On August 1, Ling-Harvey Corporation (a U. S.-based importer) placed an order to purchase merchandise from a foreign supplier at a price of 400,000 ringgits. Ling-Harvey will receive and make payment for the merchandise in three months on October 31. On August 1, Ling-Harvey entered into a forward contract to purchase 400,000 ringgits in three months at a forward rate of $0.60. It properly designates the forward contract as a fair value hedge of a foreign currency firm commitment. The fair value of the firm commitment is measured by referring to changes in the forward rate. Relevant exchange rates for the ringgit are as follows: Date Spot Rate Forward Rate (to October 31) August 1 $ 0.60 $ 0.60 September 30 0.63 0.66 October 31 0.68 N/A Ling-Harvey's incremental borrowing rate is 12 percent. The present value factor for one month at an annual interest rate of 12 percent (1 percent per month) is 0.9901. Ling-Harvey must close its books and prepare its third-quarter financial statements on September 30. Prepare journal entries for the forward contract and firm commitment through October 31. Assuming the inventory is sold in the fourth quarter, what is the impact on net income over the two accounting periods

Detailed workings are in the explanations.

Explanation:

August 1

On August 1, Ling Harvey entered into a forward contract to purchase 400000 ringgits in 3 months at a forward rate of $0.60.

If Ling Harvey has to pay 400000 ringgits now, total outflow would be $ 240000 (400000*0.60) and in forward contract it has to pay $ 240000 also (400000*0.60), so ling harvey has not incurred any loss

So, there is a firm commitment to pay $ 240000 on October, 31

For entering into a forward contract, there will be no entry.

On September, 30

Forward contract rate has increased to 0.66 from 0.60 (august, 1), so there is a increase in the fair value of the Forward Contract. Earlier its value was $240,000 on Aug,1 but now its value is $ 264,000, so there is a increase in fair value by $24,000

Since this $24000 will be realized on Oct, 31, we will book it today at present value

Present value = $24000*0.9901= $23,762.4

Journal entry would be  as follows:

Debit: Forward Contract a/c  $23,762.4

Credit: Gain on Forward Contract $23,762.4

Now, the spot rate determines the fair value of Commitment, so there is an increase in fair value of firm commitment by (0.63 - 0.60) * $400,000 =$12,000.

0.63 is the spot rate on September, 30

Since our Firm commitment value increased by $12,000, we need to book it at present value .

Present Value = $12,000*0.9901=$11,881.2

Journal Entry is as follows:

Debit: Loss on Firm Commitment a/c $11,881.2

Credit: Firm Commitment $11,881.2

So its effect on Net income is as follows:

Debit: Gain on Forward Contract a/c $23,762.4

Credit: Loss on Firm Commitment $11,881.2

Credit: Retained Earnings $11,881.2

On October 31

Today spot rate is 0.68, so the value of the forward contract when compared to its value on Aug 1

= (0.68 - 0.60) *$400,000

= $32,000

So there is an increase in Forward Contract Value by $32,000, since we have already booked $23,762.4, we will book the additional value $82,37.6 as follows:

Debit: Forward Contract a/c $8,237.6

Credit: Gain on Forward Contact $8,237.6

So, the Firm Commitment value has also increased from 0.60(Aug 1) to 0.68

Increase in value = (0.68-0.60) *$400,000 = $32,000

As we have already booked a liability of $11,881.2, we will be book the additional increase in value of $20,118.8 as follows

Debit: Loss on Firm Commitment a/c $20,118.8

Credit: Firm Commitment $20,118.8

So, its effect on Net Income is as follows

Debit: Gain on Forward Contract a/c $8,237.6

Debit: Retained Earnings a/c $11,881.2

Credit: Loss on Firm Commitment $20,118.8

So the total effect on Net income is 0, as on Sept 30 retained earnings has been credited by $11881.2 and on Oct 31, it has been debited by $11881.2... This is due to as there was no difference between spot rate & forward rate on August 1

As on 31st October, there is a debit balance of $32,000 in Forward Contract & credit balance of $32000 in Firm commitment.

Entry for Goods received & payment to foreign supplier is as follows

Debit: Inventory (At spot rate on Aug 1) $240,000

Debit: Firm Commitment (offset) $32,000

Credit: Forward contract (offset) $32,000

Credit: Cash (At forward rate on Aug 1) $240,000

The net cash outflow to foreign supplier is $240,000.