You have been recently hired as a staff accountant at Global Design, Inc., a small chain of retail home furnishing stores. You report directly to the Chief Financial Officer (CFO). The company specializes in home products with high-quality “European” design, but reasonable prices. Most of their products are manufactured in foreign countries but purchased from domestic wholesalers; these transactions are therefore denominated in U.S. dollars. However, the company’s president is interested in purchasing more products directly from foreign suppliers because he believes he could reduce product costs by doing so. The president is concerned, though, about the effects of foreign currency exchange rate risk on his company’s financial reports if he decides to purchase directly from foreign producers. He is particularly concerned about its effect on earnings volatility because the company is hoping to expand soon by raising capital through a private debt issue.
Over the weekend, the president went golfing with a college buddy who mentioned something about using forward contracts or foreign exchange options as “cash flow hedges” and how this would solve all his problems. The president has now asked the CFO to prepare a memo outlining the financial reporting effects of 1) purchasing inventory denominated in a foreign currency; 2) hedging the foreign exchange risk by using forward contracts versus FX call options; and 3) designating the hedge as a “cash flow” hedge versus a “fair value” hedge. The president has also asked the CFO to make a clear recommendation on
whether he thinks they should use forward contracts or options to hedge their exposure and whether a “cash flow” or a “fair value” hedge designation would be best for Global Design. The CFO is too busy to write the memo, so he has asked you to do it.
Note: The company president has never taken an accounting class and does not understand journal entries, so please do not include any in your memo.
