In Parts One and Two, we discussed definition, recognition, classification and measurement principles of financial assets and financial liabilities. In this part, we will discuss the definition and accounting for derivatives including principles of hedge definition, recognition and accounting.
Derivatives
A derivative is a financial instrument or other contract which has all the following 3 characteristics (para 8.1 of AS-30) :
· Its value changes in response to changes in an underlying (the underlying could be a specified interest rate, a financial instrument, a commodity, a currency, an index, a credit rating or index, or other variable).
· It requires no or small initial net investment (than the investment that would be required if an entity were to enter into other contracts that would be expected to have a similar response to changes in the price of the underlying).
· It is settled at a future date.
Common examples of derivatives are forwards, futures, calls, puts and swaps. Derivatives may be exchanged, traded or over-the-counter contracts. If the underlying is a non-financial variable, the standard specifies that the variable should not be specific to a party to the contract. Derivative contracts may be net settled or gross settled. The definition and accounting of a derivative does not depend upon the method of settlement. In both settlement systems, the accounting remains the same.
If a company buys crude oil futures on a commodity exchange, it typically pays a small initial margin that may range from 5 to 20%. The company is exposed to risk arising from movements in the price of crude oil, which will impact prices of crude oil futures resulting in gains or losses. The contract will be settled at a future date. In practice, most futures contracts are net settled. If the company bought futures at a price of $ 41 per barrel and on the date of expiry the price of spot and futures (which will converge on expiry) is $ 47, the company would have gained $ 6 per barrel, which would be paid to the company on expiry in a net settlement framework. In a gross settlement framework, the company would pay $ 41 and receive delivery of crude oil.
Recognition and Measurement
A derivative instrument is by default classified as a financial asset or a financial liability held for trading. Derivatives which are financial guarantees or designated as hedging instruments are exceptions. Assets and liabilities held for trading fall under the broader category ‘Financial Assets and Li-abilities held at fair value through Profit and Loss’.
Accordingly, derivatives (other than exceptions above) are initially recognised at fair value on the date of acquisition or issue (para 47 of AS-30). Transaction costs are recognised as expenses. Subsequently, they continue to be carried at fair value without deduction for transaction costs that may be incurred on sale or disposal (para 51 and 52 of AS-30).
As a consequence of continuous fair valuation of derivative positions, corporates will be exposed to earnings volatility. Derivative fair values are known to fluctuate substantially and a high exposure to derivatives which do not qualify for hedge accounting treatment is a major challenge that corporates need to manage well.
Example of a Forward Contract
The accounting community will be familiar with recognition and measurement of forward dollar contracts under the AS-11 framework. The principles of AS-30 are quite different and it may be useful to compare the two methodologies.
Corporate XYZ Ltd. buys a three-month forward dollar contract for $ 1 on May 1, 2009 at a forward rate of Rs. 50.25. The spot rate on that day was Rs. 49.65 and the premium paid on the forward was Rs. 0.60. The contract was entered into to hedge an import payment that is due three months later.
Let us assume that the spot rate on June 30, 2009 was Rs. 51 and the forward rate of a one month forward on June 30, 2009 was Rs. 51.12.
AS 11 Framework
The premium of Rs. 0.60 will be amortised over three months. The June quarter financials will therefore recognise an expense of Rs. 0.40 (two months proportionate amortisation). On June 30, 2009, the forward contract will be revalued to spot Rs. 51.00. However, the underlying payable will also be revalued to Rs. 51.00. The impact of revaluing the underlying payable and the long forward will offset each other so that the impact on the profit would be zero.
AS-30 Framework
There is no concept of amortisation of forward premium. The derivative contract would be recognised at fair value on the date of inception. A typical on-market forward would have a fair value of zero on the date of inception. In other words, if the corporate were to turn around and square up the contract immediately after inception, it would be able to do so at the same forward rate as it contracted.
At quarter end, the derivative contract will be fair valued. If the contracted forward rate was Rs. 50.25 and the forward rate on June 30, 2009 was Rs. 51.12, the corporate has generated a gain of Rs. 0.87. This will be present valued (discounted) as there is one month left for expiry. Suppose the present value comes to Rs. 0.86. This is the fair value of the derivative to be recognised as an Asset in the Balance Sheet as at June 30, 2009. Please note that the spot rate of the dollar on June 30, 2009 is not relevant for fair valuing the forward contract, but would be relevant for revaluing the underlying payable.
The second effect of this fair valuation could either be recorded as a gain in the Profit and Loss account or could be carried to Hedging Reserves, depending upon whether the derivative contract qualifies as a hedge and the type of hedge definition.
Hedge Accounting
Hedge Accounting is a choice of accounting policy which corporates mayor may not exercise. Hedge accounting allows the corporate to offset the volatility which earnings are exposed to as a consequence of derivative fair valuation at the end of every reporting period. It allows the corporate to either recognise an offsetting gain or loss in the profit and loss itself (and thus negate the derivatives impact) or to recognise the derivative gains or losses
directly in reserves. While it is common to hedge using derivative instruments, it is possible to use regular financial non-derivative instruments for hedging.
The AS-30 framework envisages primarily two types of hedged risks:
(a) those arising from changes in fair values of existing assets, existing liabilities or unrecognised firm commitments (Fair Value Hedging), and
(b) those arising from changes in future cash flows (which could emanate from existing assets, existing liabilities, as well as from highly probable forecasted transactions) (Cash Flow Hedging).
Both risks should affect profit and loss of the entity in order to qualify for hedge accounting treatment. Some examples of underlyings, risks, classification for the purpose of hedging and type of hedge are provided below. The type of hedge indicated here is the one most commonly designated, but it is possible to argue that a cash flow hedge also exposes a corporate to a fair value risk and vice versa and hence such designations need to be effected with care.
Hedge Definitions and Effectiveness
Each hedge should be formally documented in an elaborate manner. The documentation will include a formal risk management policy, the hedging instrument, the hedged item, the hedged risk, effectiveness testing methodology to be adopted by the corporate and approval processes. This area needs involvement of non-accounting managers from the corporate, including the top management, operations and treasury.
Effectiveness testing is required on a prospective basis to establish that the hedge is expected to be effective in managing the risk which it seeks to mitigate. At each reporting period end, the hedge needs to be retrospectively tested to establish whether it was de facto effective in its stated objective. The standard specifies that the change in the fair value of the hedging instrument should retrospectively fall between 80% to 125% of the change in the value of the hedged item attributable to the hedged risk. If the hedge is not effective, hedge accounting principles cannot be applied.
Accounting for Fair Value Hedges
In fair value hedges, gains and losses arising from both instruments, viz., the hedged item and the hedging instrument are recognised in the statement of profit and loss, thus creating an offset such that the net gains or losses impact the reported profit. In more formal terms, the following treatment is adopted:
- Gain or loss arising from re-measuring the hedging instrument at fair value is recognised in the statement of profit and loss.
- Gain or loss arising from the hedged item attributable to the hedged risk is recognised in the statement of profit and loss.
Example – Export Receivables
Corporate XYZ has exported merchandise for $ 100,000 recognised at spot rate of Rs. 50 on the day of export. The corporate sold 3-month forward dollars at Rs. 50.60 on the same day. At the quarter end, the spot rate was Rs. 50.75 and forward rate (of an equivalent tenor as that outstanding on that forward) was Rs. 51.02.
The corporate needs to designate the risk sought to be hedged in a precise manner. This risk can be defined in two ways (a) risk of the volatility of the spot dollar (b) risk of the volatility of the forward dollar. Each designation will lead to difference in hedge accounting measurements as well as effectiveness.
Risk of Spot Volatility
The spot has moved by Rs. 0.75 while the forward has moved by Rs. 0.42 between the date of export and the period end. The forward would be discounted to present value as the realisability of the forward is expected only on its final settlement. Let us assume the present value of the forward gain is Rs. 0.41. Hedge effectiveness percentage would come to 55% and the hedge would fail. The derivative fair value will be charged to the profit and loss statement while the receivable would be revalued under AS-l1 and the restatement gain taken to the profit and loss statement.
Risk of Forward Volatility
The forward element of the receivable has hypothetically moved by Rs. 0.41 (when fair valued) and the forward contract has also moved by Rs. 0.41 (when fair valued). Thus the hedge is effective. This loss on the forward would be recognised in the statement of profit and loss, while the movement in the spot would be recognised under AS-II in the profit and loss.
The final impact on the net profit is the same in this illustration, irrespective of whether the hedge is effective or otherwise. However, the line item classification within the statement of profit and loss may differ. Hedged items related gains and losses are commonly classified along with the underlying transactions while gains and losses on ineffective hedges are classified as derivative losses, which, if material, would merit a separate line item disclosure in the statement of profit and loss.
Cash Flow Hedge Accounting
Gains and losses on hedging instruments designated as cash flow hedges, if effective, are recognised directly in equity (generally in Hedging Reserves). These gains and losses are recycled into the statement of profit and loss when the underlying transaction impacts the statement of profit and loss.
Example – Forecasted Revenue
Corporate ABC forecasts dollar revenues of $ 10mio for the year to end March 2010. These sales relate to the month of January 2010. It faces a risk of dollar volatility and has sold forward dollars for each month in this financial year so as to hedge itself at Rs. 51.27 today, when the spot dollar was Rs. 50. At the end of the June quarter, spot dollar was Rs. 50.65 while the forward dollar of equivalent tenor was Rs. 51.75.
The corporate needs to designate the hedged risk in a precise manner. In particular, the hedged risk may be defined as (a) the risk of volatility in the spot or (b) the risk of volatility in the forward.
If the spot risk is designated, hedge effectiveness will be tested as under. Change in the value of the hedging instrument (based on forward dollar) is Rs 0.48, while the change in the value of the hedged item (i.e., forecasted revenues based on spot dollar) is Rs. 0.65. The hedge effectiveness ratio will work out to 74% and the hedge will be considered ineffective. Please note that the forward dollar will need to be present valued to arrive at the fair value, but that process will make the hedge further ineffective.
The loss on the forward will be recognised in the statement of profit and loss as the hedge is ineffective.
If the forward risk is designated, hedge effectiveness will be computed at 100% (as both the hedging instrument and the hedged item will change by the same amount of the present value of Rs. 0.48). The loss on the forward will therefore be recognised in equity. This accounting process will shield the present earnings from derivative volatility.
In the quarter in which the revenue forecasted actually happens (in our example the Jan.-March 2010 quarter), the cumulative gains or losses parked in reserves will be recycled into the statement of
profit and loss.
Conclusion
Derivative accounting and hedge accounting are complex areas which need a deep understanding of economic hedging, derivative instruments, risk management concepts as well as the accounting standard requirements. Systemic challenges around hedge definitions and accounting are stringent and corporates need to plan in advance to establish these systems well. In many cases, a committed involvement of operational managers as well as information technology is required to implement hedge accounting successfully.
