Derivative Instruments and Hedging Activities Paper 3
The process of bifurcation
(d) Bifurcation is the process of separating an embedded
derivative from its host contract. This process is necessary so
that hybrid instruments can be separated into their component
parts, each being accounted for using the appropriate valuation
Alvarez Corporation has two hybrid financial instruments.
According to ASC Topic 815, how can Alvarez account for these
(c) Alvarez can elect not to bifurcate the hybrid instrument,
and this election can be made on an instrument by instrument
basis. Answer (a) is incorrect because an election can be
made not to bifurcate an instrument. Answer (b) is incorrect
because hybrid financial instruments must be disclosed. Answer
(d) is incorrect because the hybrid financial instruments can be
selected on an instrument by instrument basis.
According to ASC Topic 815, when a company elects not to
bifurcate a hybrid financial instrument, the entire hybrid instrument
should be valued at
(a) If a company elects not to bifurcate a hybrid financial
instrument, the entire instrument is valued at fair value. Answers
(b), (c), and (d) are incorrect because these valuation
models are incorrect.
When an election is made not to bifurcate a hybrid financial
instrument, how should this be disclosed on the financial statements?
I. As separate line items for the fair value and non–fair value
instruments on the balance sheet.
II. As an aggregate amount of all hybrid instruments with the
amount of the hybrid instruments at fair value shown in parentheses.
III. As a footnote disclosure.
(d) The balance sheet disclosure may be presented in
one of two ways: as a separate line item for the fair value and
non–fair value instruments on the balance sheet, or as an aggregate
amount of all hybrid instruments with the amount of the
hybrid instruments at fair value shown in parentheses. Answers
(a), (b), and (c) are incorrect because two disclosures are permissible
on the balance sheet.
If a company elects not to bifurcate a hybrid financial instrument
and records the entire instrument at fair value, which of the
following is true?
(c) If a company elects not to bifurcate a hybrid financial
instrument, the entire instrument is recorded at fair value.
Changes in fair value each year are recognized in earnings for the
period. Answer (a) is incorrect because changes in fair value
must be recognized. Answer (b) is incorrect because the changes
are not recognized in other comprehensive income. Answer (d)
is incorrect, because an adjustment is only made to beginning
retained earnings in the year that a company initially adopts the
new accounting pronouncement.
Hedge accounting is permitted for all of the following types
of hedges except
(a) Hedge accounting is permitted for four types of
1. Unrecognized firm commitments.
2. Available-for-sale securities.
3. Foreign currency denominated hedge forecasted transactions.
4. Net investments in foreign operations.
Trading securities is not one of the four types.
Which of the following is a general criterion for a hedging
(a) The general criteria for a hedging instrument are
that sufficient documentation must be provided at the beginning
of the process and the hedge must be “highly effective” throughout
For an unrecognized firm commitment to qualify as a
hedged item it must
(d) For an unrecognized firm commitment to qualify as
a hedged item it must
1. Be binding on both parties.
2. Be specific with respect to all significant items including
quantity to be exchanged, the fixed price, and the timing
of the transaction.
3. Contain a nonperformance clause that makes performance
A hedge of the exposure to changes in the fair value of a
recognized asset or liability, or an unrecognized firm commitment,
is classified as a
(a) A fair value hedge is a hedge of the exposure to
changes in the fair value of a recognized asset or liability or firm
commitment. Two other types of hedges are cash flow and foreign
currency hedges. An underlying is commonly a specified
price or rate.
Gains and losses on the hedged asset/liability and the
hedged instrument for a fair value hedge will be recognized
(a) Gains and losses of a fair value hedge will be recognized
in current earnings. The effective portion of a cash flow
hedge is reported in other comprehensive income and the ineffective
portion is reported on a cumulative basis to reflect the
lesser of the cumulative gain/loss on the derivative or the cumulative
gain/loss from the change in expected cash flows from the
hedged instrument. Gains and losses from a change in the fair
value of derivative instruments are not assets and liabilities and
should not be reported on the balance sheet.