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.
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:
