FINANCIAL INSTRUMENTS

Definitions
Financial Instrument: This is any contract that gives rise to both a financial asset of one entity and a financial liability of another entity. Financial Asset: Any asset that is: 1. Cash 2. An equity instrument of another entity 3. A contractual right to receive cash or another financial asset from another entity; or to exchange financial instruments with another entity under conditions that are potentially favorable to the entity, or 4. A contract that will or may be settled in the entitys own equity instruments and is: a. A non derivative for which the entity is or may be obliged to receive a variable number of the entitys own equity instruments; or b. A derivative 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 entitys own equity instruments. Examples of financial assets include trade receivables, options, shares (when used as an investment), etc. Financial Liability: This is any liability that is: 1. A contractual obligation: a. To deliver cash or another financial asset to another entity, or b. To exchange financial instruments with another entity under conditions that are potentially unfavorable; or 2. A contract that will or may be settled in the entitys own equity instruments and is: a. A non derivative for which the entity is or may be obliged to deliver a variable number of the entitys own equity instruments; or

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b. A derivative 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 entitys own equity instruments. Examples of financial liabilities include trade payables, redeemable preference shares, debenture loans payable, forward contracts standing at a loss, etc. An Equity Instrument is any contract that evidences a residual interest in the assets of an entity after deducting all its liabilities. Fair Value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arms length transaction. Derivative: a financial instrument or other contract with all three of the following characteristics: 1. Its value changes in response to the change in a specified interest rate, financial instrument price, foreign exchange rate, index of prices or rates, credit rating or credit, or other variable sometimes called the underlying; 2. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be required to have a similar response to the changes in the market factors; and 3. It is settled at a future date Financial instruments includes both the following Primary Instruments: e.g. receivables, payables and equity securities Derivative Instruments: e.g. financial options, futures and forwards, interest rate swaps and currency swaps, whether recognized or unrecognized. Physical assets e.g. inventories, property, plant and equipment, leased assets and intangible assets are not financial instruments because control of these creates an opportunity to generate inflow of cash or other assets, but it does not give right to receive cash or other financial assets. Prepaid expenses, deferred revenue and most warranty obligations are also not financial instruments because the future economic benefit is the receipt of goods and services rather than the right to receive cash or other financial assets. As for deferred revenue and warranty obligations, the probable outflow of economic benefits is the delivery of goods and services rather than cash. Page3

Contractual rights and obligations that do not involve transfer of a financial asset e.g. commodity futures contracts and operating leases are not financial instruments. However contingent rights and obligations meet the definition of financial assets and financial liabilities respectively, even though they do not qualify for recognition in the financial statements because the contractual rights or obligations exist because of a past transaction or event. DERIVATIVES A derivative is a financial instrument that derives its value from the price or rate of an underlying item. Common examples of derivatives include: Forward contracts: these are agreements to buy or sell an asset at a fixed price at a fixed future date Futures contracts: they are similar to forward contracts except that contracts are standardized and traded on an exchange Options: these are rights (but not obligations) for the option holder to exercise at a predetermined price; the option writer loses out if the option is exercised Swaps: are agreements to swap one set of cash flows for another (normally interest rate or currency swaps) The nature of derivatives often gives rise to particular problems. The value of a derivative (and the amount at which it is eventually settled) depends on movements in an underlying item such as an exchange rate. This means that the settlement of a derivative can lead to a very different result from the one originally envisaged. A company which has derivatives is exposed to uncertainty and risk, and this can have a very material effect on its financial performance, financial position and changes in cash flows. Yet because a derivative contract normally has little or no initial cost, under traditional accounting it may not be recognized in the financial statements at all. Alternatively it may be recognized at the amount which bears no relation to its current value. This is clearly misleading and leaves users of the financial statements unaware of the level of risk that the company faces. IAS 32 FINANCIAL INSTRUMENTS: PRESENTATION The objective of IAS 32 is to enhance financial statement users understanding of the significance of financial instruments on the financial position and off financial position financial instruments to an entitys financial position, performance and cash flows. Page3

The main thrust of IAS 32 is that financial instruments need to be presented according to their substance, not merely their legal form. In particular, entities which issue financial instruments should classify them as either financial liabilities or equity. The classification of a financial instrument as a liability or as equity depends on the following The substance of the contractual arrangement on initial recognition The definition of a financial liability and an equity instrument

How should a financial liability be distinguished from an equity instrument? The critical feature of a liability is an obligation to transfer economic benefits. Therefore a financial instrument is a financial liability if there is a contractual obligation on the issuer either to deliver cash or another financial asset to the holder or to exchange another financial instrument with the holder under potentially unfavorable conditions to the issuer. The financial liability exists regardless the way in which the contractual obligation will be settled. The issuers ability to satisfy the obligation may be restricted e.g. by lack of access to foreign currency but this is irrelevant as it does not remove the issuers obligation or the holders right under the instrument. Where the above critical feature is not met, then the financial instrument is an equity instrument. Although substance and legal form are often consistent with each other, this is not always the case. In particular, a financial instrument may have the legal form of equity, but in substance it is in fact a liability. Other instruments may combine features of both equity instruments and financial liabilities e.g. preferred shares which must be redeemed by the issuer for a fixed determinable amount at a fixed determinable future date. Alternatively, the holder may have the right to require the issuer to redeem the shares on or after a certain date at a fixed amount. In such cases, the issuer has an obligation. Therefore the instrument is a financial liability and should be classified as such. Contingent Settlement Provisions An entity may issue a financial instrument where the way it is settled depends on 1. The occurrence or non occurrence of uncertain future events, or 2. The outcome of uncertain circumstances that are beyond the control of both the holder and the issuer of the financial instrument e.g. an entity might have to deliver cash instead of issuing equity shares. In this situation it is not immediately clear whether the entity has an equity instrument or a financial liability.

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Such financial instruments should be classified as financial liabilities unless the possibility of settlement is remote. Settlement Options When a derivative financial instrument gives one party choice over how it is to be settled e.g. the issuer chooses whether to settle in cash or by issuing shares, the instrument is a financial asset or a financial liability unless all the alternative choices result in it being an equity instrument. Compound Financial Instruments Some financial instruments contain both a liability and an equity element. In such cases, IAS 32 requires the component parts of the instrument to be classified separately, according to the substance of the contractual arrangement and the definitions of a financial liability and an equity instrument. One of the most common types of a compound instrument is a convertible debt. This creates a primary financial liability to the issuer and grants an option to the holder of the instrument to convert it into an equity instrument, usually ordinary shares, of the issuer. This is the economic equivalent of the issue of conventional debt plus a warrant to acquire shares in the future. In calculating the split, the following method is recommended: 1. Calculate the value for the liability component 2. Deduct this from the instrument as a whole to leave a residual value for the equity component. Illustration 1 Opija Co Ltd issues 2,000 convertible bonds at the beginning of 2008. The bonds have a three year term, and are issued at par with a face value of Kes 1,000 per bond, giving the total proceeds of Kes 2,000,000. Interest is payable annually in arrears at a nominal annual interest rate of 6%. Each bond is convertible at any time up to maturity into 250 ordinary shares. When the bonds are issued, the prevailing market interest rate for similar debt without conversion options is 9%. At the issue date the market price of one ordinary share is Kes 3. The dividends expected over the three year term of the bonds amount to Kes 0.14 per share at the end of each year. The risk free annual interest rate for the three year term is 5%. What is the value of the equity component in the bond? Treasury shares Page3

If an entity reacquires its own equity instruments, those instruments (treasury shares) shall be deducted from equity. No gain or loss shall be recognized in profit and loss on the purchase, sale, issue or cancellation of an entitys own equity instruments. Consideration paid or received shall be recognized directly to equity. Interest, dividends, losses and gains Interest, dividends, losses and gains relating to a financial instrument or a component that is a financial liability shall be recognized as income or expense in the profit or loss. Distributions to holders of equity instruments shall be debited by the entity directly to equity, net of any related income tax benefit. Transaction costs of an equity transaction, other than costs of issuing an equity instrument that are directly attributable to the acquisition of the business, shall be accounted for as a deduction from equity, net of any related income tax benefit. Offsetting a Financial Asset and a Financial Liability A financial asset and a financial liability should only be offset with the net amount reported in the statement of financial position, when and only when an entity: 1. Has a legally enforceable right of set off and 2. Intends to settle on a net basis, or to realize the assets and settle the liability simultaneously. Puttable Financial Instruments and obligations arising on liquidation IAS 32 requires that if the holder of a financial instrument can require the issuer to redeem it for cash it should be classified as a liability. Some ordinary shares and partnership interests allow the holder to put the instrument i.e. the issuer to redeem it in cash. Such shares might more usually be considered as equity, but the application of IAS 32 results in their being classified as liabilities. However instruments imposing an obligation on an entity to deliver to another party on a pro rata share of net assets only on liquidation should be classified as equity. IAS 39 FINANCIAL INSTRUMENTS: RECOGNITION AND MEASUREMENT The objective of this standard is to establish principles for recognizing and measuring financial assets, financial liabilities and some contracts to buy and sell. Initial Recognition Financial instruments should be recognized in the statement of financial position when the entity becomes party to the contractual provisions of the instrument. An important consequence of this is that all derivatives should be in the statement of

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financial position. This is different from the recognition criteria in most other standards i.e. items are normally recognized when there is a probable inflow or outflow of resources and the item has a cost or value that can be measured reliably. Illustration 2 An entity has entered into two separate contracts 1. A firm commitment (an order) to buy a specific quantity of iron. 2. A forward contract to buy a specific quantity of iron at a specified price on a specified date, provided delivery of iron is not taken. Contract 1 is a normal trading contract. The entity does not recognize a liability for the iron until the goods have actually been delivered. Note that this contract is not a financial instrument because it involves a physical asset rather than a financial asset. Contract 2 is a financial instrument. Under IAS 39, the entity recognizes a financial liability (an obligation to deliver cash) on the commitment date rather than waiting for the closing date on which the exchange takes place. Derecognition Derecognition is the removal of a previously recognized financial instrument from an entitys statement of financial position. An entity should derecognize a financial asset when: 1. The contractual rights to cash flows from the asset expire, or 2. The entity transfers substantially all the risks and rewards of ownership of financial assets to another party. An entity should derecognize a financial liability when it is extinguished i.e. when the obligation specified in the contract is discharged or cancelled or expires. It is possible for only part of a financial asset or liability to be derecognized. This is allowed if the part comprises: 1. Only specifically identified cash flows or 2. Only a fully proportionate share of the total cash flows. For example, if an entity holds a bond, it has the right to two separate sets of cash flows: those relating to the principal and those relating to the interest. It could sell the right to receive interest to another party while retaining the right to receive the principal.

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On derecognition, the amount to be included in the statement of income is calculated as follows: Carrying amount of asset/liability (or portion of asset/liability) transferred XXX Less: proceeds received/paid XXX Any cumulative gain or loss reported in equity XXX XXX Difference to net profit/loss XXX When only part of a financial asset is derecognized, the carrying amount of the asset should be allocated between the part retained and the part transferred based on their relative fair values on the date of the transfer. A gain or loss should be recognized based on the proceeds of the portion transferred. MEASUREMENT OF FINANCIAL INSTRUMENTS Initial Measurement Financial instruments are initially measured at the fair value of the consideration given or received i.e. cost plus in most cases transaction costs that are directly attributable to the acquisition or issue of the financial instrument. The exception to this rule is where a financial instrument is designated as at fair value through profit or loss. In this case, transaction costs are not added to fair value at initial recognition. Subsequent Measurement Definitions of four categories of financial instruments A financial asset or liability at fair value through profit or loss is a financial asset or liability that meets either of the following conditions: 1. It is classified as held for trading. A financial asset or liability is classified as held for trading if it meets either of the following conditions: Page3 a. Acquired or incurred principally repurchasing in the near term for the purpose of selling or

b. Part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short term profit taking, or c. A derivative (unless it is a designated and effective hedging instrument) 2. Upon initial recognition it is designated by the entity as at fair value through profit or loss. Any financial asset or financial liability within the scope of this standard may be designated when initially recognized as a financial asset or financial liability through profit or loss except for investments in equity instruments that do not have a quoted market price in an active market, and whose fair value cannot be reliably measured. Held to maturity investments are non derivative financial assets with fixed determinable payments and fixed maturity that an entity has the positive intent and ability to hold to maturity other than: 1. Those that the entity upon initial recognition designates as at fair value through profit or loss 2. Those that the entity designates as available for sale 3. Those that meet the definition of loans and receivables Loans and receivables are non derivative financial assets with fixed or determinable payments that are not quoted in an active market, other than: 1. Those that the entity intends to sell immediately or in the near term, which should be classified as held for trading and those that the entity upon initial recognition designates as at fair value through profit or loss 2. Those that the entity upon initial recognition designates as available for sale or 3. Those for which the holder may not recover substantially all the initial investment, other than because of credit deterioration, which shall be classified as available for sale. Available for sale financial assets are those financial assets that are not: 1. Loans and receivables originated by the entity, 2. Held to maturity investments, or 3. Financial assets at fair value through profit or loss Page3

After initial recognition, all financial assets should be re-measured to fair value, without any deduction for transaction costs that may be incurred on sale or other disposal, except for 1. Loans and other receivables 2. Held to maturity investments 3. Investments in equity instruments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured and derivatives that are linked to and must be settled by delivery of such unquoted equity instruments. Loans and receivables and held to maturity investments should be measured at amortized cost using the effective interest method. Amortized cost of a financial asset or financial liability is the amount at which the financial asset or liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortization of any difference between that initial amount and the maturity amount, and minus any write-down for impairment or uncollectability. The effective interest method is a method of calculating the amortized cost of a financial instrument and of allocating the interest income or interest expense over the relevant period The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the net carrying amount of the financial asset or liability Illustration 3 On 1 January 2008 Opija Ltd purchases a debt instrument for its fair value of Kes 1,000. The debt instrument is due to mature on 31 December 2012. The instrument has a principal amount of Kes 1,250 and the instrument carries a fixed interest at 4.72% that is paid annually. The effective interest rate is 10%. Required How should Opija Ltd account for the debt instrument over its five year term? Classification There is a certain amount of flexibility in that any financial instrument can be designated as fair value through profit or loss. However this is a once for all choice and has to be made on initial recognition. Once a financial instrument has been

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classified in this way it cannot be reclassified, even if it would otherwise be possible to measure it at cost or amortized cost. Derivatives must be re-measured to fair value. This is because it would be misleading to measure them at cost. For a financial instrument to be held to maturity, it must meet several criteria. The entity must have a positive intent and a demonstrated ability to hold the investment to maturity. These conditions are not met if: 1. The entity intends to hold the financial asset for an undefined period 2. The entity stands ready to sell the financial asset in response to changes in interest rates or risks, liquidity needs and similar factors. 3. The issuer has the right to settle the financial asset at an amount significantly below its amortized cost (because this right will almost certainly be exercised). 4. It does not have the financial resources available to continue to finance the investment until maturity 5. It is subject to an existing legal or other constraint that could frustrate its intention to hold the financial asset to maturity. If an entity can no longer hold an investment to maturity, it is no longer appropriate to use amortized cost and the asset must be re-measured to fair value. All the remaining held to maturity investments must also be re-measured to fair value and classified as available for sale. Subsequent Measurement of Financial Liabilities After initial recognition, all financial liabilities should be measured at amortized cost, with exception of financial liabilities at fair value through profit or loss (including most derivatives). These should be measured at fair value, but where the fair value is not capable of reliable measurement, they should be measured at cost. Illustration 3 Opija Ltd issues a bond for Kes 503,778 on 1 January 2009. No interest is payable on the bond, but it will be held to maturity and redeemed on 31 December 2011 for Kes 600,000. The bond has not been designated as fair value through profit or loss. Required: Page3 Calculate the charge to profit or loss of Opija Ltd for the year ended 31 December 2009 and the balance outstanding as at 31st December 2009.

Gains and Losses Instruments at fair value through profit or loss: gains and losses are recognized in profit or loss. Available for sale financial assets: gains and losses are recognized directly in equity through the statement of changes in equity. When the asset is derecognized the cumulative gain or loss previously recognized in equity should be recognized in profit and loss. Financial instruments carried at amortized cost: gains and losses are recognized in profit and loss as a result of the amortization process and when the asset is derecognized. Financial assets and financial liabilities that are hedged items: special rules apply. Illustration 4 Finance Cost 1 On 1 January 2008 Opija issued Kes 600,000 loan notes. The issue costs were Kes 200. The loan notes do not carry interest but are redeemable at a premium of Kes 152,389 on 31 December 2009. The effective finance cost of debentures is 12%. Required: What is the finance cost in respect of the loan notes for the year ended 31 December 2009

Illustration 5 Finance Cost 2 On 1 January 2008, an entity issued a debt instrument with a coupon rate of 3.5% at a par value of Kes 6,000,000. The directly attributable costs of the issue were Kes 120,000. The debt instrument is repayable on 31 December 2014 at a premium of Kes 1,100,000. Required What is the total amount of the finance cost associated with the debt instrument? Page3 Illustration 6 Classification

During the financial year ended 28 February 2008, Opija Ltd issued the two financial instruments mentioned below. For each of the two instruments, identify whether it should be classified as debt or equity in each case referring to the relevant International Accounting Standard or International Financial Reporting Standard. a. Redeemable Preferred shares with a coupon rate of 8%. The shares may be redeemable on 28 February 2012 at a premium of 10%. b. A grant of share options to senior executives. The options may be exercised from 28 February 2011. Illustration 7 Hybrid Financial Intrument On 1 January 2008, Opija Ltd issued 10,000 5% convertible bonds at their par value of Kes 50 each. The bonds will be redeemed on 1 January 2009. Each bond is convertible at the option of the holder at any time during the five year period. Interest on the bond will be paid annually in arrears. The prevailing market interest rate for similar debt without conversion options at the date of issue was 6%. Required: At what value should the equity element of the hybrid financial instrument be recognized in the financial statements of Opija Ltd at the date of issue? Illustration 8 Types of Investment Opija Ltd entered into the following transactions during the year ended 31 December 2008: 1. Entered into a speculative interest rate option costing Kes 10,000 on 1 January 2008 to borrow Kes 6,000,000 from BBK Ltd commencing 31 March 2010 for 6 months at 4%. The value of the option at 31 December 2008 was Kes 15,250. 2. Purchased 6% debentures in KK Ltd on 1 January 2008 (their issue date) for Kes 150,000 as an investment. Opija Ltd intends to hold the debentures until their redemption at a premium in 5 years time. The effective rate of interest of the bond is 8%. 3. Purchased 50,000 shares in KCA Ltd on 1 July 2008 for Kes 3.50 each as an investment. The share price on 31 December 2008 was Kes 3.75 Required: Page3

Show the accounting treatment and the relevant extracts from the financial statements for the year ended 31 December 2008. Opija ltd only designates financial assets at fair value through profit or loss where this is unavoidable. Impairment and Uncollectability of Financial Assets At each year end the entity should assess whether there is any evidence that a financial asset or group of assets is impaired. Indications that a financial asset or group of assets may be impaired include: 1. Significant financial difficulty of the issuer 2. A breach of contract, such as a default in interest or principal payments 3. The lender granting a concession to the borrower that the lender would otherwise not consider, for the reasons relating to the borrowers financial difficulty 4. It becomes probable that the borrower will enter into bankruptcy 5. The disappearance of an active market for that financial asset because of financial difficulties Where there is objective evidence of impairment, the entity should determine the amount of any impairment loss. Financial Assets carried at Amortized Cost The impairment loss is the difference between the assets carrying amount and its recoverable amount. The assets recoverable amount is the present value of estimated future cash flows, discounted at the financial instruments original effective interest rate. The amount of loss should be recognized in profit or loss. If the impairment loss decreases at a later date, and the decrease relates to an event occurring after the impairment loss was recognized, the reversal is recognized in profit or loss. The carrying amount of the asset must not exceed the original amortized cost. Financial Assets carried at Cost Unquoted equity instruments are carried a cost if their fair value cannot be reliably measured. The impairment loss is the difference between the assets carrying amount and the present value of estimated future cash flows, discounted at the current market rate of return for a similar financial instrument. Such impairment cannot be reversed.

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Available for Sale Financial Assets These are carried at fair value and gains or losses are recognized directly in equity. Any impairment loss on an available for sale financial asset should be removed from equity and recognized in net profit or loss for the period even though the financial asset has not been derecognized. The impairment loss is the difference between acquisition cost and the current fair value or recoverable amount, less any impairment loss on that asset previously recognized in profit or loss. Impairment losses relating to equity instruments cannot be reversed. Impairment losses relating to debt instruments may be reversed if, in a later period, the fair value of the instrument increases and the increase can be objectively related to an event occurring after the loss was recognized. Illustration 9 Impairment Opija Ltd purchased 5% debentures in KCA Ltd on 1 January 2008 for Kes 100,000. The term of the debenture was 5 years and the maturity value is Kes 130,525. The effective rate of interest on the debentures is 10% and the company has classified them as held to maturity financial asset. At the end of 2009, KCA Ltd went into liquidation. All interest had been paid until that date. On 31 December 2009, the liquidator of KCA Ltd announced that no further interest would be paid and only 80% of the maturity value would be repaid on the original repayment date. The market interest rate on similar bonds is 8% on that date. Required: a. What value should the debentures have been stated at just before the impairment became apparent? b. At what value should the debenture be stated at 31 December 2009, after the impairment? c. How will the impairment be reported in the financial statements for the year ended 31 December 2009? EMBEDDED DERIVATIVES This is a derivative instrument that is combined with a non derivative host contract to form a single hybrid instrument. Certain contracts that are not themselves derivatives [and may not be financial instruments] include derivative contracts that are embedded within them. These non derivatives are called host contracts.

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Examples of embedded derivatives 1. Possible examples include: 2. A term lease of retail premises that provides for contingent rentals based on sales: 3. A bond which is redeemable in five years time with part of the redemption price being based on the increase in the stock exchange index. 4. A construction contract priced in a foreign currency. The construction contract is a non derivative contract, but the change in foreign exchange rate is the embedded derivative. Accounting Treatment of Embedded Derivatives IAS 39 requires that an embedded derivative be separated from its host contract and accounted for as a derivative when the following conditions are met: 1. The economic characteristics and risks of embedded derivative are not closely related to the economic characteristics and risks of the host contract 2. A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative 3. The hybrid [combined] instrument is not measured at fair value with changes in fair value recognized in profit or loss [a derivative embedded in a financial asset or financial liability need not be separated out if the entity holds the combined instrument at fair value through profit or loss]. HEDGING IAS 39 requires hedge accounting where there is a designated hedging relationship between a hedging instrument and a hedged item. It is prohibited otherwise. Hedging for accounting purposes, means designating one or more hedging instruments so that their change in fair value is offset, in whole or in part, to a change in fair value or cash flows of a hedged item. A hedged item is an asset, liability firm commitment, or forecasted future transactions that: 1. Exposes the entity to risk of changes in fair value or changes in the future cash flows and 2. Is designated as being hedged Page3

A hedging instrument is a designated derivative or another financial asset or liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. Hedge effectiveness is the degree to which changes in the fair value or cash flows of the hedged item attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument. In simple terms, entities hedge to reduce their exposure to risk and uncertainty, such as changes in prices, interest rates or foreign exchange rates. Hedge accounting recognizes hedging relationships by allowing losses on a hedged item to be offset against gains on a hedging instrument. Illustration 10 Hedging A company owns inventories of 20,000 bags of maize which cost Kes 400,000 on 1 December 2008. In order to hedge the fluctuation in the market value of the maize, the company signs a futures contract to deliver 20,000 bags of maize on 31 March 2009 at the futures price of Kes 22 per bag. The market price of the maize on 31 December 2008 is Kes 23 per bag and the futures price for delivery on 31 March 2009 is Kes 24 per bag. Required: Explain the impact of the transactions on the financial statements of the company: a) Without hedge accounting b) With hedge accounting Hedging relationships are of three types: Fair value hedge: a hedge of the exposure to changes in the fair value of a recognized asset or liability, or an identified portion of such an asset or liability, that is attributable to a particular risk and could affect profit or loss. Cash flow hedge: a hedge of the exposure to variability in cash flows that a) Is attributable to a particular risk associated with a recognized asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction (such as an anticipated purchase or sale), and that b) Could affect profit or loss. Page3

Hedge of a net investment in a foreign operation: IAS 21 defines a net investment in a foreign operation as the amount of the reporting entitys interest in the net assets of that operation The hedge in the example above is a fair value hedge i.e. it hedges exposure to changes in the fair value of a recognized asset: the bags of maize. Conditions for hedge accounting Before a hedging relationship qualifies for hedge accounting, all of the following conditions must be met. a) The hedging relationship must be designated at its inception as a hedge based on the entitys risk management objective and strategy. There must be formal documentation (including identification of the hedged item, the hedging instrument, the nature of the risk that is to be hedged and how the entity will assess the hedging instruments effectiveness in offsetting the exposure to changes in the hedged items fair value or cash flows attributable to the hedged risk) b) The hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk. Note: the hedge need not necessarily be fully effective. c) For cash flow hedges, a forecast transaction that is subject to the hedge must be highly probable and must present an exposure to variations in cash flows that could ultimately affect profit or loss. d) The effectiveness of the hedge can be measured reliably. e) The hedge is assessed on an ongoing basis [annually] and has been effective during the reporting period. Accounting treatment Fair value hedges The gain or loss resulting from re-measuring the hedging instrument at fair value is recognized in profit or loss. The gain or loss on the hedged item attributable to the hedged risk should adjust the carrying amount of the hedged item and be recognized in profit or loss. Illustration 11 Fair Value Hedge Page3

On 1 July 2008, KCA Ltd acquired 10,000 bags of maize which it held in its inventory. This cost Kes 200 per bag, therefore a total of Kes 2 million. KCA Ltd was concerned that the price of this inventory would fall, and so on 1 July 2008; he sold 10,000 bags in the futures market for Kes 210 per bag for delivery on 30 June 2009. On 1 July 2008, the conditions for hedge accounting were all met. At December 2008, the end of KCA Ltds reporting period, the fair value of the inventory was Kes 220 per bag whiles the futures price for 30 June 2009 delivery was Kes 227 per bag. On 30 June 2009, KCA Ltd sold the inventory and closed out the futures position at the then spot price of Kes 230 per bag. Required: Set out the accounting entries in respect of the above transactions

Cash flow hedges The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge shall be recognized directly in equity through the statement of changes in equity. The ineffective portion of the gain or loss on the hedging instrument should be recognized in profit or loss. When a hedging instrument results in the recognition of an asset or liability, the changes in value of the hedging instrument recognized in equity either: a) Are adjusted against the carrying value of the asset or liability, or b) Affect the profit or loss at the same time as the hedged item [for example, through depreciation or sale]. Illustration 12 Cash Flow Hedge KCA Ltd signs a contract on 1 November 2007 to purchase an asset on 1 November 2008 for $ 60,000,000. KCA Ltd reports in Kes and hedges this transaction by entering into a forward contract to buy Kes 60,000,000 on 1 November 2008 at Kes 1 : $ 1.5 Spot and forward exchange rates at the following dates are: Spot 1/11/2008 Forward (for delivery on Page3

01/11/2007 31/12/2007 01/11/2008 [actual] Required:

Kes 1 : $ 1.45 Kes 1 : $ 1.20 Kes 1 : $ 1.00

Kes 1 : $ 1.50 Kes 1 : $ 1.24 Kes 1 : $ 1.00

Show the double entries relating to these transactions at 1 November 2007, 31 December 2007 and 1 November 2008. The items that can be designated as a hedged risk, and when an entity may designate a portion of the cash flows of a financial instrument as a hedged item. The risks specified are: 1. Interest rate risk: the risk that fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates 2. Foreign currency rate risk: the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates 3. Credit risk: the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation 4. Liquidity risk: the risk that the entity will encounter difficulty in meeting obligations associated with financial liabilities 5. Other price risk: the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices other than those arising from interest rate risk, or currency risk, whether those factors are caused by factors specific to the individual financial instrument or its issuer, or factors affecting all similar financial instruments traded in the market. 6. Market risk: the risk that the fair value or cash flows of a financial instrument will fluctuate because of changes in market prices. Market risk comprises three types of risk: currency risk, interest rate risk and other price risk The portions of the cash flows of a financial instrument that may be designated as a hedged item are one or more of the following 1. The cash flows of a financial instrument for part of its time period to maturity 2. A percentage of the cash flows of a financial instrument Page3

3. The cash flows of a financial instrument associated with a one sided risk of that instrument 4. Any contractually specified cash flows of a financial instrument that are independent from other cash flows of that instrument

DISCLOSURE OF FINANCIAL INSTRUMENTS

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