FAR - Derivative, Hedging, FX

Question 1

What are types of Foreign Currency hedges?

Answer 1

Four foreign currency hedges:
- unrecognized firm commitment
- available for sale security
- foreign currency denominated forecasted transaction
- net investment in foreign operations
Not to be confused with fair value or cash flow hedge (such as hedge of a recognized asset/liability)
Does not include held to maturity securities.

Question 2

What do derivative instruments contain and what are some examples?

Answer 2

1. One or more underlying and
2. One or more notional amounts
3. No initial net investment or smaller net investment than required for contracts with an expected similar response to market changes, AND
4. Terms that require or permit net settlement, net settlement by means outside the contract, and delivery of an asset that is substantially the same as net settlement
   Examples are IR swaps, currency futures, stock index options.

Question 3

What are types of derivative financial instruments?

Answer 3

1. Interest rate and foreign currency swaps
2. Currency swaps
3. Interest rate caps/floors/collars

Question 4

What qualifies as hybrid instruments that would require bifurcation? What is bifurcation?

Answer 4

Bifurcation separates an embedded derivative instrument from the basic or host contract.
Examples of hybrid instruments are a bond payable with an IR based on the S&P index and an equity instrument with a call option, allowing the issuing company to buy back the stock.

Question 5

What is the criteria for a hedging instrument?

Answer 5

The criteria for a hedging instrument are that sufficient documentation must be provided at the beginning of the process and the hedge must be highly effective throughout its life.
Not to be confused with derivative instruments.

Question 6

How are hybrid instruments disclosed when using fair value and not bifurcation?

Answer 6

It can be presented as a separate line item for the FV and non FV instruments on the BS
OR
As an aggregate amount of all hybrid instruments with the amount of hybrid instruments at FV shown in paratheses

Question 7

What is the required disclosure for entities with concentrations of credit risk?

Answer 7

Required disclosures include

• info about shared activity, region, or economic characteristics of the group
• Amount of accounting loss that the entity would incur as a result of the concentrated party’s failure to perform according to the terms of the contract
• Information regarding entity’s policy of requiring collateral

Question 8

Which are not derivative instruments?

• adjustable rate loans
• mortgage backed securities
• credit indexed contracts
• variable annuity contracts

Answer 8

These are NOT derivative instruments

• adjustable rate loans
• mortgage backed securities
• variable annuity contracts

This is a derivative instrument
- credit indexed contracts

Question 9

When are gains or losses recognized?
For example: Company purchased merchandise from company in foreign currency on Sept 22, when spot rate was .55. Bill was paid in full the next year in March 20 when rate was .65. Spot rate for year end was .7.

Answer 9

Transaction involves settlement to be made in foreign currency. A FX transaction gain or loss will result if the spot rate on settlement date is different than the rate on the transaction date. A gain/loss must be recognized at any intervening year end if there has been a rate change. In this case there would be a loss recognized at year end and a gain in the next year.

Question 10

What are the criteria for an unrecognized firm commitment to qualify as a hedged item?

Answer 10

1. be binding on both parties
2. be specific with respect to all significant items
3. contain a nonperformance clause that makes performance probable

Question 11

What are risks inherent in an interest swap agreement?

Answer 11

As cash flows are determined by different interest rates, fluctuations in IR may result in the risk of exchanging a lower IR for a higher IR.
Financial instruments, including swaps, also bear credit risk or the risk that a counterparty will not perform as expected.

Question 12

What does a perfect hedge mean?

Answer 12

There is no possibility of future gain or loss as the g/l on the hedging instrument would offset and g/l for the hedged item.

Question 13

Where are gains and losses on the hedged asset/liability and the hedged instrument for a fair value hedge recognized? For cash flow hedge?

Answer 13

G/l of a fair value hedge are recognized in current earnings.
The cash flow hedge has two parts - effective and ineffective. The effective portion is reported in OCI and the ineffective portion is reported on a cumulative basis to reflect the lesser of the cumulative g/l on the derivative or the cumulative g/l from the change in expected cash flows from the hedged instrument.

Question 14

Which are required to be accounted for under 815 - derivatives and hedging?
- employee stock options, futures contracts, interest rate caps, options to purchase or sell exchange traded securities

Answer 14

All expect for employee stock options.

Question 15

Which are not excluded from definition of derivative instruments in 815?
- leases, call/put option, adjustable rate loans, equity securities

Answer 15

Only call/put options are included in the definition of derivative financial instruments.
Leases are excluded as they require a pmt equal to the value of the right to use the property.
Equity securities and adjustable rate loans are excluded as they require an initial net investment equivalent to the FV.

Question 16

What happens when there is a firm commitment and it has to be cancelled?
For example, company entered into 3 year noncancellable contract to buy at least 200k units per year at .1$/unit. At year end, company only purchased 80k and decided to cancel sales of the product. What is the loss reported at the end of current year?

Answer 16

It would be the full remaining 52k as company is liable.
The cancellation of a firm purchase commitment to purchase goods results in an ineffective hedge and required recognition of the total liability when the contract is cancelled.

Question 17

What is the definition of a derivative financial instrument? What does underlying and notional amount mean?

Answer 17

A contract that has its settlement value tied to an underlying notional amount.
A derivative DERIVES its value as a financial instrument from something outside itself. The underlying is the rate or price that exists outside the instrument that is used to determine the value of the derivative. Notional amount is the number of units related to the derivative (ex number of barrels of oil). Notional amounts are the referenced associated asset or liability.

Question 18

What is the JE for the collection of a receivable from a foreign customer payable in the foreign currency?

Answer 18

DR Cash
DR Exchange loss
CR A/R
Gains and losses from foreign currency transactions which are of an import/export nature are reported on the IS for each period in which the exchange rate changes until the exchange is settled.

Question 19

What are the criteria for a derivative to qualify as a hedging instrument?

Answer 19

1. Sufficient documentation must be provided at beginning of the process to identify a. the objective and strategy of hedge, b. the hedging instrument and hedged item, c. how the effectiveness of the hedge will be assessed on an ongoing basis.
2. hedge must be highly effective throughout its life

Question 20

When is disclosure of fair values of the entity’s financial instruments required?

Answer 20

Required when it is practicable to estimate the values.

This only applies to material items.

Question 21

What are FX transactions and where are they shown?

Answer 21

FX transactions are transactions that are denominated in a currency other than an entity’s functional currency. The increase or decrease in expected functional currency cash flows is a foreign currency transaction gain or loss that should be included in NI for the period in which the exchange rate changes. The g/l is shown on IS as other income/loss in determining income from continuing operations.

Question 22

Foreign subsidiary has been remeasured, which rates are used for what? Current/historical?

Answer 22

When remeasuring into USD, the current rate is used for monetary items and nonmonetary items carried at market. The historical rate is used for nonmonetary items carried at cost.
Inventory carried at NRV uses current rate as NRV is a market concept.

Question 23

What happens when the functional currency of a foreign subsidiary is the local foreign currency? How are BS accounts translated?

Answer 23

Translated using the current exchange rate (rate at BS date). If the functional currency was the USD, then it would be remeasured using a combination of current and historical rates.

Question 24

What are IFRS requirements for foreign currency translation?

Answer 24

Nonmonetary items measured at historical cost are translated at the historical exchange rate.
Monetary items are translated at the year end spot rate.
If the functional currency is the same as the presentation currency, gains or losses are reported in P&L for the period.
If the functional currency is not the same as the presentation currency, gains or losses are charges to OCI.

Question 25

When is the weighted average exchange rate used?

Answer 25

When the functional currency is the local currency, exchange rates should be those in effect at the time transactions are recorded during the current period (current rate method). Weighted average rates can be used for items occurring numerous times during the accounting period.
It is used to translate revenues, expenses, gains, and losses from the functional to presentation currency. This includes depreciation, sales to customers and salaries and wages expense.

Question 26

What are the different types of losses under exchange rates and where are they recognized in the FS?
Example, for a wholly owned foreign subsidiary that has a foreign exchange loss account balance, translation loss, and AP due in local foreign currency that has increased from 100 to 106k at year end.

Answer 26

The translation adjustment is resulting from translating an entity’s FS in functional currency into the reporting currency.This is not included in NI. It is shown in components of OCI and Accumulated OCI in stockholders equity.
Gains/losses resulting from FX transactions (purchases/sales) are reported on IS under foreign exchange loss. Total FX loss is the balance plus the 6k.

IF the function is the reporting currency, then remeasurement process would have been used instead of translation, with g/l in income.

Question 27

Functional currency of subsidiary is CHF. Company borrowed CHF to hedge investment in sub. In consolidated FS, the translation loss > exchange gain on borrowing. How is it shown in FS?

Answer 27

Translation loss less exchange gain is reported as OCI under one of three alternatives and under AOCI in SE section of BS.
Translation adjustments resulting from translation of FX statements AND gains and losses on certain FX transactions should be reported as such. This includes FX transactions designated as economic hedges of a net investment in a foreign entity.

Question 28

What is the definition of terms under IFRS for functional currency and presentation currency?

Answer 28

Functional - currency of the primary economic environment in which the company operates
Presentation - currency in which FS are presented

Foreign currency is another term IFRS uses.

Question 29

Sale of goods not in functional currency. FX rates changes resulting in a gain which is reported where in FS?

Answer 29

Transaction gain reported as component of income from continuing operations. Increase/decrease in expected functional currency cash flows is a FX transaction gain/loss that is included in NI for the period in which the FX rate changes.

Question 30

What does denominated mean, when it is denominated in a currency other than the entity’s functional currency

Answer 30

Denominated means that the balance is fixed in terms of the number of units of foreign currency, regardless of changes in FX rate. In such a case, the entity assumes risk of changes in FX rate. The g/l from that are reported in continuing income.

Question 31

When is a remeasurement done and where is it recognized in FS?

Answer 31

Remeasuring a foreign sub FS from the local currency, which is not the functional currency, into the parent company will show remeasurement gains and losses that are not denominated in functional currency in income (continuing operations).
Remeasurement means that all A/L on BS and Rev/Exp on IS are translated at the rates in effect when the transactions originally occurred. Depreciation would be translated at FX rate in effect at original transaction date.

Question 32

When is a translation done and where is it recognized in FS?

Answer 32

When the foreign sub has the local currency as the functional currency, it is translated and results in OCI, and an adj to SE.

Question 33

What is a direct quote and indirect quote is 1 CAD = .9 USD

Answer 33

Direct quotation is the rate expressed in USD
$.9/1

Indirect quotation is the inverse of the direct
1/$.9

Question 34

Which rates are used to translate the Cash flow statement?

Answer 34

Cash flow statement is translated at the rates in effect at the time the transaction occurred (historical FX) or at weighted avg FX rate if not substantially different.

Question 35

IFRS, if functional currency = presentation currency, where are translation gain/losses reported?

Answer 35

On IS, in current earnings. However, there are exceptions.

Currency g/l on nonmonetary items are recorded in OCI.