Chapter 7, Problem 15EP

a.

To determine

Record journal entries and determine effect on net income using cash flow hedge.

Explanation of Solution

Cash Flow Hedging:

Companies use cash flow hedge to minimise the variability in cash flows of assets or liabilities or forecasted transactions caused by fluctuations in foreign currency exchange rates, commodity prices  or interest rates.

Recording purchase:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/1/Y1	Inventory		20,000
	Accounts payable			20,000
	(to record purchase)

Table (1)

• Since, inventory is an asset and assets are increased. Hence, accounts receivable is debited.
• Since, accounts payable is a liability and liabilities are increased. Hence, accounts payable is credited.

No entry for forward contract

Recording foreign exchange loss:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Foreign exchange loss		1,000
	Accounts payable			1,000
	(to record foreign exchange loss)

Table (2)

• Since, Foreign exchange loss is a loss and losses are increased. Hence, Foreign exchange loss is debited.
• Since, accounts payable is a liability and liabilities are increased. Hence, accounts payable is credited.

Recording gain on forward contract:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	AOCI		1,000
	Gain on forward contract			1,000
	(to record gain on forward contract)

Table (3)

• Since, AOCI i is a liability and liabilities are decreased. Hence, AOCI is debited.
• Since, gain on forward contract is a gain and gains are increased. Hence, gain on forward contract is credited.

Recording AOCI:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Forward contract		1,176.36
	AOCI			1,176.36
	(to record AOCI)

Table (4)

• Since, forward contract is a revenue and revenues are increased. Hence, forward contract is debited.
• Since, AOCI is a liability and liabilities are increased. Hence, AOCI is credited.

Recording premium expense:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Premium expense		266.67
	AOCI			266.67
	(to record premium expense)

Table (5)

• Since, premium expense is an expense and expenses are increased. Hence, premium expense is debited.
• Since, AOCI is a liability and liabilities are increased. Hence, AOCI is credited.

Recording foreign exchange loss:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
3/1/Y2	Foreign exchange loss		1,400
	Accounts payable			1,400
	(to record foreign exchange loss)

Table (6)

• Since, Foreign exchange loss is a loss and losses are increased. Hence, Foreign exchange loss is debited.
• Since, accounts payable is a liability and liabilities are increased. Hence, accounts payable is credited.

Recording gain on forward contract:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
3/1/Y2	AOCI		1,400
	Gain on forward contract			1,400
	(to record gain on forward contract)

Table (7)

• Since, AOCI is a liability and liabilities are decreased. Hence, AOCI is debited.
• Since, gain on forward contract is a gain and gains are increased. Hence, gain on forward contract is credited.

Recording AOCI:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
3/1/Y2	Forward contract		423.64
	AOCI			423.64
	(to record AOCI)

Table (8)

• Since, AOCI is a liability and liabilities are decreased. Hence, AOCI is debited.
• Since, forward contract is a revenue and revenue is decreased. Hence, forward contract is credited.

Recording premium revenue:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Premium expense		533.33
	AOCI			533.33
	(to record premium expense)

Table (9)

• Since, premium expense is an expense and expenses are increased. Hence, premium expense is debited.
• Since, AOCI is a liability, liabilities increased. Hence, AOCI is credited.

Recording payment:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Foreign currency		22,400
	Cash			20,800
	Forward contract			1,600
	(to record accounts payable)

Table (10)

• Since, foreign currency is an asset and assets are increased. Hence, foreign currency is debited.
• Since, cash is an asset and assets are decreased. Hence, cash account is credited.
• Since, forward contract is a revenue and revenue is decreased. Hence, forward contract is credited.

Recording accounts Payable:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Accounts payable		22,400
	Foreign currency			22,400
	(to record accounts payable)

Table (11)

• Since, accounts payable is a liability and liabilities are decreased. Hence, accounts payable is debited.
• Since, foreign currency is an asset and assets are decreased. Hence, foreign currency is credited.

Recording cost of goods sold:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
3/15/Y2	Cost of goods sold		20,000
	Inventory			20,000
	(to record COGS)

Table (12)

• Since, cost of goods sold is revenue and revenue is increased. Hence, cost of goods sold is debited.
• Since, inventory is an asset and assets are decreased. Hence, inventory is credited.

Impact on net income can be calculated below:

Year 1

$\mathrm{Net}income=\mathrm{Income}/gains-\mathrm{expense}/loss$

Substitute $1,000 for gain and $1,000 and $266.67 for loss in the formula,

$\begin{array}{c}\mathrm{Net}income=\$1,000-\$1,000-\$266.67\\ =\$-266.67\end{array}$

Year 2

$\mathrm{Net}income=\mathrm{Sales}+\mathrm{income}/gains-\mathrm{expense}/loss$

Substitute $1400 for gain, $1400, $533.33 and $20,000 for loss in the formula,

$\begin{array}{c}\mathrm{Net}income=\$1,400-\$1,400-\$533.33-\$20,000\\ =-\$20,533.33\end{array}$

Impact on income over both accounting period is $20,800.

Working Note:

Conversion of sale from crown to USD

$\begin{array}{c}\mathrm{Sales}(inUSD)=\mathrm{Sale}value(incrown)\times \mathrm{USD}\text{}percrown\\ =20,000\times \$1\\ =\$20,000\end{array}$

Computation of foreign exchange gain in USD:

$\begin{array}{c}\mathrm{Foreign}exchangegain=Difference\times \mathrm{Sale}value\\ =(\$1.05-\$1.00)\times \$20,000\\ =\$1,000\end{array}$

Computation of net income of both accounting periods:

$\begin{array}{c}\mathrm{Net}income(Year1and2)=\mathrm{Net}income(Year1)+\mathrm{Net}income(Year2)\\ =(-\$20,533.33)+(-\$266.67)\\ =\$20,800\end{array}$

b.

To determine

Record journal entries and determine effect on net income using fair value hedge.

Explanation of Solution

Fair Value Hedge:

A fair value hedge 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.

Recording purchase:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/1/Y1	Inventory		20,000
	Accounts payable			20,000
	(to record purchase)

Table (13)

• Since, inventory is an asset and assets are increased. Hence, accounts receivable is debited.
• Since, accounts payable is a liability and liabilities are increased. Hence, accounts payable is credited.

No entry for forward contract

Recording foreign exchange loss:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Foreign exchange loss		1,000
	Accounts payable			1,000
	(to record foreign exchange loss)

Table (14)

• Since, Foreign exchange loss is a loss and losses are increased. Hence, Foreign exchange loss is debited.
• Since, accounts payable is a liability and liabilities are increased. Hence, accounts payable is credited.

Recording gain on forward contract:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Forward contract		1,000
	Gain on forward contract			1,000
	(to record gain on forward contract)

Table (15)

• Since, AOCI is a liability and liabilities are decreased. Hence, AOCI is debited.
• Since, gain on forward contract is a gain and gains are increased. Hence, gain on forward contract is credited.

Recording foreign exchange loss:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
3/1/Y2	Foreign exchange loss		1,400
	Accounts payable			1,400
	(to record foreign exchange loss)

Table (16)

• Since, Foreign exchange loss is a loss and losses are increased. Hence, Foreign exchange loss is debited.
• Since, accounts payable is a liability and liabilities are increased. Hence, accounts payable is credited.

Recording gain on forward contract:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
3/1/Y2	Forward contract		1,400
	Gain on forward contract			1,400
	(to record gain on forward contract)

Table (17)

• Since, forward contract is a revenue and revenue is increased. Hence, forward contract is debited.
• Since, gain on forward contract is a gain and gains are increased. Hence, gain on forward contract is credited.

Recording accounts Payable:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
12/31/Y1	Accounts payable		22,400
	Foreign currency			22,400
	(to record accounts payable)

Table (18)

• Since, accounts payable is a liability and liabilities are decreased. Hence, accounts payable is debited.
• Since, foreign currency is an asset and assets are decreased. Hence, foreign currency is credited.

Recording cost of goods sold:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
3/15/Y2	Cost of goods sold		20,000
	Inventory			20,000
	(to record COGS)

Table (19)

• Since, cost of goods sold is revenue and revenue is increased. Hence, cost of goods sold is debited.
• Since, inventory is an asset amd assets are decreased. Hence, inventory is credited.

Impact on net income can be calculated below:

Year 1

$\mathrm{Net}income=\mathrm{I}\mathrm{ncome}/gains-\mathrm{expense}/loss$

Substitute $1,176.36 for gain and  $1,000 for loss in the formula,

$\begin{array}{c}\mathrm{Net}income=\$1,176.36-\$1,000\\ =\$176.36\end{array}$

Year 2

$\mathrm{Net}income=\mathrm{I}\mathrm{ncome}/gains-\mathrm{expense}/loss$

Substitute $423.64 for gain and $1400 and $20,000 for loss in the formula,

$\begin{array}{c}\mathrm{Net}income=\$423.64-\$1,400-\$20,000\\ =-\$20,976.36\end{array}$

Impact on income over both accounting period is $20,800.

Working Note:

Conversion of sale from crown to USD

$\begin{array}{c}\mathrm{Sales}(inUSD)=\mathrm{Sale}value(incrown)\times \mathrm{USD}\text{}percrown\\ =20,000\times \$1\\ =\$20,000\end{array}$

Computation of foreign exchange gain in USD:

$\begin{array}{c}\mathrm{Foreign}exchangegain=Difference\times \mathrm{Sale}value\\ =(\$1.05-\$1.00)\times \$20,000\\ =\$1,000\end{array}$

Computation of net income of both accounting periods:

$\begin{array}{c}\mathrm{Net}income(Year1and2)=\mathrm{Net}income(Year1)+\mathrm{Net}income(Year2)\\ =\$176.36+(-\$20,976.36)\\ =-\$20,800\end{array}$