Answer:
Step-by-step explanation:
Preparation of all journal entries related to the foreign currency borrowing
A. 9/30/17
Dr Cash $476,000
Cr Note payable (dudek) [$2,800,000 x $0.170] $476,000
(To record the note and conversion of $2,800,000 dudeks into $0.170 at the spot rate.)
12/31/17
Dr Interest Expense $2,450 Cr Interest Payable (dudek) $2,450
[$2,800,000 x 2% x 3/12 = $14,000 dudeks x
0.175 spot rate]
(To accrue interest for the period 9/30 – 12/31/17.)
Dr Foreign Exchange Loss $14,000
Cr Note Payable (dudek) [$2,800,000 x ($0.175 – $0.170)] $14,000
(To revalue the note payable at the spot rate of
$0.175 and record a foreign exchange loss.)
9/30/18
Dr Interest Expense [$98,000 dudeks x $0.190] $18,620
($112,000-$14,000=$98,000)
Dr Interest Payable (dudek) $2,450
[$2,800,000 x 2% x 3/12 = $14,000 dudeks x
0.175 spot rate]
Dr Foreign Exchange Loss [14,000 dudeks x (0.190 – $.175)] $210
Cr Cash [$112,000 dudeks x 0.190] $21,280
(4%*$2,800,000=$112,000)
(To record the first annual interest payment, record interest expense for the period 1/1 – 9/30/18 and record a foreign exchange loss on the interest payable accrued at 12/31/17.)
12/31/18 Interest Expense 625
Interest Payable (dudek) [5,000 dudeks x $.125] 625
(To accrue interest for the period 9/30 – 12/31/18.)
12/31/18 Foreign Exchange Loss 20,000
Note Payable (dudek) [1 mn x ($.125 – $.105)] 20,000
(To revalue the note payable at the spot rate of
$.125 and record a foreign exchange loss.)
9/30/19 Interest Expense [15,000 dudeks x $.15] 2,250
Interest Payable (dudek) 625
Foreign Exchange Loss [5,000 dudeks x ($.15 – $.125)] 125
Cash [20,000 dudeks x $.15] 3,000
(To record the second annual interest payment,
record interest expense for the period 1/1 – 9/30/19,and record a foreign exchange loss on the interest payable accrued at 12/31/18.)
Note Payable (dudek) 125,000
Foreign Exchange Loss 25,000
Cash [1 mndudeks x $.15] 150,000
(To record payment of the 1 million dudek note.)
b. The effective interest rate on the loan can be determined by summing the total interest expense and foreign exchange losses related to the loan and comparing this with the amount borrowed:
2017
Interest expense $525
Foreign exchange loss 5,000
Total $5,525 / $100,000 = 5.525% for 3 months
5.525% x 12/3 = 22.1% for 12 months
2018
Interest expense $2,425
Foreign exchange losses 20,075
Total $22,500 / $100,000 = 22.5% for 12 months
2019
Interest expense $2,250
Foreign exchange losses 25,125
Total $27,375 / $100,000 = 27.38% for 9 months
27.38% x 12/9 = 36.5% for 12 months
Because of appreciation in the value of the dudek, the effective annual interest cost ranges from 22.1% – 36.5%.
The net cash flows from this borrowing are:
Cash outflows:
Interest ($2,400 + $3,000) $5,400
Principal 150,000
$155,400
Cash inflow:
Borrowing (100,000)
Net cash outflow $ 55,400
Ignoring compounding, this results in an average effective interest rate of approximately 27.7% per year [($55,400 / $100,000) = 55.4% over two years; 55.4% / 2 years = 27.7% per year].
On September 30, 2017, Ericson Company negotiated a two-year, 2,800,000 dudek loan from a foreign bank at an interest rate of 4 percent per year. It makes interest payments annually on September 30 and will repay the principal on September 30, 2019. Ericson prepares U.S.-dollar financial statements and has a December 31 year-end. Prepare all journal entries related to this foreign currency borrowing assuming the following exchange rates for 1 dudek:
September 30, 2017$0.170
December 31, 2017 0.175
September 30, 2018 0.190
December 31, 2018 0.195
September 30, 2019 0.220
Taking the exchange rate effect on the cost of borrowing into consideration, determine the effective interest rate in dollars on the loan in each of the three years 2017, 2018, and 2019.