Derivatives, Hedging, and Foreign Currency Transactions
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CPA Financial Accounting and Reporting (FAR) › Derivatives, Hedging, and Foreign Currency Transactions
A derivative financial instrument is best described as:
A contract that conveys to a second entity a right to receive cash from a first entity
A contract that conveys to a second entity a right to future collections on A/R from a first entity
A contract that has its settlement value tied to an underlying notional amount
Evidence of an ownership interest in an entity such as shares of common stock
Explanation
A derivative is an instrument that derives its value from the value of some other instrument.
Of the following hedge examples, which would likely be a fair value hedge?
Insurance on inventory obsolescence
Flood insurance on building
None of the answer choices are correct
Both
Explanation
A fair value hedge protects the user from decreases in the fair value of an asset such as their inventory. Obsolescence is a common decrease in fair value.
Hope Company owns 100% of the outstanding shares of Howard Company. During the current year, Hope sold inventory costing \$80,000 to Howard for \$90,000. This inventory has since been sold to a third party and Howard has not paid Hope for the purchase. At the balance sheet date, Hope has total current assets of \$850,000 and Howard has total current assets of \$550,000. Assume that there were no allocations established at the date of acquisition. What is the total amount of current assets reported in the consolidated balance sheet?
\$850,000
\$1,320,000
\$1,400,000
\$1,310,000
Explanation
The consolidated statements will include the combined book values of each company's current assets, but outstanding intercompany balances will be removed. Thus the consolidated statements include $850K owned by Hope + $550K owned by Howard - $90K receivable due for the inventory.
Giant Company buys all outstanding shares of Little Company on October 1, Year 1 for \$450,000. In Year 1, Little earned revenue of \$15,000 per month and incurred expenses of \$12,000 per month. On the date of the sale, Little had only one asset, a piece of land, with a book value of \$350,000 and a fair value of \$400,000. It had no liabilities. By the end of Year 1, the land had appreciated in value and was worth \$410,000. Which of the following statements is true regarding the consolidated financial statements at the end of Year 1?
Goodwill at the end of Year 1 is reported as \$45,000
The land owned by Little will be reported in the Year 1 balance sheet at \$410,000
A gain of \$160,000 will be reported in Year 1 on the land owned by Little
Consolidated net income will include \$9,000 earned by Little
Explanation
Little had net income of $3K per month ($15K in revenue - $12K in expenses). The consolidated financial statements will only include the net income earned after the purchase of the business, which will include October-December. The net income of Little included in the consolidated statements will be $3K per month x 3 months.
During Year 1, the James Company buys all outstanding shares of the Holmes company for \$4 million even though Holmes has net assets with a fair value of only \$3.5 million. One reason for this excess payment is that Homes owns land worth \$1.5 million with a book value of only \$800,000. Prior to the purchase of Holmes, James owned its own land with a book value of \$400,000 and a fair value of \$700,000. Two years later, both companies still own this land and both have acquired additional acreage. James reports land at a book value of \$1 million and fair value of \$1.1 million; Holmes reports land with a book value of \$2 million and a fair value of \$2.5 million. At what amount will land be reported at the end of Year 3 in the consolidated balance sheet?
\$3 million
\$3.6 million
\$3.5 million
\$3.1 million
Explanation
The consolidated statements will include the combined book values of the land owned by each company ($1M in land owned by James + $2M in land owned by Holmes).
Which of the following financial instruments is not considered a derivative financial instrument?
Bank certificate of deposit
Interest rate swaps
Currency futures
Stock index options
Explanation
A bank certificate of deposit is not a derivative financial instrument. The other options are.