Question

CASE THREE, ALEXANDER Inc.

Sometimes in November Year 1 (Y1), Alexander Inc., a US based importer of olive oil placed an order for 500 cases of olive oil at a price of 100 Euros per case. The pertinent exchange rates are given below.

DATE             SPOT              FORWAR RATE                        CALL OPTION PREMIUM FOR

                        RATE           (to January 31, Y2)                        1/31/Y2 (Strike price of $1)

12/1/Y1           $1.00                       $1.08                                                       $0.04

12/31/Y1         $1.12                       $1.20                                                       $0.12

1/31/Y2           $1.15                       $1.15                                                       $0.15

Alexander Inc. has effective borrowing rate of 12% (1% per month). The company’s fiscal year ends on December 31. Present value factor at 1% per month is 0.9901.

1. Assume that the olive oil was received on December 1, Y1 and payment was made on January 31, Y2. There was no attempt to hedge the exposure to foreign exchange risk. Prepare journal entries to account for this import purchase.

2. Assume the olive oil was received on December 1, Y1 and payment was made on January 31, Y2. On December 1, Y1, Alexander Inc. entered into a two-month forward contract to purchase 50,000 Euros. The forward contract is properly designated as a fair value hedge of a foreign currency payable. Prepare journal entries to account for the import purchase and foreign currency forward contract.

3. The olive oil was ordered on December 1, Y1. It was received and paid for on January 31, Y2. On December 1, Y1, Alexander Inc. entered into a two-month forward contract to purchase 50,000 Euros. The forward contract is properly designated as a fair value hedge of a foreign currency firm commitment. The fair value of the firm commitment is measured through reference to changes in the forward rate. Prepare journal entries to account for the foreign currency forward contract, firm commitment, and import purchase.

4. The olive oil was received on December 1, Y1 and payment was made on January 31, Y2. On December 31, Y1, Alexander Inc. purchased a two-month call option for 50,000 Euros. The option was properly designated as a cash flow hedge of a foreign currency payable. Prepare journal entries to account for the import purchase and foreign currency option.

5. The olive oil was ordered on December 1, Y1. It was received and paid for on January 31, Y2. On December 1, Y1, Alexander Inc. purchased a two-month call option for 50,000 Euros. The option was properly designated as a fair value hedge of a foreign currency firm commitment. The fair value of the firm commitment is measured through reference to change in the spot rate. Prepare journal entries to account for foreign currency option, firm commitment, and import purchase.

Answer 1

1st Scenario: No Hedging

Spot Rate:

On 1st Dec: $1.00

On 31st January: $1.12

Journal entries in the books of Alexander Inc.
Date	Particular	LF	Amount ($)	Amount ($)
01-Dec	Purchases A/c dr.		50,000
	To Account Payable A/c [500 x (100*1)]			50,000
	(Being Olive oil purchased on credit)
31-Dec	Foreign Currency Transaction Loss A/c      dr.		6,000
	To Account Payable A/c [500 x (100*(1.12-1))]			6,000
	(Being loss adjusted in the year end)
31-Jan	Foreign Currency Transaction Loss A/c     dr. [500 x (100*(1.15-1.12))]		1,500
	Accounts Payable A/c dr.		56,000
	To Bank A/c			57,500
	(Being payment done in full)

2nd Scenario: Foward Contract Hedging (Fair Value)

Journal entries in the books of Alexander Inc.
Date	Particular	LF	Amount ($)	Amount ($)
01-Dec	Asset Receivable A/c [500 x (100*1)]                    dr.		50,000
	Premium on Forward Contract A/c            dr.    [500*100(1.08-1.00)]		4,000
	To Account Payable A/c			54,000
	(Being entry for future purchase of olive oil and forward contract purchased)
31-Jan	Purchases A/c        dr. [500 x (100*1.15)]		57,500
	Accounts Payable A/c     dr.		54,000
	Loss on Forward Contract A/c   dr.		-
	Asset Receivable A/c			50,000
	Premium on Forward Contract A/c			4,000
	Bank A/c   [500 x (100*1.15)]			57,500
	(Being Trade and Forward Contract settled)

3rd Scenario: Foward Contract Hedging (Fair Value with year end Adjustments)

Journal entries in the books of Alexander Inc.
Date	Particular	LF	Amount ($)	Amount ($)
01-Dec	Asset Receivable A/c [500 x (100*1)]                    dr.		50,000
	Premium on Forward Contract A/c            dr.    [500*100(1.08-1.00)]		4,000
	To Account Payable A/c			54,000
	(Being entry for future purchase of olive oil and forward contract purchased)
31-Dec	Premium on Forward Contract A/c     dr. [500*100*(1.2-1.08)*0.9901]		5,941
	Profit on Forward Contract A/c			5,941
	(Being year end Adjustments made)
31-Jan	Purchases A/c        dr. [500 x (100*1.15)]		57,500
	Accounts Payable A/c     dr.		54,000
	Profit on Forward Contract A/c   [500*100*(1.15-1.08)]			3,500
	Asset Receivable A/c			50,000
	Premium on Forward Contract A/c			4,000
	Bank A/c   [500 x (100*1.08)]			54,000
	(Being Trade and Forward Contract settled)

4th Scenario:Options Hedging (Fair Value)

Journal entries in the books of Alexander Inc.
Date	Particular	LF	Amount ($)	Amount ($)
01-Dec	Purchases A/c                                                 dr.		50,000
	To Account Payable A/c [500 x (100*1)]			50,000
	(Being Olive oil purchased on credit)
31-Jan	Premium Expenses A/c Dr. (50000*.04)		2,000
	To Bank A/c			2,000
	( Being premium paid on purchase of call)
31-Dec	Foreign Currency Transaction Loss A/c      dr.		6,000
	To Account Payable A/c [500 x (100*(1.12-1))]			6,000
	(Being loss adjusted in the year end)
31-Jan	Foreign Currency Transaction Loss A/c     dr. [500 x (100*(1.15-1.12))]		1,500
	Accounts Payable A/c                                   dr.		56,000
	To Bank A/c			57,500
	(Being payment done in full)
31-Jan	Premium Expenses A/c Dr. [50000*(0.15-0.04)]		5,500
	To Bank A/c			5,500
	( Being premium paid on purchase of call)
31-Jan	Bank A/c    dr.                 [500 x (100*1)]		50,000
	Call Option Asset A/c			50,000