Chapter 12

Financial Instruments

Thomas Chakku FCA,ACCA,CMA

 Accounting for
Financial
Instruments

IAS 32 IFRS 7 IFRS 9

Financial Instruments: Financial Instruments: Financial Instruments
Disclosures
Presentation

Thomas Chakku FCA,ACCA,CMA

Slide 2
Classification (IAS 32) Any contract that gives rise to
Financial BOTH a financial asset of
one entity and a financial
instruments liability or equity instrument
of another entity

Financial assets Financial Equity

liabilities instruments
(a) Cash
(b) Equity instrument of another Contractual obligation to:
entity - deliver cash/another FA
(c) Contractual right to: - exchange FA/FL under Compound
- receive cash/another FA conditions potentially instruments
- exchange FA/FL under unfavourable
conditions potentially - A non-derivative contract for
favourable which the entity is obliged to Ex: Convertible
(d) A non-derivative contract for deliver a variable number of Bonds
which the entity is obliged to entity's own equity instruments
receive a variable number of
entity's own equity instruments. Must be split into Equity
Ex: Trade payables. Debenture & Debt elements
Ex: Trade receivables. Options Loans, Redeemable Pref. shares Thomas Chakku FCA,ACCA,CMA
Investment in equity shares
Liability or Equity?

• The issuer of a financial instrument must

determine whether to disclose it as a liability or
equity.
– they are required to consider economic
substance rather than just the legal form

• Look at the definition of FL

Thomas Chakku FCA,ACCA,CMA

Financial Liabilities 1
Two methods can be used as decided by the management:

1. Amortized cost method:

This is the normal default method for most of the FL
2. Fair Value Through Profit or Loss (FVTPL) method:
This can be used only under any of the following circumstances:
• These are held for trading or
• The treatment significantly reduces an ‘accounting mismatch,
or
• if the liability is part or a group of financial liabilities or
financial assets and financial liabilities that is managed and
its performance is evaluated on a fair value basis
• when the FL contains one or more embedded derivatives
that would require separation. Thomas Chakku FCA,ACCA,CMA
 Financial Liabilities 2

FVTPL Method
Amortised Cost Method

Initial measurement
Initial measurement At Fair Value
[FV – Transaction cost] Measurement at B/S date
[Opening bal. + Interest at effective
Measurement at B/S date Dr Finance cost (SOPL) rate – Cash paid] and then revalued to
Amortised cost.i.e., Cr Liability FV on the B/S date
[Opening bal. + Interest at effective rate • Any gain or loss on FV change –
– Cash paid] Dr Liability
OCI section due to own credit risk
Cr Cash
• It is NOT revalued to FV at the
reporting date • Any gain or loss on FV change –
in SOPL due to other risks
For finding the FV, take the present value of the future cash flows using the current
Thomas Chakku FCA,ACCA,CMA
market interest rates if the market values are not available.
Question –FL: Amortized cost method

Laxman raises finance by issuing zero coupon bonds at

par on the first day of the current accounting period with
a nominal value of $10,000. The bonds will be redeemed
after two years at a premium of $1,449. The effective
rate of interest is 7%.

Required
Explain and illustrate how the loan is accounted for in the
financial statements of Laxman.

Thomas Chakku FCA,ACCA,CMA

Answer – FL: Amortized cost method

Laxman is receiving cash that it is obliged to repay, so this

financial instrument is classified as a financial liability.
There is no suggestion that the liability is being held for
trading purposes nor that the option to have it classified
as FVTPL has been made So, the liability will be classified
and accounted for at amortised cost The bonds are being
issued at par, so there is neither a premium nor discount
on issue. Thus Laxman initially receives $10,000. There
are no transaction costs and, if there were, they would be
deducted. Thus, the liability is initially recognised at
$10,000.
Thomas Chakku FCA,ACCA,CMA
Answer – FL: Amortized cost method

Plus
statement
Closing
of profit or
balance,
loss
being the
finance
liability
charge
on the
@7%
statement
on the
Opening Less the of financial
opening
balance cash paid position
balance

Year 1 $10,000 $700 (Nil) $10,700

Year 2
$10,700 $749 ($11,449) Nil

Thomas Chakku FCA,ACCA,CMA

Question – FL: FVTPL method

On 1 January 2011 Swann issued three year 5%

$30,000 loans notes at nominal value when the effective
rate of interest is also 4%. The loan notes will be
redeemed at par.The liability is classified at FVTPL. At the
end of the first accounting period market interest rates
have risen to 6%.

Required
Explain and illustrate how the loan is accounted for in the
financial statements of Swann in the year ended 31
December 2011.
Thomas Chakku FCA,ACCA,CMA
Answer – FL: FVTPL method

Swann is receiving cash that is obliged to repay so this

financial instrument is classified as a financial liability.The
liability is classified at FVTPL so, presumably, it is being
held for trading purposes or the option to have it
classified as FVTPL has been made.

Initial measurement is at the fair value of $30,000

received and, although there are no transaction costs in
this example, these would be expensed rather than taken
into account in arriving at the initial measurement.

Thomas Chakku FCA,ACCA,CMA

 Answer – FL: FVTPL method

Present value
6% of the future
Cash
discount factor cash flow
flow
Payment due
31 December
$1,500 x 0.943 = $1,415
2012 (interest
only)
Payment due
31 December
2013
(the final
$31,500 x 0.890 = $28,035
interest
payment and
the repayment
of the $30,000)
Fair value of
the liability at
$29,450
31 December
Thomas Chakku FCA,ACCA,CMA
2011
 Answer – FL: FVTPL method

Plus
statement
of profit
or loss
Carrying Gain
finance
Less cash value Fair value to
charge
paid (5% of the of the income
@4%
x liability at liability at statement
on the
30,000) year year end of profit
Opening opening
end or loss
balance balance
1/1/2011 $30,000 $1,200 ($1,500) $29,700 $29,450 $250

Thomas Chakku FCA,ACCA,CMA

Equity Instruments

Initial measurement
At [FV – Issue costs]

Subsequesnt Measurement at B/S date

No change

Thomas Chakku FCA,ACCA,CMA

Equity instruments
Illustration
A company issues 100,000 $1 shares when the market price is $2.60
per share. Issue costs of $3,000 are incurred.
The shares are shown at their net proceeds in accordance with IAS
32 Financial Instruments: Presentation, i.e. any issue costs reduce the
value recorded for the shares as follows:
DR Cash [(100,000 x $2.60) – $3,000] $257,000
CR Share capital (100,000 x $1) $100,000
CR Share premium [(100,000 x $1.60) – $3,000] or  $157,000

Thomas Chakku FCA,ACCA,CMA

Slide 15
 Compound instruments
Method:
1. Determine the carrying value of the liability component (by
measuring the fair value of a similar liability that does not have
an associated equity component).
2. Assign the residual amount to the equity component.
3. Amortised cost method is used for liability component
4. Equity component is shown as ‘OCE’ under Equity
5. If bonds are converted into equity shares, the difference
between the par value of shares and the total carrying value of
the bonds are shown as share premium.
6. If bonds are not converted, then the equity component
remains within the equity as non-distributable reserve.
Thomas Chakku FCA,ACCA,CMA
Question: Compound Instruments
Karaiskos SA issues 1,000 convertible bonds on 1 January 20X1 at par. The
bond is redeemable in three years' time at its par value of $2,000 per bond.
The bonds pay interest annually in arrears at an interest rate (based on nominal
value) of 6%. Each bond can be converted at the maturity date into 125 $1
shares.
The prevailing market interest rate for three-year bonds that have no right of
conversion is 9%.
Required
Show the presentation of the compound instrument in the financial statements
at inception.
3-year discount factors: Simple Cumulative
6% 0.840 2.673
9% 0.772 2.531

Thomas Chakku FCA,ACCA,CMA

Answer: Compound Instruments
Presentation
Non-current liabilities $
Financial liability component of convertible bond (Working) 1,847,720
Equity
Equity component of convertible bond (2,000,000 – (Working) 152,280
1,847,720)

Working
Fair value of equivalent non-convertible debt
$
Present value of principal payable at end of 3 years
(1,000  $2,000 = $2m  0.772) 1,544,000
Present value of interest annuity payable annually in arrears
for 3 years [(6%  $2m)  2.531] 303,720
1,847,720

Thomas Chakku FCA,ACCA,CMA

 Accounting for investments in Financial Assets

Accounting for investments in financial assets depends upon the business

model decided by the management. There are 3 business models/strategies:-

1. Business Model 1 - Held to Maturity

• Held to collect and
• solely contractual cash flows (principal & interest)
2. Business Model 2 -Trading securities
• Held for trading in the short-term
• Residual categories
3. Business Model 3 (Mixed Model)-Available for sale
• Held to collect and sell and
• solely contractual cash flows (principal & interest)

BM is decided by management Thomas Chakku FCA,ACCA,CMA

19
 Financial Assets

Equity Instruments Debt Instruments

FVTPL FVTOCI Amortized FVTPL FVTOCI

Method Method cost Method Method Method
• Initial • Initial • Initial • Initial • Initial
measurement at measurement at measurement at measurement at measurement at
FV FV + Transaction FV + Transaction FV FV + Transaction
• Transaction costs costs costs • Transaction costs costs
are expensed • At B/S date, the • At B/S date, the are expensed • At B/S date, the
• At B/S date, the asset is revalued asset is revalued • At B/S date, the asset is revalued
asset is revalued with gain or loss with gain or loss asset is revalued with gain or loss
with gain or loss recorded in OCI. recorded in with gain or loss recorded in OCI.
recorded in This gain or loss SOPL recorded in This gain or loss
SOPL will not be SOPL will not be
reclassified to reclassified to
SOPL in future SOPL in future
periods. periods.
Thomas Chakku FCA,ACCA,CMA
Investments in equity instruments not held for trading – Can be accounted under FVTOCI – It is optional
Financial assets – Accounting treatment summary

Type Held at
(a) Loans and receivables
Amortised cost
(b) Held-to-maturity investments

(c) Held for ‘trading’ and derivatives

Fair value (profit/loss)
= FVTPL

(d) Available-for-sale financial asset Fair value (changes in

(any other financial asset) reserves until disposal)
=FVTOCI

Financial assets measured at amortised cost will be subject to

impairment reviews each year
Thomas Chakku FCA,ACCA,CMA
FVTOCI – FA - Explanation
Consider the case of an equity investment accounted for at
FVTOCI that was acquired several years ago for $10,000 and by
the last reporting date has been revalued to $30,000. If the asset
is then sold for $31,000, the gain on disposal to be recognised in
the income statement is only $1,000 as the previous gain of
$20,000 has already been recognised and reported in the other
comprehensive income statement. IFRS 9 requires that gains can
only be recognised once. The balance of $20,000 in the equity
reserves that relates to the equity investment can be transferred
into retained earnings as a movement within reserves.

Thomas Chakku FCA,ACCA,CMA

 Reclassification
• Once an equity investment has been classified as FVTOCI this is
irrevocable so it cannot then be reclassified. Nor can a financial
asset be reclassified where the fair value option has been
exercised.
• However if, and only if the entity's business model objective for
its financial assets changes so its previous model assessment
would no longer apply then other financial assets can be
reclassified between FVTPL and amortised cost, or vice versa.
• Any reclassification is done prospectively from the
reclassification date without restating any previously recognised
gains, losses, or interest.

Thomas Chakku FCA,ACCA,CMA

 Recognition (IFRS 9) 1
• Financial assets and liabilities are required to be recognised in
the statement of financial position when the entity becomes a
party to the contractual provisions of the instrument.

Illustration
• Derivatives (eg a forward contract) are recognised in the
financial statements at inception even though there may have
been no cash flow, and disclosures about them are made in
accordance with IFRS 7.

Thomas Chakku FCA,ACCA,CMA

 Recognition (IFRS 9) 2
• Contracts that were entered into (and continue to be held) for
the entity's expected purchase, sale or usage requirements
of non-financial items are outside the scope of IFRS 9.

Illustration
• A forward contract to purchase cocoa beans for use in making
chocolate is not accounted for until the cocoa beans are
actually delivered.

Thomas Chakku FCA,ACCA,CMA

Derecognition (IFRS 9) 1
Derecognition happens:
• Financial assets:
– When the contractual rights to the cash flows expire
(eg because a customer has paid their debt or an option has
expired worthless); or
– The financial asset is transferred (eg sold), based on
whether the entity has transferred substantially all the risks
and rewards of ownership of the financial asset.

Thomas Chakku FCA,ACCA,CMA

Derecognition (IFRS 9) 2
• Financial liabilities:
─ When the obligation is discharged (eg paid off),
cancelled or expires.
• Where a part of a financial instrument (or group of similar
financial instruments) meets the criteria above, that part is
derecognised.

Thomas Chakku FCA,ACCA,CMA

Question: Derecognise?
Required
Discuss whether the following financial instruments would be
derecognised.
(a) AB Co sells an investment in shares, but retains a call option to
repurchase those shares at any time at a price equal to their
current market value at the date of repurchase.
(b) EF Co enters into a stocklending agreement where an investment
is lent to a third party for a fixed period of time for a fee.

Thomas Chakku FCA,ACCA,CMA

 Answer: Derecognise?

(a) AB Co should derecognise the asset as it only has an option to

purchase at the prevailing market value.

(b) EF Co should not derecognise the asset as it has retained

substantially all the risks and rewards of ownership.The stock
should be retained in its books even though legal title is
temporarily transferred.

Thomas Chakku FCA,ACCA,CMA

Financial assets at fair value
Illustration
An entity holds an investment in shares in another company, which
cost $45,000, and are classed as an available-for-sale financial asset.
At the year end their value has risen to $49,000.
The following adjustment would need to be made in an accounts
preparation question:
DR Investment in shares ($49,000 - $44,000) $4,000
CR Reserves $4,000
If the shares were held at fair value through profit and loss the gain
would be reported in profit or loss.
In either case, dividends received on the share are reported as
income

Thomas Chakku FCA,ACCA,CMA

Slide 30
Question: Financial transactions
Palermo, a publicly listed company, has requested your advice on
accounting for the following financial instrument transactions:
(a) Palermo purchased $50,000 par value of loan notes at a 10%
discount on their issue on 1 January 20X6 intending to hold
them until their maturity on 31 December 20X9. An interest
coupon of 3% of par value is paid annually on 31 December.
Transaction costs of $450 were incurred on the purchase.
The annual internal rate of return on the loan notes is 5.6%.

Thomas Chakku FCA,ACCA,CMA

Question: Financial transactions (cont'd)
(b) Palermo purchased some shares in an unquoted company as
an investment for $12,000 during March 20X6. At the year
end the directors stated that the shares might be worth
about $13,000, but a formal valuation was unable to be
performed due to lack of data.
(c) Palermo took out a speculative forward contract to buy
coffee beans for delivery on 30 April 20X7 at an agreed price
of $6,000 intending to settle net in cash. Due to a surge in
expected supply, a forward contract for delivery on 30 April
20X7 would have cost $5,000 on 31 December 20X6.

Thomas Chakku FCA,ACCA,CMA

Question: Financial transactions (cont'd)
(d) In July 20X6 Palermo sold 12,000 shares for $16,800 (their
market price at that date). It had purchased the shares
through a broker in 20X5 for $1.25 per share. The quoted
price at the 20X5 year end was $1.32–$1.34 per share. The
broker charges transaction costs of 1% purchase/sale price.

Palermo makes the irrevocable election for the changes in fair

value of investments in equity instruments not held for trading to
be presented in other comprehensive income wherever possible.

Thomas Chakku FCA,ACCA,CMA

Question: Financial transactions (cont'd)
Required
Explain how the above transactions should be accounted for in
the financial statements for the year ended 31 December 20X6.

Thomas Chakku FCA,ACCA,CMA

Answer: Financial transactions
(a) Loan notes
The loan notes should be held at amortised cost under IFRS 9 as the
company's business model was to hold them until maturity when
purchased and the contractual terms give rise to cash flows that are solely
payments of principal and interest on the principal amount outstanding.
They are therefore held at amortised cost as follows.

$
Cash paid on 1 January 20X6 ((50,000 × 90%) + 450) 45,450
Effective interest income (45,450 × 5.6%) 2,545
Coupon received (50,000 × 3%) (1,500)
Amortised cost at 31 December 20X6 46,495
Consequently, $2,545 of finance income will be recognised in profit or loss for
the year and there will be a $46,495 loan note asset.
Thomas Chakku FCA,ACCA,CMA
Answer: Financial transactions (cont'd)
(b) Unquoted shares
Investments in equity instruments must always be measured at fair value.
However, in limited circumstances, such as the case here where fair value
cannot be measured as a valuation cannot be performed, cost may be an
appropriate estimate of fair value (IFRS 9 para B5.5). The shares will
therefore remain at $12,000 as an investment asset.

Thomas Chakku FCA,ACCA,CMA

Answer: Financial transactions (cont'd)
(c) Forward contract
A forward contract not held for delivery of the entity's expected physical
purchase, sale or usage requirements (which would be outside the scope
of IFRS 9) and not held for hedging purposes is accounted for at fair value
through profit or loss.
The value of a forward contract at inception is zero.
The value of the contract at the year end is:
$
Market price of forward contract at year end for delivery on 30 April 5,000
Palermo's forward price (6,000)

(1,000)

A financial liability of $1,000 is therefore recognised with a corresponding

charge of $1,000 to profit or loss. Thomas Chakku FCA,ACCA,CMA
 Answer: Financial transactions (cont'd)
(d) Quoted shares sold
The shares are held at fair value through other comprehensive income due
to Palermo's accounting policy of holding investments in equity instruments
not held for trading at fair value through OCI wherever possible. They
were originally recorded at their cost of $15,150 in 20X5 and revalued to
market value at the year end with a gain of $690 reported in other
comprehensive income:

$
20X5 Purchase ((12,000 × $1.25) + (1%  $15,000)) 15,150 Other
compre-
Fair value gain at 31.12.20X5 β 690 hensive
Fair value at 31.12.20X5 (12,000 × $1.32 bid price) 15,840 income

Thomas Chakku FCA,ACCA,CMA

 Answer: Financial transactions (cont'd)
At the date of the derecognition in July 20X6, the shares must first be
remeasured to their fair value (ie the sales price as they were sold at market
price) and the gain is reported in other comprehensive income ('items that will
not be reclassified to profit or loss'):
DEBIT Financial asset (16,800 – 15,840) $960
CREDIT Other comprehensive income β $960

Thomas Chakku FCA,ACCA,CMA

Answer: Financial transactions (cont'd)
On derecognition, the transaction costs are charged to profit or loss:
DEBIT Cash (16,800 – (1% × 16,800)) $16,632
DEBIT Profit or loss (1% × 16,800) $168
CREDIT Financial asset $16,800

Tutorial note. Under IFRS 9, where the irrevocable election is made to hold
an investment in equity instruments not held for trading at fair value through
other comprehensive income, all changes in fair value up to the point of
derecognition are recognised in other comprehensive income and they are not
subsequently reclassified to profit or loss.

Thomas Chakku FCA,ACCA,CMA

Impairment of financial assets
Where there is evidence of a financial asset being impaired then
an impairment review must be undertaken. Impairment reviews
are only required in respect of financial assets that are debt
instruments and measured at amortised cost or at fair value
through other comprehensive income.
The following events may suggest the asset is credit-impaired:
• Significant financial difficulty of issuer or the borrower
• Breach of contract in repayments
• Granting a concession to a borrower not normally given
• High probability of bankruptcy of borrower

Thomas Chakku FCA,ACCA,CMA

 Credit losses and expected credit losses
• 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 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 present value of credit
losses that arise if the borrower defaults on the obligation at any point
during the life of the instrument.
• The 12-month expected credit losses: These are calculated by
multiplying the probability of default in the next 12 months by the lifetime
expected credit losses that would result from the default. Therefore this is
not the same as measuring the 12-month expected credit losses as solely
losses that will arise within 12 months.

Thomas Chakku FCA,ACCA,CMA

Expected credit loss approach
Credit losses would be recognised in three stages:

Stage 1 Stage 2 Stage 3

When? Initial recognition Credit risk increases Objective evidence
(and subsequently if significantly of impairment exists
no significant (rebuttable at the reporting date
deterioration in presumption if > 30
credit risk) days past due)

Credit losses 12-month expected Lifetime expected Lifetime expected

recognised credit losses credit losses credit losses

Calculation of On gross carrying On gross carrying On carrying amount

effective amount amount net of allowance for
interest credit losses after
date evidence exists

Thomas Chakku FCA,ACCA,CMA

 Expected credit loss approach
• In all three cases credit losses would be recognised in profit or
loss and held in a separate allowance account (although
this would not be required to be shown separately on the face
of the statement of financial position).
• Where the expected credit losses relate to a loan
commitment or financial guarantee contract a
provision rather than allowance would be made

Thomas Chakku FCA,ACCA,CMA

 Expected credit loss approach
• A simplified approach would be permitted for trade and
lease receivables.
• No credit loss allowance is recognised on initial recognition.
Any impairment loss will be the present value of the expected
cash flow shortfalls over the remaining life of the receivables.
(That is, recognise an allowance for lifetime expected credit
losses from initial recognition)

Thomas Chakku FCA,ACCA,CMA

Question: Impairment
Palermo, the company in the previous question, learns that the
company, which had issued the loan notes it owns, had got into
financial trouble at the end of the first year (31 December 20X6 –
all interest has been paid up to this date). On this date the
liquidator of the company that issued the notes informs Palermo
that no further interest will be paid and only 75% of the maturity
value will be repaid, on the original repayment date.
The annual market interest rate on similar bonds is 5% on that
date.

Thomas Chakku FCA,ACCA,CMA

Question: Impairment (cont'd)

Required
How much is the impairment loss and how should it be reported
in the financial statements?

Thomas Chakku FCA,ACCA,CMA

 Answer: Impairment
• Carrying amount at 31 December 20X6 (from previous question) = $46,495
• Recoverable amount at 31 December 20X6 =

$50,000  75%  = $31,845

1
1.0563*
The impairment of $14,650 ($46,495 – $31,845) should be recorded as:
DEBIT Profit or loss $14,650
CREDIT Financial asset $14,650
*There are three annual periods between 31 December 20X6 and the maturity
date 31 December 20X9. The original effective interest rate (5.6%) is used for
discounting instruments held at amortised cost,
not the market rate (5%).

Thomas Chakku FCA,ACCA,CMA

Question: Another impairment
Cascade Co purchased 6% debentures in Fountain Co on 1
January 20X6 (their issue date) for $250,000. The term of the
debentures was five years and the maturity value is $311,051. The
effective rate of interest on the debentures is 10% and the
company has classified them as a held-to-maturity financial asset.
At the end of 20X7 Fountain Co went into liquidation. All interest
had been paid until that date. On 31 December 20X7 the
liquidator of Fountain Co announced that no further interest
would be paid and only 80% of the maturity value would be
repaid, on the original repayment date.
The market interest rate on similar bonds is 8% on that date.

Thomas Chakku FCA,ACCA,CMA

Question: Another impairment (cont'd)
Required
(a) What value should the debentures have been stated at just
before the impairment became apparent?
(b) At what value should the debentures be stated at 31
December 20X7, after the impairment?
(c) How will the impairment be reported in the financial
statements for the year ended 31 December 20X7?

Thomas Chakku FCA,ACCA,CMA

Answer: Another impairment
(a) The debentures are classified as being at amortised cost:
$

Initial cost 250,000

Interest at 10% 25,000
Cash at 6% (15,000)
At 31 December 20X6 260,000
Interest at 10% 26,000
Cash at 6% (15,000)
At 31 December 20X7 271,000

Thomas Chakku FCA,ACCA,CMA

Answer: Another impairment (cont'd)
(b) After the impairment, the debentures are stated at their
recoverable amount (using the original effective interest
rate of 10%):
80%  $311,051  0.751 = $186,879

(c) The impairment of $84,121 ($271,000 – $186,879) should be

recorded:
DEBIT Profit or loss for the year $84,121
CREDIT Financial asset $84,121

Thomas Chakku FCA,ACCA,CMA

 Hedging (IFRS 9) 2
• Criteria for hedge accounting
– The hedging relationship consists of only eligible hedging
instruments and hedged items
– At the inception of the hedge, there must be formal
documentation identifying the hedged item and hedging
instrument.
– The hedging relationship meets all effectiveness
requirements.

Thomas Chakku FCA,ACCA,CMA

 Hedging Effectiveness

• Whether a hedging relationship qualifies for hedge

accounting depends on an objective-based assessment
requiring
– An economic relationship between the hedged item
and the hedging instrument
– The effect of credit risk does not dominate the value
changes that result from that economic relationship
– 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.

Thomas Chakku FCA,ACCA,CMA

Hedge accounting 1

Types of hedges
Hedges examinable are:
1. Fair value hedge
used to hedge the value of particular assets or liabilities
2. Cash-flow hedge
used to hedge a future expected cash flow

Thomas Chakku FCA,ACCA,CMA

Hedge accounting 2

Fair value hedges

• On the reporting date, all gains and losses on both the hedged
item and hedging instrument are recognised immediately in
profit or loss.
The gain or loss on the hedged item adjusts the carrying value
of hedged item.
• If the hedged item is an investment in an equity
instrument held at fair value through other
comprehensive income, the gains and losses on both the
hedged investment and the hedging instrument will be
recognised in other comprehensive income

Thomas Chakku FCA,ACCA,CMA

Hedge accounting 3
Cash flow hedges
Accounted for as follows:
(a) The gain or loss on the effective portion of the hedge is
recognised in other comprehensive income and
transferred to profit or loss when the hedged item is
recognised in profit or loss.
(b) Any excess is recognised immediately in profit or loss.

Thomas Chakku FCA,ACCA,CMA

Question: Hedging
OneAir is a successful international airline. A key factor affecting
OneAir's cash flows and profits is the price of jet fuel.
On 1 October 20X1, OneAir entered into a forward contract to
hedge its expected fuel requirements for the second quarter of
20X9 for delivery of 28m gallons of jet fuel on 31 March 20X2 at
a price of $2.04 per gallon.
The airline intended to settle the contract net in cash and
purchase the actual required quantity of jet fuel in the open
market on 31 March 20X2.

Thomas Chakku FCA,ACCA,CMA

Question: Hedging (cont'd)
At the company's year end the forward price for delivery on 31
March 20X2 had risen to $2.16 per gallon of fuel.
All necessary documentation was set up at inception for the
contract to be accounted for as a hedge. You should assume that
the hedge was fully effective.
On 31 March the company settled the forward contract net in
cash and purchased 30m gallons of jet fuel at the spot price on
that day of $2.19.

Thomas Chakku FCA,ACCA,CMA

Question: Hedging (cont'd)
Required
Discuss, with suitable computations, how the above transactions
would be accounted for in the financial statements for the year
ended 31 December 20X1 and on the date of settlement.

Thomas Chakku FCA,ACCA,CMA

Answer: Hedging
Given that OneAir is hedging the volatility of the future cash outflow to
purchase fuel, the forward contract is accounted for as a cash flow hedge,
assuming all the criteria for hedge accounting are met (ie documentation at
inception as a cash flow hedge, being a 'highly effective' hedge and ability to
measure the effectiveness of the hedge).
At inception, no entries are required as the fair value of a forward contract at
inception is zero. However, the existence of the hedge is disclosed under IFRS
7 Financial Instruments: Disclosures.

Thomas Chakku FCA,ACCA,CMA

Answer: Hedging (cont'd)
31 December 20X1
At the year end the forward contract must be valued at its fair value as follows.
$m
Market price of forward contract for
delivery on 31 March (28m × $2.16) 60.48
OneAir's forward price (28m × $2.04) (57.12)
Cumulative gain 3.36
The gain is recognised in other comprehensive income as the cash flow has not
yet occurred:
$m
DEBIT Forward contract (Financial asset in SOFP) 3.36
CREDIT Other comprehensive income 3.36

Thomas Chakku FCA,ACCA,CMA

Answer: Hedging (cont'd)
31 March 20X2
At 31 March 20X2, the purchase of 30m gallons of fuel at the market price of
$2.19 per gallon results in a charge to cost of sales of (30m × $2.19) $65.70m.
At this point the hedge the forward contract is settled net in cash at its fair
value on that date, calculated in the same way as before:
$m
Market price of forward contract for delivery
on 31 March (28m × $2.19 spot rate) 61.32
OneAir's forward price (28m × $2.04) (57.12)
Cumulative gain = cash settlement 4.20

Thomas Chakku FCA,ACCA,CMA

Answer: Hedging (cont'd)
This results in a further gain of $0.84m ($4.2m – $3.36m) in 20X2 which is
credited to profit or loss as it is a realised profit:
$m
DEBIT Cash 4.20
CREDIT Forward contract at carrying value 3.36
CREDIT Profit or loss (4.20 – 3.36) 0.84
The overall gain of $4.20m on the forward contract has compensated for
(hedged) the increase in price of fuel.

Thomas Chakku FCA,ACCA,CMA

Answer: Hedging (cont'd)
The gain of $3.36m previously recognised in other comprehensive income is
transferred to profit or loss as the cash flow has now affected profit or loss:
$m
DEBIT Other comprehensive income 3.36
CREDIT Profit or loss 3.36

Thomas Chakku FCA,ACCA,CMA

Answer: Hedging (cont'd)
The overall effect on profit or loss is:
$m
Profit or loss (extract)
Cost of sales (65.70)
Profit on forward contract:
In current period 0.84
Reclassified from other comprehensive income 3.36
(61.50)
Without hedging the company would have suffered the cost at market rates on
31 March 20X2 of $65.70m.

Thomas Chakku FCA,ACCA,CMA

Embedded derivatives (IFRS 9) 1
Example:
• Bond redeemable in five-years' time
• Part of redemption price based on increase in FTSE 100 index

'Host' contract Bond Accounted for as normal

Embedded Option on
equities
Treated as derivative
derivative

Thomas Chakku FCA,ACCA,CMA

Embedded derivatives (IFRS 9) 2
IFRS 9 requires embedded derivatives that would meet the
definition of a separate derivative instrument to be separated
from the host contract unless:
(i) The economic characteristics and risks of the embedded
derivative are closely related to those of the host contract;
or
(ii) The hybrid (combined) instrument is measured at fair value
through profit or loss; or
(iii) The host contract is a financial asset within the scope of
IFRS 9; or
(iv) The embedded derivative significantly modifies the cash
flows of the contract.
Thomas Chakku FCA,ACCA,CMA