215 OCI 9,215 9,215



[Loss is (400,000 / 0.893) – (400,000 / 0.875)]

Equipment 545,658 545,658OCI (8,368 + 9,215) 17,583 17,583 Deposit on equipment 108,696 108,696 Accounts Payable (400,000 / 0.88) 454,545 454,545

February 15, 20X6Forward contract payable 439,560 Cash (C$) 439,560

Cash (US$) (400,000 / 0.85) 470,588 470,588 Forward contract receivable 457,143 17,583 Exchange gains 13445 13,445 Cash (C$) 439,560


Notes:The gain deferred in other comprehensive income (OCI) is reclassified. We have chosen to adjust the cost of the equipment. As such, the deferred gain will be amortized into income over the life of the equipment through its effect on the depreciation expense of the equipment. The carrying value of the equipment is $545,658. It is the cost of the equipment using the spot rate [$500,000 / .92 = 543,478] plus the cost of the hedge for the period from September 7 to January 15 [$1,294 + 886 = 2,180]. If the hedge had covered the period to delivery only, then the 100% of the cost of the hedge would have to be included in the cost of the equipment.

P8-8

(Net method used to account for hedge)

November 1, 20X1 No entry required

December 1, 20X1 Machine parts inventory 360,000Accounts payable 360,000

[RMB 2,000,000 × $0.18]

December 31, 20X1 Accounts payable 20,000Exchange gains and losses 20,000

[Restate A/P to spot rate [(RMB 2,000,000 × (0.18–0.17)]



The forward exchange contract does not require an entry.

January 15, 20X2 Cash (RMB 2,000,000 × 0.19) 380,000Cash (RMB 2,000,000 × 0.16) 320,000Exchange gains and losses 60,000

[To settle the forward contract]

January 15, 20X2 Accounts payable 340,000Exchange gains and losses 40,000

Cash (RMB 2,000,000 × 0.19) 380,000[To settle the payable to the supplier]

P8-9Exchange loss

for year 20X3Exchange losses:Loan

[($400,000 × 1.14) – ($400,000 × 1.20)] $ 24,000

Accounts receivableRealized: [(€200,000 × 1.5) – (€200,000 × 1.41)] = 18,000Unrealized: [(€600,000 × 1.5) – (€600,000 × 1.35)] = 90,000Reported in 20X3 income $132,000

Summary: The 20X3 income statement will include exchange losses of $132,000, consisting of $108,000 from the € sale and $24,000 from the US $ loan. The year-end 20X3 balance sheet will show the € receivable at $810,000 (600,000 × 1.35), and will show the note payable at its current value of $480,000 (400,000 × 1.20). On the cash flow statement, the unrealized losses of $114,000 ($90,000 + $24,000) will be an add-back, using the indirect method of reporting cash flow from operating activities.

P8-10

1.November 1, 20X7: Machine 285,714

Accounts payable (€200,000 ÷ 0.70) 285,714

December 31, 20X7: Exchange loss 47,619Accounts payable 47,619

[(200,000 ÷ 0.70) – (200,000 ÷ 0.60)]

February 1, 20X8: Accounts payable 333,333Exchange gain 10,752Cash (200,000 ÷ 0.62) 322,581



2. (Net method used to account for hedge)

November 1, 20X7

Machine 285,714 Accounts payable 285,714

[200,000 ÷ 0.70]

No entry for forward contract

December 31, 20X7

Exchange loss 47,619 Accounts payable 47,619

(200,000 ÷ 0.70) – (200,000 ÷ 0.60)

Forward contract 4,960 Exchange gain 4,960

(200,000 ÷ 0.64) – (200,000 ÷ 0.63)

February 1, 20X6

Cash (€) (200,000 ÷ 0.62) 322,581 Forward contract 4,960 Exchange gain 5,121 Cash (C$) (200,000 ÷ 0.64) 312,500

Accounts payable (200,000 ÷ 0.60) 333,333 Exchange gain 10,752 Cash (€) (200,000 ÷ 0.62) 322,581

(Gross method used to account for hedge)

November 1, 20X7

Machine 285,714 Accounts payable 285,714

[200,000 ÷ 0.70]

Forward contract receivable 312,500 Forward contract payable 312,500

[200,000 / 0.64]



December 31, 20X7

Exchange loss 47,619 Accounts payable 47,619

[(200,000 ÷ 0.70) – (200,000 ÷ 0.60)]

Forward contract receivable 4,960 Exchange gain 4,960

[(200,000 ÷ 0.64) – (200,000 ÷ 0.63)]

February 1, 20X6

Forward contract payable 312,500 Cash (C $) 312,500

Cash (€) (200,000 ÷ .62) 322,581 Forward contract receivable (312,500 + 4,960) 317,460 Exchange gain 5,121

Accounts payable (200,000 ÷ 0.60) 333,333 Exchange gain 10,752 Cash (€) (200,000 ÷ 0.62) 322,581

P8-11


Entry to record the purchase:Purchases or inventory $380,000

Accounts payable (¥40,000,000 × $0.0095) $380,000

Entry to record the hedge: — No entry

Entry to record the final settlement of the hedge and the payable:

(a) Spot rate = $0.0095

Cash (yen received at today’s rate $0.0095) $ 380,000Exchange gains and losses 20,000

Cash (C$) (yen purchased at $0.0100) $400,000

Accounts payable (¥40,000,000 × $0.0095) 380,000Cash (¥40,000,000 × $0.0095) 380,000



(b) Spot rate = $0.0100

Cash (yen received at today’s rate $0.0100) $ 400,000Cash (C$) (yen purchased at $0.0100) $400,000

Accounts payable (¥40,000,000 × $0.0095) 380,000Exchange gains and losses 20,000

Cash 400,000

(c) Spot rate = $0.0093

Cash (yen received at today’s rate $0.0093) $ 372,000Exchange gains and losses 28,000

Cash (C$) (yen purchased at $0.0100) $400,000

Accounts payable (¥40,000,000 × $0.0095) 380,000Cash 372,000Exchange gains and losses 8,000

(d) Spot rate = $0.0102

Cash (yen received at today’s rate $0.0102) $ 408,000Exchange gains and losses $ 8,000Cash (C$) (yen purchased at $0.0100) 400,000

Accounts payable (¥40,000,000 × $0.0095) 380,000Exchange gains and losses 28,000

Cash 408,000 P8-12

1.(Net method used to account for hedge)

October 15, 20X1

Accounts receivable 375,000 Sales 375,000

[3,000,000 ÷ 8 = 375,000]


December 31, 20X1

Exchange loss 45,330



Accounts receivable 45,330

[(3,000,000 ÷ 9.10) = 329,670 – 375,000 = 45,330)]


[(3,000,000 ÷ 9.26) – (3,000,000 ÷ 9.30) = 323,974 – 322,581 = 1,393)]

January 13, 20X2

Cash (K) (3,000,000 ÷ 9.45) 317,460Exchange loss 12,210 Accounts receivable 329,670

[Collect account receivable]

Cash (C$) (3,000,000 ÷ 9.26) 323,974 Forward contract 1,393 Exchange gain 5,121 Cash (K) 317,460

[To settle forward contract]


October 15, 20X1


[3,000,000 ÷ 8 = 375,000]


[3,000,000 ÷ 9.26]

December 31, 20X1

Exchange loss 45,330 Accounts receivable 45,330

[(3,000,000 ÷ 9.10) = 329,670 – 375,000 = 45,330)]

Forward contract payable 1,393 Exchange gain 1,393

[(3,000,000 ÷ 9.26) – (3,000,000 ÷ 9.30) = 323,974 – 322,581 = 1,393)]



January 13, 20X2


[Collect account receivable

Forward contract payable (323,974 – 1,393) 322,581 Exchange gain 5,121 Cash (K) 317,460


Cash (C$) (3,000,000 ÷ 9.26) 323,974 Forward contract receivable 323,974


2.October 15, 20X1


[3,000,000 ÷ 8 = 375,000]

December 31, 20X1


[(3,000,000 ÷ 9.10) = 329,670 – 375,000 = 45,330]

January 13, 20X2



3.October 15, 20X1


[3,600,000 ÷ 8 = 450,000]



December 31, 20X1


[(3,600,000 ÷ 9.10) = 395,604 – 450,000 = 54,396]

December 31, 20X2

Accounts receivable 68,912 Exchange gain 68,912

[(3,600,000 ÷ 7.75) = 464,516 – 395,604 = 68,912]

P8-13


May 1, 20X3

Inventory (or Purchases) 372,000 Accounts payable 372,000

[400,000 × 0.93 = 372,000]


June 30, 20X3

Accounts payable 4,000 Exchange gain 4,000

[(400,000 × 0.92) = 368,000 – 372,000 = 4,000]

Exchange loss 8,000 Forward contract 8,000

[(400,000 × 0.945) – (400,000 × 0.925) = 378,000 – 370,000 = 8,000]

August 31, 20X3Cash (CHF) (400,000 × 0.915) 366,000Forward contract 8,000Exchange loss 4,000 Cash (C$) (400,000 × 0.945) 378,000


Accounts payable 368,000 Exchange gain 2,000 Cash (CHF) 366,000



[To settle payable]


May 1, 20X3


[400,000 × 0.93 = 372,000]


[400,000 × 0.945]

June 30, 20X3

Accounts payable 4,000 Exchange gain 4,000

[(400,000 × 0.92) = 368,000 – 372,000 = 4,000]

Exchange loss 8,000 Forward contract receivable 8,000

[(400,000 × 0.945) – (400,000 × 0.925) = 378,000 – 370,000 = 8,000]

August 31, 20X3

Forward contract payable 378,000 Cash (C$) (400,000 × 0.945) 378,000

Cash (CHF) (400,000 ×0 .915) 366,000Exchange loss 4,000 Forward contract receivable (378,000 – 8,000) 370,000


Accounts payable 368,000 Exchange gain 2,000 Cash (CHF) 366,000

[To settle payable]

P8-14

1. No Hedge Accounting




May 1, 20X3Forward contract receivable (CHF) 374,000 Forward contract payable (C$) 374,000[CHF400,000 × 0.935 ]

June 30, 20X3Forward contract (receivable) 2,800 2,800 Exchange gains 2,800 2,800[Gain is 400,000 × (0.942-0.935)]

July 30, 20X3Forward contract (receivable) 2,400 2,400 Exchange gains 2,400 2,400[Loss is 400,000 × (0.948-0.942)]

Inventory 378,000 378,000 Accounts Payable (400,000 × 0.945) 378,000 378,000

August 31, 20X3Forward contract payable 374,000 Cash (C$) 374,000

Cash (CHF) (400,000 × 0.950) 380,000 380,000 Forward contract (receivable) 379,200 5,200 Exchange gains 800 800 Cash (C$) 374,000


Notes:Without hedge accounting, the gains on the forward contract are recognized immediately in profit and loss. The inventory is carried at a higher cost than in 2. and 3. below and will result in lower income when sold. This practice introduces unnecessary volatility into income that is not reflective of the economic hedge that is in place. Hedge accounting helps to resolve this issue.

2.Fair Value Hedge Accounting





June 30, 20X3Exchange losses 3,200 3,200 Commitment Liability 3,200 3,200[Loss is 400,000 × (0.930-0.938) ]

Forward contract (receivable) 2,800 2,800 Exchange gains 2,800 2,800[Gain is 400,000 × (0.942-0.935)]

July 30, 20X3Exchange losses 2,800 2,800 Commitment Liability 2,800 2,800[Loss is 400,000 × (0.938-0.945)]

Forward contract (receivable) 2,400 2,400 Exchange gains 2,400 2,400[Loss is 400,000 × (0.948-0.942)]

Inventory 372,000 372,000Commitment liability (3,200 + 2,800) 6,000 6,000 Accounts Payable (400,000 × 0.945) 378,000 378,000




Notes:



The problem assumes that the hedge is designated a fair value hedge till the date of delivery. After the date of delivery, the accounts payable are naturally offset by the FC receivable and hedge accounting is no longer necessary. On delivery, accounts payable are recorded at the spot rate ($378,000) to reflect the value of the obligation to pay CHF400,000 to the supplier. The P.O. commitment liability is reversed as the increase in the liability is now captured in the accounts payable. Finally, the inventory is recorded at $372,000 to balance the journal entry. This results in the inventory being recorded at the spot rate (0.93) that was in effect when the purchase order was issued (400,000 × 0.930 = 372,000).

The cost of the hedge was $2,000 [400,000 × ( 0.935 – 0.930)]. Of this amount, $400 (3,200 – 2,800) was charged to operations for the period from May 1 to June 30 while $400 (2,800 – 2,400) was charged to operations for the period from July 1 to July 30 and $1,200 (2,000 – 800) was charged to operations for the period from August 1 to August 31.

3. Cash Flow Hedge Accounting



June 30, 20X3Forward contract (receivable) 2,800 2,800 OCI 2,800 2,800[Gain is 400,000 × (0.942-0.935)]

July 30, 20X3Forward contract (receivable) 2,400 2,400 OCI 2,400 2,400[Loss is 400,000 × (0.948-0.942)]

Inventory 372,800 372,800OCI (2,800 + 2,400) 5,200 5,200 Accounts Payable (400,000 × 0.945) 378,000 378,000






Notes:The loss deferred in other comprehensive income (OCI) is reclassified. We have chosen to adjust the cost of the inventory. As such, the deferred loss will be expensed in earnings when the inventory is sold. The carrying value of the inventory is $372,800. It is the cost of the inventory using the spot rate (372,000 = 400,000 × 0.930) at the time it was ordered plus part of the cost of the hedge (800 = 400 + 400) for the period from May 1 to July 30, 20X3. We do not include 100% of the cost of the hedge because the hedge covers more than the period from ordering the equipment to delivery of the equipment. If the hedge had covered only the period to delivery, then 100% of the cost of the hedge would have assigned to the cost of the inventory.

P8-151.

September 1, 20X3: Inventory (1,000,000/15) $ 66,667Accounts payable $ 66,667

October 1, 20X3: Inventory (6,000,000/80) $ 75,000Accounts payable $ 75,000

November 1, 20X3: Inventory (22,000/1.8) $ 12,222Accounts payable $ 12,222

December 31, 20X3:Adjustment of accounts payable:

Pesos: 1,000,000/10 – $66,667 $33,333 lossYen: 6,000,000/100 – 75,000 15,000 gainReais: 22,000/1.5 – 12,222 2,445 loss

$20,778 loss

Exchange loss $ 20,778Accounts payable $ 20,778

2. (Net method used to account for hedge)

September, October, and November entries and the year-end adjustment of accounts payable are the same as above, for part 1.

Adjustment of forward contracts:Pesos: 1,000,000/12 - 1,000,000/9 $27,778 gain



Yen: 6,000,000/95 - 6,000,000/105 6,015 lossReais: 22,000/1.6 - 22,000/1.45 1,422 gain

$23,185 gain

December 31, 20X3: Forward contract $ 23,185Exchange gain $ 23,185

Note: The long-term payable should be valued at amortized cost (i.e., present valued) but this is ignored in this problem for simplicity.

P8-16


October 31, 20X4


[2,000 × 1.14 = 2,280]

No entry for hedge.

December 31, 20X4

Exchange loss 40 Accounts payable 40

[(2,000 × 1.16) = 2,320 – 2,280 = 40]

Forward contract 30 Exchange gain 30

[(2,000 × 1.165) – (2,000 × 1.15) = 2,330 – 2,300 = 30]

February 28, 20X5Cash (US$2,000 × 1.19) 2,380 Forward contract 30 Exchange gain 50 Cash (C$) (2,000 × 1.15) 2,300


Accounts payable 2,320Exchange loss 60 Cash (US$) 2,380

[To settle payable]




October 31, 20X4


(2,000 × 1.14 = 2,280)

November 1, 20X4


[2,000 × .1.15].December 31, 20X4

Exchange loss 40 Accounts payable 40

[(2,000 × 1.16) = 2,320 – 2,280 = 40]

Forward contract receivable 30 Exchange gain 30

[(2,000 × 1.165) – (2,000 × 1.15) = 2,330 – 2,300 = 30]

February 28, 20X5

Forward contract payable 2,300 Cash (C$) (2,000 × 1.15) 2,300

Cash (US$2,000 × 1.19) 2,380 Forward contract receivable (2,300 + 30) 2,330 Exchange gain 50


Accounts payable 2,320Exchange loss 60 Cash (US$) 2,380

[To settle payable]

P8-17

1. No Hedge Accounting




November 1, 20X4Forward contract receivable (US$) 2,300 Forward contract payable (C$) 2,300[US$2,000 × 1.15]

December 31, 20X4Forward contract receivable 30 30 Exchange gains 30 30[Gain is (2,000 × 1.165) – (2,000 × 1.15)]

February 28, 20X5Forward contract receivable 50 50 Exchange gains 50 50[Gain is (2,000 × 1.19) – (2,000 × 1.165)]

Forward contract payable 2,300 Cash (C$) 2,300


Inventory 2,380 2,380 Cash (US$) 2,380 2,380

Notes:Without hedge accounting, the gains on the forward contract are recognized immediately in profit and loss. The inventory is carried at a higher cost than in 2. and 3. below and will result in lower income when sold. This practice introduces unnecessary volatility into income that is not reflective of the economic hedge that is in place. Hedge accounting helps to resolve this issue.2. Fair Value Hedge Accounting



December 31, 20X4Exchange losses 40 40 Commitment Liability 40 40[Loss is (2,000 × 1.16) – (2,000 × 1.14)]

Forward contract receivable 30 30 Exchange gains 30 30



[Gain is (2,000 × 1.165) – (2,000 × 1.15)]

February 28, 20X5Exchange losses 60 60 Commitment Liability 60 60[Loss is (2,000 × 1.19) – (2,000 × 1.16)]

Forward contract receivable 50 50 Exchange gains 50 50[Gain is (2,000 × 1.19) – (2,000 × 1.165)]



Inventory 2,280 2,280Commitment liability (60 + 40) 100 100 Cash (US$) 2,380 2,380

Notes:On delivery, inventory is recorded at the spot rate ($2,280 = US$2,000 × 1.14) that was in effect when the purchase order was issued. The P.O. commitment liability is reversed as the increase in the liability is now captured in the payment to the supplier.




December 31, 20X4Forward contract receivable 30 30 OCI 30 30[Gain is (2,000 × 1.165) – (2,000 × 1.15)]



February 28, 20X5Forward contract receivable 50 50 OCI 50 50[Gain is (2,000 × 1.19) – (2,000 × 1.165)]



Inventory 2,300 2,300OCI (30 + 50) 80 80 Cash (US$) 2,380 2,380

Notes:The gain deferred in other comprehensive income (OCI) is reclassified. We have chosen to adjust the cost of the inventory. As such, the deferred loss will be expensed in earnings when the inventory is sold. The carrying value of the inventory is $2,300. It is the cost of the machine using the forward rate at the time it was ordered [$2,000 × 1.15 = 2,300]. We include 100% of the cost of the hedge because the hedge only covers the period from ordering the equipment to delivery of the equipment. If the hedge had covered a period beyond delivery, then the cost of the hedge would have to be allocated to the periods covered and the cost of the inventory would not be $2,300.

P8-18

1. Year ending December 31, 20X6, the summary journal entries would be:

May to August, 20X6

Accounts receivable 1,100,000 Sales 1,100,000[1,000,000 × 1.10 = 1,100,000]

October 1, 20X6

Cash (US$1,000,000 × 1.12) 1,120,000 Exchange gain 20,000 Accounts receivable 1,100,000




Cash (C$) (1,000,000 × 1.18) 1,180,000 Exchange gain 60,000 Cash (US$) 1,120,000


Income statement amounts:Sales – $1,100,000Exchange gain – $80,000

Balance sheet amounts:Cash (C$) – $1,180,000

2. Year ending May 31, 20X6

May 31, 20X6


[(1,000,000 × 1.18) – (1,000,000 × 1.08) = 1,180,000 – 1,080,000 = 100,000]

Income statement amounts:Exchange gain – $100,000

Balance sheet amounts:Forward contract – $100,000 asset

3. Year ending May 31, 20X6(Assuming treatment as a cash-flow hedge)

May 31, 20X6

Forward contract 100,000 OCI 100,000

[(1,000,000 × 1.18) – (1,000,000 × 1.08) = 1,180,000 – 1,080,000 = 100,000]

Income statement amounts:Nil

Balance sheet amounts:Forward contract – $100,000 assetAccumulated OCI – $100,000 equity

P8-19


December 2, 20X7: Inventory (or Purchases) 171,200Accounts payable (US$160,000 × $1.07) 171,200



[The hedge needs no entry.]

December 20, 20X7: Accounts receivable (US$200,000 × $1.12) 224,000Sales 224,000

December 31, 20X7: Foreign exchange loss 11,200Accounts payable 11,200

[To adjust the liability to the current rate of $1.14:{160,000 × (1.14 – 1.07)}]

Forward contract 8,000Foreign exchange gain 8,000

[To recognize the change in value of the F.C: {160,000 × (1.10 – 1.15)}]

Accounts receivable 4,000Exchange gains and losses 4,000

[To adjust the unhedged receivable:{200,000 × (1.14 – 1.12)}]

January 31, 20X8: Accounts payable 182,400Exchange gains and losses 9,600

Cash (US$160,000 × $1.20) 192,000

[Payment of the liability]

Cash (US$$160,000 × $1.20) 192,000Exchange gains and losses 8,000Forward contract 8,000Cash (C$) ($160,000 × $1.10) 176,000

[Settlement of forward contract]

February 18, 20X8: Cash (US$200,000 × $1.17) 234,000Accounts receivable 228,000Exchange gains and losses 6,000

P8-20

1. Cash Flow Hedge

November 1, 20X3No entry



December 31, 20X3OCI 2,000 Account receivable 2,000[Loss is (100,000 × 1.42) – (100,000 × 1.40)]

February 1, 20X4OCI 3,000 Account receivable 3,000[Loss is (100,000 × 1.40) – (100,000 × 1.37)]

Cash (euros) 137,000 Accounts receivable[(€100,000 × 1.42) – 2,000 – 3,000 = 137,000]

137,000

Equipment 142,000 OCI (2,000 + 3,000) 5,000 Cash (euros) 137,000

Notes:The designated risk for this hedge was spot rate risk (This is a change from what we have seen earlier in this chapter. For cash flow hedges in this chapter, we have focused on the forward rate risk as the designated risk). The loss deferred in other comprehensive income (OCI) is reclassified. We have chosen to adjust the cost of the equipment. As such, the deferred loss will be amortized into income over the life of the machine through its effect on the depreciation expense of the machine. The carrying value of the equipment is $142,000. It is the cost of the machine using the spot rate at the time it was ordered [€100,000 × 1.42 = 142,000].

2. Fair Value Hedge

November 1, 20X3No entry

December 31, 20X3Commitment Liability 2,000 Exchange gains 2,000



[Gain is (100,000 × 1.42) – (100,000 × 1.40)]

Exchange losses 2,000 Account receivable 2,000[Loss is (100,000 × 1.42) – (100,000 × 1.40)]

February 1, 20X4Commitment Liability 3,000 Exchange gains 3,000[Gain is (100,000 × 1.40) – (100,000 × 1.37)]

Exchange losses 3,000 Account receivable 3,000[Loss is (100,000 × 1.40) – (100,000 × 1.37)]

Cash (euros) 137,000 Accounts receivable[(€100,000 × 1.42) – 2,000 – 3,000 = 137,000]

137,000

Equipment 142,000 Commitment liability (2,000 + 3,000) 5,000 Cash (euros) 137,000

Notes:On delivery, equipment is recorded at the spot rate ($142,000 = €100,000 × 1.42) that was in effect when the purchase order was issued. The P.O. commitment liability is reversed as the decrease in the liability is now captured in the payment to the supplier.

P8-21



November 30, 20X5Forward contract receivable (C$) 1,460,00

0 Forward contract payable (€) 1,460,00

0[€1,000,000 × 1.46]

December 31, 20X5OCI 61,000 61,000 Forward contract payable 61,000 61,000



[Loss is 1,000,000 × (1.521 – 1.460)]

February 1, 20X6OCI 9,000 9,000 Forward contract payable 9,000 9,000[Loss is 1,000,000 × (1.530 – 1.521)]

Cash (€) (1,000,000 × 1.53) 1,530,000

1,530,000

OCI (61,000 + 9,000) 70,000 70,000 Revenue 1,460,00

01,460,00

0

Cash (C$) 1,460,000

Forward contract payable 1,530,000

70,000

Cash (€) 1,530,000

1,530,000

Cash (C$) 1,460,000

1,460,000

Forward contract receivable (C$) 1,460,000

1,460,000

Notes:The loss deferred in other comprehensive income (OCI) is released when the sale occurs. We have chosen to net it against revenue and, as such, the deferred loss will now reduce earnings through its impact on revenue. Revenues are “recorded” at the spot rate when they occur (1.53) and then reduced by the amount of the loss released from OCI (i.e., 1,530,000 – 70,000 = 1,460,000).The result is that revenues are shown at $1,460,000, in effect, they are translated at the forward contract rate of 1.46.


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