CH10

Advanced Financial
Accounting
An IFRS® Standards Approach, 4e
Pearl Tan, Chu Yeong Lim and Ee Wen Kuah
Solutions Manual
Chapter 10
Accounting for Derivatives and Hedge Accounting
Copyright © 2019 by McGraw-Hill Education (Asia)

Advanced Financial Accounting (Tan, Lim & Kuah)
Chapter 10 solutions
CHAPTER 10
CONCEPT QUESTIONS
1 A forward contract is considered more risky from the perspective of the individual
parties to the contact as it entails counterparty risk, that is, the risk that the counterparty
will not honour the terms of the contract.
2 A holder (buyer) of a call option or put option has limited potential loss as his maximum
loss is the amount that he had paid for the option should the option expire at or out-of-
the-money. His potential gain could exceed his potential loss if the option expires in-
the-money. On the other hand, an option writer (seller)’s position is the opposite. His
gain is limited to the amount of premium that he had received while his loss may be
potentially high.
3 The factors to consider include:

 The relative cost of using a forward contract and an option contract
 The counterparty risk involved.
 Whether the contract could be terminated within a very short time or prematurely.
 Whether the contract could be tailored to the specific needs of the counterparties
 Whether the party intending to enter the contract is willing to take a position on the
short-term price movements of the commodity.
4 In a fair value hedge, the hedged item is a recognized asset or liability or unrecognized
firm commitment which is exposed to changes in fair value which could affect reported
earnings. In a cash flow hedge, the hedged item is a recognized asset or liability or a
highly probable forecasted transaction which is exposed to variability in cash flows that
could affect reported earnings.
5 A hedge of the foreign currency risk of a firm commitment may be designated either as
a cash flow hedge or a fair value hedge. It could be designated as a cash flow hedge
because changes in the foreign exchange rate could affect the cash flows when the firm
commitment is fulfilled. It could be designated as a fair value hedge because the firm
commitment carries rights and obligations and the fair value of the rights and
obligations is affected by changes in the foreign exchange rate.
6 A swap entails counterparty risk and is settled at a future date. In this respect it is similar
to a forward contract. In fact, a sway is a series of linked forward contract.
7 A firm commitment entails a commitment to purchase or sell an asset at a fixed price at

a future date. When the price of the asset rises or falls, the value of the firm commitment
is affected. Hence a hedge of a firm commitment is designated as a fair value hedge. A
forecasted transaction, on the other hand, does not entail any right or obligation or
commitment to a fixed price. The transaction will be consummated at a future price (on
the date the transaction takes place). Should the price increase or decrease, the result is
a higher or lower cash outlay for the transaction. Hence the hedge of a forecasted
transaction is designated as a cash flow hedge.
8 A hedge of a net investment is accounted for in a way similar to a cash flow hedge. The
effective portion is taken to equity and the ineffective portion, if any, is taken to income.
2
2019 © All rights reserved, McGraw-Hill Education (Asia)
Strictly For Instructors Use Only
No Further Distribution Or Reproduction Permitted
EXERCISES
Exercise 10.1
The answer is (b). The put option is in-the-money at the maturity date and the option premium
is entirely made up of the intrinsic value which is the exercise price less the market price ($3.60 -
$3.55).
Exercise 10.2
The answer is (d).

Premium received on written put option $1,800
Less loss on intrinsic value (500)
Net gain on put option $1,300
Exercise 10.3
The answer is (a). Changes in the fair value of a put option which is a fair value hedge are taken
to profit or loss, not to equity.
Exercise 10.4
The answer is (c).

Change in fair value of FVOCI taken to equity:
From 1 January to 1 July 20x5 $70,000
From 1 October to 31 December 20x5 ($10,000)
$60,000
Exercise 10.5
The answer is (b). The swap is a cash flow hedge.
Exercise 10.6
The answer is (c). The long put option position with a strike price of $3.00 ensures that the
option holder will gain if the price of the stock falls below $3.00. The gain will exactly offset
the loss on the price of the stock below $3.00 The short position on the call option with a strike
price of $4.00 means that if the price of the stock rises above $4.00 there will be a loss on the
call option which cancels out the gain on the stock when the price rises above $4.00.
Exercise 10.7
The answer is (c).

From 1/10/20x4 to 31/12/20x4
Change in fair value of firm commitment ($900,000)
[FC10,000,000 x (1.23 – 1.32)]
Change in fair value of forward contract $800,000
[FC10,000,000 x (1.33 – 1.25)
Net gain(loss) ($100,000)
3
Note: It is assumed that the forward contract is a fair value hedge of a firm commitment.
Exercise 10.8
The answer is (d).
Cost of equipment at spot rate on 1 February 20x5 $12,800,000

Less: Carrying value of firm commitment (500,000)
Adjusted cost of equipment $12,300,000
Exercise 10.9
The answer is (a).
Fair value of forward contract at maturity = FC10,000,000 x (!.28 – 1.25) = $300,000.
Exercise 10.10
The answer is (b).

If the call option is purchased for trading or speculation purpose, the change in the fair value
of the call option (comprising the time and intrinsic values) are taken to income under IFRS 9.
Exercise 10.11
The answer is (c).

This is a fair value hedge. Gain or loss on the option is taken to income.
Gain on the option = gain on intrinsic value less loss on time value.
4
PROBLEMS
Problem 10.1
(1) Journal entries
1 November 20x5
Dr Margin deposit 330,000
Cr Cash 330,000
[To record payment of margin deposit on 100 contracts @ $3,300 per contract]
31 December 20x5
Dr Futures contract 110,000
Cr Gain on futures contract 110,000
[To record gain on futures contract]
Dr Loss on inventory 100,000

Cr Inventory 100,000
[To record change in fair value of inventory]
31 January 20x6
Dr Loss on futures contract 190,000
Cr Futures contract 190,000
[To record loss on futures contract]
Dr Inventory 200,000
Cr Gain on inventory 200,000
[To record gain in fair value of inventory
Dr Cash 250,000
Cr Margin deposit 330,000
[Close futures position]
Note: In practice, the margin deposit requires topping up if it falls below a stipulated level. For
our purpose, the changes in the margin deposit (top-ups, if any) are ignored.
Problem 10.2
(1)
31 Mar 30 April 31 May
Notional amount 100,000 100,000 100,000

Spot price of oil $42 $45 $44
Strike price $40 $40 $40
Premium/unit $3 $6 $4
Fair value of option $300,000 $600,000 $400,000
Intrinsic value $200,000 $500,000 $400,000
Time value $100,000 $100,000 $0
5
(2) Journal entries
The option is a cash flow hedge. Since the time value of the option contract is excluded from
the hedge relationship and the critical terms match, the delta ratio is 1, that is, there is no
ineffective portion. It is assumed that discounting of the expected cash flow of the forecasted
transaction is ignored.
1 March 20x3
Dr Call option 200,000
Cr Cash 200,000
(Record purchase of call option)
31 March 20x3
Cr Hedging reserves – equity 200,000
(Effective portion (intrinsic value) taken to equity)
Dr Hedging reserves – equity 100,000

(OCI)
Cr Call option 100,000
(Time value is recognized in OCI)
30 April 20x3

Cr Hedging reserves – equity 300,000
31 May 20x3

(OCI)
(Time value is recognized in OCI)
Dr Purchase of jet fuel oil/inventory 4,400,000

Cr Cash 4,400,000
(Purchase of jet fuel oil)

Cr Purchase of jet fuel oil/inventory 200,000
Cr Hedging reserves - equity (OCI) 200,000
(Adjust effective portion of the hedge against cost of inventory)
6
Dr Cash 400,000
(Close position on call option)
Problem 10.3
Journal entries for hedged item Journal entries for hedging instrument
30.11.20x1 30.11.20x1
No journal entry is required to record the Dr Put option 500

firm commitment Cr Cash 500
[Purchase of put option]
30.6.20x2 30.6.20x2
Dr Loss on firm Dr Put Option 500

Commitment (P/L) 500 Cr Gain on put option (P/L) 500
Cr Firm commitment 500 [Gain in intrinsic value of put option]
[To record loss in fair value of firm
commitment]
Dr Hedging reserves - equity 300
(OCI)
300
Cr Put Option
[Loss on time value of put option]
31.7.20x2 31.7.20x2
Dr Loss on firm Dr Put option 500

Commitment (P/L) 500 Cr Gain on put option (P/L) 500
Cr Firm commitment 500 [Gain in intrinsic value of put option]
[To record loss in fair value of firm
commitment]
Dr Hedging reserves - equity
Dr. Investment 5,000
(OCI) 200
Cr Cash 5,000
Cr Put option 200
[Purchase of Fastrack shares for $5,000]
[Loss in the time value of put option]
Dr. Firm commitment 1,000 Dr Cash 1,000

Cr. Investment 1,000 Cr Put option 1,000
[Transfer loss from firm commitment to (Close put option contract)
investment ]
Dr Cash 4,000 Dr Loss on option (P/L) 500

Cr Investment 4,000 Cr Hedging reserves - equity
(Sale of Fastrack shares). (OCI) 500
Reclassify loss in time value of option to P/L
7
Problem 10.4
(1) The premium on the put option on 28 February 20x4 is $0.07 per FC.
The fair value of put option, intrinsic value and time value are as follows:
Fair Time Intrinsic

Notional Premium value value value
Date amount per FC of option of option of option
01/03/20x3 500,000 0.045 22,500 22,500 -
01/06/20x3 500,000 0.055 27,500 17,500 10,000
31/12/20x3 500,000 0.06 30,000 5,000 25,000
28/02/20x4 500,000 0.07 35,000 - 35,000
As the critical terms match perfectly, and the time value of the put option is excluded from the
hedge relationship, the hedge is fully effective.
From 1 March 20x3 to 1 June 20x3, the hedged risk is the foreign exchange risk of a forecasted
transaction. Therefore it is a cash flow hedge. From 1 June to 31 December 20x3 the option is
a hedge of a firm commitment. However, IFRS 9 allows the hedge to be designated as a cash
flow hedge or a fair value hedge. It is assumed that the hedge is redesignated as a fair value
hedge.
(2) Journal entries
1 March 20x3
Dr Put option 22,500

Cr Cash/bank 22,500
(Purchase of put option)
1 June 20x3
Dr Put option 5,000
Dr Hedging reserve- equity 5,000
Cr Hedging reserve – equity 10,000
(Record change in fair value of put option; change in intrinsic value is taken to equity
and change in time value is taken to equity because this is a transaction-related hedge.)
31 December 20x3
Dr Hedging reserve- equity 12,500
Dr Put option 2,500
Cr Hedging reserve- equity 15,000
(Record change in fair value of put option comprising gain in intrinsic value of $15,000
8
and loss in time value of -$12,500).
Dr Loss on firm commitment 15,000

Cr Firm commitment 15,000
Dr Accounts receivable 850,000

Cr Sales 850,000
(Record delivery of equipment)
Dr Firm commitment 15,000
Cr Sales 7,500
(Adjust accumulated gain on option contract to sales)
28 February 20x4
Dr Put option 5,000

Cr Gain on put option 5,000
(Record change in fair value of put option comprising gain in intrinsic value of $10,000
and loss in time value of $5,000.)
Dr Loss on account receivable 10,000

Cr Accounts receivable 10,000
(Record exchange loss on accounts receivable)
Dr Cash 840,000
Cr Accounts receivable 840,000
(Record settlement of accounts receivable)
Dr Cash 35,000
Cr Put option 35,000
(Net settlement of put option)
Problem 10.5
(1) Journal entries
1 October 20x4 (optional)

Dr Investment (FVOCI) 358,400
Cr Cash 358,400
(Purchase of FVOCI investment)
November 20x4
Dr Fair value reserves – equity 2,150
Cr Investment (FVOCI) 2,150
(Record change in fair value of FVOCI investment in equity:
Fair value of investment at 1 November 20x4 = LC2.85 x 100,000 x $1.25 = $356,250.)
9
31 December 20x4
Dr Forward contract 11,400
Cr Fair value reserves – equity 18,150
(Record change in fair value of investment attributable to change in stock price and
change in foreign exchange rate:
Fair value of investment at 1/11/20x4 $356,250

Fair value of investment at 31/12/20x4 363,000
Change in fair value $6,750
Attributable to:
Change in share price only* $18,750
[100,000 x 1.25 x ($3.00 – 2.85)
Change in foreign exchange rates (12,000)
[100,000 x 3 x ($1.21 - $1.25)
$ 6,750
Change in fair value of forward contract:
285,000 x (1.23 – 1.19) = $11,400
Dr Put option 3,630

Cr Cash 3,630
(Purchase of put option: 100,000 x 0.03 x 1.21)
31 March 20x5
Dr Fair value reserves – equity 14,250
Cr Forward contract 2,850
(Record change in fair value of investment attributable to change in stock price and change
in foreign exchange rate:
Fair value of investment at 31/12/20x4 $ 363,000
Fair value of investment at 31/03/20x5 $ 351,600
Change in fair value ($11,400)
Attributable to:
Change in share price ($8,470)
[100,000 x 1.21 x ($2.93 – 3.0)
Change in foreign exchange rates ($2,930)
[100,000 x 2.93 x ($1.20 - $1.21)
($ 11,400)
Change in fair value of forward contract:
285,000 x (1.21 – 1.20) = $2,850
10
Dr Cash 8,550
(Settle forward contract at maturity date on a net basis)
Dr Put option 6,570

Cr Deferred gain on put option (OCI) 6,570
(Deferred gain on put option: [(100,000 x 0.085 x 1.2) - $$3,630])
Note: Since both the time value and intrinsic value are taken to OCI, it is not
necessary to split the change in the fair value of the option into these two components.)
30 June 20x5
Dr Put option 7,950

Cr Deferred gain on put option (OCI) 7,950
(Record change in fair value of put option in OCI)
Dr Fair value reserve - equity 9,600

(Record change in fair value of investment attributable to price change)

Cr Fair value reserves – equity 2,850
(Change in fair value of investment attributable to change in the rate of foreign
exchange taken to equity: 100,000 x 2.85 x (1.21 – 1.20) = $2,850
Dr Cash 18,150
(Close position on put option)
Dr Cash 344,850
Cr Investment 344,850
(Liquidate FVOCI investment: 100,000 x 2.85 x 1.21)
Problem 10.6
Note: This question has two components: a forecasted transaction and a firm commitment.
The fair value hedge is applicable only from 1 February to 30 March 20x2. For the
period 1 December 20x1 to 1 February 20x2 there is a forecasted transaction. The forward
contract is required to be designated as a cash flow hedge. From 1 February 20x2 to 30
March 20x2, the forecasted transaction became a firm commitment and may be designated
either as a cash flow hedge or a fair value hedge. Consequently, it is assumed that it is
redesignated as a fair value hedge.
11
Calculation of changes in fair value of forward contract and its components

FV of Change Change
Notional Current Contracted Current Fwd in Change in in
spot Fwd FV of spot time
Date Amount rate Fwd rate rate contract Fwd element value
FC000 $000 $000 $000 $000
01/12/x1 10,000 1.74 1.7
31/12/x1 10,000 1.7 1.7 1.67 300 300 400 (100)
01/02/x2 10,000 1.65 1.7 1.63 700 400 500 (100)
30/03/x2 10,000 1.69 1.7 1.69 100 (600) (400) (200)
Calculation of change in expected cash flows

Notional
Amount Current Expected Change in
Cashflow Expected CF
Date FC000 spot rate ($000) ($000)
01/12/x1 10,000 1.74 17,400
31/12/x1 10,000 1.7 17,000 (400)
01/02/20 10,000 1.65 16,500 500

x2
30/03/20 10,000 1.69 16,900 400
x2
The hedge is effective as the critical terms match and the time value of the forward contract is
excluded from the hedging relationship.
Journal entries:
1 December 20x1 No journal entry is required as the fair value of

The forward contract is nil.
31 December 20x2
Dr Loss in time value (P/L) 100,000
(Record:
 change in fair value of forward contract
 expense off time value (interest component) to income
 defer effective portion (spot component) to equity.)
Alternative entry:
Cr Hedging reserve - equity 300,000
Time value and intrinsic value are recognized in OCI
12
1 February 20x2

Dr Loss in time value (P/L) 100,000
(Record:
 defer effective portion (spot component) to equity)
Alternative entry:
Both intrinsic value and time value recognized in OCI.
30 March 20x2
Dr Loss on forward contract (P/L) 600,000

(Record change in fair value of forward contract.)
Alternative entry:
Dr Hedging reserve - equity 200,000
To record time value in OCI for fair value hedge

Cr Gain on firm commitment 400,000
(Record change in fair value of firm commitment)
Dr Cash 16,900,000
Cr Sales 16,900,000
(Record recognition of sales revenue)
Dr Hedging reserve 900,000

Cr Sales 500,000
(Transfer/adjust effective portion of cash flow hedge and firm commitment against
sales revenue).
Alternative entry:
Cr Sales 100,000
Adjust hedging reserve and firm commitment against sales
Dr Cash 100,000
(Settlement of forward contract on a net basis).
13
Problem 10.7
The forward contract is designated as a cash flow hedge for the entire period 1 December 20x1
to 30 March 20x2. The journal entries from 1 December 20x1 to 1 February 20x2 are the same
as in P 10.6.
30 March 20x2

Dr Time value (Interest component) (I/S) 200,000
(Record:
 defer effective portion (spot component) to equity.)
Alternative entry:
Change in fair value of forward (time value recognized in OCI)
Dr Cash 16,900,000
Cr Sales 16,900,000
(Record recognition of sales revenue)

Cr Sales 500,000
(Transfer/adjust effective portion of cash flow hedge and firm commitment against
sales revenue).
Alternative entry:
Cr Sales 100,000
Adjust hedging reserve against sales
Dr Cash 100,000
(Settlement of forward contract on a net basis).
Problem 10.8
The hedged risk is the foreign exchange risk of a firm commitment. IFRS 9 permits the forward
contract to be designated either as a cash flow hedge or a fair value hedge. This question
requires the forward contract to be designated as a fair value hedge.
The calculations of the fair value of the forward contract and changes in the fair value and its
components are as follow:
14
Contract Current Fair value of Change in fair

Spot Fwd Notional Discount fwd value of
Date Rate Fwd rate rate Amount Factor contract fwd. contract
30.9.20x5 2.915 2.98 2.98 $0 $0 $0
31.12.20x5 2.937 2.98 2.969 100,000 1.0150751* (1,084) (1,084)
31.1.20x6 2.92 2.98 2.9269 100,000 1.010025 (5,257) (4,174)
31.3.20x6 2.931 2.98 2.931 100,000 1 (4,900) 357
*(1.06)^3/12
Cum.
Change Period to Period to period Period to period
in spot period change in Cum. Change in change in change in fair value
Date element spot element interest element interest element of fwd contract
(a) (b) c = (a) + (b)
30.9.20x5
31.12.20x5 2,167 2,167 (3,251) (3,251) (1,084)
31.1.20x6 495 (1,672) (5,752) (2,501) (4,174)
31.3.20x6 1,600 1,105 (6,500) (748) 357
Journal entries:
30 September 20x5 No journal entry required.
31 December 20x5
Dr Interest element (I/S) 3,251

(To record change in fair value of forward contract; effective portion (spot element) taken to
equity and interest element taken to income.)
Alternative entry:
To record change in fair value in hedging reserve
31 January 20x6
Dr Interest element (I/S) 2,502*

Dr Hedging reserve – equity 1,672
(To record change in fair value of forward contract; effective portion (spot element) taken to
equity and interest element taken to income.)
15
*includes rounding difference of 1
Alternative entry:
To record change in fair value in hedging reserve
Dr Hedging reserve 495
Cr Inventory 495
Cr Accounts payable 292,000
(To record purchase of inventory at spot rate and adjust the cumulative effective portion of the
forward contract to the cost of inventory.)
Alternative entry:
Dr Inventory 5,258
Cr Accounts payable 292,000
To adjust hedging reserve against inventory
31 March 20x6
Dr Accounts payable 292,000

Dr Exchange loss on payable 1,100
Cr Cash 293,100
(To record settlement of accounts payable and exchange loss on the payable)
Dr Forward contract 357

Cr Gain on forward contract (P/L) 357
(To record change in fair value of forward contract)
Alternative entry:
Dr Hedging reserve - equity 748
Cr Gain on forward contract (P/L) 1,105
To record change in fair value of forward contract, with change in time value recorded in OCI.

Cr Cash 4,900
(To record settlement of the forward contract on a net basis).
Problem 10.9
The critical terms of the forward contract and the hedged item match. Therefore the hedge is
fully effective. Discounting is ignored.
The following shows the calculation of the fair value of the forward contract and changes in
the fair value of the forward contract and its components.
16
Change Change
Fair value in in Change in
of FV of
Notional Spot Forward forward fwd spot interest
amount rate rate contract contract element element
01/12/20x1 10,000,000 1.84 1.8
31/12/20x1 10,000,000 1.73 1.7 1,000,000 1,000,000 1,100,000 (100,000)
01/03/20x2 10,000,000 1.7 1.68 1,200,000 200,000 300,000 (100,000)
01/04/20x2 10,000,000 1.76 1.76 400,000 (800,000) (600,000) (200,000)

Forward contract is accounted for as a fair value hedge
Journal entries
1 December 20x1 No journal entry is necessary.
31 December 20x1
Dr Forward contract 1,000,000
Cr Gain on forward contract 1,000,000
(Record change in fair value of forward contact and gain on forward contract. There is
no need to separate the spot and interest components since both are taken to profit or
loss).
Alternative entry:
Dr Forward contract 1,000,000
Cr Gain on forward contract (P/L) 1,100,000
Record change in fair value of forward contract, with time value recorded in OCI.
Dr Loss on firm commitment 1,100,000

Cr Firm commitment 1,100,000
(Record change in fair value of firm commitment based on spot rate)
1 March 20x2
Cr Gain on forward contract 200,000
(Record change in fair value of forward contact and gain on forward contract.)
Alternative entry:
Record change in fair value of forward contract, with time value recorded in OCI.
Dr Loss on firm commitment 300,000

(Record change in fair value of firm commitment based on spot rate)
17
Dr Accounts receivable 17,000,000

Cr Sales 17,000,000
(Record delivery and sales)
Dr Firm commitment 1,400,000

Cr Sales 1,400,000
(Adjust firm commitment against sale)
Alternative entry:
Dr Firm commitment 1,400,000
Dr Sakes 1,200,000
Adjust firm commitment and hedging reserve against sale.
1 April 20x2
Dr Bank 17,600,000
Cr Exchange gain 600,000
Cr Accounts receivable 17,000,000
(Settlement of accounts receivable and record exchange
gain on accounts receivable)
Dr Loss on forward contract 800,000

(Record loss on forward contract)
Alternative entry:
Record change in fair value on forward with time value recorded in OCI.
Dr Amortization of time value (P/L) 200,000

Cr Hedging reserve 200,000
Record amortization of time value to P/L.
Dr Cash 400,000
(Settlement of forward contract on a net basis)
Problem 10.10
(1) The entire forward contract is designated as the hedging instrument. To ensure that
the criterion of hedge effectiveness is met, the hedge relationship should be designated
as:
Change in the fair value of the forward contract based on changes in the forward rate
Change in the present value of cash flow based on changes in the forward rate
The hedged risk is the foreign currency risk of a firm commitment. The firm commitment
is a contractual obligation to buy a certain quantity of paper for FC100,000.
18
Should the FC appreciate, there will be a loss on the firm commitment (compared
to the date when the commitment was entered into); conversely should the FC
depreciate, there will be a gain on the firm commitment. The discounted fair values of
the forward contract and the expected cash flows (based on the forward rates) are as
follows:
Fair Change
Spot Contract Current Notional Discount value of in FV of Spot Interest
Fwd fwd.
Date Rate Fwd rate rate amount Factor contract fwd element Element
30/6/x1 1.072 1.077 1.077 $0 - - - -

(1.005)^6=
31/12/x1 1.08 1.077 1.082 100,000 1.0303775 485 485 776 (291)
(1.005)^3=
31/3/x2 1.083 1.077 1.0845 100,000 1.0150751 739 254 308 (54)
30/6/x2 1.087 1.077 1.087 100,000 1 1,000 261 416 (155)
Period to
Cum. PV of period
Notional Current Change Discount change change
Amount Fwd Expected in expected Factor in expected in PV of
Date FC000 rate Cashflow cash flows cash flows expected CF
30/6/x1 100,000 1.077 107,700 -
31/12/x1 100,000 1.082 108,200 500 1.030378 485 485
31/3/x2 100,000 1.0845 108,450 750 1.015075 739 254
30/6/x2 100,000 1.087 108,700 1,000 1 1,000 261
The hedge is fully effective as numerator and denominator are based on same forward rates.
(1) Journal entries:

30/6/20x1
Cr Cash 0 OR nil entry
[Fair value of forward contract at inception is zero as hedge is expected to be fully effective
because critical terms of forward exchange contract and purchase contract and the assessment
of hedge effectiveness are based on the forward price (Time value is not excluded).
31/12/20x1

Cr Hedging reserve (equity) 485
[To record change in fair value of the forward exchange contract between 30 Jun 20x3 and 31
Dec 20x3 directly in equity. The hedge is fully effective because the gain on the forward
exchange contract exactly offsets the change in cash flows associated with the purchase
contract based on the forward price.]
19
31/3/20x2

Cr Hedging reserve 254
Cr Payable 108,300
Dr Hedging reserves 739

Cr Inventory 739
[To recognize purchase of commodity at spot rate (1.083 x FC100,000] and remove cumulative
gain on forward exchange contract that has been recognized directly in equity and include it in
the initial measurement of purchased paper. Accordingly, initial measurement of purchased
commodity is $107,561 consisting of purchase consideration of $108,300 & hedging gain of
$739.]
30/6/20x2
Dr Exchange loss 400

Dr Payable 108,300
Cr Cash 108,700
[To record exchange loss on payable ($1.087 – 1.083)*100k and settlement of the payable]

Cr Gain on forward contract 261
Dr Cash 1,000
(2) The hedge relationship is expressed as:
Change in the fair value of the forward contract based on changes in the spot rate
Change in the present value of cash flow based on changes in the spot rate
31/12/20x1 Dr Loss (interest element) 291

Cr Equity (spot element) 776
(Please refer table in part (1) above)
[To record change in fair value of forward exchange contract between 30 Jun 20x1 & 31 Dec
20x1. Change in present value of spot settlement of forward exchange contract is a gain of
$776, which is directly recognized in equity. The change in interest element of forward
exchange contract (residual change in fair value) is a loss of $291, which is recognized in
profit or loss.
Alternative entry:
Cr Hedging reserve - equity 485
20
Record change in fair value of forward, with time value recognized in OCI.
31/3/20x2 Dr Loss (interest element) 54

Cr Equity (spot element) 308
(see table in part (a) above)
Alternative entry:
Cr Hedging reserve - equity 254
Dr Equity 1,084
Cr Inventory (hedging gain) 1,084
Cr Payable 108,300
[To recognize the purchase of paper at spot rate (1.083 x FC100,000] and to remove the
cumulative gain on spot element of the forward exchange contract that has been recognized
directly in equity and include it in the initial measurement of the purchased paper.]
Alternative entry:
Cr Inventory 739
Cr Payable 108,300
Adjust hedging reserve to inventory.
30/6/20x2 Dr Exchange loss 400

Dr Payable 108,300
Cr Cash 108,700

Alternative entry:
Cr Gain on forward contract (P/L) 416
Dr Amortization of time value (P/L) 155

Record amortization of time value.
Dr Cash 1,000
21
(3) If time value is not excluded, the time value is taken to equity (as the hedge is effective). If
time value is excluded, the interest component is taken to income. Carrying value of inventory
in this case is higher when time value is excluded.
Time value not excluded Time value is excluded

B/S: Carrying value of inventory $107,561 $107,216
Income Statement 0 (345)
Problem 10.11
The forward contract is designated as a fair value hedge of a firm commitment. Time value is
excluded from the hedge relationship.
The fair value of the forward is calculated as follows:
Change
Spot Notional Discount FV of in
Date Rate amount factor forward FV
30/6/x1 1.072 100,000
31/12/x1 1.08 100,000 1.0303775 776 776
31/3/x2 1.083 100,000 1.0150751 1,084 308
30/6/x2 1.087 100,000 1 1,500 416
(1) Journal entries

31/12/20x1
Dr Loss on firm commitment 800
Cr Firm commitment 800
Dr Hedging reserve - equity

(OCI) 24
Cr Forward contract 24
31/3/20x2
Dr Loss on firm commitment 300

Cr Firm commitment 300

22
Cr Hedging reserve (OCI) 8
Cr Payable 108,300
Cr Inventory 1,084
Cr Hedging reserve (OCI) 16
30/6/20x2
Dr Exchange loss 400
Dr Payable 108,300
Cr Cash 108,700

Alternative entry:
Record change in fair value of forward, with time value in OCI
Cr Amortization of time value (P/L) 16
Amortization of time value in P/L.
Dr Cash 1,000
(2)
Cash flow hedge Fair value hedge

Inventory @ 31/3/x2 107,216 107,216
There should not be any significant difference between the designation as a cash flow hedge or
a fair value hedge. There is no difference if there is no discounting of the future cash flows.
23
Problem 10.12
The calculation of the fair value of the swap is shown below:
LIBOR Fixed Floating Net Fair Change in

+ rate rate receipts value of fair value of
Date 150 bp payments receipts (payments) swap swap
1/1/20x3 5.5%
30/06/20x3 6.0% 1,375,000 1,375,000 0 572,463 572,463
31/12/20x3 6.5% 1,375,000 1,500,000 125,000 923,746 351,282
30/6/20x4 6.2% 1,375,000 1,625,000 250,000 494,057 (429,689)
31/12/20x4 6.0% 1,375,000 1,550,000 175,000 239,184 (254,873)
30/6/20x5 5.8% 1,375,000 1,500,000 125,000 72,886 (166,297)
31/12/20x5 1,375,000 1,450,000 75,000 0 (72,886)
30 June 20x3
Dr Interest expense 1,375,000

Cr Bank 1,375,000
(Payment of interest on floating rate loan)
Dr Interest rate swap 572,463

Cr Cash flow hedge reserve 572,463
(OCI)
(Record change in fair value of swap)
31 December 20x3

Cr Bank 1,500,000
24
Dr Bank 125,000
Cr Interest expense 125,000
(Receipt of swap differential)
Dr Interest rate swap 351,282

Cr Cash flow hedge reserve 351,282
(OCI)
(Record change in fair value of swap) 30
June 20x4

Cr Bank 1,625,000
Dr Bank 250,000
Dr Cash flow hedge reserve 429,689

(OCI)
Cr Interest rate swap 429,689
31 December 20x4

Cr Bank 1,550,000
Dr Bank 175,000

(OCI)
30 June 20x5

Cr Bank 1,500,000
Dr Bank 125,000
25


(OCI)
31 December 20x5

Cr Bank 1,450,000
Dr Bank 75,000
Dr Cash flow hedge reserve (OCI) 72,886

Dr Loan payable 50,000,000

Cr Cash 50,000,000
Repayment of loan
Problem 10.13
(1) The hedged item was the forecasted cash flow of the anticipated transaction.
The hedging instrument is the entire instrument (no separation of time value). Hedge
effectiveness is assessed by comparing the change in spot price of silver coins (not
silver) with the change in the price of the futures contract multiplied by the notional
amount.
Hedged item 1/10/x1 31/12/x1 28/2/x2 31/3/x2

Spot price of silver coin $3.30 $3.265 $3.15 $3.10
Quantity 5,000,000 5,000,000 5,000,000 5,000,000
Expected cash flows 16,500,000 16,325,000 15,750,000 15,500,000
Change in expected cash
flows -175,000 -575,000 -250,000
Futures contract
Exercise price $3.21 $3.17 $3.05 $3.00
FV of futures contract $200,000 $800,000 $1,050,000
26
Period-to-period hedge effectiveness assessment
Gain (loss) on
expected
Gain (loss) on future Delta
Date futures contract cash flows Ratio
31/12/20x1 200,000 -175,000 1.14
28/2/20x2 600,000 -575,000 1.04
31/3/20x2 250,000 -250,000 1
Hedge effectiveness assessment on a cumulative basis
Cumulative Cumulative
Gain (loss) Gain(loss)
on futures on expected Hedge
Date Contract cash flows Ratio
31/12/20x1 200,000 -175,000 1.14
28/2/20x2 800,000 -750,000 1.06
31/3/20x2 1,050,000 -1,000,000 1.05
The hedge was effective throughout the life of the futures contract.
(2) Journal entries [assume hedge effectiveness is assessed on a cumulative basis]
1 October 20x1
Dr Margin deposit 150,000

Cr Cash 150,000
[Margin deposit: $0.03 per pound of notional quantity]
31 December 20x1
Dr Futures contract 200,000 [(3.21 – 3.17) x 5,000,000]

Cr Profit or loss 25,000
[Because the cumulative gain in the fair value of the futures contract is greater than the
cumulative loss on the expected cash flows, the effective portion in the change in the
fair value of the futures contract that is taken to equity is the lesser of the two cumulative
amounts. The excess of the gain in fair value of the futures contract over the cumulative
loss on the expected cash flows is recognized in profit or loss as the ineffective portion.
Note that there is no separation of time value component as the hedge documentation
did not exclude it.]
As for the margin deposit, no top up is necessary since there is a gain on the futures
contract. In practice, there is daily settlement but for the purpose of this question it is
ignored.
27
28 February 20x2
Dr Futures contract 600,000 [(3.17 – 3.05) x 5,000,000]

Cr Profit or loss 25,000
[Because the cumulative gain in the fair value of the futures contract is greater than the
cumulative loss on the expected cash flows, the effective portion in the change in the
fair value of the futures contract that is taken to equity is the lesser of the two cumulative
amounts. The excess of the gain in fair value of the futures contract over the cumulative
loss on the expected cash flows is recognized in profit or loss as the ineffective portion.]
31 March 20x2

[Effective portion in the change in the fair value of the futures contract is taken to equity;
there is no ineffective portion]
Dr Cash 15,500,000
Cr Sales 15,500,000
Dr Cost of sales 15,000,000

Cr Inventory 15,000,000
Dr Hedging reserve 1,000,000

Cr Sales 1,000,000
[To ‘recycle’ hedging reserve against sale.]
Dr Cash 1,200,000
Cr Margin deposit 150,000
Cr Futures contract 1,050,000
[Close position on futures contract]
(3)
Without hedging With hedging

Sales 15,500,000 16,500,000
COGS (15,000,000) (15,000,000)
Gross profit 500,000 1,500,000
Gain on futures contract 50,000
Net profit $500,000 $1,550,000
Problem 10.14
(1) Journal entries
The journal entries are based on the following computations:
28
Hedged item 1/10/x1 31/1/x1 28/2/x2 31/3/x2

Spot price of silver coin $3.30 $3.265 $3.15 $3.10
Quantity 5,000,000 5,000,000 5,000,000 5,000,000
Fair value of inventory 16,500,000 16,325,000 15,750,000 15,500,000
Change in fair value -175,000 -575,000 -250,000
Cumulative change in fair value (175,000) (750,000) (1,000,000)
Options contract
Premium $0.12 $0.13 $0.175 $0.20
Exercise price $3.30 $3.30 $3.30 $3.30
FV of options $600,000 $650,000 $875,000 $1,000,000
Intrinsic value $ - $175,000 $750,000 $1,000,000
Time value $600,000 $475,000 125,000 $0
Delta ratio 1 1 1
1/10/x1
Dr Option contract 600,000

Cr Cash 600,000
Purchase of option contract
31/12/x1
Dr Loss in fair value of inventory 175,000

Record change in the fair value of the inventory
Dr Deferred loss in time value of 125,000

option (OCI)
Cr Options contract 125,000
Record loss in time value of the option contract
Dr Options contract 175,000

Cr Gain in intrinsic value 175,000
Record gain in intrinsic value of the option contract

Cr Deferred loss on time value of option (OCI) 300,000
Amortization of initial time value of option from 1 Oct to 31 Dec 20x1.
28/2/x2

29

option (OCI)


Cr Deferred loss in time value of 200,000
option (OCI)
Amortization of time value of option from 1 Jan to 28 Feb 20x2.
31/3/x2


option (OCI)

Cr Deferred loss on time value of option (OCI) 100,000
Amortization of time value of option from 1 March to 31 March 20x1.

Dr Cash 1,000,000
Cr Option contract 1,000,000
Close option position
Dr Cash 15,500,000
Cr Sales 15,500,000
Sale of inventory
Dr Cost of sales 14,000,000

Cr Inventory 14,000,000
30
(2)
Without hedging With hedging
Sales 15,500,000 15,500,000
COGS (15,000,000) (14,000,000)
Gross profit 500,000 1,500,000
Net gain on option contract 400,000
Loss on inventory (1,000,000)
Profit $500,000 $900,000
Problem 10.15
Transaction 1: Fair value hedge
31 July 30 Sept
20x5 20x5
Price of FVOCI $2.50 $2.20
Quantity 100,000 100,000
Fair value of FVOCI $250,000 $220,000
Change in FV of ($30,000)
FVOCI
Put Option
Exercise price $2.48 $2.48
Option price $0.03 $0.28
Notional amount 100,000 100,000
Fair value of option $3,000 $28,000
Intrinsic value - 28,000
Time value $3,000 $0
Delta ratio 0.93*
*The hedge would be fully effective if the put option is designated as a hedge of the share price
of Hindz Company falling below $2.48.
Journal entries:
31 July 20x5
Cr Cash 250,000
(Investment in FVOCI)
Dr Put option 3,000

Cr Cash 3,000
(Purchase of put option)
30 September 20x5
Dr Loss on fair value (OCI) 30,000
Change in fair value of FVOCI
31
Dr Put option 25,000

Cr Deferred gain on put 25,000
option (OCI)
(Change in fair value of put option: Gain in intrinsic value ($28,000) and loss on time
value ($3,000).
Dr Cash 28,000
(Close option position)
Transaction 2: (Cash flow hedge)
Journal entries:
31 March 20x5
Dr Interest expense 900,000
Cr Cash/bank 900,000
Interest expense for the quarter ended 31 March
Dr Swap asset 666,273

Cr Cash flow hedge 666,273
reserve (OCI)
Change in fair value of swap
30 June 20x5

Cr Cash/bank 1,000,000
Interest expense for the quarter ended 31 March
Dr Cash/bank 100,000
Net settlement at end of June quarter
Dr Swap asset 477,931

Cr Cash flow hedge 477,931
reserve (OCI)
Change in fair value of swap
30 September 20x5

Cr Cash/bank 1,100,000
Dr Cash/bank 200,000
Dr Cash flow hedge reserve (OCI) 470,697
32
Cr Swap asset 470,697
Transaction 3: Hedge of net investment
Fair value Change

Spot Contracted Current Notional of in Spot Interest
Fwd Fwd FV of
Date Rate Fwd rate rate amount contract fwd element Component
$’000 $’000 $’000 $’000 $’000
1/1/x5 1.8 $0 $0 $0 $0 $0
31/3/x5 1.785 1.78 1.77 2,240 22.4 $22.4 33.6 (11.20)
30/6/x5 1.765 1.78 1.755 2,240 56.0 $33.6 44.8 (11.20)
30/9/x5 1.75 1.78 1.742 2,240 85.12 $29.12 33.6 (4.48)
Hedged item: US$2,800,000 x 0.8 = US$2,240,000

The critical terms match and with time value being excluded from the hedge relationship, the
hedge is perfectly effective.
Journal entries
1 January 20x5 No entry required.
31 March 20x5

Dr Interest component (P/L) 11,200
Cr FCTR (Equity) 33,600
30 June 20x5

30 September 20x5

Exchange loss on the hedged item:
The hedged item is the net investment in the subsidiary.
Foreign currency translation reserve (FCTR) will be recognized through the normal translation
process and will be in the opposite direction of the hedging instrument. As the FC depreciates,
the FCTR arising from translation will be a loss.
33
(2) Effects on financial statements for the year ending 30 September 20x5
Income statement
Change in FV of FVOCI (30,000)

Gain on put option 25 ,000
Interest expense (2,700,000)
Interest component of
forward contract (26,880)
Balance sheet
Equity
Hedging reserve 673,507
Assets
FVOCI investment 220,000

Forward contract 85,120
Swap asset 673,507
Equity
FCTR 112,000*
* The FCTR on the hedging instrument will be offset by the FCTR on the hedged item.
However, the final net amount will not be zero as the net investment in OGRE will be larger
than the initial amount hedged.
Problem 10.16
Convert to SGD/USD rates

FX rates: SGD/USD spot SGD/USD forward Time value
maturing 30 June 2011
1 January 2010 1/1.40=0.7143 1/1.37=0.7299 0.7299-0.7143 =0.01564
30 June 2010 1/1.38=0.7246 1/1.36=0.7353 0.7353-0.7246=0.01066
31 December 2010 1/1.32= 0.7576 1/1.29=0.7752 0.7752-0.7576=0.0176
30 June 2011 1/1.20=0.8333 1.20=0.8333 0.8333-0.8333=0
30 Jun 2010 (figures in USD)

Change in fair value of FX forward during cash flow hedge period
Dr Loss on time value (P/L) (0.0156-0.0107)*S$1.4m 6,860
34
Dr Forward contract (0.7353 – 0.7299)*S$1.4m Cr 7,560

Deferred gain (OCI) (0.7246 – 0.7143)*S$1.4m 14,420
31 Dec 2010 FX loss on firm commitment

Dr Loss on firm commitment (0.7576-0.7246)*S$1.4m 46,200
Cr Firm commitment (payable) 46,200
Dr Forward contract (0.7752-0.7353)*S$1.4m 55,860

Dr Equipment (0.7576*S$1.4m) 1,060,640

Cr Equipment payable 1,060,640
Dr Deferred gain (OCI) 14,420

Dr Firm commitment (payable) 46,200
Cr Equipment 60,620
Effective cost of equipment = (1,060,640-60,620)/1,400,000 = 0.7143
30 June 2011
Dr FX loss on equipment payable 89,740
Cr Equipment payable (0.8333-0.7692)*S$1.4m 89,740
Dr Equipment payable 1,166,620

Cr Cash (US$1.4m x 0.8333) 1,166,620
Dr Forward contract (0.8333-0.7752)*S$1.4m 81,340

Dr Cash (0.8333-0.7299)*S$1.4m 144,714

(Cash settlement locked in forward rate of 0.7299)
31 Dec 2011
Depreciation for equipment
Dr Depreciation expense (1,076,880-76,860)/10 100,002
Cr Accumulated depreciation – Equipment 100,002
Problem 10.17
Swap interest settlement table (notional principal US$3,000,000) (figures in USD)
Date Libor + Rec float Pay fixed Net Period to Swap asset Change
1% 1.5% receipt/ maturity (liability) swap
(payment) asset
1 Jan 1.5% 0
2010
30 Jun 1.75% 45,000 45,000 0 5 (1) 36,536 36,536
2010
31 Dec 1.46% 52,500 45,000 7,500 4 (2) -4,714 -41,250
2010
35
30 Jun 1.40% 43,800 45,000 (1,200) 3 (3) -8,876 -4,162

2011
31 Dec 1.78% 42,000 45,000 (3,000) 2 (4) 16,578 25,454
2011
30 Jun 53,400 45,000 8,400 1
2012
31 Dec
2012
(1) PV(i=1.75%/2, PMT=3750, n=5) = 7,500*4.8714 = 36,536

(2) PV(i=1.46%/2, PMT=-600, n=4) = -1,200*3.9281 = -4,714
(3) PV(i=1.40%/2, PMT=-1500, n=3) = -3,000*2.9585 = -8,876
(4) PV(i=1.78%/2, PMT=4200, n=2) = 8,400*1.9736 = 16,578
30 June 2010
Dr Swap Asset/Liability 50,420
Cr Swap fair value P/L (36,536*1.38) 50,420
31 Dec 2010
Dr Cash (7,500*1.32) 9,900
Cr Swap interest income (7,500*1.32) or (7,500*1.34) 9,900
Swap interest receipt
Dr Swap fair value P/L (41,250*1.32) 54,450

Cr Swap Asset/Liability 54,450
Swap fair valuation on 31 Dec 2010
30 Jun 2011
Dr Swap interest income (1200*1.2) (or 1200*1.25) 1,440
Cr Cash 1,440
Dr Swap fair value P/L (4,162*1.2) 4,994

Cr Swap Asset/Liability 4,994
31 Dec 2011
Dr Swap interest income 1,950
Cr Cash (3,000*1.30) 1,950
Swap interest receipt
Dr Swap Asset/Liability 33,090

Cr Swap fair value P/L (25,454*1.30) 33,090
Swap fair valuation on 31 Dec 2011
36

CH10

Uploaded by

Copyright:

Available Formats

CH10

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH10

Uploaded by

Copyright:

Available Formats

Advanced Financial

Pearl Tan, Chu Yeong Lim and Ee Wen Kuah

Copyright © 2019 by McGraw-Hill Education (Asia)

3 The factors to consider include:

7 A firm commitment entails a commitment to purchase or sell an asset at a fixed price at

The answer is (d).

The answer is (c).

The answer is (b). The swap is a cash flow hedge.

The answer is (c).

The answer is (d).

Cost of equipment at spot rate on 1 February 20x5 $12,800,000

The answer is (a).

Fair value of forward contract at maturity = FC10,000,000 x (!.28 – 1.25) = $300,000.

The answer is (b).

The answer is (c).

(1) Journal entries

Dr Loss on inventory 100,000

31 Mar 30 April 31 May

Notional amount 100,000 100,000 100,000

(2) Journal entries

Dr Hedging reserves – equity 100,000

Dr Call option 300,000

Dr Hedging reserves – equity 100,000

Dr Purchase of jet fuel oil/inventory 4,400,000

Dr Hedging reserves – equity 400,000

No journal entry is required to record the Dr Put option 500

Dr Loss on firm Dr Put Option 500

Dr Loss on firm Dr Put option 500

Dr. Firm commitment 1,000 Dr Cash 1,000

Dr Cash 4,000 Dr Loss on option (P/L) 500

Fair Time Intrinsic

01/03/20x3 500,000 0.045 22,500 22,500 -

01/06/20x3 500,000 0.055 27,500 17,500 10,000

31/12/20x3 500,000 0.06 30,000 5,000 25,000

28/02/20x4 500,000 0.07 35,000 - 35,000

(2) Journal entries

Dr Put option 22,500

and loss in time value of -$12,500).

Dr Loss on firm commitment 15,000

Dr Accounts receivable 850,000

Dr Put option 5,000

Dr Loss on account receivable 10,000

(1) Journal entries

1 October 20x4 (optional)

Fair value of investment at 1/11/20x4 $356,250

Dr Put option 3,630

(Settle forward contract at maturity date on a net basis)

Dr Put option 6,570

Dr Put option 7,950

Dr Fair value reserve - equity 9,600

Dr Investment (FVOCI) 2,850

Calculation of changes in fair value of forward contract and its components

01/12/x1 10,000 1.74 1.7

31/12/x1 10,000 1.7 1.7 1.67 300 300 400 (100)

01/02/x2 10,000 1.65 1.7 1.63 700 400 500 (100)

30/03/x2 10,000 1.69 1.7 1.69 100 (600) (400) (200)

Calculation of change in expected cash flows

01/12/x1 10,000 1.74 17,400

31/12/x1 10,000 1.7 17,000 (400)

01/02/20 10,000 1.65 16,500 500