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19

Derivatives, Contingencies, Business Segments, and Interim Reports

Overview

This chapter contains a potpourri of topics which are either combined here because they don’t fit in well elsewhere or because they are relatively new to intermediate accounting. Most advanced accounting textbooks and courses cover some, or all, of these topics as well. Therefore, your professor may skip portions, or all, of this chapter.

Derivatives are items that derive their value from the movement in prices, interest rates, or exchange rates. They are purchased for a variety of investment reasons. Some derivatives cost money up front, but many do not. The accounting for them depends on the type of derivative. Usually there is no entry at the outset, unless the derivative costs money to obtain at the outset. Whether changes in value are reflected on the income statement or not depend on the type of derivative. Sometimes the gain or loss is shown as the value changes, and in other situations, the movement in value is deferred until a date passes or the derivative contract is completed.

Contingencies are events that may happen in the future. For accounting purposes, events must usually have already happened in order to be recognized. For some contingencies, the accounting for them takes place because an event has already happened even if the final amount is not known with 100 percent certainty. Others need to be disclosed, while others are completely omitted from the financial statements and disclosure notes until additional facts come to light, or they are never mentioned if the additional facts indicate that there actually is no accounting issue related to the previous situation.

Segment reporting requires large, publicly traded companies with numerous operations to break down their results into details by product line and geographic area so that users of the financial statements have better information. The data is still somewhat summarized so competitors aren’t really able to see extreme levels of detail.

Finally, interim reporting is required of publicly traded companies so that investors can see results on a more frequent basis than just annually. Interim reporting includes some modified accounting rules so that each quarter is not viewed entirely as a separate period. Another major difference between interim reports and annual financial statements of publicly traded companies is that interim reports are not required to be audited.

Learning Objectives

Refer to the Review of Learning Objectives at the end of the chapter. It is crucial that this section of the chapter is second nature to you before you attempt the homework, a quiz, or exam. This important piece of the chapter serves as your CliffsNotes or “cheat sheet” to the basic concepts and principles that must be mastered.

If after reading this section of the chapter you still don’t feel comfortable with all of the Learning Objectives covered, you will need to spend additional time and effort reviewing those concepts that you are struggling with.

The following “Tips, Hints, and Things to Remember” are organized according to the Learning Objectives (LOs) in the chapter and should be gone over after reading each of the LOs in the textbook.

Tips, Hints, and Things to Remember

LO1 – Understand the business and accounting concepts connected with derivatives and hedging activities.

Why? In the first few years since derivative accounting has been eligible for testing on the CPA Exam, the questions have been of the definitional/concept variety. That could change in the future, but a solid understanding of the terminology and theory behind derivatives and hedging should be a minimum requirement before you head off to take the CPA Exam (or the exam in this course should your instructor be testing on this part of this chapter).

LO2 – Identify the different types of risk faced by a business.

How? There are several different types of risk that are associated with derivatives. The risks that are discussed in the text include price risk, credit risk, interest rate risk, and exchange rate risk.

LO3 – Describe the characteristics of the following types of derivatives: swaps, forwards, futures, and options.

How? Forwards and futures are probably the two of these derivatives that are most frequently confused. Forwards and futures are basically the same thing with one exception: forwards are private contracts between two private parties and a future is traded on a market. Tie the words future and market together in your head (maybe by thinking of a phrase like “the market will be higher in the future” or “my future depends on the market”), and you will be less likely to get forwards and futures confused or flip-flopped on a test.

LO4 – Define hedging, and outline the difference between a fair value hedge and a cash flow hedge.

Why? It is very important to be able to distinguish between a fair value hedge and a cash flow hedge because the accounting for each is different.

How? Fair value hedges deal with changes in fair values of existing assets or liabilities. Cash flow hedges deal with forecasted transactions.

LO5 – Account for a variety of different derivatives and for hedging relationships.

How? Cash flow hedges are treated differently than all other hedges for accounting purposes. Cash flow hedge gains or losses are deferred by adjusting accumulated other comprehensive income on the balance sheet only until the forecasted transaction takes place. Then, they are recognized on the income statement. All other gains and losses on hedging activity (and derivative activity not considered to be hedging in nature) are recognized on the income statement as they happen.

LO6 – Apply the accounting rules for contingent items to the areas of lawsuits and environmental liabilities.

How? The three key words with respect to contingencies are probable, possible, and remote. Probable loss contingencies are recognized if the amount is known or can be reasonably estimated. A disclsoure note explaining the situation is also required. Possible loss contingencies require a disclosure note only. If the loss is merely remote, no disclosure note is required except for certain guarantees. Gain contingencies are not usually recognized. If a disclosure note is provided for a gain contingency, it should be cautious and not give misleading implications as to the likelihood (or amount) of realization.

LO7 – Prepare the necessary supplemental disclosures of financial information by product line and by geographic area.

How? Determining whether a segment of a business is reportable or not is fairly easy to remember even though there are three criteria. That is because the percentage for the three criteria (unlike leases) are all the same. The magic number for segment reporting is 10 percent. It can be 10 percent of revenue, profit, or assets. Notice the word “or.” All three criteria need not be met. So long as at least one of the three criteria are met, then segment reporting is a required disclosure for that segment in the business.

LO8 – Recognize the importance of interim reports, and outline the difficulties encountered when preparing those reports.

Why? Interim reports are important so that users of the financial statements obtain reporting from a company in a more timely manner. Without interim reports, users would only have annual information. This “most recent” information would frequently be more than 3 months old, without interim reporting, and could be as much as a year old.

How? Estimates are more common in interim reports than in annual reporting. Certain items are also ignored or adjusted for on an interim basis (such as dipping into a LIFO base layer that will be restored before year-end on an annual basis). Interim reports need not be audited, so the statements released in the quarterly 10-Q should clearly state that they are unaudited if that is the case.

The following sections, featuring various multiple choice questions, matching exercises, and problems, along with solutions and approaches to arriving at the solutions, is intended to develop your problem-solving and critical-thinking abilities. While learning through trial and error can be effective for improving your quiz and exam scores, and it can be a more interesting way to study than merely re-reading a chapter, that is only a secondary objective in presenting this information in this format.

The main goal of the following sections is to get you thinking, “How can I best approach this problem to arrive at the correct solution—even if I don’t know enough at this point to easily arrive at the proper results?” There is not one simple approach that can be applied to all questions to arrive at the right answer. Think of the following approaches as possibilities, as tools that you can place in your problem-solving toolkit—a toolkit that should be consistently added to. Some of the tools have yet to even be created or thought of. Through practice, creative thinking, and an ever-expanding knowledge base, you will be the creator of the additional tools.

Multiple Choice

MC19-1 (LO1) Which of the following transactions best describes a derivative?

|a. |cosigning on a note of a subsidiary company to protect the bank from potential subsidiary default |

|b. |purchasing a life insurance policy on a key employee to protect the company from effects of the untimely death of a key |

| |figure |

|c. |entering into a forward contract to purchase grain three months from now in order to protect from changes in prices |

| |during the three months |

|d. |purchasing shares in another company with the hope that the value of the shares will increase in value |

MC19-2 (LO2) Uncertainty about the future market value of a mortgage liability is referred to as

|a. |price risk. |

|b. |credit risk. |

|c. |interest rate risk. |

|d. |exchange rate risk. |

MC19-3 (LO3) If a cannery wanted to lock in the price they would pay for peaches several months before the harvest, they would be most likely to enter into which kind of agreement?

|a. |interest rate swap |

|b. |fixed commodities contract |

|c. |forward contract |

|d. |option |

MC19-4 (LO4) Brunson Company enters into an interest rate swap in order to hedge a $1,000,000 variable-rate loan. The loan is expected to be fully repaid this year on August 31. The contract requires that if the interest rate on June 30 of next year is greater than 10%, Brunson receives the difference on a principal amount of $1,000,000. Alternatively, if the interest rate is less than 10%, Brunson 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 fully hedged. |

|d. |This swap represents a fair value hedge. |

MC19-5 (LO5) On July 15, 2013, Gaston Company sold some limited-edition art prints to the Tanegawa Company for ¥47,850,000 to be paid on September 30 of the same year. The current exchange rate on July 15, 2013, is ¥110=$1, so the total payment at the current exchange rate would be equal to $435,000. Gaston 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 Gaston the difference in cash. Likewise, if ¥47,850,000 is worth more than $435,000, Gaston must pay the bank the difference in cash. Assuming the exchange rate on September 30 is ¥115=$1, what amount will Gaston 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 |

MC19-6 (LO5) 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 in the period of the value change. |

|b. |is recognized as an equity adjustment until the period in which the transaction is forecasted to occur. |

|c. |is recognized as part of comprehensive income until the period in which the transaction is forecasted to occur. |

|d. |is not recognized. |

MC19-7 (LO6) A contingent loss should be disclosed in a note to the financial statements but should not be recorded as a liability if the

|a. |possibility of loss is remote. |

|b. |contingency involves pending or threatened litigation. |

|c. |outcome is uncertain. |

|d. |actual incurrence of a loss is reasonably possible. |

MC19-8 (LO6) In 2013, the Jackson Company became involved in litigation. Jackson settled the suit early in 2014 before the financial statements were issued for $700,000. Also in 2013, a competitor commenced a suit against Jackson alleging violation of antitrust laws and is seeking damages of $1,100,000. Jackson denies the allegations, and the likelihood of Jackson paying any damages is remote according to their attorneys. Finally, late in 2013, the county brought action against Jackson for $900,000 for polluting the local lake. It is reasonably possible that the county will be successful, but the amount of damages Jackson will have to pay is not reasonably determinable. What amount, if any, should be accrued by a charge to income in 2013?

|a. |$2,700,000 |

|b. |$1,600,000 |

|c. |$700,000 |

|d. |$0 |

MC19-9 (LO7) Companies are to identify reportable segments by

|a. |total capital expenditures. |

|b. |product lines. |

|c. |using the same criteria used by other companies in the industry. |

|d. |using the same criteria used by management to distinguish business segments for internal reporting purposes. |

MC19-10 (LO8) Which of the following statements is NOT true regarding standards for interim reporting?

|a. |A company using LIFO encountering liquidation of the base period inventory that is expected to be replaced by the end of|

| |the annual period should not reflect the inventory liquidation in the interim report. |

|b. |Interim financial statements are required to be audited since they are submitted to the SEC and are to be used by the |

| |public. |

|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. |

Matching

Matching 19-1 (LO1, LO2, LO3) Listed below are the terms and associated definitions from the chapter for LO1 through LO3. Match the correct definition letter with each term number.

|___ 1. credit risk |a. contract giving the owner the right, but not the obligation, to buy an asset at a specified price|

| |b. contract in which two parties agree to exchange payments in the future based on the movement of |

| |some agreed-upon price or rate |

| |c. a financial instrument, such as an option or a future, that derives its value from the movement |

| |of a price, an exchange rate, or an interest rate associated with some other item |

| |d. uncertainty that the party on the other side of an agreement will abide by the terms of the |

| |agreement |

| |e. uncertainty about future interest rates and their impact on future cash flows as well as on the |

| |fair value of existing assets and liabilities |

| |f. 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 |

| |g. 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 |

| |h. 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 |

| |i. uncertainty about future U.S. dollar cash flows arising when assets and liabilities are |

| |denominated in a foreign currency |

| |j. contract in which two parties agree to exchange future interest payments on a given loan amount; |

| |usually, one set of interest payments is fixed and the other is variable |

| |k. an exchange of promises to engage in a transaction in the future |

| |l. uncertainty about the future price of an asset |

| |m. contract giving the owner the right, but not the obligation, to sell an asset at a specified |

| |price |

|___ 2. exchange rate risk | |

|___ 3. call option | |

|___ 4. forward contract | |

|___ 5. swap | |

|___ 6. derivative | |

|___ 7. executory contract | |

|___ 8. option | |

|___ 9. put option | |

|___ 10. interest rate swap | |

|___ 11. interest rate risk | |

|___ 12. futures contract | |

|___ 13. price risk | |

Matching 19-2 (LO4, LO5, LO6, LO7, LO8) Listed below are the terms and associated definitions from the chapter for LO4 through LO8. Match the correct definition letter with each term number.

|___ 1. conglomerates |a. statements showing financial position and operating results for an interval of less than a year |

| |b. concept guiding the preparation of interim statements; accounting practices may be slightly |

| |modified to make sure the interim results relate properly to the annual results |

| |c. circumstances involving potential gains that will not be resolved until some future event occurs |

| |d. complex companies that operate in multiple industries |

| |e. circumstances involving potential losses that will not be resolved until some future event occurs|

| |f. total face amount of the asset or liability that underlies a derivative contract |

| |g. derivative that offsets the change in the fair value of an asset or liability |

| |h. derivative that offsets the variability in cash flows from forecasted transactions that are |

| |probable |

| |i. structuring transactions to reduce risk |

|___ 2. notional amount | |

|___ 3. contingent losses | |

|___ 4. hedging | |

|___ 5. contingent gains | |

|___ 6. integral part of annual period | |

|concept | |

|___ 7. fair value hedge | |

|___ 8. cash flow hedge | |

|___ 9. interim financial statements | |

Problems

Problem 19-1 (LO5) Tabemono Bakeries specializes in making cakes, cookies, and other pastries out of rice flour which they grind themselves. Tabemono anticipates purchasing 60,000 pounds of rice on February 5, 2013. On November 15, 2012, Tabemono entered into a futures contract with Kome Growers to purchase 60,000 pounds of rice on February 5, 2013, at $0.50 per pound. On December 31, 2012, the prevailing market price for rice is $0.55 per pound. By February 5, 2013, the prevailing market price for rice has risen to $0.58 per pound. Tabemono purchases the rice and settles the futures contract on February 5, 2013.

Make the necessary journal entries on Tabemono’s books on (a) November 15, 2012, (b) December 31, 2012, and (c) February 5, 2013.

Problem 19-2 (LO5) On January 1, 2012, Stamper 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, 2014. 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. Stamper Ventures also entered into an interest rate swap agreement related to this loan. Under the terms of the swap agreement, in the years 2013 and 2014, Stamper Ventures will receive a swap payment based on the principal amount of $1 million. If the January 1 interest rate is greater than 9 percent, Stamper Ventures will receive a swap payment for the difference. If the January 1 interest rate is less than 9 percent, Stamper Ventures will make a swap payment for the difference. The swap payments are made on December 31 of each year. On January 1, 2013, the interest rate is 8 percent, and on January 1, 2014, the interest rate is 12 percent.

Make the necessary journal entries on Stamper Ventures’ books on (a) January 1, 2012, (b) December 31, 2012, (c) December 31, 2013, and (d) December 31, 2014. 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.)

Problem 19-3 (LO6) Snake Oil Technologies is involved in pharmaceutical research. Snake Oil is involved in a number of lawsuits related to their operations. For each case, indicate the treatment or disclosure that should be provided by Snake Oil Technologies in their annual financial statements.

1. One of their drugs, Elixir of Life, resulted in dangerous side effects of which Snake Oil was unaware. As a result, a class action lawsuit has been filed against Snake Oil. Snake Oil’s attorneys feel it is probable that the company will lose the suit, and the amount can be reasonably estimated.

2. An employee of Snake Oil is suing the company alleging that her seizures are a result of the working environment at Snake Oil. Snake Oil’s attorneys feel the suit is without merit and the chance of losing the case is remote.

3. A competitor, Sanctuary Drugs, has filed suit against Snake Oil alleging patent infringement. Snake Oil’s attorneys are unsure as to the outcome of the suit. There is a reasonable possibility that Snake Oil could lose the suit but the amount of the damages is unknown at this point.

Solutions, Approaches, and Explanations

MC19-1

Answer: c

Approach and explanation: The forward contract is the only instance of the four that derives its value from the movement of the price of something else (the grain). Choice a may offer protection, but it isn’t derived from the change in rate of a financial instrument, exchange rate, interest rate, etc. Also, it isn’t even to protect the company, but rather it is to protect the bank and allow its subsidiary to obtain the loan to begin with.

Choice d could be a derivative if it was an option to buy or sell the stock at a later date; however, actual shares of a company aren’t a derivative themselves.

MC19-2

Answer: c

Approach and explanation: When it comes to liabilities, or assets with interest attached to them (like an investment in bonds in another company), market value changes relate to interest rate risk. If the question were changed from “a mortgage liability” to “an asset,” then either choice a or choice c could be correct depending on what the asset was. Choice a would probably be the safest choice for “an asset” or other generic term not describing a specific asset.

The answer could be choice b if we were talking about an asset such as an account receivable. It could be choice d if the asset in question was foreign currency or a company’s assets and liabilities in foreign countries denominated in a foreign currency. Unless the question states the foreign information, though, it isn’t likely to be choice d.

MC19-3

Answer: c

Approach and explanation: Although choice c is the correct answer given these choices, there is another, unlisted choice that could be correct. Do you know what it is?

A futures contract is another kind of agreement that would work for this fact pattern. The difference is that a forward contract would be with a specific orchard or orchards and a futures contract would be with, or through, some sort of commodity market exchange.

Choice b is made-up nonsense. There is no such thing as a fixed commodities contract. Sometimes professors will throw terms onto an exam, such as “fixed commodities contract,” because they sound good and may be selected by a student who hasn’t bothered to even read the chapter. Don’t get fooled into selecting something that sounds good if you have never even heard of, or read about, it before.

MC19-4

Answer: c

Approach and explanation: While this is certainly a derivative instrument that Brunson has obtained, it is not fully hedged due to the timing differences between the loan repayment and the payoff of the difference in interest rate. Hedging involves the reduction of risk. In this case, risk isn’t fully reduced since the timing is not the same. Brunson may still be paying more than $1,000,000 plus 10% interest on this loan.

The swap represents a partial cash flow hedge—not a fair value hedge. Hence, choice d can’t be correct. The interest is not an asset or a liability. The interest, as of now, is a future cash flow only.

MC19-5

Answer: a

Approach and explanation: Gaston is receiving from Tanegawa the equivalent of $416,087 in US$ on September 30, computed as follows:

¥47,850,000/¥115 = $416,087

Therefore, Gaston should receive the difference between $435,000 and $416,087, or $18,913. Gaston reduced their risk in the transaction, but, in the end, they also reduced their income by hedging the transaction.

MC19-6

Answer: a

Approach and explanation: Gains or losses from fair value hedges are reported on the income statement as they happen. There is no deferral and they are recognized.

What if the question were reworded to say “cash flow hedges” instead of “fair value hedges”? The answer would change to both choices b and c. Cash flow hedges are recognized as part of comprehensive income which is an equity adjustment. This means that even if you couldn’t remember whether it was fair value or cash flow hedges that affect reported net income, you could still get the answer correct if you knew that comprehensive income affects equity. Since both choices b and c can’t be correct at the same time, then the correct choice must be a.

MC19-7

Answer: d

Approach and explanation: Choice a is incorrect because remote contingencies are not to be recorded or disclosed.

Choice b is incorrect because litigation is not usually disclosed. When it is disclosed, it is usually done so in general terms and not with respect to specific contingent losses. Litigation that is only pending or threatened would not be disclosed for practical purposes.

Choice c could be correct if the uncertain status equated to reasonably possible, but “outcome is uncertain” doesn’t contain the key terms of probable, possible, or remote—and when it comes to contingencies, those are the terms to look for when answering a multiple-choice question—so you can write choice c off.

Choice d has the “reasonably possible” buzz phrase. Reasonably possible loss contingencies should always be disclosed—not recorded.

MC19-8

Answer: c

Approach and explanation: The first lawsuit, since the amount is known and probable, should be charged to income. The second lawsuit need not even be disclosed since the loss contingency is remote.

The third lawsuit has not yet moved into the probable category, so an accrual for it is not necessary. Environmental liabilities don’t tend to be recognized or disclosed when they are still contingent. If an environmental liability was reasonably possible and the amount could be reasonably determined, then a disclosure should be made. Without an amount, it is unlikely that Jackson Company would even disclose this liability in anything other than very general terms.

MC19-9

Answer: d

Approach and explanation: How companies are to determine what a reportable segment is differs from what companies are to report on. Choices b or c could each be correct, but only if that is how management is distinguishing business segments for internal purposes.

Choice a is one of the “whats” companies are to report on. Other “whats” include revenue, assets, profits, and some income statement items.

MC19-10

Answer: b

Approach and explanation: Choice a is one of the major exceptions specifically mentioned in the textbook for interim reporting. If a company is using LIFO and they dip into their base period inventory at the end of the year, then the additional profit (assuming rising prices) would be reflected on their income statement. However, if that happens at an interim date and they plan to purchase inventory to make up for the temporary shortfall, then an estimated cost of goods sold (for goods still to be purchased) is used for interim reporting purposes.

Interim reports, even though they are submitted to the SEC and used by the public, are not required to be audited. The fact that they are not audited should be displayed on every page of the financial statements so that users are not misled to believe that they have been audited.

Matching 19-1

1. d

2. i

3. a

4. f

5. b

6. c

7. k

8. h

9. m

10. j

11. e

12. g

13. l

Complete these terminology matching exercises without looking back at the textbook or on to the glossary. After all, you probably won’t have those as a reference at test time. Learning through trial and error causes the item to be learned better and to stick in your memory longer than if you just look at the textbook, glossary, or a dictionary and “cook book” the answers. Sure you may get the answer correct on your first attempt, but missing something is sometimes best for retention. Don’t be afraid of failure while studying and practicing.

Matching 19-2

1. d

2. f

3. e

4. i

5. c

6. b

7. g

8. h

9. a

Problem 19-1

a) No entry is made to record the futures contract on November 15, 2012. As of this date, the rice futures contract has a fair value of $0.

|(b) |Futures Contract |3,000* | |

| |Other Comprehensive Income | |3,000 |

*60,000 × ($0.55 – $0.50) = $3,000

The gain from the increase in the value of Tabemono’s futures contract is deferred as part of comprehensive income under owner’s equity. The futures contract is shown as an asset on the 2012 balance sheet. The income does not show up as part of net income on the income statement. 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 60,000 pounds of rice on February 5, 2013.

|(c) |Rice Inventory |34,800a | |

| |Cash | |34,800 |

| | | | |

| |Cash |4,800b | |

| |Other Comprehensive Income |3,000 | |

| |Futures Contract | |3,000 |

| |Gain on Futures Contract | |4,800 |

a60,000 × $0.58 = $34,800

b60,000 × ($0.58 – $0.50) = $4,800

At this point, there is no asset left related to the futures contract, nor is there anything left in owner’s equity as other comprehensive income. The full amount of the gain is now recognized on the 2013 income statement.

Problem 19-2

|(a) |Cash |1,000,000 | |

| |Loan Payable | |1,000,000 |

No entry is made to record the swap agreement because, as of January 1, 2012, the swap has a fair value of $0.

|(b) |Interest Expense |90,000 | |

| |Cash | |90,000* |

| | | | |

| |Other Comprehensive Income |17,833 | |

| |Interest Rate Swap | |17,833 |

*$1,000,000 × 0.09 = $90,000

Stamper Ventures will make a swap payment on December 31, 2013, of $10,000 [(0.09 – 0.08) × $1,000,000]. At current market rates, Stamper Ventures also expects to make a $10,000 swap payment on December 31, 2014. The present value of these payments is equal to $17,833 (the present value of a $10,000 annuity for 2 periods at 8 percent). This account called “Interest Rate Swap” will show up as a liability on the balance sheet, and the debit to Other Comprehensive Income will decrease owner’s equity. Outside of the interest expense, the income statement has not yet been affected.

|(c) |Interest Expense |90,000 | |

| |Cash | |90,000a |

| | | | |

| |Interest Rate Swap |10,000 | |

| |Cash | |10,000b |

a$1,000,000 × 0.09 = $90,000

b$1,000,000 × (0.09 – 0.08) = $10,000

This entry records the swap payment that Stamper Ventures was obligated to make based on the interest rate (8 percent) at January 1, 2013.

| |Interest Expense |10,000 | |

| |Other Comprehensive Income | |10,000 |

This entry adjusts other comprehensive income for amounts previously accrued at December 31, 2012.

| |Interest Rate Swap |34,619 | |

| |Other Comprehensive Income | |34,619 |

Based on the current market rate of 12 percent at December 31, 2013, Stamper Ventures can expect to receive a swap payment of $30,000 [(0.12 – 0.09) × $1,000,000] on December 31, 2014. This payment has a present value of $26,786 (the present value of $30,000 for 1 period at 12 percent). This entry adjusts the Interest Rate Swap account to a balance of $26,786 (debit) and also adjusts the Other Comprehensive Income account to a balance of $26,786 (credit).

|(d) |Interest Expense |90,000 | |

| |Cash | |90,000* |

| | | | |

| |Cash |30,000 | |

| |Interest Rate Swap | |26,786 |

| |Other Comprehensive Income | |3,214 |

This entry records the swap payment that Stamper Ventures is entitled to receive based on the interest rate (12 percent) at January 1, 2014. 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 | |1,000,000 |

Problem 19-3

1. Because attorneys for Snake Oil feel it is probable that the company will lose the suit, the liability should be recorded on the books of Snake Oil.

For practical purposes, most companies would not record the amount, or even disclose the amount, since this relates to a lawsuit, unless a final verdict or settlement was reached before the financial statements are issued.

A general description of the lawsuits would be included as a disclosure note to the financial statements.

2. If Snake Oil’s attorneys feel that the lawsuit is without merit, then no disclosure is required. Remote contingent liabilities need not be accrued or disclosed.

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.

Glossary

Note that Appendix C in the rear portion of the textbook contains a comprehensive glossary for all of the terms used in the textbook. That is the place to turn to if you need to look up a word but don’t know which chapter(s) it appeared in. The glossary below is identical with one major exception: It contains only those terms used in Chapter 19. This abbreviated glossary can prove quite useful when reviewing a chapter, when studying for a quiz for a particular chapter, or when studying for an exam which covers only a few chapters including this one. Use it in those instances instead of wading through the 19 pages of comprehensive glossary in the textbook trying to pick out just those words that were used in this chapter.

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

cash flow hedge Derivative that offsets the variability in cash flows from forecasted transactions that are probable.

conglomerates Complex companies that operate in multiple industries.

contingent gains Circumstances involving potential gains that will not be resolved until some future event occurs.

contingent losses Circumstances involving potential losses that will not be resolved until some future event occurs.

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

derivative A financial instrument, such as an option or a future, that derives its value from the movement of a price, an exchange rate, or an interest rate associated with some other item.

exchange rate risk Uncertainty about future U.S. dollar cash flows arising when assets and liabilities are denominated in a foreign currency.

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

fair value hedge Derivative that offsets the change in the fair value of an asset or liability.

forward contract 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.

futures contract 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.

hedging Structuring transactions to reduce risk.

integral part of annual period concept Concept guiding the preparation of interim statements; accounting practices may be slightly modified to make sure the interim results relate properly to the annual results.

interest rate risk Uncertainty about future interest rates and their impact on future cash flows as well as on the fair value of existing assets and liabilities.

interest rate swap Contract in which two parties agree to exchange future interest payments on a given loan amount; usually, one set of interest payments is fixed and the other is variable.

interim financial statements  Statements showing financial position and operating results for an interval of less than a year.

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

option 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.

price risk Uncertainty about the future price of an asset.

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

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

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