Task:
FOREIGN CURRENCY HEDGE.
On November 1, 2008, King Co. sold inventory to a customer in a foreign country. King agreed to accept 96,000 local currency units (lcu) in full payment for this inventory. Payment was to be made on February 1, 2009. On December 1, 2008, King pays $1,800 for a two-month option on 96,000 lcu with a strike price of $0.32 per lcu. On December 31, 2008, the option has a fair value of $1,600. The spot rates and forward rates were as follows:
Date Rate Description Exchange Rate
November 1, 2008 Spot Rate $.35 = 1 lcu
3-Month Forward Rate $.33 = 1 lcu
2-Month Forward Rate $.34 = 1 lcu
1-Month Forward Rate $.345 = 1 lcu
December 1, 2008 Spot Rate $.32 = 1 lcu
3-Month Forward Rate $.31 = 1 lcu
2-Month Forward Rate $.30 = 1 lcu
1-Month Forward Rate $.295 = 1 lcu
December 31, 2008 Spot Rate $.29 = 1 lcu
3-Month Forward Rate $.30 = 1 lcu
2-Month Forward Rate $.285 = 1 lcu
1-Month Forward Rate $.28 = 1 lcu
February 1, 2009 Spot Rate $.33 = 1 lcu
3-Month Forward Rate $.305 = 1 lcu
2-Month Forward Rate $.31 = 1 lcu
1-Month Forward Rate $.32 = 1 lcu
The company has designated the hedge as a fair value hedge and has an incremental borrowing rate of 12%. Kingâ??s financial year-end is December 31.
Required:
a. Prepare all the journal entries relating to the above transactions.
b. Compute the effect on 2008 net income.
c. Compute the effect on 2009 net income.