Semi-serious stuff

A brief note on hedge accounting

Disclaimer - the below may or may not be correct, as it is based on my memory/understanding, which is not always guaranteed to be complete/correct.

Note: FC = Foreign Currency

Introduction

Hedge accounting is an option that can be used by an entity to avoid volatility in the Income statement.

Hedge accounting rules will come into play when all the following conditions are fulfilled -

a. the entity has a risk of variability in assets/liabilities or future estimated cashflows which could affect P&L

b. the entity has hedged that risk in an arms length contract with an external entity.

c. the entity has documented and proved that the hedge is taken against a specific item or portfolio.

d. there is documented proof based on historical data that the hedge is effective.

e.g. a interest rate swap to protect future interest cash outflow on a fixed rate loan taken is not a risk....since the future fixed rate interest cashflow is certain there is no 'risk' or 'variability' involved in it. One may have a 'view that interest rates will fall in future, and hence take a swap of "pay floating, receive fixed" to gain from falling rates, but this is considered as speculation, not a 'hedge' qualifying for hedge accounting. 

However, in the example above, if we had a floating rate interest outflow on floating rate loan, then a swap taken to convert floating rate interest payment into fixed rate interest payment would qualify as a 'hedge'.

Also, if one has a fixed rate bond as an asset (not held to maturity), with changes in value routed through P&L (value changing based on changes in interest rate) and one hedges to protect the value of the bond by taking a fixed rate loan at same rate, then one CAN do hedge accounting for the hedge.

Hedged Item and Hedging Instrument

The item hedged (asset/liability/future cashflow/firm commitment) is called a "hedged item". The derivative or other financial asset/liability taken to hedge the risk is called a "hedging instrument". Note - it is not necessary that the hedging instrument has to be a derivative. For example, a FC loan taken, whose cash flows for future repayments form a hedge to future estimated FC Sales receipts can be designated as a hedging instrument. In this case, the fluctuation in value of loan need not be taken to P&L....

A hedged item can also be a combination of an asset and a derivative. Example, if one has raised a PO to buy Oil after one month, one can buy a US$ Oil future on the New York Commodities market to lock the price of Oil. Subsequently, one also buys a Rupee-dollar forward in India to protect on the Re-$ movement. In this case the PO on Oil + Oil future is the hedged item. i.e. a commitment to buy Oil at fixed US$. The Re-$ contract is the hedging instrument.

Types of Hedges

Generally, there are 2 kinds of hedges - a fair value hedge, and a cashflow hedge.

A fair value hedge is one which is taken against a recognized asset or liability, (e.g. hedge taken on foreign currency debtor/creditor/loans accounted in the Balance Sheet.) or on a unrecognized firm commitment (e.g. a purchase order raised, pending receipt of material),

A cash flow hedge is one which is taken  on estimated future cashflows, known as "highly probable forecast transactions" (e.g. estimated foreign currency sales to a customer in the next accounting period), or on cashflows associated with recognized assets/liabilities (e.g. variable interest payments on variable interest rate loan recognized in Balance Sheet).

Hedge Accounting

Proposed IFRS 9 requires that the fluctuation in value of both hedged item and the hedging instrument in a fair value hedge be taken to Other Comprehensive Income (OCI) / Hedging Reserve i.e. not in P&L. In a hedge of a firm commitment, (e.g. hedge of a Purchase order for purchase of Oil), the cumulative gain/(loss) on the hedge will go to reduce/(increase) the value of the non-financial asset acquired at the time of recognition of the asset.

Proposed IFRS 9 requires that fluctuation in value of cash flow hedge can be taken to OCI and recycled to P&L when the forecasted transaction is recorded in P&L. e.g. if we take a forward contract for FC Sales of the next year, since sales have not yet occurred, the gain/loss on the forward at the end of the current accounting period can be taken to Hedging Reserve (the corresponding entry can be shown in debtors in the Balance Sheet). The hedging reserve should be recycled to P&L when the underlying hedged item (i.e. the FC Sales) is accounted in P&L.

Based on a cursory reading of the draft IFRS 9, I have framed certain accounting entries as per attached file. These are my interpretations of the draft, and NOT based on any example given by the IASB, hence they are not necessarily correct! 

 https://spreadsheets.google.com/ccc?key=0AjcEy7gNCZvidDBoYzk3SmhUZTlTTXVqanNYUmVaV1E&hl=en

Hedge Effectiveness

The option of accounting gain/loss of the derivative in hedging reserve & OCI can only be exercised if the hedge is "effective". i.e. a study to be done at the time of initiating the hedge. The study should typically cover the history of hedge over last 3-4 weeks/months/quarters etc. (as required by auditors) to prove that the hedge is statistically effective. IFRS 9 (Draft) seeks to do away with prescriptive method of judging effectiveness mentioned below.

Current IAS 39 requires that for an hedge to be effective, it falls within 80% to 125% effectiveness band - e.g. suppose we take a oil future to cover Mineral Turpentine Oil (MTO) prices (for MTO to be ordered in future-viz a cashflow hedge), we need to analyse at the time of taking this hedge that gain/loss on future over last few periods is correlated with  movement in MTO. Say gain in future is Rs 10 per kg in last one month and increase in MTO price is 11 per kg, effectiveness  = 10/11 = 91% or 11/10 = 110%. - as long as it is between 80% to 125%, it is considered effective and we can do hedge accounting.  The analysis to be repeated at each accounting period end to prove that hedge is still efective. Once it is ineffective, gain/loss to be transferred to P&L.

Other measures to estimate statistical effectiveness over historical periods could be things like co-efficient of correlation (for linear regression) or rank correlation (for non-linear measures)

Once a hedge is treated as ineffective, it cannot again be treated as effective (atleast auditors do not usually allow this). Ineffective hedges (either ineffective fair value hedges or ineffective cashflow hedges) are considered as speculation, and gains/losses on hedged item and hedging instrument to be accounted in P&L. This may also have tax implications as speculative losses are not allowed as a deduction against business income.

Hedge of investment in foreign operation

A hedge can be taken on the net investment in a foreign subsidiary by a Parent. This can be used to offset the Forex translation losses that accumulate in Forex Translation Reserve in Consol Accounts. The change in value of hedge is accumulated in Hedging Reserve, and is transferred to P&L, whenever the investment is disposed, along with transfer of Forex Reserve related to the Investment. This reduces the impact on P&L at the time of disposal, and also hedges the networth forex erosion/gain during the lifetime of the investment.

In my view, such hedges may typically be taken where a company has plans to dispose a subsidiary in next few years, and it wishes to protect on forex erosion going forward.

That's all folks! Please revert to the IASB for any further clarifications!

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The 6 Pillars of the Accounts function

The following is some 'gyaan' given by me to my reportees in the Accounts function when I first took charge, many years ago.

The 6 pillars, explained....

1) Ensuring that the routine objectives are met as a matter of course. Planning an activity in advance is a key to doing it without error! We must also design "early warning" feedback mechanisms to indicate to us when things are not going as per those plans. We must aim for a philosophy of "ZD" (Zero Defects) in our day to day work by identifying & routing out all possible sources of errors. Knowledge & application of problem solving methods would greatly help in this process. 

2) Compliance to Statutory & internal guidelines -At all times, we must strive to ensure 100% compliance to laws & procedures laid down. If 100% compliance is not possible, then either the guideline is to be changed or our process is to be changed! 

    Statutes and procedures include TDS, Service Tax, WCT, Excise, Sales Tax, Labour laws etc. and internal documents such as the Authority Manual and Commercial Manual. 

    We must ensure that adequate documentation in the form of contracts, quotations, etc. is available with us so that we can judge the "fairness" of any major transaction. 

    Compliance to procedures would also involve continuous knowledge updation of legal, accounting & internal laws, rules & guidelines. This should be achieved thru formal & informal training, regular reading of updates, & queries directed to relevant persons. 

3) Reducing the quantum of "Non Value Adding" (NVA) aspects of our jobs. This involves: 

    a) Doing only what is necessary AND 

    b) Doing it in the best and fastest possible manner. 

    Question activities that don’t serve any useful purpose. Make the activities that need to be done, as easy as possible. Examples could be making necessary modifications in SAP forms and reports to directly get the desired output, usage of programs and tools to automate routine reports, encourage usage of vendor/employee portals and helpdesks to avoid time spent on unnecessary queries, standardizing reporting requirements from other functions such as HR etc.,

4) Greater focus on analysis - of costs, overdues, balances & processes, using the most useful tools available, such as Business Intelligence software. We must ensure that we not only prepare necessary MIS but also analyze it regularly, & suggest improvements where required. At all times, it must be kept in mind that the person making the MIS is best equipped to continuously question it & suggest improvements. 

    Analysis needs to be prioritized, to avoid information overload. 

    Analysis also means that we need to be aware of the various processes with which we deal. Example - the person booking import bills should be aware of the entire import process, so that he is in a better position to point out areas of improvement. 

5) Increasing the "stability" of operations… 

a) thru methods such as Manuals / procedures / checklists etc. - We need to develop formal guidelines in our respective areas of expertise, to ensure that our work is not "person dependent". Such guidelines could cover the checks we do to ensure error-free operations, normal SAP transactions that we use, etc. Such guidelines should be brief, precise & easily understandable. The real test is that work should not suffer in our absence, whether on leave or otherwise. Let us remember that knowledge is not to be stored, but to be shared... 

b) Ensuring that we organize our work in such a way that documents (both soft & hard) are easily accessible to others in the years to come. This would involve the famous Japanese "5S" principles such as eliminating redundant stuff, indexing, sequencing & proper storage. 

6) Regular reviews within the department & with external departments. - Reviews & interaction help us to get a better perspective & see other people's point of view. Both formal & informal interaction is encouraged, so that we can easily solve/prevent problems. "Mail wars" should be discouraged wherever a mere discussion could solve the issue. It is important to meet regularly with departments such as Materials, HR, Marketing etc. At all times, we must strive to provide high levels of service to our internal customers. 

    Service levels must be formally monitored. If something is not measured, it cannot be improved! 

IFRS CashFlow model

Preparing a cashflow for a consolidated entity can be tough work. There are several intricacies involved including accounting for purchase / sale of companies etc. At the same time, there are some subtleties that need to be taken into account for accounting for foreign subsidiaries, ensuring IFRS compliance etc.. The cashflow model attached in this page (see bottom) helps in easing the pain involved in preparing the same!