Fair Value Hedge Accounting Quiz

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Questions and Answers

During a hedge of a recognized asset or liability, how is the fair value (FV) change of the hedged item typically recognized?

The FV change is recognized directly in the income statement.

The FV change is recognized in the statement of comprehensive income (OCI).

The FV change is recognized by adjusting the carrying amount of the hedged item on the balance sheet. (correct)

The FV change is recognized in the balance sheet as an asset or liability.

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

To reduce the risk of changes in the fair value of a specific asset or liability. (correct)

To reduce the risk of changes in the value of a derivative instrument.

To reduce the risk of changes in interest rates.

To reduce the risk of changes in the value of a portfolio of assets or liabilities.

When a firm enters into a fair value (FV) hedge for a recognized asset or liability, how is the change in fair value of the hedging instrument typically recognized?

The change in fair value is recognized directly on the balance sheet.

The change in fair value is recognized in the income statement, in offset to the change in fair value of the hedged item. (correct)

The change in fair value is recognized in the statement of comprehensive income (OCI).

The change in fair value is recognized in the income statement, separately from the change in fair value of the hedged item.

How is hedge ineffectiveness handled under FV hedge accounting?

It is recognized in the income statement in the period in which it occurs. (B) Signup and view all the answers

What is the significance of recognizing the fair value (FV) change of a hedged item earlier than under normal accounting treatment, when a firm applies FV hedge accounting?

It allows the firm to recognize gains and losses on the hedged item in a timely manner. (A) Signup and view all the answers

What is the carrying amount (CA) of a financial instrument measured at amortized cost under FV hedge accounting?

It includes the cumulative fair value changes of the instrument. (B) Signup and view all the answers

How does amortization of a financial instrument measured at FVOCI under FV hedge accounting differ from the amortization of a financial instrument measured at amortized cost?

Amortization only occurs for the gain or loss on the financial instrument that was previously recognized in the income statement. (A) Signup and view all the answers

What happens to the cumulative fair value change in a firm commitment to acquire an asset or assume a liability when the commitment is met?

It is included in the carrying amount of the recognized asset or liability. (C) Signup and view all the answers

When a company enters into an interest rate swap (IRS) to convert a fixed-rate debt into a variable one, using it as an FV hedge, what is the initial fair value (FV) of the IRS?

It is typically zero at inception. (B) Signup and view all the answers

In the example of Firm A issuing a fixed-rate bond and entering into an interest rate swap (IRS) for an FV hedge, what is the key principle that drives the accounting treatment for the subsequent changes in fair value of the IRS?

The IRS is treated as a hedging instrument, and its FV changes are recognized in offset to the changes in the FV of the hedged item. (C) Signup and view all the answers

When a lender does not apply hedge accounting and experiences a fair value loss on an interest rate swap (IRS), how is this loss treated?

The loss is recorded immediately in P&L. (A) Signup and view all the answers

Why does not applying hedge accounting create earnings volatility for a lender using an interest rate swap (IRS) to hedge a loan portfolio?

Because the fair value change on the IRS is recognized while the loan portfolio's value is not under amortized cost. (A) Signup and view all the answers

What is the primary purpose of applying fair value hedge accounting for a lender using an IRS to hedge a loan portfolio?

To eliminate any accounting mismatches from interest rate changes. (A) Signup and view all the answers

When a lender applies fair value hedge accounting, how are changes in the fair value of the loan portfolio treated?

They are recognized in the same period as changes in the fair value of the hedging instrument (IRS). (B) Signup and view all the answers

What is a disadvantage of not using hedge accounting?

It might result in earnings volatility, which does not reflect the entity's risk management activities. (B) Signup and view all the answers

According to the content provided, at the time of the prime rate decrease, does the lender record any changes to the value of their loan portfolio?

No change will be recorded to the loan portfolio because it is accounted for at amortized cost. (A) Signup and view all the answers

What is a potential benefit of adopting hedge accounting?

Reduced earnings volatility and financial statement representation consistent with the firm's risk management activities. (A) Signup and view all the answers

What is a potential challenge or drawback associated with using hedge accounting?

Strict accounting rules, heavy reporting demands, monitoring costs, and the risk that hedges might be ineffective. (B) Signup and view all the answers

In the context of the provided material, what does a pay-fixed receive-variable IRS mean?

The lender pays a fixed interest rate and receives a variable interest rate. (B) Signup and view all the answers

What happens when the Central Bank decreases the prime rate?

The fair value of the IRS liability decreases. (A) Signup and view all the answers

Under IFRS 9, what type of risk is a cash flow hedge primarily designed to mitigate?

Exposure to variability in cash flows. (D) Signup and view all the answers

Which of the following is an example of a financial instrument that is commonly used in a cash flow hedge?

Variable-rate financial instruments. (A) Signup and view all the answers

What type of risk does a fair value hedge primarily address?

Exposure to changes in fair value. (B) Signup and view all the answers

Which of the following is an example of an item commonly hedged with a fair value hedge?

Inventory. (B) Signup and view all the answers

Where are fair value changes of the hedging instrument initially recognized under cash flow hedge accounting?

In other comprehensive income (OCI). (A) Signup and view all the answers

How is a hedged item measured under cash flow hedge accounting?

Its measurement does not change. (C) Signup and view all the answers

How are fair value changes of the hedging instrument treated under a fair value hedge?

Recognized immediately in profit or loss (P&L). (A) Signup and view all the answers

In a cash flow hedge, when does the hedged item's benefit impacts profit or loss?

When the hedged item affects cash flows. (D) Signup and view all the answers

What is the primary goal of cash flow hedge accounting in terms of income statement presentation?

To match the timing of gains and losses from the hedging instrument with the hedged item. (D) Signup and view all the answers

In a fair value hedge, the main objective of measuring the hedged item at fair value is to:

Match the changes in value of the hedged item with the changes in value of the hedging instrument. (A) Signup and view all the answers

What is the immediate impact of an increase in the prime interest rate on the fair value of a pay-variable, receive-fixed interest rate swap (IRS), from the perspective of the receiver of the fixed-rate payments?

A loss, as the swap becomes less valuable. (B) Signup and view all the answers

If a company chooses not to apply hedge accounting and holds an IRS, how does a fair value loss on that IRS impact its financial statements?

It's immediately recognized in P&L, creating a mismatch with the underlying hedged item. (A) Signup and view all the answers

What is the benefit of using cash flow hedge accounting when dealing with a loss on an IRS?

It defers the loss recognition in profit or loss to future periods when the hedged item affects P&L. (B) Signup and view all the answers

In the context of the example provided, what does 'sterilize FV changes' mean in the context of a cash flow hedge?

Initially recognising the fair value loss in OCI and releasing it to P&L so that it offsets the change in the hedged item. (B) Signup and view all the answers

According to the examples provided, by applying CF hedge accounting, where is the current fair value loss on an IRS initially recognized?

In other comprehensive income (OCI). (B) Signup and view all the answers

What is the primary purpose of a cash flow hedge?

To minimize variability in cash flows related to a recognized asset or highly probable forecast transaction (A) Signup and view all the answers

What happens to the cash flow changes of the hedging instrument without hedge accounting?

Gains are recognized later than for the hedged item (B) Signup and view all the answers

Which scenario triggers immediate recognition in profit and loss (P&L)?

The changes in the hedging instrument exceed changes in the hedged item (D) Signup and view all the answers

How are gains and losses from the hedging instrument treated under hedge accounting?

They are recognized in other comprehensive income until the hedged item is recognized (A) Signup and view all the answers

What occurs when the hedged forecast transaction results in recognition of a non-financial asset?

The cash flow hedge reserve is removed and included in the initial cost of the asset (A) Signup and view all the answers

What characterizes hedge ineffectiveness in a cash flow hedge?

The changes in the hedging instrument do not correlate to the changes in the hedged item (A) Signup and view all the answers

What is the subsequent accounting treatment for cash flow hedge reserves?

They may be recognized based on the nature of the item being hedged (A) Signup and view all the answers

Which of the following best depicts the consequence of hedge accounting for cash flow hedges?

Delaying recognition of gains or losses until the associated hedged item is recognized (B) Signup and view all the answers

What was the carrying value of the IRS before it was revalued?

$1,887 (B) Signup and view all the answers

What is the total cash Firm A must pay to close out the IRS account on 31.12.X3?

$100,000 (B) Signup and view all the answers

What amount is derived from the calculation $100,000 · (10% - 8%)?

$2,000 (D) Signup and view all the answers

What type of entry is recorded when an interest charge of $9,818 is made on 31.12.X3?

Debit entry (C) Signup and view all the answers

How much interest is charged on the IRS for the amount of $1,818 at a 10% interest rate?

$182 (B) Signup and view all the answers

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

$0 (A) Signup and view all the answers

What is the effect of the additional $2,000 payment in year 3 on Firm A's financials?

Increase in liabilities (B) Signup and view all the answers

What is the total interest charge calculated for the debt of $98,182 at a 10% interest rate on 31.12.X3?

$9,818 (D) Signup and view all the answers

What is the amount Firm A records as a FV loss on 31.12.X1?

$3,667 (C) Signup and view all the answers

How is the interest expense calculated for Firm A on 31.12.X2?

6% of $103,667 (C) Signup and view all the answers

What amount does Firm A receive under the IRS contract on 31.12.X2?

$2,000 (B) Signup and view all the answers

What is the total cash outflow for interest payment incurred by Firm A on 31.12.X1?

$8,000 (C) Signup and view all the answers

What journal entry is made by Firm A to record the FV gain on 31.12.X2?

Debit IRS, Credit FV gain (B) Signup and view all the answers

What is the present value of the remaining payments on the debt at an interest rate of 10%?

$98,182 (D) Signup and view all the answers

What is the new book value of the debt before the year 2 revaluation after the annual interest payment and debt adjustment?

$101,887 (C) Signup and view all the answers

What impact does the increase in interest rates to 10% have on the FV of the IRS?

Decreases (C) Signup and view all the answers

What approach does Firm A use to account for interest expense?

Effective interest method (D) Signup and view all the answers

What was the bond amount recorded as of 01.01.20X1?

$100,000 (C) Signup and view all the answers

Study Notes

Corporate Reporting & Group Accounting

Hedge Accounting is a method of accounting for financial instruments
The slides cover the following: derivatives, hedge accounting, CF Hedge (Cash Flow Hedge), FV Hedge (Fair Value Hedge)

Derivatives (Accounting Viewpoint)

Derivatives are financial instruments whose value depends on an underlying asset or liability.
Three characteristics of a derivative: value changes in response to changes in an underlying instrument (commodity price, exchange rate, etc.); no or small initial investment; settlement at a future date.
IFRS deals with Financial Instruments through three standards: IAS 32 (Presentation); IFRS 9 (Financial instruments); IFRS 7 (Disclosure).

Derivatives: Measurement

Initial measurement of a derivative contract (FI) is at Fair Value (refer to IFRS 13).
Transaction costs are reported to P&L.
Subsequent Measurement:
- FVPL (Fair Value Through Profit or Loss): Gains and losses from FV changes are reported in P&L
- FVOCI (Fair Value Through Other Comprehensive Income): Gains and losses from FV changes are reported in OCI (Other Comprehensive Income) until realized.
- Non-hedging derivatives are always measured at FVPL.

Hedge Accounting: Hedging Tools

Hedging Instrument: Financial instruments (with exceptions, such as some derivatives), no written options (generally).
Hedged Item: Recognized asset or liability; firm's commitment; future cash flows; aggregated exposures.
Hedge Accounting: Managing risks using a hedging instrument to offset variability in FV or Cash Flows, effective formal hedging relationship, and optionality of hedge accounting.

Hedge Accounting: Types of Hedges

Hedges are categorized as either Cash Flow hedges or Fair Value hedges.
Cash Flow Hedges: designed to offset variability in Cash Flows.
Fair Value Hedges: designed to offset variability in Fair Value.

CF Hedge

Hedging the risk of CF changes in variable-rate financial instruments (IRS/options)
Identifying highly probable forecast transactions at future market prices or transactions denominated in a foreign currency (currency forwards/options.)
Measurement: FV changes in hedging instrument recognised in OCI until hedged item is recognized or affects P&L; Hedged item's measurement doesn't change.
Mismatch: CF changes recognized only when realised in cash, need to sterilise FV changes hedging instrument (OCI) to release in P&L when hedged item is effected (offsetting).

FV Hedge

Hedge the risk of FV changes of fixed-rate financial instruments (IRS/options)
Identifying firm's commitments (purchase or sale) of a commodity, commodity making up a portion of value; inventory, etc.
Measurement: FV changes in hedging instrument recognised in P&L. Hedged item measured at FV.
Mismatch: FV changes in hedging instrument recognized immediately in P&L, need to match this with offsetting changes of hedged item.

Hedge Accounting: Pros & Cons

Pros: Reduced earnings volatility, avoids risk taking (since you are hedged); financial statements representation consistent with risk management activities.
Cons: Strict reporting and disclosure requirements, ongoing monitoring costs, hedges can become ineffective.

CF Hedge: Overview

Hedging of exposure to variability in cash flows
Criteria: Recognizable asset or liability or Highly probable forecast transactions.
Accounting Treatment: Effective portion of changes in value recognised as a CF hedge reserve in Other Comprehensive Income (OCI). No changes in value are recognised if there is a mismatch between hedging instrument and hedged item.

FV Hedge: Overview

Hedging exposure to changes in fair value.
Criteria: Recognizable asset or liability or Unrecognized firm commitment.
Accounting Treatment: FV changes recognised in P&L (typical treatment for a derivative), corresponds to recognised adjustments to the carrying amount of hedged item in Balance Sheet (BS), any differences between hedging instrument and hedged item are automatically recognised.

Accounting for FV Change in Hedged Item

Firm commitment to acquire asset/assume liability
FV change of commitment recognised in the balance sheet during hedge life
When commitment is met, cumulative FV change included in carrying amount (CA) of asset/liability.
Financial instrument measured at amortised cost (FV change in instrument included in CA adjusted thru effective interest rate recalculation).
Debt instrument measured at FVOCI (FV change in instrument included in CA adjusted thru amortisation into P&L).

FV Hedge: Example 1

Firm A issues a fixed-rate bond, converts to a variable-rate bond using an IRS
On inception, the IRS fair value is zero, nothing in A's accounts.
Interest payments recognized.
Revaluation of debt.
Reconcile IRS fair value changes with the corresponding changes in the carrying amount of debt.

CF Hedge: Example 1

Firm A enters futures contract to purchase iron.
Price of iron changes, gain identified.
Gain recorded in the CF hedge reserve in OCI.

Detailed Examples and Journal Entries

Detailed examples provided for CF and FV Hedge for illustration purposes. They include journal entries for various stages (e.g., at inception, settlement, purchase).

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Description

Test your knowledge on fair value hedge accounting with this quiz. Explore how fair value changes are recognized for hedged items and the significance of hedge ineffectiveness under FV hedge accounting. Ideal for finance students or professionals looking to refresh their understanding.