Bob Jensen's Case Amendment

Bob Jensen’s Teaching Note Amendment (Revised August 15, 2008)
by
Robert E. Jensen
Emeritus Accounting Professor from Trinity University
190 Sunset Hill Road
SUGAR HILL, NH 03586
rjensen@trinity.edu

This document is Bob Jensen’s Amendment to the Teaching Note prepared by Smith and Kohlbeck for the following case:
     “Accounting for Derivatives and Hedging Activities Comparisons of Cash Flow Versus Fair Value Accounting,”
     by Pamela A. Smith and Mark J. Kohlbeck
     Issues in Accounting Education, Volume 23, Number 1, February 2008, pp. 103-118

The Case can be downloaded for a fee at http://www.atypon-link.com/AAA/loi/iace

Teaching Note: --- http://www.atypon-link.com/AAA/loi/tnae
Click on Issue 1, Volume 23(2008) to find the Teaching Note and the Smith and Kohlbeck Addendum added in August 2008
The Smith and Kohlbeck August 2008 Addendum to the Teaching Note can also be downloaded with their Original Teaching Note

Bob Jensen’s August 2008 Teaching Note Amendment can be downloaded from http://www.trinity.edu/rjensen/CaseAmendment.htm

In February 2008 Bob Jensen sent a long list of proposed corrections and extensions to Professors Smith and Kohlbeck and invited them to write an Addendum to the Teaching Note. They did not agree with some of the corrections and extensions.
After some delays and communications between the Editor, Smith and Kohlbeck, and Jensen, Jensen’s March 2008 Amendments were sent in June 2008 to two Big 4 accounting firm partners who are experts on FAS 133 for refereeing.
The Referee Report was received by all parties in July 2008.
Smith and Kohlbeck submitted an Addendum to their Teaching Note in late July 2008. This is now published along with the original Teaching Note.
Bob Jensen revised his Teaching Note Amendment based upon several suggestions by the referees. The revised August 2008 Teaching Note Amendment can now be found at http://www.trinity.edu/rjensen/CaseAmendment.htm

The bottom line of the Referee Report stated the following:

Generally agree with (Jensen’s) comments, though academics need to decide whether this additional information/clarity is needed to achieve the learning objectives.

My August 2008 Teaching Note Addendum revises March 2008 version based upon several suggestions by the referees.

I think there are huge advantages in comparing the Smith and Kohlbeck Teaching Note with the revised teaching notes that I prepared. I don’t want to leave the impression that a few items that I take issue with outweighs much of the good in the carefully-crafted Teaching Note and discussion found in the Smith and Kohlbeck Teaching Note. I highly recommend that Issues in Accounting Education serve up my notes as an addendum to the teaching note available at http://aaahq.org/pubs.cfm .

(Refereed) Addendum Teaching Note prepared by Robert E. Jensen for the following case:
     “Accounting for Derivatives and Hedging Activities Comparisons of Cash Flow Versus Fair Value Accounting,”
     by Pamela A. Smith and Mark J. Kohlbeck
     Issues in Accounting Education, Volume 23, Number 1, February 2008, pp. 103-118

The Smith and Kohlbeck Case and Teaching Note contain the following errors, misleading assumptions, and misleading wording.

Issue 1 (Misleading Wording):
The case never should’ve used the term “portfolio” at any point. It’s highly misleading to do so since for all practical purposes it is not possible to get hedge accounting for hedges of portfolios. In FAS 133, hedges of portfolios are called “macro hedges.” The authors of this case never intended to illustrate macro hedges and use of the word portfolio is an unnecessary distraction. Firms commonly hedge portfolios when it is impractical to hedge each component of a portfolio such as when Fannie Mae hedges a portfolio of 10,000 individual homeowner mortgages for interest rate risk. Such a macro hedge is probably impractical in terms of each mortgage note. To be eligible for hedge accounting under FAS 133 Paragraphs 21(a)(1), 448, and 449, each mortgage in the portfolio must have the same interest rate and maturity date. It is not practical to create portfolios that are homogeneous to this extent. Nor is it possible to get hedge accounting treatment for a portfolio of shares in different companies. The International IAS 39 was amended to allow for slight relief in the case of interest rate hedges, but for most other types of portfolios hedge accounting is not allowed except when portfolios are perfectly homogeneous.

Issue 2 (Confusing Wording)

The referees of this Amendment wrote the following:

(Jensen) is correct that it is unclear that there exists a cash flow available to be hedged. This lack of clarity exists because, while the authors allude to the fact that the AFS securities will have the relevance of a sinking fund obligation, they do not clearly state that a cash flow will occur when the securities are sold. It can be inferred from the case, however, that the proceeds from the sale of the securities will be used for sinking fund purposes.

What is confusing about the Exhibit 1 and Exhibit 2 illustrations is that the net impact of the hedges are identical since hedging the sales price of the AFS security versus hedging the value of the AFS security are essentially equivalent in that the decision to call the hedge a cash flow versus fair value hedge is absolutely arbitrary in their illustration. It’s confusing to have two different accounting treatments for what are essentially equivalent hedges on earnings impacts during the hedging period. It would be far better to illustrate these two types of hedges where fair value of the item is not perfectly correlated with its selling price. For example, if the fair value of inventory (entry value) is not equivalent to the fair value of the selling price (exit value), a cash flow hedge of selling price (exit value) of inventory previously on hand locks in a profit. A fair value hedge of purchase price (entry value) locks in the value of the inventory but does not lock in a cash flow profit if the exit value is not perfectly correlated with exit value as is the case in many inventory items such fuel prices where entry value from the supplier is not necessarily perfectly correlated with selling prices in local markets affected by competitor prices in the local market.

In the case of securities where the spot price on a given day is the purchase price and the sales price, it’s rare to enter into a cash flow hedge of existing holdings of the securities. It is common to hedge fair value. Hence the Smith and Kohlbeck Exhibit 1 is technically correct, although it is an uncommon way to view the much more common fair value hedge in Exhibit 2.

Issue 3 (Alternate Solution to Exhibit 2)
FAS 133 is not clear about the best approach to accounting for a fair value hedge of an AFS security. The problem is what to do with the “dangling AFS balance” at the start of the fair value hedge. While the AFS security is not hedged for fair value it must be adjusted to fair value with the offset going to OCI under FAS 115 and FAS 130 rules. Thus when a fair value hedge commences (e.g., on November 30 in Exhibit 2), OCI has a starting balance of $500,000 credit balance before the hedge commences. The Smith and Kohlbeck solution leaves this balance dangling during the hedging period even though it no longer applies to the value of the hedged item or the hedging contract during the hedging period. The Smith and Kohlbeck discussion also leads students into thinking that their AFS hedge accounting differs from hedges of trading securities and held-to-maturity securities not classified as AFS. In point of fact, their solution is identical for all classifications of securities.

I prefer a unique AFS hedging solution that adjusts the OCI for changes in value under FAS 115 and FAS 130 rules before and during the fair value hedging period. The changes in value of the hedging contract then go to OCI in the fair value hedge to the extent the hedge is effective and current earnings for any ineffective portion. This solution was proposed by KPMG years ago. Thus the effective portion of the fair value hedge of an AFS security passes through OCI until the hedge is settled or dedesignatied.

This better way, in my viewpoint, to account for AFS security hedges is illustrated below. It is better, in my viewpoint, because it does not leave a dangling and outdated OCI balance throughout the hedging period.

Issue 4 (Weak Discussion in the Teaching Note)

Whenever Smith and Kohlbeck took basis adjustment for cash flow hedges, such as in Exhibit 6, their Teaching Note never explains why the basis is adjusted for the cash flow hedge on the date of the inventory sale rather than on the date of the inventory purchase. They also did not explain why they use different basis adjustment timings in their Exhibit 6 versus Exhibit 7 solutions. This lack of explanation makes all basis adjustments in their exhibits confusing for students who’ve never contemplated basis adjustment in hedge accounting. The Teaching Note never explains or even mentions the term “basis adjustment.” Nor does it mention how basis adjustment differs between FAS 133 and IAS 39. You can read the following at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#B-Terms

Basis Adjustment is the adjustment of the booked value of an asset or liability as required by SFAS 80 but is no longer allowed for cash flow and foreign currency hedges under FAS 133 according to Paragraph 31 and Paragraphs 375-378 of FAS 133. Basis adjustment is required for fair value hedges under Paragraphs 22-24 on Pages 15-16 of FAS 133. An illustration of amortization of fair value hedge basis adjustments appears in Example 2 beginning in Paragraph 111 on Page 60 of FAS 133. Also see short-cut method.

The carrying value of a hedging offset account (OCI, Firm Commitment, or Balance Sheet Item) may be written off prematurely whenever the hedge becomes severely ineffective.

Under IAS 39, the carrying value of an effective hedge is written off when the hedge expires or is dedesignated. See Paragraphs 162 and 163 of IAS 39.

Under FAS 133, the carrying value of an effective hedge is carried forward until the ultimate disposition of the hedged item (e.g. inventory sale or depreciation of equipment). See Paragraph 31 of FAS 133.

The FASB decision to ban basis adjustment when a hedge is settled is controversial, although the controversy is a tempest in a teapot from the standpoint of reported net earnings each period. Suppose you are enter into a firm commitment on 1/1/99 to purchase a building for the amount of yen that you can purchase for $5 million on 1/1/99. The financial risk is that this commitment requires a payout in Japanese yen on 7/1/99 such that the building's cost may be higher or lower in terms of how many yen must be purchased on 7/1/99. To hedge the dollar/yen exchange rate, you enter into a forward contract that will give you whatever it takes make up the difference between the yen owed and the yen that $5 million will purchase on 7/1/99. On 1/1/99 the forward contract has zero value. Six months later, assume that the forward contract has been value adjusted to $1 million because of the decline in the yen exchange rate. The offsetting credit is $1 million in OCI if since this was not designated as a fair value hedge.

To close out the derivative on 7/1/99, you debit cash and credit the forward contract for $1 million. To basis adjust the cost of the building, you would debit OCI for $1 million and credit the building fixed asset account. The building would end up being booked on 7/1/99 for $4 million instead of its 1/1/99 contracted $5 million. If you did not basis adjust, the credit would stay in OCI and leave the building booked at a 7/1/99 value of $5 million. Paragraph 376 on Page 173 of FAS 133 requires that you no longer adjust the basis to $4 million as a result of the foreign currency hedge. Hence depreciation of the building will be more each year than it would be with basis adjustment.

The controversy stems over how and when to get that $1 million out of OCI and into retained earnings. Under SFAS 80, suppose that with basis adjustment the impact would have been a reduction of annual depreciation by $50,000 over the 20-year life of the building. In other words, depreciation would have been $50,000 less each year smaller $4 million adjusted basis rather than the $5 million unadjusted basis. One argument against basis adjustment in this manner is that the company's risk management outcomes become buried in depreciation expense and are not segregated on the income statement.

Without basis adjustment under FAS 133, you get $50,000 more annual depreciation but identical net earnings because you must amortize the $1 million in OCI over the life of the building. Here we will assume the amortization is $50,000 per year. Each year a $50,000 debit is made to OCI and a credit is made to the P&L closing account. When OCI is amortized, investors are reminded on the income statement that, in this example, a $50,000 per year savings accrued because the company successfully hedged $1 million in foreign currency risk exposure.

In Paragraph 31 on Page 22 of FAS 133, the amortization approach is required for this cash flow hedge outcome. You cannot basis adjust in order to take $50,000 per year lowered depreciation over the life of the building. But you report the same net earnings as if you had basis adjusted. In any case, FAS 133 does not allow you to take the entire $1 million into 7/1/99 earnings. Paragraph 376 on Page 173 of FAS 133 elaborates on this controversy.

What is wrong with the FAS 133 approach, in my viewpoint, is that it may give the appearance that a company speculated when in fact it merely locked in a price with a cash flow or foreign currency hedge. The hedge locks in a price. But the amortization approach (in the case of a long-term asset) or the write-off at the time of the sale (in the case of inventory) isolates the hedge cash flow as an expense or revenue as if the company speculated. In the above example, the company reports $50,000 revenue per year from the forward contract. This could have been a $50,000 loss if the dollar had declined against the yen between 1/1/99 and 7/1/99. If the $50,000 was buried in depreciation charges, it would seem less likely that investors are mislead into thinking that the $50,000 per year arose from speculation in forward contracts. Companies also point out that the amortization approach greatly adds to record keeping and accounting complexities when there are many such hedging contracts. Basis adjustment gives virtually the same result with a whole lot less record keeping.

It should also be noted that to the extent that the hedge is ineffective, the ineffective portion gets written off to earnings on the date the asset or liability is acquired. In the above example, any ineffective portion would have to be declared on 1/199 and never get posted to OCI. Hence it would never be spread over the life of the building. According to Paragraph 30 on Page 21 of FAS 133, ineffectiveness is to be defined at the time the hedge is undertaken. Hedging strategy and ineffectiveness definition with respect to a given hedge defines the extent to which interim adjustments affect interim earnings.

In fairness the FASB has never been as clear about basis adjustment for fair value hedges as it has been about cash flow hedges. Hence I do not contend that the basis adjustment (on the date of inventory purchase) in the Teaching Note’s Exhibit 7 is in error. What I do contend is that there is a better approach for basis adjustment at the termination of a fair value hedge. My reasoning is explained below for the case of a fair value hedge.

Issue 5 (Misleading Assumption)
Exhibits 5 and 6 ignore huge hedge ineffectiveness on every reset date. All Delta values are outside the 80%-125% limits. I show the problems and then tweak the forward and spot prices to achieve better hedging effectiveness.

Professors Smith and Kohlbeck wanted to simplify their case by not performing hedge effectiveness tests. This would be well and good except they did so with erroneous reasoning. They could have said that they were simply ignoring hedge effectiveness tests that in real life must be performed.

But instead they made the following incorrect statement on Page105:

In anticipation of this transaction, the treasurer has determined that Warfield will purchase

a futures contract at $39 per barrel (bbl) for 100,000 bbls with a maturity of January

31.2 The critical terms of the futures contract will match the anticipated transaction so the

hedge is 100 percent effective. The futures contract is at market rates, and the company

maintains a margin account with the broker; therefore, no cash will be exchanged at the

inception of the contract. The futures contract settles in cash for the difference between

the price stated on the contract and the spot price on January 31 (maturity).

The above argument is not allowed in FAS 133 or FAS 39. Indeed most hedging contracts are designed to be perfectly effective on a cumulative basis on the date of full maturity. Most tests for hedging ineffectiveness at interim dates before maturity would thereby be unnecessary if the above statement by Smith and Kohlbeck were true. But the statement is true only for the very limiting hedging contracts such as when interest rate risk is hedged using the Shortcut Method for interest rate swaps as explained in Paragraphs 114 and 132 of FAS 133. The Shortcut Method avoidance of hedge effectiveness tests does not apply to any hedging contracts other than interest rate swaps --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#ShortcutMethod

For interest rate swaps the international standard IAS 39 does not even allow the Shortcut method. Hence, for hedging contracts such as oil futures and oil forward contracts hedge effectiveness must be tested at interim points between inception and settlement of the hedge. What’s worse is that it is extremely common for hedges that are assured to be perfectly effective at maturity to be ineffective at interim points in time. The main reason is that hedged items and derivative hedging contracts are traded in different markets. Hedged items (like oil purchase contracts and inventories) are traded by users of a commodity whereas derivative contracts (like forward, futures, option, and swap contracts) are traded heavily by speculators. The two markets are correlated but they are far from perfectly correlated.

As I said, Smith and Kohlbeck could have simply said they were not illustrating effectiveness tests. I would not object had that not given an erroneous justification for ignoring these tests. But I would’ve preferred under those circumstances that the hedges they illustrated be reasonably effective. Actually their hedges are all ineffective to a point where hedge accounting is not even allowed.

Other Areas of Recommended Improvement of the Smith and Kohlbeck case

The case needs a better glossary or at least reference to a glossary such as http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#FirmCommitment

The case really needs to explain the difference between economic hedging and hedge accounting for both cash flow hedges and fair value hedges. The authors might then reference key examples in FAS 133 that illustrate fair value hedging versus cash flow hedging.

There needs to be more precise definitions of intrinsic versus time value and an elaboration about why time value is normally excluded from hedge effectiveness tests for hedges that use options contracts.

The authors really never define a forecasted transaction and what is necessary for a forecasted transaction as a hedged item, i.e. a specified notional, specified transaction date and an underlying based upon future spot rates. It should then be explained how a firm commitment differs from a forecasted transaction in that a forecasted transaction becomes a firm commitment when the underlying is contractually specified in place of the spot rate.

The authors throw out the account “Firm Commitment” invented by the FASB for purposes of hedging firm commitments without adequately explaining that the term “Firm Commitment” has two different meanings that must be taken in context. One alternative is that a firm commitment is a hedged item that with a specified notional, transaction date, and underlying. The other one is that a Firm Commitment account is simply an artificial account used in hedge accounting for firm commitments. This account, however, is not a “firm commitment” which is why the FASB never should’ve used such a name for such an account --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#FirmCommitment

Actually the authors do not adequately define and contrast cash flow hedges versus fair value hedges. Most certainly they do not make it clear that a cash flow hedge creates fair value risk and a fair value hedge creates cash flow risk. They should make it clear that it is totally naïve to make a statement about “hedging risk” without pointing out that it’s impossible to simultaneously hedge cash flow and fair value risk.

Most students are confused as to why anybody would create cash flow risk by entering into a contract to hedge fair value. A few examples here might help. For example, why would a company with fixed-rate bonds payable (with fair value risk and no cash flow risk) ever hedge these bonds for fair value (thereby creating cash flow risk)? One answer is that the company may feel that interest rates are going to decline and it may be smart to buy the bonds payable back in the market after interest rates for new debt go down. But if the company does not hedge the value of those fixed rate bonds, the bonds will be increasingly expensive to buy back or call back if interest rates plunge.

It might help to explain the advantages and disadvantages of certain types of hedges. For example, one of the great things about a purchased option is that risk is capped even in speculations. However, options are lousy as hedges if the company wants hedge accounting, because options seldom meet effectiveness tests, especially for changes in time value. It might help to discuss the relative advantages and drawbacks of futures versus forwards, at least on a basic level.

Revised Exhibit 1 Solutions (for hedge ineffectiveness) in the Smith and Kohlbeck Teaching Notes

Under the Smith and Kohlbeck assumption that they are hedging the cash flow profit their solution is acceptable except that they ignore the ineffectiveness of the hedge. They stated that they were not going to test for hedge ineffectiveness in order to simplify the solution. I take up the problem of hedging ineffectiveness later in this Amendment.

The FASB provides an excellent illustration of cash flow hedging with options. See Example 9 beginning in Paragraph 162 of FAS 133.
Also see the Excel Workbook solutions in the 133ex09a.xls file at http://www.cs.trinity.edu/~rjensen/
Also see the PowerPoint illustrations in the 05options.ppt file at http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/

Revised Exhibit 2 Solutions in the Smith and Kohlbeck Teaching Notes
In the following journal entries I compare the original Smith and Kohlbeck Exhibit 2 Dangling OCI solutions with the Jensen and KPMG revised Exhibit 2 solutions. FAS 133 provides some discretion with respect to hedging AFS Securities. Both solutions lead to a correct result, although the Smith and Kohlbeck solutions leave a “Dangling OCI” balance that is out of date during the hedging period relative to the fair value-adjusted AFS hedged item.

I actually prefer the AFS Securities hedging approach recommended in Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998. Although we do not generally use the OCI account for fair value hedges under FAS 133 rules, an exception can be made for AFS securities since FAS 115 requires use of OCI to mark the AFS securities to market with an offset to OCI.

FAS 133 does not allow hedge accounting for a hedged trading security. However, the Smith and Kohlbeck’s Exhibit 2 accounting passes everything through current earnings which is exactly what FAS 133 requires for trading securities. For a held-to-maturity (HTM) hedged item, the financial instrument is normally carried at historical cost or at amortized historical cost in the case of some bonds and mortgages. For a fair value hedge that qualifies for hedge accounting, however, FAS 133 requires that the historical cost accounting be suspended and that the hedged item be carried at fair value from the start of the hedge until settlement of the hedge or dedesignation. Hedge accounting during the hedging period is exactly the same as the AFS approach illustrated in Smith and Kohlbeck’s Exhibit 2 during the hedging period.

I don’t care for the Smith and Kohlback Exhibit 2 approach when it comes to AFS securities. If the AFS security has been adjusted to fair value before the start of the hedge, there is a balance in other comprehensive income (OCI) that remains unchanged during the hedging period even though its balance is sadly out of date relative to the hedged item’s fair value. This is why I call this hedge accounting approach the “Dangling OCI” approach for fair value hedges.

In 1998, KPMG proposed a unique solution for AFS securities that keeps OCI up to date rather than dangling. This approach cannot be applied to trading or HTM hedged items, but it can be applied to AFS hedged items. I illustrate this solution below.

The Smith and Kohlbeck approach of running everything through current earnings leaves a dangling and outdated balance in the OCI account for the AFS securities at the start of the hedging period. The balance sheet during the hedging period carries this outdated balance under the Smith and Kohlbeck approach. Jensen’s proposal to use the KPMG approach keeps this OCI or AOCI balance updated in terms of fair value adjustments. Also the OCI or AOCI account keeps the value changes of the hedging contract out of current earnings during the hedging period to the extent the hedge is effective.

The referees of Jensen’s Amendment wrote the following in July 2008:

(Jensen) reiterates the lack of a clear cash flow in this comment. See the previous comments above. Regarding the amount retained in AOCI, (Jensen) is correct that the mechanics of the accounting should follow the approach described in the KPMG FAS 133 book.

You can read more about hedge accounting in general at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#HedgeAccounting

Date

Revised Exhibit 2

Dangling OCI Solution

Jensen and KPMG Unique AFS Solution

Date	Ledger Account	Debit	Credit	Balance	Ledger Account	Debit	Credit	Balance
10/31	AFS securities	4,000,000		$4,000,000	AFS securities	4,000,000		$4,000,000
	Cash		4.000,000	($4,000,000)	Cash		4,000,000	($4,000,000)
	-Purchase of 100,000 shares				-Purchase of 100,000 shares

11/30	AFS securities	500,000		$4,500,000	AFS securities	500,000		$4,500,000
	Unrealized OCI or AOCI		500,000	($500,000)	Unrealized OCI or AOCI		500,000	($500,000)
	-FAS 115 &130 entry required to mark AFS securities to market				-FAS 115/130 entry required to mark AFS securities to market

11/30	Put option	300,000		$300,000	Put option	300,000		$300,000
	Cash		300,000	($4,300,000)	Cash		300,000	($4,300,000)
	-Purchased put option for a $300,000 premium				-Purchased put option for a $300,000 premium

12/31	Unrealized G/L (IS)	100,000		$100,000	Unrealized OCI or AOCI	100,000		($400,000)
	AFS securities		100,000	$4,400,000	AFS securities		100,000	$4,400,000
	-Entry to mark the AFS securities to market				-FAS 115/130 entry required to mark AFS securities to market
12/31	Unrealized G/L (IS)	140,000		$240,000	Unrealized G/L (IS)	140,000		$140,000
	Put option		140,000	$160,000	Put option		140,000	$160,000
	-Entry to charge the loss in time value to current earnings				-Entry to charge the loss in time value to current earnings
12/31	Put option	100,000		$260,000	Put option	100,000		$260,000
	Unrealized G/L (IS)		100,000	140,000	Unrealized OCI or AOCI		100,000	($500,000)
	-Entry to credit the increase in intrinsic value to current earnings				-Entry to credit the increase in intrinsic value to OCI because this is an AFS security

01/31	Unrealized G/L (IS)	100,000		$240,000	Unrealized OCI or AOCI	100,000		($400,000)
	AFS securities		100,000	$4,300,000	AFS securities		100,000	$4,300,000
	-Entry to mark the AFS securities to market				-FAS 115/130 entry required to mark AFS securities to market

1/31	Unrealized G/L (IS)	160,000		$300,000	Unrealized G/L (IS)	160,000		$300,000
	Put option		160,000	$100,000	Put option		160,000	$100,000
	-Entry to charge the loss in time value to current earnings				-Entry to charge the loss in time value to current earnings
1/31	Put option	100,000		$200,000	Put option	100,000		$200,000
	Unrealized G/L (IS)		100,000	$200,000	Unrealized OCI or AOCI		100,000	($500,000)
	-Entry to credit the increase in intrinsic value to current earnings				-Entry to credit the increase in intrinsic value to OCI because this is an AFS security

1/31	Cash	4,300,000		$0	Cash	4,300,000		$0
	AFS Security		4,300,000	$0	AFS Security		4,300,000	$0
	-To record sale of AFS securities				-To record sale of AFS securities

1/31	Cash	200,000		$200,000	Cash	200,000		$200,000
	Put option		200,000	$0	Put option		200,000	$0
	-To record settlement of the put option				-To record settlement of the put option

1/31	Unrealized OCI or AOCI	500,000		$0	Unrealized OCI or AOCI	500,000		$0
	Unrealized G/L (IS)		500,000	$200,000	Unrealized G/L (IS)		500,000	$200,000
	-To close out a dangling OCI balance from October 31				-To basis adjust on the date of the sale of all shares.

$300,000 = gain without a put option hedge = $4,300,000 on January 31- $4,000,000 invested on October 31.

$200,000 = gain with a put option hedge = $4,300,000 - $4,000,000 -$300,000 put option premium + $200,000 put option settlement

On November 30, the spot rate for December 31 was unknown, and Warfield Company elected to hedge against a plunge in share prices. In retrospect, Warfield Company lost an opportunity value but it also eliminated the possibility of a huge loss of the Smith Company shares had they fallen way below $42 per share = $45 strike price - $3 premium per share of the put option.

Put another way, if the price of Smith Company shares tanked to zero, Warfield would’ve lost its entire $4 million investment without a hedge. With the hedge described in the case, the company locked in a minimum gain $2 per share or $200,000.

Revised Exhibits 5 Solutions in the Smith and Kohlbeck Teaching Notes

Fair Value Hedge Needs a Third-Party Firm Commitment Contract
In Part B Smith and Kohlbeck try to define a forward price of a futures contract as a fair value hedge. When one enters a futures contract there’s cash flow risk equal to what is called the basis equal to the spot price minus the forward price at any point in time --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#B-Terms
Basis risk is cash flow risk, and it’s impossible to define a fair value hedge on a hedged item that has cash flow risk. Fair value items must have no basis (cash flow) risk. Also FAS 133 does not allow hedge accounting for derivative hedges of derivative instruments.

What Smith and Kohlbeck needed to do in Part B was to have the Warfield Company enter into firm commitment contract (hedged item) that stands alone apart from the futures contract. A firm commitment contract must have a specified underlying (price), specified quantity (such as 100,000 shares of stock or 100,000 barrels of oil), and a specified purchase/sale date --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#FirmCommitment
This contract must exist apart from whatever contract is used to hedge the fair value.

The Smith and Kohlbeck Exhibit 5 solution is confusing because there is no contracted firm commitment price that we are hedging for fair value. The implied use of the October 31 forward price is confusing since most firms have relationships with suppliers and contract for something other than what they can get on the derivatives markets. It’s best to find a third party who will possibly accept a forward price as a specified underlying, but more likely than not a third party outside the futures market will specify some price other than the forward price due to many factors impacting on that third party such as delivery costs, storage costs, interest returns, etc.

Actually the way fair value hedging typically works in practice is that users of commodities sign supply contracts with third-party suppliers for delivery at a plant such as a refinery in California. Oil and gas futures markets usually have specified delivery points in Chicago, Oklahoma, Louisiana, or Texas. The futures prices and spot rates are misleading for a market delivery point such as Louisiana. The California refinery must then add delivery, storage, and other costs to each spot price and each forward price in the futures market. This generally leads to hedging ineffectiveness such as the great Minneapolis versus Chicago Example 7 beginning in Paragraph 144 of FAS 133. That happens to be a cash flow hedge, but it could easily be converted into a fair value hedge by having JKL not just forecast the purchase of 100,000 bushels of corn but to sign a firm commitment from a supplier to buy the corn for delivery in Bismarck, North Dakota for $2.93 per bushel. The Bismarck user of corn can then hedge the firm commitment using either Minneapolis or Chicago futures markets or both markets as illustrated in Example 7. A similar example appears for South American coffee beginning in Paragraph 93 of FAS 133.

One source of hedging ineffectiveness is the shift in delivery costs between the beginning and the ultimate settlement of a hedge. The forward and spot changes over several months in a CBOT exchange in Chicago may be different that the changes in prices in Bismarck if the delivery costs of corn have greatly changed during the hedging period.

Hedge Effectiveness Testing Misleading Assumptions
Professors Smith and Kohlbeck wanted to simplify their case by not performing hedge effectiveness tests. This would be well and good except they did so erroneously. They could have said that they were simply ignoring hedge effectiveness tests that in real life must be performed.