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Hedging the Risk: AS 30, 31, 32 instruments

I have tried to summarize the topic a lot and then reached to this Short cum Lengthy Article :D. I hope it will help.

This AS came into effect in respect of accounting period commencing on or after 1-04-2009 and will be recommendatory in nature for an initial period.

Its Main Objective is to establish principles for recognizing and measuring Financial Assets(FA) and Financial Liabilities(FL) and some contracts to buy/sell non- Financial Items.

A financial Instrument is any contract that gives rise to both:

a. A Financial Asset of one entity; and

b. A Financial Liability or equity instrument of another entity.

A financial asset is defined as:

a. Cash

b. Equity instrument of another entity

c. A contractual right   

i. To receive cash or another FA from another entity.

ii. To exchange FA’s under conditions that is favorable to the entity.

Physical asset (such as inventories, plant and equipment), leased assets and Intangible assets are not FA’s as, it does not give rise to a present right to receive cash or another FA.

A financial liability is defined as:

A contractual obligation

(i) To deliver cash or another FA’s to another entity

(ii) To exchange FA’s or FL’s with another entity under conditions that is potentially unfavorable to the entity.

(iii) A Contract for which an entity is or may be obliged to deliver a variable number of its own equity instrument.

(iv) A Derivative contract that will or may be settled for a fixed number of its own equity instrument (For e.g.: a Call option which gives right to another entity to acquire a fixed number of equity instruments of an entity).

Q. How to identify Contracts as FA’s /FL’s?

A.  Whenever any contract is entered then it should see “What is the Motive of Contract”

If contract is for sale/purchase of asset, such contracts are not part of FA / FL for outstanding dues. If contracts are to be settled on “net basis”, such contracts are FA/FL as soon as they are entered.

How to know Contracts on “net basis”?

Generally,    

(i) Past Contracts of Similar nature are observed or

(ii) Management Estimate is to be obtained.

If physical delivery is taken then it will not be covered under AS 30.

- Income Tax payable/Provision is not FA/FL since there is no contractual obligation. It is payable as per Law and there is no such contractual obligation.

- Gold is not a FA since it has no contractual right o obtain cash. It is a commodity.

Financial guarantees is "a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due, in accordance with the original or modified terms of a debt instrument."

Initial Recognition: The issuer of a financial guarantee contract must initially record it at fair value, and thereafter measure it at the higher of:

- The amount that would be recorded under AS 29; or

- The amount initially recognized less, when appropriate, cumulative amortization recognized, if any.

Alert

In the separate financial statements of a parent entity any guarantees given on behalf of its subsidiaries will need to be recorded, when first given, as liabilities, at their fair value.

DERIVATIVES

Derivatives are instruments (contracts) which fulfill all the following features:

(a) It includes small investment or nil investment (margin).

(b) It is based on any underlying.

RULE: Derivative cannot exist without the Underlying.

(c) It should be based on a future date.

(d) Settlement should be based on actual delivery.

 

Derivatives can further be classified as:

- Futures   

- Forwards

- Speculative

- Options

- Forwards - Speculative

Futures

A future is a contract between two parties, where one party has right to purchase and the other party has the right to sell at a future date at an agreed price. Futures and Forwards both type of contracts allow people to buy or sell a specific type of asset at a specific time at a given price. Both of them can be differentiated as follows:

Future Contracts        

Forward Contract

1. Are exchange traded and therefore, are standardized contracts. They have clearing houses that guarantees the transactions which drastically lowers the probability.

2. Market to market daily, which means that daily changes are settled day by day until the end of the contract.

1 Are private agreements between two parties and are not rigid. There is always a chance that a party may default.

2. Settlement of the contract occurs at the end of the contract. Possess only one settlement date.

Q. When a FA/FL is recognized initially and how it is measured?

Ans. A FA/FL is recognized as follows:

i. FA/FL should be measured at fair value (1) on the date of acquisition of shares.

ii. Short Term receivables and payables – at original invoice amount (if the effect of discontinuing is immaterial)

iii. Other FA/FL – Measured at = Fair Value (+/-) transaction Costs (which are directly attributable to the acquisition or issue of FA/FL.

Instruments classified as Loans and Advances are measured at amortized cost without regard to the entity’s intention to hold them to maturity.

(1) Fair value: Fair value for a financial Instrument (i.e.…, the fair value of the consideration given or received) on initial recognition is normally the transaction price.

FA’s can be classified into four categories:

(1) Fair Value through Profit & Loss (FVTPL): FA/FL that meets either of the following are termed as FVTPL:

a) It is classified as held for trading which is defined as:

i. Acquired or incurred principally for the purpose of selling or repurchasing it in the near term; or

ii. Part of a portfolio

iii. A derivative (except for a derivative that is a Financial Guarantee Contract or an effective hedging instrument).

Initial Recognition: It should be measured at fair value on the date of acquisition which is the acquisition price directly attributed transaction cost should be charged to Profit & Loss A/c.

(2) Held-to-maturity Investments:

These are Non- Derivative FA’s with fixed or Determinable payments and fixed maturity than an entity has the positive intention and ability to hold to maturity. However, sales before maturity due to some valid reason could not raise a question about the entities intention to hold other investments to maturity.

Initial Recognition – measured at fair value on the date of acquisition which is acquisition price plus directly attributable transaction cost.

Q. What Tainting Rules apply to HTM assets?

Where an entity has violated the HTM rule in regard to assets that were classified as HTM, then it is prohibited from using the HTM classification in that year and in succeeding two years. An entity should not classify a FA’s as held to maturity if the entity has during the current financial year or during the two preceding financial years, sold or reclassified more than an insignificant before maturity.

Les see whether the following classified as HTM assets-

(1) Debt Instrument with variable Interest Rate – A debt instrument with a variable interest rate can satisfy the criteria for HTM investment.

(2) Equity Instruments – Cannot be classified as HTM investments either because they have indefinite life (such as equity shares) because the amounts the holder may receive can vary in a manner that is not predetermined.

(3) Loans & Receivables – Non – Derivative FA’s with Fixed or determinable payments that are not quoted in active market.

E.g.: Preference Shares (Non-Derivative Equity Instrument) since has fixed and determinable payments and is not quoted in an active market it can be classified as Loans and Receivables.   

Initial Recognition: Loans & Receivables which are short term with no interest rate should be measured at acquisition price plus Transaction Cost.

(4) Available for Sales (AFS) – are those non-derivative FA’s that are designated as available for sale or are not classified as (a) Loans and receivables (b) HTM, or (c) FA’s at FVTPL.

Initial Recognition: Should be measured at fair value on the date of acquisition plus directly attributable transaction cost.

****Disclosures : All the above are discloses at carrying amount on the face or in  the notes as on Balance sheet Date.

The term carrying amount is often used in place of book value. An accounting measure of value, where the value of an asset or a company is based on the figures in the company's balance sheet.

The Fair value of a FA may change during the period between the trade date and the settlement date in settlement date accounting. Such change in Fair values of FA’s is classified as below:

(i) FVTPL – In the statement of profit and loss

(ii) HTM – No entry.

(iii) AFS – Investment Revaluation Reserve

Treatment as on Reporting Date

(i) FVTPL: Should be valued at fair Market price and any change should be transferred to P & L A/c.

(ii) HTM: Should not be measured at FM Price on the reporting date because they are valued at amortized cost by using effective interest rate.

(iii) Loans & Receivables: should be measured at amortized cost by using effective rate of interest and short term Loans & advances with no stated interest rate should be measured at Invoice Price.

(iv) AFS: Should be measured at fair value on the date of reporting.

Accounting for FA’s and FL’s (Initial Recognition and Measurement)

1. FA’s – Recognized when it becomes party to the contract.

2. Sundry Receivables & Payables should be recognized in the books as asset or liability if an entity becomes the party to the contract.

3. In case of contract related to options, asset or liability should be recognized only when the buyer or writer of a option becomes the party to the contract.

4. Assets or Liabilities related

i. To Forward Contracts should be recognized on the date it is made 

ii. To purchase and sale of goods & services when minimum one of the parties has performed the contract.

Recognition of FA’s

1. FL’s classified at Fair Value (FVTPL) should be measured at fair value and the difference should be transferred to P&L a/c.

2. Short term payable at committed rate of interest at cost or invoice price.

3. Financial guarantees are recognized as per AS 29 but they must be recognized at amortized cost or valuation as per AS 29 whichever is higher.

4. Other FL’s like debentures, bonds, loans & advances should be measured at amortized cost using effective rate interest method.

Reclassifications

De-Recognition of FA’s -

De-Recognized in anyone of the following situations:

a. The contractual rights to receive cash inflows from the FA’s have been expired.

b. Entity has transferred the FA’s acc. To the manner specified as per AS – 30.

Derecognition: An entity may have transferred FA’s that part of FA’s do not qualify for Derecognition. Fllowing details of such FA’s shoud be disclosed ;

(a)The nature of assets (b)risk and rewards to which such asse is exposed.

© the terms and conditions associated with its use of the collateral.

De-Recognition of FL’s –

If a FL has been discharged or it has been expired then such liability should be recognized from book. The diff. Btw. Carrying amount of Liability Transferred & and consideration paid in cash including non cash asset should be transferred to P & L a/c.

Embedded Derivatives                                                                    

Embedded Derivatives means those derivatives that are attached with the hos contract. As per AS 30 host contracts and Derivatives should be split and accounting for host & derivatives should be done on separate basis.

Proceeds = Host Contract + advantages given to other party – disadvantages given to other party.

Let’s take an example:          

Chinna swamy is selling a flat A at Rs.

10,20,000 and providing a scheme that after 3 years even if the property price does not increase then also he will purchase it at Rs. 12 Lakhs.          

Other dealer Minna is selling flat with same specifications at Rs. 10 Lakhs.

We would obviously prefer Chinna Swamy’s deal. Here Rs. 20,000 is embedded Derivate that is attached with the main contract.

Hybrid securities are a broad group of securities that combine the elements of the two broader groups of securities, debt and equity.   

The embedded derivative needs to be separated and recorded at fair value, with gains and losses recognized in the statement of profit and loss, if:

Accounting for Embedded Derivatives 

(A) If components are separated

Host Contracts - GAAP for instruments of this type

Embedded Derivatives - Fair Value

(B) Components cannot be separated

Then the entire contracts are taken at Fair Value.

Initial Recognition of Financial Assets

Initials Measurement is to be done on a Fair value Basis.

What is hedging?

Hedging means Reducing or controlling risk. This is done by taking a position in the futures market that is opposite to the one in the physical market with the objective of reducing or limiting risks associated with price changes.

A Wheat farmer can sell wheat futures to protect the value of his crop prior to harvest. If there is a fall in price, the loss in the cash market position will be countered by a gain in futures position.

In this type of transaction, the hedger tries to fix the price at a certain level with the objective of ensuring certainty in the cost of production or revenue of sale.

Hedging is done through –

a. Currency Contracts

b. Interest Rate Swaps

a. Currency Contracts – Whenever any debtor/creditor whose settlement is at future date is to be insulated against risk of currency difference.

Let’s take an example:

Chinna Swamy has its business of export of goods as a result in order to secure his business from currency fluctuations he hedges his Sundry Debtors, which can be summarized as follows:

24/01/2006                            Rate as on 31.03.2013                    24/04/2013

Sold $ 40000 goods             Rate is Rs. 43.20/USD                    Rate is @ Rs. 42.70/USD

Spot Rate Rs. 44.20/USD

Forward to sell @ 43.70/USD          

b. Hedging – Interest Rate Swaps

These are contracts to hedge interest rate charges. These Contracts Converts fixed rate Laibility to Floating rate Liability or Vice Versa.

Types of hedges – There are 3 types of Hedging relationship for the purpose of hedging:-

1. Fair value hedge which manage the risk associated with changes in Fair Value of any asset or Liability already recognized or any unrecognized commitment of an entity or an identified portion of above

2. Cash Flow Hedge is he: - It doing arrangement used to manage the expected risk changes, in expected cash inflows and outflows.

3. Hedge of Net Investment in Foreign Currency: - used to reduce the risk arising out of translation of Financial Statements of foreign operations.

A Hedging relationship qualifies for hedge accounting if all the following conditions are met:

1. At the inception there is a formal designation and documentation of the Hedging Relationship.

2. The hedge is expected to be highly effective in achieving offsetting changes in Fair Value or cash flows attributable to the hedged risk.

3. Effectiveness can be realizably measured.

Accounting for Hedging Relationship:-

1. For Fair Value hedge

(A) In Case of Derivative – The gain or loss from re-measurement of hedging instrument at gain value in P& L A/c as profit or loss.

(B) In Case of Non- Derivative – Re-measurement of Foreign currency component should be recognized in P&L A/c as Profit or loss.

(i) The gain/loss on the hedged item should adjust the carrying amount of the Hedged Item by recognizing profit/loss through P/L A/c.

The gain/loss should be recognized in P/L A/c even if the hedged item in a Financial Asset classified as available for sale.

Fair Value Hedge is used only in case of Interest Rate Swaps.

2. for cash Flow Hedge:-

a. A portion of gain/loss relating to Hedging Instrument for its effective hedge should be recognized in hedging reserve a/c.

b. The remaining portion of gain/loss related through ineffective hedge should be recognizes through P/L A/c.

In Cash Flow Hedge, the cumulative balance of Hedging Reserve is subject to present value recognizing related to effective hedge shall be removed by adjustment against the initial recognition.

3. Hedge of Net Investment in foreign operation:-

Similar to accounting the hedging of cash flow hedges.

The recommendation of AS – 11 related to foreign operation are also used in this type of hedging.

Accounting for Interest, Dividend, losses and gain related to Financial Instruments (FI’s) :

1. Transaction Costs related to FI’s should be recognized to the Reserves & surplus after deducting any Income Tax relief related to equity component.

2. Interest, Dividend, losses and gain related to FL’s should be recognizes in P & L A/c.

3. Any change in Fair Value should be recognized n Financial Statement.

Offsetting a FA and FL:

As per AS-31, a FA and FL should be offset and the net amount should be presented in B/S, if the following 2 conditions are satisfied:

(a) Both the parties intend to settle on ne basis and

(b) Such offset is allowed by contract.

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Category Accounts, Other Articles by - Priya Agarwal 



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