Chapter 15 - Derivatives Accounting PDF

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Theory of Accounts Practical Accounting 1null15BLUE NOTESUSLCHAPTERDerivatives is a financial instrument that derives its value from the movement in commodity price, foreign exchange rate and interest rate of an underlying asset or financial instrumentPurpose of a Derivative to manage financial ris...

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BLUE NOTES

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Derivatives is a financial instrument that derives its value from the movement in commodity price, foreign exchange rate and interest rate of an underlying asset or financial instrument

Purpose of a Derivative  to manage financial risk Characteristic of a Derivative:

Types Of Financial Risk:

 must contain an underlying and a notional  requires either no initial net investment or an initial investment that is smaller than would be required for other types of contracts that have a similar response to change in market factors  readily settled at a future date by a net cash payment

   

price risk credit risk interest rate risk foreign currency risk

Measurement of Derivatives  shall be recognized as either assets or liabilities at fair value  fair value and notional amount shall be fully disclosed

Treatment of Gain or Loss Arising from Change in Fair Value of a Derivative 1. Derivative is not designated as a hedging instrument  changes in fair value are recognized in profit or loss 2. Derivative is designated as a cash flow hedge  changes in fair value are recognized as a component of other comprehensive income to the extent that the hedge is effective  ineffective portion is recognized in profit or loss 3. Derivative is designated as a fair value hedge  changes in fair value are recognized in profit or loss Stand-Alone Derivatives are financial instruments that are separate from the primary financial

instruments.

Common Forms Of Stand-Alone Derivatives: A. Interest rate swap is a contract whereby two parties agree to exchange cash flows for future interest payments based on a contract of loan B. Forward contract is a commitment to purchase or sell a specified commodity on a future date at a specified price. Parties know each other C. Futures contract is a contract to purchase or sell a specified commodity at some future date at a specified price. One party does not know the entity of the other party D. Option is a contract that gives the holder the right to purchase or sell an asset at a specified price during a definite period at some future time. It is a right not an obligation Call option – right to purchase Put option – right to sell E. Foreign currency forward contract is a contract entered into for protection against foreign currency risk Theory of Accounts Practical Accounting 1

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USL Blue Notes

Chapter 15 - Derivatives

Embedded Derivative is a component of a hybrid or combined contract that also includes a non-derivative host contract with the effect that some of the cash flows of the combined contract vary in a way similar to a stand-alone instrument. Examples of embedded derivatives:  equity conversion option in a convertible bond instrument  redemption option in an investment in redeemable preference share  investment in bond whose interest or principal payment is linked to the price of gold or silver

Accounting For Embedded Derivative  embedded derivative shall be separated from the host contract and accounted for like any stand-alone derivative

Bifurcation is the process of separating an embedded derivative from the host contract Conditions for bifurcation:  a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative  the combined contract is not measured at the fair value with change in fair value recognized in profit or loss  the economic characteristics and risks of the embedded feature are not closely related to the economic characteristics and risks of the host contract  the host contract is outside the scope of PFRS 9 Hedging is the designating one or more hedging instruments so that their change in fair value or cash flows is an offset, in whole or in part, to the change in fair value or cash flows of the hedge item.

Components of a Hedging Relationship: Hedging Instrument  derivative whose fair value or cash flow would be expected to offset changes in the fair value or cash flows of the hedge item Hedging Item  an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation  should expose the entity to risk of changes in fair value or future cash flows

Conditions for Hedge Accounting:  there is formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge  the hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk  the effectiveness of the hedge can be measured reliably  the hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the financial reporting periods for which the hedge was designated  for a cash flow hedge, a forecast transaction that is the subject of a hedge must be highly probable and must present exposure to the variation in cash flows that could ultimately affect profit or loss

Practical Accounting 1 Theory of Accounts

Chapter 15 - Derivatives

USL Blue Notes

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Illustrative Problems 1. Interest Rate Swap – Cash Flow Hedge On January 1, 2014, Solana Co. borrowed P5,000,000 from Tuguegarao Bank at a variable rate of interest for two years. Interest is payable every December 31 based on prevailing interest at the beginning of the year. To protect itself from fluctuation, Solana Co. entered into an agreement with Cagayan Bank as speculator to receive variable interest and pay fixed interest based on underlying interest rate of 10% and notional amount of P5,000,000. Interest rates on the loan: January 1, 2014 10% January 1, 2015 12% Computation of the fair value of net cash settlement between Solana Co. and Cagayan Bank. December 31, 2014 500,000 500,000 -

Receiv variable Pay fix 10% Net cash settlement

On December 31, 2014 the fair value of the derivative is: 100,000 x .893 (PV of 1 for one period at 12%) Entry on the books: Interest rate swap receivable Unrealized gain – interest rate swap

December 31, 2015 600,000 500,000 100,000

P89,300

89,300 89,300

Unrealized gain on the interest rate swap is a component of other comprehensive income because the agreement is designated as a cash flow hedge. Such unrealized gain is recognized in profit or loss in the period when the cash flow occurs.

2. Interest Rate Swap – Fair Value Hedge On January 1, 2014, Solana Co. borrowed P5,000,000 from a bank at a fixed interest rate of 10% payable every December 31 for three years. The loan is evidenced by a note. On the same day, the entity entered a receive fixed, pay variable interest rate swap with a speculator and has designated as a fair value hedge. Market interest rates: January 1, 2014 January 1, 2015 January 1, 2016

10% 12% 14% Theory of Accounts Practical Accounting 1

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USL Blue Notes

Chapter 15 - Derivatives

Computation of the fair value of note payable on December 31, 2014 PV of principal at 12% (5,000,000 x .7972) PV of fixed annual interest (500,000 x 1.69) Fair value of note payable Carrying value of note payable Decrease in liability – gain

3,986,000 845,000 4,831,000 5,000,000 169,000

Entry on the books: Note payable Gain on note payable Loss on interest rate swap Interest rate swap payable

169,000 169,000 169,000

Net cash to be paid to the speculator: (5,000,000 x 2%) PV of an ordinary annuity of 1 at 12% for two periods Interest rate swap payable

169,000

100,000 1.69 169,000

The gain on note payable and loss on interest rate swap are recognized immediately in profit or loss because interest rate swap is designated as fair value hedge.

Practical Accounting 1 Theory of Accounts...