Download Financial Reporting and Analysis Chapter 11 Web Solutions

Financial Reporting and Analysis
Chapter 11 Web Solutions
Financial Instruments as Liabilities
Problems
Web P11-1.
Put options as investments
Required entries for 1 through 3:
March 1, 2008:
DR Marketable securities—stock options
CR Cash
$300
$300
March 31, 2008:
DR Unrealized holding loss on stock options
CR Market adjustment—stock options
$100
$100
April 30, 2008:
DR Market adjustment—stock options
$1,900
CR Unrealized holding gain on stock options
$1,900
The unrealized holding gains and losses flow directly to income each month.
Requirement 4:
The option contracts are “underwater” on March 31, meaning that the $50
exercise price is below the $52 market price for Rugulo stock. (Remember,
Kenton bought “put” options—options to sell Rugulo at $50 per share.) The
options still have value on July 31 because there is some chance Rugolo’s
stock will fall below $50 before the options expire.
That’s what has happened by April 30. Now the options are “in the money”,
meaning that the $50 exercise (“sell”) price is above the $46 market price for
Rugolo stock.
Requirement 5:
If Getz exercises the stock options on May 15, he will buy 500 shares of
Rugolo stock at the market price of $42 per share, turn over the stock and the
option contracts, and receive $50 cash per share (the exercise price). The
entries are:
DR Marketable securities—Rugolo stock
$21,000
CR Cash
DR Cash
CR Marketable securities—Rugolo stock
CR Marketable securities—stock options
CR Market adjustment—stock options
CR Realized gain on stock options
$ 21,000
$25,000
$21,000
300
1,800
1,900
Requirement 6:
If the option contracts were allowed to expire on May 15 (presumably
because the market price of Rugolo stock was above $50), the entry is:
DR Realized loss on stock options
CR Marketable securities—stock options
CR Market adjustment—stock options
$2,100
$
300
1,800
Cases
Web C11-1. Managing Risk
Requirement 1:
An interest-rate swap can reduce a borrower’s exposure to cash flow
fluctuations and fair value changes associated with changing interest rates. A
borrower with fixed-rate debt outstanding can use a variable-rate swap to
“lock in” a lower interest rate when rates are falling. A borrower with variablerate debt outstanding can use a fixed-rate swap to “lock in” a lower interest
rate when rates are rising. These derivative securities help borrowers reduce
market risk and lower their overall cost of debt.
Requirement 2:
If Heinz has only fixed-rate debt outstanding, then the swap contract is for
variable-rate interest. Heinz has no cash flow exposure to changing interest
rates because the cash interest payments on the fixed-rate debt are “fixed”—
i.e., don’t fluctuate with interest rate changes. Heinz does have exposure to
fair value changes, however—the value of the fixed-rate debt declines as
interest rates rise, and increases as interest rates fall. So, the swap would
qualify as a “fair value” hedge.
Requirement 3:
Continuing our discussion from requirement 2, the “underlying instrument” is
the original fixed-rate debt. If the debt itself is settled (meaning retired) before
the swap contract is settled, the swap becomes a speculative investment (not
a hedging instrument) since there is no longer a “hedged item”. In this case,
all gains and losses on the swap contract must flow directly to income.
Requirement 4:
Heinz sells products in foreign countries and receives payment in foreign
currencies. Changes in currency exchange rates increase (or decrease) the
value of these transactions as measured in U.S. dollars. A foreign currency
futures contract can be used to “lock in” a currency exchanges rate and
insulate Heinz from this market risk.
Requirement 5:
Not all of the foreign currency contracts used by Heinz qualify for special
hedge accounting treatment. Those that do have their realized and unrealized
gains and losses deferred until the underlying transaction occurs.
Those that do not qualify for special hedge accounting rules have their
realized and unrealized gains and losses flow directly to income (and without
offsetting losses and gains being recorded on the “hedged item”).
Requirement 6:
A futures contract “locks in” a specific price for the commodity (tomatoes) at
some future date, say $10 per bushel on February 15th. Heinz can use a
futures contract to protect itself from commodity price increases from now
until when it buys the tomatoes on February 15th. But what if the price of
tomatoes falls to only $8 per bushel? Using a futures contract, Heinz would
still be obligated to the contract price of $10 per bushel even though the
market price on February 15th is only $8.
An options contract, on the other hand, allows Heinz to protect itself from
tomato price increases and still benefit from possible price declines. If
tomatoes are selling for $12 a bushel on February 15th, Heinz will exercise
the option and pay only $10 per bushel. But, if tomatoes are selling for only
$8 per bushel, Heinz will let the option expire and buy tomatoes at the $8
market price.
Requirement 7:
Heinz uses futures contracts to hedge the cash flow risk of planned
commodity purchases.
Web C11-2.
Delhaize American Inc.:
Disclosing fair value of long-term debt
Requirement 1:
The footnote indicates that the company’s debt has a fair value of $413.6
million at the end of Year 2. This is the amount that would need to be paid if
the long-term debt was purchased and retired.
Requirement 2:
DR Long-term debt
DR Long-term debt—current portion
CR Cash
CR Gain on debt extinguishment
$426,930
2,834
$413,600
16,164
Requirement 3:
The gain on loss at retirement is treated as a non-operating item on the Year
2 income statement. The impact on next year’s (Year 3) income statement
would be indirect—no interest expense would appear that year because the
company’s long-term debt was retired in Year 2.
Requirement 4:
DR Long-term debt
DR Loss on debt extinguishment
CR Cash
$495,000
39,000
$536,000
Requirement 5:
DR Long-term debt
$495,000
DR Loss on debt extinguishment
14,850
CR Cash
$509,850
(To record the call and retirement of the debt at 103% of par value—which
is assumed to be the same as book value.)
Notice that by “calling” the debt, the company reduces its cash outflow (and
extinguishment loss) for debt retirement by $26,150.
Requirement 6:
If the debt is “collateralized” by property, plant and equipment (PP&E), then
the lender can take possession of the PP&E if the borrower defaults on the
loan. Bank loans for personal automobiles are a good example. If you don’t
pay, the bank repossess your car and can then sell it to pay off your loan.
Lenders prefer these arrangements because it reduces their risk of default—
you have an incentive to pay off the loan (or you lose the car). And, if you
don’t? Well, the bank takes back the car and sells it.
Management might prefer “collateralized” debt if it lowers the cost of debt.
Collateralized loans are found in industries where there are valuable “fixed
assets” in place—trucking, construction, heavy manufacturing, etc. These
kinds of loans are not common in other industries because there are no
valuable “fixed assets” that can serve as loan collateral.
Web C11-3. ShopKo Stores Inc.:
Analyzing long-term debt--Comprehensive
Requirement 1:
ShopKo borrowed $100 million using a Senior Credit Facility during the year
ended February 2, 2002 (see footnote E). No other debt was issued by the
company that year. The “Senior unsecured notes” all increased slightly from
their beginning-of-year balances, but these increases reflect the amortization
of discounts not newly issued debt.
Requirement 2:
According to footnote E, the Senior Credit Facility carries a fixed 5.3%
interest rate.
Requirement 3:
DR Cash
CR Senior Credit Facility (long-term debt)
$100 m
$100 m
Requirement 4:
According to footnote E, the unamortized discount for each class of senior
unsecured notes decreased as follows:
Senior unsecured notes, 9.0%
Senior unsecured notes, 8.5%
Senior unsecured notes, 9.25%
Senior unsecured notes, 6.5%
Beginning
of year
$12
0
386
42
End
of year
$49
18
405
70
Amount
amortized
$37
18
19
28
$102
Thus, amortization of the discount totaled $102 million.
Requirement 5:
Without a careful examination of the company’s cash flow statement, it is
difficult to say what the company did with the money. One possibility is that
ShopKo used the $100 million as part of the $170 million it paid out to
eliminate its revolving credit facility (see footnote E).
Requirement 6:
Note E shows the “current portion” of long-term debt as $79,942. However,
both the 8.5% notes ($70,207) and the 9.25% notes ($99,614) come due
within one year, and thus would normally be classified as current.
Requirement 7:
Footnote I shows indicates that the fair market value of the company’s longterm debt (excluding capital leases) is $399,652 compared to a carrying
amount (book value) of $458,114. Based on this information, the company
would have to pay $399,652 to retire its debt. Here’s the journal entry.
DR Long-term debt
$458,554
CR Unamortized discount on long-term debt
CR Cash
CR Gain on retirement of long-term debt
$
440
$399,652
$ 58,462
Notice that the unamortized discount ($440) must be eliminated along with
the undiscounted book value of the long-term debt.