Fair value hedge on discontinuation of hedge accounting
What happens to a fair value hedge on discontinuation of hedge accounting?
Fair value hedge accounting as per the approach mentioned in the guidance note is significantly different from the fair value hedge accounting as per Ind AS 109. The fundamental difference arises on account of the concept known as ‘effective interest rate’ which runs through the entire literature of Ind AS. The effective ‘interest rate’ concept is conspicuously missing in the present iGAAP (AS). Since this guidance note is meant for those entities not covered by Ind AS, effective interest rate is also not applicable for such entities and hence it is not covered here. It should be noted that the effective interest rate occupies a very significant position in the valuation of assets and liabilities which are classified as ‘measured at amortised cost’.
Let us assume that an entity enters into a fair value hedge, to hedge an existing fixed rate liability by entering into an interest rate swap. This effectively converts the fixed rate liability to a variable rate liability. When there is a proper hedge accounting in place then the valuation of the fixed rate liability would be changed from amortised cost to fair value so long as the hedge accounting and hedging relationship subsists. When the hedging relationship ceases to exist (ie, the hedge accounting is discontinued) either on account of the hedge not being effective or not conforming to the risk management strategy of the enterprise or due to the liquidation of the hedging instrument, the valuation of the fixed rate liability would revert back to fair value measurement. The difference between the carrying value at that point of time and the maturity value of the fixed rate liability would be amrotised to the profit and loss account as interest expense/income over the remaining life of the liability. When the amortisation of liability over the life of the asset happens, the impact of this will be adjusted as part of the interest expense only.
However, in the case of fair value hedge accounting as per this Guidance Note when the hedge is effective and the hedging relationship subsists, the hedged item will be measured at fair value and the hedging instrument will also be measured at fair value, the fair value changes of both being taken to the profit and loss account. However, when the hedge accounting is discontinued (for whatever may be the reason) the fair value of the hedged item becomes the cost (not amortised cost) of the liability. There is no amortisation here. When the liability is redeemed on maturity, the difference between the carrying value of the liability and the maturity value will be taken to the profit and loss account as gains/losses on maturity. This will not be adjusted against interest expense.