LEARNING OBJECTIVES

1.         Apply and discuss the recognition and derecognition of a financial asset or financial liability.
2.         Apply and discuss the classification of a financial asset or financial liability and their measurement.
3.         Apply and discuss the treatment of gains and losses arising on financial assets and financial liabilities.
4.         Apply and discuss the treatment of impairment of financial assets.
5.         Record the accounting for derivative financial instruments, and simple embedded derivatives.
6.         Outline the principle of hedge accounting, and account for fair value hedges and cash flow hedges including hedge effectiveness.

Process

14 July 2009

IASB issues exposure draft Financial Instruments: Classification and Measurement

12 November 2009

IASB issues IFRS 9 Financial Instruments, covering classification and measurement of financial assets, as the first part of its project to replace IAS 39.

28 October 2010

IASB reissues IFRS 9 Financial Instruments, incorporating new requirements on accounting for financial liabilities and carrying over from IAS 39 the requirements for derecognition of financial assets and financial liabilities.

4 August 2011

IASB publishes an exposure draft proposing to push back the mandatory effective date of IFRS 9 Financial Instruments from 1 January 2013 to 1 January 2015

16 December 2011

IASB publishes Mandatory Effective Date and Transition Disclosures (Amendments to IFRS 9 and IFRS 7), which amends the effective date of IFRS 9 to annual periods beginning on or after 1 January 2015, and modifies the relief from restating comparative periods and the associated disclosures in IFRS 7

1 January 2013

Original effective date of IFRS 9, with early adoption permitted starting in 2009

1 January 2015

Revised effective date of IFRS 9, with early adoption permitted

2.1

Definitions

(a)        A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
(b)        A financial assets is any asset that is:
(i)         cash
(ii)        a contractual right to receive cash or another financial asset from another entity
(iii)       a contractual right to exchange financial assets/liabilities with another entity under conditions that are potentially favourable to the entity
(iv)       a contract that will or may be settled in the entity’s own equity instruments, and is a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments
(v)        a contract that will or may be settled in the entity’s own equity instruments, and is a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.

Examples:

• Trade receivables
• Options
• Investment in equity shares

(c)        A financial liability is any liability that is a contractual obligation:
(i)         to deliver cash or another financial asset to another entity, or
(ii)        to exchange financial instruments with another entity under conditions that are potentially unfavourable, or
(iii)       a contract that will or may be settled in the entity’s own equity instruments, and is a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments
(v)        a contract that will or may be settled in the entity’s own equity instruments, and is a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.

Examples:

• Trade payables
• Debenture loans
• Redeemable preference shares

(d)        An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

2.2

Example 1

Identify which of the following are financial instruments:
(a)        inventories
(b)        investment in ordinary shares
(c)        prepayments for goods or services
(d)        liability for income taxes
(e)        a share option (an entity’s obligation to issue its own shares)

Solution:

(a)        Inventory (or any other physical asset such as non-current assets) is not a financial instrument since there is no present contractual right to receive cash or other financial instruments.
(b)        An investment in ordinary shares is a financial asset since it is an equity instrument of another entity.
(c)        Prepayments for goods or services are not financial instruments since the future economic benefits will be the receipt of goods or services rather than a financial asset.
(d)        A liability for income taxes is not a financial instrument since the obligation is statutory rather than contractual.
(e)        A share option is a financial instrument since a contractual obligation does exist to deliver an equity instrument. Note, however, that an option buy or sell an asset other than a financial instrument (e.g. a commodity) would not qualify as a financial instrument.

2.9

Example 2 – Liabilities or equity?

(a)        Preference shares
If an entity issues preference shares that pay a fixed rate of dividend and that have a mandatory redemption feature at a future date, the substance is that there is a contractual obligation and, therefore, the preference shares should be recognized as a financial liability. In contrast, normal (ordinary) shares should be classified as equity as the entity does not have a contractual obligation to make any payment.
(b)        Puttable instruments (可贖回金融衍生工具) issued by mutual funds, unit trusts or co-operatives
Puttable instrument is a financial instrument that gives the holder the right to return it to the issuer for cash or another financial asset. Although the legal form of such financial instruments often includes a right to the residual interest in the assets of an entity, the inclusion of an option for the holder to put the instrument back to the entity for cash or another financial asset means that the instruments meet the definition of a financial liability, an obligation.
(c)        Share warrants or rights
Share warrant or right should be classified as equity. There is a contract that is settled by the issuer delivering a fixed number of the issuer’s own shares in exchange for a fixed amount of cash or monetary assets.

3.1

Initial recognition of financial assets and financial liabilities

(a)        An entity should recognize a financial asset or a financial liability on its statement of financial position when, and only when, it becomes a party to the contractual provisions of the instrument, rather than when the contract is settled. (Applied to IFRS 9 and IAS 39)
(b)        At initial recognition, an entity has an option to irrevocably designate a financial asset or a financial liability as measured at fair value through profit or loss. This option is termed as “fair value option” and is an accounting policy choice. (Only applied to IFRS 9)

4.1.1

Initial measurement of financial assets under IAS 39

(a)       A financial asset or liability should initially be measured at is fair value upon initial recognition. However, a financial asset not “at fair value through profit or loss” shall be measured at fair value plus transaction cost that are directly attributable to the acquisition or issue of the financial asset or financial liability.
(b)       Transaction costs are incremental costs that are directly attributable for the transaction which include commissions paid to agents, advisers, brokers, and dealers; levies by regulatory agencies and securities exchanges; and transfer taxes and duties, etc.

Financial instrument

Measurement at recognition

Subsequent measurement

Recognition in income statement / equity

Financial assets and liabilities at fair value through profit or loss

Fair value

Measured at fair value with changes in value taken through the income statement

Interest/dividends taken through profit or loss.
Fair value gains and losses recognized in income statement

Loans and receivables

Amortised cost

Measured at amortised cost using the effective interest rate

The interest calculated using the effective rate is credited to the income statement as finance income

Held-to-maturity investments

Amortised cost

Measured at amortised cost using the effective interest rate

The interest calculated using the effective rate is credited to the income statement as finance income

Available-for-sale financial assets

Fair value

Recognised at fair value with changes in value taken to equity and recycled once the asset is disposed of

Gains and losses are initially recognized in equity. When an asset is sold (or impaired or derecognised) the cumulative gain or loss previously recognized in equity is recycled to the income statement

4.2.3

Example 3 – AFS investment measured at fair value

ABC Ltd acquires the following shares in the Hong Kong Stock Exchange (HKSE) on 15 November 2011. Assume that the shares were acquired as long-term investments, and therefore are classified as AFS investments.
(a)       100,000 ordinary shares of LMN Ltd at $2.00 per share plus transaction costs of $3,000; and
(b)       200,000 ordinary shares of XYZ Ltd at $3.00 per share plus transaction costs of $5,000.
At is accounting year-end on 31 December 2011, the shares are quoted at the Hong Kong Stock Exchange at the following prices:
(a)       Ordinary shares of LMN Ltd: $1.50 per share; and
(b)       Ordinary shares of XYZ Ltd: $4.00 per share.

Assume further that at is accounting-year end on 31 December 2012, the shares are quoted on the HKSE at the following prices:
(a)       Ordinary shares of LMN Ltd: $1.30 per share; and
(b)       Ordinary shares of XYZ Ltd: $3.10 per share.

In this case, the relevant journal entries will be as follows:

In its 2011 financial statements:
(a)       Investment in AFS securities will be presented at its fair value of $950,000 in the statement of financial position.
(b)       The fair value gain on investment in AFS securities of $142,000 will be recognized in other comprehensive income and accumulated in fair value reserve on AFS securities. The fair value reserve on AFS securities of $142,000 will be presented as part of shareholders’ equity in the statement of financial position.
In its 2012 financial statements:
(a)       Investment in AFS securities will be presented at its fair value of $750,000 in the statement of financial position.
(b)       The fair value loss on investment in AFS securities of $200,000 will be recognized in other comprehensive income and reduced the fair value reserve on AFS securities, resulting in a debt balance of $58,000 to be presented as part of shareholders’ equity in the statement of financial position.

5.1.1

Initial measurement of financial assets

All financial instruments are initially measured at fair value plus or minus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs.

5.2.1

Two classifications of financial assets

IFRS 9 divides all financial assets into two classifications:
(a)       those measured at amortised cost; and
(b)       those measured at fair value.

Classification is made at the time the financial asset is initially recognized, namely when the entity becomes a party to the contractual provisions of the instrument.

5.2.2

Debt instruments

Debt instruments would normally be measured at fair value through profit or loss (FVTPL), but could be measured at amortised cost (net of any writedown for impairment) if the entity chooses to do so, provided the following two tests are passed:
(a)       Business model test –
(i)        Establishes whether the entity holds the financial asset to collect the contractual cash flows or whether the objective is to sell the financial asset prior to maturity to realize changes in fair value.
(ii)       If it is to collect the contractual cash flows, it implies that there will be no or few sales of such financial assets from a portfolio to their maturity date.
(iii)      If this is the case, the test is passed.
(iv)      If not, it would suggest that it may be disposed of to respond to changes in fair value. In this situation, the test is failed and the financial asset cannot be measured at amortised cost.
(v)       Where an entity changes its business model, it may be required to reclassify its financial assets as a consequence, but this is expected to be infrequent occurrence.
(vi)      If reclassification does occur, it is accounted for from the first day of the accounting period in which reclassification takes place.
(b)        Contractual cash flow characteristics test –
(i)         Determines whether the contractual terms of the financial asset give rise to cash flows on specified dates that are solely payments of principal and interest based upon the principal amount outstanding.
(ii)        If this is not the case, the test is failed and the financial asset cannot be measured at amortised cost.
(iii)       For example, convertible bonds contain rights in addition to the repayment of interest and principal and therefore would fail the test and must be accounted for as fair value through profit or loss.

5.2.5

Example 4 – Debt investment measured at amortised cost using the effective interest method

On 1 January 2011, XYZ Ltd pays $104,330 to acquire a bond which has a nominal value of $100,000, a coupon rate of 6% interest payable on 31 December each year and matures on 31 December 2015. XYZ Ltd holds the investment within a business model whose objective is to hold the bond until maturity date in order to collect contractual cash flows. The company measures the investment in bond at amortised cost using the effective interest method. The effective interest rate is 5%.

In this case, the carrying amount of the investment and the interest income for each relevant year will be determined, using the effective interest method, as follows:

The relevant journal entries are as follows:

5.2.6

Equity instruments

Equity instruments are measured at either:
(a)        fair value through profit or loss, or
(b)        fair value through other comprehensive income.

5.2.9

Example 5 – Equity investment measured at fair value

ABC Ltd acquires the following shares in the Hong Kong Stock Exchange on 15 November 2011, which it intends to sell in early 2012 to take advantage of the expected changes in the share prices.
(a)       100,000 ordinary shares of LMN Ltd at $2.00 per share plus transaction costs of $3,000; and
(b)       200,000 ordinary shares of XYZ Ltd at $3.00 per share plus transaction costs of $5,000.
At is accounting year-end on 31 December 2011, the shares are quoted at the Hong Kong Stock Exchange at the following prices:
(a)       Ordinary shares of LMN Ltd: $1.50 per share; and
(b)       Ordinary shares of XYZ Ltd: $4.00 per share.

In this case, the shares are financial assets at fair value through profit or loss as it is held for trading, and the relevant journal entries will be as follows:

In the statement of financial position as at 31 December 2011, the investment in trading securities will be presented at its fair value of $950,000.

In the statement of comprehensive income for the year ended 31 December 2011, the fair value gain on trading securities of $150,000 and the expense of $8,000 will be recognized in profit or loss for the year.

5.2.10

Fair value through other comprehensive income

(a)         It is possible to designate an entity instrument as fair value through other comprehensive income, provided specified conditions have been complied with as follows:
(i)        the equity instrument cannot be held for trading, and
(ii)       there must be an irrevocable choice for this designation upon initial recognition.
(b)         In this situation, initial recognition will also include directly attributable transactions costs. This may apply, for example, to strategic investments to be held on a continuing basis which are not held to take advantage of changes in fair value. Equity derivatives are excluded from adopting this designation.

6.2

Two classes of financial liabilities

(a)        Financial liabilities at fair value through profit or loss, and
(b)        Other financial liabilities. This is the default class for financial liabilities if they are not at fair value through profit or loss; these financial liabilities are measured at amortised cost. Borrowing would normally be classed under this heading.

Financial instrument

Measurement at recognition

Subsequent measurement

Recognition in statement of comprehensive income

Financial liabilities at fair value through profit or loss

Fair value

Measured at fair value with changes in value taken through profit or loss

Fair value gains and losses recognized in profit or loss

Other financial liabilities

Amortised cost

Measured at amortised cost using effective interest rate

The interest calculated using the effective rate is charged to profit or loss within the income statement as a finance cost

6.5

Example 6 – Deep discount bond

On 1 January 2012 ABC Co issued a deep discount bond with a $50,000 nominal value. The discount was 16% of nominal value, and the costs of issue were $2,000. Interest of 5% of nominal value is payable annually in arrears. The bond must be redeemed on 1 January 2017 (after 5 years) at a premium of $4,611. The effective rate of interest is 12% pa.

Required:

How will this be reported in the financial statements of ABC Co over the period to redemption?

Solution:
Firstly, we must establish at what amount the bond will be initially recognized in the statement of financial position. The calculation set out below, also works out the total finance cost to be charged to profits.

Secondly, we set up a table (similar to that used for compound instruments) to work out the balance of the loan at the end of each period.

The finance charge taken to the income statement is greater than the actual interest paid, and so the balance shown as a liability increases over the life of the instrument until it equals the redemption value at the end of its term.

In years 1 to 4 the balance shown as a liability is less than the amount that will be payable on redemption. Therefore the full amount payable must be disclosed in the notes to account.

6.8

Example 7 – Compound instruments

On 1 January 2012, BBC Co issued a $50m three-year convertible bond at par.

• There were no issue costs.
• The coupon rate is 10%, payable annually in arrears on 31 December.
• The bond is redeemable at par on 1 January 2015.
• Bondholders may opt for conversion. The terms of conversion are two 25-cent equity shares for every $1 owed to each bondholder on 1 January 2015.
• Bonds issued by similar entities without any conversion rights currently bear interest at 15%.
• Assume that all bondholders opt for conversion in full.

Required:

How will this be accounted for by BBC Co?

Solution:

On initial recognition, the method if splitting the bond between equity and liabilities is as follows.

• Calculate the present value of the debt component by discounting the cash flows at the market rate of interest for an instrument similar in all respects, except that it does not have conversion rights.
• Deduct the present value of the debt from the proceeds of the issue. The difference is the equity component.

1.      Splitting the proceeds
The cash payments on the bond should be discounted to their present value using the interest rate for a bond without the conversion rights, i.e. 15%.

2.      The annual finance costs and year end carrying amounts

3.      The conversion of the bond
The carrying amounts at 1 January 2012:

The conversion terms are two 25-cent equity shares for every $1, so $50m × 2 = $100m shares, which have a nominal value of $25m. The remaining $30,708,100 should be classified as the share premium, conversion has extinguished it.

Question 1
Epsilon is a listed entity. You are the financial controller of the entity and its consolidated financial statements for the year ended 30 September 2010 are being prepared. Your assistant, who has prepared the first draft of the statements, is unsure about the correct treatment of a number of transactions and has asked for your advice. Details of the transaction is given below:

On 1 October 2009 Epsilon issued 5 million loan notes that had a value of $1 per note. The issue costs were 3 cents per note. Each note holder will receive interest of 5 cents per note on 30 September of each year starting on 30 September 2010. The loan notes are repayable on 30 September 2019 at $1·20 per note. As an alternative to repayment the loan note holders can elect to exchange their notes for shares in Epsilon. On 1 October 2009 the credit rating of Epsilon was such that it would have had to offer investors in non-convertible loan notes a rate of return of 9% per annum on any investment. The impact of issue costs would increase the effective interest rate on such loan notes to 9·45%.

The following information regarding discount rates may be relevant:

Required:
For the above transaction prepare extracts from the financial statements for the year ended 30 September 2010. Your extracts should be supported by appropriate explanations.     (6 marks)
(Adapted ACCA Diploma in IFR December 2010 Q3(a))

6.13

Example 8 – Fair value option for liabilities

On 1 January 2012 an entity issues a 7-year bond at par value of $300,000 and annual fixed coupon rate of 9%, which is also the market rate, when LIBOR is 6%. Therefore the instrument-specific element of IRR is 3% (9% – 6%).

At 31 December 2012, LIBOR has moved to 5.5%, thus making the benchmark interest rate (5.5% + 3%) 8.5% (i.e. LIBOR plus the instrument-specific element of IRR). If the fair value of the liability is consistent with a market interest rate of, say, 8.3%, then any change in the fair value of the liability from the benchmark rate to fair value must be due to something other than the change in the benchmark rate – i.e. it must be due to the change in the liability’s credit risk.

Required:

Calculate the amounts to be included within the financial statements for the year ended 31 December 2012.

Solution:

It can be quantified by calculating the present value (PV) of the liability using the benchmark rate and comparing it with the PV of the liability using the market rate as follows:

Therefore, the change in the fair value of the liability which is not due to the change in the benchmark rate must be due to the change in the liability’s credit risk.

IFRS 9 requires that this change in fair value relating to the change in the liability’s credit risk is taken to other comprehensive income. In the above situation, it will be reflected by a reduction in equity as the carrying value of the liability is increased.

7.2

Derecognition

(a)        A financial asset should be derecognized if one of the following criteria occur:
(i)         the contractual rights to the cash flows of the financial asset have expired, e.g. when an option held by the entity has expired worthless, or
(ii)        the financial asset has been sold and the transfer qualifies for derecognition because substantially all the risks and rewards of ownership have been transferred from the seller to the buyer.

The analysis of where the risks and rewards of ownership lie after the transaction is critical. For example if an entity sells an investment in shares and enters into a total return swap with the buyer, the buyer will return any increases in value to the entity or the entity will pay the buyer for any decrease in value. In this case the entity has retained substantially all of the risks and rewards of the investment, which therefore should not be derecognized.
(b)        A financial liability should be derecognized when, and only when, the obligation specified in the contract is discharged, cancelled or expired.

(c)        On derecognition, the difference between the carrying amount of the asset or liability and the amount received or paid for it should be recognized in the profit or loss for the period.

7.3

Example 9 – Derecognition

Tech Co has two receivables that it has factored to a bank in return for immediate cash proceeds of less than the face value of the invoices. Both receivables are due from long standing customers who are expected to pay in full and on time. Tech Co has agreed a three-month credit period with both customers.

The first receivable is for $200,000 and in return for assigning the receivable Tech Co has just received from the factor $180,000. Under the terms of the factoring arrangement, the only money that Tech Co will receive regardless of when or even if the customer settles the debt, i.e. the factoring arrangement is said to be “without recourse”.

The second receivable is for $100,000 and in return for assigning the receivable Tech Co has just received $70,000. Under the terms of this, factoring arrangement if the customer settles the account on time then a further $5,000 will be paid by the factoring bank to Tech Co, but if the customer does not settle the account in accordance with the agreed terms then the receivable will be reassigned back to Tech Co who will then be obliged to refund the factor the original $70,000 plus a further $10,000. This factoring arrangement is said to be “with recourse”.

Required:

Discuss Tech Co’s accounting treatment of the monies received under the terms of the two factoring arrangements.

Solution:

The principle of derecognition here is that it needs to determine whether the risk and rewards of ownership of the factoring arrangement has passed from Tech Co to the factoring bank. The principal risk with regard to receivables is the risk of bad debt.

In the first arrangement the $180,000 has been received as a one-off non refundable sum. This is factoring without recourse for bad debts. The risk of bad debt has clearly passed from Tech Co to the factoring bank. Accordingly Tech Co should derecognize the receivable and there will be an expense of $20,000 recognised. No liability will be recognized.

In the second arrangement the $70,000 is simply a payment on account. More may be received by Tech Co implying that Tech Co retains an element of reward. The monies received are refundable in the event of default and as such represent an obligation. This means that the risk of slow payment and bad debt remains with Tech Co who is liable to repay the monies so far received. As such despite the passage of legal title, the asset (i.e. receivable) should remain recognized in the accounts of Tech Co. In substance Tech Co has borrowed $70,000 and this loan should be recognized immediately. This will increase the gearing of Tech Co.

8.1

Impairment of financial assets

Impairment of financial assets will, in due course, be included within updated requirements of IFRS 9. The present situation as at August 2010 is as follows:
(a)        Financial assets that are measured at fair value through profit or loss are not subject to an impairment review. Remeasurement of fair value at each reporting date will automatically take account of any impairment.
(b)        Similarly, financial assets measured at fair value through other comprehensive income are not subject to an impairment review. Any changes in fair value, including those which may relate to impairment, are recognized in other comprehensive income. There is no recognition or recycling of impairment to profit or loss.
(c)        For financial assets measured at amortised cost, IAS 39 requires that an assessment be made, at every reporting date, as to whether there is any objective evidence that a financial asset is impaired, i.e. whether an event has occurred that has had a negative impact on the expected future cash flows of the asset.
(d)        The event causing the negative impact must have already happened. An event causing an impairment in the future shall not be anticipated.
For example, on the last day of its financial year a bank lends a customer $100,000. The bank has consistently experienced a default rate of 5% across all its loans. The bank is not permitted immediately to write this loan down to $95,000 based on its past experience, because no default has occurred at the reporting date.

8.3

Example 10 – Impairment of financial assets measured at amortised cost

On 1 February 2009, ABC bank makes a four-year loan of $10,000 to Paul. The coupon rate on the loan is 6%, the same as the effective rate of interest. Interest is received at the end of each year.

During February 2012, it becomes clear that Paul is in financial difficulties. This is the necessary objective evidence of impairment. At this time the current market interest rate is 8%.

It is estimated that the future remaining cash flows from the loan will be only $6,000, instead of $10,600 (the $10,000 principal plus interest for the fourth year of $600).

Because the coupon rate and the effective rate are the same, the carrying amount of the principal will remain constant at $10,000.

On 1 February 2012, the carrying amount of the loan should be restated to the present value of the estimated cash flows of $6,000, discounted at the original effective interest rate of 6% for one year.

The result is an impairment loss of $4,340 ($10,000 – $5,660).

The impairment loss is recognized as an expense in profit or loss.

The asset will continue to be accounted for using amortised cost, based on the revised carrying amount of the loan. In the last year of the loan, the interest income of $340 (5,660 × 6%) will be recognized in profit or loss.

Many question this present value calculation because it uses the investment’s historical effective-interest rate – not the current market rate. As a result, the present value computation does not reflect the fair value of the debt investment, and many believe the impairment loss is misstated.

9.3.1

Measurement of derivatives

(a)        On recognition, derivatives should initially be measured at fair value.
(b)        Subsequent measurement depends on how the derivative is categorized. In many cases, this will involve the derivative being measured at fair value with changes in the fair value recognized in profit or loss.
(c)        However, if the derivative is used as a hedge, then the changes in fair value should be recognized in equity.

9.3.2

Example 11 – Measurement of derivatives

Entity A enters into a call option on 1 June 2012, to purchase 10,000 shares in another entity on 1 November 2012 at a price of $10 per share. The cost of each option is $1. Entity A has a year end of 30 September.

By 30 September the fair value of each option has increased to $1.30 and by 1 November to $1.50, with the share price on the same date being $11. Entity A exercises the option on 1 November and the shares are classified as at fair value through profit or loss.

On 1 June 2012, the cost of the option is recognized:

On 30 September the increase in fair value is recorded:

On 1 November the option is exercise, the shares recognized and the call option derecognized. As the shares are financial assets at fair value through profit or loss, they are recognized at $110,000 (10,000 × $11)

10.1.1

Definitions

(a)       Hedging is a method of managing risk by designating one or more hedging instruments so that their change in fair value is offset, in whole or in part, to the change in fair value or cash flows of a hedged item.
(b)       A hedged item is an asset or liability that exposes the entity to risks of changes in fair value or future cash flows (and is designated as being hedged).
(c)       A hedging instrument is a designated derivative whose fair value or cash flows are expected to offset changes in fair value or future cash flows of the hedged item.

10.2.1

Two types of hedges

IAS 39 identifies three types of hedge, two which are within the P2 syllabus:
(a)       Fair value hedge – This hedges against the risk of changes in the fair value of a recognized asset or liability. For example, the fair value of fixed rate debt will change as a result of changes in interest rates.
(b)       Cash flow hedge – This hedges against the risk of changes in expected cash flows. For example, a UK entity may have an unrecognized contractual commitment to purchase goods in a year’s time for a fixed amount of US dollars.

10.2.5

Hedge effectiveness

One of the requirements of IAS 39 is that to use hedge accounting, the hedge must be effective. IAS 39 describes this as the degree to which the changes in fair value or cash flows of the hedged item are offset by changes in the fair value or cash flows of the hedging instrument.

A hedge is viewed as being highly effective if actual results are within a range of 80% to 125%.

10.2.7

Accounting treatment for fair value hedge

(a)        The hedging instrument will be remeasured at fair value, with all gains and losses being reporting in profit or loss for the year.
(b)        The hedged portion of the hedged item will be remeasured at fair value, with all gains and losses being reported in profit or loss for the year.

10.2.8

Example 13 – Fair value hedge

HK Ltd (a company incorporated in HK and with 31 December accounting year-ends) has, on 1 April 2011, sold goods to FC Ltd (a company incorporated in a foreign country) invoiced at FC 100,000 payable 30 September 2011.

The exchange rates between FC and $ at the relevant dates are as follows:

Scenario A
HK Ltd decides not to hedge the foreign currency exposure. The relevant journal entries will be as follows:

Due to unfavourable shift in the exchange rate, HK Ltd suffers an exchange loss of $10,000.

Scenario B
HK Ltd decides to hedge the foreign currency exposure by entering into a forward exchange contract on 1 April 2011 to sell FC100,000 on 30 September 2011.

HK Ltd further decides to apply hedge accounting. This is a fair value hedge under IAS 39.

Using the forward rate as the basis of measurement, the journal entries to record the transactions will be as follows:

No journal entry is required for the forward exchange contract. Just a memorandum entry to record the fact that a forward exchange contract has been entered into as a fair value hedge.

Note that, with the fair value hedge, HK Ltd is protected from the foreign currency risk. Regardless of the exchange rate prevailing on 30 September 2011, the sales will be recorded at $63,000 (sales price of FC100,000 at lock-in exchange rate of FC1.00 = $0.63), and the net cash receipt is $63,000 ($55,000 + $8,000). Also the fair value loss on the trade receivable will be exactly offset by the fair value gain on the forward exchange contract.

Note however that there is a cost involved, namely, the margin made by the foreign currency dealer of $0.02 ($0.65 – $0.63). This may be more evidently reflected in the alternative treatment shown below.

Note that, due to the fair value hedge, HK Ltd is able to lock-in at the rate of FC1.00 = $0.63. In the profit or loss, there is a sales of $65,000, a premium expense of $2,000, and no fair value gain or loss. The premium charge represents the cost of hedging. The net cash receipt is $63,000 ($55,000 + $8,000).

10.2.10

Accounting treatment for cash flow hedge

(a)        The hedging instrument will be remeasured at fair value. The gain or loss on the portion of the instrument that is deemed to be an effective hedge will be taken to equity and recognized in the statement of changes in equity.
(b)        The ineffective portion of the gain or loss will be reported immediately in the income statement.
(c)        If the hedged item eventually results in the recognition of a non-financial asset or liability, the gain or loss held in equity must be recycled in one of the two following ways.
(i)         the gain/loss goes to adjust the carrying amount of the non-financial assets/liability.
(ii)        the gain/loss is transferred to profit and loss in line with the consumption of the non-financial assets/liability.

10.2.11

Example 14 – Cash flow hedge

ABC Co has contracted to buy one hundred tonnes of raw materials from a German entity. The materials will cost €500,000, and will be delivered and paid for in Euros on 30 June 2012. ABC Co takes out a forward contract to buy €500,000 on 30 June 2012 at a cost of $320,000. At the year end of 30 April 2012, the Euro has appreciated and the value of €500,000 is now $325,000.

Required:

How should this be accounted for?

Solution:

It is assumed that, at its inception, the forward contract has a cost, and fair value, of zero.

The cost of the materials is still €500,000 at the reporting date but this is now equivalent to $325,000, whereas the forward contract ensures that it will only cost the entity $320,000. Therefore the hedge has been completely effective. And therefore the entire change in the fair value of the hedging instrument, the forward contract, is recognized as other comprehensive income and recorded in a cash flow hedge reserve within other components in equity.

If the forward contract is then settled with no further changes in exchange rates, the forward contract will be settled for $320,000 cash and the materials valued at cost of $325,000.

The materials are purchased for €500,000 with a value of $325,000 and are recorded as:

Because the cash flow hedge resulted in the recognition of materials (a non-financial asset), the gain of $5,000 held in the cash flow hedge reserve is dealt with as follows.

• It is immediately deducted from the $325,000 cost of the materials, to bring the carrying amount back to $320,000.
• It is recognized in profit or loss as the materials are charged to cost of sales.

Either way, the net cost of the materials in profit or loss over time is $320,000.

Question 2
On 1 January 2011, Omega signed a contract to purchase a machine from a foreign supplier on 30 June 2011. The purchase price of the machine, payable in cash on 30 June 2011, was 2 million shillings. On 1 January 2011, Omega entered into a forward contract to purchase 2 million shillings on 30 June 2011 for $1·1 million. On 31 March 2011, a contract to buy 2 million shillings on 30 June 2011 would have required a payment of $1·2 million.

On 30 June 2011 the spot rate of exchange was 1·6 shillings = $1. The forward contract was settled by the other party making a payment of $150,000 to Omega on that date.

Omega estimated that the useful economic life of the machine was five years from 30 June 2011, with no residual value. Omega uses hedge accounting whenever permitted by IAS 39 – Financial Instruments: Recognition and Measurement. The currency contract fully complies with the criteria and conditions for hedge accounting as set out in IAS 39.

Required:

Explain the accounting treatment required for the above machine and foreign currency contract, also preparing extracts from the financial statements (statement of comprehensive income and statement of financial position) for the years ended 31 March 2011 and 31 March 2012.                                                                                                                             (9 marks)
(Adapted ACCA Diploma in IFR June 2012 Q4b)

Question 3
Seltec, a public limited company, processes and sells edible oils and uses several financial instruments to spread the risk of fluctuation in the price of the edible oils. The entity operates in an environment where the transactions are normally denominated in dollars. The functional currency of Seltec is the dollar.

The entity uses forward and futures contracts to protect it against fluctuation in the price of edible oils. Where forwards are used the company often takes delivery of the edible oil and sells it shortly afterwards. The contracts are constructed with future delivery in mind but the contracts also allow net settlement in cash as an alternative. The net settlement is based on the change in the price of the oil since the start of the contract. Seltec uses the proceeds of a net settlement to purchase a different type of oil or purchase from a different supplier. Where futures are used these sometimes relate to edible oils of a different type and market than those of Seltec’s own inventory of edible oil. The company intends to apply hedge accounting to these contracts in order to protect itself from earnings volatility. Seltec has also entered into a long-term arrangement to buy oil from a foreign entity whose currency is the dinar. The commitment stipulates that the fixed purchase price will be denominated in pounds sterling.

Seltec is unsure as to the nature of derivatives and hedge accounting techniques and has asked your advice on how the above financial instruments should be dealt with in the financial statements.

Required:

Discuss the accounting principles involved in accounting for the above transaction and how the above transaction should be treated in the financial statement of Seltec.            (14 marks)
(ACCA P2 Corporate Reporting June 2010 Q3(a))

10.2.6

Example 12 – Hedge effectiveness

On 1 January 2012 an entity purchased an equity instrument at a fair value of $900,000. As it was not acquired with the intention of taking advantage of short-term changes in fair value, it would normally be designated upon initial recognition to be classified as fair value through other comprehensive income.

Due to the exposure to risk of changes in fair value of the equity instrument, the entity entered into an interest rate swap, identifying the swap contract as a hedging instrument as part of a fair value hedging arrangement. The fair value hedge has been correctly documented and designated upon initial recognition and is expected to be an effective hedging instrument. Consequently, changes in fair value to both the equity instrument (hedged item) and the swap contract (hedge instrument) will be matched in profit or loss, rather than accounted for separately.

At the reporting date 31 December 2012, the fair value of the equity instrument has fallen to $800,000, and there has been an increase in the fair value of the interest rate swap contract of $90,000.

Required:

Illustrate and explain the accounting treatment for the fair value hedge arrangement based upon the available information.

Solution:

The fall in fair value of the entity interest of $100,000 is taken to profit or loss. This is matched with the increase in fair value of the interest rate swap contract of $90,000, resulting in a small net loss $10,000.

The effectiveness in the hedge arrangement can be evaluated by comparing the change in the hedged item and the hedged instrument as follows:

Change in hedged item $100,000
Change in hedging instrument $90,000

Either: 100,000/90,000 = 111%
Or: 90,000/100,000 = 90%

As long as either one of the two measures above falls within the range 80% – 125%, the hedge is regarded as effective.