Tuesday, December 18, 2012

Accounting for Financial Derivatives under IFRS





IFRS rules differentiate 3 types of derivatives, e.g. hedge derivatives, non-hedge derivatives, and embedded derivatives.


Hedge derivatives

Hedge accounting rules apply under 4 cumulative conditions:

  • Upon inception, the entity assigns and documents the hedging relationship and its risk management objective.
  • It expects the hedge to be highly efficient (= capacity to offset changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designed + actual results of the hedge within the range of 80-125 % + assessment of the effectiveness at least at the time an entity prepares its annual or interim financial statements).
  • The company can measure the hedge's effectiveness reliably.
  • The firm assesses the hedge on an ongoing basis.

In addition, the hedge of an overall net position, rather than of a specific item, does not qualify for hedge accounting.

Once the hedging nature of a financial instrument established, the accountant differentiates 3 hedging relationships:

  • A fair value hedge counters an exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment. The fair value hedge might also target a portion of such asset, liability or commitment if the company runs a particular risk that could affect its profit or loss.
  • A cash flow hedge matches the exposure to variability in cash flows that is linked to a particular risk of a recognized asset, liability, or highly probable forecast transaction.
  • Hedge of a net investment in a foreign operation


Accounting for a fair value hedge

The gain or loss from remeasuring the hedging instrument at fair value is recognized in profit or loss, thereby adjusting the carrying amount of the hedged item.


Accounting for a cash flow hedge

The portion of the gain or loss on the hedging instrument that constitutes an effective hedge shall be recognized on the company's balance sheet as other comprehensive income. The ineffective portion of the gain or loss on the hedging instrument shall be recognized in profit or loss.


Accounting for the hedge of a net investment in a foreign operation

Again, the portion of the gain or loss on the hedging instrument that constitutes an effective hedge shall be recognized in other comprehensive income. The ineffective portion of the gain or loss on the hedging instrument shall be recognized in profit or loss.


Non-hedge Derivatives

Non-hedge derivatives are always recognized at fair value.


Embedded Derivatives

An embedded derivative is a component of a hybrid contract that combines a derivative with a non-derivative host. In this context, “embedded” means that the derivative part is not independently transferable by way of contract.

Accounting for embedded derivatives is subject to the following rules:

The above mentioned derivative accounting rules shall apply to the hybrid contract as a whole if the underlying is an IFRS financial asset (See my December 15, 2012 post).

By contrast, if the host is not an IFRS financial asset, the embedded derivative is separated from the host. It is then recognized as a derivative if

  • the embedded derivative's economic and risk characteristics are not closely related to those of the host; or
  • the company has chosen to account the entire hybrid contract at fair value through profit or loss.


Resources:

  • IFRS 9 – Financial Instruments
  • IFRS 32 – Financial Instruments: Presentation
  • IAS 39 – Financial Instruments: Recognition and Measurement