Session 3

• Hedge of a Net Investment

in a Foreign Entity

• Compound Financial
Instrument & Embedded
Derivative
Classification of Hedging

Hedge of “the exposure to changes in fair value of a

Fair value recognized asset or liability or an unrecognized firm
hedge 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
Cash flow (i) is attributable to a particular risk associated with a
hedge 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 a net Hedge of the foreign currency risk associated with a

investment in a foreign operation whose financial statements are required
foreign entity to be translated into the presentation currency of the
parent company.
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
Cumulative change in fair value of hedging instrument (A)
Hedge effectiveness =
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.
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 recognized in 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.
Accounting for Hedge of a Net Investment
in a Foreign Entity
Functional U.S. Exchange Rates
Account Rate
Currency Dollars 1/2/X7 0.0553
Cash 25.000 0,0532 1.330 4/1/X7 0.0550
Accounts Receivable 60.000 0,0532 3.192 11/30/X7 0.0535
Inventory 160.000 0,0532 8.512
12/31/X7 0.0532
Note Receivable 25.000 0,0532 1.330
Average 0.0545
Plant and Equipment 350.000 0,0532 18.620
Cost of Goods Sold 160.000 0,0545 8.720
Depreciation Expense 10.000 0,0545 545
Other Expenses 90.000 0,0545 4.905
Dividends 80.000 0,0535 4.280
Total Debits 960.000 51.434

Acc. OCI— Translation Adjustment 382

Adjusted Total Debits 51.816

Accumulated Depreciation 10.000 0,0532 532

Accounts Payable 60.000 0,0532 3.192
Bonds Payable 180.000 0,0532 9.576
Mortgage Payable 230.000 0,0532 12.236
Common Stock 150.000 0,0553 8.295
Sales 330.000 0,0545 17.985
Total Credits 960.000 51.816
Hedge of a Net Investment
in a Foreign Entity - illustration Example

31/12/20X0
– Parent’s 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/FC 1.
31/12/20X1
– Exchange rate is $1.4/FC 1.
– Average rate is $1.3/FC 1.
– Transalation adjustment of foreign subsidiary F/S is $11,450 (credit
balance).
Hedge of a Net Investment
in a Foreign Entity – illustration (2)
1/1/20X1
Dr Cash ………….................. 60,000
Cr Loan Payable (FC) ............. 60,000
Borrow a FC denominated loan : FC 50,000 x 1.2
31/12/20X1
Dr OCI – Hedge reserve ........... 10,000
Cr Loan Payable (FC) .............. 10,000
Revalue the loan : FC 50,000 x (1.4 - 1.2)

Dr Interest Expense ………….. 3,250

Dr FC Loss ............................. 250
Cr Interest Payable (FC) ......... 3,500
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
Hedge of a Net Investment
in a Foreign Entity – illustration (3)
31/12/20X1
Dr OCI – Translation Adj .......... 10,000
Cr OCI - Hedge reserve ......... 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 ................................... 73,500
Pay the principle and interest

Balance of OCI – Hedge Reserve = 10.000 - 10.000 = 0

Balance of OCI – Translation Adj = 11.450 - 10.000 =1.450
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.
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.
– PSAK 71: No bifurcation of asset, if a hybrid contract
contains a host that is an asset within the scope of
PSAK 71.
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.
• With-or-without method.
Compound Financial Instrument (2)
Example

• 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.
Compound Financial Instrument (3)
Example

At Time of
Issuance
Compound Financial Instrument (4)
Example

Cash 2,000,000
Journal
Entry Bonds Payable 1,805,606
Share Premium—Conversion Equity 194,394
Compound Financial Instrument (5)
Example

Conversion of Bonds at Maturity. If the bonds are converted

at maturity, Roche makes the following entry.

Share Premium—Conversion Equity 194,394

Bonds Payable 2,000,000
Share Capital—Ordinary 500,000
Share Premium—Ordinary 1,694,394

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

transferred to the Share Premium—Ordinary account.
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.
Embedded Derivative (3)

• 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 Hybrid instrument is

characteristics and There is a separate not measured at fair
risk of host instrument with same value, with changes
instrument are not terms as the in fair value
closely related to that embedded derivative recognized in profit
of the derivative and loss
Embedded Derivative (4)

Hybrid (Combined)
Contract

• A hybrid instrument includes

– a non-derivative host contract and Host Contract
– an embedded derivative with the effect that Embedded
some of the cash flows of the hybrid Derivative
instrument vary in a way similar to a stand-
alone 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, i.e bonds + warrant.
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.
Embedded Derivative : Example

• Certain terms and phrases, however, may indicate the

presence of an embedded derivative in a contract:
1. right to put / call / redeem / repurchase / return.
2. right to prepay / repay early / accelerate repayment / early
exercise.
3. right to purchase / sell additional units.
4. right to terminate / cancel / extend.
5. right to exchange / exchangeable into.
6. right to convert / convertible into
7. indexed to / adjusted by / referenced to
8. pricing based on the following formula
9. conditional / contingent / optional
Embedded Derivative : Separation Criteria

PSAK 55
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.
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, example: a dual currency bond.
– A debt instrument in which the coupon and principal payments are
made in two different currencies. The currency in which the bond is
issued, which is called the base currency, will be the currency in
which interest payments are made.
– Dual currency bonds are subject to exchange rate risk.
The Separated Embedded Derivative

• If an embedded derivative is separated (bifurcated), 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.
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:
1. 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.
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.
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.
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 2,500,000
Journal
Embedded Derivative 500,000
Entry
Cash 3,000,000

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

the option is part of cash flow hedge.
Embedded Derivatives : Exercise

1. Is bifurcation of a hybrid instrument required for a derivative

embedded in another instrument if (1) that instrument is
accounted for on a mark-to market basis and (2) changes in the
instrument’s fair value are recorded in earnings?

No. Embedded derivatives within hybrid instruments that are

measured at fair value, with changes in fair value reported in
earnings, must not be bifurcated
Embedded Derivatives : Exercise

2. Is bifurcation discretionary? That is, may an entity elect to

separate an embedded derivative from the host contract if IFRS
does not require bifurcation?

No. The Board decided that the bifurcation of hybrid

instruments containing embedded derivatives should not be
discretionary
Embedded Derivatives : Exercise

3. If a variable-rate debt instrument contains an interest rate floor

or cap, such that the interest rate could never fall below or
exceed a specified level, would the issuer be required to
separate the interest rate floor or cap from the debt instrument?

No. IFRS clarifies that interest rate caps and floors are typically
considered clearly and closely related to a debt host contract.
Embedded Derivative-PSAK 71

• No bifurcation of asset, if a hybrid contract contains a host that is an asset

within the scope of PSAK 71.
• If a hybrid contract contains a host that is not an asset within the scope of
PSAK 71, an embedded derivative shall be separated from the host and
accounted for as a derivative using the same requirement with PSAK 55.

Scope of PSAK 71: All financial instruments, except:

• Interests in subsidiaries, associates and joint ventures (PSAK 15,65,66).
• Rights and obligations under leases (PSAK 30).
• Employers' rights and obligations under employee benefit plans (PSAK 24).
• Financial instruments issued by the entity that meet the definition of an equity
instrument based on PSAK 50.
• Rights and obligations arising under an insurance contractas (PSAK 62).
• Contracts between an acquirer and a vendor in a business combination (PSAK 22).
• Certain loan commitments based on PSAK 57.
• Financial instruments, contracts & obligations under share-based payment (PSAK
53).
Quiz

31/12/20X0
– Parent’s functional currency is USD.
– Acquired 100% interest in foreign company (functional currency is £)
for £100,000 (£60,000 ordinary share & £40,000 retained earnings).
1/1/20X1
– Loan of £100,000 at 6% interest taken to hedge foreign investment
(due and payable on January 1, 20X2) .
– Exchange rate is USD 1.3/£ 1.
31/12/20X1
– Exchange rate is USD 1.4/£ 1.
– Average rate is USD 1.35/£ 1.
– Transalation adjustment of foreign subsidiary F/S is USD 9,000 (credit
balance).
Sources:

• Tan & Lee – Advanced Financial Accounting.

• Lam & Lau – Intermediate Financial Reporting, 2nd Ed.
• Baker, Christensen, Cottrell – Advanced Financial
Accounting, 10th Ed.
• Mackenzie, et al – Interpretation & Application of IFRS –
2011.
• Kieso, et al – Intermediate Accounting: IFRS Adapted.
• PWC - Guide to Accounting for Derivative Instruments and
Hedging Activities