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Chapter
25 /
Financ ial In struments: Recognition and Me as urement (lAS 39)
275
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.