Deck 12: Financial Instrumentsrecognition and Measurement

Question 1

Motor Town Tunes decided to hedge its risk in several high-value variable rate mortgages. It decided to do this by agreeing with an unrelated party to pay 8 percent on the mortgages at the end of the next two years. For both years, the market rate was 9 percent. Consequently, the unrelated party had to pay Motor Town Tunes the value of the excess interest for each year. Which derivative instrument does this scenario best represent?

A) Forward
B) Future
C) Swap
D) Option
E) Not a derivative

Answer 1

Swap

Question 2

During World War II, polyethylene vinyl was in high demand while supply was in flux due to the constant air raids on manufacturing plants. Valli's Vinyl, a company that presses vinyl records, wanted to hedge its risk against the then unpredictable vinyl market. It decided to enter into a contract with its best vinyl supplier, Presley's Polyethylene Plastics to pay ?100 per metric ton of vinyl for 500 metric tons in six months. Shortly thereafter, a German air raid destroyed a large supply dump storing raw materials used in vinyl production. Consequently, the price per metric ton of vinyl shot up to ?250. At the end of the six months, Valli's Vinyl purchased the agreed-upon 500 metric tons at ?100 per ton. Presley's Polyethylene Plastics recorded a substantial loss as a result of the agreement. Which derivative instrument does this scenario best represent?

A) Forward
B) Future
C) Swap
D) Option
E) Not a derivative

Answer 2

Forward

Question 3

München Microchips manufactures silicon microchips in a sterile plant. Wittenburg Industrial Cleaning provided expensive cleaning and sterilization for München Microchips. As the two companies contracted, München Microchips offered Wittenburg 250,000 common equity shares at €5 each in return. Wittenburg bought the shares and subsequently sold them at the prevailing market price of €20 per common equity share. Which derivative instrument does this scenario best represent?

A) Forward
B) Future
C) Swap
D) Option
E) Not a derivative

Answer 3

Not a derivative

Question 4

Ocassionally, the winter weather at Schweizer Alpen Skiing doesn't produce enough snow for good skiing. Schweizer doesn't like to depend solely on the weather for cash flow. Schweizer has decided to hedge against the risk of a snowless winter by entering a contract with an insurance company that Schweizer will gross $150 million every winter. Thus, if Schweizer experiences a lousy winter, and doesn't reach $150 million, the insurance company will make up the difference. On the other hand, Schweizer will have to pay the insurance company any gross earnings above $150 million. Which derivative instrument does this scenario best represent?

A) Forward
B) Future
C) Swap
D) Option
E) Not a derivative

Question 5

Kleinsteigel Electricity contracted with Schwarzwald Coal to purchase 5 million metric tons of coal per month for the next five years at €2 million per metric ton. During that time, the price of coal rose to €2.2 million per metric ton due to a major mine collapse. Kleinsteigel was shielded by this price increase by their contract with Schwarzwald. Which derivative instrument does this scenario best represent?

A) Forward
B) Future
C) Swap
D) Option
E) Not a derivative

Question 6

Christiansfeld Akustik, a Danish acoustics entity, licensed its technologies to Nykøbing Hovedtelefoner, a headphones manufacturer. The licensing agreement isn't based on market terms because the fair value of the agreement can't be readily determined. However, the agreement calls for royalty payments of Kr2.5 million at the beginning of each year for five years. The prevailing market rate is 5.6 percent. A local consulting firm brokered the deal and wrote the contracts. They charged Christiansfeld Akustik Kr1.3 million for their services. What is the fair value of the agreement to Christiansfeld Akustik?

A) Kr12,542,703
B) Kr11,946,499
C) Kr11,242,703
D) Kr10,646,499
E) None of the above

Question 7

Which of the following is not a common example of a financial instrument?

A) Cash
B) Options
C) Convertible Debt
D) Interest Rate Swaps
E) all of the above are examples of financial instruments

Question 8

Common types of derivatives used as hedging instruments include all of the following except

A) options
B) swaps
C) convertible bonds
D) forwards and futures

Question 9

Hedges are classified into one of three categories. Which is not one of the categories?

A) fair value hedges
B) cash flow hedges
C) hedges of a net investment in a foreign operation
D) fair value through profit and loss hedges

Question 10

Gains and losses relating to the effective portion of the hedging instrument are recognized

A) in other comprehensive income
B) in profit and loss
C) by increasing or decreasing the valuation reserve
D) by increasing or decreasing the asset

Question 11

Four Seasons Music decided to license the music of one of its artists, Jonnie Valley, to radio stations throughout Europe. For each song played, the radio stations contracted to give Four Seasons a royalty of €0.50. This licensing agreement qualifies as a financial instrument.

Question 12

Johnny B. Goode & Company signed a written call option agreement with Golden Oldies Entity. The contract stipulates that in exchange for providing services, Johnny B. Goode can call 2 million of Golden Oldies' common equity shares at a strike price of €2 each. The call option expires in two years. However the price of Golden Oldies' stock never rises above €1.50 over the two year period. Thus, Johnny B. Goode never exercises the call option. This agreement between Johnny B. Goode and Golden Oldies does not qualify as a financial instrument.

Question 13

A financial asset meets the qualifications to be reported at amortized cost and not at fair value. Despite this, the financial asset could still be reported at fair value.

Question 14

On January 1, 20X4, Sirrochi Entity (SE) purchases bonds issued by Gateway Entity (SE) for $6,500,000. SE will receive an annual coupon payment of $500,000 for 5 years and an additional $5,000,000 when the bond expires on December 31, 20X9. One year after the bonds were purchased, SE loses a law suit and is short on cash. SE enters into a contractual agreement with Cash Entity to sell its rights to all future payments from the bond in exchange for $5,500,000. On the date the agreement is made, SE has an asset on its statement of financial position for the bond in the amount of $6,700,000. How will SE account for this outcome (include journal entries)?

Question 15

A financial asset is derecognized when the entity's rights to the cash flows from the financial asset expire or the entity transfers the financial asset.

Question 16

Any difference between the carrying amount and the consideration paid/received upon derecognition of a financial instrument is recognized in other comprehensive income.

Question 17

An entity can designate any financial asset (or financial liability) to the "fair value through profit or loss" (FVTPL) category on initial recognition provided that this designation results in more relevant information.

Question 18

If an entity changes its business model and subsequently the way it manages its financial assets, it must evaluate whether the change would require a change in classification and measurement.

Question 19

On initial recognition, financial assets or liabilities are measured at cost.

Question 20

A cash flow hedge is a hedge of exposure to variability in cash flows of a recognized asset, liability, or forecasted transaction that could affect earnings.

Question 21

On January 1, 20X7, Salvatori Entity (SE) purchased Lovani Entity's (LE) 5-year, 6 percent bonds with a face amount of $100,000 for $95,000. Interest is payable semiannually on June 30 and December 31.
Who has a financial asset (and what is the asset) and who has a financial liability (and what is the liability?

Question 22

Antwerp Entity (AE) holds raw diamonds as an investment. Diamonds are readily convertible into cash. Are diamonds considered financial assets? Explain your answer.

Question 23

Costa Rica Entity (CRE) enters for trading purposes into a contract to exchange 50,000
pounds of coffee for USD 1.53 per pound three months from today. What is the nature of this contract and why?

Question 24

On July 1, 20X7, Cheese Entity (CE) purchases an existing futures contract to buy milk class III. The futures contract obligates Dairy Entity (DE) to sell 1,000 cwt of milk to CE in exchange for $14.25 per cwt of milk class III on January 1, 20X8. What is CE's obligation on July, 1, 20X7?

Question 25

Money Entity (ME) obtains a three-year loan from Republic Bank (RB) for $500,000 under normal market terms, with interest payable annually at a variable rate of interest specified as one-year LIBOR plus 200 basis points. To obtain the loan, ME paid RB transactions fees of $5,000. What is the proper way ME should account for this loan?