Response to the following problems:
1. On March 17, Kennedy Baking, Inc., committed to buy 1,000 tons of commodity A for delivery in May at a cost of $118 per ton. Concerned that the price of commodity A might decrease, on March 29 the company purchased a May put option for 1,000 tons of commodity A at a strike price of $119 per ton. The change in the time value of the option is excluded from the assessment of hedge effectiveness, and the option was settled on May 18. After processing all 1,000 tons of commodity A at a cost of $25 per ton, one-half of the resulting inventories was sold for $180 per ton on June 16. Relevant values are as follows:
Required
1. Prepare all applicable entries for the months of March through June regarding the inventory and the hedging instrument assuming qualification as a fair value hedge. Record the changes in the intrinsic value and time value of the option with separate entries.
2. For the entire 1,000 tons of processed commodity A, prepare a schedule regarding the cost of the processed commodity available for sale in terms of the desired cost, the cost without the hedge, and the cost with the hedge.
2. The chief financial officer (CFO) of Baxter International has employed the use of hedges in a variety of contexts over the first quarter of the current calendar year as follows:
Futures Contract -The Company hedged against a possible decline in the value of inventory represented by commodity A. At the beginning of February, an April futures contract to sell 10,000 units of commodity A for $3.50 per unit was acquired. It is assumed that the terms of the futures contract and the hedged assets match with respect to delivery location, quantity, and quality. The fair value of the futures contract will be measured by changes in the futures prices over time, and the time value component of the futures contract will be excluded from the assessment of hedge effectiveness. Relevant values are as follows:
Forward Contract - On January 15, the company committed to sell 5,000 units of inventory for $90 per unit on March 15. Concerned that selling prices might increase over time, the company entered into a March 15 forward contract to buy 5,000 units of identical inventory at a forward rate of $92 per unit. Changes in the value of the commitment are measured based on the changes in the forward rates over time discounted at 6%. On March 15, the inventory, with a cost of $360,000, was sold, and the forward contract was settled. Relevant values are as shown on page 545.
Option - In January, the company forecasted the purchase of 100,000 units of commodity B with delivery in February. Upon receipt, the commodity was processed further and sold for $12 per unit on March 17. On January 15, the company purchased a February 20 call option for 100,000 units of commodity B at a strike price of $8 per unit. Changes in the time value of the option are excluded from the assessment of hedge effectiveness. Relevant values are as follows:
Required
For each of the above hedged events and the related hedging instruments, prepare a schedule to reflect the effect on earnings for each of the months of January through March of the current year. Clearly identify each component account impacting earnings.
3. Kaiser Exporters buys used medical equipment and sells it to various foreign health care institutions. On June 15, the company committed to sell medical equipment to a foreign hospital for 800,000 FC. The equipment, with a cost of $325,000, was shipped to the customer on August 15 with terms FOB shipping point and payment due on October 15. At the time of the commitment, Kaiser acquired a forward contract to sell 800,000 FC in 120 days. Selected spot and forward rates are as follows:
The relevant discount rate is 6% and changes in the value of the firm commitment are measured as changes in the forward rate over time.
Required
Assuming that financial statements are prepared for the second and third quarters, identify all relevant income statement and balance sheet accounts for the above transactions and determine the appropriate quarterly balances.
4. In several instances, Neibler Corporation has been engaged in transactions that were denominated or settled in foreign currencies (FC). Given recent volatility in exchange rates between the U.S. dollar and the FC, the company is considering using FC derivatives in a number of instances.
In order to communicate to management the impact of hedging, you have been asked to develop a schedule relating to several hypothetical situations. Hypothetical A involves the purchase of inventory in the amount of 100,000 FC with payment due in 60 days. Assume that the hedge would involve:
(a) An option to buy 100,000 FC in 60 days and
(b) A forward contract to buy 100,000 FC in 60 days. In both cases, the hedge is to be considered a fair value hedge.
Hypothetical B involves the same facts as Hypothetical A except that the hedge is to be considered a cash flow hedge. Hypothetical C involves a commitment to sell inventory in 90 days for 100,000 FC.
Assume that the hedge would involve:
(a) An option to sell 100,000 FC in 90 days and
(b) A forward contract to sell 100,000 FC in 90 days. In both cases, the hedge is to be considered a cash flow hedge. In the case of the option, changes in the value of the commitment are to be measured by changes in spot rates over time, whereas in the case of the forward contract, changes in the value of commitment are measured based on changes in forward rates. The inventory sold has a cost of $100,000.
Hypothetical D involves a 90-day 100,000 FC note receivable bearing interest at 6%. Both principal and interest are payable at maturity, and it is assumed that an option to sell 100,000 FC will be employed as a cash flow hedge.
Hypothetical E involves a forecasted sale of inventory in 90 days for 100,000 FC. Assume that the inventory has a cost of $110,000 and a forward contract to sell 100,000 FC in 90 days is the hedging instrument. Selected rate information is as follows:
Required
For each of the above hypothetical situations, prepare a schedule to show the activity in balance sheet accounts and income statement accounts over the course of the events assuming:
(1) No hedging and
(2) Hedging. With respect to the balance sheet accounts, show the balance in the derivative just prior to settlement and ignore an analysis of cash or foreign currency balances.
5. In order to demonstrate the use of the re-measurement process, assume that at the beginning of the year a U.S. parent company invested 100,000 foreign currency B (FCB) to form a 100% owned subsidiary. The subsidiary immediately invested the foreign currency in land at a cost of 50,000 FCB and inventory with a cost of 50,000 FCB. At midyear, 50% of the inventory was sold for 40,000 FCB. At year-end, assume that the sale is still uncollected. Although FCB is the subsidiary's functional currency, the subsidiary maintains its books of record in foreign currency A (FCA). Assume the following exchange rates:
Required
1. Prepare the entries to record the above transactions:
(a) As they would have been recorded on the books of the subsidiary and
(b) As they would have been recorded had they been recorded in terms of FCB.
Also, prepare the trial balance that would have resulted under each of the recording models.
2. Prepare a schedule to re-measure the FCA trial balance into an FCB trial balance and then translate into U.S. dollars.
3. Prepare a schedule to directly calculate the translation adjustment to be reported in other comprehensive income.
4. Compare the re-measured FCB trial balance to the FCB trial balance in part (1) and comment regarding whether the objectives of translation have been achieved.
6. Translate a trial balance and prepare a consolidation worksheet with excess of cost over book value traceable to equipment. Due to increasing pressures to expand globally, Pueblo Corporation acquired a 100% interest in Sorenson Company, a foreign company, on January 1, 2016. Pueblo paid 12,000,000 FC, and Sorenson's equity consisted of the following:
Common stock.. .. .. ... .... .. . . .. . .. .... .. .. .. . .. . . ... 3,000,000 FC
Paid-in capital in excess of par .. .. . . . .. .. .... .. ... . . .. . 2,000,000
Retained earnings ... .. . .. .. .. . . . . . .. .... .. .... . .. . . . 4,200,000
Total... . .. . . . . .. .... . .. . . . . .. ... .. .. .... .. . . . . . .. ... 9,200,000 FC
On the date of acquisition, equipment with a 10-year life was undervalued by 500,000 FC. Any remaining excess of cost over book value is attributable to additional equipment with a 20-year life.
The trial balances for Pueblo and Sorenson as of December 31, 2018, are as follows:
The investment in Sorenson consists of the following:
Initial investment (12,000,000 FC X $1.20) .. .. . . . . . .. .. . . . $14,400,000
2016Income (1,750,000 FC X $1.28).. .... .. . . . . . .. . . . . ... 2,240,000
2017Income (2,000,000 FC X $1.30).. .... .. . . . . . .. . . . . ... 2,600,000
2018Income. .. .. .. . .. .... .. .. ... .. . . . . .. . . . . . .. .... . .... 1,729,000
Total.. .. .. .... .. . .. .. .. .... ... .. . . .. . . . . . . . .. .. .. ...... $20,969,000
Relevant exchange rates are as follows:
1FC =
January 1,2016 .... ... .. .. .. . . . . . . $1.20
2016Average.. .... . .. .... .. . . . . . . 1.28
January 1,2017 .... ... .. .. .. . . . . . . 1.25
2017Average.. .... . .. .... .. . . . . . . 1.30
December 31,2018.. .. .. .... .. . . . . 1.31
2018Average.. .... . .. .... .. . . . . . . 1.33
Required
Assuming the FC is Sorenson's functional currency, prepare a consolidated worksheet.