I am Daniel, new around here. Excellent forum. very informative
I am really struggling to understand hedge accounting
Would someone be able to provide an example (very simple please) to account for hedges under fair value, cashflow and changes in net assets of subsidiaries
I tried going through IFRS 9 but couldn't understand
This is quite a vast topic that is not easy to explain in a few words. Hedge accounting is designed to address an accounting mismatch created by IFRS 9 rules. When companies hedge existing or futures exposures, they often use derivatives. Derivatives are always accounted for at FVTPL, but the hedged exposures are often accounted for differently (at amortised cost or at FVOCI), or not yet recognised on the balance sheet (e.g. highly probable future purchases or sales). A hedge is a fair value hedge, a cash flow hedge or a net investment hedge depending on the exposure that you are hedging. Below are a few examples:
- If you have a fixed rate borrowing, you are exposed to fair value risk caused by changes in interest rates movements. If interest rates go up, your liability is worth less (because you are paying less interest than the market), and if they go down your liability is worth more (because now you are paying more interest than the market). You may decide to enter into an interest rate swap where you will swap your fixed interest payments to floating interest payments. In this case you have a fair value hedge.
- Conversely, if your borrowing is at a variable rate, you have a cash flow risk because you don't know if you are paying more or less interest in the future (interest will depend on how market rates move). You may then decide to hedge this risk by swapping your floating interest payments for fixed interest payments with a float-to-fix interest rate swap. In this case you have a cash flow hedge.
- As for net investment hedges, you need to understand that when you consolidate some of your foreign subsidiaries often their functional currencies are different from the group's presentation currency. A classic example of a net investment hedge is when you have actually borrowed money in a foreign currency to acquire your foreign sub. The foreign currency borrowing will be translated into the group's functional currency (which usually is also the presentation currency) and any FX differences are booked in P&L. But when you translate the consolidated net assets of your acquired sub into the group's presentation currency, any FX differences are booked in equity in an account called cumulative translation reserve. If you want to avoid this mismatch, you can apply net investment hedge accounting and the FX differences on your foreign currency borrowing are now allowed to be booked in equity as well.
I advise you to have a look at a PwC's document called "achieving hedge accounting in practice". You can find it online. Then if you have any specific questions, you can always come back and ask.
Looking at examples, if I am meant to receive payment in USD, as a seller in UK. If I do a forward or futures contract hedge - is it cashflow hedge no?
If it is a highly probable forecast transaction, it is a cash flow hedge. But if it is a firm commitment to receive USD, it can be accounted for as a cash flow hedge or a fair value hedge.
Thanks - and for example - if we want to hedge commodities prices - this would be cash flow right? Either if forecasted or firm commitment? For example, I want to buy oil, fix the price now for what I am paying in the future.
I assume that you mean commodities prices in your own functional currency. In that case:
If you want to hedge a highly probable forecast purchase of oil, that is a cash flow hedge (you want to fix the price and not have variability in your cash flow).
If you want to hedge a firm commitment of an oil purchase (meaning that you have fixed the quantity and the price of the oil, but want to be exposed to the variability of the oil's market price), you have a fair value hedge.
on the fx side why is it that a firm commitment can be either cash flow or fair value hedge? can you give me an example? or it is just because the standard says so
First of all, because the standards says so. But it does so because of the dual character of a firm commitment exposure in a foreign currency. If you have a firm commitment in your functional currency, the only thing that is affected during the life of the exposure is its fair value (the cash flow is fixed). But if the firm commitment is in a foreign currency, not only the fair value of the commitment changes, but also the cash flow will change due to changes in the FX rates. That is why the IASB decided to allow fair value hedges or cash flow hedges for firm commitments in foreign currencies.
Can you give me a simple example please? For example say I will receive 100 in usd for a sale and the fx is 1.5 usd/gbp
The fx moves to 2 usd/gbp
So my firm commitment of 100 usd for my sales or 66,6 gbp has lost fair value to 50 gbp as the gbp appreciated
So I will hedge with a forward to fix the rate at 1.5 usd/gbp, before it moves to 2 usd/gbp to protect my sale in usd. This will be a cash flow hedge no? So what would be a fair value hedge here?
It is a cash flow hedge because the cash flow you end up receiving has changed due to changes in the FX rate. But you can also see it as a fair value hedge because the fair value of the commitment changes due to changes in the FX rate. FX risk has this dual character.
If you treat this hedge as a cash flow hedge, the entries will be (assuming 100% effectiveness):
So you end up receiving cash (and recognising revenue) for a total amount of GBP 66.6 as intended.
As you can see, hedge accounting will avoid a P&L mismatch. It basically allows you to take the derivative's gains or losses to P&L at the same time as the P&L of the hedged item is recognised. Put it simply, a cash flow hedge allows you to defer P&L in equity, whereas a fair value hedge allows you to recognise P&L from your hedged item immediately where normally it would only be allowed to be recognised at a future date. Applying one or the other is not an option (although applying hedge accounting is), unless we are talking about the FX risk in a firm commitment -- this is the only case where you can choose to apply cash flow hedge or fair value hedge accounting.
1- the gain from the hedging of 16.6 is recognised as revenue even though it is from the hedge item no?
2-On a Similar but different question - Ifrs 9 says that on fair value hedge - it should Recognise the hedging gain or loss on the hedged item in its carrying amount
If we have a hedge item as derivative asset and a in this case a liability for the sale
1 - yes, only when you recognise revenue (at that time you will then derecognise the firm commitment liability against revenue)
2 - for the fair value hedge of firm commitments, you will adjust the initial carrying amounts of the asset/liability with the cumulative fair value changes that you've been capitalising on the balance sheet once the firm commitment materialises. But this applies only to firm commitments to acquire an asset or to assume a liability (see IFRS 9 6.5.9). Your example is about a firm commitment to sell an asset.
would you mind giving me a simple example for question 2? Say now I will purchase inventory
What I know is that I will adjust the fair value of the hedged item with the hedging instrument gains or loses but not sure if this is correct and how it is accounted
Ok. So let's imagine that you are hedging the firm commitment to purchase inventory with a forward, and let's assume that the forward as a positive value for you because the value of the inventory has increased in the meantime. If you apply hedge accounting, you will measure the derivative and firm commitment as follows:
Derivative:
DR derivative asset xx
CR P&L xx
Firm commitment:
DR P&L xx
CR other liability -- firm commitment
When you purchase the inventory item, then the entries are:
Derivative:
DR Cash xx
CR derivative asset xx
Firm commitment:
DR other liability -- firm commitment xx
CR Inventory xx -- (this is when you adjust the initial carrying amount of the asset with the cumulative fair value changes that you've been capitalising on the balance sheet, because now the firm commitment has materialised)
So basically you will be recognising the inventory purchase at a lower value than the market value (because you hedged it), and when you sell that inventory item your operating profit will be higher because the COGS will be lower than if you had not hedged.
I think it was really helpful - I can contribute more as I build more knowledge as it is pretty limited at the time in the hedge recording process - but I want to review more and come to get more help when possible from DJP
I suggest you could create a extension where interesting posts can are archived by accounting standard, and refine it event to specific area under the standard.
Leo wrote: ↑18 May 2023, 11:20
I suggest you could create a extension where interesting posts can are archived by accounting standard, and refine it event to specific area under the standard.
