Chapter 10

Accounting for
Derivatives and
Hedge Accounting

Copyright © 2016 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
3
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)

4
Derivative Financial Instruments
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

5
Derivative Financial Instruments

• 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
6
Derivative Financial Instruments
• 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)

7
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”

8
Forward Contracts
• Not standardized contracts as they are not traded on an exchange
– They entail counterparty risks
– 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 r = discount rate
fixed at inception
Current forward rate is forward rate for t = period to maturity
remaining period to maturity
At inception date, the fair value of a forward contract is nil.
9
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
10
Forward Contracts
Payoff Profiles

11
Forward Contracts

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

Current forward rate Current forward rate <

> contracted forward contracted forward rate
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
asset liability

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
liability asset

12
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
– 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 underlying increases:

– a long position results in a gain
– a short position results in a loss

• When the 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)

15
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 Out-of-the-money At-the-money In-the-money
option
Holder of put In-the-money At-the-money Out-of-the-money
option
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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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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
• IAS 39 requires embedded derivatives 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

20
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
21
Accounting for Derivatives

• Default accounting treatment for derivatives under IFRS 9:

– Derivatives are classified under the Fair Value through Profit or Loss
category and changes in their fair values are taken to income statement
– Exception: when a derivative is designated as a hedge of an identified
risk and is designated as an 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

22
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

At inception During life of contract Closing position or at

expiration
Dr Cash Dr Cash
Cr Gain on future Dr Loss on future
contract contract
Cr Margin Contract
Dr Margin deposit
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

At inception During life of contract Closing position or at

expiration
Dr Option Contract Dr Cash*
Cr Gain on option Cr Gain on option
contract contract
Cr Option Contract
Dr 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 25
 Accounting for Written Option Contract

At inception During life of contract Closing position or at

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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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
27
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 purposes
Assets, liabilities, entity commitments and highly probable forecasted
transactions with external parties can be designated as hedged items

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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 (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

32
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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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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Qualifying Criteria for Hedge Accounting
(IFRS 9 Para B6.4.1)

01 Hedging relationship consists only of eligible hedging instruments and

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

35
Criteria for Hedge Accounting
(IFRS 9 Para B6.4.1)

• 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

• 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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Criteria for Hedge Accounting
(IFRS 9 Para B6.4.1)
• 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)

37
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
38
 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

39
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

40
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

• When the hedged item in a fair value hedge is a firm commitment,

the cumulative change in FV of the firm commitment attributable to
the hedged risk is recognized as an asset or a liability with the
corresponding gain or loss recognized in the P/L.
41
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

42
Illustration:
Hedge of Inventory (Fair Value Hedge)
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
– 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

43
Illustration:
Hedge of Inventory (Fair Value Hedge)
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)

44
Illustration:
Hedge of Inventory (Fair Value Hedge)
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
45
Illustration:
Hedge of Inventory (Fair Value Hedge)
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)]

For illustration on (i) Hedge of an exposed monetary asset ii) Hedge of financial assets classified
as FVOCI III) Hedge of a firm commitment, please refer to Tan, Lim & Kuah illustrations 10.6–10.9

46
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.

47
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 = cumulative change in
Effective portion
portion FV of hedging instrument
(B)
(A) – (B)

Income statement Equity Equity

48
Accounting for a Cash Flow Hedge

Cash flow hedges are applicable to the following:

An Interest rate swap

Hedge of a forecasted Hedge of an anticipated to hedge a floating rate
transaction issue of a bond financial asset or
financial liability

49
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 entity commitment

Forecasted transaction Entity commitment

 No commitment to a specific price,  Carries a fair value exposure
hence it does not entail any rights or because of commitment to a
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

50
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

51
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
52
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

53
Interest Rate Swaps
• Interest rate swaps 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 = • Adjustment of FV of swap interest
0 • Adjustment of FV of
swap

54
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
55
Using Swaps for Hedging
• Scenario 2
– Company A has fixed rate investment (classified as available-for-sale)
– Fair value hedge
– 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

56
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)
57
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

• At inception: 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

58
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

59
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 B
borrows @ borrows at
Lender
fixed rate LIBOR @
of 5% Receives fixed rate at 6% 1%

Lender

60
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%

61
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
62
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.

63
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).

64
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

65
Illustration 3:
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

66
Illustration 3:
Hedge of a Net Investment in a Foreign Entity
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

67
Illustration 3:
Hedge of a Net Investment in a Foreign Entity
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)
68
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
69
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.

70
Accounting for Time Value of Options
IFRS 9 Para 6.5.15

• The hedged item is transaction-related

– When the time value of the option is used to hedge an item that
represent part of a cost of the transaction;
– E.g. an option hedging a forecast commodity purchase which is
recognized and its initial inventory costs include transaction costs
– If hedged item subsequently results in recognition of non-financial asset
or liability or a firm commitment, the FV accumulated in OCI is adjusted
against the carrying amount of the asset or liability

71
Accounting for Time Value of Options
IFRS 9 Para 6.5.15

• The hedged item is time period-related

– When the time value is the cost for obtaining protection against a risk
over a specific time period, but does not involve transaction costs
– E.g. an interest rate cap (option) to protect against increases in interest
expenses of a floating rate bond. The time value of the cap is amortized
over the period when the cap hedges increases in interest rates
(expenses) of the bond
– the time value is accumulated in OCI and amortized over the period
during which the hedge adjustment for the intrinsic value affects profit or
loss (or OCI).
– If the hedge accounting is discontinued, the net amount in OCI is
reclassified to P/L.

72
Accounting for Time Value of Options
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.

73
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
74
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
75
Discontinuation or Termination of Hedge
Accounting
• Hedge accounting should be discontinued when the hedging
relationship ceases to meet the qualifying criteria, which is when the
hedging instrument has reached maturity date or is closed off or
terminated
– 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.

76
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

77
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
78
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

79