Derivative Instruments and Hedging Activities Paper 5

(c) If it is not practicable for an entity to estimate the fair value of a financial instrument, (1) information pertinent to estimating fair value and (2) the reasons why it is not practicable to estimate fair value should be disclosed.

(d) The following disclosures are required: Method(s) and significant assumptions used in estimating fair value. A distinction between financial instruments held or issued for trading purposes and purposes other than trading. Information pertinent to estimating the fair value of a financial instrument if it is not practicable for the entity to estimate and the reason why estimation is not practicable. Derivative financial instruments may not be combined, aggregated, or netted with nonderivative or other derivative financial instruments. If financial instruments are disclosed in more than one area in the financial statements, one note must contain a summary table cross-referencing the location of the other instruments

(d) The following disclosures are required about credit risk for financial instruments with off-balance-sheet credit risk: The amount of accounting loss the entity would incur should any party to the financial instrument fail to per686 form according to the terms of the contract and the collateral, if any, is of no value. The class of financial instruments held. Categorization between instruments held for trading purposes and purposes other than trading.

(a) Concentrations of credit risk exist when an entity has a business activity, economic characteristic, or location that is common to most of its financial instruments. Disclosure of information about significant concentrations of credit risk for all financial instruments is required.

(d) Since many of Kline Bank’s debtors have high debtto- equity ratios, this group of debtors has a similar economic characteristic, and thus, would be considered a concentration of credit risk to Kline Bank. The entity must disclose the following information regarding concentrations of credit risk: 1. Information about the shared activity, region, or economic characteristic of the group. 2. Amount of accounting loss that the entity would incur as a result of the concentrated parties’ failure to perform according to the terms of the contracts. 3. Information regarding entity’s policy of requiring collateral.

(a) Entities must disclose the fair market value of financial instruments, both assets and liabilities whether recognized or not recognized in the statement of financial position, for which it is practicable to estimate fair value. Pertinent descriptive information as to the fair value of the instrument is to be disclosed if an estimate of fair value cannot be made without incurring excessive costs.

(b) The requirement is to identify the appropriate accounting method for a cash flow hedge and a hedge of a net investment. Answer (b) is correct because such hedges are accounted for by recognizing gains and losses in other comprehensive income.

(b) The requirement is to identify the appropriate hedging strategy. Answer (b) is correct because by selling Treasury notes for delivery in the future, the company can hedge increases in short-term interest rates. If interest rates increase, the value of the Treasury notes will decline, resulting in a gain to the company. If the hedge is effective, the gain will offset the increase in the company’s interest costs. Answer (a) is incorrect because buying Treasury notes would put the company at greater risk with respect to increases in interest rates. Answer (c) is incorrect because buying an option on Treasury bonds would hedge a decline in interest rates. Answer (d) is incorrect because an option allows the purchaser the option, but not the obligation, to purchase Treasury bonds. Therefore, selling options would not be effective at hedging increases in interest rates.

(a) The requirement is to identify the technique used to value stock options. Answer (a) is correct because the Black- Scholes option-pricing model is a commonly used option-pricing model. Answer (b) is incorrect because the zero-coupon method is used to value interest rate swaps. Answer (c) is incorrect because the weighted-average method is used to determine the expected return of a portfolio.

(d) The requirement is to identify the variable that is not used in valuing an interest rate swap. Answer (d) is correct because the underlying assets are not relevant. An interest rate swap involves an exchange of cash flows, usually the exchange of fixed cash flows for variable cash flows. Answer (a), (b), and (c) are all incorrect because they are all variables that are used in the zero-coupon method.