1. The company received a variable interest rate loan and entered into an interest rate swap as a cash flow hedge to receive a fixed rate. In year 1, the company recognized interest expense on the loan and a gain on the interest rate swap.
2. In year 2, the company recognized interest expense on the loan at the higher market rate, paid interest on the loan, and recognized a loss on the interest rate swap to offset the higher market rate.
3. In year 3, the company will recognize interest expense on the loan at the higher market rate, pay interest on the loan, and make its final settlement on the interest rate swap.
1. The company received a variable interest rate loan and entered into an interest rate swap as a cash flow hedge to receive a fixed rate. In year 1, the company recognized interest expense on the loan and a gain on the interest rate swap.
2. In year 2, the company recognized interest expense on the loan at the higher market rate, paid interest on the loan, and recognized a loss on the interest rate swap to offset the higher market rate.
3. In year 3, the company will recognize interest expense on the loan at the higher market rate, pay interest on the loan, and make its final settlement on the interest rate swap.
1. The company received a variable interest rate loan and entered into an interest rate swap as a cash flow hedge to receive a fixed rate. In year 1, the company recognized interest expense on the loan and a gain on the interest rate swap.
2. In year 2, the company recognized interest expense on the loan at the higher market rate, paid interest on the loan, and recognized a loss on the interest rate swap to offset the higher market rate.
3. In year 3, the company will recognize interest expense on the loan at the higher market rate, pay interest on the loan, and make its final settlement on the interest rate swap.
1. The company received a variable interest rate loan and entered into an interest rate swap as a cash flow hedge to receive a fixed rate. In year 1, the company recognized interest expense on the loan and a gain on the interest rate swap.
2. In year 2, the company recognized interest expense on the loan at the higher market rate, paid interest on the loan, and recognized a loss on the interest rate swap to offset the higher market rate.
3. In year 3, the company will recognize interest expense on the loan at the higher market rate, pay interest on the loan, and make its final settlement on the interest rate swap.
Fill in the blanks: (ULO h) On the space provided for, write the correct answer for every item described or defined below. Futures Contract 1. It is traded in an exchange market, so the parties do not know who is on the other side of the contract. Profit or Loss 2. Under fair value hedge, loss or gain on interest rate swap is reported immediately through __________ . Interest Rate Swap 3. It is a contract where two parties agree to exchange cash flows for future interest payments based on a contract of loan. _True 4. A derivative is a financial instrument that derives its value from the movement in commodity price, foreign exchange rate and interest rate of an underlying asset of financial instrument. (True or False) Loss 5. Under fair value hedge, there is _______ on note payable when the fair value of the note payable is higher than the carrying amount.
Forward Contract 6. It is designated as a cash flow hedge; an agreement to purchase or sell a
specified commodity on a future date at a specified price.
_Other comprehensive income 7. Unrealized gain on forward contract is reported through
_______.
_Hedging 8. It is a means of protecting a financial loss such as interest rate swap, forward contract, futures contract, option and foreign currency forward contract.
Unrealized Gain/loss – interest rate swap 9. This account is debited or credited for decrease in the fair value of the swap receivable or payable due to passage of time.
Cash Flow Hedge 10. The unrealized gain or unrealized loss is a component of other comprehensive income because the derivative is designated as __________ type of a hedge.. _Purchases 11. On the date of the actual purchase, purchases is recorded equal to the market price and the unrealized gain-forward contract is to be closed by crediting/deducting it from this account.
_Option_premium 12. It is a right. Call option on the part of the buyer and put option on the part of the seller. It is to be paid for and the amount paid is called __________ .
True or false:(ULO h) Write true if the statement is true and false if the statement is wrong.
False 1. A derivative instrument is best described as a contract that conveys to a second entity a right to future collections on accounts receivable from a first entity.
1 False 2. All of the following are characteristics of a derivative: a. It is required for the purpose of generating a profit from short term fluctuation in market price. b. The value changes in response to an underlying. c. It requires no initial investment or an initial small investment. d. It is settled at a future date.
True 3. One of the following is not a characteristic of a derivative financial instrument;
a. The instrument has one or more underlying and an identified payment provision. b. The instrument requires a large investment at the inception of the contract. c. The instrument requires or permits net settlement. d. All of these are characteristics of a derivative financial instrument.
_True 4.Derivatives are measured at Fair value.
False 5. If the market price is greater than the strike or option price, the call option is out of the money.
False 6. All of the following are based on a highly probable forecast transaction; a. Forward contract b. Futures contract c. Option d. Interest rate swap True 7. The amount initially paid for a call option is Option premium.
False 8. Futures contract is unique in that it protects the owner against unfavourable movement in the price while allowing the owner to benefit from favourable movement.
_True 9. A derivative is a financial instrument that derives its value from the movement in commodity price, foreign exchange rate and interest rate of an underlying asset of financial instrument.
False 10. In a cash flow hedge, gain or loss on interest rate swap is recognized in profit or loss.
Let’s Analyze – Exercises. (ULO i) Getting acquainted with the essential terms in the study of Derivatives is not enough, what also matters is your ability to analyze, solve and journalize transactions of a problem situation. Now, I will require you to analyze, solve and journalize the following transactions of these problems.
1. Exercise 1 On January 1, 20A Rode company received a 5-year variable interest rate loan of 3,600,000 with interest payment at the end of each year and the principal to be repaid on Dec. 31, 20E.
2 The interest rate for 20A is 8% and the rate in each succeeding year is equal to market interest rate on January 1 of each year.
In connection with the loan, the entity entered into an interest rate swap agreement with another financial institution.
The entity will receive a swap payment if the interest on January 1 is more than 8% and will make a swap payment if the interest is less than 8%.
The swap payments are made at the end of the year. This interest rate swap agreement was designated as a cash flow hedge.
On January 1, 20B, the market rate of interest is 9% and on January 1, 20C, the market rate of interest is 6%. Present value of an ordinary annuity of 1 at 9% for 4 periods 3.24 Present value of 1 an ordinary annuity of 1 at 6% for 3 periods 2.67
Required: Prepare journal entries for 20A and 20B in connection with the loan and the interest rate swap agreement. Show all of the necessary solution.
3 2. Exercise 2.On January 1, year 1Kyle Company borrowed 3,000,000 from Alpas bank at a 8% fixed interest rate.
The interest is to be paid annually on December 31 of each year and the principal to be repaid on December 31, year 3. The loan is evidenced by a signed promissory note.
On January 1, year 1, the entity entered into a “receive fixed, pay variable” interest rate swap with a speculator and has designated the swap as a fair value hedge of the fixed interest rate loan.
The market rate of interest on January 1 of each year determines the interest swap settlement to be made every December 31.
Market rates of interest:
January 1, year 1 8% January 1, year 2 10% January 1, year 3 11%
The present value of 1 at 10% for two periods is .8264; the present value of an ordinary annuity of 1 at 10% for two periods is 1.7355 and the present value of 1 at 11% for one period is 0.9009.
Answer: January 1, year 1 Cash 3,000,000 Notes Payable 3,000,000
December 31 Interest expense (3,000,000*8%) 240,000
Cash 240,000
Dec. 31
PV of principal (3,000,000*.8264) 2,479,200
PV of fixed interest (240,000 *1.7355) 416,520 Total FV 2,895,720 Carrying Amount 3,000,000 Decrease in liability – gain 104,280
4 December 31 year 2 Interest expense 2,895,720*.10 = 289,572 Interest paid 3,000,000*. 08= 240,000 Amortization of discount on N/P 49,572
Interest Expense 289,572
Cash 240,000 Note payable 49,572
Another entry to recognizegain or lsos on N/P
PV of principal 3,000,000 * .9009 = 2,702,700
PV of interest 240,000 *.9009 = 216,216 Total 2,918,916 Carrying amount of N/P 2,895,720 + 49,572 = 2,945,292 Decrease in note payable - gain 26,376
Note payable 26,376
Gain on note payable 26,376
Interest rate swap payable 2%*3,000,000 60,000
Cash 60,000 To record swap payment to speculator
Net cash to be paid to speculator 11%-8% = 3% * 3,000,000= 90,000
PV of 1 at 11% for one period .9009 Interest rate swap payable end 81,081 Interest rate swap payable balance 104,130-60,000= 44,130 Increase in Interest rate swap payable 36,951
Loss on interest rate swap 36,951
Interest rate swap payable 36,951
Year 3
Interest expense FV of N/P 2,918,916 * .11 = 321,081
Interest paid 240,000 Amortization of discount 81,081
Interest expense 321,081
Cash 240,000 Note payable 81, 081
5 Dec. 31 Interest rate swap payable 3,000,000 * .03 90,000 Cash 90,000 To record payment to speculator.
Final cash payment to speculator 90,000
CA of Interest rate swap payable 81,081-90,000 8,919 Loss on interest rate swap 81,081
Loss on interest rate swap 81,081
Interest rate swap payable 81,081
Note payable 3,000,000
Cash 3,000,000
3. Exercise 3 On Sept. 1, 20A, Celine Company determined that it will need to purchase 80,000 kilos of tuna fish on January 31, 20B. Because of the volatile fluctuation in the price of tuna fish, on Sept. 1, 20A, the entity negotiated a forward contract with a reputable financial institution for the entity to purchase 80,000 kilos of tuna fish on January 31, 20B at a price of 6,400,000 or 80 per kilo. The forward contract is designated as a cash flow hedge. The market price of tuna fist per kilo is 78 on December 31, 20A and 75 on January 31 20B. Required: Prepare journal entries for 20A and 20B.
Answer: December 31, 2017 80-78=2(80,000)=160,000 Unrealized Loss – FC 160,000 Forward Contract payable 160,000
January 31, 20B
78-75=3 * 80,000 = 240,000 Unrealized loss – FC 240,000 Forward contract payable 240,000
Forward Contract payable 400,000
Cash 400,000
Purchases (80,000 * 75) 6,000,000
Cash 6,000,000
Purchases 400,000 Unrealized Loss - FC
6 4. Exercise 4 Gen Company requires 45,000 kilos of soya beans each month in the manufacture of its product. To eliminate the price risk associated with the purchase of soya beans on Dec. 1, 20A, the entity entered into a futures contract as a cash flow hedge to buy 45,000 kilos of soya beans at 150 per kilo on Feb. 1, 20B. Required: Prepare journal entries for 20A and 20B assuming: a. The market price per kilo of soya beans is 160 on Dec. 31, 20A and 165 on Feb 1, 20B. b. The market price per kilo of soya beans is 160 on Dec. 31, 20A and on Feb 1, 20B is 145. Answer: Case a 160-150=10*45,000 = 450,000 Futures Contract receivable - 450,000 Unrealized Gain – FC 450,000
Feb. 1, 20B 165-160 = 5 * 45,000 = 225,000 Futures contract receivable 225,000 Unrealized gain – FC 225,000
Cah 675,000 Futures contract rec. 675,000
Unrealized gain – FC 675,000
Purchase 675,000
Purchases 165*45,000 = 7,425,000
Cash 7425,000
Case B Dec. 31, 20A 160-150=10*45,000 = 450,000 Futures Contract receivable - 450,000 Unrealized Gain – FC 450,000
Feb 1, 20B 160-145 = 15 * 45,000 = 675,000 Unrealized Gain – FC 450,000 Unrealized loss – FC 225,000 FC receivable 450,000 FC payable 225,000
Purchases 145*45000 = 6,525,000
Cash 6,525,000
Purchases 225,000 UL- Fc 225,000
7 5. Exercise 5 Rizza company uses approximately 140,000 units of raw material in the manufacturing operations. On Dec. 1, 20A, the entity purchased a call option to buy 140,000 units of raw material on June 1, 20B at a price of 25 per unit.
The entity paid 14,000 for the call option and designated the call option as a cash flow hedge against price fluctuation for the June purchase.
On December 31, 20A, the market price of the raw material is 27 per unit and on June 1, 20B the market price is 28.
Required: Prepare journal entries for 20A and 20B to record the call option and the purchase of the raw material.
In a Nutshell In not less than 50 words, explain the importance of entering into derivative contracts from a business owner’s viewpoint. Please answer in English only. ____________________________________________________________________________ ____________________________________________________________________________
