advanced financial accounting: chapter 9 accounting for derivatives and hedge accounting tan &...

Advanced Financial Accounting: Chapter 9

Accounting for Derivatives and Hedge Accounting

Tan & Lee Chapter 9 1© 2009

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 type of hedge relationships and their accounting treatment

©2009Tan & Lee Chapter 9 2

Content

1. Derivative Financial Instruments

2. Accounting for Derivatives

3. Hedging

4. Classification of Hedging Relationships

5. Hedge of a Net Investment in a Foreign Entity

6. Discontinuation or Termination of Hedge Accounting

7. Evaluation of Hedge Accounting

Tan & Lee Chapter 9 3©2009


Derivative Financial Instruments

Tan & Lee Chapter 9 ©2009 4

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

Its value changes in response to a change in

an “underlying”Settled at a future date

Requires little or no initial investment

Scope Exemption:

IAS 39:5 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


Types of derivative instruments

Underlying Used by

Option contracts(call and put)

Security price Producers, trading firms, financial institutions, and speculators

Forward contractse.g. foreign exchange forward contract

Foreign exchange rate

Various companies

Future contractse.g. commodity futures

Commodity prices Producers and consumers

Swaps Interest rate Financial institutions

Example of derivative instruments and their underlying



• Use of derivatives1. Manage market risk

2. Reduce borrowing cost

3. Profit from trading or speculation

• Types of derivatives1. 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


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

“A” Company “B” CompanySells Forward

Contract

“Forward sales contract” “Forward purchase contract”Tan & Lee Chapter 9 7©2009

Forward Contracts

• Not standardized contracts as they are not traded on an exchange– They entail counterparty risks– They are can be tailored to specific needs of counterparties– They involve lower transaction costs

• Fair value of forward contract:

Notional amount

x(׀ Current forward rate – contracted forward rate׀)

(1+r) t

where

Contracted forward rate is forward rate fixed at inception

Current forward rate is forward rate for remaining period to maturity

r = discount rate

t = period to maturity


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

Future Contracts

• A future contract is similar to a forward contract except that it is a standardized contract and is traded on an exchange

• Futures contracts are marked-to-market and settled on a daily basis

• Futures contracts require payment of a margin deposit which has to

be maintained throughout the contract period

• Wide range of exchange-traded future contracts– Commodity futures– Interest rate futures– Currency futures


Option Contracts

• Contract that gives holder the right but not the obligation to buy or sell a specified item at a specified price

• 2 type of option contracts1. 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)


Option Contracts

• Main features– Purchaser (holder) pays premium to seller (writer of option)– Holder has the right, but not obligation to perform; while write 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> Underlying(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

Option Contracts

• Fair value of option contract


Fair value of an option = Intrinsic value + Time value

Call option = Max [0, Notional amount x (Spot price – Strike Price)Put option = Max [0, Notional amount x (Strike price – Spot Price)

Diminishes over timeZero at expiration

Listed options = quoted priceNot traded options = Valuation model ( Black-Scholes model)

Embedded Derivatives

• Derivative that is part of a hybrid financial instrument


Host Instrument

Embedded derivative:Linked to underlying and change in

underlying causes change in cash flow

Hybrid Instrument

• Example is bond whose ultimate proceed are linked to price of commodity, such as oil, or to a consumer price index

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 characteristics and risk of host instrument are not closely related to that of the derivative

Hybrid instrument is not measured at fair value,

with changes in fair value recognized in

profit and loss

There is a separate instrument with same

terms as the embedded derivative

Content



3. Hedging







Accounting for Derivatives

Default accounting treatment for derivatives under IAS 39:• 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 the hedge is effective. In this case, accounting for the derivative follows hedge accounting rules


Accounting for Forward Contract


At inception During life of contract Closing position or at expiration

No journal entry as fair value is nil

Dr Forward Contract (asset)Cr Gain on forward contract

Dr Loss on forward contractCr Forward Contract (liability)

or

Adjust fair value and record gain/loss

Close out and record net settlement of contract

Dr Cash

Cr Forward contract

Dr Forward contract

Cr Cash

Accounting for Future Contract



Dr CashCr Gain on future contract

Dr Loss on futures contractCr Cash

or

Record daily settlement of future contracts

Close out and recover margin deposit

Dr CashDr Gain on future contractCr Margin Contract

Dr CashCr Loss on future contractCr Margin Contract

Dr Margin deposit

Cr Cash

Record payment of initial margin deposit

Accounting for Purchased Option Contract



Dr Option ContractCr Gain on future contract

Dr Loss on futures contractCr Option Contract

or

Adjust for fair value and record gain/loss


Dr Cash*Dr Gain on option contractCr Option Contract

Dr Cash*Cr Loss on option contractCr Option Contract

Dr Option contract (asset)Cr Cash


(* assume expires in-the-money)

Accounting for Written Option Contract



Dr Option ContractCr Gain on future contract

Dr Loss on futures contractCr Option Contract

or

Adjust for fair value and record gain/loss


Dr Option contractCr Gain on Option Contract

Dr Option contractDr Loss on optionCr Cash

Dr CashCr Option contract (liability)


(Expires out-of-the-money)

(Expires in-the-money)

Content



3. Hedging






3. Hedging

Hedging

• Propose is to neutralize an exposed risk– Loss on hedge item offset by gain on hedging instrument– Reduce volatility than preserve gains

• 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” applies when derivatives are used for hedging purposes


Rationale of Hedge Accounting

• Arises because of the mismatch of income-offsetting effect between hedged item and hedging instrument

• Situations requiring 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 value (changes taken to equity

while the other is taken to income statement)


Risks That Qualify for Hedge Accounting


Risks must be specific risk, not general business risks

Possible for a derivative to hedge more than one risk

Specific risks that qualify for

hedge accounting

Interest rate risk

Foreign exchange risk

Price risk

Credit risk

Qualifying Hedging Instruments (IAS 39: 72 – 73)

• Instruments that qualify include:– Designated derivatives (except written options)– Embedded Derivatives– Designated non-derivatives financial asset/ liability that hedge foreign

exchange risks only

• Value used to determine hedge effectiveness– If used in its entirety, fair value is used– If broken into time value and intrinsic value, permissible to use intrinsic

value. However, it must be explicitly documented at inception

• If derivative is used as a hedge of more than 1 risk– Individual designated component must meet hedge accounting criteria– Permissible for portion of notional amount to be designated


Qualifying Hedged Items (IAS 39: 78 -79)


Qualify Do not qualify

• Financial assets and liabilities with exposure to changes in fair value

• Non-financial assets exposed to foreign exchange or price risks

• Firm commitment

• Highly probable forecast transaction with exposures to future cash flows

• Net investment in foreign entity

• Held-to-maturity instruments (regardless of fixed rate or variable rate)

• Investment in an associated company

Criteria for Hedge Accounting(IAS 39: 88)


Enterprise must have exposure to risk that affects income statement

Derivative contract specifically entered to hedge underlying exposure

Conditions to be met for hedge accounting to apply

Hedge must be highly effective

Effectiveness of hedge can be reliably measured

Hedging relationship must be formally documented at the inception of the hedge

Assessing Hedge Effectiveness

• IAS 39:9 - The degree to which changes in the fair value or cash flows of the hedged item that is attributable to a hedged risk are offset by changes in the fair value or cash flow of the hedging instrument

• Hedge effectiveness is evaluated– Prospectively on inception of hedge; and– Retrospectively on an ongoing basis

• On inception, hedge effectiveness is assessed on– Comparison of the principal or critical terms– Historical analysis– Correlation analysis



• During the duration of hedge, hedge effectiveness is assessed on dollar-offset method:

• Hedge effectiveness ratio (HER):

• Exceptions for effective hedge even if HER falls out of range– IAS 39 allows hedge effectiveness to be assessed on cumulative basis

if hedge is designated and conditions are properly documented


Hedge effectiveness(or delta ratio) =

Changes in fair value or future cash flow of hedging instrumentChanges in fair value or future cash flow of hedged item

0.8 1.25

Effective hedge (IAS 39: AG 105b)


• Exclusion of time value of certain derivatives to be excluded from hedge relationship– Derivative separated into 2 component

1. Time value (options) or interest (forwards)

2. Intrinsic (options) or spot element (forwards)– Excluded time value taken to income statement as per default treatment– Should result in highly effective hedge, as intrinsic/ spot component

moves in tandem with underlying, while time/interest component does not

– If critical terms of hedging instruments and hedged item are exactly the same, HER should be equal or around 1


Content



3. Hedging







Classification of Hedging Relationships

Causes Explanation

Hedge of “the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment, or an identified portion of such asset, liability or firm commitment, which is attributable to a particular risk and could affect profit or loss” (IAS 39:86a)


Fair valuehedge

Hedge of “the exposure to variability in cash flows that (i) is attributable to a particular risk associated with a recognized asset or liability (such as all or some future interest payment on variable debt instrument )or a highly probable future transaction, and (ii) could affect profit or loss” (IAS 39:86b)

Cash flow hedge

Hedge of a net investment in a foreign entity

Hedge of the foreign currency risk associated with a foreign operation whose financial statements are required to be translated into the presentation currency of the parent company

Classification of Hedging Relationships

• The designation of a derivative as a fair value hedge or a cash flow hedge is determined by the hedged risk, that is, whether the entity has a fair value exposure or a cash flow exposure

• An exception where a derivative can be designated as either a fair value hedge or a cash flow hedge is where the hedged risk is the foreign exchange risk of a firm commitment


Accounting for a Fair Value Hedge


Hedged Item (recognized asset or liability or firm commitment)

Hedging Instruments

Income statementGain (loss) on hedging instrument offset loss (gain) on hedged item

Balance sheet

Change in fair value adjusted against carrying amount

Change in fair value adjusted against carrying amount

Change in fair value Change in fair value

Illustration 1: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



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)

Dr Loss on inventory ……………… 100,000

Cr Inventory ……………………….. 100,000

Gain on forward contract: 10,000 x ($342 - $352)

Taken to income statement


31/3/20x4

Inventory is sold to third-party at $330 per ounce (also maturity date of forward contract

37

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

Gain on forward contract: 10,000 x ($330 - $342)

Dr Cash …………………………….. 3,300,000

Cr Sales ……………………………. 3,300,000

Sale of inventory: 10,000 x $330Tan & Lee Chapter 9 ©2009

Accounting for a Cash Flow Hedge


Effective Cash Flow Hedge (IAS 39:95)

Effective portion of gain/ loss

Ineffective portion of gain/ loss

Recognized directly in equity through statement of changes in equity

Recognized in profit or loss

Accounting for a Cash Flow Hedge


Cash flow hedges are applicable to the following:

Forecasted transactions involving

financial and non-financial

assets/liabilities which will result in cash

inflow/ outflow

Other transactions which affect future cash flows

Interest rate swaps

Illustration 2:Effective and ineffective portions of a cash flow hedge

Scenario

1/1/20x1– Entered into futures contract to hedged forecast transaction at

30/4/20x1– Classified as cash flow hedge


Period ending ∆ in fair value of future contracts

∆ in present value of expected future cash flow

31/1/20x1 $100 $(105)

28/2/20x1 90 (80)

31/3/20x1 103 (105)

30/4/20x1 (38) 45

Period ending

Cumulative ∆ in FV of

future contracts

(a)

Cumulative ∆ in PV of expected cash flow

(b)

Lesser of two

cumulative amount in absolute

terms(c)

Effective portion

credited/ (debited)

to equity in current period

(

Ineffective portion

credited/ (debited) to income statement in current

period

31/1/20x1 $100 $(105) $100 $100 $0

28/2/20x1 190 (185) 185 85 5

31/3/20x1 293 (290) 290 105 (2)

30/4/20x1 255 (245) 245 (45) 7


Illustration 2:Effective and ineffective portions of a cash flow hedge

Determination of effective and ineffective portions of a cash flow hedge

Content



3. Hedging







Hedge of a Net Investmentin a Foreign Entity

• Hedge 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

– Hedge is effective if the delta ratio is between 0.8 and 1.25.– 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.


Hedge effectiveness=Cumulative change in fair value of hedging instrument (A)Cumulative translation difference on net investment (B)

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




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 reserves (credit balance) (195,400)

Translation difference in foreign investment’s FS for 31/12/20x4

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


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 reserves …………………………

180,000

Exchange gain on FC loan taken directly to equity:FC 1,200,000 x ($1.70 - $1.85)

Taken to equity to offset translation loss


Content



3. Hedging







Discontinuation or Termination of Hedge Accounting


Consideration for discontinuation or termination of hedge accounting

Hedging instrument has reached maturity date

or is closed off or terminated

Hedge designation is revoked

Criteria for hedge accounting is no longer met

Accounting treatment depends on type of hedge

Content



3. Hedging







Evaluation of Hedge Accounting

• Objective of hedge accounting– Reflect effectiveness of hedging activities of a firm– 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


advanced financial accounting: chapter 9 accounting for derivatives and hedge accounting tan &...

Documents

forward contracts

forward type derivatives

forward purchase contract

contracted forward rate

forward sales contract

inception current forward

x current forward rate

fixed price forward