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1 Illustrations of Accounting for Derivatives Extension of Chapter 11 Web This reading illustrates the accounting for the interest rate swaps in Examples 13 and 14 in Chapter 11. Web problem DERIVATIVE 1 illustrates the accounting for the forward foreign exchange contract in Example 12 and DERIVATIVE 2 illustrates the accounting for the forward whiskey price contract in Example 15. Fair Value Hedge: Interest Swap to Convert Fixed-Rate Debt to Variable-Rate Debt Refer to Examples 9 and 13 in Chapter 11. Firm B desires to maintain the market value of its note payable in the event that it wishes to repay it prior to maturity. Changes in interest rates will change the market value of its fixed-rate note. It enters into an interest swap contract to convert the fixed-rate debt into variable-rate debt. The net market value of the debt and its related swap contract will remain at $100,000 as long as the interest rate incorporated into the swap contract is the same as the rate used by the equipment supplier to value the note payable. Firm B designates the swap contract as a fair value hedge. Firm B issues the note to the supplier on January 1, Year 1, and makes the following entry: January 1, Year 1 Equipment ,000 Note Payable ,000 The swap contract is a mutually unexecuted contract on January 1, Year 1. The variable interest rate on this date is 8 percent, the same as the fixed rate for the note to the equipment supplier. The swap contract has a market value of zero on this date. Thus, Firm B makes no entry to record the swap contract. On, Firm B makes the required interest payment on the note for Year 1: Interest Expense ( x $100,000) x $100, ,000 Cash ,000 Interest rates declined during Year 1. On December 31, the counterparty with whom Firm B entered into the swap contract resets the interest rate for Year 2 to 6 percent. Firm B must restate the note payable to market value and record the change in the market value of the swap contract caused by the decline in the interest rate. The present value of the remaining cash flows on the note payable when discounted at 6 percent is: Present Value of Interest Payments: $8,000 x $ 14,667 Present Value of Principal: $100,000 x ,000 Total Present Value $103,667 [See Table 4, 2-period row, 6% column for factor and Table 2, 2-period row, 6% column for factor ] 1

2 Firm B makes the following entry to record the change in market value: Illustration of Accounting for Derivatives Extension of Chapter 11 2 Loss on Revaluation of Note Payable ,667 Note Payable ($103,667 $100,000) ,667 Firms typically do not revalue financial instruments, such as this note payable, to market value when interest rates change. They continue to account for the financial instruments using the interest rate at the time of the initial recording of the financial instrument in the accounts. When a firm hedges a financial instrument, however, it must recognize changes in market values. It must likewise recognize changes in the market value of the swap contract. The decline in interest rates to 6 percent means that Firm B will save $2,000 each year in interest payments. The present value of a $2,000 annuity for two periods at 6 percent is $3,667 (= $2,000 x ). Thus, the value of the swap contract increased from zero at the beginning of Year 1 to $3,667 at the end of the year. Firm B makes the following entry: Swap Contract ,667 Gain on Revaluation of Swap Contract ,667 The loss from the revaluation of the note payable exactly offsets the gain from the revaluation of the swap contract, indicating that the swap contract was effective in hedging the interest rate risk. Firm B follows a similar process at the end of Year 2. First, it records interest expense on the note payable: Interest Expense (0.06 x $103,667) ,220 Note Payable (plug) ,780 Cash (0.08 x $100,000) ,000 Firm B uses the effective interest method to compute interest expense for the year. The effective interest rate for Year 2 is 6 percent and the book value of the note payable at the beginning of the year is $103,667. The cash payment of $8,000 is the amount set forth in the original borrowing arrangement with the equipment supplier. Second, the firm records interest revenue for the change in the present value of the swap contract for the year. Swap Contract Interest Expense (0.06 x $3,667) Interest expense (net) as a result of the two entries is $6,000 (= $6,220 $220), which is the variable rate for Year 2 of 6 percent times the face value of the note. Third, Firm B receives $2,000 under the swap contract from the counterparty because interest rate decreased from 8 percent to 6 percent. Cash [$100,000 x ( )] ,000 Swap Contract ,000 The $2,000 cash received from the counterparty in a sense reimburses Firm B for paying interest at 8 percent on the note whereas the swap contract provides that the firm benefits when interest rates decline, in this case to 6 percent. Fourth, Firm B must revalue the note payable and the swap contract for changes in market value. Interest rates increased during Year 2, so the bank resets the interest rate in the swap agreement to 10 percent for Year 3. The present value of the remaining payments on the note at 10 percent is: Present Value of Interest Payment: $8,000 x $ 7,273 Present Value of Principal: $100,000 x ,909 Total Present Value $98,182

3 Illustration of Accounting for Derivatives Extension of Chapter 11 3 The book value of the note payable before revaluation is $101,887 (= $103,667 - $1,780). The entry to revalue the note payable is: Note Payable (Decrease in Book Value = $101,887 $98,182) ,705 Gain on Revaluation of Note Payable ,705 3,705 The market value of the swap contract decreases. Firm B must now pay an additional $2,000 in interest to the counterparty in Year 3 because of the swap contract. Thus, the swap contract becomes a liability instead of an asset. The present value of $2,000 when discounted at 10 percent is $1,818 (= $2,000 x ). The book value of the swap contract before revaluation is an asset of $1,887 (= $3,667 + $220 $2,000). The entry to revalue the swap contract is: Loss on Revaluation of Swap Contract ,705 Swap Contract ,887 Swap Contract ,818 The gain on revaluation of the note exactly offsets the loss on revaluation of the swap contract, so the swap contract hedges the change in interest rates. The entries for Year 3 are as follows: Interest Expense (0.10 x $98,182) ,818 Note Payable (plug) ,818 Cash (0.08 x $100,000) ,000 Interest Expense (0.10 x $1,818) Swap Contract Interest expense (net) after these two entries is $10,000 (= $9,818 + $182), which equals the variable interest rate of 10 percent times the face value of the note. Firm B must pay the counterparty an extra 2 percent because the variable interest rate of 10 percent exceeds the fixed interest rate of 8 percent. Swap Contract [$10,000 x ( )] ,000 Cash ,000 Firm B must also repay the note and close out the Swap Contract. Note Payable ($98,182 + $1,818) ,000 Cash ,000 The Swap Contract account has a zero balance (= $1,818 + $182 $2,000) on, after making the entries above, so it need make no additional entries to close out this account.

4 Illustration of Accounting for Derivatives Extension of Chapter 11 4 Exhibit 1 summarizes the effect of these entries on various accounts (credit entries in parentheses). EXHIBIT 1 Effects on Various Accounts of $100,000 Fixed-Rate Note and Related Interest Rate Swap Accounted for as a Fair-Value Hedge Equipment Notes Swap Income Cash (at cost) Payable Contract Statement Year 1 Issue Note for Equipment $100,000 $(100,000) Enter Swap Contract Record Interest on Note $ (8,000) $ 8,000 Revalue Note Payable (3,667) 3,667 Revalue Swap Contract $ 3,667 (3,667) $ (8,000) $100,000 $(103,667) $ 3,667 $ 8,000 Year 2 Record Interest on Note (8,000) 1,780 $ 6,220 Record Interest on Swap Contract (220) Record Swap Interest Received ,000 (2,000) Revalue Note Payable ,705 (3,705) Revalue Swap Contract (3,705) 3, $ (14,000) $100,000 $ (98,182) $(1,818) $ 6,000 Year 3 Record Interest on Note (8,000) (1,818) $ 9,818 Record Interest on Swap Contract $ (182) 182 Record Swap Interest Paid (2,000) 2,000 Repay Note Payable (100,000) 100, $(124,000) $100,000 $10,000 Net income reflects the variable interest rate each year: 8 percent for Year 1, 6 percent for Year 2, and 10 percent for Year 3. The note payable netted against the swap contract is $100,000 at the end of each year. Cash Flow Hedge: Interest Swap to Convert Variable-Rate Debt to Fixed-Rate Debt Refer to Examples 10 and 14 in Chapter 11. Firm C desires to hedge the risk of changes in interest rates on its cash payments for interest. It enters into a swap contract with a counterparty to convert its variable rate note payable to a fixed rate note. Firm C designates the swap contract as a cash flow hedge. The facts for the case are similar to those for Firm B. The note has a $100,000 face value, an initial variable interest rate of 8 percent, which the counterparty resets to 6 percent for Year 2 and 10 percent for Year 3. The note matures on. The entry to record the note payable is: January 1, Year 1 Equipment ,000 Note Payable ,000 Firm C records interest on the note for Year 1. Interest Expense (0.08 x $100,000) ,000 Cash ,000 The market value of the note in this case, unlike that for Firm B, will not change as interest rates change because the note carries a variable interest rate. The market value of the swap contract does change. The market value on December 31, Year 1, after the counterparty resets the interest rate to 6 percent is $3,667. This amount is the present value of the $2,000 that Firm C will pay the counterparty on December 31 of Year 2 and Year 3 if the interest rate remains at 6 percent. The entry is:

5 Illustration of Accounting for Derivatives Extension of Chapter 11 5 Accumulated Other Comprehensive Income (Unrealized Loss on Swap Contract) ,667 Swap Contract ,667 The loss from the revaluation of the swap contract does not affect net income immediately on a cash flow hedge. Instead, it reduces other comprehensive income for Year 1 and accumulated other comprehensive income on. Note that the book value of the note payable of $100,000 plus the book value of the swap contract of $3,667 is $103,667. This amount is the present value of the expected cash flows under the variable rate note and swap contract combined, discounted at 6 percent. The entry on to recognize and pay interest on the variable rate note is: Interest Expense (0.06 x $100,000) ,000 Cash ,000 Firm C must also increase the book value of the swap contract for the passage of time. Accumulated Other Comprehensive Income (Unrealized Loss on Swap Contract) (0.06 x $3,667) Swap Contract Note that the interest charge does not affect net income immediately but instead decreases accumulated other comprehensive income. Firm C pays the counterparty the $2,000 [= $100,000 x ( )] required by the swap contract. The entry is: Swap Contract ,000 Cash ,000 Because the swap contract hedged cash flows related to interest rate risk during Year 2, Firm C reclassifies a portion of accumulated other comprehensive income to net income. The entry is: Interest Expense [$100,000 x ( )] ,000 2,000 Accumulated Other Comprehensive Income (Unrealized Loss on Swap Contract) ,000 The Swap Contract account has a credit balance of $1,887 (= $3,667 + $220 $2,000). Accumulated other comprehensive income on, related to this transaction likewise has a debit balance of $1,887. Interest Expense on the income statement is $8,000 (= $6,000 + $2,000). Restating the interest rate on, to 10 percent changes the value of the swap contract from a liability to an asset. The present value of the $2,000 that Firm C will receive from the counterparty at the end of Year 3 when discounted at 10 percent is $1,818. The entry to revalue to swap contract is: Swap Contract ,887 Swap Contract ,818 Accumulated Other Comprehensive Income (Unrealized Loss on Swap Contract) ,887 Accumulated Other Comprehensive Income (Unrealized Gain on Swap Contract) ,818 Accumulated other comprehensive income on, now has a credit balance of $1,818, which equals the debit balance in the Swap Contract account.

6 Illustration of Accounting for Derivatives Extension of Chapter 11 6 The entry during Year 3 to recognize and pay interest on the variable rate note is: Interest Expense (0.10 x $100,000) ,000 Cash ,000 Firm C also increases the book value of the swap contract for the passage of time. Swap Contract (0.10 x $1,818) Accumulated Other Comprehensive Income (Unrealized Gain on Swap Contract) (Unrealized Gain.... on.. Swap.... Contract) The swap contract requires the bank to pay the firm $2,000 under the swap contract. Cash [$100,000 x ( )] ,000 Swap Contract ,000 Because the swap contract hedged cash flows related to interest rate risk during Year 3, Firm C reclassifies a portion of other comprehensive income to net income. The entry is: Accumulated Other Comprehensive Income (Unrealized Gain on Swap Contract) ,000 (Unrealized Gain on Swap Contract) ,000 Interest Expense ,000 Interest expense for Year 3 is $8,000 (= $10,000 $2,000). Firm C repays the note on. Notes Payable ,000 Cash ,000 It must also close out the swap contract account. This account has a balance of zero on (= $1,818 + $182 $2,000). Thus, Firm C need make no entry. If the swap contract had been highly, but not perfectly, effective in neutralizing the interest rate risk, then accumulated other comprehensive income would have a balance related to the swap contract, which Firm C would reclassify to net income at this point. Exhibit 2 summarizes the effect of these entries on various accounts (credit entries in parentheses). EXHIBIT 2 Effect on Various Accounts of $100,000 Variable-Rate Note and Related Interest Rate Swap Accounting for as a Cash-Flow Hedge Other Equipment Notes Swap Income Compre. Cash (at cost) Payable Contract Statement Income Year 1 Issue Note for Equipment $100,000 $(100,000) Enter Swap Contract Record Interest on Note $ (8,000) $ 8,000 Revalue Swap Contract $(3,667) $ 3, $ (8,000) $100,000 $(100,000) $(3,667) $ 8,000 $ 3,667 (continued on next page)

7 (Exhibit 2 continued) Illustration of Accounting for Derivatives Extension of Chapter 11 7 Year 2 Record Interest on Note (6,000) $ 6,000 Record Interest on Swap Contract (220) 220 Record Swap Interest Paid (2,000) 2,000 Reclassify Portion of Accumulated Other Comprehensive Income ,000 (2,000) Revalue Swap Contract ,705 (3,705) $ (16,000) $100,000 $(100,000) $ 1,818 $ 8,000 $(1,818) Year 3 Record Interest on Note (10,000) $10,000 Record Interest on Swap Contract (182) Record Swap Interest Received ,000 (2,000) Reclassify Portion of Accumulated Other Comprehensive Income (2,000) 2,000 Repay Note Payable (100,000) 100,000 Close Out Swap Contract $(124,000) $100,000 $ 8,000 Note that interest expense is $8,000 each year, the fixed rate of 8 percent that Firm C accomplished by entering into the swap contract. The amounts in other comprehensive income reflect changes in the market value of the swap contract. The swap contract begins and ends with a zero value. Problems DERIVATIVE 1 Accounting for forward foreign exchange contract. Refer to Examples 8 and 11. Firm A places its firm order for the equipment on June 30, Year 1. It simultaneously signs a forward foreign exchange contract for 10,000 at the forward rate for June 30, Year 2, of $1.64 per 1. Firm A designates the forward foreign exchange contract as a fair value hedge of the firm commitment. a. GAAP do not require Firm A to record either the purchase commitment or the forward foreign exchange contract on the balance sheet as a liability and an asset on June 30, Year 1. What is GAAP s reasoning? b. On, the forward foreign exchange rate for settlement on June 30, Year 2, is $1.73 per 1. Give the journal entries to record the change in the value of the purchase commitment and the change in the value of the forward contract for Year 1. Assume an 8 percent per year interest rate for discounting cash flows to their present values on. c. Give the journal entries on June 30, Year 2, to record the change in the present value of the purchase commitment and the forward foreign exchange contract for the passage of time. d. On June 30, Year 2, the spot foreign exchange rate is $1.75 per 1. Give the journal entries to record the change in the value of the purchase commitment and the change in the value of the forward contract due to changes in the exchange rate during the first six months of Year 2. e. Give the journal entry on June 30, Year 2, to purchase 10,000 with U.S. dollars and acquire the equipment. f. Give the journal entry on June 30, Year 2, to settle the forward foreign exchange contract. DERIVATIVE 2 Accounting for forward commodity contract. Refer to the information for Firm D in Examples 11 and 15 in Chapter 11. Firm D holds 10,000 gallons of aging whiskey in inventory on October 31, Year 1, that cost $225 per gallon. Firm D expects to complete aging of the whiskey on March 31, Year 2. On October 31, Year 1, it purchases a forward contract for 10,000 gallons of whiskey for delivery on March 31, Year 2 at a price of $320 per gallon. The forward price for whiskey on, for delivery on March 31, Year 2, is $310 per gallon. The spot price for whiskey on March 31, Year 2, is $270 per gallon. Firm D sells the whiskey on this date for $270 per gallon. To simplify this problem, ignore the effects of the time value of cash. a. Assume for this part that Firm D classifies the forward contract as a fair value hedge of the value of the inventory. Give the journal entries for Firm D on October 31, Year 1,, and March 31, Year 2. b. Assume for this part that Firm D classifies the forward contract as a cash flow hedge. Give the journal entries for Firm D on October 31, Year 1,, and March 31, Year 2.

8 Illustration of Accounting for Derivatives Extension of Chapter 11 8 DERIVATIVE 3 Journal entries for hedging transactions. Fixed Issue Company issued 9 percent, fixed-rate, semiannual coupon bonds on January 1 at par for $10 million. It simultaneously entered into an interest-rate swap with Counterparty Bank: Fixed will pay the bank at the end of each six-month period if interest rates at the beginning of the six-month period exceed 9 percent; and the bank will pay Fixed if interest rates at the beginning of the six-month period are below 9 percent. If the market rate is r at the beginning of each six-month period, then the bank will pay Fixed at the end of the six-month period an amount equal to 1 2 x (0.09 r) x $10,000,000. The market interest rate is 9 percent at the time of issue. Interest rates decrease to 6 percent by the end of the first six-month period, increasing the market value of the bonds to $14 million and increasing the market value of the interest-rate swap to $3.8 million. By the end of the year, interest rates rise to 7 percent and the market value of the bonds decreases to $12.75 million. The market value of the interest-rate swap decreases to $2.7 million during the period from July 1 through December 31. a. Record journal entries for the following dates: January 1, at the time of bond issue; June 30, at the time of the first debtservice payments; and December 31, at the time of the second debt-service payments. b. Is this a fair-value hedge or a cash-flow hedge? Has the hedge fulfilled its purpose? DERIVATIVE 4 Journal entries for hedging transactions. On January 1, when the interest rate is 9 percent per year, Floating Issue Company issued at par $10 million of variable-rate bonds, with semiannual interest payments based on the market interest rate at the beginning of each six-month period. It simultaneously entered into an interest-rate swap with Counterparty Bank: it agrees to pay the bank at the end of each six months the difference between 9 percent interest and any variable interest rate below 9 percent as of the beginning of the six-month period; the bank agrees to pay Floating for any difference between the variable rate and 9 percent when the variable rate exceeds 9 percent at the beginning of the sixmonth period. If the market rate is r at the beginning of the six-month period, then Floating will pay the bank at the end of the six-month period an amount equal to 1 2 x (0.09 r) x $10,000,000. The market interest rate is 9 percent at the time of issue. Interest rates decrease to 6 percent by the end of the first six-month period. Floating will pay interest at the rate of 9 percent for the first six-month period and at the rate of 6 percent for the second six-month period. The market value of the variable-rate bonds does not change. The market value of the interest-rate swap decreases to $3.8 million by the end of the first six-month period. By the end of the year, interest rates rise to 7 percent. The market value of the variable-rate bonds continues not to change, but the market value of the interest-rate swap increases to $2.7 million. a. Record journal entries for the following dates: January 1, at the time of bond issue; June 30, at the time of the first debtservice payments; December 31, at the time of the second debt-service payments. b. Is this a fair-value hedge or a cash-flow hedge? Can you tell how effectively the hedge has fulfilled its purpose?

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