IFRS PRACTICAL IMPLEMENTATION GUIDE AND WORKBOOK

266

Wiley IFRS: Practical Implementation Guide and Workbook

7. DERIVATIVES 7.0.1 Derivatives are contracts such as options, forwards, futur es, and swaps. Because they are often entered into at no cost. many times derivatives were not recogni zed in financial statements prior to lAS 39. The potential gains and losses that may arise on settlement of derivatives, however, bear little relation to their initial cost and can be significant. To provide more useful informa tion about derivatives, therefore, lAS 39 requires derivatives to be measured at fair value in the balance sheet (unless, as already discussed, they are linked to and must be settled by an investment in an unquoted equity instrument that cannot be reliably measured at fair value). 7.0.2 Determining whether changes in fair value of a derivative should be recognized either in profit or loss or in equity in part depends on whether the entity uses the derivative to speculate or offse t risk. As a genera l rule, changes in fair value of a derivative are recognized in profit or loss. However, when the derivative is used to offset risk and special hedge accounting conditions are met, some or all changes in fair value are recognized as a separate component of equity. 7.0.3 To enable entities to properly identify derivatives, lAS 39 provides this definiti on: Derivative. A financial instrument or other con tract with all three of the following characteris– tics: (I ) Its value changes in response to the change in a specified interest rate, financial instru– ment price, commodity price, foreign exchange rate, index of prices or rates, credit rating, credit index or other variable (sometimes called the "unde rlying "). For instance, a call option that gives the holder a right to purchase a share for a fixed price increases in value when the price of that share increases . In that case, the share price is an under– lying that affects the value of the option. (2) It requires no initial net in vestment 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. For instance, a ca ll option on a share can usually be purchased for an amount much smaller than what would be required to purchase the share itself. (3) It is se ttled at a future date. 7.0.4 For instance, a call option on a share is settled on the future date on which the holder may exercise the call option to purchase the share for a fixed price. Unde r lAS 39, the expiration of an option is also considered to be a form of settlement. Example Assume Entity A enters into a call option contract on December 15, 20X5. that gives it a right, but not an obligation, to purchase 1,000 shares issued by Entity B on April 15, 20X6, at an exercise price (i.e., strike price) of $100 per share. The cost Entity A pays f or each option is $3. Theref ore. Entity A makes this j ournal entry on December 15, 20X5: Dr Derivative asset 3,000 Cr Cash 3,000 (To record the purchase 0/ 1,000 call options/o r $3.00per option) Market data suggests that Entity A could sell each option fo r $4. Theref ore. on December 31, 20X5, Entity A makes these journal entries to recognize the increase ill fair value: Dr Derivative asset 1.000 Cr Derivative gain 1,000 (To record the increase in/ air value 0/ $1.00 per option) On April 15, 20X6, the fa ir value of each option is $10. The share price on this date is $110. Since the share price is higher than the exercise price, Entity A decides to exercise the option by buying 1.000 shares fo r $100 per share. Under lAS 39. fi nancial assets are initially recognized at fair value, so the shares are recognized at their f air value of $110 per share rather than the option exercise price of$ 100 per share. In addition, the option asset is derecognized. Entity A makes these journal entries: Dr Derivative asset 6.000 Cr Derivative gain 6,000 (To record the increase in/air value 0/ $6.00 per option)