Question

In: Accounting

On September 30, 2017, Ericson Company negotiated a two-year, 1,000,000 dudek loan from a foreign bank...


On September 30, 2017, Ericson Company negotiated a two-year, 1,000,000 dudek loan from a foreign bank at an interest rate of 2 percent per year. It makes interest payments annually on September 30 and will repay the principal on September 30, 2019. Ericson prepares U.S.-dollar financial statements and has a December 31 year-end. 


a. Prepare all journal entries related to this foreign currency borrowing assuming the following exchange rates for 1 dudek: 

September 30, 2017 $0.100

December 31, 2017 0.105

September 30, 2018 0.120 

December 31, 2018 0.125

September 30, 2019 0.150 


b. Taking the exchange rate effect on the cost of borrowing into consideration, determine the effective interest rate in dollars on the loan in each of the three years 2017, 2018, and 2019.

Solutions

Expert Solution

Foreign exchange transaction

Apart from transactions in domestic currency, companies also have transactions in foreign currency which would involve import, export or taking loan from other country. Due to these transactions the currency involved would be foreign currency and company will have to convert the transactions into the domestic currency while recording in the financial statement. The transactions are recorded based on the exchange rate on the transaction date.

If there is asset or liability arouse due to these transactions then companies will have to reinstate their balance based on exchange rate on the balance sheet date each year until the transaction is settled. The change in exchange rate may give rise to foreign currency gain or loss.

a.

Journal entry for Loan

Explanation

The notes taken is a liability of the company since it is to be paid back after three years and therefore it is credited. Company would receive cash on the note negotiated and therefore cash balance would increase and so is debited.

Journal entry for accrued interest 2017

Explanation

At end of 2017, company would record accrued interest expense for 3 months which is calculated based on the year end exchange rate. The interest is an expense and therefore is debited. Since the interest is payable on due date it is liability and so credited.

Journal entry for year end adjustment to exchange rate 2017

Explanation:

At end of 2017, the exchange rate of dudek to dollars increased leading to increase in value of notes payable. The increase in value of notes payable means higher payment of debt which is loss for the company. Therefore, foreign exchange loss is debited and notes payable is credited.

Journal entry for payment in interest expense 2018

Explanation

Interest expense for current year is 9 months and therefore is recorded with interest being debited. The last year interest accrued is now paid and therefore the liability is reduced and so is debited. The change in interest rate from date 2017 to 2018 led to increase in payment of interest payable and therefore loss for the company. The foreign exchange loss is therefore debited. Since the interest is paid there is cash outflow and so cash balance would reduce and so is credited.

Journal entry for accrued interest for 2018

Explanation

At end of 2018, company would record accrued interest expense for 3 months which is calculated based on the year end exchange rate. The interest is an expense and therefore is debited. Since the interest is payable on due date it is liability and so credited.

Journal entry for year end adjustment to exchange rate 2018

Explanation:

At end of 2018, the exchange rate of dudek to dollars increased leading to increase in value of notes payable. The increase in value of notes payable means higher payment of debt which is loss for the company. Therefore, foreign exchange loss is debited and notes payable is credited.

Journal entry for payment in interest expense 2019

Explanation

Interest expense for current year is 9 months and therefore is recorded with interest being debited. The last year interest accrued is now paid and therefore the liability is reduced and so is debited. The change in interest rate from date 2018 to 2019 led to increase in payment of interest payable and therefore loss for the company. The foreign exchange loss is therefore debited. Since the interest is paid there is cash outflow and so cash balance would reduce and so is credited.

Journal entry for repayment of notes payable

Explanation

The repayment of notes payable would decrease the liability and therefore notes payable is debited. On date of payment there is increase in exchange rate leading to higher payment and so foreign exchange loss is debited. There would be cash outflow and so cash balance is credited.

b.

The effective interest on loan includes both the interest expense and foreign exchange losses of the notes which is divided by the loan amount.

Formula to calculate effective interest rate on loan

Calculate effective interest rate for 2017

The above calculate interest rate is for 3 months, the effective annual interest rate for 2017 is

Hence, the effective interest rate on loan in 2017 is

Calculate effective interest rate for 2018

Hence, the effective interest rate on loan in 2018 is

Calculate effective interest rate for 2019

The above calculate interest rate is for 9 months, the effective annual interest rate for 2019 is

Hence, the effective interest rate on loan in 2019 is


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