ACCA SBR ^INT Syllabus C. Reporting The Financial Performance Of A Range Of Entities - Hedging - Notes ^{11 / 14}

Objective

To manage risk companies often enter into derivative contracts

• e.g. Company buys wheat - so it is worried about the price of wheat rising (risk).

• To manage this risk it buys a wheat derivative that gains in value as the price of wheat goes up.

• Therefore any price increase (hedged item) will be offset by the derivative gains (hedging item)

  So, the basic idea of hedge accounting is to represent the effect of an entity’s risk management activities

IFRS 9 changes

• IFRS 9 has made hedge accounting more principles based to allow for effective risk management to be better shown in the accounts

• It has also allowed more things to be hedged, including non-financial items

• It has allowed more things to be hedging items also - options and forwards

• There also used to be a concept of hedge effectiveness which needed to be tested annually to see if hedge accounting could continue - this has now been stopped. 

  Now if its a hedge at the start it remains so and if it ends up a bad hedge well the FS will show this

Accounting Concept

The idea behind hedge accounting is that gains and losses on the hedging instrument and the hedged item are recognised in the same period in the income statement 

It is a choice - it doesn’t have to be applied

There are 3 types of hedge:

1. Fair value hedges

   IAS 39 defines a fair value hedge as 'A hedge of the exposure to changes in highly probable fair value of a recognised asset or liability; or a previously unrecognised firm commitment, or an identified portion of an asset, liability or firm commitment that is attributable to a particular risk and could affect profit or loss.'

   Here we are worried about an item losing fair value (not cash). 

   For example you have to pay a fixed rate loan of 6%. If the variable rate drops to 4% your loan has lost value. If the variable rate rises to 8%, then you have gained in fair vale

   Notice you still pay 6% in both scenarios - so the risk isn’t cashflow - it is fair value

2. Cash flow hedges

   Here we are worried about losing cash on the item at some stage in the future

   For example, you agree to buy an item in a foreign currency at a later date. If the rate moves against you, you will lose cash

3. Hedges of a net investment in a foreign operation

   This applies to an entity that hedges the foreign currency risk arising from its net investments in foreign operations

Hedged items

The hedged item is the item you’re worried about - the one which has risk (which needs managing)

A hedged item can be:

• A recognised asset or liability (financial or not)

• An unrecognised commitment

• A highly probable forecast transaction

• A net investment in a foreign operation

They must all be separately identifiable, reliably measurable and the forecast transaction must be highly probable.

When can we use hedge accounting?

The hedge must meet all of the following criteria: (replacing the old 80-125% criteria)

• An economic relationship exists between the hedged item and the hedging instrument – meaning as one goes up in FV the other will go down

  For example, a UK company selling to US customers - enters into a $100 to £ futures contract which ends when the UK company is expected to receive $100

  Here - the future $ receipt will be the hedged item and the futures contract the hedging item 

  In the above example it is an obvious economic relationship as it’s the same amount and same timing

  However, sometimes the amounts and timings won’t be the same so you may use judgement as to whether this is actually a proper hedge or not - here numbers could be used

• Credit risk doesn’t dominate the fair value changes 

  So, after having established an economic relationship (above) - IFRS 9 just wants to make sure that any credit risk to the hedged or hedging item wont affect it so much as to destroy the relationship

Accounting treatment

• Fair Value Hedges

  Gains and losses of both the Hedged and Hedging item are recognised in the current period in the income statement

• Cashflow hedges

  Here the hedged item has not yet made its gain or loss (it will be made in the future e.g. Forex)

  So, in order to match against the hedged item when it eventually makes its gain or loss, the “effective” changes in fair value of the hedging instrument are deferred in reserves (any ineffective changes go straight to the income statement)

  These deferred gains/losses are then taken from reserves/OCI and to the income statement when the hedged item eventually makes its gain or loss

• Hedges of a net investment in a foreign entity

  Same as cash-flow, changes in fair value of the hedging instrument are deferred in reserves/OCI 

  Normally individual company forex gains/losses are taken to the income statement and foreign subsidiary retranslation gains/losses taken to the OCI/Reserves.

  So, lets say a UK holding company has a UK subsid and a Maltese subsid. The Malta sub also has loaned the UK sub some cash in Euros.

  Normally the UK sub would retranslate this loan and put the difference to the income statement. Also the Maltese sub is retranslated and the difference taken to OCI. Here, it is allowed for the UK sub to hold the translation losses also is reserves (like a cashflow hedge) as long as the loan is not larger than the net investment in the Maltese sub

Special cases of hedging items which reduce P&L Volatility

1. Options - time value element when intrinsic value of option is the designated hedging  item

   If the hedging item is an option - then the time value changes in that option will be taken to the OCI (and equity)

   When the hedged item is realised, these then get reclassified to P&L

2. Forward points - when the spot element of a forward contract is the designated hedging item

   If the hedging item is a forward contract then the forward points FV changes MAY be taken to OCI, and again gets reclassified when the hedged item hits the I/S

3. Currency basis risk

   The spread from this can be eliminated from the hedge - and instead either be valued as FVTPL or FVTOCI(with reclassification)

Illustration of a FV Hedge

5% 100,000 fixed rate 5 year Receivable loan. (Current variable rates 5%).

Here we are worried that variable rates may rise above this - if they did then the FV of this receivable would worsen. 

So we would have a FV loss. 

If the variable rates go lower, then we are happy (as we are receiving a fixed rate) and so the FV would improve.

This company hedges against the variable rates going down - by entering into a variable rate swap (This is the hedging item).

With this derivative, if variable rates rise we will benefit from receiving more but the FV of our fixed rate receivable loan will have lowered. 

These 2 should cancel themselves out.

Market interest rates then increase to 6%, so that the fair value of the fixed rate bond has decreased to $96,535. 

As the bond is classified as a hedged item in a fair value hedge, the change in fair value of the bond is instead recognised in profit or loss:

At the same time, the company determines that the fair value of the swap has increased by $3,465 to $3,465.

Since the swap is a derivative, it is measured at fair value with changes in fair value recognised in profit or loss. Therefore, Entity A makes this journal entry:

Since the changes in fair value of the hedged item and the hedging instrument exactly offset, the hedge is 100% effective, and the net effect on profit or loss is zero.

Illustration Cashflow Hedge

Company has the euro as its functional currency. It will buy an asset for $20,000 next year.

It enters into a forward contract to purchase $20,000 a year´s time for a fixed amount (€10,000).

Half way through the year (the company’s Year-end)  the dollar has appreciated, so that $20,000 for delivery next year now costs €12,000 on the market.

Therefore, the forward contract has increased in fair value to €2,000

Solution

When the company comes to pay for the asset, the dollar rate has further increased, such that $20,000 costs €14,000 in the spot market.

Therefore, the fair value of the forward contract has increased to €4,000

The forward contract is settled:

The asset is purchased for $10,000 (€14,000):

The deferred gain left in equity of €4,000 should either

Remain in equity and be released from equity as the asset is depreciated or

Be deducted from the initial carrying amount of the machine.