FAQs – Hedge Accounting

Rebalancing to achieve hedge effectiveness What do you mean by rebalancing and how does it help achieve hedge effectiveness? 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. Adjusting the hedge ratio enables an entity to respond to changes in the relationship between the hedging instrument and the hedged item that arise from their underlyings. Rebalancing allows the…

Voluntary discontinuation of hedge accounting Can a hedge accounting be voluntarily discontinued and why? 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. When hedge accounting is discontinued, the hedged item would once again be…

Is hedge accounting mandatory? Is hedge accounting mandatory or optional? Hedge accounting is not mandatory. However, considering the benefits of complying with hedge accounting, entities would want to follow hedge accounting when they are in a position to comply with the requirements for hedge accounting. The biggest benefit of hedge accounting is that it reduces the volatility in the profit and loss accounts. Volatility in the profit and loss account is caused due to certain accounting mismatches arising on account of classification of a hedged item and the hedging instrument for the purpose of hedging. For example, an entity may…

Cash flow hedge Vs fair value hedge What is a cash flow hedge and how is it different from a fair value 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 a 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. However, a fair value hedge is a hedge of the exposure to changes in fair…

Reasons for revamping hedge accounting by IASB What prompted the hedge accounting standard to be revamped by IASB? The main reason for revamping the accounting standards relating to financial instruments by the IASB is the direct outcome of the shock that sent shivers through the spine of several conglomerates as a fall out of the financial crisis during the year 2008. It is perceived that the accounting standards issued by the IASB are more principle based as opposed to the accounting standards issued by the Financial Accounting Standards Board (FASB) which is considered to be rule based. Nevertheless it was…

Accounting for a cash flow hedge How would you account for a cash flow hedge? Get the lower of the cumulative fair value changes to the hedging instrument and the fair value of the hedged item, viz, the present value of expected cash flows. The amount calculated in step 1 above is taken to ‘Cash Flow Hedge Reserve’. The difference between the fair value changes to the hedging instrument and the amount taken to Cash Flow Hedge Reserve is taken to the profit and loss account. Where the hedged item ultimately results in a non-financial asset or a non-financial liability,…

Difference between hedging and speculation What is the basic difference between hedging and speculation? If an investor takes a derivative position by holding the corresponding underlying, it is called hedging. The derivative position should be in the opposite direction of the underlying position, eg, if a person holds 100 shares of Infosys and if the investor buys a put option which is equivalent to obtaining the right to sell the shares at the stipulated strike price, then the derivative position is known as hedging. If an investor gets into a derivative contract without holding any corresponding underlying, then such a…

Rebalancing and discontinuation of cash flow hedge Briefly explain rebalancing and discontinuation of cash flow hedge. If the hedge effectiveness requirements are not met, the entity should adjust the hedge ratio by a process known as ‘rebalancing’ so long as the hedging relationship continues to meet the risk management objective of undertaking the hedge. When the hedging instrument is liquidated or if the hedge is discontinued otherwise the balance in the cash flow hedge reserve will continue to remain there till the expected cash flows affecting the hedged item affects the profit and loss account. If the hedged expected future…

Difference between speculation and gambling Is there any difference between speculation and gambling? Both speculation and gambling involves taking a position in the derivative segment without having any corresponding underlying. In the case of speculation, the open interest does not exceed the sum total of the underlying outstanding. However, in the case of gambling, the open interest exceeds the outstanding underlying at a macro level. Gambling is possible in the OTC segment, especially in credit derivatives. Gambling is not possible in an exchanged traded environment where the regulatory authorities ensure that the open interest never exceeds the sum total of…

Link between hedge accounting & risk management objective What is the link between hedge accounting and the risk management objective of an entity? The objective of hedge accounting is to manage the risk that an entity faces. In the context of hedge accounting, the entity manages effectively the risk by using the appropriate financial instruments thereby moderating or reducing the impact of the same in the profit and loss account. In order to comply with hedge accounting, the basic criterion is that the hedging activity should conform to the risk management strategy of the enterprise. The risk management strategy of…

Risk management objective & risk management strategy Explain the relationship between risk management objective and risk management strategy of an entity. The risk management strategy of an entity should be distinguished from its risk management objective. The risk management strategy is established at the highest level at which an entity determines how it manages its risk. The risk management strategy is normally in place for a longer period of time. However, it may include some flexibility to react to changes in circumstances even while the strategy is in place. The risk management strategy is usually documented at the highest level…

Can hedging instrument be a non-derivative A hedging instrument should necessarily be a derivative. Do you agree? Hedging instrument need not necessarily be a derivative instrument even though mostly derivative instruments are used as hedging instruments. The key feature of a derivative instrument should be that it should help minimise the risk which it seeks to hedge. The hedging instrument should not result in taking additional risks or exposures. In other words, it should have a limited risk while having a potential to make significant gains. Normally, the hedging instrument is a purchased option based derivative contract which has a…

Written options as a hedging instrument Why a written option cannot be used as a hedging instrument? The objective of hedging is to minimise the risk and/or to protect the unrealised profits. A hedging instrument should typically restrict the exposure to loses while at the same time provide scope for unlimited profits. The bought option exactly achieves these two requirements. A bought call option has a maximum risk to the extent of the premium paid while leaves open a potential to make unlimited gains. A written call option on the other hand pegs the maximum profit which is the premium…

Interest rate swap as a hedging instrument An interest rate swap is usually designated as a hedging instrument in spite of the fact that the fair value of an interest rate swap oscillates between positive and negative fair values. Explain the anomaly. At the outset, it may seem rather strange that an interest rate swap which has the potential of having a fair value that oscillates between positive and negative values is permitted to be designated as a hedging instrument while a written option which has a negative fair value at all times is prohibited from being designated as a…

Hedge ratio in hedge accounting requirements What is meant by hedge ratio and how it is helpful in meeting the hedge accounting requirements? Hedge ratio refers to the number of units that are used as hedging instrument for the purpose of hedging a hedged item. Usually, the ratio is 1:1 for most of the financial instruments. For example, if the entity wants to hedge a fixed rate debt instrument of say Rs 10 crore, then if the hedging instrument happens to be an interest rate swap, then the notional amount of the interest rate swap would also be Rs 10…

Existing asset or liability as a hedged item Only an existing asset or liability can be designated as a hedged item in a fair value hedge. Do you agree? This statement is not correct, as the hedged item in a fair value hedge can be in addition to the above an unrecognised firm commitment or an identified portion of an asset, liability or firm commitment that is attributable to a particular risk and could affect the income statement. The hedge of a firm commitment to buy or sell a financial or non-financial asset is accounted for as a fair value…

Foreign currency risk in a firm commitment as a fair value hedge Foreign currency risk associated with a firm commitment can be designated as a fair value hedge only. Explain. No. A hedge of the foreign currency risk associated with such firm commitments may be designated as a cash flow hedge or as a fair value hedge. The reason is that as far as the foreign exchange risk is concerned, it affects both the fair value of the hedged item as well as the cash flows associated with the same. A hedge of foreign currency risk associated with a highly…

Accounting for a fair value hedge How do you account for a fair value hedge? A fair value hedge is accounted for as follows: The gain or loss on the hedging instrument is recognised in profit or loss. If the hedging instrument hedges an equity instrument classified as FVOCI, then it is recognised in other comprehensive income. The hedging gain or loss on the hedged item is adjusted against the carrying amount of the hedged item and be recognised in profit or loss. If the hedged item is a financial asset measured at FVOCI the hedging gain or loss on…

Time value of forward points in hedge accounting How is the time value of forward points in a derivative contract treated in hedge accounting? 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…