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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:

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 SFAS 133 Theory and Rules
1. (02 Points) What contract below is not eligible for hedge accounting under SFAS 133?
a. Embedded call option
b. Forward rate agreement
c. Covered call
[XXXXX Paragraph 399 on Page 180 of SFAS 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. SFAS 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 beginning on Page 153 of SFAS 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 SFAS 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 sale 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.
d. None of the above since gold cannot be a hedged item under SFAS 133.
[XXXXX Paragraph 405on Page 182 of SFAS 133. Gold price movements must be marked-to-market as
inventory. A cash flow hedge fixes the future sales price. Suppose the interim price of gold increases by
$10. Retained earnings increases when the hedged item (gold inventory) is marked to market. If the value
of the hedge (the forward contract) is deferred in OCI, the firm looks like it is doing $10 better than it really
is doing since the changes in interim prices are irrelevant if the sales price is fixed. Hence, $10 increase in
gold inventory value must be offset by a $10 decline in the value of the forward contract.]
5. (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.
[XXXXX Paragraph 29c on Page 20 of SFAS 133.]
d. None of the above since this hedge does not affect reported earnings prior to the purchase transaction or
dedesignation.
6. (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 puchase 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 29c on Page 20 of SFAS 133.]
d. None of the above since gold cannot be a hedged item under SFAS 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 Paragraph 63, especially near the top of Page 45.]
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 Paragraph 63, especially near the top of Page 45. Illustrations can be found Paragraphs 107 and
109 beginning on Page 60 of SFAS 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 on Page 68]
d. None of the above answers are correct.
10. (02 Points) AggiesInternational Corporation faces the risk of price declines on its forecasted sales of corn,
soybeans, and rice to Japan. Sales quantities are also uncertain. As a hedge, this company enters into a
contract (with a $0 premium) to sell as much as it wants to the Shimura Company for a contracted fixed
price and contracted proportions of all three grains per ton. In other words, for a fixed price and fixed
proportions, AggiesInternational has an option to sell as much as it wants to Shimura for a period of six
months. Can this option be a cash flow hedge under SFAS 133 rules.
a. No because the notional is not fixed, and no because the forecasted transaction is a compounding of three
grains subject to varying price risks.
b. No because the notional is not fixed even though it would otherwise be yes since the forecasted
transaction contains fixed proportion s of grains for which there is a single variable (portfolio) price per ton
that can be hedged.
[XXXX Paragraph 440a on Page 195 of SFAS 133 requires fixed quantities as well as fixed prices for the
notional. The question says sales quantities are uncertain. Paragraph 21 and other paragraphs listed under
“Forecasted Transaction” in Bob Jensen’s SFAS 133 Glossary will not allow a portfolio of transactions to
be hedged as a portfolio if the risks are not identical (within a 10% range). In this particular question,
however, the option’s specification for sales in a fixed proportion per ton converts the three grains into a
single product just as if the company was selling a single product that was being hedged. For example, bags
of animal feed comprised of the three grains could be hedged as “bags” if other conditions of the hedge
were satisfied.]
c. Yes because the notional is fixed but no, in the final analysis, because the forecasted transaction is a
compounding of three grains subject to varying price risks.
d. Yes because the notional is fixed, and yes since the forecasted transaction contains a fixed proportion of
grains for which there is a single variable portfolio price that can be hedged.
11. (02 Points) SFAS 133 limits hedge accounting to which of the following relationships?
a. Only cash flow hedges of derivative financial instruments.
b. Cash flow hedges of derivative financial instruments and certain fair value foreign-currencydenominated nonderivative instruments.
[XXXXX Para 246 on Page 131]
c. Cash flow hedges and fair value hedges that reduce market risk exposures.
d. Any derivative or nonderivative financial instrument for which there is no credit risk.
12. (02 Points) The FASB’s stated long-term objective of having all derivative and nonderivative financial
instruments booked at fair value on any reporting date would have what impact on hedge accounting?
a. This would eliminate all hedge accounting treatments for financial instruments.
[XXXXX Para 247 on Page 132]
b. This would have no impact on SFAS 133 hedge accounting rules unless the FASB changed SFAS 133.
c. This would eliminate cash flow hedges but not foreign currency hedge accounting.
d. Irrespective of possible answers above, the FASB has never declared that its long-term objective is to
require fair value reporting of all financial instruments.
13. (02 Points) Which of the following restrictions apply to an underlying of a derivative financial instrument?
a. The underlying must always be a market price or an interest rate derived from financial markets.
b. The underlying may be most any external index including official rainfall on a given day or the outcome
of a NFL game between the Green Bay Packers versus the Minnesota Vikings.
c. The underlying may be most any index that is stated in monetary terms (thereby excluding rainfall
amounts or sports scores).
[XXXXX Para 10e on Page 6 and Para 252 on Page 134]
d. None of the above answers are correct.
14. (02 Points) Which of the following cannot be an underlying according to SFAS 133?
a. Sales revenue attained by one of the contracting parties.
b. Independent appraisal of a building owned by one of the contracting parties.
c. Both of the above answers are correct.
[XXXX Para 253 on Page 134]
d. None of the above answers are correct.
15. (02 Points) SFAS 133 net settlement provisions call for settlement to be in cash or in assets easily
converted into cash. Which of the following does not meet the net price settlement test to qualify as a
derivative financial instrument in contract between Intel Corporation and General Electric?
a. Corn prices on the Chicago Board of Trade exchange.
b. The price of a common stock of Microsoft Corporation.
c. The price of the common stock of Intel Corporation.
[XXXXX Paragraph 286]
d. All of the above prices qualify since they are easily converted into cash in an organized market
exchange.
16. (02 Points) Which of the following embedded derivatives serves to disqualify the derivative from SFAS
133 accounting rules?
a. A prepayment option of a mortgage loan.
b. An interest-only strip embedded derivative.
c. A principal-only strip embedded derivative.
d. All of the above answers are correct.
[XXXXX Para 293 on Page 146, Para 310 on Page 152, Para 289 on Page 145 and Paragraph 10 on Page 5]
17. (02 Points) Which of the following types of contracts are generally excluded from SFAS 133 accounting
rules (including fair market value adjustment rules)?
a. A sales contract by Intel Corporation for microprocessors manufactured by Intel.
b. A purchase contract by Dell Corporation for microprocessors to be used in Dell computers.
c. A “regular-way” securities trade contract.
d. All of the above answers are correct.
[XXXXX Paragraph 10 on Page 5]
18. (02 Points) The “clearly-and-closely related” provisions of SFAS 133 apply mainly to which of the
following?
a. A decision as to whether an embedded derivative is subject to SFAS 133 accounting rules.
b. A decision as to whether an embedded derivative will be accounted for separately from its host contract.
[XXXXX Para 304 on Page 150]
c. The degree of ineffectiveness of an interest rate swap contract.
d. The degree of ineffectiveness of a foreign currency hedging contract..
19. (02 Points) The FASB feels that differences between forecasted transactions and firm commitments are
which of the following?
a. inconsequential and have no bearing on differences between accounting for forecasted transactions
versus firm commitments since neither appear in traditional financial statements.
b. important only in foreign currency hedge accounting differences arising from firm commitments versus
forecasted transactions.
c. important with respect to market price accounting differences arising from firm commitments versus
forecasted transactions.
[XXXXX Firm commitments do not need cash flow hedges. See Cash Flow Hedge in Bob Jensen’s SFAS
133 Glossary. Also see KPMG Example 21 on Page 229.]
d. None of the above are correct..
20. (02 Points) Creditor C loans Borrower B $10 million with an option to convert each bond into 20 shares of
Borrower B’s common stock. Assume that those shares, if acquired, would be available-for-sale and not
trading securities. Answer the following according to SFAS 133 revisions of SFAS 115 rules..
a. Borrower B has an embedded derivative that is clearly-and-closely related to the loan and the bonds
payable and the derivative are not accounted for separately.
b. Borrower B has an embedded derivative that is not clearly-and-closely related to the loan and the bonds
payable and the derivative are not accounted for separately.
c. Borrower B has an embedded derivative that is clearly-and-closely related to the loan and the bonds
payable and the derivative are accounted for separately.
d. None of the above.
[XXXXX Borrower B is the option writer. Written options are not derivative instruments according to
Paragraph 28c, 91, and 396-401 of SFAS 133. Also see Paragraph 61k on Page 43 and KPMG Page 51.]
Questions 21-30 Relate to Financial Risk Management
21. (02 Points) The term structure of interest rates describes the relationship between the:
(a) default risks of bonds and their yields to maturity.
(b) current yields of bonds and their yields to maturity.
(c) prices of bonds and their yields to maturity.
(d) maturities of bonds and their yields to maturity. XXXXX XXXXX
22. (02 Points) The term structure theory which predicts long-term interest rates will, on average, be higher
than short-term interest rates is called:
(a) the expectations theory.
(b) the preferred habitat theory.
(c) the segmented market theory.
(d) the liquidity preference theory. XXXXX XXXXX
23. (02 Points) The forward exchange rate locked in with a forward exchange-rate contract:
(a) will always be higher than the spot exchange rate.
(b) will always be lower than the spot exchange rate
(c) may be higher or lower than the spot exchange rate. XXXXX XXXXX
(d) is unrelated to the current spot exchange rate.
24. (02 Points) A forward rate agreement is:
(a) a loan commitment to borrow foreign currency.
(b) a forward contract on interest rates. XXXXX
(c) a forward contract on long-dated foreign currency futures.
(d) a forward loan commitment.
25. (02 Points) The process of marking futures contracts to market has the effect of:
(a) turning the futures contract into an option contract.
(b) turning the futures contract into a one-day forward contract. XXXXX
(c) understandardizing the contract’s delivery date.
(d) making the futures contract a less expensive form of hedging than the forward contract.
26. (02 Points) A person wanting to lock in an exchange rate for the payment of a foreign-currency obligation to
someone else would:
(a) sell a foreign-currency futures contract.
(b) buy a foreign-currency futures contract. XXXXX
(c) sell an interest-rate futures contract
(d) buy an interest-rate futures contract.
27. (02 Points) A call option can be replicated by:
(a) lending at the risk-free interest rate and selling common stock.
(b) lending at the risk-free interest rate and buying common stock.
(c) borrowing at the risk-free interest rate and selling common stock.
(d) borrowing at the risk-free interest rate and buying common stock. XXXXX
28. (02 Points) A major advantage of options over futures contracts for hedging purposes is:
(a) options are cheaper.
(b) options need not be exercised. XXXXX
(c) options are more liquid.
(d) options are not legally enforceable obligations.
29. (02 Points) To set a cap on the interest rate that a company must pay for a future loan, the treasurer can:
(a) buy interest-rate call options.
(b) buy interest-rate put options. XXXXX See FMR Page 103
(c) write interest-rate put options.
(d) write interest-rate call options.
30. (02 Points) Swaptions are
(a) options on futures.
(b) options on forwards.
(c) swaps of options.
(d) options on swaps. XXXXX
Part 2 (Essay)
31. (02 Points) Week 02 Possible Quiz Question 08
What are the major types of derivatives risk? 08
[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 SFAS 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 SFAS 133, Paragraphs 411-415, Pages 184-186. SFAS 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
SFAS 133, Paragraphs 411-415, Pages 184-186 lists 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 SFAS 133.
32. (02 Points) Week 03 Possible Quiz Question 14
What are the two principal underlying assumptions of agency theory (positive accounting research)?
Criticize their role in constructing a theory of accounting.
ANSWER 02.16
Chapter 02
The two principal assumptions are that individuals act in their own best interest and that the firm
is the locus or nexus of many competing types of contractual relationships. The former is virtually
true by definition while the latter (which is , of course, dependent upon the former) is an
interesting assumption that is the cornerstone of the agency theory literature in accounting. There
can be other views of the enterprise, such as Chambers' coalition view. This points out, once
again, that positive research simply cannot shake off its normative underpinnings.
33. (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 SFAS 133 accounting rules?
[See and Bob Jensen's SFAS 133 Glossary.]
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 SFAS 133.
34. (02 Points) Week 05 Possible Quiz Question 14
What is the implication of a blockage factor under SFAS 133?
[Hint: See Bob Jensen's SFAS 133 Glossary.]
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 SFAS 133, Pages 153-154, Paragraphs 312-315.
35. (04 Points) Week 06 Possible Quiz Question (Partnership Assignment)
WTD Case 05.01, Part a
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
$400,000
100,000
200,000
a. Determine the income under each of the following equity theories:
Proprietary theory
Entity theory (orthodox view)
Entity theory (unorthodox view)
Residual equity
Place your answers in the table below:
a.
Proprietary theory
_$_________
Entity theory (orthodox view)
_$_________
Entity theory (unorthodox view)|
_$_________
Residual equity
_$_________
80,000
30,000
100,000
Answer
a.
Proprietary theory
$220,000
Entity theory (orthodox view)
$300,000
Entity theory (unorthodox view)
$90,000
Residual equity
$190,000
36. (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 SFAS 133 rules for
interest rate risk exposure? Can the options receive favorable hedge accounting under SFAS 133
rules for foreign currency risk exposure?
[Hint: See Paragraph 36 beginning on Page 23 of SFAS 133. 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.]
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