Pert 3 - Embeded Derivatives-new- AKL

8/15/2019 Pert 3 - Embeded Derivatives-new- AKL

1/27

Edited by Taufik Hidayat

Session

3

• Hedge of a Net Investmentin a Foreign Entity

• Compound Financial Instrument& Embedded Derivative


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Classification of Hedging

Hedge of “the exposure to changes in fair value of arecognized asset or liability or an unrecognized firmcommitment, or an identified portion of such asset, liabilityor firm commitment, which is attributable to a particular

ris and could affect profit or loss”

!air "aluehedge

Hedge of “the exposure to variability in cash flo!s that #i$ is attributable to a particular ris associated with arecognized asset or liability #such as all or some futureinterest payment on "ariable debt instrument $or a highlyprobable future transaction, and

#ii$ could affect profit or loss”

%ash flowhedge

Hedge of a netin"estment in aforeign entity

Hedge of the foreign currency risk associated with aforeign operation whose financial statements are re&uiredto be translated into the presentation currency of theparent company


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Hedge of a Net Investment

in a Foreign Entity

• Hedge risk is foreign exchange risk ' (pplies 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• (ccounting treatment similar to cash flow hedge

' Hedge is effecti"e if the delta ratio is between )* and +-

' .nlike a fair "alue hedge or a cash flow hedge, a non/deri"ati"e isallowed to be the hedging instrument, for example, a foreign currencyloan

Hedge effecti"eness0%umulati"e change in fair "alue of hedging instrument #($

%umulati"e translation difference on net in"estment #1$


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"ccounting for Hedge of a Net Investment

in a Foreign Entity

• The gain or loss on the effecti"e portion of a hedgeof a net in"estment is recognized in othercomprehensi"e income as part of the translationad2ustment

• The amount of offset to comprehensi"e income islimited to the translation ad2ustment for the netin"estment

• (ny excess must be recognized currently in 345• 36(7 -- allows the hedging instrument in this type

of hedge to be deri"ati"e or non/deri"ati"e inapplying hedge accounting


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in a Foreign Entity # illustrationE$ample

E$ample

8+4+4)9) ' 3arent:s functional currency is the dollar #;$

' (c&uired +))< interest in foreign company #functional currency is !%$for !% -),))) #!% =),))) ordinary share > !% +),))) retainedearnings$

+4+4)9+ ' 5oan of !% -),))) at -< interest taken to hedge foreign in"estment

#due and payable on ?anuary +, )9$

' Exchange rate is ;+ to !%+

8+4+4)9+ ' Exchange rate is ;+=) to !%+

' ("erage rate is ;+8) to !%+

' Transalation ad2ustment of foreign subsidiary !46 is !% ++,=-) #credit

balance$


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in a Foreign Entity % illustration '()*)*'+,)

3)*)'*'+,)

@r A%B ' Hedgereser"e

+),)))

%r 5oan 3ayable #!%$ +),)))

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

@r %ash CCCC D),)))

%r 5oan 3ayable #!%$ D),)))

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

@r Bnterest Expense CCCC 8,-)@r !% 5oss -)

%r Bnterest 3ayable #!%$ 8,-))

!""rue the ntere#t :,250%50,000 x 5& x 1. avera'e rate

,500%50,000 x 5& x 1.4 "lo#n' rate


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in a Foreign Entity % illustration 3(

3)*)'*'+,)@r A%B ' Translation (d2 +),)))

%r A%B / Hedge reser"e +),)))

Clo#e the C *rom loan and C *rom tran#laton.

@r Bnterest 3ayable #!%$ CC 8,-))

@r 5oan 3ayable #!%$ ),)))

%r %ash 8,-))

+a the rn"le and ntere#t

)*)*'+,'



Compound Financial Instrument

& Embedded Derivative

• There are certain financial instruments that ha"e ahybrid or combined nature

• !or example, a con"ertible bond is a debt instrumentwith an embedded option to con"ert the debt

instrument to e&uity shares ' !rom the perspecti"e of the issuer, the debt instrument is a

financial liability while the embedded option may be ane&uity instrument

' !rom the perspecti"e of the holder of that con"ertible bond,

the debt instrument is a financial asset and the embeddedoption is similar to a deri"ati"e




& Embedded Derivative

• Bn 36(7 -), from the perspecti"e of an issuer, thesekinds of financial instruments are termed as compoundfinancial instruments

' 36(7 -) re&uires an issuer of a compoundfinancial instrument to separately classify different

components of the instrument in accordance with thedefinition of financial liability and e&uity instrument

• Bn 36(7 --, from the perspecti"e of a holder, these kindsof financial instruments are termed as hybrid #combined$instruments

' 36(7 -- re&uires a holder of a hybrid instrument toseparately account for the embedded derivative ofthe instrument if certain conditions are fulfilled



Compound Financial

Instrument• The most important compound instruments are those

which incorporate some elements of liability and otherelements of e&uity, such as con"ertible bonds

• Bt is re&uired that whether or not fair "alues are a"ailable

for all components of compound instruments, full fair "aluebe allocated to liability component, with only residual beingassigned to e&uity component




'(• Foche Group #@E.$ issues ,))) con"ertible bonds at the

beginning of )++

• The bonds ha"e a four/year term with a stated rate ofinterest of D percent, and are issued at par with a face

"alue of +,))) per bond #the total proceeds recei"ed fromissuance of the bonds are ,))),)))$

• Bnterest is payable annually at @ecember 8+

• Each bond is con"ertible into -) ordinary shares with a

par "alue of +• The market rate of interest on similar non/con"ertible debt

is I percent

E$ampleE$ample




3( E$ampleE$ample

"t -ime ofIssuance




.( E$ampleE$ample

%ash ,))),)))

1onds 3ayable +,*)-,D)D

6hare 3remiumJ%on"ersion E&uity +I=,8I=

/ournal

Entry




0( E$ampleE$ample

Conversion of Bonds at Maturity. Bf the bonds are con"erted

at maturity, Foche makes the following entry

6hare 3remiumJ%on"ersion E&uity +I=,8I=

1onds 3ayable ,))),)))

6hare %apitalJArdinary -)),)))

6hare 3remiumJArdinary +,DI=,8I=

N1-E2 The amount originally allocated to e&uity of +I=,8*= is

transferred to the 6hare 3remiumJArdinary account



Embedded

Derivative

• @eri"ati"e that is part of a hybrid financial instrument

Host Bnstrument

Embedded deri"ati"eK5inked to underlying and changein underlying causes change in

cash flow

Hybrid Instrument

• Example is bond whose ultimate proceed are linked toprice of commodity, such as oil, or to a consumer priceindex



Embedded Derivative

'(• 36(7 -- re&uires embedded deri"ati"es to be separately

recognized from the host instrument and accounted for inthe same way as a stand/alone deri"ati"e if the followingconditions are metK

Conditions for separation of embedded derivative

Economiccharacteristics and

risk of hostinstrument are notclosely related to that

of the deri"ati"e

Hybrid instrument isnot measured at fair

"alue, with changesin fair "aluerecognized in profit

and loss

There is a separate

instrument with sameterms as theembedded deri"ati"e



Embedded Derivative 3(

• ( hybrid instrument includes

' a non/deri"ati"e host contract and

' an embedded deri"ati"e with the effect thatsome of the cash flows of the hybridinstrument "ary in a way similar to a stand/alone deri"ati"e

• Howe"er, a deri"ati"e that is attached to a

financial instrument but is contractuallytransferable independently of that instrument, orhas a different counterparty from that instrument,is not an embedded deri"ati"e, but a separatefinancial instrument

Host ContractHost Contract

EmbeddedDerivative

EmbeddedDerivative

Hybrid Combined(Contract

Hybrid Combined(Contract



Embedded Derivative 2 E$ample

• Examples of contract with embedded deri"ati"eincludeK

+ ( call, put, or prepayment option embedded in a hostdebt contract

(n option or automatic pro"ision to extend theremaining term to maturity of a debt instrument

8 E&uity/indexed interest or principal paymentsembedded in a host debt instrument

= %ommodity/indexed interest or principal paymentsembedded in a host debt instrument

- (n e&uity con"ersion feature embedded in acon"ertible debt instrument



Embedded Derivative 2 Separation

Criteria

36(7 --



Embedded Derivative 2 Not Closely

elated

• ( put option embedded in an instrument that enables theholder to re&uire the issuer to reac&uire the instrument foran amount of cash or other assets that "aries on the basis ofthe change in an e&uity or commodity price or index

• (n option or automatic pro"ision to extend the remainingterm to maturity of a debt instrument

• E&uity/indexed interest or principal payments embedded in ahost debt instrument

• %ommodity/indexed interest or principal paymentsembedded in a host debt instrument



Embedded Derivative 2 Closely

elated

• (n embedded deri"ati"e in which the underlying is aninterest rate or interest rate index that can change theamount of interest that would otherwise be paid orrecei"ed on an interest/bearing host debt contract

• (n embedded foreign currency deri"ati"e that pro"ides astream of principal or interest payments that aredenominated in a foreign currency and is embedded in ahost debt instrument #eg a dual currency bond$



-he Separated Embedded Derivative

• Bf an embedded deri"ati"e is separated, the host contract isaccounted for

' under 36(7 -- if it is a financial instrument, and

' in accordance with other appropriate accounting

standards if it is not a financial instrument• 36(7 -- does not address whether an embedded

deri"ati"e is presented separately in the financialstatements

• The separated embedded deri"ati"e is similar to a simplederi"ati"e to be accounted for in the same manner as otherderi"ati"es


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Embedded Derivatives as

Combined Contract

• Bf a contract contains one or more embeddedderi"ati"es, an entity may designate the entire hybrid#combined$ contract as a financial asset or financialliability at fair "alue through profit or loss unlessK

+ the embedded deri"ati"e does not significantly modify thecash flows that otherwise would be re&uired by thecontractL or

it is clear with little or no analysis when a similar hybrid

instrument is first considered that separation of theembedded deri"ati"e is prohibited, such as a prepaymentoption embedded in a loan that permits the holder toprepay the loan for approximately its amortised cost

E b dd d D i ti 4 bl


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Embedded Derivatives 2 4nable

to Separate

• Bf an entity is re&uired by 36(7 -- to separate anembedded deri"ati"e from its host contract, but is unable tomeasure the embedded deri"ati"e separately #either atac&uisition or subse&uently$,

' the entity is re&uired to designate the entire hybridcontract as at fair "alue through profit or loss


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Embedded Derivatives 2

E$ample

• Tony !inance 5td in"ested in bond that would con"ertible toshares of issuing company #Foche Group$ before maturity!air "alue of bond was ;8 million and fair "alue ofembedded deri"ati"e was ;-)))))

• (nalysisK ' The in"estment comprises two elementsK bond #host$ and

con"ersion option #embedded deri"ati"e$

' Bf in"estment is designated as !MT35, separating the embeddedderi"ati"e from the host is not permitted

' The in"estment cannot be classified as HTN because of con"ersionoption

' Bf in"estment is designated as (!6, separating the embeddedderi"ati"e from the host is re&uired since 8 conditions in 36(7 --are met


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Embedded Derivatives 2

E$ample

• Bf the in"estment is designated as (!6, separating the embeddedderi"ati"e from the host is re&uired since 8 conditions in 36(7 --are met

("ailable for 6ale ,-)),)))

Embedded @eri"ati"e -)),)))%ash 8,))),)))

/ournal

Entry

• %hanges in !M of con"ersion option are recognized in 345 unlessthe option is part of cash flow hedge


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Sources

2

• Tan > 5ee ' (d"anced !inancial (ccounting• 5am > 5au ' Bntermediate !inancial Feporting, nd Ed

• 1aker, %hristensen, %ottrell ' (d"anced !inancial (ccounting, +)th Ed

• Nackenzie, et al ' Bnterpretation > (pplication of B!F6 ' )++

• 7ieso, et al ' Bntermediate (ccountingK B!F6 (dapted

5-aufi6FE4I

Documents

Pert 3 - Embeded Derivatives-new- AKL