Hedge Accounting as per Ind AS 109 / IFRS 9
It may be useful to understand the genesis of hedge accounting as to how the process itself matured over the last two decades. Even though this may not be relevant in the context of Indian Accounting Standards as we in India have inherited the accounting standards relating to financial instruments in general and hedge accounting in particular based on the accounting standards issue by the International Accounting Standards Board (IASB) as on 24 July, 2014.
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 widely felt that certain requirements relating to hedge accounting were rule based severely crippling the practical utility of implementing the scheme of hedge accounting as envisaged by the standards. The IASB along with the FASB undertook a major overhaul of the hedge accounting piece resulting in the announcement of a completely revamped set of standards relating to hedge accounting. Some of the major changes that were brought about by the amendments to IFRS 9 announced in December 2013 as opposed to the erstwhile IAS 39 are as follows.
Hedge effectiveness testing
The dogmatic 80% to 125% testing range for assessing the hedge effectiveness is dispensed with in Ind AS 109. It is now replaced with an objective test that focuses on the economic relationship between the hedged item and the hedging instrument, as there is no significance in the bright line of 80% to 125% that was in existence. The hedge effectiveness testing criteria is now completely changed.
Despite the earlier standard allowing the time value of an option or the forward element of a forward contract to be excluded from the designation of a hedging instrument, the new requirement allows such cost to be accounted for as the cost of hedging. The revised requirement has a salubrious effect of the fair value changes not affecting the profit or loss account, but instead getting allocated to the profit or loss account in a systematic way as either transaction related cost or time period related cost.
A risk component may be designated as the hedged item for non-financial items also with the only condition that such component is separately identifiable and readily measurable.
Group of Items
The new requirement allows more designations of groups of items as hedged item including layered designations and even some portions of the same. As per the previous version, a group of items is eligible to be designated as a hedged item if the individual items with the group sharing the same designated risk exposure and the change in the fair value attributable to the hedged risk for each individual item in the group is approximately proportionate to the overall change in the fair value attributable to the hedged risk of the group. However, as per the revised requirements, hedge accounting may be applied to a group of items if the group consists of items and components that would individually qualify for hedge accounting, and for risk management purposes, the items in the group are managed together on a group basis. For example, a portfolio of equity shares which are classified at fair value through other comprehensive income, may form the hedged item in a fair value hedge having index futures contract as a hedging instrument. A group designation can also be designation of a component of such group or a layered component of the group depending upon the entity’s risk management strategy and objective.
The previous version did not allow rebalancing which means that the hedge ratio once fixed at the time of inception of the hedging relationship can never be altered during the tenure of such relationship. However, the new requirement permits an entity to rebalance the quantity of either hedged item or hedging instrument or both in order to achieve better hedge effectiveness. In other words, when rebalancing occurs, the existing hedging relationship and hedge accounting need not be discontinued.
The previous version prohibited derivatives from being designated as part of a hedged item for accounting purposes. As per the new requirement, a hedged item can be an aggregated exposure which is combination of an exposure that would qualify as a hedged item and a derivative.
Realignment with risk management activities
The effect of some of the amendments to hedge accounting methodology mentioned above is that the new requirement aligns hedge accounting more closely with the risk management activities of an entity. This facilitates the entity to fully reflect its risk management activities in the financial statements. Hedge accounting will be closely and tightly coupled with the objective of hedging in such a way that it reflects the entity’s risk management activities in the financial statements.
Risk management objective/Risk management strategy
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 strategies typically identify the risks to which the entity is exposed and set out how the entity responds to them. 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 with guidance on the policies to be pursued for implementing the strategy.
The risk management objective is applied for every hedging relationship which dovetails into the risk management strategy of the enterprise. The risk management objective specifies how a particular hedging instrument that has been designated is used to hedge a particular exposure of the corresponding hedged item. A risk management strategy may have multiple hedging relationships whose risk management objectives relate to executing that overall risk management strategy.
An entity may have a risk management strategy to manage the foreign currency risk in respect of sales that it forecasts, including the resulting receivables in foreign currency. Even in that risk management strategy, the entity may have multiple hedging relationships to manage the foreign currency risk with the specific risk management objective