Question

Global Motors is a U.S. corporation that purchases automobiles from European manufacturers for distribution in the United States. A recent purchase involved the following events:
Nov. 12

Purchased automobiles from Stockholm Motors in Swedish kronor for Sk20,000,000, payable in 60 days. Current exchange rate, $0.1286 per krona. (Global uses the per-petual inventory system.)

Dec. 31

Made year-end adjusting entry relating to the Sk20,000,000 account payable to Stockholm Motors. Current exchange rate, $0.1288 per krona.

Jan. 11

Issued a check to World Bank for $2,566,800 in full payment of the account payable to Stockholm Motors.

Instructions

a. Prepare in general journal form the entries necessary to record the preceding events.

b. Compute the exchange rate (price) of the krona in U.S. dollars on January 11.

Gains and Losses Journalizing Exchange L04 Rate

c. Explain a hedging technique that Global might have used to protect itself from the possibility of losses resulting from a significant increase in the exchange rate for the krona.

Answer 1

Answer:

Global

a) General Journal

1. Purchase of automobiles

Date       Description                                         Debit          Credit

Nov. 12   Automobiles                                 $2,572,000

              Accounts Payable (Stockholm Motors)           $2,572,000

To record the purchase of automobiles at $0.1286 per krona, terms n/60.

Date       Description                                         Debit          Credit

Dec. 31: Foreign Exchange Loss/Gain          $4,000

             Accounts Payable (Stockholm Motors)                 $4,000

To recognize the current exchange rate at $0.1288 per krona.

Date       Description                                               Debit          Credit

Jan. 11: Accounts Payable (Stockholm Motors) $2,566,800

           Foreign Exchange Gain                                                $9,200

           Cash Account                                                        $2,557,600

To record full settlement of account.

b) Computation of the exchange rate of the krona in U.S. dollars on January 11:

Exchange rate = $2,566,800/ Sk20,000,000 = $0.12834

c) A hedging technique that Global might have used to protect itself from the possibility of losses resulting from a significant increase in the exchange rate for the krona is to buy an options or forwards contract in an underlying asset in Sweden equivalent to Sk20,000,000.

Explanation:

According to investopedia.com, "Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset."  A hedged asset can also reduce potential profits.  If Global had hedged the liability to Stockholm Motors, it would not have profited from the resulting gain it obtained at the end of the transaction.