IFRS for SMEs® Standard (2015) + Q&As

IFRS® Foundation—Supporting Material for the IFRS for SMEs Standard

Module 12—Other Financial

Instrument Issues
 IFRS® Foundation
Supporting Material
for the IFRS for SMEs® Standard
including the full text of
Section 12 Other Financial Instrument Issues
of the IFRS for SMEs Standard
issued by the International Accounting Standards Board in October 2015

with extensive explanations, self-assessment questions and case studies

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Contents

INTRODUCTION __________________________________________________________ 1
Which version of the IFRS for SMEs Standard? __________________________________ 1
This module ______________________________________________________________ 1
IFRS for SMEs Standard ____________________________________________________ 2
Introduction to the requirements_______________________________________________ 3
What has changed since the 2009 IFRS for SMEs Standard ________________________ 4
REQUIREMENTS AND EXAMPLES ___________________________________________ 5
Scope of Section 11 and 12 __________________________________________________ 5
Accounting policy choice ____________________________________________________ 9
Scope of Section 12 _______________________________________________________ 10
Initial recognition of financial assets and liabilities ________________________________ 18
Initial measurement _______________________________________________________ 18
Subsequent measurement __________________________________________________ 20
Fair value _______________________________________________________________ 22
Impairment of financial instruments measured at a cost or amortised cost _____________ 24
Derecognition of a financial asset or financial liability _____________________________ 25
Hedge accounting ________________________________________________________ 26
Disclosures ______________________________________________________________ 65
SIGNIFICANT ESTIMATES AND OTHER JUDGEMENTS _________________________ 72
1Scope of Section 12 _______________________________________________________ 72
1Initial measurement _______________________________________________________ 72
1Subsequent measurement __________________________________________________ 72
1Hedging ________________________________________________________________ 73
1Derecognition ____________________________________________________________ 73
COMPARISON WITH FULL IFRS STANDARDS ________________________________ 74
TEST YOUR KNOWLEDGE ________________________________________________ 77
APPLY YOUR KNOWLEDGE _______________________________________________ 82
Case study 1 ____________________________________________________________ 82
Answer to Case study 1 ____________________________________________________ 84
Case study 2 ____________________________________________________________ 88
Answer to Case study 2 ____________________________________________________ 89

IFRS Foundation: Supporting Material for the IFRS for SMEs® Standard (version 2018–08) iv
Module 12—Other Financial Instrument Issues

The accounting requirements applicable to small and medium-sized entities (SMEs)

discussed in this training module are set out in the IFRS for SMEs Standard, issued by the
International Accounting Standards Board (Board) in October 2015.
This training material has been prepared by IFRS Foundation education staff.
The contents of Section 12 Other Financial Instrument Issues of the IFRS for SMEs
Standard are set out in this module and shaded grey. The Glossary of terms of the
IFRS for SMEs Standard (Glossary) is also part of the requirements. Terms defined in the
Glossary are in bold type the first time they appear in the text of Section 12. The notes
and examples inserted by the education staff are not shaded. These notes and examples
do not form part of the IFRS for SMEs Standard and have not been approved by the
Board.

INTRODUCTION

Which version of the IFRS for SMEs® Standard?

When the IFRS for SMEs Standard was issued in July 2009, the Board said it would undertake an
initial comprehensive review of the Standard to assess entities’ experience of the first two
years of its application and to consider the need for any amendments. To this end, in
June 2012, the Board issued a Request for Information: Comprehensive Review of the IFRS for SMEs.
An Exposure Draft proposing amendments to the IFRS for SMEs Standard was subsequently
published in 2013, and in May 2015 the Board issued 2015 Amendments to the IFRS for SMEs
Standard.
The document published in May 2015 only included amended text, but in October 2015, the
Board issued a fully revised edition of the Standard, which incorporated additional minor
editorial amendments as well as the substantive May 2015 revisions. This module is based on
that version.
The IFRS for SMEs Standard issued in October 2015 is effective for annual periods beginning on
or after 1 January 2017. Earlier application is permitted, but an entity that did so was required
to disclose that fact.
Any reference in this module to the IFRS for SMEs Standard refers to the version issued in
October 2015.

This module

This module focuses on the accounting and reporting of financial instruments and
transactions, other than those covered by Section 11, applying Section 12 of the IFRS for SMEs
Standard. Section 12 applies to financial instrument issues not covered by Section 11 and
hence covers more complex financial instruments and related transactions including hedge
accounting. The module identifies the significant judgements required to account for and
report more complex financial instruments and transactions. In addition, the module
includes questions designed to test your understanding of the requirements and a case study
that provides a practical opportunity to apply the requirements to account for and report
more complex financial instruments and transactions applying the IFRS for SMEs Standard.

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Module 12—Other Financial Instrument Issues

Upon successful completion of this module you should, within the context of the IFRS for SMEs
Standard, be able to:
• identify financial assets and financial liabilities that are within the scope of Section 12;
• explain when to recognise and when to derecognise a financial instrument;
• apply the measurement requirements for financial instruments on initial recognition and
subsequently;
• identify and apply appropriate methods of determining fair value for financial
instruments;
• identify the types of transactions to which an entity may apply hedge accounting and be
able to apply hedge accounting to those scenarios;
• prepare appropriate information about financial instruments that would satisfy the
• disclosure requirements in Section 12; and
• demonstrate an understanding of the significant judgements that are required in
accounting for financial instruments and related transactions.

IFRS for SMEs Standard

1

The IFRS for SMEs Standard is intended to apply to the general purpose financial statements of
entities that do not have public accountability (see Section 1 Small and Medium-sized Entities).
The IFRS for SMEs Standard includes mandatory requirements and other non-mandatory
material.
The non-mandatory material includes:
• a preface, which provides a general introduction to the IFRS for SMEs Standard and explains
its purpose, structure and authority;
• implementation guidance, which includes illustrative financial statements and a table of
presentation and disclosure requirements;
• the Basis for Conclusions, which summarises the Board’s main considerations in reaching
its conclusions in the IFRS for SMEs Standard issued in 2009 and, separately, in the 2015
Amendments; and
• the dissenting opinion of a Board member who did not agree with the issue of the
IFRS for SMEs Standard in 2009 and the dissenting opinion of a Board member who did not
agree with the 2015 Amendments.
In the IFRS for SMEs Standard, Appendix A: Effective date and transition, and Appendix B:
Glossary of terms, are part of the mandatory requirements.
In the IFRS for SMEs Standard there are appendices to Section 21 Provisions and Contingencies,
Section 22 Liabilities and Equity and Section 23 Revenue. These appendices provide
non-mandatory guidance.

The IFRS for SMEs Standard has been issued in two parts: Part A contains the preface, all the
mandatory material and the appendices to Section 21, Section 22 and Section 23; and Part B
contains the remainder of the material mentioned above.
Further, the SME Implementation Group (SMEIG), which assists the Board with supporting
implementation of the IFRS for SMEs Standard, publishes implementation guidance as
‘questions and answers’ (Q&As). These Q&As provide non-mandatory, timely guidance on

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Module 12—Other Financial Instrument Issues

specific accounting questions raised with the SMEIG by entities implementing the IFRS for SMEs
Standard and other interested parties. At the time of issue of this module (August 2018) the
SMEIG has issued one Q&A relevant to this module and the Q&A has been reflected in this
module.

Introduction to the requirements

The objective of general purpose financial statements of a small or medium-sized entity is to

provide information about the entity’s financial position, performance and cash flows that is
useful for economic decision-making by a broad range of users who are not in a position to
demand reports tailored to meet their particular information needs. Such users include, for
example, owners who are not involved in managing the business, existing and potential
creditors and credit-rating agencies.
Section 11 Basic Financial Instruments and Section 12 Other Financial Instrument Issues specify the
financial reporting requirements for financial instruments. A financial instrument is defined
as a contract that gives rise to a financial asset of one entity and a financial liability or equity
instrument of another entity.
The IFRS for SMEs Standard contains two options for accounting for financial instruments:
• applying the requirements of both Section 11 and Section 12 in full; or
• applying the recognition and measurement requirements of IAS 39 Financial Instruments:
Recognition and Measurement (of full IFRS Standards) and the disclosure requirements in
Sections 11 and 12.
Whichever option is selected, an entity must also apply Section 22 Liabilities and Equity, which
establishes principles for classifying financial instruments as either liabilities or equity.
Section 22 also focuses on accounting for equity instruments issued to individuals or other
parties acting in their capacity as investors in equity instruments (that is, in their capacity as
owners).
Section 11 applies to basic financial instruments and is relevant to all entities that prepare
financial statements applying the IFRS for SMEs Standard, unless the companies have chosen
instead to apply IAS 39 to recognise and measure their financial instruments. For the purposes
of Section 11, basic financial instruments consist of:
• cash;
• debt instruments (such as an account, note, or loan receivable or payable) that meet
specified conditions (including that returns to the holder are either fixed and/or variable,
and if variable are based on a single referenced quoted or observable interest rate);
• commitments to receive a loan that cannot be settled net in cash where the loan is
expected to meet the same conditions as the debt instruments in the bullet point above;
and
• investments in non-convertible preference shares and non-puttable ordinary shares or
preference shares.

Overview

This module focuses on the requirements in Section 12. Section 12 applies to complex
financial instruments and transactions outside the scope of Section 11, apart from exemptions
to particular financial instruments, which are generally discussed in another section of the
IFRS for SMEs Standard (see paragraph 12.3).

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Module 12—Other Financial Instrument Issues

Section 12 requires an entity to recognise a financial asset or financial liability when the entity
becomes a party to the contractual provisions of the instrument. Financial assets and financial
liabilities are initially recognised at fair value, which is normally the transaction price.
Paragraph 12.12 provides further guidance on the treatment of transaction costs and deferred
payments as they relate to the initial measurement of financial assets and financial liabilities.
On subsequent measurement, with one exception, all financial instruments within the scope
of Section 12 are measured at fair value with changes in fair value recognised in profit or loss.
The exception is for equity instruments within the scope of Section 12 not publicly traded
whose fair value cannot otherwise be measured reliably without undue cost or effort and
contracts linked to such instruments that, if exercised, will result in delivery of the
instruments. Such instruments are measured at cost less impairment, rather than at fair
value.
Entities are required to apply the guidance on fair value and derecognition contained in
Section 11 to financial instruments that fall within the scope of Section 12.
Section 12 also provides guidance on hedge accounting. If specified criteria are met, an entity
may designate a hedging relationship between a hedging instrument and a hedged item in
such a way as to qualify for hedge accounting. Hedge accounting permits the gain or loss on
the hedging instrument, and on the hedged item, to be recognised in profit or loss at the same
time.
The following risks are the only risks for which Section 12 permits hedge accounting:
• interest rate risk of a debt instrument measured at amortised cost;
• foreign exchange or interest rate risk in a firm commitment or a highly probable forecast
transaction;
• price risk either of a commodity held or in a firm commitment or highly probable forecast
transaction to purchase or sell a commodity; and
• foreign exchange risk in a net investment in a foreign operation.
Foreign exchange risk of a debt instrument measured at amortised cost is not in the list above
because hedge accounting would not have any significant effect on the financial statements in
the light of the accounting requirements of the IFRS for SMEs Standard.

What has changed since the 2009 IFRS for SMEs Standard

The following are the changes made to Section 12 by the 2015 Amendments:
• clarification of the interaction of the scope of Section 12 with other sections of the
IFRS for SMEs Standard (see paragraph 12.3(b),(e) and (h)-)(i)); and
• clarification of the requirements for hedge accounting, including the addition of a
sentence that clarifies the treatment of exchange differences relating to a net investment
in a foreign operation for consistency with paragraphs 9.18 and 30.13 (see paragraphs
12.8(a), 12.23, 12.25 and 12.29(d)-(e)).
In addition this module reproduces other editorial changes.

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Module 12—Other Financial Instrument Issues

REQUIREMENTS AND EXAMPLES

Scope of Sections 11 and 12

12.1 Section 11 Basic Financial Instruments and Section 12 together deal with recognising,
derecognising, measuring and disclosing financial instruments (financial assets and
financial liabilities). Section 11 applies to basic financial instruments and is relevant to
all entities. Section 12 applies to other, more complex financial instruments and
transactions. If an entity enters into only basic financial instrument transactions then
Section 12 is not applicable. However, even entities with only basic financial
instruments shall consider the scope of Section 12 to ensure they are exempt.

Notes

Section 12 applies to:

• all financial instruments (as defined in the Glossary, see below) except those within
the scope of Section 11 and those specifically excluded from the scope of Section 12
by paragraphs 12.3(b)–(i); and
• some contracts to buy or sell non-financial items (see paragraphs 12.4–12.5).
Financial instruments are within the scope of Section 11 if they meet the criteria in
paragraph 11.8 and are not excluded from the scope of Section 11 by paragraph 11.7.
Instruments that are within the scope of Section 11 applying paragraph 11.8 are:
• cash;
• debt instruments (for example, accounts, notes, or loans receivable or payable)
meeting specified conditions;
• commitments to receive a loan that cannot be settled net in cash and where the
loan is expected to meet the same conditions as for the aforementioned debt
instruments; and
• investments in non-convertible preference shares and non-puttable ordinary shares
or preference shares.
For additional guidance on the identification of financial instruments within the
scope of Section 11, consult Module 11. If an entity has any other financial
instrument, it must consider Section 12.
Even entities that normally only have simple transactions may occasionally enter into
transactions within the scope of Section 12. For example, a fixed-term loan with
interest payable at EURIBOR plus 2% is accounted for applying Section 11, because the
variable rate is a single referenced quoted or observable interest rate; however, if the
interest was payable at a rate equal to the change in the published price of gold, the
instrument would be outside the scope of Section 11 and within the scope of Section
12 and accounted for accordingly.
Some financial instruments that are outside the scope of Section 11 nevertheless do
not need to be accounted for applying Section 12 because they are exempted by
paragraph 12.3.
If there are no financial instruments and no contracts that are required to be

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Module 12—Other Financial Instrument Issues

accounted for in accordance with Section 12, then the entity does not need to apply
Section 12. However the entity should continue to evaluate any new or substantially
revised financial instruments or related transactions to identify whether it needs to
apply Section 12.

In December 2017, the SME Implementation Group (SMEIG) published non-

mandatory guidance (Q&A 2017/01) in response to a question about how a
reporting entity accounts in its separate or individual financial statements for
financial guarantee contracts that it has issued. The question was raised
through the example of a parent entity issuing a financial guarantee contract
on behalf of its subsidiary whereby the parent guarantees repayment of a loan
from a bank to the subsidiary. However, in discussing the issue, the SMEIG
concluded that the same accounting treatment should also be applied to any
other case of an entity issuing a financial guarantee contract on behalf of
another entity. The SMEIG concluded that a financial guarantee contract is a
financial instrument. Because the financial guarantee contract is contingent
on a future unknown event, the criterion that there are no conditional returns
or repayment provisions in paragraph 11.9(d) is not satisfied. Thus, the
financial guarantee contract does not constitute a basic financial instrument as
described in paragraph 11.8 because the reporting entity’s financial liability
does not satisfy all the conditions in paragraph 11.9. The SMEIG noted that the
exception in paragraph 12.3(d) applies only to rights under insurance contracts
and not to obligations under insurance contracts. Consequently, the SMEIG
held the view that the reporting entity should account for the financial
guarantee contract by applying the requirements in Section 12 Other Financial
Instrument Issues—unless the reporting entity chooses to apply the recognition
and measurement requirements of IAS 39 Financial Instruments: Recognition and
Measurement (as permitted by paragraphs 11.2(b) and 12.2(b) of the IFRS for SMEs
Standard). Note, financial guarantee contracts frequently have characteristics
commonly associated with insurance contracts. The accounting treatment
outlined in Q&A 2017/01 should not be assumed to apply to other types of
insurance contracts.

Definitions

The following definitions are reproduced from the Glossary:

A financial instrument is a contract that gives rise to a financial asset of one entity
and a financial liability or equity instrument of another entity.
A financial asset is any asset that is:
(a) cash;
(b) an equity instrument of another entity;
(c) a contractual right:
(i) to receive cash or another financial asset from another entity; or
(ii) to exchange financial assets or financial liabilities with another entity
under conditions that are potentially favourable to the entity; or

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Module 12—Other Financial Instrument Issues

(d) a contract that will or may be settled in the entity’s own equity instruments
and:
(i) under which the entity is or may be obliged to receive a variable
number of the entity’s own equity instruments; or
(ii) that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the
entity’s own equity instruments. For this purpose the entity’s own
equity instruments do not include instruments that are themselves
contracts for the future receipt or delivery of the entity’s own equity
instruments.
A financial liability is any liability that is:
(a) a contractual obligation:
(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets or financial liabilities with another entity
under conditions that are potentially unfavourable to the entity; or
(b) a contract that will or may be settled in the entity’s own equity instruments
and:
(i) under which the entity is or may be obliged to deliver a variable
number of the entity’s own equity instruments; or
(ii) will or may be settled other than by the exchange of a fixed amount of
cash or another financial asset for a fixed number of the entity’s own
equity instruments. For this purpose the entity’s own equity
instruments do not include instruments that are themselves contracts
for the future receipt or delivery of the entity’s own equity instruments.
Equity is the residual interest in the assets of the entity after deducting all its
liabilities. Section 22 Liabilities and Equity establishes requirements for classifying
financial instruments as either liabilities or equity.

Notes on definitions
Financial instruments arise from rights and obligations under contracts. The terms
‘contract’ and ‘contractual’ refer to an agreement between two or more parties and is
usually enforceable by law. Contracts, and thus financial instruments, may take a
variety of forms and need not be in writing. For a contract to be valid, both parties
must give their approval. Approval may be given indirectly, for example, by an entity
acting in such a way that the other parties involved believe the entity’s intention is to
make a contract.

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Module 12—Other Financial Instrument Issues

See Module 11 for the following:

• Examples 5–14 in Module 11 are examples of items that are not financial
instruments and, therefore, are not within the scope of Section 11 or Section 12.
• Examples 15–16 and Examples 20–22 are examples of common financial
instruments and they illustrate how to identify financial instruments. The
financial instruments in Examples 16 and 20– 22 are within the scope of
Section 11.
• Examples 24–32 illustrate how to identify financial instruments that are within the
scope of Section 11. The financial instruments in these examples are within the
scope of Section 11.
Paragraphs 11.6 and 11.11 of the IFRS for SMEs Standard list the following examples of
financial instruments that are normally within the scope of Section 12 (although
exceptions exist; see, for example, paragraph 12.5):
• asset-backed securities, such as collateralised mortgage obligations (bonds that
represent claims to specific cash flows from large pools of mortgages), repurchase
agreements (a type of short-term loan whereby the seller of a security agrees to buy
it back at a specified price and time) and securitised packages of receivables
(instruments such as bonds in a special purpose vehicle that holds receivables).
• options, rights, warrants, futures contracts, forward contracts and interest rate
swaps that can be settled in cash or by exchanging another financial instrument.
• financial instruments that qualify and are designated as hedging instruments
applying the requirements in Section 12, for example, a foreign currency forward
exchange contract.
• commitments to make a loan to another entity. A commitment to make a loan is a
firm commitment to provide credit under pre-specified terms and conditions; for
example, a commitment to provide, in six months, a three-year loan of CU100,0001
with interest fixed at 4% a year.
• commitments to receive a loan if the commitment can be net settled in cash.
• an investment in another entity’s equity instruments, other than non-convertible
preference shares and non-puttable ordinary and preference shares. A puttable
instrument gives the holder the right to put the instrument back to the issuer for
cash or another financial asset or the instrument is automatically put back to the
issuer on the occurrence of particular events.
• an interest rate swap that returns a cash flow that is positive or negative or a
forward commitment to purchase a commodity or financial instrument that is
capable of being cash-settled and that, on settlement, could have positive or
negative cash flow.
• investments in convertible debt.

1 In this example, and in all other examples in this module, monetary amounts are denominated in ‘currency units (CU)’.

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Module 12—Other Financial Instrument Issues

Accounting policy choice

12.2 An entity shall choose to apply either:

(a) the requirements of both Sections 11 and 12 in full; or
(b) the recognition and measurement requirements of IAS 39 Financial Instruments:
Recognition and Measurement and the disclosure requirements of Sections 11 and
12
to account for all of its financial instruments. An entity’s choice of (a) or (b) is an
accounting policy choice. Paragraphs 10.8–10.14 contain requirements for determining
when a change in accounting policy is appropriate, how such a change should be
accounted for and what information should be disclosed about the change in accounting
policy.

Notes
An entity must select, as an accounting policy choice, either the option in
paragraph 12.2(a) or the option in paragraph 12.2(b). It must apply the option selected
to account for all of its financial instruments. This is identical to the choice set out in
paragraph 11.2.

IAS 39 is more complex and difficult to apply than are Sections 11 and 12.
Nevertheless, an entity may wish to choose the option in paragraph 12.2(b), and 11.2(b),
to apply IAS 39 rather than Sections 11 and 12; for example, because it may wish to
adopt hedge accounting using hedging instruments that qualify for hedge accounting
under IAS 39 but not under Section 12. SMEs are not permitted to apply IFRS 9.

Once an entity has chosen (a) or (b) as its accounting policy, a change to the other (for
example, a change from (a) to (b)) would be a change in accounting policy, which is
covered by paragraphs 10.8–10.14. It would not be acceptable to adopt one policy in
each year that a particular instrument was held and to adopt the other policy in a year
when such an instrument had not been held. To change the accounting policy, the
new policy must result in reliable and more relevant information and must be applied
retrospectively by restating comparative information.

Whichever of the options above an entity applies, it must also apply Section 22
Liabilities and Equity as and where applicable.

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Module 12—Other Financial Instrument Issues

Scope of Section 12
12.3 Section 12 applies to all financial instruments except the following:
(a) those covered by Section 11.
(b) investments in subsidiaries, associates and joint ventures that are accounted for in
accordance with Section 9 Consolidated and Separate Financial Statements, Section
14 Investments in Associates or Section 15 Investments in Joint Ventures.
(c) employers’ rights and obligations under employee benefit plans (see Section 28
Employee Benefits).
(d) rights under insurance contracts unless the insurance contract could result in a loss
to either party as a result of contractual terms that are unrelated to:
(i) changes in the insured risk;
(ii) changes in foreign exchange rates; or
(iii) a default by one of the counterparties.
(e) financial instruments that meet the definition of an entity’s own equity, including the
equity component of compound financial instruments issued by the entity (see
Section 22 Liabilities and Equity).
(f) leases within the scope of Section 20 Leases. Consequently, Section 12 applies to
leases that could result in a loss to the lessor or the lessee as a result of contractual
terms that are unrelated to:
(i) changes in the price of the leased asset;
(ii) changes in foreign exchange rates;
(iii) changes in lease payments based on variable market interest rates; or
(iv) a default by one of the counterparties.
(g) contracts for contingent consideration in a business combination (see Section 19
Business Combinations and Goodwill). This exemption applies only to the acquirer.
(h) financial instruments, contracts and obligations under share-based payment
transactions to which Section 26 Share-based Payment applies.
(i) reimbursement assets that are accounted for in accordance with Section 21 Provisions
and Contingencies (see paragraph 21.9).
12.4 Most contracts to buy or sell a non-financial item such as a commodity, inventory or
property, plant and equipment are excluded from this section because they are not
financial instruments. However, this section applies to all contracts that impose risks on
the buyer or seller that are not typical of contracts to buy or sell non-financial items.
For example, this section applies to contracts that could result in a loss to the buyer or
seller as a result of contractual terms that are unrelated to changes in the price of the
non-financial item, changes in foreign exchange rates or a default by one of the
counterparties.
12.5 In addition to the contracts described in paragraph 12.4, this section applies to contracts
to buy or sell non-financial items if the contract can be settled net in cash or another
financial instrument, or by exchanging financial instruments as if the contracts were
financial instruments, with the following exception: contracts that were entered into and
continue to be held for the purpose of the receipt or delivery of a non-financial item in
accordance with the entity’s expected purchase, sale or usage requirements are not
financial instruments for the purposes of this section.

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Notes—scope of Section 12

The following flow chart can be used to identify whether any financial instruments are
within the scope of Section 12 at a point in time.

Determine whether another

Does the contract meet the
section of the IFRS for SMEs
definition of a financial asset, No
Standard is applicable or apply
financial liability or equity as
Section 2 Concepts and
defined in the Glossary?
Pervasive Principles

Yes

Is the contract within the scope

of another section of the IFRS
Yes Apply the relevant section of the
for SMEs Standard and
IFRS for SMEs Standard as
therefore outside the scope of
required in paragraph 11.7
Section 11? (see paragraph
11.7)

No

Is the contract within the scope Yes

of Section 11? (see paragraph Apply Section 11
11.8)

No

Is the contract outside the • If paragraph 12.3(d) applies,

scope of Section 12? (see then apply Section 2
paragraph 12.3(d), (f) and (g)) Yes • If paragraph 12.3(f) applies,
then apply Section 20

• If paragraph 12.3(g) applies,

then apply Section 19

No

Apply Section 12

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A number of financial instruments that would otherwise be within the scope of

Section 11 or 12 are scoped out of these sections and instead fall within other sections
of the IFRS for SMEs Standard. For example interests in a subsidiary are accounted for
applying Section 9. Thus a holding of convertible preference shares in a third party
company will be within the scope of Section 12, but such a holding in a subsidiary is
accounted for applying Section 9.
For some types of contracts, the determining factor of whether the contract is within
or outside the scope of Section 12 is whether the contract exposes the parties to the
contract to one or more risks not usually expected in an equivalent ‘plain vanilla’
contract. Specifically, an insurance contract, a lease or a contract to buy or sell a non-
financial item is within the scope of Section 12 if the contract terms expose the parties
to risk of a possible loss as a result of something other than:
• one of the parties to the contract defaulting;
• changes in foreign exchange rates; or
• changes in the pricing of whatever the contract is for, for example, changes in the
price of gold if it is a forward contract to buy gold, changes in the price of a
particular machine if it is a lease of the machine, or an increase in the insurance
premiums due to a change in the insured risk such as an increase in the insurance
premiums for a factory that recently flooded during bad weather if it is buildings
insurance of the factory.
Insurance contracts, lease contracts or contracts to buy or sell a non-financial item that
expose the parties to risk of loss for these three things are outside the scope of
Section 12, but contracts that expose the parties to risk of other losses are accounted
for, applying Section 12, as financial instruments.
Paragraph 12.3(d)—rights under insurance contracts
Under insurance contracts most rights of policyholders, beneficiaries or any insurers
within the scope of the IFRS for SMEs are outside the scope of Section 12 and hence are
accounted for under other sections. For example, for policyholders, any contingent
assets would be within the scope of Section 21 Provisions and Contingencies.
However, as explained above, paragraph 12.3(d) requires that any rights under
insurance contracts be accounted for applying Section 12 if they might result in a loss
to the policyholder or the insurer as a result of contractual terms that are unrelated to
changes in the insured risk, changes in foreign exchange rates or a counterparty’s
default. For example, a life insurance contract with a maturity payout linked to the
price of a specific commodity, such as gold, will be accounted for applying Section 12.
This is because the terms of the financial instrument include a financial risk
component that alters the settlement amount of the contract in a way that is
unrelated to the insuring of the insured item.

Paragraph 12.3(e)—entity’s own equity

The exemption in paragraph 12.3(e) applies only to the issuer of the equity instrument
and not to the holder. Section 11 contains the same exemption. Section 22 Liabilities
and Equity specifies how an issuer classifies financial instruments as either financial
liabilities or equity. Consequently, before applying Section 11 and Section 12, the

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entity must decide, applying Section 22, whether a financial instrument is a financial
liability, equity or an instrument that contains both equity and liability components.
Section 11 and Section 12 apply to instruments that are financial liabilities, and to the
liability component of a financial instrument with both equity and liability
components. Neither Section 12 nor Section 11 applies to financial instruments or
components of financial instruments that are that entity’s own equity instruments.
Share-based payment transactions accounted for as equity applying Section 26
Share-based Payment are outside the scope of Section 12 and Section 11.
Paragraph 12.3(f)—leases
Most leases result in financial instruments—the lessor has a contractual right to receive
cash (future lease payments) and the lessee has a contractual obligation to pay cash
(future lease payments). Leases are generally excluded from the scope of Section 12
because Section 20 Leases sets out requirements for their accounting. However,
applying paragraph 12.3(f), a lease that could result in a loss to the lessee or the lessor
as a result of contractual terms unrelated to changes in the price of the leased asset,
such as changes in foreign exchange rates, changes in lease payments based on
variable market interest rates or a default by one of the counterparties, is to be
accounted for applying Section 12 and is excluded from the scope of Section 20 (see
also paragraph 20.1(e)). Such leases are within the scope of Section 12 because their
terms include a component that alters the settlement amount of the contract that is
unrelated to the leasing of the asset.
Judgement needs to be applied in interpreting ‘unrelated’ as used in paragraphs
12.3(d), 12.3(f) and 12.4.
An example of a lease that would fall within the scope of Section 12 would be a lease
for a retail unit in a large shopping mall for which the payments are a fixed annual
amount plus a contingent annual rental of 1% of the profit after tax made by the lessee
on its business from that retail unit. However, an example of a lease that would be
outside the scope of Section 12 (and within the scope of Section 20) would be a lease for
a retail unit in a large shopping mall for which the payments are increased each year
by a percentage equal to the percentage change in the fair value of the shopping mall.
The change in payment would be related to the change in the price of the leased asset;
so the lease would not be within the scope of Section 12.
A provision for an onerous operating lease contract, for example, a lessee’s provision
made for vacant leasehold property that it has been unable to sublet, is accounted for
applying Section 21 Provisions and Contingencies (see paragraph 21.1(a)) unless it meets
the exception in paragraph 12.3(f).

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Examples—scope of Section 12—paragraph 12.3

Ex 1 On 1 January 20X1, Entity A, which manufactures bicycles, took out a CU100,000

five-year variable-interest rate loan from Bank B. Interest is payable on the loan at
LIBOR plus 100 basis points. LIBOR increased twice during 20X3. Concerned about
rising expectations that interest rates are to increase again in the near future,
Entity A, on 1 January 20X4, takes out an interest rate swap with Bank C for the
final two years of the loan; the combined effect of the swap and the loan is a loan
with interest fixed at 4.5% for 20X4 and 20X5. In accordance with the swap, which
assumes a principal amount of CU100,000, Entity A pays 3.5% fixed interest and
receives variable interest calculated at LIBOR. LIBOR is reset quarterly under both
the loan and the swap.
The loan is within the scope of Section 11; it is a variable-rate loan meeting the
conditions in paragraph 11.9. Accounting applying Section 11 will apply throughout
the full five-year life of the loan.
The swap, on the other hand, is accounted for under Section 12, because it is a
financial instrument that is not included in paragraph 11.8 and not exempt under
paragraph 12.3.
If Entity A had not taken out the swap, but had instead repaid the loan at the end of
20X3 and taken out a new two-year loan with interest fixed at 4.5%, both the original
loan and the replacement loan would have been within the scope of Section 11.
The swap would be eligible for hedge accounting under Section 12 if specified criteria
are met; see paragraph 12.23 and Example 32 and Example 33. The impact of hedge
accounting on profit or loss in each of 20X4 and 20X5 would be the same as the impact
of a two-year loan with interest fixed at 4.5 %, that is within the scope of Section 11.
Ex 2 Entity A, a company manufacturing bicycles, contracted on 1 November 20X1 to
purchase a new machine from an overseas supplier. The machine is expected to
be ready for delivery on 31 January 20X2, at which time Entity A is contractually
required to pay the manufacturer the full price of the machine, FCU10,000(2).
Entity A was concerned about the effect of fluctuating exchange rates on its cash
flows. Consequently, on 1 November 20X1 Entity A also entered into a forward
contract with Bank B to receive FCU10,000 in exchange for CU5,000 on 31 January
20X2.
The forward contract to purchase FCU is within the scope of Section 12 because it is a
financial instrument; it is not covered by paragraph 11.8 and it is not exempt under
paragraph 12.3.
The forward contract to purchase FCU would be eligible for hedge accounting under
Section 12 if specified criteria are met. See paragraph 12.15 onwards.
The contract to purchase the machine is outside the scope of Section 12—see
Example 6.

(2)
In this example, and in all other examples in this module, foreign currency monetary amounts are denominated in
‘foreign currency units (FCU)’.

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Ex 3 Entity A, which manufactures bicycles, purchases a subsidiary that manufactures

scooters from Entity B. Entity A pays CU50,000 on the date of acquisition and
agrees to pay a further CU50,000 to Entity B two years later if the subsidiary meets
specified performance targets (that is, the second CU50,000 is contingent
consideration). The subsidiary expects to continually meet the performance
targets during the two years.
The contingent consideration payable/receivable meets the definition of a financial
liability of Entity A and a financial asset of Entity B.
Contingent consideration payable (Entity A’s financial liability) is specifically excluded
from the scope of Section 12 by paragraph 12.3(g) because it is accounted for applying
Section 19 Business Combinations and Goodwill. The contingent consideration receivable
(Entity B’s financial asset), on the other hand, is within the scope of Section 12.
Ex 4 Entity A, based in Japan, is both the policyholder and the beneficiary of a life
insurance contract. The 10-year contract requires the insurer to pay a sum of
money upon the death or terminal illness of the owner-manager of Entity A or, if
earlier, at the end of the 10-year contract. Under the contract, Entity A is required
to pay a stipulated amount annually (premium) until the earlier of 10 years and
the insured event (death or illness) occurring. If the insured event occurs, Entity A
(in its capacity as policyholder) will receive a fixed payment that is significantly
higher than the premiums paid into the plan. If the insured event has not
occurred by the end of the 10-year contract, Entity A will receive a payment that
equals the premiums paid into the plan, net of a pre-agreed fee, plus or minus a
return equal to the percentage increase or decrease in the Nikkei 225.
The contract is outside the scope of Section 11 because the bonus is variable with the
performance of the Nikkei 225, meaning that the returns to the entity are not fixed or
variable based on a single referenced quoted or observable interest rate. Entity A’s
rights under the insurance contract could result in a loss to either party, as defined in
Section 12.
The variable payment is related to the movement in the Nikkei 225 and is not related
to the insured risk (the owner-manager’s health), to foreign exchange rates or to a
counterparty’s default. Consequently, Entity A’s rights under the insurance contract
are included in the scope of Section 12 (see paragraph 12.3(d)).

Ex 5 Entity A leases a machine from Entity B under a five-year finance lease, which sets
out fixed annual rental payments. The payments are denominated in FCU.
Entity A’s functional currency is the CU. Entity B’s functional currency is the FCU.
If the FCU strengthens against the CU, Entity A, the lessee, will pay higher annual
rental payments in its functional currency. However, because the loss to the lessee
results from changes in exchange rates, the lease is accounted for under Section 20,
because it is outside the scope of Section 12 (see paragraph 12.3(f) (ii)).

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Examples—scope of Section 12—paragraph 12.4—contracts to buy or sell a

non-financial item

Ex 6 On 1 January 20X1 a machine manufacturing entity, whose functional currency is

the CU, enters into a contract to export an item of machinery to a buyer whose
functional currency is the FCU. The contract specifies that the machine will be
delivered on 1 July 20X2 and at that time the buyer will make a payment of
CU10,000. The machine is intended for use in the buyer’s business.
In this example, the payment in CU exposes the buyer to currency risk, because the
cash flows under the contract will vary with the CU/FCU exchange rate (for example, a
‘stronger’ than expected CU against FCU would result in a higher purchase price for
the buyer than under a similar fixed-price contract denominated in FCU using the
CU:FCU spot rate on the date of contracting). Because the risk imposed relating to the
change in the purchase price is due only to changes in foreign exchange rates and
because the machine is intended for use in the buyer’s business, this contract is outside
the scope of Section 12.
Before delivery of the machine, the contract is equally unperformed from the
perspective of both the buyer and of the seller. In practice, obligations under such
contracts that are equally unperformed are generally not recognised as liabilities in the
financial statements. If the contract is onerous it must be accounted for applying
Section 21.
Ex 7 On 1 January 20X0, Entity A contracts to purchase a fixed quantity of copper rods
from Entity B for delivery on 30 June 20X1. The copper rods are intended for use
in Entity A’s business. Entity A and Entity B operate in the same jurisdiction.
The purchase price is the market price in the jurisdiction on 1 January 20X0 plus
an adjustment for the jurisdiction’s producer price index (PPI) between 1 January
20X0 and 30 June 20X1.
The PPI measures average changes in prices received by domestic producers for
their output. It is one of several price indexes. The percentage change in the PPI
is a measure of inflation in that jurisdiction.
In this example, the adjustment for inflation exposes both the buyer and seller to the
risk of uncertain future cash flows. However, the price of copper rods is typically
expected to be unrelated to the PPI; instead the price of the rods typically relates to the
price of copper. Consequently, this contract would be within the scope of Section 12
for both the buyer and the seller.
Ex 8 On 1 January 20X0, Entity A contracts to purchase a fixed quantity of copper rods
from Entity B for delivery on 30 June 20X1. The copper rods are intended for use
in Entity A’s business. Entity A and Entity B operate in the same jurisdiction. The
purchase price is the market price in the jurisdiction on 1 January 20X0 plus or
minus an adjustment for the change in the price of copper between 1 January
20X0 and 30 June 20X1.
In this example, the pricing of the rods would generally be expected to vary in line
with the price of copper. Consequently, this contract is outside the scope of Section 12
for both the buyer and the seller.

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Notes—scope of Section 12—paragraph 12.5

Contracts to buy or sell a non-financial item are also accounted for as financial
instruments within the scope of Section 12 if they can be settled net in cash or another
financial instrument or by exchanging financial instruments as if the contracts were
financial instruments. For example, a contract for the purchase of a commodity at a
future date which allows the parties to settle net in cash. At settlement date, the
parties would exchange in cash the value of the difference between the price specified
in the contract and the spot price on settlement date.
However, paragraph 12.5 specifies that even contracts that can be settled net in cash
are outside the scope of Section 12 if they were entered into and continue to be held
for the purpose of the receipt or delivery of the non-financial item in accordance with
the entity’s expected purchase, sale or usage requirements (sometimes called ‘the own
use exception’). For example, extending the illustration above, even though the
contract can be settled net in cash, if the buyer entered into the contract because it
wants to use the commodity in its business and that is still the case, then the contract
will not be within the scope of Section 12.

Examples—scope of Section 12—paragraph 12.5—contracts to buy or sell

non-financial items (net settlement and expected usage
exemption)
Ex 9 An entity enters into a contract to purchase one million kilograms of copper in
12 months at a fixed price, in accordance with its expected usage requirements (a
fixed-price forward contract). The contract permits the entity to take physical
delivery of the copper at the end of 12 months or to pay or receive a net
settlement in cash, based on the spot price of copper at the end of the contract.
If the entity entered into the contract because it wants the copper to use in its
business, and this is still the case, the contract satisfies the exception from the
inclusion in paragraph 12.5 and, therefore, is not within the scope of Section 12.
Ex 10 An entity enters into a contract to purchase 10,000 kilograms of bananas in 12
months. Over the shelf life of those bananas, the entity expects to sell between
9,000 and 10,000 kilograms of the bananas in its shops. Any excess/unsold
bananas are either treated as waste or are given to the local animal charity.
The contract is not within the scope of Section 12, because it was entered into in
accordance with the entity’s expected purchase/usage requirements, and so satisfies
the exception from the inclusion in paragraph 12.5. The entity sells the bananas in the
normal course of its business.

Ex 11 Entity A, a company manufacturing bicycles, was concerned about the future price
of rubber. Consequently, it entered into a fixed-price forward contract to
purchase 5,000 bicycle tyres, 1,000 in each of five sizes, in 10 months for
CU20,000.
The tyres, when purchased, will be recognised as inventory to be used in the
manufacture of bicycles.

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The contract is not within the scope of Section 12, because it was entered into in
accordance with the entity’s expected purchase/usage requirements. The entity will
use the tyres in the normal course of its business manufacturing bicycles.
Initial recognition of financial assets and liabilities
12.6 An entity shall recognise a financial asset or a financial liability only when the entity
becomes a party to the contractual provisions of the instrument.

Notes—initial recognition
Planned future transactions, no matter how likely, are not assets and liabilities
because the entity has not become a party to a contract.
A forward contract within the scope of Section 12 including those described in
paragraph 12.5, such as a firm commitment to buy or sell non-financial items that can
be net settled, is recognised as an asset or a liability on the commitment date. When
an entity becomes a party to a forward contract, the fair values of the rights and
obligations are often equal, so consequently, the net fair value of the forward contract
at that point is often zero. If the net fair value of the rights and obligations is not zero,
the contract is recognised as an asset or liability.

Initial measurement
12.7 When a financial asset or financial liability is recognised initially, an entity shall measure it
at its fair value, which is normally the transaction price.

Examples—initial recognition and initial measurement

Ex 12 The facts are the same as in Example 2. That is, Entity A, a company
manufacturing bicycles, contracted on 1 November 20X1 to purchase a new
machine from an overseas supplier. The machine is expected to be ready for
delivery on 31 January 20X2, at which time, Entity A is contractually required to
pay the manufacturer the full price of the machine, FCU10,000. Entity A is
concerned about the effect of fluctuating exchange rates on its cash flows.
Consequently, on 1 November 20X1 Entity A also entered into a forward contract
with Bank B to receive FCU10,000 in exchange for CU5,000 on 31 January 20X2.
Since the contract to purchase the machine is not within paragraph 12.4 or 12.5, the
contract is outside the scope of Section 12.
The forward contract to purchase FCU is within the scope of Section 12, because it is a
financial instrument and it is neither listed in paragraph 11.8 nor exempt under
paragraph 12.3. The forward contract for FCU will therefore be recognised on
1 November 20X1 when Entity A becomes a party to the forward contract; and it will be
initially measured at its fair value. If Bank B, the party with whom Entity A enters into
the forward contract for FCU, is an independent third party, the price paid by Entity A
is likely to be the fair value of the forward FCU contract. In this forward contract, the
exchange rate is FCU2.00:CU1.00 (Entity A will pay CU5,000 to receive FCU10,000) and,
if this is priced at fair value, the forward rate will be based on the spot price at
1 November 20X1 (for example, FCU1.98:CU1.00) adjusted to reflect the 3-month
interest rates in the two jurisdictions. Consequently, at 1 November 20X1, CU5,000
payable in three months is equal to FCU10,000 receivable in three months. In this

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example it is assumed that the fair value of the forward contract at inception, and thus
the price paid to Bank B, was nil. See Example 17 for an illustration of calculating the
fair value of the forward contract part way through the contract.
Ex 13 Entity A, a company manufacturing bicycles, had some surplus cash and decided
to invest it in shares of a listed bicycle manufacturer. On 12 June 20X3, it
purchased 1,000 listed convertible preference shares for CU5,000. 3 Entity A
incurred a transaction fee and stamp duty on the purchase totalling CU100.
Entity A will recognise the shares on 12 June 20X3. They have to be initially measured
at fair value. Paragraph 12.12 explains that transaction costs are excluded from the
initial measurement of financial assets (and financial liabilities) that will be
subsequently measured at fair value through profit or loss. Consequently, Entity A will
measure the shares when it recognises them on 12 June 20X3, at CU5,000 (not
CU5,100—see paragraph 12.12).
Ex 14 The facts are the same as in Example 1. That is, on 1 January 20X1, Entity A, a
company manufacturing bicycles, took out a CU100,000 five-year variable-interest
rate loan from Bank B. Interest is payable on the loan at LIBOR plus 100 basis
points. LIBOR increased twice during 20X3.
Concerned about rising expectations that interest rates are to increase again in
the near future, on 1 January 20X4, Entity A takes out an interest rate swap with
Bank C for the final two years of the loan; the combined effect of the swap and the
loan is a loan with interest fixed at 4.5% for 20X4 and 20X5. The swap, which
assumes a principal amount of CU100,000, specifies that Entity A pays 3.5% fixed
interest and receives variable interest calculated at LIBOR. LIBOR is reset
quarterly under both the loan and the swap.
As explained in Example 1, the loan is within the scope of Section 11 throughout its
full five-year life, whereas the swap is accounted for under Section 12.
The swap will be recognised on 1 January 20X4 and initially measured at its then fair
value. If Bank C, the party with whom Entity A enters into the swap, is an independent
third party, the price paid by Entity A, if any, is likely to be the fair value of the swap.

3
The voting rights attached to the 1,000 shares purchased are less than a significant influence.

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Subsequent measurement

12.8 At the end of each reporting period, an entity shall measure all financial instruments
within the scope of Section 12 at fair value and recognise changes in fair value in profit
or loss, except as follows:
(a) some changes in the fair value of hedging instruments in a designated hedging
relationship are required to be recognised in other comprehensive income by
paragraph 12.23; and
(b) equity instruments that are not publicly traded and whose fair value cannot
otherwise be measured reliably without undue cost or effort and contracts linked to such
instruments that, if exercised, will result in delivery of such instruments, shall be
measured at cost less impairment.

Examples—subsequent measurement
Ex 15 The facts are the same as in Examples 2 and 12. That is, Entity A, a company
manufacturing bicycles, contracted on 1 November 20X1 to purchase a new
machine from an overseas supplier. The new machine is expected to be ready for
delivery on 31 January 20X2, at which time, Entity A is contractually required to
pay the manufacturer FCU10,000, the full price of the machine. Entity A is
concerned about the effect on its cash flow of fluctuating exchange rates.
Consequently, on 1 November 20X1 it also entered into a forward contract with
Bank B to receive FCU10,000 in exchange for CU5,000 on 31 January 20X2.
Entity A does not apply hedge accounting.
The forward contract to purchase FCU had a nil fair value when entered into on
1 November 20X1, but two months later, at Entity A’s year-end (31 December
20X1), it had a negative fair value of CU(97).
Entity A does not apply hedge accounting.
The forward contract to purchase FCU is recognised on 1 November 20X1 when Entity A
becomes a party to the forward contract. However, because the fair value of the
contract on that date was nil, it was initially measured at nil.
Entity A subsequently measures the forward contract as a financial liability at CU97
and recognises an expense of CU97, in profit or loss.

Notes—subsequent measurement (equity instruments)

The principle of Section 12 is that instruments within the scope of Section 12 are
measured at fair value with changes in fair value recognised in profit or loss. The
exception to this principle applies to equity instruments not publicly traded and whose
fair value cannot otherwise be measured reliably without undue cost or effort and to
contracts linked to such instruments that, if exercised, will result in delivery of such
instruments—for example, an option to purchase unquoted shares whose fair value
cannot be measured reliably without undue cost or effort. The exception extends to
contracts resulting in delivery of such shares, because if the shares cannot be measured
reliably, a derivative for such shares also cannot be measured reliably.
Determining whether measuring the fair value would involve undue cost or effort
depends on the entity’s specific circumstances and on management’s judgement in
assessing the costs and benefits of such measurement. This judgement requires
consideration of how the economic decisions of those that are expected to use
financial statements could be affected by not having that information. Applying a

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requirement would involve undue cost or effort by an SME if the incremental cost (for
example, valuers’ fees) or additional effort (for example, endeavours by employees)
substantially exceeds the benefits that those that are expected to use the SME’s
financial statements would receive from having the information (see paragraph 2.14B).
If an SME already has or could easily and inexpensively acquire the information
necessary to comply with a requirement, any related undue cost or effort exemption
would not be applicable. This is because, in that case, the benefits to the users of the
financial statements of having the information would be expected to exceed any
further cost or effort by the SME. Assessing whether applying a requirement would
involve undue cost or effort on initial recognition in the financial statements, for
example at the date of the transaction, should be based on information about the costs
and benefits of applying the requirement at the time of initial recognition. If the
undue cost or effort exemption also applies subsequent to initial recognition, for
example, to a subsequent measurement of an item, a new assessment of undue cost or
effort must be made at that subsequent date, based on information available at that
date (see paragraph 2.14C).

If the entity does not measure such shares at fair value, paragraph 12.8 requires them
to be measured at cost less impairment. Financial assets within the scope of Section 12
are outside the scope of Section 27, which deals with the impairment of assets.
Impairment tests should be performed applying paragraphs 11.21–11.26 (see paragraph
12.13). If the entity does not have access to the company’s budgets, management
accounts or other internal information, other sources of information that might be
useful in determining whether there has been any impairment include the company’s
financial statements. In addition, as explained in paragraph 11.23, significant changes
with an adverse effect that have taken place in the technological, market, economic or
legal environment in which the company operates may provide evidence of
impairment.

12.9 If a reliable measure of fair value is no longer available without undue cost or effort for an
equity instrument, or a contract linked to such an instrument that if exercised will result in
the delivery of such instruments, that is not publicly traded but is measured at fair value
through profit or loss, its fair value at the last date that the instrument was reliably
measurable without undue cost or effort is treated as the cost of the instrument. The
entity shall measure the instrument at this cost amount less impairment until it is able to
determine a reliable measure of fair value without undue cost or effort.

Notes
The requirement to measure at cost less impairment discussed in paragraph 12.8(b)
applies when fair value cannot be measured reliably for an unquoted equity
instrument or an option or a forward for such an instrument. When such an
instrument has been measured at fair value in earlier periods but its fair value can no
longer be measured reliably without undue cost or effort, paragraph 12.9 specifies that
cost for this purpose is deemed to be the last reliable measurement of fair value.(4) Any
fair value gains and losses that had previously been recognised in profit or loss for that
instrument must not be reversed. If there is objective evidence of impairment of the
instrument, an impairment test should be performed applying paragraphs 11.21–11.26.

(4)
This is a change in circumstance. It is not a change in accounting policy.

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Fair value

12.10 An entity shall apply the guidance on fair value in paragraphs 11.27–11.32 to fair value
measurements in accordance with this section as well as for fair value measurements in
accordance with Section 11.

Notes
Guidance on measuring the fair value of unquoted equity instruments can be found in
the Educational material on ‘Measuring the fair value of unquoted equity instruments
within the scope of IFRS 9 Financial Instruments’ (see IFRS Foundation website at
www.ifrs.org Home < Supporting implementation < Supporting materials for Standards
< IFRS 13 < Education Materials). Although an entity applying the IFRS for SMEs
Standard cannot apply IFRS 9 (see paragraph 11.2(a)), this guidance may nevertheless be
useful when measuring fair value of unquoted equity instruments for the purposes of
Section 12, because it illustrates, at a high level, the application of valuation
techniques in financial reporting.

Example—determining fair value

Ex 16 Entity A, a company manufacturing bicycles, contracted on 1 November 20X1 to

purchase a new machine from an overseas supplier (a fact-pattern that reflects
examples 2, 12 and 15). The new machine is expected to be ready for delivery on
31 January 20X2, at which time, Entity A is contractually required to pay the
manufacturer FCU10,000, the full price of the machine. Entity A is concerned
about the effect on its cash flows of fluctuating exchange rates. Consequently, on
1 November 20X1 it entered into a forward contract with Bank B to receive
FCU10,000 in exchange for CU5,000 on 31 January 20X2. Entity A does not apply
hedge accounting.
The forward contract to purchase FCU had a nil fair value when entered into on
1 November 20X1.
The following table lists key rates of exchange:

Forward rate, FCU:CU,

Date Spot rate, FCU:CU to 31 January 20X2

1 November 20X1 1.98:1.00 2.00:1.00

31 December 20X1 2.03:1.00 2.04:1.00

The forward contract to purchase FCU is recognised on 1 November 20X1 when it is

purchased. However, because the fair value of the contract on that date was nil, it was
initially measured at nil.
Under the contract, Entity A will pay CU5,000 to receive the FCU10,000 that it needs to
pay to the manufacturer of the machine. However, if it had not entered into the
three-month forward contract on 1 November 20X1 but instead entered into a
one-month forward contract on 31 December 20X1, it would need to pay only CU4,902;

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that is, CU98 less than the amount required under the forward contract that Entity A
purchased on 1 November 20X1.
Paragraph 11.27 states that the best evidence of fair value is the current bid price. This
represents the highest price that a buyer would be willing to pay for the forward
contract from Entity A. If a third party were to ‘buy’ the forward contract from
Entity A, Entity A would need to compensate that third party for taking on the contract
rather than the third party paying Entity A. The third party would need to receive
CU98 from Entity A on 31 December 20X1 to be in the same position had it taken out a
one-month forward contract at that time.
If no other risk were priced for, on 31 December 20X1 the fair value of the 1 November
forward contract to purchase FCU is CU(98); that is, it has a negative fair value, and so
is a financial liability rather than a financial asset, of CU98.
Consequently, Entity A recognises the forward contract as a liability at CU98 and
recognises the loss, a debit of CU98, in profit or loss.

12.11 The fair value of a financial liability that is due on demand is not less than the amount
payable on demand, discounted from the first date that the amount could be required to
be paid.

Example—financial liability due on demand

Ex 17 On 1 January 20X0 Entity A borrows CU100,000 from a bank with a maximum
term of five years and ‘interest’ payments indexed to the price of oil. The bank
can demand that Entity A repay the debt instrument in full at any time. Because
the interest payments are indexed to the price of oil and are neither fixed nor
referenced to a quoted or observable interest rate, the debt instrument is within
the scope of Section 12 rather than within the scope of Section 11.
On 31 December 20X0, the fair value of an identical financial liability with
interest payments indexed to the price of oil but without a demand feature, is
CU90,000. This reflects a steep fall in the price of oil that has resulted in interest
being paid at less than a market rate.
The bank has not indicated that it would demand immediate repayment.
At 31 December 20X0 Entity A measures the debt instrument at CU100,000 because of
the demand feature. It is not discounted because the full amount, CU100,000, is
repayable immediately, if demanded.

Ex 18 The facts are identical to those in Example 17, except the debt instrument is
repayable in full on demand at any time after 31 December 20X2 (rather than at
any time).
At 31 December 20X0 Entity A measures the debt instrument at the present value of
CU100,000 discounted back from 1 January 20X3 (which is the earliest date that the
bank could demand immediate repayment) if this is higher than the fair value of an
identical financial liability without a demand feature. For example, if the present
value of CU100,000 discounted back from 1 January 20X3 is CU91,000, the debt
instrument will be measured at CU91,000 whereas if the present value of CU100,000

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discounted back from 1 January 20X3 is CU89,000, the debt instrument will be
measured at CU90,000.

12.12 An entity shall not include transaction costs in the initial measurement of financial
assets and liabilities that will be measured subsequently at fair value through profit or
loss. If payment for an asset is deferred or is financed at a rate of interest that is not a
market rate, the entity shall initially measure the asset at the present value of the future
payments discounted at a market rate of interest.

Example—deferred payment

Ex 19 In an arm’s length transaction, Entity X buys 10,000 convertible preference shares

in Company Z for cash payments of CU40,000, with CU25,000 payable immediately
and CU15,000 payable in two years.
The market rate of annual interest for a two-year loan to the entity would be 6%.
The holding of the convertible preference shares is within the scope of Section 12.
Because payment of CU15,000 is deferred for two years, the fair value of the
consideration given for the shares is equal to CU25,000 plus the present value of
CU15,000.
The present value of CU15,000 is CU13,350 (15,000 ÷ 1.062).
Entity X will initially measure the shares purchased at CU38,350 (namely, CU25,000 +
CU13,350).
Because this transaction took place at arm’s length, this is considered to be fair value
on initial recognition in the absence of evidence to the contrary.
The difference between the CU40,000 cash paid out and the CU38,350, namely CU1,650,
will be recognised as interest expense in profit or loss over the two years.

Impairment of financial assets measured at cost or amortised cost

12.13 An entity shall apply the guidance on impairment in paragraphs 11.21–11.26 to financial
assets measured at cost less impairment in accordance with this section.

Notes
The only financial instruments within the scope of Section 12 to which
paragraph 12.13 applies are equity instruments not publicly traded and whose fair
value cannot otherwise be measured reliably without undue cost or effort, and
contracts linked to such instruments that, if exercised, will result in delivery of such
instruments.
At the end of each reporting period, an entity must assess whether there is objective
evidence of impairment of any of these instruments; for example, the introduction of a
new competitor or a competing product might have an adverse effect on the investee’s
profitability and thus on the value of its shares.
See Section 11 and Module 11 for guidance.

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Derecognition of a financial asset or financial liability

12.14 An entity shall apply the derecognition requirements in paragraphs 11.33–11.38 to

financial assets and financial liabilities to which this section applies.

Notes
See Section 11.
Module 11 provides explanations and examples on how to apply paragraphs 11.33 to
11.38. These paragraphs apply equally to instruments that are outside the scope of
Section 11 and within the scope of Section 12. The accounting treatment is identical,
regardless of which section of the IFRS for SMEs Standard applies.
The following examples illustrate how the derecognition requirements apply to
financial instruments within the scope of Section 12.

Example—Continued recognition of a financial asset

Ex 20 Entity Z transfers its holding of 1,000 convertible preference shares in Company C

to a bank for CU575. The shares, which are not listed or traded on any securities
exchange, are measured at fair value under Section 12 and have a fair value of
CU600 on the transfer date. Entity Z had paid CU500 to purchase the shares
18 months earlier. On transfer of the shares Entity Z provides the bank with a put
option that expires in 60 days. At the end of 60 days the bank may exercise the
put option and sell the shares back to Entity Z for CU585. In addition, Entity Z has
a call option that also expires after 60 days; at the end of 60 days Entity Z may
exercise the call option and buy the shares back from the bank for CU585.
If, after 60 days, the fair value of the shares is below CU585, it is expected that the bank
will exercise its put option and sell the shares back to Entity Z. On the other hand, if
the fair value of the shares is above CU585, it is expected that Entity Z will exercise its
call option and purchase the shares back from the bank. Either way, at inception, it is
anticipated that Entity Z will own the shares again after 60 days. Consequently,
Entity Z has retained substantially all of the risks and rewards of ownership of the
shares. Entity Z does therefore not recognise the shares.

Instead, the transaction should be accounted for as a 60-day loan of CU575. The loan is
secured by the shares. Interest of CU10 (CU585-CU575) is payable during the 60-day
period and should be amortised to profit or loss using the effective interest rate
method. If the full 60-day period falls within one accounting period, the CU10 will be
recognised in profit or loss in full in that period.

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Example—derecognition of a financial asset

Ex 21 The facts are the same as in Example 20. However, in this example, the bank pays
CU600 for the shares, Entity Z does not have a call option, and at the end of 60
days the bank may exercise the put option and sell the shares back to the entity
for CU600.
At inception, it is uncertain whether the put option will be exercised by the bank; it is
priced at an amount equal to fair value at the date of sale. In addition, Entity Z does
not hold a call option. Consequently, Entity Z has retained some of the risks and
rewards of ownership; if the fair value of the shares falls below CU600, the bank may
sell the shares back to Entity Z, but equally the bank may choose not to sell them back
to Entity Z (for example, the bank might have already sold the shares to a third party).
Because Entity Z has retained some significant risks and rewards of ownership,
paragraph 11.33(c) requires Entity Z to consider whether it has transferred control of
the shares to the bank by determining whether the bank has the practical ability to sell
the asset in its entirety to an unrelated third party and is able to exercise that ability
unilaterally and without needing to impose additional restrictions on the transfer. In
this instance, the bank does have such a practical ability; there is no call option so it
cannot be compelled by Entity Z to sell the shares back to Entity Z and its put option is
not priced in a way to make it highly likely that it would be exercised by the bank, such
as if it were priced at a large premium above the transaction date fair value. If it were
priced in such a way that the bank expected to exercise the option, then the bank
would either not sell the shares or it would sell them with restrictions attached to
ensure that it received the shares back after 60 days so that it could exercise its put
option and sell the shares back to Entity Z. The fact that the bank may or may not
choose to sell the shares is not relevant; it is whether the bank has the practical ability
to do so that is important.
Under the IFRS for SMEs Standard, in this example, derecognition is appropriate because
Entity Z has transferred control of the shares to the bank. Consequently, Entity Z must
derecognise the shares and recognise separately the written put option, that is, the
option of the bank to put (sell) the shares back to Entity Z for CU600 in 60 days’ time.

Hedge accounting

12.15 If specified criteria are met, an entity may designate a hedging relationship between a
hedging instrument and a hedged item in such a way as to qualify for hedge accounting.
Hedge accounting permits the gain or loss on the hedging instrument and on the hedged
item to be recognised in profit or loss at the same time.

Notes
On occasion, entities enter into transactions with the aim of reducing their exposure
to a specified risk or to reduce the variability in cash flows. For example, an entity may
have a variable rate bank loan, but has become concerned that interest rates may rise
in the near future. It, therefore, enters into an interest rate swap with a different
bank, in which it pays a fixed interest and receives a variable interest. The net effect,
assuming the same principal amount, is that the entity will pay a fixed rate of

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interest—see Examples 1 and 14. When an entity enters into a transaction with
another party to reduce or eliminate its exposure to a particular risk or to the
variability in cash flows, that transaction is known as a hedging transaction.
In some hedging transactions, the gain or loss attributable to the risk being hedged in
the hedged item is accounted for under the normal accounting requirements of the
IFRS for SMEs Standard, in the same period as the gain or loss on the hedging
instrument. In such cases, there is no need for any special accounting treatment. For
example, if a derivative is used to hedge a debt instrument that is within the scope of
Section 12, both the derivative and the debt instrument would be required to be
accounted for at fair value with changes in fair value being recognised in profit or loss.
Consequently, if the hedge is fully effective, the effect on profit or loss of the hedging
instrument is equal and opposite to the effect of the hedged risk in the hedged item,
thereby ‘cancelling out’ the effect on profit or loss of the hedged risk.
In other hedging transactions, the accounting for the financial instrument acquired to
hedge the exposure (the hedging instrument) and the underlying exposure being
hedged (the hedged item) will affect profit or loss in different periods under the
IFRS for SMEs Standard, for example, if a derivative is used to hedge a debt instrument
that is within the scope of Section 11. Some view this as an ‘accounting mismatch’,
because, although there is an economic hedge, it is not reflected in the accounting.
Consequently, Section 12 contains some special rules for hedge accounting designed to
‘correct’ this timing mismatch. These rules modify the normal basis for recognising
income and expenses on associated hedging instruments and/or hedged items so that
both are recognised in profit or loss in the same accounting period. Hedge accounting
does not change the overall performance/profits of the entity; it affects only the timing
and presentation of income and expenses in profit or loss.
Section 12 limits the circumstances in which hedge accounting can be applied by
specifying four conditions. One of the conditions is that the hedging instrument must
be one of four specific instruments and meet a number of criteria. Another of the
conditions is that the hedged risk must be one of five specified risks, notwithstanding
that these are expressed in paragraph 12.17 in only four bullet points. Consequently,
an entity may have a hedge that does not qualify for hedge accounting in accordance
with Section 12 despite being a valid economic hedging strategy.
If an entity wishes to apply hedge accounting to one or more of its hedging
transactions, the entity must comply with the four criteria in paragraph 12.16. Entities
are not required to apply hedge accounting to all their hedging transactions that
would otherwise meet the criteria in paragraph 12.16; they can choose to apply hedge
accounting to only some, or none, of those transactions. If the entity does not
designate and document a hedging relationship for a particular transaction applying
paragraph 12.16(a), hedge accounting would not be permitted for that transaction.
On the other hand, if the entity does designate and document a hedging relationship
applying paragraph 12.16(a) for a different transaction, hedge accounting would be
permitted for that transaction, assuming all the other criteria are satisfied.

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12.16 To qualify for hedge accounting, an entity shall comply with all of the following conditions:
(a) the entity designates and documents the hedging relationship so that the risk being
hedged, the hedged item and the hedging instrument are clearly identified and the
risk in the hedged item is the risk being hedged with the hedging instrument.
(b) the hedged risk is one of the risks specified in paragraph 12.17.
(c) the hedging instrument is as specified in paragraph 12.18.
(d) the entity expects the hedging instrument to be highly effective in offsetting the
designated hedged risk. The effectiveness of a hedge is the degree to which
changes in the fair value or cash flows of the hedged item that are attributable to the
hedged risk are offset by changes in the fair value or cash flows of the hedging
instrument.

Notes
Hedging documentation
Section 12 does not provide any specific format for the hedging documentation
required by paragraph 12.16(a). The only requirements are that there is
documentation that specifies:
• the risk being hedged;
• the hedged item; and
• the hedging instrument.
By documenting these items, it will be clear from the documentation that the risk in
the hedged item is the risk being hedged by the hedging instrument.
Section 12 limits the risks that can be hedged if hedge accounting is to be applied.
Consequently, the risk being hedged must be one of the five listed in paragraph 12.17,
notwithstanding that these are expressed in paragraph 12.17 in only four bullet points.
One of the risks for which hedge accounting is permitted is interest rate risk of a debt
instrument measured at amortised cost. For example, if an entity takes out a loan
paying a fixed rate of interest of 7%, which includes a credit spread of 2%, it may, for
example, choose to hedge the fixed interest excluding the credit spread by taking out
an interest rate swap to swap fixed 5% for variable equal to LIBOR. If so, it would be
necessary to document that the risk being hedged was the fixed interest excluding the
credit spread.
Hedge effectiveness
Hedge effectiveness is the extent to which changes in the fair value or cash flows of the
hedged item that are attributable to the hedged risk are offset by changes in the fair
value or cash flows of the hedging instrument. For the purposes of this comparison,
only the change in the fair value or cash flows of the hedged item that are attributable to
the hedged risk are considered.
To use hedge accounting, an entity is required to assess whether it expects the hedging
relationship to be highly effective in achieving offset in the future. The IFRS for SMEs
Standard does not include guidance on when a hedging relationship is considered to
be highly effective.
If a hedging transaction qualifies for hedge accounting, but, at some future point,
ceases to meet the conditions in paragraph 12.16, the hedge accounting must be
discontinued (see paragraphs 12.21 and 12.25). Consequently, the assessment of

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whether the hedging relationship is expected to be highly effective needs to be

revisited over the life of the hedging relationship. For example, a hedge involving a
counterparty may initially be expected to be highly effective, but if the counterparty’s
creditworthiness deteriorates, the hedge may become ineffective because the changes
in the fair value of the hedging instrument would be dominated by the changes in
credit risk, which will not necessarily be offset by the changes in the fair value of the
hedged item attributable to the hedged risk. If so, the entity would need to assess
whether the ineffectiveness is such that the hedge is no longer expected to be highly
effective.
Because the continuing use of hedge accounting is dependent on the conditions in
paragraph 12.16 continuing to be met, an entity might, as a minimum, assess expected
effectiveness when preparing the annual financial statements.
Section 12 contains no requirements for assessing expected hedge effectiveness. When
performing such an assessment, an entity may, for example, use one or more of the
following approaches:
(a) comparing the principal terms of the hedging instrument with those of the hedged
item. If the principal terms of the hedging instrument match those of the hedged
item there would usually be an expectation of high effectiveness. This is possibly
the most straightforward way of assessing hedge effectiveness and is expected to be
the one used most often, because matching the principal terms does not require
any calculations.
The comparison would be of terms such as notional and principal amount, term,
payment timing, repricing dates, denominated currency and maturity.
The principal terms of the hedging instrument and hedged items are those that are
critical to the assessment of hedge effectiveness, ie those that relate to the risk
being hedged. For example, if a variable-rate foreign currency debt instrument is
the hedged item, changes in the cash flows may arise because of changes in
exchange rates as well as changes in interest rates. However, if the hedging
instrument is an interest rate swap and hedges only the interest rate risk
associated with the debt instrument, changes in cash flows due to exchange rate
movements would not be considered; therefore exchange-rate movements would
not lead to the hedging relationship being ineffective.
(b) employing simple mathematical models such as ratio analysis (sometimes called
the dollar offset test) can be used. Ratio analysis involves comparing:
• changes in the fair value or cash flows of the hedging instrument; with
• changes in the fair value or cash flows of the hedged item that are attributable
to the hedged risk.
This approach can be used to assess the effectiveness of a hedge prospectively by
considering the effect of a hypothetical change in the underlying hedged risk on
both the hedging instrument and the hedged item (for example, a 5% change in the
exchange rate if foreign exchange risk is being hedged or a movement of 1% in the
benchmark interest index, such as LIBOR, if interest rate risk is being hedged).
(c) demonstrating a high statistical correlation between the fair value or cash flows of
the hedged item that are attributable to the hedged risk and those of the hedging
instrument. Regression analysis is one way to demonstrate such a statistical
correlation.
The appropriateness of a given approach in assessing expected hedge effectiveness will
depend on the nature of the risk being hedged, the type of hedging instrument used

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and the information available. The approach adopted when assessing hedge
effectiveness must be reasonable, be applied consistently over the period of the
hedging relationship and be consistent with other similar hedges, unless different
methods are explicitly justified. Depending on which approach is used, it might also
be appropriate to assess whether credit risk changes the expected hedge effectiveness.

12.17 This Standard permits hedge accounting only for the following risks:
(a) interest rate risk of a debt instrument measured at amortised cost;
(b) foreign exchange or interest rate risk in a firm commitment or a highly probable
forecast transaction;
(c) price risk of a commodity that an entity holds or in a firm commitment or highly
probable forecast transaction to purchase or sell a commodity; and
(d) foreign exchange risk in a net investment in a foreign operation.
Foreign exchange risk of a debt instrument measured at amortised cost is not in the list
because hedge accounting would not have any significant effect on the financial
statements. Basic accounts, notes and loans receivable and payable are normally
measured at amortised cost (see paragraph 11.5(d)). This would include payables
denominated in a foreign currency. Paragraph 30.10 requires any change in the carrying
amount of the payable because of a change in the exchange rate to be recognised in
profit or loss. Consequently, both the change in fair value of the hedging instrument (the
cross-currency swap) and the change in the carrying amount of the payable relating to the
change in the exchange rate would be recognised in profit or loss and should offset each
other except to the extent of the difference between the spot rate (at which the liability is
measured) and the forward rate (at which the swap is measured).

Notes
Section 12 permits hedge accounting only for changes in the fair value or cash flows of
the hedged item that are attributable to the specific risks listed in the bullet points in
paragraph 12.17. For example, paragraph 12.17(a) permits hedge accounting for the
interest rate risk of a debt instrument measured at amortised cost. Hedge accounting
is therefore permitted for hedges of changes in the cash flows of variable rate debt that
are due to changes in interest rates. Hedge accounting is also permitted for changes in
the fair value of fixed rate debt as a result of changes in interest rates, but not for
changes in the fair value that are due to other risks, such as credit risk or foreign
exchange risk.
Firm commitments
A firm commitment is a binding agreement for the exchange of a specified quantity of
resources at a specified price on a specified future date or dates (see Glossary).
Therefore, a firm commitment must have a fixed quantity, a fixed price and a fixed
timing. For example, if a company signs a contract to sell a machine to a customer on
a fixed date in the future for CU10,000, both the company and the customer have a
firm commitment. Because a firm commitment is a binding agreement, it is usually
legally enforceable.

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Forecast transactions
A forecast transaction is defined as an uncommitted but anticipated future transaction
(see Glossary). For example, if a company anticipates taking out a loan in six months to
finance an expansion of its business, it has a forecast transaction. Paragraph 12.17
permits hedge accounting only for forecast transactions considered highly probable.
The term 'highly probable' is defined as ‘significantly more likely than probable’ (see
Glossary) and indicates a much greater likelihood of occurrence than the term ‘more
likely than not’, that is, the chances of the transaction occurring is considered to be
significantly greater than a 50% chance.
Examples of circumstances that may affect the likelihood that a transaction will occur
include the following:
(a) the frequency of similar past transactions;
(b) the financial and operational ability of the entity to carry out the transaction;
(c) substantial commitments of resources to a particular activity (for example, a
manufacturing facility that can be used in the short run only to process a
particular type of commodity);
(d) the extent of loss of or disruption to operations that could result if the transaction
does not occur;
(e) the likelihood that transactions with substantially different characteristics might
be used to achieve the same business purpose (for example, an entity that intends
to raise cash in a forecast transaction may have several ways of doing so, ranging
from a short-term bank loan to an issue of ordinary shares); and
(f) the entity's business plan.
The length of time until a forecast transaction is projected to occur is also a factor in
determining probability. Other factors being equal, the more distant a forecast
transaction is, the less likely it is that the transaction would be regarded as highly
probable. For example, a transaction forecasted to occur in five years may be less likely
to occur than a transaction forecast to occur in one year. In addition, other factors
being equal, the greater the physical quantity or future value of a forecast transaction
in proportion to the entity's transactions of the same nature, the less likely it is that
the transaction would be regarded as highly probable. For example, less evidence
generally would be needed to support forecast sales of 100,000 units in the next month
than 950,000 units in that month when sales for the past three months have averaged
950,000 units per month.
A history of having designated hedges of forecast transactions and then determining
that the forecast transactions are no longer expected to occur would call into question
an entity's ability to predict forecast transactions accurately and thus the propriety of
using hedge accounting in the future for similar forecast transactions.
If a forecast transaction is being hedged it must be identifiable and documented in
such a way that when a transaction occurs it is clear whether or not it is the hedged
transaction. For example, it is possible to hedge the sale of the first 15,000 units of a
specific product during a specific three-month period. However, the last 15,000 units
of that product sold during a three-month period cannot be hedged, because it is not
possible to identify, at the time of sale, which are the last 15,000 units sold.

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An entity is not required to predict and document the exact date when a forecast
transaction is expected to occur. However, it is required to identify and document the
time period during which the forecast transaction is expected to occur within a
reasonably specific and generally narrow range of time from a most probable date, in
order to assess whether a hedging relationship is expected to be highly effective; to
assess whether a hedging relationship is expected to be highly effective, it is necessary
to ensure that changes in the fair value of the expected cash flows associated with the
hedged risk are offset by changes in the fair value of the hedging instrument and this
test may be met only if the timing of the cash flows occur in close proximity to each
other.
Net investment in a foreign operation
An entity’s net investment in a foreign operation is the amount of the entity’s interest
in the net assets of that operation. A foreign operation may be a subsidiary, associate,
joint venture or branch (see paragraph 30.5). In accordance with Section 12, the
foreign exchange risk in a net investment in a foreign operation may be ‘hedged’.
Hedge accounting for the foreign exchange risk in a net investment in a foreign
operation is relevant when the operation has been consolidated or has been accounted
for using equity accounting; because in these instances, exchange differences arising
when translating the operation’s net assets are recognised in other comprehensive
income. Without hedge accounting, the gain or loss on the hedging instrument would
be recognised in profit or loss, creating a mismatch, with one being recognised in
other comprehensive income and the other in profit or loss. The training module on
Section 30 focuses on a net investment in a foreign operation in more detail.
Paragraph 12.23 looks at the accounting for net investment hedges.
Paragraph 30.12 of the IFRS for SMEs Standard explains that when an entity has a
monetary item receivable from or payable to a foreign operation and settlement of the
monetary item is neither planned nor likely to occur in the foreseeable future, that
monetary item is, in substance, a part of the entity’s net investment in the foreign
operation. See Module 30 for more information. Paragraph 30.13 requires the
exchange differences on any such monetary items to be recognised in other
comprehensive income in the entity’s consolidated financial statements. Such
monetary items, therefore, form part of the net investment that can be hedged.
Examples of hedged risks permitted by paragraph 12.17

Examples of hedged risks permitted by paragraph 12.17 that expose the entity to a risk
of changes in future cash flows include:
• Interest rate risk of a debt instrument measured at amortised cost (paragraph
12.17(a)). Under variable-rate debt instruments, the entity is exposed to the risk of
changes in future interest payments (cash outflows or inflows) due to changes in
market interest rates. For example:
o if the entity has a loan with interest payable at EURIBOR plus 200 points and
EURIBOR increases, the entity will be required to pay more interest; or
o if the entity has an investment in a variable-rate bond with interest payments
linked to LIBOR, and LIBOR decreases, the entity will receive less interest
income.

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• Foreign exchange risk in a firm commitment (paragraph 12.17(b))

A firm sales commitment exposes the entity to the risk of changes in receipts to the
extent they are not fixed in the reporting entity’s functional currency in the
contract. For example, an entity may enter into an agreement to sell goods to an
overseas customer at a fixed amount of foreign currency in three months. For the
next three months, the entity is exposed to the risk of movement in the exchange
rate between the foreign currency and its functional currency, ie the currency of
the primary economic environment in which the entity operates. If the foreign
currency weakens against the entity's functional currency, the entity will, on sale,
receive a lower cash inflow when translated into the functional currency.
• Commodity price risk in a highly probable forecast purchase (paragraph
12.17(c))
A highly probable purchase transaction exposes the entity to the risk of changes in
expected payments. For example, if the entity needs to buy copper for use within
the business and it intends to make its next purchase in three months, the entity is
exposed to the risk of the price of copper rising significantly over the next three
months, resulting in a higher cash outflow on purchase.

Examples of risks that are permitted to be hedged by paragraph 12.17 and that expose
the entity to a risk of changes in fair value include:
• Interest rate risk of a debt instrument measured at amortised cost (paragraph
12.17(a)) A fixed-rate debt instrument held as an investment exposes the entity to
the risk of changes in the fair value of the debt instrument due to changes in
market interest rates. For example, if market interest rates rise, the fair value of
the fixed-rate debt instrument would fall. If the entity holds the instrument to
maturity it is unaffected by changes in the fair value of the debt investment
attributable to changes in interest rates. However, if the fixed-rate debt instrument
is sold in the open market, any fall in fair value would result in a lower price on
sale.
• Commodity price risk on stocks held (paragraph 12.17(c))
Holding a commodity exposes an entity to the risk of changes in the fair value of
the commodity due to changes in market price. If the entity holds a large
inventory of gold and the price of gold falls, the fair value of the inventory will also
fall.

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12.18 This Standard permits hedge accounting only if the hedging instrument has all of following
terms and conditions:
(a) it is an interest rate swap, a foreign currency swap, a foreign currency forward
exchange contract or a commodity forward exchange contract that is expected to be
highly effective in offsetting a risk identified in paragraph 12.17 that is designated as
the hedged risk;
(b) it involves a party external to the reporting entity (ie external to the group, segment or
individual entity being reported on);
(c) its notional amount is equal to the designated amount of the principal or notional
amount of the hedged item;
(d) it has a specified maturity date not later than:
(i) the maturity of the financial instrument being hedged;
(ii) the expected settlement of the commodity purchase or sale commitment; or
(iii) the occurrence of the highly probable forecast foreign currency or commodity
transaction being hedged.
(e) it has no prepayment, early termination or extension features.

Notes

Paragraph 12.18(a)
Paragraph 12.17 limits the risks for which hedge accounting may be used when
applying the IFRS for SMEs Standard. Paragraph 12.18(a) similarly limits the
instruments that can be used as hedging instruments when using hedge accounting.
For example, one of the risks that paragraph 12.17 permits to be hedged is the foreign
exchange risk in a highly probable forecast transaction. If an entity with a functional
currency of CU has a highly probable forecast transaction in a foreign currency (FCU),
such as a sale of good, the entity could, under paragraph 12.18(a), use an FCU/CU swap
or forward contract to hedge the sale, but it could not designate a loan in FCU as the
hedging instrument, because paragraph 12.18(a) does not permit it.
Paragraph 12.18(b)
For hedge accounting, only hedging instruments with a counterparty external to the
reporting entity, ie external to the group or to the individual entity that is being
reported on, can be designated as hedging instruments. An entity within a
consolidated group may enter into an instrument it wishes to designate as a hedging
instrument with another entity in the group. However, that hedging instrument
would be eliminated on consolidation. Consequently, it is not possible to use hedge
accounting in the consolidated financial statements of the group. Hedge accounting
may nevertheless be possible in the individual or separate financial statements of the
first entity if the other entity is external to the first entity.
Paragraph 12.18(c)
The notional amount is the quantity of currency units, shares, bushels, pounds or
other units specified in a financial instrument contract (see Glossary). In other words,
the notional amount is an amount of currency; a number of shares; a number of units
of weight; a number of units of volume; or other units specified in the contract. An

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entity may enter into an interest rate swap with a notional amount of CU10,000 that
requires the entity to pay a fixed interest rate, say 7.5%, and receive a variable rate of
interest, say three-month LIBOR. Under the swap, regular net settlements would be
calculated by applying the difference between 7.5% and three-month LIBOR to the
notional principal of CU10,000. For example, if LIBOR is 7% during a three-month
period then a net payment of CU12.5 (10,000 × (7.5 less 7%)) ÷ 4) is required by the entity
under the swap for that three-month period.
Paragraph 12.18(d)
The maturity date of the hedging instrument must be on or before the date the hedged
item matures; hedge accounting is not permitted if the hedging instrument matures
later than the hedged item, because this would leave the entity exposed to risk once
the hedged items matured. In contrast, an entity is permitted to designate a hedging
instrument as hedging only a portion of the period to maturity of a hedged item. For
example, an interest rate swap could be taken out to hedge the interest rate risk in the
first six months of a two-year loan, but the first six months of a two-year interest rate
swap could not be used to hedge the last six months of a loan.
Paragraph 12.18(e)
Hedge accounting is not permitted under Section 12 if the hedging instrument has
prepayment, early termination or extension features.
Overall consideration
Hedge accounting is only permitted if an entity expects the hedging instrument to be
highly effective in offsetting the designated hedged risk.

The hedging instrument is likely to be effective if:

(a) the notional amount of the hedging instrument is equal to the designated amount
of the principal or notional amount of the hedged item (see paragraph 12.18(c));
and
(b) the value of the principal terms of the hedging instrument and of the hedged item
move in opposite directions—that is one rises as the other falls.
This is because the changes in fair value and cash flows attributable to the hedged risk
are likely to offset each other fully. For example, an interest rate swap is likely to be an
effective hedge for the fixed interest rate risk in a loan if the swap is to receive fixed
interest and pay variable interest and the swap and the loan have the same notional
and principal amounts; term; repricing dates; dates of interest and principal receipts
and payments and basis for measuring interest rates. Similarly, when a commodity
forward exchange contract is used to hedge the price risk in a highly probable forecast
purchase of a commodity, the effectiveness of the hedging instrument is increased if
the quantity of the commodity is the same in the forward contract as in the forecast
purchase, the two are for the same grade of commodity, if relevant, and the delivery
time and location are the same.
Sometimes the hedging instrument offsets only part of the hedged risk. For example,
the hedge may not be fully effective if a loan’s interest rate is periodically reset but the
frequency of that reset does not match the tenor of the underlying interest rate of the
swap.

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Examples—hedged risks and hedging instruments

Ex 22 An entity acquires a 10% fixed-rate government bond with a term to maturity of

10 years. To hedge against fair value exposure on the bond associated with the
interest payments until Year 5, the entity acquires a five-year, pay-fixed, receive-
floating interest rate swap.
Interest rate risk is one of the risks that paragraph 12.17 permits to be hedged. Interest
rate swaps are permitted hedging instruments, provided the conditions in paragraph
12.18(b)–(d) are met. An entity is permitted to designate a hedging instrument as
hedging only a portion of the period to maturity of a hedged item. Provided the other
conditions in paragraph 12.18 are met, the swap may be designated as hedging the
exposure to fixed interest rate risk in the debt instrument for the five-year period.

Ex 23 An entity acquires a 10% fixed-rate government bond with a remaining term to

maturity of six years. To hedge against fair value exposure on the bond associated
with the interest rate payments for the six years, the entity acquires a 10-year, pay-
fixed, receive-floating interest rate swap.
The entity is not permitted to apply hedge accounting to the hedging relationship
between the interest rate swap and the government bond. Because the interest rate
swap matures later than the government bond, the interest rate swap does not satisfy
the condition in paragraph 12.18(d).
To qualify for hedge accounting, the entity should instead enter into a six-year
pay-fixed, receive-floating interest rate swap, ensuring that the six-year swap meets the
other conditions in paragraph 12.18.

Ex 24 An entity whose functional currency is the CU obtains from its bank a five-year
fixed rate, foreign currency-denominated loan for FCU10,000. The entity holds an
FCU10,000 five-year fixed rate bond. Both the loan and bond meet the
requirements to be measured at amortised cost under Section 11. Can the entity
designate its FCU loan as a hedging instrument for the foreign currency risk from
its FCU bond and use hedge accounting?
No. The FCU loan is not one of the hedging instruments listed in 12.18(a); only
specified derivatives are hedging instruments under the IFRS for SMEs Standard.
Consequently, the entity cannot apply hedge accounting to this transaction. However,
hedge accounting would not have had any significant effect on the entity’s financial
statements. The change in the amortised cost of both the FCU loan and the FCU bond
relating to the change in the exchange rate would be recognised in profit or loss and
would effectively offset each other in the same accounting periods.

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Ex 25 Entity A, whose functional currency is the CU, enters into a contract with Entity B,
whose functional currency is the FCU, for the sale of 10 machines to Entity B for
FCU10,000, payable on delivery. Delivery will take place in eight months. At the
same time it enters into the contract, Entity A enters into a foreign currency
forward exchange contract to sell FCU10,000 and buy CU15,000 in eight months.
This sales contract is a firm commitment between Entity A and Entity B. Foreign
exchange risk in a firm commitment is one of the risks that paragraph 12.17 permits to
be hedged. The foreign currency forward exchange contract is a hedging instrument
permitted by paragraph 12.18(a). Consequently, assuming the other criteria for hedge
accounting are met, the foreign currency forward exchange contract can be designated
as a hedging instrument to hedge the foreign currency risk of the firm commitment
(the hedged item); thus, hedge accounting can be used.

Ex 26 An entity whose functional currency is the CU obtains from its bank a five-year
variable-rate (linked to the FCU LIBOR) foreign currency-denominated loan for
FCU10,000, which meets the requirements in Section 11 to be measured at
amortised cost. To hedge its exposure to interest rate movements, the entity
enters into an interest rate swap to receive variable-rate interest (linked to the
FCU LIBOR) in FCU and pay 5% fixed-rate interest in FCU. The entity wishes to
designate the swap as a hedge of the FCU interest rate risk on the loan.
Paragraph 12.17 permits hedge accounting for the interest rate risk of a debt
instrument measured at amortised cost. The swap is a hedging instrument permitted
by paragraph 12.18(a) and consequently, assuming the other criteria for hedge
accounting are met, hedge accounting is permitted.

Ex 27 An entity regularly purchases sheets of steel as a raw material for use in

production. The steel company agrees to sell steel sheets to the entity in four
months at the market price at that date and the entity considers this to be a
highly probable forecast transaction to buy steel. Because the entity is concerned
that the price of the steel sheets will increase during that four-month period, the
entity enters into a four-month forward contract indexed to the price of iron ore,
a significant component of steel, which it intends to net settle. The entity wishes
to designate the contract as a hedge of the price risk of the steel sheets it intends
to purchase.
Steel production generally constitutes a significant portion of the consumption of iron
ore. Consequently, changes in the price of iron ore will affect changes in the price of
steel, but are unlikely to account for the entire change in the price of the steel sheets.
If the entity is able to demonstrate that the hedging instrument, the iron ore forward
exchange contract, is expected to be highly effective in hedging the price risk linked to
the purchase of the steel sheets, it will be able to designate the forward contract as a
hedging instrument in the hedging transaction. Provided that the other conditions for
hedge accounting are met, the entity can use hedge accounting under Section 12.

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Ex 28 Entity X, whose functional currency is LCX, has highly probable forecast purchases
denominated in the local currency of Country Y (LCY). Entity X is wholly owned by
Entity Z, which prepares consolidated financial statements in its functional
currency, LCZ. The consolidated financial statements of Entity Z include Entity X.
Entity Z enters into a forward contract to hedge the change in LCY relative to LCX
resulting from the highly probable forecast purchases of Entity X. Does this hedge
qualify for hedge accounting in the consolidated financial statements of Entity Z,
or must Entity X, which has the foreign currency exposure, be a party to the
hedging transaction for the hedge to qualify?
The hedge can qualify for hedge accounting in the consolidated financial statements,
provided that the other hedge accounting criteria in paragraphs 12.16–12.18 are met.
In the consolidated financial statements, the reporting entity is the group; the group is
exposed to the risk and holds the hedging instrument. In Entity X’s separate financial
statements, hedge accounting would not be appropriate as the hedging instrument is
held by Entity Z. In Entity Z’s separate financial statements, hedge accounting would
not be appropriate as the forecast transaction is expected by Entity X.

Hedge of fixed interest rate risk of a recognised financial

instrument or commodity price risk of a commodity held
12.19 If the conditions in paragraph 12.16 are met and the hedged risk is the exposure to a
fixed interest rate risk of a debt instrument measured at amortised cost or the commodity
price risk of a commodity that it holds, the entity shall:
(a) recognise the hedging instrument as an asset or liability and the change in the fair
value of the hedging instrument in profit or loss; and
(b) recognise the change in the fair value of the hedged item related to the hedged risk in
profit or loss and as an adjustment to the carrying amount of the hedged item.

12.20 If the hedged risk is the fixed interest rate risk of a debt instrument measured at amortised
cost, the entity shall recognise the periodic net cash settlements on the interest rate swap
that is the hedging instrument in profit or loss in the period in which the net settlements
accrue.

Notes
Paragraph 12.19 covers the following two types of hedging transactions:
(a) An entity holds a fixed-rate debt instrument and enters into an interest rate swap,
which hedges the risk of changes in the fair value of the debt due to changes in
interest rates.
An entity may enter into an interest rate swap on a debt instrument that is
expected to be held to maturity (that is, the entity will not be affected by changes
in the fair value of the instrument) if it wishes to swap the fixed interest payments
for variable interest payments. For example, the entity may want to offset the
variable cash flows of the swap with other payments or receipts on other
instruments linked to variable rates.
If the fixed-rate debt instrument is a financial liability, for example, a fixed-rate
bank loan, interest at the fixed rate will be paid. Consequently, the entity would
enter into a pay-variable, receive-fixed interest rate swap. The net effect of the loan
and swap will be that the entity would pay interest at the variable rate (this may be

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the variable rate plus a number of basis points, to take into account the entity’s
credit rating).
If the fixed-rate debt instrument is a financial asset, for example, an investment in
fixed-rate bonds, a fixed amount of interest income will be received. Consequently,
the entity would enter into a pay-fixed, receive-variable interest rate swap. The net
effect of the bonds and swap will be that the entity would receive interest income
at the variable rate.
(b) An entity holding a particular type of commodity as inventory enters into a
commodity forward contract (to sell) to hedge the risk of decreases in the fair value
of the commodity due to price risk over the period of the forward contract. On
maturity of the forward contract, the entity, if it settles the forward contract, will
merely pay or receive the difference between the spot price of the commodity at
maturity and the fixed price under the forward contract. The forward contract
provides a hedge against the inventory’s exposure to price risk.
The accounting for the hedges in (a)–(b) is as follows:
Accounting for the hedging instrument
Hedge accounting under paragraph 12.19 affects only the hedged item and has no
impact on the hedging instrument. The hedging instrument will be accounted for
the same way, regardless of whether it is included as part of a designated hedging
relationship applying paragraphs 12.19. The hedging instruments permitted to be
used in Section 12 are derivatives. For that reason, they will be accounted for at fair
value, with gains or losses recognised in profit or loss of the period in which the
change in fair value occurs.
In addition, when the fixed interest rate risk of a debt instrument is hedged as in (a),
the periodic net cash settlements on the swap are recognised in profit or loss when
they accrue. See the illustrative journals; this may be incorporated with the
recognition of the change in fair value of the swap, or it may be recognised
separately, in which case, the journal for the change in fair value of the swap is
adjusted accordingly.
Accounting for the hedged item
Hedge accounting applying paragraph 12.19 involves changing how the hedged item
is accounted for, that is, the hedge accounting overrides the ‘normal’ accounting for
the hedged item. In (a)–(b), if an entity applies hedge accounting to a hedging
relationship, the changes in the fair value of the hedged item attributable to
the hedged risk are recognised in profit or loss and as an adjustment to the
carrying amount of the hedged item (debt instrument or commodity) in the
statement of financial position.
Hedge ineffectiveness
Because the change in fair value of the hedging instrument and the change in the fair
value of the hedged item attributable to the hedged risk are both recognised in profit
or loss, any hedge ineffectiveness (the extent to which changes in the fair value or
cash flows of the hedged item and of the hedging instrument do not match) is
automatically recognised in profit or loss in the period in which it occurs. This
automatic recognition occurs regardless of whether the changes in the fair value of
the hedging instrument are less than, or exceed, those changes in the fair value of the
hedged item attributable to the hedged risk.

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Examples—Comparisons of not applying hedge accounting (Example 29)

with applying hedge accounting (Example 30)

Ex 29 On 1 January 20X0 Entity A took out a CU50,000 six-year fixed-rate bank loan
with Bank B. One year later, on 1 January 20X1, concerned about press reports
that interest rates would soon fall, Entity A entered into an interest rate swap
with another external party to convert the loan from a fixed-rate loan to a
variable-rate loan, so that Entity A’s interest expense is now effectively at a
variable rate. Further details about the loan and interest rate swap are:
• Entity A pays interest at an annual fixed rate of 5% in arrears on the bank
loan. At 5%, the fixed interest rate on the loan is 100 basis points or 1%
higher than the five-year swap rate as a result of Entity A’s credit rating.
• The swap is a five-year interest rate swap in which the entity will pay LIBOR
and receive a fixed 4% on a nominal value of CU50,000. The floating leg of
the swap is reset on an annual basis on 31 December. The interest rate swap
is on-market, and at inception has a fair value of zero. The swap does not
have any prepayment, early termination or extension features.
The combined effect of the loan and the swap is that, for the last five years of the
loan, the entity pays variable rate interest equal to LIBOR plus 1% on its loan of
CU50,000.
Entity A does not wish to apply hedge accounting to this transaction.
Consequently, Entity A neither designates nor documents the hedging
relationship. Entity A has a 31 December year-end. Transaction fees have been
ignored for the purpose of this example.
Details about the swap are as follows:

31 December 20X1 31 December 20X2

CU CU

Fair value at the beginning of the year 0 2,000

Fair value change in the year 2,500 (3,500)

Cash settlement during the year

(received)/paid (interest rate is 3% (20X0) and 5% (500) 500
(20X1))

Fair value of interest rate swap asset/(liability)

at end of year 2,000 (1,000)

Note: the figures in the table have not been calculated accurately and are for
illustration purposes only.

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The journal entries (5) on initial recognition (1 January 20X0) of the transaction and
subsequently are:

1 January 20X0
Loan
Dr Asset: financial asset—cash CU50,000
Cr Liability: financial liability—loan CU50,000
To recognise the loan and the receipt of cash

31 December 20X0
Loan—amortised cost
Dr Expense: profit or loss—finance costs CU2,500
Cr Asset: financial asset—cash CU2,500
To record the finance costs for the period and the payment of coupon interest

At 31 December 20X0 the carrying amount of the loan is a liability of CU50,000.

1 January 20X1
Swap
As the swap has a fair value of zero on 1 January 20X1, no entries are required on initial recognition.

31 December 20X1
Loan—amortised cost
Dr Expense: profit or loss—finance costs CU2,500
Cr Asset: financial asset—cash CU2,500
To record the finance costs for the period and the payment of coupon interest

Swap—change in fair value

Dr Asset: financial asset—swap CU2,500
Cr Income: profit or loss— change in fair value of swap CU2,500
To record the change in fair value of interest rate swap

Swap—periodic net cash settlement (LIBOR is 3%)

Dr Asset: financial asset—cash CU500
Cr Asset: financial asset—swap CU500
To record the cash flow under the swap agreement (CU50 000 x (4% (fixed rate) – 3% (LIBOR))

At 31 December 20X1 the carrying amount of the loan is a liability of CU50,000 and
the swap is an asset of CU2,000 (at fair value).
The net effect on profit or loss in 20X1 is nil, which is made up of CU2,500 finance
costs less a CU2,500 change in fair value of the swap.

(5)
This training material includes a number of illustrative journal entries. Please note that these are intended to illustrate
one way, not necessarily the only way, in which the journal entries might be structured, because the IFRS for SMEs Standard
is not written at the journal entry level.

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31 December 20X2
Loan—amortised cost
Dr Expense: profit or loss—finance costs CU2,500
Cr Asset: financial asset—cash CU2,500
To record the finance costs for the period and the payment of coupon interest

Swap—change in fair value

Dr Expense: profit or loss— change in fair value of swap CU3,500
Cr Asset/Liability: financial asset/liability—swap CU3,500
To record the change in fair value of interest rate swap

Swap—periodic net cash settlement (LIBOR is 5%)

Dr Liability: financial liability—swap CU500
Cr Asset: financial asset—cash CU500
To record the cash flow under the swap agreement (CU50 000 x (4% (fixed rate) – 5% (LIBOR))

At 31 December 20X2, the carrying amount of the loan is CU50,000 (financial liability)
and the swap is a financial liability of CU1,000 (moved from a CU2,000 asset at
31 December 20X1).
The net effect on profit or loss in 20X2 is a debit of CU6,000, which is made up of
CU2,500 finance costs plus a CU3,500 change in fair value of the swap.
Note: this example shows only the journal entries for the first three years of the loan
and the first two years of the swap. If it showed the journal entries for all five years
of the swap, it would show that the fair value of the swap at the end of the five years
is zero and that the cumulative effect of the swap on profits over the five years equals
the sum of the annual net cash settlements.
The entries recognised in profit or loss for the three years would be:
20X0 20X1 20X2

Loan interest payable (2,500) (2,500) (2,500)

Swap—change in fair value* - 2,500 (3,500)

(2,500) (-) (6,000)

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* The change in fair value is the total change since the start of the accounting period.
It is, therefore, made up of two elements:
20X1 20X2

Attributable to the current accounting period (also

equal to the net cash settlement accruing for the
accounting period) 500 (500)

Attributable to the future periods 2,000 (3,000)

2,500 (3,500)

This example shows the result of the entity taking out an interest rate swap as an
economic hedge of the interest rate risk of its fixed-rate bonds. The swap has the
effect of transforming a fixed-rate loan into a variable-rate loan. However, because
the loan is accounted for at amortised cost and the swap is recognised at fair value
each year, the resulting profits are volatile over the five-year period.

Ex 30 The facts are the same as in Example 29. However, in this example, Entity A
wishes to designate a hedging relationship between the interest rate swap and
the interest rate risk of the loan in such a way as to qualify for hedge
accounting. Consequently, on 1 January 20X1 Entity A designates and
documents the hedging relationship applying paragraph 12.16(a).
The journal entries on initial recognition (1 January 20X0) of the transaction and
subsequently are:
1 January 20X0
Loan
Dr Asset: financial asset—cash CU50,000
Cr Liability: financial liability—loan CU50,000
To recognise the loan and the receipt of cash

31 December 20X0
Loan—amortised cost
Dr Expense: profit or loss— finance costs CU2,500
Cr Asset: financial asset—cash CU2,500
To record the finance costs for the period and the payment of coupon interest

At 31 December 20X0 the carrying amount of the loan is a liability of CU50,000.

1 January 20X1
Swap
Because the swap has a fair value of zero on 1 January 20X1, no entries are required on initial
recognition.

31 December 20X1
Loan—amortised cost
Dr Expense: profit or loss— finance costs CU2,500
Cr Asset: financial asset—cash CU2,500
To record the finance costs for the period and the payment of coupon interest

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Hedge accounting: loan—change in fair value due to interest rate risk

Dr Expense: profit or loss— change in fair value (hedged CU2,000
item)
Cr Liability: financial liability—loan CU2,000
To record the change in fair value of the loan attributable to interest rate risk

Swap—change in fair value (LIBOR is 3%)

Dr Asset: financial asset—swap CU2,500
Cr Income: profit or loss—change in fair value: accrued CU500
net cash settlement (hedging instrument)
Cr Income: profit or loss—change in fair value CU2,000
(hedging instrument)
To record the change in fair value and the accrued net cash settlement of the interest rate swap

Swap—periodic net cash settlement (LIBOR is 3%)

Dr Asset: financial asset—cash CU500

Cr Asset: financial asset—swap CU500
To record the cash flow under the swap agreement (CU50 000 x (4% (fixed rate) – 3% (LIBOR))

The net effect on profit or loss is that the entity has variable rate interest; it pays the
bank fixed interest and the effect of the interest rate swap is to adjust that interest to
a variable rate.
The net effect on profit or loss in 20X1, when LIBOR is 3%, is a debit of CU2,000 (which
comprises CU2,500 interest expense less CU500 accrual for net cash payment on the
swap, with the CU2,000 other change in fair value of the swap, and the CU2,000
change in fair value of the loan due to interest rate risk, netting to zero).
At 31 December 20X1 the carrying amount of the loan is a financial liability of
CU52,000 (= CU50,000 + CU2,000) and the swap is a financial asset of CU2,000
(= CU2,500 less CU500).

31 December 20X2
Loan—amortised cost
Dr Expense: profit or loss— finance costs CU2,500
Cr Asset: financial asset—cash CU2,500
To record the finance costs for the period and the payment of coupon
interest

Hedge accounting: loan—change in fair value due to interest rate risk

Dr Liability: financial liability—loan CU3,000
Cr Income: profit or loss— hedge accounting effect CU3,000
To record the change in fair value of the loan attributable to interest rate risk

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Swap—change in fair value (LIBOR is 5%)

Dr Expense: profit or loss—change in fair value: accrued CU500
net cash settlement (hedging instrument)
Dr Expense: profit or loss— change in fair value (hedging CU3,000
instrument)
Cr Asset: financial asset—swap CU2,000
Cr Liability: financial liability—swap CU1,500
To record the change in fair value and the accrued net cash settlement of the interest rate swap.
The journal entry is split as the swap changes from an asset to a liability.

Swap—periodic net cash settlement (LIBOR is 5%)

Dr Asset: financial asset—swap CU500
Cr Asset: financial asset—cash CU500
To record the cash flow under the swap agreement (CU50 000 x (4% (fixed rate) – 5% (LIBOR))

The net effect on profit or loss is that the entity has variable-rate interest; it pays the
bank fixed interest and the effect of the interest rate swap is to adjust that interest to a
variable rate.
The net effect on profit or loss in 20X2, when LIBOR is 5%, is a credit of CU3,000 (which
comprises CU2,500 interest expense plus CU500 accrual for net cash payment on the
swap, with the CU3,000 other change in fair value of the swap, and the CU3,000 change
in fair value of the loan due to interest rate risk, netting to zero).
At 31 December 20X2 the carrying amount of the loan is a financial liability of
CU49,000 (= CU50,000 less CU1,000) and the swap is a financial liability of CU1,000
(= CU2,000 asset plus CU500 less CU3,500).

The entries recognised in profit or loss for the three years illustrated would be:
20X0 20X1 20X2

Loan interest payable (2,500) (2,500) (2,500)

Loan—change in fair value

n/a (2,000) 3,000

Swap—change in fair value:

accrual for periodic net cash settlement n/a 500 (500)

other change in fair value n/a 2,000 (3,000)

(2,500) (2,000) (3,000)

The swap was not taken out until 1 January 20X1. The net effect on profit or loss in
20X1 and 20X2 is still variable (although less variable than in Example 29, when hedge
accounting was not applied), but that is because the combined effect of the loan and
the swap is to create a loan with an effective interest rate variable at LIBOR plus 1%.

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12.21 The entity shall discontinue the hedge accounting specified in paragraph 12.19 if:
(a) the hedging instrument expires or is sold or terminated;
(b) the hedge no longer meets the conditions for hedge accounting specified in
paragraph 12.16; or
(c) the entity revokes the designation.

12.22 If hedge accounting is discontinued and the hedged item is an asset or liability carried at
amortised cost that has not been derecognised, any gains or losses recognised as
adjustments to the carrying amount of the hedged item are amortised into profit or loss
using the effective interest method over the remaining life of the hedged item.

Notes
Hedging Instrument expires, is sold or terminated
The hedging instrument no longer exists and should be derecognised.
Hedged item is not sold, terminated or extinguished
If hedge accounting is discontinued without the hedged item being sold or
extinguished, the hedged item ceases to be adjusted for future changes in its fair value
attributable to the hedged risk. The cumulative adjustment to the hedged item, for
changes in its fair value attributable to the hedged risk during the period of hedge
accounting, remains part of the carrying amount of the hedged item until the hedged
item is derecognised. It is treated as follows:
• If the hedged risk is the exposure to the commodity price risk of a commodity, the
cumulative adjustment remains part of the carrying amount of the asset up to the
date of its use, sale or impairment.
• If the hedged risk is the exposure to a fixed interest rate risk of a debt instrument
measured at amortised cost, the cumulative adjustment is amortised through
profit or loss using the effective interest method over the remaining life of the debt
instrument.
Hedging instrument is not sold, terminated or extinguished
If the hedge no longer meets the conditions for hedge accounting specified in
paragraph 12.16 but without the hedging instrument having expired, been sold or
terminated (paragraph 12.21(b)), for example, if the hedging instrument is no longer
expected to be highly effective, or if an entity revokes the hedge designation
(paragraph 12.21(c)), the entity will still hold the hedging instrument. However, the
entity should stop hedge accounting. The entity should continue to account for the
hedging instrument applying Section 12, that is, at fair value with changes in fair
value recognised in profit or loss. In addition, the entity should account for the
hedged item as set out above.

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Examples—discontinued hedge accounting

Ex 31 The facts are the same as in Example 29, but the entity applies hedge accounting.
At 31 December 20X2 the carrying amount of the loan is CU49,000 and the swap is
a liability of CU1,000 (see Example 30). However, in this example, on 1 January
20X3 the entity decides to revoke the designation prospectively, but without
closing out the swap.
At 31 December 20X3 the swap has a fair value of CU600 (liability) and LIBOR was
4.5%.
The journal entries on 31 December 20X3 are as follows:
31 December 20X3
Loan—amortised cost (see table at the end of this Example)
Dr Expense: profit or loss— finance costs CU2,815
Cr Asset: financial asset—cash CU2,500
Cr Liability: financial liability—loan CU315
To record the finance costs for the period and the payment of coupon interest

Swap—change in fair value

Dr Liability: financial liability—swap CU150(a)
Cr Income: profit or loss—change in fair value of swap CU150
To record the change in fair value of interest rate swap

(a) Change in fair value of swap = fair value at 31 December 20X3 (CU(600) )less fair value at
31 December 20X2 (CU(1,000)) less accrued net cash settlement (CU250) = CU150.
Swap—periodic net cash settlement (LIBOR is 4.5%)

Dr Liability: financial liability—swap CU250

Cr Asset: financial asset—cash CU250
To record the cash flow under the swap agreement (CU50 000 x (4% (fixed rate) – 4.5% (LIBOR))

The carrying amount of the loan is no longer adjusted for changes in fair value
attributable to interest rate risk, because hedge accounting has been discontinued.
At 31 December 20X3 the carrying amount of the loan is CU49,315 and the swap is a
liability of CU600.
The calculation of the revised effective interest rate is:
Year Carrying amount Interest at Cash inflow Carrying amount at
at 1 January 5.7447%(a) 31 December

20X3 49,000 2,815 (2,500) 49,315

20X4 49,315 2,833 (2,500) 49,648
20X5 49,648 2,852 (52,500) -

(a) Theeffective interest rate of 5.7447% is the rate that discounts the expected cash flows on the loan to the carrying
amount, CU49,000, on 31 December 20X2.

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Hedge of variable interest rate risk of a recognised financial

instrument, foreign exchange risk or commodity price risk in a
firm commitment or highly probable forecast transaction or a
net investment in a foreign operation
12.23 If the conditions in paragraph 12.16 are met and the hedged risk is:
(a) the variable interest rate risk in a debt instrument measured at amortised cost;
(b) the foreign exchange risk in a firm commitment or a highly probable forecast
transaction;
(c) the commodity price risk in a firm commitment or highly probable forecast transaction;
or
(d) the foreign exchange risk in a net investment in a foreign operation,
the entity shall recognise in other comprehensive income the portion of the change in the
fair value of the hedging instrument that was effective in offsetting the change in the fair
value or expected cash flows of the hedged item. The entity shall recognise in profit or
loss in each period any excess (in absolute amount) of the cumulative change in the fair
value of the hedging instrument over the cumulative change in the fair value of the
expected cash flows of the hedged item since inception of the hedge (sometimes called
hedge ineffectiveness). The hedging gain or loss recognised in other comprehensive
income shall be reclassified to profit or loss when the hedged item is recognised in profit
or loss, subject to the requirements in paragraph 12.25. However, the cumulative amount
of any exchange differences that relate to a hedge of a net investment in a foreign
operation recognised in other comprehensive income shall not be reclassified to profit or
loss on disposal or partial disposal of the foreign operation.
12.24 If the hedged risk is the variable interest rate risk in a debt instrument measured at
amortised cost, the entity shall subsequently recognise in profit or loss the periodic net
cash settlements from the interest rate swap that is the hedging instrument in the period
in which the net settlements accrue.

Notes

Examples of hedging transactions covered by paragraph 12.23 include the following:

• An entity has a recognised variable-rate debt instrument measured at amortised
cost and enters into an interest rate swap, which hedges the risk of changes in the
cash flows of the debt instrument due to changes in interest rates.
If the variable-rate debt instrument is a financial liability (for example, a
variable-rate loan from a bank, in which the interest rate is based on a quoted
interest rate such as LIBOR), variable-rate interest will be paid. Consequently, the
entity would enter into a pay-fixed, receive-variable interest rate swap, with the
swap referring to the same quoted observable rate as the loan (LIBOR).
The outcome of this will be that the entity pays interest at a fixed rate.
If the variable-rate debt instrument is a financial asset (for example, an investment
in variable-rate bonds in which the interest rate is based on a quoted interest rate
such as EURIBOR), variable-rate interest will be received. Consequently, the entity
would enter into a pay-variable, receive-fixed interest rate swap, with the variable
interest rate referring to the same quoted interest rate as the bonds (EURIBOR).

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The outcome of this will be that the entity receives interest income at a fixed rate.
• An entity has a firm commitment or highly probable forecast transaction to
purchase (or sell) goods in a foreign currency in the future. The entity may wish to
enter into a foreign currency swap or foreign currency forward exchange contract
that will lock in a particular exchange rate between its functional currency and the
foreign currency, instead of simply making the purchase (or sale) at the spot
exchange rate on the date of the transaction. In other words, the entity knows in
advance what amount it will pay (or will receive) in its own functional currency on
that future date.
• An entity has a firm commitment or highly probable forecast transaction to
purchase (or sell) a commodity. An entity may wish to enter into a commodity
forward contract with another party, which, by net settling, will have the effect of
locking in a particular price for the purchase (or sale) of the commodity when
combined with making the purchase (or sale) at the spot price of the commodity on
the date of the transaction. In other words, the entity knows in advance what net
amount it will pay (or will receive) on that future date.

For the examples of hedges covered by paragraph 12.23, the accounting is as follows:
Accounting for the hedged item
Hedge accounting applying paragraph 12.23 has no impact on the ‘normal’(6)
accounting for the hedged item. Paragraph 12.23 affects only the accounting for the
hedging instrument. Consequently, the hedged item will be accounted for as required
in the Standard, regardless of whether it is included in a designated hedging
relationship.
Accounting for the hedging instrument
The hedging instruments permitted to be used in Section 12 are derivatives. For that
reason, Section 12 would normally require them to be accounted for at fair value, with
gains or losses recognised in profit or loss in the period in which the change in
fair value occurs. When applying hedge accounting applying paragraph 12.23, the
instruments are still accounted for at fair value but the gain or loss on the hedging
instrument is divided into two amounts: (i) the amount that was effective in hedging
the hedged risk is recognised in other comprehensive income (OCI); and (ii) the balance
is recognised in profit or loss.
Hedge effectiveness
If an entity applies hedge accounting applying paragraph 12.23 to a hedging
relationship, the portion of the change in the fair value of the hedging instrument that
is determined to be an effective hedge is recognised in OCI. The portion of the hedging
instrument that is considered to be ineffective is the excess of the fair value of the
hedging instrument; over the change in the fair value of the expected cash flows on
the hedged item, attributable to the hedged risk. The result is recognised in profit or
loss.

(6)
The accounting that would apply in accordance with the IFRS for SMEs Standard without the
existence of paragraph 12.23.

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Reclassification of the hedging gain or loss

In accordance with paragraph 12.23, the gain or loss on the hedging instrument that
was recognised in OCI is reclassified to profit or loss when:
• the hedged item is recognised in profit or loss (for example, when the highly
probable forecast transaction, or transaction under a firm commitment, affects
profit or loss), or
• the hedging relationship ends.
A forecast transaction or transaction under a firm commitment does not always affect
profit or loss on the transaction date. For example, a transaction that involves the
purchase of an item of property, plant or equipment will affect profit or loss as the
item is depreciated and/or when it is resold. If the transaction is the sale of inventory,
the transaction will affect profit or loss on the date the sale meets the conditions to be
recognised under Section 23 Revenue (see conditions for sale of goods—paragraph 23.10).
If the hedged risk is the variable interest rate risk in a debt instrument measured at
amortised cost, the amount of the gain or loss on the interest rate swap that was
recognised in OCI will equate to the accrual of the net cash settlement for that
accounting period. Paragraph 12.24 explicitly requires this amount to be recognised in
profit or loss.
Net investment in a foreign operation
A hedge of a net investment in a foreign operation is slightly different to the other
hedges listed in paragraph 12.23. The hedges in paragraphs 12.23 (a)–(c) are hedges of
the variability in the cash flows from a hedged item due to a particular risk. A hedge
of a net investment (paragraph 12.23(d)) is not a hedge of cash flows, but is instead a
hedge of the changes in the reporting entity’s share of the net assets of a foreign
operation that are due to foreign exchange risk arising on translation of those net
assets into the parent’s functional currency in order to incorporate the net assets into
the parent’s financial statements. However, a hedge of a net investment in a foreign
operation is dealt with in the same paragraphs as the hedges in paragraph 12.23 (a)–(c)
because of the similarity in accounting treatment.
Consequently, for a hedge of a net investment, paragraph 12.23 is applied as follows:
• The entity recognises in OCI the portion of the change in the fair value of the
hedging instrument, foreign currency swap or foreign currency forward exchange
contract, that was effective in offsetting the change in the reporting entity’s net
investment in a foreign operation due to foreign exchange risk; and
• The entity recognises in profit or loss any excess of the fair value of the hedging
instrument over the change in the reporting entity’s net investment in the foreign
operation due to foreign exchange risk.
Applying paragraph 12.23, even if the hedging relationship ends, any cumulative
hedging gain or loss recognised in OCI is not reclassified to profit or loss. The gain or
loss is not recognised even when the entity disposes of the foreign operation.

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Examples—hedge risks covered by paragraph 12.23

Ex 32 On 1 January 20X0 an entity took out a three-year variable-rate loan from a bank
for CU50,000. To maintain regular cash outflows, the entity decided to enter into
an interest rate swap with an external party on the same date, to effectively
convert the loan from a variable rate to a fixed rate so that interest is payable at
the same amount each year. In addition:
• The variable rate on the loan is LIBOR plus 100 basis points and this is
annually reset. The loan is at the market rate of interest for a loan to the
entity. Interest is paid annually on 31 December based on LIBOR at the start of
the year. Initial LIBOR is 3.25%.
• The swap is a three-year pay 3.25% fixed, receive LIBOR interest rate swap with
a nominal value of CU50,000. The floating leg of the swap is annually reset.
Interest is payable at the end of the year based on LIBOR at the start of the
year. The interest rate swap is on-market at inception, has a fair value of zero
and has no prepayment, early termination or extension features. The credit
rating of the entity and of the external party remain the same throughout the
three-year period and hence the changes in the fair value of the swap are due
only to changes in interest risk; that is, the change in the fair value of the
swap is fully effective in offsetting the change in the expected cash flows of
the hedged item that is due to interest rate risk.

1 January 20X0 31 December 20X0 31 December 20X1

CU CU CU

Fair value (asset/(liability)) of 0 250 (75)

interest rate swap(7)

The entity does not wish to apply hedge accounting to this transaction.
Consequently, the entity neither designates nor documents the hedging
relationship.
Assume LIBOR is 3.5% on 1 January 20X1 and 3.1% on 1 January 20X2.
1 January 20X0
The journal entries on initial recognition are as follows:

Dr Asset: financial asset—cash CU50,000

Cr Liability: financial liability—loan CU50,000
To recognise the loan and the receipt of cash

The loan is measured initially at CU50,000, its transaction price.

Because the swap has a fair value of zero on 1 January 20X0, no entries are required on
initial recognition.

(7)
The figures in the table have not been calculated accurately and are for illustration purposes only. The effects of the time
value of money have been ignored.

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31 December 20X0
The journal entries, with LIBOR at 3.25% on 1 January 20X0, are as follows on
31 December 20X0:
Loan—interest
Dr Expense: profit or loss—finance costs CU2,125(a)
Cr Asset: financial asset—cash CU2,125
To record the finance costs for the period and the payment of coupon interest

Swap—change in fair value

Dr Asset: financial asset—swap CU250
Cr Income: profit or loss—change in fair value of CU250
swap
To record the change in fair value of interest rate swap
Swap—periodic net cash settlement
Dr Asset: financial asset—swap CU0(b)
Cr Asset: financial asset—cash CU0
To record the cash flow under the swap agreement

(a) CU50,000 × (LIBOR + 1%) = CU50,000 × (3.25% + 1%) = CU2,125.

(b) Net payment under swap = CU50,000 × (3.25% less LIBOR) = CU50,000 × (3.25% less 3.25%) = CU0. In
accordance with the terms of the swap, payments are calculated and paid at the end of each year but based
on LIBOR at the start of the year; the payment at 31 December 20X0 will therefore always be zero
regardless of the level of LIBOR at 31 December 20X0.

At 31 December 20X0 the carrying amount of the loan is a liability of CU50,000 and the
swap is an asset of CU250. The loan continues to be recorded at CU50,000 applying the
amortised cost method (see Module 11 for more explanation).
31 December 20X1
The journal entries, with LIBOR at 3.5% on 1 January 20X1, are as follows on
31 December 20X1:

Loan—interest
Dr Expense: profit or loss— finance costs CU2,250(a)
Cr Asset: financial asset—cash CU2,250
To record the finance costs for the period and the payment of coupon interest

Swap—change in fair value

Dr Expense: profit or loss—change in fair value of swap CU200
Cr Asset: financial asset—swap CU200(b)
To record the change in fair value of interest rate swap

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Swap—periodic net cash settlement

Dr Asset: financial asset—cash CU125(c)
Cr Asset financial asset—swap CU50
Cr Liability: financial liability—swap CU75

To record the cash flow under the swap agreement. The journal entry is split as the swap changes from
an asset to a liability.

(a) CU50,000 × (LIBOR + 1%) = CU50,000 × (3.5% + 1%) = CU2,250.

(b) Change in fair value of swap = CU(75) less (CU250 less CU125) = CU200.
(c) Net receipt under swap = CU50,000 × (LIBOR less 3.25%) = CU50,000 × (3.5% less 3.25%) = CU125.

At 31 December 20X1, the carrying amount of the loan is a liability of CU50,000 and
the swap is a liability of CU75.
31 December 20X2
The journal entries, with LIBOR at 3.1% on 1 January 20X2, are as follows on
31 December 20X2:
Loan—interest
Dr Expense: profit or loss—finance costs CU2,050(a)
Cr Asset: financial asset—cash CU2,050
To record the finance costs for the period and the payment of coupon interest

Swap—change in fair value

Dr Expense: profit or loss—change in fair value of swap CU0(b)
Cr Liability: financial liability—swap CU0
To record the change in fair value of interest rate swap

Swap—periodic net cash settlement

Dr Liability: financial liability—swap CU75(c)
Cr Asset: financial asset—cash CU75
To record the cash flow under the swap agreement

Loan—settlement
Dr Liability: financial liability—loan CU50,000
Cr Asset: financial asset—cash CU50,000
To record the repayment of principal under loan agreement

(a) CU50,000 × (LIBOR + 1%) = CU50,000 × (3.1% + 1%) = CU2,050.

(b) Change in fair value of swap = CU0 less (CU(75) add CU75) = CU0.
(c) Net payment under swap = CU50,000 × (3.25% less LIBOR) = CU50,000 × (3.25% less 3.1%) = CU75.

At 31 December 20X2 the loan and the swap have both reached maturity; hence, after
settlement of the loan, both have a carrying amount of nil.
This example shows the result of the entity taking out an interest rate swap of the
variable interest rate risk of its loan as an economic hedge, but not applying hedge
accounting.

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The journal entries show that the swap has the effect of transforming the loan into a
fixed-rate loan. Each year the entity effectively pays annual interest of CU2,125—it
effectively pays interest at the fixed rate of 4.25% of the principal amount—the total of
the interest payable on the loan plus (or minus) the cash payment (or receipt) under
the swap. The entity pays interest at the rate of LIBOR plus 1% on the loan and pays
3.25% interest under the swap. The entity receives interest at the rate of LIBOR under
the swap (= LIBOR + 1% + 3.25% less LIBOR = 4.25%).

Summary—entries recognised in profit or loss when not applying hedge accounting

20X0 20X1 20X2 Total

Loan interest payable (2,125) (2,250) (2,050) (6,425)

Swap—payment 0 125 (75) 50

Swap—residual change in fair value 250 (325) 75 -

(1,875) (2,450) (2,050) (6,375)

The overall effect on profit or loss of the swap is a gain of CU50, which is equal to the
sum of the net cash settlements in each of the three years. However, the swap causes
volatility in profits during each individual year because of fluctuations in its fair value
during the three-year period.

Ex 33 The facts are the same as in Example 32. However, in this example, the entity
wishes to designate a hedging relationship between the interest rate swap and the
LIBOR interest rate risk of the loan in such a way as to qualify for hedge
accounting. Consequently, on 1 January 20X0, the entity designates and
documents the hedging relationship applying paragraph 12.16(a).
The interest rate swap is expected to be highly effective, because the principal terms of
the loan and the swap match. The entity may, therefore, designate a hedging
relationship between the interest rate swap and the LIBOR interest rate risk of the loan
and, because the entity complies with all the conditions in paragraph 12.16, apply
hedge accounting.
1 January 20X0
The journal entries on initial recognition are as follows:
Dr Asset: financial asset—cash CU50,000
Cr Liability: financial liability—loan CU50,000
To recognise the loan and the receipt of cash

The loan is measured initially at CU50,000, its transaction price. Because the swap has
a fair value of zero on 1 January 20X0, no entries are required on initial recognition.

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31 December 20X0
The journal entries on 31 December 20X0 are as follows (LIBOR = 3.25% on 1 January
20X0):

Loan—interest
Dr Expense: profit or loss—finance costs CU2,125(a)
Cr Asset: financial asset—cash CU2,125
To record the finance costs for the period and the payment of coupon interest

Dr Asset: financial asset—swap CU250

Cr Income: OCI-change in fair value (hedging CU250
instrument)
To record the change in fair value of interest rate swap
Swap—accrual of periodic net cash settlement
Dr Income: OCI-change in fair value (hedging instrument) CU0(b)
Cr Income: profit or loss—change in fair value: accrued
net cash settlement (hedging instrument) CU0
To record the accrued net cash settlement of interest rate swap
Swap—periodic net cash settlement
Dr Asset: financial asset— cash CU0(b)
Cr Asset: financial asset— swap CU0
To record the cash flow under the swap agreement

(a) CU50,000 × (LIBOR + 1%) = CU50,000 × (3.25% + 1%) = CU2,125.

(b) Net payment under swap = CU50,000 × (3.25% less LIBOR) = CU50,000 × (3.25% less 3.25%) = CU0. In
accordance with the terms of the swap, payments are calculated and paid at the end of each year but based on
LIBOR at the start of the year; the payment at 31 December 20X0 will therefore always be zero regardless of the
level of LIBOR at 31 December 20X0.

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At 31 December 20X0, the carrying amount of the loan is a liability of CU50,000; the
swap is an asset of CU250.

31 December 20X1
The journal entries, with LIBOR at 3.5% on 1 January 20X1, are as follows on
31 December 20X1:

Loan—interest
Dr Expense: profit or loss—finance costs CU2,250(a)
Cr Asset: financial asset—cash CU2,250
To record the finance costs for the period and the payment of coupon interest

Swap—change in fair value

Dr Expense: OCI-change in fair value (hedging CU200
instrument)
Cr Asset: financial asset—swap CU200(b)
To record the change in fair value of interest rate swap

Swap—accrual of periodic net cash settlement

Dr Expense: OCI-change in fair value (hedging CU125(c)
instrument)
Cr Income: profit or loss—change in fair value:
accrued net cash settlement (hedging instrument) CU125
To record the accrued net cash settlement of interest rate swap

Swap—periodic net cash settlement

Dr Asset: financial asset—cash CU125(c)
Cr Asset: financial asset—swap CU50
Cr Liability: financial liability—swap CU75
To record the cash flow under the swap agreement

(a) CU50,000 × (LIBOR + 1%) = CU50,000 × (3.5% + 1%) = CU2,250.

(b) Change in fair value of swap = CU(75) less (CU250 less CU125) = CU200.

(c) Net receipt under swap = CU50,000 × (LIBOR less 3.25%) = CU50,000 × (3.5% less 3.25%) = CU125.

At 31 December 20X1, the carrying amount of the loan is a liability of CU50,000; the
swap is a liability of CU75.

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31 December 20X2
The journal entries, with LIBOR at 3.1% on 1 January 20X2, are as follows on
31 December 20X2:
Loan—interest
Dr Expense: profit or loss—finance costs CU2,050(a)
Cr Asset: financial asset—cash CU2,050
To record the finance costs for the period and the payment of coupon interest

Swap—change in fair value

Dr Liability: financial liability—swap CU0(b)
Cr Income: OCI-change in fair value (hedging
instrument) CU0
To record the change in fair value of interest rate swap

Swap—accrual of periodic net cash settlement

Dr Expense: profit or loss—change in fair value: accrued net CU75(c)
cash settlement (hedging instrument)
Cr Income: OCI-change in fair value (hedging
instrument) CU75
To record the accrued net cash settlement of interest rate swap

Swap—periodic net cash settlement

Dr Liability: financial liability—swap CU75(c)
Cr Asset: financial asset—cash CU75
To record the cash flow under the swap agreement

Loan—settlement
Dr Liability: financial liability—loan CU50,000
Cr Asset: financial asset—cash CU50,000
To record the repayment of principal under loan agreement

(a) CU50,000 × (LIBOR + 1%) = CU50,000 × (3.1% + 1%) = CU2,050.

(b) Change in fair value of swap = CU0 less (CU(75) add CU75) = CU0.
(c) Net payment under swap = CU50,000 × (3.25% less LIBOR) = CU50,000 × (3.25% less 3.1%) = CU75.

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At 31 December 20X2 the loan and the swap have both reached maturity; hence, after
settlement of the loan, both have a carrying amount of nil.
This example shows the result of the entity taking out an interest rate swap as a hedge
of the variable interest rate risk of its loan and applying hedge accounting.
As a result of entering into the interest rate swap, each year, the entity effectively pays
interest at 4.25% of the principal amount.

Summary: entries recognised in profit or loss when applying hedge accounting

20X0 20X1 20X2 Total

Loan interest (2,125) (2,250) (2,050) (6,425)

payable

Swap—
reclassification* - 125 (75) 50

(2,125) (2,125) (2,125) 6,375

* Equals the accrual for the net cash (payment)/receipt.

Instead of recognising the changes in the fair value of the swap in profit or loss as they
occur, applying paragraphs 12.23 and 12.24, hedge accounting results in the
recognition of those changes in fair value in other comprehensive income. The effect
of hedge accounting is, therefore, a reduction in the volatility of annual profit or loss
during a hedging relationship. Over the three-year period of the loan, the fair value of
the swap could fluctuate significantly if LIBOR is volatile, changing from an asset in
one period to a liability in another period. In this case, recognising the change in fair
value in other comprehensive income avoids significant debits and credits from being
recognised in profit or loss during the three-year period. Instead, the volatility only
affects the total comprehensive income figure. Because the interest rate swap has a
fair value of nil on initial recognition and maturity, the overall effect on other
comprehensive income is nil.

Summary: entries recognised in other comprehensive income when applying hedge accounting

20X0 20X1 20X2 Total

Swap—Change in fair value (250) 200 - (50)

Swap—reclassification*
- 125 (75) 50

(250) 325 (75) -

* Equals the accrual for the net cash (payment)/receipt.

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In effect, a part of the hedging gain has been reclassified from other comprehensive
income to profit or loss each year to match the time of when the effect of the risk
being hedged was recognised in profit or loss. If the annual payments under the swap
had been made one day later, that is, on 1 January rather than on 31 December, the fair
value of the swap would be as follows:

1 January 31 December 31 December 31 December

20X0 20X0 20X1 20X2
CU CU CU CU

Fair value of interest

rate swap (dirty value) 0 250 50 (75)

The journal entries at 31 December 20X1 and on 1 January 20X2, assuming that the
annual payments under the swap and the annual interest payments and capital
repayment under the loan had been made on 1 January rather than on 31 December,
would be as follows:

31 December 20X1 (LIBOR = 3.5% on 1 January 20X1)

Loan—interest
Dr Expense: profit or loss—finance costs CU2,250(a)
Cr Liability: financial liability—loan CU2,250
To record the finance costs for the period

Swap—change in fair value

Dr Expense: OCI-change in fair value (hedging instrument) CU200
Cr Asset: financial asset—swap CU200(b)
To record the change in fair value of interest rate swap

Swap— accrual of periodic net cash settlement

Dr Expense: OCI-change in fair value (hedging instrument) CU125
Cr Income: profit or loss—change in fair value: accrued CU125(c)
net cash settlement (hedging instrument)
To record the accrued net cash settlement of interest rate swap

(a) CU50,000 × (LIBOR + 1%) = CU50,000 × (3.5% + 1%) = CU2,250.

(b) Change in fair value of swap = CU50 less CU250 = CU(200).
(c) Accrual for net receipt under swap = CU50,000 × (LIBOR less 3.25%) = CU50,000 × (3.5% less 3.25%) = CU125.

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At 31 December 20X1 the carrying amount of the loan is a liability of CU52,250 and the
swap is an asset of CU50.
1 January 20X2
Loan—interest cash payment
Dr Liability: financial liability—loan CU2,250
Cr Asset: financial asset—cash CU2,250
To record the payment of coupon interest
Swap—periodic net cash settlement
Dr Asset: financial asset—cash CU125
Cr Asset/Liability: financial asset/liability—swap CU125
To record the cash flow under the swap agreement

Ex 34 On 1 November 20X0 a tin mining entity, whose functional currency is the CU,
forecasts that it will sell 500 tonnes of tin to its biggest customer in early February
20X1 at the spot price at the date that the transaction occurs. The sale is
considered to be highly probable.
The entity’s management expects the price of tin to fall by early February 20X1.
Consequently, to hedge the tin price risk in the highly probable forecast sale, the
entity enters into a forward contract with an external party to sell 500 tonnes of
tin on 1 February 20X1 for CU11,440,000. The forward contract permits the
company to net settle in cash based on the price specified in the contract and the
fair value of the tin, calculated using the spot price, at the end of the contract.
The entity intends to net settle the forward contract.
Because the contract is to be net settled, it is within the scope of Section 12.
The forward contract has no prepayment, early termination or extension features.
The entity’s reporting period ends 31 December.
At inception of the hedge, the forward contract is initiated at current market
rates and its initial fair value is nil. The entity expects the forward contract to be
highly effective in offsetting changes in the spot price of tin.
The following information relates to the fair value of tin and the forward
contract:

1 November 31 December 1 February

20X0 20X0 20X1
CU CU CU

Market value of tin per tonne 22,500 21,000 20,000

Fair value of the 500 tonnes of tin 11,250,000 10,500,000 10,000,000

Change in fair value of expected cash flows from the sale

assuming the spot price remains unaltered for the remainder - (750,000) (500,000)
of the contract (ignoring time value of money)

Price in forward contract (or notional forward contract) if

taken out on 31 December 20X0 for delivery of 500 tonnes
of tin on 1 February 20X1 10,558,000 n/a

Fair value of forward contract (ignoring time value of money) - 882,000 1,440,000

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Change in fair value of forward contract 882,000 558,000

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The entity sells 500 tonnes of tin to the customer for CU10,000,000 on 1 February
20X1.
Management does not wish to apply hedge accounting to this transaction.
Consequently, management neither designates nor documents the hedging
relationship.

The journal entries are as follows:

1 November 20X0

Because the forward contract has a fair value of zero on 1 November 20X0, no entries
are required on initial recognition.

31 December 20X0

Forward contract—change in fair value

Dr Asset: financial asset—forward contract CU882,000
Cr Income: profit or loss—change in fair value of CU882,000
forward contract
To record the change in fair value of forward contract

1 February 20X1

Forward contract—change in fair value

Dr Asset: financial asset—forward contract CU558,000
Cr Income: profit or loss—change in fair value of CU558,000
forward contract
To record the change in fair value of forward contract

Forward contract—net settlement

Dr Asset: financial asset—cash CU1,440,000(a)
Cr Asset: financial asset—forward contract CU1,440,000
To record the cash flow on termination of the forward contract

Sale of tin
Dr Asset: financial asset—cash CU10,000,000
Cr Income: profit or loss—revenue CU10,000,000
To record the sale of tin to customer and receipt of cash

(a) The cash payment of CU1,440,000 equals CU11,440,000, as specified in the forward exchange contract, less
CU10,000,000, the fair value of the tin at the end of the forward contract.

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Ex 35 The facts are the same as in Example 34. However, in this example, the entity
wishes to designate a hedging relationship between the commodity-based forward
contract and the price risk of the tin in the highly probable forecast sale in such a
way so as to qualify for hedge accounting. Consequently, on 1 November 20X0
Entity A designates and documents the hedging relationship applying paragraph
12.16(a).
The hedging relationship is expected to be highly effective, because the principal terms
of the highly probable forecast transaction and the forward contract match. The entity
may, therefore, designate a hedging relationship between the forward contract and the
tin price risk in the highly probable forecast transaction and can apply hedge
accounting, because the entity complies with all the conditions in paragraph 12.16.
The journal entries are as follows:
1 November 20X0
Because the forward contract has a fair value of zero on 1 November 20X0, no entries
are required on initial recognition.

31 December 20X0

Forward contract—change in fair value

Dr Asset: financial asset—forward contract CU882,000
Cr Income: OCI-change in fair value (hedging CU750,000
instrument) (8)
Cr Income: profit or loss—ineffective portion of hedging CU132,000
instrument(a)
To record the change in fair value of forward contract

1 February 20X1

Forward contract—change in fair value

Dr Asset: financial asset—forward contract CU558,000
Cr Income: OCI-change in fair value (hedging CU500,000
instrument)
Cr Income: profit or loss—ineffective portion of hedging CU58,000
instrument(a)
To record the change in fair value of forward contract

Forward contract—net settlement

Dr Asset: financial asset—cash CU1,440,000(b)
Cr Asset: financial asset—forward contract CU1,440,000
To record the cash flow on termination of the forward contract

(8)
This hedge is a hedge of commodity price risk in a highly probable forecast sale, not a hedge of commodity price risk of
inventory. Accordingly, the accounting is in accordance with paragraph 12.23, not paragraph 12.19.

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Sale of tin
Dr Asset: financial asset—cash CU10,000,000
Cr Income: profit or loss—revenue CU10,000,000
To record the sale of tin to customer and receipt of cash
Reclassification from other comprehensive income to profit or loss(9)
Dr Income: OCI-change in fair value (hedging instrument) CU1,250,000
Cr Income: Profit or loss— fair value income (hedging CU1,250,000
instrument – re sale of tin)
To record the reclassification of hedging gain from OCI to profit or loss

(a) In accordance with paragraph 12.23, the ineffective portion of the hedging instrument is the excess of the fair value
of the hedging instrument (CU882,000 at 31 December 20X0) over the change in the fair value of the expected
cash flows of the hedged item (CU750,000 at 31 December 20X0).
(b) The cash payment of CU1,440,000 equals CU11,440,000, as specified in the forward exchange contract, less
CU10,000,000, the fair value of the tin at the end of the forward contract.

The income attributable to the hedging instrument recognised in other comprehensive

income must be reclassified from other comprehensive income to profit or loss on
1 February 20X1 (that is, when the hedged item is recognised in profit or loss or when
the hedging relationship ends—in this case both events are on the same date).
The effect of hedge accounting does not change total profits over time, but it reduces
the volatility of reported annual profits during a hedging relationship. If the price risk
was hedged over a longer period, say 10 years, and during this period, tin prices were
volatile, the fair value of the forward contract would fluctuate significantly, possibly
even changing from an asset in one period to a liability in another period. Recognising
the effective portion of the gains and losses in other comprehensive income, applying
hedge accounting, avoids reflecting volatility in profit or loss until the conclusion of
the hedging relationship.

12.25 The entity shall discontinue prospectively the hedge accounting specified in paragraph
12.23 if:
(a) the hedging instrument expires or is sold or terminated;
(b) the hedge no longer meets the criteria for hedge accounting in paragraph 12.16;
(c) in a hedge of a forecast transaction, the forecast transaction is no longer highly
probable; or
(d) the entity revokes the designation.
If the forecast transaction is no longer expected to take place or if the hedged debt
instrument measured at amortised cost is derecognised, any gain or loss on the hedging
instrument that was recognised in other comprehensive income shall be reclassified to
profit or loss.

(9)
Conceptually, there is neither income nor expense because there has been no change in the entity’s assets or liabilities
(see paragraph 2.23). This journal entry is moving, from OCI to profit or loss, income that was recognised previously.

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Examples—discontinued hedge accounting

Ex 36 The facts are the same as in Example 35. However, in this example, because the
inventory is damaged in a fire at the storage facility on 8 January 20X1, the
forecast sale to the customer does not take place. The entity is not sure when the
tin will be in a condition to be suitable for sale.
On 8 January 20X1 the fair value of the forward contract is CU985,000 and the fair
value of 500 tonnes of tin is CU10,400,000.
On 1 January 20X1 the forecast transaction is considered highly probable. However,
because of the fire (a change in circumstances), this assessment must be repeated on
8 January 20X1. Upon reassessment, the forecast transaction is no longer considered to
be highly probable, even though a sale of part of the cleaned-up tin is possible later in
the year.
Consequently, on 8 January 20X1 hedge accounting must be discontinued as illustrated
in the following journal entries.

31 December 20X0 (same as Example 35)

Forward contract—change in fair value

Dr Asset: financial asset–forward contract CU882,000
Cr Income: OCI-change in fair value (hedging CU750,000
instrument)
Cr Income: profit or loss—ineffective portion of CU132,000
hedging instrument
To record the change in fair value of forward contract

8 January 20X1

Forward contract—change in fair value during period hedge is effective (from 1 January 20X1 to
8 January 20X1)
Dr Asset: financial asset—forward contract CU103,000(a)
Cr Income: OCI-change in fair value (hedging CU100,000(b)
instrument)
Cr Income: profit or loss—ineffective portion of CU3,000
hedging instrument
To record the change in fair value of forward contract

Transfer from other comprehensive income to profit or loss on 8 January 20X1

Dr Income: OCI—change in fair value (hedging CU850,000
instrument)
Cr Profit or loss—fair value income (hedging CU850,000
instrument – re expected sale of tin)
To record the reclassification of hedging gain from OCI to profit or loss on termination of the
hedging relationship

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1 February 20X1

Forward contract—change in fair value

Dr Asset: financial asset—forward contract CU455,000(c)
Cr Income: profit or loss—change in fair value of CU455,000
forward contract
To record the change in fair value of forward contract

Forward contract—net settlement

Dr Asset: financial asset—cash CU1,440,000
Cr Asset: financial asset—forward contract CU1,440,000
To record the cash flow on termination of the forward contract

(a) CU985,000 less CU882,000 = CU103,000.

(b) CU10,500,000 less CU10,400,000 = CU100,000.
(c) CU558,000 change in fair value from 1 January to 1 February less CU103,000 change in fair value from 1 January
to 8 January, recognised on 8 January = CU455,000 change in fair value from 9 January to 1 February. Because
hedge accounting has been discontinued from 8 January 20X1, all of the change in fair value is recognised
directly in profit or loss.

Disclosures

12.26 An entity applying this section shall make all of the disclosures required in Section 11
incorporating in those disclosures financial instruments that are within the scope of this
section as well as those within the scope of Section 11. In addition, if the entity uses
hedge accounting, it shall make the additional disclosures in paragraphs 12.27–12.29.

Notes
Module 11 illustrates and discusses the disclosures required under Section 11.
The examples and notes in Module 11 focus on financial instruments within the scope
of Section 11. Paragraph 12.26 requires the Section 11 disclosure requirements to be
applied to financial instruments within the scope of Section 12. Example 37 and
Example 38 illustrate paragraph 11.40 (summary of significant accounting policies for
financial instruments) and paragraph 11.43 (disclosure of the basis for determining fair
value) disclosures for two of the more common financial instruments within the scope
of Section 12. In addition to illustrating some of the disclosures required by Section
11, Example 38 illustrates some of the disclosures required by Section 12.
Example 37 is for reference only and should not be used by entities as a template.
Entities should explain their own specific facts and circumstances and provide
information relevant to users. In particular, if an entity uses a valuation technique in
the measurement of any financial instrument, it must disclose which valuation
technique has been used and the significant assumptions applied (paragraph 11.43).
Such disclosures will be specific to the entity and the type of financial instrument
being valued; they will make users of the financial statements aware of the extent to
which judgement was exercised in performing the valuation. Disclosures provided
should be sufficient for users to assess the level of subjectivity involved and assess
whether the assumptions used by the entity’s management are appropriate.

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Example—general disclosures
Ex 37 Extract from notes to Entity A’s financial statements for the year ended
31 December 20X2 10

Note 2: Accounting policies (extract)

Forward contracts and interest rate swaps

Foreign currency forward exchange contracts and interest rate swaps are used to
manage exposure to foreign exchange and interest rate risk. The forward contracts
and interest rate swaps are initially recognised at fair value, which is zero if the
contract is entered into at market prices or rates. Any transaction costs are recognised
in profit or loss immediately. Such contracts are subsequently measured at fair value,
with changes in fair value recognised in profit or loss during the period, unless the
instrument is designated as, and is expected to be effective as, a hedging instrument,
in which case, the policy for hedge accounting is applied.
The fair value of foreign currency forward contracts is calculated by comparing the
contracted rates with the current forward exchange rates for contracts with similar
maturity profiles and discounting the difference in expected cash flows to reflect the
time value of money. The fair value of interest rate swaps is determined by reference
to market values for similar instruments and specific valuations performed by
counterparties at the balance sheet date.

Note 20: Derivative financial instruments (extract)

Foreign currency forward exchange contracts

The fair value of foreign currency forward contracts is calculated by comparing the
contracted rates with the current forward exchange rates for contracts with similar
maturity profiles and, using LIBOR, discounting the difference in expected cash flows
to reflect the time value of money.
Interest rate swaps
The fair value of interest rate swaps is determined by reference to market values for
similar instruments and specific valuations performed by counterparties at the
balance sheet date.

10 Management should tailor disclosures to an entity's own particular facts and circumstances to enhance this disclosure.
Entity A’s policy for hedge accounting is illustrated in Example 38.

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12.27 An entity shall disclose the following separately for hedges of each of the four types of
risks described in paragraph 12.17:
(a) a description of the hedge;
(b) a description of the financial instruments designated as hedging instruments and their
fair values at the reporting date; and
(c) the nature of the risks being hedged, including a description of the hedged item.

Notes
In the absence of hedge accounting as the IFRS for SMEs Standard permits, gains and
losses on hedging instruments or hedged items would be recognised in different
accounting periods.
Hedge accounting disclosures are necessary for the user to understand the nature of an
entity’s hedging relationships and the effect those hedging relationships have had on
the entity’s performance during the current and prior periods; the disclosures also
show the effects the entity expects in future periods.

Example—disclosures for hedge accounting

Ex 38 Extract from notes to Entity A’s financial statements for the year ended
31 December 20X2

Note 2: Accounting policies (extract)

Hedge accounting
Forward contracts and interest rate swaps are used to reduce currency risk and
interest rate risk. When the contracts or swaps are expected to be highly effective in
offsetting the designated risk, hedge accounting is applied to the transaction. Hedge
accounting overrides other reporting requirements to permit the gain or loss on the
hedging instrument or on the hedged item, as appropriate, to be recognised in profit
or loss at the same time.
The entity uses the following types of hedging instruments:
• Interest rate swaps. The swaps are used to offset variable interest rate risk in bank
loans by exchanging variable-rate interest for fixed-rate interest. When the swap
and the loan qualify for hedge accounting, the portion of the change in the fair
value of the swap that is effective in offsetting the changes in interest payments
due to changes in market interest rates is recognised in other comprehensive
income. The balance, if any, of the change in fair value of the swap is recognised in
profit or loss. An amount equal to the periodic net cash settlements accruing
under the swap for the financial period is reclassified to profit or loss in that
financial period. The variable rate interest payable on the loan being hedged is also
recognised in profit or loss. The resulting effect is that fixed-rate interest is
recognised in profit or loss in each period in which the hedge is effective. When
the loan is derecognised, for example on early settlement, any cumulative gain or
loss on the hedging instrument that has been recognised in other comprehensive
income is reclassified to profit or loss.

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• Foreign currency forward exchange contracts. These forward contracts are used to
offset foreign exchange risk in firm commitments to purchase specialised
point-of-sale computer systems and computer equipment from overseas suppliers
when the purchase price is denominated in a foreign currency. Such a forward
contract is measured at fair value at each reporting date. The portion of the change
in the fair value of the forward contract that is effective in offsetting the change in
the purchase price due to movements in exchange rates is recognised in other
comprehensive income. Any excess of the change in the fair value of the forward
contract over the change in the purchase price due to movements in exchange rates
is recognised in profit or loss. The cumulative hedging gain or loss that has been
recognised in other comprehensive income is reclassified to profit or loss when the
computer system is recognised as an expense, usually as it is depreciated.
Note 20: Derivative financial instruments (extract)
20X2 20X1
CU CU

Fair values of derivative instruments held and designated as hedging

instruments:

Interest rate swaps 9,500 (5,000)

Foreign currency forward exchange contracts 7,050 3,200

12.28 If an entity uses hedge accounting for a hedge of fixed interest rate risk or commodity
price risk of a commodity held (paragraphs 12.19–12.22) it shall disclose the following:
(a) the amount of the change in fair value of the hedging instrument recognised in profit
or loss for the period; and
(b) the amount of the change in fair value of the hedged item recognised in profit or loss
for the period.

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Example—disclosures using hedge accounting (fixed interest rate risk or

commodity price risk)

Ex 39 Extract from notes to Entity A’s financial statements for the year ended
31 December 20X2

Note 10: Profit for the year (extract)

20X2 20X1
CU CU
Profit for the year is stated after recognising the following:

Gains/(losses) arising on forward contracts for wheat in a designated

hedge accounting relationship 35,000 (28,000)

Gains/(losses) arising on adjustment to inventory of wheat in a

designated hedge accounting relationship (36,000) 28,000

12.29 If an entity uses hedge accounting for a hedge of variable interest rate risk, foreign
exchange risk, commodity price risk in a firm commitment or highly probable forecast
transaction or a net investment in a foreign operation (paragraphs 12.23–12.25) it shall
disclose the following:
(a) the periods when the cash flows are expected to occur and when they are expected
to affect profit or loss;
(b) a description of any forecast transaction for which hedge accounting had previously
been used, but which is no longer expected to occur;
(c) the amount of the change in fair value of the hedging instrument that was recognised
in other comprehensive income during the period (paragraph 12.23);
(d) the amount that was reclassified to profit or loss for the period (paragraphs 12.23 and
12.25); and
(e) the amount of any excess of the cumulative change in fair value of the hedging
instrument over the cumulative change in the fair value of the expected cash flows
that was recognised in profit or loss for the period (paragraph 12.23).

Notes

These disclosures are required in respect of hedge accounting applying paragraphs

12.23 to 12.25 inclusive; that is, they are in respect of what might be termed cash flow
hedges.
In Example 40, the disclosures required by paragraph 12.29(c)–(e) have been shown in
the statement of comprehensive income rather than in note 20. Actuarial gains and
losses are shown in shading because an entity is not specifically required to disclose
them, applying Section 12. The gains and losses are included to show what else may
appear in other comprehensive income together with the hedging entries (see
Section 28 Employee Benefits).

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Example—disclosures where hedge accounting is used for hedges of

variable interest rate risk, foreign exchange risk and/or
commodity price risk in a highly probable forecast transaction

Ex 40 Extract from Entity A’s statement of comprehensive income for the year ended
31 December 20X2
Notes 20X2 20X1
CU CU
Profit for the year 1,121,250 865,500

Other comprehensive income:

Items that will not be reclassified to profit or loss:

Actuarial gains (losses) on defined benefit pension plans (67) 13

(67) 13

Items that may be reclassified subsequently to profit or

loss:

Change in fair value of hedging instruments net of

reclassification11 20 (2,319) (1,506)

(2,319) (1,506)

Other comprehensive income for the year (2,386) (1,493)

Income tax related to items in other comprehensive income 597 373

Total comprehensive income for the year 1,119,461 864,380

11
This illustrates the aggregated presentation, with disclosure of the current year gain or loss and reclassification
adjustment presented in the notes. Alternatively, a gross presentation can be used.

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Extract from notes to Entity A’s financial statements for the year ended
31 December 20X2

Note 20: Derivative financial instruments (extract)

The entity has entered into a number of interest rate swaps to achieve a fixed interest
rate on its variable-rate interest exposure that arises from bank loans. One of the
swaps has three years still to run while all the other swaps have two years to run.
The entity has a number of foreign currency forward contracts to hedge changes in
the price of specialised point-of-sale computer systems and computer equipment as a
result of foreign exchange rate movements. It is highly probable that the entity will
purchase the equipment in July 20X3 from overseas suppliers. The point-of-sale
computer systems and computer equipment will be depreciated over their useful lives
of five years.
In 20X2, the entity abandoned a highly probable forecast purchase of yet-to-be-
manufactured computer equipment following the liquidation of the supplier when its
plant was destroyed by a tsunami. Consequently, the purchase transaction never took
place and all accumulated hedging gains on the forward contract were reclassified to
profit or loss in 20X2.
The entity chooses an aggregated presentation of gains and losses on hedging
instruments recognised in other comprehensive income. The amounts for
reclassification adjustments and current year gain (loss) are as follows:

20X2 20X1
CU CU

Gains/(losses) arising during the year 251 (4,510)

Transfers to profit or loss of (gains)/losses on hedges previously recognised in

other comprehensive income (1,840) 3,004

Transfer to profit or loss of gains on a forward exchange contract that is no longer

used as a hedge (730) –

Change in fair value of hedging instruments net of reclassification (2,319) (1,506)

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SIGNIFICANT ESTIMATES AND OTHER JUDGEMENTS

Applying the requirements of the IFRS for SMEs Standard to transactions and events often
requires judgements, such as estimates. Information about significant judgements and key
sources of estimation uncertainty are useful in assessing the financial position, performance
and cash flows of an entity. Consequently, applying paragraph 8.6, an entity must disclose the
judgements that management has made in the process of applying the entity’s accounting
policies and that have the most significant effect on the amounts recognised in the financial
statements. Furthermore, applying paragraph 8.7, an entity must disclose information about
the key assumptions concerning the future, and other key sources of estimation uncertainty at
the reporting date, that have a significant risk of causing a material adjustment to the
carrying amounts of assets and liabilities within the next financial year.
Other sections of the IFRS for SMEs Standard require disclosure of information about particular
judgements and estimation uncertainties. Significant estimates and other judgements in
accounting for financial instruments applying Section 12 are set out in this section.

Scope of Section 12

Judgement may need to be applied in interpreting ‘unrelated’, as used in paragraphs 12.3(d),

12.3(f) and 12.4. In particular, assessing whether some contracts to buy, sell, lease or insure
non-financial items are within the scope of Section 12 may require judgement if they contain
risks partially but not completely related to common risks such as foreign exchange risk or
price risk. For example, a contract to buy, sell, lease or insure a non-financial item may
include a risk that is related to the price risk of a different non-financial item, but judgement
is required if the price of that non-financial item nevertheless shows some correlation with the
price of the non-financial item in the contract.

Initial measurement
1

Assessing whether a transaction has taken place at arm’s length may require judgement if the
transaction does not take place in an active market or if the parties to the transaction are
related. If the transaction does not take place at arm’s length, judgement will need to be
applied in determining fair value at initial recognition, for example, when using valuation
techniques to determine fair value.

Subsequent measurement
1

Judgement is required in determining the fair value of financial instruments when there is
not an active market for such instruments. In particular, choosing and applying valuation
techniques often involves a significant amount of judgement. Often the inputs into the
valuation model and other assumptions used when applying the model involve judgement.
For example, for present value calculations, judgement is required in determining which cash
flows to use (for example if there is significant uncertainly of the cash flows or there are early
repayment features), what adjustments to make for the risk premium required by investors
and what is an appropriate discount factor. If an external valuer is used, management must
assess the reasonableness of the external valuation and check that the valuer used techniques

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that market participants usually apply to such instruments and that those techniques are
consistent with the IFRS for SMEs Standard. The fact that a range of estimates of fair value may
exist reflects the fact that different entities might make different judgements in particular
situations. However, a single entity must apply judgements consistently (across time and by
type of instrument) when measuring fair value.
Judgement may also be required in assessing whether a market is active (if transactions are not
occurring frequently) and also in assessing whether the transactions taking place are forced
transactions. An active market is one in which transactions are taking place regularly on an
arm's length basis. The determination of what is ‘regularly’ is a matter of judgement and
depends upon the facts and circumstances of the market for the instrument being measured
at fair value.
Recent transactions for similar instruments might provide evidence of fair value. What
constitutes a 'similar instrument' is a matter of judgement and requires a clear understanding
of the terms of the instruments. Further judgement is then required to decide what
adjustments need to be made to the fair value of the similar instrument to estimate the fair
value of the instrument held by the entity.
Judgement needs to be applied before concluding that the fair value of some equity
instruments cannot be measured reliably without undue cost or effort. Such instruments are
measured at cost less impairment.
Performing an impairment test for equity instruments measured at cost requires significant
judgement. An entity only measures an instrument at cost if the fair value cannot be
measured reliably; consequently, in most cases, the best estimate of the amount that the
entity would receive for the asset if it were to be sold at the reporting date will also be difficult
to determine. The Standard does not permit the impairment to be omitted on the grounds
that the measurement is difficult; consequently, the entity must use judgement to estimate
the impairment.

Hedging
1

Management must apply judgement when assessing whether it expects a particular hedging
instrument to be highly effective in offsetting a specific designated risk, particularly if the
principal terms of the hedging instrument and the hedged item relating to the particular risk
are not perfectly matched.
Section 12 permits hedge accounting to be applied for forecast transactions if they are
considered to be highly probable to occur. Judgement needs to be applied in determining how
likely it is that a transaction will occur.

Derecognition
1

Judgement is sometimes required in assessing whether substantially all the risks and rewards
are transferred to another party and thus whether to derecognise a financial asset or financial
liability.

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COMPARISON WITH FULL IFRS STANDARDS

When the IFRS for SMEs Standard was issued in July 2009, Section 12 was based on IAS 39
Financial Instruments: Recognition and Measurement and IFRS 7 Financial Instruments: Disclosures.
At that time IFRS 9 Financial Instruments had not been issued. Since then, the completed version
of IFRS 9 Financial Instruments has been issued and is effective for annual periods beginning on
or after 1 January 2018. Because paragraph 11.2(b) of the IFRS for SMEs Standard allows
preparers to apply the recognition and measurement requirements of IAS 39 instead of those
of Section 12, the comparison will continue to be made using IAS 39. A comparison with
IFRS 9 is also provided.

Comparison with IAS 39/IFRS 7

IAS 39 /IFRS 7 and the IFRS for SMEs Standard (Section 11 Basic Financial Instruments and Section
12 Other Financial Instrument Issues) share some similar principles for the recognition,
measurement, derecognition and disclosure of financial instruments. However, full
IFRS Standards and the IFRS for SMEs Standard also have significant differences.
In the IFRS for SMEs Standard the accounting for basic financial instruments is addressed
separately from the accounting for more complex financial instrument transactions and the
requirements have been written in simplified language. In addition the detail has a number
of differences.
Applying the IFRS for SMEs Standard, an entity chooses to account for all of its financial
instruments either by:
(a) applying the provisions of both Section 11 and Section 12 in full; or
(b) applying the recognition and measurement provisions of IAS 39 Financial Instruments:
Recognition and Measurement and the disclosure requirements of Section 11 and
Section 12.

If an entity chooses to apply the recognition and measurement provisions of IAS 39 and the disclosure
requirements of Section 11 and Section 12
The difference between applying IAS 39 and Section 11 and 12 of the IFRS for SMEs Standard
and applying full IFRS Standards (before the initial application of IFRS 9) is the applicable
disclosure requirements. IFRS 7 sets out three main categories of disclosures: significance of
financial instruments, risk and transfers of financial assets. Section 11 includes many of the
significance of financial instruments disclosures in IFRS 7. However, the IFRS for SMEs Standard
includes none of the ‘risk’ disclosures in IFRS 7. The only disclosure from IFRS 7 relating to
‘transfers of financial assets’ included in the IFRS for SMEs Standard relates to transfers of
financial assets that do not qualify for derecognition.
The reasons the IFRS for SMEs Standard omits so many of the IFRS 7 disclosures include:
• many of the IFRS 7 disclosures are designed for financial institutions (which are not
eligible to use the IFRS for SMEs Standard);
• many of the IFRS 7 disclosures are designed for entities whose securities trade in public
capital markets (which are also ineligible to use the IFRS for SMEs Standard); or
• requiring disclosures such as fair values for all financial instruments measured at
amortised cost would be burdensome for small or medium-sized entities and contrary to
the objective of Section 11, which is an amortised cost section for basic financial
instruments.

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The only disclosures required by Section 12 that are additional to those required in Section 11
are disclosures for entities applying hedge accounting. The only difference from the hedge
accounting disclosures in IFRS 7 (which are part of the ‘significance’ disclosures) is that
Section 12 does not require separate disclosure of the amount of the gain or loss on a hedging
instrument that has been included in the cost of a non-financial asset or liability; the
IFRS for SMEs Standard does not permit this accounting treatment and hence the disclosure
requirement is not applicable.

If an entity chooses to apply the provisions of both Section 11 and Section 12 in full
The many differences in the recognition and measurement requirements of Section 11 and
full IFRS Standards are covered in Module 11. The disclosure differences between sections 11
and 12 and full IFRS Standards are mentioned in the section above. The other key differences
between Section 12 and full IFRS Standards, assuming IFRS 9 is not being applied, are as
follows:
• Classification and measurement. If a financial instrument is within the scope of Section
12, the entity is required to measure it at fair value through profit or loss, with the
exception of equity instruments whose fair value is not reliably measurable. In contrast,
IAS 39 requires entities to classify financial instruments into categories that will then
determine the measurement requirements. Applying IAS 39, only financial instruments
held for trading are automatically classified and measured at fair value through profit or
loss. Section 11 requires the entity to measure the majority of its financial instruments at
amortised cost. Therefore, companies that apply Section 12 will not have to apply the
requirement in IAS 39 to assess management’s intentions regarding financial instruments
to classify them.
• Derivative financial instruments. Unlike IAS 39, Section 12 does not require separate
accounting for ‘embedded derivatives’. However, in general, non-financial contracts that
include a risk component with economic characteristics not closely related to the host
contract will be included within the scope of Section 12 and will be accounted for in their
entirety at fair value. This means that for some contracts, Section 12 will require the
entire contract to be at fair value, whereas IAS 39 would only require the embedded
contract with the risk component to be recognised at fair value.
• Hedge accounting. Section 12 focuses on the types of hedging that SMEs are likely to use
and only allows hedge accounting for particular risks.
• IAS 39 is not as restrictive as regards risks that can qualify for hedge accounting.
• Section 12 requires periodic recognition and measurement of hedge ineffectiveness, but
under less strict conditions than those in IAS 39.
• Section 12 permits hedge accounting only if the hedging instrument is one of four
instruments listed in paragraph 12.18. IAS 39 is less restrictive with regards the terms and
conditions of hedging instruments. Consequently, hedge accounting cannot be achieved
under Section 12 by using debt instruments, such as a foreign currency loan, as hedging
instruments, whereas IAS 39 permits this for a hedge of a foreign currency risk. Similarly,
hedge accounting is not permitted under Section 12 for an option-based hedging strategy.
• Hedge accounting for portfolios is not permitted under Section 12.
• Derecognition: Differences are explained in Module 11.

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Comparison with IFRS 9

In July 2014 the Board completed the development of a new Standard on financial instruments
and issued the completed version of IFRS 9 Financial Instruments, with an effective date of
annual periods that begin on or after 1 January 2018.
IFRS 9 sets out a new model for the classification and measurement of financial assets and a
new impairment model. The requirements for recognition and derecognition, and
classification and measurement of financial liabilities, are largely unchanged between IAS 39
and IFRS 9.
IFRS 9 has three categories for the classification and measurement of financial assets: fair
value through profit or loss, fair value through other comprehensive income and amortised
cost. IFRS 9 does not permit any instruments to be measured at cost.
The classification and measurement of financial assets applying IFRS 9 is based on the
contractual cash flows characteristics of the asset as well as on the business model in which it
is held. Such criteria are different to the criteria used for classification of financial
instruments in Section 12.
The requirements in IFRS 9 for financial liabilities are similar to those of Section 12.
IFRS 9 makes more hedging relationships eligible for hedge accounting than does Section 12.
For example, applying IFRS 9, an entity can designate non-derivative financial instruments as
hedging instruments if they are classified as fair value through profit or loss. Also, hedged
items can be groups of financial instruments and even include zero-positions or aggregated
derivative and non-derivative instruments.
Under IFRS 9, an entity cannot decide to revoke a hedge designation. Such designations can be
revoked only if the risk management objective for that designated hedging relationship
changes.
Section 11 and full IFRS Standards differ in other ways that are not covered in this module.

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TEST YOUR KNOWLEDGE

Test your knowledge of the requirements for the accounting and reporting of financial
instruments applying the IFRS for SMEs Standard by answering the questions provided.
You should assume that all amounts mentioned are material.
Once you have completed the test, check your answers against those set out beneath it.

Mark the box next to the most correct statement.

Question 1

Which one of the following financial instruments held by an entity is within the scope of
Section 12?
(a) a loan from a bank with a rate of interest equal to a single referenced quoted interest rate.
(b) a financial instrument that qualifies and is designated as a hedging instrument applying
the IFRS for SMEs Standard.
(c) a quoted fixed interest bond.
(d) an obligation to pay employees who serve throughout the year a specified proportion of
profit earned by the entity for that year. The payment will be made nine months after
year-end.
(e) an obligation under a finance lease to pay a stream of payments to a lessor. The lease does
not contain any unusual embedded risks.

Question 2

Which one of the following financial instruments held by an entity is within the scope of
Section 12?
(a) trade receivables.
(b) a 5% holding in the non-puttable ordinary shares of another entity (investee).
(c) a 30% holding in the non-puttable ordinary shares of another entity (investee) where the
investee is classified as an associate of the entity.
(d) a contract to purchase FCU500 for CU10,000 in four months.

Question 3

Which one of the following contracts is within the scope of Section 12?
(a) a contract to purchase a property in six months that could result in an additional payment
of 10% of the purchase price if the consumer price index in the jurisdiction of the property
increases by 1% during the six-month period.
(b) a contract to purchase a property in six months that could result in an additional payment
of 1% of the purchase price if the consumer price index in the jurisdiction of the property
increases by 1% during the six-month period.
(c) a contract to sell a property in six months that could result in a loss to the seller if the
buyer defaults because of financial difficulties.
(d) a contract to sell a property in six months to an overseas buyer for CU1,000,000 that could
result in a loss to the buyer if the currency in the buyer's jurisdiction depreciates against
CU during the six-month period.

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Question 4

An entity enters into a futures contract to purchase 20,000 bushels of wheat in six months at a
fixed price in accordance with its expected usage requirements (a fixed price future).
The contract permits the entity to take physical delivery of the wheat at the end of six months
or to pay or receive a net settlement in cash at the end of six months.
Which of the following statements is true?
(a) The contract is within the scope of Section 12 because it can be net settled in cash.
(b) The contract is outside the scope of Section 12 because it is a contract for the purchase of a
non-financial asset.
(c) The contract is outside the scope of Section 12 only if the entity intends to accept delivery
of the wheat.
(d) The contract is within the scope of Section 12 because it is a hedging instrument.

Question 5

On 1 January 20X0, an entity purchased 100 share options from a bank for cash of CU2,000 in
an arm’s length transaction. The share options permit the entity to purchase shares in a listed
entity, XYZ, for CU50 per share at any time during the next two years. XYZ’s share price is
currently quoted at CU44 per share.
On 1 January 20X0 the entity incurred (and paid to the bank) transaction fees of CU20 for the
purchase of the options.
At what amount should the entity measure the 100 share options purchased on initial
recognition?
(a) CU1,380.
(b) CU1,980.
(c) CU2,000.
(d) CU2,020.
(e) CU4,040.

Question 6

The facts are the same as in Question 5. On 31 December 20X0 the option has not yet been
exercised and the shares are trading at CU47 per share. The fair value of the option has
increased to CU2,500.
At what amount should the entity subsequently measure the 100 share options held on 31
December 20X0?
(a) CU1,980.
(b) CU2,000.
(c) CU2,020.
(d) CU2,500.
(e) CU4,700.

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Question 7
Which of the following statements is true for an entity that does not apply hedge accounting?
(a) At the end of each reporting period, an entity must measure all financial instruments
within the scope of Section 12 at fair value and recognise changes in fair value in profit or
loss.
(b) At the end of each reporting period, an entity must measure all publicly traded financial
instruments within the scope of Section 12 at fair value and recognise changes in fair
value in profit or loss. Financial instruments not publicly traded are measured at cost less
impairment.
(c) At the end of each reporting period, an entity must measure all financial instruments
within the scope of Section 12 at fair value and recognise changes in fair value in profit or
loss, except equity instruments that are not publicly traded and whose fair value cannot
otherwise be measured reliably without undue cost or effort (and contracts linked to such
instruments that, if exercised, will result in delivery of such instruments), which are
measured at cost less impairment.
(d) At the end of each reporting period, an entity must measure all financial instruments
within the scope of Section 12 at cost less impairment.

Question 8

Section 12 permits hedge accounting for selected risks. Which of the following risks is not
permitted for hedge accounting under Section 12?
(a) interest rate risk of a debt instrument measured at amortised cost.
(b) foreign exchange risk of a debt instrument measured at amortised cost.
(c) foreign exchange risk in a firm commitment.
(d) foreign exchange risk in a net investment in a foreign operation.

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Question 9

A jeweller holds an inventory of miniature gold ingots for use in a range of jewellery that will
be ready for sale in roughly three months. The entity is worried that the price of gold may
decline in the next three months and to hedge this risk, the entity enters into a commodity
forward contract that can be net settled to hedge the commodity price risk of the commodity
it holds. This relationship meets the conditions for hedge accounting; the entity documents
the hedge and chooses to apply hedge accounting. Which of the following is the appropriate
accounting treatment?
(a) Recognise the commodity forward contract as an asset or liability at fair value and the
change in the fair value of the forward contract in profit or loss. Recognise the change in
the fair value of the gold inventory in profit or loss and as an adjustment to the carrying
amount of the gold inventory.
(b) Recognise the commodity forward contract as an asset or liability at fair value and the
change in the fair value of the forward contract in profit or loss. Recognise the change in
the fair value of the gold inventory attributable to the hedged risk in profit or loss and as
an adjustment to the carrying amount of the gold inventory.
(c) Recognise the commodity forward contract as an asset or liability at fair value and the
change in the fair value of the forward contract in other comprehensive income.
Recognise the change in the fair value of the gold inventory attributable to the hedged risk
in other comprehensive income and as an adjustment to the carrying amount of the gold
inventory.
(d) Recognise the commodity forward contract as an asset or liability at fair value and the
change in the fair value of the forward contract in other comprehensive income. Do not
recognise any change in the fair value of the gold inventory because inventory is measured
at cost.

Question 10

Under what circumstances must an entity discontinue hedge accounting for a hedging
relationship that previously met the requirements to qualify for hedge accounting as set out
in paragraph 12.16?
(a) The hedging instrument expires or is sold or terminated.
(b) The hedge no longer meets the conditions for hedge accounting specified in paragraph
12.16.
(c) The entity revokes the designation.
(d) In a hedge of a forecast transaction, the forecast transaction is no longer highly probable.
(e) Any of (a)–(d).

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Answers

Q1 (b) see paragraphs 12.3, 11.8 and 11.9

Q2 (d) see paragraphs 12.3 and 11.8
Q3 (a) see paragraph 12.4
Q4 (c) see paragraph 12.5
Q5 (c) see paragraphs 12.7 and 12.12
Q6 (d) see paragraph 12.8
Q7 (c) see paragraph 12.8
Q8 (b) see paragraph 12.17
Q9 (b) see paragraph 12.19
Q10 (e) see paragraphs 12.21 and 12.25

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APPLY YOUR KNOWLEDGE

Apply your knowledge of the requirements for the accounting and reporting of financial
instruments, other than those covered by Section 11,applying the IFRS for SMEs Standard by
completing the case studies provided.
Once you have completed a case study, check your answers against those set out beneath it.

Case study 1

On 1 November 20X0 SME A, whose functional currency is CU, enters into a firm commitment
with SME B, whose functional currency is FCU, to purchase an item of specialised equipment
for FCU750,000 for use within the sales function of SME A’s business. Both delivery and
payment are scheduled for 1 July 20X1.

Also on 1 November 20X0, SME A enters into a foreign currency forward exchange contract
(forward contract) with an external party to buy FCU750,000 and sell CU500,000 on 1 July
20X1. SME A enters into the forward contract to hedge its future exposure to FCU arising from
the firm commitment with SME B. As a result of the contract, SME A will receive and pay
FCU750,000 on the on a single date, and hence, when viewed from a net position, it has no
exposure to change in the FCU/CU exchange rate. The forward contract effectively ‘locks in’
the exchange rate at FCU1.5/CU1 for FCU750,000. The fair value of the forward contract at
inception (on 1 November 20X0) is zero. The forward contract has no prepayment, early
termination or extension features.

The spot rate at:

• 1 November 20X0 = FCU1.55/CU1
• 31 December 20X0 = FCU1.47/CU1
• 1 July 20X1 = FCU1.2/CU1.
All changes in fair value of the currency forward are due to changes in the spot and forward
FCU/CU exchange rates.

The fair value of the currency forward at various dates is shown in the table:

1 November 20X0 31 December 20X0 1 July 20X1

Fair value of forward contract CU0 CU24,475 CU125,000

From 1 July 20X1 SME A will, applying Section 17, depreciate the equipment on the
straight-line method over its estimated useful life of 15 years to a residual value of CU25,000
(estimated net proceeds that would be obtained on 1 July 20X1 from disposal of the equipment
if the equipment were already 15 years old and in the condition expected at the end of its
useful life).

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SME A has a 31 December financial year-end.

SME A does not recognise executory contracts(12) unless explicitly required to do so by the
IFRS for SMEs Standard (for example, when executory contracts are onerous a provision must be
recognised applying Section 21). On 1 July 20X1 the recoverable amount of the specialised
equipment is expected to be at least CU625,000.

Part A:
SME A chooses not to use hedge accounting under Section 12.

Prepare the journal entries necessary to record the transactions for the year ended 31
December 20X0 and for the year ended 31 December 20X1.

Part B:
SME A wishes to designate a hedging relationship between the forward contract and the
foreign exchange risk in the firm commitment in such a way as to qualify for hedge
accounting.

Can SME A use hedge accounting for the hedging relationship between the forward
contract and the foreign exchange risk in the firm commitment? If so, what actions
must management take in order to use hedge accounting?

Part C:
Unlike in Part A, in this part (Part C) SME A does use hedge accounting applying Section 12.

Prepare journal entries to record the transactions for the year ended
31 December 20X0 and for the year ended 31 December 20X1. Ignore the time value of
money.

Part D:
The facts are the same as in Part C. On 31 December 20X2 the equipment has a recoverable
amount of CU400,000 because of damage from bad weather conditions experienced towards
the end of 20X2.

Prepare journal entries to record the transactions for the year ended
31 December 20X2.

Part E:
The facts are the same as in Part D. On 1 January 20X3 management estimates that the
equipment has a residual value of CU20,000. Estimated useful life remains 15 years from the
original date of acquisition. On 31 May 20X3 the equipment is sold for CU390,500 because of
changes in business plans.

Prepare journal entries to record the transactions for the year ended
31 December 20X3.

(12)
contracts under which neither party has performed any of its obligations or both parties have partially performed their
obligations to an equal extent (see paragraph 21.2 of the IFRS for SMEs Standard)

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Answer to Case study 1

Part A:

1 November 20X0
Because the forward contract has a fair value of zero on 1 November 20X0, no entries are
required on initial recognition.

The firm commitment to buy the equipment entered into on 1 November 20X0 is outside
the scope of Section 12, because contracts that were entered into, and continue to be held,
for the purpose of the receipt of a non-financial item in accordance with the entity’s
expected usage requirements are not financial instruments for the purposes of Section 12,
even if the contract can be net settled; see paragraph 12.5. Because the contract is not
onerous, applying SME A’s accounting policies, no entries are made for the commitment
entered into on 1 November 20X0 to buy the equipment.

31 December 20X0
Dr Asset: financial asset—forward contract CU24,475
13
Cr Income: profit or loss—change in fair value of forward contract CU24,475
To recognise the change in the fair value of the forward contract between 1 November 20X0 and
31 December 20X0.

No entries are required at 31 December 20X0 for the firm commitment entered into on 1 November 20X0 to
buy the equipment (for the same reasons as at 1 November 20X0).

1 July 20X1
Dr Asset: financial asset—forward contract CU100,525(a)
Cr Income: profit or loss—change in fair value of forward contract CU100,525
To recognise the change in the fair value of the forward contract from 1 January 20X1 to 1 July 20X1.
Note: changes in fair value are recognised in profit or loss because the forward contract is not designated as
a hedging instrument.

Dr Asset: financial asset—cash CU125,000

Cr Asset: financial asset—forward contract CU125,000
To recognise the settlement under the forward contract on expiry (pay CU500,000 to receive FCU750,000
(= CU625,000)).

Dr Asset: property, plant and equipment—equipment cost CU625,000(b)

Cr Asset: financial asset—cash CU625,000
To recognise the purchase of the equipment on 1 July 20X1 in exchange for FCU750,000 (= CU625,000).
31 December 20X1
Dr Expense: profit or loss—depreciation CU20,000(c)
Cr Asset: property, plant and equipment—equipment accumulated
depreciation CU20,000
To recognise depreciation on the equipment for the six months between 1 July 20X1 and 31 December
20X1.
Note: on 31 December 20X1, the carrying amount of the equipment is an asset of CU605,000(c).

13
Changes in fair value are recognised in profit or loss because the forward contract is not designated as a hedging
instrument.

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Part B:

SME A may designate a hedging relationship between the forward contract and the
foreign exchange risk in the firm commitment and apply hedge accounting applying
paragraph 12.23, provided that SME A designates and documents the hedging relationship
appropriately; the other conditions in paragraph 12.16 appear to be satisfied, as follows:
• The hedged risk—foreign exchange risk in a firm commitment—is one of the risks
specified in paragraph 12.17.
• A foreign currency forward exchange contract is one of four hedging instruments
specified in paragraph 12.18. The contract also meets all the other conditions in
paragraph 12.18: the forward contract is entered into with a party external to SME A;
the foreign currency amount in the forward contract is equal to the purchase price of
FCU750,000; the maturity date of the forward contract is the same as the date of the
firm commitment and the forward contract has no prepayment, early termination or
extension features.
• The principal terms of the forward contract and of the firm commitment, which relate
to foreign exchange risk, match, so the changes in the fair value of the forward
contract are expected to be, both at inception and subsequently, highly effective in
offsetting the changes in the expected cash flow from the firm commitment that is
attributable to foreign exchange risk. The principal terms include the maturities of
the commitment and the forward exchange contract (in eight months), the foreign
currency (FCU), and the amount of each (FCU750,000)). In addition, the fair value of
the forward contract at inception is zero.
However, potential sources of ineffectiveness include subsequently agreed changes in the
date of sale of the equipment, termination of the contract by both parties and changes in
the creditworthiness of the counterparty to the forward contract.

Part C:

1 November 20X0

Because the forward contract has a fair value of zero on 1 November 20X0, no entries are
required on initial recognition.
The firm commitment entered into on 1 November 20X0 to buy the equipment is outside
the scope of Section 12, because contracts that were entered into, and continue to be held,
for the purpose of the receipt of a non-financial item, in accordance with the entity’s
expected usage requirements are not financial instruments for the purposes of Section 12,
even if the contract can be net settled; see paragraph 12.5. Because the contract is not
onerous, applying SME A accounting policies, no entries are made for the commitment
entered into on 1 November 20X0 to buy the equipment.

31 December 20X0
Dr Asset: financial asset—forward contract CU24,475
Cr Income: OCI-change in fair value (hedging instrument) CU24,475(d)
To recognise the change in the fair value of the forward contract between 1 November 20X0 and
31 December 20X0 applying paragraph 12.23.

No entries are required at 31 December 20X0 for the firm commitment entered into on
1 November 20X0 to buy the equipment (for the same reasons as at 1 November 20X0).

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1 July 20X1
Dr Asset: financial asset—forward contract CU100,525(a)
Cr Income: OCI-change in fair value (hedging instrument) CU100,525(e)
To recognise the change in the fair value of the forward contract between 1 January 20X1 and 1 July 20X1
applying paragraph 12.23.

Dr Asset: financial asset—cash CU125,000

Cr Asset: financial asset—forward contract CU125,000
To recognise the settlement under the forward contract on expiry (on 1 July 20X1).

Dr Asset: property, plant and equipment—equipment CU625,000(b)

Cr Asset: financial asset—cash CU625,000
To recognise the purchase of the equipment on 1 July 20X1.

31 December 20X1
Dr Expense: profit or loss—depreciation CU20,000(c)
Cr Asset: property, plant and equipment—equipment accumulated
depreciation CU20,000
To recognise depreciation on the equipment for the six months between 1 July 20X1 and 31 December
20X1.
Dr Income: OCI-change in fair value (hedging instrument) CU4,167(f)
Cr Income: profit or loss—reclassification of hedging gain CU4,167
To reclassify an appropriate portion of the cumulative hedging gain from other comprehensive income to
profit or loss as the equipment is depreciated.

On 31 December 20X1 the carrying amount of the equipment is an asset of CU605,000(c)

and CU120,833(f) of cumulative hedging gains in other comprehensive income are still to
be reclassified in relation to that asset.

Part D:

31 December 20X2
Dr Expense: profit or loss—depreciation CU40,000(c)
Cr Asset: property, plant and equipment—equipment accumulated
depreciation CU40,000
To recognise depreciation on the equipment for the year ended 31 December 20X2.

Dr Expense: profit or loss—impairment CU165,000(g)

Cr Asset: property, plant and equipment—equipment (accumulated CU165,000
impairment and accumulated depreciation)
To recognise the impairment of the equipment at 31 December 20X2.

Dr Income: OCI-change in fair value (hedging instrument) CU42,708(h)

Cr Income: profit or loss—reclassification of hedging gain CU42,708
To reclassify an appropriate portion of the cumulative hedging gain from other comprehensive income to
profit or loss as the equipment is depreciated and as it is written down for impairment.

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On 31 December 20X2 the carrying amount of the equipment is an asset of CU400,000 and
CU78,125(i) of cumulative hedging gains in other comprehensive income are still to be
reclassified in relation to that asset.
Part E:

31 May 20X3
Dr Expense: profit or loss—depreciation CU11,728(j)
Asset: property, plant and equipment—equipment (accumulated
depreciation and accumulated impairment) CU11,728
To recognise depreciation on the equipment for the five months between 1 January 20X3 and 31 May 20X3.

Dr Asset: financial asset—cash CU390,500

Dr Asset: property, plant and equipment—equipment (accumulated
depreciation and impairment) CU236,728(k)
Cr Asset: property, plant and equipment—equipment (cost) CU625,000
Cr Income: profit or loss: gain on disposal of equipment CU2,228(k)
To recognise the sale of the equipment on 31 May 20X3.

Dr Income: OCI-change in fair value (hedging instrument) CU78,125(i)

Cr Income: profit or loss CU78,125
To reclassify the cumulative hedging gain from other comprehensive income to profit or loss as the
equipment is depreciated and to reclassify the remaining balance in the account on the sale of the
equipment.

Calculations and explanatory notes:

(a) Change in fair value between 1 January 20X0 and 1 July 20X1: CU125,000 less CU24,475 = CU100,525.
(b) Cost of equipment: FCU750,000 ÷ 1.2 (spot rate on 1 July 20X1) = CU625,000.
(c) Depreciable amount: CU625,000 less CU25,000 = CU600,000.
Annual depreciation charge: CU600,000 ÷ 15 = CU40,000.
Depreciation charge for the six months from 1 July to 31 December 20X1: CU20,000.
Carrying amount of equipment at 31 December 20X1: CU625,000 less CU20,000 = CU605,000.
(d) The change in fair value of the forward contract is recognised in full in OCI as the hedge is fully effective:
Change in fair value of the expected cash flows = present value of (FCU750,000/1.55 less FCU750,000/1.47) =
present value of (CU483,871 less CU510,204) = present value of CU(26,333).
The instructions say to ignore discounting, so for this purpose the change in the fair value of the expected cash flows
= CU(26,333).
Because the change in the fair value of the expected cash flows is greater than the change in the fair value of the
hedging instrument, there is no hedge ineffectiveness.
(e) Change in fair value of the expected cash flows, ignoring discounting = FCU750,000/1.47 less FCU750,000/1.20
= CU510,204 less CU625,000 = CU(114,796).
Because the change in the fair value of the expected cash flows is greater than the change in the fair value of the
hedging instrument, there is no hedge ineffectiveness.
(f) Cumulative exchange gain recognised in other comprehensive income = CU24,475 + CU100,525 = CU125,000.
Reclassification of cumulative exchange gain to match with annual depreciation = CU125,000 ÷ 15 = CU8,333.
Reclassification of cumulative exchange gain to match with six months’ depreciation = CU8,333 ÷ 2 = CU4,167.
Because the total depreciable amount of the equipment is CU600,000, an alternative method of calculation is
(CU20,000 ÷ CU600,000) × CU125,000 = CU4,167.
Amount still to be reclassified at 31 December 20X1 = CU125,000 less CU4,167 = CU120,833.
(g) Additional impairment charge = CU605,000 less CU40,000 less CU400,000 = CU165,000.
(h) Appropriate reclassification of cumulative exchange gain for annual depreciation charge and impairment charge =
(CU165,000 + CU40,000) ÷ CU600,000 × CU125,000 = CU42,708.
(i) Amount of cumulative exchange gains in other comprehensive income still to be reclassified at 31 December 20X2 =
CU120,833(f) less CU42,708(h) = CU78,125.
(j) Depreciable amount at 1 January 20X3 = CU400,000 less CU20,000 = CU380,000. Depreciation for the five months
ended 31 March 20X3 = CU380,000 ÷ 13.5 × 5 ÷ 12 = CU11,728.
(k) Carrying amount of the equipment on 31 May 20X3 = CU400,000 less CU11,728 = CU388,272.
Profit on sale = CU390,500 less CU388,272 = CU2,228.
Total accumulated depreciation and impairment at 31 May 20X3 = CU20,000 + CU40,000 + CU165,000 + CU11,728
= CU236,728.

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Case study 2

The facts are the same as in Case Study 1. As in Part C of that case study, assume that SME A
designates a hedging relationship between the forward contract and the foreign exchange risk
in the firm commitment in such a way as to qualify for hedge accounting.

Prepare disclosures sufficient to satisfy the requirements in Section 12 both for the year
ended 31 December 20X0 and the year ended 31 December 20X1.

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Answer to Case study 2

Extract from SME A’s statement of comprehensive income for the year ended 31
December 20X0

Note 20X0 20W9

CU CU
Profit for the year(a) XXX,XXX XXX,XXX

Other comprehensive income:

Items that may be reclassified subsequently to profit or

loss:
Gains on hedges of foreign exchange 18 24,475 (b) -

Other comprehensive income for the year, net of taxes XXX,XXX XXX,XXX

Total comprehensive income for the year XXX,XXX XXX,XXX

Extract from SME A’s notes to financial statements for the year ended 31 December 20X0

Note 2 Accounting policies

Foreign exchange forward contracts
Foreign exchange forward contracts are occasionally entered into to manage exposure to
foreign exchange rate risk on firm commitments or highly probable forecast transactions to
purchase specialised imported equipment.
Forward contracts are initially recognised at fair value at the date the contract is entered into
and are subsequently remeasured to their fair value at the end of each reporting period. The
resulting gain or loss is recognised in profit or loss immediately, unless the forward contract is
designated and effective as a hedging instrument, in which case the effective portion of the
gain or loss is recognised in other comprehensive income and the ineffective portion, if any, is
recognised in profit or loss.
Amounts previously recognised in other comprehensive income are reclassified to profit or
loss in the periods when the cost of the specialised equipment is recognised in profit or loss in
the form of depreciation/impairment, or on sale.
Hedge accounting is discontinued if the hedging relationship is revoked, if the forward
contract expires, is sold, terminated, or exercised or when the relationship no longer qualifies
for hedge accounting. Provided the forecast transaction is still highly probable, any
cumulative gain or loss recognised up to that date continues to be deferred in other
comprehensive income and will be recognised in profit or loss when the specialised
equipment is depreciated, impaired or sold. If a hedged forecast transaction or firm
commitment is no longer expected to occur, the cumulative gain or loss recognised in other
comprehensive income is recognised immediately in profit or loss.
The fair value of the foreign exchange forward contracts is determined by reference to forward
exchange rates for contracts which, at the end of the reporting period, have the same
maturities as those held by the entity, and discounting the difference between the cash flows
specified in the contract held by the entity and those that would occur using the forward rate
relevant at the end of the reporting period, using a risk free rate, usually EURIBOR, to reflect
the time value of money.

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Note 18 Hedge reserve

On 1 November 20X0, the company entered into a firm commitment to purchase an item of
specialised equipment for FCU750,000 with cash payment to be made on the delivery date of
1 July 20X1. On 1 November 20X0, the company also entered into an eight-month foreign
currency forward contract and designated it as a hedge of the foreign exchange risk under the
firm commitment.
On 31 December 20X0, the fair value of the forward contract was CU24,475, the entire amount
of which represents a gain. The entire gain of CU24,475 was recognised in other
comprehensive income. The net gain or loss at 1 July 20X1 will be reclassified to profit or loss
in the same periods during which the specialised equipment affects profit or loss. This will be
in the periods following 1 July 20X1 when the equipment is depreciated or any impairment
expense is recognised. The item of equipment will be depreciated from 1 July 20X1 over its
15-year life to its scrap value.
In 20X0 (and 20W9) the company had no other hedging relationships.

Extract from SME A’s statement of comprehensive income for the year ended 31
December 20X1

Note 20X1 20X0

CU CU
Profit for the year XXX,XXX XXX,XXX

Other comprehensive income:

Items that may be reclassified subsequently to profit or loss:

Gains on hedges of foreign exchange net of gains reclassified to 20 96,358(c) 24,475

profit or loss
Other comprehensive income for the year, net of taxes XXX,XXX XXX,XXX

Total comprehensive income for the year XXX,XXX XXX,XXX

Extract from SME A’s notes to financial statements for the year ended 31 December 20X1

Note 2 Accounting policies

Same as in extracts from financial statements for the year ended 31 December 20X0.

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Note 20 Hedge reserve

On 1 July 20X1 the company purchased an item of equipment for FCU750,000 (CU625,000); the
contract for the purchase was entered into on 1 November 20X0. On 1 November 20X0, the
company also entered into an eight-month foreign currency forward contract, to receive
FCU750,000 and pay CU500,000, and designated it as a hedge of the foreign exchange risk
under the firm commitment. The hedge was effective in offsetting the changes in the

20X1 20X0
CU CU
Accumulated gains on hedging instruments in effective hedges of
forecast transactions recognised in other comprehensive income at
the beginning of the year 24,475 –
Gains arising in the year on hedging instruments recognised in other
comprehensive income in the year 100,525 (d) 24,475
125,000 24,475
Reclassified from other comprehensive income to profit or loss in the
year (4,167) (e) -
Accumulated gains on hedging instruments in effective hedges of
forecast transactions recognised in other comprehensive income at 120,833 24,475
the end of the year
expected cash flows under the firm commitment that were due to foreign exchange risk.

On 31 December 20X0, the fair value of the foreign currency forward contract was CU24,475.
At 1 July 20X1, when the forward contract matured, CU125,000 in gains on the forward
contract had been recognised in other comprehensive income. These gains are being
reclassified to profit or loss in the same periods in which the specialised equipment affects
profit or loss through depreciation and, if relevant, impairment. Depreciation of the
equipment commenced on 1 July 20X1 and will continue over the equipment's 15-year
estimated useful life. At 31 December 20X1 the amount of gains still to be reclassified to profit
or loss totals CU120,833.
In 20X1 and 20X0 the company had no other hedging relationships.

Gains and reclassifications from hedge accounting

The calculations and explanatory notes (a)–(e) do not form part of the proposed disclosures:
(a) Had there been any hedge ineffectiveness, it would have been included in the “Profit for the year”. However, in this
example there was no hedge ineffectiveness (see Case Study 1).
(b) Change in fair value of the forward contract from 1 November 20X0 to 31 December 20X0 less hedge ineffectiveness =
CU24,475 (see Case Study 1).
(c) CU96,358 = the change in fair value between 1 January 20X1 and 1 July 20X1 (CU100,525—see note (d)) less the amount
reclassified to profit or loss to match with six months’ depreciation (CU4,167—see note (e)).
(d) Change in fair value between 1 January 20X1 and 1 July 20X1 = CU100,525 (see Case Study 1, note (a)).
(e) Reclassification of cumulative exchange gain to match with six months’ depreciation = CU4,167 (see Case Study 1, note
(f)).

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