Question

On June 1, our company purchases $10 million book value of corporate bonds that we classify as available-for-sale (AFS). We intend to sell these securities on September 30 to meet planned funding needs. Since an increase in interest rates will cause the fair value of the securities to decrease, we decide to hedge against the risk of loss in the fair value of the debt securities that would result if the interest rates were to rise. As a result, we sell September Treasury note futures contracts on June 1 in the amount of the debt securities. We have determined that the hedging relationship between the futures contracts and the debt securities is highly effective (both at the inception of the relationship and on an ongoing basis) in achieving offsetting changes in the fair value that are due to changes in the benchmark interest rate. Accordingly, this transaction is designated as a fair value hedge. Interest rates rise as we had predicted, and the prices of the corporate bonds (the hedged item) and the futures contracts (the hedging instrument), and the resulting gains and losses, are as follows:

Date............................................Securities Loss............Futures..............Gain Net

August ...................................... $(100,000)....................$75,000.............$(25,000)

September ................................... (50,000)......................50,000....................0

We sell the debt securities on September 30 at their fair value of $9,850,000.

Prepare the journal entries to record the following:

a. Purchase of the debt securities and futures contracts on June 1

b. Accrue changes in fair value of AFS debt securities and futures contract in August

c. Accrue changes in fair value of AFS debt securities and futures contract in September

d. Record sale of securities in September

Answer 1

(a) On Purchase of Debt Securities and Futures Contract on 1st June

Corporate Bonds Dr.    10000000

To Bank A/c             10000000

(Being Corporate Bonds Purchased)

No Entry For Entering into Futures Contract

(b) On 31/8

Futures Contract Receivable Dr.     75000

     To Fair Value Hedge Reserve                   75000

(Being Gain on futures Contract Recorded)

Fair Value Hedge Reserve Dr.   100000

           To Corporate Bonds                  100000

(Being Bonds Fair Value Adjusted)

(c)

On 30/9

Futures Contract Receivable Dr.     50000

     To Fair Value Hedge Reserve                   50000

(Being Gain on futures Contract Recorded)

Fair Value Hedge Reserve Dr.   50000

           To Corporate Bonds                  50000

(Being Bonds Fair Value Adjusted)

(d) ON 30/9

Bank a/c Dr.      9975000

   To Corporate Bonds            9850000

   To   Futures Contract Receivable        125000

(Being Sale of Bonds and Closure of Futures Contract Recorded)

ON Closing of Financial Year

Transfer 25000 Loss to Profit & loss a/c

Fair Value Hedge Reserve Dr   25000

       To   Profit & loss A/c                 25000

(Being loss transferred)