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ADVANCED TOPICS IN FINANCIAL ACCOUNTING AND REPORTING (MODADV3)

UNIT 6 DERIVATIVES (IAS 32, 39, IFRS 7, 9, IFRIC 9)


ESTIMATED TIME: 4 HOURS

Problem 1 Interest rate swap


On January 1, 20A1, Timberland Company received a 5-year, P5,000,000 loan bearing an
interest equivalent to T-bill plus 5%. The T-bill rate will be the rate on January 1 of each year.
The interest is payable the end of each year while the principal will be repaid on December 31,
20A5. The T-bill rate on January 1, 20A1 is 3%. In conjunction with this loan, Timberland
entered into an interest rate swap with a finance company. Under this arrangement, Timberland
will be paying finance company 8% while the finance company will be paying Timberland T-bill
plus 5%. The swap payments will be made every December 31. On January 1, 20A2 the T-bill
rate is 5% while on December 31, 20A2, the rate is 2%.
Required:
1. Determine whether the hedge is a cash flow or fair value hedge.
2. Prepare all the necessary journal entries in the books of Timberland in 20A1 and 20A2. For
purposes of estimating future swap payments, assume that the current interest rate is the
best forecast of the future interest rate.
3. Determine the carrying amount of Derivative asset/liability as of December 31, 20A1 and
20A2 and the gain or loss to be recognized directly to profit or loss and to other
comprehensive income for the year ended December 31, 20A1 and 20A2.

Problem 2 Forward contract, foreign currency receivable


Mishkin Manufacturing Company is engaged in the sale of semiconductor products. Its
functional currency is Philippine peso and adopts the calendar year accounting period.

On December 1, 20A1, it sold US$500,000 worth of semi-conductor products to Pearson


Company, a US company, payable on February 1, 20A2. The foreign exchange rate on
December 31, 20A1 is US$1=P46. Mishkin expects the Philippine peso to appreciate. Hence,
there is a risk that it may incur foreign exchange loss on the said sales transaction. On the same
date, Mishkin entered into a forward contract to sell US dollars on February 1, 20A2, with
Stanley bank at US$1=P46. The foreign exchange rate of December 31, 20A1 is US$1=P43.

Mishkin collected the receivable from Pearson on February 1, 20A2. At the same time, the
forward contract was settled. The foreign exchange rate on the said date is US$1=P45.
Required:
1. Determine whether the hedge is a cash flow or fair value hedge.
2. Prepare all necessary journal entries in the books of Mishkin in 20A1 and 20A2.
3. Determine the carrying amount of derivative asset/liability as of December 31, 20A1, and the
gain or loss to be recognized directly to profit or loss and to other comprehensive income for
the year ended December 31, 20A1.

Problem 3 Forward contract, foreign currency loan


Megan Rose Cuisine operates a chain of fine seafood restaurants. The company is undergoing
expansion and in order to finance its expansion program, it obtained a Euro300,000 loan on
September 30, 20A1 from Angela Bank, a French company. The loan is payable on September
30, 20A4 while the interest based on market rate is payable every September 30. The interest
rate on the loan is based on the interest rate every September 30, (i.e. interest for the first year
is based on September 30, 20A1, interest for the second year is based on September 30, 20A2
and so on.) The exchange rate on September 30,20A1 is Euro1=P52. Because of the volatility
of foreign exchange rate, the company negotiated a special forward contract to buy Euro on
September 30, 20A4 with Premier Investment Bank for Euro1=P52. This is to hedge the
principal on the loan. Megan Rose paid the loan on September 30, 20A4. The forward contract
was also settled on the same date.
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The foreign exchange rates on various dates are as follows:
September 30, 20A2 Euro1=P53
September 30, 20A3 Euro1=P51
September 30, 20A4 Euro1=P55

Megan Rose adopts the fiscal year accounting period ending September 30. The discount rates
on various dates are as follows:
September 30, 20A1 7%
September 30, 20A2 8%
September 30, 20A3 6%
September 30, 20A4 9%

Required:
1. Determine whether the hedge is a cash flow or fair value hedge.
2. Prepare all necessary journal entries in the books of Megan Rose for 20A1, 20A2, 20A3 &
20A4
3. Determine the carrying amount of derivative asset/liability as of September 30 20A1, 20A2,
20A3 and 20A4, and the gain or loss to be recognized directly to profit or loss and to other
comprehensive income for the year ended September 30, 201A1, 20A2, 20A3 and 20A4.

Problem 4 Futures contract, future purchase transaction


Yokochan Bakeries specializes in making cakes, cookies and other pastries out of rice flour
which they grind themselves. Yokochan anticipates purchasing 40,000 kilograms of rice on
January 31, 20A2. On November 1, 20A1, Yokochan entered into a futures contract with Sagara
Growers to hedge against the risk of rising prices of rice.

Yokochans management expected that the futures contract was an effective hedge of the
anticipated purchase transaction and that the other conditions for hedge accounting are met.
For the purpose of assessing hedge effectiveness, the entire change in fair value of the futures
contract was compared with the change in the expected cash flows.

The sport prices of rice and the prices of rice futures contracts are as follows:

Spot price of rice Futures price of rice


per kg. per kg. for January
31, 20A2 delivery
November 1, 20A1 P50.00 P51.00
December 31, 20A1 55.20 55.50
January 31, 20A2 58.00 58.00

Yokochan purchased the rice and settled the futures contract on January 31, 20A2.
Required:
1. Determine whether the hedge is a cash flow or fair value hedge.
2. Assess the effectiveness of the hedge during the life of the futures contracts on a period-to-
period basis as well as on a cumulative basis.
3. Prepare all the necessary journal entries in the books of Yokochan for 20A1 and 20A2.
Assume the hedge effectiveness is assessed on a cumulative basis.
4. Determine the carrying amount of derivative asset/liability as of December 31, 20A1 and the
gain or loss to be recognized directly to profit or loss and to other comprehensive income for
the year ended December 31, 20A1.

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Problem 5 Futures contract, forecasted sale of inventory
Eastern Company had inventory of 5 million ounces of one-ounce silver coins which were
carried at a cost of P15 million (current market value is P16.5 million). The selling price of the
silver coins was largely determined by the spot price of silver which accounted for the bulk of
the manufacturing costs. In recent months, the price of silver had risen substantially due to
disruption in supply as a result of strikes in Australia which is the main producer of silver. The
management of Eastern Company was concerned about a potential fall in the price of silver
when the supply shortage eases to hedge against the risk, the management of Eastern
Company sold silver futures contracts with a total notional quantity of 5 million ounces at P3.29
per ounce on October 1, 20A1. The contract matured on June 30, 20A2. The commodity
exchange required a margin deposit of P0.03 per ounce for the futures contract. The level of
margin deposit had to be maintained at all times.

The management of Eastern Company had proven that there was a very high correlation
between the spot prices of silver and the selling price of silver coins. Therefore, the
management expected that the futures contract was an effective hedge of the anticipated sale
and that the other conditions for hedge accounting were met. For the purposes of assessing
hedge effectiveness, the entire change in the fair value of the futures contract was compared
with the change in the expected cash flows.

The spot prices of silver coins and the prices of silver futures contracts for June 30, 20A2
delivery are as follows:
Spot price of Futures price per
one-ounce silver ounce for June 30,
coin 20A2 delivery
October 1, 20A1 P3.300 P3.290
December 31, 20A1 3.268 3.252
March 31, 20A2 3.155 3.141
June 30, 20A2 3.015 3.015

The entire inventory was sold off on June 30, 20A2 at P3.015 per ounce. Eastern Company
adopts the calendar year accounting period.
Required:
1. Determine whether the hedge is a cash flow or fair value hedge.
2. Assess the effectiveness of the hedge during the life of the futures contracts on a period-to-
period basis as well as on a cumulative basis.
3. Prepare all the necessary journal entries in the books of Eastern Company for 20A1 and
20A2. Assume the hedge effectiveness is assessed on a cumulative basis. Ignore
movement in the margin deposit.
4. Compute and compare the profit on the sale of the inventory with and without the hedging.

Problem 6 Call option, forecasted purchase transaction


On March 1, 20A1, East West Airlines, Inc., purchased an at-the-money call option on
100,000barrels of jet-fuel oil with an exercise price of P40 per barrel for delivery on May 31,
20A1. East West paid a premium of P200,000 for the call option. The following are the quoted
spot prices for the jet-fuel oil and the call option from March 1, 20A1 to May 31, 20A1.
Spot price of Price of May 31, 20A1
Jet-fuel oil Call Option
March 1, 20A1 P40 per barrel P2 per barrel
March 31, 20A1 P42 per barrel P3 per barrel
April 30, 20A1 P45 per barrel P6 per barrel
May 31, 20A1 P44 per barrel P4 per barrel

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The option contract was to hedge against the forecasted purchase of 100,000 barrels of jet-fuel
oil on May 31, 20A1. The option contract was an effective hedge as the critical terms matched
and the time value of the option contract was excluded from the hedging relationship. The
contract would be settled on a net basis. East West financial year-end is April 30.
Required:
1. Determine whether the hedge is a cash flow or fair value hedge.
2. Calculate the time value and intrinsic value of the option contract on March 31, 20A1, April
30, 20A1 and May 31, 20A1.
3. Prepare all the necessary journal entries in the books of East West Airlines Inc. for 20A1.

Problem 7 Put option, firm commitment


On November 30, 20A1, Systech Ltd. Entered into a non-cancellable contract to buy 100,000
shares of Fastrack LTD. For P6,500,000 on July 31, 20A2. On the same date Systech Ltd.
purchased a put option on 100,000 Fasttrack shares for P350,000 to hedge the risk of a fall in
the fair value of the commitment. The exercise price was P65 per share. The put options
expiration date was July 31, 20A2. Data on the price movements of Fastrack shares and the put
option are as follows:
Price of Fastrack Shares Put Option
November 30, 20A1 P65 P350,000
June 30, 20A2 59 800,000
July 31, 20A2 55 1,100,000

Systech designated the option contract as a hedge of the risk of changes in the fair value of the
firm commitment resulting from changes in the price of Fastracks shares. Systech excluded the
time value of the option contract from the hedging relationship. Systech Ltd. Closed the position
on the put option on July 31. 20A2, fulfilled its obligations under the contract and sold off its
shares on the same date. Systech year-end is June 30.
Required: Prepare all the necessary journal entries in the books of Systech for 20A1 and 20A2.

Problem 8 Hedge of net investment


In prior years, Campbell acquired an 80% interest in the capital stock of Atticus, Ltd., a Hong
Kong Company with paid-up capital of HKD 5,000,000 and retained earnings of HKD750,000.
Subsequent to the date of acquisition, the Hong Kong dollars (HKD) began to depreciate
against the peso. On January 1, 20A1, Campbell entered into a 12-month forward contract to
sell HKD 5,600,000 to hedge the investment.

The equity section of Atticus Ltd.s statement of financial position as of January 1, 20A1 is as
follows:
Share Capital HKD 5,000,000
Retained Earnings 2,000,000

The exchange rates on certain dates are as follows:


Spot rate (P/HKD) December 31, 20A1 Forward rate
January 1, 20A1 P6.215 P6.180
March 31, 20A1 6.190 6.170
June 30, 20A1 6.175 6.160
September 30, 20A1 6.140 6.140

Campbell designated the forward contract as a hedge of the net investment in Atticus and
excluded the time value of the forward contract from the hedging relationship. Ignore
discounting. Campbells financial year-end is September 30. Campbells functional currency is
the Philippine peso.
Required: Prepare all the necessary journal entries in the books of Campbell from January to
September 20A1.
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