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CPA Exam Review - BEC > BEC 1 > Flashcards

BEC 1 Flashcards

1
Q

What is COSO?

A

Committee of Sponsoring Organizations. An independent “private sector” initiative initially established in the 1980s to study factors that lead to fraud.

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2
Q

Why did COSO release “Internal Control” - Integrated Framework?

A

To assist organizations in developiong comprehensive assessments of internal control effectiveness.

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3
Q

How many objectives, components and principles are in the COSO internal controls framework?

A

3 objectives, 5 components, 17 principles.

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4
Q

Who uses the framework?

A

Company management and the Board create the framework to obtain an initial understanding of what constitutes an effective system of internal control and to provide insight as to when internal controls are being properly applied within an organization. The framework also provides confidence to external stakeholders that an organization has a system of internal control in place that is conducive to achieving its objectives.

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5
Q

What does an effective system of internal control require of management?

A

More than the adherence to policies and procedures by managment, the board, and internal auditors. It requires the use of judgement. Not black and white, thus not rules-based.

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6
Q

Define Internal Control

A

Process that is designed and implemented by an organization’s management, board, and other employees to provide reasonable assurance that the organization will achieve its operating, reporting, and compliance objectives.

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7
Q

What areas does the framework assist an entity’s management and board of directors (internal takeholders)?

A
  • Effectively applying internal controls
  • Determining requirements of an effective system of internal controls.
  • Allowing judgement and flexibility in its designe and implementation within all operation and functional ares.
  • Identifying and analyzing risks, developing responses.
  • Eliminating redundant, ineffective, or inefficient controls.
  • Extending internal control application beyond organization’s financial reporting.
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8
Q

How does the framework provide value to external stakeholders?

A
  • Understanding of effective internal controls.
  • Confidence in management’s management of controls.
  • Confidence in Board Oversight.
  • Confidence orgnization will achieve objectives and will be capable of identifying, analyzing, and responding to risks.
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9
Q

Name the categories of objectives.

A

ORC:

  • Operating
  • Reporting
  • Compliance
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10
Q

Name the internal control components.

A

CRIME:

  • Control environment.
  • Risk Assessment
  • Information and Communication
  • Monitoring Activities
  • (Existing) Control Activities
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11
Q

Name the basic levels of organizational structure.

A

Entity level, division, operating unit, and function.

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12
Q

Operational Objectives relate to what? And ensure what?

A

Relate to effectiveness and efficiency of an entity’s’ operations. Includes financial and operation performance goals as well as ensuring that the assets of the organization are adequately safeguarded againast potential losses.

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13
Q

Reporting Objectives pertain to what?

A

Pertain to reliability, timeliness, and transparency of an entity’s external and internal financial and nonfinancial reporting as established by regulators, accounting standard setters, or firm’s internal policies.

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14
Q

Compliance Objectives ensure what?

A

Ensure the entity is adhering to all apllicable laws and regulations (in all countries and states).

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15
Q

What is needed to achieve the three objectives of internal control (ORC)?

A

CRIME. The five components of internal control.

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16
Q

Name and describe the five compenents of internal control (CRIME).

A

Control Environment - Tone @ top, ethics.
Risk Assessement - Financial statements misstated, not efficient, breaking law.
Information and Communication - Fair, accurate, complete, timely (FACT).
Monitoring Activities - Effectiveness of controls or report deficiencies.
(Existing) Control Activities - Policies/Procedures to mitigate risks.

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17
Q

What are the principles related to the control environment?

A

EBOCA (5)

  1. Committment to ethics and integrity.
  2. Board Independence and Oversight
  3. Organizational Structure.
  4. Committment to competence.
  5. Accountability
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18
Q

What are the principles related to risk assessment?

A

SAFR (4)

  1. Specify objectives
  2. Identify and analyze risks.
  3. Consider the potential for fraud.
  4. Identify and Assess changes.
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19
Q

What are the principles related to information and communcation?

A

OIE (3)

  1. Obtain useful information.
  2. Internally communication information.
  3. Communicate with external parties.
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20
Q

What are the principles related to monitoring activies?

A

SOD (2)

  1. Ongoing and Separate Evaluations.
  2. Communication of deficiencies.
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21
Q

What are the principles related to (existing) control activities?

A

CA T P (3)

  1. Select and develop control activities.
  2. Select and develop technology control.
  3. Deployment of policies and procedures.
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22
Q

What are the general requirements of effective internal control?

A

Effective system of internal control provides “reasonable” assurance that the entity’s objecttives will be achieved.

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23
Q

What does an organization want all five compenents and 17 principles that are relevant to be?

A

Present and functioning. Also, that all five components operate together as an integrated system in order to reduce risk that an entity will not ahieve its objectvies.

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24
Q

Define present (design).

A

Compenents and relevant principles are included in teh design and implementation of the internal control system.

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25
Q

Define functioning (operating effectively).

A

Components and relevant principles are currently operating as designed in the internal control system.

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26
Q

To be considered an effective system of internal control, seniot management and the board must have reasonable assurance that the entity:

A
  • Achieves effective and efficient operations.
  • Understands the extent to which operations are managed effectively and efficiently.
  • Complies with all applicable rules, regulations, external standards, and laws.
  • Prepares reports that are in conformity with the entity’s reporting objectives and all applicable standards, rules and regulations (FACT).
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27
Q

What must senior management and the board do to make sure that the entity achieves effective and efficient operations?

A
  • Make external threats unlikely to have a significant impact on the achievement of objectives.
  • The organization can reasonably predict and mitigate the impact of external events to an acceptable level.
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28
Q

Why must senior management and the board understand the extent to which operations are managed effectively and efficiently?

A
  • External events may have a significant impact on the achievement of objectives.
  • The organization can reasonably predict and mitigate the impact of external events to an acceptable level.
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29
Q

What do ineffective internal controls increase?

A

The risk that ORC (objectives) are not achieved goes ↑.

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30
Q

What is a major deficiency?

A

Represets a matieral internal control deficiency, or a combination of deficiencies, that significantly reduces the likelihood that an organization can achieve its objectives.

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31
Q

What can an entity not conclude when a major deficiency has been found?

A

That the company has met the requirements for an effective internal control system under the COSO framework.

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32
Q

What are the inherent limitations that may exist even in a n effective internal control system?

A
  1. Breakdowns in internal control due to errors or human failure.
  2. Faulty or biased judgment used in decision-making.
  3. Issues relating to the suitability of the entity’s objectives.
  4. External events beyond the control of the entity.
  5. Circumvention of controls through collusion.
    Management override of internal controls.
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33
Q

Define risk (according to COSO).

A

The possibility that an event will occur and adversely affect the achievement of objectives.

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34
Q

Why did COSO issues Enterprise Risk Management (ERM)?

A

To assist organizations in developing a comprehensive response to risk management.

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35
Q

What is the underlying premise of ERM?

A

Every entity exists to provide value for stakeholders, that all entities face uncertainty, and that management must determine how much uncertainty to accept as it strives to grow stakeholder value.

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36
Q

What is the intent of ERM?

A

To allow management to effectively deal with uncertainty, evaluate risk acceptance, and build value.

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37
Q

When is value maximized?

A

When strategy balances risks and returns as well as efficiency and effectiveness in accomplishing objectives.

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38
Q

Define enterprise risk management.

A

Process effected by an entity’s board, management, and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events the entity, and manage risk to be within its risk appetite, to provide reasonable assirance regarding the achievement of entity objectives.

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39
Q

What are the ERM framework themes?

A
  1. Aligning risk appetite and strategy.
  2. Enhancing risk response decisions.
  3. Reducing operational surprises and losses.
  4. Identifying and managing multiple and cross-enterprise risks.
  5. Seizing opportunities.
  6. Improving deployment of capital.
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40
Q

Name and describe the enterprise objectives?

A

S + ORC

  1. Strategic - high-level goals designed to achieve the mission.
  2. Operations - Achievement of objectives through the effective and efficient use of resources.
  3. Reporting - Achievement of reliable and consistent reporting.
  4. Compliance - Ensuring compliance with laws and regulations.
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41
Q

What are the components of Enterprise Risk Management?

A

IS EAR AIM

  1. Internal environment.
  2. Setting objectives.
  3. Event identification.
  4. Assessment of risk.
  5. Risk response.
  6. control Activities.
  7. Information and communication.
  8. Monitoring
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42
Q

Internal Environment =

A

Control Enviroment (EBOCA)

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43
Q

Risk Assessement =

A

SEAR

1. Setting objectives, event identification, assessment of risk and response (SAFR)

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44
Q

Control Activites =

A

CA T P

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45
Q

Information and communication =

A

OIE

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46
Q

Monitoring =

A

SO D

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47
Q

Elements of Internal Environment

A

EBOCA + HRR

  1. commitment to Ethical values and integrity.
  2. Board oversight
  3. Organizational structure.
  4. commitment to Competence.
  5. assignment of Authority and responsibility.
  6. Risk management philosophy.
  7. Human resources standards.
  8. Risk appetite.
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48
Q

Elements of Objective Setting

A
  1. Strategic objectives
  2. Related objectives
    a. Operations objectives
    b. Reporting objectives
    c. Compliance objectives.
  3. Selected Objectives
  4. Risk appetite
  5. Risk tolerance
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49
Q

Elements of event identification

A
  1. Events
  2. Influencing factors (internal and external)
  3. Event identification techniques (forecast event in advance).
  4. Event interdependencies (how change ins ind. variable affects dep. variable).
  5. Event categories (External and internal)
  6. Distinguishing risks and opportunities.
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50
Q

Elements of Risk assessment

A
  1. Inherent and residual risk
  2. Establishing likelihood and impact.
  3. Data sources.
  4. Assessment techniques
  5. Event relationships
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51
Q

Elements of risk response.

A
  1. Evalutation posible responses (ARSA)
  2. Selected responses.
  3. Portfolio view.
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52
Q

Elements of control activities.

A
  1. Integration with risk response
  2. Types of control activities
  3. Controls over information systes
  4. Entity-specific controls
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53
Q

Information and Communication

A
  • Information is needed at all levels of an organization to manage risks.
  • Communication is internal and external.
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54
Q

Elements of monitoring

A
  1. Ongoing monitoring activities
  2. Separate evaluations.
  3. Reporting deficiencies.
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55
Q

When is ERM effective?

A

It is a matter of judgment resulting from an assessment of whether the eight components are present and functioning effectively.

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56
Q

What are the elements of effectiveness?

A

IS EAR AIM (8)

  • Each component must be present and functioning.
  • No material weaknesses.
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57
Q

What is the significance of effective ERM?

A
  • Management and the board have reasonabl assurance that they understand the extent to which the entity’s strategic and operating objectives are being achieved, and reporting is reliable and applicable laws and regulations are being complied with.
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58
Q

What are some limitations of ERM?

A

Human judgment limitations include faulty decisions, simples errors or mistakes, collusion, and management override.

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59
Q

WHAT does ARSA stand for?

A

Avoid (terminate)
Reduce (invest)
Share (Insurance)
Accept (Do nothing…for now)

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60
Q

What were the goals of the Sarbanes-Oxley Act of 2002?

A
  • Increase corporate responsibility.
  • Enhance disclosures
  • Address fraud.
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61
Q

What did SOX affect?

A

The financial reporting requirements of public companies, specifically by expanding disclosures and specific requirements that must accompany financial statements.

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62
Q

What does title III of SOX address?

A

Corporate responsibility of the audit committee and CEO and CFO reps.

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63
Q

What are public companies required to establish?

A

An audit committee that is directly responsible for the appointment, compensation, and oversight of the work of the public accounting firm employed by that public company.

64
Q

Who does the auditor report to?

A

The audit committee.

65
Q

Who is responsible for resolving disputes between auditors and management?

A

The audit committee.

66
Q

What is required to be a member of an audit committee?

A

Must be members of the issuers board of directors but are otherwise independent.

67
Q

What constitutes independence for an audit committee member?

A
  • Cannot receive compensation for consulting or advisory services.
  • May not be an affiliated person of the issue (meaning they cannot innfluence financial decisions).
68
Q

What must audit committees establish, and what must these accomodate?

A
  • Procedures to accept reports of complaints regarding audit, accounting, or internal control issues (whistleblower hotlines).
  • Procedures must accomodate confidential, anonymous reports, and the receipt and retention of complaints as well as a method to address those complaints.
69
Q

Who must sign certain representations regarding annual and quarterly reports?

A

Corporate officials, usually the CEO and CFO.

70
Q

What assertions must corporate officials make when they sign representations regarding annual and quarterly reports?

A
  • That they have reviewed the report.

- Report contains no untrue statements or ommissions.

71
Q

Can officers or directors influence the conduct of audits?

A

They cannot take any action that would fraudulaently influence, coerce, mislead, or manipulate the auditor in a manner that would make the financial statements materially misleading.

72
Q

What may CEOs and CFOs be required to give up if an issuer is required to prepare an accounting restatement due to material noncompliance with any financial reporting requirement unde the securities laws?

A
  • Bonuses or equity-based compensation.

- Gains on sale of securities during that 12-month period.

73
Q

What is does Title IV of SOX address?

A

Enhanced Financial Disclosure (internal controls and audit committee operations).

74
Q

What are disclosures in periodic reports intended to do?

A

Ensure that GAAP is applied and reflects the economics of the transactions included in the report and that those transactions are transparent to the reader.

75
Q

What are the enhanced disclosure requirements?

A
  • All material correcting adjustments identified by the auditor shouls be reflected in the financial statement.s
  • The financial statements should include all material off-b/s transactions (operating leases, contigent obligations, relationships w/ unconsolidated subs).
  • Conformance of pro forma financial statements to the following requirements.
    a. No untrue statements b. No omitted material info
    c. Reconciled w/ GAAP basis financial statements.
  • Use of special purpose entities (SPEs).
76
Q

Can issuers make personal loans to directors or executive officers?

A

No, they are prohibited from doing so. However, exceptions apply:

  • if the consumer credit loans are made in the ordinary course of business
  • if the terms offered to the officer are generally made available to the public under similar terms abd conditions w/ no preferential treatment.
77
Q

When must disclosures be made for related-party transactions?

A
  • When persons have direct or indirect ownership of > 10% of any class of most any equity security. Disclosures are made by filing a statement.
78
Q

When must related-party disclosures be filed?

A
  • At the time of registration.
  • When the person achieves 10% ownership.
  • If there has been a change in ownership.
79
Q

What is Title IV §404 and what does it require?

A

The assessment of internal controls that each report is required to contain:

  • A statement that management is responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting.
  • An assessment, as of the end of the most recent fiscal year of the issuer, of teh effectiveness of the internal control structure and procedures for financial reporting.
80
Q

Who is exempt from §404?

A

Investment companies.

81
Q

What must an issuer disclose that it has adopted for senior officers?

A

A code of ethics.

82
Q

***The code of ethics contemplates standards that promote what?

A
  • Honest and ethical conduct.
  • Full, fair, accurate, and timely disclosures in periodic financial reports.
  • Compliance w/ laws, rules, and regs.
83
Q

What should one member of each audit committee be?

A

A financial expert.

84
Q

What qualifies a board member as a financial expert?

A

Education, past experience as a CPA or principle financial officer, controller, or principal accounting office for an issure.

85
Q

What knowledge should a financial expert have?

A
  • Understanding of GAAP
  • Experience in the preparation or auditing of financial statements for comparable issuers.
  • Application of GAAP
  • Experience w/ internal controls.
  • Understandin go audit committee functions.
86
Q

Who must review period disclosures by issuers and why?

A

The SEC must review them on a regular and systematic basis for the protection of investors.

87
Q

What should the SEC consider when reviewing financial statements?

A
  • Issuers that have issued matieral restatements of financial results.
  • Issuers that experience significant volatility in their stock prices when compared to other issuers.
  • Issuers with the largest market capitalization.
  • Emerging companies with disparities in price-to-earning ratios.
  • Issuers whose operations significantly affect any material sector of the economy (“too big to fail”).
88
Q

What does title VIII of SOX deal with?

A

Corporate and criminal fraud accountability.

89
Q

What are criminal penalties for altering (destroying, mutilating, concealing, covering up, falsifym etc) documents?

A
  • Fined and/or up to 20 years in prison.
90
Q

How long do auditors have to retain audit and review workpayers? What could happen if they don’t meet this requirement?

A
  • Seven years

- Fine(s) and/or impisonment of up to 10 years.

91
Q

What is the stature of limitations for securities fraud?

A
  • No later than the earlier of two years after the dicsovery of the facts constituting the violation, or five years after the violation.
  • “2 + 5”
92
Q

How are whistleblowers protected?

A
  • Cannot be discharged, demoted, suspended, threatened, harassed, or in any other matter discriminated against for providing such info.
93
Q

What happens if an employee alleges discharge or discrimination for providing evidence of fraud by filing a complaint to the Secretary of Labor?

A

Compensator damages including:

  • Reinstatement
  • Back pay w/ interest
  • Compensation for any special damages.
94
Q

Penalties for securities fraud?

A
  • An individual who knowlingy executes, or attempts to execute, securities fraud will be fined, imprisoned not more than 25 years.
95
Q

What does title IX of SOX deal with?

A

White collar crime penalty enhancements.

96
Q

What are the white collar crime and penalty enhancements?

A
  • Individuals who attempt or conspire to commit white-collar crime will be subject to the same penalties as those who commit the offesne.
  • Penalities for mail and wire fraud were increased from 5 years to 20 years.
  • Penalities for violating ERISA were increased from not more than $5,000 to no more than $100,000 annd from not more that 1 year to not more than 10 years for individuals.
  • fines upon persons who are not individuals cannot exceed $500,000.
97
Q

Who will amend and review sentencing guidelines and Attempt and Conspiracy Act (as needed) related to certain white-collar offenses?

A

The US Sentencing Commission.

98
Q

Any issuer periodic report which contains financial stetemtns that is filed with the SEC must be accompanied by what?

A
  • A written statement that the periodic report fully complies with the SEC Act of 1934.
  • A written statement that the information contained in the report fairly presents, in all material respects, the financial condition and operating results of the issuer.
  • The written statements above must be signed by teh CEO & CFO of the issuer.
99
Q

Any party that certifies the periodic financial report and/or its content knowing that it does not satisfy all the requirements shall be what? Specifically a party who?

A
  • Fined and/or imprisoned.
  • Certifies any statement knowing that it does not comply w/ all requirements will be fined no more than $1,000,000 abd/or improned not more than 10 years; or
  • Willfully certifies any statement knowing that it does not comply w/ all requirements will be fined not more than $5,000,000 and/or imprisoned not more than 20 years.
100
Q

What does Title XI of SOX deal with?

A

Corporate Fraud Accountability

101
Q

What happens to someone who tampers with record or impeding an official proceeding?

A

-fined and/or no more than 20 years.

102
Q

What is temporary freeze authority?

A

The authority of the SEC (should it determine it is likely the issuer will be required to make penalty payments) to petition a federal district court tto require the issuer to escrow the payments in an interest-bearing account for 45 days,.

103
Q

Can the SEC prohibit someone from serving as officers or directors?

A

Yes. If that individual has violated securities rules and regulations and the SEC determines that individual unfit.

104
Q

Can an individual retaliate against informants?

A

No. Imprisonment for no more than 10 years.

105
Q

Define risk

A

Chance of financial loss, uncertainty.

106
Q

Define Return

A

Total gain or loss experienced.

107
Q

What are the three basic risk preference behaviors?

A
  1. Risk-indifferent behavior (exception)
  2. Risk-averse behavior (general rule)
  3. Risk-seeking behavior (exception)
108
Q

What is interest rate risk?

A
  • Fluctuations in the value of instruments in response to changes in interest rates.
  • As IR ↑, value of fixed income ↓
  • Fixed coupon / (1+r)↑ = value ↓
109
Q

What is market/systematic/nondiversifiable risk?

A
  • fluctuation in value as a result of operating within an economy.
  • Sometimes called nondiversifiable risk because it is inherent in operatin within an economy.
  • War, inflation, international incidents, and political events.
110
Q

What is Unsystematic/Firm-specific/Diversifiable Risk

A
  • Represents risk associated w/ random cause and can be eliminated through diversification.
  • Strikes, lawsuits, regulatory actions, loss of key account.
111
Q

What is DUNS?

A
  • Represents the two broad categories of risk classification.
    DU 1. Diversifiable risk - Unsystematic risk (nonmarket, firm specific).
    NS 2. Nondiversifiable risk - Systematic risk (market).
112
Q

What is Credit Risk?

A
  • Affects borrowers
  • includes a company’s inability to secure financing or secure favorable credit terms as a result of poor credit ratings.
113
Q

What is Default risk?

A
  • Affects lenders

- Possibility debtors may not repay principal or interest due to their indebtedness on a timely basis.

114
Q

What is Liquidity risk?

A
  • Affects lenders (investors)
  • General rule: not publically traded (think real estate).
  • When investors desire to sell their security, but cannot do so in a timely manner or when material price concession have to be made to do so.
115
Q

What is price risk?

A
  • A decline in value of individual securities or portfolios.
  • Increases with volatility.
  • Related to diversifiable (unsystematic) risk.
116
Q

Define stated interest rate.

A
  • Sometime referred to as nominal interest rate.
  • Represents the rate of interest charged before any adjustment for compounding or market factors.
  • Shown in the agreement of indebtedness.
117
Q

Define effective interest rate.

A
  • Represents the actual finance charge associated with a borrowing after reducing loan proceeds for charges and fees related to a loan origination.
  • Assume annualized
118
Q

Define Annual percentage rate.

A
  • Represents a noncompounded version of the effective annual percentage rate described and computed below.
  • Required for disclosure by federal regs.
119
Q

Define effective annual percentage rate.

A
  • Represents the stated interest rate adjusted for the number of compounding periods per year.
  • Abbreviated APR.
    i = stated interest rate
    p = compounding periods per year
    Effective APR = [1 + (i/p)]^p - 1
120
Q

Define simple interest

A 
- Amount represented by interest paid only on the original amount of principal without regard to compounding.
SI = P0(i)(n)
P0 = Original Principal
I = Interest rate per time period
n = Number of time periods
121
Q

Define Compound Interest

A
  • The amount represented by interest earnings or expense that is based on the original principal plus any unpaid interest earnings or expense.
  • Interest earnings or expense, compounds and yields an amount higher than simple interest.
122
Q

How is the Require Rate of Return calculated?

A

RR = Risk free rate + MRP + Purchasing power risk or inflation premium (IP) = Liquidity risk premium (LP) + Default risk premium (DRP).

123
Q

How can financial risk be mitigated or controlled?

A
  • Diversification (of unsystematic/firm-specific risk)

- Strategies to mitigate and control specific financial risks.

124
Q

What are the strategies to control specific financial risks?

A
  • Mitigating interest rate risk.
  • Mitigating market risk.
  • Mitigating unsystematic risk
  • Mitigating Credit risk
  • Mitigating default risk
  • Mitigating liquidity risk
  • Mitigating price risk
125
Q

How can interest rate risk be mitigated?

A
  • investing in floating rate debt securities.
  • Derivatives such as forward rate agreements (FRAs) or interest rate swaps where the investor pays a fixed interest rate and receives floating interest rate.
126
Q

How can market risk be mitigated?

A
  • Invest in derivatives that provide gains to the investor when the market declines.
  • Short selling
127
Q

How can unsystematic risk be mitigated?

A
  • Divesification
128
Q

How can credit risk be mitigated?

A
  • Improvements in credit rating.
129
Q

How can default risk be mitigated?

A
  • Lenders can choose to lend only to borrower with low risk of default.
  • Adjust the interest rates charged ro better reflet the risk of each borrower.
130
Q

How can liquidity risk be mitigated?

A
  • Allocating greater % of capital to investments that trade on active markets, such as equities, corporate bonds, futures contracts, and options.
131
Q

How can price risk be mitigated?

A
  • Diversification

- Short selling or derivates, such as put options.

132
Q

Why does exchange rate risk exist?

A

Exchange rate (FX0 risk exists becuase the relationship between domestic and foreign currencies may be subject to volatility.

133
Q

What types of factors influence exchange rates? Name some of these factors.

A
  1. Trade-related factors
    - Relative inflation rates.
    - Relative income levels.
    - Government controls (trade restrictions)
  2. Financial factors
    - Relative interest rates
    - Capital flows
134
Q

Define transaction exposure

A
  • The potential that an organization could suffer economic loss or experience economic gain upon settlement of individual transactions as a result of changes in the exchange rates.
135
Q

How is transaction exposure measured?

A

Two Steps:

  1. Project foreign currency inflows (AR) and foreign currency outflows (AP). Calculate “net” assets.
  2. Estimate the variability (risk) associated with the foreign currency.
136
Q

Define Economic Exposure

A

The potential that the PV of an organization’s cash flows could increase or decrease as a result of changes in the exchange rates.

137
Q

Define currency appreciation and depreciation.

A

Appreciation - strengthening of a currency relative to other currencies.
Depreciation - weakening of a currency relative to other currencies.

138
Q

What is the effect of domestic currency appreciation?

A

Domestic exports become more expensive, foreign imports become less expensive.

139
Q

What is the effect of domestic currency depreciation?

A

Domestic exports become less expensive, foreign imports become more expensive.

140
Q

Define Translation Exposure

A
  • The risk that assets, liabilityies, equity, or income of a consolidated organization that includes foreign subsidiaries will change as a result of changes in exchange rates.
  • Defined by the degree of foreign involvement, the location of foreign subs, and the accounting methods used and measured in relation to the effect on the organization’s earning or comprehensive income.
141
Q

How does the degree of foreign involvement affect translation exposure?

A

Translation exposure increases as the proportion of foreign involvement by subs increases.

142
Q

How do the locations of foreign investments affect translation exposure?

A

The more stable the exchange rate, the lower the translation risk. The more volatile the exchange rate, the higher the translation risk.

143
Q

What are the methods of managing the transaction exposure associated with exchange rate risks?

A
  1. Measuring specific net transaction exposure.
  2. Selective hedging - forwards, futures, options, swaps
  3. Identifying Net Transaction Exposure
  4. Adjusting invoice policies - timing of payments
  5. Futures Hedges
  6. Forward Hedges
  7. Money Market Hedges
  8. Currency option hedges
  9. “Long-Term” Transcations - forwards, swaps
  10. Alternative heding techniques - leading and lagging, cross-hedgin, currency diversification.
144
Q

What is net transaction exposure and how is it calculated?

A
  • The aggregate exposure associated with a particular foreign currency for a particular time.
  • Computed as follows:
    1. Accumulate the inflows and outflows of foreign currencies by subsidiary.
    2. Consolidate the effects on the subsidiary by currency type.
    3. Compute the net effect in total.
145
Q

What do futures hedges do?

A
  • Entitles its holder to either purchase or sell a particular number of currency units of an identified currency for a negotiated price on stated date.
  • Denominated in standard amounts and tend to be used for smaller transactions.
146
Q

What do forward hedges do?

A
  • Entitles its holder to either purchase or sell currency units of an identified currency for a negotiated price at a future point.
  • Forward hedges are contracts between businesses and commercial banks and normally are larger transactions.
147
Q

What do money market hedges do?

A

-Use international money markets to lock in the exchange rate associated with the foreign currency needed to satisfy payables when they come due.

148
Q

What do currency option hedges do?

A
  • Use the same principles as forward hedge contracts and money market hedge transactions, but, instead of requiring a commitment to a trnsaction, the currency option hedge gives the business the option of executing the option contract or purely settling its originally negotiated transaction without the benefit of the hedge.
149
Q

What are long-term forward contracts?

A

Deal w/ same issues as any other forward contracts. Set up to stabilize exposure over long periods. Long-term purchase contracts may be hedged with long-term forward contracts.

150
Q

What are currency swaps?

A

Two firms with coincidental needs for internation currencies may agree to swap currencies collected in a future period at a specified exchange rate.

151
Q

What is leading and lagging?

A

Represent transactions between subs or a sub and a parent. The entity that is owed may bill in advance if the exchange rate warrans (leading) or possibly wait until the exchange rate is favorable before settling (lagging).

152
Q

What is cross-hedging?

A

Hedging one instrument’s risk with a different instrument by taking a position in a related derivatives contract.

153
Q

What is currency diversification?

A

Using many different kinds of currency to hedge changes decreases in value.

154
Q

How is economic exposure defined?

A
  • By the degree to which (pv) cash flows of the business can be affected by fluctuations in exchange rates.
155
Q

What are the techniques for economic exposure mitigation.

A

Examples:

  1. Reduce foreign sales to preserve cash flows when fearful of depreciating foreign currency.
  2. Increase reliance on those suppliers who take advantage of paying for raw materials or supplies with cheaper currency.
156
Q

What do economic exposures usually relate to?

A
  • Economic exposures typically relate to organization-wide issues and can usually only be mitigated with organization-wide approaches that involve restructuring and adjustments to the business plan.
    Restructuring - Restucturing the sources of income and expense to the consolidated entity.

CPA Exam Review - BEC (2 decks)

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