Embedded derivatives best 1 to read

Embedded derivatives are a component of a hybrid contract that also includes a non-derivative host, so some cash flows vary similar to a stand alone derivative

Designated hedged items – best complete IFRS 9 read

Designated hedged items

This narrative provides an overview of the eligible hedged items that are permitted in IFRS 9.

Definition of hedged item

Under IFRS 9, 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:Designated hedged items

  • A single item, or
  • A group of items.

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

Risk components of non-financial items

Under IFRS 9, risk components of financial items (such as the SONIA rate (replacement of LIBOR rate) in a loan that bears interest at a floating rate of SONIA plus a spread) could be designated as a hedged item, provided they are separately identifiable and reliably measurable and risk components can be designated for non-financial hedged items, provided the component is separately identifiable and the changes in fair value or cash flows of the item attributable to the risk component are reliably measurable. This requirement could be met where the risk component is either explicitly stated in a contract (contractually specified) or implicit in the fair value or cash flows (non-contractually specified).

Entities that hedge commodity price risk that is only a component of the overall price risk of the item, are likely to welcome the ability to hedge separately identifiable and reliably measurable components of non-financial items.

In practice

An example of a contractually specified risk component that exists in practice is a contract to purchase a product (such as aluminium cans), in which a metal (such as aluminium) is used in the production process. Contracts to purchase aluminium cans are commonly priced by market participants based on a building block approach, as follows:

  • The first building block is the London Metal Exchange (LME) price for a standard grade of aluminium ingot.
  • The next building block is the grade premium or discount to reflect the quality of aluminium used, as compared to the standard LME grade.
  • Additional costs will be paid for conversion from ingot into cans and delivery costs.
  • The final building block is a profit margin for the seller.

Many entities may want to use aluminium LME futures or forwards to hedge their price exposure to aluminium. However, IAS 39 did not allow just the LME component of the price to be the hedged item in a hedge relationship. All of the pricing elements had to be designated as being hedged by the LME future.

This caused ineffectiveness, which was recorded within P&L; and, in some cases, it caused sensible risk management strategies to fail to qualify for hedge accounting. By contrast, IFRS 9 allows entities to designate the LME price as the hedged risk, provided it is separately identifiable and reliably measurable.

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Designated hedging instruments under IFRS 9

Designated hedging instruments

Most derivative financial instruments can be designated as hedging instruments, provided they are entered into with an external party. Intra-group derivatives or other balances do not qualify as hedging instruments in consolidated financial statements irrespective of whether a proposed hedging instrument, such as an intercompany borrowing, will affect consolidated profit or loss. But they might qualify in the separate financial statements of individual entities in the group.

The main changes to hedging instruments in IFRS 9 are: how to account for the time value of options; the interest element of forward contracts; and the currency basis of cross-currency swaps when used as hedging instruments.

Derivative financial instruments

IFRS 9 contains no restrictions regarding the circumstances in which a derivative can be designated as a hedging instrument (provided the hedge accounting criteria are met), except for some written options.

– Non-derivative financial instruments measured at fair value through P&L

Under IFRS 9, non-derivative financial instruments are allowed as hedging instruments of foreign currency risk provided that such non-derivative financial instruments are not investments in equity instruments for which the entity has elected to present the changes in fair value in OCI.

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Fair Value Hedges in IFRS 9

Fair Value Hedges

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

Fair value hedges recognize the change in fair value of the hedged item in the current reporting period to offset the change in the related hedging instrument. Therefore, there is earlier recognition of the fair value change in the hedged item than if hedge accounting was not applied.

For example, inventory is ordinarily measured at the lower of net realizable value and cost. A farming company withFair Value Hedges cattle inventory could seek to hedge its commodity price risk with a forward contract for the sale of its cattle. This derivative would be measured at FVPL. Any increase in the market price of the cattle would result in a loss on the derivative.

However, without applying hedge accounting, the increase in the fair value of the cattle inventory would not be recognized until the physical inventory is sold. Conversely, designation of a fair value hedging relationship would allow the Company to record the impact of the change in market prices for the cattle in profit or loss on both the derivative and its physical inventory to accurately reflect the company’s risk management practices.

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Cash Flow Hedges in IFRS 9

Cash Flow Hedges

In short – A 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.

Without hedge accounting, there is a mismatch in the timing of when the gains or losses arising from the change in cash flows of the hedging instrument and hedged item are reflected in profit or loss. The change in the cash flows of the hedging instrument is recognized prior to that for the hedged item. With hedge accounting, the gains or losses arising from the change in cash flows of the hedging instrument are accumulated and held in a separate component of equity until the hedged item is recognized. Therefore, a cash flow hedge delays the recognition of the change in cash flows related to the hedging instrument.

Example of a Cash Flow Hedge

ABC Credit Union provides member loans bearing interest at variable rates. The variable-rate member loans areIFRS 9 Cash Flow Hedges measured at amortized cost. The Credit Union hedges its exposure to changes in market interest rates using an interest rate swap that pays out a variable interest rate in exchange for receiving a fixed interest rate.

Assessment: In effect, the Credit Union has converted the variable rate loan assets into fixed rate loan assets and hedged their exposure to changes in market interest rates.

If hedge accounting is not applied, a decrease in market interest rates would result in a gain on the swap which is recognized in profit or loss because the swap is a derivative. Since the member loans are measured at amortized cost there would be no change in their stated value. Accordingly, an earnings mismatch results. It is this mismatch that cash flow hedge accounting aims to address by recognizing the effective portion of the change in the swap in a separate cash flow hedge reserve in equity until the actual cash flows of the loan assets affects profit or loss.

When cash flow hedge accounting is applied, the effective portion of the gains or losses on the hedging instrument is recognized in Other comprehensive income (‘OCI’). These gains or losses are accumulated in a separate component of equity known as the cash flow hedge reserve. The ineffective portion of the gains or losses on the hedging instrument is recognized in profit or loss.

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Example Disclosure financial instruments

Example Disclosure financial instruments

The guidance for this example disclosure financial instruments is found here.

7 Financial assets and financial liabilities

This note provides information about the group’s financial instruments, including:

  • an overview of all financial instruments held by the group
  • specific information about each type of financial instrument
  • accounting policies
  • information about determining the fair value of the instruments, including judgements and estimation uncertainty involved.

The group holds the following financial instruments: [IFRS 7.8]

Amounts in CU’000

Notes

2020

2019

Financial assets

Financial assets at amortised cost

– Trade receivables

7(a)

15,662

8,220

– Other financial assets at amortised cost

7(b)

4,598

3,471

– Cash and cash equivalents

7(e)

55,083

30,299

Financial assets at fair value through other comprehensive income (FVOCI)

7(c)

6,782

7,148

Financial assets at fair value through profit or loss (FVPL)

7(d)

13,690

11,895

Derivative financial instruments

– Used for hedging

12(a)

2,162

2,129

97,975

63,162

Example Disclosure financial instruments

Financial liabilities

Liabilities at amortised cost

– Trade and other payables1

7(f)

13,700

10,281

– Borrowings

7(g)

97,515

84,595

– Lease liabilities

8(b)

11,501

11,291

Derivative financial instruments

– Used for hedging

12(a)

766

777

Held for trading at FVPL

12(a)

610

621

124,092

107,565

The group’s exposure to various risks associated with the financial instruments is discussed in note 12. The maximum exposure to credit risk at the end of the reporting period is the carrying amount of each class of financial assets mentioned above. [IFRS 7.36(a), IFRS 7.31, IFRS 7.34(c)]

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Derivative meaning for IFRS 9

Derivative meaning

A derivative, by definition, is a financial instrument or other contract within the scope 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.

Accounting

A derivative financial asset is always classified as held at fair value through profit or loss (FVPL).

A derivative financial liability is also always classified as held at fair value through profit or loss (FVPL).

Always is at initial recognition and subsequent measurement

Fair value changes of a derivative financial liability attributable to own credit risk is recognized in OCI except if this creates or enlarges an accounting mismatch.

Example derivatives

Typical examples of derivatives are futures and forward, swap and option contracts. A derivative usually has a notionalDerivative meaning amount, which is an amount of currency, a number of shares, a number of units of weight or volume or other units specified in the contract. However, a derivative instrument does not require the holder or writer to invest or receive the notional amount at the inception of the contract.

Alternatively, a derivative could require a fixed payment or payment of an amount that can change (but not proportionally with a change in the underlying) as a result of some future event that is unrelated to a notional amount. For example, a contract may require a fixed payment of CU1,000 if six-month LIBOR increases by 100 basis points. Such a contract is a derivative even though a notional amount is not specified.

Gross/Net Settlement

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Accounting for macro hedging

Accounting for macro hedging – Financial institutions, particularly retail banks, have as a core business, the collection of funds by depositors that are subsequently invested as loans to customers. This typically includes instruments such as current and savings accounts, deposits and borrowings, loans and mortgages that are usually accounted for Read more

Excellent Study IFRS 9 Eligible Hedged items

IFRS 9 Eligible Hedged items

the insured items of business risk exposures

Although the popular definition of hedging is an investment taken out to limit the risk of another investment, insurance is an example of a real-world hedge.

Every entity is exposed to business risks from its daily operations. Many of those risks have an impact on the cash flows or the value of assets and liabilities, and therefore, ultimately affect profit or loss. In order to manage these risk exposures, companies often enter into derivative contracts (or, less commonly, other financial instruments) to hedge them. Hedging can, therefore, be seen as a risk management activity in order to change an entity’s risk profile.

The idea of hedge accounting is to reduce (insure) this mismatch by changing either the measurement or (in the case of certain firm commitments) FRS 9 Eligible Hedged itemsrecognition of the hedged exposure, or the accounting for the hedging instrument.

The definition of a Hedged item

A hedged item is an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that

  1. exposes the entity to risk of changes in fair value or future cash flows and
  2. is designated as being hedged

The hedge item can be:

Only assets, liabilities, firm commitments and forecast transactions with an external party qualify for hedge accounting. As an exception, a hedge of the foreign currency risk of an intragroup monetary item qualifies for hedge accounting if that foreign currency risk affects consolidated profit or loss. In addition, the foreign currency risk of a highly probable forecast intragroup transaction would also qualify as a hedged item if that transaction affects consolidated profit or loss. These requirements are unchanged from IAS 39.

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Hedge accounting under IFRS 9

Hedge accounting If investors purchase a high level of risk security, they may want to reduce risk with an opposing item purchase referred to as a hedge