Accounting for fair value hedge

Qualifying criteria

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.

Hedging instrument

Fair value changes to the hedging instrument should be recognised in the profit and loss account.

Hedged item

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.

Example

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.

Financial 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.

Steps in a cash flow hedge

Identify the hedged item Identify the hedging instrument Designation/qualifying criteria of the hedge Hedge effectiveness requirements to be fulfilled Account for the hedging relationship Rebalancing and discontinuance of hedge accounting
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What is a fair value hedge?

Fair value hedging as the name implies strives to hedge the fair value of an existing asset or liability and certain other firm commitments. In a fair value hedge, the fair value changes to the hedging instrument and the hedged item are recognised in profit and loss account.
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Steps involved in fair value hedge accounting

Identify the hedged item Identify the hedging instrument Designation/qualifying criteria of the hedge Hedge effectiveness requirements to be fulfilled Account for the hedging relationship Rebalancing and discontinuance of hedge accounting
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Accounting for the forward element

Change in the fair value of the forward element of a forward contract that hedges a transaction related hedged item should be recognised in other comprehensive income to the extent it relates to the hedged item. The cumulative change in the fair value arising from the forward element of the forward contract shall be accounted for as follows:
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Treatment of time value /forward points in derivatives

An entity is allowed to designate only the change in the intrinsic value of an option contract in a hedging instrument. Similarly an entity can also designate only the change in the spot value of a forward contract in a hedging instrument. In such cases, the time value of the option/forward points is accounted for depending upon the type of the hedged item that the option/forward contract hedges. The option/forward contract could be to either to hedge a transaction-related hedged item or a time-period-related hedged item.
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Accounting for the time value of options

The time value of options contract may be separated from the fair value of options contracts and the entity can designate only the change in the intrinsic value of the option. If the entity chooses to do so, then the time value of the option contract is dealt with in the following manner:
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Hedge effectiveness requirements

Rebalancing is permitted for the purpose of maintaining the hedge ratio to comply with the hedge effectiveness requirements. Changes to designate quantities of a hedged item or hedging instrument for a different purpose do not constitute rebalancing.
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Rebalancing by changing the hedge ratio

Rebalancing is a new concept introduced by a major amendment to IFRS 9 during November 2013. Rebalancing means adjustments made to the quantities of the hedged item or the hedging instrument of an existing hedging relationship for the purpose of maintaining a hedge ratio that complies with the hedge effectiveness requirements.
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Discontinuance of hedge accounting

As per the new requirements, hedge accounting cannot be voluntarily discontinued. Hedge accounting can be discontinued only if the hedge effectiveness requirements are not met or that the hedging instrument is liquidated. Even when the hedge effectiveness requirements are not met, the entity should adjust the hedge ratio through the process of rebalancing and continue with hedge accounting so long as the hedging relationship continues to meet the risk management objectives of the enterprise.
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What is a Cash flow hedge?

A cash flow hedge is a hedge of the exposure to variability in cash flows attributable to a particular risk associated with a recognised asset or liability or a component thereof. It covers future interest payments on variable-rate debt. It also covers a highly probable forecast transaction. The requirement is that such cash flows should affect the profit and loss account.
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