You are on page 1of 95

Session 1 and

2

Accounting for Derivative
Instruments

Edited by Taufik Hidayat

Agend
a
1.
2.
3.
4.
5.
6.
7.

Financial Intruments and Derivative.
Forward Contracts.
Future Contracts.
Hedge using forward and future contracts.
Option.
Swap.
Hedge using option and swap.

Edited by Taufik Hidayat

Session 1

Session 2

Financial Instruments
• Financial instrument is formally defined in PSAK 50 while PSAK 55
refers to the same definition as follows:
• A financial instrument is any contract that gives rise to
– a financial asset of one entity and
– a financial liability or equity instrument of another entity.

Financial
Financial
instrument
instrument

Financial
Financial
asset
asset

Financial
Financial
liability
liability

of one entity

or

Equity
Equity
instrument
instrument

Edited by Taufik Hidayat

of another entity

• say specified puttable financial instruments. or instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments Edited by Taufik Hidayat . For this purpose the entity’s own equity instruments do not include certain instruments.Financial Instruments (2) Financial Financial asset is any asset that is: Financial asset asset • Cash Financial Financial instrument • An equity instrument of another entity instrument • A contractual right i) to receive cash or another financial asset from another entity ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity • A contract that will or may settled in the entity’s own equity instruments and is i) a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments. or ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.

(For this purpose. or ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.Financial Instruments (3) Financial liability is any liability that is • A contractual right i) to deliver cash or another financial asset from another entity ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity • A contract that will or may settled in the entity’s own equity instruments and is i) a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments. certain other conditions are required to observe) Financial Financial instrument instrument Financial Financial liability liability Edited by Taufik Hidayat .

commodity price. index of prices or rates. or other variable (sometimes called the ‘underlying’).Definition of Derivative Derivative  is a financial instrument or other contract within the scope of PSAK 55 with all 3 of the following characteristics: Value Valuechange changebased based on onan anunderlying underlying a) its value changes in response to the change in a specified interest rate. Edited by Taufik Hidayat . credit rating or credit index. Little Littleor orno noinitial initialnet net investment investment b) 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. foreign exchange rate. and Settled Settledat at aafuture date future date c) it is settled at a future date. financial instrument price.

since Melody and Tony have a netting agreement. Edited by Taufik Hidayat . Yes. • Is this a derivative under PSAK 55? Yes.and andfuture futuresettlement).Derivative Instruments Example Example • Melody Limited makes a five-year fixed rate loan to Tony Inc. •• This This meets meets the the definition definition of of aa derivative derivative (that (that isis to to say. variable. factors. • There are no transfers of principal at inception of the two loans. say. settlement).no noinitial initialnet netinvestment investmentor oran aninitial initialnet netinvestment investment that that isis smaller smaller than than would would be be required required for for other other types types of of contracts contracts that that would would be be expected expected to to have have aa similar similar response response to to changes changes inin market market factors. while Tony at the same time makes a five-year variable rate loan for the same amount to Melody. there there isis an an underlying underlyingvariable.

commodity futures Commodity prices Producers and consumers Swaps Interest rate Financial institutions Edited by Taufik Hidayat .Derivative Instruments (2) Example of derivative instruments and their underlying Types of derivative instruments Underlying Used by Option contracts (call and put) Security price Producers. financial institutions. and speculators Forward contracts e. trading firms.g. foreign exchange forward contract Foreign exchange rate Various companies Future contracts e.g.

Derivative Instruments (3) • Use of derivatives 1. caps and collars and warrants 3. Reduce borrowing cost 3. Forward type derivatives such as forward contracts. Embedded derivatives Edited by Taufik Hidayat . Manage market risk 2. Profit from trading or speculation • Types of derivatives 1. Free standing derivatives 4. Option-type derivatives such as call and put options. future contracts and swaps 2.

– From the perspective of the issuer. a convertible bond is a debt instrument with an embedded option to convert the debt instrument to equity shares. the debt instrument is a financial liability while the embedded option may be an equity instrument.Compound Financial Instrument & Embedded Derivative • There are certain financial instruments that have a hybrid or combined nature. • For example. Edited by Taufik Hidayat . – From the perspective of the holder of that convertible bond. the debt instrument is a financial asset and the embedded option is similar to a derivative.

these kinds of financial instruments are termed as hybrid (combined) instruments. from the perspective of a holder. – PSAK 50 requires an issuer of a compound financial instrument to separately classify different components of the instrument in accordance with the definition of financial liability and equity instrument.Compound Financial Instrument & Embedded Derivative • In PSAK 50. these kinds of financial instruments are termed as compound financial instruments. • In PSAK 55. – PSAK 55 requires a holder of a hybrid instrument to separately account for the embedded derivative of the instrument if certain conditions are fulfilled. Will Will be be discussed discussed in in session session 33 Edited by Taufik Hidayat . from the perspective of an issuer.

• In other accounting standards. Edited by Taufik Hidayat Imply Imply trade trade date date accounting accounting Imply Imply settlement settlement date date accounting accounting . the entity becomes a party to the contractual provisions of the instrument.Initial Recognition • Initial recognition requirements for financial assets and financial liabilities in PSAK 55: • An entity is required to recognise a financial asset or a financial liability on its balance sheet when. and 2) the cost of the item can be measured reliably. and only when. the recognition criteria are 1) it is probable that future economic benefits associated with the item will flow to (or flow out from) the entity.

• The trade date is the date purchase or sell an asset.Initial Recognition (2) • The settlement date is the to or by an entity. Edited by Taufik Hidayat . date that an asset is delivered that an entity commits itself to PSAK 55 require an entity to or financial liability when it contractual provisions of the – These criteria imply an entity to recognise financial asset or financial liability on a trade date basis. • The recognition criteria in recognise financial asset becomes a party to the instruments.

Edited by Taufik Hidayat . • PSAK 55 specifically states that a contract that requires or permits net settlement of the change in the value of the contract (such as derivative contract) is not a regular way contract. – Such contract is accounted for as a derivative in the period between the trade date and the settlement date. an entity is also required to recognise all of its contractual rights and obligations under derivatives in its balance sheet as assets and liabilities. – In other words.Initial Recognition (3) • In consequence of the recognition criteria of PSAK 55. become “on-balance sheet” from the trade date. all the financial assets and liabilities. including derivatives (such as options and futures).

1. Derivative Derivative   FVTPL FVTPL Edited by Taufik Hidayat . its transactions costs that are directly attributable to the acquisition or issue of the financial asset or financial liability. • In the case of a financial asset or financial liability that will be classified as financial asset or financial liability at fair value through profit or loss (FVTPL). its transaction costs should not be recognised. its fair value plus 2.Initial Measurement • When a financial asset or financial liability (except for it at fair value through profit or loss) is recognised initially. an entity is only required to measure it at its fair value only 2. an entity is required to measure it at: 1.

between knowledgeable. willing parties in an arm’s length transaction. An incremental cost is one that would not have been incurred if the entity had not acquired. • Transaction costs are incremental costs that are directly attributable to the acquisition. • New definition of Fair Value based on PSAK 68: Fair Value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Edited by Taufik Hidayat . issue or disposal of a financial asset or financial liability. or a liability settled.Initial Measurement (2) • Fair value is the amount for which an asset could be exchanged. issued or disposed of the financial instrument.

In this case. accounting for the derivative follows hedge accounting rules. • Financial instrument at fair value through profit or loss (including derivative) is initially recognised at fair value only. • After initial recognition. an entity is required to measure financial instrument at fair value through profit or loss (including derivative) at their fair values.Subsequent Measurement • Default accounting treatment for derivatives under PSAK 55: – Derivatives are classified under the Fair Value through Profit or Loss category and changes in their fair values are taken to income statement – Exception . Edited by Taufik Hidayat .when a derivative is designated as a hedge of an identified risk and the hedge is effective.

or 2. the “risks and rewards test” and the “control test”).e. the entity transfers the financial asset that meet the conditions set out in PSAK 55 (i. and only when: 1. Edited by Taufik Hidayat . the contractual rights to the cash flows from the financial asset expire.Derecognition of a Financial Asset • The general derecognition criteria in accordance with PSAK 55 require an entity to derecognise a financial asset when. “asset transfer test”) and the transfer qualifies for derecognition in accordance with PSAK 55 (i.e.

and only when.Derecognition of a Financial Liability • An entity is required to remove a financial liability (or a part of a financial liability) from its balance sheet (i.e. – PSAK 55 explains that a financial liability is extinguished when the obligation specified in the contract is discharged or cancelled or expires. or 2. • A financial liability or part of it is extinguished when the debtor either: 1. discharges the liability or part of it by paying the creditor. it is extinguished. Edited by Taufik Hidayat . normally with cash. is legally released from primary responsibility for the liability (or part of it) either by process of law or by the creditor. derecognise a financial liability) when. other financial assets. goods or services.

Forward Contracts • An agreement between two parties (counterparties) whereby one party agrees to buy and the other party agrees to sell a specified amount (notional amount) of an item at a fixed price (forward rate) for delivery at a specified future date (forward date). “A” Company Sells Forward Contract “Forward sales contract” “B” Company “Forward purchase contract” Edited by Taufik Hidayat . • Can either be a forward purchase contract or a forward sales contract. depending on the perspective of the counterparties.

Forward Contracts (2) • Not standardized contracts as they are not traded on an exchange – They entail counterparty risks – They are can be tailored to specific needs of counterparties – They involve lower transaction costs • Fair value of forward contract: Notional x amount (Current forward rate – contracted forward rate) t (1+r) where Contracted forward rate is forward rate fixed at inception r = discount rate Current forward rate is forward rate for remaining period to maturity t = period to maturity Edited by Taufik Hidayat .

Forward Contracts: Journal Entries At inception No journal entry as fair value is nil During life of contract Closing position or at expiration* Dr Forward Contract (asset) Cr Gain on forward contract Dr Cash Cr Forward contract or Dr Loss on forward contract Cr Forward Contract (liability) Dr Forward contract Adjust fair value and record gain/loss Close out and record net settlement of contract Cr Cash * It’s also required the journals to adjust fair value and settlement of underlying at expiration. Edited by Taufik Hidayat .

000) for delivery on May 30. Following exchange rates are given: Date Spot rate $/FC May 30 forward rate $/FC March 1 $1.21 April 30 1.215 1.Forward Contracts : illustration Example Example • On March 1.20 March 31 1.000. Company A entered into a forward contract with a foreign exchange dealer to buy 1 million foreign currency (FC 1.185 $1.19 1.205 May 30 1.20 1.215 Edited by Taufik Hidayat . 20X5. 20X5.

000.2 .000 10.000 10.000 To record change in fair value of forward contract (1.Forward Contracts: illustration (2) Example Example Date March 1 Account Amount No Entry Fair value of forward contract is zero at inception March 31 Dr Forward Contract (asset) Cr Gain on Forward Contract April 30 May 30 10.000 To record change in fair value of forward contract (1.000 Dr Forward Contract (asset) Cr Gain on Forward Contract 10.000 • When forward contracts fall due more than 12 months after the reporting period.205) x 1.000.215) x 1.1.215.21 .2) x 1.000 Dr Loss on Forward Contract Cr Forward Contract (liability) 5.000 (1.000 1.205) x 1. .21 .000 1.000.215 x 1.1.000 1.000 To record change in fair value of forward contract (1.000.000 15.215.215 .000 Dr Cash Cr Forward Contract To close forward contract at maturity Dr Foreign Currency Cr Cash To record settlement of underlying 5.000 15. they should be Edited by Taufik Hidayat discounted.000.1.1.

000 Dr Foreign Currency Cr Cash Cr Forward Contract To close forward contract at maturity Edited by Taufik Hidayat 5.21 .1.205) x 1.000 15.000 To record change in fair value of forward contract (1.000 1.000 10.000 To record change in fair value of forward contract (1.200.Forward Contracts: illustration (3) Example Example Alternative journal entries: Date March 1 Account Amount No Entry Fair value of forward contract is zero at inception March 31 Dr Forward Contract (asset) Cr Gain on Forward Contract April 30 May 30 10.215) x 1.000.21 .2) x 1.000 10.215.000 .1.2 .215 .205) x 1.000 Dr Loss on Forward Contract Cr Forward Contract (liability) 5.1.000* *(1.000.000 1.000 Dr Forward Contract (asset) Cr Gain on Forward Contract 10.000.1.000.000 To record change in fair value of forward contract (1.

Futures Contracts
• A future contract is similar to a forward contract except that it is
a standardized contract and is traded on an exchange.
• Futures contracts are marked-to-market and settled on a daily
basis.
• Futures contracts require payment of a margin deposit which
has to be maintained throughout the contract period.
• Margin account is not part of initial investment but as collateral
for counterparty or clearinghouse.
• Margin accounts are separate assets and accounted separately.
• Wide range of exchange-traded future contracts:
• Commodity futures
• Interest rate futures
• Currency futures
Edited by Taufik Hidayat

Futures Contracts: Journal Entries
At inception
Dr Margin deposit
Cr Cash

During life of contract

Closing position or
at expiration*

Dr Futures Contract
Cr Gain on future
contract

Dr Cash
Dr Gain on future
contract
Cr Margin deposit

or
Dr Loss on future
contract
Cr Futures Contract

Record payment of
initial margin deposit

Record daily settlement of
future contracts

Edited by Taufik Hidayat

Dr Cash
Cr Loss on future
contract
Cr Margin deposit
Close out and and recover
margin deposit

Futures Contracts : illustration
Example
Example

• On March 1, 20X5, Company A speculates that the price of gold
will increase and purchases 10 gold futures contracts at a price of
$800/ounce. Each contract is for 100 ounces of gold and maturity
date is May 30. The futures exchange requires a payment of 10%
of notional amount as margin deposit. Following prices are given:

Date

Price/ounce

May 30 futures
price/ounce

March 1

$798

$800

March 31

797

799

April 30

799

801

May 30

802

802

Edited by Taufik Hidayat

Futures Contracts: illustration (2) Date March 1 Account Dr Margin Deposit Cr Cash 80.000 To record change in fair value and return of margin (802 .799) x 100 x 10 Dr Futures Contract Cr Gain on Futures Contract 2.801) x 100 x 10 Edited by Taufik Hidayat 2.000 1.000 To record settlement or change in fair value (801 .000 1.000 .000 To record payment of margin deposit 10% x $800.000 March 31 Dr Loss on Futures Contract Cr Futures Contract April 30 May 30 Amount 80.799) x 100 x 10 Dr Cash Dr Futures Contract Cr Gain on Futures Contract Cr Margin Deposit 80.000 80.000 To record settlement or change in fair value (800 .000 1.000 1.

801) x 100 x 10 Dr Gold Cr Margin deposit Cr Cash Cr Futures Contract To close forward contract at maturity Edited by Taufik Hidayat 2.000 80.Futures Contracts: illustration (3) Example Example Alternative journal entries: Date March 1 Account Dr Margin Deposit Cr Cash 80.000 March 31 Dr Loss on Futures Contract Cr Futures Contract April 30 May 30 Amount 80.000 1.000 720.799) x 100 x 10 Dr Futures Contract Cr Gain on Futures Contract 1.000 2.000 1.000 To record payment of margin deposit 10% x $800.799) x 100 x 10 Dr Futures Contract Cr Gain on Futures Contract 2.000 To record settlement or change in fair value (802 .000 802.000** **(802 .800) x 100 x 10 .000 To record settlement or change in fair value (801 .000 To record settlement or change in fair value (800 .000 1.

– Put option – right.Option Contracts • Contract that gives holder the right but not the obligation to buy or sell a specified item at a specified price. • Can also be customized (not traded) or standard contract quoted on exchange (listed options). but not obligation to buy. • 2 type of option contracts: – Call option – right. but not obligation to sell. • Can be American option (exercisable anytime to expiration) or European option (exercisable only on maturity date). Edited by Taufik Hidayat .

but not obligation to perform. while write has obligation to perform. Strike price>Underlying (spot price) Strike price= Underlying (spot price) Strike price<Underlying (spot price) Holder of call option Out-of-the-money At-the-money In-the-money Holder of put option In-the-money At-the-money Out-of-the-money Edited by Taufik Hidayat .Option Contracts (2) • Main features: – Purchaser (holder) pays premium to seller (writer of option). – Holder has the right. – Asymmetrical pay-off profile: • Holder has limited loss (due to premium) and unlimited gain. • Writer has limited gain and unlimited loss.

Notional amount x (Spot price – Strike Price) Put option = Max [0.Option Contracts (3) • Fair value of option contract Fair value of an option = Intrinsic value + Listed options = quoted price Not traded options = Valuation model ( Black-Scholes model) Time value Diminishes over time Zero at expiration Call option = Max [0. Notional amount x (Strike price – Spot Price) Edited by Taufik Hidayat .

Purchased Option Contracts: Journal Entries At inception During life of contract Dr Option Contract Cr Gain on future contract Dr Option contract (asset) Cr Cash Closing position or at expiration Dr Cash* Cr Gain on option contract Cr Option Contract or Dr Loss on futures contract Cr Option Contract Dr Cash* Dr Loss on option contract Cr Option Contract (* assume expires in-the-money. If out-ofthe –money. no cash entry is needed) Record payment of initial margin deposit Adjust for fair value and record gain/loss Edited by Taufik Hidayat Close out and record net settlement of contract .

Written Option Contracts: Journal Entries At inception During life of contract Dr Option Contract Cr Gain on future contract Dr Cash Cr Option contract (liability) Closing position or at expiration Dr Option contract Cr Gain on Option Contract (Expires out-of-the-money) or Dr Loss on futures contract Cr Option Contract Dr Option contract Dr Loss on option Cr Cash (Expires in-the-money) Record payment of initial margin deposit Adjust for fair value and record gain/loss Edited by Taufik Hidayat Close out and record net settlement of contract .

50 March 31 6.000 unit of call option of Company B with strike price of $35 and premium $4.80 April 30 43 8.80 April 30 8.25 Edited by Taufik Hidayat . current market price of Company B stock was $38/share. 20X5 to third party.50 March 31 41 6.25 8 0.80 6 0. Following prices are given: Date Stock Price Option Price March 1 $38 $4.Call Option Contracts : illustration Example Example • On March 1.50 $3 $1.25 Date Option Price Intrinsic Value Time Value March 1 $4.5. Company A purchased 100. 20X5. Company A settle the option on Aprill 30. On that date.

25 – 0.000 70.000 To change in time value (0.000 March 31 Dr Call Option Cr Gain on Option Contract To record change in intrinsic value March 31 Dr Loss on Option Contract Cr Call Option April 30 April 30 Amount 300.000 Dr Loss on Option Contract Cr Call Option To record change in time value Alternative: record the net amount Edited by Taufik Hidayat 200.5 x 100.000 (6 – 3) x 100.000 (0.000 Dr Call Option Cr Gain on Option Contract 200.000 70.000 55.000 450.5) x 100.000 300.Call Option Contracts: Buyer Date March 1 Account Dr Call Option Cr Cash 450.8 – 1.000 .000 To record payment of premium $4.000 To record change in intrinsic value (8 – 6) x 100.000 55.8) x 100.

000 825.000 3.500. 20X5 : Date Account Dr AFS Cr Call Option Cr Cash Amount 4.500.000 To record settlement of option • If company A exercise the option on Aprill 30.000 To record the exercise and close option contract Date Account Dr Trading / FVTPL Dr Loss on Exercise of Option Cr Call Option Cr Cash To record the exercise and close option contract Edited by Taufik Hidayat Amount 4.Call Option Contracts: Buyer Date April 30 Account Dr Cash Cr Call option Amount 825.000 3.000 825.000 .000 825.300.000 25.325.

000 55.000 To record change in time value (0.Call Option Contracts: Writer Date March 1 Account Dr Cash Cr Call Option 450.8) x 100.000 March 31 Dr Loss on Option Contract Cr Call Option To record change in intrinsic value March 31 Dr Call Option Cr Gain on Option Contract April 30 April 30 Amount 450.000 .000 70.000 70.000 55.000 To change in intrinsic value (8 – 6) x 100.000 To record payment of premium $4.000 (6 – 3) x 100.5 x 100.25 – 0.8 – 1.000 Dr Loss on Option Contract Cr Call Option 200.5) x 100.000 (0.000 300.000 Dr Call Option Cr Gain on Option Contract To record change in time value Edited by Taufik Hidayat 200.000 300.

500.Call Option Contracts: Writer • If company A exercise the option on Aprill 30.000 4. Following prices are given: Date Account Dr Cash Dr Call Option Cr AFS Cr Gain on Exercise of Option To record the exercise and close option contract Edited by Taufik Hidayat Amount 3.300. 20X5.000 825.000 .000 25.

current market price of Company C stock was $34/share. 20X5.00 April 30 4.80 Date Option Price Intrinsic Value Time Value March 1 $2. 20X5 to third party.50 March 31 32 4.80 4 0.Put Option Contracts : illustration Example Example • On March 1.80 Edited by Taufik Hidayat . Following prices are given: Date Stock Price Option Price March 1 $34 $2.000 unit of put option of Company C with strike price of $35 and premium $2.50 March 31 4.5. Company A settle the option on Aprill 30.00 April 30 31 4. On that date.00 3 1.50 $1 $1. Company A purchased 100.

000 (3 – 1) x 100.8 – 1.000 50.Put Option Contracts: Buyer Date March 1 Account Dr Put Option Cr Cash 250.5) x 100.000 To record change in time value (1.000 Dr Put Option Cr Gain on Option Contract 100.000 20.0 – 1.000 50.000 To record payment of premium $2.5 x 100.000 200.000 To record change in intrinsic value (4 – 3) x 100.000 .000 (0.000 20.000 March 31 Dr Put Option Cr Gain on Option Contract To record change in intrinsic value March 31 Dr Loss on Option Contract Cr Put Option April 30 April 30 Amount 200.0) x 100.000 250.000 Dr Loss on Option Contract Cr Put Option To record change in time value Edited by Taufik Hidayat 100.

100.500.Put Option Contracts: Buyer Date April 30 Account Dr Cash Cr Put option Amount 480.000 80.000 480.000 . 20X5 : Date Account Dr Cash Dr Loss on Exercise of Option Cr Put Option Cr AFS To record the exercise and close option contract Edited by Taufik Hidayat Amount 3. and exercise the put option on Aprill 30.000 3.000 480.000 To record settlement of option • If company A already had Company C stock (assume: no hedge relationship).

000 March 31 Dr Loss on Option Contract Cr Put Option To record change in intrinsic value March 31 Dr Put Option Cr Gain on Option Contract April 30 April 30 Amount 250.0 – 1.000 To record change in time value (1.000 50.000 (0.0) x 100.5 x 100.000 Dr Loss on Option Contract Cr Put Option 100.8 – 1.5) x 100.000 20.000 50.000 Dr Put Option Cr Gain on Option Contract To record change in time value Edited by Taufik Hidayat 100.000 (3 – 1) x 100.000 To record payment of premium $2.000 .000 200.000 To record change in intrinsic value (4 – 3) x 100.000 200.Put Option Contracts: Writer Date March 1 Account Dr Cash Cr Put Option 250.000 20.

Put Option Contracts: Writer
• If company A exercise the option on Aprill 30, 20X5. Following
prices are given:
Date

Account
Dr AFS
Dr Put Option
Cr
Cash

Amount
3,020,000
480,000
3,500,000

To record the exercise and close option contract

Date

Account
Dr Trading / FVTPL
Dr Put Option
Cr
Cash
Cr
Gain on Exercise of Option
To record the exercise and close option contract

Edited by Taufik Hidayat

Amount
3,100,000
480,000
3,500,000
80,000

Hedging
• Propose is to neutralize an exposed risk
• Loss on hedge item offset by gain on hedging instrument
• Reduce volatility than preserve gains

• Other ways of hedging through non-derivative
derivatives
• Money market instruments (money market hedge)
• Natural hedge (offsetting foreign currency assets and
liability in the same currency)

• Special accounting rules called “hedge accounting”
applies when derivatives are used for hedging
purposes
Edited by Taufik Hidayat

Rationale of Hedge Accounting
• Arises because of the mismatch of incomeoffsetting effect between hedged item and hedging
instrument
• Situations requiring hedge accounting:
• Hedge item and hedging instrument are measured using
different bases (One is at cost while the other is at fair
value)
• Hedged item yet to be recognized in financial statement
• Different treatment for changes in fair value (changes
taken to equity while the other is taken to income
statement)
Edited by Taufik Hidayat

Risks That Qualify for Hedge Accounting Interest rate risk Foreign exchange risk Specific risks that qualify for hedge accounting Risks must be specific risk. not general business risks Price risk Credit risk Possible for a derivative to hedge more than one risk Edited by Taufik Hidayat .

• Designated non-derivatives financial asset/ liability that hedge foreign exchange risks only. • Non-financial assets exposed to foreign exchange or price risks. • Highly probable forecast transaction with exposures to future cash flows. • Net investment in foreign entity. Edited by Taufik Hidayat . • Instruments that qualify as hedged items include: • Financial assets and liabilities with exposure to changes in fair value. • Embedded Derivatives. • Firm commitment.Qualifying Hedging Instruments and Hedged Items • Instruments that qualify as hedging instruments include: • Designated derivatives (except written options).

Qualifying Hedged Items (IAS 39: 78 -79) Qualify Do not qualify • Financial assets and liabilities with exposure to changes in fair value • Held-to-maturity instruments (regardless of fixed rate or variable rate) • Non-financial assets exposed to foreign exchange or price risks • Investment in an associated company • Firm commitment • Highly probable forecast transaction with exposures to future cash flows • Net investment in foreign entity Tan & Lee Chapter 9 ©2009 50 .

Criteria for Hedge Accounting (IAS 39: 88) Conditions to be met for hedge accounting to apply Enterprise must have exposure to risk that affects income statement Derivative contract specifically entered to hedge underlying exposure Hedge must be highly effective Effectiveness of hedge can be reliably measured Hedging relationship must be formally documented at the inception of the hedge Tan & Lee Chapter 9 ©2009 51 .

Assessing Hedge Effectiveness • IAS 39:9 . and – Retrospectively on an ongoing basis • On inception. hedge effectiveness is assessed on – Comparison of the principal or critical terms – Historical analysis – Correlation analysis Tan & Lee Chapter 9 ©2009 52 .The degree to which changes in the fair value or cash flows of the hedged item that is attributable to a hedged risk are offset by changes in the fair value or cash flow of the hedging instrument • Hedge effectiveness is evaluated – Prospectively on inception of hedge.

25 Effective hedge Edited by Taufik Hidayat .8 1. hedge effectiveness is assessed on dollar-offset method: • Hedge effectiveness ratio (HER): Hedge effectiveness Changes in fair value or future cash flow of hedging instrument = (or delta ratio) Changes in fair value or future cash flow of hedged item 0.Assessing Hedge Effectiveness • During the duration of hedge.

Intrinsic (options) or spot element (forwards) – Excluded time value taken to income statement as per default treatment – Should result in highly effective hedge.Assessing Hedge Effectiveness • Exclusion of time value of certain derivatives to be excluded from hedge relationship – Derivative separated into 2 component 1. HER should be equal or around 1 Tan & Lee Chapter 9 ©2009 54 . Time value (options) or interest (forwards) 2. while time/interest component does not – If critical terms of hedging instruments and hedged item are exactly the same. as intrinsic/ spot component moves in tandem with underlying.

or an identified portion of such asset. liability or firm commitment. which is attributable to a particular risk and could affect profit or loss”. and (ii) could affect profit or loss”.Classification of Hedging Fair value hedge Cash flow hedge Hedge of a net investment in a foreign entity Hedge of “the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment. Edited by Taufik Hidayat . Hedge of “the exposure to variability in cash flows that (i) is attributable to a particular risk associated with a recognized asset or liability (such as all or some future interest payment on variable debt instrument )or a highly probable future transaction. Hedge of the foreign currency risk associated with a foreign operation whose financial statements are required to be translated into the presentation currency of the parent company.

that is. whether the entity has a fair value exposure or a cash flow exposure. Edited by Taufik Hidayat .Classification of Hedging (2) • The designation of a derivative as a fair value hedge or a cash flow hedge is determined by the hedged risk. • An exception where a derivative can be designated as either a fair value hedge or a cash flow hedge is where the hedged risk is the foreign exchange risk of a firm commitment.

Discontinuation or Termination of Hedge Accounting Consideration for discontinuation or termination of hedge accounting Hedging instrument has reached maturity date or is closed off or terminated Criteria for hedge accounting is no longer met Hedge designation is revoked Accounting treatment depends on type of hedge Tan & Lee Chapter 9 ©2009 57 .

Accounting for a Fair Value Hedge Hedged Item (recognized asset or liability or firm commitment) Hedging Instruments Change in fair value Change in fair value Income statement Gain (loss) on hedging instrument offset loss (gain) on hedged item Balance sheet Change in fair value adjusted against carrying amount Change in fair value adjusted against carrying amount Edited by Taufik Hidayat .

000 ($300 per ounce) •Price of gold was $352 per ounce 1/11/20X3 •Sold forward contract on 10. 20X3 342 340 March 31.000 ounces of gold •Carried at cost of $3.000 ounce for forward price of $350 ounce •Forward contract matures on 31/3/20X4 Date Spot Rate March 31 Forward Rate Nov 1. 20X3 $352 $350 Dec 31.000. 20X4 330 330 Edited by Taufik Hidayat .Fair Value Hedge – Forward Contract Example Example Ilustration: 31/10/20X3 •Inventory of 10.

000 x ($340 -$350) Taken to income statement Dr Loss on inventory ………… Cr Inventory ………………….. 100.000 x ($342 .000 Gain on forward contract: 10.Fair Value Hedge – Forward Contract (2) Example Example 1/10/20X1 No entry or just a memorandum entry as the fair value of the forward contract is nil 31/12/20X3 Dr Forward contract …………. Cr Gain on forward contract ..$352) Edited by Taufik Hidayat 100.000 100.000 . 100..000 Gain on forward contract: 10.

000 120..300.$342) Dr Cash ……………………….000 x ($330 -$340) Dr Loss on inventory ………… Cr Inventory …………………. 100. Cr Sales ……………………….000 x ($330 .000 Gain on forward contract: 10.000 100.000 Sale of inventory: 10.300..Fair Value Hedge – Forward Contract (3) Example Example 31/3/20X4 Inventory is sold to third-party at $330 per ounce (also maturity date of forward contract Dr Forward contract …………..000 x $330 Edited by Taufik Hidayat 3.000 Loss on forward contract: 10. 120.000 .. Cr Gain on forward contract . 3.

... 2. Cr Forward Contract ……..Fair Value Hedge – Forward Contract (4) Example Example 31/3/20X4 Dr Cost of Good Sold ……… Cr Inventory .780...$330) Edited by Taufik Hidayat ....000...000 ......000 x ($350 ..000 Close forward contract and record net receipt on settlement: 10.........000 200...$120.780...$100.. 200.000 Cost of Good Sold: $3...000 2....000 Dr Cash …………..........000 ..

.. 520.000 Gain on inventory from inception: 10.000 3...000 x ($350 .......Fair Value Hedge – Forward Contract (5) Example Example 31/3/20X4 If inventory is NOT sold to third-party but SETTLED at maturity date Dr Inventory ………….... Cr Cr Forward Contract …….......000 Close forward contract and record net receipt on settlement: 10. Cr Gain on inventory .........000 520..... Inventory ......500. 3...000 200......000 x ($352 -$300) Dr Cash …………..$330) Edited by Taufik Hidayat .300..

20X5.000 unit of put option of Company D with strike price of $35 and premium $2.80 April 30 31 4.50 March 31 32 3.5 on the same date. Company A purchased 100. Company A purchased 100. Following prices are given: Date Stock Price Option Price March 1 $34 $2.00 Edited by Taufik Hidayat .Fair Value Hedge – Option Contract Example Example • On March 1. Company A settle the option on Aprill 30. 20X5 (maturity date). • To protect itself against a loss in value of the investment.000 of Company D shares at $34/share.

80 3 0.50 March 31 32 3.00 4 0.80 April 30 4.50 $1 $1.Fair Value Hedge – Option Contract (2) Date Stock Price Option Price March 1 $34 $2.00 Date Option Price Intrinsic Value Time Value March 1 $2.80 April 30 31 4.50 March 31 3.00 Edited by Taufik Hidayat .

000 70.8 – 1.000 200.000 P/L To record change in fair value of AFS Edited by Taufik Hidayat 200.000 3.000 To record payment of premium $2.000 March 31 Dr Loss on Option Contract Cr Put Option 70.5) x 100.000 (0.000 250.000 Dr Put Option Cr Cash 250.5 x 100.000 To record change in time value March 31 Dr Loss on Investment Cr AFS 200.000 To record payment of premium $34 x 100.400.400.000 March 31 Dr Put Option Cr Gain on Option Contract To record change in intrinsic value 200.000 .000 (32 – 34) x 100.Fair Value Hedge – Option Contract (3) Date March 1 March 1 Account Amount Dr AFS Cr Cash 3.000 (3 – 1) x 100.

000 To record change in fair value of AFS (31 – 32) x 100.500.000 80.000 400.8) x 100.000 80.000 Dr Loss on Option Contract Cr Put Option 100.Fair Value Hedge – Option Contract (3) Date April 30 April 30 April 30 April 30 Account Amount Dr Loss on Investment Cr AFS 100.000 Dr Cash Cr Put Option Cr AFS 3.100.000 To record change in time value (0 – 0.000 .000 To record the exercise and close option contract Edited by Taufik Hidayat 100.000 3.000 To record change in intrinsic value (4 – 3) x 100.000 Dr Put Option Cr Gain on Option Contract 100.

e. or 2) transfer the deferred gains or losses to adjust initial cost or other carrying amount of the asset or liability Edited by Taufik Hidayat .Accounting for a Cash Flow Hedge • Change in FV of the hedging instrument is adjusted to its carrying value in the balance sheet • The change in FV of the hedging instrument is separated into effective portion and ineffective portion (if any) • The effective portion is deferred to equity and the ineffective portion (if any) is recognized as an expense in the I/S • The effective portion that is deferred to equity is the lesser of the : 1) cumulative gain (loss) on the hedging instrument from the inception. and 2) the cumulative changing in the PV of the expected FCF on the hedged item from the inception of the hedge • If the hedged item is financial asset or a financial liability. the deferred gain or loss in equity is taken to PL in the same period or periods during which the assets acquired or the liability assumed affects PL (i. in the period that interest income (expense) recognized) • If the hedged item is forecasted transaction that will result in the recognition of a non financial liability: 1) recognized deferred gain or loss in PL proportionately when the assets is amortized (depreciated).

Accounting for a Cash Flow Hedge Effective Cash Flow Hedge Effective portion of gain/ loss Ineffective portion of gain/ loss Recognized directly in equity through statement of changes in equity Recognized in profit or loss Edited by Taufik Hidayat .

Accounting for a Cash Flow Hedge (2) Cash flow hedges are applicable to the following: Forecasted transactions involving financial and non-financial assets/liabilities which will result in cash inflow/ outflow Interest rate swaps Edited by Taufik Hidayat Other transactions which affect future cash flows .

Illustration 2: Effective and ineffective portions of a cash flow hedge Scenario 1/1/20x1 – Entered into futures contract to hedged forecast transaction at 30/4/20x1 – Classified as cash flow hedge Period ending ∆ in fair value of future contracts ∆ in present value of expected future cash flow 31/1/20x1 $100 $(105) 28/2/20x1 90 (80) 31/3/20x1 103 (105) 30/4/20x1 (38) 45 Tan & Lee Chapter 9 ©2009 71 .

previous balance of (c) **(a) .(c) .Assessing Effective Portion of Cash Flow Hedge Example Example Lesser of Effective two portion cumulative credited/ amount in (debited) absolute to equity in terms current (c) period* Ineffective portion credited/ (debited) to income statement in current period** Cumulative ∆ in FV of future contracts (a) Cumulative ∆ in PV of expected cash flow (b) 31/1/201 $100 $(105) $100 $100 $0 28/2/20x1 190 (185) 185 85 5 31/3/20x1 293 (290) 290 105 (2) 30/4/20x1 255 (245) 245 (45) 7 Period ending * (c) .previous balance Edited by Taufik Hidayat .

20X2 3. •Futures contract matures on 31/3/20X2.000 ounces of silver.3 per ounce •Sold futures contract on 5. 20X2 3.30 $3.000 ounce for $3.000.19 3.000.Cash Flow Hedge – Futures Contract Example Example Ilustration: 1/10/20X1 •Inventory of 5.32 Dec 31.03 per ounce.32 /ounce. •Required deposit was $0.29 Feb 28.000 ($3 per ounce).10 3. DatemarginSpot Price/ounce March 31 Futures Price Oct 1. •Carried at cost of $15. 20X1 $3. 20X1 3.10 Edited by Taufik Hidayat .000.265 3. •Price of silver was $3.20 March 31.

Cash Flow Hedge – Futures Contract (2) Example Example Calculation of expected cash flows & fair value of futures contract Edited by Taufik Hidayat .

Cash Flow Hedge – Futures Contract (3) Example Example Period-to-period & cumulative hedge effectiveness assessment Edited by Taufik Hidayat .

000 150.previous balance of (c) **(a) .000 450.Cash Flow Hedge – Futures Contract (4) Example Example Determination of effective and ineffective portions of a cash flow hedge Period ending Cumulative Cumulative ∆ in FV of ∆ in PV of future expected contracts cash flow (a) (b) Lesser of two cumulative amount in absolute terms (c) Effective portion credited/ (debited) to equity in current period* Ineffective portion credited/ (debited) to income statement in current period** 31/12/X1 150.000 50.000) 1.previous balance Edited by Taufik Hidayat .000 0 28/2/X2 600.000 31/3/X2 1.000.(c) .000 (1.000 (175.000.000) 550.000 (550.100.000 50.000 400.000 * (c) .000) 150.

Cr Cash ...03 x 5.000 150..... 150. 450.000.Cash Flow Hedge – Futures Contract (5) Example Example 1/10/20X1 Dr Margin deposit …………....000 Cr Gain on futures contract .000 Record fair value adjustment of futures contract 28/2/20X2 Dr Futures contract …………....000 ounce 31/12/20X1 Dr Futures contract …………....... Cr OCI – Hedge reserve ...... 50.....000 Record fair value adjustment of futures contract Edited by Taufik Hidayat .........000 150....... 150.000 Cr OCI – Hedge reserve . 400.......000 Margin deposit: $0..

. 450..000..000..500.. 500......000 Cr OCI – Hedge reserve .. 15.000 .000 To ‘recycle’ hedging reserveEdited against Profit & Loss by Taufik Hidayat 1..........000 Cost of Good Sold at carried cost Dr OCI – Hedge reserve .000 Cr Gain on futures contract ..000 15... 1.. Cr Cost of Good Sold/Sales ...000 15... 50.500.. Cr Sales ……………………….....1 Dr Cost of Good Sold ……… Cr Inventory .000 x $3..000..Cash Flow Hedge – Futures Contract (6) Example Example 31/3/20X2 Dr Futures contract …………....000 Record fair value adjustment of futures contract Dr Cash ………………………...000.. 15.000.000 Sale of inventory: 5.

......000 Cr Futures Contract ……....... 150....000 Close the futures contract and record receipt of margin Edited by Taufik Hidayat .250...Cash Flow Hedge – Futures Contract (7) Example Example 31/3/20X2 Dr Cash ………….... 1. 1............100..000 Cr Margin deposit ......

two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals.Swap • In a swap. Edited by Taufik Hidayat . • 2 type of basic swap: – Single Currency Interest rate swap • “Plain vanilla” fixed-for-floating swaps in one currency. – Cross Currency Interest Rate Swap (Currency swap) • Fixed for fixed rate debt service in two (or more) currencies.

Swap (2) • Interest Rate Swap: – Used by companies and banks that require either fixed or floating-rate debt. only interest payments are exchanged (net). – Fair value hedge  changes in FV of swap are recognized in P/L. – Since principal is in the same currency and the same amount. • Hedge using interest rate swap: – Cash flow hedge  changes in FV of swap are recognized in equity. Edited by Taufik Hidayat . – Interest rate swaps allow the companies (or banks) and the swap bank to benefit by swapping fixed-for-floating interest payments.

Swap (3) • Interest Rate Swap: Pay floating Company A Receive prefers floating fixed Swap Bank Pay fixed Receive Floating Company B prefers fixed Issue floating Issue fixed Edited by Taufik Hidayat .

Swap • Cash flow hedge : Swap from floating to fixed rate. Zero fair value of swap at inception. FASB allows a “short cut” method. – Interest payments are taken to P/L.Cash Flow Hedge . Matching index interest of swap with floating rate of loan. • Accounting treatment: – Changes in fair value of swap are taken to equity. Edited by Taufik Hidayat . • Determining hedge effectiveness can be highly complex based on PSAK 55. – To protect future cash flow (interest) payments. No prepayment of interest. whereby no hedge ineffectiveness if: – – – – Matching of notional amount with principal amount.

95% March.75% Dec. 20X5. Company A entered into swap contract with Company B on June 30. Interest settlement were made at the end of each quarter.75% on notional amount $10 million to Company B over 1 year for the receipt of floating rate of LIBOR + 50 basis point. 31 7. Under this contract.Cash Flow Hedge – Swap : Ilustration Example Example • Company A had $10 million loan with interest at LIBOR + 50 basis points. • To protect itself against an increase in interest rate. 31 7.25% 6. The rates are as follows: Date LIBOR LIBOR + 50 bp June.75% Sept.00% Edited by Taufik Hidayat . Company A paid interest at fixed rate of 7. 30 6. 30 7.50% 8.25% 7.45% 7.

– Current floating rate continues to prevail till the end of the swap tenure. Company A prefers fixed Issue LIBOR + 50 bp Pay 7.75% Receive LIBOR + 50 bp Pay LIBOR + 50 bp Company B prefers floating Issue fixed Edited by Taufik Hidayat .75% Receive 7.Cash Flow Hedge – Swap : Ilustration (2) Example Example • Assumption: – Fair value of swap at inception is zero. – FV swaps are discounted with LIBOR + 50 bp.

30 6.583) 200.75% 193.00% 198.Cash Flow Hedge – Swap : Ilustration (3) Example Example Date Current Receipt of LIBOR + previous 50 bp LIBOR + 50 bp (a) Payment of 7.750 193.710 82. 30 (a) (b) (c) (d) (e) 0 (72.75% x notional amount.538) (previous LIBOR + 50 bp) x notional amount. 31 8. 31 7.000 193.750 0 Dec.750 (25.750 193.750 5.250 0 (6.75% Sept.750 193. 7.127 (3.95% 168.538) (72.248 March. (a) – (b) PV of [ next period of (c) x number of next payments] Previous (e) + (d) Edited by Taufik Hidayat .75% (b) Current net receipt (paid) (c) FV of Swap asset (liability) (d) Change in FV (e) June.750 6.000 6.000) 9. 30 7.127) June.

538 72.000 To record settlement of swap differential Dec 31 Dr Interest rate swap asset/liability Cr FV adjustment (equity) To record fv adjustment Edited by Taufik Hidayat 82.248 .Cash Flow Hedge – Swap : Ilustration (4) Example Example Date Sept 30 Account Dr Interest Expense Cr Cash Amount 193.750 168.750 To record payment of interest at floating rate Sept 30 Dr FV adjustment (equity) Cr Interest rate swap asset/liability 72.750 193.000 25.248 82.538 To record fv adjustment Dec 31 Dr Interest Expense Cr Cash 168.750 To record payment of interest at floating rate Dec 31 Dr Interest Expense Cr Cash 25.

250 To record settlement of swap differential June 30 Dr FV adjustment (equity) Cr Interest rate swap asset/liability To record fv adjustment Edited by Taufik Hidayat 6.000 To record settlement of swap differential March 31 Dr FV adjustment (equity) Cr Interest rate swap asset/liability 3.000 To record payment of interest at floating rate June 30 Dr Cash Cr Interest Expense 6.750 To record payment of interest at floating rate March 31 Dr Cash Cr Interest Expense 5.583 To record fv adjustment June 30 Dr Interest Expense Cr Cash 200.000 200.750 198.Cash Flow Hedge – Swap : Ilustration (5) Date Account March 31 Dr Interest Expense Cr Cash Amount 198.250 6.127 6.127 .000 5.583 3.

• Changes in fair value of swap are taken to P/L. • Changes in fair value of debt represent discount/premium but not amortised as long as the hedge is in place. Edited by Taufik Hidayat . • Even though the debt is carried at amortised cost under PSAK 55. the carrying amount should be adjusted by it’s fair value  P/L. the value of fixed rate debt increases. – If market rate decreases.Swap • Fair value hedge : Swap from fixed to floating rate: – To protect from increase of value of debt.Fair Value Hedge .

3% LIBOR+150 bp 5. Under this contract. • To protect itself against an increase in interest rate. Interest settlement were made at the end of each interest payment.5% on notional amount $50 million to Company B over 3 year for the receipt of floating rate of LIBOR + 150 basis point.5% 4.0% 5.7% 4.5% 6. 20X3.0% 4.8% Edited by Taufik Hidayat . Company A paid interest at fixed rate of 5. Interest was payable half-yearly on June 30 and December 31.5% 5. The rates are as follows: Date 1/1X3 30/6X3 31/12X3 30/6/X4 31/12/X4 30/6/X5 LIBOR 4.Cash Flow Hedge – Swap : Exercise • Company A had $50 million bank loan with interest at LIBOR + 150 basis points to be repaid at the end of 20X5. Company A entered into swap contract with Company B on January 1.0% 4.5% 6.2% 6.0% 6.

Cash Flow Hedge – Swap : Exercise (2) • The calculation of the fair value of the swap: Edited by Taufik Hidayat .

Cash Flow Hedge – Swap : Exercise (3) Edited by Taufik Hidayat .

Cash Flow Hedge – Swap : Exercise (4) Edited by Taufik Hidayat .

Cash Flow Hedge – Swap : Exercise (5) Edited by Taufik Hidayat .

Christensen. Cottrell – Advanced Financial Accounting. • Baker. • Lam & Lau – Intermediate Financial Reporting. @Taufik_FEUI Edited by Taufik Hidayat . 10th Ed. 2nd Ed.Sources : • Tan & Lee – Advanced Financial Accounting. • Mackenzie. et al – Interpretation & Application of IFRS – 2011.