(upbeat music)
-: Some assets and liabilities are volatile,
and their fair values may change drastically.
This could have serious negative consequences
if the fair value changes are unfavourable.
So entities take out fair value hedges
to protect themselves from drastic changes
in the fair value of their recognised assets,
liabilities, or unrecognised firm commitments
to purchase or sell a resource.
For example, Cornwell Limited is a company
that hold inventory of corn.
The fair value of corn has been fluctuating in recent years,
and Cornwell Limited want to protect itself against this
by taking out a forward derivative contract
to sell some of the corn at a set price.
Assume Cornwell took out a forward derivative contract
on the 1st of January to sell 50,000 tonnes of corn
on 31st December for $100 a tonne.
The hedged item would be the corn,
whose fair value fluctuates.
The hedging instrument would be
the forward derivative contract, which secures the price
and offers a level of protection.
Let's look at the theory of how this should be treated
over the next 12 months.
The inventory of corn would still require
fair value adjustments.
However, the opposite movement would be recorded.
IFRS nine, paragraph 6.5.8, requires the gains
or losses on the hedging instrument
and hedged item to be recognised in profit and loss.
However, gains or losses in fair value of equity instruments
should be recognised in other comprehensive income.
Assume that on the 1st of January,
the fair value of corn was $4.7 million, and the fair value
of the forward derivative contract was zero.
On 30th June, the corn inventory had a fair value
of $4.9 million, and the fair value
of the forward derivative contract
was a credit balance of $150,000.
On 31st December, the fair value of the corn inventory
was $4.8 million, and the fair value
of the forward derivative contract was $200,000.
What would be the journal entries on the 1st of January,
30th of June, and 31st of December?
On the 1st of January, there would be no journal entry
since the fair value
of the forward derivative contract is zero.
On 30th June, the fair value of the corn
increased by $200,000, so the journal would be
to debit corn inventory to increase it by this $200,000
and a credit to a gaining profit and loss
by the same amount.
Note that the gain on the hedged item
is taken to profit and loss.
On 30th June, the fair value
of the forward derivative contract decreased by $150,000.
The journal would be a debit to a loss
in profit and loss for $150,000 and a credit
to the forward derivative contract with $150,000.
Note that the loss on the hedging instrument
is taken to profit and loss.
On 30th December, the fair value of the corn inventory
decreased by $100,000, so the journal would be a debit
to a loss in the profit and loss with $100,000
and a credit to corn inventory to decrease
the inventory to its fair value.
On 31st December, the fair value
of the forward derivative contract increased by $350,000
to get to a fair value of $200,000.
Note that the $350,000 increase is the movement
in the balance from negative on 30th June
to a positive on 31st December.
So the journal would be a debit
to the forward derivative contract with $350,000
and to credit a gain in profit and loss
with the same amount.
$200,000 is the fair value
of the forward derivative contract on 31st December,
which is also the majority date.
Because this is a positive balance,
it indicates that Cornwell Limited
will be receiving this balance.
So the journal would be to debit bank with $200,000
and a corresponding credit
to the forward derivative contract.
To recap, fair value hedges protect against exposure
of fair value changes to recognised assets,
liabilities, and unrecognised firm commitments
to buy or sell a resource.
As a general rule, gains or losses on fair value hedge items
and instruments are taken to profit and loss
unless the item being hedged is an equity instrument,
in which case the gains or losses are recognised
in other comprehensive income.