AFA - 4e - PPT - Chap10 (For Students)

8/6/2023
Chapter 10
Accounting for
Derivatives and
Hedge Accounting
Copyright © 2019 by McGraw-Hill Education (Asia). All rights reserved. 1
Learning Objectives
1. Understand what constitutes a derivative

instrument;
2. Understand the different types of derivatives;
3. Know how derivatives are used;
4. Understand the accounting treatment of
derivatives;
5. Understand hedge accounting, its rationale, and
the conditions for applying hedge accounting; and
6. Appreciate the three main types of hedge
relationships and their accounting treatments.
2
Content
1. Derivative Financial Instruments

2. Accounting for Derivatives
3. Hedging
4. Classification of Hedging Relationships
5. Hedging Against Interest Rate Risk
6. Hedge of a Net Investment in a Foreign Entity
7. Other Issues in Hedge Accounting
8. Evaluation of Hedge Accounting
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Derivative Financial Instruments
A derivative is a financial instrument that meets the following three criteria:
Its value changes in

Requires little or no initial
response to a change in Settled at a future date
investment
an “underlying”
Scope Exemption:
IFRS 9 exempts contracts which meet the definition of a derivative from the
standard if the contract is entered into to meet the entity’s usual purchase,
sale or usage requirements (own use exemption)

Examples of derivative instruments and their underlying
Types of derivative instruments Underlying
Option contracts Security price
(call and put)
Forward contracts Foreign exchange rate
e.g. foreign exchange forward contract
Future contracts Commodity prices
e.g. commodity futures
Swaps Interest rate
• Uses of derivatives
1. Manage market risks such as foreign exchange and interest rate risk
2. Reduce borrowing cost
3. Profit from trading or speculation
• Types of derivatives
1. Forward type derivatives such as forward contracts, future contracts
and swaps
2. Option-type derivatives such as call and put options, caps and collars
and warrants
3. Free standing derivatives
4. Embedded derivatives
• Derivative that combine with a host instrument that is not a
derivative
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• Derivatives may be based on interest rates, foreign exchange, equities,

credit and commodities
• Within the forward-type and option-type derivatives, each group includes
derivatives of different types.
– “Forwards” category
• Interest rate derivatives: Interest rate swaps and futures
• Foreign exchange rate derivatives: FX spot, forwards and swaps
– “Options” category
• Interest rate derivates caps and floors
• Foreign exchange rate derivatives: FX options
• Derivatives used to hedge or trade on different types of risks
– Interest rate risk (duration and interest rate repricing or gapping risks)
– Credit risk (functions of probabilities of default and losses)
– Counterparty credit risks (interaction between interest rate and credit risk)
Forward Contracts
• An agreement between two parties (counterparties) whereby one

party agrees to buy and the other party agrees to sell a specified
amount (notional amount) of an item at a fixed price (forward rate)
for delivery at a specified future date (forward date)
• Can either be a forward purchase contract or a forward sales

contract, depending on the perspective of the counterparties
Sells Forward
“A” Company Contract “B” Company
“Forward sales contract” “Forward purchase contract”

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Forward Contracts
• Not standardized contracts as they are not traded on an exchange
– They entail higher counterparty risks than other similar instruments
– They can be tailored to specific needs of counterparties (flexibility)
– They involve lower transaction costs
• Fair value of forward contract:

Notional (|Current forward rate – Contracted forward rate|)
x
amount (1+r)t
where
Contracted forward rate is forward rate fixed
r = discount rate
at inception
Current forward rate is forward rate for
remaining period to maturity t = period to maturity
At inception date, the fair value of a forward contract is nil.

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Forward Contracts
• At the date of maturity of the forward contract → forward rate

converges to the spot rate
– Fair value of the forward contract at maturity:
• (Difference between the spot rate at maturity date and the
contracted forward rate) x Notional amount of the contract
• Premium (or discount) on the forward contract is the interest or time

value
– Measured by the difference or spread between the forward rate and the
spot rate at a point in time
• Changes in the time value component are due to a number of

factors including:
– Cost of holding the commodity or underlying by the counterparty
– Risk free rate
– Period to maturity
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Forward Contracts
• Payoff Profiles
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Forward Contracts
• Changes in fair value of a forward contract after inception date
Current forward rate > Current forward rate <

contracted forward rate contracted forward rate
Forward purchase • Fair value is positive • Fair value is negative

contract • Gain is recorded • A loss is recorded
• Forward contract is an • Forward contract is a liability
asset
Forward sale • Fair value is negative • Fair value is positive

contract • A loss is recorded • A gain is recorded
• Forward contract is a • Forward contract is an asset
liability
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Illustration 1: Fair value of a forward contract
• On 1 March 20x5, Company A entered into a forward contract to buy

one million FC units (FC 1,000,000) for delivery on 30 May 20x5
Date Spot Rate 30 May Forward Rate

$/FC $/FC
1 March 20x5 $1.185 $1.20
31 March 20x5 1.19 1.21
30 April 20x5 1.20 1.205
30 May 20x5 1.215 1.215
• The fair value of forward contract is calculated using a 5% (per

annum) discount rate
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Illustration 1: Fair value of a forward contract
Date Contracted Current Notional Discount Fair value Change

forward forward amount factor (d) of forward in fair
rate (a) rate (b) (c) contract value
[(b-a) x c)/d
1 Mar 20x5 $1.20 $1.20 1,000,000 0 0 0
31 Mar 20x5 1.20 1.21 1,000,000 1.00835 9,917 9,917
30 Apr 20x5 1.20 1.205 1,000,000 1.004167 4,979 (4,938)
30 May 20x5 1.20 1.215 1,000,000 1.0 15,000 10,021
• At inception, the fair value of forward contract is nil

• At 31 Mar 20x5, Fair value = [$1,000,000 X (|1.21-1.20|)] / (1 + 0.05/12)^2
= $10,000/1.00835 = $9,917
• The fair value is positive as amount payable ($1,200,000) is less than amount
receivable (1,125,000) → reported as an asset
– The fair value can be negative if forward contract show a loss
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Future Contracts
• A future contract is a contract between a buyer or seller and a clearing

house or an exchange.
• Wide range of exchange-traded future contracts

– Commodity futures
– Interest rate futures
– Currency futures
• A future contract is similar to a forward contract except that it:

– is a standardized contract and is traded on an exchange
– can be closed out before maturity by entering into an identical contract that is in
opposite position
– requires the payment of a margin deposit which has to be maintained through the
contract period
– marked-to-market and settled on a daily basis, no discounting is necessary
– Rarely result in physical delivery
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Future Contracts
• Long position: purchaser of a futures contract

• Short position: seller of a futures contract
• Since futures are traded on exchange, quoted price of futures contracts

readily provides a measure of the fair value of a futures contract
• When the spot price (underlying) increases:

– a long position results in a gain
– a short position results in a loss
• When the spot price (underlying) decreases

– a long position results in a loss
– a short position results in a gain
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Option Contracts
• Contract that gives holder the right but not the obligation to buy or
sell a specified item at a specified price during a specified period
of time
• 2 type of option contracts

1. Call option – right, but not obligation to buy
2. Put option – right, but not obligation to sell
• Can be American option (exercisable anytime to expiration) or

European option (exercisable only on maturity date)
• Can also be customized (not traded) or standard contract quoted on

exchange (listed options)
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Option Contracts
• Main features
– Purchaser (holder) pays premium to seller (writer of option)
– Holder has the right, but not obligation to perform; while writer or seller
has obligation to perform
– Asymmetrical pay-off profile
• Holder has limited loss (due to premium) and unlimited gain
• Writer has limited gain and unlimited loss
Relationship between the strike price and the underlying

Strike price > Strike price = Strike price <
Underlying Underlying Underlying
(spot price) (spot price) (spot price)
Holder of call option Out-of-the-money At-the-money In-the-money
Holder of put option In-the-money At-the-money Out-of-the-money
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Option Contracts
• Pay-off profile for options
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Option Contracts
• Fair value of option contract
Fair value of an option = Intrinsic value + Time value
Listed options = quoted price

Diminishes over time
Not traded options = Valuation
Zero at expiration
models (Black-Scholes model)
Call option = Max [0, Notional amount x (Spot price – Strike Price)
Put option = Max [0, Notional amount x (Strike price – Spot Price)
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Option Contracts
• How options are reported in the statement of financial position

– From the option buyer’s perspective, a put or call option is always an asset, as
long as it has not reached the expiration date
• This applies in the case of both at-the-money or out-of-the-money position,
where intrinsic value is nil
• Buyer did not suffer any loss because he has no obligation to exercise the
option and as long as the option has not expired, there is a chance that it
may move into an in-the-money position
– From the option seller’s perspective, the position of option is the opposite.
• An option is always a liability until it expires out-of-the-money
Option is: Presentation of an Presentation of an

unexpired option contract unexpired option contract
in the holder’s F/S in the writer’s F/S
Out-of-the-money Asset (time value only) Liability
At-the-money Asset (time value only) Liability
In-the-money Asset (intrinsic + time value) Liability
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Embedded Derivatives
• Derivative that is part of a hybrid financial instrument
Hybrid Instrument
Host Instrument
Embedded derivative:
Linked to underlying and change in
underlying causes change in cash flow
• Example is bond whose ultimate proceed are linked to price of

commodity, such as oil, or to a consumer price index
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Split Accounting of Embedded Derivatives
• IFRS 9 requires embedded derivatives of a host instrument that is

not in the scope of IFRS 9 to be separately recognized from the host
instrument and accounted for in the same way as a stand-alone
derivative if the following conditions are met:
Conditions for separation of embedded derivative
Economic Hybrid instrument is not

There is a separate
characteristics and risk measured at fair value,
instrument with same
of host instrument are with changes in fair
terms as the embedded
not closely related to value recognized in
derivative
that of the derivative profit and loss
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Content

3. Hedging
24
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Accounting for Derivatives
• Default accounting treatment for derivatives under IFRS 9:

– Derivatives are classified under FVTPL and changes in their fair values
are taken to profit and loss
– Exception: Default treatment no longer applies when a derivative is
designated as a hedge of an identified risk (effective hedge). In this
case, accounting for the derivative follows hedge accounting rules
• Fair valuation of derivatives factor in credit quality

– Credit Valuation Adjustment (CVA): Credit risk of counterparty defaulting
on a derivative transaction when entity has a positive inception gain
– Debit Valuation Adjustment (DVA): Credit risk of the reporting entity
defaulting on derivative transaction when the entity has a negative
inception loss
– CVA and DVA calculated using a variety of methods such as simulations
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Accounting for Forward Contract
At inception During life of contract Closing position or at

expiration
Dr Forward Contract Dr Cash
(asset)
Cr Gain on forward Cr Forward contract
contract
No journal entry as or or
fair value is nil
Dr Loss on forward Dr Forward contract
contract
Cr Forward Contract Cr Cash
(liability)
Adjust fair value and Close out and record

record gain/loss net settlement of
contract
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Accounting for Future Contract

expiration
Dr Cash Dr Cash
Cr Gain on future Dr Loss on future
contract contract
Dr Margin deposit Cr Margin Contract
or or
Cr Cash Dr Loss on futures Dr Cash
contract Cr Gain on future
Cr Cash contract
Cr Margin Contract
Record payment of Record daily Close out and recover

initial margin deposit settlement of future margin deposit
contracts
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Accounting for Purchased Option Contract

expiration
Dr Option Contract Dr Cash*
Cr Gain on option Cr Gain on option
contract contract
Dr Option contract Cr Option Contract
(asset) or or
Cr Cash Dr Loss on option Dr Cash*
contract Dr Loss on option
Cr Option Contract contract
Cr Option Contract
(*assume expires in-the-money; if
out-of-money, no entries needed)
Record payment of Adjust for fair value Close out and record
initial margin deposit and record gain/loss net settlement of
contract
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Accounting for Written Option Contract

expiration
Dr Option Contract Dr Option contract
Cr Gain on option Cr Gain on Option
contract Contract
Dr Cash (Expires out-of-the-
Cr Option contract or money)
(liability) Dr Loss on option Dr Option contract
contract Dr/CR Loss on
Cr Option Contract option/Gain on option
Cr Cash
(Expires in-the-money)
Record payment of Adjust for fair value Close out and record
initial margin deposit and record gain/loss net settlement of
contract
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Illustration 2A: Accounting for a forward

contract (profit)
• Assume that in illustration 1, the forward contract was entered for
speculative purposes
Journal entries:
1 Mar 20x5
No entry need to be recorded. Fair value of forward contract is nil at inception
31 Mar 20x5
Dr Forward contract 9,917
Cr Gain on forward contract 9,917
To record change in fair value of forward contract
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contract (profit)
Journal entries:
30 Apr 20x5
Dr Loss on forward contract 4,938
Cr Forward contract 4,938
30 May 20x5
Cr Gain on forward contract 10,021
Dr Cash 15,000
To close forward contract on maturity
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contract (profit)
Journal entries in practice:
31 Mar 20x5
Same as above
30 Apr 20x5
Dr Gain on forward contract (P/L) 9,917
Cr Unrealized profit on forward contract 9,917
(asset)
To reverse prior period fair value of forward contracts
Dr Unrealized profit on forward contract 4,979
Cr Gain on forward contract (P/L) 4,979
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contract (profit)
Journal entries in practice:
30 May 20x5
Dr Gain on forward contract (P/L) 4,979
To record current period fair value of forward contracts
Dr Cash 15,000
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Illustration 2B: Accounting for a forward

contract (loss)
• Assume that in illustration 1, the fair values of forward contract on 30
Apr 20x5 and 30 May 20x5 are -$1,000 and -$8,000 respectively
Journal entries:
1 Mar 20x5
No change
31 Mar 20x5
No change
30 Apr 20x5
Dr Gain on forward contract 9,917
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contract (loss)
Journal entries:
30 Apr 20x5
30 May 20x5
Cr Loss on forward contract 1,000
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contract (loss)
Journal entries:
30 May 20x5
30 May 20x5
Cr Cash 8,000
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Illustration 3: Accounting for a futures

contract
Scenario
• On 1 March, Capital Trust speculates that price of gold will increase
and purchases ten gold futures contracts at a price of $800/ounce
• Each contract is for 100 ounces of gold
• Maturity date is on 31 May
• Payment of 10% of notional amount as margin deposit
• On 31 March, price of gold rose to $850 per ounce and Capital Trust
closes its long position
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Illustration 3: Accounting for a futures

contract
Journal entries:
1 Mar
Dr Margin deposit 80,000
Cr Cash 80,000
To record payment of margin deposit on ten gold futures contracts
31 Mar
Dr Cash 130,000
Cr Margin deposit 80,000
Cr Gain on futures contract 50,000
To record gain on futures contract, close out futures contract and return of
margin deposit
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Illustration 4: Accounting for an option

contract
Scenario
• Current market share price of Worldwide Enterprise is $38 and a
hedge fund speculating on the share price decided to purchase:
– Put option on 100,000 units with a strike price of $35, at a premium of
$1.50 per unit
– Call option on 100,000 units with a strike price of $41 at a premium of
$1.50 per unit
• Assume that stock price of Worldwide Enterprise increased to $43
• The hedge fund decides to close both options at prevailing market
prices
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contract
• Overall, the buyer realizes a net gain of $45,000 from the two options
contract
• Options are accounted for as FVTPL
– Separation between time and intrinsic value is not important for speculative
trades as changes between both elements are taken to P&L (FVTPL)
Call option Put option

Option buyer:
Fair value $295,000 $50,000
Less premium paid (150,000) (150,000)
Buyer’s gain/(loss) on option at closure $145,000 $(100,000)
Option writer:
Premium received $150,000 $150,000
Less fair value of option at closure (295,000) (50,000)
Writer’s gain/(loss) on option $(145,000) $100,000
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contract
Journal entries (Option buyer):
At inception
Dr Call option 150,000
Dr Put option 150,000
Cr Cash 300,000
Purchase of options
At closing of the option positions

Dr Cash 295,000
Cr Call option 150,000
Cr Gain on futures contract 145,000
Dr Loss on put option 100,000

Dr Cash 50,000
Cr Put option 150,000
Closing out positions on options
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contract
Journal entries (Option writer):
At inception
Dr Cash 300,000
Cr Put option 150,000
Writing of options
At closing of the option positions

Dr Loss on call option 145,000
Cr Cash 295,000
Dr Put option 150,000

Cr Cash 50,000
Cr Gain on put option 100,000
Closing out positions on options
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Content

3. Hedging
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Hedging
• Purpose is to neutralize an exposed risk
– Loss on hedged item offset by gain on hedging instrument (effective hedge)
– Reduce P/L volatility (when instruments of symmetrical payoffs are used)
• Other ways of hedging through non-derivative derivatives

– Money market instruments (money market hedge)
– Natural hedge (offsetting foreign currency assets and liability in the same
currency)
• Special accounting rules called “hedge accounting” apply when derivatives

are used for hedging purpose
– Assets, liabilities, entity commitments and highly probable forecasted
transactions with external parties can be designated as hedged items
• IFRS 9 Chapter 6
– Aligns hedge accounting more closely with the entity’s risk management activities
– Represent the effect of an entity’s risk management activities through use of
financial instruments to manage exposures arising from particular risks
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Rationale of Hedge Accounting
• Arises because of income-offsetting effects between hedged item

and hedging instrument
• Situations that require hedge accounting

– Hedge item and hedging instrument are measured using different bases
(One is at cost while the other is at fair value)
– Hedged item yet to be recognized in financial statement
– Different treatment for changes in fair values of hedged item and
hedging instrument (e.g. changes taken to equity while the other is
taken to income statement)
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Rationale of Hedge Accounting
• Major departure from normal accounting rules is required to reflect

the hedging relationship and the effectiveness of the hedge
– Changes in the fair values of the entity commitment are recognized in
the income statement to offset opposite changes in fair values of the
hedging instrument
• Without hedge accounting rules

– Effectiveness of the hedge will not be reflected in the financial
statements → increased volatility of the reported earnings → contrary to
the economic effects of an effective hedging arrangement
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Risks that Qualify for Hedge Accounting
Interest rate risk Specific risks Market Price risk

that qualify for
hedge accounting
Foreign exchange risk Credit risk
Risks must be specific risk, Possible for a derivative to

not general business risks hedge more than one risk
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Qualifying Hedging Instruments

IFRS 9
• Qualifying hedging instruments include:
a) Derivatives measured at FVTPL (except for net written options and derivatives
embedded in hybrid financial instruments)
b) Designated non-derivative financial assets/liabilities measured at FVTPL (except
for financial liability with changes in FV recognized in OCI)
Or a combination of (a) and (b)
• Contracts must be with parties external to the reporting entity
• Hedging instruments should be designated in its entirety in a hedging
relationship except for:
– Change in intrinsic value and not time value of an option
– Spot element and not the forward element of forward contract
– A proportion of the nominal amount of the hedging instrument
– The FX risk component of all non-derivative financial instruments that is
calculated in accordance with IAS 21
The above may be designated as hedging instruments
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Qualifying Hedged Items
• Items qualified as hedged items for purpose of hedge accounting

– Recognized assets or liabilities;
– Unrecognized firm commitments;
– Highly probable forecast transactions with exposures to changes in future cash
flow; and
– A net investment in a foreign entity
All the above items can be a component of such an item or group items
• The items must be with an external party before they qualify for hedge
accounting
– Exception: the foreign currency risk of an intragroup monetary item such as a
payable or receivable between two subsidiaries (if the exposure to FX gains or
losses that are not fully eliminated on consolidation)
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Qualifying Hedged Items
• IFRS now allows an aggregated exposure

– A combination of an exposure that could qualify as a hedged item in accordance
with the above requirements and a derivative may be designated as a hedged
item
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Hedges of Group of Items
• A group of items is an eligible item only if

a) Each item individually is an eligible hedged item;
b) They are managed on a group basis for risk management purposes.
c) For a cash flow hedge, it is a FX risk hedge and the designation of the
net position specifies the nature, volume and the reporting period in
which forecasted transactions are expected to affect profit or loss.
• A layer component of a group of items is eligible if:

a) the component is separately identifiable and reliably measurable;
b) the risk management objective is to hedge a layer component;
c) the items in the overall group where the layer is identified are exposed
to the same hedged risk; or
d) for a hedge of existing items (e.g. an unrecognized firm commitment),
the overall group can be identified and tracked.
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• Hedged item can also be a component of such an item or group of

items Component refers to a hedged item that is less than the entire
item and only reflects some of the risks.
• List of components of items include:

(a) Changes in cash flows/fair values of item attributable to specific risk (i.e.
risk component), which is separately identifiable and reliably measurable;
(b) One or more selected contractual cash flows;
(c) Components of a nominal amount
– (i) Proportion of entire item
– (ii) Layer component specified from defined nominal amount
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• Entity will have to assess the risk component in the context of the
market structure to which the risks relates and in which the hedging
takes place
• Separate identification criterion

– Risk components could be either explicitly specified in a contract or
implicit in the fair values or cash flows of that entire item (i.e
contractually and non-contractually)
• IFRS includes a rebuttable presumption that inflation risk is not

separately identifiable and reliably measureable unless contractually
specified
– It is possible in limited cases for instance, inflation-linked bonds in a
liquid market
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Qualifying Criteria for Hedge Accounting

(IFRS 9 Para B6.4.1)
Hedging relationship consists only of eligible hedging instruments and

01 eligible hedged items
At the inception of the hedge, there has to be formal designation and

02 documentation of hedging relationship, risk management objective and
strategy for undertaking the hedge
03 The hedging relationship meets all of the following hedge effectiveness

requirements:
i. Economic relationship between hedge item and hedging instrument;

ii. Credit risk does not dominate the value changes from (i)
iii. Hedge ratio of hedging relationship is the same as that resulting from
quantity of hedged item that entity hedges and quantity of hedging
instrument the entity uses to hedge that quantity of hedge item
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Criteria for Hedge Accounting

Relationship between Hedged Item and Hedging instrument
• Economic relationship between hedged item and hedging

instrument means they have values that move in opposite direction
due to the same risk
– The hedged risk arising from same underlying or underlying that are
economically linked
• Hedging instrument: there is possibility that values of the hedging

instrument and hedged item move in same direction when
– Price differential between the two related underlyings changes while the
underlyings themselves do not move significantly
• The existence of an economic relationship depends on the possible

behaviour of the hedging relationship during its term
– Whether it meets the risk management objective
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Effect of credit risk and Hedge Ratio
• Credit risk may dominate the economic relationship between the hedging
instrument and hedged item
– Example: when the increase in credit risks of the counterparty to a commodity
derivative dominates the changes in commodity prices
• The hedge ratio from the quantities of the hedging instrument and the
hedged item should not reflect imbalance between weightings of hedged
item and hedging instrument
• Rebalancing: changes made to the designated quantities of hedged item

and hedging instrument to maintain hedge ratio for hedge effectiveness
• Hedge ineffectiveness is recognized before adjusting the hedge relationship
• Allows the entity to respond to changes of the underlying variables (e.g. indices,
rates, prices)
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Hedge effectiveness
• Hedge effectiveness is the extent to which changes in fair value or

cash flows of the hedging instrument offset the changes in the fair
value or cash flows of the hedged item
• Hedge ineffectiveness is the extent to which the changes in fair

value or cash flows of the hedging instrument are greater or less
than those on the hedged item
• IFRS requires the entity to analyze the sources of hedge

ineffectiveness prospectively:
– On inception
– On a going basis or when significant change in circumstances affecting
hedge effectiveness occurs
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Hedge effectiveness
• Assessing hedge effectiveness using the “hypothetical derivative”

method, which is used to calculate the change in value of a hedged item
– Change in value of the hypothetical derivative is then compared against the
change in value of hedging instrument
– IFRS states that hypothetical derivative cannot include features that do not exist
in the hedged item
– IFRS also requires entities to factor in time value of money (present value basis)
• Causes of hedge ineffectiveness

– Inclusion of time value or interest component of the hedging instrument
– The hedging relationship is not correctly designated
– Hedged item has multiple risks and hedging instrument may also have multiple
underlyings
– One or more of the critical terms of the hedged item and hedging instrument do
not match
• Maturity date
• Underlying’s base
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Designating the Hedge Accounting Ratio
• For hedge accounting purposes, the hedge ratio would have to be

based on the hedge ratio of 1:1 for the hedge to be deemed
effective
• Examples where hedge ratio may not be 1:1 (ineffective hedge)

– Buying 100 tonnes worth of coffee futures contracts to hedge 85 tonnes
of coffee exposure
• Consequently, if hedge ratio becomes ineffective (e.g changes in fair

value of futures), some hedge ineffectiveness will be recognized in
P&L.
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Rebalancing
• Rebalancing: changes made to the designated quantities of hedged

item and hedging instrument to maintain hedge ratio for hedge
effectiveness
– Objective is to allow the continuation of a hedging relationship in
situations where relationship between hedging instrument and hedged
item has changed
– Rebalancing only applies if the risk management objective remains
unchanged
– Purpose of rebalancing needs can only be due to compliance with
hedge effectiveness requirement
• IFRS 9 Para B6.5.8 – Recognize ineffective portion of hedge

ineffectiveness in P&L before adjusting the hedging relationship
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Rebalancing
• Different methods to achieve rebalancing
– Increasing volume of hedged item
– Decreasing volume of hedged item
– Increasing volume of hedging instrument
– Decreasing volume of hedging instrument
• If there is a decrease in volume of hedging instrument, they are no longer

part of the hedging relationship
– Entity will have to account for the portion for which the volume was reduced
under normal accounting rules
– As part of the original amount remains as a hedging instrument, the entity
continues to retain the volume that is no longer needed
– Hence, the entity will account for the undesignated part of the derivatives at fair
value through P&L
• IFRS 9 also requires the entity to update its analysis of sources of hedge
ineffectiveness and to document the hedging relationship after rebalancing
61
Illustration 6: Accounting for the effects of

rebalancing
Scenario
• On 30 Jun 20x1, Coffee Ltd designates a coffee futures contract of 102.1
tonnes as a hedging instrument as a cash flow hedge for a highly probable
forecast purchase of 100 tonnes of coffee
• Hedge ratio of 1.02:1
• On 31 Dec 20x1, the cumulative change in FV of futures contract is a loss of
$50,000
• The cumulative change in fair value of highly probable forecast purchase of
coffee is a gain of $48,000 on the same date
• Coffee Ltd decides to rebalance the hedge relationship on 31 Dec 20x1 as
0.85:1, hence designating 85 tonnes out of the 102.1 tonnes in the coffee
future contract
62
Illustration 6: Accounting for the effects of

rebalancing
Journal entries on 31 Dec 20x1
Dr Fair value reserve – OCI (effective 48,000
portion)
Dr Fair value change relating to hedge 2,000
ineffectiveness – P&L
Cr Futures contract – Hedging instrument 50,000
Accounting for effective and ineffective portion of cash flow hedge of highly
probably forecast purchase
Dr Futures contract – Held for trading 8,550

Cr Futures contract – Hedging instrument 8,550
Accounting for rebalancing
Reclassifying (102.1 tonnes – 85 tonnes) = 17.1 tonnes of fair value of coffee futures
from being a hedging instrument to a held for trading instrument
63
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Content

3. Hedging
64
Classification of Hedging Relationships

Three types of hedges Explanation
Hedge of “the exposure to changes in fair value of a recognized

Fair value asset or liability or an unrecognized entity commitment, or an
hedge identified portion of such asset, liability or entity commitment, which
is attributable to a particular risk and could affect profit or loss”
Hedge of “the exposure to variability in cash flows that

(i) is attributable to a particular risk associated with a recognized
Cash flow
asset or liability (such as all or some future interest payment on
hedge variable debt instrument) or a highly probable future transaction; and
(ii) could affect profit or loss”
Hedge of a net Hedge of the foreign currency risk associated with a foreign
investment in a operation whose financial statements are required to be translated
foreign entity into the presentation currency of the parent company
65
Fair Value Hedge Accounting
• Examples of FV hedges include but not limited to

1. Hedge of a FVOCI security
2. Hedge of a fixed rate investment
3. Hedge of inventory
4. Hedge of a firm commitment
• A firm commitment is “a binding agreement for a exchange of a

specified quantity of resources at a specified price on a specified
future date”
– Hedge of a entity commitment is a FV hedge because the commitment
carries a contractual obligation that is tied to a fixed price
– Fair value hedges are typically hedges against fixed rate exposures
– However, IFRS 9 (B6.5.3) clarifies that foreign currency risk of a firm
commitment could alternatively be accounted for as a cash flow hedge
66
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Fair Value Hedge Accounting
• Change in FV of the hedging instrument is recognized in P/L

– Exception: when the hedged item is an equity instrument with change in FV to
OCI, the gains or losses on the hedging instrument is recognized in OCI to allow
offsetting
• Basis adjustment: The gain or loss on the hedged item attributable to the
hedged risk is taken to P/L. Its carrying amount is adjusted by the amount of
gain or loss.
– Applies even if the hedged item is otherwise at cost, e.g. inventory
– If hedge item is an equity instrument for which the entity has elected to present
changes in FVOCI, the gain or loss will remain in OCI
• When the hedged item in a fair value hedge is a firm commitment, the
cumulative change in FV of the firm commitment is recognized as an
asset or a liability with the corresponding gain or loss recognized in the
P&L
67
Accounting for a Fair Value Hedge
Hedged Item (recognized

asset or liability or entity Hedging Instruments
commitment)
Exception: when the
hedged item is an
Change in fair value Change in fair value equity instrument with
changes in FV to OCI,
Income statement the gains or losses on
the hedging instrument
Gain (loss) on hedging instrument is recognized in OCI to
offset loss (gain) on hedged item allow offsetting
Balance sheet
Change in fair value adjusted Change in fair value adjusted
against carrying amount against carrying amount
68
Accounting for Time Value of Options

IFRS 9 Para 6.5.15
IFRS 9 allows us to designate only the

change in intrinsic value as the hedging
Intrinsic instrument
value
Time
value The change in time value is
An option recognized initially in OCI;
contract Subsequently, the accounting
depends on whether the
hedged item is transaction-
related or time period-related.
69
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• IFRS 9 (Para 6.2.4(a)) – Separate the intrinsic and time value of an option
contract and designate only the change in intrinsic value of an option as the
hedging instrument
• The change in time value in the hedging instrument is recognized initially in

OCI in both transaction-related and time-related hedges
• The subsequent treatment depends on the characteristics of the hedged

item, i.e whether it is transaction-related or time period-related
– It is transaction-related if the time value of option used to hedge an item
represents part of the cost of the transaction
– It is time period-related if the time value is the cost for obtaining protection
against a risk over a specific time period, but does not involve transaction costs
70
• Transaction-related hedged item

– Typically arises from a hedge of a highly probable transaction or firm
commitment
– If hedged item subsequently results in recognition of non-financial asset
or liability or a firm commitment, the fair value accumulated in OCI is
adjusted against the intial cost or carrying amount of the asset or liability
• Time period-related hedged item

– Covers the risks of recognized asset or liability
– The fair value accumulated in OCI and amortized over the period during
which the hedge adjustment for the intrinsic value affects P&L
• Exception: The hedged item has been elected to present changes in fair
value in OCI
71

IFRS 9 Para 6.5.15
• The accounting for time value of options applies to the net nil time
value in the combination of a purchased and a written option
– Changes in time value are recognized in OCI
– For transaction related hedged item, the time value that adjusts hedged
item or is reclassified to P/L at the end of the hedging relationship is nil.
– For time-related hedged item, the amortization expense is nil.
• If the critical terms of the hedging option and the hedged item are
not fully aligned, the aligned time value is determined as:
a) If at inception, actual time value > aligned time value, the aligned time
value is accumulated in OCI and the difference is accounted for in P/L.
b) If at inception, aligned time value > actual time value, the lower of the
two is accumulated in OCI and the remainder of the change in actual
time value is recognized in P/L.
72
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Illustration 7: Transaction-related hedge

using options
Scenario
• On 1 Apr 2018, an entity (functional currency is in SGD) purchases a piece
of equipment for USD 12,000,000 to be delivered on 31 Dec 2018
• The entity hedges the downside risk with an option buy USD 12,000,000
and sell SGD with the same terms as the highly probably purchase of
equipment, with exercise price of 1.30
• The entity designates the intrinsic value of the option as a cash flow hedge
• On 31 Dec 2015, the SGD 50,000 in FV reserve is included in the
equipment cost, when the equipment has been delivered
Date USD/SGD Time values of Changes in time

exchange rate option (SGD) value of option (SGD)
1 April 2018 1.30 50,000
30 June 2018 1.36 30,000 20,000
30 Sep 2018 1.37 14,000 16,000
31 Dec 2018 1.40 14,000
73

using options
Journal entries
1 April 2018
Cr Cash 50,000
Purchase of call option
30 June 2018
Dr Cash flow hedge reserve (OCI) 20,000
Decline in time value fom 1 April to 30 June
Dr Call option (1.36-1.3) x 12 mil 720,000
Cr Cash flow hedge reserve (OCI) 720,000
Increase in intrinsic value from 1 April to 30 June
74

using options
Journal entries
30 Sep 2018
Decline in time value from 30 June to 30 Sep
Increase in intrinsic value from 30 June to 30 Sep
31 Dec 2018
Decline in time value from 30 Sep to 31 Dec
Increase in intrinsic value from 30 Sep to 31 Dec 75
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using options
Journal entries
31 Dec 2018
Dr Equipment 16,800,000
Cr Cash (12 mil x 1.4) 16,800,000
Delivery of equipment
Cr Cash flow hedge reserve (OCI) 1,200,000
Adjust equipment cost for the cash flow hedge reserve
Dr Cash 1,200,000
Cr Call option 1,200,000
Exercise of call option on expiry date
76
Illustration 8: Time period-related hedge

using options
Scenario
• On 1 Apr 2018, an entity (functional currency is in SGD) issued a five-year
floating rate (nominal amount SGD 1 million, at interest rate LIBOR + 3%
payable annually) bond in SGD
• To hedge against interest rate increasing, the entity bought an interest rate
cap on 1 April 2018 with maturity of five years
• Entity designates the intrinsic value of the cap as the cash flow hedge
• LIBOR rate was 2% on 1 April 2018
Date Time values of Fair value of interest

interest rate cap rate cap (SGD)
(SGD)
1 April 2018 100,000 100,000
31 Dec 2018 88,000 92,000
77

using options
Journal entries
1 April 2018
Dr Cash 1,000,000
Cr Bond payable 1,000,000
To record issuance of bond
Dr Interest rate cap 100,000

Cr Cash 100,000
To record purchase of interest rate cap
78
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using options
Journal entries
31 Dec 2018
Dr Interest expense 37,500
Cr Interest payable 37,500
To record interest accrual on bond payable

Cr Interest rate cap (100,000 – 88,000) 12,000
Change in time value of interest rate cap from 1 Apr to 31 Dec 2018
Dr Amortization of interest rate cap (P&L) 15,000

Record amortization of interest rate cap time value
79
Accounting for Forward Element of Forwards

IFRS 9 Para 6.5.16
• When forward and spot elements of forward are separated → only

change in spot values designated as hedging instruments
• The forward element is cumulated in OCI and amortized over the

period over which the forward element related
– If the hedge accounting discontinues, the net amount in OCI is
reclassified into P/L
• If critical terms are not fully aligned with hedged item

– If at inception, absolute forward element > aligned forward element, the
aligned forward element accumulated in OCI, the difference is
accounted for in P/L
– If at inception, aligned forward element > absolute forward element: the
lower of the two is accumulated in OCI, and the remainder of change is
recognized in P/L
80
Fair Value Hedge Examples
Hedge of an
exposed Hedge of
monetary inventory
asset
Hedge of
Hedge of a equity
firm instruments
commitment classified as
FVOCI
81
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Example 1: Fair Value Hedge of an Exposed

Monetary Asset
Scenario
• Gemini Enterprise, whose functional currency is the dollar, sold merchandise
at FC 100,000 on 2 Dec 20x4 (when exchange rate was $1.85/FC 1) with
payment due on 31 Jan 20x5
• Gemini hedged the exposed A/R by entering into a forward exchange
contract to sell FC 100,000 on 31 Jan 20x5 at forward rate of $1.835/FC 1
• Ignore discounting
Date Spot Rate 31 Jan 20x5 Forward Rate
31 Dec 20x4 $1.835/FC 1 $1.825/FC 1

31 Jan 20x5 $1.82/FC 1 $1.82/FC 1
82

Monetary Asset
• Journal entries (2 Dec 20x4)
Dr Accounts receivable (FC) 185,000
Cr Sales 185,000
Sale of merchandise with invoice value of FC 100,000 at the spot
exchange rate
Dr Loss on accounts receivable (P/L) 1,500

Cr Accounts receivable (FC) 1,500
Remeasure A/R to closing spot rate as it is a monetary item and
recognize a transaction loss: [FC100,000 x (1.835 – 1.85)]
83

Monetary Asset
Intrinsic value gain on forward contract: [FC 100,000 x (1.835 – 1.85)]
Dr Deferred loss on forward (OCI) 500

Cr Forward contract 500
Time value change of forward from 2 Dec to 31 Dec 20x4
(1.85 – 1.835) – (1.835 – 1.825) x 100,000
Dr Amortization of time value (P/L) 750

Cr Deferred loss on forward (OCI) 750
Amortization of intial time value of forward to P/L
(1.85 – 1.835) x 100,000 x 1/2
84
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Monetary Asset
• Journal entries (31 Jan 20x5)
Dr Loss on accounts receivables (P/L) 1,500
Remeasure A/R to closing spot rate and record transaction loss
[FC100,000 x (1.82 – 1.835)]

Cr Gain on forward contract (P/L) 750
Intrinsic value gain on forward contract: FC100,000 x (1.85 – 1.82)
Dr Deferred loss on forward (OCI) 1,000

Time value change of forward from 31 Dec 20x4 to 31 Jan 20x5
(1.835 – 1.825) x 100,000
85

Monetary Asset
• Journal entries (31 Jan 20x5)
Dr Amortization of time value (P/L) 750
Cr Deferred loss on forward (OCI) 750
Amortization of intial time value of forward to P/L
Dr Cash 183,500
Settlement of A/R and closing of forward contract
A/R is settled at spot rate at settlement date (FC 100,000 x 1.82)
86

Monetary Asset
• A comparison of consequence from hedging and apply hedge
accounting, hedging and not applying hedge accounting and no
hedging is as follows
Accounts Hedging and Hedging and No hedging
apply hedge not apply hedge
accounting accounting
P&L effects
Sales 185,000 185,000 185,000
Gain on forward contract 1,500 1,500 -
Loss on accounts receivable 3,000 3,000 3,000
Cash flow effects
Sales proceeds 185,000 185,000 185,000
Proceeds from forward 1,500 1,500 -
contract
87
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Example 2: Fair Value Hedge of Inventory
Scenario
31/10/20x3
– Inventory of 10,000 ounces of gold
– Carried at cost of $3,000,000 ($300 per ounce)
– Price of gold was $352 per ounce
1/11/20x3
– Sold forward contract on 10,000 ounce for forward price of $350 ounce
– Lock in profit of $500,000 ($50 x 10,000)
– Forward contract matures on 31/3/20x4
31/12/20x3
– Forward price for 31/3/20x4 contract was $340 per ounce and spot price
of gold was $342 per ounce
– Hedge effective ratio of 1 on 31/12/20x3
88
1/11/20x3
No entry or just a memorandum entry as the fair value of the
forward contract is nil
31/12/20x3
Dr Forward contract ………………. 100,000
Cr Gain on forward contract ……... 100,000
Gain on forward contract: 10,000 x ($340 – $350)
Taken to income
statement
Dr Loss on inventory ……………… 100,000
Cr Inventory ……………………….. 100,000
Fair value loss on inventory: 10,000 x ($342 – $352)
89
31/3/20x4
Inventory is sold to third-party at $330 per ounce (also maturity date of
forward contract
Dr Forward contract ………………. 100,000
Cr Gain on forward contract ……... 100,000
Gain on forward contract: 10,000 x ($330 – $340)
Dr Loss on inventory ……………… 120,000

Cr Inventory ……………………….. 120,000
Loss on inventory: 10,000 x ($330 – $342)
Dr Cash …………………………….. 3,300,000

Cr Sales ……………………………. 3,300,000
Sale of inventory: 10,000 x $330
90
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31/3/20x4 (continued)
Dr Cost of goods sold ………….. 2,780,000
Cr Inventory …………………….. 2,780,000
Cost of goods sold: $3,000,000 – $100,000 – $120,000
Dr Cash …………………………….. 200,000

Cr Forward contract ………………. 200,000
Close forward contract and record net receipt on settlement, which is the
notional amount multiplied by the difference between the contracted forward
rate and spot rate on settlement [10,000 x ($350 – $330)]
91
• A comparison of consequence from hedging and apply hedge accounting,

hedging and not applying hedge accounting and no hedging is as follows
P&L effects
Sales 3,300,000 3,300,000 3,300,000
COGS (2,780,000) (3,000,000) (3,000,000)
Gain on forward contract 200,000 200,000 -
Loss on inventory (220,000) - -
Net profit or loss 500,000 500,000 300,000
Cash flow effects
Sales proceeds 3,300,000 3,300,000 3,300,000
Proceeds from forward 200,000 200,000 -
contract
Lock in profit 92
Example 3: Fair Value Hedge of FVOCI

equity instrument with a purchase put option
Scenario
• On 30 Nov 20x1, Systech Ltd purchased 1,000 shares of Fastrack Ltd at $5
per share. To protect a loss in value of Fastrack shares, Systech purchased
an at-the-money put option (exercise price = $5 per share) on 1,000
Fastrack shares for $500 on the same date
• Put option matured on 31 Jul 20x2
• Systech classified the investment as FVOCI
• On 31 Jul 20x2, Systech closed the option and disposed of its investment in
Fastrack
Date Price of Fastrack Price of put option

share
30 Nov 20x1 $5.00 $500
30 Jun 20x2 4.50 700
31 Jul 20x2 4.00 1,000
93
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Analysis
• Time value of put option was excluded from hedging relationship (IFRS(9)
• At inception, Systech assesses the economic relationship between the hedged item
and hedging instrument qualitatively
• As the hedged exposure is exactly matched by hedging instrument, there is an
economic relationship between them (critical terms matched)
• Hedge ratio is based on a put option on 1,000 Fastrack shares at $5 per share for
existing 1,000 Fastrack shares held by Syntech (1:1 ratio)
FV computations 30 Nov 20x1 30 Jun 20x2 31 Jul 20x2
Fastrack shares:
Per share $5 $4.50 $4.00
Total (1,000 shares) 5,000 4,500 4,000
Put option:
Fair value (a) 500 700 1,000
Less: Intrinsic value (b) 0 500 1,000
Time value (a) – (b) $500 $200 $0
94

• Journal entries (30 Nov 20x1)
Hedged item Hedging instrument
Dr FVOCI investment 5,000 Dr Put option 500
Cr Cash 5,000 Cr Cash 500
FVOCI Investment Purchase of put option
• Journal entries (30 Jun 20x2)

Dr Deferred loss on 500 Dr Put option 500
FVOCI Investment (OCI)
Cr FVOCI Investment 500 Cr Deferred gain on 500
put option (OCI)
Loss in Fair value of FVOCI Gain in intrinsic value of put option
95

• Journal entries (31 Jul 20x2)
Dr Deferred loss on 500 Dr Deferred loss on 300
FVOCI Investment (OCI) put option (OCI)
Cr FVOCI Investment 500 Cr Put option 300
Loss in Fair value of FVOCI instrument Loss in time value of put option

Dr Cash 4,000 Dr Put option 500
Cr FVOCI Investment 4,000 Cr Deferred gain on 500
put option (OCI)
Sale of FVOCI Investment Gain in intrinsic value of put option
96
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Dr Retained earnings 1,000 Dr Deferred loss on 200
put option (OCI)
Cr Deferred loss on 1,000
FVOCI Investment (OCI) Cr Put option 200
Reclassification of amounts accumulated
Loss in time value of put option
in OCI to retained earnings on disposal of
FVOCI Investment Dr Deferred gain on 500
put option (OCI)
Cr Retained earnings 500
Reclassify from deferred gain to RE
Dr Cash 1,000
Cr Put option 1,000
Exercise put option
97

• A comparison of consequence from hedging and apply hedge
accounting, hedging and not applying hedge accounting and no
hedging is as follows
P&L effects
Gain from put option - 500 -
FVOCI Equity investment - - -
Cash flow effects
Sales proceeds 4,000 4,000 4,000
Proceeds from put option 1,000 1,000 -
98
Example 4: Fair Value Hedge of a Firm

Commitment
Scenario
• On 30 Jun 20x5, Decca Co entered into a firm commitment to sell 10,000
tons of palm oil at $298 per ton to a customer with delivery and payment on
30 Sep 20x5. Hence, Decca is exposed to fair value changes in palm oil
• Decca decided to hedge the commitment by purchasing ten Sep 20x5
futures contracts (each had a notional amount of 1,000 tons) at $300
• Decca was also required to pay a margin deposit of $10,000 per contract
30 Jun 31 Jul 31 Aug 30 Sep
Spot price/ton $298 $305 $309 $315
30 Sep futures price/ton 300 307 310 315
99
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Commitment
• The following table shows the changes in fair values of the futures contracts
and the firm commitment
31 Jul 31 Aug 30 Sep

Spot price/ton $305 $309 $315
30 Sep futures price/ton 307 310 315
Contracted futures price 300 300 300
Quantity (tons) 10,000 10,000 10,000
Fair value of futures contract 70,000 100,000 150,000
Change in fair value of futures 70,000 30,000 50,000
Value of firm commitment (70,000) (110,000) (170,000)
Change in value of firm (70,000) (40,000) (60,000)
commitment
Hedge effectiveness ratio 1 0.91 0.88
100

Commitment
• Journal entries (30 Jun 20x5)
No journal entry is required to record the Dr Margin deposit 100,000
firm commitment
Cr Cash 100,000
Payment of margin deposit on ten contracts

Dr Loss on firm 70,000 Dr Futures 70,000
commitment (P&L) contract
Cr Firm commitment 70,000 Cr Gain on futures 70,000
contract (P&L)
Loss in fair value of firm commitment as a Gain on futures contract
result of the increase in spot price of palm oil
101

Commitment
• Journal entries (31 Aug 20x5)
contract (P&L)
Loss in fair value of firm commitment Gain on futures contract
• Journal entries (30 Sep 20x5)

contract (P&L)
Loss on firm commitment Gain on futures contract
102
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Commitment
• Journal entries (30 Sep 20x5)
Dr Cash 2,980,000 Dr Cash 250,00
0
Cr Sales 2,980,000
Record sale of palm oil at contracted price of
Cr Futures contract 150,000
$298 per ton
Close position on the futures contract and
Dr Firm commitment 170,000 record refund of the margin deposit
Cr Sales 170,000
Adjust firm commitment against sales
103

Commitment

apply hedge not apply
accounting hedge
accounting
P&L effects
Sales 3,150,000 2,980,000 2,980,000
Gain on futures contract 150,000 150,000 -
Loss on firm commitment (170,000) - -
Net profit/loss 3,130,000 3,130,000 2,980,000
Cash flow effects
Sales proceeds 2,980,000 2,980,000 2,980,000
Proceeds from futures contract 150,000 150,000 -
104

Commitment
Hedged Hedged Unhedged Unhedged
Spot price on 30 Sept 315 290 315 290
Sales 3,150,000 2,900,000 2,980,000 2,980,000
Cost of sales (3,150,000) (2,900,000) (3,150,000) (2,900,000)
Gross profit - - (170,000) 80,000
Gain/(loss) on firm (170,000) 80,000 0 0
commitment (a)
Gain/(loss) on futures 150,000 (100,000) 0 0
contracts (b)
Net Profit (20,000) (20,000) (170,000) 80,000
(a) Gain or loss is the difference between the contracted price and the spot price
(b) Gain or loss on the futures contract is the difference between the spot and the contracted price
105
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Cash Flow Hedge Accounting
• A cash flow hedge applies when:

1. Hedge of a recognized asset or liability with a variable interest rate
(resulting in a variable future cash flow); and
2. A highly probable future transaction.
Cash flow hedges are typically hedges against floating rate exposures.
• Certain types of hedges have the characteristics of both a fair value

hedge and a cash flow hedge.
– E.g. the hedge of a firm commitment denominated in a foreign currency
FV hedge view: An exchange rate movement will affect the fair value of the
commitment, implying a fair value change.
CF hedge view: The cash flows from a foreign currency denominated firm
commitment are exposed to exchange rate changes when the commitment
is ultimately settled.
106
Accounting for a Cash Flow Hedge

Derivative is
designated as a cash
flow hedge
Cumulative change in fair value of hedging instrument (A)

Cumulative change in present value of expected cash flow (B)
(A) > (B) (A) ≤ (B)
No ineffective portion; Effective

Ineffective portion Effective portion portion = cumulative change in
(A) – (B) (B) FV of hedging instrument
Profit or loss Other comprehensive Other comprehensive income

income
107
Accounting for a Cash Flow Hedge
Cash flow hedges are applicable to the following:
An Interest rate swap

Hedge of an
Hedge of a forecasted to hedge a floating rate
anticipated issue of a
transaction financial asset or
bond
financial liability
108
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Highly Probable Forecasted Transaction
• One that has a high probability of occurrence

– Similar to a entity commitment in that it is a future transaction that has
yet to occur
• Differences between forecasted transaction and firm commitment

Forecasted transaction Firm commitment
✓ No commitment to a specific price, ✓ Carries a fair value exposure
hence it does not entail any rights because of commitment to a
or obligations specific price
✓ Has a cash flow exposure that ✓ If the price changes, there is either
stems from changes in the price of a gain or a loss on the fair value of
the forecasted item → expose an the commitment
entity to a cash flow risk that will
affect reported earnings
109
Highly Probable Forecasted Transaction
• An entity can designate the forecasted purchase or sale of an asset:

– at the market price
– at the date of purchase or sale
– as a hedged transaction because the asset will be recorded at that
future purchase or sale price
• There is higher (relative to commitment) possibility that the

forecasted transaction may be:
– Postponed
– Cancelled
110
Illustration 9: Cash Flow Hedge of a Highly

Probable Forecast Transaction
Scenario
• On 30 Nov 20x5, Alpha forecasted the purchase of an equipment costing
FC 2,000,000 on 30 Jan 20x6
• Alpha’s functional currency is the dollar. Alpha hedged against the risk of an
appreciation of FC by entering into a two-month forward exchange contract
to purchase FC 2,000,000 for delivery on 31 Jan 20x6
• Alpha designated the forward exchange contract as a cash flow hedge.
Fiscal year end is 31 Dec
• Assume discount rate of 6% per annum
Date Spot Price, 1 FC = Forward price for 31

Jan, 1 FC =
30 Nov 20x5 $1.70 $1.72
31 Dec 20x5 1.73 1.74
31 Jan 20x6 1.75 1.75
111
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Fair value of forward contract and the spot and interest rate components
Date Spot Forward rate FV of Spot Interest element Hedge

rate to 31 Jan forward element in in forward effectiveness
FC 1 = 20x6 FC 1 = contract forward contract ratio
contract
30 Nov $1.70 $1.72
20x5
31 Dec 1.73 1.74 $39,801 $59,701 $(19,900) 1
20x5
31 Jan 1.75 1.75 60,000 100,000 (40,000) 1
20x6
112

Journal entry (30 Nov 20x5)
No journal entry is needed. Only memorandum record as the value of

forward contract is zero at inception
Journal entry (31 Dec 20x5)
Dr OCI (Interest element) 19,900
To recognize FV gain on forward contract between 30 Nov 20x5 and 31

Dec 20x5
113

Journal entry (30 Jan 20x6)

Dr OCI (interest element) 20,100
To recognize FV gain on forward contract between 31 Dec 20x5 and 30
Jan 20x6
Cr Cash 3,500,000
To record purchase of equipment for FC2,000,000 at rate of FC 1 = $1.75

Cr Equipment 100,000
To record the basis adjustment of the carrying value of equipment
114
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Journal entry (30 Jan 20x6)
Dr Cash 60,000
Net settlement received from the dealer on maturity of forward contract
Dr Equipment 40,000
Cr OCI (interest element) 40,000
To record the basis adjustment of the carrying value of the equipment in
respect of the interest component of forward contract (transaction related
hedge)
115

• An alternative method of using forward rates for the hedging instrument are
allowed by the standard

P&L effects
Gain on forward contract - 60,000 -
Cash flow effects
Purchase payment (3,500,000) (3,500,000) (3,500,000)
Proceeds from forward contract 60,000 60,000 -
116
Content

3. Hedging
117
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Hedging Against Interest Rate Risk
• Entities that issue debt or have investment in debt instruments face

interest rate risks
• Type of interest rate derivatives that are commonly used to manage

interest rate risk include:
– Interest rate futures
– Options on interest rate futures
– Forward rate agreements
– Interest rate caps
– Interest rate floors
– Interest rate collars
– Interest rate swaps
118
Illustration 10: Cash flow hedge of an anticipated

issue of bonds using interest rate futures contracts
Scenario
• On 30 Jun 20x1, Company X intends to finance a $50m five-year bonds in
Jan 20x2. Interest rate for similar bonds on that date is 6% on that date,
with semi-annual payments.
• Co X is concerned that market interest rates would rise before the bond was
issued on 1 Jan 20x2 and thus, decides to hedge the interest rate risk from
the date it decided to issue the bond to the date the bonds were issued
• To hedge, Co X sell 488 five-year treasury notes futures contract. Each
contract has a face value of $100,000
• At 30 June 20x1, a 31 Dec 20x1 five-year treasury note carried an interest
rate of 5% was selling at par
• Margin requirement is $800 per contract
• Co X designates the futures as cash flow hedge
• As expected, the market interest rate increased and thus, price of interest
rate futures on five-year treasury notes decreased
119

Date Price of futures Total value of 488 Cumulative gain on

contract futures contracts futures contract
30 Jun 20x1 $100,000 $48,800,000
30 Sep 20x1 97,906 47,778,128 1,021,872
31 Dec 20x1 95,875 46,787,000 2,013,000
Date Forecasted Expected Cum. Change in PV of change in

borrowing interest semi-annual interest payment
rate payment interest payment at 6% per annum
30 Jun 20x1 6.0% $1,500,000
30 Sep 20x1 6.5% 1,625,000 125,000 1,066,275
31 Dec 20x1 7.0% 1,750,000 250,000 2,132,551
120
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Date Cumulative change in Cumulative change in PV Hedge
FV of futures contract of expected interest effectiveness
payments ratio
30 Sep 20x1 1,021,872 1,066,275 0.958
31 Dec 20x1 2,013,000 2,132,551 0.944
Journal entry (30 Jun 20x1)
Dr Margin deposit 390,400

Cr Cash 390,400
To record the margin deposit of $800 per contract on 488 contracts
Journal entry (30 Sep 20x1)
Dr Futures contract 1,021,872
Cr Hedging reserve (OCI) 1,021,872
To record gain on futures contract that is taken to equity
Note: no ineffective portion in the hedge as the delta ratio is less than 1
121

Journal entry (31 Dec 20x1)
Dr Futures contract 991,128

Cr Hedging reserve (OCI) 991,128
To record the gain on futures contract that is taken to equity
Note: no ineffective portion in the hedge as the cumulative change in
hedging instrument is less than cumulative change in PV of expected CF
Dr Cash 2,403,400
Cr Futures contract 2,013,000
To record the refund of margin deposit and the closing off of futures position
*The deferred gain taken to hedging reserve (equity) will be recycled to profit or loss
over the life of the bond using the effective interest method
122



P&L effects
Gain on futures contract - 2,013,000 -
Cash flow effects
Proceeds from forward contract 2,013,000 2,013,000 -
123
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Interest Rate Swaps
• An interest rate swap is an agreement between two counterparties to

exchange interest payments based on a notional amount and agreed upon
interest rates
1 Jan 20x1 30 Jun 20x1 31 Dec 20x1
• Inception of • Interest rate reset • Interest rate reset

swap • Net settlement of interest • Net settlement of
• FV of swap = 0 • Adjustment of FV of swap interest
• Adjustment of FV of
swap
124
Using Swaps for Hedging
• Swaps are used to manage two types of interest rate risk

– Cash flow risk (scenario 1)
– Price risk (scenario 2)
• Scenario 1
– Company A has floating rate debt but wishes to pay fixed interest rate
– Swaps interest rate flows with company B
– Cash flow hedge as it transforms future variable cash outflows into fixed cash
outflows
Pays fixed interest to B
Lender Company A
Receives SFP: Floating Company B

floating rate debt
rate (liability)
receipts Receives floating rate interest
from B
125
Using Swaps for Hedging
• Scenario 2
– Company A has fixed rate investment (classified as available-for-sale)
– Fair value hedge as a fixed rate asset or debt is exposed to changes in
fair value
– When interest rates rise, the fair value of the fixed rate asset or debt
declines and vice versa
Pays fixed interest to B

Investee Company A
Company B
Pays fixed SFP: Fixed
rate rate asset
payments
Receives floating rate interest
from B
126
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Determining the Fair Value of Swap
• Estimation of fair value of swap requires computation of the present value of

net payment for each future period and aggregating the present values for
all periods
• Discount rate = forward interest rate
• The market yield curve, which relates interest rates to the time to maturity
can be used to estimate the interest rate for each period
– Interest rates change at each settlement period
• Upward sloping yield curve: Long-term interest rates are higher than short
term interest rates [opposite for inverted yield curve]
• Easiest method to estimate fair value of swap: assume a flat yield curve
(which implies a constant forward interest rate)
127
Determining the Fair Value of Swap
• If swap is based on LIBOR, fair value can be obtained from the

International Swap Dealers Association
• At inception: fair value of swap is 0

– the present value of the net difference between the fixed rate stream of
payments and floating rate stream of payments must be zero
– Else, one party will gain while the other party will suffer loss at inception
• After inception: fair value of swap will be either positive or negative

because shape of curve will change over time
128
Short-cut Method for Accounting for Swap

Hedges
• FASB allows the assumption of a perfect hedge if certain conditions
are met. These conditions include:
– Matching of the notional amount of swap with principal amount of
interest bearing asset or liability
– Zero fair value of the swap at inception
– No prepayment on interest-bearing asset or liability
– Matching of index interest rate with interest rate of hedged item for a
variable interest rate asset or liability
• Note: IAS 39 and IFRS 9 do not have the above provisions
129
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Illustration 11a: Hedge of interest rate risk using a

swap (cash flow hedge)
Scenario
• Co A has a floating rate one-year loan of $10mil, with quarterly interest
payable at LIBOR + 50 basis points
• Co A entered into a contract with Firm B on 30 June 20x5 to swap interest
payments
• Under this arrangement, Co A paid fixed interest at 7.75% p.a on a notional
principal of $10mil to Firm B in exchange for the receipt of floating LIBOR +
50 basis points. Interest payments are settled at the end of each quarter
• Floating rate payment was “reset” at LIBOR at the beginning of each
quarter. The LIBOR rate at the beginning of each quarter is as follows:
Date Rates
30 June 20x5 7.25%
30 September 20x5 6.25%
31 December 20x5 7.45%
31 March 20x6 7.50%
130

Quarter Floating Floating Fixed rate Current Fair value of Change in

ended rate rate receipt payments at net swap asset/ fair value
(LIBOR + (Amount 7.75% receipt/ (liability)
50bp) received) (Amount paid) (payment)
Start of swap
30 Jun 20x5 7.75% 0
30 Sep 20x5 6.75% $193,750 $193,750 0 $(72,538) $(72,538)
31 Dec 20x5 7.95% 168,750 193,750 (25,000) 9,710 82,248
31 Mar 20x5 8.00% 198,750 193,750 5,000 6,127 (3,583)
30 Jun 20x6 200,000 193,750 6,250 0 (6,127)
131

Journal entry
30 Sep 20x5
Cr Bank 193,750
Payment for interest on floating rate loan
Dr Fair value adjustment (OCI) 72,538

Cr Interest rate swap 72,538
Fair value unfavorable adjustment
132
44
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Journal entry
31 Dec 20x5
Cr Bank 168,750

Cr Bank 25,000
Settlement of swap differential
Dr Interest rate swap 82,248

Cr Fair value adjustment (OCI) 82,248
Fair value favorable adjustment
133

Journal entry
31 Mar 20x6
Cr Bank 168,750
Dr Bank 5,000
Cr Interest expense 5,000
Receipt of swap differential

134

Journal entry
30 Jun 20x6
Cr Bank 200,000
Dr Bank 6,250
Receipt of swap differential

135
45
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Accounts Hedging and Hedging and No

apply hedge not apply hedge hedging
P&L effects
Fair value gain/loss on swaps (20x5) - 9,710 -
Interest expense on bank loan (20x5) (362,500) (362,500) (362,500)
Interest expense on swap (20x5) (25,000) (25,000) -
Net profit/loss (387,500) (377,790) (362,500)
Cash flow effects
Interest expense on bank loan (362,500) (362,500) (362,500)
Interest expense on swap (25,000) (25,000) -
136
Illustration 11b: Hedge of interest rate risk using a

• Alternatively, Co A can pass the following set of accounting entries which
demonstrate the recycling of effective portion of cash flow hedge to P&L in
the same period when the hedged cash flows affect the P&L
• Co A will have to compute “dirty” fair value of the swap
– Fair value of the swap that includes the net cash flow settled at the end of year
• The fair value calculated below is the “clean” fair value which excludes the
net cash flow settled at the end of the year
Fair value of swap 30 Sep 20x5 31 Dec 20x5 31 Mar 20x6 30 Jun 20x6
Beginning fair value of swap - (72,538) 9,710 6,127
Movement during the year (72,538) 57,248 1,417 123
“Dirty” fair value of swap (72,538) (15,290) 11,127 6,250
Net cash flow - 25,000 (5,000) (6,250)
paid/(received)
“Clean” fair value of swap (72,538) 9,710 6,127 -
137

Journal entry
30 Sep 20x5
Cr Bank 193,750

Cr Swap 72,538
Fair value of swap recognized
138
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Journal entry
31 Dec 20x5
Cr Bank 168,750
Dr Swap 25,000
Cr Bank 25,000
Dr Swap 57,248
Dirty FV of swap recognized in OCI
Effective portion of cash flow hedge reclassified to profit or loss
139

Journal entry
31 Mar 20x6
Cr Bank 168,750
Dr Cash 5,000
Cr Swap 5,000
Dr Swap 1,417
Dirty fair value of swap recognized in OCI
140

Journal entry
30 Jun 20x6
Cr Bank 200,000
Dr Cash 6,250
Cr Swap 6,250
Dr Swap 123
Cr Cash flow hedge reserve (OCI) 123
Dirty fair value of swap recognized in OCI
141
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Illustration 12: Hedge of fixed interest notes

payable (a fair value hedge)
Scenario
• On 1 Jan 20x1, Alpha Co borrowed a $20m two-year loan from a bank at a
fixed rate of 10% per annum, with interest due on a semi-annual basis
• Anticipating that interest rates may drop in the future, Alpha entered into a
swap to receive a fixed rate of 10% p.a. in exchange for payment of LIBOR
• The swap was settled, and the variable rate was reset for the following
semi-annual payment based on the beginning LIBOR
• Relevant rates are as follows:
Date LIBOR as at this date used for

subsequently half-year payments
1 Jan 20x1 10.0% p.a.
30 Jun 20x1 9.5% p.a.
31 Dec 20x1 9.0% p.a.
30 Jun 20x2 8.8% p.a.
142

Period half- Floating Floating rate Fixed rate Current net FV of Change in
year ended rate payment receipts at receipt/(pay swap FV:
LIBOR (Amount 10% p.a. ment) asset/(liab gain/(loss
paid) (Amount ility) )
received)
Start of swap
1 Jan 20x1 10.0% 0
30 Jun 20x1 9.5% 1,000,000 1,000,000 0 136,803 136,803
31 Dec 20x1 9.0% 950,000 1,000,000 50,000 187,267 50,464
30 Jun 20x2 8.8% 900,000 1,000,000 100,000 114,943 (72,324)
31 Dec 20x2 880,000 1,000,000 120,000 0 (114,943)
143

Journal entry
1 Jan 20x1
Dr Cash 20,000,000
Cr Loan payable 20,000,000
Inception of loan
30 Jun 20x1
Dr Interest expense 1,000,000
Cr Cash 1,000,000
Interest expense on fixed rate loan
Dr Interest rate swap asset 136,803
Cr Unrealized gain on swap (P&L) 136,803
Change in the value of the swap
144
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Journal entry
30 Jun 20x1
Dr Unrealized loss on loan (P&L) 136,803
Cr Loan payable 136,803
Change in the value of debt attributable to the change in interest rate
31 Dec 20x1
Cr Cash 1,000,000
Dr Cash 50,000
Receipt of interest rate difference on swap: 9.5% vs 10% on $20m x ½ year
145

Journal entry
31 Dec 20x1
Dr Interest rate swap asset 50,464
Cr Unrealized gain on swap (P&L) 50,464
Change in the value of the swap
Dr Unrealized loss on loan (P&L) 50,464
Cr Loan payable 50,464
30 Jun 20x2
Cr Cash 1,000,000
146

Journal entry
30 Jun 20x2
Dr Cash 100,000
Receipt of interest rate difference on swap: 9% vs 10% on $20m x ½ year
Dr Unrealized loss on swap (P&L) 72,324
Cr Interest rate swap asset 72,324
Change in the value of swap
Dr Loan payable 72,324
Cr Unrealized loss on swap (P&L) 72,324
Change in the value of debt attributable to change in interest rate
147
49
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Journal entry
31 Dec 20x2
Cr Cash 1,000,000
Dr Cash 120,000
Receipt of interest rate difference on swap: 8.8% vs 10% on $20m x ½ year
Dr Unrealized loss on swap (P&L) 114,943
Cr Interest rate swap asset 114,943
Write down swap value to zero at the end of contract
148

Journal entry
31 Dec 20x2
Dr Loan payable 114,943
Cr Unrealized gain on loan (P&L) 114,943
Dr Loan payable 20,000,000
Cr Cash 20,000,000
Repayment of loan
149


Accounts Hedging and Hedging and No

apply hedge not apply hedge hedging
P&L effects
Unrealized loss on loan (20x1) (187,267) - -
Fair value gain on swap (20x1) 187,267 187,267 -
Interest expense on bank loan (20x1) (2,000,000) (2,000,000) (2,000,000
)
Interest income on swap (20x1) 50,000 50,000 -
Cash flow effects
Interest expense on bank loan (20x1) (2,000,000) (2,000,000) (2,000,000
)
Interest income on swap (20x1) 50,000 50,000 -
150
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8/6/2023
Using Swaps to Reduce Cost of Borrowing
Borrower Can borrow at fixed rate Can borrow at floating rate

Company A ……… 5% LIBOR + 0.5%
Company B ……… 7% LIBOR + 1%
Difference: ………. 2% 0.5%
Pays LIBOR + 0.5%

Company A Company
borrows @ B borrows
Lender
fixed rate at LIBOR
of 5% Receives fixed rate at 6% @ 1%
Lender
151
Using Swaps to Reduce Cost of Borrowing
Company A Company B
Originally pays …………. Fixed 5% LIBOR + 1%
Under swap:
Pays …………………….. LIBOR + 5% Fixed 6%
Receives ……………….. Fixed 6% LIBOR + 0.5%
Net result ……………….. Pays LIBOR – 0.5% Pays fixed 6.5%
Gain …………………….. 1% 0.5%
152
Content

3. Hedging
153
51
8/6/2023
Hedge of a Net Investment

in a Foreign Entity
• Hedged risk is foreign exchange risk
– Applies to foreign operations whose functional currencies are the
currencies of the country where the foreign operations are located
– Closing rate method may result in significant translation loss from
depreciating currencies
• Accounting treatment similar to cash flow hedge

– Unlike a fair value hedge or a cash flow hedge, a non-derivative is
allowed to be the hedging instrument, for example, a foreign currency
loan.
154
Illustration 13:
Hedge of a Net Investment in a Foreign Entity
Scenario
– Functional currency is the dollar ($)
– Acquired 100% interest in foreign company (functional currency is FC)
31/12/20x3
– Exchange rate is $1.85 to FC1
– Loan of FC1,200,000 at 5% interest taken to hedge foreign investment
– Foreign currency translation reserves showed $15,000 (credit balance)
31/12/200x4
– Exchange rate is $1.70 to FC1
– Average rate is $1.78 to FC1
– Foreign company reported net profit of FC380,000
155
Illustration 13:
Translation difference in foreign investment’s FS for 31/12/20x4
On net assets on 1/1/20x4 (FC 1,200,000 x $(1.70-1.85) ……. $(180,000)
On net profit for 20x4 (FC380,000 x $(1.70-1.85) …………….. (30,400)
Translation loss for 20x4 $(210,400)
Foreign currency translation reserve on 31/12/20x4 (credit (195,400)
balance)
Journal entries for parent
31/12/20x3
Dr Cash …………………………….. 2,200,000
Cr Loan payable …………………... 2,200,000
The loan payable is designated as a hedge of the net investment:
FC1,200,000 x spot rate of $1.85
156
52
8/6/2023
Illustration 13:
31/12/20x4
Dr Interest expense ………………. 106,800
Cr Accrued interest ……………….. 106,800
Interest expense during the year at 5% x FC1,200,000 x $1.78
Dr Accrued interest ……………….. 106,800

Cr Cash …………………………….. 102,000
Cr Exchange gain …………………. 4,800
Settlement of accrued interest at year-end
Dr Loan payable …………………... 180,000

Cr Foreign currency translation 180,000 Taken to equity
reserves ………………………… to offset
translation loss
Exchange gain on FC loan taken directly to equity:
FC 1,200,000 x ($1.70 – $1.85) 157
IFRIC 16 Hedges of a Net Investment in a

Foreign Operation
• IFRIC 16 clarifies three main issues on hedges of net investment in
foreign operations:
• Issue 1: Where does risk arise from?

a) Risk arises from foreign currency exposure to functional currency
of foreign operation and parent entity; or
b) Risk arises from foreign currency exposure to functional currency
of foreign operation and presentation currency of parent entity’s
consolidated financial statements
IFRIC 16 concludes that the parent entity can apply hedge accounting
only in situation (a) and NOT (b).
158
IFRIC 16 Hedges of a Net Investment in a

Foreign Operation
• Issue 2: Which entity within a group can hold a hedging
instrument (in a hedge of a net investment in a foreign operation)?
Must the parent entity hold the hedging instrument?
IFRIC 16 concludes that the parent entity can apply hedge accounting
only in situation (a) and NOT (b).
• Issue 3: How an entity should determine the amounts to be

reclassified from equity to P&L for the hedging instrument and
hedged item when the entity disposes of the investment?
For the hedging instrument (in parent’s consolidated financial
statements): determined using IFRS 9/IAS 39
For the hedged item (in the FCTR of that foreign operation):
determined using IAS 21
159
53
8/6/2023
Content

3. Hedging
160
Option to Designate a Credit Exposure at

FVTPL
• A financial instrument with credit risk managed by a credit derivative
measured at FVTPL can be measured at FVTPL
– If name of the credit exposure and seniority of financial instrument matches that
of the reference entity (IFRS 9 para 6.7)
• The financial instrument could be outside the scope of IFRS 9 (e.g. firm
commitment)
• The designation of FVTPL may be done while the loan commitment is

unrecognized, at initial recognition or subsequent to initial recognition
– If occurs after initial recognition: difference between FV and carrying amount is
recognized in P/L
• Measurement of financial instrument at FVTPL is discontinued

– When the qualifying criteria are no longer met
– FV at the date of discontinuation becomes new carrying amount, which is
subsequently amortized
161
Own Use Contracts
• Under IFRS 9, contracts to buy or sell a non-financial item that can be

settled net in cash or using another financial instrument are included within
the IFRS scope
– Same treatment apply if such contracts can be settled through the exchange of
financial instruments as if the contracts were financial instruments
• Exception: When these contracts are entered into and 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.
– This is known as own-use scope exemption
– Will not account for these contracts as financial instruments under IFRS 9 but
instead account for this as normal purchase or sales contract
162
54
8/6/2023
Own Use Contracts

• However, entities may enter into contracts for both their own use
requirements as well as for risk management purposes
– Accounting mismatch ensues:
• Change in FV of contracts designated for risk management is recognized in
P&L
• Change in FV of contract for own use is not recognized
• To eliminate the accounting mismatch: The FV changes on contracts

designated as hedging instruments would offset the changes in FV on the
hedged items
– Entity could apply hedge accounting by designating the own-use contracts as a
hedged item in a fair value hedge relationship
– The own-use contracts would be measured at FV with changes taken to P&L
• Administratively burdensome and FV hedge relationships will have to be

monitored, managed and adjusted frequently
163
Discontinuation or Termination of Hedge

Accounting
• Hedge accounting should be discontinued when the hedging relationship
ceases to meet the qualifying criteria, or when the hedging instrument has
reached maturity date or is closed off or terminated
– IFRS 9 does not allow voluntary discontinuation of hedge accounting
– The discontinuation of hedge accounting is implemented prospectively
• The accounting treatment on the discontinuation of a hedge depends on the

type of hedge.
– E.g., for a hedge of a net investment in a foreign entity, the accumulated gains or
losses remain in the foreign exchange translation reserves until the foreign entity
is disposed of
164
Discontinuation or Termination of Hedge

Accounting
Scenarios in which Hedge Hedged item Hedging instrument
Accounting is discontinued
Hedge effectiveness • Adjustments made prior to hedge discontinuation will • If derivative,
qualifying criteria is no continue to be reflected in the carrying value continue to account
longer met (for instance: the • Carrying value of hedged item ceases to be adjusted for FV for at fair value
effect of credit risk starts to changes arising from the hedged risk from date where hedge through P&L
dominate economic relationship is discontinued
between the hedging instrument • Accounting reverts to the normal accounting principles as
and hedged item) set out in the IFRS Standards
• If hedged item is a financial instrument measured at
amortized cost, amortize adjustments to profit or loss using a
recalculated effective interest rate
The hedged item is sold, • Hedged item is derecognized with gains or losses • If derivative,
terminated or no longer recognized in P&L continue to account
expected to occur/take place • If firm commitment, previous fair value changes are de- for at fair value
recognized to P&L through P&L
The hedging instrument has • Adjustments made prior to hedge discontinuation will • Hedging instrument
reached its maturity date or is continue to be reflected in the carrying value is derecognized
sold, terminated or exercised • Carrying value of hedged item ceases to be adjusted for FV
changes arising from the hedged risk from date where hedge
is discontinued
• Accounting reverts to the normal accounting principles as
set out in the IFRS
• If hedged item is a financial instrument measured at
amortized cost, amortize adjustments to P&L using a
recalculated effective interest rate 165
55
8/6/2023
Hedges Where Hedge Accounting is Not

Required
• Main objective of hedge accounting:
– Ensure that the offsetting gains and losses of the hedged item and
hedging instrument are reported in the same accounting period to
reduce volatility of reported earnings
• If normal accounting treatment for hedged item and hedging

instrument results in offsetting gains and losses being reported in
same period
– No need to apply hedge accounting
• Example: Hedge of a financial instrument classified as FVTPL
166
Content

3. Hedging
167
Evaluation of Hedge Accounting
• Objective of hedge accounting

– Reflect effectiveness of hedging activities of a entity
– Reduce volatility of reported earnings
• Compliance with hedge accounting may result in considerable expenditure

of resources
• There are challenges in compliance with hedge accounting criteria for

macro hedges
• Issue is whether the additional costs of compliance more than offset the
benefit of applying hedge accounting
• In IFRS 9, the assessment of hedge effectiveness can be qualitative or

quantitative
– Critical terms of hedging instrument and hedged item are qualitatively assessed
to be closely aligned → economic relationship exist
168
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Copyright © 2019 by McGraw-Hill Education (Asia). All rights reserved. 1

1. Understand what constitutes a derivative

1. Derivative Financial Instruments

Derivative Financial Instruments

A derivative is a financial instrument that meets the following three criteria:

Its value changes in

Derivative Financial Instruments

Derivative Financial Instruments

Derivative Financial Instruments

• Derivatives may be based on interest rates, foreign exchange, equities,

• An agreement between two parties (counterparties) whereby one

• Can either be a forward purchase contract or a forward sales

“Forward sales contract” “Forward purchase contract”

• Fair value of forward contract:

At inception date, the fair value of a forward contract is nil.

• At the date of maturity of the forward contract → forward rate

• Premium (or discount) on the forward contract is the interest or time

• Changes in the time value component are due to a number of

• Changes in fair value of a forward contract after inception date

Current forward rate > Current forward rate <

Forward purchase • Fair value is positive • Fair value is negative

Forward sale • Fair value is negative • Fair value is positive

Illustration 1: Fair value of a forward contract

• On 1 March 20x5, Company A entered into a forward contract to buy

Date Spot Rate 30 May Forward Rate

• The fair value of forward contract is calculated using a 5% (per

Illustration 1: Fair value of a forward contract

Date Contracted Current Notional Discount Fair value Change

• At inception, the fair value of forward contract is nil

• A future contract is a contract between a buyer or seller and a clearing

• Wide range of exchange-traded future contracts

• A future contract is similar to a forward contract except that it:

• Long position: purchaser of a futures contract

• Since futures are traded on exchange, quoted price of futures contracts

• When the spot price (underlying) increases:

• When the spot price (underlying) decreases

• 2 type of option contracts

• Can be American option (exercisable anytime to expiration) or

• Can also be customized (not traded) or standard contract quoted on

Relationship between the strike price and the underlying

Holder of put option In-the-money At-the-money Out-of-the-money

• Fair value of option contract

Fair value of an option = Intrinsic value + Time value

Listed options = quoted price

• How options are reported in the statement of financial position

Option is: Presentation of an Presentation of an

• Derivative that is part of a hybrid financial instrument

• Example is bond whose ultimate proceed are linked to price of

Split Accounting of Embedded Derivatives

• IFRS 9 requires embedded derivatives of a host instrument that is

Conditions for separation of embedded derivative

Economic Hybrid instrument is not

1. Derivative Financial Instruments

Accounting for Derivatives

• Default accounting treatment for derivatives under IFRS 9:

• Fair valuation of derivatives factor in credit quality

Accounting for Forward Contract

At inception During life of contract Closing position or at