This is the second of two articles on the topic of financial instruments. This article covers:
According to IFRS 9, Financial Instruments, a derivative is a contract that:
Derivatives can be used by companies to manage risk. For example, a company that manufactures bread may reduce its exposure to changes in the price of wheat by entering into futures contracts to buy wheat for a fixed price in six months’ time. These contracts will be settled net in cash: if wheat prices rise, the company will make a gain on the contracts; if wheat prices fall, the company will make a loss.
All derivatives are measured at fair value. Changes in fair value are recognised in profit or loss (unless the entity has elected to apply hedge accounting by designating the derivative as a hedging instrument in an eligible hedging relationship.)
Note that a contract that otherwise meets the definition of a derivative would not be accounted for as a financial instrument if the company entered into it for the purpose of receiving a non-financial item (such as wheat) in accordance with its expected usage requirements.
Insert Co entered into a forward contract to buy fuel, which was to be settled on 31 December 20X7. The fuel was to be physically delivered to the head office and to be used by Insert Co to heat its premises. The fuel was not for resale. The contract could not be settled through net cash settlement. A penalty was payable if Insert Co did not take delivery of the fuel. Insert Co had never failed to take delivery in the past.
Should the contract be accounted for in accordance with IFRS 9?
IFRS 9 should be applied to those contracts to buy or sell a non‑financial item that can be settled net in cash. The exception are those contracts that are for purpose of the entity’s expected purchase, sale or usage requirements. Therefore, in this case, IFRS 9 does not apply to the fuel contract as it will be physically received and used in the company’s business.
As Insert Co has never failed to take delivery in the past and a penalty is payable if Insert Co did not take delivery of the petroleum, it is unlikely that there will be net settlement of the contract. Therefore, the purchase of the fuel should be accounted for in accordance with IAS 2, Inventories.
As noted above, derivatives are used by companies to manage risk. In the financial statements, they are remeasured to fair value at each reporting date, with the gain or loss recognised in profit or loss. However, the item that was generating the risk may not be recognised in the financial statements (such as a future purchase of wheat), or it may be accounted for in a different way (such as inventories of wheat, which are measured at the lower of cost and net realisable value). This gives rise to an accounting mismatch. This causes volatility in profit or loss that can make the company look like a riskier investment to its shareholders, even though the company has taken proactive steps to manage its risk. This outcome is at odds with the purpose of hedging and can be reduced or eliminated if the company chooses to apply hedge accounting.
The hedge accounting requirements in IFRS 9 are optional. If certain eligibility and qualification criteria are met, hedge accounting allows an entity to reflect risk management activities in the financial statements by matching gains or losses on financial hedging instruments (derivatives) with losses or gains on the risk exposures they hedge.
Hedge accounting can be applied to the following examinable types of hedging relationships:
A hedging relationship qualifies for hedge accounting only if all of the following criteria are met:
In order to qualify for hedge accounting, the hedge relationship must meet the following effectiveness criteria at the beginning of each hedged period:
Fair value hedge accounting
If the fair value hedge meets the qualifying criteria, the hedging instrument is re-measured at fair value. The gain or loss is recognised in profit or loss. The carrying amount of the hedged item is adjusted for the gain or loss attributable to the hedged risk only and is also recognised in profit or loss. Thus, all gains and losses attributed to the hedged risk are recognised in the statement of profit or loss, with the result that there is no net profit and loss effect, other than any hedge ineffectiveness.
Note that if the hedged item is an equity instrument designated to be measured at FVOCI, then the gains and losses on the hedged item and hedging instrument are both reported in other comprehensive income.
Cash flow hedge accounting
If the cash flow hedge meets the qualifying criteria, the hedging instrument is re-measured at fair value. Gains or losses on the effective portion of the hedging instrument are recognised in OCI. These amounts will be taken to a ‘cashflow hedging reserve’ as a separate component of equity. The ineffective portion of the gain or loss on the hedging instrument is recognised in the statement of profit or loss.
When cash flows relating to the hedged item are reported in profit and loss, amounts in OCI are reclassified (‘recycled’) to the statement of profit or loss.
Where a hedge of a forecast transaction results in the recognition of a financial asset or liability, the gains or losses on the hedging instrument that have previously been recognised in OCI are reclassified (‘recycled’) in the same period as the asset or liability affects profit or loss (for example, in the periods when interest expense or income is recognised). If a hedged forecast transaction subsequently results in the recognition of a non-financial asset or non-financial liability, the company removes that amount from the cash flow hedge reserve and includes it directly in the initial cost or other carrying amount of the asset or the liability. This is not a reclassification adjustment and hence it does not affect other comprehensive income. However, if a company expects that any of a loss recognised in OCI will not be recovered in future periods, it should reclassify to profit or loss the amount that is not expected to be recovered.
Review Co is preparing its financial statements for the year ended 31 December 20X7. Review Co wishes to protect itself against the foreign exchange risk arising on 3 million dinars which it expects to receive on 31 January 20X8.
Review Co enters into a forward currency contract on 1 November to sell 3 million dinars on 31 January 20X8, designating the contract as the hedging instrument in a cash flow hedging relationship. Management assesses the hedge to be effective. On 31 December 20X7, the currency contract has a positive fair value of $100,000 which is matched by a decrease in the fair value of the forecast cash flow of $98,000. The source of hedge ineffectiveness was analysed, and it was deemed that the hedge effectiveness criteria were still met and that no rebalancing was required.
On 31 January 20X8, Review Co receives the expected 3 million dinars and terminates the currency contract which has a fair value of $104,000. As such, there was no hedge ineffectiveness.
(The above example also assumes that the sale is recognised at the same point in time that cash is received)
Discuss the accounting for the above cash flow hedge.
The effective portion of the hedge, that is the ‘matched’ $98,000 increase in fair value, is credited to OCI as the lesser of the cumulative gain on the hedging instrument and the cumulative change in the fair value of the expected future cash-flows. This will be taken to a cash flow hedging reserve, which is an ‘other component of equity’. The ineffective portion ($2,000) is credited to profit or loss. The accounting entries will be:
Dr Currency contract – $100,000
Cr OCI – $98,000
Cr Profit or loss – $2,000
On 31 January 20X8, the fair value of the hedge has increased by $4,000. However, the hedge is now fully effective, so that the cumulative amount in OCI needs to reflect the entire $104,000 increase in fair value.
Dr Currency contract – $4,000
Cr OCI – $6,000
Dr Profit or loss – $2,000
On 31 January 20X8, the cumulative fair value in equity must be ‘reclassified to profit or loss when the transaction is completed. The accounting entries are:
Dr OCI – $104,000
Cr Profit or loss – $104,000
The currency contract is net settled and thus cash of $104,000 will be received
Dr Cash – $104,000
Cr Currency c
Written by a member of the DipIFR examining team