DERIVATIVES

 There is no universally satisfactory answer to the question of what a

derivative is
 Executory Contract
o Taking bets on what will happen to the underlying financial
instrument in the future.
o It is not a transaction but an exchange promises about future action.

FINANCIAL RISKS

Price Risk – Uncertainty about future price of an asset.

Credit Risk – Uncertainty over whether a counterparty or the party on the
other side of the contract will honor the terms of the contract
Interest Rate Risk – Uncertainty about future interest rates and their
impact on cash flows and the fair value of the financial instruments.
Foreign Exchange Risk – Uncertainty about future Philippine peso cash
flows on foreign currency denominated financial instruments.

WHAT IS DERIVATIVE

A financial instrument that derives its value from the movement in commodity
price, foreign exchange rate and interest rate of an underlying asset or financial
instrument.

It gives one party a contractual right to exchange financial asset or financial liability
with another party under conditions that are potentially favorable. The other party
has the contractual obligation to exchange under potential unfavorable conditions.

CHARACTERISTICS:

 Value changes as response to the change in an underlying variable. (e.g.

specified interest rate, commodity price, foreign exchange rate, price index,
and other variable.)
 Must contain a notional (amount of currency, # of shares or # of units or
volume) - speculation
 Require either no initial net investment or an initial small net investment.
 Readily settled at a future date by a net cash payment.

HEDGING

Designating one or more hedging instruments so that the change in fair value or
cash is an offset, in whole or in part, to the change in fair value or cash flows of a
hedged item. It simply means protecting a financial loss or the structuring of a
transaction to reduce risk.

Fair value hedge

Cash Flow hedge

Hedge of a net inv. In a foreign operation

 Hedging Instrument – Derivative whose fair value or cash flows would be

expected to offset changes in the fair value or cash flows of the hedged
item.
 Hedged Item – An asset, liability, firm commitment, highly probable
forecast transaction or net investment in a foreign operation.

MEASUREMENT

 Recognize either asset or liability at FAIR VALUE

 FAIR VALUE and NOTIONAL shall be disclosed
 Unrealized gain or loss is recognized when there is change in fair value

P/L OR OCI

 The derivative is not designated as a hedging instrument

 Designated as Cash flow hedge or fair value hedge
 No hedging instrument (in this case, derivative - speculation)

CASH FLOW HEDGE

 Offset in whole or in part the variability in cash flows from a probable

forecast transaction.
 Uncommitted but anticipated future transaction
 Hedging instrument is measured at fair value
 Change in fair value is recognized as component of OCI
 Ineffective portion is recognized in P/L
 Hedged Item is not adjusted to conform with fair value

FAIR VALUE HEDGE

 Derivative that offsets in whole or in part the change in the fair value of an
asset of a liability.
 Hedging instrument is measured at fair value
 Hedged item is also measured at fair value
 Changes in fair value are recognized in P/L
 TYPES OF DERIVATIVES - “stand-alone”
- A contract whereby two parties agree to
INTEREST RATE SWAP
exchange cash flows for future interest
payments based on a contract of loan.

- Commitment to purchase or sell a

FORWARD CONTRACT specified commodity, security o foreign
currency on a specified future date at a
specified price or exchange rate.

- Commitment to purchase or sell a

specified commodity on a future date
at a specified price
- Standard contract traded in a future
FUTURES CONTRACT
exchange market and one party will
never know who is on the other side of
the contract.
- Private contract between two parties
who know each other very well

- Gives the holder the right to purchase

CALL OPTION an asset
- It must be paid for – requires an initial
small payment (option premium)
- Give the holder the right to sell an asset
PUT OPTION
- It must be paid – requires an initial
small payment (option premium)

EMBEDDED DERIVATIVE
Component of a hybrid or combined contract. A basic contract known as the “host
contract” that has an embedded derivative.

TYPES

EQUITY
REDEMPTION INVESTMENT IN
CONVERSION
OPTION BOND
OPTION
Convertible bond Investment in Interest in principal
instrument is the host redeemable preference payment is linked to the
 price of gold and silver
Investment in bond is the
share is the host contract
contract and equity host contract and the
and the redemption
conversion feature is the embedded derivative is
option feature is the
embedded derivative the payment of interest
embedded derivative
or principal based on the
price of gold or silver.

PFRS 9
 Embedded derivative shall be separated from the host contract
 CONDITIONS
 Separate instrument with the same terms as the embedded feature
would meet the definition of a derivative
 The combined contract is not measured at fair value through P/L
 Economic characteristics and risks embedded feature are not
closely related to the economic characteristics and risks of the host
contract
 The host contract is outside the scope of PFRS 9
 If separated, the embedded derivative is accounted for at fair value and the
host contract is accounted for in accordance with the appropriate PFRS
 If the host contract is within the scope of PFRS 9, the classification applies
to the combined contract in its entirety

EXAMPLE – Interest Rate Swap

Problem 23-2

Loan – P6,000,000

Interest Rate - Jan. 2019 (10%) ; Jan. 2020 (13%)

Due Date – December 31, 2020

“Receive Variable, Pay Fixed” – CASH FLOW HEDGE

Required:

Journal entries for 2019 and 2020

Problem 23-2

2019
Jan 1 Cash 6,000,000

Loan Payable 6,000,000

Dec 31 Interest expense 600,000 Interest to be paid

Cash (10% x 6,000,000) 600,000

31 Interest rate swap receivable 159,300 PV of Interest you will receive next
year

Unrealized gain - interest rate swap 159,300

(6,000,000 x 13% x .885)

INVESTMENT PROPERTY
Definition of Terms:

– property held for rent or capital

INVESTMENT PROPERTY appreciation
-Not for sale or use in production
-Only land and building can qualify
-Property held for production, supply of
OWNER-OCCUPIED
goods and services or administrative
PROPERTY
services.

-Goods in various stages of being made

INVENTORY
ready for sale.

CLASSIFICATION ALTERNATIVE:

 Property held by lessee under operating lease may be classified as

investment property
 Property must meet definition of investment property (held for rent income
and capital appreciation)
 Lessee must recognize all investment property at fair value and fair value
disclosures made
NOT INVESTMENT
NOT PROPERTY
INVESTMENT INVESTMENT
Property occupied
PROPERTY PROPERTY by employees,
whether or not the
Land held long- employees pay rent
Property held for at market rate
term capital sale
appreciation Vacant building but
Owner-occupied
is leased out under property awaiting
building leased operating lease PAS 11 for disposal
out under Construction
operating lease Contracts Property held for sale in
the ordinary course of
Investment business or in the
Property under Owner-occupied process of construction
Property or devt for such sale
construction
Property being
Property that is being constructed or
constructed or developed for Land helf for a developed on behalf
future use as inv. property undetermined use
of third parties

Land held for a currently Leased to another

entity under a
undetermined use finance lease
 COMBINATIONS AND ANCILLARY SERVICES
(MEASUREMENT)
Insignificant portion ancilliary services
INVESTMENT
Insignificant portion used for production/admin
PROPERTY

Significant ancilliary services

OWNER-OCCUPIED Significant portion used for production/admin

Account for them separately

separately
SEPARATE PORTIONS
Investment and owner-occupied portion can be sold

RECOGNITION

Investment property should be recognized as an asset when:

 It is probable that the future economic benefit that are associated with the
property will flow to the entity.
 The cost of the property can be reliably measured.

INITIAL MEASUREMENT

Purchase
price
Property/Transfer Direct
taxes Expenditure

@cost +
transaction
cost Costs when
construction is
Legal fees completed

EXCLUDED:

 Start-up costs
 Abnormal waste
 Operating losses before planned level of occupancy

FAIR VALUE MODEL

- Investment property is re-measured at fair value which is the price that

would receive to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.
COST MODEL

- After initial recognition, investment property is accounted for in accordance

with the cost model as set out in PAS 16 Property, Plant and Equipment –
cost less accumulated depreciation and less accumulated impairment losses.

MEASUREMENT AFTER RECOGNITION: ACCOUNTING POLICY

Recognize gains or
losses in P&L every
period
Fair Value Model
Change from FV to
Cost Model not
Choose and Apply appropriate
to all investment
property Depreciation
method, useful lofe,
carrying amount
Cost Model

Disclose Fair Value

 Commencement of owner-occupation (transfer from investment property to

owner-occupied property)
 Commencement of dev’t with a view to sale (transfer from investment
property to inventories)
 End of owner-occupation (transfer from owner-occupied property to
investment property)
 Commencement of an operating lease to another party (transfer from
inventories to investment property)
 End of construction or development (transfer from property in the course of
construction/dev’t to investment property)

RULES APPLIED FOR TRANSFERS BETWEEN CATEGORIES

Investment Property @ Fair Value => The fair value at the change of use is
Inventory the “cost” of the property under its
new classification

IP @ FV => Owner-Occupied Property The fair value at the change of use is

the “cost” of the property under its
new classification

Inventory => IP @ FV PAS 16 should be applied up to the

date of reclassification
Owner-occupied => IP @ FV PAS 16 should be applied up to the
date of reclassification

 When an entity completes construction/development of an investment

property that will be carried at fair value, any difference between the fair
value at the date of transfer and the previous carrying amount should be
recognized in profit or loss.

 When an entity uses the cost model for investment property, transfers
between categories do not change the carrying amount of the property
transferred, and they do not change the cost of the property for
measurement or disclosure purposes.

DISPOSAL

 Derecognize from balance sheet when no future economic benefit expected

 Net disposal proceeds – carrying amount = P/L in period of disposal
 Recognize compensation for impairment or loss in profit & loss when
receivable.

DISCLOSURE: FAIR VALUE MODEL & COST MODEL

 Whether fair value or cost model applied

MODEL  Reasons for classifying property under
operating lease as investment property

 Criteria to distinguish owner-occupied

from investment property
 Methods and assumption to calculate fair
VALUE value
 Market evidence to support fair value
 Whether or not a professional valuation
was obtained.

 Restrictions on realizability (existence

and amounts)
OBLIGATIONS  Contractual obligations to develop,
repair, maintain or obligations enhance
investment property
  Rental income
 Direct operating expenses relating to
rental income
AMOUNTS IN P/L  Direct operating expenses not related to
rental income
 Cumulative change in fair value from
sale of asset at cost to fair value pools.

DISCLOSURE: COST MODEL (additional)

 Reconciliation between carrying amount at beginning and end of period

 Additions
o From acquisition
o From subsequent expenditure
o From acquisitions through business combination
 Assets classified as held for sale
 Net gain or loss from fair value adjustments
 Net exchange difference on translation
 Transfer to and from inventories and owner-occupied property
 Significant adjustments to an outside valuation
 Depreciation methods used
 Useful lives
 Gross carrying amount
 Accumulated Depreciation and impairment loss at beg and end of period
 Additions
o From subsequent expenditure
o From acquisitions
 Assets classified as held for sale
 Depreciation
 Impairment loss recognized and reversed
 Net exchange difference on translation
 Transfers to and from inventories and owner-occupied property
 Fair value of investment property or
o Description of property
o Reason why fair value cannot be determined
o Range of estimate in which fair value is likely to lie
SUMMARY
Investment property is held for rent or capital appreciation
Measure initially at cost including transaction costs
Choose fair value or cost model after initial recognition and apply to all
properties
Recognizes changes in Fair value in P&L for the period
Transfer when investment property becomes owner-occupied or used in
another way
Derecognize when disposed and recognize Profit or Loss on disposal
Make detailed disclosures and reconciliation of opening and closing
carrying values