Several of our readers requested to have clarity on Hedge Accounting, However it will indeed be a very long topic hence from now onwards, we will start taking this subject in detail within the series of 'Hedge Accounting'.
Considering the dynamic nature of businesses, it is inevitable to have several financial risks in day to day business dealings which are mainly due to changes in Interest, prices, liquidity risks etc. Every business tends to find a way to mitigate these financial risks and usually buy/opt either available financial product e.g. Options, futures, Forwards contracts etc. or creates it own mitigation techniques which might arise a situation where the so called products/ tools that have been used to mitigate the identified risk will create an inconsistency while doing its accounting in such a manner where these tools will be fair valued in different time period comparing to the fair value of the risk that is being mitigated and hence it creates some kind of inconsistency.
To remove this kind of inconsistency in accounting relating to the values changes into the risk that is being mitigated and value changes of tool that is been used to mitigate such risk , Hedge accounting is being used to make consistency in timing to reflect in PL. Although Hedge Accounting is not MANDATORY under Ind-As however one can choose (after meeting eligibility criteria) to mitigate such kind of inconsistency into the Financial Statements.
To start with this topic, lets first get a sense about the term 'Risk Management Strategy' and 'Risk Management Objective' from the perspective of Hedge Accounting which is entirely be working around these concepts hence one should have a sense of these terms. As per the relevant Standards below are some references -
Appendix B of Ind-As 109 - Financial Instruments
Para B6.5.24- 'For the purposes of this Standard, an entity's risk management strategy is distinguished from its risk management objectives. The risk management strategy is established at the highest level at which an entity determines how it manages its risk. Risk management strategies typically identify the risks to which the entity is exposed and set out how the entity responds to them. A risk management strategy is typically in place for a longer period and may include some flexibility to react to changes in circumstances that occur while that strategy is in place (for example, different interest rate or commodity price levels that result in a different extent of hedging). This is normally set out in a general document that is cascaded down through an entity through policies containing more specific guidelines. In contrast, the risk management objective for a hedging relationship applies at the level of a particular hedging relationship. It relates to how the particular hedging instrument that has been designated is used to hedge the particular exposure that has been designated as the hedged item. Hence, a risk management strategy can involve many different hedging relationships whose risk management objectives….'
The Risk management strategy and risk management objective is important to understand not only from the point of view to understand Hedge Accounting but these terms are required to be DISCLOSED in detail within the Financial Statements of the Entity and this can be referenced from the below para-
Ind-As 107 - Financial Instruments - Disclosures
Para 21A - An entity shall apply the disclosure requirements in paragraphs 21B-24F for those risk exposures that an entity hedges and for which it elects to apply hedge accounting. Hedge Accounting disclosures shall provide information about:
(a) an entity's risk management strategy and how it is applied to manage risk;'
Let's have a discussion and create a sense about these words and to understand what exactly is the relevance of these terms for those who are applying Hedge Accounting -
As we have discussed, an Entity could have several risks against which it is exposed to, and hence at the Management/ Entity level there must be a policy framework which will talk about the risks that exists for a business and what is the plan of the Entity to overcome,
The framework will be like a broad level identification of all risks that are there for the Entity and overall range that the management intended to mitigate/ expose themselves, e.g. One can identify a risk related to 'Floating Interest rates' of debt issued and Management intention is to have some 80% ratio of debt must be at fixed Interest rate, call it as 'Risk Management Strategy',
All big companies will be required to have these kind of document in place which talks about the risks for the company and what are the acceptable limits for the risks, however in various other companies these kind of strategy document will not be there FORMALLY however there will be a sense among the top management relating such risks that are there for the Entity and the acceptable limits or strategy towards that risk (call it as range of the acceptable limits),
Now, Risk Management Objective will be a specific tool/ Instrument which will be within the range of 'RISK MANAGEMENT STRATEGY' (as we discussed above) which mitigates the risk using different Instruments e.g. A Interest Rate Swap (floating to fixed) is being taken for specific loan to achieve overall target limit of 80% as set in 'Risk Management Strategy' (as per point 2 above) ,
Hence one can draw a conclusion that the Risk Strategy is kind of framework which provides a direction to the entity which will further drill down to opt for various Instruments (eg. Options, Future, mixed products etc) to mitigate that specific risks by using Risk Management Objective.
One needs to be clear about the risk management objective (which is essentially is specific to a risk at micro level) because that will be a first step to start with Hedge accounting. The Risk Management Objective will be clearly defined within the document where the risk will be mitigated by using an Instruments (e.g. options, futures etc). And if there is a change in Risk Management Objective then Hedge Accounting will be DISCONTINUED which may still be within the framework of Risk Management Strategy. Hence discontinuation will be depending upon a change in Risk management Objective and NOT Risk Management Strategy.
Risk Management Objective will be applied on different hedging relationships which are within a Risk Management Strategy framework. Risk Management Objective will always be used to define a borderline where if there is a change in such objective, Hedge Accounting will be discontinued. Risk Management Objective is kind of execution strategy of RISK MANAGEMENT STRATEGY.
Readers will appreciate about the main objective of the standard and an approach which one can follow while keeping in mind the basis of origin of such requirements. There could possibly be some specific situations or circumstances where the interpretation of any standard will be different as we should always keep in mind that IND-AS is principle based standards and lot more areas need management judgment in line with the standards relevant interpretation and best practices.
One has to look into all related facts and patterns before concluding this type of assessment based on this concept. Readers are requested not to take this article as any kind of advice (it is not exhaustive in nature) and should evaluate all relevant factors of each individual cases separately.
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