Flashcards in Financial Instruments Deck (64):
What items are included under Financial Instruments?
-Evidence of an ownership interest in an entity
-Contracts that result in an exchange of cash or ownership interest in an entity
How does IFRS define financial assets and libilities?
What is accounting mismatch?
a liability at fair value, but a related asset would otherwise be measured at other than fair value
What items must be disclosed for all financial instruments?
1. Fair Value;
2. Related carrying amount;
3. Whether the instrument/amount is an asset or liability.
What is "Practicable to estimate"
Means that fair value estimates can be made without incurring excessive costs
Can fair values of different financial instruments be netted?
No, even if they are of the same class or otherwise related.
What is credit risk?
Is the possibility of loss from the failure of another party (or parties) to perform according to the terms of a contract.
What is a concentration of credit risk?
Occurs when an entity has contracts of material value with one or more parties in the same industry or region or having similar economic characteristics
Is market risk a required disclosure for all financial instruments?
Is credit risk a required disclosure for all financial instruments?
What is market risk?
is the possibility of loss from changes in market value due to changes in economic circumstances, not necessarily due to the failure of another party
What is a derivative?
Is a financial instrument (or other contract) with all three of the following elements
-It has 1 or more underlyings and 1 or more notional amounts
-It requires no initial net investment
-Its terms require or permit a net settlement
What is an underlying
a specified price, rate, or other variable
What is a notional amount?
a specified unit of measure
What is a host contract?
may have a derivative "embedded" into the contract.
An embedded derivative exists when the host contract contains a term or component that behaves like a derivative.
The instrument containing both the host contract and the embedded derivative is called a hybrid instrument.
How do you treat an embedded derivative?
should be separated from the host contract (the hybrid contract should be bifurcated) and accounted for as a separate derivative instrument if, and only if, it meets all of the following requirements
How do you account for a derivative not designated for hedge accounting?
An acquired contract that is a derivative instrument is initially measured and recorded at the then-current fair value.
Changes in the fair value of these derivatives result in:
1. Adjusting the carrying value of the derivative instrument to current fair value (i.e., increase or decrease an asset or a liability); and
2. Recognizing the related gain or loss in current income.
What is a call
right to buy
What is a put
right to sell
How do you determine option value?
Intrinsic value + time value.
What is time value?
Time value is associated with the time value of money or the anticipated passage of time
What is intrinsic value?
intrinsic value is value associated with the amount of benefit that is associated with the derivative terms relative to the market price
what is hedging?
Hedging means that the entity utilizes a derivative financial instrument to offset the risk related to a transaction, item or event
What are the 2 basic elements involved in hedging?
The hedged item, and the hedging intrument
What is a hedged item?
The recognized asset, recognized liability, commitment, or planned transaction that is at risk of loss; it is the possible loss on the hedged item that is hedged.
What is a hedging instrument?
The contract or other arrangement that is entered into to mitigate or eliminate the risk of loss associated with the hedged item.
What are the two types of hedge accounting?
Fair Value Risk
Cash Flow Risks
What type of risks can be hedged?
1. Commodity price risk;
2. Interest rate risk, where the interest rate being hedged is a benchmark rate;
3. Foreign exchange risk;
4. Credit risk (except not for investments in available-for-sale securities).
What is a forecasted transaction?
A transaction that is expected to occur for which there is no firm commitment. Because no transaction or event has yet occurred, when the transaction or event does occur, it will be at the prevailing market price
What are the benefits of a forecasted transaction?
1. Flexibility with respect to vendor, price, quantity, quality, delivery specifics;
2. Allows the company to complete due diligence on potential vendors;
3. Allows the company to "shop around" on the days prior to the purchase;
4. Increased possibility for price concessions in the days prior to the purchase (i.e., discounts and incentives);
5. Prices may decrease and the purchase price will be lower.
What are the limitations of a forecasted transaction?
1. Prices may increase;
2. Shortage of supply and cannot obtain the fuel oil (or must obtain substandard quality);
3. No opportunity to build a relationship with a single vendor.
What are the benefits of a firm commitment?
a. Certainty with respect to vendor, price, quantity, quality, delivery specifics;
b. Permits better budgeting;
c. Allows the company to develop a relationship with a specific vendor;
d. Increases the likelihood of obtaining the product if there is a shortage;
e. Mitigates the risk of prices increasing.
What are the limitations of a firm commitment?
a. Prices may decrease;
b. Vendor may go bankrupt;
c. Less opportunity to build relationships with other vendors;
d. Cannot take advantage of last minute discounts.
What is a firm commitment?
An agreement with an unrelated party that is binding on both parties and usually legally enforceable. The agreement usually specifies all significant terms (including quantity to be exchanged, fixed price, timing of the transaction) and includes a disincentive for nonperformance that is sufficiently large enough to make performance probable
What items are excluded from being used as a hedging instrument?
-a nonderivative investment
-components of a compound derivative used for different types of risk
- certain hybrid financial instruments
What is a fair value hedge?
The hedge of an exposure to changes in fair value of a (recognized) asset, liability, or an unrecognized firm commitment. A fair value hedge converts a fixed price to a floating price.
A derivative may be used to create a fair value hedge only if both the hedging instrument and the hedged item meet the following criteria:
the hedge must be expected to be highly effective in offsetting changes in fair value of the hedged item, with an assessment of effectiveness required when financial statements are prepared and at least every 3 months.
Which two interest rates are considered to be benchmark interest rates?
Direct U.S. Treasury obligations.
London Interbank Offer Rate (LIBOR)
How do you account for changes in the fair value of both the hedging instrument and hedged item for fair value hedges?
Adjust the carrying amount of both the derivative and the hedged item to fair value.
Recognize gains and losses from revaluing both the derivative and the hedged item in current income.
What is a cash flow hedge?
The hedge of an exposure to variability (changes) in the cash flow associated with a (recognized) asset, liability, or a forecasted transaction due to a particular risk. A cash flow hedge converts a floating price to a fixed price.
What is a forecasted transaction?
a planned or expected transaction with a third party, but for which there is not yet a firm commitment and there are not yet any established rights or obligations associated with the planned transaction.
How do you account for changes in the fair value of both the hedging instrument and hedged item for cash flow hedges?
1. Determining for each period the change in (1) the fair value of the derivative (hedging instrument) and (2) the present value of the cash flows associated with the asset, liability, or forecasted transaction being hedged (hedged item).
2. Determine for each period (1) the cumulative change in the fair value of the derivative and (2) the cumulative change in the present value of the cash flows associated with the hedged item.
3. Recognize the change in the fair value of the derivative for the period (write up or write down the derivative).
4. Recognize as an item of "Other Comprehensive Income" an amount equal to the (cumulative) change in the present value of cash flows associated with the hedged item. This is the "effective portion" of the hedge; the extent to which the change in the value of the hedge offsets the change in value of the hedged item.
5. Recognize as a gain or loss in current income the amount by which the (cumulative) change in the derivative is different from the (cumulative) change in the present value of the cash flows associated with the hedged item. This is the"ineffective portion" of the hedge; the extent to which the hedge is more or less than the change in value of the hedged item.
What is a foreign currency hedge?
The hedge of an exposure to changes in the dollar value of assets or liabilities (including certain investments) and planned transactions that are denominated (to be settled) in a currency other than an entity's functional currency (i.e., a foreign currency).
What items can be hedged using a foreign currency hedge?
Forecasted foreign-currency-denominated transactions
Unrecognized foreign-currency-denominated firm commitments
Foreign-currency-denominated recognized assets
Investments in available-for-sale securities
Net investments in foreign operations
What is hedge effectiveness?
To qualify for hedge accounting, the hedging instrument must be highly effective, both at inception of the hedge and on an on-going basis, in offsetting changes in the fair value or the cash flows of the hedge item. This correlation must be between 80 - 125% in order for the hedge to qualify for hedge accounting.
How do you measure the ineffectiveness of a hedge?
The measurement of the ineffectiveness is important because in hedge accounting the ineffective portion of the hedge is accounted for separate from the effective portion of the hedge.
What are the 2 stages that are used to hedge effectiveness?
1. The prospective assessment should consider all reasonable possible changes in fair value and/or cash flows of both the hedged item and the hedging instrument.
2. The prospective assessment can be based on:
a. Regression analysis or other statistical analysis of past changes in fair value or cash flows.
b. Qualitative assessment of the extent to which the critical terms (e.g., nominal amounts, expiration date, etc.) of the hedging instrument and the hedged item match.
The retrospective evaluation can be accomplished using a number of approaches, including:
a. A dollar-offset approach - an assessment based on how well the dollar change in the hedging instrument actually has offset the dollar change in the hedged item, with the assessment performed either on a period-by-period basis or on a cumulative basis.
b. Regression analysis or other statistical analysis.
c. Qualitative assessment.
What is a perfect hedge?
where changes in the value of the hedged item and hedging instrument offset each other perfectly
What is the difference in the definition of a derivative for US GAAP and IFRS?
Unlike U.S. GAAP, the IFRS definition does not:
1. Include reference to a "notional" concept or element.
2. Specify that net settlement is required or permitted, only that the contract will be settled at a future date.
When is a transfer of financial assets considered a sale?
If the criteria for surrender of control are met, and the financial asset has not been divided into components prior to transfer, the transfer is accounted for as a sale; the asset will be derecognized by the transferor.
When is a transfer of financial assets considered secured borrowing?
If the entire asset is transferred, but the criteria for surrender of control have not been met, then this is treated as a secured borrowing.
When does the surrender of control component occur in a transfer of financial assets?
a. Sale - If the criteria for surrender of control are met, and the financial asset has been divided into components prior to transfer, the transfer can be accounted for as a sale only if all of the components involve participating interest (as previously defined in an earlier lesson).
b. Secured borrowing - If the criteria for surrender of control are not met or components of the transferred asset do not involve participating interest, the transfer is accounted for as a secured borrowing with pledge of collateral; the asset will not be derecognized by the transferor.
How does the accounting work during a transfer of financial assets?
1. Derecognize a financial asset (or portion thereof) for which the transfer qualifies as a sale.
2. Continue to carry in its balance sheet any retained interest in the transferred asset. Such retained interest may include, for example:
a. The entire asset in the case of a secured borrowing.
b. Components of the transferred asset over which the transferor has not relinquished control in the case of a sale (e.g., portion of the asset not transferred).
i. In this case, the carrying amount of the asset before the transfer would be allocated between the portion transferred and the portion retained based on relative fair values at the date of transfer.
3. Recognize any assets or liabilities that result from the transfer (e.g., servicing rights, repurchase obligations, options, etc.).
How does the transferor and transferee account for transfers as sales?
Write off assets sold
Write on assets obtained or liabilities incurrect
Measure all at fair value
Recognize gain or loss
Write on all assets obtained
Measure all at fair value
How does the transferor account for transfers as secured borrowing?
1. Initial Recognition -- Upon transfer, the transferor initially will recognize asset(s) received from the transferee and a liability to the transferee.
2. Subsequent Recognition --
a. If the transferor (debtor) has not defaulted under the terms of the contract, the transferor will continue to carry the collateral on its books as an asset (and the transferee will not recognize the pledged asset).
b. However, if the transferee has the right to sell or repledge the collateral, the transferor must reclassify and report the pledged asset separate from other assets in its Balance Sheet (e.g., "Security Pledged to Creditors").
c. If the transferor (debtor) has defaulted under the terms of the contract and is no longer entitled to redeem the pledged asset, the transferor will write off (derecognize) the pledged asset (and the transferee will recognize the asset).
How does the transferee account for transfers as secured borrowing?
1. Initial Recognition -- Upon transfer, the transferee initially will recognize a receivable from the transferor and a reduction in the asset(s) transferred to the transferor.
2. Subsequent Recognition --
a. If the transferor has not defaulted under the terms of the contract, the transferee will not recognize the pledged asset.
b. If the transferee has the right to sell the asset and exercises that right, the transferee will recognize the following journal entry:
DR: Cash Proceeds From Sale $XX
CR: Pledged Collateral Liability $XX
c. If the transferor has defaulted under the terms of the contract, the transferee will
i. Recognize the collateral as its asset, at fair value or
ii. Derecognize its liability to the transferor, if the collateral has been sold.
Is the servicing function inherent in all financial assets?
What can the servicing function include?
1. Collecting principle, interest, escrow amounts and fees, etc.;
2. Paying taxes, insurance and other obligations; and
3. Performing accounting and other services.
What is a servicing asset?
results when estimated future revenues are expected to exceed estimated costs of servicing the assets, as reflected by its fair value.
Waht is a servicing liability?
results when estimated future revenues are not expected to be as much as expected costs of servicing the assets, as reflected by its fair value.
How do you measure a servicing contract?
Initially at fair value
1. Amortized in proportion to and over the period of estimated net income or net loss and assess the asset or liability for impairment or increased obligation based on fair value, or
2. Adjusted to fair value at each reporting date with gains or losses recognized in current income (the fair value option).
How do you calcualte the gain or loss when extinguising liabilities?
GAIN/LOSS = Reacquisition Price - Net Carrying Amount
Net Carrying Amount = Face Value of Debt
+ Unamortized Premium OR
When should a debtor write off a liability?
If it is extinguished or...
The debtor pays the creditor and is relieved of its obligation for the liability.
The debtor is legally released from being the primary obligator under the liability either by the creditor or by law/courts.