Hedging a net position – cash flow hedge
The previous conversion of IFRS 9, viz, IAS 39 did not allow a net position to be hedged. However, for several group companies, it is a normal practice for the risks to be transferred to one central business unit within the enterprise and take hedging position on a net basis. The risks transferred to the central business unit usually off sets one another’s risk. This enables the entity to reduce the transaction cost and also minimise the counter party credit risk. Ind AS 109 effectively allows hedging on the basis of net position for fair value hedge and for cash flow hedges. This enables hedge on a net position basis to cover foreign exchange risk.
For example, one unit may have the requirement to import raw materials denominated in dollar terms while certain other business units may be expecting cash flows from sales revenue to be realised in dollar terms. It makes economic and commercial sense to hedge the net effect of the cash flows and the new requirement better aligns the hedge accounting with the kind of risk management strategy that the entity undertakes.
Eligibility for hedge accounting and designation of a net position
A net position is eligible for hedge accounting only if an entity hedges on a net basis for risk management purposes. This is a matter of fact and not merely of assertion or documentation. An entity cannot apply hedge accounting on a net basis solely to achieve a particular accounting outcome if that would not reflect its risk management approach. Net position hedging must form part of an established risk management strategy approved by key management personnel.
Where an entity has a firm commitment to pay in foreign currency for expenses in future and a firm commitment to sell finished goods at a future date, the entity enters into a foreign currency derivative that settles at the same future date. If the entity does not manage foreign currency risk on a net basis then it cannot apply hedge accounting for a hedging relationship between the foreign currency derivative and the net position.
If the entity manages foreign currency risk on a net basis and did not enter into the foreign currency derivative (because it increases its foreign currency risk exposure instead of reducing it), then the entity would be in a natural hedged position for nine months. Normally, this hedged position would not be reflected in the financial statements because the transactions are recognised in different reporting periods in the future. The nil net position would be eligible for hedge accounting.
When a group of items that constitute a net position is designated as a hedged item, an entity shall designate the overall group of items that includes the items that can make up the net position. An entity is not permitted to designate a nonspecific abstract amount of a net position. It must designate a gross amount of purchases and a gross amount of sales that together give rise to the hedged net position. An entity shall designate gross positions that give rise to the net position so that the entity is able to comply with the requirements for the accounting for qualifying hedging relationships.
Hedge effectiveness requirements for hedge of a net position
When an entity determines whether the hedge effectiveness requirements are met when it hedges a net position, it shall consider the changes in the value of the items in the net position that have a similar effect as the hedging instrument in conjunction with the fair value change on the hedging instrument.
When determining whether the hedge effectiveness requirements are met, the entity should consider the relationship between:
- the fair value change on the forward exchange contract together with the foreign currency risk related changes in the value of the firm sale commitments; and
- the foreign currency risk related changes in the value of the firm purchase commitments.
If the entity had a nil net position, then it should consider the relationship between the foreign currency risk-related changes in the value of the firm sale commitments and the foreign currency risk-related changes in the value of the firm purchase commitments when determining whether the hedge effectiveness requirements are met.
Cash flow hedges that constitute a net position
When an entity hedges a group of items with offsetting risk positions (ie, a net position), the eligibility for hedge accounting depends on the type of hedge. If the hedge is a fair value hedge, then the net position may be eligible as a hedged item.
If the hedge is a cash flow hedge, then the net position can only be eligible as a hedged item if it is a hedge of foreign currency risk and the designation of that net position specifies the reporting period in which the forecast transactions are expected to affect profit or loss and also specifies their nature and volume.
When determining the amounts that are recognised in the cash flow hedge reserve the entity should compare:
- the fair value change on the forward exchange contract together with the foreign currency risk related changes in the value of the highly probable forecast sales; with
- the foreign currency risk-related changes in the value of the highly probable forecast purchases.
The entity should recognise only amounts related to the forward exchange contract until the highly probable forecast sales transactions are recognised in the financial statements, at which time the gains or losses on those forecast transactions are recognised (ie, the change in the value attributable to the change in the foreign exchange rate between the designation of the hedging relationship and the recognition of revenue).
If the entity had a nil net position, then it should compare the foreign currency risk related changes in the value of the highly probable forecast sales with the foreign currency risk related changes in the value of the highly probable forecast purchases. However, those amounts are recognised only once the related forecast transactions are recognised in the financial statements.