IFRS 9 Financial Instruments

Financial Instruments

IAS 32 Presentation

Compound financial instruments

Interest, dividends, losses and gains

IFRS 7 Financial instruments: Disclosures

IFRS 9: Financial Instruments

Recognition and derecognition

Classifications*

Reclassifications

Factoring of receivables

Impairment

Standard summary

Key definitions

IAS 32 Financial Instruments: Presentation

This standard covers classification of financial instruments into liabilities and equity as well as the presentation of compound instruments.

IFRS 7: Financial Instruments: Disclosures

This standard covers with the disclosure of financial instruments in the accounts.

IFRS 9: Financial Instruments

This standard covers recognition, derecognition, measurement, remeasurement, impairment and hedge accounting of financial instruments.

Example – Classification of financial instruments:

Whether the following preference shares should be classified as financial liabilities or equity in the financial statements?

1. 1m preference shares for $3 each and the company will redeem these by issuing ordinary shares worth $3m. The exact number of ordinary shares issuable will be based on their fair value in two years.
2. 3m preference shares for $5 each. No dividends are payable. The preference shares will be redeemed in 3 years’ time by issuing 10m ordinary shares.
3. 10m preference shares for $5 each. They are not mandatorily redeemable. A dividend is payable if, an only if, dividends are paid on ordinary shares.

Answer:

1. It should be classified as liability. 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’s obliged to deliver a variable number of its own equity instruments. Hence the $3m received from the preference share issue should be classified as a liability on the statement of financial position.
2. A contract that will be settled by the entity receiving/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. Therefore, the $15m from the preference share issue should be classified as equity in the statement of financial position.
3. A financial liability exists if there is an obligation to deliver cash or another financial asset. But there is no obligation for the company 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 be classified as equity in the statement of financial position.

Example: Convertible debts

A business issued 1 million convertible bonds on 1 June 20x1. The convertible bonds have a three-year term and were issued at $100 million fair value which is the same as the par value.

Interest is paid annually in arrears at a rate of 6% per year. Other similar bonds without the conversion option attracted a prevailing market interest rate of 9% per year on 1 June 20x1.

The company incurred issue costs of $1 million. The impact of the issue costs is to increase the effective interest rate to 9·38%.

If those convertible bonds are not converted into shares, then they would be redeemed at par.

At maturity, all of the convertible bonds are converted into 25 million ordinary shares, and the par value of each share is $1.

The directors are uncertain how the bonds should have been accounted for up to the date of the conversion on 31 May 20x4.

Required:

Show the initial measurement and subsequent measurement for the convertible bond.

Answer:

Initial Measurement:

*Discount future interest and redemption value at the prevailing (average) interest rate for similar debt without conversion options.

The issue cost should be deducted from the proceeds of the issue on a pro-rata basis.

Subsequent measurement: ($m)

Each year, the journal entries for interest expense and instalment are as follows:

Interest expense: ($m)

Instalment: ($m)

Conversion into ordinary shares:

Conversion into cash:

The residual equity interest is not recycled or reclassified into retained earnings, and it simply stays in the non-distributable reserve.

Exam rehearsal question - Stent Co (b)

Preference shares

On 1 October 20X8, the CEO and finance director each paid $2m cash in exchange for preference shares from Stent Co which provide cumulative dividends of 7% per annum. These preference shares can either be converted into a fixed number of ordinary shares in two years’ time, or redeemed at par on the same date, at the choice of the holder. The finance director suggests to the accountant that the preference shares should be classified as equity because the conversion is into a fixed number of ordinary shares on a fixed date (‘fixed for fixed’) and conversion is certain (given the current market value of the ordinary shares).

Required:

Discuss appropriate accounting treatments which Stent Co should adopt for all issues identified above and their impact upon gearing. (4 marks)

Answer:

Convertible redeemable preference shares

Preference shares convertible into a fixed number of ordinary shares on a fixed date should be classified as equity. Stent Co has issued convertible redeemable preference shares, as they offer the holder the benefit of conversion into ordinary shares if share prices rise, and the security of redemption (at the choice of the holder) if share prices fall.

Based on substance over form, a preference share which provides for mandatory redemption for a fixed or determinable amount at a fixed or determinable future date or gives the holder the right to require the issuer to redeem the instrument at a particular date for a fixed or determinable amount is a financial liability. Such components are classified separately as compound financial instruments, recognising separately the components of a financial instrument which creates both a financial liability and an equity instrument.

As per IFRS 9, when the initial carrying amount of a compound financial instrument is allocated to its equity and liability components, the equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component. Stent Co would measure the fair value of the consideration in respect of the liability component based on the fair value of a similar liability without any associated equity conversion option. The equity component is assigned the residual amount.

Gearing would increase if the draft financial statements had included the preference shares within equity: the correction would increase non-current debt (the present value of the future obligations) and decrease equity.

Interest, dividends, losses and gains relating to a financial instrument or a component that is a financial liability shall be recognised as income or expense in profit or loss.

(IAS 32: para. 35)

Example:

1. The business incurs $1 million interest expenses from the issued debt instrument every year.

Required:

Accounting entry.

Answer:

Example:

1. The investor (company B) bought the debt instrument issued by company A and accured the interest revenue of $1 million.

Required:

Accounting entry.

Answer:

Example

1. Company C issued $30 million redeemable preference shares and accured $0.2 million preference share dividends.

Required:

Accounting entry for the preference share dividends.

Answer:

Example

1. Company C sold $25 million worth financial assets for $32 million.

Required:

Accounting entry.

Answer:

Example

1. Company D has $50 million irredeemable preference shares and accured $0.3 million irredeemable preference share dividends.

Required:

Accounting entry.

Answer:

Example

1. Company E has $60 million ordinary shares and declared to pay $0.6 million ordinary share dividends to ordinary shareholders.

Required:

Accounting entry.

Answer:

Example

Company F issued 30 million shares for $5 each, and the par value of each share is $1. Company F also incurred $2.5 million transaction costs.

Required:

Accounting entry.

Answer:

Issue of shares:

Transaction costs:

In the following situations, the assets and liabilities MUST be offset against each other when the following two conditions are met:

1. The entity has a legally enforceable right to set off the amounts. In other words, law permits it;
2. Intends to settle on a net basis (For example, in a bilateral arrangement where A owes $80 to B and B owes $60 to A, with both parties’ consent, a net $20 is made from A to B – a reduction of receivables of $60 in A and payables of $60 in B).

(IAS 32, para 42)

Offsetting is different from derecognition as offsetting financial assets and liabilities would not result in gains or losses to be recognised; however, in derecognition, gains or losses arise.

(IAS 32, para 44)

1

Information about the significance of each financial instrument:

2

Information about risks of each financial instrument:

Previous OCI gain:

Dr OCI/Other components of equity (OCE)

Cr Retained earnings

Previous OCI loss:

Dr Retained earnings

Cr OCI/Other components of equity (OCE)

Previous OCI gain:

Dr OCI/Other components of equity (OCE)

Cr P/L

Previous OCI loss:

Dr P/L

Cr OCI/Other components of equity (OCE)

Example: whether the financial assets should be derecognised?

Willian holds equity investments at fair value through profit or loss. Due to short-term cash flow shortages, Willian sold some equity investments for $7m when the carrying value was $3m.

The terms of the disposal state that Willian has the right to repurchase the shares at any point over the next 3 years at their fair value on the repurchase date.

Willian has not derecognised the investment because its directors believe that a repurchase is highly likely.

Required:

Whether the directors’ comments are correct?

Answer:

The financial asset should be derecognised if:

1. The entity has transferred the substantial rewards of ownership of the asset.

Willian can have the right to repurchase the shares at the fair value rather than the pre-fixed price and therefore, Willian does not retain the risks and rewards related to the price fluctuation.

This also means that Willian will have no incentive to repurchase the shares if the price in 3 years’ time is not advantageous to him.

2. The entity has transferred the substantial risks of ownership of the asset.

There is no obligation for Willian to repurchase those shares in three years’ time and this means that Willian will not suffer any price risks for those shares.

Hence Willian should derecognise those shares and put the gains or losses in the statement of profit or loss:

Dr Bank $7m

Cr Financial asset (FVTOCI) $3m

Cr Gain(P/L) $4m

Example: Partial financial asset derecognition

A business invested in a $1 million debt instrument and sold the right to receive future interest to a local bank. On the sale date, the fair value of the right to receive future interest payment is $0.3 million, and the fair value of the right to receive redemption value from the debt instrument is $0.8 million. The sale of the right to receive future interest payment is at its fair value of $0.3 million.

Required:

Accounting treatment.

Answer:

A retained servicing asset (the right to receive future redemption value) shall be treated as a part that continues to be recognised.

Example: Partial financial liability derecognition

The business issued 100 million $1 twenty-year bonds which are traded in the capital markets, ie fair value of those bonds is $100 million. Four years later, the business made a market purchase of 10 million bonds at the current market price of $0.7 each, ie the total purchase price is $7 million. On the repurchase date, the carrying value of the financial liability is $92 million.

Required:

Accounting entry.

Answer:

Example: (FVTPL)

A business acquired an investment in equity instrument (buying shares in another business) at the fair value of $60 million and incurred $5 million transaction costs. The business intends to trade the equity instrument.

At the end of March, the fair value of the investment has gone up to $64 million.

In April, the business received $0.3 million interim dividends paid from those shares.

At the end of June, the fair value of the investment has gone down to $34 million.

At the end of June, the investment was sold for $40 million.

Required:

Accounting entries.

Answer:

When the investment is acquired:

At the end of March:

In April, when dividends are received:

At the end of June:

Sold:

Example: (FVTOCI)

A business acquired an investment in equity instrument (buying shares in another business) at the fair value of $60 million and incurred $5 million transaction costs. The business intends to hold the investment long term on a strategic basis and has made an irrevocable election to designate the investment as the FVTOCI equity instrument.

At the end of March, the fair value of the investment has gone up to $90 million.

In April, the business received $0.3 million interim dividends paid from those shares.

At the end of June, the fair value of the investment has gone down to $80 million.

At the end of June, the investment was sold for $40 million.

Required:

Accounting entry.

Answer:

When the investment is acquired:

At the end of March:

In April, when dividends are received:

At the end of June:

Sold:

Remaining OCI ($25m - $10m) =$15m:

The $15m OCI can remain in the OCI and reserve section, or it can be reclassified into retained earnings by:

FVTPL Model

(If one of the answers is no)

Business Model Test

(Hold this till maturity?)

Contractual Cash Flow Test

(Solely payments of principal and interest/SPPI test)

Amortised Cost Model

Example: Amortised cost

A business invested $10,000, the nominal value, in 5% (nominal or coupon rate) loan notes in year one. The business incurred transaction costs of $500 when the loan note was acquired. Loan notes will be redeemed in three years’ time at a premium of $1,255. The effective interest rate is 7%.

Required:

Accounting entries.

Answer:

Initial Measurement:

Subsequent Measurement:

Accounting entries for finance income:

Accounting entries for instalments:

6. *Effective interest rate

This is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortised cost of financial liability.

(IFRS 9: Appendix A)

In other words, the effective interest rate is simply the internal rate of return of all those cash flows. For instance, the above 7% effective interest rate from the example can be calculated as follows:

If there is no premium or discount when the financial asset is issued and redeemed, the effective interest rate is the same as the coupon rate, ie the impact on P/L is the same as the impact on cash flows.

Example: FVTOCI and FVTPL debt instruments

Required:

Based on the previous example, explain the accounting adjustments if:

1. The business may sell the loan notes if the possibility of an investment with a higher return arises and it qualifies the FVTOCI designation.
2. The business plans to trade the bond in the short term, and this is designated as the FVTPL debt instrument.

Suppose the fair value of the debt instrument is as follows:

At the end of year one: $12,000

At the end of year two: $11,000

Answer:

1. FVTOCI debt instrument:
2. The transaction cost should be included in the debt instrument value, ie the same treatment under the amortised cost method.
3. The interest income to be recognised in the FVTOCI debt instrument should be the same as those measured using amortised cost. In other words, interest income $735, $751 and $769 is the same because this is calculated based on the effective interest rate.
4. The fair value of the debt instrument should be updated each year and carry this forward to the next year. Gains and losses from fair value changes should be recognised in the ‘other comprehensive income/OCI’ section as well as in reserve.
5. When the debt instrument matures, the reduction in value should also be recognised in OCI.

Initial Measurement:

Subsequent Measurement:

Accounting entries for finance income:

Accounting entries for instalments:

Accounting entries for changes in fair value each year:

Year one: $1,265 increase in fair value:

Year two: $1,251 decrease in fair value:

Year three: the debt instrument matures with $14 value reduction to zero:

1. FVTPL debt instrument:

Initial measurement:

Transaction cost:

Subsequent measurement:

Interest income:

Changes in fair value:

At the end of the first year: a $2,000 increase in fair value ($12,000 - $10,000)

At the end of the second year: the debt instrument is sold at fair value of $11,000

Investment in Debt Instruments

Amortised Cost

FVTOCI

FVTPL*

(irrevocable option)

Initial measurement

Fair value + transaction costs

Fair value + transaction costs

Fair value; Transaction costs in P/L

Subsequent measurement

Amortised cost

Amortised cost + fair value changes to OCI

Fair value changes to P/L

Derecognition

Gains and losses from disposal: P/L

Gains and losses from disposal: P/L

Previous OCI is taken to P/L

(IFRS 9: para. 5.71.10)

Gains and losses from disposal:

P/L

Investment in Equity Instrument

FVTOCI

(Long term)

(Irrecoverable Option)

FVTPL

(Held for trading)

Financial Liability

Amortised Cost

(Non-derivative)

FVTPL

(Derivative/Fair value option)

Example: Financial liabilities

A business issued $10,000, the nominal value, in 5% (nominal or coupon rate) loan notes in year one. The business incurred transaction costs of $500 when the loan note was acquired. Loan notes will be redeemed in three years’ time at a premium of $1,322. The effective interest rate is 11%.

Required:

Accounting entries.

Answer:

Initial Measurement:

Transaction cost:

Subsequent Measurement:

Accounting entries for finance costs:

Accounting entries for instalments:

Example: Deep discount bond

A business issued a $9,500 million deep discount bond, and it is redeemed at the end of the second year for $11,000 million. During these two years, no interest payment will be made to investors. The effective interest rate of this deep discount bond is 7.6%.

Required:

Accounting entry.

Answer:

Initial measurement:

Subsequent measurement using amortised cost method:

Accounting entries for interest expense at the effective interest rate of 7.6%:

When the deep discount bond is repaid at the end of the second year:

A gain or loss on a financial asset or financial liability that is measured at fair value shall be recognised in profit or loss unless it is a financial liability designated as at fair value through profit or loss and the entity is required to present the effects of changes in the liability’s credit risk in other comprehensive income. For instance, changes in credit rating, country risk (affect the foreign currency reserve) and the internal credit risk rating (commonly exist in banks)

(IFRS 9: 5.7.1 (c))

Example

Vicky regularly purchases investment properties, and she funds those purchases by issuing bonds. The bonds are initially carried at amortised cost. To avoid accounting mismatch, Vicky has used the fair value option to measure those bonds at fair value through profit or loss.

The fair value of bonds fell by $100m during the year, of which $30m related to its creditworthiness.

Required:

Accounting treatment.

Answer:

The fair value movement of the financial liability should be split into:

1. Fair value movement due to the credit risk should go into OCI.
2. The remaining fair value movement should be taken to the P/L.

Presentation example:

Statement of profit or loss and other comprehensive income:

Account receivables should be derecognised

Explanations

Non-refundable fixed sum from the business.

For instance, the factoring company provides 90% of the receivable balance ($100 million) $90 million to the business as the loan in advance, and the $90 million is not refundable by the business if the factoring company could not collect money from the business’s credit customers.

The business has no rights to further sums from the factor.

For instance, from the previous example, if the business does not have any rights to the remaining 10% or $10 million of the account receivables any more.

Without recourse basis factoring

This means if the factoring company could not collect money from credit customers, the factoring company has to bear all the losses.

Accounting treatment:

Derecognise the account receivable by:

Dr Bank

Cr Account receivables

Dr/Cr (Loss) or Gain on disposal

Account receivables should stay in the business’s accounts

Explanations

With recourse basis factoring

This means if the factoring company could not collect money from credit customers, the factoring company can chase the money back from the business. Therefore, if the full amount is with recourse basis or partial amount is with recourse basis, the full or partial amount should not be derecognised by the business.

Money in advance should be paid back

If the amount is required to be paid back by the business, ie on an agreed date, the amount should not be derecognised by the business.

The business still bears the slow-moving risk of the account receivables

For instance, the factoring company charges the business 2% of the outstanding receivables as the administrative or finance cost if the account receivables are not paid in 30 days. In this case, the business bears the slow-moving risk of the account receivables, and therefore, the account receivables should remain in the business’s accounts.

Example: without recourse

A business factored its $2 million receivables to the factoring company, and the factoring company provides 80% of the $2 million as loan to the business.

The factoring company has the right to claim a maximum $100,000 from the business for any losses.

The total receivables of the business at the time of the factoring agreement are $10 million.

Required:

Accounting entries.

Answer:

The factoring arrangement contains both the without recourse and with recourse part, ie only $100,000 is with recourse part.

Therefore, the business should not derecognise the $100,000 account receivables from the account.

The $1.6 million (20% x 80%) is without recourse part and therefore, the business can derecognise $1.6 million account receivables from the account:

If the business receives the entire excess from the factor (the remaining $0.4 million), the business should:

If the business receives only $0.35 million from the factoring company due to bad debt reasons:

If the business needs to reimburse the factor for $100,000 if the remaining balance is not collected by the factoring company, the business should:

Example: Full with recourse

A business factored its $2 million receivables to the factoring company, and the factoring company provides 80% of the $2 million as loan to the business. The advance is with full recourse basis.

Required:

Accounting entry.

Answer:

Account receivables should not be derecognised in this case since it is under full recourse basis, ie the business needs to bear the non-payment risks from the credit customers.

If the financial asset is either measured at FVTOCI or amortised cost, the expected loss model should be used to estimate the impairment expense, which would go into the P/L.

The impairment loss adjustment depends on whether it is twelve months (credit risks have not increased significantly) or a lifetime expected credit loss (credit risks have increased significantly, ie contractual payments are more than 30 days overdue at the reporting date).

(IFRS 9: para. 5.5)

Initial Recognition for Financial Assets

Q: William (FVTOCI Debt Instrument Impairment Introductory Q)

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

At the reporting date of 31 December, the fair value of the instrument has fallen to $950. There has not been a significant increase in credit risk since the bond has been issued so expected credit losses should be measured at 12-month expected credit losses.

The expected credit loss is $20.

Required:

Accounting treatment for the above.

Answer:

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

Dr OCI $50

Cr Financial Asset (FVTOCI) $50

The 12-month expected credit losses of $20 will be taken to the statement of profit or loss as a loss, at the same time, it will be recorded against other comprehensive income:

Dr Impairment loss (P/L) $20

Cr OCI $20

Overall:

Dr OCI $50 - $20 = $30

Dr Impairment loss (P/L) $20

Cr Financial Asset (FVTOCI) $50

Q: Hu plc (Amoritsed Cost Debt Instrument Impairment)

On 31^st Dec 2020, Hu plc bought a bond for $1m measured at amortised cost. Coupon interest of 10% was the same as the effective interest rate. Repayment is due on 31 December 2023 (3-year bond).

On 31^st Dec 2021 it was estimated that the probability of default on the bond within the next 12 months would be 0.5%.

If default happens within the 1^st 12 months, then Hu plc estimated that only 50% of the capital will be repaid on 31 December 2023.

Required:

Accounting treatment of the financial asset at 31 December 2021.

Answer:

Expected credit loss: (The discount rate is the original effective interest rate of 10%.)

The credit risk on the financial asset has not significantly increased. Hence, a loss allowance should be made equal to 12-month expected credit losses.

Up to 31^st December 2022: $1m x 10% = $100,000 / 1.1^1= $90,909

Up to 31^st December 2023: $1m x 10% = $100,000/1.1^2 = $82,644

Repayment: (December 2023): 50% x $1m/1.1^2= $413,223

Credit Loss= $586,776

x Probability of 0.5% 0.5%

12months Expected Credit Loss = $2,933

Hence:

Dr P/L $2,933

Cr Financial Asset at amortised cost $2,933

Note:

In future periods, interest will be charged to amount which is before deducting any impairment losses, i.e., 10% based on $1m (carrying value at the 1^st year end).

This is different from lifetime expected losses where the interest should be charged on the carrying value which has deducted the impairment loss.

Q: Jack (Amortised Cost Debt Instrument Impairment)

The carrying value of the debt instrument bought by Jack is $10,000.

As at the year end, the company who issued the instrument has been in significant financial difficulties.

Jack estimates that it will receive no more interest from the company. It also estimates that only $6,000 of the capital will be repaid in 2 years.

The original effective discount rate is 6%.

Required:

Accounting treatment for the above impairment loss.

Answer:

Since the company who issued the debt instrument is in significant financial difficulties, the lifetime expected loss model will be used to account for the impairment loss for the debt instrument.

The debt instrument is credit impaired and hence the subsequent interest income will be calculated based on $5,340 and this needs to be recognised in the statement of profit or loss.

Q Jesco plc (Speculation purpose)

Jesco plc purchased 5 oil future contracts in the year ended 30 June 20x4. Each contract contains the right to purchase 1,000 barrels of oil at $40/barrel in December 20x5.

The contracts were purchased at nil cost and at 30^th June 20x4 the contracts were trading at $45/barrel. On 30^th June 20x5 the contracts are trading at $48/barrel.

It is subsequently sold at $80,000 on 30^th August 20x5.

Required:

Show the accounting treatment above.

Answer:

Gains on 30th June 20x5:

Total gain= ($8/barrel-$5/barrel) x 1,000 barrels x 5 contracts =$15,000

Dr Financial asset $15,000

Cr Gain on derivative (P/L) $15,000

Sold:

Dr Cash $80,000

Cr Financial asset $40,000

Cr Gain on disposal (P/L) $40,000

Airline businesses with fuel costs

The numbers are set because for some industries such as airline companies, where the fuel price fluctuates and if the airline company wants to determine the selling price of ticket in advance, it may buy a fuel oil futures contract to lock the fuel price today.

However, these companies may also want to lock the fuel prices in two or three years’ time, however, for fuel oil futures, there are no contracts which are beyond one year. Therefore, these companies may need to enter futures contracts of something else, for instance, oil futures contract which may be available in 5-10 years’ time. The effectiveness of this may be questionable.

Q Fair Ltd (Fair value hedge)

On 1 August 2016 Fair Ltd bought 200 tons of copper at $1,400 a ton for inventory. Fair Ltd was concerned about price fluctuations so sold all 200 tons on a futures contract for delivery on 31 March 2017 at $1,480 a ton.

At 31 December 2016, the reporting date, the market value of copper was $1,500 a ton, and the futures price for 31 March 2017 delivery was $1,568 a ton.

Required:

Show the treatment for the fair value hedge.

Answer:

Effectiveness: 20,000/17,600 = 113.6% and this is highly effective.

1. Revalue inventories:

Dr Inventory 20,000

Cr P/L 20,000

2. Revalue hedging instrument:

Dr P/L 17,600

Cr Financial liability 17,600

Q Fairer Ltd (Fair Value Hedge, FVTOCI)

At the year start, Fairer Ltd 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.

It has entered into a futures contract to sell the shares for $900,000 as at the year end.

As at the year end, 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:

Show the treatment for the fair value hedge.

Answer:

Effectiveness: $90,000/$100,000 = 90% and this is highly effective.

The hedged item is an investment in equity instrument which is measured at fair value through other comprehensive income.

Hence the increase in the fair value of the derivative of $90,000 and the fall in fair value of the equity instrument of $100,000 since the inception of the hedge are taken to OCI.

Hedging instrument:

Dr Financial Asset $90,000

Cr OCI $90,000

Hedged item:

Dr OCI $100,000

Cr Financial Asset $100,000

Q Justice Ltd (Fair Value Hedge, Firm Commitments)

Justice Ltd has a firm commitment to purchase the machinery next year.

As at the year end, because of the exchange rate movement, the cost to purchase the machinery has risen by $100,000. The gain on the future contract has risen by $95,000.

Required:

Show the treatment for the fair value hedge.

Answer:

Effectiveness: $95,000/$100,000 = 95% and this is highly effective.

Hedged item:

Dr Expense $100,000

Cr Firm commitment liability $100,000

Hedging instrument:

Dr Financial Asset $95,000

Cr Gain (P/L) $95,000

Illustrated example:

A forecasted sales in foreign currency is expected with a loss of $100 million as a result of changes in foreign exchange rates. The business has taken out a foreign currency futures contract and the market value has increased by $118 million.

Accounting treatment:

1. Revenue – no treatment as it does not take place yet

2. Derivative – the effective proportion is $100 million as these are the real losses to be protected by the gains in derivative, ie taken to OCI. The remaining $18 million should be taken to P/L as they are ineffective portion:

Dr Financial Asset $118 million

Cr OCI $100 million (effective proportion)

Cr P/L $18 million (ineffective proportion)

Until when the sales occur, and let’s suppose that the profits look like this:

Profits have decreased by $100 million which can be offset against the OCI reserve of $100 million:

Dr OCI $100 million

Cr P/L $100 million

For non-financial assets such as inventories and PP&E, OCI could be used to offset against their costs. However, it’s entity’s choice of whether to offset OCI against P/L or costs.

Q Cashy Ltd (Cash Flow Hedge)

Cashy Co has decided on 1 November 2016 to purchase an asset on 1 November 2017 for €60,000,000. This is highly likely to take place. Cashy reports in US$ and hedges this transaction by entering into a forward contract to buy €60,000,000 on 1 November 2017 at US$1: €1.5.

Spot and forward exchange rates at the following dates are:

Required:

Show the double entries relating to these transactions at 1 November 2016, 31 December 2016 and 1 November 2017.

Answer:

1.11.2016- 31.12. 2016

Hedging instrument (forward contract):

Hedged item:

Effectiveness: 8,387,096/8,620,690=97% and hence this is effective and therefore, hedge accounting is used.

Dr Financial asset (Forward a/c) $8,387,096

Cr OCI $8,387,096

31.12. 2016-1.11.2017

Hedging instrument (forward contract):

Hedged item:

Effectiveness: 11,612,904/10,000,000=116% and hence this is effective and therefore, hedge accounting is used.

Dr Financial asset (Forward a/c) $11,612,904

Cr OCI $10,000,000 (Effective proportion)

Cr Profit or loss $1,612,904 (Ineffective proportion)

1.11. 2017

Purchase of asset at market price

Dr Asset (€60,000,000/1.0) $60,000,000

Cr Cash $60,000,000

Settlement of forward contract

Dr Cash $20,000,000

Cr Financial asset (Forward a/c) $20,000,000

Realisation of gain on hedging instrument

The cumulative gain of $18,387,096 recognised in equity:

• Is transferred to profit or loss as the asset is used, i.e. over the asset's useful life; or
• Adjusts the initial cost of the asset (reducing future depreciation).

Exam rehearsal question – Crypto June 2019

On 1 April 20X7, Crypto, which has a functional currency of the dollar, entered into a contract to purchase a fixed quantity of electricity at 31 December 20X8 for 20 million euros. At that date, the spot rate was 1·25 dollars to the euro. The electricity will be used in Crypto’s production processes. Crypto has separated out the foreign currency embedded derivative from the electricity contract and measured it at fair value through other comprehensive income (FVTOCI).

However, on 31 December 20X7, there was a contractual modification, such that the contract is now an executory contract denominated in dollars. At this date, Crypto calculated that the embedded derivative had a negative fair value of 2 million euros. The directors of Crypto would like advice as to whether they should have separated out the foreign currency derivative and measured it at FVTOCI, and how to treat the modification in the contract. (5 marks)

Answer:

IFRS 9 Financial Instruments states that ‘any embedded derivative included in a contract for the sale or purchase of a non-financial item that is denominated in a foreign currency shall be separated when its economic characteristics and risks are not closely related to those of the host contract’. Thus, in contrast to the treatment for hybrid contracts with financial asset hosts, derivatives embedded with a financial liability will often be separately accounted for. That is, they must be separated if they are not closely related to the host contract, they meet the definition of a derivative, and the hybrid contract is not measured at fair value through profit or loss (FVTPL).

The contract is a hybrid contract containing a host contract which is an executory contract to purchase electricity at a price of 20 million euros and a non-closely related embedded foreign currency derivative with an initial fair value of zero to buy 20 million euros, sell 25 million dollars. However, the derivative should have been valued at FVTPL and not fair value through other comprehensive income.

At the date of the modification of the contract to the functional currency of Crypto, there is a significant change to the contract which will trigger a reassessment of its position under IFRS 9. As the contract no longer has a non-closely related embedded derivative, the entire arrangement will be accounted for prospectively as an executory contract which is outside the scope of IFRS 9. The embedded derivative will be derecognised and it is likely that Crypto will have to pay the counterparty 2 million euros in compensation.

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