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Ind AS-109 Hedge Accounting: Deciding Between Fair Value and Cash Flow Hedges

Introduction

Ind AS 109 provides a comprehensive framework for hedge accounting, helping entities manage financial risks associated with recognized assets, liabilities, and forecast transactions. Deciding whether to use a fair value hedge or a cash flow hedge under Ind AS 109 is critical for effective risk management. This article explores the key differences, accounting treatments, and practical applications of these two types of hedges.

Understanding Hedge Accounting

Hedge accounting aligns the accounting for hedging instruments with the accounting for the underlying hedged items, aiming to reduce the volatility in profit or loss. Choosing between a fair value hedge and a cash flow hedge depends on the specific risk being managed and the entity’s financial objectives.

Fair Value Hedge

Objective: To hedge exposure to changes in the fair value of a recognized asset or liability, or an unrecognized firm commitment.

Example: If Entity A has a fixed-rate debt and wants to hedge against changes in the debt’s fair value due to interest rate fluctuations, it would use a fair value hedge. Rising interest rates would decrease the fair value of the debt, and gains or losses from the hedging instrument would offset these changes.
Accounting Treatment:

  • Changes in the fair value of both the hedging instrument and the hedged item are recognized in profit or loss.
  • Adjustments are made to the carrying amount of the hedged item.

Ind AS 109 Hedge Accounting Fair Value vs Cash Flow Hedges

Journal Entries for Fair Value Hedge:

Gain on Hedging Instrument:

  • Dr. Financial Assets from Hedging Instruments
  • Cr. Profit or Loss (Fair Value Gain)

Loss on Hedged Item:

  • Dr. Profit or Loss (Fair Value Loss)
  • Cr. Hedged Item (e.g., Debt Liability

Cash Flow Hedge

Objective: To hedge exposure to variability in cash flows attributable to a particular risk associated with a recognized asset or liability, or a highly probable forecast transaction.

Example: If Entity A expects to make future payments in a foreign currency and wants to hedge against foreign currency risk, it would use a cash flow hedge. This ensures stability in future cash flows.

Accounting Treatment:

• The effective portion of the gain or loss on the hedging instrument is recognized in other comprehensive income (OCI).

• The ineffective portion is recognized in profit or loss.

• The amounts recognized in OCI are reclassified to profit or loss when the hedged item affects profit or loss.

Journal Entries for Cash Flow Hedge:

Effective Portion:

  • Dr. OCI – Cash Flow Hedge Reserve
  • Cr. Financial Liabilities from Hedging Instruments. OCI – Cash Flow Hedge Reserve

Ineffective Portion:

  • Dr. Profit or Loss (Ineffective Portion of Loss)
  • Cr. Financial Liabilities from Hedging Instruments
  • Practical Example: Hedging Fixed-Rate Debt

Scenario: Entity A has issued a EUR 10 million fixed-rate bond with a 5% annual coupon rate. To hedge against the risk of rising interest rates increasing the fair value of its debt, Entity A enters into an interest rate swap to pay floating rates and receive fixed rates.

Fair Value Hedge:

  • Hedged Item: Fixed-rate bond.
  • Hedging Instrument: Interest rate swap.
  • Impact: Any changes in the fair value of the bond due to interest rate changes are offset by changes in the fair value of the swap. Both effects are recognized in profit or loss.

Cash Flow Hedge:

  • Scenario: Entity A might instead want to hedge the variability in interest payments (cash flows) on a variable-rate debt.
  • Hedged Item: Future variable interest payments.
  • Hedging Instrument: Interest rate swap to fix the interest rate.
  • Impact: The effective portion of the swap’s fair value changes is recorded in OCI and reclassified to profit or loss when the hedged cash flows affect profit or loss.

Key Points on Hedge Effectiveness

Ind AS 109 requires demonstrating an economic relationship between the hedged item and the hedging instrument. Hedge effectiveness must be assessed both at the inception of the hedge and on an ongoing basis. The standard allows for more flexibility compared to previous requirements, focusing on the economic relationship rather than strict quantitative measures.

Effectiveness Testing:

  • Methods: Critical terms match, dollar offset, regression analysis.
  • Documentation: Formal documentation at the inception of the hedge must include the risk management objective, nature of the risk being hedged, identification of the hedged item and hedging instrument, and the method for measuring effectiveness.

Conclusion

Choosing between a fair value hedge and a cash flow hedge under Ind AS 109 depends on the specific risk management objectives and the nature of the exposure. Proper documentation and ongoing assessment of hedge effectiveness are critical for successful hedge accounting. By understanding the principles outlined in this article, entities can make informed decisions that enhance their financial stability.

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Fellow member of the Institute of Chartered Accountants of India (ICAI) having extensive experience in Statutory Audits. Certified in IFRS from ICAI. A versatile and dynamic professional, he has a thorough grasp of Accounting Standards/IFRS/Ind-AS principles, corporate and taxation laws, and stat View Full Profile

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