Reference no: EM131007277
A conceptual question in accounting for derivatives is: Should gains and losses on a hedge instrument be recorded as they occur, or should they be recorded to coincide (match) with income effects of the item being hedged?
ABI Wholesalers plans to issue long-term notes in May that will replace its $20 million of 9.5% bonds when they mature in July. ABI is exposed to the risk that interest rates in July will have risen, increasing borrowing costs (reducing the selling price of its notes). To hedge that possibility, ABI entered a (Treasury bond) futures contract in May to deliver (sell) bonds in July at their current price.
As a result, if interest rates rise, borrowing costs will go up for ABI because it will sell notes at a higher interest cost (or lower price). But that loss will be offset (approximately) by the gain produced by being in the opposite position on Treasury bond futures.
Two opposing viewpoints are:
View 1: Gains and losses on instruments designed to hedge anticipated transactions should be recorded as they occur.
View 2: Gains and losses on instruments designed to hedge anticipated transactions should be recorded to coincide (match) with income effects of the item being hedged.
In considering this question, focus on conceptual issues regarding the practicable and theoretically appropriate treatment, unconstrained by GAAP. Your instructor will divide the class into two to six groups depending on the size of the class. The mission of your group is to reach consensus on the appropriate accounting for the gains and losses on instruments designed to hedge anticipated transactions.
Required:
1. Each group member should deliberate the situation independently and draft a tentative argument prior to the class session for which the case is assigned.
2. In class, each group will meet for 10 to 15 minutes in different areas of the classroom. During that meeting, group members will take turns sharing their suggestions for the purpose of arriving at a single group treatment.
3. After the allotted time, a spokesperson for each group (selected during the group meetings) will share the group's solution with the class. The goal of the class is to incorporate the views of each group into a consensus approach to the situation.
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