Question

Icebreaker Company (a U.S.-based company) sells parts to a foreign customer on December 1, 2020, with payment of 16,000 dinars to be received on March 1, 2021. Icebreaker enters into a forward contract on December 1, 2020, to sell 16,000 dinars on March 1, 2021. The forward points on the forward contract are excluded in assessing hedge effectiveness and are amortized to net income using a straight-line method on a monthly basis. Relevant exchange rates for the dinar on various dates are as follows: Date Spot Rate Forward Rate (to March 1, 2021) December 1, 2020 $ 2.70 $ 2.775 December 31, 2020 2.80 2.900 March 1, 2021 2.95 N/A Icebreaker must close its books and prepare financial statements at December 31. Company purchases materials from a foreign supplier on December 1, 2020, with payment of 16,000 dinars to be made on March 1, 2021. The materials are consumed immediately and recognized as cost of goods sold at the date of purchase. On December 1, 2020, Brandlin enters into a forward contract to purchase 16,000 dinars on March 1, 2021.

a-1. Assuming that Icebreaker designates the forward contract as a cash flow hedge of a foreign currency payable, prepare journal entries for the import purchase and foreign currency forward contract in U.S. dollars. a-2. What is the impact on 2020 net income? a-3. What is the impact on 2021 net income? a-4. What is the impact on net income over the two accounting periods? b-1. Assuming that Icebreaker designates the forward contract as a fair value hedge of a foreign currency payable, prepare journal entries for the import purchase and foreign currency forward contract in U.S. dollars. b-2. What is the impact on net income in 2020 and in 2021? b-3. What is the impact on net income over the two accounting periods?

Journal Entries for a-1: Record the purchase of materials. Record the forward contract. Record the entry to revalue the foreign currency account payable. Record the change in the fair value of the forward contract. Record the foreign exchange gain or loss on the forward contract. Record the amortization of the forward contract premium or discount. Record the entry to revalue the foreign currency account payable. Record the entry to adjust the carrying value of the forward contract to its current fair value. Record the foreign exchange gain or loss on the forward contract. Record the amortization of the forward contract premium or discount. Record settlement of the forward contract. Record the payment of dinars to the foreign supplier. Journal entries for b-1: Record the purchase of materials. Record the forward contract. Record the entry to revalue the foreign currency account payable. Record the change in the fair value of the forward contract Record the foreign exchange gain or loss on the forward contract. Record the entry to adjust the net amount recognized as foreign exchange gain or loss to reflect the amortization of the forward contract premium or discount. Record the entry to revalue the foreign currency account receivable. Record the entry to adjust the carrying value of the forward contract to its current fair value. Record the foreign exchange gain or loss on the forward contract.Record the entry to adjust the net amount recognized as foreign exchange gain or loss to reflect the amortization of the forward contract premium or discount. Record the settlement of the forward contract. Record the payment of dinars to the foreign supplier.

Answer 1

The dinar is selling at a premium in the forward market (forward rate > spot rate). The forward contract includes a premium of $1,200 [($2.775 − $2.70) x 16,000 dinars]. The premium will be amortized as an increase to net income over the life of the forward contract at the rate of $400 per month [$1,200 / 3 months].

a. Cash Flow Hedge

Date Journal Entry Debit   Credit

12/1/20 Accounts Receivable (dinars) 43,200   

Sales 43,200

To record sales revenue and a foreign currency

account receivable.

[$2.70 x 16,000 dinars]

No entry for the forward contract.

12/31/20 Accounts Receivable (dinars) 1,600

Foreign Exchange Gain or Loss 1,600

To revalue the foreign currency account receivable

and recognize a foreign exchange gain.

[($2.80 − $2.70) x 16,000 dinars]

OCI 2,000

Forward Contract 2,000

To record the change in fair value of the forward

contract as a liability.

[($2.90 − $2.775) x 16,000 dinars]

Foreign Exchange Gain or Loss 1,600

OCI 1,600

To record a foreign exchange loss on the forward

contract to offset the foreign exchange gain on the

account receivable.

OCI 400

Foreign Exchange Gain or Loss 400

To amortize the forward contract premium to net income

over the life of the contract.

[$1,200 x 1/3 = $400]

Impact on 2020 net income:

Sales $43,200

Foreign exchange gain (loss) 400

Total   $43,600

Date Journal Entry Debit   Credit

3/1/21 Accounts Receivable (dinars) 2,400

Foreign Exchange Gain or Loss 2,400

To revalue the foreign currency account receivable

and recognize a foreign exchange gain.

[($2.95 − $2.80) x 16,000 dinars]

OCI 800

Forward Contract 800

To adjust the carrying value of the forward

contract to its current fair value.

[($2.95 − $2.775) x 16,000 = $2,800 − $2,000 = $800]

Foreign Exchange Gain or Loss 2,400

OCI 2,400

To record a foreign exchange loss on the forward

contract to offset the foreign exchange gain on the

account receivable.

OCI 800

Foreign Exchange Gain or Loss 800

To amortize the forward contract premium to net income

over the life of the contract.

[$1,200 x 2/3 = $800]

Foreign Currency (dinars) 47,200

Accounts Receivable (dinars) 47,200

To record the receipt of dinars from the foreign

customer.

[$2.95 x 16,000 dinars]

Cash [$2.775 x 16,000 dinars] 44,400

Forward Contract 2,800

Foreign Currency (dinars) 47,200

To record settlement of the forward contract.   

  

Impact on 2021 net income:

Foreign exchange gain (loss) $800

Total $800

Impact on net income over both periods, which is equal to net cash inflow:

$43,600 + $800 = $44,400

b. Fair Value Hedge

Date Journal Entry   Debit   Credit

12/1/20 Accounts Receivable (dinars) 43,200   

Sales 43,200

To record sales revenue and a foreign currency

account receivable.

[16,000 x $2.70]

No entry for the forward contract.

12/31/20 Accounts Receivable (dinars) 1,600

Foreign Exchange Gain or Loss 1,600

To revalue the foreign currency account receivable

and recognize a foreign exchange gain.

[16,000 x ($2.80 − $2.70)]

Foreign Exchange Gain or Loss 2,000

Forward Contract 2,000

To record the change in fair value of the forward

contract as a liability and recognize a foreign

exchange loss on the forward contract.

[16,000 x ($2.90 − $2.775)]

OCI 800

Foreign Exchange Gain or Loss 800

To adjust the net amount recognized as foreign exchange loss to reflect the current period’s amortization of the forward contract premium.

Note that the amount recognized in OCI is closed to AOCI at the end of the period.

Impact on 2020 net income:

Sales $43,200

Foreign exchange gain (loss) 400

Total   $43,600

Date Journal Entry Debit   Credit

3/1/21 Accounts Receivable (dinars) 2,400

Foreign Exchange Gain or Loss 2,400

To revalue the foreign currency account receivable

and recognize a foreign exchange gain.

[16,000 x ($2.95 − $2.80)]

Foreign Exchange Gain or Loss 800

Forward Contract 800

To adjust the carrying value of the forward

contract to its current fair value and recognize

a foreign exchange loss.

[16,000 x ($2.95 − $2.775) = $2,800 − $2,000 = $800]

Foreign Exchange Gain or Loss 800

AOCI 800

To adjust the net amount recognized as foreign

exchange gain to reflect the current period's

amortization of forward contract premium by transferring

the amount of loss deferred in AOCI to net income

Foreign Currency (dinars) 47,200

Accounts Receivable (dinars) 47,200

To record the receipt of dinars from the foreign

customer.

Cash 44,400

Forward Contract 2,800

Foreign Currency (dinars) 47,200

To record settlement of the forward contract.   

  

Impact on 2021 net income:

Foreign exchange gain (loss) $800

Total $800

Impact on net income over both periods, which is equal to net cash inflow:

$43,600 + $800 = $44,400