IFRS PRACTICAL IMPLEMENTATION GUIDE AND WORKBOOK

Chapter 25/ Financial In struments: Recognition and Measurement (lAS 39)

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effective, because changes in fair value will offset each other. If the hedge is not 100% effec tive (i.e., the changes in fair value do not fully offset), such ineffectiveness is automatically reflected in profit or loss. Example Fair value hedges include • A hedge of the exposure to changes in the fair value of a fix ed interest rate loan due to changes in market interest rates. Such a hedge could be entered into by either the bo rrower or the lender. • A hedge ofthe exposure to changes in the fa ir value of an available-far-sale investment • A hedge ofthe exposure to changes in the fair value ofa nonfinancial asset (e.g., inventory) • A hedge of the exposure to changes in the fair value of a firm commitment to purchase or sell a nonfinancial item (e.g., a contract to purchase or sell gold f or a fix ed price on a fut ure date) Example On January 1. 20X5. Entity A purchases a five -year bond that has a principal amount of $100.000 and pays annually fix ed interest rate of 5% per year (i.e., $5.000 per year). Entity A classifies the bond as an available-far-sale fi nancial asset. Current market interest rates f or similar five-year bonds are also 5% such that the fa ir value of the bond and the carrying amount of the bond on the acquisition date is equal to its principal amount of $100.000. Because the interest rate is fixed, Entity A is exposed to the risk of declines in fa ir value of the bond. If market interest rates increase above 5%. for example. the fair value of the bond will decrease below $100,000. This is because the bond would pay a lower fi xed interest rate than equivalent alternative investments availab le in the market (i.e.. the present value of the principa l and interest cash fl ows discounted using market interest rates would be less than the principal amount of the bond) . To eliminate the risk of declines in fa ir value due to increases in market interest rates. Entity A en– ters into a derivative to hedge (offset) this risk. More specifically, on January I , 20X5. Entity A en– ters into an interest rate swap to exchange the fixe d interest rate payments it receives on the bond fo r fl oating interest rate payments. If the derivative hedging instrument is effective. any declin es in the fair value of the bond should offset by opposi te increases in the fair value of the derivati ve instrument. Entity A designates and documents the swap as a hedging instrument ofthe bond. On entering into the swap on January 1. 20X5. the swap has a net fair value of zero. (In practice. swaps usually are entered into at a zero fair value. This is achieved by setting the inte rest payments that will be paid and received such that the present value of the expec ted float ing interest payments Entity A will receive exactly equals the present value of the fix ed interest payments Entity A will pay because of the swap agreement.) Therefore. no journal entry is required on this date. At the end of 20X5. the bond has accrued interest of$5.000. Entity A makes this journa l entry: Dr [merest receivable 5,000 Cr [merest income 5,000 In addition, market interest rates have increased to 6%. such that the fair value of the bond has de– creased to $96,535. Because the bond is classified as available fo r sale, the decrease in f air value would normally have been recorded directly in equity rather than in profit or loss. However. since the bond is classified as a hedged item in a fa ir value hedge of the exposure to interest rate risk. this change in f air value of the bond is instead recognized in profit or loss: Dr Hedging loss (hedged item) 3,465 Cr Available-for-sale financial asset 3,465 At the same time. Entity A determines that the fa ir value of the swap has increased by $3.465 to $3.465. Since the swap is a derivative. it is measured at fa ir value with changes in fair value recog– nized in profit or loss. Therefore. Entity A makes this journal entry: Dr Swapasset 3.465 Cr Hedging gain (hedging instrument} 3,465 Since the changes in fa ir value of the hedged item and the hedging instrument exactly offset. the hedge is 100% effective, and the net effect on profit or loss is zero.