Question

19. On August 1, Year 1, Huntington Corporation placed an order to purchase merchandise from a foreign supplier at a price of 100,000 dinars. The merchan- dise is received and paid for on October 31, Year 1, and is fully consumed by December 31, Year 1. On August 1, Huntington entered into a forward contract to purchase 100,000 dinars in three months at the agreed-on forward rate. The forward contract is properly designated as a fair value hedge of a foreign cur rency firm commitment. The fair value of the firm commitment is measured through reference to changes in the forward rate. Relevant exchange rates for the dinar are as follows: Date Forward Rate (to October 31, Year 1) $1.310 1.325 Spot Rate $1.300 1.305 1.320 August 1 ........ September 30............ October 31 ....... Huntington's incremental borrowing rate is 12 percent. The present value factor for one month at an annual interest rate of 12 percent (1 percent per month) is 0.9901. Huntington Corporation must close its books and pre- pare its third-quarter financial statements on September 30, Year 1. Required: Prepare journal entries for the forward contract and firm commitment. What is the impact on net income in Year 1? What is the net cash outflow on the pur- chase of merchandise from the foreign customer?

Answer 1

Debit Credit Date 8/1/Y1 General Journal No entry is required since it is executory contract. 9/30/Y1 $ 1,485.15 Forward Contract Gain on Forward Contract $ 1,485.15 $ 1,485.15 Loss on firm commitment Firm commitment $ 1,485.15 10/31/Y1 $ 485.15 Loss on forward contract Forward contract $ 485.15 $ 485.15 Firm commitment Gain on firm commitment $ 485.15 $1,32,000.00 Foreign currency (Dinar) Cash Forward contract $1,31,000.00 $ 1,000.00 $1,32,000.00 Inventory Foreign currency (Dinar) $1,32,000.00 $ 1,000.00 Firm commitment Adjustment to net income $ 1,000.00 12/31/Y1 $ 1,32,000.00 Cost of goods sold Inventory $1,32,000.00

Date 8/1/Y1 9/30/Y1 (Note 1) 10/31/Y1 (Note 2) Forward rate to Forward Contract | Firm commitment Change in Change in 10/31/Y1 Fair Value Fair Value Fair Value Fair Value $ 1,310 $ -. $ - 1,325 $ 1,485.15 + $1485.15 ($1485.15) ($1485.15) 1320 (spot) | $ 1,000 $485.15)) ($1,000 + $485.15 Explanation:- Note 1 ($132,500 - $131,000) = $1,500 x.9901 = $1,485.15; where 9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01 Note 2 ($132,000 - $131,000) = $1,000

Computation of net cash flow of purchase from foreign Net gain on forward contract Net loss on firm commitment Cost of goods sold Adjusted to net income Net impact on net income 1,000 (1,000) (1,32,000) 1,000 (1,31,000 The net cash outflow is $131,000