Advanced Financial Accounting: Chapter 9 Accounting for Derivatives and Hedge Accounting Tan & Lee Chapter 9 © 2009

Learning Objectives Understand what constitutes a derivative instrument; Understand the different types of derivatives; Know how derivatives are used; Understand the accounting treatment of derivatives; Understand hedge accounting, its rationale and the conditions for applying hedge accounting; and Appreciate the three main type of hedge relationships and their accounting treatment Tan & Lee Chapter 9 ©2009

Content Derivative Financial Instruments Accounting for Derivatives Hedging Classification of Hedging Relationships Hedge of a Net Investment in a Foreign Entity Discontinuation or Termination of Hedge Accounting Evaluation of Hedge Accounting 1. Derivative Financial Instruments Tan & Lee Chapter 9 ©2009

Derivative Financial Instruments 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 Tan & Lee Chapter 9 ©2009

Derivative Financial Instruments Example of derivative instruments and their underlying Types of derivative instruments Underlying Used by Option contracts (call and put) Security price Producers, trading firms, financial institutions, and speculators Forward contracts e.g. foreign exchange forward contract Foreign exchange rate Various companies Future contracts e.g. commodity futures Commodity prices Producers and consumers Swaps Interest rate Financial institutions Tan & Lee Chapter 9 ©2009

Derivative Financial Instruments Use of derivatives Manage market risk Reduce borrowing cost Profit from trading or speculation Types of derivatives Forward type derivatives such as forward contracts, future contracts and swaps Option-type derivatives such as call and put options, caps and collars and warrants Free standing derivatives Embedded derivatives Tan & Lee Chapter 9 ©2009

Sells Forward Contract 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” Company Sells Forward Contract “Forward sales contract” “Forward purchase contract” Tan & Lee Chapter 9 ©2009

Forward Contracts Not standardized contracts as they are not traded on an exchange They entail counterparty risks They are can be tailored to specific needs of counterparties They involve lower transaction costs Fair value of forward contract: Notional amount x (׀Current forward rate – contracted forward rate ׀) (1+r) t where Contracted forward rate is forward rate fixed at inception Current forward rate is forward rate for remaining period to maturity r = discount rate t = period to maturity At inception date, the fair value of a forward contract is nil. Tan & Lee Chapter 9 ©2009

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 Tan & Lee Chapter 9 ©2009

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 contracts Call option – right, but not obligation to buy 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) Tan & Lee Chapter 9 ©2009

Strike price> Underlying Option Contracts Main features Purchaser (holder) pays premium to seller (writer of option) Holder has the right, but not obligation to perform; while write has obligation to perform Asymmetrical pay-off profile Holder has limited loss (due to premium) and unlimited gain Writer has limited gain and unlimited loss Relationship between the strike price and the underlying Strike price> Underlying (spot price) Holder of call option Out-of-the-money At-the-money In-the-money Holder of put option Tan & Lee Chapter 9 ©2009

Option Contracts Fair value of option contract Fair value of an option = Intrinsic value + Time value Listed options = quoted price Not traded options = Valuation model ( Black-Scholes model) Diminishes over time Zero at expiration Call option = Max [0, Notional amount x (Spot price – Strike Price) Put option = Max [0, Notional amount x (Strike price – Spot Price) Tan & Lee Chapter 9 ©2009

Embedded Derivatives Derivative that is part of a hybrid financial instrument Host Instrument Embedded derivative: Linked to underlying and change in underlying causes change in cash flow Hybrid Instrument Example is bond whose ultimate proceed are linked to price of commodity, such as oil, or to a consumer price index Tan & Lee Chapter 9 ©2009

Split Accounting of Embedded Derivatives IAS 39 requires embedded derivatives to be separately recognized from the host instrument and accounted for in the same way as a stand-alone derivative if the following conditions are met: Conditions for separation of embedded derivative Economic characteristics and risk of host instrument are not closely related to that of the derivative Hybrid instrument is not measured at fair value, with changes in fair value recognized in profit and loss There is a separate instrument with same terms as the embedded derivative Tan & Lee Chapter 9 ©2009

Content Derivative Financial Instruments Accounting for Derivatives Hedging Classification of Hedging Relationships Hedge of a Net Investment in a Foreign Entity Discontinuation or Termination of Hedge Accounting Evaluation of Hedge Accounting 2. Accounting for Derivatives Tan & Lee Chapter 9 ©2009

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 Tan & Lee Chapter 9 ©2009

Accounting for Forward Contract At inception During life of contract Closing position or at expiration Dr Forward Contract (asset) Cr Gain on forward contract Dr Cash Cr Forward contract No journal entry as fair value is nil or Dr Loss on forward contract Cr Forward Contract (liability) Dr Forward contract Cr Cash Adjust fair value and record gain/loss Close out and record net settlement of contract Tan & Lee Chapter 9 ©2009

Accounting for Future Contract At inception During life of contract Closing position or at expiration Dr Cash Cr Gain on future contract Dr Cash Dr Gain on future contract Cr Margin Contract Dr Margin deposit Cr Cash or Dr Loss on futures contract Cr Cash Dr Cash Cr Loss on future contract Cr Margin Contract Record payment of initial margin deposit Record daily settlement of future contracts Close out and recover margin deposit Tan & Lee Chapter 9 ©2009

Accounting for Purchased Option Contract At inception During life of contract Closing position or at expiration Dr Option Contract Cr Gain on future contract Dr Cash* Dr Gain on option contract Cr Option Contract Dr Option contract (asset) Cr Cash or Dr Loss on futures contract Cr Option Contract Dr Cash* Cr Loss on option contract Cr Option Contract (* assume expires in-the-money) Record payment of initial margin deposit Adjust for fair value and record gain/loss Close out and record net settlement of contract Tan & Lee Chapter 9 ©2009

Accounting for Written Option Contract At inception During life of contract Closing position or at expiration Dr Option Contract Cr Gain on future contract Dr Option contract Cr Gain on Option Contract Dr Cash Cr Option contract (liability) (Expires out-of-the-money) or Dr Loss on futures contract Cr Option Contract Dr Option contract Dr Loss on option Cr Cash (Expires in-the-money) Record payment of initial margin deposit Adjust for fair value and record gain/loss Close out and record net settlement of contract Tan & Lee Chapter 9 ©2009

Content Derivative Financial Instruments Accounting for Derivatives Hedging Classification of Hedging Relationships Hedge of a Net Investment in a Foreign Entity Discontinuation or Termination of Hedge Accounting Evaluation of Hedge Accounting 3. Hedging Tan & Lee Chapter 9 ©2009

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 Tan & Lee Chapter 9 ©2009

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) Tan & Lee Chapter 9 ©2009

Risks That Qualify for Hedge Accounting Specific risks that qualify for hedge accounting Interest rate risk Foreign exchange risk Price risk Credit risk Risks must be specific risk, not general business risks Possible for a derivative to hedge more than one risk Tan & Lee Chapter 9 ©2009

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 Tan & Lee Chapter 9 ©2009

Qualifying Hedged Items (IAS 39: 78 -79) 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 Tan & Lee Chapter 9 ©2009

Criteria for Hedge Accounting (IAS 39: 88) Enterprise must have exposure to risk that affects income statement Derivative contract specifically entered to hedge underlying exposure Conditions to be met for hedge accounting to apply Hedge must be highly effective Effectiveness of hedge can be reliably measured Hedging relationship must be formally documented at the inception of the hedge Tan & Lee Chapter 9 ©2009

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 Tan & Lee Chapter 9 ©2009

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 Hedge effectiveness (or delta ratio) = Changes in fair value or future cash flow of hedging instrument Changes in fair value or future cash flow of hedged item 0.8 1.25 Effective hedge (IAS 39: AG 105b) Tan & Lee Chapter 9 ©2009

Assessing Hedge Effectiveness Exclusion of time value of certain derivatives to be excluded from hedge relationship Derivative separated into 2 component Time value (options) or interest (forwards) 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 Tan & Lee Chapter 9 ©2009

Content Derivative Financial Instruments Accounting for Derivatives Hedging Classification of Hedging Relationships Hedge of a Net Investment in a Foreign Entity Discontinuation or Termination of Hedge Accounting Evaluation of Hedge Accounting 4. Classification of Hedging Relationships Tan & Lee Chapter 9 ©2009

Classification of Hedging Relationships Causes Explanation Hedge of “the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment, or an identified portion of such asset, liability or firm commitment, which is attributable to a particular risk and could affect profit or loss” (IAS 39:86a) Fair value hedge 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 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 Hedge of a net investment in a foreign entity Tan & Lee Chapter 9 ©2009

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 Tan & Lee Chapter 9 ©2009

Accounting for a Fair Value Hedge Hedged Item (recognized asset or liability or firm commitment) Hedging Instruments Income statement Gain (loss) on hedging instrument offset loss (gain) on hedged item Balance sheet Change in fair value adjusted against carrying amount Change in fair value Tan & Lee Chapter 9 ©2009

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 Tan & Lee Chapter 9 ©2009

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 31/12/20x3 Dr Forward contract ………………. 100,000 Cr Gain on forward contract ……... Gain on forward contract: 10,000 x ($340 -$350) Taken to income statement Dr Loss on inventory ……………… 100,000 Cr Inventory ……………………….. Gain on forward contract: 10,000 x ($342 - $352) Tan & Lee Chapter 9 ©2009

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 Dr Forward contract ………………. 100,000 Cr Gain on forward contract ……... Gain on forward contract: 10,000 x ($330 -$340) Dr Loss on inventory ……………… 120,000 Cr Inventory ……………………….. Gain on forward contract: 10,000 x ($330 - $342) Dr Cash …………………………….. 3,300,000 Cr Sales ……………………………. Sale of inventory: 10,000 x $330 Tan & Lee Chapter 9 ©2009

Accounting for a Cash Flow Hedge Effective Cash Flow Hedge (IAS 39:95) Effective portion of gain/ loss Ineffective portion Recognized directly in equity through statement of changes in equity Recognized in profit or loss Tan & Lee Chapter 9 ©2009

Accounting for a Cash Flow Hedge Cash flow hedges are applicable to the following: Forecasted transactions involving financial and non-financial assets/liabilities which will result in cash inflow/ outflow Other transactions which affect future cash flows Interest rate swaps Tan & Lee Chapter 9 ©2009

∆ in present value of expected future cash flow Illustration 2: Effective and ineffective portions of a cash flow hedge Scenario 1/1/20x1 Entered into futures contract to hedged forecast transaction at 30/4/20x1 Classified as cash flow hedge Period ending ∆ in fair value of future contracts ∆ in present value of expected future cash flow 31/1/20x1 $100 $(105) 28/2/20x1 90 (80) 31/3/20x1 103 (105) 30/4/20x1 (38) 45 Tan & Lee Chapter 9 ©2009

Illustration 2: Effective and ineffective portions of a cash flow hedge Determination of effective and ineffective portions of a cash flow hedge 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) $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 Tan & Lee Chapter 9 ©2009

Content Derivative Financial Instruments Accounting for Derivatives Hedging Classification of Hedging Relationships Hedge of a Net Investment in a Foreign Entity Discontinuation or Termination of Hedge Accounting Evaluation of Hedge Accounting 5. Hedge of a Net Investment in a Foreign Entity Tan & Lee Chapter 9 ©2009

Hedge of a Net Investment in a Foreign Entity Hedge risk is foreign exchange risk Applies to foreign operations whose functional currencies are the currencies of the country where the foreign operations are located Closing rate method may result in significant translation loss from depreciating currencies Accounting treatment similar to cash flow hedge Hedge is effective if the delta ratio is between 0.8 and 1.25. Unlike a fair value hedge or a cash flow hedge, a non-derivative is allowed to be the hedging instrument, for example, a foreign currency loan. Hedge effectiveness = Cumulative change in fair value of hedging instrument (A) Cumulative translation difference on net investment (B) Tan & Lee Chapter 9 ©2009

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 Tan & Lee Chapter 9 ©2009

Illustration 3: Hedge of a Net Investment in a Foreign Entity Translation difference in foreign investment’s FS for 31/12/20x4 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) Journal entries for parent 31/12/20x3 Dr Cash …………………………….. 2,200,000 Cr Loan payable …………………... The loan payable is designated as a hedge of the net investment: FC1,200,000 x spot rate of $1.85 Tan & Lee Chapter 9 ©2009

Illustration 3: Hedge of a Net Investment in a Foreign Entity 31/12/20x4 Dr Interest expense ………………. 106,800 Cr Accrued interest ……………….. Interest expense during the year at 5% x FC1,200,000 x $1.78 Dr Accrued interest ……………….. 106,800 Cr Cash …………………………….. 102,000 Exchange gain …………………. 4,800 Settlement of accrued interest at year-end Taken to equity to offset translation loss Dr Loan payable …………………... 180,000 Cr Foreign currency translation reserves ………………………… Exchange gain on FC loan taken directly to equity: FC 1,200,000 x ($1.70 - $1.85) Tan & Lee Chapter 9 ©2009

Content Derivative Financial Instruments Accounting for Derivatives Hedging Classification of Hedging Relationships Hedge of a Net Investment in a Foreign Entity Discontinuation or Termination of Hedge Accounting Evaluation of Hedge Accounting Discontinuation or Termination of Hedge Accounting Tan & Lee Chapter 9 ©2009

Discontinuation or Termination of Hedge Accounting Consideration for discontinuation or termination of hedge accounting Hedging instrument has reached maturity date or is closed off or terminated Criteria for hedge accounting is no longer met Hedge designation is revoked Accounting treatment depends on type of hedge Tan & Lee Chapter 9 ©2009

Content Derivative Financial Instruments Accounting for Derivatives Hedging Classification of Hedging Relationships Hedge of a Net Investment in a Foreign Entity Discontinuation or Termination of Hedge Accounting Evaluation of Hedge Accounting 7. Evaluation of Hedge Accounting Tan & Lee Chapter 9 ©2009

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 Tan & Lee Chapter 9 ©2009