Future of hedging: Indian Accounting Standards a giant leap forward in commodity risk management

Published: October 19, 2018 1:58 AM

hedge accounts, accounting standardThe basics of hedge accounting have not changed over the previous regime.

“Without change there is no innovation, creativity, or incentive for improvement. Those who initiate change will have a better opportunity to manage the change that is inevitable.”— William Pollard.

The transition to the Indian Accounting Standards (Ind AS) regime is a landmark for Indian industry, bringing about a paradigm shift in reporting and disclosures, besides improving transparency of financial statements, benchmarking them to global standards and accounting practices. It is said that “no matter how great the talent or efforts, some things just take time.” The standards have been adopted, but the transition and implementation in the industry ecosystem will take some gestation time. As per the ICAI study “Ind AS Impact Analysis and Industry Experience”, a key driver of the impact for participant businesses in financial markets has been ‘Ind AS 109 Financial Instruments’ and 58% respondents acknowledged that ‘Hedge Accounting’ has been highly challenging to understand and implement. Hence, an attempt has been made herewith to evaluate the upgrade introduced in ‘Hedge Accounting’ by Ind AS 109 over AS 30 and IAS 39.

Hedge accounting is a technique that modifies the normal basis for recognising gains and losses on associated hedging instruments and hedged items, so that both are recognised in P&L account or Other Comprehensive Income (OCI) in the same accounting period. Ind AS permits an entity to apply hedge accounting to represent the effect of risk management activities that use financial instruments to manage exposures arising from particular risks that could affect P&L or OCI.

The basics of hedge accounting have not changed over the previous regime. However, change as mandated by Ind AS 109 lies in widening the range of situations to which one can apply hedge accounting. Under Ind AS, hedge accounting can be applied to all hedge relationships, with the exception of ‘fair value macro hedges’. The rules are now more practical, principle-based and place greater emphasis on an entity’s risk management practices. They provide more flexibility, and allow corporates to apply hedge accounting where previously they would not have been able to. As a result, it’s an opportunity for corporate treasurers and boards to review their current hedging strategies and accounting, and to consider whether they continue to be optimal in view of the new accounting regime.

Flexibility in qualifying hedging instruments: Under the earlier regime of IAS 39/AS 30, corporates had limited choice of hedging instruments. Either they took some derivatives, or used non-derivative financial asset or liability in a hedge of a foreign currency risk only. Ind AS 109 allows a broader range of hedging instruments, so now one can use non-derivative financial asset or liability measured at fair value through P&L for hedging risks, even other than forex risks. For example, an oil and gas company may hedge fair value movement in its crude inventory through an investment in a fund whose return is linked to NYMEX WTI crude index. Under earlier regime of IAS 39/AS 30, one could not apply hedge accounting in a similar case, because in a fair value hedge, one could use non-derivative instruments only to hedge foreign exchange risk.

Economic relationship—a new concept: Ind AS 109 requires the existence of an economic relationship between the hedged item and the hedging instrument. It is unlikely that an entity would use an instrument that did not provide a valid economic relationship for risk management purposes, and so this is unlikely to be an arduous requirement in the case of most corporates. But there must be an expectation that the value of the hedging instrument and that of the hedged item will systematically change in response to movements in either the same underlying or underlyings that are economically related in a way that they respond in a similar way to the risk that is being hedged (for example, Brent and WTI crude oil).

Relaxed norms for hedge effectiveness: Ind AS 109 relaxes requirements for hedge effectiveness, removing the bright line test of 80-125%. It outlines more principle-based criteria compared with specific numerical thresholds as prescribed by the outgoing accounting standard. In Ind AS 109, an entity needs to demonstrate that an ‘economic relationship’ exists between the hedged item and the hedging instrument on a prospective basis. This change could result in more hedging relationships qualifying for hedge accounting based on actual risk management strategies of a company. For example, most petrochemical companies employ naphtha cracker units for cracking naphtha into polymers and olefins. Since naphtha is an end-product from fractional distillation of crude oil, its price movement is highly correlated with that of crude. Hence, Brent and WTI crude hedges are most common proxy hedges due to economic relationship with naphtha.

Depending on the factors, entities can perform either a qualitative or a quantitative assessment and a hedge would qualify for hedge accounting if:

* There is an economic relationship between the hedging instrument and the hedge item;

* The effect of credit risk does not dominate fair values of the hedging instrument and the hedged item;

* The hedge ratio is designated based on actual quantities of the hedged item and the hedging instrument.

Hedging practices of modern industry: Ind AS 109 introduces the concept of ‘rebalancing’—it refers to adjustments made to designated quantities of the hedged item or the hedging instrument of an already existing hedging relationship for the purpose of maintaining a hedge ratio that complies with hedge effectiveness requirements. It means modifying the hedge by adjusting a hedge relation for risk management purposes and respond to changes that arise from the underlying or risk variables. Under AS 30, rebalancing was not allowed and required terminating the current hedge relationship and starting a new one. This lead to de-designation or re-designation of a hedge, making it onerous. For example, company X produces industrial gas and requires three units of power to produce one unit of gas. In view of firm commitment sales of 5,000, company X hedges prospective purchase of 15,000 units of power, through futures contract. Later, on account of improved efficiency, company X requires only 2.5 units of power to produce one unit of industrial gas. So, it will adjust its hedge ratio from 3:1 to 2.5:1, and account this adjustment as rebalancing. At the time of this rebalancing, gain or loss on excess 2,500 units of power futures is immediately recognised in P&L.

Thus, Ind AS is providing a new direction to all corporates to make hedging an economically-sustainable activity as opposed to plain-vanilla hold. Freed from the narrow boundaries of the outgoing accounting standards, commodity price risk management has the potential to become a mainstream activity in line with international best practices.

By Punit Ajani and Ruchi Shukla. Ajani is Director, Financial Services Risk Management, EY; Shukla is AVP, Research, MCX. Views are personal.

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