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
Let us see the details of each of these steps.
|1. Identify the hedged item|
|1. A hedged item can be a recognised asset or a liability with potential variability in cash flows impacting profit.|
2. An unrecognised firm commitment to buy or sell a non-financial asset – only for foreign exchange risk.
3. A highly probable forecasted transaction impacting profit.
|i. The variability in cash flows should have an impact on profit.|
ii. The foreign exchange risk in an unrecognised firm commitment to buy or sell a non-financial asset in foreign currency affects both the fair value as well as future cash flows that impact the profit. Hence, can be accounted as either fair value hedge or cash flow hedge.
iii. A component of an item can also be designated as hedged item. A component of an item means changes attributable to a specific risk component.
|2. Identify the hedging Instrument|
|1. The hedging instrument should be a derivative but not a written option.|
2. Non-derivative measured at fair value through profit or loss (FVTPL) can also be a hedging instrument.
3. FX component of a non-derivative financial asset or a non-derivative financial liability can also be a hedging instrument.
|i. Hedging instrument should be designated in its entirety.|
ii. Exception for (i) above: Designating only the changes in the intrinsic value of an option contract is allowed or designating only the changes in the spot element of a forward contract is allowed.
iii. A portion of the hedging instrument can be designated.
iv. A portion of the time period of the hedging instrument cannot be designated.
|3. Designation / Qualifying criteria of hedge|
|1. Identify the hedged item and the corresponding hedging instrument.||i. Hedge should be designated at the inception of the hedging relationship.|
ii. Hedging relationship consists only of eligible hedging instruments and eligible hedged items.
iii. Formal designation and documentation of hedging relationship is required.
iv. Documentation to contain entity’s risk management objective and strategy for undertaking hedge.
v. The nature of risk being hedged and the method by which the hedge effectiveness would be assessed should be mentioned.
|4. Hedge effectiveness requirements|
|1. Economic relationship should exist between the hedged item and the hedging instrument.|
2. Effect of credit risk should not dominate the hedge.
3. Hedge ratio for accounting purposes should be the same as actually deployed by the entity.
|i. The effect of credit risk would vitiate the fair value changes that occur exclusively due to the economic relationship between the hedged item and the hedging instrument.|
ii. The hedge ratio actually deployed by the entity should be the same as the one designated in the hedge documentation.
iii. Hedge qualification is based on qualitative, forward-looking hedge effectiveness assessments and not based on the relative movements of the fair values of the hedged item and hedging instrument.
|5. Accounting for the hedging relationship|
|1. Get the lower of the cumulative fair value changes to the hedging instrument and the fair value of the hedged item, viz, the present value of expected cash flows.|
2. The amount calculated in step 1 above is taken to ‘Cash Flow Hedge Reserve’.
3. The difference between the fair value changes to the hedging instrument and the amount taken to Cash Flow Hedge Reserve is taken to the profit and loss account.
4. Where the hedged item ultimately results in a non-financial asset or a non-financial liability, the balance in the cash flow hedge reserve is adjusted with the carrying value of such item known as ‘Basis Adjustment’.
5. Where the hedged item ultimately results in actual sales, the balance in the cash flow hedge reserve is reclassified to profit and loss account as ‘Reclassification Adjustment’ during the same period as the hedged item affects the profit and loss account.
6. Where the hedged item is a financial instrument impacting future cash flows in the form of interest, the balance in the cash flow hedge reserve is reclassified to profit and loss account as ‘Reclassification Adjustment’ during the same period as the hedged item affects the profit and loss account.
7. If cash flow hedge reserve shows a debit balance and if the loss is not expected to be covered in future cash flows, then to that extent it is immediately taken to the profit and loss account.
|i. Qualifying and effectiveness criteria should be met.|
ii. If the hedged item is an unrecognised firm commitment the cumulative fair value changes of the hedged item is recognised as an asset or a liability. Subsequently, this amount gets adjusted with the carrying amount of the asset or liability that ultimately results.
iii. If the hedged item is an existing asset or a liability, then the carrying amount of the hedged item is adjusted for the fair value changes of that instrument. Subsequently, this amount is effectively amortised based on the effective interest rate computed after the hedge accounting is discontinued.
|6. Discontinuance of hedge accounting|
|1. If the hedge effectiveness requirements are not met, the entity should adjust the hedge ratio by a process known as ‘rebalancing’ so long as the hedging relationship continues to meet the risk management objective of the enterprise.|
2. When the hedging instrument is liquidated or if the hedge is discontinued otherwise, the balance in the cash flow hedge reserve will continue to remain there till the expected cash flows affecting the hedged item affects the profit and loss account.
3. If the hedged expected future cash flows are not expected to occur, then to that extent it is immediately recognised in profit and loss account.
|i. A properly designated hedge cannot be discontinued voluntarily by an entity unless the risk management objective of undertaking the hedge continues to the same.|
ii. Rebalancing means adjustments made to the designated quantities of the hedged item or the hedging instrument for the purpose of maintaining a hedge ratio to comply with the hedge effectiveness requirements.
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…
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.
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.
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.
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.
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
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.
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:
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.
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: