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With Answers
ACCT 5341 Examination 1 (Part 1)
Dr. Jensen
Spring 2001
Students are allowed to use the following examination aids:
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Calculator
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Notes that you have written yourself
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File 1 printouts
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File 2 printouts
Students are not allowed to use the following in Part 1
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Photocopies
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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
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Part 1 (Multiple Choice)
Choose the best answer to each question when more than one answer is correct.
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Answers are to be recorded both on the question sheet and on the answer sheet.
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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