Entities generally enter into certain derivative transactions to protect or hedge themselves from risk of fluctuation in certain key variables (such as currency exchange rates, interest rates or commodity prices) that may have a detrimental impact on their profit and loss accounts. In a hedging transaction, there is usually a hedged item and a hedging instrument such that the hedging instrument protects an entity from fluctuations in the value of the hedged item. In order to reflect the impact of hedging activities in the profit or loss account, an entity may elect to apply the hedge accounting principles under IFRS (or Ind AS). These principles provide guidance on designating hedge relationships by identifying qualifying hedged items, hedging instruments and hedged risks.
Qualifying hedged items can be recognised assets, liabilities, unrecognised firm commitments, highly probable forecast transactions or net investments in foreign operations. In general, only derivative instruments entered into with an external party qualify as hedging instruments. However, for hedges of foreign exchange risk only, non-derivative financial instruments (for example, loans) may qualify as hedging instruments.
Hedge accounting allows an entity to either :
• measure assets, liabilities and firm commitments selectively on a basis different from that otherwise stipulated in IFRS or Ind AS (“fair value hegde accounting model”); or
• defer the recognition in profit or loss of gains or losses on derivatives (“cash flow hedge accounting model” or “net investment hedging”).
Hedge accounting is voluntary; however, it is permitted only when strict documentation and effectiveness requirements, as stated in IAS 39 are met. The Ind AS criteria are similar to the IFRS criteria. These criteria are:
• There is formal designation and written documentation at the inception of the hedge.
• The effectiveness of the hedging relationship can be measured reliably. This requires the fair value of the hedging instrument, and the fair value (or cash flows) of the hedged item with respect to the risk being hedged, to be reliably measurable.
• The hedge is expected to be highly effective in achieving fair value or cash flow offsets in accordance with the original documented risk management strategy.
• The hedge is assessed and determined to be highly effective on an ongoing basis throughout the hedge relationship. A hedge is highly effective if changes in the fair value of the hedging instrument, and changes in the fair value or expected cash flows of the hedged item attributable to the hedged risk, offset within the range of 80-125 percent.
• For a cash flow hedge of a forecast transaction, the transaction is highly probable and creates an exposure to variability in cash flows that ultimately could affect profit or loss.
One of the more common hedging transactions entered into by entities is a hedge of highly probable forecast transactions (purchases or sales), considered a cash flow hedge. A cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability, or a highly probable forecast transaction that could affect profit or loss. In the case of hedges of highly probable forecast purchase or sale transactions in foreign currency, the hedged risk would be currency risk, the hedged items are the forecast purchases/sales and the hedging instruments typically used are currency forwards.
Given below is an example of applying hedge accounting to the cash flow hedge of a highly probable forecast purchase.
Example:
Company R is an Indian company with Indian Rupees (INR) as the functional currency. The reporting dates of Company R are 30th June and 31st December.
On 1st January 20X0, Company R expects to purchase a significant amount of raw materials in future for its production activities. A Company based in the US will supply the raw materials. Company R’s management forecasts 100,000 units of raw material will be received and invoiced on 31st July 20X1 at a price of USD 75 per unit. For convenience, it is assumed that the invoice will also be paid on 31st July 20X1.
The Company’s management decides to hedge the foreign currency risk arising from this highly probable forecast purchase. R enters into a forward contract to buy USD and sell INR. The negotiations with the US Company are in advanced stages and the board of Company R has approved the transaction.
On 1st January 20X0, the Company enters into a US Dollar forward contract, to purchase USD 7,500,000 at a forward rate of INR/USD 46.245, by selling an equivalent INR sum of INR 346,837,500 on 31st July 20X1.
Exchange Rates on various dates are as shown in Table 1 :
Annualised interest rates applicable for discounting cash flows on 31 July 20X1 at various dates of the hedge are as shown in Table 2:
The fair value of the foreign currency forward contract at each measurement date is computed as the present value of the expected settlement amount, which is the difference between the contractually set forward rate and the actual forward rate on the date of measurement, multiplied by the discount factor.
On 1st January 20X0, which is the start date of the forward contract, the fair value of the derivative will be nil, as the difference between the contractually set forward rate and the actual forward rate (7,500,000 * (46.2450 – 46.2450)) is Nil.
On 30th June 20X0, the actual forward rate is 45.9732 and discount factor of 0.9138. Accordingly, the fair value of the currency forward contract is Rs. (1,862,774) i.e. [(7,500,000 * (45.9732 – 46.2450)) * 0.9138].
The fair value of the currency forward contract at each measurement date is computed in the same manner. Accordingly, the fair values at each measurement date are shown in Table 3.
The company designates this hedge relationship on 1st January 20X0.
Hedge effectiveness testing needs to be performed on a prospective as well as on a retrospective basis. A common way to measure hedge effectiveness is the cumulative dollar offset method which is a quantitative method that consists of comparing the change in fair value or cash flows of the hedging instrument with the change in fair value or cash flows of the hedged item attributable to the hedged risk.
Prospective testing will consider the expected variability in cash flows based on possible movements in exchange rates using dollar offset/hypothetical derivative method. Retrospective testing will consider actual variability in value/cash flows based on actual changes in forward rates.
In the given case, hedge effectiveness has been assessed prospectively and retrospectively using the cumulative dollar offset method and a hypothetical derivative for the notional amount of hedged purchases to demonstrate a relationship between the change in fair value of the hedging instrument and the change in fair value of the hedged item. The hypothetical derivative method is used to measure hedge effectiveness and ineffectiveness and is based on the comparison of the change in the fair value of the actual contracts designated as the hedging instrument and the change in the fair value of a hypothetical hedging instrument for purchases in the month of payment (considering that payment is the designated hedged item). In the given case, the hypothetical derivative that models the hedged cash flows would be a forward contract to pay $ 7,500,000 in return for INR.
The effectiveness of the relationship will be demonstrated by the following ratio:
Cumulative change in the fair value of the forward contract(s) by designated expiry.
Cumulative change in the fair value of the Hypo-thetical Derivative.
If the ratio of the change is within the range of 80% to 125%, the hedge will be determined to both continue to be, and to have been highly effective.
In this example, using the cumulative dollar offset method and a hypothetical derivative, the hedge effectiveness has been assessed as 100% effective at each measurement date. This is primarily because the date of maturity of the currency forward contract and date of the forecasted purchase payment, and the notional amount being hedged is the same. Hence, the ratio of fair value of the forward contract undertaken (hedging instrument) and the hypothetical derivative is 100% in each case. In practice, ineffectiveness often arises due to any changes in the expected timing of the purchase/ collection and the maturity date of the derivative. For example, though the derivative matures at the end of the month, the payment may occur at any time during the month.
Journal Entries (ignoring the impact of taxes) for the transaction using hedge accounting:
