In continuation to our earlier article on 'Risk Management Strategy vs. Risk Management objectives', let's understand what is allowed to be hedged as per the Accounting Standard.
WHY do we hedge?
Simple answer is to mitigate all expected losses or adverse effect on fair values of any balance sheet items (e.g. Investments etc) or an effect on Profit/Loss due to changes expected in cash outflow. Accounting Standard on Financial Instrument requires/ defines certain specific items which can be hedged or in other words these are those items which can be identified to mitigate their risks on Financial Statements subject to the Risk Management Strategies.
Let's first look at the Accounting standard reference which talks about the scope of items which can be considered for hedge accounting -
Para -6.3.1 - A hedged item can be a recognized asset or liability, an unrecognized firm commitment, a forecast transaction or a net investment in a foreign operation. The hedged item can be:
(a) a single item; or
(b) a group of items (subject to paragraphs 6.6.1-6.6.6 and B6.6.1-B6.6.16).
A hedged item can also be a component of such an item or group of items.
Para-6.3.3 - If a hedged item is a forecast transaction (or a component thereof), that transaction must be highly probable.
Para-6.3.4 - An aggregated exposure that is a combination of an exposure that could qualify as a hedged item in accordance with paragraph 6.3.1 and a derivative may be designated as a hedged item.…………………….(further text)
Para-6.3.5 -For hedge accounting purposes, only assets, liabilities, firm commitments or highly probable forecast transactions with a party external to the reporting entity can be designated as hedged items……………………………………………………..(further text)
Without getting into too much formal discussion on this, let's have point wise notes on what items would be eligible for Hedge Accounting-
Let's understand what is Recognized assets/ liability and what is Unrecognized Assets/ Liability?
A recognized assets/ liabilities are those which have been accounted in the books of accounts/ Financial Statements. The related assets or expected liability which fulfills the basic framework for recognizing any assets/ liabilities will be called recognized asset/ liability. If we look at the logic by using recognized asset/ liability only, then we would realize that the recognized asset or liability will be exposed towards risks e.g. interest rate, foreign currency etc and it make sense to touch only recognized assets/ liabilities because it is certain to have all effect on Financial Statements related to the risks associated with these asset/ liability. Hence Standard requires recognized assets/ liability in order to identify its eligibility to go for Hedge Accounting.
In contrast, there are certain unrecognized assets/ liabilities which are still eligible for Hedge accounting if falls under these two category -
Firm Commitment - It is a legal binding agreement between the Entity and a party external with an agreed price (fixed agreed price), future date specification. The Firm Commitment would be having legal consequences in case it does not complete. Standard allows such UNRECOGNISED firm commitment for hedge accounting.
Example- Entity P enters into a Firm commitment on April 2017 to purchase 1000 Kg of Sugar at a price of 13/Per KG in Jan 2018. The price of Sugar would vary at the closing of Financial Statement and till it is actually settled and hence a Fair value Hedge accounting can be initiated if other conditions meet.
Forecast Transaction- There are certain transactions which are not firm(confirmed yet) but highly probable to occur in future would be eligible for Hedge Accounting. Such transactions are those which are yet to become either Firm commitment or recognized asset/ liability but it is highly probable that it will be done in near future. One can argue that what is highly probable?, it means 'more likely than not' i.e. more than 50% chances to happen. Hence if these kind of unrecognized transactions which qualifies as highly probable then it may be considered for Hedge Accounting. Since the transaction will affect future cash outflow, hence it will be covered under 'Cash Flow Hedge' subject to the fulfilment of other criteria.
Example- A highly probable forecast purchase of 1000 tons of copper is expected to be done on March 2018. It has been assessed that the purchase requirement is in line with the production requirements of the entity and it's more likely than not, that this purchase will happen. This Forecast transaction may be eligible for Cash Flow Hedge accounting subject to other conditions.
The standard also allows 'Net Investment in foreign operations' which essentially means that translation exposure in a foreign currency entity in which an Investment is made other than in functional currency. The exposure towards foreign exchange in net investment may be used for Hedge Accounting subject to other conditions, Net Investment could also cover loans given to such investment entities subject to some conditions,
Standard specifically allows using either a SINGLE item of recognized assets/ liabilities or firm commitment, forecast transactions or it can be used in a GROUP that means similar type of risks could be hedged in a Group if risks are common among the Group items.
Example- Entity P is having debt instruments with different fixed rate coupons and different maturities but falls over all in a range of 4-5 years maturity. The debt instrument is having risk of fair value which can be hedged by using an Interest rate swap on Group basis. The fair value of each bond will change in line with market Risk-free rate in a proportionate of its value. It means one debt will be having a value at inception when we club together in a grouped hedged item concept, now after the Interest changes in the market comparing to risk- free rate which eventually affect all debt in similar way (same direction) in respect of their values and hence the risk will be in a proportion to overall group. Hence Fair Value Hedge accounting may be considered subject to other conditions.
It is quite clear that all hedged items which are to be used for Hedge Accounting purposes must expose towards the risk of changes in either Fair value or Cash flows which essentially effect PROFIT or LOSS, that could be either be current year PL or future period PL,
One can conclude that there is nothing which can be hedged on Equity items or items affecting directly to equity,
Standard allows to hedge financial items e.g. forwards, options etc and/or Non-financial items e.g. Inventory etc for Hedge Accounting purposes, Both are allowed,
Standard is emphasizing on all such recognized or Unrecognized i.e. firm commitment and Forecast transaction MUST be with a party EXTERNAL to the entity with some exceptions,
Net position of any item is not allowed to be used as Hedged item, for Example- There are certain foreign currency purchase and sale transaction for the same item will not be allowed to use as net exposure on such transaction as one can see that the risk involved in sale and purchase will work in opposite direction and hence cannot be used as net exposure for Hedge Accounting.
Since Hedge Accounting needs more deliberation and proper understanding of various terms and structure of financial products, hence we would be going step by step to understand Hedge Accounting process in detail in future articles time to time.
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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