Advanced Financial Accounting Premium and Adjustment to Net Income Question

Question

I need detailed help with steps on how to solve :

On March 1st, Pimlico Corp (a US based company) , expects to order merchandise from a supplier in Sweden in 3 months. On March 1st, when spot rate is $0.10 per Swedish krona, Pimlico enters into a forward contract to purchase 500,000 Swedish kroner at a forward contract rate of $0.12. At the end of 3 months, when the spot rate is $0.115 per Swedish Krona, Pimlico orders and receives merchandise, paying 500,000 Swedish Krona. 

Question : What amount does Pimlico report in net income as a result of this transaction ?

 

A) 10,000 premium expense plus 7,500 positive adjustment to net income when merchandise purchased

B) 10,000 discount expense plus 5,000 positive adjustment to net income when merchandise purchased

C) 2,500 premium expense plus 5,000 negative adjustment to net income when merchandise purchased

D) 2,500 premium expense plus 2,500 positive adjustment to net income when merchandise purchased

Answer was A) but again I need exact calculations and logic on how numbers were calculated

Answer 1

The correct answer for this problem is A.

Explanation: On March 1st Pimlico entered into agreement to purchase merchandise valued at 500,000 krona from a Swedish which its value at that time was 50.000USD using the exchange rate 0.10 to convert the 500,000 krona to USD. To protect itself from currency fluctuations Pimlico opted to buy a forward contract for the 500,000 Krona using the exchange rate 0.12 when the forward contract was bought and it paid 60,000USD. As a result of this transaction a currency exchange loss of 10,000USD was incurred and it should be recognized as such on the P&L statement; reducing profits.
At the end of 3 month when the exchange rate was .0115, Pimlico orders and receives the merchandise paying the 500,000 Krona at 57,500 USD value. This transaction resulted in currency exchange gain for which inventory was stated at actual paid price of 57,500 resulting in a gain of 7,500 thereby partially offsetting the previous loss of 10,000.