Meagan's Kilts Inc. (MKI) imports top quality kilts and accessories directly from Scotland for sale to Canadian and American customers. Because of its international suppliers and customers, MKI uses IFRS. On November 1, 2012, MKI plans to enter into a firm commitment to purchase inventory from a supplier in Scotland for 100,000 British pounds. Payment is to be made upon delivery of the inventory on February 28, 2013. Because of uncertain foreign currency markets, the owner-manager, Meagan, is considering entering into a forward contract to hedge the currency risk but is uncertain how this will affect the financial statements. She wants you, the company accountant, to determine the effect of these transactions on MKI's 2012 and 2013 income statements (year end is December 31) under the following assumptions:
On November 1, 2012, MKI enters into a forward contract with a bank to buy £100,000 at the 4-month forward rate.
The payment to the supplier is made on February 28, 2013.
All inventory obtained in this purchase is sold in 2013.
Meagan would like you to use the following assumed exchange rates in your calculations:
Spot Rates Forward Rates
November 1, 2012 1.40 1.46 (4-month forward)
December 31, 2012 1.32 1.36 (2-month forward)
February 28, 2013 1.52 1.52
Meagan would also like you to provide some information about hedge accounting, so the company can make an informed decision on whether or not to use this approach.
Required
Calculate the effect of exchange rate changes for the above scenario on MKI's 2012 and 2013 statements of profit or loss, assuming that hedge accounting is not used. Your calculations should include both the income effect of exchange gains and losses and cost of goods sold. Ignore income taxes.
Explain how hedge accounting would avoid the effects on the statement of profit or loss calculated in part (a) assuming that the forward contract is designated as
i) a fair value hedge
ii) a cash flow hedge