Session 2
Accounting for Derivative
Instruments & Hedge Accounting
Updated by Teguh I. Maulana
Edited by Taufik Hidayat
Agenda
1. Financial Intruments and Derivative.
2. Forward Contracts. Session 1
3. Future Contracts.
4. Option.
5. Swap.
6. Hedge using forward and future contracts. Session 2
7. Hedge using option and swap.
Edited by Taufik Hidayat
Hedging
• Propose is to neutralize an exposed risk
• Loss on hedge item offset by gain on hedging instrument
• Reduce volatility than preserve gains
• Other ways of hedging through non-derivative
• Natural hedge (offsetting foreign currency assets and
liability in the same currency)
• Special accounting rules called “hedge accounting”
applies when derivatives are used for hedging
purposes
Edited by Taufik Hidayat
Rationale of Hedge Accounting
• Arises because of the mismatch of income-
offsetting effect between hedged item and hedging
instrument
• Situations requiring hedge accounting:
• Hedge item and hedging instrument are measured using
different bases (One is at cost while the other is at fair
value)
• Hedged item yet to be recognized in financial statement
• Different treatment for changes in fair value (changes
taken to equity while the other is taken to income
statement)
Edited by Taufik Hidayat
Risks That Qualify for Hedge Accounting
Interest rate risk Specific risks Price risk
that qualify for
hedge accounting
Foreign exchange risk Credit risk
Risks must be specific risk, Possible for a derivative to
not general business risks hedge more than one risk
Edited by Taufik Hidayat
Example of Hedge Risk
Singapore Airlines Annual Report 2015/2016
Edited by Taufik Hidayat
Qualifying Hedging Instruments and
Hedged Items
• Instruments that qualify as hedging instruments include:
• Designated derivatives (except written options).
• Embedded Derivatives.
• Designated non-derivatives financial asset/ liability that hedge
foreign exchange risks only.
• Instruments that qualify as hedged items include:
• Financial assets and liabilities with exposure to changes in fair
value.
• Non-financial assets exposed to foreign exchange or price risks.
• Firm commitment.
• Highly probable forecasted transaction with exposures to future cash
flows.
• Net investment in foreign entity.
Edited by Taufik Hidayat
Assessing Hedge Effectiveness
• During the duration of hedge, hedge effectiveness is
assessed on dollar-offset method:
• Hedge effectiveness ratio (HER):
Hedge effectiveness Changes in fair value or future cash flow of hedging instrument
=
(or delta ratio) Changes in fair value or future cash flow of hedged item
0.8 1.25
Effective hedge
Edited by Taufik Hidayat
Classification of Hedging
Hedge of “the exposure to changes in fair value of a
Fair value recognized asset or liability or an unrecognized firm
hedge commitment, or an identified portion of such asset, liability
or firm commitment, which is attributable to a particular
risk and could affect profit or loss”.
Hedge of “the exposure to variability in cash flows that
Cash flow (i) is attributable to a particular risk associated with a
hedge recognized asset or liability (such as all or some future
interest payment on variable debt instrument )or a highly
probable future transaction, and
(ii) could affect profit or loss”.
Hedge of a net Hedge of the foreign currency risk associated with a
investment in a foreign operation whose financial statements are required
foreign entity to be translated into the presentation currency of the
parent company.
Edited by Taufik Hidayat
Classification of Hedging (2)
• The designation of a derivative as a fair value
hedge or a cash flow hedge is determined by the
hedged risk, that is, whether the entity has a fair
value exposure or a cash flow exposure.
• An exception where a derivative can be designated
as either a fair value hedge or a cash flow hedge is
where the hedged risk is the foreign exchange risk
of a firm commitment.
Edited by Taufik Hidayat
Accounting for a Fair Value Hedge
Hedged Item (recognized asset
Hedging Instruments
or liability or firm commitment)
Change in fair value Change in fair value
Income statement
Gain (loss) on hedging instrument
offset loss (gain) on hedged item
Balance sheet
Change in fair value adjusted Change in fair value adjusted
against carrying amount against carrying amount
Edited by Taufik Hidayat
Fair Value Hedge – Forward Contract
Example
Ilustration:
31/10/20X3
• Inventory of 10,000 ounces of gold
• Carried at cost of $3,000,000 ($300 per ounce)
• Price of gold was $352 per ounce
1/11/20X3
• Sold forward contract on 10,000 ounce for forward price of
$350 per ounce
• Forward contract matures on 31/3/20X4
Date Spot Rate March 31 Forward Rate
Nov 1, 20X3 $352 $350
Dec 31, 20X3 342 340
March 31, 20X4 330 330
Edited by Taufik Hidayat
Fair Value Hedge – Forward Contract (2)
Example
1/11/20X1
No entry or just a memorandum entry as the fair value of the forward
contract is nil
31/12/20X3
Dr Forward contract …………. 100,000
Cr Gain on forward contract ... 100,000
Gain on forward contract: 10,000 x ($340 -$350)
Recognized in income statement
Dr Loss on inventory ………… 100,000
Cr Inventory ………………….. 100,000
Gain on inventory: 10,000 x ($342 - $352)
In Fair Value Hedge, Hedge Item & Hedging Instrument are measured at Fair Value
Edited by Taufik Hidayat
Fair Value Hedge – Forward Contract (3)
Example
31/3/20X4
Inventory is sold to third-party at $330 per ounce (also maturity date of
forward contract
Dr Forward contract …………. 100,000
Cr Gain on forward contract ... 100,000
Gain on forward contract: 10,000 x ($330 -$340)
Dr Loss on inventory ………… 120,000
Cr Inventory ………………….. 120,000
Loss on inventory: 10,000 x ($330 - $342)
Dr Cash ……………………….. 3,300,000
Cr Sales ………………………. 3,300,000
Sale of inventory: 10,000 x $330
Edited by Taufik Hidayat
Fair Value Hedge – Forward Contract (4)
Example
31/3/20X4
Dr Cost of Good Sold ……… 2,780,000
Cr Inventory ......................... 2,780,000
Cost of Good Sold: $3,000,000 - $100,000 - $120,000
Dr Cash ………….................. 200,000
Cr Forward Contract ……..... 200,000
Close forward contract and record net receipt on settlement:
10,000 x ($350 - $330)
Edited by Taufik Hidayat
Accounting for a Cash Flow Hedge
Effective Cash Flow Hedge
Effective portion Ineffective portion
of gain/ loss of gain/ loss
Recognized directly
in equity through Recognized in profit
statement of or loss
changes in equity
Edited by Taufik Hidayat
Assessing Effective Portion of Cash Flow
Hedge Example
Ineffective
Lesser of Effective portion
two portion credited/
Cumulative Cumulative cumulative credited/ (debited)
∆ in FV of ∆ in PV of amount in (debited) to income
future expected absolute to equity in statement
Period contracts cash flow terms current in current
ending (a) (b) (c) period* period**
31/1/20X1 $100 $(105) $100 $100 $0
28/2/20x1 190 (185) 185 85 5
31/3/20x1 293 (290) 290 105 (2)
30/4/20x1 255 (245) 245 (45) 7
* (c) - previous balance of (c)
**(a) - (c) - previous balance
Edited by Taufik Hidayat
Accounting for a Cash Flow Hedge (2)
Cash flow hedges are applicable to the following:
Forecasted
transactions
involving financial Other transactions
Interest rate swaps
and non-financial which affect future
(floating to fixed)
assets/liabilities cash flows
which will result in
cash inflow/ outflow
Edited by Taufik Hidayat
Cash Flow Hedge – Futures Contract
Example
Ilustration:
1/10/20X1
• Inventory of 5,000,000 ounces of silver.
• Carried at cost of $15,000,000 ($3 per ounce).
• Price of silver was $3.3 per ounce
• Sold futures contract on 5,000,000 ounce for $3.32 /ounce.
• Futures contract matures on 31/3/20X2.
• Required margin deposit was $0.03 per ounce.
Date Spot Price/ounce March 31 Futures Price
Oct 1, 20X1 $3.30 $3.32
Dec 31, 20X1 3.265 3.29
Feb 28, 20X2 3.19 3.20
March 31, 20X2 3.10 3.10
Edited by Taufik Hidayat
Cash Flow Hedge – Futures Contract (2)
Example
Calculation of expected cash flows & fair value of futures contract
Edited by Taufik Hidayat
Cash Flow Hedge – Futures Contract (3)
Example
Period-to-period & cumulative hedge effectiveness assessment
Edited by Taufik Hidayat
Cash Flow Hedge – Futures Contract (4)
Example
Determination of effective and ineffective portions of a cash flow hedge
Ineffective
Lesser of Effective portion
two portion credited/
Cumulative Cumulative cumulative credited/ (debited)
∆ in FV of ∆ in PV of amount in (debited) to to income
future expected absolute equity in statement
Period contracts cash flow terms current in current
ending (a) (b) (c) period* period**
31/12/X1 150,000 (175,000) 150,000 150,000 0
28/2/X2 600,000 (550,000) 550,000 400,000 50,000
31/3/X2 1,100,000 (1,000,000) 1,000,000 450,000 50,000
* (c) - previous balance of (c)
**(a) - (c) - previous balance of **
Edited by Taufik Hidayat
Cash Flow Hedge – Futures Contract (5)
Example
1/10/20X1
Dr Margin deposit …………. 150,000
Cr Cash ................................. 150,000
Margin deposit: $0.03 x 5,000,000 ounce
31/12/20X1
Dr Futures contract ………….. 150,000
Cr OCI – Hedge reserve ....... 150,000
Record fair value adjustment of futures contract
28/2/20X2
Dr Futures contract ………….. 450,000
Cr OCI – Hedge reserve ....... 400,000
Cr Gain on futures contract ... 50,000
Record fair value adjustment of futures contract
Edited by Taufik Hidayat
Cash Flow Hedge – Futures Contract (6)
Example
31/3/20X2
Dr Futures contract ………….. 500,000
Cr OCI – Hedge reserve ....... 450,000
Cr Gain on futures contract ... 50,000
Record fair value adjustment of futures contract
Dr Cash ……………………….. 15,500,000
Cr Sales ………………………. 15,500,000
Sale of inventory: 5,000,000 x $3.1
Dr Cost of Good Sold ……… 15,000,000
Cr Inventory ......................... 15,000,000
Cost of Good Sold at carried cost
Dr OCI – Hedge reserve ....... 1,000,000
Cr Cost of Good Sold/Sales .. 1,000,000
To ‘recycle’ hedging reserveEdited
against Profit & Loss
by Taufik Hidayat
Cash Flow Hedge – Futures Contract (7)
Example
31/3/20X2
Dr Cash ………….................. 1,250,000
Cr Margin deposit ................ 150,000
Cr Futures Contract ……...... 1,100,000
Close the futures contract and record receipt of margin
Edited by Taufik Hidayat
Fair Value Hedge – Option Contract
Example
• On March 1, 20X5, Company A purchased 100,000 of Company
D shares at $34/share.
• To protect itself against a loss in value of the investment,
Company A purchased 100,000 unit of put option of Company D
with strike price of $35 and premium $2.5 on the same date.
Company A settle the option on Aprill 30, 20X5 (maturity date).
Following prices are given:
Date Stock Price Option Price
March 1 $34 $2.50
March 31 32 3.80
April 30 31 4.00
Edited by Taufik Hidayat
Fair Value Hedge – Option Contract (2)
Date Stock Price Option Price
March 1 $34 $2.50
March 31 32 3.80
April 30 31 4.00
Date Option Price Intrinsic Value Time Value
March 1 $2.50 $1 $1.50
March 31 3.80 3 0.80
April 30 4.00 4 0.00
Edited by Taufik Hidayat
Fair Value Hedge – Option Contract (3)
Date Account Amount
March 1 Dr AFS 3,400,000
Cr Cash 3,400,000
To record payment of premium $34 x 100,000
March 1 Dr Put Option 250,000
Cr Cash 250,000
To record payment of premium $2.5 x 100,000
March 31 Dr Put Option 200,000
Cr Gain on Option Contract 200,000
To record change in intrinsic value (3 – 1) x 100,000
March 31 Dr Loss on Option Contract 70,000
Cr Put Option 70,000
To record change in time value (0.8 – 1.5) x 100,000
March 31 Dr Loss on Investment P/L 200,000
Cr AFS 200,000
To record change in fair value of AFS (32 – 34) x 100,000
Edited by Taufik Hidayat
Fair Value Hedge – Option Contract (3)
Date Account Amount
April 30 Dr Loss on Investment 100,000
Cr AFS 100,000
To record change in fair value of AFS (31 – 32) x 100,000
April 30 Dr Loss on Option Contract 80,000
Cr Put Option 80,000
To record change in time value (0 – 0.8) x 100,000
April 30 Dr Put Option 100,000
Cr Gain on Option Contract 100,000
To record change in intrinsic value (4 – 3) x 100,000
April 30 Dr Cash 3,500,000
Cr Put Option 400,000
Cr AFS 3,100,000
To record the exercise and close option contract
Edited by Taufik Hidayat
Swap
• In a swap, two counterparties agree to a
contractual arrangement wherein they agree to
exchange cash flows at periodic intervals.
• 2 type of basic swap:
– Single Currency Interest rate swap
• “Plain vanilla” fixed-for-floating swaps in one currency.
– Cross Currency Interest Rate Swap (Currency swap)
• Fixed for fixed rate debt service in two (or more)
currencies.
Edited by Taufik Hidayat
Swap (2)
• Interest Rate Swap:
– Used by companies and banks that require either fixed
or floating-rate debt.
– Interest rate swaps allow the companies (or banks) and
the swap bank to benefit by swapping fixed-for-floating
interest payments.
– Since principal is in the same currency and the same
amount, only interest payments are exchanged (net).
• Hedge using interest rate swap:
– Cash flow hedge Floating to fixed changes in FV of
swap are recognized in equity
– Fair value hedge Fixed to floating changes in FV of
swap are recognized in P/L.
Edited by Taufik Hidayat
Swap (3)
• Interest Rate Swap:
Pay floating Swap Pay fixed
Bank
Company A Company B
Receive Receive
prefers floating fixed Floating prefers fixed
Issue fixed Issue floating
Edited by Taufik Hidayat
Cash Flow Hedge - Swap
• Cash flow hedge : Swap from floating to fixed rate.
– To protect future cash flow (interest) payments.
• Accounting treatment:
– Changes in fair value of swap are taken to equity.
– Interest payments are taken to P/L.
• Determining hedge effectiveness can be highly
complex based on PSAK 55. FASB allows a “short cut”
method, whereby no hedge ineffectiveness if:
– Matching of notional amount with principal amount;
– Zero fair value of swap at inception;
– No prepayment of interest;
– Matching index interest of swap with floating rate of loan.
Edited by Taufik Hidayat
Cash Flow Hedge – Swap : Ilustration
Example
• Company A had $10 million loan with interest at LIBOR + 50
basis points.
• To protect itself against an increase in interest rate, Company A
entered into swap contract with Company B on June 30, 20X5.
Under this contract, Company A paid interest at fixed rate of
7.75% on notional amount $10 million to Company B over 1 year
for the receipt of floating rate of LIBOR + 50 basis point. Interest
settlement were made at the end of each quarter. The rates are
as follows:
Date LIBOR LIBOR + 50 bp
June, 30 7.25% 7.75%
Sept, 30 6.25% 6.75%
Dec, 31 7.45% 7.95%
March, 31 7.50% 8.00%
Edited by Taufik Hidayat
Cash Flow Hedge – Swap : Ilustration (2)
Example
• Assumption:
– Fair value of swap at inception is zero.
– Current floating rate continues to prevail till the end of
the swap tenure.
– FV swaps are discounted with LIBOR + 50 bp.
Pay Receive
7.75% 7.75%
Company A Company B
prefers fixed prefers floating
Receive Pay
LIBOR + LIBOR
50 bp + 50 bp
Issue LIBOR + Issue fixed
50 bp
Edited by Taufik Hidayat
Cash Flow Hedge – Swap : Ilustration (3)
Example
Date Current Receipt of Payment Current FV of Change
LIBOR previous of 7.75% net Swap in FV
+ 50 bp LIBOR + 50 receipt asset
bp (paid) (liability)
(a) (b) (c) (d) (e)
June, 30 7.75% 0
Sept, 30 6.75% 193,750 193,750 0 (72,538) (72,538)
Dec, 31 7.95% 168,750 193,750 (25,000) 9,710 82,248
March, 31 8.00% 198,750 193,750 5,000 6,127 (3,583)
June, 30 200,000 193,750 6,250 0 (6,127)
(a) (previous LIBOR + 50 bp) x notional amount.
(b) 7.75% x notional amount.
(c) (a) – (b)
(d) PV of [ next period of (c) x number of next payments]
(e) (d) - previous (d)
Edited by Taufik Hidayat
Cash Flow Hedge – Swap : Ilustration (4)
Example
Date Account Amount
Sept 30 Dr Interest Expense 193,750
Cr Cash 193,750
To record payment of interest at floating rate
Sept 30 Dr FV adjustment (equity) 72,538
Cr Interest rate swap asset/liability 72,538
To record fv adjustment
Dec 31 Dr Interest Expense 168,750
Cr Cash 168,750
To record payment of interest at floating rate
Dec 31 Dr Interest Expense 25,000
Cr Cash 25,000
To record settlement of swap differential
Dec 31 Dr Interest rate swap asset/liability 82,248
Cr FV adjustment (equity) 82,248
To record fv adjustment
Edited by Taufik Hidayat
Cash Flow Hedge – Swap : Ilustration (5)
Date Account Amount
March 31 Dr Interest Expense 198,750
Cr Cash 198,750
To record payment of interest at floating rate
March 31 Dr Cash 5,000
Cr Interest Expense 5,000
To record settlement of swap differential
March 31 Dr FV adjustment (equity) 3,583
Cr Interest rate swap asset/liability 3,583
To record fv adjustment
June 30 Dr Interest Expense 200,000
Cr Cash 200,000
To record payment of interest at floating rate
June 30 Dr Cash 6,250
Cr Interest Expense 6,250
To record settlement of swap differential
June 30 Dr FV adjustment (equity) 6,127
Cr Interest rate swap asset/liability 6,127
To record fv adjustment
Edited by Taufik Hidayat
Fair Value Hedge - Swap
• Fair value hedge : Swap from fixed to floating rate:
– To protect from increase of value of debt.
– If market rate decreases, the value of fixed rate debt
increases.
• Changes in fair value of swap are taken to P/L.
• Even though the debt is carried at amortised cost
under PSAK 55, the carrying amount should be
adjusted by it’s fair value P/L.
• Changes in fair value of debt represent
discount/premium but not amortised as long as the
hedge is in place.
Edited by Taufik Hidayat
Fair Value Flow Hedge – Swap : Exercise
• Company A had $100 million bank loan with interest at fixed rate 8%.
Interest was payable quarterly starting on January 31. Company A
measures its debt at fair value.
• To protect itself against an increase in value of debt, Company A entered
into swap contract with Company B on January 31, 20X5. Under this
contract, Company A paid interest at JIBOR + 150 basis point on notional
amount $100 million to Company B over 1 year for the receipt of fixed rate
of 8%. Interest settlement were made at the end of each interest payment.
The rates are as follows:
Date JIBOR
Jan 31, 20X5 6,50%
Apr 30, 20X5 5,90%
Jul 31, 20X5 6,10%
Okt 31, 20X5 7,50%
Jan 31, 20X6 6,75%
PVOA (2% ; 4) 3,8077 PVOA (1,9% ; 2) 1,9444
PVOA (1,85% ; 3) 2,8923 PVOA (2,25% ; 1) 0,9780
Edited by Taufik Hidayat
Fair Value Flow Hedge – Swap : Exercise (2)
• The calculation of the fair value of the swap:
Edited by Taufik Hidayat
Fair Value Flow Hedge – Swap : Exercise (3)
Against the loss on increase
of FV of Debt
Edited by Taufik Hidayat
Disclosures
Singapore Airlines Annual Report 2015/2016
Edited by Taufik Hidayat
Disclosures
Singapore Airlines Annual Report 2015/2016
Edited by Taufik Hidayat
Disclosures
Edited by Taufik Hidayat
PSAK 55 vs PSAK 71
Notes PSAK 55 PSAK 71
Hedging Only derivatives can be designated as Allows entities to designate non-derivative
Instrument hedging instruments and non-derivative Financial assets/liabilities that are accounted
financial assets/liabilities used as a for
hedge of foreign currency risk at FVTPL as hedging instruments
Hedged Is more restrictive with respect to which Allows the following instruments to be
Items items can be designated as hedged classified as hedged items which would not
items. For example, PSAK 55 only have qualified under PSAK 55:
allows components of financial items to • Exposures that combine a derivative and an
be hedged items (e.g. the prime-rate eligible hedged item (i.e.,an aggregated
component of a floating-rate bond). exposure) if the exposure is managed as one
Components of non-financial exposure.
instruments could not be designated as • Financial instruments in the FVOCI category.
hedged items except for foreign • Components of certain financial and non-
currency risks. financial items. An example of a non-financial
• Derivatives cannot be classified as hedged item is a contract price that is based
hedged items. on a commodity price plus a fixed
• Limited instances where hedge percentage where an entity might hedge the
accounting can be applied to groups commodity price component which is a non-
of items. financial hedged item.
• More groups of items.
Edited by Taufik Hidayat
PSAK 55 vs PSAK 71
Notes PSAK 55 PSAK 71
Hedge Requires that hedge effectiveness Outlines more principle-based criteria for
Effectiveness be calculated using a numerical determining hedge effectiveness with no
Testing range of 80-125%. specific numerical thresholds.
Focuses on the economic relationship between
the hedged item and the hedging instrument,
the effect of credit risk on that economic
relationship, and the hedge ratio of the hedging
relationship.
Rebalancing Requires terminating the current If the quantity of the hedged item or hedging
hedge relationship and starting a instrument changes for risk management
new relationship purposes, the current hedge relationship
continues. However, the hedge ratio for hedge
accounting purposes must change to align with
the new hedge ratio for risk management
purposes.
Discontinuance Entities can discontinue hedge Can only discontinue hedge accounting when
accounting at any time. the qualifying criteria are no longer met.
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Edited by Taufik Hidayat
Sources:
• Tan & Lee – Advanced Financial Accounting.
• Lam & Lau – Intermediate Financial Reporting,
2nd Ed.
• Baker, Christensen, Cottrell – Advanced
Financial Accounting, 10th Ed.
• Mackenzie, et al – Interpretation & Application
of IFRS – 2011.
Edited by Taufik Hidayat
