1 .

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I
CHAPTER
kHJiSFLUE^CE
•i'iJROi
-^Homsinatiohs

M' JIOH WEORIE'

^Jionmethoo

Rfnn^'-

:FI]''

[Accounting for Derivatives and

Hedge Accounting

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

Understand what constitutes c
derivative instrument;
Understand the different types of
derivatives;
Know how derivatives are used;
Understand the accounting treatment
of derivatives;
Understand hedge accounting, its
rationale, and the conditions for
applying hedge accounting; and
Appreciate the three main types
of hedge relationships and their
accounting treatments.

1
 816 ADVANCED FINANCIAL ACCOUNTING
DERIVATIVE FINANCIAL INSTRUMENTS
The term "derivative financial instruments" or "derivatives" brings to mind the spectacular headline stories
of the collapse of Barings Bank Ltd and the sudden bankruptcy of Long Term Capital Management and
Orange County. However, these unfortunate and exceptional incidents should not overshadow the fact that
derivative instruments serve a variety of purposes and play a very important role in the risk management
strategies of banks, insurance companies, and commercial enterprises. The versatility of derivatives explains
their popularity and widespread use.
Accounting for derivative instruments depends on the purpose for entering into derivative contracts.
It is important, therefore, from an accounting point of view, to understand what constitutes a derivative
and the reasons enterprises enter into contracts involving derivatives.
IFRS 9 defines a derivative as a financial instrument or other contract within the scope of IFRS 9 that
meets three criteria:
1. Its value changes in response to a change in an "underlying." The underlying can be the price of
a commodity, such as soybeans, or a financial instrument, such as a fixed rate bond. It can also
be a rate such as a foreign exchange rate or a specified interest rate, for example, the London
Interbank Offer Rate;
2. It requires little or no initial net investment; and
3. It is settled at a future date.
Although net settlement (i.e. the settling of the difference between the contracted price and the spot price
at closure or maturity date) is not a condition for a derivative, net settlement is a common practice in financial
markets. If a derivative is settled through the receipt or payment of cash or other financial instruments, the
derivative is also a financial instrument that falls within the scope of IFRS 9. For example, an oil derivative is
a financial instrument if it is likely to be settled net in cash at closure. Net settlement gives rise to an expected
exchange of cash or other financial instruments that qualifies it as a financial instrument as defined by IAS
32 paragraph 11. However, if an entity enters into an oil derivative contract for the purpose of taking physical
delivery of the od at the maturity date, it is a commodity derivative and not a financial instrument because there
is an expected receipt of physical inventory. IFRS 9 requires an evaluation of whether the contracts were "entered
into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance
with the entity's expected purchase, sale or usage requirements," commonly known as the own use exemption.
A derivative must also entail little or no initial net investment. A prepaid forward contract to purchase
inventory to be delivered in six months does not meet the criterion of little or no investment as the price
has been paid in full. Table 10.1 shows some typical derivatives and their underlying. These derivatives
can be used by producers, consumers, trading firms, corporates, and financial institutions.
TABLE 10.1 Examples of derivofive instruments and their underlying
Type of derivative instruments Underlying
Options contract (call and put) Security price
Forward contracts, e.g. foreign exchange Foreign exchange rates
forward contracts
Futures contracts, e.g. commodity Commodity prices
futures
Swaps, e.g. interest rate swap Interest rate
ACCOUNTING FOR DERIVATIVES AND HEDGE ACCOUNTING 817
In HSBC's 2009 annual reports, derivatives make up 11% of HSBC's total assets and total liabilities.
These are the unrealized profits (assets) and unrealized losses (liabilities) on derivatives.
Uses of Derivatives
Generally, entities or individuals transact in derivatives to:
1. Manage market risks such as foreign exchange risk and interest rate risk;
2. Reduce borrowing costs; or
3. Profit from trading or speculation.
Types of Derivatives
Derivatives differ in terms of characteristics that influence their fair values. For oui purpose, we can
distinguish between two main groups of derivatives:
1. Forward-t)q)e derivatives such as forward contracts, futures contracts, and swaps; and
2. Option-t)'pe derivatives such as call and put options, caps, and collars and warrants.
There are two forms that derivatives can take: free-standing derivatives and embedded derivatives. An
embedded derivative is a derivative that is combined with (or embedded in) a host instrument that is not
a derivative. An appreciation of the characteristics and form of derivatives is important to understanding
the accounting treatment of derivatives.
The following sections discuss the major types of derivatives, how their fair values are derived, an
the accounting treatment of derivatives as speculative trading and hedging instruments. Derivatives may
be based on interest rates, foreign exchange, equities, credit, or commodities as the underlying risk types^
Within the two main groups of derivatives (forwards and options), each group includes derivatives
different risk types. Examples of interest rate derivatives in the "forwards category include interest r^^
swaps, futures, forward rate agreements, and in the "options" category, include caps and floors, ore j,
exchange derivatives in the "forwards" category include FX spot, FX forwards, FX swaps, cross curren y
swaps, and in the "options" category, include FX options. Exchange-traded derivative fair
calculated based on quoted market prices. Over-the-counter derivative fair values are derived from va ua
models such as discounted cash flow and option pricing models.
Derivatives are used to hedge or trade/speculate on different types of risks. A brief overview
risk types is as follows. Interest rate risks cover duration risk and interest rate repricing or gapping
Credit risks are functions of the probabilities of default and losses given default. Counterparty ere it
arise when a trade is in-the-money and the counterparty defaults. It is an interaction between
risk and credit risk. An example when counterparty risk arises is in an interest rate swap
Market price risks include commodity risk, for example, oil and gas and agricultural products.
risks arise from the inability to sell or close the open trade in an inactive market. During the ere i ^
the market became illiquid after Lehman Brothers became insolvent as financial institutions were unw »
to lend to one another out of concern over credit risks, which morphed into a liquidity crisis.
Forward Contracts
A forward contract is an agreement between two parties (called counterparties) wheieby one party agrees
to buy and the other party agrees to sell a specified amount of an item (the notional amount) at afixed price
(also called forward price or forward rate) for delivery at a specified future date (also known as maturity
date or forward date). Forward contracts are two-sided as they involve performances by both parties.
 818
accounting for DERIVATIVES AND HEDGE ACCOUNTING 819
ADVANCED FINANCIAL ACCOUNTING

. r ■ I .o n forward contract after inception date

A forward contract is either a forward purchase contract or a forward sales contract from the table 10.2 Changes in the fair value ot a torwara
perspective of the individual counterparties. For example, on 1 June 20x4, Ace Company, \vhose functional Current forward rate < contracted
currency is the dollar, purchased goods from an overseas supplier at an invoiced price of 100,000 euros current forward rate > contracted forward rate
forward rate
with payment due on 31 July 20x4. It could wait until 31 July 20x4 to purchase euros from the spot Fair value is negative.
exchange market to pay the supplier or it could enter into a forward contract to purchase 100,000 euros Forward purchase contract Fair value is positive. A loss is recorded.
for delivery on 31 July 20x4. Suppose that the forward rate on the contract was $1.80/euro. This means A gain is recorded. In the statement of financial
that on 31 July 20x4, Ace Company would pay $180,000 to the foreign exchange broker and receive In the statement of financial position, the forward contract is a
100,000 euros no matter what the euro-dollar exchange rate was on that date. Thus, the forward purchase position, the forward contract is an liability.
asset.
contract locks in the purchase price in dollars. On the other hand, a local exporter selling goods denominated
in the euros to an European customer may want to lock in the sales proceeds in dollars by entering a tor\N'ard Forward sale contract Fair value is negative.
Fair value is positive.
A gain is recorded.
sales contract for the euros that is equivalent to the invoiced amount for delivery on the settlement date. A loss is recorded. In the statement of financial
Forward contracts are not standardized contracts as they are not traded on an exchange. Therefore, In the statement of financial position, the forward contract is an
there is no readily available quoted price for such contracts. Because they are not traded on regulated position, the forward contract is a asset.
liability.
exchanges, forward contracts carry higher counterparty risks than other similar instruments such as futures
contracts. However, they have the advantage of flexibility as they can be tailored to the specific needs of
the counterparties. Additionally, forward contracts generally involve lower transaction costs as compared • $1.80/FC
spot exchange rate now is on/uG 11 (1
n FC unit buys $1.80).
, ,, The entity
, can-i-either wait three
u months to
to other types of derivatives such as options contracts. ,, ^ tUp amount into dollars at the prevailing spot exchange rate then
collect the FC 100,000 and then convert the amouni mio , r p, vq/ug i c .u ..u
The fair value of a forward contract can be estimated as follows: or enter into a three-month1 forward
c ,o,-4 sales
cales contract at a forward
. , rate
i of $1.78/FC 1. Suppose uthat three
4-
^ . i- -, on/FG 1 If the entity had not entered into the forward contract,
(|Current forward rate - Contracted forward rate|)
months later,^ the spot
^ exchange rate isreceive
^„ld $1-8 /upon converting the FC innonn m nhave u
100,000 would eionnnn
been $180,000.
Notional amount X the amount in dollars that it woulu receiv y j-rr f nnn or. -toa w
(I + r)' . , ,.„rrart it received $178,000. The difference of $2,000 [($1.80 - $1.78) x
By entering into the forward contract, it receive m. , . / cu u • v
where contracted forward rate is the forward rate fixed at the inception of the contract, current forward UG 100,000] represents
FC . .u of ot tbe
the cost the forward
lorw contract transaction (or
.the
.icost of hedging).
i av u c j i
rate is the forward rate for the remaining period to maturity (also known as the "market forward rate ), Figure 10.1 shows .he pay-off diagrsnis for a purchase forward contract panel A) and a forward sales
r is the discount rate and t is the period to maturity. The reason for discounting is the time value in the contract (panel B). With reference to panel A. assume that the underlying is the pr.ce of a cornmodity and
forward contract as it is settled only at a future date (the maturity date) and, therefore, represents a future the forward price is $1.20 per unit. The horizontal axis represents the prtce of the underlying. At incept,on,
cash amount.
the fair value of the forward contract is nil. If the underlying (the price of the commodity) exceeds $1.20.
The fair value of a forward contract at inception date is nil. There is no initial outlay, and neither there is a gain on the forward purchase contract and the fair value of the forward contract becomes
party has a gain or a loss at the inception of the contract. From the inception date to maturity, positive (shown as an asset in the statement of financial position). On the other hand, if the price of the
am va ue of a forward contract can either be positive (indicating a gain and an asset) or negative underlying falls below $1.20 per unit, there is a loss on the forward purchase contract and the fair value
in ica ing a loss and a liability) depending on the relationship between the current forward rate and
t e contracted forward rate, and whether it is a forward purchase or a forward sale contract (see
Table 10.2). ^ FIGURE 10.1 Pay-off diagrams for a forward contract
It should be noted that at the date of maturity of the forward contract, the forward rate converges to
the spot rate on that date since there is no further period remaining on the contract. This means that the (A) Forward purchase contract
(B) Forward sales contract
fair value of the forward contract at maturity date is the difference between the spot rate at the maturity
date and the contracted forward rate multiplied by the notional amount of the contract. Contracted forward
The premium (or discount) on the forward contract is considered the interest or time value, which is Contracted forward
price/rate
price/rate
measured by the difference or spread between the forward rate and the spot rate at a point in time. Changes
Gain
in the time value component are not directly related to changes in the underlying (the spot price or market Gam

rate), but are due to a number of factors including the costs of holding the commodity or underlying by the Price of underlying
counterparty, the risk-free rate and the period to maturity. If the forward contract is for hedging purposes, 1^.20
the premium or discount can be considered as the cost of hedging. As an example, suppose a entity expects Loss

to receive FC 100,000 (100,000 foreign currency units) from a certain party in three months' time, and the

1
820 ADVANCED FINANCIAL ACCOUNTING ACCOUNTING FOR DERIVATIVES AND HEDGE ACCOUNTING 821

of the forward contract is negative (shown as a liability in the statement of financial position). Panel B The cash flow from the bank's perspective is shown below:
shows the pay-offs for a forward sales contract. Using the same example of a forward price of S1.20 per
unit, the pay-offs are opposite those of a purchase contract. The forward sales contract results in a gain Currency
if the underlying is less than $1.20 per unit and a loss if it is above this price. As a forward contract can Spot trade @ 2.00
result in either a gain or a loss, it is said to have a symmetric pay-off profile. Illustration 10.1 shows the Spot date 47,619.05 (96,154)
(47,619.05) 96,154
determination of the fair value of a forward contract.
Deposit @ 10% Loan @ 4%
An FX forward price is a combination of the spot price and the cost of carry. FX spot prices are
provided by spot market makers while swap prices are supplied by money market traders. A hypothetical
example of the FX forward pricing is as follows: Client receives 100,000 units of foreign currency C in Repayments
Future date 52,885 -► (100,000)
one year and wants to hedge the decline in C against base currency B. The current spot exchange rate is Forward trade @ 1.8909
2.00 and the interest rates are C: 4% and B: 10%. (52,885) (100,000)

Borrow spot cash flow (currency C) for Fligh yielding "base" B (lower yielding "counter" C) results in a forward rate lower than the spot rate (the
one year at 4% in deposit markets: C 96,154
buyer of B has the benefit in the use of currency B from spot date to the forward date). Buying currency
B forward gives the buyer a benefit in the form of a lower price relative to the spot rate.

C 100,000 (offset against the Non-deliverable Forwards: Net Settled in USD For example, on 5 January 2002, bank X offers non-
C 100,000 client receives In one year) deliverable forward (NDF) with these terms: maturity = 3 months, notional principal 1 = USD 100 million,
notional principal 2 = THB 3.0 billion, reference rate: spot THB/USD exchange rate, rate set at maturity,
Use
payment date: spot settlement, bank X (customer) pays if reference rate < (>) THB 30.00/USD. Market risks
FV of NDF are due to NDF (spot and interest rate) market rates. Credit risks are assessed based on customer
PV =
(1 + g) business (whether the positions in the right or wrong way).
_ C 100,000
~ (1 + 4%)
If spot > 30, pay (spot - 30) x USD 100 million/spot
= C 96,154 Customer Bank X

Sell discounted cash flow in the spot market to generate cash flow in B: If spot < 30, pay (30 - spot) x USD 100 million/spot

C96,154
= B48,077 If the customer is a Thai exporter, receipts are in USD, strengthening of USD improve its USD receipt
2.00
values and credit quality. The Thai customer has to pay on the NDF. The NDF is a right way trade to the
customer because the gain on USD export receipts offset the loss on the NDF trade.
Lend the base currency cash flow for one year at 10% in the deposit markets: A special case of FX forward instrument is FX spot, in which the exchange or settlement of different
FV = P X (1 -F g)
currencies takes place two working days after the transaction date (spot date). The bulk of FX spot trades
are interbank transactions. One unit of traded commodity/base currency is priced in terms of another
= B 48,077 X (1 + 10%)
counter currency, and the difference between the buy or bid rate and the sell or offer rate is the spread.
= B 52,885
A FX swap is a combination of a spot and a forward contract. An example of an outright six-month
The forward price is
forward trade with a client is shown below:

C100,000
= 1.8909
B52,885 AUD 1 million

Bank Client

JPY 85 million
 823
accounting for DERIVATIVES AND HEDGE ACCOUNTING
822 ADVANCED FINANCIAL ACCOUNTING

1 . o,. ^vrhnnre of interest cash flows between two parties: one

There are two types of risks: spot exchange risk and interest rate risk. The forward trade with client is for illustration. An interest rate swap imo%e ^ m the same currency to another party. The
covered by spot hedge (to cover spot exchange risk) and FX swap (spot leg and forward leg to cover interest party receives fi.xed interest cash flows and pays floating hedging or trading. If the exchange of interest
rate risk). The residual JPY cash flow is JPY 30,000. underlying reasons for carr>nng out an ^ currency swap. An industrial entity typically does an
flows is in different currencies, the swap is called a cross-currency s^ p ^ _
Currency interest rate or cross-currency swap for hedging
Spot hedge @ 85.90 Trading in swaps is not the core function , because the entity can borrow more cheaply
Spot date (1,000,000) Eurodollars to fund its business operations in ^ US dollars. In order to eliminate the
1,000,000
Spot leg @ 85.87
(85,870,000) in Eurodollars, which is the entitys domestic industrial entity carries out a cross-currency
foreign exchange risk bet.veen Eurodollars and ^ dolla fl.e mdus^^^^^^ pnrodoUars to the bank
Forward leg @ 85.00
swap w„h a bank. In .his bade, .he life of the cross-currency
Future date (1,000,000) 85,000,000 on trade date. The opposite cash Hows aie xhe industrial entity uses this
(6 months) 1,000,000
Forward trade (client) @ 85.00
(85,000,000) swap, the interest cash flows are made in both Eu ' ^ j- mv, Kant records a Eurodollar versus
transaction to convert the Eurodollar funding to a US dollar funding. The
US dollar cross-currency
t.uiit:iit_j s^vap.
c p The bank faces both foreignr-r.rart
exchange
cir toand interest
trade on theraswap. The
_ .bank, ,has /
to
An FX swap is equivalent to a pair of opposite FX trades (spot and forward). Alternatively, the bank decide to offset its risks with an interbank cross-cuirency s p kti-. •+
could borrow AUD and invest JPY cash flow for six months. At the end of six months, the bank receives fair value the trading swap under IFRS 9. Under fair value accounting, an asset 1 em la ity item is
the AUD from the client to repay the AUD borrowing, and uses the JPY from investment to pay the client. created for fair value gains and losses respectively with the corresponding gams or losses m the profit or loss.
However, the money market trades are on the statement of financial position and would put pressure on This generic accounting treatment applies to most trading products, even though the valuation gams
a banks capital adequacy ratios. Conversely, the credit risk on FX swaps is a "replacement risk." The swap or losses of the products differ. The cash flows of a trading product are genera y recognized as gams or
price is derived as follows: losses in the income statement since the market value of the product has factored m the cash flows. For
_ Spot rate X (Gc — Gb)
example, when interest is settled in cash for the cross-currency swap, the market adjusts the swap value for
the cash settlement because the swap value is the present value of its discounted cas ows. The rationale is
(1 + Gb) similar to that of stock price adjustment for ex-dividends. Other trading products include credit derivatives
such as credit linked notes and credit default swaps, as well as equity derivatives such as equity swaps.
Assume the following rates for six months (182 days): AUD 3.3/8% — 3.1/4% and JPY 1/4% — 1/8%, In the example below,' an interest rate swap is used to convert cash flows for ABC from fixed rate
spot AUD/JPY 84.98/03; swap market makers set all spot legs at 85.00. For the side of swap where the liability to floating rate liability.
market maker charges points, use AUD interest rate (higher yielding currency) for borrowing cost (deposit
dealers offer rate) (Gb) and JPY interest rate (lower yielding currency) for investment returns (deposit ABC issued at par a EUR 100 mlillon two-year bond with a 3.78% annual coupon
dealer's bid rate) (Gc).
3.78% per annum
85.00 X (0.00125 - 0.03375) x 182/360 ABC
i
Swap points Bond holders
1 + (0.03375 X 182/360)
i L

= -1.37 or -137 pips

For the side of swap where market maker pays away points, use AUD interest rate (higher yielding Eurlbor 3M quarterly 3.78% per annum
currency) for investment returns (deposit dealer's bid)(Gb) and JPY interest rate (lower yielding currency)
'
for borrowing cost (deposit dealer's offer rate) (Gc).
XYZ bank
85.00 X (0.0025 - 0.0325) X 182/360
Swap points =
1 + (0.0325 X 182/360)
= —1.27 or —127 pips
Swap price is the net present value of discounted cash flows, with interpolation of discount factors for the
The two-way swap quote derived from above money market rates is 137/127. The top portion of the quote Value dates. A special case of swaps is the overnight index swaps (OlS). In an OlS, the overnight interest
indicates that the swap trader is charging points because the user is effectively borrowing the higher yielding rate is set daily. The OlS switches term funding into overnight funding or switches interest earne on
currency. The bottom portion of the quote indicates that the swap trader is giving points since the user investments based on long-term fixed rates into overnight rates. The latter approach aims to increase t e
is effectively lending the higher yielding currency. yield on term investments when overnight rates are higher than term rates.
Examples of interest rate derivatives include interest rate swaps, interest rate futures, forward rate agreements,
and interest rate options such as caps and floors. One of the simplest derivatives, an interest rate swap, is used ' Ramirez, J., (2007), Accounting for Derivatives: Advanced Hedging under IFRS, Chichester, UK; John Wiley & Sons Ltd, p. --10.

1
824 ADVANCED FINANCIAL ACCOUNTING ACCOUNTING FOR DERIVATIVES AND HEDGE ACCOUNTING 825

The fair value of the forward contract is calculated using a 5% (per annum) discount rate. The changes
Notional amount x Average overnight rates during interest period x No. of days
Payment = in the fair value of the forward purchase contract are as follows:
Days per year basis

Contracted Current Fair value

Bank A

Fixed rate cash flow

Notional amount x Fixed Rate x No. of days
Bank B
1 forward rate
(a)
forward rate
(b)
Notional
amount
Discount
factor
of forward
contract
Change
in fair
Date FC 1 = FC1 = (0 (d) [(b - a) X c]/d t value
Days per year basis
1 March 20x5 $1.20 $1.20 $1,000,000 $ 0 $ 0 $ 0
31 March 20x5 1.20 1.21 1,000,000 1.00835 9,917 9,917
In cross-currency swaps, there are exchanges of principal sums in different currencies. The counterparties 30 April 20x5 1.20 1.205 1,000,000 1.004167 4,979 (4,938)
in a cross-currency swap are effectively borrowing in one currency and lending in another currency. 30 May 20x5 1.20 1.215 1,000,000 ' 1.0 15,000 10,021

Forward Rate Agreement A forward rate agreement (FRA) is an over-the-counter (OTC) agreement
between a buyer and seller based on a fixed interest rate to be paid or received on a notional amount at
a determined future date. The buyer of a FRA hedges against interest rate increases and receives payment
when the reference rate is above the fixed rate and the seller hedges against interest rate declines.
For example, X lends to Y for the period between T^ and T,. For a three-month to six-month FRA, the fixed
interest rate starts in three months' time T^ and last for three months to T,. The fixed rate is agreed between X
and Y at T^. The reference rate is the forward LIBOR rate between T^ and T,. X pays Y the following settlement
amount at T^. This is the difference between reference rate and fixed rate multiplied by the notional principal
and time between T^ and T^ in years, discounted from T,to T^ (denominator is the discount factor).
Notional amount x [(Reference rate - fixed rate) x No. of days/(360 or 365)]
Payment =
1 + Reference rate x No. of days/(360 or 365)
3-6 FRAs - the fixed Interest rate starts in 3 months'time and last for 3 months
3 months 6 months
The following points should be noted:
1. At inception, the fair value ol the forward contract is nil. The fair value of the forward contract
after inception is determined based on the change in the forward rate from the inception date to
the end of the current period, discounted at 5%.
2. At 31 March 20x5, there were two months remaining in the forward contract. The fair value of
the forward contract is $9,917, which is calculated as follows:
[$1,000,000 X (|1.21 - 1.20|)] -F (1 -f 0.05/12)- = $10,000/1.00835
3. At 30 April 20x5, the fair value of the forward contract was $4,979 [1,000,000 X ([1.205 - 1.20|)]
-F (1 -F 0.05/12). At 30 May 20x5, the fair value of the forward contract was (|1.215 — 1.20|) —
1,000 000 = $15,000. The number of days left in the contract is zero, so the discount factor is 1.
4. The fmr value of the purchase forward contract is positive, as the amount payable under the contract
($1,200,000) is less than the amount receivable ($1,215,000) based on the spot rate at maturity. In
the statement of financial position, the forward contract will be reported under Current Assets.
However, it is possible for a forward contract to show a loss. For example, if the $/FC spot rate
on 30 May 20x5 is $1.19, the fair value of the forward contract is -$10,000.

•Payment calculated over period T, to

Futures Contracts
A futures contract is a contract between a buyer or seller and a clearing house or an exchange Examples
ILLUSTRATION 10.1 Fair value of a forward contract
of the exchanges include the Chicago Board of Trade (CBOT), LIFFE (London International Financial
Futures and Options Exchange, until it was taken over by Euronext foUowed by the Euronext merger wi
On 1 March 20x5, Company A entered into a forward contract with a foreign exchange dealer to buy one
NYSE), CME (Chicago Mercantile Exchange) and the Singapore Exchange (SGX). There is a wi e rang
million foreign currency (FC) units (FC 1,000,000) for delivery on 30 May 20x5. The following exchange
of exchange-traded futures contracts. Some of the main types of futures contracts are.
rates are given: 1. Commodity futures, for example, wheat, cotton, sugar, and pork bellies;
2. Interest rate futures, for example, treasury bill futures, treasury bond futures. Eurodollar tutuies,
Spot rate 30 May forward rate
Euribor futures, Euroyen futures; and
Date $/FC $/FC
3. Currency futures.
1 March 20x5 $1,185 $1.20
31 March 20x5 1.19 1.21
A futures contract shares some similarities with a forward contract. As with a forward contract, a
30 April 20x5 1.20 1.205 futures contract involves obligations on the part of the buyer to take delivery and the seller to make delivery
30 May 20x5 1.215 1.215 of a specified quantity of an item at a specified date in the future. Both futures and forward contracts
have a symmetric pay-off profile. At inception, there is a difference between the spot price or i ate and the
826 ADVANCED FINANCIAL ACCOUNTING
ACCOUNTING FOR DERIVATIVES AND HEDGE ACCOUNTING 827

futures price or rate, which is often referred to as the spol-forward differential. This is equivalent to the
premium or discount on forward contracts. However, futures contracts possess many characteristics that
are not present in forward contracts. The following are some of these characteristics:
1. A futures contract is traded on an exchange in standard lot sizes (quantity) and for designated
items only. In this respect, it is not as flexible as a forward contract, which can be tailored to the
specific needs of at least one of the parties. However, the involvement of an exchange virtually
eliminates the counterparty risk in a forward contract.
2. Futures contracts can be closed out before maturity by entering into an identical contract that
is in the opposite position. For example, a long position in a futures contract is closed out by a
short position in an identical futures contract.
3. A futures contract requires the payment of a margin deposit, which may range from 1% to 10%
of the notional value. The margin deposit, which has to be maintained throughout the duration
of the contract, serves as a type of security deposit and does not represent the transaction cost
or the initial investment. The margin deposit has to be topped up in the event that losses on the
futures contract erode the required maintenance margin. The margin deposit is refunded when
the contract is closed. The margin requirements mitigate counterparty credit risk.
4. As futures contracts are marked-to-market and changes in the value of outstanding contracts are
usually settled in cash on a daily basis, no discounting is necessary, unlike forward contracts. The
requirement to settle on a daily basis also reduces default risk.
5. Futures contracts rarely result in physical delivery. In practice, a party that has bought or sold a
futures contract usually closes the open position before maturity date by entering into an offsetting
futures position.
The purchaser of a futures contract is said to have a long position while the seller of a futures contract is
said to have a short position. The interest rate future is sold to hedge against interest rate increases because
when interest rate increases, the value of futures will fall and the seller makes a profit on the short futures
position. Since futures contracts are traded on an exchange and are marked-to-market, the quoted price
readily provides a measure of the fair value of a futures contract (for example, the price of an interest
rate future is 100, less interest rate). When the spot price (the underlying) increases, a long position in a
futures contract results in a gain while a short position results in a loss. Conversely, when the underlying
decreases, a long position results in a loss while a short position produces a gain. Thus, as with forward
contracts, futures contracts have a symmetrical pay-off profile.
negotiated between the buyer and the seller, for example, with regard to whether the option can be closed
prematurely.
In the case of listed options, they trade in the same manner as listed shares. When an investor
buys a call option, he is said to have a long position in the option. When an investor sells a caU option,
he has a short position in the option. To close the long position, the buyer can sell his call option to
market participants. Similarly, a seller can close his short position by buying the call option from the market.
The main features of option contracts are as follows:
1. The purchaser of a call or a put option pays a premium to the seller (writer of the option). The
option premium may be in the form of a lump sum figure or, in the case of listed options, quoted
on a per unit basis. For example, on the Chicago Board of Exchange, an option is quoted as $2 per
standard contract of 100 units of a particular commodity, resulting in a total premium of $200.
2. While the holder of an option contract has the right but not the obligation to perform, the seller
(writer of the option contract) has the obligation to perform.
3. Option contracts have an asymmetrical pay-off profile. The purchaser (holder) of an option
contract has a limited loss and a theoretically unlimited gain. The option holder's loss is limited
to the premium that he has paid. However, the potential gain could be very high. The position
of an option writer is the opposite. His gain is limited to the premium he has received from the
sale of the option. His loss is potentially unlimited. Consider the following situation:
Type of option contract: Call option
Notional quantity: 1,000 units of Security A
Premium (price of call option): $500
Strike price: $1.50
The buyer of the option pays $500 for the call option, which gives him the right but not the obligation
to buy each unit of Security A at a price of $1.50. Obviously the buyer will not exercise his right unless
the price of Security A goes above $1.50. The seller (writer) of the option receives $500 for the option.
This is the maximum amount that the seller can gain from selling the option if the price of Security A
stays at or below $1.50. Therefore, in writing the option, the option writer is effectively taking a bet that
the price of Security A is unlikely to go above the strike price of $1.50.
The pay-offs to the option buyer and the option writer are shown in the following table:

Option Contracts Price of Security A Pay-off to caii Pay-off to caii option writer
(the underiying) option buyer (selier)
An option contract is a contract that gives the holder the right but not the obligation to buy or sell a
specified item (which can be a commodity, a financial instrument or an equity instrument) at a specified $1.30 $(500) $500
price (called the exercise or strike price) during a specified period of time. A call option gives the holder 1.50 (500) 500
1.70 (300) 300
the right but not the obligation to buy a specified item at the strike price. A put option gives the holder 2.00 0 0
the right to sell (or require the options writer to buy) a specified item at a strike price. There are two 3.00 1,000 (1,000)
types of options: the American option and the European option. An American option is exercisable 5.00 3,000 (3,000)
any time between inception and maturity date. A European option can only be exercised on the Note: The pay-offs are net of the option premium of $500.
maturity date. Options can be in the form of customized contracts (which are not traded) or standard
contracts quoted on an exchange (listed options). For customized options, the terms and conditions are In the above example, if the price of Security A rises to $3, the option buyer makes a net gain of
$1,000 (after deducting the cost of the option) and the option writer makes a net loss of $1,000. If the price

JL
828 ADVANCED FINANCIAL ACCOUNTING ACCOUNTING FOR DERIVATIVES AND HEDGE ACCOUNTING 829

of security A rises to $5, the option buyers net gain is $3,000 and the option writer's net loss is $3,000. unit, the buyer breaks even as the gain on the option is $500 [1,000 units X ($2.00 - $1.50)] and the cost
However, if the price of security A stays at or below $1.50 from the inception to the expiration of the of the option is also $500. Only when the price of Security A exceeds $2 will there be a net gain. A call
option, the option buyer's loss is limited to $500. It is this "one-sided" feature of an option that makes option is said to be at-the-money when the strike price equals the underlying; it is out-of-the-money when
this derivative so attractive. It limits the loss to the option buyer (to the price paid for the option the strike price exceeds the underlying (or spot price). In the case of a put option, the option is in-the-
premium) while allowing him to benefit from any favourable movements in the underlying. For this money when the strike price is greater than the underlying (or spot price), and out-of-the-money when
reason, option contracts are generally more costly than other derivatives such as forward contracts when the strike price less than the underlying (or spot price). Table 10.3 summarizes the relationship between
used for the same purpose, for example, hedging a specific risk. Note that the pay-offs amount to a the strike price and the underlying for call and put options.
zero-sum game as the option writer's gain (or loss) mirrors that of the option buyer's, but in the opposite
direction. TABLE 10.3 Relationship between the strike price and the underlying
The gain or loss that accrues to a holder of a call option is a function of the premium paid for
the option and the relationship between the exercise or strike price and the underlying (the price Strike price > Underiying Strike price = Underiying Strike price < Underlying
(spot price) (spot price) (spot price)
of the optioned item). The pay-offs for long and short positions in call and put options are shown in
Figure 10.2. Holder of a call Out-of-the-money At-the-money In-the-money
When the underlying (the price of the optioned item) is greater than the exercise or strike price, the option
call option is said to be in-the-money. In the previous example, if the price of Security A reaches $2 per Holder of a put In-the-money At-the-money Out-of-the-money
option

FIGURE 10.2 Pay-off diagrams for long and short col! and put options The cost of an option at the time of purchase is the premium; this is also the fair value of the
option. The fair value of an option contract is made up of two components - time value and intrinsic
value.
(A) Pay-offs to a holder of a call option (B) Pay-offs to a holder of a put option
Fair value of an option = Intrinsic value + Time value
Gain Gain
If we know any two of the three values, the remaining value can be derived as a residual. For example,
Strike price
if the fair value of an option contract is $1,000 and the intrinsic value is $600, the time value component
Strike price
must be $400. The time value diminishes over time and is zero at the expiration of the contract. The loss
1 1 in time value is also known as "time decay." The loss in time value is not uniform over the life of the
$1.50 Price of underlying $1.50 Price of underlying contract, but normally, the loss increases exponentially in the last 30 days of the contract. The intrinsic
Loss

Out-of-the-money In-the-money
Premium
} In-the-money
Loss value is derived as follows:

Intrinsic value of a call option = Max [0, Notional amount (Quantity)

X (Spot price^ - Strike price)]

(C) Pay-offs to a writer of a call option (D) Pay-offs to a writer of a put option Intrinsic value of a put option = Max [0, Notional amount (Quantity)
X (Strike price - Spot price)]
Gain Gain
At the time an option contract is written, it is usually written out-of-the money or at the money
Strike price Strike price The deeper an option is out-of-the money, the lower the premium (cost of the option). In this case, t
premium is made up entirely of the time value component. By buying an out-of-the-money option, t e
buyer keeps his investment cost low and hopes to benefit from any favourable price changes subsequent y
Gain

$1.50
Premium
Price of underlying
} Gain
However, it is possible to purchase an option that is in-the-money if the option has been tra e
^ $1.50 Price of underlying an exchange for some time after its initial issue but still has some time left to maturity. In t is c
Loss >
the option premium is much higher as it consists of both an intrinsic value component an
Loss value component.

- The spot price is the underlying.

 831
830 ADVANCED FINANCIAL ACCOUNTING
accounting for DERIVATIVES AND HEDGE ACCOUNTING

Z7r°'f!Z\CeZ f
contract from the perspectives Z ZZ'""""'
of the holder and the writer are as shown below.P-.-cmatio,, of an option ACCOUNTING FOR PERiVATIVES
Presentation of an unexpired option
contract in the hoider's
Presentation of an unexpired option Prior to IAS 39, the predecessor standar of IFRS 9, most derivatives were "off-balance-sheet," that is, they
financial assets or financial liabilities. Under IAS 39 and
Option is: statement of financial position contract in the writer's Were not recognized in the financial statem^ ^ derivative that is a financial instrument must be recognized
Out-of-the-money
statement of financial position
IFRS 9, a contract meeting the definition o de/uulf assumption with regard to derivatives under IFRS
At-the-money
Asset (time value only)
Asset (time value only)
Liability as a financial asset or a financial liability. ^ yolue with changes in fair value taken to the profit or
In-the-money Asset (intrinsic + time value) Liability 9 is that they are trading securities nicasui ^ j^gjae an identified risk and is designated as an effective
Liability loss. However, if the derivative is emp oye d instead, the derivative is accounted for under what
hedge, then the default assumption no longer tpp
a put option perspective, a purchased option, regardless of whether it is a call option or is termed as "hedge accounting rules. ^ values. When the fair value of a transaction gives a
the option is' at-the- reached the expiration date. This is the case even if Derivatives are measured and recogni nized as assets. Conversely, losses from derivatives are
nil. The option buyeT^i7no't ^^e option is out-of-the-money. the intrinsic value is positive inception gain, the positive gain i fg]- offsetting (or netting) gains and losses on the
buyer has no obligation tn oss (other than the option premium paid) because the option recognized as liability items. There are strict losses is allowed only if the different transactions
option's value for an out- ^ ^ option when it is out-of-the-money (or at-the-money). Thus, the statement of financial position. Netting o ^ offset with proper legal documentation and if
option has not exnired tb at-the-money option is purely its time value. As long as an are with the same counterparty, if there is a ej,
From an option buver\ r, ^ option may move into an in-the-money position. there is an intention to offset. quality. The credit risk of the counterparty defaulting on a
negative intrinsic I contract can never be a liability, that is, it can never have a Fair valuation of derivatives factor m inception gain is termed credit valuation adjustment
, Vfl/we or a negative time value. derivative transaction when the entity has a p j.gporting entity defaulting on its derivative transaction
liability until it expires opposite. From his perspective, a written option is always a (CVA). On the other hand, the credit ris' o^ ^gj.j^ed debit valuation adjustment (DVA). As CVAs and
the option writer recmm" ° a ^^^^e option stays out-of-the-money during the entire period, when the entity has a negative are calculated using a variety of methods such
or at the expiration of ^ uction m the time value component as a gain during the option period E)VAs are tied to the values of the derh atn DVA calculations to the Basel capital requirements,
(knock-in, knock-out) h'inary,
^ thecombinations
plain vanilla (straddle,
call and put options are barrier as simulations. Banks also tried to link t le futures, and options contracts under the default
sian, lookback, and other strangle, etc.). Table 10.4 summarizes the ^ j contract, a futures contract and an option contract are
assumption. The accounting entries tor a
Determining the Fnir .r ^ ^ shown in Illustrations 10.2, 10.3, and 10.4, lespectivey.
quoted price is normall i i ^ Option Contracts If an option contract is traded on an exchange, the
even if it is traded b ^ ^ represent its fair value. However, if the option contract is not traded, or
theory has simnlir thinly, the fair value may have to be obtained through other means. Finance table 10.4 Summary of accounting for derivatives
an option contract TV, u u
i"elationships
,
in useful ^'loueis
models that enable to determine the fair value of Option contract
vvv.H.lc T. ,
models. In a eti,, thepath-breaking
fair value orBlack-Scholes modelisisaone
price of an option of the ofmost
function fivewidely used option
key variables, pricing
namely the Forward contract
Futures contract

Purchased option:
volatility of the underlyi
underlying (price f to expiration, the risk-free interest rate, the strike price, and the Dr Margin deposit Dr Option contract (asset)
of the Black-Sch 1 ® ^option
^ optioned item). It is beyond the scope of this textbook to explain the derivation At No journal entry as fair value of Cr Cash Cr Cash
pricing model. inception forward contract is nil
To record payment of initial Written option:
can d^er from\h^"r options. In practice, the implied volatilities margin deposit.
Dr Cash
ptions have h' h Black-Scholes option model. The in-the-money and out-of-inoney Cr Option contract (liability)
°sk averse to e t
" ., , , .
volatilities than the at-the-money options probably because the traders are
P"ce movements. This gives rise to a graph the shape of a smile (typically called volatility
To record option premium.

"irnphed volatilities are plotted against strike prices. {continued)

1
 r ,c n

r
833
832 ADVANCED FINANCIAL ACCOUNTING
accounting FOR DERIVATIVES AND HEDGE ACCOUNTING

TABLE 10.4 {continued)

ILLUSTRATION 10.2A Accounting tor
tor a forward contract (profit)
Forward contract Futures contract Option contract
- ,ard contractniaturity
Assume that in Illustration lO.l, the tons a
was entered into for speculative purposes. The journal
are as follows:
During Purchased option:
life of entries to record the transaction from inc p . 4. t ■ nil nt inceotion
contract
Dr Forward contract (asset)
Cr Gain on forward contract
Dr Cash/Deposit
Cr Gain on futures contract
Dr Option contract
Cr Gain on option contract 1 Mar 20x5
, m be
No entry need to o
recorded. Fair value of forward contract ,s ml at mception.
9,917
Or Or Or
31 Mar 20x5 D"" Forward contract. • 9,917
Dr Loss on forward contract Dr Loss on futures contract Dr Loss on option contract
Cr Forward contract (liability) Cr Cash Cr Option contract
To adjust fair value of forward To record dally settlement To adjust fair value of 4,938
contract and record gain/loss. of futures contract. option and record gain/loss.
30 Apr 20x5 Dr Loss on forward contract... 4,938
Written option:
Similar, but when there is a gain ^::;::^::^i^rva,ueoffo;^^^^
on the purchased option, there 10,021
is a loss on the written option.
30 May 20x5 Dr Forward contract. " 10,021
Closing of Purchased option:
position 15,000
Dr Cash Dr Cash Dr Cash*
or at
Cr Forward contract Dr Loss on futures contract Cr Gain on option contract
DrCash
expiration
Cr Margin deposit Cr Option contract Cr Forward contract •
of
contract Or
To close forward contract on maturity.
Or Or

Dr Forward contract Dr Cash Dr Cash* Entries in practice:

Cr Cash
To close out forward contract
and record net settlement of
contract.
Cr Gain on futures contract Dr Loss on option contract
31 Mar 20x5 Same as above
Cr Margin deposit Cr Option contract
9,917
To close out futures contract
and recover margin deposit.
* It is assumed that the option
expires in-the-money. If the option
30 Apr 20x5 Dr Gain on forward contract (P/U " '"'"' ' 9,917
expires out-of-the money, no Cr Unrealized profit on forward contract (Asset)
entry is needed as the time value TO mverse prior period fair value of forward contracts.
would have been expensed off.

Written option: Dr Unrealized profit on forward contract (Asset) 4,979

Cr Gain on forward contract (P/L)
Dr Option contract TO record current period fair value of forward contracts.
Cr Gain on option contract
(option expires out-of-the- ^ ,p,, ^ 4,979
money) 30 May 20x5 Dr Gain on forward contrac ' . _'" ,Accpt)
Cr Unrealized profit on forward contract (Asset)
Or
To reverse prior period fair value of forward contracts.
Dr Option contract
Dr Loss on option Dr Unrealized profit on forward contract (Asset) 15,000 .,5 qoo
Cr Cash (option expires Cr Gain on forward contract (P/L)
in-the-money) To record current period fair value offorward contracts.
15,000
Dr Cash j5,000
Cr Unrealized profit on forward contract
To close forward contract on maturity.
834 ADVANCED FINANCIAL ACCOUNTING
accounting for derivatives AND HEDGE ACCOUNTING 835

31 Mar Dr Cash 130,000

ILLUSTRATION 10.2B Accounting for o forward contract (loss) Cr Margin deposit 80,000
Cr Gain on futures contract 50,000
Assume that in Illustration 10.1, the forward contract was entered into for speculative purposes, the fair
values of forward contract on 30 April 20x5 and 30 May 20x5 are -$I,000 and -$8,000, respectively. The To record gain of $50,000($50 x 100 x 10) on
futures contract and to close out futures contract and
changes to the journal entries are as follows: return of margin deposit.

1 Mar 20x5 No change.

Note that in practice, movements in the margin deposit account are recorded daily.

31 Mar 20x5 No change.

ILLUSTRATION 10.4 Accounting for an option contract

30 Apr 20x5 Dr Gain on forward contract (P/L) 9,917
Cr Unrealized profit on forward contract (SFP) 9,917 A hedge fund decides to speculate on the share price of Worldwide Enterprise whose current market
To reverse prior period fair value of forward contracts. price is $38. It simultaneously purchases a put option on 100,000 units of the stock with a strike price of
Dr Loss on forward contract (P/L) 1,000
$35 at a premium of $1.50 per unit, and a call option on 100,000 units of the stock with a strike price
Cr Unrealized loss on forward contract (SFP) 1,000
of $41 at a premium of $1.50 per unit.^ Assume that the stock price of Worldwide Enterprise rises to
To record current period fair value of forward contracts. $43, at which point the call option is in-the-nioney witli a market price of $2.95 per unit. The put
option is deeply out-of-the-money with a market price of $0.50. Capital Trust decides to close both
the options at the prevailing market prices. The pay-offs to the option buyer and the option writer are
30 May 20x5 Dr Unrealized loss on forward contract (SFP) 1,000 as follows:
Cr Loss on forward contract (P/L) 1,000
To reverse prior period fair value of forward contracts.
Call option Put option

Dr Loss on forward contract (P/L) 8,000

Cr Unrealized loss on forward contract (SFP) 8,000 Option buyer:
$ 295,000 $ 50,000
Fair value
To record current period fair value of forward contracts. (150,000) (150,000)
Less premium paid
$ 145,000 $(100,000)
Dr Unrealized loss on forward contract (SFP) 8,000 Buyer's gain/(loss) on option at closure
Cr Cash 8,000
Option writer:
To close forward contract on maturity. $ 150,000 $ 150,000
Premium received
(295,000) (50,000)
Less fair value of option at closure
$(145,000) $ 100,000
Writer's gain/(loss) on option

ILLUSTRATION 10.3 Accounting for a futures contract

On 1 March, Capital Trust speculates that the price of gold will increase and purchases ten gold futures Overall, the buyer of the options realizes a net gain of $45,000 from the two options con o^the
contracts at a price of $800 per ounce. Each contract is for 100 ounces of gold and the maturity date is of $145,000 from the call option and a loss of $100,000 on the purchased call option. T e p „ of a
31 May. The futures exchange requires a payment of 10% of the notional amount as margin deposit. On option writer is the opposite. He incurs a loss of $45,000 from the two written options c p
31 March, the price of gold increases to $850 per ounce and Capital Trust closes its long position. The loss of $145,000 on the call option and a gain of $100,000 on the put option.
journal entries to record the transaction are as follows: The options are accounted for as fair value through profit or loss (FVTPL). The separation betveen
time and intrinsic value is not important for speculative trades as changes in both the time an
1 Mar Dr Margin deposit 80,000
Cr Cash 80,000
To record the payment of margin deposit on ten gold
futures contracts.

This strategy is called a straddle.

836 ADVANCED FINANCIAL ACCOUNTING accounting for DERIVATIVES AND HEDGE ACCOUNTING 837

values are taken to the income statement if the instrument is accounted for under the PVTPL category. The hedged item and the hedging instrument are measured using different bases, for example, the
1.
The following journal entries are recorded in the books of the buyer and the writer of the options. hedged item is measured at cost and tlie hedging instrument is measured at fair value. This is a
consequence of the mixed-attribute accounting model that entities generaUy adopt.
Option buyer Option writer* 2. The hedged item is yet to be recognized in the financial statements.
3. Different treatments are applied to changes in the fair value of the hedged item and the hedging
At inception Dr Call Option
Dr Put Option
150,000
150,000
Dr Cash 300,000 instrument. For example, changes in the fair value of the hedged item are taken to other
Cr Cash 300,000
Cr Call Option
Cr Put Option
150,000
150,000
comprehensix-e income while changes in the fair value of the hedging instrument are taken to the
Purchase of options. Writing of options.
profit or loss.
Consider the following situations;
At closing of the Dr Cash 295,000 Dr Loss on call option.... 145,000
option positions Cr Call option 150,000 Dr Call option 150,000 1. A FVOCI/AFS security is hedged by a derivative. Both the hedged item and the hedging mstru-
Cr Gain on call option . 145,000 Cr Cash 295,000 ment are carried at fair value. Changes in the fair value of the FVOCI/AFS security are deferred
Dr Loss on put option 100,000 Dr Put option 150,000
in other comprehensive income under IFRS 9/IAS 39, and are recognized as a gain or loss when
Dr Cash 50,000 Cr Cash 50,000
the FVOCI/AFS security is disposed of. Under IFRS 9/IAS 39, changes in the fair value of the
Cr Put option 150,000 Cr Gain on put option . 100,000 derivative are taken to the profit or loss.
Closing out positions on options. Closing out positions on options. Althoucrh there is a hedging relationship, there is no offsetting of gains and losses on the
hedged item and the hedging instrument in tliis case. To reflect the effectiveness of the hedge,
It is assumed that both options are written by the same party. hedge accounting rules requires the recognition of the change in the fair value of the hedged item
(the FVOCI/AFS security) in the profit or loss to offset the change in the fair value of the hedging
instrument in the same period.
2. A entity enters into a non-cancellable contract (a firm commitment) to purchase an asset at a
fixed price. The transaction will occur at a future date. The entity faces the risk that when the
firm commitment is fulfilled at the future date, the price of the asset might have decreased.
HEDGING Thus, it will have to pay the agreed price when it could have paid less if it had not entered into
the firm commitment. So, the entity enters into a derivative transaction to hedge the risk on the
The purpose of hedging is to neutralize an exposed risk, for example, by transferring it to a third party,
commitment. The objective of the hedge is to offset any loss on the firm commitment with a
corresponding gain on the derivative.
and to reduce the volatility in earnings. When hedging is effective, a loss on the hedged item is completely
or nearly completely offset by a gain on the hedging instrument. Hedging is more likely to reduce volatility
However, under conventional accounting treatment, the commitment is an executory contrac ,
than to preserve gains, particularly when instruments with symmetrical pay-offs are used. It is this offsetting
and no asset or liability is recognized in the statement of financial position until the contract
effect that reduces the volatility in reported earnings. While the focus here is on the use of derivatives for
is fulfilled in a later period. On the other hand, changes in the fair value of the derivative are
hedging purposes, it must be borne in mind that there are other ways of hedging that make use of non-
recognized in profit or loss under IFRS 9/IAS 39 under the default treatment. Without e ge
derivatives, such as money market instruments (called money market hedge), and natural hedge, such as
accounting, the gain (or loss) on the derivative will not offset the corresponding loss (or gam) on
the firm commitment in the same period. rture
offsetting foreign currency assets and liabilities denominated in the same currency. Where derivatives are Hence, to reflect the hedging relationship and the effectiveness of the hedge, a major depa
used for hedging purposes, a set of special accounting rules called "hedge accounting" applies. from normal accounting rules is required. Under IFRS 9/IAS 39, changes in the fair va
In IAS 39 and phase 4 of IFRS 9, assets, liabilities, firm commitments, and highly probable forecasted firm commitment attributable to the hedged risk are recognized in the income statemen o o
transactions with external parties can be designated as hedged items (paragraph 6.3.5 of IFRS 9). The the opposite changes in the fair value of the hedging instrument. An example on the accoun mg
hedge accounting in IFRS 9 (except for macro hedging) is effective for annual periods beginning on or treatment for the hedge of a firm commitment is given in Illustration 10.8.
after 1 January 2018, but earlier application is permitted.
Without special hedge accounting rules, the effectiveness of the hedge will not be reflecte
financial statements, resulting in an increased volatility of reported earnings that is contrary to t e e
Rationiale for Hedge Accounting effects of an effective hedging arrangement. Before discussing the procedural aspects of hedge acc g,
4 he need tor special hedge accounting rules arises because under conventional accounting treatment, there it is important to examine the following issues:
are certain situations where the income-offsetting effects will not occur in the same period as the gain (or 1. What risks qualify for hedge accounting?
loss) on the hedging instrument will be reported in one period and the loss (or gain) on the hedged item 2. What financial instruments qualify as hedging instruments?
in another period. The following are the situations that require hedge accounting. 3. What items qualify as hedged items?
 839

Acco
risk besides
besides int
int erest rate
838 ADVANCED FINANCIAL ACCOUNTING

Credi c Ri s k Hru« bt»«Vsecufitlf^'^^ ^Thulds a deb(i s sued ZHf

by Fi r m Jr^^t
Z wdl
risk. The credi, mfiFS 'yor examP'- ' C grade, risk affects the fair value of
RISKS THAT QUALIFY FOR HEDGE ACCOUNTING of the securities issued by ilj" ^ gg 8'f^Tfeed) """ „ , ,,
rating of Firm Z is " flmrs, .nc risk although it is possible
For hedge accounting purposes, the risks that are hedged should be specific risks and not general business decline significantly thorc ' ,,te,ed cas' 3, a speci """(.("hThedged item may
risks. The specific risks that qualify for hedge accounting are interest rate risk, foreign exchange risk, a finaucial asset as udl - > ^.t,:be h"d =d U -suit in hedge
risk, and credit risk. Typically, a deiu^ gxa' ^ .„ed is , non of the risk to :„vests in a fixed rate
<0 hedge more than one ,3 be ,peci m ""'"(.gVinvesment is exposed to interest
Interest Rate Risk Interest rate risk takes two forms. First, changes in interest rates affect inte•rest 'S important that tlw n- .^hose fbn ^pmpany. This mterest rate swap
payments or receipts on variable (or floating) rate debt. This affects the cash Hows of the issuer (as ^e Incorporate more than on ^ conT^"^ by hedges the , hedge may not
ly lieno nui. be
lxv, effective as the
investors of this instrument). Second, changes in interest rates affect the value of fixed rate debt Ineffectiveness. For " f die ofof the bond,
the bond, the ^ interest rate,
.^^erest rate, aa change
change
bond denominated m
t^ond denominatecl credit , fair val^e ^ change im the Bri British company s credit
carried at fair value The carrying value of the fixed rate instrument varies inversely with interest
Adjustments to the fair value of the instrument affect the profit or loss (unless these are classified a' oatande rispecifies
sk, currency ■ r.t clytirciVrtlrh^
the^u-s 0^' "yi
h-nHC ^ , P-tbeVh^f^bVnges
the ho.a ...id th q,, the o
in tbe farr value of .be
Qn
to-maturity or available-tor-sale).
change in the fah ' .he dollih,".,.,
J^en the
tn the exchange rate be . of hrtee r.
Foreign Exchange Risk As discussed in Chapter 8, changes in foreign exchange rates affc'^^
the I'atino
;"ki.ig, r^,-
or ac,a con-.-
"ating, or rnnibimh'ea'
combimfi^"-^'^ •. ^-rily tl
following: interest rate swap ict ee [OMEftS
Monetary items, for example, accounts rereivaKio f cvminate'^
QUALIFYINGHEP^L-- ti-unaeA^PC inclnhe-.fit or los®; except^f forto. . written
1.
r • currencies.
foreign • TuThese uhave to .be adjusted
receivable,
for accounts
,-L pavable ana
F''yaDie> and loans
loa denonmj-esult'"^„ some written
wiac-au options". IFRS 9
exchange gains or losses are taken to the profit or loss^"^^^ exchange rates an options rio
do not
fit 01 not qualify
qualify t written opuui.o .... x .

)Under IFRS f>, qiiaW"'

(fvin» Ii- "*®', ,t"®fu""".alu' . as» hedges bn n
2. Securities denominated in foreign currencies A
exchange rates affect the fair value of such sen "u '^^^^"red at fair value. Changes the alityn'- vaw ' "°"®ll™stFRS 9)- Dcrivabve embeddedinstruments^
in hybrid financial
profit or loss if the securittes are dassifmd" mpi TeTc""ities measured ' the n of not measured at fair value through
(e.g. bond instruments). However, the exchanop • monetary available-for sa fah
^ f certain tc'h^ ^ aragt^ ^^oaucial Uabd recognized
value changes, and are taken dirictl^i; o of ^
monetary assets (i.e, equity instruments) and ciSfed t"FVnrT°""
^
'
iOn'
""7) °i g"that^^-^
^^hedg'^g «»■'""" mass^^^'i
• '< o"-''"'' b fak withfah^
written
instruments curanci' . aiiCia' " , -nv instruments. However, adoes not
3.
Entities With foreign operations are required to tra 1
subsidiaries before incorporating them into th financial statements of t n r ovef^^'
;eas
(b) Non-derivafi
profit or loss
for , ,ion a«'<rr;rop'- - ^
4.
result of changes in foreign exchange rates ^
Future transactions that are firm commitments o
accounts. Translation differences a
K A n
r:;h:;co-p«7,inF^»''
^ xu.v ronipt^'
, ,b) couW," ,„getba
" fives

currencies. When these transactions eventually talL^ 1 transactions denominate iffe';Ct coth ta; aif>- - j op--

the future cash flows of these transactions ^^ changes in foreign exchange ra C'ption and a prrrc^' .^^gtrnfa^'
finalify as a hedging ^
■ct
Market Price Risk Entities transacting or investing in com n-
to price risk. For example, entities in the transport industry fa financial securities f i.ev/4 at; an oiibci IV. - f

entities with short^ or long-term investments in financial of volatile fuel oil pncesare rneidt ^
w»" r;"; o.i»
, viy dcsig'd
■
to fluctuations in the prices of the financial assets. Price rTk carried at fair value a or jo'" ,,e not permitted to be biturcated
vviill ..fy as hedg'tS \ through profit or loss and designated as
commitments. For example, a gold mining company's inventorv ^o pFich opd''":„,dnot'l^^ismefiWred^tttair
in turn affect the gross profit margin when the gold is sold If m ^ P"" A coi^iiiaJittc^ A' written
vvimcii option
not qa
^
„c oiie
oP ^"" :t ,aa n^t
a portion of its gold reserves m forward sales, the fair value f t company had '-tirnbined with au pan-tt'
- ..iuinea wun t- ,n -
,n , pi
i uybn
by movements in the price of gold. ° ae commitment would also at that combination is ^pibedabe P"'.( ot
' tn particular, denvat'|^ '^'"Vretyi
tttider IFRS 9 (althoug gn i
ii ^t>e hedging instrume"' '
 A 1

'H

,gOkD®VAT,VESAbDHbOCEACCOCNT,NC 841

ACCObtTIf
AA-- y, receivable between
840 ADVANCED FINANCIAL ACCOUNTING anelary , fi .tatements if it results m an
, f an intt»S'»»P consolidalion. In addition,
tha, the foreign crirrencv ri* ; it'" fall, el»n.nj ^ „iremenr is also unchanged
The contracts must be with parties external to the reporting entity to be designated as cjualif) ^
hedging instruments. Hedging instruments are required to be designated in its entirety in ^ hedg
t»o snbsidiarles would c,m'ltlV ' „ loss" f ineasinof"- Tl""
relationship except for the following:
'xposure to foreign ® liedge't to ^ ^ g exposure that is a o'"-")'"''"""
IFRS 9 requires the it'"' ° allo« ,he above
(i) Changes in intrinsic value, and not the time value of an option can be designated as the
IAS 39 is ilen, "J^tpUs an in
hedging instrument.
(li) Spot element, and not the forward element of a forward contract can be designated as th^
hedging instrument.
ofa::'x;:;:f:w'»t;;(;::fhedy'';
tlerivative m.iy be ' "'®[!,''(' „pany ^ i) aS"'®' '"'arreticy of e^ffee can be viewed as a
(iii) A proportion of the nominal amount of the entire hedging instrument may be design"!'''!« exposure. Specitically. • g ,tanS' fooctio"' p ^res contra ^ „ gedge using
hedging instruments. IS months rnne (i." '"^"tsnnae ;;^t osure for Company
For hedges of foreign cnrretrcy risk, IFRS 9 allows the foreign currency risk component of "H fnures conrrac, .(probable '
derivative financial instruments that ,s calculated in accordance with IAS 21 to be designated as hedg"" eombination of the h.gbt) I |ur (<>« " g,
instruments. For instance, the entity which is hedging a foreign currency risk m a forecasted sale trans"" I-raonth fixed-amonnt US^^^ ,5 n>e»
15-

in the next 24 months can designate a 2 year loan that is denomiLted the same currency "S forward sale contract o
forecasted sale as the hedging instrument. However, hass --
elected to 1 only if-
, . r ■ 1 • instruments for which the entity of Group
present changes m fair value m other comprehensive inrrMoo i iji wmcn i ■.nctriiment '
a Ihedge
t oofr toreign
ledge r • currency risK.
foreign • I TU
risk. E'ciiensive
tne rationale
The is thatincomef ' does
the fair valuenotchqualifv as
as aanot
nges are
loamy hedging
b & instrm
i recognised^ m ^ron group of items
' tn liable h^dg^^ ,,sh flows not proportional
or loss and accordingly, it is inconsistent with the arrnnmf , "^"ges
accounting mechanics of fairare notand cashflow
value b jiedgo^
(a, Each ,.e,n 'inJ^ej;„„
' a tUV
a basis fi^' -tems with varia
.ff^oreiS";tr"ei«"l fransacions are designation
expected to ofafftheec,
^^ ge. .he overat. group of
QUALIFYING HEDGED ITEMS
to overall cash fl» ,„e foP jfRS 91 ,e,ed as a h S Igy
tiprotit
e. positioicw-
n spee- « repi, A"gi. ' ^ posit- b the be -""F^ytme hedge ora cash flowo hedge,
o fpir value acugx.
Paragraph 6.3.1 of IFRS 9 sets out the items that rnnlrl c i f c of hedg^ profit or losA IP" , gi v es a " gos.t »■ g^gge i s . ^j„ed item if g
h is , hedge
f^^dge of foreign
"f" '((pciidsfon"""":: -h'S and volnine and the reporting
fitenisi ,.,qoinA whsi .. uUp as a heag , _.„i„^p pnd the reporting
accounting. These include: Sfalify as hedged items for purposes ot When the gronP " "" '
1. Recognised assets or liabilities; 'lenis rather than a n"' g iteif gjui "
2. Unrecognised firm commitments^ "^f net position as a h^dS^
ne former ehgn ^gsigi^ •on "SectP^'
. US cligihle
't he''8""r
. ^,jg,ble f hedge accounting if:
d'he formPi- is eligifl^^ ''r .aairatio'
3. Highly probable forecast transactions^ with exnnc.
4. A net investment in a foreign entity.
. .
changes in future cash flows,
. ymd
-FAiiency risk
"^nrrencv risK and
aac -
-A:;Ui''»=feiig.««'':digi''ie
^ ^-ans
:c«»" is
. ,
period when the
, Ccvi-eC
^eligi :bleg"""'.!!,>"" liably
All the items that qualify as hedged items can be a r f itc'^^ A(
component is a hedged item less than the entire item ^"ch an item or group o ax •
piupciEv.x.-
A proportion of an oneiitp of- a
o
■i ecive, A layee cofoP
Obi lai-al^^^'
.raiel*
-den
■'<dge'lay®""■ke'^ SffierS »P°-^ "
entire item
item oror only
only the risks
risks toto some
some extent
extent . Tui
The ..r'
T '^ocnponent reflects only some of 1 , jji is -ommitment), the overall group can 'be
that entire
contract or implicit in the fair values or cash flows of that^ '^"^Ponents could be explicitly ,i iy (a) the eo»!P''"„'-"(Sohiea'Ahefe
°yfoe"' *„'lp
gronp «' :ecogiii^^'
,d firm
specified risk .components respectively). An examnU of^c
example r non-co'
item (contractually and non-coO g;r^S (b) the risk nia""8 ^^^,."11
ovel' « uni'
an
ffecting different profit or loss line items
oil component in a long-term supply contract for naturaU^^T^"^^^^ specified risk componeoj
• _ 1 u I O' contractiipll,,

formula that references commodity prices. As the gas oil c ^

;r- , • , .-lent H ficO
.r.,

P^ced using a contractually^

: ibiy (c) the items m
or
wis (e -S'
itena^
isk "rfpreSed in a line separate from those
measurable, it is a risk component that is eligible as a h separately identifiable an a® (d) for a hedg^ ^''cked^ q ^vitP1 offs^^'
! infi ^g®^"
^ins or
hedged items, there2 are
are certain
certain requirementQ
requirements tLnt
that must be^^ ^em. For a^ group of items to ^ j^elo^' identified and
As with IAS 39, IFRS 9 further stipulates that for purp!^^^ discuss this in more inIII' For a hedge of & -j^coir^®'
be with an external party before they qualify for hedge ^edge
ge accounting. Theaccounting,
exception tothethisitems a«
requF^ iiA other compreb^'^'^^j.j.j
Other comprt"
effected by hedged i

dc"
" A firm commitment is defined m IFRS 9 as a binding agreement for the e k ■d P
a specified future date or dates, ^"change of a specified quantity of resources a* " Fleci fie

A forecast tran.saction is defined m IFRS 9 as an uncommitted bu, anticipated future

transaction.
 843

ADVANCED FINANCIAL ACCOUNTING

hedg® contracts that have a contract

taUSTRATlON 10-5; Designating cojfe (equivalent to
Coffee Ltd hedges 100 tonu^sq ofof coffee ^otfee can onlvoly use
umeei^er t,ty
CRITERIA FOR HEDGE ACCOUNTING
of the standard
The qualifying criteria for hedge accounting (IFRS 9 paragraph 6.4.1) arc as follows: ®.e of 37,500 lbs lP";(Utb«ly) to enter into that exact quant,ty
^5.0 and 102.1 tonnes rcsp tortuc „ (^oiie
(a) Hedging relationship consists only of eligible hedging instruments and eligible hedged item^^ , that It determined as the bed joeses " j ratio
ratio that results jom
that ^"uhs frorn the
(b) At the inception of the hedge, there has to be formal designation and documentation 01 ^
hedging relationship, risk management objective and strategy for undertaking the hedge- IH yolu^TriTfofiee fuUh--^
ui Uiv:

requires firms that apply hedge accounting to disclose their risk management strategy, hedging instrument (a
manage risk, the extent of risk exposures that are managed, how their hedging activities attee In ,h,s case, ^ lv
f^„„„acts .b» '^,,„.tch
T td it ' . .ug
,„oun.,ng
o
„eiBhttugs,
that is incoiii>i5>Lciit

uumber of coftee tutuic ,s' result

amount, timing and uncertainty of cash flows and the effects that hedge accounting has
the firms fmancial positions and financial performance. In addition, firms should descnbs some
—w hedge
ttckigc itttu-t.-.-. al reason for futures
neffectivcue-s^^^^ case- ^ulhjg ^a val^ita commercifutures canP be contracts
futures customisedasas totobed
contracts hedging
i
meet
hedging ins rumen s used to hedge risk exposures, how the economic relationships bet"« j UTstrument
'Wtrument. Howevek
However ui as t qrat the^
the ^orth o„ e fireffectivenes ta
i„effeniveuess
hedging instrument and hedged item are determined and how the hedge ratios are detc""" purpose of hedge va
and the sources ot hedge ineffectiveness fnaraarc^u -rt a cat
fe e Ltd-s requiremeid
--iree Ltds recfuue...^
.w.
ptu - is tbctefo^^^L
isllnt XtTmposl S'hedge
would have m he^ed ^^e
(c) The hedging relationship meets all of the followinehed ' rnstru ments. However, nf 0-^^ ec- ,-tivencss A e ratio wouiQ udvc lax
(r) Economic relationship between hedg d tlm Id l'V requirements. <bis case, this hefige rat.o
tk:_ . . , J„.u ratio 01
.neb^;:::
.^Hfectn
(ii) Credit
Credit risk
risk does
does not
not dominate
dntqnimob. the value changes fronf m '
mstrumcnt;
(hi) Hedge ratio of hedging relationship is the s •h of he<^8^
item that an entity hedges and the'quantitv^ork T Ls to «ot,nti„g; AccorchnS'V. fot»-" great" —^ profit or loss-
that quantity of hedged item. For example instrument the entity t o b^dge ratio of 1:1
a financial instrument, the hedge ratio is h' " hedges an exposure using an jU the fair value ot to ^ instrument in an
the quantity of hedged item that it bed hedging hedge ineffectiveness ^— ^f hedge perf are rebalancing. On
,o ik co)rela.io„®ra,io td .,natedid hedge f f^X'Teiationship. Rebalancing allows
tests under IAS 39 are no longer requn''
The economic relationship between hedged item and h n • • have vi"-
tho ""f hedS' 'Tre adjtn'M h g i„s)
that generally move in the opposite direction due to the ^ §'"8 instrument means that they Changes that aiC ' ro reco8'g»'' ^«^ljps
^ betvee" *Lr/;;i,gn
foreign cnrreucy
c^trenc^ deriva.ive
pegged,,s when
to he thege
but are economically related, there is a possibility that th!™^i underlyings are j jte'^ ^^Isting hedge telat^® ^r ^^,atioU examP^^j^^ currencies effectiveness.
move in the same direction when the price differential kT hedging instrument changes
J gg \vh'^^ ''balancing, hedge in |,,,„ges jtruO"^ g and ^balanced to nt
the underlyings themselves do not move significantly I related underlyings c ainstf--^l,at
i-uni^
die entirv respond to <« be ' fluctuations arouuO 6 ^
—dgn current - - ■w-
^i^aFg^^''"techaFS' get off^;f
it isUse ratro can reduce
and hedged item are expected to typically move in the ^ ^ values of the hedging iTiove ce the latter,
is still consistent with an economic relationship betw^! directions when the underlying^ ,ten

of an economic relationship depends on the possible b i ^ ghtg 'nscrument

instrument and
and hedged
hedged item.
item. T^ ^ ^gj-
fpi' hogged exchange t' „naly^ un fO .uveue^s- ^ .,^y
6 5 -14)-
whether it meets the risk management objective. ^viour of the hedging relationship during T''matnvalidorthatd'
hee.a,,,y„,llueed ;,rrdg'/;°ln'^^^^^
asb'jS IrsBd
to "■

The credit risk may dominate the economic relation h' k d thedg
item. An example is when the increase in credit risks^ f^ between the hedging instrument an^^^■ivatiiV^ "cognizes .he fl"0"'"°pRS 9 P" ®
dominates the changes in commodity prices. When that h 'Counterparty to a commodity .be dg^' hedge ineffectiveness
Item
item and hedging instrument may go away. ^ ^ppens, the level of offset between t
The hedge ratio from the quantities of the hedging instn m not
lalance between weightings
imbalance weigntmgs of
ot hedged item and hedginn
hedgin ' hedged item shou^^ ..^eF
inconsistent with hedge accounting. For example, if the'^! '"^^'"ument that creates hedge lit

does not allow it to hedge the exact quantity of hedged it volume or lot of hedging we.^'^
,^nti S 4
of hedging instrument and hedged item is not inconsi t' commercial reason for the
illustrates this. hedge accounting. B6.4.l(h)
 nPOkOHk.VAT.VhSAAOHBOCEACCOU.™c 845

-rniJNTlNG FOK
ACCO"''""' ^
aes attributable to the risk being hedged
844 ADVANCED FINANCIAL ACCOUNTING 1 for fair value chaiio adjustment will only take
t is made only fo , for all risks a ^ financial
value as the i.e. » - Jcoun.h'8f carrying value is amort,sed to
(e.g. foreign eui rvhich ° adjustment ' ^joi instrument.
CLASSIFICATION OF HEDGING RELATIONSHIPS 1,L. fornenlthecarr.ed
J-^rlrtised
at an
^ e teres. for
rffed » ^ ^ commit
^e i„ rhe
^^^^t or a
IFRS 9 categorizes three types of hedging relationships: or loss using » "■ecalcEW'l
^ ,ii, v*'ddge
^ ^gleis ato.r«th'"J y recogn^ed
httd.' „,he firm commUment
3. ...... the hedged't'" „,itmeot ,recognt®) ,L cumulative change in the fan
When
1. Fair value hedge;
fa,r value of the f.rn. g ga.» „cr,rrence ^ cn,uun. of the asset or hahrhty
2. Cash flow hedge; and
habihty with the asset or .be .mttal
3. Hedge of a net investment in a foreign entity. .sf„i. ,heacquls,..o;;„cn.t>»'""^"
In the following sections, we will describe these three types in detail value of the tum o
when the commUit""'
when tne cu.

FAIR VALUE HEDGE ACCOUNTING

^'GURE 10.3 Accounimg ^
Afa,r value hedge ie a hedge of"the exposure to changes in the fair value of a recognized asset ■ liabilf^y
an unrecognized Arm conrmitment;or an identified pCrtioii'rf'sulh an asset htbihly w nm coh-m'^^jee
on nnr/:»mam7Pn Tirm commitmpnt nr ji _ o
lit'
Change in fair value
which is attrtbutable to a particular risk and could affect profit or loss" ExamDlel of a fair " or liabllity^^L.^
include, but are not limited to, the following; '
1. Hedge of FVOCI security; Chang®
infai""'"'
stateiment u rnent
2. Hedge of a fixed rate investment; inclOlU® instr
dging
3. Hedge of inventory; or (loss)on I
on
h edged item
Ga'"^ (gai
4. Hedge of a firm commitment. loss
off5®^
A firm commitment is "a binding agreement for the exchano. r- . • f resources'
specified price on a specified future date or dates."
date^" Aa had ° ^ specified quantity ofair^ value -
because the commitment carries a contractual obligation m commitment is a poSC'
ses " ''"^'rhange in fair value adjusted
enterprise to the risk that a change in the market price will r "l I comm't^^'w "statem®"' ^^gainst carrying amount
B6.5.3 of IFRS 9 clarifies that a hedge of the foreign currencv r'T r IH ,
be accounted for as a cashflow hedge. Fair value hedges are typically
of a firm commitment
hedges coulrate exF
against fixed pxpusO'
Chang®'
_,inS

Accounting for a Fair Value Hedge

The accounting procedures for a fair value hedge a<; ruarri2^^ -ate
as follows (see Figure 10.3): Paragraph 6.5.8 of IFRS 9 are su
The
The following ^ i<' trati'"' ^ fVOCl ^ ' g)
The change in the fair value of the hedging i
value of the hedging instrument is adjustedlor^r^"^
rtf c
n ca*"
profit or loss; t e^^ ^\i\ , f an i.ee V '^^Itiotr
requirement is when the hedged item is an equh i ^ in fair value. The ^''^oepRO
in other comprehensive income. In this id
ef ;4. sTrW>'
Hedge of a '
is recognised in other comprehensive inrnr.x' ^ on the hedging ^ pth^
'
comprehensive income. ^ allow the offset to be carried out
The gain or loss on the hedged item attributabl \o^^'
,fit or ^
The carrying amount of the hedged item is aTu ^'^'fged risk is taken to the pr^' paU ^
"basis adjustment." Basis adjustment applies everh'^ amount of gain or loss. Thi^^ if
for example, inventory. What this means k n, I hedged item is otherwise measun^
« 'hat
the case of a fair value hedge may result in the
tb L ^
adjusted carrying value of the *-hedS^„„r b>
rallying vaiue oi
^ edged item being carried at neither COi St
846 ADVANCED FINANCIAL ACCOUNTING
ACCOUNTING FOR DERIVATIVES AND HEDGE ACCOUNTING 847

31 Jan 20x5 Dr Cash 183,500

ILLUSTRATION 10.6 Hedge of on exposed monetary asset Cr Forward contract 1,500
Cr Accounts receivable (FC) 182,000
Gemini Enterprise, whose functional currency is the dollar, sold merchandise with an invoice value of Settlement of accounts receivable and dosing of forward
EC 100,000 on 2 December 20x4 with payment due on 31 January 20x5. The spot exchange rate on that contract. The accounts receivable is settled at the spot rate
date was $1.85/FC 1. Gemini hedged the exposed accounts receivable by entering into a forward exchange at settlement date (FC 100,000 x 1.82).
contract to deliver (sell) EC 100,000 on 31 January 20x5 at the forward rate of SI.835/EC 1. The exchange
The settlement amount of the forward contract is the balance in the forward contract account. It
rates between the EC and the dollar are as follows;
can also be checked by multiplying the notional amount with the difference between the contracted
forward rate and the spot rate at settlement date [FC 100,000 X (1.835 - 1.82)]. In this situation, there
Spot rate 31 January 20x5 forward rate is a receipt due from the Innker because the contracted forward rate is higher than the final spot rate.
The net cash proceeds of $183,500 effectively locks in the overall settlement at the forward rate of 1.835.
31 December 20x4 $1.835/FC 1 $1.825/FC 1
31 January 20x5 $1.82/FC 1 $1.82/FC 1
There is a loss of S3,000 on the accounts receivable that is partially offset by a gain of $1,500 on the
forward contract as a result of the depreciation of the FC against the dollar. The difference of $1,500 is
the forward discount on the contract; it represents the cost of hedging. Since the loss on the accounts
Gemini's year-end is 31 December. Discounting is ignored in order to simplify the illustration.
Gemini Enterprise records the following entries to account for the hedge:
receivable and the gain on the forward contract are both taken to the income statement, special rules for
hedge accounting are not needed to achieve the offset.
2 Dec 20x4 Or Accounts receivable (FC) 185,000
Cr Sales 185,000
Sale of merchandise with invoice value of
FC i00,000 at the spot exchange rate. ILLUSTRATION 10.7 Hedge of inventory (fair value hedge)
gems Mining Company had an inventory of 10,000 ounces of gold at 31 October 20x3, which was carried
31 Dec 20x4 Dr Loss on accounts receivable 1,500
at cost at $3,000,000 ($300 per ounce). The price of gold on that date was $352 per ounce. On 1 November
Cr Accounts receivable (FC) 1,500 20x3, GEMS sold a gold forward contract on 10,000 ounces of gold at a forward price of $350 per ounce.
Remeasure accounts receivable to closing spot rate as The contract matured on 31 March 20x4. The forward contract was deemed a financial instrument under
it is a monetary item and recognize a transaction loss: IFRS 9 as GEMS intended to settle the contract on a net settlement basis. The purpose of entering into this
[FC 100,000 X (1.835- 1.85)].
contract was to lock in a net margin of $50 per ounce or $500,000 in total when the gold was eventually
sold. On 31 December 20x3, the financial year-end of GEMS, the forward price for a 31 March 20x4 gold
Dr Forward contract 1,000 contract was $340 per ounce while the spot price of gold was $342 per ounce. There was a gain of $100,000
Cr Gain on forward contract 1,000
on the forward contract, and a corresponding loss was recorded on the inventory.
Revalue forward contract and record a transaction gain on forward The financial year-end of GEMS is 31 December. In documenting the hedge, GEMS designated the
contract):[FC 100,000 x (1.825- 1.835)]. risk as the change in the value of the gold inventory as a result of changes in the spot price of gold. GEMS
measured hedge effectiveness by comparing the cumulative change in the fair value of the forward contract
with the cumulative change in the fair value of the inventory. Since the hedged item is the inventory of gold
31 Jan 20x5 Dr Loss on accounts receivable 1,500
Cr Accounts receivable (FC)
whose value changes with the price of gold, the hedge was designated as a fair value hedge. At inception,
1,500
Remeasure accounts receivable to dosing spot rate the hedge was expected to be highly effective as the critical terms match. Discounting of the forward
and record a transaction loss: [FC 100,000 x contract was ignored to simplify^ the illustration. At 31 December 20x3, the hedge was fully effective as
(1.82 - 1.835)]. the change in the fair value of the forward contract ($100,000) was fully offset by the change in the fair
value of the inventory ($100,000). The hedge effectiveness ratio was 1. The journal entries to recoi'd the
fair value hedge for the year ended 31 December 20x3 are as follows:
31 Jan 20x5 Dr Forward contract 500
Cr Gain on forward contract 500
1 Nov 20x3 No entry or Just a memorandum entry as the fair value of the forward
Revalue forward contract and record a transaction
contract is nil.
gain on forward contract:[FC 100,000 x (1.82- 1.825)].

31 Dec 20x3 Dr Forward contract 100,000

Cr Gain on forward contract 100,000
Gain on forward contract: 10,000 x ($340- $350).
848 ADVANCED FINANCIAL ACCOUNTING ACCOUNTING FOR DERIVATIVES AND HEDGE ACCOUNTING 849

31 Dec 20x3 Dr Loss on inventory 100,000 Comparing the hedged position with one that is without the hedge, the hedge has achieved its objective:
Cr Inventory 100,000
Loss on inventory: 10,000 x ($342- $352).
Without hedging With hedging

Notes Proceeds from sales $3,300,000 $3,300,000

1. Since this is a fair value hedge, the change in the fair value of the hedging instrument (the forward Proceeds from forward contract 200,000
contract)and the change in the value ofthe hedged item (the inventory) are taken to the income statement. Total proceeds $3,300,000 $3,500,000
2. The carrying value of the inventory is adjusted for the fair value change so that the ollsetting changes
Sales $3,300,000 $3,300,000
in the fair value of the hedged item and the hedging instrument are recorded in the same period. The
Cost of goods sold (3,000,000) (2,780,000)*
adjusted carrying value of the inventory becomes the new cost basis for the purpose of applying the
$ 300,000 $ 520,000
lower of cost or net realizable value rule. 100,000
Gain on forward contract (20x4)
Assume that the inventory is sold to a third party at a price of $330 an ounce on 31 March 20x4, which Loss on inventory (20x4) (120,000)

was also the maturity date of the forward contract. (Note that the sale of the inventory is not settlement Net profit effect $ 300,000 $ 500,000
of the forward contract by physical delivery.) The journal entries to record the sale and the hedge for the
year ended 31 December 20x4 are as follows: After adjusting for change in the fair value of inventory of $100,000 in 20x3 and $120,000 in 20x4.

31 Mar 20x4 Dr Forward contract 100,000

Cr Gain on forward contract 100,000 ILLUSTRATION 10.8 Fair value hedge of FVOCI investment with a put option
Gain on forward contract: 10,000 x ($330- $340).
On 30 November 20x1, Systech Ltd purchased 1,000 shares of Fastrack Ltd at $5 per share. To protect
itself against a loss in the value of the investment should the share price of Fastrack Ltd fall, Systech Ltd
31 Mar 20x4 Dr Loss on inventory 120,000 purchased an at-the-money put option (that is, the exercise price was $5 per share) on 1,000 Fastrack
Cr Inventory 120,000
shares for $500 on the same date. The put option matured on 31 July 20x2. Systech's financial year-end is
Loss in value of inventory: 10,000 x ($330- $342).
30 June. The price movements of Fastrack shares and the put option are as follows:

31 Mar 20x4 Dr Cash 3,300,000

Price of Fastrack share Price of put option
Cr Sales 3,300,000
Sale of inventory: 10,000 x $330. 30 November 20x1 $5.00 i 500
30 June 20x2 4.50 700
31 July 20x2 4.00 1,000
31 Mar 20x4 Dr Cost of goods sold 2,780,000
Cr Inventory 2,780,000
Cost of goods sold: $3,000,000 -$100,000- $120,000. Systech classified the investment as FVOCI. Systech designated the hedged risk as the risk that Fastrack's
share price would fall below $5. The time value component of the put option was excluded from the hedging
relationship. System documented the hedge as a fair value hedge. At inception, the hedge was expected to
31 Mar 20x4 Dr Cash 200,000 be highly effective as the critical terms matched. On 31 July 20x2, Systech closed the option and disposed
Cr Forward contract 200,000 of its investment in Fastrack.
Close forward contract and record net receipt on
settlement, which is the notional amount multiplied by
The hedge is depicted in the following timeline diagram.
the difference between the contracted forward rate and
the spot rate on settlement[10,000 x ($350 - $330)].

30 November 20x1 30 June 20x2 31 July 20x2

Purchased shares in Year-end Exercise of put
Fastrack and put option option and sale of
shares

i.
 851

ACCOUNTING FOR
FO derivatives AND HEDGE ACCOUNTING
t <3 000 as follows;
advanced financial accounting
Mbecasl-i-no""'
4. The hedge has 1 ■. Vfect of lockiRo $4,000
Fair value computations

30 November 20x1 30 June 20x2 S"" July 2®*^ Proceeds"S

Fastrack shares:
Per share $ 5
$ 4.00
$ 4.50 4,000
Total (1,000 shares).... 5,000 4,500
" jii 10,000 tons of palm oil
illustration 10.9 Fair value he 9 i9to a fi commi®^ t^ price of palm oil at 30to
Put option:
Fair value (a) 500 700 g^p^ember exposure
Less: Intrinsic value (b).
Time value (a) -(b)—
0 500 r.On 30 June 20x5, TODec-ca Company
deUveD ' . payment
^nto the comnriW®"_^' be less thandelivery, Deccaprice
the market wouldof
r~500 $ 200
per ton to a custoniei gpt ^ pain pj-ice w futures contracts (each
hm 20x5 was oil, « tlte purcha»"8» f palm ott increased to above
changes in the price ot 1 pitmen per ton- J Company was required to pay a
Journal entries to record the hedged item and the hedging instrument are as follows staffer a loss on hedg^ f'ooO contract^ D ^ ^fe of the futum
vn', Hedged item
Hedging instrument

30 Nov 20x1 Dr FVOCl investment

CrCash
5,000
30 Nov 20x1 Dr Put option ^00 5OO
ir.;rr,:;T»s e-s
"'argin deposit 01
^
ued the "
rlpsisndtea d
A-'is. 1.
.o^easun^ miulativ
FVOCl investment
5,000
Cr Cash Oecca Company
Purchase of put option. palm oil. The managen ootract , as ,,M9Ust 30 September
the fair value of the pqce
30 Jun 20x2 Dr Deferred Loss on FVOCl
Investment 590 30 Jun 20x2 Dr Put option ^OO The selected spot an
Cr FVOCl investment Cr Deferred gain on put 5OO
500
Loss in fair value FVOCl: Refer to option
notes 1-3. Cain in intrinsic value of
put option. Spot price/ton ,
30 September
'f 8'"''"°°''"'"°'''''°'''"""I'"''"'
31 August
30 Septeniber
31 Jui 20x2 Dr Deferred Loss on FVOCl itres if
Investment 599 3IJuI20x2 Dr Put option 300
309
315

Cr FVOCl investment Cr Deferred gain on 3OO ■ unnwsth 305

$
310
315

Loss in fair value of FVOCl

500
put option The following taoi^^^^^p ' 307 300
300
300 10,000
investment. Cain in intrinsic value of 10,000
10,000 $150,000
put option. $100,000"
50,000
31 Jui 20x2 DrCash ; 4 999 • •••■" ire/tff'" $ 70,000' 30,000
Spot price/ton pr 70,000 (110,000)" (170,000)
Cr FVOCl
Investment 30 Septemb^price-
Contracted tu
- gf --' _ ,..•••■ (70,000) (40,000) (60,000)
4,000 (70,000) 0.9H
0.88'
Sale of FVOCl Investment- Quantity " ures co 1
Refer to note 4. Fair value o ^^,^6 0 . . -J^^ept-'' price)
ChangeinD miff ortitf futures P
Value of fiff ^%ff<o. .--- ,3- p revious
LCS

When a financial asset is classified as FVOCl, IFRS 9 vViith

Cbanoein;j::„asS«°°
Hedge effect ^pre"^
,a,«r'^ ^an'renr^P°' price) X , V Quantity

valrfe
changes in the fair value taken to other comprehen ' inrnmA
—r^'-ucnsive measured at fair rO.Od j nric®
When a FVOCl equity security is part of an effective hed^ i^ricome.
IC\Ct pnnitv sernritv is nart nf „cc . » ($307 - S300)
2. 'aln^ leO' ^$310-5300)
security are taken to other comprehensive income whUe ch^^ ""^^^tionship, changi the fair v;
iilF'
' ($298 -. $305)
$305) X
are also recognized
—o— in other comprehensive
1 income and
arm acn 1 ^ eqr id d (5298 -
Any deferred gain or loss on a FVOCl secnrin,
^„y security prior in
i a separate reserve m ips d $100,000 $ 0
3.
equity until the security is disposed of. ^ commencement of a hedg^ ' $150,000/$!
 ,O.OB«.VAT.VHS AND HEOCB ACCOUNT,NO 853

accounting
1- oKIp on 30 September. To hedge this
852 ADVANCED FINANCIAL ACCOUNTING ,11 nt $298$300
per to"' '^' deliverable on 30 September. Hence if
r dfgtures-es contractW fo buy at $300 perloseton,o^^
fhe- company has ['"V
-nmntitnaen p , — — loss on theit
° If the price of the palm °il decreases,
decreases
The journal entries to record the hedged item and the hedging instrument for 20x5 arc as foU^ exposure, it enters into a ^i,ove gontiact. Regardless of the price change,
Hedged item
puce of .he pal;., 0,1
me price ot tne pam- , the g""' gn i ,„,ehase coahaC.
Hedging instrument sales
PC contract „ronld
would he
he ooltsec ; ^^,^yid
Id 10
rvould on the —-
gain on
uiu gam sales contrac -.^rpntory
30 Jun No journal entry is required to 30 Jun Dr Margin deposit® 100,000 ggOO net profit will be that the m ^ Hedged Unhedged Unhedged
record the firm commitment.
Cr Cash ^ For comparability, 290
315
To record payment of margin 290
2,980,000 2,980,000
deposit on ten contracts. 2,900,000
(3,150,000) (2,900,000)
IjfoToo, 1^00,0001 80,000
31 Jul Dr Loss on firm 31 Jul Dr Futures contract 70,000 Spot Price on 30 Sept
commitment (l/S) 70,000 Sales
Cr Gain on futures contract... 0 0
Cr Firm commitment 70,000 To record gain on futures Cost of sales 80,000
To record loss in fair value of
(170,000) (100,000) 0 0

firm commitment as a result of

contract. The hedge is effective 150,000
as the hedge effectiveness ratio Gross profit (170,000) 80,000
the Increase in the spot price of
is within the range of 0.8 to 1.25. itment (1)
palm oil. Discounting of the firm
commitment has been ignored
Gain/(Loss) on firm ''°^gtract 0
Gain/(loss) on futures
to simplify the illustration. and tl'^
Net Profit ^ firm comm'tmm ,^„mlative change in the fair
31 Aug Dr Loss on firm icdged 'tern, die „ corresponding
commitment (l/S) 40,000 ■3 Mug Dr Futures contract 30,000 ^^ qqO Note (,) »,• km » i, is recogni^'d
f Ceding instrument
Cr Gain on futures contract. . • P,,e changes m J
Cr Firm commitment
To record loss In fair value of
40,000 To record gain on futures MS M p,„„s,„py, « ,0 be ediuseei » •>,, k.igei itete.
firm commitment.
contract. The hedge is effective
OS the hedge effectiveness ratio
is within the range of 0.8 to 1.25.

30 Sep Dr Loss on firm

30 Sep Dr Futures contract 50,000 Paragraph S6(l>) "■'!
InSS
fi,ef'i""^^
commitment (l/S) 60,000
Cr Gain on futures 50,0^^ Note (2) (Jain m r an executory contract is normally
Cr Firm commitment
To record loss on firm
60,000
contract A explai"'^'^ Hdes an exception to this rule and
To record gain on futures X iitract- IFRS 9 pro ^ the financial statements
commitment.
contract. The hedge is effective Kcoi a f,," 7;':'™.. ccmmitmen. is nil. As .h=
OS the hedge effectiveness ratio ent finals
'cial ' V .1,' "" Ihe &" av become positive (classified under the
IS Within the range of 0.8 to 1.25. Anotfirmrecognized
comm ..,,7,, f>-"!"'„:„TLlhilr»es
moU °V.g Lhe nder^hc^ me date of delivery.
secti o n). Th.s . s a temporary
the date oi ueuvu-.;.
30 Sep Dr Cash
Cr Sales
2,980,000 30 Sep Dr Cash 250,000 requires .he r«^ ysloTJ^^ssi ff reve^;;", M any ,„ss from thethe increase
loss from increase mm .thee papalmm
To record sale of palm oil at
2,980,000
Cr Margin deposit ^50,0^° At.in annlvmS
app.yu.& - tm ' .^gaathC^'' gginst.
y^ilisr ,,.,v to to avoid any
the contracted price of $298 Cr Futures contract
o close the position on the
underlying cdtrU^^^.^g) gj ". .re
uiiueiiymg a..-
per ton. Current Assets
fotures contract and record 0 the be"." is t° of =
refund of the margin deposit. account and beiey'M pnfi'^^
30 Sep Dr Firm commitment .... 170,000 The effect of th^ cotf it i'^'
Cr Sales 170,000 oil price above
To adjust firm commitment
against sales.

•rti"
» In practice, futures are marked-to-market on a daily basis with adjustments i H t"V qt,
lOb"
purposes, changes in margin deposit aie ignored unless losses on the fi.t ares contracts that
"r^tgin account If necessary. However.
result require topping up of the niatg j^p,
 855

OUNTlNG for
pepivatives and hedge accounting
ACC
shown in Figure 10.4.
of a fforecasieu
-pnsted transaction is
854 ADVANCED FINANCIAL ACCOUNTING hedge
ash flow
Piit of a ^
The accounting trcaimt hedg®
cash
CASH FLOW HEDGE ACCOUNTING flGURE 10.4 Accounting

A cash flow hedge is a "hedge of the exposure to variability in cash flows that (i) is attributable to^^^ trument
particular risk, associated with a recognized asset or liability (such as all or some future interest puy ,sh
hedging

on variable rate debt) or a highly probable forecast transaction, and (ii) could affect profit " ^
flow hedge applies to the following situations:
1. Hedge of a recognized asset or liability with a variable interest rate (resulting in a variriable future
cash flow); and
2. A highly probable future transaction.
Certain types of hedges have the chatacteristics of both a fair value hedge and a cash flow NO '"^^^00^10^°= Cumulative change
example is the hedge of a firm commitment denominated in a foreign currency. An exchange rate .no«n' ASwlk of insuumam
will affect tire fair value of the commitment, implying a fair value change. An alternative vtew is that tl«
flows from a foreign currency denominamd firm commitment are exposed to exchange rate chatages «!'« Ineffective portio
commrttnen. ts nltunately settled. Ue hedge of a foreign currency denominated firm commitmetat can be ' (A) - (B)
Equity

a fan value hedge or a cash flow hedge. Cash flow hedges are typically hedges against floating rate exposu'
• p and ineffective portions (if any) m
Accounting for a Cosh Flow Hedge Income statement • ing the (70S in the fair
Irt the tair value
vdiuc of
u the hedging
o
f the heog^'
fnr detef"''' hedge- 8 Itwelv If the time value component
The procedures for account.ng for a cash flow hedge are more complex than those for a fan vahn
The procedures as set out m Paragraph 6.5.11 of Ippg 9 .oredv"^ V'ha the life.Cell
of^ Jhip,flthe,e dme
of 1 ,3as eumulati^^T^^ time
t.me value component
,iodbasts;;^dhedgi>ag^'^flrrdL
rioi-
uedesig
instrument is an option
„„„,...f.hehedg.n ^
1. The change in the fair value of the hedgine iiritrnmrt n • . xmlue the
statement of financial position. ^^ adjusted to its carrying valu •iiisi'
sicvab^'
2. The change in the fair value of the hedging instrnmpmh • • nortioi^ aU^ 'Dstrumenl are calev .» excW '»rk8«"tra")«'''"'irCc.rr
1^ jagin!
1 ioains
. he'
.ng value of,he en,he
bUhe hedging ins"""!, an") °'''l ^
an ineffective portion, if any. ® ® '"strument ,s separated into an effective po. 1^ taken to protit or o^^^ ^ '"tn Cf n ep»°"
latins e effc"i«»®
Likewise- th^f' I v*e of the expected
? Uocw ctnd cumulatively.
The effective portion is deferred to equity (cashfln... i...a ■ .. nottiP^..
jntrin ^,.3tio 10i„in v.- f^sItsjts i-^
fxi,, val«- "S!lpe„odP basis and^^agin
cumula,iv.ly-_^_^^
3. neriod basis anu
any) is recognized as an expense in the profit or loss ThF the ef'®'"" contract) or the spo-.
spo^^J, ^ i„trin-
sp"' f» ,periou-^ g instrument
portion is that the transaction (the hedged item) has ^ 1'"°" f"^he
hedved i„„T >be deferment oof the hedging instrument,
instrument- t fle tntn^ change m the of the
The effective portion that is deferred to equitv is ""-ecognized yet. its)' also used to nrenstu^;^. ^,ted ^^.tion/ cuiti^^^u^ ^he change m the fair value
(a) The cumulative gain or loss on the hedging in the following (in absolu gji hedging instrument is' jtm'^ flod- presen ^effe statement of financial
(b) The cumulative change In the presen^vTue of th'"™' ^re eash flows of the in V mstrument is greater than the
item from the inception of the hedge ^ ^^pected future cash flows on At the end of jflie l^^^ng r value of th^ the ineffective portiom
If the hedged item is a financial asset or financial liahilm n. uv is j
Is compared with the eii of he'l- tb' flows- the exc gy^pected cash
5.
to profit or loss in the same period or periods during wh^h th 'r HlitY former'"less than the ^ ca b er p,,.,, of the change in
affects profit or.T.rwa
loss.0(such as in thetransaction
periods thatthatinterest inr' ^^q^ired or the habis ^i^^^, the hedging ''^;Jthe b^^^.^t deemed to be ineffective is recognized as a
6.
.
If the hedged item is a
. forecasted will
deferred gamTorT
asset or non-financial liability, transfer the defeJreT
1°"^^ interest expense
■ 1 the ,y
!,!?' ?"'■ rrr.:
eukZlve-Ilnge ^v? :cV';'i;«ho"
P«'-■
This rs logical be«" " ,oss) T1-'
cost or other carrying amount of the asset or
cv,. liahilin^Tu-
i;_i -i-. losses in equity to adjn wiH flows „.,h the gv." 'Aging >"! ate""
:he hedged
when the hedged forecast
forecast transaction
transaction of
of a no f accounting treatmen ^ ^ fpi Ifle fair value of tW
commitment for which fair value hedge acmnnp- asset or liability becorn Sain or expense in
7. Foc all olhec hedges, the amount accululwrf" )
and loss as a reclassification adjustment in the be reclassified from ^d 1^^''^
cashflows affect the profit or loss. Penod (or periods) when the he g
When cash flow hedge accounting is discontinued thp u Id be'-
(i) reclassified to profit or loss if the hedged futu' hedge reserve shouoccni';
(ii) remain until the hedged future cash flows expected to oe^-
^ 1 these cash flows are still
856 ADVANCED FINANCIAL ACCOUNTING ACCOUNTING FOR DERIVATIVES AND HEDGE ACCOUNTING 857

It is possible that in a particular period, the cumulative change in the fair value of the hedging instrument a cash flow hedge of a forecast purchase of an equipment on 30 November.® All other hedge accounting
is greater than the cumulative change in the present value of the expected cash flows and in a subsequent conditions in IFRS 9 were met. The equipment was delivered on schedule. Alpha's year-end is 31 December.
period, the position is reversed. In this situation, the amount taken to hedging reserves in the subsequent period The following are the relevant spot and forward rates:
would be greater than the change in the fair value of the hedging instrument for that period. To balance the
entry, the income statement is debited or credited by an amount equal to the difference (see Illustration 10.9).
Spot rate Forward rate for 30 January
Examples of cash flow hedges include: FCl = 20x6 delivery
1. Hedge of a forecasted transaction (see Illustration 10.10); 30 November 20x5
2. Hedge of an anticipated issue of a bond (see illustration 10.11). 31 December 20x5
3. An interest rate swap to hedge a floating rate financial asset or financial liability (see illustration 10.12); 30 January 20x6

We will discuss also in more details the financial instruments that can be adopted to hedge against
interest rate risks such as interest rate swaps. A discount rate of 6% per annum is applicable to the forward contract. When a firm uses a forward
contract as the hedging instrument in a cash flow hedge, the measurement of hedge effectiveness can be based
on either the spot rate or the forward rate. Thus, in order to ensure that tlie hedge meets the effectiveness
Forecasted Transaction
criterion for hedge accounting. Alpha Company should designate the hedging relationship in one of two ways:
A forecasted transaction is one that has a high probability of occurrence. In one respect, it is similar
to a firm commitment in that it is a future transaction that has yet to occur. However, the fundamental Change in fair value of forward contract based on the spot rate
Situation A:
difference is that in a forecasted transaction, there is no commitment to a specific price, hence, it does Change in expected cash flows based on the spot rate
not entail any rights or obligations. A firm commitment, on the other hand, carries a fair value or

exposure because of its commitment to a specific price. If the price changes by the time the transaction
takes place, there is either a gain or a loss on the fair value of the commitment. A forecasted transaction
does not involve such an exposure because of the absence of a commitment to a specific price.
A forecasted transaction, however, has a cash flow exposure that stems from changes in the price of the
forecasted item. Depending on the price eventually received or paid, the amount of cash flow of the
related revenue or purchase may differ from when the transaction is first forecasted. Thus, forecasted
transactions expose an entity to a cash flow risk that will affect reported earnings. An entity can designate
the forecasted purchase or sale of an asset (such as an inventory) at the market price at the date of purchase or
sale as a hedged transaction because the asset (inventory) will be recorded at that future purchase or sale price.
The possibility that the forecasted transaction may be postponed, or even cancelled, cannot be ruled
out. However, since it is highly probable that the transaction will take place, the firm is exposed to cash
flow risk because of changes in the price of the hedged item when the transaction eventually occurs.
Change in fair value of forward contract based on the forward rate
Situation B:
Change in expected cash flows based on the forward rate
In Situation A, the interest element (time value) in the forward contract is excluded from the designated
hedging relationship. The hedging instrument is defined as the spot element of the forward contract. The
hedge is likely to be highly effective because the critical terms match and changes in both the hedged cash
flows and the value of the hedging instrument are based on spot rates. In Situation B, the interest element
is not excluded from the hedge relationship. In this case, the entire change in the fair value of the forward
contract is taken into account in determining hedge effectiveness. That is, the time value is included in the
measurement of hedge effectiveness. However, the hedge is likely to be highly effective because changes in
both the hedged cash flows and the value of the hedging instrument are based on forward rates.
The fair value of the forward contract and the spot rate and interest elements in the forward contract
over the life of the contract are shown in Table 10.5.

ILLUSTRATION 10.10 Cash flow hedge of a forecast transaction TABLE 10.5 Fair value of forward contract and the spot and interest rote components
On 30 November 20x5, Alpha Company forecast the purchase of an equipment costing FC 2,000,000 on Fair value
interest element
Forward rate to
Spot element In in forward
30 January 20x6. Alpha Company's functional currency is the dollar. Alpha Company was concerned that Spot rate 31 January 20x6 of forward
contract
(c) contract forward contract
the FC might have appreciated by the time the delivery of the equipment was made, and decided to hedge Date (b)
(f)
(a) FC 1 = (d) = (e) + (f) (e)
against the risk of an appreciation of the FC by entering into a two-month forward exchange contract to FC 1 =

purchase FC 2,000,000 for delivery on 31 January 20x6. It designated the forward exchange contract as 30 Nov 20x5 $1.70 $1.72
1.74 $39,801 (Note 1) $ 59,701 (Note 2) $(19,900) (Note 3)
31 Dec 20x5.... 1.73
(40,000)
30 Jan 20x6 1.75 1.75 60,000 (Note 4) 100,000

'IFRS 9 allows the hedge of the foteigti currency risk of a firm commitment to be designated either as a cash flow hedge or a fair value hedj,e.
 ADVANCED FINANCIAL ACCOUNTING
accounting for derivatives AND HEDGE ACCOUNTING 859

Note 1. Note 1. (SI.70 - $1.73) X 2,000,000 = -S60,000

Note 2. -$60,000/(1 + 0.06/12)(or $60,000/1.005)
(11.74 - 1.72|) X $2,000,000
Note 3. ($1.72 - $1.74) X 2,000,000 = -$40,000
Note 2.
1 + 0.06/12
Note 4. -$40,000/(1 + 0.06/12) (or-$40,000/1.005)
Notes. ($1.70 - SI.75) X 2,000,000 =-$100,000 .. ,
(|1.73 - 1.70|) X $2,000,000 ic 1 since there is no future period remaining)
Note 6. -$100,000/1 (Discount rate IS 1 since I f
1 + 0.06/12 Note 7. ($1.72 - 1.75) X 2,000,000 = -$60,000
The comparison ot the 1-1" -e amounts of the hedged
portion forcash flowsAand
Situation andthe change Binisthe
Situation fair value
summarized
Note 3. The interest element in the forward contract can be obtained as follows:
of the hedging instrument to determine
^Current period Contracted or previous below.
X Notional amount
^ Discount factor for the remaining
Uorward premium period forward premium period of the contract
Situation A
_ (|1.74 - 1.73|) - (|1.72 - 1.70|) X $2,000,000 Cumulative change in Cumulative change
In present value of Hedge
1 + 0.06/12 fair value
expected cash flows effectiveness
of derivative
Alternatively, it can be derived as the difference between the fair value of the forward contract and (based on spot rate) (based on spot rate) ratio
the spot element in the forward contract: $39,801 - $59,701 = -$19,900. Date
1
$ 59,701 5 59,/UI
31 December 20x5
Note 4. At 31 January 20x6, the fair value of the forward contract is $60,000. This is calculated as follows: 100,000 100,000 1
31 January 20x6

(Forward rate at maturity date* - Contracted forward rate) x Notional amount

Situation B
= (|1.75 - 1.72|) X $2,000,000
= $60,000 Cumulative change
Hedge
Cumulative change in in present value
* The forward rate at maturity is equal to the spot rate as the remaining period of the forward contract effectiveness
fair value of derivative of expected cash flows
is nil. This figure is not discounted since it represents the present value at the date of maturity. ratio
(based on forward rate)
The changes in the expected cash flows associated with the forecasted transaction based on spot rate Date
(based on forward rate)
and forward rate are shown in Table 10.6. $39,801
31 December 20x5
60,000 60,000
31 January 20x6

TABLE 10.6 Changes in expected cosh flows of forecasted transation based on spot rate and A can 1be seen from
r theti above, there
As there is no ucog
is no hedge ineffectiveness
. , as, ,the hedging relationship is correctly
;f the numerator uses
forward rate ■r- u T-u ,. and
A nonnminator
specified. The numerator denommaior calculation
cawui bases should be consistent,
. , it ttie nu
m r-pflpct the same
Cumulative
spot. (forward)
yr A\ rates,
y othe denominator
u n-iimtor uses
uses spot
sp (forward)
v . rates. Both situations
^ should reti
thp hedeed item and
Change in Present value Change Present value hedge effectiveness ratio for the same economic scenario. The journal entries for the hedgeu
Spot
rate Forward
cumulative
expected
of cumulative
change In cash
In expected of cumulative hedging instrument in the forward contract for both situations are as follows:
cash flow change In cash
fb) rate (c) Cash flow based flow based on based on flow based on
;i Date (ai) FC 1 = FC 1 = on spot rate (d) spot rate (e) forward rate (f) forward rate (g)
30 November 20x5.. $1.70 $1.72
31.12.20x5
1.74 $ (60,000)(Note 1) $ (59,701)(Note 2) $(40,000)(Note 3) $(39,801)(Note 4)
31.1.20x6 (100,000)(Note 5) (100,000)(Note 6) (60,000)(Note 7) (60,000)
1.75
 861
erivativRS and hedge accounting
UNTING for d ated has accounting consequences.
ACCO'

ADVANCED FINANCIAL ACCOUNTING

relationship IS design:
, ,,,.w a
s that the Situation
Situation
Illustration 10.10 honvs: B
Situation A (based on spot rate) A
Situation B(based on forward rate) Ihese are suniniau/a.*-

30 Nov 20x5 No journal entry is needed. Only 30 Nov 20x5 No journal entry is needed. Only 19,900
memorandum record as the value of
memorandum record as the value 0 20,100
forward contract is zero at inception.
forward contract is zero at inception.
in income sta ^ent)
nt)
Time value tinted ....^- „ nnn
$3,400,000 $3,440,000

31 Dec 20x5 Dr Forward contract 39,801 31 Dec 20x5 Dr Forward contract 39,801
39,801 ' ••• ■ Cgi posit'°" •• • • ■ ^ deferred gain -
is
Dr Profit or loss
(interest element) 19,900
Cr Equity
To record the change (gain) in
in sSement of -I'r IPRS 9. The journal
Cr Equity 59,701 fair value of the forward contract
To record the change (gain) in between 30 November 20x5 and
fair value of the forward contract
between 30 November 20x5 and
31 December 20x5. The hedge is fully
31 December 20x5: the gain Is taken to
equity. The hedge is fully effective as the As ,hc forccssled
either
^'ff "SrtU"of .t>« drfo""!
gain on the forward contract ($39,801)
effective as the gain in the spot element is exactly offset by the loss on the entries in
of the forward contract ($59,701)* is expected cash flow ($39,801)."
exactly offset by the loss on the expected that
cash flow based on the spot settlement the former
the fo option, t re ^^^^j^-irevei"
of the forward contract ($59,701).** The
gain on the effective portion is taken to niakes no
equity. The interest element Is taken to * Column (d) in Table 10.7.
profit or loss. ** Column (g) in Table 10.8.
* Column (e) in Table 10.7.
** Column (e) in Table 10.8.
the foreign exchange risk and
Dr Forward contract 20,199
• „ti«s to *f .his chapter fflustrates the use
30 Jan 20x6
Dr Profit or loss 20,100 an 20x6 Dr Forward contract 20,109 199
20,
hedging AG' use of '""„uio.n8
accounting Pprocedures.
risk.AsInterest
discussed
• rr nroceauics.
rateearlier
risk is .

Cr Equity 40,299
Cr Equity
To record the change in the fair .s 'ssets-1'"
ncirft
Hal 1- .a
. lied acconntmS
f^'''7^ents face r^terest Interest rate riskthat,s
aerivatives
To record the change In the hf-itioir^ fijiar^ -ck , p instHi"^'^ -xactrunients. ine lyp'^
value of forward contract between
fair value of the forward contract
between 31 December 20x5 and 31 December 20x5 and 30 January
-re preceding r jiijes ai^ rate de debt 1 7
30 January 20x6. The hedge is fully 20x6. The hedge Is fully effective as the price risk of conrirr , of sunnrr^''^^^
effective. The effective portion is taken
to equity and the interest element In
change in fair value on the forward
contract ($60,000 - $39,801= $20,199)
Of derivatives to mrV^1 issU^ ^
the forward contract taken to profit 's exactly offset by the change in the entities that issue de .^^jeud pi ^est
r . , r..-t-ns tlrar
^ate
or loss. expected cash flow ($60,000 - $39,801 Characteristics
= -$20,199).
^Te commonly used for
he'
aQr66S to dslivor 9
30 Jan 20x6 Dr Equipment 3,500,000
30 Jan 20x6 Dr Equipment 3,500,000 ivdlW®' ^^^^^^^^^^Thereby one ^ another
Cr Cash
3,500,000 ooo of treasury-bond futures, and
To record the purchase of Ca.h
Cr Cash 3,500 ^^BLE 10.7 Type^
equipment for FC 2,000,000 To record the purchase of AO ^ atiioff"\,,mp'e5 are
at the exchange rate of equipment for FC 2,000,000 flivfiff ,„rtie e'^ , . r,t hut not the obligation to
FC I = $1.75 "l^he exchange rate of
F0I = $1.75
Interest rate futui®^ ,ct u
30 Jan 20x6 Dr Equity
Cr Equipment ..
100,000
100,000
30 Jan 20x6
OH" Equity 60,000
A-s.;-,„adpeno. (continued]
To record the basis adjustment of Cr Equipment for'
the carrying value of the equipment. basis adjustment
futn"' nric®
This entry is recorded if IAS 39 foe carrying value of the t-iptions on intetet
paragraph 98b is adopted. eguipment. This entry Is recorded
'4S 39 paragraph 98b is adopted.
30 Jan 20x6 Dr Cash 60,000
30 Jan 20x6
Cr Forward contract — 60,000 Dr Cash 60,000
Net settlement received from Cr Forward contract
the dealer on maturity of forward Net settlement received from
contract. the dealer on maturity of forward
contract.
 863
862 ADVANCED FINANCIAL ACCOUNTING .accounting for DERIVATIVES AND HEDGE ACCOUNTING

TABLE 10.7 [continued) Because the relationship between the gfmarket

futuresinterest rateto and
contracts the bond
effectively hedgeprice was non-linear.
the forecasted bond
Company X had to determine the niim called duration, which measures the price sensitivity of
Type of interest rate derivative
Characteristics
issue. This was accomplished by usii^ a n percentage change in the price of a bond for
Forward rate agreements
a bond to interest rate movements. Dura lo
rate differo k parties agree to exchange an interest a given change in yield. Hicated that Company X should sell 488 five-year treasury notes
■
nrvflona1^principal ^
amount atrate and afuture
a given floating interest rate based
date. Assume that duration calculations m c contract had a face value of $100,000.
Interest rate caps futures contracts to provide an ef ectne ^ fjow hedge of the future interest payments
a g rathat
e provides protection
e t increasing to the
beyond holder against
a specified maximumthelevel.
interest on Company X designated j.,gss .^^as calculated as the ratio of the cumulative change in
Interest rate floors
on its forecasted bond issue. He gee cumulative change in the present value of changes in the
protects the holder from declines in the interest rate by the fair value ol the futures contracts (q changes in market interest rates. Assume that all
"inriov" ^ P^yrnent to the holder when an underlying interest rate (the expected interest payments on the on a i positions would be closed in January 20x2 when
"floor r^e")^ erence interest rate) falls below a specified strike rate (the other conditions for hedge accounting are met. ine sno p
Interest rate collars the bonds were issued. December 20x1, the market interest rate increased. The follow-
combines the purchase of a cap and the sale of a floor As expected, from 30 June 20x1 to forecasted interest rate on the to-be-issued
thp hiiuf^r ■ within a specific range. The contract protects ing table shows the yield on five-year tieasu y
the benefifq^^r^V
benefits of a drop^ in that^floating
significant
rate.rise in a floating rate, but limits bond.
Interest rate swaps
Forecasted interest
er w ic eac agrees entered
to makeinto between two counterparties Yield on S-year
periodic payments to the other for an treasury notes on to-be-issued bond
agreed period of time based on a notional amount of principal.
5.0% 6%
30 June 20x1 5 50/0 6.5%
Illustration 10.11 provides an exatpp,. of a cash flow hedge „f a ,o-be-issued bond. 30 September g 0% 7%
31 December 20x1

. , f, • • • tprest rates the pprice of interest rate futures on five-year treasury notes
As a result of the increase in mterest rates,
ILLUSTRATION 10.11 Cash flov/hedge
y
of an anticipafed Uci, j • • » » r
P ted issue of bonds using inferesf rate futures
decreased.
contracts
Total value of 488
Cumulative gain on
Price of futures
futures contract
On 30 June 20x1, the board of Company X approved the invpct.,, ■ ■ u. n. contract futures contracts
u- u
which was .
to 1be financed
r- partly byn the
ry ^ appauvcu
issue uie million
of a $50 investment
f in a pro ■ icost $150
u ect that n million,
mi
■ ^ r , , 30 June 20x1 $100'000
mterest rate for a bond similar to the proposed bond was miinon
6o/o at 30five-year bonds in January 20x2 The
June 20x1, with semi-annual interest 30 September 20x1 97,906 Aayaynna
$1,021,872
2,013,000
payments. Company X was concerned that market interest rates would rise before the bond was issued 31 December 20x1 95,875 46,787,000
on 1 January 20x2. If interest rates went up before 1 January 20x2, the bond would have to be issued at
a higher coupon rate, which translated into higher interest payments on the bond. Therefore, Company The changes in the expected interest payments are calculated as follows.
X decided to hedge the interest rate risk from the date it decided to issue the bond to the date the bonds
were issued. Cumulative
PV of ichange in
Company X performed historical correlation to identify the appropriate instrument that was likely Forecasted Expected change In semi^
interest payment
to provide an effective hedge of the bond. The results showed a high correlation between tlve-year borrowing Interest
payment
annual interest
payment at 6% per annum
treasury notes and the type of bond that Company X would be issuing. If the interest rate increased, the rate

price of treasury notes decreased; the futures contracts on treasury notes would show a gain, offsetting 30 June 20x1 6% $1,500,000 $1,066,275^
the higher interest payments on the bond when it was issued. At 30 June 20x1, a 31 December 20x1 30 September 20x1 6.50% 1,625,000 $125,000 2,132,55D
five-year treasury note that carried an interest rate of 5% was selling at par (assumed to be $100). The 31 December 20x1 7.00% 1,750,000 250,000
futures exchange required a margin of $800 per contract. "Ten semi-annual payments of $125,000 discounted at the effective interest rate of6%(3% semi-annually) at the inception of the hedge.
" Ten semi-annual payments of $250,000 discounted at 6%(3% semi-annually).
 865
864 ADVANCED FINANCIAL ACCOUNTING accounting for DERIVATIVES AND HEDGE ACCOUNTING

The ratio of the cumulative change in the fair r. . .

Interest Rate Swops ^ 4^ u j
in thee present value of
r^f the
i-u change
u in■ interest
• payment as at 30 September and 31 toDecember
futures contracts ?0x I is change
the cumulative within
the effectiveness range of 0.80 to 1.25 as shown in the following table. -0^1 An interest rate swap is an agreement hoet^veen two counterparties to exchange
common interest
variety, knownpayments based
as a plain on
vanilla
a notional amount and agreed upon mteres payments for fixed rate interest payments based on a
sirup, involves the exchange of floating ^ exchange of the principal amount, a notional
Cumulative change Cumulative change in Hedge notional amount in the same currency. A ° j^^tual cash amounts that will be periodicaUy
in fair value of
futures contract
present value of expected effectiveness amount of the principal is required m order ^ interest rate swap on each settlement date are
interest payments ratio exchanged. The cash floivs to be exchange difference between the fixed and floating
30 September 20x1. typically "netted" (or offset), so ivhat is pai periodic net settlements,
$1,021,872 $1,066,275 0.958
31 December 20x1
2,013,000 2,132,551 0.944 rates of interest on the notional interest rates. It is important to note
an interest rate swap is in essence a se es ^^ent flows provides a complete settlement of
The accounting entries for the cash flow hedge are as follows: that m the case ot a forward contract _ |.ch,,n„es of payment flows under an interest rate swap
the contract at maturity. In contrast the value of the swap does not reduce to
provides only a partial periodic settlement o
30 Jun 20x1 Dr Margin deposit 390 400 zero until at the end of the swap contract.
Cr Cash 390,400
To record the margin deposit of $800 per contract 30 June 20x1
31 December 20x1
on 488 contracts. 1 January 20x1

Interest rate reset

30 Sep 20x1 Dr Futures contract 1,021,872 Inception of swap interest rate reset
Net settlement of interest
Cr Hedging reserve (equity) 1,021,872 FV of swap = 0 Net settlement of interest Adjustment of fair value of swap
To record the gain on futures contract that is Adjustment of fair value of swap
taken to equity.
Note: There is no ineffective portion in the
hedge as the deita ratio is less than 1. Changes An .h.n. wishes .o enter into a swap trpicallp faces two 'aeS
in the margin deposit are ignored. a counterparty with opposite ntatehing requirements. For example, a firm ™th a 8
Wishes to pay a fixed mterest rate wili have to find a counterparty wtlhng to pay » Qoatmg^
and receive a fixed rate interest based on a common notional amount. The se counterparty
31 Dec 20x1 Dr Futures contract 991,128 such a counterparty be found, there is still the issue of counterparty ris ' ^ ' gg in The swap dealer
Cr Hedging reserve (equity) 991,128 will fulfil its obligations. This is where a financial intermediary or a swap dealer „„posite matching
To record the gain on futures contract that is taken
to equity.
assumes the counterparty risk and at the same time seeks out a counterparty with opposite m g
Note: There is no ineffective portion in the hedge as
requirements. In return, the counterparty charges a commission or spread. .„,,,rance companies.
the cumulative change in the hedging instrument Interest rate swaps are used extensively by commercial and investment b^s msura
is less than the cumulative change in the present non-financial entities, investment trusts, and governments for one or more of the followi g
value of expected cash flows.
1. To hedge interest rate exposure;
2. To obtain lower cost of funding;
31 Dec 20x1 Dr Cash 2,403,400
3. As part of an entity's asset or liability management strategies; and
Cr Margin deposit 390,400 4. To gain by speculating on interest rate movements.
Cr Futures contract 2,013,000
To record the refund of margin deposit and the
closing off of the futures position.
Using Swops for Hedging
Swaps are commonly used to manage two types of interest rate risk cash flow risk and p ^ follows-
The deferred gain taken to hedging reserve (equity) will be recycled to profit or loss over the life of two types of risks are explained under two different situations labelled Scenario I and Scena
fhe bond using the effective interest method.

A floating interest rate is an interest rate that is tied to a specific interest rate index such as the prime rate, the London Interbank Offer
Rate (LIBOR) or a treasury bill rate.
 ^CCOflNTlI^
c for derivatives and hedge accounting
866 ADVANCED FINANCIAL ACCOUNTING

Scenario 1 Company A has a floating rate debt but wishes to pay a fixed interest rate. It swaps inter Liture periods." fi 1 SwaP
^\s'ap -.u vflrvi^D maturities- n as discussed earlier, an
rate flows with Company B (who may be a financial intermediary). The swap is a cash flow hedge as i| ncd from the h'N-"""" ,«ps will' fair ° .t
_ _ 1,,^^ of the sw p hetween two

transforms future variable cash outflows, into fixed cash outflows thereby removing the uncertainty o with snndardiied prir'"S , , ,, incep"""' ,e and floatin„
future cash flows. Effectively, the swap creates what is called a "synthetic fixed rate" debt. It is important to „ ( ,"u). note is *»' T„„_a of b=<«r» make a gain and the other
note that Company A still has a floating rate debt in its books, but it ends up paying a fixed rate interest "tlcrest rate r*'- a" s a combination of fixed and floating
because of the creation of the synthetic instrument. Parties. A.imgmcepi
ICS. At
ni inception
ti^e floating
floali
Iiicep. i o u.
rale stream
f h c Pr-^mts
. gernarn'r
mn^;;
i',
^
, navme"" , , me "s«ap can
' can
uortoWiaS
rate stream »! P ' ,ai,vely, y' i„g and »° "r
b' xg
V-
" be, „„ subsefiuent, repayment
loan at mcep
r i
' g gf
inception must 0 mue, the fair
plly
of the principal,pa„y
rue
value
party a lo« at mcepdoo-
loss„x.,-nvnt
u.ccpt'»;\^tAi I'O mii"'"^7tl.e
ha jme il""°8 ^ gate, with <1"^ J „ p,igg the swap
rate loans except thai th = ;^^„g ,oan .gg ii.« " of the >;f;;7,„ap ig gfro.
„o that thcie ^ loaiW" _ incept
Lender
i-*
Company A
Pays fixed rate interest to B net
Wil present
gau, valuebyofborro'
simply .he i'^^
';|,ggHofr^'ityg
or n ^beta"' * ^e fair val»e
gain si
Receives SFP: Floating Company B of the swap will be either
nf the
settle' ^
floating rate rate debt Receives floating rate interest from B initially will change ovei
receipts (liability)

£ j j-ate ,„3 method w conditions include

Short-cut Method fo"" g "sh°''^'^x\in conditions ar mterest-bearing asset or
scenario 2 Company A has a fixed rate mvestmen,(classified as available-for-sale) The hedge portrey^'' Determining
in Scenario 2 is a fair value hedge. A fixed rate asse'asset or debt
"' is exposed to changes in fair value -ctup Accounting Standaids ^^^gss) c ^^,ap prepay item
interest rates rise, the fair value of the fixed rate asset or debt declines and vice versa. In per • dt; ofvolat^^^
interest rates, this results in volatile earnings. This volatility i
'vo
hedge (no hedge mc ^^00"^ ° ^ provisions- xllustrations 10.12 and
ave su-( ^ t rate swaps, iua.txctenxoxxo
Zfi;;;:ha;;VtL";k:d 'natching of the notioH' sWaP ^^jtb t^ t ha^e pmterestf -rratevalue
s of > an ^merest rate swap is
li.Kim,. r.a;.- value .est yen ^^.eatment ot of an interest
mt^^ rate swap xb,
fixed rate asset (which still remains in Company As booksl ^ fc Changes in the air v are inde^ fnittdlyno'«>«^''"'''''''""™™
swap asset or liability. Note the following: ' ''r changes in the fair value cumg .9 and' ^ . ^'the/^'^ac.covndff
a an«t ,,sume tha irfflostmiio-
enabling us to focus on
1. A swap (assuming it is effective as a hedge) is a rash n
rate asset or liability. ®
c ,
^edge if the hedged item is a d
- a floati"6
^sset or liability-
For the purpose
IAS
lA^ oni<:u^'>
d iilustn^"'
jseotn' *■"^5^:ir;;puta.ioos.
.^gtrati'^^f ^ Whd^ pie this
FASBTicOt«r-V.to6r;;gomP^
V^oa' .„,o,itfitions.

10-13
^ will adopt. the .flatyr^slbr" io.olve'l'"
2. A swap (assuming it is effective as a hedge) is a fair yr.i u c • fixed r^t^ determined based on '
determined' a ' ^ang
asset (not held to maturity) or liability. '^=''8= if the hedged item is e <■« is normally upwarf ''"Pj «
^he accounting treatm (cosh now hedge)
Investee
i
Company A
^ risk n5'"9 . , at LIBOR + 50 basis points.
^ ► Pays fixed rate intPrccr
to B
I O of *
with to swap interest
milli°'^' <10 inn® 20X
payments. Under
a notional principal of
Pays SFP; Fixed
fixed rate rate asset
Receives floating rate
Company B
"■LUSTRATION ! a' gate 1°")
,n "fwilb" f fix'edfraia
■» 'gg"riAhe
foi tte receipt of a floating rate interest
ygg
payments interest from B

Company has aa floatit'^/aj co" i, .nie^ ,gti^„g„.s

A has
tdornpany A
Comna,.;,
Company A eiitete'l » ^^„y ^ygt
<""= g„mp»»] A PPy^a „net
od'T!^ggst
est
Deternniiiniing the Fair Value of a Swap this arrangements y
^lO million to
The estimation of the fair value of a swap contract requires tbp i.,p of hused on liboR
net payment or receipt for each future period and aggregatinpTi?'^"^''^'®" T nerio^'"'
The discount rate is the forward interest rate, which is the pv.pccteda future interest rate for oao h . ,JW P'"' rate. ^ , ^33 Accounting for Derivative Instruments and
period. What makes the estimation of the fair value of a swap complex is that interest rates cha gt IVI.A- Veaf'^Upun'
each settlement period. To simplify the estimation, the market vi x j-ates
the time to maturity, can be used to estimate the interest rate for
be quite complex if the yield curve is upward sloping or downwa'^-d 1 'Af the fair value i^-^' V'''"
yield curve"). An upward sloping yield curve implies that lonp8 teim i nterest (also
rates known as an
are higher the " Pinancial AccoununS lU-
term interest rates while an inverted yield curve implies the opnocit tu .tin-
iiatc - ,• lodging Activities pAi'®
fair value of a swap is to assume a flat yield curve, which imnL ' a methodinterest
constant forward to e. fu
 'Ili

869

ACCOOMTI
-COE"^"^'
,0 FOR ACCOUNTING
„ tn6 25% and the floating rate
868 ADVANCED FINANCIAL ACCOUNTING
,,,(W ber Kj,
20X5).
20x5 is
U-ipr iUX-. " 'ntOOO.OOO x 0.0675
of $25,000
,rmpnt Ot on 31 XDecember
A)- The
vrxx --

year-end is 31 December. Floating rate payment was "reset" by using LIBOR at the beginning of A..be end of .be f- din" 51 expected net ne« fh^^ree quarters.
''Using'
a
quarter. The rates are as follows; receipt tor the next rhe estimated fai>
30 June 20x5
30 September 20x5
y 25%
6.25% - b=
discount rate ot V; esti"' ^
rises ^0^ _...
payment is $193,750,
31 December 20x5
31 March 20x6
7.45%
y
30 September 20x- - Deceo^^er ^^^3^50. since ^ppiy for the
financial position. quafiet( 2OX assu"^®'^ ^ receipts for
A..he end of.he ^rch 20^'' .ggrega.e Uabdify) to
The sequence of exchanges is as follows: receip. for ,he "^'^SS.OOO"" .Yo ,„„e 2 has f""
there is a net receipt an of h
(3) Pays a variable rate (LIBOR + sobp) onnriPrQ ending
quarters ending 5 51 h' ^q.710. The
Lender these two quaiteis rd
Company A
positive (swap asset r .be «W"
(1) Pays a fixed rate of 7.75% The process is tepe 31 March
SI-k: h-ioaiing
rate loan
(2) Receives a variable rate (LIBOR + sobp) Company B
journal entries are
as 200,000
(Counterparty) 200,000

Assumptions:
1. Fair value of swap at inception is zero. Hr interest expense • • • ■'
2. Fair value of swap at the end of each subsequent period- Cr Bank ' 25,0" 75,000
,-ve Payment for inter^^^
a. Current floating rate continues to nrevail till fU , ciH'
assumption). ^ the swap tenure (flat floating rate loon-
b. Next immediate net receipt/(payment) applies to future periods l-ir Interest expense • • ■
Cr Bank ''-
The schedule of interest rate payments and net settlempr^t ■ • Pe/ng settlement of
settlement is given in Table 10.8.
'differential.
TABLE 10.8 Schedule of interest payments and net settlement Pir Bank ' ,.
Cr interest expense
Floating rate
Floating Being receipt of sv^tiP
rate receipt 'differential.
Fixed rate Fair vdlue
(LIBOR +
50bp) as at
(based on
payments at
Chadf
previous 7.75% to swap Current net of swap ih 15r Fair value adjnstnn
Quarter ended this date LIBOR) receipt/
counter-party (equity) '''□
(payment) (liability) Cr Interest rate s
Start of swap:
liability/asset
30 June 20x5 7.75%
30 September 20x5 6.75% 0 i^oir value unfavouro
$193,750
31 December 20x5 7.95% $193,750 0 $(72,538) 'Adjustment.
168,750
31 March 20x6 8.00% 198,750
193,750
193,750
$(25,000) 9,710
6,127
(3,- fdt Interest rate sW^P _ .
30 June 20x6 200,000 5,000 (6, 27) asset/liability w .j^jtrne
193,750 6,250 0
Cr Fair value
Notes „ (equity) '
Po/r value favourao
1. At inception date (30 June 20x5), LIBOR is 7.25%; this rat f 1 caw-
:al'^ 'Adjustment.
the floating rate receipt for the quarter ending 30 Septemb 9^^ points) is used to
Thus, for the quarter ending 30 September 20x5, the floati payment
rate receipt is also $193,750. Thus, the net receipt or payme^ Payment is $193,750, an th
flat yield curve assumption, this is assumed to apply for the fo ^ September 20x5 is nil-
the estimated fair value of the swap at 30 June 20x5 is nil "J^^^rters of the swap tenuie-
 ACCOUNTING 871

lUNTlNG for
a oeRIVat'«5 and hedge
ACCO'
criven in Table 10.9.
870 ADVANCED FINANCIAL ACCOUNTING payments is
-t and svap
The schedule ot mtere^' ^ j swap P°y'
An extract of the income statement is shown below:

table 10.9 Schedule of current Fair value Change in

30 September 31 December 30 June ixed rate of swap
31 March fair value:
20x5 20x5 20x6

Interest expense 193,750 193,750

20x6

193,750
(pjment) Hiability) gain/O^
193,750

Below is an extract from the statement of financial position: Period half-year $136,803 $ 136,803
187,267 50,464
50,000 (72,324)
30 September 114,943
31 December 30 June 100,000 (114,943)
31 March 8tart of swap;
20x5
20x5 20x6 950,00° 120,000
20x6 1 January 20x1 gOO,000
Equity - fair value 30 June 20x1 ... 880.000
8w
adjustment accumulated 31 December 20x1
gains/(losses) (72,538) 30 June 20x2
9,710 6,127
Swap asset/diability) (72,538) 31 December 20x2 20,000,000
9,710 6,127 20,000,000

as
follo^s'S-
The journal entries m'e
DC ■
20X1
ILLUSTRATION 10 .13 Hedge of a fixed interest notes poyoble (o foir value ftedge) 1 Jan 1,000,000
1,000,000

On 1 lanuary 20x1, Alpha Company borrowed a $20,000,000 loan from a bank at a fixed rate of ^ ef
,ens^
annum with interest due on a semi-annual basis The Imto , <• a uicipat^''" eresr eXP' loan-
that interest rates were likely to decline and wishin, to ch ' ate 136,803
Alpha Company entered into a swap to receive a fixed rate o^fo/^ obligations to a boating inte-
136,803
of aft variable
variahlp LIBOR.
TTBOR Differences
DiffprpnrPQ Bptxsrp«m t-k„ fixed2. and, vo • ki o/o per annum m return for tne p
between the
payment. The notional amount of the swap was $20 000 000 ''C ''ariablo ,W3P on
„ gwap

20*1 aUCttie"^ 136,803

136,803
30
L/X''ng'' (l/S).-""'
loan
to the

LIBORasatthis date used for DI

sequent half-year payment 20»' "erf- Ik .rote-
1 January 20x1 30 1,000,000
30 June 20x1 10.0% per annum cxo<"""" 1,000,000

31 December 20x1 9-5% per annum

9.0% per annum
30 June 20x2
8-8% per annum
aeXP®'^^^.. /ofR-
50,000
50,000
Notes
1. At the inception of the swap agreement, the fair value of th jvvfp
. 9.5%

2. Flat yield curve assumptions hold. ^ contract was zero. 1.•' ,p eXp® .g .f
3. Other risks such as credit risk which affect the fair value of tb
isi
4. The loan was for two years and matured on 31 Decembe 7n remains constant. 31
Qec
after that point in time; the fair value of the swap agreemp t ^ Therefore, the swap .j-p P
1
the agreement. ® « >he end of the
872 ADVANCED FINANCIAL ACCOUNTING
accounting for DERIVATIVES AND HEDGE ACCOUNTING 873
114,943
31 Dec 20x1 Or Interest rate swap asset 50 464 31 Dec 20x2 Dr Loan payable 114,943
Cr Unrealized gain on swap (l/S) 50,464
Change in the value of the swap. change in interest rate.

31 Dec 20x1 Dr Unrealized loss on loan (l/S) 50,464 20,000,000

Cr Loan payable 50,464 31 Dec 20x2 Dr Loan payable 20,000,000
Change in the value of debt attributable to the change Cr Cash
in interest rate.
Repayment of loan.

Notes . of the debt is adjusted by an amount equal

30 Jun 20x2 Dr Interest expense
CrCash
interest expense on fixed rate loan.
30 Jun 20x2 Dr Cash
Cr Interest expense
Receipt ofinterest rate difference on swap:9% vs
10% on $20,000,000 x 16 year.
1,000,000
1,000,000 1- Even though the debt is earned at co , attributable to the change in LIBOR (the benchmark
to the change in the fair value of the e
interest rate). ,, represents a premium or discount on the
2. The adjustment to the carrying va ue 0 discount as long as the hedge is in place,
100,000 debt. There is no need to amortize th p
100,000

An interesting point to note is• that

m t f.ir value exposures andexposure
cash flowbut
exposures areincreases
generaUy mutuallythe
exclusive
other
Dr Unrealized loss on swap (l/S) 72,324 m interest rate swaps. In other words, the s^'^ P ^ ^ fj^iw hedge of a variable rate loan) results
Cr Interest rate swap asset 72,324 exposure. For example, a pay-hxed-receiv ' ° variable rate loan to a fixed rate loan, thereby
Change in the value of the swap. in fixed interest receipts (or expenses), lan However, it creates an exposure to the risk of
.he expoeuee .o risk of s W J
30 Jun 20x2 Dr Loan payable 72,324
a change in the fair value of the . combined fair value of the loan and the
Cr Unrealized gain on loan 72,324 at most change minimally) with market rates > determining fair value, the changes
Change in the value of debt attributable to the swap will change. Additionally, since cash flows aie a major lac °
change in interest rate. in the fair value of an asset or liability are inseparable from its expected cash

31 Dec 20x2 Dr Interest expense 1,000,000 Using Swaps to Reduce the Cost of Borrowing
CrCash 1,000,000 , J, „„„„ intprest risk or currency
While swaps are widely used to manage interes ;
risk or both, they can also be +used
■ j-rr
to
,-onltal
interest expense on fixed rate loan.
reduce fmanclng costs by exploiting the different comparahve advantage of borrowers m different capita^
markets. Consider two companies with different credit ratings. Both compantes can borrow at fixed and
floating rates but on different terms.
31 Dec 20x2 Dr Cash 120,000
Cr Interest expense 120,000
Receipt of interest rate difference on swap:8.8% vs Borrower Can borrow at fixed rate Can borrow at floating rate
10% on $20,000,000 x Pi year. . 5% LIBOR + 0.5%
)
Company B
7% LIBOR +1%
^
Difference: 2o/o 0.5%
31 Dec 20x2 Dr Unrealized loss on swap (l/S) 114,943
Cr Interest rate swap asset 114,943
Write down swap value to zero at the end of
Company A has an absolute advantage in fixed rate and floating rate borrowings. However, Company
contract. As advantage is greater for fixed rate borrowing than for floating rate borrowing. Company A is said to
have a comparative advantage in fixed rate borrowing. Company B has a comparative advantage m floating
r

875
874 ADVANCED FINANCIAL ACCOUNTING
accounting for DERIVATIVES AND HEDGE ACCOUNTING

rate borrowing. The difference in the cost of fixed rate borrowing between the two companies is 29& . ■ Th,„
affect the group's eejuity position. entities with foreign operations in such countries may find it
while the difference in floating rate borrowing is 0.5%. The net difference is 1.5%. Both parties can enjoy necessary to hedge the foreign exchange ris'. ^ jj.,vestment in a foreign entity is a hedge of foreign
a total savings of 1.5% if they enter into a swap arrangement. However, the sharing of the gain depends It is important to note that the hedge o^j investment. Therefore, it cannot be a
on the bargaining power of the two companies. It is clear from the situation depicted, since Company A exchange rate risk and not a hedge ot chang . changes in exchange rates is taken to
has absolute advantage m both types of borrowing, its bargaining power should be greater than that of fair value hedge. Since the translation dit eren translation difference,
Company B. Company A will probably enjoy a greater share of the savings. equity, the hedging gain or loss should a has a time value component, this component
Assume that Company A prefers to borrow at a floating rate, and Company B prefers to borrow at Additionally, if the hedging instrument is a ' effectiveness (delta)
a fixed rate. Because Company A has a comparative advantage in fixed rate borrowing, it borrows at a may be excluded from iTe hedging relationship and taken p
fixed rate. Similarly, Company B borrows at a floating rate where it has a comparative advantage. The ratio is calculated as follows: . - .c
two parties then enter into a swap whereby Company A makes floating rate payments to Company B and CumulchveAcng^^^
receives fixed rate payments from the latter. The swap should result in Company A paying a floating rate
at LIBOR + less than 0.5% and Company B paying a fixed rate at less than 7%. For example, assume that ^ d ■.

the terms of the swap provide for Company A paying LIBOR + 0.5% to Company B and receiving a fixed There is an ineffective portion •fif(A)
f Ai is ogreaterffective
than (B). The (if
portion change
any),inwith
thethe
faireffective
value ofportion
the hedging
taken
rate at 6% from Company B, which borrows at LIBOR + 1%. instrument should be split into an effective an me accounting treatment of a hedge
to equity and the ineffective portion to the ^ flow hedge. The effective hedging
of a net investment in a foreign operation is sin rpcoonized in income when the investment in
Pays LIBOR + 0.5% gain o,- loss, together with the translation adjustments, is reco.n
Company Company B the foreign operation is disposed of. Viedse of a net investment in a foreign entity to be a
Lender A borrows
at fixed Receives fixed rate at 6%
borrows at
LIBOR +
IFRS 9 allows the hedging instrument in a ^^g^^ g^-rency taken by the parent company. IFRIC 16
rate of 5% 1%
derivative or a non-derivative such as a loan m t,Hditional euidance on the type of accounting.
Hedges of a Ne, ineesdneu, in a Foreign OperoUm provides addtUona gu
, Jopo of net investment in foreign operations.
IFRIC 16 clarifies three main issues on o xnosure to functional currency of foreign operation
Lender Issue I: Whether risk arises from (a) foreign currency e, p , gj-gncy of foreign operation and
and pareu. entity or fron,(b) foreign -rrency exposure o ut. tmnal y
As can be seen from the table below, both counterparties benefit from the swap in terms of lower presentation currency of parent entity s consolidated tinancia
' I borrowing costs. .hat the parent entity can apply hedge accounting only m s.tuat.on (a) and not t ;
^ j
Issue 2; Which entity within a group can hold a jpjug 16 concludes
Company A Company B foreign operation and whether the parent entity must also hold the hedging mstrumen
that any entity within the group can hold the hedging mstrumen .
Originally pays. Fixed 5% LIBOR + 1%
Under swap;
Pays LIBOR + 0.5% Fixed 6% Issue 3: How an entity should determine the amounts to be reclass^ified IFMC 16 concludes
Receives Fixed 6% LIBOR + 0.5% hedging instrument and hedged item when the entity isposes i„t;nn reserve in the consolidated
Net result Pays LIBOR - 0.5% Pays fixed 6.5% that the reclassification to the profit/loss from the fomign currency fPRS 9/IAS
Gain 1% 0.5% financial statements of the parent in respect of the he ging ms rumen i j-gserve in respect of that
39. For the hedged item, the amount included in the foreign currency translation reserve P
foreign operation is based on the requirements in IAS 21.
HEDGE OF A NET INVESTMENT IN A FOREIGN ENTITY

The hedge of a net investment in a foreign entity applies to foreign operations (foreign subsidiaries and
associated companies) whose functional currencies are the currencies of the country where the foreign
operations are located. The translation method is the closing rate method, with the translation difference
taken to other comprehensive income. If the foreign operations operate in countries with depreciating
currencies, the cumulative translation differences can result in significant translation losses, and adversely
ILLUSTRATION 10.14 Hedge of a net investment in a foreign entity
Four Seas Corporation, whose functional currency is the dollar, acquired a ^
Locom Inc, a foreign company, several years ago. Locom's functional currency ^
31 December 20x3, Locom's share capital Wcis FC 1,000,000 and retained earnings FC 20U,uuu. i ue
exchange rate on 31 December 20x3 was $1.85 to FC 1. On the same date, Foui Seas orp

i\
 m
accounting 877
ERIVATIVES and hedge
for G
ACCOLIiNTING

876 ADVANCED FINANCIAL ACCOUNTING

options
decided to hedge its investment in Locom by taking a loan of FC 1,200,000 at 5% interest. For the value 0' ^ value of an option contract
year ended 31 December 20x4, Locom Inc reported a net profit of FC 380,000. No dividend bad been tp the intdnsi'^ an ^alue as
paid. The exchange rate at 31 December 20x4 was $1.70 to FC 1; the average exchange rate for the f"'
ear entity to n option ^nd "Ot initially in other
was $1.78 to FC 1. Assume that the foreign currency translation reserves in the group accounts as at - ,rp<; 9 allo^'''^ value hedged itei characteristics of the
Paragraph 6.2.4(a) ot IhR- intn ^ Vfrne value depends o ^^ jpRS 9]. The
31 December 20x3 showed a credit balance of $15,000. and designates only the e^ ["accounting ° perieriou-'-'
od-related hedge an item
item that
uini- represent
The translation difference in Locom Inc's translated financial statements for the year ended the hedging instrunien. • ine.-
subseqn^"-„„.rel«K''"
jated or 7,be
1 op'i"'U„lcast
jion is n^e commodity
commodity purchase
purchase which
31 December 20x4 is as follows; comprehensive income- I transact'
comprehensive trausact-o ,e ^glue
value hedging a ^ which
'hedged item i.e. whethei
'wedged whethd 1n _ jf,i tthee _ gn "P
c ^ion costs- recognition of non-financi
On net assets at 1 January 20x4 [FC 1,200,000 x $(i 70 - 1 rsII 0001 hedged Item is transaction- '""Lts subsequently c" ^
On net profit for 20x4 [FC 380,000 X $(1.70 - 1.78) (3o'400) pen of a cost of the 'nvebte'l 1 hedge"!-'''e^mliehW-
>.etl c reLered„dass,flca.ion
in future, theedfair
uslmenb
value
Translation loss for 20x4 y.i.i.'i.LL! ^ IS

mitinent. - expected
as- » crwe
ted ru ^^ ,eclassification
reclassihcation adjustment.
aa)usuTT.44c.
asset ;; „Tim7or » '"arr)fin" 7:^'-'..ik^lfted " Pfled .to» P«»:0;
jgen th®e los^. redas^' jg the cos tor oh.a.nl ng protection
obtaining
grnple, againstof
the time value
The forergn currency translation reserves as at 31 December 20x4 showed a debit balance of "u.si the
Against tne initial
inuutt cOSt ^ituatron^ . ^tonre va costs- Fo
($210,400 - $15,000). In Four Seas Corporation's books, the following entries would have been record^''- In other cases and grpreben^' [ated ^ ^ P' ^^eases in interest expenses of
accumulated
--..uuidieu m
i.t othe. e perio
r- . lit d' n ths is t against
31 Dec 20x3 Dr Cash The hedged it^a^ for (oP""" "! o«'
Cr Loan payable 2,220,000 ^ risk over a speed
speciho mpyv ^^t r^^.gte P goltiz
The loan payable is designated as a he'dqe of ' 2,220,000 "P.ionhedg,ngaconr."°77in.=y;fg.ecaP''
"ation hedging a coi g,i in
the net investment: FC 1,200,000 x
$1.85.
spot rate of wiod. Another
period.
-x f,
Another e»nl^,j,uev»
.
exami
. .„rl The ti
„„d.
» HooUng rate b"" ot • option
interest rates (e P ^ pta„s to b y P
31 Dec 20x4 Dr Interest expense
Cr Accrued interest ^ 06,800
Interest expense during the'yearat5% xFr
1,200,000 X $1.78.

31 Dec 20x4 Dr Accrued interest

CrCash 106,800
Cr Exchange gain 102,000
Settlement of accrued Interest at year-end.
On t ApriUO>^pk4.0«">, "fofah''''" _
31 Dec 20x4 Dr Loan payable
SGD 30,000, and jGP p SO-" ^ ^ ther comprehensive income and
Cr Foreign currency translation "reserved Value reserve (O ...miS, tla® i
On 31 December 2 ^gj,ere ' ^
-cunrulatch
punrulatcu m 7" . ing affects profit or loss (^or
'' entfoc^he
for ihe ^g„ges in fair value
tor
Exchange gain on FC loan taken directiv tn^'"v''' ^ ^alue min other
other
FC 1,200,000 X ($170- $i85). ^ equipment has be"\^--^e <"»Dge »di»J^„ elected „,her comprehensive
■
The amount hedged is the net investment at the end of 20x3
For ttme-reWe^IE d»';?fhe
Notes
amortized over the P . jgcOiT® .rti^^^^
1, Under IAS 21, the foreign currency loan, being a mon • a isioS tb^ rather comprehetrsr
comprehensive mc ^hhiU
dosing rate at reporting date and the exchange gain takert'oFr""' """"""HoweveF ■- , th

the application of hedge accounting, the exchange gain is k mcome statement. Ho i^ss-
2, There is no ineffective portion on the hedging instrument^ since it is a non-derivative that
IW UllNCl — J

have a time value component.

 ''/i'

879

878 ADVANCED FINANCIAL ACCOUNTING

INMl , treasured at FVTPL can itself be

ILLUSTRATION 10.16 Time period-related hedge using option) —
OPTION TO DESlGt^ credit derivativ
. D managed by ' ^g„ionty of t
instrument matches
of
On 1 April 2015, an entity with functional currency Singapore dollar issued a five-year Hoating rate bo"^ A financial inslrumv"! p.■,h credit nsb ^
,e of!'« j, 6.7). ^ ^„,,cial instrument
"j'vTPf """f ,be designationcommitment
occurs after
in Singapore dollars. In order to protect itself from interest rate increases the entity bought an interest measured a. fiVTU il 'U 9 amlx is "recognized in profit
rate cap on 1 April 2015 with maturity of five years. The entity designates the intrinsic value of the cap that of the rolcrence eiH ; „itineiil- bseflt'T., , a„d e"""' ° pyTPL is discontinued when
as the cash flow hedge. IFRS tj, for example loan p " ognih"" ° , eeo lite W J , instroment .jy fYTPL.
On 1 April 2015 and 31 December 2015, the time values „f the interest rate cap arc SOD 100,000 an is unrecognized, at '""'f , rente T;Te»'"'"rf . .... u ...Useouentlv
subsequently
SGD 88,000,
' '
respectively.
,
The time
0 1 T-X
values are1 amortized on a straight.line
1- '-krvi
basts over the hedge rpn""'';'
Straight-lUlt: UdblS OVCI mC- .r the i„„ia(reeogni..on. th' The ^ the fi.«» " re ne« e«eyt
the period 1 April to 31 December 2015, the amortization of time value to expense is SGD lOOtOOO/-^
mp^OOO/-' LllUC \
0' loss at the desigmttto" „„geri»et » g,coi«ee
n I^ ^
9/12 = SGD 15,000. The OCI balance is credit SGD 3,000 (SGD 88 .000 -(SGD
-1 I "X 1 ^ /A 'I ' v-\ I 1# i 1*^ I *1 a-, _ _. _ ^ a"—"S ^ J
15,000))- foe qualifying criteria am jisconf'
100,000 - SGD
^be
the fair value at the e '> ^7,
uc; 6-i-
llTl clV'''
^mortized (IFRS 9 pin-^S "
The accounting for time, value of options applies lo
vajaccwr.., ctppiiLs to the
the net
net nil
nil time
time value
value in
in the
the com!
combination
v-Fdicprl and a written option. Chanpes in lit-na ,,.,1, -icoine- 1 •„ ceases to meet the qualifying
purchased and a written option. Changes in time value are rernon' u -
transaction-related hedged item, the time value that adjusts hef T
transaciion-reiaLcu ncugcu ncin, uic uine value that adincic i •
u
comprehensne i
,
• m iiiwc-
.-nfit or hedpnyfT;:;
hcdgins a „ or iiss dosed
dosed off or terminated. 1 n
at the end of the hedging
hedgtng relationship
relationsh.p is nil,
nil. Fm
For til rZn
Tl'! r f ^^ P''e ^e .s nil DlSCONTlNl -^„|ie» "''Td me'-Tihe etttityh risk management objective.
If the crttical terL of the hedging option al the h d ^ "(.Ted ti""=
value (that is, value of option that with terms that perfect ""T"' T mined
accounted for as follows: hedged item) ,s determine wineii

If at inception of hedging relationship, actual time value , .p the '^^placement ot a hee g'J
aligned time value is accumulated in other com ^
y-\ \ t 4"-l /-i T IllzCi ir> ny
higher than aligned time
t t %-v-. J • «
^gen Note that the q,
actual and aligned time values are accounted fl ;"' b'eatment on the dis
.til I"'
(b) If at inception of hedging relationship, aligned timi^l'^ 1^" • valne' a- hed
"eage ot a net - iS
lower of the two is accumulated in other comorehe ■
in actual time value is recognized in profit or loss
higher than actual
and the remainder o
'chnn^^ exchange translation ir^lTrf-nattiral hedging" can
r the elltGl-S
atl nS ot hedge acco unting is
'ht "Ing nstrument,r-rountina
are reported m the
ACCOUNTING FOR ^ HEDGES WHtlT^eaPfT^S
J pf^f hcdge'^ be ^
the hedging
,nd losses being reported in
treatment

^ot all hedge relati•niiship^

110'". Jjid , jce tb®
to ^,V resol
InSSO' " v,e VOf'-'' Tl^s'obSedging
of fo® Uatilifolac° the offsebii^i'
^^ au example
res^._^.
o
t is„fa the heugmg
i.ui^eeexr..
nstrument
_ ^ financial and the
^ instrumentiFp
Paragraph 6.2.4(b) of IFRS 9 also allows an entity to separate th f elenie*'''- be achieved through . ^, aaif
^^ins , to t® uritb' ,-nuUt^'^^' dr^jr valo
values that are denominated
a forward contract and designate only the change in the v 1 ^ element and the spot to ensure that oftsd..^
to ensiii-p iFat offeott . . ol' t» *;Tenk ^F;»Trr;:se«,entem or a. the
and not the forward element as the hedging instrument ^Th ^ element of a forwar ^ ^ame accounting P ^ tb^ apP josS- g whe^^ , tf a foreign currency, monetary. item
item
1

forward element is accumulated in other comprehensive inco ^ ^ ^1 for the hedged „eej pfofR > d; I»TT'»» "^70^ the gmn or loss on the hedmna
"»®
o"" ir.« It a toreigii

aame period, theiT f g,ron J eaTge 8»'((ake«'"^T/ireor seeroftset

Ich'HT„Tls,ration
'iten^ the gain103).
. Ilfo^tration
or loss on the hedging
Tiin^tration 10.5).
...

exists at inception amortized in profit or loss over the per'^T (aligned) forward e en io.5).
If the hedge accounting is discontinued, the net amount in" forward eleme ^ plates
tlfo dassified as fair "T e* ■"
cumulative amortization, is reclassified to profit or loss. The f" ^comprehensive income iF hedged item wiU n" rh® grs
to the hedged item if the critical terms of forward contract amTn^ element of a forward coi ; If ■'' m foreign xuriemy n^JtinS loss "p lS>' monetary items-
critical terms are not fully aligned, the amount is accumulated if"other
^ ^''g"od with the hedge mportingdate.T , giO
comprehensive income foil""" '
lernis die nui imi; czii5».u.v.v, is accumnhtpU ; , pc •teiiiy
ifi it laf
fopeiS
Is hedged by a .aiitf'S.tr to
(a) If at inception of hedging relationship, the absolute actn.l r , . . man
than fostrument in the s^
forward element, the aligned forward element is accu element is higher »dg«

the difference
the difference between
between actual
actual and
and aligned
aligned forward
forward^ocui-nulated
el^"
1 other comprehensive iiico
fo Ipss-,iute ion

Tf — „c u„u„j,.|g relationship, the alivnprl

(b) If at inception of hedging relationship, the aligned j: accounted for
accounted ti... in pfO b ot
tFRS 9 paragraph 0 - rftt
actual forward element, fL zvCf,:.
the lower of . is accu fo'-ward element
the two element isi. higher
hiaher than
than the aP^ " IPRS 9 does not p-'h
iiiie
nPO
the remainder of the change in actual forward ement is recognized other comprehensive
in profit or loss i
 881
880 ADVANCED FINANCIAL ACCOUNTING accounting for derivatives AND HEDGE ACCOUNTING

EVALUATION OF HEDGE ACCOUNTING

This chapter concludes with an assessment of hedge accoiini;^ nc
twofold: to reflect the effectiveness of hedging activities of
i■
a "bhTttves t.t hedge accounting ar
• ri i - ire
appendix 10A
earnings. Generally, firms(and investors) prefer stable to vlh,i™'
hedge accounting. Compl.ance with the requirements of IAS q n "T e
expenditure of resources, in particular, the need for detailed Iw
of the hedging instruments hedge effectiveness throughom tir°"""',""r n , , -n '
vonsideraW
"
Embedded Derivatives and
problem for a business firm with a limited number of hed
hedging activities, especially financial institutions, entities deaTi?
' " vL
""'i' """"ive
Split Accounting
exposure to currency risks, the cost can be substantial Iruf, b" '7
and made them consistent with the entity's risk management I,
Many entities, particularly financial institutions do not h , . ijv k t iN nart of a instrument,
hybrid financial
the hedges are on a portfolio basis. Applying hedge accoumi^ff "" An embedded derivative is a derivative that whichinstrument. The principal
is not a derivative. While
challenging. Manv nnrhfryiimc. ■ <- f r. j t- , to portfolio hedges will prove particularly component of the hybrid instrument is known as ^ ^i^gj-e may be more than one embedded
exposed to and X rnaru ° d Addv n "f lyP= "f r sk they are there is only one host instrument in a hybri salient feature of an embedded derivative is that it is
hedge acc„„„.l*' Additionally, hedges are often made on a net basis. Co,nphance with derivative that cannot be separately transacted. exchange rate or the price of a commodity, such
hedge accountmg
Organizations suchcriteria fol portfoho
as Freddie Mac and
aQ PnzsUci-
(orFanni,
maclohXTsVlX"""
i\A
c "'f ?"challenging,
xxa.y..c *"= Particularly
jr
1 ",f
• itm"""
xw not iimpossible-
pdriicuiariy cnaiienguig, 11 not i mpos linked to an underlying such as the interest rate, flows°of the hybrid instrument. An example of
TTC In
US, have " breddie
encounterorl m ki Mac-nuand xu Fannie
■ • Mae. ""ucn
which are
arm very uhuge financial
r- ■ i corporations
• • ihe
in tiie that changes in the underlying, cause changes in e c linked to the price of a commodity,
niered problems with their interpretation anri • / • r xi i j f ttct
requirements of SFaq m^ih a u- i_ • . implementation
orAts 133 p (which are very similar to tA*; fim -ya, „ , . of the
, ■ hedge accounting
x-w,o a hybrid financial instrument is a bond whose ultimate pioc
approach to dynamic
rdiamic imr
interestx rate risk
• i management to addrccc fu Board
. j is■ exploring an accounting such as oil, or to a consumer price index. instrument and accounted for
Hedge accountiThry •
■ 1 ,
x j to • . dauress the macro hedging issues.
unting IS not mandatory. Business firms have tk i ■
IAS 39 requires the embedded derivative to be separateu t
simply by no, complying with the documentation criterion X
most enthies
i i j x-ccr '''X accouhtin„ as a derivative when the following three cot, itiotrs are^^^ i„3„u„,ent are not closely related to the
that they
enttttes may still find thm thev need to have effect.vTo"
eff,c.„. ""'PPhod
» applied or not,
1. The economic characteristics an t e ris's instrument and the embedded
" hedging
oi their s^ng acfi
edging a vit.es. -cl
activities.
ctixru- TherefoL
Therefore,
c the
the
i issue
issue
■ is• whether
is wbe.k"
. the
^Fciaimg ,
systems momtor
c
to momior the eflect.venesa
i-tne i o.-i
ettectivenefp-
economic characteristics and ° if their fair values are affected by different
offset the benefit of o i • ihedge
or applying ■
, accounting. additional costs of compliance more than derivative are not consideied to be y
economic factors. embedded derivative will meet the definition
2. A separate instrument with tne same
of a derivative. . , g-kanges in the fair value recognized in
3. The hybrid .nstrument is not measured at fair value, with changes
profit or loss. . to the
The requirement ,o split the embedded der.vative frotn the host 'XXXd'derWlve at the
measurability criterion. If it is not possible to measure the air va u financial asset
point of splhting or subsequently, then the entire hybrid mstrument is treated as etther
or a financial iiabiiity that is held for trading. . i j x rm xrt that entitles investors to
An example of a hybrid instru.nent is a five-year equ.ty-hnked ^""Xent is based
receive a return on the investment via interest payments made at maturity. The ua P ^ maturity,
on the relative values of the Dow Jones industrial Average DJIA) at the t.me o
if the index value a, maturity date is higher than the level at the issuance date, 'hvestor^^^^^^^
receive a return at the lower of 25% or the notional percentage growth of the ind , only
principal repayment. If the index value at maturity falls below the issuance level, the investor
m the principal sum of his investment, without any interest.
The problems of n:.- j i i. kU
financial pre.ss in the'us'"-a x^.x^x 'ccxxxx-x .
L IIT • r-
'""edging derivatives have been well documented in the
• uei ivaiiv'

S- Both companie.s had to restate their financial statements at huge expenses. "IAS 39 paragraph II
882 ADVANCED FINANCIAL ACCOUNTING ACCOUNTING FOR DERIVATIVES AND HEDGE ACCOUNTING 883

This ELN is a hybrid financial instrument with a host instrument and two embedded derivatives. The
ELN is equivalent to a regular unsecured debt contract plus a long position in a call option with a strike
price based on the DJIA level at issuance date and a short position in a call option on the DJIA with the
strike price equivalent to 125% of the index at the date of issuance.
The economic characteristics of the host and the embedded derivative are not related. The fair value
of the bond depends on interest rates and the credit standing of the issuer while the embedded derivatives
APPENDIX
10B
are affected by the stock prices of the companies that are included in the Dow Jones index. Thus, the
host instrument (the bond) and the embedded derivative (the equity option) have different economic
characteristics and risks. The embedded derivatives should be separated if they meet the requirements of Hedge Accounting under IAS 39
IAS 39.

Qualifying Hedging Instruments (IAS 39:72-73)

Instruments that qualify as hedging instruments are:
1. Designated derivatives with the exception of witten options.'® A written option increases rather
than decreases the risk of the writer and entails high potential loss;
2. Embedded derivatives;''' and
3. A designated non-derivative financial asset or non-derivative financial liability that hedges the
risk of changes in foreign currency rates only, for example, a foreign currency loan, or all risks
(IAS 39:82).
Normally, when a derivative is designated as a hedging instrument in its entirety, the change in the
fair value of the derivative is used to determine hedge effectiveness. However, when t e air va ue o
the hedging instrument can be decomposed into its time value and intrinsic value (or spot price rate
components, it is permissible (but not required) to exclude the time value or interest component rom
the hedging relationship (IAS 39:74). If this option is adopted, the hedging instrument is the intrinsic
(or spot) component; changes in this component are used to assess hedge effectiveness. W en an en i
excludes the time value component from the hedging relationship, it must be explicitly ocume
the inception of the hedge.
A single derivative may be designated as a hedge of more than one risk if the derivative has more than
one element, for example, a cross-currency interest-rate swap (CIRCUS) may be used to e ge J
risk and foreign exchange risk. Hmvever, the individual components designated for hedging eac sp
risk must meet the hedge accounting criteria (IAS 39:76). It is permissible for a proportion o ^ .
amount of a derivative to be designated for hedging, but not a portion of time perio o

Qualifying Hedged Items (IAS 39:78-79)

These include:

1. Financial assets and liabilities with exposures to changes in fair value;

2. Non-financial assets exposed to foreign exchange or price risks, for example, commo i les.

An exception is when a written option is designated as an offset to a purchased option (IAS 39:AG 94).
''' An embedded derivative is a component in a hybrid instrument that includes a non-derivative host contract (IAS
features of a stand-alone derivative, but combined with a host instrument.
 884 ADVANCED FINANCIAL ACCOUNTING accounting for DERIVATIVES AND HEDGE ACCOUNTING 885
3. Firm commitmentsF" j.,.,a^urity and underlying) match the hypothetical derivative and
4. Highly probable forecast transactions with exoosnrpc n ■ r instrument (such as the nominal amoun jg j-j^e hedge is effective. If the critical terms do
5. A net investment in a foreign entity. ^ the counterparty credit risk of he pffectiveness in the hedge ratio analysis need to be carried out.
not match, the quantitative tests on hedg
The following do not qualify as hedged items:
Hedge eflectixencss rat" _ trospective Change
Change in fair value of hedging instrument
in fair value of hypothetical derivative
tests at reporting dates o
rate risk or prepayment risk is inconsistent with h Hedging .nteres o r reouired
Retrospective tests are no onge under
jrjjqQ.^ying IFRS 9.may be used to assess whether the hedge is
methods
If there is an intention to hold the investment to m 'n«roment to maturity At the inception ol the he ge, ^ff.pttinc changes in fair value or cash flows over future periods:
a result of changes in tnterest rates will be irreleva^r,"",b likely to be highlv effective in achieving ollsettin^
2. '■"Stment m an associated company cannot be hei I '""'T ■ , c f ,he " ' . . . tenrif- of the hedging instrument and hedged item (e.g. notional
investment. However, if the associated company .s m st 1- Comparison of the printtpd delivery dates). If the critical terms are the same, a high
the effect of exchange rate fluctuations on the i„vesr'''I' ""'u'"' ' " amounts, maturity, quantit)', ^ssunied. For example, the critical terms match in an arrangement
in the foreign as^sociate. degree of hedge effectiveness exmected to be received in 30 days, is hedged by a
n IAS 39:88, in order to be able to apply hedge accountintr m r n j- •
. . the following conditions must be met: where a US$10,000 accoun s r uS$10,000.
n enterprise must have an exposure to risk that , n rr i 30-day torivard exchange changes in the fair" value or cash flows of the hedging instrument
(a)
V j A
^ foreign
loreign mrrra t
currency monetary •
item; affect the income statement, for example- 2. Historical analysis: comp^t'ison o H
(b) A fixed interest rate security; and hedged item.-' ,hnH>;tical analysis to determine the degree of correlation between the
(c) An equity security; 3. Correlation analysts: hedging instrument and hedged item.^-^
(d) A firm commitment for a future sale or purchase- changes in tair value or casn , i j
fej An anticipated future sale or purchase fnot . ,, x r . u Upp the
2. The derivativfs t * ■ -r- n committed but probable); During the dure.ion "V''''''tf; ' H„dollar-offset
(sorneLesmethod may beasused
also known the to"delta
evaluate
ratio")continuing hedge
is expressed as
a derivative contract is specifically entered into tr. h n u j i • effectiveness. The hedge etfectiveness
3- The hedge must be highly effective; '''" underlying exposure; follows:
5 Th! df the hedge can be reliably measured; and ws, in 0- fair value or future cash flows of hedging instrument
Hedge ef-fectiveness ^ ^ f„,„e cash flows of hedged item
should cover the firm's risk
S'cig relationship mustmanagement objectiw Influ
be formally documentpH • d'^ r
CfU u n '' f-r.n
th^ (or delta ratio) GnanoC . , , m xw,
nature of the risk that is being hedged, the type "f h n I the hedge, ■!« lAH
When a ihedge
n is- perfect,
c 1 the
the hedc^e
hed^e effectiveness ratio is one. However, in practice,
effectiveness hedges are
to be defined as aserange,
o
effectiveness is to be measured and whether fte
me beg '""'TT'
hedge is likely to be highly effective. perfect for a number of reasons. In view of this, IA8 39 ailows neage o q to l 25 range (IAS 39:
To qualify as an effective hedge, the hedge effectiveness ratio must be with.n the 0.8 to 1.25 range t
Assessing Hedge Effectiveness AG 105b). As an example, assume the following situation.
Change in fair value of hedged item = $200
thlifrettXTaS: T "T a T' """t '''u"®'!
instrument- (IAS 1, m »Hedge effectiveness
"sk are offset
f"" ™lue or cash flows of the hedged item Change in fair value of hedging instrument = $160
VUT.O jy:yj. mustbybechanges in the fair value or cash flows of the hedging
evaluated-
The hedge is effective as the ratio is 0.8.
h Prospectively at the inception of the hedge; and Change in the fair value of hedging instrument ^ 160 ^ ^ g
etrospectively on an ongoing
o o basis while the hedee n in
gc is - place.
i Change in the fair value of hedged item 200
durmrthe'heLf ^7 n > expectation of hedge being highly effective The dollar-offset method is arguably the most common method used to assess j|^';^7hedi
changes in fa^ vT substitute hedged item with hypothetical derivative
g tair values offset perfectly changes m fair values of hedged item If the that haveterms
critical termsofsuch that
hedging In addition to its simplicity, it offers the advantage that the mformation ''Wis method
effectiveness is based on accounting and other information that is read.ly available. However,

Tirl a ""l"" ■■ "■ T""" "li ■"'T'" t.mv .... ■ IAS 39 Application Guidance AG 108 and Statement of Financial Accounting Standard (SFAS) 133 Accounting for Derivatives and Hedging
'I HTM.5 i-f Non-perfo™®"''® usually results m a heavy penalty. Activities, paragraph 65.
r'uidanceT2 prohibits a variable rate debt from being designated as a hedged item Besides IAS rate
tor interest 39 paragraph
risks. 79, IAS 39 Implementation IAS 39 Application Guidance AG 105a.
IAS 39 Application Guidance AG 105a.
 886 advanced financial accounting
accounting for derivatives and hedge ACCOUNTING 887
is highly sensitive to small price changes, which mav re<;iili ti u i rr ^ figure lOB.l Overview of hedge accounting
the permitted range. An alternative method to the dollar offL me,h i "'1° ®° ide

Should hedge effectiveness be assessed on. method is statistical analysis. Derivative

cases, bothwhere
situations shouldtheresult
heri in the
f ii hedge
^ -jbeing
u either
rr- effective
I^^tive or h
or ineffective. However, there may^asis? In naos
be exceptional
V No
baSis if the hed»rieTo rfeT , H andn ,fr that
hedge .a so designated I condition is appropriately doctnnented.
to be arrcsaed on a cumolath" Is the derivative Intended
Treat derivative as a trading
security. Change in fair value
to hedge an exposed risk?
taken to income statement (l/S).
TABLE 10B.1 Assessment of hedge effectiveness Yes

V
No
Does the derivative have a
Change in Change in time value component?
Change in Change in fair value fair value
fair value of fair value of of hedging Yes
of hedging Delta
hedged item hedged item instrument V
instrument ratio Delta ratio
(current) (cumulative) (current) (cumulative) Is the time value component No
(cumulative) (current)
30 Sep 20x3 excluded from the hedge?
$(4,000) $3,950
31 Dec 20x3
(4,480) 4,310 Yes
31 Mar 20x4
(3,980) 3,830 V
Determine hedge effectiveness as; Determine hedge effectiveness as.
Change in intrinsic (spot) value of derivative Chance in fair value of entire derivative
derivftte^is^3g™'^® derivatives to be excluded from a hedge relationship. The Change in fair value/expected cash flows of hedged item Change in fair value/expected cash flows of
hedged item
contracts)^ conf options) or interest (in the case of forward
value component ■ intrinsic (option contracts) or spot element (forward contracts). If the time
as the hedging i ^ ^^'^'rided from the hedge relationship, only the intrinsic/spot component is considered V
No
Hedge is ineffective.
Is ratio between 0.80 and 1.25?
value of the accounting rules of IAS 39. The change in the fair Discontinue hedge accounting
value (or expected^'^''^^"^ component of the hedging instrument is compared with the change in the fair Yes prospectively.
delta ratio is w'tm hedged item to determine whether the hedge is effective, that is, the V
Since the ^ range (see Figure lOB.l). Hedge is effective.
the default treat"^^ component is not part of the hedge, it is treated like any other derivative and
result in the hed"^^""^ applies, that is. it is taken to the income statement. Exclusion of the time value wiH
range. This is be^^ highly effective, that is, the hedge effectiveness ratio falls within the permissible V
Hedge is designated as:
the time value( intrinsic value (or spot) compom
component moves in tandem with the underlying whh^
If the crif ^'^^erest) component generally does not.
1 or terms
the time value
lue or th 1■ TTf"^3offAEithe
the
hedging instrument and hedged item
r<-F A-.^ »-s. v—»-« »-« 4- r*In I-I 1 t-ynr-iilt- •> Tn n In/-> y-J/-vn /-v
are exactly
v-. 4-ttAacny
_ •~ —
the
mc same,
j.1 _sciinc,
the exclusion
_ 1 /uie exclusion
_ .
of
Cash fl ow hedge Hedge of a net investment
with 100% off interest component should result in a hedge effectiveness ratio of 1 (a perfect hedge Fair value hedge

risk, and a f ^ "^^ry near to 1. To illustrate this, assume that the hedged risk is a foreign exchange
item is the ■ *-°ntract is used as the hedging instrument. The change in the fair value of the hedged V V
Time value is taken to l/S,
hedging instr^*^'""^^
strument isamount multiplied
the change in thebyforward
the change
rate in the spotbyrate.
multiplied theThe changeamount.
notional in the fair value of die
Mathematically'
Apply hedge
accounting in accordance
Time value is taken to
l/S;* apply hedge accounting apply hedge accounting in
with IAS 39:89 in accordance with accordance with IAS 39:102.
Change in spot rate x Notional amount (see Figure 10.3). IAS 39:95-100
Hedge effectiveness ratio
Change in forward rate X Notional amount (see Figure 10.4).

Only if the time value is excluded from the hedge relationship.

IAS 39 ImnlemA
- IAS .W specificallvr"" -^'""^^'
.ihiire man\ siinjl. ■ "nly option contract.^ and forward contracts. It does not mention futures contract. However, futures contracts
■>''"ties with forward contracts and exclusion of the time value should also be extended to futures.

jk
 889

ACCOl
n—
AG for DBRtVAT'VES AND HEDGEchange
ACCOUNTING
in the fair value of
888 ADVANCED FINANCIAL ACCOUNTING
of the he<ig= PI ,esent value o ey ^ome
Assessment ot the eilecliveu«t°',,a
; ettecthen . change ,n
** P „.8 to 1.25 range
Since forward rate = Spot rate ± Forward premium or discount (the time value component), n, theai"^"' he xiHta ^ratio ^
nte futures contract
the conln^ct \Mth ^ ^ as {he de 1,
Ig^-tive r cosh flow hedge
, rr . ■
Hedge effectiveness ratio — —
Change in spot rate x Notional amount
[Change ^m spot rate +(-) Change
i
in premium/(discount)l X Notional an
that the hedge is highly rated lO
. .,c iiidiC'
hedge ineffectiveness »- af the
effective
„d ineffective portionso^^^^^ Ineffective

credited/
Excluding the time value component, table 10B.2 Determin°^°" Effective
(debited) to
portion
income
credited/
Hedge effectiveness ratio = — in spot rate x Notional amount Cumulet'v® Lesser of the (debited)to
statement

Change in spot rate x Notional amount .«tive uange'n two cumulet'V® equity in in current

= 1 current period
$0
$100
Causes of Hedge Ineffectiveness future® (ash $100 85
5

185 (2)
There are several possible reasons for hedge ineffeetiveness. One of these is the incktsion of the tim' Period ending _ 290
105
7
value or linterest
value ueicb component of the ffcugmg
eufupuff.dt .yn. hedgitrg instrument in the
msiTument in the hedging
hedging relationship.
relationship. As discussed
discussed eari«. $ioo
245
(45)

this problem ts eas.ly

iblem is resolved by
easily resolved by excluding the time
excluding the time value
vp1„p. or
w. inteLt^ component
. from
r the hedg'"^«
the 3l January 190
relationship. Another reason is when one or more of the rritiml tc r , , j j t nn nnd hedg"''' 28 February 20x1 — 293
,. 1 r. <- u mu 1 critical terms of the hedged item ant .
instrument do not match. The critical terms may not mnirt, o ui i
,T ,o , . .instrument
, , and
^n Vn
m uhedeed
J ; ■
J item "'y
. • i .amounts 2l March 255 .contract is less than the change
the hedmns : the uT ^ not match
A\(r^^ ^
exactly
ttactly because the notional aniot
the hedging mstrnmen. and the hedged item differ, or the maturity date for the hedged item f
7 'heeause the notiomil tumo"'''.' , 30 April
. future futures
.value entire change ineffective portion
from that of the hedgmg instrument, or the underlyings base is different from that of the bedg'»
tnstrumenti for example, an .n.erest ra« swap, the hedged item may be a variable deb. batted »
prime rate while the swap is based on LIBOR (I onHAn Tvst l . "X cie a vaiiau „,upre ^ I^otes , Auce luea t"',"-;, to eq'
hedged item is a commodity, such as gold, the location where'the
whpm m! qo\T' the sp'
sp«^^ h At 31 January 20^^ ^ ^nd I$l05)-n„e ."be
j^g fu»"«
futures TT,y)raroiuTe
absol^ute terms. As a result,
result,
price of the hedged item to differ significantly from the nr' r. Produced m y ^nsp^ r; ;csen.
„,vAt value ffgctivc
«r.: r ^ --r"
/tfOO' ot ot -pou „,„„imxrp rhanse

c'osts. Another reason is that the hedged item h'as mumpL^,;!:"f r e'x '"Tairtc)boA d, contract ts co^' „ge■",[tbe<uefub'"L
^pectv^ ^un. taken to equity In February $85,
..nio I' in the .gn

and the hedging relationship is not correctly designated On tK ' u

a,so have mtit.pie underlymgs, for exampil, a cfmted
^ foreign nay
bnay DV'st* .0. «hi cb ,ess .ban
cause some hedge ineffectiveness. currency sw^p, the change ^In the P^ -n the ' ^,pee
futn' loss as conr cumulative change ^jT'^Jumulatke change in the present
the cunaulatN^- valrie
in the present v IS - . m <b' Uec.e'' ,,,3, ay^ «yen t°'knlV - M-h »
and the , 70X1.i, " cb.^P»', w"" ohItra" ' ,eases f ;;x„„
o: The
in equHY
(ries;;^$293 and $290.
„f ,he
ILLUSTRATION 10.17 Effective and ineffective Hornons
portions in
in o cosh. flow
c. hedge At 31 March2»
'I" „ the p^.ese.futPte'
t e°coO '' ^(fectfe V ,h,„ the c „f ,he amount
the change
ug^ ira nf th^{^e ^ ,-e ^^ash t of A/iarch ts a reversal ( taken to equity is less
On 1 January 20x1, a company entered into a futures contract t L n at the e^ n^ in the fair vafo
of April 20x1 and appropriately classified it as a cash flow h d ° ^ ^ forecasted transaction idg^
value of the et'P ,„rpe,;»;>ae..ve
accounting are met. Hedge effectiveness is assessed on a cu ^^1 the conditions by
of $105
.ptuj so
.A that
v.-
A^p

the H tite P '" ffset

comparing the changes in the fair value of the futures contr"^^! four-monthly P Note that tl -cctdHi'
qnrroS^^^g iU _^gtiy 103
mt oi.rlF=;,„e«»'
■act
expected future cash flows. The following table shows the rhr changes in the presen iiitt futures contr 2

and changes in the present value of expected future cash flowT^^ recognized P coOitra'^
105

Change in fair vaiue

than the a-;,-y F<forl°'''
nroflt
Change in present vaiue of entry is as .
Period ending of futures contract pr
Cr
®xpected future cash flow 31
31 January 20x1 $100
28 February 20x1 — 90 $(105)
31 March 20x1 103 (80)
30 April 20x1 (38) (105)
45
 ''L

fni erivatives and hedge ACCOUNTING 891

for de
ACCOb mting
890 ADVANCED FINANCIAL ACCOUNTING

4. At 30 April 20x1, the change in the fair value of the derivative is a loss of S38, and the change m CONCEPT Q
uestions futures contract?
present value of expected future cash flow is a gain of $45. The cumulative change in the fair valu'^ o tract
different from a
the futures contract is reduced to $255, and the cumulative change in present value of expected tuture how IS "T
a forward con' writer?
cash flow is reduced to $245 (in absolute terms). The balance in the cumulative effective portio ^ CQ10.1 From a risk
, „.cnecth'^'
F
equity at the beginning of April is $290. Therefore an adjustment of S45 is made to equity to bring tion , decide wheterto^e a forw«d
the balance at 30 April 20x1 to $245. Since the change in the fair value of the derivative in April IS sition
of an op' , risk has to ^^jTsider before deciding
($38), an amount of $7 is credited to profit or loss as the ineffective portion for the period. CQ10.2 How does the pn should tl>ef.™°

SQIO.3 a firm that to a"V

eom,-act or an options t YOU valae hedge.
on the type of contrae aedse s"
or a cash flow hedge? Explain
cas valne hedge
rish betw''" • either a fair
CQIO.4 Distinguis be
a item ^
a h^^
ilicac
CCH0.5 In what
why each type nP hedo contra',ct?
forwa'rd future transaction. Why is
•I'lT
tta»'>''rreiteVtransaction a cash flow hedge?
as.«T'!a::of.f°«"^'
CQIO.6 How is aa sw
s 'ap ,Ho'f;dahetlF
accoun'ted for?
entity
CQ,0.7 Both a fittnnlltio foreign
utirr
Ptedge of a firm conan tnrr'
iuves'
et
of^'^'
hedg^
^QlO.8 How is tr

J FlO.2- cViares The option premium

exercise^ e'"-'"" ootion <»'iorr^^P^'^'
ah^^^'.uaprrtiroPtUtA- - n-
September 20x1.The prices
Isold) The nP
atm" .s$3.60-^^reas follows-
Atlasf'Axetc- put option premium
per share
On 31July20xl. <,the ptioh
Was $0.18 per sha jthe P
rrf Listco shares an

31 juiy 20X1
31 Ac5>er2
30
 893
892 ADVANCED FINANCIAL ACCOUNTING
accounting for DERIVATIVES AND HEDGE ACCOUNTING

El0.1 The put option premium per share on 30 September 20x1 was: El0.4 The amount of fair ,.,ue changes taken to equity as a, 31 Decetnber 20x5 was:
(a) $0 (a) $10,000
(b) $0.05 (b) $20,000
(c) $0.20 (c) $60,000
(d) $0.15 (d) $70,000
(e) None of the above
E10.2 Assume that Atlas Company did not make any journal entries relating to the put option. Atlas
Company would have to report the following gain/(loss) on the put option on 30 September 20x1: El0.5 If Gemini has a floating rate loan and enters into afollowing
pay-fixed-and-receive-floating
statements is the mostinterest swap
appropriate
(a) $5,000 transaction with the same principal amount, wi
(b) $1,800 I '<r
for Gemini? deferred in equity with corresponding changes
(c) $(1,800)
(d) $1,300
(a) Changes in the fair value of the sr^p should be deferred
recognized in the carrying amount of t le oam ,n ^ equity with corresponding changes
Use the following information to answer E10.3 and E10.4.
(b) Chatrges in the fair value of the swap should be
recognized in a swap asset or s^vap habi ity. . ?■ income statement with corresponding
Alpha Corporation had the following transactions in 20x5: (c) Changes in the fair value of the swap should
changes recognized in the carr>ang ° recognized in the income statement with corresponding
(d) Changes in the fair value of the swap should be recog
Transaction changes recognized in a swap asset or swap la
1 January 20x5 Bought 100,000 units of shares of Company X at the market price of $3.80 per share.
d • to a contract to sell 10,000 shares in XYZ Company
Alpha Corporation classified the investment as avaiiabie-for sale (AFS). El0.6 On 1 April 20x6, ABC '"below $3.00 per share and not higher than $4.00 per
1 July 20x5 Purchased a put option, which gave it the right but not the obligation to sell 100,000 for delivery on 30 June 20x6 at a price a
units of shares of Company X at a price of $4.50 which was the prevailing market price. share. The current market price is $3.50. ^
Alpha paid a premium of $12,000 for the put option. The put option expired on
30 September 20x5. Alpha Corporation classified the put option as a fair value hedge of
Which of the following statements is correct embedded long
its investment in Company X. Hedge effectiveness was measured based on the ratio of (a) The contract has an embedded long call op ion
the cumulative change in the intrinsic value of the put option to the cumulative change put option with a strike price of $3.00. <tc! no and an embedded written (short)
in the fair value of the AFS. (b) The contract has an embedded call option with a strdte pt.ce of $3.00 and
30 September Alpha Corporation closed the long position on the put option but retained the AFS put option with a strike price of $4.00. ctrike nrice of $4.00 and an embedded
20x5
investment. The market price of Company X's shares was $4.00. (c) The contract has an embedded written (short) call opt.on wtth a strike pnce
(long) put option with a strike price of $3.00. <|:r oo and an embedded (long)
At 31 December 20x5, the price of Company Xs shares was $3.90. (d) The contract has an embedded (long) call option with a strdce pnce of $3.00 and an
put option with a strike price of $4.00.
El0.3 The amount of gain (loss) taken to equity in respect of the put option for the year ended 3l Use the following information to answer E10.7, E10.8 and E10.9 ,. , iH F>p
December 20x5 was:
On , October 20x4, SingCo committed to purchase machinery for PC
(a) $0 delivered on 1 February 20x5. At the same time. SingCo mteied into a orwa P designated
(b) Gain of $38,000 FC 10,000,000, which would mature on 1 February 20x5. The orwar pure a forward contract
(c) Gain of $12,000 as a hedge of the fixed asset foreign currency purchase commitment. T.me value of the forward
(d) Gain of $50,000 Was excluded in determining hedge effectiveness. Details are as o ows.
(e) None of the above
 ■'A

894 ADVANCED FINANCIAL ACCOUNTING

accounting for derivatives AND HEDGE ACCOUNTING 895

(a) Loss in time value is expensed o

at ff m the income statement wliQe gain in intrinsic value is deferred in
1 October 31 December 1 February equity. ■ ..Hnsic value are taken to the income statement.
20x4 20x4 20x5 (b) Loss in time value and gam m n
Notional amount of forward purchase contract
Spot rate ($: FC 1) FC 10,000,000 (c) Loss and gain are disclosed in . statement while gain in intrinsic value is adjusted to
Forward rate for 1 Feb 20x5 delivery ($: FC 1) . 1.23 1.32 1.28 (d) Loss in time value is expensed o to t
1.25 1.28
1.33 the cost of the shares.

Ignore discounting. SingCos functional currency is the dollar. The financial year-end is 31 December. ElO.ll Ignore the previous question, n n 1 Aoril 20x4,
priceXYZ
for Company
delivery onentered
30 Juneinto20x4.
a commitment to sell
If the call option
10,000 units of securities in S Compan) at a ^ pvrlnded) of the commitment, which of the following
E10.7 What IS the gain/(loss) to be recognized in the income statement for 20x4 under IAS 39? f
was deermad as an effaciva hedge (with hnw
Statements is most appnopriate under
(a) $800,000
(b) 0 (a) Profit on sale of securities will increase by $L300.
(c) $(100,000) (b) Profit on sale of securities will increase by $1.5" ■
(d) $(200,000) (c) Income from opition will increase by 1'^
(e) $100,000 (d) Deferred gain in equity will increase )

E10.8 What should be the total cost of the equipment as at 1 February 20x5 under IAS 39:98b?
(a) $12,800,000
(b) $12,500,000 PROBLEMS
(c) $11,500,000
(d) $12,300,000
PI0.1 Fair value hedge of inventory of
On 1 November 20x5 Company X, a manu
fnrtnrpr of sold jewellery and ornaments, had an inventory o
^ ounce. Company X
3^1 is the overall net cash inflow/(outflow) arising from the forward contract?
10,000 ounces of gold ingots that cost $780 an ounce^ p g February 20x6.
(a) $300,000
(b) ($300,000)
expeel ed .0 usa .L gold » P-th^^ST^.d^ritu,
Company X was concerned that the pr
n alfec. pdce ol gold
inventory by seUing gold futures on
(c) ($12,800,000)
(d) ($12,500,000) corns. Therefore, Co^P^ny ^ ^^^ed in 100 troy ounce contracts; Company X entered into
the commodity exchange. Gold futures ^ exchange required a margin deposit of
Use e following information to answer ElO.lO and ElO.ll. 100 31 January 20x6 contracts at a price of $952 per ounce, rue ^ ^ follows-
$3,300 per contract. The spot price and the price of January futures contracts are as follow
XYZ Company purchased a call option on 1 April 20x4, which was exercised on 30 June 20x4. The change^
in time an intrinsic value ofthe call option to purchase 10,000 units ofsecurities in S Company are as follows: Spot price of gold January gold futures
(per ounce) (per ounce)

$950 $952
At 30 June 20x4 1 November 20x5
Loss In time value .... (200) 31 December 20x5
Gain in Intrinsic value 1,500 31 January 20x6

glO.IOof If XYZ Company purchased the call option primarily to benefit from an expected rising market Company X designated the futures contract as a fair value hedge of the change m
va ue o t e call option, which of the following statements best describes the appropriate accounting
treatment as at 30 June 20x4 under IAS 39?
gold inventory due to chmiges in the spot price of gold. Hedge effectiveness is assessed based
of the change in the entire fair value of the futures contract to the change m the value of the y
based on the spot gold price.
896 ADVANCED FINANCIAL ACCOUNTING ACCOUNTING FOR DERIVATIVES AND HEDGE ACCOUNTING 897

Required: Required:
1. Assess the effectiveness of the hedge at inception and during the life of the futures contract. Prepare the journal entries on 30 November 20x1, 30 June 20x2, and 31 July 20x2.
2. Prepare journal entries to record the hedging instrument and the hedged item.
PI0.4 Hedge of foreign exchange rate risk
PI0.2 Hedge of a forecasted transaction
On 1 March 20x3, ABC Corporation, whose functional currency is the dollar, was informed that it had
On 1 March 20x3, East-West Airlines Inc purchased an at-the-money call option on 100,000 barrels of jet- been successful in its tender for a contract to supply plant and equipment to an overseas customer. ABC
fuel oil with an exercise price of $40 per barrel for delivery on 31 May 20x3. East-West paid a premium Corporations tender price for the contract was FC 500,000. However, the contract would only be signed on
of $200,000 for the call option. The following are the quoted spot prices for the jet-fuel oil and the call 1 June 20x3 as there were certain technical details to be agreed upon. The delivery date was 31 December
option from 1 March 20x3 to 31 May 20x3. 20x3. Since the customer had indicated that it would give ABC Corporation a hank guarantee for the
entire contract sum, ABC Corporation agreed to have the entire sum settled on 28 February 20x4. The
Spot price of jet-fuel oil Price of 31 May 20x3 equipment was delivered on schedule and the amount was settled on the due date.
$/barrei call option In anticipation of the signing of the contract, ABC Corporation purchased a put option contract
1 March 20x3 $40 $2 per barrel with a notional amount of FC 500,000 on 1 March 20x3. The option, which had an exercise price of $1.75/
31 March 20x3 $42 $3 per barrel EC 1, expired on 28 February 20x4. ABC Corporation paid a premium of $0,045 per FC 1 for the option.
30 April 20x3 $45 $6 per barrel The purchase of the put option was to hedge the foreign exchange risk of the forecasted transaction on 1
31 May 20x3 $44 $4 per barrel March 20x3 and the resulting receivable after the transaction materializes. The spot exchange rates between
The option contract was to hedge against the forecasted purchase of 100,000 barrels of jet-fuel oil on
the dollar and the FC, and the price of a 28 February 20x4 put option are as follows:
31 May 20x3. The option contract was an effective hedge as the critical terms matched and the time value
of the option contract was excluded from the hedging relationship. The contract would be settled on a net FC 1 = Price of option
basis. East-West Airlines Inc's financial year-end is 30 April.
1 March 20x3 $1.75 $0.045/FC 1
Required: 1 June 20x3 1.73 0.055/FC 1
1. Calculate the time value and the intrinsic value ofthe option contract on 31 March 20x3,30 April 20x3 and 31 December 20x3 1.70 0.06/FC 1

31 May 20x3. 28 February 20x4.. 1.68

2. Prepare the journal entries relating to the hedging instrument.

Assume that the option contract qualifies as an effective hedge and the time value component of the option
PI0.3 Hedge of a firm commitmenf contract is excluded from the hedge relationship.

On 30 November 20x1, Systech Ltd entered into a non-cancellable contract to buy 1,000 shares of Required:
Eastrack Ltd for $5,000 on 31 July 20x2. On the same date, Systech Ltd purchased a put option on 1,000 1. What is the price of the option on 28 February 20x4?
Fastrack shares for $500 to hedge the risk of a fall in the fair value of the commitment. The exercise 2. Show all journal entries (with narratives) relating to the hedge from 1 March 20x3 to 28 February 20x4.
price was $5 per share. The put options expiration date was 31 July 20x2. Data on the price movements
of Fastrack shares and the put option are as follows: PI0.5 Hedge of a foreign-currency-denominated investment
Atticus Ltd, whose functional currency is the dollar, purchased 100,000 shares of Scotts Corporation (a
Price of Fastrack's share Put option foreign company listed in country X whose currency is the LC) at a price of LC 2.80 per share when
30 November 20x1 $5.00 $ 500
the spot exchange rate was LC 1 to $1.28 on 1 October 20x4. Atticus Ltd classified the investment as
30 June 20x2 $4.50 $ 700 availahle-for-sale (AFS). The shai'e price of Scotts Corporation on 31 December 20x4 was LC 3.00 and
31 July 20x2 $4.00 $1,000 the spot exchange rate was LC 1 = $1.21. Atticus Ltd's financial year-end is 31 December. The following
additional information is available:

Systech designated the option contract as a hedge of the risk of changes in the fair value of the firm
commitment resulting from changes in the price of Fastrack's shares. Systech excluded the time value of
the option contract from the hedging relationship. Systech Ltd closed the position on the put option on
31 July 20x2, fulfilled its obligations under the contract, and sold off its shares on the same date. Systech's
year-end is 30 June 20x2.
(a) On 1 November 20x4, the price of Scotts Corporation's share had risen to LC 2.85. Atticus Ltd entered
into a contract with a bank to sell forward LC 285,000 for delivery on 31 March 20x5. The spot exchange
rate was LC 1 to $1.25 and the forward rate on the contract was LC 1 to $1.23. The purpose of the
contract was to hedge the foreign currency risk associated with the investment in Scotts Coi poration
as Atticus Ltd anticipated a possible depreciation of the LC vis-a-vis the dollar.
r
898 ADVANCED FINANCIAL ACCOUNTING accounting for DERIVATIVES AND HEDGE ACCOUNTING 899
(b) On 31 December 20x4, Atticus Ltd Durchased a r,,.f ^
shares with a strike price of LC 3.00. The purpose of the Corporation The relevant exchange rates are as folloiNS.
in the share price of Scotts Corporation beUlC 3a.UU.
00 Thl T'°" a ?o
Ihe option expired on 30 June 20x;5.
"
The following information on the price of Scotts Corporation shares the VIC exchange rates and the viMi
J

premium on the put option is available: excnange laies anu

1 December 20x1.
31 December 20x1
1 February 20x2..
TJiVr 31 December 20x4 31 March 20x5
30 March 20x2
Share price of Scotts Corporation
Spot LC/$ exchange rate 2.93
Forward exchange rate for 31 March 20x5 contract Required: contract as a fair value hedge of the foreign
Premium on put option (per unit of underlying) ^^'2° Assume that Alpha Corporation of the forward contract is excluded from the
t ■;
^ LC 0.03 LC 0.085
exchange risk related to the transaction. ^^"'^j^^^' griod 1 December 20x1 to 30 March 20x2. (To
hedging relationship. Prepare the forward contract.)
sharilTcote S,r'i' '^7" °° ' "" "■= <">« "<I =<>">"""=1 to hold il« simplify the computations, ignore discounting
-:a..hc—f—r-
Required: ° PlO-7 Accounting for a cash flow hedge , r, u j xvCtVifa
the forward contract as a cash flow hedge of the
Refer to P10.6. Assume that Alpha Corpoiation ^ ° ^ journal entries for the period 1 December 20x1
AeZwarf
value element he Jed " w '"h d designates
exchange the option
risk. Atticus contract
excludes .and
the time
foreign exchange risk related to discounting of the forward contract.)
to 30 March 20x2. (To simplify the computat . o
forward contractTnJ
nudct and Jh T®option
the put '^''"'™*'PVn
on the following'"""''"t"-
dates: Show the journal entries pertaining to the
(a) 1 November 20x4 PI0.8 Cosh flow hedge of o firm commitment using a forward co t f 100 000
(b) 31 December 20x4
(c) 31 March 20x5
On 30 September 20x5, Singco entek r^d into a non-cancellable
navment due contract to purchase
on 31 March inventory
20x6. Singco wasfor 100,000
concerned
(d) 30 June 20x5
euros to be delivered on 31 January 2 x wi i transaction took place. To hedge against the
that the euro might appreciate by t ^ ime ^ sbc-month forward exchange contract on
Show workings and include brief narratives. Ignore discounting of the forward contract. risk of an appreciation of the euro, mg March 20x6 It designated the forward exchange
30 September 20x5 to — 31 January 20x6 and .he
contract as a cash flow hedge of a fir tgrms matched closely, the hedge was
PI0.6 Hedge of a foreign-currency-denominated forecasted transacHon and firm commitment 100,000 euros payable arising from the tia
I
■t
i
The following information pertains to Alpha Corporation whose ftmctional currency is the dollar. expected to be highly effective. scheduled and Singco settled the resulting accounts
i

i
year-end is 31 December. Relevant exchange rates are as o o
)
1 December 20x1
A highly probable sales transaction of Pc IG.qoooqq , forecasted to arise from Spot rate Forward rate to
fi s
successful negotiations with a customer. $ to euro 31 March 20x6

\\ Alpha Corporation entered into a forward exchange contract to deliver (sell) FC 2.915 2.980
10,000,000 on 30 March 20x2 to hedge the foreign exchange risk of the forecasted sales 30 September 20x5. 2.969
2.937
31 December 20x5 .
transaction. 2.920 2.926
31 January 20x6
31 December 20x1 2.931 2.931
Alpha Corporation's financial year-end. 31 March 20x6
1 February 20x2
Signed a non-cancellable contract with the customer for an order of FC 10,000,oqo with
an agreed delivery and settlement date of so March 20x2.
30 March 20x2
Delivery made to the customer. Net settlement of forward contract.
900 ADVANCED FINANCIAL ACCOUNTING ACCOUNTING FOR DERIVATIVES AND HEDGE ACCOUNTING 901

Assume the following: Required:

(a) A discount rate of 6% per annum.
(b) Singco's accounting policy was to apply basis adjustment under IAS 39 paragraph 98b to non-financial
assets that resulted from hedged transactions. Singco designates the hedge as a cash flow hedge in
accordance with the alternative permitted under IAS 39 paragraph 87.
Required:
1. Singco designated the hedging relationship for changes in the spot rate element of the forward
contract, that is, the interest element in the forward contract was excluded from the measurement of
hedge effectiveness. Prepare the journal entries to record the transactions from 30 September 20x5 to
31 March 20x6. (Hint: Treat the firm commitment as though it is a forecast transaction.)
2. Ignore (a) above. Singco designated the hedging relationship as being for changes in the fair value
'■t
of the forward contract; that is, the interest element in the forward contract was not excluded from
the measurement of hedge effectiveness. Prepare the journal entries to record the transactions from
30 September 20x5 to 31 March 20x6. (The hint in part (1) applies.)
PI 0.9 All-in-one hedge of foreign exchange rote risk
Lexco Company's functional currency is the dollar. On 1 December 20x1, Lexco entered into a four-month
forward contract to sell PC (foreign currency) units. Terms of the contract are as follows:
1. Prepare the journal entries from 1 December 20x1 to 1 April 20x2 applying the requirements of
IAS 39 and IAS 21. The purpose of the forward contract is to hedge the foreign exchange risk; the
interest element in the forward contract is excluded from the hedging relationship. The forward
contract is designated as a cash tlow hedge of the commitment and the resultant receivable. Assume
all other requirements for hedge accounting are met.
2. How \vill the journal entries differ if the forward contract is accounted for as a fair value hedge?
PI0.10 Hedge of the foreign exchange risk of a forecast transaction
Alfalfa Company's functional currency is the dollar. On 30 June 20x1, it entered into a forward exchange
contract to purchase FC 100,000 at the forward rate of $1,077 for delivery on 30 June 20x2. The spot
exchange rate was $1,072. It designated the forward exchange contract as a hedging instrument in a cash
flow hedge of a forecast transaction to purchase commodity on 31 March 20x2 and the resulting payable
was to be paid on 30 June 20x2. All hedge accounting conditions in IAS 39 were met. The purchase of
the commodity occurred on 31 March 20x2 as expected.
The following exchange rates apply for the period to 30 June 20x2.
Spot rate
$ to FC 1 Forward rate to 30 June 20x2

Notional amount PC 10,000,000 30 June 20x1 1.072 1.077

Maturity 1 April 20x2 31 December 20x1 1.080 1.082

Forward sales rate: $1.80 to PC 1 31 March 20x2 1.083 1.0845

30 June 20x2 1.087 1.087

The applicable interest rate was per annum throughout the period. Alfalfa's financial year end is
Spot rates (SR) Forward rate (FR) for period to
31 December.
$ to FC1 1 April 20x2

1 December 20x1 1.84 1.8

Required:
31 December 20x1 (year-end) 1.73 1.7 1. Show the journal entries if the hedging relationship is designated as being for changes in the fair value
1 March 20x2 1.7 1.68 of the entire forward exchange contract and Alfalfa's accounting policy is to adjust the cost of non-
1 April 20x2 1.76 1.76 (maturity) financial assets that result from hedged forecast transaction (hint: IAS 39 allows the expected cash
flows to be based on either spot rate or forward rate).
2. Show the journal entries if the hedging relationship is designated as being for changes in the
element of the forward exchange contract and the interest element is excluded from the designate
hedging relationship (IAS 39:74), and Alfalfa's accounting policy is to adjust the cost of non-financia
1 December 20x1. . Non-cancellable order to sell goods for PC 10,000,000. Delivery on assets that result from hedged forecast transaction.
1 March 20x2. Forward contract was entered into to hedge the 3. Is there any difference in the financial statements between (1) and (2) above?
foreign currency receipts from the sales order.
31 December 20x1 Year-end.
1 March 20x2 Fulfilment of sales order. PI 0.11 Fair value hedge of a firm commitment
1 April 20x2 Settlement of accounts receivable by customer.
Net settlement of forward contract. Assume the same information as in PIO.IO, except that the hedged item is a firm commitment and
the forward contract was designated as a fair value hedge of the foreign exchange risk of a firm commitment.
902 ADVANCED FINANCIAL ACCOUNTING ACCOUNTING FOR DERIVATIVES AND HEDGE ACCOUNTING 903

Required: $3.21 per ounce on 1 October 20x1. The contract matured on 31 March 20x2. The commodity exchange
1. Prepare the journal entries for the hedging instrument and the hedged item for the duration of the required a margin deposit of $0.03 per pound for the futures contract. The level of margin deposit had
hedge. Assume that the time value (interest element) is excluded from the hedge relationship. to be maintained at all times.
2. Is there any difference between designating the hedge as a fair value hedge and as a cash flow hedge The management of Eastern Company had designated the futures contracts as a cash flow hedge of the
as in P10.10(2)? anticipated sale of silver coins. Past experience had proven that there was a very high correlation between
the spot price of silver and the selling price of silver coins. Therefore, the management expected that the
PI0.12 Interest rate sv/op
futures contracts were an effective hedge of the anticipated sale and that the other conditions for hedge
accounting were met. For the purpose of assessing hedge effectiveness, the entire change in the fair value
Cusso Corporation had a bank loan of $50,000,000, which was to be repaid at the end of 20x5. The loan of the futures contract was compared with the change in the expected cash flows. The spot prices of silver
carried an interest rate based on the three-month London Interbank Offer Rate (LIBOR) plus 150 basis coins and the prices of silver futures contracts for 31 March 20x2 delivery are as follows:
points. Interest on the loan was payable half-yearly on 30 June and 31 December. Cusso, concerned that
interest rates might increase during the next three years, decided to enter into a swap with a financial
Spot price of one-ounce Futures price of silver per ounce for
intermediary on 1 January 20x3, which involved Cusso paying a fixed rate of 5.5% per annum and receiving
silver coin 31 March 20x2 delivery
LIBOR plus 150 basis points. The notional amount of the swap was $50,000,000.
LIBOR was reset semi-annually beginning with 1 January 20x3 in order to determine the next interest 1 October 20x1 .... $3.30 $3.21
payment. Differences between the fixed rate and the variable rate would be settled on a semi-annual basis. 31 December 20x1 3.265 3.17
28 February 20x2.. 3.15 3.05
The following interest rates occurred over the term of the swap.
31 March 20x2 3.10 3.00

LIBOR LIBOR +150 basis points

The entire inventory was sold off on 31 March 20x2 at $3.10 per pound. Ignore the discoimting of the
1 January 20x3 4.0% 5.5% expected future cash flow.
30 June 20x3 4.5% 6.0%
31 December 20x3 5.0% 6.5%
Required:
30 June 20x4 4.7% 6.2% 1. Assess the effectiveness of the hedge during the life of the futures contracts on a period-to-period
31 December 20x4 4.5% 6.0% basis as well as on a cumulative basis.
30 June 20x5 4.3% 5.8%
2. Show the journal entries for the hedging relationship and the sale of the inventory at all the dates
given above. Assume the hedge effectiveness is assessed on a cumulative basis. Ignore movement in
The following assumptions are made: the margin deposit.
3. Compare the protit on the sale of the inventory with and without hedging.
(a) The yield curve is flat.
(b) No hedge ineffectiveness (the conditions for the FASB's "short-cut" method are assumed to be met).
(c) Other risks remain constant. PI0.14 Hedge of inventory

Cusso designates the swap as a cash flow hedge. The information is tlie same as in P10.13 except that on 1 October 20x1, the management of Eastern
Company acquired 50 options contracts that gave the holder the right but not the obligation to sell 100,000
Required: one-ounce silver coins per contract at a price of $3.30 per coin. The option contracts expired on 31 Marc
Prepare the journal entries required to account for the loan and the swap over the period of the swap. 20x2. The premiums on the option are as follows:

PI0.13 Hedge of a forecasted sole of inventory Option premium (per coin)

Eastern Company had inventory of 5,000,000 one-ounce silver coins, which were carried at a cost of $15 1 October 20x1
$0.12
million (current market value is $16.5 million). The selling price of the silver coins was largely determined 31 December 20x1 0.13
0.175
by the spot price of silver, which accounted for the bulk of the manufacturing costs. In recent months, the 28 February 20x2 .
price of silver had risen substantially due to disruption in supply as a result of strikes in Australia, which
is the main producer of silver. The management of Eastern Company was concerned about a potential The management of Eastern Company designated the options contracts as a hedge of the fair value of the
fall in the price of silver when the supply shortage eases. To hedge against this risk, the management inventory. The time value of the options was excluded from the hedging relationship. The entire inventory
of Eastern Company sold silver futures contracts with a total notional quantity of 5 million pounds at was sold off on 31 March 20x2 at $3.10 per coin.
 904 ADVANCED FINANCIAL ACCOUNTING
accounting for DERIVATIVES AND HEDGE ACCOUNTING 905

Required: Jnsaction 3 On 1 January 20xj, Camibell

^ acquired
^ qoo.QOO,an and
80%retained
interest earnings
in the share
of FCcapital of OGRE
300,000. Inc, a
Subsequent
■eign companv with a paid-up capita o ' ^gainst the dollar and on 1 January 20x5 Cambell
'■ ""k I??"'
31 Marcn 20x2. the hedged item from 1 October 20x1 to 1 1 ' 1
the date of acquisition, the re. to ClCpAtCltHC
^ g
hedge the investment. rr-il
The equity section
2. Compare the profit on the sale of the inventory with and without hedging.
of OGRE Inc's statement of financial position as I
PI0.15 Comprehensive problem on hedge accounting
Camhell Corporation had the following transactions in derivatives in 20x5: 2,000,000
Share capital. 800,000
Transaction 7 Camhell Corporation bought 100,000 shares of Hindz Company on 31 July 20x5 at Retained earnings 2,800,000
2.50 per share. The investment is classified as available-for-sale. At the same date, Cambell Corporation r

purchased an out-of-the-money put option on 100,000 shares of Hindz Company and paid a premium of
$3,000. The put option had an exercise price of $2.48 and expired on 30 September 20x5. The purpose of Ic
the put option was to provide Cambell Corporation with partial protection against declines in the share Information on relevant exchange rates is ghen
price of Hindz Company. Cambell Corporation designated the change in the intrinsic value of the put as
the hedging instrument and the hedge as a fair value hedge of changes in the fair value of its investment Spot rate December 20x5
in Hindz Company. At 30 September, Cambell Corporation continued to hold the 100,000 shares in Hindz ($/FC) Forward rate
Company and the put option position was closed on a net basis. The prices of Hindz Company shares $1.80 $1-78
and the put option are as follows: 1 January 20x5 1.785 T77
31 March 20x5 ^ -1755
30 June 20x5 1.742
Share price of Price per unit 30 September 20x5
Hindz Company of put option

30 September , $2.20 $0.28 ... ambell designated the forwar j con 1 hedee
j„:np of the net investment
relationship. in OGRE Cambell
Ignore discounting. and excluded the time
Corporations
value of ,he forward ccn.racl currency is the dollar'
The time value of the option contract was excluded from the assessment of hedge effectiveness. financial year ends on 30 September. Camb
Transaction 2 On 1 January 20x5, Cambell Corporation borrowed $80,000,000 from a bank for a period quired. tnnsactions pertaining to the derivatives and the hedged items
of 24 months at an interest rate based on the London Interbank Offer Rate (LIBOR) plus 50 basis points. 1. Prepare journal entries to record all the transacnoiis p &
Interest on the loan was payable quarterly. Cambell entered into a swap with a financial intermediary on -
from 1 January 20x5 to 30 September 20x5. + u n f financial
in tVip fi nancial statements of Cambell Corporation tor the tinanciai
1 January 20x5, which involved Cambell paying a fixed rate of 4.5% per annum and receiving LIBOR 2. Show the effects of the transactions m the tmanciai 1-
plus 50 basis points. The notional amount of the swap was $80,000,000. LIBOR rates were reset quarterly year ending 30 September 20x5.
beginning with 1 January 20x5 in order to determine the next interest payment. Differences between the
fixed rate and the variable rate would be settled on a quarterly basis. The following information pertaiiis PI0.16 Hedging foreign exchonge risk in purchase of equipment
to interest rates and fair value of the swap over 20x5. The functional currency of K Co is the US dollar. On 1 January 2010, the management of «
a deeision to buy equipment tor S$ 1.400,000. The equipment does not meet the conditior^s of » T^htjnng
LIBOR Fair value of swap
asset as defined by FRS 23 Bcrrowing Costs. After carrying an mtens.ve search for
>V.%i
2010, K Co places a non-canceUable order to purchase the equipment. The equipment is delivered on
1 January 20x5 4.0% December 2010 and the payable is settied on 30 June 2011. The equipment is depreciated over usetul
;!] 31 March 20x5 4.5% $ 665,273 life of ten years with zero residual value.
30 June 20x5 5.0% 1,144,204 K Co entered into a foreign exchange (FX) forward transaction on 1 January 2010 with an external
30 September 20x5 4.7% 673,507
broker B Co to buy S$ 1,400,000 and sell US dollar to hedge the foreign exchange risk m the purchase ot
Cambell designated the swap as a cash flow hedge. Assume there is no hedge ineffectiveness. equipment. The US$/S$ forward rate is 1.37 (that is, 1 US$ S$1.37) and maturity date is 30 June 2011.
 ACCOUNTING FOR DERIVATIVES AND HEDGE ACCOUNTING 907
906 ADVANCED FINANCIAL ACCOUNTING

Swap settlements are made at the end of each half-year and the LIBOR rates are reset at the beginning
USO/S$ forward maturing
Foreign exchange rates USD/S$ spot 30 June;
of each half-year. The six-month LIBOR rates are as follows;

1 January 2010 1.40 1.37

Rate(%)
Average 1st half 2010 1.39
30 June 2010 1.38 1.36 1 January 2010 0.50
Average 2"'' half 2010 1.34 30 June 2010 0.75
31 December 2010 1.32 1.29 31 December 2010/1 January 2011 0.46
Average year 2010 1.36 1.33 30 June 2011 0.40
Average T' half 2011 1.25 31 December 2011 0.78
30 June 2011 1.20 1.20

Average 2"'' half 2011 1.24 Required:

31 December 2011 1.30 Prepare the journal entries in A Cos book in relation to the swap from 1 January 2010 to 31 December 2011.
Average year 2011 1.24
30 June 2012 1.28

Average T' half 2012 1.29

Required:
Prepare the journal entries in K Cos book in 2010 and 2011 for the equipment and foreign exchange
(FX) forward in accordance with FRS 39 Financial Instruments: Recognition and Measurement and
FRS 21 The Effects of Changes in Foreign Exchange Rates. Ignore taxes. (Convert the US$/S$ rates to
S$/USD$ rates). State the effective FX rates at which the equipment cost and cash settlement are locked in.

PI0.17 Hedging bond with interest rate swap

A Co has as its functional currency the Singapore dollar (S$) and enters into the following transaction.
The business model of A Co is to hold investments for the long term or to maturity but A Co avoids
classifying debt investments as held-to-maturity because of the tainting rules.

Investment in quoted convertible bond of K Co

i'.' he vhle I'o;
Date of purchase 1 January 2010
Purchase price US$3,000,000 ■' ;. i . ••v.'Ui''/ .
Principal sum US$2,600,000 iV Si''
Coupon rate 1.50% per half-year (settled every half-year)
Years to maturity from inception 3 years
Effective interest rate 1% per semi-annual.
Fair value as at 31 Dec 2010 US$2,500,000
Fair value as at 31 Dec 2011 US$2,050,000
,

Fair values of option in convertible bond remain unchanged on 31 December 2010 and 31 December
2011. A Co enters into an interest rate swap with an external party B Co in an attempt to hedge the fixed '6 '

rate convertible bond purchased on 1 January 2010. In the interest rate swap contract, A Co receives iM

floating interest rate LIBOR + 1%, reset and receivable every six months and pays fixed rate 1.50% semi-
annually. Notional principal of the swap is US$3,000,000 and the swap maturity date is 31 December 2012.