hedge new rules

ASSURANCE & ADVISORY

IAS 39Financial Instruments : Recognition and Measurement

John Kidd

Partner

Financial Services Group

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Foreign Currency Transaction - Example

• 2 Jan 2004, Tinman Ltd expects to sell of 100 tonnes of Tin

• Receipt from sale = USD 550,000• Tinman hedges the foreign currency risk• Estimated Settlement Date = 10 April 2004 • Tinman enters into a forward foreign exchange contract

– sell USD 550,000– value date 10 April 2004– forward rate .60– spot rate at transaction date .61

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Foreign Currency Transaction – Hedge Steps

1. Determine your functional currency2. Determine the type of hedge 3. Document, Document, Document

• Policy document supported by• Individual hedge documentation

4. Value the derivative5. Quantify the degree of ineffectiveness6. Prepare the journal entries

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Impact on Hedging• Situation – Sales in USD, Cost in AUD

• Functional Currency – USD or AUD?

• Impact on hedging – Functional currency will determine source of foreign currency risk. Hence impacts your risk management approach

E.g. If FC = AUD - then hedge FX exposure on USD SalesIf FC = USD – then hedge FX exposure on AUD

Costs

• Functional Currency decision is subjective and the consequences of the decision must be considered re hedging impact

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Factors re Functional Currency

Factors to consider re the Currency

– That mainly influences sales prices– Of the country whose competitive forces and

regulations – mainly determine the sales prices– That mainly influences labour, material and other

costs

When indicators are mixed and the functional currency is not obvious, management uses judgement to determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions.

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Overview - Hedge Relationship– hedging instrument– hedged item

AND

– formal documentation of the hedging relationship– hedge is highly effective– any forecasted transactions (underlying) must be highly probable (Cash Flow

Hedges)– effectiveness can be reliably measured– effectiveness assessed on an on-going basis and shown to be effective

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• Derivative• Must be designated in its entirety (IAS 39.74)

• Including embedded derivatives • "Proportion" is allowed (IAS 39.75)• not permitted for certain written options (IAS 39.77 & AG92)• time value can be excluded (IAS 39.74)• cannot split the derivative on a time basis (IAS 39.75)• combinations are permitted (IAS 39.77)• must be external to the group in consolidate accounts (IAS 39.73)

• Other financial instruments (IAS 39.72)• Foreign currency risk only• Entity’s own securities are not financial assets/liabilities

Overview – Hedging Instrument

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• Recognised Asset • Recognised Liability• Unrecognised Firm Commitment• Highly Probable Forecast Transaction• Net Investment in a Foreign Operation

Overview - Hedged Item (1 of 2)

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2/1/2004

Expected Sale

Enter into

sell USD

buy AUD

forward fx contract

Recognition Date

10/4/2004

Record Sale

Spot Rate plus gain/loss on fx contact

Record Receivable

Spot Rate

Settle the USD forward

Settle the USD receivable

Foreign Currency Transaction – Example, Sequence

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Overview – Exposures

Net Net investmentinvestmentin a foreignin a foreign

entityentity

Net Net investmentinvestmentin a foreignin a foreign

entityentity

Cash flowCash flowCash flowCash flowFair Fair ValueValueFair Fair

ValueValue

Exposure ?Exposure ?

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• Firm Commitment– Fixed volume– Fixed price– Fixed maturity date

Can be Fair Value or Cash Flow

• Highly probable forecast transaction

Always Cash Flow

Type of Hedge

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Example of Documentation

• Policy Document Summarises key aspects of IAS 39 for

your business / hedge arrangements

• Individual Hedge Documentation Documents hedge relationship for each

derivative

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Hedge Documentation Checklist

• Identification of:• the hedging instrument • and the hedged item

• The nature of the risk being hedged• Type of Hedge• Time value included or excluded• The risk management strategy• The risk management objective• How effectiveness will be assessed• Effectiveness assessment

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Nature of the Risk to be Hedged

• Commodity– FX Risk or– Overall Risk

• Financial Asset or Liability– Overall Risk– Credit Risk– Benchmark Interest Rate Risk– FX Risk

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Strategy / Objective

Strategy• Board policy has set a strategy of hedging 100% of

firm commitments to minimise foreign currency risk

Objective• The objective of the hedge is to offset cash flows of

the hedged item from foreign exchange risk, such that when the hedge item and the hedge are combined the AUD cash flow associated with the purchase is fixed.

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Assessing Effectiveness

• IAS 39 AG 105. • A hedge is highly effective if:

– Prospective– at inception and throughout the life of the hedge, the entity can expect changes in the fair value or cash

flows of the hedged item that are attributable to the hedged risk to be almost fully offset by the changes in the fair value or cash flows of the hedging instrument

– Retrospective– and actual results are within a range of 80%-125%

– For example, if actual results are such that the loss on the hedging instrument is CU 120 and the gain on the cash instrument is CU 100, offset can be measured by 120/100 which is 120%, or by 100/120 which is 83%. In this example, the entity would conclude that the hedge is highly effective.

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Assessing Effectiveness: How?

• Regression analysis

• Ratio dollar offset (period-to-period or cumulative)

• Volatility Reduction Method

• Matched terms

• Treatment of time value

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Ratio Dollar Offset

• Ratio of 80% to 125% considered highly effective

• Ratio = Change in FV of derivative Change in FV of hedged item

• Period-to-Period– Compare prices over distinct intervals (Q1 v. Q2)

• Cumulative– Compare prices at two different points in time (beginning of

hedge v. today)• Issues

– Small dollar changes– Point-in-time measurement– Non-statistical

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Month ended

Derivative Gain (Loss) in Period

Hedge Item Gain (Loss) in Period

Period Change Ratio

Cumulative Change Ratio

Aug 2000 100 (95) 105% 105%

Sept 2000 30 (25) 120% 108%

Oct 2000 (10) 10 100% 109%

Nov 2000 (7) 10 70% 113%

Dec 2000 20 (5) 400% 127%

Example – Ratio Dollar Offset

• Entity has firm commitment to purchase copper in January 2006

• Use derivative to hedge against price risk

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Matched Terms Method• If critical terms of the hedging instrument and of the entire

hedged asset or liability or hedged forecasted transaction are the same, conclude no ineffectiveness– Same quantity– Same underlying (including grade, if a commodity)– Same time– Same location– Fair value of the hedging instrument at inception = zero

• Need to consider credit risk and liquidity• Subsequent assessments of effectiveness:

– Verify and document whether the critical terms of the hedge and the underlying risk have changed during the period in review

– Consider risk of default of counterparty

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Highly Probable – FX Exposure

• Considerations– consistency with planned or budgeted production – capacity– frequency of past transactions

• Hedged Item– Project ID expected to occur in a month

• If project schedule rolls than potentially hedge rolls– Not unlimited– Depends on documented hedge strategy– No project / roll limits breached, P&L recognition

• Forecasts– incentive not to change expected dates for future accounting

periods– changes to expected dates within current account period will have

same profit and loss impact

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Settle the USD forward

Settle the USD receivable

Forecast Foreign Currency Transaction – Example

1/2/2004

Forecast Sale

Recognition Date

10/4/2004

Recognise Sale

Recognise Accounts Receivable

Hedged risk is FX cash flow exposure on Hedged risk is FX cash flow exposure on receivable to be settled in 10 April.receivable to be settled in 10 April.

What is the accounting?What is the accounting?

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Forecasted Foreign Currency Transaction – Example, Information • Spot rates

– Recognition date – sale (or purchase) – At each receivable (or payable) remeasurement date

• Forward rates– At inception– At each remeasurement date

• Risk-free Interest Rates– Discount cash flows on forward / forecasted transaction*

• * For purposes of this illustration, using notional resulting from change in forward rates, but typically must discount using applicable risk free interest rates

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Forecasted Foreign Currency Transaction – Example, fair Value

Deal 0.5500 Dealt Rate

Buy AUD 1,000,000 Sell USD 550,000

Data

Spot Rate 0.6000Forward Points -10Convert -0.0010Forward Outright 0.5990

Days to Maturity 33Discount Rate 5.0%

Fair Value

AUD Equivalent 918,197 of USD at Forward RateNotional Gain/Loss 81,803 GainFair Value 81,435 Discounted 81,.803 / ( 1+ ( 5 % x 33 / 365 ) )

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Where does ineffectiveness come from?

• If all terms are matched the relationship between the hedging instrument and hedged item should be 100% effective

• Ineffectiveness arise when terms are not matched• Examples

– Different reference rate – Different currency – Different grade commodity– Different delivery location

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Effectiveness Assessment and Measurement of Ineffectiveness

• Expectation (assessment) of high effectiveness differs from the measurement of ineffectiveness

• 2 Step Process

– Assessment of effectiveness:• Can hedge accounting be applied?• Prospective and Retrospective

– Measurement of ineffectiveness:• Net profit impact• Based on actual results• Ineffectiveness is not used to determine whether hedge accounting

should be applied• But it may indicate that high effectiveness can no longer be expected

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Measuring Ineffectiveness: Cash Flow

• Need to calculate ineffectiveness separately• Amounts recognised in equity are limited to the

lesser of:– Fair value change of the derivative OR– Expected future cash flows of the hedged transaction

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Measuring Ineffectiveness: Cash Flow

• Limits in Equity:– Derivative fair value changes by more than the change in cash

flows of the hedged item• Derivative increases by $100; expected future cash flows decrease by

$90• $10 would be recorded in earnings as ineffectiveness while $90 would

go to equity as the effective portion of the hedge

– Derivative fair value changes by less than the change in cash flows of the hedged item

• Derivative increases by $90; expected future cash flows decrease by $100

• $0 would be recorded in earnings as ineffectiveness and entire $90 would go to equity as the effective portion of the hedge

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Overview - Fair Value Hedge Accounting

Hedging instrument

Changes in fair value go to Net Profit

Hedged item

Fair value the hedged item due to the hedged risk and recognise changes in fair value in Net Profit

Net Profit (net impact = ineffectiveness)Net Profit (net impact = ineffectiveness)

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Overview - Cash Flow Hedge – Accounting (Method 1)

Changes in Fair Value of Hedging Instrument

Net ProfitSeparate

component of Equity (reserve)

Effective portion

Ineffective portion

Recognised with hedged

itemIAS 39.95

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Overview - Cash Flow Hedge – Accounting ( Method 2 – Amendment )

Changes in Fair Value of Hedging Instrument

Net ProfitSeparate

component of Equity (reserve)

Effective portion

Ineffective portion

Basis Adjustment to Hedged Item IAS 39.98(b)

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Forecasted Foreign Currency Transaction – Example, High Level

1/2/2004

Forecast Sale

Recognition Date

10/4/2004

Revalue fx contract to fair value through equity

Record Sale.

Revalue Accounts Receivable at spot through Net Profit

Revalue fx contract to fair value through net profit

Transfer equity to sales (net profit)

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Implementation - Plan

1. Form implementation team

2. Review risk management policies

3. Compile inventory of derivatives & related exposures

4. Categorise inventory & exposures

5. Assess processes/technology and implement changes

6. Develop and test hedge effectiveness / valuation models

7. Determine tax impact / transition adjustments

8. Evaluation of disclosures

9. Develop ongoing monitoring process

10. Inform stakeholders

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• Timeline for companies with June year-end:

Timetable

2005

31stDecember

31stDecember

2004

1stJanuary

Present first reportManage Investor Relations

20052004Scope the impactIdentify business issuesPlan the implementation

Design and implement systemsTrain staff

Implement business decisionsParallel run and test system

INTRODUCTIONOF IFRS

STANDARDS

Full YearComparatives Due

2004 System and documentation requirementsimplemented

2006

31stDecember

2006First Full Year

IFRS CompliantFinancial

StatementsDue

Opening balance sheet

under IFRS

For Nylex, the first presentation of fully compliant financial statements will be for the year ended 30 June 2006

First consolidation and comparatives

hedge new rules

Economy & Finance