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P11-6. Call options as investments (LO 11-7)
Required entries for 1 through 3:
July 1, 2017:
July 31, 2017:
August 31, 2017:
The unrealized holding gains and losses flow directly to income
each month.
Requirement 4:
The option contracts are “underwater” on July 31, meaning that the
$40 exercise price is above the $38 market price for Selmer stock.
That’s what has happened by August 31. Now the options are “in
Requirement 5:
If Getz exercises the stock options on September 15, he will turn in
September 15, 2017:
Requirement 6:
If the option contracts were allowed to expire on September 15
(presumably because the market price of Selmer stock was below
$40), the entry is:
P11-7. Fair value option and retiring debt early (LO 11-2, LO 11-4, LO
11-5)
Requirement 1: Bond price at issuance
Because the coupon rate and the market rate are the same, the
Market value - tables
Paymen
$3,000,000 = $75,000,000 x 8% ÷ 2.
Requirement 2: Journal entries during 2017
January 1, 2017
To record bond issuance
June 30, 2017
To record interest expense
December 31, 2017
To record interest expense
To record change in bond price
After the second journal entry, the bonds payable net of the
*Price adjustment calculation
Remaining periods 18
Market rate 6%
Payments per year 2
Fair value (tables)
Requirement 3: General rates remain at 6% but Tango's rate is 10%
June 30, 2018
To record interest expense
December 31, 2018
To record interest expense
To record change in bond price
To record change in bond price
a
Price adjustment that effects net income
The fair value changes because there are fewer payments remaining.
Fair value (tables)
This adjustment will decrease the book value of the bond.
b
Price adjustment that affects OCI
Fair value (tables)
Check of bond payable book value
Requirement 4 - Bond retirement on 1/1/2019
DR OCI - Bonds payable gain (credit risk)
17,549,490
To transfer gain from AOCI
Requirement 5 - Bond retirement on 1/1/2019 (no fair value option)
The gain is lower because the debt had not been increased to fair value in prior years.
P11-8. Citigroup and the fair value option (LO 11-4)
Requirement 1:
The bonds were issued on January 1, 2005 at par, so the proceeds
received by Citigroup are equal to the face value ($500 million) of
Requirement 2:
Using a market interest rate of 12%, the market value of the bonds
Requirement 3:
Let’s illustrate the effect of escalating credit risk using the results in
Requirements 1 and 2. Investors who believe on January 1, 2005
that Citigroup’s credit risk is accurately captured by the 6% stated
interest rate will be willing to pay par value ($500 million) for the
Now, let’s jump forward in time. If investors still believed on January
1, 2009 that Citigroup’s credit risk is accurately captured by the 6%
stated interest rate, they will continue to price the bonds at par value
($500 million). [You should verify this fact.] On the other hand, if
Requirement 4:
Citigroup elected to use the fair value option in accounting for its
debt, and thus recorded the following journal entry:
The fair value adjustment reduces the balance sheet carrying value
Requirement 5:
Opponents of the fair value accounting option for debt point to the
counter-intuitive financial statement result: as a company’s credit
risk increases and the slow march toward bankruptcy ensues, it
reports higher earnings because of the fair value accounting
P11-9. Chalk Hill: Using an interest-rate swap as a speculative
investment
(LO 11-7, LO 11-8)
Because the swap contract does not qualify for special hedge
accounting rules, two aspects of the solution in Exhibit 11.11 will
change: (1) interest expense on the company’s variable rate debt
January 1, 2017:
December 31, 2017:
December 31, 2018:
December 31, 2019:
P11-10. Hedging raw material price swings (LO 11-7, LO 11-8)
Requirement 1:
Pulp-paper futures contracts can be used to “lock in” a specific
price for anticipated future inventory purchases. However, the
Requirement 2:
If commodity prices fall, the value of Brosnan’s pulp-paper futures
contracts will also decline. At the same time, Brosnan will be
paying less for its anticipated paper purchases. Some or all of the
Requirement 3:
By executing a forward contract for ink with a supplier, Brosnan
can again “lock in” its inventory purchase price. The upside
potential for Brosnan is that the supplier (and Brosnan) may agree
Requirement 4:
There’s downside risk as well: Brosnan and the supplier may
agree to a contract price that is above the actual future price of ink.
