CPA Exam - FAR (Financial Accounting and Reporting)Select TransactionsHard
A company enters into a derivatives contract to hedge its exposure to changes in the fair value of a recognized asset. The derivative is designated as a fair value hedge. At the end of the reporting period, the fair value of the derivative increased by $10,000, and the fair value of the hedged asset decreased by $9,500. What is the impact on the company's net income for the period?
- AIncrease of $500
- BDecrease of $9,500
- CIncrease of $10,000
- DDecrease of $500
Show answer & explanationAnswer & explanation
Correct answer: A. Increase of $500
In a fair value hedge, both the change in the fair value of the derivative and the change in the fair value of the hedged item (attributable to the hedged risk) are recognized in net income. The derivative gain is $10,000, and the hedged item loss is $9,500. The net impact on income is $10,000 (gain) - $9,500 (loss) = $500 increase.
Why the other options are wrong
- B. Incorrect. This only considers the loss on the hedged item, ignoring the gain on the derivative.
- C. Incorrect. This only considers the gain on the derivative, ignoring the loss on the hedged item.
- D. Incorrect. This would be the case if the hedged item's loss exceeded the derivative's gain.
Fair Value Hedge
A type of hedge that mitigates exposure to changes in the fair value of a recognized asset or liability, or an unrecognized firm commitment. Both the gain/loss on the derivative and the offsetting gain/loss on the hedged item are recognized immediately in earnings.
- Hedges exposure to changes in fair value.
- Derivative and hedged item gains/losses are recognized in current earnings.
- Aims for zero net impact on earnings if perfectly effective.
- Used for recognized assets/liabilities or firm commitments.
- Effectiveness is measured by how well the derivative offsets the hedged item's fair value changes.
Memory trick: Fair Value Hedge: Earnings Embrace Both – derivative and asset changes hit income together.