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October 2012

Accounting for fair value hedge s and hedge s of net in vestment in foreign operations

By Jamil Khatri, Akeel Master
Chartered Accountants
Reading Time 10 mins
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In our previous article, we discussed the need for hedge accounting by companies as well as the basic principles of hedge accounting and criteria required to qualify for hedge accounting. We gave an example of a cash flow hedge of a highly probable forecast purchase transaction and illustrated the impact of hedge accounting on a companies’ profit or loss account through the term of the hedging instrument. In this article, we shall elucidate the accounting using fair value hedges and the hedge of a net investment in a foreign operation and illustrate the accounting treatment through examples.

Fair value hedges:

A fair value hedge is a hedge of changes in the fair value of a recognised asset or liability, an unrecognised firm commitment, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss. The following are examples of fair value hedges: a hedge of interest rate risk associated with a fixed rate interest-bearing asset or liability (e.g. converting a fixed rate instrument to a floating rate instrument using an interest rate swap); a hedge of a firm commitment to purchase an asset or to incur a liability; or a hedge of interest rate risk on a portfolio basis (a portfolio fair value hedge).

Accounting for a fair value hedge:

  • l Hedging instruments that are derivatives – Fair value changes are recognised in the profit or loss account.
  •  Hedging instruments that are non derivatives – Foreign currency components of their carrying amounts measured in accordance with Ind-AS 21 are recognised in the profit or loss account.
  •  Hedged item otherwise measured at amortised cost (Eg. fixed rate borrowing) or through other comprehensive income (Eg. available for sale financial asset) – Adjustment to the carrying amount of the hedged item related to the hedged risk are recognised in the profit or loss account.
  • The categorisation of the fair value hedge adjustment as either a monetary or a non-monetary item, under Ind-AS 21, should be consistent with the categorisation of the hedged item under Ind-AS 21.
  •  In a fair value hedge, any ineffectiveness automatically is reported in profit or loss through the accounting process, unlike in a cash flow hedge, in which the ineffectiveness has to be calculated and recognised separately.

 If the fair value hedge is fully effective, the gain or loss on the hedging instrument would fully offset the gain or loss on the hedged item attributable to the risk being hedged. Accordingly, there would be no net impact to the profit or loss account.

The qualifying criteria for hedge accounting remain the same across types of hedges, i.e. cash flow hedges, fair value hedges or net investment in foreign operation.

Let us look into fair value hedges in more detail by way of the following example.

Example 1: Fair Value Hedges

RV International Limited (RVIL) is a manufacturer with an Indian Rupees (Rs.) functional currency with trade transactions with several countries. The company has the maximum number of trade transactions with companies in the United States of America. RVIL’s reporting dates are 30th September and 31st March.

On 15th July 20X1, RVIL enters into a contract to sell its manufactured units to a company in the United States. As per the contract, RVIL is committed to deliver 1,000 units at a price of INRNaN per unit on 30th June 20X2. The contract contains several specifications of the units to be delivered and also contains a penalty clause that states that if RVIL fails to adhere to its time and quality commitment, as per the specifications of the contracts, it shall be liable to a penalty of INRNaN million. The invoice is payable on 31st August 20X2. RVIL expects that is shall incur costs of Rs. 67.5 million in manufacturing and packing the units. All such costs are denominated in its functional currency, Rs.

On the date that RVIL enters into the contract of sale, its management decides to hedge the resulting foreign currency risk and enters into a forward contract to sell INRNaN million against Rs. The terms of the sale transactions and of the forward contract are as shown in Table 1 and Table 2

RVIL accordingly adopts a risk management strategy to hedge its firm commitment denominated in $ as a fair value hedge. The management of the company designates the spot component of the forward contract as a hedge of the change in the fair value of the contracted firm commitment attributable to movements in spot rates. All critical terms of the hedged item and hedging instruments match, on the date of inception – 15th July 20X1. The hedge is determined to be 100% effective on a prospective basis considering that all the critical terms match. The fair value of the forward contract (hedging instrument) is Nil as on the date of inception. Fair value is calculated as the difference between the discounted fair value of the forward contract at the forward rate on inception (18,000,000 * 45.9420 * discount factor at 10.6500% = Rs. 749,959,475) with the discounted fair value of the forward contract on testing date (18,000,000 *45.9420 * discount factor at 10.6500% = Rs. 749,959,475). On 30th September the fair value shall be Rs. 37,707,866 [(18,000,000 * discount factor at 10.8600 * (48.2040 – 45.9420)]. Hedge accounting principles also require retrospective effectiveness testing at each date which is determined to be 100% in this example for each testing date.

In this example, the designated hedged risk is the spot component i.e. hedge effectiveness is measured on the basis of changes in spot component of the forward rates. The change in the fair value of the derivative attributable to the forward points is excluded from the hedge relationship. This forward points component does not therefore give rise to any ineffectiveness. It is recognised in profit or loss as ‘other operating income and expense’. Alternatively, the forward points can be recognised as ‘interest income and expense’.

Also important to note is that in a fair value hedge, the full fair value of the hedging instrument is recognised in the profit and loss account. Hence, ineffectiveness is not measured separately. The journal entries for the transaction are as shown in Table 3.

Hence the revenue is recognised, at a net amount of Rs. 810,000,000, which is equivalent to the value at the hedged rate i.e. the spot rate on the date of inception (18,000,000 * 45.000).

Net Investment in a Foreign Operation: Ind-AS 39 does not override the principles of Ind- AS 21, but it does provide the hedge accounting model for hedging an entity’s foreign exchange exposure arising from net investments in foreign operations.

A net investment hedge is a hedge of the foreign currency exposure, arising from a net investment in a foreign operation, using a derivative and/or a non-derivative monetary item as the hedging instrument.

The hedged risk is the foreign currency exposure arising from a net investment in a foreign operation when the net assets of that foreign operation are included in the financial statements. The application of hedge accounting for a net investment in foreign operation is relevant only for the consolidated financial statements of a group of companies.

Accounting for net investment hedges:

  •     If the hedging instrument in a net investment hedge is a derivative, then it is measured at fair value. The effective portion of the change in fair value of the hedging instrument is computed by reference to the functional currency of the parent entity against whose functional currency the hedged risk is measured.

  •     This effective portion is recognised in other comprehensive income and presented within equity in the foreign currency translation reserve. The ineffective portion of the gain or loss on the hedging instrument is immediately recognised in profit or loss.

  •     If the hedging instrument is a non-derivative, e.g. a foreign currency borrowing, then the effective portion of the foreign exchange gain or loss, arising on translation of the hedging instrument into the functional currency of the hedging entity, is recognised in Foreign Currency Translation Reserve.

  •     The effective portion is computed by reference to the functional currency of the parent entity, against whose functional currency the hedged risk is measured. Effectiveness is usually achieved if currency matches and notional amount of invest-ment is unlikely to go below notional amount of derivative, for e.g., due to losses incurred.

Hence, cumulative amounts are recognised in the other comprehensive income – changes on foreign currency translation of the foreign operation and effective portion of the gains or loss on the hedging instrument.

When a net investment in a foreign operation is disposed of, the cumulative amounts recognised previously in other comprehensive income, are re-classified to profit or loss. However, it is necessary for an entity to keep track of the amount recognised in other comprehensive income separately in respect of each foreign operation, in order to identify the amounts to be reclassified to profit or loss on disposal or partial disposal.

Let us look into net investment in foreign operations hedges in more detail by way of the following example.

Example 2: Hedges of net investment in a foreign operation

Company P is an Indian company with an Rs. functional currency. It has a subsidiary in the US, Company S, whose functional currency is $. The net investment of Company P in Company S is $ 10 million. The reporting dates of Company P for its consolidated financial statements are 30th September and 31st March. The group’s presentation currency is Rs.

On 1st April 20×1, Company P takes a two-year $ 10 million floating rate (Six month LIBOR) loan. Interest payment dates are 30th September and 31st March of the respective years. The loan matures on 31st March 20X3. It is assumed that no transaction costs are incurred relating to the loan issuance.

The management of Company P has decided to hedge its net investment in Company S by designating the $ denominated loan, in order to reduce the volatility in its consolidated balance sheet on account of foreign currency translation of its net investment in Company S. The net investment of Company P is not expected to fall below $ 10 million as company S is a profitable entity and has a profit forecast for future years as approved by the board of directors of Company P. However, on 30th September 20X2, the net investment of Company P in Company S decreases to $ 9.8 million on account of unexpected losses incurred by Company S.

As per hedge effectiveness testing, the hedge is 100% effective upto the time when losses are incurred by Company S which leads to a certain amount of ineffectiveness. Relevant details of the exchange and interest rates are as shown in Table 4 and Table 5 on page 90.

The journal entries for the transaction are as under:

At each period, following the process of consolidation of a foreign subsidiary’s net assets, Company P records a Foreign Currency Translation Reserve (FCTR) which is presented in Column C above. Journal entries relating to the loan are given in Table 6:

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