Financial Accounting and Reporting-CPA Practice Exam

What is a fair value hedge?

1. An instrument to hedge cash flow variations

2. An agreement to maintain purchase prices stable

3. A hedge against changes in fair value of recognized assets or liabilities

4. A private agreement between two companies

The correct answer is: A hedge against changes in fair value of recognized assets or liabilities

A fair value hedge is specifically designed to offset the risk of changes in the fair value of recognized assets or liabilities. This type of hedge is concerned with fluctuations that can affect the earnings reported on the financial statements, particularly those related to assets and liabilities that are currently recognized on the balance sheet. For example, if a company holds an investment in a financial instrument that is subject to price fluctuations, it might enter into a fair value hedge using a derivative, such as a forward or option, to mitigate the potential losses from those fluctuations. This allows the company to stabilize its financial performance and report more predictable earnings by reducing the volatility associated with changes in the value of its assets or liabilities. In contrast to this, some of the other options refer to different forms of hedging or agreements. An instrument aimed at hedging cash flow variations pertains to cash flow hedges rather than fair value hedges, which focus on changes in value rather than timing of cash flows. Maintaining purchase prices stable speaks to a strategy of cost management but does not specifically address fair value in the context of recognized assets or liabilities. Lastly, a private agreement between two companies could refer to any number of contractual arrangements and does not specifically capture the essence of what a fair value hedge is designed