C.V.O. CAS NEWS & VIEWS VOL. 19 NO.

8 / FEBRUARY 2016

Contributed by :
ACCOUNTING FOR HEDGE AND CA Harsh Dedhia
(a member of the association)
OTHER FINANCIAL INSTRUMENTS
he can be reached at
harsh_dedhia86@yahoo.com

Introduction:
Accounting for financial instruments is as complicated as several of the present-day financial
instrumentsthemselves. Built on the basic theme of reporting at relevant, current values, the process of
rewriting hoaryhistorical cost accounting rules is still continuing hence, there has never been stabilityon
the international landscape of accounting standards on financial instruments accounting.Fair value
accounting standards, hedge accounting standards, accounting standards for de-recognition of financial
assets and liabilities, and derivative accounting standards All of this adds up into a veritable web of
complex accounting rules. Whatmakes the rules even more daunting is that the standards have been in a
flux over the last few years.Although, India had kept pace with the rest of the world by introducing all
kinds of financial instruments in the markets including derivatives, the pace at which accounting guidance
for these instruments was introduced was not in tandem.

Classification of Financial Instruments:

Financial Instruments, as defined under Indian Accounting Standards (Ind AS) 32,is any contract that
gives rise to a financial asset of oneentity and a financial liability or equity instrument of another entity.An
entity should recognize a financial asset or a financial liability in its balance sheet, when, and only when,
the entity becomes party to the contractual provisions of the instrument and also classify the same
according to measurement basis. For instance, planned future transactions, no matter how likely, are not
assets and liabilities because the entity has not become a party to contract. Ind-AS 109 requires that a
financial asset or a financial liability should be measured at initial recognition at its fair value (+/-)
transaction costs that are directly attributable to such asset or liability.

As per Ind-AS 109, financial assets are classified according to the measurement basis. Subsequent to initial
recognition, the financial assets are measured at Amortized Cost, Fair Value through Other
Comprehensive Income (FVTOCI), Fair Value through Profit and Loss (FVTPL) on the basis of entitys
business model for managing the financial assets and the contractual cash flow characteristics of the
financial asset. The classification categories that are possible for different financial assets are summarized
below:

Measurement Type of Financial assets

Category Derivative Investment in Investment in

Instrument an equity a debt instrument
Amortized Cost X
FVTOCI:
classified X
elected at initial recognition X
FVTPL:
classified X X X
elected at initial recognition X

Love is the spiritual essence of what we do. Technique is the manifestation of the preparation
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and investment as a result of the love.
VOL. 19 NO. 8 / FEBRUARY 2016 C.V.O. CAS NEWS & VIEWS

Intricacy of Regulations on Accounting for Derivative Contracts:

Due to the disparity in guidance by regulatory bodies like ICAI, Reserve Bank of India (RBI) and Ministry
of Corporate Affairs (MCA) varied practices wereapplied by different companies for financial instruments
and hedge accounting based on different Accounting Standards (AS). Indian Accounting Standard (Ind-AS)
109 provides comprehensive guidance for accounting for financial instruments and is much wider in
scope.However, as per the Ind-AS roadmap issued by the Ministry of Corporate Affairs (MCA), Ind-ASwill
currently not be applicable to Banks, NBFCs, Insurance companies and unlisted companies with a net-
worth of INR 250 crore. This would again lead to disparity in accounting between companies that would
transition to Ind-AS and those that would be out of the Ind-AS net.

In order to resolve this conundrum, as far as it relates with Derivative and Hedge Accounting, and bring
uniformity of practice in accounting for derivatives, the ICAI has issued a guidance note on accounting for
derivative contracts. The objective of this Guidance Note is to provide guidance on recognition,
measurement, presentation and disclosure for derivative contracts so as to bring uniformity in their
accounting and presentation in the financial statements.This Guidance Note becomes applicable for
accounting periods beginning on or after 1st April, 2016. Whilst the guidance note appears to be an interim
measure till Ind-AS 109 becomes applicable, it would impact entities that are currently scoped out of the
requirement to adoptInd-AS.

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C.V.O. CAS NEWS & VIEWS VOL. 19 NO. 8 / FEBRUARY 2016

Hedge Accounting:

The guidance note requires that all derivative contracts should be recognized on the balance sheet and
measured at fair value.Therefore all derivatives would be marked to market and changes in the fair value
would be recognized in the income statement.Fair value in the context of derivative contracts represents
the exit price i.e. the price that would be paid to transfer a liability or the price that would be received
when transferring an asset to a knowledgeable, willing counterparty. The fair value would also incorporate
the effect of credit risk associated with the fulfilment of future obligations.If any entity decides not to use
Hedge Accounting as described in the Guidance Note, it should account for its derivatives at fair value with
changes in fair value being recognised in the statement of profit and loss.If an entity decides to apply hedge
accounting as described in this Guidance Note, it should be able to clearly identify its risk management
objective, the risk that it is hedging, how it will measure the derivative instrument if its risk management
objective is being met and document this adequately at the inception of the hedge relationship and on an
ongoing basis.

The accounting for derivative instruments at fair value creates a common issue for organizations that
hedge risks using such instruments. Specifically, such organizations may face an accounting mismatch
between the derivative instrument which is measured at fair value, and the underlying exposure being
hedged, as typically underlying exposures are recognised assets or liabilities that are accounted for on a
cost or an amortized cost basis, or future transactions that have yet to be recognised. This accounting
mismatch results in volatility in the financial statements as there is no offset to the change in the fair value
of the derivative instrument.

Hedge accounting provides this offset by effectively eliminating/ reducing the accounting mismatch
through one of the following three ways:

Fair Value Hedge: which is achieved by accounting for the underlying exposure, asset or liability or
an unrecognized firm commitment(typically referred to as the hedged item) by adjusting the carrying
value for changes in the hedged risk, which would then offset, to the extent effective, the change in
the fair value of the hedging instrument. The result of such offsetting will have no net impact in the
statement of profit and loss except for the impact of ineffectiveness.

Measurement of Hedging Instrument

Change in
Fair Value
Profit
and
Measurement of HedgedItem
Loss
Change in Fair Value Statement
attributable to risk hedged

Cash Flow Hedge: seeks to offset certain risks of the variability of cash flows in respectof an existing
asset or liability or a highly probable forecast transaction that are deferred in shareholders equity
(cash flow hedge reserve),until the underlying exposure impacts statement of profit and loss in a
future period. For e.g. the use of a swap to change the future floating interest payments ona recognised
liability to fixed rate payments.

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of life everything he's got.
VOL. 19 NO. 8 / FEBRUARY 2016 C.V.O. CAS NEWS & VIEWS

Measurement of Hedging Instrument

Effective Portion Cash Flow

Hedge Reserve
Change
in Fair *
Value
Ineffective Portion Profit and Loss
Statement

*Amounts are subsequently transferred out of Cash Flow Hedge Reserve based on the same timing as
the hedged item impacts Profit and Loss Statement (e.g. interest income, interest expense, etc.)

An option of the basis adjustment approach (gains/losses are included as separate adjustmentthat is
clubbed with carrying amountof the asset or liability) is only relevant for hedges of forecastpurchases
of non-financial assets such as inventory or fixed assets. Any basis adjustment or accumulated balance
in the hedgingreserve will require to be tested at least at every reporting date for impairment.

Net Investment Hedge: which is a variation in a cash flow hedge, used to hedge foreign exchange risk
associated with net investments in foreign currency denominated operations. The hedging instrument
can either be a derivative instrument (foreign exchange forward contract) or a non-derivative
instrument (foreign currency denominated debt instrument), or a combination of a derivative and non-
derivative instruments.
Measurement of Hedging Instrument
Net Investment in
Foreign Operations
Effective Shareholders
Change Equity Foreign Currency
Portion Gain/ Loss
in
*
Fair
Value Ineffective
Profit and Loss
Portion Statement

*Amounts are subsequently transferred out of Net Investment Hedge Reserve in the same period
during which corresponding exchange gains or losses arising from the translation of the financial
statements of the foreign operation are recognised in profit and loss statement.

When the net investment is disposed, the cumulative amount in the foreign currencytranslation reserve in
equity is transferred to the statement of profit and loss as anadjustment to the profit or loss on disposal
of the investment. Therefore, it is necessary foran entity to keep a track of the amount recognised directly
in equity separately in respect ofeach foreign operation, in order to identify the amounts to be transferred
to the statement ofprofit and loss on disposal.

Synthetic accounting, i.e., accounting of combining a derivative and the underlying together as a single
package is not permitted. For instance, if any entity has aforeign currency borrowing that it has hedged
by entering into a cross currency interest rateswap, it would require the entity to recognize the loan
liability separately from the crosscurrency interest rate swap and not treat them as a package (synthetic
accounting) as INRloan. Netting off of assets and liabilities isalso not permittedfor presentation in
financial statements and hence all the amounts presented inthe financial statements should be gross
amountsexcept where basis adjustment is applied under cash flow hedges.Anentity is not permitted to
follow hedge accounting as recommended in the Guidance Noteretrospectively.
Continued on page no. 26

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