Workbook on IFRS 9 Financial Instruments

Introduction

Objective and Scope

The objective of IFRS 9 is to establish principals for the reporting of financial assets and liabilities that will present relevant and useful information to users of financial statements for their assessment of the amounts, timing and uncertainty of the undertaking’s future cash flows.

Definitions:

derecognition: The removal of a previously recorded financial asset or financial liability from an undertaking's statement of financial position

derivative : A financial instrument, or other contract, within the scope of IFRS 9 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.
It is settled at a future date.

fair value: 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 (see IFRS 13).

financial guarantee contract : 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.

financial liability at fair value through profit or loss : A financial liability that meets either of the following conditions:
(i) It meets the definition of held for trading.
(ii) Upon initial recognition, it is designated by the undertaking as at fair value through profit or loss.

held for trading : A financial asset or financial liability that:
(i)     is acquired, or incurred, principally for the purpose of selling, or settling, it in the near term;
(ii)     on initial recognition, is part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking; or
(iii)     is a derivative (except for a financial guarantee contract or a hedging instrument).

Initial recognition and measurement of financial assets

An undertaking shall record a financial asset in its statement of financial position (balance sheet) only when the undertaking becomes party to the contractual provisions of the instrument.

A financial asset shall be measured at fair value (the standard situation) unless it is measured at amortised cost (the exceptional situation).

Classification

There are two basic aims of holding financial assets:

An undertaking can buy a financial asset that it plans to sell at a profit. To do so, there must be a future buyer and probably a market of buyers. Such financial instruments will normally be valued at fair value, if the business model reflects this type of transaction. Most of its profit comes from the resale, though some income may accrue from interest, or dividends, while it is held.

An undertaking can provide a loan to another party, hold it to maturity, collect the interest and principal repayments. Its profit is derived from the client. It will normally be measured at amortised cost, but only if the business model reflects this type of transaction.

An undertaking will designate a financial asset as measured at fair value through profit or loss (‘FVTPL’), if this reflects the business model. An undertaking may have more than one business model (different portfolios of financial instruments).

Also, it uses FVTPL if it eliminates, or significantly reduces, a measurement or recognition inconsistency (an ‘accounting mismatch’), that would otherwise arise from measuring assets or liabilities, or recording the gains and losses on them, on different bases.

EXAMPLE: ACCOUNTING MISMATCH

Razilya’s bank provides mortgage loans to home owners, but finances them with

back-to-back loans. Both assets and liabilities are at variable interest rates. In order to match the assets, liabilities and their transaction costs accurately, FVTPL may be a better method of accounting than amortised cost.

An undertaking shall classify financial assets as subsequently measured at either fair value or amortised cost on the basis of both:

(i) the undertaking’s business model for managing the financial assets; and

(ii) the contractual cash flow characteristics of the financial asset.

Amortised Cost

Summary

Amortised cost can only be used if:

-the assets are debt instruments (not equity instruments) and

-the business model’s objective is to hold assets in order to collect contractual cash flows, and

-the cash flows that are solely payments of principal and interest, and

-there must not be an accounting mismatch that could be remedied by FVTPL.

Otherwise, Fair Value must be used.

Amortised cost is a misnomer. If the asset has a discount, or a premium, at the time of purchase, the discount or premium is amortised over the asset life, using the effective interest rate. The cost is never amortised.

No discount, no premium = no amortisation.

The discount (or premium) are included in the cost of the asset on purchase, then are progressively diminished by the amortisation until they disappear at the maturity date.

Transaction costs will be included in the discount or premium, if they are material. If there is no premium, nor discount, bookkeeping reflects giving of the loan, then the accruals of receipts of interest and principal.

A financial asset shall be measured at amortised cost if both of the following conditions are met:

(i) the asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows.

(ii) the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. Also, there must not be an accounting mismatch that could be remedied by FVTPL.

Interest is charge for the time value of money and for the credit risk.

Measurement

Initial measurement of financial assets:

At initial recognition, an undertaking shall measure a financial asset at its fair value. Transaction costs relating to the acquisition of the financial asset will be added to this value ONLY if it will be measured at amortised cost. Otherwise, they are immediately expensed.

Subsequent measurement of financial assets

After initial recognition, an undertaking shall measure a financial asset at fair value, or amortised cost.

An undertaking shall apply the impairment requirements of IAS 39 to financial assets measured at amortised cost. Impairment charges (and reversals) always go to profit or loss. (Fair value changes include any impairment, so no further work is necessary for fair value bookkeeping.

An undertaking shall apply the hedge accounting requirements in IAS 39 to a financial asset that is designated as a hedged item.

Gains and losses

A gain, or loss, on a financial asset that is measured at fair value shall be recorded in profit or loss.

A gain, or loss, on a financial asset that is measured at amortised cost shall be recorded in profit or loss when the financial asset is derecognised, impaired or reclassified, and through the amortisation process.

A gain or loss on financial assets that are

(i) hedged items, or

(ii) accounted for, using settlement date accounting,

shall be recorded in accordance with IAS 39.

Fair value through OCI, (introduced 24 July 2014)

Financial assets held within a business model in which assets are managed both in order to collect contractual cash flows and for sale (subject to the contractual cash flow characteristics assessment; ie these are debt instruments).

Interest revenue, credit impairment and any gain or loss on derecognition would be recognised in profit or loss; all other gains or losses (ie the difference between these items and the total change in fair value) would be recognised in OCI.

Interest income and credit impairment would be computed and recognised in the same manner as for financial assets measured at amortised cost. A financial asset classified at the proposed ‘fair value through OCI’ category is treated as if it were measured at amortised cost in the foreign currency.

Accordingly, exchange differences resulting from changes in amortised cost are recognised in profit or loss.

Cumulative gain, or loss, recognised in OCI would be reclassified to profit or loss when the financial asset is derecognised. That would result in amortised cost information being provided in profit or loss and fair value information being provided in the statement of financial position.

Investments in equity instruments (Special exception)

At initial recognition, an undertaking may make an irrevocable election to present in other comprehensive income subsequent changes in the fair value of an investment in an equity instrument within the scope of IFRS 9 that is not held for trading.

The gain, or loss, from changes in fair value that is presented in other comprehensive income includes any related foreign exchange component.

(The bookkeeping transfers the gain, or loss, to a reserve in equity. The changes are reflected in other comprehensive income in the financial statements.)

This election is made on an instrument-by-instrument (share-by-share) basis.

Investments in equity instruments not held for trading could be strategic holdings of shares in other companies, either with a view to a future purchase of the entire undertaking, or held as part of a trading relationship, or a political requirement. Any changes in fair value would be recorded in other comprehensive income until final disposal of the asset.

EXAMPLE: BP and ROSNEFT (Russia)

In 2011, oil companies BP and Rosneft proposed a joint venture which would have involved Rosneft owning 5% of BP’s shares and BP owning 9.5% of Rosneft’s shares.

These strategic holdings (which would have been held for a number of years) would be suitable for this treatment. Both are listed companies and their share prices change frequently, so gains and losses (including exchange gains and losses) would be recorded in each period by both companies in other comprehensive income.

If an undertaking makes the election, it shall record dividends in profit or loss from that investment on an accruals basis, unless the dividend clearly represents a recovery of part of the cost of the investment. (In such a case, the dividend would reduce the fair value of the investment.)

Any impairment would also go to profit and loss.

Amounts presented in other comprehensive income shall not be subsequently transferred to profit or loss. This is the difference between this classification and Fair value through OCI, (introduced 24 July 2014).However, the undertaking may transfer the cumulative gain, or loss, within equity to retained earnings.

Classification of the undertaking’s business model for managing financial assets

Based on the undertaking’s business model, IFRS 9 requires an undertaking to classify the financial assets as subsequently measured at fair value, or amortised cost. The business model is determined by the undertaking’s key management.

There are two options: fair value or amortised cost models.

Amortised cost can only apply to debt instruments, not to equity portfolios. Fair value can apply to either debt or equity instruments, or to a portfolio of both.

The business model overrides management’s intentions for an individual instrument. A single undertaking may have more than one business model for managing its financial instruments.

EXAMPLE: TWO PORTFOLIOS

An undertaking may hold a portfolio of investments that it manages in order to collect contractual cash flows and another portfolio of investments that it manages in order to trade to speculate. It will account for the two portfolios separately.

Although the objective of an undertaking’s business model may be to hold financial assets in order to collect contractual cash flows, the undertaking need not hold all of those instruments until maturity.

Thus an undertaking’s business model can be to hold financial assets to collect contractual cash flows even when sales of financial assets occur.

EXAMPLES: REASONS FOR ASSET SALES (holding financial assets to collect contractual cash flows)

The undertaking may sell a financial asset if:

(i) the financial asset no longer meets the undertaking’s investment policy (the credit rating of the asset declines);

(ii) an investor adjusts its investment portfolio to reflect a change in the expected timing of payouts; or

(iii) an undertaking needs cash.

However, if frequent sales are made out of a portfolio, the undertaking needs to assess whether, and how, such sales are consistent with an objective of collecting contractual cash flows.

Managing a portfolio of assets to realise fair value changes

If an undertaking actively manages (and/or measures) a portfolio of assets in order to realise fair value changes, its business model would be considered a fair value model. The undertaking’s objective results in active buying and selling to realise fair value gains rather than to collect the contractual cash flows.

Also, a portfolio of financial assets that are held for trading would be considered a fair value model.

Contractual cash flows that are solely payments of principal and interest on the principal amount outstanding

An undertaking shall assess whether contractual cash flows are solely payments of principal and interest on the principal amount.

Leverage (gearing) is a contractual cash flow characteristic of some financial assets. Leverage increases the variability of the contractual cash flows with the result that they do not have the economic characteristics of interest.

Options, forward and swap contracts are examples of financial assets that include leverage. Thus such contracts cannot be (subsequently) measured at amortised cost.

Liquidation before maturity – put options

Contractual provisions that permit the issuer (the debtor) to prepay a debt instrument (such as a loan or a bond), or permit the holder (the creditor) to put (resell) a debt instrument back to the issuer before maturity, result in contractual cash flows that are solely payments of principal and interest on the principal amount outstanding only if:

(1) the provision is not contingent on future events, other than to protect:

(i) the holder against the credit deterioration of the issuer (such as defaults, credit downgrades or loan covenant violations), or a change in control of the issuer; or

(ii) the holder, or issuer, against changes in relevant taxation or law; and

(2) the prepayment amount substantially represents unpaid amounts of principal and interest, which may include reasonable additional compensation for the early termination of the contract.

EXAMPLE: PUT OPTION
Gulnara has a 10 year mortgage loan to buy a home. If she repays it early, she will have to pay the full amount outstanding, plus a penalty. The penalty is based on the additional costs the lender to reorganise its finances as a result of the early repayment.

This loan would qualify as ‘solely payments of principal and interest’.

Liquidation after maturity- extension option

Contractual provisions that permit the issuer, or holder, to extend the contractual term of a debt instrument (an extension option) result in contractual cash flows that are solely payments of principal and interest on the principal amount outstanding only if:

(1) the provision is not contingent on future events, other than to protect:

(i) the holder against the credit deterioration of the issuer (eg defaults, credit downgrades or loan covenant violations) or a change in control of the issuer; or

(ii) the holder or issuer against changes in relevant taxation or law; and

(2) the terms of the extension option result in contractual cash flows during the extension period that are solely payments of principal and interest.

EXAMPLE: EXTENSION OPTION
Gulnara has a 10 year mortgage loan to buy a home. There is an extension option, for which she must pay a higher interest rate (if she needs the extension). The higher rate reflects ‘the credit deterioration of the issuer’ – Gulnara would be a higher risk due to failing to repay the loan in full, on time. The lender may also have additional costs to reorganise its finances as a result of the delay in repayment.

This loan would qualify as ‘solely payments of principal and interest’.

Changes of timing or amounts of payment amounts

A contractual term that changes the timing, or amount, of payments of principal or interest does not result in contractual cash flows that are solely principal and interest on the principal amount outstanding unless it:

(i) is a variable interest rate that is consideration for the time value of money and the credit risk (which may be determined at initial recognition only); and

(ii) if the contractual term is a prepayment option and meets the conditions above; or

(iii) if the contractual term is an extension option and meets the conditions above.

Measurement - Initial measurement of financial assets

The fair value of a financial asset at initial recognition is normally the transaction price.

However, if part of the price is for something other than the financial instrument, the fair value of the financial instrument is estimated using a valuation technique.

EXAMPLE: VALUATION TECHNIQUE

The fair value of a long-term loan, or receivable, that carries no interest can be estimated as the present value of all future cash receipts, discounted using the prevailing market rate(s) of interest for a similar instrument with a similar credit rating.

Any additional amount lent is an expense, or a reduction of income, unless it qualifies for recognition as some other type of asset.

EXAMPLE: OFF-MARKET INTEREST RATE

If an undertaking originates a loan that bears an off-market interest rate (for example, 7 per cent when the market rate for similar loans is 10 per cent), and receives an upfront fee as compensation, the undertaking records the loan at its fair value (discounted at 10 per cent), net of the fee it receives.

Subsequent measurement of financial assets

If a financial asset is measured at fair value and its fair value decreases below zero, it is a financial liability.

EXAMPLE: VALUE FALLS BELOW ZERO

Nadia has a swap contract. She will receive Yen in exchange for paying Roubles. The Rouble rises against the Yen, so she has to pay on the contract. It becomes a financial liability.

Investments in unquoted equity instruments (and contracts on those investments that must be settled by delivery of the unquoted equity instruments)

In limited circumstances, cost may be an appropriate estimate of fair value. That may be the case if more recent information is lacking to determine fair value.

An undertaking shall use all information about the performance and operations of the investee that becomes available after the date of initial recognition. To the extent that any such relevant factors exist, they may indicate that cost might not (or may no longer be) be representative of fair value.

In such cases, the undertaking must estimate fair value.

EXAMPLE: UNQUOTED EQUITY INSTRUMENTS

Marina’s bank buys some shares in a client company for 100 to secure some business. This is a rare purchase as the shares have limited liquidity, causing adverse impacts on the bank’s liquidity ratios.

Fair value is taken as cost (100). Later, the company has problems and is restructured.

The shares are revalued at 60, using valuations based on anticipated discounted cash flows, and Marina’s bank records an impairment charge of 40.

Cost is never the best estimate of fair value for investments in quoted equity instruments (or contracts on quoted equity instruments, such as derivatives).

Reclassification

IFRS 9 requires an undertaking to reclassify financial assets if the undertaking’s business model for managing those financial assets changes. Such changes are expected to be very infrequent.

Such changes must be determined as a result of external, or internal, changes significant to the undertaking’s operations and demonstrable to external parties.

If an undertaking reclassifies financial assets, it shall apply the reclassification prospectively from the reclassification date (onwards). The undertaking shall not restate any previously recorded gains, losses or interest.

If an undertaking reclassifies a financial asset to be measured at fair value, its fair value is determined at the reclassification date. Any gain, or loss, arising from a difference between the previous carrying amount and fair value is recorded in profit or loss.

If an undertaking reclassifies a financial asset to be measured at amortised cost, its fair value at the reclassification date becomes its new carrying amount.

EXAMPLES: RECLASSIFICATION

Such changes could include the closure of a portfolio, or part of the business, and the transfer of assets from collecting contractual cash flows to being held for sale.

A change in the objective of the undertaking’s business model must be effected (no new business written between the decision and the reclassification date.)

EXAMPLE: RECLASSIFICATION AND CEASING TO WRITE NEW BUSINESS

A firm decides on 15 December to shut down its retail mortgage business and hence must reclassify all affected financial assets on 1 January (the first day of the undertaking’s next reporting period), the undertaking must not accept new retail mortgage business after 15 December.

The following are not changes in business model:

(i) a change in intention related to particular financial assets (even in circumstances of significant changes in market conditions);

(ii) a temporary disappearance of a particular market for financial assets;

(iii) a transfer of financial assets between parts of the undertaking with different business models.

Gains and losses on foreign exchange

IAS 21 requires any foreign exchange gains, and losses, on monetary assets to be recorded in profit or loss. (An exception is a monetary item that is designated as a hedging instrument in either a cash flow hedge, or a hedge of a net investment.)

If an undertaking recognises financial assets using settlement date accounting, any change in the fair value of the asset to be received during the period between the trade date and the settlement date is not recognised for assets measured at amortised cost (other than impairment losses).

For assets measured at fair value, however, the change in fair value shall be recognised in profit or loss, or in other comprehensive income.

Collateral (including REPO’s)

If a transferor provides non-cash collateral (such as debt or equity instruments) to the transferee, the accounting for the collateral by the transferor and the transferee depends on whether the transferee has the right to sell, or repledge, the collateral and on whether the transferor has defaulted.

The transferor (borrower) and transferee (lender) shall account for the collateral as follows:

(i) If the transferee has the right to sell, or repledge, the collateral, then the transferor shall reclassify that asset in its statement of financial position (for example, as a loaned asset, pledged equity instruments or repurchase receivable) separately from other assets. It will be matched by a liability in favour of the transferor.

(ii) If the transferee sells collateral pledged to it, it shall recognise the proceeds from the sale, and a liability measured at fair value, for its obligation to return the collateral.

(iii) If the transferor defaults under the terms of the contract and is no longer entitled to redeem the collateral, it shall derecognise the collateral, and the transferee shall recognise the collateral as its asset initially measured at fair value or, if it has already sold the collateral, derecognise its obligation to return the collateral.

(iv) Except as provided in (iii), the transferor (borrower) shall continue to carry the collateral as its asset, and the transferee (lender) shall not recognise the collateral as an asset.

Fair value measurement (see IFRS 13)

In determining the fair value of a financial asset or a financial liability, an undertaking shall apply IFRS 13:

Fair value hierarchy

The hierarchy categorises the inputs used in valuation techniques into three levels.

The hierarchy gives the highest priority to (unadjusted) quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.

If the inputs are categorised into different levels of the fair value hierarchy, the fair value measurement is categorised in its entirety in the level of the lowest level input that is significant to the entire measurement (based on the application of judgement).

Financial Liabilities

Classification of financial liabilities

An undertaking shall classify all financial liabilities as subsequently measured at amortised cost using the effective interest method, except for:

(1) financial liabilities at fair value through profit or loss. Such liabilities, including derivatives that are liabilities, shall be subsequently measured at fair value.

(2) financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition, or when the continuing involvement approach applies.

(3) financial guarantee contracts. After initial recognition, an issuer of such a contract shall subsequently measure it at the higher of:

(i) the amount determined in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets and

(ii) the amount initially recognised less, when appropriate, cumulative amortisation recognised in accordance with IFRS 15 Revenue.

(4) commitments to provide a loan at a below-market interest rate (often to related parties). After initial recognition, an issuer of such a commitment shall subsequently measure it at the higher of:

(i) the amount determined in accordance with IAS 37 and

(ii) the amount initially recognised less, when appropriate, cumulative amortisation recognised in accordance with FIRS 15.

Option to designate a financial liability at fair value through profit or loss

An undertaking may, at initial recognition, irrevocably designate a financial liability as measured at fair value through profit or loss when doing so results in more relevant information, because either:

(i) it eliminates or significantly reduces a measurement or recognition inconsistency ('accounting mismatch') that would otherwise arise from measuring assets (or liabilities) or recognising the gains and losses on them on different bases; or

(ii) a group of financial liabilities, or financial assets and financial liabilities is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the undertaking's key management.

An undertaking shall not reclassify any financial liability.

The following changes in circumstances are not reclassifications:

(i) A derivative that was previously a designated and effective hedging instrument in a cash flow hedge, or net investment, hedge no longer qualifies as such.

(ii) A derivative becomes a designated and effective hedging instrument in a cash flow hedge, or net investment, hedge.

The fair value of a financial liability with a demand feature (such as a demand deposit) is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid.

Liabilities designated as at fair value through profit or loss

An undertaking shall present a gain, or loss, on a financial liability designated as at fair value through profit or loss as follows:

(i) The amount of change in the fair value of the financial liability that is attributable to changes in the credit risk of that liability shall be presented in other comprehensive income, and

(ii) the remaining amount of change in the fair value of the liability shall be presented in profit or loss

unless the treatment of the effects of changes in the liability's credit risk described in (i) would create, or enlarge, an accounting mismatch in profit or loss.

EXAMPLES: LIABILITIES CHANGING IN VALUE

The idea that liabilities would fluctuate in value may not be immediately apparent.

They may change if they are denominated in a foreign currency and that currency moves in relation to the reporting currency. There may be a liability for a commodity, or a derivative of a commodity. Also, a trader may have sold a security that he/she does not yet own (a ‘short sale’) and plans to buy one at a lower price to fulfil the sale.

In such cases, these changes in value would be recorded in profit and loss.

Credit-value adjustments (see below) relate to the credit risk, and are recorded in other comprehensive income.

If the requirements would create, or enlarge, an accounting mismatch in profit or loss, an undertaking shall present all gains or losses on that liability (including the effects of changes in the credit risk of that liability) in profit or loss.

An undertaking shall present in profit or loss all gains, and losses, on loan commitments and financial guarantee contracts that are designated as at fair value through profit or loss.

Credit-value adjustments

Credit-value adjustments have been used by many banks, though can be used by any company with financial liabilities, turning credit rating downgrades into profits. The issue relates to bonds that they have issued which have a market price.

The idea is that if you have a liability of 100 and can settle it for 80, then you have made a realised profit of 20. (Realised profit is fine; it is the next step which lacks integrity.)

This is then extended to the situation when you have not settled the liability, but the market price is 80 (maybe due to foreign exchange fluctuations, or perceived increased risk of your company). In this case, IFRS enables you to mark the liability to the market price and recognise a gain.

Credit-value adjustments relate to the special case of bonds (liabilities) issued by the banks themselves. If our bank has issued a bond worth 100 with a 10% coupon, then a rise in market interest rates to (say) 15% will make the bond less attractive to investors and it will probably be priced at a discount. The bank has a choice to buy it in the market (if it has the cash available) and make a profit, or wait until the bond matures and pay 100 to the investor.

Credit-value adjustments - gains are a fallacy

Such a gain is a fallacy. If a rise in market rates to 15% had caused the fall in the price of bonds, the bank would have to borrow money at 15% to redeem the 10% bond. Thus, an immediate profit would have to be matched with increased interest payments of 15%, contrasted with the current cost of 10%.

If the bond is trading at a discount because the bank’s reputation is damaged and there is a perceived risk of default of the bond, the bank could only raise finance at (say) 18-20% to buy back the bond, and would be saddled with future interest payments of 18-20%, instead of 10%.

Derecognition of financial assets and liabilities

A financial asset is derecognised when it is sold, cancelled or expires.

An undertaking shall remove a financial liability (or a part of a financial liability) from its statement of financial position only when it is extinguished - when the obligation specified in the contract is discharged, or cancelled or expires.

In general, derecognition of a financial asset, or a liability, is achieved when the asset is sold, or the liability is settled.

If an asset is sold with some ongoing commitment (risk and/or reward), such as a guarantee, or a commitment to repurchase (a ‘REPO’) derecognition in full may not be permitted. A REPO should be treated as a loan with collateral, not a sale and repurchase.

If the seller of the financial asset sells it and then collects cash relating to the asset, as an agent for the new owner, derecognition is allowed. The agent must promptly pass cash to the new owner and must not be liable to the new owner for any amounts that the agent has not received relating to the asset. There must not be any further risk in relation to the asset.

Problems arise if a liability is only partially settled, is transferred with recourse – if the transferee does not pay, you will have to do so-and where some risks and rewards relating to the liability remain. The continuing commitments must be recorded.

Such problems were prevalent in the 2008 financial crisis. Financial institutions found that assets and liabilities that they had derecognised, sometimes to off-balance-sheet vehicles, presented them with further, unforeseen risks (and a few rewards).

An exchange between an existing borrower and lender of debt instruments with substantially different terms shall be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability.

EXAMPLE: DEBT INSTRUMENTS WITH SUBSTANTIALLY DIFFERENT TERMS

A member country of the Euro group is unable to pay the principal of its (3,5%) 5 year bond and replaces it with a 30 year bond paying 6%. The new bond should be considered as a new financial liability and the original bond derecognised when all holders have agreed to the changes.

Similarly, a substantial modification of the terms of an existing financial liability, or a part of it (whether or not attributable to the financial difficulty of the debtor) shall be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability.

The difference between the carrying amount of a financial liability (or part of a financial liability) extinguished, or transferred to another party, and the consideration paid, including any non-cash assets transferred, or liabilities assumed, shall be recognised in profit or loss.

If an undertaking repurchases a part of a financial liability, the undertaking shall allocate the previous carrying amount of the financial liability between the part that continues to be recognised and the part that is derecognised, based on the relative fair values of those parts on the date of the repurchase.

The difference between (i) the carrying amount allocated to the part derecognised and (ii) the consideration paid, including any non-cash assets transferred or liabilities assumed, for the part derecognised shall be recognised in profit or loss.

A gain, or loss, on a financial liability that is measured at amortised cost (and is not part of a hedging relationship) shall be recognised through the amortisation process and when the financial liability is derecognised in profit or loss.

Bookkeeping for Financial Instruments

(These comparisons only apply to bookkeeping: several classifications have changed.)

Summary (IFRS 9 comparisons with IAS 39)

Bookkeeping Unchanged from IAS 39

-FVTPL Assets

-FVTPL Liabilities (except Credit-value adjustments which are generally recorded through Other Comprehensive Income)

-Other Liabilities

Amortised cost (amortisation of discount and premium)

Identical to IAS 39 Loans and Receivables and Held to Maturity

Fair Value through Other Comprehensive Income (introduced 24 July 2014)

Identical to IAS 39 Available for Sale (debt instruments– impairments can be reversed).

Equity instrument not held for trading

Identical to IAS 39 Available for Sale (debt instruments– impairments can be reversed), except that transaction costs are expensed

and the profits (or losses) are not transferred (recycled) to the income statement.

Notes:

Available for Sale, Loans and Receivables and Held to Maturity classifications from IAS 39 have all disappeared in IFRS 9.

The cost model of IAS 39 is now accounted for under FVTPL.

Transaction costs are expensed.

DETAILED BOOKKEEPING EXAMPLES

In the following examples,

I/B refers to Income Statement and Balance Sheet (Statement of Financial Position).

Financial assets at fair value through profit and loss
Buy asset for 60 + 5 transaction costs

EXAMPLE - Financial assets at fair value through profit and loss
	I/B	DR	CR
Asset	B	60
Transaction costs	I	5
Cash	B		65

Revalue to 63

EXAMPLE - Financial assets at fair value through profit and loss
	I/B	DR	CR
Asset	B	3
Revaluation income	I		3

Impairment reduces value to 33

EXAMPLE - Financial assets at fair value through profit and loss
	I/B	DR	CR
Revaluation expense	I	30
Asset	B		30

Interest received 4

EXAMPLE - Financial assets at fair value through profit and loss
	I/B	DR	CR
Cash	B	4
Interest received	I		4

Asset revalued to 70

EXAMPLE - Financial assets at fair value through profit and loss
	I/B	DR	CR
Asset	B	37
Revaluation income	I		37

Asset sold for 79

EXAMPLE - Financial assets at fair value through profit and loss
	I/B	DR	CR
Cash	B	79
Profit on sale of asset	I		9
Asset	B		70

Note: Financial assets at fair value through profit and loss:

No change from IAS 39

Equity instrument not held for trading

Buy asset for 60 + 5 transaction costs

EXAMPLE - Equity instrument not held for trading
	I/B	DR	CR
Asset	B	60
Transaction costs	I	5
Cash	B		65

Revalue to 63

EXAMPLE - Equity instrument not held for trading
	I/B	DR	CR
Asset	B	3
Revaluation gain -equity	B		3

Impairment reduces value to 33

EXAMPLE - Equity instrument not held for trading
	I/B	DR	CR
Impairment of equity instrument	I	30
Asset	B		30

(Note: 3 might be charged against the revaluation gain, 27 to the Income Statement as an alternative.)

Dividend received 4

EXAMPLE - Equity instrument not held for trading
	I/B	DR	CR
Cash	B	4
Dividend received	I		4

Asset revalued to 70

EXAMPLE - Equity instrument not held for trading
	I/B	DR	CR
Asset	B	37
Reversal of Impairment of equity instrument	I		30
Revaluation gain -equity	B		7

Asset sold for 79

EXAMPLE - Equity instrument not held for trading
	I/B	DR	CR
Asset	B	9
Revaluation gain –equity	B		9
Cash	B	79
Asset	B		79
Revaluation gain –equity - transfer	B	10
Retained earnings (NOT profit and loss)	B		10

Note: Equity instrument not held for trading:

The bookkeeping is the same as an available for sale debt instrument under IAS 39, though the classification is different. However, transaction costs are expensed and the profits (or losses) are not transferred (recycled) to the income statement.

Amortised Cost – Amortisation of Discount – Loan

Year	Opening Value	Cash Interest	Amortisation of discount	Effective Interest	Closing Value	Effective Interest Rate
1	93400	6000	1133	7133	94533	7,64%
2	94533	6000	1220	7220	95753	7,64%
3	95753	6000	1313	7313	97066	7,64%
4	97066	6000	1413	7413	98479	7,64%
5	98479	6000	1521	7521	100000	7,64%

Elena issues a 5-year loan at 6% interest. Interest is paid at the end of each year.Galina, the client, pays commission of 6.600 on day 1 for the loan. She therefore receives only 93.400 in cash, a discount of 6.600. This commission forms part of the effective interest rate – an effective rate of 7,64%.

The discount is amortised in Elena’s books over the period of the loan, using the effective interest rate (7.64%).

Accounting on Day 1

EXAMPLE - Amortised Cost – Amortisation of Discount
	I/B	DR	CR
Loan - Galina	B	100.000
Cash	B		93.400
Deferred commission	B		6.600

End of year 1

EXAMPLE - Amortised Cost – Amortisation of Discount
	I/B	DR	CR
Cash	B	6.000
Interest receivable	I		6.000
Deferred commission	B	1.133
Commission	I		1.133

End of year 2

EXAMPLE - Amortised Cost – Amortisation of Discount
	I/B	DR	CR
Cash	B	6.000
Interest receivable	I		6.000
Deferred commission	B	1.220
Commission	I		1.220

End of year 3

EXAMPLE - Amortised Cost – Amortisation of Discount
	I/B	DR	CR
Cash	B	6.000
Interest receivable	I		6.000
Deferred commission	B	1.313
Commission	I		1.313

End of year 4

EXAMPLE - Amortised Cost – Amortisation of Discount
	I/B	DR	CR
Cash	B	6.000
Interest receivable	I		6.000
Deferred commission	B	1.413
Commission	I		1.413

End of year 5

EXAMPLE - Amortised Cost – Amortisation of Discount
	I/B	DR	CR
Cash	B	106.000
Interest receivable	I		6.000
Loan - Tamara	B		100.000
Deferred commission	B	1.521
Commission	I		1.521

Note: Amortised Cost – Amortisation of Discount –

The bookkeeping is the same as either Loans and Receivables or Held to Maturity under IAS 39

Amortised Cost – Amortisation of Premium – Bond

Year	Opening Value	Cash Interest	Amortisation of premium	Effective Interest	Closing Value	Effective Interest Rate
1	106600	6000	-1203	4797	105397	4,5%
2	105397	6000	-1257	4743	104140	4,5%
3	104140	6000	-1314	4686	102826	4,5%
4	102826	6000	-1373	4627	101453	4,5%
5	101453	6000	-1454	4546	100000	4,5%

Anna buys a 5-year listed bond for 106.600, paying a premium of 6.600 as it has a face value of 100.000.

The bond pays 6% interest at the end of each year. Anna paid the premium as 6% is an attractive rate of interest compared to other similar investments.

Anna will hold the bond to maturity. She will amortise the premium over the life of the bond. Her effective interest rate is 4,5% after adjusting for the premium.

Accounting on Day 1

EXAMPLE - Amortised Cost – Amortisation of Premium
	I/B	DR	CR
Bond	B	100.000
Bond premium	B	6.600
Cash	B		106.600

End of year 1

EXAMPLE - Amortised Cost – Amortisation of Premium
	I/B	DR	CR
Cash	B	6.000
Interest receivable	I		6.000
Interest expense	I	1.203
Bond premium	B		1.203

End of year 2

EXAMPLE - Amortised Cost – Amortisation of Premium
	I/B	DR	CR
Cash	B	6.000
Interest receivable	I		6.000
Interest expense	I	1.257
Bond premium	B		1.257

End of year 3

EXAMPLE - Amortised Cost – Amortisation of Premium
	I/B	DR	CR
Cash	B	6.000
Interest receivable	I		6.000
Interest expense	I	1.314
Bond premium	B		1.314

End of year 4

EXAMPLE - Amortised Cost – Amortisation of Premium
	I/B	DR	CR
Cash	B	6.000
Interest receivable	I		6.000
Interest expense	I	1.373
Bond premium	B		1.373

End of year 5

EXAMPLE - Amortised Cost – Amortisation of Premium
	I/B	DR	CR
Cash	B	106.000
Interest receivable	I		6.000
Bond	B		100.000
Interest expense	I	1.454
Bond premium	B		1.454

Note: Amortised Cost – Amortisation of Premium –

The bookkeeping is the same as either Loans and Receivables or Held to Maturity under IAS 39

Fair value through other comprehensive income – debt instrument (Impairment can be reversed)

Note: As the instrument is due to be sold, it is marked to market. This causes the revaluations.

Buy asset for 60 + 5 transaction costs

EXAMPLE - . Fair value through other comprehensive income – debt instrument
	I/B	DR	CR
Asset	B	65
Cash	B		65

Revalue to 63

EXAMPLE - . Fair value through other comprehensive income – debt instrument
	I/B	DR	CR
Revaluation loss -equity	B	2
Asset	B		2

Impairment reduces value to 33

EXAMPLE - . Fair value through other comprehensive income – debt instrument
	I/B	DR	CR
Impairment of debt instrument	I	30
Asset	B		30

Interest received 4

EXAMPLE - . Fair value through other comprehensive income – debt instrument
	I/B	DR	CR
Cash	B	4
Interest received	I		4

Asset revalued to 70 (Impairment is reversed)

EXAMPLE - . Fair value through other comprehensive income – debt instrument
	I/B	DR	CR
Asset	B	37
Impairment of debt instrument - reversal	I		30
Revaluation gain -equity	B		7

Asset sold for 79

EXAMPLE - . Fair value through other comprehensive income – debt instrument
	I/B	DR	CR
Cash	B	79
Profit on sale of asset	I		14
Asset	B		70
Revaluation gain -equity- reversal	B	7
Revaluation loss -equity- reversal	B		2

Financial liability at fair value through profit and loss

Olga’s bank has a (forward position) liability for a commodity contract. The commodity is listed on a commodity exchange.

Client pays Olga 65 to take on the liability

EXAMPLE - Financial liability at fair value through profit and loss
	I/B	DR	CR
Cash	B	65
Commodity liability	B		65

Revalue to 63

EXAMPLE - Financial liability at fair value through profit and loss
	I/B	DR	CR
Commodity liability	B	2
Revaluation income	I		2

Commodity liability revalued to 33

EXAMPLE - Financial liability at fair value through profit and loss
	I/B	DR	CR
Commodity liability	B	30
Revaluation income	I		30

Commodity liability revalued to 70

EXAMPLE - Financial liability at fair value through profit and loss
	I/B	DR	CR
Revaluation expense	I	37
Commodity liability	B		37

Commodity liability settled for 79

EXAMPLE - Financial liability at fair value through profit and loss
	I/B	DR	CR
Commodity liability	B	70
Loss on settlement of liability	I	9
Cash	B		79

Note: Financial liability at fair value through profit and loss –

Same bookkeeping as under IAS 39

Other Financial liability - Amortisation of Discount – Amortised Cost

Year	Opening Value	Cash Interest	Amortisation of discount	Effective Interest	Closing Value	Effective Interest Rate
1	93400	6000	1133	7133	94533	7,64%
2	94533	6000	1220	7220	95753	7,64%
3	95753	6000	1313	7313	97066	7,64%
4	97066	6000	1413	7413	98479	7,64%
5	98479	6000	1521	7521	100000	7,64%

Katya’s bank issues a 5-year bond that will pay interest of 6% at the end of each year.

On the date of issue, interest rates for similar instruments rise and she issues the bond at a discount of 6.600. This lifts the effective interest rate to 7,64%. Katya will amortise the premium over the life of the bond using the effective interest rate of 7,64%.

Accounting on Day 1

EXAMPLE - Other Financial liability – Amortisation of Discount – Amortised Cost
	I/B	DR	CR
Cash	B	93.400
Bond discount	B	6.600
Bond	B		100.000

End of year 1

EXAMPLE - Other Financial liability – Amortisation of Discount – Amortised Cost
	I/B	DR	CR
Interest paid	I	6.000
Cash	B		6.000
Interest paid	I	1.133
Bond discount	B		1.133

End of year 2

EXAMPLE - Other Financial liability – Amortisation of Discount – Amortised Cost
	I/B	DR	CR
Interest paid	I	6.000
Cash	B		6.000
Interest paid	I	1.220
Bond discount	B		1.220

End of year 3

EXAMPLE - Other Financial liability – Amortisation of Discount – Amortised Cost
	I/B	DR	CR
Interest paid	I	6.000
Cash	B		6.000
Interest paid	I	1.313
Bond discount	B		1.313

End of year 4

EXAMPLE - Other Financial liability – Amortisation of Discount – Amortised Cost
	I/B	DR	CR
Interest paid	I	6.000
Cash	B		6.000
Interest paid	I	1.413
Bond discount	B		1.413

End of year 5

EXAMPLE - Other Financial liability – Amortisation of Discount – Amortised Cost
	I/B	DR	CR
Bond	B	100.000
Interest paid	I	6.000
Cash	B		106.000
Interest paid	I	1.521
Bond discount	B		1.521

Note: - Other Financial liability – Bookkeeping the same as under IAS 39

Securitisation

An undertaking has a business model with the objective of originating loans to clients and subsequently selling those loans to a securitisation vehicle (a separate legal undertaking that may, or may not, be controlled by the undertaking) .

Securitisation is a lenders’ method of selling loans (and other future cash flows) to third parties, in order to receive immediate cash. For financial institutions with legislated minimum capital requirements, it enables them to recycle the capital, dedicated to the original loans, to make new loans.

The securitisation vehicle issues instruments to investors, who buy them in exchange for future cash flows.

The undertaking originated the loans with the objective of selling them: it would be considered a fair value model.

Securitisation - Contractually linked instruments

In some types of transactions (especially in securitisations), an undertaking may prioritise payments to the holders of financial assets using multiple, contractually-linked instruments that create concentrations of credit risk (tranches). Each tranche has a ranking that specifies the order in which any cash flows generated by the issuer are allocated to the tranche.

In such situations, the holders of a tranche have the right to payments of principal and interest on the principal amount outstanding only if the issuer generates sufficient cash flows to satisfy higher-ranking tranches.

In such transactions, a tranche has cash flow characteristics that are payments of principal and interest on the principal amount outstanding only if:

(i) the contractual terms of the tranche being assessed for classification give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding (eg the interest rate on the tranche is not linked to a commodity index);

and

(ii) the exposure to credit risk in the underlying pool of financial instruments inherent in the tranche is equal to, or lower than, the exposure to credit risk of the underlying pool of financial instruments (for example, this condition would be met if the underlying pool of instruments were to lose 50 per cent as a result of credit losses and, under all circumstances, the tranche would lose 50 per cent or less).

An undertaking must look through until it can identify the underlying pool of instruments that are creating (rather than passing through) the cash flows. This is the underlying pool of financial instruments.

The underlying pool must contain one, or more, instruments that have contractual cash flows that are solely payments of principal and interest on the principal amount outstanding.

Embedded derivatives

An embedded derivative is a component of a hybrid contract that also includes a non-derivative host—with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative.

An embedded derivative causes some, or all, of the cash flows of the contract to be modified. This may be according to 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.

If a hybrid contract contains a host that is within the scope of IFRS 9, IFRS 9 applies to the entire hybrid contract.

Separate financial instruments

If a hybrid contract contains a host that is not an asset within the scope of IFRS 9, an embedded derivative shall be separated from the host and accounted for as a derivative under IFRS 9 only if:

(i) the characteristics and risks of the embedded derivative are not closely related to the characteristics and risks of the host;

(ii) a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and

(iii) the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss (a derivative that is embedded in a financial liability at fair value through profit or loss is not separated).

If an embedded derivative is separated, the host contract shall be accounted for in accordance with the appropriate IFRSs.

However, if a contract contains one, or more, embedded derivatives and the host is not an asset within the scope of IFRS 9, an undertaking may designate the entire hybrid contract as at fair value through profit or loss unless:

(i) the embedded derivative(s) do(es) not significantly modify the cash flows that otherwise would be required by the contract; or

(ii) it is clear with little, or no, analysis when a similar hybrid instrument is first considered that separation of the embedded derivative(s) is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay the loan for approximately its amortised cost.

If an undertaking is required by IFRS 9 to separate an embedded derivative from its host, but is unable to measure the embedded derivative separately, either at acquisition, or at the end of a subsequent financial reporting period, it shall designate the entire hybrid contract as at fair value through profit or loss.

If an undertaking is unable to determine reliably the fair value of an embedded derivative on the basis of its terms and conditions,

the fair value of the embedded derivative is the difference between the fair value of the hybrid contract and the fair value of the host,

if those can be determined under IFRS 9. If the undertaking is unable to determine the fair value of the embedded derivative using this method, the hybrid contract is designated as at fair value through profit or loss.

Hedge accounting

For those readers who already use hedging, or know hedging under IAS 39, we start this topic with:

Summary of the issues and changes of IFRS 9 Hedging (from Straight away IFRS bulletin from PwC 20 November 2013)

What’s the issue?

The new requirements align hedge accounting more closely with risk management, and so should result in more ‘decision-useful’ information to users of financial statements. The revised standard also establishes a more principles-based approach to hedge accounting and addresses inconsistencies and weaknesses in the current model in IAS 39.

What are the key changes?

Hedge effectiveness tests and eligibility for hedge accounting

IFRS 9 relaxes the requirements for hedge effectiveness and, consequently to apply hedge accounting.

Under IAS 39, a hedge must be highly effective, both going forward and in the past (that is, a prospective and retrospective test, with results in the range of 80%-125%).

IFRS 9 replaces this bright line with a requirement for an economic relationship between the hedged item and hedging instrument, and for the ‘hedged ratio’ to be the same as the one that the entity actually uses for risk management purposes.

Hedge ineffectiveness will continue to be reported in profit or loss account. An entity is still required to prepare contemporaneous documentation; however, the information to be documented under IFRS 9 will differ.

Hedged items

The new requirements change what qualifies as a hedged item, primarily removing restrictions that currently prevent some economically rational hedging strategies from qualifying for hedge accounting. For example:

 Risk components of non-financial items can be designated as hedged items, provided they are separately identifiable and reliably measurable. This is good news for entities that hedge for only a component of the overall price of non-financial items (such as the oil price component of jet fuel price exposure), because it is likely that more hedges will now qualify for hedge accounting.

 Aggregated exposures (that is, exposures that include derivatives) can be hedged items.

 IFRS 9 makes the hedging of groups of items more flexible, although it does not cover macro hedging (this will be the subject of a separate discussion paper in the future). Treasurers commonly group similar risk exposures and hedge only the net position (for example, the net of forecast purchases and sales in a foreign currency).

Under IAS 39, such a net position cannot be designated as the hedged item; but IFRS 9 permits this if it is consistent with an entity’s risk management strategy. However, if the hedged net position consists of forecast transactions, hedge accounting on a net basis is only available for foreign currency hedges.

 IFRS 9 allows hedge accounting for equity instruments measured at fair value through other comprehensive income (OCI), even though there will be no impact on P&L from these investments.

Hedging instruments

IFRS 9 relaxes the rules on the use of some hedging instruments as follows:

 Under IAS 39, the time value of purchased options is recognised on a fair value basis in P&L, which can create significant volatility. IFRS 9 views a purchased option as similar to an insurance contract, such that the initial time value (that is, the premium generally paid for an at- or out-of-the-money option) must be recognised in P&L, either over the period of the hedge (if the hedge item is time related, such as a fair value hedge of inventory for six months), or when the hedged transaction affects P&L (if the hedge item is transaction related, such as a hedge of a forecast purchase transaction). Any changes in the option’s fair value associated with time value will be recognised in OCI.

 A similar accounting treatment to options can also be applied to the forward element of forward contracts and to foreign currency basis spreads of financial instruments. This should result in less volatility in P&L.

 Non-derivative financial items can be used as hedging instruments, provided they are accounted for at fair value through P&L, unless they are hedging foreign currency (FX) risk. Under IAS 39, non-derivative financial items were only allowed for hedges of FX risk.

Accounting, presentation and disclosure

The accounting and presentation requirements for hedge accounting in IAS 39 remain largely unchanged in IFRS 9. However, entities will now be required to reclassify the gains and losses accumulated in equity on a cash flow hedge to the carrying amount of a non-financial hedged item when it is initially recognised.

This was permitted under IAS 39, but entities could also choose to accumulate gains and losses in equity. Additional disclosures are required under the new standard.

Am I affected?

All entities that engage in risk management activities, regardless of whether they currently use hedge accounting, could potentially benefit from the changes to hedge accounting.

IFRS 9 is available for immediate application. The standard provides an accounting policy choice for an entity to continue to apply hedge accounting (and hedge accounting only) under IAS 39 instead of IFRS 9 until the IASB completes its separate macro hedging project.

Entities can elect to apply IFRS 9 for any of the following:

 The own credit risk requirements for financial liabilities.

 Classification and measurement (C&M) requirements for financial assets.

 C&M requirements for financial assets and financial liabilities.

 The full current version of IFRS 9 (that is, C&M requirements for financial assets and financial liabilities and hedge accounting).

The transitional provisions described above are likely to change once the IASB completes all phases of IFRS 9.

IFRS 9 applies retrospectively; however, hedge accounting is to be applied prospectively (with some exceptions).

What do I need to do?

It will be beneficial for entities to revisit their risk management strategies to assess whether more relationships might qualify for hedge accounting under IFRS 9. Entities should also carefully assess the IFRS 9 transitional provisions (described above) and decide whether to apply IFRS 9 or IAS 39 for hedge accounting. Each alternative could bring opportunities and challenges, for example:



Retaining IAS 39 hedge accounting might be beneficial for financial institutions that currently have macro hedges and do not want to change their hedge accounting practices in advance of the Board’s proposals in this area, but it will not have the benefits introduced by IFRS 9.

 On the other hand, IFRS 9 might be beneficial for non-financial entities that currently hedge risk components.

For those readers who are new to the topic, the next section introduces hedging:

What is hedging?

Whilst most businesses would like to earn profits without risk, such profits are rare. Therefore, businesses take risks to earn profits.

Many use risk management techniques to limit their risks. Having identified a risk in an asset, liability, contingent liability, or forward order, it seeks a way of limiting the risk if it cannot eliminate the risk. The method of risk management may increase costs or reduce costs.

If it uses additional assets, liabilities, contingent liabilities, forward orders or derivatives to reduce the risk, these are described as ‘hedging instruments’ and they are being used to reduce the risk in a ‘hedged item’.

Examples

Currency assets and liabilities

If an undertaking will receive 100 million Japanese Yen (a foreign currency) at the end of June, and owes the same amount to a supplier at the end of June,

The simple solution is to use the incoming funds to pay the supplier. The receivable asset is hedged by the payable liability.

This reduces the risk of losses on exchange in changing the Yen to its own currency. Also, it eliminates commission charges.

This is a perfect hedge, with all of the foreign exchange risk eliminated.

Taking the same example, but changing the supplier payment to the end of December complicates the decision. Holding the Yen for 6 months between the receipt and payment eliminates exchange risk and commissions, but may result in receiving lower interest payments if the national interest rate is higher than that of the Yen. Also, sufficient, local currency funds must be available during the 6 months to run the business without using the Yen.

Extending the example and changing the supplier payment to two payments (liabilities) for a total of 115 million Yen at the end of December will mean that 100 million Yen of the 2 liabilities are hedged, 15 million Yen is exposed to currency exchange loss. It will incur commissions when the currency is purchased.

This is a partial hedge and may be worthwhile as it avoids the costs of selling and buying 100 million Yen and the risk of exchange loss when aggregating the 2 transactions. The hedge comprises one asset and two liabilities.

Currency asset and a forward contract

An undertaking will receive US$60 million (a foreign currency) at the end of November, with no planned payable in US$. It decides to buy a forward contract (a commitment) to sell the US$60 million at an exchange rate that is fixed today. This eliminates exchange risk (including the chance to make an exchange profit). The contract will increase expenses as a cost of eliminating the exchange risk.

The hedged item is the currency asset, the hedging instrument is the forward contract.

A payment (liability) of the same amount with a forward commitment to buy US$60 million at an exchange rate that is fixed today would have a similar impact.

A futures contract

As an airline, your business needs to buy jet fuel to operate. The price of jet fuel changes daily. You need to fix the future cost of fuel to set your ticket prices. Your agent buys oil futures, firm contracts for standard amounts of standard quality for specific dates.

The contracts are traded in a futures exchange

A call (buy) option

The facts are as in ‘3 A futures contract’ above except that the agent does not have firm contracts. Instead, the agent buys options to pay a maximum of $120 per barrel of oil for a fixed number of barrels each month. These are rights, but not obligations, to buy fuel at a price of $120 each month.

If the market price is higher in any month, the agent will exercise the options and pay $120 per barrel. If the market price is below $120, the agent will buy in the market at the lower price. The option will not be exercised if the market price is lower than $120.

The call option has been purchased to provide a maximum price (a ‘cap’) for fuel bought at future dates. The price paid for the option is called the ‘premium’ and will be lost if the option is not exercised.

A put (sell) option

You have bought some equity shares as an investment. You have paid 140 each for the shares. The shares are volatile (move dramatically up and down in price). If the price goes up to 200, you will sell and make a profit. You want to limit potential losses, knowing that a fall in price may happen faster than you can react.

There are two methods of doing this. You can instruct your broker to sell the shares if the price falls to 100. This is called a ‘stop loss’ instruction. In a market crisis, the broker may fail to sell at 100, leaving you with additional losses.

The more-expensive alternative is to buy a put option to sell the shares at 100. You then have the right (but not the obligation) to sell the shares for 100, creating a minimum sales price (‘floor’) to limit your potential loss.

If the share price never falls to 100, the option is not exercised and the cost of the option is an additional expense (but has limited your risk).

Hedge of a net investment in a foreign operation

You decide to invest in an undertaking in South Africa (a foreign country). You accept the risk of doing business there, but are concerned that you have a long-term asset (your investment) in Rand. If the Rand falls in relation to your currency, your asset will fall in value in your currency.

One opportunity is to finance the investment by borrowing in Rand. Now, you have an asset in Rand and a matching liability. If the Rand rises (against your currency) the asset’s growth, in your currency, is matched by a growth in the liability (the loan). If the Rand falls, your asset will fall in value, but so will your liability and finance costs.

Whilst such a hedge may not be 100% effective over the life of the investment, it may reduce your risks to a level acceptable to make investments.

Asset Liability Management

Financial institutions which trade large quantities of financial instruments often have formal systems of Asset Liability Management.

A very simplistic structure would be a portfolio of assets matched (hedged) by a portfolio of liabilities (often borrowed money),

the difference from which they earn a profit. As individual assets and liabilities are sold or mature, or risks change, the portfolios have to be updated. The hedge is unlikely to be 100%, otherwise no profit will be earned, so there is a focus on the aspects that are not effectively hedged.

All businesses have to manage their balance sheets to have sufficient liquidity to pay their debts when they fall due.

Most Risk Management actions do not result in hedges

Many decisions taken to reduce risk, such as additional locks, more people added to building security, more personnel checks for new recruits, require standard accounting.

If an asset is hedged by a liability, both of which are marked to market at the reporting date, and gains and losses recognized in the profit and loss account, the accounting reflects the hedges. This would apply to our example of matching foreign currency trade receivables and payables, example 1 above.

The same would apply if both are reported at amortised cost. A company providing car loans and financing them with similar deposits,

both of which qualify to be accounted for under amortised cost.

Where accounting does not reflect risk management activities (and might qualify for hedging)

Where the hedged item and the hedging instruments have different accounting treatments, there may be a difference in time between the

gains and losses of one and the losses and gains of the other. This will cause phantom profits and losses that may be reversed over time.

The hedge of a net investment in a foreign operation reflects that the asset will be revalued and the gains and losses reflected directly in equity, whilst the foreign currency loan will reflect gains in the profit and loss account. If the investment is classified as an Equity instrument not held for trading, the gains and losses of the asset will never be reflected in the profit and loss account (except for impairments) – see bookkeeping section above- whilst the gains and losses of the financing loan will be.

Problems may also arise when the undertaking is expecting a major order and structures its finances in anticipation. The expected order cannot be recognized, but the restructured finances may cause gains and losses.

Example: Liability but no asset

Expecting an export order from Brazil, priced in Brazilian Reals, the undertaking sets up a Brazilian Real overdraft account that will be closed when the money is received from Brazil on completion of the order. This fixes an exchange rate for the order. However, there is no asset to revalue whilst it is still an expected order, whilst the overdraft liability will be revalued at every reporting date, creating phantom entries in the profit and loss account.

Alternatives to hedging

Hedges must be documented at the outset of the hedge activity and remeasured for hedging effectiveness at each reporting date. To avoid this extra work that hedges entail, there may be other alternatives to hedging. The risk management has priority over the accounting, but the activity may be able to be structured to meet its goals without the need for hedging.

Normally, the hedged items have been identified and cannot be changed, but there may be alternative hedging instruments that can be used without losing effectiveness.

Another example is the choice, under IAS 39 and IFRS 9, to designate a financial asset or liability as classified as at Fair Value Through Profit and Loss to provide matching. If this option can be applied, both asset and liability will be marked to market at the balance sheet date, the losses of one matching the profits of the other.

Hedging benefits

Cash flow hedges example:

Hedges of the foreign currency risk associated with firm commitments may be designated as cash flow hedges. The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge is recognised directly in equity.

Net investment in a foreign operation hedge (see example 6 above)

Fair value hedge example: If you hold a fixed rate bond, changes of interest rates will affect the fair value of the bond (the fixed rate will become more or less attractive to traders).The hedging of a fixed–interest loan against changes in fair value due to changes in the market interest rate by a payer using an interest swap, or the hedging of credit risk or interest risk during the fixed interest period of a variable interest bond.

The benefit of hedge accounting for cash flow and net investment in a foreign operation hedges is that unrealised gains and losses on any component of the hedge can be held in equity, rather then being posted into the income statement, until the hedge is ended.

Only at the end of the hedge will any net gain or loss impact the income statement.

Fair value hedges enable unrealised gains and losses of the hedging instrument and its matching asset or liability to be taken to the income statement together.

The hedging details of IFRS 9

Objective and scope of hedge accounting

The objective of hedge accounting is to represent, in the financial statements, the effect of an undertaking’s risk management activities that use financial instruments to manage exposures arising from particular risks that could affect profit or loss (or other comprehensive income).

An undertaking may choose to designate a hedging relationship between a hedging instrument and a hedged item.

When the hedged item is a group of items, an undertaking shall comply with the additional requirements below.

For a fair value hedge of the interest rate exposure of a portfolio of financial assets or financial liabilities (and only for such a hedge), an undertaking may apply the hedge accounting requirements in IAS 39 (see IFRS 32/39 workbook 4) instead of those in IFRS 9.

Hedging instruments

Qualifying instruments

A derivative measured at fair value through profit or loss may be designated as a hedging instrument, except for some written options.

A non-derivative financial asset, or a non-derivative financial liability, measured at fair value through profit or loss may be designated as a

hedging instrument, unless it is a financial liability designated as at fair value through profit or loss for which the amount of its change in fair value that is attributable to changes in the credit risk of that liability is presented in other comprehensive income.

For a hedge of foreign currency risk, the foreign currency risk component of a non-derivative financial asset or a non-derivative

financial liability may be designated as a hedging instrument provided that it is not an investment in an equity instrument for which an undertaking has elected to present changes in fair value in other comprehensive income.

Only contracts with a party external to the reporting undertaking (ie external to the group, or individual undertaking) can be designated as hedging instruments.

Designation of hedging instruments

A qualifying instrument must be designated in its entirety as a hedging instrument. The only exceptions permitted are:

(a) separating the intrinsic value and time value of an option contract and designating as the hedging instrument only the change in intrinsic value of an option (and not the change in its time value);

(b) separating the forward element and the spot element of a forward contract and designating as the hedging instrument only the change in the value of the spot element of a forward contract (and not the forward element); similarly, the foreign currency basis spread may be separated and excluded from the designation of a financial instrument as the hedging instrument; and

(c) a proportion of the entire hedging instrument, such as 50 per cent of the nominal amount, may be designated as the hedging instrument in a hedging relationship, (but not for a part of its change in fair value that results from only a portion of the time period during which the hedging instrument remains outstanding).

An undertaking may jointly designate as the hedging instrument, any combination of the following:

(a) derivatives or a proportion of them; and

(b) non-derivatives or a proportion of them.

except, a derivative instrument that combines a written option and a purchased option, nor a net written option at the date of designation.

Hedged items

Qualifying items

A hedged item can be a recognised asset or liability, an unrecognised firm commitment, a forecast transaction or a net investment in a foreign operation. The hedged item can be:

(a) a single item; or

(b) a group of items or a hedged item can also be a component of such an item or group of items.

If a hedged item is a forecast transaction, that transaction must be highly probable.

An aggregated exposure that is a combination of an exposure that could qualify as a hedged item and a derivative may be designated as a hedged item.

Hedge accounting can be applied to transactions between undertakings in the same group only in the individual or separate financial statements of those undertakings and not in the consolidated financial statements of the group, except where transactions between an investment undertaking and its subsidiaries measured at fair value through profit or loss will not be eliminated in the consolidated financial statements.

Exception: the foreign currency risk of an intragroup monetary item (for example, a payable/receivable between two subsidiaries) may qualify as a hedged item in the consolidated financial statements, if it results in an exposure to foreign exchange rate gains or losses that are not fully eliminated on consolidation.

Designation of hedged items

An undertaking may designate an item in its entirety, or a component of an item, as the hedged item.

An entire item comprises all changes in the cash flows or fair value of an item.

Using a component, an undertaking may designate only the following types of components (including combinations) as hedged items:

(a) only changes in the cash flows or fair value of an item attributable to a specific risk, or risks, (risk component), provided that the risk component is separately identifiable and reliably measurable.

(b) one or more selected contractual cash flows.

Qualifying criteria for hedge accounting

A hedging relationship qualifies for hedge accounting only if all of the following criteria are met:

(a) the hedging relationship consists only of eligible hedging instruments and eligible hedged items.

(b) at the inception of the hedging relationship, there is formal designation and documentation of the hedging relationship and

the undertaking’s risk management objective and strategy for undertaking the hedge.

That documentation shall include identification of the hedging instrument, the hedged item, the nature of the risk being hedged and how the undertaking will assess whether the hedging relationship meets the hedge effectiveness requirements (including its analysis of the sources of hedge ineffectiveness, and how it determines the hedge ratio).

(i) there is an economic relationship between the hedged item and the hedging instrument;

(ii) the effect of credit risk does not dominate the value changes that result from that economic relationship

(iii) the hedge ratio of the hedging relationship is the same as the ratio of hedged item and hedging instrument.

Accounting for qualifying hedging relationships

There are three types of hedging relationships:

(a) fair value hedge: a hedge of the exposure to changes in fair value of a recognised asset, or liability, or an unrecognised firm

commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss.

(b) cash flow hedge: a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or

a component of, a recognised asset or liability (such as all or some future interest payments on variable-rate debt) or a highly-probable forecast transaction, and could affect profit or loss.

If the hedged item is an equity instrument for which changes in fair value appear in other comprehensive income, the hedged exposure must be one that could affect other comprehensive income. In that case, and only in that case, the recognised hedge ineffectiveness is presented in other comprehensive income.

A hedge of the foreign currency risk of a firm commitment may be accounted for as a fair value hedge, or a cash flow hedge.

If a hedging relationship ceases to meet the hedge effectiveness requirement relating to the hedge ratio, but the risk management objective remains the same, an undertaking shall adjust the hedge ratio of the hedging relationship so that it meets the qualifying criteria again ( ‘rebalancing’).

An undertaking shall discontinue hedge accounting prospectively only when the hedging relationship (or a part of a hedging relationship) ceases to meet the qualifying criteria.

This includes instances when the hedging instrument expires or is sold, terminated or exercised. The replacement, or rollover, of a hedging instrument into another hedging instrument is not an expiration, or termination, if it is consistent with the undertaking’s risk management objective.

For this purpose there is not an expiration, or termination, of the hedging instrument if:

(a) due to laws or regulations, the parties to the hedging instrument agree that one or more clearing counterparties replace their original counterparty to become the new counterparty to each of the parties.

When the parties replace their original counterparties, the requirement is met only if each of those parties effects clearing with the same central counterparty.

(b) other changes, if any, to the hedging instrument are limited to those that are necessary to effect such a replacement of the counterparty. Such changes are limited to those that are consistent with the terms that would be expected if the hedging instrument were originally cleared with the clearing counterparty.

An undertaking shall:

(a) transfer gains and losses to profit and loss when it discontinues hedge accounting for a fair value hedge for which the hedged item is (or is a component of) a financial instrument measured at amortised cost; and

(b) amounts shall be immediately reclassified from the cash flow hedge reserve to profit or loss as a reclassification adjustment (through other comprehensive income) when it discontinues hedge accounting for cash flow hedges.

Fair value hedges

The hedging relationship shall be accounted for as follows:

(a) the gain or loss on the hedging instrument shall be recognised in profit or loss (or other comprehensive income, if the hedging

instrument hedges an other comprehensive income equity instrument).

(b) the gain or loss on the hedged item shall adjust the carrying amount of the hedged item (if applicable) and be recognised in profit or loss. However, if the hedged item is an other comprehensive income equity instrument, those amounts shall remain in other comprehensive income.

When a hedged item is an unrecognised firm commitment, the cumulative change is recognised as an asset or a liability, with a corresponding gain or loss recognised in profit or loss.

Cash flow hedges shall be accounted for as follows:

(a) the separate component of equity associated with the hedged item (cash flow hedge reserve) is adjusted to the lower of the following

(in absolute amounts):

(i) the cumulative gain or loss on the hedging instrument from inception of the hedge; and

(ii) the cumulative change in fair value (present value) of the hedged item (ie the present value of the cumulative change

in the hedged expected future cash flows) from inception of the hedge.

(b) the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge (ie the portion that is offset by

the change in the cash flow hedge reserve calculated in accordance with (a)) shall be recognised in other comprehensive income.

(c) any remaining gain or loss on the hedging instrument (or any gain or loss required to balance the change in the cash flow hedge

reserve calculated in accordance with (a)) is hedge ineffectiveness and shall be recognised in profit or loss.

(d) the amount that has been accumulated in the cash flow hedge reserve in accordance with (a) shall be accounted for as follows:

(i) if a forecast transaction results in the recognition of a non-financial asset or non-financial liability, the undertaking shall remove that amount from the cash flow hedge reserve and include it directly in the initial cost, or other carrying amount, of the asset or the liability.

This is not a reclassification adjustment (see IAS 1) and hence it does not affect other comprehensive income.

(ii) for cash flow hedges other than those covered by (i), that amount shall be reclassified from the cash flow hedge reserve to profit or loss as a reclassification adjustment (see IAS 1) in the same period, or periods, during which the hedged expected future cash flows affect profit or loss (for example, in the periods that interest income, or interest expense, is recognised or when a forecast sale occurs).

(iii) however, if that amount is a loss and an undertaking expects that all or a portion of that loss will not be recovered in one or more future periods, it shall immediately reclassify the amount that is not expected to be recovered into profit or loss as a reclassification adjustment (see IAS 1).

When an undertaking discontinues hedge accounting for a cash flow hedge, it shall account for the amount that has been accumulated in the cash flow hedge reserve as follows:

(a) if the hedged future cash flows are still expected to occur, that amount shall remain in the cash flow hedge reserve until the future cash flows occur.

(b) if the hedged future cash flows are no longer expected to occur, that amount shall be immediately reclassified from the cash flow hedge reserve to profit or loss as a reclassification adjustment (see IAS 1). A hedged future cash flow that is no longer highly probable to occur may still be expected to occur.

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), shall be accounted for similarly to cash flow hedges:

(a) the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge shall be recognised in other

comprehensive income; and

(b) the ineffective portion shall be recognised in profit or loss.

The cumulative gain or loss on the hedging instrument relating to the effective portion of the hedge that has been accumulated in the foreign currency translation reserve shall be reclassified from equity to profit or loss as a reclassification adjustment (see IAS 1) on the disposal, or partial disposal, of the foreign operation.

Hedges of a group of items

Eligibility of a group of items as the hedged item

A group of items (including a group of items that constitute a net position) is an eligible hedged item only if:

(a) it consists of items (including components of items) that are, individually, eligible hedged items;

(b) the items in the group are managed together on a group basis for risk management purposes; and

(c) in the case of a cash flow hedge of a group of items whose variabilities in cash flows are not expected to be approximately

proportional to the overall variability in cash flows of the group so that offsetting risk positions arise:

(i) it is a hedge of foreign currency risk; and

(ii) the designation of that net position specifies the reporting period in which the forecast transactions are expected to affect profit or loss, as well as their nature and volume.

Presentation

For a hedge of a group of items with offsetting risk positions (ie in a hedge of a net position) whose hedged risk affects different line items in the statement of profit or loss and other comprehensive income, any hedging gains or losses in that statement shall be presented in a separate line from those affected by the hedged items. Hence, in that statement the amount in the line item that relates to the hedged item itself (for example, revenue or cost of sales) remains unaffected.

For assets and liabilities that are hedged together as a group in a fair value hedge, the gain or loss in the statement of financial position on the individual assets and liabilities shall be recognised as an adjustment of the carrying amount of the respective individual items comprising the group.

Option to designate a credit exposure as measured at fair value through profit or loss

Eligibility of credit exposures for designation at fair value through profit or loss

If an undertaking uses a credit derivative that is measured at fair value through profit or loss to manage the credit risk of all, or a part of, a financial instrument (credit exposure) it may designate that financial instrument to the extent that it is so managed (ie all or a proportion of it) as measured at fair value through profit or loss if:

(a) the name of the credit exposure (for example, the borrower, or the holder of a loan commitment) matches the reference undertaking of the credit derivative (‘name matching’); and

(b) the seniority of the financial instrument matches that of the instruments that can be delivered in accordance with the credit derivative.

Accounting for credit exposures designated at fair value through profit or loss

If a financial instrument is designated as measured at fair value through profit or loss after its initial recognition, the difference at the time of designation between the carrying amount, if any, and the fair value shall immediately be recognised in profit or loss.

An undertaking shall discontinue measuring the financial instrument that gave rise to the credit risk, or a proportion of that financial instrument, at fair value through profit or loss if:

(a) the qualifying criteria are no longer met,

(b) the financial instrument that gives rise to the credit risk is not otherwise required to be measured at fair value through profit or loss.

A financial asset that had originally been classified as measured at amortised cost would revert to that measurement and its effective interest rate would be recalculated based on its new carrying amount on the date of discontinuing measurement at fair value

through profit or loss. Similarly, a loan commitment or a financial guarantee contract would be measured at the higher of:

(a) the amount determined in accordance with IAS 37; and

(b) the new carrying amount at the date of discontinuation less cumulative amortisation. The amortisation period is the remaining life of the instrument.

Difference Between Fair Value Hedge and Cash Flow Hedge

The first thing you need to do is to determine the TYPE of hedge relationship with which you are dealing.

The type of hedge determines your accounting entries.

Types of hedges

We have:

Fair Value Hedge;

Cash Flow Hedge, and

Hedge of a Net Investment in a Foreign Operation –it has almost the same mechanics as a cash flow hedge.

Fair Value Hedge

Fair value hedge is a hedge of the exposure to changes in fair value of a recognized asset, liability, or unrecognized firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss.

So here, you have some “fixed item” and you are worried that its value will fluctuate with the market.

How to Account for a Fair Value Hedge?

You need to make the following steps:

Step 1:
Determine the fair value of both your hedged item and hedging instrument at the reporting date;
Step 2:
Recognize any change in fair value (gain or loss) on the hedging instrument in profit or loss (in most cases). You need to do the same in most cases even if you do not apply the hedge accounting, because you need to measure all derivatives (your hedging instruments) at fair value anyway.
Step 3:
Recognize the hedging gain, or loss, on the hedged item in its carrying amount.

Accounting entries for a fair value hedge:

(A gain (or loss) on the hedged item will be offset by a loss (or gain) on the hedging instrument)

Description	Debit	Credit
*Hedging instrument:*
Loss on the hedging instrument	P/L – FV loss on hedging instrument	FP – Financial liabilities from hedging instruments
OR
Gain on the hedging instrument	FP – Financial assets from hedging instruments	P/L – FV gain on hedging instrument
*Hedged item:*
Gain on the hedged item	FP – Hedged item (e.g. inventories)	P/L – Gain on the hedged item
OR
Loss on the hedged item	P/L – Loss on the hedged item	FP – Hedged item (e.g. inventories)

Note: P/L = profit or loss, FP = statement of financial position.

What is a Cash Flow Hedge?

Cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognized asset, or liability, or a highly probable forecast transaction, and could affect profit or loss.

Here, you have some ”variable item” and you’re worried that you might receive less money, or have to pay more money in the future than now.

Equally, you can have a highly-probable forecast transaction that has not been recognized in your accounts yet.

How to Account for a Cash Flow Hedge?

Assuming your cash flow hedge meets all hedge accounting criteria, you will need to make the following steps:

Step 1:
Determine the gain, or loss, on your hedging instrument and hedge item at the reporting date;
Step 2:
Calculate the effective, and ineffective, portions of the gain, or loss, on the hedging instrument;
Step 3:
Recognize the effective portion of the gain, or loss, on the hedging instrument in other comprehensive income (OCI). This item in OCI will be called “Cash flow hedge reserve” in OCI and equity.
Step 4:
Recognize the ineffective portion of the gain, or loss, on the hedging instrument in profit or loss.
Step 5:
Deal with a cash flow hedge reserve, when necessary. You would do this step basically when the hedged expected future cash flows affect profit or loss, or when a hedged forecast transaction occurs.

To sum up the accounting entries for a cash flow hedge:

Description	Debit	Credit
Loss on the hedging instrument – effective portion	OCI – Cash flow hedge reserve	FP – Financial liabilities from hedging instruments
Loss on the hedging instrument – ineffective portion	P/L – Ineffective portion of loss on hedging instrument	FP – Financial liabilities from hedging instruments
OR
Gain on the hedging instrument – effective portion	FP – Financial assets from hedging instruments	OCI – Cash flow hedge reserve
Gain on the hedging instrument – ineffective portion	FP – Financial assets from hedging instruments	P/L – Ineffective portion of gain on hedging instrument

Note: P/L = profit or loss, FP = statement of financial position, OCI = other comprehensive income.

As you can see, you do not even touch the hedged item here and you only deal with the hedging instrument. So this is completely different from fair value hedge accounting.

How to Distinguish Fair Value Hedge and Cash Flow Hedge?

Please, ask first:

What kind of item are we hedging?

Basically, you can hedge a fixed item, or a variable item.

Fixed items:

Fixed-interest loan

Fixed-interest bonds

Inventories

Unrecognised firm commitments

Variable items:

Variable-interest loan

Variable-interest bonds

Forecast transactions

Hedging a Fixed Item

A fixed item means that the item has a fixed value in your accounts and it may provide, or require, a fixed amount of cash in the future.

The same applies for unrecognized firm commitments that have not been sitting in your accounts yet, but they will be in the future.

And when it comes to hedging fixed items, then you’re practically dealing with the fair value hedge.

Why is that?

Well, here, you are worried, that in the future, you would be paying or receiving a different amount than the market or fair value will be. So you do not want to FIX the amount, you want to RECEIVE or PAY exactly the market price.

You are worried that the item will have a different carrying amount in your books that its fair value.

Fair Value Hedge Example

You issued some bonds with coupon 2% p.a.

It is nice that you always know how much you will pay in the future.

BUT you are worried that in the future, market interest rate will be much lower than 2% and you will be overpaying (in other words, you could sell the loan at much lower interest in the future than you will be paying at the fixed rate of 2%).

Therefore, you enter into an interest rate swap to receive 2% fixed / pay LIBOR12M + 0.5% (M= months). This is a fair value hedge – you tied the fair value of your interest payments to market rates.

Hedging a Variable Item

A variable item means that the expected future cash flows from this item change as a result of certain risk exposure, for example, variable interest rates, or foreign currencies.

When it comes to hedging variable items, you are practically speaking of a cash flow hedge.

Here, you are worried that you will receive, or pay, a different amount of money in certain currency in the future that you would now.

In fact, in a cash flow hedge, you want to FIX the amount of money you will receive or pay – so that this amount would be the same NOW as IN THE FUTURE.

Cash Flow Hedge Example

You issued some bonds with coupon LIBOR 12M+0.5% (M= months).

It means that in the future, you will pay interest in line with the market, because LIBOR reflects the market conditions.

BUT – you do not want to pay in line with market. You want to know how much you will pay in the future, as you need to make some budget, etc.

Therefore you enter into interest rate swap to receive LIBOR 12 M + 0.5% / pay 2% fixed. This is cash flow hedge – you fixed your cash flows and you will always pay 2%.

Summary

The same derivative – interest rate swap – can be a hedging instrument in a cash flow hedge as well as in a fair value hedge.

The key to differentiate is WHAT RISK you hedge. Always ask yourself, why you are undertake the hedging operation.

If you wish to change a Fixed Instrument into a Variable Instrument, use a fair value hedge.

If you want to change a Variable Instrument into a Fixed Instrument, use a cash flow hedge.

There are some exceptions:

For example, even when you have a fixed item, you can still hedge it under cash flow hedge to protect it against foreign currency risk.

Equally, you can hedge a variable rate debt against fair value changes – and that is the fair value hedge.

Therefore, please refer to the following table summarizing the types of hedges according to risks and items hedged:

Item hedged	Risk hedged	Type of hedge
Fixed-rate assets and liabilities	Interest rates, Fair value, Termination Options	Fair value hedge
Fixed-rate assets and liabilities	Foreign currency, credit risk	Fair value hedge or cash flow hedge
Unrecognized firm commitments	Interest rates, Fair value, Credit risk	Fair value hedge
Unrecognized firm commitments	Foreign currency	Fair value hedge or cash flow hedge
Variable-rate assets and liabilities	Fair value, termination options	Fair value hedge
Variable-rate assets and liabilities	Interest rates, foreign currencies, credit risk	Cash flow hedge (in most cases)
Highly probable forecast transactions	Fair value, interest rates, credit risk, foreign currency	Cash flow hedge

Summary

The table below gives an overview of the accounting treatment of each category of financial assets:

sset category	Measurement	Fair value changes
At amortised cost	Initial recognition at fair value Subsequent recognition at amortised cost less impairment. Any premium or discount is amortised to profit or loss	Not relevant unless impaired Interest income, impairment and foreign exchange gains/losses recognised in profit or loss. Impairment can be reversed through profit or loss
At FVTPL	Fair value	Changes in fair value recorded in profit or loss No impairment recorded
At FVOCI	Fair value	Changes in fair value recorded in OCI For debt instruments: interest revenue, credit impairment and foreign exchange gains or losses recognised in profit or loss. On derecognition any cumulative gains and losses in OCI reclassified to profit or loss For equity investments: no impairment is recorded. Dividends recorded in profit or loss

sset category

Measurement

Fair value changes

At amortised cost

Initial recognition at fair value

Subsequent recognition at amortised cost less impairment. Any premium or discount is amortised to profit or loss

Not relevant unless impaired

Interest income, impairment and foreign exchange gains/losses recognised in profit or loss. Impairment can be reversed through profit or loss

At FVTPL

Fair value

Changes in fair value recorded in profit or loss

No impairment recorded

At FVOCI

Fair value

Changes in fair value recorded in OCI

For debt instruments: interest revenue, credit impairment and foreign exchange gains or losses recognised in profit or loss. On derecognition any cumulative gains and losses in OCI reclassified to profit or loss

For equity investments: no impairment is recorded. Dividends recorded in profit or loss

Summary of Reclassification

Reclassification to
Asset category	Amortised cost	FVOCI	FVTPL
From: At amortised cost	N/A	Remeasure at fair value with any difference in OCI The effective interest rate determined at initial recognition remains unchanged	New carrying amount is the fair value on reclassification date Any difference between amortised cost and fair value is recognised in profit or loss
From: At FVOCI	Accumulated OCI recycled out of equity, with offsetting entry against fair value carrying amount Adjusted carrying amount is existing amortised cost The effective interest rate determined at initial recognition remains unchanged	N/A	Accumulated OCI amount recycled to profit or loss Asset continues to be measured at fair value Subsequent changes in fair value recognised in profit or loss
From: At FVTPL	New amortised cost is the fair value on reclassification date The effective interest rate is calculated	Asset continues to be measured at fair value Subsequent changes in fair value recognised in OCI The effective interest rate is calculated	N/A

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Workbook on IFRS 9 Financial Instruments

Introduction

Initial recognition and measurement of financial assets

Amortised Cost

Measurement

Fair value through OCI, (introduced 24 July 2014)

Investments in equity instruments (Special exception)

Classification of the undertaking’s business model for managing financial assets

Liquidation before maturity – put options

Measurement - Initial measurement of financial assets

Subsequent measurement of financial assets

Investments in unquoted equity instruments (and contracts on those investments that must be settled by delivery of the unquoted equity instruments)

Reclassification

Gains and losses on foreign exchange

Collateral (including REPO’s)

Financial Liabilities

Derecognition of financial assets and liabilities

Bookkeeping for Financial Instruments

Securitisation

Embedded derivatives

Hedge accounting

What is hedging?

The hedging details of IFRS 9

Difference Between Fair Value Hedge and Cash Flow Hedge

How to Distinguish Fair Value Hedge and Cash Flow Hedge?

Summary

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