Ben Inc. uses oil to operate its machines (fuel expense). Ben enters into a call option contract with Holly Investment Co. on November 1, 2020. This contract gives Ben the option to purchase 1,000 barrels of oil at $100 per barrel on January 1, 2021, which the 1,000 barrels will be used for operation in January. One barrel of oil is trading at $100 on November 1, 2020, at which time Ben pays $1,000 for the call option.
Question 1 (Hedge accounting – options):
Ben Inc. uses oil to operate its machines (fuel expense). Ben enters into a call option contract with Holly Investment Co. on November 1, 2020. This contract gives Ben the option to purchase 1,000 barrels of oil at $100 per barrel on January 1, 2021, which the 1,000 barrels will be used for operation in January. One barrel of oil is trading at $100 on November 1, 2020, at which time Ben
pays $1,000 for the call option.
Required:
(1) Prepare all necessary journal entries on Ben’s book at November 1, 2020.
(2) Prepare all necessary journal entries on Ben’s book at December 31, 2020, assuming that the
price of one barrel of oil has risen to $120.
(3) Prepare all necessary journal entries on Ben’s book at January 1, 2021.
Question 2 (Hedge accounting – forward):
On July 1, 2020, Plum Company sold some limited edition art prints to Marigold Company for ¥47,850,000 to be paid on January 1, 2021. The current exchange rate on July 1, 2020, was ¥110=$1, so the total payment at the current exchange rate would be equal to $435,000. Plum 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 Plum the difference in cash. Likewise, if ¥47,850,000 is worth more than $435,000, Plum must pay the bank the difference in cash.
Required:
(1) Prepare all necessary journal entries on Plum’s book at July 1, 2020.
(2) Prepare all necessary journal entries on Plum’s book at December 31, 2020, assuming that the exchange rate is ¥100=$1.
(3) Prepare all necessary journal entries on Plum’s book at January 1, 2021.
Question 3 (Hedge accounting – interest rate swap):
On January 1, 2019, Poppy Inc. received a two-year, $3 million loan with interest payments due at the end of each year and the principal to be repaid on December 31, 2020. The interest rate for the first year is the prevailing market rate of 7 percent, and the rate each succeeding year will be equal to the prevailing market rate on January 1 of that year. On January 1, 2019, Poppy also entered into an interest rate swap agreement related to this loan and designated this swap as a hedge against fluctuations for its interest payments. Under the terms of the swap agreement, in the year 2020, Poppy will receive a swap payment based on the principal amount of $3 million. If the January 1 interest rate is greater than 7 percent, Poppy will receive a swap payment for the difference; and if the January 1 interest rate is less than 7 percent, Poppy will make a swap payment for the difference. The swap payments are made on December 31 of each year. On January 1, 2020, the interest rate is 5 percent.
Required:
Make the necessary entries on Poppy’s book 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, 2019.
(2) December 31, 2019.
(3) December 31, 2020.
