Question

Christina Company (a U.S.-based company) has a subsidiary in Canada that began operations at the start of 2020 with assets of 157,000 Canadian dollars (CAD) and liabilities of CAD 104,000. During this initial year of operation, the subsidiary reported a profit of CAD 51,000. It distributed two dividends, each for CAD 7,500 with one dividend declared on March 1 and the other on October 1. Applicable U.S. dollar ($) exchange rates for 1 Canadian dollar follow: January 1, 2020 (start of business) $0.83

March 1, 2020 0.81
Weighted average rate for 2020 0.80
October 1, 2020 0.79
December 31, 2020 0.78 a. Assume that the Canadian dollar is this subsidiary's functional currency. What translation adjustment would the company report for the year 2020? b. Assume that on October 1, 2020, Christina entered into a forward exchange contract to hedge the net investment in this subsidiary. On that date, the company agreed to sell CAD 210,000 in three months at a forward exchange rate of $0.79/CAD1. Prepare the journal entries required by this forward contract. c. Compute the net translation adjustment the company will report in accumulated other comprehensive income for the year 2020 under this second set of circumstances.

Answer 1

a. The translation adjustment for the year 2020 is CAD 3,460. b. The journal entries for the forward exchange contract are: Debit Forward contract receivable: CAD 210,000 and Credit Forward contract liability: CAD 210,000. c. The net translation adjustment in accumulated other comprehensive income for the year 2020 under the second set of circumstances is CAD 10,500.

Step-by-step explanation:

a. The translation adjustment that the company would report for the year 2020 can be calculated by determining the change in the subsidiary's net assets due to the fluctuating exchange rates.

Net assets = Assets - Liabilities
Initial net assets = CAD 157,000 - CAD 104,000 = CAD 53,000
Profit for the year = CAD 51,000
Dividends = 2 x CAD 7,500 = CAD 15,000

Translation adjustment = (Ending net assets - Initial net assets) - Profit - Dividends
Ending net assets = CAD 157,000 x 0.78 = CAD 122,460
Translation adjustment = (CAD 122,460 - CAD 53,000) - CAD 51,000 - CAD 15,000 = CAD 3,460

b. The journal entries for the forward exchange contract entered into on October 1, 2020, to hedge the net investment in the subsidiary are as follows:

October 1, 2020:
Debit Forward contract receivable: CAD 210,000
Credit Forward contract liability: CAD 210,000

December 31, 2020 (Adjustment when the contract is settled):
Debit Forward contract liability: CAD 210,000
Credit Unrealized gain on forward contract: CAD 10,500

c. The net translation adjustment that the company will report in accumulated other comprehensive income for the year 2020 under the second set of circumstances can be calculated as follows:

Net translation adjustment = Realized gain/loss on forward contract + Unrealized gain/loss on forward contract
Realized gain/loss on forward contract = (CAD 210,000 - CAD 210,000) = CAD 0
Unrealized gain/loss on forward contract = CAD 10,500
Net translation adjustment = CAD 0 + CAD 10,500 = CAD 10,500

Answer 2

a. Because the Canadian dollar is the subsidiary's main currency, there's no translation adjustment. Financial statements in Canadian dollars are converted using the annual exchange rate, avoiding translation gains or losses.

b. Date | Account | Debit | Credit

------- | -------- | -------- | --------

October 1, 2020 | Foreign Exchange Gain | $2,100 | |

| Deferred Foreign Exchange Gain | | $2,100 |

c. $2,100

Since the gain is positive, it will be recorded as a debit to Foreign Exchange Gain and a credit to Deferred Foreign Exchange Gain.

How to solve and explain

Forward Exchange Contract

When the forward exchange contract concludes in three months, a gain or loss will arise based on the contrast between the forward exchange rate ($0.79/CAD1) and the expected spot exchange rate ($0.78/CAD1).

Therefore, the gain or loss is:

($0.79/CAD1 - $0.78/CAD1) * CAD 210,000 = $2,100

Since the gain is positive, it will be recorded as a debit to Foreign Exchange Gain and a credit to Deferred Foreign Exchange Gain.

The journal entry for the forward exchange contract is as follows:

Date | Account | Debit | Credit

------- | -------- | -------- | --------

October 1, 2020 | Foreign Exchange Gain | $2,100 | |

| Deferred Foreign Exchange Gain | | $2,100 |

When the forward exchange contract is settled, the following journal entry will be made:

Date | Account | Debit | Credit

------- | -------- | -------- | --------

March 1, 2021 | Deferred Foreign Exchange Gain | $2,100 | |

| Cash | | $2,100 |

These journal entries will correctly reflect the gain on the forward exchange contract in the company's financial statements.