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.

A cash flow hedge is accounted for the following:

a)     The separate component of equity associated with the hedged item (cash flow hedge reserve) is adjusted to the lower of the following (in absolute amounts):

(i)    the cumulative gain or loss on the hedging instrument from inception of the hedge; and

(ii)   the cumulative change in fair value (present value) of the hedged item (ie, the present value of the cumulative change in the hedged expected future cash flows) from inception of the hedge.

b)     The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge (ie, the portion that is offset by the change in the cash flow hedge reserve is recognised in other comprehensive income.

  1.          Any remaining gain or loss on the hedging instrument or any gain or loss required to balance the change in the cash flow hedge reserve is hedge ineffectiveness that is recognised in profit or loss.
  2.          The amount that has been accumulated in the cash flow hedge reserve is accounted for the following:

(i)    If a hedged forecast transaction subsequently results in the recognition of a non-financial asset or non-financial liability, or a hedged forecast transaction for a non-financial asset or a non-financial liability becomes a firm commitment for which fair value hedge accounting is applied, the entity should remove that amount from the cash flow hedge reserve and include it directly in the initial cost or other carrying amount of the asset or the liability. This is known as the basis adjustment entry and not a reclassification adjustment and hence it does not affect other comprehensive income.

(ii)   For cash flow hedges other than those covered by (i), that amount shall be reclassified from the cash flow hedge reserve to profit or loss as a reclassification adjustment in the same period or periods during which the hedged expected future cash flows affect profit or loss (for example, in the periods that interest income or interest expense is recognised or when a forecast sale occurs).

(iii)  If that amount is a loss and an entity expects that all or a portion of that loss will not be recovered in one or more future periods, the amount that is not expected to be recovered should be immediately reclassified into profit or loss as a reclassification adjustment.

When an entity discontinues hedge accounting for a cash flow hedge the amount that has been accumulated in the cash flow hedge reserve is accounted for as follows:

  1. If the hedged future cash flows are still expected to occur, that amount shall remain in the cash flow hedge reserve until the future cash flows occur.
  2. If the hedged future cash flows are no longer expected to occur, that amount shall be immediately reclassified from the cash flow hedge reserve to profit or loss as a reclassification adjustment. A hedged future cash flow that is no longer highly probable to occur may still be expected to occur.

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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Disclosures in respect of hedge accounting

An entity shall apply the disclosure requirements for those risk exposures that an entity hedges and for which it elects to apply hedge accounting. Hedge accounting disclosures shall provide information about:
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Hedging fixed rate debt instrument with IRS

To calculate the change in the value of the hedged item for the purpose of measuring hedge ineffectiveness, an entity may use a derivative that would have terms that match the critical terms of the hedged item (this is commonly referred to as a ‘hypothetical derivative’), and, for example, for a hedge of a forecast transaction, would be calibrated using the hedged price (or rate) level.
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Relationship between components – cash flow hedge

If a component of the cash flows of a financial or a non-financial item is designated as the hedged item, that component must be less than or equal to the total cash flows of the entire item. However, all of the cash flows of the entire item may be designated as the hedged item and hedged for only one particular risk (for example, only for those changes that are attributable to changes in LIBOR or a benchmark commodity price).
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Are RBI circulars relevant for ECL computation as per Ind AS 109?

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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Hedging a net position – cash flow hedge

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…
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Hedges of a net investment in a foreign operation

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.
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Accounting for net investment hedge – Only functional currency

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.
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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.
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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
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