Question

Assumes that Ricky Corporation (Ricky) normally sells goods in France and therefore has a stream of...

  1. Assumes that Ricky Corporation (Ricky) normally sells goods in France and therefore has a stream of income which is denominated in Euros. Ricky enters into a master agreement with a bank to convert this future stream of Euros into US dollars. Determine whether this agreement is considered a derivative under both the US GAAP and under the IFRS. Support your decision with reference(s) to the appropriate literature issued by both standard setters.
  2. The Potato Company (Potato) produces frozen French fries and therefore uses potatoes as the major raw material in its manufacturing process. Potato enters a forward exchange contract to purchase 20 bushels of potatoes in 30 days for $1,200. The contract has a net settlement provision.

Part 1: Assume that the potatoes are worth $1,250 at the end of 30 days. Explain in detail how the forward exchange contract might or would be settled in 30 days? What are Potato’s options with respect to the forward exchange contract?

Part 2: Assume that potatoes are not easily convertible into cash and that Potato has a history of taking delivery of the potatoes under these types of contracts (gross settlement). Potato has decided NOT to document the instrument as a normal purchase and sales contract. Prepare the journal entries required under both the US GAAP and IFRS separately, with detailed explanations of the basis for each dollar journal entry amount, and a detailed journal entry explanation with appropriate reference(s) to the accounting literature for both standard-setters for each respective journal entry.

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Answer #1

Derivative is a Financial Instrument that has the following characteristics:
a. derives value from underlying asset,
b. initial investment is negligible or nil,
c. the transaction is settled by other than delivery, ie, settled in cash.

In the given case, Ricky corporation (US entity) sells goods in France, therefore exposed to foreign currency risk exposure.
To hedge receivables, the entity enters into an agreement with a bank for conversion of euros in dollars on a future date.
Hence, the hedging strategy is 'Forward contract.
Forward contract is a type of derivative instrument.
Test whether the Forward contract meets the definition of a derivative:
a. derives value from underlying asset - The underlying asset is receivables.
b. initial investment is negligible - no details given about initial investment, therefore assumed nil.
c. transaction settled by other than delivery - the transaction shall be settled on the predetermined date by booking gain or loss on the transaction.
Hence, the given situation is a derivative contract.

Case 2:
Part 1:
The given situation is an example of Fair value hedge, ie, hedging is done to safeguard against risk of future payable due to currency fluctuations.
When the contract is settled net in 30 days, Potato company would book Gain on Fair value hedge to the extent of ($50 * 20 bushels) = $ $1,000.
Since, the situation is a Cash Flow Hedge, gain on the hedge shall be reported in the Income Statement as Income from continuing operations.
Potato company has the right and obligation to purchase 20 bushels of potatoes in 30 days for $1,200.



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