Following on from the three previous modules, which discuss the nature, use and management of derivatives, this module provides the accounting rules for derivatives and hedge relationships as well as the interaction with the accounting for foreign currency transactions.
Key areas covered include accounting for embedded derivatives and hedge accounting under IFRS 9.
IFRS 9 Financial Instruments
updated standard (replaces IAS 39)
mandatory for reporting periods starting on or after 1 Jan 2018
can choose to early adopt
new hedge effectiveness requirements + other changes
continued interaction with IFRS 7, 13, IAS 21, 32
why was it introduced
simplified, but still complex for accountants
objective-based approach (but still very much rules-based)
aligned with entity's risk management approach
Part A: Accounting concepts
A.1 Accounting for derivatives
Derivatives - IFRS 9
a financial instrument... with all three of the following characteristics:
its value changes in response to the value of an underlying variable
it requires no initial net investment or ...[relatively minimal] initial investment
it is settled at a future date
Financial instrument
value changes with changes in the 'underlying':
interest rates
financial instrument price
commodity price
foreign exchange rate
index of prices or rates
credit rating or index
or another variable [non-financial variables must not be specific to a party to the contract]
excluded under IFRS 9:
items that meet the definition under IFRS 9 but are specifically excluded
typically where the item is dealt with by another standard
examples:
contracts to buy/sell non-financial items (e.g. gold) as part of normal business AND the items are physically delivered
employee benefits (IAS 19)
company issues options over its own shares (IAS 32)
IFRS 9 - Derivatives accounting treatment
Fair value
generally: price between market participants in an arm's length transaction (market value)
IFRS 13: price received to sell an asset or paid to transfer a liability, in an orderly transaction at measurement date
FV of derivative includes credit risk (CVA)
recorded at fair value at inception
subsequent changes in fair value to be recorded in financial statements
A.2 Embedded derivatives
Identification of Embedded derivatives
Example
hybrid instrument: purchase of a machine Pay (USD 1,000)
host contract: purchase of a machine Pay (AUD 1,250)
embedded derivative: FEC (foreign exchange contract): sell USD/buy AUD Receive (AUD 1,250) Pay (USD 1,000) - accounted for separately if not closely related
Separation of Embedded derivatives
Which of the following embedded derivatives would likely be considered closely related and therefore would not need to be separated under IFRS 9?
a borrowing contract with an interest rate cap where the benchmark rate at inception is higher than the cap
a sales contract for machinery between an Australian supplier and a Chinese customer that is denominated in USD
a purchase contract for clothing between an Australian importer and a NZ supplier denominated in USD
Exemptions from separating embedded derivatives
Exemptions from separating - closely related
(a) interest rate cap on debt
- cap rate >= benchmark interest rate at inception, and not leveraged
(b) interest rate collars on debt
- cap and floor is either side of market interest rate at inception, and not leveraged
(c) foreign currency derivative for a non-financial instrument
- not leveraged, does not contain an option feature, and with payment in:
functional currency of a substantial party to the contract; or
currency which the goods are routinely denominated; or
currency commonly used in the particular economic environment
(d) inflation linked derivative in lease contracts
- inflation index relates to entity's economic environment, and not leveraged
A.3 Accounting for embedded derivatives
Accounted for as per derivatives
recorded at fair value at inception
changes in fair value to P&L
can be designated in a hedge relationship if it qualifies
if the embedded derivative cannot be measured, it needs to fair value the hybrid instrument (and the hybrid cannot be measured as a hedging instrument)
Valuation of embedded derivatives
Non-option derivative: fair value equals zero at inception (e.g. forward contracts or swaps)
Option derivative: value based on terms of the option (e.g. puts, calls, caps, floors or swaption)
Aces Pty Ltd is an Australian resident company that entered into a contract with Clubs Ltd in New Zealand to purchase new manufacturing equipment on 15 March 20X6 for USD 100,000. Legal ownership of the equipment passed to Aces on this date.
Payment of the full amount is due on 31 May 20X6. On 15 March 20X6, the spot rate was AUD/USD 0.7500 and the forward rate for 31 May 20X6 was AUD/USD 0.7400. On 31 March 20X6, the 2-month forward rate was AUD/USD 0.7450 and the 2-month discount rate was 0.50137%.
1. Why does an embedded derivative exist in the contract?
contract could have been in AUD, but requires payment in USD > embedded FX derivative
hybrid instrument = (host contract + embedded derivative) = payment of USD 100,000
host contract is the AUD payment amount using the forward rate of AUD/USD 0.7400 = AUD 135,135
embedded derivative is a FEC to sell USD 100,000 and receive AUD 135,135 on 31 of March 20X6
2. Why would the embedded derivative need to be separated for accounting purposes?
host contract is not a financial instrument and so it's unlikely to be fair value
the embedded derivative is an FEC which satisfies the definition of a derivative
BUT, the embedded derivative is not closely related and so needs to be separated
pass
contract is not leveraged and does not contain an option
fail
USD is not the functional currency of either party
equipment not normally sold in USD around the world
USD not commonly used to purchase goods in the economic environment
3. Assuming the embedded derivative is separated, prepare the accounting entries that would be required on the following dates:
15 March 20X6
31 March 20X6
foreign exchange contract to sell USD 100,000 and receive AUD on 31/05/20X6 at the forward rate of AUD/USD 0.7400
AUD notional at inception (0.7400) AUD 100,000/0.7400 = $135,135.14
15/03/20X6
DR Equipment $135,135.14
CR Accounts payable/Purchases $135,135.14
Record purchase at inception forward rate AUD/USD 0.7400
AUD notional at 31 March (0.7450) AUD 100,000/0.7450 = $134,228.19
AUD notional gain on USD exposure AUD $135,135.14 - $134,228.19 = $906.95
Discount notional gain to PV at 31 March 906.95/(1+ 0.50137%) = $902.42
31/03/20X6
DR Embedded derivative (asset) $902.42
CR Gain on embedded derivative (P&L) $902.42
Record gain on the embedded derivative
Part B: Hedge concepts
B.1 IFRS 9 requirements
hedge instrument (e.g. derivative) is used to hedge (i.e. cover adverse movements) the value of the hedged item (e.g. loan)
derivatives must be recorded at fair value on the balance sheet
any changes in the value of a derivative is required to be taken to P&L, unless it qualifies for hedge accounting
hedge accounting requirements
- must only include eligible hedging instruments and eligible hedged items
- must have formal designation and documentation (prospectively)
hedging instrument
hedged item
nature of risk being hedge
how effectiveness will be assessed
- must meet the hedge effectiveness requirements
economic relationship between hedged item and hedging instrument
credit risk must not dominate changes in value
hedge ratio of hedging relationship matches the actual hedge in place
Quiz. hedge instruments
A bought option is a derivative that is an eligible hedge instrument for the purposes of a hedging relationship. Remembering that options have both time value and intrinsic value... can the time value of an option used as a hedge instrument be excluded from the hedge relationship?
yes
no
only if the option is out of the money
hedge instruments must be used in their entirety... they cannot be dissected or divided into component parts, with some in and some out of the hedge relationship.
but there are 3 exceptions, with one being that an entity can separate the 'intrinsic value' and 'time value' from an option contract - and then only designate the intrinsic value component in the hedge relationship.
B.2 eligible hedge instruments
a derivative - excluding sold (written) options
financial asset/liabilities at fair value through P&L - provided credit changes on liabilities not recorded in OCI
FX risk component of financial assets/liabilities - excluding equity instruments at fair value through OCI
Conditions
- must be with an external party
- must be used in its entirety
cannot be split into component parts, except for:
time value of options (intrinsic vale in hedge relationship)
forward element of forward contract (spot element in hedge relationship)
splitting on a proportionate basis (for value of a hedge, but not time basis of a hedge)
- combinations of instruments are permitted
none are sold options OR
combined instrument is not a net sold option (ie. collar arrangement)
e.g. hedging the price of gold in USD, then hedging the USD price to AUD
ABC Ltd is an Australian company and wishes to hedge its exposure relating to a wholly owned subsidiary company in Vietnam that has a different functional currency. What type of risk is it hedging?
transaction risk
translation risk - arises when B/S items need to be converted back to the home functional currency
competitive risk
B.3 eligible hedged items
aggregated exposure - hedged item in hedge relationship with derivative (e.g. variable rate debt with payer swap)
recognised asset or liability - financial or non-financial (normally part of a fair value hedge relationship)
unrecognised firm commitment - binding agreement for exchange on future date (e.g. sales or purchase order)
highly probable forecast transaction - matter of judgment, based on likelihood, observable fats (e.g. track record and capacity/capability)
net investment in a foreign operation - where functional currency differs, translation risk arises (which can be the hedged item)
items external to the group - plus: inter-company monetary items (FX gain/loss) and forecast inter-company transactions (FX risk)
Designation
- hedge item in hedging relationship must be clearly defined
- hedging permitted in its entirety or for specific components:
specific risk(s), if separately identifiable and reliably measurable
one or more contractual cash flows
components of a nominal amount
- group of hedged items
all items int eh group must qualify as hedge items
must be managed as a group (per the risk management strategy)
- specific or layer specification
specified items (i.e. low volume, high value; designate specific transaction)
bottom layer period-based (i.e. high volume, low value; designate particular value in a period)
Oil Traders Ltd is an Australian company with the AUD as its functional currency. It purchases oil from domestic and foreign oil producers. What type of risk(s) would Oil Traders likely hedge in a hedge relationship?
commodity price risk
benchmark interest rate risk
foreign currency risk
commodity price risk and foreign currency risk
Hedged risks
loan = benchmark interest rate risk
foreign currency loan = benchmark interest rate risk; FX risk
commodity sale/purchase = commodity price risk; FX risk; all risk
import/export transactions = FX risk
Hedge accounting summary
ABD Pty Ltd is considering borrowing $250,000 on a variable rate basis in about six months' time. What type of hedge can ABD implement now that will qualify for hedge accounting?
any type of hedge
fair value hedge
cash flow hedge
no hedge will qualify
an eligible hedge item needs to be reliably measured and so would need to be a highly probable forecast transaction.
It is unlikely that 'considering' a floating rate borrowing would be meet the criteria. If the borrowing was more probable or actually locked in, it would likely be a cash flow hedge.
B.5 cash flow hedge
fixes cash flows that would otherwise be variable and would affect profits (= effective)
change in the cash flows of the hedging instrument offset the changes in the cash flow of the underlying item
hedges of highly probable forecast transactions (e.g. future sales) and floating rate loans/investments
positive derivative value = asset
negative derivative value = liability
B.5 fair value hedge
offsets exposure to changes in fair value of the hedged item that would affect profits (= effective)
fair value hedge offsets fair value changes from a fixed rate exposure
hedge items include recognised asset/liability, unrecognised firm commitment and aggregated exposure
primary example of a hedged item is a fixed rate loan, with hedging instrument being a pay-floating swap
B.5 net investment hedge
foreign operations with different functional currency require translation with gains/losses to OCI
hedge of FX risk in a foreign net investment eliminates FX gains/losses on net assets of the foreign entity
without hedge accounting, FX gains/losses on any hedge of foreign net investment would go to P&L (instead of OCI)
net investment hedges (e.g. FX borrowing) are in the nature of fair value hedges, accounted for like cash flow hedges
Complex hedge topics
option hedge strategy and treatment of time value and the premium
forward contract and amortisation of forward element
basis risk in cross-currency swaps
fair value option
cash flow hedge of a net position
nil net positions
macro hedge
Accounting for cash flow hedges
SOI Pty Ltd borrowed $200,000 from the TYM Bank on a 2-year term at a variable rate of the BBSW plus that 20 basis points, reset semi-annually. The terms of the loan require interest repayments every six months. At inception, the BBSW across all periods is 5%.
To hedge the interest rate risk, SOI enters into an interest rate swap for a 2-year term on a notional principal of $200,000 to receive BBSW every six months and pay a fixed rate of 5%. The swap has a fair value of zero at inception, and assume the discount rate is 5% per annum. Assume the hedge is highly effective.
$5,200 / $200,000 x 2 = 5.20%
Journal entries - Period 1
DR Cash $200,000
CR Bank loan $200,000
Record the loan drawdown at inception
DR Interest expense $4,450
CR Cash $4,450
Loan interest expense payment for the period
DR Interest expense $750
CR Cash $750
Swap payment for the period
DR Equity $2,142
CR Derivative (liability) $2,142
Fair value of the derivative at the end of the period
B.7 Accounting for fair value hedges
SOI Pty Ltd borrowed $200,000 from the TYM Bank on a 2-year term at a fixed rate of 6%. Interest repayments are required every 6 months during the term of the loan. With a fixed rate debt, SOI is economically subject to fair value exposure to interest rate changes.
To eliminate this economic fair value risk, SOI enters into an interest rate swap for a 2-year term on a notional principal of $200,000 to pay BBSW every 6 months and receive a fixed rate of 5.75%.The applicable discount rate is 5%.
BBSW + 0.25%
Journal entries - Period 1
DR Cash $200,000
CR Bank loan $200,000
Record the loan drawdown
DR Interest expense $6,000
CR Cash $6,000
Loan interest expense payment
DR Interest expense $500
CR Cash $500
Swap net receipt
DR Derivative (asset) $1,428
CR Derivative gain $1,428
Fair value of the derivative
DR Loan change in FV loss $1,428
CR Loan $1,428
Record change in fair value of loan
Quiz. net investment in a foreign operation
LMN Ltd has the AUD as its functional currency and has a net investment in a foreign operation that has a different functional currency. The initial investment in the subsidiary was for NZD 220,000 and this amount has remained in cash. The historical exchange rate at inception was AUD/NZD 1.1000 and the year-end exchange rate was AUD/NZD 1.0000.
What is LMN's consolidated group reported value of cash at year-end?
AUD 100,000
AUD 200,000
AUD 220,000
the original investment was AUD 200,000 (i.e. NZD 220,000 / 1.1000)
As a result of the weakening AUD over the year, the AUD value of the NZD cash holdings has now increased to AUD 220,000 (i.e. NZD 220,000 / 1.0000).
B.8 Accounting for net investment hedge
forward points amortisation: $11,111/2 = $5,556
forward element time value: $11,111 - $5,000 = $6,111
fair value of hedge: $111,111 - $125,000 = ($13,889)
B.9 Hedge effectiveness
To be considered effective, the hedge must meet the 80% - 125% range under the dollar offset method.
true
false
under IFRS 9, there is no longer a 'rule' of 80% - 125% for hedge effectiveness.
This guideline, as the effectiveness test now considers a wider range of more qualitative information (e.g.matched terms)
Hedge effectiveness
prospective assessment at inception and ongoing
measure and recognise hedge ineffectiveness each period
principles-based approach to hedge effectiveness testing
Conditions
- economic relationship must exist
between hedged item and hedged instrument (i.e. must move in opposite directions)
objective basis (e.g. matched terms; quantitative assessment), but also requires jugment
- credit risk cannot dominate fair value changes
requires judgment
could arise from counterparty's credit risk or the entity's own credit risk
- hedge ratio for accounting must match that for risk management
quantity of the hedging instrument and quantity of the hedged item
will usually match in notional terms, but can differ and the hedge ratio may require rebalancing
Measuring hedge effectiveness
Qualitative
- matched terms method
effective if critical terms of hedge item and hedge instrument are aligned
Quantitative
- dollar offset method
effective if single period or cumulative period offset calculation is within a benchmark range (e.g. 80%-125%):
[change in FV of derivative / change in FV of hedged item]
- regression
effective if the spread against the line of best fit (R^2) is between e.g. 0.80 - 1.00
effective if the slope of the line of bet fit (X variable 1) is between e.g. -0.80 and -1.25
Hypothetical derivative
theoretical derivative that will create a perfect hedge
fair value of zero at inception
terms that match the critical terms of the hedged item
not a hedge effectiveness method in itself
used in a quantitative process to assess an economic relationship - only relevant for CF & net investment hedges
used to determine any ineffectiveness in a hedge (to P&L) - only relevant for CF & net investment hedges
Measurement of ineffectiveness
fair value hedge
changes in both the FV of the derivative AND the FV of the hedged item are recognised in P&L
ineffectiveness in the hedge is already recognised in P&L
cash flow hedge
effective component of hedge gains/losses deferred to OCI
ineffectiveness where an entity is over-hedged:
[e.g. change in FV of actual derivative > change in FV of hypothetical derivative]
no ineffectiveness where an entity is under-hedged (unintentionally):
[e.g. change in FV of hypothetical derivative > change in FV of actual derivative]
Example
want to hedge the exposure to floating interest rates... so enter a pay-fixed interest rate swap
based on economic relationship, hedge is deemed effective prospectively
assess any effectiveness in the hedge using the hypothetical derivative - which would eliminate exposure perfectly
effective portion of the hedge gain/loss goes to OCI (i.e. the lessor of the change in the hypothetical or the actual)
ineffective portion of the hedge gain/loss goes to P&L (i.e. any over-hedged amount where the change in actual > change in hypothetical)
change in FV of actual derivative: $150 increase - over-hedged, ineffective component to P&L
change in FV of hypothetical derivative: $120 increase
actual derivative 150 DR
equity reserve 120 CR
profit & loss 30 CR
change in FV of actual derivative: $140 increase - under-hedged, no ineffective component
change in FV of hypothetical derivative: $160 increase
actual derivative 140 DR
equity reserve 160 CR
B.10 Hedge accounting documentation
IFRS 9 documentation
hedging policy (overarching - general)
- management intent
- set by senior management/board/audit and risk committee
- includes:
purpose
permitted hedges
highly probable forecast basis
embedded derivatives
documentation
effectiveness assessment
ineffectiveness measurement
hedge documentation (specific)
- created at/before inception
- formal designation and documentation of hedge relationship
hedging instrument
hedged item/transaction
risk management strategy/objective
nature of risk being hedged
assessment of effectiveness
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