Corporate Reporting & Group Accounting: Hedge Accounting
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Questions and Answers

What is the initial value of the bond recorded in Firm A's accounts at the beginning of Year 1?

  • $\$100,000 (correct)
  • $\$98,182
  • $\$8,000
  • $\$103,667

    • How much interest expense does Firm A record on its debt at the end of Year 1?

  • $\$2,000
  • $\$3,667 (correct)
  • $\$6,220
  • $\$8,000

    • What is the fair value of the debt at the end of Year 1?

  • $\$98,182
  • $\$101,887
  • $\$100,000
  • $\$103,667 (correct)

    • What is the fair value of the interest rate swap (IRS) at the end of Year 1?

    <p>$$3,667 (C)</p> Signup and view all the answers

    What is the effective interest rate used to calculate the interest expense in Year 2?

    <p>$$6%$ (D)</p> Signup and view all the answers

    How much cash does Firm A receive under the IRS contract at the end of Year 2?

    <p>$$2,000 (D)</p> Signup and view all the answers

    What is the book value of the debt before the revaluation at the end of Year 2?

    <p>$$101,887 (D)</p> Signup and view all the answers

    What journal entry is made to record the revaluation of the debt at the end of Year 2?

    <p>Debit Bond for $$3,705 and Credit FV Gain for $$3,705 (C)</p> Signup and view all the answers

    What is the primary reason Firm A uses the effective interest method to account for the interest expense in Year 2?

    <p>To align the recognition of interest expense with the timing of cash flows related to the debt (D)</p> Signup and view all the answers

    Why does the fair value of the IRS decrease at the end of year 2?

    <p>Because the IRS has a fixed rate and the market interest rate increased (A)</p> Signup and view all the answers

    What is the total amount Firm A must repay to close out the IRS as recorded in the journal entry on 31.12.X3?

    <p>$100,000 (D)</p> Signup and view all the answers

    What was the interest charge recorded on 31.12.X3 based on the IRS amount?

    <p>$182 (A)</p> Signup and view all the answers

    What is the primary purpose of a cash flow hedge?

    <p>To hedge against variability in cash flows attributable to specific risks (B)</p> Signup and view all the answers

    Which of the following journal entries indicates an interest charge for the debt on 31.12.X3?

    <p>Interest charge (10%· $98,182) (D)</p> Signup and view all the answers

    What was the purpose of the entry on 31.12.X3 where Firm A recorded 'Cash (8%· $100,000)'?

    <p>To recognize payment for debt service (C)</p> Signup and view all the answers

    What happens to gains or losses from the hedging instrument without hedge accounting?

    <p>They are recognized prior to the hedged item. (D)</p> Signup and view all the answers

    How much additional IRS Firm A must pay due to the change in the IRS rate?

    <p>$2,000 (B)</p> Signup and view all the answers

    Under hedge accounting, where are gains or losses from the hedging instrument held until recognized?

    <p>In other comprehensive income (OCI) (B)</p> Signup and view all the answers

    What is the final balance of the IRS account after the entries made on 31.12.X3?

    <p>$0 (C)</p> Signup and view all the answers

    What occurs if the change in value of the hedging instrument exceeds the change in the hedged item?

    <p>The difference is recognized in P&amp;L immediately. (C)</p> Signup and view all the answers

    Which of the following calculations correctly reflects the IRS fee increase percentage for Firm A?

    <p>2% increase on a $100,000 IRS (B)</p> Signup and view all the answers

    What will happen to the cash flow related to the hedged item once it is recognized?

    <p>It will affect P&amp;L directly or through an asset or liability. (A)</p> Signup and view all the answers

    What treatment is applied to the cash flow hedge reserve for non-financial assets or liabilities?

    <p>It is removed and included in the initial cost of the asset or liability. (D)</p> Signup and view all the answers

    What happens to the FV loss on the interest rate swap (IRS) if Lender B does not apply hedge accounting?

    <p>It is recorded immediately in P&amp;L. (B)</p> Signup and view all the answers

    What was the Gross Value (FV) Loss recorded on 31.12.X2?

    <p>$3,705 (A)</p> Signup and view all the answers

    What is the primary benefit of adopting hedge accounting for Lender B?

    <p>Reduction of earnings volatility. (A)</p> Signup and view all the answers

    What does hedge ineffectiveness refer to in the context of cash flow hedging?

    <p>When changes in the hedging instrument do not correlate with changes in the hedged item. (D)</p> Signup and view all the answers

    Which of the following statements best describes the accounting treatment of the effective portion of a CF hedge?

    <p>It is recognized as part of equity and not in profit and loss. (D)</p> Signup and view all the answers

    What risks does Lender B face by holding a fixed interest loan portfolio?

    <p>Fair value (FV) risk from fluctuations in interest rates. (C)</p> Signup and view all the answers

    Which accounting treatment creates earnings volatility for Lender B?

    <p>Not applying hedge accounting for the IRS. (C)</p> Signup and view all the answers

    What occurs when Lender B purchases a pay-fixed receive-variable IRS?

    <p>It matches the IRS with the hedged item. (D)</p> Signup and view all the answers

    What is a primary challenge associated with hedge accounting?

    <p>Strict accounting rules and disclosure requirements. (B)</p> Signup and view all the answers

    What is the impact of not using hedge accounting on Lender B's loan portfolio at amortized cost?

    <p>The loan portfolio’s value remains unchanged without FV recognition. (B)</p> Signup and view all the answers

    What financial statement effect occurs when interest rates decline for Lender B?

    <p>Increase in liability due to IRS loss. (A)</p> Signup and view all the answers

    Which statement is true about the treatment of FV changes in hedge accounting?

    <p>FV changes are recognized in the same period as the derivative impacts P&amp;L. (A)</p> Signup and view all the answers

    Which of the following statements highlights a benefit of hedge accounting?

    <p>Accurate representation of risk management activities. (C)</p> Signup and view all the answers

    What is the purpose of a fair value (FV) hedge?

    <p>To recognize changes in FV due to specific risks affecting P&amp;L. (C)</p> Signup and view all the answers

    How are fair value changes in a hedged item treated in FV hedges?

    <p>They are recognized in P&amp;L in the current period. (A)</p> Signup and view all the answers

    What happens to cumulative FV changes when a firm commitment is met?

    <p>They are included in the carrying amount of the recognized asset or liability. (A)</p> Signup and view all the answers

    In the context of FV hedges, how are changes in value of a financial instrument measured at amortized cost treated?

    <p>They are included in the carrying amount and amortized into P&amp;L. (C)</p> Signup and view all the answers

    What is the effective interest rate recalculation used for in FV hedges?

    <p>To amortize FV changes into P&amp;L. (B)</p> Signup and view all the answers

    How is the fair value change of a debt instrument measured at FVOCI recognized?

    <p>It applies only to cumulative gains or losses previously recognized in P&amp;L. (B)</p> Signup and view all the answers

    What type of instrument did Firm A use to convert the fixed-rate bond to a variable rate?

    <p>Interest rate swap (IRS) (D)</p> Signup and view all the answers

    What is recognized through the differences between the hedging instrument and the hedged item?

    <p>Hedge ineffectiveness. (C)</p> Signup and view all the answers

    What is true about the fair value of the IRS at inception for Firm A?

    <p>It had a fair value of zero. (A)</p> Signup and view all the answers

    What does the application of hedge accounting ensure?

    <p>It allows earlier recognition of the FV change in the hedged item. (A)</p> Signup and view all the answers

    What is the primary objective of hedge accounting?

    <p>To manage risks by offsetting variability in the fair value or cash flows of a hedged item (A)</p> Signup and view all the answers

    Which of the following is NOT a characteristic of a derivative?

    <p>Measured at fair value through profit or loss (FVPL) (C)</p> Signup and view all the answers

    What is the primary standard that governs the accounting for financial instruments?

    <p>IFRS 9 (B)</p> Signup and view all the answers

    Which of the following is NOT a requirement for a hedging relationship to be recognized for hedge accounting?

    <p>The hedging instrument must be a derivative with no written option (A)</p> Signup and view all the answers

    What is the main difference between the FVPL and FVOCI measurement methods for derivatives?

    <p>FVPL recognizes gains and losses on fair value changes in profit or loss (P&amp;L), while FVOCI recognizes them in equity (C)</p> Signup and view all the answers

    Which of the following is an example of a hedged item?

    <p>All of the above (D)</p> Signup and view all the answers

    When is hedge accounting mandatory?

    <p>Hedge accounting is always optional (D)</p> Signup and view all the answers

    Which of the following statements about the initial measurement of derivative contracts is correct?

    <p>They are initially measured at fair value, with transaction costs charged to profit or loss (C)</p> Signup and view all the answers

    What is the difference between a derivative and a financial instrument?

    <p>There is no difference; all derivatives are considered financial instruments (C)</p> Signup and view all the answers

    Study Notes

    Corporate Reporting & Group Accounting: Hedge Accounting

    • Topics covered in the presentation include derivatives, hedge accounting, CF Hedges, and FV Hedges.
    • The presentation outlines the accounting treatment for derivatives, specifically for initial and subsequent measurement.
    • IFRS standards, particularly IAS 32, IFRS 9, and IFRS 7, are mentioned as guiding the presentation of financial instruments.
    • Derivatives are financial instruments with value that changes in response to changes in specified underlying instruments (like commodity prices or FX rates), with no or little initial investment and settled at a future date.
    • Derivatives are measured at fair value initially and subsequently measured using FVPL (fair value through profit or loss) or FVOCI (fair value through other comprehensive income).
    • Transaction costs are recorded in the profit or loss (P&L) account.
    • Hedge Accounting is a method managing risks from fluctuations in the fair value or cash flows of a hedged item.
    • Hedge Accounting is optional.
    • A hedge accounting relationship must be formally designed and effective.
    • There are two types of hedges: Cash Flow (CF) and Fair Value (FV).
    • CF Hedges are used to manage risks in cash flow fluctuations, while FV hedges manage risks from changes in fair value.
    • CF Hedge accounting treatment, gains or losses from changes in the hedging instrument (e.g., derivative) are initially recorded in Other Comprehensive Income (OCI) and then transferred to the profit or loss (P&L) statement when the hedged item affects P&L.
    • FV Hedge accounting treatment will generally record gain or losses immediately on the profit or loss (P&L) statement.
    • Hedge accounting has both advantages and disadvantages, including reduced earnings volatility and consistent representation in financial statements, but also strict rules and substantial record-keeping requirements.
    • Several examples (CF hedge and FV hedge) are provided to illustrate the application of the related accounting entries. The examples include firms, initial situations with variable or fixed interest rates impacting a portfolio of loans, and subsequent events where interest rates change.

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    Description

    This quiz explores the principles of hedge accounting as outlined in corporate reporting. Key topics include derivatives, CF Hedges, FV Hedges, and related IFRS standards. Gain insights into the measurement and treatment of financial instruments and their impact on financial statements.

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