Overview of IAS 39

Objective
The objective of IAS 39 is to establish principles for recognizing and measuring financial
assets, financial liabilities, and some contracts to buy or sell non-financial items. The
principles in IAS 39 complement those of IFRS 7 Financial Instruments: Disclosures, and for
presentation of information about them in IAS 32 Financial Instruments: Presentation. As
with IAS 32 and IFRS 7, IAS 39 is different from most other Standards in its Appendixes —
the appendixes are an integral part of the Standard.
Scope
IAS 39 applies to all entities and to all types of financial instruments, except where it
specifically defers to another Standard and/or a different accounting treatment (¶2). Even at
that, it often includes qualifiers that effectively scope the item back into IAS 39.
For example,
IAS 39 states that it does not apply to interests in subsidiaries, associates, or joint ventures
that are accounted for in accordance with IAS 27 Consolidated and Separate Financial
Statements, IAS 28 Investments in Associates, or IAS 31 Interests in Joint Ventures
respectively.
However, IAS 39 then adds, “entities shall apply this Standard to an interest in a
subsidiary, associate, or joint venture that according to IAS 27, IAS 28, or IAS 31 is accounted
for under this Standard.” In essence, it seems to say that even if it doesn’t apply, it does!

Similarly, paragraph 2 states that IAS 39 does not apply to rights and obligations under leases
to which IAS 17 Leases applies. However, IAS 39 then recaptures at least part of what it just
scoped out: lease receivables recognized by a lessor, and finance lease payables recognised by
a lessee, are subject to the derecognition and impairment provisions in IAS 39, and derivatives
embedded in leases are subject to the embedded derivatives provisions of IAS 39.

IAS 39 does not apply to employers’ rights and obligations under employee benefit plans to
which IAS 19 Employee Benefits applies, nor does it apply to financial instruments, contracts,
and obligations under share-based payment transactions to which IFRS 2 Share-based
Payment applies, except for limited exceptions that are deemed within the scope of IAS 39.

IAS 39 does not apply to financial instruments issued by the entity that meet the definition of
an equity instrument or to instruments that are required to be classified as equity instruments
by the issuer in accordance with paragraphs 16A and 16B or paragraphs 16C and 16D of
IAS 32. However, the holder of any such equity instruments must apply IAS 39 to those
instruments, unless they are accounted for in accordance with IAS 27, IAS 28, or IAS 31
respectively.

Likewise, IAS 39 does not apply to rights and obligations arising under an insurance contract
as defined in IFRS 4 Insurance Contracts, other than an issuer’s rights and obligations arising
under an insurance contract that meet the definition of a financial guarantee contract3 in
IAS 39, or to a contract that is within the scope of IFRS 4 because it contains a discretionary
participation feature. However, like leases, IAS 39 recaptures some aspects of insurance
contracts: it does apply to any derivatives embedded in a contract within the scope of IFRS 4
if the derivative is not itself a contract within the scope of IFRS 4.

IAS 39 does not apply to loan commitments other than those loan commitments4 described in
paragraph 4. Instead, IAS 37 Provisions, Contingent Liabilities and Contingent Assets is
applied to loan commitments that are not within the scope of IAS 39. However, all loan
commitments are subject to the derecognition provisions of IAS 39.

Finally, IAS 39 applies to contracts to buy or sell a non-financial item that can be settled net
in cash or another financial instrument, or by exchanging financial instruments, as if the
contracts were financial instruments, with the exception of contracts that were entered into
and continue to be held for the purpose of the receipt or delivery of a non-financial item in
accordance with the entity’s expected purchase, sale, or usage requirements.---(Main
business?)
Definitions
Recognizing the linked nature of the three financial instruments standards, IAS 39 states that
the
terms defined in IAS 32 are used with the meanings specified in paragraph 11 of IAS 32 (¶8).
A financial guarantee contract is a contract that requires the issuer to make specified payments
to reimburse the holder for a loss it incurs because a specified debtor fails to make payment
when due in accordance with the original or modified terms of a debt instrument.
Loan commitments within the scope of IAS 39 are loan commitments that the entity designates
as financial liabilities at fair value through profit or loss; loan commitments that can be settled
net in cash or by delivering or issuing another financial instrument; and commitments to
provide a loan at a below-market interest rate.

Paragraph 9 then provides the key definitions for applying IAS 39 (and Handbook
section 3855) to financial instruments:

A derivative is a financial instrument or other contract within the scope of IAS 39 with all
three of the following characteristics:
• its value changes in response to the change in a specified interest rate, financial instrument
price, commodity price, foreign exchange rate, index of prices or rates, credit rating or
credit index, or other variable, provided in the case of a non-financial variable that the
variable is not specific to a party to the contract (sometimes called the ‘underlying’)
• 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, (Margin Money)
and
• it is settled at a future date

A financial asset or financial liability at fair value through profit or loss –(MTM) is a financial
asset
or financial liability that meets either of the following conditions: it is classified as held for
trading or upon initial recognition, it is designated by the entity as at fair value through profit
or loss. IAS 39 stipulates that investments in equity instruments that do not have a quoted
market price in an active market and whose fair value cannot be reliably measured are not to
be designated as at fair value through profit or loss.

Held-to-maturity investments are non-derivative financial assets with fixed or determinable

payments and fixed maturity that an entity has the positive intention and ability to hold to
maturity other than those that the entity upon initial recognition designates either as at fair
value through profit or loss or available for sale, or those that meet the definition of loans and
receivables. In order to prevent (or at least to limit) management manipulation, IAS 39
stipulates that an entity cannot classify any financial assets as held to maturity if the entity
has, during the current financial year or during the two preceding financial years, sold or
reclassified more than an insignificant amount of held-to-maturity investments before
maturity (where more than insignificant is in relation to the total amount of held-to-maturity
investments) other than sales or reclassifications that:
• are so close to maturity or the financial asset’s call date that changes in the market rate of
interest would not have a significant effect on the financial asset’s fair value’
• occur after the entity has collected substantially all of the financial asset’s original principal
through scheduled payments or prepayments, or
• are attributable to an isolated event that is beyond the entity’s control, is non-recurring and
could not have been reasonably anticipated by the entity

Loans and receivables are non-derivative financial assets with fixed or determinable payments
that are not quoted in an active market other than those:
• that the entity intends to sell immediately or in the near term, which must be classified as
held for trading, and those that the entity upon initial recognition designates as at fair value
through profit or loss
• that the entity upon initial recognition designates as available for sale, or
• for which the holder may not recover substantially all of its initial investment, other than
because of credit deterioration, which are to be classified as available for sale

Available-for-sale financial assets are those non-derivative financial assets that are designated
as available for sale or are not classified as loans and receivables, held-to-maturity investments
or financial assets at fair value through profit or loss — in other words, anything left over!
IAS 39, Financial Instruments: Recognition and Measurement• 5

Definitions relating to recognition and measurement

The amortized cost of a financial asset or financial liability is the amount at which the
financial asset or financial liability is measured at initial recognition minus principal
repayments,
plus or minus the cumulative amortization using the effective interest method of
any difference between that initial amount and the maturity amount,
and minus any reduction
(directly or through the use of an allowance account) for impairment or uncollectibility.

The effective interest method is a method of calculating the amortized cost of a financial asset
or a financial liability (or group of financial assets or financial liabilities) and of allocating the
interest income or interest expense over the relevant period such that it exactly discounts
estimated future cash payments or receipts through the expected life of the financial
instrument
or, when appropriate, a shorter period, to the net carrying amount of the financial asset or
financial liability.

Derecognition is the removal of a previously recognized financial asset or financial liability

from an entity’s statement of financial position.

Fair value is the amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm’s length transaction.

A regular way purchase or sale is a purchase or sale of a financial asset under a contract whose
terms require delivery of the asset within the time frame established generally by regulation
or convention in the marketplace concerned.

Transaction costs are incremental costs that are directly attributable to the acquisition, issue
or disposal of a financial asset or financial liability.

Definitions relating to hedge accounting

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.

A forecast transaction is an uncommitted but anticipated future transaction.

A hedging instrument is a designated derivative or (for a hedge of the risk of changes in

foreign currency exchange rates only) a designated non-derivative financial asset or
non-derivative financial liability whose fair value or cash flows are expected to offset changes
in the fair value or cash flows of a designated hedged item.

A hedged item is an asset, liability, firm commitment, highly probable forecast transaction or
net investment in a foreign operation that exposes the entity to risk of changes in fair value or
future cash flows and is designated as being hedged.
Hedge effectiveness is the degree to which changes in the fair value or cash flows of the
hedged item that are attributable to a hedged risk are offset by changes in the fair value or
cash flows of the hedging instrument.

Overview of the standard

Recognition and derecognition
All financial assets and financial liabilities, including derivative instruments, must be
recognized on the balance sheet . In order to remove (i.e. derecognize) assets from its
balance sheet, an entity must lose control over those financial assets. In addition, a substantive
risk from the assets must be transferred. To derecognize liabilities, the debtor must be legally
released from its primary obligation related to that liability .

Measurement
Financial assets must be classified into one of the four categories:
fair value through profit or
loss; (mtm)
loans and receivables;
held to maturity;
and available for sale.
Financial liabilities are categorised as either fair value through profit or loss
or amortized cost .
The categorisation determines whether and where any remeasurement to fair value is
recognized in an entity’s financial statements.
Financial assets are to be carried at fair value, with the exceptions being loans and receivables,
held to maturity assets, and the rare circumstances where the fair value of an equity
instrument
cannot be reliably measured (¶46).
Remeasurement to fair value must be performed at each
financial reporting date. The effect of remeasurement to fair value must be recognized and
consistently applied in one of two ways — an entity can choose to recognize all changes in
fair value in the income statement, or it can choose to recognize changes in fair value of
instruments deemed fair value through profit or loss in the income statement, and available
for sale instruments as other comprehensive income. These latter amounts “hit” the income
statement when the instrument is sold or becomes impaired.

Derivatives and hedge accounting

Under IAS 39, all derivatives (including some embedded derivatives) must be measured at
fair value in the balance sheet. This is regardless of whether they are categorized as fair value
through profit or loss or as hedging instruments. Unless they qualify as hedging instruments,
all fair value gains and losses are recognized immediately in the income statement.
A non-derivative financial instrument can have certain characteristics that cause it to behave
like a derivative. These characteristics need to be evaluated to determine whether they should
be separated from the financial instrument and accounted for separately as a stand-alone
derivative.

Hedge accounting is a choice that each entity makes for each economic hedge that it has in
place. The choice reflects a trade-off between the cost of achieving hedge accounting and the
potential benefit achieved by reducing the income statement volatility that would otherwise
arise. There are three hedge accounting models under IAS 39, which are the fair value hedge,
the cash flow hedge, and the hedge of a net investment in a foreign entity (¶86). The
appropriate accounting model for a hedge relationship depends on the nature of the item being
hedged.

In order to qualify for hedge accounting, an entity must designate its hedge relationships and
document how it will measure effectiveness (¶88). Each individual relationship between a
derivative and its hedged asset, liability, or future cash flow must be documented separately.
An entity must demonstrate that each hedge has been highly effective in each reporting period.
In order to continue hedge accounting, there must be an expectation that future gains and
losses on the hedged item and hedging instrument will almost fully offset.
Dollar offset ratio method

Reclassifications
In order to prevent (or limit) management manipulations (as with held to maturity
investments), IAS 39 proscribes reclassification of financial instruments except in very
specific circumstances. Paragraph 50 states that an entity cannot reclassify any financial
instrument into the fair value through profit or loss category after initial recognition. It further
states that an entity cannot reclassify a derivative out of the fair value through profit or loss
category while it is held or issued nor can it reclassify any financial instrument out of the fair
value through profit or loss category if upon initial recognition it was designated by the entity
as at fair value through profit or loss.

However, IAS 39 does allow that an entity may, if a financial asset is no longer held for the
purpose of selling or repurchasing it in the near term (notwithstanding that the financial asset
IAS 39, Financial Instruments: Recognition and Measurement• 7
may have been acquired or incurred principally for the purpose of selling or repurchasing it in
the near term), reclassify that financial asset out of the fair value through profit or loss
category if the requirements in paragraph 50B or 50D are met.
Paragraph 50B then says that a financial asset under review applies (except a financial asset
of the type described in paragraph 50D) may be reclassified out of the fair value through
profit or loss category only in rare circumstances.
50D states that a financial asset that would have met the definition of loans
and receivables (if the financial asset had not been required to be classified as held for trading
at initial recognition) may be reclassified out of the fair value through profit or loss category
if the entity has the intention and ability to hold the financial asset for the foreseeable future
or until maturity.
What about other categories?
Paragraph 50E states that a financial asset classified as available for sale that would have met
the definition of loans and receivables (if it had not been designated as available for sale) may
be reclassified out of the available-for-sale category to the loans and receivables category if the
entity has the intention and ability to hold the financial asset for the foreseeable future or until
maturity.
Finally, if as a result of a change in intention or ability it is no longer appropriate to classify
an investment as held to maturity, it must be reclassified as available for sale and remeasured
at fair value (¶51).

Gains and losses

IAS 39 requires an entity to recognize a gain or loss arising from a change in the fair value of
a financial asset or financial liability that is not part of a hedging relationship depending on
the classification of the financial instrument. Obviously, a gain or loss on a financial
asset or financial liability classified as at fair value through profit or loss is recognised in
profit or loss. A gain or loss on an available for sale financial asset is recognised in other
comprehensive income, except for impairment losses and foreign exchange gains and losses,
until the financial asset is derecognised.
Finally, for financial assets and financial liabilities carried at amortized cost, a gain or loss is
recognised in profit or loss when the financial asset or financial liability is derecognised and
through the amortisation process. Changes in fair value are not recognized, unless the financial
asset or financial liability is impaired.

Impairment
IAS 39 requires an entity to test a financial instrument for impairment at the end of each
reporting period. The challenge is to recognize whether there has been impairment since it
may not be possible to identify a single, discrete event that caused the impairment. According
to IAS 39, impairment exists if, and only if, there is objective evidence as a result of one or
more events that occurred after the initial recognition of the asset (a ‘loss event’) and that loss
event (or events) has an impact on the estimated future cash flows of the financial asset or
group of financial assets that can be reliably estimated (¶59).
Impairment is not just a decline in value (¶60). The disappearance of an active market
because an entity’s financial instruments are no longer publicly traded is not evidence of
impairment. A downgrade of an entity’s credit rating is not, of itself, evidence of impairment
(although it may be evidence of impairment when considered with other available information).
A decline in the fair value of a financial asset below its cost or amortized cost is not
necessarily evidence of impairment (it may result from an increase in the risk-free interest
rate).

Instead, an entity must refer to a “shopping list” provided by paragraph 59, recognizing
that the loss events cited do not represent an exhaustive list.
1. If there is objective evidence that an impairment loss on loans and receivables or held-
tomaturity
investments carried at amortized cost has been incurred, the amount of the loss
IAS 39, Financial Instruments: Recognition and Measurement• 8
is measured as the difference between the asset’s carrying amount and the present value
of estimated future cash flows (excluding future credit losses that have not been incurred)
discounted at the financial asset’s original effective interest rate. The carrying amount of
the asset is reduced either directly or through use of an allowance account. The amount of
the loss is recognized in profit or loss (¶63).
If, in a subsequent period, the amount of the impairment loss decreases and the decrease
can be related objectively to an event occurring after the impairment was recognised
(such as an improvement in the debtor’s credit rating), the previously recognised
impairment loss can be reversed either directly or by adjusting an allowance account (¶65).
However, the reversal cannot result in a carrying amount of the financial asset that
exceeds what the amortized cost would have been had the impairment not been recognized
at the date the impairment is reversed (similar to IAS 16). The amount of the reversal is
recognized in profit or loss (since the original loss was also recognized in profit or loss).

2. If there is objective evidence that an impairment loss has been incurred on an unquoted
equity instrument that is not carried at fair value because its fair value cannot be reliably
measured, or on a derivative asset that is linked to and must be settled by delivery of such
an unquoted equity instrument, the amount of the impairment loss is measured as the
difference between the carrying amount of the financial asset and the present value of
estimated future cash flows discounted at the current market rate of return for a similar
financial asset. Such impairment losses are not to be reversed (¶66).

3. When a decline in the fair value of an available for sale financial asset has been recognized
in other comprehensive income and there is objective evidence that the asset is impaired,
the cumulative loss that had been recognized in other comprehensive income should be
reclassified from equity to profit or loss as a reclassification adjustment even though the
financial asset has not been derecognized. Impairment losses arising from equity
instruments are not to be reversed (¶69). However, if the fair value of a debt instrument
classified as available for sale subsequently increases, the impairment loss is reversed,
with the amount of the reversal recognized in profit or loss (¶70).

Hedging
In addition to the recognition and measurement of financial instruments, IAS 39 also provides
the standards for hedge accounting. Hedge accounting recognizes the offsetting effects on
profit or loss of changes in the fair values of the hedging instrument and the hedged item (¶85).
Generally speaking, IAS 39 does not restrict the circumstances in which a derivative may be
designated as a hedging instrument provided the conditions in paragraph 88 are met, except
for some written options. However, a non-derivative financial asset or non-derivative
financial liability may be designated as a hedging instrument only for a hedge of a
foreign
currency risk.

Note that IAS 39 does not recognize what are called “natural” hedges. For example, a
Canadian firm (SRL Limited) may deal with customers domiciled in the United States, and so
it bills these clients in US dollars. It may also deal with suppliers in Germany, who choose to
bill the Canadian firm in US dollars. Suppose SRL is owed one million US dollars by its US
clients. Further, suppose SRL owes its German supplier $500,000 US. SRL has no currency
risk with respective to its accounts payable since it is owed an amount equal to its debt in the
same currency. The problem for SRL is that there is no legal right of offset, so it cannot hedge
the payable with its receivable for the purposes of IAS 39. However, SRL has effectively
“hedged” the payable — its receivable will cover its payable. This is a natural hedge.
Likewise, hedges between sub-units that are eventually consolidated are not recognized since
the “hedges” will be eliminated on consolidation. Only instruments that involve a party
external to the reporting entity (i.e., external to the group or individual entity that is being
reported on) can be designated as hedging instruments.

Hedged items
A hedged item can be a recognized asset or liability, an unrecognised firm
commitment, a highly probable forecast transaction or a net investment in a
foreign operation. The hedged item can be a single asset, liability, firm
commitment, highly probable forecast transaction or net investment in a foreign
operation, a group of assets, liabilities, firm commitments, highly probable
forecast transactions or net investments in foreign operations with similar risk
characteristics or in a portfolio hedge of interest rate risk only, a portion of the
portfolio of financial assets or financial liabilities that share the risk being hedged
(¶78).
Despite the general notion that an entity can protect itself from potential risks, not all
financial instruments can be hedged. For example, a held-to-maturity investment cannot be a
hedged item with respect to interest-rate risk or prepayment risk because designation of an
investment as held to maturity requires an intention to hold the investment until maturity
without regard to changes in the fair value or cash flows of such an investment attributable to
changes in interest rates (¶79).

However, a held-to-maturity investment can be a hedged item

with respect to risks from changes in foreign currency exchange rates and credit risk.
Also, as noted earlier, only assets, liabilities, firm commitments or highly probable forecast
transactions that involve a party external to the entity can be designated as hedged items —
art least for hedge accounting purposes (¶80). Furthermore, it isn’t necessary (although it
would be hard to understand why) for an entity to hedge all of the risk associated with a
financial instrument. That is, a financial asset or financial liability may be a hedged item with
respect to the risks associated with only a portion of its cash flows or fair value (such as one
or more selected contractual cash flows or portions of them or a percentage of the fair value)
provided that effectiveness can be measured.

IAS 39 permits an entity to hedge some of the risks associated with any non-financial items it
may hold. However, If the hedged item is a non-financial asset or non-financial liability, it
can only be designated as a hedged item either for foreign currency risks, or in its entirety for
all risks, because of the difficulty of isolating and measuring the appropriate portion of the cash
flows or fair value changes attributable to specific risks other than foreign currency risks (¶82).
Finally, similar assets or similar liabilities can be aggregated and hedged as a group (¶83).
However, such action is only permitted if the individual assets or individual liabilities in the
group share the risk exposure that is designated as being hedged. Furthermore, the change in
fair value attributable to the hedged risk for each individual item in the group needs to be
approximately proportional to the overall change in fair value attributable to the hedged risk
of the group of items. If this latter condition is not present or determinable, then the item
cannot be part of the group.

Note that because an entity assesses hedge effectiveness by comparing the change in the fair
value or cash flow of a hedging instrument and a hedged item, comparing a hedging
instrument with an overall net position (e.g., the net of all fixed rate assets and fixed rate
liabilities with similar maturities), rather than with a specific hedged item, does not qualify
for hedge accounting (¶84).

Hedging relationships
Hedging relationships are of three types (¶86). These types are:
1. A fair value hedge — a hedge of the exposure to changes in fair value of a recognized
asset or liability (financial or non financial or both) or an unrecognized firm commitment, or
an identified portion of such an
asset, liability or firm commitment, that is attributable to a particular risk and could affect
profit or loss.

2. A cash flow hedge — a hedge of the exposure to variability in cash flows that is either
attributable to a particular risk associated with a recognized asset or liability (such as all
or some future interest payments on variable rate debt) or to a highly probable forecast
transaction and could affect profit or loss.

3. A hedge of a net investment in a foreign operation as defined in IAS 21 (which is

accounted for the same way as a cash flow hedge).

Hedged qualifications
Paragraph 88 of IAS 39 stipulates that a hedging relationship qualifies for hedge accounting
if, and only if, all of the following conditions are met:
• At the inception of the hedge there is formal designation and documentation of the hedging
Relationship—(testing effectiveness of hedge by dollar offset method??) and the entity’s risk
management objective and strategy for undertaking the hedge.

• The hedge is expected to be highly effective in achieving offsetting changes in fair value or
cash flows attributable to the hedged risk, consistently with the originally documented risk
management strategy for that particular hedging relationship.

• For cash flow hedges, a forecast transaction that is the subject of the hedge must be highly
probable and must present an exposure to variations in cash flows that could ultimately
affect profit or loss.

• The effectiveness of the hedge can be reliably measured, ie the fair value or cash flows of
the hedged item that are attributable to the hedged risk and the fair value of the hedging
instrument can be reliably measured.

• The hedge is assessed on an ongoing basis and determined actually to have been highly
effective throughout the financial reporting periods for which the hedge was designated.
Assuming the conditions are met, paragraphs 89–102 of the Standard describe the accounting
treatment associated with the three types of hedges.

Fair value hedges

The gain or loss from remeasuring the hedging instrument at fair value (for a derivative
hedging instrument) or the foreign currency component of its carrying amount measured in
accordance with IAS 21 (for a non-derivative hedging instrument) is recognized in profit or
loss. Likewise, the gain or loss on the hedged item attributable to the hedged risk is used to
adjust the carrying amount of the hedged item and is recognized in profit or loss. The effect
— assuming a perfect hedge — is no net impact on profit and loss. Recognition of the gain or
loss attributable to the hedged risk in profit or loss applies if the hedged item is an availablefor-
sale financial asset (¶89).

An entity discontinues prospectively hedge accounting if the hedging instrument expires or is

sold, terminated or exercised; the hedge no longer meets the criteria for hedge accounting; or
the entity revokes the designation. Note that the replacement or rollover of a hedging
instrument into another hedging instrument is not considered “expiration” or “termination” if
the replacement or rollover is part of the entity’s documented hedging strategy (¶91).

Cash flow hedges

The gain or loss from remeasuring the hedging instrument for a cash flow is treated
differently than for a fair value hedge. Here, the portion of the gain or loss on the hedging
instrument that is determined to be an effective hedge is recognized in other comprehensive

income, while any ineffective portion of the gain or loss on the hedging instrument is
recognized in profit or loss. (¶95) Basically, any gains and losses associated with cash flow
hedges are deferred to other comprehensive income until the hedging relationship is ended
(however that may happen).

The underlying perspective is that by hedging, an entity locks its

cash flows. Consequently, it makes no sense to recognize any gains or losses until the cash
flows are actually realized or paid. Only when that event occurs would it be appropriate for
the entity to recognize the benefits (or costs) of its decision to hedge its cash flows.
Consider our earlier example of SRL Limited. It is November 3, 2009. The firm is worried
about fluctuations in the US/Canadian dollar exchange rate, so it decides to hedge its
receivable. Knowing that it will receive one million US dollars on March 1, 2010, SRL
negotiates a rate of 0.925 with its bank. Doing so locks the amount of cash that SRL will
receive on March 1, 2010 — $1,081,108.10 Canadian. Now, suppose between November 4,
2009 and December 31, 2009, the US/Canadian exchange rate fluctuates between 0.93 and
0.97. Should SRL recognize a gain on its financial statements? It could be argued it should,
since the amount of Canadian dollars it could receive on December 31, 2009 is different from
the amount of dollars it will receive on March 1, 2010. However, this is an unrealized gain
since no transaction has actually occurred — all that has happened is that the US/Canadian
exchange rate changed. Because the firm hedged its cash flows, it is insensitive to changes in
the exchange rate.

Furthermore the US/Canadian exchange rate will continue to change and it might go back to
around 0.92 by the time March 1 rolls around. A loss will arise on settlement since the
Canadian dollar has dropped since December 31, 2009. The net effect would be to recognize a
loss that “offsets” the gain recognized in the previous fiscal period. Realistically, the firm has
not suffered a loss, nor did it make a gain in the previous period. However, the change in
valuation of the hedging item (the negotiated exchange with the bank) is a derivative, and the
unrealized gain must be recognized at fiscal year end (December 31 in this case). Since, this
scenario classifies as a cash flow hedge, the change in valuation qualifying as an effective
hedge is reported in other comprehensive income. Any ineffective amounts are recorded in
profit and loss.

As with fair value hedges, an entity discontinues prospectively hedge accounting if the
hedging instrument expires or is sold, terminated or exercised; the hedge no longer meets the
criteria for hedge accounting; or the entity revokes the designation. In addition, if a forecast
transaction is no longer expected to occur, hedge accounting is ended (¶101). Discontinuing
the hedging relationship requires an entity to reclassify amounts that had been recognized in
other comprehensive income from equity to profit or loss as a reclassification adjustment (see
IAS 1) in the same period or periods during which the hedged forecast cash flows affect profit
or loss (¶100).

Hedges of a net investment in a foreign operation

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 IAS 21), are accounted for similarly to cash
flow hedges. In other words, the portion of the gain or loss on the hedging instrument that is
determined to be an effective hedge is recognized in other comprehensive income while any
ineffective portion is recognized in profit or loss. Any gain or loss on the hedging instrument
relating to the effective portion of the hedge that has been recognized in other comprehensive
income is reclassified from equity to profit or loss as a reclassification adjustment (see IAS 1)
in accordance with paragraphs 48–49 of IAS 21 on the disposal or partial disposal of the
foreign operation (¶102).