Derivatives and Foreign Exchange

Question 1

How are gains and losses on financial instruments that hedge trading securities reported?

Answer 1

Reported in earnings with reporting unrealized gains and losses on trading securities

Question 2

Define derivative instrument

Answer 2

A derivative instrument is a financial instrument or other contract that derives its value from the value of some other instrument and has all three of the following characteristics:
1. one or more underlyings and one or more notional amounts or payment provisions (or both)
2. requires no intiial net investment
3/ its terms require or permit a net settlement

Question 3

Define underlying and notional amount

Answer 3

Underlying: Specified price, rate, or other variable (e.g., interet rate, security price, foreign exchnage rate, index or preices or rates, etc.)

Notional amount: A specified unit of measure (currency nuits, shares, bushels)

Question 4

Name the four common derivative instruments

Answer 4

1. options
2. futures
3. forward
4. swaps

Question 5

Identify the three types of hedge designations

Answer 5

Fair value hedge
Cash flow hedge
foreign currency hedge

Question 6

describe the accounting for changes in fair value associated with each type of hedge designation

Answer 6

Fair value hedge: Included in current earnings with gain or loss from change in value of offsetting asset/liability

cash flow hedge: Effective portion- included in OCI until cash flows from hedge item are realized
Ineffective portion- included in current earnings

Foreign currency hedge-
Fair value hedge- included in current earnings with gain or loss from change in value of offsetting asset/liability
Cash flow hedge- included in OCI (effective portion)
net investment hedge- included in oci as cumulative translation adjustment

Question 7

What are monetary items

Answer 7

assets and liabilities that are fixed in amount by contract or in terms of number of dollars

• examples include: cash, accounts and notes rec, and accounts and notes payable
• these items are already stated in constant dollars

Question 8

What are nonmonetary items

Answer 8

• assets and liabilities that fluctuate in value with inflation/deflation
• i.e., inventories, property, plan and equipment, and capital stock. These items need to be restated to constant dollar

Question 9

Identify the two foreign currency activities

Answer 9

• foreign currency translations

- Transactions

Question 10

What is an entity’s functional currency under GAAP?

Answer 10

The functional currency is the currency of the primary economic environment in which the entity operates. All of the following conditions must be met:

1. The foreign operations are relatively self-contained and integrated within the country
2. the day to day operations do not depend on the parents of investor’s functional currency
3. The local economy of the foreign entity is not highly inflationary

Question 11

When is the translation method used?

Answer 11

Translation is used to restate financial statements denominated in the functional currency to the reporting currency

Question 12

When is the remeasurement method used?

Answer 12

Remeasurement is used to restate financial statements from the foreign currency to the entity’s functional currency when:

1. The reporting currency is the functional currency
2. The financial statements must be restated in the entity’s functional currency prior to translating from the functional currency to the reporting currency

Question 13

Identify the exchange rate to be used when remeasuring different components of the balance sheet and income statement

Answer 13

Balance sheet:

• monetary- current exchange rate
• non-monetary- historical rate

Income statement-

• balance sheet related- historical rate
• non-balance sheet related- weighted average

Question 14

Identify the exchange rate to be used when translating different components of the balance sheet and income statement

Answer 14

Assets and liabilities:
current exchange rate

common stock and APIC:
historical rate

Revenue and expenses:
weighted average exchange rate for the period

Question 15

Where are remeasurement gains/losses reported in the financial statements

Answer 15

Remeasurement gains and losses are recognized on the income statement

Question 16

Where are translation adjustments reported in the financials?

Answer 16

Translations gains and losses are reported in OCI. They are treated as unrealized gains and losses

Question 17

State two types of foreign currency transactions

Answer 17

• operating transactions, such as importing, exporting, borrowing, lending, and investing
• Forward exchange contracts- which are agreements to exchange two different currencies at a specified future date and at a specific rate

Question 18

Where are foreign currency transaction gains and losses reported in the financial statements

Answer 18

foreign currency transaction gains or losses are included in determining net income for the period

Question 19

For operating transactions in foreign currency, detail the recording process

Answer 19

• record original transaction exchange or spot rate on date of transaction
• At balance sheet date, compute gain/loss on the transaction by recalculating using the current exchange or spot rate
• On payment date, compute gains/loss on the transaction by using the exchange rate on payment date