question archive On October 17, 2017, KENT Inc
Subject:AccountingPrice:4.86 Bought14
On October 17, 2017, KENT Inc. purchased from a Thailand firm an inventory costing 10,000 baht. Payment is due on January 15, 2018. Also on October 17, KENT entered into a foreign exchange forward to buy 10,000 baht on January 15, 2018.
10/17/17 12/31/17 1/15/18
Spot rate P1.30 P1.42 P1.40
Forward rate P1.30 P1.42 P1.40
1. The December 31, 2017 profit and loss statement, foreign exchange gain or loss due to hedged item amounted to:
2. The December 31, 2017 profit and loss statement, foreign exchange gain or loss due to hedging instrument-forward contract:
Hedge item (change in spot rate x base)
= (1.42-1.3) x 10000
= 1200
Hedge transaction (change in forward rate x base)
= (1.42-1.3) x 10000
= 1200
Step-by-step explanation
Transactions entered into by companies which are payable with foreign currency denominations usually incurs losses and gains due to the fluctuations of the exchange rates from which will be the base of the amount a company is obliged to pay. These fluctuations will affect changes in the cash flow, like for example, the problem -
You entered in to a foreign denominated purchase transaction on October for an amount payable of 10000 baht (peso equivalent = 10000 x P1.30 = 13000) however on the end of the period (December) and up to the date of settlements (Jan) the exchange rate fluctuates from P1.42 (10000x 1.42 = 14200) to P1.40 (10000 x 1.40 = 14000). As you can see the amount payable in baht is doesn't exchange however the equivalent peso you need to pay in order to be converted to baht changes. These changes on liabilities, now therefore, are the ones that the company wants to ignore for it may affect their income.
The company, then, will enter into another transaction that would eliminate these risks of cash flow fluctuations. one transaction can be the forward contract. A forward contract is a contract to buy or sell a foreign currency at a specified amount and time at a price agreed today.
for the problem:
Specified amount - (1.30 x 1000 baht)
Specified time - January 15,2018
It offsets the gain or loss arrived from the recognized payable - purchase transaction. It is measured basing on the the changes of the forward rates.
In the problem, forward contract is the hedging instrument and the recognized payable is the hedged item.
To record:
Hedge Item
10/17/17
Purchases ---13000
--------Accounts payable 13000
(10000baht x 1.30)
12/31/17
Loss on Foreign Exchange 1200
--------------------Accounts payable 1200
payable on this date should be equivalent to the peso (1000baht x 14.2)
therefore the change (14200 - 13000) is recorded above.
Hedge instrument
10/17/17 ---- No entry
12/31/17
Forward contract 1200
--------Gain on Forward Contract 1200
(1.42 - 1.3) x 10000 baht
There is gain because the company would still be paying 13000 in exchange of 1000baht to the forward party( specific amount in forward contract) even though the rate is at a higher peso equivalent (14000) amount. The savings therefore, is recorded as gain. See it offsets
To simplify, shortcuts are:
Hedge item (change in spot rate x base) = (1.42-1.3) x 10000 = 1200
Hedge transaction (change in forward rate x base) = (1.42-1.3) x 10000 = 1200