Hedge Accounting for Foreign Currency Firm Commitments

(In Continuation of my previous article)

Application of AS 30 under existing Indian GAAP as per ICAI’s announcement:

i. ICAI wide its circular dated 11^th February 2011, has clarified that in respect of the financial statements or other financial information for the accounting periods commencing on or after 1^st April 2009 and ending on or before 31^st March 2011, the status of AS 30 would be as below:

ii. To the extent of accounting treatments covered by any of the existing notified accounting standards (for eg. AS 11, AS 13 etc,) the existing accounting standards would continue to prevail over AS 30.

iii. In cases where a relevant regulatory authority has prescribed specific regulatory requirements (e.g. Loan impairment, investment classification or accounting for securitizations by the RBI, etc), the prescribed regulatory requirements would continue to prevail over AS 30.

The preparers of the financial statements are encouraged to follow the principles enunciated in the accounting treatments contained in AS 30. The aforesaid is, however, subject to (i) and (ii) above.

From 1st April 2011 onwards:

i. the entities to which converged Indian accounting standards will be applied as per the roadmap issued by MCA, the Indian Accounting Standard (Ind AS) 39, Financial Instruments; Recognition and Measurement , will apply.

ii. for entities other than those covered under paragraph (i) above, the status of AS 30 will continue as clarified in paragraph above.

Application of AS 30 under existing Indian GAAP as per ICAI’s announcement:

Let us take an example of an Indian entity:

a. Entered into a $ 100 payable commitment to import raw material on January 1, 20xx

b. Delivery of raw material is on December 31, 20xx and payment on the same date.

c. On January 1, 20xx, the entity enters into a forward contract to hedge the foreign currency risk

d. As part of the treasury policy, the entity first enters a shorter period contract till June 30, 20xx

e. Rolls it over on June 30, 20xx to meet the cash outflow on December 31, 20xx

f. Refer Table 3 for details of exchange rates and MTMs on various dates.

* Only for completeness, not relevant for accounting schema.

Note:

a. Forward rates mentioned in the above table are the Mark to Market (MTM) rates. They are arrived at by considering the spot rate with reference to reporting date plus premium quoted for balance maturity of each contract on that date.

b. Forward rate and spot rate on final settlement is same because the balance period in that case for premium quote is Zero.

c. Entity has designated the forward to hedge ‘forward rates’ and has been fully effective during the period.

Accounting Schema as follows:

January 1, 20xx: 

The contract has zero value; therefore no entry is required. The commitment is also not yet recognized. The hedge is designated as Cash flow hedge in line with the choice available under para 97 of AS 30 read with notification issued by ICAI in February 2011.

Example: A Forward cover is taken on 01/01/xx with maturity of 30/06/xx @ Rs. 42.5/$ for USD 100. There would be no accounting entry as on 01/01/xx.

March 31, 20xx:

The commitment is not yet recognised. MTM gain/loss on cover till the date of period closing would be recognized in hedging reserve (Equity), following cash flow hedge accounting.

As on 31/03/xx, forward cover for maturity of 30/06/xx is available @ Rs. 43.50/$, thus MTM gain of Rs. 1.00/$ (MTM forward rate – Original forward rate) would be accounted as under.

June 30, 20xx:

The commitment is not yet recognised hence the cover is rolled forward. The rolled forward contract is treated as a new contract, part of the existing hedge strategy. It is still a Cash flow hedge.

[Paragraph 112a of AS 30:”……replacement or rollover of a hedging instrument into another hedging instrument is not an expiration or termination if such replacement or rollover is part of the entity’s documented hedging strategy”.]

As on 30/06/xx, the rolled forward rate is Rs. 44/$ for maturity of 31/12/xx when the spot rate is Rs. 43.75/$, thus following entries are passed:

a. For booking Settlement gain on cover  (43.75/$ - 43.50/$) (i.e. Spot value – last MTM forward rate)

b. Rollover gain received from bank (43.75/$ - 42.50/$) (i.e. Spot value – Original forward value)

September 30, 20xx:

The commitment is not yet recognised. MTM gain/loss on cover till the date of period closing would be recognised in hedging reserve (Equity), following cash flow hedge accounting.

As on 30/09/xx, forward cover with maturity of 31/12/xx is available @ Rs. 44.50/$, thus MTM gain of Rs 0.50/$. (MTM forward rate $44.50– original forward rate of the rolled over contract $ 44.00)

December 31, 20xx:

a. Record the purchase at spot rate of 43.5/$:

b. For booking MTM Settlement loss  (43.50/$ - 44.50/$) (i.e. Spot value – last MTM forward rate)

c. Record the payment of the liability to vendor

d. Net Settlement loss paid to bank(43.5/$ - 44.0/$) (i.e. Spot value – Original forward value)

e. Balance in hedging reserve transferred to income statement

The commitment recognised in books at the rate mentioned in Bill of lading and the change in fair value of forward contract from the date of inception to the date of recognising commitment is allocated to cost of raw material consumed.

“Paragraph 109b of AS 30:  “It removes the associated gains and losses that were recognised in other comprehensive income in accordance with paragraph 106, and includes them in the initial cost or other carrying amount of the asset or liability”

Note: As per AS 30 para 109b, head of Profit & Loss Account would depend upon the nature of underlying for which the cover the taken. Since AS 2 on Inventory Valuation does not permit MTM as part of valuation for unsold goods, the MTM will be released from hedging reserve to profit & loss account as and when the inventory is consumed. Thus the MTM will remain in Hedging Reserve till the underlying transaction is debited in Profit & loss account. This essentially in line with option available under para 109a of AS 30.

Refer table 4 for accounts at a glance for accounting entries passed above at various dates:

Table 4: Accounts at Glance for Accounting under AS 30

Commercial Analysis:

It can be seen in the above example, that the organisation had an exposure on import of raw material. The exposure started from the date when it entered into a firm commitment and ended when the actual outflow is made.

The exchange rate has been volatile during the period as it moved upwards from Rs 42.5/$ as on 01/1 to Rs 44.25/$ on 30/9 before closing at Rs 43.5/$ on 31/12. The Company decided to fix its outflow on the date of its commitment and entered into a forward contract to buy dollars @ 42.5 per USD. Subsequently the same contract was rolled over for meeting the scheduled payment to the creditor by incurring 0.25 paisa premium per dollar bought. The Company’s exposure was hedged by two contracts at the effective cost of 42.75 per dollar. These types of two contracts are common where the underlying exposure is longer.

The Company’s cost of raw material has not been impacted on account of the volatilities in foreign exchange rate and is accounted at Rs. 4,275. Refer table 5 below to understand the effective rate per $.

Table 5: Effective Rate per Dollar

The above entries hold true even when the entity has a commitment for capital asset. The raw material account in the above example will be replaced by fixed asset account / depreciation.

Accounting without application of AS 30 principles

The forward contract being taken for a firm commitment, will not fall under AS 11. It will have to follow the conservative principles of AS 1 as laid down by ICAI in its announcement on 29-03-08.

“In case an entity does not follow AS 30, keeping in view the principle of prudence as enunciated in AS 1, Disclosure of Accounting Policies, the entity is required to provide for losses in respect of all outstanding derivative contracts at the balance sheet date by marking them to market.”

In above example, as on March 31, the MTM is a gain and hence there is no accounting entry for this contract. Had there been a loss in the contract, entity would have provided for the same.

The auditors would consider making appropriate disclosures in their reports if the aforesaid accounting treatment and disclosures are not made.

One may note that ICAI’s announcement dated 16-12-05 on disclosure continues to apply in both scenerios (i.e. AS 30 is applied or ICAI announcement dated 29-03-08 is followed). Thus enterprises continue to make the following disclosures regarding Derivative Instruments in their financial statements irrespective of accounting choice:

1. category-wise quantitative data about derivative instruments that are outstanding at the balance sheet date,

2. the purpose, viz., hedging or speculation, for which such derivative instruments have been acquired, and

3. the foreign currency exposures that are not hedged by a derivative instrument or otherwise.

Industry Applications

Mahindra & Mahindra Ltd (March 2012)

Derivative instruments and hedge accounting:

The Company uses foreign currency forward contracts / options to hedge its risks associated with foreign currency fluctuations relating to certain forecasted transactions. Effective April 1st 2007 the Company designates some of these as cash flow hedges applying the recognition and measurement principles set out in the Accounting Standard 30 "Financial Instruments: Recognition and Measurements"(AS 30).

Foreign currency forward contract/option derivative instruments are initially measured at fair value and are re-measured at subsequent reporting dates. Changes in the fair value of these derivatives that are designated and effective as hedges of future cash flows are recognized directly in reserves and the ineffective portion is recognized immediately in Profit and Loss Account.

The accumulated gains and losses on the derivatives in reserves are transferred to Profit and Loss Account in the same period in which gains or losses on the item hedged are recognized in Profit and Loss Account.

Changes in the fair value of derivative financial instruments that do not qualify for hedge accounting are recognized in the Profit and Loss Account as they arise.

Great Eastern Shipping (March 2012)

Derivative Financial Instruments and Hedging

Cash Flow Hedge:

Commodity future contracts, forward exchange contracts entered into to hedge foreign currency risks of firm commitments or highly probable forecast transactions, forward rate options, interest rate swaps and currency swaps which do not form an integral part of the loans, that qualify as cash flow hedges, are recorded in accordance with the principles of hedge accounting enunciated in Accounting Standard (AS) 30 – Financial Instruments : Recognition and Measurement as issued by the Institute of Chartered Accountant of India. The gains or losses on designated hedging instruments that qualify as effective hedges is recorded in the Hedging Reserve Account and is recognised in the Statement of Profit and Loss in the same period or periods during which the hedged transaction affects profit and loss or is transferred to the cost of the hedged non-monetary asset upon acquisition. Gains or losses on the ineffective transactions are immediately recognized in the Statement of Profit and Loss. When a forecasted transaction is no longer expected to occur, the gains and losses that were previously recognised in the Hedging Reserve, are transferred to the Statement of Profit and Loss immediately.

Companies that have adopted AS 30 under Indian GAAP include Essar Shipping Limited, First Source Solutions, Tata Coffee, Sterlite Industries (I) Limited, etc.

CA Sanjay Chauhan