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:
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:
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.
Example 2: Hedges of net investment in a foreign operation
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: