On August 1, Ling-Harvey Corporation (a U.S.-based importer) placed an order to

Question

On August 1, Ling-Harvey Corporation (a U.S.-based importer) placed an order to purchase merchandise from a foreign supplier at a price of 400,000 ringgits. Ling-Harvey will receive and make payment for the merchandise in three months on October 31. On August 1, Ling-Harvey entered into a forward contract to purchase 400,000 ringgits in three months at a forward rate of $0.60. It properly designates the forward contract as a fair value hedge of a foreign currency firm commitment. The fair value of the firm commitment is measured by referring to changes in the forward rate. Relevant exchange rates for the ringgit are as follows: Date Spot Rate Forward Rate (to October 31) August 1 $ 0.60 $ 0.60 September 30 0.63 0.66 October 31 0.68 N/A Ling-Harvey'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. Ling-Harvey must close its books and prepare its third-quarter financial statements on September 30. Prepare journal entries for the forward contract and firm commitment through October 31. Assuming the inventory is sold in the fourth quarter, what is the impact on net income over the two accounting periods? What net cash outflow results from the purchase of merchandise from the foreign supplier?

Explanation / Answer

On August 1, Ling Harvey entered into a forward contract to purchase 400000 ringgits in 3 months at a forward rate of $0.60.

If Ling Harvey has to pay 400000 ringgits now, total outflow would be $ 240000 (400000*0.60) and in forward contract it has to pay $ 240000 also (400000*0.60), so ling harvey has not incurred any loss

So, there is a firm commitment to apy $ 240000 on October, 31

For entering into a forward contract, there will be no entry.

On September, 30

Forward contract rate has increased to 0.66 from 0.60 (august, 1), so there is a increase in the fair value of the Forward Contract. Earlier its value was $240000 on Aug,1 but now its value is $ 264000, so there is a increase in fair value by $24000

Since this $ 24000 will be realised on Oct, 31, we will book it today at present value

Present avlue = $24000*0.9901= $ 23762.4

Entry would be

Forward Contract a/c DR 23762.4

To Gain on Forward Contract 23762.4

Now, the spot rate determines the fair value of Commitment, so there is an increase in fair value of firm commitment by (0.63 - 0.60) * 400000 =12000.

0.63 is the spot rate on Sept, 30

Since our Firm commitment value increased by $12000, we need to book it at present value

Present Value = 12000*0.9901=$11881.2

Entry is as follows:

Loss on Firm Commitment a/c DR 11881.2

To Firm Commitment 11881.2

So its effect on Net income is as follows:

Gain on Forward Contract a/c Dr 23762.4

To Loss on Firm Commitment 11881.2

To Retained Earnings 11881.2

On October 31

Today spot rate is 0.68, so the value of the forward contract when comapred to its value on Aug 1

= (0.68 - 0.60) *400000

= 32000

So there is an increase in Forward Contract Value by 32000, since we have already booked 23762.4, we will book the additional value 8237.6 as follows:

Forward Contract a/c DR 8237.6

To Gain on Forward Contact 8237.6

So, the Firm Commitment value has also increased from 0.60(Aug 1) to 0.68

Increase in value = (0.68-0.60) *400000 = $ 32000

As we have already booked a liability of 11881.2, we will be book the additional increase in value of 20118.8 as follows

Loss on Firm Commitment a/c DR 20118.8

To Firm Commitment 20118.8

So, its effect on Net Income is as followss

Gain on Forward Contract a/c DR 8237.6

Retained Earnings a/c DR 11881.2

To Loss on Firm Commitment 20118.8

So the total effect on Net income is 0, as on Sept 30 retained earnings has been credited by $ 11881.2 and on Oct 31, it has been debited by $ 11881.2... This is due to as there was no difference between spot rate & forward rate on August 1

As on 31st October, there is a debit Bal of $ 32000 in Forward Contract & credit Bal of $ 32000 in Firm commitment

Entry for Goods received & payment to foreign supplier is as follows

The net cash outflow to foreign supplier is $ 240000

Particulars Remarks DR Cr Inventory At spot rate on Aug 1 240000 Firm Commitment Offset 32000 Forward Contract Offset 32000 Cash At forward rate on Aug 1 240000

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