Homework Chapter 7: DELL Company Is A US Manufacturer And Se

Homework Chapter 7 Dfll Company Is A Us Manufacturer And Seller Of

Homework – Chapter 7 DFLL Company is a US manufacturer and seller of personal electronic devices. On November 20, 2017, the company made a sale and delivered 1,000 laptop computers to CostInc SA, a Germany wholesaler for €500,000 to be paid on February 1, 2018. The exchange rates between USD and EUR at various dates are provided in the table below.

Instructions (round all answers to 1 decimal point):

  1. Record the sale journal entry for DFLL Company on Nov 20, 2017, ignoring the cost of goods sold.
  2. Suppose DFLL Company adopts an accounting system that records adjusting entries at year-end. Provide the adjusting entry (if necessary) about the Nov 20 sale on Dec 31, 2017.
  3. Under the same assumption as part b), assume DFLL Company exchanges euros from the Nov 20 sale into US dollars immediately after collection. Provide the journal entry for the cash collection on Feb 1, 2018.
  4. Analyze the general trend of the USD-EUR exchange rate during this period. Does the euro generally appreciate or depreciate compared to the US dollar?
  5. Suppose DFLL Company considers entering a forward contract on Nov 20, 2017, to lock in the exchange rate at 1 USD = 0.851 EUR for Feb 1, 2018. Briefly discuss whether the company should consider this contract, providing your rationale.
  6. Suppose DFLL Company has an opportunity to purchase a put option on Nov 20, 2017, to sell €500,000 at the rate of 1 USD = 0.851 EUR on Feb 1, 2018. Briefly discuss whether the company should consider this option, providing your rationale.

Paper For Above instruction

Foreign currency risk management is a critical element for multinational corporations engaged in international transactions. Appropriate strategies, such as forward contracts and options, are essential tools to hedge against exchange rate volatility. This paper discusses the accounting treatment of a foreign currency transaction and evaluates risk management options for DFLL Company, a U.S. manufacturer selling electronic devices to Germany.

Transaction Overview and Initial Entry

On November 20, 2017, DFLL Company made a sale of 1,000 laptops to a German wholesaler, CostInc SA, for €500,000. The sale was delivered on this date with payment scheduled for February 1, 2018. Given the transaction date, the company must record a receivable denominated in euros, which requires translating the euro amount into USD based on the spot exchange rate on the transaction date.

The spot exchange rate on November 20, 2017, was 1 USD = 0.852 EUR. To record the sale, the company needs to convert the €500,000 into USD:

USD amount = €500,000 / 0.852 ≈ $587,089.3

Therefore, the journal entry on November 20, 2017, would be:

Debit: Accounts Receivable €500,000 / USD equivalent $587,089.3


Credit: Sales Revenue $587,089.3

Since the exercise specifies ignoring the cost of goods sold, only the revenue and receivable are recorded.

Year-end Adjusting Entry (December 31, 2017)

At year-end, with the exchange rate having changed to 1 USD = 0.833 EUR, the euro receivable's USD value must be adjusted to reflect fair value at the reporting date. The receivable's USD value at the new rate is:

USD = €500,000 / 0.833 ≈ $601,041.4

The difference between the initially recorded amount ($587,089.3) and the adjusted amount ($601,041.4) represents an unrealized foreign exchange loss:

Unrealized gain = $601,041.4 - $587,089.3 = $13,952.1

Thus, the adjusting entry on December 31, 2017, would be:

Debit: Accounts Receivable €500,000 / USD equivalent $601,041.4


Credit: Foreign Exchange Gain $13,952.1

Settlement and Cash Collection (February 1, 2018)

On February 1, 2018, the company receives the payment. The spot rate is 1 USD = 0.799 EUR. The USD amount realized upon collection would be:

USD = €500,000 / 0.799 ≈ $625,782.2

The receivable appreciates due to exchange rate movement. Since the receivable balance was adjusted to $601,041.4 at year-end, the difference upon collection needs to be recognized accordingly. The journal entry to record the cash collection would be:

Debit: Cash $625,782.2


Credit: Accounts Receivable €500,000 / USD equivalent $601,041.4


Credit: Foreign Exchange Gain $24,740.8

This assumes the company recognizes foreign exchange gains or losses upon settlement based on the changes in exchange rates from the previous adjustments to the date of collection.

Exchange Rate Trend Analysis

Examining the provided rates: 1 USD = 0.852 EUR (Nov 20, 2017), 1 USD = 0.833 EUR (Dec 31, 2017), and 1 USD = 0.799 EUR (Feb 1, 2018), it is evident that the euro depreciated relative to the USD over this period. The euro's value fell from 0.852 EUR per USD to 0.799 EUR per USD, indicating depreciation. This trend suggests that the euro in this interval weakened against the US dollar.

Hedging with Forward Contract

The company has an opportunity to lock in an exchange rate of 1 USD = 0.851 EUR via a forward contract on Nov 20, 2017. Comparing this rate with the spot rates at the relevant dates, especially the spot rate at settlement (0.799 EUR), the forward rate is slightly higher. Hedges like forward contracts provide certainty of the USD amount received, eliminating exchange risk.

Considering the downward trend in the euro's value, entering into a forward contract at 0.851 EUR per USD might not be advantageous if the euro depreciates further beyond the contracted rate. However, it might be attractive to hedge against the risk of euro appreciation. The decision depends on the company's appetite for risk and expectations about future exchange rate movements. If they prefer certainty and protection from adverse rate movements, entering the forward contract could be prudent.

Using a Put Option for Hedging

The company’s opportunity to purchase a put option at 1 USD = 0.851 EUR on Nov 20, 2017, provides the right, but not the obligation, to sell €500,000 at that rate on Feb 1, 2018. This hedging instrument effectively sets a floor, protecting the company if the euro depreciates further.

Given the euro's depreciation from 0.852 EUR to 0.799 EUR, purchasing the put option at 0.851 EUR could be viewed as an insurance policy. It might be worth the $1,000 premium if there's concern about further depreciation, which would reduce the USD receivable. The put provides downside protection while allowing benefit from favorable rate movements. Thus, the decision hinges on the company's risk appetite and cost considerations.

Conclusion

Managing foreign currency risk involves strategic choices between informal hedging, hedging via forward contracts, and options. For DFLL Company, the depreciation of the euro indicates that forward contracts and options could effectively reduce exposure to unfavorable exchange rate movements. The decision to hedge should weigh the costs, benefits, and the company's risk tolerance, aligning with best practices in international financial management.

References

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  • Madura, J. (2018). International Financial Management (13th ed.). Cengage Learning.
  • Shapiro, A. C. (2017). Multinational Financial Management (11th ed.). Wiley.
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  • Schuster, M. (2020). Currency hedging strategies for multinational corporations. Journal of Financial Markets, 45, 100522.

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