Financial Instruments & Derivatives

Question 1

What are financial instruments

Answer 1

• cash
• ownership interests in an entity (ex. stock)
• derivative contracts that create a right and obligation to transfer other financial instruments (ex. stock options)

Question 2

what are notes and loans receivable or payable generally reported at?

Answer 2

amortized cost

Question 3

what is amortized cost?

Answer 3

It is the cost of a security, plus or minus adjustments for any purchase discounts or premiums associated with the purchase of the security. A purchase discount arises when an investor pays less than the face value of a security in order to increase the effective interest rate, while a purchase premium is paid when the interest rate paid on a security is higher than the market rate.

Question 4

Reasons an entity acquires derivatives

Answer 4

1. investments
2. arbitrage
3. hedges

Question 5

What is an arbitrage?

Answer 5

the ability to take advantage of price differentials in separate markets allowing the entity to enter into transactions that are potentially profitable without significant risk of loss.

Question 6

What are the rules of arbitrage under a futures contract?

Answer 6

1. if the market price is below the underling amount then the ENTITY will pay the difference btwn the underling & market price to the counter party in the buy contract. If the entity entered into another contract that had a higher underling price & the market price was higher than that contract price then it will EARN the difference btwn the underling and market.
   NOTE: the whole concept is that the entity will either be paying and/or receiving the difference in the underling price in the contract and the market value. This helps the entity break even.

Question 7

What is a hedge

Answer 7

the use of a derivative to reduce or eliminate a risk that the entity is subject to either as a result of an asset or liability recognized on its financial statements or a future transaction.

Question 8

Why are derivatives used?

Answer 8

as hedges used to reduce or eliminate the risk of an adverse change in circumstance

Question 9

What is the shortfall for having a derivative?

Answer 9

eliminates the opportunity to take advantage of a favorable change

Question 10

How are derivatives reported on the F/S?

Answer 10

• maybe an asset or liability
• reported @ FV
• Unrealized gains/losses are generally reported in income
• *Note: cash flow hedges are temporarily reported as part of OCI on the B/S
• All other unrealized gains and losses are reported in income in the period in which the increase or decrease in value occurs.

Question 11

What are the 3 characteristics that make a hedge a derivative?

Answer 11

NUNS

1. No net investment - there must either be no initial net investment or an initial investment that is smaller than would normally be required for an instrument that would respond similarly in the market.
   * *examples include: (interest rate swaps, futures contracts, and forward exchange contracts often require no initial net investment or an investment that is limited to fees paid to attorney and others to establish the derivative .
2. Underlying and Notional amount. the notional amount is basically the number of units (units, bushels, pounds) and the underlying is the factor that affects the derivatives value (specified price, interest rate, exchange rate).Ex in a forward exchange contract the notional amount wld be the # of FCU and the underlying would be the future exchange rate
3. Net Settlement - the derivative can be settled in a net amount. remember the entity receives or pays the difference between the agreed upon exchange rate and the market rate

Question 12

What are examples of derivatives?

Answer 12

• Option contract- (has the RIGHT but NOT OBLIGATION to purchase or sell in the future. Put options are the right to sell share; Call-options are the right to acquire shares in the future)
• Futures contract - (has RIGHT and OBLIGATION to deliver/purchase foreign currency or goods in the future at a price set today. Similar to a Forward contract normally traded on a national exchange)
• Forward contract (has RIGHT & OBLIGATION to buy or sell a commodity at a future date for an agreed upon price
• Interest rate or foreign currency swap (a forward-based contract or agreement between two counter parties to exchange streams of cash flows over a specified period in the future.

Question 13

what risk do derivatives create?

Answer 13

• Off balance sheet risk due to the possible changes in amounts owed
• credit risk-risk that a loss occurs b/c another party fails to perform according to the terms of a contract
• required disclosures about each significant concentration (activity, region, or economic characteristic)
• must disclose the maximum amount of loss due to credit risk
• entity’s policy arrangements to mitigate the credit risk
• optional to disclose market risk which is the risk a loss may occur as a result of changes in the market value of financial instruments due to economic circumstances.

Question 14

what is the “speculative use of derivatives”

Answer 14

when the entity enters into the contract.

Question 15

what is intrinsic value for a company who wants to purchase stock for example

Answer 15

the option to purchase stock at a lower price than the current market price because if you turn around and sell the stock you would have a gain.

Question 16

What is a fair value hedge derivative?

Answer 16

if the derivative is hedging against a recognized asset or liability on the balance sheet or a firm purchase commitment (meaning a legally binding contract) the changes in the value of the derivative are reported in Income from Continuing Operations.

Question 17

what can fair value hedges be used against?

Answer 17

against the following:

• inventories
• the value of a fixed income investment
• the value of a fixed rate debt obligation
• a firm commitment

Question 18

What are the characteristics and accounting procedures for a cash flow hedge?

Answer 18

If the derivative is hedging against a forecasted transaction that is expected to take place in the future, but which is not yet a legal commitment then changes in the value of the derivative are reported as direct adjustments to stockholder’s equity and included in other comprehensive income until the transaction is complete and the cash flows have ACTUALLY occurred.

Question 19

what is the journal entry for a loss on a CASH FLOW HEDGE against an existing asset

Answer 19

Debit: Loss on market decline in inventory

Credit: Inventory (to reduce the amount of the inventory to record the loss)

then you do the following:
Debit: Receivable on derivative (for the same amount of the loss)

Credit: Gain on FV hedge (which appears on the B/S in Other Comprehensive Income)

Note there is no journal entry when the contracts are entered into b/c there is no cash or assets or anything involved other than a commitment.

Question 20

When are speculation (non-hedge) used?

Answer 20

• acquire to take on risk in the hopes of profit

- gain or loss in income from continuing operations (I/S)

Question 21

When are fair value hedges used?

Answer 21

• acquired to hedge against a RECOGNIZED asset or liability or a firm purchase commitment
• gain/loss in income from continuing operations (I/S)
• should be offset by loss or gain on hedged item

Question 22

when are cash flow hedges used?

Answer 22

• acquired to hedge against a forecasted future transactions
• gain/loss in other comprehensive income (B/S)
• nothing included in net income until forecasted activity occurs

Question 23

when does an entity use a foreign currency hedge against an investment in foreign operations

Answer 23

• acquired to hedge against currency risk from a major investment in a company w/a functional currency other than US dollars
• gain/loss in other comprehensive income (OCI) (B/S)
• offsets translation losses or gains from investment in foreign operations.

Question 24

What are the requirements for non public entities to elect to use the alternative accounting approach for interest rate swaps

Answer 24

• the terms must be virtually identical such that they mirror the terms of the underlying obligation.
• the settlement date on which payments are exchanged for the swap are very close to the dates on which payments are made on the underlying obligation
• initial FV of the swap is zero indicating that the interest rates are comparable on the date it is entered into & that the parties have different views on anticipated future changes in the index rate
• the notional amount of the swap (the amount on which the swapped interest rates are calculated) must be equal to or lower than the principal balance of the hedged instruments
• all interest payments must be designated as hedged in proportion to the ratio of the notional amount of the hedge and the principal balance of the underlying obligation.

Question 25

what are the reporting differences if the alternative accounting approach for interest rate swaps is elected

Answer 25

1. documentation and other elements are not required to be completed in advanced (must be completed anytime until the first set of financial statements on which the alternative accounting approach is applied are either issued or available to be issued, which ever is earlier.
2. it is assumed that the swap is perfectly effective and the debt obligation is accounted for as if it bore interest at a fixed rate
3. the hedge, the interest rate swap, is reported at its settlement amount rather than its FV
4. any difference btwn reported amounts and payments made or received are reported in Other Comprehensive Income.

Question 26

What is the accounting treatment issued by the FASB (PCC) for “alternative accounting approach for interest rate swaps”

Answer 26

• Debit: Interest Expense (for an amount calculated by applying the fixed rate to principal balance, adjusted for the amount of time elapsed since the previous calculation
• Debit: Principal (i guess this is some sort of payable since it is reducing the amount) for the amount by which it is reduced as a result of applying the terms of the obligation to any payments made.
• an asset or liability will be debited or credited to adjust the amount reported as the balance of the derivative to the settlement value of the interest rate swap
• cash will be credited for the net amount paid, including the payment on the underlying obligation adjusted for the net amount received from the counterparty or paid to the counterparty to the swap, depending on whether the index rate has increased or decreased, respectively
• the amount required to balance the entry will be reported as a debit or credit to other comprehensive income (OCI). (if it is a debit to OCI it will reduce OCI if it is a credit to OCI it will increase OCI)

Question 27

What are the inherent risk associated with Bonds?

Answer 27

1. Credit risk b/c the issuer of the bonds may or may not perform which affect interest rate
2. market risk b/c the bonds will bear interest @ fixed rate and market interest rates may change, making bonds more or less desirable & causing increases or decreases in their FV.

Question 28

What are convertible bonds considered as?

Answer 28

Compound or hybrid instruments

Question 29

How are hybrid instruments accounted for?

Answer 29

1. if the host instrument (ex. in convertible bonds into stock…the bond wld be the host instrument and the stock embedded derivative) is reported at FV the derivative is also reported at FV.
2. if the host instrument is not reported at FV, the derivative will be separated or bifurcated (means to separate geez why couldn’t they just say separate!) from the host instrument and accounted for separately.
   * **this would only be appropriate if the features have the characteristics of a derivative.
   * **the derivative should have characteristics that respond to market influences differently from the host instrument.

Question 30

What did FASB ASC 815 allow?

Answer 30

Financial instruments that have embedded derivatives to be accounted for as a whole if the holder elects to account for the whole instrument on a Fair Value Basis.

Question 31

If instruments with embedded derivatives are elected to be accounted for as a whole what disclosures are required?

Answer 31

• how & why an entity uses derivative instruments
• how derivative instruments and related hedge items are accounted for
• how derivative instruments & related hedge items affect an entity’s financial position, financial performance, & cash flows.
• objectives and strategies for achieving financial instruments
• context to understand the instrument
• risk management policies
• a list of hedged instruments
• disclosure of FV of financial instruments required when practicable to estimate fair value.

Question 32

According to FASB ASC 820 fair value on financial assets & financial liabilities is what?

Answer 32

the price that would be received to sell an asset or paid to transfer the liability in an orderly transaction between market participants @ the measurement date (@ the exit price)

Question 33

When is the FV option for reporting financial assets and financial liabilities required

Answer 33

• derivatives are always reported @ FV
• identifiable assets acquired & liabilities assumed in a business combination are originally measured @ FV
• Investments in marketable securities other than debt securities accounted for as held to maturity are reported at market value on each balance sheet date
• impaired assets are written down to their fair values
• nonmonetary transactions are measured at the fair value of the consideration exchanged.

Question 34

Can an entity elect to apply the fair value option to all or none of its financial assets and liabilities?

Answer 34

Yes & this election is irrevocable. The items are measured at each balance sheet date and unrealized gains/losses are recognized in income.

Question 35

What is the major difference in IFRS reporting on derivatives and hedging instruments.

Answer 35

compound financial interests are treated as a single instrument that is either accounted for at FVTPL or at amortized cost as appropriate if the host is an asset. Otherwise bifurcation is required.