Financial instruments p2

  • Introduction

 

Definitions

 

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’ (IAS 32, para 11).

 

A financial asset is any asset that is:

 

  • ‘cash

 

  • an equity instrument of another entity

 

  • a contractual right to receive cash or another financial asset from another entity

 

  • a contractual right to exchange financial instruments with another entity under conditions that are potentially favourable to the entity

 

  • a non-derivative contract for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments’ (IAS 32, para 11).

 

A financial liability is any liability that is a:

 

  • ‘contractual obligation to deliver cash or another financial asset to another entity

 

  • contractual obligation to exchange financial instruments with another entity under conditions that are potentially unfavourable

 

  • a non-derivative contract for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments.’ (IAS 32, para 11).

 

An equity instrument is ‘any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities’ (IAS 32,

 

para 11).

 

Reporting standards

 

There are three reporting standards within the P2 syllabus that deal with financial instruments:

 

  • IAS 32 Financial Instruments: Presentation

 

  • IFRS 7 Financial Instruments: Disclosures

 

  • IFRS 9 Financial Instruments

 

 

IAS 32 deals with the classification of financial instruments and their financial statement presentation.

 

IFRS 7 deals with the disclosure of financial instruments in financial statements.

 

IFRS 9 is concerned with the initial and subsequent measurement of financial instruments.

 

2 Classification of financial liabilities and equity

 

IAS 32 provides rules on classifying financial instruments.

 

The issuer of a financial instrument must classify it as a financial liability or equity instrument on initial recognition according to its substance and the definitions provided at the start of this chapter.

 

Test your understanding 1 – Liabilities or equity?

 

Coasters wishes to purchase a new ride for its ‘Animation Galaxy’ theme park but requires extra funding. On 30 September 20X3, Coasters issued the following preference shares:

 

  • 1 million preference shares for $3 each. No dividends are payable. Coasters will redeem the preference shares in three years’ time by issuing ordinary shares worth $3 million. The exact number of ordinary shares issuable will be based on their fair value on 30 September 20X6.

 

  • 2 million preference shares for $2.80 each. No dividends are payable. The preference shares will be redeemed in two years’ time by issuing 3 million ordinary shares.

 

  • 4 million preference shares for $2.50 each. They are not mandatorily redeemable. A dividend is payable if, and only if, dividends are paid on ordinary shares.

 

Required:

 

Discuss whether these financial instruments should be classified as financial liabilities or equity in the financial statements of Coasters for the year ended 30 September 20X3.

 

Interest, dividends, losses and gains

 

The accounting treatment of interest, dividends, losses and gains relating to a financial instrument follows the treatment of the instrument itself.

 

  • Dividends paid in respect of preference shares classified as a liability will be charged as a finance expense through profit or loss

 

  • Dividends paid on shares classified as equity will be reported in the statement of changes in equity.

 

The impact of classification

 

The classification of a financial instrument as either a liability or as equity will have a major impact on the financial statements.

 

  • If an entity issues an instrument and classifies it as a liability, then gearing will rise and the entity will appear more risky to potential investors. The servicing of the finance will be charged to profit or loss reducing profits.

 

  • If an entity issues an instrument and classifies it as equity then gearing will fall. The servicing of the finance will be charged directly to retained earnings and so will not impact profit.

 

Offsetting financial assets and liabilities

 

IAS 32 states that a financial asset and a financial liability may only be offset in very limited circumstances. The net amount may only be reported when the entity:

 

  • ‘has a legally enforceable right to set off the amounts

 

  • intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously’ (IAS 32, para 42).

 

3 Recognition and measurement of financial liabilities

 

Initial recognition of financial liabilities

 

At initial recognition, financial liabilities are measured at fair value.

 

  • If the financial liability will be held at fair value through profit or loss, transaction costs should be expensed to the statement of profit or loss

 

  • If the financial liability will not be held at fair value through profit or loss, transaction costs should be deducted from its carrying amount.

 

Subsequent measurement of financial liabilities

 

The subsequent treatment of a financial liability is that they can be measured at either:

 

  • amortised cost

 

  • fair value through profit or loss.

 

Amortised cost

 

Most financial liabilities, such as borrowings, are subsequently measured at amortised cost using the effective interest method. This is considered in more detail below:

 

Effective rate of interest

 

Assume that a company takes out a $10m bank loan for 5 years. Interest of 10% is payable annually in arrears:

 

  • The interest payable each year is $1m ($10m × 10%)

 

  • The total cost of the loan is $5m ($1m × 5 years).

 

Now assume that a company issues a bond. This has a nominal value of $10m and interest of 10% is payable annually in arrears. However, the company issues the bond for only $9m and has agreed to repay $12m to the bond holders in five years’ time.

 

  • Interest of $1m ($10m × 10%) will be paid per year

 

  • Total interest payments over the life of the bond are $5m ($1m × 5 years).

 

  • On top of this interest, the entity must pay back $3m more ($12m – $9m) than it received.

 

The total cost of the loan is actually $8m ($5m + $3m) and, in accordance

 

with the accruals concept, this should be spread over the 5 year period. This is achieved by charging interest on the liability using the effective rate of interest. The effective rate is the internal rate of return of the

 

investment.

 

Calculating amortised cost

 

The initial carrying amount of a financial liability measured at amortised cost is its fair value less any transaction costs (the ‘net proceeds’ from issue).

 

A finance cost is charged on the liability using the effective rate of interest.

 

This will increase the carrying amount of the liability:

 

Dr Finance cost (P/L)

 

Cr Liability

 

The liability is reduced by any cash payments made during the year:

 

Dr Liability

 

Cr Cash

 

Amortised cost table

 

In the exam, assuming interest is paid in arrears, you might find the following working useful:

 

Opening Finance cost Cash payments Closing
liability (op. liability × (nom. value × liability
effective %) coupon %)
X X (X) X

 

The finance cost is charged to the statement of profit or loss.

 

The cash payment will be part of ‘interest paid’ in the statement of cash flows.

 

The closing liability will appear on the statement of financial position.

 

Illustration 1 – Loan issues at a discount

 

On 1 January 20X1 James issued a loan note with a $50,000 nominal value. It was issued at a discount of 16% of nominal value. The costs of issue were $2,000. Interest of 5% of the nominal value is payable annually in arrears. The bond must be redeemed on 1 January 20X6 (after 5 years) at a premium of $4,611.

 

The effective rate of interest is 12% per year.

 

Required:

 

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

 

Solution

 

The liability will be initially recognised at the net proceeds received:

 

$
Face value 50,000
Less: 16% discount (8,000)
Less: Issue costs (2,000)
––––––
Initial recognition of liability 40,000
––––––
The liability is then measured at amortised cost:
Year Opening Finance cost Cash payments Closing
balance (Liability × 12%) ($50,000 × 5%) balance
$ $ $ $
1 40,000 4,800 (2,500) 42,300
2 42,300 5,076 (2,500) 44,876
3 44,876 5,385 (2,500) 47,761
4 47,761 5,731 (2,500) 50,992
5 50,992 6,119 (2,500) 54,611
–––––– ––––––
27,111 (12,500)
–––––– ––––––
To: Profit or loss To: Statement of cash To: SOFP
flows

 

According to the above working, the total cost of the loan over the five year period is $27,111.

 

This is made up as follows:
Repayments: $ $
Capital 50,000
Premium 4,611
–––––– 54,611
Interest 12,500
($50,000 × 5% × 5 years) ––––––
67,111
Cash received (40,000)
––––––
Total finance cost 27,111
––––––

 

The finance charge taken to profit or loss in each year is greater than the actual interest paid. This means that the value of the 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 the accounts.

 

 

 

Test your understanding 2 – Hoy

 

Hoy raised finance on 1 January 20X1 by the issue of a two-year 2% bond with a nominal value of $10,000. It was issued at a discount of 5% and is redeemable at a premium of $1,075. Issue costs can be ignored. The bond has an effective rate of interest of 10%.

 

Wiggins raised finance by issuing $20,000 6% four-year loan notes on 1 January 20X4. The loan notes were issued at a discount of 10%, and will be redeemed after four years at a premium of $1,015. The effective rate of interest is 12%. The issue costs were $1,000.

 

Cavendish raised finance by issuing zero coupon bonds at par on 1 January 20X5 with a nominal value of $10,000. The bonds will be redeemed after two years at a premium of $1,449. Issue costs can be ignored. The effective rate of interest is 7%.

 

The reporting date for each entity is 31 December.

 

Required:

 

Illustrate and explain how these financial instruments should be accounted for by each company.

 

 

 

Fair value through profit or loss

 

Out of the money derivatives and liabilities held for trading are measured at fair value through profit or loss.

 

It is also possible to measure a liability at fair value when it would normally be measured at amortised cost if it would eliminate or reduce an accounting mismatch. In this case, IFRS 9 says that any movement in fair value is split into two components:

 

  • the fair value change due to own credit risk (the risk that the entity which has issued the financial liability will be unable to repay or discharge it), which is presented in other comprehensive income

 

  • the remaining fair value change, which is presented in profit or loss.

 

Illustration – Fair value through profit or loss

 

On 1 January 20X1, McGrath issued a financial liability for its nominal value of $10 million. Interest is payable at a rate of 5% in arrears. The liability is repayable on 31 December 20X3. McGrath trades financial liabilities in the short-term.

 

At 31 December 20X1, market rates of interest have risen to 10%.

 

Required:

 

Discuss the accounting treatment of the liability at 31 December 20X1.

 

Solution

 

The financial liability is traded in the short-term and so is measured at fair value through profit or loss.

 

The liability must be remeasured to fair value at the reporting date. Assuming that the fair value of the liability cannot be observed from an active market, it can be calculated by discounting the future cash flows at a market rate of interest.

 

 

Date Cash flow ($m) Discount rate
31/12/X2 0.5* 1/1.1
31/12/X3 10.5 1/1.12

 

* The interest payments are $10m × 5% = $0.5m

 

Present value ($m)

 

0.45

 

8.68

 

––––

 

9.13

 

––––

 

The fair value of the liability at the year-end is $9.13 million.

 

The following adjustment is required:
Dr Liability ($10m – $9.13m) $0.87m
Cr Profit or loss $0.87m

 

 

 

Test your understanding 3 – Bean

 

Bean regularly invests in assets that are measured at fair value through profit or loss. These asset purchases are funded by issuing bonds. If the bonds were not remeasured to fair value, an accounting mismatch would arise. Therefore, Bean designates the bonds to be measured at fair value through profit or loss.

 

The fair value of the bonds fell by $30m during the reporting period, of which $10m related to Bean’s credit worthiness.

 

Required:

 

How should the bonds be accounted for?

 

4 Compound instruments

 

A compound instrument is a financial instrument that has characteristics of both equity and liabilities. An example would be debt that can be redeemed either in cash or in a fixed number of equity shares.

 

Presentation of compound instruments

 

IAS 32 requires compound financial instruments be split into two components:

 

  • a financial liability (the liability to repay the debt holder in cash)

 

  • an equity instrument (the option to convert into shares).

 

These two elements must be shown separately in the financial statements.

 

The initial recognition of compound instruments

 

On initial recognition, a compound instrument must be split into a liability component and an equity component:

 

  • The liability component is calculated as the present value of the repayments, discounted at a market rate of interest for a similar instrument without conversion rights.

 

  • The equity component is calculated as the difference between the cash proceeds from the issue of the instrument and the value of the liability component.

 

Illustration 2 – Compound instruments

 

On 1 January 20X1 Daniels 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 20X4.

 

  • Bondholders may opt for conversion in the form of shares. The terms of conversion are two 25-cent equity shares for every $1 owed to each bondholder on 1 January 20X4.

 

  • Bonds issued by similar entities without any conversion rights currently bear interest at 15%.

 

  • Assume that all bondholders opt for conversion in shares.

 

Required:

 

How will this be accounted for by Daniels?

 

Solution

 

On initial recognition, the proceeds received must be split between liabilities and equity.

 

  • The liability component is calculated as the present value of the cash repayments at the market rate of interest for an instrument similar in all respects, except that it does not have conversion rights.

 

  • The equity component is the difference between the proceeds of the issue and the liability component.

 

  • 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%.

 

Date Cash Discount Present
flow factor (15%) value
$000 $000
31-Dec-X1 Interest 5,000 1/1.15 4,347.8
31-Dec-X2 Interest 5,000 1/1.152 3,780.7
31-Dec-X3 Interest 5,000 1/1.153 3,287.6
1-Jan-X4 Principal 50,000 1/1.153 32,875.8
–––––––
Liability component A 44,291.9
Net proceeds of issue B 50,000.0
Equity component B – A 5,708.1

 

  • Measuring the liability at amortised cost

 

The liability component is measured at amortised cost. The working below shows the finance costs recorded in the statement of profit or loss for each year as well as the carrying value of the liability in the statement of financial position at each reporting date.

 

Opening bal. Finance Payments Closing bal.
cost (15%)
$000 $000 $000 $000
20X1 44,291.9 6,643.8 (5,000) 45,935.7
20X2 45,935.7 6,890.4 (5,000) 47,826.1
20X3 47,826.1 7,173.9 (5,000) 50,000.0

 

  • The conversion of the bond

 

The carrying amounts at 1 January 20X4 are:

 

$000
Equity 5,708.1
Liability – bond 50,000.0
––––––––
55,708.1
––––––––

 

The conversion terms are two 25-cent equity shares for every $1. Therefore 100m shares ($50m × 2), will be issued which have a nominal value of $25m. The remaining $30,708,100 should be classified as the share premium, also within equity. There is no remaining liability, because conversion has extinguished it.

 

The double entry is as follows:
$000
Dr Other components of equity 5,708.1
Dr Liability 50,000.0
Cr Share capital 25,000.0
Cr Share premium 30,708.1

 

Test your understanding 4 – Craig

 

Craig issues a $100,000 4% three-year convertible loan on 1 January 20X6. The market rate of interest for a similar loan without conversion rights is 8%. The conversion terms are one equity share ($1 nominal value) for every $2 of debt. Conversion or redemption at par takes place on 31 December 20X8.

 

Required:

 

How should this be accounted for:

 

  • if all holders elect for the conversion?

 

  • no holders elect for the conversion?

 

5 Initial recognition of financial assets

 

IFRS 9 says that an entity should recognise a financial asset ‘when, and only when, the entity becomes party to the contractual provisions of the instrument’ (IFRS 9, para 3.1.1).

 

Examples of this principle are as follows:

 

  • A trading commitment to buy or sell goods is not recognised until one party has fulfilled its part of the contract. For example, a sales order will not be recognised as revenue and a receivable until the goods have been delivered.

 

  • Forward contracts are accounted for as derivative financial assets and are recognised on the commitment date, not on the date when the item under contract is transferred from seller to buyer.

 

  • Option contracts are accounted for as derivative financial assets and are recognised on the date the contract is entered into, not on the date when the item subject to the option is acquired.

 

 

6 Accounting for investments in equity instruments

 

Classification

 

Investments in equity instruments (such as an investment in the ordinary shares of another entity) are measured at either:

 

  • fair value either through profit or loss, or

 

  • fair value through other comprehensive income.

 

Fair value through profit or loss

 

The normal expectation is that equity instruments will have the designation of fair value through profit or loss.

 

Fair value through other comprehensive income

 

It is possible to designate an equity instrument as fair value through other comprehensive income, provided that the following conditions are complied with:

 

  • the equity instrument must not be held for trading, and

 

  • there must have been an irrevocable choice for this designation upon initial recognition of the asset.

 

Measurement

 

Fair value through profit or loss

 

Investments in equity instruments that are classified as fair value through profit or loss are initially recognised at fair value. Transaction costs are expensed to profit or loss.

 

At the reporting date, the asset is revalued to fair value with the gain or loss recorded in the statement of profit or loss.

 

Fair value through other comprehensive income

 

Investments in equity instruments that are classified as fair value through other comprehensive income are initially recognised at fair value plus transaction costs.

 

At the reporting date, the asset is revalued to fair value with the gain or loss recorded in other comprehensive income. This gain or loss will not be reclassified to profit or loss in future periods.

 

Test your understanding 5 – Ashes’ financial assets

 

Ashes holds the following financial assets:

 

  • Investments in ordinary shares that are held for short-term speculation.

 

  • Investments in ordinary shares that, from the purchase date, are intended to be held for the long term.

 

Required:

 

How should Ashes classify and account for its financial assets?

 

 

 

Summary

7 Accounting for investments in debt instruments

 

Classification

 

Financial assets that are debt instruments can be measured in one of three ways:

 

  • Amortised cost

 

  • Fair value through other comprehensive income

 

  • Fair value through profit or loss.

 

Amortised cost

 

IFRS 9 says that an investment in a debt instrument is measured at amortised cost if:

 

  • The entity’s business model is to collect the asset’s contractual cash flows

 

– This means that the entity does not plan on selling the asset prior to maturity but rather intends to hold it until redemption.

 

  • The contractual terms of the financial asset give rise to cash flows that are solely payments of principal, and interest on the principal amount outstanding

 

– For example, the interest rate on convertible bonds is lower than market rate because the holder of the bond gets the benefit of choosing to take redemption in the form of cash or shares. The contractual cash flows are therefore not solely payments of principal and interest on the principal amount outstanding.

 

Fair value through other comprehensive income

 

An investment in a debt instrument is measured at fair value through other comprehensive income if:

 

  • The entity’s business model involves both collecting contractual cash flows and selling financial assets

 

– This means that sales will be more frequent than for debt instruments held at amortised cost. For instance, an entity may sell investments if the possibility of buying another investment with a higher return arises.

 

  • The contractual terms of the financial asset give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding.

 

Fair value through profit or loss

 

An investment in a debt instrument that is not measured at amortised cost or fair value through other comprehensive income will be measured, according to IFRS 9, at fair value through profit or loss.

 

Test your understanding 6 – Paloma

 

Paloma purchased a new financial asset on 31 December 20X3. The asset is a bond that will mature in three years. Paloma buys debt investments with the intention of holding them to maturity although has, on occasion, sold some investments if cash flow deteriorated beyond acceptable levels. The bond pays a market rate of interest. The Finance Director is unsure as to whether this financial asset can be measured at amortised cost.

 

Required:

 

Advise the Finance Director on how the bond will be measured.

 

Re-classification of financial assets

 

Financial assets are classified in accordance with IFRS 9 when initially recognised.

 

If an entity changes its business model for managing financial assets, all affected financial assets are reclassified (e.g. from fair value through profit or loss to amortised cost). This will only apply to investments in debt.

 

Measurement

 

Amortised cost

 

For investments in debt that are measured at amortised cost:

 

  • The asset is initially recognised at fair value plus transaction costs.

 

  • Interest income is calculated using the effective rate of interest.

 

Fair value through other comprehensive income

 

For investments in debt that are measured at fair value through other comprehensive income:

 

  • The asset is initially recognised at fair value plus transaction costs.

 

  • Interest income is calculated using the effective rate of interest.

 

  • At the reporting date, the asset will be revalued to fair value with the gain or loss recognised in other comprehensive income. This will be reclassified to profit or loss when the asset is disposed.

 

 

Fair value through profit or loss

 

For investments in debt that are measured at fair value through profit or loss:

 

  • The asset is initially recognised at fair value, with any transaction costs expensed to the statement of profit or loss.

 

  • At the reporting date, the asset will be revalued to fair value with the gain or loss recognised in the statement of profit or loss.

 

Note on loss allowances

 

For debt instruments measured at amortised cost or at fair value through other comprehensive income, a loss allowance must also be recognised. This detail is covered in the next section.

 

Test your understanding 7 – Tokyo

 

On 1 January 20X1, Tokyo bought a $100,000 5% bond for $95,000, incurring issue costs of $2,000. Interest is received in arrears. The bond will be redeemed at a premium of $5,960 over nominal value on 31 December 20X3. The effective rate of interest is 8%.

 

The fair value of the bond was as follows:

 

31/12/X1   $110,000

 

31/12/X2   $104,000

 

Required:

 

Explain, with calculations, how the bond will have been accounted for over all relevant years if:

 

  • Tokyo’s business model is to hold bonds until the redemption date.

 

  • Tokyo’s business model is to hold bonds until redemption but also to sell them if investments with higher returns become available.

 

  • Tokyo’s business model is to trade bonds in the short-term. Assume that Tokyo sold this bond for its fair value on 1 January 20X2.

 

The requirement to recognise a loss allowance on debt instruments held at amortised cost or fair value through other comprehensive income should be ignored.

 

Test your understanding 8 – Magpie

 

On 1 January 20X1, Magpie lends $2 million to an important supplier. The loan, which is interest-free, will be repaid in two years’ time. The asset is classified to be measured at amortised cost. There are no transaction fees.

 

Market rates of interest are 8%. The loss allowance is highly immaterial and can be ignored.

 

Required:

 

Explain the accounting entries that Magpie needs to post in the year ended 31 December 20X1 to account for the above.

 

 

 

Summary

Impairment of financial assets

 

 

From incurred losses to expected losses

 

Under previous accounting standards, a financial asset could only be impaired if there was objective evidence of impairment. Losses expected as a result of future events, no matter how likely, could not be recognised. This was known as an incurred loss model.

 

Following the credit crunch, it was argued that many banks had not written down assets, despite having little expectation of receiving any benefits. With the benefit of hindsight this resulted in profit and assets being overstated. No early warning system was in place.

 

In response, the Board has introduced an expected loss model for financial asset impairment accounting. Entities now determine and account for expected credit losses instead of waiting for an actual default.

 

The expected loss model makes it is less likely that assets will be over-stated. It also provides timely information to the users of the financial statements because they will be warned about potential losses relatively early.

 

However, the expected loss model requires a lot of judgement. This could be argued to reduce verifiability and also to increase the scope for the manipulation of profits. The expected loss model also differs from the US GAAP treatment of financial asset impairments, therefore reducing comparability between companies. Another criticism is that the cost of implementing the expected loss model will be high for businesses that hold large volumes of financial assets (such as banks).

 

 

 

Loss allowances

 

IFRS 9 says that loss allowances must be recognised for financial assets that are debt instruments and which are measured at amortised cost or at fair value through other comprehensive income.

 

  • If the credit risk on the financial asset has not increased significantly since initial recognition, the loss allowance should be equal to 12-month expected credit losses.

 

  • If the credit risk on the financial asset has increased significantly since initial recognition then the loss allowance should be equal to the lifetime expected credit losses.

 

Adjustments to the loss allowance are charged (or credited) to the statement of profit or loss.

 

Unless credit impaired, interest income is recognised on the asset’s gross carrying amount (i.e. excluding the loss allowance).

 

Definitions

 

‘Credit loss: The difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flow that the entity expects to receive (i.e. all cash shortfalls), discounted at the original effective interest rate

 

Expected credit losses: The weighted average of credit losses with the respective risks of a default occurring as the weights.

 

Lifetime expected credit losses: The expected credit losses that result from all possible default events over the expected life of a financial instrument.

 

12-month expected credit losses: The portion of lifetime expected credit losses that represent the expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date’ (IFRS 9, Appendix A).

 

Significant increases in credit risk

 

To assess whether there has been a significant increase in credit risk, IFRS 9 requires entities to compare the asset’s risk of default at the reporting date with its risk of default at the date of initial recognition.

 

Entities should not rely solely on past information when determining if credit risk has increased significantly.

 

An entity can assume that credit risk has not increased significantly if the instrument has a low credit risk at the reporting date.

 

Credit risk can be assumed to have increased significantly if contractual payments are more than 30 days overdue at the reporting date.

 

Test you understanding 9 – Tahoe

 

San Fran is a company that has issued a public bond. It reports to its shareholders on a bi-annual basis.

 

Tahoe, a company which holds financial assets until maturity, is one of many investors in San Fran’s bond. On purchase, Tahoe deemed the bond to have a low credit risk due to San Fran’s strong capacity to fulfil its short-term obligations. It was perceived, however, that adverse changes in the economic environment could have a detrimental impact on San Fran’s liquidity.

 

At Tahoe’s reporting date, it has access to the following information about

 

San Fran:

 

  • Sales have declined 15% over the past 6 months

 

  • External agencies are reviewing its credit rating, but no changes have yet been made

 

  • Although market bond prices have remained static, San Fran’s bond price has fallen dramatically.

 

Required:

 

Discuss the accounting treatment of the bond in Tahoe’s financial statements at the reporting date.

 

Financial instruments

 

Measuring expected losses

 

An entity’s estimate of expected credit losses should be:

 

  • unbiased and probability-weighted

 

  • reflective of the time value of money

 

  • based on information about past events, current conditions and forecasts of future economic conditions.

 

If an asset is credit impaired at the reporting date, IFRS 9 says that the expected credit losses should be measured as the difference between the asset’s gross carrying amount and the present value of the estimated future cash flows when discounted at the original effective rate of interest.

 

Indications of credit impairment

 

IFRS 9 says that the following events may suggest the asset is credit-impaired:

 

  • significant financial difficulty of the issuer or the borrower

 

  • a breach of contract, such as a default

 

  • the borrower being granted concessions

 

  • it becoming probable that the borrower will enter bankruptcy

 

If an asset is credit-impaired, interest income is calculated on the asset’s net carrying amount (i.e. the gross carrying amount less the loss allowance).

 

 

Test your understanding 10 – Napa

 

On 1 January 20X1, Napa purchased a bond for $1m which is measured at amortised cost. Interest of 10% is payable in arrears. Repayment is due on 31 December 20X3. The effective rate of interest is 10%.

 

On 31 December 20X1, Napa received interest of $100,000. It estimated that the probability of default on the bond within the next 12 months would be 0.5%. If default occurs within the next 12 months then Napa estimated that no further interest will be received and that only 50% of the capital will be repaid on 31 December 20X3.

 

The asset’s credit risk at 31 December 20X1 is low.

 

Required:

 

Discuss the accounting treatment of the financial asset at 31 December 20X1.

 

Test your understanding 11 – Eve

 

On 1 February 20X6, Eve made a four-year loan of $10,000 to Fern. 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.

 

On 1 February 20X9, Fern tells Eve that it is in significant financial difficulties. At this time the current market interest rate is 8%.

 

Eve estimates that it will receive no more interest from Fern. It also estimates that only $6,000 of the capital will be repaid on the redemption date.

 

Eve has already recognised a loss allowance of $1,000 in respect of its loan to Fern.

 

Required:

 

How should this be accounted for?

 

Purchased or originated credit impaired financial assets

 

A purchased or originated credit-impaired financial asset is one that is

 

credit-impaired on initial recognition. Interest income is calculated on such assets using the credit-adjusted effective interest rate.

 

The credit adjusted effective interest rate incorporates all the contractual terms of the financial asset as well as expected credit losses. In other words, the higher the expected credit losses, the lower the credit adjusted effective interest rate.

 

Since credit losses anticipated at inception will be recognised through the credit-adjusted effective interest rate, the loss allowance on

 

purchased or originated credit-impaired financial assets should be measured only as the change in the lifetime expected credit losses

 

since initial recognition.

 

Debt instruments at fair value through other comprehensive income

 

These assets are held at fair value at the reporting date and therefore the loss allowance should not reduce the carrying amount of the asset in the statement of financial position. Instead, the allowance is recorded against other comprehensive income.

 

Test your understanding 12 – FVOCI and expected losses

 

An entity purchases a debt instrument for $1,000 on 1 January 20X1. The interest rate on the bond is the same as the effective rate. After accounting for interest for the year to 31 December 20X1, the carrying amount of the bond is still $1,000.

 

At the reporting date of 31 December 20X1, the fair value of the instrument has fallen to $950. There has not been a significant increase in credit risk since inception so expected credit losses should be measured at 12-month expected credit losses. This is deemed to amount to $30.

 

Required:

 

Explain how the revaluation and impairment of the financial asset should be accounted for.

 

 

 

Simplifications

 

IFRS 9 permits some simplifications:

 

  • The loss allowance should always be measured at an amount equal to lifetime credit losses for trade receivables and contract assets (recognised in accordance with IFRS 15 Revenue from Contracts with Customers) if they do not have a significant financing component.

 

  • For lease receivables, as well as trade receivables and contract assets with a significant financing component, the entity can choose as its accounting policy to measure the loss allowance at an amount equal to lifetime credit losses.

 

Impairment reversals

 

At each reporting date, the loss allowance is recalculated.

 

It may be that the allowance was previously equal to lifetime credit losses but now, due to reductions in credit risk, only needs to be equal to 12-month expected credit losses. As such, there may be a substantial reduction in the allowance required.

 

Gains or losses on remeasurement of the loss allowance are recorded in profit or loss.

 

9 Derecognition of financial instruments

 

A financial asset should be derecognised if one of the following has occurred:

 

  • The contractual rights have expired.

 

– For example, an option held by the entity may have lapsed and become worthless.

 

  • The financial asset has been sold and 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 a transaction is critical. If an entity has retained substantially all of the risks and rewards of a financial asset then it should not be derecognised, even if it has been legally ‘sold’ to another entity.

 

A financial liability should be derecognised when the obligation is discharged, cancelled or expires.

 

The accounting treatment of derecognition is as follows:

 

  • The difference between the carrying amount of the asset or liability and the amount received or paid for it should be recognised in profit or loss for the period.

 

  • For investments in equity instruments held at fair value through other comprehensive income, the cumulative gains and losses recognised in other comprehensive income are not recycled to profit or loss on disposal.

 

  • For investments in debt instruments held at fair value through other comprehensive income, the cumulative gains and losses recognised in other comprehensive income are recycled to profit or loss on disposal.

 

 

Test your understanding 13 – Ming

 

Ming has two receivables that it has factored to a bank in return for immediate cash proceeds. Both receivables are due from long standing customers who are expected to pay in full and on time. Ming had agreed a three-month credit period with both customers.

 

The first receivable is for $200,000. In return for assigning the receivable, Ming has received $180,000 from the factor. Under the terms of the factoring arrangement, Ming will not have to repay this money, even if the customer does not settle the debt (the factoring arrangement is said to be ‘without recourse’).

 

The second receivable is for $100,000. In return for assigning the receivable, Ming has received $70,000 from the factor. The terms of this factoring arrangement state that Ming will receive a further $5,000 if the customer settles the account on time.

 

If the customer does not settle the account in accordance with the agreed terms then the receivable will be reassigned back to Ming who will then be obliged to refund the factor with the original $70,000 (this factoring arrangement is said to be ‘with recourse’).

 

Required:

 

Discuss the accounting treatment of the two factoring arrangements.

 

 

Test your understanding 14 – Case

 

Case holds equity investments at fair value through profit or loss. Due to short-term cash flow shortages, Case sold some equity investments for $5 million when the carrying amount was $4 million. The terms of the disposal state that Case has the right to repurchase the shares at any point over the next two years at their fair value on the repurchase date. Case has not derecognised the investment because its directors believe that a repurchase is highly likely.

 

Required:

 

Advise the directors of Case as to the acceptability of the above accounting treatment.

 

Test your understanding 15 – Jones

 

Jones bought an investment in equity shares for $40 million plus associated transaction costs of $1 million. The asset was designated upon initial recognition as fair value through other comprehensive income. At the reporting date the fair value of the financial asset had risen to $60 million. Shortly after the reporting date the financial asset was sold for $70 million.

 

Required:

 

  • How should the investment be accounted for?

 

  • How would the answer have been different if the investment had been classified to be measured at fair value through profit and loss?

 

 

  • Derivatives

 

Definitions

 

IFRS 9 says that a derivative is a financial instrument with the following characteristics:

 

  • Its value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index or similar variable (called the ‘underlying’).

 

  • It requires little or no initial net investment relative to other types of contract that have a similar response to changes in market conditions.

 

  • It is settled at a future date.

 

 

The problems of derivatives

 

Derivatives were originally designed to hedge against fluctuations in agricultural commodity prices on the Chicago Stock Exchange. A speculator would pay a small amount (say $100) now for the contractual obligation to buy a thousand units of wheat in three months’ time for $10,000. If in three months’ time one thousand units of wheat costs $11,000, then the speculator would make a profit of $900 (11,000 – 100

 

– 10,000). This would be a 900% return on the original investment over 3 months. But if the price had dropped to $9,000, then the trader would have made a loss of $1,100 (100 + 1,000) despite the initial investment only having been $100.

 

This shows that losses on derivatives can be far greater than their historical cost. Therefore, it is important that derivatives are recognised and disclosed in the financial statements as they have very little initial outlay yet expose the entity to significant gains and losses.

 

 

 

Typical derivatives

 

Derivatives include the following types of contracts:

 

Forward contracts

 

  • The holder of a forward contract is obliged to buy or sell a defined amount of a specific underlying asset, at a specified price at a specified future date.

 

  • For example, a forward contract for foreign currency might require £100,000 to be exchanged for $150,000 in three months’ time. Both parties to the contract have both a financial asset and a financial liability. For example, one party has the right to receive $150,000 and the obligation to pay £100,000.

 

  • Forward currency contracts may be used to minimise the risk on amounts receivable or payable in foreign currencies.

 

Forward rate agreements

 

  • Forward rate agreements can be used to fix the interest charge on a floating rate loan.

 

  • For example, an entity has a $1m floating rate loan, and the current rate of interest is 7%. The rates are reset to the market rate every six months, and the entity cannot afford to pay more than 9% interest. The entity enters into a six-month forward rate agreement (with, say, a bank) at 9% on $1m. If the market rates go up to 10%, then the bank will pay them $5,000 (1% of $1m for 6 months) which in effect reduces their finance cost to 9%. If the rates only go up to 8% then the entity pays the bank $5,000. The forward rate agreement effectively fixes the interest rate payable at 9% for the period.

 

 

Futures contracts

 

  • Futures contracts oblige the holder to buy or sell a standard quantity of a specific underlying item at a specified future date.

 

  • Futures contracts are very similar to forward contracts. The difference is that futures contracts have standard terms and are traded on a financial exchange, whereas forward contracts are tailor-made and are not traded on a financial exchange. Also, whilst forward contracts will always be settled, a futures contract will rarely be held to maturity.

 

Swaps

 

  • Two parties agree to exchange periodic payments at specified intervals over a specified time period.

 

  • For example, in an interest rate swap, the parties may agree to exchange fixed and floating rate interest payments calculated by reference to a notional principal amount.

 

  • This enables companies to keep a balance between their fixed and floating rate interest payments without having to change the underlying loans.

 

Options

 

  • These give the holder the right, but not the obligation, to buy or sell a specific underlying asset on or before a specified future date.

 

 

 

A contract to buy or sell a non-financial item (such as inventory or property, plant and equipment) is only a derivative if:

 

  • it can be settled net in cash (or using another financial asset), and

 

  • the contract was not entered into for the purpose of receipt or delivery of the item to meet the entity’s operating requirements.

 

Derivatives and net settlement

 

IFRS 9 says that a contract to buy or sell a non-financial item is considered to be settled net in cash when:

 

  • the terms of the contract permit either party to settle the contract net

 

  • the entity has a practice of settling similar contracts net

 

  • the entity, for similar contracts, has a practice of taking delivery of the item and then quickly selling it in order to benefit from fair value changes

 

  • the non-financial item is readily convertible to cash.

 

 

 

If the contract is not a derivative then it is a simple executory contract (a contract where neither party has yet performed its obligations). Such contracts are not normally accounted for until the sale or purchase date.

 

Measurement of derivatives

 

On initial recognition, derivatives should be measured at fair value.

 

Transaction costs are expensed to the statement of profit or loss.

 

At the reporting date, derivatives are remeasured to fair value. Movements in fair value are recognised in profit or loss.

 

Accounting for derivatives

 

Entity A has a reporting date of 30 September. It enters into an option on 1 June 20X5, to purchase 10,000 shares in another entity on 1 November 20X5 for $10 per share. The purchase price of each option is $1. This is recorded as follows:

 

Debit Option (10,000 × $1) $10,000
Credit Cash $10,000

 

By 30 September the fair value of each option has increased to $1.30.

 

This increase is recorded as follows:

 

Debit Option (10,000 × ($1.30 – 1)) $3,000
Credit Profit or loss $3,000

 

On 1 November, the fair value per option increases to $1.50. The share price on the same date is $11.50. A exercises the option on 1 November and the shares are classified at fair value through profit or loss. Financial assets are recognised at their fair value so the shares are initially measured at $115,000 (10,000 × $11.50):

 

Debit Investment in shares (at fair value) $115,000
Credit Cash (10,000 × $10) $100,000
Credit Option ($10,000 + $3,000) $13,000
Credit Profit or loss (gain on option) $2,000

 

 

 

Test your understanding 16 – Hoggard

 

Hoggard buys 100 options on 1 January 20X6 for $5 per option. Each option gives Hoggard the right to buy a share in Rowling on 31 December 20X6 for $10 per share.

 

Required:

 

How should this be accounted for, given the following outcomes?

 

  • The options are sold on 1 July 20X6 for $15 each.

 

  • On 31 December 20X6, Rowling’s share price is $8 and Hoggard lets the option lapse unexercised.

 

  • The option is exercised on 31 December when Rowling’s share price is $25. The shares are classified as held for trading.

 

 

 

Embedded derivatives

 

An embedded derivative is a ‘component of a hybrid contract that also includes a non-derivative host, with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative’ (IFRS 9, para 4.3.3).

 

With regards to the accounting treatment of an embedded derivative, if the host contract is within the scope of IFRS 9 then the entire contract must be classified and measured in accordance with that standard.

 

If the host contract is not within the scope of IFRS 9 (i.e. it is not a financial asset or liability), then the embedded derivative can be separated out and measured at fair value through profit or loss if:

 

  • ‘the economic risks and characteristics of the embedded derivative are not closely related to those of the host contract
  • a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative, and

 

  • the entire instrument is not measured at fair value with changes in fair value recognised in profit or loss’ (IFRS 9, para 3.3).

 

Because of the complexity involved in splitting out and measuring an embedded derivative, IFRS 9 permits a hybrid contract where the host element is outside the scope of IFRS 9 to be measured at fair value through profit or loss in its entirety.

 

Therefore, for the vast majority of embedded derivatives, the whole contract will simply be measured at fair value through profit or loss.

 

Embedded derivatives: an example

 

An entity has an investment in a convertible bond, which can be converted into a fixed number of equity shares at a specified future date. The bond is a non-derivative host contract and the option to convert to shares is therefore a derivative element.

 

The host contract, the bond, is a financial liability and so is within the scope of IFRS 9. This means that the rules of IFRS 9 must be applied to the entire contract.

 

The bond would fail the contractual cash flow characteristics test and therefore the entire contract should be measured at fair value through profit or loss.

 

11 Hedge accounting

 

 

The need for hedge accounting

 

An entity has inventories of gold that cost $8m and whose value has increased to $10m. The entity is worried that the fair value of this inventory will fall, so it enters into a futures contract on 1 October 20X1 to sell the inventory for $10m in 6 months’ time.

 

By the reporting date, the fair value of the inventory had fallen by $1m to $9m. There was a $1m increase in the fair value of the derivative.

 

In accordance with IFRS 9, the $1m gain on the derivative will be recognised through profit or loss:

 

Dr Derivative                                                                                                                    $1m

 

Cr Profit or loss                                                                                                               $1m

 

In accordance with IAS 2, the $1m decline in the inventory’s fair value will not be recognised because inventories are measured at the lower of cost ($8m) and NRV ($9m, assuming no selling costs).

 

The derivative has created volatility in profit or loss. However, if the entity had chosen to apply hedge accounting, this volatility would have been eliminated. This section of the text will outline the criteria for, and accounting treatment of, hedge accounting in more detail.

 

Definitions

 

Hedge accounting 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, by the change in fair value or cash flows of a hedged item.

 

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). There are 3 types of hedged item:

 

  • A recognised asset or liability

 

  • An unrecognised firm commitment – a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date

 

  • A highly probable forecast transaction – an uncommitted but anticipated future transaction.

 

A hedging instrument is a designated derivative, or a non-derivative financial asset or financial liability, whose fair value or cash flows are expected to offset changes in fair value or future cash flows of the hedged item.

 

Types of hedge accounting

 

IFRS 9 identifies three types of hedge. Two of these are within the P2 syllabus:

 

  • ‘Fair value hedge: a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment that is attributable to a particular risk and could affect profit or loss (or other comprehensive income for equity investments measured at fair value through other comprehensive income).

 

  • Cash flow hedge: a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability or a highly probable forecast transaction and that could affect profit or loss’ (IFRS 9, para 6.5.2).

 

 

 

Criteria for hedge accounting

 

Under IFRS 9, hedge accounting rules can only be applied if the hedging relationship meets the following criteria:

 

  • The hedging relationship consists only of eligible hedging instruments and hedged items.

 

  • At the inception of the hedge there must be formal documentation identifying the hedged item and the hedging instrument.

 

  • The hedging relationship meets all effectiveness requirements (see latter section for more details).

 

Accounting treatment of a fair value hedge

 

At the reporting date:

 

  • The hedging instrument will be remeasured to fair value.

 

  • The carrying amount of the hedged item will be adjusted for the change in fair value since the inception of the hedge.

 

The gain (or loss) on the hedging instrument and the loss (or gain) on the hedged item will be recorded:

 

  • in profit or loss in most cases, but

 

  • in other comprehensive income if the hedged item is an investment in equity that is measured at fair value through other comprehensive income.

 

Simple fair value hedge

 

An entity has inventories of gold that cost $8m but whose value has increased to $10m. The entity is worried that the fair value of this inventory will fall, so it enters into a futures contract on 1 October 20X1 to sell the inventory for $10m in 6 months’ time. This was designated as a fair value hedge.

 

By the reporting date of 31 December 20X1, the fair value of the inventory had fallen from $10m to $9m. There was a $1m increase in the fair value of the derivative.

 

The entity believes that all effectiveness criteria have been met.

 

Under a fair value hedge, the movement in the fair value of the item and instrument since the inception of the hedge are accounted for. The gains and losses will be recorded in profit or loss.

 

The $1m gain on the future and the $1m loss on the inventory will be accounted for as follows:

 

Dr Derivative                                                                                                                    $1m

 

Cr Profit or loss                                                                                                               $1m

 

Dr Profit or loss                                                                                                               $1m

 

Cr Inventory                                                                                                                      $1m

 

By applying hedge accounting, the profit impact of remeasuring the derivative to fair value has been offset by the movement in the fair value of the inventory. Volatility has, in this example, been eliminated.

 

Note that the inventory will now be held at $7m (cost of $8m – $1m fair value decline). This is neither cost nor NRV. The normal accounting treatment of inventory has been changed by applying hedge accounting rules.

 

Test your understanding 17 – Fair value hedge

 

On 1 January 20X8 an entity purchased equity instruments for their fair value of $900,000. They were designated upon initial recognition to be classified as fair value through other comprehensive income.

 

At 30 September 20X8, the equity instrument was still worth $900,000 but the entity became worried about the risk of a decline in value. It therefore entered into a futures contract to sell the shares for $900,000 in six months’ time. It identified the futures contract as a hedging instrument as part of a fair value hedging arrangement. The fair value hedge was correctly documented and designated upon initial recognition. All effectiveness criteria have been complied with.

 

By the reporting date of 31 December 20X8, the fair value of the equity instrument had fallen to $800,000, and the fair value of the futures contract had risen by $90,000.

 

Required:

 

Explain the accounting treatment of the fair value hedge arrangement based upon the available information.

 

Test your understanding 18 – Firm commitments

 

Chive has a firm commitment to buy an item of machinery for CU2m on 31 March 20X2. The Directors are worried about the risk of exchange rate fluctuations.

 

On 1 October 20X1, when the exchange rate is CU2:$1, Chive enters into a futures contract to buy CU2m for $1m on 31 March 20X2.

 

At 31 December 20X1, CU2m would cost $1,100,000. The fair value of the futures contract has risen to $95,000. All effectiveness criteria have been complied with.

 

Required:

 

Explain the accounting treatment of the above in the financial statements for the year ended 31 December 20X1 if:

 

  • Hedge accounting was not used.

 

  • On 1 October 20X1, the futures contract was designated as a fair value hedge of the movements in the fair value of the firm commitment to purchase the machine.

 

Accounting treatment of a cash flow hedge

 

For cash flow hedges, the hedging instrument will be remeasured to fair value at the reporting date. The gain or loss is recognised in other comprehensive income.

 

However, if the gain or loss on the hedging instrument since the inception of

 

the hedge is greater than the loss or gain on the hedged item then the excess gain or loss on the instrument must be recognised in profit or loss.

 

Test your understanding 19 – Cash flow hedge

 

A company enters into a derivative contract in order to protect its future cash inflows relating to a recognised financial asset. At inception, when the fair value of the hedging instrument was nil, the relationship was documented as a cash flow hedge.

 

By the reporting date, the loss in respect of the future cash flows amounted to $9,100 in fair value terms. It has been determined that the hedging relationship meets all effectiveness criteria.

 

Required:

 

Explain the accounting treatment of the cash flow hedge if the fair value of the hedging instrument at the reporting date is:

 

  • $8,500

 

  • $10,000.

 

  • If the hedged item eventually results in the recognition of a financial asset or a financial liability, the gains or losses that were recognised in equity shall be reclassified to profit or loss as a reclassification adjustment in the same period during which the hedged forecast cash flows affect profit or loss (e.g. in the period when the hedged forecast sale occurs).

 

  • 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 adjusted against the carrying amount of the non-financial asset/liability. This is not a reclassification adjustment and therefore it does not affect other comprehensive income.

 

Test your understanding 20 – Bling

 

On 31 October 20X1, Bling had inventories of gold which cost $6.4m to buy and which could be sold for $7.7m. The management of Bling are concerned about the risk of fluctuations in future cash inflows from the sale of this gold.

 

To mitigate this risk, Bling entered into a futures contract on 31 October 20X1 to sell the gold for $7.7m. The contracts mature on 31 March 20X2. The hedging relationship was designated and documented at inception as a cash flow hedge. All effectiveness criteria are complied with.

 

On 31 December 20X1, the fair value of the gold was $8.6m. The fair value of the futures contract had fallen by $0.9m.

 

There is no change in fair value of the gold and the futures contract between 31 December 20X1 and 31 March 20X2. On 31 March 20X2, the inventory is sold for its fair value and the futures contract is settled net with the bank.

 

Required:

 

  • Discuss the accounting treatment of the hedge in the year ended 31 December 20X1.

 

  • Outline the accounting treatment of the inventory sale and the futures contract settlement on 31 March 20X2.

 

 

Test your understanding 21 – Grayton

 

In January, Grayton, whose functional currency is the dollar ($), decided that it was highly probable that it would buy an item of plant in one year’s time for KR 200,000. As a result of being risk averse, it wished to hedge the risk that the cost of buying KRs would rise and so entered into a forward rate agreement to buy KR 200,000 in one year’s time for the fixed sum of $100,000. The fair value of this contract at inception was zero and it was designated as a hedging instrument.

 

At Grayton’s reporting date of 31 July, the KR had depreciated and the value of KR 200,000 was $90,000. The fair value of the derivative had declined by $10,000. These values remained unchanged until the plant was purchased.

 

Required:

 

How should this be accounted for?

 

Hedge effectiveness

 

Hedge accounting can only be used if the hedging relationship meets all effectiveness requirements. In the examples so far, it has been assumed that this is the case.

 

According to IFRS 9, an entity must assess at the inception of the hedging relationship, and at each reporting date, whether a hedging relationship

 

meets the hedge effectiveness requirements. The assessment should be forward-looking.

 

The hedge effectiveness requirements are as follows

 

  • ‘There must be an economic relationship between the hedged item and the hedging instrument’ (IFRS 9, para 6.4.1).

 

– For example, if the price of a share falls below $10, the fair value of a futures contract to sell the share for $10 rises.

 

  • ‘The effect of credit risk does not dominate the value changes that result from that economic relationship’ (IFRS 9, para 6.4.1).

 

– Credit risk may lead to erratic fair value movements in either the hedged item or the hedging instrument. For example, if the counterparty of a derivative experiences a decline in credit worthiness, the fair value of the derivative (the hedging instrument) may fall substantially. This movement is unrelated to changes in the fair value of the item and would lead to hedge ineffectiveness.

 

  • ‘The hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item’ (IFRS 9, para 6.4.1).

 

Hedge ratios – example 1

 

An entity owns 120,000 gallons of oil. It enters into 1 futures contract to sell 40,000 gallons of oil at a fixed price.

 

It wishes to designate this as a fair value hedge, with 120,000 gallons of oil as the hedged item and the futures contract as the hedging instrument. If deemed effective, this would mean that the fair value gain or loss on the hedged item (the oil) and the fair value loss or gain on the hedging instrument (the futures contract) would be recorded and recognised in profit or loss.

 

However, the hedge ratio means that the gain or loss on the item would probably be much bigger than the loss or gain on the instrument. This would create volatility in profit or loss that is at odds with the purpose of hedge accounting. Therefore, the hedge ratio must be adjusted to avoid the imbalance.

 

It may be that the hedged item should be designated as 40,000 gallons of oil, with the hedging instrument as 1 futures contract. The other 80,000 gallons of oil would be accounted for in accordance with normal accounting rules (IAS 2 Inventories).

 

 

 

Hedge ratios – example 2

 

In deciding whether the hedge ratio is appropriate, an entity should consider if there is a commercial reason for any imbalance between the quantity of the designated item and the quantity of the designated instrument.

 

Example

 

An entity wishes to fix the purchase price of 100 tonnes of coffee. Coffee futures contracts are denominated in Llbs (pounds).These contracts are traded in standard amounts, and therefore it is not possible to hedge 100 tonnes exactly. Five contracts would hedge the equivalent of 85 tonnes of coffee whilst six contracts would hedge the equivalent of 102.1 tonnes of coffee.

 

Although this is an imbalance that will lead to ineffectiveness (the movements on the item and instrument will most likely not offset), there is a commercial reason for this that is not at odds with the aim of hedge accounting. Therefore, the hedging ratio should not be adjusted.

 

Assuming that the entity enters into five futures contracts, then the hedged ratio is 20 tonnes of coffee to 1 contract:

 

  • If the item is designated as the purchase of 100 tonnes of coffee, then the hedging instrument should be designated as five futures contracts.

 

  • If the item is designated as the purchase of 60 tonnes of coffee, then the hedging instrument should be designated as three futures contracts. The other two futures contracts will be accounted for as derivatives in the usual way (fair value through profit or loss).

 

12 Discontinuing hedge accounting

 

 

Discontinuance

 

An entity must cease hedge accounting if any of the following occur:

 

  • The hedging instrument expires or is exercised, sold or terminated.

 

  • The hedge no longer meets the hedging criteria.

 

  • A forecast future transaction that qualified as a hedged item is no longer highly probable.

 

The discontinuance should be accounted for prospectively (entries posted to date are not reversed).

 

Upon discontinuing a cash flow hedge, the treatment of the accumulated gains or losses on the hedging instrument within reserves depends on the reason for the discontinuation. IFRS 9 says:

 

  • If the forecast transaction is no longer expected to occur, gains and losses recognised in other comprehensive income must be taken to profit or loss immediately.

 

  • If the transaction is still expected to occur, the gains and losses will be retained in equity until the former hedged transaction occurs.

 

 

 

13 Disclosure of financial instruments

 

IFRS 7 provides the disclosure requirements for financial instruments.

 

The main disclosures required are:

 

  • Information about the significance of financial instruments for an entity’s financial position and performance.

 

  • Information about the nature and extent of risks arising from financial instruments.

 

Financial instruments

 

IFRS 7 Disclosures

 

Significance of financial instruments

 

  • An entity must disclose the significance of financial instruments for their financial position and performance. The disclosures must be made for each class of financial instruments.

 

  • An entity must disclose items of income, expense, gains, and losses, with separate disclosure of gains and losses from each class of financial instrument.

 

Nature and extent of risks arising from financial instruments

 

Qualitative disclosures

 

The qualitative disclosures describe:

 

  • risk exposures for each type of financial instrument

 

  • management’s objectives, policies, and processes for managing those risks

 

  • changes from the prior period.

 

Quantitative disclosures

 

The quantitative disclosures provide information about the extent to which the entity is exposed to risk, based on information provided internally to the entity’s key management personnel. These disclosures include:

 

  • summary quantitative data about exposure to each risk at the reporting date

 

  • disclosures about credit risk, liquidity risk, and market risk as further described below

 

  • concentrations of risk.

 

The key types of risk are outlined below.

 

Types of risk

 

There are four types of financial risk:

 

  • Market risk – This refers to the possibility that the value of an asset (or burden of a liability) might go up or down. Market risk includes three types of risk: currency risk, interest rate risk and price risk.

 

  • Currency risk is the risk that the value of a financial instrument will fluctuate because of changes in foreign exchange rates.

 

  • Fair value interest rate risk is the risk that the value of a financial instrument will fluctuate due to changes in market interest rates. This is a common problem with fixed interest rate bonds. The price of these bonds goes up and down as interest rates go down and up.

 

  • Price risk refers to other factors affecting price changes. These can be specific to the enterprise (bad financial results will cause a share price to fall), relate to the sector as a whole (all Tech-Stocks boomed in the late nineties, and crashed in the new century) or relate to the type of security (bonds do well when shares are doing badly, and vice versa).

 

Market risk embodies not only the potential for a loss to be made but also a gain to be made.

 

  • Credit risk – The risk that one party to a financial instrument fails to discharge its obligations, causing a financial loss to the other party. For example, a bank is exposed to credit risk on its loans, because a borrower might default on its loan.

 

  • Liquidity risk – This is also referred to as funding risk. This is the risk that an enterprise will be unable to meet its commitments on its financial instruments. For example, a business may be unable to repay its loans when they fall due.

 

  • Cash flow interest rate risk – This is the risk that future cash flows associated with a monetary financial instrument will fluctuate in amount due to changes in market interest rates. For example, the cash paid (or received) on floating rate loans will fluctuate in line with market interest rates.

Test your understanding answers

 

 

Test your understanding 1 – Liabilities or equity?

 

1m preference shares

 

IAS 32 states that a financial liability is any contract that may be settled in the entity’s own equity instruments and is a non-derivative for which the entity is obliged to deliver a variable number of its own equity instruments.

 

Therefore, a contract that requires the entity to deliver as many of the entity’s own equity instruments as are equal in value to a certain amount should be treated as debt.

 

Coasters must redeem the first set of preference shares by issuing ordinary shares equal to the value of $3 million. The $3 million received from the preference share issue should be classified as a liability on the statement of financial position.

 

2m preference shares

 

A contract that will be settled by the entity receiving (or delivering) a fixed number of its own equity instruments in exchange for a fixed amount of cash or another financial asset is an equity instrument.

 

Coasters will redeem the second preference share issue with a fixed number of ordinary shares. Therefore, the $5.6 million from the second preference share issue should be classified as equity in the statement of financial position.

 

4m preference shares

 

A financial liability exists if there is an obligation to deliver cash or another financial asset.

 

There is no obligation for Coasters to repay the instrument.

 

Dividends are only payable if they are also paid on ordinary shares. There is no obligation to pay dividends on ordinary shares so there is no obligation to pay dividends on these preference shares.

 

The instrument is not a financial liability. The proceeds from the preference share issue should therefore be classified as equity in the statement of financial position.

 

Test your understanding 2 – Hoy

 

Hoy has a financial liability to be measured at amortised cost.

 

The financial liability is initially recorded at the fair value of the consideration received (the net proceeds of issue). This amount is then increased each year by interest at the effective rate and reduced by the actual repayments.

 

Hoy has no issue costs, so the net proceeds of issue were $9,500

 

($10,000 less 5%). The annual cash payment is $200 (the 2% coupon rate multiplied by the $10,000 nominal value of the debt).

 

Bal b/fwd Finance Cash paid Bal c/fwd
costs (10%)
Rep date $ $ $ $
31 Dec X1 9,500 950 (200) 10,250
31 Dec X2 10,250 1,025 (200)
––––– (11,075)
1,975
–––––

 

Wiggins has a liability that will be classified and accounted for at amortised cost and thus initially measured at the fair value of consideration received less the transaction costs:

 

$
Cash received ($20,000 × 90%) 18,000
Less the transaction costs (1,000)
–––––
Initial recognition 17,000
–––––

 

The effective rate is used to determine the finance cost for the year – this is charged to profit or loss. The coupon rate is applied to the nominal value of the loan notes to determine the cash paid to the holder of the loan notes:

 

Bal b/fwd Finance Cash paid Bal c/fwd
costs (12%)
Rep date $ $ $ $
31 Dec X4 17,000 2,040 (1,200) 17,840
31 Dec X5 17,840 2,141 (1,200) 18,781
31 Dec X6 18,781 2,254 (1,200) 19,835
31 Dec X7 19,835 2,380 (1,200)
––––– (21,015)
8,815
–––––

 

Cavendish has a financial liability to be measured at amortised cost.

 

It is initially recorded at the fair value of the consideration received. There is no discount on issue, nor is there any issue costs to deduct from the initial measurement.

 

The opening balance is increased each year by interest at the effective rate. The liability is reduced by the cash repayments – there are no interest repayments in this example because it is a zero rate bond.

 

Bal b/fwd Finance Cash paid Bal c/fwd
costs (7%)
Rep date $ $ $ $
31 Dec X5 10,000 700 Nil 10,700
31 Dec X6 10,700 749 (11,449)

 

Test your understanding 3 – Bean

 

When a financial liability is designated to be measured at fair value through profit or loss to reduce an accounting mis-match, the fair value movement must be split into:

 

  • fair value movement due to own credit risk, which is presented in other comprehensive income (OCI)

 

  • the remaining fair value movement, which is presented in profit or loss.

 

The value of Bean’s liability will be reduced by $30 million. A credit of $10 million will be recorded in OCI and a credit of $20 million will be recorded in profit or loss.

 

 

 

Test your understanding 4 – Craig

 

Up to 31 December 20X8, the accounting entries are the same under both scenarios.

 

  • 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. 8%.

 

Date Cash Discount Present
flow factor value
(8%)
$ $
31/12/X6 Interest 4,000 1/1.08 3,704
31/12/X7 Interest 4,000 1/1.082 3,429
31/12/X8 Interest and 104,000 1/1.083 82,559
principal
––––––
Liability component A 89,692
Net proceeds of issue were B 100,000
Equity component B – A 10,308

 

 

  • The annual finance costs and year end carrying amounts
Opening Finance cost Cash paid Closing
balance (8%) balance
$ $ $ $
X6 89,692 7,175 (4,000) 92,867
X7 92,867 7,429 (4,000) 96,296
X8 96,296 7,704 (4,000) 100,000

 

(3) (a) Conversion

 

The carrying amounts at 31 December 20X8 are:

 

$

 

Equity                                                                                                           10,308

 

Liability – bond                                                                                     100,000

 

–––––––

 

110,308

 

–––––––

 

If the conversion rights are exercised, then 50,000 ($100,000 ÷

 

  • equity shares of $1 are issued and $60,308 is classified as share premium.

 

  • Redemption

 

The carrying amounts at 31 December 20X8 are the same as under 3a. On redemption, the $100,000 liability is extinguished by cash payments. The equity component remains within equity, probably as a non-distributable reserve.

 

Test your understanding 5 – Ashes’ financial assets

 

  • Investments in equity held for short-term speculative purposes must be classified and accounted for as fair value through profit or loss. Such assets are initially recognised at fair value. Any transaction costs are expensed to profit or loss. The assets are remeasured to fair value at the reporting date with the gains and losses on remeasurement recognised in profit or loss.

 

  • Investments in equity that, from the outset, are going to be held indefinitely may be irrevocably designated upon initial recognition as fair value through other comprehensive income. Such assets are initially recognised at fair value plus transaction costs. They are remeasured to fair value at the reporting date and gains and losses on remeasurement are recognised in other comprehensive income. If no such election on purchase is made then the investment must be classified and accounted for as fair value through profit or loss (see

 

(1) above).

 

 

Test your understanding 6 – Paloma

 

A debt instrument can be held at amortised cost if

 

 

  • the entity intends to hold the financial asset to collect contractual cash flows, rather than selling it to realise fair value changes.

 

  • the contractual cash flows of the asset are solely payments of principal and interest based upon the principal amount outstanding.

 

Paloma’s objective is to hold the financial assets and collect the contractual cash flows. Making some sales when cash flow deteriorates does not contradict that objective.

 

The bond pays a market level of interest, and therefore the interest payments received provide adequate compensation for the time value of money or the credit risk associated with the principal amount outstanding.

 

This means that the asset can be measured at amortised cost.

 

Test your understanding 7 – Tokyo

 

  • The business model is to hold the asset until redemption. Therefore, the debt instrument will be measured at amortised cost.

 

The asset is initially recognised at its fair value plus transaction costs of $97,000 ($95,000 + $2,000).

 

Interest income will be recognised in profit or loss using the effective rate of interest.

 

Bfd Interest (8%) Receipt Cfd
$ $ $ $
y/e 31/12/X1 97,000 7,760 (5,000) 99,760
y/e 31/12/X2 99,760 7,981 (5,000) 102,741
y/e 31/12/X3 102,741 8,219 (5,000) nil
(105,960)

 

In the year ended 31 December 20X1, interest income of $7,760 will be recognised in profit or loss and the asset will be held at $99,760 on the statement of financial position.

 

In the year ended 31 December 20X2, interest income of $7,981 will be recognised in profit or loss and the asset will be held at $102,741 on the statement of financial position.

 

In the year ended 31 December 20X3, interest income of $8,219 will be recognised in profit or loss.

 

  • The business model is to hold the asset until redemption, but sales may be made to invest in other assets will higher returns. Therefore, the debt instrument will be measured at fair value through other comprehensive income.

 

The asset is initially recognised at its fair value plus transaction costs of $97,000 ($95,000 + $2,000).

 

Interest income will be recognised in profit or loss using the effective rate of interest.

 

The asset must be revalued to fair value at the year end. The gain will be recorded in other comprehensive income.

Bfd Interest Receipt Total Gain/ Cfd
(per (a)) (loss)
$ $ $ $ $ $
y/e 97,000 7,760 (5,000) 99,760 10,240110,000
31/12/X1 110,000 7,981 (5,000) 112,981 (8,981) 104,000
y/e
31/12/X2 104,000 8,219 (5,000) 1,259 (1,259) nil
y/e
31/12/X3 (105,960)

 

Note that the amounts recognised in profit or loss as interest income must be the same as if the asset was simply held at amortised cost. Therefore, the interest income figures are the same as in part (a).

 

In the year ended 31 December 20X1, interest income of $7,760 will be recognised in profit or loss and a revaluation gain of $10,240 will be recognised in other comprehensive income. The asset will be held at $110,000 on the statement of financial position.

 

In the year ended 31 December 20X2, interest income of $7,981 will be recognised in profit or loss and a revaluation loss of $8,981 will be recognised in other comprehensive income. The asset will be held at $104,000 on the statement of financial position.

 

In the year ended 31 December 20X3, interest income of $8,219 will be recognised in profit or loss and a revaluation loss of $1,259 will be recognised in other comprehensive income.

 

  • The bond would be classified as fair value through profit or loss.

 

The asset is initially recognised at its fair value of $95,000. The transaction costs of $2,000 would be expensed to profit or loss.

 

In the year ended 31/12/X1, interest income of $5,000 ($100,000 × 5%) would be recognised in profit or loss. The asset would be revalued to $110,000 with a gain of $15,000 ($110,000 – $95,000) recognised in profit or loss.

 

On 1/1/X2, the cash proceeds of $110,000 would be recognised and the financial asset would be derecognised.

 

Test your understanding 8 – Magpie

 

The loan is a financial asset because Magpie has a contractual right to receive cash in two years’ time.

 

Financial assets are initially recognised at fair value. Fair value is the price paid in an orderly transaction between market participants at the measurement date.

 

Market participants would receive 8% interest on loans of this type, whereas the loan made to the supplier is interest-free. It would seem that the transaction has not occurred on fair value terms.

 

The financial asset will not be recognised at the price paid of $2 million as this is not the fair value. Instead, the fair value must be determined. This can be achieved by calculating the present value of the future cash flows from the loan (discounted using a market rate of interest).

 

The financial asset will therefore be initially recognised at $1.71 million ($2m × 1/1.082). The entry required to record this is as follows:

 

Dr Financial asset $1.71m
Dr Profit or loss $0.29m
Cr Cash $2.00m

 

The financial asset is subsequently measured at amortised cost:

 

1 Jan X1 Interest (8%) Receipt 31 Dec X1
$m $m $m $m
y/e 31/12/X1 1.71 0.14 1.85

 

Interest income of $0.14 million is recorded by posting the following:

 

Dr Financial asset $0.14m
Cr Profit or loss $0.14m

 

The loan is interest-free, so no cash is received during the period.

 

The financial asset will have a carrying amount of $1.85 million as at 31 December 20X1.

 

By 31 December 20X2, the financial asset will have a carrying amount of $2 million. This amount will then be repaid by the supplier.

 

Test you understanding 9 – Tahoe

 

Using available information, Tahoe needs to assess whether the credit risk on the bond has increased significantly since inception.

 

It would seem that San Fran’s performance has declined and this may have an impact on its liquidity.

 

The review of San Fran’s credit rating by external agencies is suggestive of wider concerns about the performance and position of San Fran.

 

The fact that market bond prices are static suggests that the decline in San Fran’s bond price is entity specific. This is likely to be a response to San Fran’s increased credit risk.

 

Based on the above, it would seem that the credit risk of the bond is no longer low. As a result, it can be concluded that credit risk has increased significantly since inception.

 

This means that Tahoe must recognise a loss allowance equal to lifetime expected credit losses on the bond.

 

 

 

Test your understanding 10 – Napa

 

The credit risk on the financial asset has not significantly increased. Therefore, a loss allowance should be made equal to 12-month expected credit losses. The loss allowance should factor in a range of possible outcomes, as well as the time value of money.

 

The credit loss on the asset is $586,777 (W1). This represents the present value of the difference between the contractual cash flows and the expected receipts if a default occurs.

 

The expected credit loss is $2,934 ($586,777 credit loss × 0.5% probability of occurrence). A loss allowance of $2,934 will be created and an impairment loss of $2,934 will be charged to profit or loss in the year ended 31 December 20X1.

 

The net carrying amount of the financial asset on the statement of financial position is $997,066 ($1,000,000 – $2,934).

 

Note: Interest in future periods will continue to be charged on the asset’s gross carrying amount of $1,000,000.

 

Date of receiptExpected cash shortfallDiscount ratePresent value

 

$ $
31/12/X2 100,000 1/1.1 90,909
31/12/X3 100,000 1/1.12 82,645
31/12/X3 500,000 1/1.12 413,223

–––––––

 

586,777

 

––––––

Test your understanding 11 – Eve

 

Evidence about the significant financial difficulties of Fern mean that the asset is now credit impaired.

 

Expected losses on credit impaired assets are calculated as the difference between the asset’s gross carrying amount and the present value of the expected future cash flows discounted using the original effective rate of interest.

 

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

 

The present value of the future cash flows discounted using the original effective rate is $5,660 ($6,000 × 1/1.06).

 

The expected losses are therefore $4,340 ($10,000 – $5,660) and so a loss allowance should be recognised for this amount. Therefore, the existing loss allowance must be increased by $3,340 ($4,340 – $1,000) with an expense charged to profit or loss.

 

The asset is credit impaired and so interest income will now be calculated on the net carrying amount of $5,660 (the gross amount of $10,000 less the loss allowance of $4,340). Consequently, in the last year of the loan, interest income of $340 (5,660 × 6%) will be recognised in profit or loss.

 

Test your understanding 12 – FVOCI and expected losses

 

A loss of $50 ($1,000 – $950) arising on the revaluation of the asset to fair value will be recognised in other comprehensive income.

 

Dr OCI $50
Cr Financial asset $50

 

The 12-month expected credit losses of $30 will be debited to profit or loss. The credit entry is not recorded against the carrying amount of the asset but rather against other comprehensive income:

 

Dr Impairment loss (P/L) $30
Cr OCI $30

 

There is therefore a cumulative loss in OCI of $20 (the fair value change of $50 offset by the impairment amount of $30).

 

 

 

Test your understanding 13 – Ming

 

The principle at stake with derecognition or otherwise of receivables is whether, under the factoring arrangement, the risks and rewards of ownership pass from Ming to the factor. The key 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 Ming to the factoring bank.

 

Accordingly Ming should derecognise the receivable and there will be an expense of $20,000 recognised.

 

In the second arrangement the $70,000 is simply a payment on account. More may be received by Ming implying that Ming 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 Ming who is liable to repay the monies so far received. Despite the passage of legal title the receivable should remain recognised in the accounts of Ming. In substance Ming has borrowed $70,000 and this loan should be recognised immediately. This will increase the gearing of Ming.

 

Test your understanding 14 – Case

 

An entity has transferred a financial asset if it has transferred the contractual rights to receive the cash flows of the asset.

 

IFRS 9 says that if an entity has transferred a financial asset, it must evaluate the extent to which it has retained the significant risks and rewards of ownership. If the entity transfers substantially all the risks and rewards of ownership, the entity must derecognise the financial asset.

 

Gains and losses on the disposal of a financial asset are recognised in the statement of profit or loss.

 

Case is under no obligation to buy back the shares and is therefore protected from future share price declines. Moreover, If Case does repurchase the shares, this will be at fair value rather than a pre-fixed price and therefore Case does not retain the risks and rewards related to price fluctuations.

 

The risks and rewards of ownership have been transferred and, as such, Case should derecognise the financial asset. A profit of $1m ($5m – $4m) should be recognised in profit or loss.

 

 

 

Test your understanding 15 – Jones

 

  • On purchase the investment is recorded at the consideration paid. The asset is classified as fair value through other comprehensive income and, as such, transaction costs are included in the initial value:

 

Dr Asset 41m
Cr Cash 41m

 

At the reporting date the asset is remeasured to fair value and the gain of $19m ($60m – $41m) is recognised in other comprehensive income and taken to equity:

 

Dr Asset 19m
Cr Other components of equity 19m

 

On disposal, the asset is derecognised. The profit or loss on disposal, recorded in the statement of profit or loss, is determined by comparing disposal proceeds with the carrying value of the asset:

 

Dr Cash 70m
Cr Asset 60m
Cr Profit or loss 10m

 

Note that the any gains or losses previously taken to equity are not recycled upon derecognition, although they may be reclassified within equity.

 

  • If Jones had designated the investment as fair value through profit and loss, the transaction costs would have been recognised as an expense in profit or loss. The entry posted on the purchase date would have been:

 

Dr Asset 40m
Cr Cash 40m
Dr Profit or loss 1m
Cr Cash 1m

 

At the reporting date, the asset is remeasured to fair value and the gain of $20m ($60m – $40m) is recognised in the statement of profit or loss:

 

Dr Asset 20m
Cr Profit or loss 20m

 

On disposal the asset is derecognised and the profit on disposal is recorded in the statement of profit or loss:

 

Dr Cash 70m
Cr Asset 60m
Cr Profit or loss 10m

 

Note that the reported profit on derecognition of $10 million is the same whether the asset was designated as fair value through profit or loss or fair value through other comprehensive income.

 

Test your understanding 16 – Hoggard

 

In all scenarios the cost of the derivative on 1 January 20X6 is $500 ($5 × 100) and an asset is recognised in the statement of financial position.

 

Dr Asset – option $500
Cr Cash $500

 

Outcome A

 

If the option is sold for $1,500 (100 × $15) before the exercise date, it is derecognised at a profit of $1,000.

 

Dr Cash $1,500
Cr Asset – option $500
Cr Profit or loss $1,000

 

Outcome B

 

If the option lapses unexercised, then it is derecognised and there is a loss to be taken to profit or loss:

 

Dr Profit or loss $500
Cr Asset – option $500

 

Outcome C

 

If the option is exercised then the option is derecognised, the entity records the cash paid upon exercise, and the investment in shares is recognised at fair value. An immediate profit is recognised:

 

Dr Asset – investment (100 × $25) $2,500
Cr Cash (100 × $10) $1,000
Cr Asset – option $500
Cr Profit or loss $1,000

 

Test your understanding 17 – Fair value hedge

 

The hedged item is an investment in equity that is measured at fair value through other comprehensive income (OCI). Therefore, the increase in the fair value of the derivative of $90,000 and the fall in fair value of the equity interest of $100,000 since the inception of the hedge are taken to OCI.

 

Dr Derivative $90,000
Cr OCI $90,000
Dr OCI $100,000
Cr Equity investment $100,000

 

The net result is a small loss of $10,000 in OCI.

 

Test your understanding 18 – Firm commitments

 

  • The futures contract is a derivative and is measured at fair value with all movements being accounted for through profit or loss.

 

The fair value of the futures contract at 1 October 20X1 was nil. By the year end, it had risen to $95,000. Therefore, at 31 December 20X1, Chive will recognise an asset at $95,000 and a gain of $95,000 will be recorded in profit or loss.

 

  • If the relationship had been designated as a fair value hedge then the movement in the fair value of the hedging instrument (the future) and the fair value of the hedged item (the firm commitment) since inception of the hedge are accounted for through profit or loss.

 

The derivative has increased in fair value from $nil at 1 October 20X1 to $95,000 at 31 December 20X1. Purchasing CU2 million at 31 December 20X1 would cost Chive $100,000 more than it would have done at 1 October 20X1. Therefore the fair value of the firm commitment has fallen by $100,000.

 

At year end, the derivative will be held at its fair value of $95,000, and the gain of $95,000 will be recorded in profit or loss.

 

The $100,000 fall in the fair value of the commitment will also be accounted for, with an expense recognised in profit or loss.

 

In summary, the double entries are as follows:
Dr Derivative $95,000
Cr Profit or loss $95,000
Dr Profit or loss $100,000
Cr Firm commitment $100,000

 

The gain on the derivative and the loss on the firm commitment largely net off. There is a residual $5,000 ($100,000 – $95,000) net expense in profit or loss due to hedge ineffectiveness. Nonetheless, financial statement volatility is far less than if hedge accounting had not been used.

 

 

 

Test your understanding 19 – Cash flow hedge

 

  • The movement on the hedging instrument is less than the movement on the hedged item. Therefore, the instrument is remeasured to fair value and the gain is recognised in other comprehensive income.

 

Dr Derivative $8,500
Cr OCI $8,500

 

  • The movement on the hedging instrument is more than the movement on the hedged item. The excess movement of $900 ($10,000 – $9,100) is recognised in the statement of profit or loss.

 

Dr Derivative $10,000
Cr Profit or loss $900
Cr OCI $9,100

 

Test your understanding 20 – Bling

 

  • Between 1 October 20X1 and 31 December 20X1, the fair value of the futures contract had fallen by $0.9m. Over the same time period, the hedged item (the estimated cash receipts from the sale of the inventory) had increased by $0.9m ($8.6m – $7.7m).

 

Under a cash flow hedge, the movement in the fair value of the hedging instrument is accounted for through other comprehensive income. Therefore, the following entry is required:

 

Dr Other comprehensive income $0.9m
Cr Derivative $0.9m

 

The loss recorded in other comprehensive income will be held within equity.

 

(b) The following entries are required:
Dr Cash $8.6m
Cr Revenue $8.6m
Dr Cost of sales $6.4m
Cr Inventory $6.4m
To record the sale of the inventory at fair value
Dr Derivative $0.9m
Cr Cash $0.9m
To record the settlement of the futures contract
Dr Profit or loss $0.9m
Cr OCI $0.9m

 

To recycle the losses held in equity through profit or loss in the same period as the hedged item affects profit or loss.

 

Test your understanding 21 – Grayton

 

The forward rate agreement has no fair value at its inception so is initially recorded at $nil.

 

This is a cash flow hedge. The derivative has fallen in value by $10,000 but the cash flows have increased in value by $10,000 (it is now $10,000 cheaper to buy the asset).

 

Because it has been designated a cash flow hedge, the movement in the value of the hedging instrument is recognised in other comprehensive income:

 

Dr Other comprehensive income $10,000
Cr Derivative $10,000

 

(Had this not been designated a hedging instrument, the loss would have been recognised immediately in profit or loss.)

 

The forward contract will be settled and closed when the asset is purchased.

 

Property, plant and equipment is a non-financial item. The loss on the hedging instrument held within equity is adjusted against the carrying amount of the plant.

 

The following entries would be posted:

 

Dr Liability – derivative $10,000
Dr Plant $90,000
Cr Cash $100,000

 

Being the settlement of the derivative and the purchase of the plant.

 

Dr Plant $10,000
Cr Cash flow hedge reserve $10,000

 

Being the recycling of the losses held within equity against the carrying

 

amount of the plant. Notice that the plant will be held at $100,000

 

($90,000 + $10,000) and the cash spent in total was $100,000. This was

 

the position that the derivative guaranteed.

 

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