Financial Accounting and Reporting-CPA Practice Exam

Which risk exposures should be distinguished in derivative disclosures?

1. Investment risk and market risk

2. Credit risk and operational risk

3. Risk management hedging or those used for other purposes

4. Liquidity risk and foreign exchange risk

The correct answer is: Risk management hedging or those used for other purposes

In the context of derivative disclosures, distinguishing between risk management hedging activities and those used for other purposes is crucial. This differentiation provides valuable insights into the entity's risk management strategies and financial objectives. Derivative instruments can serve various purposes, notably hedging against risks (such as interest rate or foreign currency risks) or for speculative purposes, which can significantly impact the financial statements and risk profile of a company. When derivatives are used for hedging, they are typically aligned with risk management strategies to mitigate potential losses from underlying exposures. Conversely, when derivatives are used for speculative purposes, the associated risks can be significantly higher and may indicate a more aggressive risk-taking approach. Highlighting this distinction in disclosures helps stakeholders, including investors and analysts, to assess how effectively the company manages risks and how much risk it is willing to accept. It also informs them about the nature of the derivatives in question and the purpose they serve within the overall financial strategy of the entity. The other options involve various types of risk exposures, but they do not emphasize the critical distinction between hedging and non-hedging purposes that is central to understanding how derivatives are strategically utilized by a company. Thus, option C captures the essence of what should be disclosed to provide a clearer picture of the