IFRS PRACTICAL IMPLEMENTATION GUIDE AND WORKBOOK

Chapter 25 / Financ ial In struments: Recognition and Me as urement (lAS 39)

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8.5.4 To the extent the cash flow hedge is not fully effecti ve, the ineffective port ion of the change in fair value of the deri vative is recognized immediately in profit or loss. Example Cash flow hedges include • A hedge of the expos ure to variable interest cash fl ows on a bond that pays fl oatin g interest payments • A hedge of the cash fl ows from a fo recast sale of an ass et • A hedge of the foreign currency expo sure associated with a fi rm commitment to pu rchase or sell a nonfinancial item Examp le Entity A has the euro as its func tional currency. It expects to purcha se a machin e fo r $10.000 0 11 October 31. 20X6. Accordingly. it is exposed to the risk of increases in the dollar rate. If the dollar rate increases bef ore the purcha se takes place. the entity will have to pay more euros to obtain the $10,000 that it will have to pay fo r the machine. To offset the risk of ill creases ill the dollar rate, the entity enters into a forward contract 0 11 April 30. 20X6. to purchase $10.000 ill six month s f or a fi xed amount (£8.000). Entity A designates the forward contract as a hedging instrument ill a cash fl ow hedge of its expos ure to increas es in the dollar rate. At inception. the fo rwa rd contract has a fair value of zero. so 110 journal elltry is required. On July 31 the dollar has appreciat ed. such that $10.000 f or deli very 0 11 Octob er 31. 20X6. costs £9.000 on the market. Therefore. the forward contract has increased ill fair value to £1.000 (i.e.. the difference betwee n the committed pri ce of £8.000 and the current p rice of £9.000 (igno ring. f or simplicity. the effect of differences in interes t rates between the two currencies). Entity A still ex– pects to purchase the machine for $10,000. so it concludes that the hedge is 100% effec tive. Becau se the hedge is f ully effective. the entire change in the f air value of the hedging instrument is recog– nized directly ill equity. Entity A makes this entry: Dr Forward asset 1.000 Cr Equity 1,000 On October 31. 20X6. the dollar rate has fu rther increas ed. such that $10.000 cost £9.500 in the spot market. Theref ore. the f air value of the fo rward contract has ill creased to £1.500 (i.e.• the difference between the committed pri ce of £8.000 and the spo t pri ce of £9.500. It still expec ts to purchase the machine fo r $10.000 and makes this journal entry: Dr Forward asset 500 Cr Equity 500 The forward contract is settled and Entity A makes this entry: Dr Cash 1,500 Cr Forward asset 1,500 Entity A purchases the machine fo r $10.000 (£9.500) and makes this journal entry: Dr Machine 9,500 Cr Accounts Payable 9,500 Depending on Entity A 's accounting policy, the def erred gain or loss remaining in equity of f / ,500 should either ( I) remain ill equity and be release d fro m equity as the machin e is depreciated or oth– erwise affects profit or loss or (2) be deducted from the initial carrying amount of the machine. As– suming tlte latter treatment, Entity A would make this journal entry: Dr Equity 1,500 Cr Machine 1,500 The net effe ct of the cash flow hedge is to lock in a price of£8.000 f or the machine. Examp le At the beginnin g of20XO. Entity B issues a Hi-year liability with a pr incipal amount of$ IOO.OOOfo r $100.000 (i.e.. at par). The bond pays fl oat ing interest that resets each year as market interest rates change. Entity A measures the liability at amortized cost ($100.000). Because the interest rate regularly resets to market interest rates. the f air value of the liability rema ins approximately constant irrespective of how market interest rates change. However, Ent ity B wishes to conve rt the flo ating rate payments to fixed rate payments in order to hedge its exposure to change s in cash fl ows due to changes in mark et interest rates ove r the life of the liability.