MQ1 University of Saint Louis Tuguegarao (Review P2)

1. On September 1, 2003, Bain Corp. received an order for equipment from a foreign
customer for 300,000 local currency units (LCU) when the US dollar equivalent was
$96,000. Bain shipped the equipment on October 15, 2003, and billed the customer for
300,000 LCU when the US dollar equivalent was $100,000. Bain received the customer’s
remittance in full on November 16, 2003, and sold the 300,000 LCU for $105,000. In its
income statement for the year ended December 31, 2003, Bain should report as part of
net income a foreign exchange transaction gain of
a. $0
b. $4,000
c. $5,000
d. $9,000
Answer: C

2. Lindy, a US corporation, bought inventory items from a supplier in Argentina on

November 5, 2002, for 100,000 Argentine pesos, when the spot rate was $.4295. At
Lindy’s December 31, 2002 year-end, the spot rate was $.4245. On January 15, 2003,
Lindy bought 100,000 pesos at the spot rate of $.4345 and paid the invoice. How much
should Lindy report as part of net income for 2002 and 2003 as foreign exchange
transaction gain or loss?
2002 2003
a. $ 500 $(1,000)
b. $0 $ (500)
c. $ (500) $0
d. $(1,000) $ 500
Answer: A

3. On November 30, 2003, Tyrola Publishing Company, located in Colorado, executed a

contract with Ernest Blyton, an author from Canada, providing for payment of 10%
royalties on Canadian sales of Blyton’s book. Payment is to be made in Canadian dollars
each January 10 for the previous year’s sales. Canadian sales of the book for the year
ended December 31, 2003, totaled $50,000 Canadian. Tyrola paid Blyton his 2003
royalties on January 10, 2004. Tyrola’s 2003 financial statements were issued on February
1, 2004. Spot rates for Canadian dollars were as follows:
November 30, 2002 $.87
January 1, 2003 $.88
December 31, 2003 $.89
January 10, 2004 $.90
How much should Tyrola accrue for royalties payable at December 31, 2003?
a. $4,350
b. $4,425
c. $4,450
d. $4,500
Answer: C

4. Which of the following statements is(are) true regarding derivative financial

instruments?
I. Derivative financial instruments should be measured at fair value and reported in the
balance sheet as assets or
liabilities.
II. Gains and losses on derivative instruments not designated as hedging activities should
be reported and recognized in earnings in the period of the change in fair value.
a. I only.
b. II only.
c. Both I and II.
d. Neither I nor II.
Answer: C

5. If the price of the underlying is greater than the strike or exercise price of the
underlying, the call option is
a. At the money.
b. In the money.
c. On the money.
d. Out of the money.
Answer: B

6. Which of the following is not a distinguishing characteristic of a derivative instrument?

a. Terms that require or permit net settlement.
b. Must be “highly effective” throughout its life.
c. No initial net investment.
d. One or more underlyings and notional amounts.
Answer: B

7. An example of a notional amount is

a. Number of barrels of oil.
b. Interest rates.
c. Currency swaps.
d. Stock prices.
Answer: A

8. Which of the following is not a derivative instrument?

a. Futures contracts.
b. Credit indexed contracts.
c. Interest rate swaps.
d. Variable annuity contracts.
Answer:D

9. Which of the following criteria must be met for bifurcation

to occur?
a. The embedded derivative meets the definition of a derivative instrument.
b. The hybrid instrument is regularly recorded at fair value.
c. Economic characteristics and risks of the embedded instrument are “clearly and
closely” related to
those of the host contract.
d. All of the above.
Answer: A

10. Financial instruments sometimes contain features that separately meet the definition
of a derivative instrument. These features are classified as
a. Swaptions.
b. Notional amounts.
c. Embedded derivative instruments.
d. Underlyings.
Answer:C

11. The process of bifurcation

a. Protects an entity from loss by entering into a transaction.
b. Includes entering into agreements between two counterparties to exchange cash flows
over specified period of time in the future.
c. Is the interaction of the price or rate with an associated asset or liability.
d. Separates an embedded derivative from its host contract.
Answer: C

12. On December 12, 2003, Imp Co. entered into three forward exchange contracts, each
to purchase 100,000 euros in ninety days. The relevant exchange rates are as follows:
Spot rate Forward rate
(for March 12, 2004)
November 30, 2003 $.87 $.89
December 12, 2003 .88 .90
December 31, 2003 .92 .93

. Imp entered into the first forward contract to hedge a purchase of inventory in
November 2003, payable in
March 2004. At December 31, 2003, what amount of foreign currency transaction gain
from this forward contract should Imp include in net income?
 a. $0
b. $ 3,000
c. $ 5,000
d. $10,000
Answer: B

13. At December 31, 2003, what amount of foreign currency transaction loss should Imp
include in income from the revaluation of the Accounts Payable of 100,000 euros incurred
as a result of the purchase of inventory at November 30, 2003, payable in March 2004?
a. $0
b. $3,000
c. $4,000
d. $5,000
Answer: D

14. Imp entered into the third forward contract for speculation.
At December 31, 2003, what amount of foreign currency
transaction gain from this forward contract should Imp
include in net income?
a. $0
b. $ 3,000
c. $ 5,000
d. $10,000
Answer: B

15. The risk of an accounting loss from a financial instrument due to possible failure of
another party to perform according to terms of the contract is known as
a. Off-balance-sheet risk.
b. Market risk.
c. Credit risk.
d. Investment risk.
Answer:: C

16. Examples of financial instruments with off-balancesheet risk include all of the
following except
a. Outstanding loan commitments written.
b. Recourse obligations on receivables.
c. Warranty obligations
d. Futures contracts.
Answer: C

17. Off-balance-sheet risk of accounting loss does not result from

a. Financial instruments recognized as assets entailing conditional rights that result in a
loss greater than the amount recognized in the balance sheet.
b. Financial instruments not recognized as either assets or liabilities yet still expose the
entity to risk of accounting loss.
c. Financial instruments recognized as assets or liabilities where the amount recognized
reflects the risk of accounting loss to the entity.
d. Financial instruments recognized as liabilities that result in an ultimate obligation that
is greater than
the amount recognized in the balance sheet.
Answer:C

PROBLEM

1. North Shore Railroad operates between Chicago and upper Michigan and Wisconsin. Dallas Ingold,
purchasing manager of North Shore Railroad, anticipates the price of diesel fuel will increase over the next few
months. On September 4th, Ingold purchased an out-of-the-money November call option for $1,100. The option
has a notional amount of 80,000 barrels and a strike price of $2.16 per barrel. Diesel fuel spot rates and option
values at selected dates follow:

Spot Rate Option

Date per Barrel Value
September 30 $2.17 $1,130
October 31 2.13 1,026
November 27 2.19 2,400

a. For each of the above dates, calculate the intrinsic value and the time value of the option.

b. If the price of diesel fuel remained below $2.16 per barrel through November, calculate the
effect on earnings traceable to the hedge.

ANS:
a. Sept. 30 Oct. 31 Nov. 30
Total value $1,130 $1,026 $2,400
Intrinsic value:
80,000  ($2.17 $2.16) 800
Out of the money 0
80,000  ($2.19 $2.16) 2,400
Time value $ 330 $1,026 $ 0

b. If the price of diesel fuel remained below $2.16 per barrel, the option would have been out
of the market, and the option would have no value. The effect on earnings would have
been a loss equal to the $1,100 premium paid for the option.

30. Pedro Corporation, a Philippine Company starts a subsidiary in New Zealand, the subsidiary
had the NZ Dollar as its functional currency. On January 1, 2008, Pedro acquired all of the
subsidiary's common stock for 20,000 NZ Dollar. On April 1, 2008, the subsidiary purchased
inventory for 20,000 NZ Dollar, with payment made on May 1, 2008. This inventory is sold on
August 1, 2008 for 30,000 NZ Dollar, which is collected on October 1, 2008. Currency
exchange rates 1 NZ Dollar for 2008 are as follows:

January 1 P15
April 1 P17
May 1 P18
August 1 P19
October 1 P20
December 31 P21

What Foreign Currency Translation Adjustment will be reported in preparing consolidated

financial statements on December 31, 2008?

31. The subsidiary in Japan of Manila Company, a Philippine enterprise has plant assets with a cost
of P3,600,000 yen on December 31, 2008. Of this amount, plant assets with a cost of 2,400,000
yen were acquired in 2006 when the exchange rate was 1 yen = P0.625; and plant assets with a
cost of 1,200,000 yen were acquired in 2007 when the exchange rate was 1 yen = P0.556. The
exchange rate on December 31, 2007 was 1 yen = P0.500, and the weighted average rate for
2008 was 1 yen = P0.521. The japanese subsidiary depreciates plant assets by the straight
method over a 10 year economic life with no residual value.

What is the 2008 depreciation expense for the Japanese subsidiary in Philippine peso for
the translated income statement?

32. A wholly-owned foreign subsidiary of a Philippine Company had selected expense accounts
stated in local currency unit (LCUs) for the fiscal year ended November 30, 2008 as follows:

Bad Depbts expense LCU 60,000

Amortization of patent (patent was acquired on Dec. 1, 2005) 40,000
Rent expense 100,000

The exchnge rates of LCUs at various dates were as follows:

December 1, 2005 P0.25

 November 30, 2008 0.20
Average for fiscal year ended November 30, 2008 0.22

What is the peso amount to be included in the translated income statement of the
Philippine Company's foreign subsidiary for the fiscal year ended November 30, 2008 for the
foreignoing expense accounts?

33. A wholly-owned subsidiary of Philippine Inc. has certain expense accounts for the year ended
December 31, 2008 stated in local currency units (LCU) as follows:

LCU
Depreciation of equipment (related assets were
purchased January 1, 2006 120,000
Provision for doubtful accounts 80,000
Rent 200,000
The exchange rates at various dates are as follows:

Peso equivalent
of 1 LCU
December 31, 2008 P.40
Average for year ended 12/31/2008 .44
January 1, 2006 .50

Assume that charges to the expense accounts occurred approximately evenly during the
year. What total peso amount should be included in Philippine's 2008 consolidated income
statement to reflect these expenses?

34. On December 31, 2008 a foreign subsidiary in Hongkong submitted the following balance sheet
stated in foreign currency:

Hongkong Dollar
Total assets $100,000
Total liabilities 20,000
Common stock 50,000
Retained earnings, 12/31 30,000
The exchange rates are:

Current rate P7.40

Historical rate P7.10
Weighted average rate P7.00

Assuming that the retained earnings of the subsidiary on December 31, 2008 translated to
Philippine Peso is P212,000. What amount of Cumulative Transaction Adjustment is to be
reported in the Consolidated Balance Sheet on December 31, 2008?

Items 36 to 38 are based on the following data:

Jenjen Company sold computer printer ink cartridges to a Pakistan computer parts store on
March 10. The sales price of 100,000 Rupee (R) will be received in 30 days. JenJen anticipates
that the exchange rate of the Rupee to Philippine peso will decrease in 30 days. Therefore,
JenJen decides to purchase a put option on 100,000 Rupee at a strike price of P.73, paying a
premium of P.005 per units. The following are the relevant data for the term of the option:

Spot Rates:
March 10 P.73
March 31 P.727
April 9 P.723

36. On April 9, what is the entry to record the settlement of the accounts receivable from the
Pakistan customer?
 37. What is the entry to record the exercise of the put option on April 9?

38. What is the impact on the net income for the first quarter of 2008?

39. On June 1, 2008 Jenna Corporation (a Pilipino company) sold pool cues to a customer in
Thailand for 100,000 Baht when the spot rate is P1.50 per Baht. The pool cues are to be paid on
September 1, 2008. On june 1, Jenna Corporation acquires a three-month option to sell 100,000
Baht. The strike price is P1.50 and the premium is P.05 per unit. On September 1, 2008 Jenne
receives 100,000 Baht in settlement of the pool cues. The spot rate at that date is P1.43 per
Baht.

What is the amount that Jenna would report in income as a result of this transactions?

Items 40 to 43 are based on the following data:

On July 1, 2007, Pedro Company purchased 1,000 shares of Jenny Co. common stock at a cost of P150
per share per and classified it as an available for sale security. On October 1, Pedro Company
purchased an at-the-money put option on jenny at a premium of p35,000 with a strike price of P250
per share and an expiration date of April 2008.

Pedro Company specifies that only the intrinsic value of the option is to be used to measure
effectiveness. Thus, the time value decreases of the put will be charged againts the income of
the period, and not offset against the change in value of the underlying, hedged item. The
following shows the fair value of the hedged item and the hedging instrument.

10/1/07 12/31/07 3/3/08 4/17/08

Hedged item:
Jenny share price P 250 P 220 P 200 P 200
Number of shares 1,000 1,000 1,000 1,000

Hedging instrument
Put option (1,000 shares):
Intrinsic value P 0 P30,000 P50,000 P50,000
Time value 35,000 21,500 5,300 0
Fair value P35,000 P51,500 P55,300 P50,000

40. On December 31, 2008, how much is the value of the put option to be presented on the balance
sheet?
41. What is the cumulative effect on retained earnings of the hedge and sale?
42.What is the entry to record the exercise of the put option on April 17, 2008?
1.Answer: C

2.Answer: A

3.Answer: C

4. Answer: C

5. Answer: B

6. Answer: B

7. Answer: A

8. Answer:D

9. Answer: A

10.Answer:C

11.Answer: C

12.nswer: B

13.Answer: D

14.Answer: B

15.Answer:: C

16.Answer: C

17.Answer:C

PROBLEM

1.ANS:
a. Sept. 30 Oct. 31 Nov. 30
Total value $1,130 $1,026 $2,400
Intrinsic value:
80,000  ($2.17 $2.16) 800
Out of the money 0
80,000  ($2.19 $2.16) 2,400
Time value $ 330 $1,026 $ 0

b. If the price of diesel fuel remained below $2.16 per barrel, the option would have been out
of the market, and the option would have no value. The effect on earnings would have
been a loss equal to the $1,100 premium paid for the option.