NEWTON

Question 1: Cash Flow Hedge

Newton plc is a London-based manufacturing company operating in the defence

industry with its functional currency the British Pound. On 1 January 20X6, the
directors of Newton plc signed a contract to buy a conveyor system from a German
company. The conveyor system will be delivered on 30 April 20X6. The entire cost
including transaction costs was €900,000 payable on delivery. The directors of
Newton plc believed that the British Pound was likely to decline against the exchange
rate of Euro, which would make the conveyor system more expensive. Thus, on 1
January 20X6 the company entered into a forward contract to buy €900,000 for
£792,000, for delivery on 30 April 20X6. When Newton plc entered into a forward
contract the hedging instrument was designated as a cash flow hedge. The following
exchange rates are relevant:

Spot Forward rate for

rate 30 April 20X0
Date €1= delivery €1=
1 January 20X6 £0.85 £0.88
31 March 20X6 £0.95 £0.97
30 April 20X6 £1.00 £1.00

Required:

I) Explain how hedge effectiveness should be assessed by Newton plc at 31 March

20X6 in accordance with IFRS 9 Financial Instruments.

II) Show how the conveyor system should be measured and recognised in the
financial statements as at 31 March 20X6 in accordance with IFRS 9 Financial
Instruments.

II) Show how the conveyor system should be measured and recognised in the
financial statements as at 30 April 20X6 in accordance with IFRS 9 Financial
Instruments.

Question 2: IAS 32 & IFRS 9 – For guidance please refer to Alexander et al.

Identify how the following financial instruments would be presented and measured in
a statement of financial position in accordance with IAS 32 and IFRS 9:

i. An investment in a government bond. The company intends to hold the bond

until the redemption date.
ii. Trade receivable that is due in three months.
iii. Redeemable preference shares at the option of the holder recently issued
with a fixed rate of dividend payable at the issuer’s discretion.
iv. The shares of an investment in a quoted company that is being held for the
long term.
v. An investment in an option to sell shares of ordinary shares in British Airways.
SOLUTION: NEWTON plc - Question 1: Cash Flow Hedge

I) Hedge effectiveness on 31 March 20X6

Hedge accounting can only be used when the hedging effectiveness requirements are
satisfied. These requirements are as follows:

 There must be an economic relationship between hedging instruments and

hedged items.
 The effect of credit risk should not dominate the value changes that result from the
economic relationship.
 The hedge ratio of the hedging relationship is the same as that resulting from the
quantity of the hedged item that the entity actually hedges and the quantity of the
hedging instrument that the entity actually uses to hedge that quantity of hedged
item.

In the case of Newton plc, hedge of the foreign currency risk arising from highly probable
forecast purchase of a conveyor system. The hedged item (the conveyor system) creates
an exposure to foreign currency risks (£/€ risks). The forward contract is to buy €900,000
and sell £. There is a clear economic relationship between hedged item and hedging
instrument. There is no evidence to show a decline in credit worthiness. The hedge ratio
is based on a notional amount of €900,000. There is a hedge ratio of 1:1 (100% - perfect
hedging). On the basis of nominal amount, currency and maturity, the hedge
effectiveness requirements are satisfied.

II) Measurement and recognition

£
Changes in the fair value of forward
contract: 81,000
(0.97-0.88) x 900,000

01-Jan-20X6
The value of the forward contract at inception date is recognised in the statement of
position at its fair value of zero.

31-Mar-20X6
DR Financial Assets 81,000
CR Equity - other comprehensive income 81,000

This gain on the effective portion is held in a hedging reserves and is not taken to the
income statement. Instead it is recognised in the equity as at 31 March 20X6.

Statement of financial position as at 31 March 20X6

Financial assets: £81,000
Equity – OCI: £81,000
III) Re-measurement and settlement

30-Apr-20X6

Gain on hedging instrument:

(1.00-0.88) x 900,000
=108,000 – 81,000 = 27,000

DR Financial Assets 27,000

CR Equity - Other comprehensive income 27,000

30-Apr-20X6
DR Cash 108,000
CR Financial assets 108,000
Settlement of the forward contract
(81,000+27,000)

30-Apr-20X6
DR Conveyor system (€1:£1) 900,000
CR Cash 900,000

DR Equity 108,000
CR Conveyor system 108,000