IFRS—FOREIGN CURRENCY TRANSACTIONS AND HEDGES
U. S. Dollar per Mexican Peso
Call Option Premium Forward Rate for October 31 Date Spot Rate to October 31 (strike price $0.080)
August 1 $0.080 $0.085 $0.0052
September 30 0.086 0.088 0.0095
October 31 0.091 0.091 0.0110
Comprehensive Illustration PROBLEM
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Foreign Currency Transactions and Hedging Foreign Exchange Risk 413
Part A
On August 1, Zelm imports parts from its Mexican supplier at a price of 1 million Mexican pesos. It receives the parts on August 1 but does not pay for them until October 31. In addition, on August 1, Zelm enters into a forward contract to purchase 1 million pesos on October 31. It appropriately designates the forward contract as a cash flow hedgeof the Mexican peso liability exposure. Zelm’s incremental borrowing rate is 12 percent per annum (1 percent per month), and the company uses a straight-line method on a monthly basis for allocating forward discounts and premia.
Part B
The facts are the same as in Part A with the exception that Zelm designates the forward contract as a fair value hedgeof the Mexican peso liability exposure.
Part C
On August 1, Zelm imports parts from its Mexican supplier at a price of 1 million Mexican pesos. It receives the parts on August 1 but does not pay for them until October 31. In addition, on August 1, Zelm purchases a three-month call option on 1 million Mexican pesos with a strike price of $0.080. The option is appropriately designated as a cash flow hedgeof the Mexican peso liability exposure.
Part D
On August 1, Zelm orders parts from its Mexican supplier at a price of 1 million Mexican pesos. It receives the parts and pays for them on October 31. On August 1, Zelm enters into a forward contract to purchase 1 million Mexican pesos on October 31. It designates the forward contract as a fair value hedge of the Mexican peso firm commitment. Zelm determines the fair value of the firm commitment by referring to changes in the forward exchange rate.
Part E
On August 1, Zelm orders parts from its Mexican supplier at a price of 1 million Mexican pesos. It receives the parts and pays for them on October 31. On August 1, Zelm purchases a three-month call option on 1 million Mexican pesos with a strike price of $0.080. The option is appropriately designated as a fair value hedgeof the Mexican peso firm commitment. The fair value of the firm commitment is by reference to changes in the spot exchange rate.
Part F
Zelm anticipates that it will import component parts from its Mexican supplier in the near future. On August 1, Zelm purchases a three-month call option on 1 million Mexican pesos with a strike price of
$0.080. It appropriately designates the option as a cash flow hedgeof a forecasted Mexican peso trans- action. Zelm receives and pays for parts costing 1 million Mexican pesos on October 31.
Required
Prepare journal entries for each of these independent situations in accordance with U.S. GAAP standards and determine the impact each situation has on the September 30 and October 31 trial balances.
SOLUTION
Part A. Forward Contract Cash Flow Hedge of a Recognized Foreign Currency Liability 8/1 Parts Inventory . . . . 80,000
Accounts Payable (Mexican pesos) . . . . 80,000 To record the purchase of parts and a Mexican peso account
payable at the spot rate of $0.080.
The forward contract requires no formal entry. Zelm prepares a memorandum to designate the forward contract as a hedge of the risk of changes in the cash flow to be paid on the foreign currency payable resulting from changes in the U.S. dollar–Mexican peso exchange rate.
9/30 Foreign Exchange Loss . . . . 6,000
Accounts Payable (Mexican pesos) . . . . 6,000 To adjust the value of the Mexican peso payable to the new
spot rate of $0.086 and record a foreign exchange loss resulting from the appreciation of the peso since August 1.
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414 Chapter 9
Forward Contract . . . . 2,970
Accumulated Other Comprehensive Income (AOCI) . . . . 2,970
To record the forward contract as an asset at its fair value of
$2,970 with a corresponding credit to AOCI.
Zelm determines the fair value of the forward contract by referring to the change in the forward rate for a contract that settles on October 31: ([$0.088 $0.085] 1 million pesos $3,000. The present value of $3,000 discounted for one month [from October 31 to September 30] at an interest rate of 12 percent per year [1 percent per month] is calculated as follows: $3,000 0.9901 $2,970.)
Accumulated Other Comprehensive Income (AOCI) . . . . 6,000
Gain on Forward Contract . . . . 6,000 To record a gain on forward contract to offset the foreign
exchange loss on account payable with a corresponding debit to AOCI.
Premium Expense . . . . 3,333
Accumulated Other Comprehensive Income (AOCI) . . . . 3,333
To allocate the forward contract premium to income over the life of the contract using a straight-line method on a monthly basis ($5,000 2⁄3$3,333).
The original premium on the forward contract is determined by the difference in the peso spot rate and three-month forward rate on August 1: ($0.085 $0.080) 1 million pesos $5,000.
Trial Balance—September 30 Debit Credit Parts Inventory . . . $80,000 –0–
Accounts Payable (Mexican pesos) . . . $86,000 Forward Contract (asset) . . . 2,970
AOCI . . . 303 Foreign Exchange Loss . . . 6,000
Gain on Forward Contract . . . 6,000 Premium Expense . . . 3,333 –0–
$92,303 $92,303
10/31 Foreign Exchange Loss . . . . 5,000
Accounts Payable (Mexican pesos) . . . . 5,000 To adjust the value of the Mexican peso payable to the new
spot rate of $0.091 and record a foreign exchange loss resulting from the appreciation of the peso since September 30.
Forward Contract . . . . 3,030
Accumulated Other Comprehensive Income (AOCI) . . . . 3,030
To adjust the carrying value of the forward contract to its current fair value of $6,000 with a corresponding credit to AOCI.
The current fair value of the forward contract is determined by referring to the difference in the spot rate on October 31 and the original forward rate: ($0.091 $0.085) 1 million pesos $6,000. The for- ward contract adjustment on October 31 is calculated as the difference in the current fair value and the carrying value at September 30: $6,000 $2,970 $3,030.
Accumulated Other Comprehensive Income (AOCI) . . . . 5,000
Gain on Forward Contract . . . . 5,000 To record a gain on forward contract to offset the foreign exchange
loss on account payable with a corresponding debit to AOCI.
Premium Expense . . . . 1,667
Accumulated Other Comprehensive Income (AOCI) . . . . 1,667
To allocate the forward contract premium to income over the life of the contract using a straight-line method on a monthly basis ($5,000 1/3$1,667).
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Foreign Currency Transactions and Hedging Foreign Exchange Risk 415
Foreign Currency (Mexican pesos) . . . . 91,000
Cash . . . . 85,000 Forward Contract . . . . 6,000 To record settlement of the forward contract: Record payment
of $85,000 in exchange for 1 million pesos, record the receipt of 1 million pesos as an asset at the spot rate of $0.091, and remove the forward contract from the accounts.
Accounts Payable (pesos) . . . . 91,000
Foreign Currency (pesos) . . . . 91,000 To record remittance of 1 million pesos to the Mexican supplier.
Trial Balance—October 31 Debit Credit
Cash . . . $85,000 Parts Inventory . . . $80,000 –0–
Retained Earnings, 9/30 . . . 3,333 –0–
Foreign Exchange Loss . . . 5,000 –0–
Gain on Forward Contract . . . –0– 5,000 Premium Expense . . . 1,667 –0–
$90,000 $90,000
Part B. Forward Contract Fair Value Hedge of a Recognized Foreign Currency Liability 8/1 Parts Inventory . . . . 80,000
Accounts Payable (Mexican pesos) . . . . 80,000 To record the purchase of parts and a peso account payable
at the spot rate of $0.080.
The forward contract requires no formal entry. A memorandum designates the forward contract as a hedge of the risk of changes in the cash flow to be paid on the foreign currency payable resulting from changes in the U.S. dollar–peso exchange rate.
9/30 Foreign Exchange Loss . . . . 6,000
Accounts Payable (Mexican pesos) . . . . 6,000 To adjust the value of the peso payable to the new spot rate
of $0.086 and record a foreign exchange loss resulting from the appreciation of the peso since August 1.
Forward Contract . . . . 2,970
Gain on Forward Contract . . . . 2,970 To record the forward contract as an asset at its fair value of
$2,970 and record a forward contract gain for the change in the fair value of the forward contract since August 1.
Trial Balance—September 30 Debit Credit Parts Inventory . . . $80,000 –0–
Accounts Payable (Mexican pesos) . . . $86,000 Forward Contract (asset) . . . 2,970 –0–
Foreign Exchange Loss . . . 6,000 –0–
Gain on Forward Contract . . . –0– 2,970
$88,970 $88,970
10/31 Foreign Exchange Loss . . . . 5,000
Accounts Payable (Mexican pesos) . . . . 5,000 To adjust the value of the peso payable to the new spot rate
of $0.091 and record a foreign exchange loss resulting from the appreciation of the peso since September 30.
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416 Chapter 9
Forward Contract . . . . 3,030
Gain on Forward Contract . . . . 3,030 To adjust the carrying value of the forward contract to its
current fair value of $6,000 and record a forward contract gain for the change in fair value since September 30.
Foreign Currency (Mexican pesos) . . . . 91,000
Cash . . . . 85,000 Forward Contract . . . . 6,000 To record settlement of the forward contract: Record payment
of $85,000 in exchange for 1 million pesos, record the receipt of 1 million pesos as an asset at the spot rate of $0.091, and remove the forward contract from the accounts.
Accounts Payable (pesos) . . . . 91,000
Foreign Currency (pesos) . . . . 91,000 To record remittance of 1 million pesos to the Mexican supplier.
Trial Balance—October 31 Debit Credit Cash . . . –0– $85,000 Parts Inventory . . . $80,000 –0–
Retained Earnings, 9/30 . . . 3,030 –0–
Foreign Exchange Loss . . . 5,000 –0–
Gain on Forward Contract . . . –0– 3,030
$88,030 $88,030
Part C. Option Cash Flow Hedge of a Recognized Foreign Currency Liability
The following schedule summarizes the changes in the components of the fair value of the peso call option with a strike price of $0.080:
Change Change Spot Option Fair in Fair Intrinsic Time in Time
Date Rate Premium Value Value Value Value Value
8/1 $0.080 $0.0052 $ 5,200 –0– –0– $5,200* –0–
9/30 0.086 0.0095 9,500 $ 4,300 $ 6,000† 3,500† $1,700
10/31 0.091 0.0110 11,000 1,500 11,000 –0–‡ 3,500
*Because the strike price and spot rate are the same, the option has no intrinsic value. Fair value is attributable solely to the time value of the option.
†With a spot rate of $0.086 and a strike price of $0.08, the option has an intrinsic value of $6,000. The remaining $3,500 of fair value is attrib- utable to time value.
‡The time value of the option at maturity is zero.
8/1 Parts Inventory . . . . 80,000
Accounts Payable (Mexican pesos) . . . . 80,000 To record the purchase of parts and a peso account payable
at the spot rate of $0.080.
Foreign Currency Option . . . . 5,200
Cash . . . . 5,200 To record the purchase of a foreign currency option as an asset.
9/30 Foreign Exchange Loss . . . . 6,000
Accounts Payable (pesos) . . . . 6,000 To adjust the value of the peso payable to the new spot rate
of $0.086 and record a foreign exchange loss resulting from the appreciation of the peso since August 1.
Foreign Currency Option . . . . 4,300
Accumulated Other Comprehensive Income (AOCI) . . . . 4,300
To adjust the fair value of the option from $5,200 to $9,500 with a corresponding credit to AOCI.
Accumulated Other Comprehensive Income (AOCI) . . . . 6,000
Gain on Foreign Currency Option . . . . 6,000 hoy36628_ch09_375-434.qxd 1/23/10 2:12 PM Page 416
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Foreign Currency Transactions and Hedging Foreign Exchange Risk 417 To record a gain on forward currency option to offset the
foreign exchange loss on account payable with a corresponding debit to AOCI.
Option Expense . . . . 1,700
Accumulated Other Comprehensive Income (AOCI) . . . . . 1,700
To recognize the change in the time value of the foreign currency option as an expense with a corresponding credit to AOCI.
Trial Balance—September 30 Debit Credit Cash . . . $ 5,200 Parts Inventory . . . $80,000 –0–
Foreign Currency Option (asset) . . . 9,500 –0–
Accounts Payable (Mexican pesos) . . . –0– 86,000 Foreign Exchange Loss . . . 6,000 –0–
Gain on Foreign Currency Option . . . –0– 6,000 Option Expense . . . 1,700 –0–
$97,200 $97,200
10/31 Foreign Exchange Loss . . . . 5,000
Accounts Payable (Mexican pesos) . . . . 5,000 To adjust the value of the peso payable to the new spot rate
of $0.091 and record a foreign exchange loss resulting from the appreciation of the peso since September 30.
Foreign Currency Option . . . . 1,500
Accumulated Other Comprehensive Income (AOCI) . . . . 1,500
To adjust the carrying value of the foreign currency option to its current fair value of $11,000 with a corresponding credit to AOCI.
Accumulated Other Comprehensive Income (AOCI) . . . . 5,000
Gain on Foreign Currency Option . . . . 5,000 To record a gain on foreign currency option to offset the
foreign exchange loss on account payable with a corresponding debit to AOCI.
Option Expense . . . . 3,500
Accumulated Other Comprehensive Income (AOCI) . . . . 3,500
To recognize the change in the time value of the foreign currency option as an expense with a corresponding credit to AOCI.
Foreign Currency (Mexican pesos) . . . . 91,000
Cash . . . . 80,000 Foreign Currency Option . . . . 11,000 To record exercise of the foreign currency option: Record
payment of $80,000 in exchange for 1 million pesos, record the receipt of 1 million pesos as an asset at the spot rate of
$0.091, and remove the option from the accounts.
Accounts Payable (pesos) . . . . 91,000
Foreign Currency (pesos) . . . . 91,000 To record remittance of 1 million pesos to the Mexican supplier.
Trial Balance—October 31 Debit Credit
Cash ($5,200 credit balance $80,000 credit) . . . –0– $85,200
Parts Inventory . . . $80,000 –0–
Retained Earnings, 9/30 . . . 1,700 –0–
Foreign Exchange Loss . . . 5,000 –0–
Gain on Foreign Currency Option . . . –0– 5,000 Option Expense . . . 3,500 –0–
$90,200 $90,200
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418 Chapter 9
Part D. Forward Contract Fair Value Hedge of a Foreign Currency Firm Commitment 8/1 The forward contract or the purchase order requires no formal
entry. A memorandum would be prepared designating the forward contract as a fair value hedge of the foreign currency firm commitment.
9/30 Forward Contract . . . . 2,970
Gain on Forward Contract . . . . 2,970 To record the forward contract as an asset at its fair value
of $2,970 and record a forward contract gain for the change in the fair value of the forward contract since August 1.
Loss on Firm Commitment . . . . 2,970
Firm Commitment . . . . 2,970 To record the firm commitment as a liability at its fair value
of $2,970 based on changes in the forward rate and record a firm commitment loss for the change in fair value since August 1.
Trial Balance—September 30 Debit Credit Forward Contract (asset) . . . $2,970 –0–
Firm Commitment (liability) . . . –0– $2,970 Gain on Forward Contract . . . –0– 2,970 Loss on Firm Commitment . . . 2,970 –0–
$5,940 $5,940
10/31 Forward Contract . . . . 3,030
Gain on Forward Contract . . . . 3,030 To adjust the carrying value of the forward contract to its
current fair value of $6,000 and record a forward contract gain for the change in fair value since September 30.
Loss on Firm Commitment . . . . 3,030
Firm Commitment . . . . 3,030 To adjust the value of the firm commitment to $6,000 based
on changes in the forward rate and record a firm commitment loss for the change in fair value since September 30.
Foreign Currency (Mexican pesos) . . . . 91,000
Cash . . . . 85,000 Forward Contract . . . . 6,000 To record settlement of the forward contract: Record
payment of $85,000 in exchange for 1 million pesos, record the receipt of 1 million pesos as an asset at the spot rate of $0.091, and remove the forward contract from the accounts.
Parts Inventory . . . . 91,000
Foreign Currency (Mexican pesos) . . . . 91,000 To record the purchase of parts through the payment of
1 million pesos to the Mexican supplier.
Firm Commitment . . . . 6,000
Adjustment to Net Income–Firm Commitment . . . . 6,000 To close the firm commitment account as an adjustment
to net income.
(Note:The final entry to close the Firm Commitment account to Adjustment to Net Income must be made onlyin the period in which Parts Inventory affects net income through Cost of Goods Sold. The Firm Commitment account remains on the books as a liability until that point in time.)
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Foreign Currency Transactions and Hedging Foreign Exchange Risk 419
Trial Balance—October 31 Debit Credit
Cash . . . –0– $85,000 Parts Inventory (Cost of Goods Sold) . . . $91,000 –0–
Gain on Forward Contract . . . –0– 3,030 Loss on Firm Commitment . . . 3,030 –0–
Adjustment to Net Income–Firm Commitment . . . –0– 6,000
$94,030 $94,030
Part E. Option Fair Value Hedge of a Foreign Currency Firm Commitment
8/1 Foreign Currency Option . . . . 5,200
Cash . . . . 5,200 To record the purchase of a foreign currency option as an asset.
9/30 Foreign Currency Option . . . . 4,300
Gain on Foreign Currency Option . . . . 4,300 To adjust the fair value of the option from $5,200 to $9,500
and record an option gain for the change in fair value since August 1.
Loss on Firm Commitment . . . . 5,940
Firm Commitment . . . . 5,940 To record the firm commitment as a liability at its fair value
of $5,940 based on changes in the spot rate and record a firm commitment loss for the change in fair value since August 1.
The fair value of the firm commitment is determined by referring to changes in the spot rate from August 1 to September 30: ($0.080 ⫺$0.086) ⫻1 million pesos ⫽$(6,000). This amount must be discounted for one month at 12 percent per annum (1 percent per month): $(6,000) ⫻0.9901 ⫽$(5,940).
Trial Balance—September 30 Debit Credit
Cash . . . –0– $ 5,200 Foreign Currency Option (asset) . . . $ 9,500 –0–
Firm Commitment (liability) . . . –0– 5,940 Gain on Foreign Currency Option . . . –0– 4,300 Loss on Firm Commitment . . . 5,940 –0–
$15,440 $15,440
10/31 Foreign Currency Option . . . . 1,500
Gain on Foreign Currency Option . . . . 1,500 To adjust fair value of the option from $9,500 to $11,000 and
record an option gain for the change in fair value since September 30.
Loss on Firm Commitment . . . . 5,060
Firm Commitment . . . . 5,060 To adjust the fair value of the firm commitment from $5,940
to $11,000 and record a firm commitment loss for the change in fair value since September 30.
The fair value of the firm commitment is determined by referring to changes in the spot rate from August 1 to October 31: ($0.080 ⫺$0.091) ⫻1 million pesos ⫽$(11,000).
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420 Chapter 9
Foreign Currency (Mexican pesos) . . . . 91,000
Cash . . . . 80,000 Foreign Currency Option . . . . 11,000 To record exercise of the foreign currency option: Record payment
of $80,000 in exchange for 1 million pesos, record the receipt of 1 million pesos as an asset at the spot rate of $0.091, and remove the option from the accounts.
Parts Inventory . . . . 91,000
Foreign Currency (pesos) . . . . 91,000 To record the purchase of parts through the payment of 1 million pesos
to the Mexican supplier.
Firm Commitment . . . . 11,000
Adjustment to Net Income–Firm Commitment . . . . 11,000 To close Firm Commitment account to Adjustment to Net Income.
(Note:The final entry to close the Firm Commitment to Adjustment to Net Income is made onlyin the period in which Parts Inventory affects net income through Cost of Goods Sold. The Firm Commitment account remains on the books as a liability until that point in time.)
Trial Balance—October 31 Debit Credit
Cash ($5,200 credit balance $80,000 credit). . . –0– $85,200 Parts Inventory (Cost of Goods Sold) . . . $91,000 –0–
Retained Earnings, 9/30 . . . 1,640 –0–
Gain on Foreign Currency Option . . . –0– 1,500 Loss on Firm Commitment . . . 5,060 –0–
Adjustment to Net Income–Firm Commitment . . . –0– 11,000
$97,700 $97,700
Part F. Option Cash Flow Hedge of a Forecasted Foreign Currency Transaction 8/1 Foreign Currency Option . . . . 5,200
Cash . . . . 5,200 To record the purchase of a foreign currency option as an asset.
9/30 Foreign Currency Option . . . . 4,300
Accumulated Other Comprehensive Income (AOCI) . . . . 4,300
To adjust the fair value of the option from $5,200 to $9,500 with a corresponding adjustment to AOCI.
Option Expense . . . . 1,700
Accumulated Other Comprehensive Income (AOCI) . . . . 1,700
To recognize the change in the time value of the foreign currency option as an expense with a corresponding credit to AOCI.
Trial Balance—September 30 Debit Credit Cash . . . –0– $ 5,200 Foreign Currency Option (asset) . . . $ 9,500 –0–
Accumulated Other Comprehensive Income . . . –0– 6,000
Option Expense . . . 1,700 –0–
$11,200 $11,200
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Foreign Currency Transactions and Hedging Foreign Exchange Risk 421
10/31 Foreign Currency Option . . . . 1,500
Accumulated Other Comprehensive Income (AOCI) . . . . 1,500
To adjust the fair value of the option from $9,500 to $11,000 with a corresponding adjustment to AOCI.
Option Expense . . . . 3,500
Accumulated Other Comprehensive Income (AOCI) . . . . 3,500
To recognize the change in the time value of the foreign currency option as an expense with a corresponding credit to AOCI.
Foreign Currency (Mexican pesos) . . . . 91,000
Cash . . . . 80,000 Foreign Currency Option . . . . 11,000 To record exercise of the foreign currency option: Record
payment of $80,000 in exchange for 1 million pesos, record the receipt of 1 million pesos as an asset at the spot rate of
$0.091, and remove the option from the accounts.
Parts Inventory . . . . 91,000
Foreign Currency (Mexican pesos) . . . . 91,000 To record the purchase of parts through the payment of
1 million pesos to the Mexican supplier.
Accumulated Other Comprehensive Income (AOCI) . . . . 11,000
Adjustment to Net Income–Forecasted Transaction . . . . 11,000 To close AOCI as an adjustment to net income.
(Note:The final entry to close AOCI to Adjustment to Net Income is made at the date that the forecasted transaction was expected to occur, regardless of when the parts inventory affects net income.)
Trial Balance—October 31 Debit Credit
Cash ($5,200 credit balance $80,000 credit) . . . –0– $85,200 Parts Inventory (Cost of Goods Sold) . . . $91,000 –0–
Retained Earnings, 9/30. . . 1,700 –0–
Foreign Currency Option expense . . . 3,500 –0–
Adjustment to Net Income–Forecasted Transaction . . . –0– 11,000
$96,200 $96,200
Questions 1. What concept underlies the two-transaction perspective in accounting for foreign currency transactions?
2. A company makes an export sale denominated in a foreign currency and allows the customer one month to pay. Under the two-transaction perspective, accrual approach, how does the company account for fluctuations in the exchange rate for the foreign currency?
3. What factors create a foreign exchange gain on a foreign currency transaction? What factors create a foreign exchange loss?
4. What does the term hedgingmean? Why do companies elect to follow this strategy?
5. How does a foreign currency option differ from a foreign currency forward contract?
6. How does the timing of hedges of (a) foreign currency denominated assets and liabilities, (b) foreign currency firm commitments, and (c) forecasted foreign currency transactions differ?
7. Why would a company prefer a foreign currency option over a forward contract in hedging a foreign currency firm commitment? Why would a company prefer a forward contract over an option in hedging a foreign currency asset or liability?
8. How do companies report foreign currency derivatives, such as forward contracts and options, on the balance sheet?
9. How does a company determine the fair value of a foreign currency forward contract? How does it determine the fair value of an option?
10. What is hedge accounting?
11. Under what conditions can companies use hedge accounting to account for a foreign currency option used to hedge a forecasted foreign currency transaction?
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