E 12-3 Firm sales commitment

Brookings Company signs a firm sales commitment with Rivers Company. The contract is to sell 100,000 widgets deliverable in three months, on January 31, 2009, at the prevailing market price of widgets at that date. On November 1, 2008, the current sales price of widgets is $5 each. Brookings is concerned that the sales price could decrease by the time the delivery is to occur. On November 1, 2008, Brookings contracts with Lynn Company to buy 100,000 widgets deliverable on January 31, 2009, for $5 each. The forward contract is to be settled net. Assume that 6% is a reasonable annual discount rate.

Prepare the journal entries to record the firm sales commitment and forward contract on the following dates:

a. November I, 2008, assuming a sales price of S5.00 per widget

b. December 31, 2008, assuming a sales price of $4.50 per widget

c. January 31, 2009, assuming a sales price of $6 per widget

E 12-4 Hedging of an Existing Asset

Wilson Company has 100,000 units of widgets in its inventory on October 1, 2008. Wilson purchased them for $1 per unit one month ago. It hedges the value of the widgets by entering into a forward contract to sell 100,000 widgets on January 31, 2009, for $2 each. The contract is to be settled net. Assume that a discount rate of 6% is reasonable.

Prepare the journal entries to properly account for this hedge of an existing asset on the following dates:

a October 1, 2008, when the widget price is $1.50

b December 31, 2008, when the widget price is $2.50

c January 31, 2009, when the widget price is $2.30

E 12-5 Hedge of an anticipated purchase

On December 1, 2008, Jolly Rice Company enters into a 90-day forward contract with a rice speculator to purchase 500 tons of rice at $1,000 per ton. Jolly Rice enters into this contract in order to hedge an anticipated rice purchase. The contract is to be settled net. The spot price of rice at December 1, 2008, is $950. On December 31, 2008, the forward rate is $980 per ton. The contract is settled and rice is purchased on February 28, 2009. The spot and forward rates when the contract is settled are $1,005. Assume that Jolly purchases 500 tons of rice on the date of the forward contract's expiration. Assume that this contract has been documented to be an effective hedge. Also assume an appropriate interest rate is 6%.

1. Prepare the required journal entries to account for this hedge situation and the subsequent rice purchase on:

a. December 1, 2008

b. December 31, 2008

c. The settlement date

2. Assume that the rice is subsequently sold by Jolly on June 1, 2009, for $1,200 per ton. What journal entries will Jolly make on that date?

P 12-1 Cash flow hedge, futures contract

Northwest Gas Works, a consumer gas provider, estimates a rather cold winter. As a result it decides to enter into a futures contract on the NYMEX for natural gas on November 2, 2008. The trading unit is 10,000 million British thermal units (MMBtu). The three-month futures contract rate is $7.00 per MMBtu, so each contract will cost Northwest Gas Works $70,000. In addition, the exchange requires a $5,000 deposit on each contract. Northwest enters into 20 such contracts.

REQUIRED with calculation:

1. Why is this futures contract likely to be considered an effective hedge and therefore qualified for hedge accounting?

2. Why would this transaction be accounted for as a cash flow hedge?

3. Assume that the December 31, 2008, futures contract rate is $6.75 for delivery on February 2, 2009, and the spot rate on February 2, 2009, is $6.85. Assume that Northwest Gas Works sells all of the gas on February 3, 2009, for $8.00 per MMBtu. Prepare all the necessary journal entries from November 2, 2008, through February 3, 2009, to account for this hedge situation.

P 12-2 Cash flow hedges, Interest rate swap

On January 1, 2008, Campion Company borrows $400,000 from Veneta Bank. The five-year term note is a variable-rate one in which the 2006 interest rate is determined to be 8%, the LIBOR rate at January 1, 2008 2%. Subsequent years' interest rates are determined in a similar manner, with the rate set for a particular year equal to the beginning-of-the-year LIBOR rate + 2%. Interest payments are due on December 31 each year and are computed assuming annual compounding. Also on January 1, 2008, Campion decides to enter into a pay-fixed, receive-variable interest rate swap arrangement with Graham, Inc. Campion will pay 8%. Assume that the LIBOR rate on December 31, 2008, is 5%.

1. Why is this considered a cash flow hedge instead of a fair value hedge?

2. Do you think that this hedge would be considered effective and therefore would qualify for hedge accounting?

3. Assuming that this hedge relationship qualifies for hedge accounting:

a. Determine the estimated fair value of the hedge at December 31, 2008, Recall that the hedge contract is in effect for the 2009, 2010, 2011, and 2012 interest payments.

b. Prepare the entry at December 31, 2008, to account for this cash flow hedge as well as the December 31, 2008, interest payment.

4. Assuming that the LIBOR rate is 5.5% on December 31, 2009, prepare all the necessary entries to account for the interest rate swap at December 31, 2009, including the 2009 interest payment.

F 12-3 Fair value hedge, option

Instrument Works makes sophisticated medical equipment. A key component of the equipment is Grade A silver. On May 1, 2008, Instrument Works enters into a firm purchase agreement to buy 1,200,000 troy ounces (equal to 100,000 pounds) of Grade A silver from Silver Refiners, Inc., for delivery ori February 1, 2009, at the market price on that date. To hedge against volatility in price, Instrument Works also enters into an option contract with Currency Traders to put 1,200,000 troy ounces on February 1, 2009, for $10 per troy ounce, the market price on May 1, 2008. If the mar-ket price of silver is below $10 per troy ounce on May 1, then Instrument Works will let the option expire. If it is above $10 per troy ounce, then it will exercise the option. The option is to be settled net. Commodity Traders will pay Instrument Works the difference between the market price and the exercise price. The option costs Instrument Works $1,000 initially. Assume that a 6% annual incremental borrowing rate is reasonable.

1. Why would you expect this situation to qualify for hedge accounting?

2. Why should this hedge be accounted for as a fair value hedge instead of as a cash flow hedge?

3. What entries should be made on May 1, 2008, to account for the firm commitment and the option?

4. Assume that the market price for Grade A silver is $9 per troy ounce on December 31, 2008. What are the required entries?

5. Assume that the market price of Grade A silver is $9.50 per troy ounce on February 1, 2009, when Instrument Works receives the silver from Silver Refiners. Prepare the appropriate journal entries on February 1, 2009.

p 1 2-4

Accounting for foreign currencydenominated [receivables and payables-multiple years

The accounts of Lincoln International, a U.S. corporation, show $81,300 accounts receivable and $38,900 accounts payable at December 31, 2008, before adjusting entries are made. An analysis of the balances reveals the following:

Accounts Receivable

Receivable denominated in U.S. dollars $28,500

Receivable denominated in 20,000 Swedish krona 11,800

Receivable denominated in 25,000 British pounds 41,000

Total $81,300

Accounts Payable

Payable denominated in U.S. dollars $ 6,850

Payable denominated in 10,000 Canadian dollars 7,600

Payable denominated in 15,000 British pounds 24,450

Total $38,900

Current exchange rates for Swedish krona, British pounds, and Canadian dollars at December 3 1, 2006, are $0.66, $1.65, and $0.70, respectively.

REQUIRED with calculation:

1. Determine the net exchange gain or loss that should be reflected in Lincoln's income statement for 2008 from year-end exchange adjustments.

2. Determine the amounts at which the accounts receivable and accounts payable should be included in Lincoln's December 31, 2008, balance sheet.

3. Prepare journal entries to record collection of the receivables in 2009 when the spot rates for Swedish krona and British pounds are $0.67 and $1.63, respectively.

4. Prepare journal entries to record settlement of accounts payable in 2009 when the spot rates for Canadian dollars and British pounds are $0.71 and $1.62, respectively.