Chapter 26 Acctg FOR Derivatives & Hedging Transactions PART 3 AFAR PART 2 PDF

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Chapter 26Accounting for Derivatives and HedgingTransactions (Part 3)PROBLEM 26-1: TRUE OR FALSE1. FALSE 6. FALSE2. FALSE 7. FALSE3. FALSE 8. TRUE4. TRUE 9. FALSE5. TRUE 10. TRUEPROBLEM 26-2: THEORY1. A 6. C2. B 7. C3. C 8. B4. C 9. C5. C 10. BPROBLEM 26-3: THEORY1. D 6. A2. A 7. C3. B 8. B4. C 9. A...

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Chapter 26 Accounting for Derivatives and Hedging Transactions (Part 3) PROBLEM 26-1: TRUE OR FALSE 1. FALSE 6. FALSE 2.

FALSE

7.

FALSE

3.

FALSE

8.

TRUE

4.

TRUE

9.

FALSE

5.

TRUE

10.

TRUE

PROBLEM 26-2: THEORY 1. A

6.

C

2.

B

7.

C

3.

C

8.

B

4.

C

9.

C

5.

C

10.

B

PROBLEM 26-3: THEORY 1. D 6.

A

2.

A

7.

C

3.

B

8.

B

4.

C

9.

A

5.

A

10.

C

PROBLEM 26-4: THEORY & COMPUTATIONAL 1.

C

2.

B

3.

A

1

4.

Solution:

Hedged item – None

Futures contract (Derivative) Dec. 1, 20x1 Deposit with broker ……..80K Cash………………………..80K to record the initial margin deposit with the broker

Dec. 31, 20x1 Futures contract (asset)...1M [(100 - 90) x 100,000]

Gain on futures contract….. 1M to record the value of the derivative computed as the change in the underlying multiplied by the notional amount.

Feb. 1, 20x2 Cash …………………1,580,000 Futures contract (asset).. 1M Gain on futures contract… 500K [(90 - 85) x 100,000]

Deposit with broker……..... 80K to recognize gain on the change in the fair value of the futures contract and to record the net cash settlement of the futures contract.

5.

Solution:

Hedged item – Highly probable forecast transaction

Hedging instrument – Futures contract

Nov. 1, 20x2 No entry

Nov. 1, 20x2 No entry

Dec. 31, 20x1 No entry

Dec. 31, 20x1 Futures contract (asset) 2,000 (0.55 – 0.50) x 40,000 Accumulated OCI……….. 2,000

Jan. 1, 20x3 Inventory………..22,000 (0.55 x 40,000) Cash……………………22,000

Jan. 1, 20x3 Cash……………………2,000 Futures contract (asset) …. 2,000

2

Jan. 19, 20x3 Accumulated OCI …2,000 Cost of goods sold ………..2,000 6.

D

7.

Solution:

Hedged item – Highly probable forecast transaction

Hedging instrument – Put option (Derivative)

Nov. 1, 20x2 No entry

Nov. 1, 20x2 Call option ……..……..1.2K Cash………..………………1.2K to record the purchase of option contract

Dec. 31, 20x2 No entry

Dec. 31, 20x2 Call option……………… 23.8K [(.45 - .40) x 500,000] – 1.2K Accumulated OCI…..……..23.8K to recognize the change in the fair value of the option.

Jan. 1, 20x3 Inventory…………..201,200 (.45 x 500,000) - 23.8K Accumulated OCI…23,800 Cash……………………225,000

Jan. 1, 20x3 Cash…………………... 25K Call option………………… 25K

to record the actual purchase

to record the net cash settlement of the put option

8.

D

9.

D

10. A 11. B

12. Solution: Analysis:  Eden has a variable interest rate loan. However, Eden wants to pay fixed interest instead. Therefore, Eden enters into a “receive variable, pay fixed” interest rate swap.  Regardless of the movements in interest rates, Eden’s cash outflow for interest will be fixed at the 9% pre-agreed rate.  The risk being hedged is Eden’s exposure to variability in cash flows. Therefore, the hedge is a cash flow hedge.

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Solution:

Hedged item – Variable interest payments

Hedging instrument – Interest rate swap (Derivative)

Jan. 1, 20x2 Cash……………….1M Loan payable………...………1M

Jan. 1, 20x2 No entry

to recognize loan payable

The net cash settlement on the swap is determined as follows: 20x2 Receive variable (1M x 8%) 80,000 Pay 9% fixed 90,000 Net cash settlement – 10,000 payment Net cash settlements – payment (each due on Dec. 31, 20x2 and Dec. 31, 20x3)

PV of ordinary annuity of 1 @ 8%, n=2 Fair value of derivative - 12/31/x1 (asset)

10,000 1.78326 17,833

Dec. 31, 20x1 Interest expense……90,000 Cash (1M x 9%)….……...…90,000

Dec. 31, 20x1 Accumulated OCI……….17,883 Interest rate swap….. 17,883

to recognize interest expense on the variable-rate loan

to recognize the change in the fair value of the interest rate swap

Dec. 31, 20x2 Interest expense……80,000 Cash (1M x 8%)….……...…80,000

Dec. 31, 20x2 Interest rate swap…..10,000 Cash………. 10,000

to recognize interest expense on the variable-rate loan

to record the periodic net cash settlement on the interest rate swap - (see previous

computation)

Dec. 31, 20x2 Interest expense……...10,000 Accumulated OCI……10,000 to record a piecemeal reclassification of accumulated OCI to profit or loss

The net cash settlement in 20x3 is determined as follows: 4

20x3 120,000 90,000 30,000

Receive variable (1M x 12%) Pay 9% fixed Net cash settlement – receipt Net cash receipt (due on Dec. 31, 20x3 – maturity date) Multiply by: PV of 1 @12%, n=1 Fair value of derivative - 12/31/x2 (asset)

30,000 0.892857 26,786

The change in the fair value of the interest rate swap is determined as follows: Fair value of interest rate swap – Dec. 31, 20x2 - (asset) 26,786 Less: Carrying amount of interest rate swap – Dec. 31, 20x2 (17,833 liability – 10,000 net cash settlement) - (liability) 7,833 34,61 Change in fair value – gain 9

Hedged item – Variable interest payments

Hedging instrument – Interest rate swap (Derivative) Dec. 31, 20x2 Interest rate swap……34,619 Accumulated OCI………34,619 to recognize the change in the fair value of the interest rate swap

The balances of the accounts on Dec. 31, 20x2 are analyzed as follows: Interest rate swap 17,833 12/31/x2 12/31/x2

12/31/x1

Accumulated OCI 17,833

10,000 34,619

10,000 34,619 26,786

bal.

12/31/x2 12/31/x2

26,786

Hedged item – Variable interest payments

Hedging instrument – Interest rate swap (Derivative)

Dec. 31, 20x3 Interest expense…120,000 Cash (1M x 12%)…………120,000

Dec. 31, 20x3 Cash…………………30,000 Interest rate swap………26,786 Accum. OCI (squeeze)….3,214

5

to recognize interest expense on the variable-rate loan

to record the final net cash settlement on the interest rate swap

Dec. 31, 20x3 Loan payable……….1M Cash………………………….1M

Dec. 31, 20x2 Accumulated OCI……30,000* Interest expense……....30,000

to record the settlement of the loan

to record the final reclassification of accumulated OCI to profit or loss

*26,786 balance on Dec. 31, 20x2 + 3,214, the amount squeezed above = 30,000

The effect of the hedging instrument on Eden’s cash outflows for interests is analyzed as follows: Cash outflows for interests: Dec. 31, 20x1 Dec. 31, 20x2 Net cash settlement – payment Dec. 31, 20x3 Net cash settlement – receipt Payment for interest

Without hedging instrument 90,000q 80,000

With hedging instrument 90,000 80,000

-

10,000

120,000

120,000

-

(30,000)

290,000

270,000

Notice that with the hedging instrument, Eden has effectively fixed its cash outflows for interests at the fixed rate of 9% (i.e., 1M x 9% x 3 years = ₱270,000).

PROBLEM 26-5: MULTIPLE CHOICE: COMPUTATIONAL 1. C Explanations:  Choice (c) is correct. The entity wants to fix the number of dollars it will receive from the DM400,000 which is at $200,000. The entity pays any excess and receives any deficiency. The futures contract is a contract to sell the DM (i.e., the entity collects the DM400,000 from the account receivable and sells it to the bank at the pre-agreed price of $200,000).  Choice (a) is incorrect. There is insufficient information that would support Choice (a).  Choice (b) is incorrect. See explanation for Choice (c).

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

Choice (d) is incorrect. If the value of dollar increases (over DM), the DM400,000 will worth less than $200,000. Therefore, the entity receives the deficiency from the bank.

2. D Explanations:  Choice (d) is correct because the hedged item (highly probable forecasted purchase transaction) is in the amount of DM400,000 only while the hedging instrument is at DM800,000. Therefore, the excess DM400,000 is regarded as speculative investment.  Choice (a) is incorrect. There is insufficient information that would support Choice (a). There are two risks that are being hedged: (1) The risk that the expected purchase price in DM will increase and (2) The risk that the value of DM in U.S. dollars will change.  Choice (b) is incorrect: See explanation for Choice (a).  The hedging instrument fixes the amount of outflow in U.S. dollars. Therefore, the futures contract is a contract to purchase 800,000DM at $400,000, not sell. 3.

B (12% - 10%) x 500,000 x PV of 1 @ 12%, n=1 = 8,929

4. B Solution: Payment without the call option (¥80M ÷ ¥93)

860,215.05

Payment by exercising the call option (¥80M ÷ ¥100)

800,000.00

Savings

60,215.05

Less: Cost of call option

(12,000.00)

Net savings

48,215.05

5. D Solution: Payment without the call option (¥80M ÷ ¥105) Payment by exercising the call option (¥80M ÷ ¥100) Loss from exercising the option

761,904.76 800,000.00 (38,095.24)

6. C Solution: (10% pay fixed - 8% receive variable) x 500,000 = 10,000 payment 7. D Solution: (12% receive variable - 10% pay fixed) x 500,000 = 10,000 receipt

7

OR “Cougar pays Aggie’s fixed interest” (10% x 500,000) = 50,000 “Aggie pays Cougar’s variable interest” (12% x 500,000) = 60,000 Net settlement = Cougar receives the difference of 10,000

PROBLEM 26-6: EXERCISES: COMPUTATIONAL 1. Solution: Hedged item – None

Put option (Derivative)

July 7, 20x4

July 7, 20x4 Put option ……..…….. 170 Cash………..……………… 170

Hedged item – None

Put option (Derivative)

Sept. 30, 20x4

Sept. 30, 20x4 No entry 1 Sept. 30, 20x4 Loss on put option……….82 (170 – 88)

Put option……………………..82 to record the decrease in the fair value of the put option due to the decrease in time value. 1 The option is out of the money (i.e., the entity is better off selling in the market at the market price of $54 rather than exercising the put option and sell at $50.

The entity need not recognize a loss from the change in intrinsic value because the option is not designated as a hedging instrument. Only the change in the time value is accounted for. The maximum loss that would be recognized in an option is the premium paid (i.e., $170) which is equal to the time value of the option on initial recognition.

Hedged item – None

Put option (Derivative)

Dec. 31, 20x4

Dec. 31, 20x4 No entry (see explanation above) Dec. 31, 20x4 Loss on put option……….53 (88 - 35)

Put option……………………..53

8

to record the decrease in the fair value of the put option due to the decrease in time value.

Hedged item – None

Put option (Derivative)

Jan. 31, 20x5

Jan. 31, 20x5 No entry (see explanation above) Jan. 31, 20x5 Loss on put option……….35 (35 - 0)

Put option……………………..35 to record the decrease in the fair value of the put option due to the decrease in time value.

The movements in the put option account are analyzed as follows: Put option 7/7/x 4

170 82 53 35 -

9/30/x4 12/31/x4 1/31/x5

2. Solution: Hedged item – None

Put option (Derivative)

Jan. 7, 20x4

Jan. 7, 20x4 Put option ……..…….. 270 Cash………..……………… 270

The entries on March 31, 20x1 are as follows: Hedged item – None Put option (Derivative) March 31, 20x4

March 31, 20x4 Put option ……..…….. 1,200 [(64 – 60) x 300]

Gain on put option………. 1,200 to record the increase in the fair value of the put option due to the increase in intrinsic value (excess of market value of shares over exercise price).

March 31, 20x4 Loss on call option……….120

9

(270 – 150)

Put option……………………..120 to record the decrease in the fair value of the put option due to the decrease in time value.

Hedged item – None June 30, 20x4

Put option (Derivative) June 30, 20x4 Loss on put option…

600

[(60 – 62) x 300]

Put option ……..……..

600

to record the decrease in the fair value of the put option due to the decrease in intrinsic value.

June 30, 20x4 Loss on call option……….82 (150 – 68)

Put option……………………..82 to record the decrease in the fair value of the put option due to the decrease in time value.

Variation 1: Short-cut Hedged item – None July 31, 20x4

Put option (Derivative) July 31, 20x4 Cash…………..

1,800

[(64 - 58) x 300]

Put option…………………. 668* Gain on put option ……. 1,132 to record the net settlement of the put option

* Put option 1/7/x4 3/31/x4

270 1,200

120 600 82 668

10

3/31/x4 6/30/x4 6/30/x4 balance

Variation 2: Long-cut Hedged item – None

Put option (Derivative)

July 31, 20x4

July 31, 20x4 Put option…………..

1,200

[(62 - 58) x 300]

Gain on put option …….

1,200

to record the increase in the fair value of the put option due to the increase in intrinsic value.

July 31, 20x4 Loss on call option……….48 (68 - 20)

Put option……………………..48 to record the decrease in the fair value of the put option due to the decrease in time value.

July 31, 20x4 Cash…………..

1,800

[(64 - 58) x 300]

Loss on put option … 20 Put option……………… 1,820** to record the net settlement of the put option

** Put option 1/7/x4 3/31/x4

7/31/x4

270 1,200

120 600 82 48 1,820

1,200

3/31/x4 6/30/x4 6/30/x4 7/31/x4 balance

The net gain or loss recognized on July 31, 20x4 under each of the “short-cut” and “long-cut” methods are analyzed as follows:  Short-cut method: net gain of 1,132  Long-cut method: (1,200 – 48 – 20) = net gain of 1,132

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