Refer to Examples 16 and 20 in the chapter. Firm A places its order for the equipment on June 30, 2010. It simultaneously signs a forward foreign exchange contract for 10,000 GBP. The forward rate on June 30, 2010, for settlement on June 30, 2011, is $1.64 per GBP. Firm A designates the forward foreign exchange contract as a fair value hedge of the firm commitment.
Required
a. GAAP and IFRS do not require Firm A to record the purchase commitment or the forward foreign exchange contract on the balance sheet as a liability and an asset on June 30, 2010. What is the logic for this accounting?
b. On December 31, 2010, the forward foreign exchange rate for settlement on June 30, 2011, is $1.73 per GBP. Using the financial statement effects template, show the financial statement effects of recording the change in the value of the purchase commitment and the change in the value of the forward contract for 2010. Assume an 8 percent per year interest rate for discounting cash flows to their present values on December 31, 2010.
c. Show the financial statement effects on June 30, 2011, of recording the change in the present value of the purchase commitment and the forward foreign exchange contract for the passage of time.
d. On June 30, 2011, the spot foreign exchange rate is $1.75 per GBP. Show the financial statement effects of recording the change in the value of the purchase commitment and the change in the value of the forward contract due to changes in the exchange rate during the first six months of 2011.
e. Show the financial statement effects of the June 30, 2011, purchase of 10,000 GBP with U.S. dollars and acquisition of the equipment.
f. Show the financial statement effects on June 30, 2011, to settle the forward foreign exchange contract.
g. How would the effects in Parts b-f differ if Firm A had chosen to designate the forward foreign exchange contract as a cash flow hedge instead of a fair value hedge?
h. Suggest a scenario that would justify Firm A treating the forward foreign exchange contract as a fair value hedge and a scenario that would justify the firm treating the contract as a cash flow hedge.