tbch18

 CHAPTER 18  Derivatives,Contingencies,Business Segments, and Interim Reports MULTIPLE CHOICE QUESTIONS Theory/Definitional Questions 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Definition of a price risk Definition of a credit risk Definition of a forward contract Definition of a futures contract Use of a futures contract Definition of an option Timing of option owner’s payment Option protects owner against unfavorable price/rate movements Effect of fair value hedges on net income Definition of cash flow hedge Disclosures on derivative contracts Effect of an obligation contingent on the occurrence of a future event Financial statement disclosure of a contingent loss How firms identify reportable segments Example of a call option Reportable segments under FASB Statement No. 14 APB Opinion No. 28 and interim financial reporting Hedge of an account payable Hedge relating to equipment purchase Interest rate swap and hedging Accounting for a call option Accounting for a call option Accounting for a call option Accounting for a call option Accounting for a call option Identifying business segments Disclosures under disaggregated information standard Reporting disaggregated information for interim periods Interim reporting Call option and hedging

171

172

Chapter 18  Derivatives, Contingencies, Business Segments, and Interim Reports

31 Accounting for interim period inventory loss Computational Questions 32 Computation of payment on forward contract 33 Computation of payment on forward contract 34 Computation of accrued liability from a lawsuit 35 Computation of call option contract savings/loss 36 Computation of call option contract savings/loss 37 Computation of call option contract savings/loss 38 Computation of interest rate swap agreement settlement payments 39 Computation of interest rate swap agreement settlement payments * 40 Computation of interest rate swap agreement settlement payments 41 Computation of fair value on forward contract agreement 42 Computation of disclosed liability from litigation 43 Computation of disclosed liability from litigation 44 Computation of accrued liability from litigation

PROBLEMS 1 2 3 4 5 6

Journal entries on execution of futures contract and disclosure Journal entries on execution of call option and disclosure Journal entries on execution of interest rate swap Litigation and required financial statement disclosures Identifying the risks confronting an enterprise Improving segment disclosures

*This question requires the use of present value tables to solve.

MULTIPLE CHOICE QUESTIONS a LO2

1. Uncertainty about the future market value of an asset is referred to as a. price risk. b. credit risk. c. interest rate risk. d. exchange rate risk.

b LO2

c LO3

2. Uncertainty that the party on the other side of an agreement will abide by the terms of the agreement is referred to as a. price risk. b. credit risk. c. interest rate risk. d. exchange rate risk. 3. A contract, traded on an exchange, that allows a company to buy a specified quantity of a commodity or a financial security at a specified price on a specified future date is referred to as a(n) a. interest rate swap. b. forward contract. c. futures contract. d. option.

b LO3

4. An agreement between two parties to exchange a specified amount of a commodity, security, or foreign currency at a specified date in the future with the price or exchange rate being set now is referred to as a(n) a. interest rate swap. b. forward contract. c. futures contract. d. option.

c

5. If a cannery wanted to lock in the price they would pay for peaches in August four months before harvest (in April of the same year), they would be most likely to enter into which kind of agreement? a. Interest rate swap b. Fixed commodities contract c. Futures contract d. Option

LO3

d LO3

6. A contract giving the owner the right, but not the obligation, to buy or sell an asset at a specified price any time during a specified period in the future is referred to as a(n) a. interest rate swap. b. forward contract. c. futures contract. d. option.

d LO3

7. In exchange for the rights inherent in an option contract, the owner of the option will typically pay a price a. only when a call option is exercised. b. only when a put option is exercised. c. when either a call option or a put option is exercised. d. at the time the option is received regardless of whether the option is exercised or not. d LO3

8. Which type of contract is unique in that it protects the owner against unfavorable movements in the prices or rates while allowing the owner to benefit from favorable movements? a. Interest rate swap b. Forward contract c. Futures contract d. Option

a

9. When gains or losses on derivatives designated as fair value hedges exceed the gains or losses on the item being hedged, the excess a. affects reported net income. b. is recognized as an equity adjustment. c. is recognized as part of comprehensive income. d. is not recognized.

LO5

b LO5

c LO5

10. For which type of derivative are changes in the fair value deferred and recognized as an equity adjustment? a. Fair value hedge b. Cash flow hedge c. Operating hedge d. Notional value hedge 11. Which choice best describes the information that should be disclosed related to derivative contracts? a. Fair value b. Notional amount c. Both a and b d. Neither a or b

d LO6

d LO6

12. An obligation that is contingent on the occurrence of a future event should be reported in the balance sheet as a liability if a. the future event is likely to occur. b. the amount of the obligation can be reasonably estimated. c. the occurrence of the future event is at least reasonably possible and the amount is known. d. the occurrence of the future event is probable and the amount can be reasonably estimated. 13. A contingent loss should be disclosed in a note to the financial statements but should not be recorded as a liability if a. the possibility of loss is remote. b. the contingency involves pending or threatened litigation. c. the outcome is uncertain. d. the actual incurrence of a loss is reasonably possible.

d LO7

14. According to Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information,” how do firms identify reportable segments? a. By geographic regions b. By product lines c. By industry classification d. By designations used inside the firm

c LO3

15. On February 1, Shoemaker Corporation entered into a firm commitment to purchase specialized equipment from the Okazaki Trading Company for ¥80,000,000 on April 1. Shoemaker would like to reduce the exchange rate risk that could increase the cost of the equipment in U.S. dollars by April 1, but Shoemaker is not sure which direction the exchange rate may move. What type of contract would protect Shoemaker from an unfavorable movement in the exchange rate while allowing them to benefit from a favorable movement in the exchange rate? a. Interest rate swap b. Forward contract c. Call option d. Put option

d LO7

16. Which of the following tests may be used to determine if an industry segment of an enterprise is a reportable segment under FASB Statement No. 131? a. Its revenue (both from external customers and internal segments) is equal to or greater than 10 percent of total revenue (external and external). b. The absolute value of its operating profit is equal to or greater than 10 percent of the total of the operating profit for all segments that reported profits (or the total of the losses for all segments that reported losses). c. The segment contains 10 percent or more of the combined assets of all operating segments. d. All of the above.

d LO8

17. In considering interim financial reporting, how does APB Opinion No. 28 conclude that such reporting should be viewed? a. As reporting for a basic accounting period b. As useful only if activity is evenly spread throughout the year so that estimates are unnecessary c. As a "special" type of reporting that need not follow generally accepted accounting principles d. As reporting for an integral part of an annual period

c

18. A company enters into a futures contract with the intent of hedging an account payable of DM400,000 due on December 31. The contract requires that if the U.S. dollar value of DM400,000 is greater than $200,000 on December 31, the company will be required to pay the difference. Alternatively, if the U.S. dollar value is less than $200,000, the company will receive the difference. Which of the following statements is correct regarding this contract? a. The Deutsche mark futures contract effectively hedges against the effect of exchange rate changes on the U.S. dollar value of the Deutsche mark payable. b. The futures contract is a contract to buy Deutsche marks at a fixed price. c. The futures contract is a contract to sell Deutsche marks at a fixed price. d. The contract obligates the company to pay if the value of the U.S. dollar increases.

LO4

d LO4

19. A company enters into a futures contract with the intent of hedging an expected purchase of some equipment from a German company for DM400,000 on December 31. The contract requires that if the U.S. dollar value of DM800,000 is greater than $400,000 on December 31, the company will receive the difference. Alternatively, if the U.S. dollar value is less than $400,000, the company will pay the difference. Which of the following statements is correct regarding this contract? a. The Deutsche mark futures contract effectively hedges against the effect of exchange rate changes on the U.S. dollar value of the Deutsche mark commitment. b. The futures contract exceeds the amount of the commitment and thus hedges movements in the Deutsche mark exchange rate. c. The futures contract is a contract to sell Deutsche marks at a fixed price. d. The extra DM400,000 would be accounted for as a speculative investment.

c LO4

20. A company enters into an interest rate swap in order to hedge a $5,000,000 variable-rate loan. The loan is expected to be fully repaid this year on June 10. The contract requires that if the interest rate on April 30 of next year is greater than 11%, the company receives the difference on a principal amount of $5,000,000. Alternatively, if the interest rate is less than 11%, the company must pay the difference. Which of the following statements is correct regarding this contract? a. The swap agreement effectively hedges the variable interest payments. b. The timing of the swap payment matches the timing of the interest payments and, therefore, the variable interest payments are hedged. c. The timing of the swap payment does not match the timing of the interest payments and, therefore, the variable interest payments are not hedged. d. This swap represents a fair value hedge.

Questions 21-25 are based on the following information: Hall, Inc., enters into a call option contract with Bennett Investment Co. on January 2, 2002. This contract gives Hall the option to purchase 1,000 shares of WSM stock at $100 per share. The option expires on April 30, 2002. WSM shares are trading at $100 per share on January 2, 2002, at which time Hall pays $100 for the call option. a LO1

21. The call option would be recorded in the accounts of Hall as a. an asset. b. a liability. c. a gain. d. would not be recorded in the accounts (memorandum entry only).

c LO1

22.Assume that the price of the WSM shares has risen to $120 per share on March 31, 2002, and the Hall is preparing financial statements for the quarter ending March 31. As regards this option, Hall, Inc., would report which of the following? a. A $20,000 realized gain. b. A $20,000 unrealized gain. c. a description of the change in price would be disclosed in the notes to the financial statements, but would not be reflected in the financial statements. d. Nothing would be reported in the financial statements or the notes thereto.

b LO1

23. The 1,000 shares of WSM stock in this contract is referred to as a. the collateral. b. the notional amount. c. the option premium. d. the derivative.

a LO1

24. The $400 paid by Hall, Inc., to Baird Investment is referred to as a. the option premium. b. the notional amount. c. the strike price. d. the intrinsic value.

c and LO1

25. Assume that the price per share of WSM stock is $120 on April 30, 2002,

b LO7

26. Cosmos Corporation sells 5 different types of products. The company is divided for internal reporting purposes into 5 different divisions based on these 5 different product lines. The company should prepare the note disclosure for disaggregated information based upon a. the 5 types of products. b. the 5 different divisions. c. the materialty of each product line based on the revenue or operating profits generated by each product line or the assets utilized by each product line. d. the geographic areas in which the 5 products are sold.

that the time value of the option has not changed. In order to settle the option contract, Hall, Inc., would most likely a. pay Baird Investment $20,000. b. purchase the shares of WSM at $100 per share and sell the shares at $120 per share to Baird. c. receive $20,000 from Baird Investment. d. receive $400 from Baird Investment.

c LO7

c LO7 LO8

27. Which of the following is not required under current GAAP for disaggregated information relating to geographic area information? a. Revenues from external customers from the home country of the firm and from all foreign countries in total. b. The total of long-lived assets located in the firm’s home country and located in foreign countries. c. Operating profits from external customers from the home country of the firm and from all foreign countries in total. d. Revenues for any foreign country for which the revenues from that country are material to the firm. 28. When a company with reportable segments issues interim condensed financial statements, current GAAP requires that the interim reports provide all of the following for each reportable segment except a. revenues for external customers. b. intersegment revenues. c. a measure of segment profit or loss. d. total assets.

a LO8

29. Which of the following is not true regarding standards for interim reporting? a. Declines in inventory value should be deferred to future interim periods. b. Use of the gross margin method for computing cost of goods sold must be disclosed. c. Costs and expenses not directly associated with interim revenue must be allocated to interim periods on a reasonable basis. d. Gains and losses that arise in an interim period should be recognized in the interim period in which they arise if they would not normally be deferred at year-end.

c LO4

30. Alpha Company purchases a call option to hedge an investment in 20,000 shares of Beta Company stock. The option agreement provides that if the prices of a share of Beta Company stock is greater than $30 on October 25, Alpha receives the difference (multiplied by 20,000 shares). Alternatively, if the price of the stock is less than $30, the option is worthless and will be allowed to expire. Which of the following statements regarding this call option is correct? a. The call option effectively hedges the investment in the shares of Beta stock. b. The call option is an option to sell Beta Company stock at a fixed price. c. The call option represents a speculative option rather than a hedge. d. Alpha could have purchased a put option or a call option to effectively hedge the investment in the shares of Beta stock.

c LO8

31. An inventory loss from market decline of $900,000 occurred in April 2002. CD Company recorded this loss in April 2002 after its March 31, 2002, quarterly report was issued. None of this loss was recovered by the end of the year. How should this loss be reflected in the quarterly income statements of CD Company? Three months ended (2002): March 31 June 30 September 30 December 31 a. 0 0 0 $900,000 b. 0 $300,000 $300,000 $300,000 c. 0 $900,000 0 0 d. $225,000 $225,000 $225,000 $225,000

a LO5

32. On July 1, 2002, Cahoon Company sold some limited edition art prints to Sitake Company for ¥47,850,000 to be paid on September 30 of that year. The current exchange rate on July 1, 2002, was ¥110=$1, so the total payment at the current exchange rate would be equal to $435,000. Cahoon entered into a forward contract with a large bank to guarantee the number of dollars to be received. According to the terms of the contract, if ¥47,850,000 is worth less than $435,000, the bank will pay Cahoon the difference in cash. Likewise, if ¥47,850,000 is worth more than $435,000, Cahoon must pay the bank the difference in cash. Assuming the exchange rate on September 30 is ¥115=$1, what amount will Cahoon pay to, or receive from, the bank (rounded to the nearest dollar)? a. $18,913 payment b. $18,913 receipt c. $20,714 payment d. $20,714 receipt

c LO5

33. On July 1, 2002, Cahoon Company sold some limited edition art prints to Sitake Company for ¥47,850,000 to be paid on September 30 of that year. The current exchange rate on July 1, 2002, was ¥110=$1, so the total payment at the current exchange rate would be equal to $435,000. Cahoon entered into a forward contract with a large bank to guarantee the number of dollars to be received. According to the terms of the contract, if ¥47,850,000 is worth less than $435,000, the bank will pay Cahoon the difference in cash. Likewise, if ¥47,850,000 is worth more than $435,000, Cahoon must pay the bank the difference in cash. Assuming the exchange rate on September 30 is ¥105=$1, what amount will Cahoon pay to, or receive from, the bank (rounded to the nearest dollar)? a. $18,913 payment b. $18,913 receipt c. $20,714 payment d. $20,714 receipt

c LO6

34. Landon Construction Co. carries $10,000,000 comprehensive public liability insurance with a $200,000 deductible clause. A suit for personal injury damages was brought against Landon in 2002. Landon’s counsel believes it probable that the insurance company will settle out of court for an estimated amount of $550,000. At December 31, 2002, Landon should report an accrued liability of a. $550,000. b. $350,000. c. $200,000. d. $0.

b

35. On June 18, Edwards Corporation entered into a firm commitment to purchase specialized equipment from the Okazaki Trading Company for ¥80,000,000 on August 20. The exchange rate on June 18 is ¥100 = $1. To reduce the exchange rate risk that could increase the cost of the equipment in U.S. dollars, Edwards pays $12,000 for a call option contract. This contract gives Edwards the option to purchase ¥80,000,000 at an exchange rate of ¥100 = $1 on August 20. On August 20, the exchange rate is ¥93 = $1. How much did Edwards save by purchasing the call option (answers rounded to the nearest dollar)? a. $12,000 b. $48,215 c. $60,215 d. Edwards would have been better off not to have purchased the call

LO5

option. d LO5

36. On March 1, Chow Corporation entered into a firm commitment to purchase specialized equipment from the Gifu Trading Company for ¥80,000,000 on June 1. The exchange rate on March 1 is ¥100 = $1. To reduce the exchange rate risk that could increase the cost of the equipment in U.S. dollars, Chow pays $20,000 for a call option contract. This contract gives Chow the option to purchase ¥80,000,000 at an exchange rate of ¥100 = $1 on June 1. On June 1, the exchange rate is ¥105 = $1. How much did Chow save by purchasing the call option (answers rounded to the nearest dollar)? a. $20,000 b. $27,619 c. $47,619 d. Chow would have been better off not to have purchased the call option.

c LO6

37. During 2002, Jackson Company became involved in a tax dispute with the IRS. At December 31, 2002, Jackson’s tax adviser believed that an unfavorable outcome was probable and a reasonable estimate of additional taxes was $500,000 but could be as much as $650,000. After the 2002 financial statements were issued, Jackson received and accepted an IRS settlement offer of $550,000. What amount of accrued liability would Jackson have reported in its December 31, 2002, balance sheet? a. $650,000 b. $550,000 c. $500,000 d. $0

c LO5

38. On January 1, 2002, Cougar Company received a two-year $500,000 loan. The loan calls for payments to made at the end of each year based on the prevailing market rate at January 1 of each year. The interest rate at January 1, 2002, was 10 percent. Aggie company also has a two-year $500,000 loan, but Aggie’s loan carries a fixed interest rate of 10 percent. Cougar Company does not want to bear the risk that interest rates may increase in year two of the loan. Aggie Company believes that rates may decrease and they would prefer to have variable debt. So the two companies enter into an interest rate swap agreement whereby Aggie agrees to make Cougar’s interest payment in 2003 and Cougar likewise agrees to make Aggie’s interest payment in 2003. The two companies agree to make settlement payments, for the difference only, on December 31, 2003. If the interest rate on January 1, 2003 is 8 percent, what will be Cougar’s settlement payment to/from Aggie? a. $5,000 payment b. $5,000 receipt c. $10,000 payment d. $10,000 receipt

d LO5

39. On January 1, 2002, Cougar Company received a two-year $500,000 loan. The loan calls for payments to made at the end of each year based on the prevailing market rate at January 1 of each year. The interest rate at January 1, 2002, was 10 percent. Aggie company also has a two-year $500,000 loan, but Aggie’s loan carries a fixed interest rate of 10 percent. Cougar Company does not want to bear the risk that interest rates may increase in year two of the loan. Aggie Company believes that rates may decrease and they would prefer to have variable debt. So the two companies enter into an interest rate swap agreement whereby Aggie agrees to make Cougar’s interest payment in 2003 and Cougar likewise agrees to make Aggie’s interest payment in 2003. The two companies agree to make settlement payments, for the difference only, on December 31, 2003. If the interest rate on January 1, 2003, is 12 percent, what will be Cougar’s settlement payment to/from Aggie?

a. b. c. d.

$5,000 payment $5,000 receipt $10,000 payment $10,000 receipt

b LO5

40. On January 1, 2002, Cougar Company received a two-year $500,000 loan. The loan calls for payments to be made at the end of each year based on the prevailing market rate at January 1 of each year. The interest rate at January 1, 2002, was 10 percent. Aggie company also has a two-year $500,000 loan, but Aggie’s loan carries a fixed interest rate of 10 percent. Cougar Company does not want to bear the risk that interest rates may increase in year two of the loan. Aggie Company believes that rates may decrease and they would prefer to have variable debt. So the two companies enter into an interest rate swap agreement whereby Aggie agrees to make Cougar’s interest payment in 2003 and Cougar likewise agrees to make Aggie’s interest payment in 2003. The two companies agree to make settlement payments, for the difference only, on December 31, 2003. If the interest rate on December 31, 2002 is 12 percent, what amount will Cougar report as the fair value of the interest rate swap at December 31, 2002 (answers rounded to the nearest dollar)? a. $0 b. $8,929 c. $10,000 d. $500,000

b

41. On November 1, 2002, Cahoon Company sold some limited edition art prints to Sitake Company for ¥47,850,000 to be paid on January 1, 2003. The current exchange rate on November 1, 2002, was ¥110=$1, so the total payment at the current exchange rate would be equal to $435,000. Cahoon entered into a forward contract with a large bank to guarantee the number of dollars to be received. According to the terms of the contract, if ¥47,850,000 is worth less than $435,000, the bank will pay Cahoon the difference in cash. Likewise, if ¥47,850,000 is worth more than $435,000, Cahoon must pay the bank the difference in cash. Assuming the exchange rate on December 31, 2002 is ¥115=$1, what amount will Cahoon disclose as the fair value of the forward contract on December 31, 2002 (answers rounded to the nearest dollar)? a. $0 b. $18,913 c. $20,714 d. $416,087

LO5

c LO6

42. In May 2002, the Marlins Company became involved in litigation. As a result of this litigation, it is probable that Marlins will have to pay $700,000. In July 2002, a competitor commenced a suit against Marlins alleging violation of antitrust laws seeking damages of $1,100,000. Marlins denies the allegations, and the likelihood of Marlins paying any damages is remote. In September 2002, Braves County brought action against Marlins for $900,000 for polluting Lake Tomahawk. It is reasonably possible that Braves County will be successful, but the amount of damages Marlins will have to pay is not reasonably determinable. What amount, if any, should be accrued by a charge to income in 2002? a. $2,700,000 b. $1,600,000 c. $700,000 d. $0

a LO6

43. On January 17, 2002, an explosion occurred at an Orioles Fireworks plant causing extensive property damage to area buildings. Although no claims had yet been asserted against Orioles by March 10, 2002, Orioles’ management and counsel concluded that it is reasonably possible Orioles will be responsible for damages and that $2,500,000 would be a reasonable estimate of its liability. Orioles’ $10,000,000 comprehensive public liability policy has a $500,000 deductible clause. In Orioles’ December 31, 2001, financial statements, which were issued on March 25, 2002, how should this item be reported? a. As a footnote disclosure indicating the possible loss of $500,000 b. As an accrued liability of $500,000 c. As a footnote disclosure indicating the possible loss of $2,500,000 d. As an accrued liability of $2,500,000

c LO6

44. On November 5, 2002, a Timp Rental truck was in an accident with an auto driven by Fred Meyer. Timp Rental received notice on January 12, 2003, of a lawsuit for $700,000 damages for personal injuries suffered by Meyer. Timp Rental’s counsel believes it is probable that Meyer will be awarded an estimated amount in the range between $200,000 and $450,000, and that $300,000 is a better estimate of potential liability than any other amount. Timp’s accounting year ends on December 31, and the 2002 financial statements were issued on March 2, 2003. What amount of loss should Timp accrue at December 31, 2002? a. $0 b. $200,000 c. $300,000 d. $450,000

PROBLEMS Problem 1 Yokochan Bakeries specializes in making cakes, cookies, and other pastries out of rice flour which they grind themselves. Yokochan anticipates purchasing 40,000 pounds of rice in January 2003. On November 1, 2002, Yokochan entered into a futures contract with Sagara Growers to purchase 40,000 pounds of rice on January 1, 2003, at $0.50 per pound. On December 31, 2002, and January 1, 2003, the prevailing market price for rice is $0.55 per pound. Yokochan purchases the rice and settles the futures contract on January 1, 2003. Make the necessary entries on Yokochan’s books at (a) November 1, 2002 (b) December 31, 2002 (c) January 1, 2003 Solution 1 LO5 (1) (a) No entry is made to record the futures contract on November 1, 2002. As of this date, the rice futures contract has a fair value of $0. (b)

Futures Contract (asset).................................... Other Comprehensive Income...................

2,000 2,000

The gain from the increase in the value of Yokochan’s futures contract is deferred as part of comprehensive income. The futures contract is a cash flow hedge, with the futures contract payment intended to offset the increased amount that the company will have to pay to make its forecasted purchase of 40,000 pounds of rice on January 1, 2003. (c)

Rice Inventory (40,000 lbs x $0.55)................... Cash...........................................................

22,000

Cash (futures contract settlement)..................... Futures Contract (asset)............................

2,000

Other Comprehensive Income........................... Gain on Futures Contract...........................

2,000

22,000 2,000 2,000

Problem 2 Stiggins Fitness Enterprises uses soybeans to make one of their nutritional supplement products. Stiggins anticipates a need of 500,000 pounds of soybeans

in January of 2003. On November 1, 2002, Stiggins purchased a call option for 500,000 pounds of soybeans on January 1, 2003, at a price of $0.40 per pound, which is the market price on November 1. Stiggins paid $1,200 for the call option and designated this option as a hedge against price fluctuations for their January purchase of soybeans. On December 31, 2002, and January 1, 2003, the prevailing market price for soybeans is $0.45 per pound. On January 1, 2003, Stiggins purchased 500,000 pounds of soybeans. Make the necessary entries on Stiggins’s books at (a) November 1, 2002 (b) December 31, 2002 (c) January 1, 2003 Solution 2 LO5 (1) (a) Soybean Call Option (asset).............................. Cash...........................................................

1,200 1,200

No entry is made on November 1 to record the forecasted purchase of soybeans to occur in January 2003. (b)

Soybean Call Option (asset).............................. Other Comprehensive Income...................

23,800 23,800

With the prevailing market price of $0.45 per pound on December 31, 2002, Stiggins can expect to receive a payment of $25,000 [($.45 – $.40) x 500,000 lbs.] on January 1, 2003, to settle the option. Accordingly, the option is worth $25,000 on December 31, 2002. (c)

Soybean Inventory............................................. 225,000 Cash (500,000 lbs x $0.45)........................ Cash................................................................... Soybean Call Option..................................

25,000

Other Comprehensive Income........................... Gain on Soybean Call Option....................

23,800

225,000 25,000 23,800

The soybean call option is allowed to expire unused. The deferred loss recorded in Other Comprehensive Income in 2002 is recognized in the earnings on January 1, 2003, the date of the forecasted transaction (soybean purchase) that was hedged using the soybean call option. Problem 3

On January 1, 2002, Eden Ventures, Inc., received a three-year, $1 million loan with interest payments due at the end of each year and the principal to be repaid on December 31, 2004. The interest rate for the first year is the prevailing market rate of 9 percent, and the rate each succeeding year will be equal to the prevailing market rate on January 1 of that year. Eden also entered into an interest rate swap agreement related to this loan. Under the terms of the swap agreement, in the years 2003 and 2004, Eden will receive a swap payment based on the principal amount of $1 million. If the January 1 interest rate is greater than 9 percent, Eden will receive a swap payment for the difference; and if the January 1 interest rate is less than 9 percent, Eden will make a swap payment for the difference. The swap payments are made on December 31 of each year. On January 1, 2003, the interest rate is 8 percent, and on January 1, 2004, the interest rate is 12 percent. Make all the journal entries necessary on Eden’s books at the dates shown below. For purposes of estimating future swap payments, assume that the current interest rate is the best forecast of the future interest rate (round all entries to the nearest dollar). (1) (2) (3) (4)

January 1, 2002 December 31, 2002 December 31, 2003 December 31, 2004

Solution 3 LO5 (1) Cash............................................................................1,000,000 Loan Payable.....................................................

1,000,000

No entry is made to record the swap agreement because, as of January 1, 2002, the swap has a fair value of $0. (2) Interest Expense......................................................... Cash ($1,000,000 x .09).....................................

90,000

Other Comprehensive Income................................... Interest Rate Swap.............................................

17,833

90,000 17,833

Eden will make a swap payment on December 31, 2003, of $10,000 (9 percent – 8 percent x $1,000,000). At current market rates, Eden also expects to make a $10,000 swap payment on December 31, 2004. The present value of these payments is equal to $17,833 (10,000 x 1.7833 [present value of annuity for 2 periods at 8 percent]). (3) Interest Expense......................................................... Cash ($1,000,000 x .09).....................................

90,000 90,000

Interest Rate Swap..................................................... Cash ($1,000,000 x [.09 - .08])..........................

10,000 10,000

This entry records the swap payment Eden was obligated to make based on the interest rate (8 percent) at January 1, 2003. Interest Expense......................................................... Other Comprehensive Income...........................

10,000 10,000

This entry adjusts other comprehensive income for amounts previously accrued at December 31, 2002. Interest Rate Swap..................................................... Other Comprehensive Income...........................

34,620 34,620

Based on the current market rate of 12 percent at December 31, 2003, Eden can expect to receive a swap payment of $30,000 (12 percent – 9 percent x $1,000,000) at December 31, 2004. This payment has a present value of $26,787 ($30,000 x 0.8929 [present value factor for one period at 12 percent]). This entry adjusts the interest rate swap account to a balance of $26,787 (debit) and also adjusts the other comprehensive income account to a balance of $26,787 (credit). (4) Interest Expense......................................................... Cash ($1,000,000 x .09).....................................

90,000

Cash (from Interest Rate Swap)................................. Interest Rate Swap............................................. Other Comprehensive Income...........................

30,000

90,000 26,787 3,213

This entry records the swap payment Eden is entitled to receive based on the interest rate (12 percent) at January 1, 2004. It reduces the value of the interest rate swap account to zero, reflecting the expiration of the contract, and it increases the balance of the other comprehensive income account to $30,000, the value of the swap payment received. Other Comprehensive Income................................... 30,000 Interest Expense................................................. 30,000 This entry uses amounts previously recognized in Other Comprehensive Income to adjust earnings by offsetting interest expense. Loan Payable..............................................................1,000,000 Cash................................................................... Problem 4

1,000,000

Vita Technologies is involved in cancer research. Vita is involved in a number of lawsuits related to their operations. For each case, indicate the disclosure that should be provided by Vita Technologies in the annual financial statement. (1) One of their drugs, Hypothiaman, resulted in dangerous side effects of which Vita was unaware. As a result, a class action lawsuit has been filed against Vita. Vita’s attorneys feel it is probable that the company will lose the suit, and the amount can be reasonably estimated. (2) An employee of Vita is suing the company alleging that his seizures are a result of the working environment at Vita. Vita’s attorneys feel the suit is without merit. (3) A competitor, Mancro Drugs, has filed suit against Vita alleging patent infringement. Vita’s attorneys are unsure as to the outcome of the suit. Solution 4 LO6 (1) Because attorneys for Vita feel it is probable that the company will lose the suit, the liability should be recorded on the books of Vita. (2) If Vita’s attorneys feel that the lawsuit is without merit, then no disclosure is required. (3) In many instances, it is difficult to assess the final outcome of litigation. The most common solution when the outcome of litigation is uncertain is to provide extensive footnote disclosure. In this case, the attorneys are unsure as to the outcome. If, in this case, the lawsuit is deemed to be material, footnote disclosure would be appropriate.

Problem 5 Quest Company began operations five years ago. The company produces and sells software. The company’s primary market is in the United States, where 60% of sales occur. Ten percent of the company’s sales occur in Japan and 30% of sales occur in Europe. Foreign sales are denominated in local currencies. Major software purchases may be paid over a one-year period. Quest Company has obtained is long-term financing from U.S., Japanese, and German banks. Approximately one-half of the loans from U.S. banks are variablerate loans, with the remainder of the company’s loans being fixed-rate obligations. Quest Company has seen dramatic fluctuations in earnings during is five years of existence. Identify the types of risk faced by Quest Company. Solution 5 LO2 Quest Company faces the following types of risk: 

Price risk. Quest faces price risk as a result of the demand for the product it sells. The nature and function of the software sold by the company was not specified. If the software is not absolutely necessary for operation of a computer, however, consumers may elect not to purchase the software, particularly when general economic conditions are unfavorable. The fact that the company is operating in three different major markets (U.S., Japan, and Germany) also complicates any assessment of price risk for the company.



Interest Rate Risk. Quest faces uncertainty regarding the amount of future interest payments as a result of the company’s variable-rate loan obligations. The company also faces risk related to interest rates on its fixed-rate loans. If interest rates fall, Quest could find itself obligated for interest rates above the market rate.



Exchange rate risk. Quest faces exchange rate risk in connection with its loans denominated in Japanese yen and German Deutsche marks and with sales of software denominated in foreign currency. Most international trade involves a delay between setting the price of the transaction (in this case, the sale of software by Quest) and receiving payment for the software. Quest faces the risk of losing some amount of purchasing power due to fluctuation in the exchange rate before payment is received.

Problem 6 Current standards of financial accounting and reporting for disaggregated information focus primarily on disclosure of quantitative financial information. Additional information about the nature of the business environments in which an enterprise’s activities are conducted also may be necessary to help financial statement users better assess the risk and return prospects of an enterprise’s business operations. Identify items of descriptive or explanatory information currently not required by existing standards that might be useful to financial statement users in assessing the risk and return prospects of an enterprise’s business operations. Solution 6 LO7 The following items of descriptive information might be useful in assessing an enterprise’s risk and prospective returns: 1.

A description of the industry in which the segment operates, including: a. b. c.

d. 2.

Definition of the industry. Economic, social, demographic, technological, political, and regulatory trends that affect the industry. Economic structure of the industry (ability of new companies to enter the industry, risks of substitute products and services, resource availability including supplier dominance, customer dominance, and competitiveness). Economic outlook for the industry.

Narrative description of the segment’s business to include: a. b. c. d. e. f. g. h.

Principal products and services. Principal market served by products and services and size of the market. Process used to make the products or provide the services. Key inputs to the process. Distribution methods for products and services. Seasonality and cyclicality. Regulation and legislation affecting the segment. Importance of patents, trademarks, licenses, franchises, and concessions held.

3.

A statement of the segment’s mission.

4.

The segment’s strategy and alignment of that strategy with external trends and employee incentives.

5.

The segment’s position within the industry, including: a. Market share and trends in market share. b. Competitors (number, names, resources, relative profitability, and other strengths and weaknesses). c. Relative competitive advantages and disadvantages of the segment (identity, source, and sustainability). 6. The segment’s ability to innovate, adapt to change, and continuously improve, including: a. Elements of the organization’s infrastructure allowing innovation, adaptation to change, and improvement (organizational structure, business strategy, management philosophy, and employee incentives). b. Recent process, product, or service innovations. c. Recent changes in the environment and the nature and timing of the segment’s response. d. Rate of change in the segment’s performance (key operating and financial measures, trend in rate of change, and reason for the change). 7. Quantified nonfinancial operating data. 8. The identity of key trends and relationships among the various financial and nonfinancial data reported for the segment and the reasons why those relationships may differ from those related to competitors, the industry, or the economy.

CHAPTER 18 -- QUIZ A

Name _________________________ Section ________________________

T F

1. All derivative contracts require an initial journal entry to record the existence of a contract.

T F

2. Firms holding derivative contracts are always subject to more risk than firms that do not hold any derivative contracts.

T F

3. Firms must take delivery or make delivery of the underlying asset or financial instrument for a derivative contract to exist.

T F

4. Derivative contracts make it possible to effectively change a variable rate obligation into a fixed rate obligation.

T F

5. Futures contracts can be traded on a public exchange.

T F

6. Futures contracts deal only with commodities.

T F

7. A call option gives the owner the right to sell an asset at a specified price.

T F

8. A put option gives the owner the right to sell an asset at a specified price.

T F

9. A firm commitment is the same as a purchase.

T F 10. The holder of a call option has no incentive to exercise the option after the market price has moved above the option price.

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CHAPTER 18 -- QUIZ B

A. Cash flow hedge Price risk B. Price risk C. Notional amount D. Swap E. Interest rate risk F. Futures contract

Name_________________________ Section________________________ G. Executory contract H. I. J. K. L.

Option Exchange rate risk Put option Firm commitment Derivative

M. Credit risk N. Hedging O. Forward contract P. Fair value hedge

Select the term that best fits each of the following definitions and descriptions. Indicate your answer by placing the appropriate letter in the space provided. ____ 1.

Agreement between two parties to exchange a specified amount of a commodity, security, or foreign currency at a specified date with the price being set now.

____ 2.

Uncertainty about future interest rates and their impact on future cash flows.

____ 3.

Total face amount of the asset or liability that underlies a derivative contract.

____ 4.

Contract, traded on an exchange, that allows a company to buy a specified quantity of a commodity or a financial security at a specified price on a specified future date.

____ 5.

Financial instrument that derives its value from the movement of the price, foreign exchange rate, or interest rate of some other underlying asset or financial instrument.

____ 6.

Structuring of transactions to reduce risk.

____ 7.

Reliable promise to purchase or sell an asset in the future at a price that is set now.

____ 8.

An exchange of promises to engage in a transaction in the future.

____ 9.

Uncertainty that the party on the other side of an agreement will abide by the terms of the agreement.

____ 10.

Contract in which two parties agree to exchange payments in the future based on the movement of some agreed-upon price or rate.

____ 13.

Contact giving the owner the right to buy or sell an asset at a specified price any time during a specified period.

____ 14.

Uncertainty about the future price of an asset.

____ 15.

Contract giving the owner the right, but not the obligation, to sell an asset at a specified price.

194

Test Bank, Intermediate Accounting, 14th ed.

CHAPTER 18 -- QUIZ SOLUTIONS Quiz A 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

F F F T T F F T F T

Quiz B 1. O 2. E 3. C 4. F 5. L 6. N 7. K 8. G 9. M 10. D 11. A 12. I 13. H 14. B 15. J

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Chapter 18  Derivatives, Contingencies, Business Segments, and Interim

Reports

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