Go for hedge accounting

The rupee depreciation against the dollar has adversely impacted several companies, especially those that are import-dependent. Similarly, many companies, lured by low interest rates and easy access, have raised debt in foreign currencies. With their revenue largely denominated in rupee, they have huge foreign currency exposures on their balance sheet. Conversely, foreign currency volatility also affects exporters.

These companies commonly manage foreign currency risk through derivative contracts to hedge their exposure. For instance, an importer or exporter can manage its exposure to the cash outflow variability resulting from exchange rate movements through a forward contract that fixes the amount to be paid or received on settlement. Similarly, foreign currency debt raised through foreign currency convertible bonds or external commercial bonds often carry the dual risk of variable interest rates and foreign exchange risk, which can be hedged using cross-currency swaps.

Indian accounting standards do not have a comprehensive framework for derivative instruments. The current accounting for forward exchange contracts used to hedge existing balance sheet exposures is governed by Accounting Standard 11 — The effects of changes in foreign exchange rates. It requires amortising the premium or discount arising at the inception of the forward exchange contract as expense or income over the life of the contract. Further, the exchange difference on such contracts should be recognised under profit or loss to offset the exchange differences recorded on the underlying balance sheet exposure.

For forward exchange contracts not covered by AS-11 — that is, contracts without on-balance sheet underlying (for example, contracts to hedge forecasted purchase or sale transactions) — and other derivative contracts, the guidance from the Institute of Chartered Accountants of India requires companies to reflect mark-to-market losses at each reporting date in their profit or loss statement, using the principle of prudence. For such a contract, recognition of mark-to-market gains is prohibited. Therefore, even if an entity is hedging its forecasted transactions, such asymmetrical accounting may present a distorted picture of the management strategy in its financial statements.

An option to address such incongruent accounting and insulate the profit or loss from volatility is available under AS-30 — Financial instruments: recognition and measurement. Not mandatory yet, the voluntary adoption of AS-30 can permit an entity to adopt hedge accounting for derivative instruments such as forward contracts used to hedge forecasted purchase and sales transaction.

Hedge accounting is optional under AS-30 and is increasingly used to manage volatility in financial statements due to foreign currency movements. It permits two models of hedge accounting to address foreign exchange risk. Under the fair value hedge accounting model, an entity matches the basis of measurement of the hedged exposure with the derivative. Under the cash flow hedging model, an entity defers the recognition of gains and losses on derivatives until the underlying hedged transaction affects earnings (for example, until the forecasted sales or purchases occur). This aligns the measurement and reporting of the underlying exposure — such as a loan or foreign currency exposure, and the hedging instrument — such as the forward exchange contract, interest rate or cross-currency swap.

Hedge accounting can also be used for a more appropriate presentation. Thus, while companies that do not follow hedge accounting are required to reflect foreign exchange gains and losses as a separate component in the profit-and-loss, hedge accounting may enable presenting the gains and losses on hedging derivatives along with the underlying transactions (for example, gains and losses on forward exchange contracts to hedge forecasted sales may be presented as a component of sales).

It should be noted that hedge accounting is a privilege, not a right. It is permitted only when the criteria prescribed in AS-30 are met. These include formal designation and written documentation, as well as testing the hedge effectiveness at inception and on an ongoing basis. Its implementation can sometimes present challenges in terms of determining the hedging relationship and identifying upfront the methods for testing hedge effectiveness. Complexity in underlying transactions often leads to complexity in designing an ideal hedging solution, whereas the availability of a wide range of derivative products can often lead to valuation and testing methodology challenges.

Therefore, while hedge accounting can enable fairer representation of an entity’s foreign exchange risk profile in its financial statements, it brings its share of challenges. However, careful evaluation of the requirements at inception, embedding them into the financial reporting framework and employee training can facilitate smoother transition to hedge accounting. The benefits far outweigh the efforts.

The author is Global Head of Accounting Advisory Services, KPMG in India

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