Question

30. On September 30, 2017, Ericson Company negotiated a two-year, 1,000,000 dudek loan from a for- eign bank at an interest rate of 2 percent per year. It makes interest payments annually on Septem- ber 30 and will repay the principal on September 30, 2019. Ericson prepares U.S.-dollar financial statements and has a December 31 year-end. a. Prepare all journal entries related to this foreign currency borrowing assuming the following exchange rates for 1 dudek: September 30, 2017 December 31, 2017 September 30, 2018 December 31, 2018 September 30, 2019 $0.100 0.105 0.120 0.125 0.150 b. 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.

Answer 1

a.     9/30/17        Cash                                                                                          100,000

                          Note payable (dudek) [1,000,000 x $.10]                                             100,000

(To record the note and conversion of 1 million

dudeks into $ at the spot rate.)

12/31/17      Interest Expense                                                                              525

                          Interest Payable (dudek)                                                                              525

   [1,000,000 x 2% x 3/12 = 5,000 dudeks x

$.105 spot rate]

(To accrue interest for the period 9/30 – 12/31/17.)

                    Foreign Exchange Loss                                                                 5,000

                          Note Payable (dudek) [1 mn x ($.105 – $.10)]                                         5,000

(To revalue the note payable at the spot rate of

$.105 and record a foreign exchange loss.)

9/30/18        Interest Expense [15,000 dudeks x $.12]                                     1,800

                    Interest Payable (dudek)                                                                  525

                    Foreign Exchange Loss [5,000 dudeks x ($.12 – $.105)]                  75

                          Cash [20,000 dudeks x $.12]                                                                    2,400

  (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].