University of San Jose – Recoletos

College of Commerce
Accountancy and Finance Department

Accounting 106: Valuation Concepts

Mr. Jun Brian Alenton, CPA, CMA, CAT, RCA, MICB

ACCOUNTING FOR DERIVATIVES AND HEDGE RELATIONSHIPS

(PFRS 9)

Part A: Accounting for Derivatives

What is a derivative?
PAS 39 defines a derivative as a financial instrument:
 Whose value changes in response to the change in an underlying variable such as an interest rate,
commodity or security price, or index;
 That requires no initial investment, or one that requires a smaller investment than would be required for a
contract with similar response to changes in market factors; and
 That is settled at a future date.

Types of derivatives

1. Futures
 Futures are exchange-traded standardized forward contracts. There are many futures exchanges, mostly
offering trading in different contracts. For each contract there are four settlement dates in each year and
futures are bought and sold for those settlement dates. Futures can be bought or sold to create a long or a
short position. The position can subsequently be closed by selling or buying the same number of contracts
for the same settlement date, at any time up to the settlement date. When a futures position is closed,
there will be either a gain or a loss on the futures trading, depending on the difference between the buying
and the selling prices.
 Most futures positions are closed before the settlement date. Open positions at settlement date are settled,
either by cash settlement for difference or by delivery of the underlying item.
 A feature of futures is that initial transactions are made between a buyer and seller, but the central
counterparty for the futures exchange immediately steps in, and becomes the buying counterparty for the
seller and the selling counterparty for the buyer. In this way, buyers and sellers have reduced credit risk,
because their counterparty is the exchange itself, in all cases.
 The exchange protects itself from credit risk by taking payments of deposits (‘margin’) from buyers and
sellers. Additional payments have to be made if the futures price subsequently moves adversely and creates
a loss on the position.
 Although futures can be used to hedge exposures to financial risk, non-bank corporates usually arrange
forward contracts rather than deal in futures.

2. Forwards

What is a forward contract?

 A forward contract is a derivative contract between two parties, one of which is usually a financial
institution, to exchange a financial product or the value of an index or other benchmark at an agreed rate on
a specified future date.
 Forwards are only available to companies that have a line of credit with their bank.

ACCTG 106 PFRS 9: DERIVATIVES AND HEDGING Page 1 of 9

  Comparison between futures and forwards can be summarized as follows:

What are the common types of forward contracts?

 Foreign exchange forward contracts
 Contract that fixes an exchange rate now for buying / selling a quantity of currency (in exchange for
another currency) at a future date.
 FX forward contract is a binding obligation on both parties (bank and customer).
 It removes risk of adverse movements in spot rate. It also removes opportunity to benefit from
favourable movements in spot rate.
 The exchange rate in a forward contact is not the expected spot rate at the settlement date for the
contract. It is derived from current interest rate differentials between the two currencies.
 Interest rate forwards
 A contract to pay or receive a fixed rate of interest in exchange for a variable (benchmark) rate of
interest:
 On a notional short-term amount of funds.
 For a stated interest period.
 Starting a date in the future (typically within 12 months).
 The most common form of interest rate forward contract is the forward rate agreement (FRA).
 Commodity price forwards
 Forward prices for commodities are driven by:
 Supply and demand
 Storage and spoilage issues (warehousing costs and interest income foregone on money tied
up)
 When commodities are priced in a foreign currency (usually USD) fixing a forward price involves:
 A forward commodity price in foreign currency and
 A forward FX contract to fix the exchange rate into domestic currency.
 Forward price relative to spot price
 Cotango – Forward price is greater than the spot price. This is normal for non-perishable
commodities that have a cost of carry.
 Backwardation – Forward price is lesser than the spot price. Occurs when spot price is
expected to fall over time; for example, perishable commodities.

ACCTG 106 PFRS 9: DERIVATIVES AND HEDGING Page 2 of 9

 3. Swaps

What is a swap?
A swap is an agreement to exchange one stream of payments in exchange for another. Swaps are usually in a
form of interest rate swaps, currency swaps, or commodity swaps.

Discuss the relevance of time value of money in accounting for swaps.

 A significant feature of swaps is the long term duration of the agreement – unlike forward contracts and
futures. Thus, the effect of the time value of money is significant.
 Money has time value, since it can be invested to make more money. Money available at the present time is
worth more than the same amount of money available at some time in the future.
 Discounting the series of swap payments enables all cash flows to be brought back to a common base (today
or t0).

What is an interest rate swap?

 An interest rate swap (IRS) is an agreement between two parties to exchange cash on a notional principal
sum that is not exchanged.
 In an IRS:
 One party to the contract pays a fixed rate (the swap rate) on a notional amount of principal.
 The other party pays a variable (benchmark) rate on the same amount of principal.
 Date for exchanges of payments are agreed in the contract.
 Netting of payments: one party pays the other for the difference between the fixed swap rate and
the variable benchmark rate.

4. Options

What is an option?
 An option contract gives the buyer (holder) the right but not the obligation to buy (call option) or sell (put
option) an asset at an agreed price (exercise or strike price) at or before an agreed future date (expiry date).
 Options can be bought over the counter or an exchange in:
 Commodities
 Swaptions (options on interest rate swaps)
 Short-term interest rates (underlying item = notional loan)
 Foreign currency
 An option buyer pays a premium to the option seller (option writer).
 Option seller must fulfil the contract if the option is exercised by the buyer.
 An option lapses at expiry if not exercised.
 European style option – can be exercised only at expiry date.
 American style option – can be exercised at any time up to and including expiry date.
 Below is an outline of the four basic types of options.

ACCTG 106 PFRS 9: DERIVATIVES AND HEDGING Page 3 of 9

 What are the two main components of an option premium?
An option’s premium (price) has the following main components:
 Intrinsic value - represents the difference between the forward price of the underlying asset and the
option’s exercise price, or strike price.
 Time value - the remaining premium in excess of intrinsic value before expiration.

When can an option be considered in-the-money?

 A call option is in-the-money when the forward price is higher than the strike price.
 A put option is in-the-money when the forward price is less than the strike price.

How to account for derivatives?

 The basic principle is that derivatives should be recorded in the statement of financial position at their fair value,
and changes in fair value should be reported through either the income statement or through a reserve account,
depending on whether there is a hedge relationship involving the derivative.
 The interaction of financial instrument classification and derivatives is outlined as follows:

Define fair value.

 The original definition of fair value in PAS 39 has been replaced by the definition in IFRS 13 Fair value
measurement.
 'Fair value' is 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.
 Under IFRS 13, the estimated cash flows for a derivative should be discounted to present value using a discount
rate that includes a margin for credit risk.
 A margin for counterpar
 \ty credit risk, when the derivative has a positive value (asset).
 A margin for the company's own credit risk, when the derivative has a negative value (asset): this is
because the company will be more likely than the counterparty to default in this situation.

ACCTG 106 PFRS 9: DERIVATIVES AND HEDGING Page 4 of 9

 What is an embedded derivative?
 An embedded derivative is a derivative that forms part of a financial instrument or contract.
 The terminology for assessing the accounting treatment of an embedded derivative is summarized as follows:
Component Terminology
Derivative Embedded derivative
Non-derivative Host contract
Total Hybrid instrument

Do embedded derivatives need to be separated?

The process of identifying embedded derivatives and determining whether they need to be separated is summarized
below.

Step 1: Is the host contract fair valued?

If a host contract is already fair valued, and movements in fair value are reflected in the income statement, there
is no need to separate the embedded derivative. The value of the embedded derivative will already be reflected
in the value of the host contract.
Step 2: Is the embedded derivative really a derivative?
The next question is whether the potential embedded derivative that has been identified meets the definition of
a derivative on its own.
Step 3: Is the embedded derivative closely related to the host contract?
Finally, the embedded derivative does not need to be separated when it is closely related to the host contract.
Assessing whether it is closely related requires an analysis of the economic characteristics and risks of the host
contract to determine whether the embedded derivative changes the nature of the risks involved in the host
contract.
If an embedded derivative is not closely related to the host contract, it must be separated from the host contract
and fair valued.

How to account for embedded derivatives?

The basic rule in PAS 39 is that embedded derivatives should be separated from the ‘host’ contract and valued at fair
value, with any gains or losses from changes in fair value taken to the income statement unless the hedge
accounting rules apply.
If an entity is required to separate an embedded derivative from its host contract but is unable to measure the
embedded derivative separately (either at acquisition or at a subsequent financial reporting date), it shall treat the
entire combined contract as a financial asset or financial liability that is held for trading and record the combined
instrument at fair value through the profit and loss statement. Such an instrument will not qualify for hedge
accounting.

ACCTG 106 PFRS 9: DERIVATIVES AND HEDGING Page 5 of 9

 These rules are summarized as follows:

How to value an embedded derivative at inception date?

There are specific rules on the basis of valuing embedded derivatives at inception. These depend on whether the
embedded derivative is a non-option contract or an option derivative.
 An embedded non-option derivative (i.e. an embedded forward or swap) is separated from its host
contract on the basis of its stated or implied substantive terms. This results in it having a fair value of zero at
initial recognition.
 An embedded option-based derivative (i.e. an embedded put, call, cap, floor or swaption) is separated from
its host contract on the basis of the stated terms of the option feature. The initial carrying amount of the
host instrument is the residual amount after the embedded derivative has been separated.

Part B: Hedge accounting

Conditions that must be met before hedge accounting will apply

To qualify as a hedge under PAS 39, the following conditions must be satisfied:
1. At inception, there must be formal designation of hedge and documentation of hedging relationship.
2. Hedge must be highly effective (ratio between 80% and 125%).
3. For a cash flow hedge, the forecast transaction that is subject of the hedge must:
 Be highly probable; and
 Create and exposure that could affect profit or loss.
4. It must be possible to measure the effectiveness of the reliably.
5. The hedge is assessed on an ongoing basis and determined to have been highly effective throughout the
financial reporting periods for which the hedge was designated (PAS 39.88).
For non-financial items, including purchases and sales of non-financial assets, hedging is restricted by PAS 39 to
foreign exchange risk.

Importance of accounting rules in relation to hedging

 The accounting standard provides guidance on the appropriate method to be used in accounting for hedging.
 The benefits of PAS 39 include the potential to:
 increase the level of transparency, given that companies must clearly document the risks being hedged
and the basis for determining that the hedges are highly effective; and
 create a consistent basis for measuring derivatives—all derivatives must be measured at fair value.

What qualifies as a hedge instrument?

 Typically, a hedge instrument is a derivative.
 A combination of two or more derivatives can be a hedging instrument, but only if neither of them is a
written (sold) option or the combined instrument is not a new written option.
 A non-derivative financial instrument (such as a foreign currency loan or deposit) can only be used as a
hedge instrument when hedging FX risk.
 Written (sold) options can only be used as a written option when used in an interest rate collar
arrangement.
 Derivatives may be split proportionately between two hedge relationships, but not on a time basis (not for
one hedge relationship in one year, say, and another hedge relationship in the next year).

What is a hedged item?

 The hedged item can be:
 a recognised asset or liability - any assets or liabilities on the balance sheet—be they financial or

ACCTG 106 PFRS 9: DERIVATIVES AND HEDGING Page 6 of 9

 non-financial.
 a firm commitment - a binding agreement for the exchange of a specified quantity of resources at a
specified price on a specified future date or dates.
 a highly probable forecast transaction - term ‘highly probable’ indicates a much greater likelihood of
happening than the term ‘more likely than not’.
 a net investment in a foreign operation - the amount of the reporting entity’s interest in the net
assets of that operation, together with loan funds provided to the foreign operation, which are not
expected to be repaid in the foreseeable future.
 It is important to note that a derivative can never hedge another derivative, as a derivative is not a
permissible hedged item.

What exactly is the risk being hedge in a hedge relationship?

 A financial asset or liability could be hedged for:
 overall fair value risk;
 a benchmark interest rate or risk-free interest rate (the impact of interest rates on the fair value of
the hedged item);
 credit risk; and
 foreign exchange risk.
 A hedge of non-financial items is limited to:
 foreign exchange risk; or
 overall price/cash flow risk.

Types of hedges and their accounting treatment

A hedge can be designated as a:
 Cash flow hedge
 Definition
A cash flow hedge is a hedge arrangement whereby the change in cash flows of the hedging
instrument offsets the change in cash flow of the underlying hedged item. It is also a hedge of highly
probable forecast transactions including firm commitments.
 Accounting treatment
For a cash flow hedge, gains or losses in the fair value of the hedging instrument are deferred in
equity (to the extent that the hedge is effective). The gain or loss is reported in ‘other
comprehensive income’ and not in profit/loss. If the derivative has gained in value, an asset is
reported in the balance sheet, a liability for a loss on a derivative. The gain/loss deferred in equity is
subsequently transferred to profit/loss to match the loss/gain on the underlying hedged item.
If a cash flow hedge is terminated, any cumulative gain or loss deferred in equity should continue to
be deferred until the underlying hedged item affects the reported profit or loss, except when the
forecast hedged transaction is now no longer expected to occur. In this situation, all the cumulative
gain or loss held in deferred equity should be transferred immediately to profit/loss.

ACCTG 106 PFRS 9: DERIVATIVES AND HEDGING Page 7 of 9

 Circumstances may result in the termination of the cash flow hedge are summarized as follows:

Where a deferred loss in equity exists and an organisation expects that all or a portion of the loss
will not be recovered in future periods, it must reclassify the amount not expected to be recovered
from equity into profit and loss.

 Fair value hedge

 Definition
A fair value hedge is a hedge that seeks to offset the exposure to fair value changes that affect the
profit and loss.
It is considered effective if the fair value changes of the derivative offset the value changes of the
underlying hedged item.
Per PAS 39, the following items can be hedged in a fair value hedge relationship:
 a recognised asset;
 a recognised liability; and
 a firm commitment.
 Accounting treatment
For a fair value hedge, both the hedged item and the hedging instrument are valued at fair value in
the balance sheet and gains or losses on both of them are included in profit/loss. Gains or losses
from changes in the fair value of the hedging instrument should offset losses or gains in the fair
value of the underlying item.
An organisation must terminate its fair value hedge accounting if:
 the hedge derivative expires, is sold, is terminated or is exercised;
 the hedge no longer qualifies for hedge accounting; or
 the organisation revokes the designation.
Upon termination, the previous fair value adjustments to the loan, while in the hedge relationship,
will become part of the amortized cost base of the hedged item (the loan). The interest calculation
on the hedged item will subsequently adjust to reflect the amortization of the deferred gain or loss
on an effective yield basis over the remaining life of the loan.

 Net investments in a foreign operation

 Definition
A hedge of the foreign currency exposure to changes in the reporting entity’s share in the net assets
of that foreign operation.
Parent companies cannot hedge forecast profits. Profits are a net outcome of different transactions
and thus do not qualify as a hedge item under PAS 39.

ACCTG 106 PFRS 9: DERIVATIVES AND HEDGING Page 8 of 9

  Accounting treatment
Hedge is in the nature of a fair value hedge, but is of a net investment in foreign operation
accounted for like a cash flow hedge.
Gains or losses on the hedging instrument are reported in other comprehensive income and taken to
a translation reserve.

 Hedge effectiveness
Some understanding of tests of effectiveness for a hedge is also required. For a cash flow hedge,
effectiveness can be measured by a ‘matched terms’ comparison/test.
If the critical terms of the hedge match those of the hedged item, it can be concluded that the
hedge is effective. This can only be used for prospective tests, not retrospective tests of
effectiveness (since actual measurements of effectiveness can be made).
For a net investment hedge, tests of effectiveness may use a hypothetical derivative. This is a
derivative that would give a perfect hedge for the risk exposure. The hypothetical derivative is
compared with the actual hedging instrument used.
 If the value of the actual derivative is less than the value of the hypothetical derivative, all
gains or losses on the hedging instrument can be transferred to a translation reserve.
 If the value of the actual derivative is more than the value of the hypothetical derivative,
then only a proportion of the gains of losses on the actual derivative may be transferred to
equity. The rest of the gains must be reported in profit/loss. For example, if the actual
derivative has a value of 110 compared to the value of a hypothetical derivative which is
100, only 100/110 of the changes in the value of the actual derivative can be transferred to
the translation reserve.
 Hedge documentation
Hedge accounting must be documented from the inception of the transaction to be hedged.
 It is important to have a hedging policy that is easily understood and can be used by front,
middle and back office staff.
 At the inception of every hedge, there must be formal designation and documentation of
the hedge, with a specification of the objective for undertaking the hedge.
 Foreign currency transactions
Under the rules of PAS 21, when a company has a foreign subsidiary the assets and liabilities of the
subsidiary should be translated at the closing rate and income/expenses should be translated at the
actual or average rate for the year. All resulting gains or losses are reported as other comprehensive
income and transferred directly to equity (and not reported in profit/loss).
If the company has taken out a foreign currency loan as a hedge against its foreign currency net
investment, in the absence of hedge accounting gains or losses on the loan would be reported in
profit/loss.
The accounting treatment for the three types of hedges can be summarized as follows:

ACCTG 106 PFRS 9: DERIVATIVES AND HEDGING Page 9 of 9