Question

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On June 1, Parker-Mae Corporation (a U.S.-based company) received an order to sell goods to a...

On June 1, Parker-Mae Corporation (a U.S.-based company) received an order to sell goods to a foreign customer at a price of 145,000 francs. Parker-Mae will ship the goods and receive payment in three months, on September 1. On June 1, Parker-Mae purchased an option to sell 145,000 francs in three months at a strike price of $1.12. The company designated the option as a fair value hedge of a foreign currency firm commitment. The option's time value is excluded in assessing hedge effectiveness, and the change in time value is recognized in net income. The fair value of the firm commitment is measured by referring to changes in the spot rate (discounting to present value is ignored). Relevant exchange rates and option premiums for the franc are as follows:

Date Spot Rate Put Option Premium
for September 1
(strike price $1.12)
June 1 $ 1.12 $ 0.020
June 30 1.06 0.072
September 1 0.98 N/A


Parker-Mae Corporation must close its books and prepare its second-quarter financial statements on June 30.

  1. Prepare journal entries for the foreign currency option, foreign currency firm commitment, and export sale.

  2. What is the impact on net income in each of the two accounting periods?

  3. What is the amount of net cash inflow resulting from the sale of goods to the foreign customer?

Solutions

Expert Solution

Solution-
1)
For June 1, calculate the value of the foreign currency option:
Foreign Currency Option = 145,000 * 0.020 = $ 2900
Journal entry for June 1:

DATE PARTICULARS DEBIT CREDIT
1-JUN FOREIGN CURRENCY OPTION A/C 2900
TO CASH A/C 2900

There is no need to record the sales agreement since it is considered as an executive contract.
Since the spot rates decreased between the two dates of June, there is a loss on the firm commitment.
Loss on firm commitment = [ 145,000 * ( 1.06- 1.12) ] = ($8700)
Since the Put Option Premium rates increased in value between the two dates in June, there is a gain on the foreign currency option.
Gain on foreign currency option = 145,000 * ( 0.072 - 0.020) = $7540
Appropriate journal entry for June 30-

DATE PARTICULARS DEBIT CREDIT
30-JUN LOSS ON FIRM COMMITMENT A/C 8700
TO FIRM COMMITMENT A/C 8700
(Being loss on firm commitment)
FOREIGN CURRENCY OPTION A/C 7540
TO GAIN ON FOREIGN CURRENCY OPTION A/C 7540
(Being Gain on firm commitment)

For September 1, the spot rate values have decreased from the previous two dates, therefore, causing a loss on the value of the firm commitment.
Loss on firm commitment = [ 145,000 * ( 0.98- 1.12) ] + 8700= ($11600)
Since the value of the Put option has increased, there is a gain on the foreign currency option
Gain on Foreign Currency = [ 145,000  * ( 1.12- 0.98) - ( 145,000  * 0.072) = $ 9860
Amount to be recorded as sales on September 1:
Foreign Currency = 145,000 * 0.98= $142100

Amount of cash to be recorded on September 1:
Cash = 145,000 * $1.12= $162400
It is taken as the rate of $1.12 because that was the agreed upon strike price at the time of purchase and not at the spot rate of $0.98.

Amount that will be reported from the foreign currency option:

Foreign Currency Option = Cash - Foreign Currency

= $162400- $142100

= $20300
Journal entry detailing the transactions:

DATE PARTICULARS DEBIT CREDIT
1-SEP LOSS ON FIRM COMMITMENT A/C 11600
TO FIRM COMMITMENT A/C 11600
FOREIGN CURRENCY OPTION A/C 9860
TO GAIN ON FOREIGN CURRENCY OPTION A/C 9860
FOREIGN CURRENCY (francs)A/C 142100
TO SALES A/C 142100
CASH A/C 162400
TO FOREIGN CURRENCY A/C 142100
TO FOREIGN CURRENCY OPTION A/C 20300
FIRM COMMITMENT A/C 20300
TO ADJUSTMENT TO NET INCOME A/C 20300

2) The impact of net income in each of the two accounting periods-

PARTICULARS AMOUNT$
LOSS ON FIRM COMMITMENT -8700
GAIN ON FOREIGN CURRENCY OPTION 7540
IMPACT ON NET INCOME -1160

The impact on net income for the second quarter is a negative $ -1160
Impact of net income over the third quarter:

PARTICULARS AMOUNT
SALES 142100
LOSS ON FIRM COMMITMENT -11600
GAIN ON FOREIGN CURRENCY OPTION 9860
ADJUSTED TO NET INCOME 20300
IMPACT ON NET INCOME 160660

The impact of net income over the third quarter is $160660 an amount that more than makes up for the loss on net income for the second quarter.

3) Net cash inflow from the sale of goods to the foreign customer
Net cash inflow = 162400- 2900= $159500.


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