Sem 11 HedgeAccounting - Part II (NTUL)

7.
1 Fair value hedge

• The gain or loss on the hedging instrument shall be recognised in profit
or loss (or other comprehensive income, if the hedging instrument
hedges an equity instrument for which an entity has elected to present
changes in fair value in other comprehensive income in accordance with
paragraph 5.7.5).
• The hedging gain or loss on the hedged item shall adjust the carrying
amount of the hedged item and be recognised in profit or loss. If the
hedged item is a financial asset (or a component thereof) that is
measured at fair value through other comprehensive income in
accordance with paragraph 4.1.2A, the hedging gain or loss on the
hedged item shall be recognised in profit or loss. However, if the hedged
item is an equity instrument for which an entity has elected to present
changes in fair value in other comprehensive income in accordance with
paragraph 5.7.5, those amounts shall remain in other comprehensive
income. When a hedged item is an unrecognised firm commitment, the
cumulative change in the fair value of the hedged item subsequent to its
designation is recognised as an asset or a liability with a corresponding
gain or loss recognised in profit or loss.
22 March 2018 © Lee Kin Wai 1
Accounting for a Fair Value Hedge
Source: TLK Figure 10-3
Hedged Item (recognized Exception: when

Hedging the hedged item is
asset or liability or entity
commitment) Instruments an equity
instrument with
Change in fair value Change in fair value changes in FV to
OCI, the gains or
Income statement losses on the
Gain (loss) on hedging hedging
instrument offset loss (gain) on instrument is
hedged item recognized in OCI
to allow offsetting
Balance sheet
Change in fair value adjusted Change in fair value adjusted
against carrying amount against carrying amount
TLK Illustration 10.6 Hedge of an exposed monetary asset
• Gemini Enterprise, whose functional currency is the dollar, sold

merchandise with an invoice value of FC 100,000 on 2 December 20x4
with payment due on 31 January 20x5. The spot exchange rate on that
date was FC1 = $1.85.
• Gemini hedged the exposed accounts receivable by entering into a
forward exchange contract to deliver (sell) FC 100,000 on 31 January
20x5 at the forward rate of FC1 = $1.835.
• spot rate forward rate for maturity on 31-1-20x5
• FC 1 = S$ FC 1 = S$
• 2 Dec 20x4 1.850 1.835
• 31 Dec 20x4 1.835 1.825
• 31 Jan 20x5 1.820 1.820

•Hedged item is the investment as an exposed monetary asset

which is account receivable.
•Hedging instrument is the forward contract to sell foreign
currency (FC).
•The hedged risk is the foreign exchange rate risk between FC
and $.
•We designate the change in entire fair value of the forward
contract as the hedging instrument to hedge the change in the
fair value of the account receivable. Thus, we assess hedge
effectiveness by comparing the change in entire fair value of
the forward contract against the change in the fair value of the
account receivable. This means we include the change in time
value of the forward contract in assessing hedge effectiveness.

2 Dec 20x4
E1
Dr. Account receivables 185,000
Cr. Sales 185,000
Sales to customer at FC 100,000 x 1.850 spot 2-12-20x4 = $ 185,000
Fair value of forward contract = 0 at inception. No journal entry for forward contract.
31 Dec 20x4
E2
Dr. exchange loss (P/L) 1,500
Cr. Account receivables 1,500
Exchange loss = FC 100,000 x (1.835 spot 31-12-20x4 - 1.850 spot 2-12-20x4) = $1,500
Contracted forward rate maturing on 31-Jan-20x5 that is "locked in" on 2-12-20x4 = 1.835
Current forward rate maturing on 31-jan-20x5 on 31-12-20x4 = 1.825
Change in forward rate 0.010
Change in fair value of forward contract = 0.010 x FC 100,000 = 1,000
E3
Dr. Forward contract (derivative asset) 1,000
Cr. Gain on forward contract (P/L) 1,000
Revalue forward contract and
record a transaction gain on forward contract): [FC 100,000 × (1.825 – 1.835)].
31 Jan 20x5
E4
Dr. exchange loss (P/L) 1,500
Exchange loss = FC 100,000 x (1.835 spot 31-12-20x4 - 1.820 spot 31-1-20x5) = $1,500
Current forward rate maturing on 31-Jan-20x5 on 31-12-20x4 =1.825

Current forward rate expired on 31-Jan-20x5 (= spot rate 31-Jan-20x5) =1.820
Change in forward rate 0.005
Change in fair value of forward contract =0.005 x FC 100,000 = 500
E5
Dr. Forward contract (derivative asset) 500
Cr. Gain on forward contract (P/L) 500
Revalue forward contract and record a transaction gain on forward
contract): [FC 100,000 × (1.82 – 1.825) ].

E6
Dr. Cash 182,000
collect cash from customer
E7
Dr. Cash 1,500
Cr. Forward contract (derivative asset) 1,500
close forward contract at settlement date
•The settlement amount of the forward contract
= notional amount x difference between the contracted forward rate and spot rate at settlement date
=[FC 100,000 × (1.835 – 1.82)] = 1,500
•At settlement, the forward contract is a derivative asset as there a receipt due from the broker because the
contracted forward rate is higher than the final spot rate.
•The net cash proceeds of $183,500 effectively locks in the overall settlement at the forward rate of 1.835.
•There is a loss of $3,000 on the accounts receivable that is partially offset by a gain of $1,500 on the
forward contract as a result of the depreciation of the FC against the dollar.
•The difference of $1,500 = forward discount on the contract = the cost of hedging.
•Since the loss on the accounts receivable and the gain on the forward contract are both taken to the income
statement, special rules for hedge accounting are not needed to achieve the offset.

1 2 3
Hedge but No hedging
Hedge and did NOT (i.e. no
apply hedge apply hedge forward
accounting accounting contract)
Statement of comprehensive income
Sales in 20x4 185,000 185,000 185,000
Exchange loss (P/L) on receivable in 20x4 (1,500) (1,500) (1,500)
Exchange loss (P/L) on receivable in 20x5 (1,500) (1,500) (1,500)
Gain on forward contract (P/L) in 20x4 1,000 1,000 0

Gain on forward contract (P/L) in 20x5 500 500 0
Net profit 183,500 183,500 182,000
OCI 0 0 0
Total comprehensive income 183,500 183,500 182,000
Economic consequences
Cash flow in 20x4 and 20x5
Cash inflow from sales (collect from customer) 182,000 182,000 182,000
Cash inflow from forward contract 1,500 1,500 0
Total cash inflow / (outflow) 183,500 183,500 182,000

1.“Hedging and apply hedge accounting” means we hedge and we apply the rules
relating to hedge accounting (in this case the fair value hedge). In this example, the
change in fair value of hedged item (account receivable) is recognized in P&L and
the change in fair value of hedging instrument (forward contract) is recognized in
P&L. Thus, the gain / (loss) on of hedged item (account receivable) in the P&L, offset
the (loss)/ gain on hedging instrument (forward contract) in the P&L.
2.“Hedging but did not apply hedge accounting” means that although we engage in
hedging, we choose NOT apply the rules relating to hedge accounting (in this case
the fair value hedge). In this example, the change in fair value of hedged item
(account receivable) is recognized in P&L and the change in fair value of hedging
instrument (forward contract) is recognized in P&L.
3.“No hedging” means we did not engage in hedging. In this example, it means we
did not enter into the forward contract.
•In summary, this example shows that hedging is more beneficial than no hedging.
Hedging reduces volatility of income versus the no-hedge case. “Hedging and apply
hedge accounting” and “hedging but do not apply hedge accounting” have
1. Same net profit (accounting consequences)
2. Same total comprehensive income (accounting consequences)
3. Same net cash flow effect (economic consequences)

TLK 10.7 Fair value hedge of inventory
• GEMS Mining Company had an inventory of 10,000 ounces of gold at 31
October 20x3, which was carried at cost at $3,000,000 ($300 per ounce). The
price of gold on that date was $352 per ounce.
• On 1 November 20x3, GEMS sold a gold forward contract on 10,000 ounces of
gold at a forward price of $350 per ounce. The contract matured on 31 March
20x4. The forward contract was deemed a financial instrument under IFRS 9 as
GEMS intended to settle the contract on a net settlement basis. The purpose of
entering into this contract was to lock in a net margin of $50 per ounce or
$500,000 in total when the gold was eventually sold.
• On 31 December 20x3, the financial year-end of GEMS, the forward price for a
31 March 20x4 gold contract was $340 per ounce while the spot price of gold
was $342 per ounce. There was a gain of $100,000 on the forward contract, and
a corresponding loss was recorded on the inventory.
• The financial year-end of GEMS is 31 December. In documenting the hedge,
GEMS designated the risk as the change in the value of the gold inventory as a
result of changes in the spot price of gold.
• GEMS measured hedge effectiveness by comparing the cumulative change in
the fair value of the forward contract with the cumulative change in the fair value
of the inventory. Since the hedged item is the inventory of gold whose value
changes with the price of gold, the hedge was designated as a fair value hedge.
• At inception, the hedge was expected to be highly effective as the critical terms
match. Ignore discounting.

• GEM designated the forward contract as a fair value hedge of the

change in the value of the gold inventory due to changes in the spot
price of gold. Hedge effectiveness is assessed based on the ratio of
the change in the entire fair value of the forward contract (based on
forward price of gold) to the change in the value of the inventory
(based on the spot price of gold).
• In this example:-
1. The hedged item is gold inventory (existing asset).
2. The hedging instrument is the forward contract to sell gold.
3. The hedged risk is the price risk of the gold inventory (i.e.
decline in price in gold when subsequently sold).

fair value hedge of inventory spot price of gold forward price of gold for maturity on 31 March 20x4
1 November 20x3 352 350
31 December 20x3 342 340
31 March 20x4 330 330
Gold (units) 10,000

original costs of inventory $ per unit 300
inventory (asset) at cost - 31 Oct 20x3 3,000,000
Assess hedge effectiveness 1 2 3 4 5 6 7 8

Month Fair value of Fair value of Change in Fair valueChange in Fair value Change in Fair value Change in Fair value delta ratio delta ratio
hedged item hedging of of of hedging of hedging current cumulative
instrument hedged item hedged item instrument instrument
current cumulative current cumulative
1 November 20x3 3,520,000 0

31 December 20x3 3,420,000 100,000 (100,000) (100,000) 100,000 100,000 -1.000 -1.000
31 March 20x4 3,300,000 200,000 (120,000) (220,000) 100,000 200,000 -0.833 -0.909
1 November 20x3
No journal entry is needed for forward contract. Only a memorandum record to reflect
forward contract on gold.
No journal entry is needed for existing inventory (at cost = $300 per unit x 10,000 units =
$ 3,000,000 in balance sheet).
31 December 20x3
E1
Dr. Forward contract (asset) 100,000
[change in fair value of forward contract ]
E2
Dr. Loss on inventory (P/L) 100,000
Cr. Inventory (asset) 100,000
[ change in fair value of inventory ]
Note - Inventory is marked to market from the spot price of $352 per unit (i.e. spot price
on 1- November-20x3).
There is no marking to market of inventory from original cost of $300 per unit.

31 March 20x4
E3
E4
Dr. Loss on inventory (P/L) 120,000
Cr. Inventory (asset) 120,000
[ change in fair value of inventory ]
E5
Dr. Cash 3,300,000
Cr. Sale 3,300,000

Inventory at original cost 3,000,000

Less adjustment to inventory (100,000) E2
Less adjustment to inventory (120,000) E4
Inventory at 31 MARCH 20x4 2,780,000
E6
Dr. cost of sales (P/L) 2,780,000
Cr. Inventory (asset) 2,780,000
[record cost of sales of inventory]
E7
Dr. Cash 200,000
Cr. Forward contract (asset) 200,000
[close forward contract ]
1 2 3
Hedging and Hedging but No hedging
Accounting consequences apply did not apply i.e. no forward
hedge accounting hedge accounting contract
Statement of comprehensive income 1-October-20x3 to 31 March 20x4
Sale 3,300,000 3,300,000 3,300,000
Less cost of sales (2,780,000) (3,000,000) (3,000,000)
Gross profit / (loss) 520,000 300,000 300,000
Loss on inventory (P/L) (100,000) 0 0

Loss on inventory (P/L) (120,000) 0 0
Gain / (loss) on forward contract (P/L) 100,000 100,000 0

Gain / (loss) on forward contract (P/L) 100,000 100,000 0
Net profit / (loss) 500,000 500,000 300,000
OCI 0 0 0
total comprehensive income/ (loss) 500,000 500,000 300,000
Cash inflow / (outflow) from 1 october 20x3 to 31 March 20x4
Sell inventory 3,300,000 3,300,000 3,300,000
Sell forward contract 200,000 200,000 0
total cash inflow / (outflow) 3,500,000 3,500,000 3,300,000

1.“Hedging and apply hedge accounting” means we hedge and we apply the rules relating
to hedge accounting (in this case the fair value hedge). In this example, the change in fair
value of hedged item (INVENTORY) is recognized in P&L and the change in fair value of
hedging instrument (FORWARD CONTRACT) is recognized in P&L. Thus, the gain / (loss)
on of hedged item (INVENTORY) in the P&L, offset the (loss)/ gain on hedging instrument
(FORWARD CONTRACT) in the P&L.
2.“Hedging but did not apply hedge accounting” means that although we engage in hedging,
we choose NOT apply the special rules relating to hedge accounting (in this case the fair
value hedge). In this example, the existing asset (INVENTORY) is recognized in
HISTORICAL COST and the change in fair value of hedging instrument (FORWARD
CONTRACT) is recognized in P&L.
3.“No hedging” means we did not engage in hedging. In this example, it means we did not
SELL the FORWARD CONTRACT.
•In summary, this example shows that hedging is more beneficial than no hedging. Hedging
reduces volatility of income versus the no-hedge case. “Hedging and apply hedge
accounting” and “hedging but do not apply hedge accounting” have
–Different gross profit
–Same net profit
–Same total comprehensive income
–Same net cash flow effect
Example 3 - Fair value hedge of existing asset (FVOCI)
• On 1-Jan-20x1, company A purchased 1,000 shares in company X at $40 per

share. A classified the investment as FVOCI.
• On the same day, company A purchased a put option on 1,000 shares for
$3,000. The exercise price of the option is $40 per share and the option
expires on 30 April 20x1. The put option is to hedge the decline in share price
of investment in X below $40. Company A classified the hedging relationship
as a fair value hedge and designated the hedged risk as the risk that
company X’s share price would fall below $40.
• On 31-March-20x1, the market price of shares in company X is $30 per
share. Fair value of put option is $11,000.
• On 30 April 20x1, the market price of shares in company X is $12 per share
and company A sold the shares in X for $12 per share.
• On 30 April 20x1, company A exercised the put option. Fair value of put
option is $28,000.
•Hedged item is the investment as FVOCI investment.

•Hedging instrument is the put option purchased
•The hedged risk is change in fair value of FVOCI investment.
1.We designate the change in intrinsic value of the put option as the
hedging instrument to hedge the change in the fair value of the FVOCI
investment. Thus, we assess hedge effectiveness by comparing the
change in intrinsic value of the put option against the change in the fair
value of the FVOCI investment. This means we exclude the change in
time value of the put option in assessing hedge effectiveness.
2.Alternatively, we designate the change in entire fair value of the put

option as the hedging instrument to hedge the change in the fair value
of the FVOCI. Thus, we assess hedge effectiveness by comparing the
change in entire fair value of the put option against the change in the
fair value of the FVOCI investment. This means we include the change
in time value of the put option in assessing hedge effectiveness.

Assess hedge effectiveness based on intrinsic value of option

Fair value of Intrinsic value of Change in Fair value Change in intrinsic value Change in intrinsic value Change in intrinsic value delta ratio delta ratio
put option current cumulative current cumulative
1 Jan 20x1 40,000 0

31 March 20x1 30,000 10,000 (10,000) (10,000) 10,000 10,000 -1.000 -1.000
30 april 20x1 12,000 28,000 (18,000) (28,000) 18,000 28,000 -1.000 -1.000
Assess hedge effectiveness based on fair value of option

Month Fair value of Fair value of Change in Fair value Change in Fair value Change in Fair value Change in Fair value delta ratio delta ratio
current cumulative current cumulative
1 Jan 20x1 40,000 3,000

31 March 20x1 30,000 11,000 (10,000) (10,000) 8,000 8,000 -0.800 -0.800
30 april 20x1 12,000 28,000 (18,000) (28,000) 17,000 25,000 -0.944 -0.893



1 Jan 20x1
E1
Dr. Investment in X (FVOCI) 40,000
Cr. Cash 40,000
[buy shares in X and classify as FVOCI ]
E2
Dr. Put option purchased (asset) 3,000
Cr. Cash 3,000
[ buy put option and designate as fair value hedge of
financial assets classified as FVOCI]

31 March 20x1
E3
Dr. Deferred loss on FVOCI investment (equity / OCI) 10,000
Cr. Investment in X (FVOCI) 10,000
[loss in fair value of FVOCI ]
E4
Dr. Put Option (asset) 8,000
Cr. Deferred gain on put option ( equity / OCI) 8,000
[ increase in fair value of put option ]
Alternatively we can separate the fair value of put option into 1) intrinsic value & 2) time value.
Thus, we can decompose E4 into E4A and E4B as follow:-
E4A
[ change in the intrinsic value of put option ]
E4B
Dr. Deferred gain on put option ( equity / OCI) 2,000
Cr. Put option (asset) 2,000
[ CHANGE in time value of put option ]
30 april 20x1
E5
Dr. Deferred loss on FVOCI investment (equity / OCI) 18,000
[loss in fair value of AFS]
E6
[ increase in fair value of put option ]
Alternatively we can separate the fair value of put option into 1) intrinsic value and 2) time value
Thus, we can decompose E6 into E6A and E6B as follow:-
E6A
Cr. Deferred Gain on put option (equity/ OCI) 18,000
[ change in the intrinsic value of put option ]
E6B
Dr. Deferred gain on put option ( equity / OCI) 1,000
[CHANGE in time value of put option ]
E7
Dr. Cash 12,000
[sell investment in X (FVOCI) ]
E8
Dr. Cash 28,000
[ sell put option ]

1 2 3
Hedging and Hedging but No hedging
Accounting consequences apply did not apply
hedge accounting hedge accounting
Statement of comprehensive income 1-1-20x1 to 30-april 20x1
Fair value gain/ (loss) put option (P/L) - March 20x1 0 8,000 0
Fair value gain/ (loss) put option (P/L) - April 20x1 0 17,000 0
Net profit / (loss) 0 25,000 0
OCI - fair value gain/ (loss) investment (FVOCI)- March 20x1 (10,000) (10,000) (10,000)
OCI - fair value gain/ (loss) investment (FVOCI) - April 20x1 (18,000) (18,000) (18,000)
OCI - fair value gain/ (loss) put option - March 20x1 8,000 0 0
OCI - fair value gain/ (loss) put option - April 20x1 17,000 0 0
total comprehensive income / (loss) (3,000) (3,000) (28,000)
Cash inflow / (outflow) from 1 Jan 20x1 to 30 April 20x1
buy Investment ( FVOCI) (40,000) (40,000) (40,000)
Buy put option (3,000) (3,000) 0
sell Investment ( FVOCI) 12,000 12,000 12,000

Sell put option 28,000 28,000 0
total cash inflow / (outflow) (3,000) (3,000) (28,000)

1. “Hedging and apply hedge accounting” means we hedge and we apply the special
rules relating to hedge accounting (in this case the fair value hedge). In this example,
the change in fair value of hedged item (FVOCI) is recognized in OCI/ equity and the
change in fair value of hedging instrument (put option) is recognized in OCI/ equity
Thus, the gain / (loss) on of hedged item (FVOCI) in the OCI/equity , offset the (loss)/
gain on hedging instrument (put option) in the OCI/equity .
2. “Hedging but did not apply hedge accounting” means that although we engage in
hedging, we choose NOT apply the special rules relating to hedge accounting (in this
case the fair value hedge). In this example, the change in fair value of hedged item
(FVOCI) is recognized in OCI/ equity and the change in fair value of hedging instrument
(put option) is recognized in P&L.
3. “No hedging” means we did not engage in hedging. In this example, it means we did
not buy the put option.
• In summary, this example shows that hedging is more beneficial than no hedging.
Hedging reduces volatility of income versus the no-hedge case. “Hedging and apply
hedge accounting” and “hedging but do not apply hedge accounting” have
1. Different net profit
2. Same total comprehensive income
3. Same net cash flow effect

Accounting consequences and economic consequences.
• Thus, the decision to “hedge” or “not to hedge” has both

1. accounting consequences (such as impact on net profit, total
comprehensive income and balance sheet recognition of assets,
liabilities and equity) and
2. economic consequences (such as net cash inflow or outflow).
• In contrast, the decision to “hedge and apply hedge accounting” or
“hedge but do not apply hedge accounting” has only accounting
consequences (such as impact on net profit, total comprehensive
income and balance sheet recognition of assets, liabilities and
equity). The economic consequences (such as net cash inflow or
outflow) are usually similar under both decisions.

Fair value hedge of firm commitment
• A firm commitment is a binding agreement for the exchange of a
specified quantity of resources at a specified price on a specified
future date or dates.
• Issue : The hedged item is a firm commitment. However, the firm
commitment is not recognized as an existing asset or existing
liability until the actual exchange of resources at specified future
date.
• If there is an effective fair value hedge of the firm commitment, we
can recognize firm commitment as an existing asset or existing
liability until the actual exchange of resources at specified future
date.
• A hedge of the foreign currency risk of a firm commitment may be
accounted for as a fair value hedge or as a cash flow hedge.

Example 4 - fair value hedge of firm commitment
• Company D is a manufacturing company listed in Singapore. Its

functional currency and presentation currency is SGD. On 1-1-20x1,
Company D enters into a firm commitment (a binding non-
cancellable contract) to purchase of an equipment costing USD
100,000 for delivery on 30-9-20x1. Company D is concerned that the
USD might appreciate against SGD by the time the delivery of the
equipment was made, and decided to hedge against the risk of an
appreciation of the USD by entering into forward exchange contract
to purchase USD 100,000 on 30-9-20x1.
• It designated the forward exchange contract as a fair value hedge of
a firm commitment (a binding non-cancellable contract) to
purchase an equipment on 30-9-20x1.
spot exchange rate forward exchange rate
Date USD 1 = SGD for maturity at 30Sept20x1
USD 1 = SGD
1-Jan 20x1 1.27 1.30
31 March 20x1 1.31 1.35
30 June 20x1 1.40 1.49
30 Sept 20x1 1.56 1.56

• It has also designated the change in the fair value of the

forward exchange contract based on the forward rate as a
hedge against the change in the fair value of the firm
commitment based on the forward rate. On 30 September
20X1, the equipment is purchased, and the forward exchange
contract settled. Ignore the time value of money.
1. The hedged item is the firm commitment to buy the
equipment.
2. The hedging instrument is the purchase of a forward contract
(to buy USD forward).
3. The hedged risk is the exchange risk associated with the firm
commitment to buy the equipment. If USD appreciate against
SGD, company will suffer a SGD transaction exchange loss
on the USD liability.

Notional amount of forward USD 100,000

<--- FV = current forward rate - previous forward rate--->
Date spot exchange rate forward exchange rate Fair value of Spot element in Time value in
USD 1 = SGD for maturity at 31 Oct 20x1 forward contract forward contract forward contract
USD 1 = SGD
1-Jan 20x1 1.27 1.30

31 March 20x1 1.31 1.35 5,000 4,000 1,000
30 June 20x1 1.40 1.49 14,000 9,000 5,000
30 Sept 20x1 1.56 1.56 7,000 16,000 (9,000)
total 26,000 29,000 (3,000)

1-Jan 20x1
No journal entry is needed for forward contract. Only a memorandum record to reflect forward contract.
31 March 20x1
E1
Dr. Loss on firm commitment (P/L) 5,000
Cr. Firm commitment (liability) 5,000
[ fair value adjustment for firm commitment ]
E2
30 June 20x1
E3
E4
22 March
[change in 2018 © Lee Kincontract
fair value of forward Wai ] 34
30 Sept 20x1
E5
E6
E7
Dr. Equipment ( asset) 156,000
Cr. Cash 156,000
[buy equipment ]
compute firm commitment (B/S)

March 20x1 - Firm commitment (liability) 5,000 E1
June 20x1 - Firm commitment (liability) 14,000 E3
Sept 20x1 - Firm commitment (liability) 7,000 E5
Total firm commitment (liability) 26,000
E8
Dr. Firm commitment (liability) 26,000
Cr. Equipment ( asset) 26,000
[ to close firm commitment ]
Initial cost of equipment based on spot rate 156,000 E7
firm commitment adjustment (26,000) E8
Adjusted carrying value of equipment 130,000
Hence, equipment of $130,000 will be subsequently depreciated over its useful life.
E9
Dr. Cash 26,000
[ net settlement of forward contract ]
1 2 3
Fair value hedge of firm commitment Fair value hedge
Accounting consequences Hedge accounting Hedge accounting No hedge
apply not applicable i.e. no forward
Statement of comprehensive income 1- January-20x1 to 30 September 20x1 contract
Loss on firm commitment (P/L) - March (5,000)
Loss on firm commitment (P/L) - June (14,000)
Loss on firm commitment (P/L) - Sept (7,000)
Gain / (loss) on forward contract (P/L) - March 5,000 5,000

Gain / (loss) on forward contract (P/L) - June 14,000 14,000
Gain / (loss) on forward contract (P/L) - Sept 7,000 7,000
total comprehensive income/ (loss) 0 26,000 0
Total depreciation over useful life of equipment (130,000) (156,000) (156,000)
Net profit : 1-1-20x1 to end of useful life of PPE (130,000) (130,000) (156,000)
Total Comprehensive Income : 1-1-20x1 to end of useful life of PPE (130,000) (130,000) (156,000)
Cash inflow / (outflow) from 1 Jan 20x1 to 31 Oct 20x1
Cash outflow to buy equipment (156,000) (156,000) (156,000)

• In summary, this example shows that hedging is more

beneficial than no hedging.
• Hedging reduces volatility of income versus the no-
hedge case.
• “Hedging and apply hedge accounting” and “hedging but
do not apply hedge accounting” have
1. Different profit for year 20x1 but the Same net profit
from inception to end of useful life of PPE.
2. Different total comprehensive income for year 20x1 but
same total comprehensive income from inception to end
of useful life of PPE.
3. Same net cash flow effect.

7.2 Cash Flow Hedges
SFRS(I)-9 Paragraph 6.5.11 of IFRS 9 outline procedures for cash flow
hedge:
1. The change in the fair value of the hedging instrument is adjusted to
its carrying value in the statement of financial position.
2. The change in the fair value of the hedging instrument is separated
into an effective portion and an ineffective portion, if any.
3. The effective portion is deferred to equity (cash flow hedge reserve)
and the ineffective portion (if any) is recognized as an expense in the
profit or loss. The reason for the deferment of the effective
portion is that the transaction (the hedged item) has not been recognized
yet.
4. The effective portion that is deferred to equity is the lesser of the
following (in absolute amounts):
(a) The cumulative gain or loss on the hedging instrument from the
inception of the hedge; and
(b) The cumulative change in the fair value of hedged item (present
value of the expected future cash flows on the hedged item) from the
inception
22 March 2018of the hedge
© Lee Kin Wai 39
7.2 Cash Flow Hedges
5. If the hedged item is a financial asset or financial liability, the deferred
gain or loss in equity is taken to profit or loss in the same period or periods
during which the asset acquired or the liability assumed affects profit or
loss (such as in the periods that interest income or interest expense is
recognized).
6. If the hedged item is a forecasted transaction that will result in the
recognition of a non-financial asset or non-financial liability, transfer the
deferred gains or losses in equity to adjust the initial cost or other carrying
amount of the asset or liability.
7. For all other hedges, the amount accumulated in equity will be
reclassified from equity to profit and loss as a reclassification adjustment in
the same period (or periods) when the hedged future cash flows affect the
profit or loss.
8. When cash flow hedge accounting is discontinued, the cash flow hedge
reserve should be:
(i) reclassified to profit or loss if the hedged future cash flows are not
expected to occur;
(ii) remain until the hedged future cash flows occur if these cash flows are
still 22expected
March 2018 to occur.
© Lee Kin Wai 40
Accounting for a Cash Flow Hedge
Source TLK Figure 10-4
Derivative is designated as a cash flow hedge
Cumulative change in fair value of hedging instrument (A)

Cumulative change in present value of expected cash flow (B)
(A) > (B) (A) ≤ (B)

-No ineffective portion.
Ineffective portion Effective portion -Effective portion = cumulative
(A) – (B) (B) change in FV of hedging instrument
Income statement Equity Equity

Example 5 – Cash flow hedge of forecasted purchase
• Company D is a manufacturing company listed in Singapore. Its functional currency

and presentation currency is SGD. On 1-1-20x1, Company D enters into a highly
probable forecast transaction to purchase of an equipment costing USD 100,000
for delivery on 30-9-20x1. Company D is concerned that the USD might appreciate
against SGD by the time the delivery of the equipment was made, and decided to
hedge against the risk of an appreciation of the USD by entering into forward
exchange contract to purchase USD 100,000 on 30-92-0x1.
• It designated the forward exchange contract as a cash flow hedge of a forecast
purchase of an equipment on 30-9-20x1.
• It has also designated the change in the fair value of the forward exchange contract
based on the forward rate as a hedge against the fair value of the highly probable
forecast purchase transaction based on the forward rate.
• On 30 September 20X1, the equipment is purchased, and the forward exchange
22contract
March 2018settled. © Lee Kin Wai 42
1. The hedged item is the forecast transaction to buy the equipment.
2. The hedging instrument is the purchase of a forward contract (to buy
USD forward).
3. The hedged risk is the exchange risk associated with the forecast
transaction to buy the equipment. If USD appreciate against SGD,
company will suffer a SGD transaction exchange loss on the USD liability.
<--- FV = current forward rate - previous forward rate--->
Date spot exchange rate forward exchange rate Fair value of Spot element in Time value in
USD 1 = SGD for maturity at 31 Oct 20x1 forward contract forward contract forward contract
USD 1 = SGD
1-Jan 20x1 1.27 1.30

31 March 20x1 1.31 1.35 5,000 4,000 1,000
30 June 20x1 1.40 1.49 14,000 9,000 5,000
30 Sept 20x1 1.56 1.56 7,000 16,000 (9,000)
total 26,000 29,000 (3,000)

1-Jan 20x1
No journal entry is needed for forward contract. Only a memorandum
record to reflect forward contract.
31 March 20x1
E1
Cr. Cash flow hedge reserve (OCI/ equity) 5,000
30 June 20x1
E2

30 Sept 20x1
E3
E4
Cr. Cash 156,000
[buy equipment ]
• Thus the forecasted purchase subsequently results in the recognition of an existing
asset when equipment is purchased.

compute cash flow hedge reserve (equity)
31 March 20x1 - Cr. Cash flow hedge reserve (OCI/ equity) 5,000 E1
30 June 20x1 - Cr. Cash flow hedge reserve (OCI/ equity) 14,000 E2
30 Sept 20x1 - Cr. Cash flow hedge reserve (OCI/ equity) 7,000 E3
Total Cash flow hedge reserve (equity) 26,000
E5
Dr. Cash flow hedge reserve (OCI/ equity) 26,000
[ basis adjustment of the Cash flow hedge reserve (OCI/ equity) against the initial cost of asset
(equipment) ]

Basis adjustment (26,000) E5
E6
Dr. Cash 26,000
[ net settlement of forward contract ]

forward rate vs forward rate Cash flow hedge
Accounting consequences Hedge accounting Hedge accounting No hedge
Gain / (loss) on forward contract (P/L) - March 0 5,000

Gain / (loss) on forward contract (P/L) - June 0 14,000
Gain / (loss) on forward contract (P/L) - Sept 0 7,000
OCI - cash flow hedge - March 5,000 0

OCI - cash flow hedge - June 14,000 0
OCI - cash flow hedge - Sept 7,000 0
OCI - basis adjustment - Sept (26,000) 0
Other comprehensive income 0 0 0
total comprehensive income/ (loss) 0 26,000 0
Net profit from 1-1-20x1 to end of useful life of equipment (130,000) (130,000) (156,000)


hedge case.
1. Different profit for year 20x1 but the same net profit from
inception to end of useful life of PPE.
2. Same total comprehensive income from inception to
end of useful life of PPE.

Example 6 cash flow hedge – spot versus spot
• Same facts as previous example 5 except that Company D has designated
the change in the fair value of the forward exchange contract based on
the spot rate as a hedge against the change in the fair value of the
forecast purchase transaction based on the spot rate. On 30 September
20X1, the equipment is purchased, and the forward exchange contract
settled. Ignore the time value of money.
1. The hedged item is the forecast transaction to buy the equipment.
2. The hedging instrument is the purchase of a forward contract (to buy
USD forward).
3. The hedged risk is the exchange risk associated with the forecast
transaction to buy the equipment. If USD appreciate against SGD,
company will suffer a SGD transaction exchange loss on the USD liability.

Example 6 - cash flow hedge – spot versus spot
1-Jan 20x1
No journal entry is needed for forward contract. Only a memorandum record to
reflect forward contract.
31 March 20x1
E1
Cr. Time value in forward contract (P/L) 1,000
30 June 20x1
E2
Cr. Time value in forward contract (P/L) 5,000

30 Sept 20x1
E3
Dr. Time value in forward contract (P/L) 9,000
E4
Cr. Cash 156,000
[buy equipment ]
Thus the forecast transactions (i.e. forecast purchase) becomes as
existing asset when equipment is purchased.

compute cash flow hedge reserve (equity)

March 20x1 - Cr. Cash flow hedge reserve (OCI/ equity) 4,000 E1
June 20x1 - Cr. Cash flow hedge reserve (OCI/ equity) 9,000 E2
Sept 20x1 - Cr. Cash flow hedge reserve (OCI/ equity) 16,000 E3
Total Cash flow hedge reserve (equity) 29,000
E5
Dr. Cash flow hedge reserve (OCI/ equity) 29,000
[ basis adjustment of the Cash flow hedge reserve (OCI/ equity) against the initial cost of
asset (equipment) ]
Basis adjustment (29,000) E5
E6
Dr. Cash 26,000
[ net settlement
22 March 2018 of forward
© Lee Kincontract
Wai ] 52
spot vs spot Cash flow hedge
Accounting consequences Hedge accounting Hedge accounting
No hedge
Time value of forward contract - March 1,000
Time value of forward contract - June 5,000
Time value of forward contract - Sept (9,000)
Gain / (loss) on forward contract (P/L) - March 0 5,000

Gain / (loss) on forward contract (P/L) - June 0 14,000
Gain / (loss) on forward contract (P/L) - Sept 0 7,000
Net profit / (loss) (3,000) 26,000 0
OCI - cash flow hedge - March 4,000

OCI - cash flow hedge - June 9,000
OCI - cash flow hedge - Sept 16,000
OCI - basis adjustment - Sept (29,000)
Other comprehensive income 0 0 0
total comprehensive income/ (loss) (3,000) 26,000 0
Net profit from 1-1-20x1 to end of useful life of equipment (130,000) (130,000) (156,000)


hedge case.
1. Different profit for year 20x1 (excluding depreciation).
3. Same total net profit and same total comprehensive
income from inception (1-1-20x1) to end of useful life of
equipment.

7.3 Hedges of a Net Investment
6.5.13: Hedges of a net investment in a foreign operation, including
a hedge of a monetary item that is accounted for as part of the net
investment (see SFRS(I) 1-21), shall be accounted for similarly to
cash flow hedges:
(a) the portion of the gain or loss on the hedging instrument
that is determined to be an effective hedge shall be recognised
in other comprehensive income; and
(b) the ineffective portion shall be recognised in profit or loss.
6.5.14: The cumulative gain or loss on the hedging instrument

relating to the effective portion of the hedge that has been
accumulated in the foreign currency translation reserve shall be
reclassified from equity to profit or loss as a reclassification
adjustment (see SFRS(I) 1-1) in accordance with paragraphs 48–49
of SFRS(I) 1-21 on the disposal or partial disposal of the foreign
operation.

Example 7 - Hedge of a net investment in a foreign operation
• Company A, whose functional currency is S$, acquired 100% control of

company X, whose functional currency is FC, in 20x1. As at 31-12-20x4,
the net assets of X is FC 5,000,000 (comprising share capital FC 2,000,000
and retained earnings FC 3,000,000). On the same day, A hedges its
investment in X by borrowing FC 5,000,000 at 4% interest payable on 31
December yearly. Exchange rate on 31-12-20x4 was FC1 = S$ 2. For year
ended 31-12-20x5, X has a net profit of FC1,000,000. Exchange rate on 31-
12-20x5 was FC1=S$1.6 and average rate for the year 20x5 was FC1=S$
1.78.
1. The hedged item is the net investment in foreign subsidiary (FC).
2. The hedging instrument is the FC loan liability.
3. The hedged risk is the exchange risk associated with the net investment
in foreign FC subsidiary. If FC depreciate against SGD, company will suffer
a SGD translation exchange loss on the net investment in foreign
subsidiary (FC).

Example 7 - Hedges of a net investment in a foreign operation
Translation difference in X’s translated financial statements
-On opening net assets 1-1-20x5 = (2 - 1.60)* 5,000,000 = 2,000,000
-on net profit for the year 20x5= (1.78 - 1.60)* 1,000,000 = 180,000
Translation loss for year 20x5 2,180,000
31-12-20x4
Dr. Cash S$ 10,000,000
Cr. Long term loan S$ 10,000,000
[record long term loan = 5,000,000 x 2 = S$ 10,000,000)
31-12-20x5
Dr. interest expense (P/L) S$ 320,000
Cr. Cash S$ 320,000
(record interest expense = 5,000,000 x 4% x 1.6 = 320,000)
Dr. Long term loan S$ 2,000,000

Cr. Foreign currency translation reserve (OCI/equity)=5,000,000 x (2 – 1.6) = S$ 2,000,000
(exchange gain on Long term loan taken to OCI/ equity)
• Thus, translation loss on foreign subsidiary (taken to OCI/equity) is hedged by
exchange gain on long term loan taken to OCI/ equity.
8. Discontinuation of hedge accounting
SFRS(I) 9 : Paragraph 6.5.6
• An entity shall discontinue hedge accounting prospectively only
when the hedging relationship (or a part of a hedging relationship)
ceases to meet the qualifying criteria (after taking into account any
rebalancing of the hedging relationship, if applicable).
• This includes instances when the hedging instrument expires or is

sold, terminated or exercised.
• For this purpose, the replacement or rollover of a hedging

instrument into another hedging instrument is not an expiration or
termination if such a replacement or rollover is part of, and
consistent with, the entity’s documented risk management objective.
• Discontinuing hedge accounting can either affect a hedging

relationship in its entirety or only a part of it (in which case hedge
accounting continues for the remainder of the hedging relationship).
9. Summary of hedge accounting
• Hedge accounting (HA) is a special accounting rule that

aims to reduce accounting mismatch in a hedging
relationship & thus, reduces profit or loss volatility.
• Key issues in HA:-

1. Qualifying hedged items.
2. Qualifying hedging instruments
3. Hedge effectiveness
4. Documentation of hedging relationship.
5. Accounting for qualifying hedging relationships.
6. Discontinuation of hedge accounting.

• 3 types of Hedging relationships:-

1. Fair value hedge
– gain/ (loss) on both hedged item and hedging instrument are recognized
and offset each other in profit or loss during the same accounting periods
and thus reduces income volatility.
-Exception: if hedged item is an equity instrument at FVOCI, gain/ (loss) on
the hedged item remains in OCI and the gain/ (loss) on hedging instrument
is also recognized in OCI.
2. Cash flow hedge
-defer gain/ (loss) on hedging instrument in OCI so that gain/ (loss) on
both hedged item and hedging instrument are recognized and offset each
other in profit or loss only subsequent to the period of hedge (generally
after the hedged item is recognized).
3. Hedge of a net investment in foreign operations
-to offset the translation gain/ (loss) arising from the hedged item and
hedging instruments in OCI.
•To hedge or not to hedge is an economic / business decision.

•We need to distinguish the economic consequences (such as
cash flows) and accounting consequences (effect of profit after
tax and OCI in terms of magnitude/amount, timing of
recognition, and volatility).
•Hedge accounting [HA] is not mandatory. Firms have a choice
whether to apply or not to apply HA.
•To apply or not apply HA is an accounting decision.
•Thus, the decision to apply or not apply HA has only
accounting consequences.
10. Lessons from empirical research on hedging
• Derivatives can be value-increasing or value-destroying. Lessons from

research on derivatives (we will do an overview of 5 minutes per paper):
1. Fauver and Naranjo (2010) – USA Listed firms – association between firm
valuation and derivatives usage.
2. Lee (2013) Listed firms in Asia- : Does derivatives usage increase firm
valuation ? Under what conditions, do derivative usage increase or
decrease firm value ?
3. How can derivatives destroy shareholder value? Discuss (i)
Pricewaterhouse Coopers Report on its investigation into the oil trading
losses from China Aviation Oil, 2005 and (ii) Deloitte, The China Aviation
Oil Debacle, 2006.
4. How do derivatives affect cost of debt (borrowing), capital expenditure
investments and debt covenants? How do we measure the usage of
derivative and extent of hedging by the firm? Discuss Campello, Lin, Ma,
Zou (2011) The Real and Financial Implications of Corporate Hedging,
(focus on page 1615 to page 1624 and page 1642 to page 1644).

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7.

1 Fair value hedge

Hedged Item (recognized Exception: when

• Gemini Enterprise, whose functional currency is the dollar, sold

• spot rate forward rate for maturity on 31-1-20x5

22 March 2018 © Lee Kin Wai 3

•Hedged item is the investment as an exposed monetary asset

22 March 2018 © Lee Kin Wai 4

Current forward rate maturing on 31-Jan-20x5 on 31-12-20x4 =1.825

22 March 2018 © Lee Kin Wai 6

22 March 2018 © Lee Kin Wai 7

Gain on forward contract (P/L) in 20x4 1,000 1,000 0

Total comprehensive income 183,500 183,500 182,000

Cash inflow from forward contract 1,500 1,500 0

Total cash inflow / (outflow) 183,500 183,500 182,000

22 March 2018 © Lee Kin Wai 8

22 March 2018 © Lee Kin Wai 9

22 March 2018 © Lee Kin Wai 10

• GEM designated the forward contract as a fair value hedge of the

22 March 2018 © Lee Kin Wai 11

Gold (units) 10,000

Assess hedge effectiveness 1 2 3 4 5 6 7 8

1 November 20x3 3,520,000 0

22 March 2018 © Lee Kin Wai 13

22 March 2018 © Lee Kin Wai 14

Inventory at original cost 3,000,000

Less cost of sales (2,780,000) (3,000,000) (3,000,000)

Gross profit / (loss) 520,000 300,000 300,000

Loss on inventory (P/L) (100,000) 0 0

Gain / (loss) on forward contract (P/L) 100,000 100,000 0

Net profit / (loss) 500,000 500,000 300,000

total comprehensive income/ (loss) 500,000 500,000 300,000

Sell inventory 3,300,000 3,300,000 3,300,000

Sell forward contract 200,000 200,000 0

total cash inflow / (outflow) 3,500,000 3,500,000 3,300,000

• On 1-Jan-20x1, company A purchased 1,000 shares in company X at $40 per

•Hedged item is the investment as FVOCI investment.

2.Alternatively, we designate the change in entire fair value of the put

22 March 2018 © Lee Kin Wai 19

Assess hedge effectiveness based on intrinsic value of option

1 Jan 20x1 40,000 0

Assess hedge effectiveness based on fair value of option

1 Jan 20x1 40,000 3,000

22 March 2018 © Lee Kin Wai 20

22 March 2018 © Lee Kin Wai 21

22 March 2018 © Lee Kin Wai 22

22 March 2018 © Lee Kin Wai 23

22 March 2018 © Lee Kin Wai 26

Net profit / (loss) 0 25,000 0

total comprehensive income / (loss) (3,000) (3,000) (28,000)

sell Investment ( FVOCI) 12,000 12,000 12,000

total cash inflow / (outflow) (3,000) (3,000) (28,000)

22 March 2018 © Lee Kin Wai 27

22 March 2018 © Lee Kin Wai 28

• Thus, the decision to “hedge” or “not to hedge” has both

22 March 2018 © Lee Kin Wai 29

22 March 2018 © Lee Kin Wai 30

• Company D is a manufacturing company listed in Singapore. Its

22 March 2018 © Lee Kin Wai 31

• It has also designated the change in the fair value of the

22 March 2018 © Lee Kin Wai 32

Notional amount of forward USD 100,000

1-Jan 20x1 1.27 1.30