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When we create a derivative position we’re selecting a directional movement. In the case of Barings, it was a totally speculative, and naked position in which you either gained significantly or lost significantly and we all know the outcome here. However, when derivatives are used in a hedging capacity the entity is seeking in theory effectively an NGNL position (no gain no loss) in which any additional cost (loss) is offset by a gain on the derivatives contract.
And what is this risk? If an entity knows, for example, that in six months it has to pay a significant amount in a foreign currency and there is a risk the currency could move against them thus increasing the US dollar cost. It is that loss that derivatives can mitigate by creating a financial offset or a neutral position. The IASB in developing the standards sought to ensure that only legitimate hedge transactions would qualify for special accounting treatment. It also ensured that mark to market and/or fair valuation would bring to the surface, transparency, of all directional movements both positive and negative. The rules under codifications are particularly important to ensure that speculative positions do not receive special accounting treatment. It was the application of derivatives in a hedging capacity that gave rise to Other Comprehensive Income (OCI). Without OCI there literally would be no legitimate location within accounting (definitions within the framework) to record market movements. Clearly, market movements qualify as neither revenue nor expenses and are certainly not a Balance Sheet, i.e., Statement of Financial Position, items. But like everything examples illustrate underlying accounting entries.
So, what are the characteristics of derivatives:
1-3 Derivatives
A derivative is a financial instrument with all three of the following characteristics
- Its value changes in response to a specified underlying (interest rate, commodity price, exchange rate etc.); and
- It requires no or little initial investment; and
- It is settled at a future date
(Emile Woolf Essentials IFRS Guide 2018)
And as we have seen earlier Derivatives can be classified into two broad categories:
- Forward arrangements (commit parties to a course of action)
Forward contracts
Futures
Swaps
- Options (Gives the option buyer a choice over whether or not to exercise his rights under the contract)
(Emile Woolf Essentials IFRS Guide 2018)
There are two main types of hedging, fair value and cash flow hedge.
Illustration: Intermediate Accounting, IFRS 2nd Edition, Kieso, Weygandt, &Warfield
Fair value hedge:
A company uses a derivative to hedge (offset) the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized commitment.
Companies commonly use several types of fair value hedges.
- interest rate swaps
- put options
Cash flow hedge:
Used to hedge exposures to cash flow risk, which results from the variability in cash flows. Reporting:
- Fair value on the statement of financial position.
- Gains or losses in equity, as part of other comprehensive income.
Example of Purchasing Tons of Aluminium
In September 2015 Allied Can Co. anticipates purchasing 1,000 metric tons of aluminium in January 2016. As a result, Allied enters into an aluminium futures contract. In this case, the aluminium futures contract gives Allied the right and the obligation to purchase 1,000 metric tons of aluminium for ¥1,550 per ton (amounts in thousands). This contract price is good until the contract expires in January 2016. The underlying for this derivative is the price of aluminium. Allied enters into the futures contract on September 1, 2015. Assume that the price to be paid today for inventory to be delivered in January—the spot price—equals the contract price. With the two prices equal, the futures contract has no value. Therefore no entry is necessary.
On December 31, 2015, the price for January delivery of aluminium increases to ¥1,575 per metric ton. Allied makes the following entry to record the increase in the value of the futures contract.
| EXAMPLE | |||
| I/B | DR | CR | |
| Futures Contract | B | 25000 ¹ | |
| Unrealized Holding Gain or Loss—Equity (OCI)
([¥1,575 – ¥1,550] x 1,000 tons) | I | 25000 |
Allied reports the futures contract in the statement of financial position as a current asset and the gain as part of other comprehensive income.
In January 2016, Allied purchases 1,000 metric tons of aluminium for ¥1,575 and makes the following entry.
| EXAMPLE | |||
| I/B | DR | CR | |
| Aluminum Inventory | B | 1575000 | |
| Cash (¥1,575 x 1,000 tons) | B | 1575000 |
At the same time, Allied makes a final settlement on the futures contract. It records the following entry.
| EXAMPLE | |||
| I/B | DR | CR | |
| Cash | B | 25000 | |
| Futures Contract (¥1,575,000 – ¥1,550,000) | B |
| 25,000 ¹ |
There are no income effects at this point. Allied accumulates in equity the gain on the futures contract as part of other comprehensive income until the period when it sells the inventory.
Assume that Allied processes the aluminium into finished goods (cans). The total cost of the cans (including the aluminium purchases in January 2016) is ¥1,700,000. Allied sells the cans in July 2016 for ¥2,000,000 and records this sale as follows.
| EXAMPLE | |||
| I/B | DR | CR | |
| Cash | B | 2000000 | |
| Sales Revenue | I | 2000000 |
| EXAMPLE | |||
| I/B | DR | CR | |
| Cost of Goods Sold | I | 1700000 | |
| Inventory (Cans) | B | 1700000 |
Since the effect of the anticipated transaction has now affected earnings, Allied makes the following entry related to the hedging transaction.
| EXAMPLE | |||
| I/B | DR | CR | |
| Unrealized Holding Gain or Loss—Equity (OCI)
([¥1,575 – ¥1,550] x 1,000 tons) | I | 25000 | |
| Cost of Goods Sold | I | 25000 |
The gain on the futures contract, which Allied reported as part of other comprehensive income, now reduces the cost of goods sold. As a result, the cost of aluminium included in the overall cost of goods sold is ¥1,550,000.
IASB, eIFRS, states that:
2 This Standard shall be applied by all entities to all financial instruments within the scope of |FRS 9:
(a) IFRS 9 permits the hedge accounting requirements of this Standard to be applied
(b) a financial instrument is part of a hedging relationship that qualities
Now let’s move onto IAS 39
Accounting Theory – Advanced Part 22 (IAS 32 Financial Instruments Presentation)
Part III and IAS 39
(Financial Instruments: Recognition and Measurement) Part I
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