Hedge your Re with care

Yogesh Sharma | Updated on July 14, 2013 Published on July 14, 2013

Hedge accounting rules under international accounting standards are being simplified and Indian standards should follow suit. Picture: Reuters

The rupee last week touched another record low at 61.21 against the dollar, sparking concern all round. Regulators and analysts are debating the causes and corrective actions needed. Certainly, no one could have imagined this in 1917 when a rupee equalled 13 dollars, or even in 1990 when it was about 18 rupees to a dollar. In fact, not many would have anticipated the rupee’s record plunge as about nine months ago it strengthened sharply to 52 from below 55.5 per dollar. But now with the rupee falling, Indian corporates are getting bruised with little to shield them.

Some of the large technology companies, which derive a significant portion of their revenues in dollars, recently posted substantial foreign exchange losses as their current hedges become ineffective and the losses on derivatives get recognised in profit or loss; they seem to have been caught off-guard. Others impacted would be the large companies in sectors such as communications, infrastructure, power and metals, as they have significant foreign currency borrowings, and will incur more costs on account of higher rupee liability and interest expense in the June quarter.

While Indian corporates may have no control over the macroeconomic effects of rupee volatility, an effective hedging strategy can somewhat help predict the direct effects of the volatile rupee on the bottom line. However, in the uncertain times the rupee is going through, economic hedging generally involving the use of derivatives may turn out to be a costly bet. But an effective hedging strategy coupled with hedge accounting can help protect the bottom line against currency volatility.

Hedge accounting produces results that, in substance, reflect the company’s hedging strategy. International accounting standards set out detailed requirements for hedge accounting. Cash flow hedging and fair value hedging are two common hedge accounting techniques. Simply put, cash flow hedging is used to hedge cash flow risks, and fair value hedging is use to hedge the fair value risk of a financial instrument that affects profit or loss. For example, a variable-rate debt has the risk of unfavourably increasing interest amounts if interest rates rise and, thus, can be cash flow hedged in accounting. Similarly, a fixed-rate debt has the risk of unfavourably gaining fair value if interest rates fall and can be fair value hedged.

In the current context, consider the example of an Indian company whose revenues are in dollars and which had hedged its foreign exchange risk exposures using forward contracts. It would recognise the losses from the falling rupee on such derivatives in profit or loss, while the gain from its dollar revenues may not have been recognised yet. This can happen when the forward contracts are obtained to hedge revenues in the future — say, a forward contract at the time of entering the sales contract.

Now, even though the company had economically hedged its risk, it is still exposed to volatility in its bottom line as the gain or loss on the hedged item and the hedging instrument are not necessarily recognised at the same time. This, in accounting, is known as a ‘mismatch’, which hedge accounting seeks to eliminate. With hedge accounting, conceptually the company would have been able to temporarily defer the recognition of loss on the forward contract and recognised it in profit or loss in the same period as the revenues are recognised. This is achieved by cash flow hedging.

Under Indian accounting standards, hedge accounting rules are contained in AS-30 and the proposed IndAS-39. While the Indian standards have similar guidance as the international standards, the former is not mandatory. Also, the hedge accounting rules are strict and can sometimes even be onerous. The significant requirements for systems and processes may go beyond accounting. These include formalisation of the risk management objective and strategy, evaluation and documentation of hedged risks and hedging instruments, and an ongoing assessment of hedge effectiveness involving complex mathematical computations. For the same reasons, there is a move to simplify hedge accounting rules under international accounting standards. Indian accounting standards too should be amended to encourage Indian corporates to adopt hedge accounting.

The rupee’s recovery, at best, can be expected to be uncertain and slow. What that might also mean is a bumpy ride home for the rupee and only more volatile times ahead. As Indian corporates realign their hedges to the changing sentiments and expectations, hedge accounting may be worth a consideration for its costs and benefits.

The author is Partner, Assurance, Grant Thornton India LLP

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Published on July 14, 2013
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