On May 1, 2021, Mosby Company received an order to sell a machine to a customer in Canada at a price of 2,000,000 Mexican pesos. The machine was shipped and payment was received on March 1, 2022. On May 1, 2021, Mosby purchased a put option giving it the right to sell 2,000,000 pesos on March 1, 2022 at a price of $190,000. Mosby properly designates the option as a fair value hedge of the peso firm commitment. The option cost $3,000 and had a fair value of $3,200 on December 31, 2021. The following spot exchange rates apply: Mosby's incremental borrowing rate is 12%, and the present value factor for two months at a 12% annual rate is 0.9803.What was the impact on Mosby's 2021 net income as a result of this fair value hedge of a firm commitment?
A)$1,760.60 decrease.
B)$1,960.60 decrease.
C)$1,000.00 decrease.
D)$1,760.60 increase.
E)$1,960.60 increase.

Question

On May 1, 2021, Mosby Company received an order to sell a machine to a customer in Canada at a price of 2,000,000 Mexican pesos. The machine was shipped and payment was received on March 1, 2022. On May 1, 2021, Mosby purchased a put option giving it the right to sell 2,000,000 pesos on March 1, 2022 at a price of $190,000. Mosby properly designates the option as a fair value hedge of the peso firm commitment. The option cost $3,000 and had a fair value of $3,200 on December 31, 2021. The following spot exchange rates apply:  Mosby's incremental borrowing rate is 12%, and the present value factor for two months at a 12% annual rate is 0.9803.What was the impact on Mosby's 2021 net income as a result of this fair value hedge of a firm commitment?
A)$1,760.60 decrease. 
B)$1,960.60 decrease. 
C)$1,000.00 decrease. 
D)$1,760.60 increase. 
E)$1,960.60 increase.

Quizplus · Accepted Answer

The fair value of the put option on December 31, 2021, was $3,200, and Mosby properly designated the option as a fair value hedge of a peso firm commitment. Therefore, the change in fair value of the put option is recognized in earnings, offsetting the change in fair value of the peso firm commitment.
The fair value of the put option increased by $200 ($3,200 - $3,000). The change in fair value is recognized in earnings and is equal and opposite to the change in fair value of the peso firm commitment. The peso was stronger on December 31, 2021, than on May 1, 2021, so the peso firm commitment decreased in value. The decrease is equal to the change in fair value of the put option, or $200. The decrease in the peso firm commitment is recognized in other comprehensive income, net of tax.
The $200 decrease in the peso firm commitment is translated at the spot exchange rate of 0.0513 as of December 31, 2021, resulting in a decrease of $10.26 (200,000 pesos × 0.0513). This decrease is net of tax and is recognized in other comprehensive income in shareholders' equity.
The total impact on net income for 2021 is a decrease of $1,760.60 [$10.26 + $1,750.34 (option premium of $3,000 amortized over 10 months using the effective interest method: $3,000 × (2/12) × 0.9803)].

On May 1, 2021, Mosby Company Received an Order to Sell