1

FINANCIAL INSTRUMENTS :
DERIVATIVES AND HEDGING
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Objectives
1. Definition-derivatives
2. Examples of common derivatives
3. Accounting for derivatives
4. Hedge accounting
5. Discontinuation of hedging
6. Disclosures
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DERIVATIVES
 A financial derivative is a contract between two (or
more) parties where payment is based on (i.e.,
"derived" from) some agreed-upon benchmark.
 Since a financial derivative can be created by means
of a mutual agreement, the types of derivative
products are limited only by imagination and so there
is no definitive list of derivative products.
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DEFINITION
Derivative is a financial instrument or other contract with three
characteristics:
1. Its value changes in response to the change in a specified
“underlying variable”
 i.e. the change in a specified interest rate, financial instrument price,
commodity price, foreign exchange rate, index of prices or rates, credit rating
or credit index, or other variable (in case of a non-financial variable, the
variable must not be specific to a party to the contract).

2. It requires no initial investment or an initial net investment that is

smaller than would be required for other types of contracts that
would be expected to similar response to changes in the market
factors, and
3. It is settled in a future date
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Example
Yukon Entity (YE) enters for trading purposes into a contract to
exchange 100,000 barrels of crude oil for USD101 a barrel three
months from today. By entering into forward contract, YE “locks
into” a price to be received for crude oil.
• The forward contract is a derivative because:
1.Its value changes in response to changes in underlying
variable (commodity –crude oil price)
2.there is no initial net investment and;
3.the settlement occurs at a future date (three months) when
YE makes delivery of the oil.
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EXAMPLES OF COMMON DERIVATIVES

 Forward
 Options
 Futures
 Structured Notes
 Swaps
 Embedded derivatives
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FORWARD
 A forward contract is a customized contract between two parties to
buy or sell an asset at an agreed price on a specific date in the
future.
 both the seller and the purchaser are obligated to trade a security or
other asset at a specified date in the future.

 The price paid for the security or asset may be agreed upon at the time
the contract is entered into or may be determined at delivery.

 Can be on any underlying investment asset(e.g. gold, equity),

consumption asset(e.g. crude palm oil), foreign currency (e.g. USD
or £ -GBP) or reference interest rates (e.g. KLIBOR).

 Forward Contracts generally are traded OTC.

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FORWARD…cont
 Example:
Suppose that on 1 January 2021 ABC expects to purchase 1,000
tonnes of palm oil on 1 April 2021. As ABC is exposed to price
fluctuation risk, ABC enter into a palm oil forward contract to
purchase 1,000 tonnes of palm oil at 1 April 2021 at RM1,951 per
tonne.
The forward contract locks in the price when ABC purchases the
palm oil on 1 April 2021. Therefore, ABC agrees on 1 January 2021
to purchase 1,000 tonnes of palm oil at the price of RM1,951,000
(1,000 tonnes x RM1,951) on 1 April 2021.
If the price of palm oil goes up, ABC profits from the forward
contract. However, if the price goes down, it loses.
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FORWARD…cont
 Forward contracts may be settled by physical delivery or cash
settlement.
 If settled by physical delivery - the seller is required to deliver the
asset to the buyer on the settlement date, and the buyer makes
payment as agreed in the contract.
 If settled by cash settlement - the asset is never delivered to the
buyer. Instead, payment is made on the settlement date for the value
of the forward contract (ie. the difference between the current market
price and the agreed contract price).
 Assume the current market price of palm oil on 1 April 2021 is RM2,010 per
tonne, then ABC makes a profit of RM59,000 [(RM2,010 – RM1,951) x 1,000
tonnes)] from the forward contract. For cash settlement contract, ABC gets paid
cash of RM59,000
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OPTION
 The purchaser of an Option has rights (but not obligations) to buy or sell
the asset during a given time for a specified price (the "Strike" price or
exercise price).

 2 types of option:
1. Call Option - an Option to buy
2. Put Option - an Option to sell
 A call option gives the holder of the option to buy, but the seller of a Call
Option is obligated to sell the asset to the party that purchased the
Option.
 A put option gives the holder of the option to sell, but the seller of a Put
Option is obligated to buy the asset.
 Options are traded on organized exchanges and OTC (over the
counter)
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OPTION…cont
 The purchaser of option must pay for the option premium
 Example:
Assume that MNO Bhd purchases a call option contract on 2 January
2021, when ABC shares are trading at $100 per share. The contract gives
it the option to purchase 1,000 shares (referred to as the notional amount)
of ABC shares at an option price of $100 per share. The option expires on
30 April 2021. The company purchases the call option for $400.
On 31 March 2021, the price of ABC shares increases to $120 per share.
The company exercise the call option and purchase 1,000 shares at the
strike price of $100 per share.
Option premium = $400
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OPTION…cont
 Value of Option = Intrinsic Value + Time Value.
 The intrinsic value = the market price - the strike price.
 It is the amount to be realized by the option holder when the option is
exercised.
 Refer to the example - the intrinsic value of the call option at 31 March
2021 is $20,000 [ie ($120 - $100) x 1,000]
 An option is said to be “in the money” when it has a positive intrinsic value.
 The time value of an option is the expectation that the market price of the
asset will change over time during the option term and it will cause the
option to become in the money.
 The call option holder can exercise the option ( if asset value increase) or
let the option expire (if asset value decrease)
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Futures
 A Future is a contract to buy or sell a standard quantity and quality
of an asset or security at a specified date and price.
 Futures are similar to Forward Contracts, but are standardized and
traded on an exchange, and are valued daily. The daily value
provides both parties with an accounting of their financial
obligations under the terms of the Future.
 Futures contracts are settled on daily basis until the end of the
contract
 Unlike Forward Contracts, the counterparty to the buyer or seller in
a Futures contract is the clearing corporation on the appropriate
exchange.
 Futures often are settled in cash or cash equivalents, rather than
requiring physical delivery of the underlying asset.
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Structured Notes
 Structured Notes are debt instruments where the principal and/or
the interest rate is indexed to an unrelated indicator.
 Eg: a bond whose interest rate is decided by interest rates in England
or the price of a barrel of crude oil would be a Structured Note,
 Sometimes the two elements of a Structured Note are inversely
related, so as the index goes up, the rate of payment (the "coupon
rate") goes down. This instrument is known as an "Inverse Floater."
 With leveraging, Structured Notes may fluctuate to a greater
degree than the underlying index. Therefore, Structured Notes can
be an extremely volatile derivative with high risk potential and a
need for close monitoring.
 Structured Notes generally are traded OTC.
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SWAPS
 A Swap is a simultaneous buying and selling of the same
security or obligation. Perhaps the best-known Swap occurs
when two parties exchange interest payments based on an
identical principal amount, called the "notional principal
amount."
 Some other examples of swap include cross-currency swap
and commodity swap.
 Most swap contracts are traded over the counter (OTC),
although some may be traded in the futures market.
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EMBEDDED DERIVATIVES
 Defined in MFRS 9:
“a component of a hybrid (combined) instruments that also
includes a non-derivative host contract, with the effect that
some of the cash flows of the combined instruments vary in
a way similar to a stand-alone derivative.”

 Example - A convertible bond consists of two parts: (1) a

debt security (host security), combined with (2) an option to
convert the bond to ordinary shares.
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ACCOUNTING FOR DERIVATIVES

1. Initial recognition
 Most derivatives (forward, futures and swap) do not
require initial outlay.
 On the contract date (initial recognition), recognise the
derivative at the net fair value of nil (if there is no
outlay) or at the premium paid or received (for option
derivatives);
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Accounting for derivatives…Cont.

2. Remeasure the derivative to Fair Value (mark to market, if
there is quoted price) at each reporting date (e.g. quarterly)
 recognise any change in value as gain or loss in profit or
loss (unless hedge accounting applies);
3. Remeasure the derivative on the date it is closed out or on
maturity date
 recognise gain or loss in profit or loss (unless hedge
accounting applies);
4. Close out the contract and derecognised the derivative upon
settlement.
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Accounting for derivatives…Cont.

Subsequent measurement (2 & 3 ):
 As the fair value of derivatives can change over time, there is a
need for adjustments to the carrying value of the assets and
liabilities. These adjustments would require the recognition of
gains and losses.
 If the use of the derivative instruments is for speculation
purposes, any gain or loss should be recognized in profit or loss
statement.
 If the use is for hedging purposes, any gain or loss would be
recorded based on the type of hedge used.
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Accounting for derivatives…Cont.

Journal entry:
Description Debit Credit
Initial Recognition:

No initial outlay No journal entry

Premiun paid Financial assets (Option) Cash
Subsequent measurement:

Increase in fair value FP – Financial assets P/L – FV gain

OR
Decrease in fair value P/L – FV Loss FP – Financial asset/Liability
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EXAMPLE 1:FORWARD
Aman Bhd enters into a forward contract with BB Bank to purchase
1,000,000 shares of Solo Bhd in an anticipation that the share price
of Solo Bhd will rise in the next 6 months. The following information
is available at the date of transaction:
Contract date: 1 April 2021
Maturity date : 30 Sept 2021
Share price of Solo Bhd at contract date: RM3 per share
6-Month risk free rate: 4%(annual)
Dividend yield of Solo Bhd Shares : 2%(annual)
The financial year of Aman Bhd: 30 June 2021

market price of Solo Bhd increases to RM3.10 on 30/6/2021 and

closes at RM3.30 at maturity date.
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Example 1…cont
Required:
1) Compute the forward price of the forward contract on the contact
date, 1/4/2021. Prepare the required journal entries.
2) Compute the forward price of the forward contract and calculate
any gain or loss at year end, 30/6/2021. Prepare the journal
entries.
3) Compute the forward price of the forward contract and
determine any gain or loss at maturity, 30/9/2021. Prepare the
journal entries.
4) Record the accounting entries to account for the settlement of
forward contract on 30 Sept 2021.
5) Record the journal entries to account for the purchase of shares
on 30 Sept 2021.
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Example 1…cont
1) Compute the forward price of the forward contract on the contact
date 1 April 2021:
Formula to calculate forward price:
Fo = So (1+R-Y)T with simple compounding
Fo = So e(Rf-Y)T with continuous compounding
Where,
Fo = the forward price
So = the spot price
R = The risk free rate of return
T = The time to maturity, express in years, or fraction of year
Y = dividend yield
e = is the natural log =constant of 2.71828
For investment with no income, the cost of carry is risk free
rate of return
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Example 1…cont
1) the forward price of the forward contract on 1 April 2021

Fo = So (1+R-Y)T with simple compounding

= RM3 (1+0.04-0.02)1/2 time to maturity in year
= RM3 x 1.0099
= RM3.03
This is the contract price.
No journal entry required on 1/4/2021 (no initial outlay)
Write a memorandum to indicate the signing of forward contract
with the principal amount of RM3,030,000 (1 mil x RM3.03)
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Example 1…cont
2) The fair value of the forward contract at year end, 30/6/2021:
Fo = So (1+R-Y)T with simple compounding
= RM3.10(1+0.04-0.02)1/4 time to maturity in year
= RM3.10 x 1.00496
= RM3.115

Fair value of forward contract: Calculate the present value

= (3.115-3.03)/(1.04)1/4 x 1,000,000
= (0.085/1.00985) x 1,000,000
= RM84,171

Forward contract is an asset (as fair value is higher than contract

price) in Financial Position
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Example 1…cont
2) 30/6/2021:
Fair value gain = RM84,171 – RM0 = RM84,171

Journal entry at 30/6/2021:

Dr Forward Contract (Asset)-Solo shares RM84,171
Cr Gain on Forward Contract (Profit/loss) RM84,171
To recognise gain on change in FV of forward contract
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Example 1…cont
3) The fair value of the forward contract at maturity, 30/9/2021
Fo = So (1+R-Y)T with simple compounding
= RM3.30(1+0.04-0.02)0 time to maturity in year
= RM3.30

Fair value of forward contract: Calculate the present value

= (3.30-3.03) x 1,000,000
= 0.27x 1,000,000
= RM270,000

Forward contract is an asset (as fair value is higher than contract

price) in Financial Position
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Example 1…cont
3) 30/9/2021:
Fair value gain = RM270000- RM84,171= RM185,829

Journal:
Dr Forward Contract (Asset)-Solo shares RM185,829
Cr Gain on Forward Contract (Profit/loss) RM185,829

To recognise gain on change in FV of forward contract

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Example 1…cont

4. Settlement of forward contract on 30 Sept 2021:

Dr Cash 270,000
Cr Forward Contract -Solo shares 270,000
To record net cash settlement of forward contract

5. Purchase of shares on 30 Sept 2021:

Dr Investment in shares - Solo 3 300 000
Cr Cash 3 300 000
(RM3.30 x 1,000,000)

Net cash outflow = 3,300,000 – 270,000 = 3,030,000

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Example 2
Assuming the same case as in Example 1 and BB
Bank year end is also 30 June 20X3, prepare the
journal entries for the forward contract for BB Bank.

SOLUTION:
1) 1 April 2021
No journal entry
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Example 2…cont
2) 30 June 2021
Dr Loss on forward contract (Profit/Loss) 84,171
Cr Forward Contract (Liability)-Solo Shares 84,171
To recognise loss on forward contract
Derivative on Statement of Financial Position is Liability of 84,171

3) 30 Sept 2021:
Dr Loss on forward contract (Profit/Loss) 185,829
Cr Forward Contract (Liability)-Solo Shares 185,829
To record loss on forward contract on maturity
Derivative on Statement of Financial Position is Liability of 270,000
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Example 2…cont

4) Settlement of forward contract on 30 Sept 2021:

Dr Forward Contract (Liability)-Solo Shares 270,000

Cr Cash 270,000
To record net cash settlement of forward contract
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Example 3: Call Option

Abrar Bhd purchases a call option on 1 June 2021. It gives right to purchase
10,000 shares of Binary Bhd. at a price of RM10 per share. The cost of the option
is RM100. On this day, the shares are trading at RM10 per share. The option
expires on 30 Nov 2021.
Abrar Bhd has a year end of 30 September.
At 30 Sept. 2021 the time value of the option is RM80, and the shares are trading
at RM12 per share.
Abrar Bhd exercises the option on 29 Nov. 2021 when the shares are trading at
RM13 per share. The time value of the option is RM0 on this day.
The option is classified as at FVTPL.

Required
Prepare the required journal entries
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Solution example 3
• Option Premium = Intrinsic Value + Time Value
• Intrinsic Value = Market Price – Strike Price
 Represent the amount realized by the option holder, if exercising the option
immediately
• Time Value = the option value over and above its intrinsic value.
 Reflect the possibility that the option has a fair value greater than zero.
Because there is some expectation that the price of shares will increase
above the strike price during the option term.
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Solution example 3
1 June 2021: Record the purchase of call option
Dr Call option 100
Cr Cash 100

30 Sept 2021: Record change in FV of option

Increase in intrinsic value:
Dr Call option (10K)(RM12-RM10) 20 000
Cr Gain on option (Profit/Loss) 20 000

Decrease in time value:

Dr Loss on option(Profit/Loss) (RM100-RM80) 20
Cr Call option 20
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Solution example 3
29 Nov 2021: Record change in FV of option

Increase in intrinsic value:

Dr Call option (10K)(RM13-RM12) 10 000
Cr Gain on option (Profit/Loss) 10 000

Decrease in time value:

Dr Loss on option (Profit/Loss) (RM80-RM0) 80
Cr Call option 80
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Solution example 3
29 Nov 2021: Exercise of option, shares classified at FVTPL

Dr Investment in shares-Binary 130,000*

Cr Cash (10000 x RM10) 100,000
Call option 30,000
*(10K x RM13)

# Other alternative, Abrar can settle the option.

Net settlement – investors generally do not have to actually buy
& sell the shares to settle the option & realized the gain.
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HEDGE
• Entities are exposed to financial risks arising from many
aspects of their businesses (ex: changes in exchange rates or
interest rates, or commodity prices).
• Entities implement different risk management strategies to
eliminate or reduce their risk exposures.
• Therefore, hedge arrangements are entered into to protect
entities from those risks.
• A hedging is making an investment or acquiring some
derivative or non-derivative instruments (hedging instrument)
in order to offset potential losses (or gains) that may be
incurred on some items (hedged item) as a result of particular
risk
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HEDGE
• Hedging instrument - a financial asset or financial liability
whose fair value or cash flows are expected to offset changes
in the fair value or cash flows of a designated hedge item
o A derivative measured at fair value through profit or loss may be
designated as a hedging instrument

• Hedged item - can be a recognized asset or liability, an

unrecognized firm commitment, a forecast transaction or a net
investment in a foreign operation
o The hedged item can be a single item or a group of items.
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Example of a hedge
Company ABC that normally operates is USD has decided to spread its business to
Europe and made a contract to sell some goods to European customer for 20 million EUR
with delivery in 9 months.
However, your company is afraid that due to movements in foreign currency rates it will
get significantly less USD after 9 months and therefore, it enters into offsetting foreign
currency forward contract with bank to sell 20 mil. EUR for some fixed rate after 9 months.
What’s the hedge here?
Hedged risk - a foreign currency risk.
Hedged item - a highly probable forecast transaction (sale).
Hedging instrument - a foreign currency forward contract to sell EUR for a fixed rate at a
fixed date.
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Example of a hedge
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HEDGE ACCOUNTING
• Hedge accounting is a technique to recognize gains and losses on
associated hedging instruments and hedged items in P&L (or
OCI) in the same accounting period.
• The objective of hedge accounting is to represent, in the financial
statements, the effect of risk management activities that use
financial instruments to manage exposures arising from particular
risks that could affect profit or loss (P&L) or other comprehensive
income (OCI).
• It eliminates or reduces the volatility in the statement of
comprehensive income that otherwise would arise if the hedged
item and the hedging instrument were accounted for separately.
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HEDGE ACCOUNTING
Hedge Item
• For hedge accounting purposes, only assets, liabilities, firm
commitments or highly probable forecast transactions with a party
external to the reporting entity can be designated as hedged items.
• An entity may designate an item in its entirety or a component of
an item as the hedged item in a hedging relationship.

Hedging Instruments
• For hedge accounting purposes, only contracts with a party
external to the reporting entity (ie external to the group or individual
entity that is being reported on) can be designated as hedging
instruments.
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HEDGE ACCOUNTING
• A qualifying instrument must be designated in its entirety as a hedging
instrument. Exceptions permitted are:
(a) separating the intrinsic value and time value of an option contract
and designating as the hedging instrument only the change in
intrinsic value of an option and not the change in its time value
(b) separating the forward element and the spot element of a forward
contract and designating as the hedging instrument only the
change in the value of the spot element of a forward contract and
not the forward element
(c) a proportion of the entire hedging instrument, such as 50 per cent of
the nominal amount, may be designated as the hedging instrument
in a hedging relationship.
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HEDGE ACCOUNTING
Hedging relationship
• A hedging relationship qualifies for hedge accounting only if all of
the following criteria are met:
(a) the hedging relationship consists only of eligible hedging
instruments and eligible hedged items.
(b) at the inception of the hedging relationship there is formal
designation and documentation of the hedging relationship and
the entity’s risk management objective and strategy for
undertaking the hedge.
(c) the hedging relationship meets hedge effectiveness
requirements
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HEDGE ACCOUNTING
Hedged Effectiveness
• Hedge effectiveness is the extent to which changes in the fair
value or the cash flows of the hedging instrument offset changes
in the fair value or the cash flows of the hedged item.
• Hedge ineffectiveness is the extent to which the changes in the
fair value or the cash flows of the hedging instrument are greater
or less than those on the hedged item.
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HEDGE ACCOUNTING
Hedging position
1) A long hedge
 is taking a long or buy position in the hedging instruments.
 The objective is to protect against an increase in price before the
actual asset is purchased in the cash market.
2) A short hedge
 Taking a short or sell position in the hedging instruments.
 The objective is to protect an investor who plans to sell an asset
in the future against the risk of declining prices
 48

Hedge Accounting
3 Types of Hedges:
1. Fair value hedge
2. Cash flow hedge
3. Hedge of a net investment in a foreign operation
 49

1.FAIR VALUE HEDGE

• A hedge of the exposure to changes in fair value of a recognised asset or
liability or an unrecognised firm commitment, or a component of any
such item, that is attributable to a particular risk and could affect profit or
loss.
• Changes in fair value might arise through changes in interest rates (for
fixed-rate loans), foreign exchange rates, equity prices or commodity
prices.
• Accounting treatment:
1) The hedging instrument is measured at fair value. Changes in fair
value are recognised in P&L.
2) The carrying value of the hedged item is adjusted for fair value
changes attributable to the risk being hedged. Fair value changes are
recognised in P&L
 50

1. FAIR VALUE HEDGE…cont

Accounting treatment:
• Step 1:
Determine the fair value of both your hedged item and hedging instrument at
the reporting date;
• Step 2:
Recognize any change in fair value (gain or loss) on the hedging instrument
in profit or loss (in most cases).
(same as even if you don’t apply the hedge accounting, because you need to
measure all derivatives (hedging instruments) at fair value anyway (in most
cases)).
• Step 3:
Recognize the hedging gain or loss on the hedged item in its carrying amount.

1. FAIR VALUE HEDGE CONT..
Accounting treatment:
Description
Loss on the hedging instrument
Gain on the hedging instrument
Gain on the hedged item
Loss on the hedged item
51
Debit Credit
Hedging instrument:
P/L – FV loss on hedging FP – Financial liabilities from
instrument hedging instruments
OR
FP – Financial assets from P/L – FV gain on hedging
hedging instruments instrument
Hedged item:
FP – Hedged item (e.g. P/L
inventories) – Gain on the hedged item
OR
P/L – Loss on the hedged item FP – Hedged item (e.g. inventories)
 52

EXAMPLE 4: Forward Contract (FV HEDGE)

MZ Bhd, a Malaysian company, sold goods to SP, a company in
Singapore for S$10,000 on 1 April 2021. Payment is to be received
on 30 September 2021. To hedge its exposure to foreign currency
risk, MZ entered into a forward contract with AAA Bank to deliver
S$10,000 on 30 September 2021.
Financial year end is on 31 December. The exchange rates are as
follows:

Date Spot Rate Forward Rate

1 April 2021 RM2.20 = S$1.00
30 Sept 2021 RM2.05 = S$1.00 RM2.10 = S$1.00
 53

Solution example 4
1 April 2021:
Dr Accounts receivable (S$) 22,000
Cr Sales 22,000
(To record sales of S$10,000 at spot rate of RM2.20)

No journal entry for forward contract when the contract was

entered. Just prepare a memorandum to record forward contract
has been entered.
 54

Solution example 4
30 Sept 2021:
Foreign exchange loss 1,500
Accounts receivable (S$) 1,500
(To adjust the value of receivable to the new spot rate of RM2.05 and record
foreign exchange loss : 10,000 x (RM2.20 – RM2.05) = 1,500)

Forward contract 500

Gain on forward contract 500
(To record the forward contract as an asset at its fair value of RM500 (10,000 x
(RM2.10 – RM2.05)] and record a forward contract gain for the change in fair value]
 55

Solution example 4
30 Sept 2021:
Foreign currency (S$) 20,500
Accounts receivable (S$) 20,500
(To record receipt of S$10,000 from S at spot rate of RM2.05)

Cash (10,000 x 2.10) 21,000

Foreign currency (S$) 20,500
Forward contract 500
(To record settlement of contract – receipt of RM21,000 in exchange for
S$10,000 and remove forward contract from the account)
 56

Example 5:Forward Contract (FV hedge)

Assume Taso Bhd has 5,000 tonnes of palm oil inventory, carried at cost of
RM1,940 per tonne as at 1 June 2019. The palm oil inventory is to be sold on 31
August 2019. In view of the volatility in palm oil prices, on 1 June 2019 Taso enters
into a net-settled palm oil forward contract to sell 5,000 tonnes of palm oil at
RM1,990 per tonne on 31 August 2019.
Palm oil forward prices for a contract maturing 31 August 2019 and palm oil spot
prices at various dates are as follows:
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Example 5:FV hedge…cont

Taso settles the palm oil forward contract and sells 5,000 tonnes of palm oil at
RM2,090 per tonne on 31 August 2019. It prepares interim financial statements
at 30 June. Annual interest rate is 12%.
Taso applies hedge accounting and designates it as fair value hedge

Required:
Prepare relevant journal entries.
 58

Example 5:FV hedge…cont

SOLUTION:
1 June 2019 – No journal entry

30 June 2019 (reporting date)

Dr. Loss on Forward Contract (P&L) 294,000
Cr. Forward Contract – Palm Oil 294,000
[(RM1,990 – RM2,050) x 5,000 tonnes = RM300,000.
The present value factor for 2 months at an annual interest rate of 12% is 0.980:
RM300,000 x 0.980 = RM294,000]

*Dr. Inventory 250,000

*Cr. Gain on Revaluation of Inventory (P&L) 250,000
[(RM2,000 – RM1,950) x 5,000 tonnes = RM250,000]
 59

Example 5:FV hedge…cont

31 August 2019 (settlement date)
Dr. Loss on Forward Contract (P&L) 200,000
Cr. Forward Contract – Palm Oil 200,000
[(RM2,050 – RM2,090) x 5,000 tonnes = RM200,000]

*Dr. Inventory 450,000

*Cr. Gain on Revaluation of Inventory (P&L) 450,000
[(RM2,090 - RM2,000) x 5,000 tonnes = RM450,000]

Dr. Forward Contract – Palm Oil 494,000

Cr. Cash 494,000
(RM294,000 + RM200,000)
 60

Example 5:FV hedge…cont

31 August 2019 (settlement date)...cont

Dr. Cash 10,450,000

Cr. Sales 10,450,000
(RM2,090 x 5,000 tonnes)

Dr. Cost of Sales 10,400,000

Cr. Inventory 10,400,000
[(RM1,940 x 5,000 tonnes) + RM250,000 + RM450,000]

*If Taso does not apply hedge accounting, no adjustment on changes in fair value of
inventory (ie Gain on revaluation RM250,000 & RM450,000)
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Comparison of Hedge accounting

P/L hedge Without Hedge
accounting accounting
30 June 2019
Loss on Forward Contract (294,000) (294,000)
Gain on Revaluation of Inventory 250,000 -
Net effect in P/L (44,000) (294,000)

31 Dec 2019
COGS 10,400,000 9,700,000
Gross profit +700,000
Loss on Forward Contract (200,000) (200,000)
Gain on Revaluation of Inventory 450,000 -
net effect in P/L 250,000 500,000
-
Total net effect in P/L 206,000 206,000
 62

2.CASH FLOW HEDGE

• A hedge of the exposure to variability in cash flows that is
attributable to a particular risk associated with all, or a component
of, a recognised asset or liability (such as all or some future
interest payments on variable-rate debt) or a highly probable
forecast transaction, and could affect profit or loss.
• The purpose of a cash flow hedge is to defer the gain or loss on the
hedging instrument to a period or periods in which the hedged
expected future cash flows affect profit or loss.
 63

2. CASH FLOW HEDGE

Accounting treatment:
 Provided the hedge is effective, changes in the fair value of the
hedging instrument are initially recognised in OCI.
 The ineffective portion of the change in the fair value of the
hedging instrument (if any) is recognised directly in P&L.
 The amount recognised in OCI should be the lower of:
 The cumulative gain or loss on the hedging instrument from
the inception of the hedge, and
 The cumulative change in the fair value (present value) of
the expected cash flows on the hedged item from the
inception of the hedge.
 64

2. CASH FLOW HEDGE

• If the cumulative change in the hedging instrument exceeds the
change in the hedged item (sometimes referred to as an ‘over-
hedge’), ineffectiveness will be recognised in P&L.
• If the cumulative change in the hedging instrument is less than the
change in the hedged item (sometimes referred to as an ‘under-
hedge’), no ineffectiveness will be recognised
 65

2. CASH FLOW HEDGE

• Step 1:
Determine the gain or loss on your hedging instrument and hedge item at the reporting date;
• Step 2:
Calculate the effective and ineffective portions of the gain or loss on the hedging instrument;
• Step 3:
Recognize the effective portion of the gain or loss on the hedging instrument in other
comprehensive income (OCI). This item in OCI will be called “Cash flow hedge reserve”
in OCI.
• Step 4:
Recognize the ineffective portion of the gain or loss on the hedging instrument in profit or
loss.
• Step 5:
Deal with a cash flow hedge reserve when necessary.
You would do this step basically when the hedged expected future cash flows affect profit or
loss, or when a hedged forecast transaction occurs.
 66

2. CASH FLOW HEDGE

Description Debit Credit
Loss on the hedging instrument – OCI – Cash flow hedge reserve FP – Financial liabilities from
effective portion hedging instruments

Loss on the hedging instrument – P/L – Ineffective portion of loss on FP – Financial liabilities from
ineffective portion hedging instrument hedging instruments

OR
Gain on the hedging instrument – FP – Financial assets from hedging OCI – Cash flow hedge reserve
effective portion instruments

Gain on the hedging instrument – FP – Financial assets from hedging P/L – Ineffective portion of gain on
ineffective portion instruments hedging instrument

* Adjustment only deal with the hedging instrument. So that’s completely different from fair value
hedge accounting.
 67

Example 6: Futures (Cash Flow Hedge)

In September 2019 Allied Can Co. anticipates purchasing 1,000 metric tons of
aluminum in January 2020. As a result, Allied enters into an aluminum futures
contract. In this case, the aluminum futures contract gives Allied the right and the
obligation to purchase 1,000 metric tons of aluminum for $1,550 per ton. This
contract price is good until the contract expires in January 2020. The underlying for
this derivative is the price of aluminum.
Allied enters into the futures contract on September 1, 2019. The price to be paid
today for inventory to be delivered in January—the spot price—equals the contract
price.
At December 31, 2019, the price for January delivery of aluminum increases to
$1,575 per metric ton.
 68

Example 6: Cash Flow Hedge

In January 2020, Allied purchases 1,000 metric tons of aluminum for $1,575. At the
same time, Allied makes final settlement on the futures contract
Allied processes the aluminum into finished goods (cans). The total cost of the cans
(including the aluminum purchases in January 2020) is $1,700,000. Allied sells the
cans in July 2020 for $2,000,000.
The reporting date for Allied is 31 December.

Required:
Prepare relevant journal entries.
 69

Solution example 6
1 September 2019:
- No entry is necessary
Due to the price to be paid today for inventory to be delivered in
January(spot price) equals the contract price. With the two prices equal, the
futures contract has no value.

31 December 2019:
Dr. Futures Contract 25,000
Cr. Cash Flow Hedge Reserve (OCI) 25,000
([$1,575 - $1,550] x 1,000 tons)
(to record the increase in the value of the futures contract)

Allied reports the futures contract in the balance sheet as a current asset and
the gain as part of other comprehensive income (CF Hedge Reserve).
 70

Solution example 6
January 2020:
Dr. Aluminum Inventory 1,575,000
Cr. Cash ($1,575 x 1,000 tons) 1,575,000
( to record purchases 1,000 metric tons of aluminum)

Dr. Cash 25,000

Cr. Futures Contract ($1,575,000 - $1,550,000) 25,000
(to record final settlement on the futures contract)

There are no income effects at this point. Allied accumulates in equity the gain on
the futures contract as part of other comprehensive income (CF Hedge Reserve)
until the period when it sells the inventory.
 71

Solution example 6
July 2020:
Dr. Cash 2,000,000
Cr. Sales Revenue 2,000,000
Dr. Cost of Goods Sold 1,700,000
Cr. Inventory (Cans) 1,700,000
(to record COGS on $2M sale)

Dr. Cash Flow Hedge Reserve (OCI) 25,000

Cr. Cost of Goods Sold 25,000
(the hedged expected future cash flows affect profit (step 5))

The gain on the futures contract, which Allied reported as part of CF Hedge
Reserve (OCI), now reduces cost of goods sold. As a result, the cost of aluminum
included in the overall cost of goods sold is $1,550,000 (ie. $$1,575,000 - $25,000)
 72

Example 7- Forward Contract (CF Hedge)

Jerai Bhd is a Malaysian company that manufactures cooking oil using

palm oil. It prepares interim financial statements at 30 June and 31
December. The company’s risk management objective and strategy is to
hedge the palm oil price risk based on the expected consumption up to
12 months before delivery.
Based on the production plan for the first quarter of 2020, it is estimated
that palm oil consumption would be 10,000 tonnes. In line with its risk
management objective and strategy, on 1 April 2019 the company enters
into a net-settled palm oil forward contract to purchase 10,000 tonnes
palm oil with a maturity of 31 January 2020.
 73

Example 7…cont
Palm oil forward prices for a contract maturing 31 January 2020 at various dates during the
hedge are as follows:

The exchange rates at various dates during the hedge are as follows:
 74

Example 7…cont
Annual interest rate is 12%.
In May 2019, the company orders 10,000 tonnes palm oil for delivery on
31 January 2020. The price is based on the spot price on the delivery
date.
The company is able to demonstrate that all the requirements for hedge
accounting as per MFRS 9 Financial Instruments are met and therefore
it classifies the hedging of palm oil price risk as cash flow hedges.

Required:
Prepare relevant journal entries.
 75

Example 7…cont
SOLUTION:
1 April 2019 - no journal enty (as the fair value of the palm oil forward contract is zero)

30 June 2019 (reporting date)

Change in FV of forward contract = (USD507 - USD512) x 10,000 tonnes = (USD50,000)
The present value factor for 7 months at an annual interest rate of 12% is 0.933:
= (USD50,000) x 0.933
= (USD46,650)
The exchange rate at 30 June 2019 is 4.05: (USD46,650) x 4.05 = (RM188,932.50)

Dr. Cash Flow Hedge Reserve (OCI) 188,932.50

Cr. Forward Contract – Palm Oil 188,932.50
 76

Example 7…cont
31 December 2019 (FYE):
Change in FV of forward contract = (USD525 – USD507) x 10,000 tonnes = USD180,000

The present value factor for 1 month at an annual interest rate of 12% is 0.990:
= USD180,000 x 0.990
= USD178,200
The exchange rate at 31 December 2019 is 4.12: USD178,200 x 4.12 = RM734,184

Dr. Forward Contract – Palm Oil 734,184

cr. Cash Flow Hedge Reserve (OCI) 734,184
 77

Example 7…cont
31 January 2020 (settlement of forward contract):
Change in FV of forward contract = (USD530 - USD525) x 10,000 tonnes = USD50,000
The exchange rate at 31 January 2020 is 4.17: USD50,000 x 4.17 = RM208,500

Dr. Forward Contract – Palm Oil 208,500

Cr. Cash Flow Hedge Reserve (OCI) 208,500

Dr. Cash 753,751.50

Cr. Forward Contract – Palm Oil 753,751.50
(settlement of forward contract: (- RM188,932.50 + RM734,184 + RM208,500)

Dr. Inventory – raw material 22,101,000

Cr. Cash (10,000 x 530 x 4.17) 22,101,000

Cash Flow Hedge Reserve (OCI) RM753,751.50 will be reclassified to profit or loss during the
period when the hedged expected future cash flow affects profit or loss
 78

Example 8 – Put Option (CF Hedge)

Exim manufactures and sells electrical parts to various customers. On 1 December
2019, its customer in the US has agreed to purchase goods at a price of $500,000. The
delivery date is scheduled on 1 February 2020 and payment is expected to be made on
1 March 2020. To hedge the exposure to foreign exchange risk arising from the highly
probable sale forecast, Exim purchases a foreign currency put option on 1 December
2019. The put option give Exim the right to sell USD500,000 on 1 March 2020 at a
strike price of RM4.13. Exim pays a premium of RM0.01 per dollar. Therefore Exim
pays RM5,000 (USD500,000 x RM0.01) for the put option.
During the hedging period, the spot exchange rate and the price of option premium are
as follows:
 79

Example 8…cont
Composition of the fair value of the put option is as follows:

Exim designates the foreign currency put option as a cash flow hedge. It separates
the intrinsic value and the time value of the put option. Only the change in the
intrinsic value is designated as the hedging instrument, and not the time value.
On 1 February 2020 Exim delivers goods to the customers in the US and receives
payment of USD500,000 from its customer at 1 March 2020.
Required:
Prepare relevant journal entries.
 80

Example 8…cont
SOLUTION:
1 December 2019:
Dr. Foreign Currency Put Option 5,000
Cr. Cash 5,000

31 December 2019 (FYE):

Dr. Foreign Currency Put Option 19,000
a
Cash Flow Hedge Reserve (OCI) – Time value element 1,000
b
Cr. Cash Flow Hedge Reserve (OCI) – Hedging element 20,000
a: 4,000 – 5,000 = (1,000)
b: 20,000 – 0 = 20,000
If firm elects to designate only the intrinsic value of the option as the hedging instrument,
changes in the time value of the option is recorded in OCI,
 81

Example 8…cont
1 February 2020:
Dr. Accounts Receivable 2,070,000
Cr. Sale 2,070,000
(USD500,000 x 4.14)

1 March 2020:
Dr. Accounts Receivable 30,000
Cr. Gain on foreign exchange 30,000
(4.20 – 4.14) x USD500,000

Dr. Cash 2,100,000

Cr. Accounts Receivable 2,100,000
(USD500,000 x 4.20)
 82

Example 8…cont
1 March 2020:
Dr. Loss on Foreign Currency Put Option 24,000
Cr. Foreign Currency Put Option 24,000
(foreign currency put option expires out of the money)

Dr. Reclassification Adjustment – P&L 1,000

Cr. Cash Flow Hedge Reserve (OCI) – Time value element 1,000
(reclassification adjustment)

Dr. Cash Flow Hedge Reserve (OCI) – Hedging element 20,000

Cr. Reclassification Adjustment – P&L 20,000
(reclassification adjustment)
 83

3. Hedge of a net investment

• Hedge of currency risk associated with the translation of the net
assets of foreign operations (overseas subsidiaries, associates, joint
ventures or branches) into the parent entity’s functional currency.
• Accounting treatment:
 Exchange differences arising on the consolidation of these net
assets are deferred in equity until the foreign operation is
disposed of or liquidated. They are recognised in P&L, on disposal
or liquidation, as part of the gain or loss on disposal.
 The foreign currency gains or losses on the hedging instrument
are deferred in OCI, to the extent that the hedge is effective, until
the subsidiary is disposed of or liquidated, when they become part
of the gain or loss on disposal.
 84

Discontinuation of Hedging:
• An entity shall discontinue the specified hedge when:
a) The hedging instruments expires/sold;
b) The hedge no longer meet the criteria for hedge
accounting;
c) The forecast transaction is no longer expected to occur (CF
hedge)
• Discontinuation of hedge accounting applies prospectively
 85

EXAMPLES :
PRESENTATION
& DISCLOSURES
 86

MFRS 7 Financial Instruments: Disclosures

• Disclosure is required so that users are able to
a) Evaluate the significance of financial instruments
for the entity’s financial position and performance
b) Evaluate the nature and extent of risks arising from
financial instruments to which the entity is exposed
during the reporting period and how the entity
manages the risks
 87

The disclosures requirements include

a) Classes of financial instruments
b) Significance of financial instruments in Statement of
Financial Position
c) Significance of financial instruments in Statement of
Comprehensive Income
d) Reclassification, de recognition and collateral
e) Accounting policies and description regarding hedge
accounting
f) Fair value disclosures
g) Qualitative, quantitative and sensitivity analysis
disclosures on risks (credit risks, liquidity risks, price
risks, market risks & interest rate risks).
 88

Financial Instruments in In Statement of Financial Position

 89

FI: Derivatives financial liabilities

 90

FI in Statement of P/L & OCI

 91

Disclosure notes: examples

 92

Disclosure notes: example

 93

Narrative disclosure
 94

Hedging -disclosure