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Flashcards in Hedging & Firm Commitments - Leases Deck (21):
1

What general kind of hedge is the hedge of a forecasted transaction to be denominated in a foreign currency?

A.
Fair value.

B.
Cash flow.

C.
Economic.

D.
Income.

B.
Cash flow.


The hedge of a forecasted transaction to be denominated in a foreign currency is a cash flow hedge. The risk being hedged is the variability in expected cash flows (inflows or outflows) on the planned transaction that would result from changes in the exchange rate.

2

Which of the following statements concerning foreign currency hedging is/are correct?

I. The item being hedged is denominated in a foreign currency.

II. The item being hedged must be recorded on the entity’s books in order to be hedged.

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

A. I only.

Correct:
In foreign currency hedging, the item being hedged is denominated in a foreign currency (Statement I). The item being hedged does not have to be recorded on the entity's books in order to be hedged (Statement II). For example, forecasted transactions and unrecognized firm commitments may be hedged because they are subject to the same risk of foreign currency exchange rate changes as are already booked (recognized) assets and liabilities.

Incorrect:
Statement II is not correct. In foreign currency hedging, the item being hedged does not have to be recorded on the entity's books in order to be hedged (Statement II). For example, forecasted transactions and unrecognized firm commitments may be hedged because they are subject to the same risk of foreign currency exchange rate changes as are already booked (recognized) assets and liabilities. Statement I, the item being hedged is denominated in a foreign currency, is correct.

3

For accounting purposes, a hedge to offset the risk of exchange rate changes on a planned transaction would be classified as the hedge of:

A.
A firm commitment.

B.
A forecasted transaction.

C.
A recognized asset.

D.
An unrecognized asset.

B.
A forecasted transaction.

A hedge to offset the risk of exchange rate changes on a planned transaction would be the hedge of a forecasted transaction. A forecasted transaction is a non-firm, but planned or expected transaction that will be denominated in a foreign currency.

4

Which of the following types of planned transactions to be denominated in a foreign currency can be hedged?

Planned Sale Planned Purchase
Yes Yes
Yes No
No Yes
No No

Planned Sale Planned Purchase
Yes Yes
Either a planned sale or a planned purchase would be a forecasted transaction and, if denominated in a foreign currency, could be hedged

5

What kind of hedge can be used to hedge a foreign currency firm commitment?

Cash Flow Fair Value
Yes Yes
Yes No
No Yes
No No

Cash Flow Fair Value
Yes Yes
A forward contract used to hedge a foreign currency firm commitment can be either a cash flow hedge (as permitted by the FASB's Derivatives Implementation Group) or a fair value hedge (as permitted by FASB #133).

6

A hedge to offset the risk of exchange rate changes on converting the financial statements of a foreign subsidiary to the domestic (functional) currency would be the hedge of:

A.
A forecasted transaction.

B.
A recognized asset.

C.
A net investment in a foreign operation.

D.
An available-for-sale investment.

C.
A net investment in a foreign operation.

A hedge to offset the risk of exchange rate changes on converting the financial statements of a foreign subsidiary to the domestic (functional) currency would be the hedge of a net investment in a foreign operation. Changes in exchange rates will result in changes in the amount of domestic (functional) currency that will result from converting (translating) financial statements from a foreign currency. Hedges of net investments in a foreign operation are intended to offset that risk.

7

Which of the following statements concerning the hedging of the fair value of a foreign currency commitment is/are correct?

I. The change in fair value of a forward contract used to hedge a foreign currency firm commitment will be recognized as a gain or loss in current income.

II. The change in fair value of a hedged foreign currency firm commitment will be recognized as a gain or loss in current income.

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

C. Both I and II.
Both Statement I and Statement II are correct. The change in fair value of both a foreign currency firm commitment and a forward contract used to hedge a foreign currency firm commitment will be recognized as a gain or loss in current income. To the extent the two do not exactly offset each other, there will be a net effect on current income.

8

Based on preliminary discussions with a foreign customer, Alcoco, a U.S. entity, budgeted a significant sale to the foreign entity denominated in its foreign currency expected in June 20X9. To hedge the risk of an adverse exchange rate change on the dollar value of the expected sale, on January 2, 20X9, Alcoco entered into a forward exchange contract to sell an amount of the foreign currency equal to the expected sale. On March 31, 20X9, the value of the expected sale amount in dollars had decreased by $3,800. The fair value of the forward contract at that date had increased by $4,000. Which one of the following is the amount that should be recognized in other comprehensive income for the forward contract only (the hedging instrument) in Alcoco's quarterly financial statements as of March 31?

A.
$200

B.
$3,800

C.
$4,000

D.
$7,800

B.
$3,800

The effective portion of the hedge ($3,800) should be reported in other comprehensive income, and the ineffective portion ($200) should be reported in current income. The effective portion of the hedge is the amount of change in the forward contract (hedging instrument) equal to the change in the fair value of the expected sale amount (the hedged item) ($3,800); the ineffective portion is the difference ($200).

9

Which one of the following is not a criterion that must be met in order to use a forward contract to hedge a forecasted transaction?

A.
A specific forecasted transaction (or group of similar transactions) must be identified.

B.
The forecasted transaction must be at risk from foreign currency price changes.

C.
The forecasted transaction must be expected to be initiated by the entity hedging the forecasted transaction.

D.
The hedge must be highly effective in offsetting the effects of exchange rate changes.

C.
The forecasted transaction must be expected to be initiated by the entity hedging the forecasted transaction

The use of a forward contract to hedge a forecasted transaction does not require that the forecasted transaction be expected to be initiated by the entity hedging the forecasted transaction. The forecasted transaction could be expected to be initiated by the other party to the transaction; for example, it could be expected that another party initiate a purchase.

10

On December 12, 20X8, Imp Co. entered into a forward exchange contract to hedge a firm commitment to purchase equipment being manufactured to Imp's specifications. The forward contract was to purchase 100,000 Euros in 90 days as a fair value hedge of the equipment. The relevant direct exchange rates were as follows:

Spot Rate Forward Rate (for 3/12/X9)
December 12, 20X8 $1.86 $1.80
December 31, 20X8 $1.96 $1.83
At December 31, 20X8, what amount of foreign currency transaction gain should Imp include in income from this forward contract only? (Ignore discount and present value considerations.)

A. $-0-
B. $3,000
C. $6,000
D. $10,000

B. $3,000

The gain (or loss) recognized on the contract (disregarding the discount at initiation of the contract and without using a present value factor) will be computed as the number of Euros to be purchased (100,000E) multiplied by the change in the forward exchange rate between the date the contract was executed ($1.80) and the end of the fiscal period, December 31, 20X8 ($1.83). Therefore, the gain recognized will be 100,000E x ($1.83 - $1.80 = $0.03) = $3,000. It is a gain because the forward contract increased in value as of December 31. The gain on the forward contract will partially offset the loss on the equipment commitment for the period. A complete determination of the gain on the forward contract (only) would include amortization of the difference between the spot rate and forward rate at the initiation of the contract ($6,000) and discounting the nominal gain of $3,000 for the period December 31 to the March settlement date.

11

Which one of the following is not a characteristic associated with hedging foreign currency firm commitments?

A.
The hedged item is for purchase or sale to be recorded in the future.

B.
The hedged item is for an already booked asset or liability.

C.
The hedged item is evidenced by a contract or similar legal commitment.

D.
The risk being hedged exists prior to an asset or liability being recognized.

B.
The hedged item is for an already booked asset or liability.

A firm commitment exists when an entity has a contractual obligation or right, but has not yet recorded the obligation or right because it does not meet the requirements of GAAP. Therefore, an asset or liability has not been booked (recognized) already.

12

What are the components of the lease receivable for a lessor involved in a direct-financing lease?

A.
The minimum lease payments plus any executory costs

B.
The minimum lease payments plus residual value

C.
The minimum lease payments less residual value

D.
The minimum lease payments less initial direct costs

B.
The minimum lease payments plus residual value

The net lease receivable initial balance is the present value of the minimum lease payments (payments expected to be received under the lease) plus the present value of the residual at the end of the lease term. The value used for the residual (before discounting) is the estimated fair value of the asset at the end of the lease term, not the end of the asset's useful life.

13

Able Co. leased equipment to Baker under a noncancelable lease with a transfer of title. Will Able record depreciation expense on the leased asset and interest revenue related to the lease?

Depreciation expense Interest revenue
Yes Yes
Yes No
No No
No Yes

Depreciation expense Interest revenue

No Yes

Able is the lessor. In a capital lease, the physical asset is replaced with a financial asset on which interest revenue is recognized. Each payment includes principal and interest (with the exception of the first payment if due at signing). The lessor has no physical asset to depreciate. The lessee depreciates the asset if it is a capital lease to the lessee

14

Steam Co. acquired equipment under a capital lease for 6 years. Minimum lease payments were $60,000 payable annually at the year's end. The interest rate was 5% with an annuity factor for 6 years of 5.0757. The present value of the payments was equal to the fair value of the equipment. What amount should Steam report as interest expense at the end of the first year of the lease?

A.
$0

B.
$3,000

C.
$15,227

D.
$18,000

Interest: You take payments * P.V = total value
Total Value (P.V) * Interest Rate= Interest Expense (First Year)

Long way:

60,000*6=360,000 Total Lease Payments
360,000*5.0757= 1,827,252
1,827,252*.05(I.R)= 91,362.6
91,362.6 (total I.R)/6(years)= 15,227

CPA Way:

This lease is capitalized because the present value of the lease payments is 90% or more of the fair value of the asset (in this case, 100%).

The capitalized lease liability at inception is $60,000 x 5.0757 = $304,542.

Interest expense at the end of the first year is .05 x $304,542 = $15,227.

A capitalized lease liability is much like a mortgage note with payments including both principal and interest.

The principal portion of the first payment is $60,000 - $15,227, or $44,773.

15

Koby Co. entered into a capital lease with a vendor for equipment on January 2 for 7 years. The equipment has no guaranteed residual value. The lease required Koby to pay $500,000 annually on January 2, beginning with the current year. The present value of an annuity due for 7 years was 5.35 at the inception of the lease.
What amount should Koby capitalize as leased equipment?

A. $500,000
B. $825,000
C. $2,675,000
D. $3,500,000

Capitalize Lease:
Annual Payments *P.V = Total P.V of lease

16

On January 1, 20x4, Harrow Co. as lessee signed a 5-year noncancelable equipment lease with annual payments of $100,000 beginning December 31, 20x4.
Harrow treated this transaction as a capital lease. The five lease payments have a present value of $379,000 at January 1, 20x4 based on interest of 10%.
What amount should Harrow report as interest expense for the year ending December 31, 20x4?

A. $37,900
B. $27,900
C. $24,200
D. $0

Interest: You take payments * P.V = total value
Total Value (P.V) * Interest Rate= Interest Expense (First Year)


A. $37,900

The beginning lease liability balance at 1/1/x4 is $379,000. That balance is unchanged the entire year because the first lease payment is made 1 year later. Therefore, the interest expense for the first year is $37,900 (.10 x $379,000).

17

On January 1, 20x5, Blaugh Co. signed a long-term lease for an office building.
The terms of the lease required Blaugh to pay $10,000 annually, beginning December 30, 20x5 and continuing each year for 30 years.

The lease qualifies as a capital lease. On January 1, 20x5, the present value of the lease payments is $112,500 at the 8% interest rate implicit in the lease.

In Blaugh's December 31, 20x5 balance sheet, the capital lease liability should be

A. $102,500.
B. $111,500.
C. $112,500.
D. $290,000.

B. $111,500.

The entry at December 31, 20x5:

Interest expense ($112,500 x .08) 9,000
Lease liability 1,000
Cash 10,000
The ending lease liability for 20x5 is $111,500 ($112,500 - $1,000 from entry).

Due to the journal Entry!

Cash did not equal the annual payments liability.

If the 10,000 payments are the only payments that are owe, are they only paying

**NEED THIS TO BE EXPLAINED*** NO IDEA, WHY!

18

On December 31, 20x5, Neal, Inc. leased machinery with a fair value of $105,000 from Frey Rentals Co. The agreement is a 6-year noncancelable lease requiring annual payments of $20,000 beginning December 31, 20x5.
The lease is appropriately accounted for by Neal as a capital lease.
Neal's incremental borrowing rate is 11%. Neal knows the interest rate implicit in the lease payments is 10%.

The present value of an annuity due of $1 for 6 years at 10% is 4.7908.
The present value of an annuity due of $1 for 6 years at 11% is 4.6959.
In its December 31, 20x5 balance sheet, Neal should report a lease liability of

A. $75,816.
B. $85,000.
C. $93,918.
D. $95,816.

Incorrect:
D. $95,816.

This answer is the initial lease liability. The required answer must reflect the reduction in principal caused by the first payment, which is all principal. The correct answer is $20,000 less than this answer.

Correct:

A. $75,816.

20,000*4.7908= 95816 - 20,000 (current payment) = 75,816

The $75,816 lease liability at December 31, 20x5 is the initial liability at inception less the first payment, which is completely a principal payment. The first payment occurs at inception and therefore could have no interest component. The initial liability at inception is the present value of an annuity due of six periods.

Ending 20x5 lease liability = liability at inception - $20,000 first payment
= $20,000(4.7908) - $20,000
= $75,816
The lessee must use the lower of its incremental borrowing rate (11%) and the rate implicit in the lease (10%), hence the use of the 4.7908 present value factor.

19

Glade Co. leases computer equipment to customers under direct-financing leases.
The equipment has no residual value at the end of the lease, and the leases do not contain bargain purchase options. Glade wishes to earn 8% interest on a 5-year lease of equipment with a fair value of $323,400. The present value of an annuity due of $1 at 8% for 5 years is 4.312.

What is the total amount of interest revenue that Glade will earn over the life of the lease?

A. $51,600
B. $75,000
C. $129,360
D. $139,450

Interest Revenue!:

1. Payment per year ( 5)- Total Fair Value = Interest Revenue


A. $51,600

Total interest over the term equals the difference between total lease payments and the fair value of the property at inception.

The lease payment is $75,000 ($323,400/4.312). Thus, total interest is 5($75,000) - $323,400 = $51,600.

20

On January 2, 20x5, Dix Machine Shops, Inc. signed a 10-year noncancelable lease for a heavy-duty drill press.
The lease stipulated annual payments of $30,000 starting at the end of the first year, with the title passing to Dix at the expiration of the lease. Dix treated this transaction as a capital lease.
The drill press has an estimated useful life of 15 years, with no salvage value. Dix uses straight-line depreciation for all of its fixed assets. Aggregate lease payments were determined to have a present value of $180,000, based on implicit interest of 10%.

In its 20x5 income statement, what amount of interest expense should Dix report from this lease transaction?

A. $0
B. $12,000
C. $15,000
D. $18,000

D. $18,000

Interest expense for 20x5 on this lease equals the interest rate multiplied by the initial capitalized value because payments are due at the end of each year. The lease liability balance at the beginning of 20x5 is $180,000. Interest expense, therefore, is $18,000 ($180,000 x .10) for 20x5.

21

Oak Co. leased equipment for its entire 9-year useful life, agreeing to pay $50,000 at the start of the lease term on December 31, 20x4 and $50,000 annually on each December 31 for the next 8 years. The present value on December 31, 20x4 of the nine lease payments over the lease term, using the rate implicit in the lease, which Oak knows to be 10%, was $316,500. The December 31, 20x4 present value of the lease payments using Oak's incremental borrowing rate of 12% was $298,500. Oak made a timely second lease payment. What amount should Oak report as capital lease liability in its December 31, 20x5 balance sheet?
A. $350,000
B. $243,150
C. $228,320
D. $0

B. $243,150


The lessee uses 10% because it is the lower of the two rates and is known to the lessee. The lease liability balance immediately after the first payment (at inception) is $266,500 ($316,500 - $50,000). The first payment includes no interest because it is made immediately. The entry for the 12/31/x5 payment is:
Lease liability 23,350
Interest expense .10($266,500) 26,650
Cash 50,000
The ending lease liability balance is $266,500 - $23,350 = $243,150.