ACTG 6160 Lecture Notes - Lecture 8: Hedge Accounting, Cash Flow Hedge, Foreign Exchange Risk
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Please answer all parts of the problem.
Palmerstown Company established a subsidiary in a foreigncountry on January 1, Year 1, by investing 8 million pounds whenthe exchange rate was $1.00/pound. Palmerstown negotiated a bankloan of 4 million pounds on January 5, Year 1, and purchased plantand equipment in the amount of 10 million pounds on January 8, Year1. Plant and equipment is depreciated on a straight-line basis overa 10 year useful life. The first purchase of inventory in theamount of 1 million pounds was made on January 10, Year 1.Additional inventory of 12 million pounds was acquired at threepoints in time during the year at an average exchange rate of$0.86/pound. Inventory on hand at year-end was acquired when theexchange rate was $0.83/pound. The first-in, first-out (FIFO)method i sused to determine cost of goods sold. Additional exchangerates for the pound during Year 1 are as follows:
Jan 1-31, Year 1 - $1.00
Average, Year 1 - $.90
Dec 31, Year 1 - $.80
The foreign subsidiary's income statement for Year 1 and balancesheet at December 31, Year 1, are as follows:
| IncomeStatement | ||
| Forthe Year Ended December 31, Year 1 | ||
| Pounds | ||
| Sales | 15,000 | |
| Costof goods sold | 9,000 | |
| Gross profit | 6,000 | |
| Selling/admin expense | 3,000 | |
| Depreciation expense | 1,000 | |
| Incomebefore tax | 2,000 | |
| Income tax | 600 | |
| Net income | 1,400 | |
| Retained earnings, 1/1/Y1 | - | |
| Retained earnings, 12/31/Y1 | 1,400 | |
| BalanceSheet | ||
| December 31, Year 1 | ||
| Pounds | ||
| Cash | 2,400 | |
| Inventory | 4,000 | |
| Fixed assets | 10,000 | |
| Less: accumdepn | (1,000) | |
| Total assets | 15,400 | |
| Currentliabilities | 2,000 | |
| Long-termdebt | 4,000 | |
| Contributedcapital | 8,000 | |
| Retainedearnings | 1,400 | |
| Translationadjustment | ||
| Totalliabilites/ | 15,400 | |
| stockholders'equity | ||
As the Controller for Palmerstown Company, you have evaluatedthe characteristics of the foreign subsidiary to determine that thepound is the subsidiary's functional currency.
1.) Use an electronic spreadsheet to translate the foreignsubsidiary's financial statements into US dollars at December 31,Year 1, in accordance with US GAAP. Insert a row in the spreadsheetafter retained earnings and before total liabilities andstockholders' eequity for the cumulative translation adjustment.Calculate the translation adjustment separately to erify the amountobtained as a balancing figure in the translation worksheet.
2.) Use an electronic spreadsheet to translate the foreignsubsidiary's financial statements into US dollars at December 31,Year 1, assuming that the US dollar is the subsidiary's functionalcurrency. Inserta row in the spreadsheet after depreciation expenseand before income before taxes for the remeasurementgain/(loss)
3.) Prepare a report for the chief executive offer ofPalmerstown Company summarizing the differences that will bereported in the Year 1 consolidated financial statements becausethe pound, rather than the US dollar, is the foreign subsidiary'sfunctional currency. In your repoert, discuss the relationshipbetween the current ratio, the debt-to-equity ration, and theprofit margin calculated form the foeign currency financialstatments and from the translated US dollar financial statements.Also, include a discussion of the meaning of the translated USdollar amounts for inventory and for fixed assets.
Please answer all parts of the problem.
Please answer all parts of the question.
Palmerstown Company established a subsidiary in a foreigncountry on January 1, Year 1, by investing 8 million pounds whenthe exchange rate was $1.00/pound. Palmerstown negotiated a bankloan of 4 million pounds on January 5, Year 1, and purchased plantand equipment in the amount of 10 million pounds on January 8, Year1. Plant and equipment is depreciated on a straight-line basis overa 10 year useful life. The first purchase of inventory in theamount of 1 million pounds was made on January 10, Year 1.Additional inventory of 12 million pounds was acquired at threepoints in time during the year at an average exchange rate of$0.86/pound. Inventory on hand at year-end was acquired when theexchange rate was $0.83/pound. The first-in, first-out (FIFO)method i sused to determine cost of goods sold. Additional exchangerates for the pound during Year 1 are as follows:
Jan 1-31, Year 1 - $1.00
Average, Year 1 - $.90
Dec 31, Year 1 - $.80
The foreign subsidiary's income statement for Year 1 and balancesheet at December 31, Year 1, are as follows:
| IncomeStatement | ||
| Forthe Year Ended December 31, Year 1 | ||
| Pounds | ||
| Sales | 15,000 | |
| Costof goods sold | 9,000 | |
| Gross profit | 6,000 | |
| Selling/admin expense | 3,000 | |
| Depreciation expense | 1,000 | |
| Incomebefore tax | 2,000 | |
| Income tax | 600 | |
| Net income | 1,400 | |
| Retained earnings, 1/1/Y1 | - | |
| Retained earnings, 12/31/Y1 | 1,400 | |
| BalanceSheet | ||
| December 31, Year 1 | ||
| Pounds | ||
| Cash | 2,400 | |
| Inventory | 4,000 | |
| Fixed assets | 10,000 | |
| Less: accumdepn | (1,000) | |
| Total assets | 15,400 | |
| Currentliabilities | 2,000 | |
| Long-termdebt | 4,000 | |
| Contributedcapital | 8,000 | |
| Retainedearnings | 1,400 | |
| Translationadjustment | ||
| Totalliabilites/ | 15,400 | |
| stockholders'equity | ||
As the Controller for Palmerstown Company, you have evaluatedthe characteristics of the foreign subsidiary to determine that thepound is the subsidiary's functional currency.
1.) Use an electronic spreadsheet to translate the foreignsubsidiary's financial statements into US dollars at December 31,Year 1, in accordance with US GAAP. Insert a row in the spreadsheetafter retained earnings and before total liabilities andstockholders' eequity for the cumulative translation adjustment.Calculate the translation adjustment separately to erify the amountobtained as a balancing figure in the translation worksheet.
2.) Use an electronic spreadsheet to translate the foreignsubsidiary's financial statements into US dollars at December 31,Year 1, assuming that the US dollar is the subsidiary's functionalcurrency. Inserta row in the spreadsheet after depreciation expenseand before income before taxes for the remeasurementgain/(loss)
3.) Prepare a report for the chief executive offer ofPalmerstown Company summarizing the differences that will bereported in the Year 1 consolidated financial statements becausethe pound, rather than the US dollar, is the foreign subsidiary'sfunctional currency. In your repoert, discuss the relationshipbetween the current ratio, the debt-to-equity ration, and theprofit margin calculated form the foeign currency financialstatments and from the translated US dollar financial statements.Also, include a discussion of the meaning of the translated USdollar amounts for inventory and for fixed assets.
Please answer all parts of the question.
Excerpt from the multipage Note 7â¦
The Company is required to provide standby letters of creditto support certain obligations that arise in the ordinary course ofbusiness. Although the letters of credit are an off-balance sheetitem, the majority of obligations to which they relate arereflected as liabilities in the Consolidated Balance Sheet.Outstanding letters of credit totaled $211 million at December 31,2007.
The net book value of the assets pledged as collateral forthe Companyâs secured borrowings, primarily aircraft and engines,was $660 million at December 31, 2007.
As of December 31, 2007, aggregate annual principalmaturities of debt and capital leases (not including amountsassociated with interest rate swap agreements and interest oncapital leases) for the five-year period ending December 31, 2012,were $40 million in 2008, $42 million in 2009, $50 million in 2010,$44 million in 2011, $418 million in 2012, and $1.5 billionthereafter.
included Excerpted from Southwest Airlines, Inc. 10-K for yearended 12/31/2007
2007 2006 inmillions
7 7/8 % Notes due2007 $- -
French Credit Agreements due2012 32 37
6 ½ % Notes due2012 386 369
5 ¼ % Notes due2014 352 336
5 ¾ % Notes due2016 300 300
5 1/8 % Notes due2017 311 300
French Credit Agreements2017 94 100
Pass ThroughCertificates 480 --
7 3/8 % Debentures due2027 103 100
Capital Leases (note8) 52 63
2110 1705
Less Currentmaturities 41 16
Less debt discount and issuancecosts 19 16
$ 2050 1567
Here is a copy of the credit report by Fitch Ratings, Ltd. atSouthwestâs $385 million, 6.5% note issuance, duein 2012:
Ratings | |||||||
Maturity Date | Currency | Total Amount | Coupon Rate | Long-term | Short-term | CUSIP | ISIN |
01-MAR-2012 | USD | $385,000,000 | 6.5% | A | -- | 844741AV0 | US844741AV08 |
Here is a price quote on those same Southwest notes atthe date of issuance:
Ratings | Ticker | Description | Coupon | Maturity | YTC/YTM | Price |
Baa/A | LUV | Southwest Airls Co | 6.500 | 03-01-2012 | 7.450 | 97.29 |
1-4. What is the value of these notes at the 2007 balance sheetdate? Read the excerpt from
Note 10.
Prior to 2007, the Company had entered into interest rate swapagreements relating to its $385 million 6.5% senior unsecured notesdue 2012 and⦠Under each of these interest rate swapagreements, the Company pays the London InterBank Offered Rate(LIBOR) plus a margin every six months on the notional amount ofthe debt [what amounts to the market price of thedebt], and receives payments based on the fixedstated rate of the notes every six months until the date the notesbecome due [this is why it is called aswap]. Under the agreement related to its$385 million 6.5% senior unsecured notes due 2012, the averagefloating rate paid during 2007 is estimated to be 7.31 percentbased on actual and forward rates at December 31, 2007.
The primary objective for the Companyâs use of interest ratehedges is to reduce the volatility of net interest income by bettermatching the repricing of its assets and liabilities. The Companyâsinterest rate swap agreements qualify as fair value hedges, asdefined by SFAS 133. The fair values of the interest rate swapagreements, which are adjusted regularly, are recorded in theConsolidated Balance Sheet, as necessary, with a correspondingadjustment to the carrying value of the long-term debt. The fairvalue of the interest rate swap agreements, excluding accruedinterest, at December 31, 2007, was an asset of approximately $16million and is recorded in âOther deferred liabilitiesâ in theConsolidated Balance Sheet. In accordance with fair value hedging,the offsetting entry is an adjustment to increase the carryingvalue of long-term debt. See Note 7. [we will discuss theaccounting for fair value hedges (and cash flow hedges) inInternational Accounting]
1-5. So what has happened to the general trend of interest ratesbetween the date of issuance and the end of 2007? How can you tell?What was the market rate at issuance for notes of equivalentrisk?
1-6. Why might Southwest pay off these notes back beforematurity? What effect would a repurchase at the 12/31/07 marketrate (ignoring the interest rate swap) have on Southwestâs majorfinancial statements?
