ACCT 5341 Answers for Class 03

Last Revised on January 7, 1999

ACCT 5341 Syllabus
Bob Jensen at Trinity University

Table of Contents

Possible Quiz Questions for Class 03

International Accounting Theory Helpers and Links

Reading Assignments for This Week

 

 

Possible Quiz Questions and Answers for Class 03

Please keep your answers to all possible quiz questions for the entire semester. They may reappear in future quizzes and they may help in your course project.

If a case assignment or other question points to a particular section of a textbook chapter or other reading section, you are responsible to take notes on that particular section in its entirety.

If a case assignment or other question points to a particular section of a textbook chapter or other reading section, you are responsible to take notes on that particular section in its entirety.

The Excel questions for this week are on the TUCC Drive J:\courses\acct5341\0assign\sfas133


Remember that your partnership must go over some or all these questions with the ACCT 5341 Teaching Assistant and fill out the attest.htm form.

File 1 Question 01 (With Answer)
What are some of the main distinctions between firm commitments versus forecasted transactions in terms of SFAS 133 rules?

[Hint: See Paragraphs 4 (with Footnote 2), 21 (including Footnote 8), 28, 29 (especially for details), 37, and 323-324 of SFAS 133.   For a summary look up these terms in Bob Jensen's SFAS 133 Glossary at http://WWW.Trinity.edu/rjensen/acct5341/speakers/133glosf.htm]

A firm commitment fixes the cash flows with a strong disincentive to break the contract.  As a result, it is not possible to hedge the cash flows (except for foreign currency risk).  Firm commitments can have fair value hedges.

A forecasted transaction is highly probable, but there can be variations in cash flows.  There can be cash flow hedges of forecasted transactions if the hedged item will not be adjusted to fair value at each reporting date with the unrealized gains and losses being booked to current earnings.

Differences between firm commitments versus forecasted transactions are elaborated upon in Paragraphs 320-326 beginning on Page 157 of SFAS 133.  Respondents did not necessarily agree that the differences are important.   The FASB argues that they are important.  As a result,  firm commitments do not need cash flow hedges unless there is foreign currency risk.  They may   need fair value hedging since values may vary from committed prices.   According to Paragraph 325, forecasted transactions have fewer rights and obligations vis-a-vis firm commitments.  All significant terms of the exchange should be specified in the agreement, including the quantity to be exchanged and the fixed price.  A forecasted transaction has no contractual rights and obligations.  Firm commitments differ from long-term purchase commitments. Generally long-term purchase agreements such as agreements to purchase timber of trees not yet planted or oil not yet pumped from the ground can usually be broken with a relatively small amount of penalty equal to damages sustained in the breaking of a contract. A firm commitment usually entails damage awards equal to or more than the contractual commitment. Hence they are less likely to be broken than purchase commitments. Firm commitments are discussed at various points in SFAS 133.  See Paragraphs 37, 362, 370, 437-442, and 458-462.

To be a hedged item, a forecasted transaction must meet "clearly-and-closely related" criteria.

 


File 1 Question 02  (With Answer)
Many fair value hedges are tied to forecasted transactions.  How do SFAS 133 rules on such hedges differ if the hedges are for existing assets and liabilities as opposed to forecasted transactions?

[Hint: Go to Paragraphs 362-370 on Pages 168-171 of SFAS 133.]

No except for an existing net investment hedge in a foreign operation ala Paragraph 42 on Page 26 of SFAS 133.

 

 


File 1 Question 03  (With Answer)
What is an "underlying" in the context of SFAS 133?  What is a "notional" of a derivative instrument?  Suppose a firm purchases a call option to buy 100 shares of General Electric at a fixed price.   Assume the option expires in three months.  Is this a derivative instrument under SFAS 133?  Identify the underlying and notional or lack thereof in this call option contract.  Would your answer change if the shares were in a privately-held corporation and the shares must be physically delivered if the option is exercised?

[Hint: For a definition of terms got to Bob Jensen's SFAS 133 Glossary.  For elaboration go to Paragraphs 6, 10, and 11 of SFAS 133.   Especially note Paragraph 6c.]

q01.01      q01.02

 


File 1 Question 04  (With Answer)
Suppose a firm enters into a three day forward contract for physical delivery of 10,000 shares of  General Electric.  Is this a derivative instrument contract subject to SFAS 133 rules?

[Hint:  Look up "regular-way" in Bob Jensen's SFAS 133 Glossary.  Also see Paragraph 10a of SFAS 133.]

q06.15

The term "net settlement" refers to a contract provision that allows for netting out payables and receivables. For example in an interest rate swap where Party A owes $25 to Party B and Party B owes $20 to Party A can be fully settled with a net payment of $5 by Party A. Details of net settlements are discussed in SFAS 133, Page 4, Paragraph 9. According to Paragraphs 10 and 275-276, regular-way security trades are contracts with no net settlement provisions and not market mechanism to facilitate net settlements. Actual delivery of the security is required in a regular-way contract. Paragraph 10 also defines regular-way, normal purchases, and normal sales in a somewhat similar manner. Also see Paragraphs 57c, 274, and 259-266.


File 1 Question 05  (With Answer)
What are embedded derivatives and how do they differ from compound derivatives?   Provide three examples of an embedded derivative.

[Hint: Go to Bob Jensen's SFAS 133 Glossary.]

Embedded derivatives are portions of contracts that meet the definition of a derivative when the entire nonderivative contract cannot be considered a financial instruments derivative. Types of embedded derivative  instruments are often indexed debt and investment contracts such as commodity indexed interest or principal payments, convertible debt, credit indexed contracts, equity indexed contracts, and inflation indexed contracts.  Embedded derivatives are discussed in SFAS 133, pp. 7-9, Paragraphs 12-16.  Embedded derivatives such as commodity indexed and equity indexed contracts and convertible debt require separation of the derivative from the host contract in SFAS 133 accounting.  In contrast, credit indexed and inflation indexed embedded derivatives are not separable from the host contract.   Also see Paragraphs 51, 60, 61, 176-178, and 293-311. The overall contract is sometimes referred to as a "hybrid" that contains one or more embedded derivatives.  Embedded derivatives within embedded derivatives generally meet the closely-and-clearly related test and cannot be accounted for as separate derivatives.  Paragraph 10 notes that interest only strips and principal only strips are not subject to SFAS 133 accounting rules under conditions noted in Paragraph 14. In Paragraph 15, it is noted that embedded foreign currency derivatives "shall not be separated from the host contract and considered a derivative instrument."   Prepayment options on mortgage loans also do not qualify for accounting under SFAS 133 according to Paragraph 293 on Page 146. 

Compound derivatives encompass more than one contractual provision such that different risk exposures are hedged in the compound derivative contract.  Paragraph 18 on Pages 9-10 prohibits separation of a compound derivative into components to designate different risks and then use only one or a subset of components as a hedging instrument.  SFAS 133, Pages 167-168, Paragraphs 360-361 discusses how the FASB clung to its position on pro rata decomposition in SFAS 133 vis-à-vis the earlier Exposure Draft 162-B that also did not allow pro rata decomposition. Further discussion is given in Paragraphs 523-524.  See circus, derivative, embedded derivatives, and option.

Closely related are synthetic instruments arising when multiple financial instruments are synthetically combined into a single instrument, possibly to meet hedge criteria under SFAS 133. SFAS 133 does not allow synthetic instrument accounting. See Paragraphs 349-350 on Page 164 of SFAS 133.  Examples 12-34 beginning in Paragraph 176 on Page 93 illustrate clearly-and-closely-related criteria in embedded hybrid derivative instruments.  These criteria are discussed under hedge.

In summary, for hedging purposes, a compound grouping of multiple derivatives (e.g., a portfolio of options or futures or forward contracts or any combination thereof) is prohibited from "separating a derivative into either separate proportions or separate portions and designating any component as a hedging instrument or designating different components as hedges of different exposures."   See Paragraphs 360-362 beginning on Page 167 of SFAS 133.  Paragraphs dealing with compound derivative issues include the following:


File 1 Question 06  (With Answer)
What is the status of SFAS 80?  Are commodity contracts covered by SFAS 133?   Can short sale commodity contracts be hedging items under SFAS 133?  Contrast with commodity contracts with commodity-indexed embedded derivatives.

[Hint: Go to Paragraph 525 on Page 227 and Paragraphs 267-270 on Pages 138-139 of SFAS 133.  Also see Bob Jensen's SFAS 133 Glossary.]

SFAS 133 supercedes SFAS 80 in its entirety.

 


File 1 Question 07  (With Answer)
Suppose a firm agrees to pay 50 basis points in a firm commitment to borrow $1 million at a fixed rate on a specified future date.  Is this derivative financial instrument subject to SFAS 133 rules?    Would your answer be the same if the contract was not a firm commitment and the company had an option (for a 50 basis point fee) to enter into the loan at any time over the next three months?    Explain the FASB's reasoning on this issue.

[Hint:   See Paragraph 6c of SFAS 133.  Also see Bob Jensen's SFAS 133 Glossary.]

No. The contract settles through delivery of a promissory note (in exchange for making the loan (i.e., cash)
that is equal to the notional amount and is neither readily convertible to cash nor does a market mechanism exist to facilitate net settlement. For this reason, I believe the loan commitment does not meet the net settlement criterionpursuant to Paragraph 6c of SFAS 133 and, as such, does not meet the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133.

PWC q05.11


File 1 Question 08  (With Answer)
What is a fair value hedge?  Provide three examples of a fair value hedge.

[Hint: Go to Bob Jensen's SFAS 13 Glossary at http://WWW.Trinity.edu/rjensen/acct5341/speakers/133glosf.htm   ]
Answer is in SFAS 133 Glossary
Examples 1, 2, and 3 beginning on Page 59 of SFAS 133 illustrate fair value hedges.

 


File 1 Question 09  (With Answer)
What are the main conclusions in SFAS 133 regarding fair value accounting for derivative financial instruments?

[Hint: Go to Paragraphs 215-229 on Pages 121-127 of SFAS 133.  FASB guidance for measuring fair value can be found in Paragraphs 312-319 on Pages 153-155 of SFAS 133.  Especially note Paragraphs 247 on Page 132 and 331-337 on Pages 159-161 of SFAS 133.     Jim Leisingring comments about " first shot in a religious war" in my tape31.htm.   Also see Bob Jensen's SFAS 133 Glossary.]

 


File 1 Question 10  (With Answer)
What FASB standard covers investments in general but does not give much guidance to accounting for derivative financial instruments?

This question will not appear on the quiz, although it is a prime CPA Examination question area.  I will give you the answer to this question below:

SFAS 115 Accounting for Certain Investments in Debt and Equity Securities

This Statement addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Those investments are to be classified in three categories and accounted for as follows:

19. For securities classified as available-for-sale and separately for securities classified as held-to-maturity, all reporting enterprises shall disclose the aggregate fair value, gross unrealized holding gains, gross unrealized holding losses, and amortized cost basis by major security type as of each date for which a statement of financial position is presented. In complying with this requirement, financial institutions \6/ shall include in their disclosure the following major security types, though additional types also may be included as appropriate.


File 1 Question 11  (With Answer)
What is the SFAS 133 treatment of securities classified under SFAS 115 as "trading," "available-for-sale," and "held-to-maturity?"   Explain the FASB's reasons for different accounting treatments for hedges under these three classifications.

[Hint: Look up these terms in  Bob Jensen's SFAS 133 Glossary.  For a negative aspect of the classification "available-for-sale,", see the Eigth Circuit of Appeals court case referenced at under "Fair Value" in Bob Jensen's SFAS 133 Glossary.]

Securities designated as "held-to-maturity" need not be revalued for changes in market value and are maintained at historical cost-based book value.  Securities not being held-to-maturity securities (in either the trading or available-for-sale categories) are adjusted for changes in fair value.  Whether or not the unrealized holding gains or losses affect net income depends upon whether the securities are classified as trading securities versus available-for-sale securities.  Unrealized holding gains and losses on available-for-sale securities are deferred in comprehensive income instead of being posted to current earnings.  This is not the case for securities classified as trading securities rather than available-for-sale.  The three classifications are of vital importance to cash flow hedge accounting under SFAS 133.  See cash flow hedge and held-to-maturity.   Also see equity method.

A trading security (not subject to APB 15 equity method accounting and as defined in SFAS 115) cannot be a SFAS 133 hedged item.  That is because SFAS 115 requires that trading securities be revalued (like gold) with unrealized holding gains and losses being booked to current earnings.  Conversely, Paragraphs 4c on Page 2, 38 on Page 24, and 479 on Page 209 of SFAS 133 state that a forecasted purchase of an available-for-sale can be a hedged item, because available-for-sale securities are revalued under SFAS 115 have holding gains and losses accounted for in comprehensive income rather than current earnings.  Unlike trading securities, available-for-sale securities can be SFAS 133-allowed hedge items.   Mention of available-for sale is made in Paragraphs 4, 18, 23, 36, 38, 49, 52-55, 123, 479-480, and 534 of SFAS 133.  Held-to-maturity securities can also be SFAS 133-allowed hedge items.

Suppose a company expects dividend income to continue at a fixed rate over the two years in a foreign currency.  Suppose the investment is adjusted to fair market value on each reporting date.  Forecasted dividends may not be firm commitments since there are not sufficient disincentives for failure to declare a dividend.  A cash flow hedge of the foreign currency risk exposure can be entered into under Paragraph 4b on Page 2 of SFAS 133.  Whether or not gains and losses are posted to other comprehensive income, however, depends upon whether the securities are classified under SFAS 115 as available-for-sale or as trading securities.   There is no held-to-maturity alternative for equity securities.

 


File 1 Question 12  (With Answer)
What is the six-month forward spot rate (in dollars) of one British pound based upon yesterday's spot rates?  Identify where you obtained the spot rate.   Illustrate a hedge using a forward contract and discuss the SFAS 133 accounting treatment.

[Hint:  Go to  Bob Jensen's SFAS 133 Glossary.]

 


File 1 Question 13  (With Answer)
What is the distinction between a forward rate contract and a forward rate agreement?

[Hint:  See Chapter 2 of Managing Financial Risk (handed out in class).]

FRA is a forward contract on interest rates.

 


File 1 Question 14  (With Answer)
What is a FXA?

[Hint:  See Chapter 2 of Managing Financial Risk (handed out in class).]

FXA is a forward contract on foreign exchange rates.


File 1 Question 15  (With Answer)
If derivative financial instruments are recorded at fair value, why is it common for forward contracts to not be recorded at the date they are entered into as a derivative instrument?

[Hint:  See Chapter 2 of Managing Financial Risk (handed out in class) and Example 1 beginning on Page Page 59 of SFAS 133.]

There is no premium in most instances.


File 1 Question 16  (With Answer)
In a forward rate contract, what is the common source of the forward interest rate?

[Hint:  The answer is not LIBOR since this question is looking for a more general answer.  See Chapter 2 of Managing Financial Risk (handed out in class).   The terminology on Page 39 is elaborated upon in Bob Jensen's SFAS 133 Glossary.]

See Page 39 on "from where does the contractual rate come?"
It is derived from a yield curve (term structure of interest rates
.


File 1 Question 17  (With Answer)
Explain why the dollar price of forward yen will be more than the spot price if Eurodollar interest rates are higher than Euroyen interest rates.

[Hint:  See Chapter 2 of Managing Financial Risk (handed out in class).]

See "Covered Interest Rate Parity" on Page 28 of Chapter 2.  Without it there would be a possibility of riskless arbitrage.

 


File 1 Question 18  (With Answer)
The U.S. dollar forward exchange rate premium or discount on the British pound sterling is most likely to be equal to what cause?

[Hint:  Discuss in terms of treasury bill rates, prime rates, domestic bank rates, and Eurodollar versus Eurosterling deposit rates.]

The difference between Eurodaollar and Eurosterling deposit rates.  See the top of Page 29 in Chapter 2.

 


File 1 Question 19  (With Answer)
How would you derive a contractual rate on a Norwegian forward rate agreement?

[Hint:  See Chapter 2 of Managing Financial Risk (handed out in class).]

See Page 43 of Chapter 2.

 


File 1 Question 20  (With Answer)
What are the fundamental differences between the FASB and the IASC?

[Hint:  Compare the Beresford article on Pages 27-34 with the overview by Paul Pacter in my pacter.htm file.  ]

 


File 2 (EXCEL) Assignment
 Provide answers to questions listed in Sheet 1 of 133ex02q.xls in the TUCC Network Path J:\courses\acct5341\0assign\sfas133

Each student should make his or her own copy of the solution on an Excel file on a floppy disc.  A solution disc should also be turned in at the beginning of the next class.  Only one solution disc should be turned in for each partnership.  On that disc, please note the names of the partners on on the front of the disc and at the top of Sheet 1 in the answer spreadsheet.  Professor Jensen will place partnership solution files in the TUCC Network Path J:\courses\acct5341\0assign\students

 


On Your Own Review of Chapter 2 of Managing Financial Risk
You should review the various forward contracts and be able to answer questions on how such contracts are commonly used to alter financial risk.  Take notes on all parts of Chapter 2 on Managing Financial Risk. 

 


By Yourself Reading  Reading Assignments (take hand-written notes of assigned readings):


I am still in the process of preparing examination questions and answers for this course.  Some of the answer hints are given in the Answer Hints section of the course Helpers.

(You are required to bring your textbooks and extra floppy discs to class)

Go to Jensen's Web Site

Go to Course Syllabus

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