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Dear Sir,
I would like to ask about the Cash Flow Hedge, Example 6.5.4 – ACCA P2 Text book of BPP – Chapter Financial Instrument
Questions:
Bets Co signs a contract on 01 November 20X1 to purchase an asset on 01 November 20X2 for EUR60,000,000
Bets reports in $US and hedges this transaction by entering into a forward contract to buy EUR60,000,000
on 01 November 20X2 at $1US: EUR1.5Spot and forward exchanges rate at the following dates are:
Spot Forward (For delivery on 01.11.20X2)
01.11.20X1 USD1:EUR1.45 USD1:EUR1.5
31.12.20X1 USD1:EUR1.20 USD1:EUR1.24
01.11.20X2 USD1:EUR1.00 USD1:EUR1.00 (actual)
The IFRS9 hedging criteria have been metRequired: Show the double entries relating to these transactions at 1 November 20X1,
31 December 20X1 and 01 November 20X2Solution:
Entries at 01 November 20X1
The value of the forward contract at inception is zero so no entries is recorded
(other than any transaction costs), but risk disclosure will be made
The contractual commitment to buy the asset would be disclosed if material (IAS16)At 31 December 20X1
[a] Hedging instrument:Value of contract as at 31. December . 20X1 (60,000,000EUR/1.24) 48,387,097
Value of contract as at 01. November . 20X1 (60,000,000EUR/1.5) 40,000,000
FV gain of hedging instrument 8,387,097[b] Hedged item
FV of hedged item at 01.11.20X1 (60,000,000EUR/1.45) 41,379,310
FV of hedged item at 31.12.20X1 (60,000,000EUR/1.20) 50,000,000
Changes in FV of hedged item 8,620,690Changes in FV of hedging instrument 97%
Changes in FV of hedged itemAs this is higher, the hedge is deemed fully effective at this point:
Dr. Financial asset 8,387,097
Cr. Comprehensive income 8,387,097Entries at 01 November 20X2
[a] Hedging instrument
Additional gain on forward contract
FV of forward contract as at 31 December 20X1 48,387,097
FV of forward contract as at 01 November 20X2 60,000,000
FV gain of hedging instrument 11,612,903[b] Hedged item
FV of hedged item as at 31 December 20X1 50,000,000
FV of hedged item as at 01 November 20X2 60,000,000
Changes in FV of hedged item 10,000,000Hedge effectiveness ratio 116%
=> Over-hedge
=> Ineffectiveness should be recognized in P&L
Ineffectiveness portion: 1,612,903
Dr. FA – Forward contract 11,612,903
Cr. OCT – Gain 10,000,000
Cr.P&L 1,612,903Balance of forward contract at expiry date: 11,612,903 + 8,387,097 =20,000,000
Dr. Asset 60,000,000
Cr. Cash 40,000,000
Cr. FA – Forward contract 20,000,000The cumulative gain of 18,387,097 recognized in equity is removed from equity
(the cashflow hedge reserve) and included directly in initial cost of assetWhat I do not understand is the last sentence: The cumulative gain of 18,387,097 recognized in equity is removed from equity (the cashflow hedge reserve) and included directly in initial cost of asset.
As I do not see the entries of removing cumulative gain of 18,387,097 from equity, how the Company accounts for this removal. is this accounted by transfer this cumulative gain to retained earnings
Dr. Equity: 18,387,097
Cr: Retained earnings:18,387,097The way I understand it, subject to the tutor’s confirmation, is this:
1. The fear at the beginning was that the price will rise hence the reason for betting against the fear. So if price rises you’ll gain on the instrument & the price falls, you’ll loose on the instrument. The whole idea is to use one gain to offset a loss.2. Because the transaction is taking place on 01/11/20X2, which is the date Cash would flow, you will not do anything until that day. It’s on this day that you’ll know if you had made a loss or gain on the item. So, on the 31/12/20X1 nothing will be recorded as far as the item is concerned. But on this day, you’ll determine if gain or loss was made on the instrument. This will probably be a gain because at inception the fair value of the instrument was zero, so the gain will be 48,387,097 (I’m using your figures; I’ve not confirmed their accuracy). So on 31/12/20X1 you credit OCI and debit the instrument.
3. On the transaction date, you re-measure the fair value of the instrument by comparing the 31/12/20X1 value of 48,387,097 with its value on transaction date which is 60,000,000. So on the instrument a gain of 11,612,903 was made. With this you’d be put on the alert that there will be a loss on the item.
4. Similarly, on the transaction date, you determine if a gain or loss was made on the item. At the inception, the forward exchange rate agreed was €1.5 to $1. So you had fixed your mind to paying $40,000,000 (60,000,000/1.5). But on this day € strengthen against $, so instead of paying $40,000,000 you will now be paying $60,000,000 therefore making a loss of $20,000,000.
5. You made a gain of 11,612,093 on the instrument and a loss of 20,000,000 on the item. The net loss to you is 8,387,987. This is the beauty of the hedging exercise. If there was no hedging, the loss would have been 20,000,000 but with the hedge the loss was reduced to 8,387,987.
6. On effectiveness. We are accounting for the instrument and not for the loss on the item. Because the gain on the instrument (11,612,093) is less than the loss (20,000,000) there is ineffectiveness – the gain did not fully cover the loss. This ineffective portion of 8,387,987 is debited to Profit or Loss account and credit the item’s account.
7. This is the way I would have approached the question. Is the approach ideal? Over to the tutor, please.
@ladesmunic said:
The way I understand it, subject to the tutor’s confirmation, is this:
1. The fear at the beginning was that the price will rise hence the reason for betting against the fear. So if price rises you’ll gain on the instrument & the price falls, you’ll loose on the instrument. The whole idea is to use one gain to offset a loss.2. Because the transaction is taking place on 01/11/20X2, which is the date Cash would flow, you will not do anything until that day. It’s on this day that you’ll know if you had made a loss or gain on the item. So, on the 31/12/20X1 nothing will be recorded as far as the item is concerned. But on this day, you’ll determine if gain or loss was made on the instrument. This will probably be a gain because at inception the fair value of the instrument was zero, so the gain will be 48,387,097 (I’m using your figures; I’ve not confirmed their accuracy). So on 31/12/20X1 you credit OCI and debit the instrument.
3. On the transaction date, you re-measure the fair value of the instrument by comparing the 31/12/20X1 value of 48,387,097 with its value on transaction date which is 60,000,000. So on the instrument a gain of 11,612,903 was made. With this you’d be put on the alert that there will be a loss on the item.
4. Similarly, on the transaction date, you determine if a gain or loss was made on the item. At the inception, the forward exchange rate agreed was €1.5 to $1. So you had fixed your mind to paying $40,000,000 (60,000,000/1.5). But on this day € strengthen against $, so instead of paying $40,000,000 you will now be paying $60,000,000 therefore making a loss of $20,000,000.
5. You made a gain of 11,612,093 on the instrument and a loss of 20,000,000 on the item. The net loss to you is 8,387,987. This is the beauty of the hedging exercise. If there was no hedging, the loss would have been 20,000,000 but with the hedge the loss was reduced to 8,387,987.
6. On effectiveness. We are accounting for the instrument and not for the loss on the item. Because the gain on the instrument (11,612,093) is less than the loss (20,000,000) there is ineffectiveness – the gain did not fully cover the loss. This ineffective portion of 8,387,987 is debited to Profit or Loss account and credit the item’s account.
7. This is the way I would have approached the question. Is the approach ideal? Over to the tutor, please.
I understand the above points and the answers except for the last sentence:
The cumulative gain of 18,387,097 recognized in equity is removed from equity (the cashflow hedge reserve) and included directly in initial cost of asset.As I do not see the entries of removing cumulative gain of 18,387,097 from equity, how the Company accounts for this removal. Is this accounted by transfer this cumulative gain to retained earnings
Dr. Equity: 18,387,097
Cr: Retained earnings:18,387,097What is your opinion regarding the last sentences?
When the PPE is purchased:
Dr Cash flow hedge reserve and Cr PPE – with cumulative gain.
This will have the effect of reducing depreciation charge each year – so that the gain is effectively credited to the P&L over the life of the asset
I didn’t get this.
I think we are buying the asset on 01/11/20X2 and we’re asked to prepare the entries as at that day. Can you please explain further? Thanks.@stephenwidberg said:
When the PPE is purchased:Dr Cash flow hedge reserve and Cr PPE – with cumulative gain.
This will have the effect of reducing depreciation charge each year – so that the gain is effectively credited to the P&L over the life of the asset
Dear Sir,
Based on the above, the accounting entries would be:
Dr. Cash flow hedge reserve – from Equity: 18,387,097
Cr. PPE – Cumulative gain: 18,387,097Is it right
Hello dear tutor,
Hope you are fine.
Why in this example the gain was transferred DIRECTLY from RESERVE to PPE?
Why we didn’t reclassified it through P&L as stated in the opentuition notes?I mean:
Dr OCI
Cr PPEinstead of:
Dr Reserve
Cr PPEThank you for your help
The transfer to P&L needs to hit the P&L in the same accounting period as the hedged item.
So, if the hedged item is inventory, then the transfer will be in the period that the inventory is purchased.
If the hedged item is PPE, it needs to hit the P&L over the depreciable life of the asset (like a government grant). One way to do this is credit the CA of the PPE.
All you really need to know for the exam is the first sentence of my answer.
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