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(Embedded Derivatives) Olongapo Company invests P2,000,000 in a convertible debt instrument issued by
Subic Corporation in 5 years at Olongapo’s option. Otherwise, the bond will pay P2,000,000 at maturity. The
estimated fair value of the conversion option at initial recognition is P260,000.
Required: Prepare the journal entry on the books of Olongapo Company to record the acquisition of investment
under the following assumptions:
1. The investment is classified as held for trading.
2. The investment is classified as available for sale.
3. The investment is classified as held to maturity.
2. (Effectiveness Range) Wallnut Company loss P150 on a hedging and had a corresponding gain on the hedged
item of P100. The effectiveness range for these associated transactions is:
a. 67%-150% b. 100%-150% c. 20%-30% d. 0%-15%
3. (Closely Related) On March 31, 20X9, Square Company entered into a lease contract that has a rent adjustment
clause based on inflation. The contract requires Square Company to pay a monthly rent of P200,000 for a period
of five years. On March 31, 20X9, the fair value of the derivative contract is P40,000 on December 31, 20X9; it has
a fair value of P80,000. What amount of a derivative Square Company should recognize separately in its
December 31, 20x9 statement of financial position?
a. P200,000 b. P40,000 c. P80,000 d. P0
Problem No. 1 Interest Rate Swap (Cash Flow Hedge)
On January 1, 20X1, Bataan Venturers, Inc. received a three-year, P1 million loan with interest payments due at the
end of each year and the principal to be repaid on December 31, 20X3. The interest rate for the first year is the
prevailing market rate of 9 percent, and the rate each succeeding year will be equal to the prevailing market rate
on January 1 of that year.
Bataan also entered into an interest rate swap agreement related to this loan. Under the terms of the swap
agreement, in the years 20X2 and 20X3, Bataan will receive a swap payment based on the principal amount of P1
million.
If the January 1 interest rate is greater than 9 percent, Bataan will received a swap payment for the difference; and
if the January 1 interest rate is less than 9 percent, Bataan will make swap payment for the difference. The swap
payments are made on December 31 of each year.
On January 1, 20X2, the interest rate is 8 percent, and on January 1, 20X3, the interest rate is 12 percent.
Required: Prepare all the journal entries necessary on Bataan’s book at the dates show below. For purposes of
estimating future swap payments, assume that the current interest rate is the best forecast of the future interest
rate (round all entries to nearest peso).
(1) January 1, 20X1 (3) December 31, 20X2
(2) December 31, 20X1 (4) December 31, 20X3
Problem No. 2 Interest Rate Swap (Fair Value Hedge)
On January 1, 20X1, C Company borrowed P5,000,000 from a bank at a 10% fixed interest rate with interest to be
paid annually on December 31 of each year and the principal to be repaid on December 31,20X3. The loan is
evidenced by a promissory note.
On January 1, 20X1, the entity entered into a “received fixed, pay variable” interest rate swap with a speculator and
has designated the swap as a fair value hedge and the fixed interest rate loan. The market rate of interest on
January 1 of each year determines the interest swap settlement to be made every December 31.
This means that C Company will make a swap payment if the market rate of interest on January 1 is higher than
the 10% fixed rate, and will receive a swap payment if the market rate of interest on January 1 is lower than the
10% fixed rate.
Observed that this is the reverse of the “received variable, pay fixed” interest rate swap.
The market rates of interest are as follows:
January 1, 20X1 10%
January 1, 20X2 12%
January 1, 20X3 14%
PV of 1 @12% for two periods .7972; PV of OA of 12% @ 2 periods 1.69; PV of 1@14% for 1 period .8772
Required: Prepare the necessary entries on the books of C Company.

Quizzer 1 On January 1, 20X1, Mercy Company borrowed P5,000,000 from a bank at a variable rate of interest for
2 years. Interest will be paid annually to the bank on December 31 and the principal is due on December 31, 20X2.
Under the agreement, the market rate of interest every January 1 resets the variable rate for that period and the
amount of interest to be paid on December 31. In conjunction with the loan, Carla Company entered into a
“receive variable, pay fixed” interest rate swap agreement with another bank speculator as a cash flow hedge. The
market rates of interest are 10% on January 1, 20X1 and 14% on January 1, 20X2. The “underlying” fixed interest
rate is 10%. What is the derivative asset or liability on December 31, 20X1? The PV of 1 at 10% for one period is
.91and the PV of 1 at 14% for one period is .88.
a. P176,000 asset b. P176,000 liability c. P182,000 asset d.P182,000 liability
Quizzer 2 On January 1, 20X1, Minerva Company received a four-year P5,000,000 loan with interest payments
occurring at the end of each year and the principal to be repaid on December 31, 2013. The interest for 20X1 is
the prevailing market rate of 10% on January 1, 20X1, and the market interest rate every January 1 resets the
variable rate of interest for that year. The “underlying” fixed interest rate is 10%. In conjunction with the loan,
Minerva Company entered into a “receivable variable, pay fixed” interest rate swap agreement as cash flow
hedge. The interest payment will be made on December 31 of each year. The market rate of interest is 7% on
January 1, 20X2. What is the derivative asset or liability on December 31, 20X1? The PV of an ordinary annuity of 1
at 7% for three periods is 2.62.
a. 140,250 asset b. P140,250 liability c. P393,000 asset d. P393,000 liability
Quizzer 3 Sherrylyn Company operates a chain of seafood restaurants. On July 1, 20X1, Sherrylyn determined that
it will need to purchase 50,000 kilos of deluxe fish on July 1, 20X2. Because of the volatile fluctuation in the price
of deluxe fish, on July 1, 20X1, Sherrylyn negotiated a forward contract as a cash flow hedge with a reputable bank
for Sherrylyn to purchase 50,000 kilos of deluxe fish on July 1, 20X2 at a strike price of P50 per kilo or P2,500,000.
This derivative forward contract provides that if the market price of deluxe fish on July 1, 20X2 is more than P50,
the difference is paid by the bank to Sherrylyn. On the other hand, if the market price on July 1, 20X2 is less than
P50, Sherrylyn will pay the difference to the bank. The market price per kilo of the deluxe fish is P55 on December
31, 20X1 and P65 on July 1, 20X2. What is the derivative asset or liability on December 31, 20X1?
a. P750,000 asset b. P750,000 liability c. P250,000 asset d. P250,000 liability
Quizzer 4 Liane Company requires 100,000 kilos of raw material in its operations. To eliminate the price risk
associated with the raw material purchases, On October 1, 20X1, Liane entered into a future contract as a cash
flow hedge to buy 100,000 kilos of raw materials on July 1, 20X2. The future strike price is P50 per kilo. The future
contract is managed through an exchange, so Liane does not know the other party on the other side of the
contract. As with most derivative contracts, this future contract is settled by an exchange of cash side of the
contract. As with most derivative contracts, this future contract is settled by an exchange of cash on July 1, 20X2
based on the price of raw material on that date. The market price per kilo is P48 on December 31, 20X1 and P45
on July 1, 20X2. What is the derivative asset or liability on December 31, 20X1?
a. P200,000 asset b. P200,000 liability c. P500,000 asset d. P500,000 liability
Quizzer 5 Zyra Company makes colorful 100% cotton shirts that are very popular among sophisticated business
executives. Zyra uses 50,000 kilos of raw materials in its production process. On December 1, 20X1, Zyra
purchased a call option as a cash flow hedge to buy 50,000 kilos on July 1, 20X2. The option strike price is P100
per kilo. Zyra paid P50,000 for the call option. This derivative option contract means that if the market price is
higher than P100, Zyra can exercise the option and buy the asset at the strike option price of P100. If the market
price is lower than P100, Zyra can throw away the option and buy the asset at the cheaper price. The market price
per kilo is P110 on December 31, 20X1 and P115 on July 1, 20X2. What is the derivative asset on December 31,
20X1?
a. P500,000 b. P450,000 c. P750,000 d. P700,000