Purpose of the Article:- Hedge accounting is a method of accounting where entries for the ownership of a security and the opposing hedge are treated as one. Hedge accounting attempts to reduce the volatility created by the repeated adjustment of a financial instrument's value, known as marking to market. As per IND-AS Hedge Accounting is done via Indian Accounting Standard IND-AS 109 which covers all sorts of Derivatives Instruments.
Sitting today Corporates across India are taking 3 types of hedges like Cash Flow Hedges, Fair Value Hedges also known as Balance Sheet Hedges and Net Investment Hedging.
Cash Flow Hedging:- Cash Flow Hedging is done to protect Cash Flow positions of the Company from change in the exchange rate fluctuation. Take an example – Indian IT Industry is generating $ 150 Billion of Foreign Currency Revenue where by majority of the cost is in INR however receivables is in Foreign Currency henceforth they are doing Cash Flow Hedging to protect their Foreign Currency Receivables from change in exchange rates.
Fair Value Hedging:- Fair Value Hedging is the hedging of exposures of all Foreign Currency Receivables and Payables in your books which are subject to revaluation and subject to hit either credit and debit side of P&L. Fair Value Hedging is done either in Offshore Treasury Centres like New York, London, Singapore, Australia (Melbourne, Sydney), Tokyo, Hong Kong, Dubai, Philippines and Malta Financial Centre or local currency books.
Net Investment Hedging:- Hedge accounting of the foreign currency risk arising from a net investment in a foreign operation will apply only when the net assets of that foreign operation are included in the financial statements. The item being hedged with respect to the foreign currency risk arising from the net investment in a foreign operation may be an amount of net assets equal to or less than the carrying amount of the net assets of the foreign operation.
The new hedge accounting model under Ind AS 109 Financial Instruments will allow entities to reduce profit or loss and balance sheet volatility by applying hedge accounting in more circumstances. The change in accounting treatment is expected to prompt some companies to review their risk management activities which may have been previously restricted for the purpose of hedge accounting.
Currently, Indian accounting standards do not have a comprehensive framework for derivative instruments and hedge accounting. The current accounting for forward exchange contracts used to hedge existing balance sheet exposures is governed by AS 11 the Effects of Changes in Foreign Exchange Rates. Entities were also allowed to manage volatility in profit and loss by optionally adopting hedge accounting described in AS 30 Financial Instruments: Recognition and Measurement
Going forward, for entities that transition to Ind AS, hedge accounting will be done as prescribed by Ind AS 109. The new model will more closely align an entity’s hedge accounting with its risk management, resulting in more useful information for users of financial statements. The requirements are less rules-based than before and allow companies more opportunities to mitigate earnings volatility.
Key aspects of Hedge Accounting: -Every Hedge Accounting is having 2 aspects where by one is Exposure and other is Derivatives.
Exposures could be Foreign Currency Receivables, Foreign Currency Payables, Inter Company Accounts Receivables, External Commercial Borrowings (ECB) loans, Foreign Currency Cash or respective. Well out of the same Foreign Currency Receivables, Inter Company Settlements as well as ECB loans qualifies for Cash Flow as well as Fair Value Hedging in the books of Corporates.
Derivatives used to hedge aforesaid exposures could be Plain Vanilla Forwards Contracts which are further divided into 3 parts – Short Term Forwards Contracts, Medium Term Forwards Contracts or Long Term Forwards Contracts. Options Derivatives which are further divided into Plain Vanilla Options Derivatives , Options Payoffs Strategies like Range Forwards( Exporters), Range Forwards (Importers), Seagull (Exporters), Seagull (Importers), Bullish Call Spread, Bearish Call Spread, Bull Put Spread, Bear Put Spread , Digital Options, Knock in Knock Out Options and respective.
IND-AS (AS 109) – Hedging using Options Derivatives :-Under the new standard, the accounting treatment ofoption contracts designated as hedging instruments would be less volatile in profit or loss. The new requirements apply to a variety of vanilla and structured option contracts including those that hedge commodity price risk, interest rate risk and foreign exchange risk.
The fair value of an option consists of the intrinsic value and the time value. When using option contracts for hedging, only the intrinsic value is used for offsetting the fair value changes attributable to the hedged risk. Entities may designate an option as a hedging instrument in its entirety, or may separate the time value and designate only the intrinsic value. There is no change to this approach.
However, under AS 30, the change in time value was recognized in profit or loss either way –
i. if the option was designated in its entirety, there was greater ineffectiveness resulting in a failed prospective assessment test with possible discontinuation of hedge accounting
ii. If only the intrinsic value was designated, the time value would be accounted for at fair value through profit or loss, resulting in volatility in profit or loss.
What has changed in IND-AS?
Ind AS 109 does not change how an option is designated in a hedge relationship i.e., in its entirety or just the intrinsic value. However, the new standard requires the change in the time value of an option, which can be volatile, to be recognised initially in other comprehensive income (OCI) with subsequent recognition as a basis adjustment or in profit or loss on a more predictable basis (e.g. amortised over the life of the hedge or recognised as a single amount when the hedged item effects profit or loss).
Hedge Effectiveness Testing:- United States and International accounting standards require testing “hedge effectiveness” by measuring the alignment of the change in fair value of the two components comprising a hedge:
1. The hedged item, and
2. The hedging instrument.
A hedge is effective from an accounting perspective if and when the change in fair value of (1) and (2) are closely aligned. Otherwise, gains or losses reported for the hedge accounting election could be disallowed, with the ineffectiveness having a potentially significant impact on earnings.
Types of positions that may require hedge effectiveness testing
Categorizing a hedge can be important for determining the appropriate accounting treatment. Types of hedges and examples of each include:-
Cash flow hedges
• Interest rate swap to transform floating debt to fixed debt
• Forward-starting swap to fix the interest rate on future debt
• FX forward to lock in USD-equivalent cash from foreign revenues
• FX collar to limit risk outside a band on foreign-denominated payments
• Commodity future (or swap) to lock in price of inputs to production
• Commodity options to reduce volatility of future sales
Fair value hedges
• Interest rate swap to transform fixed to floating new debt
• Interest rate swap to transform fixed to floating extant debt (late hedge)
• Commodity futures to unlock price of firmly committed fixed-price purchases (effectively hedging fair value of existing inventory)
Hedge Accounting under IND-AS:
Hedge accounting relationships would no longer have to meet the 80-125% offset criteria previously required for prospective and retrospective effectiveness testing. Instead an entity would need to demonstrate that an ‘economic relationship’ exists between the hedged item and hedging instrument on a prospective basis.
This will reduce the burden of complying with the hedge accounting requirements. Under Ind AS 109, provided the economic relationship is present at the beginning of each hedged period, come the end of the period, actual hedge ineffectiveness is measured regardless of the amount. For example, if the hedge happens to be only60% effective, then that is the effectiveness recorded (unlike previously where no hedge accounting would be applied because it falls outside the 80-125% range).This change could result in more hedging relationships qualifying for hedge accounting, especially when combined with other changes to the requirements.
The changes introduced in Ind AS 109 should be well understood by not only the accounting function but also those responsible for risk management. Risk management policies should be reviewed in light of these changes and their effect on longer term risk management decisions considered. Furthermore, they should be considered as part of any planning and decisions around risk management, treasury and accounting systems.
Allowing hedge accounting for risk components in nonfinancial items will increase the scope for applying hedge accounting. However, greater judgement needs to be exercised when hedging risk components that are not contractually specified.
Analysis to demonstrate that the hedged risk component is separately identifiable and reliably measurable will be necessary. Once these criteria are satisfied, the next hurdle will be to demonstrate that the hedge is expected to meet the hedge effectiveness requirements, although these are less restrictive under the new model.
Author View:- On Paper Hedge Accounting seems very fancy under IND-AS however is always very convenient to have Hedge Accounting as per IFRS as it covers majority of the exposures along with Hedge Accounting support to variety of Derivatives Instruments. CA members are advised to read IFRS guidelines comprehensively before going for IND-AS in their books.