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Flashcards in Derivatives Hedging Translation Deck (45):
1

How are derivatives recorded?

At cost when acquired and re-valued to fair value each period on Balance Sheet.

3

How are unrealized gains/losses on trading securities recorded?

Recorded on income statement

4

How are gains and losses on Available for Sale (AFS) securities recorded?

They are included in Other Comprehensive Income.

5

What is a Fair Value Hedge? How is it recorded?

Fair Value Hedge offsets exposure to changes in the value of a recognized asset/liability or of an unrecognized commitment

Initially recorded on Balance Sheet at Fair Value

Gains/Losses recorded on Income Statement

6

What is a Cash Flow Hedge? How is it recorded?

Cash flow hedges protect from exposure to fluctuations in cash flows.

Initially recorded on Balance Sheet at Fair Value

Gains/Losses going to OCI

Example: A cereal company enters into a futures contract on grain purchases to offset the risk that grain will go up in price.

7

Where are gains and losses on foreign currency hedges recorded?

In Other Comprehensive Income (OCI)

8

How do transactions denominated in a currency other than a company's functional currency affect the income statement?

Fluctuations in that currency cause a gain or loss that must be recognized on the income statement as Income from Continuing Operations

9

For the balance sheet, which date's translation rate is used to report assets and liabilities?

The current translation rate as of the balance sheet date is used to report assets and liabilities.

10

What disclosures are required for derivative transactions?

Objectives and Strategies

Context to help investor understand the instrument

Risk Management Policies

Complete List of Hedged Instruments

11

If the functional currency is the reporting currency which exchange rate is used on the foreign currency financial statements?

Foreign Currency Financial Statements are remeasured into the Reporting Currency (Dollar) using the weighted-average exchange rate

12

Which date's currency translation rate is used for the reporting of revenue and expense transactions in a foreign currency?

Use the weighted average exchange rate for the current year.

13

Where are re-measurement gains and losses due to foreign currency translation reported?

On the income statement as Other Income.

14

How are asset and liability accounts translated when the functional currency of a foreign subsidiary is the foreign currency?

When the functional currency of a foreign subsidiary is the foreign currency, asset and liability accounts are translated using the current exchange rate (the rate of translation in effect at the balance sheet date)

15

How are asset and liability accounts translated when the functional currency of a foreign subsidiary is the US dollar?

If the functional currency of a foreign subsidiary is the US dollar, balance sheet accounts would be remeasured using a combination of historical and current rates

16

When will a translation adjustment arise?

Translation adjustments result from translating an entity's financial statements into the reporting currency

Such adjustments will result when the entity's functional currency is the foreign currency and should NOT be included in net income. Instead, such adjustments should be reported as OCI and Accumulated OCI in the stockholders' equity section

17

When will a remeasurement arise?

If the functional currency is the reporting currency (US dollar), a remeasurement process takes place, with the resulting gain or loss included in net income

18

Assuming that a foreign subsidiary's trail balance is translated from its functional currency to the functional currency of the parent and the subsidiary's functional currency = local currency, what is the exchange rate for each item

Assume year-end is 12/31/2013

Assume company began on 12/31/2008

1. Cash

Assets are valued at the current rate at year-end - 12/31/2013

2. Inventory that had been purchased evenly throughout the year

Assets are valued at the current rate at year-end - 12/31/2013

3. A/P for equipment purchased on 4/1/2013

Liabilities are valued at the current rate at year-end - 12/31/2013

4. COGS

Expense accounts are valued at the average rate for the current year of business

5. Sales

Revenue accounts are valued at the average rate for the current year of business

6. Dividend declared on 10/1/2013

Dividends are valued at the rate of the date of declaration - 10/1/2013

7. Dividend declared on 10/1//2013 were paid 1/2/2014

Liabilities (dividends payable) are valued at the current rate at year-end - 12/31/2013

8. Retained earnings

The retained earnings are carried over from 1/1/2013 with the translated net income added and translated dividends subtracted - thus NO translation rate is used

9. Common stock

Common stock is valued at the historical rate when it was issued - 12/31/2008 - the inception of the company

19

What type of financial instruments or other contracts that are EXCLUDED from the definition of derivative instruments in ASC Topic 815?

The following items are EXCLUDED from the definition of derivative instruments per ASC Topic 815:

1. Leases are excluded because they require a payment equal to the value of the right to use the property

2. Equity securities and adjustable rate loans are excluded because they require an initial net investment equivalent to fair value

3. Variable annuity contracts are also NOT derivative instruments

4. Debt securities

5. Normal purchases and sales

6. Regular-way (3 day settlement) security trades

7. Mortgage-backed securities

8. Royalty agreements and other contracts tied to sales volumes

9. Employee stock options (NOTE: Normal company stock option ARE considered to be derivative instruments)

10. Guaranteed investment contracts

11. Adjustable rate loans

12. Non-exchanged traded contracts tied to physical variables

13. Derivatives that serve as impediments to sales accounting (i.e. guaranteed residual value in a leasing arrangement)

NOTE: Call (put) options are NOT specially excluded from the definition of a derivative instrument per ASC Topic 815; thus these are considered to be derivatives

20

When an election is made NOT to bifurcate a hybrid financial instrument, how should this be disclosed on the financial statements?

The balance sheet disclosure may be presented in one of 2 ways:

1. As a separate line item for the fair value and non-fair value instruments on the balance sheet

or...

2. As an aggregate amount of all hybrid instruments with the amount of the hybrid instruments at fair value shown in parentheses

Just note that 2 disclosures are permissible on the balance sheet

21

What is credit risk?

Credit risk is the risk of accounting loss from a financial instrument due to possible failure of another party to perform according to the terms of the contract

22

What is Off-balance-sheet risk?

Off-balance-sheet risk is the possible amount of loss from an instrument that is not reflected on the balance sheet

23

What is Market risk?

Market risk is the risk that future changes in market prices may make a financial instrument less valuable

24

How are cash flow and net investment hedges accounted for under IFRS?

Under IFRS, a cash flow hedge and a hedge of a net investment are accounted for by recognizing gains and losses in OCI

25

What qualifications must exist for an unrecognized firm commitment to qualify as a hedged item?

For an unrecognized firm commitment (this is like a purchase order; something that's NOT recorded on the B/S) to qualify as a hedged item it must:

1. Be binding on both parties

2. Be specific with respect to all significant items including quantity to be exchanged, the fixed price, and the timing of the transaction

3. Contain a non-performance clause that makes performance probable

26

What if Bifurcation?

Bifurcation is the process of separating an embedded derivative from its host contract

This process is necessary so that hybrid instruments (a financial instrument or other contract that contains an embedded derivative) can be separated into their component parts, each being accounted for using the appropriate valuation techniques

Note: The classic example of this is convertible debt, from the investor's viewpoint. This means that an investor purchased an investment in a convertible bond and with the convertible feature; they really have an investment in a bond and a stock option because at their option; the investor can convert the bond to shares of common stock

27

What is a Derivative instrument?

Derivative instruments are defined by their 3 distinguishing characteristics. Specifically, derivative instruments are financial instruments or other contracts that have

1. One or more underlyings and one or more notional amounts (or payment provisions or both)

2. No initial net investment or a smaller net investment than required for contracts expected to have a similar response to market changes

3. No terms that require or permit:

a. Net settlement

b. Net settlement by means outside the contract

c. Delivery of an asset that results in a position substantially the same as net settlement

28

What is an Embedded derivative?

An embedded derivative is a feature on a financial instrument or other contract, which if the feature stood alone, would meet the definition of a derivative

29

What is a Forward contract?

A forward contract is an agreement between 2 parties to buy & sell a specific quantity of a commodity, foreign currency, or financial instrument at an agreed-upon price, with delivery and/or settlement at a designated future date.

Because a forward contract is NOT formally regulated by an organized exchange, each party to the contract is subject to the default of the other party

30

What is a Forward exchange contract?

A forward exchange contract is an agreement to exchange at a specified future date currencies of different countries at a specified rate (forward rate)

31

What is a Futures contract?

A futures contract is a forward-based contract to make or take delivery of a designated financial instrument, foreign currency, or commodity during a designated period, at a specified price or yield

The contract frequently has provisions for cash settlement. A futures contract is traded on a regulated exchange and; therefore, involves less credit risk than a forward contract

32

What is a Firm commitment?

A firm commitment is an agreement with an unrelated party, binding on both, usually legally enforceable, specifying all significant terms and including a disincentive for nonperformance sufficient to make performance likely

33

What is a Forecasted transaction?

A forecasted transaction is a transaction expected to occur for which there is NO firm commitment, and thus, which gives the entity NO present rights or obligations

Forecasted transactions can be hedged and special hedge accounting can be applied

34

What is the concept of Net settlements?

To qualify as a derivative instrument, one of the following settlement criteria must be met:

1. No delivery of an asset equal to the notional amount is required (i.e. an interest rate sway does not involve delivery of the instrument in which the notional amount is expressed)

2. Delivery of an asset equal to the notional amount is required of one of the parities, but an exchange (or other market mechanism, institutional arrangement or side agreement) facilitates net settlement (i.e. a call option has this attribute)

3. Delivery by one of the parties of an asset equal to the notional amount is required but the asset is either readily convertible to cash (as with a contract for the delivery of a marketable equity security) or is required but that asset is itself a derivative instrument (as in the case for a swaption- an option on a swap)

35

In regards to derivative instruments where net settlement occurs; what does the 3rd criteria mean?

This characteristic means that the derivative instrument can be settled by a net delivery of assets (the medium of exchange does NOT have to be cash)

Contract terms based on changes in the price or rate of the national amount that implicitly or explicitly require or permit net settlement qualify. Situations where one of the parties can liquidate their net investment or be relieved of the contract rights or obligations without significant transaction costs because of a market arrangement (broadly interpreted) or where the delivered asset can be readily converted to cash also meet the requirements for net settlement

It is assumed that an exchange traded security is readily converted to cash. Thus, commodity-based contracts for gold, oil, wheat, etc. are now included under this standard

The convertible to cash condition requires an active market and consideration of interchangeability and transaction volume. Determining if delivery of a financial asset or liability equal to the notional amount is a derivative instrument may depend upon whether it is readily convertible into cash

Different accounting will result if the notional amount is not readily converted to cash. Using the notional amount as collateral does NOT necessarily mean it is readily convertible to cash

36

What does Notional amount mean?

The notional amount (or payment provision) is the referenced associated asset or liability

A notional amount is commonly a number of units such as:

1. shares of stock
2. principal amount
3. face value
4. stated value
5. basis points
6. barrels of oil

It may be that amount plus a premium or minus a discount

The interaction of the price or rate (underlying) with the referenced associated asset or liability (notional amount) determines whether settlement is required and, if so, the amount

37

What is the concept of Initial net investment?

A derivative instrument is one where the initial investment is zero or is less than the notional amount (possibly plus a premium or minus a discount). This characteristic refers to the relative amount of investment. Derivative instruments allow the opportunity to take part in the rate or price change without owning the asset or owning the liability

If an amount approximating the notional amount must be invested or received, it is NOT a derivative instrument. The two basic forms of derivative instruments are futures contracts and option

The futures contract involves little or no initial net investment. Settlement is usually near the delivery date

Call options, when purchased, require a premium payment that is less than the cost of purchasing the equivalent number of shares. Even though this distinguishing characteristic is the result of only one of the parties, it determines the application for both

38

What is an Underlying?

An underlying is commonly a specified price or rate such as a stock price, interest rate, currency rate, commodity price, or a related index

However, any variable (financial or physical) with

1. observable changes, or

2. objectively verifiable changes such as credit rating, insurance index, climatic or geological condition (temperature, rainfall) qualifies

Unless it is specifically excluded, a contract based on any qualifying variable is accounted for under ASC Topic (SFAS 133) if it has the distinguishing characteristics stated above

This is the thing that causes variability within a financial instrument; it is the thing that causes risk within a financial instrument

39

What type of financial instruments are INCLUDED in the definition of a derivative?

The following financial instruments are considered to be derivatives:

1. Options to purchase (call) or sell (put) exchange traded securities. NOTE: Employee stock options are NOT derivatives

2. Futures contracts

3. Interest rate swaps

4. Currency swaps

5. Swaptions (an option on a swap)

6. Credit indexed contracts

7. Interest rate caps/floors/collars - these have ceilings and floors

40

What are the FASB rules regarding bifurcation of a financial instrument?

The FASB rules use say the holder of a hybrid instrument (i.e. an investor with convertible debt financial instrument) had to bifurcate.

Now, the holder can make an election NOT to bifurcate the instrument. Instead, the entire instrument is valued a fair value

1. The election is irrevocable and is made on an instrument-by-instrument basis

2. Changes in fair value of the hybrid instruments are recognized each year in earnings

3. If a company elects to use fair value measurement on selected hybrids instruments, the balance sheet disclosure may be presented in one of 2 ways

41

In what ways do derivatives differ between GAAP and IFRS?

The derivative definition is much shorter for IFRS in comparison to GAAP - since GAAP is more rule-based and IFRS is more principle- based

Other than that, the definition is similar; except for different terminology used in IFRS

42

How are assets, liabilities, and SHE measured using the current rate method?

When using the current rate method:

1. Assets are measured using the current rate

2. Liabilities are measured using the current rate

3. SHE is measured using the historical rate, EXCEPT retained earnings, which is based on a calculation:

Beginning R/E (last year)
+ NI or -NL (weighted average)
= Subtotal
(historical rate)
= Ending R/E (calculation)

43

How are assets, liabilities, and SHE measured using the Re-measurement method:

When using the re-measured method:

1. Monetary assets are measured using the current rate

2. Non-monetary assets are measured using the historical rate

3. Monetary liabilities (i.e. payables) are measured using the current rate

4. Non-monetary liabilities (i.e. unearned revenue) are measured using the historical rate

5. SHE is measured using the historical rate, EXCEPT retained earnings, which is based on a calculation:

Beginning R/E (last year)
+ NI or -NL (weighted average)
= Subtotal
(historical rate)
= Ending R/E (calculation)

44

With respect to foreign financial statements, what do you do if the Functional Currency = Local Currency?

If the Functional Currency = Local Currency...

Translate into US dollars using the Current Rate Method

45

With respect to foreign financial statements, what do you do if the Functional Currency = Reporting Currency?

If the Functional Currency = Reporting Currency...

Re-measure into US Dollars (use the Re-measurement Method)

46

With respect to foreign financial statements, what do you do if the Functional Currency DOES NOT = Local Currency or Reporting Currency?

If the Functional Currency DOES NOT EQUAL Local Currency or Reporting Currency...

1st - Re-measure into functional foreign currency (using the re-measurement method)

2nd - Translate into US dollars using the current rate method