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Cash and cash equivalents

Overall

Cash is simple to summarize:

Cash comprises cash on hand and cash in bank.
Companies generally hold more cash equivalents than cash.
Cash may also be restricted.

In common usage, "cash on hand" often refers to both physical currency and deposits with financial institutions. However, in an accounting context, cash on hand refers to currency.

Note: IAS 7 uses the term "cash on hand" while the ASC glossary "currency on hand." In practice, the two are synonyms.

Also note: neither IFRS nor US GAAP use the term petty cash. However, in common practice, petty cash generally refers to an amount of currency that could be stored in a desk drawer or carried in a pocket. If, on the other hand, the currency would require a safe or motorized transport, it should be referred to as cash on hand | currency on hand.

In their respective glossaries, IFRS and US GAAP use the term "demand deposits" when discussing cash held at banks or other financial institutions. However, in practice, "cash in bank" is more common.

Note: "cash in bank" may sometimes be referred to as "bank accounts" or just "bank," particularly in international contexts. However, these border terms may also include items, such as certificates of deposit, that would fall into the cash equivalents category (below), so should be avoided if precision is required.

To maximize returns, companies typically invest excess cash. When cash is expected to be needed soon, firms allocate it to highly liquid, short-term investments. If these have a maturity of three months or less, they are classified as cash equivalents. Otherwise, they are classified as investments, either short or long-term investments depending their maturity and/or management intent.

Both IFRS and US GAAP define cash equivalents as short-term, highly liquid investments readily convertible to known amounts of cash. Interestingly, while a three-month-or-less criterion is present in both, IAS 7 includes it within the guidance, whereas ASC 230 includes it in the definition.

More importantly, IAS 7.7 (edited) states "...an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three-months-or-less..." while ASC 230 definition (edited) states: "generally, only investments with original maturities of three-months-or-less qualify..."

IFRS does not specify how to interpret "say."

In practice, it is commonly interpreted as two to three business days, but never exceeding five.

While seemingly minor, the absence of the qualifier means, for example, a promissory note with an original maturity of 93 days would qualify as a cash equivalent under IFRS but not US GAAP, where the limit is 92 days (or 90 if it were acquired on the first of January of a non-leap year).

Interestingly, ASC refers to 'original maturity' without defining it, an apparent role reversal compared to IFRS which does not use the term but rather states "from the date of acquisition," which is the definition of original maturity.

Note: many investments that qualify as cash equivalents pay interest. However, their three-months-or-less term invariably makes any potential difference between their present and future values so insignificant that it is not given accounting recognition making amortized cost accounting generally unnecessary.

IFRS and US GAAP do not specifically define restricted cash. They do, however, require its disclosure. While this does not mean it must be kept in a separate account, it would be good practice.

In ASU 2016-18, the EITF discusses its reasoning for not doing so.

In BC8 (edited) it states: The Task Force considered, but rejected, classifying changes in restricted cash or restricted cash equivalents that result from transfers between cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents on the basis of either the nature of the restriction (that is, investing activities) or the purpose for the restriction. The Task Force believes that internal transfers between cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents do not represent a cash inflow or outflow of the entity because there is no cash receipt or cash payment with a source outside of the entity that affects the sum of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents...

In BC9 (edited, emphasis added) it continues... The Task Force considered defining restricted cash; however, it ultimately decided that the issue resulting in diversity in practice is the presentation of changes in restricted cash on the statement of cash flows. The Task Force's intent is not to change practice for what an entity reports as restricted cash or restricted cash equivalents.

Reading between the lines, what the EITF seems to be saying is: we would rather not define restricted cash because, to paraphrase Supreme Court Justice Potter Stewart, "You know it when you see it."

Like US GAAP, IFRS does define restricted cash, although it does not explain why.

In US GAAP, the guidance is provided by ASC 210, so applies to cash, the balance sheet item.

In IFRS, it is provided by IAS 7, which primarily deals with the change in cash, a.k.a. cash flow.

Restricted cash is discussed in ASC 210-10-45-4.a. While much of the guidance focuses on sinking and similar funds, by analogy it would apply to any cash balance that the entity cannot use in its day-to-day operations, particularly to pay employees, suppliers or other creditors.

The existence of a restriction implies the entity is committed to remitting cash to a particular creditor(s), so that cash would not be available to satisfy the claims of other creditors.

Note: if the creditors that have a claim to the restricted cash are creditors because the entity applied IAS 37 | ASC 450, the balancing entry would be a provision | contingent liability. This page discusses and illustrates the accounting for provisions | contingent liabilities.

Note: ASC 470-10-50-1 provides additional guidance aimed specifically at sinking funds.

Also note: while they feature prominently in IFRS guidance, ASC 210 does not specifically mention the exchange controls or other legal restrictions discussed in IAS 7.49.

While IAS 7 focuses on cash flow (the change in cash), (black letter paragraph) IAS 7.48 does address cash (the balance) stating: an entity shall disclose, together with a commentary by management, the amount of significant cash and cash equivalent balances held by the entity that are not available for use by the group.

Unfortunately, the following (grey letter) paragraph expands on this guidance by specifying these generally comprise "cash and cash equivalent balances held by a subsidiary that operates in a country where exchange controls or other legal restrictions..."

Why is that unfortunate? Because it is occasionally interested to mean that only restrictions based in law must be disclosed. Thus, for example, a restriction associated with a sinking fund would not need to be disclosed because it based in contract, not law.

However, a careful read of the paragraph reveals that it actually states (emphasis added) "Examples include cash and cash equivalent balances held by a subsidiary that operates in a country where exchange controls or other legal restrictions... This implies restrictions beyond legal may also require disclosure.

When viewed through the lens of practice statement 2 (Making Materiality Judgements), the guidance means any material restriction, especially one that prevents an entity from using an amount of cash in regular, day-to-day operations falls into the category of restricted cash.

Note: unlike ASC 210-10-45-4.a, where sinking funds feature prominently, IFRS only mentions them in passing (in IFRS 7.18.a and IAS 32.49.d).

ASC 210-10-45-4.a (edited, emphasis added) states: ...Even though not actually set aside in special [bank] accounts, funds that are clearly to be used in the near future for the liquidation of long-term debts, payments to sinking funds, or for similar purposes shall also, under this concept, be excluded...

While, by implication, a separate accounting account is not necessary either, it does make tracking easier.

Note: IAS 7.48 does not go into similar operating detail, but the logic is comparable.

Restricted cash is usually associated with:

Pension funds
Sinking funds
Security deposits
Customer pre-payments
Compensating balances
Minimum bank balances
Mandatory deposits at central banks
Letters of credit or standby LOCs
Collateral
Escrow
Legal contingencies
Exchange controls
Capital expenditures
Etc.

While ASC 210-10-45-4.a provides blanket guidance for any "cash and claims to cash that are restricted as to withdrawal or use for other than current operations..." it mostly focuses on sinking funds implying that this form of restriction is a priority for the FASB.

While IFRS 7.48 provides guidance for "...significant cash and cash equivalent balances held by the entity that are not available for use by the group," IAS 7.49 focuses on "exchange controls or other legal restrictions."

While ASC 810-10-15-10.a.1.iii does mention foreign exchange restrictions, controls, or other governmentally imposed uncertainties, these are only discussed in the context of consolidation of foreign operations, not restricted cash balances.

Both IAS 7.50.c and ASC 210-10-45-4.a discuss cash restricted to fund expected capital expenditures.

However, as such restrictions are only based on management intent, they would not be comparable to, for example, pension funds or escrow accounts, where these funds are held by third parties and only disbursed if pre-set conditions are met.

Since this distinction is important for financial statement users, material restrictions of a discretionary nature should be reported separately in a way that clearly reflects their nature.

Note: while IFRS and US GAAP do not preclude restricting cash for capital expenditures or repairs and maintenance, on the other side of the balance sheet, they would not allow a provision | contingent liability to be recognized simply because of management intent. An additional discussion of this issue is provided on this page.

Note: in addition to cash, cash equivalents or other financial instruments may also be restricted.

The accounting for cash is even simpler to summarize.

Cash is the balancing entry for a variety of transactions or events.

Cash is easy to recognize and even easier to measure, so IFRS | US GAAP focus on the other side of the transaction.

While the term cash is obvious, both IFRS and US GAAP define it stating (respectively):

Cash comprises cash on hand and demand deposits.
Consistent with common usage, cash includes not only currency on hand but demand deposits with banks or other financial institutions. Cash also includes other kinds of accounts that have the general characteristics of demand deposits in that the customer may deposit additional funds at any time and also effectively may withdraw funds at any time without prior notice or penalty. All charges and credits to those accounts are cash receipts or payments to both the entity owning the account and the bank holding it. For example, a bank's granting of a loan by crediting the proceeds to a customer's demand deposit account is a cash payment by the bank and a cash receipt of the customer when the entry is made.

That cash is measured at nominal value is so obvious, neither IFRS nor US GAAP go to the trouble of stating the obvious.

If an entity receives cash as a pre-payment for a future service, it applies IFRS 15 | ASC 606 to the credit side.

If an entity receives cash because it collects on a receivable, it also applies IFRS 15 | ASC 606 to the credit side.

This is because IFRS 15 | ASC 606 had already been applied when the receivable was initially recognized.

Note: IFRS 15.108 | ASC 606-10-45-4 states "...An entity shall account for a receivable in accordance with IFRS 9 | ASC 310 and ASC 326-20..." so IFRS 9 | ASC 310 and ASC 326-20 is, technically, the guidance applicable to the receivable, but mentioning this would only be picking nits.

If an entity receives cash as a result of borrowing, it applies IFRS 9 | ASC 405, 470, 480, 835, etc. to the credit side.

If an entity restricts cash to cover a potential legal judgment, it applies IAS 37 | ASC 450 to the debit side.

Technically, since both are cash, the guidance applies to both sides, though more so to the debit side.

If an entity expends cash to acquire raw materials, a machine or a patent, it applies—well, you get the picture.

Cash

As noted above, the accounting for cash is simple. But, for the sake of completeness, a few examples:

Cash sale

1/1/X1, XYZ sold goods for 1,000 in cash.

XYZ uses a periodic inventory method so does not recognize cost of sales at the time of the sale.

More on this issue on this page.

1/1/X1 \| 1.1.X1
Cash on hand		1,000
	Revenue		1,000

Collection on a receivable

On 1/31/X1, XYZ collected 1,000 on an invoice issued a month earlier.

1/31/X1 \| 31.1.X1
Cash in bank		1,000
	Accounts receivable		1,000

Payment on a payable

On 1/31/X1, XYZ paid 1,000 to settle an invoice it received a month earlier.

31/1/X1 \| 31.1.X1
Accounts payable		1,000
	Cash in bank		1,000

A loan taken out

1/1/X1, XYZ took out a loan of 1,000,000.

1/1/X1 \| 1.1.X1
Cash in bank		1,000,000
	Loan		1,000,000

Capital investment

1/1/X1, XYZ's owners contributed capital of 1,000,000.

1/1/X1 \| 1.1.X1
Cash in bank		1,000,000
	Paid-in Capital		1,000,000

Stock sale

1/1/X1, XYZ sold shares with a 1,000 par value for 1,000,000.

1/1/X1 \| 1.1.X1
Cash in bank		1,000,000
	Paid-in Capital		1,000
	Additional paid-in Capital		999,000

Cash in transit is more involved, but not significantly so.

Cash in transit (float)

In some jurisdictions, cash in transit is not an issue.

12/31/X1, XYZ withdrew 500 to replenish petty cash, paid 250,000 rent, 850,000 wages, and collected 25,000 and 75,000 from two customers. Its operations were in a jurisdiction where real-time banking was the norm.

For example, SEPA (Single Euro Payment Area) payments usually clear the same day while Instant Credit Transfers (SCT Inst) clear in seconds.

12/31/X1 \| 31.12.X1
Petty cash		500
	Cash in bank		500
Pre-paid rent		250,000
	Cash in bank		250,000
Wages payable		850,000
	Cash in bank		850,000
Cash in bank		25,000
	Accounts receivable: ABC		25,000
Cash in bank		75,000
	Accounts receivable: DEF		75,000

In other jurisdictions, the bank balance and balance sheet balance need to be reconciled.

12/31/X1, XYZ paid 250,000 rent, 850,000 wages, and collected 25,000 and 75,000 from two customers. It's operations were in a jurisdiction where bank transfers clear in 48 hours.

In the EU, instant payments under the Instant Payments Regulation (IPR) are processed in real time, meaning funds are available within seconds. Traditional SEPA (Single Euro Payments Area) credit transfers typically clear within one business day for electronic payments and two business days for paper-based transactions. Payments outside SEPA but using IBANs generally take 24 to 48 hours, depending on the banks involved and currency conversion. SWIFT (Society for Worldwide Interbank Financial Telecommunication) payments in non-IBAN jurisdictions can take anywhere from 1 to 5 business days, though in some cases, particularly with compliance checks or intermediary banks, they may take a week or more.

While not specifically targeted at cash, the guidance for trade date versus settlement date should be applied by analogy to cash receipts/payments. The timing of receipt/payment recognition may also be influenced by national legislation.

IFRS 9.B3.1.3 (edited) states: A regular way purchase or sale of financial assets is recognised using either trade date accounting or settlement date accounting as described in paragraphs B3.1.5 and B3.1.6...

The trade date is the date that an entity commits itself to purchase or sell an asset...
The settlement date is the date that an asset is delivered to or by an entity...

ASC 965-320-25-1 states: The accrual basis of accounting requires that purchases of securities be recorded on a trade-date basis. However, if the settlement date is later than the financial statement date, accounting on a settlement-date basis for such purchases is acceptable if both of the following conditions exist:

The fair value less costs to sell, if significant, of the securities purchased just before the financial statement date does not change significantly from the trade date to the financial statement date.
The purchases do not significantly affect the composition of the plan's assets available for benefits.

For example, one EU member state's legal requirements are: The moment of accounting recognition is the day of payment or currency acceptance, day of purchase or sale of currencies, foreign exchange, or of securities, date of payment, or direct debit from the client's account, the day of the order to the correspondent to make the payment, the settlement day of the bank's orders with the national bank clearing center, the day of crediting (currency) of the funds according to the report received from the bank's correspondent (message means a message in the SWIFT system, a bank notice, adopted medium, account statement, or other documents), negotiation date and settlement date spot trades (the accounting unit chooses whether to use accounting by day for spot trades trade or settlement day and consistently follows the chosen method within each group), date of negotiation and settlement of derivative transactions, date of issuance or acceptance of guarantee, or of the loan promise, the day the values are taken into custody, the day in accordance with paragraph 2.3.

XYZ Inc. Bank reconciliation schedule 12/31/X1 \| 31.12.X1
Cash on statement		2,000,000
-	Unrealized bank transfer (rent)	(250,000)
-	Unrealized bank transfer (payroll)	(850,000)
+	Unrealized bank transfers (accounts receivable: ABC, DEF)	100,000
Cash in bank		1,000,000

Assuming XYZ's bank sends preadvice notices of incoming payments. Otherwise:

XYZ Inc. Bank reconciliation schedule 12/31/X1 \| 31.12.X1
Cash on statement		2,000,000
-	Unrealized bank transfer (rent)	(250,000)
-	Unrealized bank transfer (payroll)	(850,000)
Cash in bank		900,000

Same facts except, XYZ's jurisdiction was vieux jeu.

While most of the world has shifted to electronic cash transfers, some jurisdictions cling to physical bills of exchange (link). For example, in the United States, paper checks are still used for around 20% of all payments (link).

XYZ Inc. Bank reconciliation table 12/31/X1 \| 31.12.X1
Cash on statement		2,000,000
-	Check number 2510549	(250,000)
-	Check numbers 2510550 to 2510933	(850,000)
+	Checks number 5441058 (ABC) and 287710 (DEF)	100,000
Cash in bank		1,000,000

Same facts except XYZ elected to journalize the transactions.

In some jurisdictions, particularly with legalistic national GAAPs that prescribe accounting procedures, accountants think they must journalize everything. As neither IFRS nor US GAAP dwell on accounting formalities, a reconciliation is sufficient. Nevertheless, journalizing is not disallowed and can be done.

12/31/X1 \| 31.12.X1
Rent		250,000
Wages & salaries		850,000
Cash: Cash in transit (clearing account)		100,000
	Cash: Cash in transit (clearing account)		250,000
	Cash: Cash in transit (clearing account)		850,000
	Receivables		100,000

1/2/X2 \| 2.1.X2
Cash: Cash in transit (clearing account)		250,000
Cash: Cash in transit (clearing account)		850,000
Cash: Cash in bank		100,000
	Cash: Cash in bank		250,000
	Cash: Cash in bank		850,000
	Cash: Cash in transit (clearing account)		100,000

Cash equivalents

Certificate of deposit

1/1/X1, XYZ acquired a three-month CD for 100,000. 3/31/X1, it received 100,864.

Implying an annual interest rate (in Excel syntax) of: 3.5%=((1+RATE(1,-100864,100000,0))^4)-1.

Dr/Cr

1/1/X1 \| 1.1.X1
Cash equivalents: Certificate of deposit		100,000
	Cash		100,000

3/31/X1 \| 31.3.X1
Cash		100,864
	Cash equivalents: Certificate of deposit		100,000
	Interest revenue		864

Same facts except XYZ acquired a revolving, three-month CD it intended to hold for six months.

Dr / Cr

1/1/X1 \| 1.1.X1
Cash equivalents: Certificate of deposit		100,000
	Cash		100,000

3/31/X1 \| 31.3.X1
Cash equivalents: Certificate of deposit		864
	Interest revenue		864

The interest was credited to the CD.

Its balance on 3/31/X1 (100,864) implied an annual interest rate (in Excel syntax) of:
3.5%=((1+RATE(1,-100864,100000,0))^4)-1 for Q1.

6/30/X1 \| 30.6.X1
Cash		101,612
	Cash equivalents: Certificate of deposit		100,864
	Interest revenue		748

The CD's balance on 6/30/X1 was 101,612 implying an annual interest rate (in Excel syntax) of:
3.0%=((1+RATE(1,-101612,100864,0))^4)-1 for Q2.

Same facts except XYZ expected interest rates to decline so it acquired a six-month CD. 6/30/X1, it received 101,735.

Implying an annual interest rate (in Excel syntax) of: 3.5%=((1+RATE(1,-101735,100000,0))^2)-1.

Dr / Cr

1/1/X1 | 1.1.X1

Investments: Certificate of deposit

100,000

Cash

100,000

ASC 230 defines cash equivalents as highly liquid investments readily convertible to known amounts of cash with a maturity of three-months-or-less. While the IAS 7 definition does not discuss maturity, the three-months-or-less criterion is specified by IAS 7.7. As the CD was for 6 months, XYZ classified it as a short term investment.

Note: if an order of liquidity balance sheet is prepared for IFRS purposes, this item would be reported in other financial assets (OtherFinancialAssets) not cash and cash equivalents (CashAndCashEquivalents).

3/31/X1 \| 31.3.X1
Cash		101,735
	Investments: Certificate of deposit		100,000
	Interest revenue		1,735

Financial instrument

1/1/X1, XYZ acquired a three-month, zero-coupon, 100,000 face value, investment grade promissory note for 98,906.

Implying an annual interest rate (in Excel syntax) of: 4.5% = ((1+(1+(RATE(1,-100000,98906,0)))^(1)-1)^4) - 1.

Dr/Cr

1/1/X1 \| 1.1.X1
Cash equivalents: Commercial paper		98,906
	Cash		98,906

In the United States, commercial paper refers to high quality financial instruments with an original maturity of no more than 270 days. Internationally, the term may be used more loosely. However, any company that mischaracterizes commercial paper in an SEC filing may face disciplinary action.

Commercial paper is not defined by US GAAP but the Securities Act of 1933 (link) Sec 3.3 (edited): Any note, draft, bill of exchange, or banker’s acceptance which arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months...

For example, while the IASB staff assumes "commercial paper is a short-term debt instrument that is sold publicly and held widely, and which matures in 90 or 180 days" (link / local link), EFRAG discusses "commercial paper/certificates of deposits with a maturity up to 12 months" (link / local link).

For example, Portugal Telecom was fined $1,250,000 (link) for mischaracterizing a note as commercial paper.

Proper accounting recognizes the face value of financial instrument separately from the associated discount or premium:

1/1/X1 \| 1.1.X1
Cash equivalents: Note		100,000
	Cash equivalents: Note / Discount		1,094
	Cash		98,906

3/31/X1 \| 31.3.X1
Cash		100,000
	Cash equivalents: Note		100,000
Cash equivalents: Note / Discount		1,094
	Interest revenue		1,094

Nevertheless, with instruments classified as commercial paper (and short-term investments in general), the simplified approach illustrated here could be used. See the liabilities page for additional illustrations of discounts / premiums.

3/31/X1 \| 31.3.X1
Cash		100,000
	Cash equivalents: Commercial paper		98,906
	Interest revenue		1,094

Same facts except the note was originally issued on 31.3.X0 with a one year term.

Dr/Cr

1/1/X1 \| 1.1.X1
Cash equivalents: Note		98,906
	Cash		98,906

Commercial paper is generally understood to mean a financial instrument with an original maturity 270 days or less.

While this criterion comes from US law, it is recognized throughout the investing and regulatory communities.

The Securities Act of 1933 (link) Sec 3.3 (edited) as: Any note, draft, bill of exchange, or banker's acceptance which arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months...

While we could not find an example of an ESMA enforcement action aimed at this issue, this regulator also interprets "commercial paper" the same way (link / local link). This implies, if a company misrepresents an unqualifying financial instrument as commercial paper, it may be subject to regulatory enforcement even if it is outside the authority of the US SEC.

In 2016, the SEC fined Portugal Telecom (link) $1,250,000 for mischaracterizing an unqualified note as commercial paper.

As the note's maturity on the date of issue was one year, XYZ did not recognize it as commercial paper. However, as its remaining maturity on the day of acquisition was three months, XYZ did recognize it as a cash equivalent.

3/31/X1 \| 31.3.X1
Cash		100,000
	Cash equivalents: Note		98,906
	Interest revenue		1,094

Same facts except the note was originally issued on 8/1/X0, matured on 4/30/X1 and XYZ paid 98,543.

Technically, the note had an original maturity of 273 days not the 270 days discussed above. However, for simplicity, accountants use 270 as shorthand, so every month has 30 days and a year 360 ¯\_(ツ)_/¯

Implying an annual interest rate (in Excel syntax) of: 4.5% = ((1+RATE(1,-100000,98543,0))^(12/4))-1.

Dr / Cr

1/1/X1 \| 1.1.X1
Short-term investments: Commercial paper		98,543
	Cash		98,543

As outlined in the IAS 7.7 | ASC 230 definition, an investment must have an original maturity (maturity on the date of acquisition) of three-months-or-less. As the note had four months to maturity, XYZ recognized or reported it as an investment instead.

3/31/X1 | 31.3.X1

N/A

As outlined in the ASC 230 definition, an investment with an original maturity exceeding three months does not become a cash equivalent when its remaining maturity is three months. While not as explicit, IAS 7.7 does state (edited, emphasis added): "an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three-months-or-less from the date of acquisition." Different words, same result.

4/30/X1 \| 30.4.X1
Cash		100,000
	Short-term investments: Commercial paper		98,543
	Interest revenue		1,457

Negative rates

nnnnnnnnnnnnn not displayed nnnnnnnnnnnnn

1/1/X1 XYZ acquired a 90 day, 100,000 note for 100,125 and held it to maturity.

Implying an annual interest rate of -0.4984%.

Determined using Excel's =RATE function adjusted for quarterly periodicity: -0.4984% = ((1+RATE(1,-100000,100125,0,0,10%))^4) - 1

Dr/Cr

1/1/X1 \| 1.1.X1
Cash equivalents: Very short-term security		100,000
Cash equivalents: Deferred interest		125
	Cash		100,125

3/31/X1 \| 31.3.X1
Cash		100,000
	Cash equivalents: Very short-term security		100,000
Interest expense		125
	Cash equivalents: Deferred interest		125

Same facts except XYZ transferred the funds to a zero-interest account.

1/1/X1 \| 1.1.X1
Cash: Account 123		100,000
	Cash: Account 321		100,000

3/31/X1 \| 31.3.X1
Cash: Account 321		100,000
	Cash: Account 123		100,000

Same facts except XYZ decided withdraw currency (ignoring bank charges).

1/1/X1 \| 1.1.X1
Cash: Currency		100,000
	Cash		100,000

3/31/X1 \| 31.3.X1
Cash		100,000
	Cash: Currency		100,000

Liquid valuable

1/1/X1, XYZ purchased postage and revenue stamps with nominal values of 1,000 and 2,000 respectively. In January, it mailed letters at a cost of 100 and paid 200 in administrative fees.

While most have moved on, some jurisdictions cling to traditional adhesive labels attached to physical documents to designate the payment taxes or administrative fees (never forgetting the all-important rubber stamp) the same way they prefer physical, paper, certified letters over, for example, DocuSign.

Dr/Cr

1/1/X1 \| 1.1.X1
Cash equivalents: Postage stamps		1,000
	Cash		1,000
Cash equivalents: Revenue stamps		2,000
	Cash		2,000

Although the guidance in IAS 7 and ASC 230 suggests that cash equivalents may only comprise items such as treasury bills, commercial paper, and money market funds, companies may also hold other cash-like items, such as postage and revenue stamps. As these "liquid valuables" can both be used to pay for goods or services and be readily converted back into cash, they should be recognized as cash equivalents on judgment alone.

In January
Postage		100
	Cash equivalents: Postage stamps		100
Taxes and fees		200
	Cash equivalents: Revenue stamps		200

Same fact except it purchased credit for a postage machine.

1/1/X1 \| 1.1.X1
Pre-paid postage		1,000
	Cash		1,000

In contrast to stamps, pre-paid postage cannot be readily converted back into cash. Consequently, it should be classified as an accrual (pre-paid expense), rather than a cash equivalent.

In January
Postage		100
	Pre-paid postage		100

1/1/X1, XYZ purchased employee meal vouchers with a nominal value of 60,000. It paid 60,300 including a 0.5% processing fee. 1/31/X1, it included vouchers with a nominal value of 20,000 in January employee compensation.

In XYZ's jurisdiction, employee benefits such as meal allowances receive favorable tax treatment but only if provided in the form of vouchers or pre-paid debit cards.

In XYZ's jurisdiction, employees are compensated on a monthly basis. In some jurisdiction a different periodicity, for example weekly or bi-weekly, is used.

Dr/Cr

1/1/X1 \| 1.1.X1
Cash equivalents: Vouchers or Pre-paid employee benefits: Vouchers		60,000
Pre-paid employee benefits: Voucher fee		300
	Cash in bank		60,300

The definition of cash equivalents (IAS 7.7 | ASC 230) suggests they may only comprise financial instruments such as treasury bills, commercial paper or money market funds. However, in some jurisdictions companies hold other cash like instruments such postage stamps, revenue stamps, meal vouchers, etc. Occasionally questions as to their proper classification arise. As a general rule, if they can be readily converted back into cash, they would be cash equivalents otherwise they would be pre-paid expense.

Note: as the amounts involved are usually insignificant, this issue is rarely given, outside of academic circles, much thought, so practice varies.

1/31/X / 31.1.X1
Payroll: Fringe benefits: Food and beverage		20,100
	Cash equivalents: Vouchers or Pre-paid employee benefits: Vouchers		20,000
	Pre-paid employee benefits: Voucher fee		100

Restricted cash

1/1/X1, XYZ sold 1000, 10 year, 4.5% bonds with a sinking fund. XYZ paid both the coupon and 21,036 fund contribution each quarter. The fund's custodian guaranteed repayment.

As a rule, bond buyers prefer lump-sum principal repayments at the end of the bond term. However, as the default risk is higher than if principal is repaid periodically, only the most highly rated public and private entities are able to issue such term bonds.

One way less credit worthy organizations can do so is to insure them. However, the cost of insurance can be prohibitive.

Depending on the circumstances, a more cost effective alternative could be to, in effect, turn the term bond into a serial bond with a sinking fund. In this scenario, the debtor makes periodic payments to a trustee who retires the bond. This in effect substituting trustee's credit standing for the debtor’s allowing even less credit worth debtors to access the segment of the market that deals in term bonds.

In this illustration, the trustee's rating was AA while XYZ's only B. If XYZ had placed the bonds itself (assuming it could have), it would have had to offer a coupon in line with its credit standing. Assuming a AA rate of 4.5% and 3% spread, it would have had to offer a 7.5% coupon.

Thus, while the trustee did lock XYZ into a sub-market return, it was offset by the lower coupon.

A contribution of 21,036 implies a 3.5% annual return. At the time of the issue, the yield on AAA rated corporate debt implied an annual market rate of 4.2%. The difference compensated the trustee for the guarantee.

To determine the contribution, the trustee made this calculation:
21,036 = 1,000,000 ÷ (((1 + (1 + 3.5%)^1÷4 - 1)^10x4 - 1) ÷ ( (1 + 3.5%)^1÷4 - 1))

In excel syntax (rounded): 21036=1000000/(((1+(1+3.5%)^(1/4)-1)^(10*4)-1)/((1+3.5%)^(1/4)-1))
or simplified 21036=1000000/(((1+(1+3.5%)^(1/4)-1)^40-1)/((1+3.5%)^(1/4)-1)).

Note: the calculation may also be made: 20988=1000000/(((1+3.5%/4)^(10*4)-1)/(3.5%/4)). However, because this fails to scale the annual rate to an interim rate accurately, it should only be used by those who are afraid of good math, like the authors of this page (link) (link).

In excel syntax (rounded): 3.5%=((1+RATE(40,-21036,0,1000000,0))^4)-1.

As the sinking fund allowed XYZ to, in effect, substitute the trustee's credit standing for its own, it was able to offer a 4.5% coupon instead of at least 7.5%. The difference between the total cash outlay associated with the bond plus sinking fund (1,291,449) and a 7.5% loan (1,417,590) was significant.

In Excel syntax (rounded): 1291449=(40*21036)+10*1000000*4.5%.

In Excel (rounded): 1417590=40*1000000/((1-(1/(1+((1+7.5%)^(1/4)-1))^(10*4)))/((1+7.5%)^(1/4)-1)).

Note: the trustee had the option to purchase bonds on the open market, effectively retiring them early.However, as XYZ's creditor, the trustee was required to hold any such bonds until maturity.

Also note: for simplicity, the illustration assumes the bonds were placed at face value. See the liabilities page for illustrations of bond discounts / premiums.

Dr / Cr

1/1/X1 \| 1.1.X1
Cash		1,000,000
	Bond		1,000,000

3/31/X1 \| 31.3.X1 So accruing entries need not be illustrated, the payment was made and recognized the last day of the quarter.
Bond sinking fund (restricted cash)		21,036
	Cash		21,036
Interest expense		11,250
	Cash		11,250

While both address the issue, IFRS and US GAAP only provide cursory guidance. This is unfortunate because the lack of specificity leads to differences of opinion as to what qualifies as "restricted cash."

For example, neither explicitly define "restricted cash."

This does not, however, mean they fail to address it at all.

For example, the IFRS definition of current assets (sub-paragraph d) suggests that a restriction turns cash, normally current, into a non-current asset. This in turn implies restricted cash must be evaluated as a separate, stand-alone accounting item regardless of whether it is specifically defined as such.

Similarly, IAS 7.7 specifies that for an investment to be reported as a cash equivalent, it must have a maturity of three-months-or-less. As the economic substance of a restriction is comparable to a maturity, if applied to cash by analogy, this guidance suggests that any cash subject to a restriction exceeding three months cannot be classified as regular cash.

Also, in its Tentative Agenda Decision on Demand Deposits with Restrictions on Use arising from a Contract with a Third Party, the IFRIC addressed this issue. In the fact pattern described, the entity "holds a demand deposit whose terms and conditions do not prevent the entity from accessing the amounts held..." Based on this fact pattern, the IFRIC concluded "the entity presents the demand deposit as cash and cash equivalents." By implication, if an entity held a demand deposit whose terms and conditions prevented it from accessing the amounts held, it would not classify it as cash or cash equivalents. While, obviously, the Tentative Agenda Decision does not specify what it would be classified as, restricted cash seems the logical choice.

US GAAP also avoids explicitly defining restricted cash. However, ASC 210-10-45-4.a does require non-current restricted cash to be reported separately. While the guidance does not explicitly state it must be classified as "restricted cash," doing so makes sense.

Specifically, ASC 210-10-45-4.a requires restricted cash to be segregated from regular cash if the restriction is for over a year.

While the guidance also suggests restricted cash need not be segregated at the bank account level, this is common (and good) practice.

In ASU 2016-18.BC9 (edited) the EITF also states: ... The Task Force considered defining restricted cash; however, it ultimately decided that the issue resulting in diversity in practice is the presentation of changes in restricted cash on the statement of cash flows. The Task Force's intent is not to change practice for what an entity reports as restricted cash or restricted cash equivalents...

What this (somewhat cryptic) explanation seems to be suggesting: restricted cash is too broad to define but, to paraphrase Supreme Court Justice Potter Stewart, "You know it when you see it."

More importantly, at least for entities registered with it, the US SEC sees it this way (edited, emphasis added):

Separate disclosure shall be made of the cash and cash items which are restricted as to withdrawal or usage. The provisions of any restrictions shall be described in a note to the financial statements. Restrictions may include legally restricted deposits held as compensating balances against short-term borrowing arrangements, contracts entered into with others, or company statements of intention with regard to particular deposits; however, time deposits and short-term certificates of deposit are not generally included in legally restricted deposits... (CFR § 210.5-02: link).

Nevertheless, this lack of specificity does not mean restricted cash can be ignored. Instead, it needs to be reported separately, especially if the restriction exceeds one year.

IAS 1.66.d specifies that if cash or a cash equivalent is "restricted from being exchanged or used to settle a liability for at least twelve months," it cannot be classified as current. Similarly, in IASB XBRL, RestrictedCashAndCashEquivalents is a separate item with reference is IAS 1.55 (rather than 1.66.d). This reference suggests that material (link) restricted cash must be recognized and reported separately from unrestricted cash, even in an order of liquidity balance sheet.

In US GAAP, ASC 210-10-45-4.a specifies that restricted cash must be segregated from regular cash if the restriction exceeds one year.

Note: while the guidance suggests restricted cash does not need to be segregated at the bank account level, maintaining separate bank or similar accounts is good practice

Similarly, ASC 230-10-50-8 suggests restricted cash and cash equivalents need to be disaggregated on the statement of financial position if material.

Note: if multiple reasons for restrictions exist, restricted cash should be further disaggregated by type.

To emphasize the point, in FASB XBRL, RestrictedCash and RestrictedCashEquivalents have the same prominence as Cash and CashEquivalentsAtCarryingValue.

In addition to the balance sheet, additional footnote disclosure is also required. Specifically, ASC 230-10-50-7 (edited) states: An entity shall disclose information about the nature of restrictions on its cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents...

While IFRS does not define restricted assets, the Glossary does define current assets (edited, emphasis added): ...(d) the asset is cash or a cash equivalent (as defined in IAS 7) unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period.

Similarly, as outlined in 210-10-45-4.a, noncurrent restricted cash and claims cannot be included in current assets. To reinforce this guidance, the FASB XBRL includes RestrictedCashCurrent and RestrictedCashEquivalentsCurrent, and RestrictedCashNoncurrent and RestrictedCashEquivalentsNoncurrent tags. The items also point to ASC 230-10-50-8, suggesting each is to be presented as separate balance sheet line item if material.

For example, some web pages (link, link, link) fail to distinguish between cash restricted due to legal or contractual constraints and cash restricted solely based on management intent. These sources incorrectly classify cash reserved for capex as restricted. Fortunately, the authors other pages (link, link, link) are more enlightened.

As far as ifrs-gaap.com is concerned; for cash to be reported as restricted on the balance sheet, it must be restricted due to a legal or contractual obligation. Any cash "restricted" simply on the basis of management intent (e.g. cash held for expected future major repairs, capex, M&A, etc.) may be (if at all) disclosed in the footnotes only.

In CFR § 210.5-02 (link) the SEC specifies (emphasis added): Separate disclosure shall be made of the cash and cash items which are restricted as to withdrawal or usage. The provisions of any restrictions shall be described in a note to the financial statements. Restrictions may include legally restricted deposits held as compensating balances against short-term borrowing arrangements, contracts entered into with others, or company statements of intention with regard to particular deposits; however, time deposits and short-term certificates of deposit are not generally included in legally restricted deposits. In cases where compensating balance arrangements exist but are not agreements which legally restrict the use of cash amounts shown on the balance sheet, describe in the notes to the financial statements these arrangements and the amount involved, if determinable, for the most recent audited balance sheet required and for any subsequent unaudited balance sheet required in the notes to the financial statements. Compensating balances that are maintained under an agreement to assure future credit availability shall be disclosed in the notes to the financial statements along with the amount and terms of such agreement.

As the SEC makes fairly clear, legal or contractual restrictions should be presented on the balance sheet while restrictions based solely on company intent should only be discussed in the footnotes.

If good enough for the SEC, good enough for us.

This also applies to cash equivalents and securities.

Since this restriction exceeded one year, XYZ reported the sinking fund (restricted cash) in non-current assets.

Note: if an order of liquidity balance sheet is prepared for IFRS purposes, the sinking fund would be reported in other financial assets (OtherFinancialAssets) not cash and cash equivalents (CashAndCashEquivalents).

In excel syntax (rounded): 21036 = 1000000/(((1+(1+3.5%)^(1/4) - 1)^40-1)/((1+3.5%)^(1/4) - 1)).

In excel syntax: 11250 = 1000000 * 4.5% / 4

6/30/X1 \| 30.6.X1
Bond sinking fund		21,218
	Cash		21,036
	Interest income		182
Interest expense		11,250
	Cash		11,250

P	Fund contribution	Accumulated contribution	Interest rate	Interest income	Interest payment
A	B	C=B+C_(C+1)+E	D=(1+3.5%)^1÷4-1	E=CxD	F
1	21,036	21,036	0.86%	0	11,250
2	21,036	42,254	0.86%	182	11,250
3	21,036	63,655	0.86%	365	11,250
-	-	-	-	-	-
39	21,036	970,580	0.86%	8,131	11,250
40	21,036	1,000,000	0.86%	8,383	11,250
	841,449				450,000

1,291,449 = 841,449 + 450,000

1/1/X1, XYZ leased office space for an indefinite term and collected a 100,000 security deposit. It kept the funds in separate account. 12/31/X10, the lessee vacated the premises and XYZ returned the deposit.

Although ASC 210-10-45-4.a suggests restricted cash need not be segregated at the bank account level, doing so is good practice. IFRS does not specifically discuss this issue.

Neither IFRS nor US GAAP define restricted cash but, in addition to security deposits, it may be associated with:

As discussed in ASU 2016-18, the EITF considered but rejected defining restricted cash.

Specifically, in BC8 (edited) it states: The Task Force considered, but rejected, classifying changes in restricted cash or restricted cash equivalents that result from transfers between cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents on the basis of either the nature of the restriction (that is, investing activities) or the purpose for the restriction. The Task Force believes that internal transfers between cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents do not represent a cash inflow or outflow of the entity because there is no cash receipt or cash payment with a source outside of the entity that affects the sum of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents...

Reading between the lines, what the EITF seems to be saying is: we would rather not define restricted cash because, to paraphrase Supreme Court Justice Potter Stewart, "You know it when you see it."

IFRS also eschews defining restricted cash, but fails to discuss its reasons.

Note: in addition to cash, cash equivalents or other securities may also be restricted.

Unlike a sinking fund (previous example), a security deposit is recognized point of time. Also unlike a sinking fund, it is not discounted.

Specifically, ASC 835-30-15-3.c exempts "amounts intended to provide security for one party to an agreement (for example, security deposits, retainages on contracts)" from ASC 835-30-55-2 to 55-3 (which prescribe the interest method) so the restricted cash associated with these items is recognized at nominal value.

While IFRS does not provide similar, blanket guidance on interest imputation, IFRS 15.62.c does specify that deposits whose purpose is to provide protection to a service provider, in this case a lessor, need not be discounted.

Note: as ASC 606 and IFRS 15 are converged standards, the same outcome could also be achieved by applying ASC 606-10-32-17.c instead of ASC 835-30-15-3.c.

Pensions
Sinking funds
Customer pre-payments
Compensating balances
Mandatory central bank deposits
Letters of credit or standby LOCs
Collateral
Escrow
Etc.

The only restriction specifically discussed in IFRS is (IAS 7.48 to 52): "cash equivalent balances held by a subsidiary that operates in a country where exchange controls or other legal restrictions apply when the balances are not available for general use by the parent or other subsidiaries." This issue is not addressed by US GAAP nor, as it is even less common than sinking funds, illustrated here.

Foreign exchange restrictions, controls, or other governmentally imposed uncertainties are addressed by ASC 810-10-15-10.a.1.iii, but this guidance applies to foreign subsidiaries, not just cash balances.

Dr / Cr

1/1/X1 \| 1.1.X1
Cash (restricted)		100,000
	Returnable security deposit		100,000

12/31/X10 \| 31.12.X10
Returnable security deposit		100,000
	Cash (restricted)		100,000

Same facts except XYZ kept the funds in a 3.5% CD account.

1/1/X1 \| 1.1.X1
Cash: CD (restricted)		100,000
	Returnable security deposit		100,000

3/31/X1 \| 31.3.X1
Cash: CD (restricted)		864
	Returnable security deposit		864

P	Opening	Interest rate	Interest	Closing
A	B=E_(E+1)	C=(1+3.5%)^(1/4)-1	D=B*C	E=B+D
1	100,000	0.86%	864	100,864
2	100,864	0.86%	871	101,735
-	-	-	-	-
39	138,654	0.86%	1,198	139,852
40	139,852	0.86%	1,208	141,060

For the sake of simplicity, this example assumes the interest rate remained constant throughout the lease term.

12/31/X10 \| 31.12.X10
Returnable security deposit		141,060
	Cash: CD (restricted)		141,060

Financial assets other than cash

Investments

Overall

Investments come in two basic forms:

Investments are either debt or equity. There is no middle ground. True, some instruments, such as bonds convertible into shares, may seem like a blend, but a convertible bond is just a plain vanilla bond with a derivative (the conversion option) stuck on.

Like a butterfly, it starts off as debt then, if the conditions are right, it metamorphoses into equity, takes wing and flies into blue and sunny skies.

Or at least that is the way it could be described if one were trying to be poetical.

Stripped of such flourishes, these types of investments are generally labeled hybrid.

Then, if one keeps adding features, they cross into the realm of exotic (below).

On initial examination, it may seem counterintuitive to call debt an investment. Debts are usually liabilities, not assets.

Nevertheless, a "debt investment" represents a creditor's claim to specified economic resources, most often cash, of a debtor. Thus, from the perspective of the creditor, a.k.a. debt investor, it is an asset even though, from the perspective of the debtor, it is a liability.

Debt investments may take various forms. The most common are financial instruments, e.g. bonds or promissory notes, and loan agreements.

Regardless of form, the salient characteristic of debt investments is that debt investors have priority over equity investors (below) in the event of bankruptcy.

Note: while loans have the same general economic characteristics as debt securities, notes and bonds, the accounting treatment differs sufficiently enough to warrant a separate sub-section.

Like debt investments (above), equity investments represent a claim to economic resources. Unlike debt investments, this claim is not to specified, pre-defined resources, but rather the resources that remain after the claims of creditors have been settled.

Equity investments most often take the form of shares of stock. However, they may also be a stake in limited liability company or share in a partnership.

Regardless of form, the salient characteristics of equity investments is their holders lack a claim to specific economic resources, and their claims are fulfilled only after debt investors have been satisfied.

While various classes of shares can exist, few have a palpable effect on the investor's accounting. One (minor) exception: puttable preferred (priority) shares. While the effect is not nearly as dramatic as on the issuer, which has to report them as liabilities, investors holding puttable preferred shares may need to bifurcate the investment, stripping out the put option and accounting for it as an embedded derivative (below).

ASC 480-10-25-4 states: A mandatorily redeemable financial instrument shall be classified as a liability unless the redemption is required to occur only upon the liquidation or termination of the reporting entity.

While not as succinct, IAS 32.16–20 (including recently added 16A–F) provide comparable guidance.

Debt
Equity

Once acquired, investment are:

These investments are initially measured at historical cost.

If an investment is acquired in a market transaction, common practice is to simply record the amount paid, its "historical cost," and move on. This practice generally yeilds an acceptable result.

Historically, the initial cost of assets, including investments, has been determined on the basis of arm's-length transactions. Over time, the guidance has evolved. Currently, the reference point is the orderly transaction between market participants discussed in IFRS 13 | ASC 820.

While the primary guidance for value is IFRS 13 | ASC 820, arm's-length transactions have not ceased to exist. For example, IAS 36 continues to mention market transactions, arm's-length transactions and orderly transactions. In the ASC, ASC 835-30-05-2 mentions both business transactions and bargained transactions entered into at arm's length. ASC 350-30-25-4 also mentions bargained exchange transactions that are conducted at arm's length, which provide reliable evidence about the existence and fair value of [in this case intangible] assets.

ASC 820-10-35-2A summarizes the key considerations for establishing fair value:

The asset or liability
The transaction
Market participants
The price
Application to nonfinancial assets
Application to liabilities and instruments classified in a reporting entity's shareholders' equity
Application to financial assets, financial liabilities, and nonfinancial items accounted for as derivatives under

While IFRS 9 fails to provide a similar summary, IFRS 9.15 to 56 do provide comparable guidance.

Generally, but not always. For example, IFRS 9.5.1.1 specifies that a financial asset or financial liability is initially measured at fair value plus or minus transaction costs unless that asset is carried at FVTPL in which case they would be expensed.

Unlike IFRS 9, US GAAP does not contain explicit guidance comparable to paragraph 5.1.1 regarding the treatment of transaction costs but relies on general accounting principles and practices to arrive at the same conclusion.

Nevertheless, the point is, when a financial instrument is acquired in an arm's-length transaction, its value is typically equal to the amount paid and would be recorded without adjustment. If it the instrument pays interest, the implied interest rate would be considered reasonable. However, if the instrument were not acquired in an arm's-length transaction, both its value and the any interest rate would need to be confirmed and, if they differed from fair value, adjusted.

If it was not acquired in such a transaction, its fair value is determined and it is initially measured at fair value.

Subsequently, they are remeasured to fair value at each balance sheet date.

Fair value is discussed in more detail on this page. However, the optimal way to determine fair value is on an active market.

IFRS | US GAAP defines active market: a market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis (a list of active markets is included in the first equity illustration below).

If an active market does not exist, accountants face more challenges. These are discussed throughout the page as they relate to particular issues.

The changes in fair value are recognized and reported as gains or losses.

Depending on whether the investment is debt or equity and on whether IFRS or US GAAP is being applied, these gains and losses are reported in either profit and loss (IFRS) or net income (US GAAP), or other comprehensive income (common to both).

The former are accumulated in retained earnings, the latter in a separate subsection of equity (the exact classification depends on whether IFRS or US GAAP disclosure guidance is being applied).

Note: under IFRS, the gains and losses that pass through OCI may or may not be recycled to P&L, depending on the nature of the underlying item.

IFRS versus US GAAP.

While similar, IFRS and US GAAP are not identical. Some differences are minor others major.

For example, while IFRS classifies financial assets as fair value through profit and loss (FVTPL), fair value through other comprehensive income (FVOCI) and amortized cost (AC). US GAAP classifies financial assets as trading, available-for-sale (AFS) and held-to-maturity (HTM). However, as investments classified as trading are remeasured to fair value and reported in net income, AFS at fair value through other comprehensive income and HTM at amortized cost, this difference is mostly semantic.

Previously to IFRS 9, IAS 38 used classification very similar to current ASC 320-10-25-1 namely (IAS 39(2008).45 edited):

financial assets at fair value through profit or loss
held-to-maturity investments
loans and receivables
available-for-sale financial assets

IFRS 9, however, eliminated the held-to-maturity / loans and receivables categories replacing them with amortized cost and the available-for-sale classification replacing it with fair value through other comprehensive income.

While it retained the old approach for debt instruments (FVOCI gains and losses are recycled to P&L like they were when they were AFS), it eliminated recycling for equity investments, though it did retain the (irrevocable) option to classify these investments as FVOCI.

For its part, US GAAP took a somewhat more drastic approach by eliminating the AFS option for equity investments altogether.

So, FVOCI and AFS can still be considered synonyms, but only in the context of debt investments.

For example, IFRS requires all equity investments to be remeasured to fair value and offers the (irrevocable) option to classify then as FVOCI. US GAAP no longer offers an AFS option for equity investments but does allow them to be carried at cost less impairment (except by investment companies).

More broadly, IFRS tends to emphasize the economics of transactions, whereas ASC focuses more on explicit contractual terms.

This difference is subtle but pervasive. For example, comparing the IFRS | US GAAP definition of an effective interest rate one notices that the latter starts with the contractual interest rate while the former with estimated future cash payments or receipts. Digging deeper, one also notices that the former even finds contractual terms somewhat distasteful by specifying that contractual cash flows can be used but only in those rare cases when it is not possible to reliably estimate the cash flows or the expected life.

Emphasis added: The rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortised cost of a financial liability. When calculating the effective interest rate, an entity shall estimate the expected cash flows by considering all the contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) but shall not consider the expected credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate (see paragraphs B5.4.1–B5.4.3), transaction costs, and all other premiums or discounts. There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be estimated reliably. However, in those rare cases when it is not possible to reliably estimate the cash flows or the expected life of a financial instrument (or group of financial instruments), the entity shall use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments).

Emphasis added: The rate of return implicit in the financial asset, that is, the contractual interest rate adjusted for any net deferred fees or costs, premium, or discount existing at the origination or acquisition of the financial asset. For purchased financial assets with credit deterioration, however, to decouple interest income from credit loss recognition, the premium or discount at acquisition excludes the discount embedded in the purchase price that is attributable to the acquirer's assessment of credit losses at the date of acquisition.

To some extent, US GAAP's preference for contractual terms is anderstandable given the SEC's predilection for legal form, a common characteristic of most governmental agencies, and its close working relationship with the FASB.

Evidenced by, for example, the FASB's decision to include the SEC's guidance in the ASC, which some go as far as calling kowtowing.

Another difference often mentioned as major is IFRS 9.4.2A (particularly the business model test in subparagraph a) versus ASC 320-10-25-1 (particularly subparagraphs a and b), which some interpret to mean US GAAP allows entities to use AFS (above) willy nilly.

ASC 320-10-25-1 (edited, emphasis added) states: At acquisition, an entity shall classify debt securities into one of the following three categories:

Trading securities. If a security is acquired with the intent of selling it within hours or days, the security shall be classified as trading. However, at acquisition an entity is not precluded from classifying as trading a security it plans to hold for a longer period. Classification of a security as trading shall not be precluded simply because the entity does not intend to sell it in the near term.
Available-for-sale securities. Investments in debt securities not classified as trading securities or as held-to-maturity securities shall be classified as available-for-sale securities.

Some interpret this wording to suggest that unless the company is a day trader, it can classify all its investments as AFS.

And, in the past, before AFS was restricted to just debt securities, this may have been true. However, given that current US GAAP does not allow equity investments to be classified as AFS, its guidance is objectively stricter than IFRS, at least as far as equity investments go.

Further details and additional differences are explored throughout this section.

As above, these investments are initially measured at historical cost.

If an investment is acquired in a market transaction, common practice is to simply record the amount paid, its "historical cost," and move on. This practice generally yeilds an acceptable result.

ASC 820-10-35-2A summarizes the key considerations for establishing fair value:

The asset or liability
The transaction
Market participants
The price
Application to nonfinancial assets
Application to liabilities and instruments classified in a reporting entity's shareholders' equity
Application to financial assets, financial liabilities, and nonfinancial items accounted for as derivatives under

While IFRS 9 fails to provide a similar summary, IFRS 9.15 to 56 do provide comparable guidance.

Nevertheless, the point is, if for example debt instrument is acquired in an arm's-length transaction its value would typically equal the transaction price and would be recorded without adjustment. Similarly, the implied interest rate would be a priori reasonable. However, if it were not acquired in an arm's-length transaction both its value and the interest rate would need to be confirmed and, if they differed from fair value, adjusted.

A similar approach applies to evaluating equity investments, though in this case, interest rate considerations are not relevant.

If it was not acquired in such a transaction, its fair value is determined and it is initially measured at fair value.

Unlike above, these investments are not subsequently remeasured, but accounted for at amortized cost.

Amortized cost accounting begins by assuming that the historical cost of an investment equals the present value of cash flows associated with the investment.

If the interest rate implied by this present value is reasonable, the investment is recognized at its nominal value. Subsequently, any interest received is recorded as interest revenue without adjustment.

However, if the implicit rate is not reasonable, the investment is recognized at its present value determined using an imputed interest rate. The difference between this present value and the investment's nominal value (discount, premium or deferred interest) is then amortized using the effective interest method. This amortization adjusts the amount of interest revenue recognized.

In the ASC, the imputation of imputed interest is so important that it deserves its own sub-topic: ASC 835-30.

While it would have been nice if IFRS had followed suit, unfortunately, it does not discuss "imputation" or even address the issue in the core standard. So, instead of a nice, memorable term such as "imputed interest" to describe situations where an entity determines that the fair value at initial recognition differs from the transaction price (with reference to IFRS 9's B section). Fortunately, once there IFRS 9.B5.1.2A provides guidance that leads to the same result as ASC 835-30.

Determining and using an imputed rate not only fulfills the specific guidance outlined in ASC 835-30 | IFRS 9.B5.1.2A, but also the general fair value guidance discussed above.

IFRS versus US GAAP

While similar, IFRS and US GAAP are not identical. Some differences are major, others minor.

Perhaps the most obvious difference is how the two standards treat equity investments.

Under IFRS 9, all equity investments are remeasured to fair value, but may be reported either FVPL or FVOCI (although the FVOCI election is irrevocable).

Under ASC 321, equity investments are remeasured to fair value with no option to report remeasurement gains and losses in OCI. However entities may elect to measure equity investments without readily determinable fair values at cost less impairment. In addition, entities that do remeasure to fair value have the option (ASC 820-10-35-59) to apply a simplified net asset value per share approach, which IFRS does not offer.

Note: this difference mostly disappears at investment companies that apply ASC 946, because this topic requires fair value. However, the ASC 820-10-35-59 option is available to all entities.

More broadly, IFRS tends towards the economics of transactions, while the ASC prefers to focus on explicit contractual terms.

US GAAP's preference for contractual terms is further reinforced by the SEC's predilection for legal form, a common characteristic of most governmental agencies, and its close working relationship with the FASB.

Evidenced by, for example, the FASB's decision to include the SEC's guidance in the ASC, which some go as far as calling kowtowing.

Some may consider the IFRS versus US GAAP approach to impairment a major difference. Specifically, IFRS uses a so-called two bucket approach, while US GAAP prefers to dance with CECL.

Somewhat confusingly, the "two bucket" approach actually comprises three stages.

In the first bucket, stage one impairments on assets with normal credit risk (12-month expected credit losses) are recognized.

In the second bucket, stage two impairments (assets with significant credit risk increase, lifetime expected credit losses) and stage three impairments (credit-impaired assets—lifetime expected credit losses, along with interest income calculated on the net basis) are recognized.

The current expected credit loss model requires entities to estimate lifetime expected credit losses for most financial assets right from initial recognition, regardless of changes in credit risk

While some argue that US GAAP’s single-stage approach is more conservative, given its immediate recognition of lifetime expected credit losses, its overall impact compared to IFRS’s three-stage model is often marginal. Some argue that US GAAP’s single-stage approach is more conservative due to its immediate recognition of lifetime expected credit losses. However, its overall impact compared to IFRS’s three-stage model is often marginal.

Further details and additional differences are explored throughout this section.

Remeasured
Not remeasured

While not merely semantic, IFRS 9 does devote 4 paragraphs (B3.1.3 to B3.1.6) to the marginal issue of trade date versus settlement date accounting. The ASC briefly touches on the topic in ASC 940, 942, and 946 for banks, broker-dealers, and investment companies.

An even more marginal difference, IFRS 9 does devote 4 paragraphs (B3.1.3 to B3.1.6) to the marginal issue of trade date versus settlement date accounting while ASC only briefly on the issue in ASC 940, 942, and 946 for banks, broker-dealers, and investment companies.

Loan

1/1/X1, XYZ lent ABC 500,000. The loan agreement specified an interest rate of 7.5% and annual repayments of 123,582.

The loan agreement was entered into at arm's length so the explicit interest rate equaled the implicit rate and XYZ had no need to determine an imputed rate.

Although IFRS 13 and ASC 820 provide the default guidance on determining value, rather than confirming whether its agreement with ABC qualified as an orderly transaction between market participants, XYZ went old-school. It considered whether it and ABC were unrelated (they were), whether it and ABC were fully informed (they were), and whether it and ABC had acted voluntarily (they did).

Although gradually phased out, arm’s length transactions are still near and dear to the hearts of many accountants who find that the modern version, the orderly transactions between market participants, doesn't exactly roll off the tongue.

The determination of an asset’s initial cost, encompassing both investment-related assets and broader asset categories, has traditionally been grounded in the application of transactions conducted at arm’s length. This principle, which ensures that transactions occur between independent entities without coercion, undue influence, or related-party considerations, has historically been regarded as an essential mechanism for establishing fair and unbiased valuation metrics in financial reporting. However, over successive iterations of financial accounting guidance, the emphasis has progressively shifted toward reliance on orderly transactions between market participants, which now constitute the primary reference framework for fair value measurement, as articulated in IFRS 13.15–23 and ASC 820-10-35-3 to 9. These standards explicitly define fair value as the price that would be received in a hypothetical sale conducted within an orderly, structured market, reinforcing the notion that valuation should reflect market conditions devoid of distress or compulsion.

Despite this fundamental shift, arm’s length transactions continue to maintain a residual presence in various accounting standards and financial reporting frameworks. Although their conceptual prominence has diminished, they are still referenced in multiple contexts, particularly in relation to impairment assessments, business combinations, and intangible asset valuation methodologies. For example, IAS 36, which governs impairment of assets, continues to incorporate terminology related to market transactions, orderly transactions, and arm’s length transactions as part of its broader valuation considerations. Additionally, under the Accounting Standards Codification (ASC) framework, ASC 835-30-05-2 explicitly references business transactions and bargained transactions executed at arm’s length, underscoring the ongoing relevance of independent market-driven transactions in certain financial contexts. Similarly, ASC 350-30-25-4 retains a reliance on bargained exchange transactions conducted at arm’s length as a means of providing reliable and objectively verifiable evidence regarding both the existence and fair value of intangible assets.

It is important to note that neither IFRS nor US GAAP include an explicit, formalized definition of the term "arm’s length transaction." Consequently, the most widely recognized authoritative definition originates from the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines, which provide extensive documentation on the application of arm’s length pricing in the context of international taxation and corporate transfer pricing arrangements. The OECD Transfer Pricing Guidelines (link) establish the principle that transactions between related enterprises should be conducted in a manner that reflects terms equivalent to those that would exist between independent market participants, ensuring equitable treatment across jurisdictions in taxation and corporate reporting. However, it should be noted that while the OECD definition serves as the most widely recognized reference point, its primary application pertains to taxation and cross-border transfer pricing rather than financial reporting under IFRS or US GAAP frameworks.

Orderly transactions between market participants are discussed in IFRS 13.15–23 | ASC 820-10-35-3 to 9 and are currently the primary method of determining fair value.

Since the agreement was at arm's length, XYZ concluded 7.5% was fair and adequate, and called it a day.

Although, orderly transactions between market participants (above) are the primary method of determining fair value, ASC 835-30-05-2 (edited, emphasis added) continues to state: ... When a note is exchanged for property, goods, or service in a bargained transaction entered into at arm's length, there should be a general presumption that the rate of interest stipulated by the parties to the transaction represents fair and adequate compensation to the supplier for the use of the related funds...

Note: while IFRS does not dedicate a standard, or even a section of a standard, to interest imputation, the guidance in IFRS 9.B5.1.2A leads to a comparable result.

An explicit or stated interest rate is the interest rate specified in the loan agreement.

An implicit interest rate is the interest rate implied by the cash flows associated with the loan agreement.

If the timing of the payments is regular and amounts equal, the simplest way to calculate the implicit rate is:

7.5%=RATE(5,-123582,500000,0,0,1%) or, since the [guess] is optional, 7.5%=RATE(5,-123582,500000,0,0).

Alternatively, it can also be calculated using the =irr function, but some setup is required:

Row	Period	Cash flow
	A	B
1	0	(500,000.00)
2	1	123,582
3	2	123,582
4	3	123,582
5	4	123,582
6	5	123,582
		=IRR(B1:B6) equals: 7.50%

This method is more versatile, so can be used if the amounts vary:

Row	Period	Cash flow
	A	B
1	0	(500,000.00)
2	1	123,500
3	2	123,400
4	3	123,300
5	4	123,800
6	5	124,000
		=IRR(B1:B6) equals: 7.50%

If both the timing and amounts vary, =xirr allows the input to be expanded to include exact dates:

Row	Period	Cash flow
	A	B
1	0 01/01/2001	(500,000.00)
2	1 12/30/2001	123,500
3	2 01/06/2003	123,400
4	3 01/10/2004	123,300
5	4 12/20/2004	123,800
6	5 12/31/2005	124,000
		=XIRR(B1:B6,A1:A6) equals: 7.50%

Alternatively, one can use the tried-and-tested trial-and-error method (my preferred approach).

Note: as anyone old enough to remember this method is also old enough to know how to use it, an illustration is unnecessary.

Also note: anyone old enough to remember being taught to use extrapolation tables like the ones found in old Intermediate Accounting textbooks, should learn to use a better method.

US GAAP places significant emphasis on interest imputation, dedicating an entire sub-topic (ASC 835-30). By comparison, IFRS briefly addresses the issue, providing only a single paragraph (IFRS 9.B5.1.2A) that does not even mention imputation by name. However, when applied correctly, both frameworks yield comparable results.

1/1/X1 \| 1.1.X1
Loan		500,000
	Cash		500,000

12/31/X1 \| 31.12.X1
Cash		123,582
	Interest income		37,500
	Loan		86,082

Period	Loan	Interest rate	Interest	Payment	Amortization
A	B = B_(B+1) - E	C	D = B x C	E	F = E - D
1	500,000	7.50%	37,500	123,582	86,082
2	413,918	7.50%	31,044	123,582	92,539
3	321,379	7.50%	24,103	123,582	99,479
4	221,900	7.50%	16,643	123,582	106,940
5	114,960	7.50%	8,622	123,582	114,960
					500,000

12/31/X5 \| 31.12.X5
Cash		123,582
	Interest income		8,622
	Loan		114,960

Same facts except with monthly payments.

1/1/X1 \| 1.1.X1
Loan		500,000
	Cash		500,000

1/31/X1 \| 31.1.X1
Cash		9,961
	Interest income		3,022
	Loan		6,938

In excel syntax: 9961=ROUND(500000/((1-(1/(1+((1+7.5%)^(1/12)-1))^(5*12)))/((1+7.5%)^(1/12)-1)),0).

Period	Principal	Interim rate	Interest	Payment	Amortization
B	B = B_{(b-1) - E}	C = (1 + 7.5%)^1÷12 - 1	D = B x C	E = D - C	E = D - C
1	500,000	0.604%	3,022	9,961	6,938
2	493,062	0.604%	2,981	9,961	6,980
3	486,082	0.604%	2,938	9,961	7,022
4	479,059	0.604%	2,896	9,961	7,065
5	471,995	0.604%	2,853	9,961	7,107
6	464,887	0.604%	2,810	9,961	7,150
7	457,737	0.604%	2,767	9,961	7,194
8	450,543	0.604%	2,723	9,961	7,237
9	443,306	0.604%	2,680	9,961	7,281
10	436,025	0.604%	2,636	9,961	7,325
11	428,700	0.604%	2,591	9,961	7,369
12	421,331	0.604%	2,547	9,961	7,414
13	413,918	0.604%	2,502	9,961	7,459
14	406,459	0.604%	2,457	9,961	7,504
15	398,956	0.604%	2,412	9,961	7,549
16	391,407	0.604%	2,366	9,961	7,595
17	383,812	0.604%	2,320	9,961	7,640
18	376,172	0.604%	2,274	9,961	7,687
19	368,485	0.604%	2,227	9,961	7,733
20	360,752	0.604%	2,181	9,961	7,780
21	352,972	0.604%	2,134	9,961	7,827
22	345,145	0.604%	2,086	9,961	7,874
23	337,271	0.604%	2,039	9,961	7,922
24	329,349	0.604%	1,991	9,961	7,970
25	321,379	0.604%	1,943	9,961	8,018
26	313,361	0.604%	1,894	9,961	8,066
27	305,295	0.604%	1,845	9,961	8,115
28	297,180	0.604%	1,796	9,961	8,164
29	289,016	0.604%	1,747	9,961	8,214
30	280,802	0.604%	1,697	9,961	8,263
31	272,539	0.604%	1,647	9,961	8,313
32	264,226	0.604%	1,597	9,961	8,363
33	255,862	0.604%	1,547	9,961	8,414
34	247,448	0.604%	1,496	9,961	8,465
35	238,984	0.604%	1,445	9,961	8,516
36	230,468	0.604%	1,393	9,961	8,567
37	221,900	0.604%	1,341	9,961	8,619
38	213,281	0.604%	1,289	9,961	8,671
39	204,610	0.604%	1,237	9,961	8,724
40	195,886	0.604%	1,184	9,961	8,776
41	187,109	0.604%	1,131	9,961	8,830
42	178,280	0.604%	1,078	9,961	8,883
43	169,397	0.604%	1,024	9,961	8,937
44	160,460	0.604%	970	9,961	8,991
45	151,470	0.604%	916	9,961	9,045
46	142,425	0.604%	861	9,961	9,100
47	133,325	0.604%	806	9,961	9,155
48	124,170	0.604%	751	9,961	9,210
49	114,960	0.604%	695	9,961	9,266
50	105,695	0.604%	639	9,961	9,322
51	96,373	0.604%	583	9,961	9,378
52	86,995	0.604%	526	9,961	9,435
53	77,560	0.604%	469	9,961	9,492
54	68,068	0.604%	411	9,961	9,549
55	58,519	0.604%	354	9,961	9,607
56	48,912	0.604%	296	9,961	9,665
57	39,248	0.604%	237	9,961	9,723
58	29,524	0.604%	178	9,961	9,782
59	19,742	0.604%	119	9,961	9,841
60	9,901	0.604%	60	9,961	9,901
					500,000

The explicit and implicit rates were not equal.

Although the loan agreement specified a 7.5% annual rate, XYZ calculated the payment using simple interim interest (0.625% = 7.5% ÷ 12) instead of effective interim interest (0.604% = (1 + 7.5%)^(1÷12) - 1) resulting in a payment of 10,019 rather than 9,961. The implicit annual rate was thus 7.76% = (1 + 0.625%)¹²-1, while the explicit annual rate was 7.5%.

In excel syntax: 10019=ROUND(500000*((0.00625*(1+0.00625)^60)/((1+0.00625)^60-1)),0).

Note: the question is, why was this approach chosen? Was it due to a lack of mathematical finesse or because it led to higher payments? Hard to say. But I do have personal experience with a broker that calculates its margin interest this way. Given that running brokerages usually requires some degree of mathematical finesse, the answer seems, in this situation, obvious.

In excel syntax: 9961=ROUND(500000/((1-(1/(1+((1+7.5%)^(1/12)-1))^(5*12)))/((1+7.5%)^(1/12)-1)),0).

Nevertheless, since ABC agreed to pay 10,019, XYZ recorded:

1/1/X1 \| 1.1.X1
Loan		500,000
	Cash		500,000

1/31/X1 \| 31.1.X1
Cash		10,019
	Interest income		3,125
	Loan		6,894

In excel syntax: 9961=ROUND(500000/((1-(1/(1+((1+7.5%)^(1/12)-1))^(5*12)))/((1+7.5%)^(1/12)-1)),0).

Period	Principal	Interim rate	Interest	Payment	Amortization
A	B = B_{(B-1) - E}	C	D = B x C	E	F = E - D
1	500,000	0.625%	3,125	10,019	6,894
2	493,106	0.625%	3,082	10,019	6,937
3	486,169	0.625%	3,039	10,019	6,980
4	479,189	0.625%	2,995	10,019	7,024
5	472,164	0.625%	2,951	10,019	7,068
6	465,097	0.625%	2,907	10,019	7,112
7	457,984	0.625%	2,862	10,019	7,157
8	450,828	0.625%	2,818	10,019	7,201
9	443,627	0.625%	2,773	10,019	7,246
10	436,380	0.625%	2,727	10,019	7,292
11	429,089	0.625%	2,682	10,019	7,337
12	421,751	0.625%	2,636	10,019	7,383
13	414,368	0.625%	2,590	10,019	7,429
14	406,939	0.625%	2,543	10,019	7,476
15	399,464	0.625%	2,497	10,019	7,522
16	391,941	0.625%	2,450	10,019	7,569
17	384,372	0.625%	2,402	10,019	7,617
18	376,755	0.625%	2,355	10,019	7,664
19	369,091	0.625%	2,307	10,019	7,712
20	361,379	0.625%	2,259	10,019	7,760
21	353,618	0.625%	2,210	10,019	7,809
22	345,810	0.625%	2,161	10,019	7,858
23	337,952	0.625%	2,112	10,019	7,907
24	330,045	0.625%	2,063	10,019	7,956
25	322,089	0.625%	2,013	10,019	8,006
26	314,083	0.625%	1,963	10,019	8,056
27	306,027	0.625%	1,913	10,019	8,106
28	297,921	0.625%	1,862	10,019	8,157
29	289,764	0.625%	1,811	10,019	8,208
30	281,556	0.625%	1,760	10,019	8,259
31	273,297	0.625%	1,708	10,019	8,311
32	264,986	0.625%	1,656	10,019	8,363
33	256,623	0.625%	1,604	10,019	8,415
34	248,208	0.625%	1,551	10,019	8,468
35	239,740	0.625%	1,498	10,019	8,521
36	231,220	0.625%	1,445	10,019	8,574
37	222,646	0.625%	1,392	10,019	8,627
38	214,018	0.625%	1,338	10,019	8,681
39	205,337	0.625%	1,283	10,019	8,736
40	196,601	0.625%	1,229	10,019	8,790
41	187,811	0.625%	1,174	10,019	8,845
42	178,966	0.625%	1,119	10,019	8,900
43	170,065	0.625%	1,063	10,019	8,956
44	161,109	0.625%	1,007	10,019	9,012
45	152,097	0.625%	951	10,019	9,068
46	143,029	0.625%	894	10,019	9,125
47	133,904	0.625%	837	10,019	9,182
48	124,722	0.625%	780	10,019	9,239
49	115,482	0.625%	722	10,019	9,297
50	106,185	0.625%	664	10,019	9,355
51	96,830	0.625%	605	10,019	9,414
52	87,416	0.625%	546	10,019	9,473
53	77,943	0.625%	487	10,019	9,532
54	68,412	0.625%	428	10,019	9,591
55	58,820	0.625%	368	10,019	9,651
56	49,169	0.625%	307	10,019	9,712
57	39,457	0.625%	247	10,019	9,772
58	29,685	0.625%	186	10,019	9,833
59	19,851	0.625%	124	10,019	9,895
60	9,956	0.625%	62	10,019	9,957
					500,000

The monthly payment was correct, but XYZ's accountant was inexperienced.

While XYZ's finance department calculated the payment correctly (above), the junior accountant tasked with recognizing the loan was fresh out of university in a jurisdiction where simple interest was standard practice and drafted an amortization schedule the way they were taught. Puzzled why it kept yielding a balance of 4,233, they showed it to the supervisor. Rather than getting angry, the supervisor simply pointed out that, unlike national GAAP, IFRS | US GAAP does not recognize simple interest.

Period	Loan	Interest rate	Interest	Payment	Amortization
A	B = B(B+1) - E	C = 7.5% ÷ 12	D = B x C	E	F = E - D
1	500,000	0.625%	3,125	9,961	6,836
2	493,164	0.625%	3,082	9,961	6,878
3	486,286	0.625%	3,039	9,961	6,921
4	479,365	0.625%	2,996	9,961	6,965
5	472,400	0.625%	2,953	9,961	7,008
6	465,392	0.625%	2,909	9,961	7,052
7	458,340	0.625%	2,865	9,961	7,096
8	451,244	0.625%	2,820	9,961	7,140
9	444,104	0.625%	2,776	9,961	7,185
10	436,919	0.625%	2,731	9,961	7,230
11	429,689	0.625%	2,686	9,961	7,275
12	422,414	0.625%	2,640	9,961	7,321
13	415,093	0.625%	2,594	9,961	7,366
14	407,727	0.625%	2,548	9,961	7,412
15	400,315	0.625%	2,502	9,961	7,459
16	392,856	0.625%	2,455	9,961	7,505
17	385,351	0.625%	2,408	9,961	7,552
18	377,799	0.625%	2,361	9,961	7,599
19	370,199	0.625%	2,314	9,961	7,647
20	362,553	0.625%	2,266	9,961	7,695
21	354,858	0.625%	2,218	9,961	7,743
22	347,115	0.625%	2,169	9,961	7,791
23	339,324	0.625%	2,121	9,961	7,840
24	331,484	0.625%	2,072	9,961	7,889
25	323,595	0.625%	2,022	9,961	7,938
26	315,657	0.625%	1,973	9,961	7,988
27	307,670	0.625%	1,923	9,961	8,038
28	299,632	0.625%	1,873	9,961	8,088
29	291,544	0.625%	1,822	9,961	8,138
30	283,406	0.625%	1,771	9,961	8,189
31	275,216	0.625%	1,720	9,961	8,241
32	266,976	0.625%	1,669	9,961	8,292
33	258,684	0.625%	1,617	9,961	8,344
34	250,340	0.625%	1,565	9,961	8,396
35	241,944	0.625%	1,512	9,961	8,448
36	233,495	0.625%	1,459	9,961	8,501
37	224,994	0.625%	1,406	9,961	8,554
38	216,440	0.625%	1,353	9,961	8,608
39	207,832	0.625%	1,299	9,961	8,662
40	199,170	0.625%	1,245	9,961	8,716
41	190,454	0.625%	1,190	9,961	8,770
42	181,684	0.625%	1,136	9,961	8,825
43	172,859	0.625%	1,080	9,961	8,880
44	163,979	0.625%	1,025	9,961	8,936
45	155,043	0.625%	969	9,961	8,992
46	146,052	0.625%	913	9,961	9,048
47	137,004	0.625%	856	9,961	9,104
48	127,899	0.625%	799	9,961	9,161
49	118,738	0.625%	742	9,961	9,218
50	109,520	0.625%	684	9,961	9,276
51	100,244	0.625%	627	9,961	9,334
52	90,910	0.625%	568	9,961	9,392
53	81,517	0.625%	509	9,961	9,451
54	72,066	0.625%	450	9,961	9,510
55	62,556	0.625%	391	9,961	9,570
56	52,986	0.625%	331	9,961	9,629
57	43,357	0.625%	271	9,961	9,690
58	33,667	0.625%	210	9,961	9,750
59	23,917	0.625%	149	9,961	9,811
60	14,106	0.625%	88	9,961	9,872
					495,767

Period	Principal	Interim rate	Interest	Payment	Amortization
B	B = B_{(b-1) - E}	C = (1 + 7.5%)^1÷12 - 1	D = B x C	E = D - C	E = D - C
1	500,000	0.604%	3,022	9,961	6,938
2	493,062	0.604%	2,981	9,961	6,980
3	486,082	0.604%	2,938	9,961	7,022
4	479,059	0.604%	2,896	9,961	7,065
5	471,995	0.604%	2,853	9,961	7,107
6	464,887	0.604%	2,810	9,961	7,150
7	457,737	0.604%	2,767	9,961	7,194
8	450,543	0.604%	2,723	9,961	7,237
9	443,306	0.604%	2,680	9,961	7,281
10	436,025	0.604%	2,636	9,961	7,325
11	428,700	0.604%	2,591	9,961	7,369
12	421,331	0.604%	2,547	9,961	7,414
13	413,918	0.604%	2,502	9,961	7,459
14	406,459	0.604%	2,457	9,961	7,504
15	398,956	0.604%	2,412	9,961	7,549
16	391,407	0.604%	2,366	9,961	7,595
17	383,812	0.604%	2,320	9,961	7,640
18	376,172	0.604%	2,274	9,961	7,687
19	368,485	0.604%	2,227	9,961	7,733
20	360,752	0.604%	2,181	9,961	7,780
21	352,972	0.604%	2,134	9,961	7,827
22	345,145	0.604%	2,086	9,961	7,874
23	337,271	0.604%	2,039	9,961	7,922
24	329,349	0.604%	1,991	9,961	7,970
25	321,379	0.604%	1,943	9,961	8,018
26	313,361	0.604%	1,894	9,961	8,066
27	305,295	0.604%	1,845	9,961	8,115
28	297,180	0.604%	1,796	9,961	8,164
29	289,016	0.604%	1,747	9,961	8,214
30	280,802	0.604%	1,697	9,961	8,263
31	272,539	0.604%	1,647	9,961	8,313
32	264,226	0.604%	1,597	9,961	8,363
33	255,862	0.604%	1,547	9,961	8,414
34	247,448	0.604%	1,496	9,961	8,465
35	238,984	0.604%	1,445	9,961	8,516
36	230,468	0.604%	1,393	9,961	8,567
37	221,900	0.604%	1,341	9,961	8,619
38	213,281	0.604%	1,289	9,961	8,671
39	204,610	0.604%	1,237	9,961	8,724
40	195,886	0.604%	1,184	9,961	8,776
41	187,109	0.604%	1,131	9,961	8,830
42	178,280	0.604%	1,078	9,961	8,883
43	169,397	0.604%	1,024	9,961	8,937
44	160,460	0.604%	970	9,961	8,991
45	151,470	0.604%	916	9,961	9,045
46	142,425	0.604%	861	9,961	9,100
47	133,325	0.604%	806	9,961	9,155
48	124,170	0.604%	751	9,961	9,210
49	114,960	0.604%	695	9,961	9,266
50	105,695	0.604%	639	9,961	9,322
51	96,373	0.604%	583	9,961	9,378
52	86,995	0.604%	526	9,961	9,435
53	77,560	0.604%	469	9,961	9,492
54	68,068	0.604%	411	9,961	9,549
55	58,519	0.604%	354	9,961	9,607
56	48,912	0.604%	296	9,961	9,665
57	39,248	0.604%	237	9,961	9,723
58	29,524	0.604%	178	9,961	9,782
59	19,742	0.604%	119	9,961	9,841
60	9,901	0.604%	60	9,961	9,901
					500,000

Same facts except the loan carried an adjustable interest rate.

While monthly is more common, a quarterly reset makes schedules easier to read.

With the initial annual 7.50% rate.

Period	Loan	Interest rate	Interest	Payment	Amortization
A	B = B_(B+1) - E	C = (1 + 7.5%)^1÷12 - 1	D = B x C	E	F = E - D
1	500,000	0.604%	3,022	9,961	6,938
2	493,062	0.604%	2,981	9,961	6,980
3	486,082	0.604%	2,938	9,961	7,022
4	479,059	0.604%	2,896	9,961	7,065
5	471,995	0.604%	2,853	9,961	7,107
6	464,887	0.604%	2,810	9,961	7,150
7	457,737	0.604%	2,767	9,961	7,194
8	450,543	0.604%	2,723	9,961	7,237
9	443,306	0.604%	2,680	9,961	7,281
10	436,025	0.604%	2,636	9,961	7,325
11	428,700	0.604%	2,591	9,961	7,369
12	421,331	0.604%	2,547	9,961	7,414
13	413,918	0.604%	2,502	9,961	7,459
14	406,459	0.604%	2,457	9,961	7,504
15	398,956	0.604%	2,412	9,961	7,549
16	391,407	0.604%	2,366	9,961	7,595
17	383,812	0.604%	2,320	9,961	7,640
18	376,172	0.604%	2,274	9,961	7,687
19	368,485	0.604%	2,227	9,961	7,733
20	360,752	0.604%	2,181	9,961	7,780
21	352,972	0.604%	2,134	9,961	7,827
22	345,145	0.604%	2,086	9,961	7,874
23	337,271	0.604%	2,039	9,961	7,922
24	329,349	0.604%	1,991	9,961	7,970
25	321,379	0.604%	1,943	9,961	8,018
26	313,361	0.604%	1,894	9,961	8,066
27	305,295	0.604%	1,845	9,961	8,115
28	297,180	0.604%	1,796	9,961	8,164
29	289,016	0.604%	1,747	9,961	8,214
30	280,802	0.604%	1,697	9,961	8,263
31	272,539	0.604%	1,647	9,961	8,313
32	264,226	0.604%	1,597	9,961	8,363
33	255,862	0.604%	1,547	9,961	8,414
34	247,448	0.604%	1,496	9,961	8,465
35	238,984	0.604%	1,445	9,961	8,516
36	230,468	0.604%	1,393	9,961	8,567
37	221,900	0.604%	1,341	9,961	8,619
38	213,281	0.604%	1,289	9,961	8,671
39	204,610	0.604%	1,237	9,961	8,724
40	195,886	0.604%	1,184	9,961	8,776
41	187,109	0.604%	1,131	9,961	8,830
42	178,280	0.604%	1,078	9,961	8,883
43	169,397	0.604%	1,024	9,961	8,937
44	160,460	0.604%	970	9,961	8,991
45	151,470	0.604%	916	9,961	9,045
46	142,425	0.604%	861	9,961	9,100
47	133,325	0.604%	806	9,961	9,155
48	124,170	0.604%	751	9,961	9,210
49	114,960	0.604%	695	9,961	9,266
50	105,695	0.604%	639	9,961	9,322
51	96,373	0.604%	583	9,961	9,378
52	86,995	0.604%	526	9,961	9,435
53	77,560	0.604%	469	9,961	9,492
54	68,068	0.604%	411	9,961	9,549
55	58,519	0.604%	354	9,961	9,607
56	48,912	0.604%	296	9,961	9,665
57	39,248	0.604%	237	9,961	9,723
58	29,524	0.604%	178	9,961	9,782
59	19,742	0.604%	119	9,961	9,841
60	9,901	0.604%	60	9,961	9,901
					500,000

At the end of Q1, the rate reset to 7.75%.

Period	Loan	Interest rate	Interest	Payment	Amortization	IRR
A	B = B(B+1) - E	C	D = B x C	E	F = E - D	G
1	500,000	0.604%	3,022	9,961	6,938
2	493,062	0.604%	2,981	9,961	6,980
3	486,082	0.604%	2,938	9,961	7,022	(479,059)
4	479,059	0.624%	2,989	10,013	7,024	10,013
5	472,035	0.624%	2,945	10,013	7,068	10,013
6	464,967	0.624%	2,901	10,013	7,112	10,013
7	457,855	0.624%	2,857	10,013	7,157	10,013
8	450,698	0.624%	2,812	10,013	7,201	10,013
9	443,497	0.624%	2,767	10,013	7,246	10,013
10	436,251	0.624%	2,722	10,013	7,291	10,013
11	428,959	0.624%	2,677	10,013	7,337	10,013
12	421,622	0.624%	2,631	10,013	7,383	10,013
13	414,240	0.624%	2,585	10,013	7,429	10,013
14	406,811	0.624%	2,538	10,013	7,475	10,013
15	399,336	0.624%	2,492	10,013	7,522	10,013
16	391,814	0.624%	2,445	10,013	7,569	10,013
17	384,246	0.624%	2,398	10,013	7,616	10,013
18	376,630	0.624%	2,350	10,013	7,663	10,013
19	368,966	0.624%	2,302	10,013	7,711	10,013
20	361,255	0.624%	2,254	10,013	7,759	10,013
21	353,496	0.624%	2,206	10,013	7,808	10,013
22	345,688	0.624%	2,157	10,013	7,856	10,013
23	337,831	0.624%	2,108	10,013	7,906	10,013
24	329,926	0.624%	2,059	10,013	7,955	10,013
25	321,971	0.624%	2,009	10,013	8,004	10,013
26	313,967	0.624%	1,959	10,013	8,054	10,013
27	305,912	0.624%	1,909	10,013	8,105	10,013
28	297,807	0.624%	1,858	10,013	8,155	10,013
29	289,652	0.624%	1,807	10,013	8,206	10,013
30	281,446	0.624%	1,756	10,013	8,257	10,013
31	273,189	0.624%	1,705	10,013	8,309	10,013
32	264,880	0.624%	1,653	10,013	8,361	10,013
33	256,519	0.624%	1,601	10,013	8,413	10,013
34	248,106	0.624%	1,548	10,013	8,465	10,013
35	239,641	0.624%	1,495	10,013	8,518	10,013
36	231,123	0.624%	1,442	10,013	8,571	10,013
37	222,551	0.624%	1,389	10,013	8,625	10,013
38	213,927	0.624%	1,335	10,013	8,679	10,013
39	205,248	0.624%	1,281	10,013	8,733	10,013
40	196,515	0.624%	1,226	10,013	8,787	10,013
41	187,728	0.624%	1,171	10,013	8,842	10,013
42	178,886	0.624%	1,116	10,013	8,897	10,013
43	169,989	0.624%	1,061	10,013	8,953	10,013
44	161,036	0.624%	1,005	10,013	9,009	10,013
45	152,027	0.624%	949	10,013	9,065	10,013
46	142,962	0.624%	892	10,013	9,121	10,013
47	133,841	0.624%	835	10,013	9,178	10,013
48	124,662	0.624%	778	10,013	9,236	10,013
49	115,427	0.624%	720	10,013	9,293	10,013
50	106,134	0.624%	662	10,013	9,351	10,013
51	96,782	0.624%	604	10,013	9,410	10,013
52	87,373	0.624%	545	10,013	9,468	10,013
53	77,904	0.624%	486	10,013	9,527	10,013
54	68,377	0.624%	427	10,013	9,587	10,013
55	58,790	0.624%	367	10,013	9,647	10,013
56	49,144	0.624%	307	10,013	9,707	10,013
57	39,437	0.624%	246	10,013	9,767	10,013
58	29,669	0.624%	185	10,013	9,828	10,013
59	19,841	0.624%	124	10,013	9,890	10,013
60	9,951	0.624%	62	10,013	9,951	10,013
					500,000	0.624%
						7.75%

The quickest way to calculate the actual effective rate is by using a helper column: 0.624%=IRR(G3:G60).

7.75% = (1+0.624%)¹² - 1

At the end of Q2, the rate reset to 8.00%.

Period	Loan	Interest rate	Interest	Payment	Amortization	IRR
A	B = B(B+1) - E	C	D = B x C	E	F = E - D	G
1	500,000	0.604%	3,022	9,961	6,938
2	493,062	0.604%	2,981	9,961	6,980
3	486,082	0.604%	2,938	9,961	7,022
4	479,059	0.624%	2,989	10,000	7,011
5	472,049	0.624%	2,945	10,000	7,055
6	464,994	0.624%	2,901	10,000	7,099	(457,896)
7	457,896	0.643%	2,946	10,065	7,119	10,065
8	450,777	0.643%	2,900	10,065	7,164	10,065
9	443,613	0.643%	2,854	10,065	7,210	10,065
10	436,402	0.643%	2,808	10,065	7,257	10,065
11	429,145	0.643%	2,761	10,065	7,304	10,065
12	421,842	0.643%	2,714	10,065	7,351	10,065
13	414,491	0.643%	2,667	10,065	7,398	10,065
14	407,093	0.643%	2,619	10,065	7,445	10,065
15	399,648	0.643%	2,571	10,065	7,493	10,065
16	392,154	0.643%	2,523	10,065	7,542	10,065
17	384,613	0.643%	2,475	10,065	7,590	10,065
18	377,023	0.643%	2,426	10,065	7,639	10,065
19	369,384	0.643%	2,377	10,065	7,688	10,065
20	361,696	0.643%	2,327	10,065	7,738	10,065
21	353,958	0.643%	2,277	10,065	7,787	10,065
22	346,171	0.643%	2,227	10,065	7,837	10,065
23	338,333	0.643%	2,177	10,065	7,888	10,065
24	330,445	0.643%	2,126	10,065	7,939	10,065
25	322,507	0.643%	2,075	10,065	7,990	10,065
26	314,517	0.643%	2,024	10,065	8,041	10,065
27	306,476	0.643%	1,972	10,065	8,093	10,065
28	298,383	0.643%	1,920	10,065	8,145	10,065
29	290,238	0.643%	1,867	10,065	8,197	10,065
30	282,041	0.643%	1,815	10,065	8,250	10,065
31	273,791	0.643%	1,762	10,065	8,303	10,065
32	265,488	0.643%	1,708	10,065	8,357	10,065
33	257,131	0.643%	1,654	10,065	8,410	10,065
34	248,721	0.643%	1,600	10,065	8,464	10,065
35	240,257	0.643%	1,546	10,065	8,519	10,065
36	231,738	0.643%	1,491	10,065	8,574	10,065
37	223,164	0.643%	1,436	10,065	8,629	10,065
38	214,535	0.643%	1,380	10,065	8,684	10,065
39	205,851	0.643%	1,324	10,065	8,740	10,065
40	197,110	0.643%	1,268	10,065	8,796	10,065
41	188,314	0.643%	1,212	10,065	8,853	10,065
42	179,461	0.643%	1,155	10,065	8,910	10,065
43	170,551	0.643%	1,097	10,065	8,967	10,065
44	161,583	0.643%	1,040	10,065	9,025	10,065
45	152,558	0.643%	982	10,065	9,083	10,065
46	143,475	0.643%	923	10,065	9,142	10,065
47	134,334	0.643%	864	10,065	9,200	10,065
48	125,133	0.643%	805	10,065	9,260	10,065
49	115,874	0.643%	746	10,065	9,319	10,065
50	106,554	0.643%	686	10,065	9,379	10,065
51	97,175	0.643%	625	10,065	9,439	10,065
52	87,736	0.643%	564	10,065	9,500	10,065
53	78,236	0.643%	503	10,065	9,561	10,065
54	68,674	0.643%	442	10,065	9,623	10,065
55	59,051	0.643%	380	10,065	9,685	10,065
56	49,367	0.643%	318	10,065	9,747	10,065
57	39,620	0.643%	255	10,065	9,810	10,065
58	29,810	0.643%	192	10,065	9,873	10,065
59	19,937	0.643%	128	10,065	9,936	10,065
60	10,000	0.643%	64	10,065	10,000	10,065
					500,000	0.643%
						8.00%

The quickest way to calculate the actual effective rate is a helper column: 0.643%=IRR(G6:G60).

8.00% = (1+0.643%)¹² - 1

The annual payment was unrealistic due to an additional benefit.

In addition to the loan, XYZ and ABC agreed to an exclusive supply agreement. Due to the advantageous terms of the agreement, XYZ offered ABC a below-market, annual interest rate of 2% and payments of 106,079.

Note: the periodicity was switched back to annual for readability.

1/1/X1 \| 1.1.X1
Loan		500,000
	Cash		500,000

As stated in IFRS 9B5.1.2A (edited): The best evidence of the fair value of a financial instrument at initial recognition is normally the transaction price (i.e. the fair value of the consideration given or received, see also IFRS 13)...

As there was no question about the value of the consideration given which was cash, XYZ recognized the loan at 500,000. However, as the below-market interest rate of 2% led to below-market payments of 106,079 it did need to account for the difference (17,503 = 123,582 - 106,079) as shown below.

12/31/X1 \| 31.12.X1
Cash		106,079
Revenue (sales to ABC)		17,503
	Interest income		37,500
	Loan		86,082

As the advantage allowed XYZ to charge ABC more than it otherwise would have, it reclassified the amount included in interest income from sales revenue.

Period	Principal	Rate	Interest	Payment	Privilege	Amortization
A	B=B_(B+1) - H	C	D = B x C	E	F	H = F + G
1	500,000	7.50%	37,500	106,079	17,503	86,082
2	413,918	7.50%	31,044	106,079	17,503	92,539
3	321,379	7.50%	24,103	106,079	17,503	99,479
4	221,900	7.50%	16,643	106,079	17,503	106,940
5	114,960	7.50%	8,622	106,079	17,503	114,960
			117,912		87,516	500,000

87,516 = 117,912 - 30,396

Period	Principal	Rate	Interest	Payment	Amortization
1	500,000	2.00%	10,000	106,079	96,079
2	403,921	2.00%	8,078	106,079	98,001
3	305,920	2.00%	6,118	106,079	99,961
4	205,959	2.00%	4,119	106,079	101,960
5	103,999	2.00%	2,080	106,079	103,999
			30,396		500,000

While generally comparable, US GAAP provides subtly different guidance that will influence the accounts used.

ASC 835-30-25-6 (edited, emphasis added) states: ... in some cases the parties may also exchange unstated (or stated) rights or privileges, which are given accounting recognition by establishing a note discount or premium account ...

1/1/X1 \| 1.1.X1
Loan		500,000
Deferred interest income		87,516
	Cash		500,000
	Discount		87,516

12/31/X1 \| 31.12.X1
Cash		106,079
Revenue (sales to ABC)		17,503
Discount		17,503
	Interest income		37,500
	Loan		86,082
	Deferred interest income		17,503

Assuming the agreement did not specify a sales amount.

If it had, for example, specified total sales of 175,032 units and XYZ had sold 40,000 X1:

12/31/X1 \| 31.12.X1
Cash		106,079
Revenue (sales to ABC)		20,000
Discount		17,503
	Interest income		37,500
	Loan		68,579
	Deferred interest income		20,000

The annual payment was unrealistic because XYZ and ABC were related.

ABC was XYZ's subsidiary. While related party transactions often mirror arm's-length terms, in this illustration ABC agreed to an above-market interest rate of 15% and payments of 149,158. Despite this, XYZ elected to recognize and measure the loan to reflect a market rate.

With one notable difference, IFRS and US GAAP require entities to disclose related party transactions.

IAS 24.3 requires transactions between related parties to be disclosed even if they are eliminated in consolidation.

In contrast, ASC 850-10-50-1 only requires disclosure of transactions not eliminated in consolidation.

However, if a consolidated entity publishes separate financial statements, as is often the case with majority-owned rather than wholly-owned subsidiaries, it must report and/or disclose related party transactions in those separate financial statements.

Transactions consummated with arm's-length terms may be disclosed without additional detail (again, with one difference). However, transactions that deviate from arm's length must be disclosed along with explanations of the differences.

Because IAS 24 requires all transactions between related parties to be disclosed, even if eliminated in consolidation, IFRS reporting entities commonly include a footnote listing the involved parties, amounts, and transaction types.

A more detailed discussion of this issue, including cross-references to the applicable guidance, is provided on this page.

Assuming auditor approval, if an entity recognizes, measures, and reports a transaction without arm's-length terms to reflect the appearance of an arm's-length transaction, it may avoid the stigma of disclosing that the related party transaction was not consummated on arm's-length terms.

1/1/X1 \| 1.1.X1
Loan		500,000
	Cash		500,000

As there was no question about the value of the consideration given which was cash, XYZ recognized the loan at 500,000. However, as the above market interest rate of 15% led to above market payments of 149,158 it did need to account for the difference (25,575 = 149,158 - 123,582) as shown below.

12/31/X1 \| 31.12.X1
Cash		149,158
	Related party revenue		25,575
	Interest income		37,500
	Loan		86,082

As the advantage allowed XYZ to charge ABC more than it otherwise would have, it reclassified the amount included in interest income from sales revenue.

Period	Principal	Rate	Interest	Payment	Privilege	Amortization
A	B = B(B+1) - H	C	D = B x C	E	F	H = F + G - D
1	500,000	7.50%	37,500	149,158	(25,575)	86,082
2	413,918	7.50%	31,044	149,158	(25,575)	92,539
3	321,379	7.50%	24,103	149,158	(25,575)	99,479
4	221,900	7.50%	16,643	149,158	(25,575)	106,940
5	114,960	7.50%	8,622	149,158	(25,575)	114,960
			117,912		(127,877)	500,000

(127,877) = 117,912 - 245,789

Period	Principal	Rate	Interest	Payment	Amortization
1	500,000	15.00%	75,000	149,158	74,158
2	425,842	15.00%	63,876	149,158	85,281
3	340,561	15.00%	51,084	149,158	98,074
4	242,487	15.00%	36,373	149,158	112,785
5	129,702	15.00%	19,455	149,158	129,702
			245,789		500,000

While generally comparable, US GAAP provides subtly different guidance that will influence the accounts used.

1/1/X1 \| 1.1.X1
Loan		500,000
Premium		127,877
	Cash		500,000
	Deferred related party revenue		127,877

12/31/X1 \| 31.12.X1
Cash		149,158
Deferred related party revenue		25,575
	Related party revenue		25,575
	Interest income		37,500
	Loan		86,082
	Deferred interest income		25,575

Debt

1/1/X1, XYZ acquired a five-year, non-negotiable, 500,000 face value, 7.5% coupon note for 500,000.

XYZ acquired the note from its issuer in an arm's-length transaction. The explicit interest rate equaled the implicit rate, and XYZ had no need to determine an imputed rate.

Orderly transactions between market participants are discussed in IFRS 13.15–23 | ASC 820-10-35-3 to 9 and are currently the primary method of determining fair value.

Since the agreement was at arm's length, XYZ concluded 7.5% was fair and adequate, and called it a day.

Note: while IFRS does not dedicate a standard, or even a section of a standard, to interest imputation, the guidance in IFRS 9.B5.1.2A leads to a comparable result.

An explicit or stated interest rate is the interest rate specified in the loan agreement.

An implicit interest rate is the interest rate implied by the cash flows associated with the loan agreement.

As the note only specified a rate not the payment itself, there was no implicit rate to calculate.

US GAAP places significant emphasis on interest imputation, dedicating an entire sub-topic. By comparison, IFRS briefly addresses the issue, providing only a single paragraph (IFRS 9.B5.1.2A). However, when applied correctly, this guidance yields comparable results to ASC 835-30.

1/1/X1 \| 1.1.X1
Note		500,000
	Cash		500,000

12/31/X1 \| 31.12.X1
Cash		37,500
	Interest income		37,500

With a term note, where the periodic payments are interest only, the note's nominal equals its present value as confirmed by this schedule:

Period	Principal	Interim rate	Interest
A	B	C	D=B/(1+C)^A
1	37,500	7.50%	34,884
2	37,500	7.50%	32,450
3	37,500	7.50%	30,186
4	37,500	7.50%	28,080
5	537,500	7.50%	374,400
			500,000

Consequently, no amortization is necessary.

12/31/X5 \| 31.12.X5
Cash		537,500
	Interest income		37,500
	Note		500,000

Same facts except prevailing interest rates were 8% and XYZ paid 490,018.

1/1/X1 \| 1.1.X1
Note		500,000
	Discount		9,982
	Cash		490,018

12/31/X1 \| 31.12.X1
Cash		37,500
Discount		1,701
	Interest income		39,201

Period	Principal	Interim rate	Interest	Payment	Amortization
A	B	C	D = B x C	E	F = D - F
1	490,018	8.00%	39,201	37,500	1,701
2	491,720	8.00%	39,338	37,500	1,838
3	493,557	8.00%	39,485	37,500	1,985
4	495,542	8.00%	39,643	37,500	2,143
5	497,685	8.00%	39,815	37,500	2,315
					9,982

12/31/X5 \| 31.12.X5
Cash		537,500
Discount		2,315
	Interest income		39,815
	Note		500,000

Same facts except prevailing interest rates were 6% and XYZ paid 531,593.

1/1/X1 \| 1.1.X1
Note		500,000
Premium		31,593
	Cash		531,593

12/31/X1 \| 31.12.X1
Cash		37,500
	Premium		5,604
	Interest income		31,896

Period	Principal	Interim rate	Interest	Payment	Amortization
A	B	C	D = B x C	E	F = D - F
1	531,593	6.00%	31,896	37,500	(5,604)
2	525,988	6.00%	31,559	37,500	(5,941)
3	520,048	6.00%	31,203	37,500	(6,297)
4	513,750	6.00%	30,825	37,500	(6,675)
5	507,075	6.00%	30,425	37,500	(7,075)
					(31,593)

12/31/X5 \| 31.12.X5
Cash		537,500
	Premium		7,075
	Interest income		30,425
	Note		500,000

Same facts except the note was zero coupon.

1/1/X1 \| 1.1.X1
Note		500,000
	Discount		151,721
	Cash		348,279

12/31/X1 \| 31.12.X1
Discount		26,121
	Interest income		26,121

Period

Principal

Discount

Interim rate

Interest

Payment

Amortization

E = (B + C) x D

F = 0

G = F - E

Just kidding.

500,000

(151,721)

7.50%

26,121

500,000

(125,600)

7.50%

28,080

500,000

(97,520)

7.50%

30,186

500,000

(67,334)

7.50%

32,450

500,000

(34,884)

7.50%

34,884

151,721

12/31/X5 \| 31.12.X5
Cash		500,000
Cash		34,884
	Interest income		34,884
	Note		500,000

Same facts except the note was repaid in annual instalments of 123,582.

The payment implied an interest rate of 7.5%. As the note was acquired arm's-length, imputation was not necessary.

If the timing of the payments is regular and amounts equal, the simplest way to calculate an implicit rate is:

7.5%=RATE(5,-123582,500000,0,0,1%) or, since the [guess] is optional, 7.5%=RATE(5,-123582,500000,0,0).

Alternatively, it can also be calculated using the =irr function, but some setup is required:

Row	Period	Cash flow
	A	B
1	0	(500,000.00)
2	1	123,582
3	2	123,582
4	3	123,582
5	4	123,582
6	5	123,582
		=IRR(B1:B6) equals: 7.50%

This method is more versatile, so can be used if the amounts vary:

Row	Period	Cash flow
	A	B
1	0	(500,000.00)
2	1	123,500
3	2	123,400
4	3	123,300
5	4	123,800
6	5	124,000
		=IRR(B1:B6) equals: 7.50%

If both the timing and amounts vary, =xirr allows the input to be expanded to include exact dates:

Row	Period	Cash flow
	A	B
1	0 01/01/2001	(500,000.00)
2	1 12/30/2001	123,500
3	2 01/06/2003	123,400
4	3 01/10/2004	123,300
5	4 12/20/2004	123,800
6	5 12/31/2005	124,000
		=XIRR(B1:B6,A1:A6) equals: 7.50%

Or, one can go old school and use the tried and tested trial and error (my preferred method).

Note: as anyone old enough to remember this method is also old enough to know how to use it, an illustration is unnecessary.

Also note: anyone old enough to remember being taught to use extrapolation tables like the ones found in old Intermediate Accounting textbooks, should learn to use a better method.

Orderly transactions between market participants are discussed in IFRS 13.15–23 | ASC 820-10-35-3 to 9 and are currently the primary method of determining fair value.

Since the agreement was at arm's length, XYZ concluded 7.5% was fair and adequate, and called it a day.

Note: while IFRS does not dedicate a standard, or even a section of a standard, to interest imputation, the guidance in IFRS 9.B5.1.2A leads to a comparable result.

1/1/X1 \| 1.1.X1
Note		500,000
	Cash		500,000

12/31/X1 \| 31.12.X1
Cash		123,582
	Interest income		37,500
	Note		86,082

Period	Principal	Interest rate	Interest	Payment	Amortization
A	B = B_(B+1) - E	C	D = B x C	E	F = E - D
1	500,000	7.50%	37,500	123,582	86,082
2	413,918	7.50%	31,044	123,582	92,539
3	321,379	7.50%	24,103	123,582	99,479
4	221,900	7.50%	16,643	123,582	106,940
5	114,960	7.50%	8,622	123,582	114,960
					500,000

12/31/X5 \| 31.12.X5
Cash		123,582
	Interest income		8,622
	Note		114,960

Same facts except the note was repaid in annual instalments of 50,000 and a balloon payment of 477,395.

1/1/X1 \| 1.1.X1
Note		500,000
	Cash		500,000

12/31/X1 \| 31.12.X1
Cash		50,000
	Interest income		37,500
	Note		12,500

Period	Principal	Interest rate	Interest	Payment	Amortization
A	B = B_(B+1) - E	C	D = B x C	E	F = E - D
1	500,000	7.50%	37,500	50,000	12,500
2	487,500	7.50%	36,563	50,000	13,438
3	474,063	7.50%	35,555	50,000	14,445
4	459,617	7.50%	34,471	50,000	15,529
5	444,088	7.50%	33,307	477,395	444,088
					500,000

12/31/X5 \| 31.12.X5
Cash		477,395
	Interest income		33,307
	Note		444,088

Same facts except the note was repaid in annual instalments of 118,698.

1/1/X1 \| 1.1.X1
Note		500,000
	Discount		19,761
	Cash		480,239

12/31/X1 \| 31.12.X1
Cash		118,698
Discount		6,018
	Interest income		36,018
	Note		82,680

Effective principal	Effective interest	Payment	Principal amort.	Nominal principal	Nominal interest	Discount amort.
A=A_(A-1)-E	B=Ax7.50%	C	D=C-F	E=E_(E-1)-C+F_(F-1)	F=Ex6.00%	H=B-F
480,239	36,018	118,698	88,698	500,000	30,000	6,018
397,559	29,817	118,698	94,020	411,302	24,678	5,139
308,678	23,151	118,698	99,661	317,282	19,037	4,114
213,130	15,985	118,698	105,641	217,620	13,057	2,928
110,417	8,281	118,698	111,979	111,979	6,719	1,563
			500,000			19,761

Note: due to space constraints and because it is not necessary for calculation purposes, the period column is not shown in this schedule.

Same facts except the note carried no interest rate and was repaid in annual installments of 100,000.

1/1/X1 \| 1.1.X1
Note		500,000
	Discount		95,412
	Cash		404,588

12/31/X1 \| 31.12.X1
Cash		100,000
Discount		30,344
	Interest income		30,344
	Note		100,000

P	Principal	Effective rate	Effective interest / Discount amortization	Payment	Principal amortization
A	B	C	D = B x C	E	F = E - D
1	404,588	7.50%	30,344	100,000	69,656
2	334,933	7.50%	25,120	100,000	74,880
3	260,053	7.50%	19,504	100,000	80,496
4	179,557	7.50%	13,467	100,000	86,533
5	93,023	7.50%	6,977	100,000	93,023
			95,412		404,588

Note: unlike the above situation, a separate calculation for discount amortization is not necessary. Instead, the effective interest calculation can serve both purposes.

Same facts except the note carried an adjustable interest rate.

The rate changed to 7.75% in X2 and 8.00% in X3, etc. The payments thus changed to 124,276 and 124,838, etc.

Note: the adjustments only impact the calculation of interest/amortization. The accounting entries follow the same principles as outlined above and are not shown again.

Period	Loan	Interest rate	Interest	Payment	Amortization
A	B = B(B+1) - E	C	D = B x C	E	F = E - D
1	500,000	7.50%	37,500	123,582	86,082
2	413,918	7.50%	31,044	123,582	92,539
3	321,379	7.50%	24,103	123,582	99,479
4	221,900	7.50%	16,643	123,582	106,940
5	114,960	7.50%	8,622	123,582	114,960
					500,000

Period	Loan	Interest rate	Interest	Payment	Amortization	IRR
A	B = B(B+1) - E	C	D = B x C	E	F = E - D	G
1	500,000	7.50%	37,500	123,582	86,082	(413,918)
2	413,918	7.75%	32,079	124,276	92,197	124,276
3	321,721	7.75%	24,933	124,276	99,342	124,276
4	222,378	7.75%	17,234	124,276	107,041	124,276
5	115,337	7.75%	8,939	124,276	115,337	124,276
					500,000	7.75%

The quickest way to calculate the actual effective rate is a helper column: 7.75%=IRR(G1:G5)

Period	Loan	Interest rate	Interest	Payment	Amortization	IRR
A	B = B(B+1) - E	C	D = B x C	E	F = E - D	G
1	500,000	7.50%	37,500	123,582	86,082
2	413,918	7.75%	32,079	124,276	92,197	(321,721)
3	321,721	8.00%	25,738	124,838	99,101	124,838
4	222,620	8.00%	17,810	124,838	107,029	124,838
5	115,591	8.00%	9,247	124,838	115,591	124,838
					500,000	8.00%

The quickest way to calculate the actual effective rate is a helper column: 8.00%=IRR(G2:G5)

Same facts except XYZ acquired the note on the market.

Although the note was market-traded, XYZ intended to hold it until maturity.

By default, financial assets are always remeasured to fair value.

IFRS 9.4.1.2 establishes that remeasurement is the default option by outlining the conditions that must be satisfied for an asset to avoid fair value remeasurement and be accounted for at amortized cost instead.

Although somewhat less apparent, ASC 320-10-25-1.c does the same by specifying the criteria necessary for an asset to be classified as held-to-maturity (in that held-to-maturity assets are accounted for at amortized cost).

Note: Remeasurement gains and losses may, under specified conditions, be reported in Other Comprehensive Income (OCI). However, this does not obviate the requirement to remeasure fair value where applicable.

However, if an entity intends to hold the asset to maturity, it accounts for it as illustrated above.

While IFRS does not use the term "held-to-maturity," IFRS 9.4.1.2 does specify that amortized cost accounting is used if an asset is "held within a business model whose objective is to hold financial assets in order to collect contractual cash flows."

These cash flows must be specified, for example, in a debenture agreement or explicitly on the face of a promissory note. They must also pass a "solely payments of principal and interest" test.

While this SPPI test is often a formality, when the debt instrument is flavored with, for example, a conversion option, it can dramatically change the accounting (as illustrated below).

The result of applying IFRS 9.4.1.2 is thus the same as applying ASC 320-10-25-1.c which does use the term.

Same facts except XYZ did not intend to hold the note to maturity.

On the last trading day of the X0, XYZ acquired 500 notes on an active market for 999 each. The closing price on that day was 1,000 each. On 12/31/X1 and 12/31/X2 the notes closed at 1,017 and 987.

12/31/X0 \| 31.12.X0 (3:46 PM \| 15:46)
Note		499,500
	Cash		499,500

12/31/X0 \| 31.12.X0 (4:00 PM \| 16:00)
Note		500
	Gain		500

While just a detail, IFRS 9 B5.1.2A.b restricts the recognition of day-one gains/losses to level 1 assets. However, as it was market-traded, this restriction has no effect on this note.

12/31/X1 \| 31.12.X1
Cash		37,500
Note		8,468
	Interest income		37,500
	Gain		8,468

While XYZ would remeasure the note each reporting period, for illustrative purposes only the year end is shown.

12/31/X2 \| 31.12.X2
Cash		37,500
Loss		14,911
	Interest income		37,500
	Note		14,911

Same facts except the note was not trade, but was negotiable.

12/31/X0 \| 31.12.X0 (3:46 PM \| 15:46)
Note		499,500
	Cash		499,500

12/31/X0
Note		500
	Gain (US GAAP)		500

While just a detail, IFRS 9 B5.1.2A.b restricts the recognition of day-one gains/losses to level 1 assets. Since this note was not market-traded, this gain would be recognized only under US GAAP, which does not impose a similar restriction.

12/31/X1 \| 31.12.X1
Cash		37,500
Note		8,468
	Interest income		37,500
	Gain (IFRS)		8,468

As noted above, IFRS restricts day one gains/losses to market-traded assets.

As a result, the gain would be included in this remeasurement for a total of 8,968.

First, XYZ estimated that the note's issuer would have had a rating between B and BB if it had had a rating. Next it determined the rates associated with otherwise comparable market-traded notes issued by B and BB entities. Next, it extrapolated an applicable rate which it used to calculate the present value of the note, which was thus corroborated (IFRS 13.82.d | ASC 820-10-35-4.d) by market inputs.

12/31/X2 \| 31.12.X2
Cash		37,500
Loss		14,911
	Interest income		37,500
	Note		14,911

Same facts except XYZ initially intended to hold it until maturity. In X3 it changed its mind and sold it anyway.

Mind changing is frowned upon by this site. Do not do it.

In IFRS, reclassification is only allowed if the entity changes its business model (IFRS 9.4.4.1) in that additional guidance is provided by IFRS 9.B4.4.1–B4.4.3 and IFRS 9.B5.6.1–B5.6.2. It is also it is only allowed for assets. IFRS 9.4.4.2 prohibits reclassifying liabilities. In US GAAP it is discussed in ASC 320-10-35-10, ASC 320-10-35-10A, ASC 320-10-35-10B and ASC 320-10-35-11 to 16.

Same facts except XYZ classified it as FVOCI | AFS.

If an debt investment is classified as FVOCI | AFS, the accounting is practically the same as above.

To complete its quest for scrupulous precision, IFRS 9.4.1.1 introduced the term fair value through other comprehensive income to go with the previous fair value through profit and loss classification. As neither exactly roll off the tongue, they are best known by their acronyms: FVOCI and FVTPL.

Previously, IAS 39.45 classified financial assets:

financial assets at fair value through profit or loss;
held-to-maturity investments;
loans and receivables; and
available-for-sale financial assets.

In a demonstrably deliberate effort to exhibit semantic precision — or, perhaps, merely to distinguish itself from US GAAP — the IASC elected to adopt the terminologically rigorous, albeit somewhat excessively convoluted, fair value through profit and loss as an equivalent for US GAAP's "trading." The IASB completed the task by adopting fair value through other comprehensive income to replace available-for-sale.

Somewhat surprisingly, it also decided to merge held-to-maturity investments and loans and receivables into the straightforward 'amortized cost' classification. Go figure.

In contrast, US GAAP refers to the same accounting treatment as available for sale. which is usually abbreviated as AFS.

The disadvantage of this term is that it is not obvious (to a non-accountant) unless explained. The advantage is that it is easy to say and write.

As far as the accounting is concerned, the difference between FVOCI and AFS is only semantic. The two are synonyms.

In the context of debt investments. When it comes to equity investments, US GAAP no longer allows AFS so there is no equivalent for IFRS FVOCI when it comes to these instruments.

US GAAP refers to the account treatment of reporting gains and losses in other comprehensive income as available-for-sale.

In contrast IFRS refers to the same accounting treatment as fair value through other comprehensive income.

The advantage of the former is that it is easy to say and abbreviate (AFS). The disadvantage, unlike the IFRS version, it is not self-explanatory.

As far as the accounting is concerned, the difference between AFS and FVOCI is only semantic. The two are synonyms.

In the context of debt investments. When it comes to equity investments, US GAAP no longer allows AFS so there is no equivalent for IFRS FVOCI when it comes to these instruments.

The only difference, "unrealized" gains / losses are reported in other comprehensive income (OCI) instead of profit and loss | net income. They are then accumulated on the balance sheet separately from retained earnings. When the investment is sold, the previously "unrealized" gains / losses become "realized" and so are recycled | reclassified into profit and loss | net income. This procedure is counterintuitive and simply too bizarre to illustrate (just kidding).

Labeling these gains and losses as "unrealized" is the IASB's and FASB's way of having their cake and eating it too.

Historically, management preferred to keep "unrealized" gains and losses out of the financial report.

Why? Because they didn't want investors to notice when they made bad investments until circumstances forced them to sell, thereby "crystallizing" the losses.

Obviously, keeping these gains and losses secret led to problems. Although the change was not precipitated by a particular crisis, the FASB felt that the modern age required accounting rules that would force management to report all the gains and losses—"realized" and "unrealized"—before it was too late.

Obviously, management was not enthusiastic. They preferred the tried-and-true - obfuscate, deny, and pretend everything is fine until it’s not approach that had served them well for over a century.

Nevertheless, the FASB did manage to issue FAS 130 (comprehensive income) in 1997. This standard did, on the one hand, force management to report all gains and losses, but also allowed them to continue pretending that those gains and losses reported in OCI were not really real.

Next came FAS 157 (fair value). Again, after much gnashing of teeth, management finally relented and agreed to actually calculate those gains and losses using reasonable assumptions and good math.

Where was the IASC during this? At the time, it was busy with its transformation into the IASB and convincing the European Union to adopt IAS (now IFRS). Consequently, they left the heavy lifting to the FASB and, with a few cosmetic and grammatical changes, simply adopted its guidance.

Since then, the IASB has been a bit proactive but, besides some minor differences such as retaining the ability to report equity instruments in comprehensive income, a two-bucket impairment test, and convincing the FASB to simplify its fair value guidance, they have not made any substantial changes.

Anyway, since applying IFRS 13 | ASC 820 means there is no actual distinction between "realized" and "unrealized"—the game of charades with OCI aside.

And this fact has not been lost on financial statement users.

Jump ahead twenty years. Investors have become accustomed to comprehensive income, appreciate it for what it is, and whenever they see it, they simply ignore any "realized" / "unrealized" labels and focus on the results.

So, how long will Other Comprehensive Income be with us?

Hard to say but probably not forever. For example, ASU 2016-01 took a big first step by eliminating OCI for equity investments.

But, in the meantime, accountants still need to deal with bizarre procedures like having to, as the IASB likes to call it, recycle gains and losses into net income.

¯\(ツ)/¯

XYZ acquired the note on 1/1/X1 for 500,000. The note's market price was 508,468 and 493,557 on 12/31/X1 and 12/31/X2. XYZ sold the note for 502,252 on 6/20/X3. It reported the sale in its annual, X3 report.

To keep the illustration as readable as possible, the accounting for the day one gains/losses is not covered again.

To keep the illustration as readable as possible, interim reports are not presented.

1/1/X1 \| 1.1.X1
Note		500,000
	Cash		500,000

12/31/X1 \| 31.12.X1
Note		8,468
	Gain in OCI		8,468
Gain in OCI		8,468
	AOCI		8,468

To recognize the gain in other comprehensive income.

Somewhat confusingly, IFRS classifies the accumulation as a "reserve" (specifically: Reserve of gains and losses on remeasuring available-for-sale financial assets, in XBRL ReserveOfGainsAndLossesOnRemeasuringAvailableforsaleFinancialAssets) but includes it as a subclassification of Accumulated other comprehensive income (in XBRL AccumulatedOtherComprehensiveIncomeAbstract).

In the FASB XBRL, it is classified as AOCI, Debt Securities, Available-for-Sale, Adjustment, after Tax (AccumulatedOtherComprehensiveIncomeLossAvailableForSaleSecuritiesAdjustmentNetOfTax) and presented as a subclassification of Accumulated Other Comprehensive Income (Loss), Net of Tax (AccumulatedOtherComprehensiveIncomeLossNetOfTaxAbstract).

To close the period and accumulate the gain outside of retained earnings.

12/31/X2 \| 31.12.X2
Loss in OCI		14,911
	Note		14,911
AOCI		14,911
	Loss in OCI		14,911

6/20/X3 \| 20.6.X3
Note		8,695
	Gain in OCI		8,695
Cash		502,252
	Gain in NI		8,695
	Note		493,557

To recognize the gain in other comprehensive income.

To recognize the gain in net income. This will be included in net income for the period and reclassified to retained earnings when the period's books are closed.

12/31/X3 \| 31.12.X3
Gain in OCI		8,695
	AOCI		8,695
AOCI		2,252
	Reclassification adjustment		2,252

2,252 = 2,252 = 8,468 + (14,911) + 8,695

The reclassification adjustment reflects the cumulative net gains / losses previously recognized in AOCI. When the period is closed, this balance is derecognized from AOCI and rerecognized (recycled) into net income.

Note: in practice, this adjustment may also be performed at the time of the sale rather than at period-end, depending on the entity's accounting policies.

To close the period and reclassify (recycle) the gain to net inocme.

Same facts except XYZ acquired 500, 30-year, 2.5% coupon rate bonds.

Had the bond carried a market rate, XYZ would have likely paid face value and accounted for it as above (just over 30 years instead of 5). However, the bond paid a below-market coupon, so XYZ paid only 204,740.

If the investor acquires bonds directly from the issuer or underwater, they most often pay face value (assuming the bonds carry a market interest rate). However, bonds are also often acquired on secondary markets. In this case, the investor pays market price which is rarely face value. This will lead to a premium or, as shown here, discount.

Period	Payment	Interim rate	Present value
A	B	C	D = B ÷ (1 + C)^A
1	12,500	7.50%	11,628
2	12,500	7.50%	10,817
3	12,500	7.50%	10,062
4	12,500	7.50%	9,360
5	12,500	7.50%	8,707
6	12,500	7.50%	8,100
7	12,500	7.50%	7,534
8	12,500	7.50%	7,009
9	12,500	7.50%	6,520
10	12,500	7.50%	6,065
11	12,500	7.50%	5,642
12	12,500	7.50%	5,248
13	12,500	7.50%	4,882
14	12,500	7.50%	4,541
15	12,500	7.50%	4,225
16	12,500	7.50%	3,930
17	12,500	7.50%	3,656
18	12,500	7.50%	3,401
19	12,500	7.50%	3,163
20	12,500	7.50%	2,943
21	12,500	7.50%	2,737
22	12,500	7.50%	2,546
23	12,500	7.50%	2,369
24	12,500	7.50%	2,203
25	12,500	7.50%	2,050
26	12,500	7.50%	1,907
27	12,500	7.50%	1,774
28	12,500	7.50%	1,650
29	12,500	7.50%	1,535
30	512,500	7.50%	58,538
			204,740

1/1/X1 \| 1.1.X1
Bond		500,000
	Discount		295,260
	Cash		204,740

12/31/X1 \| 31.12.X1
Cash		12,500
Discount		2,856
	Interest income		15,356

Period	Principal	Discount	Interim rate	Interest	Payment	Amortization
A	B	C	D	E = (B - C) x D	F	G = E - F
1	500,000	295,260	7.50%	15,356	12,500	2,856
2	500,000	292,404	7.50%	15,570	12,500	3,070
3	500,000	289,334	7.50%	15,800	12,500	3,300
4	500,000	286,035	7.50%	16,047	12,500	3,547
5	500,000	282,487	7.50%	16,313	12,500	3,813
6	500,000	278,674	7.50%	16,599	12,500	4,099
7	500,000	274,574	7.50%	16,907	12,500	4,407
8	500,000	270,167	7.50%	17,237	12,500	4,737
9	500,000	265,430	7.50%	17,593	12,500	5,093
10	500,000	260,337	7.50%	17,975	12,500	5,475
11	500,000	254,862	7.50%	18,385	12,500	5,885
12	500,000	248,977	7.50%	18,827	12,500	6,327
13	500,000	242,650	7.50%	19,301	12,500	6,801
14	500,000	235,849	7.50%	19,811	12,500	7,311
15	500,000	228,538	7.50%	20,360	12,500	7,860
16	500,000	220,678	7.50%	20,949	12,500	8,449
17	500,000	212,229	7.50%	21,583	12,500	9,083
18	500,000	203,146	7.50%	22,264	12,500	9,764
19	500,000	193,382	7.50%	22,996	12,500	10,496
20	500,000	182,886	7.50%	23,784	12,500	11,284
21	500,000	171,602	7.50%	24,630	12,500	12,130
22	500,000	159,472	7.50%	25,540	12,500	13,040
23	500,000	146,433	7.50%	26,518	12,500	14,018
24	500,000	132,415	7.50%	27,569	12,500	15,069
25	500,000	117,346	7.50%	28,699	12,500	16,199
26	500,000	101,147	7.50%	29,914	12,500	17,414
27	500,000	83,733	7.50%	31,220	12,500	18,720
28	500,000	65,013	7.50%	32,624	12,500	20,124
29	500,000	44,889	7.50%	34,133	12,500	21,633
30	500,000	23,256	7.50%	35,756	12,500	23,256
						295,260

12/31/X30 \| 31.12.X30
Cash		512,500
Discount		23,256
	Interest income		35,756
	Bond		500,000

Same facts except the bonds were convertible and XYZ aquired them on 12/31/X0.

XYZ acquired the bonds directly from their issuer during the day. The bonds paid a coupon of 2.5% and were convertible into the issuers shares at a ratio of 1:10 provided the share price exceeded 200. The bonds were also sold to other investors and began to trade on a market. At the end of trading on 12/31/X0, the issuer's shares closed at 101 and the bonds at 1,002. At the end of trading on 12/31/X1, the issuer's shares closed at 124 and bonds 1,050.

As the bonds failed the SPPI (Solely Payments of Principal and Interest) test (IFRS 9.4.1.2.b), XYZ remeasured them to fair value. It also elected to not apply IFRS 9.4.1.4, so it recognized the associated gains and losses in profit and loss.

For US GAAP purposes, since the bonds were convertible XYZ remeasured them to fair value. While it would have been permissible to classify them available-for-sale (ASC 320-10-25-1.b), XYZ elected to classify them as trading (ASC 320-10-25-1.a).

Convertible debt securities are specifically addressed by ASC 320-10-25-5.g, which states that they may never be classified as held-to-maturity. Since these instruments are thus remeasured to fair value, bifurcation (ASC 815-15-25-1) is not necessary. Instead, the whole instrument is reassured.

As the bond was traded on the market, determining its fair value was simple. If a bond is not traded, GLWT.

Good luck with that.

Seriously.

Seriously, good luck with that.

While IFRS 13 discusses how to determine fair value for non-traded (level 3) assets, the most useful guidance, if you can call it that, is actually found in US GAAP.

As stated in ASC 718-10-55-11, if observable market prices of identical or similar equity or liability instruments of the entity are not available, the fair value of equity and liability instruments awarded to grantees shall be estimated by using a valuation technique that meets all of the following criteria:

ASC 718, though specific to employee stock options, offers the most detailed valuation guidance, applicable by analogy to other option-like instruments.

It is applied in a manner consistent with the fair value measurement objective and the other requirements of this Topic.
It is based on established principles of financial economic theory and generally applied in that field (see paragraph 718-10-55-16). Established principles of financial economic theory represent fundamental propositions that form the basis of modern corporate finance (for example, the time value of money and risk-neutral valuation).

ASC 718-10-55-16 (emphasis added): A lattice model (for example, a binomial model) and a closed-form model (for example, the Black-Scholes-Merton formula) are among the valuation techniques that meet the criteria required by this Topic for estimating the fair values of share options and similar instruments granted in share-based payment transactions. A Monte Carlo simulation technique is another type of valuation technique that satisfies the requirements in paragraph 718-10-55-11 [¯\_(ツ)_/¯]. Other valuation techniques not mentioned in this Topic also may satisfy the requirements in that paragraph. Those valuation techniques or models, sometimes referred to as option-pricing models, are based on established principles of financial economic theory. Those techniques are used by valuation professionals, dealers of derivative instruments, and others to estimate the fair values of options and similar instruments related to equity securities, currencies, interest rates, and commodities. Those techniques are used to establish trade prices for derivative instruments and to establish values in adjudications. As discussed in paragraphs 718-10-55-21 through 55-50, both lattice models and closed-form models can be adjusted to account for the substantive characteristics of share options and similar instruments granted in share-based payment transactions.

While there is often no other option, I am not a fan of valuation techniques described as "faking it a billion times until the reality emerges" so my site does not cover it.

However, those interested can start on this page (link), which provides a decent summary.

It is worth noting how careful the FASB was in its wording stating "those techniques are used by valuation professionals" without going so far as stating an entity should rely on such professionals.

This is especially relevant for international subsidiaries of multinational companies. In many jurisdictions, accountants rely on external valuation experts. However, this reliance often leads to a critical misinterpretation of US GAAP, mistakenly assuming an expert’s opinion alone qualifies as an acceptable valuation technique. This is not the case. Regardless of who makes the estimate, the entity's management remains ultimately responsible for its accuracy. Failing to recognize this ultimate responsibility can result in serious compliance risk and regulatory scrutiny.

To put it simply, hiding behind an expert's opinion is no way to apply US GAAP and a red flag for both auditors and the SEC.

If you have gotten this far, please continue at asc.fasb.org/1943274/2147480397/718-10-55-21

It reflects all substantive characteristics of the instrument (except for those explicitly excluded by this Topic, such as vesting conditions and reload features)...

While they do not mention Monte Carlo simulation techniques, IFRS 2.B1 to B41 provide comparably useful instructions

12/31/X0 (1:30 p.m.) \| 31.12.X0 (13:30)
Bond		500,000
	Cash		500,000

12/31/X0 (4:00 p.m.) \| 31.12.X0 (16:00)
Bond		1,000
	Gain		1,000

12/31/X1 \| 31.12.X1
Cash		12,500
Bonds		24,000
	Interest income		12,500
	Gain		24,000

Equity

1/1/X1, XYZ acquired 5000 shares in ABC on an active market for 100 each.

IFRS | US GAAP defines active market: a market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.

The FASB published XBRL includes this list of markets it considers active.

A AND G BANCA PRIVADA SAU
A2X
AB NASDAQ VILNIUS
ABANCA
ABAXX EXCHANGE
ABBEY NATIONAL TREASURY SERVICES PLC
ABG SUNDAL COLLIER AB
ABIDE FINANCIAL DRSP LIMITED APA
ABN AMRO BANK NV
ABU DHABI SECURITIES EXCHANGE
ACCESS FINTECH
ACCX
ACE DERIVATIVES & COMMODITY EXCHANGE LTD
ACS EXECUTION SERVICES, LLC
ACX CLEARING CORPORATION LTD.
ACX
ADVISE TECHNOLOGIES - APA TRANSPARENCY REPORTING
AEGIS SWAP EXECUTION FACILITY
AFRICAN STOCK EXCHANGE
AFRINEX LIMITED
AFS - OTF - BONDS
AGRICULTURAL FUTURES EXCHANGE OF THAILAND
AIAF - MERCADO DE RENTA FIJA
AKIS - BANCO BPM
AKTIESELSKABET ARBEJDERNES LANDSBANK
ALBANIA SECURITIES EXCHANGE
ALGIERS STOCK EXCHANGE
ALIOR BANK
ALLT - OTF
ALM. BRAND BANK
ALPHA BANK
ALPHA-X
ALT XCHANGE (U)
ALTERNATIVA FRANCE
ALTERNATIVE PLATFORM FOR SPANISH SECURITIES
ALTEX - ATS
AMMAN STOCK EXCHANGE - NON-LISTED SECURITIES MARKET
APX POWER NL
AQSE GROWTH MARKET (EQUITY)
AQUIS EXCHANGE EUROPE AUCTION ON DEMAND (AOD)
ARCA DARK
ARCHAX - DIGITAL ASSETS
ARCHAX
AREX - AUTOMATED RECEIVABLES EXCHANGE
ARIAN TRADING FACILITY
ARITAS FINANCIAL LTD
ARKONIS
ARMENIA SECURITIES EXCHANGE
ARRACO GLOBAL MARKETS LTD
ARTEX MTF
ASIA PACIFIC CLEAR
ASIANEXT CRYPTO SPOT
ASSENT ATS
ASSET MATCH PRIVATE EXCHANGE
ASTANA INTERNATIONAL EXCHANGE LTD
ASX - ALL MARKETS
ATADEL FUNDS
ATFUND MTF
ATHENS EXCHANGE - APA
ATHLOS CAPITAL INVESTMENT SERVICES LTD
ATLANTIC SECURITIES MARKET
ATONLINE LIMITED
AUREL - OTF
AUREL
AUSTRALIA AND NEW ZEALAND BANKING GROUP LIMITED - SYSTEMATIC INTERNALISER
AUSTRALIAN WHEAT BOARD
AUTILLA - BASE METALS
AUTILLA
AUTOBAHN FX
AUTOMATED EQUITY FINANCE MARKETS
B3 S.A. - BRASIL BOLSA BALCAO
BAADER BANK
BAHAMAS INTERNATIONAL SECURITIES EXCHANGE
BAHRAIN BOURSE
BAKKT
BAKU INTERBANK CURRENCY EXCHANGE
BALKAN GAS HUB EAD
BALTEX - FREIGHT DERIVATIVES MARKET
BALTPOOL
BANCA DI ASTI
BANCO BILBAO VIZCAYA ARGENTARIA S.A. - UK
BANGALORE STOCK EXCHANGE LTD
BANJA LUKA STOCK EXCHANGE - FREE MARKET
BANK BGZ BNP PARIBAS S.A.
BANQUE DE LUXEMBOURG
BARBADOS STOCK EXCHANGE - INTERNATIONAL SECURITIES MARKET
BARCLAYS ATS
BAXTER FINANCIAL SERVICES
BAYERNLB - BONDS MARKET
BAYERNLB
BB SECURITIES LTD
BEIJING STOCK EXCHANGE
BELARUS CURRENCY AND STOCK EXCHANGE
BELFIUS BANK NV/SA FIXED INCOME
BELGIAN POWER EXCHANGE
BELGRADE STOCK EXCHANGE
BENDIGO STOCK EXCHANGE LIMITED
BERENBERG FIXED INCOME UK
BERENBERG
BERMUDA STOCK EXCHANGE LTD
BERNER KANTONALBANK OTC-X
BERNSTEIN CROSS (BERN-X)
BET OTC BILAT COMMODITY DERIVATIVES
BETA MARKET
BGC BROKERS LP - OTF
BGL BNP PARIBAS
BIDS TRADING L.P.
BITNOMIAL
BKS BANK AG
BLINK MTF
BLOCK EVENT
BLOCKMATCH EUROPE DARK
BLOOMBERG - APA
BLOX
BLUE OCEAN ALTERNATIVE TRADING SYSTEM
BLUENEXT
BME - APA
BMO CAPITAL MARKETS - CAD OTC TRADES
BNP PARIBAS ALTERNATIVE TRADING SYSTEM
BNPP CORTEX ATS
BNY MELLON MARKETS EUROPE LIMITED
BOERSE BERLIN - BERLIN SECOND REGULATED MARKET
BOFA SECURITIES EUROPE - RFQ
BOLSA BOLIVIANA DE VALORES S.A.
BOND ELECTRONIC EXCHANGE
BONDBLOX EXCHANGE
BONDMATCH
BONDS.COM, INC.
BONDSCAPE
BONDVISION EUROPE MTF
BORSA ISTANBUL - DEBT SECURITIES MARKET
BOSTON SECURITY TOKEN EXCHANGE LLC
BOTSWANA STOCK EXCHANGE - EXCHANGE TRADED FUNDS (ETF)
BOURSE AFRICA LIMITED
BOX OPTIONS EXCHANGE
BRAEMAR SECURITIES LTD
BRATISLAVA STOCK EXCHANGE - MTF
BRAZILIAN ENERGY EXCHANGE
BRD - GROUPE SOCIETE GENERALE S.A. - LIQUIDITY PROVIDER
BRED BANQUE POPULAIRE
BROKERCREDITSERVICE (CYPRUS) LIMITED
BROKERTEC AMERICAS LLC - RFQ PLATFORM
BRUT ECN
BRYAN GARNIER AND CO LIMITED
BSE LTD
BSP REGIONAL ENERGY EXCHANGE - SOUTH POOL
BTL OTC BILAT COMMODITY DERIVATIVES
BUDAPEST STOCK EXCHANGE - XBOND
BULGARIAN ENERGY TRADING PLATFORM
BURSA MALAYSIA
BX DIGITAL
CA CHEUVREUX
CADE - MERCADO DE DEUDA PUBLICA ANOTADA
CAIXABANK
CALCUTTA STOCK EXCHANGE
CAMBODIA SECURITIES EXCHANGE
CAN - ATS
CANADIAN IMPERIAL BANK OF COMMERCE
CANDEAL.CA INC
CANNEX FINANCIAL EXCHANGE LTS
CANTOR FINANCIAL FUTURES EXCHANGE
CANTORCO2E.COM LIMITED
CAPE VERDE STOCK EXCHANGE
CAPI - APPROVED PUBLICATION ARRANGEMENT
CAPTIN
CARACAS STOCK EXCHANGE
CARNEGIE AS
CARTAX
CASABLANCA STOCK EXCHANGE
CASPY COMMODITY EXCHANGE
CASSA DI COMPENSAZIONE E GARANZIA SPA - BONDS CCP SERVICE
CATS
CAVEAT EMPTOR
CAVENDISH MARKETS B.V.
CAYMAN ISLANDS STOCK EXCHANGE
CBM SARB
CBOE EUROPE - LIS SERVICE
CECABANK
CENTRAL COUNTERPARTY CLEARING CENTER MFB - JOINT-STOCK COMPANY
CESKA SPORITELNA, A.S.
CESKOSLOVENSKA OBCHODNA BANKA, A.S.
CESKOSLOVENSKÁ OBCHODNÍ BANKA, A.S. - OTHER LIQUIDITY PROVIDER (OLP)
CETIP S.A. - MERCADOS ORGANIZADOS
CEVALDOM - OTC MARKET
CHICAGO BOARD OF TRADE (FLOOR)
CHINA FINANCIAL FUTURES EXCHANGE
CHINAFICC
CHINESE GOLD & SILVER EXCHANGE SOCIETY
CHITTAGONG STOCK EXCHANGE LTD.
CHI-X CANADA ATS
CIB BANK
CIBC WORLD MARKETS PLC
CIMD S.V. S.A. - APPROVED PUBLICATION ARRANGEMENT
CINNOBER BOAT
CITADEL CONNECT EUROPE - EU
CITI DARK
CITIBANK EUROPE PLC - LONDON BRANCH
CITIGROUP GLOBAL MARKETS EUROPE AG - EMEA LIQUIDITY HUB
CITI-ONE
CLEAR MARKETS EUROPE LIMITED
CLEARCORP DEALING SYSTEMS (INDIA) LTD.
CLEARPOOL EXECUTION SERVICES, LLC - NATURAL LIQUIDITY ALLIANCE
CLIMEX
CLSA AMERICAS - LIQUIDITY HUB
CMC MARKETS UK PLC
CME AMSTERDAM B.V. - APA
CNODE
CODA MARKETS - MICRO AND BLOCK
COINBASE DERIVATIVES
COLOMBO STOCK EXCHANGE
COMHAR CAPITAL MARKETS, LLC - US EQUITIES
COMMERG LTD.
COMMERG
COMMERZBANK COMMODITY DERIVATIVES
COMMODITIES EXCHANGE CENTER
COMMONWEALTH BANK OF AUSTRALIA - LONDON BRANCH
CONCORDE SECURITIES LTD.
CONTINENTAL CAPITAL MARKETS LIMITED - OTF
CONVERGEX
CREDEM BANCA
CREDIT AGRICOLE BANK POLSKA S.A.
CREDITEX BROKERAGE LLP - MTF
CROATIAN POWER EXCHANGE
CROSSFINDER AUSTRALIA
CRYEX - FX AND DIGITAL CURRENCIES
CRYEX
CRYPTO FACILITIES
CUREX FX
CURRENEX IRELAND MTF - RFQ
CURRENEX
CX2
CYPRUS STOCK EXCHANGE - OTC
D.E. SHAW DARK
D2X - CRYPTO DERIVATIVES
DAIWA CAPITAL MARKETS EUROPE LIMITED
DALIAN COMMODITY EXCHANGE
DAMASCUS SECURITIES EXCHANGE
DANSK OTC
DANSKE BANK A/S - LONDON BRANCH
DAR ES SALAAM STOCK EXCHANGE
DASH ATS
DCX (DERIVATIVES CURRENCY EXCHANGE)
DEAL DONE TRADING
DEALERWEB FIXED INCOME
DEKABANK DEUTSCHE GIROZENTRALE
DELHI STOCK EXCHANGE
DEN JYSKE SPAREKASSE
DERIVATIVES REGULATED MARKET - BVB
DEUTSCHE BANK - MANUAL OTC
DEX LIMITED
DHAKA STOCK EXCHANGE LTD
DIGITAL VEGA
DNB BANK ASA
DOUALA STOCK EXCHANGE
DOWGATE - MTF (MADRID)
DOWGATE
DRIVEWEALTH INSTITUTIONAL LLC
DSK BANK EAD
DUBAI FINANCIAL MARKET
DUTCH CARIBBEAN SECURITIES EXCHANGE
DW SEF LLC
DZ BANK
EAST EUROPEAN STOCK EXCHANGE
EASTERN CARIBBEAN SECURITIES EXCHANGE
EBM - MTF
EBS MARKET- CLOB - FOR THE TRADING OF SPOT FX, PRECIOUS METALS AND OTHER FX PRODUCTS
ECB EXCHANGE RATES
EDMOND DE ROTHSCHILD (FRANCE)
EDX MARKETS
EEX ASIA PTE. LTD.
E-EXCHANGE
EG MARKET TECHNOLOGIES
EGYPTIAN EXCHANGE
EL SALVADOR STOCK EXCHANGE
ELECTRICITY DAY-AHEAD MARKET
ELECTRONIC BOND MARKET
ELIXIUM S.A.
ELIXIUM
ELX
EMERGING MARKETS BOND EXCHANGE LIMITED
EMS EXCHANGE
ENCLEAR
ENERGY BROKING IRELAND GAS TRADING PLATFORM
ENGNSOL - OMP
ENGNSOL
ENTERPRISE COMMODITY SERVICES LIMITED
E-OTC
EPEX SPOT SE
EQUILEND CANADA CORP.
EQUITY EXPRESS SECURITIES EXCHANGE (EESE)
EQUOS DERIVATIVES
EQUOS
ERSTE BANK HUNGARY ZRT.
ESSEX RADEZ, LLC
ESWATINI STOCK EXCHANGE
ETORO EU
ETS EURASIAN TRADING SYSTEM COMMODITY EXCHANGE
EUREX CLEARING AG - SME
EURO MTF
EUROBANK
EURO-FINANCE AD
EUROMTS LIMITED
EURONEXT - ACCESS MILAN
EUROPEAN COMMODITY CLEARING AG
EUROTLX
EUWAX AG
EUWAX
EVOLUTION MARKETS
EXANE BNP PARIBAS - BID-OFFER CROSSING
EXOTIX CAPITAL - OTF
EXPERT MARKET
FENICS - US TREASURIES
FEX GLOBAL
FIDELITY CROSSSTREAM ATS
FINANCIAL AND RISK TRANSACTIONS SERVICES IRELAND LIMITED - FORWARDS MATCHING
FINANCIALCONTENT - DIGITAL ASSET TRADE REPORTING FACILITY
FINANCIALCONTENT
FINANTIA UK LIMITED
FINECO BANK
FINESTI S.A.
FINRA ALTERNATIVE DISPLAY FACILITY (ADF)
FINRA/NASDAQ TRF CARTERET (TRADE REPORTING FACILITY)
FINRA/NYSE TRF (TRADE REPORTING FACILITY)
FINRA
FIRST NORTH DENMARK – AUCTION ON DEMAND
FIRSTPLACE WIENER BOERSE
FIS SECURITIES FINANCE MATCHING PLATFORM
FISH POOL ASA
FISHEX
FLOW TRADERS - SYSTEMATIC INTERNALISER
FMX SECURITIES
FORECASTEX, LLC
FORTE - OTF
FRANKFURT CEF SC
FREIGHT INVESTOR SERVICES LIMITED
FTSEF LLC
FTX US DERIVATIVES
FTX
FUKUOKA STOCK EXCHANGE
FX CONNECT - MTF - ALLOCATIONS
FXALL
FXCM - MTF
FXCM
G1 EXECUTION SERVICES
G360
GALAXY
GALLARDO SECURITIES LIMITED
GAMI ASSET INVESTMENT L.L.C
GARANTUM FONDKOMMISSION AB
GASPOINT NORDIC A/S
GATE US LLC
GEMMA (GILT EDGED MARKET MAKERS’ASSOCIATION)
GEORGIA STOCK EXCHANGE
GESTORE MERCATO ELETTRICO - ITALIAN POWER EXCHANGE
GFI AUSTRALIA PTY LTD
GHANA STOCK EXCHANGE
GLMX
GLOBAL COAL LIMITED
GLOBALCLEAR MERCANTILE EXCHANGE
GLOMAX EXCHANGE LTD
GMEX EXCHANGE
GMG BROKERS LIMITED
GOLDMAN SACH MTF
GOODBODY STOCKBROKERS UC
GOVEX
GPB-FINANCIAL SERVICES LTD
GRIFFIN MARKETS EUROPE - OTF
GS PRINCIPAL LIQUIDITY ASIA
GSX CHINA
GTSX
GTX ECN
GX MARKETCENTER
HANOI STOCK EXCHANGE - DERIVATIVES
HANSEATISCHE WERTPAPIERBOERSE HAMBURG
HELABA
HELEX ELECTRONIC BOOK BUILDING
HELLENIC EXCHANGE OTC MARKET
HENEX ELECTRICITY SPOT MARKET
HOCHIMINH STOCK EXCHANGE
HONG KONG EXCHANGES AND CLEARING LTD
HPC ENERGY TRADING
HRTEU LIMITED
HSBC BANK POLSKA S.A.
HSBC
HSBC-X HONG KONG
HSH NORDBANK
HUDSON RIVER TRADING - SYSTEMATIC INTERNALISER
HUNGARIAN DERIVATIVE ENERGY EXCHANGE
HWH ENERGIMEGLING
IBERCAJA BANCO SA
IBERIAN GAS HUB
IBKR ATS
ICAP ELECTRONIC BROKING (US)
ICBC STANDARD BANK
ICE BENCHMARK ADMINISTRATION
ICMA
IDX MARKETS, LLC
IEX DAP LLC
IKB DEUTSCHE INDUSTRIEBANK AG
IMC FINANCIAL MARKETS
IMC
IMMH – INTESA SANPAOLO
IMX HEALTH - FUTURES
INDEPENDENT BULGARIAN ENERGY EXCHANGE
INDEX AND OPTIONS MARKET
INDIA INTERNATIONAL EXCHANGE (IFSC) LIMITED
INDIAN COMMODITY EXCHANGE LTD.
INDONESIA COMMODITY AND DERIVATIVES EXCHANGE
INFRONT FUNDS MARKET
ING BANK NV - FOREIGN EXCHANGE
INSTINET BLOCKCROSS ATS
INSTINET
INSTITUTIONAL FINANCIAL SECURITIES MARKET
INTEGRAL MTF
INTELLIGENTCROSS - NATURAL LIQUIDITY CROSS
INTELLIGENTCROSS
INTERACTIVE BROKERS CORP
INTER-CONNECTED STOCK EXCHANGE OF INDIA LTD
INTERCONTINENTAL EXCHANGE
INTERNATIONAL MARTIME EXCHANGE
INTERNET DIRECT-ACCESS EXCHANGE
INVESCO CANADA PTF TRADES
INVEST BANCA - IBIS EQUITY
INVESTEC BANK PLC
INVESTORS EXCHANGE - DARK
INVESTRO
IPSX PRIME
IPSX
IRAN FARA BOURSE
IRAQ STOCK EXCHANGE
IRISH STOCK EXCHANGE - GLOBAL EXCHANGE MARKET
ISDAFIX
ISE GEMINI EXCHANGE
ISLAND ECN LTD, THE
ISWAP EURO MTF - ORDERBOOK
ITALIAN DERIVATIVES MARKET
J AND E DAVY - IRISH GOVERNMENT BOND
J.P. MORGAN SE
JAKARTA FUTURES EXCHANGE (BURSA BERJANGKA JAKARTA)
JAMAICA STOCK EXCHANGE
JANE STREET CAPITAL, LLC
JAPAN EXCHANGE GROUP
JAPANNEXT - J - MARKET
JEFFERIES ASIA
JOHANNESBURG STOCK EXCHANGE
JOINT ASIAN DERIVATIVES EXCHANGE
JOINT-STOCK COMPANY “STOCK EXCHANGE INNEX”
JP MORGAN - JPMI MARKET
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KELER
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KNIGHT
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MATCH NOW
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MS LONG CROSS
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OHV OTF
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POSIT - ASIA PACIFIC
POSIT
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RAYMOND JAMES
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SCOTIABANK
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SEB LITHUANIA
SEB
SECDEX CLEARING LIMITED
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SECURITISED DERIVATIVES MARKET
SEED CX
SEMOPX
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SFOX
SG AMERICAS SECURITIES, LLC - SECOND VENUE
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SI ENTER
SIB CYPRUS LTD
SIBERIAN EXCHANGE
SIEGE FX LIMITED
SIGMA X AUSTRALIA
SIM VENTURE SECURITIES EXCHANGE
SINGAPORE CATALIST MARKET
SISTEMA ELETRÓNICO DE NEGOCIACION DE ACTIVOS FINANCIEROS
SIX DIGITAL EXCHANGE
SKB BANKA D.D. LJUBLJANA
SKYTRA
SMALL EXCHANGE, INC - DESIGNATED CONTRACT MARKET
SMBC BANK EU AG
SOCIAL STOCK EXCHANGE
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SOCIETY3 FUNDERSMART
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SSY FUTURES LTD - FREIGHT SCREEN
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STATE STREET BANK AND TRUST COMPANY
STIFEL EUROPE BANK AG
STIFEL, NICOLAUS AND COMPANY, INCORPORATED
STOCK EXCHANGE OF HONG KONG LIMITED - SHANGHAI - HONG KONG STOCK CONNECT
STONEX FINANCIAL INC.
STOXX LIMITED - CUSTOMIZED INDICES
STX FIXED INCOME
SUMITOMO MITSUI BANKING CORPORATION - BRUSSELS BRANCH
SUN TRADING LLC
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SVENSKA HANDELSBANKEN AB - SVEX
SWAPEX, LLC
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SWEDBANK
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SWX SWISS BLOCK
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SYNOPTION
T.F.S. DERIVATIVES HK LIMITED
TAIPEI EXCHANGE
TAIWAN FUTURES EXCHANGE
TAURUS TDX
TD SECURITIES
TEHRAN STOCK EXCHANGE
TEL AVIV STOCK EXCHANGE
TERAEXCHANGE
TFS CURRENCIES PTE LTD
THAILAND FUTURES EXCHANGE
THE BALTIC EXCHANGE
THEMIS TRADING LLC
TIDE CM
TIRANA STOCK EXCHANGE
TOKYO COMMODITY EXCHANGE
TORA CROSSPOINT
TORONTO DOMINION BANK - LONDON BRANCH
TOTAN ICAP CO. LTD
TOWER RESEARCH CAPITAL EUROPE LTD
TP ICAP E AND C OTF - COMMODITY AND ENERGY DERIVATIVES
TPSEF, INC - VOICE
TRACK ECN
TRADE REPUBLIC BANK
TRADECHO EU APA
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TRADELINK
TRADEPLUS
TRADEWEB AUSTRALIA
TRADING 212 LIMITED
TRADITION ASIA LIMITED
TRADITION
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TRAD-X EUROPE
TRAD-X
TRAIANA INC
TRINIDAD AND TOBAGO STOCK EXCHANGE
TRUEEX LLC - DESIGNATED CONTRACT MARKET (DMC)
TRUMID ATS
TSAF OTC - OTF
TSX VENTURE EXCHANGE - DRK
TULLETT PREBON (EUROPE) LIMITED
TUNIS STOCK EXCHANGE (BOURSE DE TUNIS) - BONDS MARKET
TURKISH MERCANTILE EXCHANGE - ELECTRONIC WAREHOUSE RECEIPT MARKET
TURQUOISE EUROPE - DARK
TURQUOISE
TW SEF LLC
TWO SIGMA SECURITIES, LLC
UBS AG LONDON BRANCH - TRADING
UEDA TRADITION SECURITIES LTD.
UFEX
UGANDA SECURITIES EXCHANGE
UKRAINIAN EXCHANGE
UNICREDIT BANK AG - LONDON BRANCH - UK
UNION BANK OF INDIA UK LTD
UNIPOL BANCA S.P.A.
UNITED STOCK EXCHANGE
UNITEDBLOCKTRADE
UNIVERSAL BARTER EXCHANGE CREDIT UNION
UZBEK COMMODITY EXCHANGE
UZBEKISTAN REPUBLICAN CURRENCY EXCHANGE
VANTAGE CAPITAL MARKETS LLP - OTF
VEGA-CHI
VENOMEX LIMITED (EX. YOSHI MARKETS)
VERTICAL
VERTO MTF
VESTIMA
VICTORIA FALLS STOCK EXCHANGE
VIRTU AMERICAS LLC
VIRTUAL AUCTION GLOBAL LIMITED
VONTOBEL LIQUIDITY EXTENDER
VORVEL BONDS
VP BANK AG
VSEOBECNA UVEROVA BANKA, AS
VTB CAPITAL PLC
VWD - APA SERVICE
WALL STREET ACCESS NYC - VNDM
WARSAW STOCK EXCHANGE - OTHER THAN XOFF OR XXXX
WEL
WELLS FARGO BANK NA - LONDON BRANCH
WESTPAC BANKING CORPORATION
WIENER BOERSE AG - APA
WINTERFLOOD SECURITIES LIMITED - ELECTRONIC PLATFORM
WOOD & COMPANY FINANCIAL SERVICES, A.S.
XBERRY
XETRA – FREIVERKEHR– OFF-BOOK
XETRA
XP INVESTMENTS UK LLP
XTEND
XTRD
XTX DIRECT
ZAGREB MONEY AND SHORT TERM SECURITIES MARKET INC
ZAR X
ZERO HASH
ZHENGZHOU COMMODITY EXCHANGE
ZIMBABWE STOCK EXCHANGE
ZOBEX
ZODIA MARKETS
ZURCHER KANTONALBANK - EKMU-X
11MERCADO DE VALORES LATINOAMERICANOS (LATIBEX SMN)
21X
24 EXCHANGE
360 TRADING NETWORKS INC.
4 AFRICA EXCHANGE (PTY) LTD
42 FINANCIAL SERVICES - MTF

1/1/X1 \| 1.1.X1
Shares: ABC		500,000
	Cash		500,000

12/31/X1, the shares closed at 124.

12/31/X1 \| 31.12.X1
Shares: ABC		120,000
	Gain		120,000

Same facts except XYZ made the irrevocable decision to classify the investment as FVOCI (IFRS only).

As outlined in IFRS 9.4.1.4, an entity may elect to remeasure an equity instrument through other comprehensive income. However, this election must be made when the instrument is first recognized and is irreversible. IFRS 9.5.7.5 & 6, and IFRS 9.5.7.1A provide additional guidance on this issue.

1/1/X1 \| 1.1.X1
Shares: ABC		500,000
	Cash		500,000

12/31/X1, the shares closed at 124.

12/31/X1 \| 31.12.X1
Shares: ABC		120,000
	Gain: OCI		120,000

12/31/X1 \| 31.12.X1
Gain: OCI		120,000
	Reserve of gains and losses on financial assets FVOCI		120,000

12/1/X2, XYZ sold the shares 150.

12/1/X2 \| 1.12.X2
Shares: ABC		130,000
	Gain: OCI		130,000

12/1/X2 \| 1.12.X2
Gain: OCI		130,000
	Reserve of gains and losses on financial assets FVOCI		120,000

12/31/X2 \| 31.12.X2
Reserve of gains and losses on financial assets FVOCI		250,000
	Retained earnings		250,000

As stated in IFRS 9.B5.7.1 (edited): ... Amounts presented in other comprehensive income shall not be subsequently transferred to profit or loss. However, the entity may transfer the cumulative gain or loss within equity...

XYZ applied this guidance by reclassifying the net gain it had accumulated in the FVOCI reserve (a.k.a. AOCI) to retained earnings.

Note: While XYZ could have elected to make this reclassification immediately when it liquidated the investment, it performed it as part of its period-end close instead.

ASU 2016-01 updated ASC 825-10 eliminating the option to classify equity investments as AFS (which is generally comparable to IFRS's FVOCI).

Instead, entities may classify non-traded equity investments at cost less impairment (an option not available in IFRS).

Same facts except the shares were not traded.

XYZ acquired the shares in a private placement from the underwriter for 500,000.

As the transaction was orderly (IFRS 13.15 to 21) and between market participants (IFRS 13.22 and 23), the price (IFRS 13.24 to 26) reflected the fair value of the shares with no adjustment necessary.

1/1/X1 \| 1.1.X1
Shares		500,000
	Cash		500,000

On 12/31/X1, XYZ calculated fair value at 124 per share.

Simple in theory, determining the fair value of any company's shares, especially a private company's shares, is exceedingly difficult in practice.

For example, a quick internet search will come up with: ifrs.org link, accaglobal link, grantthornton link or deloitte link.

All these present fair value as if the calculation was a snap. But none actually try to illustrate it.

Even for public companies, where the market price represents the consensus of thousands of professionals (and amateurs) all doing their best to calculate it accurately, it is commonly all over the place.

For example, over the course of five years, Palantir shares went from 9 to 35 to 6 to 119 to 67 to 113, and so on. And this is one of the most widely studied, commented and traded companies out there.

But, as they say, if it were easy, everyone would be doing it.

Investment professionals often follow the approach summarized in this recent, Big 4-audited, report from KKR (excerpt: local link), which uses a blend of purchase price, Level 2 (market comparables), WAGs and the arbitrary, but de rigueur 10% illiquidity discount common across the industry.

Also known as Level 3, unobservable inputs, these valuations often rely on significant estimation and judgment—sometimes bordering on speculation, or, a bit more colloquially, wild ass guesses.

Foolproof? No, not really. Good enough to satisfy IFRS 9.5.2.1 b or c? Absolutely.

Note: US GAAP, on the other hand, implicitly acknowledges the fallacy in requiring fair value for non-traded investments by allowing them to be carried at cost less impairment.

12/31/X1 \| 31.12.X1
Shares		120,000
	Gain		120,000

Same facts except XYZ elected to carry the investment at impaired cost (US GAAP only)

As above, XYZ acquired the shares in a private placement from the underwriter but found it practically impossible to accurately determine their fair value.

Simple in theory, determining the fair value of any company's shares, especially a private company's shares, is exceedingly difficult in practice.

For example, a quick internet search will come up with: ifrs.org link, accaglobal link, grantthornton link or deloitte link.

All these present fair value as if the calculation was a snap. But none actually try to illustrate it.

For example, over the course of five years, Palantir shares went from 9 to 35 to 6 to 119 to 67 to 92, and so on. And this is one of the most widely studied, commented and traded companies out there.

But, as they say, if it were easy, everyone would be doing it.

Also known as Level 3, unobservable inputs, these valuations often rely on significant estimation and judgment—sometimes bordering on speculation, or, a bit more colloquially, wild ass guesses.

US GAAP implicitly acknowledges the fallacy in requiring fair value for non-traded investments by allowing them to be carried at cost less impairment.

1/1/X1 \| 1.1.X1
Shares		500,000
	Cash		500,000

On 12/31/X1, XYZ recognized:

12/31/X1 \| 31.12.X1
Shares		N/A
	Gain		N/A

When ASU 2016-01 updated ASC 825-10 and eliminated the option of classifying equity investments as AFS, it gave entities (except investment companies) the option of carrying equity investments at cost (less impairment if applicable). As a result, few companies remeasure non-traded equity investments to fair value.

Impairment

This section is currently under construction. Please check back soon.

The 2025 audit season is drawing to a close so we are about to enter our busy season, when our clients start working on their systems so things will go smoother next year.

After that, we have August where all of Europe, including us, takes vacation.

Hopefully, this section will be posted in the first half of September, before our fall busy season starts.

Derivatives

Overall

Derivatives are not difficult to summarize:

Derivatives are financial instruments based on (derived from) something else
Derivatives come as either options or forwards

Most derivatives trade on exchanges and so resemble securities.

Derivatives are not, by definition, securities. However, as most trade on exchanges, they have all the salient characteristics of securities. The main difference, unlike stocks or bonds, derivatives are primarily a tool for speculation or hedging, not investment.

The ASC master glossary defines security (emphasis added): a share, participation, or other interest in property or in an entity of the issuer or an obligation of the issuer that has all of the following characteristics:

It is either represented by an instrument issued in bearer or registered form or, if not represented by an instrument, is registered in books maintained to record transfers by or on behalf of the issuer.
It is of a type commonly dealt in on securities exchanges or markets or, when represented by an instrument, is commonly recognized in any area in which it is issued or dealt in as a medium for investment.
It either is one of a class or series or by its terms is divisible into a class or series of shares, participations, interests, or obligations.

A derivative is not a share, participation, or other interest in property or in an entity of the issuer or an obligation of the issuer but rather a financial instrument derived from a share, participation, or other interest in property or in an entity of the issuer or an obligation of the issuer. As such, it does not meet the definition of security.

Note: IFRS does not define the term security.

Some derivatives, such as stock options, can also be used as a form of currency, especially options used to compensate employees.

However, derivatives may also be just contracts or even parts of contracts.

The ASC master glossary defines financial asset as (edited): cash, evidence of an ownership interest in an entity, or a contract that both:

Imposes on one entity a contractual obligation either:
1. To deliver cash or another financial instrument to a second entity
2. To exchange other financial instruments on potentially unfavorable terms with the second entity.
Conveys to that second entity a contractual right either:
1. To receive cash or another financial instrument from the first entity
2. To exchange other financial instruments on potentially favorable terms with the first entity.

The use of the term financial instrument in this definition is recursive (because the term financial instrument is included in it), though it is not circular. The definition requires a chain of contractual obligations that ends with the delivery of cash or an ownership interest in an entity. Any number of obligations to deliver financial instruments can be links in a chain that qualifies a particular contract as a financial instrument.

Contractual rights and contractual obligations encompass both those that are conditioned on the occurrence of a specified event and those that are not. All contractual rights (contractual obligations) that are financial instruments meet the definition of asset (liability) set forth in FASB Concepts Statement No. 6, Elements of Financial Statements, although some may not be recognized as assets (liabilities) in financial statements—that is, they may be off-balance-sheet—because they fail to meet some other criterion for recognition...

Note, the IFRS glossary provides a much simpler definition of financial instrument: any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

Both IFRS and US GAAP define a contract broadly: an agreement between two or more parties that creates enforceable rights and obligations. However, if a contract meets the definition, it ceases being a simple agreement between two or more parties and becomes a derivative.

Interestingly, the IFRS definition is somewhat broader than its US GAAP counterpart so more instruments may qualify as derivatives under these standards.

IFRS master glossary (edited, emphasis added) states: a derivative is a financial instrument or other contract ... with all three of the following characteristics:

its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’).
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 expected to have a similar response to changes in market factors.
it is settled at a future date.

ASC 815-10-15-83 (emphasis added) states: A derivative instrument is a financial instrument or other contract with all of the following characteristics:

While the basic IFRS definition does not specify that a notional amount must be stated, the expanded definition (IFRS 9.BA.1 to BA.5) does state that a derivative usually has a notional amount.

Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:
1. One or more underlyings
2. One or more notional amounts or payment provisions or both.
Initial net investment. The contract 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 expected to have a similar response to changes in market factors.
Net settlement. The contract can be settled net by any of the following means:
1. Its terms implicitly or explicitly require or permit net settlement.
2. It can readily be settled net by a means outside the contract.
3. It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

The most obvious difference, unlike ASC 815, IFRS 9 does not require net settlement.

IFRS 9 discusses its lack of this requirement in more detail in BA.2 which states (edited, emphasis added): the definition of a derivative in this Standard includes contracts that are settled gross by delivery of the Underlying item (eg a forward contract to purchase a fixed rate debt instrument). An entity may have a contract to buy or sell a non-financial item that can be settled net in cash or another financial instrument or by exchanging financial instruments (eg a contract to buy or sell a commodity at a fixed price at a future date). Such a contract is within the scope of this Standard unless it was entered into and continues to be held for the purpose of delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements. However, this Standard applies to such contracts for an entity’s expected purchase, sale or usage requirements if the entity makes a designation in accordance with paragraph 2.5 (see paragraphs 2.4–2.7).

Note: if the contract "was entered into and continues to be held for the purpose of delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements," it would fulfill the definition of firm commitment "a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates." This implies that an entity could hedge one firm commitment with another firm commitment.

Nevertheless, since both IFRS 9 and ASC 815 require a zero or small net investment, arguably the most important distinguishing feature of a derivative, the impact of other differences, while not negligible, remains marginal in day-to-day practice.

Most forwards (including swaps) and some options (e.g. embedded options) fall into this category.

Embedded derivatives only become an issue if they alter a simple contract in a way that makes it, or a portion, look like or, more importantly, behave like a derivative.

In other words, if a contract that would not normally need to be accounted for as a derivative (remeasured to fair value) includes a provision(s) making it resemble a derivative, it, or the offending portion, will need to be treated as if it were derivative (remeasured to fair value).

While not identical, the guidance on how to deal with embedded derivative(s) under IFRS and US GAAP is comparable.

IFRS 9.4.3.4 (emphasis added): If a hybrid contract contains a host that is not an asset within the scope of this Standard, an embedded derivative shall be separated from the host and accounted for as a derivative under this Standard if, and only if:

the economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host (see paragraphs B4.3.5 and B4.3.8);
a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss (e.g. a derivative that is embedded in a financial liability at fair value through profit or loss is not separated).

ASC 815-15-25-1 (emphasis added): An embedded derivative shall be separated from the host contract and accounted for as a derivative instrument pursuant to Subtopic 815-10 if and only if all of the following criteria are met:

The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)

Also worth noting, embedded derivatives certainly have legitimate applications, for example, a straightforward conversion option attached to a bond serves a clear purpose. However, their presence in contracts is often anything but straightforward. Rather than existing to facilitate transparency, they are frequently included as a tool to gratuitously obfuscate the actual economic reality, distorting the visibility of market risks in a way that is anything but accidental. This intentional complication not only makes it harder for financial statement users to assess a contract's true nature, but also turns the process of identifying and bifurcating them into a formidable challenge for accountants and auditors alike. These professionals must comb through layers of contractual language, dissect financial instruments, and apply complex accounting standards just to unveil what should have been apparent from the outset.

However, once identified, the accounting itself is simple: the host contract is accounted for as a contract, and the derivative as a derivative.

For this reason, there is no need for separate illustrations specifically aimed at embedded derivatives.

Note: while only US GAAP defines embedded derivatives, IFRS does a good job explaining them.

ASC 815.20 (edited) defines: [an] embedded derivative [comprises] implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by a contract in a manner similar to a derivative instrument.

IFRS 9.4.3.1 explains: an embedded derivative is a component of a hybrid contract that also includes a non-derivative host—with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified according to a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract. A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty, is not an embedded derivative, but a separate financial instrument.

IFRS 9.4.3.1 makes this point clearly by stating (edited): An embedded derivative is a component of a hybrid contract that also includes a non-derivative host—with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified ...

While somewhat less succinct, the guidance in 815-15-15-2 and 815-15-15-4 makes the same general point.

An additional discussion of how to identify a derivative, which would also be applicable in identifying an embedded derivative, is provided in the following sub-section.

IFRS and US GAAP thus refer to them generically as financial instrument.

The IFRS master glossary (edited, emphasis added) defines a derivative as: a financial instrument or other contract...with all three of the following characteristics...

ASC 815-10-15-83 (edited, emphasis added): a derivative instrument is a financial instrument or other contract with all of the following characteristics...

That something else is known as an underlying.

An underlying is usually a financial, industrial or agricultural commodity.

The salient issue is fungibility.

With financial commodities, it tends to be absolute. One share of XYZ stock is the same as any other (in the same class). One 100 EUR bank note is the same as any other 100 EUR bank note (even if the serial numbers are different). One percent point of interest is the same as any other percent point.

With industrial and agricultural commodities, the issue becomes somewhat more complicated.

While the underlying oil in all (US) oil futures is the same, the actual oil is not. For example, ASC 815-10-55-82 discusses various grades (light versus heavy, sweet versus sour) stored at various locations (e.g. Cushing, Oklahoma). Similarly, while every pork belly future is the same, not every pork belly makes bacon with the same degree of deliciousness.

Fortunately, while it will make the hedge less than 100% effective, it will not preclude hedge accounting.

For example, the underlying for a call option on XYZ's stock is XYZ's stock. The underlying in an EUR/USD swap is the euro (for one party) and dollar (for the other). The underlying in a pork belly future is the pork belly (or, actually, a bunch of pork bellies). The underlying in an oil forward is, well, oil.

However, the underlying may also be an event or condition, for example average temperature or rainfall during a specified period, which is why both IFRS and US GAAP provide a definition.

As is its habit, US GAAP provides more thorough guidance.

ASC 815-10-15-88 states (edited): an underlying is a variable that ... usually is one or a combination of the following:

A security price or security price index
A commodity price or commodity price index
An interest rate or interest rate index
A credit rating or credit index
An exchange rate or exchange rate index
An insurance index or catastrophe loss index
A climatic or geological condition (such as temperature, earthquake severity, or rainfall), another physical variable, or a related index
The occurrence or nonoccurrence of a specified event (such as a scheduled payment under a contract).

More succinctly, IFRS discusses the underlying in its definition of a derivative (edited): ... [a derivative's] value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’)....

When the underlying is a security or commodity, the accounting is not particularly difficult.

Derivatives based on securities (stocks or bonds) or commodities (such as grain or oil) commonly trade on markets so act as securities. As such, these "plain vanilla" derivatives are easy to recognize and simple to measure. All one needs to do is find their symbol and record the corresponding closing price.

Although commonly referred to as securities, derivatives do not meet the technical definition of securities.

This issue is discussed in more detail above.

Technically, only the fair value of market-traded derivatives is obvious. If, for example, the fair value of an untraded employee stock option needs to be determined, some effort will be required. This issue is discussed in more detail below.

While common in the US or UK, not all markets use symbols.

For example, Börse Frankfurt (link) refers to its securities by name.

All derivatives are remeasured to fair value.

For this reason, US GAAP provides clear and concise guidance.

ASC 815-10-35-1 states: All derivative instruments shall subsequently be measured at fair value.

ASC 815-10-35-1A includes an exception (a.k.a. practical expedient) for receive-variable, pay-fixed interest rate swaps used for hedging, but only for non-public companies within the scope of ASC 815-20-25-133 to 138.

To ensure the point gets across ASC 815-10-10-1.b states: Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments. Derivative instruments should be measured at fair value, and adjustments to the carrying amount of hedged items should reflect changes in their fair value (that is, gains or losses) that are attributable to the risk being hedged and that arise while the hedge is in effect.

While IFRS eschews similarly clear statements, the result is comparable.

As outlined in IFRS 9.4.1.1, a financial asset is measured at amortised cost, fair value through other comprehensive income (FVOCI) or fair value through profit or loss (FVTPL).

As outlined in IFRS 9.4.1.2, a financial asset is measured at amortised cost if it (a) "is held within a business model whose objective is to hold financial assets in order to collect contractual cash flows and (b) the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding."

As outlined in IFRS 9.4.1.2A, a financial asset is measured at FVOCI if it (a) "is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets and (b) the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding."

Since a derivative (that is an asset) does not qualify to be classified as outlined in either IFRS 9.4.1.2 or IFRS 9.4.1.2A, it is classified, by process of elimination, as FVTPL.

While seemingly obvious and perhaps redundant, IFRS 9.5.2.1.c requires that, once classified as FVTPL under the above guidance, it be subsequently measured at FVTPL.

When it comes to liabilities, IFRS 9.4.2.1 states (edited, emphasis added): An entity shall classify all financial liabilities as subsequently measured at amortised cost, except for: (a) financial liabilities at fair value through profit or loss. Such liabilities, including derivatives that are liabilities, shall be subsequently measured at fair value...

For traded derivatives, this is usually their market price.

For non-traded derivatives, and traded derivatives held for hedging, it is usually something other than market price.

A more detailed discussion is available below.

Even hybrid derivatives, such as condors and butterflies and iron condors and iron butterflies (the more colorful the name the better), as they are assembled out of plain vanilla derivatives, are not particularly challenging.

When the underlying is something more "exotic," such as a condition (e.g. temperature or rainfall) or event (e.g. earthquake, flood, payment or default), recognizing and measuring the derivative can be more challenging.

Exotic derivatives are usually "exotic" because they have a non-standard underlying.

While neither the best nor most reliable source for accounting and finance information (aside from its chart of accounts page: link), Wikipedia does occasionally provide a useful list (link).

Derivatives with exotic underlyings often involve only two parties which can make them harder to identify than their "plain vanilla" cousins, especially if they are hiding inside a larger contract.

Market-traded derivatives are obvious. Similarly, any derivative that involves a third party clearing agent, tends to be based on an agreement that clearly spells out the rights and obligations of the contracting parties, making it too simple to identify.

But if structured as a contract between only two parties, where the sole barrier to convoluted phraseology designed to befuddle, confuse, and obfuscate is sheer imaginativeness, deciphering the deliberate obscurantism can prove challenging, although both IFRS and US GAAP do give it the old college try.

As defined in the master glossary, a derivative is a financial instrument or other contract within the scope of IFRS 9 (see paragraph 2.1 of IFRS 9) with all three of the following characteristics:

its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’).
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 expected to have a similar response to changes in market factors.
it is settled at a future date.

Note: as this definition is somewhat broader than its US GAAP counterpart, more instruments qualify as derivatives under IFRS than US GAAP.

Unlike ASC 815, the IFRS 9 definition does not specify that a notional amount be stated or that the contract must allow net settlement. However as the key characteristic of a derivative, a zero or small net investment, is included in both definitions, applying the guidance in practice yields few palpable differences.

Note: unlike IFRS 9, ASC 815-10-15-13 also outlines 15 specific contracts beyond its scope, and then goes on to explain, in some detail, the criteria that must be met for each exception to be applied.

As stated in ASC 815-10-15-83: A derivative instrument is a financial instrument or other contract with all of the following characteristics:

Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:
1. One or more underlyings
2. One or more notional amounts or payment provisions or both.
Initial net investment. The contract 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 expected to have a similar response to changes in market factors.
Net settlement. The contract can be settled net by any of the following means:
1. Its terms implicitly or explicitly require or permit net settlement.
2. It can readily be settled net by a means outside the contract.
3. It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

While only US GAAP defines embedded derivatives, IFRS does a good job explaining them.

ASC 815.20 (edited) states: [an] embedded derivative [comprises] implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by a contract in a manner similar to a derivative instrument.

IFRS 9.4.3.1 states: an embedded derivative is a component of a hybrid contract that also includes a non-derivative host—with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified according to a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract. A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty, is not an embedded derivative, but a separate financial instrument.

In general, embedded derivatives are only an issue if they alter a contract, which would not normally be accounted for as a derivative, in such a way that it, with their inclusion, begins to resemble a derivative.

While somewhat less succinct, the guidance in 815-15-15-2 and 815-15-15-4 makes the same general point.

Or, put differently, if a contract that would not normally need to be remeasured to fair value includes provisions that make fair value appropriate, that contract will either need to be accounted for entirely as a derivative or bifurcated, with its derivative portion(s) remeasured at fair value.

While not identical, the guidance on how to deal with embedded derivative(s) under IFRS and US GAAP is comparable.

the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host (see paragraphs B4.3.5 and B4.3.8);
a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss (i.e. a derivative that is embedded in a financial liability at fair value through profit or loss is not separated).

The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)

Also worth noting, while embedded derivatives have legitimate uses, for example a conversion option attached to a bond, they can also be included in contracts to gratuitously obfuscate the actual market risks inherent in those contracts. In these situations, identifying and bifurcating embedded derivatives is one of the more challenging tasks facing both accountants and auditors.

However, once found and removed, the accounting is simple. The host contract is accounted for as a contract and the derivative as a derivative. For this reason, there is no need for separate illustrations specifically aimed at embedded derivatives.

If the underlying is a market-traded security or commodity, pricing a derivative is relatively straightforward. If the underlying is an index of market-traded securities or commodities, since the constituents of the index are market-traded, pricing the derivative is still relatively straightforward.

If, however, the index is based on, for example, property values, inflation, the weather, public/market/political mood (a.k.a. macro events), which need to be estimated and evaluated, getting a reliable result becomes more challenging.

Fortunately, in practice, identifying a derivative is not particularly difficult.

Any contract trying to be creative with its terms probably is, or at least contains, a derivative.

For example, a contract where XYZ agrees to deliver 100 units of item X with quality Y on 6/30/X1 and ABC agrees to pay 10,000 on 7/31/X1 is most certainly not a derivative.

On the other hand, a contract where XYZ agrees to pay and ABC 10,000 if it rains for more than 10 days from 6/30/X1 to 7/31/X1 while ABC agrees to do the same if it does not, most certainly is.

As a rule of thumb, a derivative is a contract, or part of a contract, that includes the word "if", if this two-letter word determines or alters the timing, and especially amount, of the cash that will eventually change hands.

The same applies if this if is buried deep in the bowels of a contract that tries, very, very hard to pretend no if is present.

While only US GAAP defines embedded derivatives, IFRS does a good job explaining them.

While somewhat less succinct, the guidance in 815-15-15-2 and 815-15-15-4 makes the same general point.

Or, put differently, if a contract that would not normally need to be remeasured to fair value includes provisions that make fair value appropriate, that contract will either need to be accounted for as a derivative as a whole, or bifurcated with its derivative portion(s) accounted for as a derivative(s): remeasured to fair value.

Derivatives are all about fair value.

For this reason, US GAAP provides clear and concise guidance.

ASC 815-10-35-1 states: All derivative instruments shall be measured subsequently at fair value.

ASC 815-10-35-1A does include an exception (a.k.a. practical expedient) for receive-variable, pay-fixed interest rate swaps used for hedging, but only for non-public companies (in the scope of ASC 815-20-25-133 to 138).

To make certain the point gets across ASC 815-10-10-1.b states: Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments. Derivative instruments should be measured at fair value, and adjustments to the carrying amount of hedged items should reflect changes in their fair value (that is, gains or losses) that are attributable to the risk being hedged and that arise while the hedge is in effect.

While IFRS eschews similarly clear statements, the result is comparable.

As outlined in IFRS 9.4.1.1, a financial asset is measured at amortised cost, fair value through other comprehensive income (FVOCI) or fair value through profit or loss (FVTPL).

Since a derivative (that is an asset) does not qualify to be classified as outlined in either IFRS 9.4.1.2 or IFRS 9.4.1.2A, it is classified, by process of elimination, as FVTPL.

While seemingly obvious and perhaps redundant, if a financial asset is classified as FVTPL in accordance with the above guidance, IFRS 9.5.2.1.c specifies that it will subsequently be measured at FVTPL.

Derivatives are not investments. They are tools for speculation or hedging.

Thus, while a case can be made for not remeasuring some investments to fair value, there is no valid reason for not doing so with derivatives.

Unfortunately, not that all managers see it this way. Instead, some would rather pretend derivatives, especially embedded derivatives, did not exist or, if they do, their value did not change.

This is also why the guidance, particularly US GAAP's guidance, is as involved and extensive (once requiring its own DIG: Derivatives Implementation Group) as it is: to shock and awe unruly managers, bludgeoning them into submission with its sheer bulk and complexity.

But enough hyperbole, the need for extensive guidance was famously demonstrated at Enron (link) and somewhat less famously at companies like GE (link).

Here, managers refused to acknowledge, until it was too late, the real value of contracts they signed and financial instruments they created. Worse, auditors not only went along, but some even helped. Why? Some say greed. Others claim the accounting guidance in force at the time was not up to the task.

Whatever the reason, most managers at most companies have since learned to live with guidance specifically designed to make gaming the system impossible, or at least very, very difficult. Unfortunately, some still balk at having to report the real value of derivatives by devising ever more complex and convoluted contractual terms whose only purpose is to obscure and obfuscate the existence of derivatives.

For this reason, at some companies, applying the guidance and auditing the results, especially the guidance on embedded derivatives, continues to be a game of Whac-A-Mole.

Unfortunately, even the best guidance cannot end the game unless it is applied diligently. Fortunately, given its volume and complexity, a diligent accountant should always find the appropriate paragraph if he or she looks hard enough.

On the flip side, this volume and complexity also puts covering every detail beyond the scope of this page. Also, as there are other sites that do a decent job, such as this 500 page roadmap (link) or 300 page guide (link, local link), it is unnecessary.

While not identical, the guidance on how to deal with embedded derivative(s) under IFRS and US GAAP is comparable.

the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host (see paragraphs B4.3.5 and B4.3.8);
a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss (ie a derivative that is embedded in a financial liability at fair value through profit or loss is not separated).

The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)

Or, to paraphrase Supreme Court Justice Potter Stewart, "You know it when you see it."

Overall, derivatives can be classified as either options or forwards.

An option conveys the right but not obligation to perform at a specified price and time.

That performance generally involves either the purchase or sale of the underlying, though it can involve an exchange of one underlying for another, or simply a payment.

Note: the time need not be fixed. For example, while European style options may only be exercised at expiration, American style options can be exercised at any time, provided they are in the money.

A forward conveys the right and obligation to perform at a specified price and time.

Forwards may be further subdivided into futures and swaps, but can also be more difficult to pin down.

Forwards only involve two parties, e.g. a buyer and seller.

Futures, in contrast, go through clearing agencies (a.k.a. clearing houses or exchanges) so they involve three parties: the buyer, the seller and the exchange. This both increases liquidity and eliminates counterparty risk.

As a rule, futures are also marked to market daily (the daily gain or loss is added or subtracted from the trader’s margin account). Thus, if the market goes against one of the two parties, the third (the clearing agent) issues a margin call or closes out the losing position, which eliminates the risk of non-performance. The exchange may also suspend trading if the price movement exceeds a set range.

Consequently, forwards are only used when the two parties trust one another enough to accept counterparty risk. As the parties to forwards generally comprise sophisticated organizations, the market for these derivatives has traditionally been unregulated.

However, in reaction to past problems, legislative changes (for example link, link) have sought to eliminate counterparty risk by making more contracts centrally cleared. While these derivatives still (technically) involve only two parties, they have standardized terms and initial margin requirements set by a clearing house, so are safer.

Note: in the US, clearing agencies are regulated at the national level by the SEC (link) or CFTC (link). In the EU (link / local link) they are regulated at the member state level. In other jurisdictions, e.g. Canada (link) they may be regulated at a sub-national level.

Unlike regular forwards, requiring the two parties to purchase / sell the underlying, swaps involve the exchange of cash flows pegged to an underlying, for example, interest or interest rates, foreign currencies or foreign currency exchange rates, inflation, etc. Like forwards, swaps are often acquired directly from a counterparty or OTC, so carry comparable counterparty risk unless centrally cleared (for example link).

The accounting for the same swap may also be different for each of the two counterparties.

For example, a fixed for variable interest rate swap would be accounted for as a fair value hedge by one party while the variable for fixed swap as a cash flow hedge by the counterparty.

For example, a credit default swap is not really a swap (obligating the two parties to exchange the underlying or associated cash flows). Instead, a CDS is more like an option, requiring the protection seller to pay the protection buyer if the reference entity defaults (or some other trigger event occurs).

Or, even more accurately, it is a form of insurance (one of the better summaries: link / local link). As a result, both IFRS and US GAAP devote attention to comparing derivatives and insurance to make sure each is recognized appropriately. While interesting, a detailed discussion of this guidance is beyond the scope of this page.

Note: it has been argued that all options are, in fact, a form or insurance. This page does not share this opinion. The reason, insurance contracts are generally negotiated by two comparably informed and rational parties so faithfully reflect the cost of the risk being transferred. Options, on the other hand, trade on markets so often reflect the market's occasional bouts of, in the words of one central banker, irrational exuberance (or its bipolar opposite).

For this reason, this page recommends not using options, or any option-like derivatives, for any purpose other than speculation, even though neither IFRS nor US GAAP preclude designating them as hedges.

That performance generally involves either the purchase or sale of the underlying, though it can involve an exchange of one underlying for another, or simply a payment.

Some derivatives may be either or.

For example ASC 815-20 defines a weather derivative as: a forward-based or option-based contract for which settlement is based on a climatic or geological variable. One example of such a variable is the occurrence or nonoccurrence of a specified amount of snow at a specified location within a specified period of time.

Note: while IFRS 9 mentions weather derivatives (IFRS 9.B2.1), it does not define them.

While complicated in detail, the accounting for derivatives is equally easy to summarize:

Derivatives may be recognized as assets, liabilities or expenses
Derivatives are initially measured at fair value or zero
Derivatives are subsequently remeasured to fair value
If used to mitigate risk, hedge accounting is applicable.

IFRS | US GAAP hedging guidance is extensive and complicated, and with good reason.

Like the Force, derivatives can be used for good or evil.

In the right hands, they can eliminate risk and iron out volatility.

For example, if XYZ's management knows XYZ will need 20,000 million BTUs of gas next year, it can always wait until next year. But, what if a major gas producer invades a major gas distributor and the price of gas skyrockets?

To eliminate the risk, XYZ could buy the gas today. But, where would it keep it? And, how would it pay for it?

Or, XYZ could put down a small percentage and get a future instead. Sure the margin account will need to be maintained, but that is a small price for knowing, with 99.9999% certainty, that XYZ will get its 20,000 million BTUs at a price that is certain today.

Maintaining a margin account (as illustrated below) can be expensive. To avoid the cost, XYZ could get a forward instead. But, unless it is 99.9999% certain the counterparty will not renege in case of catastrophe or war (or simply because it wants to), the future is the safer option.

One can never eliminate the possibility of a meteor, but the odds are pretty low.

In the wrong ones, they can manage earnings or even threaten the economy.

Everyone remembers Enron, the poster child for using under reported financial instruments to show profits right up to bankruptcy (link). Not that other, seemingly more respectable, companies have not stooped to managing earnings with derivatives, even if less famously (link).

For example, unlike XYZ (above) ABC has no need for gas but its management has been considering the rhetoric coming out of one, unnamed country and thinks the price of natural gas will go up.

To take the bet, all it needs is a bit of cash for a margin deposit on a future. If war breaks out, party time. If not, ABC's shareholders, and perhaps its creditors if things go badly enough, take the hit.

Worse, what if, instead of a future, ABC's management convinced an unsuspecting counterparty to take the other side of a forward, perhaps by obfuscating the forward's existence by embedding it into a contract whose esoteric nomenclature was specifically designed to befuddle and confuse the uninitiated?

And what about that counterparty’s owners and creditors, and their creditors, and their creditors...?

Sure, most of the time, nothing that dramatic happens. But, once in a while, organizations like LTCM or AIG remind everyone how explosive the mix of passion, ambition, greed, recklessness and excess trust can be.

Enron, the poster child for obfuscation, does not make this list because, having emerged from a merger between Houston Natural Gas and InterNorth, it was never trusted by anyone of consequence and thus never posed a systemic risk.

The regulator's job is to make sure managers stick to the right side of even though, all about chasing peace with little passion and not much ambition, doing so is about as much fun as driving the speed limit. The accounting guidance, and practitioners applying it, are there to make sure regulators get the information they need.

IFRS | US GAAP explicitly states it exists to serve investors and creditors (a.k.a capital providers).

This point is explicitly made in the conceptual framework.

CF 1.2 | CON 8.1.OB2 (emphasis added) states: The objective of general purpose financial reporting1 is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit.

It is not aimed at regulators.

While implied by its stated aim (above), to make sure the point gets across, the conceptual framework also states:

CF 1.10 | CON 8.1.OB2 OB10: Other parties, such as regulators and members of the public other than investors, lenders, and other creditors, also may find general purpose financial reports useful. However, those reports are not primarily directed to these other groups.

Nevertheless, unlike the everyday items every company reports (revenue, cost of sales, PP&E, debt, leasing, etc.), only some companies report derivatives. Given the danger the careless use of derivatives can pose, regulators pay extra special attention to that subset, not only to ensure compliance with accounting guidance but also to prevent managers from doing anything silly.

So, while financial reports may not be primarily directed to this "other group", the nature and detail of the information they require make clear that standard setters (especially the FASB) were thinking about the needs of regulators when it comes to derivatives.

Note: in the past, it has been argued that management did not always misuse derivatives intentionally but rather lacked adequate information due to accountants working with insufficient guidance. Given that most managers are taught about derivatives in MBA programs, and can design their own managerial accounting if they need additional information, this argument has always seemed dubious, though perhaps plausible. Not anymore. Given the scope and detail of today's IFRS, and especially US GAAP, ignorance is no longer a valid excuse.

And just the guidance itself has an ataractic effect. At over 300 pages printed out, ASC 815 is formidable. Its sheer volume and detail makes finding novel ways of avoiding it so difficult all but the most determined give up.

While not nearly as voluminous, the hedge accounting section in IFRS 9 is no easy, bedtime reading either.

Companies may also choose to continue applying IAS 39, an option that will remain until the IASB finalizes its macro hedging project.

Also worth noting, IFRS and US GAAP remain far from converged, making a dual filer’s job significantly harder.

For example, just one illustration of how to assess hedge effectiveness is almost a page long.

ASC 815-25-55-1E This Example illustrates the guidance in Sections 815-20-25, 815-20-35, and 815-25-35 for how an entity may assess hedge effectiveness in a fair value hedge of natural gas inventory with futures contracts. Assume that the hedge satisfied all of the criteria for hedge accounting at inception.

ASC 815-25-55-2 Entity A has 20,000 million British thermal units of natural gas stored at its location in West Texas. To hedge the fair value exposure of the natural gas, Entity A sells the equivalent of 20,000 million British thermal units of natural gas futures contracts on a national mercantile exchange. The futures contracts prices are based on delivery of natural gas at the Henry Hub gas collection point in Louisiana.

ASC 815-25-55-3 The price of Entity A's natural gas inventory in West Texas and the price of the natural gas that is the underlying for the futures contracts it sold will differ as a result of regional factors (such as location, pipeline transmission costs, and supply and demand). Entity A therefore may not automatically assume that the hedge will be highly effective at achieving offsetting changes in fair value, and it cannot assess effectiveness by looking solely to the change in the price of natural gas delivered to the Henry Hub. The use of a hedging instrument with a different underlying basis than the item or transaction being hedged is generally referred to as a cross-hedge. The principles for cross-hedges illustrated in this Example also apply to hedges involving other risks. For example, the effectiveness of a hedge of interest rate risk in which one interest rate is used as a surrogate for another interest rate would be evaluated in the same way as the natural gas cross-hedge in this Example.

ASC 815-25-55-4 Both at inception of the hedge and on an ongoing basis, Entity A might assess the hedge's expected effectiveness on a quantitative basis based on the extent of correlation in recent years for periods similar to the spot prices term of the futures contracts between the spot prices of natural gas in West Texas and at the Henry Hub. If those prices have been and are expected to continue to be highly correlated, Entity A might reasonably expect the changes in the fair value of the futures contracts attributable to changes in the spot price of natural gas at the Henry Hub to be highly effective in offsetting the changes in the fair value of its natural gas inventory. In assessing effectiveness during the term of the hedge, Entity A must take into account actual changes in spot prices in West Texas and at the Henry Hub. The period of time over which correlation of prices should be assessed would be based on management's judgment in the particular circumstance.

ASC 815-25-55-5 Entity A may not assume that the change in the spot price of natural gas located at Henry Hub, Louisiana, is the same as the change in fair value of its West Texas inventory. The physical hedged item is natural gas in West Texas, not natural gas at the Henry Hub. In identifying the price risk that is being hedged, Entity A also may not assume that its natural gas in West Texas has a Louisiana natural gas component. Use of a price for natural gas located somewhere other than West Texas to assess the effectiveness of a fair value hedge of natural gas in West Texas would be inconsistent with this Subtopic and could result in an assumption that a hedge was highly effective when it was not. If the price of natural gas in West Texas is not readily available, Entity A might use a price for natural gas located elsewhere as a base for estimating the price of natural gas in West Texas. However, that base price must be adjusted to reflect the effects of factors, such as location, transmission costs, and supply and demand, that would cause the price of natural gas in West Texas to differ from the base price.

ASC 815-25-55-6 Consistent with Entity A's method of assessing whether the hedge is expected to be highly effective, the hedge would not be perfectly effective and there would be a net earnings effect to the extent that the actual change in the fair value of the futures contracts attributable to changes in the spot price of natural gas at the Henry Hub did not offset the actual change in the spot price of natural gas in West Texas per million British thermal units multiplied by 20,000.

ASC 815-25-55-7 That method excludes the change in the fair value of the futures contracts attributable to changes in the difference between the spot price and the forward price of natural gas at the Henry Hub in assessing effectiveness. The excluded amount would be recognized in earnings through an amortization approach in accordance with paragraph 815-20-25-83A or a mark-to-market approach in accordance with paragraph 815-20-25-83B and presented in the same income statement line item as the earnings effect of the hedged item in accordance with paragraph 815-20-45-1A.

Making that volume and detail approachable to a casual observer is a fool's errand.

Googling hedge accounting either leads to pages that simply reiterate the guidance omitting all detail (e.g. link, link) or ones, such as this 500 page roadmap (link) or 300 page guide (link, local link), that makes one think one may be better off simply reading the original.

Note: this page (link), while a bit short on references, provides a good, approachable comparison of US GAAP and IFRS, and is recommended.

Having said that, this site's aim is to make that volume and detail approachable to a casual observer (disclaimer).

This section glosses over many details so is not aimed at the practitioner who will be applying the guidance in the real world. Instead, it is aimed at the casual observer curious what the fuss is about or who would just like to join in the dinner conversation when it turns, as all dinner conversations inevitably do, to derivatives and hedging.

Options that begin as assets remain assets (just as options that begin as liabilities).

For example, if XYZ acquired a 90 day call option with an exercise price of 100 on a stock that was trading for 90, it would pay around 148 and recognize an asset. If it wrote a put option instead, it would receive around 1,047 and recognize a liability.

Note: while an option's fair value can decline to zero, it can never cross zero so an option will remain an asset (liability) until it expires (or is so close to expiration that it stops trading).

Forwards and futures, on the other hand, may change back and forth.

For example, a 200 forward call contract on a commodity trading for 210 would be an asset. If the commodity's price fell to 190, it would change from an asset into a liability. If the price again increased to 205, it would change back into an asset, and so on.

For example, if XYZ and ABC agreed to buy/sell (or settle net) 100 units a commodity at 10 per unit when its market price was 10 per unit, the forward would have zero value until the commodity's market price changed.

For example, if XYZ granted its employees options to acquire its shares, it would recognize a compensation expense equal to the fair value of those options.

Derivatives are all about fair value. Unlike other financial assets and liabilities, derivatives are mostly used for speculation or hedging, so no reason for not remeasuring them exists.

For example, one cornerstones of US GAAP's guidance on derivatives (ASC 815-10-10-1.b, edited) is: Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments...

While the IASB has never spelled out any "cornerstones," since IFRS requires all derivatives to be measured at fair value, presumably it shares the same opinion.

Remeasuring receivables makes little sense. No active market for them exists and, while they can be factored, most companies hold them until collection. The same applies to loans, notes or bonds a company holds solely to collect interest and principal. It makes even less sense to remeasure payables.

While a case can be made for remeasuring other financial liabilities, the fact a decrease in the debtor's credit standing would generate gains means such proposals have never gained any traction (outside academic circles).

Derivatives may also be used as a form of employee compensation and occasionally to buy goods or other services.

However, determining fair value in these transactions is just as important.

For this reason, IFRS 2 and ASC 718 require share-based payment transactions, including transactions involving stock options, to be measured at fair value. The only difference, unlike options used for speculation or hedging, those given to employees as compensation for services to be rendered need not be remeasured to fair value each reporting date.

While on the topic, while similar, the guidance in IFRS 2 and ASC 718 is not identical.

Specifically, IFRS 2.10 requires equity-settled share-based payment transactions to be measured at the fair value of the goods and services received and then at the fair value of the equity instruments issued only if the fair value of the goods or services cannot be estimated reliably.

In contrast, ASC 718-10-30-2 specifies that “the cost of goods obtained or services received in exchange for awards of share-based compensation generally shall be measured based on the grant-date fair value of the equity instruments ...” It does not give the option of measuring the equity instruments by reference to the goods or services acquired.

However, as most services acquired in share-based transactions come from employees (in which case IFRS 2.11 and 12 require the services to be measured at the fair value of the equity instruments), this difference has little impact in most situations.

As a result, US GAAP provides categorical guidance.

ASC 815-10-35-1 states: All derivative instruments shall be measured subsequently at fair value.

While IFRS eschews similarly clear statements, the result is comparable.

As outlined in IFRS 9.4.1.1, a financial asset is measured at amortised cost, fair value through other comprehensive income (FVOCI) or fair value through profit or loss (FVTPL).

Since a derivative (that is an asset) does not qualify to be classified as outlined in either IFRS 9.4.1.2 or IFRS 9.4.1.2A, it is classified, by process of elimination, as FVTPL.

Unfortunately, not all managers see it this way.

Instead, some would rather pretend derivatives, especially embedded derivatives, did not exist or, if they did, their value did not change.

But enough hyperbole, the need for extensive guidance was famously demonstrated at Enron (link) and somewhat less famously at companies like GE (link).

Whatever the reason, most managers at most companies have since learned to live with guidance specifically designed to make gaming the system impossible, or at least very, very hard. Unfortunately, some still balk at having to report the real value of derivatives by devising ever more complex and convoluted contractual terms whose only purpose is to obscure and obfuscate the existence of derivatives.

For this reason, at some companies, applying the guidance and auditing the results, especially the guidance on embedded derivatives, continues to be a game of Whac-A-Mole.

Unfortunately, even the best guidance cannot stop the game unless it is applied diligently. Fortunately, given its volume and complexity, a diligent accountant should always find the appropriate paragraph if he or she looks hard enough.

On the flip side, this volume and complexity make covering every detail beyond the scope of this page. Also, as there are other sites that do a decent job, such as this 500 page roadmap (link) or 300 page guide (link, local link), it is unnecessary.

A derivative's fair value may be its market, intrinsic or calculated (determined) value.

While IFRS 9 | ASC 815 requires derivatives to be measured at / remeasured to fair value, it does not specify how fair value should be determined. Instead, this is addressed IFRS 13 | ASC 820 (see the fair value page).

To summarize, IFRS 13 | ASC 820 requires fair value to be determined on the basis market value if possible.

Thus, if a derivative is market-traded, its fair value reflects its market price. If the derivative is not market-traded but the underlying is, the derivative's fair value reflects its intrinsic value. If neither the derivative nor the underlying are market-traded, the derivative's fair value must be determined.

After fair value has been determined, IFRS 9 (IAS 39) | ASC 815 takes over, providing the remaining guidance.

To summarize, IFRS 9 | ASC 815 requires the changes in the derivative's fair value (gains/losses) to be:

recognized in net income (speculation),
offset with the gains/losses on the underlying (fair value hedge) or
recognized in comprehensive income (cash flow hedge).

Note: in some situations, the derivative’s fair value is broken down into its components (intrinsic value and time value). The gains/losses on each of part are then recognized separately. Occasionally, only the gains/losses on intrinsic value are recognized.

When both the derivative and its underlying is market-traded, time value is calculated by subtracting intrinsic value from market value. When a derivative is not market-traded but its underlying is, fair value is determined by adding time value (which needs to be calculated) to intrinsic value. When neither the derivative nor its underlying is traded on the market, the fair value of the derivative as a whole is determined first. This fair value may then be then allocated to the intrinsic and time value components.

As outlined in ASC 815-20-25-82, time value may be broken down further into θ (theta), ν (vega) and ρ (rho) in that any of these components may be excluded from the assessment of a hedge's effectiveness.

As outlined in IFRS 9.6.5.15, an option’s time and intrinsic values may be accounted for separately, but IFRS 9 does not allow breaking time value down into its constituent parts.

Also note: IFRS 9 allows IAS 39, which is comparable overall but different in detail, to continue to be applied.

Market value should be obvious. It is the price at which the derivative is trading on the applicable market.

In general, futures and options are measured at market value.

Note: some derivatives only trade OTC where market prices may not be reliable or available. In this case, fair value needs to be determined. Some derivatives are also embedded in larger contracts. If comparable market-traded derivatives cannot be found, their fair value must also be determined.

Also note: some derivatives trade on multiple markets. For this reason, IFRS 13.18 | ASC 820-10-35-6 specifies that market price should be the price on the principal market even if even the price on a different market is better.

Intrinsic value is somewhat less obvious than market price. It is the difference between the underlying's market price and the derivative's strike price (or zero).

While neither IFRS nor US GAAP provide a general definition of intrinsic value, both discuss it in the context of stock options.

IFRS 2 defined terms: The difference between the fair value of the shares to which the counterparty has the (conditional or unconditional) right to subscribe or which it has the right to receive, and the price (if any) the counterparty is (or will be) required to pay for those shares. For example, a share option with an exercise price of 15 on a share with a fair value of 20 has an intrinsic value of 5.

ASC master glossary: The amount by which the fair value of the underlying stock exceeds the exercise price of an option. For example, an option with an exercise price of $20 on a stock whose current market price is $25 has an intrinsic value of $5. (A nonvested share may be described as an option on that share with an exercise price of zero. Thus, the fair value of a share is the same as the intrinsic value of such an option on that share.)

For example, both a 90 call forward (or future) and 90 call option on a 100 stock would have an intrinsic value of 10.

However, a 100 call forward on a 90 stock would have an intrinsic value of (10), while the option's would be 0.

In general, forwards, exotics and non-traded derivatives, such as embedded options, are measured at intrinsic value.

Occasionally, most often with embedded options, fair value cannot be determined by reference to a market. In these situations, a valuation technique is used instead.

While it would be logical to refer to fair value calculated using such a technique as "calculated fair value," the ASC master glossary defines "calculated value: a measure of the value of a share option or similar instrument determined by substituting the historical volatility of an appropriate industry sector index for the expected volatility of a nonpublic entity's share price in an option-pricing model."

To avoid potential confusion, this page labels fair value calculated using a valuation technique determined fair value.

IFRS does not define "calculated value" so using this term in an IFRS context would be acceptable.

Regardless of terminology, the model generally used to value forwards and futures is straightforward.

S₀ = F₀ x (1 + R_f)^T

S₀ = Spot price, F₀ = Future (forward) price, R_f = Risk free rate for maturity T, T = Time.

While various models for options exist, Black–Scholes (a.k.a. Black–Scholes–Merton) is the most commonly used in practice.

Note: while this model can be built in Excel with a few deceptively simple formulas or found incorporated into several web pages (link, link, link) applying Black–Scholes in practice is less straightforward.

While building the model is not particularly challenging, getting it to yield an acceptable result is.

The reason, as programmers say, GIGO.

For the model to produce an accurate result, it has to be fed accurate data including volatility.

While calculating historical volatility is simple (e.g., in Excel format =STDEVP(A1:A12)*SQRT(12)), using historical volatility to estimate future value is absurd.

Instead, for the result to make any sense, expected future volatility needs to be used. And there is the rub. Estimating future volatility accurately is difficult, and estimating it with 100% accuracy impossible.

So, to avoid implying that calculating the fair value of options is simple or straightforward, we do not include this model in our downloadable Excel file.

However, for those willing to take the chance, this site (link) provides easy to follow instructions.

While the model is deceptively simple, getting it to produce accurate results requires an accurate estimate of future volatility.

And this is hard even with plain vanilla options where some market data is available. When it comes to options with special features, such as those used to compensate employees, the difficult increases.

For example, determining the fair value of an option award that vests over 10 years but only if the company achieves a specified profit target and its shares trade above a set amount in each of those ten years, and the employee remains with the company, can be a challenge, even for a PhD.

But, as they say, if it were easy, everyone would be doing it.

Note: as Black–Scholes is only appropriate for market-traded ("plain vanilla") options with no friction, ASC 718-10-55-16 discusses additional ways to value options with special features. These models can also be used to estimate the value of options on commodities where there may be considerable friction (storage costs, transportation fees, an underlying not identical to the hedged item, etc.).

Also note: to avoid having to deal with the issue of friction, this page assumes all our options are perfectly aligned (see IFRS 9 B6.5.32 and 33).

Myron Scholes and Fischer Black developed the original formula while Robert Merton improved it. For their contribution, Scholes and Merton received a Nobel prize in 1997 (Fischer Black unfortunately died in 1995).

Interestingly, both Scholes and Merton also served on the board of LTCM (Long-Term Capital Management) and helped John Meriwether develop the strategy that almost led to the meltdown of the financial system in 1998 (the Federal Reserve stepped up for the rescue).

Is there a moral to this story? Hard to say, but perhaps that developing a mathematical model in an academic clean room is different from making it work in the not so spotless real world.

Or maybe that only really smart people get to make the really big mistakes, since no one else is ever trusted enough by enough people to really F... things up.

If used for speculation, the list is be applied in order: 1. market value, 2. intrinsic value, 3. determined value.

If the derivative is traded on a market, its fair value equals its market price. Simple.

If the derivative is not traded on a market but the underlying is, its fair value equals its intrinsic value. Also simple.

Unless the derivative is an option with special features that need to be considered.

If neither the derivative nor the underlying is traded on a market, the accountant first takes a deep breath then, after the panic attack subsides, uses a valuation technique (as discussed in more detail on this page).

For hedging, it depends how hedge is designated, how its effectiveness measured, the exemption(s) applied, etc.

As the above sentence implies, the guidance on hedging with derivatives is not succinct, easy to read or simple to apply.

For example, in IFRS, just the guidance on hedge effectiveness comprises IFRS 9.6.4.1.c (and B6.4.4 to 11) or IAS 39.AG105 to AG113A (IFRS 9 allows entities to continue to apply IAS 39).

In US GAAP, it is even more voluminous (ASC 815-20-25-72 to 131).

Perusing the guidance, it almost seems like the standard setters went out of their way to make it as arcane as possible so as to dissuade all but the most determined.

Be that as it may, the basics are not overly complicated and can be summarized in a few, relatively simple examples.

Disclaimer

Trying to learn how to apply all IFRS | US GAAP guidance on hedging by surfing the internet is like trying how to learn how to use a table saw by watching YouTube.

So, while the few rudimentary examples on this page illustrate how hedge accounting works in general, they are no substitute for a detailed study of the guidance preferably assisted by a qualified and experienced professional.

Derivatives may be used to create risk, a.k.a. trading or speculation.

Everyone knows the adage: no risk, no reward.

Derivatives make creating risk easy.

For example, if XYZ's management believes the price of crude oil will rise, it could create risk by buying oil. If the risk pays off, the reward is the resulting gain. However, this risk would be difficult and expensive to create. Not only would XYZ need to find a seller and finance the purchase, it would also need to cover transportation and/or storage costs. And, as no one sells just a few barrels of oil, the initial outlay would be significant.

Or, XYZ could enter into a futures contract (link). Not only would finding a seller be easy (assuming it had an account with a broker or exchange), but a few futures contracts cost considerably less than a tanker full of oil. Also, as it would only need to come up with a margin deposit (around 10%, give or take), the initial outlay would be a fraction. And that's not all. If the risk pays off, the resulting gain is amplified by the margin, perhaps more than 10 fold.

Party time!

However, people sometimes forget the corollary: no risk, no punishment.

If, instead of going up, the price of oil falls, XYZ's punishment would be swift. It would receive a margin call. Then, it would either have to top up its margin deposit, putting more money at risk, or the account would be closed, locking in the loss forever.

The safer way to create risk is with an option.

With an option, as the position’s value can never turn negative, there is no risk of a margin call (unless one borrowed to acquire the option).

However, as the cost of options is usually higher, the reward is lower but, punishment remains more or less the same (assuming one does not top up one's margin deposit).

Note: while acquireing (both call and put) options is, relatively speaking, safe. Writing them? Not so much. Puts are not that bad. All they may require is paying more than market. Calls are another story. If someone really wants to really ride the roller-coaster, writing naked calls is the ticket (assuming one has a level III brokerage account).

Actually, this metaphor does not do this particular risk justice.

A more apt comparison: playing Russian roulette with 3 full cylinders.

Derivatives may also be used to mitigate risk, a.k.a. hedging.

A classic, but nonetheless good, example is a baker and farmer.

The baker's risk is that a failed crop will drive up prices making its future grain cost more. The farmer's risk is that a bumper crop will drive down prices making its harvest worth less.

The baker can mitigate risk with a call future which puts a ceiling on the price it will need to pay. Obviously, if there is a bumper crop, the baker will pay more than market, but this risk is offset by the elimination of the price uncertainty.

While it could be argued that the risk has been eliminated, hedging is rarely 100% effective.

For example, a grain future is pegged to a generic grain delivered at a central location while the baker may need a specific variety delivered somewhere else.

Unlike futures, forward contracts are negotiated by the two parties, so these contracts are often 100% effective.

ASC 815-25-55-38 provides a brief illustration of this issue. However, even though it addresses natural gas, ASC 815-25-55-1 to 7 provides a more thorough discussion of the various factors that affect effectiveness.

Fortunately, neither IFRS nor US GAAP requires a hedging relationship to be 100% effective to qualify for hedge accounting. Instead, the hedge only needs to be highly effective, which IAS 39.AG105.b defines as 80% to 125%.

Note: IFRS 9 and ASC 815-20 eschew similar numeric quantification.

IFRS 9.6.4.1.c has moved to an effectiveness criterion that assesses the economic relationship, effect of credit risk and hedge ratio. Nevertheless, entities may continue to apply IAS 39, so 80% to 125% is still commonly, though not universally, used in practice.

Entities that have transitioned to IFRS 9 apply the guidance outlined in IFRS 9.B6.4.4–B6.4.6 (economic relationship), IFRS 9.B6.4.7–B6.4.8 (effect of credit risk) and IFRS 9.B6.4.9–B6.4.11 (hedge ratio).

US GAAP has never provided similar bright line guidance. Instead, ASC 815-20-25-72 to 131 provide an extensive discussion of hedge effectiveness.

Nevertheless, 80% to 125% is commonly used as rule of thumb when making an initial assessment of whether a hedge will likely qualify before its effectiveness is examined more thoroughly.

Note: while ASC 815-20-25-102 to 104 outline a "shortcut method" under which an entity can assume 100% effectiveness for an interest rate swap provided specified conditions are met, this does not mean that the hedge will necessarily be 100% effective.

The farmer can mitigate risk by writing a call future. Obviously, the farmer's situation is more complex. If its crop fails, the farmer will still need to deliver the grain or (since a future is a derivative) settle net (pay the difference between the strike and market price). To eliminate all risk, the farmer will need a more sophisticated hedging strategy (or crop insurance).

Derivatives are always remeasured to fair value (above).

If held for speculation, this makes net income more volatile.

If held for hedging, it has the opposite effect.

Hedge accounting allows the remeasurement gains/losses to either bypass net income (cash flow hedge) or cancel each other out (fair value hedge).

IFRS and US GAAP outline three basic types of hedges:

IFRS 9 specifies the three types of hedges in IFRS 9.6.5.2.

It outlines the accounting for each in IFRS 9.6.5.8 to 6.5.10, IFRS 9.6.5.11 to 12, and IFRS 9.6.5.13 and 14.

ASC 815 both specifies the hedges and outlines the basic accounting in ASC 815-20-35-1.

The ASC then discusses the individual types in separate sub-topics: ASC 815-25, ASC 815-30 and ASC 815-35.

In addition to the three basic types, ASC 815 provides guidance for contracts in entity's own equity (ASC 815-40) and weather derivatives (ASC 815-45).

In contrast, IFRS 9 only mentions weather derivatives in passing (IFRS 9.B2.1) and does not specifically address "contracts in entity's own equity." In this Webinar (link, local link) the IASB did, however, discuss how its guidance applies to the classification of derivatives on own equity.

cash flow
fair value
net investment (not covered)

I realize I'm breaking the fourth wall but, in my experience, no one cares about net investment hedging.

The main reason I hear, consolidation forex differences end up OCI just like cash flow hedges. So, even though the hedge would slightly rearrange OCI, financial statement users would not notice or, if they did, care much.

Also, investments in subsidiaries tend to be long-term. To hedge them properly would require a constant stream of new hedges. Again, not worth the aggravation or expense. Sure, if a loan was used to set up a foreign operation, why not designate it as a hedging instrument. But who in their right mind would take out a loan, and pay interest, just to rearrange OCI a bit.

So, I decided why bother. Putting these pages together isn't easy so why waste time and effort on something no one cares about? However, this may just be my experience and I may have made a mistake. So, if net investment hedging is a burning a hole in your brain, please write. If I get enough requests, I'll add an example or two.

As the name implies, a cash flow hedge fixes the amount of an expected future receipt or disbursement of cash.

IFRS refers to this as a forecast transaction while in US GAAP the transaction is forecasted.

IFRS 9 defines forecast transaction: an uncommitted but anticipated future transaction.

The ASC glossary defines Forecasted Transaction: a transaction that is expected to occur for which there is no firm commitment. Because no transaction or event has yet occurred and the transaction or event when it occurs will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or a present obligation for future sacrifices.

For example, before the end of a period, XYZ estimated it would probably need to buy goods, with a then market price of 20,000, in a future period at a future market price. To hedge that forecasted transaction, it entered into an at-the-money call forward. At the end of the period, the market price of the goods increased to 22,000, so XYZ recognized a gain of 2,000 on the forward. Since there was no offsetting loss, it recognized the gain in other comprehensive income and accumulated on the balance sheet in a separate section of equity dedicated to cash flow hedges. When it bought the goods, their market price was 24,000. However, as it had timed the forward correctly, the counterparty settled for 4,000, making XYZ's net outlay 20,000 (XYZ could have also exercised the forward, in which case it would have paid the counterparty 20,000 and the counterparty would have delivered the goods).

As outlined in IFRS 9.6.3.3 | ASC 815-20-25-15.b, to qualify for hedge accounting, a forecast transaction must be highly probable | probable. As discussed in more detail on this page, highly probable | probable equates to a likelihood of 75% to 80% or higher.

In contrast to futures, forwards can be customized so the underlying can be anything, not just a commodity. They are also often entered into without any premium being paid or received, so they are free.

However, as they are only between two parties, they do carry counterparty risk.

In contrast to fair value hedges (below), there is no offsetting gain or loss associated with a hedged item.

Note: if XYZ had, instead of merely forecasting it would need to buy the goods, entered into a firm commitment to buy the goods (with a third party), it could have designated that firm commitment as a hedged item and accounted for the forward as a fair value hedge.

In order for a financial instrument to be classified as a derivative according to ASC 815, it has to allow net settlement (either directly or through a market mechanism). While IFRS 9 does have the same strict requirement, since practically all derivatives are settled net anyway, it is a moot point.

Note: this example also assumes the counterparty did not renege on its obligation, which is always a risk associated with forwards though not futures.

Note: the amount accumulated in equity is, as illustrated below, treated differently under IFRS and US GAAP.

Like a cash flow hedge (above), a fair value hedge can fix the amount of an expected future receipt or disbursement. Unlike a cash flow hedge, it paired with an asset or liability so, instead of bypassing net income, the gain/loss on the derivative is offset against the loss/gain on the hedged item.

For example, if the derivative hedges a firm commitment involving a payment or disbursement, it is, in effect, hedging that cash flow. Same as if, for example, it is used to hedge a receivable or payable denominated in a foreign currency against foreign exchange risk.

However, IFRS 9.6.5.2.a does not preclude, and 815-20-25-12.e specifically allows, any asset or liability, including a non-financial asset or liability, being designated the hedged item. The derivative can thus hedge the fair value of any item, even one the entity does not intend to sell or settle (convert to cash).

In addition to recognized assets and liabilities, unrecognized firm commitments may also be designated as hedged items.

Before designation, such a firm commitment is unrecognized, so is neither an asset nor a liability. After designation, it is remeasured to fair value so becomes an asset or liability. As its fair value changes, it can also change from one to the other, back and forth.

For example, before the end of a period, XYZ agreed to buy a commodity, with a then market price of 20,000, in a future period at a future market price. To hedge that firm commitment, it entered into an at-the-money call future. At the end of the period, the market price of the commodity increased to 22,000, so XYZ recognized a gain of 2,000 on the forward and an offsetting loss of 2,000 on the firm commitment. When it bought the commodity, its market price was 24,000. However, as it had timed the future correctly, its broker settled for 4,000, making XYZ's net outlay 20,000 (XYZ could have also exercised the future, in which case it would have taken delivery and paid the 20,000 balance).

In addition to recognized assets and liabilities, IFRS 9.6.5.2.a | ASC 815-20-25-12.a allows unrecognized firm commitments to be designated as hedged items.

IFRS 9 defines a firm commitment: a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

ASC 815 also defines firm commitment, but somewhat more thoroughly: an agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:

The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield. The binding provisions of an agreement are regarded to include those legal rights and obligations codified in the laws to which such an agreement is subject. A price that varies with the market price of the item that is the subject of the firm commitment cannot qualify as a fixed price. For example, a price that is specified in terms of ounces of gold would not be a fixed price if the market price of the item to be purchased or sold under the firm commitment varied with the price of gold.
The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. In the legal jurisdiction that governs the agreement, the existence of statutory rights to pursue remedies for default equivalent to the damages suffered by the nondefaulting party, in and of itself, represents a sufficiently large disincentive for nonperformance to make performance probable for purposes of applying the definition of a firm commitment.

Unlike forwards, futures are easy to acquire. To get one, one does not need to find a counterparty willing to take the other side of the contract, but merely have an account with a broker or exchange.

However, also unlike forwards, where the counterparties are often willing to transact cost free, futures come at a premium. They also require a margin deposit, usually somewhere around 10% of the strike price.

For simplicity, this example ignores both the transaction cost and deposit. Also for the sake of simplicity, it assumes the firm commitment was for a commodity identical to the future's underlying.

In order for a financial instrument to be classified as a derivative according to ASC 815, it has to allow net settlement (either directly or through a market mechanism). While IFRS 9 does have the same strict requirement, since futures are traded on a market the market itself facilitates net settlement.

Note: both IFRS 9 and ASC 815 discusses fair value hedges before cash flow hedges. However, as cash flow hedges are more popular, this site presents them first.

Besides foreign currencies and firm commitments, few companies have any use for fair value hedging.

While most EU / US based companies face little foreign exchange risk, companies in smaller jurisdictions can face enormous foreign exchange challenges, so commonly hedge their exposure. Fortunately, they mostly only hedge currency pairs, so the accounting, as illustrated on this page, is straightforward.

In contrast, large, multinational companies operating across multiple jurisdictions often use more sophisticated strategies to both manage and exploit forex risk. However, a discussion of these strategies, and the associated accounting, is beyond the scope of this web site.

When a company agrees to buy or sell at a fixed price well into the future, it exposes itself to considerable risk. As most companies try to avoid such risk, these agreements are relatively uncommon. Nevertheless, for the subset of companies that do make firm commitments, hedging the exposure is a very good idea.

ASC 815 defines firm commitment: An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:

The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield. The binding provisions of an agreement are regarded to include those legal rights and obligations codified in the laws to which such an agreement is subject. A price that varies with the market price of the item that is the subject of the firm commitment cannot qualify as a fixed price. For example, a price that is specified in terms of ounces of gold would not be a fixed price if the market price of the item to be purchased or sold under the firm commitment varied with the price of gold.
The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. In the legal jurisdiction that governs the agreement, the existence of statutory rights to pursue remedies for default equivalent to the damages suffered by the nondefaulting party, in and of itself, represents a sufficiently large disincentive for nonperformance to make performance probable for purposes of applying the definition of a firm commitment.

While the IFRS 9 definition (A binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates) is not as comprehensive, it is comparable.

Note: if a company merely wants to hedge its exposure to market prices without making any commitments, it can always designate the derivative as a cash flow hedge so, in effect, have its cake and eat it too.

Why would, for example, a manufacturer or refrigerators hedge the fair value of the steel it has already bought and intends to use to make refrigerators? Similarly, it makes little sense to hedge the fair value of receivables or payables (unless they happen to be denominated in a foreign currency) or swap predictable fixed interest payments for unpredictable variable ones.

As a rule, commodities producers do a lot of fair value hedging. But, this exception proves the rule. Most companies are not commodities producers. It makes little sense for a manufacturer of products to hedge the fair value of raw material going into those products.

What does, on the other hand, make sense, hedging the cash that will need to be expended to acquire the raw material. The further into the future, and the more volatile the price, the more sense it makes.

However, this would be a cash flow hedge, not a fair value hedge.

Fixed-for-variable swaps are accounted for as fair value hedges, while variable-for-fixed as cash flow hedges. Swapping fixed interest payments for variable ones thus only makes sense if the liability is remeasured to fair value. Since most liabilities at most companies are measured at amortized cost, this type of hedging is only common at providers of financial services and generally part of a sophisticated strategy, a discussion of which is beyond the scope of this web page.

Caveat

While hedge accounting basics are straightforward and can be illustrated with a few, simple examples (below), at over 300 pages, US GAAP's guidance on derivatives and hedging is neither succinct nor easy to digest.

While not as circumlocutory, IFRS's guidance is no easy, bedtime reading either.

Making matters somewhat more complicated, IFRS 9 does, however, allows entities to continue to apply the hedging guidance in IAS 39, at least for now.

Not that the internet is much help. Googling hedge accounting either brings up pages that simply reiterate the guidance omitting all detail (e.g. link, link) or pages like this 500 page roadmap (link) or 300 page guide (link, local link), which make one think one is better off reading the original.

Not that surfing the internet looking instructions on how to account for derivatives is a good idea anyway. Like those trying to learn how to use a table saw by watching YouTube, most people will sooner or later realize hedge accounting is something best taught by qualified, and especially experienced, professionals. And hopefully, they will realize this while they still have a few fingers left.

Option

Options: trading

12/1/X1, XYZ acquired a 60 day, 100 strike, at-the-money call option contract on ABC stock for 4.448. 12/31/X1, ABC stock closed at 110. 31/1/X2, it closed at 120 and XYZ exercised the option.

As most non-financial companies have no need to hold stock in other companies, when they do acquire stock options, the most common purpose, as in this illustration, is speculation. In contrast, other types of options, e.g. those related to commodities, are usually acquired for hedging as illustrated below.

There is, however, no rule requiring purchased options to be accounted for as speculative, and vice versa.

As a general principle, written options are designated speculative instruments unless integrated within a collar structure.

As stated in IFRS 9.B6.2.4: a written option does not qualify as a hedging instrument unless it is designated as an offset to a purchased option, including one that is embedded in another financial instrument (for example, a written call option used to hedge a callable liability). Further clarification is provided by IFRS 9.B6.5.31.

Although not entirely identical nor as exhaustive, the guidance in ASC 815-20-25-94 through 97 and ASC 815-20-55-45 yields broadly comparable results.

For illustrative purposes, ABC stock's price was exactly 100, interest rates 5%, dividend yield 0, implied volatility 25% and the option traded at exactly determined value. In the real world, strike and exercise prices are practically never equal and options do not trade at their determined values.

For options, the most common model is Black–Scholes (a.k.a. Black–Scholes–Merton), which can be built in Excel with a few deceptively simple formulas. It is also incorporated into several web pages (e.g. link, link, link).

While building the model is not particularly difficult, getting it to yield an acceptable result requires an accurate estimate of (future) volatility. Not easy. Thus, to avoid implying that calculating the value of options is simple or straightforward, our site does not include it in its downloadable Excel file.

However, for those willing to take the chance, this site (link) provides easy to follow instructions.

Because this model relies on an estimate of volatility, and the market's consensus differs from that of any particular participant, the market price and determined value are never exactly equal.

Options generally expire on Friday, regardless of date. This example assumes 12/31/X1 was a Friday, simply for readability purposes.

Dr/Cr

12/1/X1 \| 1.12.X1
Financial assets: Call options: ABC 01/31/20X2 100 C Options trade in round lots so 100 x 4.448 = 445 (rounded).		445
	Cash		445
12/31/X1 \| 31.12.X1
Financial assets: Call options: ABC 01/31/20X2 100 C		625
	Gain		625

While the underlying economics can be complex, the accounting for derivatives is straightforward. As specified in ASC 815-10-35-1, derivatives are simply remeasured to fair value (at each balance sheet date).

Instead of providing similar, stand-alone guidance for (non-embedded) derivatives, IFRS 9 incorporates them into its guidance for financial assets (IFRS 9.4.1.1 to 4.1.5) and liabilities (IFRS 9.4.2.1 and 4.2.2). The result, however, is comparable.

Note: like US GAAP, IFRS provides separate, stand-alone guidance for derivatives used in hedging operations.

1/31/X2 \| 31.1.X2
Financial assets: Call options: ABC 01/31/20X2 100 C		931
	Gain		931
Investments: ABC stock		12,000
	Cash		10,000
	Financial assets: Call options: ABC 01/31/20X2 100 C		2,000

Same facts except ABC stock closed at 95 on 12/31/X1 and 90 on 1/31/X2.

Dr/Cr

12/1/X1 \| 1.12.X1
Financial assets: Call options: ABC 01/31/20X2 100 C		445
	Cash		445
12/31/X1 \| 31.12.X1
Loss		420
	Financial assets: Call options: ABC 01/31/20X2 100 C		420

Note: like US GAAP, IFRS provides separate, stand-alone guidance for derivatives used in hedging operations.

1/31/X2 \| 31.1.X2
Loss		24
	Financial assets: Call options: ABC 01/31/20X2 100 C		24

12/1/X1, XYZ sold a 60 day, 100 strike, at-the-money put option contract on ABC stock for 3.629. 12/31/X1, ABC stock closed at 110. 31/1/X2, it closed at 120.

However, for those willing to take the chance, this site (link) provides easy-to-follow instructions.

Because this model relies on an estimate of volatility, and the market's consensus differs from that or any particular participant's, the market price and determined value never exactly equal.

Dr/Cr

12/1/X1 \| 1.12.X1
Cash Options trade in round lots so 100 x 3.629 = 363 (rounded).		363
	Financial Liabilities: Put options: ABC 01/31/20X2 100 P		363
12/31/X1 \| 31.12.X1
Financial Liabilities: Put options: ABC 01/31/20X2 100 P		335
	Gain		335

Note: like US GAAP, IFRS provides separate, stand-alone guidance for derivatives used in hedging operations.

1/31/X2 \| 31.1.X2
Financial Liabilities: Put options: ABC 01/31/20X2 100 P		28
	Gain		28

Same facts except ABC stock closed at 95 on 12/31/X1 and 90 on 1/31/X2.

Dr/Cr

12/1/X1 \| 1.12.X1
Cash		363
	Financial Liabilities: Put options: ABC 01/31/20X2 100 P		363
12/31/X1 \| 31.12.X1
Loss		203
	Financial Liabilities: Put options: ABC 01/31/20X2 100 P		203

Note: like US GAAP, IFRS provides separate, stand-alone guidance for derivatives used in hedging operations.

1/31/X2 \| 31.1.X2
Loss		434
	Financial Liabilities: Put options: ABC 01/31/20X2 100 P		434
Financial Assets: ABC stock		9,000
Financial Liabilities: Put options: ABC 01/31/20X2 100 P		1,000
	Cash		10,000

Options: Compensation

12/31/X1, XYZ granted an employee an option to buy 1,000 of its shares at 125 per share in two years. The market price of the shares was 100 and comparable options traded for 9.286. The option vested immediately. 12/31/X3, the employee exercised the option.

As outlined in IFRS 2.11 | ASC 718-10-30-6, the expense associated with stock-based compensation is measured at the grant date.

In this illustration, the option did not have any special features, so was comparable to other market-traded options.

As this example illustrates a hypothetical transaction, this "market price" was calculated using the Black-Scholes option pricing model (link), a 5% interest rate and 25% implied volatility.

In the real world, options practically never trade at their determined value.

As outlined in IFRS 2.16 and ASC 718-10-30-2, stock-based compensation, including options, is measured at fair value while IFRS 2.16 specifies this value should reflect market price (if available). Although ASC 718-10-30-2 does not specifically mention market price, as market price is a level one input, its guidance is comparable.

Note: options granted to employees often include features which make their market price impossible to determine. In this situation, a valuation technique is used. Both IFRS 2.B1 to B38 and ASC 718-10-55-13 to 58 provide additional guidance on valuation techniques.

A discussion of fair value is available on this page.

Dr/Cr

12/31/X1 \| 31.12.X1
Expense: SBC		9,286
	APIC: SBC		9,286

As outlined in IFRS 2.14, if the grant vests immediately, the expense is recognized on the grant date.

In contrast, ASC 718-10-35-2, only addresses awards that vest over time (presumably because grant date vesting is uncommon in the US). However, in the absence of a vesting period, the expense would likewise be recognized at the grant date.

As outlined in ASC 718-10-35-2, the corresponding credit is made to equity (generally, paid-in capital). While IFRS 2.15 also outlines an increase in equity, it does not specify where in equity the increase should be recognized (presumably because it is obvious).

In this illustration, as XYZ's shares had a par value, so XYZ recognized the option in additional paid in capital.

12/31/X4 \| 31.12.X4
Cash		125,000
APIC: SBC		9,286
	Paid in capital		1,000
	APIC		133,286

Assuming each share had a par value of 1.

Same facts except the options vested at the end of each quarter.

Dr/Cr

12/31/X1 \| 31.12.X1
N/A		9,286
	N/A		9,286

While they go about it differently, IFRS and US GAAP require the award to be measured at the grant date.

IFRS 2 defines measurement date (emphasis added): the date at which the fair value of the equity instruments granted is measured for the purposes of this IFRS. For transactions with employees and others providing similar services, the measurement date is the grant date. For transactions with parties other than employees (and those providing similar services), the measurement date is the date the entity obtains the goods or the counterparty renders service.

In contrast, the ASC defines measurement date: the date at which the equity share price and other pertinent factors, such as expected volatility, that enter into measurement of the total recognized amount of compensation cost for an award of share-based payment are fixed.

ASC 718-10-30-6 then goes on to state (emphasis added): the measurement objective for equity instruments awarded to grantees is to estimate the fair value at the grant date of the equity instruments that the entity is obligated to issue when grantees have delivered the good or rendered the service and satisfied any other conditions necessary to earn the right to benefit from the instruments (for example, to exercise share options). That estimate is based on the share price and other pertinent factors, such as expected volatility, at the grant date.

However, as the award did not vest immediately, there was nothing to recognize.

3/31/X2 \| 31.3.X2
Expense: SBC		1,161
	APIC: SBC		1,161
Etc.

As outlined in IFRS 2.15 | ASC 718-10-35-2, the expense associated with stock-based compensation is recognized over the vesting period.

Same facts, except the option vested each year over 10 years but only if the company hit its sales and profitability targets, average annual share price had to exceed a specified amount, close above a second threshold, and (obviously) the employee had to remain with the company. The portion of the grant that did not vest in any particular year expired.

Dr/Cr

12/31/X1 \| 31.12.X1
N/A		GLWT
	N/A		GLWT

Good luck with that.

Seriously.

Seriously, good luck with that.

While ASC 718 applies specifically to employee stock options, it does provide the most detailed guidance for how to value options. This guidance can be applied (by analogy) to any situation where an option or option-like instrument needs to be valued.

It is applied in a manner consistent with the fair value measurement objective and the other requirements of this Topic.
It is based on established principles of financial economic theory and generally applied in that field (see paragraph 718-10-55-16). Established principles of financial economic theory represent fundamental propositions that form the basis of modern corporate finance (for example, the time value of money and risk-neutral valuation).

While there is often no other option, I am not a fan of valuation techniques described as "faking it a billion times until the reality emerges" so my site does not cover it.

However, those interested may refer to this page (link), which offers a reasonable summary.

It is worth noting how careful the FASB was in its wording stating "those techniques are used by valuation professionals" without going so far as stating an entity should rely on such professionals.

This is especially important when US GAAP is applied at an international subsidiary of a multinational company. As accountants in many jurisdictions rely on external valuation professionals to support accounting measurements, they may misinterpret this guidance to suggest that the opinion of such an expert is, in and of itself, an acceptable valuation technique.

The point is, regardless of who makes the estimate, the entity's management remains ultimately responsible for its accuracy.

Hiding behind an expert options is not an option US GAAP offers, nor will it be a defense the SEC, if it goes that far, will accept.

If you have gotten this far, please continue at asc.fasb.org/1943274/2147480397/718-10-55-21

It reflects all substantive characteristics of the instrument (except for those explicitly excluded by this Topic, such as vesting conditions and reload features)...

While they do not mention Monte Carlo simulation techniques, IFRS 2.B1 to B41 provide comparably useful instructions.

3/31/X2 \| 31.3.X2
Expense: SBC		GLWT
	APIC: SBC		GLWT
Etc.

Forward (future)

12/15/X1, XYZ and ABC entered into a 30 day forward contract to buy/sell 10,000 units of item X at 50 per unit. Item X's unit fair value was 50.00 on 12/15/X1, 51.10 on 12/31/X1 and 47.40 on 1/14/X2. The contract allowed net settlement, but XYZ took delivery.

In practice, most futures contracts have a longer duration. They also generally expire on the third Friday of the month.

This example assumes a one-month duration and expiration halfway through the month.

While unrealistic, it is meant to make this and the following illustrations easier to follow.

Item X was not a commodity, so did not have a level 1 fair value. It did, however, have a level 2b fair value.

Please go to this page for a discussion of fair value, valuation models and the levels of inputs for the valuation models.

As outlined in ASC 815-10-15-83, to be recognized as a derivative, a contract must require or permit net settlement. In contrast, IFRS is not as strict.

ASC 815-10-15-83.c specifies that a contract allows net settlement if:

Its terms implicitly or explicitly require or permit net settlement.
It can readily be settled net by a means outside the contract.
It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

Items 1 and 2 are self-explanatory. Item 3 applies to situations where, for example, one party must pay a contract penalty if they renege (e.g. the buyer refuses to buy if market price falls below contract price) and that penalty is sufficient to compensate the other party for its loss.

Note: as US GAAP takes net settlement seriously, ASC 815-10-15-99 to 139 discuss it in some detail.

In the IFRS 9 definition, a contract may be considered a derivative even if it does not allow net settlement.

XYZ: Dr/Cr

12/15/X1 \| 1.15.X1: XYZ and ABC
Forward contract #123		N/A

As the two parties trusted one another, no cash changed hands, the forward had no value and no accounting recognition was necessary. Nevertheless, XYZ opened an account, so it could recognize the expected, future changes in fair value.

Note: as the account's value was zero, no balancing entry was made.

12/31/X1 \| 31.12.X1
Derivative financial assets: Forward contract #123		11,000
	Gain		11,000

1/14/X2 \| 14.1.X2
Loss		37,000
	Derivative financial liabilities: Forward contract #123		37,000
Inventory		474,000
Derivative financial liabilities: Forward contract #123		26,000
	Cash		500,000
Or simply

1/14/X2 \| 14.1.X2
Loss		37,000
	Derivative financial liabilities: Forward contract #123		11,000
Inventory		474,000
	Cash		500,000

Same facts except the companies settled net.

1/14/X2 \| 14.1.X2
Loss		37,000
	Derivative financial liabilities: Forward contract #123		11,000
	Cash		26,000

ABC: Dr/Cr

12/15/X1 \| 1.15.X1
Forward contract #123		N/A

As the two parties trusted one another, no cash changed hands, the forward had no value and no accounting recognition was necessary. Nevertheless, ABC opened an account, so it could recognize the expected, future changes in fair value.

Note: as the account's value was zero, no balancing entry was made.

12/31/X1 \| 31.12.X1
Loss		11,000
	Derivative financial liabilities: Forward contract #123		11,000

1/14/X2 \| 14.1.X2: ABC
Derivative financial assets: Forward contract #123		37,000
	Gain		37,000
Cash		500,000
	Revenue		474,000
	Derivative financial assets: Forward contract #123		26,000
Cost of sales		250,000
	Inventory		250,000

ABC had produced item X at a cost of 25 per unit.

Same facts except the companies settled net.

1/14/X2 \| 14.1.X2
Derivative financial assets: Forward contract #123		11,000
Cash		26,000
	Gain		37,000

Same facts except XYZ reneged.

If XYZ paid a contract penalty, ABC would use the net settlement procedure illustrated above. If not, ABC would record:

1/15/X2 \| 15.1.X2: ABC
Loss		11,000
	Derivative financial assets: Forward contract #123		11,000

As legitimate companies rarely renege on their agreements, the accounting for XYZ is not illustrated.

12/15/X1, XYZ entered into a 30 day futures contract to buy 10,000 units of commodity X at 50 when its market price was 50. The exchange required an initial margin deposit of 6%. Maintenance margin was 4%. Mark-to-market gains/losses were debited/credited to the margin account. XYZ settled margin calls by the end of the day.

In practice, most futures contracts have a longer duration. They also generally expire on the third Friday of the month.

This example assumes a one month duration and expiration halfway through the month.

While unrealistic, it should make the illustration below easier to follow.

Futures are generally marked to market each day.

For example (link):"Corn futures trade on CME Globex beginning the previous evening and officially settle for the day at 13:15 Central Time (CT). CME Group staff determine the daily settlement price of corn based on trading activity in the last minute of trading between 13:14:00 and 13:15:00.

"E-mini S&P 500 futures trading on CME Globex begin trade the previous evening (CT) at 5:00 p.m. The final daily settlement price is determined by a volume-weighted average price (VWAP) of all trades executed in the full-sized, floor-traded (the Big) futures contract and the E-mini futures contract for the designated lead month contract between 15:14:30 and 15:15:00 CT. The combined VWAP for the designated lead month is then rounded to the nearest 0.10 index point. This contract then remains closed for fifteen minutes between 15:15:00 and 15:30:00 and then resumes trading until 16:00:00 (4:00 p.m. CT) when CME Globex shuts down for one hour..."

The settlement price of commodity X, the fair value of the future (CX) and daily gain/loss

Date	Per unit	Total	CX	(Gain)/Loss
The future (CX) can be either an asset or (liability) balance. As losses are debited and gains (credited), the schedule presents them: (Gain) / Loss.
	A = Mkt	B = A x 10,000	C = B - 500,000	D = C_(C-1) - C
12/15/X1	50.0	500,000	0	0
12/16/X1	51.5	515,000	15,000	(15,000)
12/17/X1	52.5	525,000	25,000	(10,000)
12/18/X1	51.2	512,000	12,000	13,000
12/19/X1	49.7	497,000	(3,000)	15,000
12/20/X1	49.2	492,000	(8,000)	5,000
12/23/X1	48.2	482,000	(18,000)	10,000
12/24/X1	47.5	475,000	(25,000)	7,000
12/25/X1	43.7	437,000	(63,000)	38,000
12/26/X1	45.4	454,000	(46,000)	(17,000)
12/27/X1	47.7	477,000	(23,000)	(23,000)
12/30/X1	50.6	506,000	6,000	(29,000)
12/31/X1	51.1	511,000	11,000	(5,000)
01/01/X2	48.0	480,000	(20,000)	31,000
01/02/X2	44.6	446,000	(54,000)	34,000
01/03/X2	42.8	428,000	(72,000)	18,000
01/06/X2	41.9	419,000	(81,000)	9,000
01/07/X2	44.8	448,000	(52,000)	(29,000)
01/08/X2	47.5	475,000	(25,000)	(27,000)
01/09/X2	49.4	494,000	(6,000)	(19,000)
01/10/X2	49.9	499,000	(1,000)	(5,000)
01/13/X2	48.9	489,000	(11,000)	10,000
01/14/X2	47.4	474,000	(26,000)	15,000
				26,000

Dr/Cr

12/15/X1 \| 15.12.X1
Derivatives: Futures: CXF02		N/A
Due to its short duration, XYZ measured the derivative at intrinsic value which was zero. Although there was no asset or liability to recognize, XYZ opened an account so it could keep track of the derivative as its value changed. Note: As the derivative had no initial value, a balancing entry was not required.
Margin account		30,000
	Cash		30,000

XYZ recognized the change in fair value at the end of the reporting period: Dr/Cr

12/23/X1 \| 23.12.X1
Margin account		18,000
	Cash		18,000

12/23/X1, commodity X's market price (above) was 48.2.

This brought the derivative's value to (18,000) and the margin account to 12,000 = 30,000 + (18,000) triggering a margin call. XYZ deposited an additional 18,000 to bring the account's balance back up to 30,000 and keep the position open.

The following trading day, commodity X's market price settled at 47.5 which brought CX's value to (25,000) and the margin account's value to 23,000 = 48,000 + (25,000). As XYZ had deposited a total of 48,000, it did not receive a margin call.

Etc.

12/25/X1 | 25.12.X1

For illustrative purposes, this example ignores holidays. While unrealistic, it hopefully makes it easier to follow.

Margin account

45,000

Cash

45,000

12/25/X1, commodity X's market price (above) was 47.5 which brought CX's value to (63,000) and the account's value to (5,000) = 48,000 + (63,000). To keep the position open, XYZ deposited another 45,000.

Note: for illustrative purposes, this example ignores holidays. While unrealistic, it hopefully makes it easier to follow.

12/31/X1 \| 31.12.X1
Financial assets: Derivatives: Futures: CXF02		11,000
	Gain		11,000

By 12/31/X1, the market (above) moved back in XYZ's favor, so the derivative had a net asset value.

Note: XYZ's policy was to not withdraw increases to the margin account until the derivative's expiration.

1/6/X2 \| 6.1.X2
Margin account		18,000
	Cash		18,000

1/14/X2 \| 14.1.X2
Loss		37,000
	Financial liabilities: Derivatives: Futures: CXF02		37,000
Commodity X		474,000
Financial liabilities: Derivatives: Futures: CXF02		26,000
	Margin account		111,000
	Cash		389,000
Or simply

1/14/X2 \| 14.1.X2
Loss		37,000
Commodity X		474,000
	Financial liabilities: Derivatives: Futures: CXF02		11,000
	Margin account		111,000
	Cash		389,000

XYZ adjusted the derivative to fair value daily: Dr/Cr

12/16/X1 \| 16.12.X1
Financial assets: Derivatives: Futures: CXF02		15,000
	Gain		15,000

The initial change in market price (above) indicated a net gain, so XYZ recognized the derivative as an asset.

12/17/X1 \| 17.12.X1
Financial assets: Derivatives: Futures: CXF02		10,000
	Gain		10,000

12/18/X1 \| 18.12.X1
Loss		13,000
	Financial assets: Derivatives: Futures: CXF02		13,000

12/19/X1 \| 19.12.X1
Loss		15,000
	Financial liabilities: Derivatives: Futures: CXF02		15,000
The change in market price (above) indicated a net loss, so XYZ reclassified the derivative as a liability. Etc.

12/23/X1 \| 23.12.X1
Loss		10,000
	Financial liabilities: Derivatives: Futures: CXF02		10,000
Margin account		18,000
	Cash		18,000
12/23/X1, commodity X's market price (above) was 48.2. This brought the derivative's value to (18,000) and the margin account to 12,000 = 30,000 + (18,000). This triggered a margin call and XYZ had to deposit an additional 18,000 to bring the account back up to 30,000. Etc. The following trading day, commodity X's market price settled at 47.5 which brought CX's value to (25,000) and the margin account's value to 23,000 = 48,000 + (25,000). As XYZ had deposited a total of 48,000, it did not receive a margin call. The day after that, commodity X's market price settled at 47.5 which brought CX's value to (63,000) and the account's value to (5,000) = 48,000 + (63,000). To bring the account back up to 30,000, XYZ deposited 45,000. Etc. Etc.

1/14/X2 \| 14.1.X2
Loss		15,000
	Financial liabilities: Derivatives: Futures: CXF02		15,000
Commodity X		474,000
Financial liabilities: Derivatives: Futures: CXF02		26,000
	Margin account		111,000
	Cash		389,000
Or simply

1/14/X2 \| 14.1.X2
Loss		15,000
Commodity X		474,000
Financial liabilities: Derivatives: Futures: CXF02		11,000
	Margin account		111,000
	Cash		389,000

XYZ settled with the exchange daily: Dr/Cr

12/15/X1 \| 15.12.X1
Margin account		30,000
	Cash		30,000

12/16/X1 \| 16.12.X1
Financial assets: Derivatives: Futures: CXF02		15,000
Cash		15,000
	Gain		15,000
	Margin account		15,000

12/17/X1 \| 17.12.X1
Financial assets: Derivatives: Futures: CXF02		10,000
Cash		10,000
	Gain		10,000
	Margin account		10,000

12/18/X1 \| 18.12.X1
Loss		13,000
Margin account		13,000
	Financial assets: Derivatives: Futures: CXF02		13,000
	Cash		13,000
Etc.

XYZ settled net: Dr/Cr

Rather than taking delivery, XYZ liquidated the position. The exchange returned the balance on the margin account.

1/14/X2 \| 14.1.X2
Loss		37,000
Cash		85,000
	Financial assets: Derivatives: Futures: CXF02		11,000
	Margin account		111,000

XYZ paid a premium (the derivative had an initial value): Dr/Cr

When XYZ entered into the contract, commodity X's market price was 49.90.

12/15/X1 \| 15.12.X1
Deferred expense		1,000
Margin account		30,000
	Financial assets: Derivatives: Futures: CXF02		1,000
	Cash		30,000

12/31/X1 \| 31.12.X1
Financial assets: Derivatives: Futures: CXF02		11,000
	Gain		11,000

1/14/X2 \| 14.1.X2
Loss		37,000
	Financial liabilities: Derivatives: Futures: CXF02		37,000
Commodity X		475,000
Financial liabilities: Derivatives: Futures: CXF02		26,000
	Margin account		111,000
	Cash		389,000
	Deferred expense		1,000
Or simply

1/14/X2 \| 14.1.X2
Loss		37,000
Commodity X		475,000
	Financial liabilities: Derivatives: Futures: CXF02		11,000
	Margin account		111,000
	Cash		389,000
	Deferred expense		1,000

Hedging

Forward (cash flow hedge)

As above, 12/15/X1, XYZ and ABC entered into a 30-day forward contract to buy/sell 10,000 units of item X at 50 per unit. Item X's unit fair value was 50.00 on 12/15/X1, 51.10 on 12/31/X1 and 47.40 on 1/14/X2. The contract allowed net settlement. Both designated the forward as a cash flow hedge. They did so because they expected to resell / sell item X in one month's time item and wanted to lock in its current market price.

Item X was not a commodity, so did not have a level 1 fair value. It did, however, have a level 2b fair value.

Please go to this page for a discussion of fair value, valuation models and the levels of inputs for the valuation models.

As outlined in ASC 815-10-15-83, to be recognized as a derivative, a contract must require or permit net settlement. In contrast, IFRS is not as strict.

ASC 815-10-15-83.c specifies that a contract allows net settlement if:

Its terms implicitly or explicitly require or permit net settlement.
It can readily be settled net by a means outside the contract.
It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

Note: because US GAAP takes net settlement seriously, ASC 815-10-15-99 to 139 discuss it in detail.

In the IFRS 9 definition, a contract may be considered a derivative merely because it is settled at a future date.

As this is a characteristic shared by practically every contract involving the purchase or sale of some item and to make sure the definition is interpreted correctly, IFRS 9.BA2 includes an expanded discussion of this issue: The definition of a derivative in this Standard includes contracts that are settled gross by delivery of the underlying item (eg a forward contract to purchase a fixed rate debt instrument). An entity may have a contract to buy or sell a non-financial item that can be settled net in cash or another financial instrument or by exchanging financial instruments (eg a contract to buy or sell a commodity at a fixed price at a future date). Such a contract is within the scope of this Standard unless it was entered into and continues to be held for the purpose of delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements. However, this Standard applies to such contracts for an entity’s expected purchase, sale or usage requirements if the entity makes a designation in accordance with paragraph 2.5 (see paragraphs 2.4–2.7).

In a fair value hedge, the hedged item is an asset or liability making the accounting straightforward. In a cash flow hedge, the hedged item is not an asset or liability, which makes the accounting a two-step process.

It may also be a firm commitment which, once designated, becomes an asset or liability as its fair value changes.

The ASC defines firm Commitment: an agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:

The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield. The binding provisions of an agreement are regarded to include those legal rights and obligations codified in the laws to which such an agreement is subject. A price that varies with the market price of the item that is the subject of the firm commitment cannot qualify as a fixed price. For example, a price that is specified in terms of ounces of gold would not be a fixed price if the market price of the item to be purchased or sold under the firm commitment varied with the price of gold.
The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. In the legal jurisdiction that governs the agreement, the existence of statutory rights to pursue remedies for default equivalent to the damages suffered by the nondefaulting party, in and of itself, represents a sufficiently large disincentive for nonperformance to make performance probable for purposes of applying the definition of a firm commitment.

While comparable, the IFRS 9 definition is more succinct: a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

Note: only firm commitments designated as hedged items receive accounting recognition. Undesignated firm commitments do not make it to the balance sheet.

In a fair value hedge, the change in fair value (gain/loss) associated with the hedging instrument (the derivative) and the gain/loss associated with the hedged item are both recognized in net income. However, since they are inversely correlated, they offset one another so the net gain/loss is zero (if the hedge is 100% effective).

Instead, the hedged item is an expected (forecasted) transaction. As a forecasted transaction is not recognized as an asset or liability, it cannot generate the gain/loss to offset the gain/loss on derivative.

The ASC defines Forecasted Transaction: a transaction that is expected to occur for which there is no firm commitment. Because no transaction or event has yet occurred and the transaction or event when it occurs will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or a present obligation for future sacrifices.

While comparable, the IFRS 9 definition is more succinct: an uncommitted but anticipated future transaction.

In order to bypass net income, the gain/loss is first included in other comprehensive income (OCI) then accumulated in its own, stand-alone section of equity. The manner in which this accumulation is derecognized, then depends on if the entity is applying IFRS or US GAAP.

Overcomplicated? Perhaps. But, this was the only way the standard setters could think of to have their cake (recognize all gains and losses) and eat it too (avoid making net income more volatile as a result).

XYZ: Dr/Cr

12/15/X1 \| 1.15.X1
Forward contract #123		N/A

As XYZ and the counterparty trusted one another, no cash changed hands, the forward had no value and no accounting recognition was necessary. Nevertheless, ABC opened an account to recognize expected future changes in fair value.

Note: as the account's value was zero, no balancing entry was made.

12/31/X1 \| 31.12.X1: to remeasure the derivative to other comprehensive income
Derivative financial assets: Forward contract #123		11,000
	OCI: Gain (Forward contract #123)		11,000

Item X's unit market price was 50.00 on 12/15/X1 and 51.10 on 12/31/X1.

As the duration was short, there was no material difference between the fair value of the contract and the spot element | price that needed to be considered (see IFRS 9.6.2.4.b | ASC 815-20-25-82.d).

In a cash flow hedge, the gain/loss from the remeasurement of the derivative bypasses net income and is recognized in other comprehensive income (OCI) instead.

Technically, as outlined in IFRS 9.6.5.11.b (IAS 39.95.a) | ASC 815-30-35-3, if the relationship between the hedged item and hedging instrument is highly effective, the change in the fair value of the designated hedging instrument that is included in the assessment of hedge effectiveness is recognized in other comprehensive income.

In other words, the ineffective gain/loss is stripped out and recognized in net income.

However, in this illustration, the hedge was fully effective, so the entire gain was recognized in OCI.

12/31/X1 \| 31.12.X1: to close the period
OCI: Gain (Forward contract #123)		11,000
	AOCI (Forward contract #123)		11,000

In a cash flow hedge, the gain/loss from the remeasurement of the derivative bypasses net income and is recognized in other comprehensive income (OCI). Similarly, the accumulation bypasses retained earnings and is recognized in accumulated other comprehensive income (AOCI).

While US GAAP (i.e ASC 815-10-25-3) consistently refers to this section of equity as accumulated other comprehensive income, IFRS somewhat confusingly, considers it a reserve. Thus, the cash flow hedge reserve (IFRS 9.6.9.7) would be presented on a (XBRL tagged) balance sheet in the Other Reserves (OtherReserves) section.

However, in the footnotes, the section is labeled Accumulated Other Comprehensive Income (AccumulatedOtherComprehensiveIncomeAbstract) section ¯\_(ツ)_/¯.

1/14/X2 \| 14.1.X2: to remeasure the derivative to OCI
OCI: Loss (Forward contract #123)		37,000
	Derivative financial liabilities: Forward contract #123		37,000
Item X's unit market price was 47.40 on 1/14/X2.
1/14/X2 \| 14.1.X2: to move the loss to accumulated other comprehensive income.
AOCI (Forward contract #123)		37,000
	OCI: Loss (Forward contract #123)		37,000

1/14/X2 \| 14.1.X2
IFRS \| US GAAP

1/14/X2 | 14.1.X2: to acquire item X, settle the derivative and move (not reclassify) the AOCI to inventory

As stated in IFRS 9.6.5.11.d.i (edited, emphasis added): if a hedged forecast transaction subsequently results in the recognition of a non-financial asset [like inventory] or non-financial liability ... the entity shall remove that amount from the cash flow hedge reserve and include it directly in the initial cost or other carrying amount of the asset [such as inventory] or the liability. This is not a reclassification adjustment (see IAS 1) and hence it does not affect other comprehensive income.

While similar, the guidance in IAS 39 for reclassification adjustments is subtly different:

IAS 39.98 (edited): If a hedge of a forecast transaction subsequently results in the recognition of a non-financial asset or a non-financial liability ... then the entity shall adopt (a) or (b) below:

It reclassifies the associated gains and losses that were recognised in other comprehensive income in accordance with paragraph 95 to profit or loss as a reclassification adjustment (see IAS 1 (revised 2007)) in the same period or periods during which the asset acquired or liability assumed affects profit or loss (such as in the periods that depreciation expense or cost of sales is recognised). However, if an entity expects that all or a portion of a loss recognised in other comprehensive income will not be recovered in one or more future periods, it shall reclassify from equity to profit or loss as a reclassification adjustment the amount that is not expected to be recovered.
It removes the associated gains and losses that were recognised in other comprehensive income in accordance with paragraph 95, and includes them in the initial cost or other carrying amount of the asset or liability.

Inventory		474,000
Derivative financial liabilities: Forward contract #123		26,000
	Cash		500,000
Inventory		26,000
	AOCI (Forward contract #123)		26,000

XYZ re-sold item X on 1/31/X2.

To simplify the illustration, XYZ sold item X in a single sale.

1/31/X2 \| 31.1.X2
Accounts receivable		1,000,000
	Revenue		1,000,000
Cost of sales		500,000
	Inventory		500,000

1/14/X2 \| 14.1.X2: to acquire item X and settle the derivative
Inventory		474,000
Derivative financial liabilities: Forward contract #123		26,000
	Cash		500,000

XYZ re-sold item X on 1/31/X2.

To simplify the illustration, XYZ sold item X in a single sale.

1/31/X2 | 31.1.X2: to recognize the hedged transaction in earnings

ASC 815-30-35-39 states (emphasis added): If the hedged transaction results in the acquisition of an asset or the incurrence of a liability, the gains and losses in accumulated other comprehensive income that are included in the assessment of effectiveness shall be reclassified into earnings in the same period or periods during which the asset acquired or liability incurred affects earnings (such as in the periods that depreciation expense, interest expense, or cost of sales is recognized).

Applying this guidance, accumulated gains/losses will remain in AOCI until the forecast transaction occurs. In this illustration, this is when XYZ sold item X, not when it bought item X.

If item X had been a raw material, XYZ would have had to keep track of the accumulation as it moved through the manufacturing process and recognize it in income when the goods produced with item X were sold. Likewise, if item X had been a machine, it would have had to keep track so it could have been added to the machine’s depreciation.

In some situations, keeping track can prove challenging.

For example, when this guidance was first introduced, one of our clients decided to cease hedging its purchases of polyisobutylene because it would have been too difficult to keep track of. Specifically it lacked the software to keep track of each bulk polyisobutylene purchase as it made its way through the manufacturing process to eventually emerge as a piece of chewing gum.

Accounts receivable		1,000,000
	Revenue		1,000,000
Cost of sales		500,000
	Inventory		474,000
	AOCI (Forward contract #123)		26,000

ABC: Dr/Cr

12/15/X1 \| 1.15.X1
Forward contract #123		N/A

As ABC and the counterparty trusted one another, no cash changed hands, the forward had no value and no accounting recognition was necessary. Nevertheless, ABC opened an account, so it could recognize the expected, future changes in fair value.

Note: as the account's value was zero, no balancing entry was made.

12/31/X1 \| 31.12.X1: to remeasure the derivative to other comprehensive income
OCI: Loss (Forward contract #123)		11,000
	Derivative financial liability: Forward contract #123		11,000

Item X's unit market price was 50.00 on 12/15/X1 and 51.10 on 12/31/X1.

As the duration was short, there was no material difference between the fair value of the contract and the spot element | price that needed to be considered (see IFRS 9.6.2.4.b | ASC 815-20-25-82.d).

In a cash flow hedge, the gain/loss from the remeasurement of the derivative bypasses net income and is recognized in other comprehensive income (OCI) instead.

In other words, the ineffective portion of the gain/loss is stripped out and recognized in net income.

However, in this illustration, the hedge was fully effective, so the entire gain was recognized.

12/31/X1 \| 31.12.X1: to close the period
AOCI (Forward contract #123)		11,000
	OCI: Loss (Forward contract #123)		11,000

While US GAAP (i.e ASC 815-10-25-3) consistently refers to this section of equity as accumulated other comprehensive income, IFRS, somewhat confusingly, considers it a reserve. Thus, the cash flow hedge reserve (IFRS 9.6.9.7) would be presented on the balance sheet in the Other Reserves (OtherReserves) section.

However, in the footnotes, the section is labeled Accumulated Other Comprehensive Income (AccumulatedOtherComprehensiveIncomeAbstract) section ¯\_(ツ)_/¯.

1/14/X2 \| 14.1.X2: to remeasure the derivative to OCI
Derivative financial assets: Forward contract #123		37,000
	OCI: Gain (Forward contract #123)		37,000
Item X's unit market price was 47.40 on 1/14/X2.
1/14/X2 \| 14.1.X2: to move the gain to accumulated other comprehensive income.
OCI: Gain (Forward contract #123)		37,000
	AOCI (Forward contract #123)		37,000

To sell item X at its market price (47.40 per unit) on 1/14/X2.

1/14/X2 \| 14.1.X2
Accounts receivable		474,000
	Revenue		474,000

While the derivative was cash settled, ABC sold item X with customary, 30-day payment terms.

Cash		26,000
	Derivative financial assets: Forward contract #123		26,000
AOCI (Forward contract #123)		26,000
	Revenue		26,000
Or simply

1/14/X2 \| 14.1.X2
Accounts receivable		474,000
Cash		26,000
AOCI (Forward contract #123)		26,000
	Derivative financial assets: Forward contract #123		26,000
	Revenue		500,000

Forward (fair value hedge)

As above, 12/15/X1, XYZ and ABC entered into a 30 day forward contract to buy/sell 10,000 units of item X at 50 per unit. Item X's unit fair value was 50.00 on 12/15/X1, 51.10 on 12/31/X1 and 47.40 on 1/14/X2. The contract allowed net settlement. Both designated the forward as a hedge of fair value. XYZ did so because it was committed to sell item X to DEF for 600,000 on 1/15/X2. ABC did so because, it wanted to lock in the market price of its item X in stock.

In practice, most futures contracts have a longer duration. They also generally expire on the third Friday of the month.

This example assumes a one month duration and expiration halfway through the month.

While unrealistic, it is meant to make this and the following illustrations easier to follow.

Item X was not a commodity, so did not have a level 1 fair value. It did, however, have a level 2b fair value.

Please go to this page for a discussion of fair value, valuation models and the levels of inputs for the valuation models.

As outlined in ASC 815-10-15-83, to be recognized as a derivative, a contract must require or permit net settlement. In contrast, IFRS is not as strict.

ASC 815-10-15-83.c specifies that a contract allows net settlement if:

Its terms implicitly or explicitly require or permit net settlement.
It can readily be settled net by a means outside the contract.
It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

Note: because US GAAP takes net settlement seriously, the ASC discusses it, in some detail, in ASC 815-10-15-99 to 139.

In the IFRS 9 definition, a contract may be considered a derivative merely because it is settled at a future date.

As this is a characteristic shared by practically every contract involving the purchase or sale of some item and to make sure the definition is interpreted correctly, IFRS 9.BA2 includes an expanded discussion of this issue: The definition of a derivative in this Standard includes contracts that are settled gross by delivery of the underlying item (e.g. a forward contract to purchase a fixed rate debt instrument). An entity may have a contract to buy or sell a non-financial item that can be settled net in cash or another financial instrument or by exchanging financial instruments (eg a contract to buy or sell a commodity at a fixed price at a future date). Such a contract is within the scope of this Standard unless it was entered into and continues to be held for the purpose of delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements. However, this Standard applies to such contracts for an entity’s expected purchase, sale or usage requirements if the entity makes a designation in accordance with paragraph 2.5 (see paragraphs 2.4–2.7).

As outlined in IFRS 9.6.5.2.a | ASC 815-20-25-12.a, only a recognized asset, liability or unrecognized firm commitment may be designated as the hedged item in a fair value hedge.

The ASC defines firm Commitment: an agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:

The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield. The binding provisions of an agreement are regarded to include those legal rights and obligations codified in the laws to which such an agreement is subject. A price that varies with the market price of the item that is the subject of the firm commitment cannot qualify as a fixed price. For example, a price that is specified in terms of ounces of gold would not be a fixed price if the market price of the item to be purchased or sold under the firm commitment varied with the price of gold.
The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. In the legal jurisdiction that governs the agreement, the existence of statutory rights to pursue remedies for default equivalent to the damages suffered by the nondefaulting party, in and of itself, represents a sufficiently large disincentive for nonperformance to make performance probable for purposes of applying the definition of a firm commitment.

While comparable, the IFRS 9 definition is more succinct: a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

Item X was a near commodity ABC had acquired previously.

As outlined in IFRS 9.6.5.2.a | ASC 815-20-25-12.a, any recognized asset, including inventory, may be designated as the hedged item in a fair value hedge. However, most manufacturers see little point in trying to hedge their finished goods. Even if they did, since it is not possible to use a future, finding a counterparty to a forward would be challenging.

Hedge accounting mitigates the earnings volatility undesignated derivatives (above) cause. Thus, if an entity does enter into a future or forward contract, designating it as a hedging item, if possible, yields benefits.

Note: the accounting for a fair value hedge of inventory is discussed in ASC 330-10-35-7A which (edited) states: If inventory has been the hedged item in a fair value hedge, the inventory's cost basis for purposes of subsequent measurement shall reflect the effect of the adjustments of its carrying amount made pursuant to [ASC] 815-25-35-1.b. ASC 815-25-35-1.b (edited) states: The gain or loss ... on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings... Example 7 (ASC 815-25-55-30 to 39) reinforces this guidance with an illustration.

Also note: while IAS 2 does not specifically discuss inventory hedging, IFRS 9.6.5.8.b (edited) does state "the hedging gain or loss on the hedged item shall adjust the carrying amount of the hedged item ... and be recognised in profit or loss." The result is thus comparable.

In contrast, producers of commodities or near commodities do. Commodities trade on active markets, so are simple to hedge. While near commodities are not as easy, their producers are usually sophisticated enough to perceive when current market prices are high enough to make locking them in worthwhile.

Physical commodities (metals, minerals, hydrocarbons, grains, meats, etc.) with "quoted prices ... in active markets for identical assets or liabilities..." have level 1 fair value.

As a general rule, whenever an asset has level 1 fair value, a future associated with that asset is also traded on an active market so as easy to acquire as opening a margin account.

Note: the advantage of futures is they are easy to acquire. The disadvantage of futures is that their underlying commodity is practically never identical to the item being hedged. As a result, hedging with futures (unless the underlying is a financial commodity such as a share, bond, foreign currency or interest rates), is practically never fully effective. In contrast, because they are negotiated by the two parties, perfectly effective forwards are not uncommon.

Some manufactured items, such as transistors or capacitors are, for all intents and purposes, commodities. Other items, such as memory chips, solenoids, electric motors or linear actuators, while not identical, are very, very similar. Nevertheless, these items do not trade on "active markets" so have level 2.b fair value: "quoted prices for identical or similar assets or liabilities in markets that are not active."

Thus, if an entity wishes to hedge such an item, it first needs to find a counterparty willing to take the other side of a forward contract, which is not always simple or easy.

Note: unlike futures which are rarely 100% effective, because they are negotiated by the two parties, the opposite is often true with forwards.

XYZ: Dr/Cr

12/15/X1 \| 1.15.X1
Forward contract		N/A

As XYZ and the counterparty trusted one another, no cash changed hands, the forward had no value and no accounting recognition was necessary. Nevertheless, XYZ opened an account, so it could recognize the expected, future changes in fair value.

Note: as the account value was zero, no balancing entry was made.

12/31/X1 \| 31.12.X1: to remeasure the derivative and firm commitment so a financial report could be drafted
Derivative financial assets: Forward contract		11,000
	Gain		11,000
Loss		11,000
	Firm commitment		11,000

As the duration was short, there was no material difference between the fair value of the contract and the spot element | price that needed to be considered (see IFRS 9.6.2.4.b | ASC 815-20-25-82.d).

1/14/X2 \| 14.1.X2: to remeasure the derivative and firm commitment
Loss		37,000
	Derivative financial liabilities: Forward contract		37,000
Firm commitment		37,000
	Gain		37,000

1/14/X2 \| 14.1.X2: to acquire the inventory and settle the derivative
Inventory		474,000
Derivative financial liabilities: Forward contract		26,000
	Cash		500,000

1/15/X2 \| 15.1.X2: to resell the inventory and honor the firm commitment
Receivable: DEF		600,000
	Revenue		600,000
Cost of goods sold		500,000
	Inventory		474,000
	Firm commitment		26,000

ABC: Dr/Cr

12/15/X1 \| 1.15.X1
Forward contract		N/A

Note: as the account's value was zero, no balancing entry was made.

12/31/X1 \| 31.12.X1: to remeasure the derivative and inventory so a financial report could be drafted
Loss		11,000
	Derivative financial liabilities: Forward contract		11,000
Inventory		11,000
	Gain		11,000

As the duration was short, there was no material difference between the fair value of the contract and the spot element | price that needed to be considered (see IFRS 9.6.2.4.b | ASC 815-20-25-82.d).

1/14/X2 \| 14.1.X2: to remeasure the derivative and inventory
Derivative financial assets: Forward contract		37,000
	Gain		37,000
Loss		37,000
	Inventory		37,000

1/14/X2 \| 14.1.X2: to sell the inventory and settle the derivative
Cash		500,000
	Revenue		474,000
	Derivative financial assets: Forward contract		26,000
Cost of goods sold		374,000
	Inventory		374,000

ABC had acquired the inventory for 400,000. It carried it at cost until it was sold.

374,000 = 400,000 + 11,000 - 37,000.

Future (cash flow hedge)

As above 12/15/X1, XYZ entered into a 30 day futures contract to buy 10,000 units of commodity X at 50 when its market price was 50. The exchange required an initial margin deposit of 30,000. XYZ acquired the future because it expected to sell 10,000 units of item X in a month and so designated the future as a cash flow hedge. Commodity X's unit market price was 51.10 on 12/31/X1 and 47.40 on 1/14/X2. Item X's market price was 51.25 on 12/31/X1 and 47.15 on 1/14/X2. XYZ settled the future net.1/31/X2.

In practice, most futures contracts have a longer duration. They also generally expire on the third Friday of the month.

This example assumes a one month duration and expiration halfway through the month.

While unrealistic, it is meant to make this and the following illustrations easier to follow.

Both margin deposit accounting and marking to market are illustrated above.

Item X was a specific grade of commodity X. While not identical, it was generally comparable.

It may also be a firm commitment which, once designated, becomes an asset or liability as its fair value changes.

The ASC defines firm Commitment: an agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:

The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield. The binding provisions of an agreement are regarded to include those legal rights and obligations codified in the laws to which such an agreement is subject. A price that varies with the market price of the item that is the subject of the firm commitment cannot qualify as a fixed price. For example, a price that is specified in terms of ounces of gold would not be a fixed price if the market price of the item to be purchased or sold under the firm commitment varied with the price of gold.
The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. In the legal jurisdiction that governs the agreement, the existence of statutory rights to pursue remedies for default equivalent to the damages suffered by the nondefaulting party, in and of itself, represents a sufficiently large disincentive for nonperformance to make performance probable for purposes of applying the definition of a firm commitment.

While comparable, the IFRS 9 definition is more succinct: a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

Note: only firm commitments designated as hedged items receive accounting recognition. Undesignated firm commitments do not make it to the balance sheet.

While comparable, the IFRS 9 definition is more succinct: an uncommitted but anticipated future transaction.

Unlike commodity X, item X did not trade on market so did not have a level 1 fair value. Its fair value could, however, be determined using a level 2 input.

To simplify the illustration, XYZ sold commodity X in a single sale.

Dr/Cr

12/15/X1 \| 15.12.X1
Derivatives: Futures: CXF02		N/A
Due to its short duration, XYZ measured the derivative at intrinsic value which was zero. Although there was no asset or liability to recognize, XYZ opened an account so it could keep track of the derivative as its value changed. Note: As the derivative had no initial value, a balancing entry was not required.
Margin account		30,000
	Cash		30,000

12/23/X1 \| 23.12.X1
Margin account		18,000
	Cash		18,000

12/23/X1, commodity X's market price was 48.2.

The market price of commodity X, the fair value of the future (CX) and daily gain/loss

Date	Per unit	Total	CX	(Gain)/Loss
The future (CX) can be either an asset or (liability) balance. As losses are debited and gains (credited), the schedule presents them: (Gain) / Loss.
	A = Mkt	B = A x 10,000	C = B - 500,000	D = C_(C-1) - C
12/15/X1	50.0	500,000	0	0
12/16/X1	51.5	515,000	15,000	(15,000)
12/17/X1	52.5	525,000	25,000	(10,000)
12/18/X1	51.2	512,000	12,000	13,000
12/19/X1	49.7	497,000	(3,000)	15,000
12/20/X1	49.2	492,000	(8,000)	5,000
12/23/X1	48.2	482,000	(18,000)	10,000
12/24/X1	47.5	475,000	(25,000)	7,000
12/25/X1	43.7	437,000	(63,000)	38,000
12/26/X1	45.4	454,000	(46,000)	(17,000)
12/27/X1	47.7	477,000	(23,000)	(23,000)
12/30/X1	50.6	506,000	6,000	(29,000)
12/31/X1	51.1	511,000	11,000	(5,000)
01/01/X2	48.0	480,000	(20,000)	31,000
01/02/X2	44.6	446,000	(54,000)	34,000
01/03/X2	42.8	428,000	(72,000)	18,000
01/06/X2	41.9	419,000	(81,000)	9,000
01/07/X2	44.8	448,000	(52,000)	(29,000)
01/08/X2	47.5	475,000	(25,000)	(27,000)
01/09/X2	49.4	494,000	(6,000)	(19,000)
01/10/X2	49.9	499,000	(1,000)	(5,000)
01/13/X2	48.9	489,000	(11,000)	10,000
01/14/X2	47.4	474,000	(26,000)	15,000
				26,000

This brought the derivative's value to (18,000) and the margin account to 12,000 = 30,000 + (18,000).

This triggered a margin call and XYZ had to deposit an additional 18,000 to bring the account back up to 30,000.

Etc.

The day after that, commodity X's market price settled at 47.5 which brought CX's value to (63,000) and the account's value to (5,000) = 48,000 + (63,000). To bring the account back up to 30,000, XYZ deposited 45,000.

Etc.

Note: as illustrated in the futures example above, XYZ could have elected to recognize the changes in fair value each day. If it had, in addition to increases in the margin deposit, it would have recognized gains/losses on both the derivative and the forest transaction. However, daily recognition is unusual and not illustrated.

12/25/X1 | 25.12.X1

For illustrative purposes, this example ignores holidays.

While unrealistic, it hopefully makes the example easier to follow.

Margin account

45,000

Cash

45,000

12/31/X1 \| 31.12.X1: to remeasure the derivative to OCI
Derivative financial assets: CXF02		11,000
	OCI: Gain (CXF02)		11,000

Commodity X's unit market price was 50.00 on 12/15/X1 and 51.10 (see above) on 12/31/X1.

As the duration was short, there was no material difference between the fair value of the contract and the spot element | price that needed to be considered (see IFRS 9.6.2.4.b | ASC 815-20-25-82.d).

Note: as illustrated in the futures example above, XYZ could have elected to recognize the changes in fair value each day. However, daily recognition is unusual, so a single, end-of-period adjustment was made instead.

In a cash flow hedge, the gain/loss from the remeasurement of the derivative bypasses net income and is recognized in comprehensive income (OCI).

In other words, the ineffective gain/loss is stripped out and recognized in net income.

However, in this illustration, the hedge was fully effective, so the entire gain was recognized.

12/31/X1 \| 31.12.X1: to close the period
OCI: Gain (CXF02)		11,000
	AOCI (CXF02)		11,000

However, in the footnotes, the section is labeled Accumulated Other Comprehensive Income (AccumulatedOtherComprehensiveIncomeAbstract) section ¯\_(ツ)_/¯.

1/6/X2 \| 6.1.X2
Margin account		18,000
	Cash		18,000

1/14/X2 \| 14.1.X2: to remeasure the derivative to OCI
OCI: Loss (CXF02)		37,000
	Derivative financial liabilities: CXF02		37,000
Item X's unit market price was 47.40 on 1/14/X2.
1/14/X2 \| 14.1.X2: to classify the loss in accumulated other comprehensive income.
AOCI (CXF02)		37,000
	OCI: Loss (CXF02)		37,000

1/14/X2 \| 14.1.X2
IFRS \| US GAAP

1/14/X2 | 14.1.X2: to acquire item X, settle the derivative and move (not reclassify) the AOCI to inventory

As stated in IFRS 9.6.5.11.d.i (edited, emphasis added): if a hedged forecast transaction subsequently results in the recognition of a non-financial asset [like inventory] or non-financial liability ... the entity shall remove that amount from the cash flow hedge reserve and include it directly in the initial cost or other carrying amount of the asset [like inventory] or the liability. This is not a reclassification adjustment (see IAS 1) and hence it does not affect other comprehensive income.

While similar, the guidance in IAS 39 for reclassification adjustments is subtly different:

It reclassifies the associated gains and losses that were recognised in other comprehensive income in accordance with paragraph 95 to profit or loss as a reclassification adjustment (see IAS 1 (revised 2007)) in the same period or periods during which the asset acquired or liability assumed affects profit or loss (such as in the periods that depreciation expense or cost of sales is recognised). However, if an entity expects that all or a portion of a loss recognised in other comprehensive income will not be recovered in one or more future periods, it shall reclassify from equity to profit or loss as a reclassification adjustment the amount that is not expected to be recovered.
It removes the associated gains and losses that were recognised in other comprehensive income in accordance with paragraph 95, and includes them in the initial cost or other carrying amount of the asset or liability.

Inventory		474,000
Derivative financial liabilities: CXF02		26,000
	Cash		500,000
Inventory		26,000
	AOCI (CXF02)		26,000

1/31/X2 \| 31.1.X2
Accounts receivable		1,000,000
	Revenue		1,000,000
Cost of sales		500,000
	Inventory		500,000

1/14/X2 \| 14.1.X2: to acquire item X and settle the derivative
Inventory		474,000
Derivative financial liabilities: CXF02		26,000
	Cash		500,000

1/31/X2 | 31.1.X2: to recognize the hedged transaction in earnings

Applying this guidance, accumulated gains/losses will remain in AOCI until the forecast transaction occurs. In this illustration, this is when XYZ sold item X, not when it bought item X.

If item X had been a raw material, XYZ would have had to keep track of the accumulation as it moved through the manufacturing process and recognize it in income when the goods produced with item X were sold. Likewise, if item X had been a machine, XYZ would have had to keep track of it so it could be incorporated into the machine’s depreciation.

In some situations, keeping track can prove challenging.

Accounts receivable		1,000,000
	Revenue		1,000,000
Cost of sales		500,000
	Inventory		474,000
	AOCI (CXF02)		26,000

Same facts except the hedge was highly but not fully effective.

The future was for commodity X, a standard grade of X. XYZ actually expected to acquire was commodity Xa, a specific grade of X. As a result, the hedge was not 100% effective and XYZ actually paid 480,000 in total.

ASC 815-30-55-1A (Example 1) illustrates this issue in a stand-alone example. IFRS 9 does not provide a similar illustration, but Example 16 does illustrate combined commodity price risk and foreign currency risk hedge (cash flow hedge/cash flow hedge combination).

While forward contracts involve only two parties so can be customized to eliminate all ineffectiveness, future contracts are standardized and practically never fully effective.

Fortunately, neither IFRS nor US GAAP require the hedge to be fully effective to qualify for hedge accounting.

As stated in IFRS 9.6.4.1.c (edited): the hedging relationship [must meet] all of the following hedge effectiveness requirements:

there is an economic relationship between the hedged item and the hedging instrument ...
the effect of credit risk does not dominate the value changes that result from that economic relationship ... and
the hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. However, that designation shall not reflect an imbalance between the weightings of the hedged item and the hedging instrument that would create hedge ineffectiveness (irrespective of whether recognised or not) that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting...

The guidance continues in IFRS B6.4.4 to 11 (IAS 39.AG105 to AG113A), but a detailed discussion of this guidance is beyond the scope of this illustration.

As stated in 815-20-25-75 (edited): To qualify for hedge accounting, the hedging relationship, both at inception of the hedge and on an ongoing basis, shall be expected to be highly effective in achieving either of the following:

Offsetting changes in fair value attributable to the hedged risk during the period that the hedge is designated (if a fair value hedge)
Offsetting cash flows attributable to the hedged risk during the term of the hedge (if a cash flow hedge)...

The guidance continues up ASC 815-20-25-131, but a detailed discussion of this guidance is beyond the scope of this illustration.

IFRS | US GAAP

1/14/X2 | 14.1.X2: to acquire item X, settle the derivative and move the AOCI to inventory

As stated in IFRS 9.6.5.11.d.i (edited, emphasis added): if a hedged forecast transaction subsequently results in the recognition of a non-financial asset [like inventory] or non-financial liability ... the entity shall remove that amount from the cash flow hedge reserve and include it directly in the initial cost or other carrying amount of the asset [like inventory] or the liability. This is not a reclassification adjustment (see IAS 1) and hence it does not affect other comprehensive income.

While similar, the guidance in IAS 39 for reclassification adjustments is subtly different:

It reclassifies the associated gains and losses that were recognised in other comprehensive income in accordance with paragraph 95 to profit or loss as a reclassification adjustment (see IAS 1 (revised 2007)) in the same period or periods during which the asset acquired or liability assumed affects profit or loss (such as in the periods that depreciation expense or cost of sales is recognised). However, if an entity expects that all or a portion of a loss recognised in other comprehensive income will not be recovered in one or more future periods, it shall reclassify from equity to profit or loss as a reclassification adjustment the amount that is not expected to be recovered.
It removes the associated gains and losses that were recognised in other comprehensive income in accordance with paragraph 95, and includes them in the initial cost or other carrying amount of the asset or liability.

Inventory		480,000
Derivative financial liabilities: CXF02		26,000
	Cash		506,000
Inventory		26,000
	AOCI (CXF02)		26,000

1/31/X2 \| 31.1.X2
Accounts receivable		1,000,000
	Revenue		1,000,000
Cost of sales		506,000
	Inventory		506,000

1/14/X2 \| 14.1.X2: to acquire item X and settle the derivative
Inventory		480,000
Derivative financial liabilities: CXF02		26,000
	Cash		506,000

1/31/X2 | 31.1.X2: to recognize the hedged transaction in earnings

Applying this guidance, accumulated gains/losses will remain in AOCI until the forecast transaction occurs. In this illustration, this is when XYZ sold item X, not when it bought item X.

In some situations, keeping track can prove challenging.

Accounts receivable		1,000,000
	Revenue		1,000,000
Cost of sales		506,000
	Inventory		480,000
	AOCI (CXF02)		26,000

Future (fair value hedge)

As above 12/15/X1, XYZ entered into a 30 day futures contract to buy 10,000 units of commodity X at 50 when its market price was 50. The exchange required an initial margin deposit of 30,000. XYZ acquired the future because it had committed to sell 10,000 units of item X to DEF for 60 per unit on 1/15/X1 and so designated the future as a fair value hedge of a firm commitment. Commodity X's market price was 51.10 on 12/31/X1 and 47.40 on 1/14/X2. Item X's market price was 51.25 on 12/31/X1 and 47.15 on 1/14/X2. XYZ settled the future net.

In practice, most futures contracts have a longer duration. They also generally expire on the third Friday of the month. This example assumes a one month duration and expiration halfway through the month. While unrealistic, this assumption simplifies the illustration.

Both the accounting for a margin deposit and marking to market is illustrated above.

As outlined in IFRS 9.6.5.2.a | ASC 815-20-25-12.a, only a recognized asset, liability or unrecognized firm commitment may be designated as the hedged item in a fair value hedge.

The ASC defines firm Commitment: an agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:

The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield. The binding provisions of an agreement are regarded to include those legal rights and obligations codified in the laws to which such an agreement is subject. A price that varies with the market price of the item that is the subject of the firm commitment cannot qualify as a fixed price. For example, a price that is specified in terms of ounces of gold would not be a fixed price if the market price of the item to be purchased or sold under the firm commitment varied with the price of gold.
The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. In the legal jurisdiction that governs the agreement, the existence of statutory rights to pursue remedies for default equivalent to the damages suffered by the nondefaulting party, in and of itself, represents a sufficiently large disincentive for nonperformance to make performance probable for purposes of applying the definition of a firm commitment.

While comparable, the IFRS 9 definition is more succinct: a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

Item X was a specific grade of commodity X. While not identical, it was generally comparable.

Unlike commodity X, item X did not trade on market so did not have a level 1 fair value. Its fair value could, however, be determined using a level 2 input.

Dr/Cr

12/15/X1 \| 15.12.X1
Derivatives: Futures: CXF02		N/A
Due to its short duration, XYZ measured the derivative at intrinsic value which was zero. Although there was no asset or liability to recognize, XYZ opened an account so it could keep track of the derivative as its value changed. Note: As the derivative had no initial value, a balancing entry was not required.
Margin account		30,000
	Cash		30,000

12/31/X1 \| 31.12.X1: to remeasure the derivative and firm commitment so a financial report could be drafted
Derivative financial assets: Forward contract		11,000
	Gain		11,000
Loss		12,500
	Firm commitment		12,500

As the duration was short, there was no material difference between the fair value of the contract and the spot element | price that needed to be considered (see IFRS 9.6.2.4.b | ASC 815-20-25-82.d).

As the hedge was not 100% effective, 1,500 = 12,500 - 11,000 was reported in net income.

1/14/X2 \| 14.1.X2: to remeasure the derivative and firm commitment
Loss		37,000
	Derivative financial liabilities: Forward contract		37,000
Firm commitment		41,000
	Gain		41,000

1/14/X2 \| 14.1.X2: to settle the derivative and acquire the inventory
Cash		4,000
Derivative financial liabilities: Forward contract		26,000
	Margin account		30,000
Inventory		471,500
	Cash		471,500

1/31/X2 \| 31.1.X2: to resell the inventory and honor the firm commitment
Receivable: DEF		600,000
	Revenue		600,000
Cost of goods sold		500,000
	Inventory		471,500
	Firm commitment		28,500

Variable for fixed swap (cash flow hedge)

1/1/X1, XYZ acquired a five-year, 500,000 nominal value note paying a variable, semi-annual coupon of benchmark rate + 7%. The coupon was paid in arrears each 7/15 and 1/15 to the holder of record each 6/15 and 12/15. To hedge the cash flows associated with the note, XYZ entered into a five-year variable for fixed swap at 8% (for illustrative purposes, the swap is settled on the interest payment date). The benchmark rates 1/1/X1, 3/31/X1, 6/30/X1, 9/30/X1 and 12/31/X1 were 1.00%, 1.20%, 1.18%, 1.21% and 1.15%. XYZ did not sell the notes.

Dr/Cr

1/1/X1 \| 1.1.X1
Notes		500,000
	Cash in bank		500,000

3/31/X1 \| 31.3.X1
Comprehensive income: Loss: Hedged investment		3,897
	Interest rate swap		3,897
accumulated comprehensive income (reserve)		3,897
	Comprehensive income: Loss: Hedged investment		3,897
Accrued interest		10,048
	Net income: Interest income		10,048
Net income: Interest income (reclassification adjustment)		240
	accumulated comprehensive income		240

P	Nominal interest	Swapped interest	Difference	Variable interest rate	PV of difference
A	B=500,000 x ((1+8.00%)^1/2-1)	C=500,000 x ((1+8.20%)^1/2-1)	D = C - B	E = (1 + 8.24%)^1/2 - 1	F = D ÷ (1 + E)^A
1	20,096	19,615	(481)	4.02%	(462)
2	20,096	19,615	(481)	4.02%	(444)
-	-	-	-	-	-
9	20,096	19,615	(481)	4.02%	(337)
10	20,096	19,615	(481)	4.02%	(324)
					(3,897)

6/30/X1 \| 30.6.X1
Interest rate swap		680
	Comprehensive income: Gain: Hedged investment		680
Comprehensive income: Gain: Hedged investment		680
	accumulated comprehensive income (reserve)		680
Accrued interest		10,048
	Net income: Interest income (interest on notes)		10,048
Net income: Interest income (reclassification adjustment)		192
	accumulated comprehensive income		192

(680) = 3,217 - 3,897

P	Nominal interest	Swapped interest	Difference	Variable interest rate	PV of difference
A	B=500,000 x ((1+8.00%)^1/2-1)	C=500,000 x ((1+8.20%)^1/2-1)	D = C - B	E = (1 + 8.24%)^1/2 - 1	F = D ÷ (1 + E)^A
1	20,048	19,615	(433)	4.01%	(416)
2	20,048	19,615	(433)	4.01%	(400)
-	-	-	-	-	-
8	20,048	19,615	(433)	4.01%	(316)
9	20,048	19,615	(433)	4.01%	(304)
					(3,217)

7/15/X1 \| 15.7.X1
Cash in bank		20,096
	Accrued interest (receipt of interest)		20,096
Interest rate swap (settlement of swap)		433
	Cash in bank		433

Fixed for variable swap (fair value hedge)

1/1/X1, XYZ acquired a five-year note with a nominal value of 500,000 and fixed, semi-annual coupon of 19,615.25 for 500,000. The coupon was paid each 7/15 and 1/15 to the holder of record each 6/15 and 12/15. To hedge the notes' fair value, XYZ acquired five-year fixed for variable swap at benchmark rate + 7% (for illustrative purposes, the swap is settled on the interest payment date). 1/1/X1, 3/31/X1, 6/30/X1, 9/30/X1 and 12/31/X1 the benchmark rates were 1.00%, 1.20%, 1.18%, 1.21% and 1.15%. XYZ sold the notes for 497,571 on 12/31/X1.

Implicit rate 7.999899%=((1+RATE(10,19615,-500000,500000,0,1))^2) - 1

Dr/Cr

1/1/X1 \| 1.1.X1
Notes		500,000
	Cash in bank		500,000
Interest rate swap		0
	Cash in bank		0

3/31/X1 \| 31.3.X1
Loss: Hedged investment		3,897
	Notes		3,897
Interest rate swap		3,897
	Gain: Hedging instrument		3,897
Accrued interest		10,048
	Interest income: Notes		9,808
	Interest income: Interest rate swap		240

(3,897) = 496,103 - 500,000

P	Expected cash flow	Variable interest rate on 3/31/X1	Present value
A	B	C = (1 + 8.20%)^1/2 - 1	D = B ÷ (1 + C)^A
1	19,615	4.02%	18,857
2	19,615	4.02%	18,129
-	-	-	-
9	19,615	4.02%	13,759
10	519,615	4.02%	350,385
			496,103

P	Fixed interest	Variable interest	Difference	Variable rate	PV of difference
A	B	C = 500,000 x ((1+8.20%)^1/2-1)	D = C - B	E = (1 + 8.24%)^1/2 - 1	F = D ÷ (1 + E)^A
1	19,615	20,096	481	4.02%	462
2	19,615	20,096	481	4.02%	444
-	-	-	-	-	-
9	19,615	20,096	481	4.02%	337
10	19,615	20,096	481	4.02%	324
					3,897

6/30/X1 \| 30.6.X1
Notes		680
	Gain: Hedged investment		680
Loss: Hedging instrument		680
	Interest rate swap		680
Accrued interest		10,000
	Interest income: Notes		9,808
	Interest income: Interest rate swap		192

680 = 496,783 - 496,103

P	Expected cash flow	Variable interest rate on 6/30/X1	Present value
A	B	C = (1 + 8.18%)^1/2 - 1	D = B ÷ (1 + C)^A
1	19,615	4.01%	18,859
2	19,615	4.01%	18,132
-	-	-	-
8	19,615	4.01%	14,322
9	519,615	4.01%	364,771
			496,783

(680) = 3,217 - 3,897

P	Fixed interest	Variable interest	Difference	Variable rate	PV of difference
A	B	C=500,000 x ((1+8.18%)^1/2-1)	D = C - B	E = (1 + 8.24%)^1/2 - 1	F = D ÷ (1 + E)^A
1	19,615	20,048	433	4.01%	416
2	19,615	20,048	433	4.01%	400
-	-	-	-	-	-
8	19,615	20,048	433	4.01%	316
9	19,615	20,048	433	4.01%	304
					3,217

7/15/X1 \| 15.7.X1
Cash in bank (interest payment)		19,615
Cash in bank (swap settlement)		433
	Accrued interest		20,048

12/31/X1 \| 31.12.X1
Loss: Hedged investment		967
	Notes		967
Interest rate swap		967
	Gain: Hedging instrument		967
Accrued interest		9,916
	Interest income: Notes		9,808
	Interest income: Interest rate swap		108
Cash in bank		497,571
	Notes		497,571
Cash in bank		2,429
	Interest rate swap		2,429

1/15/X2 \| 15.1.X2
Cash in bank (interest payment)		19,615
Cash in bank (swap settlement)		361
	Accrued interest		19,976

Forex hedge

The accounting for a forex hedge is illustrated on this page.

Option

1/1/X1 XYZ forecast it would need to acquire 2,000 units of a commodity on 12/31/X1. For some inexplicable reason, it decided to hedge the cash flow with an option and so paid a 24,472 premium to acquire an at-the-money call.

This illustration assumes the option was for the exact grade of commodity XYZ intended to acquire. It also assumes the option traded at exactly its determined value and there was no need to make any adjustments to reflect storage fees, transportation costs or other actual conditions. The option was also for a short enough period that the time value of money (IFRS 9.B6.5.4 | ASC 815-20-25-84, ASC 815-20-25-120 and 121) did not need to be considered.

As outlined in IFRS 9 B6.5.32 and 33, hedge accounting only applies to the "aligned time value" of options.

Aligned time value is the time value of an option where all critical terms (life, underlying, etc.) are fully aligned with hedged item. If the two are not fully aligned, the entity applies accounting based on a hypothetical option (IFRS 9.B6.5.5), recognizing differences between this hypothetical option and the actual option in net income.

Although ASC does not define an aligned time value concept, ASC 815-20-25-84 provides guidance on evaluating the critical terms of both the hedging instrument and the hedged item. A hypothetical derivative method is mentioned in ASC 815-20-25-3.F and discussed in ASC 815-30-35-25 through 35-29. It also figures in the evaluation of the Shortcut Method (ASC 815-20-25-117D).

While unrealistic, these assumptions make the accounting simpler and illustration easier to present.

Unlike forwards and futures, options act like insurance. While this characteristic makes them ideal for speculation, it makes them poor and expensive tools for managing risk.

Like forwards and futures, options can be used to manage risk.

Unlike forwards and futures, they do not merely substitute one for another but, just like insurance, eliminate it.

Forwards and futures do not eliminate risk; they reorganize it.

In the classic baker/farmer example, the baker exchanges one risk (having to pay more if a failed crop drives up prices) for another (not being able to pay less if a bumper crop drives prices down).

This obviously makes sense if one risk (having to pay more than one has budgeted especially if what one has budgeted is all one has or can borrow) is worse than the other.

For the farmer, the situation is reversed.

This characteristic makes forwards and futures mutually beneficial and (practically) cost free.

Forwards, are between just two parties and so, for the most part, cost free.

Futures, as they involve at least one third party (the clearing agent), carry a cost (e.g. link). Nevertheless, relative to the notional amount, this cost is generally small.

Well, not just like.

While acquireing a put option on oil is comparable to insuring a ship full of oil (below), the probability the price of oil will sink is higher than a ship. Since no rational party takes on high probability risk without adequate compensation, relative to the notional amounts, options tend to be considerably more expensive. This cost is often further inflated by the asymmetry between buyers and sellers of options (below) that is less prevalent between buyers and sellers of insurance.

If an oil producer acquires a put option on oil and the price of oil goes down. No worries, the risk has been eliminated.

Well, not really. The risk is still there. It has simply been assumed by the counterparty to the option.

So, unlike forwards and futures (above), options are not mutually beneficial. Since no rational party takes on risk without compensation, their cost is significant (below).

Since options are asymmetrical, they limit losses but offer (theoretically) unlimited gains.

Obviously, for a gain on a call option to be unlimited, the underlying's price would have to rise to infinity. This is not possible. Gains on put options are always limited because an underlying's value cannot fall below zero (unless the underlying is interest and central banks again decide to start charging savers a fee for saving).

For example, a 90 day at-the-money call on a stock trading at 100 would cost around 550. If the stock's price went up by 50%, that 550 would turn into a gain of 4,450. If the price went down, the loss would be at most 550.

The same cannot be said about forwards and futures. Since they are symmetrical, the potential loss can be as high as, or even higher than, the potential gain. For those old enough to remember, this was entertainingly fictionalized in the movie Trading Places.

Note: writing options is riskier, especially uncovered calls, which carry a risk comparable to futures.

Since options are one-sided, their reaction to the market is also one-sided.

While neither IFRS nor US GAAP preclude designating options as asymmetrical, loss-only hedges, they do not make the accounting easy or, in US GAAP's case, particularly appealing.

Similarly to IFRS.9.6.2.4.a, ASC 815-20-25-82 allows the time and intrinsic elements of options to be separated from one another.

Unlike IFRS 9, both of ASC 815's subsequent measurement options (ASC 815-20-25-82A and 82B) lead to an expense being recognized throughout the hedge term, even if the hedged transaction (as illustrated in Example 31, ASC 815-20-55-235 to 238) occurs several years later.

As stated in IFRS 9.6.5.15.b.i (edited): if the hedged item subsequently results in the recognition of a non-financial asset ... the entity shall remove the amount from the separate component of equity and include it directly in the initial cost or other carrying amount of the asset ...

As illustrated in the body of the example, this guidance means an expense is not recognized until the non-financial asset affects P&L (e.g. the inventory is sold).

This expense front loading more or less eliminates any benefit from excluding all or a part of the hedging instrument's time value, which makes options unattractive instruments for hedging unless their total fair value makes them effective, which does not happen very often.

As option writer always requires a fee (demands a premium) for taking on the risk. Given that most option writers are more sophisticated than most options buyers, most option buyers end up overpaying.

Writing puts or covered calls is fairly common, even among amateur investors.

However, while all option traders share a gambler's mentality (if they did not, they would stick to AAA bonds or dividend paying blue-chips), buyers are generally more willing to try their luck than sellers, who, since their upside is limited, prefer to back up their trading with rigorous analysis and rarely open a position unless the market is, as one central banker once put it, irrationally exuberant.

In contrast, buyers of insurance not only tend to be comparably savvy to sellers of insurance but usually go out of their way to, coolly and rationally, negotiate mutually beneficial contracts that do not result in their overpaying.

This fact is not lost on the standard setters. For example, in ASC 815-20-55-235 to 237 the option buyer spends $9,250 to get $6,000 back in four years. Hardly a good investment. In the similarly realistic example presented on this page, the option buyer loses 59% of the 24,472 paid in just one year.

Note: occasionally, an option may also be embedded in larger contracts and may appear, at least on the surface, cost free. However, as no rational entity assumes risk without compensation, the cost of the option(s) is always buried somewhere, usually a purchase or sales price higher than it would have been. For this reason, embedded options, like all other derivatives, must be separated from the host contract and accounted for as derivatives (assuming the entire contract is not remeasured to fair value as discussed in IFRS 9.B4.3.1 | ASC 815-15-25-4).

Consequently, this site recommends against using options for hedging purposes.

However, as the guidance does not preclude using them this way, a few examples are, unfortunately, necessary.

While an option as whole may be designated as the hedge, this is not sufficiently common to warrant a separate illustration. Instead, options are generally separated into time value and intrinsic value in that each component is accounted for separately as outlined in IFRS 9.6.2.4.a | ASC 815-20-25-82.

Note: unlike IFRS 9, ASC 815-20-25-82 also allows time value to be broken down into its components θ (theta), ν (vega), ρ (rho). However, illustrations of all the permutations are beyond the scope of this page.

For illustrative purposes, the commodity traded at exactly the call's strike price of 100 when XYZ opened the position.

The commodity’s market price and call option's fair value at the end of each month were:

Date	Per unit market price	Position intrinsic value	Per option fair value	Position fair value
An option's fair value comprises its intrinsic value and its time value. The ASC master glossary defines the time value of an option: the time value of an option is equal to the fair value of an option less its intrinsic value. Rearranging the equation, fair value is the sum of time value and intrinsic value. Interestingly, while IFRS 9.6.5.15 does discusses how to account for time value, IFRS does not specifically define the term. Not that it makes any difference, as the rest of the guidance makes it clear that time value plus intrinsic value equals fair value. While IFRS 9.6.5.15 \| ASC 815-20-25-82 allows only intrinsic value to be designated as a hedging instrument, time value must still be accounted for. This implies the option's fair value must be periodically updated. In this illustration, XYZ does so each month. Note: if an option is actively traded, its fair value equals its market price. If it is not, its fair value must be calculated. A discussion of this issue is provided in the introduction to this section.
	A	B = (A -100) x 2000, If > 0	C	D = 2,000 x C
1/1/X1	100	0	12.236	24,472
1/31/X1	104	8,000	14.237	28,474
2/29/X1	111	22,000	18.698	37,396
3/31/X1	104	8,000	12.924	25,848
4/30/X1	95	0	6.890	13,780
5/31/X1	90	0	4.054	8,108
6/30/X1	87	0	2.496	4,992
7/31/X1	92	0	3.543	7,086
8/31/X1	104	8,000	9.026	18,052
9/30/X1	108	16,000	10.996	21,992
10/31/X1	106	12,000	8.416	16,832
11/30/X1	107	14,000	8.025	16,050
12/31/X1	105	10,000	0.000

IFRS | US GAAP

XYZ recognized changes in fair value monthly and published quarterly financial reports.

P	Fair value	Intrinsic value	Time value	∆ intrinsic value	∆ time value	Total gain (loss)
	A above	B above	C = A - B	D=B_(B+1)-B	E=C_(C+1)-C	F = D + E
0	24,472	0	24,472	0	0	0
1	28,474	8,000	20,474	8,000	(3,998)	4,002
2	37,396	22,000	15,396	14,000	(5,078)	8,922
3	25,848	8,000	17,848	(14,000)	2,452	(11,548)
4	13,780	0	13,780	(8,000)	(4,068)	(12,068)
5	8,108	0	8,108	0	(5,672)	(5,672)
6	4,992	0	4,992	0	(3,116)	(3,116)
7	7,086	0	7,086	0	2,094	2,094
8	18,052	8,000	10,052	8,000	2,966	10,966
9	21,992	16,000	5,992	8,000	(4,060)	3,940
10	16,832	12,000	4,832	(4,000)	(1,160)	(5,160)
11	16,050	14,000	2,050	2,000	(2,782)	(782)
12	10,000	10,000	0	(4,000)	(2,050)	(6,050)
				10,000	(24,472)	(14,472)

1.1.X1
Derivative		24,472
	Cash		24,472

31.1.X1: to remeasure the derivative to other comprehensive income
Derivative		8,000
	OCI (IV G/L)		8,000
OCI (TV G/L)		3,998
	Derivative		3,998

As a general rule, when entities do use options as hedging instruments, they separate time and intrinsic values, and designate intrinsic values as the hedge.

The reason, an option's total fair value rarely changes in a way that makes the option as a whole a sufficiently effective hedging instrument. While not impossible, it is uncommon enough that it need not be illustrated.

As outlined in IFRS 9.6.5.15 (B6.5.29 to 33), when the intrinsic and time values of an option are separated and intrinsic value is designated as the hedge, the fair value of each of the components is accounted for separately.

This item represents the gain or loss from remeasuring the intrinsic value of the option.

This item represents the gain or loss from remeasuring the time value of the option.

28.2.X1
Derivative		14,000
	OCI (IV G/L)		14,000
OCI (TV G/L)		5,078
	Derivative		5,078

31.3.X1
OCI (IV G/L)		14,000
	Derivative		14,000
Derivative		2,452
	OCI (TV G/L)		2,452
To close the period and recognize the accumulated gain/loss
OCI (IV G/L)		8,000
	AOCI (IV reserve)		8,000
AOCI (TV reserve)		6,624
	OCI (TV G/L)		6,624
Etc.

For illustrative purposes, XYZ recognized the remeasurement gains and losses on a monthly basis but reported them on a quarterly basis. Consequently, at the end of the quarter, it accumulated the net three-month gain or loss on the balance sheet in accumulated other comprehensive income (AccumulatedOtherComprehensiveIncome).

Note: the items comprising accumulated other comprehensive income are (with one exception) labeled "reserves".

IASB XBRL AccumulatedOtherComprehensiveIncome:

RevaluationSurplus
ReserveOfExchangeDifferencesOnTranslation
ReserveOfCashFlowHedges
ReserveOfGainsAndLossesOnHedgingInstrumentsThatHedgeInvestmentsInEquityInstruments
ReserveOfChangeInValueOfTimeValueOfOptions
ReserveOfChangeInValueOfForwardElementsOfForwardContracts
ReserveOfChangeInValueOfForeignCurrencyBasisSpreads
ReserveOfGainsAndLossesOnFinancialAssetsMeasuredAtFairValueThroughOtherComprehensiveIncome
ReserveOfInsuranceFinanceIncomeExpensesFromInsuranceContractsIssuedExcludedFromProfitOrLossThatWillBeReclassifiedToProfitOrLoss
ReserveOfInsuranceFinanceIncomeExpensesFromInsuranceContractsIssuedExcludedFromProfitOrLossThatWillNotBeReclassifiedToProfitOrLoss
ReserveOfFinanceIncomeExpensesFromReinsuranceContractsHeldExcludedFromProfitOrLoss
ReserveOfGainsAndLossesOnRemeasuringAvailableforsaleFinancialAssets
ReserveOfRemeasurementsOfDefinedBenefitPlans
AmountRecognisedInOtherComprehensiveIncomeAndAccumulatedInEquityRelatingToNoncurrentAssetsOrDisposalGroupsHeldForSale
ReserveOfGainsAndLossesFromInvestmentsInEquityInstruments
ReserveOfChangeInFairValueOfFinancialLiabilityAttributableToChangeInCreditRiskOfLiability

The gains/losses associated with the change in fair value of the intrinsic value are accumulated in equity and presented (IASB XBRL) as ReserveOfCashFlowHedges.

Specifically, the label documentation states: a component of equity representing the accumulated portion of gain (loss) on a hedging instrument that is determined to be an effective hedge for cash flow hedges. [Refer: Cash flow hedges [member]].

Note: this item would also be used if the option as a whole were designated as the hedging item. However, this would be unusual as, when entities do use options as hedging instruments, they generally separate time and intrinsic values, designating only intrinsic values as hedges.

The gains/losses associated with the change in fair value of the time value are accumulated in equity and presented as (IASB XBRL) ReserveOfChangeInValueOfTimeValueOfOptions.

Specifically, the label documentation states: a component of equity representing the accumulated change in the value of the time value of options when separating the intrinsic value and time value of an option contract and designating as the hedging instrument only the changes in the intrinsic value.

30.4.X1
OCI (IV G/L)		8,000
	Derivative		8,000
OCI (TV G/L)		4,068
	Derivative		4,068

31.5.X1
Derivative		0
	OCI (IV G/L)		0
OCI (TV G/L)		5,672
	Derivative		5,672

30.6.X1
Derivative		0
	OCI (IV G/L)		0
OCI (TV G/L)		3,116
	Derivative		3,116
AOCI (IV G/L)		8,000
	OCI (IV G/L)		8,000
AOCI (TV G/L)		10,404
	OCI (TV G/L)		10,404

31.7.X1
Derivative		0
	OCI (IV G/L)		0
Derivative		2,094
	OCI (TV G/L)		2,094

31.8.X1
Derivative		8,000
	OCI (IV G/L)		8,000
Derivative		2,966
	OCI (TV G/L)		2,966

30.9.X1
Derivative		8,000
	OCI (IV G/L)		8,000
OCI (TV G/L)		4,060
	Derivative		4,060
OCI (IV G/L)		16,000
	AOCI (IV G/L)		16,000
OCI (TV G/L)		1,000
	AOCI (TV G/L)		1,000

31.10.X1
OCI (IV G/L)		4,000
	Derivative		4,000
OCI (TV G/L)		1,160
	Derivative		1,160

30.11.X1
Derivative		2,000
	OCI (IV G/L)		2,000
OCI (TV G/L)		2,782
	Derivative		2,782

31.12.X1
OCI (IV G/L)		4,000
	Derivative		4,000
OCI (TV G/L)		2,050
	Derivative		2,050
AOCI (IV G/L)		6,000
	OCI (IV G/L)		6,000
AOCI (TV G/L)		5,992
	OCI (TV G/L)		5,992

31.12.X1: to close the position and derecognize the accumulated reserves
Cash		10,000
	Derivative		10,000
AOCI (IV G/L)		10,000
	Inventory		10,000
Inventory		24,472
	AOCI (TV G/L)		24,472

Same facts except XYZ recognized the change in time value as an expense.

As outlined in IFRS 9.B6.5.29.b, if the hedge relates to a time period, the changes in time value are recognized as an expense. This unrealistic example shows this approach using the same facts as above.

IFRS 9.B6.5.29 outlines two approaches to time value.

The first (B6.5.29.a), applies if the option is hedging a transaction, while the second (B6.5.29.b) if it is hedging a time period.

As a rule, cash flow hedges hedge transactions, while fair value hedge time periods.

Note: unlike ASC 815-20-25-83A/83B, which offer a similar policy election, IFRS 9 does not allow the entity to make the choice. Instead, if the entity is hedging a transaction, B6.5.29.a is mandatory. If it is hedging a time period, B6.5.29.b is mandatory.

Important

This example is included for comparison purposes only. The following illustration is realistic.

1.1.X1
Derivative		24,472
	Cash		24,472

31.1.X1
Derivative		8,000
	OCI (IV G/L)		8,000
OCI (TV G/L)		1,959
Expense		2,039
	Derivative		3,998

28.2.X1
Derivative		14,000
	OCI (IV G/L)		14,000
OCI (TV G/L)		3,039
Expense		2,039
	Derivative		5,078

31.3.X1
OCI (IV G/L)		14,000
	Derivative		14,000
Derivative		2,452
Expense		2,039
	OCI (TV G/L)		4,491
OCI (IV G/L)		8,000
	AOCI (IV G/L)		8,000
OCI (TV G/L)		506
	AOCI (TV G/L)		506
Etc.

30.4.X1
OCI (IV G/L)		8,000
	Derivative		8,000
OCI (TV G/L)		2,029
Expense		2,039
	Derivative		4,068

31.5.X1
Derivative		0
	OCI (IV G/L)		0
OCI (TV G/L)		3,633
Expense		2,039
	Derivative		5,672

30.6.X1
Derivative		0
	OCI (IV G/L)		0
OCI (TV G/L)		1,077
Expense		2,039
	Derivative		3,116
AOCI (IV G/L)		8,000
	OCI (IV G/L)		8,000
OCI (TV G/L)		6,738
	AOCI (TV G/L)		6,738

31.7.X1
Derivative		0
	OCI (IV G/L)		0
Derivative		2,094
Expense		2,039
	OCI (TV G/L)		4,133

31.8.X1
Derivative		8,000
	OCI (IV G/L)		8,000
Derivative		2,966
Expense		2,039
	OCI (TV G/L)		5,005

30.9.X1
Derivative		8,000
	OCI (IV G/L)		8,000
OCI (TV G/L)		2,021
Expense		2,039
	Derivative		4,060
OCI (IV G/L)		16,000
	AOCI (IV G/L)		16,000
OCI (TV G/L)		7,118
	AOCI (TV G/L)		7,118

31.10.X1
OCI (IV G/L)		4,000
	Derivative		4,000
Expense		2,039
	OCI (TV G/L)		879
	Derivative		1,160

30.11.X1
Derivative		2,000
	OCI (IV G/L)		2,000
OCI (TV G/L)		743
Expense		2,039
	Derivative		2,782

31.12.X1
OCI (IV G/L)		4,000
	Derivative		4,000
OCI (TV G/L)		11
Expense		2,039
	Derivative		2,050
AOCI (IV G/L)		6,000
	OCI (IV G/L)		6,000
AOCI (TV G/L)		126
	OCI (TV G/L)		126

31.12.X1
Cash		10,000
	Derivative		10,000
AOCI (IV G/L)		10,000
	Inventory		10,000

More realistically ABC paid 14,850 for a put option to hedge a decline in the commodity's fair value.

Dr/Cr

Date	Per unit market price	Position intrinsic value	Per option fair value	Position fair value
An option's fair value comprises its intrinsic value and its time value. The ASC master glossary defines the time value of an option: the time value of an option is equal to the fair value of an option less its intrinsic value. Rearranging the equation, fair value is the sum of time value and intrinsic value. Interestingly, while IFRS 9.6.5.15 does discuss how to account for time value, IFRS does not specifically define the term. Not that it makes any difference, because the rest of the guidance makes it clear that time value plus intrinsic value equals fair value. While IFRS 9.6.5.15 \| ASC 815-20-25-82 allows only intrinsic value to be designated as a hedging instrument, time value must still be accounted for. This implies the option's fair value must be periodically updated. In this illustration, XYZ does so each month. Note: if an option trades on a market, fair value equals its market price. If an option does not trade on a market, its fair value needs to be determined (calculated). A discussion of this issue is provided in the introduction to this section. Also note: While both IFRS and US GAAP require time value to be separated and accounted for, their methodologies and reported results differ significantly.
	A	B = (A -100) x 2000, If > 0	C	D = 2,000 x C
1/1/X1	100	0	7.425	14,850
1/31/X1	104	0	5.817	11,634
2/29/X1	111	0	3.672	7,344
3/31/X1	104	10,000	5.293	10,586
4/30/X1	95	20,000	8.656	17,312
5/31/X1	90	26,000	11.218	22,436
6/30/X1	87	16,000	13.061	26,122
7/31/X1	92	0	9.509	19,018
8/31/X1	104	0	3.396	6,792
9/30/X1	108	00	1.771	3,542
10/31/X1	106	0	1.598	3,196
11/30/X1	107	0	0.615	1,230
12/31/X1	105	0	0.000

As they react differently to market forces, puts and calls do not trade at symmetrical prices.

As outlined in IFRS 9.6.3.7, an entity may designate an item in its entirety or a component of an item as the hedged item. In this illustration, ABC only designated the decline (not increase) in the commodity's fair value as the hedged item.

ABC recognized changes in fair value each month and published quarterly financial reports.

Period	Position fair value	Intrinsic value	Time value	∆ intrinsic value	∆ time value	Total gain (loss)
0	14,850	0	14,850	0	0	0
1	11,634	0	11,634	0	(3,216)	(3,216)
2	7,344	0	7,344	0	(4,290)	(4,290)
3	10,586	0	10,586	0	3,242	3,242
4	17,312	10,000	7,312	10,000	(3,274)	6,726
5	22,436	20,000	2,436	10,000	(4,876)	5,124
6	26,122	26,000	122	6,000	(2,314)	3,686
7	19,018	16,000	3,018	(10,000)	2,896	(7,104)
8	6,792	0	6,792	(16,000)	3,774	(12,226)
9	3,542	0	3,542	0	(3,250)	(3,250)
10	3,196	0	3,196	0	(346)	(346)
11	1,230	0	1,230	0	(1,966)	(1,966)
12	0	0	0	0	(1,230)	(1,230)
				0	(14,850)	(14,850)

1.1.X1
Derivative		14,850
	Cash		14,850

31.1.X1
Derivative		0
	Gain		0
Loss		0
	Inventory		0
OCI (TV)		1,979
Expense		1,238
	Derivative		3,216

28.2.X1
Derivative		0
	Gain		0
Loss		0
	Inventory		0
OCI (TV)		3,053
Expense		1,238
	Derivative		4,290

31.3.X1
Derivative		0
	Gain		0
Loss		0
	Inventory		0
Derivative		3,242
Expense		1,238
	OCI (TV)		4,480
OCI (TV)		552
	AOCI (TV)		552
Etc.

30.4.X1
Derivative		10,000
	Gain		10,000
Loss		10,000
	Inventory		10,000
OCI (TV)		2,037
Expense		1,238
	Derivative		3,274

31.5.X1
Derivative		10,000
	Gain		10,000
Loss		10,000
	Inventory		10,000
OCI (TV)		3,639
Expense		1,238
	Derivative		4,876

30.6.X1
Derivative		6,000
	Gain		6,000
Loss		6,000
	Inventory		6,000
OCI (TV)		1,077
Expense		1,238
	Derivative		2,314
OCI (TV)		6,752
	AOCI (TV)		6,752

31.7.X1
Loss		10,000
	Derivative		10,000
Inventory		10,000
	Gain		10,000
Derivative		2,896
Expense		1,238
	OCI (TV)		4,134

31.8.X1
Loss		16,000
	Derivative		16,000
Inventory		16,000
	Gain		16,000
Derivative		3,774
Expense		1,238
	OCI (TV)		5,012

30.9.X1
Derivative		0
	Gain		0
Loss		0
	Inventory		0
OCI (TV)		2,013
Expense		1,238
	Derivative		3,250
AOCI (TV)		7,133
	OCI (TV)		7,133

31.10.X1
Derivative		0
	Gain		0
Loss		0
	Inventory		0
Expense		1,238
	OCI (TV)		892
	Derivative		346

30.11.X1
Derivative		0
	Gain		0
Loss		0
	Inventory		0
OCI (TV)		729
Expense		1,238
	Derivative		1,966

31.12.X1
Derivative		0
	Gain		0
Loss		0
	Inventory		0
Expense		1,238
	OCI (TV)		8
	Derivative		1,230
AOCI (TV)		171
	OCI (TV)		171

Note: as the derivative had a zero balance, there was nothing to recognize.

Similarly, as the Accumulated other comprehensive income (TV) account also had a zero balance, there was nothing to derecognize.

Same facts except the hedged item was a firm commitment in a fair value hedge.

1.1.X1
Derivative		24,472
	Cash		24,472

31.1.X1: to remeasure the derivative
Derivative		8,000
	Gain		8,000
Loss		8,000
	Firm commitment		8,000
OCI (TV G/L)		3,998
	Derivative		3,998

As outlined in IFRS 9.6.5.15, when the intrinsic and time values of an option are separated and intrinsic value is designated as the hedge, the fair value of each of these two components is accounted for separately (also see IFRS 9.B6.5.29 to 33).

While the gain/loss from the change in intrinsic value can be offset, the gain/loss from the change in time value continues to be recognized in other comprehensive income (OCI).

28.2.X1
Derivative		14,000
	Gain		14,000
Loss		14,000
	Firm commitment		14,000
OCI (TV G/L)		5,078
	Derivative		5,078

31.3.X1
Loss		14,000
	Derivative		14,000
Firm commitment		14,000
	Gain		14,000
Derivative		2,452
	OCI (TV G/L)		2,452
Etc.

31.12.X1: to close the position
Cash		10,000
	Derivative		10,000
Inventory		24,472
	AOCI (TV G/L)		24,472

XYZ recognized changes in fair value each month and published quarterly financial reports.

P	Fair value	Intrinsic value	Time value	∆ intrinsic value	∆ time value	Total gain (loss)
	A above	B above	C = A - B	D=B_(B+1)-B	E=C_(C+1)-C	F = D + E
0	24,472	0	24,472	0	0	0
1	28,474	8,000	20,474	8,000	(3,998)	4,002
2	37,396	22,000	15,396	14,000	(5,078)	8,922
3	25,848	8,000	17,848	(14,000)	2,452	(11,548)
4	13,780	0	13,780	(8,000)	(4,068)	(12,068)
5	8,108	0	8,108	0	(5,672)	(5,672)
6	4,992	0	4,992	0	(3,116)	(3,116)
7	7,086	0	7,086	0	2,094	2,094
8	18,052	8,000	10,052	8,000	2,966	10,966
9	21,992	16,000	5,992	8,000	(4,060)	3,940
10	16,832	12,000	4,832	(4,000)	(1,160)	(5,160)
11	16,050	14,000	2,050	2,000	(2,782)	(782)
12	10,000	10,000	0	(4,000)	(2,050)	(6,050)
				10,000	(24,472)	(14,472)

Note: this schedule is comparable the one presented in example 31.

ASC 815-20-55-235 to 237 (edited):

	12/31/X1	12/31/X2	12/31/X4	12/31/X4
Ending market price of commodity	77	76	74	81

Time value	7,500	5,500	3,000	-
Intrinsic value	2,000	1,000	-	6,000
Total (ending fair value of position)	9,500	6,500	3,000	6,000

Change in time value	(1,750)	(2,000)	(2,500)	(3,000)
Change in intrinsic value	2,000	(1,000)	(1,000)	6,000
Total gain (loss)	250	(3,000)	(3,500)	3,000

Dr/Cr

12/31/X0
Derivative		9,250
	Cash		9,250

12/31/X1
Derivative		250
	OCI		250
COGS		2,313
	OCI		2,313

12/31/X2
OCI		3,000
	Derivative		3,000
COGS		2,313
	OCI		2,313

12/31/X3
OCI		3,500
	Derivative		3,500
COGS		2,313
	OCI		2,313

12/31/X4
Derivative		3,000
	OCI		3,000
COGS		2,313
	OCI		2,313

7/1/X5
Cash		6,000
	Derivative		6,000
AOCI		6,000
	COGS		6,000

However, for the sake of readability, the periods are presented in rows, as in all our illustrations.

1/1/X1
Derivative		24,472
	Cash		24,472

1/31/X1: to remeasure the derivative to other comprehensive income
Derivative		4,002
	OCI		4,002
COGS		2,039
	OCI		2,039

Obviously, amortizing the derivative through COGS leads to a mismatch of revenue and expenses. To avoid this mismatch, the derivative could be amortized to inventory.

Unfortunately, ASC 815-20-25-83A explicitly states (and example 31 illustrates) "the initial value of the component excluded from the assessment of effectiveness shall be recognized in earnings using a systematic and rational method over the life of the hedging instrument."

ASC 815-20-55-235 to 237 (edited):

	12/31/X1	12/31/X2	12/31/X4	12/31/X4
Ending market price of commodity	77	76	74	81

Time value	7,500	5,500	3,000	-
Intrinsic value	2,000	1,000	-	6,000
Total (ending fair value of option)	9,500	6,500	3,000	6,000

Change in time value	(1,750)	(2,000)	(2,500)	(3,000)
Change in intrinsic value	2,000	(1,000)	(1,000)	6,000
Total gain (loss)	250	(3,000)	(3,500)	3,000

12/31/X0
Derivative		9,250
	Cash		9,250

12/31/X1
Derivative		250
	OCI		250
COGS		2,313
	OCI		2,313

12/31/X2
OCI		3,000
	Derivative		3,000
COGS		2,313
	OCI		2,313

12/31/X3
OCI		3,500
	Derivative		3,500
COGS		2,313
	OCI		2,313

12/31/X4
Derivative		3,000
	OCI		3,000
COGS		2,313
	OCI		2,313

7/1/X5
Cash		6,000
	Derivative		6,000
AOCI		6,000
	COGS		6,000

This mismatch makes hedging with options an unattractive policy choice for most entities.

2,039 = 24,472 ÷ 12

2/28/X1
Derivative		8,922
	OCI		8,922
COGS		2,039
	OCI		2,039

3/31/X1: to close the period and recognize the accumulated gain/loss
OCI		11,548
	Derivative		11,548
COGS		2,039
	OCI		2,039
OCI		7,494
	AOCI		7,494
Etc.

4/30/X1
OCI		12,068
	Derivative		12,068
COGS		2,039
	OCI		2,039

5/31/X1
OCI		5,672
	Derivative		5,672
COGS		2,039
	OCI		2,039

6/30/X1
OCI		3,116
	Derivative		3,116
COGS		2,039
	OCI		2,039
AOCI		14,738
	OCI		14,738

7/31/X1
Derivative		2,094
	OCI		2,094
COGS		2,039
	OCI		2,039

8/31/X1
Derivative		10,966
	OCI		10,966
COGS		2,039
	OCI		2,039

9/30/X1
Derivative		3,940
	OCI		3,940
COGS		2,039
	OCI		2,039
OCI		23,118
	AOCI		23,118

10/31/X1
OCI		5,160
	Derivative		5,160
COGS		2,039
	OCI		2,039

11/30/X1
OCI		782
	Derivative		782
COGS		2,039
	OCI		2,039

12/31/X1
OCI		6,050
	Derivative		6,050
COGS		2,039
	OCI		2,039
AOCI		5,874
	OCI		5,874

12/31/X1: to close the position and derecognize the accumulated other comprehensive income.
Cash		10,000
	Derivative		10,000
AOCI		10,000
	COGS		10,000

Same facts except XYZ recognized the gains/losses in earnings.

As a policy choice, XYZ opted to apply ASC 815-20-25-83B instead of ASC 815-20-25-83A:

1/1/X1
Derivative		24,472
	Cash		24,472

1/31/X1
Derivative		4,002
COGS		3,998
	OCI		8,000

While both ASC 815-20-25-83B and illustration showing how to apply ASC 815-20-25-83B (example 10) specify that the change in fair value of the excluded component is included in earnings, neither specifies the exact expense item that should be recognized.

While example 10 (ASC 815-30-55-63 to 64) and example 31 (ASC 815-20-55-235 to 237) illustrate the two ways to account for options (ASC 815-20-25-83B and ASC 815-20-25-83A), example 10 does so on a per commodity item basis. Not only is this somewhat less realistic (options generally trade in round lots), this makes the two examples slightly harder to compare.

ASC 815-30-55-63 and 64 (edited):

	12/31/X1	12/31/X2	12/31/X4	12/31/X4
Ending market price of commodity	127.25	125.50	124.25	130.75

Time value	7.50	5.50	3.00	0.00
Intrinsic value	2.25	0.50	0.00	5.75
Total (ending fair value of option)	9.75	6.00	3.00	5.75

Change in time value	(1.75)	(2.00)	(2.50)	(3.00)
Change in intrinsic value	2.25	(1.75)	(0.50)	5.75
Total gain loss	0.50	(3.75)	(3.00)	2.75

12/31/X0
Derivative		9.25
	Cash		9.25

12/31/X1
Derivative		0.50
Earnings		1.75
	OCI		2.25

12/31/X2
OCI		1.75
Earnings		2.00
	Derivative		3.75

12/31/X3
OCI		0.50
Earnings		2.50
	Derivative		3.00

12/31/X4
Derivative		2.75
Earnings		3.00
	OCI		5.75

7/1/X5
Cash		5.75
	Derivative		5.75
AOCI		5.75
	Earnings		5.75

To rectify these shortcomings, example 10 (edited) is presented here with the same assumptions as example 31:

	12/31/X1	12/31/X2	12/31/X4	12/31/X4
Ending market price of commodity	77	76	74	81

Time value	7,500	5,500	3,000	-
Intrinsic value	2,000	1,000	-	6,000
Total (ending fair value of position)	9,500	6,500	3,000	6,000

Change in time value	(1,750)	(2,000)	(2,500)	(3,000)
Change in intrinsic value	2,000	(1,000)	(1,000)	6,000
Total gain (loss)	250	(3,000)	(3,500)	3,000

12/31/X0
Derivative		9,250
	Cash		9,250

12/31/X1
Derivative		250
Earnings		1,750
	OCI		2,000

12/31/X2
OCI		1,000
Earnings		2,000
	OCI		3,000

12/31/X3
OCI		1,000
Earnings		2,500
	OCI		3,500

12/31/X4
Derivative		3,000
Earnings		3,000
	OCI		6,000

7/1/X5
Cash		6,000
	Derivative		6,000
AOCI		6,000
	COGS		6,000

However, since the derivative is hedging an expected inventory acquisition, it would be logical to recognize it as cost of goods sold, similarly to how the expense is recognized example 31 (which illustrates how to apply ASC 815-20-25-83A).

2/28/X1
Derivative		8,922
COGS		5,078
	OCI		14,000

3/31/X1
OCI		14,000
	Derivative		11,548
	OCI		2,452
AOCI		6,624
	OCI		6,624
Etc.

Same facts except the hedged item was a firm commitment in a fair value hedge.

1/1/X1
Derivative		24,472
	Cash		24,472

1/31/X1
Derivative		4,002
	Gain		4,002
Loss		4,002
	Firm commitment		4,002
COGS		2,039
	Derivative		2,039

Obviously, amortizing the derivative through COGS leads to a mismatch of revenue and expenses. To avoid this mismatch, the derivative could be amortized to inventory.

Unfortunately, ASC 815-20-25-83A explicitly states "the initial value of the component excluded from the assessment of effectiveness shall be recognized in earnings using a systematic and rational method over the life of the hedging instrument."

This mismatch makes hedging with options an unattractive policy choice for most entities.

2,039 = 24,472 ÷ 12

2/28/X1
Derivative		8,922
	Gain		8,922
Derivative		8,922
	Firm commitment		8,922
COGS		2,039
	Derivative		2,039

3/31/X1
Loss		11,548
	Derivative		11,548
Firm commitment		11,548
	Gain		11,548
COGS		2,039
	Derivative		2,039
Etc.

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