- chapter 7 - Hedging Foreign curency Exchange Rate Risk forward Coniraci) prouetlon e ef owe astvative financial insiruments" or “derivatives” brings fo mind the spectocuior headline stores of of Boing: Bank Lid and the sudden bontruptey of tang Term Copal Management ond ‘County. Hawever, these unfortunate and ex¢epicnal incidents should no! overdnodow the foc! ve instruments serve @ voriety.oF purposes ond ploy @ very imporiont role in the tik 1 strategies of bonks, insurance companies and commercial enterprise. The verily of explains their popularly and widessread use. orig for defile insrulnents depends onthe puspese for ening no devive conto. ac etter Kom on accounling point ol vow, 10 mdentand what cortiuls 0 derratie spitoamsetepres enter ifo Conic valving dewvorves. defines o derivative cx a financial instument or other contac! within the scope of PERS ha! meets et: ¥ etl robe changes in response to G change in an “uneseryg". The undeshing con be the pce ofa ‘commadly, sch os soybeons, oa financial insrumént, such os fred rate bond, con ao be:o role such 03 a foreign exchonge rate of a spectied interest vate, for exomple, the Landon Interbank Offer Rate: «+ lrequtesitte cr no intial net ivestments and > Ibsetlled of a future date. sreegh net setlement (ie. the setiing of the difference belween the contracted pice and the spot ceo osu or maturity date) is not a condition foro derivative, net setiement & a canmon practice in pocia martes _adesotre Tut olso entail litle oF no initial net investment. A prepaid forword contract to purchase jpentry lo be delivered in sc moths does not meet the crleion of lille ono iwesiment asthe price has peopl, 3 pachaple wil focus only on using forward contact as hedging instument. defvative Instruments Adetivative Instrument may be defined as a financial insiument that, by is terms at ‘rceplion or upon occurrence of a specified event, provides the holder (or writer) with ie fight (or obligation) to participate in some or all of the price changes of another inderying volve of meosure, but does not require the holder to own or deliver the indatying volue of measure. Thus, its valve is derived from it Ihe undertying value of measure may be one or more referenced: foreign currencies (to be thoroughly discussed in this chapter), financial instruments, or . commodities, or other assets, or other specific iterfis to which a rate such as interest rates (foreign cumency exchange rates as indicated earlier), an index of prices, or anather market indicator is applied. In most cases, derivatives ciffer from traditional instruments (stocks and bonds, for example). Afracced Financial Acéounting ~ A Comprehensive & Procedural Approach a ‘Scanned with CamScanner-- CHAPTER 3 we The cash payments involved ore made at the end of the contract rather than ot & inception for the most par, and the instruments have consequenty been healed ny ‘Das in many coses 0s a type of off-balance sheet agreement, The Four Foundations of FFRS F The IASB idenfiied the folowing as comertone decisions for the accounting ¢ derivative instruments: 1, Derivatives are contacts thal create righls ond obligations that meet ty definitions of assetr and Rablltes (thus these righls and obligation ore repeieg | in the bolonce sheet not in on “offbalonce-sheet manner). | 2. Fair value is the only relevant measwe for reporting of derivatives that oe reported in the balance sheet a! thei fair valves = whether or not they hedge cy iter, : 3. Only items that ore assels and abilities are reportable on the balonce shee Ithus loses on derivafves cannot be deferred and reported as assels, Revie, ‘gainson derivatives cannot be defered and reported as Babies). 4, Gains ond losses on derivatives rust be seported in earnings cumently = excep in cedain specified stvations in which the goins and losses must be Inay reported in the other comprehensive income, Furthermore, in cesfoin specitied situations in which the gain or loss onthe ‘hedging iransaciion mus! be reported in net income (or ather comprehensive income in some cases). . Currently, the normal accounting for the hedged item must be propery denied 0 that the offsetting lass or gain on the hedged item is also reported curentyin ne income (or ofher comprehensive income in sone cases). The eccounting treatment for both types of these cerfoin specified stvoans comprises what i colectively refered to as *hedge accounting’. 7 Although over a thousand diferen! types of derivative instruments have been creied, they ore sometimes classified into the folowing two broad categories: +. Forward-based derivatives (examples ore forwards, futures, ond swops). Under these contacts, t has a “wa-sided exposure” wherein each party has 0 fovorable or unfavorable outcome but not both simultaneously (e.g.. both wil not simultaneously have favorable outcomes). Consequently, the downside rik cond the upside potential onthe hedged item are counterbalanced. + Oplion-based derivatives [examples ore option contracts, inlerest rate cops and interest rote floors}. Under these: contracts, it has a “one-sided expasure’.in which only one specified party can potentially have a favorable aulcome ondt agrees fo pay a premium at inception for this potentiality, The other partyispad the premium, and if can potentially have only one unfavorable ovicome. Consequenily, only the downside risk on the hedged item is counferbalonced. — Note: Opfion contac! on foreign curency ls no! included i the syllobus of CPA Ucensure Erominat) Devivatives are recognized in the balance sheet at theirfair value. = Advanced Financial Accounting = A Comprehensive & Procedural Approach ‘Scanned with CamScannerofhat value is 60s€¢ on the changes in the underlying value of measure Ho, financial insiuments, commodities, other assets, ele.) and on cote seoected future Cosh flows, The results a payable position fev one of ee! aries ‘ond a receivable postion for the other. ay “ae financial instrument nomaty inciuces notional amount. e jon of o derivative does NOT INCLUDE o requirement that a notional gs eect. PFRS GescOes contacts wil payment provisions an vnderying el pelt lor way as an example of a contract without a notional amount that is @ eet oe unt jroo | ee eenaunt the Toto! foce amount ef the esse or fobity that underies the controch, The notionc! amount con be misleading becouse the value of a oe Srrunction of Changes in prices.orinlerest rales ands nomoty equal to jus gon jonal tne national Omount ofthe underlying asset. ‘ Foe unt moy be expressed in the number of cuency unis. shares, bushels, oe ritsspecified in the fnencial instrument, {ceive a Ntfanal Amoun! : raz 9 forword controct fo Purchase 0 certain amount of feeign curency for 08 One nofional ameunt af the forward contact i: P.00,000 but hos @ a goo en the doy tne forwara controct agreement & signed. However, he ae conlroct has value only if exchange rotes change. The foward contract i we og ue Inti fre han Ine nofena omc youedong? d making on Investment! or acquiring some derivolive or non-derivative offset potential losses (or gains) that may be incuned on some slo Fisk, i f po! es Thot a Philippine company that notmaly operates in peso. Recently, the jar nos dacided to soread is buiness 0 Unled Sates and mae a ae of rome oan Ametican cuslomer ior $200,000. invoice io American customers dve after ten (10} months. * owen he Phiippine company is aftaid that due to movements in foreign eurency past wl ge! significantly less pesos ater ten (10) months ond therefore. it enters into ‘beling frelgn currency forward contract with bank te sel $200,000 far some fed rote-after ten {10] months —ie., at o specified {future} date. worse hedge here ? + Hedged risk a foreign cumency fk [Le., the exposed, US dollar (S)) «+ Hedged item is o receivable in foreign cunency exposed asse! + Hedging instrument is 0 foreign currency forward contac to sll US dolors for a bbed (faword) rate at a fixed date ‘alisa Hedge Accounting? ‘ieige accounting affects the timing of recognition of hedging gains and losses. By ‘Selying hedge accounting, entities can better maich the gains of losses of the “ ““eesced Financial Accounting =A Comprehensive & Procedural Approach ’ ‘Scanned wth CamScanner600 CHAPTER 7 hedging instrument with gains or losses of their comesponding hedged item (hedging insiument versus hedged item). The objective of hedge accounting is fo represent, in the financial statements, the effec) of risk management activities that use financial instruments to manage exposure, ‘ring trom paricular risks thal could affect proft or loss (Ral) or other comerehensg income (OC). \F on entity chooses nal fo apply hedge accounting, hedging instruments wil need jy be classified and measured like any other financial Insiuments os required by PFRS Gains and fosses on the hedging instruments may not be recognized in P&L. OCI in the same accounting periad as the gains and losses on thelr comesponding hedgeq fems, Hedge accounting is thus based on the fundamental “matching” concept, and kelpy 40 reduce the volatility in the income statement caused by the accounting mismatch between the hedging instrument and hedged item and were accounted ire separately under PFRS, Therefore, hedge accouniing means designating one or mare hedging instruments, that thet change in far value ofsels or the change in eash flows of a hedged item + Without hedge accounting, ony gain or loss resuling ftom the change in fa valve of foreign curency forward contract would be recognized directly fo proft orloss. + With hedge accouniing, this hedge would be accounted for as a cash flow hedge’(to be discussed on the later porl)It means that you would reeognie fu or @ part of gain or loss from foreign eunency forward directly to equity (other comprehensive income), The impact of the some foreign cumency forword contract on proft or los slokement ‘with hedge accounting can be significantly lower than without it Why Hedge Accounting? Fist of all, hedge accounting is NOT mandatory. It is optional, entities may elect not lo follow it and recognize all gains or losses fram hedging instruments to profit or loss, However, when applying hedge accounting. the readers of the financial statements, . may; «That has knowledge that the, company faces certain risks, + That the entity moy have certain sk management strategies in order to miigate those risks. a « Howeffective these shategies are. In foct, with hedge accountirig. the company's profit and loss statement is fess voldile, because basically maiching these gains and losses with gains / losses on the hedged item, ‘Scanned with CamScannerpiingushing between “Hedging” and "Hedge Accounting” eword “hedging” is @ broad and general term; its 0 means of minimising fk. The eps! hedge fs when an enterprise purchase merchandise in foreign curency fo be pad lew months affer and buy foreign cunency easter Jo preven! the velotly fuchafon] of exchange rates. ° pe foreign cumency strengthens (meaning o gain). then the value of the asset and ge burden of the ability will increase (meaning a loss) by the same amovnl, any gains asses willbe concelled out, sedge occounling recogrizes proportionately the olfseitin effects on net prof or loss iq ebonges In the fair valves of the hedging instument ond the related item being peged -pahedging instrument wil normally be 0 desivative. edged Accounting, fedge accounting generally, results fo a closer matching of the balance sheet or daement of financial posiion effect with the proft of loss elfect, ond protects the afolement of profit or loss and other comprehensive income fom volatility caused by ‘anges in fair valve from period to period, The hedge accounting rules in FFRS 9 ore: sj presciiptive. 185 32.and PFRS 9 provides special rules for hedging actives (Le.. hedge accounting] Hedge accounting allows gains and fosses on the hedged item fo be matched with ‘esses ond gains on the hedging instrument in the same period. |t is important io note ‘thot hedge accounting is optional as previously mentioned. edge accounting is’a formal accounting description ond not simply a net result. Heclively, the cumency risks from the receivables ond fhe payables should offset each her fo some extent, The sort of offsetting position is sometimes called c natural impli) hedge - any gain or loss from the receivables will be offset by the loss or gain fomthe payables, ‘Theforelgn exchange gains or losses will flow through net income and naturally tend fo ‘lset each other. White this is 0 form of hedge in substance, it isnot what the PFRS cols hedge accounting was, + 'woimportont concepts need tobe understood: « the hedging instrument; ond © the hedged item, The Hedging Instruments Hedging instrument is defined os: “o designated derivative or (for a hedge of the risk of ‘changes in foreign currency exchange rates only] a designated non-derivative fnonclal asset or non-derivative financial liability whose fair value or cash flows ore ‘@pecied to offset changes in the fair valve or cash flows of a designated hedged bem, ‘Scanned wath CamScanner602 CHAPTER > An lasrument must meet eight essential criteria for it to be classtied os a hedging insitument: 1, I must be designated as such. This means that management must document fg dela of the hedging instrument and the item itis hedging, of the inception g the hedge, 2 It mus! be o derivative unless criterion No. 3is met 4. Its hedging foreign cumency exchange sisk, in which case it can be a ion. derivative. 4, | mus! be expected to offset changes in the fair value or cash flows of the ‘hedged item. 5. It must be with o porty extemalto the reporting enlily — extemal to thy consolidated graup oF individual entity being reported. There is-one exception fy nee in respect of intra-group monetary items when certain conditions ore met. 4. itcannot be spiftinto component parts, except for separating the fime value ang intrinsic value in an pion canlract, and the interest element and spot price ing forward contact. 7. A proportion of the entire hedging instrument, such as 50% of the nolan ‘omount, may be designated as the hedging instrument. However, o hedging relationship may not be designated for only a portion ofthe fime period during which the hedging instrument remains outstanding. 8. A single hedging instrument may be designated as a hedge of more than ane type of risk. Examples of hedging instumenis are forward foreign cumency exchange. option contracts, future contracts, and swaps (such os interest, cross currency. ec). Option, futures and syops will not be discussed in this chapter since they were riot included the fopics for CPA Licensure Examination, Ralionale for Hedge Accounting The need for special hedge cecounting rules arises because under conventional ‘accounling freciment there are certain stuations where the income-ofseting efects wil nat occur cs the gain (or loss) or the hedging instrument will be reported in one petiod ond the loss (or gain) on the hedged item in another period. The following ore the situations that zequie hedge accounting: + The hedged item ond the hedging instrument cre measured using ferent bboses, for exomiple, the hedged item is measured at cost and the hedging instrument is measured at fir valve. This is model that fms generally adopl. ‘The hedged item has yet fo be recognized in the financial siatements + Different reatments are applied to ehonges in the fair value of the hedged ilem and the hedging instrument. for example, changes in the fair valve of the ‘hedged instrument are token fo other comprehensive income wile changes in the fair valve of the hedging em are taken fo the income statement. Advenced Financiel Accounting ~ A Comprehensive & Procedural Approach ie ‘Scanned with CamScannerGM CURRENCY TE RISK | “pettedged lem edged item is defined 03 “an assef, liability, fim commitment, highly probable jgecastransaction or nef investment in a foreign operation that (a) exposes the entity fie of changes in fair value or fulure cash flows ond (b) is designated os belng elolowing ere hedged items: 1 Exposed assel or liability (nol a hedged accounting) » Fim Commitment (hedged accounting - fair value hedge or cash flow hedge) + Forecasted transaction (hedged accounting ~ cosh flow hedge) + Speculation (not a hedged accounting) « Net Investment in a foreign operation (hedged accounting - cash flow hedge) tre ocoounling stondords perils groups of assets, fables ond so on fo be the redged lle, provided they have similar tsk charactessties and proparionate for ove changes. s yowever, a.net position cannot be hedged (e.g. the net of a group of similar assets and siniar labilties). The hedged item can be o financial item or a non-financial item. What ls 0 Firm Commitment and Forecasted Transaction? Anicipated transactions are those that ore expected ta occur in the future bu for wich na asset or liability has been recognized. In discussing anticipated transactions, ‘hestondard distinguished between o firm commilment ond a forecasted fransaction: he disinction between a firm commitment and a forecasted transaction is important. Ader PERS: «the hedge of a firm commitment is accounted for as a fair-value hedge: } - a firm commitment is o binding agreement for the exchange of resources where the quantity, price, and dates ore specified. An example of a firm commitment would be a purchase or soles order that has been accepted by the supplier company. - afm commitment cories o fair valve exposure becouse of ifs commitment to a specific price. If the price changes by the time the fransacifon fakes place, there is ether a gain or a loss on the fair valve of the commitment. ~ Under PFRS 9 unike the US standord, a hedge of the foreign currency risk of a firm commitment con be accounted for 0} either a folrevolue hedge or a cash-flow hedge, + the hedge of a highly probable forecasted transaction is accounted for os a cash-flow hedge. + 0 forecasted transaction is an anticipated transaction for which no firm commitment exists. An example of a forecasted transaction would be on ‘anticipated soles transaction or an anficipaled inventory purchase + forecasted transaction is an “uncommitted bit anticipated fulure transaction” - a forecasted hansaction may subsequently result to the recognition of a financial item. (such as equity invesiment &r a loan) or 9 non-financial item (such as inventory or property, plant and equipment. Advanced Financial Accounting ~ A Comprehersive 4 Proxedural Approach ‘Scanned with CamScannerbog CHAPTER 7 CY > Gforecasted transaction is one that has o high probability of occurence, + Inone respect, itis similar to a firm commitment since itis o future transaction, that has yel to occur, However, the fundamental difference is that in @ forecasted transaction, there is ng commitment fa a specific price, hence itdaes not entail rights or obligations, Aorecasled transaction does not involve such an expasure because of the absence of ‘2 Commilment toa specilic price. ‘i Aforecasted fansoetion, sill, has a eash flow exposure that stems from changes iy ‘the price ofthe forecasted item. Depending on the price eventually received oid, the cmount of cash flow of the related revenue or purchase may differ wnen ‘the fransoetion isfirst forecasted. Therefore, forecasted fransactions expose on entity to a cash flow risk thot wil alle Teported other comprehensive income. The possibilty that the forecasted transaction may be postponed or even canceled cinnat be ruled out, However, since it is highly probable thof the transaction wil fake ploce, the fim is exposed fo cash flow risk becouse of chonges in the price of the hedged ifem when the transaction eventualy occus, Requiremenisin Assessing Hedge EHectiveness The rlio of 80-125% quantitalive threshold criterion for applying hedge accounting has been removed in PFRS 9. The PFRS 9 hedge accounting model employs @ more pptinciples-based approach. In order to qualify for hedge accounting, the hedge relationship must moet the following effectiveness criteria at the beginning of each hedged period: 1. there is on economic relefionship between the hedged item and the hedging instrument - rearing that the hedging instrument and the hadged item mus! be expected to have offsetting changes in fair value 2. the effect of credif risk does not dominate the value changes thot result from that economic relationship; and 3. the hedge ratio of the hedging relationship is the same as that actually used ia the economic hedge, ic.. hedge ratio is designated based an actual quaniiies of hedged item and the hedging instrument. Hedge effectiveness is the extent a which changesin the fair valve or cosh flows of he hedging instrument aise! changes in the fair value or cash flows of the hedged ilem. Hedge inefiectiveness is the extent to which there is no such offset or the changes in the fair valve or cosh foe oe hedging instrument mare than offset those on the hedged item. Under the new requirements, in order fo qualify borin ‘accounting only prospective hedge effectiveness testing is quired, + For simple hedge relalionships, entities cre epecled to be able to apply o quoitaive test (2.9. cftical terms match where the ssk, quantity and fiming of the hedged item matches the hedging instrument). © «For more complex hedging relationships, such as where the hedged item is of itferent rode to the hedging instrument (¢.9. where o bass diference ext a “Adoanced Financial Accounting ~ A Comprehensive & Proceduraf Approach ‘Scanned with CamScanner| yEDGING FOREICN CURRENCY CHANGE RATE RISK 605 more detailed quantitative testis ikely to be required. qeboloncing ond Discontinuation jeboloncing Is a new concept introduced by the hadge accounting requirements of #969 Financial Instruments ing refers ta the prospective alteration of the hedge ratio (either by charging tte quantities of the hedged item or the hedging instrument] without ‘scontinuing/lerminating the evisting hedge accounting relationship, tre new model requires rebalancing when there is a change in the economic sdofarsip between the hedged item and the hedging istument such that i eads fo qnodusiment of the economic hedge ratio, rample 3- Rebalancing Enfily A enters into. c fore’gn cunency hedging instrument fo hedge ils exposure 10 the ‘loled. However, the hedged item that Entity A hedges i of a higher grade thon the relerence undetjying hedging instrument of the derivative, AI the stad of the hedge, tne price/valve differentiol between the two (hedged item ond hedging instrument) i ‘10% ond (lo maximize offset) Eniity A sets hedge ratio of 0.8 [0.8 hedged item fo 1 edging insument). Thee months loter, dve to supply and demand factor, the pice/valva differential between the two hedged item and hedging instrument) has increased fo 308. io maximize offset, the Entity “rebalarces" and takes out adkétional (ottettng] hedging insfrument so that the hedge ratio is now 0.7 (0.7 hedged item to | hedging Av entity discontinues hedge accounting prospectively only when the hedging slionship (or part of a hedging relationship} ceases fo meet the qualifying eiifetio [per any rebotancing). | Tis includes instonces when the hedging instrument expires or is sold, ferminated or exercised, Okcontinving hedge accauniing can either affect o hedging relationship in is entirety crenly o part of it fin which cose hedge accounting conlinues for the remoinder of the hedging relationship). Hedges where Hedge Accounting Is Not Required ‘hl ll hedge relationships require the application of hedge accounting as the effects df'nafural hedging’ is achieved through normal acecunting procedures, fecal thal the main objective of hedge accounting ensures thot offsetting gains and losses of the hedged item and the hedging instument ore reported in the some eeeounting period in order to reduce the volatility of reported eomings. {normal accounting hreafment for the hedged item and the hedging insiument resuils {othe offsetting gains and losses being reported in same period, then there is na need loapply hedge accounting, An example i hedge ofa financial instrument classed «nfoir value through profit or lass. ‘Advenced Financial Accounting = A Comprehensive & Procedural Appreach ‘Scanned with CamScanner606 CHAPTER» att Ea ee Ee Te ee Changes in he fo volves ofthe hedging instumen! and the hedged Hem Ww aan, offset each othey in the income stotement. Since he: fime valve component it Mer of the hedge. itis tected lke any other derivative and the default treatment angie, thatis. itis token to the income slolement. 4 ‘Again, the inrinsle and time valve element is of significance when it comes to opie, controcts, but this chapter focuses SOLELY on Forward Contracts. Classification of Hedging Relationships Hedge accounting includes three fypes of hedging: 1. Fair volve hedge: 2. Cosh iow hedge: and 4. Hedge of ane! investment in forelgn ently. A fair value hedge is hedging of o potenti! changes in fair value thot result, chonges in foreign exchange rates and that alfect profit or loss, Its hedge ol thy emposure fo changes in the Jak valve of a recognized assel or liability or ay unrecognized firm commitment, or an identified portion of such an asset, liabilty ey fim commitment, 'n 0 fol valve hedge, the enity vses @ hedging Instrument fo hedge aga hy fluciuation in the fair value of the hedged item. This method will be used when ihe hedged item (such as.an asset or liability) willbe meosured ot fair value. The resus 1. The goin or loss in the falr values of the hedging inskument ond hedged tem are BOTH recognized in profit or loss in the period of the change in volves, 2 With one exception. if the hedging Instrument hedges an equity instumeni {such os commonfordinary stock] for which on entity hos elected fo presen changes in fair valve in other comprehensive income, then the gain or oss on the hedging instrument s oko presented in olher comprehensive income, Under PFRS 9, the above mentioned, for valve hedges of an equity isumenl ‘accounted for at foir value through other comprehensive income, gains/iosses of equity inshuments ore never recycled fo profit and loss (PA) ~ (chongesin the foir value of the hedging instrument are oso recorded in OCI wihout recycling fo PBL. . ¢ Some of the examples of a fair value hedge include, but are not limited fo, he folowing: . “+ Hedge of inventory or + Hedge ofa fem commiiment. ‘A hedge of a firm commitment is 0 foir value hedge’ becouse the commilment caries a confracival obligation that Is fled to a fixed price, and thus exposes the company to the risk that a change in the marke? price wil result to loss or gain on the commitment. Advanced Finandal Accounting = A Comprehensive & Procedurol Approach ‘Scanned wth Camcanner