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.