Accounting for fair value hedge
The hedge should be designated at the inception of the hedging relationship and a formal designation and documentation of the same required. The documentation should contain the entity’s risk management strategy and objective for undertaking the hedge. The effect of the credit risk involved in the hedging instrument, viz, the counterparty credit risk should not be such that it would vitiate the fair value changes of the hedging instrument.
Fair value changes to the hedging instrument should be recognised in the profit and loss account.
The hedged item should be valued at fair value irrespective of the classification of the asset or liability and the fair value changes should be recognised in the profit and loss account. The carrying amount of the hedged item should be adjusted accordingly. The cumulative fair value changes to the hedged item which is recognised as an asset or liability is subsequently adjusted with the carrying amount of the asset or liability that ultimately results.
Let us assume that the fair value changes to the hedging instrument as on the reporting date since inception is Rs 14,500. Let us also assume that the fair value of the firm commitment to buy a non-financial asset is, say, Rs 15,000. Both these amounts would be taken to the profit and loss account representing the net loss of Rs 500 only. The derivative would be valued at the fair value of Rs 14,500 and the firm commitment which represents a liability would be valued at Rs 15,000. When the non-financial asset is recognised in the books of accounts of purchase, the value of such non-financial asset would be reduced by Rs 15,000. The hedging instrument would eventually realise Rs 14,500, being fair value of that instrument.
Hedging a non-financial asset
The hedged item can be a recognised asset or a liability which can either be a financial or a non-financial item. A hedged item can also be an unrecognised firm commitment to buy or sell a non-financial asset. A hedged item can be a firm commitment to buy or sell a non-financial item. For example, the entity which produces copper may want to sell in the derivatives market its finished product in order to fix the value of its sales revenue when the markets are favourably placed. The finished product, viz, copper may not be available at that point of time or else the entity can sell directly its finished product. The entity has the choice of selling it in the futures market, the delivery being scheduled after the production process is completed. In this case, the entity would be able to quantify its value of sales and thereby minimised its risk in terms of fluctuations in the market price and its finished product. Needless to say that the sales value fixed as per the futures market may sometimes go against the entity which means that the price of copper may go up than the price fixed for the delivery in the futures market. Nevertheless, the entity would be assured of a fixed value for its sales. When the entity enters into a futures contract to sell its finished goods, it is hedging a non-financial asset (which would go into existence once the production cycle is completed) with a derivative instrument, viz, futures contract to peg its sales revenue. Fluctuations in the market price of the futures contract should not affect the profit or loss of the entity, as the purpose of the futures contract is only to fix the sales revenue and not to generate any profit on its own.
Fluctuations in the price of the derivatives representing the change in the fair value of the derivative instrument is effectively set off against the fair value changes of the hedged item, viz, the firm commitment to sell copper futures. If the prices of the spot market versus futures market move in tandem, then the profit or loss in the hedged item would be set off completely by the profit or loss in the derivative instrument.
If the hedged item is an existing asset or liability, then the carrying amount of the hedged item is adjusted for the fair value changes of that instrument.
Measurement of hedge ineffectiveness
When measuring hedge ineffectiveness, an entity shall consider the time value of money. Consequently, the entity determines the value of the hedged item on a present value basis and therefore the change in the value of the hedged item also includes the effect of the time value of money.