Derivatives

Any contract with three features;

• The initial cost is zero or nominal as compared to other contracts
that has similar response to changes in market value
Use of Derivative
• It will be settled in future
• Speculation
• Its value depends on certain underlying items • Hedging
• Competitive advantage
Example
A. Future or forward contracts (OTC)
B. Options (right to buy or sell)
C. Swap contracts

Accounting treatment

Classified in FVTPL category of financial instruments

Initial measurement Fair Value

Subsequent measurement fair value and any gain/loss charge to

profit or loss account

(A).Farward/Future/Swap

Contract to buy or sell in future at specified price, specified quantity at

prespecified date

Initial measurement Nil

Subsequent measurement Fair value

gain loss in profit and loss

Formula
𝑓𝑎𝑖𝑟 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑎𝑟𝑤𝑎𝑟𝑑/𝑓𝑢𝑡𝑢𝑟𝑒
= 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑢𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑚𝑔 𝑖𝑡𝑒𝑚(𝑓𝑟𝑜𝑚 𝑓𝑢𝑡𝑢𝑟𝑒 𝑚𝑎𝑟𝑘𝑒𝑡)
− 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑢𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔 𝑖𝑡𝑒𝑚

Financial asset or Financial liability ?

Standing at gain financial asset
Standing at loss financial liability

contract to buy contract to sell

➢ Increase in price are benefits ➢ Decrease in price are benefits
➢ Decrease in price are losses ➢ Increase in price are losses

Zubair Saleem AAFR notes IFRS-9 1

 (B).Options

Call option right to buy increase in price are benefits

Put option right to sell decrease in price are benefits

Right to buy or sell in future at specified time at, specified price

Initial recognition (fair value) cost (premium paid)

Subsequent measurement fair value and any gain/loss charge to p/l

Financial Asset for option holder or option buyer

Financial liability for option writer or option provider

(C).Swap contracts

Exchange of stream of cashflows with another entity

(Series of forward and future contract)

Initial measurement Nil

Subsequent measurement fair value and any gain/loss charge to p/l

Zubair Saleem AAFR notes IFRS-9 2

 Embedded derivatives
Hybrid instrument = non derivative contract + derivative contract

Accounting depends on nature of host contract

If host contract is a financial asset if host contract is a financial liability or non

financial contracts
E.g. E.g.
Investment in convertible loans issue of convertible loans
Investment in bonds where interest lease / construction contracts in foreign
Rate vary with gold price currency

No separation required Criteria;

Hybrid financial instruments will be classified Economic characteristics should be
As FVTPL different (host contract or derivative)

Host contract should not be measure at

FVTPL

Embedded derivative should meet the

definition of “stand alone derivative “

If criteria met
Separation required

Zubair Saleem AAFR notes IFRS-9 3

 Hedging
Method or technique to mitigate risk

Hedge item Anything (financial instrument, non-financial item or highly committed transections) that
exposes entity toward risk

Hedge instrument Anything (normally derivative) that is used to mitigate/minimize the risk

Hedge accounting criteria

There must be a formal documentation (including identification of hedge item and hedge
instrument and the nature of risk

There is an economic relationship between hedge item and hedge instrument

(hedge item and hedge instrument are always opposite in nature)

The effect of credit risk does not dominate the value changes that result from the economic
relationship

The hedge ratio of hedging relationship is the same as that resulting from the quantity of
hedge item and hedge instrument

If criteria met then apply hedge accounting otherwise normal accounting will appl
Types of hedging

Fair value hedge; (Risk is increase/decrease in fair value. Cash flow hedge
Hedge item FVTOCI other than (risk is that outflow will increase and inflow will decrease)
Investment FVTOCI investment Hedge item not recognized in financial statement
FVTOCI FVTPL
Hedge instrument Hedge instrument (fair value)
(derivative) Gain/loss will be splitted into effective and ineffective
Depends upon portion
hedge item FVTOCI FVTPL Ineffective portion will charge to p/l immediately
accounting
Effective portion charge to OCI and then
cashflow hedge reserve

Adjust carrying Reclassify towards

Value of asset or p/l as hedge item is
Liability (Non-financial items) charged to p/l

*split gain/loss on hedge instrument in two portions

First one is effective portion which is upto
the gain/loss of hedge item
Second one is ineffective which is over and
above of gain/loss of hedge item

Zubair Saleem AAFR notes IFRS-9 4

 Example-1

Entity X holds an inventory of 100 barrels of oil at a cost of $70 a barrel.

30th September 20X1: Oil is trading at $100 a barrel. Entity X decides to hedge the fair value of its oil
inventory by entering into a 12m forward contract to sell the oil at $100 per barrel.

31st December 20X1: Oil is trading at $90 per barrel.

Required Assuming that the hedge has been properly documented explain the accounting treatment
for this hedge (ignore time value).

Answer-1

Zubair Saleem AAFR notes IFRS-9 5

 Example-2

Solution 2

Zubair Saleem AAFR notes IFRS-9 6

 Example 3

Example Entity X is based in France. It expects to sell $1,000 of airline seats for cash in six months’
time. The current spot rate is €1 = $1. It sells the future dollar receipts forward to fix the amount to be
received in euros and to provide a hedge against the risk of a fall in the value of the dollar against the
euro.

End of the reporting period Three months later, at the end of the reporting period, the fair value of the
forward contract is reassessed. The contract is now a financial asset with a value of €80. The change in
expected cash flows in euros from the forecast seat sales has fallen by €75, from €1,000 to €925.

At settlement At the end of six months, suppose that the forward contract is settled with a gain of
€103. The airline seats are sold, but the proceeds in euros are €905, not the €925 estimated at the end
of the reporting period: – a further drop of €20.

Solution 3

At inception, the anticipated future sale is not recorded in the accounts, and the derivative (the
forward contract) has an initial value of zero.

At year end

Settlement date

Between the end of the previous reporting period and settlement date for the forward contract, the
derivative has generated a further gain of €23 (€103 – €80). This must be split into effective and
ineffective: Effective = €20 (€ 925 – € 905, which is the loss on the euro receipts) Ineffective = €3
(the balance, €23 – €20).

When the cash flows from the seat sales occur, the ‘effective’ gains on the derivative, currently held in
the equity reserve, can be released to profit or loss. (Note: The effective gain previously reported as
other comprehensive income must also be reported as a reclassification adjustment in other
comprehensive income.) In this way the gain on the effective part of the hedge offsets the ‘loss’ in
actual cash flows (the lower sales revenue now shown in profit).

Zubair Saleem AAFR notes IFRS-9 7

 The income from the sale is €905. The accumulated reserve created by the effective gains is €95 (€75
in the previous financial year and €20 in the current year). The release of the €95 to profit or loss
means that the total income from the seat sales and the effective hedged gains is €1,000. This was the
amount of income that was ‘hedged’ by the original forward contract.

The hedge accounting has offset the loss on the underlying position (cash receipts) with gains on the
derivatives position.

Cash flow hedge – Basis adjustment

A cash flow hedged transaction might be the future purchase of a non-financial asset.

Example-4

Entity X is based in the UK and has a December year end. Its functional currency is sterling (GBP). Entity
X forecasts the purchase of a machine from a US supplier and will be paid for in dollars (USD). The
purchase is expected to occur on 1st January 20X3. It is now 30th September 20X2. The cost of the
machine is $15,000. The exchange rate is $1.5=£1 giving a cost to Entity X of £10,000. Entity X hedges
the exchange risk be entering into a forward contract for $15,000 @ $1.5=£1. This is designated as a
cash flow hedge and accounted for accordingly.

Zubair Saleem AAFR notes IFRS-9 8

 1st January 20X3

Entity X buys the machine for $15,000. The exchange rate is $1.47=£1 giving a cost to Entity X of
£10,200.

A gain on the forward contract of £200 has been recognised through OCI by this date. This means that
there is a credit balance of £200 in the cash flow hedge reserve in equity.

This must be released to profit as the hedged transaction impacts the profit and loss account. The
hedged transaction impacts the profit and loss account as the asset is depreciated.

IFRS 9 says that if a hedged forecast transaction subsequently results in the recognition of a non-
financial asset or non-financial liability (or a hedged forecast transaction for a non-financial asset or a
non-financial liability becomes a firm commitment for which fair value hedge accounting is applied),
the amount held in the cash flow hedge reserve is included directly in the initial cost of the asset or the
liability. This is not a reclassification adjustment (see IAS 1) and hence it does not affect other
comprehensive income. This is known as a basis adjustment

Zubair Saleem AAFR notes IFRS-9 9

 Third type-Hedges of a net investment in a foreign operation

A later chapter explains the accounting treatment, for consolidation purposes, of an investment in a
foreign subsidiary or other foreign operation. The net assets of the foreign subsidiary are translated at
the end of each financial year, and any foreign exchange differences are recognised in other
comprehensive income (until the foreign subsidiary is disposed of, when the cumulative profit or loss is
then reclassified from ‘equity’ to profit or loss).

IFRS 9 allows hedge accounting for an investment in a foreign subsidiary. An entity may designate an
eligible hedging instrument for a net investment in a foreign subsidiary, provided that the hedging
instrument is equal to or less than the value of the net assets in the foreign subsidiary.

For example, suppose that a German company has a US subsidiary and a German subsidiary, and the
German subsidiary has a US dollar loan as a liability. If the German parent chooses to use hedge
accounting, the US dollar loan in its German subsidiary can be accounted for as a hedge for the parent
company’s net investment in the US subsidiary, provided that the size of the dollar loan is not larger
than the net investment in the US subsidiary.

• In the absence of hedge accounting, any gain or loss arising on the translation of the currency
loan would be reported in profit or loss for the German subsidiary, and so in profit or loss for
the group. Any exchange gain or loss arising from the net investment in the US subsidiary
would be reported in other comprehensive income.
• With hedge accounting, any gain or loss arising on the translation of the currency loan would
be recognised in other comprehensive income and included within the foreign exchange
differences arising on translation. The gain or loss on the hedge would offset the loss or gain
on the translation of the net assets of the subsidiary.

Zubair Saleem AAFR notes IFRS-9 10