Many firms use derivative instruments to hedge exposure to changes in the fair value of an asset or liability, or to hedge exposure to variability in expected future cash flows. As an analyst examining the financial reports of a company that uses derivative instruments to hedge, what questions should you ask when thinking about derivatives and accounting quality?

(Select one or more)

a.

Of what quality are the market values that are being used to mark derivatives to market at the balance sheet date? Are the market values obtained from liquid markets with many participants?

b.

Does the derivative has one or more underlyings? Underlyings are a specified interest rate, commodity price, foreign exchange rate, or other variable.

c.

Has the company done a fair job of classifying its derivative hedges as either fair value hedges or cash flow hedges? Gains and losses on cash flow hedges affect earnings later than those of fair value hedges.

d.

Are the company's net gains or losses each period relatively small or large? Are the net gains or losses volatile? Large and volatile net gains or losses may signal a poor use of derivatives.

Answer rating: 100% (QA)

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