CHAPTER 18 Derivatives,Contingencies,Business

Segments, and Interim Reports

MULTIPLE CHOICE QUESTIONS

Theory/Definitional Questions

1 Definition of a price risk2 Definition of a credit risk3 Definition of a forward contract4 Definition of a futures contract5 Use of a futures contract6 Definition of an option7 Timing of option owner’s payment8 Option protects owner against unfavorable price/rate movements9 Effect of fair value hedges on net income

10 Definition of cash flow hedge11 Disclosures on derivative contracts12 Effect of an obligation contingent on the occurrence of a future event13 Financial statement disclosure of a contingent loss14 How firms identify reportable segments15 Example of a call option16 Reportable segments under FASB Statement No. 1417 APB Opinion No. 28 and interim financial reporting18 Hedge of an account payable19 Hedge relating to equipment purchase20 Interest rate swap and hedging21 Accounting for a call option22 Accounting for a call option23 Accounting for a call option24 Accounting for a call option25 Accounting for a call option26 Identifying business segments27 Disclosures under disaggregated information standard28 Reporting disaggregated information for interim periods29 Interim reporting30 Call option and hedging

683

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

31 Accounting for interim period inventory lossComputational Questions

32 Computation of payment on forward contract33 Computation of payment on forward contract34 Computation of accrued liability from a lawsuit35 Computation of call option contract savings/loss36 Computation of call option contract savings/loss37 Computation of call option contract savings/loss38 Computation of interest rate swap agreement settlement payments39 Computation of interest rate swap agreement settlement payments

* 40 Computation of interest rate swap agreement settlement payments41 Computation of fair value on forward contract agreement42 Computation of disclosed liability from litigation43 Computation of disclosed liability from litigation44 Computation of accrued liability from litigation

PROBLEMS

1 Journal entries on execution of futures contract and disclosure2 Journal entries on execution of call option and disclosure3 Journal entries on execution of interest rate swap4 Litigation and required financial statement disclosures5 Identifying the risks confronting an enterprise

6 Improving segment disclosures

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

MULTIPLE CHOICE QUESTIONS

a 1. Uncertainty about the future market value of an asset is referred to asLO2 a. price risk.

b. credit risk.c. interest rate risk.d. exchange rate risk.

b 2. Uncertainty that the party on the other side of an agreement will abide by the

LO2 terms of the agreement is referred to asa. price risk.b. credit risk.c. interest rate risk.d. exchange rate risk.

c 3. A contract, traded on an exchange, that allows a company to buy a specified

LO3 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 4. An agreement between two parties to exchange a specified amount of a LO3 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

LO3 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 swapb. Fixed commodities contractc. Futures contractd. Option

d 6. A contract giving the owner the right, but not the obligation, to buy or sell an LO3 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 7. In exchange for the rights inherent in an option contract, the owner of the LO3 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 8. Which type of contract is unique in that it protects the owner against LO3 unfavorable movements in the prices or rates while allowing the owner to

benefit from favorable movements?a. Interest rate swapb. Forward contractc. Futures contractd. Option

a 9. When gains or losses on derivatives designated as fair value hedges exceed

LO5 the gains or losses on the item being hedged, the excessa. affects reported net income.b. is recognized as an equity adjustment.c. is recognized as part of comprehensive income.d. is not recognized.

b 10. For which type of derivative are changes in the fair value deferred and LO5 recognized as an equity adjustment?

a. Fair value hedgeb. Cash flow hedgec. Operating hedged. Notional value hedge

c 11. Which choice best describes the information that should be disclosed related

LO5 to derivative contracts?a. Fair valueb. Notional amountc. Both a and bd. Neither a or b

d 12. An obligation that is contingent on the occurrence of a future event should be

LO6 reported in the balance sheet as a liability ifa. 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.

d 13. A contingent loss should be disclosed in a note to the financial statements but

LO6 should not be recorded as a liability ifa. 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 14. According to Statement of Financial Accounting Standards No. 131, LO7 “Disclosures about Segments of an Enterprise and Related Information,”

how do firms identify reportable segments?a. By geographic regionsb. By product linesc. By industry classificationd. By designations used inside the firm

c 15. On February 1, Shoemaker Corporation entered into a firm commitment to LO3 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 swapb. Forward contractc. Call optiond. Put option

d 16. Which of the following tests may be used to determine if an industry segment

LO7 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 17. In considering interim financial reporting, how does APB Opinion No. 28 LO8 conclude that such reporting should be viewed?

a. As reporting for a basic accounting periodb. As useful only if activity is evenly spread throughout the year so that

estimates are unnecessaryc. As a "special" type of reporting that need not follow generally accepted

accounting principlesd. 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

LO4 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.

d 19. A company enters into a futures contract with the intent of hedging an LO4 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 20. A company enters into an interest rate swap in order to hedge a $5,000,000 LO4 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 21. The call option would be recorded in the accounts of Hall as LO1 a. an asset.

b. a liability.c. a gain.d. would not be recorded in the accounts (memorandum entry only).

c 22.Assume that the price of the WSM shares has risen to $120 per share onLO1 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 23. The 1,000 shares of WSM stock in this contract is referred to as LO1 a. the collateral.

b. the notional amount.c. the option premium.d. the derivative.

a 24. The $400 paid by Hall, Inc., to Baird Investment is referred to asLO1 a. the option premium.

b. the notional amount.c. the strike price.d. the intrinsic value.

c 25. Assume that the price per share of WSM stock is $120 on April 30, 2002, andLO1 that the time value of the option has not changed. In order to settle the

option contract, Hall, Inc., would most likelya. 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.

b 26. Cosmos Corporation sells 5 different types of products. The company is LO7 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 upona. 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.

c 27. Which of the following is not required under current GAAP for disaggregated

LO7 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.

c 28. When a company with reportable segments issues interim condensed financial

LO7 statements, current GAAP requires that the interim reports provide all of theLO8 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 29. Which of the following is not true regarding standards for interim reporting?LO8 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 30. Alpha Company purchases a call option to hedge an investment in 20,000 LO4 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 31. An inventory loss from market decline of $900,000 occurred in April 2002. CD

LO8 Company recorded this loss in April 2002 after its March 31, 2002, quarterlyreport 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 CDCompany?

Three months ended (2002):March 31 June 30 September 30 December 31

a. 0 0 0 $900,000b. 0 $300,000 $300,000 $300,000c. 0 $900,000 0 0d. $225,000 $225,000 $225,000 $225,000

a 32. On July 1, 2002, Cahoon Company sold some limited edition art prints to LO5 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 paymentb. $18,913 receiptc. $20,714 paymentd. $20,714 receipt

c 33. On July 1, 2002, Cahoon Company sold some limited edition art prints to LO5 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 paymentb. $18,913 receiptc. $20,714 paymentd. $20,714 receipt

c 34. Landon Construction Co. carries $10,000,000 comprehensive public liability LO6 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 ofa. $550,000.b. $350,000.c. $200,000.d. $0.

b 35. On June 18, Edwards Corporation entered into a firm commitment to purchase

LO5 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. $12,000b. $48,215c. $60,215d. Edwards would have been better off not to have purchased the call

option.

d 36. On March 1, Chow Corporation entered into a firm commitment to purchase LO5 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. $20,000b. $27,619c. $47,619d. Chow would have been better off not to have purchased the call option.

c 37. During 2002, Jackson Company became involved in a tax dispute with the IRS.

LO6 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. $650,000b. $550,000c. $500,000d. $0

c 38. On January 1, 2002, Cougar Company received a two-year $500,000 loan. LO5 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 paymentb. $5,000 receiptc. $10,000 paymentd. $10,000 receipt

d 39. On January 1, 2002, Cougar Company received a two-year $500,000 loan. LO5 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. $5,000 paymentb. $5,000 receiptc. $10,000 paymentd. $10,000 receipt

b 40. On January 1, 2002, Cougar Company received a two-year $500,000 loan. LO5 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. $0b. $8,929c. $10,000d. $500,000

b 41. On November 1, 2002, Cahoon Company sold some limited edition art prints

LO5 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. $0b. $18,913c. $20,714d. $416,087

c 42. In May 2002, the Marlins Company became involved in litigation. As a result

LO6 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. $2,700,000b. $1,600,000c. $700,000d. $0

a 43. On January 17, 2002, an explosion occurred at an Orioles Fireworks plant LO6 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 $500,000b. As an accrued liability of $500,000c. As a footnote disclosure indicating the possible loss of $2,500,000d. As an accrued liability of $2,500,000

c 44. On November 5, 2002, a Timp Rental truck was in an accident with an auto LO6 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. $0b. $200,000c. $300,000d. $450,000

PROBLEMS

Problem 1Yokochan 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 1LO5(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).................................... 2,000Other Comprehensive Income................... 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)................... 22,000Cash.......................................................... 22,000

Cash (futures contract settlement).................... 2,000Futures Contract (asset)............................ 2,000

Other Comprehensive Income........................... 2,000Gain on Futures Contract.......................... 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 2LO5(1) (a) Soybean Call Option (asset).............................. 1,200

Cash.......................................................... 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).............................. 23,800Other Comprehensive Income................... 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............................................. 225,000Cash (500,000 lbs x $0.45)....................... 225,000

Cash.................................................................. 25,000Soybean Call Option.................................. 25,000

Other Comprehensive Income........................... 23,800Gain on Soybean Call Option.................... 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 3On 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) January 1, 2002(2) December 31, 2002(3) December 31, 2003(4) December 31, 2004

Solution 3LO5(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........................................................ 90,000Cash ($1,000,000 x .09).................................... 90,000

Other Comprehensive Income................................... 17,833Interest Rate Swap............................................ 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........................................................ 90,000Cash ($1,000,000 x .09).................................... 90,000

Interest Rate Swap.................................................... 10,000Cash ($1,000,000 x [.09 - .08]).......................... 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........................................................ 10,000Other Comprehensive Income........................... 10,000

This entry adjusts other comprehensive income for amounts previously accrued at December 31, 2002.

Interest Rate Swap.................................................... 34,620Other Comprehensive Income........................... 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........................................................ 90,000Cash ($1,000,000 x .09).................................... 90,000

Cash (from Interest Rate Swap)................................ 30,000Interest Rate Swap............................................ 26,787Other Comprehensive Income........................... 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.............................................................1,000,000Cash.................................................................. 1,000,000

Problem 4Vita 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 4LO6(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 5Quest 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 variable-rate 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 5LO2Quest 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 6Current 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 6LO7The 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. Definition of the industry.b. Economic, social, demographic, technological, political, and regulatory

trends that affect the industry.c. 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).

d. Economic outlook for the industry.

2. Narrative description of the segment’s business to include:

a. Principal products and services.b. Principal market served by products and services and size of the market.c. Process used to make the products or provide the services.d. Key inputs to the process.e. Distribution methods for products and services.f. Seasonality and cyclicality.g. Regulation and legislation affecting the segment.h. 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 andnonfinancial data reported for the segment and the reasons why thoserelationships may differ from those related to competitors, the industry, or the economy.

CHAPTER 18 -- QUIZ AName _________________________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.

707

CHAPTER 18 -- QUIZ B Name_________________________

Section________________________

A. Cash flow hedge Price risk

G. Executory contract

B. Price risk C. Notional amountD. SwapE. Interest rate riskF. Futures contract

H. OptionI. Exchange rate riskJ. Put optionK. Firm commitmentL. Derivative

M. Credit riskN. HedgingO. Forward contractP. 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.

708

Test Bank, Intermediate Accounting, 14th ed. 709

CHAPTER 18 -- QUIZ SOLUTIONS

Quiz A Quiz B

1. F 1. O2. F 2. E3. F 3. C4. T 4. F5. T 5. L6. F 6. N7. F 7. K8. T 8. G9. F 9. M

10. T 10. D11. A12. I13. H14. B15. J

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

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