Chapter 7, Problem 64P

a.

To determine

Compute the value of the forward contract as of the end of February, March and April.

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

A forward contract is a custom designed agreement between two parties to buy or sell an asset on a future date at a specified price. For hedging or speculation a forward contract may be used, although its non-standardized nature makes it particularly suitable for hedging.

Date	Forward rate ($US:CAD)	Value of forward Contract
February 28	$0.7067	$33,500 = CAD 5MM of ($0.7067 − $0.7000)
Mar 31	$0.7143	$71,500 = CAD 5MM of ($0.7143 −$0.7000)
April 30	$0.7353	$176,500 = CAD 5MM of ($7353 − $0.7000)

b.

To determine

Prepare the journal entries as of the end of February, March and April..

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

A forward contract is a custom designed agreement between two parties to buy or sell an asset on a future date at a specified price. For hedging or speculation a forward contract may be used, although its non-standardized nature makes it particularly suitable for hedging.

Date	Account title and Explanation		Debit	Credit
Feb 28	Forward Contract		$\$33,500$
	Gain on forward contract			$\$33,500$
	(To record change in fair value of forward contract)
	Loss on firm commitment		$\$33,500$
	Fair value of firm commitment			$\$33,500$
	(To record change in fair value of firm commitment)
Mar 31	Forward contract		$\$38,000$
	Gain on forward contract			$\$38,000$
	(To record change in fair value of forward contract = $38,000 = $71,500 − $33,500)
	Loss on firm commitment		$\$38,000$
	Fair value of firm commitment			$\$38,000$
	(To record change in fair value of firm commitment)

	Inventory	$\$3,546,000$
	Accounts Payable		$\$3,546,000$
	(To record purchase of inventory at the spot exchange rate at March 31 –CAD 5,000,000 of $0.7092:CAD 1 = $3,546,000)
	Fair value of firm commitment	$\$71,500$
	Inventory		$\$71,500$
	(To adjust inventory value to reflect the hedge ofthe firm commitment)
Apr 30	Forward contract	$\$105,000$
	Gain on forward contract		$\$105,000$
	(To record the change in fair value of forward contract)
	Loss on transaction remeasurement of accounts payable	$\$130,500$
	Accounts Payable		$\$130,500$
	(To remeasure the carrying amount of accounts payable at the prevailing spot rate in accordance with ASC 830 – CAD 5,000,000 x $0.7353:CAD 1 = $3,676,500 − $3,546,000 = $130,500)
	Accounts Payable	$\$3,676,500$
	Cash		$\$3,676,500$
	(To record payment of accounts payable ($3,546,000 + $130,500 )
	Cash	$\$176,500$
	Forward Contract		$\$176,500$
	(To record net settlement of forward contract)

c.

To determine

Specify the economic theory of given transaction in brief.

Explanation of Solution

A derivative instrument is a financial instrument or other contract with all three of the following features:

•    Has one or more underlying provisions and one or more notional amounts or payment provisions or both. These terms determine the settlement or settlement amount and, in some cases, whether a settlement is necessary or not.

•    It involves no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be forced to respond to changes in market factors in a similar way.

•    Its terms allow or warrant net settlement, it can simply be net settled through means outside the deal or it allows for the distribution of an item that places the receiver in a role not substantially different from net settlement.

All derivatives must always be calculated and published at fair value on each interim and annual financial reporting date in the balance sheet. The fair value of financial instruments is the most relevant measure and the only valid factor for derivative instruments.

Gains and losses on fair value hedges on different types of derivatives are expressed in the statement of income offsetting losses and gains on hedged trades.

If a derivative instrument qualifies as a fair value hedge, at each statement date, both the derivative and the asset or liability to which it relates shall be reported at fair value. In the derivative financial instrument, gains or losses on the hedged assets or liabilities are offset (in whole or in part) by losses or gains.

A forward contract is a custom designed agreement between two parties to buy or sell an asset on a future date at a specified price. For hedging or speculation a forward contract may be used, although its non-standardized nature makes it particularly suitable for hedging.

The cash paid for the inventory is $3,676,500 − $ 176,500 = $3,500,000, the amount that

is locked in when the forward contract was started. If not hedged this exposure, then the

cash outlay would have been higher than $176,000. inventory is recognized at

$3,546,000 − $ 71,500 = $3,474,500 in carrying value. When the inventory is sold, that

will be the amount reflected in COGS. The difference between COGS and the cash

outflow for the $25,500 payable settlement reflects the gain from the forward contract

between the March 31 purchase of inventory and the April 30 settlement of the forward

contract and account due. Eventually, the transaction loss on re-evaluating the account

payable in the amount of $130,500 is almost offset by the $105,000 gain on the forward

contract.