Recognition and de- recognition Recognition when the company becomes a party to the contractual provisions of the instrument, rather than when the contract is settled. (ie, derivatives)
Recognition and de- recognition De-recognition Financial Assets (FA): -- the contractual rights to the cash flows expired, or -- substantial risks and the rewards of ownership of the financial asset has been transferred (eg sold).
Recognition and de- recognition Financial liabilities (FL): --when it is extinguished that is when the obligation is discharged, cancelled or expired
Classification and measurement Business model and contractual characteristics are critical. Initial measurement Amortised cost Fair value
Classification and measurement FA – three categories Amortised cost: Business model+ Contractual characteristics FV: (1) Option to report changes to OCI----Equity investments not held for trading (2) FV through P/L
Classification and measurement FL — Three categories Amortised cost (most financial liabilities) FV through P/L Cost
Derivatives 1 characteristics (a) its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate (b) little cost or no cost and (c) settled at a future date.
Derivatives 2 categories: forward contracts (including forward, future and swap) and option contracts. Forward contract gives the entity obligation to buy or sell something in future whereas option only grants the entity rights but no obligation to buy or sell in future.
Hedge Definition Hedge accounting is a risk management technique designed to offset changes in fair value or cash flow
Hedge It ’ s optional to apply hedge accounting The main impact of hedge accounting is that gains and losses on the hedging instrument and the hedged item are recognised in the same period.
Hedge Conditions to be met: Formal designation and documentation in place The hedge is expected to be highly effective The effectiveness of the hedge can be reliably measured. The hedge is assessed on an ongoing basis and determined to have been highly effective throughout the financial reporting periods for which the hedge was designated. Effectiveness 80% - 125% G/L on Hedging instrument G/L on hedged item
Hedge FV hedge changes in FV of the hedged item That is attributable to a particular risk and will affect reported income G/L of hedging instrument and hedged item are recognised in IS as incurred even if the hedged item is measured at other way
Hedge Cash flow hedge a hedge of the exposure to variability in cash flow
Hedge Accounting treatment The gain or loss on the hedging instrument from “ effective ” hedge should be recognised directly in OCI. If a hedge of a forecast transaction subsequently results in the recognition of a FA or a FL, G/L in OCI shall be reclassified from equity to IS.
Hedge If a hedge of a forecast transaction subsequently results in the recognition of a non-financial asset or a non-financial liability entity can either keep deferred gain/loss in reserve and release from reserve as asset or liability realised or deduct the initial CV of asset or liability (basis adjustment).
Slide 26 Embedded derivatives Example: Bond redeemable in 5 years' time Part of redemption price based on increase in FTSE 100 index 'Host' contract Bond Embedded derivative Option on equities Accounted for as normal Treated as derivative
Embedded derivatives Separation conditions: meets the definition of a derivative. The combined contract is not measured at fair value with changes in fair value recognised in profit or loss.
Embedded derivatives Separation conditions: The economic characteristics and risks of the embedded feature are not closely related to those of the host contract.
Embedded derivatives The artifacts produced by the company require special packaging materials in order to store and deliver the product. Artright has entered into a one year contract with a local supplier to deliver these materials on a quarterly basis until the end of the contract on 30 November 2005.
Embedded derivatives The agreed price of each delivery is ￡ 100,000 sterling (UK pounds) payable quarterly. Required: Discuss the nature of the contracts to purchase packaging materials.