Chapter 9 Virtual Tutorial

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Centennial College *

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Jan 9, 2024

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Chapter 9 Virtual Tutorial – This session is recorded We will be assuming that the businesses that we are accounting for maintain their accounting records in Canadian dollars; therefore, we will need to convert any non-Canadian-dollar amounts (foreign currency amounts) to a Canadian- dollar equivalent. Foreign currency exchange risk – The risk that exchange rates will fluctuate and the final cash settlement amount will differ from the amount at the time the transaction was entered into  Account for foreign currency transactions and balances for both monetary and non-monetary items.  Explain hedging and the objectives of hedging  Account for foreign currency forward contracts using both the gross and net methods. Question 1 Cameron Ltd. purchased inventory that cost £1,000. Translate to Canadian $ a) Assume the following exchange rate: b) Assume the following exchange rate Answer:

Question 2 Canadian Co. purchased inventory from a company in the United Kingdom (UK). The purchase order was dated April 1 and was for £1,000,000 of goods. The goods were delivered on May 8 with payment due in 45 days. Canadian Co. paid the amount owing on Jun 11. What is the journal entry required? Did the Cdn $ strengthen or weaken April 1 £1 = $1.7382 Cdn. No entry is required Not applicable May 8 sale £1 = $1.7715 Cdn. Dr Inventory $1,771,500 Cr AP $1,771,500 Not applicable June 11 payment £1 = $1.6851 Cdn. Fx gain or loss? It will cost Canadian Co. less to settle this payable than was previously recorded The amount that Canadian Co. owes, in Canadian dollars, is different than the amount recorded on May 8. Dr AP $1,771,500 Cr Cash $1,685,100 Cr FX gain $86,400 Canadian dollar strengthened against the British pound —it became cheaper to acquire the pounds needed to pay the supplier. ( Assuming that Canadian Co. does not hold pounds, it will need to purchase them to make the payment).

Key takeaway: Whether an entity recognizes a foreign exchange gain or a loss depends on whether the business has a foreign-currency-denominated asset or liability position and whether the change in exchange rates is a strengthening or weakening of the Canadian dollar relative to the foreign currency. Hedging Foreign currency exchange risk – The risk that exchange rates will fluctuate and the final cash settlement amount will differ from the amount at the time the transaction was entered into. Hedge – A position that is taken to reduce or eliminate risk: It is an investment or contract that takes an offsetting position to the adverse price movement of a specific risk ( Involves taking a position that is opposite to the position at risk). Currency forward contract – a contract with another party to purchase or sell foreign currency at a specified price at, or before, some date in the future Forward contracts, commonly referred to as forwards , are a type of derivative instrument where two parties enter into a contractual arrangement to make an exchange of currency at a specified price on a specified date. Forwards are financial instruments and, in accordance with IFRS 9, they must be stated at fair value through profit and loss at each reporting date. A forward contract has two sides to it: the amount that has to be delivered to the third party (i.e., a broker), and the amount that will be received from the third party. For the purposes of this course, we will assume that for all forward contracts, one side of the contract is Canadian dollars. Updating the contract to its fair

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value requires that we remeasure the side of the contract that is stated in a foreign currency . Situation 1: Canadian company has a future accounts payable denominated in a foreign currency it need to pay its supplier. Forward contract receivable: Due from broker is the foreign currency needed to settle the future accounts payable. The Due from broker is adjusted for any change in the forward contract rate at settlement date. Remeasuring, or revaluing, the foreign side of the contract will result in a foreign exchange gain or loss. The other side of this forward contract will be to deliver Canadian dollars to the broker ( Due to broker ). This is a fixed amount in Cdn $ at the set forward contract rate. This Canadian dollar side will not need to be updated in the accounts. Situation 2: Canadian company has a future accounts receivable denominated in a foreign currency it will receive from its customer. Forward contract payable: Due to broker is the foreign currency received from the customer. The Due to broker is adjusted for any change in the forward contract rate at settlement date. Remeasuring, or revaluing, the foreign side of the contract will result in a foreign exchange gain or loss. The other side of this forward contract (Due from broker) is in Canadian $ and is a set amount. There are two methods that we can use to account for forward contracts: the gross method and the net method. Under the gross method, we record in one account the amount that is due from broker and in a separate account the amount that is due to broker. With the net method, only one account is used and it reports the net position of the contract. We will call this account Forward Contract, and it may be either an asset or a liability account, depending on the overall position of the contract. The forward contract needs to be revalued at each intervening reporting period and at the date of settlement. The foreign denominated side of the forward contract will be revalued

to its fair value with reference to the forward rate in effect for contracts settling on the same settlement date. Example: Forward contract Anchor Ltd. is a Canadian manufacturer specializing in manufacturing leather boots. On January 25, 2022, Anchor received an order for merchandise from an Australian retailer for A$1,000,000 (Australian dollars (A$)). The merchandise was delivered to the Australian retailer on March 1, 2022 with a requirement to pay within 30 days. Anchor received payment on March 31, 2022. The merchandise delivered had a cost of $550,000 Cdn. On January 25, 2022, in order to reduce the foreign exchange risk associated with the sale, Anchor enters into a forward exchange contract (payable) to deliver A$1,000,000 to the broker on March 31, 2022. Anchor has a February 28 year end. The relevant exchange spot rates and forward rates for contracts settling on March 31, 2022, are: Spot rate Forward rates* January 25, 2022 A$1 = 0.967 0.955 February 28/ March 1, 2022 A$1 = 0.945 0.962 March 31, 2022 A$1 = 0.936 n/a * For contracts expiring on March 31, 2022 Required: Prepare the journal entries (in Cdn. dollars) for the forward contract and the order using the net method and gross method

Summary of events Transaction Gross Method Net Method January 25, 2022: Enter into forward contract with broker Dr. Due from broker (Cdn) Cr Due to broker (A$) To set up the forward contract payable at the agreed upon exchange rate of .955 No entry February 28, 2022 (year-end adjustment) Dr. Exchange loss on forward contract Cr Due to broker To revalue the forward contract to the forward contract rate at year-end of 0.962 Dr. Exchange loss on forward contract Cr. Forward contract To revalue the forward contract to the forward contract rate at year-end of 0.962 March 1, 2022 Delivery of goods and receipt of payment from customer Dr. Accounts receivable Cr. Sales Dr. Cost of sales Cr. Inventory Set up using the spot rate on March 1 - A$1 = 0.945 Dr. Accounts receivable Cr. Sales Dr. Cost of sales Cr. Inventory Set up using the spot rate on March 1 - A$1 = 0.945 March 31, 2022 Receive payment from customer in A$ (same for both net and gross method) Dr. Cash (A$) .936 Dr. Exchange loss Cr. Accounts receivable Translate customer payment at the spot rate on March 31 of A$1 = 0.936 and book exchange loss Dr. Cash (A$) .936 Dr. Exchange loss Cr. Accounts receivable Translate payment at the spot rate on March 31 of A$1 = 0.936 and book exchange loss March 31 – settle the forward contract Dr Due to broker Cr. Exch gain on fwd contract Cr Cash (A$) 0.936 Settle up with broker and clear the Due to broker A/C Dr Cash (Cdn) Cr Due from broker Receive $1,000,000 x .955 fwd rate Dr. Forward contract Dr. Cash (Cdn.) Cr. Cash (A$) .936 Cr. Exch gain on fwd contract Receive 1000,000 x .955 fwd rate Settle up with broker at the agreed upon rate Note: Since Anchor has an accounts receivable, the forward contract is a payable (Due to broker).

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January 25, 2022: Enter into forward contract with broker Net method No entry required under the net method. Gross method Dr. Due from broker (Cdn) $$955,000 Cr Due to broker (A$1,000,000) $955,000 1,000,000 x .955 Net Gross Jan 25, 2022 No entry Dr Due from broker (Cdn) $955,000 Cr Due to broker (A$ $1,000,000) $955,000 The contract is initially valued at the forward rate for the date of settlement. Note that the Due from broker amount is a fixed value of $955,000 Cdn. This account will remain at $955,000 until the contract is settled. February 28, 2022 (year-end adjustment) Net method Dr. Exchange loss on forward contract 7,000 Cr. Forward contract 7,000 To revalue the forward contract (Fwd contract payable) at year end ((A1,000,000 × 0.955) − (A1,000,000 × 0.962)). The forward contract payable will cost more to settle up as the company will need Cdn $0.962 for each A$1. Was 955,000, now 962,000 Gross method Dr. Exchange loss on forward contract $ 7,000 Cr Due to broker $7,000 To revalue the forward contract at year end ((A1,000,000 × 0.955) − (A1,000,000 × 0.962)) Net Gross Feb 28 Dr Exch loss on fwd contract $7,000 Cr Forward contract $7,000 Dr Exch loss on fwd contract $7,000 Cr Due to broker $7,000

March 1, 2022 Delivery of goods and receipt of payment from customer (Same for both net and gross method) Dr. Accounts receivable $945,000 Cr. Sales 945,000 Dr. Cost of sales $550,000 Cr. Inventory 550,000 March 31, 2022 From customer Dr. Cash (A$) $936,000 Dr. Exchange loss (1,000,000 x (.936-.945) 9,000 Cr. Accounts receivable $945,000 Receipt the payment from customer. (A1,000,000 × 0.936). The AR was worth $945,000 now its worth $936,000 (for every A$1, the company is only getting Cdn $0.936); therefore, an exchange loss. March 31 – settle the forward contract Net method Dr. Forward contract (Bring to zero balance) 7,000 Dr. Cash (Cdn.) Receive 1000,000 x .955 955,000 Cr. Cash (A$) Settle up with broker 936,000 Cr. Exchange gain on forward contract 26,000 To record the settling of the Fwd contract; each party delivers the full amount of currency stipulated in the contract. The balance in the Fwd Contract account needs to be eliminated, and the cash transactions recorded. Gross method Dr Due to broker $962,000 Cr. Exchange gain on fwd contract $26,000 Cr Cash (A$ 1000,000) $936,000 Settle up with broker Dr Cash (Cdn) $955,000 Receive $1,000,000 x .955 fwd rate Cr Due from broker $955,000 Net Gross Jan 15, No entry Dr Due from broker (Cdn) $955,000

2022 Cr Due to broker (A$ $1,000,000) $955,000 Net Gross Feb 28 Dr Exch loss on Fwd contract $7,000 Cr Forward contract $7,000 Dr Exch loss on Fwd contract $7,000 Cr Due to broker $7,000 Ma r 31 Dr. Forward contract $7,000 Dr. Cash (Cdn.) $955,000 Cr. Cash (A$) $936,000 Cr. Exch gain on Fwd cont $26,000 Dr Due to broker $962,000 Cr. For exchange gain $26,000 Cr Cash $936,000 Dr Cash (Cdn) $955,000 Cr Due from broker $955,000 Value agreed to receive for A$1,000,000 (fwd contract) $ 955,000 Value of A$1,000,000 received on March 31 (from customer) 936,000 Net gain on forward contract $ 19,000 Wrap up 1) Which of the following statements is true? A) The gross method of accounting for forward contracts will result in a different net exchange gain (loss) when compared to the net method. B) Both the gross and net methods of accounting for forward contracts require an entry when the forward contract is entered into. C) The foreign exchange gain (loss) will be the same regardless of whether the gross or net method is used to account for a forward contract. D) When using the net method to account for forward contracts, there will be a forward contract receivable and forward contract payable reported separately on the statement of financial position (SFP). Answer: C

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