Concept explainers
On June 1, Cairns Corporation purchased goods front 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 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 | $0.002 |
June 30 | 0.858 | 0.007 |
September 1 | 0.872 | N/A |
Cairns must close its books and prepare its second-quarter financial statements on June 30.
- a. Assuming that Cairns designates the foreign currency option as a cash flow hedge of a foreign currency payable, prepare
journal entries for these transactions in U.S. dollars. What is the impact on net income over the two accounting periods? - b. Assuming that Cairns designates the foreign currency option as a fair value hedge of a foreign currency payable, prepare journal entries for these transactions in U.S. dollars. What is the impact on net income over the two accounting periods?
a.
Prepare journal entries for foreign currency option as a cash flow hedge of a foreign currency payable. Identify be the impact on net income over the two accounting periods.
Explanation of Solution
The journal entries read to be passed in year (June month) (Cash flow hedge):
Date | Particulars | Post Ref. | Debit($) | Credit($) |
06/01/2017 | Goods Purchase | 852,000 | ||
Account Payable ( francs) | 852,000 | |||
( To record purchase of goods and 1000,000 francs at the spot rate @ $0.852 ) | ||||
Foreign currency option | 2,000 | |||
Cash | 2,000 | |||
( To record the purchase of the foreign currency option at fair value at the rate of $0.002) | ||||
30/6/2017 | Foreign exchange loss | 6,000 | ||
Account payable | 6,000 | |||
( To adjust the value of the fracas at spot rate @ $0.858 and record the loss resulting from appreciation in francs since June 1) | ||||
09/11/2017 | Foreign currency option | 5,000 | ||
AOCI ( Accumulated other comprehensive Income) | 5,000 | |||
(To adjust the fair value of the option from $0.002 to $0.007 with corresponding credit to AOCI ( Accumulated other comprehensive Income) ) | ||||
AOCI ( Accumulated other comprehensive Income) | 6,000 | |||
Gain on foreign currency option | 6,000 | |||
(To record gain on foreign currency option to affect the loss an account payable) | ||||
AOCI ( Accumulated other comprehensive Income) | 5,000 | |||
Option Income | 5,000 | |||
(To recognized the change in the time value of the option as an increase in net income) |
Table: (1)
Impact on the net income for quarter ending on 30th June:
Particulars | Amount($) | Amount($) |
Purchase | 852,000 | |
Foreign exchange loss | (6,000) | |
Gain on foreign currency option | 6,000 | |
Net gain / ( loss) | - | |
Option income | 5,000 | |
Impact on net income | 857,000 |
Table: (2)
Journal Entries as on 1st September:
Date | Particulars | Post Ref. | Debit($) | Credit($) |
9/1/2017 | Account Payable ( francs) | 14,000 | ||
Foreign exchange gain | 14,000 | |||
( To adjust the value of the fracas payable to new spot rate of $0.872) | ||||
AOCI ( Accumulated other comprehensive Income) | 20,000 | |||
Foreign exchange option | 20,000 | |||
(To adjust the fair value of the option from $0.852 to $0.872 with corresponding credit to AOCI ( Accumulated other comprehensive Income) ) | ||||
30/6/2017 | Loss on foreign currency option | 14,000 | ||
AOCI ( Accumulated other comprehensive Income) | 14,000 | |||
(To record gain on foreign currency option to affect the foreign currency loss an account payable with corresponding credit to AOCI ( Accumulated other comprehensive Income) ) | ||||
9/1/2017 | Account payable | 872,000 | ||
foreign currency | 872,000 | |||
(To record payment of francs 1000,000 so supplied at the spot rate) | ||||
Foreign currency | 872,000 | |||
Cash | 852,000 | |||
foreign currency option | 20,000 | |||
( To record exercise of option @ $0.852 and remove foreign currency from accounts) |
Table: (3)
Impact on the net income as on 1st September:
Particulars | Amount($) | Amount($) |
Foreign exchange gain | 14,000 | |
Gain on foreign currency option | ( 14,000) | |
Net gain / ( loss) | 0 | |
Option income | 0 | |
Impact on net income | 0 |
Table: (4)
b.
Prepare journal entries for foreign currency option as a fair value hedge of a foreign currency payable. Identify the impact on net income over the two accounting periods.
Explanation of Solution
The following entries need to be passed in year (June month) (Fair value hedge):
Date | Particulars | Post Ref. | Debit($) | Credit($) |
6/1/2017 | Goods Purchase | 852,000 | ||
Account Payable ( francs) | 852,000 | |||
( To record purchase of goods and 1000,000 francs at the spot rate @ $0.852 ) | ||||
Foreign currency option | 2,000 | |||
Cash | 2,000 | |||
( To record the purchase of the foreign currency option at fair value @ $0.888) | ||||
30/6/2017 | Foreign exchange loss | 6,000 | ||
Account payable (francs) | 6,000 | |||
( To adjust the value of the fracas at new spot rate @ $0.858) | ||||
Foreign currency option | 5,000 | |||
Gain on foreign currency option | 5,000 | |||
(To adjust the fair value of the option from $0.007 and record the gain an foreign currency option) |
Table: (5)
Impact on net income as on 30th June:
Particulars | Amount($) | Amount($) |
Purchase | 852,000 | |
Foreign exchange loss | (6,000) | |
Gain on foreign currency option | 5,000 | |
Net gain / ( loss) | (1,000) | |
Option income | 0 | |
Impact on net income | 851,000 |
Table: (6)
Journal entries on 1st September:
Date | Particulars | Post Ref. | Debit($) | Credit($) |
9/1/year | Account Payable ( francs) | 14,000 | ||
Foreign exchange gain | 14,000 | |||
( To adjust the value of the fracas payable at new spot rate of $0.872) | ||||
Account Payable ( francs) | 872,000 | |||
Foreign currency | 872,000 | |||
( To record payment of francs 1000,000 to supplies at spot rate @ $0.872 ) | ||||
Foreign currency (francs) | 872,000 | |||
Cash | 852,000 | |||
Foreign currency option | 20,000 | |||
( To record exercise of the option and remove foreign currency option from the accounts) |
Table: (7)
Impact on net income on 30th September:
Particulars | Amount($) |
Foreign exchange gain | 14,000 |
Net impact | 14,000 |
Table: (8)
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Chapter 9 Solutions
EBK ADVANCED ACCOUNTING
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