2011 Financial 7 Text Update - This first page gives a...

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This first page gives a listing of the corrected lecture text pages that follow. Print these corrected pages and insert in the lecture text. FINANCIAL Date Added Lecture Page Number Description 03/17/2011 F-7 10 Text change 03/17/2011 F-7 17 Text change 03/17/2011 F-7 37 Text change 03/17/2011 F-7 45 Add text to graphic 03/24/2011 F-7 11 Reword sentence 03/24/2011 F-7 56 Add text
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Financial 7 Becker Professional Education | CPA Exam Review F7- 10 © 2010 DeVry/Becker Educational Development Corp. All rights reserved. EXAMPLE – FAIR VALUE HEDGE On September 30, Year 1, Smith Company signed a contract to purchase 100,000 lbs. of copper wire on December 31, Year 1 for $1.55/lb. Risk: When it enters into this firm purchase commitment, Smith faces the risk that the price of the copper wire could fall below $1.55/lb. A loss must be recognized on a firm purchase commitment when the contract price exceeds the market price (discussed in F-4). Hedge : To hedge the risk of loss on the firm purchase commitment, Smith takes a short position in a forward contract in which Smith agrees to sell 100,000 lbs. of copper for $0.92/lb. on December 31, Year 1. If the price of copper goes down, Smith will record a gain on the hedge because Smith has "locked in" a higher selling price. This hedge is classified as a fair value hedge because Smith is hedging the change in the value of the firm purchase commitment. Smith expects this hedge to be highly effective because the price of copper wire is directly related to the price of copper. The prices of copper wire and of the copper forward contract are as follows: Copper Wire/lb. Copper Forward/lb. September 30, Year 1 $1.550 $0.920 December 31, Year 1 $1.480 $0.851 No journal entries are recorded on September 30, Year 1. The following journal entries must be recorded on December 31, Year 1. Journal Entry: To record the loss on the firm purchase commitment [($1.480/lb. - $1.550/lb.) x 100,000 lbs. = $7,000]. Loss on firm purchase commitment 7,000 Firm purchase commitment liability 7,000 Journal Entry: To record the gain on the forward contract hedge [($0.851/lb. - $0.920/lb.) x 100,000 lbs. = $6,900]. Fair value hedge 6,900 Gain on fair value hedge 6,900 Earnings impact of purchase commitment (no hedge) = $7,000 loss Earnings impact of purchase commitment (with hedge) = $100 loss ($7,000 loss - $6,900 gain) Journal Entry: To record the net settlement of the forward contract. Smith will receive $6,900 because the forward contract allows Smith to sell copper for $0.92/lb. when the price of copper is $0.851/lb (the forward price is equal to the spot price of copper on the settlement date). Cash 6,900 Fair value hedge 6,900 Journal Entry: To record the purchase of 100,000 lbs. of copper wire for $1.55/lb. under the firm purchase commitment. Firm purchase commitment liability
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This note was uploaded on 09/25/2011 for the course ACCOUNTING AC591 taught by Professor W during the Spring '11 term at Keller Graduate School of Management.

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2011 Financial 7 Text Update - This first page gives a...

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