Calamba Review Center - Laguna (LCRC)

2F MMCO Building, 8000 Lakeview Ph3 Angela Street, Halang, Calamba City Laguna, Philippines
Tel No. (02) 330-8617, (049) 523-6031; (02) 330-6057
CPA REVIEW (May 2020 Batch)
AFAR Marc Oliver Castañeda, CPA

LIQUIDATION OF A CORPORATION
A corporation is considered insolvent when it is unable to pay its debts as they come due, or when its total debts exceed
the fair value of its assets. The inability to make payments in due course is referred to as equity insolvency, whereas, having
total debts that exceed the fair value of total assets is referred to as bankruptcy insolvency. Debtor Corporation that are
insolvent in the equity sense may be able to avoid bankruptcy proceedings by negotiating an agreement directly with creditors
which we call debt restructuring, whereas, Debtor Corporation that are insolvent in the bankruptcy sense will ordinarily be
reorganized or liquidated under the supervision of a bankruptcy court.
What we will discuss only in this handout will be about liquidation of a corporation. The following financial reports are
prepared to aid the creditors and the court as to the progress of the liquidation.

STATEMENT OF AFFAIRS
An accounting statement that does provide relevant information for a liquidating company is referred as the statement
of affairs. This statement is a legal document prepared for the bankruptcy court. The accountant’s statement of affairs is a
financial statement that emphasizes liquidation values and provides relevant information for the trustee in liquidating the debtor
corporation. It also provides information that may be useful to creditors and to the bankruptcy court. A statement of affairs is
prepared as of a specific date, and its shows balance sheet information with assets measured at expected net realizable values
and classified on the basis of availability for fully secured, partially secured, priority, and unsecured creditors. Liabilities are
classified in the statement of affairs as priority, fully secured, partially secured, and unsecured. Historical cost valuations are also
included in the statement for reference purposes. An example is shown below. The following information was taken from the
Statement of Affairs filed by S Corporation to the bankruptcy court on August 1, 2017:

S Corporation
Statement of Affairs
August 1, 2017

Assets
Realizable Values - Realizable values
Liability Offsets for Available for
Book value Secured Creditors Unsecured Creditor
Pledged for Fully Secured Creditors
P 55,000 Land and building – net P60,000
Less: Mortgage payable P50,000
Interest payable 5,000 55,000 P 5,000

Pledged for Partially Secured Creditors

25,000 Accounts receivable P22,000
Less: Notes payable to bank P25,000
Interest payable 2,000 27,000 0

Available for Priority and Unsecured Creditors

3,000 Cash 3,000
7,000 Marketable securities 7,000
50,000 Inventories 55,000
4,000 Prepaid expenses 0
30,000 Equipment – net 12,000
6,000 Intangible assets 0
Total available for priority and unsecured creditors 82,000
Less: Priority liabilities 15,000
Total available for unsecured creditors 67,000
Estimated deficiency 8,000
P180,000 P75,000

Liabilities and Stockholders’ Equity

Book Secured and Unsecure
Value Priority Claims Nonpriority
Claims Priority Liabilities
P 13,000 Wages payable P 13,000
Property taxes payable 2,000
P 15,000

Fully Secured Creditors

50,000 Mortgage payable P 50,000
5,000 Interest payable 5,000
P55,000
Partially Secured Creditors
25,000 Notes payable - bank P25,000
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 5,000 Interest payable 2,000
P27,000
Less: Accounts receivable pledged 22,000 P 5,000
Unsecured Creditors
65,000 Accounts payable 65,000
5,000 Notes payable to suppliers 5,000
Stockholders’ Equity
200,000 Capital stock
( 187,000) Retained earnings .
P180,000 P75,000
Determine the estimated amount payable per peso of unsecured nonpriority liability.
Answer: P67,000/P75,000 = P0.8933 per peso

STATEMENT OF CASH RECEIPTS AND DISBURSEMENTS

This statement shows the beginning balance of cash, the various sources of cash, example, collection of accounts, sales of
assets and refund of prepaid items and also shows the various uses of cash, example the payment of various expenses and
liabilities. All disbursements require the approval of the court, so the statement should be a useful financial summary. An
example is shown below:

S Corporation in Trusteeship
Statement of Cash Receipts and Disbursements
From August 1 to August 31, 2017
Cash balance, August 1, 2017 P 3,000
Add: Cash receipts
Sale of inventory items P30,000
Sale of equipment 14,200
Sale of land and building 64,000
Refund from insurance policy 1,000
Collection of receivables 21,000
Total cash receipts 130,200
133,200
Deduct: Cash disbursements
Wages payable (priority claim) P13,000
Property taxes payable (priority claim) 2,000
Mortgage payable and interest (fully secured) 55,000
Bank note payable and interest (for secured portion) 21,000
Administrative expense (priority item) 3,000
Total cash disbursements 94,000
Cash balance, August 31, 2017 P 39,200

STATEMENT OF CHANGES IN ESTATE EQUITY

This statement shows the losses and gains from sale of noncash assets, the losses from the write-offs of intangible assets,
accounts written off, discovered liabilities, expenses paid like trustees fees, etc. Therefore, the statement explains the changes
on the estate equity (owners’ equity), for a certain period of time resulting from the liquidation of the corporation. An example is
shown below:

S Corporation in Trusteeship
Statement of Changes in Estate Equity
From August 1 to August 31, 2017
Estate equity August 1, 2017 P 13,000
Less: Net loss on asset liquidation (see schedule below)P 18,800
Liability for utilities discovered 500
Administrative expenses 3,000
Trustee’s fee 2,000
Net decrease for the period ( 24,300)
Estate deficit August 31, 2017 P 11,300

Schedule of Net Losses on Asset Liquidation

Book value Proceeds on Gain or

August 1 Realization (loss)
Accounts receivable P25,000 P21,000 P( 4,000)
Inventories 50,000 48,000 ( 2,000)
Land and building 55,000 64,000 9,000
Equipment 30,000 14,200 (15,800)
Intangible assets 6,000 0 ( 6,000)
Net loss on liquidation of assets P (18,800)

STATEMENT OF REALIZATION AND LIQUIDATION

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This statement is an activity statement that is intended to show progress toward the liquidation of a debtor’s estate. Its original
purpose is to inform the bankruptcy court and interest creditors of the accomplishments of the trustee. An example is shown
below:
Below is an illustrative statement of realization and liquidation of Apple Company which is under receivership, for the month
ended December 31, 2017.

Apple Company in Receivership

Star, Receiver
Statement of Realization and Liquidation
For the Month Ended December 31, 2017
Assets
Assets to be realized: Assets realized:
Marketable securities P 15,000 Marketable securities P 18,500
Accounts receivable 30,000 Accounts receivable 11,500
Merchandise 50,000 Assets not realized:
Assets acquired: Accounts receivable 22,000
Accounts receivable 5,000 Merchandise 20,000

Liabilities
Liabilities liquidated: Liabilities to be liquidated:
Accounts payable 35,000 Accounts payable 65,000

Liabilities not liquidated: Liabilities assumed:

Accounts payable 31,500 Accounts payable 1,500
Accrued expenses 350
Profit and Loss
Supplementary charges: Supplementary credits:
Purchases 1,500 Sales on account 5,000
Payment of expenses of Interest on marketable securities 150
receivership 7.500 Sales for cash 25,000

Determine the net income or loss for the period.

Answer: Assets:
Total assets to be realized P 95,000
Total assets acquired 5,000
P100,000
Total assets realized P 30,000
Total assets not realized 42,000
P 72,000 P28,000 net loss
Liabilities
Total liabilities to be liquidated P 65,000
Total liabilities assumed 1,500
P 66,500
Total liabilities liquidated P 35,000
Total liabilities not liquidated 31,850
66,850 P 350 net loss
Profit and Loss
Supplementary credits P 30,150
Supplementary debits 9,000 P21,150 net income
Net loss for the period P 7,200 net loss

MULTIPLE CHOICE
1. In a Statement of Affairs, assets pledged for partially secured creditors are:
a. Included with assets pledged for fully-secured creditors
b. Offset against partially-secured liabilities
c. Included with free assets.
d. Disregarded.

2. The preferred sequence of listing (1) fully secured liabilities, (2) partially secured liabilities, (3) unsecured liabilities with
priority and (4) unsecured liabilities without priority in the liabilities and stockholders’ equity section of a statement of affairs
is:
a. (1), (2), (3), and (4) c. (1), (3), (2), and (4)
b. (3), (1), (2), and (4) d. (1), (3), (4), and (2)
3. The estimated amount available for Free Assets in a Statement of Affairs for a business enterprise undergoing bankruptcy
liquidation is equal to the assets’:
a. Carrying amounts less current fair values.
b. Carrying amounts plus gain or less loss on realization.
c. Carrying amounts plus loss or less gain on realization.

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 d. Current fair values less carrying amounts.

4. In corporate liquidation, creditors having priority are what type of creditors?

Secured Creditors? Unsecured Creditors?
a. Yes Yes
b. Yes No
c. No Yes
d. No No

Items 5 and 6 are based on the following information:

When SPENCER Company filed for liquidation with the Securities and Exchange Commission, it prepared the following
balance sheet.
Current assets, net realizable value, P50,000 P 80,000
Land and buildings, fair value, P240,000) 200,000
Goodwill, fair value, P0 40,000
Total assets P 320,000
Accounts payable P 160,000
Mortgage payable, secured by land and building 200,000
Common stock 100,000
Retained earnings, deficit ( 140,000)
Total equities P 320,000

5. What is the estimated deficiency to unsecured creditors?

a. P 70,000 b. P 90,000 c. P120,000 d. P140,000

6. What percentage of their claims are the unsecured creditors likely to get?
a. 43.75% b. 50.00% c. 56.25% d. 100.00%

7. ROCKFORD Corp., is undergoing liquidation since August 1, 2017. Five months later, on December 31, 2017, its condensed
realization and liquidation statement shows the following:
Assets:
To be realized P1,375,000
Acquired 750,000
Realized 1,200,000
Not realized 1,375,000
Liabilities:
Liquidated 1,875,000
Not liquidated 1,700,000
To be liquidated 2,250,000
Assumed 1,625,000
Supplementary:
Charges 3,125,000
Credits 2,800,000
The net gain (loss) for the five-month period is:
a. P (325,000) b. P250,000 c. P425,000 d. P750,000

8. The statement of affairs of SM Co. shows the following:

Estimated gains on realization of assets P 1,440,000
Estimated losses on realization of assets 2,000,000
Additional assets 1,280,000
Additional liabilities 960,000
Capital stock 2,000,000
Deficit 1,200,000

The pro-rate payment on the peso, to stockholders, is:

a. P0.30 b. P0.43 c. P0.57 d. P0.70

9. REH Co. filled a voluntary bankruptcy petition on August 15, 2017 and the statement of affairs reflect the following
amounts:
BOOK CARRYING ESTIMATED CURRENT
VALUE VALUE
Assets pledge with fully secure creditors P 150,000 P 185,000
Assets pledge with partially secured 90,000 60,000
creditors 210,000 160,000
Free Assess P 450,000 P 405,000

Liabilities
Liabilities with priority P 35,000
Fully secured creditors 130,000
Partially secured creditors 100,000
Unsecured creditors 270,000
P 535,000

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 Assumes that the assets are converted into cash at the estimated current value and the business is liquidated. How much
cash will be available to pay the unsecured non-priority claims?
a. P240,000 b. P180,000 c. P160,000 d. P125,000

10. NOBLE Co. has been forced into bankruptcy and liquidated. Unsecured claims will be paid at the rate of P0.50 on the peso.
TON Co. hold a non-interest bearing note receivable from NOBLE Co. in the amount of P50,000 collateralized by machinery
with a liquidation value of P10,000. The total amount to be realized by TON on this note receivable is:
a. P35,000 b. P30,000 c. P25,000 d. P10,000

11. The statement affair for GREENCROSS Corp. shows that approximately P0.78 on the peso probably will be paid to unsecured
creditors without priority. The Corp. owes Boy Co. P23,000 on a promissory note, plus accrued interest of P940. Inventories
with a current fair value of P19,200 collateral the note payable.
Compute the amount that the Boy should receive from GREENCROSS assuming that the actual payments to unsecured
creditors without priority consist of 78% of total claims. Round all amounts to the nearest peso.
a. P19,200 b. P22,897 c. P33,987 d. P52,200

12. The following information is available concerning Taal Inc. on the date the Co. entered bankruptcy proceeding:
Account Balance per Books
Cash P2,860
Accounts receivable 52,260
Inventory 28,000
Prepaid expenses 430
Buildings, net 59,000
Equipment, net 5,600
Goodwill 5,650
Wages payable (2,500)
Taxes payable (1,810)
Accounts payable (79,000)
Notes payable (15,150)
Common stock (72,000)
Retained earnings, Deficit 16,660
Inventory with a book value of P20,000 is security for notes of P10,000. The other notes are secured by the equipment.
Expected realizable values of the assets are:
Accounts receivable P44,100
Inventory 18,500
Buildings 22,000
Equipment 2,000
What is the estimated deficiency to unsecured creditors?
a. P79,000 b. P65,500 c. P72,500 d. P 9,000

Items 13 to 16 are based on the following:

Because of inability to pay its debts, the John Manufacturing Co. has been forced into bankruptcy as of April 30, 2017.
The balance sheet on that date shows:

ASSETS
Cash P 2,700
Accounts Receivable 39,350
Notes Receivable 18,500
Inventories 87,850
Prepaid expenses 950
Land and building 61,250
Equipment 48,800
P 259,400
LIABILITIES
Accounts payable P52,500
Notes payable – PNB 15,000
Note payable – suppliers 51,250
Accrued wages 1,850
Accrued taxes 4,650
Mortgage bond payable 90,000
Common stock – P10 par 75,000
Retained earnings (30,850)
P 259,400

Additional information:
a. Accounts receivable of P16,110 and notes receivable of P12,500 are expected to be collectible. The good notes are
pledged to Phil. National Bank.
b. Inventories are expected to bring in P45,100 when sold under bankruptcy condition.
c. Land and buildings have an appraised value of P95,000. they serve as security on the bonds.
d. The current value of the equipment, net of disposal cost is P9,000.

13. The estimated loss on asset disposition is:

a. P82,550 b. P29,240 c. P11,700 d. P 112,840
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14. What is the estimated gain on asset disposition?
a. P45,100 b. P33,750 c. P0 d. none of these

15. What is the estimated payment to creditors?

a. P102,500 b. P215,250 c. P118,750 d. 180,410

16. The expected recovery percentage is:

a. 47% b. 50% c. 48% d. 35%

FOREIGN EXCHANGE

Objectives, Scope and Definitions of IAS 21

An entity may carry on foreign activities either by conducting transactions in foreign currencies, for example purchasing a non-
current asset from an overseas supplier, exporting goods to an overseas customer or arranging a loan in a foreign currency, or
by having foreign operations, for example a subsidiary or branch located overseas.

In addition, an entity may choose to present its financial statements in a foreign currency.

The objective of IAS 21 is to prescribe how to include foreign currency transactions and foreign operations in the financial
statements of an entity, and how to translate financial statements into a different currency for presentation purposes.

I AS 21 applies to:
• accounting for transactions that the entity enters into which are in a foreign currency and any resulting balances (note
that items that fall within the scope of IAS 39
Financial instruments: recognition and measurement are dealt with by that standard);
• translating the financial statements of foreign operations that are included in the financial statements of another entity,
for example, on consolidation of subsidiaries or the inclusion of associates by the equity accounting method; and
• translating an entity's results and financial position into a different currency for the presentation of its financial
statements.

Initial recognition
An entity should record foreign currency transactions, for example the buying or selling of goods or services whose price is
denominated in a foreign currency, in a consistent manner. IAS 21 requires that an entity does this by recognising each
transaction at the spot exchange rate on the date that the transaction took place.

Where there are high volumes of such transactions, for practical reasons an average exchange rate over the relevant period
may be used as an approximation. However, if exchange rates fluctuate significantly over short periods of time it is not
appropriate to use an average rate since it would not be a fair approximation for actual rates.
Reporting at the ends of subsequent reporting periods
At the end of each reporting period the following translations of foreign currency should be carried out.
Item Exchange rate
Monetary items Closing rate (i.e. the spot exchange rate at
the end of the reporting period)
Non-monetary items Rate of exchange at the date of the original
measured at historical cost transaction (i.e. the date of purchase of the
non-current asset)
Non-monetary items Exchange rate at the date when fair value
measured at fair value was determined

Recognition of exchange differences

The difference that arises from translating the same amounts at different exchange rates is referred to as an exchange
difference. Such amounts will generally arise in the preparation of a set of financial statements from the settlement of monetary
amounts payable or receivable in a foreign currency and the retranslation at the entity’s period end.
Exchange differences should normally be recognised as part of the profit or loss for the period. However, where gains and
losses on a non-monetary item are recognised in other comprehensive income, for example a gain on the revaluation of a
property in accordance with IAS 16 Property, plant and equipment, any exchange difference resulting from retranslation of the
revalued asset is also reported as part of other comprehensive income.
Transactions settled within the period
When a foreign currency transaction is settled within the same accounting period as that in which it was originally recorded, any
exchange differences arising are recognised in the profit or loss of that period.
Transaction balance is outstanding at the end of the reporting period
When a foreign currency transaction is settled in a different accounting period to the one in which the transaction originated,
the exchange difference recognised in profit or loss for each period, up to the date of settlement, is determined by the change
in exchange rates during each period.
Essentials in Translating Foreign Currency Financial Statements
The functional currency
The overall approach required by IAS 21 is for an entity to translate foreign currency items and transactions into its functional
currency.

A functional currency “is the currency of the primary economic environment in which the entity operates” and the primary
economic environment ”is normally the one in which it primarily generates and expends cash”.
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In a group, each entity, for example the parent, each subsidiary and associate, needs to determine its own functional currency
rather than adopting a single one which is common across the whole group.

An entity cannot choose its functional currency; instead, management needs to make an informed assessment of the facts. IAS
21 includes a number of practical indicators to assist entities in identifying their functional currency, for example:
• the currency that mainly influences the prices at which goods and services are sold;
• the country whose competitive forces and regulations mainly influence the pricing structure for the supply of goods and
services;
• the currency in which financing is generated; and
• the currency in which cash generated from an entity’s operating activities is usually retained.
The presentation currency
Although the overall approach required by IAS 21 is for an entity to translate foreign currency items and transactions into its
functional currency, it is not required to present its financial statements using this currency. An entity has a completely free
choice of the currency in which its financial statements are presented. This is referred to as the presentation currency.
Monetary and non-monetary items
IAS 21 distinguishes between monetary and non-monetary items.
Monetary items are units of currency held, and assets and liabilities to be received or paid in a fixed or determinable number of
units of currency, for example cash, receivables, payables and loans.
Non-monetary items are therefore those which do not give rise to a right to receive (or an obligation to deliver) a fixed or
determinable amount of money, for example property, plant and equipment, goodwill, inventories and intangible assets.
Procedures for translation into presentation currency
This section sets out how an entity should retranslate amounts from its functional currency into a different presentational
currency. As mentioned above, an entity has a completely free choice over its presentation currency, assuming this is permitted
by the jurisdiction in which the entity prepares its financial statements.

The translation into a presentation currency can be undertaken by an individual entity, if it decides to present its financial
statements in a currency different to its functional currency. Much more commonly, it is undertaken when entities within a
group have functional currencies different from the presentation currency of the parent. For the preparation of the group’s
consolidated financial statements, such entities will need to retranslate their financial statements into the presentation currency
being used.

The steps to translate financial statements into a different presentation currency are:
• retranslate the assets and liabilities for each statement of financial position presented (i.e. the current period end and
the comparative period) at the closing rate at the date of that statement of financial position;
• retranslate income and expenditure recorded in each statement of comprehensive income presented (i.e. the current
period and the comparative period) at the exchange rates at the dates of the transactions; for practical reasons
an AVERAGE RATE may be used for each period, assuming that the exchange rate does not fluctuate
significantly during the period; and
• recognise all resulting exchange differences in other comprehensive income.

Where exchange differences relate to a foreign operation that is not wholly owned, accumulated exchange differences
attributable to the minority shareholders should be allocated to minority interests in the consolidated statement of financial
position.

Financial Reporting in Hyperinflationary Economies (IAS No. 29)

Restatement of Financial Statements
The basic principle in IAS 29 is that the financial statements of an entity that reports in the currency of a hyperinflationary
economy should be stated in terms of the measuring unit current at the balance sheet date. Comparative figures for prior
period(s) should be restated into the same current measuring unit.
Historical Cost Financial Statements
Restatements are made by applying a general price index.
1. M onetary item s are not restated that are already stated at the measuring unit at the balance sheet date are not
restated.
2. Assets and liabilities linked by agreement to changes in prices should be adjusted in accordance with the agreement.
3. All other assets and liabilities are non-m onetary . Some non-m onetary item s are carried at am ounts current at
the balance sheet date, such as net realizable value and m arket value, so they are not restated. All other
non-m onetary assets and liabilities are restated.
4. All items in the income statement are expressed in terms of the measuring unit current at the balance sheet date.
Therefore, all amounts need to be restated by applying the change in the general price index from the dates when the items
of income and expenses were initially recorded in the financial statements.
5. A gain or loss on the net m onetary position is included in net incom e . It should be disclosed separately.
The Standard does not establish an absolute rate at which hyperinflation is deemed to arise – but allows judgment as to when
restatement of financial statements becomes necessary. Characteristics of the economic environment of a country which
indicate the existence of hyperinflation include:
1. the general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency.
Amounts of local currency held are immediately invested to maintain purchasing power;
2. the general population regards monetary amounts not in terms of the local currency but in terms of a relatively stable
foreign currency. Prices may be quoted in that currency;
3. sales and purchases on credit take place at prices that compensate for the expected loss of purchasing power during
the credit period, even if the period is short;
4. interest rates, wages and prices are linked to a price index; and

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 5. the cumulative inflation rate over three years approaches, or exceeds, 100%
IAS 29 describes characteristics that may indicate that an economy is hyperinflationary. However, it concludes that it is a
matter of judgment when restatement of financial statements becomes necessary.
When an economy ceases to be hyperinflationary and an enterprise discontinues the preparation and presentation of financial
statements in accordance with IAS 29, it should treat the amounts expressed in the measuring unit current at the end of the
previous reporting period as the basis for the carrying amounts in its subsequent financial statements.

Functional Currency is the Currency of a Hyperinflationary Economy.

For an entity whose functional currency is the currency of a hyperinflationary econom y , and for which the
com paratives am ounts are translated into the currency of a different hyperinflationary shall be translated into a
different presentation currency using the following procedures:
a. All amounts (i.e., assets, liabilities, equity items, income and ex penses, including com paratives) shall be translated
at the closing rate at the date of the most recent balance sheet (i.e., last year’s comparatives, as adjusted for
subsequent changes in the price level, are translated at this year’s closing rate), except that
b. when amounts are translated into the currency of a non-hyperinflationary econom y , comparative amounts shall be
those that were presented in the prior year financial statements (i.e., not adjusted for subsequent changes in the price level
or subsequent changes in exchange rates)
Disposal of a foreign operation
Where a foreign entity is disposed of, any exchange differences that have been recognised in
other comprehensive income and accumulated in a separate component of equity are required to form part of the profit or loss
on disposal. Such amounts will therefore be reclassified from equity to profit or loss as a reclassification adjustment in the
period in which the disposal takes place. [IAS 21.48]

DERIVATIVES AND HEDGING ACTIVITIES

KEY ISSUES:

1. Derivatives are contracts that create rights and obligations that meet the definitions of assets and liabilities (thus these
rights and obligations are reported in the balance sheet - not in an “off-balance-sheet” manner).

2. Fair Value is the only relevant measure for reporting of derivatives, thus derivatives are reported in the balance sheet at
their fair values - whether or not they hedge an item.

3. Only items that are assets and liabilities are reportable on the balance sheet (thus losses on derivatives cannot be deferred
and reported as assets, likewise, gains on derivatives cannot be deferred and reported as liabilities).

4. Gains and losses on derivatives - Must be reported in earnings currently - except in certain specified situations in
which the gains and losses must be initially reported in the equity section. Furthermore, in certain specified situations in
which the gain or loss on the hedging transaction must be reported in earnings currently, the normal accounting for the
hedged item must be altered so that the offsetting loss or gain on the hedged item is also reported currently in earnings.
The accounting treatment for both types of these certain specified situations comprises what is collectively referred to as
“hedge accounting”.

Types of Derivatives
Derivatives can be generally categorized into one of the following categories:

Option-based derivatives (examples are option contracts, interest rate caps, and interest rate floors). Under these contracts,
it has a “one sided exposure” wherein the party can potentially have a favorable outcome for which it pays a premium at
inception; the other party can potentially have only an unfavorable outcome for which it is paid the premium at inception.
Consequently, only the downside risk on the hedged item is counterbalanced.

Forward-based derivatives (examples are forwards, futures, and swaps). Under these contracts, it has a “two-sided
exposure” wherein each party has a favorable or unfavorable outcome. Consequently, the downside risk and the upside
potential on the hedged item are counterbalanced.
Distinguishing between “Hedging” and “Hedge Accounting”

The word “hedging” is a broad and general term, it is a mean of minimizing risk. The simplest hedge is when an enterprise
takes out of foreign currency loan to finance a foreign currency investment. If the foreign currency strengthens, then the value
of the asset and the burden of the liability will increase by the same amount. Any gains or losses will be cancelled out.

Hedge accounting - recognizes symmetrically the offsetting effects on net profit or loss of changes in the fair values of the
hedging instrument and the related item being hedged. The hedging instrument will normally be a derivative.

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PAS 39 identifies three types of hedge:
Fair value hedge - this hedges against the risk of changes in the fair value of a recognized asset or liability or an
unrecognized firm commitment (or portion of such asset, liability, or firm commitment) attributable to a particular risk. Such
as the fair value of fixed rate debt will change as a result of changes in interest rates.
Cash flow hedge - this hedge against the risk of changes in expected cash flows. It is a hedge of the exposure to
variability in cash flows that is attributable to a particular risk associated with:
a. A recognized asset or liability such as future interest payments or variable-interest debt or
b. A highly probable forecasted transaction such as a forecasted sale or purchase that will affect future reported
profit or loss.

Hedge of a net investment in foreign operations

FORWARD CONTRACTS
A forward contract is an agreement between a buyer and a seller that requires the delivery of some commodity at a
specified future date at a price agreed to today (the exercise price). A typical example of forward contracts is Foreign Currency
Forward Contracts.
A foreign currency forward contract is an agreement to buy or sell a foreign currency at:
(1) A specified future date (usually within 12 months), and
(2) A specified exchange rate. This rate is called the forward rate.

At the inception of the contract, the forward rate normally varies from the spot rate. The difference between the two rates is
referred to as a discount (premium) if the forward rate is less than (greater than) the spot rate.

The use of forward contracts includes the following:

Hedges
a) Forward contracts used as a hedge of a foreign currency transaction. These include importing and exporting
transactions denominated in foreign currency. These hedges do not qualify for hedge accounting under PAS 39
because the foreign exchange gains and losses are already reported at market value on the balance sheet.
b) Forward contracts used as a hedge of an unrecognized firm commitment (This type of hedge are now treated as a
fair value hedges rather than cash flow hedges. However, PAS 39 par 87 clarifies that a hedge of the foreign
currency risk of a firm commitment can be treated as either a cash flow hedge or fair value hedge). Hedge
accounting rules apply. Both the change in the value of the hedge and the value of the hedged item are reported in
earnings (before the contract is reported in the books).

An example of an unrecognized firm commitment would be when the firm enters into a contract to purchase an
asset in two months for a fixed amount of foreign currency.

c) Forward contract used as a hedge of a foreign currency denominated forecasted transaction a cash flow hedge).
Initially foreign exchange gains and losses on the hedging instrument are recognized in equity, while no offsetting
amount is reported on the hedged item. Eventually, the exchange gains and losses will be reported in earnings in
the period, the hedged items affect earnings (i.e., if the item hedged is a forecasted purchase of inventory, the
gains and losses on the hedge will be reclassified) into earnings when inventory is sold, or when a forecasted
purchase of equipment, the gains and losses on the hedge will be reclassified into earnings as the equipment is
depreciated.)

An example of a forecasted transaction is a situation where the firm has planned sales receipts (expected to occur
in the near future) and uses the forward contract as a means to hedge the cash flow risk.

d) Forward contracts as a hedge of a net investment in foreign operations. A foreign currency transaction is considered
a hedge of a net investment in a foreign entity if the forward contract is designated as, and is effective as, a hedge
of the net investment. The gain or loss on the hedging instrument is reported in the equity the same manner as the
translation adjustment.

Speculation - Forward contracts used to speculate changes in foreign currency. Forward rate should be used because a firm
speculating in foreign currency changes is exposed to the risk of movements in the forward rate. Foreign exchange gains and
losses are reported currently in the income statement.

Hedge Accounting Summary

Fair value Hedge Cash Flow Hedge
Hedging Instrument (forward On balance sheet carried On balance sheet carried at Fair Value
contract) at Fair Value
Gain or loss on Hedging Recognized immediately in To the extent, the hedge is effective, recognized in
Instrument P&L EQUITY
The ineffective portion of the gain or loss will be reported
immediately in P & L.
Gain or loss on the HEDGED Recognized immediately in Not applicable forecasted transactions are not recognized.
ITEM due to hedged risk P & L.
Gain or loss in the EQUITY Not applicable If the item hedged is a forecasted purchase of inventory,
section is transferred to P & L the gains and losses on the hedge will be reclassified into
earnings when inventory is sold, or when a forecasted
purchase of equipment, the gains and losses on the hedge

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 will be reclassified, into earnings as the equipment is
depreciated.

Assessing Hedge Effectiveness

1. A hedge is highly effective (effectiveness) if there will be an approximate offset.

Changes in fair value Highly Changes in the fair

of the cash flows of the Offset value risk of the
hedged item (80% to hedging instrument
125%

2. Initial expectation must be that they “almost fully offset”

3. Actual offsetting within a range of 80% to 125% is acceptable.
4. Method of assessing hedge effectiveness depends on the documented risk management strategy.
5. No single method for assessing hedge effectives is prescribed, but time value of money should be considered (refer to
discussion of Split Accounting).

Split Accounting in Assessing/Measuring Hedge Effectiveness

PAS 39 requires all derivatives to be valued at their fair values. Thus, both the time value element and the intrinsic value
element are valued fair value. Accordingly, the need to determine the breakdown of the total fair value occurs only if split
accounting is used.

Intrinsic value may be viewed as being conceptually different from the time value; it theoretically can be accounted for
separately from the time value. Carving out the time value element and reporting its gain or loss separately from the manner of
reporting the intrinsic value element’s gain or loss is referred to as split accounting.

Intrinsic value is the incremental premium paid (difference between the spot price and the exercise price - to be placed in this
favorable position). The entire premium is called the time value (time value is analogous to a prepaid insurance that could be
amortized over the life of the option period.)

PAS 39 permits (but does nor require) an entity to exclude all or part of a derivative’s time value element in assessing hedge
effectiveness. Thus, split accounting (accounting for the time value element in a separate manner from the intrinsic value
element) is permitted.
For forward contracts purposes, time value element applies to premium and discounts on forward rates.
If hedge effectiveness were assessed by excluding time value element the presumed change in fair value of the foreign
currency commitment would be based on the change in the spot rate - not the change in the forward rate. Thus, one compares:
1. Only the foreign currency forward’s intrinsic value change (attributable to the change in the spot rate) with,
2. The change in the foreign currency commitment’s fair value using the change in the spot rate.

OPTION CONTRACTS
An option contract between two parties - the buyer and the seller - gives the buyer (option holder) the right, but not the
obligation, to purchase or sell something to the option seller (option writer) at a date in the future at a price agreed to at the
time the option contract is exchanged.
A foreign currency option contract is a contractual agreement giving the holder the right to buy or sell a given amount of
currency at a specified price (the exercise or strike price for a period of time or a point in time.
Option terminologies
1. Call is an option to buy
2. Put is an option to sell
3. Holder is the party having the right to buy or sell
4. From the perspective of the holder, the option contract is referred to as a Purchased Option.
5. Writer is the party that grants the holder this contractual right.
6. From the perspective of the writer, the option contract is referred to as a Written Option.

Foreign Currency Option Situations

Option Spot Market Price Equals the Spot Market Price is More Spot Market Price is Less
Exercise Strike Price (P = P10) than the Exercise Strike than the Exercise Strike
Price (P10 > P9) Price (P9 < P10)
Call (buy) At the money In the money Out of the money
Put (sell) At the money Out of the money In the money

In the money - the holder would exercise the option since it is favorable to the holder.

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Out of the money - the holder would not exercise the option since it is unfavorable to holder.

Accounting for Foreign Currency Option Premiums

Time Value Element - if at the inception of the foreign currency option, the option is either out of the money or at the
money, the entire premium is called the time value. The time value is analogous to a prepaid insurance premium that could be
amortize to income over the life of the option period.

Intrinsic Value - on the other hand, if at the inception of the foreign currency option, the option is in the money, the option
holder will have paid a higher premium - the incremental amount equaling - the difference between spot market price and the
exercise strike price - to be placed in this favorable position. This incremental premium paid is called the foreign currency’s
intrinsic value.

FUTURES CONTRACT
A futures contract is the same thing with forward contracts except that instead of being negotiated between two parties, the
contract is a standard one that is sponsored by an organized exchange. With a futures contract, the exchange handles the cash
settlements between the two parties to the contract. Accordingly, with a futures contract, the two parties to the agreement
almost never directly contact one another. This is not true with forward contracts because they are directly negotiated between
the two parties.

SWAP
A sw ap is a contract in which two parties agreed to exchange payments in the future based on the movement of some agreed-
upon price or rate. It is a hedging instrument used in managing interest-rate exposure.
The most common type of swap is an interest rate sw ap . In an interest rate swap, two parties agree to exchange future
interest payments on a given loan amount; usually, one set of interest payments is based on fixed interest rate and the other is
based on a variable interest rate.
Sw aps, forw ards, and futures provide tw o-sided protection . If these derivative instruments are used in a hedging
relationship, they hedge against both increases and decreases in prices or rates. An option provides one-sided hedging :
protection against unfavorable movements in prices or rates without taking away the ability of the firm to profit from a favorable
movement in prices or rates. Because of the one-sided nature of an option, an option has value at the agreement date and the
buyer of the option must pay this amount a the beginning of the contract period.

QUIZZER: FOREX/HEDGING
1. CRC Company, a Philippine Corporation, bought inventory from a supplier in Japan on November 2, 2017 for 50,000 yen,
when the spot rate was P.4245. On December 31, 2017, the spot rate was P.4295. On January 15, 2018, CRC bought
50,000 yen at a spot rate of P.4250 and paid the invoice. How much should CRC report in its income statements for (1)
2017 and (2) 2018 as foreign exchange gain or (loss)
a. (1) P250; (2) (P225) c. (1) P0; (2) (P225)
b. (1) (P250); (2) P225 d. (1) P0; (2) P220

2. On July 1, 2017, ACE Corporation borrowed 1,680,000 yen from a Japanese Lender evidenced by an interest-bearing note
due July 1, 2018. The Philippine Peso equivalent of the note principal was as follows:
July 1, 2017 - Date borrowed P210,000
Dec. 31, 2017 - ACE’s year-end 240,000
July 1, 2018 - Date repaid 280,000
In its income statement for 2018, what amount should ACE include as a foreign Exchange gain or loss?
a. P70,000 gain c. P40,000 gain
b. P70,000 loss d. P40,000 loss

3. On July 1, 2017, ACCENTURE Company lent P308,000 to a US supplier, evidenced By an interest-bearing-note due on July
1, 2018. The note is equivalent to $8,000 on the loan date. The note principal was appropriately included at P328,000 in
ACCENTURE’s December 31, 2017 balance sheet. The note was repaid to ACCENTURE on July 1, 2018. Due date when the
exchange rate was P39 to $1. In its income statement for the year Ended December 31, 2018 what amount should
ACCENTURE company include As a foreign currency transaction gain or loss?
a. P0 c. P16,000 gain
b. P26,000 gain d. P16,000 loss

4. Certain balance sheet accounts of a foreign subsidiary in FIL-AM, Inc at December 31, 2018 have been translated into
Philippine pesos as follows:
Current rate Historical Rate
Accounts receivable P120,000 P100,000
Prepaid insurance 55,000 50,000
Copyright 75,000 85,000
What was the total amount included in FIL-AM’s December 31, 2018 consolidated balance sheet for the above accounts?
a. P255,000 c. P240,000
b. P235,000 d. P250,000

5. Matthew, a money changer speculate in foreign currency as his business. On October 1, 2017, Matthew bought a 180-day
forward contract to purchase 5, 000 FC at a forward rate of FC1= P56.50 when the spot rate was P56.00. Other exchange
rates were as follows:
Spot Rate Forward Rate for March 31, 2018
Dec. 31, 2017 P56.30 P56.60
Mar. 31, 2018 56.32

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 The forex gain (loss) recognized by Matthew from this forward contract is:
a. P1,500 c. P500
b. P(900) d. P(10,000)

6. The following information applies to WAYA Corporation’s sales of 10,000 foreign currency units under a forward contract
dated November 1, 2017, for delivery on January 31, 2018:

November 1, 2017 December 31, 2017

Spot rate P0.80 P0.83
30-day futures 0.79 0.82
90-day futures 0.78 0.81

WAYA entered into a contract to speculate in the foreign currency. In WAYA’s income statement for the December 31, 2017,
what amount of forex should be reported from this forward contract?
a. P100 c. P200
b. P300 d. P(400)

Items 7 through 16 are based on the following information:

On October 1, 2017 ABC Corp. ordered a custom-built equipment from a Japanese firm. The purchase order is
noncancelable. The purchase price is 1,000,000 yens with delivery and payment to be on March 31, 2018. On October 2,
2017, ABC Corp. entered into a forward contract to buy 1,000,000 yens on March 31, 2018 for P.53. On March 31, 2018,
the custom-built passenger van was delivered:

October 1, December 31, March 31,

2017 2017 2018
Spot rate (yen) P .50 P .56 P .57
Forward rate (yen) .53 .58

7. The December 31, 2017 profit and loss statement, foreign exchange gain or loss on hedged/item commitment amounted to
a. P50,000 loss c. P60,000 loss
b. P50,000 gain d. P60,000 gain

8. The December 31, 2017 profit and loss statement, foreign exchange gain or loss on the hedging instrument (forward
contract) amounted to .
a. P50,000 loss c. P60,000 loss
b. P50,000 gain d. P60,000 gain
9. The Firm Commitment account balance as shown in the December 31, 2017 balance sheet amounted to_.
a. P50,000 asset c. P50,000 liability
b. P60,000 liability d. None, since it is a fair value hedge
10. The December 31, 2017 profit and loss statement, net foreign exchange gain or loss amounted to.
a. P10,000 net gain c. Zero
b. P10,000 net loss d. Not applicable since hedge accounting does not apply
11. The December 31, 2017 Accounts Payable amounted to
a. P500,000 c. P580,000
b. P530,000 d. None, since there is no transaction yet.
12. The December 31, 2017 Foreign Currency Receivables from Exchange Dealer amounted to
a. P580,000 b. P560,000 c. P530,000 d. P500,000
13. On March 31, 2018, foreign exchange gains or loss on hedged item/commitment amounted to
a. P10,000 gain c. P7,000 loss
b. P10,000 loss d. P4,000 loss
14. On March 31, 2018, foreign exchange gains or loss on the hedging instrument (forward contract) amounted to
a. P10,000 gain c. P7,400 gain
b. P10,000 loss d. P4,000 gain
15. The Firm Commitment account balance on March 31, 2018 amounted to
a. P10,000 asset c. P40,000 asset
b. P50,000 liability d. P40,000 liability
16. The value of the equipment on March 31, 2018 amounted to
a. P500,000 b. P530,000 c. P560,000 P570,000

Items 17 through 23 are based on the following information:

On October 12, 2017, DEF Corp. obtained a noncancelable sales order from a Thailand firm for a custom-made machine.
The contract price was 100,000 baht. On October 12, 2017 DEF Corp. entered into a foreign exchanged forward to sell
100,000 baht in 100 days at the forward rate of P3.15. The machine was delivered on December 11, 2017 and collection
on January 20, 2018.

10/12/2017 12/11/2017 12/31/2017 1/20/2018

Spot rate (baht) P 3.20 P 3.00 P 3.09 P 2.97
Forward rate (baht) 3.15 2.98 3.08

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17. The December 11, 2017 profit and loss statement, foreign exchange gain or loss on the hedging item/commitment
amounted to
a. P17,000 loss c. P20,000 loss
b. P17,000 gain d. P20,000 gain
18. The December 11, 2017 profit and loss statement, foreign exchange gain or loss on the hedging instrument (forward
contract) amounted to
a. P17,000 loss c. P20,000 loss
b. P17,000 gain d. P20,000 gain
19. What is the reportable sales amount in the income statement in 2017
a. P300,00 b. P308,000 c. P309,000 d. P317,000
20. The December 31, 2017 Accounts receivable amounted to
a. P298,000 b. P300,000 c. P309,000 d. P320,000

21. On December 31, 2017 the foreign exchange gain or loss on the amount receivable amounted to
a. P9,000 loss c. P10,000
b. P9,000 gain d. P11,000 loss

22. On December 31, 2017 foreign exchange gains or loss on the hedging instrument (forward contract) amounted to
a. P7,000 gain c. P9,000 gain
b. P7,000 loss d. P11,000 loss
23. On January 20, 2018, the net foreign exchange gain or loss amounted to
a. P 0 c. P1,000 net gain
b. P2,000 net gain d. P1,000 net loss

Items 24 through 28 are based on the following information:

On December 16, 2017 GHI Corp sold merchandise to a JKL Co. of Malaysia. Payment of 1,000,000 Malaysian Ringgit is
due on February 14, 2018. GHI simultaneously paid P 4,000 cash to acquire a 60-day put option for 1,000,000 Malaysian
Ringgit. GHI uses calendar basis for reporting:
12/16/2017 12/31/2017 2/14/2018
Spot rate (market price) P .16 P .15 P .147
Strike price (exercise price) .16 . 16 . 16
Fair value of put option P 4,000 P 13,300 P 13,000

24. The December 31, 2017 Accounts Receivable amounted to

a. P160,000 c. P147,000
b. P150,000 d. None, since there is no transaction yet.
25. The December 31, 2017 Foreign Currency Contract Value – Option amounted to
a. P1,000 b. P4,000 c. P13,000 d. P13,300
26. The December 31, 2017 net foreign exchange gain or loss amounted to
a. P700 loss – equity c. P700 loss – current earnings
b. P1,000 loss – current earnings d. P700 gain – current earnings
27. The February 14, 2018 expiration date, net/total foreign exchange gain or loss amounted to
a. P3,300 loss – equity c. P3,300 gain – equity
b. P700 loss – earnings d. P3,300 loss – current earnings
28. The February 14, 2018 expiration date, Foreign Contract Value – Option amounted to
a. P1,000 b. P4,000 c. P13,000 d. P13,300

Items 29 through 35 are based on the following information:

On January 1, 2018, MNO Corp. paid P 16,000 cash to acquire a put foreign exchange option for 1,000,000 Thailand baht
valid until December 31, 2018. The option hedge’s 2018’s forecasted exporting sales of 1,000,000 baht. MNO Corp. fiscal
year ends June 30:
1/1/2018 6/30/2018 12/31/2018
Spot rate (market price) P 1.20 P 1.12 P 1.15
Strike price (exercise price) 1.19 1.19 1.19
Fair value of put option at 6/30/2018 P 81,000

29. Calculate the option’s time value at inception

a. P81,000 b. P16,000 c. P10,000 d. P6,000
30. Calculate the intrinsic value at inception
a. P16,000 b. P10,000 c. P6,000 d. P0
31. The June 30, 2018 Foreign Currency Contract Value – Option amounted to
a. P6,000 b. P10,000 c. P16,000 d. P81,000
32. The June 30, 2018 foreign exchange gain or loss amounted to
a. P65,000 loss – equity c. P65,000 gain – equity
b. P81,000 gain – equity d. P65,000 gain - earnings
33. The December 31, 2018 foreign exchange gain or loss to be recognized in current earnings if zero export sales for 2018
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 a. zero b. P26,000 c. P39,000 d. P65,000
34. The December 31, 2018 foreign exchange gain or loss to be recognized in current earnings if export sales of 1,000,000
baht – all occurred in December 2018
a. None b. P26,000 c. P39,000 d. P65,000
35. The December 31, 2018 foreign exchange gain or loss to be recognized in current earnings if export sales of 1,000,000
baht – 60% of which occurred in the first six months
a. None b. P26,000 c. P39,000 d. P65,000

Items 36 through 41 are based on the following information:

On January 1, 2018, PQR paid P 17,000 cash to acquire a call foreign currency option for 1,000,000 Indonesian Rupiah,
to expire on December 31, 2018. The option hedges 2006 forecasted importing purchases of 1,000,000 Indonesian
Rupiah. A June 30, 2018, import purchases totaled 750,000 Indonesian Rupiah, of which 600,000 Indonesian Rupiah had
been resold to Philippine customers. The firm’s accounting period ends June 30.
1/1/2018 6/30/2018 12/31/2018
Spot rate (market price) P 1.15 P 1.18 P 1.17
Strike price (exercises price) 1.14 1.14 1.14
Fair value of call option at 6/30/2018 P 44,000

36. Calculate the option’s time value at inception

a. P 0 b. P7,000 c. P10,000 d. P17,000

37. Calculate the intrinsic value at inception

a. P 0 b. P7,000 c. P10,000 d. P17,000

38. The June 30, 2018 Foreign Currency Contract Value – Option amounted to
a. P17,000 b. P27,000 c. P30,000 d. P44,000

39. The June 30, 2018 foreign exchange gain or loss to be recognized in equity amounted to
a. P5,400 gain b. P5,400 loss c. P27,000 gain d. P 0

40. The June 30, 2018 foreign exchange gain or loss to be recognized in current earnings
a. P5,400 gain b. P21,000 loss c. P21,600 gain d. P27,000 gain

41. The December 31, 2018 foreign exchange gain or loss to be recognized in current earnings
a. P5,400 gain b. P8,600 gain c. P8,600 loss d. P21,600 gain

Items 42 and 43 are based on the following information:

A Philippine firm entering into speculative purposes in anticipation for a gain, enters into a contract on March 1, 2017 to
acquire US$10,000 on March 1, 2018, a currency in which the company has no receivable, payables or commitments.
Spot Rate Forward Rate (for 3/1/2018)
March 1, 2017 P55.00 P 56.00
December 31, 2017 55.60 P 56.50
March 1, 2018 55.10
 Interest was not considered noteworthy, assume that the effects of discounting are insignificantly thus, ignore affects of
discounting or present value.
42. The December 31, 2017 profit and loss statement, foreign exchange gain or loss due to hedging instrument (forward
contract) amounted to
a. P14,000 loss b. P5,000 gain c. P5,000 loss d. P14,000 gain
43. On March 1, 2018, foreign exchange gains or loss on forward contract amounted to:
a. P14,000 loss b. P5,000 gain c. P5,000 loss d. P14,000 gain

Items 44 through 50 are based on the following information:

On December 1, 2017, Lehman Company paid cash to purchase 90-day call option for 500,000 Pakistan Rupee. The
option’s purpose is to protect an exposed liability of 500,000 Pakistan Rupee relating to an inventory purchase receive on
December 1, 2017 and to be paid on March 1, 2018
12/1/2017 12/31/2017 3/1/2018
Spot rate (market price) P1.20 P1.28 P1.27
Strike price (exercise price) 1.20 1.20 1.20
Fair value of call option P3,000 P42,000 P35,000

44. The notional amount of the option should be:

a. 500,000 b. P3,000 c. P35,000 d. P42,000
45. The fair value of call option on December 1, 2017?
a. P0 b. P3,000 c. P35,000 d. P42,000
46. What is the intrinsic value (IV) and the (TV) of option on December 1, 2017
Intrinsic Value Time Value Intrinsic Value Time Value
a. P0 P 0 c. P3,000 P0
b. 3,000 40,000 d. 0 3,000 *

47. What is the intrinsic value (IV) and the (TV) of option on December 31, 2017
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 Intrinsic Value Time Value Intrinsic Value Time Value
a. P40,000 P2,000 c. P42,000 0
b. 2,000 40,000 d. 0 P42,000

48. What is the intrinsic value (IV) and the (TV) of option on March 1, 2018
Intrinsic Value Time Value Intrinsic Value Time Value
a. P42,000 0 c. P35,000 0
b. 40,000 2,000 d. 0 P35,000
49. The foreign exchange gain or loss on option contract (hedging instrument) on December 31, 2017 if changes in the time
value will be included from the assessment of hedge effectiveness (nonsplit accounting) should be
a. P1,000 loss b. P1,000 gain c. P39,000 gain d. P40,000 gain

50. The foreign exchange gain or loss on option contract (hedging instrument) due to change in intrinsic value on December
31, 2017 if changes in the value will be excluded from the assessment of hedge effectiveness (split accounting) should be:
a. P1,000 loss b. P1,000 gain c. P39,000 gain d. P40,000 gain

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