the U.S. Generally Accepted Accounting Principles (GAAP)
Q#1 Assumes that Ricky Corporation (Ricky) normally sells goods in France and therefore has a stream of income which is denominated in Euros. Ricky enters into a master agreement with a bank to convert this future stream of Euros into U.S. dollars. Determine whether this agreement is considered a derivative under both the US GAAP and under the IFRS. Support your decision with reference(s) to the appropriate literature issued by both standard setters.
According to the U.S. Generally Accepted Accounting Principles (GAAP), derivatives are characterized various aspects including the lack of initial net investment or an investment that is lower than that which would be required for any other kind of contract. Derivatives terms allow net settlements, and it has one or more underlying which determine if a settlement is required or not. GAAP divides derivative accounting two hedge and non-hedge accounting. The hedge accounting is concerned about accounting for derivatives whose functions is to prevent market risks, including foreign exchange rates, fluctuations and commodity price movement. Putra (2009) indicates that a derivative is an asset whose value depends on the value of something else. Therefore, based on the U.S. GAAP, the agreement between Ricky Corporation and the bank is a derivative. By entering the contract to convert future streams into Euros, Ricky Corporation is aiming to minimize the impacts associated with losing money that is associated with converting Euros into U.S. dollars.
Based on the International Financial Reporting Standards (IFRS), derivatives are accounting instruments that are characterized by a value change with changes in the underlying asset, a settlement at a future date and minimal or no initial investment is needed when compared to other types of contracts. Therefore, based on IFRS, the agreement qualifies to be a derivative. Based on the agreement, the bank would concert future streams from Euros to U.S. dollars with an underlying aspect which is foreign exchange rates. Hence, this means that the value of the contract would change based on the foreign exchange rates at that particular time. This contract does not have an initial investment, and the fact that it can be settled in the future makes it a derivative under the IFRS.
Q#2 The Potato Company (Potato) produces frozen French fries and therefore uses potatoes as the major raw material in its manufacturing process. Potato enters a forward exchange contract to purchase 20 bushels of potatoes in 30 days for $1,200. The contract has a net settlement provision. Assume that the potatoes are worth $1,250 at the end of 30 days. Explain in detail how the forward exchange contract might or would be settled in 30 days? What are Potato’s options with respect to the forward exchange contract?
Forward exchange contracts are agreements made between two parties that enable them to exchange two deiminated currencies at a particular time in the future. Such exchanges protect both the parties from risks associated with the adverse movement of money. The delivery method is one way that would help to settle the forward contract in 30 days. Finance Train (2012) argues that when there is a deliverable forward contract, the underlying assent is delivered by the party that is short the forward contract to the party that is long the forward contract. The underlying asset is usually delivered to the party that is long the forward contract during the expiration of the agreed settlement date stipulated in the contract. The forward price is therefore received after the underlying is delivered hence settling the remaining provision. An alternative is that Potato uses the cash settlement method, which requires the party with a negative value to pay the one with a positive value. In this case, the potatoes are bought at $1,200 but have a value of $1250 after 30 days. Therefore, the contract has a positive value of $50 for Potato and a similar negative value for the other party. As such, the other party would complete the forward exchange contract by paying Potato $50.
Q#3 Assume that potatoes are not easily convertible into cash and that Potato has a history of taking delivery of the potatoes under these types of contracts (gross settlement). Potato has decided NOT to document the instrument as a normal purchase and sales contract. Prepare the journal entries required under both the US GAAP and IFRS separately, with detailed explanations of the basis for each dollar journal entry amount, and a detailed journal entry explanation with appropriate reference(s) to the accounting literature for both standard setters for each respective journal entry.
Underlying refers to a variable that causes changes in the fair market values or the flow of a derivative when they fluctuate. A notional amount is a term used to refer to a fixed amount or quantity that shows the amount of change that results from fluctuation in the underlying. In the case of Potato, the price of potatoes is the underlying notional amount. The contract price of the notable underlying when being settled with the net settlement provision is $1,200 while the market price at the end of 30 days is $1,250. Therefore, the fluctuation in the market price of the underlying asset is $50 since this price will be higher with the same amount in the future. Thus, rather than delivering the actual potatoes, $50 is paid to cover the difference. Gross settlements regard to transactions that are settled on a one-to-one basis without netting or bundling with other operations. This means that payments cannot be revoked once the payment is processed or paid (Accounting Tools, 2017). Under the U.S. GAAP accountants should record journals to enter every transaction that occurs in a company. In each of these entries, the credit and debit amounts should be equal. According to IFRS, journal entries are similar to those by GAAP and includes both credit and debit names in addition to the accounting period during the entry period.
Journal entry of the forward contract:
Debit record to receivable account=$1,200
Credit record to liability account =$1,200
Journal entry of the settlement transaction:
Debit record liability account =$1,200
Credit record cash =$1,200
Journal entry of delivery and loss of the contract
Debit record inventory=$1,200
Debit record loss on account=$50
Credit record receivable amount=$1,250