Professional Documents
Culture Documents
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Solutions Manual, Chapter 10
A brief description of the major points covered in each case and problem.
CASES
Case 10-1
This case discusses differing ways to measure gains and losses on foreign currency
transactions and forward contracts used to hedge these transactions.
Case 10-2 (prepared by Peter Secord, Saint Marys University)
This case requires a discussion of the risks that can occur as a result of import/export
transactions denominated in foreign currency and suggested solutions that the company can
use to cope with the problem.
Case 10-3
In this case, adapted from a CPA exam, students are asked to discuss accounting issues
related to the establishment of a manufacturing operation in Russia and the exporting and
importing of goods to and from Russia.
Case 10-4
In this case, adapted from a CPA exam, students are asked to discuss the accounting issues
and financial viability of a professional football team. The issues involve intercompany and
related party transactions, revenue recognition, push-down accounting, foreign currency
translation and provisions.
Case 10-5
In this case, adapted from a CPA exam, students are asked to discuss the accounting issues
for the high technology company that is planning to go public. The issues involve revenue
recognition, development costs, currency swap and warranty costs.
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PROBLEMS
Problem 10-1 (30 min.)
This problem requires journal entries and financial statement presentation of a foreign currency
sales transaction and a forward contract to hedge the monetary position both with and without
discounting for the time value of money.
Problem 10-2 (30 min.)
This problem requires journal entries for a forward contract to hedge an existing monetary
position using both a cash flow hedge and a fair value hedge.
Problem 10-3 (20 min.)
This problem requires journal entries required for a noncurrent monetary liability denominated
in a foreign currency.
Problem 10-4 (25 min.)
This problem requires journal entries and financial statement presentation for a forward
contract used to hedge a highly probable forecasted foreign transaction.
Problem 10-5 (20 min.)
This problem requires journal entries required for a foreign-denominated investment in bonds
assuming that the bonds are: a) held-to-maturity bonds, b) held-for-trading bonds, and c)
available-for-sale bonds.
Problem 10-6 (40 min.)
Journal entries are required to record the hedge of an expected credit sale assuming a cash
flow hedge and then assuming a fair value hedge. Analysis of the impact on the current ratio of
the two types of hedges is also required.
Problem 10-7 (35 min.)
This problem requires journal entries and financial statement presentation of a foreign currency
purchase transaction and a forward contract to hedge the monetary position both with and
without discounting for the time value of money.
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In this problem, a foreign currency denominated loan is used to hedge a future revenue
stream. Journal entries are required for the cash flow hedge.
Problem 10-15 (10 min.)
This CGA-Canada-adapted problem requires a calculation of the amounts presented for
exchange gains or losses when a company has a long-term foreign currency denominated
liability.
2.
A pegged exchange rate arises when governments of various countries agree in advance
to establish the rates at which their currencies will trade in terms of some single currency.
The price of a unit of foreign currency tends to stay stable in relation to other currencies
under such a system. Floating exchange rates arise when market forces determine the
prices of currencies. The price of a unit of foreign currency will increase or decrease in
relation to other currencies under a system of floating rates.
3.
"One U.S. dollar equals 1.15 Canadian dollars" is a direct quotation. The amount of an
indirect quotation can be obtained by taking the reciprocal of the direct quotation. In this
case, one Canadian dollar equals 0.8696 U.S. dollars.
4.
A spot rate is the rate at which a unit of foreign currency can be purchased on a particular
day. A forward rate on a particular day is the rate for exchange of currencies on a
particular future date.
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5.
On the transaction date, foreign currency denominated assets and liabilities are
measured in Canadian dollars by translating the foreign currency amount at the spot rate.
Nonmonetary assets remain at that amount on subsequent balance sheet dates even
though the currency rate has changed. (An exception would apply in the situation where
the assets are measured at market under the lower of cost and net realizable value
requirement, in which case the closing rate at the date of the balance sheet would be
used.) Monetary assets and liabilities are translated at the closing rate as at the date of
subsequent balance sheets. This results in the recording of unrealized gains or losses
when the exchange rate has changed.
6.
The exchange rate should be applied to produce a translated amount consistent with the
way we normally measure assets and liabilities. If an item is to be measured at historical
cost, we should apply the historical rate to the historical value in foreign currency to
derive the historical cost in Canadian dollars. If an item is to be measured at current
value, we should apply the closing rate to the current value in foreign currency to derive
the current value in Canadian dollars.
7.
The spot rate is the exchange rate in effect at a particular point in time. The closing rate
is the exchange rate in effect at the close of business at the end of the reporting period.
8.
A fair value hedge uses a hedging instrument to hedge the change in fair value of the
hedged item. Gains or losses are reported in profit in the period they occur for both the
hedged item and the hedging instrument. A cash flow hedge uses a hedging instrument
to hedge future cash flows. Gains or losses on the hedging instrument are reported in
other comprehensive income and are deferred as a component of shareholders equity
until the hedged item is reported in income.
9.
Generally speaking, in order to hedge against the effects of foreign currency exchange
fluctuations, one takes a foreign currency position opposite to the position that one
wishes to protect. For example, if you wish to protect an asset position, you hedge with a
liability position of the same amount. The following items could act as a hedge:
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10. A forward exchange contract may be acquired to act as a hedge for either an existing
monetary position or an expected future monetary position. Alternatively, a contract may
be acquired for speculative purposes.
11. Foreign currency denominated monetary assets or liabilities must be translated at the
closing rate on the date of the balance sheet regardless of whether the item has been
hedged. If the item has been hedged, offsetting gains or losses on the hedging
instrument will be reflected in the income statement to match against the gains or losses
on the hedged item.
12. The lower of cost and net realizable value requirement is applied by comparing the
Canadian dollar historical cost of the original items with the current foreign currency
denominated net realizable value for these items, translated at the closing rate and
valuing the inventory at the lower of the two numbers.
13. For the fair value hedge of an unrecognized firm commitment, the change in both the fair
value of the hedging instrument and the hedged item are recognized in profit as they
occur. For the cash flow hedge of an unrecognized firm commitment, the exchange gains
or losses are reported in other comprehensive income and deferred as a separate
component of shareholders equity until the committed transaction occurs. It will later be
transferred out of other comprehensive income and become part of the cost or selling
price of the item being hedged and reported in income when the hedged item is reported
in income.
14. Hedge accounts are netted for reporting purposes. The receivable from, and payable to,
the bank are offset against each other. The resultant debit or credit balance is reported as
a deferred charge or credit on the balance sheet. The reason for this is that these are
executory contracts, and because neither party has performed, no assets or liabilities
exist.
15. The term "hedge accounting" is used for a system of accounting that ensures that the
gains or losses from a hedged position are offset in the same accounting period by the
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losses or gains from the hedging instrument. Therefore, if gains or losses from one occur
before those from the other they are deferred until the matching can take place.
16. Hedge accounting would not be used in this situation because the gains and losses from
the hedging instrument and the hedged item occur will both be reported in the same
period and will offset each other. Hedge accounting comes into play when gains or losses
from one item would otherwise be recognized in a different period than the offsetting
losses or gains from the other item.
17. The long-term debt is usually equal to the expected amount of the future revenue stream
at the inception of the hedge. The amount of the debt remains constant while the amount
of future revenue that it hedges declines. In this manner, an increasing portion of debt
ceases to be a hedge each year and is therefore exposed to exchange rate changes.
18. If the inventory is being purchased for cash, the premium paid on a forward contract will
initially be reported in other comprehensive income and deferred as a separate
component of shareholders equity. The premium will be removed from other
comprehensive income and reported in regular income when the inventory is sold. If the
inventory is purchased on account and the forward contract is designated as both a
hedge of the item and the ensuing monetary liability, the portion of the premium
pertaining to the commitment will be reported as previously explained. The portion of the
premium relating to the monetary liability will also be deferred in other comprehensive
income and will be recognized in regular income over the term of the accounts payable,
i.e., from the purchase date of the inventory to the settlement date of the accounts
payable.
SOLUTIONS TO CASES
Case 10-1
Interfast Corporation could have received $1,600,000 from its export sale to Loznia if it had
required immediate payment. Instead, Interfast allows its customer six months to pay.
Interfast would have received only $1,360,000 (LR400,000 x 3.4) if it had not entered into the
forward contract. This would have resulted in a decrease in cash inflow of $240,000. The
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decrease in the value of the LR receivable would have been recognized as a foreign exchange
loss of $240,000. This loss represents the cost of extending credit to the foreign customer if
the LR receivable is left unhedged.
However, rather than leaving the LR receivable unhedged, Interfast sells LRs forward at a price
of $1,440,000 (LR400,000 x 3.60). Since the spot rate was $3.40 on the settlement date of
the contract, the forward contract provides a benefit, increasing the amount of cash received
from the export sale by $80,000. The $80,000 change in the fair value of the forward contract
(from zero initially to $80,000 at maturity) is recognized as a gain on the forward contract. This
gain reflects the cash flow benefit from having entered into the forward contract, and is the
appropriate basis for evaluating the performance of the foreign exchange risk manager.
(Students should be reminded that the forward contract would not always improve cash inflow.
For example, if the future spot rate were $3.70, the forward contract would result in $40,000
less cash inflow than if the transaction were left unhedged.)
The net impact on income resulting from the fluctuation in the value of the LR is a loss of
$160,000. Clearly, Interfast forgoes $160,000 in cash inflow by allowing the customer time to
pay for the purchase, and the net loss reported in income correctly measures this. The
$160,000 loss is useful to management in assessing whether the sale to Loznia generated an
adequate profit margin, but it is not useful in assessing the performance of the foreign
exchange risk manager. The net loss must be decomposed into its component parts to fairly
evaluate the risk managers performance.
Gains and losses on forward contracts are relevant measures for evaluating the performance
of foreign exchange risk managers.
Case 10-2
Long Life Enterprises*
Note to instructor: This case is intended only to raise awareness of the potential complexity
of foreign currency exposure for an importer/exporter, and to reinforce the notion that a
business has multiple flows and does not operate one transaction at a time, as many
conventional "problems" are structured. This is the element this case is meant to draw out in
class discussion; preparation of a detailed solution would be beyond the scope of the typical
accounting course, but the note below may be of interest.
* Case solution prepared by Peter Secord, Saint Mary's University. Used with permission.
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Losses on foreign currency positions only occur when there is an exposure that is, an
uncovered position in a foreign currency and the substantial losses of the firm are a
consequence of having an uncovered position at a time of currency fluctuation.
The complexity of the cash flow patterns suggests that this may require the use of
sophisticated computer software for tracking the balance (receivable or payable) outstanding
with respect to any particular foreign currency. The company could then follow the practice of
hedging net amounts to guard from uncovered losses. Such software can now be readily
incorporated into payables and receivables modules of most accounting packages.
Over the longer haul, maintenance of floats in foreign currency (and perhaps associated lines
of credit) can reduce the realized transaction gains and losses on actual currency conversion.
The idea, however, is to always have the foreign currency receivables and payables in balance
(provided that this is cost effective) in order to minimize the net exposure at any given time. In
this regard, terms can be modified for both receivables and payables in order that a closer
matching of flows can be attempted. Aggressive management of the net position is necessary
to ensure there are no surprises.
Case 10-3
Memo to:
Partner
From:
Staff accountant
Subject:
The establishment of accounting policies for this division is critical since future profit sharing
will be based on the division's financial statements. We must take into account CCI's financial
reporting objectives for these operations. CCI will want to maximize profits for the Russian
operations for two reasons: 1) Since CCI is a public company, it wants to maximize profits to
attract and retain investors in the company. 2) CCI wants to maximize the withdrawal of vodka
from Russia for sale in the Canadian market.
Given the unusual nature of the restrictions for operations in Russia, extensive disclosure will
be essential to allowing the readers of CCI's financial statements to understand these
operations. This disclosure could include the nature of the joint operations agreement, the type
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and quantity of assets (i.e., vodka) that were received, or other specific assets contributed.
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alternative the recording in the accounts of an estimate of the future benefit to be derived from
this asset. However, this "value in use" will also be very difficult to estimate.
recording all revenues and expenses at the time profit is determined in rubles at their
equivalent value in vodka, as determined by the prevailing export market price in
Russia and in Canada. The obvious problem with this alternative is that the ultimate
amount to be received, in Canadian dollars upon the sale of vodka, may change. The
prevailing export price in Russia (i.e., the price of vodka in rubles) may change, thereby
changing the profit previously recorded. Furthermore, the market value of vodka in
Canada may change. However, past history suggests that this is not a significant risk
since the government liquor boards in many provinces control prices, and there is little,
if any, past history of declines in liquor prices. In contrast, there is a strong possibility
that market prices may decline given the limited number of buyers in Canada and the
possibility that they may be confronted with too much supply (e.g., other joint venturers
may also have vodka to sell, or CCI's Russian profits may exceed Canadian demand
for vodka).
recording all revenues and expenses at the time the rubles are converted to vodka.
This alternative eliminates the risk that the price of vodka in rubles may change.
However, there is still the risk that the market value of vodka being sold to Canada may
change significantly, as discussed above.
recording revenues and expenses only when the vodka is sold to the Canadian market
and the exact profit in Canadian dollars is reliably measured. This would obviously be
the most conservative approach since the gains are recognized only when they are
realized.
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Other issues
Since the operations in Russia may be significant to CCI, it may be necessary to disclose
segmented information on these operations.
We must also consider how to treat losses that may arise from these operations. For example,
it may be necessary to recover previous losses before any future profits are converted to
vodka.
Case 10-4
To: Marie Caisse
From: CPA
Subject: UFL Players Association (UFLPA) Engagements
The following items are those for which the accounting treatment adopted by Calgary Cowboys
Limited (CCL) is not or may not be in accordance with ASPE and therefore could distort the
analysis of CCLs financial viability.
1. Push-down accounting
CCL appears to have used push-down accounting to record the sale of CCL shares to
Crystal Roberts Management (CRM). However, under CPA Canada Handbook Section
1625, push-down accounting would not be applicable because it does not meet the
following criteria (Section 1625.4):
a. All or virtually all of the equity interests in the enterprise have been acquired, in one or
more transactions between non-related parties, by an acquirer who controls the
enterprise after the transaction or transactions; or
b. The enterprise has been subject to a financial reorganization, and the same party does
not control the enterprise both before and after the reorganization;
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the team and, as a result, will bring CCL identifiable future benefits that arise from a
contractual right in the way of wins or increased interest from fans.
According to Section 3064.18, an intangible asset should only be recognized if the item
meets the definition of an intangible asset and if the recognition criteria are met. Paragraph
21 contains the recognition criteria:
An intangible asset should be recognized if, and only if: a) it is probable that the expected
future economic benefits that are attributable to the asset will flow to the entity; and b) the
cost of the asset can be measured reliably.
I believe that both of these criteria have been met. We are told that the signing bonus is
refundable within the first year should the player decide to leave; therefore, the signing
bonus guarantees that the entity will derive a future benefit from having that player on the
team for a minimum of a year. Also, the cost of the signing bonus is known.
As a result, the signing bonus should be capitalized as an asset in the financial statements.
Because a recognized intangible asset should be amortized over its useful life, the next
step is determining the useful life of the asset. The contracts are, on average, for a period
of two to four years with an additional one-year renewal option. In addition, the bonus
becomes refundable should a player leave within the first year. Therefore, the signing
bonuses have a definite life that could be as short as one year or as long as five years,
assuming the renewable option is exercised. One could argue that the average life of a
contract, three years, should be used, but the argument for a useful life of one year is also
valid, seeing as there is no guarantee that the player will stay beyond the first year, as
demonstrated by Jimmy Swagger, the defensive tackle who has asked to be traded. For
purposes of the calculation, I have assumed a useful life of one year.
There were $5 million in signing bonuses expensed in Year 8. We know that $1 million of
this total relates to Jimmy Swagger and was paid at the start of the Year 8 season, which
would have been the beginning of July Year 8. As the statements are as at December 31,
Year 8, only six months have passed by year-end, and therefore only half of the signing
bonus related to Jimmy should have been amortized up to that point. While we know that
Jimmy asked to be traded after year-end, the contract requires him to stay with the team
for the full year or refund the bonus, so either way, his signing bonus still has value. With
regards to the remaining $4 million in bonuses expensed in Year 8, we do not know when
these contracts were signed and therefore cannot calculate the exact amount of
amortization. If we assume that the contracts and related signing bonuses were paid
evenly throughout the year, then we can assume that approximately half of the balance
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should be amortized by December 31, Year 8. Therefore, the Year 8 signing bonus
expense should be decreased by half ($500,000 for Jimmy and $2 million for the rest). This
adjustment increases the Year 8 net income figure by $2.5 million. If we make a similar
assumption for Year 7, then the Year 7 net income figure increases by $2 million [$4 million
50%]. This also means that the Year 8 net income figure should be reduced by $2 million
to recognize the second half of the Year 7 signing bonus expense.
5. Related party transactions (TV rights and interest) The contract CCL signed with the
Calgary Sports Channel is a related party transaction since the TV network is owned by
Crystals holding company. CCL billed the network for $1.5 million, even though an
unrelated entity was prepared to pay $8 million for these rights. The transfer price is
therefore significantly lower than the fair value of the service provided.
Per Section 3840.18-19, A monetary related party transaction, or a non-monetary related
party transaction that has commercial substance, should be measured at the exchange
amount when it is in the normal course of operations, unless paragraph 3840.22 applies.
The transaction between CCL and the Calgary Sports Channel is monetary.
One could argue that this transaction was not done in the normal course of business due to
the magnitude of the difference between the agreed-upon amount ($1.5 million) and the
fair value of the TV rights ($8 million). The fact that these contracts are negotiated only
once per year or every few years could also put the normal course of business concept in
question. On the other hand, this transaction appears to be in the normal course of
operations as it is not uncommon for a sports team to enter into a contract with a TV
network for the right to broadcast its games. I conclude that this transaction should be
measured at the exchange amount. Per Section 3840.23, The exchange amount reflects
the actual amount of the consideration given for the item transferred or service provided.
Therefore, it was appropriate for CCL to record the transaction at $1.5 million, the amount
paid by the Calgary Sports Channel.
As with the local TV revenue, interest on the advance from the parent company is a related
party transaction that should be measured at the exchange amount because it is a
monetary transaction conducted in the ordinary course of business. Therefore, it has been
recorded in accordance with ASPE. However, CCL should disclose the nature and amount
of the related party transaction in its financial statements.
These adjustments would result in the following revised income:
Income before income taxes per current statements
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Year 8
Year 7
(6,025,000)
(6,524,000)
Adjustments:
Amortization non-competition clause
4,850,000
4,850,000
442,000
124,000
3,000,000
2,500,000
(2,000,000)
2,000,000
$ 2,767,000
$ 450,000
Exchange gains
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dollar per year. The parking lot is adjacent to the stadium, and we can assume that the only
reason the city leases the lot to CRM for such a low fee is because it was an incentive
offered to encourage Crystal to open the football franchise. CRM would not be able to
make such a profit off the parking lot if it did not own the Cowboys; the revenue is related
to spectators using the lot during games and the cost of the lot is next to nothing because
CRM owns the franchise. Therefore, this revenue should be included in the calculation of
the viability of the franchise.
4. Food and beverage revenue
It is not clear where the food and beverage revenue has been recognized, but it does not
appear to be on CCLs income statement. Since 40,000 spectators spend an average of
$25 per game each on food and beverages, I estimate gross revenue from this activity at
about $10 million. By conservatively estimating the contribution margin at 50% of sales,
this adds up to an additional $5 million in income taken out of CCL. Again, this revenue is
directly linked to owning the franchise since it is money earned during the games.
5. Travel expenses
Finally, the expenses related to Crystals private jet are entirely charged to CCL, even
though she uses the jet for other activities.
If CCL were to fly commercial, the travel expenses would total approximately $1 million per
year (50 people $2,000 10 trips) instead of the $2 million CCL is now paying. I estimate
that only $1 million should be charged to CCL for the purpose of evaluating its viability,
which means that its income increases by an additional $1 million.
As a result of these findings, the adjustment to CCLs net income for Year 7 and Year 8, when
applying ASPE and including all revenues generated by the Cowboys and only those expenses
relating specifically to the teams operations is as follows:
Year 8
Year 7
$ 2,767,000
$ 450,000
6,500,000
6,750,000
206,400
330,600
Parking revenue
1,500,000
1,500,000
5,000,000
5,000,000
Travel expenses
1,000,000
1,000,000
16,973,400
15,030,600
150,000
150,000
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4,500,000
2,000,000
(5,000,000)
(4,000,000)
$ 16,623,400 $ 13,180,600
Far from being in a loss position, CCLs operations generate adjusted income before income
taxes of $17 million in Year 8 and $15 million in Year 7.
Since the stadium is leased, capital investment is immaterial, and the investment in working
capital (inventories, accounts receivable) is negligible, CCLs operating cash flows can be used
as a cash cow for Crystals other investments.
Once the income is converted into cash flow, results are just as good. The amortization
expense for the non-competition clause ($150,000 per year) has no impact on cash flow, but
the signing bonuses do have a direct impact on them.
This cash flow is extremely attractive for Crystal. CCL has no outside debt, and the advance
from the parent company is completely offset when we include the revenues generated by the
Cowboys that are currently distributed to the parent company. The long-term debt/equity ratio
is therefore virtually nil.
Consequently, I feel it is wrong to claim that the current player compensation system
jeopardizes the survival of the Calgary Cowboys. This may not be the case for other teams, but
based on the information presented, my analysis shows that CCL appears to be a highly
profitable enterprise, very solvent, and in no way threatened with extinction.
Pervasive Qualities and Skills
My analysis indicates that CCL adopted several overly conservative accounting treatments. In
addition, the corporate structure of CCL, its parent company (CRM), and the other subsidiaries
of CRM is such that revenues directly related to the football teams operations are accounted
for in the parent company, while expenses relating to the parent company are recorded in
CCL.
As can be seen, each adjustment that I previously noted related to the choice of accounting
policy increases CCLs net income compared with the amount shown in the income statement
prepared by the teams management. This would suggest that CCL deliberately selected overly
conservative accounting policies to project a less rosy viability picture and add weight to the
owners argument at the negotiating table.
The organizational structure of Crystal Roberts companies means that some of the Cowboys
operating revenues are recognized outside CCL while expenses of the parent company are
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recognized in CCL. For example, the parking revenue is earned by the parent company, which
benefits from spectator attendance at the Cowboys games. In a similar vein, revenue from the
sale of food and beverages at the stadium during the games is not reported by CCL, so I
assume its reported by CRM. In addition, the travel expenses include the full operating costs
of the private jet owned by Crystal, even though CCL uses the jet for only 10 trips per year.
Clearly, the income statement shows a significantly understated income figure that is of little
use in evaluating the teams actual viability. Once the necessary adjustments are made to
show a net income that is more representative of the actual viability of the Calgary Cowboys
income before taxes for Year 8 goes from negative $6 million to positive $17 million.
This systemic bias is a result of the negotiation process with the UFLPA. The team owners
have an incentive to show a poor financial position so that the players will accept the newly
proposed compensation system. Since the Cowboys are one of the teams claiming to be
facing extinction because of financial difficulties resulting from the current player compensation
system, it is not surprising that CCLs accounting policies have an obvious bias.
The team owners claim that most of the teams have a negative bottom line and chose to
present CCLs financials as an example of a troubled team. Therefore, it is possible that what
is occurring at CCL is also occurring across the league: other teams may be manipulating their
results in the same fashion as CCL. The other teams financials may need to be reviewed
before the new compensation plan proposed by the owners can be properly evaluated and
before strike negotiations can be resolved.
Case 10-5
Memo to:
Partner
From:
CPA
Re:
Overview
There are a number of significant new issues pertaining to this years ZIM engagement,
particularly the pending initial public offering (IPO).
important component in setting the offering price of an IPO. As a result, ZIMs management
will likely want to maximize net income by maximizing assets and minimizing liabilities in an
effort to positively influence the offering price of the IPO. For example, ZIMs preliminary
financial statements indicate that a significant portion of its sales was recorded in the last
month of the year. Given the circumstances, I have to wonder whether these are real sales or
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there prospective legal problems if the previous employer decides that it has a proprietary right
to the technology?
Transact revenue recognition
ZIM sells the Transact software at a loss but generates a profit overall on the product because
it sells training at a significant profit. The training is necessary if customers are to obtain
optimal benefits from Transact. This arrangement raises questions about revenue recognition
as well as the appropriate accounting for the deferred development costs associated with the
product.
ZIM appears to have recognized all the revenue associated with Transact training during July
Year 8, even though the actual training has not yet been purchased by the customers, and
customers are not likely to purchase the training until fiscal Year 9.
We must determine
whether some or all of the revenue from the training should be recognized when the
equipment is sold or whether the revenue from the two components should be recognized
separately. The issue at hand is whether management can offset the losses incurred on the
loss-leader Transact product with the profits earned on the connected profitable Transact
training sales transaction.
The issue to consider is whether or not, in substance, a single transaction, or separate
transactions, are involved.
represent components of a single transaction if one was always sold with the other, particularly
when considering that the company would likely not sell a product at a loss. However, the
products appear to be sold separately, and the customer does not appear to have an
obligation to purchase the training once it has purchased the software. These facts support
that the components represent separate transactions, as opposed to components of a single
transaction, such that revenue would be recognized separately for each component.
Nonetheless, if the software is not fully functional without the training, and historical experience
supports that customers almost always purchase the training subsequently then this might lend
support to the components being linked as a single transaction.
If it is determined that the facts support these transactions are separate, then, while it would be
appropriate to recognize revenue for the sale of the software component in July Year 8, it
would only be appropriate to recognize revenue for any subsequent sale of the training
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deferring some of these costs to Year 9, resulting in higher income in the current period and
potentially have a positive effect on the offering price of the IPO. If, however, the sale of
software and training are considered to be two separate transactions, then the deferred
development costs should be written off in Year 8 since the Transact software does not
generate profits. This would result in lower income in the current period.
My preliminary conclusion is that the transactions are separate since the customer has no
obligation to purchase the Transact training. Therefore, revenue for sale of the training should
only be recognized when such sale has been made and over the period that the training is
being provided. Consistent with this conclusion, deferred development costs related to the
Transact software should be written off in Year 8. We will need to carefully review the sales
contracts and sales histories to verify the particular facts and circumstances surrounding the
sale of the Transact software and training.
IDSL Software
The IDSL 600 product was delivered to customers in two parts, with the deliveries of the
components spanning the year-end. The hardware was sold and delivered in May Year 8 while
the custom software required to operate the equipment was delivered to customers via the
Internet in September Year 8.
representing about 8% of revenues for Year 8. This is a material amount. If we find that some
or all of the revenue from this product should not be recognized until fiscal Year 9, income for
Year 8 will decrease and the valuation of the shares for the IPO is likely to be negatively
affected.
There are three possible times when revenue can be reasonably recognized: first, when the
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Solutions Manual, Chapter 10
equipment is shipped; second, proportionatelythat is, recognize part of the revenue when
the equipment was shipped and part when the software was shipped; and third, when the
product is operationalthat is, when the hardware and software have both been delivered to
and accepted by the customer. For full recognition in fiscal Year 8 to be allowable, the crucial
question is whether the earnings process can be considered complete before the customer
receives the software. From the information we have, the hardware is not operational without
the custom software provided by ZIM. (Since custom software is involved, software does not
appear to be available from other providers that could be used to operate the hardware.) This
situation would support not allowing full recognition during fiscal Year 8.
The earnings process could be considered complete if, for all intents and purposes, work on
the software was virtually complete, there were few uncertainties about the completion at the
date of shipment of the hardware (and certainly by the year end), and the software was
incidental to the functionality of the hardware. However, as this custom software is required to
operate the equipment, this does not appear to be a viable alternative.
As for recognizing part of the revenue when the equipment has been delivered and part when
the software has been delivered, this would be appropriate if the two components were
separately identifiable components of a single transaction, and the fair values of each
component could be separately determined.
software are not sold separately, and the custom software is essential to the functionality of the
hardware, it is difficult to view the equipment and the software as separately identifiable
components. Therefore, these facts would support delaying revenue recognition until both
components have been delivered.
We should determine whether there are any customer acceptance provisions. If the customer
can return the hardware and the software if the software does not meet the customers custom
design requirements, then revenue recognition should be delayed until such customer
acceptance has been obtained.
It is clear that ZIM has a strong incentive to recognize this revenue during fiscal Year 8
because of the effect on revenue and income and therefore on the IPO.
My preliminary
recommendation is to delay revenue recognition until the custom software has been delivered.
Revenue for both the hardware and software components should be recognized at that time,
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Solutions Manual, Chapter 10
should be disclosed if there is a possibility that a material amount could have to be paid.
If the hacker discloses the flaws despite receiving the ransom payment, or if the flaws become
public knowledge by some other means, then the revenue generating ability of the product will
be impaired. Under these circumstances, it is appropriate to consider whether the deferred
development costs related to Firewall Plus should be written down.
We must still consider how to account for the ransom payment: whether it should be
capitalized or expensed. Capitalization can be justified because the payment protects the
design of the product and allows it to continue to be a marketable product, thereby protecting
revenues already earned. Without the payment, the value of the Firewall product would be
significantly impaired because of disclosure of the security flaw. That said, expensing seems
to make more sense. Even with the payment the hacker could still disclose the flaw, or the
flaw could become public knowledge in some other way, so future benefit is not assured. Also,
the payment does not enhance the service potential of the software; it merely maintains it.
Therefore, my preliminary recommendation is that the ransom payment should be expensed.
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28
Headhunter fee
ZIM incurred $178,000 in placement fees for new employees. The company has capitalized
the amount and is amortizing it over five years. Alec Zimmer may be motivated to defer the
fees to improve earnings because of the IPO. If capitalization can be justified, the five-year
amortization period would probably be too long because there is no guarantee that an
employee will stay five years, especially in view of the high turnover often seen in high-tech
industries. If capitalization was considered appropriate, a shorter amortization period should
be considered, for example a one-year period since some employees may not work out and
ZIM would receive a refund from the headhunter for anyone leaving the company within one
year of being hired.
On the other hand, since this outlay is an ordinary operating cost, it is likely more appropriate
to expense the amount in the current period. This is on the grounds that there is no future
economic benefit to be generated from the placement fee, and therefore, it does not meet the
definition of an asset. While ZIM may be entitled to a refund in the future of some of the
placement fees paid, this would represent at best a contingent asset, which is not recognized
under IFRS. ZIM would only recognize an asset for such a receivable when its realization is
virtually certain (i.e. when a termination/resignation within the one year hire period has
occurred such that ZIM becomes entitled to a refund of the placement fees).
My preliminary recommendation, therefore, is that the placement fees should be expensed in
the year incurred.
PC capitalization policy
The company has extended the write-off period for desktop computers from one year to two.
Either write-off period is reasonable, and both reflect the short lives of desktop computers.
The issue is that the amount involved is material, and the change in treatment will affect the
financial statements. Managements motivation for the change may be to lower current period
expenses for the IPO.
Consideration must be given to whether the change in write-off period is a change in
accounting policy or a change in estimate.
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policy (rather than an expensing policy), which means that extending the write-off period to two
years is simply a change in the estimate of the computers usefulness.
Swap
It must be determined whether the swap and settlement of the debt are two distinct
transactions or part of a single transaction. If they are two separate transactions, then the gain
can be recognized since it is no longer hedged. This approach can be supported since it can
be argued that the swap is now speculative and the full gain/loss should be brought into
income. If, however, the swap and settlement are really part of the same transaction, then the
gain should be deferred and the final gain or loss recognized when the swap ends.
The question remains of whether to account for the outstanding swap and, if so, how to
account for it. The treatment of the swap instrument that remains should correspond to the
treatment of the $3 million gain. (If the gain is recognized right away, then recognize future
gains/losses each year.) The details of the remaining swap and the accounting policy used
should be disclosed.
ACC problem
It appears that another firm in the industry may have stolen some of ZIMs computer programs.
The important issue is whether there is any impairment of the revenue generating ability of
ZIMs products as a result of its programs having fallen into the hands of competitors. If the
revenue generating ability of products has been impaired, then it might be necessary to write
down their balance sheet value.
SOLUTIONS TO PROBLEMS
Problem 10-1
(a)
(i)
December 1, Year 5
Accounts receivable (FC)
Sales
444,600
444,600
(FC600,000 .741)
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30
December 3, Year 5
Memorandum Entry
Company entered into forward contract to pay FC600,000 to the bank in exchange for
$468,600 (FC600,000 .781) to be received from the bank on April 1, Year 6. The payable to
the bank will offset the receivable from the customer.
(ii)
December 31, Year 5
Accounts receivable (FC)
9,600
Exchange gain
9,600
6,000
Forward contract
6,000
27,000
Exchange gain
27,000
6,600
Forward contract
6,600
481,200
481,200
(FC600,000 .802)
Cash
468,600
Forward contract
12,600
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Cash (FC)
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32
481,200
(b)
Manitoba Exporters Inc.
Balance Sheet
at December 31, Year 5
Assets
Accounts receivable
454,200
Liabilities
Forward contract
(c)
6,000
(i)
December 1, Year 5
Accounts receivable (FC)
444,600
Sales
444,600
(FC600,000 .741)
December 3, Year 5
Memorandum Entry
Company entered into forward contract to pay FC600,000 to the bank in exchange for
$468,600 to be received from the bank on April 1, Year 6. The payable to the bank will offset
the receivable from the customer.
(ii)
December 31, Year 5
Accounts receivable (FC)
9,600
Exchange gain
9,600
5,911
Forward contract
5,911
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(iii)
April 1, Year 6
Accounts receivable (FC)
27,000
Exchange gain
27,000
6,689
Forward contract
6,689
481,200
481,200
(FC600,000 .802)
Cash
468,600
Forward contract
12,600
Cash (FC)
481,200
(FC600,000 .802)
Problem 10-2
Note: debits are without brackets and credits are with brackets.
(a)
(b)
444,600
444,600
(444,600)
(444,600)
December 1, Year 5
Accounts receivable (FC)
Sales
(FC600,000 .741)
December 3, Year 5
Memorandum Entry
Company entered into forward contract to pay FC600,000 to the bank in exchange for
$468,600 (FC600,000 .781) to be received from the bank on April 1, Year 6. The spot
element of the payable to the bank will offset the receivable from the customer. The forward
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34
element of the payable to the bank (i.e. the premium on the forward contract) will be accounted
for as a hedge expense.
December 31, Year 5
Accounts receivable (FC)
Exchange gain
9,600
9,600
(9,600)
(9,600)
9,600
Exchange loss
9,600
Forward contract
(9,600)
(9,600)
9,600
(9,600)
6,000
6,000
(6,000)
(6,000)
27,000
27,000
(27,000)
(27,000)
27,000
Exchange loss
27,000
Forward contract
(27,000)
(27,000)
27,000
(27,000)
2016 McGraw-Hill Education. All rights reserved.
35
18,000
18,000
(18,000)
(18,000)
481,200
481,200
(481,200)
(481,200)
468,600
468,600
12,600
12,600
(481,200)
(481,200)
Forward contract
Expense premium of forward contract over 4 months
Cash (FC)
Accounts receivable (FC)
(FC600,000 .802)
Cash
Forward contract
Cash (FC)
(c)
The journal entries are exactly the same except for the following:
- the entry to adjust the forward contract to fair value is put through OCI for a cash flow hedge
but charged/credited directly to exchange gains/losses for a fair value hedge
- an extra entry is made for the cash flow hedge to reclassify the exchange adjustment from
OCI to net income to offset the exchange gain/loss on the hedged item
The net effect of all entries is exactly the same under the two methods.
Problem 10-3
(a)
January 1, Year 1
Cash
46,360,000
Loan payable
46,360,000
(40,000,000 1.159)
December 31, Year 1
Exchange loss
Loan payable
360,000
360,000
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36
5,584,800
Exchange loss
21,600
5,606,400
(b)
Exchange gains (losses) would appear on the yearly income statements of Moose Utilities as
shown below.
Date
Loan
Interest
Jan.1/1
1.159
Dec.31/1
1.168
(360,000)
(21,600)
Dec.31/2
1.160
320,000)
19,200
Dec.31/3
1.152
320,000
19,200
Dec.31/4
1.155
(120,000)
(7,200)
160,000
9,600)
Total (4 years)
Problem 10-4
October 31, Year 1
Memorandum entry
Company entered into forward contract to receive MP1,000,000 from the bank in exchange for
a payment of $750,000 (MP10,000,000 x 0.075) to the bank on March 1, Year 2. The
receivable from the bank will offset the payable to the supplier.
December 31, Year 1
Forward contract
10,000
10,000
20,000
20,000
780,000
Forward contract
30,000
Cash
750,000
Inventory
780,000
Cash (TL)
780,000
(MP10,000,000 0.078)
Accumulated OCI cash flow hedge
30,000
Inventory
30,000
DR
Forward contract *
CR
$10,000
$10,000
$10,000
$10,000
Problem 10-5
Note: debits are without brackets and credits are with brackets.
(a)
(b)
(c)
January 1, Year 5
HTM
HFT
AFS
3,062,400
3,062,400
3,062,400
(3,062,400)
(3,062,400)
(3,062,400)
Investment in bonds
Cash
(US$2,200,000 x 1.392)
December 31, Year 5
Exchange loss
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38
112,200
112,200
112,200
Investment in bonds
(112,200)
(112,200)
(112,200)
59,004
59,004
(59,004)
(59,004)
354,024
354,024
354,024
6,732
6,732
6,732
(360,756)
(360,756)
(360,756)
Problem 10-6
Note: debits are without brackets and credits are with brackets.
October 1, Year 6
(a)
(c)
CF Hedge
FV Hedge
Memorandum Entries
Company signed a contract to sell merchandise for SF400,000 for delivery on January 31,
Year 7.
Company entered into forward contract to pay SF400,000 to the bank in exchange for
$480,000 (SF400,000 1.20) to be received from the bank on January 31, Year 7. The
payable to the bank will offset the receivable from the customer.
December 31, Year 6
Exchange loss
8,000
8,000
Forward contract
(8,000)
(8,000)
8,000
Exchange gain
(8,000)
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Solutions Manual, Chapter 10
476,000
476,000
(476,000)
(476,000)
12,000
12,000
(SF400,000 1.19)
Forward contract
Other comprehensive income
(12,000)
Exchange gain
(12,000)
12,000
Commitment receivable
(12,000)
4,000
4,000
(4,000)
(4,000)
480,000
480,000
(4,000)
(4,000)
(476,000)
(476,000)
(b)
Trial balance, December 31, Year 6
CF Hedge
Commitment receivable
Forward contract liability
Exchange gains & losses
Other comprehensive income
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40
(d)
FV Hedge
8,000 B/S
(8,000)
0
(8,000) B/S
0 I/S
8,000
(e) Under the fair value hedge, a current asset and current liability of $8,000 are reported
whereas only an $8,000 current liability is reported under the cash flow hedge. Therefore,
the fair value hedge shows a slightly better liquidity position.
Problem 10-7
(a) (i)
December 1, Year 3
Inventory
462,202
462,202
(DM613,000 0.754)
December 3, Year 3
Memorandum Entry
Company entered into forward contract to receive DM613,000 from the bank in exchange for a
payment of $486,722 (DM613,000 x 0.794) to the bank on April 1, Year 4. The receivable from
the bank will offset the payable to the supplier.
(ii)
December 31, Year 3
Exchange loss
9,808
9,808
3,065
Exchange gain
3,065
27,585
27,585
9,808
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Exchange gain
9,808
499,595*
Forward contract
12,873
Cash
486,722
*(DM613,000 0.815)
(b)
Hamilton Importing Corp.
Statement of Financial Position
at December 31, Year 3
Assets
Forward contract
$3,065
Liabilities
Accounts payable
$472,010
(c) (i)
December 1, Year 3
Inventory
462,202
462,202
(DM613,000 x 0.754)
December 3, Year 3
Memorandum Entry
Company entered into forward contract to receive DM613,000 from the bank in exchange for a
payment of $486,722 (DM613,000 x 0.794) to the bank on April 1, Year 4. The receivable from
the bank will offset the payable to the supplier.
(ii)
December 31, Year 3
Exchange loss
Accounts payable (DM)
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9,808
9,808
2,997
Exchange gain
2,997
27,585
27,585
9,876
Exchange gain
9,876
499,595*
Forward contract
12,873
Cash
486,722
* (DM613,000 0.815)
Problem 10-8
August 1, Year 3
Memorandum Entry
Company signed a contract to purchase machinery for HK$500,000 for delivery on
December 31, Year 3 i.e. will pay HK$500,000
August 2, Year 3
Memorandum Entry
Company entered into forward contract to receive HK$500,000 from the bank in exchange for
a payment of $82,500 (HK$500,000 x 0.165) to the bank on December 31, Year 3. The
receivable from the bank will offset the payable to the supplier.
(a)
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Solutions Manual, Chapter 10
(b)
(c)
October 1, Year 3
Machinery
82,000
82,000
82,000
82,000
82,000
82,000
(HK$500,000 x 0.164)
Forward contract
1,500
OCI
1,500
1,500
1,500
Exchange gains/losses
1,500
1,500
1,500
Machinery
1,500
1,500
Commitment liability
1,500
1,500
Machinery
1,500
500
OCI
500
500
500
Exchange gains/losses
500
500
2,500
Account payable
2,500
2,500
2,500
2,500
2,500
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44
500
Exchange gains/losses
500
84,500
Forward contract
Cash
84,500
84,500
2,000
2,000
2,000
82,500
82,500
82,500
84,500
Cash (HK$)
84,500
84,500
84,500
84,500
84,500
(Pay supplier)
Summary journal entry
Machinery
80,500
80,500
82,000
2,000
2,000
500
Exchange gains/losses
Cash
82,500
82,500
82,500
(d)
The cash outflow of $82,500 is the same under all three scenarios and is equal to the amount
paid to the bank to get the HK$ to be paid to the supplier. The difference between the three
parts is based on how the exchange adjustment on the forward contract is allocated. In parts
a) and b), the full exchange adjustment prior to delivery is allocated to the machinery due to
the special rules under hedge accounting. In part c), all of the exchange adjustments end up
in exchange gains/losses.
Problem 10-9
(i) Sale of software when delivered (600,000 / 5.09)
Parts a & b
Part c
117,878
117,878
(445)
117,433
117,878
445
on accounts receivable
[600,000 / 5.14 600,000 / 5.09)]
1,147 loss
1,147 loss
901 loss
901 loss
2,048 loss
2,493 loss
115,385
115,385
on forward contract
[600,000 / 5.18 600,000 / 5.14)]
Net exchange gains/losses
(iii) Cash flows for the period
(= amount received from bank through forward contract)
(c)
The cash inflow of $115,385 is the same under all three scenarios and is the amount received
from the bank in exchange for the Danish Krona as fulfilment of the forward contract. The
difference in the sales and exchange gains/losses is based on how the exchange adjustment
prior to the installation of the software was allocated. In parts a) and b), the full exchange
adjustment prior to installation was allocated to the sale. In the part c), it was allocated to
exchange gains/losses.
Problem 10-10
a)
January 10, Year 1
Cash
11,600
11,600
105,300
11,600
Sales
116,900
May 1, Year 1
Land (US$200,000 x 1.19)
238,000
119,000
119,000
5,400
Exchange gain
5,400
Exchange loss
4,000
4,000
1,210
20
1,230
1,800
Exchange gain
1,800
112,500
Accounts receivable
112,500
b)
The market value of the land at June 30, Year 1 is C$258,300 (US$200,000 x 1.23).
Problem 10-11
May 1 & 2, Year 1
Memorandum Entries
JDH ordered equipment from a German supplier for payment of 100,000 on delivery on
October 1, Year 1.
Company entered into a forward contract to receive 100,000 from the bank in exchange for a
payment of $138,000 to the bank on October 1, Year 1. The receipt of 100,000 from the bank
will offset the payable to the supplier.
October 1, Year 1
Forward contract (100,000 [1.39 1.36])
1,000
1,000
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Solutions Manual, Chapter 10
137,000
Accounts payable ()
137,000
1,000
Equipment
1,000
3,000
Forward contract
3,000
1,000
1,000
136,000
Forward contract
2,000
Cash
138,000
136,000
Cash ()
136,000
Problem 10-12
Note: Debits without brackets and credits with brackets
(a) (i)
(c)
(d)
June 2, Year 3
Memorandum entry
Company entered into forward contract to receive TL217,000 from the bank in exchange for a
payment of $195,300 (TL217,000 x 0.90) to the bank on March 1, Year 2. The receivable from
the bank will offset the payable to the supplier.
June 30, Year 3
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48
1,085
1,085
Forward contract
(1,085)
(1,085)
1,085
(1,085)
3,255
3,255
(3,255)
(3,255)
3,255
Commitment liability
(3,255)
197,470
197,470
197,470
(2,170)
(2,170)
(2,170)
(195,300)
(195,300)
(195,300)
(TL217,000 0.90)
Inventory
Cash (TL)
197,470
197,470
197,470
(197,470)
(197,470)
(197,470)
(TL217,000 0.91)
Commitment liability
2,170
2,170
(2,170)
(2,170)
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2,170
Inventory
(2,170)
DR
CR
$1,085
Payable to bank**
$1,085
$1,085
$1,085
197,470
Cash (TL)
197,470
(e)
Inventory is the only current asset that would be different under the four options. There would
be no differences for current liabilities. Inventory would be reported at $197,470 when no
forward contract was entered and at $195,300 for the other options. Therefore, the current
ratio would be higher under option b) where no forward contract was entered.
Problem 10-13
(a)
October 15, Year 4
Inventory
340,300
340,300
(RL820,000 .415)
Memorandum entry
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50
Company entered into forward contract to receive RL820,000 from the bank in exchange for a
payment of $350,960 (RL 820,000 .428) to the bank on December 15, Year 4. The receivable
from the bank will offset the payable to the supplier.
December 1, Year 4
Accounts receivable (AP)
677,800
Sales
677,800
(AP2,520,000 .269)
Memorandum entry
Company entered into forward contract to pay AP2,520,000 to the bank in exchange for
$619,920 (AP2,520,000 .246) from the bank on January 31, Year 5. The payable to the bank
will offset the receivable from the customer.
December 15, Year 4
Accounts payable (RL)
6,560
6,560
17,220
Forward contract
17,220
333,740
Forward contract
17,220
Cash
350,960
333,740
Cash (RL)
333,740
40,320
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40,320
10,080
10,080
637,560
Forward contract
10,080
Problem 10-14
January 1, Year 1
Cash
1,470,000
Loan payable
1,470,000
(SF1,400,000 1.05)
During Year 1
Cash
616,000
Sales revenue
616,000
(SF560,000 1.10)
Interest expense (12% SF1,400,000 1.10)
Exchange loss
Cash (12% SF1,400,000 1.15)
184,800
8,400
193,200
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140,000
Loan payable
140,000
56,000
56,000
(560/1,400 140,000)
During Year 2
Cash
588,000
Sales revenue
588,000
(SF490,000 1.20)
Interest expense (12% SF1,400,000 1.20)
Exchange loss
201,600
8,400
210,000
84,000
Exchange loss*
56,000
Loan payable
140,000
98,000
49,000
49,000
(490/1,400 140,000)
During Year 3
Cash
444,500
Sales revenue
444,500
(SF350,000 1.27)
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213,360
5,040
218,400
17,500
52,500
Loan payable
70,000
87,500
35,000
35,000
17,500
Loan payable
1,820,000
Cash
1,820,000
Problem 10-15
Year
Gain (loss)
Gain (loss)
Loan Payable
Interest Payment
Year 4
(6,240) *
(234) ***
Year 5
12,480 **
468 ****
**
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