FAR - Specific Transactions, Events, & Disclosures - Financial Instruments Flashcards
Financials Instruments are
1) cash (demand deposits + foreign currency)
2) evidence of ownership interest in an entity (stock, PTP interest, LLC interest)
3) contracts (exchange of cash or ownership interest) OR impose contractual obligation and contractual right (A/R, A/P, Invest in Bonds/B/P, N/R, N/P)
Financial Instruments identified
Assets: cash, A/R, investments
Liab: A/P, B/P
“Special” - options, futures, forwards, swaps
Financial Instrument Valuation/presentation
Most likely valuation = FV (depends on type of instrument)
IF carried @ FV, disclosure requirements exist so users understand basis of FV
IFRS - Financial instruments
GAAP:
1) don’t define assets/liab separately
2) no specific category for “loans/receivables”
3) impairment testing completed relative to FV
IFRS:
1) defines assets/liab separately
2) identifies specific categories for “loans/receivables”
3) impairment testing completed relative to recoverable amount
FV Disclosure Requirements
Following info must be disclosed for which it is practicable to estimate FV:
1) FV
2) Related CV
3) whether instrument is an asset/liab
Required disclosures in either
1) body of financials, OR
2) notes to financials
Practicable to Estimate Defined
means that FV estimates can be made w/o incurring excessive costs (cost-benefit assessment)
If FV = not practicable to estimate, entity must disclose:
1) why not
2) additional info:
a) CV
b) effective interest rate
c) maturity date/value
Concentrations of Credit Risk Disclosure
must disclose all concentrations of credit risk:
1) credit risk: possibility of loss from failure of other party to perform according to contract
2) concentration of credit risk: contracts of material value w/parties that have same characteristics:
a) same industry
b) same country/region
c) same economic characteristics
Info to disclose about each significant concentration of credit risk
1) info about activity, region, other characteristics
2) max amount of loss that occur due to each credit risk
3) entity’s policy of requiring collateral or other security to support credit risk
Market Risk Disclosure
For financial instruments are NOT required
- market risk disclosures encouraged
- market risk = possibility of loss from change in MKT value due to changes in economic circumstances:
1) changes in market rate of interest
2) changes in rate of inflation
true/false
All entities must disclose all significant concentrations of credit risk arising from all financial instruments, whether from a single entity or a group of parties that engage in similar activities and that have similar economic characteristics
true
true/false
Disclosure of the fair values of an entity’s financial instruments is required when it is practicable to estimate those fair values.
true
Derivatives defined
Financial instrument w/following elements
1) “underlying” AND “notional amount” OR “payment provision” (IF -> THEN)
2) Requires no/very small initial investment
3) Permits/requires settlement in cash, in lieu of delivery
“Underlying” and “Notional Amount”
Underlying - specified price/rate
- stock price
- commodity price
- foreign currency exchange rate
Notional amount - specified unit of measure
- shares of stock
- pounds/bushels of commodity
- number of foreign currency units
*IF -> THEN (much like a bet)
Derivative Examples
1) option contracts - stock options
2) futures contracts - contracts made w/ clearinghouse for exchange in future at current price
3) forward contracts - similar to futures, BUT directly between contracting parties (not clearinghouse)
4) swap contracts - swap fixed rate debt for variable rate debt or vice versa
Recognition/Measurement
Entities that hold derivative instruments must:
- recognize as either assets (contract. rights) or liab (contract. obligations)
- measure @ FV
- changing FV = gains/losses recognized in earnings unless meets specific hedging criteria
Embedded derivatives
portion/term in a contract that acts like a derivative which is embedded (hidden) in a “host” contract
EX of host contracts:
1) debt instruments
2) equity instruments
3) leases
*if embedded derivative = definition of a derivative, you may need to bifurcate (separate)
Bifurcation of embedded derivatives
If host contract & embedded derivative are NOT clearly/closely related -> must be separated into 2 instruments:
1) embedded derivative
2) non-derivative host contract
EXCEPTION: when host contract = FV
Clearly & Closely Related
1) Debt Instrument:
- inflation
- interest rates
- creditworthiness
2) Equity Instrument
- Share price of equity instrument
3) Lease
- Inflation
- Interest Rates
Accounting for Embedded Derivatives
1) allocate CV of hybrid contract between
- new embedded derivative
- remaining host contract
2) allocate CV by:
- recording derivative @ FV
- assigning remaining CV to host contract
3) Acct treatment:
- embedded derivative = derivative instrument
- host contract using relevant GAAP
Derivatives Held for Speculation
Not designated (or qualify) to hedge risk
Entered into to obtain profit
Adj. FV @ B/S Date:
DR: Derivative Instrument
CF: Gain on Derivative (I/S)
Hedging
Hedging is a risk management strategy which involves making an investment (the hedge) so as to offset (or counter) another investment (the hedged item) so that a loss on one investment (the hedged item) would be offset (at least in part) by a gain on the other investment (the hedge), and vice versa. A perfect hedge is achieved when the hedge investment has a 100% inverse correlation to the initial investment (hedged item) so that there is no possibility of future gain or loss. A perfect hedge rarely exists.
value or settlement amount of a derivative determined?
multiplication (or other calculation) of the notional amount and the underlying
true/false
intrinsic value of a call option is the difference between the exercise (strike) price and the market price
true
true/false
derivative does not require contractual satisfaction by delivery of the subject matter of the contract
true
*contract that has it settlement value tied to an underlying notional amount best describes a derivative financial instrument
Hedging Elements
Hedging item - recognized asset/liab, firm commitment, or transaction subject to risk of possible loss
Hedging instrument - contract/arrangement to mitigate/eliminate risk of possible loss with hedged item
Natural/Economic Hedge
Hedge Acct
use derivative to offset price of commodity, interest %, anticipated purchase, foreign exchange exposure, etc.
- no special hedge acct, market-to-market derivative/exposure through earnings
Use a derivative to offset price of commodity, interest %, anticipated purchase, foreign exchange exposure, etc.
- when criteria met, there is special act for hedging instrument/hedged item
Items eligible for hedge acct
commodity risk price - risk of loss due to commodity value
foreign exchange risk - risk of loss due to exchange rate change
interest rate risk - risk of loss due to interest rate changes
credit risk - risk of loss with credit risk changes
FV risk - risk of loss due to change in FV of hedged item
Convert fixed risk -> floating
CF risk - risk of loss due to change in CFs of hedged item
Converts floating risk -> Fixes
- other identified risks are forms of FV/CFs risk - EX:
1) foreign currency risk
2) net investment in foreign operations
Forecasted Transaction
expected to occur when there is NO firm commitment b/c no transaction/event has yet occurred, when transaction/event does occur, it will be at prevailing market price
Firm Commitment
agreement with unrelated party that is binding on both parties/usually legally enforceable; specifies all significant terms (quantity, fixed price, timing) and includes disincentive for nonperformance that is large enough to make performance probable.
- firm commitment = purchase commitment
Forecasted Transaction benefits/limitations
Benefits:
- flexibility
- allows due diligence
- increased possibility for price concessions
- prices may go down
Limitations:
- shortage of supply
- no opportunity to build relationship w/ vendor
- prices may go up
Firm commitment - benefits/limitations
Benefits:
- certainty of vendor, price, quantity, quality
- permits better budgeting
- develop relationship w/vendor
- increase likelihood of obtaining product if there is shortage
- mitigates risk of prices increasing
Limitations:
- prices may decrease
- vendor may go bankrupt
- less opportunity to build relationships w/other vendors
- cannot take advantage of last minute discounts
four different possible uses of derivatives.
1) Derivatives not used as a hedge;
2) Fair value hedges;
3) Cash flow hedges;
4) Foreign currency hedges.
true/false
risks associated with a foreign currency that can be hedged can be either the risk to fair value in the foreign currency or the risk to cash flows in the foreign currency
true
true/false
Derivative instruments can be used not only for hedging purposes but also for speculative purposes.
In addition, derivative instruments can be used not only to hedge fair value, but also to hedge cash flows.
true
true/false
fair value of an investment accounted for using the equity method of accounting cannot be hedged for accounting purposes.
true
FV Hedge
Hedge of an exposure to changes in FV of asset, liab, or unrecognized firm commitment from a particular risk
- unrecognized firm commitment = legally binding contract not yet recognized as asset/liab under GAAP
- FV hedge converts fixed price exposure -> floating price
Requirements for FV Hedges
Derivative (hedging instrument) asset, liab, or Firm Commitment (hedged item):
1) must have formal doc of hedging objective/relationships, risk being hedged, and how effectiveness will be assessed
2) derivative must be highly effective in offsetting changes in FV of hedged item, with assessment at least quarterly & at B/S date
FV Hedge of Fixed Interest %
FV hedge of a fixed interest % would convert the fixed rate to a floating rate
- Only benchmark % may be hedged
- Only 2 rates are benchmark rates
1) Direct US Treasury Obligations
2) London Interbank Offer Rate (LIBOR)
Hedge of Non-financial asset/liab
Risk hedged = risk of change in FV of asset/liab
- FV of portion of asset/liab cannot be hedged item
FV Hedge Acct
1) Adj. hedging instrument to FV @ B/S date
2) Adj. hedged item (asset, liab, Firm Comm.) to FV @ B/S date
3) Recognize in current income gain/loss from revaluing both
* to extent gain/loss on derivative doesn’t exactly offset loss/gain on hedged item = net gain/loss in current income
conditions under which an “unrecognized firm commitment” exists
entity enters into a contract to buy or sell but has not yet booked the transaction
accounting requirements for a change in the fair value of a fair value hedging instrument and the asset, liability, or firm commitment being hedged?
1) Adj CV of the derivative/hedged item to FV
2) Recognizing gains/losses from revaluing the derivative and the hedged item in current income.
formal documentation required at the inception of a fair value hedge?
1) hedging relationship;
2) objective/strategy for undertaking the hedge;
3) Identification of the hedging instrument;
4) Nature of the risk being hedged;
5) How effectiveness of the hedge will be assessed.
true/false
derivative cannot be used to hedge the risk associated with an unrecognized forecasted transaction, primarily because, since the transaction is only “forecasted,” there is no established fair value to hedge
true
true/false
firm commitment occurs when an entity has a contractual obligation or contractual right, but no transaction has been recorded (and no asset or liability recognized) because GAAP requirements for recognition have not yet been met. Nevertheless, the subject matter of the firm commitment is at risk of change in fair value and can be hedged.
true
FV Hedge Current Year Net Income (Loss)
changes of FV of the hedged item and hedging instrument offset each other resulting in net income (loss)
Effective vs Ineffective Portion of hedges
effective - OCI
ineffective - net income (loss)
changes of FV of the hedged item and hedging instrument offset each other resulting in net income (loss) -> the net income (loss) represent ineffective (loss) and effective (income) portions of the hedge.
CF Hedge
hedge of changes in CF associated with asset, liab, forecasted transaction
“forecasted transaction” - planned transaction w/ another party for rights/obligations not yet established
- CF hedge converts floating price -> fixed price
Requirements for CF Hedge
derivative (hedging instrument) and asset, liab, or forecasted transaction (hedged item):
- must have formal docs of objective, risk being hedged, and how effectiveness will be assessed
- derivative must be highly effective in offsetting changes in CF of hedged item, with assessment at leas quarterly and at B/S date
Exclusions from CF Hedge
1) business combo
2) parent’s equity in a sub
3) entity’s own equity instruments
CF Hedge Acct
- Determine/adj. derivative for changes in its FV
- Determine change in PV of expected CF of hedged item (asset, liab, forecasted)
- Recognize change in FV of derivative:
Up to amount of change in PC of expected CF as OCI - effective portion
- Amount different than change in PV of expected CF in current income - ineffective portion
conditions necessary for a forecasted transaction to be the hedged item in a cash flow hedge?
1) Specifically identified as a single transaction or group of individual transactions with the same risk exposure;
2) Probable of occurring;
3) With an external party (with limited exceptions);
4) Capable of affecting cash flows and earnings;
5) Not for acquisition of an asset or incurrence of a liability accounted for at fair value with the change reported in current income.
true/false
To the extent the change in the fair value of the hedging instrument offsets the change in the fair value of the hedged item, the hedge is effective, and that amount is recognized in other comprehensive income, not current income. To the extent the change in the fair value of the hedging instrument is different than the change in the fair value of the hedged item, the hedge is ineffective, and that amount is recognized in current income
true
true/false
When the fair value of a financial instrument is hedged, gains (and losses) from changes in the value of the hedged item and the hedging instrument (derivative) are recognized in current income. When the cash flow of a financial instrument is hedged, gains (and losses) from changes in the value of the hedged item are recognized in other comprehensive income, along with the change in the value of the hedging instrument (derivative) up to the change in amount of the hedged item. Any change in the hedging instrument in excess of the change in the value of the hedged item is recognized in current income.
true
Foreign Currency Hedge
Mitigate changes in value of assets, liab, and forecasted transactions that are denominated in foreign currency
- “denominated foreign currency” = asset, liab, or planned transaction settled in a foreign country
- hedge is to mitigate changes in exchange rates between currencies
Foreign Currency Hedges Examples
1) forecasted tranaction - CF (OCI)
2) Firm Commitment - FV (I/S) or CF (OCI)
3) Recognized asset/liab - FV (I/S) or CF (OCI)
4) Invest. in Avail-For-Sale- FV (I/S)
5) Net invest. in foreign operations - FV (I/S) of converted financials or CF (OCI) gain/loss offsets translation adj.
Effectiveness of hedging
2 terms associated w/effectiveness
1) assessing hedge effectiveness - “right” to use hedge acct
2) measuring ineffectiveness - determination of how much the hedge needs to be recognized in earnings
Assessing Effectiveness
Prospective assessment
forward-looking assessment of entity’s expectation that a planned hedging relationship will be effective over future periods
- consider all possible changes in hedged item/hedged instrument
- approaches:
1) regression analysis
2) qualitative assessment
3) probability-weighted analysis
Assessing Effectiveness
Retrospective
on-going assessment of hedging relationship for effectiveness and to measure any ineffectiveness
- carried out @ each B/S date and at least every 3 months
- approaches:
1) cumulative dollar offset: how well the dollar changing in hedging instrument offsets dollar change in hedged item
2) regression analysis
3) qualitative assessment
Measuring Ineffectiveness
change in hedging instrument doesn’t offset change in hedged item
change in derivative value /change in hedged item value
*recognize income in current period of change
Effectiveness Short-Cut Method
Applies ONLY to interest-rate risk hedge of recognized interest-bearing financial asset/liab using interest-rate swap
Very difficult to qualify
Derivative Disclosure Requirements
entities that issue/hold derivative instruments must disclose:
1) objectives, context for objectives, strategies to meet each
2) FV hedge - gain/loss recognized in period
3) CF hedge - gain/loss recognized in income in the period in OCI and an estimate in next 12 months
* for hedges of net invest. in foreign operations - G/L included in cumulative translation adj.
