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.

image 1

Amount of hedged item in consolidated balance sheet

Option 1

With hedge accounting

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Hedged item: Parent hedges net investment in Subsidiary D amounting to $50 million

Hedging instrument: ECB held by Subsidiary B $50 million which is a non-derivative and hence only the spot component of foreign exchange risk can be designated as the hedged risk

Accounting treatment:

  1. The foreign exchange difference on translation of $50 million which is the net investment in Subsidiary D will be taken to Foreign Currency Translation Reserve to the extent the hedge is effective.
  2. The foreign exchange difference on $ 50 million which is the ECB of Subsidiary B will be taken to Foreign Currency Translation Reserve to the extent the hedge is effective.
  3. The ineffective portion is taken to profit and loss account in the consolidated financial statement of the Parent A.

Without hedge accounting

Subsidiary B’s foreign exchange difference would be taken the Profit and Loss account in the consolidated statement of accounts of Parent A.

Foreign exchange difference on account of net investment in Subsidiary D would be taken to other comprehensive income in the consolidated statement of accounts of Parent A.

Option 2

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Hedged item: Subsidiary C’s net investment in Subsidiary D, viz, GBP/USD – FX risk on $ 50 million

Hedging instrument: ECB held by Subsidiary B $50 million which is a non-derivative and hence only the spot component of foreign exchange risk can be designated as the hedged risk

Accounting treatment:

The translation difference of INR/USD pertaining to the net investment in Subsidiary D would be reflected in the consolidated balance sheet of the Parent A as follows:

  1. GBP/USD FX difference would be shown in Foreign Currency Translation Reserve of Subsidiary D
  2. GBP/EUR FX difference translated to INR would be shown in the Profit and Loss account
  3. EUR/INR FX difference would be shown in the other comprehensive income

Parent A cannot designate ECB in Subsidiary B as hedging instrument for both INR/USD (net investment in Subsidiary D) as well as GBP/USD (net investment of Subsidiary C in Subsidiary D) in the consolidated financial statements. A single hedging instrument can be used in a hedge only once.

Note: Subsidiary C in its consolidated financial statements cannot apply hedge accounting as the hedging instrument, viz, $ 50 million ECB is held by Subsidiary B which is outside the group (Subsidiary C and Subsidiary D).

What happens when Subsidiary D is disposed of?

The following amount will be reclassified to Profit and Loss account from Foreign Currency Translation Reserve on disposal of Subsidiary D:

  1. Foreign exchange difference recognised in Foreign Currency Translation Reserve as the effective portion of the hedge from the hedging instrument-ECB amounting to $ 50 million by Subsidiary B; and
  2. Foreign exchange difference recognised in Foreign Currency Translation Reserve as the effective portion of the hedge from the hedged item of net investment in Subsidiary D amounting to $ 50 million.

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.
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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
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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.
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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:
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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.
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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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