On May 1, 2011, 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, 2012. On May 1, 2011, Mosby purchased a put option giving it the right to sell 2,000,000 pesos on March 1, 2012 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, 2011. The following spot exchange rates apply:

Mosby's incremental borrowing rate is 12 percent, and the present value factor for two months at a 12 percent annual rate is .9803.
What was the impact on Mosby's 2011 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, 2011, 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, 2012. On May 1, 2011, Mosby purchased a put option giving it the right to sell 2,000,000 pesos on March 1, 2012 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, 2011. The following spot exchange rates apply:

Mosby's incremental borrowing rate is 12 percent, and the present value factor for two months at a 12 percent annual rate is .9803.
What was the impact on Mosby's 2011 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

Under a fair value hedge, changes in the fair value of the hedging instrument are recognized in net income. As of December 31, 2011, the option had a fair value of $3,200, representing an increase in value of $200. This increase in value should be recognized as a loss in net income, as it offsets the potential gain on the firm commitment of selling the machine for 2,000,000 pesos. The loss recognized in net income is calculated as ($3,200 fair value - $3,000 option cost) x .9803 present value factor = $1960.60. However, since the loss is recognized as an increase in the liability for the firm commitment, the net impact on net income is a decrease of $1,760.60 ($1,960.60 loss + $200 potential gain on the firm commitment).

On May 1, 2011, Mosby Company Received an Order to Sell