Steps involved in fair value hedge accounting
The broad steps involved in a fair value hedge are as follows:
- 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 (financial or non-financial).|
2. Or an unrecognised firm commitment to buy or sell a non-financial asset.
3. Or a component of the above two.
4. Identify the risk that is to be hedged.
|i. The firm commitment should be with a party external to the entity.|
ii. Foreign currency risk of an intra group monetary item can be hedged if there is a net exposure after consolidation.
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.
iv. A forecast transaction cannot be designated as a hedged item in a fair value hedge.
|2.. Identify the hedging Instrument|
|1. The hedging instrument should normally be a derivative but not a net 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. Similarly designating only the changes in the spot element of a forward contract is also 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.
|C. 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. Qualifying and effectiveness criteria should be met.|
2. Fair value changes to the hedging instrument should be recognised in profit and loss.
3. Hedging gain/loss on the hedged item should be recognised in profit and loss and the carrying amount of the hedged item should be adjusted. In other words, the hedged item should be valued at fair value irrespective of the classification of such asset or liability.
|i. 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.|
ii. 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 hedged item will be measured at amortised cost.
|i. A properly designated hedge cannot be discontinued voluntarily by an entity so long as the hedging relationship meets the risk management strategy of the enterprise.|
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.