11.3 Derivatives and Hedge Accounting (PFRS 9)
Key Takeaways
A derivative's value changes with an underlying, requires little or no initial net investment, and is settled at a future date.
A forward that hedges a recognized foreign currency payable or receivable needs no hedge accounting, because both are remeasured through profit or loss.
In a fair value hedge of a firm commitment, gains and losses on the derivative and the commitment both go to profit or loss, and the commitment balance adjusts the cost of the asset acquired.
In a cash flow hedge, the effective portion goes to OCI and is later reclassified or added to the cost of a non-financial item; the ineffective portion goes to profit or loss.
PFRS 9 hedge accounting requires designation and documentation, an economic relationship, credit risk that does not dominate, and an appropriate hedge ratio.
Derivatives and Hedge Accounting (PFRS 9)
Derivatives and hedging carry four AFAR items (syllabus topic 9.0), usually in the form of foreign currency forward contracts. This section defines derivatives, compares fair value and cash flow hedges, and works through forward contracts that hedge an exposed position, a firm commitment, and a forecast transaction, plus speculation and net investment hedges.
1. PFRS 9 Derivatives and Hedge Accounting Fundamentals
A derivative is a financial instrument or other contract within the scope of PFRS 9 that possesses all three of the following characteristics:
- Its value changes in response to the change in a specified underlying variable (e.g., foreign exchange rate, interest rate, commodity price, credit rating);
- It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts expected to have a similar response to market factors; and
- It is settled at a future date.
Common Derivatives in Foreign Exchange Management:
- Forward Contracts: Over-the-counter (OTC) agreements to purchase or sell a specified amount of foreign currency at a specified forward exchange rate on a specified future date. Custom-tailored between two counterparties.
- Futures Contracts: Standardized, exchange-traded contracts with standardized amounts and settlement dates, marked-to-market daily through a clearinghouse margin account.
- Options: Contracts granting the buyer the right, but not the obligation, to buy (call) or sell (put) a foreign currency at a predetermined strike price on or before expiration. The buyer pays a non-refundable option premium.
- Currency Swaps: Contracts where two parties exchange principal and interest cash flows in two different currencies over an agreed timeline.
Hedge Accounting Categories under PFRS 9
PFRS 9 Hedge Accounting Models
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┌─────────────────────────┴─────────────────────────┐
▼ ▼
Fair Value Hedge Cash Flow Hedge
Hedges exposure to changes in FV of Hedges exposure to variability in cash flows
recognized asset/liability or firm commitment of recognized item or forecast transaction
Derivative remeasured: PROFIT OR LOSS Effective portion: OTHER COMPREHENSIVE INCOME
Hedged item remeasured: PROFIT OR LOSS Ineffective portion: PROFIT OR LOSS
| Attribute | Fair Value Hedge | Cash Flow Hedge |
|---|---|---|
| Hedged Risk | Exposure to changes in the fair value of a recognized asset or liability or unrecognized firm commitment attributable to a specific risk. | Exposure to variability in cash flows attributable to a particular risk associated with an asset/liability or a highly probable forecast transaction. |
| Accounting for Derivative | Remeasured to fair value at reporting date; gain or loss recognized in Profit or Loss. | Remeasured to fair value at reporting date; Effective portion recognized in OCI (Hedge Reserve); Ineffective portion recognized in Profit or Loss. |
| Accounting for Hedged Item | Carrying amount of hedged item is adjusted for fair value changes attributable to the hedged risk; gain or loss recognized in Profit or Loss. | Hedged item is not remeasured. Accumulated OCI hedge reserve is reclassified to profit or loss when the hedged cash flows affect earnings. |
| Basis Adjustment | Not applicable. | If a hedged forecast transaction results in recognition of a non-financial asset/liability, the accumulated amount in OCI is removed and added directly to the initial carrying cost of the non-financial item (basis adjustment). |
2. Worked Example: Forward Contract on an Exposed Liability (No Hedge Accounting)
On November 1, 2026, Pasig Motors buys parts from a US supplier for USD 100,000, payable January 30, 2027. The spot rate is PHP 56.00, and Pasig Motors enters a 90-day forward contract to buy USD 100,000 at PHP 56.40. On December 31, 2026, the spot rate is PHP 57.00 and the forward rate for January 30 delivery is PHP 57.20; on January 30, 2027, the spot rate is PHP 57.50. (For simplicity, the forward's fair value is not discounted.)
| Date | Accounts Payable (Spot) | Exchange Loss on Payable | Forward Contract Fair Value | Gain on Forward |
|---|---|---|---|---|
| Nov 1, 2026 | 5,600,000 | 0 | ||
| Dec 31, 2026 | 5,700,000 | 100,000 | 80,000 | 80,000 |
| Jan 30, 2027 | 5,750,000 | 50,000 | 110,000 | 30,000 |
Because the payable is a monetary item already remeasured through profit or loss, no hedge accounting is needed: the forward's gains offset most of the exchange losses. The net cost is PHP 20,000 in each year, a total of PHP 40,000, exactly the forward premium locked in on November 1: (56.40 - 56.00) x 100,000.
3. Worked Example: Fair Value Hedge of a Firm Commitment
On November 1, 2026, Laguna Foods signs a binding commitment to buy a machine for USD 200,000 on February 1, 2027, and enters a forward contract to buy USD 200,000 at PHP 56.50, designated as a fair value hedge of the firm commitment. The forward rate for February 1 delivery is PHP 57.10 on December 31, 2026, and the spot rate on February 1, 2027 is PHP 57.30.
| Date | Forward Contract | Firm Commitment |
|---|---|---|
| Dec 31, 2026 | Asset of (57.10 - 56.50) x 200,000 = PHP 120,000; gain in profit or loss | Liability of PHP 120,000; loss in profit or loss |
| Feb 1, 2027 | Asset rises to PHP 160,000; gain of PHP 40,000 | Liability rises to PHP 160,000; loss of PHP 40,000 |
On February 1, the machine is bought for 200,000 x 57.30 = PHP 11,460,000, and the PHP 160,000 firm commitment liability is closed against the machine's cost, which becomes PHP 11,300,000, the PHP 56.50 rate locked in by the forward. The forward is settled for PHP 160,000 net cash. Profit or loss is unaffected in both years because the gains and losses offset.
4. Cash Flow Hedges, Speculation, and Net Investment Hedges
- Cash flow hedge of a forecast transaction: if the same machine purchase were only highly probable (not a firm commitment), the forward would be a cash flow hedge. The effective portion of its gain goes to OCI (cash flow hedge reserve), and on purchase the reserve is removed from equity and included in the machine's initial cost (a basis adjustment); any ineffective portion goes to profit or loss.
- Speculation: a forward entered without any underlying exposure is simply a derivative at FVPL; every change in its fair value goes to profit or loss.
- Hedge of a net investment in a foreign operation: the effective portion of the hedging instrument's gain or loss goes to OCI alongside the cumulative translation adjustment and is reclassified to profit or loss on disposal of the foreign operation.
- Options and futures: an option's time value may be excluded from the hedge relationship and accounted for as a cost of hedging through OCI; futures are settled daily through margin accounts, so their fair value changes are realized in cash each day.
PFRS 9 qualifying criteria for hedge accounting: formal designation and documentation at inception, an economic relationship between the hedged item and hedging instrument, credit risk that does not dominate the value changes, and a hedge ratio consistent with the entity's actual risk management. There is no longer a bright-line 80-125% effectiveness test.
On October 1, 2026, Manila Aviation Corp. enters into a forward contract to hedge the cash flow risk of a highly probable forecast purchase of aviation jet fuel scheduled for March 31, 2027. The contract is designated and qualifies as a cash flow hedge under PFRS 9. At December 31, 2026, the forward contract has an increase in fair value of PHP 1,200,000, of which PHP 1,100,000 is determined to be the effective portion and PHP 100,000 is ineffective. On March 31, 2027, Manila Aviation purchases the fuel for cash and settles the derivative. How should the PHP 1,200,000 fair value change at December 31, 2026 be accounted for?
PHP 1,100,000 recognized in Other Comprehensive Income (Cash Flow Hedge Reserve) and PHP 100,000 recognized in Profit or Loss
PHP 1,200,000 recognized entirely in Profit or Loss as an unrealized derivative gain
PHP 1,200,000 recognized entirely in Other Comprehensive Income without any profit or loss recognition
PHP 1,100,000 deducted directly from the carrying amount of aviation fuel inventory and PHP 100,000 recognized in OCI
An importer records a USD 50,000 payable when the spot rate is PHP 55.80 and buys a forward contract to purchase USD 50,000 at PHP 56.10, not designated as a hedge. At year-end the spot rate is PHP 56.60 and the forward rate for the remaining period is PHP 56.80. Ignoring discounting, what is the net effect on year-end profit or loss?
Net loss of PHP 5,000
Net loss of PHP 40,000
Net gain of PHP 35,000
Net loss of PHP 15,000
An entity designates a forward contract as a fair value hedge of a firm commitment to buy equipment for USD 100,000. The forward rate locked in is PHP 57.00; at delivery the spot rate is PHP 58.00, and the firm commitment liability recognized to date is PHP 100,000. At what amount is the equipment initially recognized?
PHP 5,800,000
PHP 5,900,000
PHP 5,700,000
PHP 5,750,000
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