(Advanced Financial

Accounting and Reporting

Part 2)
LECTURE AID

2017

ZEUS VERNON B. MILLAN

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 Accounting for Derivatives and Hedging
Transactions
Overview on the topic:
Chapter Title Sub-topics___
24 (Part 1) Introduction to basic concepts
25 (Part 2) Accounting for forward contracts
26 (Part 3) Acctg. for futures contracts, options & swaps
27 (Part 4) Acctg. for net investment hedges & embedded
derivatives
Related standards:
• PFRS 9 Financial Instruments
• PAS 39 Financial Instruments: Recognition and Measurement
• PAS 32 Financial Instruments: Presentation
• PFRS 7 Financial Instruments: Disclosures
• Section 12 of the PFRS for SMEs
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Chapter 24 Accounting for Derivatives and
Hedging Transactions (Part 1)

  Learning Objectives

• Identify the characteristics of a derivative.

Give examples of derivatives.
• State the purposes of acquiring derivatives.
• Enumerate the qualifying hedged items.
• Differentiate fair value hedge from cash
flow hedge.
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Definition of a derivative

A derivative is a financial instrument or other

contract that derives its value from the changes in
value of some other underlying asset or other
instrument.

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Characteristics of a derivative

1. its value changes in response to the change in an

underlying;
2. requires no initial net investment or a very minimal
initial net investment; and
3. it is settled at a future date.

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Common types of derivatives

1. Forward contract – is an agreement between two parties to

exchange a specified amount of a commodity, security, or foreign
currency at a specified date in the future at a pre-agreed price.
 

2. Futures contract – is a contract traded on an exchange that

allows an entity to buy or sell a specified quantity of commodity or a
financial security at a specified price on a specified future date.

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AFAR PART 2: Zeus Vernon B. Millan
Common types of derivatives (Continuation)

3. Option – is a contract giving the holder the right, but not the
obligation, to buy or sell an asset at a specified price any time during a
specified period in the future. When the holder exercises his right, the
writer of the option is obligated to perform his obligation on the option
contract.

• Types of options as to right of holder:

1. Call option – an option to buy
2. Put option – and option to sell

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 At the money – holder may or may not exercise option; no
gain or loss in exercising
 In the money – holder should exercise; gain in exercising
 Out of the money – holder should not exercise; loss in
exercising

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Common types of derivatives (Continuation)

4. Swap – is a contract in which two parties agree to exchange

payments in the future based on the movement of some agreed-upon
price or rate. Common examples include:
• Interest rate swap – is a contract between two parties who agree
to exchange future interest payments on a given loan amount.
Usually, one set of interest payments in based on a fixed interest
rate and the other is based on a variable interest rate.
• Foreign currency swap – is a contract between two parties who
agree to exchange sum of money in one currency for another
currency.

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Common types of derivatives (Continuation)

5. Caps, floors and collars – are essentially options designed to shift

the risk of an upward and/or downward movement in variables such as
interest rates. These are normally linked to a notional amount and a
reference rate.

6. Swaption – is an option on a swap. The option provides the holder

with the right to enter into a swap at a specified future date at specified
terms. This derivative has characteristics of an option and a swap.
 
7. Weather derivative – a contract that requires payment based on
climatic, geological or other physical variables.
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Purpose of derivatives

1. to speculate (incur risk); or

2. to hedge (avoid or manage risk).

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Measurement of derivatives

• All derivatives are measured at fair value. The

accounting for fair value changes depends on whether
the derivative is:
1. Not designated as a hedging instrument;
2. Designated as fair value hedge; or
3. Designated as cash flow hedge.

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No hedging designation (held for speculation)

• Derivatives not designated as hedging instrument are

accounted for as held for trading securities.
Accordingly, fair value changes are recognized in profit
or loss (i.e., FVPL).

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Hedging

Hedging means designating one or more hedging

instruments so that their change in fair values or cash flows
offset, in whole or in part, the change in the fair value or
cash flows of the hedged item.

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Components of a hedging relationship
1. Hedging instrument – a designated derivative or a
designated non-derivative financial asset or 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.

2. Hedged item – an asset, liability, firm commitment, highly

probable forecast transaction or net investment in a foreign
operation that (a) exposes the entity to risk of changes in fair
value or future cash flows and (b) is designated as being hedged.

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Hedged items

A hedged item can be a:

1. Recognized asset or liability (e.g., recorded receivables or
recorded payables)
2. Unrecognized firm commitment (e.g., receivable not yet
recorded on a future sale commitment or payable not yet recorded on
a future purchase commitment)
3. Highly probable forecast transaction (e.g., a planned but not
committed future sale or future purchase; the “girly stuff” you want to
purchase)
4. Net investment in a foreign operation (e.g., a foreign
subsidiary)

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• 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.
• Forecast transaction – is an uncommitted but anticipated future
transaction.
• Foreign operation – is an entity that is a subsidiary, associate,
joint venture or branch of a reporting entity whose activities are
based or conducted in a country or currency other than those of the
reporting entity.
• Net investment in a foreign operation – is the amount of the
reporting entity’s interest in the net assets of that operation.

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Hedging relationships

• Hedging relationships are of three types:

1. Fair value hedge
2. Cash flow hedge
3. Hedge of a net investment in a foreign operation

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• (APPLICATIONS: PROBLEM 22-4: #’s 1 to 15)

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 OPEN FORUM
QUESTIONS????
REACTIONS!!!!!

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IFA PART 1A: Zeus Vernon B. Millan
 END

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