_________________________________ Name (Please Print) With Answers ACCT 5341 Examination 1 (Part 1) Dr. Jensen Spring 2001 Students are allowed to use the following examination aids: Calculator Notes that you have written yourself File 1 printouts File 2 printouts Students are not allowed to use the following in Part 1 Photocopies Books Notes or any other materials written by other students other than File 1 and File 2 printouts that were joint efforts between you and a partner Part 1 (Multiple Choice) Choose the best answer to each question when more than one answer is correct. Answers are to be recorded both on the question sheet and on the answer sheet. The term “earnings” does not include “comprehensive earnings.” Questions 1-20 Relate to FAS 133 Theory and Rules 1. (02 Points) What contract below is not eligible for hedge accounting under FAS 133? a. Embedded call option b. Forward rate agreement c. Covered call [XXXXX Paragraph 399 of FAS 133.] d. Interest rate futures 2. (02 Points) The price of a block of 10,000 options may be different than the price of a single option if all 10,000 are sold in a block. FAS 133 requires a fair market value blockage adjustment as follows: a. Upward b. Downward c. Both answers a and b above d. Neither answers a or b above [XXXXX Paragraph 315 of FAS 133.] 3. (02 Points) Suppose that a change in the price of a lumber inventory forecasted purchase is effectively offset by a forward cash flow hedge. The hedge may result in which of the following outcomes, relative to having no hedge, in periods prior to the purchase of the inventory? a. The hedge may reduce reported earnings prior to the transaction. b. The hedge may increase reported earnings prior to the transaction. c. Both answers a and b are possible depending upon the direction of the price movements. d. None of the above since this hedge does not affect reported earnings prior to the purchase transaction or dedesignation. [XXXXX Paragraph 30 on Page 121and Paragraph 152 beginning on Page 81 of FAS 133. Prior to the purchase transaction itself, gains and losses are deferred in OCI and do not affect current earnings.] 4. (02 Points) Suppose that a change in the price of gold inventory forecasted purchase is effectively offset by a forward contract cash flow hedge. The hedge may result in which of the following outcomes (relative to having no hedge in periods prior to the sale of the inventory)? a. The hedge may reduce reported earnings prior to the transaction. b. The hedge may increase reported earnings prior to the transaction. c. Both answers a and b are possible depending upon the direction of the price movements. [XXXXX Paragraph 405 of FAS 133. Special hedge accounting is not necessary if both the hedged item and the hedging instrument are measured at fair value with changes in fair value reported in earnings as they occur because offsetting gains and losses will be recognized in earnings together. The Board therefore decided to specifically prohibit hedge accounting if the related asset or liability is, or will be, measured at fair value, with changes in fair value reported in earnings when they occur. That prohibition results from the Board's belief that a standard on hedge accounting should not provide the opportunity to change the accounting for an asset or liability that would otherwise be reported at fair value with changes in fair value reported in earnings. Thus, for a fair value hedge, the prohibition is intended to prevent an entity from recognizing only the change in fair value of the hedged item attributable to the risk being hedged rather than its entire change in fair value. For a cash flow hedge, the prohibition is intended to prevent an entity from reflecting a derivative's gain or loss in accumulated other comprehensive income when the related asset or liability will be measured at fair value upon acquisition or incurrence..(In other words, no OCI is to be carried forward for any gain or loss of the hedge.)] d. None of the above since gold cannot be a hedged item under FAS 133. 5. (02 Points) Suppose that a change in the price of a lumber inventory forecasted sale is effectively offset by a forward fair value hedge. The hedge may result in which of the following outcomes, relative to having no hedge, in periods prior to the sale of inventory on hand? a. The hedge may reduce reported earnings prior to the transaction. b. The hedge may increase reported earnings prior to the transaction. c. Both answers a and b are possible depending upon the direction of the price movements. d. None of the above since this hedge does not affect reported earnings prior to the purchase transaction or dedesignation. [Increases or decreases in the value of the forward contract charged to earnings are offset by a changed accounting of the lumber inventory from historical cost accounting to fair value accounting. See Paragraph 22 of FAS 133.] 6. (02 Points) Suppose that a change in the price of gold inventory forecasted sale is effectively offset by a forward contract fair value hedge. The hedge may result in which of the following outcomes (relative to having no hedge in periods prior to the purchase of the inventory)? a. The hedge may reduce reported earnings prior to the transaction. b. The hedge may increase reported earnings prior to the transaction. c. Both answers a and b are possible depending upon the direction of the price movements. [XXXXX See Paragraph 21(2)(c) and Paragraph 405. The hedged item (gold inventory) is currently carried at fair value without a hedge such that it cannot be a hedged item in a fair value hedge.)] d. None of the above since gold cannot be a hedged item under FAS 133. 7. (02 Points) Suppose that a change in the price of a lumber inventory forecasted purchase is hedged by a call option designated in advance as a cash flow hedge. An ineffective hedge will result in which of the following outcomes relative to an effective hedge in periods prior to the sale of the inventory? a. Ineffectiveness may reduce reported earnings prior to the transaction. b. Ineffectiveness may increase reported earnings prior to the transaction. c. Both answers a and b are possible depending upon the direction of the hedge’s ineffectiveness. [XXXXX See the last portion of Paragraph 63. c. If the effectiveness of a hedge with a forward or futures contract is assessed based on changes in fair value attributable to changes in spot prices, the change in the fair value of the contract related to the changes in the difference between the spot price and the forward or futures price would be excluded from the assessment of hedge effectiveness. In each circumstance above, changes in the excluded component would be included currently in earnings, together with any ineffectiveness that results under the defined method of assessing ineffectiveness. As noted in Paragraph 62, the effectiveness of similar hedges generally should be assessed similarly; that includes whether a component of the gain or loss on a derivative is excluded in assessing effectiveness. No other components of a gain or loss on the designated hedging instrument may be excluded from the assessment of hedge effectiveness.] d. None of the above since ineffectiveness does not affect reported earnings prior to the sale transaction 8. (02 Points) Suppose that a change in the price of a lumber inventory forecasted sale is hedged by a put option designated in advance as a cash flow hedge. An ineffective hedge will result in which of the following outcomes relative to an effective hedge in periods prior to the sale of the inventory? a. The hedge may reduce reported earnings prior to the transaction b. The hedge may increase reported earnings prior to the transaction c. Both answers a and b are possible depending upon the direction of the price movements. [XXXXX See the last portion of Paragraph 63. Illustrations can be found Paragraphs 107 and 109 of FAS 133.] d. None of the above since this hedge does not affect reported earnings prior to the sale transaction. 9. (02 Points) Suppose a forward contract is used as a fair value foreign currency hedge of an asset denominated in Mexican pesos. Hedge effectiveness is judged by comparing changes in the fair value of the forward contract with changes in the fair value of the U.S. dollar vis-à-vis the peso. What will be the impact of hedge ineffectiveness? a. No impact since only cash flow hedges are subject to hedge accounting that may be judged ineffective. b. No impact if the asset is an available-for-sale security denominated in pesos. c. No impact if the asset is a firm commitment at a future date rather than an available-for–sale asset. [XXXXX Footnote 22 in the Appendix B Example 3 Paragraph 123 of FAS 133. If the hedged item were a foreign-currency-denominated available-for-sale security instead of a firm commitment, Statement 52 would have required its carrying value to be measured using the spot exchange rate. Therefore, the spot-forward difference would have been recognized immediately in earnings either because it represented ineffectiveness or because it was excluded from the assessment of effectiveness.] d. None of the above answers are correct. 10. (02 Points) The “clearly-and-closely related” provisions of FAS 133 apply mainly to which of the following? a. A decision as to whether an embedded derivative is subject to FAS 133 accounting rules. b. A decision as to whether an embedded derivative will be accounted for separately from its host contract. [XXXXX Paragraph 304 of FAS 133] c. The degree of ineffectiveness of an interest rate swap contract. d. The degree of ineffectiveness of a foreign currency hedging contract.. Part 1 (Essay) 11. (08 Points) Relates to the Week 2 Assignment of Case 2 from Chapter 1 of your WTD textbook. Consider the two account balances shown below: Accounts receivable Inventory 20x1 $1,000,000 $5,000,000 20x2 $2,000,000 $8,000,000 Suppose that the general price index moved from 163 to 174 between the beginning of the period and the end of the period. Compute the purchasing power gain or loss in the above items: Purchasing power loss (gain) = $_______________________ ANSWER Ignore inventory since inventory is a non-monetary asset. 174/163 for beginning balance and [174/(163+174)/2] for change in net monetary assets HC/ND Net monetary position 20x1 $1,000,000 Increase in net monetary position $1,000,000 PLA monetary position at the end of 20x2 Net monetary position at the end of 20x2 $2,000,000 Net purchasing power loss (gain) RATIO 174/163 [174/(163+174)/2 HC/CD $1,067,485 $1,032,641 $2,100,126 $2,000,000 $ 100,126 12. (02 Points) Week 02 Possible Quiz Question 08 What are the major types of financial instruments derivatives risk? 08 (If you don’t have the answer to copy directly from your notes, it is best to move on to another question, because the point weighting of this question is too low to spend much time on during the examination.) [Hint 1: In addition to FAS 133, students may find definitions and examples in "Summary of Derivative Types" --- http://www.rutgers.edu/Accounting/raw/fasb/derivsum.exe Trinity University students may download from J:\courses\acct5341\fasb\sfas133\derivsum22 Especially note pp. 19-21 and 84-85.] [Hint 2: Bob Jensen's Glossary a http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm] Bob Jensen's FAS 133 Glossary defines risks as follows the various types of financial risks, including market price risk, market interest rate risk, foreign exchange risk, and credit risk. These are discussed in FAS 133, Paragraphs 411-415, Pages 184-186. FAS 133 does not take up such things as tax rate swaps and credit swaps. Mention is given to nonfinancial assets and liabilities in Paragraphs 416-421. Other risks are mentioned in Paragraph 408. A good site dealing with credit risk is at http://www.numa.com/ref/volatili.htm FAS 133, Paragraphs 411-415 list the following types of risk: a. Market price risk. A fair value hedge focuses on the exposure to changes in the fair value of the entire hedged item. The definition of fair value requires that the fair value of a hedged item be based on a quoted market price in an active market, if available. Similarly, a cash flow hedge focuses on variations in cash flows, for example, the cash flows stemming from the purchase or sale of an asset, which obviously are affected by changes in the market price of the item. The Board therefore concluded that the market price risk of the entire hedged item (that is, the risk of changes in the fair value of the entire hedged item) should be eligible for designation as the hedged risk in a fair value hedge. Likewise, variable cash flows stemming from changes in the market price of the entire item are eligible for designation as the hedged risk in a cash flow hedge. b. Market interest rate risk. For financial assets and liabilities, changes in market interest rates may affect the right to receive (or obligation to pay or transfer) cash or other financial instruments in the future or the fair value of that right (or obligation). The time value of money is a broadly accepted concept that is incorporated in generally accepted accounting principles (for example, in APB Opinion No. 21, Interest on Receivables and Payables, and FASB Statement No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases). Because the marketplace has developed techniques to delineate and extract interest rate risk from financial instruments, the Board decided that the risk that changes in market interest rates will affect the fair value or cash flows of the hedged item warrants being identified as a risk that may be designated as being hedged. c. Foreign exchange risk. The fair value (expressed in the entity's functional currency) of an asset such as a foreign debt or equity security that is classified as available for sale, as well as the fair value of the financial component of a firm commitment that is denominated in a currency other than the entity's functional currency, generally is exposed to changes in foreign exchange rates. Similarly, the cash flows of a forecasted transaction generally are exposed to changes in foreign exchange rates if the transaction will be denominated in a foreign currency. Statement 52 specifies special accounting for reflecting the effects of changes in foreign exchange rates, and this Statement continues much of that accounting. The Board therefore decided that the risk of changes in foreign exchange rates on the fair value of certain hedged items and on the cash flows of hedged transactions warrants being identified as a risk that may be designated as being hedged. d. Default (credit) risk. A financial asset embodies a right to receive cash or another financial instrument from a counterparty. A financial asset thus embodies a risk that the counterparty will fail to perform according to the terms of the contract; that risk generally is referred to as credit risk. Because that risk affects the fair value of a financial asset, as well as the related cash flows, the Board decided that the risk of the counterparty's default on its obligation is a risk that may be designated as being hedged. Focusing on those four risks is consistent with the belief that the largest amount of present hedging activity is aimed at protecting against market price, credit, foreign exchange, or interest rate risk. Those also were the risks generally accommodated by special hedge accounting before this Statement. Focusing on those four risks also is consistent with responses to the Exposure Draft. Although the notice for recipients did not ask respondents to comment on the type of risks that should be eligible for hedge accounting, respondents generally discussed hedging transactions in terms of those four risks. There are added risks such as legal risks, security (fraud) risks, internal control risks and other risks that are not mentioned in FAS 133. 13. (02 Points) Week 04 Possible Quiz Question 04 Explain why a "ratchet floater" cannot usually be separated from the hedged item and accounted for as a derivative instrument under FAS 133 accounting rules. (If you don’t have the answer to copy directly from your notes, it is best to move on to another question, because the point weighting of this question is too low to spend much time on during the examination.) A ratchet floater pays a floating interest rate with an adjustable cap and an adjustable floor. The embedded derivatives must be accounted for separately under Paragraph 12. An example is provided in Paragraph 182 beginning on Page 95 of FAS 133. 14. (02 Points) Week 05 Possible Quiz Question 14 What is the implication of a blockage factor under FAS 133? (If you don’t have the answer to copy directly from your notes, it is best to move on to another question, because the point weighting of this question is too low to spend much time on during the examination.) Blockage is the impact upon financial instrument valuation of a large dollar amount of items sold in one block. In the case of derivatives, the FASB decided not to allow discounting of the carrying amount if that amount is to be purchased or sold in a single block. Some analysts argue that if the items must be sold in a huge block, the price per unit would be less than marginal price of a single unit sold by itself. Certain types of instruments may also increase in value due to blockage. In the case of instruments that carry voting rights, there may be sufficient "block" of voting rights to influence strategy and control of an organization (e.g., a 51% block of voting shares or options for voting shares that provide an option for voting control). If voting power is widely dispersed, less than 51% may constitute a blockage factor if the "block" is significant enough to exercise control. The FASB in SFAS 107does not allow blockage factors to influence the estimation of fair value up or down. Disallowance of blockage is discussed in FAS 133, Pages 153-154, Paragraphs 312-315. 15. (04 Points) Week 06 Possible Quiz Question (Partnership Assignment) What are the answers to WTD Case 05.01, Part a? (If you don’t have the answer to copy directly from your notes, it is best to move on to another question, because the point weighting of this question is too low to spend much time on during the examination.)Assume the following for the year 2000 for the Staubus company: Revenues Operating expenses Cost of goods sold Depreciation Salaries and wages Bond interest (8% Debentures sold at maturity value of $1,000,000) Dividends declared on 6% Preferred Stock (par value $500,000) Dividends declared of $5 per share on Common Stock (20,000 shares outstanding a par value of $100 per share) $1,000,000 $400,000 100,000 200,000 80,000 30,000 100,000 a. Given the above Case 05.01 data, determine the income under each of the following equity theories: Proprietary theory Entity theory (orthodox view) Entity theory (unorthodox view) Residual equity Place your answers in the table below: a. Proprietary theory _$_________ Entity theory (orthodox view) _$_________ Entity theory (unorthodox view)| _$_________ Residual equity _$_________ Answer a. Proprietary theory Entity theory (orthodox view) Entity theory (unorthodox view) $220,000 $300,000 $90,000 $190,000 Residual equity (02 Points) Week 07 Possible Quiz Question 10 Tomorrow morning Americana intends to borrow 10 million British pounds sterling from an Irish bank with interest payments indexed to LIBOR. In order to hedge against both interest rate and foreign currency risk, Americana will also enter into an interest rate swap in a rather complicated succession of independent transactions. Americana will first enter into an interest rate swap in which it pays a fixed rate and receives a variable rate of interest indexed to LIBOR in amounts equal to the interest payment obligations to the Irish bank. Then Americana will purchase options to hedge the foreign currency risk exposure. Can this swap receive favorable cash flow hedge accounting under FAS 133 rules for interest rate risk exposure? Can the options receive favorable hedge accounting under FAS 133 rules for foreign currency risk exposure? [Hint: Note that the interest rate swap and the foreign currency swap are independent transactions. Assume that the hedged item (the debt to the Irish bank) need not be adjusted to fair value each period.] Answer Yes. The Irish bank debt obligation will not be remeasured to fair value for changes in interest rates and, therefore, cash flows of the debt obligation presenting an interest rate exposure may qualify as a hedged item. In this instance the interest rate swap is denominated in the same currency as the debt obligation, therefore, there is no need to separate the derivative instrument into components