ACCT 5341 Possible Quiz Answers for Class 06

Last Revised on March 6, 2006

ACCT 5341 Syllabus
Bob Jensen at Trinity University

Table of Contents

Possible Quiz Questions for the Next Class

International Accounting Theory Helpers and Links

Reading Assignments for This Week

Possible Quiz Questions and Answers for Class 06

Please keep your answers to all possible quiz questions for the entire semester. They may reappear in future quizzes and they may help in your course project.

If a case assignment or other question points to a particular section of a textbook chapter or other reading section, you are responsible to take notes on that particular section in its entirety.

If a case assignment or other question points to a particular section of a textbook chapter or other reading section, you are responsible to take notes on that particular section in its entirety.

The Excel questions for this week are on the TUCC Drive J:\courses\acct5341\0assign\sfas133

Each student must submit an mentor attestation form.  This form is to be signed and turned in each week in class.  These forms can be found at http://www.trinity.edu/rjensen/acct5341/AttestMentor.htm

This week Bob Jensen's answers are provided for most of the questions.  Many of the problems are from a CPA exam review manual published by KPMG.  The manual is no longer in print.

File 1 (HTML) Question 01
What are the implications in SFAS 133 for denomination in a foreign currency of an acquired asset or liability?

[Hint:  See Paragraph 29g  and 29h beginning on Page 20 of SFAS 133.]

g. If the hedged transaction is the forecasted purchase or sale of a nonfinancial asset, the designated risk being hedged is (1) the risk of changes in the functional-currency-equivalent cash flows attributable to changes in the related foreign currency exchange rates or (2) the risk of changes in the cash flows relating to all changes in the purchase price or sales price of the asset (reflecting its actual location if a physical asset), not the risk of changes in the cash flows relating to the purchase or sale of a similar asset in a different location or of a major ingredient. Thus, for example, in hedging the exposure to changes in the cash flows relating to the purchase of its bronze bar inventory, an entity may not designate the risk of changes in the cash flows relating to purchasing the copper component in bronze as the risk being hedged for purposes of assessing offset as required by paragraph 28(b).

h. If the hedged transaction is the forecasted purchase or sale of a financial asset or liability or the variable cash inflow or outflow of an existing financial asset or liability, the designated risk being hedged is (1) the risk of changes in the cash flows of the entire asset or liability, such as those relating to all changes in the purchase price or sales price (regardless of whether that price and the related cash flows are stated in the entity’s functional currency or a foreign currency), (2) the risk of changes in its cash flows attributable to changes in market interest rates, (3) the risk of changes in the functional-currency-equivalent cash flows attributable to changes in the related foreign currency exchange rates (refer to paragraph 40), or (4) the risk of changes in its cash flows attributable to default or changes in the obligor’s creditworthiness. Two or more of the above risks may be designated simultaneously as being hedged. An entity may not designate prepayment risk as the risk being hedged (refer to paragraph 21(f)).

File 1 Question 02
On December 14, 19x1  the HedgedEm Company hedged a forecasted purchase of 10,000 shares of Microsoft Corporation common shares with a forward contract.  The contracted forward price is $130 per unit equal to the market price on December 14.    On December 31, 19x1,  the price of the shares increased by $10 per share.  On February 14, 19x2 HedgedEm purchased 8,000 shares with no immediate intention of purchasing the other 2,000 Microsoft shares.  The February 14 price was $138 per share.  The Forward contract was settled for cash using  the 10,000 notional amount on February 14.

2.1 
What are the journal entries on December 14 to record the forward contract?

No entry other than a memorandum entry since there is no mention of a premium or discount on that date.

 

2.2 
What are the journal entries on December 31 under available-for-sale versus trading securities classification of the investment when the share price is $140 per share?  Note that the securities have not yet been purchased.  Assume the forward contract has not yet cleared for cash.

[Hint:  Look up the term "available-for-sale" in Bob Jensen's SFAS 133 Glossary.]

Bob Jensen's Answer

The forward contract increases in value by ($140-$130)(10,000 shares) = $100,000.  Since trading unrealized gains and losses do affect current earnings when securities are not classified as available-for-sale or held-to-maturity, the hedge's gain must be credited to P&L.  See the term "available-for-sale" in Bob Jensen's SFAS 133 Glossary.

Since available-for-sale unrealized gains and losses do not affect current earnings, the hedge's gain can be credited to OCI.  See the term "available-for-sale" in Bob Jensen's SFAS 133 Glossary.

 

2.3 
What are the journal entries on February 14 under available-for-sale versus trading securities classification of the investment when the securities are acquired?  The share price on February 14 is $138 per share.  Recall that the Forward contract price was $130 per share.  Assume this contract is cleared for cash.

 

Bob Jensen's Answer
When Microsoft shares are classified as trading securities:

 

When Microsoft shares are classified as available-for-sale securities:

Paragraph 31 on Page 22 of SFAS 133 states that the net gain in OCI related to a hedging instrument should be reclassified into earnings when the hedged forecasted transaction affects earnings (i.e., when the available-for-sale equity securities are sold). In addition, the amount in OCI should be reclassified in earnings if: 

• it becomes probable that the forecasted purchase of the available-for-sale equity securities will not occur (paragraph 33); or
  
  Since only 8,000 (80%) if the 10,000 forecasted purchase quantity is all that the company intends to acquire, this leaves 80% of the forward contract's gain or loss to be deferred until earnings are affected by the ultimate sale and 20% to be written off on February 14.

• there is an other-than-temporary impairment of the available-for-sale equity securities that is included in earnings (paragraph 35). In this circumstance, any offsetting net gain related to the transaction should be reclassified into earnings immediately.

KPMG q19.19 (Page 228) illustrates an easier version of this problem.

 

2.4 
Suppose 5,000 shares are sold on June 10 for $133 per share.  What are all required journal entries under available-for-sale versus trading securities classification of the investment in Microsoft shares?   What must the price of the remaining 3,000 unsold shares fall to in order for the company to break even on all these transactions?

[Hint:  See Paragraph 31 on Page 22 of SFAS 133.]

Bob Jensen's Answer
When Microsoft shares are classified as trading securities:

Note that 3,000 shares remain unsold.  They cost $138 per share and have a June 10 value of $133 per share.  This makes their market value $399,000.  On June 10, the accumulated balance is a $40,000 gain = $399,000 - $359,000.  The gain came from the forward contract settlement cash flow of $80,000. 

When Microsoft shares are classified as available-for-sale securities:

Note that 3,000 shares remain unsold.  They cost $138 per share and have a June 10 value of $133 per share.  This makes their market value $399,000.  On June 10, the accumulated balance is a $40,000 gain = $399,000 - $359,000.  The gain is came from the forward contract settlement. In the available-for-sale classification, 31,875 of this is realized in current earnings (P&L) and $8,125 remains deferred in OCI.

When classified as available-for-sale, $8,125 of unrealized gain is deferred, whereas under the trading classification the entire $40,000 gain to date is posted to current earnings whether it is realized or unrealized.  In this case, $31,875 is realized and $8,125 remains unrealized.  That distinction does not matter when accounting for trading securities.

On June 10, HedgedEm Company's net cash outflow to date on these transactions is $359,000.  However, the company still owns 3,000 shares of Microsoft currently valued at $133 bringing remaining value to $399,000.  The accrued gain to date is $40,000 = $399,000 - $359,000.   This is also equal to (8,000 shares)($138 - $133) = $40,000.  To break even on the deal, the price of the remaining shares must fall to $133 - ($40,000/3000) = $119.67.

KPMG q19.19 (Page 228) illustrates an easier version of this problem.

File 1 Question 03
On December 14, 19x1  the HedgedEm Company hedged a forecasted purchase of 10,000 shares of Microsoft Corporation common shares with a call option priced at $15,000.   The strike price is $5 per share higher than the December 14 price of $130 per share.  On December 31, 19x1,  the price of the shares increased by $10 per share.  On February 14, 19x2 HedgedEm settled its call option for $30,000 in cash and immediately purchased 8,000 Microsoft shares.  The February 14 price was $138 per share.  Assume that the Microsoft shares will be classified as being available for sale if and when they are acquired.

3.1
What are the journal entries on December 14 to record the call option?

[Hint:  Look up the term "premium" in Bob Jensen's SFAS 133 Glossary.]

Bob Jensen's Answer

Since the strike price exceeds the December 14 share price, the entire $15,000 must be viewed as time value of the call option.  The intrinsic value is $0 unless the strike price exceeds market price.

 

3.2
What are the journal entries on December 31 under available-for-sale securities classification of the investment when the share price is $140 per share?  Note that the securities have not yet been purchased.  Assume the call option has a market value of $66,154.  What are the advantages and disadvantages of the call option in Question 3.2 versus the forward contract in Question 2.2?

[Hint:  The entire premium of $15,000 on December 14 must be considered time value since the option is out of the money at that time by $5 per share.  The intrinsic value is $0 on December 14.  On December 31, the intrinsic value (spot price - strike price)(10,000 shares)  is ($140-$135)(10,000) = $50,000.  Thus the change in intrinsic value is $50,000.  Changes in intrinsic value are posted to OCI in available-for-sale classifications.  The time value of the option on December 31 is $66,154 - $50,000 = $16,154.  The $16,154 - $15,000 = $1,154 change in time value between December 14 and December 31 is posted to current earnings.]

Bob Jensen's Answer

Since there is no premium on the forward contract, there is a $100,000 credit to OCI in Question 2.2 as opposed to smaller $50,000 credit in Question 3.2.  However, the forward contract has much higher risk, because HedgedEm Company has an obligation to pay cash if Microsoft shares fall below $130 and receives cash only if the price rises higher than $130.  In the case of the option, the $15,000 premium is a loss bound equal to the most that can be lost on the hedge.  HedgedEm Company has an option to exercise if Microsoft shares rise above the $135 strike price but will not lose anything more the sunk cost of $15,000 if the option is not in the money.

KPMG Example 5.5 beginning on Page 165 is remotely related to Problem 3.

3.3
What are the journal entries on February 14 under available-for-sale versus trading securities classification of the investment when the securities are acquired?  The strike price is $135 per share.

[Hint 1:  The problem does not specify the value of the option on February 14.  Hence, the change in the option's value cannot be computed unless the option expires on that date.  The balance in OCI can be derived in another way on the date of settlement.  On February 14, the option's settlement brings in ($138-$135)(10,000 shares) = $30,000.  The option's cash premium was $15,000.  The gain on the option is thus $15,000.  This $15,000 would have been deferred in OCI until the 10,000 shares were sold if the company had purchased all 10,000 shares. 

[Hint 2:  Under the available-for-sale classification, only 20% of the gain on the option contract  settlement is to be deferred in OCI until the securities are sold.  This is because only 80% of the forecasted 10,000 shares were actually purchased on February 14 and there is no intention of further purchase.]

Bob Jensen's Answer

The option settles for (10,000 shares)($138-$135) = $30,000.  This leaves a gain on the option of ($30,000 - $15,000) = $15,000.   But since only 8,000 Microsoft shares were actually purchased instead of the forecasted 10,000 shares, only 80% of the option's gain is deferred in OCI.  This leaves 20% of the $15,000 gain to be taken into earnings on Februrary 14.

3.4
Suppose 5,000 shares are sold on June 10 for $133 per share.  What are all required journal entries under available-for-sale classification of the investment in Microsoft shares?  What must the price of the remaining 3,000 unsold shares become in order for the company to break even on all these transactions?

Bob Jensen's Answer

On June 10, HedgedEm Company's net cash outflow to date on these transactions is $424,000.  However, the company still owns 3,000 shares of Microsoft currently valued at $133.  The accrued loss to date is $25,000 = $424,000 - $399,000.  Since the call option gain was $15,000 above the premium cost, the market price losses to date are $25,000 + $15,000 = $40,000.  This is also equal to (8,000 shares)($138 - $133) = $40,000.  To break even on the deal, the price of the remaining shares must be $133 + ($25,000/3000) = $141.33.

3.5
Suppose the strike price has been $145 instead of $135 per share.  How would this affect the December 31 entries in your answers to Question 3.2? Assume the call option has a market value of $10,000.

[Hint:  The entire premium of $15,000 on December 14 must be considered time value since the option is out of the money at that time by $5 per share.  On December 31, the intrinsic value (spot price - strike price)(10,000 shares)  is ($140-$145)(10,000) = -$50,000.  Negative intrinsic values are ignored because if settled today, the option would not be exercised.]

Bob Jensen's Answer

Unlike forward contracts and Forward contracts, purchased call options cannot have negative market values.  The reason is that the option purchaser has no obligation to make up the difference when the option is out of the money.   Another thing to consider is that an option that is out of the money does not usually have a zero value if it has not expired.  Indeed purchased options are not usually in the money when they are purchased for a premium price.

Note that if the share price had fallen rather than increased to $140 on December 31, HedgeEm Company would not be required to assess hedge ineffectivenss in the case of the option hedge.  It would be required to assess ineffectiveness of forward and Forward contracts.  The reason is that the option cannot lose any money due to price declines, whereas forward and Forward contracts can lose when prices decline.

3.6
Suppose the strike price has been $145 instead of $135 per share.  How would this affect the February 14 entries (in your Question 3.3 answers) to settle the call option and to purchase 8,000 shares for $138 per share?  What would the future price Microsoft have to become for 8,000 shares for HedgedEm Company to break even on all these transactions assuming a $145 strike price?  If 5,000 shares are sold for $133 on June 10, what is the break even price for the remaining 3,000 shares?

Bob Jensen's Answer

The option settles for (10,000 shares)($0) = $0.   This leaves a net loss on the option of equal to the $10,000 posted on February 14 and $5,000 posted on December 31.  These losses sum to the $15,000 premium paid for the option.

On February 14, the company has a total cash outflow of $15,000 for the option and $1,104,000 for 8,000 shares of Microsoft stock.    This sums to $1,119,000.  To break even on 8,000 shares, the selling price must be $139.88 per share.  ($139.88 = $1,119,000/8,000)

If the company sold 5,000 shares on June 10 for $133 per share, the proceeds of $665,000 reduce the cash outflows to  $454,000.  The remaining 3,000 unsold shares thus would have a break even price of $151.33 needed to recover all cash outflow. ($151.33 = $454,000/3,000)

KPMG Example 5.5 beginning on Page 165 is remotely related to Problem 3.

File 1 Question 04
On December 14, 19x1  the HedgedEm Company hedged a forecasted purchase of 10,000 units of merchandise inventory with a forward contract.  The contracted forward price is $130 per unit equal to the market price on December 14.  On December 31, 19x1,  the price increased by $10 per unit.  On February 14, 19x2, HedgedEm purchased 8,000 units with no immediate intention of purchasing the other 2,000 units of inventory.  The February 14 price was $138 per unit.

4.1
What are the journal entries on December 14 to record the forward contract?

No entry other than a memorandum entry since there is no mention of a premium or discount on that date.

4.2
What are the journal entries on December 31 assuming no cash clearance of the forward contract?

Bob Jensen's Answer

Question 4.2 With a Forward Contract Under an Inventory Classification

Date	Account	Debit (Credit)	Balance
December 31	Forward contracts	100,000	$100,000
	OCI	(100,000)	($100,000)

The increase in the value of the forward contract is ($140-$130)(10,000 units) = $100,000 assuming no cash clearance on this date.

 

4.3
What are the journal entries on February 14 assuming cash clearance of the forward contract?

Paragraph 31 on Page 20 Reads as Follows:

Amounts in accumulated other comprehensive income shall be reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings (for example, when a forecasted sale actually occurs). If the hedged transaction results in the acquisition of an asset or the incurrence of a liability, the gains and losses in accumulated other comprehensive income shall be reclassified into earnings in the same period or periods during which the asset acquired or liability incurred affects earnings (such as in the periods that depreciation expense, interest expense, or cost of sales is recognized).  However, if an entity expects at any time that continued reporting of a loss in accumulated other comprehensive income would lead to recognizing a net loss on the combination of the hedging instrument and the hedged transaction (and related asset acquired or liability incurred) in one or more future periods, a loss shall be reclassified immediately into earnings for the amount that is not expected to be recovered. For example, a loss shall be reported in earnings for a derivative that is designated as hedging the forecasted purchase of inventory to the extent that the cost basis of the inventory plus the related amount reported in accumulated other comprehensive income exceeds the amount expected to be recovered through sales of that inventory.

 

4.4
Suppose 5,000 units of the merchandise are used in production on June 10.  What are all required journal entries on June 10?  Assume the inventory is written down to $133 per unit under lower-of-cost-or-market (LCM) rules.  What would the price have to fall to in order to break even on these transactions?

Bob Jensen's Answer

Note that 3,000 units of inventory remain unsold.  They cost $138 per unit and have a June 10 value of $133 per unit.  This makes their LCM booked value $399,000.  They carry with them a $24,000 unrealized credit balance in the OCI account. 

On June 10, HedgedEm Company's net cash outflow to date on these transactions is $359,000.  However, the company still owns 3,000 units of inventory booked at $133 for a balance of  $399,000.  The unrealized gain to date is $40,000 = $399,000 - $359,000.  This gain results from the forward contract. To break even on the deal, the price of the remaining units must fall to $133 - ($40,000/3000) = $119.67.   That price would wipe out the gain on the forward contract.

4.5
Suppose the merchandise had been gold or silver?.  Would the cash flow hedge of a forecasted inventory purchase differ from the forecasted sale of existing inventory of gold or siver?

[Hint:  See Paragraph 405 on Page 182 of SFAS 133.]

Yes.  The forecasted purchase hedge would be accounted for as illustrated above.  The forecasted sale hedge, however, cannot impact on OCI.

Gold price movements must be marked-to-market as inventory. A cash flow hedge fixes the future sales price. Suppose the interim price of gold increases by $10. Retained earnings increases when the hedged item (gold inventory) is marked to market. If the value of the hedge (the forward contract) is deferred in OCI, the firm looks like it is doing $10 better than it really is doing since the changes in interim prices are irrelevant if the sales price is fixed. Hence, $10 increase in gold inventory value must be offset by a $10 decline in the value of the forward contract.]

Paragraph 405 on Page 182 of SFAS 133 reads as follows:

405. Special hedge accounting is not necessary if both the hedged item and the hedging instrument are measured at fair value with changes in fair value reported in earnings as they occur because offsetting gains and losses will be recognized in earnings together. The Board therefore decided to specifically prohibit hedge accounting if the related asset or liability is, or will be, measured at fair value, with changes in fair value reported in earnings when they occur. That prohibition results from the Board's belief that a standard on hedge accounting should not provide the opportunity to change the accounting for an asset or liability that would otherwise be reported at fair value with changes in fair value reported in earnings. Thus, for a fair value hedge, the prohibition is intended to prevent an entity from recognizing only the change in fair value of the hedged item attributable to the risk being hedged rather than its entire change in fair value. For a cash flow hedge, the prohibition is intended to prevent an entity from reflecting a derivative's gain or loss in accumulated other comprehensive income when the related asset or liability will be measured at fair value upon acquisition or incurrence

File 1 Question 05
On January 10, a wholesale distributor called Hopeful Corporation entered into a sales contract with a retail firm called ABC Company for 1,000 units of product on at retail market prices on July 10.    The current spot market price was $100 per unit on January 10.  The contract specified a 75% penalty escrow account for damages if either party reneges on the deal.  As an economic hedge on January 10, Hopeful pays $5,000 for a European-style put option to sell 1,000 units on July 10.   The strike price is $100 per unit. 

The above sales contract was not a short sale.  On January 10, prior to signing the sales contract with ABC Company, Hopeful Corporation entered into a firm commitment its foreign supplier, Barker Manufacturing, Ltd.., to purchase the 1,000 units for $90 on June 10.  Under the perpetual inventory method, Hopeful Corporation had those 1,000 units of the product inventoried at $90 per unit on the morning of July 10.  All journal entries required in this problem are from the perspective of Hopeful Corporation's accounting records.

5.1 
Record the Hopeful Corporation January 10 journal entries for the sales contract, purchase contract,  and put option if the contracted price was the July 10 spot price.

Bob Jensen's Answer

The contract with ABC Company is not a firm commitment since the sales price is not fixed.  As a result, Hopeful can enter into a put option as a cash flow hedge of a forecasted transaction.

Since the strike price is equal to the January 10 market price, the entire $15,000 must be viewed as time value of the put option.  The intrinsic value is $0 unless the strike price exceeds market price.

There is no entry for the sales contract since it is only a forecasted transaction.  The purchase contract, however, is defined as a firm commitment.

There is no entry for the purchase contract unless there is an anticipated serious loss, in which case a loss reserve would be set up much like an allowance for bad debts or warranty expense.

 

5.2
On March 31, Hopeful Corporation closed its books.  What adjusting entries were made under SFAS 133 rules for the sales contract and the put option assuming the March 31 spot price was $90 per unit?  Also assume the put option had a market value of $12,400 on March 31.

[Hint:  The intrinsic value of the put option on March 31 is ($100-$90)(1,000 units) = $10,000.  The time value becomes $12,400-$10,000 = $2,400.   The time value on January 10 was $5,000.]

Bob Jensen's Answer

The debit to put options is ($12,400 - $5,000) = $7,400.   This leaves a plug of $10,000 - $7,400 = $2,600 hit to current earnings.

There is no entry for the purchase contract (firm commitment) since this is not a derivative contract.

5.2(b)
Record the June 10 journal entries for the purchase of  1,000 units at $90 per unit under the purchase contract.

Purchase of 1,000 Units of Inventory

Date	Account	Debit (Credit)	Balance
March 31	Merchandise inventory	90,000	$90,000
	Cash	(90,000)	($95,000)

 

5.3
Record the July 10 journal entries for the sale to ABC Company at the July 10 spot price of $85 per unit.  Assume that the inventory was previously acquired under the firm commitment with Barker and that this is already booked to the Merchandise Inventory account for $80,000.   Also make the entry to take the goods out of inventory with a debit to Cost of Goods Sold.  In addition,  record the cash settlement of the put option.  Assume no adjusting entries were made to the put option account since March 31.  Show the closing entries for Cost of Goods Sold and Sales.

Bob Jensen's Answer

The cash balance is computed as follows:

The net gain from the put option is $15,000-$5,000 = $10,000.  This is also equal to the July 10 and March 31 P&L entries of $12,600-$2,600 = $10,000.  Hopeful lost $5,000 on the difference between inventory cost and sales amounts.  This brings the net profit form all transactions to $10,000-$5,000 = $5,000.  This is also the sum of the July 10 and March 31 P&L balances of $7,600-$2,600 = $5,000.

 

5.4 
Revise all your journal entries for January 10 (Question 5.1) if there was a contracted sales price with ABC at $100 per unit for the 1,000 units to be sold on July 10.  Assume the penalty clause remains at 75%.   Although there is no longer a need for the put option, assume that Hopeful enters into the put option as a speculation rather than a hedge.

[Hint:  See Paragraph 29c on Page 20 of SFAS 133.]

Bob Jensen's Answer

5.5
On March 31, Hopeful Corporation closed its books.  What adjusting entries were made under SFAS 133 rules for the sales contract and the put option assuming the March 31 spot price was $90 per unit?  For this part of the problem, assume the sales contract had a firm price of $100 per unit for the July 10 deal.  Also assume that that the put option speculation had a market value of $12,400 on March 31.  Your assignment here is to revise all your previous Question 5.2 journal entries.

Bob Jensen's Answer

Question 5.5 With a Put Option Speculation

Date	Account	Debit (Credit)	Balance
March 31	Put options	7,400	$12,400
	P&L	(7,400)	($7,400)
	OCI	(0)	($0)

Since there can never be a cash flow hedge of a firm commitment and there is no fair value hedge in this problem, the put option must be accounted for as a speculation. 

 

5.6
Record the July 10 journal entry to record the sale of the units to ABC Company for a contracted price of $100 per unit for 1,000 units to be sold on July 10.  In other words revise all Question 5.3 journal entries if the ABC sales contract is a firm commitment.

Bob Jensen's Answer

The cash balance is computed as follows:

The net gain from the put option is $15,000-$5,000 = $10,000.  This is also equal to the July 10 and March 31 P&L entries of $7,400+$2,600 = $10,000.  Hopeful gained $10,000 on the difference between inventory cost and sales amounts.  This brings the net profit form all transactions to $10,000+$10,000 = $20,000.  This is also the sum of the July 10 and March 31 P&L balances of $12,600+$7,400 = $20,000.

5.7
Please review your answer to Question 5.2 above.  Now you are to assume that Hopeful Corporation really gambled on the sales contract with ABC Company by selling short.   In other words, assume for the moment that there was no purchase contract Barker Manufacturing, Inc.  What are the March 31 adjusting entries in this short sale situation?  You are to assume that the put option is still in effect.

[Hint:  Look up the term "short sale" in Bob Jensen's SFAS 133 Glossary.]

Bob Jensen's Answer

Short sales cannot be hedges.  However, they can be hedged themselves with derivative financial instruments such as put options used to hedge the price of $100 per unit.

This is the opposite of KPMG 17.05 (Page 221)

 

5.8
Please review your answer to Question 5.4 above.  Would your answer change if the penalty clause is reduced from 75% to 2%?  Please revise all of your Question 5.4 journal entries if you conclude changes are necessary.

[Hint:  Look up the term "firm commitment" in Bob Jensen's SFAS 133 Glossary.]

Bob Jensen's Answer

Paragraph 540b requires the following for a firm commitment:

b. The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable.

Reduction of the penalty clause from 75% to 2% probably leaves the sales contract without a sufficient disincentive for nonperformance.  The sales contract is not a firm commitment.  Nor can it be a forecasted transaction since the notional (1,000 units) and the price ($100) are contracted and not allowed to vary.  Hence the put option cannot be a hedge of either a firm commitment or a forecasted transaction.  It must be accounted for as a speculation.

5.9
Please review your answer to Question 5.5 above.  Would your answer change if the penalty clause is reduced from 75% to 2%?   Please revise all of your Question 5.4 journal entries if you conclude changes are necessary.

The answers to Question 5.5 and Question 5.9 are identical.

 

5.10
Please review your answers to Questions 5.2 above.  Would your answers change if the contracted amount of 1,000 units is changed to a contracted range between 500 and 1,000 units of inventory at the discretion of the seller (Hopeful Corporation).  In other words, the sales quantity may fall anywhere in the specified range at the discretion of the seller?  Assume the seller still forecasts a 1,000 unit sale.

[Hint:  Look up the term "forecasted transaction" in Bob Jensen's SFAS 133 Glossary.]

This contractual clause has no impact since the seller can have a forecasted transaction without any sales contract per se.  If the seller forecasts a 1,000 unit sale the answers in Question 5.2 remain unchanged.  Paragraph 29b on Page 20 of SFAS 133 requires only that the transaction be probable.

 

5.11
Would your answer in 5.10 change if only the buyer (ABC Company)  had the contractual discretion of altering the sales quantity with the specified range?

My answer would not change as long as Hopeful Corporation still forecasted a 1,000 unit sale.  The fact that the buyer can change the quantitiy does not necessarily change the forecasted transaction.  Paragraph 29b on Page 20 of SFAS 133 requires only that the transaction be probable.

 

5.12
Please review your answer to Question 5.2 above.  Would your answer change if the   seller, Hopeful Corporation,  hoped as of March 31 but no longer expected the spot price to rise above in June and July.  Show your revised Question 5.2 journal entires in light of the dismal expectations of the product's selling price.

[Hint:  Look up the term "impairment" in Bob Jensen's SFAS 133 Glossary.]

If the Question 5.2 answers were deferring a loss in OCI, then the impairment tests in Paragraph 31 on Page 22 of SFAS 133 would require that the loss in OCI be reclassified into P&L for the amount of the loss that is expected to be realized due to impairment.  However, the Question 5.2 answers are deferring an OCI gain.  One would not want to reclassify the deferred gain into P&L if there is impairment.  I would not change the Question 5.2 answers.

KPMG 20.22 (Page 229)  illustrates a loss reclassification.

 

5.13
Please review your answer to Question 5.4 above. Would your answer change if Hopeful Corporation wrote an European-style call option instead of purchasing the put option?   In other words assume that there is still sales contract with ABC Company for 1,000 units at July 10 spot prices.   In addition, you are now to assume that some unknown company through a broker paid $5,000 on January 10 to Hopeful Corporation for a call option to buy 1,000 units on July 10 from Hopeful at $100 per unit.  The option is to be settled in cash rather than priduct units.  What are Hopeful Corporation's January 10 journal entries?  Do you think that, in theory, your revised January 10 solution adequately accounts for Hopeful Corporation's financial risk as the writer of this call option?

Bob Jensen's Answer

The relevant rules for a written option hedge of a forecasted transaction are given in Paragraph 28c on Page 19 of SFAS 133.  The hedged item must be a booked asset or liability.  In the case of the forecasted transaction with ABC Company, there is no booked asset or liability.  Hence, the written option cannot be accounted for as a cash flow hedge in this instance.  It must be accounted for as a speculation even though it does, in a sense, hedge the forecasted transaction.   Note, however, that unlike the purchased put option, the written call option exposes Hopeful Corporation to huge cash flow losses if the product price rises dramatically.  Showing the $5,000 written option liability may badly understate the ultimate unfavorable cash settlement.

KPMG 17.04 (Page 220)

File 1 Question 06
Can forecasted transactions with a minority interest company be hedged items by the parent of a subsidiary company?  Can the subsidiary company have a forecasted transaction with a minority interest owner? 

[Hint:  Look up the term "minority interest" in Bob Jensen's SFAS 133 Glossary.]

No. Paragraph 29f on Page 20 of SFAS 133 prohibits forecasted cash flows associated with minority interest in a consolidated subsidiary from being designated as a hedged item in a cash flow hedge. Because the preferred securities are classified as minority interest, it is precluded from designating the swap as a hedge of the variability in cash flows attributable to the preferred dividends.

KPMG q18.17 (Page 227)

File 1 Question 07
Suppose that Texaco has a take-or-pay contract to purchase 1 million gallons of crude from a joint venture in which it has a 30% interest.  If the price can vary with spot rates, can this contract be a hedged item under SFAS 133 rules?

[Hint:  Look up the term "take-or-pay" in Bob Jensen's SFAS 133 Glossary.]

According to Paragraph 290 on Page 145 of SFAS 133, the FASB did not take a definitive position on take-or-pay contracts as derivative instruments.  With such a large stake (30%) in the profits of the joint venture, I question whether a hedge on the oil price fluctuations can get preferred cash flow accountng treatment under SFAS 133. 

File 1 Question 08
What are the SFAS 133 rules regarding hedged items and their hedges that have unequal maturity dates?

[Hint:  Look up the term "forecasted transaction" in Bob Jensen's SFAS 133 Glossary.]

The hedge can have a shorter maturity than the hedged item.  Paragraph 20 allows this for fair value hedges.  For cash flow hedges of forecasted transactions, Paragraph 28a is silent as to whether a portion of a forecasted transaction can be a hedged item, but it seems reasonable to assume so.

It is more difficult when the hedge has a longer maturity than the hedged item.  It must be demonstrated that the hedge does does not have different risks over different intervals of time.  Most hedges do not have uniform risks for all subsets of time.  See Paragraph 18 beginning on Page 9 of SFAS 133.  

KPMG q18.13 (Page 225) and q18.14 (Page 226)

File 1 Question 09
Minigates Company trades in technology securities.  Can Minigates use SFAS 133 rules for a hedge of a forecasted transaction for 100,000 shares of Microsoft Corporation where the hedge is an an exchange-traded option on Microsoft's common share prices?  Assume the option will have a net cash settlement rather than delivery of shares.  Assume the shares themselves are classified as trading rather than available-for-sale under SFAS 115.    Explain the FASB's reasoning on this issue.

[Hint:  See Paragraph 29d on Page 20 of SFAS 133.]

No, trading securities cannot be hedged items for cash flow hedges under Paragraph 29d on Page 20 of SFAS 133.  The reason is that movements up and down in prices of these securities are posted to current earnings whether or not the movements are realized or unrealized gains and losses.  If the price movements themselves cannot be deferred (by either non-recognition or OCI postings), then there is no justification for deferring gains and losses on their hedging instruments.

Paragraphs 4c on Page 2, 38 on Page 24, and 479 on Page 209 of SFAS 133 state that a forecasted purchase of an available-for-sale can be a hedged item, because available-for-sale securities are revalued under SFAS 115 have holding gains and losses accounted for in OCI rather than current earnings, because movements of prices in those securities themselves are posted to OCI rather than current earnings.

KPMG q18.12 (Page 225)

File 1 Question 10
Can a pork belly Forward contract be used to hedge a forecasted sale of pork sausage from the inventory of a sausage making company?

[Hint:  See Paragraph 29g on Page 20 of SFAS 133.]

Yes if effectiveness tests are satisfied. In a hedge of a forecasted sale or purchase of a nonfinancial asset, paragraph 29g requires the designated risk to be the risk of changes in the cash flows relating to all changes in the purchase price or sales price of the asset (reflecting its actual location if a physical asset). Thus, we believe that the pork sausage forecasted sale could qualify for hedge accounting if it uses a pork belly Forward contract to hedge the risk of changes in cash flows relating to all changes in the sales price of the sausage. The sausage manufacturer must establish that this Forward contract is highly effective at achieving offsetting changes in the cash flows of the sausage inventory relating to all changes in the sales price of the sausage. The sausage manufacturer would be required to recognize hedge ineffectiveness to the extent that the cumulative gain or loss on the pork belly Forward contract does not move in tandem with the cumulative change in the expected future cash flows attributable to the forecasted sale of sausage inventory.

KPMG q18.09 (Page 223)

File 1 Question 11
Suppose an interest rate swap indexed to LIBOR is designated as a cash flow hedge of a variable interest rate portfolio linked to the U.S. prime rate of interest.  Can this be a cash flow hedge under SFAS 133 rules?   Explain the FASB's reasoning on this issue.

[Hint:  Look up the term "index" in Bob Jensen's SFAS 133 Glossary.]

No. Paragraph 29(a) of SFAS 133 states that if the hedged transaction is a group of individual transactions, those transactions must share the same risk exposure for which they are designated as being hedged. Further, Paragraph 462 of SFAS 133 includes an example such that the FASB concluded that forecasted interest payments on several variable-rate debt instruments must vary with the same index to qualify for hedge accounting with a single derivative instrument.

KPMG q18.07 (Page 222)

File 1 Question 12
What is a swaption?  Can a an instrument that contains a swaption qualify as a cash flow hedge under SFAS 133 rules?

[Hint:  See Paragraph 18c on Page 19 of SFAS 133 and  Bob Jensen's SFAS 133 Glossary.]

Yes, in certain circumstances.  SFAS 133 provides that a derivative instrument that results from combining a net written option and any other nonoption derivative instrument shall be considered a net written option.   As a written swaption fits this description, the entity would need to consider the net written option criteria of paragraph 28c to determine whether hedge accounting is appropriate.  A swaption qualifies for cash flow hedge accounting only if the combination of the hedged item (which must be a recognized asset or liability) and the swaption (or net written option) provides at least as much potential for favorable cash flows as exposure to unfavorable cash flows.  The test is met if a percentage favorable change in the underlying would provide at least as much favorable cash flows as the unfavorable cash flows that would be incurred from an unfavorable change in the underlying of the same percentage.  These situations should be rare for cash flow hedges.

In addition, when a derivative instrument is embedded in another derivative instrument, the entire instrument must qualify for hedge accounting in order for the derivative instrument to qualify for hedge accounting. For example, an entity may not separate a compound derivative instrument into two derivative instruments such that one would qualify for hedge accounting, while the other would not.

KPMG q17.03 (Page220)

File 1 Question 13
Compare Exhibit 5-1 on Pages 91-92 options with a current version of these same options.  For a given option (e.g., an American style Japanese yen option) show how the market has changed since July 21, 1992 for that option.   Then explain how the option might be used as a hedge and how it would be accounted for under SFAS 133.  Also discuss how to deal with having to purchase in blocks of   6,250,000 yen when the hedged transaction is specified at 10,000,000 yen.
 

Most questions are answered on Pages 94-95.  In order to hedge 10,000,000 yen, the basic choices are to have some hedge innefectiveness resulting for under-hedging (with one 6,350,000 contract) or over-hedging (with tw 6,350,000 contracts) .  It may be possible for the broker to arrange an odd lot deal, but this is not common in options trading.

File 1 Question 14
What makes accounting for options one of the most controversial areas of accounting for derivative financial instruments under FAS 133 rules?

[Hint:  "Hedge Desirability Under FAS 133," by John Bird ---http://www.gtnews.com/articles2/1623.html  
Trinity University students may find the article at  J:\students\acct5341\readings\133probs.htm ]

File 1 Question 15
Why was the need for an international standard "clearly seen a number of years ago when Daimler-Benz announced its financial results"?  Also discuss the other reasons given by Bird for international standards, including Paul Pacter's examples cited by John Bird.

[Hint:  "Focus on Hedging:  FAS 133, IAS 39 and the Movement Toward International Accounting Standards," by John Bird --- http://www.gtnews.com/articles3/1887.html
Trinity University students may find the article at  J:\courses\Acct5341\readings\133focus.htm ]

File 1 Question 16
What are interest rate options, and what are the most common ways that they are used to manage financial risk?

See Page 101 --- CBOT is the major exchange.

File 1 Question 17
Explain the concept of an option premium and then relate to that option's delta and lambda.
 

An option's delta is also called its hedge ratio.  It depicts the elasticity of the premium (price of the option) vis-a-vis price movements of the underlying asset of liability.  Technically is is the partial derivative of the premium with respect to the underlying.  It is the C/S ratio in the Black-Scholes model.  For the call option the range is [0<=P<=1] and the put option [-1<=P<=0].

File 1 Question 18
Explain why firms might want to write call options instead of purchasing put options to hedge foreign currency risk exposures?  What implications does this have for SFAS 133 accounting?

Page 98.  They want to receive the premium rather than pay a premium.  In doing so, option writers take on huge risks.  However, if they write many options and are careful about strike prices, the odds are in their favor unless the market prices plunge drastically.  An option write can prevent huge losses with covered calls.   Paragraph 399 on Page 180 of SFAS 133 does not allow covered call strategies that permit an entity to write an option on an asset that it owns.

From Bob Jensen's SFAS 133 Glossary:

An option written by an "option writer" who sells options collateralized by a portfolio of securities or other performance bonds. Typically a written option is more than a mere "right" in that it requires contractual performance based upon another party's right to force performance. The issue with most written options is not whether they are covered by SFAS 133 rules.  The issue is whether they will be allowed to be designated as cash flow hedges.  Written options are referred to at various points in SFAS 133. For example, see Paragraphs 20c, 28c, 91-92 (Example 6), 199, and 396-401.. For rules regarding written options see Paragraphs 396-401 on Pages 179-181 of SFAS 133.  Exposure Draft 162-B would not allow hedge accounting for written options.  SFAS 133 relaxed the rules for written options under certain circumstances explained in Paragraphs 396-401.  Note that written options may only hedge recorded assets and liabilities.  They may not be used to hedge forecasted purchase and sales transactions.

File 1 Question 19
Do some outside reading on the Black-Scholes model and its outgrowths for options other than European style options having no interim cash flows.  What are some of the advantages and limitations of these valuation models.  You need not write more than one page for this answer.  Try to write a very condensed summary of the advantages and limitations.

Main advantages are robustness and logical derivation.   Drawbacks are all the unrealistic assumptions (no transactions costs, normal distribution, etc.)

File 1 Question 20
After reading pp. 162-166 from your S&C textbook and the Johnson, Reither, and Swieringa article on pp. 175-187 of your S&C textbook, write down what you speculate are Professor Abdel-Khalik's reasons for calling comprehensive income a "garbage can" in my 133rasha.htm file.

Confusion over analyzing this element of the financial statements and the way OCI distorts the relationship between balance sheet items and income statement items.

File 1 Question 21
Since there are arguments for and against reporting unrealized holding gains and losses of assets in income statements, why don't standard setters such as the FASB and the IASC simply require two income st