Students Are Allowed to Use the Following Examination Aids

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With Answers

ACCT 5341 Examination 1 (Part 1)

Dr. Jensen

Spring 2005

Students are allowed to use the following examination aids:

·  Calculator

·  Notes that you have written yourself

·  File 1 printouts

·  File 2 printouts

Students are not allowed to use the following in Part 1

·  Photocopies

·  Books

Notes or any other materials written by other students other than File 1 and File 2 printouts that were joint efforts between you and a partner

Part 1 (Multiple Choice)

·  Choose the best answer to each question when more than one answer is correct.

·  Answers are to be recorded both on the question sheet and on the answer sheet.

·  The term “earnings” does not include “comprehensive earnings.”

Questions 1-20 Relate to SFAS 133 Theory and Rules

1.  (02 Points) What contract below is not eligible for hedge accounting under SFAS 133?
a. Embedded call option
b. Forward rate agreement
c. Covered call
[XXXXX Paragraph 399 on Page 180 of SFAS 133.]
d. Interest rate futures

2.  (02 Points) The price of a block of 10,000 options may be different than the price of a single option if all 10,000 are sold in a block. SFAS 133 requires a fair market value blockage adjustment as follows:
a. Upward
b. Downward
c. Both answers a and b above
d. Neither answers a or b above
[XXXXX Paragraph 315 beginning on Page 153 of SFAS 133.]

3.  (02 Points) Suppose that a change in the price of a lumber inventory forecasted purchase is effectively offset by a forward cash flow hedge. The hedge may result in which of the following outcomes, relative to having no hedge, in periods prior to the purchase of the inventory?
a. The hedge may reduce reported earnings prior to the transaction.
b. The hedge may increase reported earnings prior to the transaction.
c. Both answers a and b are possible depending upon the direction of the price movements.
d. None of the above since this hedge does not affect reported earnings prior to the purchase transaction or dedesignation.
[XXXXX Paragraph 30 on Page 121and Paragraph 152 beginning on Page 81 of SFAS 133. Prior to the purchase transaction itself, gains and losses are deferred in OCI and do not affect current earnings.]

4.  (02 Points) Suppose that a change in the price of gold inventory forecasted sale is effectively offset by a forward contract cash flow hedge. The hedge may result in which of the following outcomes (relative to having no hedge in periods prior to the sale of the inventory)?
a. The hedge may reduce reported earnings prior to the transaction.
b. The hedge may increase reported earnings prior to the transaction.
c. Both answers a and b are possible depending upon the direction of the price movements.
d. None of the above since gold cannot be a hedged item under SFAS 133.
[XXXXX Paragraph 405on Page 182 of SFAS 133. Gold price movements must be marked-to-market as inventory. A cash flow hedge fixes the future sales price. Suppose the interim price of gold increases by $10. Retained earnings increases when the hedged item (gold inventory) is marked to market. If the value of the hedge (the forward contract) is deferred in OCI, the firm looks like it is doing $10 better than it really is doing since the changes in interim prices are irrelevant if the sales price is fixed. Hence, $10 increase in gold inventory value must be offset by a $10 decline in the value of the forward contract.]

5.  (02 Points) Suppose that a change in the price of a lumber inventory forecasted purchase is effectively offset by a forward cash flow hedge. The hedge may result in which of the following outcomes, relative to having no hedge, in periods prior to the purchase of the inventory?
a. The hedge may reduce reported earnings prior to the transaction.
b. The hedge may increase reported earnings prior to the transaction.
c. Both answers a and b are possible depending upon the direction of the price movements.
[XXXXX Paragraph 29c on Page 20 of SFAS 133.]
d. None of the above since this hedge does not affect reported earnings prior to the purchase transaction or dedesignation.

6.  (02 Points) Suppose that a change in the price of gold inventory forecasted purchase is effectively offset by a forward contract cash flow hedge. The hedge may result in which of the following outcomes (relative to having no hedge in periods prior to the puchase of the inventory)?
a. The hedge may reduce reported earnings prior to the transaction.
b. The hedge may increase reported earnings prior to the transaction.
c. Both answers a and b are possible depending upon the direction of the price movements.
[XXXXX Paragraph 29c on Page 20 of SFAS 133.]
d. None of the above since gold cannot be a hedged item under SFAS 133.

7.  (02 Points) Suppose that a change in the price of a lumber inventory forecasted purchase is hedged by a call option designated in advance as a cash flow hedge. An ineffective hedge will result in which of the following outcomes relative to an effective hedge in periods prior to the sale of the inventory?
a. Ineffectiveness may reduce reported earnings prior to the transaction.
b. Ineffectiveness may increase reported earnings prior to the transaction.
c. Both answers a and b are possible depending upon the direction of the hedge’s ineffectiveness.
[XXXXX Paragraph 63, especially near the top of Page 45.]
d. None of the above since ineffectiveness does not affect reported earnings prior to the sale transaction

8.  (02 Points) Suppose that a change in the price of a lumber inventory forecasted sale is hedged by a put option designated in advance as a cash flow hedge. An ineffective hedge will result in which of the following outcomes relative to an effective hedge in periods prior to the sale of the inventory?
a. The hedge may reduce reported earnings prior to the transaction
b. The hedge may increase reported earnings prior to the transaction
c. Both answers a and b are possible depending upon the direction of the price movements.
[XXXXX Paragraph 63, especially near the top of Page 45. Illustrations can be found Paragraphs 107 and 109 beginning on Page 60 of SFAS 133.]
d. None of the above since this hedge does not affect reported earnings prior to the sale transaction.

9.  (02 Points) Suppose a forward contract is used as a fair value foreign currency hedge of an asset denominated in Mexican pesos. Hedge effectiveness is judged by comparing changes in the fair value of the forward contract with changes in the fair value of the U.S. dollar vis-à-vis the peso. What will be the impact of hedge ineffectiveness?
a. No impact since only cash flow hedges are subject to hedge accounting that may be judged ineffective.
b. No impact if the asset is an available-for-sale security denominated in pesos.
c. No impact if the asset is a firm commitment at a future date rather than an available-for–sale asset.
[XXXXX Footnote 22 on Page 68]
d. None of the above answers are correct.

10.  (02 Points) AggiesInternational Corporation faces the risk of price declines on its forecasted sales of corn, soybeans, and rice to Japan. Sales quantities are also uncertain. As a hedge, this company enters into a contract (with a $0 premium) to sell as much as it wants to the Shimura Company for a contracted fixed price and contracted proportions of all three grains per ton. In other words, for a fixed price and fixed proportions, AggiesInternational has an option to sell as much as it wants to Shimura for a period of six months. Can this option be a cash flow hedge under SFAS 133 rules.
a. No because the notional is not fixed, and no because the forecasted transaction is a compounding of three grains subject to varying price risks.
b. No because the notional is not fixed even though it would otherwise be yes since the forecasted transaction contains fixed proportion s of grains for which there is a single variable (portfolio) price per ton that can be hedged.
[XXXX Paragraph 440a on Page 195 of SFAS 133 requires fixed quantities as well as fixed prices for the notional. The question says sales quantities are uncertain. Paragraph 21 and other paragraphs listed under “Forecasted Transaction” in Bob Jensen’s SFAS 133 Glossary will not allow a portfolio of transactions to be hedged as a portfolio if the risks are not identical (within a 10% range). In this particular question, however, the option’s specification for sales in a fixed proportion per ton converts the three grains into a single product just as if the company was selling a single product that was being hedged. For example, bags of animal feed comprised of the three grains could be hedged as “bags” if other conditions of the hedge were satisfied.]
c. Yes because the notional is fixed but no, in the final analysis, because the forecasted transaction is a compounding of three grains subject to varying price risks.
d. Yes because the notional is fixed, and yes since the forecasted transaction contains a fixed proportion of grains for which there is a single variable portfolio price that can be hedged.

11.  (02 Points) SFAS 133 limits hedge accounting to which of the following relationships?
a. Only cash flow hedges of derivative financial instruments.
b. Cash flow hedges of derivative financial instruments and certain fair value foreign-currency-denominated nonderivative instruments.
[XXXXX Para 246 on Page 131]
c. Cash flow hedges and fair value hedges that reduce market risk exposures.
d. Any derivative or nonderivative financial instrument for which there is no credit risk.

12.  (02 Points) The FASB’s stated long-term objective of having all derivative and nonderivative financial instruments booked at fair value on any reporting date would have what impact on hedge accounting?
a. This would eliminate all hedge accounting treatments for financial instruments.
[XXXXX Para 247 on Page 132]
b. This would have no impact on SFAS 133 hedge accounting rules unless the FASB changed SFAS 133.
c. This would eliminate cash flow hedges but not foreign currency hedge accounting.
d. Irrespective of possible answers above, the FASB has never declared that its long-term objective is to require fair value reporting of all financial instruments.

13.  (02 Points) Which of the following restrictions apply to an underlying of a derivative financial instrument?
a. The underlying must always be a market price or an interest rate derived from financial markets.
b. The underlying may be most any external index including official rainfall on a given day or the outcome of a NFL game between the Green Bay Packers versus the Minnesota Vikings.
c. The underlying may be most any index that is stated in monetary terms (thereby excluding rainfall amounts or sports scores).
[XXXXX Para 10e on Page 6 and Para 252 on Page 134]
d. None of the above answers are correct.

14.  (02 Points) Which of the following cannot be an underlying according to SFAS 133?
a. Sales revenue attained by one of the contracting parties.
b. Independent appraisal of a building owned by one of the contracting parties.
c. Both of the above answers are correct.
[XXXX Para 253 on Page 134]
d. None of the above answers are correct.

15.  (02 Points) SFAS 133 net settlement provisions call for settlement to be in cash or in assets easily converted into cash. Which of the following does not meet the net price settlement test to qualify as a derivative financial instrument in contract between Intel Corporation and General Electric?
a. Corn prices on the Chicago Board of Trade exchange.
b. The price of a common stock of Microsoft Corporation.
c. The price of the common stock of Intel Corporation.
[XXXXX Paragraph 286]
d. All of the above prices qualify since they are easily converted into cash in an organized market exchange.

16.  (02 Points) Which of the following embedded derivatives serves to disqualify the derivative from SFAS 133 accounting rules?
a. A prepayment option of a mortgage loan.
b. An interest-only strip embedded derivative.
c. A principal-only strip embedded derivative.
d. All of the above answers are correct.
[XXXXX Para 293 on Page 146, Para 310 on Page 152, Para 289 on Page 145 and Paragraph 10 on Page 5]

17.  (02 Points) Which of the following types of contracts are generally excluded from SFAS 133 accounting rules (including fair market value adjustment rules)?
a. A sales contract by Intel Corporation for microprocessors manufactured by Intel.
b. A purchase contract by Dell Corporation for microprocessors to be used in Dell computers.
c. A “regular-way” securities trade contract.
d. All of the above answers are correct.
[XXXXX Paragraph 10 on Page 5]

18.  (02 Points) The “clearly-and-closely related” provisions of SFAS 133 apply mainly to which of the following?
a. A decision as to whether an embedded derivative is subject to SFAS 133 accounting rules.
b. A decision as to whether an embedded derivative will be accounted for separately from its host contract.
[XXXXX Para 304 on Page 150]
c. The degree of ineffectiveness of an interest rate swap contract.
d. The degree of ineffectiveness of a foreign currency hedging contract..

19.  (02 Points) The FASB feels that differences between forecasted transactions and firm commitments are which of the following?
a. inconsequential and have no bearing on differences between accounting for forecasted transactions versus firm commitments since neither appear in traditional financial statements.
b. important only in foreign currency hedge accounting differences arising from firm commitments versus forecasted transactions.
c. important with respect to market price accounting differences arising from firm commitments versus forecasted transactions.
[XXXXX Firm commitments do not need cash flow hedges. See Cash Flow Hedge in Bob Jensen’s SFAS 133 Glossary. Also see KPMG Example 21 on Page 229.]
d. None of the above are correct..