[californiaholic]

Jamison owns 50,000 shares of Redstone stock that were purchased at $40 per share and are being accounted for as available for sale securities. It purchased the stock to secure a relationship with Redstone, a supplier of some of Jamison’s raw materials. Jamison is securing a new source for the raw material and expects to rely on Redstone for the next two years. Jamison has entered into a put contract involving the sale of Redstone at the end of two years for Jamison’s purchase price of $40, which is being accounted for as a fair value hedge. At December 31, the stock had a fair value $42 per share. How will Jamison report the investment and the put contract on its December 31 balance sheet and its income statement for the year then ended?

Answer: Jamison will recognize the investment at its fair value of $2,100,000 and will recognize the put contract as a $100,000 liability. Both the $100,000 increase in the investment and the $100,000 increase in the liability will be reported in the income statement.

Can someone explain this to me?

[Lentilcounter]

There are cash flow hedges and fair value hedges. A hedge of a net investment in a foreign operation works the same as a cash flow hedge.

What is the definition of a perfect hedge? It is when your hedge position offsets any gains or losses. If you have gains, it still isn't a perfect hedge.

($42-$40)*50,000 = $100,000 is recognized on the income statement in earnings because it represents the ineffective portion of the hedge.

The second part of the answer I'm not entirely sure about but I can try to explain it.

A put option is an option contract giving the owner the right but not the obligation to a sell a specified amount of an underlying security at a specified price within a specified time.

$2*50,000 = $100,000 –> why does it show up on the income statement as a liability? I don't know but maybe someone else can explain that part.

BEC = 72 (6/08/16)
FAR = ?
REG = ?
AUD = ?

[californiaholic]

I'm still confused as to why the unrealized gain from investment isn't going to OCI on the balance sheet. If it's accounted for as a cash flow hedge, aren't unrealized gains and losses supposed to be reported n OCI?

[Anonymous]

The Redstone stock is the hedged item here and the put contract is the hedging instrument. The fact has said the hedging instrument is fair value hedge. The unrealized gain or loss of AFS security normally goes to OCI until it's realized. If the AFS has a fair value hedge to reduce risks from AFS, the unrealized gain/loss of AFS should be recognized in earnings to offset the gain/loss from hedge. So the entries as of 12/31 (FYE) would be

to record FV change for AFS:
Debit AFS security – redstone 100K (($42-$40)x50K)
Credit Gain from hedged AFS 100K

to record the change for the FV hedge:
Debit Loss from FV hedge – put contract 100K (didn't say any ineffective portion, so assume the hedge is fully effective to mitigate the risk)
Credit Liability-put contract 100K

An derivative can be either asset or liability depends on it's fair value is positive or negative.

Compound the two entries, the gain and loss offset each other, so the entry can be written as a single one
Debit AFS security – redstone 100K (($42-$40)x50K)
Credit Liability-put contract 100K

A liability is not reported in income statement, but it's change (either increase or decrease, results loss or gain, respectively) could be.

[Author]

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