Hedge Accounting PDF

Corporate Reporting & Group Accounting Hedge Accounting  Agenda: Plan of the Day 1. Derivatives (accounting viewpoint) 2. Hedge Accounting 3. CF Hedge 4. FV Hedge 2 ...

Corporate Reporting & Group Accounting Hedge Accounting  Agenda: Plan of the Day 1. Derivatives (accounting viewpoint) 2. Hedge Accounting 3. CF Hedge 4. FV Hedge 2  Derivatives: Overview What are Derivatives? Derivatives FI (assets or liabilities) with three characteristics Value Initial Investment Settlement Changes in value in response to changes in a No initial net specified underlying investment (or a very Settled at a future date instrument (commodity small one) price, FX rate…) 3  Derivatives: Overview IFRS deals with financial instruments through the following standards: IFRS 9 Financial Instruments IAS 32 IFRS 7 Presentation Disclosure Financial Instruments 4  Derivatives: Measurement Derivative Contracts (FI) Initial Measurement Subsequent Measurement Fair Value (refer to IFRS 13) FVPL (FV through P&L)(1) Transaction costs are charged to P&L FVOCI (FV through OCI)(2) Measurement FVPL: gains and losses on FV changes in P&L (as you do with trading securities) FVOCI: gains and losses on FV changes in equity (OCI section) until they are realized (1) Non-hedging derivatives are always measured at FVPL 5 (2) OCI = Other Comprehensive Income  Hedge Accounting: Hedging Tools Hedging Instrument Hedged Item Financial instruments at FVPL (with Recognized asset or liability some exception) Firm’s commitment Derivatives Future cash flows No written option (generally) Aggregated exposures Hedge Accounting Managing risks using hedging instrument purposely to offset the variability in FV or Cash Flows of a hedged item (hedging relationship) Hedging relationship must be formally designed and effective Hedge accounting is optional! 6  Hedge Accounting: Types of Hedges Principle Hedges Risks Exposure to Cash Flow variability in CF IFRS 9 Exposure to Fair Value changes in FV 7  Hedge Accounting: Types of Hedges Two types of Hedging CF Hedge FV Hedge Hedge the risk in CF changes of: Hedge the risk in FV changes of: Variable-rate financial instruments Fixed-rate financial instruments (IRS/options) (IRS/options) Highly probable forecast transactions at Firm’s commitment to purchase or sell a future market price (forwards/options) commodity or a product for which that commodity makes up a portion of the Highly probable forecast transactions value (forwards/options) denominated in a foreign currency (currency forwards/options) Inventory (forwards/options) 8  Hedge Accounting: Types of Hedges FV changes in hedging instrument in OCI until the hedged item is recognized or affects P&L(1) Measurement CF Hedge Hedged item’s measurement doesn’t change FV changes in hedging instrument in P&L FV Hedge Hedged item measured at FV (changes in P&L) CF changes of hedged item recognised only when realized in cash CF Hedge Need to sterilize FV changes in hedging instrument (OCI) and release them in P&L as the Mismatch hedged item affects it (offsetting) FV changes of hedging instrument recognized immediately in P&L FV Hedge Need to match this with offsetting changes of hedged item Thus, measure hedged item at FV (1) The ineffective portion of the hedge (if any) is immediately recognized in P&L 9  Hedge Accounting: CF Hedge Lender A holds a portfolio of loan assets bearing variable interest based on the Central Bank Prime Lender A Rate Loan Portfolio (variable Lender A is exposed to CF risk due to fluctuations interest) in interest rates To hedge its position, Lender A purchases a pay- variable receive-fixed IRS matching with the Variable Fixed hedged item On 31.12.20X1, the Central Bank increases the prime rate by 0.25% Lender A takes a loss on the IRS because its FV declines due to higher future interest rate (IRS is Bank thus a liability) 10  Hedge Accounting: (NO) CF Hedge The FV loss on the IRS is recorded immediately in P&L If Lender A does NOT apply hedge accounting The positive impact of higher rates on the loan portfolio is only recognized as interest payments 1 are received over future periods This creates earnings’ volatility as the FV change on the IRS is recognized immediately but the 2 corresponding increase in earnings is recognized over future periods As a result, this accounting treatment does not accurately reflect the entity’s risk management 3 activities 11  Hedge Accounting: CF Hedge To prevent this accounting mismatch Lender A can choose to adopt hedge accounting (CF hedge) This would allow it to defer the current loss on the IRS to the periods where the variable interest rates affect P&L Without Hedging With Hedging(1) Current Subsequent Current Subsequent period period period period IRS Loss on IRS (100) - - (100) Increase in interest Portfolio income - 100 - 100 Total (100) 100 - - (1) If you apply Hedge Accounting (CF Hedge), the current FV loss is recognized in OCI (nothing goes to P&L). That loss will be shown in P&L over future periods, as the (increased) 12 interest income on the loan portfolio will be received  Hedge Accounting: FV Hedge Lender B holds a portfolio of loan assets bearing interest at 5% (fixed) which is accounted for at Lender B amortized cost Loan Portfolio (fixed Lender B is exposed to FV risk due to fluctuations interest) in interest rates To hedge its position, Lender B purchases a pay- fixed receive-variable IRS matching with the Fixed Variable hedged item On 12.31.20X1, the Central Bank decreases the prime rate by 0.25% Lender B takes a loss on the IRS because its FV declines due to lower future interest rate (IRS is Bank thus a liability) 13  Hedge Accounting: (NO) FV Hedge The FV loss on the IRS is recorded immediately in P&L If Lender B does NOT apply hedge accounting There is no change in the loans’ value (accounted for at amortized cost) and no impact on 1 earnings This creates earnings’ volatility as the FV change on the IRS is recognized but not for the loan 2 portfolio As a result, this accounting treatment does not accurately reflect the entity’s risk management 3 activities 14  Hedge Accounting: FV Hedge To prevent this accounting mismatch Lender B can choose to adopt hedge accounting (FV hedge) This would allow it to recognize FV changes of the loan portfolio in the same period as the derivative affects P&L Without Hedging(1) With Hedging Current Subsequent Current Subsequent period period period period IRS Loss on IRS (100) - (100) - Portfolio Gain in loans FV - - 100 - Total (100) - - - (1) Without hedging, there is no FV gain on the loan portfolio because it is recorded at amortized cost 15  Hedge Accounting: Pros & Cons Pros & Cons of hedge accounting Pros Reduced earnings volatility Avoid risk taking (since you are hedged) Benefits Financial statement representation consistent with the firm’s risk management activities Cons Strict account rules and heavy reporting & disclosure requirements Challenges Ongoing monitoring costs Hedges can become ineffective 16  CF Hedge: Overview What is a Cash Flow Hedge? CF Hedge Hedge of exposure to variability in CF that is attributable to a particular risk that could affect P&L associated with a Recognized asset or Highly probable forecast OR liability transaction Without hedge accounting, the CF changes of the hedging instrument is recognized prior to that for the hedged item(1) (1) With hedge accounting, gains or losses arising from CF changes of the hedging instrument are held in OCI until the hedged item is recognized. Therefore, a CF hedge delays the 17 recognition of the CF changes related to the hedging instrument  CF Hedge: Overview Hedging The effective portion of changes in value are recognized as a CF hedge reserve in OCI CF Hedge (accounting treatment) Instrument No changes in value are recognized Hedge Item ∆ Hedging Instrument > ∆ Hedged Item Recognized immediately in P&L Hedge ineffectiveness ∆ Hedging Instrument < ∆ Hedged Item Recognized in P&L when affected CF occur 18  CF Hedge: Overview Eventually, CF relating to hedged item will be recognized in P&L, either directly or through an asset or liability (they that will affect P&L in future periods) The subsequent accounting for the CF hedge reserve depends on the item being hedged Hedged forecast transaction resulting in recognition of a non-financial asset or non-financial liability Remove and include in the initial cost of the asset and liability. There is no impact on P&L until the asset or liability is amortized, sold or settled All other hedged items Reclassified to P&L in the same period(s) during which the hedged item’s CF affect P&L 19  CF Hedge: Example 1 On 30.09.20X1, Firm A entered into a futures contract to purchase 20 tons of iron on 15.01.20X2 for $80/ton Firm A did this to hedge its exposure to price risk in relation to its highly probable purchase of 20 tons of iron on 15.01.20X2 At 31.12.20X1, a futures for 15.01.20X2 delivery of iron is priced at $85/tons, resulting in a gain of $100 Gain = 20 tons * ($85/tons – $80/tons) = $100 Because the critical terms of the arrangement match (i.e. the underlying, delivery date and nominal amounts are all identical), there is no hedge ineffectiveness 20  CF Hedge: Example 1 Journal Entries are as follows: Date Journal Entry (JE) Dr ($) Cr ($) 30.09.X1 (Nothing since futures contract)(1) - - 31.12.X1 Derivative asset 100 31.12.X1 OCI 100 At 30.09.X1, no JE since a future doesn’t require any cash movement at inception (opposite to options) At 31.12.X1, FV changes in the futures are recognized in OCI (effective portion) P&L (ineffective portion; nothing in this case) (1) We assume transaction costs are irrelevant 21  CF Hedge: Example 1 On 15.01.20X2, Firm A: 1 Settles the futures net when the spot price is $84.50/ton, receiving cash of $90(1) 2 Records an adjustment to the CF hedge reserve of $10(2) 3 Completes the purchase of iron for $1,690 (20 tons · $84.50) The Company also records the adjustment of the CF hedge reserve to the carrying value of the inventory on initial recognition (1) This is equal to 20 tons · ($84.50/ton - $80/ton) 22 (2) This is equal to 20 tons · ($85/ton - $84.50/ton)  CF Hedge: Example 1 Journal Entries are as follows: Date Journal Entry (JE) Dr ($) Cr ($) 15.01.20X2 Cash 90 Futures Settlement 15.01.20X2 OCI 10 15.01.20X2 Derivative asset 100 15.01.20X2 Inventory 1,600 Inventory 15.01.20X2 OCI 90 purchase 15.01.20X2 Cash 1,690 Without Hedge Accounting, inventory would have been recognized for $1,690 Instead, we recognize it for $1,600 because we use the OCI reserve to offset the difference ($90) 23  FV Hedge: Overview What is a Fair Value Hedge? FV Hedge Hedge of exposure to changes in FV that is attributable to a particular risk that could affect P&L associated with a Recognized asset or Unrecognized firm OR liability commitment FV hedges recognize the FV change of the hedged item in the current period to offset the change in the hedging instrument(1) (1) Therefore, there is earlier recognition of the FV change in the hedged item than if the hedge accounting was not applied 24  FV Hedge: Overview Hedging Recognize FV changes in P&L (typical treatment for a derivative) FV Hedge (accounting treatment) Instrument Recognize: FV change in P&L, corresponding adjustment to carrying amount of Hedge Item hedged item on the BS Hedge Recognized automatically through any differences between the amount by which ineffectiveness the hedging instrument and the hedged item are adjusted 25  FV Hedge: Overview Accounting for FV change in the hedged item: 1 Firm commitment to acquire asset or assume liability FV change of commitment recognized during the hedge life in the BS as an asset or liability with a corresponding P&L entry When the commitment is met, the cumulative FV change is included in the CA(1) of the recognized asset/liability 2 Financial instrument measured at amortized cost FV change of financial instrument included in the CA of the asset or liability and amortized into P&L through recalculation of the effective interest rate Amortization may begin as soon as an adjustment exists 3 Debt instrument measured at FVOCI FV change of the financial instrument is included in the CA of the asset or liability and amortized into P&L Amortization only applies to the amount of the debt instrument that represents the cumulative gain/loss previously recognized in P&L (1) CA = Carrying Amount 26  FV Hedge: Example 1 On 01.01.20X1, Firm A issues a fixed-rate bond for $100,000 paying 8% yearly and maturing in three years It then enters into an IRS to convert the fixed-rate debt into a variable one (FV Hedge) It receives 8% fixed It pays LIBOR (8% at inception) On inception, the IRS has a FV of zero. Therefore: Nothing shows up in Firm A’s accounts 27  FV Hedge: Example 1 Journal Entry at 01.01.20X1: Date Journal Entry (JE) Dr ($) Cr ($) 01.01.X1 Cash 100,000 01.01.X1 Bond 100,000 On 31.12.20X1, Firm A makes the required interest payment Date Journal Entry (JE) Dr ($) Cr ($) 31.12.20X1 Interest charge 8,000 31.12.20X1 Cash 8,000 During Year 1, interest rates declined to 6%. Firm A must then Record its debt at FV (since it applies FV Hedge Accounting) Record the change in FV of the IRS (nil at inception) 28  FV Hedge: Example 1 Firm A makes the following entry to record its debt at FV: Date Journal Entry (JE) Dr ($) Cr ($) 31.12.X1 FV Loss 3,667 31.12.X1 Bond 3,667 The debt PV over its remaining 2-year life at 6% is, in fact, $103,667 The fall in interest rates to 6% means that Firm A will save $2,000 each year in interest payment The PV of a $2,000 annuity for two periods at 6% is $3,667 The FV of the IRS thus increases from $0 to $3,667 Date Journal Entry (JE) Dr ($) Cr ($) 31.12.X1 IRS 3,667 31.12.X1 FV gain 3,667 29  FV Hedge: Example 1 In year 2, Firm A records interest expense on its debt: Date Journal Entry (JE) Dr ($) Cr ($) 31.12.X2 Interest charge (6%· $103,667) 6,220 31.12.X2 Debt (plug) 1,780 31.12.X2 Cash (8%· $100,000) 8,000 Firm A uses the effective interest method Then, it records interest revenue for the PV change of the IRS Date Journal Entry (JE) Dr ($) Cr ($) 31.12.X2 IRS 220 31.12.X2 Interest income (6%· $3,667) 220 Third, it receives $2,000 under the IRS contract Date Journal Entry (JE) Dr ($) Cr ($) 31.12.X2 Cash [$100,000 · (8% - 6%)] 2,000 31.12.X2 IRS 2,000 30  FV Hedge: Example 1 Lastly, Firm A must revaluate its debt and IRS for FV changes: Interest rates increased during year 2 to 10% The PV of the remaining payments on the debt at 10% is $98,182 Debt BV before this revaluation was $101,887 ($103,667 - $1,780) Date Journal Entry (JE) Dr ($) Cr ($) 31.12.X2 Bond 3,705 31.12.X2 FV gain ($101,887 - $98,182) 3,705 The FV of the IRS decreases. Firm A must now pay an additional $2,000 in year 3 because of the IRS (FV of $2,000 at 10% is $1,818) IRS BV before this revaluation was $1,887 ($3,667 + $220 - $2,000) Date Journal Entry (JE) Dr ($) Cr ($) 31.12.X2 FV Loss 3,705 31.12.X2 IRS (asset) 1,887 31.12.X2 IRS 1,818 31  FV Hedge: Example 1 The entries for year 3 are following: Date Journal Entry (JE) Dr ($) Cr ($) 31.12.X3 Interest charge (10%· $98,182) 9,818 31.12.X3 Debt (plug) 1,818 31.12.X3 Cash (8%· $100,000) 8,000 Date Journal Entry (JE) Dr ($) Cr ($) 31.12.X3 Interest charge (10%· $1,818) 182 31.12.X3 IRS 182 Firm A must also pay an extra 2% on the IRS contract Date Journal Entry (JE) Dr ($) Cr ($) 31.12.X3 IRS [$100,000 · (10% - 8%)] 2,000 31.12.X3 Cash 2,000 32  FV Hedge: Example 1 Lastly, Firm A must repay the debt and close out the IRS Date Journal Entry (JE) Dr ($) Cr ($) 31.12.X3 Bond ($98,182 + $1,818) 100,000 31.12.X3 Cash 100,000 The IRS has a zero balance ($1,818 + $182 - $2,000) on 31.12.20X3 after making the entries above Therefore, no additional entries are required to close out this account 33