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.

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:
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Hedge effectiveness requirements

Rebalancing is permitted for the purpose of maintaining the hedge ratio to comply with the hedge effectiveness requirements. Changes to designate quantities of a hedged item or hedging instrument for a different purpose do not constitute rebalancing.
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Rebalancing by changing the hedge ratio

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.
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Discontinuance of hedge accounting

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.
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What is a Cash flow 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 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.
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Hedging fixed rate debt instrument with IRS

To calculate the change in the value of the hedged item for the purpose of measuring hedge ineffectiveness, an entity may use a derivative that would have terms that match the critical terms of the hedged item (this is commonly referred to as a ‘hypothetical derivative’), and, for example, for a hedge of a forecast transaction, would be calibrated using the hedged price (or rate) level.
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Disclosures in respect of hedge accounting

An entity shall apply the disclosure requirements for those risk exposures that an entity hedges and for which it elects to apply hedge accounting. Hedge accounting disclosures shall provide information about:
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Are RBI circulars relevant for ECL computation as per Ind AS 109?

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 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.
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Relationship between components – cash flow hedge

If a component of the cash flows of a financial or a non-financial item is designated as the hedged item, that component must be less than or equal to the total cash flows of the entire item. However, all of the cash flows of the entire item may be designated as the hedged item and hedged for only one particular risk (for example, only for those changes that are attributable to changes in LIBOR or a benchmark commodity price).
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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.
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