RATIONALE FOR HEDGE ACCOUNTING

SITUATIONS THAT REQUIRE HEDGE

ACCOUNTING:

Hedged item and hedging instrument are measured using different

bases
Hedged item has yet to be recognized in the FS
Different treatments are applied to changes in the fair value of the

hedged item and the hedging instrument

CRITERIA FOR HEDGE ACCOUNTING

1. An enterprise must have an exposure to risk that will affect the income

statement
2. The derivative contract is specifically entered into to hedge the underlying

exposure
3. The hedge must be highly effective
4. The effectiveness of the hedge can be reliably measured; and
5. The hedging relationship must be formally documented at the inception of the

hedge

Derivative

No
Is the derivative intended to hedge an exposed
risk?
Ye
s

Treat Derivative as a
trading security. Change in
FV taken to income
statement (I/S)

Does the derivative have a time value

component?
Is the time value component excluded from the
hedge?
Determine hedge effectiveness as:
change in intrinsic value of derivative
Change in FV/ expected cash flows of hedged
item

Determine hedge effectiveness

as: Change in FV of entire
derivative.
Change in FV / expected cash
flows of hedged item

Is the ratio between 0.80 and 1.25?

Hedge is ineffective. Discontinue
hedge accounting prospectively.
Hedge is effective.

Hedge is designated
as:

Fair Value Hedge

Apply hedge
accounting in
accordance with PAS
39 / PFRS 9

Cash Flow Hedge

Hedge of a Net Investment

Time value is taken to I/S; apply

hedge accounting in accordance
with PAS 39 / PFRS 9

Time value is taken to I/S;

apply hedge accounting in
accordance with PAS 39 /
PFRS 9

HEDGED ITEM
An asset, liability, firm commitment, highly
probable forecast transaction or net
investment in a foreign operation that (a)
exposes the entity to risk of changes in
fair value or future cash flows and (b) is
designated as being hedged

HEDGED ITEMS:
Exposed asset or liability
Firm Commitment
Forecasted transaction
Speculation

ANTICIPATED TRANSACTIONS
Are those that are
expected to occur
in the future but for
which no asset or
liability has been
recognized.

Firm Commitment- is a binding

agreement for the exchange of
resources where the quantity,
price, and dates are specified
Forecasted Transaction- an
anticipated transaction for which
no firm commitment exists.

Under PFRS:
Hedge of a firm commitment is accounted for as fair- value
hedge
Hedge of a highly probable forecasted transaction is
accounted for as a cash- flow hedge
However, a hedge of a foreign currency risk of a firm
commitment can be accounted for as either a fair- value hedge
or a cash flow hedge

Illustration 20-2
On December 1, 20x4, Dominador Company entered into four forward exchange contracts to purchase
US $1,000 in 90 days for delivery on March 1, 20x5 for P40.15. The exchange rates available on
various dates are as follows (fiscal year- end is December 31):
Spot rate.
30-day forward rate
60-day forward rate
90-day forward rate

12/1/20x4
P40.00
40.05
40.10
40.15

12/31/20x4
P40.30
40.45
40.40
40.45

3/1/20x5
P40.20
40.40
40.50
40. 60

In relation to the above data, the following relevant exchange rates are needed for further analysis in
relation to hedged item and hedging instrument:
Spot Rate
Settlement
December 1, 20x4. ..
December 31, 20x4..
March 1, 20x5...

P40.00
40.30
40.20

Forward rate for 31/1/20x5

P40.15 (90 days)
40.40 (60 days)

Illustration 20-2
A. On December 1, 20x4, Dominador Company purchased inventory for US $1,000 payable on March
1, 20x5 (i.e., the transaction is payable in dollars)
Also, on December 1, 20x4, Domindaor Company entered into the first forward contract to buy $1,000
on March 1, 20x5 for P40.15.

B. On December 1, 20x4, Dominador Company contracts to purchase special order goods from New
York Company. The contract meets the requirement of a firm commitment fair value hedge. Their
manufacture and delivery will take place in 90 days (on March 1, 20x5). The contract price is $1,000 to
be paid by March 1, 20x5. Thus, the transaction date and the settlement date are both March 1, 20x5.
Also, on December 1, 20x4, Dominador Company entered into the second forward contract in hedging
foreign currency payable commitment with a contract to receive $1,000 in 90 days at the forward rate of
P40.15.

Illustration 20-6 Discounting the FV of the Forward Contract (Discount rate is 12%)
On December 1, 20x4, Dominador Company entered into four forward exchange contracts to purchase
US $1,000 in 90 days for delivery on March 1, 20x5 for P40.15. The exchange rates available on
various dates are as follows (fiscal year- end is December 31):
Spot rate.
30-day forward rate
60-day forward rate
90-day forward rate

12/1/20x4
P40.00
40.05
40.10
40.15

12/31/20x4
P40.30
40.45
40.40
40.45

3/1/20x5
P40.20
40.40
40.50
40. 60

In relation to the above data, the following relevant exchange rates are needed for further analysis in
relation to hedged item and hedging instrument:
Spot Rate
Settlement
December 1, 20x4. ..
December 31, 20x4..
March 1, 20x5...

P40.00
40.30
40.20

Forward rate for 31/1/20x5

P40.15 (90 days)
40.40 (60 days)

A. Not a Hedge Accounting- Importing transaction (exposed liability)

Hedged Item- Importing Transaction
(Exposed Liability)

Hedging Instrument- Forward Contracts

(Broad Approach or Gross Position
Accounting)
December 1, 20x4

Transaction Date
Purchases
Accounts Payable
($1000 x 40)

Date of Inception/ Hedging 90 days

Forwards
FC Receivable from
XD
40,150

40,000
40,000

Pesos Payable to XD
(40.10 x $1,000)

40,150

December 31, 20x4

(Balance Sheet Date an intervening financial reporting date)
FC Transaction Loss
Accounts Payable
[(40.30-40) x $1000]

300
300

FC Receivable from XD
FC transaction Gain
245

245

Gain [(40.40- 40.15) x $1,000 .. P

250
Less: Discount (250 x 12% x 2/12)
5

Pesos Payable from XD

Cash

40,150
40,150

Investment in FC
40, 200
FC Receivable from XD
200
Accounts Payable
Cash

40,200
40,200

Cash
Investment in FC

40,

40, 200
40, 200

B. Fair- value hedge- Hedging an Unrecognized Foreign Currency Firm Commitment

Hedged Item- (unrecognized
foreign currency firm commitment

Hedging Instrument- Forward Contracts

(Broad Approach Or Gross Position
Accounting
December 1, 20x4

Date of Commitment (Date of Issuing the

Purchase Order)

No journal entry is required to record the firm

commitment. The hedge is accounted for as a
fair value hedge

Date of Inception/ Hedging of 90 days

Forwards
FC Receivable from XD
Pesos Payable to XD
(40.15 x $1,000)

40, 150
40, 150

December 31, 20x4

(Balance Sheet on Intervening Financial Reporting Date)

FC Transaction Loss
Firm Commitment

245
245

FC Receivable from XD
FC Transaction Gain

245
245

March 1, 20x5
Date of Transaction and Settlement
Firm Commitment
FC Transaction Gain

Settlement Date/ Date of Expiration of

Contract
FC Transaction Loss
195

195

195

FC Receivable from XD

Pesos Payable from XD

Cash

195

40,150
40,150

Investment in FC
40, 200
FC Receivable from XD
200

Accounts Payable
Cash

40,200
40,200

Cash
Investment in FC

40,

40, 200
40, 200

Hedge Item- Speculation

Hedging Instrument- Forward Contracts

(Broad Approach or Gross Position
Accounting)
December 1, 20x4
Date of Inception/ Hedging of 90 days
Forwards
FC Receivable
40,150
Pesos Payable to XD
40,150
December 31, 20x4

FC Receivable from XD
FC Transaction Gain
FC Transaction Loss
FC Receivable from XD
Pesos Payable from XD
Cash
40,150
Investment in FC

245
245
195

195
40,150
40,200

FC Receivable from XD
40,200
Cash
40,200
Investment in FC
40,200