advanced financial accounting: chapter 9 accounting for derivatives and hedge accounting tan &...
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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
1. Derivative Financial Instruments
Derivative Financial Instruments
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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
Derivative Financial Instruments
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
Tan & Lee Chapter 9 5©2009
Derivative Financial Instruments
• 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
Tan & Lee Chapter 9 6©2009
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
Tan & Lee Chapter 9 8©2009
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
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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
• 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)
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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 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
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Relationship between the strike price and the underlying
Strike price> Underlying(spot price)
Strike price> Underlying(spot price)
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
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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
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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:
Tan & Lee Chapter 9 ©2009 14
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
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 15©2009
2. Accounting for Derivatives
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
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Accounting for Forward Contract
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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
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At inception During life of contract Closing position or at expiration
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
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At inception During life of contract Closing position or at expiration
Dr Option ContractCr Gain on future contract
Dr Loss on futures contractCr Option Contract
or
Adjust for fair value and record gain/loss
Close out and record net settlement of contract
Dr Cash*Dr Gain on option contractCr Option Contract
Dr Cash*Cr Loss on option contractCr Option Contract
Dr Option contract (asset)Cr Cash
Record payment of initial margin deposit
(* assume expires in-the-money)
Accounting for Written Option Contract
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At inception During life of contract Closing position or at expiration
Dr Option ContractCr Gain on future contract
Dr Loss on futures contractCr Option Contract
or
Adjust for fair value and record gain/loss
Close out and record net settlement of contract
Dr Option contractCr Gain on Option Contract
Dr Option contractDr Loss on optionCr Cash
Dr CashCr Option contract (liability)
Record payment of initial margin deposit
(Expires out-of-the-money)
(Expires in-the-money)
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 21©2009
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
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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)
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Risks That Qualify for Hedge Accounting
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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
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Qualifying Hedged Items (IAS 39: 78 -79)
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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)
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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
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Assessing Hedge Effectiveness
• 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
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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)
Assessing Hedge Effectiveness
• 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
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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 31©2009
4. Classification of Hedging Relationships
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)
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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
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Accounting for a Fair Value Hedge
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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
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Illustration 1: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
Tan & Lee Chapter 9 ©2009 36
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
Illustration 1: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
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
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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
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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
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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 $0
28/2/20x1 190 (185) 185 85 5
31/3/20x1 293 (290) 290 105 (2)
30/4/20x1 255 (245) 245 (45) 7
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Illustration 2:Effective and ineffective portions of a cash flow hedge
Determination of effective and ineffective portions of a cash flow hedge
Content
1. Derivative Financial Instruments
2. Accounting for Derivatives
3. Hedging
4. Classification of Hedging Relationships
5. Hedge of a Net Investment in a Foreign Entity
6. Discontinuation or Termination of Hedge Accounting
7. Evaluation of Hedge Accounting
Tan & Lee Chapter 9 42©2009
5. Hedge of a Net Investment in a Foreign Entity
Hedge of a Net Investmentin a Foreign Entity
• Hedge risk is foreign exchange risk– Applies to foreign operations whose functional currencies are the
currencies of the country where the foreign operations are located– Closing rate method may result in significant translation loss from
depreciating currencies
• Accounting treatment similar to cash flow hedge
– Hedge is effective if the delta ratio is between 0.8 and 1.25.– Unlike a fair value hedge or a cash flow hedge, a non-derivative is
allowed to be the hedging instrument, for example, a foreign currency loan.
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Hedge effectiveness=Cumulative change in fair value of hedging instrument (A)Cumulative translation difference on net investment (B)
Illustration 3:Hedge of a Net Investment in a Foreign Entity
Scenario– Functional currency is the dollar ($)– 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
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Illustration 3:Hedge of a Net Investment in a Foreign Entity
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
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 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
Tan & Lee Chapter 9 46©2009
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 47©2009
6. Discontinuation or Termination of Hedge Accounting
Discontinuation or Termination of Hedge Accounting
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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
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 49©2009
7. Evaluation of Hedge Accounting
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
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