Solution manual advanced accounting 4e jeter ch12

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.. When a transaction

CHAPTER 12

ANSWERS TO QUESTIONS

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

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

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 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 Deivative 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

** 600,000 $0.490 = $294,000

Exercise 12-7

Part A Oct 2 Accounts Receivable (300,000 $.4737) 142,110

(300,000 $.473= $141,900)

Transaction Gain [(300,000 $.4895 = 146,850) - 142,110] 4,740

31 Transaction Loss [(300,000 $.4810 = $144,300) - $141,900] 2,400

2 Cumulative effect on net income: $144,450 - $2,550 = $141,900

3 Cash received = $141,900

Exercise 12-8

1 Merchandise Inventory 131,700

Exercise 12-9

Exercise 12-10

Dollars Payable to Exchange Dealer (900,000 $.5085) 457,650

[(900,000 $.4996 = $449,640) - $457,650]

Dollars Payable to Exchange Dealer (100,000 $1.01) 101,000

Foreign Exchange Gain – Other Comprehensive Income 1,000 [100,000 $1.01- $1.02)]

Foreign Exchange Gain – Other Comprehensive Income 2,000 [100,000 $1.02- $1.04)]

Exercise 12-14

Alternative entries are presented assuming the forward contract is not formally recorded on the books Dec 1 Dollars Receivable from Exchange Dealer (1,000,000 $.0948) 94,800

[1,000,000 $.0948 - $.0944)]

[1,000,000 $.0948 - $.0944)]

Alternative entries assuming the forward contract is not formally recorded

Dec 1 No Entry

[1,000,000 $.0948 - $.0944)]

[1,000,000 $.0948 - $.0944)]

Exercise 12-14 continued

Exercise 12-15

Part A If the Krona weakens relative to the dollar, it means that the firm would receive fewer dollars

for each Krona received and an exchange loss would be recognized

Part B A put option is used when foreign currency to be received in the future needs to be sold and

converted into dollars

Part C

To adjust the option to its intrinsic value of $3,000

Problem 12-2

(210,000 $.1314 = $27,594)

Part B The aggregate transaction gain of $228 ($126 - $126 + $228) is included in the firm's income

statement as part of continuing operations

Part B Net income decreased by $75,100 in 2008 and increased by $73,100 in 2009 This results in a

net decrease of $2,000 over both years The decrease is equal to the difference between the cash received on the settlement date of $442,100 and the amount of sales recorded of

$444,100

Part C Dec 1 Dollars Receivable from Exchange Dealer 445,100

(1,000,000 $.4451 = $445,100)

Transaction Gain [(1,000,000 $.3810 = $381,000)- $445,100] 64,100

Jan 31 Transaction Loss [(1,000,000 $.4421 = $442,100)- $381,000] 61,100

FC Payable to Exchange Dealer (16,500,000 $.1442 = $2,379,300) 2,379,300

Problem 12-4 (continued)

Dollars Receivable from Exchange Dealer (50,000 $1.5920 = 79,600) 79,600

Problem 12-5 (continued)

Part B

Dec 31 FC Payable to Exchange Dealer ((50,000 $1.5800 = $79,000) - $79,600) 600

Mar 1 Transaction Loss ((50,000 $1.6543 = $82,715) - $79,000) 3,715

Cash paid to complete forward contract 79,600

Part A Oct 1 Sales contract - No entry required since it is a commitment to sell

1 Dollars Receivable from Exchange Dealer 371,341

50,100,000 $.007412 = $371,341

Problem 12-6 (continued)

Jan 28 Accounts Receivable (50,100,000 $.007623) 381,912

Accounts Receivable is recorded at spot rate

Problem 12-7

Part A Rather than focusing on the solution, students should focus on the rational supporting their

conclusions Accordingly, the following questions should be given consideration:

1 What is the purpose of the company policy? Under what conditions might it be justified to deviate from company policy, if any?

2 In whose best interest was the controller acting? Is there some overall "best interest" which supersedes company policy?

3 Is it appropriate to have "situation specific" ethics?

Eliminates potential to take advantages of any favorable exchange rate changes

3 SFAS No 133 specifies the disclosure requirements concerning concentrations of credit risk for all financial instruments SFAS No 107 is relied on to provide valuation guidance for measuring fair value

SFAS No 133 requires that an entity recognize all derivatives as either assets or liabilities measured at fair value Specific disclosures required under SFAS No 133 are the objectives

of the instruments, the context needed to understand them, the strategies for achieving them, the risk management policy, and a description of items or transactions that are hedged for each

of the following:

1 Fair value hedges

2 Cash flow hedges

3 Foreign currency net investment hedges; and

4 All other derivatives

For derivative instruments not designated as hedges, the purpose of their activity must be disclosed Qualitative disclosures concerning the use of derivative instruments are encouraged, particularly in a context of overall risk management, as well as for financial instruments or nonfinancial assets and liabilities related by activity to derivative instruments

Part C 1 Options are to (a) enter into foreign currency hedges or (b) leave the contracts exposed to

future currency fluctuations

2 Rather than focusing on the specific decision, students should give consideration to the conflict between fiduciary responsibility to shareholders and desire for individual financial gain

Exchange Gain – Other Comprehensive Income (balance sheet equity) 3,000

To record a gain on the change in option value ($9,000 - $6,000)

February 25, 2010

To adjust the option value to its current realizable value of $12,000:

the value of the option [($.60 exercise price less $.57 spot rate) x 400,000 francs]

of $12,000 less the carrying value of the option ($9,000)

To exercise the option and settle with the trader

Problem 12-9

Dec 1 Dollars Receivable from Exchange Dealer (200,000 $1.02) 204,000

Foreign Exchange Gain – Other Comprehensive Income 4,000 [200,000 $1.02- $1.00)]

Foreign Exchange Gain – Other Comprehensive Income 2,000 [200,000 $1.00 - $0.99)]

Foreign Exchange Gain – Other Comprehensive Income ($4,000 + $2,000) 6,000

To reclassify other comprehensive income into earnings

Problem 12-10

Note: Settlement date should be stated as 11/15/08

Part A

Oct 1 FC Receivable from Exchange Dealer (300,000 $1.23) 369,000

Problem 12-11

Part A

Oct 1 FC Receivable from Exchange Dealer (300,000 $1.23) 369,000

[300,000 ($1.30 - $1.28)] (using changes in forward rate)

[300,000 ($1.30 - $1.28)] using changes in spot rate)

Problem 12-12

Part A

To adjust the option to its intrinsic value of $18,000