42. North Shore Railroad operates between Chicago and upper Michigan and Wisconsin. Dallas Ingold,
purchasing manager of North Shore Railroad, anticipates the price of diesel fuel will increase over the next few
months. On September 4th, Ingold purchased an out-of-the-money November call option for $1,100. The option
has a notional amount of 80,000 barrels and a strike price of $2.16 per barrel. Diesel fuel spot rates and option
values at selected dates follow:
Spot Rate
Option
Date
per Barrel
Value
September 30
$2.17
$1,130
October 31
2.13
1,026
November 27
2.19
2,400
a.
For each of the above dates, calculate the intrinsic value and the time value of the option.
b.
If the price of diesel fuel remained below $2.16 per barrel through November, calculate the effect on earnings traceable to the hedge.
Sept. 30
Oct. 31
Nov. 30
Total value
$1,130
$1,026
$2,400
Intrinsic value:
80,000 ´ ($2.17 $2.16)
Out of the money *
0
80,000 ´ ($2.19 $2.16)
Time value
$ 330
$1,026
$ 0
43. During the second quarter of 20X5, Bertke Company entered into a futures contract that calls for the sale of
2,500 tons of soybean meal in July at a future price of $13.26 per ton. Bertke Company designated the contract
as a hedge on a forecasted sale of soybean meal. The changed in the time value of the futures contract is
excluded from the assessment of hedge effectiveness. The information regarding the contract and soybean meal
is as follows:
April 1
April 30
June 30
Spot price per ton
$13.21
$13.18
$13.10
Futures price per ton
13.16
13.12
13.05
Required:
Prepare a schedule to show the effect of this hedge on current earnings of Bertke Company.
Apr. 1
Apr. 30
May 31
Jun. 30
Fair value of contract:
2,500 x (13.26 – 13.16)
$250
2,500 x (13.26 – 13.12)
$350
2,500 x (13.26 – 13.11)
$375
2,500 x (13.26 – 13.05)
$525
Intrinsic value of contract:
2,500 x (13.18 – 13.21)
75
2,500 x (13.14 – 13.18)
100
2,500 x (13.10 – 13.14)
100
Change in fair value
100
25
150
Change in intrinsic value
(100)
(100)
Change in time value (effect on earnings)
25
50
44. On January 3, 20X4, Realto Company issued a $5,400,000, 3-year note payable with a fixed interest rate of
8% payable semiannually. By the end of June 20X5, Realto’s controller, believed that interest rate would fall
over the next year. On July 3, 20X5, Realto Company entered into an interest rate swap with the First Columbia
Bank. The bank required a premium of $10,400. The swap had a notional amount of $5,400,000 and called for
the payment of a variable interest rate in exchange for the 8% fixed rate. The variable rates are reset
semiannually beginning on July 1, 20X5, in order to determine the next interest payment. Differences between
rates on the swap will be settled on a semiannual basis. Variable interest rates and the value of the swap on
selected dates are as follows:
Variable
Interest
Value of
Rate
the Swap
July 1, 20X5
7.90%
December 31, 20X5
7.60
$18,900
June 30, 20X6
7.35
16,200
Required:
For December 31, 20X5, determine:
a.
The net interest expense.
b.
The carrying value of the note payable.
Net interest expense:
Fixed interest (8% ´ $5,400,000 ´ 1/2 year)
$216,000
Settlement of rate difference:
(8% vs. 7.9% on $5,400,000 ´ 1/2 year)
(2,700)
Net interest expense
$213,300
b.
Carrying value of note payable
Original face value of note
$5,400,000
Change in value of debt
18,900
Carrying value of debt
$5,418,900
45. On March 1, 20X1, Adler Company issued a 5 year, $150,000 note at 7% fixed interest, payable
semiannually on August 31st and February 28th. Based on the economic conditions on March 1, 20X3, Adler
Company believes the interest rate will decline over the next few years. As a result Adler Company enters into
an interest rate swap where it agrees to pay the LIBOR of 6.75% for the first 6 months. At the end of each 6-
month period the variable rate will be reset to the current LIBOR. The LIBOR on September 1, 20X3 is 7.75%.
Required:
a.
For August 31, 20X3 and February 28, 20X4, determine the net interest expense.
b.
Identify the type of hedge.
August 31
February 28
20X3
20X4
Net interest expense:
Fixed interest
($150,000 ´ 7% ´ 1/2)
$5,250.00
$5,250.00
Settlement of rate differences:
$150,000 ´ (6.75% – 7%) ´ 1/2
(187.50)
$150,000 ´ (7.75% – 7%) ´ 1/2
562.50
Net interest expense
$5,062.50
$5,812.50
46. On June 30, 20X5, Adams Company had a $500,000, 7.4% fixed rate note due in 2 years. The note has been
outstanding since May 26, 20X4 and the interest on the note is paid on June 30 and December 31 each year. The
controller of Adams believed that interest rates would drop over the next two years, so he entered into a 2-year
swap with Belmont National Bank to convert the fixed-rate note into a variable-rate note. According to the
agreement, Adams Company will receive interest at a fixed rate of 7.4% and will pay a variable rate as
determined by LIBOR. The LIBOR on June 30, 20X5 was 7.1%. The swap agreement calls for the variable rate
to be reset each six months. The swap fair value on December 31, 20X5 was $6,300.
Required:
a.
Present the journal entries, if
any, to record the following
events:
1.
The entry to record the swap on June 30, 20X5.
2.
The entries to record the semiannual interest payment on the debt and the settlement of the semiannual
swap on December 31, 20X5.
3.
The entries to record changes in fair value required by the above information on December 31, 20X5.
b.
Present a partial balance sheet
and income statement for the
fiscal year ended December 31,
20X5 to include accounts
affected by the above
information.
1.
No entry is necessary on June 30 since the fair value
of the swap at inception is zero.
2.
December 31, 20X5
Interest expense
18,500
Cash
18,500
$500,000 ´ 7.4% ´ 1/2
Cash
750
Interest expense
750
(7.4% – 7.1%) ´ $500,000 ´ 1/2
3.
December 31, 20X5
Loss on debt
6,300
Note payable
6,300
Interest rate swap asset
6,300
Gain on swap
6,300
b.
Adams Company
Partial Balance Sheet
December 31, 20X5
Assets
Interest rate swap asset
$6,300
Liabilities
Notes payable
$506,300
47. Jensen Company forecasts a need for 200,000 pounds of cotton in May. On April 11, the company acquires
a call option to buy 200,000 pounds of cotton in May at a strike price of $0.3765 per pound for a premium of
$814. Spot prices and options values at selected dates follow:
April 11
April 30
May 3
Spot price per pound
$0.3718
$0.3801
$0.3842
Fair value of option
814
1,137
1,689
Jensen Company settled the option on May 3 and purchased 200,000 pounds of cotton on May 17 at a spot price of $0.3840 per pound. During the
last half of May and the beginning of June the cotton was used to produce cloth. One third of the cloth was sold in June. The change in the option’s
time value is excluded from the assessment of hedge effectiveness.
Required:
a.
Prepare all journal entries necessary through June to record the above transactions and events.
b.
What would the effect on earnings have been if the forecasted purchase were not hedged?
48. Pearson Industries uses platinum in its manufacturing process. The company will need 1,500 troy ounces of
platinum for a production run in June. The company is concerned that platinum prices will rise over the next
several months. On May 14, in order to hedge against rising prices, Pearson Industries purchases 30 June call
options on platinum. Each option is for 50 troy ounces and has a strike price of $477 per troy ounce. The
company excludes changes in the time value of the options from hedge effectiveness. Spot prices and option
value per troy ounce of platinum are as follows:
May 14
May 31
Spot price
$479
$486
Option value per oz.
9.60
14.38
On June 8, the company settled the options and on June 9 purchased 3,250 troy ounces of platinum on account for $493 per ounce. The platinum was
used in the production process through the end of September. Platinum used during June was 325 troy ounces. Assume that the hedge satisfies all
necessary criteria for special hedge accounting.
Required:
Prepare all journal entries necessary to account for the above transactions and events.
May 14
May 31
June 8
Strike price
$ 477
$ 477
$ 477
Spot price
479
486
492
Notional amount
1,500
1,500
1,500
Intrinsic value
(Strike < spot)
Time value
11,400
8,070
2,010
Total value
($9.60 ´ 1,500)
14,400
($14.38 ´ 1,500)
21,570
($16.34 ´ 1,500)
24,510
May
14
Investment in call option (1,500 ´ $9.60)
14,400
Cash
14,400
May
31
Investment in call option (21,570 – 14,400)
7,170
Loss on option (8,070 – 11,400)
3,330
Other comprehensive income
10,500
June
8
Investment in call option (24,510 – 21,570)
2,940
Loss on option (2,010 – 8,070)
6,060
Other comprehensive income
9,000
June
8
Cash
24,510
Investment in call option (1,500 x $16.34)
24,510
June
9
Inventory of platinum (1,500 ´ $493)
739,500
Accounts payable
739,500
June
Cost of goods sold (325 x $493)
160,225
Inventory of platinum
160,225
June
Other comprehensive income
4,225
Cost of good sold
4,225
49. On July 1, 20X1, Littleton Inc. loaned a key supplier of raw material $2,000,000 to construct a new
processing facility. The loan is due on July 1, 20X3 and pays interest each December 31 and June 30. The
supplier insisted on a variable rate loan. Charles Upton, controller of Littleton Inc., wants to avoid the risk of
variable interest rate fluctuations. As a result, Littleton Inc. entered into an interest rate swap in which it will
pay the variable rate on $2,000,000 in exchange for a fixed interest rate of 8.3%. The swap is settled on the
interest payment dates. Variable interest rates and the value of the swap on selected dates are as follows:
Variable
Interest
Value of
Rate
the Swap
July 1, 20X1
7.90%
December 31, 20X1
7.75%
$10,400
Required:
Prepare all entries to record this hedge through December 31, 20X1.
July 1, 20X1
Notes receivable
2,000,000
Cash
2,000,000
Dec 31, 20X1
Cash
79,000
Interest income
79,000
$2,000,000 ´ 7.9% ´ 1/2
Cash [(8.3% – 7.9%) ´ $2,000,000 ´ 1/2]
4,000
Other comprehensive income
14,400
Other comprehensive income
4,000
Interest income
4,000
50. Paton Company has an $11,000,000, note payable outstanding with a variable rate equal to LIBOR of 8.4%
which matures on June 30, 20X3. The variable rates are reset each 6 months for the following 6-month period.
The company believes that interest rates have bottomed, and they will begin to rise. At the end of June 20X1,
Paton Company negotiated an interest rate swap with York National Bank of Bellingham that would allow
Paton to pay a fixed rate of 7.75% in exchange for receiving interest based on the LIBOR. The swap is effective
July 1, 20X1. The settlement date for the swap coincides with the company’s interest payment dates.
The criteria for special accounting have been satisfied, and the hedging relationship has been properly
documented. Management of Paton Company has concluded that the hedge will be highly effective. Paton
Company’s fiscal year end is June 30. The LIBOR and swap values are as follows:
LIBOR
Swap Value
June 30, 20X1
8.40%
December 31, 20X1
8.55%
$19,300
June 30, 20X2
8.10%
(8,010)
Required:
Present the journal entries to record the above events from December 31, 20X1 through June 30, 20X2.
December 31, 20X1
Interest expense [8.4% $11,000,000 1/2]
Cash
462,000
Cash [(8.4% 7.75%) $11,000,000 1/2]
Interest rate swap
19,300
Other comprehensive income
55,050
Other comprehensive income
35,750
Interest expense
35,750
June 30, 20X2
Interest expense [8.55% $11,000,000 1/2]
Cash
470,250
Cash [(8.55% 7.75%) $11,000,000 1/2]
Interest rate swap (19,300 + 8,010)
27,310
Other comprehensive income
16,690
Other comprehensive income
44,000
Interest expense
44,000
51. Explain how a derivative instrument may be used to reduce or avoid the exposure to risk associated with
other transactions.
52. Identify the various types of information that should be included in disclosures regarding derivative
instruments and hedging.
The FASB requires entities that hold or issue derivative instruments that are designated and qualify as hedging
instruments to disclose information that allows users to understand: