Accounting M-3 M-5

Problem M-3  (LO  3,  4,  7,  8) Impact on earnings of various hedged relation-
ships. 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:
                                                                    February 28  March 31
Number of units per contract. . . . . . . . . . . . . .  10,000     10,000
Spot price per unit . . . . . . . . . . . . . . . . . . . . . .  $3.45       $3.40
Futures price per unit . . . . . . . . . . . . . . . . . . . .  $3.50       $3.44
Forward Contract —On January 15, the company committed to sell 5,000 units of inven-
tory 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

 

                                                            January 15  January 31  February 28  March 15
Number of units per contract. . . . . . . .  5,000           5,000             5,000           5,000
Spot price per unit . . . . . . . . . . . . . . . .  $90.00       $90.20            $90.50        $90.60
Forward rate per unit. . . . . . . . . . . . . .  $92.00        $91.50            $91.20       $90.60

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 fol-
lows:
                                                           January 15  January 31  February 20  March 17
Number of units per option . . . . . . . . .  100,000      100,000       100,000
Spot price per unit . . . . . . . . . . . . . . . .  $8.05            $8.02          $7.95
Strike price per unit . . . . . . . . . . . . . . .  $8.00           $8.00           $8.00
Fair value of option . . . . . . . . . . . . . . .  $6,000        $2,400               $—
Processing costs per unit . . . . . . . . . . .                                                             $1.10

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.

 

 

 Problem M-5 (LO 8) Prepare entries to account for a cash flow hedge involving
an option. Industrial Plating Corporation coats manufactured parts with a variety of coatings
such as Teflon, gold, and silver. The company intends to purchase 100,000 troy ounces of silver
in September. The purchase is highly probable, and the company has become concerned that
the prices of silver may increase, and, therefore, the forecasted purchase will become even more
expensive. In order to reduce the exposure to rising silver prices, on July 10 the company pur-
chased 20 September call (buy) options on silver. Each option is for 5,000 troy ounces and has a
strike price of $5.00 per troy ounce. The company excludes from hedge effectiveness changes in
the time value of the option. Spot prices and option value per troy ounce of silver are as follows:

                                                           July 10  July31  August 31  September 10
Spot price . . . . . . . . . . . . . . . . . . .       $5.10    $5.14      $5.35          $5.32
Option value . . . . . . . . . . . . . . . . .         0.20      0.23       0.37            0.33

On September 10, the company settled the option and on September 15 purchased
100,000 troy ounces of silver on account at $5.33 per ounce. The silver was used in the com-
pany’s production process over the next three months. In September and October, plating ser-
vices were provided as follows:

                                                                                                       September          October     

 Units of silver used                                                                           15,000               50,000
Other costs. . . . . . . . . . . . . . . . . . . .                                              $105,000            $350,000
Plating revenues . . . . . . . . . . . . . . .                                                $225,000           $750,000

Prepare all necessary entries to account for the above activities through October. Assume that
the hedge satisfies all necessary criteria for special hedge accounting.