Module 5:

Foreign Currency Transactions

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INTERNATIONAL FINANCE
AND ACCOUNTING
 LO1
Introduction
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— Export sale
— Import purchase
— 3M suppliers:
https://www.3m.com/3M/en_US/suppliers-
direct/global-landing/
— Denominated currency
— Exchange rate
— Date of sale/purchase, date of balance sheet, date of
payment

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 Introduction
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— Denominated currency
– which currency is agreed to make payment in

¡ Is Canadian dollars if the parties involved in an import or export

transaction agree that the payment will be in Canadian dollars.

¡ Is foreign currency when the agreement calls for the transaction to

be settled (paid) in foreign currency

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 Introduction
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— When denominated currency is foreign currency

¡ If the transaction is a purchase (import), the Canadian

company will have to buy foreign currency in order to make
payment.
¡ If the transaction is a sale (export), the Canadian company will
receive foreign currency as a result of its exports, and
will have to sell the foreign currency in order to receive
Canadian dollars.

— The company is said to have an exposure to foreign

exchange risk. Specifically, a transaction exposure.

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 Foreign Currency Transactions
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— Example
¡ Joe Inc., a U.S. company, makes a sale and ships goods to Jose,
SA, a Mexican customer on Dec 1, 2020
¡ Sales price is 1,000,000 pesos to be paid in three months, i.e.,
Mar 2, 2021
¡ The current exchange rate is 1 peso = $0.10 USD

¡ Joe expects to receive 1,000,000 pesos, worth of $100,000

USD (= 1,000,000 x $0.10)

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 Foreign Currency Transactions
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— Joe has foreign exchange risk exposure because he

may receive more or less than $100,000 USD.
— Suppose the peso depreciates such that the exchange
rate is 1 peso = $0.09 USD on Mar 2, 2021.
— Joe will receive 1,000,000 pesos which will be worth
$90,000 USD (1,000,000 x $0.09) and Joe receives
$10,000 USD less due to exchange rate fluctuation.

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 Introduction
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Three dates are involved:

— Date of sale/purchase, date of balance sheet, date of payment

¡ Date of transaction: The time the transaction occurs

¡ Date of balance sheet: The date at which the financial statements are
reported and
¡ The date of payment: receipt or payment of the foreign-currency-
denominated receivable or payable

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 Introduction
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— The exchange rate can change between these dates

— The value of accounts receivable (or accounts payable)

change accordingly
— Need to make accounting adjustment on these dates to
reflect the changes

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 Example 1: Export
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— On November 15, Year 1, Regina Malt Producers (Canadian company)

shipped a carload of malt to a brewery in the US, with full payment to
be received on January 31, Year 2. The selling price of the malt was
US$26,000. Regina Malt has a December 31 year-end. The following
exchange rates existed on the dates significant for accounting purposes:

Exchange Rate
Transaction date Nov 15, Year 1 US$1 = CDN$1.125
Year-end Dec 31, Year 1 US$1 = CDN$1.129
Settlement date Jan 31, Year 2 US$1 = CDN$1.119

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 Exchange Rate

Example 1:Nov
Export
15, Year 1 US$1 = CDN$1.125
Dec 31, Year 1 US$1 = CDN$1.129
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Jan 31, Year 2 US$1 = CDN$1.119
— On November 15, Year 1, Regina Malt Producers shipped a carload of
malt to a brewery in the US, with full payment to be received on
January 31, Year 2. The selling price of the malt was US$26,000.
Regina Malt has a December 31 year-end.

— The journal entries on the Nov 15, Year 1 noted are as follows:

Transaction Nov 15, Year 1 US$1 = CDN$1.125

date
Dr. Accounts receivable 29,250 (=26,000*1.125)
Cr. Sales 29,250

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 Exchange Rate

Example 1:Nov
Export
15, Year 1
Dec 31, Year 1
US$1 = CDN$1.125
US$1 = CDN$1.129
11 Jan 31, Year 2 US$1 = CDN$1.119
— On November 15, Year 1, Regina Malt Producers shipped a carload of
malt to a brewery in the US, with full payment to be received on
January 31, Year 2. The selling price of the malt was US$26,000.
Regina Malt has a December 31 year-end.

— The journal entries on the dates noted are as follows:

Year-end Dec 31, Year 1 US$1 = CDN$1.129

Dr. Accounts receivable 104 =26,000*(1.129-1.125)
Cr. Exchange gain 104

Accounts receivable is translated at the closing rate to produce a

current value in Canadian dollars, consistent with recording monetary
items at current values.

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 Exchange Rate

Example 1:Nov
Export
15, Year 1
Dec 31, Year 1
US$1 = CDN$1.125
US$1 = CDN$1.129
12 Jan 31, Year 2 US$1 = CDN$1.119
— On November 15, Year 1, Regina Malt Producers shipped a carload of
malt to a brewery in the US, with full payment to be received on
January 31, Year 2. The selling price of the malt was US$26,000.
Regina Malt has a December 31 year-end.

— The journal entries on the dates noted are as follows:

Settlement date Jan 31, Year 2 US$1 = CDN$1.119

Dr. Cash 29,094 = 26,000*1.119
Dr. Exchange loss 260
Cr. Accounts receivable 29,354 = 29,250 + 104

Exchange gains and losses are reflected in income in the year in which
they occur. (Net loss $156 –Year 1: 104 gain; Year 2: 260 loss)

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 Exercise: Export Sale
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— Garden Grove Corporation (a US company) made a sale to a foreign

customer on September Year 1, for 100,000 foreign currency units
(FCU). Payment was received on October 15, Year 1. Assume Garden
Grove closes its books on September 30 to prepare interim financial
statements. The following exchange rate apply:

— Prepare journal entries for Garden Grove in connection with this sale.

Date U.S. Dollar per FCU

September 15, Year 1 $0.40
September 30, Year 1 0.42
October 15, Year 1 0.37

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 Exercise: Import Purchase
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• On December 1, Year 1, Primero Company purchased inventory from

an foreign supplier for 40,000 coronas. Payment was agreed to be
made within 90 days. Primero paid the entire amount on February
14, Year 2. Primero has a December 31 fiscal year end. The following
exchange rates for 1 corona apply:
• Prepare journal entries for Primero in connection with this purchase.

Date U.S. Dollar per Corona

December 1, Year 1 $0.87
December 31, Year 1 0.82
February 15, Year 2 0.91

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Accounting for Foreign Currency Transactions
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Transaction Type of Foreign Foreign

Exposure Currency Currency
Appreciates Depreciates
Export Sale Asset Gain Loss
(Accounts
Receivable)
Import Liability Loss Gain
Purchase (Accounts Payable)

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 Forward Exchange Contracts
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A forward contract is a private agreement between two parties

giving the buyer an obligation to purchase an asset (and the seller an
obligation to sell an asset) at a set price at a future point in time.

In a forward exchange contract, two parties agree today to

exchange currencies at a future date at a specified exchange rate.

There is no up-front cost to enter into a forward contract

Example:
— Assume that Interco enters into a forward contract on Nov 1 to sell 1
million South Africa rand on May 1 at a forward rate of $0.15 per
rand, or a total of $150,000

— There is no cost for Interco to enter into the forward contract, and
the forward contract has no value on Nov 1.
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 LO1

Exchange Rate Quotations

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— The spot rate is the rate to exchange currency today.

— The forward rate is the rate agreed to today for exchanging

currency at a future date.

— Just like the spot rate can change over time, the forward rate
also fluctuates.

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 Forward Exchange Contracts
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— Forward contracts must be reported at fair value according to

IFRS.
¡ When the forward rate changes, the fair value of the forward contract changes.

Example:
— Assume that Interco enters into a forward contract on Nov 1 to sell
1 million South Africa rand on May 1 at a forward rate of $0.15 per
rand, or a total of $150,000
— On Dec 31, when Interco prepare financial statements, the forward
rate to sell South Africa rand on May 1 has changed to $0.147
— The forward contract now has a positive value: 1m X (0.15-0.147)
= $3000; that is, the forward contract saved Interco from a $3000
loss in foreign currency exchange.

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 Forward Exchange Contracts
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Example:
— The forward contract now has a positive value: 1m X
(0.15-0.147) = $3000; that is, the forward contract
saved Interco from a $3000 loss in foreign currency
exchange.
— Journal Entry:
Dr. Forward contract 3000
Cr. Gain on Forward contract 3000

If the forward rate on Dec 31 has changed to 0.157 instead,

Dr. Loss on Forward contract 7,000
Cr. Forward contract 7,000

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 Hedges
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— Foreign currency losses can be significant, and prudent

management suggests that they should be guarded
against if possible.
— This type of protection is generally referred to as
“hedging”, which can be defined as a means of
offsetting the risk exposure rising from foreign
exchange (or interest rate, or price) fluctuations.
— Forward exchange contract allows you to lock the
exchange rate ahead of time; therefore it is often
used as a hedging instrument.

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 Hedge Example
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Previous Example
¡ Joe Inc., a U.S. company, makes a sale and ships goods to Jose,
SA, a Mexican customer on Dec 1, 2020
¡ Sales price is 1,000,000 pesos to be paid in three months, i.e.,
Mar 2, 2021
¡ The current exchange rate is $0.10 USD per 1 peso
¡ Suppose the peso depreciates such that the exchange rate is
$0.09 USD per 1 peso on Mar 2, 2021.
¡ Joe will receive 1,000,000 pesos which will be worth $90,000
USD (1,000,000 x $0.09) and Joe receives $10,000 USD less
due to exchange rate fluctuation.

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 Hedging Foreign Exchange Risk
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— Go back to December 1, 2020. Assume that to offset the

exchange risk Joe entered a foreign currency forward
contract on December 1, 2020 that agrees to sell 1,000,000
pesos for $0.105 USD per peso on March 2, 2021.
— In this case, Joe would collect $105,000 USD for certain,
regardless how the exchange rate of peso fluctuates in the
next three months.
— In other words, the risk exposure rising from foreign
exchange fluctuations is hedged

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 Hedges
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— The hedged item is the item with the risk exposure that the
entity has taken steps to mitigate. A hedging instrument is the
item used to offset the risk exposure.

— In the previous example

Hedged item is The accounts receivable to be settled in Mar 2021;

Hedging instrument is The forward contract to sell pesos in Mar 2021;

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 Example: A Hedged Import Purchase
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Budvar Company purchases parts from a foreign supplier on

December 1, Year 1, with payment of 20,000 crowns to be made on
March 1, Year 2. On December 1, Year 1, Budvar enters into a
forward contract to purchase 20,000 crowns on March 1, Year 2.
Date Spot Rate Forward Rate
(to March 1, Year 2)
December 1, Year 1 $1.00 $1.04
December 31, Year 1 1.05 1.10
March 1, Year 2 1.12

— Record journal entries on the relevant dates. Ignore time value of

money.
— Observe the impact of the forward contract (how it offset the gains
and losses rising from the exchange rate fluctuations, i.e., smooth
out the net income numbers)

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 Example: A Hedged Import Purchase
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12/1/Y1 Inventory $20,000

Accounts payable (crown) [20,000 x $1.00] $20,000

No entry for the forward contract.

12/31/Y1 Foreign exchange loss $1,000

Accounts payable (crown) [20,000 x ($1.05-$1.00)] $1,000

Forward contract $1,200

Gain on forward contract $1,200
[20,000 x ($1.04-$1.10) = $1,200]

Impact on Year 1 income:

Foreign exchange loss $(1,000)
Gain on forward contract 1,200
Total $ 200

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 Example: A Hedged Import Purchase
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3/1/Y2 Foreign exchange loss $1,400
Accounts payable (crown) [20,000 x ($1.12-$1.05)] $1,400

Forward contract $400

Gain on forward contract $400
[20,000 x ($1.12-$1.10) = $400]

Foreign currency (crown) [20,000 x $1.12] $22,400

Cash [20,000 x $1.04] $20,800
Forward contract 1,600

Accounts payable (crown) $22,400

Foreign currency (crown) $22,400

Impact on Year 2 income:

Foreign exchange loss $(1,400)
Gain on forward contract 400
Total $(1,000)
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Exercise: Case 6-1
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 Exercise: Case 6-1
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Required:

• Assume the olive oil was received on December 1, Year 1, and payment
was made on January 31, Year 2. There was no attempt to hedge the
exposure to foreign exchange risk. Prepare journal entries to account
for this import purchase.

• Assume the olive oil was received on December 1, Year 1, and payment
was made on January 31, Year 2. On December 1, Zorba Company
entered into a two-month forward contract to purchase 50,000 crowns.
Determine the impact of this forward contract on each year’s net
income. Prepare journal entries to account for the import purchase and
the forward contract.

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 Hedge Accounting
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— Hedge accounting is defined and described in IFRS 9

¡ An entity can choose to apply hedge accounting if the conditions for
its use are present, but does not necessarily have to use it.

1. The derivative hedges either a fair value exposure or cash flow

exposure to foreign currency exchange risk.
2. The derivative is highly effective in offsetting changes in the fair
value or cash flows related to the hedged item.
3. The derivative is properly documented as a hedge.

— Under hedge accounting, the exchange gains or losses on the

hedged item will be recognized in the income statements in the
same period as the exchange gains or losses on the hedging
instrument (when they would otherwise be recognized in
different periods).
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 Hedge Accounting
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— Fair value exposure: changes in exchange rates affect the fair

value of an asset or liability with corresponding potential to
affect net income if it is not hedged.
— Cash flow exposure: changes in exchange rates affect the
amount of cash flow to be realized with a corresponding effect on
net income.

— Hedge accounting requires derivatives be classified as either:

• A fair value hedges: foreign currency assets, liabilities, firm
commitments, or.
• A cash flow hedge: all of the above, and forecasted foreign
currency transactions.

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 Hedge Accounting
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— Gains/losses on fair value hedges recognized immediately

in net income.
— Gains/losses on a cash value hedge are included in other
comprehensive income.

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 Hedge Accounting Example
Date Spot Rate 32 Forward Rate
June 2 US$1=CDN$1.26 US$1 = CDN$1.28
June 30 US$1 = CDN$1.275
August 1 US$1 = CDN$1.272 US$1 = CDN$1.272

— On June 2, Year 2, when the spot rate was US$1=CDN$1.26, Manning

Inc. of Vancouver from an American supplier for US$350,000. ordered
merchandise
— Delivery was scheduled for August 1 with payment to be made in full on
delivery.
— Upon placing the order, Manning immediately entered into a 60-day
forward contract with its bank to purchase US$350,000 on August 1 at
the forward rate of US$=CDN$1.28.
— Manning’s year-end is June 30.
— On August 1, the merchandise was received, and Manning purchased
the US dollars from the bank at the previously agreed rate and paid its
supplier.
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 Hedge Accounting Example
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Three dates are involved:

— Date of sale/purchase, date of balance sheet, date of payment

— Order was made June 2, but delivery was not until August 1; so
even though order was made in Year 2, gain or loss from this
transaction will be reported in Year 3 rather than Year 2

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 Hedge Accounting Example
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If Hedge Accounting is Not Used:

— Date of sale/purchase, date of balance sheet, date of
payment

Forward
Contract

Import
Purchase

Reported in Year 2 Reported in Year 3

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 Hedge Accounting Example
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If Hedge Accounting is Not Used:

— Date of sale/purchase, date of balance sheet, date of
payment

A Memo

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Hedge Accounting Example
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 Date Spot Rate Forward Rate LO1
June 2 US$1=CDN$1.26 US$1 = CDN$1.28
June 30 US$1 = CDN$1.275
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August 1 US$1 = CDN$1.272 US$1 = CDN$1.272
If Hedge Accounting is Not Used:
— Date of sale/purchase, date of balance sheet, date of
payment Forward rate = 1.272

Record the change of

value for the forward
contract:

Dr. Loss on Forward Contract 1050

Cr. Forward contract 1050
Forward rate = Forward rate =
1.28 1.275
Settle forward contract:
A Memo Record the change
Dr. Cash US$ 445200
of value for the
Dr. Forward contract 2800
forward contract:
Cr. Cash CAD$ 448000
Dr. Loss on Forward Contract 1750 Record Import Purchase:
Cr. Forward contract 1750
Dr. Inventory 445200
Cr. Cash US$ 445200
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 Hedge Accounting Example
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If Hedge Accounting is Used (say FV hedge):

— Date of sale/purchase, date of balance sheet, date of payment

Under hedge accounting, the exchange gains or losses on the hedged

item will be recognized in the income statements in the same period as
the exchange gains or losses on the hedging instrument (when they
would otherwise be recognized in different periods)

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 Hedges of Unrecognized Foreign Currency
Firm Commitments
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Firm commitment: a company signs a contract to deliver merchandise at

a future date with receivables in a foreign currency also at a future date.
• No journal entry when contract is signed.

— If it is a fair value hedge, (taken when the contract is signed, before any
accounting record of future transaction):
1. Gain/loss on the hedging instrument is recognized in net income.
2. Gain/loss on the firm commitment attributable to the hedged risk is
also recognized in net income.

Accounting Requires:
1. Measuring the fair value of the firm commitment.
2. Recognizing the change in fair value in net income.
3. Reporting the firm commitment on the balance sheet as an asset or liability.

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 LO1
Hedge Accounting Example
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If Hedge Accounting is Used (say FV hedge):

— Date of sale/purchase, date of balance sheet, date of payment

Forward rate =
1.28

A Memo

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Hedge Accounting Example
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 Date Spot Rate Forward Rate
June 2 US$1=CDN$1.26 US$1 = CDN$1.28
Hedge
JuneAccounting
30 Example
US$1 = CDN$1.275
August 1 42 = CDN$1.272
US$1 US$1 = CDN$1.272
If Hedge Accounting is Used (say FV hedge):

— Date of sale/purchase, date of balance sheet, date of payment

Record the change of value Record the change of value for the
A Memo for the forward contract: forward contract:

Dr. Loss on Forward Contract 1750 Dr. Loss on Forward Contract 1050
Cr. Forward contract 1750 Cr. Forward contract 1050

Record the change of value for the Record the change of value for the
upcoming Accounts Payable: upcoming Accounts Payable:
Dr. Firm Commitment 1750 Dr. Firm Commitment 1050
Cr. Gain on Firm Commitment 1750 Cr. Gain on Firm Commitment 1050

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 Date Spot Rate Forward Rate
June 2 US$1=CDN$1.26 US$1 = CDN$1.28
Hedge
JuneAccounting
30 Example
US$1 = CDN$1.275
August 1 43 = CDN$1.272
US$1 US$1 = CDN$1.272
If Hedge Accounting is Used (say FV hedge):

— Date of sale/purchase, date of balance sheet, date of payment

Continued:
Record the change of value Settle forward contract:
A Memo for the forward contract: Dr. Cash US$ 445200
Dr. Loss on Forward Contract 1750 Dr. Forward contract 2800
Cr. Forward contract 1750 Cr. Cash CAD$ 448000

Record the change of value for thePurchase of inventory & adjust NI

upcoming Accounts Payable: Dr. Inventory 445200
Cr. Cash US$ 445200
Dr. Firm Commitment 1750
Dr. Adjustment to Net Income. 2800
Cr. Gain on Firm Commitment 1750
Cr. Firm Commitment 2800

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 LO1

Exercise: Case 6-1, part 3

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 Exercise: Case 6-1, part 3
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Required:

• Assume the olive oil was ordered on December 1, Year 1. It was

received and paid for on January 31, Year 2. On December 1, Zorba
Company entered into a two-month forward contract to purchase
50,000 crowns. The forward contract is properly designated as a fair
value hedge of a foreign currency firm commitment. The fair value of
the firm commitment is measured through reference to changes in the
forward rate.

• How would hedge accounting make a difference on each year’s net

income? Prepare journal entries to account for the forward contract,
firm commitment, and import purchase.

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 Hedges
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¡ Fair value hedge:
÷ The entity uses a hedging instrument to hedge against the
fluctuation in the fair value of the hedged item.
÷ This method will be used when the hedged item will be measured
at fair value.
÷ The gain or loss in the fair values of the hedging instrument and
hedged items are both recognized in profit or loss in the period of
the change in values

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 Hedges
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¡ Cash flow hedge:

÷ The entity uses a hedging instrument (such as derivative) to
hedge against the fluctuation in the Canadian-dollar value of
future cash flows (such as future sales).
÷ The gain or loss on the hedging instrument is initially reported
in OCI and subsequently reclassified to profit when the hedged
item affects profit.

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 Analysis and Interpretation of Financial
Statements
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— The fair value hedge method shows the best liquidity

position because the firm commitment is included in the
balance sheet. Changes in the fair value of both the hedged
item and the hedging instrument are recognized in the
income statement.

— The cash flow hedge method shows the best performance

because exchange losses are reported in OCI and do not
negatively affect net income.

— The fair value hedge method shows the best solvency

position because shareholders’ equity is not negatively
affected by exchange losses.
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