FAR-F6-M4-Derivatives and Hedge Accounting

Question 1

What is a derivative?

Answer 1

A derivative is a financial instrument with an underlying, a notional amount, and a net settlement.

Question 2

What is an underlying?

Answer 2

An underlying is the UNDERLYING ASSET that a derivative is based on. For example, with stock options, the underlying is the specific stock that the option contract is based on.

Question 3

What is a notional amount?

Answer 3

A notional amount is a specified unit of measure, such as the # of shares.

Question 4

What is a settlement amount?

Answer 4

A settlement amount is determined by the underlying amount being multiplied by the notional amount, such as 100 shares at $20 per share.

Question 5

How are derivatives measured?

Answer 5

Derivatives are measured at fair value

Question 6

What is a hedging item?

Answer 6

A hedging item is an asset or liability that is subject to a possible loss. A hedging instrument is a contract that mitigates the possible loss of the hedging item.

Question 7

What are the qualifications for a derivative?

Answer 7

A derivative has ALL 3 of the following characteristics:
1. one or more underlyings and one or more notional amounts
2. it requires no initial net investment or one that is smaller than would be required for other types of similar contracts.
3. It’s terms require or permit a net settlement or it can be settled net outside the contract.

Question 8

Is the following statement true or false? When a hedge is effective, the change in the value of the derivative OFFSETS the change in the value of a hedged item or the cash flows of the hedged item. The perfect hedge results in neither gains no losses.

Answer 8

TRUE. When a hedge is effective, the change in the value of the derivative OFFSETS the change in the value of a hedged item or the cash flows of the hedged item. The perfect hedge results in neither gains no losses.

Question 9

What are the most common types of derivatives?

Answer 9

Acronym: OFFS
Option Contracts
Future Contracts
Forward Contracts
Swap Contracts

Question 10

What is an option contract?

Answer 10

With an option contract, the buyer of the option contract owns a RIGHT.
The seller of the option contract has a LEGAL OBLIGATION.

Question 11

What is the concept of a call option?

Answer 11

A call option gives the holder the right to buy from the option writer at a specified price during a specific period. The buyer would hope that the price goes up since they can buy it low.

Question 12

What is the concept of a put option?

Answer 12

A put option gives the holder the right to sell to the option writer at a specified price during a specific period of time. A put option locks in the sales price of a stock. If the stock decreases in value, the put option holder will have locked in the now higher price/ he can sell it a higher price then its worth to the writer, who has an OBLIGATION to buy it at the higher price.

Question 13

What are the types of risks inherent in deratives?

Answer 13

Market risk and credit risks that are inherent in all derivative instruments.

Question 14

What is market risk?

Answer 14

Market risk is the risk that the entity will incur a loss on the derivative contract.

Question 15

What is credit risk?

Answer 15

Credit risk is the risk that the other party to the derivative contract will not perform according to the terms of the contract.

Question 16

Are all derivative instruments recognized on the balance sheet as assets or liabilities?

Answer 16

Yes, all derivative instruments are recognized on the balance sheet as assets or liabilities at fair value.

Question 17

What is a fair value hedge?

Answer 17

A fair value hedge is an instrument designed to hedge the exposure from changes in the fair value of a recognized asset or liability or of an unrecognized FIRM COMMITTMENT that are attributable to a particular risk. Gains and losses on both the fair value hedge itself and the hedged item are recognized in earnings in the same accounting period.

Question 18

When can a derivative be designated as a fair value hedge?

Answer 18

A derivative may be designated and qualify as a fair value hedge if a set of criteria relating to the derivative and the hedged item are met. The most significant criteria are:
1. There is formal documentation of hedging relationship between the derivative and the hedged item.
2. The hedge must be expected to be highly effective in offsetting changes in the fair value of the hedged item.
3. The hedged item is specifically identified.
4. The hedged item presents exposure to changes in fair value that could offset income.

Question 19

What is a cash flow hedge?

Answer 19

A cash flow hedge is an instrument designated as hedging the exposure to variability in expected future cash flows attributable to a particular risk.

Question 20

Where are cash flow hedges gains and losses recognized?

Answer 20

Cash flow hedges gains and losses are recorded as a component of OCI.

Question 21

Where are gains and losses from fair value hedges recorded in?

Answer 21

The gains and losses on fair value hedges are recorded in current income.

Question 22

Is the following statement true or false? Companies must disclose information that distinguishes between fair value derivatives and cash flow derivatives. Both the net gain or loss recognized in earnings during the period and the amount of gain or loss deferred in OCI must be disclosed.

Answer 22

TRUE. Companies must disclose information that distinguishes between fair value derivatives and cash flow derivatives. Both the net gain or loss recognized in earnings during the period and the amount of gain or loss deferred in OCI must be disclosed.