Advanced Accounting 11th Edition by Paul Fischer,William Tayler, Rita Cheng

Exercise 10

Measuring changes in the value of derivatives and accounting for such changes. A company has acquired two derivatives: an option to buy foreign currency (FC) and a forward contract to buy FC. Both derivatives were acquired on the same day, for the same notional amount and expire on May 31. Relevant information involving the derivatives is as follows:
1. Calculate the intrinsic and the time value of the option for each of the above dates and indicate how the changes in each of these values would be accounted for if the option hedged: (a) a forecasted FC transaction and (b) a recognized FC-denominated liability.
2. Calculate the value of the forward contract at each of the above dates and indicate how the changes in each of these values would be accounted for if the contract hedged: (a) an unrecognized FC firm commitment (b) a recognized FC-denominated liability. Assume a 6% interest rate for any discounting purposes.
3. In part (2), assume that the two hedged items involved the purchase of inventory. Explain how the changes in value of the hedging instruments would affect the basis of the inventory.