ch12_test bank jeter advanced accounting 3rd edition

Chapter 12

Accounting for Foreign Currency Transactions

And Hedging Foreign Exchange Risk

Multiple Choice

1. A discount or premium on a forward contract is deferred and included in the measurement of the

related foreign currency transaction if the contract is classified as a:

a. hedge of a net investment in a foreign entity.

b. hedge of an exposed asset or liability position.

c. hedge of an identifiable foreign currency commitment.

d. contract acquired to speculate in the movement of exchange rates.

2. The discount or premium on a forward contract entered into as a hedge of an exposed asset or

liability position should be:

a. included as a separate component of stockholders‟ equity.

b. amortized over the life of the forward contract.

c. deferred and included in the measurement of related foreign currency transaction.

d. none of these.

3. An indirect exchange rate quotation is one in which the exchange rate is quoted:

a. in terms of how many units of the domestic currency can be converted into one unit of foreign

currency.

b. for the immediate delivery of currencies exchanged.

c. in terms of how many units of the foreign currency can be converted into one unit of domestic

currency.

d. for the future delivery of currencies exchanged.

4. A transaction gain is recorded when there is an:

a. importing transaction and the exchange rate increases.

b. exporting transaction and the exchange rate increases.

c. exporting transaction and the exchange rate decreases.

d. none of these.

5. During 2011, a U.S. company purchased inventory from a foreign supplier. The transaction was

denominated in the local currency of the seller. The direct exchange rate increased from the date of

the transaction to the balance sheet date. The exchange rate decreased from the balance sheet date to

the settlement date in 2012. For the years 2011 and 2012, transaction gains or losses should be

recognized as:

2011 2012

a. gain gain

b. gain loss

c. loss loss

d. loss gain

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Test Bank to accompany Jeter and Chaney Advanced Accounting 3rd

Edition

12-2

6. A transaction gain or loss is reported currently in the determination of income if the purpose of the

forward contract is to:

a. hedge a net investment in a foreign entity.

b. hedge an identifiable foreign currency commitment.

c. speculate in foreign currency.

d. none of these.

7. On November 1, 2011, American Company sold inventory to a foreign customer. The account will

be settled on March 1 with the receipt of $500,000 foreign currency units (FCU). On November 1,

American also entered into a forward contract to hedge the exposed asset. The forward rate is $0.70

per unit of foreign currency. American has a December 31 fiscal year-end. Spot rates on relevant

dates were:

Per Unit of

Date Foreign Currency

November 1 $0.73

December 31 0.71

March 1 0.74

The entry to record the forward contract is

a. FCU Receivable 350,000

Premium on Forward Contract 15,000

Dollars Payable 365,000

b. Dollars Receivable 365,000

Discount on Forward Contract 15,000

FCU Payable 350,000

c. FCU Receivable 365,000



d. Dollars Receivable 350,000


FCU Payable 365,000




Chapter 12 Accounting for Foreign Currency Transactions


12-3

8. On November 1, 2011, American Company sold inventory to a foreign customer. The account will

be settled on March 1 with the receipt of $450,000 foreign currency units (FCU). On November 1,

American also entered into a forward contract to hedge the exposed asset. The forward rate is $0.70

per unit of foreign currency. American has a December 31 fiscal year-end. Spot rates on relevant

dates were:

Per Unit of


November 1 $0.73

December 31 0.71

March 1 0.74

What will be the adjusted balance in the Accounts Receivable account on December 31, and how

much gain or loss was recorded as a result of the adjustment?

Receivable Balance Gain/Loss Recorded

a. $319,500 $9,000 gain

b. $319,500 $9,000 loss

c. $333,000 $4,500 gain

d. $333,000 $18,000 gain

9. A transaction gain or loss at the settlement date is:

a. a change in the exchange rate quoted by a foreign exchange trader.

b. synonymous with the translation of foreign currency financial statements into dollars.

c. the difference between the recorded dollar amount of an account receivable denominated in a

foreign currency and the amount of dollars received.

d. the difference between the buying and selling rate quoted by a foreign exchange trader at the

settlement date.

10. From the viewpoint of a U.S. company, a foreign currency transaction is a transaction:

a. measured in a foreign currency.

b. denominated in a foreign currency.

c. measured in U.S. currency.

d. denominated in U.S. currency.

11. The exchange rate quoted for future delivery of foreign currency is the definition of a(n):

a. direct exchange rate.

b. indirect exchange rate.

c. spot rate.

d. forward exchange rate.

12. A transaction loss would result from:

a. an increase in the exchange rate applicable to an asset denominated in a foreign currency.

b. a decrease in the exchange rate applicable to a liability denominated in a foreign currency.

c. the import of merchandise when the transaction is denominated in a foreign currency.

d. a decrease in the exchange rate applicable to an asset denominated in a foreign currency.





Edition

12-4

13. The forward exchange rate quoted for the remaining term of a forward contract is used to account

for the contract when the forward contract:

a. extends beyond one year or the current operating cycle.

b. is a hedge of an identifiable foreign currency commitment.

c. is a hedge of an exposed net liability position.

d. was acquired to speculate in foreign currency.

14. A transaction gain or loss on a forward contract entered into as a hedge of an identifiable foreign

currency commitment may be:

a. included as a separate item in the stockholders‟ equity section of the balance sheet.

b. recognized currently in the determination of net income.

c. deferred and included in the measurement of the related foreign currency transaction.

d. none of these.

15. Craiger, Inc. a U.S. corporation, bought machine parts from Reinsch Company of Germany on

March 1, 2011, for 70,000 marks, when the spot rate for marks was $0.5395. Craiger‟s year-end was

March 31, 2011, when the spot rate for marks was $0.5445. Craiger bought 70,000 marks and paid

the invoice on April 20, 2011, when the spot rate was $0.5495. How much should be shown in

Craiger‟s income statements as foreign exchange (transaction) gain or loss for the years ended

March 31, 2011 and 2012?

2011 2012

a. $0 $0

b. $0 $350 loss

c. $350 loss $0

d. $350 loss $350 loss

16. A forward exchange contract is transacted at a discount if the current forward rate is:

a. less than the expected spot rate.

b. more than the expected spot rate.

c. less than the current spot rate.

d. more than the current spot rate.

17. Stuart Corporation a U.S. company, contracted to purchase foreign goods. Payment in foreign

currency was due one month after delivery. Between the delivery date and the time of payment, the

exchange rate changed in Stuart‟s favor. The resulting gain should be reported in the financial

statements as a(n):

a. component of other comprehensive income.

b. component of income from continuing operations.

c. extraordinary income.

d. deferred income.






12-5

18. Jackson Paving Company purchased equipment for 350,000 British pounds from a supplier in

London on July 7, 2011. Payment in British pounds is due on Sept. 7, 2011. The exchange rates to

purchase one pound is as follows:

July 7 August 31, (year end) September 7

Spot-rate 2.08 2.05 2.04

30-day rate 2.07 2.03 --

60-day rate 2.06 1.99 --

On its August 31, 2011 income statement, what amount should Jackson Paving report as a foreign

exchange transaction gain:

a. $14,000.

b. $7,000.

c. $10,500.

d. $0.

19. On September 1, 2011, Swash Plating Company entered into two forward exchange contracts to

purchase 250,000 euros each in 90 days. The relevant exchange rates are as follows:

Forward Rate

Spot rate For Dec. 1, 2011

September 1, 2011 1.46 1.47

September 30, 2011 (year-end) 1.50 1.48

The first forward contract was to hedge a purchase of inventory on September 1, payable on

December 1. On September 30, what amount of foreign currency transaction loss should Swash

Plating report in income?

a. $0.

b. $2,500.

c. $5,000.

d. $10,000.

20. On September 1, 2011, Swash Plating Company entered into two forward exchange contracts to

purchase 250,000 euros each in 90 days. The relevant exchange rates are as follows:

Forward Rate

Spot rate For Dec. 1, 2011

September 1, 2011 1.46 1.47

September 30, 2011 (year-end) 1.50 1.48

The second forward contract was strictly for speculation. On September 30, 2011, what amount of

foreign currency transaction gain should Swash Plating report in income?

a. $0.

b. $2,500.

c. $5,000.

d. $10,000.





Edition

12-6

21. On November 1, 2011, Prism Company sold inventory to a foreign customer. The account will be

settled on March 1 with the receipt of 250,000 foreign currency units (FCU). On November 1, Prism

also entered into a forward contract to hedge the exposed asset. The forward rate is $0.90 per unit of

foreign currency. Prism has a December 31 fiscal year-end. Spot rates on relevant dates were:

Per Unit of


November 1 $0.93

December 31 0.91

March 1 0.94

The entry to record the forward contract is

a. FCU Receivable 225,000



b. Dollars Receivable 232,500


FCU Payable 225,000

c. FCU Receivable 232,500



d. Dollars Receivable 225,000


FCU Payable 232,500

22. On November 1, 2011, National Company sold inventory to a foreign customer. The account will be

settled on March 1 with the receipt of 200,000 foreign currency units (FCU). On November 1,

National also entered into a forward contract to hedge the exposed asset. The forward rate is $0.80

per unit of foreign currency. National has a December 31 fiscal year-end. Spot rates on relevant

dates were:

Per Unit of


November 1 $0.83

December 31 0.81

March 1 0.84

What will be the adjusted balance in the Accounts Receivable account on December 31, and how

much gain or loss was recorded as a result of the adjustment?

Receivable Balance Gain/Loss Recorded

a. $170,000 $4,000 gain

b. $162,000 $4,000 loss

c. $168,000 $2,000 gain

d. $164,000 $2,000 loss






12-7

23. Caldron Company purchased equipment for 375,000 British pounds from a supplier in London on

July 3, 2011. Payment in British pounds is due on Sept. 3, 2011. The exchange rates to purchase one

pound is as follows:

July 3 August 31, (year end) September 3

Spot-rate 1.58 1.55 1.54

30-day rate 1.57 1.53 --

60-day rate 1.56 1.49 --

On its August 31, 2011, income statement, what amount should Caldron report as a foreign

exchange transaction gain:

a. $18,750.

b. $3,750.

c. $11,250.

d. $0.

24. On April 1, 2011, Trent Company entered into two forward exchange contracts to purchase 300,000

euros each in 90 days. The relevant exchange rates are as follows:

Forward Rate

Spot rate For Aug. 1, 2011

April 1, 2011 1.16 1.17

April 30, 2011 (year-end) 1.20 1.18

The first forward contract was to hedge a purchase of inventory on April 1, payable on December 1.

On April 30, what amount of foreign currency transaction loss should Trent report in income?

a. $0.

b. $3,000.

c. $9,000.

d. $12,000.

25. On April 1, 2011, Trent Company entered into two forward exchange contracts to purchase 300,000

euros each in 90 days. The relevant exchange rates are as follows:

Forward Rate

Spot rate For Aug. 1, 2011

April 1, 2011 1.16 1.17

April 30, 2011 (year-end) 1.20 1.18

The second forward contract was strictly for speculation. On April 30, 2011, what amount of foreign

currency transaction gain should Trent report in income.

a. $0.

b. $3,000.

c. $9,000.

d. $12,000.





Edition

12-8

Problems

12-1 On November 1, 2010, Dorsey Company sold inventory to a company in England. The sale was for

600,000 British pounds and payment will be received on February 1, 2011. On November 1, Dorsey

entered into a forward contract to sell 600,000 British pounds on February 1 at the forward rate of

$1.65. Spot rates for the British pound are as follows:

November 1 $1.61

December 31 1.67

February 1 1.62

Dorsey has a December 31 fiscal year-end.

Required:

Compute each of the following:

1. The dollars to be received on February 1, 2011, from selling the 600,000 pounds to the exchange

dealer.

2. The dollars that would have been received from the account receivable if Dorsey had not hedged the

sale contract with the forward contract.

3. The discount or premium on the forward contract.

4. The transaction gain or loss on the exposed asset related to the sale in 2010 and 2011.

5. The transaction gain or loss on the forward contract in 2010 and 2011.

6. The amount of the discount or premium on the forward contract amortized in 2010 and 2011.

12-2 On December 1, 2010, Derrick Corporation agreed to purchase a machine to be manufactured by a

company in Brazil. The purchase price is 1,150,000 Brazilian reals. To hedge against fluctuations in

the exchange rate, Derrick entered into a forward contract on December 1 to buy 1,150,000 reals on

April 1, the agreed date of machine delivery, for $0.375 per real. The following exchange rates were

quoted:

Forward Rate

Date Spot Rate (Delivery on 4/1)

December 1 0.390 0.375

December 31 0.370 0.373

April 1 0.385 --

Required:

Prepare journal entries necessary for Derrick during 2010 and 2011 to account for the transactions described

above.






12-9

12-3 Colony Corp., a U.S. corporation, entered into a contract on November 1, 2010, to sell two

machines to Crown Company, for 95,000 foreign currency units (FCU). The machines were to be

delivered and the amount collected on March 1, 2011.

In order to hedge its commitment, Colony entered into a forward contract for 95,000 FCU delivery

on March 1, 2011. The forward contract met all conditions for hedging an identifiable foreign

currency commitment.

Selected exchange rates for FCU at various dates were as follows:

November 1, 2010 – Spot rate $1.3076

Forward rate for delivery on March 1, 2011 1.2980

December 31, 2010 – Spot rate 1.3060

Forward rate for delivery on March 1, 2011 1.3150

March 1, 2011 – Spot rate 1.2972

Required: Prepare all journal entries relative to the above on the books of Colony Corp. on the following dates:

1. November 1, 2010.

2. Year-end adjustments on December 31, 2010.

3. March 1, 2011. (Include all adjustments related to the forward contract.)

12-4 On October 1, 2010, Nance Company purchased inventory from a foreign customer for 750,000 units

of foreign currency (FCU) due on January 31, 2011. Simultaneously, Nance entered into a forward

contract for 750,000 units of FC for delivery on January 31, 2011, at the forward rate of $0.75.

Payment was made to the foreign customer on January 31, 2011. Spot rates on October 1, December

31, and January 31, were $0.72, $0.73, and $0.76, respectively. Nance amortizes all premiums and

discounts on forward contracts and closes its books on December 31.

Required:

A. Prepare all journal entries relative to the above to be made by Nance on October 1, 2010.

B. Prepare all journal entries relative to the above to be made by Nance on December 31, 2010.

C. Compute the transaction gain or loss on the forward contract that would be recorded in 2011.

Indicate clearly whether the amount is a gain or loss.

12-5 On October 1, 2010, Kline Company shipped equipment to a foreign customer for a foreign currency

(FC) price of FC 3,000,000 due on January 31, 2011. All revenue realization criteria were satisfied

and accordingly the sale was recorded by Kline Company on October 1. Simultaneously, Kline

entered into a forward contract to sell 3,000,000 FCU on January 31, 2011 for $1,200,000. Payment

was received from the foreign customer on January 31, 2011. Spot rates on October 1, December 31,

and January 31 were $0.42, $0.425, and $0.435, respectively. Kline amortizes all premiums and

discounts on forward contracts and closes its books on December 31.

Required:

Prepare all journal entries relative to the above to be made by Kline during 2010 and 2011.





Edition

12-10

12-6 On July 15, Worth, Inc. purchased 88,500,000 yen worth of parts from a Tokyo company paying

20% down, and the balance is due in 90 days. Interest is payable at a rate of 8% on the unpaid

balance. The exchange rate on July 15, was $1.00 = 118 Japanese yen. On October 13, the exchange

rate was $1.00 = 114 Japanese yen.

Required:

Prepare journal entries to record the purchase and payment of this foreign currency transaction in U.S.

dollars.

12-7 On November 1, 2010, Bisk Corporation, a calendar-year U.S. Corporation, invested in a

speculative contract to purchase 700,000 euros on January 31, 2011, from a German brokerage firm.

Bisk agreed to buy 700,000 euros at a fixed price of $1.46 per euro. The brokerage firm agreed to

send 700,000 euros to Bisk on January 31, 2011. The spot rates for euros are:

November 1, 2010 1 euro = 1.45

December 31, 2010 1 euro = 1.43

January 31, 2011 1 euro = 1.44

Required:

Prepare the journal entries that Bisk would record on November 1, December 31, and January 31.

12-8 Consider the following information:

1. On November 1, 2011, a U.S. firm contracts to sell equipment (with an asking price of 500,000

pesos) in Mexico. The firm will take delivery and will pay for the equipment on February 1,

2012.

2. On November 1, 2011, the company enters into a forward contract to sell 500,000 pesos for

$0.0948 on February 1, 2012.

3. Spot rates and the forward rates for February 1, 2012, settlement were as follows (dollars per

peso):

Forward Rate

Spot Rate for 2/1/12

November 1, 2011 $0.0954 $0.0948

Balance sheet date (12/31/11) 0.0949 0.0944

February 1, 2012 0.0947

4. On February 1, the equipment was sold for 500,000 pesos. The cost of the equipment was

$20,000.

Required:

Prepare all journal entries needed on November 1, December 31, and February 1 to account for the forward

contract, the firm commitment, and the transaction to sell the equipment.






12-11

Short Answer

1. Accounting for a foreign currency transaction involves the terms measured and denominated. Describe

a foreign currency transaction and distinguish between the terms measured and denominated.

2. There are a number of business situations in which a firm may acquire a forward exchange contract.

Identify three common situations in which a forward exchange contract can be used as a hedge.

Short Answer Questions from the Textbook

1. Define currency exchange rates and distinguish between “direct” and “indirect” quotations.

2. Explain why a firm is exposed to an added risk when it enters into a transaction that is to be settled

in a foreign currency.

3. Name the three stages of concern to the accountant in accounting for import–export transactions.

Briefly explain the accounting for each stage.

4. How should a transaction gain or loss be reported that is related to an unsettled receivable recorded

when the firm‟s inventory was exported?

5. A U.S. firm carried a receivable for 100,000 yen. Assuming that the direct exchange rate declined

from $.009 at the date of the transaction to $.006at the balance sheet date, compute the transaction

gain or loss. What balance would be reported for the receivable in the firm‟s balance sheet?

6. Explain what is meant by the “two-transaction method” in recording exporting or importing trans-

actions. What support is given for this method?

7. Describe a forward exchange contract.

8. Explain the effects on income from hedging a foreign currency exposed net asset position or net

liability position.

9. What criteria must be satisfied for a foreign currency transaction to be considered a hedge of an

identifiable foreign currency commitment?

10. The FASB classifies forward contracts as those acquired for the purpose of hedging and those

acquired for the purpose of speculation. What main differences are there in accounting for these two

classifications?

11. How are foreign currency exchange gains and losses from hedging a forecasted transaction handled?

12. What is a put option, and how might it be used to hedge a forecasted transaction?

13. Define a derivative instrument, and describe the keystones identified by the FASB for the ac-

counting for such instruments.

14. Differentiate between forward-based derivatives and option-based derivatives.

15. List some of the criteria laid out by the FASB that are required for a gain or loss on forecasted trans-

actions (a cash flow hedge) to be excluded from the income statement. If these criteria are satisfied,





Edition

12-12

where are the gains or losses reported, and when (if ever) are they shown in the income statement?

What is the rationale for this treatment?

Business Ethics Question from Textbook

Executive stock options (ESOs) are used to provide incentives for executives to improve company

performance. ESOs are usually granted “at-the-money,” meaning that the exercise price of the options is set

to equal the market price of the underlying stock on the grant date. Clearly, executives would prefer to be

granted options when the stock price (and thus the exercise price) is at its lowest. Backdating options is the

practice of choosing a past date when the market price was particularly low. Backdating has not, in the past,

been illegal if no documents are forged, if communicated to the shareholders, and if properly reflected in

earnings and in taxes.

1. Since backdating gives the executive an “instant” profit, why wouldn‟t the firm simply grant an

option with the exercise price lower than the cur-rent market price?

2. Suppose the executive was not involved in back-dating the ESOs. Does the executive face any

ethical issues?






12-13

ANSWER KEY

Multiple Choice

1. c

2. b

3. c

4. b

5. d

6. c

7. d

8. b

9. c

10. b

11. d

12. d

13. d

14. c

15. d

16. a

17. b

18. c

19. d

20. b

21. d

22. b

23. c

24. d

25. b

Problems

12-1 1. Dollars received = 600,000 × $1.65 = $990,000

2. Dollars received = 600,000 × $1.62 = $972,000

3. Premium on forward contract = ($1.65 - $1.61) × 600,000 = $24,000

4. 2010 transaction gain = ($1.67 - $1.61) × 600,000 = $36,000

2011 transaction loss = ($1.67 - $1.62) × 600,000 = $(30,000)

5. 2010 transaction loss = ($1.67 - $1.61) × 600,000 = ($36,000)

2011 transaction gain = ($1.67 - $1.62) × 600,000 = $30,000

6. Premium amortized in 2010 = $24,000 × 2/3 = $16,000

Premium amortized in 2011 = $24,000 × 1/3 = $8,000

12-2 2010

Dec. 1 FC Receivable from Exchange Dealer 448,500

Deferred Transaction Adjustment 17,250

Dollars Payable to Exchange Dealer 431,250

Dec. 31 Deferred Transaction Adjustment 23,000

FC Receivable from Exchange Dealer 23,000

($0.39 - $0.37) × 1,150,000)





Edition

12-14

12-2 (Continued)

2011

Apr. 1 FC Receivable from Exchange Dealer 17,250


($0.385 - $0.370) × 1,150,000)

Investment in Foreign Currency 442,750



Cash 431,250

Machine 442,750



Machine 11,500

12-3 1. November 1, 2010

Dollars Receivable from Exchange Dealer 123,310

Deferred Transaction Adjustment 912

FC Payable to Exchange Dealer 124,222

($1.2980 × 95,000 = $123,310)

[($1.3076 - $1.2980) × 95,000 = $912)

($1.3076 × 95,000 = $124,222)

2. December 31, 2010

FC Payable to Exchange Dealer 152


[($1.3076 - $1.3060) × 95,000 = $152]

3. March 1, 2011

FC Payable to Exchange Dealer 836


[($1.3060 - $1.2972) × 95,000 = $836]


Sales 123,234

($1.2972 × 95,000 = $123,234)



($1.2972 × 95,000 = $123,234)

Cash 123,310


($1.2980 × 95,000 = $123,310)


Sales 76

[($1.2980 - $1.2972) × 95,000 = $76]






12-15

12-4 A. October 1

Purchases 540,000

Accounts Payable 540,000

($0.72 × 750,000 = $540,000)




($0.72 × 750,000 = $540,000)

($0.75 - $0.72) × 750,000 = $22,500)

($0.75 × 750,000 = $562,500)

B. December 31

Transaction Loss 7,500


[($0.73 - $0.72) × 750,000 = $7,500]


Transaction Gain 7,500

[($0.73 - $0.72) × 750,000 = $7,500]

Amortization Expense 16,875


[($0.75 - $0.72) × 750,000 × (3/4) = $16,875]

C. Value of FC receivable – January 31

$0.76 × 750,000 $570,000

Carrying value – December 31 547,500

Transaction gain $ 22,500

12-5 October 1

Accounts Receivable 1,260,000

Sales 1,260,000

Dollars Receivable from Exchange Dealer 1,200,000


FC Payable to Exchange Dealer 1,260,000

December 31

Accounts Receivable 15,000


(3,000,000 × 0.425) = 1,275,000 – 1,260,000

Transaction 15,000


Amortization Expense (60,000 × 3/4) 45,000






Edition

12-16

12-5 (Continued)

January 31

Accounts Receivable 30,000


($3,000,000 × 0.435) = $1,305,000 – $1,275,000



Investment in FC 1,305,000

Accounts Receivable 1,305,000

Cash 1,200,000

FC Payable to Exchange Dealer 1,305,000

Dollars Receivable from Exchange Dealer 1,200,000


Amortization Expense 15,000


12-6

July 15 Purchases 750,000


Cash 150,000

(88,500,000 yen / 118)

Oct. 13 Accounts Payable 600,000


Cash 621,053

(70,800,000 yen / 114)

Interest Expense 12,421

Cash 12,421

(70,800,000 yen × (90/360) × 8% = 1,416,000 yen / 114 = 12,421)

12-7

Nov. 1, 2010 FC Receivable from Exchange Dealer 1,022,000

Dollars Payable to Exchange Dealer 1,022,000

(700,000 × $1.46)

Dec. 31, 2010 Transaction Loss 14,000


(700,000 × ($1.44 – $1.46))






12-17

12-7 (Continued)

Jan. 31, 2011 Dollars Payable to Exchange Dealer 1,022,000


Cash 1,022,000

FC Receivable from Exchange Dealer 1,008,000

Cash 1,008,000


12-8

Nov. 1 Dollars Receivable from Exchange Dealer (500,000 × $0.0948) 47,400


Dec. 31 FC Payable from Exchange Dealer 200

Foreign Exchange Gain 200

[(500,000 × ($0.0948 - $0.0944)]

Foreign Exchange Loss 200

Firm Commitment 200

[(500,000 × ($0.0948 - $0.0944)]

Feb. 1 Foreign Exchange Loss 150

FC Payable from Exchange Dealer 150

[(500,000 × ($0.0944 - $0.0947)]

Firm Commitment 150

Foreign Exchange Gain 150

[(500,000 × ($0.0944 - $0.0947)]

Investment in FC 47,350

Firm Commitment 50

Sales (500,000 × $0.0948) 47,400

Cash 47,400


Investment in FC 47,350


Cost of Goods Sold 20,000

Inventory 20,000





Edition

12-18

Short Answer

1. A foreign currency transaction is a transaction that requires settlement in a foreign currency, not in

U.S. dollars.

Transactions are normally measured and recorded in terms of the currency in which the reporting

entity prepares its financial statements. Assets and liabilities are denominated in a currency if their

amounts are fixed in terms of that currency.






12-19

2. Forward exchange contracts can be used as a hedge of a (an):

a. foreign currency transaction.

b. unrecognized firm commitment (a fair value hedge).

c. foreign-currency-denominated “forecasted” transaction (a cash flow hedge).

d. net investment in foreign operations.

(Note: question only asked for 3 situations)

Short Answer Textbook Question Solutions

1. An exchange rate is the ratio between a unit of one currency and the amount of another

currency for which that unit can be exchanged at a particular time. A direct quotation is one in

which the exchange rate is quoted in terms of how many units of the domestic currency can be

converted into one unit of foreign currency. An indirect quotation is stated in terms of

converting one unit of domestic currency into units of foreign currency.

2. When a transaction is to be settled in a foreign currency, a change in the exchange rate

increases or decreases the expected cash flow to be received or paid when the account is

settled.

3. (1) Transaction Date -- at this date, the transaction is recorded. If the transaction is stated in

foreign currency units, the exchange rate prevailing at this date is used to convert the

foreign currency units to domestic units.

(2) Balance Sheet Date -- at this date, recorded dollar balances (or other domestic currency, if

applicable) representing receivables or payables that are to be settled in foreign currency

units are revalued at the exchange rate on this date. The adjustment is recorded as a

transaction gain or loss.

(3) Settlement Date -- the foreign currency received or paid is converted into domestic

currency at the spot rate. A difference between the conversion and the carrying value of

the receivable or payable is a transaction gain or loss.

4. A transaction gain (loss) related to an unsettled receivable should be included in the

determination of net income for the current period.

5. Receivable recorded at the transaction date 100,000 $.009 $900

Receivable recorded at the balance sheet date 100,000 $.006 600

Transaction loss $300

Receivable is reported at $600 in the balance sheet.

6. A purchase (sale) is viewed as a transaction separate from the method of settlement. Once the

purchase (sale) is made, a firm has the choice of settling at the transaction date, thus incurring

no gain or loss from subsequent changes in the exchange rate; or purchasing a forward

contract, and also avoiding a gain or loss from holding foreign currency commitments. The

choice of settlement rests with management, and their decision should have no effect on the

valuation of a purchase or sales transaction.





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7. A forward exchange contract is an agreement to buy or sell foreign currency units at a

particular time for an agreed upon exchange rate. This rate will usually be the forward rate at

the time the contract is entered into and any difference between the forward rate and the spot

rate is amortized to income over the life of the contract.

8. A forward contract to buy (sell) foreign currency has an opposite effect on income compared to

the gain or loss associated with translation of a payable (receivable) to be settled in the foreign

currency units.

In other words, as the exchange rate fluctuates, the forward contract will gain or lose the same

amount as the payable or receivable will lose or gain. Therefore, no net transaction gain or

loss will be incurred.

9. The transaction must be designated as, and is effective as, a hedge of a foreign currency

commitment, and the foreign currency commitment is firm.

10. Forward contracts are valued using changes in forward rates and generally any gains or losses

are recognized in the same period as changes in value of hedged item (Fair Value hedges).

Gains or losses in Cash Flow hedges are deferred until the hedged item is included in income.

A forward contract held for speculation is recorded at the transaction date using the forward

rate. There is no separate accounting for a discount or premium. Subsequent valuations (at

balance sheet dates) are based on the forward rate available for the remaining life of the

forward contract.

11. Foreign currency exchange gains (losses) from hedging a forecasted transaction are deferred

and included in the determination of the foreign currency transaction at transaction date.

12. A put option is a contract that gives the holder the right to sell an asset (such as a unit of

foreign currency) at a specified price within a specified time period. Firms use these options to

protect against expected unfavorable changes in exchange rates. If a company has a contract to

sell inventory and is expected to receive a foreign currency, the company can use the option to

sell the foreign currency received from the sale to deliver on the option, thus locking into a

foreign exchange rate.

13. A derivative instrument may be defined as a financial instrument that by its terms at inception

or upon occurrence of a specified event, provides the holder (or writer) with the right (or

obligation) to participate in some or all of the price changes of another underlying value of

measure, but does not require the holder to own or deliver the underlying value of measure.

Thus its value is derived from the underlying value of measure. In SFAS No. 133, the FASB

identified the following as keystones for the accounting for derivative instruments:

* Derivative instruments represent rights or obligations that meet the definitions of assets or

liabilities and should be reported in financial statements.

* Fair value is the most relevant measure for financial instruments and the only relevant

measure for derivative instruments.

* Only items that are assets or liabilities should be reported as such in the balance sheet.

* Special accounting for items designated as being hedged should be provided only for






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qualifying items, as demonstrated by an assessment of the expectation of effective offsetting

changes in fair values or cash flows during the term of the hedge for the risk being hedged.

14. Derivative instruments can be divided into two broad categories:

a) Forward-based derivatives, such as forwards, futures, and swaps, in which either party can

potentially have a favorable or unfavorable outcome, but not both simultaneously (e.g., both

will not simultaneously have favorable outcomes).

b) Option-based derivatives, such as interest rate caps, option contracts, and interest rate floors,

in which only one party can potentially have a favorable outcome and it agrees to a premium at

inception for this potentiality; the other party is paid the premium, and can potentially have

only an unfavorable outcome.

15. The FASB allows deferral of the income statement recognition of the gains and losses on

forecasted transactions if certain criteria are met. Like other gains and losses that are excluded

from the income statement, they must be included as components of “other comprehensive

income” and reported in the stockholders‟ equity section of the balance sheet. The criteria for

this treatment include:

The forecasted transaction is specifically identifiable at the time of the designation as a

single transaction or a group of individual transactions.

The forecasted transaction is probable and it presents exposure to price changes that are

expected to affect earnings and cause variability in cash flows.

The forecasted transaction involves an exchange with an outside (unrelated) party

(intercompany foreign currency transactions are excluded)

The forecasted transaction does not involve a business combination.

They are reclassified into earnings when the forecasted transaction occurs and the item is

recorded in earning.

Business Ethics

Business ethics solutions are merely suggestions of points to address. The objective is to raise the

students' awareness of the topics, and to invite discussion. In most cases, there is clear room for

disagreement or conflicting viewpoints.

1. Stock options, in theory, are used to create incentives for the firm‟s executives to increase

operating performance. The practice of backdating options defeats this purpose. The point of

backdating options is to avoid issuing „in the money‟ stock options which would have had both

accounting and tax consequences not favorable to the firm. Backdating avoids accounting

recognition.

2. Executives always have the right not to exercise options if they feel that there is an ethical issue.

However, if the proper disclosures are followed (which is rarely the case), then back-dating options

is not illegal under current laws.




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