pert 1 & 2 - derivative-complete-new

Qualifying Hedged Items (IAS 39: 78 -79)Tan & Lee Chapter 92009*QualifyDo not qualifyFinancial 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 entityHeld-to-maturity instruments (regardless of fixed rate or variable rate)

Investment in an associated company

Edited by Taufik Hidayat

Criteria for Hedge Accounting(IAS 39: 88)Tan & Lee Chapter 92009*Hedge must be highly effectiveEffectiveness of hedge can be reliably measuredHedging relationship must be formally documented at the inception of the hedge


Assessing Hedge EffectivenessIAS 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 evaluatedProspectively on inception of hedge; andRetrospectively on an ongoing basis

On inception, hedge effectiveness is assessed onComparison of the principal or critical termsHistorical analysisCorrelation analysis

Tan & Lee Chapter 92009*



Assessing Hedge EffectivenessDuring the duration of hedge, hedge effectiveness is assessed on dollar-offset method:

Hedge effectiveness ratio (HER):


Assessing Hedge EffectivenessExclusion of time value of certain derivatives to be excluded from hedge relationshipDerivative separated into 2 componentTime value (options) or interest (forwards)Intrinsic (options) or spot element (forwards)Excluded time value taken to income statement as per default treatmentShould result in highly effective hedge, as intrinsic/ spot component moves in tandem with underlying, while time/interest component does notIf critical terms of hedging instruments and hedged item are exactly the same, HER should be equal or around 1Tan & Lee Chapter 92009*



Classification of HedgingHedge 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.Fair valuehedgeHedge 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.Cash flow hedgeHedge of a net investment in a foreign entityHedge 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 (2)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.


Discontinuation or Termination of Hedge AccountingTan & Lee Chapter 92009*Consideration for discontinuation or termination of hedge accountingHedging instrument has reached maturity date or is closed off or terminatedHedge designation is revokedCriteria for hedge accounting is no longer metAccounting treatment depends on type of hedge



Accounting for a Fair Value Hedge



Fair Value Hedge Forward ContractExampleIlustration:31/10/20X3Inventory of 10,000 ounces of goldCarried at cost of $3,000,000 ($300 per ounce)Price of gold was $352 per ounce1/11/20X3Sold forward contract on 10,000 ounce for forward price of $350 ounce Forward contract matures on 31/3/20X4

DateSpot RateMarch 31 Forward RateNov 1, 20X3$352$350Dec 31, 20X3 342 340March 31, 20X4 330 330



Fair Value Hedge Forward Contract (2)1/10/20X1No entry or just a memorandum entry as the fair value of the forward contract is nil31/12/20X3Taken to income statementExample

DrForward contract .100,000CrGain on forward contract ...100,000Gain on forward contract: 10,000 x ($340 -$350)

DrLoss on inventory 100,000CrInventory ..100,000Gain on forward contract: 10,000 x ($342 - $352)



Fair Value Hedge Forward Contract (3)31/3/20X4Inventory is sold to third-party at $330 per ounce (also maturity date of forward contractExample

DrForward contract .100,000CrGain on forward contract ...100,000Gain on forward contract: 10,000 x ($330 -$340)

DrLoss on inventory 120,000CrInventory ..120,000Loss on forward contract: 10,000 x ($330 - $342)

DrCash ..3,300,000CrSales .3,300,000Sale of inventory: 10,000 x $330



Fair Value Hedge Forward Contract (4)31/3/20X4Example

DrCost of Good Sold 2,780,000CrInventory .........................2,780,000Cost of Good Sold: $3,000,000 - $100,000 - $120,000

DrCash ..................200,000CrForward Contract .....200,000Close forward contract and record net receipt on settlement: 10,000 x ($350 - $330)



Fair Value Hedge Forward Contract (5)31/3/20X4If inventory is NOT sold to third-party but SETTLED at maturity dateExample

DrCash ..................3,500,000CrCrForward Contract .....Inventory .......................200,0003,300,000Close forward contract and record net receipt on settlement: 10,000 x ($350 - $330)

DrInventory .520,000CrGain on inventory ...520,000Gain on inventory from inception: 10,000 x ($352 -$300)



Fair Value Hedge Option ContractExampleOn March 1, 20X5, Company A purchased 100,000 of Company D shares at $34/share. To protect itself against a loss in value of the investment, Company A purchased 100,000 unit of put option of Company D with strike price of $35 and premium $2.5 on the same date. Company A settle the option on Aprill 30, 20X5 (maturity date). Following prices are given:

DateStock PriceOption PriceMarch 1$34$2.50March 31 32 3.80April 30 31 4.00



Fair Value Hedge Option Contract (2)

DateOption PriceIntrinsic ValueTime ValueMarch 1$2.50$1$1.50March 31 3.80 3 0.80April 30 4.00 4 0.00

DateStock PriceOption PriceMarch 1$34$2.50March 31 32 3.80April 30 31 4.00



Fair Value Hedge Option Contract (3)P/L

DateAccountAmountMarch 1Dr AFSCr CashTo record payment of premium3,400,0003,400,000$34 x 100,000

March 1Dr Put OptionCr CashTo record payment of premium250,000250,000$2.5 x 100,000March 31Dr Put OptionCr Gain on Option ContractTo record change in intrinsic value200,000200,000(3 1) x 100,000March 31Dr Loss on Option ContractCr Put OptionTo record change in time value 70,000 70,000(0.8 1.5) x 100,000March 31Dr Loss on InvestmentCr AFSTo record change in fair value of AFS200,000200,000(32 34) x 100,000



Fair Value Hedge Option Contract (3)

DateAccountAmountApril 30Dr Loss on InvestmentCr AFSTo record change in fair value of AFS100,000100,000(31 32) x 100,000April 30Dr Loss on Option ContractCr Put OptionTo record change in time value 80,000 80,000(0 0.8) x 100,000April 30Dr Put OptionCr Gain on Option ContractTo record change in intrinsic value100,000100,000(4 3) x 100,000April 30Dr CashCr Put OptionCr AFSTo record the exercise and close option contract3,500,000 400,000 3,100,000



Accounting for a Cash Flow HedgeChange in FV of the hedging instrument is adjusted to its carrying value in the balance sheetThe change in FV of the hedging instrument is separated into effective portion and ineffective portion (if any)The effective portion is deferred to equity and the ineffective portion (if any) is recognized as an expense in the I/SThe effective portion that is deferred to equity is the lesser of the : 1) cumulative gain (loss) on the hedging instrument from the inception; and 2) the cumulative changing in the PV of the expected FCF on the hedged item from the inception of the hedgeIf the hedged item is financial asset or a financial liability, the deferred gain or loss in equity is taken to PL in the same period or periods during which the assets acquired or the liability assumed affects PL (i.e. in the period that interest income (expense) recognized)If the hedged item is forecasted transaction that will result in the recognition of a non financial liability: 1) recognized deferred gain or loss in PL proportionately when the assets is amortized (depreciated); or 2) transfer the deferred gains or losses to adjust initial cost or other carrying amount of the asset or liability



Accounting for a Cash Flow Hedge



Accounting for a Cash Flow Hedge (2)


Illustration 2:Effective and ineffective portions of a cash flow hedgeScenario1/1/20x1Entered into futures contract to hedged forecast transaction at 30/4/20x1Classified as cash flow hedge

Tan & Lee Chapter 92009*

Period ending in fair value of future contracts in present value of expected future cash flow31/1/20x1$100$(105)28/2/20x190(80)31/3/20x1103(105)30/4/20x1(38)45



Assessing Effective Portion of Cash Flow HedgeExample* (c) - previous balance of (c)**(a) - (c) - previous balance

Period endingCumulative 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**31/1/201$100$(105)$100$100$028/2/20x1190(185)18585531/3/20x1293(290)290105(2)30/4/20x1255(245)245(45)7



Cash Flow Hedge Futures ContractExampleIlustration:1/10/20X1Inventory of 5,000,000 ounces of silver.Carried at cost of $15,000,000 ($3 per ounce).Price of silver was $3.3 per ounceSold futures contract on 5,000,000 ounce for $3.32 /ounce. Futures contract matures on 31/3/20X2.Required margin deposit was $0.03 per ounce.

DateSpot Price/ounceMarch 31 Futures PriceOct 1, 20X1$3.30$3.32Dec 31, 20X1 3.265 3.29Feb 28, 20X2 3.19 3.20March 31, 20X2 3.10 3.10



Cash Flow Hedge Futures Contract (2)Calculation of expected cash flows & fair value of futures contractExample



Cash Flow Hedge Futures Contract (3)Period-to-period & cumulative hedge effectiveness assessmentExample



Cash Flow Hedge Futures Contract (4)Determination of effective and ineffective portions of a cash flow hedge* (c) - previous balance of (c)**(a) - (c) - previous balance

Example

Period endingCumulative 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**31/12/X1150,000(175,000)150,000150,000028/2/X2600,000(550,000)550,000400,00050,00031/3/X21,100,000(1,000,000)1,000,000450,00050,000



Cash Flow Hedge Futures Contract (5)1/10/20X131/12/20X128/2/20X2Example

DrFutures contract ..150,000CrOCI Hedge reserve .......150,000Record fair value adjustment of futures contract

DrMargin deposit .150,000CrCash .................................150,000Margin deposit: $0.03 x 5,000,000 ounce

DrFutures contract ..450,000CrOCI Hedge reserve .......400,000CrGain on futures contract ...50,000Record fair value adjustment of futures contract



Cash Flow Hedge Futures Contract (6)31/3/20X2Example

DrCash ..15,500,000CrSales .15,500,000Sale of inventory: 5,000,000 x $3.1

DrFutures contract ..500,000CrOCI Hedge reserve .......450,000CrGain on futures contract ...50,000Record fair value adjustment of futures contract

DrCost of Good Sold 15,000,000CrInventory .........................15,000,000Cost of Good Sold at carried cost

DrOCI Hedge reserve .......1,000,000CrCost of Good Sold/Sales ..1,000,000To recycle hedging reserve against Profit & Loss



Cash Flow Hedge Futures Contract (7)31/3/20X2Example

DrCash ..................1,250,000CrMargin deposit ................150,000CrFutures Contract ......1,100,000Close the futures contract and record receipt of margin



SwapIn a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals.2 type of basic swap:Single Currency Interest rate swapPlain vanilla fixed-for-floating swaps in one currency.Cross Currency Interest Rate Swap (Currency swap)Fixed for fixed rate debt service in two (or more) currencies.



Swap (2)Interest Rate Swap:Used by companies and banks that require either fixed or floating-rate debt.Interest rate swaps allow the companies (or banks) and the swap bank to benefit by swapping fixed-for-floating interest payments.Since principal is in the same currency and the same amount, only interest payments are exchanged (net).Hedge using interest rate swap:Cash flow hedge changes in FV of swap are recognized in equity.Fair value hedge changes in FV of swap are recognized in P/L.



Swap (3)SwapBankCompany A prefers floatingCompany B prefers fixedPay fixedPay floatingReceiveFloatingReceive fixedIssue floatingIssue fixedInterest Rate Swap:



Cash Flow Hedge - SwapCash flow hedge : Swap from floating to fixed rate.To protect future cash flow (interest) payments.Accounting treatment:Changes in fair value of swap are taken to equity.Interest payments are taken to P/L.Determining hedge effectiveness can be highly complex based on PSAK 55. FASB allows a short cut method, whereby no hedge ineffectiveness if:Matching of notional amount with principal amount;Zero fair value of swap at inception;No prepayment of interest;Matching index interest of swap with floating rate of loan.



Cash Flow Hedge Swap : IlustrationExampleCompany A had $10 million loan with interest at LIBOR + 50 basis points. To protect itself against an increase in interest rate, Company A entered into swap contract with Company B on June 30, 20X5. Under this contract, Company A paid interest at fixed rate of 7.75% on notional amount $10 million to Company B over 1 year for the receipt of floating rate of LIBOR + 50 basis point. Interest settlement were made at the end of each quarter. The rates are as follows:

DateLIBORLIBOR + 50 bpJune, 30 7.25% 7.75%Sept, 30 6.25% 6.75%Dec, 31 7.45% 7.95%March, 31 7.50% 8.00%



Cash Flow Hedge Swap : Ilustration (2)Company A prefers fixedCompany B prefers floatingPay 7.75%Pay LIBOR + 50 bpReceiveLIBOR + 50 bpReceive7.75%Issue fixedIssue LIBOR + 50 bpAssumption:Fair value of swap at inception is zero.Current floating rate continues to prevail till the end of the swap tenure.FV swaps are discounted with LIBOR + 50 bp.Example



Cash Flow Hedge Swap : Ilustration (3)(previous LIBOR + 50 bp) x notional amount.7.75% x notional amount.(a) (b)PV of [ next period of (c) x number of next payments]Previous (e) + (d)

Example

DateCurrent LIBOR + 50 bpReceipt of previous LIBOR + 50 bp(a)Payment of 7.75%

(b)Current net receipt (paid)(c)FV of Swap asset (liability)(d)Change in FV

(e)June, 30 7.75%0Sept, 30 6.75% 193,750193,7500(72,538)(72,538)Dec, 31 7.95% 168,750193,750(25,000)9,71082,248March, 318.00%198,750193,7505,0006,127(3,583)June, 30200,000193,7506,2500(6,127)



Cash Flow Hedge Swap : Ilustration (4)Example

DateAccountAmountSept 30Dr Interest ExpenseCr CashTo record payment of interest at floating rate193,750193,750

Sept 30Dr FV adjustment (equity)Cr Interest rate swap asset/liabilityTo record fv adjustment 72,538 72,538

Dec 31Dr Interest ExpenseCr CashTo record payment of interest at floating rate168,750168,750Dec 31Dr Interest ExpenseCr CashTo record settlement of swap differential 25,000 25,000Dec 31Dr Interest rate swap asset/liabilityCr FV adjustment (equity)To record fv adjustment 82,248 82,248



Cash Flow Hedge Swap : Ilustration (5)

DateAccountAmountMarch 31Dr Interest ExpenseCr CashTo record payment of interest at floating rate198,750198,750March 31Dr CashCr Interest ExpenseTo record settlement of swap differential 5,000 5,000March 31Dr FV adjustment (equity)Cr Interest rate swap asset/liabilityTo record fv adjustment 3,583 3,583June 30Dr Interest ExpenseCr CashTo record payment of interest at floating rate200,000200,000June 30Dr CashCr Interest ExpenseTo record settlement of swap differential 6,250 6,250June 30Dr FV adjustment (equity)Cr Interest rate swap asset/liabilityTo record fv adjustment 6,127 6,127



Fair Value Hedge - SwapFair value hedge : Swap from fixed to floating rate:To protect from increase of value of debt.If market rate decreases, the value of fixed rate debt increases.Changes in fair value of swap are taken to P/L.Even though the debt is carried at amortised cost under PSAK 55, the carrying amount should be adjusted by its fair value P/L.Changes in fair value of debt represent discount/premium but not amortised as long as the hedge is in place.



Cash Flow Hedge Swap : ExerciseCompany A had $50 million bank loan with interest at LIBOR + 150 basis points to be repaid at the end of 20X5. Interest was payable half-yearly on June 30 and December 31.To protect itself against an increase in interest rate, Company A entered into swap contract with Company B on January 1, 20X3. Under this contract, Company A paid interest at fixed rate of 5.5% on notional amount $50 million to Company B over 3 year for the receipt of floating rate of LIBOR + 150 basis point. Interest settlement were made at the end of each interest payment. The rates are as follows:

Date1/1X330/6X331/12X330/6/X431/12/X430/6/X5LIBOR 4.0% 4.5%5.0%4.7%4.5%4.3%LIBOR+150 bp5.5%6.0%6.5%6.2%6.0%5.8%



Cash Flow Hedge Swap : Exercise (2)The calculation of the fair value of the swap:



Cash Flow Hedge Swap : Exercise (3)









Sources:Tan & Lee Advanced Financial Accounting.Lam & Lau Intermediate Financial Reporting, 2nd Ed.Baker, Christensen, Cottrell Advanced Financial Accounting, 10th Ed.Mackenzie, et al Interpretation & Application of IFRS 2011.@Taufik_FEUI


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