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chapter

Today, international business transactions are a regular occurrence. In its 2015 annual report, Lockheed Martin Corporation reported export sales of $9.5 billion, representing 21 percent of total sales. Some businesses are very significantly involved in transactions occurring through-

out the world as evidenced by this excerpt from Cirrus Logic, Inc.’s fiscal year

2015 annual report: “Export sales, principally to Asia, including sales to U.S.-

based customers that manufacture at plants overseas, were approximately

$869.9 million in fiscal year 2015, $673.7 million in fiscal year 2014, and

$764.9 million in fiscal year 2013. Export sales to customers located in Asia

were 92 percent of net sales in fiscal years 2015 and 2014 and 91 percent in

fiscal year 2013. All other export sales represented 3 percent of net sales in

each of fiscal years 2015, 2014, and 2013.”

Collections from export sales or payments for imported items might be

made not in U.S. dollars but in pesos, pounds, yen, and the like depending on

the negotiated terms of the transaction. As foreign currency exchange rates

fluctuate, so does the U.S. dollar value of these export sales and import pur-

chases. Companies often find it necessary to engage in some form of hedg-

ing activity to reduce losses arising from fluctuating exchange rates. At the

end of fiscal year 2015, in conjunction with its foreign currency hedging activi-

ties, Apple, Inc., reported having outstanding foreign exchange contracts with

a notional value of $119.2 billion.

This chapter covers accounting issues related to foreign currency trans-

actions and foreign currency hedging activities. To provide background for

subsequent discussions of the accounting issues, the chapter begins by

describing foreign exchange markets. The chapter then discusses account-

ing for import and export transactions, followed by coverage of various hedg-

ing techniques. Because they are most popular, the discussion concentrates

on foreign currency forward contracts and options. Understanding how to

account for these items is important for any company engaged in inter-

national transactions.

9 Foreign Currency Transactions and Hedging Foreign Exchange Risk Learning Objectives

After studying this chapter, you should be able to:

LO 9-1 Understand concepts related to foreign currency, exchange rates, and foreign exchange risk.

LO 9-2 Account for foreign currency transactions using the two- transaction perspective, accrual approach.

LO 9-3 Account for foreign currency borrowings.

LO 9-4 Understand the different types of foreign exchange risk that can be hedged and how foreign currency forward contracts and foreign currency options can be used to hedge those risks.

LO 9-5 Understand the accounting guidelines for derivative financial instruments.

LO 9-6 Understand the basic concepts of hedge accounting.

LO 9-7 Account for forward contracts and options used as hedges of foreign currency denominated assets and liabilities.

LO 9-8 Account for forward contracts and options used as hedges of foreign currency firm commitments.

LO 9-9 Account for forward contracts and options used as hedges of forecasted foreign currency transactions.

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Foreign Exchange Markets Each country (or group of countries) uses its own currency as the unit of value for the purchase and sale of goods and services. The currency used in the United States is the U.S. dollar, the currency used in Mexico is the Mexican peso, the currency used by a subset of European Union countries is the euro, and so on. If a U.S. citizen travels to Mexico and wishes to purchase local goods, Mexican merchants require payment to be made in Mexican pesos. To make a purchase in Mexico, a U.S. citizen would need to acquire pesos using U.S. dollars. The foreign currency exchange rate is the price at which the foreign currency can be acquired (or sold). A variety of factors determine the exchange rate between two currencies; unfortunately for those engaged in international business, the exchange rate can fluctuate over time.1

Exchange Rate Mechanisms Exchange rates have not always fluctuated. During the period 1945–1973, countries fixed the value of their currency in terms of the U.S. dollar, and the value of the U.S. dollar was fixed in terms of gold. In March 1973, most countries allowed their currencies to float in value. Today, several different currency arrangements exist. Some of the more important ones and the countries affected follow:

1. Independent float: The value of the currency is allowed to fluctuate freely according to market forces with little or no intervention from the central bank (example countries include Australia, Brazil, Canada, Japan, Sweden, Switzerland, the United Kingdom, and the United States).

2. Pegged to another currency: The value of the currency is fixed (pegged) in terms of a particular foreign currency and the central bank intervenes as necessary to maintain the fixed value. For example, Bahrain, Panama, and Saudi Arabia peg their currency to the U.S. dollar. China has pegged its currency, the yuan (or Renminbi), to the U.S. dollar since 1994, while allowing a revaluation in 2005 and again in 2015. By managing the value of its currency (downward) rather than allowing it to float freely, the Chinese government has made it easier for Chinese companies to export their products overseas.

3. European Monetary System (euro): In 1998, the countries comprising the European Mon- etary System adopted a common currency called the euro and established a European Central Bank.2 Until 2002, local currencies such as the German mark and French franc continued to exist but were fixed in value in terms of the euro. On January 1, 2002, local currencies disappeared, and the euro became the currency in 12 European countries. Today, 19 countries are part of the euro zone. The value of the euro floats against other currencies such as the Swiss franc, British pound, and U.S. dollar.

Foreign Exchange Rates Exchange rates between the U.S. dollar and many foreign currencies are published on a daily basis in The Wall Street Journal and major U.S. newspapers. Exchange rates also are avail- able online at websites such as www.oanda.com and www.x-rates.com. To illustrate exchange rates and the foreign currency market, next we examine exchange rates for selected currencies reported for December 1-2, 2015, as shown in Exhibit 9.1.

The exchange rates shown in Exhibit 9.1 are for trades between banks; that is, these are interbank or wholesale prices. Prices charged by banks to retail customers, such as companies engaged in international business, are higher. These are selling rates at which banks will sell currency to one another. The prices that banks are willing to pay to buy foreign currency are

LO 9-1

Understand concepts related to foreign currency, exchange rates, and foreign exchange risk.

1 Several theories attempt to explain exchange rate fluctuations but with little success, at least in the short term. An understanding of the causes of exchange rate changes is not necessary to comprehend the con- cepts underlying the accounting for changes in exchange rates. 2 Most longtime members of the European Union (EU) are “euro zone” countries. The major exception is the United Kingdom, which elected not to participate. Switzerland is another important European country not part of the euro zone because it is not a member of the EU.

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somewhat less than the selling rates. The difference between the buying and selling rates is the spread through which the banks earn a profit on foreign exchange trades. For example, the December 1, 2015, selling rate for the euro was $1.0607, while the the buying rate was $1.0596. On that date, banks were willing to buy euros for $1.0596 and sell them for $1.0607, earning a profit of $0.0011 per euro.

Two columns of information are shown for each day’s exchange rates. The first col- umn reports direct quotes, which indicate the number of U.S. dollars needed to purchase one unit of foreign currency. The direct quote for the Brazilian real on December 1 was $0.2584; in other words, 1.0 Brazilian real (BRL) could be purchased for $0.2584. The second column reports indirect quotes, which indicate the number of foreign currency units that could be purchased with one U.S. dollar. These rates are simply the inverse of direct quotes (indirect quote = 1 ÷ direct quote). If one BRL can be purchased with $0.2584, then 3.87 BRL can be purchased with $1.00. To avoid confusion, direct quotes are used exclusively in this chapter.

The third and fourth columns in Exhibit 9.1 show exchange rates for December 2, 2015. Two of the currencies shown increased in U.S. dollar price (appreciated) from December 1 to December 2, namely the euro and Brazilian real. For example, the euro increased in price by $0.0078 from one day to the next. As a result, the purchase of 100,000 euros on December 2, 2015, would have cost $780 more than on the previous day. In contrast, the U.S. dollar price for two currencies decreased (depreciated) from one day to the next, namely the British pound and Canadian dollar. The Chinese yuan did not change in U.S. dollar value because this cur- rency was effectively pegged to the U.S. dollar.

Foreign Currency Forward Contracts Foreign currency trades can be executed on a spot or forward basis. The spot rate is the price at which a foreign currency can be purchased or sold today. In contrast, the forward rate is the price available today at which foreign currency can be purchased or sold sometime in the future. Because many international business transactions take some time to be completed, the ability to lock in a price today at which foreign currency can be purchased or sold at some future date has definite advantages.

A foreign currency forward contract can be negotiated by a firm with its bank to exchange foreign currency for U.S. dollars, or vice versa, on a specified future date at a predetermined exchange rate. A forward contract can be written for whatever currency and for whatever future date is required. Entering into a forward contract has no up-front cost; the firm and its bank simply agree today to exchange foreign currency for U.S. dollars at the forward rate on a future date. Similar to how banks make a profit in the spot market, there is a spread between the buying and selling rates in the forward market. For example, on Febru- ary 1 a bank might agree to buy 500,000 British pounds in three months from one customer at a forward rate of $1.50 and simultaneously agree to sell 500,000 British pounds (GBP) in three months to another customer at a rate of $1.51. In this way, the bank generates a profit of $5,000 (500,000 GBP x $0.01) from entering into these two forward contracts.

The forward rate can exceed the spot rate on a given date, in which case the foreign cur- rency is said to be selling at a premium in the forward market, or the forward rate can be less than the spot rate, in which case the currency is selling at a discount. Currencies sell at a pre- mium or a discount because of differences in interest rates between two countries. When the interest rate in the foreign country exceeds the domestic interest rate, the foreign currency

December 1, 2015 December 2, 2015

Country/Currency Direct* Indirect† Direct* Indirect†

Euro zone euro . . . . . . . . . . . . . . . . . 1.0607 0.9428 1.0685 0.9359 UK pound . . . . . . . . . . . . . . . . . . . . . 1.5078 0.6632 1.5027 0.6655 Canada dollar . . . . . . . . . . . . . . . . . . 0.7491 1.3349 0.7480 1.3369 Brazil real . . . . . . . . . . . . . . . . . . . . . . 0.2584 3.8700 0.2595 3.8536 China yuan . . . . . . . . . . . . . . . . . . . . 0.1560 6.4103 0.1560 6.4103

EXHIBIT 9.1 Exchange Rates for Selected Currencies (December 1-2, 2015)

Source: http://www.oanda.com/currency/historical-rates. *www.oanda.com/currency/historical-rates. †Indirect quotes have been calculated by the author.

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sells at a discount in the forward market. Conversely, if the foreign interest rate is less than the domestic rate, the foreign currency sells at a premium.3

The forward exchange rate for a specific future settlement date will change over time due to changes in the spot exchange rate and/or changes in the differential interest rates between two countries. For example, assume on April 15 the U.S. dollar (USD) per Mexi- can peso (MXN) spot rate is $0.11 and the forward rate for a forward contract to be settled on June 15 is $0.105. The peso is selling at a discount of $0.005 in the two-month forward market due to a higher interest rate in Mexico than in the United States. If the USD/MXN spot rate decreases to $0.08 on May 15, the forward rate for a June 15 settlement-date forward contract also will decrease, to an amount less than $0.08. The peso will continue to sell at a discount in the one-month forward market because of the higher interest rate in Mexico.

Until December 2014, The Wall Street Journal published forward rates offered by New York banks for several major currencies on a daily basis. Since then, it has been difficult for third parties to obtain data on foreign currency forward rates. The spot rate for Swiss francs (CHF) on December 8, 2014, was reported to be $1.0245. On the same day, the one-month forward rate was reported as $1.0250, so the CHF was selling at a premium in the forward market. By entering into a forward contract on December 8, 2014, it would have been possible for a firm to guarantee that CHF could be purchased on January 8, 2015, at a price of $1.0250, regardless of what the spot rate turned out to be on January 8. Entering into the forward con- tract to purchase CHF would have been beneficial if the spot rate on January 8 was more than $1.0250. On the other hand, such a forward contract would have been detrimental if the spot rate was less than $1.0250. In either case, the firm must execute the forward contract and pur- chase CHF on January 8 at $1.0250.

As it turned out, the spot rate for CHF on January 8, 2015, was $0.9819, so entering into a one-month forward contract on December 8, 2014, to purchase CHF at $1.0250 on January 8, 2015, would have resulted in a loss because CHF could have been purchased at a lower price using the spot rate on that date.

Foreign Currency Options To provide companies more flexibility than exists with a forward contract, a market for foreign currency options has developed. A foreign currency option gives the holder of the option the right but not the obligation to trade foreign currency in the future. A put option is for the sale of foreign currency by the holder of the option; a call option is for the purchase of foreign cur- rency by the holder of the option. The strike price is the exchange rate at which the option will be executed if the option holder decides to exercise the option. The strike price is similar to a forward rate. There are generally several strike prices to choose from at any particular time. Foreign currency options can be purchased on the Philadelphia Stock Exchange or the Chicago Mercantile Exchange, but most foreign currency options are purchased directly from a bank in the so-called over-the-counter (OTC) market. Options purchased in the OTC market usu- ally have a strike price that is equal to the spot rate on that date. These options are said to be “at-the-money.”

Unlike a forward contract, for which banks earn their profit through the spread between buying and selling rates, options must actually be purchased by paying an option premium, which is a function of two components: intrinsic value and time value. An option’s intrinsic value is equal to the gain that could be realized by exercising the option immediately. For example, if the spot rate for the euro is $1.00, a call option (to purchase euros) with a strike price of $0.97 has an intrinsic value of $0.03 per euro. Euros can be purchased for $0.97 and sold for $1.00, generating a gain of $0.03 per euro. On the other hand, when the spot rate for the euro is $1.00, a put option (to sell euros) with a strike price of $0.97 has an intrinsic

3 This relationship is based on the theory of interest rate parity that indicates the difference in national inter- est rates should be equal to, but opposite in sign to, the forward rate discount or premium. This topic is cov- ered in detail in international finance textbooks.

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value of zero. An option with a positive intrinsic value is said to be “in-the-money.” The time value of an option relates to the fact that the spot rate can change over time and cause the option’s intrinsic value to increase. Even though a call option with a strike price of $1.00 has zero intrinsic value when the spot rate is $1.00, it will have a positive time value because there is a chance that the spot rate could increase over the next 90 days and bring the option into the money. As time passes, the time value of an option decreases because there is less time remaining for the option to increase in intrinsic value. The fair value of a foreign currency option on a specific date is the sum of its intrinsic and time values on that date.

The fair value of a foreign currency option can be determined by applying an adaptation of the Black-Scholes option pricing formula. This formula is discussed in detail in international finance books. In very general terms, the value of an option is a function of the difference between the current spot rate and strike price, the difference between domestic and foreign interest rates, the length of time to expiration, and the potential volatility of changes in the spot rate. For purposes of this book, the premium originally paid for a foreign currency option and its subsequent fair value up to the date of expiration derived from applying the pricing formula will be given.

On December 17, 2015, when the USD spot rate for euros was $1.09, the Chicago Mer- cantile Exchange indicated that a January 2016 call option in euros with a strike price of $1.09 could have been purchased by paying a premium of $0.0068 per euro. Thus, the right to purchase a standard contract of 125,000 euros in December 2016 at a price of $1.09 per euro could have been acquired by paying $850 ($0.0068 × 125,000 euros). Because the spot rate and the strike price were both $1.09, the euro call option had zero intrinsic value and a time value of $850. If the spot rate for euros on January 17, 2016, is more than $1.09, the option will be exercised and euros purchased at the strike price of $1.09. If, on the other hand, the January 17, 2016, spot rate is less than $1.09, the option will not be exercised; instead, euros will be purchased at the lower spot rate. The call option establishes the maxi- mum amount that would have to be paid for euros but does not lock in a disadvantageous price should the spot rate fall below the option strike price. The actual spot rate for euros on January 17, 2016, turned out to be $1.091, so the option would have been exercised and euros purchased for $1.09.

Foreign Currency Transactions Export sales and import purchases are international transactions; they are components of what is called trade. When two parties from different countries enter into a transaction, they must decide which of the two countries’ currencies to use to settle the transaction. For exam- ple, if a U.S. computer manufacturer sells to a customer in Japan, the parties must decide whether the transaction will be denominated (payment will be made) in U.S. dollars or in Japanese yen.

Assume that a U.S. exporter (Amerco) sells goods to a German importer that will pay in euros (€). In this situation, Amerco has entered into a foreign currency transaction. It must restate the euro amount that it actually will receive into U.S. dollars to account for this trans- action. This happens because Amerco keeps its books and prepares financial statements in U.S. dollars. Although the German importer has entered into an international transaction, it does not have a foreign currency transaction (payment will be made in its currency) and no restatement is necessary.

Assume that, as is customary in its industry, Amerco does not require immediate pay- ment and allows its German customer 30 days to pay for its purchases. By doing this, Amerco runs the risk that the euro might depreciate against the U.S. dollar between the sale date and the date of payment. If so, the sale would generate fewer U.S. dollars than it would have had the euro not decreased in value, and the sale is less profitable because it was made on a credit basis. In this situation Amerco is said to have an exposure to foreign

LO 9-2

Account for foreign currency transactions using the two- transaction perspective, accrual approach.

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exchange risk. Specifically, Amerco has a transaction exposure that can be summarized as follows:

∙ Export sale: A transaction exposure exists when the exporter allows the buyer to pay in a foreign currency and allows the buyer to pay sometime after the sale has been made. The exporter is exposed to the risk that the foreign currency might depreciate (decrease in value) between the date of sale and the date payment is received, thereby decreasing the U.S. dollars ultimately collected.

∙ Note that there is no exposure to foreign exchange risk if the exporter requires the for- eign customer to make payment on the date of sale. In that case, the exporter would receive foreign currency and immediately convert it into U.S. dollars at the spot rate on the date of sale.

∙ Import purchase: A transaction exposure exists when the importer is required to pay in foreign currency and is allowed to pay sometime after the purchase has been made. The importer is exposed to the risk that the foreign currency might appreciate (increase in price) between the date of purchase and the date of payment, thereby increasing the U.S. dollars that have to be paid for the imported goods.

∙ Note that there is no exposure to foreign exchange risk if the importer makes payment in foreign currency on the date of purchase. In that case, the importer converts U.S. dollars into foreign currency at the spot rate on the date of purchase and immediately makes payment.

Accounting Issue The major issue in accounting for foreign currency transactions is how to deal with the change in U.S. dollar value of the sales revenue and account receivable resulting from the export when the foreign currency changes in value. (The corollary issue is how to deal with the change in the U.S. dollar value of the account payable and goods being acquired in an import purchase.) For example, assume that Amerco, a U.S. company, sells goods to a German cus- tomer at the price of 1 million euros when the spot exchange rate is $1.32 per euro. If payment were received at the sale date, Amerco could have converted 1 million euros into $1,320,000; this amount clearly would be the amount at which the sales revenue would be recognized. Instead, Amerco allows the German customer 30 days to pay for its purchase. At the end of 30 days, the euro has depreciated to $1.30 and Amerco is able to convert the 1 million euros received on that date into only $1,300,000. How should Amerco account for this $20,000 decrease in value?

FASB ASC 830-20 Foreign Currency Matters–Foreign Currency Transactions requires companies to use what can be referred to as a two-transaction perspective in accounting for foreign currency transactions. This perspective treats the export sale and the subsequent col- lection of cash as two separate transactions. Because management has made two decisions— (1) to make the export sale and (2) to extend credit in foreign currency to the customer—the company should report the income effect from each of these decisions separately. The U.S. dollar value of the sale is recorded at the date the sale occurs. At that point, the sale has been completed; there are no subsequent adjustments to the Sales account. Any difference between the number of U.S. dollars that could have been received at the date of sale and the number of U.S. dollars actually received at the date of collection due to fluctuations in the exchange rate is a result of the decision to extend foreign currency credit to the customer. This difference is treated as a foreign exchange gain or loss that is reported separately from Sales in the income statement.

Similarly, an import purchase denominated in a foreign currency and the subsequent pay- ment of cash must be accounted for separately. The U.S. dollar value of the goods purchased is recorded at the date of purchase, with no subsequent adjustments to the cost of the goods. Any difference between the number of U.S. dollars that could have been paid on the date of purchase and the actual number of U.S. dollars that is paid on the payment date due to a change in the exchange rate is treated as a foreign exchange gain or loss.

Using the two-transaction perspective to account for its export sale to the German cus- tomer, Amerco would make the following journal entries:

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Date of Sale: Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . 1,320,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000 To record the sale and euro receivable at

the spot rate of $1.32. Date of Collection: Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . 20,000

Accounts Receivable (€) . . . . . . . . . . . . . . . . . . 20,000 To adjust the value of the euro receivable to the new

spot rate of $1.30 and record a foreign exchange loss resulting from the depreciation in the euro.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . 1,300,000 To record the receipt of 1 million euros and conver-

sion into U.S. dollars at the spot rate of $1.30.

Foreign Currency (FC)

Transaction Type of Exposure Appreciates Depreciates

Export sale Asset (receivable) Gain Loss Import purchase Liability (payable) Loss Gain

Sales are reported in income at the amount that would have been received if the customer had not been given 30 days to pay the 1 million euros—that is, $1,320,000. A separate Foreign Exchange Loss of $20,000 is reported in net income to indicate that because of the decision to extend foreign currency credit to the German customer and because the euro decreased in value, Amerco actually received fewer U.S. dollars.4

Note that Amerco keeps its Account Receivable (€) account separate from its U.S. dollar receivables. Companies engaged in international trade need to keep separate receivable and payable accounts in each of the currencies in which they have transactions. Each foreign cur- rency receivable and payable should have a separate account number in the company’s chart of accounts.

We can summarize the relationship between fluctuations in exchange rates and foreign exchange gains and losses as follows:

4 Note that the foreign exchange loss results because the customer is allowed to pay in euros and is given 30 days to pay. If the transaction were denominated in U.S. dollars, no loss would result, nor would there be a loss if the euros had been received at the date the sale was made.

A foreign currency receivable arising from an export sale creates an asset exposure to foreign exchange risk. If the foreign currency appreciates, the foreign currency asset increases in U.S. dollar value and a foreign exchange gain arises; depreciation of the foreign currency causes a foreign exchange loss. A foreign currency payable arising from an import purchase creates a liability exposure to foreign exchange risk. If the foreign currency appreciates, the foreign currency liability increases in U.S. dollar value and a foreign exchange loss results; deprecia- tion of the currency results in a foreign exchange gain.

Balance Sheet Date before Date of Payment The question arises as to what adjustments should be made if a balance sheet date falls between the date of sale (or purchase) and the date of collection (or payment). For example, assume that Amerco shipped goods to its German customer on December 1, 2017, with pay- ment to be received on March 1, 2018. Assume that at December 1, the spot rate for the euro was $1.32, but by December 31, the euro has appreciated to $1.33. Is any adjustment needed at December 31, 2017, when the books are closed to account for the fact that the foreign cur- rency receivable has changed in U.S. dollar value since December 1?

Authoritative accounting literature requires foreign currency balances such as a foreign currency receivable or a foreign currency payable to be revalued at the balance sheet date to account for the change in exchange rates. Under the two-transaction perspective, this means that a foreign exchange gain or loss arises at the balance sheet date. The next question then is

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12/1/17 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . 1,320,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000

To record the sale and euro receivable at the spot rate of $1.32.

12/31/17 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . 10,000

Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . 10,000

To adjust the value of the euro receivable to the new spot rate of $1.33 and record a foreign exchange gain in 2017 net income resulting from the appreciation in the euro since December 1.

3/1/18 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . 30,000

Accounts Receivable (€) . . . . . . . . . . . . . . . . . . 30,000

To adjust the value of the euro receivable to the new spot rate of $1.30 and record a foreign exchange loss in 2018 net income resulting from the depreciation in the euro since Decem- ber 31.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Accounts Receivable (€) . . . . . . . . . . . . . . . . . . 1,300,000

To record the receipt of 1 million euros and con- version at the spot rate of $1.30.

what should be done with these foreign exchange gains and losses that have not yet been real- ized in cash. Should they be included in net income?

U.S. GAAP requires unrealized foreign exchange gains and losses to be reported in net income in the period in which the exchange rate changes. This is consistent with accrual accounting as it results in reporting the effect of a rate change that will have an impact on cash flow in the period when the event causing the impact takes place. Thus, any change in the exchange rate from the date of sale to the balance sheet date results in a foreign exchange gain or loss to be reported in net income in that period. Any change in the exchange rate from the balance sheet date to the date of collection results in a second foreign exchange gain or loss that is reported in net income in the second accounting period. Amerco makes the following journal entries under this approach:

The net impact on income in 2017 is a sale of $1,320,000 and a foreign exchange gain of $10,000; in 2018, Amerco records a foreign exchange loss of $30,000. This results in a net increase of $1,300,000 in Retained Earnings that is balanced by an equal increase in Cash over the two-year period. Over the two-year period Amerco recognizes a net foreign exchange loss of $20,000.

One criticism of the accrual approach is that it leads to a violation of conservatism when an unrealized foreign exchange gain arises at the balance sheet date. In fact, this is one of only a few situations in U.S. GAAP in which it is acceptable to recognize an unrealized gain in net income. (This treatment is similar to how changes in the fair value of equity investments are recognized.)

Restatement at the balance sheet date is required for all foreign currency assets and liabil- ities carried on a company’s books. In addition to foreign currency payables and receivables arising from import and export transactions, companies might have dividends receivable from foreign subsidiaries, loans payable to foreign lenders, or lease payments receivable from foreign customers that are denominated in a foreign currency and therefore must be restated at the balance sheet date. Each of these foreign currency denominated assets and liabilities is exposed to foreign exchange risk; therefore, fluctuation in exchange rates result in foreign exchange gains and losses on all foreign currency denominated assets and liabilities.

Many U.S. companies report foreign exchange gains and losses on the income statement in a line item often titled Other income (expense). Companies include other incidental gains and losses such as gains and losses on sales of assets in this line item as well. Companies

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are required to disclose the magnitude of foreign exchange gains and losses if material. For example, in the Notes to Financial Statements in its 2014 annual report, Merck indicated that the income statement item Other (Income) Expense, Net, included exchange losses of $180 million in 2014, $290 million in 2013, and $185 million in 2012.

International Accounting Standard 21—The Effects of Changes in Foreign Exchange Rates Similar to U.S. GAAP, IAS 21, “The Effects of Changes in Foreign Exchange Rates,” also requires the use of a two-transaction perspective in accounting for foreign currency transac- tions with unrealized foreign exchange gains and losses accrued in net income in the period of exchange rate change. There are no substantive differences between IFRS and U.S. GAAP in the accounting for foreign currency transactions.

Foreign Currency Borrowing In addition to the receivables and payables that arise from import and export activities, com- panies often must account for foreign currency borrowings, another type of foreign currency transaction. Companies borrow foreign currency from foreign lenders either to finance foreign operations or perhaps to take advantage of more favorable interest rates. The facts that both the principal and interest are denominated in foreign currency and both create an exposure to foreign exchange risk complicate accounting for a foreign currency borrowing.

To demonstrate the accounting for foreign currency debt, assume that on July 1, 2017, Multicorp International borrowed 1 billion Japanese yen (¥) on a one-year note at a per annum interest rate of 5 percent. Interest is payable and the note comes due on July 1, 2018. The fol- lowing exchange rates apply:

LO 9-3

Account for foreign currency borrowings.

Date U.S. Dollars per Japanese Yen Spot Rate

July 1, 2017 $0.00921 December 31, 2017 0.00932 July 1, 2018 0.00937

On July 1, 2017, Multicorp borrows ¥1 billion and converts it into $9,210,000 in the spot market. On December 31, 2017, Multicorp must revalue the Japanese yen note payable with an offsetting foreign exchange gain or loss reported in income and must accrue interest expense and interest payable. Interest is calculated by multiplying the loan principal in yen by the rel- evant interest rate. The amount of interest payable in yen is then translated to U.S. dollars at the spot rate to record the accrual journal entry. On July 1, 2018, any difference between the amount of interest accrued at year-end and the actual U.S. dollar amount that must be spent to pay the accrued interest is recognized as a foreign exchange gain or loss. These journal entries account for this foreign currency borrowing:

7/1/17 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,210,000

Note Payable (¥) . . . . . . . . . . . . . . . . . . . . . . 9,210,000

To record the ¥ note payable at the spot rate of $0.00921 and the conversion of ¥1 billion into U.S. dollars.

12/31/17 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 233,000

Accrued Interest Payable (¥) . . . . . . . . . . . . 233,000

To accrue interest for the period July 1– December 31, 2017: ¥1 billion × 5% × ½ year = ¥25 million × $0.00932 = $233,000.

(continued )

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Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . 110,000

Note Payable (¥) . . . . . . . . . . . . . . . . . . . . . . 110,000

To revalue the ¥ note payable at the spot rate of $0.00932 and record a foreign exchange loss of $110,000 [¥1 billion × ($0.00932 − $0.00921)].

7/1/18 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . 234,250

Accrued Interest Payable (¥) . . . . . . . . . . . . 234,250

To accrue interest for the period January 1–July 1, 2018: ¥1 billion × 5% × ½ year = ¥25 million × $0.00937 = $234,250.

Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . 1,250

Accrued Interest Payable (¥) . . . . . . . . . . . 1,250

To revalue the ¥ interest payable that was accrued on December 31, 2017, at the spot rate of $0.00937 and record a foreign exchange loss of $1,250 [¥25 million × ($0.00937 − $0.00932)].

Accrued Interest Payable (¥) . . . . . . . . . . . . . . . . 468,500

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 468,500

To record the cash interest payment of $468,500 [¥50 million x the spot rate of $0.00937] and remove the ¥ accrued inter- est payable from the books.

Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . 50,000

Note Payable (¥) . . . . . . . . . . . . . . . . . . . . . . 50,000

To revalue the ¥ note payable at the spot rate of $0.00937 and record a foreign exchange loss of $50,000 [¥1 billion × ($0.00937 − $0.00932)].

Note Payable (¥) . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,370,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,370,000

To record repayment of the ¥1 billion note through purchase of ¥1 billion at the spot rate of $0.00937 and remove the ¥ note payable from the books..

The total U.S. dollar borrowing cost on the 1 billion Japanese yen note payable is equal to the difference between the U.S. dollar cash outflows and cash inflow: $9,370,000 + $468,500 – $9,210,000 = $628,500. This borrowing cost is reflected in Multicorp’s financial statements as a combination of interest expense ($467,250) and foreign exchange loss ($161,250). Taking the exchange rate effect on the cost of borrowing into consideration results in an “effective” interest rate of 6.8% ($628,500/$9,210,000), even though the stated interest rate is only 5%.

Foreign Currency Loan At times companies lend foreign currency to related parties, creating the opposite situation from a foreign currency borrowing. The accounting involves keeping track of a note receiv- able and related interest receivable, both of which are denominated in foreign currency. Fluc- tuations in the U.S. dollar value of the principal and interest generally give rise to foreign exchange gains and losses that would be included in net income. An exception arises when the foreign currency loan is made on a long-term basis to a foreign branch, subsidiary, or equity method affiliate. Foreign exchange gains and losses on “intra-entity foreign currency transac- tions that are of a long-term investment nature (that is, settlement is not planned or anticipated in the foreseeable future)” are deferred in accumulated other comprehensive income until the

(continued )

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loan is repaid.5 Only the foreign exchange gains and losses related to the interest receivable are recorded currently in net income.

Hedges of Foreign Exchange Risk In the example provided in the earlier section on foreign currency transactions, Amerco has an asset exposure in euros when it sells goods to the German customer and allows the cus- tomer three months to pay for its purchase. If the euro depreciates over the next three months, Amerco will incur a net foreign exchange loss. For many companies, the uncertainty of not knowing exactly how many U.S. dollars an export sale will generate is of great concern. To avoid this uncertainty, companies often use derivative financial instruments to hedge against the effect of unfavorable changes in the value of foreign currencies. A derivative financial instrument, or simply derivative, derives its value from some “underlying.” In the case of foreign currency derivatives, the underlying is the currency exchange rate. The two most com- mon derivatives used to hedge foreign exchange risk are foreign currency forward contracts and foreign currency options. In our example, Amerco will receive euros in three months when it collects the receivable and it will need to sell those euros at that time. Through a for- ward contract, Amerco can lock in the price at which it will sell the euros it receives in three months. An option establishes a price at which Amerco will be able, but is not required, to sell the euros it receives in three months. If Amerco enters into a forward contract or purchases a put option on the date the sale is made, the derivative is being used as a hedge of a recognized foreign currency denominated asset (the euro account receivable).

Companies engaged in foreign currency activities often enter into hedging arrangements as soon as they receive a noncancelable sales order or place a noncancelable purchase order. A non- cancelable order that specifies the foreign currency price and date of delivery is known as a for- eign currency firm commitment. Assume that on June 1, Amerco accepts an order to sell parts to a customer in South Korea at a price of 5 million Korean won. The parts will be delivered and payment will be received on August 15. On June 1, before the sale has been made, Amerco enters into a forward contract to sell 5 million Korean won on August 15. In this case, Amerco is using a foreign currency derivative as a hedge of an unrecognized foreign currency firm commitment.

Some companies have foreign currency transactions that occur on a regular basis and can be reliably forecasted. For example, Amerco regularly purchases materials from a supplier in Hong Kong for which it pays in Hong Kong dollars. Even if Amerco has no contract to make future purchases, it has an exposure to foreign currency risk if it plans to continue making purchases from the Hong Kong supplier. Assume that on October 1, Amerco forecasts that it will make a purchase from the Hong Kong supplier in one month. To hedge against a possible increase in the price of the Hong Kong dollar, Amerco acquires a call option on October 1 to purchase Hong Kong dollars in one month. The foreign currency option represents a hedge of a forecasted foreign currency denominated transaction.

Derivatives Accounting FASB ASC Topic 815, “Derivatives and Hedging,” governs the accounting for derivatives, including those used to hedge foreign exchange risk. This authoritative literature provides guidance for hedges of the following sources of foreign exchange risk:

1. Recognized foreign currency denominated assets and liabilities. 2. Unrecognized foreign currency firm commitments. 3. Forecasted foreign currency denominated transactions. 4. Net investments in foreign operations.

Different accounting applies to each type of foreign currency hedge. This chapter demon- strates the accounting for the first three types of hedges. The next chapter covers hedges of net investments in foreign operations. 5 FASB ASC (para. 830-20-35-3b).

LO 9-4

Understand the different types of foreign exchange risk that can be hedged and how foreign currency forward contracts and foreign currency options can be used to hedge those risks.

LO 9-5

Understand the accounting guidelines for derivative finan- cial instruments.

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Fundamental Requirement of Derivatives Accounting The fundamental requirement of FASB ASC 815 is that companies carry all derivatives on the balance sheet at their fair value. Derivatives are reported on the balance sheet as assets when they have a positive fair value and as liabilities when they have a negative fair value. The first issue in accounting for derivatives is the determination of fair value.

The fair value of derivatives can change over time, causing adjustments to be made to the carrying values of the assets and liabilities. The second issue in accounting for derivatives is the treatment of the gains and losses that arise from these fair value changes.

Determination of Fair Value of Derivatives The fair value of a foreign currency forward contract is determined by reference to changes in the forward rate over the life of the contract, discounted to the present value. Three pieces of information are needed to determine the fair value of a forward contract at any point in time:

1. The forward rate when the forward contract was entered into. 2. The current forward rate for a contract that matures on the same date as the forward con-

tract entered into. 3. A discount rate—typically, the company’s incremental borrowing rate.

Assume that Exim Company enters into a forward contract with its bank on December 1 to sell 1 million Mexican pesos on March 1 at a forward rate of $0.085 per peso, or a total of $85,000. Exim incurs no cost to enter into the forward contract, which has no value on Decem- ber 1. On December 31, when Exim closes its books to prepare financial statements, the for- ward rate to sell Mexican pesos on March 1 has changed to $0.082. On that date, a forward contract for the delivery of 1 million pesos could be negotiated, resulting in a cash inflow of only $82,000 on March 1. This represents a favorable change in the value of Exim’s forward contract of $3,000 ($85,000 − $82,000). The undiscounted fair value of the forward contract on December 31 is $3,000. Assuming that the company’s incremental borrowing rate is 12 percent per annum, the undiscounted fair value of the forward contract must be discounted at the rate of 1 percent per month for two months (from the current date of December 31 to the settlement date of March 1). The fair value of the forward contract at December 31 is $2,940.90 ($3,000 × 0.9803).6

The manner in which the fair value of a foreign currency option is determined depends on whether the option is traded on an exchange or has been acquired in the over-the-counter mar- ket. The fair value of an exchange-traded foreign currency option is its current market price quoted on the exchange. For over-the-counter options, fair value can be determined by obtain- ing a price quote from an option dealer (such as a bank). If dealer price quotes are unavailable, the company can estimate the value of an option using the modified Black-Scholes option pricing model (briefly mentioned earlier). Regardless of who does the calculation, principles similar to those of the Black-Scholes pricing model can be used to determine the fair value of the option.

Accounting for Changes in the Fair Value of Derivatives Changes in the fair value of derivatives must be included in comprehensive income, which consists of two components: net income and other comprehensive income. Other comprehen- sive income consists of income items that current authoritative accounting literature require to be deferred in stockholders’ equity such as unrealized gains and losses on available-for-sale debt securities. Other comprehensive income is accumulated and reported as a separate line in the stockholders’ equity section of the balance sheet. This book uses the account title Accumu- lated Other Comprehensive Income to describe this stockholders’ equity line item.

In accordance with U.S. GAAP, gains and losses arising from changes in the fair value of derivatives are recognized initially either (1) in net income or (2) in other comprehen- sive income (reflected on the balance sheet in accumulated other comprehensive income).

6 The present value factor for two months at 1 percent per month is calculated as 1/1.012, or 0.9803.

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Recognition treatment depends partly on whether the company uses derivatives for hedging purposes or for speculation.

Although using derivatives for speculation is not commonly done by nonfinancial institu- tions, financial entities might acquire derivative financial instruments as investments for spec- ulative purposes. For example, assume that the three-month forward rate for British pounds is $2.00, and a speculator believes the British pound spot rate in three months will be $1.97. In that case, the speculator would enter into a three-month forward contract to sell British pounds. At the future date, the speculator purchases pounds at the spot rate of $1.97 and sells them at the contracted forward rate of $2.00, reaping a gain of $0.03 per British pound. Of course, such an investment might as easily generate a loss if the spot rate does not move as expected. For speculative derivatives, the change in the fair value of the derivative must be recognized immediately as a gain or loss in net income.7

The accounting for changes in the fair value of derivatives used for hedging depends on the nature of the foreign exchange risk being hedged and on whether the derivative qualifies for hedge accounting.

Hedge Accounting Companies enter into hedging relationships to minimize the adverse effect that changes in exchange rates have on cash flows and net income. As such, companies would like to account for hedges in a way that recognizes the gain or loss from the hedge in net income in the same period as the loss or gain on the risk being hedged. This approach is known as hedge account- ing. U.S. GAAP allows hedge accounting for foreign currency derivatives only if three condi- tions are satisfied:

1. The derivative is used to hedge either a cash flow exposure or a fair value exposure to for- eign exchange risk.

2. The derivative is highly effective in offsetting changes in the cash flows or fair value related to the hedged item.

3. The derivative is properly documented as a hedge.

Each of these conditions is discussed in turn.

Nature of the Hedged Risk Derivatives for which companies wish to use hedge accounting must be designated as either a cash flow hedge or a fair value hedge. For hedges of recognized foreign currency assets and liabilities and hedges of foreign currency firm commitments, companies must choose between the two types of designation. Hedges of forecasted foreign currency transactions can qualify only as cash flow hedges. Accounting procedures differ for the two types of hedges. In general, gains and losses on cash flow hedges are included in other comprehensive income (and therefore deferred on the balance sheet in accumulated other comprehensive income), and gains and losses on fair value hedges are recognized immediately in net income.

A fair value exposure exists if changes in exchange rates can affect the fair value of an asset or liability reported on the balance sheet. To qualify for hedge accounting, the fair value risk must have the potential to affect net income if it is not hedged. For example, a fair value risk is associated with a foreign currency account receivable. If the foreign currency depreci- ates, the receivable must be written down with an offsetting loss recognized in net income. The authoritative literature has determined that a fair value exposure also exists for foreign currency firm commitments.

A cash flow exposure exists if changes in exchange rates can affect the amount of cash flow to be realized from a foreign currency transaction with changes in cash flow reflected in net income. A foreign currency account receivable, for example, has both a fair value exposure and a cash flow exposure. A cash flow exposure exists for (1) recognized foreign currency

7 In the next section we will see that the change in fair value of a derivative designated as the fair value hedge of a foreign currency denominated asset or liability also is recognized immediately in net income.

LO 9-6

Understand the basic concepts of hedge accounting.

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assets and liabilities, (2) foreign currency firm commitments, and (3) forecasted foreign cur- rency transactions.

Hedge Effectiveness For hedge accounting to be used initially, the hedge must be expected to be highly effective in generating gains and losses that offset losses and gains on the item being hedged. The hedge actually must be effective in generating offsetting gains and losses for hedge accounting to continue to be applied over the life of the hedge.

At inception, a foreign currency derivative can be considered an effective hedge if the criti- cal terms of the hedging instrument match those of the hedged item. Critical terms include the currency type, currency amount, and settlement date. For example, a forward contract to pur- chase 100,000 Canadian dollars in 30 days would be an effective hedge of a 100,000 Canadian dollar liability that is payable in 30 days.

Hedge Documentation For hedge accounting to be applied, U.S. GAAP requires formal documentation of the hedg- ing relationship at the inception of the hedge (i.e., on the date a foreign currency forward contract is entered into or a foreign currency option is acquired). The hedging company must prepare a document that identifies the hedged item (for example, a 100,000 Canadian dollar liability), the hedging instrument (a forward contract to purchase 100,000 Canadian dollars), the nature of the risk being hedged (a cash flow exposure), how the hedging instrument’s effectiveness will be assessed (through reference to changes in the forward rate), and the risk management objective and strategy for undertaking the hedge (to minimize risk associated with a possible Canadian dollar appreciation).

Hedging Combinations The specific accounting procedures followed and journal entries needed to account for a for- eign currency hedging relationship are determined by a combination of the following factors:

1. The type of foreign currency item being hedged: a. Foreign currency denominated asset or liability. b. Foreign currency firm commitment. c. Forecasted foreign currency transaction.

2. The type of hedging instrument used: a. Forward contract. b. Option.

3. The nature of the hedged risk: a. Cash flow exposure. b. Fair value exposure.

4. The nature of the foreign currency item being hedged: a. Asset (existing or future). b. Liability (existing or future).

In the next three sections in this chapter we discuss the accounting for hedges of (1) for- eign currency denominated assets/liabilities, (2) foreign currency firm commitments, and (3) forecasted foreign currency transactions. We demonstrate through examples the use of both forward contracts and options to hedge these items, and we selectively demonstrate the accounting for both cash flow and fair value hedges. We focus on hedges entered into by an exporter that has a current or future foreign currency asset that is exposed to foreign exchange risk. The comprehensive example at the end of this chapter demonstrates the accounting for hedges entered into by an importer that has an existing or future foreign currency liability. Exhibit 9.2 provides an overall summary of the procedures followed in accounting for hedges of foreign exchange risk for those combinations presented in this chapter. By examining this exhibit, the similarities and differences in the procedures followed and accounting entries pre- pared to account for each hedge combination can be discerned.

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in g

fo r

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ge s

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or ei

gn E

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(c o n ti

n u ed

)

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422 Chapter 9

hoy44953_ch09_407-472.indd 422 10/27/16 09:15 PM

H e

d g

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Foreign Currency Transactions and Hedging Foreign Exchange Risk 423

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Hedges of Foreign Currency Denominated Assets and Liabilities Hedges of foreign currency denominated assets and liabilities, such as accounts receivable and accounts payable, can qualify as either cash flow hedges or fair value hedges. To qualify as a cash flow hedge, the hedging instrument must completely offset the variability in the cash flows associated with the foreign currency receivable or payable. If the hedging instrument does not qualify as a cash flow hedge or if the company elects not to designate the hedging instrument as a cash flow hedge, the hedge is designated as a fair value hedge. The following summarizes the basic accounting for the two types of hedges of foreign currency denominated assets and liabilities.

Cash Flow Hedge At each balance sheet date, the following procedures are required:

1. The hedged asset (foreign currency account receivable) or liability (foreign currency account payable) is adjusted to fair value based on changes in the spot exchange rate, and a foreign exchange gain or loss is recognized in net income (Cash Flow Hedge Step B.1. in Exhibit 9.2).

2. To comply with the fundamental requirement of derivatives accounting, the derivative hedging instrument (forward contract or option) is adjusted to fair value (resulting in an asset or liability reported on the balance sheet) with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI) (Cash Flow Hedge Step B.2. in Exhibit 9.2).

3. An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability (Cash Flow Hedge Step B.3. in Exhibit 9.2).

4. An additional amount is removed from AOCI and recognized in net income to reflect (a) the current period’s amortization of the original discount or premium on the forward contract (if a forward contract is the hedging instrument) or (b) the change in the time value of the option (if an option is the hedging instrument) (Cash Flow Hedge Step B.4. in Exhibit 9.2).

Fair Value Hedge At each balance sheet date, the following procedures are required:

1. Adjust the hedged asset or liability to fair value based on changes in the spot exchange rate and recognize a foreign exchange gain or loss in net income (Fair Value Hedge Step B.1. in Exhibit 9.2).

2. Adjust the derivative hedging instrument to fair value (resulting in an asset or liability reported on the balance sheet) and recognize the counterpart as a gain or loss in net income (Fair Value Hedge Step B.2. in Exhibit 9.2).

Forward Contract Used to Hedge a Foreign Currency Denominated Asset We now return to the Amerco example in which the company has a foreign currency account receivable to demonstrate the accounting for a hedge of a recognized foreign currency denom- inated asset.8 In the preceding example, Amerco has an asset exposure in euros when it sells goods to the German customer and allows the customer three months to pay for its purchase. To hedge its exposure to a possible decline in the U.S. dollar value of the euro, Amerco enters into a forward contract.

LO 9-7

Account for forward contracts and options used as hedges of foreign currency denominated assets and liabilities.

8 The comprehensive illustration at the end of this chapter demonstrates the accounting for the hedge of a foreign currency denominated liability.

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Assume that on December 1, 2017, the three-month forward rate for euros is $1.305 and Amerco signs a contract with New Manhattan Bank to deliver 1 million euros in three months in exchange for $1,305,000. No cash changes hands on December 1, 2017. Because the spot rate on December 1 is $1.32, the euro (€) is selling at a discount in the three-month forward market (the forward rate is less than the spot rate). Because the euro is selling at a discount of $0.015 ($1.305 - $1.320) per euro, Amerco receives $15,000 less than it would had payment been received at the date the goods are delivered ($1,305,000 versus $1,320,000). This $15,000 reduction in cash flow can be considered as an expense; it is the cost of extending foreign currency credit to the foreign customer.9 Conceptually, this expense is similar to the transaction loss that arises on the export sale. It exists only because the transaction is denomi- nated in a foreign currency. The major difference is that Amerco knows the exact amount of the discount expense at the date of sale, whereas when it is left unhedged, Amerco does not know the size of the transaction loss until three months pass. (In fact, it is possible that the unhedged receivable could result in a transaction gain rather than a transaction loss.)

Because the future spot rate turns out to be only $1.30, selling euros at a forward rate of $1.305 is obviously better than leaving the euro receivable unhedged: Amerco will receive $5,000 more as a result of the hedge. This can be viewed as a gain resulting from the use of the forward con- tract. Unlike the discount expense, the exact size of this gain is not known until three months pass. (In fact, it is possible that use of the forward contract could result in an additional loss. This would occur if the spot rate on March 1, 2018, is more than the forward rate of $1.305.)

Amerco must account for its foreign currency transaction and the related forward contract simultaneously but separately. The process can be better understood by referring to the steps involving the three parties—Amerco, the German customer, and New Manhattan Bank— shown in Exhibit 9.3.

Because the settlement date, currency type, and currency amount of the forward contract match the corresponding terms of the account receivable, the hedge is expected to be highly effective. If Amerco properly designates the forward contract as a hedge of its euro account receivable position, it may apply hedge accounting. Because it completely offsets the vari- ability in the cash flows related to the account receivable, Amerco may designate the forward

9 This should not be confused with the cost associated with normal credit risk—that is, the risk that the cus- tomer will not pay for its purchase. That is a separate issue unrelated to the currency in which the transac- tion is denominated.

EXHIBIT 9.3 Hedge of a Foreign Currency Account Receivable with a Forward Contract

Steps on December 1, 2017

1. Amerco ships goods to the German customer, thereby creating an Account Receivable of 1 million. Amerco then sells 1 million three months forward to New Manhattan Bank, creating an executory contract to pay 1 million and receive $1,305,000.

The German customer remits 1 million to Amerco—the Account Receivable has been received and Amerco has 1 million reflected in an account Foreign Currency ( ). Amerco delivers 1 million to New Manhattan Bank.

Steps on March 1, 2018

4. 5. New Manhattan Bank pays Amerco $1,305,000.

German customer New Manhattan BankAmerco

5. 03/1/18—$1,305,000 received

executory contract

1. 12/1/17—goods shipped

3. 03/1/18— 1 million received 4. 03/1/18— 1 million delivered

2. 12/1/17— sold forward

1 million receivable

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Account Receivable (€) Forward Rate to 3/1/18

Forward Contract

Date Spot Rate U.S. Dollar

Value Change in U.S.

Dollar Value Fair Value Change in Fair Value

12/1/17 $1.32 $1,320,000 — $1.305 $ –0– — 12/31/17 1.33 1,330,000 +$10,000 1.316 (10,783)* −$10,783 3/1/18 1.30 1,300,000 − 30,000 1.30 5,000† + 15,783

*$1,305,000 − $1,316,000 = $(11,000) × 0.9803 = $(10,783), where 0.9803 is the present value factor for two months at an annual interest rate of 12 percent (1 percent per month) calculated as 1/1.012. †$1,305,000 − $1,300,000 = $5,000. This is the difference between the dollars that will be received when the forward contract is executed (based on the original forward rate) and the dollars that would have been received if no forward contract had been entered into (based on the spot rate on the date the euros are received).

contract as a cash flow hedge. Alternatively, because changes in the spot rate affect not only the cash flows but also the fair value of the foreign currency receivable, Amerco may elect to account for this forward contract as a fair value hedge.

In either case, Amerco determines the fair value of the forward contract by referring to the change in the forward rate for a contract maturing on March 1, 2018. The relevant exchange rates, U.S. dollar value of the euro receivable, and fair value of the forward contract are deter- mined as follows:

Amerco pays nothing to enter into the forward contract at December 1, 2017, and the for- ward contract has a fair value of zero on that date. The original discount on the forward con- tract is $15,000, determined by the difference in the euro spot rate and three-month forward rate on December 1, 2017 [($1.305 − $1.32) × €1 million]. At December 31, 2017, the for- ward rate for a contract to deliver euros on March 1, 2018, is $1.316. Amerco could enter into a forward contract on December 31, 2017, to sell 1 million euros for $1,316,000 on March 1, 2018. Because Amerco is committed to sell 1 million euros for $1,305,000, the nominal value of the forward contract is $(11,000). The fair value of the forward contract is the present value of this amount. Assuming that Amerco has an incremental borrowing rate of 12 percent per year (1 percent per month) and discounting for two months (from December 31, 2017, to March 1, 2018), the fair value of the forward contract at December 31, 2017, is $(10,783). Because the fair value is negative, the forward contract is a liability on December 31, 2017. On March 1, 2018, the forward rate to sell euros on that date is, by definition, the spot rate of $1.30. At that rate, Amerco could sell 1 million euros for $1,300,000. Because Amerco has a contract to sell euros for $1,305,000, the fair value of the forward contract on March 1, 2018, is $5,000. At this point, the forward contract is an asset because it has a positive fair value. From December 31, 2017, to March 1, 2018, the fair value of the forward contract has increased by $15,783.

Forward Contract Designated as Cash Flow Hedge Assume that Amerco designates the forward contract as a cash flow hedge of a foreign cur- rency denominated asset. In this case, it allocates the original forward discount or premium to net income over the life of the forward contract using an effective interest method. The company prepares the following journal entries to account for the foreign currency transaction and the related forward contract:

2017 Journal Entries—Forward Contract Designated as a Cash Flow Hedge

12/1/17 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000

To record the sale and €1 million account receivable at the spot rate of $1.32 (Cash Flow Hedge Step A.1. in Exhibit 9.2).

Amerco makes no formal entry for the forward contract because it is an executory contract (no cash changes hands) and has a fair value of zero (Cash Flow Hedge Step A.2. in Exhibit 9.2).

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Amerco prepares a memorandum designating the forward contract as a hedge of the risk of changes in the cash flow to be received on the foreign currency account receivable resulting from changes in the U.S. dollar–euro exchange rate. Following steps B.1.-B.4. in accounting for a cash flow hedge presented in Exhibit 9.2, the company prepares the following journal entries on December 31:

12/31/17 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

To adjust the value of the € receivable to the new spot rate of $1.33 and record a foreign exchange gain resulting from the appreciation of the € since December 1 (Cash Flow Hedge Step B.1. in Exhibit 9.2).

Accumulated Other Comprehensive Income (AOCI) . . . . . . . . . . . . . 10,783

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,783

To record the forward contract as a liability at its fair value of $10,783 with a corresponding debit to AOCI (Cash Flow Hedge Step B.2. in Exhibit 9.2).

Loss on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Accumulated Other Comprehensive Income (AOCI) . . . . . . . . 10,000

To record a loss on forward contract to offset the foreign exchange gain on account receivable with a corresponding credit to AOCI (Cash Flow Hedge Step B.3. in Exhibit 9.2).

Discount Expense 5,019

Accumulated Other Comprehensive Income (AOCI) . . . . . . . . 5,019

To allocate the forward contract discount to net income over the life of the contract using the effective interest method with a corre- sponding credit to AOCI (Cash Flow Hedge Step B.4. in Exhibit 9.2).

Loss on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Accumulated Other Comprehensive Income (AOCI) . . . . . . . . . . . . . . . . . . . . . . . 783

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,783

The first entry at December 31, 2017, serves to revalue the foreign currency account receivable and recognize a foreign exchange gain of $10,000 in net income. Because the for- ward contract has a negative fair value of $(10,783), GAAP requires it to be reported on the balance sheet as a liability. Thus, the second entry makes a credit of $10,783 to Forward Con- tract. Under cash flow hedge accounting, the change in the fair value of the forward contract, which has gone from $0 to $(10,783) is not recognized immediately in income, but is instead deferred in stockholders’ equity. Thus, the debit of $10,783 in the second entry is made to AOCI. The third entry achieves the objective of hedge accounting by transferring $10,000 from AOCI to a loss on forward contract. As a result of this entry, the loss on forward contract of $10,000 and the foreign exchange gain on the account receivable of $10,000 exactly offset one another, and the net impact on income is zero. As a result of the second and third entries, the forward contract is reported on the balance sheet as a liability at fair value of $(10,783); a loss on forward contract is recognized in the amount of $10,000 to offset the foreign exchange gain; and AOCI has a negative (debit) balance of $783. The second and third entries could be combined into one entry as follows:

The negative balance in AOCI of $783 can be viewed as that portion of the loss on the forward contract (decrease in fair value of the forward contract) that is not recognized in net income but instead is deferred in stockholders’ equity. Under cash flow hedge accounting, a loss on the hedging instrument (forward contract) is recognized only to the extent that it off- sets a gain on the item being hedged (account receivable).

The last entry uses the effective interest method to allocate a portion of the $15,000 forward contract discount as an expense to net income. The company calculates the implicit interest rate

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associated with the forward contract by considering the fact that the forward contract will gen- erate cash flow of $1,305,000 from a foreign currency asset with an initial value of $1,320,000. Because the discount of $15,000 accrues over a three-month period, the effective interest rate is calculated as 1− 3 √

_____________________ [$1,305, 000/$1,320, 000] = .0038023 The amount of discount to

be allocated to net income for the month of December 2017 is $1,320,000 × .0038023 = $5,019. A debit of $5,019 is made to Discount Expense in the last journal entry on December 31, 2017. By making the credit in this journal entry to AOCI, the theoretically correct amounts are reported in net income and on the balance sheet, and the balance sheet remains in balance.

The impact on net income for the year 2017 follows:

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $1,320,000 Foreign exchange gain . . . . . . . . . . $10,000 Loss on forward contract . . . . . . . . (10,000) Net gain (loss) . . . . . . . . . . . . . . . . . . –0– Discount expense . . . . . . . . . . . . . . (5,019) Impact on net income . . . . . . . . . $1,314,981

Assets Liabilities and Stockholders’ Equity

Accounts receivable (€) . . . . . . . . . $1,330,000 Forward contract . . . . . . $ 10,783 Retained earnings . . . . . 1,314,981 AOCI . . . . . . . . . . . . . . . . . 4,236

$1,330,000

2018 Journal Entries—Forward Contract Designated as Cash Flow Hedge From December 31, 2017, to March 1, 2018, the euro account receivable decreases in value by $30,000 and the forward contract increases in value by $15,873. In addition, on March 1, 2018, the remaining discount on forward contract must be amortized to expense. The com- pany prepares the following journal entries on March 1 to reflect these changes:

3/1/18 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

To adjust the value of the € receivable to the new spot rate of $1.30 and record a foreign exchange loss resulting from the depreciation of the € since December 31 (Cash Flow Hedge Step C.1. in Exhibit 9.2).

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,783

Accumulated Other Comprehensive Income (AOCI) . . . . . . . . 15,783

To adjust the carrying value of the forward contract to its current fair value of $5,000 with a corresponding credit to AOCI (Cash Flow Hedge Step C.2. in Exhibit 9.2).

Accumulated Other Comprehensive Income (AOCI) . . . . . . . . . . . . 30,000

Gain on Forward Contract. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

To record a gain on forward contract to offset the foreign exchange loss on account receivable with a corresponding debit to AOCI (Cash Flow Hedge Step C.3. in Exhibit 9.2).

Discount Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,981

Accumulated Other Comprehensive Income (AOCI) . . . . . . . . 9,981

To allocate the remaining forward contract discount to net income ($15,000 − 5,019 = $9,981) with a corresponding credit to AOCI (Cash Flow Hedge Step C.4. in Exhibit 9.2).

As a result of these entries, the balance in AOCI is zero: $4,236 + $15,783 − $30,000 + $9,981 = $0.

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The next two journal entries recognize the receipt of euros from the customer, close out the euro account receivable, and record the settlement of the forward contract.

3/1/18 Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

To record receipt of €1 million from the German customer as an asset (Foreign Currency) at the spot rate of $1.30 (Cash Flow Hedge Step C.5. in Exhibit 9.2).

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,305,000

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

To record settlement of the forward contract (i.e., record receipt of $1,305,000 in exchange for delivery of €1 mil- lion) and remove the forward contract from the accounts (Cash Flow Hedge Step C.6. in Exhibit 9.2).

The impact on net income for the year 2018 follows:

Foreign exchange loss . . . . . . . . . . . . . . . $(30,000) Gain on forward contract . . . . . . . . . . . . . 30,000

Net gain (loss) . . . . . . . . . . . . . . . . . . . . . . . –0– Discount expense . . . . . . . . . . . . . . . . . . . $(9,981)

Impact on net income . . . . . . . . . . . . . . $(9,981)

The net effect on the balance sheet over the two years is a $1,305,000 increase in Cash with a corresponding increase in Retained Earnings of $1,305,000 ($1,314,981 − $9,981). The cumulative amount recognized as Discount Expense of $15,000 reflects the cost of extending credit to the German customer.

The net benefit from entering into the forward contract is $5,000. This “gain” is not directly reflected in net income. However, it can be calculated as the difference between the net gain on the forward contract ($10,000 loss in 2017 plus $30,000 gain in 2018 = $20,000 net gain) and the cumulative amount of discount expense ($15,000) recognized over the two periods: $20,000 − $15,000 = $5,000.

Effective Interest versus Straight-Line Methods Use of the effective interest method results in allocating the forward contract discount $5,019 at the end of the first month and $9,981 at the end of the next two months. Straight-line alloca- tion of the $15,000 discount on a monthly basis results in a reasonable approximation of these amounts:

12/31/17 $15,000 × 1∕3 = $5,000

3/1/18 $15,000 × 2∕3 = $10,000

Determining the effective interest rate is complex and provides no conceptual insights. For the remainder of this chapter, we use straight-line allocation of forward contract discounts and premiums. The important thing to keep in mind in this example is that with a cash flow hedge, an expense equal to the original forward contract discount is recognized in net income over the life of the contract.

What if the forward rate on December 1, 2017, had been $1.326 (i.e., the euro was selling at a premium in the forward market)? In that case, Amerco would receive $6,000 more through the forward sale of euros ($1,326,000) than had it received the euros at the date of sale ($1,320,000). Amerco would allocate the forward contract premium as an increase in net income at the rate of $2,000 per month: $2,000 at December 31, 2017, and $4,000 at March 1, 2018.

Forward Contract Designated as Fair Value Hedge Assume that Amerco decides to designate the forward contract not as a cash flow hedge but as a fair value hedge. In that case, it takes the gain or loss on the forward contract

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directly to net income and does not separately amortize the original discount on the for- ward contract.

2017 Journal Entries—Forward Contract Designated as a Fair Value Hedge

12/1/17 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000

To record the sale and €1 million account receivable at the spot rate of $1.32 (Fair Value Hedge Step A.1. in Exhibit 9.2).

12/31/17 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

To adjust the value of the € receivable to the new spot rate of $1.33 and record a foreign exchange gain resulting from the appreciation of the € since Decem- ber 1 (Fair Value Hedge Step B.1. in Exhibit 9.2).

Loss on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,783

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,783

To record the forward contract as a liability at its fair value of $10,783 and record a forward contract loss for the change in the fair value of the forward contract since December 1 (Fair Value Hedge Step B.2. in Exhibit 9.2).

The forward contract requires no formal entry (Fair Value Hedge Step A.2. in Exhibit 9.2). A memorandum designates the forward contract as a hedge of the risk of changes in the fair value of the foreign currency account receivable resulting from changes in the U.S. dollar– euro exchange rate.

Following the two steps in accounting for a fair value hedge presented in Exhibit 9.2, the company prepares the following entries on December 31:

The first entry at December 31, 2017, serves to revalue the foreign currency account receivable and recognize a foreign exchange gain of $10,000. The second entry recognizes the forward contract as a liability of $10,783 on the balance sheet. Because the forward contract has been designated as a fair value hedge, the debit in the second entry recognizes the entire change in fair value of the forward contract as a loss in net income; there is no deferral of loss in stockholders’ equity. A net loss of $783 is reported in net income as a result of these two entries.

The impact on net income for the year 2017 is as follows:

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,320,000 Foreign exchange gain . . . . . . . . . . . . . . . . $10,000 Loss on forward contract . . . . . . . . . . . . . . (10,783) Net gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . (783) Impact on net income . . . . . . . . . . . . . . . $1,319,217

The effect on the December 31, 2017, balance sheet follows:

Assets Liabilities and Stockholders’ Equity

Accounts receivable (€) . . . . . . $1,330,000 Forward contract . . . . . . . . $ 10,783

Retained earnings . . . . . . . 1,319,217

$1,330,000

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Discussion Question

DO WE HAVE A GAIN OR WHAT?

Ahnuld Corporation, a health juice producer, recently expanded its sales through exports to foreign markets. Earlier this year, the company negotiated the sale of several thousand cases of turnip juice to a retailer in the country of Tcheckia. The customer is unwilling to assume the risk of having to pay in U.S. dollars. Desperate to enter the Tcheckian market, the vice president for international sales agrees to denominate the sale in tchecks, the national currency of Tcheckia. The current exchange rate for 1 tcheck is $2.00. In addition, the customer indicates that it cannot pay until it sells all of the juice. Payment of 100,000 tchecks is scheduled for six months from the date of sale.

Fearful that the tcheck might depreciate in value over the next six months, the head of the risk management department at Ahnuld Corporation enters into a forward contract to sell tchecks in six months at a forward rate of $1.80. The forward contract is designated as a fair value hedge of the tcheck receivable. Six months later, when Ahnuld receives payment from the Tcheckian customer, the exchange rate for the tcheck is $1.70. The corporate treasurer calls the head of the risk management department into her office.

Treasurer: I see that your decision to hedge our foreign currency position on that sale to Tcheckia was a bad one. Department head: What do you mean? We have a gain on that forward contract. We’re $10,000 better off from having entered into that hedge. Treasurer: That’s not what the books say. The accountants have recorded a net loss of $20,000 on that particular deal. I’m afraid I’m not going to be able to pay you a bonus this year. Another bad deal like this one and I’m going to have to demote you back to the interest rate swap department. Department head: Those bean counters have messed up again. I told those guys in inter- national sales that selling to customers in Tcheckia was risky, but at least by hedging our exposure, we managed to receive a reasonable amount of cash on that deal. In fact, we ended up with a gain of $10,000 on the hedge. Tell the accountants to check their debits and credits again. I’m sure they just put a debit in the wrong place or some accounting thing like that.

Have the accountants made a mistake? Does the company have a loss, a gain, or both from this forward contract?

3/1/18 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

To adjust the value of the € receivable to the new spot rate of $1.30 and record a foreign exchange loss result- ing from the depreciation of the € since December 31 (Fair Value Hedge Step C.1. in Exhibit 9.2).

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,783

Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . 15,783

To adjust the carrying value of the forward contract to its current fair value of $5,000 and record a forward contract gain for the change in the fair value since December 31 (Fair Value Hedge Step C.2. in Exhibit 9.2).

2018 Journal Entries—Forward Contract Designated as a Fair Value Hedge The company prepares the following entries on March 1:

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Foreign exchange loss . . . . . . . . . . $ (30,000) Gain on forward contract . . . . . . . . 15,783

Impact on net income . . . . . . . . . . . $ (14,217)

3/1/18 Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

To record receipt of €1 million from the German customer as an asset at the spot rate of $1.30 (Fair Value Hedge Step C.3. in Exhibit 9.2).

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,305,000

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

To record settlement of the forward contract (i.e., record receipt of $1,305,000 in exchange for delivery of €1 mil- lion) and remove the forward contract from the accounts (Fair Value Hedge Step C.4. in Exhibit 9.2).

The impact on net income for the year 2018 follows:

The net effect on the balance sheet for the two periods is an increase of $1,305,000 in Cash with a corresponding increase in Retained Earnings of $1,305,000 ($1,319,217 − $14,217).

Under fair value hedge accounting, the company does not amortize the original forward contract discount systematically over the life of the contract. Instead, it recognizes the dis- count in income as the difference between the foreign exchange Gain (Loss) on the account receivable and the Gain (Loss) on the forward contract—that is, $(783) in 2017 and $(14,217) in 2018. The net impact on net income over the two years is $(15,000), which reflects the cost of extending credit to the German customer. The net gain on the forward contract of $5,000 ($10,783 loss in 2017 and $15,783 gain in 2018) reflects the net benefit (i.e., increase in cash inflow) from Amerco’s decision to hedge the euro receivable.

Companies often cannot or do not bother to designate as hedges the forward contracts they use to hedge foreign currency denominated assets and liabilities. In those cases, the company accounts for the forward contract as if it were a speculative investment. The company reports an undesig- nated forward contract on the balance sheet at fair value as an asset or liability and immediately recognizes changes in the fair value of the forward contract in net income. This accounting treat- ment is exactly the same as if the forward contract had been designated as a fair value hedge. The only difference between a forward contract designated as a fair value hedge of a foreign currency denominated asset or liability and an undesignated (speculative) forward contract is the manner in which the company discloses it in the notes to the financial statements. E.I. du Pont de Nemours and Company provided the following disclosure related to this in its 2014 Form 10-K (page F-43):

Derivatives Not Designated in Hedging Relationships

Foreign Currency Contracts The company routinely uses forward exchange contracts to reduce its net exposure, by currency, related to foreign currency-denominated monetary assets and liabilities of its operations so that exchange gains and losses resulting from exchange rate changes are minimized. The netting of such exposures precludes the use of hedge accounting; however, the required revaluation of the forward contracts and the associated foreign currency-denominated monetary assets and liabili- ties intends to achieve a minimal earnings impact, after taxes.

Cash Flow Hedge versus Fair Value Hedge A forward contract used to hedge a foreign currency denominated asset or liability can be des- ignated as either a cash flow hedge or a fair value hedge when it completely offsets the vari- ability in cash flows associated with the hedged item. The total impact on income is the same regardless of whether the forward contract is designated as a fair value hedge or as a cash flow hedge. In our example, Amerco recognized an expense (or loss) of $15,000 in both cases, and the company knew what the total expense was going to be as soon as the contract was signed.

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A benefit to designating a forward contract as a cash flow hedge is that the company knows the forward contract’s effect on net income each year as soon as the contract is signed. The net impact on income is the periodic amortization of the forward contract discount or premium. In our example, Amerco knew on December 1, 2017, that it would recognize a discount expense of $5,000 in 2017 and $10,000 in 2018. The impact on each year’s income is not as system- atic when the forward contract is designated as a fair value hedge—loss of $783 in 2017 and $14,217 in 2018. Moreover, the company does not know what the net impact on 2017 income will be until December 31, 2017, when the euro account receivable and the forward contract are revalued. Because of the potential for greater volatility in periodic net income that results from a fair value hedge, companies may prefer to designate forward contracts used to hedge a foreign currency denominated asset or liability as cash flow hedges.

Foreign Currency Option Used to Hedge a Foreign Currency Denominated Asset As an alternative to a forward contract, Amerco could hedge its exposure to foreign exchange risk arising from the euro account receivable by purchasing a foreign currency put option. A put option would give Amerco the right but not the obligation to sell 1 million euros on March 1, 2018, at a predetermined strike price. Assume that on December 1, 2017, Amerco pur- chases an over-the-counter option from its bank with a strike price of $1.32 when the spot rate is $1.32 and pays a premium of $0.009 per euro.10 Thus, the purchase price for the option is $9,000 (€1 million × $0.009).

Because the strike price and spot rate are the same, no intrinsic value is associated with this option. The premium is based solely on time value; that is, it is possible that the euro will depreciate and the spot rate on March 1, 2018, will be less than $1.32, in which case the option will be “in the money.” If the spot rate for euros on March 1, 2018, is less than the strike price of $1.32, Amerco will exercise its option and sell its 1 million euros at the strike price of $1.32. If the spot rate for euros in three months is more than the strike price of $1.32, Amerco will not exercise its option but will sell euros at the higher spot rate. By purchasing this option, Amerco is guaranteed a minimum cash flow from the export sale of $1,311,000 ($1,320,000 from exercising the option less the $9,000 cost of the option). There is no limit to the maximum number of U.S. dollars that Amerco could receive.

As is true for other derivative financial instruments, authoritative accounting literature requires foreign currency options to be reported on the balance sheet at fair value. The fair value of a foreign currency option at the balance sheet date is determined by reference to the premium quoted by banks on that date for an option with a similar expiration date. Banks (and other sellers of options) determine the current premium by incorporating relevant variables at the balance sheet date into the modified Black-Scholes option pricing model. Changes in value for the euro account receivable and the foreign currency option are summarized as follows:

10 The seller of the option determined the price of the option (the premium) by using a variation of the Black- Scholes option pricing formula.

Account Receivable (€)

Option Premium for 3/1/18

Foreign Currency Option

Date Spot Rate U.S. Dollar

Value Change in U.S.

Dollar Value Fair Value Change in Fair Value

12/1/17 $1.32 $1,320,000 $ –0– $0.009 $ 9,000 $ –0– 12/31/17 1.33 1,330,000 + 10,000 0.006 6,000 − 3,000 3/1/18 1.30 1,300,000 − 30,000 0.020 20,000 + 14,000

The fair value of the foreign currency put option at December 1 is its cost of $9,000. The spot rate for the euro increases during December, which causes a decrease in the fair value of the put

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option; the right to sell euros at $1.32 is of even less value when the spot rate is $1.33 (on Decem- ber 31) than when the spot rate was $1.32 (on December 1). The bank determines the fair value of the option at December 31 to be $6,000. By March 1, the euro spot rate has decreased to $1.30. By exercising its option on March 1 at the strike price of $1.32, Amerco will receive $1,320,000 from its export sale, rather than only $1,300,000 if it were required to sell euros in the spot mar- ket on March 1. Thus, the option has a fair value of $20,000 on March 1.

We can decompose the fair value of the foreign currency option into its intrinsic value and time value components as follows:

Date Fair Value Intrinsic Value Time Value Change in Time Value

12/1/17 $ 9,000 $ –0– $9,000 $ –0– 12/31/17 6,000 –0– 6,000 −3,000 3/1/18 20,000 20,000 –0– −6,000

Because the option strike price is less than or equal to the spot rate at both December 1 and December 31, the option has no intrinsic value at those dates. The entire fair value is attribut- able to time value only. On March 1, the date of expiration, no time value remains, and the entire amount of fair value is attributable to intrinsic value.

Option Designated as Cash Flow Hedge Assume that Amerco designates the foreign currency option as a cash flow hedge of a for- eign currency denominated asset. In this case, Amerco recognizes the change in the option’s time value immediately in net income. The company prepares the following journal entries to account for the foreign currency transaction and the related foreign currency option:

2017 Journal Entries—Option Designated as a Cash Flow Hedge

12/1/17 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000

To record the sale and €1 million account receivable at the spot rate of $1.32 (Cash Flow Hedge Step A.1. in Exhibit 9.2).

Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

To record the purchase of the foreign currency option as an asset at its fair value of $9,000 (Cash Flow Hedge Step A.2. in Exhibit 9.2).

From December 1 to December 31, the euro account receivable increases in value by $10,000 and the option decreases in value by $3,000. The company prepares the following journal entries on December 31 to reflect these changes:

12/31/17 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

To adjust the value of the € receivable to the new spot rate of $1.33 and record a foreign exchange gain result- ing from the appreciation of the € since December 1 (Cash Flow Hedge Step B.1. in Exhibit 9.2).

Accumulated Other Comprehensive Income (AOCI) . . . . . . . 3,000

Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

To adjust the fair value of the option from $9,000 to $6,000 with a corresponding debit to AOCI (Cash Flow Hedge Step B.2. in Exhibit 9.2).

Loss on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . 10,000

Accumulated Other Comprehensive Income (AOCI) . . . 10,000

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The first three journal entries prepared on December 31 result in the euro account receiv- able and the foreign currency option being reported on the balance sheet at fair value with a net gain (loss) of zero reflected in net income, which is consistent with the concept of hedge accounting. The final entry serves to amortize a portion of the option cost to expense in net income. On March 1, the remaining $6,000 of option cost will be expensed.

The impact on net income for the year 2017 follows: Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,320,000 Foreign exchange gain . . . . . . . . . . . . . . . . $ 10,000 Loss on foreign currency option . . . . . . . . (10,000)

Net gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . –0– Option expense . . . . . . . . . . . . . . . . . . . . . . (3,000)

Impact on net income . . . . . . . . . . . . . . . . . $1,317,000

Assets Liabilities and Stockholders’ Equity

Cash . . . . . . . . . . . . . . . . . . . . . . . $ (9,000) Retained earnings . . . . . . . . . . . $1,317,000 Accounts receivable (€) . . . . . . 1,330,000 AOCI . . . . . . . . . . . . . . . . . . . . . . . 10,000

Foreign currency option . . . . . . 6,000 $1,327,000

$1,327,000

3/1/18 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 To adjust the value of the € receivable to the new spot rate

of $1.30 and record a foreign exchange loss resulting from the depreciation of the € since December 31 (Cash Flow Hedge Step C.1. in Exhibit 9.2).

Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 Accumulated Other Comprehensive Income (AOCI) . . . 14,000 To adjust the fair value of the option from $6,000 to $20,000

with a corresponding credit to AOCI (Cash Flow Hedge Step C.2. in Exhibit 9.2).

Accumulated Other Comprehensive Income (AOCI) . . . . . . . 30,000 Gain on Foreign Currency Option . . . . . . . . . . . . . . . . . . . 30,000 To record a gain on foreign currency option to offset the for-

eign exchange gain on account receivable with a correspond- ing debit to AOCI (Cash Flow Hedge Step C.3. in Exhibit 9.2).

Option Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Accumulated Other Comprehensive Income (AOCI) . . . 6,000 To recognize the change in the time value of the option as a

decrease in net income with a corresponding credit to AOCI (Cash Flow Hedge Step C.4. in Exhibit 9.2).

To record a loss on foreign currency option to offset the foreign exchange gain on the account receivable with a corresponding credit to AOCI (Cash Flow Hedge Step B.3. in Exhibit 9.2).

Option Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Accumulated Other Comprehensive Income (AOCI) . . . 3,000 To recognize the change in the time value of the option

as a decrease in net income with a corresponding credit to AOCI (Cash Flow Hedge Step B.4. in Exhibit 9.2).

(continued )

The effect on the December 31, 2017, balance sheet is as follows:

At March 1, 2018, the option has increased in fair value by $14,000—time value decreases by $6,000 and intrinsic value increases by $20,000. The accounting entries made in 2018 are presented next:

2018 Journal Entries—Option Designated as a Cash Flow Hedge

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3/1/18 Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

To record receipt of €1 million from the German cus- tomer as an asset at the spot rate of $1.30 (Cash Flow Hedge Step C.5. in Exhibit 9.2).

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . 20,000

To record exercise of the option (i.e., record receipt of $1,320,000 in exchange for delivery of €1 million) and remove the foreign currency option from the accounts (Cash Flow Hedge Step C.6. in Exhibit 9.2).

Foreign exchange loss . . . . . . . . . . . . . . . . . . . . . $(30,000) Gain on foreign currency option . . . . . . . . . . . . . 30,000

Net gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– Option expense . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,000)

Impact on net income . . . . . . . . . . . . . . . . . . $(6,000)

The first three entries on March 1 result in the euro account receivable and the foreign cur- rency option being reported at their fair values, with a net gain (loss) of zero. The fourth entry amortizes the remaining cost of the option to expense. As a result of these entries, the balance in AOCI is zero: $10,000 + $14,000 − $30,000 + $6,000 = $0.

The next two journal entries recognize the receipt of euros from the customer, close out the euro account receivable, and record the exercise of the foreign currency option.

The impact on net income for the year 2018 follows:

Over the two accounting periods, Amerco reports sales of $1,320,000 and a cumulative option expense of $9,000. The net effect on the balance sheet is an increase in the cash account of $1,311,000 ($1,320,000 − $9,000) with a corresponding increase in the retained earnings account of $1,311,000 ($1,317,000 − $6,000).

The net benefit from having acquired the option is $11,000. This is the difference between the amount Amerco received from executing the option ($1,320,000) and the amount Amerco would have received if it had not acquired the option ($1,300,000), net of the option’s cost ($9,000): $1,320,000 − $1,300,000 − $9,000 = $11,000. Amerco indirectly reflects this “gain” in net income as the net gain on foreign currency option ($10,000 loss in 2017 plus $30,000 gain in 2018) less the cumulative option expense ($9,000) recognized over the two accounting periods: $20,000 − $9,000 = $11,000.

Option Designated as Fair Value Hedge Assume that Amerco decides not to designate the foreign currency option as a cash flow hedge but to treat it as a fair value hedge. In that case, it takes the gain or loss on the option directly to net income. The change in the time value of the option is not recognized, so there is no option expense recorded.

2017 Journal Entries—Option Designated as a Fair Value Hedge

12/1/17 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000

To record the sale and €1 million account receivable at the spot rate of $1.32 (Fair Value Hedge Step A.1. in Exhibit 9.2).

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The impact on net income for the year 2017 follows:

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,320,000 Foreign exchange gain . . . . . . . . . . . . . . . . . . . . $10,000 Loss on foreign currency option . . . . . . . . . . . . (3,000)

Net gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Impact on net income . . . . . . . . . . . . . . . . . . . $1,327,000

3/1/18 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000

Gain on Foreign Currency Option . . . . . . . . . . . . . . . . . 14,000

To adjust the fair value of the option from $6,000 to $20,000 and record a gain on foreign currency option for the change in fair value since December 31 (Fair Value Hedge Step C.2. in Exhibit 9.2).

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

To record receipt of €1 million from the German cus- tomer as an asset at the spot rate of $1.30 (Fair Value Hedge Step C.3. in Exhibit 9.2).

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

To record exercise of the option (i.e., record receipt of $1,320,000 in exchange for delivery of €1 million) and remove the foreign currency option from the accounts (Fair Value Hedge Step C.4. in Exhibit 9.2).

Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

To record the purchase of the foreign currency option as an asset at its fair value of $9,000 (Fair Value Hedge Step A.2. in Exhibit 9.2).

12/31/17 Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Loss on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . 3,000

Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

To adjust the fair value of the option from $9,000 to $6,000 and record a loss on foreign currency option for the change in the fair value of the option since December 1 (Fair Value Hedge Step B.2. in Exhibit 9.2).

2018 Journal Entries—Option Designated as a Fair Value Hedge

(continued )

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Over the two accounting periods, Amerco reports sales of $1,320,000 and a cumulative net loss of $9,000 ($7,000 net gain in 2017 and $16,000 net loss in 2018). The net effect on the balance sheet is an increase in cash of $1,311,000 ($1,320,000 − $9,000) with a corresponding increase in retained earnings of $1,311,000 ($1,327,000 − $16,000). The net benefit from hav- ing acquired the option is $11,000. Amerco reflects this in net income through the net gain on foreign currency option ($3,000 loss in 2017 and $14,000 gain in 2018) recognized over the two accounting periods.

The accounting for an option used as a fair value hedge of a foreign currency denominated asset or liability is the same as if the option had been considered a speculative derivative. The only advantage to designating the option as a fair value hedge relates to the disclosures made in the notes to the financial statements.

Spot Rate Exceeds Strike Price If the spot rate at March 1, 2018, had been more than the strike price of $1.32, Amerco would allow its option to expire unexercised. Instead it would sell its foreign currency (€) at the spot rate. The fair value of the foreign currency option on March 1, 2018, would be zero. The journal entries for 2017 to reflect this scenario would be the same as the preced- ing ones. The option would be reported as an asset on the December 31, 2017, balance sheet at $6,000 and the € receivable would have a carrying value of $1,330,000. The entries on March 1, 2018, assuming a spot rate on that date of $1.325 (rather than $1.30), would be as follows:

Foreign exchange loss . . . . . . . . . . . . . . . . . . . . . $(30,000) Gain on foreign currency option . . . . . . . . . . . . . 14,000

Impact on net income . . . . . . . . . . . . . . . . . . . . $(16,000)

Foreign exchange loss . . . . . . . . . . . . . . . . . . . . . . $ (5,000) Loss on foreign currency option . . . . . . . . . . . . . . (6,000)

Impact on net income . . . . . . . . . . . . . . . . . . . . . $(11,000)

The impact on net income for the year 2018 follows:

3/1/18 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

To adjust the value of the € receivable to the new spot rate of $1.325 and record a foreign exchange loss resulting from the depreciation of the € since Decem- ber 31 (Fair Value Hedge Step C.1. in Exhibit 9.2).

Loss on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . 6,000

Foreign Currency Option 6,000

To adjust the fair value of the option from $6,000 to $0 and record a loss on foreign currency option for the change in fair value since December 31 (Fair Value Hedge Step C.2. in Exhibit 9.2).

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,325,000

Accounts Receivable (€) . . . . . . . . . . . . . . . . . . . . . . . . . 1,325,000

To record receipt of €1 million from the German cus- tomer as an asset at the spot rate of $1.325 (Fair Value Hedge Step C.3. in Exhibit 9.2).

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,325,000

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,325,000

To record the sale of €1 million at the spot rate of $1.325 (Fair Value Hedge Step C.4. in Exhibit 9.2).

The overall impact on net income for the year 2018 is as follows:

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Hedges of Unrecognized Foreign Currency Firm Commitments In the examples thus far, Amerco does not enter into a hedge of its export sale until it actually makes the sale. Assume now that on December 1, 2017, Amerco receives and accepts an order from a German customer to deliver goods on March 1, 2018, at a price of 1 million euros. Assume further that under the terms of the sales agreement, Amerco will ship the goods to the German customer on March 1, 2018, and will receive immediate payment on delivery. In other words, Amerco will not extend credit to the German customer. Although Amerco will not make the sale until March 1, 2018, it has a firm commitment to make the sale and receive 1 million euros in three months. This creates a euro asset exposure to foreign exchange risk as of December 1, 2017. On that date, Amerco wants to hedge against an adverse change in the value of the euro over the next three months. This is known as a hedge of a foreign cur- rency firm commitment. U.S. GAAP allows hedges of firm commitments to be designated either as cash flow or fair value hedges. However, because the results of fair value hedge accounting are intuitively more appealing, we do not cover cash flow hedge accounting for firm commitments.

A firm commitment is an executory contract; the company has not delivered goods nor has the customer paid for them. Normally, executory contracts are not recognized in financial statements. However, when a firm commitment is hedged using a derivative financial instru- ment, hedge accounting requires explicit recognition on the balance sheet at fair value of both the derivative financial instrument (forward contract or option) and the firm commitment. The change in fair value of the firm commitment results in a gain or loss that offsets the loss or gain on the hedging instrument (forward contract or option), thus achieving the goal of hedge accounting. This raises the conceptual question of how to measure the fair value of the firm commitment. When a forward contract is used as the hedging instrument, the fair value of the firm commitment is determined through reference to changes in the forward exchange rate. Changes in the spot exchange rate are used to determine the fair value of the firm commitment when a foreign currency option is the hedging instrument.

Forward Contract Used as Fair Value Hedge of a Firm Commitment To hedge its firm commitment exposure to a decline in the U.S. dollar value of the euro, Amerco decides to enter into a forward contract on December 1, 2017. Assume that on that date, the three-month forward rate for euros is $1.305 and Amerco signs a contract with New Manhattan Bank to deliver 1 million euros in three months in exchange for $1,305,000. No cash changes hands on December 1, 2017. Amerco measures the fair value of the firm com- mitment through changes in the forward rate. Because the fair value of the forward contract is also measured using changes in the forward rate, the gains and losses on the firm commitment and forward contract exactly offset. The fair value of the forward contract and firm commit- ment are determined as follows:

LO 9-8

Account for forward contracts and options used as hedges of foreign currency firm commitments.

Date

Forward Rate to 3/1/18

Forward Contract Firm Commitment

Fair Value Change in Fair Value Fair Value

Change in Fair Value

12/1/17 $ 1.305 $ –0– $ –0– $ –0– $ –0– 12/31/17 1.316 (10,783)* − 10,783 10,783* + 10,783 3/1/18 1.30 (spot) 5,000† + 15,783 (5,000)† − 15,783

Amerco pays nothing to enter into the forward contract at December 1, 2017. Both the forward contract and the firm commitment have a fair value of zero on that date. As a result, there are no journal entries needed on December 1, 2017. At December 31,

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2017, the forward rate for a contract to deliver euros on March 1, 2018, is $1.316. A forward contract could be entered into on December 31, 2017, to sell 1 million euros for $1,316,000 on March 1, 2018. Because Amerco is committed to sell 1 million euros for $1,305,000, the value of the forward contract is $(11,000); present value is $(10,783), a liability. The fair value of the firm commitment is also measured through reference to changes in the forward rate. As a result, the fair value of the firm commitment is equal in amount but of opposite sign to the fair value of the forward contract. At December 31, 2017, the firm commitment is an asset of $10,783. To apply the two steps in accounting for a fair value hedge of a firm commitment at the balance sheet date, on December 31, 2017, Amerco will:

1. Adjust the forward contract to fair value, which results in the recognition of a liability of $10,783, and recognize the counterpart as a loss in net income (Fair Value Hedge Step B.1. in Exhibit 9.2).

2. Adjust the firm commitment to fair value, which results in the recognition of an asset of $10,783, and recognize the counterpart as a gain on firm commitment in net income (Fair Value Hedge Step B.2. in Exhibit 9.2).

The journal entries in 2017 to account for the forward contract fair value hedge of a foreign currency firm commitment are as follows:

2017 Journal Entries—Forward Contract Fair Value Hedge of Firm Commitment

12/1/17 There is no entry to record either the sales agreement or the forward contract because both are executory con- tracts. A memorandum designates the forward contract as a hedge of the risk of changes in the fair value of the firm commitment resulting from changes in the U.S. dollar– euro forward exchange rate (Fair Value Hedge Steps A.1. and A.2. in Exhibit 9.2).

12/31/17 Loss on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,783

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,783

To record the forward contract as a liability at its fair value of $(10,783) and record a forward contract loss for the change in the fair value of the forward contract since December 1 (Fair Value Hedge Step B.1. in Exhibit 9.2).

Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,783

Gain on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . 10,783

To record the firm commitment as an asset at its fair value of $10,783 and record a firm commitment gain for the change in the fair value of the firm commitment since December 1 (Fair Value Hedge Step B.2. in Exhibit 9.2).

Consistent with the objective of hedge accounting, the gain on the firm commitment off- sets the loss on the forward contract, and the impact on 2017 net income is zero. Amerco reports the forward contract as a liability and reports the firm commitment as an asset on the December 31, 2017, balance sheet. This achieves the objective of making sure that derivatives are reported on the balance sheet and ensures that there is no impact on net income.

On March 1, 2018, the forward rate to sell euros on that date, by definition, is the spot rate, $1.30. At that rate, Amerco could sell 1 million euros for $1,300,000. Because Amerco has a contract to sell euros for $1,305,000, the fair value of the forward contract on March 1, 2018, is $5,000 (an asset). The firm commitment has a value of $(5,000), a liability.

On March 1, 2018, Amerco first recognizes changes in the fair value of the forward con- tract and firm commitment since December 31. The company then records the sale and the

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settlement of the forward contract. Finally, the $5,000 balance in the firm commitment account is closed as an adjustment to net income. The required journal entries are as follows:

2018 Journal Entries—Forward Contract Fair Value Hedge of Firm Commitment

3/1/18 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,783

Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . 15,783

To adjust the fair value of the forward contract from $(10,783) to $5,000 and record a forward contract gain for the change in fair value since December 31 (Fair Value Hedge Step C.1. in Exhibit 9.2).

Loss on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,783

Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,783

To adjust the fair value of the firm commitment from $10,783 to $(5,000) and record a firm commitment loss for the change in fair value since December 31 (Fair Value Hedge Step C.2. in Exhibit 9.2).

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

To record the sale and the receipt of €1 million as an asset at the spot rate of $1.30 (Fair Value Hedge Step C.3. in Exhibit 9.2).

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,305,000

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

To record settlement of the forward contract (receipt of $1,305,000 in exchange for delivery of €1 million) and remove the forward contract from the accounts (Fair Value Hedge Step C.4. in Exhibit 9.2).

Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Adjustment to Net Income—Firm Commitment . . . . . . 5,000

To close the firm commitment as an adjustment to net income (Fair Value Hedge Step C.5. in Exhibit 9.2).

Once again, the gain on forward contract and the loss on firm commitment offset. As a result of the last entry, the export sale increases 2018 net income by $1,305,000 ($1,300,000 in sales plus a $5,000 adjustment to net income). This exactly equals the amount of cash received. In practice, companies use a variety of account titles for the adjustment to net income that results from closing the firm commitment account.

The net gain on forward contract of $5,000 ($10,783 loss in 2017 plus $15,783 gain in 2018) measures the net benefit to the company from hedging its firm commitment. Without the forward contract, Amerco would have sold the 1 million euros received on March 1, 2018, at the spot rate of $1.30 generating cash flow of $1,300,000. Through the forward contract, Amerco is able to sell the euros for $1,305,000, a net gain of $5,000.

Option Used as Fair Value Hedge of Firm Commitment Now assume that to hedge its exposure to a decline in the U.S. dollar value of the euro, Amerco purchases a put option to sell 1 million euros on March 1, 2018, at a strike price of $1.32. The premium for such an option on December 1, 2017, is $0.009 per euro. With this option, Amerco is guaranteed a minimum cash flow from the export sale of $1,311,000 ($1,320,000 from option exercise less $9,000 cost of the option).

Amerco measures the fair value of the firm commitment by referring to changes in the U.S. dollar–euro spot rate. In this case, Amerco must discount the fair value of the firm commit- ment to its present value. The fair value and changes in fair value for the firm commitment and foreign currency option are summarized here:

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At December 1, 2017, given the spot rate of $1.32, the firm commitment to receive 1 mil- lion euros in three months would generate a cash flow of $1,320,000. At December 31, 2017, the cash flow that the firm commitment could generate increases by $10,000 to $1,330,000. The fair value of the firm commitment at December 31, 2017, is the present value of $10,000 discounted at 1 percent per month for two months. Amerco determines the fair value of the firm commitment on March 1, 2018, by referring to the change in the spot rate from December 1, 2017, to March 1, 2018. Because the spot rate declines by $0.02 over that period, the firm commitment to receive 1 million euros has a fair value of $(20,000) on March 1, 2018. The journal entries to account for the foreign currency option and related foreign currency firm commitment are discussed next:

2017 Journal Entries—Option Fair Value Hedge of Firm Commitment

12/1/17 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

To record the purchase of the foreign currency option as an asset (Fair Value Hedge Step A.2. in Exhibit 9.2).

12/31/17 Loss on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . 3,000

Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

To adjust the fair value of the option from $9,000 to $6,000 and record the change in the value of the option as a loss (Fair Value Hedge Step B.1. in Exhibit 9.2).

Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,803

Gain on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . 9,803

To record the firm commitment as an asset at its fair value of $9,803 and record a firm commitment gain for the change in the fair value of the firm commitment since December 1 (Fair Value Hedge Step B.2. in Exhibit 9.2).

Date

Option Premium for 3/1/18

Foreign Currency Option

Spot Rate

Firm Commitment

Fair Value Change in Fair Value Fair Value

Change in Fair Value

12/1/17 $0.009 $ 9,000 $ –0– $1.32 $ –0– $ –0– 12/31/17 0.006 6,000 − 3,000 1.33 9,803* + 9,803 3/1/18 0.020 20,000 +14,000 1.30 (20,000)† −29,803 *$1,330,000 − $1,320,000 = $10,000 × 0.9803 = $9,803, where 0.9803 is the present value factor for two months at an annual interest rate of 12 percent (1 percent per month) calculated as 1/1.012. †$1,300,000 − $1,320,000 = $(20,000).

There is no entry to record the sales agreement because it is an executory contract (Fair Value Hedge Step A.1. in Exhibit 9.2). Amerco prepares a memorandum to designate the option as a hedge of the risk of changes in the fair value of the firm commitment resulting from changes in the spot exchange rate.

Because the fair value of the firm commitment is based on changes in the spot rate whereas the fair value of the option is based on a variety of factors, the gain on the firm commitment and loss on the option do not exactly offset.

The impact on net income for the year 2017 is as follows:

Gain on firm commitment . . . . . . . . . . . . . $ 9,803 Loss on foreign currency option . . . . . . . (3,000)

Impact on net income . . . . . . . . . . . . . . . . $ 6,803

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The effect on the December 31, 2017, balance sheet follows:

Assets Liabilities and Stockholders’ Equity

Cash . . . . . . . . . . . . . . . . . . . . . $ (9,000) Retained earnings . . . . . . . $6,803

Foreign currency option . . . . 6,000 Firm commitment . . . . . . . . . . 9,803

$ 6,803

3/1/18 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000

Gain on Foreign Currency Option . . . . . . . . . . . . . . . . . 14,000

To adjust the fair value of the foreign currency option from $6,000 to $20,000 and record a gain on foreign currency option for the change in fair value since December 31 (Fair Value Hedge Step C.1. in Exhibit 9.2)

Loss on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,803

Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,803

To adjust the fair value of the firm commitment from $9,803 to $(20,000) and record a firm commitment loss for the change in fair value since December 31 (Fair Value Hedge Step C.2. in Exhibit 9.2)

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

To record the sale and the receipt of €1 million as an asset at the spot rate of $1.30 (Fair Value Hedge Step C.3. in Exhibit 9.2).

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

To record exercise of the foreign currency option (receipt of $1,320,000 in exchange for delivery of €1 million) and remove the foreign currency option from the accounts (Fair Value Hedge Step C.4. in Exhibit 9.2).

Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Adjustment to Net Income—Firm Commitment 20,000

To close the firm commitment as an adjustment to net income (Fair Value Hedge Step C.5. in Exhibit 9.2).

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,300,000 Loss on firm commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . (29,803) Gain on foreign currency option . . . . . . . . . . . . . . . . . . . . . . 14,000 Adjustment to net income–firm commitment . . . . . . . . . . . 20,000

Impact on net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,304,197

On March 1, 2018, following fair value hedge accounting procedures, Amerco first recog- nizes changes in the fair value of the option and of the firm commitment since December 31. The company then records the sale and the exercise of the option. Finally, the $20,000 balance in the firm commitment account is closed as an adjustment to net income. The required journal entries are as follows:

2018 Journal Entries—Option Fair Value Hedge of Firm Commitment

The following is the impact on net income for the year 2018:

The net increase in net income over the two accounting periods is $1,311,000 ($6,803 in 2017 plus $1,304,197 in 2018), which exactly equals the net cash flow realized on the export sale ($1,320,000 from exercising the option less $9,000 to purchase the option). The net gain

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on the option of $11,000 (loss of $3,000 in 2017 plus gain of $14,000 in 2018) reflects the net benefit from having entered into the hedge. Without the option, Amerco would have sold the 1 million euros received on March 1, 2018, at the spot rate of $1.30 for $1,300,000.

Hedge of Forecasted Foreign Currency Denominated Transaction Cash flow hedge accounting also is used for foreign currency derivatives used to hedge the cash flow risk associated with a forecasted foreign currency transaction. For hedge account- ing to apply, the forecasted transaction must be probable (likely to occur), the hedge must be highly effective in offsetting fluctuations in the cash flow associated with the foreign currency risk, and the hedging relationship must be properly documented.

Accounting for a hedge of a forecasted transaction differs from accounting for a hedge of a foreign currency firm commitment in two ways:

1. Unlike the accounting for a firm commitment, there is no recognition of the forecasted transaction or gains and losses on the forecasted transaction. (Because there is no recogni- tion of an asset or liability, there is no fair value exposure to foreign exchange risk. Thus, fair value hedge accounting is not appropriate for hedges of forecasted transactions.)

2. The company reports the hedging instrument (forward contract or option) at fair value, but because no gain or loss occurs on the forecasted transaction to offset against, the company does not report changes in the fair value of the hedging instrument as gains and losses in net income. Instead, it reports them in other comprehensive income. On the projected date of the forecasted transaction, the company transfers the cumulative change in the fair value of the hedging instrument from accumulated other comprehensive income (balance sheet) to net income (income statement).

Forward Contract Cash Flow Hedge of a Forecasted Transaction To demonstrate the accounting for a hedge of a forecasted foreign currency transaction, assume that Amerco has a long-term relationship with its German customer and can reliably forecast that the customer will require delivery of goods costing 1 million euros in March 2018. Confident that it will receive 1 million euros on March 1, 2018, Amerco enters into a forward contract on December 1, 2017, to sell 1 million euros on March 1, 2018, at a rate of $1.30. The facts are essentially the same as those for the hedge of a firm commitment except that Amerco does not receive a sales order from the German customer until late February 2018. Relevant exchange rates and the fair value of the forward contract are as follows:

LO 9-9

Account for forward contracts and options used as hedges of forecasted foreign currency transactions.

Date Forward Rate

to 3/1/18

Forward Contract

Fair Value Change in Fair Value

12/1/17 $1.305 $ –0– $ –0– 12/31/17 1.316 (10,783)* − 10,783 3/1/18 1.30 (spot) 5,000 + 15,783

*($1,305,000 − $1,316,000) = $(11,000) × 0.9803 = $(10,783), where 0.9803 is the present value factor for two months at an annual interest rate of 12 percent (1 percent per month) calculated as 1/1.012. The original discount on the forward contract is determined by the difference in the € spot rate and the three-month forward rate on December 1, 2017: ($1.305 − $1.32) × €1 million = $15,000.

2017 Journal Entries—Forward Contract Hedge of a Forecasted Transaction

12/1/17 There is no entry to record either the forecasted sale or the forward con- tract. A memorandum designates the forward contract as a hedge of the risk of changes in the cash flows related to the forecasted sale resulting from changes in the spot rate (Cash Flow Hedge Steps A.1. and A.2. in Exhibit 9.2).

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On December 31, the forward contract is recognized as a liability at its fair value, with the counterpart reflected in AOCI, and discount expense is recognized due to the passage of time, with the counterpart also reflected in AOCI. The necessary journal entries are:

12/31/17 Accumulated Other Comprehensive Income (AOCI) . . . . . . 10,783

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,783

To record the forward contract as a liability at its fair value of $10,783 with a corresponding debit to AOCI (Cash Flow Hedge Step B.2. in Exhibit 9.2).

Discount Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Accumulated Other Comprehensive Income (AOCI) . . 5,000

To record straight-line allocation of the forward contract discount: $15,000 × ⅓ = $5,000 (Cash Flow Hedge Step B.4. in Exhibit 9.2).

Assets Liabilities and Stockholders’ Equity

No effect Forward contract . . . . . . . . . . . . . . . . . . . . . . . . . $10,783 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . (5,000) AOCI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,783)

$ –0–

3/1/18 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,783

Accumulated Other Comprehensive Income (AOCI) . . . 15,783

To adjust the carrying value of the forward contract to its current fair value of $5,000 with a corresponding credit to AOCI (Cash Flow Hedge Step C.1. in Exhibit 9.2).

3/1/18 Discount Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Accumulated Other Comprehensive Income (AOCI) . . . 10,000

To record straight-line allocation of the forward contract discount: $15,000 × ⅔ = $10,000 (Cash Flow Hedge Step C.2. in Exhibit 9.2).

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

To record the sale and the receipt of €1 million as an asset at the spot rate of $1.30 (Cash Flow Hedge Step C.3. in Exhibit 9.2).

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,305,000

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

To record settlement of the forward contract (receipt of $1,305,000 in exchange for delivery of €1 million) and remove the forward contract from the accounts (Cash Flow Hedge Step C.4. in Exhibit 9.2).

Accumulated Other Comprehensive Income (AOCI) . . . . . . 20,000

Adjustment to Net Income–Forecasted Transaction. . . . 20,000

To close AOCI as an adjustment to net income (Cash Flow Hedge Step C.5. in Exhibit 9.2).

Discount expense reduces 2017 net income by $5,000. The impact on the December 31, 2017, balance sheet is as follows:

On March 1, 2018, the carrying value of the forward contract is adjusted to fair value and the discount is amortized to expense. Then, the sale and the settlement of the forward contract are recorded. Finally, the balance in AOCI related to the hedge of the forecasted transaction is closed as an adjustment to net income. The following entries are required:

2018 Journal Entries—Forward Contract Hedge of a Forecasted Transaction

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Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,300,000 Discount expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (10,000) Adjustment to net income–forecasted transaction . . . . 20,000

Impact on net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,310,000

Date

Option Premium for 3/1/18

Foreign Currency Option

Fair Value Change in Fair Value

Intrinsic Value

Time Value

Change in Time Value

12/1/17 $0.009 $ 9,000 $ –0– $ –0– $9,000 $ –0– 12/31/17 0.006 6,000 − 3,000 –0– 6,000 − 3,000 3/1/18 0.020 20,000 +14,000 20,000 –0– − 6,000

As a result of these entries, the forward contract liability reported at December 31, 2017, has been reduced to zero, as has the balance in AOCI related to this forward contract.

The impact on net income for the year 2018 follows:

Over the two accounting periods, the net impact on net income is $1,305,000, which equals the amount of net cash inflow realized from the sale.

Option Designated as a Cash Flow Hedge of a Forecasted Transaction Now assume that Amerco hedges its forecasted foreign currency transaction by purchasing a 1 million euro put option on December 1, 2017. The option, which expires on March 1, 2018, has a strike price of $1.32 and a premium of $0.009 per euro. The fair value of the option at relevant dates is as follows (same as in previous examples):

2017 Journal Entries—Option Hedge of a Forecasted Transaction

12/1/17 Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

To record the purchase of the foreign currency option as an asset (Cash Flow Hedge Step A.2. in Exhibit 9.2).

There is no entry to record the forecasted sale. A memo- randum designates the foreign currency option as a hedge of the risk of changes in the cash flows related to the forecasted sale (Cash Flow Hedge Step A.1. in Exhibit 9.2).

At December 31, the carrying value of the option is decreased for the change in fair value since December 1, and the change in the time value of the option is recognized as option expense. The required journal entries are as follows:

12/31/17 Accumulated Other Comprehensive Income (AOCI) . . . . . . 3,000

Foreign Currency Option 3,000

To adjust the carrying value of the option to its fair value with a corresponding debit to AOCI (Cash Flow Hedge Step B.2. in Exhibit 9.2).

Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Accumulated Other Comprehensive Income (AOCI) . . . 3,000

To recognize the change in the time value of the option as a decrease in net income with a corresponding credit to AOCI (Cash Flow Hedge Step B.4. in Exhibit 9.2).

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3/1/18 Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000

Accumulated Other Comprehensive Income (AOCI) . . . 14,000

To adjust the carrying value of the option to its fair value with a corresponding credit to AOCI (Cash Flow Hedge Step C.1. in Exhibit 9.2).

Option Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Accumulated Other Comprehensive Income (AOCI) . . . . 6,000

To recognize the change in the time value of the option as a decrease in net income with a corresponding credit to AOCI (Cash Flow Hedge Step C.2. in Exhibit 9.2).

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

To record the sale and the receipt of €1 million as an asset at the spot rate of $1.30 (Cash Flow Hedge Step C.3. in Exhibit 9.2).

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000

Foreign Currency (€) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000

Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . 20,000

To record the exercise of the foreign currency option (receipt of $1,320,000 in exchange for delivery of €1 million) and remove the foreign currency option from the accounts (Cash Flow Hedge Step C.4. in Exhibit 9.2).

Accumulated Other Comprehensive Income (AOCI) . . . . . 20,000

Adjustment to Net Income–Forecasted Transaction. . . 20,000

To close AOCI as an adjustment to net income (Cash Flow Hedge Step C.5. in Exhibit 9.2).

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,300,000 Option expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,000) Adjustment to net income–forecasted transaction . . . . 20,000

Impact on net income . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,314,000

The impact on net income for the year 2017 follows:

Option expense . . . . . . . . . . . . . . . . . . . . . . . . . $(3,000)

Impact on net income . . . . . . . . . . . . . . . . . . $(3,000)

A foreign currency option of $6,000 is reported as an asset on the December 31, 2017, bal- ance sheet. Cash is decreased by $9,000, and Retained Earnings is decreased by $3,000.

On March 1, 2018, first the carrying value of the option is adjusted to fair value and the change in the time value of the option is recognized as option expense. Then, the sale and the exercise of the foreign currency option are recorded. Finally, the balance in AOCI related to the hedge of the forecasted transaction is closed as an adjustment to net income. The following entries are required:

2018 Journal Entries—Option Hedge of a Forecasted Transaction

The following is the impact on net income for the year 2018:

Over the two periods, a total of $1,311,000 is recognized as net income, which is equal to the net cash inflow realized from the export sale ($1,320,000 from the sale less $9,000 for the option).

Use of Hedging Instruments There are probably as many different corporate strategies regarding hedging foreign exchange risk as there are companies exposed to that risk. Some companies require hedges of all foreign currency transactions. Others require the use of a forward contract hedge when the forward

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rate results in a larger cash inflow or smaller cash outflow than with the spot rate. Still other companies have proportional hedging policies that require hedging on some predetermined percentage (e.g., 50 percent, 60 percent, or 70 percent) of transaction exposure. For example, on page 79 of its 2014 annual report, Johnson Controls, Inc., states: “The Company hedges 70% to 90% of the nominal amount of each of its known foreign exchange transactional exposures.”

Companies are required to provide information on the use of derivative financial instruments to hedge foreign exchange risk in the notes to financial statements. Exhibit 9.4 presents disclo- sures made by Abbott Laboratories in its 2014 annual report. Abbott Labs uses forward con- tracts to hedge foreign exchange risk associated with anticipated foreign currency transactions, foreign currency denominated payables and receivables, and foreign currency borrowings. Much of its hedging activity relates to intra-entity transactions involving foreign subsidiaries. The table in Exhibit 9.4 discloses that (1) Abbott’s forward contracts primarily are to sell for- eign currencies to receive U.S. dollars, (2) 49 percent of Abbott’s $15,562 million in forward contracts at December 31, 2014, was in euros, and (3) the net fair value of all the company’s forward contracts was positive and reported on the balance sheet as an asset (receivable).

Abbott Labs uses forward contracts exclusively to manage its foreign exchange risk. Thermo Fischer Scientific uses foreign currency forward contracts as well as options to hedge exposures resulting from changes in currency exchange rates. In contrast, The Coca-Cola Company employs a combination of forward contracts, currency options, and collars11 in its foreign exchange risk-hedging strategy.

11 A foreign currency collar is created by simultaneously purchasing a call option and selling a put option in a foreign currency to fix a range of prices at which the foreign currency can be purchased at a predetermined future date.

EXHIBIT 9.4 Disclosures Related to Hedging Foreign Exchange Risk in Abbott Laboratories’ 2014 Annual Report

Foreign Currency Sensitive Financial Instruments

Certain Abbott foreign subsidiaries enter into foreign currency forward exchange contracts to manage exposures to changes in foreign exchange rates for anticipated intercompany purchases by those subsidiaries whose functional currencies are not the U.S. dollar. These contracts are designated as cash flow hedges of the variability of the cash flows due to changes in for- eign exchange rates and are marked-to-market with the resulting gains or losses reflected in Accumulated other comprehen- sive income (loss). Gains or losses will be included in Cost of products sold at the time the products are sold, generally within the next twelve to eighteen months. At December 31, 2014 and 2013, Abbott held $1.5 billion and $135 million, respec- tively, of such contracts. Contracts held at December 31, 2014 will mature in 2015 or 2016 depending on the contract. Contacts held at December 31, 2013 matured in 2014.

Abbott enters into foreign currency forward exchange contracts to manage its exposure to foreign currency denominated intercompany loans and trade payables and third-party trade payables and receivables. The contracts are marked-to- market, and resulting gains or losses are reflected in income and are generally offset by losses or gains on the foreign currency exposure being managed. At December 31, 2014 and 2013, Abbott held $14.1 billion and $13.8 billion, respec- tively, of such contracts, which generally mature in the next twelve months.

The following table reflects the total foreign currency forward contracts outstanding at December 31, 2014.

(dollars in millions) Contract Amount

Weighted Average Exchange

Rate

Fair and Carrying Value Receivable/

(Payable)

Receive primarily U.S. Dollars in exchange for the following currencies: Euro $ 7,574 1.2458 $ 19 British pound 1,295 1.5790 9 Japanese yen 2,258 115.0311 56 Canadian dollar 371 1.1197 13 All other currencies 4,064 N/A 31

Total $15,562 $128

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The Euro The introduction of the euro as a common currency throughout much of Europe in 2002 reduced the need for hedging in that region of the world. For example, a German company purchasing goods from a Spanish supplier no longer has an exposure to foreign exchange risk because both countries use a common currency. This is also true for German subsidiaries of U.S. parent com- panies. However, any euro-denominated transactions between the U.S. parent and its German (or other euro zone) subsidiary continue to be exposed to foreign exchange risk.

One advantage of the euro for U.S. companies is that a euro account receivable from sales to a customer in, say, the Netherlands acts as a natural hedge of a euro account payable on purchases from, say, a supplier in Italy. Assuming that similar amounts and time periods are involved, any foreign exchange loss (gain) arising from the euro payable is offset by a foreign exchange gain (loss) on the euro receivable. A company does not need to hedge the euro account payable with a hedging instrument such as a foreign currency option.

International Financial Reporting Standard 9— Financial Instruments IFRS 9, “Financial Instruments,” provides guidance on the accounting for hedging instruments including those used to hedge foreign exchange risk. Rules and procedures in IFRS 9 related to foreign currency hedge accounting generally are consistent with U.S. GAAP. Similar to current U.S. standards, IFRS 9 allows hedge accounting for foreign currency–denominated assets and liabilities, firm commitments, and forecasted transactions when documentation requirements and effectiveness tests are met and requires hedges to be designated as cash flow or fair value hedges. While the hedge accounting models in U.S. GAAP and IFRS are based on similar principles, a number of differences exist in the application guidance pro- vided by the two sets of standards.

One difference between the two sets of standards relates to the type of financial instru- ment that can be designated as a foreign currency cash flow hedge. Under U.S. GAAP, only derivative financial instruments can be used as a cash flow hedge, whereas IFRS 9 also allows nonderivative financial instruments, such as foreign currency loans, to be designated as hedg- ing instruments in a foreign currency cash flow hedge.

The standards also differ with regard to the recognition of changes in fair value of forward contracts used as fair value hedges. IFRS 9 allows companies to choose between recognizing these changes either in net income (as is required under U.S. GAAP) or in other comprehen- sive income.

Another difference relates to the accounting for the time value of options. Under IFRS 9, the initial time value of an option must be amortized to net income on a systematic and ratio- nal (e.g., straight-line) basis. To achieve this, changes in time value are reflected initially in AOCI rather than in net income, with an amount equal to the current period’s amortization reclassified from AOCI to net income. The total amount recognized as option expense in net income will be the same under both IFRS and U.S. GAAP, but the timing of income state- ment recognition is likely to differ.

1. Several exchange rate systems are used around the world. Most national currencies fluctuate in value against other currencies over time. However, some countries have pegged their national cur- rency to the U.S. dollar.

2. Exposure to foreign exchange risk exists when a payment to be made or to be received is denomi- nated (stated) in terms of a foreign currency. Appreciation in a foreign currency results in a foreign exchange gain when the foreign currency is to be received and a foreign exchange loss when the foreign currency is to be paid. Conversely, a decrease in the value of a foreign currency results in a foreign exchange loss when the foreign currency is to be received and a foreign exchange gain when the foreign currency is to be paid.

3. Companies must revalue foreign currency assets and liabilities to their current U.S. dollar value using current exchange rates when financial statements are prepared. The change in U.S. dollar

Summary

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value of foreign currency balances is recognized as a foreign exchange gain or loss in net income in the period in which the exchange rate change occurs. This is known as the two-transaction perspec- tive, accrual approach.

4. Borrowing foreign currency creates two exposures to foreign exchange risk. Foreign exchange gains and losses both on the foreign currency note payable and on the accrued foreign currency interest payable are recognized in net income over the life of the debt.

5. IFRS rules related to the accounting for foreign currency transactions generally are consistent with U.S. GAAP. IAS 21 requires a two-transaction, accrual approach in accounting for foreign currency transactions.

6. Exposure to foreign exchange risk can be eliminated through hedging. Hedging involves establish- ing a price today at which a foreign currency to be received in the future can be sold in the future or at which a foreign currency to be paid in the future can be purchased in the future.

7. The two most popular derivative financial instruments for hedging foreign exchange risk are for- eign currency forward contracts and foreign currency options. A forward contract is a binding agreement to exchange currencies at a predetermined rate. An option gives the buyer the right, but not the obligation, to exchange currencies at a predetermined rate.

8. Hedge accounting is appropriate when three criteria are met: (1) the derivative is used to hedge either a fair value exposure or cash flow exposure to foreign exchange risk, (2) the derivative is highly effective in offsetting changes in the fair value or cash flows related to the hedged item, and (3) the derivative is properly documented as a hedge. Hedge accounting requires reporting gains and losses on the hedging instrument in net income in the same period as gains and losses on the item being hedged.

9. Companies must report all derivatives, including forward contracts and options, on the balance sheet at their fair value. Changes in fair value are included in accumulated other comprehensive income if the derivative is designated as a cash flow hedge and in net income if it is designated as a fair value hedge.

10. Authoritative accounting literature provides guidance for hedges of (a) recognized foreign currency denominated assets and liabilities, (b) unrecognized foreign currency firm commitments, and (c) forecasted foreign currency denominated transactions. Cash flow hedge accounting can be used for all three types of hedges; fair value hedge accounting can be used only for (a) and (b).

11. If a company hedges a foreign currency firm commitment and designates the hedging instrument as a fair value hedge, it should recognize gains and losses on the hedging instrument as well as on the underlying firm commitment in net income. The firm commitment account created to offset the gain or loss on firm commitment is treated as an adjustment to the underlying transaction when it takes place.

12. If a company hedges a forecasted transaction, it must designate the hedging instrument as a cash flow hedge and report changes in the fair value of the hedging instrument in accumulated other comprehensive income. The cumulative change in fair value reported in other comprehensive income is included in net income in the period in which the forecasted transaction was originally anticipated to take place.

13. Similar to U.S. GAAP, IFRS 9 allows hedge accounting for hedges of foreign currency assets and lia- bilities, firm commitments, and forecasted transactions, provided that the hedge is properly documented and is effective. Foreign currency hedging instruments are designated either as a cash flow or a fair value hedge; in either case the hedging instrument must be reported at fair value. Unlike U.S. GAAP, when a fair value hedge is designated, IFRS 9 allows fair value changes to be reported in accumulated other comprehensive income. Similarly, the change in time value of an option is reported in AOCI.

(Estimated Time: 60 to 75 minutes) Zelm Company is a U.S. company that produces electronic switches for the telecommunications industry. Zelm regularly imports component parts from a supplier located in Guadalajara, Mexico, and makes payments in Mexican pesos. The following spot exchange rates, forward exchange rates, and call option premium for Mexican pesos exist during the period August to October.

Comprehensive Illustration

Problem

U.S. Dollar per Mexican Peso

Date Spot Rate Forward Rate to October 31

Call Option Premium for October 31

(strike price $0.080)

August 1 $0.080 $0.085 $0.0052 September 30 0.086 0.088 0.0095 October 31 0.091 0.091 0.0110

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8/1 Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Accounts Payable (Mexican pesos) . . . . . . . . . . . . . 80,000 To record the purchase of parts and a peso account

payable at the spot rate of $0.080.

Part A

On August 1, Zelm imports parts from its Mexican supplier at a price of 1 million Mexican pesos. It receives the parts on August 1 but does not pay for them until October 31. In addition, on August 1, Zelm enters into a forward contract to purchase 1 million pesos on October 31. It appropriately desig- nates the forward contract as a cash flow hedge of the Mexican peso liability exposure. Zelm’s incremen- tal borrowing rate is 12 percent per annum (1 percent per month), and the company uses a straight-line method on a monthly basis for allocating forward discounts and premiums.

Part B

The facts are the same as in Part A with the exception that Zelm designates the forward contract as a fair value hedge of the Mexican peso liability exposure.

Part C

On August 1, Zelm imports parts from its Mexican supplier at a price of 1 million Mexican pesos. It receives the parts on August 1 but does not pay for them until October 31. In addition, on August 1 Zelm purchases a three-month call option on 1 million Mexican pesos with a strike price of $0.080. The option is appropriately designated as a cash flow hedge of the Mexican peso liability exposure.

Part D

On August 1, Zelm orders parts from its Mexican supplier at a price of 1 million Mexican pesos. It receives the parts and pays for them on October 31. On August 1, Zelm enters into a forward contract to purchase 1 million Mexican pesos on October 31. It designates the forward contract as a fair value hedge of the Mexican peso firm commitment. Zelm determines the fair value of the firm commitment by referring to changes in the forward exchange rate.

Part E

On August 1, Zelm orders parts from its Mexican supplier at a price of 1 million Mexican pesos. It receives the parts and pays for them on October 31. On August 1, Zelm purchases a three-month call option on 1 million Mexican pesos with a strike price of $0.080. The option is appropriately designated as a fair value hedge of the Mexican peso firm commitment. The fair value of the firm commitment is by reference to changes in the spot exchange rate.

Part F

Zelm anticipates that it will import component parts from its Mexican supplier in the near future. On August 1, Zelm purchases a three-month call option on 1 million Mexican pesos with a strike price of $0.080. It appropriately designates the option as a cash flow hedge of a forecasted Mexican peso trans- action. Zelm receives and pays for parts costing 1 million Mexican pesos on October 31.

Required Prepare journal entries for each of these independent situations in accordance with U.S. GAAP and determine the impact each situation has on the September 30 and October 31 trial balances.

Solution Part A. Forward Contract Cash Flow Hedge of a Recognized Foreign Currency Liability

The forward contract requires no formal entry. Zelm prepares a memorandum to designate the for- ward contract as a hedge of the risk of changes in the cash flow to be paid on the foreign currency pay- able resulting from changes in the U.S. dollar–Mexican peso exchange rate.

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Zelm determines the fair value of the forward contract by referring to the change in the forward rate for a contract that settles on October 31: ($0.088 − $0.085) × 1 million pesos = $3,000. The present value of $3,000 discounted for one month (from October 31 to September 30) at an interest rate of 12 percent per year (1 percent per month) is calculated as follows: $3,000 × 0.9901 = $2,970.

9/30 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Accounts Payable (Mexican pesos) . . . . . . . . . . . . 6,000 To adjust the value of the Mexican peso payable to

the new spot rate of $0.086 and record a foreign exchange loss resulting from the appreciation of the peso since August 1.

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,970 Accumulated Other Comprehensive

Income (AOCI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,970 To record the forward contract as an asset at its fair

value of $2,970 with a corresponding credit to AOCI.

Accumulated Other Comprehensive Income (AOCI) . . . . 6,000 Gain on Forward Contract. . . . . . . . . . . . . . . . . . . . . . . 6,000 To record a gain on forward contract to offset the foreign

exchange loss on account payable with a corresponding debit to AOCI.

Premium Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,333 Accumulated Other Comprehensive Income (AOCI) . . . 3,333 To allocate the forward contract premium to income over

the life of the contract using a straight-line method on a monthly basis ($5,000 × ⅔ = $3,333).

The original premium on the forward contract is determined by the difference in the peso spot rate and three-month forward rate on August 1: ($0.085 − $0.080) × 1 million pesos = $5,000.

Trial Balance—September 30 Debit Credit

Parts inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 $ –0– Accounts Payable (Mexican pesos) . . . . . . . . . . . . . . . 86,000 Forward Contract (asset) . . . . . . . . . . . . . . . . . . . . . . . . . 2,970 AOCI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303 Foreign exchange loss . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Gain on forward contract . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Premium expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,333 –0–

$92,303 $92,303

10/31 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 Accounts Payable (Mexican pesos) . . . . . . . . . . . . 5,000 To adjust the value of the Mexican peso payable to

the new spot rate of $0.091 and record a foreign exchange loss resulting from the appreciation of the peso since September 30.

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,030 Accumulated Other Comprehensive Income

(AOCI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,030 To adjust the carrying value of the forward contract to

its current fair value of $6,000 with a corresponding credit to AOCI.

The current fair value of the forward contract is determined by referring to the difference in the spot rate on October 31 and the original forward rate: ($0.091 − $0.085) × 1 million pesos = $6,000. The forward contract adjustment on October 31 is calculated as the difference in the current fair value and the carry- ing value at September 30: $6,000 − $2,970 = $3,030.

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Part B. Forward Contract Fair Value Hedge of a Recognized Foreign Currency Liability

Accumulated Other Comprehensive Income (AOCI) . . . . . 5,000 Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . 5,000 To record a gain on forward contract to offset the for-

eign exchange loss on account payable with a corre- sponding debit to AOCI.

Premium Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,667 Accumulated Other Comprehensive Income (AOCI) . . 1,667 To allocate the forward contract premium to income

over the life of the contract using a straight-line method on a monthly basis ($5,000 × ⅓ = $1,667).

Foreign Currency (Mexican pesos) . . . . . . . . . . . . . . . . . . . . 91,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 To record settlement of the forward contract: Record

payment of $85,000 in exchange for 1 million pesos, record the receipt of 1 million pesos as an asset at the spot rate of $0.091, and remove the forward contract from the accounts.

Accounts Payable (pesos) . . . . . . . . . . . . . . . . . . . . . . . . . . . 91,000 Foreign Currency (pesos) . . . . . . . . . . . . . . . . . . . . . . . . 91,000 To record remittance of 1 million pesos to the Mexican

supplier.

8/1 Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Accounts Payable (Mexican pesos) . . . . . . . . . . . . 80,000 To record the purchase of parts and a Mexican peso

account payable at the spot rate of $0.080.

The forward contract requires no formal entry. A memorandum designates the forward contract as a hedge of the risk of changes in the cash flow to be paid on the foreign currency payable resulting from changes in the U.S. dollar–peso exchange rate.

9/30 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Accounts Payable (Mexican pesos) . . . . . . . . . . . . . . 6,000 To adjust the value of the peso payable to the new

spot rate of $0.086 and record a foreign exchange loss resulting from the appreciation of the peso since August 1.

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,970 Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . 2,970 To record the forward contract as an asset at its fair

value of $2,970 and record a forward contract gain for the change in the fair value of the forward contract since August 1.

Trial Balance—October 31 Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $85,000 Parts inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 –0– Retained earnings, 9/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,333 –0– Foreign exchange loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 –0– Gain on forward contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– 5,000 Premium expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,667 –0–

$90,000 $90,000

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Trial Balance—October 31 Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ –0– $85,000 Parts inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 –0– Retained earnings, 9/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,030 –0– Foreign exchange loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 –0– Gain on forward contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– 3,030

$88,030 $88,030

Trial Balance—September 30 Debit Credit

Parts inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 $ –0– Accounts payable (Mexican pesos) . . . . . . . . . . . . . . . . . . . . . 86,000 Forward contract (asset). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,970 –0– Foreign exchange loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 –0– Gain on forward contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– 2,970

$88,970 $88,970

10/31 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 Accounts Payable (Mexican pesos). . . . . . . . . . . . . . 5,000 To adjust the value of the peso payable to the new

spot rate of $0.091 and record a foreign exchange loss resulting from the appreciation of the peso since Sep- tember 30.

Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,030 Gain on Forward Contract. . . . . . . . . . . . . . . . . . . . . . 3,030 To adjust the carrying value of the forward contract to

its current fair value of $6,000 and record a forward contract gain for the change in fair value since Septem- ber 30.

Foreign Currency (Mexican pesos) . . . . . . . . . . . . . . . . . . 91,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 To record settlement of the forward contract: Record

payment of $85,000 in exchange for 1 million pesos, record the receipt of 1 million pesos as an asset at the spot rate of $0.091, and remove the forward contract from the accounts.

Accounts Payable (pesos) . . . . . . . . . . . . . . . . . . . . . . . . . . 91,000 Foreign Currency (pesos) . . . . . . . . . . . . . . . . . . . . . . 91,000 To record remittance of 1 million pesos to the Mexican

supplier.

Part C. Option Cash Flow Hedge of a Recognized Foreign Currency Liability

The following schedule summarizes the changes in the components of the fair value of the peso call option with a strike price of $0.080:

Date Spot Rate

Option Premium

Fair Value

Change in Fair Value

Intrinsic Value

Time Value

Change in Time Value

8/1 $0.080 $0.0052 $ 5,200 $ –0– $ –0– $5,200* $ –0– 9/30 0.086 0.0095 9,500 +4,300 6,000† 3,500† − 1,700 10/31 0.091 0.0110 11,000 +1,500 11,000 –0–‡ − 3,500

*Because the strike price and spot rate are the same, the option has no intrinsic value. Fair value is attributable solely to the time value of the option. †With a spot rate of $0.086 and a strike price of $0.08, the option has an intrinsic value of $6,000. The remaining $3,500 of fair value is attributable to time value. ‡The time value of the option at maturity is zero.

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8/1 Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Accounts Payable (Mexican pesos) . . . . . . . . . . . . . . . 80,000 To record the purchase of parts and a peso account pay-

able at the spot rate of $0.080. Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,200 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,200 To record the purchase of a foreign currency option as an

asset. 9/30 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Accounts Payable (pesos) . . . . . . . . . . . . . . . . . . . . . . . 6,000 To adjust the value of the peso payable to the new spot

rate of $0.086 and record a foreign exchange loss result- ing from the appreciation of the peso since August 1.

Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,300 Accumulated Other Comprehensive Income (AOCI). . . 4,300 To adjust the fair value of the option from $5,200 to

$9,500 with a corresponding credit to AOCI. Accumulated Other Comprehensive Income (AOCI) . . . . . 6,000 Gain on Foreign Currency Option . . . . . . . . . . . . . . . . 6,000 To record a gain on forward currency option to offset the

foreign exchange loss on account payable with a corre- sponding debit to AOCI.

Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 Accumulated Other Comprehensive Income (AOCI) . . 1,700 To recognize the change in the time value of the foreign

currency option as an expense with a corresponding credit to AOCI.

Trial Balance—September 30 Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,200 Parts inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 –0– Foreign currency option (asset) . . . . . . . . . . . . . . . . . . . . . . . 9,500 –0– Accounts payable (Mexican pesos) . . . . . . . . . . . . . . . . . . . . –0– 86,000 Foreign exchange loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 –0– Gain on foreign currency option . . . . . . . . . . . . . . . . . . . . . . –0– 6,000 Option expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 –0–

$97,200 $97,200

10/31 Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 Accounts Payable (Mexican pesos). . . . . . . . . . . . . . . . . 5,000 To adjust the value of the peso payable to the new spot

rate of $0.091 and record a foreign exchange loss resulting from the appreciation of the peso since September 30.

Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 Accumulated Other Comprehensive Income (AOCI) . . 1,500 To adjust the carrying value of the foreign currency option

to its current fair value of $11,000 with a corresponding credit to AOCI.

Accumulated Other Comprehensive Income (AOCI) . . . . . . 5,000 Gain on Foreign Currency Option . . . . . . . . . . . . . . . . . . . . 5,000 To record a gain on foreign currency option to offset the

foreign exchange loss on account payable with a corre- sponding debit to AOCI.

Option Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 Accumulated Other Comprehensive Income (AOCI). . . 3,500 To recognize the change in the time value of the foreign

currency option as an expense with a corresponding credit to AOCI.

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Foreign Currency (Mexican pesos) . . . . . . . . . . . . . . . . . . . . . 91,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . . 11,000 To record exercise of the foreign currency option: Record

payment of $80,000 in exchange for 1 million pesos, record the receipt of 1 million pesos as an asset at the spot rate of $0.091, and remove the option from the accounts.

Accounts Payable (pesos) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91,000 Foreign Currency (pesos) . . . . . . . . . . . . . . . . . . . . . . . . . 91,000 To record remittance of 1 million pesos to the Mexican

supplier.

Trial Balance—October 31 Debit Credit

Cash ($5,200 credit balance + $80,000 credit). . . . . . . . . $ –0– $85,200 Parts inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 –0– Retained earnings, 9/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 –0– Foreign exchange loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 –0– Gain on foreign currency option . . . . . . . . . . . . . . . . . . . . . . –0– 5,000 Option expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 –0–

$90,200 $90,200

Part D. Forward Contract Fair Value Hedge of a Foreign Currency Firm Commitment

8/1 The forward contract or the purchase order requires no for- mal entry. A memorandum would be prepared designating the forward contract as a fair value hedge of the foreign cur- rency firm commitment.

9/30 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,970 Gain on Forward Contract. . . . . . . . . . . . . . . . . . . . . . . . 2,970 To record the forward contract as an asset at its fair

value of $2,970 and record a forward contract gain for the change in the fair value of the forward contract since August 1.

Loss on Firm Commitment. . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,970 Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,970 To record the firm commitment as a liability at its fair value

of $2,970 based on changes in the forward rate and record a firm commitment loss for the change in fair value since August 1.

Trial Balance—September 30 Debit Credit

Forward contract (asset). . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,970 $ –0– Firm commitment (liability) . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– 2,970 Gain on forward contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– 2,970 Loss on firm commitment. . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,970 –0–

$5,940 $5,940

10/31 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,030 Gain on Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . 3,030 To adjust the carrying value of the forward contract to its

current fair value of $6,000 and record a forward contract gain for the change in fair value since September 30.

Loss on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,030 Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,030 To adjust the value of the firm commitment to $6,000 based

on changes in the forward rate and record a firm commit- ment loss for the change in fair value since September 30.

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Foreign Currency (Mexican pesos) . . . . . . . . . . . . . . . . . . . . . 91,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000 Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 To record settlement of the forward contract: Record pay-

ment of $85,000 in exchange for 1 million pesos, record the receipt of 1 million pesos as an asset at the spot rate of $0.091, and remove the forward contract from the accounts.

Parts Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91,000 Foreign Currency (Mexican pesos) . . . . . . . . . . . . . . . . . 91,000 To record the purchase of parts through the payment of

1 million pesos to the Mexican supplier. Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Adjustment to Net Income–Firm Commitment . . . . . . . 6,000 To close the firm commitment account as an adjustment to

net income.

(Note: The final entry to close the Firm Commitment account to Adjustment to Net Income must be made only in the period in which Parts Inventory affects net income through Cost of Goods Sold. The Firm Commitment account remains on the books as a liability until that point in time.)

Trial Balance—October 31 Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ –0– $85,000 Parts inventory (cost of goods sold) . . . . . . . . . . . . . . . . . . . 91,000 –0– Gain on forward contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– 3,030 Loss on firm commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,030 –0– Adjustment to net income–firm commitment . . . . . . . . . . . –0– 6,000

$94,030 $94,030

Part E. Option Fair Value Hedge of a Foreign Currency Firm Commitment

8/1 Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . . . 5,200 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,200 To record the purchase of a foreign currency option as

an asset. 9/30 Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . . . 4,300

Gain on Foreign Currency Option . . . . . . . . . . . . . . . 4,300 To adjust the fair value of the option from $5,200 to

$9,500 and record an option gain for the change in fair value since August 1.

Loss on Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . 5,940 Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,940 To record the firm commitment as a liability at its fair

value of $5,940 based on changes in the spot rate and record a firm commitment loss for the change in fair value since August 1.

The fair value of the firm commitment is determined by referring to changes in the spot rate from August 1 to September 30: ($0.080 − $0.086) × 1 million pesos = $(6,000). This amount must be dis- counted for one month at 12 percent per annum (1 percent per month): $(6,000) × 0.9901 = $(5,940).

Trial Balance—September 30 Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ –0– $ 5,200 Foreign currency option (asset) . . . . . . . . . . . . . . . . . . . . . . . . 9,500 –0– Firm commitment (liability) . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– 5,940 Gain on foreign currency option . . . . . . . . . . . . . . . . . . . . . . . –0– 4,300 Loss on firm commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,940 –0–

$15,440 $15,440

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10/31 Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 Gain on Foreign Currency Option . . . . . . . . . . . . . . . . . . 1,500 To adjust fair value of the option from $9,500 to $11,000

and record an option gain for the change in fair value since September 30.

Loss on Firm Commitment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,060 Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,060 To adjust the fair value of the firm commitment from $5,940

to $11,000 and record a firm commitment loss for the change in fair value since September 30.

The fair value of the firm commitment is determined by referring to changes in the spot rate from August 1 to October 31: ($0.080 − $0.091) × 1 million pesos = $(11,000).

payment of $80,000 in exchange for 1 million pesos, record the receipt of 1 million pesos as an asset at the spot rate of $0.091, and remove the option from the accounts.

Parts Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91,000 Foreign Currency (pesos) . . . . . . . . . . . . . . . . . . . . . . . . . 91,000 To record the purchase of parts through the payment of

1 million pesos to the Mexican supplier. Firm Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000 Adjustment to Net Income–Firm Commitment . . . . . . . 11,000 To close Firm Commitment account to Adjustment to Net

Income.

(Note: The final entry to close the Firm Commitment to Adjustment to Net Income is made only in the period in which Parts Inventory affects net income through Cost of Goods Sold. The Firm Commitment account remains on the books as a liability until that point in time.)

Trial Balance—October 31 Debit Credit

Cash ($5,200 credit balance + $80,000 credit). . . . . . . . . . $ –0– $85,200 Parts inventory (cost of goods sold) . . . . . . . . . . . . . . . . . . . . 91,000 –0– Retained earnings, 9/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,640 –0– Gain on foreign currency option . . . . . . . . . . . . . . . . . . . . . . . –0– 1,500 Loss on firm commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,060 –0– Adjustment to net income–firm commitment . . . . . . . . . . . . –0– 11,000

$97,700 $97,700

Part F. Option Cash Flow Hedge of a Forecasted Foreign Currency Transaction

8/1 Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,200 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,200 To record the purchase of a foreign currency option as an

asset. 9/30 Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,300

Accumulated Other Comprehensive Income (AOCI) . . . 4,300 To adjust the fair value of the option from $5,200 to

$9,500 with a corresponding adjustment to AOCI. Option Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 Accumulated Other Comprehensive Income (AOCI) . . . 1,700 To recognize the change in the time value of the foreign

currency option as an expense with a corresponding credit to AOCI.

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(Note: The final entry to close AOCI to Adjustment to Net Income is made at the date that the forecasted transaction was expected to occur, regardless of when the parts inventory affects net income.)

Trial Balance—September 30 Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ –0– $ 5,200 Foreign currency option (asset) . . . . . . . . . . . . . . . . . . . . . . 9,500 –0– Accumulated other comprehensive income . . . . . . . . . . . –0– 6,000 Option expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 –0–

$11,200 $11,200

10/31 Foreign Currency Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500 Accumulated Other Comprehensive Income (AOCI) . . 1,500 To adjust the fair value of the option from $9,500 to

$11,000 with a corresponding adjustment to AOCI. Option Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 Accumulated Other Comprehensive Income (AOCI) . . 3,500 To recognize the change in the time value of the foreign

currency option as an expense with a corresponding credit to AOCI.

payment of $80,000 in exchange for 1 million pesos, record the receipt of 1 million pesos as an asset at the spot rate of $0.091, and remove the option from the accounts.

Parts Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91,000 Foreign Currency (Mexican pesos) . . . . . . . . . . . . . . . . . 91,000 To record the purchase of parts through the payment of

1 million pesos to the Mexican supplier. Accumulated Other Comprehensive Income (AOCI) . . . . . . 11,000 Adjustment to Net Income–Forecasted Transaction . . 11,000 To close AOCI as an adjustment to net income.

Trial Balance—October 31 Debit Credit

Cash ($5,200 credit balance + $80,000 credit). . . . . . . . . . $ –0– $85,200 Parts inventory (cost of goods sold) . . . . . . . . . . . . . . . . . . . . 91,000 –0– Retained earnings, 9/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 –0– Foreign currency option expense . . . . . . . . . . . . . . . . . . . . . . 3,500 –0– Adjustment to net income–forecasted transaction . . . . . . . –0– 11,000

$96,200 $96,200

Questions 1. What concept underlies the two-transaction perspective in accounting for foreign currency transactions?

2. A company makes an export sale denominated in a foreign currency and allows the customer one month to pay. Under the two-transaction perspective, accrual approach, how does the company account for fluctuations in the exchange rate for the foreign currency?

3. What factors create a foreign exchange gain on a foreign currency transaction? What factors create a foreign exchange loss?

4. In what way is the accounting for a foreign currency borrowing more complicated than the account- ing for a foreign currency account payable?

5. What does the term hedging mean? Why do companies elect to follow this strategy? 6. How does a foreign currency option differ from a foreign currency forward contract? 7. How does the timing of hedges of (a) foreign currency denominated assets and liabilities, (b) for-

eign currency firm commitments, and (c) forecasted foreign currency transactions differ?

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8. Why would a company prefer a foreign currency option over a forward contract in hedging a for- eign currency firm commitment? Why would a company prefer a forward contract over an option in hedging a foreign currency asset or liability?

9. How do companies report foreign currency derivatives, such as forward contracts and options, on the balance sheet?

10. How does a company determine the fair value of a foreign currency forward contract? How does it determine the fair value of an option?

11. What is hedge accounting? 12. Under what conditions can companies use hedge accounting to account for a foreign currency

option used to hedge a forecasted foreign currency transaction? 13. What are the differences in accounting for a forward contract used as (a) a cash flow hedge and

(b) a fair value hedge of a foreign currency denominated asset or liability? 14. What are the differences in accounting for a forward contract used as a fair value hedge of (a) a

foreign currency denominated asset or liability and (b) a foreign currency firm commitment? 15. What are the differences in accounting for a forward contract used as a cash flow hedge of (a) a

foreign currency denominated asset or liability and (b) a forecasted foreign currency transaction? 16. How are changes in the fair value of an option accounted for in a cash flow hedge? In a fair value

hedge?

Problems 1. Which of the following combinations correctly describes the relationship between foreign currency transactions, exchange rate changes, and foreign exchange gains and losses?

LO 9-1

Type of Transaction Foreign Currency Foreign Exchange

Gain or Loss

a. Export sale Appreciates Loss b. Import purchase Appreciates Gain c. Import purchase Depreciates Gain d. Export sale Depreciates Gain

2. In accounting for foreign currency transactions, which of the following approaches is used in the United States? a. One-transaction perspective; accrue foreign exchange gains and losses. b. One-transaction perspective; defer foreign exchange gains and losses. c. Two-transaction perspective; defer foreign exchange gains and losses. d. Two-transaction perspective; accrue foreign exchange gains and losses.

3. On October 1, 2017, Tile Co., a U.S. company, purchased products from Azulejo, a Portuguese company, with payment due on December 1, 2017. If Tile’s 2017 operating income included no foreign exchange gain or loss, the transaction could have a. Been denominated in U.S. dollars. b. Resulted in an unusual gain. c. Generated a foreign exchange gain to be reported as a deferred charge on the balance sheet. d. Generated a foreign exchange loss to be reported as a separate component of stockholders’

equity. 4. Brief, Inc., had a receivable from a foreign customer that is payable in the customer’s local cur-

rency. On December 31, 2017, Brief correctly included this receivable for 200,000 local currency units (LCU) in its balance sheet at $110,000. When Brief collected the receivable on February 15, 2018, the U.S. dollar equivalent was $120,000. In Brief’s 2018 consolidated income statement, how much should it report as a foreign exchange gain? a. $–0– b. $10,000 c. $15,000 d. $25,000

LO 9-2

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5. On July 1, 2017, Mifflin Company borrowed 200,000 euros from a foreign lender evidenced by an interest-bearing note due on July 1, 2018. The note is denominated in euros. The U.S. dollar equiva- lent of the note principal is as follows:

LO 9-2, 9-3

Date Amount

July 1, 2017 (date borrowed) . . . . . . . . . . . . . . . . . . . . . . . . . $225,000 December 31, 2017 (Mifflin’s year-end) . . . . . . . . . . . . . . . . 220,000 July 1, 2018 (date repaid) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210,000

In its 2018 income statement, what amount should Mifflin include as a foreign exchange gain or loss on the note? a. $15,000 gain b. $15,000 loss c. $10,000 gain d. $10,000 loss

6. Grace Co. had a Chinese yuan payable resulting from imports from China and a Mexican peso receivable resulting from exports to Mexico. Grace recorded foreign exchange losses related to both its yuan payable and peso receivable. Did the foreign currencies increase or decrease in dollar value from the date of the transaction to the settlement date?

LO 9-1, 9-2

Yuan Peso

a. Increase Increase b. Increase Decrease c. Decrease Increase d. Decrease Decrease

7. Matthias Corp. had the following foreign currency transactions during 2017: ∙ Purchased merchandise from a foreign supplier on January 20 for the U.S. dollar equivalent of

$60,000 and paid the invoice on April 20 at the U.S. dollar equivalent of $50,000. ∙ On September 1, borrowed the U.S. dollar equivalent of $300,000 evidenced by a note that is

payable in the lender’s local currency in one year. On December 31, the U.S. dollar equivalent of the principal amount was $320,000.

In Matthias’s 2017 income statement, what amount should be included as a net foreign exchange gain or loss? a. $10,000 gain b. $10,000 loss c. $20,000 gain d. $30,000 loss

8. A U.S. exporter has a Thai baht account receivable resulting from an export sale on June 1 to a customer in Thailand. The exporter signed a forward contract on June 1 to sell Thai baht and desig- nated it as a cash flow hedge of a recognized Thai baht receivable. The spot rate was $0.022 on that date, and the forward rate was $0.021. Which of the following did the U.S. exporter report in net income? a. Discount expense b. Discount revenue c. Premium expense d. Premium revenue

9. St. Philip Company ordered parts costing €100,000 from a foreign supplier on January 15 when the spot rate was $0.20 per €. A one-month forward contract was signed on that date to purchase €100,000 at a forward rate of $0.23. The forward contract is properly designated as a fair value hedge of the €100,000 firm commitment. On February 15, when the company receives the parts, the spot rate is $0.22. At what amount should St. Philip Company carry the parts inventory on its books? a. $20,000 b. $21,000 c. $22,000 d. $23,000

LO 9-2, 9-3

LO 9-7

LO 9-8

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10. On December 1, 2017, Ringling Company (a U.S.-based company) entered into a three-month for- ward contract to purchase 1,000,000 pesos on March 1, 2018. The following U.S. dollar per peso exchange rates apply:

LO 9-5

Date Spot Rate Forward Rate

(to March 1, 2018)

December 1, 2017 $0.044 $0.047 December 31, 2017 0.046 0.049 March 1, 2018 0.050 N/A

Ringling’s incremental borrowing rate is 12 percent. The present value factor for two months at an annual interest rate of 12 percent (1 percent per month) is 0.9803.

Which of the following correctly describes the manner in which Ringling Company will report the forward contract on its December 31, 2017, balance sheet? a. As an asset in the amount of $1,960.60. b. As an asset in the amount of $2,940.90. c. As a liability in the amount of $980.30. d. As a liability in the amount of $2,940.90.

Use the following information for Problems 11 and 12. MNC Corp. (a U.S.-based company) sold parts to a South Korean customer on December 1, 2017, with payment of 10 million South Korean won to be received on March 31, 2018. The following exchange rates apply:

Date Spot Rate Forward Rate

(to March 31, 2018)

December 1, 2017 $0.0035 $0.0034 December 31, 2017 0.0033 0.0032 March 31, 2018 0.0038 N/A

MNC’s incremental borrowing rate is 12 percent. The present value factor for three months at an annual interest rate of 12 percent (1 percent per month) is 0.9706. 11. Assuming that MNC did not enter into a forward contract, how much foreign exchange gain or loss

should it report on its 2017 income statement with regard to this transaction? a. $5,000 gain b. $3,000 gain c. $2,000 loss d. $1,000 loss

12. Assuming that MNC entered into a forward contract to sell 10 million South Korean won on December 1, 2017, as a fair value hedge of a foreign currency receivable, what is the net impact on its net income in 2017 resulting from a fluctuation in the value of the won? a. No impact on net income. b. $58.80 decrease in net income. c. $2,000 decrease in net income. d. $1,941.20 increase in net income.

13. On March 1, Pimlico Corporation (a U.S.-based company) expects to order merchandise from a supplier in Sweden in three months. On March 1, when the spot rate is $0.10 per Swedish krona, Pimlico enters into a forward contract to purchase 500,000 Swedish kroner at a three-month for- ward rate of $0.12. At the end of three months, when the spot rate is $0.115 per Swedish krona, Pimlico orders and receives the merchandise, paying 500,000 kroner. What amount does Pimlico report in net income as a result of this cash flow hedge of a forecasted transaction? a. $10,000 premium expense plus a $7,500 positive adjustment to net income when the merchan-

dise is purchased. b. $10,000 Discount expense plus a $5,000 positive adjustment to net income when the merchan-

dise is purchased.

LO 9-2

LO 9-7

LO 9-9

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c. $2,500 premium expense plus a $5,000 negative adjustment to net income when the merchan- dise is purchased.

d. $2,500 premium expense plus a $2,500 positive adjustment to net income when the merchan- dise is purchased.

14. Torres Corporation (a U.S.-based company) expects to order goods from a foreign supplier at a price of 100,000 pounds, with delivery and payment to be made on September 20. On July 20, Torres pur- chased a two-month call option on 100,000 pounds and designated this option as a cash flow hedge of a forecasted foreign currency transaction. The option has a strike price of $1.25 per pound and costs $600. The spot rate for pounds is $1.25 on June 20 and $1.30 on September 20. What amount will Torres Corporation report as an option expense in net income for the quarter ended September 30? a. $300 b. $600 c. $2,000 d. $5,000

Use the following information for Problems 15 through 17. On September 1, 2017, Jensen Company received an order to sell a machine to a customer in Canada at a price of 100,000 Canadian dollars. Jensen shipped the machine and received payment on March 1, 2018. On September 1, 2017, Jensen purchased a put option giving it the right to sell 100,000 Canadian dollars on March 1, 2018, at a price of $80,000. Jensen properly designated the option as a fair value hedge of the Canadian dollar firm commitment. The option cost $2,000 and had a fair value of $2,300 on December 31, 2017. The fair value of the firm commitment was measured by referring to changes in the spot rate. The following spot exchange rates apply:

LO 9-9

Date U.S. Dollar per

Canadian Dollar

September 1, 2017 $0.80 December 31, 2017 0.79 March 1, 2018 0.77

Jensen Company’s incremental borrowing rate is 12 percent. The present value factor for two months at an annual interest rate of 12 percent (1 percent per month) is 0.9803. 15. What was the net impact on Jensen Company’s 2017 income as a result of this fair value hedge of a

firm commitment? a. $–0–. b. $680.30 decrease in income. c. $300 increase in income. d. $980.30 increase in income.

16. What was the net impact on Jensen Company’s 2018 income as a result of this fair value hedge of a firm commitment? a. $–0–. b. $1,319.70 decrease in income. c. $77,980.30 increase in income. d. $78,680.30 increase in income.

17. What was the net increase or decrease in cash flow from having purchased the foreign currency option to hedge this exposure to foreign exchange risk? a. $–0–. b. $1,000 increase in cash flow. c. $1,500 decrease in cash flow. d. $3,000 increase in cash flow.

Use the following information for Problems 18 through 20. On June 1, 2017, Micro Corp. received an order for parts from a Mexican customer at a price of 1,000,000 Mexican pesos with a delivery date of July 31, 2017. On June 1, when the U.S. dollar–Mexican peso

LO 9-8

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spot rate is $0.115, Micro Corp. entered into a two-month forward contract to sell 1,000,000 pesos at a forward rate of $0.12 per peso. Micro designates the forward contract as a fair value hedge of the firm commitment to receive pesos, and the fair value of the firm commitment is measured by referring to changes in the peso forward rate. Micro delivers the parts and receives payment on July 31, 2017, when the peso spot rate is $0.118. On June 30, 2017, the Mexican peso spot rate is $0.123, and the forward contract has a fair value of $2,400. 18. What is the net impact on Micro’s net income for the quarter ended June 30, 2017, as a result of this

forward contract hedge of a firm commitment? a. $–0–. b. $2,400 increase in net income. c. $4,000 decrease in net income. d. $8,000 increase in net income.

19. What is the net impact on Micro’s net income for the quarter ended September 30, 2017, as a result of this forward contract hedge of a firm commitment? a. $–0–. b. $115,000 increase in net income. c. $118,000 increase in net income. d. $120,000 increase in net income.

20. What is Micro’s net increase or decrease in cash flow from having entered into this forward contract hedge? a. $–0–. b. $1,000 increase in cash flow. c. $1,500 decrease in cash flow. d. $2,000 increase in cash flow.

Use the following information for Problems 21 and 22. On November 1, 2017, Dos Santos Company forecasts the purchase of raw materials from a Brazil- ian supplier on February 1, 2018, at a price of 200,000 Brazilian reals. On November 1, 2017, Dos Santos pays $1,500 for a three-month call option on 200,000 reals with a strike price of $0.40 per real. Dos Santos properly designates the option as a cash flow hedge of a forecasted foreign cur- rency transaction. On December 31, 2017, the option has a fair value of $1,100. The following spot exchange rates apply:

LO 9-8

Date U.S. Dollar per Brazilian Real

November 1, 2017 $0.40 December 31, 2017 0.38 February 1, 2018 0.41

21. What is the net impact on Dos Santos Company’s 2017 net income as a result of this hedge of a forecasted foreign currency transaction? a. $–0–. b. $400 decrease in net income. c. $1,000 decrease in net income. d. $1,400 decrease in net income.

22. What is the net impact on Dos Santos Company’s 2018 net income as a result of this hedge of a forecasted foreign currency transaction? Assume that the raw materials are consumed and become a part of the cost of goods sold in 2018. a. $80,000 decrease in net income. b. $80,600 decrease in net income. c. $81,100 decrease in net income. d. $83,100 decrease in net income.

LO 9-9

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23. Turbo Corporation (a U.S.-based company) acquired merchandise on account from a foreign sup- plier on November 1, 2017, for 100,000 markkas. It paid the foreign currency account payable on January 17, 2018. The following exchange rates for 1 markka are known:

LO 9-2

November 1, 2017 $0.754 December 31, 2017 0.742 January 15, 2018 0.747

a. How does the fluctuation in exchange rates affect Turbo’s 2017 income statement? b. How does the fluctuation in exchange rates affect Turbo’s 2018 income statement?

24. On December 20, 2017, Butanta Company (a U.S. company headquartered in Miami, Florida) sold parts to a foreign customer at a price of 50,000 ostras. Payment is received on January 10, 2018. Currency exchange rates for 1 ostra are as follows:

LO 9-2

December 20, 2017 $1.05 December 31, 2017 1.02 January 10, 2018 0.98

a. How does the fluctuation in exchange rates affect Butanta’s 2017 income statement? b. How does the fluctuation in exchange rates affect Butanta’s 2018 income statement?

25. Peerless Corporation (a U.S. company) made a sale to a foreign customer on September 15, for 100,000 crowns. It received payment on October 15. The following exchange rates for 1 crown apply:

LO 9-2

September 15 $0.60 September 30 0.66 October 15 0.62

Prepare all journal entries for Peerless in connection with this sale, assuming that the company closes its books on September 30 to prepare interim financial statements.

26. On December 15, 2017, Lisbeth Inc. (a U.S. company) purchases merchandise inventory from a foreign supplier for 50,000 schillings. Lisbeth agrees to pay in 45 days after it sells the merchan- dise. Lisbeth makes sales rather quickly and pays the entire obligation on January 25, 2018. Cur- rency exchange rates for 1 schilling are as follows:

LO 9-2

March 1 Bought inventory costing 100,000 pesos on credit. May 1 Sold 60 percent of the inventory for 80,000 pesos on credit. August 1 Collected 70,000 pesos from customers. September 1 Paid 60,000 pesos to suppliers.

December 15, 2017 $0.28 December 31, 2017 0.30 January 25, 2018 0.33 January 31, 2018 0.34

Prepare all journal entries for Lisbeth Company in connection with this purchase and payment. 27. Voltac Corporation (a U.S. company located in Charlotte, North Carolina) has the following import/

export transactions denominated in Mexican pesos in 2017: LO 9-2

Currency exchange rates for 1 peso for 2017 are as follows:

March 1 $0.10 May 1 0.12 August 1 0.13 September 1 0.14 December 31 0.15

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For each of the following accounts, how much will Voltac report on its 2017 financial statements? a. Inventory. b. Cost of Goods Sold. c. Sales. d. Accounts Receivable. e. Accounts Payable. f. Cash.

28. On April 1, 2017, Mendoza Company borrowed 500,000 euros for one year at an interest rate of 5 percent per annum. Mendoza must make its first interest payment on the loan on October 1, 2017, and will make a second interest payment on March 31, 2018, when the loan is repaid. Mendoza prepares U.S.-dollar financial statements and has a December 31 year-end. Prepare all journal entries related to this foreign currency borrowing assuming the following exchange rates for 1 euro:

LO 9-3

September 30, 2017 $0.100 December 31, 2017 0.105 September 30, 2018 0.120 December 31, 2018 0.125 September 30, 2019 0.150

April 1, 2017 $1.10 October 1, 2017 1.20 December 31, 2017 1.24 March 31, 2018 1.28

29. Benjamin, Inc., operates an export/import business. The company has considerable dealings with companies in the country of Camerrand. The denomination of all transactions with these companies is alaries (AL), the Camerrand currency. During 2017, Benjamin acquires 20,000 widgets at a price of 8 alaries per widget. It will pay for them when it sells them. Currency exchange rates for 1 AL are as follows:

LO 9-2

September 1, 2017 $0.46 December 1, 2017 0.44 December 31, 2017 0.48 March 1, 2018 0.45

a. Assume that Benjamin acquired the widgets on December 1, 2017, and made payment on March 1, 2018. What is the effect of the exchange rate fluctuations on reported income in 2017 and in 2018?

b. Assume that Benjamin acquired the widgets on September 1, 2017, and made payment on December 1, 2017. What is the effect of the exchange rate fluctuations on reported income in 2017?

c. Assume that Benjamin acquired the widgets on September 1, 2017, and made payment on March 1, 2018. What is the effect of the exchange rate fluctuations on reported income in 2017 and in 2018?

30. On September 30, 2017, Ericson Company negotiated a two-year, 1,000,000 dudek loan from a for- eign bank at an interest rate of 2 percent per year. It makes interest payments annually on Septem- ber 30 and will repay the principal on September 30, 2019. Ericson prepares U.S.-dollar financial statements and has a December 31 year-end. a. Prepare all journal entries related to this foreign currency borrowing assuming the following

exchange rates for 1 dudek:

LO 9-3

b. Taking the exchange rate effect on the cost of borrowing into consideration, determine the effective interest rate in dollars on the loan in each of the three years 2017, 2018, and 2019.

31. Brandlin Company of Anaheim, California, sells parts to a foreign customer on December 1, 2017, with payment of 16,000 korunas to be received on March 1, 2018. Brandlin enters into a forward

LO 9-7

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contract on December 1, 2017, to sell 16,000 korunas on March 1, 2018. Relevant exchange rates for the koruna on various dates are as follows:

Date Spot Rate Forward Rate (to March 1, 2018)

December 1, 2017 $2.70 $2.775 December 31, 2017 2.80 2.900 March 1, 2018 2.95 N/A

Brandlin’s incremental borrowing rate is 12 percent. The present value factor for two months at an annual interest rate of 12 percent (1 percent per month) is 0.9803. Brandlin must close its books and prepare financial statements at December 31. a. Assuming that Brandlin designates the forward contract as a cash flow hedge of a foreign

currency receivable and recognizes any premium or discount using the straight-line method, prepare journal entries for these transactions in U.S. dollars. What is the impact on 2017 net income? What is the impact on 2018 net income? What is the impact on net income over the two accounting periods?

b. Assuming that Brandlin designates the forward contract as a fair value hedge of a foreign cur- rency receivable, prepare journal entries for these transactions in U.S. dollars. What is the impact on 2017 net income? What is the impact on 2018 net income? What is the impact on net income over the two accounting periods?

32. Use the same facts as in Problem 31 except that Brandlin Company purchases materials from a foreign supplier on December 1, 2017, with payment of 16,000 korunas to be made on March 1, 2018. The materials are consumed immediately and recognized as cost of goods sold at the date of purchase. On December 1, 2017, Brandlin enters into a forward contract to purchase 16,000 koru- nas on March 1, 2018. a. Assuming that Brandlin designates the forward contract as a cash flow hedge of a foreign cur-

rency payable and recognizes any premium or discount using the straight-line method, prepare journal entries for these transactions in U.S. dollars. What is the impact on 2017 net income? What is the impact on 2018 net income? What is the impact on net income over the two account- ing periods?

b. Assuming that Brandlin designates the forward contract as a fair value hedge of a foreign cur- rency payable, prepare journal entries for these transactions in U.S. dollars. What is the impact on net income in 2017 and in 2018? What is the impact on net income over the two accounting periods?

33. 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:

LO 9-7

Alexander must close its books and prepare its second-quarter financial statements on June 30. a. Assuming that Alexander designates the foreign currency option as a cash flow hedge of a for-

eign currency receivable, prepare journal entries for these transactions in U.S. dollars. What is the impact on net income over the two accounting periods?

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

34. On June 1, Cairns Corporation purchased goods from 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

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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

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Date Spot Rate Forward Rate

(to January 31, 2018)

November 30, 2017 $0.53 $0.52 December 31, 2017 0.50 0.48 January 31, 2018 0.49 N/A

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

Date Spot Rate Forward Rate

(to April 30, 2018)

November 1, 2017 $0.21 $0.20 December 31, 2017 0.19 0.17 April 30, 2018 0.18 N/A

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

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?

35. On November 1, 2017, Bernard Company (a U.S.-based company) sold merchandise to a foreign customer for 100,000 FCUs with payment to be received on April 30, 2018. At the date of sale, Bernard entered into a six-month forward contract to sell 100,000 FCUs. The company properly designates the forward contract as a cash flow hedge of a foreign currency receivable. The follow- ing exchange rates apply:

LO 9-7

Bernard’s incremental borrowing rate is 12 percent. The present value factor for four months at an annual interest rate of 12 percent (1 percent per month) is 0.9610. a. Prepare all journal entries, including December 31 adjusting entries, to record the sale and for-

ward contract. b. What is the impact on net income in 2017? c. What is the impact on net income in 2018?

36. Eximco Corporation (based in Champaign, Illinois) has a number of transactions with companies in the country of Mongagua, where the currency is the mong. On November 30, 2017, Eximco sold equipment at a price of 500,000 mongs to a Mongaguan customer that will make payment on Janu- ary 31, 2018. In addition, on November 30, 2017, Eximco purchased raw materials from a Mon- gaguan supplier at a price of 300,000 mongs; it will make payment on January 31, 2018. To hedge its net exposure in mongs, Eximco entered into a two-month forward contract on November 30, 2017, to deliver 200,000 mongs to the foreign currency broker in exchange for $104,000. Eximco properly designates its forward contract as a fair value hedge of a foreign currency receivable. The following rates for the mong apply:

LO 9-7

Eximco’s incremental borrowing rate is 12 percent. The present value factor for one month at an annual interest rate of 12 percent (1 percent per month) is 0.9901. a. Prepare all journal entries, including December 31 adjusting entries, to record these transactions

and the forward contract.

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b. What is the impact on net income in 2017? c. What is the impact on net income in 2018?

37. On October 1, 2017, Sharp Company (based in Denver, Colorado) entered into a forward contract to sell 100,000 rubles in four months (on January 31, 2018) and receive $39,000 in U.S. dollars. Exchange rates for the ruble follow:

LO 9-7, 9-8

Date Spot Rate Forward Rate

(to January 31, 2018)

October 1, 2017 $0.35 $0.39 December 31, 2017 0.38 0.41 January 31, 2018 0.40 N/A

Sharp’s incremental borrowing rate is 12 percent. The present value factor for one month at an annual interest rate of 12 percent (1 percent per month) is 0.9901. Sharp must close its books and prepare financial statements on December 31. a. Prepare journal entries, assuming that Sharp entered into the forward contract as a fair value

hedge of a 100,000 ruble receivable arising from a sale made on October 1, 2017. Include entries for both the sale and the forward contract.

b. Prepare journal entries, assuming that Sharp entered into the forward contract as a fair value hedge of a firm commitment related to a 100,000 ruble sale that will be made on January 31, 2018. Include entries for both the firm commitment and the forward contract. The fair value of the firm commitment is measured by referring to changes in the forward rate.

38. On August 1, Ling-Harvey Corporation (a U.S.-based importer) placed an order to purchase mer- chandise from a foreign supplier at a price of 400,000 ringgits. Ling-Harvey will receive and make payment for the merchandise in three months on October 31. On August 1, Ling-Harvey entered into a forward contract to purchase 400,000 ringgits in three months at a forward rate of $0.60. It properly designates the forward contract as a fair value hedge of a foreign currency firm commit- ment. The fair value of the firm commitment is measured by referring to changes in the forward rate. Relevant exchange rates for the ringgit are as follows:

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Date Spot Rate Forward Rate

(to October 31)

August 1 $0.60 $0.60 September 30 0.63 0.66 October 31 0.68 N/A

Ling-Harvey’s incremental borrowing rate is 12 percent. The present value factor for one month at an annual interest rate of 12 percent (1 percent per month) is 0.9901. Ling-Harvey must close its books and prepare its third-quarter financial statements on September 30. a. Prepare journal entries for the forward contract and firm commitment through October 31. b. Assuming the inventory is sold in the fourth quarter, what is the impact on net income over the

two accounting periods? c. What net cash outflow results from the purchase of merchandise from the foreign supplier?

39. On June 1, Vandervelde Corporation (a U.S.-based manufacturing firm) received an order to sell goods to a foreign customer at a price of 100,000 leks. Vandervelde will ship the goods and receive payment in three months on September 1. On June 1, Vandervelde purchased an option to sell 100,000 leks in three months at a strike price of $1.00. It properly designated the option as a fair value hedge of a foreign currency firm commitment. The fair value of the firm commitment is mea- sured by referring to changes in the spot rate. Relevant exchange rates and option premiums for the lek are as follows:

LO 9-8

Date Spot Rate

Put Option Premium for September 1

(strike price $1.00)

June 1 $1.00 $0.020 June 30 0.94 0.028 September 1 0.88 N/A

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Vandervelde’s incremental borrowing rate is 12 percent. The present value factor for two months at an annual interest rate of 12 percent (1 percent per month) is 0.9803. Vandervelde Corporation must close its books and prepare its second-quarter financial statements on June 30. a. Prepare journal entries for the foreign currency option and firm commitment. b. What is the impact on net income over the two accounting periods? c. What is the net cash inflow resulting from the sale of goods to the foreign customer?

40. Spitz Company ordered merchandise from a foreign supplier on November 20 at a price of 100,000 forints when the spot rate was $0.50 per forint. Delivery and payment were scheduled for Decem- ber 20. On November 20, Spitz acquired a call option on 100,000 forints at a strike price of $0.50, paying a premium of $0.01 per forint. It designates the option as a fair value hedge of a foreign cur- rency firm commitment. The fair value of the firm commitment is measured by referring to changes in the spot rate. The merchandise arrives and Spitz makes payment according to schedule. Spitz sells the merchandise by December 31, when it closes its books. a. Assuming a spot rate of $0.53 per forint on December 20, prepare all journal entries to

account for the foreign currency option, foreign currency firm commitment, and purchase of inventory.

b. Assuming a spot rate of $0.48 per forint on December 20, prepare all journal entries to account for the foreign currency option, foreign currency firm commitment, and purchase of inventory.

41. Based on past experience, Leickner Company expects to purchase raw materials from a foreign supplier at a cost of 1,000,000 marks on March 15, 2018. To hedge this forecasted transaction, the company acquires a three-month call option to purchase 1,000,000 marks on December 15, 2017. Leickner selects a strike price of $0.58 per mark, paying a premium of $0.005 per unit, when the spot rate is $0.58. The spot rate increases to $0.584 at December 31, 2017, causing the fair value of the option to increase to $8,000. By March 15, 2018, when the raw materials are purchased, the spot rate has climbed to $0.59, resulting in a fair value for the option of $10,000. a. Prepare all journal entries for the option hedge of a forecasted transaction and for the purchase

of raw materials, assuming that December 31 is Leickner’s year-end and that the raw materials are included in the cost of goods sold in 2018.

b. What is the overall impact on net income over the two accounting periods? c. What is the net cash outflow to acquire the raw materials?

42. Vino Veritas Company, a U.S.-based importer of wines and spirits, placed an order with a French supplier for 1,000 cases of wine at a price of 200 euros per case. The total purchase price is 200,000 euros. Relevant exchange rates for the euro are as follows:

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LO 9-9

LO 9-7, 9-7, 9-8

Date Spot Rate Forward Rate to October 31

Call Option Premium for October 31

(strike price $1.00)

September 15 $1.00 $1.06 $0.035 September 30 1.05 1.09 0.070 October 31 1.10 1.10 0.100

Vino Veritas Company has an incremental borrowing rate of 12 percent (1 percent per month) and closes the books and prepares financial statements at September 30. a. Assume that the wine arrived on September 15, and the company made payment on October 31.

There was no attempt to hedge the exposure to foreign exchange risk. Prepare journal entries to account for this import purchase.

b. Assume that the wine arrived on September 15, and the company made payment on October 31. On September 15, Vino Veritas entered into a 45-day forward contract to purchase 200,000 euros. It properly designated the forward contract as a fair value hedge of a foreign currency payable. Prepare journal entries to account for the import purchase and foreign currency for- ward contract.

c. Vino Veritas ordered the wine on September 15. The wine arrived and the company paid for it on October 31. On September 15, Vino Veritas entered into a 45-day forward contract to purchase 200,000 euros. The company properly designated the forward contract as a fair value hedge of a foreign currency firm commitment. The fair value of the firm commitment is mea- sured by referring to changes in the forward rate. Prepare journal entries to account for the foreign currency forward contract, firm commitment, and import purchase.

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d. The wine arrived on September 15, and the company made payment on October 31. On Septem- ber 15, Vino Veritas purchased a 45-day call option for 200,000 euros. It properly designated the option as a cash flow hedge of a foreign currency payable. Prepare journal entries to account for the import purchase and foreign currency option.

e. The company ordered the wine on September 15. It arrived on October 31, and the company made payment on that date. On September 15, Vino Veritas purchased a 45-day call option for 200,000 euros. It properly designated the option as a fair value hedge of a foreign currency firm commitment. The fair value of the firm commitment is measured by referring to changes in the spot rate. Prepare journal entries to account for the foreign currency option, firm commitment, and import purchase.

Develop Your Skills

RESEARCH CASE—INTERNATIONAL FLAVORS AND FRAGRANCES

Many companies make annual reports available on their corporate web page, often under an Investors tab. Annual reports also can be accessed through the SEC’s EDGAR system at www.sec.gov (under Fil- ings, click Company Filings Search, type in Company Name, and under Filing Type, search for 10-K).

Access the most recent annual report for International Flavors and Fragrances (IFF) to complete the following requirements.

Required

1. Identify the location(s) in the annual report where IFF provides disclosures related to its manage- ment of foreign exchange risk.

2. Determine the types of hedging instruments the company uses and the types of hedges in which it engages.

3. Determine the manner in which the company discloses the fact that its foreign exchange hedges are effective in offsetting gains and losses on the underlying items being hedged.

CPA skills

ACCOUNTING STANDARDS CASE—FORECASTED TRANSACTIONS

Fergusson Corporation, a U.S. company, manufactures components for the automobile industry. In the past, Fergusson purchased actuators used in its products from a supplier in the United States. The com- pany plans to shift its purchases to a supplier in Portugal. Fergusson’s CFO expects to place an order with the Portuguese supplier in the amount of 200,000 euros in three months. In contemplation of this future import, the CFO purchased a euro call option to hedge the cash flow risk that the euro might appreciate against the U.S. dollar over the next three months. The CFO is aware that a foreign currency option used to hedge the cash flow risk associated with a forecasted foreign currency transaction may be designated as a hedge for accounting purposes only if the forecasted transaction is probable. However, he is unsure how he should demonstrate that the anticipated import purchase from Portugal is likely to occur. He wonders whether management’s intention to make the purchase is sufficient.

Required Search current U.S. authoritative accounting literature to determine whether management’s intent is suf- ficient to assess that a forecasted foreign currency transaction is likely to occur. If not, what additional evidence must be considered? Identify the FASB ASC guidance for answering these questions.

CPA skills

EXCEL CASE—DETERMINE FOREIGN EXCHANGE GAINS AND LOSSES

Import/Export Company, a U.S. company, made a number of import purchases and export sales denom- inated in foreign currency in 2015. Information related to these transactions is summarized in the fol- lowing table. The company made each purchase or sale on the date in the Transaction Date column and made payment in foreign currency or received payment on the date in the Settlement Date column.

CPA skills

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Balance Sheet 3/31/17 5/1/17

Forward contract (liability) $(1,980)* $ –0– AOCI (credit) (2,020) –0– Change in cash –0– (106,000)

Foreign Currency Type of Transaction Amount in

Foreign Currency Transaction

Date Settlement

Date

Brazilian real (BRL) Import purchase (130,000) 1/10/2015 5/10/2015 Chilean peso (CLP) Import purchase (30,000,000) 1/10/2015 5/10/2015 Swiss franc (CHF) Export sale 50,000 1/10/2015 4/10/2015 Swiss franc (CHF) Import purchase (50,000) 4/10/2015 7/10/2015 Euro Export sale 45,000 1/10/2015 4/10/2015 Euro Export sale 45,000 4/10/2015 7/10/2015 Chinese yuan (CNY) Import purchase (300,000) 1/10/2015 7/10/2015

Required

1. Create an electronic spreadsheet with the information from the preceding table. Label columns as follows: Foreign Currency Type of Transaction Amount in Foreign Currency Transaction Date Exchange Rate at Transaction Date $ Value at Transaction Date Settlement Date Exchange Rate at Settlement Date $ Value at Settlement Date Foreign Exchange Gain (Loss)

2. Use historical exchange rate information available on the Internet at www.x-rates.com, Historic Lookup, to find the 2015 exchange rates between the U.S. dollar and each foreign currency on the relevant transaction and settlement dates.

3. Complete the electronic spreadsheet to determine the foreign exchange gain (loss) on each transac- tion. Determine the total net foreign exchange gain (loss) reported in Import/Export Company’s 2015 income statement.

4. Explain why a foreign exchange gain arises for some transactions and a foreign exchange loss occurs for other transactions.

ANALYSIS CASE—CASH FLOW HEDGE

On February 1, 2017, Linber Company forecasted the purchase of component parts on May 1, 2017, at a price of 100,000 euros. On that date, Linber entered into a forward contract to purchase 100,000 euros on May 1, 2017. It designated the forward contract as a cash flow hedge of the forecasted transaction. The spot rate for euros on February 1, 2017, was $1 per euro. On May 1, 2017, the forward contract was settled, and the component parts were received and paid for. The parts were consumed in the second quarter of 2017.

Linber’s financial statements reported the following amounts related to this cash flow hedge (credit balances in parentheses):

CPA skills

Income Statement First Quarter 2017 Second Quarter 2017

Premium expense $4,000 $ 2,000 Cost of goods sold –0– 103,000 Adjustment to net income –0– 3,000

*$2,000 × 0.9901 = $1,980, where 0.9901 is the present value factor for one month at an annual interest rate of 12 percent calculated as 1/1.01.

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Required

1. On February 1, 2017, what was the U.S. dollar per euro forward rate to May 1, 2017? 2. On March 31, 2017, what was the U.S. dollar per euro forward rate to May 1, 2017? 3. Was Linber better off or worse off as a result of having entered into this cash flow hedge of a fore-

casted transaction? By what amount? 4. What does the total premium expense of $6,000 reflect?

Customer Location Invoice Price

Rama Properties Ltd. New Delhi 3,319,000 Indian rupees (INR) Luzon Island Group Manila 2,337,000 Philippine pesos (PHP) Mishima Industries Inc. Tokyo 6,017,000 Japanese yen (JPY) Melayu Trading Company Kuala Lumpur 214,800 Malaysian ringgit (MYR)

INTERNET CASE—HISTORICAL EXCHANGE RATES

The Pier Ten Company, a U.S. company, made credit sales to four customers in Asia on September 15, 2015, and received payment on October 15, 2015. Information related to these sales is as follows:CPA

skills

The Pier Ten Company’s fiscal year ends September 30.

Required

1. Use historical exchange rate information available on the Internet at www.x-rates.com, Historical Lookup, to find exchange rates between the U.S. dollar and each foreign currency for September 15, September 30, and October 15, 2015.

2. Determine the foreign exchange gains and losses that Pier Ten would have recognized in net income in the fiscal years ended September 30, 2015, and September 30, 2016, and the overall foreign exchange gain or loss for each transaction. Determine for which transaction, if any, it would have been important for Pier Ten to hedge its foreign exchange risk.

3. Pier Ten could have acquired a one-month put option on September 15, 2015, to hedge the foreign exchange risk associated with each of the four export sales. In each case, the put option would have cost $100 with the strike price equal to the September 15, 2015, spot rate. Determine for which hedges, if any, Pier Ten would have recognized a net gain on the foreign currency option.

COMMUNICATION CASE—FORWARD CONTRACTS AND OPTIONS

Palmetto Bug Extermination Corporation (PBEC), a U.S. company, regularly purchases chemicals from a supplier in Switzerland with the invoice price denominated in Swiss francs. PBEC has experienced several foreign exchange losses in the past year due to increases in the U.S. dollar price of the Swiss currency. As a result, Dewey Nukem, PBEC’s CEO, has asked you to investigate the possibility of using derivative financial instruments, specifically foreign currency forward contracts and foreign currency options, to hedge the company’s exposure to foreign exchange risk.

Required Draft a memo to CEO Nukem comparing the advantages and disadvantages of using forward contracts and options to hedge foreign exchange risk. Recommend the type of hedging instrument you believe the company should employ and justify this recommendation.

CPA skills

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