BA 119

Assignment: Hedge Accounting

Requirement:
(1) For each scenario, identify the hedged item, the hedging instrument and the hedging relationship.
Moreover, give the details of the hedging instrument identify the derivative used, the position
and the nominal principal.
(2) Answer the additional questions at the end of every scenario.

1. On January 3, 20X4, Realto Company issued a $5,400,000, 3-year note payable with a fixed
interest rate of 8% payable semiannually. By the end of June 20X5, Realto's controller, believed
that interest rate would fall over the next year. On July 3, 20X5, Realto Company entered into an
interest rate swap with the First Columbia Bank. The bank required a premium of 10,400. The
swap had a notional amount of $5,400,000 and called for the payment of a variable interest rate in
exchange for the 8% fixed rate. The variable rates are reset semiannually beginning on July 1,
20X5, in order to determine the next interest payment. Differences between rates on the swap will
be settled on a semiannual basis. Variable interest rates and the value of the swap on selected
dates are as follows:

July 1, 20X5
December 31, 20X5
June 30, 20X6

Variable
Interest
Rate
7.90%
7.60
7.35

Value of
the Swap
$18,900
16,200

Required:
For December 31, 20X5, determine:
a. The net interest expense
b. The carrying value of the note payable
2. On March 1, 20X1, Adler Company issued a 5 year, $150,000 note at 7% fixed interest, payable
semiannually on August 31st and February 28th. Based on the economic conditions on March 1,
20X3, Adler Company believes the interest rate will decline over the next few years. As a result
Adler Company enters into an interest rate swap where it agrees to pay the LIBOR of 6.75% for
the first 6 months. At the end of each 6-month period the variable rate will be reset to the current
LIBOR. The LIBOR on September 1, 20X3 is 7.75%.
Required:
For August 31, 20X3 and February 28, 20X4, determine the net interest expense and the net
unrealized gain or loss on the swap.

3. On June 30, 20X5, Adams Company had a $500,000, 7.4% fixed rate note due in 2 years. The
note has been outstanding since May 26, 20X4 and the interest on the note is paid on June 30 and
December 31 each year. The controller of Adams believed that interest rates would drop over the
next two years, so he entered into a 2-year swap with Belmont National Bank to convert the
fixed-rate note into a variable-rate note. According to the agreement, Adams Company will
receive interest at a fixed rate of 7.4% and will pay a variable rate as determined by LIBOR. The
LIBOR on June 30, 20X5 was 7.1%. The swap agreement calls for the variable rate to be reset
each six months. The swap fair value on December 31, 20X5 was $6,300.
Required:
1. Present the journal entries, if any, to record the following events:
a. The entry to record the swap on June 30, 20X5.
b. The entries to record the semiannual interest payment on the debt and the settlement of
the semiannual swap on December 31, 20X5.
c. The entries to record changes in fair value required by the above information on
December 31, 20X5.
2. Present a partial balance sheet and income statement for the fiscal year ended December 31,
20X5 to include accounts affected by the above information.
3. On July 1, 20X1, Littleton Inc. loaned a key supplier of raw material $2,000,000 to construct a
new processing facility. The loan is due on July 1, 20X3 and pays interest each December 31 and
June 30. The supplier insisted on a variable rate loan. Charles Upton, controller of Littleton Inc.,
wants to avoid the risk of variable interest rate fluctuations. As a result, Littleton Inc. entered into
an interest rate swap in which it will pay the variable rate on $2,000,000 in exchange for a fixed
interest rate of 8.3%. The swap is settled on the interest payment dates. Variable interest rates and
the value of the swap on selected dates are as follows:

July 1, 20X1
December 31, 20X1

Variable
Interest
Rate
7.9 %
7.75%

Value of
the Swap
$10,400

Required:
Prepare all entries to record this hedge through December 31, 20X1.
4. Paton Company has an $11,000,000, note payable outstanding with a variable rate equal to
LIBOR of 8.4% which matures on June 30, 20X3. The variable rates are reset each 6 months for
the following 6-month period. The company believes that interest rates have bottomed, and they
will begin to rise. At the end of June 20X1, Paton Company negotiated an interest rate swap with
York National Bank of Bellingham that would allow Paton to pay a fixed rate of 7.75% in
exchange for receiving interest based on the LIBOR. The swap is effective July 1, 20X1. The
settlement date for the swap coincides with the company's interest payment dates.
The criteria for special accounting have been satisfied, and the hedging relationship has been
properly documented. Management of Paton Company has concluded that the hedge will be
highly effective. Paton Company's fiscal year end is June 30. The LIBOR and swap values are as
follows:
LIBOR

Swap Value

June 30, 20X1

December 31, 20X1
June 30, 20X2

8.4 %
8.55%
8.1 %

$19,300
(8,010)

Required:
Present the journal entries to record the above events from December 31, 20X1 through June 30,
20X2.
5. Jensen Company forecasts a need for 200,000 pounds of cotton in May. On April 11, the company
acquires a call option to buy 200,000 pounds of cotton in May at a strike price of $0.3765 per
pound for a premium of $814. Spot prices and options values at selected dates follow:
Spot price per pound
Fair value of option

April 11
$0.3718
814

April 30
$0.3801
1,137

May 3
$0.3842
1,689

Jensen Company settled the option on May 3 and purchased 200,000 pounds of cotton on May 17
at a spot price of $0.3840 per pound. During the last half of May and the beginning of June the
cotton was used to produce cloth. One third of the cloth was sold in June. The change in the
option's time value is excluded from the assessment of hedge effectiveness.
Required:
1. Prepare all journal entries necessary through June to record the above transactions and events.
2. What would the effect on earnings have been if the forecasted purchase were not hedged?
6. Pearson Industries uses platinum in its manufacturing process. The company will need 1,500 troy
ounces of platinum for a production run in June. The company is concerned that platinum prices
will rise over the next several months. On May 14, in order to hedge against rising prices, Pearson
Industries purchases 30 June call options on platinum. Each option is for 50 troy ounces and has a
strike price of $477 per troy ounce. The company excludes changes in the time value of the
options from hedge effectiveness. Spot prices and option value per troy ounce of platinum are as
follows:

Spot price
Option value

May 14
$479
9.60

May 31
$486
14.38

June 8
$492
16.34

On June 8, the company settled the options and on June 9 purchased 3,250 troy ounces of
platinum on account for $493 per ounce. The platinum was used in the production process
through the end of September. Platinum used during June was 325 troy ounces. Assume that the
hedge satisfies all necessary criteria for special hedge accounting.
Required:
Prepare all journal entries necessary to account for the above transactions and events.

7. On October 9, 20X1, Bertatie Company acquired 8,000 shares of Bulloch Company common
stock at $39.20 per share. Bertatie Company classifies the investment as available-for-sale.
Bertatie Company is considering a long-term relationship with Bulloch Company and may
acquire a more substantial interest. In the mean time, to hedge against a decline in Bulloch stock
price, Bertatie Company purchased a put option for a premium of $740. The option gives Bertatie
Company the right to sell 8,000 shares at a strike price of $39.20 per share. The option expires on
April 21, 20X2. On December 31, 20X1, the price of Bulloch Company stock was $38.75 and the
time value of the put option was $614.

Required:
1. Prepare the journal entries to the purchase of the Bulloch Company stock and the December
31, 20X1 year end adjusting entries.
2. Prepare a partial balance sheet and income statement for the year ended December 31, 20X1
for Bertatie Company.