Question

Lo 9-7, 9-8

37. On October 1, 2020, Mertag Company ( a U.S.-based comany) receives an order from a customer in Poland to deliver goods on January 31,2021, for a price of 1,000,000 Polish zotys (PLN). Mertag enters into a forward contract on October 1, 2020, to sell PLN 1,000,000 in four months ( on January 31, 2021). U.S. dollar-Polis zioty exchange rates are follows:

October 1, 2020 $0.25 $0.29

December 31, 2020 0.28 0.31

January 31, 2021 0.30 N/A

Mertag designates the forward contract as a fair value hedge of a foreign currency firm commitment. The fair value of the firm commitment is measured b referring to changes in the forward rate, and, therefore, forward points are included in assessing hedge effectiveness. Mertag must close its books and prepare financial statements on December 31. Discounting to present value can be ignored.

a. Prepare journal entries for the foreign currency forward contract, foreign currency firm commitment and export sale.

b. Determine the net benefit, if any, realized by Mertag from entering into the forward contract.

Answer 1

Because the forward exchange rate is used to measure the fair value of the firm commitment, forward points may not be excluded in assessing hedge effectiveness. Therefore, the forward contract premium is not amortized to net income.

a.

Journal Entries

10/1/20   There is no entry to record either the sales agreement or the forward contract as both are executory contracts.

12/31/20 Foreign Exchange Gain or Loss 20,000

Forward Contract 20,000

[($0.31 − $0.29) x PLN 1,000,000]

Firm Commitment 20,000

Foreign Exchange Gain or Loss 20,000

1/31/21 Forward Contract 10,000

Foreign Exchange Gain or Loss 10,000

Foreign Exchange Gain or Loss 10,000

Firm Commitment 10,000

Foreign Currency (PLN) 300,000

Sales 300,000

Cash 290,000

Forward Contract 10,000

Foreign Currency (PLN) 300,000

Sales 10,000

Firm Commitment 10,000

Overall impact on net income is:

Sales   $290,000

Impact on net income $290,000 = Cash Inflow

b.

The company would have been better off without the forward contract by $10,000. In that case the increase in Cash would have been $300,000 [$0.30 spot rate on 1/31/21 x PLN 1,000,000]. With the forward contract, the company generates only $290,000 of cash inflow.