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P11-23. Hedging a Planned Sale (LO 11-7, LO 11-8)
Requirement 1:
Newton plans to sell some of its corn inventory next March, six
months from now (October). This sale will take place at the March
market price. However, Newton does not want to be exposed to
Requirement 2:
The forward contract has zero value at inception, as indicated in
Requirement 4:
The following entries are made on March 15:
DR Other comprehensive income $70,000
DR Cash $25,000
Notice that the total revenue and cash flow from selling corn is
Requirement 5:
The answer to this question depends on how Newton designates
the forward contract hedge. If Newton designates the forward
contract as a cash flow hedge of 50% of planned sale of corn
inventory, the hedge is “fully effective”. In this case, the entries
If Newton designates the forward contract as a cash flow hedge of
the entire planned sale of corn inventory, the hedge would be
considered “ineffective” under GAAP and thus not qualify for
P11-24. Using an interest-rate swap as a cash flow hedge (LO 11-7, LO
11-8)
Requirements 1 and 2:
The analysis is summarized in the following table.
Notional Interest Cash
amount rate interest
July 1, 2018:
The July 1, 2018 “net cash settlement” for Basie is zero because
the fixed-rate payment and the variable-rate payment are the
Basie pays First Kansas City $300,000 on July 1, 2018 and
$312,500 on July 1, 2019. Notice that the July 1, 2019 payment is
Requirements 3 and 4:
The swap contract has zero value at inception, as indicated in the
problem statement, so there is no entry made when the contract is
signed.
No entry is made to record “net cash settlement” for the swap
because it is zero.
The following entry is made on July 1, 2018:
Although not required by the problem statement, the following
entries are made on July 1, 2018:
P11-25. Using an interest-rate swap as a fair value hedge (LO 11-7, LO
11-8)
Requirement 1: Cash settlements on swap:
The December 31, 2017 “net cash settlement” for Four Brothers is
zero because the fixed-rate and the variable-rate are the same,
Requirement 2: Cash paid to Guiffrie on bond
Requirement 3: 2017 journal entries
The swap contract has zero value at inception, as indicated in the
problem statement, so there is no entry made when the contract is
signed.
DR Guiffrie Bank Loan (debt) $45,000
(To record the change in fair value of the swap contract)
No entry is made to record “net cash settlement” for the swap
contract because it is zero.
Requirement 4: 2018 journal entries
CR Cash $25,000
(To record the “net cash settlement” payment to Herman Bank)
DR Swap contract $68,000
Swap Contract
P11-26. Determining hedge Effectiveness (LO 11-7, LO
11-8)
Requirement 1: Journal entries – no hedge treatment
Because the futures contracts are deemed “ineffective” for GAAP
purposes, the special hedge accounting rules cannot be used.
October 1, 2017:
December 31, 2017:
DR Futures contracts $200,000
CR Gain (loss) on futures contracts $200,000
(To record the change in fair value of the futures contracts: 5
million pounds at 4 cents per pound.)
February 26, 2018:
DR Cash $ 50,000
DR Accounts receivable$9,400,000
DR Cost of goods sold 6,500,000
(To record the sale of copper and reduce the inventory account
by the original cost of the copper.)
Requirement 2: Journal entries with half the futures effective
Now the futures contracts are deemed “effective” for GAAP
October 1, 2017:
No journal entry
December 31, 2017:
February 26, 2018:
DR Cash $ 50,000
DR Copper inventory $150,000
(To record the sale of copper and reduce the inventory account
by the adjusted cost of the copper.)
Requirement 3: Impact on financial statements
These journal entries illustrate how the income statement and the
balance sheet are affected by the definition of the hedged item.
Notice how the first set of entries (requirement 1) gives rise to
greater earnings volatility because changes in the fair value of the
Financial Reporting and Analysis (7th Ed.)
Chapter 11 Solutions
Financial Instruments and Liabilities
Cases
Cases
C11-1. Century and beyond bonds (LO 11-1, LO 11-2)
Requirement 1: Present value of principal to price
The issue price of Draper’s $200 million century bonds is also $200
million. The follows from the fact that the market yield (7.5%)
exactly equals the stated interest rate. A financial calculator on
To find the principal contribution to issue price, we need to
determine the present value of $200 million to be received 100
years from January 1, 2017 using the market yield of 7.5% as our
discount rate. The present value factor for a single payment in 100
periods at 7.5% is 0.000723. Multiplying this factor by the amount
of the payment ($200 million) yields a present value of $145,000
What about the interest payment stream? Well, interest payments
must contribute the remaining amount of the issue price
Requirement 2: Tax savings
The present value of the company’s interest tax deduction is equal
to the present value of the interest payment stream, multiplied by
the effective tax rate of 35%. This tax savings present value is
To find the amount of tax savings lost if only the first 40 years of
interest payments are deductible, we first need to find the present
interest payment—at 7.5% is $188.916 million. The tax benefit of
this 40-year deduction is $66.121 million ($188.916 million x 35%) in
Requirement 3: Issue price at different rates
The market yield (8.5%) is above the stated (coupon) interest rate,
and this means the $200 million century bonds will sell at a discount
to their face value. To find the issue price using a financial calculator
Requirement 4: Ohio State bond
A major source of cash for educational institutions such as The Ohio
State University is tuition paid by students. The primary economic
benefit from issuing century bonds is that Ohio State has access to
$500 million cash immediately rather having to wait until sometime
Requirement 5: Reason for Treasury or Congress intervention
Both the treasury and Congress are concerned that these bonds do
not meet the definition of debt, and therefore, should not receive the
Requirement 6: GAAP treatment
GAAP currently treats century and millennium bonds, as they are
described here, as debt. This may change in the future.
