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:

  1. 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
  2. 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:

  1. 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
  2. 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.

Hedges of a net investment in a foreign operation

As per Ind AS 21, net investment in any foreign operation is the amount of the reporting entity’s interest in the net asset of that operation. Such foreign operations may be subsidiaries, associates, joint ventures or branches. Ind AS 21 requires an entity to determine the functional currency of each of its foreign operations as the currency of the primary economic environment of that operation. When translating the results and financial position of a foreign operation into a presentation currency, the entity is required to recognise foreign exchange differences in other comprehensive income until the foreign operation is disposed off.
Read More

Accounting for net investment hedge – Only functional currency

Hedge accounting is applicable only to the foreign exchange differences arising between the functional currency of the foreign operation and the parent entity’s functional currency. It is not applicable for translation differences arising on account of presentation currency.
Read More

Illustration of a net investment hedge by a parent entity

Entity A is the Parent having INR as its functional currency. Subsidiary B has Euro as its functional currency. Subsidiary C has GBP as its functional currency and the functional currency of Subsidiary D is USD. Subsidiary B has ECB amounting to $ 50 million. The following diagram best illustrates the hierarchy with corresponding investments in the subsidiary entities.
Read More

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
Read More

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.
Read More

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
Read More

Accounting for fair value hedge

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.
Read More

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:
Read More

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.
Read More

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:
Read More
Scroll to Top