IFRS 9 Derivatives – Definition, Types and Accounting

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IFRS 9 Derivatives STATES the definition and further EXPLAINS that derivatives including those linked to ‘unquoted equity investments‘ are MEASURED at fair value.

[Value changes are recognized in Profit or Loss UNLESS the entity has elected to apply Hedge Accounting by designating the derivative as a hedging instrument in an eligible hedging relationship.]

IFRS 9 Derivatives – Definition

A derivative is a Financial Instrument:
– Whose value changes in response to the change in an underlying variable such as an Interest Rate, Commodity, Security Price or Index;
– Where the initial investment is zero or is small in relation to the value of the underlying variable; AND
– That is settled at a future date.
These INCLUDE futures contracts, forwards, options, and swaps.
Over the life of the derivative contract, its fair value will depend on the spot exchange rates and at the time of the end of the contract.
It can be used for ‘Hedging‘ or ‘Speculation‘.
IFRS 9 Derivatives

Derivatives Accounting (As Per IFRS 9)

The accounting is based upon the PURPOSE for which it is used as it can be used for speculation, i.e. to earn profit from derivatives transactions and hedging, i.e. to control the risk of future contracts.

1. Initial Measurement

All derivatives have to be initially RECOGNIZED at fair value, i.e. at consideration paid or received at the inception of the contract.

2. Subsequent Measurement

All derivatives shall be accounted for at FVPL UNLESS designated as a ‘Hedging Instrument’.

IFRS 9 Derivatives – Types

1. Futures Contract

´Futures´ is a standardized contract to buy or sell:
– A particular commodity/financial asset
– At a predetermined price
– At a specified time in future
Futures details the ‘quality and quantity‘ of the underlying asset;
They are standardized to facilitate trading on a futures exchange.
Some contracts call for physical delivery of the asset, while others are settled in cash.

2. Forward Contract

´Forward Contract´ is a tailor-made or customized contract to buy or sell:
– A specified amount
– A specified item (commodity or financial item)
– On a specified future date
– At a specified price agreed upon today
The settlement can occur on a cash or delivery basis.
They do NOT trade on a centralized exchange and are therefore regarded as ‘Over the Counter’ (OTC) instruments.

3. Options

Under ´Option Contract´ the holder/buyer of the option has entered into a contract that gives the right but not the obligation to buy (call option) or sell (put option) a specified amount of a specified commodity at a specific price.
An option differs from a forward arrangement. An option not only offers its buyer/holder the choice to exercise his rights under the contract, but also the choice not to enforce the contract terms.
The issuer/seller of the option must fulfill the terms of the contract, but only if the option holder chooses to enforce them.
The option holder has to pay (Premium) to the option seller. This premium is paid when the option is arranged and non-refundable if the holder later decides not to exercise his rights under the option.
For holder, option will only ever be recorded as an asset, initially at the premium. The holder would exercise the option only if it is beneficial to do so. Therefore it could only be an asset.

4. Swap Derivatives

A ´Swap´ is an agreement between parties to exchange cash flows related to an underlying obligation.
The common type is an Interest Rate Swap (IRS). In an IRS, two parties agree to exchange interest payments on the same notional amount of principal, at regular intervals over an agreed number of years.
[One party pay interest to other party at variable rate and in return the other party pay interest at a fixed rate.]
A ‘Swap’ might be an asset or liability at any particular date depending upon the interaction between the amount to be paid and the amount to be received.

Synopsis

IFRS 9 Derivatives are ‘Financial Instruments‘ whose value is derived from an Underlying Asset, Index, or Rate. IFRS 9 requires entities to ASSESS the purpose and design of derivatives to determine their accounting classification, with a focus on Managing Risks or Speculation.

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