Chapter 24

Accounting for Derivatives and Hedging

Transactions (Part 3)

PROBLEM 24-1: TRUE OR FALSE

1. FALSE 6. FALSE
2. FALSE 7. FALSE
3. FALSE 8. TRUE
4. TRUE 9. FALSE
5. TRUE 10. TRUE

PROBLEM 24-2: THEORY

1. A 6. C
2. B 7. C
3. C 8. B
4. C 9. C
5. C 10. B

PROBLEM 24-3: THEORY

1. D 6. A
2. A 7. C
3. B 8. B
4. C 9. A
5. A 10. C

PROBLEM 24-4: 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 Hedging instrument –
probable Futures contract
forecast transaction

!2
Nov. 1, 20x2 Nov. 1, 20x2
No entry No entry

Dec. 31, 20x1 Dec. 31, 20x1

No entry Futures contract (asset) 2,000
(0.55 – 0.50) x 40,000
Accumulated OCI………..
2,000

Jan. 1, 20x3 Jan. 1, 20x3

Inventory………..22,000 Cash……………………2,000
(0.55 x 40,000) Futures contract (asset) ….
Cash……………………22,000 2,000

Jan. 19, 20x3

Accumulated OCI …2,000
Cost of goods sold ………..
2,000

6. D

7. Solution:
Hedged item – Highly Hedging instrument –
probable Put option (Derivative)
forecast transaction
Nov. 1, 20x2 Nov. 1, 20x2
No entry Call option ……..……..1.2K
Cash………..………………1.2K

to record the purchase of option contract

Dec. 31, 20x2 Dec. 31, 20x2

No entry 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.

!3
 Jan. 1, 20x3 Jan. 1, 20x3
Inventory…………..201,200 Cash…………………... 25K
(.45 x 500,000) - 23.8K Call option…………………
Accumulated OCI…23,800 25K
Cash……………………225,000
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.

Solution:
Hedged item – Hedging instrument –
Variable interest payments Interest rate swap (Derivative)
Jan. 1, 20x2 Jan. 1, 20x2
Cash……………….1M No entry
Loan payable………...………
1M
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 – payment 10,000

!4
Net cash settlements – payment
10,000
(each due on Dec. 31, 20x2 and Dec. 31, 20x3)

PV of ordinary annuity of 1 @ 8%, n=2 1.78326

Fair value of derivative - 12/31/x1 (asset) 17,833

Dec. 31, 20x1 Dec. 31, 20x1

Interest expense……90,000 Accumulated OCI……….17,883
Cash (1M x 9%)….……...… Interest rate swap…..
90,000 17,883

to recognize interest expense on the to recognize the change in the fair value
variable-rate loan of the interest rate swap

Dec. 31, 20x2 Dec. 31, 20x2

Interest expense……80,000 Interest rate swap…..10,000
Cash (1M x 8%)….……...… Cash………. 10,000
80,000
to record the periodic net cash
to recognize interest expense on the settlement on the interest rate swap -
variable-rate loan (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:

20x3
Receive variable (1M x 12%) 120,000
Pay 9% fixed 90,000
Net cash settlement – receipt 30,000

Net cash receipt (due on Dec. 31, 20x3 – maturity date) 30,000
Multiply by: PV of 1 @12%, n=1 0.892857

!5
Fair value of derivative - 12/31/x2 (asset) 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
Change in fair value – gain 34,619

Hedged item – Hedging instrument –

Variable interest payments 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 Accumulated OCI

17,833 12/31/x1 17,833

12/31/x2 10,000 10,000 12/31/x2

12/31/x2 34,619 34,619 12/31/x2

26,786 bal. 26,786

Hedged item – Hedging instrument –

Variable interest payments Interest rate swap (Derivative)

!6
 Dec. 31, 20x3 Dec. 31, 20x3
Interest expense…120,000 Cash…………………30,000
Cash (1M x 12%)………… Interest rate swap………
120,000 26,786
Accum. OCI (squeeze)….
3,214
to recognize interest expense on the
variable-rate loan to record the final net cash settlement
on the interest rate swap

Dec. 31, 20x3 Dec. 31, 20x2

Loan payable……….1M Accumulated OCI……30,000*
Cash………………………….1M 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 Without hedging With hedging

interests: instrument instrument
Dec. 31, 20x1 90,000q 90,000
Dec. 31, 20x2 80,000 80,000
Net cash settlement –
- 10,000
payment
Dec. 31, 20x3 120,000 120,000
Net cash settlement –
- (30,000)
receipt
Payment for interest 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 24-5: MULTIPLE CHOICE: COMPUTATIONAL

!7
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).
➢ 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) 761,904.76
Payment by exercising the call option (¥80M ÷ ¥100) 800,000.00
Loss from exercising the option (38,095.24)

6. C

!8
Solution:
(10% pay fixed - 8% receive variable) x 500,000 = 10,000 payment

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

PROBLEM 24-6: 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)

!9
Dec. 31, 20x4 Dec. 31, 20x4
No entry (see explanation above)

Dec. 31, 20x4

Loss on put option……….53
(88 - 35)
Put option……………………..53

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/x4 170

82 9/30/x4

53 12/31/x4

35 1/31/x5

2. Solution:
Hedged item – None Put option (Derivative)
Jan. 7, 20x4 Jan. 7, 20x4
Put option ……..…….. 270
Cash………..……………… 270

!10
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
(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 Put option (Derivative)

June 30, 20x4 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 Put option (Derivative)

!11
 July 31, 20x4 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 270

3/31/x4 1,200 120 3/31/x4

600 6/30/x4

82 6/30/x4

668 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.

!12
 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 270

3/31/x4 1,200 120 3/31/x4

600 6/30/x4

82 6/30/x4

7/31/x4 1,200 48 7/31/x4

1,820 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

!13