Section 5 - Financial Instruments and Derivatives

Question 1

What are financial instruments?

Answer 1

COD (smells fishy)

1) Cash
2) Ownership interests in an entity (ie stock)
3) Derivative contracts that create a right and obligation to transfer other financial instruments (ie stock options)

Question 2

Three reasons entities acquire DERIVATIVES

Answer 2

1) Investments
2) Arbitrage
3) Hedge

Question 3

What is a HEDGE?

Answer 3

The use of a derivative to reduce or eliminate risk that the entity is subject to either as a result of an asset or liability.

Question 4

Are derivatives an asset or liability?

Answer 4

Both - can be assets or liability

Question 5

Are derivatives reported at fair value?

Answer 5

Yes, always

Question 6

How are derivatives UNREALIZED gains and losses recognized in income?

Answer 6

• CASH FLOW HEDGES are temporarily recognized in other “comprehensive income” on B/S
• FAIR VALUE HEDGES are recognized in income (I/S)

Question 7

What are the three characteristics derivatives must have?

Answer 7

NUNS

1) No net investment
2) an Underlying and a Notional amount
3) net Settlement

Question 8

What is a derivative UNDERLYING and NOTIONAL amount?

Answer 8

• Underlying is the factor that affects the derivative’s value (specified price, interest rate, exchange rate)
• Notional amount is the number of units (units, bushels, pounds)

Question 9

What is Cash Flow Hedge?

Answer 9

• acquired to hedge against a FORECASTED FUTURE TRANSACTION
• gain or loss in other comprehensive income (OCI) (B/S)
• nothing included in net income until forecasted activity occurs

Question 10

What is Fair Value Hedge?

Answer 10

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

Question 11

How are compounded financial instruments treated under IFRS?

Answer 11

They are treated as a single instrument that is either accounted for at FVTPL or at amortized cost. Otherwise bifurcation is required.

Question 12

What is the intrinsic value?

Answer 12

The intrinsic method is the excess of the market price over the exercise price.