Chapter 7, Problem 63P

a.

To determine

Mention whether the given transaction will be treated as a fair value hedge or a cash flow

hedge and explain its reason.

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

Gains and losses on cash flow hedges are stationed in accrued other systematic earnings until the sales arise and then allocated to the income statement to offset the losses and benefits in those transactions.

Hedging the exposure of a recognized asset or liability or a forecast transaction to cash flow variability that is attributable to a particular risk (referred to as a cash flow hedge).

This transaction will be taken into account as a cash-flow hedge. Our projected sales are considered a transaction foreseen. A foreign currency cash flow hedge will be a derivative instrument that hedges the foreign currency exposure to the variability of cash flows associated with a forecast transaction. Using an option contract to offset a loss qualifies for accounting for cash-flow hedge, provided it is highly effective.

b.

To determine

Mention the accounting treatment for this transaction.

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

Gains and losses on cash flow hedges are stationed in accrued other systematic earnings until the sales arise and then allocated to the income statement to offset the losses and benefits in those transactions.

Hedging the exposure of a recognized asset or liability or a forecast transaction to cash flow variability that is attributable to a particular risk (referred to as a cash flow hedge).

The fair value of the option contract is to be recorded on the balance sheet. Changes of the option's time value are currently recorded in earnings. Changes in the intrinsic value of the option are recorded in other comprehensive revenue, to the extent that they are effective as a hedge. The balance in other comprehensive income at the date of sale is reclassified into earnings.

c.

To determine

Compute the option’s intrinsic value and total value on Sep 30, Dec 31 and March 31.

Explanation of Solution

An options contract is an agreement between a buyer and a seller which gives the option

buyer the right to buy or sell a particular asset at an agreed price at a later date. Options

contracts are often used in transactions involving securities, commodities, and real

estate.

Date	Time Value (Dealer Quote)	Intrinsic Value	Total Value
Sep 30	$20,000	$0	$20,000
Dec 31	$9,000	$238,095	$247,095
Mar 31 (next year)	$0	$652,174	$652,174

Working notes:

Intrinsic value is computed based on the changes in spot rates as compared to the strike rate: (NZD 10,000,000/2.00 = $5,000,000) less (NDZ 10,000,000/2.10 = $4,761,905) = $238,095. (NZD 10,000,000/2.00 = $5,000,000) less (FC 10,000,000/2.30 = $4,347,826) = $652,174. The increase in intrinsic value is $414,079 ($652,174 less $238,095).

d.

To determine

Prepare the journal entries for the following:

1. 1. Purchase of the purchased option premium of $20,000 on March 31.
2. 2. The change in the time value and intrinsic value of the option on December 31.
3. 3. The change in the time value and intrinsic value of the option on March 31.
4. 4. Cash sales to foreign customer in the amount of NZD 10,000,000 at the spot rate of NZD 2.30:$1.
5. 5. Net cash settlement of the option at its maturity on March 31.
6. 6. Adjusting entry to transfer any deferred gains (losses) from AOCI into current earnings as of March 31.

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

A forward contract is a custom designed agreement between two parties to buy or sell an asset on a future date at a specified price. For hedging or speculation a forward contract may be used, although its non-standardized nature makes it particularly suitable for hedging.

1.	Foreign currency option	$\$20,000$
	Cash		$\$20,000$
	(To record the premium paid on the purchased option)
2.	Loss on hedging activity	$\$11,000$
	Foreign currency option		$\$11,000$
	(To record the change in the time value of the option ($9,000 − $20,000))
	Foreign currency option	$\$238,095$
	Other comprehensive income		$\$238,095$
	(To record the change in the intrinsic value of the option ($238,095 −  $0))
3.	Loss on hedging activity	$\$9,000$
	Foreign currency option		$\$9,000$
	(To record the change in the time value of the option))
	Foreign currency option	$\$414,079$
	Other comprehensive income		$\$414,079$
	(To record the change in the intrinsic value of the option)
4.	Cash	$\$4,347,856$
	Sales		$\$4,347,856$
	(To record NZD 10,000,000 in sales at a spot rate of NZD 2.30 : $1)
5.	Cash	$\$652,174$
	Foreign currency option		$\$652,174$
	(To record net cash settlement of the option at its maturity)
6.	Accumulated other comprehensive income	$\$652,174$
	Sales		$\$652,174$
	(To transfer the gain on the hedging activity to earnings)

e.

To determine

Specify the economic theory of the given transaction.

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

A forward contract is a custom designed agreement between two parties to buy or sell an asset on a future date at a specified price. For hedging or speculation a forward contract may be used, although its non-standardized nature makes it particularly suitable for hedging.

By signing the contract option, there is a contract to receive $5,000,000 from anticipated

NZD 10,000,000 sales, less the contract premium option. On March 31 received

$4,347,826 from sales at spot rate and also recognized in sales $652,174 from the option

contract gain for a total of $5,000,000.