Session

Hedge of a Net Investment

in a Foreign Entity
Compound Financial Instrument
& Embedded Derivative

Edited by Taufik Hidayat

Classification of Hedging

Fair value
hedge

Cash flow
hedge

Hedge of a net
investment in a
foreign entity

Hedge of the exposure to changes in fair value of a

recognized asset or liability or an unrecognized firm
commitment, or an identified portion of such asset, liability
or firm commitment, which is attributable to a particular
risk and could affect profit or loss.
Hedge of the exposure to variability in cash flows that
(i) is attributable to a particular risk associated with a
recognized asset or liability (such as all or some future
interest payment on variable debt instrument )or a highly
probable future transaction, and
(ii) could affect profit or loss.
Hedge of the foreign currency risk associated with a
foreign operation whose financial statements are required
to be translated into the presentation currency of the
parent company.
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Hedge of a Net Investment

in a Foreign Entity
Hedge risk is foreign exchange risk
Applies to foreign operations whose functional currencies are the
currencies of the country where the foreign operations are located.
Translation method may result in significant translation loss from
depreciating currencies.

Accounting treatment similar to cash flow hedge

Hedge effectiveness =

Cumulative change in fair value of hedging instrument (A)

Cumulative translation difference on net investment (B)

Hedge is effective if the delta ratio is between 0.8 and 1.25.

Unlike a fair value hedge or a cash flow hedge, a non-derivative is
allowed to be the hedging instrument, for example, a foreign currency
loan.
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Accounting for Hedge of a Net Investment

in a Foreign Entity
The gain or loss on the effective portion of a hedge
of a net investment is taken to other
comprehensive income as part of the translation
adjustment.
The amount of offset to comprehensive income is
limited to the translation adjustment for the net
investment.
Any excess must be recognized currently in P/L.
PSAK 55 allows the hedging instrument in this type
of hedge to be derivative or non-derivative in
applying hedge accounting.
Edited by Taufik Hidayat

Hedge of a Net Investment

in a Foreign Entity - illustration

Example
Example

31/12/20X0
Parents functional currency is the dollar ($).
Acquired 100% interest in foreign company (functional currency is FC)
for FC 50,000 (FC 40,000 ordinary share & FC 10,000 retained
earnings).

1/1/20X1
Loan of FC 50,000 at 5% interest taken to hedge foreign investment
(due and payable on January 1, 20X2) .
Exchange rate is $1.2 to FC1.

31/12/20X1
Exchange rate is $1.40 to FC1.
Average rate is $1.30 to FC1.
Transalation adjustment of foreign subsidiary F/S is FC 11,450 (credit
balance).
Edited by Taufik Hidayat

Hedge of a Net Investment

in a Foreign Entity illustration (2)
1/1/20X1

Dr

Cash

..................

Cr

Loan Payable (FC) .............

60,000
60,000

Borrow a FC denominated loan : $50,000 x 1.2

31/12/20X1

Dr

OCI Hedge
reserve ...........

10,000

Cr

Loan Payable (FC) ..............

Revalue the loan : $50,000 x (1.4 - 1.2)

10,000

Dr

Interest Expense ..

3,250

Dr

FC Loss .............................

250

Cr

Interest Payable (FC) .........

Accrue the interest :

3,250=50,000 x 5% x 1.3 average rate
3,500=50,000 x 5% x 1.4 closing rate
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3,500

Hedge of a Net Investment

in a Foreign Entity illustration (3)
31/12/20X1

Dr

OCI Translation Adj ..........

Cr

OCI - Hedge reserve .........

10,000
10,000

Close the OCI from loan and OCI from translation.

1/1/20X2
Dr

Interest Payable (FC) ..

3,500

Dr

Loan Payable (FC) .............

70,000

Cr

Cash ...................................

Pay the principle and interest

Edited by Taufik Hidayat

73,500

Compound Financial Instrument

& Embedded Derivative
There are certain financial instruments that have a
hybrid or combined nature.
For example, a convertible bond is a debt instrument
with an embedded option to convert the debt
instrument to equity shares.
From the perspective of the issuer, the debt instrument is a
financial liability while the embedded option may be an
equity instrument.
From the perspective of the holder of that convertible bond,
the debt instrument is a financial asset and the embedded
option is similar to a derivative.

Edited by Taufik Hidayat

Compound Financial Instrument

& Embedded Derivative
In PSAK 50, from the perspective of an issuer, these
kinds of financial instruments are termed as compound
financial instruments.
PSAK 50 requires an issuer of a compound
financial instrument to separately classify different
components of the instrument in accordance with the
definition of financial liability and equity instrument.
In PSAK 55, from the perspective of a holder, these kinds
of financial instruments are termed as hybrid (combined)
instruments.
PSAK 55 requires a holder of a hybrid instrument to
separately account for the embedded derivative of
the instrument if certain conditions are fulfilled.

Edited by Taufik Hidayat

Compound Financial
Instrument

The most important compound instruments are those

which incorporate some elements of liability and other
elements of equity, such as convertible bonds.
It is required that whether or not fair values are available
for all components of compound instruments, full fair value
be allocated to liability component, with only residual being
assigned to equity component.

Edited by Taufik Hidayat

Compound Financial Instrument

Example
Example
(2)
Roche Group (DEU) issues 2,000 convertible bonds at the
beginning of 2011.
The bonds have a four-year term with a stated rate of
interest of 6 percent, and are issued at par with a face
value of 1,000 per bond (the total proceeds received from
issuance of the bonds are 2,000,000).
Interest is payable annually at December 31.
Each bond is convertible into 250 ordinary shares with a
par value of 1.
The market rate of interest on similar non-convertible debt
is 9 percent.

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Compound Financial Instrument

Example
Example
(3)
At Time of
Issuance

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Compound Financial Instrument

Example
Example
(4)

Journal
Entry

Cash

2,000,000

Bonds Payable
Share PremiumConversion Equity
Edited by Taufik Hidayat

1,805,606
194,394

Compound Financial Instrument

Example
Example
(5)
Conversion of Bonds at Maturity. If the bonds are converted
at maturity, Roche makes the following entry.
Share PremiumConversion Equity
Bonds Payable

194,394
2,000,000

Share CapitalOrdinary
Share PremiumOrdinary

500,000
1,694,394

NOTE: The amount originally allocated to equity of 194,384 is

transferred to the Share PremiumOrdinary account.

Edited by Taufik Hidayat

Embedded
Derivative
Derivative that is part of a hybrid financial instrument.
Hybrid Instrument
Host Instrument
Embedded derivative:
Linked to underlying and change
in underlying causes change in
cash flow

Example is bond whose ultimate proceed are linked to

price of commodity, such as oil, or to a consumer price
index.
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Embedded Derivative
(2)
PSAK 55 requires embedded derivatives to be separately
recognized from the host instrument and accounted for in
the same way as a stand-alone derivative if the following
conditions are met:
Conditions for separation of embedded derivative
Economic
characteristics and
risk of host
instrument are not
closely related to that
of the derivative

There is a separate
instrument with same
terms as the
embedded derivative

Edited by Taufik Hidayat

Hybrid instrument is
not measured at fair
value, with changes
in fair value
recognized in profit
and loss

Embedded Derivative (3)

A hybrid instrument includes
a non-derivative host contract and
an embedded derivative with the effect that
some of the cash flows of the hybrid
instrument vary in a way similar to a standalone derivative.
However, a derivative that is attached to a
financial
instrument
but
is
contractually
transferable independently of that instrument, or
has a different counterparty from that instrument,
is not an embedded derivative, but a separate
financial instrument.

Edited by Taufik Hidayat

Hybrid
Hybrid(Combined)
(Combined)
Contract
Contract

Host
HostContract
Contract
Embedded
Embedded
Derivative
Derivative

Embedded Derivative : Example

Examples of contract with embedded derivative
include:
1. A call, put, or prepayment option embedded in a host
debt contract.
2. An option or automatic provision to extend the
remaining term to maturity of a debt instrument.
3. Equity-indexed interest or principal payments
embedded in a host debt instrument.
4. Commodity-indexed interest or principal payments
embedded in a host debt instrument.
5. An equity conversion feature embedded in a
convertible debt instrument.
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Embedded Derivative : Separation

Criteria

PSAK 55

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Embedded Derivative : Not Closely

Related
A put option embedded in an instrument that enables the
holder to require the issuer to reacquire the instrument for
an amount of cash or other assets that varies on the basis of
the change in an equity or commodity price or index.
An option or automatic provision to extend the remaining
term to maturity of a debt instrument.
Equity-indexed interest or principal payments embedded in a
host debt instrument.
Commodity-indexed interest or principal payments
embedded in a host debt instrument.

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Embedded Derivative : Closely

Related
An embedded derivative in which the underlying is an
interest rate or interest rate index that can change the
amount of interest that would otherwise be paid or
received on an interest-bearing host debt contract.
An embedded foreign currency derivative that provides a
stream of principal or interest payments that are
denominated in a foreign currency and is embedded in a
host debt instrument (eg a dual currency bond).

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The Separated Embedded Derivative

If an embedded derivative is separated, the host contract is
accounted for
under PSAK 55 if it is a financial instrument, and
in accordance with other appropriate accounting
standards if it is not a financial instrument.
PSAK 55 does not address whether an embedded
derivative is presented separately in the financial
statements.
The separated embedded derivative is similar to a simple
derivative to be accounted for in the same manner as other
derivatives.

Edited by Taufik Hidayat

Embedded Derivatives as
Combined Contract
If a contract contains one or more embedded
derivatives, an entity may designate the entire hybrid
(combined) contract as a financial asset or financial
liability at fair value through profit or loss unless:
the embedded derivative does not significantly modify the
cash flows that otherwise would be required by the
contract; or
2.it is clear with little or no analysis when a similar hybrid
instrument is first considered that separation of the
embedded derivative is prohibited, such as a prepayment
option embedded in a loan that permits the holder to
prepay the loan for approximately its amortised cost.
1.

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Embedded Derivatives : Unable

to Separate
If an entity is required by PSAK 55 to separate an
embedded derivative from its host contract, but is unable to
measure the embedded derivative separately (either at
acquisition or subsequently),
the entity is required to designate the entire hybrid
contract as at fair value through profit or loss.

Edited by Taufik Hidayat

Embedded Derivatives :
Example
Tony Finance Ltd invested in bond that would convertible to
shares of issuing company (Roche Group) before maturity.
Fair value of bond was $3 million and fair value of
embedded derivative was $500.000.
Analysis:
The investment comprises two elements: bond (host) and
conversion option (embedded derivative).
If investment is designated as FVTPL, separating the embedded
derivative from the host is not permitted.
The investment cannot be classified as HTM because of conversion
option.
If investment is designated as AFS, separating the embedded
derivative from the host is required since 3 conditions in PSAK 55
are met.
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Embedded Derivatives :
Example
If the investment is designated as AFS, separating the embedded
derivative from the host is required since 3 conditions in PSAK 55
are met.
Available for Sale
Journal
Entry

Embedded Derivative

2,500,000
500,000

Cash
3,000,000

Changes in FV of conversion option are recognized in P/L unless

the option is part of cash flow hedge.

Edited by Taufik Hidayat

Sources
:
Tan & Lee Advanced Financial Accounting.
Lam & Lau Intermediate Financial Reporting, 2 nd Ed.
Baker, Christensen, Cottrell Advanced Financial
Accounting, 10th Ed.
Mackenzie, et al Interpretation & Application of IFRS
2011.
Kieso, et al Intermediate Accounting: IFRS Adapted.

@Taufik_FEUI
Edited by Taufik Hidayat