Section 3D - Derivatives & Hedge Accounting

Question 1

Which of the following is a criterion that must be satisfied for a financial instrument to qualify as a derivative financial instrument?

The financial instrument has at least one underlying or notional amount.

The terms of the financial instrument require or permit net settlement.

All of the answer choices must be satisfied.

The financial instrument requires little or no initial net investment.

Answer 1

All of the answer choices must be satisfied

In order for a financial instrument to qualify as a derivative financial instrument, it must have at least one underlying or notional, it must require little or no initial net investment, and the terms must require or permit net settlement..

Question 2

Derivative instrument: A financial instrument or other contract with all three of the following characteristics:

1. It has (a) one or more ___, (b) one or more ___amounts or payment ___, or (c) both.
2. It requires little or no initial net ___.
3. Its terms require or permit net ____, it can readily be settled net by a means ___the contract, or it provides for ___of an asset that puts the recipient in a position not substantially different from net settlement.

______: A specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable

____amount: A number of currency units, shares, bushels, pounds, or other units specified in a derivative instrument

Answer 2

Underlyings, notional , payment

investment

settlement, outside, delivery

Underlying

Notional

Question 3

• Neron Co. has two derivatives related to two different financial instruments, Instrument A and Instrument B, both of which are debt instruments.
• The derivative related to Instrument A is a fair value hedge, and the derivative related to Instrument B is a cash flow hedge.
• Neron experienced gains in the value of Instruments A and B due to a change in interest rates.

Which of the gains should be reported by Neron in its income statement?

Neither gain in value of debt Instrument A or B

Gain in value of both debt Instruments A and B

Gain in value of debt Instrument B only

Gain in value of debt Instrument A only

Answer 3

Gain in value of debt Instrument A only

FASB ASC 815-25-35-1 requires that gains or losses associated with changes in the fair value of the hedging instrument be recognized in net income in the period in which the change in fair value takes place.

The gain or loss resulting from changes in the fair value of a cash flow hedge is included in other comprehensive income.

Consequently, only the gain in the value of Instrument A would be included in net income.

Question 4

For ____hedges, gains or losses associated with changes in the fair value of the hedging instrument are recognized in earnings in the period in which the change in fair value takes place.

In addition, changes in the fair value of the hedged item (i.e., the asset, liability, or firm commitment) must be simultaneously recognized in ___and as an adjustment to the carrying amount of the hedged item.

If an entity excludes a portion of the hedging instrument from the assessment of the effectiveness, the initial value of the excluded component is recognized in earnings through ___.

Subsequently, the difference between the change in fair value of the excluded component and the amounts recognized in earnings is recognized in ___income unless the entity elects to recognize the excluded component gain or loss in earnings.

The gain or loss resulting from changes in the fair value of a ___hedge is included in other comprehensive income.

Answer 4

fair value

net income

amortization

other comprehensive

cash flow

Question 5

Derivatives designated as hedges of anticipated or forecasted transactions are carried at __value.

The gain or loss resulting from changes in the fair value of the derivative is recognized in ___income rather than in net income.

When the amounts are reclassified from OCI to earnings, they are presented in the same income statement line item as the hedged item effect

. If an entity excludes a portion of the hedging instrument from the assessment of the effectiveness, the initial value of the excluded component is recognized in earnings through ___.

The subsequent difference between the change in fair value of the excluded component and the amounts recognized in earnings is recognized in ___income unless the entity elects to recognize the excluded component gain or loss in earnings.

Answer 5

fair

other comprehensive

amortization

other comprehensive

Question 6

Grey Co. purchased stock in Cherry Co. Grey purchased a put option on the stock. The strike price is the current market price. What is the most likely reason Grey purchased the put option?

Cherry stock has decreased in price, but Grey believes the stock is going to increase in price.

Cherry stock has increased in price, but Grey is concerned that the price might decrease.

Cherry stock has increased in price, and Grey believes the stock is going to continue to increase in price.

Cherry stock has remained flat, and Grey believes the stock is going to remain at its original purchase price.

Answer 6

Cherry stock has increased in price, but Grey is concerned that the price might decrease.

• Options allow the holder of the contract to buy (call option) or sell (put option) a given item at a specific price during a specific period of time.
• If an individual believes that the price of a company’s stock will decrease, the individual might consider purchasing a put option with a strike (or exercise price) equal to its current market price.
• This option gives the holder of the option the right to sell the stock at its strike price, even if the price falls below that threshold, and then repurchase the stock at its new lower market price.

Question 7

___: Allows the holder of the contract to buy or sell a given item at a specific price during a specific period of time.

There are two fundamental types of options—___options and ___options.

A ___option gives its owner the right to buy (call) a specific item at a specific price during a specific period of time.

A ___option gives its owner the right to sell (put) a specific item at a specific price during a specific period of time.

Answer 7

Options

call or put

call

put

Question 8

How should gains or losses from fair value hedges be recognized?

1. No gain or loss recognition in the period of fair value change, but subsequent recognition of gain or loss in earnings in the period net settlement occurs
2. As a component of other comprehensive income in the period of fair value change and subsequently in earnings in the period net settlement occurs
3. The gain or loss, along with the offsetting loss or gain attributable to the hedged risk, should be recognized currently in earnings in the same accounting period.
4. As an extraordinary item in the period of fair value change because of the unusual and infrequent nature of derivative contracts

Answer 8

The gain or loss, along with the offsetting loss or gain attributable to the hedged risk, should be recognized currently in earnings in the same accounting period.

The FASB requires that the following be recognized for fair value hedges:

1. Changes in the fair value of the fair value hedge
2. Changes in the fair value of the item being hedged

Note that the concept of “extraordinary” items has been eliminated from GAAP; the presentation for items that are unusual in nature or occur infrequently will be expanded to include items that are both unusual in nature and infrequently occurring.

Question 9

The FASB requires that the following be recognized for fair value hedges:

changes in the fair value of the ___hedge

Changes in the fair value of the ___being hedged

Fair value hedges protect against the ___in value caused by __terms, rates, or prices.

In contrast, ___hedges protect against the risk caused by ___prices, costs, rates, or terms that cause future cash flows to be uncertain.

Answer 9

fair value

item

changes

cash flow

Question 10

• On December 1 of the current year, Bann Co. entered into an option contract to purchase 2,000 shares of Norta Co. stock for $40 per share (the same as the current market price) by the end of the next two months. The time value of the option contract is $600.
• At the end of December, Norta’s stock was selling for $43, and the time value of the option is now $400

. If Bann does not exercise its option until January of the subsequent year, which of the following changes would reflect the proper accounting treatment for this transaction on Bann’s December 31, year-end financial statements?

Current assets will decrease by $200.

Other comprehensive income will increase by $6,000.

Net income will increase by $5,800.

The option value will be disclosed in the footnotes only.

Answer 10

Net income will increase by $5,800.

Options do not qualify for hedge accounting. The gain or loss must be currently recognized.
$43 x 2,000 = $86,000; $86,000 + $400 = $86,400
$40 x 2,000 = $80,000; $80,000 + $600 = 80,600
Gain = $ 5,800

Question 11

Instruments That Do Not Qualify for Hedge Accounting

The gain or loss on a derivative instrument that does not qualify as a hedge must be recognized currently in __income.

Answer 11

net

Question 12

Which of the following risks are inherent in an interest rate swap agreement?

1. The risk of exchanging a lower interest rate for a higher interest rate
2. The risk of nonperformance by the counterparty to the agreement

II only

Both I and II

I only

Neither I nor II

Answer 12

Both I and II

An interest rate swap agreement is entered into in the hope of additional safety or other benefits, but it carries both the risks identified above, the potential of counterparty nonperformance or an undesirable exchange

Question 13

Swaps: A contract between two or more parties, referred to as ___, to exchange sets of cash flows over a specified period in the future.

The two most prevalent types of swaps are __rate swaps and ___swaps.

An interest rate swap agreement is entered into in the hope of additional ___or other benefits, but it carries both the risks identified above, the potential of counterparty ___or an ___exchange

Answer 13

counterparties

interest rate , currency

safety , nonperformance , undesirable

Question 14

Which of the following financial instruments is not considered a derivative financial instrument?

A fair value hedge

A forward exchange contract

Commercial paper

A futures contract for raw cocoa

Answer 14

Commercial paper

One of the characteristics of a derivative instrument is that it derives its value or cash flow from some other security or index, called an underlying. FASB ASC 815-10-20 defines an underlying as follows:

“An underlying is a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable. An underlying may be a price or rate of an asset or liability but is not the asset or liability itself.”

Commercial paper is a debt agreement and does not have this characteristic of derivative financial instruments.

Question 15

Futures: An agreement between a buyer and a seller that is executed through a clearing house and that calls for delivery of some commodity or financial instrument at a specified ___date at a price established at the time of contracting.

The two most prevalent financial futures are ____ ___ futures and ____ rate futures.

___contracts: An agreement reached at a point in time that calls for the delivery of a financial instrument or commodity at a specified later date at a price established at the time of contracting.

The most widely used forward contracts are those for____ currency. These contracts are agreements to exchange, at a specified future date, currencies of different countries at a specified rate of exchange.

Answer 15

‘later

Foreign currency & Interest

Forward

foreign currency

Question 16

Which of the following items is a required disclosure regarding fair value hedges?

The amount of net gain or loss recognized in earnings when a hedged firm commitment no longer qualifies as a fair value hedge

The estimated net amount of the existing gains or losses at the reporting date that is expected to be reclassified into earnings within the next 12 months

The net amount of gains or losses included in the cumulative translation adjustment during the reporting period

A description of the transactions or other events that will result in the reclassification into earnings of gains and losses that are reported in accumulated other comprehensive income

Answer 16

The amount of net gain or loss recognized in earnings when a hedged firm commitment no longer qualifies as a fair value hedge

Of the answer choices listed, only “the amount of net gain or loss recognized in earnings when a hedged firm commitment no longer qualifies as a fair value hedge” is a disclosure requirement for a fair value hedge.

The other answer choices are disclosure requirements for a cash flow hedge.

Question 17

FASB ASC 815-10-25-1 (Derivatives and Hedging—Recognition) provides for all of the following

derivatives should be recognized as ___ or ___on the financial statements.

gains and losses from hedge transactions are accounted for in different ways, depending on whether it is designated and qualifies for hedge accounting. T/F

derivatives should be reported at ___.

Answer 17

assets or liabilities

true

fair value

Question 18

Fair value or cash flow hedge disclosure?

The amount of net gain or loss recognized in earnings when a hedged firm commitment no longer qualifies as a fair value hedge

The estimated net amount of the existing gains or losses at the reporting date that is expected to be reclassified into earnings within the next 12 months

The net amount of gains or losses included in the cumulative translation adjustment during the reporting period

A description of the transactions or other events that will result in the reclassification into earnings of gains and losses that are reported in accumulated other comprehensive income

Answer 18

FV

Cash

Cash

Cash

Question 19

An entity must recognize all of its derivative instruments in its____ as either assets or liabilities. Thus, merely disclosing derivative instruments in the notes to the financial statements is ___. They must be measured at the ___amount and included in the column totals of the balance sheet.

All derivatives must be recognized on the balance sheet at __value.

Fair value is the amount at which an asset (liability) could be bought (incurred) or sold (settled) in a current transaction between willing parties in other than a forced or liquidation sale t/f.

Answer 19

balance sheet, unacceptable, dollar

fair

true

Question 20

• On November 1 of the current year, Fruita Corporation entered into an option contract to purchase 800 shares of Silt Company stock for $19 per share (the same as the current market price) by the end of the next three months. The option is purchased for speculative purposes.
• The time value of the option contract is $500 at purchase. At the end of December, Silt’s stock was selling for $23, and the time value of the option is now $120.

If Fruita does not exercise its option until January of the subsequent year, which of the following changes would reflect the proper accounting treatment for this transaction on Fruita’s December 31, year-end financial statements?

The option value will be disclosed in the footnotes only.

Other comprehensive income will increase by $3,200.

Net income will increase by $2,820.

Current assets will decrease by $380.

Answer 20

Net income will increase by $2,820.

Question 21

Which of the following financial instruments is not considered a derivative financial instrument?

Stock-index options

Interest-rate swaps

Currency futures

Bank certificates of deposit

Answer 21

Bank certificates of deposit

One of the characteristics of a derivative instrument is that it derives its value or cash flow from some other security or index, called an underlying. FASB ASC 815-10-20 defines an underlying as follows:

“An underlying is a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable. An underlying may be a price or rate of an asset or liability but is not the asset or liability itself.”

Bank certificates of deposit clearly do not have this characteristic.

Question 22

A derivative financial instrument is best described as:

evidence of an ownership interest in an entity such as shares of common stock.

a contract that has its settlement value tied to an underlying notional amount.

a contract that conveys to a second entity a right to future collections on accounts receivable from a first entity.

a contract that conveys to a second entity a right to receive cash from a first entity.

Answer 22

a contract that has its settlement value tied to an underlying notional amount.

A derivative instrument has three characteristics:

1. There is an underlying or notional amount.
2. There is little or no initial net investment.
3. Its term requires or permits net settlement.

Question 23

A derivative instrument has three characteristics:

There is an __or ___amount.

There is little or no ___net investment.

Its term requires or permits net ___.

Answer 23

underlying or notional

initial

settlement

Question 24

Answer 24

$100

FASB ASC 815 requires that the gains and losses associated with speculative forward contracts be included in net income in the period(s) in which the changes in fair value of the forward contracts take place. The change in fair value is $100 [10,000 pounds × ($2.06 − $2.05)].

Question 25

Answer 25

Option (Futures Contract) 200,000
____ Unrealized holding gain-equity 200,000

• Since the price of gold has risen, the value of the futures contract (the derivative) increased in value. Since the contract was a 6-month contract, it expires on December 31, 20X1, and has a fair value just before it expires of $200,000 ($4,200,000 price of gold at December 31, 20X1, less $4,000,000 contract price of the futures contract).
• That $200,000 increase in fair value of the derivative results in a debit to the Futures Contract account (an asset) of $200,000 and a credit to unrealized gain of $200,000.
• Since the futures contract serves as a hedge of an “anticipated” transaction (the probable purchase of 10,000 ounces of gold on January 1, 20X2), if it satisfies all other conditions for a hedge, the derivative represents a cash flow hedge rather than a fair value hedge.
• Accordingly, the unrealized gain of $200,000 would be included in other comprehensive income rather than in net income.

Question 26

Which of the following is the characteristic of a perfect hedge?

The possibility of future gain and no future loss

No possibility of future gain or loss

No possibility of future gain only

No possibility of future loss only

Answer 26

No possibility of future gain or loss

The purpose of a hedge is to reduce exposure to a particular type of risk. A perfect hedge would remove all of the risk—that is, remove the possibility of any future gain or loss.

Question 27

FASB ASC 815-10-50-1A requires that an entity that holds or issues derivative instruments (or nonderivative instruments that are designated and qualify as hedging instruments) disclose which of the following?

All of the answer choices are required disclosures.

Its strategies for achieving those objectives

Its context needed to understand those objectives

Its objectives for holding or issuing those instruments

Answer 27

All of the answer choices are required disclosures.

All of the listed disclosures are required under FASB ASC 815-10-50-1A:

Its objectives for holding or issuing those instruments

Its context needed to understand those objectives

Its strategies for achieving those objectives

Question 28

All of the listed disclosures are required under FASB ASC 815-10-50-1A:

Its ___for holding or issuing those instruments

Its ___needed to understand those objectives

Its ___for achieving those objectives

Answer 28

objectives

context

strategies

Question 29

Answer 29

$2,500

• Futures contracts are a selected type of derivative instrument. All derivatives must be recognized on the balance sheet at fair value.
• Fair value is $0.70 on November 2, 20X1. Accounting for the changes in fair value depends on whether it has been designated as and qualifies for hedge accounting.
• Platt Co. has not hedged the risk of the futures contract and FASB ASC 815-20-35-1 specifies that gains and losses must be included in income for these contracts.
• Since this is a futures contract, the future 30-day rate ($0.65) is used to measure the gain or loss for the year ended December 31, 20X1. The foreign currency exchange loss for 20X1 is ($.70 - $.65) × 50,000 = $2,500.

Question 30

A foreign currency___ is an agreement to exchange different currencies at a specified future date and at a specified rate

There are three types of foreign currency hedges that qualify for hedge accounting: foreign currency __value hedges, foreign currency ___ hedges, and hedges of a foreign currency ____in a foreign entity.

Answer 30

forward contract

fair

cash flow

net investment

Question 31

Answer 31

Option (Futures Contract) 120,000
Unrealized holding gain–equity 120,000

Since the price of crude oil has fallen, the value of the futures contract (the derivative) increased in value. Since the contract was a 6-month contract, it expires on June 30, 20X6, and has a fair value just before it expires of $120,000 (($60 per barrel future − $54 per current barrel) × 20,000 barrels). That $120,000 increase in fair value of the derivative results in a debit to the Futures Contract account (an asset) of $120,000 and a credit to unrealized gain of $120,000.

Since the futures contract serves as a hedge of an “anticipated” transaction (the probable sale of 20,000 barrels of crude oil on July 1, 20X6), if it satisfies all other conditions for a hedge, the derivative represents a cash flow hedge rather than a fair value hedge. Accordingly, the unrealized gain of $120,000 would be included in other comprehensive income rather than in net income.