TEACHING NOTES
The purpose of this case is to introduce students to two different types of derivative financial instruments. The accounting for these derivatives is somewhat in a state of disarray and, therefore, both the traditional settlement accounting as well as the accounting that would be required under Exposure Draft 162-B are required of the student.
The calculations for this case have been somewhat simplified in order to help the student concentrate on learning the fundamentals about each type of derivative while not feeling overwhelmed by the complexity of the contracts.
1. Prepare the journal entries to account for the forward contract at December 11, December 31, and January 10.
December 11, 19X1
At the time of the sale and inception of the forward contract, two journal entries must be made to record the sale and record the forward contract.
Accounts Receivable (spot
rate)
1,315,350
Sales
Revenue
1,315,350
To record the sales revenue from the sale to Joey Z’s.
Contract Receivable (forward
rate) 1,308,240
Discount
7,110
Contract Payable (spot
rate)
1,315,350
To record the forward contract to sell £790,000 on Jan. 10, 19X2.
December 31, 19X1
At year-end, MGM must record adjustments to Accounts Receivable and Contract Payable for the foreign currency fluctuations and 2/3 of the Discount must be amortized. When a foreign currency net asset position is properly hedged, all Exchange Gains will be offset by Exchange Losses. SFAS 52 states that, when hedging a net asset or a net liability foreign currency position, premiums and discounts must be amortized over the life of the contract.
Accounts
Receivable
11,850
Exchange
Gain
11,850
To adjust A/R at December 31 for foreign currency fluctuations.
Exchange
Loss
11,850
Contract
Payable
11,850
To adjust Contract Payable at December 31 for foreign currency fluctuations.
Amortization
Expense
4,740
Discount
4,740
To amortize 2/3 of the Discount on the forward contract.
January 10, 19X2
On January 10, MGM must record collection of the Accounts Receivable, payment of the Contract Payable, collection of the Contract Receivable, and amortize the remaining Discount.
Cash
1,335,890
Exchange
Gain
8,690
Accounts
Receivable
1,327,200
To record collection of the Accounts Receivable.
Contracts
Payable
1,327,200
Exchange
Loss
8,690
Cash
1,335,890
To record payment of the Contract Payable.
Cash
1,308,240
Contract
Receivable
1,308,240
To record cash received from the sale of £790,000 at the December 11, 19X1 forward rate.
Amortization
Expense
2,370
Discount
2,370
To amortize the remaining 1/3 of the Discount.
2. Summarize SFAS 52’s position regarding the market adjustment of the asset/liability and amortization of the discount/premium.
Regarding market adjustment of the asset/liability, SFAS No. 52 says, "A change in exchange rates between the functional currency and the currency in which a transaction is denominated increases or decreases the expected amount of functional currency cash flows upon settlement of the transaction. That increase or decrease in expected functional currency cash flows is a foreign currency transaction gain or loss that generally shall be included in determining net income for the period in which the exchange rate changes." (SFAS 52, P15) Therefore, gains or losses due to exchange rate fluctuations are to be recognized in the period the exchange rates change.
SFAS No. 52 states that the discount or premium on a hedge of an exposed net asset or liability position is required to be amortized over the term of the forward contract. In the case of an identifiable foreign currency purchase commitment, the discount or premium can either be amortized over the term of the contract or deferred and treated as an adjustment to the related foreign currency transaction.
3. Discuss the impact of this transaction on MGM’s net income (total impact for 19X1 and 19X2). Was this hedge good or bad for MGM, Inc.? Explain.
The swap itself has no income statement effect for MGM. Since MGM’s position was effectively hedged by the forward contract, the exchange gains and losses offset each other.
In hindsight, this hedge does not appear to have been good for MGM, Inc. If MGM had not entered into the forward contract, the Company could have realized an exchange gain of $20,540. However, it is easy to look back and criticize MGM’s actions. MGM wanted to lock in a guaranteed return on its sales to Joey Z’s Imports, and that objective was accomplished. Also, had the exchange rates gone in the opposite direction, the Company would have been very happy with the forward contract, as it would have saved MGM from losing a good deal of money on exchange rate losses.
4. Prepare the journal entries to account for the swap on MGM’s books at January 1, 19X3, December 31, 19X3, December 31, 19X7 and January 1, 19X8 under traditional settlement accounting and under Exposure Draft 162-B.
January 1, 19X3
Settlement
Cash
10,000,000
Long Term Debt
(FC)
10,000,000
To record Note Payable for loan.
Currency Swap Receivable
(FC)
10,000,000
Cash
10,000,000
To record Receivable portion of currency swap.
Cash
10,000,000
Currency Swap
Payable
10,000,000
To record the Payable portion of currency swap.
Exposure Draft
(click here to see chart for Exposure Draft valuations)
The journal entries are the same as settlement at the date of inception.
December 31, 19X3
Settlement
Interest
Expense
900,000
Loss on Exchange Rate
Change
19,286
Cash
919,286
To record Interest Expense on the original debt.
Cash
919,286
Gain on Exchange Rate
Change
19,286
Interest
Revenue
900,000
To record Interest Revenue on the Receivable portion of the swap.
Interest
Expense
800,000
Cash
800,000
To record 12 months of interest on the $10,000,000.
Loss on Exchange Rate
Change
214,286
Long Term Debt
(FC)
214,286
To record the loss on the exchange rate fluctuation.
Currency Swap Receivable
(FC)
214,286
Gain on Exchange Rate
Change
214,286
To record the gain on exchange rate fluctuation.
Exposure Draft
(click here to see chart for Exposure Draft valuations)
(Includes all of the above entries as well as the following entries)
Interest Rate
Swap
323,972
Comprehensive
Income
323,972
To record the present value of the Interest Rate Swap at 12/31/X3.
Foreign Currency
Swap
62,481
Comprehensive
Income
62,481
To record the present value of the FC Swap at 12/31/X3.
December 31, 19X7
Settlement
Interest
Expense
900,000
Gain on Exchange Rate
Change
24,490
Cash
875,510
To record Interest Expense on the original debt.
Cash
875,510
Loss on Exchange Rate
Change
24,490
Interest
Revenue
900,000
To record Interest Revenue on the Receivable portion of the swap.
Interest
Expense
800,000
Cash
800,000
To record payment of Interest Expense for Payable portion of swap.
Loss on Exchange Rate
Change
100,288
Long Term Debt
(FC)
100,288
To record the loss on the exchange rate fluctuation.
Currency Swap Receivable
(FC)
100,288
Gain on Exchange Rate
Change
100,288
To record the gain on exchange rate fluctuation.
Exposure Draft
(click here to see chart for Exposure Draft valuations)
(Includes all of the above entries as well as the following entries)
Comprehensive
Income
91,473
Interest Rate
Swap
91,473
To restate the Interest Rate Swap amount to zero at 12/31/97.
Foreign Currency
Swap
14,187
Comprehensive
Income
14,187
To restate the Foreign Currency Swap to zero at 12/31/97.
January 1, 19X8
Settlement
Cash
9,727,891
Currency Swap Receivable
(FC)
9,727,891
To record receipt of the £5,720,000 principal on the Receivable portion of the swap.
Long Term Debt
(FC)
9,727,891
Cash
9,727,891
To record repayment of the original £5,720,000 principal.
Currency Swap
Payable
10,000,000
Cash
10,000,000
To record payment of the $10,000,000 to S&S at the end of the swap.
Exposure Draft
(click here to see chart for Exposure Draft valuations)
The journal entries are the same as settlement at the date of termination as the Interest Rate Swap and Foreign Currency Swap accounts have been reduced to zero at 12/31/X7.
5. What is the impact of this swap on MGM’s interest expense for the five-year swap period (swap vs. no swap)?
Over the five-year period, this swap decreased MGM’s interest expense by $463,755. The following table illustrates the interest savings realized by MGM in the swap:
Int. Exp. ($) 19X3 19X4 19X5 19X6 19X7
W/Swap (8%) 800,000
800,000 800,000
800,000 800,000
W/O Swap (9%) 919,286 895,304
889,119 884,536 875,510
Savings
119,286 95,304
89,119 84,536
75,510
6. At the end of the swap period, MGM receives £5,720,000 from S&S. What is the aggregate gain or loss associated with the repayment of the principal?
At the end of the swap period, MGM has no gains or losses regarding the repayment of this principal because MGM is effectively hedged against exchange rate fluctuations. MGM receives £5,720,000 from S&S, but that is the exact amount MGM borrowed from the British bank. Therefore, there is no gain or loss on the repayment of principal.
7. Discuss MGM’s exchange rate risk regarding the swap. Is this risk any different than if the Company had borrowed the funds directly from a bank in the United States?
MGM does not have any exchange rate risk on this swap. In this case, MGM was very fortunate to find a counterparty like S&S that would give them a better fixed interest rate on the swap than MGM could arrange on its own. Had MGM borrowed the funds directly from a bank in the United States, the Company would have paid a higher interest rate, but would not have had any exchange rate risk as the loan from the bank in the U.S. would have been denominated in dollars.
8. What would happen to MGM if S&S defaulted on its obligation to MGM?
Nothing would happen to MGM if S&S defaults on its obligation to MGM. In a foreign currency swap, if one party defaults on its payments, the counterparty has the right to offset nonpayment of interest or principal with a comparable nonpayment. Therefore, MGM would immediately be relieved of any obligations to S&S if S&S defaulted on its obligation to MGM.
9. Why might S&S be willing to enter into this swap with MGM?
S&S may be willing to give up its fixed 8% for 9% fixed for two reasons. First, S&S is not able to obtain the necessary currency (£) through any other means and needs the money to expand into England. Without the swap with MGM, S&S could not finance expansion into England. Second, S&S may believe that the pound will strengthen against the dollar significantly during the five-year swap period, thus negating a large portion of the losses guaranteed by swapping an 8% fixed rate for a 9% fixed rate. In order for one company to hedge itself through a swap (MGM), another company must speculate (S&S). Both companies cannot be hedged in the same transaction.