How to determine fair value hedge or cash flow hedge under Ind AS 109

CA Sumit Sarda  on 07 May 2019


Hedge accounting as covered under Para 6 of Ind AS 109 needs to determine the TYPE of hedge relationship that an entity is dealing with because the type of hedge determines accounting entries. If incorrectly identified the type of the hedge, then accounting will be totally wrong.

All types of hedges are defined in Ind AS 109, understanding the differences and distinguishing one type from the other one requires thorough understanding

Types of hedges?

There are three types of hedge explained in para 6.5.2

  1. Fair Value Hedge;
  2. Cash Flow Hedge, and
  3. Hedge of a Net Investment in a Foreign Operation - similar to cash flow hedge.

Fair Value Hedge

Para 6.5.2 (a) says 'a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss'

In short there is some 'fixed return instrument' and we are worried that its value may fluctuate with the market.

What is a Cash Flow Hedge?

Para 6.5.2 (a) says' Cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all or a component of a recognized asset or liability or a highly probable forecast transaction, and could affect profit or loss.'

In short there is some 'variable return financial instrument' and we might get less money or have to pay more money in the future than now.

Equally, there can be a highly probable forecast transaction that hasn't been recognized in accounts yet.

How to Distinguish Fair Value Hedge and Cash Flow Hedge?

Distinguishment Depends on what kind of item are we hedging. We can hedge a fixed return FI or a variable return FI.

Hedging a Fixed return Financial Instrument

A fixed return financial instrument means that the item has a fixed value in your accounts and it may repay or return fixed amount of cash in the future.

The same applies for unrecognized firm commitments that have not been accounted in your accounts yet, but they will be in the future.

And when it comes to hedging fixed return financial instruments, and then we're dealing with the fair value hedge.

Justification: We think that in the future, we would be paying or receiving a different amount than the fair value of the instrument will be and we don't want to FIX the amount, we don't wish a different carrying amount in books and account exactly what market value is.

Fair Value Hedge Example

Entity issued some bonds with interest 10% p.a.

Entity knows what they have to pay in future, however thay may think, market interest rate will be much lower than 10% and will end up paying higher interest.

Therefore, thay enter into interest rate swap to receive 10% fixed / pay MIBOR + 0.25% lets say. This is a fair value hedge - they hedged the fair value of your interest payments to market rates.

Hedging a Variable return financial instrument

A variable return financial instrument means that the expected future cash flows from this instrument changes as a result of risk exposure, for example, variable interest rates or foreign currencies fluctuation.

When it comes to hedging variable items, we're dealing with cash flow hedge.

Justification: Entity may think that they may end up paying or receiving different amount of money in certain currency in the future that you would get now.

In a cash flow hedge, we wish to FIX the amount of money to be received or to be repaid - so that this amount would be the same as NOW and IN THE FUTURE. Ie. amount should be known

Cash Flow Hedge Example

Entity issued some bonds with coupon MIBOR +0.25%.

It means that in the future, Entity will pay interest in line with the market, because MIBOR reflects the market conditions and entity doesn't want to pay in line with market. Entity wish to know how much they will pay in the future, as they don't wish to carry risk of fluctuation.

Therefore they enter into interest rate swap to receive MIBOR + 0.25% / pay 10% fixed. This is cash flow hedge - entity has fixed cash flows and will always pay 10%.

How to Account for a Fair Value Hedge?

Para 6.5.8 specifies 'As long as a fair value hedge meets the qualifying criteria in paragraph 6.4.1, the hedging relationship shall be accounted for as follows:

(a) the gain or loss on the hedging instrument shall be recognised in profit or loss (or other comprehensive income, if the hedging instrument hedges an equity instrument for which an entity has elected to present changes in fair value in other comprehensive income in accordance with paragraph 5.7.5).

(b) the hedging gain or loss on the hedged item shall adjust the carrying amount of the hedged item (if applicable) and be recognised in profit or loss. If the hedged item is a financial asset (or a component thereof) that is measured at fair value through other comprehensive income in accordance with paragraph 4.1.2A, the hedging gain or loss on the hedged item shall be recognised in profit or loss. However, if the hedged item is an equity instrument for which an entity has elected to present changes in fair value in other comprehensive income in accordance with paragraph 5.7.5, those amounts shall remain in other comprehensive income. When a hedged item is an unrecognised firm commitment (or a component thereof), the cumulative change in the fair value of the hedged item subsequent to its designation is recognised as an asset or a liability with a corresponding gain or loss recognised in profit or loss.'

This can be explained in summarized pattern as under

Step 1: Determine the fair value of both your hedged item and hedging instrument at the reporting date;
Step 2: Recognize any change in fair value (gain or loss) on the hedging instrument in profit or loss.
Step 3: Recognize the hedging gain or loss on the hedged item in its carrying amount.

Accounting entries for a fair value hedge:

Particulars

Debit

Credit

Hedging instrument:

Loss on the hedging instrument

P/L - FV loss on hedging instrument

B/S - Financial liabilities from hedging instruments

OR

Gain on the hedging instrument

B/S - Financial assets from hedging instruments

P/L - FV gain on hedging instrument

Hedged item:

Gain on the hedged item

B/S - Hedged item (e.g. inventories)

P/L - Gain on the hedged item

OR

Loss on the hedged item

P/L - Loss on the hedged item

B/S - Hedged item (e.g. inventories)

How to Account for a Cash Flow Hedge?

Para 6.5.11 specifies that 'As long as a cash flow hedge meets the qualifying criteria in paragraph 6.4.1, the hedging relationship shall be accounted for as follows:

(a) the separate component of equity associated with the hedged item (cash flow hedge reserve) is adjusted to the lower of the following (in absolute amounts):

(i) the cumulative gain or loss on the hedging instrument from inception of the hedge; and

(ii) the cumulative change in fair value (present value) of the hedged item (ie the present value of the cumulative change in the hedged expected future cash flows) from inception of the hedge.

(b) the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge (ie the portion that is offset by the change in the cash flow hedge reserve calculated in accordance with (a)) shall be recognised in other comprehensive income.

(c) any remaining gain or loss on the hedging instrument (or any gain or loss required to balance the change in the cash flow hedge reserve calculated in accordance with (a)) is hedge'

To summarise we may say that

Step 1: Determine the gain or loss on your hedging instrument and hedge item at the reporting date;

Step 2: Calculate the effective and ineffective portions of the gain or loss on the hedging instrument;

Step 3: Recognize the effective portion of the gain or loss on the hedging instrument in other comprehensive income (OCI). This item in OCI will be called 'Cash flow hedge reserve' in OCI.

Step 4: Recognize the ineffective portion of the gain or loss on the hedging instrument in profit or loss.

Accounting entries for a cash flow hedge:

Particulars

Debit

Credit

Loss on the hedging instrument - effective portion

OCI - Cash flow hedge reserve

B/S - Financial liabilities from hedging instruments

Loss on the hedging instrument - ineffective portion

P/L - Ineffective portion of loss on hedging instrument

B/S - Financial liabilities from hedging instruments

OR

Gain on the hedging instrument - effective portion

B/S - Financial assets from hedging instruments

OCI - Cash flow hedge reserve

Gain on the hedging instrument - ineffective portion

B/S - Financial assets from hedging instruments

P/L - Ineffective portion of gain on hedging instrument

Summary

Item hedged

Risk hedged

Type of hedge

Fixed-rate assets and liabilities

Interest rates, Fair value, Termination Options

Fair value hedge

Fixed-rate assets and liabilities

Foreign currency, credit risk

Fair value hedge or cash flow hedge

Unrecognized firm commitments

Interest rates, Fair value, Credit risk

Fair value hedge

Unrecognized firm commitments

Foreign currency

Fair value hedge or cash flow hedge

Variable-rate assets and liabilities

Fair value, termination options

Fair value hedge

Variable-rate assets and liabilities

Interest rates, foreign currencies, credit risk

Cash flow hedge (most cases)

Highly probable forecast transactions

Fair value, interest rates, credit risk, foreign currency

Cash flow hedge

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