Beams AdvAcc11 Chapter13

Chapter 13

Accounting for Derivatives and Hedging Activities Answers to Questions

1

Hedge accounting refers to accounting designed to record changes in the value of the hedged item and the hedging instrument in the same accounting period. This enhances transparency because because the hedged item and hedging instrument accounting are linked. Prior to hedge accounting, the financial statement effect of the hedged item and hedging instrument were not linked. Since companies enter into hedges to mitigate risks, the accounting should reflect the effect of this strategy and should clearly communicate the strategy. The accounting and footnote disclosures required for derivatives attempt to do this.

2

An option is a contract that allows the holder to buy or sell a security at a particular date. The holder is not obligated to buy or sell the security. They may allow the contract to expire. Typically, the holder must pay an upfront fee to the writer of the option. The writer of the option collects a fee, or premium for the option, and in exchange they are obligated to perform under the option contract. A forward contract or a futures contract are similar because both sides of the contract are obligated to perform. A forward contract is negotiated between two parties, they agree upon delivering a certain quantity of goods or currency at a specific date in the future. future. Many allow net settlement which means the “winner” of the contract receives cash consideration for the difference between the market price of the commodity and the contracted amount on the date the contract expires. The initial amount exchanged exchanged at the date the contract is entered into is negligible; however, as noted in Chapter 12, forward contracts hold the risk that the opposing party will not be able to perform. A futures contract is traded on a market. The amount of commodity to be exchanged and the date of delivery are standardized. The futures rate is determined by the market market at the date the contract is entered into. These contracts are settled daily. As noted in Chapter 12, a potential cost of this type of contract is that the contract is defined by the market, so it cannot be tailored to hedge a specific risk.

3

Hedge effectiveness involves assessing how well the hedge mitigates the gains or losses of the asset, liability and/or anticipated transaction that it is entered into to mitigate. The most common approaches to determining hedge effectiveness are critical term analysis and statistical analysis. Under critical term analysis, the nature of the underlying variable, the notional amount of the derivative and the item being hedged, the delivery date of the derivative and the settlement date for the item being hedged are examined. If the critical terms of the derivative and the hedged item are identical, then an effective hedge is assumed. A statistical approach is used if critical terms don’t match. One such approach involves comparing the correlation between changes in the price of the item being hedged and the derivative. While the FASB does not specify a specific benchmark correlation coefficient, cash flow offsets of between 80% and 125% are considered to be highly effective. Outside of these ranges, the hedge would not be considered highly effective.

4

Under a firm purchase or sales commitment, if the hedge is considered to be effective, then it would qualify as a fair value hedge. The item being hedged (regardless of whether it is an asset asset or liability position) and the offsetting derivative are both marked to fair value at the financial statement date. If the hedge relationship is not considered to be effective, then the derivative is marked to market at the balance

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Accounting for Derivatives and Hedging Activity

sheet date, regardless of when the gain or loss on the item that is being hedged is recognized. No offsetting changes in the fair value of the item being hedged are recorded until they are realized. 5

A company that has an existing loan that involves a variable or floating interest rate enters into a pay-fixed, receive variable swap. The company is swapping its variable interest rate payments for fixed ones. These contracts are typically settled net. For example, if the fixed rate agreed upon is 10% for the term of the swap agreement and in one year the variable rate is 9%, then the company with the variable rate loan must pay the difference in rates multiplied by the noti onal amount of the loan to the other party. If the variable rate is 12%, then the company will receive the difference in rates multiplied by the notional amount of the loan. Regardless of the movement in interest rates over the term of the swap, the company will pay the fixed rate, net. This type of swap is aimed at reducing the variability in cash flows related to the debt; therefore it is designated as a cash flow hedge.

6

A receive fixed, pay variable swap is entered into if a company has an existing loan that involves a fixed interest rate and desires to swap those fixed payments for variable payments. For example, a company has a loan with an 8% fixed rate and enters into a swap arrangement so that it will pay LIBOR + 1%. If the variable rate for a year is 9%, then the company will pay 1% multiplied by the notional amount as well as the 8% for the loan. Thus, the company has paid 9%, the floating rate. If the variable rate is 6% (5% LIBOR + 1%), then the company will pay 8% on the loan, but will receive 2% related to the swap. Thus, the company will pay 6%, the floating rate. This type of swap is aimed at reducing the variability in the fair value of the underlying loan therefore it is designated as a fair value hedge.

7

Fair value hedge accounting is used when the company is attempting to reduce the price risk of an existing asset/liability or firm purchase/sale commitment. Cash flow hedge accounting is appropriate when the company is attempting to reduce the variability in cash flows thus it is appropriate when hedging anticipated purchases and sales. Under certain circumstances, hedges of existing foreign currency denominated receivables and payables are accounted for as cash flow hedges instead of fair value hedges. See question 8’s solution for these cases.

8

Cash flow hedge accounting can be used when hedging recognized foreign-currency denominated assets and liabilities if the variability of cash flows is completely eliminated by the hedge. This criterion is generally met if all of the critical terms of the hedged item and the hedge match such as the settlement date, currency type and currency amounts. If these don’t match, then it must be accounted for as a fair value hedge. The key difference between this situation and the more general cash flow hedge case is that an existing asset or liability is being accounted for here. Under the more general case, the recognition of gains and losses is deferred because an anticipated transaction is being hedged. The foreign currency asset or liability is marked to fair value at year-end and the resulting gain or loss account is recognized, however, the gain or loss is offset by reclassifying an equal amount from other comprehensive income. Thus, the asset and liability are marked to fair value, but no gain or loss related to that adjustment is included in current period income. The premium or discount related to the hedge contract is amortized to income over the length of the contract using the effective interest method. For example, if a 100,000 euro foreign currency receivable due in 60 days is recorded at the spot rate of $1.20/euro or $120,000 and at the same date, a forward contract is entered into to deliver 100,000 euros in 60 days at a forward rate of $1.18, the company knows that it will lose $2,000. This $2,000 must be amortized to income over the 60 day period.

Pear son Educat i on, I nc. publ i shi ng as Pr ent i ce Hal l

Chapter 13

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9

International Accounting Standards No. 32 and 39 prescribe the accounting for derivatives. Their requirements are similar to SFAS No. 133 and 138 in terms of determining when hedge accounting can be used. The requirements for determining hedge effectiveness are very similar. Both fair value and cash flow hedge definitions and general requirements are similar. However, under IAS 39, firm sale or purchase commitments can be accounted for as either fair value or cash flow hedges which di ffers from the FASB requirement that they must be accounted for as fair value hedges.

10

A forward contract of an anticipated foreign currency transaction is accounted for as a cash flow hedge. The contract is marked to fair value at each financial date and the corresponding gain or loss is included in other comprehensive income. Any premium or discount must be amortized to income over the contract term using an effective interest rate method. The gain (loss) credit (debit) is offset by a debit (credit) from other comprehensive income. When the anticipated transaction occurs and the forward contract is settled, the resulting other comprehensive income balance is amortized to income in the same period as the underlying transaction is recognized in income.


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SOLUTIONS TO EXERCISES Solution E13-1 1

a. b.

December 1, 2011 No entry is necessary December 31, 2011

Ot her Compr ehensi ve I ncome ( - OCI , - SE)

$9, 901

For war d Cont r act ( +L) $9, 901 For ward cont r act val ue at 12/ 31/ 11( $1, 000 - $980) *500 = $10, 000/ ( 1. 005) 2= $9, 901 l i abi l i t y c.

Settlement date February 28, 2012

For ward Cont r act ( - L) For war d Cont r act ( +A)

$9, 901 2, 500

Ot her Compr ehensi ve I ncome

$12, 401

( +OCI , +SE)

For ward cont r act val ue at 2/ 28/ 12( $1, 000 - $1, 005) *500 = $2, 500 asset . The f or war d cont r act l i abi l i t y at 12/ 31/ 11 i s el i mi nat ed and t he asset est abl i shed. Accor di ngl y, t he cor r espondi ng cr edi t t o ot her compr ehensi ve i ncome, $12, 401, wi l l r esul t i n an endi ng bal ance of $2, 500 credi t i n ot her compr ehensi ve i ncome. Ri ce I nvent or y ( +A) ( $1, 005 * 500) $502, 500 Cash ( - A) To r ecor d t he r i ce pur chase at mar ket pr i ce $2, 500 For war d Cont r act ( - A) To r ecor d t he f or war d cont r act set t l ement

$502, 500

Cash ( +A)

2

$2, 500

Settlement date June 1, 2012

Cash ( +A)

$600, 000 Sal es ( +R)

Cost of Goods Sol d ( +E) Ot her Compr ehensi ve I ncome ( - OCI , - SE) I nvent ory ( - A)

$600, 000 $500, 000 2, 500 $502, 500

Solution E13-2 1

a.

b.

December 1, 2011 No entry is necessary December 31, 2011

Loss on f orwar d cont r act ( +Lo, - SE) $9, 901 For war d Cont r act ( +L) $9, 901 For ward cont r act val ue at 12/ 31/ 11( $1, 000 - $980) *500 = $10, 000/ ( 1. 005) 2= $9, 901 l i abi l i t y Fi r m Pur chase Commi t ment ( +A) Gai n on f i r m pur chase commi t ment ( +G, +SE)

$9, 901


$9, 901

Chapter 13

c.

13-5

Settlement date February 28, 2012

For war d Cont r act ( - L) $9, 901 For war d Cont r act ( +A) 2, 500 Gai n on f or ward cont r act $12, 401 ( +G, +SE) Forwar d cont r act val ue at 2/ 28/ 12( $1, 000 - $1, 005) *500 = $2, 500 asset . Loss on f i r m pur chase commi t ment ( +Lo, - SE) Fi r m pur chase commi t ment ( - A) Fi r m pur chase commi t ment ( +L)

$12, 401 $9, 901 2, 500

Ri ce I nvent or y ( +A) $500, 000 Fi r m pur chase commi t ment ( - L) 2, 500 Cash ( - A) To r ecor d t he r i ce pur chase at mar ket pr i ce Cash ( +A)

$502, 500

$2, 500

For war d Cont r act ( - A) To r ecor d t he f or war d cont r act set t l ement

$2, 500

2. Cash ( +A)

$600, 000 Sal es ( +R, +SE)

Cost of Goods Sol d ( +E, - SE) I nvent ory ( - A)

$600, 000 $500, 000 $500, 000

Solution E13-3

1

2

November 1, 2011 Memor andum ent r y onl y December 31, 2011 For war d Cont r act ( +A) $49, 751 Gai n on For war d Cont r act ( +G, +SE) ( 100, 000 x . 50) / 1. 005 To r ecor d t he change i n f ai r val ue of t he f or war d cont r act at t r i but abl e t o t he di scount ed change i n t he f or ward pr i ce Loss on f i r m sal es commi t ment ( +Lo, - SE) Fi r m sal es commi t ment ( +L)

$49, 751

$49, 751 $49, 751

To r ecor d t he change i n f ai r val ue of t he f i r m commi t ment

3

J anuar y 31, 2012 Loss on For ward Cont r act ( +Lo, - SE) $149, 751 For war d Cont r act ( +L) ( $6- $5= 1. 00 x 100, 000) ( To recor d t he change i n f ai r val ue of t he f or war d cont r act at t r i but abl e t o t he di scount ed change i n t he f or ward pr i ce


$149, 751

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Fi r m Sal es Commi t ment ( +A) Gai n on f i r m sal es commi t ment ( +G, +SE)

$149, 751 $149, 751

( To recor d t he change i n f ai r val ue of t he f i r m commi t ment t o sel l ) Cash f r om f i r m sal es commi t ment ( +A) $500, 000 Wi dget i nvent or y ( +A) $500, 000 COGS ( +E, - SE) $500, 000 Gai n on f i r m sal es commi t ment ( - G, - SE) $100, 000 Cash f or f or ward cont r act pur chase ( - A) Wi dget i nvent or y ( - A) Sal es ( +R, +SE) To r ecor d t he set t l ement of t he f or war d cont r act at J anuar y 31, 2012, and pur chase of 100, 000 wi dget s and sal e pur suant t o t he cont r act

$500, 000 $500, 000 $600, 000

Solution E13-4 (Using a mixed attribute model; other solutions are acceptable)

1

Oct ober 1, 2011 Ear ni ngs ( - SE) $49, 012 For ward cont r act ( +L) ( 100, 000 x ( $2. 00 - $1. 50) ) / ( 1. 005) ^4 To r ecor d t he change i n f ai r val ue of t he f or war d cont r act at t r i but abl e t o t he di scount ed change i n t he f or war d pri ce I nvent or y ( +A) Ear ni ngs ( +SE) To r ecor d i nvent or y mar ked t o mar ket

2

3

$50, 000 $50, 000

December 31, 2011 For war d cont r act ( +A) $49, 751 Ear ni ngs ( +SE) ( 100, 000 x ( $2. 00 - $2. 50) ) / ( 1. 005) To r ecor d t he change i n f ai r val ue of t he f or war d cont r act at t r i but abl e t o t he di scount ed change i n t he f or war d pri ce Ear ni ngs ( - SE) I nvent ory( - A) To r ecor d i nvent or y mar ked t o mar ket J anuar y 31, 2012 Cash ( +A) Ear ni ngs ( - SE) For ward Cont r act ( - A) To r ecor d t he f or war d cont r act set t l ement ( 100, 000 x ( $2. 00 - $2. 30) Cash

$49, 012

$49, 751

$50, 000 $50, 000

$200, 000 739 $200, 739

$200, 000

I nvent or y To sel l i nvent or y on cont r act


$200, 000

Chapter 13

13-7

Solution E13-5 [ Based on AI CPA] 1

Assumi ng t hat thi s i s a f ai r val ue hedge: At 12/ 31/ 11, $3, 000 i s t he f or war d cont r act f ai r val ue [100, 000*( $. 90 f or war d r at e cont r act ed $. 93 Forwar d cont r act r at e at 12/ 31/ 11) = $3, 000] . Si nce t hi s cont r act wi l l not be set t l ed f or 72 days, t he pr esent val ue of t he cont r act i s $2, 929 usi ng . 03288% [ i =12%/ 365 days] , n=72 and f ut ur e val ue of $3, 000. The exchange gai n r el at ed t o t hi s cont r act i s r ecorded at 12/ 31/ 11 and t he f orwar d cont r act asset account i s debi t ed. December 31, 2011

For war d Cont r act ( +A) Exchange Gai n ( +G, +SE) To r ecor d f or war d cont r act at mar ket

$2, 929 $2, 929

Exchange Loss ( +L, - SE) $10, 000 Account s Payabl e( f c) ( +L) $10, 000 To mar k account s payabl e t o f ai r val ue at 12/ 31/ 11 ( t hi s ass umes t hat t he account s payabl e was mar ked t o mar ket on 12/ 12/ 11, t he dat e t he f orwar d cont r act was ent er ed i nt o) 2

Thi s f i r m purchase commi t ment woul d be account ed f or as a f ai r val ue hedge. December 31, 2011

3

For war d Cont r act ( +A) Exchange Gai n ( +G, +SE)

$2, 929

Exchange Loss ( +Lo, - SE) Fi r m pur chase commi t ment ( +L)

$2, 929

$2, 929 $2, 929

The f or ward cont r act woul d agai n be r ecor ded at f ai r val ue t hr oughout t he l i f e of t he cont r act . Ther ef or e, a $2, 929 gai n woul d be r eport ed at 12/ 31/ 11.

Solution E13-6 April 1, 2011

Cont r act r ecei vabl e ( +A) $35, 250 Cont r act payabl e ( f c) ( +L) $35, 250 To r ecor d f or war d cont r act t o sel l 50, 000 Canadi an dol l ar s t o t he exchange br oker at t he f or ward r at e of . 705 f or del i ver y on May 31 f or $35, 250. May 31, 2011

Cash ( f c) ( +A) $36, 250 Sal es ( +R, +SE) $36, 250 To r ecor d sal e of f i t t i ngs t o Wi ndsor f or 50, 000 Canadi an dol l ar s: ( $. 725  50, 000 Canadi an) Cont r act payabl e ( f c) ( - L) $35, 250 Exchange l oss on f or war d cont r act ( +Lo, - SE) 1, 000 Cash ( f c) ( - A) $36, 250 To r ecor d payment of t he cont r act denomi nat ed i n Canadi an dol l ar s t o t he exchange br oker . Cash ( +A)

$35, 250


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Cont r act r ecei vabl e ( - A) $35, 250 To r ecor d r ecei pt of t he $35, 250 f r om t he exchange br oker t o set t l e t he account r ecei vabl e denomi nat ed i n U. S. dol l ar s. Sal es ( - R)

$ 1, 000

Exchange l oss ( - Lo, +SE) $ 1, 000 To r ecl ass i f y exchange l oss on f or war d cont r act as an adj ust ment of t he s el l i ng pr i c e. Alternative solution: On April 1, 2011, no ent r y i s necessar y i f t he f or war d cont r act al l owed net set t l ement . I f t hi s i s t he case, t he May 31, 2011 ent r i es woul d be: May 31, 2011

Cash ( +A)

$36, 250 Sal es ( +R, +SE) $36, 250 To r ecor d sal e of f i t t i ngs t o Wi ndsor f or 50, 000 Canadi an dol l ar s: ( $. 725  50, 000 Canadi an) . Ass umi ng i mmedi at e conver si on of t he Canadi an dol l ar s t o U. S. dol l ar s at t he cur r ent exchange rat e.

Exchange l oss on f or war d cont r act ( +Lo, - SE) 1, 000 Cash ( - A) To r ecor d net set t l ement of t he exchange cont r act .

$1, 000

Sal es ( - R, - SE) $ 1, 000 Exchange l oss ( - Lo, +SE) $ 1, 000 To r ecl ass i f y exchange l oss on f or war d cont r act as an adj ust ment of t he s el l i ng pr i c e.

Solution E13-7 1

Ent r y on November 2 f or cont r act wi t h t he exchange br oker : Cont r act r ecei vabl e ( f c) ( +A) $ 7, 800 Cont r act payabl e ( +L) $ 7, 800 To r ecor d cont r act t o pur chase 1, 000, 000 yen i n 90 days at t he f ut ur e r at e. I f t hi s cont r act al l owed f or net set t l ement , t hen no ent r y woul d be necess ar y on November 2.

2

No j our nal ent r y needed as t he 30- day f ut ur e r at e at t he end of t he year i s at $. 0078 whi ch was t he same r at e as t he 90- day r at e on November 2.

SOLUTIONS TO PROBLEMS Solution P13-1

1.

Thi s hedge i s desi gned t o mi t i gat e t he i mpact of pr i ce changes on nat ural gas. Si nce one woul d expect t hat nat ur al gas pr i ce changes and f ut ur es mar ket pr i ces of nat ur al gas t o be hi ghl y cor r el at ed, t hi s i s l i kel y t o be a hi ghl y ef f ect i ve hedge.


Chapter 13

13-9

2.

Thi s woul d be account ed f or as a cash f l ow hedge si nce t hi s i s a hedge of an ant i ci pat ed t r ansact i on.

3.

November 2, 2011

Fut ur es cont r act ( +A) $100, 000 Cash ( - A) Deposi t i s $5, 000 * 20 cont r act s = $100, 000

$100, 000

December 31, 2011

Ot her Compr ehensi ve I ncome ( - OCI , - SE) $50, 000 Fut ur es Cont r act ( - A) $50, 000 At 12/ 31/ 11, t he f ut ur es cont r act pr i ce f or del i ver y on t he same dat e as our cont r act i s $6. 75 - $7. 00 = $. 25 l oss per MMBt u * 10, 000 * 20 cont r act s = $50, 000 l oss. February 2, 2012

Fut ur es cont r act ( +A) $20, 000 Ot her Compr ehensi ve I ncome $20, 000 ( +OCI , +SE) $6. 85 - $6. 75 = $. 10 * 10, 000 * 20 cont r act = $20, 000 gai n Cash ( +A)

$70, 000

Fut ur es cont r act ( - A) To r ecor d f i nal set t l ement of f ut ur es cont r act .

$70, 000

Gas I nvent or y ( +A) $1, 370, 000 Cash ( - A) To r ecor d t he pur chase of nat ur al gas at mar ket r at es.

$1, 370, 000

February 3, 2012

Cash ( +A)

$1, 600, 000

Gas Revenue ( +R, +SE) To r ecor d gas sal e at $8. 00 per MMBt u Cost of Goods Sol d ( +E, - SE) Gas I nvent or y ( - A)

$1, 600, 000

$1, 370, 000 $1, 370, 000

Cost of Goods Sol d ( +E, - SE) $30, 000 Ot her Compr ehensi ve I ncome $30, 000 ( +OCI , +SE) To r ecor d cos t of goods sol d so t hat i t r ef l ect s t he f ut ur es cont r act r at e per t he hedgi ng cont r act , $7. 00 per MMBt u. Solution P13-2

1.

Because t he t er ms of t he pur chase commi t ment and t he hedge i nst r ument mat ch.

2.

Thi s i s a f ai r val ue hedge because a f i r m pur chase commi t ment i s bei ng hedged i nst ead of an ant i ci pat ed pur chase.

3.


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Si l ver opt i ons ( +A) Cash ( - A) 4.

$1, 000 $1, 000

December 31, 2011

Loss on f i r m pur chase commi t ment ( +Lo, - SE) Change i n val ue of f i r m pur chase commi t ment ( +OCI , +SE)

$1, 194, 030 $1, 194, 030

Si l ver opt i ons ( +A) $1, 193, 030 Gai n ( +G, +SE) $1, 193, 030 1, 200, 000 * $1 change ( $10- $9) = $1, 200, 000 whi ch wi l l occur i n 1 mont h ( pur chase and opt i on expi r at i on) . $1, 200, 000/ 1. 005 = $1, 194, 030. Thi s i s t he pr esent val ue of t he f i r m pur chase commi t ment and t he opt i on at 12/ 31/ 11 assumi ng 6% annual i nt er est . Si nce t he opt i on al r eady has a $1, 000 bal ance, $1, 193, 030 wi l l need t o be r ecor ded. 5.

Change i n val ue of f i r m pur chase commi t ment ( $594, 030 OCI , - SE) Gai n ( +G, +SE) $594, 030 To r ecor d t he change i n t he f i r m pur chase commi t ment . ( $9 - $9. 50) * 1, 200, 000. The endi ng bal ance i s $600, 000 af t er t hi s adj ust ment . Loss ( +Lo, - SE) Si l ver opt i on ( - A) The si l ver opt i ons val ue has al so decl i ned. s t i l l exer c i s e t he opt i on.

$594, 030 $594, 030 However , t he company wi l l

Cash ( +A)

$600, 000

Si l ver opt i on ( - A) To r ecor d exer ci se of opt i on.

$600, 000

Si l ver i nvent ory ( +A) Change i n val ue of f i r m pur chase commi t ment ( OCI , - SE) Cash ( - A) To r ecor d pur chase of si l ver i nvent or y.

$11, 400, 000 600, 000 $12, 000, 000

Solution P13-3 1

The pur pose of t hi s hedge i s t o r educe var i abi l i t y i n cash f l ows i n t he f ut ur e si nce t he f i r m ent er ed i nt o a var i abl e i nt er est l oan and i s swappi ng t hat f or a f i xed i nt er est r at e. Thi s i s t her ef or e a cash f l ow hedge.

2

One woul d expect that t hi s i s a hi ghl y ef f ect i ve hedge i f t he not i onal amount , $400, 000 and t he l engt h of t he t er m of t he swap agr eement agr ee.

3

a. The LI BOR r at e at 12/ 31/ 11 i s 5%, t hus 2012’ s i nt er est r at e on t he var i abl e l oan wi l l be 5% + 2% = 7%. The swap f i xed r at e i s 8%. Campi on wi l l pay . 01 per cent more t han t he var i abl e r at e. The f ai r val ue of t he swap i s t he pr esent val ue of t he est i mat ed f ut ure net payment s. Dat e of payment

Est i mat ed payment based on 12/ 31/ 11 LI BOR r at e

Fact or


Present Val ue

Chapter 13

13-11

12/ 31/ 12 12/ 31/ 13 12/ 31/ 14 12/ 31/ 15 Tot al

. 01*$400, 000 . 01*$400, 000 . 01*$400, 000 . 01*$400, 000

1/ ( 1. 07) 1/ ( 1. 07) 1/ ( 1. 07) 1/ ( 1. 07)

$ 3, 738 3, 493 3, 265 3, 051 $13, 547

b. December 31, 2011

Ot her Compr ehensi ve I ncome ( - OCI , - SE) $13, 547 I nt er est Rat e Swap ( +L) $13, 547 To r ecor d t he f ai r val ue of i nt er est r at e swap, cash f l ow hedge at 12/ 31/ 11. I nt erest Expense ( +E, - SE) Cash ( - A) To r ecor d i nt er est payment .

$32, 000 $32, 000

4. December 31, 2012

I nt erest Expense ( +E, - SE) $28, 000 Cash ( - A) $ 28, 000 To r ecor d payment t o Venet a Bank of t he i nt er est expense f or t he year under t he var i abl e r at e l oan. The r at e set on t he l oan at 1/ 1/ 12 was 7%. I nt er est Expense ( +E, - SE) $ 4, 000 Cash ( - A) $ 4, 000 To r ecor d t he payment due on t he i nt er est r at e swap because t he f i xed r at e i s 8%. Thi s r epr esent s t he net set t l ement amount . I nt er est r at e swap ( - L) $ 8, 347 Ot her Compr ehensi ve I ncome ( $ 8, 347 OCI , +SE) To r ecor d t he change i n f ai r val ue of t he i nt er est r at e swap. The new var i abl e r at e f or 2012 whi ch i s set at 12/ 31/ 11 i s 5. 5% + 2%. As a r esul t , t he est i mat ed amount t hat Campi on woul d pay i s r educed f r om 1% t o . 5%. Dat e of payment 12/ 31/ 13 12/ 31/ 14 12/ 31/ 15 Tot al

Est i mat ed payment based on 12/ 31/ 12 LI BOR r at e . 005*$400, 000 . 005*$400, 000 . 005*$400, 000

Fact or

Present Val ue

1/ ( 1. 075) 1/ ( 1. 075) 1/ ( 1. 075)

$ 1, 860 1, 731 1, 610 $ 5, 200

The unadj ust ed I nt er est Rat e Swap l i abi l i t y i s $13, 547 cr edi t , but t he adj ust ed i s $5, 200 cr edi t . The I nt er est Rat e Swap Li abi l i t y must be r educed by $8, 347.

Solution P13-4


13-12

1.


Thi s i s a f ai r val ue hedge because t he f i xed r at e l oan’ s f ai r val ue f l uct uat es over t i me as mar ket i nt er est r at es change. By ent eri ng i nt o t hi s swap agr eement t hat f l uct uat i on i s el i mi nat ed. So whi l e t he i nt er est r at e f l uct uat es, t he l oan’ s f ai r val ue r emai ns const ant , r ef l ect i ng t he f i xed r at e i n t he swap.

2.

Li ke P13- 3, t he t er ms mat ch, t hus t hi s i s consi der ed t o be a hi ghl y ef f ect i ve hedge.

3.

a.

Dat e of payment 12/ 31/ 129 12/ 31/ 13 12/ 31/ 14 12/ 31/ 15 Tot al

b.

Est i mat ed payment based on 12/ 31/ 11 LI BOR r at e . 01*$400, 000 . 01*$400, 000 . 01*$400, 000 . 01*$400, 000

Fact or

Present Val ue

1/ ( 1. 09) 1/ ( 1. 09) 1/ ( 1. 09) 1/ ( 1. 09)

$ 3, 670 3, 367 3, 089 2, 834 $12, 960

December 31, 2011

I nt er est Expense ( +E, - SE) $32, 000 Cash ( - A) $32, 000 To r ecor d i nt er est due on f i xed r at e l oan at 12/ 31/ 11 Loan Payabl e ( - L) $12, 960 I nt er est Rat e Swap ( +L) $12, 960 To r ecor d t he i nt er est r at e swap at f ai r val ue, comput at i ons above. Not i ce t hat t he car r yi ng val ue of t he l oan i s now $387, 040 ( $400, 000 $12, 960) . Thi s agr ees wi t h t he pr esent val ue of t he l oan at t he market r at e of 9%. 4 Proof: $400, 000/ ( 1. 09) = $283, 370 <= t he pr esent val ue of t he mat ur i t y val ue. The pr esent val ue of t he i nt er est payment s i s $32, 000*PVI FA( i =9, n=4) = $103, 670. The t ot al mar ket val ue of t he l oan i s $283, 370 + $103, 670 = $387, 040. 4. Dat e of payment D ecember 31, 2012

Est i mat ed payment based on 12/ 31/ 12 LI BOR r at e . 005*$400, 000 . 005*$400, 000 . 005*$400, 000

12/ 31/ 13 12/ 31/ 14 12/ 31/ 15 Tot al I nt er est Expense ( +E, - SE)

Fact or

Present Val ue

1/ ( 1. 085) 1/ ( 1. 085) 1/ ( 1. 085)

1, 843 1, 699 1, 566 $ 5, 108

$32, 000

Cash ( - A) To r ecor d i nt er est due on f i xed r at e mor t gage I nt erest Expense ( +E, - SE) Cash ( - A) To r ecor d swap payment

$32, 000

$4, 000


$4, 000

Chapter 13

13-13

I nt er est Rat e Swap ( - L) $7, 852 Loan Payabl e ( +L) To adj ust i nt er est r at e swap t o f ai r val ue, $5, 108.

$7, 852

Not i ce t hat now t he l oan payabl e car r yi ng val ue i s: $400, 000 – 12, 960 + 7, 852 = $394, 892. Thi s amount agr ees wi t h t he pr esent val ue of t he l oan at t he mar ket r at e on t hi s dat e, 8. 5%. Proof : $400, 000/ ( 1. 085) 3 = $313, 163—Pr esent val ue of t he mat ur i t y val ue of t he l oan. The pr esent val ue of t he i nt er est payment s = $32, 000*PVI FA( i =8. 5, n=3) = $81, 729. The pr esent val ue of t he l oan at a mar ket r at e of 8. 5% i s t her ef or e $313, 163 + $81, 729 = $394, 892.

Solution P13-5 1

Ent r i es on Apr i l 1 Account s r ecei vabl e ( pesos) ( +A) $33, 060 Sal es ( +R, +SE) $33, 060 To r ecor d sal es on account denomi nat ed i n pesos: 200, 000 pesos / 6. 0496 LCUs No ent r y t o recor d t he cont r act i s necessar y

2

Ent r i es on May 30 Cash ( pesos) ( +A) $33, 378 Account s r ecei vabl e ( pesos) ( - A) $33, 060 Exchange gai n ( +G, +SE) 318 To r ecor d col l ect i on of r ecei vabl e i n LCUs: 200, 000 LCUs / 5. 992 LCUs Cash ( +A) $33, 228 Exchange l oss ( +Lo, - SE) 150 Cash ( pesos) ( - A) $33, 378 To r ecor d del i ver y of 200, 000 pesos t o t he exchange br oker .

Solution P13-6 1

Entry on October 2, 2011

Cont r act r ecei vabl e ( eur os) ( +A) $31, 750 Cont r act payabl e ( +L) $31, 750 To r ecor d f or war d cont r act t o pur chase 50, 000 eur os at $. 6350 as a hedge of a f i r m commi t ment . 2

December 31, 2011 adjustment

Cont r act r ecei vabl e ( eur os) ( +A) $ 350 Exchange gai n ( +G, +SE) $ 350 To adj ust t he cont r act r ecei vabl e f or 50, 000 eur os t o t he $. 6420 f ut ur e exchange r at e at December 31, 2011: 50, 000 eur os  ( $. 6420 - $. 6350) . Exchange l oss ( +Lo, - SE)

$

350


13-14


Change i n val ue of f i r m commi t ment

$

350

( +OCI , +SE) To r ecor d t he change i n t he val ue of t he under l yi ng f i r m commi t ment hedged. 3

Entries on March 31, 2012

Cont r act payabl e ( +L) $31, 750 Cash ( - A) $31, 750 To pay exchange br oker f or 50, 000 eur os at t he f or war d r at e of $. 6350 est abl i shed on Oct ober 2, 2011. Cash ( eur os) ( +A) $32, 800 Cont r act r ecei vabl e ( eur os) ( - A) $32, 100 Exchange gai n ( +G, +SE) 700 To r ecor d r ecei pt of 50, 000 eur os f r om exchange br oker when spot r at e i s $. 6560. Exchange Loss ( +Lo, - SE) $ 700 Change i n val ue of f i r m commi t ment $ 700 ( +OCI , +SE) To r ecor d t he change i n t he val ue of t he under l yi ng f i r m commi t ment hedged. Pur chases ( +E, - SE) $32, 800 Cash ( eur os) ( +A) $32, 800 To r ecor d pur chase and payment i n eur os at $. 6560 spot r at e. Change i n val ue of f i r m commi t ment ( - OCI , - SE) $ 1, 050 Pur chases ( - E, +SE) 1, 050 To r ecor d t he adj ust ment of pur chases f or t he change i n t he val ue of t he f i r m commi t ment . Thi s ef f ect i vel y f i xes t he pur chase at t he or i gi nal f or war d r at e. Solution P13-7

We wi l l assume t hat t he hedge cont r act i s t o be set t l ed net . December 2, 2011

No ent r y December 31, 2011

Ot her compr ehensi ve i ncome: exchange l oss ( $ 4, 950 OCI , - SE) Forwar d cont r act ( +L) $ 4, 950 For war d cont r act , 12/ 31/ 11, $1. 69 – cont r act r at e $1. 68 = $. 01 * 500, 000 = $5, 000. Thi s i s t o be pai d i n t wo mont hs so t he present val ue assumi ng 6% annual i nt er est r at e i s: $5, 000/ ( 1. 005) 2 = $4, 950. Exchange Loss ( +Lo, - SE) $ 3, 346 Ot her compr ehensi ve i ncome ( +OCI , +SE) To r ecor d di sc ount amor t i zat i on. See t abl e bel ow

$ 3, 346

March 1, 2012

Cash ( f c) ( +A) $855, 000 Sal es ( +R, +SE) $855, 000 To r ecor d del i ver y of equi pment t o Ramsay Lt d. and col l ect i on of 500, 000 pounds at t he $1. 71 spot r at e.


Chapter 13

13-15

Ot her compr ehensi ve i ncome: exchange l oss ( +Lo, $10, 050 SE) For war d cont r act ( +L) $10, 050 To i ncr ease t he f or war d cont r act t o t he f i nal l i abi l i t y amount : $1. 71- $1. 68 = $. 03*500, 000 = $15, 000 - $4, 950 = $10, 050 adj ust ment . Exchange Loss ( +Lo, - SE) $6, 653 Ot her compr ehensi ve i ncome ( +OCI , +SE) To r ecor d di sc ount amor t i zat i on. ( See t abl e bel ow) For war d cont r act ( - L) Cash ( –A) To r ecor d f or war d cont r act payment .

$15, 000

Sal es ( - R, - SE) Ot her compr ehensi ve i ncome ( +OCI , +SE)

$10, 000

$6, 653

$15, 000

$10, 000

Di scount amort i zat i on: The spot r at e at t he dat e t he f or war d cont r act was ent er ed i nt o $1. 70*500, 000 = $850, 000. $1. 68 * 500, 000 = $840, 000. The di scount of $10, 000 must be amor t i zed over t he cont r act per i od. The ef f ect i ve i nt erest r at e equat es t hese t wo amount s usi ng a 3 mont h t i me peri od, t hat r at e i s . 3937%. Dat e

Di scount amor t i zat i on

December 31, 2011 J anuar y 31, 2012 Mar ch 1, 2012

$

Bal ance $ 850, 000 846, 654 843, 320 840, 000

3, 346 3, 333 3, 320

Solution P13-8 1

December 16, 2011

Equi pment ( +A) $668, 000 Account s payabl e ( f c) ( +L) $668, 000 To r ecor d pur chase of equi pment ( 400, 000 pounds  $1. 67) . 2

December 31, 2011

Account s payabl e ( f c) ( - L) $ 8, 000 Exchange gai n ( +G, +SE) $ 8, 000 To adj ust account s payabl e f or cur r ency exchange r at e change: 400, 000 pounds  ( $1. 67 - $1. 65) . Ot her Compr ehensi ve I ncome ( - OCI , - SE) $ 7, 980 For war d Cont r act ( +L) To r ecor d t he f or war d cont r act l oss at 12/ 31/ 08 Exchange l oss ( +Lo, - SE)

$

8, 000


$

7, 980

13-16


Ot her Compr ehensi ve I ncome

$

8, 000

( +OCI , +SE) To r ecl ass i f y an amount f r om Ot her Compr ehensi ve I ncome t o of f set t he gai n on t he account s payabl e Exchange Loss ( +Lo, - SE) $ 1, 994 Ot her Compr ehensi ve I ncome $ 1, 994 ( +OCI , +SE) To amor t i ze t he pr emi um. The pr emi um i s t he di f f er ence bet ween t he $668, 000 spot pr i ce f or pounds at t he dat e t he cont r act was ent er ed i nt o and $672, 000, t he cont r act ed amount . Thi s di f f er ence must be amor t i zed t o i ncome over t he 30 day per i od. The ef f ect i ve i nt er est r at e i s comput ed as f ol l ows: $672, 000 = $668, 000* ( 1+r ) 30, s ol vi ng f or r ( t he dai l y i nt er e st r at e) = . 0199025%. $668, 000*. 000199025*15= $1, 994. December 31, 2011 account bal ances: Account s Payabl e $660, 000 For war d Cont r act 7, 980 cr edi t Ot her compr ehensi ve i ncome 2, 014 cr edi t Exchange l oss ( net ) 3

1, 994

January 15, 2012

Account s payabl e ( f c) ( - L) $4, 000 Exchange gai n ( +G, +SE) To mar k t he account s payabl e t o f ai r val ue. Ot her compr ehensi ve i ncome ( - OCI , - SE) $8, 020 Forwar d cont r act ( +L) To mar k t he f or war d cont r act t o f ai r val ue.

$

$

4, 000

8, 020

Exchange l oss ( +Lo, - SE) $4, 000 Ot her Compr ehensi ve I ncome $ 4, 000 ( +OCI , +SE) To r ecor d t he r ecl ass i f i cat i on f r om OCI t o of f set t he exchange gai n on t he account s payabl e Exchange l oss ( +Lo, - SE) $2, 006 Ot her Compr ehensi ve I ncome $2, 006 ( +OCI , +SE) To r ecor d t he amor t i zat i on of t he pr emi um The t ot al pr emi um i s $4, 000 ( $672, 000 - $668, 000) , t he por t i on l ef t t o be amort i zed i s $4, 000 - $1, 994 = $2, 006. Cash ( f c) ( +A) $656, 000 For ward cont r act ( +L) 16, 000 Cash ( - A) To r ecor d t he set t l ement of t he f or war d cont r act . Account s payabl e ( f c) ( - L) $656, 000 Cash ( f c) ( - A) To r ecor d payment of account s payabl e i n pounds. J anuar y 15, 2012 account bal ances: Account s Payabl e: $0


$672, 000

$656, 000

Chapter 13

13-17

For war d Cont r act : $7, 980 cr edi t + $8, 020 – $16, 000 = $0 Ot her Compr ehensi ve I ncome: $2, 014 cr edi t - $8, 020 dr + $4, 000 cr + $2, 006 cr = $0 Exchange Loss ( net ) :

$2, 006


Beams AdvAcc11 Chapter13

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