Question

Assignment 4

USE U.S. GAAP CODIFICATION

For each of the following financial instruments Company A is a party to, fully explain whether the instrument qualifies as a derivative (show how the instrument meets all the requirements). Provide codification references where appropriate to justify your answer.

1. Company A has entered into a purchase agreement with Company B to purchase 5 special order machines for $100,000. The agreement stipulates that Company B must have the machines ready for shipment no earlier than 3 months from the agreement date and no later than 6 months from the agreement. Company A must accept delivery and make payment when Company B ships the machines within the acceptable time period.

2.         Company A has variable rate debt outstanding and is concerned about      an increase in market interest rates occurring in the next two years. Too offset this possibility, Company A has entered into a two-year pay fixed,       receive variable interest rate swap with a financial institution covering 75%      of its variable rate debt.

3.         Company A purchased 100,000 stock options allowing the company to        purchase shares of Company B (a publicly traded company) anytime in the next three years for $80, the current market price of Company B stock.            The options cost $3 each.

4.         Company A paid $10,000 for the option to purchase a tract of land at its current market value during the next 18 months. The current market value of the land is $1,500,000.

5.         Company A has guaranteed some of the debt of one of its subsidiaries.       Company must pay the debt if the subsidiary’s credit rating is           downgraded two levels during the life of the debt.

Assignment 4 USE GAAP CODIFICATIONS For each of the following financial instruments Company A is a party to, fully explain whether the instrument qualifies as a derivative (show how the instrument meets all the requirements). Provide codification references where appropriate to justify your answer 1 Company A has entered into a purchase agreement with Company B to purchase 5 special order machines for $100,000. The agreement stipulates that Company B must have the machines ready for shipment no earlier than 3 months from the agreement date and no later than 6 months from the agreement. Company A must accept delivery and make payment when Company B ships the machines within the acceptable time period 2. Company A has variable rate debt outstanding and is concerned about an increase in market interest rates occurring in the next two years. Too offset this possibility, Company A has entered into a two-year pay fixed receive variable interest rate swap with a financial institution covering 75% of its variable rate debt 3. Company A purchased 100,000 stock options allowing the company to purchase shares of Company B (a publicly traded company) anytime in the next three years for $80, the current market price of Company B stock. The options cost $3 each. 4.Company A paid $10,000 for the option to purchase a tract of land at its current market value during the next 18 months. The current market value of the land is $1,500,000 5. Company A has guaranteed some of the debt of one of its subsidiaries. Company must pay the debt if the subsidiary's credit rating is downgraded two levels during the life of the debt

Answer 1

Answer: To qualify as a derivative in US GAAP, following all features must be there in an instrument or a contract: a. b. c. d. The instrument or contract should have underlying. It must contain some payment conditions or should have some value involved in it. Terms should settle the contract. The contract can be settled through delivery of its underlying asset or by such means as would make contract or involved instrument settled. It may have a term of No initial payment or some small initial payment. e. 1) The contract between company A and Company B has underlying asset of M ii Value involved in a contract is $ 100000 i Terms of delivering the machines with payment of $ 100000 within acceptable time period will settle the contract. iv)The contract terms has no initial payment conditions Since the present contract has fulfilled all the conditions of derivative. Hence this contract qualifies as a "Derivative". 2) This is case of Interest rate swaps. Since the contract has no underlying involved in it hence the contract does not qualify as "Derivative"

3) The Contract of stock option has underlying of Company B shares. i) The condition of payment is there that Company A will purchase Company B shares anytime in the next 3 years for $ 80. i) Terms of stock options will settle the contract by delivering the Company B shares for $ 80. iv) t is involving the initial payment of $3 each. Since the stock option contract has fulfilled all the conditions of derivative. Hence this contract qualifies as a "Derivative" 4)The instrument has underlying a tract of Land. ii Value involved in a contract is $1500000. ii) The contract can be settled by delivering the tract of Land for a consideration of $ 1500000. iv) The contract is having the term to pay an initial payment of $ 10000. Since the contract to buy a tract of land is fulfilling all the conditions of derivative. Hence this instrument qualifies as a "Derivative" 5) The contract is not involving any underlying in it though it involves the contract to be settled by paying the amount involved in it. Still it does not qualify as "Derivative".