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.
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
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.
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:
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.
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.
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.
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.