CHAPTER 11 Financial Instruments and Liabilities
Use the following to answer questions 53 and 54:
REFERENCE: Ref. 11_03
Dot Company issued $200,000 of bonds on January 1, 2018 with interest payable each year. The
bonds had a stated rate of 8%. The bonds were set up as floating-rate debt with the rated pegged
to LIBOR plus 3%.
REFER TO: Ref. 11_03
53. Which of the following will be the interest expense for year 1 if LIBOR is 5% ?
a. $ 6,000
b. $10,000
c. $16,000
d. $18,000
54. Which of the following will be the interest expense for year 1 if LIBOR is 7%?
a. $ 6,000
b. $14,000
c. $16,000
d. $20,000
55. Which of the following is not a valid statement regarding floating-rate debt?
a. The accounting entries are more complex due to the risk-sharing characteristics of floating
rate debt.
b. Floating-rate debt may benefit the issuing company if market rates fall.
c. Floating-rate debt can protect the investor if market rates increase.
d. Floating-rate debt is used to lower the company’s overall borrowing cost.
CHAPTER 11 Financial Instruments and Liabilities
56. Which of the following statements is not accurate with respect to the reporting requirements
regarding the fair value accounting option?
a. Firms may elect the fair value option for a single eligible instrument without electing it for
other identical instruments.
b. Once the choice is made to adopt the fair value option, the decision is irrevocable.
c. Financial statement disclosures must include management’s rationale for electing the fair
value option.
d. The fair value option is not available for security investments that are accounted for using
the equity method.
57. On January 1, 2018, Ross Corporation issued bonds with a maturity value of $200,000; the
bond’s stated rate of interest equaled the market interest rate on the issue date. On December 31,
2018, the market value of the bonds was $188,926; on December 31, 2019, the market value of
the bonds was $191,325. Which of the following correctly describes Ross Corporation’s finan-
cial reporting if Ross elects to measure the bond liability using the fair value accounting option?
a. For the year ending December 31, 2018, Ross will report an unrealized holding loss of
$11,074 in its income statement.
b. For the year ending December 31, 2019, Ross will report an unrealized holding gain of
$8,675 in its income statement.
c. For the year ending December 31, 2019, Ross will report an unrealized holding loss of
$8,675 in its income statement.
d. For the year ending December 31, 2019, Ross will report an unrealized holding loss of
$2,399 in its income statement.
58. Which of the following is not an accurate description of the controversies surrounding the
fair value accounting option?
a. Advocates argue that accounting-induced volatility is eliminated and financial statement
transparency is improved.
b. Critics argue that opportunities are enhanced for companies to manipulate their earnings
and balance sheet.
c. Critics argue that companies that can use the fair value option in situations where there is
not necessarily a relationship between the financial assets and liabilities which promotes
the opportunity to manage earnings.
d. Advocates argue that financial reporting is more accurate and transparent for those com-
panies in financial distress.
59. When a company retires debt, which of the following is not an accurate statement?
a. If the debt is retired at maturity, there is no opportunity for a gain or loss.
b. If the debt was recorded using the fair value accounting option, there is no opportunity for a
gain or loss.
c. If a company retires debt early by issuing new debt at a lower market rate of interest, a gain
on the extinguishment of debt will be recorded if the company did not elect to use the fair
value accounting option.
d. If a company finances the early retirement of debt by issuing new debt, GAAP prohibits re-
cording a gain on the early retirement.
60. A bond with a $500,000 maturity value is immediately retired for $515,000 plus accrued in-
terest. The premium on bonds payable (bond premium) at the retirement date is $17,500. Which
of the following statements is correct?
a. The loss on the debt extinguishment is $32,500.
b. The gain on the debt extinguishment is $2,500.
c. The gain on the debt extinguishment is $32,500.
d. The gain or loss on the debt extinguishment can’t be determined without knowing the dollar
amount of the accrued interest.
61. A bond with a $750,000 maturity value is immediately retired for $745,000 plus accrued in-
terest. The discount on bonds payable (bond discount) at the retirement date is $25,500. Which
of the following statements is correct?
a. The gain on the debt extinguishment is $5,000.
b. The loss on the debt extinguishment is $20,500.
c. The gain on the debt extinguishment is $30,500.
d. The gain or loss on the debt extinguishment can’t be determined without knowing the dollar
amount of the accrued interest.
62. When interest rates have increased and bonds are retired before maturity, market value is
a. below book value generating an accounting gain.
b. below book value generating an accounting loss.
c. above book value generating an accounting gain.
CHAPTER 11 Financial Instruments and Liabilities
d. above book value generating an accounting loss.
63. Which of the following is not a true statement regarding the fair value accounting option?
a. The fair value option mutes earnings volatility.
b. The fair value option reduces the need to comply with complex hedge accounting guidance.
c. The fair value option increases earning volatility.
d. The fair value option converges U.S. GAAP and IFRS by having an identical standard.
64. Which of the statements is not true when applying both IFRS and U.S. GAAP accounting for
long-term debt?
a. Periodic interest expense is computed using the contractual interest rate.
b. Fixed-rate bonds are recorded at the amount of the net proceeds.
c. The balance sheet carrying value is amortized cost determined using the effective interest
rate at the issue date.
d. Changes in interest rates after the issue date do not alter the carrying value unless fair value
accounting is used.
65. Some financial analysts contend that reporting debt at amortized historical cost rather than at
fair value
a. makes it more difficult to manipulate accounting numbers.
b. makes it easier to manipulate accounting numbers.
c. has no impact on the accounting numbers.
d. makes it impossible to manipulate the accounting numbers.
66. Special financial statement disclosures are required so that investors and analysts
can understand all of the following except:
a. management’s rationale for electing the fair value accounting option.
b. the impact of changes in fair values on earnings for the period.
c. management’s rationale for not electing the fair value accounting option.
d. the difference between fair values and contractual cash flows for certain items.
67. Assuming 100% hedge effectiveness, if the fair value of a hedged item increases by $1, the
derivative fair value will
a. increase by $1.
b. decrease by $1
c. increase by $2
d. decrease by $2
68. Which of the following is not an accurate statement regarding the retirement of debt?
a. When debt is retired on the maturity date, the book value is always equal to the market value.
b. The gain or loss on the extinguishment of debt is categorized on the income statement as part
of continuing operations.
c. When debt is retired before the maturity date, a loss occurs if the market rate of interest in-
creased subsequent to the issue of the bond.
d. When debt is retired before the maturity date, a gain occurs if the market rate of interest in-
creased subsequent to the issue of the bond.
69. Investors need to review transactions involving debt-for-debt swaps carefully to ensure that
there is an underlying
a. loss.
b. gain.
c. rationale.
d. economic benefit.
70. On February 1, 2018, Hills Company had 10,000 pounds of inventory costing $1.50 per
pound; the market value per pound was $1.95 on this date. Hills entered into a futures contract to
sell the 10,000 pounds of inventory during May 2018 at $2.25 per pound. Which of the following
statements does not accurately describe the impact of this futures contract?
a. Hills has foregone the benefit of additional profits (the upside potential) if the price per
pound exceeds $2.25 during the month of May.
CHAPTER 11 Financial Instruments and Liabilities
b. Hills has eliminated the risk of reduced profits (the downside potential) if the price per pound
is less than $2.25 during the month of May.
c. Hills’ gross profit in May will be $3,000 regardless of the actual price per pound in May.
d. The value of the futures contract decreases as the market price per pound of inventory in-
creases.
71. When two parties agree to the sale of some asset or commodity on some specified future date
at a price specified today it is a/an
a. forward contract.
b. swap contract.
c. performance contract.
d. options contract.
72. A variation of a forward contract that is traded daily in a market with many buyers and
sellers and does not have a predetermined settlement date is a/an
a. futures contract.
b. swap contract.
c. performance contract.
d. options contract.
73. All of the statements below are true of futures contracts except that futures contracts
a. result in predictable cash flows.
b. eliminate downside risk and upside potential.
c. eliminate downside risk while allowing for upside potential.
d. result in predictable gross profits.
74. A derivative instrument that gives the holder the right but not the obligation to do something
is a/an
a. future contract.
b. swap contract.
c. performance contract.
d. options contract.
75. In order to use hedge accounting, management must do all of the following except
a. designate the derivative as a hedging instrument.
b. describe the hedging strategy.
c. get external auditor approval to use hedge accounting.
d. document its effectiveness in eliminating a specific market risk for a specific hedged item.
76. On December 1, 2018 a company bought a call option costing $100,000 as a speculative in-
vestment. The call option gave the company the right to purchase 100,000 barrels of oil for $110
per barrel during April 2019. As of December 31, 2018 the call option had a value of $125,000.
The company liquidated the call option on April 15, 2019 in exchange for $175,000. Which of
the following accurately describes GAAP accounting for this call option?
a. The realized gain applicable to the year ending December 31, 2018 is $25,000.
b. The realized gain recognized on April 15, 2019 is $75,000.
c. The unrealized gain recognized on April 15, 2019 is $50,000.
d. The call option will be reported on the December 31, 2018 balance sheet at $125,000 and a
$25,000 unrealized gain will be reported as a component of income from continuing opera-
tions for the year ending December 31, 2018.
77. Which of the following statements does not properly describe GAAP accounting for deriva-
tives?
a. Derivatives are reported in the balance sheet at fair value.
b. Speculative investments in derivative contracts can increase earnings volatility.
c. Changes in the fair value of a derivative must be included in net income when they occur.
d. A derivative’s unrealized holding gain or loss for a particular year is not a component of that
year’s income from operations.
78. A hedged item can be any of the following except:
a. an anticipated (forecasted) transaction.
b. an existing asset or liability on the company’s books.
c. a past transaction.
d. a firm commitment.
CHAPTER 11 Financial Instruments and Liabilities
79. Which of the following statements does not accurately describe the accounting for deriva-
tives?
a. The holding gain resulting from a fair value hedge that qualifies for hedge accounting is rec-
ognized in net income along with the offsetting loss on the hedged item.
b. The holding loss resulting from a cash flow hedge that qualifies for hedge accounting is rec-
ognized in net income during the year of the loss.
c. Management must be able to describe its hedging strategy in order to meet the GAAP criteria
to qualify for hedge accounting.
d. Derivatives that fail to meet the GAAP criteria for hedge accounting are accounted for as
speculative investments.
80. Which of the following risks may not be accounted for using hedge accounting?
a. foreign currency exchange rates.
b. labor strikes.
c. commodity prices.
d. changes in benchmark interest rates.
81. A hedge of the exposure to changes in the fair value of an existing asset or liability or a firm
commitment is a/an
a. fair value hedge.
b. cash flow hedge.
c. foreign currency exposure hedge.
d. marked-to-market hedge.
82. Which one of the following contingencies must be accrued on the balance sheet?
a. The likely loss on a lawsuit that the firm’s attorneys believe will be dropped.
b. The probable loss on a lawsuit that the firm’s attorneys believe will be settled for $50,000.
c. The reasonably possible loss on a lawsuit that the firm’s attorneys believe will be dropped.
d. The reasonably possible loss on a lawsuit that the firm’s attorneys believe will be settled for
$50,000.
83. A contingent liability that is probable and can be reasonably estimated will immediately re-
sult in
a. an increase in both liabilities and stockholders’ equity.
b. an increase in liabilities and a decrease in net income.
c. an increase in liabilities without any need for financial statement disclosure.
d. an increase in liabilities and a decrease in assets.
84. Which one of the following contingencies requires financial statement disclosure?
a. A lawsuit that the firm’s attorneys believe will be dropped.
b. A lawsuit that the firm’s attorneys believe will probably be settled for $75,000.
c. A reasonably possible loss on a lawsuit that the firm’s attorneys cannot estimate the loss.
d. A reasonably possible loss on a lawsuit that the firm’s attorneys believe will be settled for
$100,000.
85. Losses must be accrued if they are
a. remote and estimable.
b. reasonably possible and estimable.
c. probable and reasonably estimable.
d. probable and not estimable.
86. Losses must be disclosed if they are
a. remote and estimable.
b. reasonably possible and estimable.
c. probable and reasonably estimable.
d. reasonably possible but not estimable.
87. Which of the following statements is not correct with respect to accounting for Guarantees?
CHAPTER 11 Financial Instruments and Liabilities
a. When one company guarantees the debt of another company, that contingency must be dis-
closed even if the contingency is only remotely possible.
b. The Guarantee liability account represents deferred revenue associated with the stand ready
fee.
c. Both the “stand ready obligation” and the contingent future obligation are recorded at fair
value.
d. The Guarantee liability account decreases over the life of the loan as revenue is earned.
88. Which of the following regarding the recognition of contingencies is not correct?
a. IFRS guidance is built around a balance sheet perspective.
b. Both IFRS and U.S. GAAP require recognition of a contingent liability when it is both prob-
able and can be reasonably estimated.
c. U.S. GAAP relies on an income statement perspective.
d. Only U.S. GAAP requires recognition of a contingent liability, called a provision under
IFRS—and the associated contingent loss—when it is both probable and can be reasonably
estimated.
89. Which of the following regarding the recognition of contingencies is a correct statement?
a. IFRS uses the term contingent liability to include possible but unrecognized contingent obli-
gations.
b. U.S. GAAP discloses contingent liabilities in the notes to the financial statements only for
recognized contingent loss obligations.
c. The threshold for recognition of a contingent obligation is the same under both GAAP and
IFRS.
d. If the estimated liability is a range in which no value is deemed more reliable than another –
both IFRS and GAAP will record the mid-point of the range as the value.
CHAPTER 11 Financial Instruments and Liabilities
90. Which of the following statements is correct with respect to the use of fair value accounting
for liabilities under IFRS?
a. Both IFRS and U.S. GAAP require changes in credit quality to be recorded in operating in-
come.
b. The fair value option is permitted under IFRS only under two specific sets of circumstances.
c. U.S. GAAP is more restrictive than IFRS regarding the use of fair value accounting for lia-
bilities.
d. Fair value accounting under IFRS is only permitted if the liabilities are actively managed on
a fair value basis as part of the company’s documented risk management or investment strat-
egy.
Use the following to answer questions 91 and 92:
REFERENCE: Ref. 11_04
On January 1, 2018 when the effective interest rate was 12%, Philips Co. issued bonds with a
maturity value of $200,000. The stated rate of interest is 12% and the bonds pay interest semi-
annually. Philips Co. paid $2,000 in bond issue costs on this date.
REFER TO: Ref. 11_04
91. Under IFRS the bonds will be recorded on the January 1, 2018 balance sheet of Philips Co. at
a. $200,000
b. $202,000
c. $198,000
d. Cannot be determined based on the information provided.
CHAPTER 11 Financial Instruments and Liabilities
REFER TO: Ref. 11_04
92. If Philips Co. uses IFRS, the effective interest rate will be
a. slightly lower than 12%.
b. slightly higher than 12%.
c. 12%.
d. Cannot be determined based on the information provided.
Problems
93. On January 1, 2018, Sharp Company issued bonds with a face value of $500,000. The bonds
mature in ten years and have a stated rate of 8%.
Requirements:
1. Determine the selling price of the bonds if the market rate of interest was 10%.
2. Determine the selling price of the bonds if the market rate of interest was 6%.
94. The following information pertains to a bond issue of the Atomic Corporation:
Maturity value: $1,000,000
Maturity date: January 1, 2023
Stated interest rate: 8%
Interest payments are made annually on December 31st
Date of issue: January 1, 2018
The bond is dated January 1, 2018
Effective (market) interest rate: 10%
Requirements:
1. At what price were the bonds issued?
2. Using the effective interest method, prepare an amortization schedule showing annu-
al interest expense, annual discount or premium amortization, and carrying value
through December 31, 2020.
3. Prepare the necessary journal entries on January 1, 2018 and December 31, 2019.
4. How should the bonds be shown on Atomic’s December 31, 2018 balance sheet?
95. On January 1, 2018, when the market rate of interest was 12%, Habs Company issued five–
year bonds with a maturity value of $750,000. The bonds have a 10% stated rate and pay interest
semi-annually on July 1 and December 31.
Requirements:
1. Calculate the bond discount as of the date of issue.
2. Calculate the bond discount balance as of January 1, 2018.
96. On July 1, 2018, The Wings Corporation paid $460,000 plus accrued interest to retire bonds
with
a maturity value of $500,000. The bonds had a book value of $475,131 on January 1, 2018.
The stated interest rate is 8% with interest payments being made annually on December 31;
the bonds were issued at a time when the market interest rate was 10%.