the budvar company purchases parts from a foreign

Question

The Budvar Company purchases parts from a foreign customer on December 1, Year 1, with payment of 20,000 crowns 20,000 crowns to be made on March 1, Year 2.  Budvar enters into a forward contract on December 1, Year 1, to purchase 20,000 crowns on March 1, Year 2. The parts purchased on December 1, Year 1, become a part of the cost of goods sold on March 15, Year 2.

Relevant exchange rates for the crown on various dates are as follows:

Date	Spot Rate	Forward Rate
		(to March 1, Year 2)
December 1, Year 1	$1.00	$1.04
December 31, Year 1	1.05	1.1
March 1, Year 2	1.12

 

udvar's incremental borrowing rate is 12 percent. The present value factor for two months at an annual interest rate of 12 percent (1 percent per month) is 0.9803. Budvar must close its books and prepare financial statements at December 31.

Required:

a.       Assuming that Budvar designates the forward contract as a cash flow hedge of a foreign currency payable, prepare journal entries for these transactions in US dollars. What is the impact on Year 1 net income? What is the impact on Year 2 net income? What is the impact on net income over the two accounting periods?

b.      Assuming that Budvar designates the forward contract as a fair value hedge of a foreign currency payable, prepare journal entries for these transactions in US dollars. What is the impact on Year 1 net income? What is the impact on Year 2 net income? What is the impact on net income over the two accounting periods?

a)	Forward Contract Cash Flow Hedge of Foreign Currency Receivable
	Journal Entries:
	Date	Particulars					Debit	Credit
	Year 1
	1-Dec	Accounts receivable (crowns) [20,000 x $1.00]					20,000
			Sales					20,000
	31-Dec	Accounts receivable (crowns) [20,000 x ($1.05-$1.00)]					1,000
			Foreign exchange gain					1,000
		Loss on forward contract					1,000
			Accmt other comprehensive income					1,000
		Accmt other comprehensive income					1,176
			Forward Contract					1,176
		([20,000 x ($1.10-$1.04) = $1,200 x .9803 = $1,176.36])
		Accmt other comprehensive income					267
			Premium revenue					267
		([20,000 x ($1.04-$1.00) = $800 x 1/3 = $266.67])
	Impact on Year 1 Income:
	Sales						20,000
	Foreign Exchange gain						1,000
	Loss on forward contract						-1,000
	premium revenue						267
							20,267
	Year 2
	1-Mar	Accounts receivable (crowns) [20,000 x ($1.12-$1.05)]					1,400
			Foreign exchange gain					1,400
		Loss on forward contract					1,400
			Accmt other comprehensive income					1,400
		Accmt other comprehensive income					424
			Forward contract					424
		([20,000 x ($1.12-$1.04) = $1,600 - 1,176.36])
		Accmt other comprehensive income					533
			Premium revenue					533
		([20,000 x ($1.04-$1.00) = $800 x 2/3 = $266.67])
		Foreign currency (crown) [20,000 x $1.12]					22,400
			Accounts receivable (crown)					22,400
		Cash [20,000 x $1.04]					20,800
		Forward contract					1,600
			Foreign currency (crown)					22,400
	Impact on Year 2 Income:
	Foreign Exchange gain						1,400
	Loss on forward contract						-1,400
	premium revenue						533
							533
	Impact on Net Income over both the periods:						20,800
b)	Forward Contract Fair Value Hedge of Foreign Currency Receivable
	Journal Entries:
	Date	Particulars					Debit	Credit
	Year 1
	1-Dec	Accounts receivable (crowns) [20,000 x $1.00]					20,000
			Sales					20,000
	31-Dec	Accounts receivable (crowns) [20,000 x ($1.05-$1.00)]					1,000
			Foreign exchange gain					1,000
		Loss on forward contract					1,176
			Forward contract					1,176
		([20,000 x ($1.04-$1.10) = $1,200 x .9803 = $1,176.36])
	Impact on Year 1 Income:
	Sales						20,000
	Foreign Exchange gain						1,000
	Loss on forward contract						-1,176
							19,824
	Year 2
	1-Mar	Accounts receivable (crown) [20,000 x ($1.12-$1.05)]					1,400
			Foreign exchange gain					1,400
		Loss on forward contract					424
			Forward contract					424
		([20,000 x ($1.12-$1.04) = $1,600 - 1,176.36])
		Foreign currency (crown) [20,000 x $1.12]					22,400
			Accounts receivable (crown)					22,400
		Cash [20,000 x $1.04]					20,800
		Forward contract					1,600
			Foreign currency (crown)					22,400
	Impact on Year 2 Income:
	Foreign Exchange gain						1,400
	Loss on forward contract						-424
							976
	Impact on Net Income over both the periods:						20,800