Derivative Instruments and Hedging Activities Paper 5
If it is not practicable for an entity to estimate the fair value
of a financial instrument, which of the following should be disclosed?
I. Information pertinent to estimating the fair value of the
II. The reasons it is not practicable to estimate fair value.
(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.
Disclosure requirements for financial instruments include
(d) The following disclosures are required:
??Method(s) and significant assumptions used in estimating
??A distinction between financial instruments held or issued
for trading purposes and purposes other than
??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
??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
Disclosure of credit risk of financial instruments with offbalance-
sheet risk does not have to include
(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.
Disclosure of information about significant concentrations
of credit risk is required for
(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.
Kline Bank has large amounts of notes receivable from companies
with high debt-to-equity ratios as a result of buyout transactions.
Kline is contemplating the following disclosures for the
notes receivable in its year-end financial statements:
I. Information about shared activity, region, or economic
II. A brief description of collateral supporting these financial
Which of the above disclosures are required under GAAP?
(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.
Whether recognized or unrecognized in an entity’s financial
statements, disclosure of the fair values of the entity’s financial
instruments is required when
(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
Under IFRS, a cash flow hedge and a hedge of a net investment
are accounted for by
(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
Strobel Company has a large amount of variable rate financing
due in one year. Management is concerned about the possibility
of increases in short-term rates. Which of the following
would be an effective way of hedging this risk?
(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.
Which of the following techniques is used to value stock
(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.
In valuing interest rate swaps, the zero-coupon method uses
all of the following variables except
(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