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Introduction
Institute of Chartered Accountants of India
(ICAI) had come out with an announcement in February 2011, on
Application of AS 30, Financial instruments: Recognition and
Measurement. It was clarified that ‘the prepares of Financial Statements
are encouraged to follow the principles enunciated in accounting
treatments contained in AS 30’. This is subject to any existing
accounting standard or any regulatory requirement, which will prevail
over AS 30. Thus, considering the above exception, an entity can only
follow ‘Hedge Accounting’ only to a certain extent i.e. only for forward
contracts for highly probable future transactions or firm commitments
in foreign currency, as these are excluded from the scope of AS 11.
This
Article brings out the aspect of hedging currency exposure during the
commitment period, by applying cash flow hedge accounting, taking a
currency forward contract as an example for the concept, accounting and
measurement; with limited application of AS 30, in line with ICAI’s
announcement in February 2011 in comparison to accounting such contract
without applying AS 30.
To begin with, till the time Ind AS
implementation dates are notified, entities can take the benefit of
following hedge accounting and avoid volatility in income statement that
arises from mark to market of forward contracts, taken for highly
probable forecast transactions or firm commitments.
Entities
enter into foreign exchange transactions during its regular course of
business. These foreign exchange transactions include purchase &
sale of goods and services as well as financing transactions such as
foreign currency borrowings to leverage the interest rates of the
international market. It is to be noted that these entities continue to
operate in India and are thus exposed to foreign exchange fluctuation.
Foreign Currency Exposure in a Business
Let
us consider an entity that has started a trading business with a $100
loan, received on 1/4/xx when the rate was Rs. 45. Thus the total loan
amount received in is Rs. 4,500. The same amount was invested to buy
goods for trade in the Indian domestic market. Assume the repayment
period of 12 months and margin of 10%, the entity could recover Rs.
4,950 (Rs. 4,500 investment and Rs. 450 profit) over a period of 12
months. If the exchange rate remains constant, there is no risk or
exposure to the entity on foreign exchange borrowings. It will be able
to retain Rs. 450 in its own bank account and repay the $100 loan by
transferring Rs. 4,500 to the lending bank.
In the above case,
if the exchange rate depreciates to Rs. 50, the expected cash obligation
for repayment of $100 loan will be Rs. 5,000. In this case, the entity
would lose the entire margin earned from its pure business and incur a
loss of Rs. 50 (Rs. 4,950 – Rs. 5,000).
The above example
considers one side exposure of foreign exchange. If the business was to
trade the goods in the international market with the dollar, it would
have been able to get some natural offset on exchange fluctuations on
the revenue front. This is because the debtors would have also got
converted in Rupees at a higher rate. Thus, the loss would have
restricted only to the extent of mismatch in foreign currency inflows
and outflows.
What is Hedge?
In simple terms, it is a
technique or an approach whereby the entity in the above example can
secure or protect its profit margin, even when the exchange rate
depreciates to Rs. 50. However, if the exchange rate goes to Rs. 40, the
opportunity to take advantage of the exchange is lost. Thus, the profit
may not increase but will remain intact.
It is to note that
hedging is not about gaining or losing. It is about fixing the price
risk, like freezing the volatility for the future. It can be on account
of interest rates, commodity prices, currency, etc.
“Hedge is a way of protecting oneself against financial loss or other adverse circumstances” – Oxford Dictionary
“A hedge
is an investment position intended to offset potential losses that may
be incurred by a companion investment. In simple language, Hedge
(Hedging Technique) is used to reduce any substantial losses suffered by
an individual or an organization.” – Wikipedia
An entity
can protect its profits and meet its business plan by entering into
various types of derivative contracts. Exposure on foreign currency can
be hedged by forward contracts, future contracts and currency options,
etc. These contracts can be entered into with various banks as counter
parties.
The entity can buy these contracts from market
participants such as banks who charge certain costs that include the
interest differential and transaction fees. This cost is known as
‘premium’. In above example discussed, the entity could protect its
margin by paying a premium, say Rs. 50, and thus, secure a net margin of
Rs. 400 irrespective of change in exchange rates.
Hedge Accounting:
“A hedging instrument
is a designated derivative or (for a hedge of the risk of changes in
foreign currency exchange rates only) a designated nonderivative
financial asset or non-derivative financial liability whose fair value
or cash flows are expected to offset changes in the fair value or cash
flows of a designated hedged item.
“A hedged item is an
asset, liability, firm commitment, highly probable forecast transaction
or net investment in a foreign operation that (a) exposes the entity to
risk of changes in fair value or future cash flows and (b) is designated
as being hedged”. (Paragraph 8 of AS 30)
The objective of Hedge accounting is to offset the gain/loss of the Hedge instrument with that of the hedge item.
A
hedge taken by way of a forward contract can be of two types, namely
cash flow hedge or fair value hedge. The governing factor for
identifying the correct type of designation is dependent on the hedged
item and goes with the objective of hedge accounting.
“Cash flow hedge is a hedge of the exposure to variability in cash flows that:
(i)
is attributable to a particular risk associated with a recognised asset
or liability (such as all or some future interest payments on variable
rate debt) or a highly probable forecast transaction and
(ii) could affect profit or loss.
Fair
value hedge is a hedge of the exposure to changes in fair value of a
recognised asset or liability or 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.” (Paragraph 86 of AS 30)
“A hedge of the foreign currency risk of a firm commitment may be accounted for as a fair value hedge or as a cash flow hedge.” (Paragraph 97 of AS 30)
As an exception to the identification of a type of hedge, entities can choose to account derivatives taken such as forward contracts, to hedge the foreign currency exposure on raw material or capital commitments, as either a ‘cash flow hedge’ or a ‘fair value hedge’.
As seen from various practical implementations, an entity usually chooses to designate such forward contracts as a cash flow hedge. This designation allows posting of mark to market (MTM) gains and losses in ‘hedging reserve’, which is part of reserves and surplus, without impacting the profit & loss account. Since the transaction will happen in the future, there is no offset available in the current period’s profit & loss account and hence, it is more logical to defer the impact till the transaction happens.
The documentation, accounting treatment and hedge effectiveness testing can be done on the assumption that the hedge is entered into prior to booking the asset and related liability in the accounts, i.e. there is only a commitment at the point the hedge is entered into.
Sample documentation for hedging a foreign currency exposure on firm commitment for purchase of raw material is illustrated in Table 2.
Table 2: Documentation for Hedging of a Foreign Currency Exposure
COMPLETED BY: ______________________________________
DATE: _________________
Application of AS 30 under existing Indian GAAP as per ICAI’s announcement:
ICAI vide its circular dated 11th February 2011, has clarified that in respect of the financial statements or other financial information for the accounting periods commencing on or after 1st April 2009 and ending on or before 31st March 2011, the status of AS 30 would be as below:
(i) To the extent of accounting treatments covered by any of the existing notified accounting standards (for eg. AS 11, AS 13 etc,) the existing accounting standards would continue to prevail over AS 30.
(ii) In cases where a relevant regulatory authority has prescribed specific regulatory requirements (e.g. Loan impairment, investment classification or accounting for securitisations by the RBI, etc), the prescribed regulatory requirements would continue to prevail over AS 30.
(iii) The preparers of the financial statements are encouraged to follow the principles enunciated in the accounting treatments contained in AS 30. The aforesaid is, however, subject to (i) and (ii) above.
From 1st April 2011 onwards
(i) the entities to which converged Indian accounting standards will be applied as per the roadmap issued by MCA, the Indian Accounting Standard (Ind AS) 39, Financial Instruments; Recognition and Measurement, will apply.
(ii) for entities other than those covered under paragraph (i) above, the status of AS 30 will continue as clarified in paragraph above.
Let us take an example of an Indian entity:
– Entered into a $ 100 payable commitment to import raw material on 1st January, 20xx
– Delivery of raw material is on 31st December, 20xx and payment on the same date.
– On 1st January, 20xx, the entity enters into a forward contract to hedge the foreign currency risk
– As part of the treasury policy, the entity first enters a shorter period contract till 30th June, 20xx
– Rolls it over on 30th June, 20xx to meet the cash outflow on 31st December, 20xx
– Refer Table 3 for details of exchange rates and MTMs on various dates.
Note:
a. Forward rates mentioned in the above table are the Mark to Market (MTM) rates. They are arrived at by considering the spot rate with reference to reporting date plus premium quoted for balance maturity of each contract on that date.
b. Forward rate and spot rate on final settlement is same because
the balance period in that case for premium quote is Zero.
c. Entity has designated the forward to hedge ‘forward rates’ and has been fully effective during the period.
Accounting Schema as follows:
1st January, 20xx:
The contract has zero value; therefore no entry is required. The commitment is also not yet recognised. The hedge is designated as cash flow hedge in line with the choice available under para 97 of AS 30 read with notification issued by ICAI in February 2011.
Example: A Forward cover is taken on 01/01/xx with maturity of 30/06/xx @ Rs. 42.5/$ for $100. There would be no accounting entry as on 01/01/xx.
31st March, 20xx:
The commitment is not yet recognised. MTM gain/loss on cover till the date of period closing would be recognised in hedging reserve (Equity), following cash flow hedge accounting.
As on 31/03/xx, forward cover for maturity of 30/06/xx is available @ Rs. 43.50/$, thus MTM gain of Rs. 1.00/$ (MTM forward rate – Original forward rate) would be accounted as under.
31/03/11 Debit Derivative Asset 100
Credit Hedging Reserve 100
30th June, 20xx:
The commitment is not yet recognised hence the cover is rolled forward. The rolled forward contract is treated as a new contract, part of the existing hedge strategy. It is still a Cash flow hedge.
[Paragraph 112a of AS 30:”……replacement or rollover of a hedging instrument into another hedging instrument is not an expiration or termination if such replacement or rollover is part of the entity’s documented hedging strategy”.]
As on 30/06/xx, the rolled forward rate is Rs. 44/$ for maturity of 31/12/xx when the spot rate is Rs. 43.75/$, thus following entries are passed:
a. For booking Settlement gain on cover (43.75/$ – 43.50/$) (i.e. Spot value – last MTM forward rate)
30/06/xx Debit Derivative Asset 25
Credit Hedging Reserve 25
b. Rollover gain received from bank (43.75/$ – 42.50/$) (i.e. Spot value – Original forward value)
30/06/xx Debit Bank 125
Credit Derivative Asset 125
30th September, 20xx :
The commitment is not yet recognised. MTM gain/ loss on cover till the date of period closing would be recognised in hedging reserve (Equity), following cash flow hedge accounting.
As on 30/09/xx, forward cover with maturity of 31/12/xx is available @ Rs. 44.50/$. Thus, MTM gain of Rs. 0.50/$ . (MTM forward rate $44.50– original forward rate of the rolled over contract $ 44.00)
30/09/xx Debit Derivative Asset 50
Credit Hedging Reserve 50
31st December, 20xx :
a. Record the purchase at spot rate of 43.5/$:
31/12/xx Debit Raw Material 4,350
Credit Liability 4,350
b. For booking MTM Settlement loss (43.50/$ – 44.50/$) (i.e. Spot value – last MTM forward rate)
31/12/xx Debit Hedging Reserve 100
Credit Derivative Asset 100
c. Record the payment of the liability to vendor
31/12/xx Debit Liability 4,350
Credit Bank 4,350
d. Net Settlement loss paid to bank (43.5/$ – 44.0/$) (i.e. Spot value – Original forward value)
31/12/xx Debit Derivative Asset 50
Credit Bank 50
e. Balance in hedging reserve transferred to income statement
31/12/xx Debit Hedging Reserve 75
Credit Cost of Goods Sold 75
The commitment recognised in books at the rate mentioned in Bill of lading and the change in fair value of forward contract from the date of inception to the date of recognising commitment is allocated to cost of raw material consumed.
“Paragraph 109b of AS 30: “It removes the as-sociated gains and losses that were recognised in other comprehensive income in accordance with paragraph 106, and includes them in the initial cost or other carrying amount of the asset or liability”
Note: As per AS 30 para 109b, head of Profit & Loss Account would depend upon the nature of underlying for which the cover the taken. Since AS 2 on Inventory Valuation does not permit MTM as part of valuation for unsold goods, the MTM will be released from hedging reserve to profit & loss account as and when the inventory is consumed. Thus the MTM will remain in Hedging Reserve till the underlying transaction is debited in Profit & loss account. This essentially in line with option available under para 109a of AS 30.
Refer table 4 for various accounts at a glance for entries passed above at various dates.
Commercial Analysis
It can be seen in the above example, that the organisation had an exposure on import of raw material. The exposure started from the date when it entered into a firm commitment and ended when the actual outflow is made.
The exchange rate has been volatile during the period as it moved upwards from Rs. 42.5/$ as on 01/1 to Rs. 44.25/$ on 30/9 before closing at Rs. 43.5/$ on 31/12. The company decided to fix its outflow on the date of its commitment and entered into a forward contract to buy dollars at Rs..42.5 per dollar. Subsequently the same contract was rolled over for meeting the scheduled payment to the creditor by incurring 0.25 paisa premium per dollar bought. The Company’s exposure was hedged by two contracts at the effective cost of Rs. 42.75 per dollar. These types of two contracts are common where the underlying exposure is longer.
The Company’s cost of raw material has not been impacted on account of the volatilities in foreign exchange rate and is accounted at Rs. 4,275. Refer Table 5 below to understand the effective rate per $.
The above entries hold true even when the entity has a commitment for capital asset. The raw material account in the above example will be replaced by fixed asset account/depreciation.
Accounting without Application of AS 30 Principles
The forward contract being taken for a firm commitment, will not fall under AS 11. It will have to follow the conservative principles of AS 1 as laid down by ICAI in its announcement on 29-03-08.
“In case an entity does not follow AS 30, keeping in view the principle of prudence as enunciated in AS 1, Disclosure of Accounting Policies, the entity is required to provide for losses in respect of all outstanding derivative contracts at the balance sheet date by marking them to market.”
In the above example, as on 31st March, the MTM is a gain and hence, there is no accounting entry for this contract. Had there been a loss in the contract, entity would have provided for the same.
The auditors would consider making appropriate disclosures in their reports if the aforesaid accounting treatment and disclosures are not made.
One may note that ICAI’s announcement dated 16-12-05 on disclosure continues to apply in both scenarios (i.e. AS 30 is applied or ICAI announcement dated 29-03-08 is followed). Thus, enterprises continue to make the following disclosures regarding Derivative
Instruments in their financial statements irrespective of accounting choice:
1. category-wise quantitative data about derivative instruments that are outstanding at the balance sheet date,
2. the purpose, viz., hedging or speculation, for which such derivative instruments have been acquired, and
3. the foreign currency exposures that are not hedged by a derivative instrument or otherwise.
A. Industry Applications
Mahindra & Mahindra Ltd (March 2012)
Derivative Instruments and Hedge Accounting:
The Company uses foreign currency forward contracts/options to hedge its risks associated with foreign currency fluctuations relating to certain forecasted transactions. Effective 1st April, 2007, the company designates some of these as cash flow hedges, applying the recognition and measurement principles set out in the Accounting Standard 30 “Financial Instruments: Recognition and Measurements”(AS 30).
Foreign currency forward contract/option derivative instruments are initially measured at fair value and are re-measured at subsequent reporting dates. Changes in the fair value of these derivatives that are designated and effective as hedges of future cash flows are recognised directly in reserves and the ineffective portion is recognised immediately in Profit & Loss Account.
The accumulated gains and losses on the derivatives in reserves are transferred to Profit and Loss Account in the same period in which gains or losses on the item hedged are recognised in Profit & Loss Account.
Changes in the fair value of derivative financial instruments that do not qualify for hedge accounting are recognised in the Profit & Loss Account as they arise.
Great Eastern Shipping (March 2012)
Derivative Financial Instruments and Hedging
Cash Flow Hedge:
Commodity future contracts, forward exchange contracts entered into to hedge foreign currency risks of firm commitments or highly probable fore-cast transactions, forward rate options, interest rate swaps and currency swaps which do not form an integral part of the loans, that qualify as cash flow hedges, are recorded in accordance with the principles of hedge accounting enunciated in Accounting Standard (AS) 30–Financial Instruments: Recognition and Measurement as issued by the Institute of Chartered Accountant of India. The gains or losses on designated hedging instruments that qualify as effective hedges is recorded in the Hedging Reserve Account and is recognised in the Statement of Profit and Loss in the same period or periods during which the hedged transaction affects profit and loss or is transferred to the cost of the hedged non-monetary asset upon acquisition. Gains or losses on the ineffective transactions are immediately recognised in the Statement of Profit and Loss. When a forecasted transaction is no longer expected to occur, the gains and losses that were previously recognised in the Hedging Reserve, are transferred to the Statement of Profit and Loss immediately.
Companies that have adopted AS 30 under Indian GAAP include Essar Shipping Limited, First Source Solutions, Tata Coffee, Sterlite Industries (I) Limited, etc.
