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Flashcards in Financial Instruments Deck (57):
1

Which of the following statements concerning contracts that are financial instruments is/are correct?

  • I. They result in the exchange of cash or ownership interest in an entity.
  • II. They impose on one entity a contractual obligation and grant another entity a contractual right.
  • III. They must be settled within one year or the operating cycle, whichever is longer.

I and II ONLY.

Both Statements I and II are correct; Statement III is incorrect. Contracts that are financial instruments both result in the exchange of cash or an ownership interest (Statement I) and impose on one entity a contractual obligation and grant to another entity a contractual right (Statement II). Statement III is incorrect; contracts that are financial instruments do not have to be settled within one year or the operating cycle, whichever is longer.

2

For financial accounting purposes, which one of the following is not a type of hedge carried out using derivatives?

  1. Fair value.
  2. Cash Flow
  3. Speculative
  4. Foreign Currency

Speculative.

When derivatives are used for speculative purposes, the intent is not to hedge an existing position, because there is no existing position to hedge. Rather, when used for speculative purposes, the intent is to make a profit.

3

If it is not practicable for an entity to estimate the fair value of a financial instrument, which of the following should be disclosed?

  • I. Information pertinent to estimating the fair value of the instrument.
  • II. The reasons it is not practicable to estimate fair value.

BOTH.

When it is not practicable for an entity to estimate the fair value of a financial instrument, both information pertinent to estimating the fair value of the instrument and the reasons it is not practicable to estimate fair value must be provided.

4

Disclosure of information about significant concentrations of credit risk is required for:

  1. All financial instruments.
  2. Financial instruments with off-balance-sheet credit risk only.
  3. Financial instruments with off-balance-sheet market risk only.
  4. Financial instruments with off-balance-sheet risk of accounting loss only.

All financial instruments.

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.

5

When a concentration of credit risk must be disclosed and the exact amount is uncertain, which one of the following amounts must be disclosed?

  1. Minimum amount at risk.
  2. Current period average amount at risk.
  3. Historic average amount at risk.
  4. Maximum amount at risk.

Maximum amount at risk.

When a concentration of credit risk exists, the maximum amount at risk must be disclosed. The maximum amount is measured as the gross fair value of all financial instruments that would be lost if the other parties fail completely to perform according to the terms of the contract(s) and assuming any collateral was of no value.

6

Fair value disclosure of financial instruments may be made in the:

  • Body of Financial Statements    
  • Footnotes to Financial Statements 

BOTH.

Fair value disclosure of financial instruments may be made in either the body of the financial statements or in the footnotes to the financial statements. If in the footnotes, one note must show fair values and carrying amounts for all financial instruments.

7

Whether recognized or unrecognized in an entity's financial statements, disclosure of the fair values of the entity's financial instruments is required when:

  1. It is practicable to estimate those values.
  2. The entity maintains accurate cost records.
  3. Aggregate fair values are material to the entity.
  4. Individual fair values are material to the entity.

It is practicable to estimate those values.

Disclosure of the fair values of an entity's financial instruments is required when it is practicable to estimate those fair values.

8

Assume Instco acquires an option to buy (a call option) 100 shares of Opco for $50 per share when the market price of Opco is $45 per share and that Instco paid a premium of $1.00 per share to acquire the options. Which one of the following is the total notional amount related to Instco's options?

  1. 100 shares.
  2. $5,000.00
  3. $4,500.00
  4. $100.00

100 shares.

Stock options are derivatives; they derive their value from the value of the stock to which the option applies. The notional amount of a derivative is a specified unit of measure, in this case the total number of options (100) acquired by Instco. The specified price of those options would be the underlying.

9

Assume Instco acquires an option to buy (a call option) 100 shares of Opco for $50 per share when the market price of Opco is $45 per share and that Instco paid a premium of $1.00 per share to acquire the options. Which one of the following is the underlying related to Instco's options?

  1. 100 shares.
  2. $1.00 per option.
  3. $45.00 per option.
  4. $50.00 per option.

$50.00 per option.

Stock options are derivatives; they derive their value from the value of the stock to which the option applies. The underlying of a derivative is a specified price, rate, or other monetary variable, in this case the (strike) price of each option, $50.00.

10

A derivative designated as a fair value hedge must be:

  • I. Specifically identified to the asset, liability, or firm commitment being hedged.
  • II. Expected to be highly effective in offsetting changes in the fair value of the hedged item.

 

BOTH.

A derivative designated as a fair value hedge must both be expected to be highly effective in offsetting changes in the fair value of the hedged item, and be specifically identified to the asset, liability, or firm commitment being hedged.

11

Which one of the following is least likely to be a characteristic of a firm commitment?

  1. It is evidenced by a contractual obligation.
  2. It can be the hedged item in a fair value hedge.
  3. It has been recorded as an asset or liability.
  4. It is subject to the risk of change in fair value.

It has been recorded as an asset or liability.

A firm commitment has not been recorded (yet) as an asset or liability. A 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.

12

On October 1, 2008, Buyco entered into a legally enforceable contract to acquire raw material inventory in 180 days for $20,000. In order to mitigate the risk of a change in the value of the raw materials, Buyco also entered into a qualified 180-day forward contract to hedge the fair value of the raw materials. At December 31, 2008, the value of the raw materials had decreased by $500, and the fair value of the futures contract had increased by $480. On March 29, 2009, the date the raw materials were delivered to Buyco, they had a fair value of $19,300, and the forward contract had a fair value of $700. Which one of the following is the net gain or loss that would be recognized on the raw material and related forward contract by Buyco over the life of the contract?

  1. $ -0-
  2. $20
  3. $220
  4. $700

$ -0-

Because Buyco entered into the forward contract (hedging instrument) to hedge the risk of change in the fair value of the raw materials (hedged item), the change in the fair value of the forward contract over the life of the contract offsets the change in the fair value of the raw materials. Specifically, the decrease in the value of the raw materials, $700 ($20,000 - $19,300 = $700), was offset by the increase in the value of the forward contract of $700 (given), so the net gain recognized over the life of the contract was $700 - $700 = $-0-, which is the correct answer.

13

A derivative cannot be used as a fair value hedge for:

  1. A recognized asset.
  2. A recognized liability.
  3. An unrecognized forecasted transaction.
  4. An unrecognized firm commitment.

An unrecognized forecasted transaction.

For GAAP purposes, a 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. A derivative can be used to hedge the risk associated with a recognized asset, recognized liability, or unrecognized firm commitment, but not an unrecognized forecasted transaction.

14

On October 1, 2008, Buyco entered into a legally enforceable contract to acquire raw material inventory in 180 days for $20,000. In order to mitigate the risk of a change in the value of the raw materials, Buyco also entered into a qualified 180-day forward contract to hedge the fair value of the raw materials. At December 31, 2008, the value of the raw materials had decreased by $500, and the fair value of the futures contract had increased by $480. On March 29, 2009, the date the raw materials were delivered to Buyco, they had a fair value of $19,300, and the forward contract had a fair value of $700. Which one of the following is the net gain or loss that would be recognized on the raw material and related forward contract by Buyco in its 2009 net income?

  1. $ -0-
  2. $20
  3. $200
  4. $220

$20

Because Buyco entered into the forward contract (hedging instrument) to hedge the risk of change in the fair value of the raw materials (hedged item), the change in fair value of the forward contract during 2009 offsets the change in the fair value of the raw materials. Specifically, the decrease in the value of the raw materials, $200 ($19,500 - $19,300 = $200), was offset by the increase in the value of the forward contract of $220 ($700 - $480 = $220), so the net gain recognized in 2009 was $220 - $200 = $20, which is the correct answer.

15

Bigco, Inc. transferred long-term receivables with a carrying value of $500,000 and a fair value of $450,000 to Banco for $425,000 cash. Of the $450,000 fair value, $45,000 is attributable to collection of future fees and penalties, which Bigco will retain. The surrender of control requirements have been met, therefore the transfer qualifies as a sale. What amount of loss should Bigco recognize at the time of the transfer?

  1. $ -0-
  2. $25,000
  3. $50,000
  4. $75,000

$25,000

Bigco's loss is the difference between the carrying value of the portion of the asset transferred and the cash received for the transferred portion. In this case, the total carrying value of $500,000 must be allocated between the portion of the asset surrendered and the portion retained, based on relative fair values. The relative fair values are:

Amount / Percent

  • Asset retained $45,000 / 10%
  • Asset transferred $405,000 / 90%
  • Total fair value $450,000 / 100%

Therefore, the carrying value of the asset transferred is .90 x $500,000 = $450,000. The resulting loss is carrying value transferred $450,000 - cash received $425,000 = $25,000 loss.

16

Which one of the following is not associated with accounting for a transfer of a financial asset treated as a sale by the transferor?

  1. Derecognizing the asset(s) sold.
  2. Recognizing asset(s) obtained or liability(ies) incurred.
  3. Measuring assets and liabilities at fair value.
  4. Deferring any gain or loss in other comprehensive income.

Deferring any gain or loss in other comprehensive income.

Any gain or loss resulting from the transfer of financial assets would not be deferred in other comprehensive income (outside net income) by the transferor, but rather would be recognized in current income.

17

Which of the following statements concerning the transfer of financial assets that qualifies as a sale is/are correct?

  • I. The transferor may retain an interest in the asset transferred.
  • II. The transferor may recognize a gain or a loss on the transfer.
  • III. The transferor's proceeds are decreased by any liability it incurs in the transfer.

All THREE.

All three statements are correct. The transferor may retain an interest in the asset transferred (Statement I), the transferor may recognize a gain or loss on the transfer (Statement II), and the transferor's proceeds from the transfer are decreased by any liability incurred in the transfer (Statement III).

18

Which one of the following is not associated with accounting for a transfer of a financial asset treated as a purchase by the transferee?

  1. Measuring assets and liabilities at fair value.
  2. Recognizing any gain or loss on the transfer in current income.
  3. Recognizing the asset(s) obtained.
  4. Recognizing the liability(ies) incurred.

Recognizing any gain or loss on the transfer in current income.

In a transfer of a financial asset treated as a purchase by the transferee, no gain or loss would be recognized by the transferee. The transferee is the recipient of the transferred asset. As such, assets and liabilities recognized by the transferee would be recorded at fair value.

19

On February 1, Rayco transferred a bond it owned with a maturity value of $50,000 to Dayco as security for a short-term loan from Dayco. By terms of the agreement, Dayco cannot resell or otherwise use the bond except as collateral for its loan to Rayco. Rayco defaulted on its repayment of the loan from Dayco on August 1 when the bond had a fair value of $48,000. On what date and in what amount should Dayco recognize the bonds on its books?

  • Recognize On?    
  • Recognize?

  • Recognize On August 1st
  • Recognize $48,000

Since the transfer of the bond is used only as security for the loan, and not as a sale of the bond, Dayco would not recognize the bond on its books at the time of the transfer. The bond would be recognized on Dayco's books on the date Rayco defaulted and at its fair value at that time.

20

If the transfer of a financial asset does not meet the requirements of surrender of control by the transferor, how will it be treated by the transferor and by the transferee?

  • Transferor   
  • Transferee

  • Transferor - Borrowing with Collateral
  • Transferee - Secured Lending

21

Which of the following characteristics is associated with the transfer of a financial asset when surrender of control has not occurred?

  1. The transfer will be treated as a sale of the asset by the transferor.
  2. The transferor can recognize a gain or loss on the transfer.
  3. The transferred asset will be treated as collateral held by the transferee.
  4. The transfer will be treated as a purchase of the asset by the transferee.

The transferred asset will be treated as collateral held by the transferee.

If surrender of control of the transferred asset has not occurred, the transfer will be treated as a secured borrowing by the transferor and a lending with collateral by the transferee.

22

Will a transferor have to allocate the carrying value of a financial asset when the transferor retains an interest in the transferred asset or when the transferor does not retain an interest in the transferred asset?

Allocate Carrying Value When:

  • Interest Retained
  • No Interest Retained  

  • Interest Retained - YES
  • No Interest Retained - NO

The transferor will have to allocate the carrying value of a financial asset when it is transferred and the transferor retains an interest in the asset, but allocation of the carrying value is not necessary when the transferor does not retain an interest in the asset. When no interest is retained, the full carrying value of the asset will be written off by the transferor.

23

A financial asset is transferred with one component of the asset appropriately treated as sold and another component appropriately treated as retained. How will the amount to be written off as sold be determined?

  1. Write off the fair value of the component sold.
  2. Write off a portion of the asset carrying value based on the relative fair values of the components.
  3. Write off the portion of the asset carrying value left after deducting the fair value of the retained interest.
  4. Write off the present value of the cash flows of the component sold.

Write off a portion of the asset carrying value based on the relative fair values of the components.

The carrying amount of the asset before the transfer will be allocated to the component sold and the component retained based on the relative fair values of the components at the date of the transfer. The portion of the carrying value allocated to the component sold will be written off.

24

For accounting purposes, which one of the following circumstances would not be considered the transfer of a financial asset?

  1. The transfer of accounts receivable to a factor for cash.
  2. The transfer of a bond investment to another unrelated investor for cash.
  3. The transfer of a bond investment upon maturity to the issuing entity for cash.
  4. The transfer of a stock investment to another unrelated investor for cash.

The transfer of a bond investment upon maturity to the issuing entity for cash.

The transfer of a bond investment to the issuing entity upon maturity of the bond would not be considered the transfer of a financial asset for accounting purposes. Because the bond is being transferred to the entity that issued the financial asset (at the time the bond matures), it is not considered a transfer of a financial asset for accounting purposes.

25

Recognized servicing assets should be assessed for impairment and servicing liabilities should be assessed for understatement. In which of the following cases will an impairment loss be recognized?

  1. Servicing asset with carrying value less than fair value.
  2. Servicing asset with fair value greater than carrying value.
  3. Servicing liability with carrying value less than fair value.
  4. Servicing liability with fair value less than carrying value.

Servicing liability with carrying value less than fair value.

When a liability has a carrying value less than fair value, an unrealized loss exists. Adjusting the carrying value of the liability to the higher fair value will result in a loss; DR: Impairment Loss (+), CR: Liability (+).

26

On January 2, 20X8, Fiserveco acquired a five-year right to service mortgage contracts for which it paid $120,000. Fiserveco estimated that servicing and other fees would generate $400,000 over the five-year period. During 20X8 the contract generated $100,000 in revenues. Which one of the following is the amount of expense, if any, that Fiseerveco should recognize in 20X8 as amortization of its servicing asset?

  1. $ -0-
  2. $24,000
  3. $30,000
  4. $100,000

$30,000

Since Fiserveco acquired the servicing rights asset in the market, it should recognize a servicing asset at its fair value, which is the cost to Fiserveco in the market. Therefore, it should recognize an asset of $120,000 on January 2, 20X8. That servicing asset should be amortized each period over the life of the contract in the same proportion that period revenues have to expected total revenues. During 20X8, $100,000 of an expected $400,000 total revenues was earned. Therefore, $100,000/$400,000, or ¼ of the servicing asset should be amortized. One-fourth of $120,000 = $30,000, the correct answer.

27

On January 2, 20X8, Fiserveco acquired a five-year right to service mortgage contracts for which it paid $120,000. Fiserveco estimated that servicing and other fees would generate $400,000 over the five-year period. During 20X8, the contract generated $100,000 in revenues. Which one of the following is the amount, if any, that Fiserveco should recognize as an asset on January 2, 20X8?

  1. $ -0-
  2. $100,000
  3. $120,000
  4. $400,000

$120,000

Since Fiserveco acquired the servicing rights asset in the market, it should recognize a servicing asset at its fair value, which is the cost to Fiserveco in the market. Therefore, it should recognize an asset of $120,000 on January 2, 20X8.

28

Servco, a loan servicing agency, paid $60,000 to acquire a three-year right to service $1,000,000 of Banco's loans. Servco will be entitled to a servicing fee of 1% of the interest and fees collected during the three-year period. Servco expects its servicing fees to be:

  • Year 20X1 $40,000
  • Year 20X2 $30,000
  • Year 20X3 $10,000

Which one of the following is the amount of gross profit after amortization of the servicing asset that Servco expects to earn over the three-year life of the service contract?

  1. $ -0-
  2. $10,000
  3. $20,000
  4. $80,000

$20,000

Over the three-year life of the contract, expected fees (revenues) are $80,000 ($40,000 + $30,000 + $10,000 = $80,000). Total amortization (expense) will be $60,000, the full cost of the servicing asset. Therefore, the expected gross profit is $80,000 - $60,000 = $20,000.

29

Which of the following is not a characteristic associated with the servicing of financial assets?

  1. The servicing function is inherent in all financial assets.
  2. The right to service financial assets can result in either a separate asset or a separate liability.
  3. If a servicing asset is retained as a component in a sale of a financial asset, the servicing asset is measured as a portion of the carrying value of the transferred asset.
  4. If a servicing asset is acquired in the market, the servicing asset is measured at fair value.

If a servicing asset is retained as a component in a sale of a financial asset, the servicing asset is measured as a portion of the carrying value of the transferred asset.

When a servicing asset is retained as a component in a sale of a financial asset, the servicing asset is not measured as a portion of the carrying value of the transferred asset, but rather at fair value at the date of transfer of the financial asset.

30

Servco, a loan servicing agency, paid $60,000 to acquire a three-year right to service $1,000,000 of Banco's loans. Servco will be entitled to a servicing fee of 1% of the interest and fees collected during the three-year period. Servco expects its servicing fees to be:

  • Year 20X1 $40,000
  • Year 20X2 $30,000
  • Year 20X3 $10,000

Which one of the following is the amount of the $60,000 acquisition fee that Servco should amortize during year 1?

  1. $ -0-
  2. $20,000
  3. $30,000
  4. $40,000

$30,000

Servco would record the $60,000 as a servicing asset and would amortize it in proportion to and over the period of the estimated income. In this case, during year 20X1, $40,000 of the total $80,000 estimated income would be earned. Therefore, 50% of the servicing asset would be amortized in year 20X1. Thus, $60,000 x .50 = $30,000 amortization in year 20X1.

31

Assume a creditor releases a debtor from being primarily responsible for a liability because an unrelated third-party legally assumes the liability, with the original debtor becoming secondarily liable for the obligation. Which of the following statements is correct?

  • I. The original debtor's liability has been extinguished.
  • II. The original debtor became a guarantor of the liability.
  • III. The original debtor may recognize a gain or loss on its release from the obligation.

All THREE.

The original debtor's liability has been extinguished, the debtor has become a guarantor of the liability now held by a third-party, and the original debtor may recognize a gain or loss on its release from the obligation.

32

A firm selling put options to sell the firm's stock

  1. Increases owners' equity for the fair value of the options.
  2. Does not recognize any change in its financial position at sale of the options.
  3. Increases a liability for the fair value of the options.
  4. Records an expense equal to the fair value of the options.

Recognizes a $3,000 loss.

Shifter paid $5,000 more for the treasury stock than its fair value: 1,000 shares x ($20 - $15). The $2,000 fee (1,000 x $2) offsets that loss yielding a net loss of $3,000.

33

A firm selling put options to sell the firm's stock

A.  Increases owners' equity for the fair value of the options.

B.  Does not recognize any change in its financial position at sale of the options.

C.  Increases a liability for the fair value of the options.

The liability will be extinguished when the option is exercised or when it expires.

D.  Records an expense equal to the fair value of the options.

Increases a liability for the fair value of the options.

The liability will be extinguished when the option is exercised or when it expires.

34

The Marvin Company has a receivable from a foreign customer which is payable in the local currency of the foreign customer.  The amount receivable for 900,000 local currency units (LCU), has been translated into $315,000 on Marvin’s December 31, year 2 balance sheet. On January 15, year 3, the receivable was collected in full when the exchange rate was 3 LCU to $1. What journal entry should Marvin make to record the collection of this receivable?

  • Cash $300,000
  • Exchange loss $15,000
    • Accounts receivable $315,000

The receivable balance was $315,000 when 900,000 LCU were received at an exchange rate of 3 LCU to $1. Thus $300,000 was received (900,000 LCU @ 3 LCU/$1) to settle a $315,000 receivable, resulting in a $15,000 foreign currency transaction loss. Note that gains and losses from foreign currency transactions which are of an import/export nature are reported on the income statement for each period in which the exchange rate changes until the exchange is settled.

35

Which of the following is not a type of foreign currency hedge?

  1. A net investment in foreign operations.
  2. A held-to-maturity security.
  3. A forecasted transaction.
  4. An unrecognized firm commitment.

A held-to-maturity security.

The four foreign currency hedges are

  1. an unrecognized firm commitment,
  2. available-for-sale securities,
  3. foreign currency denominated forecasted transactions, and
  4. net investments in foreign operations.

36

Which of the following is not required to be accounted for under ASC Topic 815, Derivatives and Hedging?

  1. Employee stock options.
  2. Futures contracts.
  3. Interest rate caps.
  4. Options to purchase or sell exchange-traded securities.

Employee stock options.

Employee stock options are excluded from ASC Topic 815 treatment. Futures contracts, interest rate caps, and options to purchase or sell exchange-traded securities are required to be accounted for under ASC Topic 815.

Included

  • Options to purchase (call) or sell (put) exchange-traded securities
  • Futures contracts
  • Interest rate swaps
  • Currency swaps
  • Swaptions (an option on a swap)
  • Credit indexed contracts
  • Interest rate caps/floors/collars

Excluded

  • Normal purchases and sales (does not exclude "take or pay" contracts with little or no initial net investment and products that are readily convertible to cash)
  • Equity securities
  • Debt securities
  • Regular-way (3-day settlement) security trades (this exclusion applies to "to be announced" and "when issued" trades)
  • Leases
  • Mortgage-backed securities
  • Employee stock options
  • Royalty agreements and other contracts tied to sales volumes
  • Variable annuity contracts
  • Adjustable rate loans
  • Guaranteed investment contracts
  • Nonexchanged traded contracts tied to physical variables
  • Derivatives that serve as impediments to sales accounting (e.g., guaranteed residual value in a leasing arrangement)

37

A December 15, year 2 purchase of goods was denominated in a currency other than the entity’s functional currency. The transaction resulted in a payable that was fixed in terms of the amount of foreign currency, and was paid on the settlement date, January 20, year 3. The exchange rates between the functional currency and the currency in which the transaction was denominated changed between the transaction date and December 31, year 2, and again between December 31, year 2, and January 20, year 3. Both exchange rate changes resulted in gains. The amount of the gain that should be included in the year 3 financial statements would be

  1. The gain from December 31, year 2, to January 20, year 3.
  2. The gain from December 15, year 2, to January 20, year 3.
  3. The gain from December 15, year 2, to December 31, year 3.
  4. Zero.

The gain from December 31, year 2, to January 20, year 3.

Foreign currency transactions (economic activities denominated in a currency other than the entity’s recording currency) must be translated into the currency used by the reporting company at each balance sheet date as well as at the settlement date. The difference between the original payable and the translated amount is a foreign exchange transaction gain or loss to be recognized in the period of the adjustment. Thus, the gain caused by exchange rate fluctuations between 12/31/Y2 and 1/20/Y3 should be reported on the year 3 income statement.

38

Gains and losses of the effective portion of a hedging instrument will be recognized in current earnings in each reporting period for which of the following?

  • Fair value hedge
  • Cash flow hedge

  • Fair value hedge - YES
  • Cash flow hedge - NO

Fair value hedges will recognize gains and losses for the effective portion of the hedging instrument in current earnings for each reporting period. Cash flow hedges will recognize gains and losses for the effective portion of the hedging instrument in other comprehensive income.

39

LaValley Corp. issues monthly financial statements to its creditors. LaValley should perform assessments of hedge effectiveness on a(n)

  1. Semiannual basis.
  2. Annual basis.
  3. Monthly basis.
  4. Quarterly basis.

Monthly basis.

If a company issues monthly financial statements, the assessment of hedge effectiveness should be performed on a monthly basis. The effectiveness of the hedging relationship must be assessed when financial statements are prepared and at least every 3 months.

Two primary criteria must be met in order for a derivative instrument to qualify as a hedging instrument.
 

  1. Sufficient documentation must be provided at the beginning of the process to identify at a minimum (1) the objective and strategy of the hedge, (2) the hedging instrument and the hedged item, and (3) how the effectiveness (see below) of the hedge will be assessed on an ongoing basis.
  2. The hedge must be "highly effective" throughout its life.  Effectiveness is measured by analyzing the hedging instrument’s (the derivative instrument) ability to generate changes in fair value that offset the changes in value of the hedged instrument.  At a minimum, its effectiveness will be measured every 3 months and whenever earnings or financial statements are reported.  A "highly effective" hedge has been interpreted to mean that "the cumulative change in the value of the hedging instrument should be between 80 and 125% of the inverse cumulative changes in the fair value or cash flows of the hedged item."  The method used to assess effectiveness must be used throughout the hedge period and must be consistent with the approach used for managing risk.  Similar hedges should usually be assessed for effectiveness in a similar manner unless a different method can be justified.  (Even though a hedging item may meet the criterion for being highly effective, it may not eliminate variations in reported earnings, because to the extent that a hedging item is not 100% effective, the difference in net loss or gain in each period must be reported in current earnings.)

40

According to ASC Topic 815, hybrid instruments must be accounted for

  1. By bifurcating the instrument and valuing the components separately.
  2. At fair value if an election is made not to bifurcate the hybrid instrument.
  3. At net realizable value of the instrument.
  4. At the present value of the cash flows of the instrument.

At fair value if an election is made not to bifurcate the hybrid instrument.

A company may elect not to bifurcate the instrument and account for the hybrid instrument in its entirety at fair value.

ASC Subtopic 815-15 allows the holder of a hybrid instrument normally requiring bifurcation to make an election NOT to bifurcate the instrument. Instead, the entire instrument is valued at fair value. This election is irrevocable and is made on an instrument by instrument basis. Changes in fair value of the hybrid instruments are recognized each year in earnings. If a company elects to use fair value measurement on selected hybrid instruments, the balance sheet disclosure may be presented in one of two ways: (a) as separate line items for the fair value and non-fair value instruments on the balance sheet, or (b) as an aggregate amount of all hybrid instruments with the amount of the hybrid instruments at fair value shown in parentheses.

41

On July 1, year 2, Stone Company lent $120,000 to a foreign supplier, evidenced by an interest-bearing note due on July 1, year 3. The note is denominated in the currency of the borrower and was equivalent to 840,000 local currency units (LCU) on the loan date. The note principal was appropriately included at $140,000 in the receivables section of Stone’s December 31, year 2 balance sheet. The note principal was repaid to Stone on the July 1, 2011 due date when the exchange rate was 8 LCU to $1. In its income statement for the year ended December 31, year 3, what amount should Stone include as a foreign currency transaction gain or loss?

  1. $0.
  2. $15,000 loss.
  3. $15,000 gain.
  4. $35,000 loss.

$35,000 loss.

Since the rate is denominated in a foreign currency at a fixed 840,000 (LCU), fluctuations in the exchange rates will produce foreign currency gains (losses). The increase (decrease) in expected functional currency cash flows is a foreign currency transaction gain (loss) to be included in income in the period during which the exchange rate changes. At December 31, year 2, changes in the exchange rates produce a recognized gain of $20,000 ($140,000 − $120,000). At the repayment date (July 1, year 3) changes in the exchange rate resulted in a realized loss of $35,000 computed as follows:

Received from borrower 840,000 LCU ÷ 8 LCU for each $1 = $105,000

  • Note carrying value $140,000
  • Cash received ($105,000)
  • Translation loss $35,000

42

On September 22, year 2, Yumi Corp. purchased merchandise from an unaffiliated foreign company for 10,000 units of the foreign company’s local currency. On that date, the spot rate was $.55. Yumi paid the bill in full on March 20, year 3, when the spot rate was $.65. The spot rate was $.70 on December 31, year 2. What amount should Yumi report as a foreign currency transaction loss in its income statement for the year ended December 31, year 2?

  1. $0
  2. $ 500
  3. $1,000
  4. $1,500

$1,500

A transaction has occurred for which settlement will be made in a foreign currency. A foreign exchange transaction gain (loss) will result if the spot rate on the settlement date is different than the rate on the transaction date. A gain (loss) must be recognized at any intervening year-end date if there has been a rate change. Thus, in year 2, Yumi would recognize a $1,500 foreign exchange transaction loss [10,000 × ($.70 − $.55)]. Yumi would recognize a foreign exchange transaction gain of $500 in year 3 [10,000 × ($.65 − $.70)].

43

On November 15, year 2, Celt, Inc., a US company, ordered merchandise FOB shipping point from a foreign company for 200,000 LCUs.  The merchandise was shipped and invoiced to Celt on December 10, year 2.  Celt paid the invoice on January 10, year 3.  The spot rates for LCUs on the respective dates are as follows:

  • November 15, year 2 $ .4955
  • December 10, year 2 $.4875
  • December 31, year 2 $.4675
  • January 10, year 3 $.4475

In Celt’s December 31, year 2 income statement, the foreign exchange transaction gain is

  1. $9,600
  2. $8,000
  3. $4,000
  4. $1,600

$4,000

No journal entry is prepared on 11/15/Y2 when the goods are ordered, so the spot rate for LCUs on that date ($.4955) is not relevant to the solution of this problem. On 12/10/Y2, Celt would record the purchase and related accounts payable at $97,500 (200,000 LCUs × $.4875).  A foreign exchange transaction gain (loss) is to be recognized if the spot rate on the settlement date (or any intervening balance sheet date) is different from the rate on the transaction date.  At 12/31/Y2, the spot rate is $.4675, which means the account payable must be adjusted down to $93,500 (200,000 LCUs × $.4675), resulting in a gain of $4,000. A shortcut approach is to multiply the change in the exchange rate ($.4875 − $.4675 = $.02) by the payable balance in LCUs ($.02 × 200,000 LCUs = $4,000).

44

For an unrecognized firm commitment to qualify as a hedged item, all of the following conditions must be met except:

  1. Be binding on both parties.
  2. Be specific with respect to all significant terms.
  3. Contain a nonperformance clause that makes performance probable.
  4. The item being hedged must trade on an organized exchange. 

The item being hedged must trade on an organized exchange. 

For an unrecognized firm commitment to qualify as a hedged item it must:

  1. Be binding on both parties.
  2. Be specific with respect to all significant items.
  3. Contain a nonperformance clause that makes performance probable.

45

When in its financial statements should a company disclose information about its concentration of credit risk?

  1. No disclosure is required.
  2. The notes to the financial statements.
  3. Supplementary information to the financial statements.
  4. Management’s report to shareholders.

The notes to the financial statements.

concentration of credit risks should be disclosed in the notes to the financial statements.

46

Disclosures related to financial instruments, both derivative and nonderivative, that are used as hedging instruments must

  • I.Include information on risk management policies.
  • II.Be separated by type of hedge.

BOTH.

Disclosures related to financial instruments, both derivative and nonderivative, that are used as hedging instruments must include the following information: (1) objectives and the strategies for achieving them, (2) context to understand the instrument, (3) risk management policies, and (4) a list of hedged instruments. These disclosures have to be separated by type of hedge and reported every time a complete set of financial statements is issued.

47

Which hedge of the following foreign currency items is not accounted for as either a fair value hedge or a cash flow hedge?

  1. Available-for-sale securities.
  2. Unrecognized firm commitments.
  3. Net investments in foreign operations.
  4. Foreign currency denominated forecasted transactions.

Net investments in foreign operations.

ASC Topic 830 remains in effect for hedges of net investments in foreign operations. The hedged net investment is viewed as a single asset. The provisions for recognizing the gain or loss on the hedged asset/liability and the hedging instrument in ASC Topic 815 do not apply to the hedges of net investments in foreign operations.

48

Dale, Inc., a U.S. corporation, bought machine parts from Kluger Company of Germany on March 1, year 2, for 30,000 euros, when the spot rate for euros was $1.10. Dale’s year-end was March 31, year 2, when the spot rate for euros was $1.07. Dale bought 30,000 euros and paid the invoice on April 20, year 2, when the spot rate was $1.12. How much should be shown in Dale’s income statements as foreign exchange transaction gain or loss for the years ended March 31, year 2 and year 3?

  • Year 2
  • Year 3

  • Year 2 - $900 Gain
  • Year 3 - ($1,500) Loss

When payment for a purchase is in a currency other than the functional currency of the purchaser (in this case, the currency for the transaction is the euro), a foreign exchange transaction (gain) loss will result if the spot rate on the settlement date is different than the rate existing on the transaction date. Additionally, a provision must be made at any intervening year-end date for such rate changes. At 3/31/Y2 a $900 gain [30,000 × ($1.07 − $1.10)] would be recognized. On the date of settlement (4/20/Y2), a $1,500 loss [30,000 × ($1.12 − $1.07)] would be recognized. Therefore, Dale’s income statements would show a $900 foreign exchange transaction gain in F/Y 10 and a $1,500 loss in F/Y 11.

49

50

Which of the following meets the definition of a derivative instrument and must be accounted for using ASC Topic 815, Derivatives and Hedging?

  1. Adjustable rate loans.
  2. Mortgage-backed securities.
  3. Credit indexed contracts.
  4. Variable annuity contracts.

Credit indexed contracts.

Credit indexed contracts meet the definition of a derivative instrument and must be accounted for using ASC Topic 815. Adjustable rate loans, mortgage-backed securities, and variable annuity contracts are not required to be accounted for under ASC Topic 815.

Included

  • Options to purchase (call) or sell (put) exchange-traded securities
  • Futures contracts
  • Interest rate swaps
  • Currency swaps
  • Swaptions (an option on a swap)
  • Credit indexed contracts
  • Interest rate caps/floors/collars

Excluded

  • Normal purchases and sales (does not exclude "take or pay" contracts with little or no initial net investment and products that are readily convertible to cash)
  • Equity securities
  • Debt securities
  • Regular-way (3-day settlement) security trades (this exclusion applies to "to be announced" and "when issued" trades)
  • Leases
  • Mortgage-backed securities
  • Employee stock options
  • Royalty agreements and other contracts tied to sales volumes
  • Variable annuity contracts
  • Adjustable rate loans
  • Guaranteed investment contracts
  • Nonexchanged traded contracts tied to physical variables
  • Derivatives that serve as impediments to sales accounting (e.g., guaranteed residual value in a leasing arrangement)

51

When a company elects not to bifurcate a hybrid instrument and accounts for the hybrid instrument at fair value, which method(s) of disclosure are permissIble?

  • I.As a separate line item for fair value and non-fair value instruments on the balance sheet.
  • II.As an aggregate amount of all hybrid instruments on the balance sheet.
  • III.As an aggregate amount of all hybrid instruments with the amount of the hybrid instruments at fair value shown in parentheses on the balance sheet.
  • IV.As a footnote disclosure with elected amounts.

1 and 3.

If a company elects to use fair value measurement on selected hybrid instruments, the balance sheet disclosure may be presented in one of two ways: as either a separate line item for the fair value and non--fair value instruments on the balance sheet, or as an aggregate amount of all hybrid instruments with the amount of hybrid instruments at fair value shown in parentheses.

52

Which of the following is not an underlying, according to ASC Topic 815?

  1. An interest rate index.
  2. A security price.
  3. An average daily temperature.
  4. The other three choices could each be an underlying.

The other three choices could each be an underlying.

Each of the other choices meets the basic definition of an underlying, which is any financial or physical variable that has either observable changes or objectively verifiable changes.

Underlyings. 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 a 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 815 if it has the distinguishing characteristics stated above.

53

Which of the following does not qualify as an underlying?

  1. Exchange rate.
  2. Commodity price.
  3. Stock shares.
  4. Insurance index.

Stock shares.

Exchange rates, commodity prices, and an insurance index all qualify as underlyings. Shares of stock is a notional amount, not an underlying.

Underlyings. 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 a 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 815 if it has the distinguishing characteristics stated above.

54

On October 1 of the current year, a US company sold merchandise on account to a British company for 2,000 pounds (exchange rate, 1 pound = $1.43). At the company’s December 31 fiscal year-end, the exchange rate was 1 pound = $1.45. The exchange rate was 1 pound = $1.50 on collection in January of the subsequent year. What amount would the company recognize as a gain (loss) from foreign currency translation when the receivable is collected?

  1. $0
  2. $100
  3. $140
  4. $(140)

$100

On October 1 of the current year, the company would record the accounts receivable and sale at the spot rate of $2,860 (2,000 pounds × $1.43). At the end of the year, the account receivable would be adjusted to the end of year spot rate. In this case, the account receivable would be revalued to $2,900 (2,00 pounds × $1.45 ), and an adjustment would be made to accounts receivable by debiting accounts receivable by $40 and crediting a gain on foreign currency transactions for $40. This gain on foreign currency transactions would be recognized in the income statement of the current year. In the subsequent year, when the receivable was collected, the exchange rate was $1.50. Accordingly, the account receivable would be revalued to $3,000 (2,000 pounds × $1.50), and a gain of $100 ($3,000 less $2,900 fair value at end of previous year) would be recognized in income in the year that the receivable is collected.

55

Which of the following is a general criterion for a hedging instrument?

  1. Sufficient documentation must be provided at the beginning of the process.
  2. Must be "highly effective" only in the first year of the hedge’s life.
  3. Must contain a nonperformance clause that makes performance probable.
  4. Must contain one or more underlyings.

Sufficient documentation must be provided at the beginning of the process.

The general criteria for a hedging instrument are that sufficient documentation must be provided at the beginning of the process and the hedge must be "highly effective" throughout its life.

  1. Sufficient documentation must be provided at the beginning of the process to identify at a minimum (1) the objective and strategy of the hedge, (2) the hedging instrument and the hedged item, and (3) how the effectiveness (see below) of the hedge will be assessed on an ongoing basis.
  2. The hedge must be "highly effective" throughout its life.  Effectiveness is measured by analyzing the hedging instrument’s (the derivative instrument) ability to generate changes in fair value that offset the changes in value of the hedged instrument.  At a minimum, its effectiveness will be measured every 3 months and whenever earnings or financial statements are reported.  A "highly effective" hedge has been interpreted to mean that "the cumulative change in the value of the hedging instrument should be between 80 and 125% of the inverse cumulative changes in the fair value or cash flows of the hedged item."  The method used to assess effectiveness must be used throughout the hedge period and must be consistent with the approach used for managing risk.  Similar hedges should usually be assessed for effectiveness in a similar manner unless a different method can be justified.  (Even though a hedging item may meet the criterion for being highly effective, it may not eliminate variations in reported earnings, because to the extent that a hedging item is not 100% effective, the difference in net loss or gain in each period must be reported in current earnings.)

56

Which of the following provides the holder the right to sell the underlying at an exercise or strike price, anytime during a specified period of time a gain accrues to the holder as the market price of the underlying falls below the strike price?

  1. Call option.
  2. Forward contract.
  3. Put option.
  4. Swaption.

Put option.

This meets the definition of an American put option. An American call option provides the holder the right to acquire an underlying at an exercise or strike price, anytime during the option term. The forward contract is an agreement between two parties to buy and 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. A swaption is an option on a swap that provides the holder with the right to enter into a swap at a specified future date at specified terms or to extend or terminate the life of an existing swap.

57

Derivative instruments are characterized by having which of the following?

  • Notional amounts
  • Underlyings

  • Notional amounts - YES
  • Underlyings - YES

Derivative instruments are financial instruments or other contracts that have one or more underlyings and one or more notional amounts. In addition, derivative instruments have no initial net investment or a smaller net investment than required for contracts expected to have a similar response to market changes. Finally, derivative instruments have terms that require or permit (1) net settlement, (2) net settlement by means outside the contract, and (3) delivery of an asset that results in a position substantially the same as net settlement.