Accounting

for Derivatives and

Hedging Activities
 Definition of Hedging

Hedging for accounting purposes, means designating one or more hedging instruments so
that their change in fair value or cash flows is an offset, in whole or in part, to the change in fair
value or cash flows or a hedged item.
A hedge is highly effective if the changes in fair value or cash flow of the hedged item and the
hedging derivative offset each other to a significant extent.
Hedge Accounting is recognizing the offsetting effects on profit or loss of changes in the fair
values of the hedging instrument and the hedged item.
 Objective
Hedging financial risks

Manage
currency risk
exposure

Manage Manage
Risk
interest rate risk commodity price
Management
exposure exposure

Manage
credit risk
 Economic and accounting
hedging
The general idea of hedging is to mitigate the market risk of an entity due the
volatility of the market they have entered to.

Hedging Concept

Economic Accounting
Hedging Hedging
• Economic hedging is an act of • Accounting hedging is an
hedge by entering a hedge accountancy process in recording
instrument (usually derivatives) in hedge instruments in financial
order to reduce the risk. statement.

• Common hedge instruments : • IFRS 9 governs the standard of a

Swap, Forwards, Futures, Options. hedge instruments before applying
hedge accounting.
 Hedge instruments and hedge
items
Main components of Hedge Accounting:

1. Hedging Instrument Swaps Options

► A designated derivative or (in limited
Futures Forwards
circumstances a non-derivative financial instrument)
► whose fair value or cash flows are expected to Non-derivatives
offset changes in the fair value or cash flows of a
designated hedged item

2. Hedged Item Fixed / Variable Bonds

Is an asset, liability, firm commitment, forecast
Forecast sales or purchases
future transaction or net investment that:
► exposes the entity to the risk of changes in: Receivables and payables
• fair value; or
Borrowings and investments
• future cash flows; and
► is designated as being hedged Loans
 Types of contracts
Forward contracts
•buy or sell asset at certain future time for
certain price
•no premium required; no initial net
investment
•parties are required to buy or sell the
underlying asset
•examples: forex forward, cross currency
swap, interest rate swap
•traded over the counter
Futures contracts
•same as forward contracts but normally
traded on the exchange
Options
•parties involved: (a) underwriter / issuer /
seller; (b) holder / buyer
•call option gives holder a right to buy an
underlying asset by a certain date for certain
price
•put option gives the holder a right to sell an
underlying asset by a certain date for certain
price
•holder is not obligated to buy or sell; option
may not be exercised by holder
•asymmetrical risk
•exercise price or strike price
•usually premium is involved; exotic options
may have zero premium
•American or European type
•traded both exchanges or over-the-counter
 Markets

• standardized contracts defined by the exchange

Exchange traded
• futures, options (forex, equities, equity indices)
market
• credit risk is minimized or eliminated

• much larger market

• telephone and computer-linked network of dealers
Over-the-counter • financial institutions act as market makers
market • bid price and offer price
• some credit risk involved
• forward contracts, options, bonds, etc.
 Types of players / users

Hedgers
•use derivatives to reduce risks from potential future movements
of a market variable

Speculators Arbitrageurs
•use derivatives to bet on the future •take offsetting positions in two or more
direction of a market variable instruments to lock in profit
 Forward Valuation
The concept (1/2)
► An agreement between two parties to buy or sell an asset at a certain future time for a certain price agreed
today
► FX Forward is an “Over-the-Counter” (OTC) product, which means it is likely many contracts will differ in some
manner
► Underlying assets can be foreign currency, commodities, or other assets (such as fuel, fixed assets, motor
vehicles, heavy equipments, etc)

Party Agrees to Party At point

A BUYS
PURCHASE A
► Underlying assets can be foreign currency,
commodities, or other assets (such as fuel, fixed
assets, motor vehicles, heavy equipments, etc)
At point
Party Party ► The purchase/sell will be conducted at
Agrees to SELL SELLS maturity, on an agreed price of X
B B
► Both parties have the OBLIGATION to either
purchase/sell as agreed initially
► Gain or loss will be realized based on the
Market DIFERRENCE of MARKET PRICE with
price AGREED PRICE
Agreed
price at X

Actual market price movement of

Agreed asset price
the underlying asset
 Forward Valuation
The concept (2/2)
Party Agrees to Party
A BUYS A
PURCHASE

Transaction period / maturity

Party period Party
B Agrees to SELL SELLS B

Market
price

Agreed
price at X

Market price movement

At point During the duration At point

► Both parties enters into an agreement
to purchase/ sell an underlying asset in
the future for a specified amount and
price.
► No cash flow movement will exist, and
no exchange of ownership of the asset
through out the period
► Although the market price of the
underlying asset may go up/down, the
agreed price stays on a fixed amount
► The purchase/sell will be conducted at
maturity, on an agreed price of X
► Both parties have the OBLIGATION to
either purchase/sell as agreed initially
► Gain/loss will be realized based on the
DIFERRENCE of MARKET PRICE with
AGREED PRICE
 Characteristics for a Derivative
1. It has one or more underlyings and one or more
notional amounts or payment provisions, or both.
2. It requires no initial net investment or an initial net
investment that is smaller than would be required for
other types of contracts that would be expected to
have a similar response to changes in market factors.
3. Its terms require or permit net settlement, so it can
readily be settled net by a means outside the contract,
or it provides for delivery of an asset that puts the
recipient in a position not substantially different from
net settlement.
 Assessing Hedge Effectiveness
Critical Term Analysis

Examining the nature of the underlying variable, the notional amount of the
derivative and the item being hedged, the delivery date for the derivative,
and the settlement date for the item being hedged.

If the critical terms of the derivative and the hedged item are identical, then
an effective hedge is assumed.
 Example of Effectiveness
Item to be hedged
–Accounts payable
–Due January 1, 2012
–For delivery of 10,000 euros
–Variable is the changing value of euros
Hedge instrument
–Forward contract
–To accept delivery of 10,000 euros
–On January 1, 2012
 Major types of hedges

Fair Value Hedge – Cash Flow Hedge – You are

Something is already “locking in” something
“locked in” and you need to
protect it
 Cash flow and fair value
hedges - examples
Definition
1. Cash flow hedge (includes foreign currency cash flow hedge)

Examples:
► Interest volatility from floating rate instruments: Hedge strategy - convert
floating rate to fix rate
► Cash flow volatility from forecasted payment in foreign currency: Hedge
strategy
- enter into forward foreign currency contract
► Forecast USD highly probable foreign currency sales of airlines seats in
September hedged by a USD/Euro forward contract.

2. Fair value hedge

Examples:
► Change in FV of fixed rate debt instruments: Hedge strategy - convert fix rate to
floating rate
► Oil held in inventory and hedged using a 6 month oil forward.
► A firm commitment to buy a machine in 6 months time for a fixed USD foreign
currency amount hedged by a USD/£ forward contract.
 Cash Flow Hedge Accounting
A Cash Flow Hedge is used for
anticipated or forecasted
transactions where there is risk of
variability in future cash flows
 Cash Flow Hedge Accounting
A Cash Flow Hedge is
• recorded at cost
• adjusted to fair value at each reporting
date
• accounted for in Other Comprehensive
Income (OCI) when there are gains or
losses
When the forecasted transaction impacts the
income statement
• Reclassify OCI to the hedged revenue or
expense account
 Cash Flow Hedge – Forward Contract
• Gre anticipates producing and selling copper in one year.
• The expected cost of the 100,000-pound production was
$28,900,000.
• Gre enters into a forward contract with Bro that locks in
a $300 per pound price for the copper.
• Gre will sell the copper in the open market at the
prevailing price and will then either receive or pay the
difference between the market price and $300 so that
Gre nets $300 per pound.
• The forward contract is signed on October 1, 2011, and
will be settled in one year, on September 30, 2012.
Assume that the market price of copper is $300 on
October 1, 2011.
 Cash Flow Hedge – Forward Contract
• October 1, 2011.
No Entry.
• December 31, 2011.
Assume that the market price of copper is $310 on this date;
discount rate of 1 percent per month.
*(1,000,000/(1.01)9 = $914,340)
Other comprehensive income (-SE) 914,340
Forward contract (+L) 914,340*
Notes:
1. If the market price stays the same, Gre would pay Bro (310-
300)x100,000 = $1,000,000 at the expiration of the contract in nine
months.
2. Because the $1,000,000 is our estimate of a payment to be paid in
nine months, we must use present value concepts to estimate its
fair value on December 31, 2011.
 Cash Flow Hedge – Forward Contract
• March 31, 2012.
Assume that the market price of copper is $295.
*($500,000/(1.01)6 = $471,023)
Forward contract (+A) 471,023*
Forward contract (-L) 914,340
Other comprehensive income (+SE) 1,385,363
Notes:
1. If the market price stays the same, Gre would receive (300-
295)x100,000 = $500,000 at the expiration of the contract in six
months.
2. Because the $500,000 is our estimate of a payment to be received
in six months, we must use present value concepts to estimate its
fair value on December 31, 2011.
3. The balance for other comprehensive income has moved from a
debit balance of $914,340 to a credit balance of $471,023.
 Cash Flow Hedge – Forward Contract
• June 30, 2012.
Assume that the market price of copper is $290.
*($1,000,000/(1.01)3 = $970,590)
Forward contract (+A) 499,567
Other comprehensive income (+SE) 499,567
Notes:
1. If the market price stays the same, Gre would receive (300-
290)x100,000 = $1,000,000 at the expiration of the contract in three
months.
2. Because the $1,000,000 is our estimate of a payment to be received
in three months, we must use present value concepts to estimate its
fair value on December 31, 2011.
3. Increase the forward contract asset and other comprehensive
income by $499,567 ($970,590* desired balance -$471,023 current
balance)
 Cash Flow Hedge – Forward Contract
• September 30, 2012.
The market price of copper on this date is $310.
Gre sells the copper in the market at $310 and will settle the forward
contract by paying Bro $1,000,000 [($310 - $300)*100,000]
The journal entries to record the sale:
Cash (+A) 31,000,000
Sales (+R, +SE) 31,000,000
Cost of goods sold (+E, -SE) 28,900,000
Inventory (-A) 28,900,000

The journal entries to record the settlement of the forward contract:

Sales (-R, -SE) 1,000,000
Other comprehensive income (-SE) 970,590
Cash (-A) 1,000,000
Forward contract (-A) 970,590
 Fair Value Hedge Accounting
A Fair Value Hedge is used for an
asset or liability position, or firm
purchase or sale commitment,
where there is a risk of variability in
the value of the position
 Fair Value Hedge Accounting
Both the item being hedged and the
derivative are
• adjusted to fair value at each
reporting date
• accounted for immediately in
income with offsetting gains or
losses
 Fair Value Hedge Accounting
• To hedge existing assets/liabilities
- Forward Contract
The fair value of forward contract adjusted
quarterly until the contract is settled (by using
Present Value (PV)); the fair value adjusted by
comparing to the initial value
The fair value of the hedged item has to be
adjusted quarterly until the contract is settled as
well (not adjusted to PV)
• To hedge firm purchase/sales commitment
 Fair Value Hedge – Existing
Assets/Liabilities
• Wav Company refines oil.
• Wav purchases raw crude from various producers and,
after the refinement process, sells it to gasoline
wholesalers.
• Because of some factory breakdowns, it has about
100,000 barrels of oil that will not be processed for six
months.
• Wav enters into a forward contract to sell the crude for
$90 per barrel in six months.
• The contract will be settled net.
• This type of contract will allow it to maintain the fair
value of the crude on its books.
 How does the contract work?
• If the price of crude is $95 per barrel: Wav will
pay the counterparty to the forward $5 per
barrel; and also have crude that is worth $95.
• If the price of crude is $70 per barrel: Wav will
receive $20 per barrel, which will help to
compensate it for the lower value of its crude
inventory.
 Fair Value Hedge – Existing
Assets/Liabilities
• Assume that the forward contract price of $90 equals
the spot price at the contract date.
• Wav’s book value of the oil is $86, its historical cost.
• Use mixed-attribute model:
If the values are different, the inventory will be
changed only by the difference between its fair value
and the fair value at the derivative contract signing
date.
• Assume that Wav is located in West Texas and that it is
located next door to a major West Texas producer. The
appropriate spot rate would be West Texas Crude.
 Fair Value Hedge – Existing
Assets/Liabilities
• On November 1, 2011.
No entry.
• On December 31, 2011.
If the market price of crude oil is $92; assuming 1 percent per month
interest.
*($200,0000/(1.01)4 = $192,196)
Loss on Forward contract (+Lo, -SE) 192,196
Forward contract (+L) 192,196*
Inventory (+A) 200,000
Gain on Inventory (+Ga, +SE) 200,000

The change in the inventory value from November 1, 2011 is also $2

($92 - $90). So the inventory would be increased by $200,000.
 Fair Value Hedge – Existing
Assets/Liabilities
• On March 31, 2012.
The spot price is $89.
*($100,000/1.01 = $99,009)
Forward contract (+A) 99,009*
Forward contract (-L) 192,196
Gain on Forward contract (+Ga, +SE) 291,205
*(($92 - $89)*100,000 = $300,000)
Loss on Inventory (+Lo, -SE) 300,000
Inventory (-A) 300,000*

The book value of the inventory is now $8,500,000

($8,600,000 + $200,000 - $300,000).
 Fair Value Hedge – Existing
Assets/Liabilities
• On April 30, 2012.
The spot price is $87.50.
Wav will receive $250,000 [($90-$87.50)*100,000] to settle
the contract.
-- Settlement of Forward Contract
Cash (+A) 250,000
Forward contract (-A) 99,009
Gain on Forward contract (+Ga, +SE) 150,991
-- Inventory Adjustment
Loss on Inventory (+Lo, -SE) 150,000
Inventory (-A) 150,000
Fair Value Hedge – Existing
Assets/Liabilities
Fair Value Hedge Accounting: Foreign Currency–Denominated
Receivable Example

ILLUSTRATION: HEDGE AGAINST

EXPOSED NET ASSET (ACCOUNTS
RECEIVABLE) POSITIONS
• U.S. Oil Company sells oil to Monato Company of
Japan for 15,000,000 yen on December 1, 2011.
• The billing date for the sale is December 1, 2011,
and payment is due in 60 days, on January 30,
2012.
• Concurrent with the sale, U.S. Oil enters into a
forward contract to deliver 15,000,000 yen to its
exchange broker in 60 days. This transaction will
not be settled net. The yen will be delivered to
the broker.

The bold rates are the relevant rates for accounting purposes
• Journal entries on the books of U.S. Oil are as
follows:
 • At December 31, 2011, the accounts
receivable from the sale is adjusted to reflect
the current exchange rate

• Calculating the exchange gain on the

forward:
• 15,000,000 yen*($0.007490 - $0.007489)/(1.01)
• Over the contract period, the forward rate will
approach the spot rate, exactly equaling it on
the settlement date.
THE REST OF CHAPTER IS YOURS