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Chapter
25/
Financial In struments: Recognition and Measurement
(lAS
39)
273
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.