Guide to Hedge Accounting under Ind AS 109/IFRS 9

– Qasim Saif | Manager | finserv@vinodkothari.com

Accounting of Hedge

Entities are exposed to financial risks arising from many aspects of their business. The nature of the risks varies with the nature of the business activities carried on by the business entities, for example, some entities might be concerned about exchange rates or interest rates, while others might be concerned about commodity prices. Entities implement different risk management strategies to eliminate or reduce their risk exposures.

The objective of hedge accounting is to represent, in the financial statements, the effect of risk management activities that use financial instruments to manage exposures arising from particular risks that could affect profit or loss (P&L) or other comprehensive income (OCI).

In simple terms, hedge accounting is a technique that modifies the normal basis for recognising gains and losses (or income and expenses) on associated hedging instruments and hedged items, so that both are recognised in P&L (or OCI) in the same accounting period. This is a matching concept that eliminates or reduces the volatility in the statement of comprehensive income that otherwise would arise if the hedged item and the hedging instrument were accounted for separately.

Under IFRS 9/Ind AS 109, hedge accounting is an option, and management can decide whether to use it after fulfilling the criteria for recognizing the hedge.

An entity is permitted but not mandated to designate a derivative contract as a hedging instrument. An entity may choose to designate a hedging relationship between a hedging instrument and hedged item in accordance with paragraphs 6.2.1–6.3.7 and B6.2.1–B6.3.25 of Ind AS 109/IFRS 9.

Where an entity designates a derivative contract as a hedging instrument, it needs to, meet the qualifying criteria as set under:

• Identify its risk management objective;
• Demonstrate how the derivative contract helps meet that risk management objective;
• Specify how it plans to measure the fair value of the derivative instrument if the derivative contract is effective in meeting its risk management objective (including the relevant hedge ratio);
• Document this assessment (of points (i), (ii), (v), (vi) and (vii) of this paragraph) at inception of the hedging relationship and subsequently at every reporting period;
• Demonstrate in cases of hedging a future cash flow that the cash flows are highly probable of occurring;
• Conclude that the risk that is being hedged could impact the statement of profit and loss; and
• Adequately disclose its accounting policies, risk management objectives and hedging activities in its financial statements.

In case a derivative contract is not classified as a hedging instrument because it does not meet the required criteria or an entity decides against such designation, it will be measured at fair value and changes in fair value will be recognised immediately in the statement of profit and loss.

Type of Hedges

The Ind AS 109/IFRS 9 retains the 3 classes of hedge as was previously in the IAS 39;

Fair Value Hedge

The risk being hedged in a fair value hedge is a change in the fair value of an asset or liability or an unrecognised firm commitment that is attributable to a particular risk and could affect P&L

Cash Flow Hedge

The risk being hedged in a cash flow hedge is the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability, an unrecognised firm commitment (currency risk only) or a highly probable forecast transaction, and could affect P&L.

Net Investment Hedge

An entity might have overseas subsidiaries, associates, joint ventures or branches (‘foreign operations’). It might hedge the currency risk associated with the translation of the net assets of these foreign operations into the parent entity’s functional currency.

Accounting of Fair Value Hedges

A fair value hedge seeks to offset the risk of changes in the fair value of an existing asset or liability or an unrecognised firm commitment that may give rise to a gain or loss being recognised in the statement of profit and loss.

When applying fair value hedge accounting, the hedging instrument is measured at fair value with changes in fair value recognised in the statement of profit and loss.

The hedged item is remeasured to fair value in respect of the hedged risk. Any resulting adjustment to the carrying amount of the hedged item related to the hedged risk is recognised in the statement of profit and loss even if normally such a change may not be recognised, e.g., for inventory being hedged for fair value changes.

The fair value changes of the hedged item and the hedging instrument will offset and result in no net impact in the statement of profit and loss except for the impact of ineffectiveness

An exception to recognition of fair value hedges through statement of profit and loss is fair value hedges of an equity instrument accounted for at fair value through other comprehensive income (FVOCI) since, gains/losses of equity instruments are not treated through P&L, changes in the fair value of the hedging instrument are also recorded in OCI.

However, a key aspect to be noted while deploying hedge accounting is that the adjusted carrying amounts of the hedged assets in a fair value hedging relationship are subject to impairment testing under other applicable Accounting Standards such as Accounting Standard (AS) 28, Impairment of Assets, Accounting Standard (AS) 2, Valuation of Inventories, Accounting Standard (AS) 13, Accounting for Investments etc.

Accounting of Cashflow Hedges

A cash flow hedge is a hedge of the exposure to variability in cash flows that

1. 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 or a firm commitment in respect of foreign currency and
2. could affect the statement of profit and loss. An example of a cash flow hedge is the hedge of future highly probable sales in a foreign currency using a forward exchange contract. Another example of a cash flow hedge is the use of a swap to change the future floating interest payments on a recognised liability to fixed rate payments.

Under a cash flow hedge, the hedging instrument is measured at fair value, but any gain or loss that is determined to be an effective hedge is recognised in equity, i.e. under cash flow hedge reserve. This is intended to avoid volatility in the statement of profit and loss in a period when the gains and losses on the hedged item are not recognised therein.

In order to match the gains and losses of the hedged item and the hedging instrument in the statement of profit and loss, the changes in fair value of the hedging instrument recognised in equity must be recycled from equity and recognised in the statement of profit and loss at the same time that the impact from the hedged item is recognised in the statement of profit and loss. The manner in which this is done depends on the nature of the hedged item.

Accounting of Net Investment Hedge

With rapid development of global economy, the companies with operations in multiple jurisdictions are exposed to changes in the carrying amount of the assets of the foreign operation arising from the conversion of those assets into the reporting currency of the investor as Ind AS 21 requires an entity to determine the functional currency of each of its foreign operations as the currency of the primary economic environment of that operation. When translating the results and financial position of a foreign operation into a presentation currency, the entity is required to recognise foreign exchange differences in other comprehensive income.

Hedge accounting of the foreign currency risk arising from a net investment in a foreign operation will apply only when the net assets of that foreign operation are consolidated.

Broadly Net Investment hedges shall be accounted as follows:

• foreign exchange gains and losses on a net investment in a foreign operation are recognised directly in equity i.e. through creation of a reserve
• gains and losses on foreign currency derivatives to the extent that the hedge is considered to be effective, used as hedging instruments are recognised directly in equity hence providing a netting off effect.
• the ineffective portion of the gains and losses on the hedging instruments is recognised in the statement of profit and loss
• When the net investment is disposed off, the cumulative amount in the foreign currency translation reserve in equity is transferred to the statement of profit and loss as an adjustment to the profit or loss on disposal of the investment

Hedge Effectiveness

Hedge effectiveness is the extent to which changes in the fair value or the cash flows of the hedging instrument offset changes in the fair value or the cash flows of the hedged item.

Hedge ineffectiveness is the extent to which the changes in the fair value or the cash flows of the hedging instrument are greater or less than those on the hedged item.

Criteria for determining hedge effectiveness

A hedging relationship is effective if it meets all of the following requirements:

• There is an economic relationship between the hedged item and the hedging instrument.
• The effect of credit risk does not dominate the value changes that result from that economic relationship.
• The hedging relationship is expected to be highly effective in achieving the stated risk management objective and the entity is in a position to reliably measure the achievement of this objective both at inception and on an ongoing basis during the tenure of the hedging relationship.

Assessment of Hedge Effectiveness

An entity will assess at the inception of the hedging relationship, and on an ongoing basis, whether a hedging relationship meets the hedge effectiveness requirements. At a minimum, an entity should perform the ongoing assessment at each reporting date or upon a significant change in the circumstances. The assessment relates to expectations about hedge effectiveness and is therefore only forward-looking.

There is normally a single fair value measure for a hedging instrument in its entirety, and the factors that cause changes in fair value are co-dependent. Thus, a hedging relationship is designated by an entity for a hedging instrument in its entirety that is to say splitting of instrument to designate as hedging instrument is not permitted (except in cases specified^[1]).

There is no one single method for how hedge effectiveness testing and ineffectiveness measurement should be conducted. The appropriate method for each entity will depend on the facts and circumstances relevant to each hedging programme and be driven by the risk management objective of the entity. Entities may apply commonly used measures such as critical terms match, dollar offset or regression methods as appropriate to assess hedge effectiveness.

Measurement of hedge effectiveness in itself can be a huge area for study. An effective method to determine hedge effectiveness would be the one having a blend of quantitative analysis and qualitative criteria.

Various statistical methods supported by proper documentation should be deployed in determining effectiveness of hedge. We shall try to deal with this topic in further detail in our subsequent write-ups.

Documentation at Inception of Hedge

At the inception of a hedge, formal documentation of the hedge relationship must be established. The hedge documentation prepared at inception of the hedge must include a description of the following:

1. the entity’s risk management objective and strategy for undertaking the hedge;
2. the nature of the risk being hedged;
3. clear identification of the hedged item (asset, liability or cash flows) and the hedging instrument;
4. demonstrate how the derivative contract helps meet that risk management objective;
5. identify how it plans to measure the derivative if the derivative contract is effective in meeting its risk management objective;
6. demonstrate in cases of hedging a future cash flow that the cash flows are highly probable of occurring; and
7. conclude that the risk that is being hedged could impact the statement of profit and loss.

There is no specific format for the documentation and in practice hedge documentation may vary in terms of lay-out, manner etc. Any format may be acceptable as long as the documentation includes the contents identified above.

Disclosure in Financial Statements

An entity should satisfy the broader disclosure requirements by describing its overall financial risk management objectives, including its approach towards managing financial risks. Disclosures should explain what the financial risks are, how the entity manages the risk and why the entity enters into various derivative contracts to hedge the risks.

The entity should disclose its risk management policies. This would include the hedging strategies used to mitigate financial risks. This may include a discussion of:

• how specific financial risks are identified, monitored and measured;
• what specific types of hedging instruments are entered into and how these instruments modify or eliminate risk; and
• details of the extent of transactions that are hedged.

An entity is also required to make specific disclosures about its outstanding hedge accounting relationships. The following disclosures are made separately for fair value hedges, cash flow hedges and hedges of net investments in foreign operations:

• a description of the hedge;
• a description of the financial instruments designated as hedging instruments for the hedge and their fair values at the balance sheet date;
• the nature of the risks being hedged;
• for hedges of forecast transactions, the periods in which the transactions are expected to occur, when they are expected to affect the statement of profit and loss, and a description of any forecast transactions that were originally hedged but now are no longer expected to occur. This Guidance Note does not specify the future time bands for which the disclosures should be made. Entities should decide on appropriate groupings based on the characteristics of the forecast transactions;
• if a gain or loss on derivative or non-derivative financial assets and liabilities designated as hedging instruments in cash flow hedges has been directly recognised in the hedging reserve: –
  • the amount recognised in hedge reserves during the period.
  • the amount recycled from the hedge reserve and reported in the statement of profit and loss.
  • the amount recycled from hedge reserve and added to the initial measurement of the acquisition cost or other carrying amount of a non-financial asset or non-financial liability in a hedged forecast transaction.
• a breakup of the balance in the hedge reserve between realised and unrealised components and a reconciliation of the opening balance to the closing balance for each reporting period.

Insofar as disclosure of derivatives designated for hedging foreign currency risks are concerned, the same should be disclosed in the Format attached as Appendix I to the Guidance Note on Accounting of Derivatives Contracts^[2], which also requires disclosure of all foreign exchange assets and liabilities including contingent liabilities, both hedged and unhedged.

Conclusion

In recent times, risk management has been an area of special interest for market participants as well as regulators, in such scenarios accounting plays a vital role in providing a true and fair view of the operations of the entity. Stakeholders expect accounting standards specially IFRS/Ind AS to enable companies to communicate better about their risk management, in particular how they use derivatives to manage risk.

Ind AS 109’s/IFRS 9’s hedge accounting requirements go beyond financial reporting. Their application may require changes to systems, processes and documentation and, in some cases, to the way companies view and manage risk. The accounting standards though act as a guide to financial reporting are slowly mandating an increased focus on non-financial reporting hence paving a way for integrated reporting

Accounting standards have lately been designed to enable the accounting to better reflect the risk management strategy, and that the disclosures are intended to bring increased transparency. This may well result in more attention and closer questioning of underlying risk management strategies, both by boards and by capital market participants and regulators.

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[1] (a) separating the intrinsic value and time value of an option contract and designating as the hedging instrument only the change in intrinsic value of an option and excluding change in its time value; and

(b) separating the interest element and the spot price of a forward contract.

[2] Guidance Note on Accounting of Derivatives Contracts