CHAPTER 11 Financial Instruments and Liabilities
Requirement:
Determine the gain or loss on the bond retirement.
97. The Hockey Supply Company acquires its inventory from a Canadian supplier. As a result,
the company purchases call options in order to hedge its foreign currency risk. On December 1,
2018, Hockey Supply Company made a commitment to purchase inventory during February
2019; the payment of one million Canadian dollars is due at the time of the inventory purchase.
The company immediately purchased a call option on one million Canadian dollars at a strike
price of $.98 per Canadian dollar; the call option cost $5,200. The call option is considered to be
a fair value hedge. As of December 31, 2018, the spot rate was $0.975 U.S. dollars per Canadian
dollar, and the fair value of the call option was $1,300. Hockey Supply Company purchased the
inventory on February 5, 2019. The spot rate at the time of purchase was $0.99 U.S. dollars per
Canadian dollar and the fair value of the call option was $8,900.
Requirement:
CHAPTER 11 Financial Instruments and Liabilities
Prepare the necessary journal entries for December 1, 2018, December 31, 2018, and February
5, 2019.
98. On December 15, 2018, The International Company received and accepted an order to deliv-
er goods to a foreign customer on February 1, 2019 in exchange for 3 million euros. Internation-
al must deliver the goods on February 1, 2019 and the foreign customer is required to pay for the
goods at the time of delivery. On December 15, 2018, International agreed to a forward contract
to deliver 3 million euros to the Speculative Bank on February 1, 2019 in exchange for
CHAPTER 11 Financial Instruments and Liabilities
$2,730,000. The forward rate as of December 31, 2018 was $0.915; the spot rate as of February
1, 2019 was $0.904.
Requirement:
Prepare the necessary journal entries on December 31, 2018 and February 1, 2019 assuming that
the forward contract is being used as a fair value hedge.
99. On January 1, 2018, Hitchcock Corporation entered into a 5-year interest rate swap
agreement. The agreement called for the company to make payments based on an 8% fixed no-
tional amount of $500,000 and to receive interest based on a floating interest rate. The contract
called for cash settlement of the net interest amount at the end of each year. The floating rate was
to be reset at each cash settlement date. Thus, the floating rate for determining each end of year
payment is the rate as of the end of the prior year.
CHAPTER 11 Financial Instruments and Liabilities
Market (LIBOR) interest rates were 8% at January 1, 2018, 6.5% at December 31,
2018, and 9% at December 31, 2019. The fair value of the swap is as follows:
January 1, December 31, December 31,
2018 2018 2019
Fair value of interest rate swap 0 ($25,693) $12,656
Requirements:
1. Complete the following table to show the amounts appearing in Hitchcock’s financial
statements related to the swap for the years ended December 31, 2018 and December
31, 2019. There may be zeros in several of the cells. Indicate debits and credits by
putting parentheses around credits. Show your work within the table.
December 31, 2018
December 31, 2019
Balance sheet
Swap asset (liability)
Retained earnings
Accumulated other
comprehensive income
Statement of comprehensive
income
Net income
Other comprehensive income
2. Complete the following table to show the amounts appearing in Hitchcock’s state-
ment of comprehensive income related to the swap and the hedged item for the years
ended December 31, 2018 and December 31, 2019, assuming that the interest rate
CHAPTER 11 Financial Instruments and Liabilities
swap is being used as a perfectly effective cash flow hedge for a $500,000 variable
rate note payable issued by Hitchcock. There may be zeros in multiple cells. Indicate
debits and credits by placing parentheses around the credits. Show your work within
the table.
December 31, 2018
December 31, 2019
Statement of comprehensive
income
Net income
Other comprehensive income
3. Complete the following table to show the amounts appearing in Hitchcock’s state-
ment of comprehensive income related to the swap and the hedged item for the years
ended December 31, 2018 and December 31, 2019, assuming that the interest rate
swap is being used as a perfectly effective fair value hedge for a $500,000 investment
in a fixed rate note. The note is classified as an available-for-sale security. There may
be zeros in multiple cells. Indicate debits and credits by placing parentheses around
the credits. Show your work within the table.
December 31, 2018
December 31, 2019
Statement of comprehensive
income
Net income
Other comprehensive income
CHAPTER 11 Financial Instruments and Liabilities
1.
25,693 + 7,500 – 38,349 =
(5,156)
comprehensive income
2.
40,000
3.
100. Refer to the Year 3 IBM financial statement excerpts presented which appear following
the requirements listed for this problem. Use the information in the excerpts to answer
these questions. All questions relate to fiscal Year 3 unless stated otherwise.
Required:
1. Explain the risks that IBM is trying to manage with its derivatives.
2. Explain how the gains and losses on the fair value hedges affect net income and other
comprehensive income during Year 3. Give specific accounts and amounts where
possible.
3. Explain how the gains and losses on non-hedge/other derivatives affect net income
and other comprehensive income during Year 3. Give specific accounts and amounts
where possible.
4. Explain how the gains and losses on the cash flow hedges affect net income and other
comprehensive income during Year 3. Give specific accounts and amounts where
possible.
5. Was it a good idea for IBM to enter into its cash flow hedges?
Excerpt from IBM December 31, Year 3 Financial Statements
K
BORROWINGS
SHORT-TERM DEBT
(dollars in millions)
AT DECEMBER 31: Year 3 Year 2
Commercial paper $ 2,349 $ 1,302
Short-term loans 1,124 1,013
Long-term debt—Current maturities 3,173 3,716
Total $ 6,646 $ 6,031
The weighted-average interest rates for commercial paper at December 31,
Year 3 and Year 2, were 1.0 percent and 1.7 percent, respectively. The
weighted-average interest rate for short-term loans was 2.5 percent at both
December 31, Year 3 and Year 2.
Pre-Swap Activity (dollars in millions)
AT DECEMBER 31: MATURITIES Year 3 Year 2
CHAPTER 11 Financial Instruments and Liabilities
U.S. Dollars:
Debentures:
5.875% Year 32 $ 600 $ —
6.22% Year 27 500 500
6.5% Year 28 319 700
7.0% Year 25 600 600
7.0% Year 45 150 150
7.125% Year 96 850 850
7.5% Year 13 550 550
8.375% Year 19 750 750
3.43% convertible notes* Year 7 309 328
Notes: 5.9% average Year 4 Year 13 3,034 2,130
Medium-term note program: 3.7%Year 4 Year 18 4,690 7,113
average
Other: 4.0% average Year 4 Year 9 508 610
12,860 14,281
Other currencies (average
Interest rate at December 31,
Year 3, in parentheses):
Euros (5.3%) Year 4 Year 9 1,174 2,111
Japanese yen (1.1%) Year 4 Year 15 4,363 4,976
Canadian dollars (5.8%) Year 4 Year 11 201 445
Swiss francs (4.0%) Year 3 – 180
Other (6.0%) Year 4 Year 14 770 730
19,368 22,723
Less: Net unamortized discount/ 15 (1)
(premium)
Add: ASC Topic 815 fair value 806 978
adjustment**
20,159 23,702
Less: Current maturities 3,173 3,716
Total $16,986 $19,986
* On October 1, Year 2, as part of the purchase price consideration for the
PwCC acquisition, as addressed in note C, Acquisitions/ Divestitures, on
pages 89 to 92, the company issued convertible notes bearing interest at
a stated rate of 3.43 percent with a face value of approximately $328
million to certain of the acquired PwCC partners. The notes are convert-
ible into 4,764,543 shares of IBM common stock at the option of the
holders at any time after the first anniversary of their issuance based on a
fixed conversion price of $68.81 per share of the company’s common
stock. As of December 31, Year 3, a total of 274,347 shares had been is-
sued under this provision.
CHAPTER 11 Financial Instruments and Liabilities
** In accordance with the requirements of FASB ASC Topic 815, the
portion of the company’s fixed rate debt obligations that is hedged is re-
flected in the Consolidated Statement of Financial Position as an amount
equal to the sum of the debt s carrying value plus a ASC Topic 815 fair
value adjustment representing changes recorded in the fair value of the
hedged debt obligations attributable to movements in market interest
rates and applicable foreign currency exchange rates.
L. DERIVATIVES AND HEDGING TRANSACTIONS
The company operates in approximately 35 functional currencies and is a
significant lender and borrower in the global markets. In the normal course
of business, the company is exposed to the impact of interest rate changes
and foreign currency fluctuations, and to a lesser extent equity price
changes and client credit risk. The company limits these risks by following
established risk management policies and procedures including the use of
derivatives and, where cost-effective, financing with debt in the currencies
in which assets are denominated. For interest rate exposures, derivatives
are used to align rate movements between the interest rates associated with
the company’s lease and other financial assets and the interest rates asso-
ciated with its financing debt. Derivatives are also used to manage the re-
lated cost of debt. For foreign currency exposures, derivatives are used to
limit the effects of foreign exchange rate fluctuations on financial results.
The company does not use derivatives for trading or speculative purposes,
nor is it a party to leveraged derivatives. Further, the company has a policy
of only entering into contracts with carefully selected major financial insti-
tutions based upon their credit ratings and other factors, and maintains
strict dollar and term limits that correspond to the institution’s credit rat-
ing.
In its hedging programs, the company employs the use of forward con-
tracts, futures contracts, interest rate and currency swaps, options, caps,
floors or a combination thereof depending upon the underlying exposure.
A brief description of the major hedging programs follows.
DEBT RISK MANAGEMENT
The company issues debt in the global capital markets, principally to fund
its financing lease and loan portfolio. Access to cost-effective financing
can result in interest rate and/or currency mismatches with the underlying
assets. To manage these mismatches and to reduce overall interest cost,
the company primarily uses interest-rate and currency instruments, princi-
CHAPTER 11 Financial Instruments and Liabilities
pally swaps, to convert specific fixed-rate debt issuances into variable-rate
debt (i.e., fair value hedges) and to convert specific variable-rate debt and
anticipated commercial paper issuances to fixed rate (i.e., cash flow hedg-
es).
The resulting cost of funds is lower than that which would have been
available if debt with matching characteristics was issued directly. The
weighted-average remaining maturity of all swaps in the debt risk man-
agement program is approximately four years.
A significant portion of the company’s foreign currency denominated debt
portfolio is designated as a hedge of net investment to reduce the volatility
in stockholders equity caused by changes in foreign currency exchange
rates in the functional currency of major foreign subsidiaries with respect to
the U.S. dollar. The company also uses currency swaps and foreign ex-
change forward contracts for this risk management purpose. The currency
effects of these hedges (approximately $200 million for the current period,
net of tax) are reflected as a loss in the Accumulated gains and (losses) not
affecting retained earnings section of the Consolidated Statement of Stock-
holders Equity, thereby offsetting a portion of the translation of the appli-
cable foreign subsidiaries net assets.
ANTICIPATED ROYALTIES AND COST TRANSACTIONS
The company’s operations generate significant nonfunctional currency,
third party vendor payments and intercompany payments for royalties, and
goods and services among the company’s non-U.S. subsidiaries and with
the parent company. In anticipation of these foreign currency cash flows
and in view of the volatility of the currency markets, the company selec-
tively employs foreign exchange forward and option contracts to manage
its currency risk. These contracts may have extended maturities beyond
one year and from time to time that extend to three years. As of December
31, Year 3, the maximum remaining maturity of these derivative instru-
ments was approximately 18 months, commensurate with the underlying
hedged anticipated cash flows.
SUBSIDIARY CASH AND FOREIGN CURRENCY AS-
SET/LIABILITY MANAGEMENT
The company uses its Global Treasury Centers to manage the cash of its
subsidiaries. These centers principally use currency swaps to convert cash
flows in a cost-effective manner. In addition, the company uses foreign
exchange forward contracts to hedge, on a net basis, the foreign currency
exposure of a portion of the company’s nonfunctional currency assets and
liabilities. The terms of these forward and swap contracts are generally less
CHAPTER 11 Financial Instruments and Liabilities
than one year. The changes in fair value from these contracts and from the
underlying hedged exposures are generally offsetting and are recorded in
Other (income) and expense in the Consolidated Statement of Earnings.
EQUITY RISK MANAGEMENT
The company is exposed to certain equity price changes related to certain
obligations to employees. These equity exposures are primarily related to
market value movements in certain broad equity market indices and in the
company’s own stock. Changes in the overall value of this employee com-
pensation obligation are recorded in SG&A expense in the Consolidated
Statement of Earnings. Although not designated as accounting hedges, the
company utilizes equity derivatives, including equity swaps and futures to
economically hedge the equity exposures relating to this employee com-
pensation obligation. To match the exposures relating to this employee
compensation obligation, these derivatives are linked to the total return of
certain broad equity market indices and/or the total return of the compa-
ny’s common stock. These derivatives are recorded at fair value with gains
or losses also reported in SG&A expense in the Consolidated Statement of
Earnings.
OTHER DERIVATIVES
The company holds warrants in connection with certain investments that,
although not designated as hedging instruments, are deemed derivatives
since they contain net share settlement clauses. During the year, the com-
pany recorded the change in the fair value of these warrants in net income.
The company is exposed to a potential loss if a client fails to pay amounts
due the company under contractual terms (credit risk). The company has es-
tablished policies and procedures for mitigating credit risk on principal
transactions, including reviewing and establishing limits for credit expo-
sure, maintaining collateral, and continually assessing the creditworthiness
of counterparties. In Year 3, the company began utilizing credit default
swaps to economically hedge certain credit exposures. These derivatives
have terms of two years. The swaps are not designated as accounting hedges
and are recorded at fair value with gains and losses reported in SG&A in
the Consolidated Statement of Earnings.
The tables on page xx summarize the net fair value of the company’s de-
rivative and other risk management instruments at December 31, Year 3
and Year 2 (included in the Consolidated Statement of Financial Position).
RISK MANAGEMENT PROGRAM
CHAPTER 11 Financial Instruments and Liabilities
(dollars in millions)
Hedge Designation
AT DECEMBER 31, Year 3 Fair Cash flow Net Non-Hedge/
Value Investment Other
Derivatives-net asset/
(liability):
Debt risk management $297 $(23) $ — $(10)
Long-term investments — — (27) —
in foreign
subsidiaries (net
investments)
Anticipated royalties — (643) — —
and cost transactions
Subsidiary cash and — — — (31)
foreign currency asset/
liability management
Equity risk management — — — 39
Other derivatives — — — 8
Total derivatives 297 (b) (666)(c) (27) (d) 6 (e)
Debt:
Long-term investments — — (2,470) (a) —
in foreign
subsidiaries (net
investments)
Total $297 $(666) $(2,497) $ 6
(a) Represents fair value of foreign denominated debt issuances formally desig-
nated as a hedge of net investment.
(b) Comprises assets of $1,083 million and liabilities of $786 million.
(c) Comprises liabilities of $666 million.
(d) Comprises liabilities of $27 million.
(e) Comprises assets of $73 million and liabilities of $67 million.
CHAPTER 11 Financial Instruments and Liabilities
(dollars in millions)
Hedge Designation
AT DECEMBER 31, Year 3 Fair Cash flow Net Non-Hedge/
Value Investment Other
Derivatives-net asset/
(liability):
Debt risk management $643 $ (7) $ — $ 3
Long-term investments — — 2 —
in foreign
subsidiaries (net
investments)
Anticipated royalties — (469) — —
and cost transactions
Subsidiary cash and — — — (109)
foreign currency asset/
liability management
Equity risk management — — — 6
Other derivatives — — — 10
Total derivatives 643 (b) (476)(c) 2 (d) (90) (e)
Debt:
Long-term investments — — (2,474) (a) —
in foreign
subsidiaries (net
investments)
Total $643 $(476) $(2,472) $(90)
(a) Represents fair value of foreign denominated debt issuances formally desig-
nated as a hedge of net investment.
(b) Comprises assets of $754 million and liabilities of $111 million.
(c) Comprises assets of $2 million and liabilities of $478 million.
(d) Comprises assets of $2 million.
(e) Comprises assets of $26 million and liabilities of $116 million.
ACCUMULATED DERIVATIVE GAINS OR LOSSES
As illustrated above, the company makes extensive use of cash flow hedg-
es, principally in the Anticipated royalties and cost transactions risk man-
agement program. In connection with the company’s cash flow hedges, it
has recorded approximately $454 million of net losses in Accumulated
gains and (losses) not affecting retained earnings as of December 31, Year
CHAPTER 11 Financial Instruments and Liabilities
3, net of tax, of which approximately $405 million is expected to be re-
classified to net income within the next year, providing an offsetting eco-
nomic impact against the underlying anticipated cash flows hedged.
The table on page xxx summarizes activity in the Accumulated gains and
(losses) not affecting retained earnings section of the Consolidated State-
ment of Stockholders Equity related to all derivatives classified as cash
flow hedges held by the company during the periods January 1, Year 1
(the date of the company’s adoption of FASB Topic ASC 815) through
December 31, Year 3:
(dollars in millions, net of tax) DEBIT/
(CREDIT)
Cumulative effect of adoption of FASB Topic ASC 815 as of January 1,
Year 1 $ (219)
Net gains reclassified into earnings from equity during Year 1 379
Changes in fair value of derivatives in Year 1 (456)
December 31, Year 1 (296)
Net losses reclassified into earnings from equity during Year 2 (5)
Changes in fair value of derivatives in Year 2 664
December 31, Year 2 363
Net losses reclassified into earnings from equity during Year 3 (713)
Changes in fair value of derivatives in Year 3 804
December 31, Year 3 $ 454
At December 31, Year 3, there were no significant gains or losses on deriva-
tive transactions or portions thereof that were either ineffective as hedges,
excluded from the assessment of hedge effectiveness, or associated with an
underlying exposure that did not occur; nor are there any anticipated in the
normal course of business.
Answer:
