Hedging Foreign Currency Firm Commitments

Introduction

Institute of Chartered Accountants of India (ICAI) had come out with an announcement in February 2011, on Application of AS 30, Financial instruments: Recognition and Measurement. It was clarified that ‘the prepares of Financial Statements are encouraged to follow the principles enunciated in accounting treatments contained in AS 30’. This is subject to any existing accounting standard or any regulatory requirement, which will prevail over AS 30.  Thus, considering the above exception, an entity can only follow ‘Hedge Accounting’ only to a certain extent i.e. only for forward contracts for highly probable future transactions or firm commitments in foreign currency, as these are excluded from the scope of AS 11. 

This Article brings out the aspect of hedging currency exposure during the commitment period by applying Cash flow hedge accounting, taking a Currency Forward Contract as an example for the Concept, Accounting and Measurement; with limited application of AS 30, in line with ICAI’s announcement in February 2011 in comparison to accounting such contract without applying AS 30.

To begin with, till the time Ind AS implementation dates are notified, entities can take the benefit of following hedge accounting and avoid volatility in income statement that arise from mark to market of forward contracts, taken for highly probable forecast transactions or firm commitments.

Entities enter into foreign exchange transactions during its regular course of business. These foreign exchange transactions include purchase & sale of goods and services as well as financing transactions such as foreign currency borrowings to leverage the interest rates of the International market. It is to be noted that these entities continue to operate in India and are thus exposed to foreign exchange fluctuation.

Foreign currency exposure in a business

Let us consider an entity that has started a trading business with a $100 loan, received on 1/4/xx when the rate of INR was 45. Thus the total loan amount received in INR is Rs 4,500. The same amount was invested to buy goods for trade in Indian domestic market. Assume the repayment period of 12 months and margin of 10%, the entity could recover Rs 4,950 (Rs 4,500 investment and Rs 450 profit) over the period of 12 months. If the exchange rate remains constant, there is no risk or exposure to the entity on foreign exchange borrowings. It will be able to retain Rs 450 in its own bank account and repay the $100 loan by transferring Rs 4,500 to the lending bank.

In the above case, if the exchange rate depreciates to Rs 50, the expected cash obligation for repayment of $100 loan will be Rs 5,000. In this case, the entity would lose the entire margin earned from its pure business and incur a loss of Rs 50 (Rs 4,950 – Rs 5,000).

Above example, considers one side exposure of foreign exchange. If the business was to trade the goods in international market in US$, it would have been able to get some natural offset on exchange fluctuations on revenue front. This is because the debtors would have also got converted in INR at a higher rate and thus the loss would have restricted only to the extent of mis-match in foreign currency inflows and outflows.

What is hedge?

In simple terms, it is a technique or an approach whereby the entity in above example can secure or protect its profit margin even when the exchange rate depreciates to Rs 50. However, if the exchange rate goes to Rs 40, the opportunity to take advantage of exchange is lost. Thus the profit may not increase but will remain intact.

It is to note that hedging is not about gaining or losing. It is about fixing the price risk, like freezing the volatility for the future. It can be on account of interest rates, commodity prices, currency, etc.

“Hedge is a way of protecting oneself against financial loss or other adverse circumstances” – Oxford Dictionary

“A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment. In simple language, Hedge (Hedging Technique) is used to reduce any substantial losses suffered by an individual or an organization.” – Wikipedia

An entity can protect its profits and meet its business plan by entering into various types of derivative contracts. Exposure on foreign currency can be hedged by Forward Contracts, Future Contracts and Currency Options, etc.  These contracts can be entered into with various banks as counter parties.

The entity can buy these contracts from market participants such as Banks who charge certain cost that include the interest differential and transaction fees. This cost is known as ‘Premium’. In above example discussed, the entity could protect its margin by paying a premium say Rs 50 and thus secure a net margin of Rs 400 irrespective of change in exchange rates.

Hedge Accounting:

“A hedging instrument is a designated derivative or (for a hedge of the risk of changes in foreign currency exchange rates only) a designated non-derivative financial asset or non-derivative financial liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item.

“A hedged item is an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that (a) exposes the entity to risk of changes in fair value or future cash flows and (b) is designated as being hedged”. (Paragraph 8 of AS 30)

The objective of Hedge accounting is to offset the gain / loss of the Hedge instrument with that of the hedge item.

A hedge taken by way of a forward contract can be of two types, namely Cash flow hedge or Fair value hedge. The governing factor for identify the correct type of designation is dependent on the hedged item and goes with the objective of hedge accounting.

“Cash flow hedge is a hedge of the exposure to variability in cash flows that:

i. Is attributable to a particular risk associated with a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction and

ii. Could affect profit or loss.

Fair value hedge is a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss.” (Paragraph 86 of AS 30)

“A hedge of the foreign currency risk of a firm commitment may be accounted for as a fair value hedge or as a cash flow hedge.” (Paragraph 97 of AS 30)

Brief differences between a Cash flow hedge and a Fair value hedge are shown in Table 1

Table 1:

As an exception to the identification of a type of hedge, entities can choose to account derivatives taken such as forward contracts, to hedge the foreign currency exposure on raw material or capital commitments, as either a ‘Cash flow hedge’ or a ‘Fair value hedge’.

As seen from various practical implementations, an entity usually chooses to designate such forward contracts as a Cash flow hedge. This designation allows posting of mark to market (MTM) gains and losses in ‘Hedging reserve’, which is part of reserves and surplus, without impacting the profit & loss account. Since the transaction will happen in future, there is no offset available in current period profit & loss account and hence it is more logical to defer the impact till the transaction happens.

The documentation, accounting treatment and hedge effectiveness testing can be done on the assumption that the hedge is entered into prior to booking the asset and related liability in the accounts, i.e. there is only a commitment at the point the hedge is entered into.

Sample documentation for hedging a foreign currency exposure on firm commitment for purchase of raw material is illustrated in Table 2:

Table 2: Documentation for Hedging of a Foreign Currency Exposure

Company: XYZ Limited.

Functional Currency: INR

COMPLETED BY: _________________________________               DATE: ____________

Practical aspect will be continued in second part.

CA Sanjay Chauhan