Tracking IFRS Hedging made simple: Part 5 Hedging using options

Transcription

1 Issue 2 October 20 For Private circulation only Tracking IFRS Hedging made simple: Part 5 Hedging using options. Hedging made simple the series Hedging made simple is a series of editions of Tracking IFRS to discuss concepts, principles, guidance, practices, application and illustrations of hedge accounting under AS 30 Financial Instruments: Recognition and Measurement. It may be noted that the guidance for hedge accounting in AS 30 is similar to guidance in Indian Accounting Standards (Ind AS) converged with International Financial Reporting Standards (IFRS) i.e. Ind AS 39 Financial Instruments: Recognition and Measurement. Part and 2 in the series contained basic concepts and principles of hedge accounting. Part 3 contained a detailed example illustrating cash flow hedge of a highly probable forecast transaction using forward contracts. Part 4 contained a detailed example illustrating a cash flow hedging of a variable rate debt using a variable-to-fixed cross-currency interest rate swap. It is recommended that this publication be read along with the concepts and principles discussed in Part and 2. This edition contains key principles of hedge accounting using options as hedging instruments and illustrates hedge accounting for cash flow hedge of a forecast transaction using a purchased foreign currency (forex) call option. Written options and net written options As a general rule, a written option does not qualify as a hedging instrument as the potential loss on an option that an entity writes could be significantly greater than the potential gain in value of a related hedged item. In other words, a written option is not effective in reducing the profit or loss exposure of a hedged item. Similarly, an instrument that combines a written option and a purchased option does not qualify as a hedging instrument if it is, in effect, a net written option (i.e. for which a net premium is received, or the notional amount on the written option exceeds that on the purchased option). Thus, a combination of two or more instruments (or proportions of them) may be designated as the hedging instrument only if none of them is a written option or a net written option. Forex options Option contracts can be structured using various financial variables e.g. foreign currency exchange rates, interest rates, stock prices, etc. This publication illustrates the hedge accounting principles using only the forex options. 2. Options as hedging instruments The standard does not restrict the circumstances in which options may be designated as a hedging instrument provided the conditions for hedge accounting are met, except for some written options. The standard permits separating the intrinsic value and time value of an option contract and designating as the hedging instrument only the change in intrinsic value of an option and excluding change in its time value. This helps in achieving high hedge effectiveness, as designating total option value will have inherent ineffectiveness because for accounting purposes, hedged risk comprises only of one-sided risk corresponding to the intrinsic value of the option.

2 Exhibit Forex options Basic concept Forex options (also known as currency options), by the very nature of the instrument, typically give the holder a right to buy or sell an agreed notional amount of foreign currency at an agreed fixed exchange rate. The holder of the instrument only has a right but not an obligation to exercise the option and hence, has no possibility of a loss on the contract. In order to provide the option to the holder of the instrument, the option writer (generally banks) charges a premium (price of the option) from the holder. In practice, the terms and pricing of the forex options are based on market expectations of the foreign currency exchange rates. Forex options Structures A simple, plain-vanilla option contract provides the holder a right to buy (a call option) or a right to sell (a put option) foreign currency. The holder of an option is said to have a long position e.g. holder of a call option is said to have a long-call. The seller or the writer of the option is said to have a short position e.g. writer of a call option is said to have a short-call. Forex option contracts can be structured in many ways. A complex option structure can involve a combination of option contracts e.g. a combination of call and put options (e.g. a long-call and long-put), or a combination of purchased and written options (for example as a collar). Such instruments are generally structured in ways that one leg finances the premium of the other leg e.g. financing the call option with a put option; and the net premium of the composite instrument at inception is zero. The same is generally achieved by combining an in-the-money option (beneficial for the holder) with an out-of -money option (beneficial for the writer), also known as a zero-cost collar (example of a collar can be an instrument that combines a long-call with a strike price of USD-INR exchange rate of `45 and a short-call with a strike price of USD-INR exchange rate of `48; thus, if the exchange rate goes higher than `45 the long-call will get triggered and the holder will gain, but the maximum gain is limited to `3 since if the exchange rate goes higher than `48 the short-call will also get triggered. In zero-cost collar, generally one leg of the instrument is out-of-the money, like the aforesaid instrument could be traded at spot prices less than `45, say, `44, and the probability of exchange rate going as high as `48 is low). There can also be exotic, more complex option structures, achieved by combining different combinations of long and short calls and puts. Forex options Valuation Like any option contract, the value of a forex option has two components viz. intrinsic value and time value. Intrinsic value is the difference between the spot price and the option s strike price. Thus, for a purchased call option which is in-the-money, the intrinsic value will be spot price minus the strike price; and for which is at-themoney or out-of-money, the intrinsic value will be zero. The time value of an option represents the potential of changes in the value of the option until expiry. Time value is computed as the difference between the option value and the intrinsic value. Option value (also called the theoretical option price) is determined using complex mathematical estimation techniques such as Black-Scholes or Binomial model, and requires the use of valuation experts. Forex options hedge accounting It may be noted that the standard prohibits designation of written options and net written options as hedging instruments, except in very limited situations. The following factors taken together suggest that an interest rate collar or other derivative instrument that includes a written option is not a net written option. (a) No net premium is received either at inception or over the life of the combination of options. The distinguishing feature of a written option is the receipt of a premium to compensate the writer for the risk incurred. (b) Except for the strike prices, the critical terms and conditions of the written option component and the purchased option component are the same (including underlying variable or variables, currency denomination and maturity date). Also, the notional amount of the written option component is not greater than the notional amount of the purchased option component. It may also be noted that the standard does not permit to split a single complex derivative instrument that consists more than one option and designate just the purchased option component as a hedging instrument. Therefore, a careful assessment of the eligibility of the option contract as a hedging instrument is required to be made before following hedge accounting. 2

3 3. Illustrative case study XYZ India Limited (the Company) is an Indian company engaged in manufacturing and trading of rail engines and coaches, respectively. XYZ imports coaches from AMRACO, a US manufacturer and resells to its customers. The transactions with the US supplier are made in USD. XYZ s reporting date is 3 March and prepares interim financial statements on a quarterly basis. XYZ, on April 2008, contracted to supply metro rail coaches to State Government of Karnataka for Bangalore Metro Project. The award of the contract to XYZ was based on a competitive techno-price bid. However, the contract was divided in 3 phases covered by 3 separate contracts; and the formal contract for phase 2 and 3 was to be executed based on satisfactory completion of the phase and 2, respectively. The contract is priced in INR. XYZ has completed phase and 2. The state government, on 30 June 200, has certified the satisfactory completion of phase 2. Based on its performance under phase and 2, XYZ is anticipating to also execute phase 3 of the contract. To achieve timely delivery in phase 3, XYZ has also already initiated talks with AMRACO to supply coaches for phase 3. The expected amount of purchase is USD,000,000 and the supply is expected to take place in March 202. On April 20, XYZ's management decides to hedge the foreign currency risk arising from its highly probable forecast purchase from AMRACO. Accordingly, XYZ purchases a call option i.e. a right to purchase USD against INR. On that date, the forecast purchase is considered as highly probable, as the execution of phase 3 is almost certain, and talks with the US supplier had already been initiated. The terms of the forward contract are as follows: Option: Purchased call Execution date: April 20 Maturity date: 3 March 202 Type: European Strike price: $ = ` Notional amount: $,000,000 Premium: ` 0,000 Relevant exchange rates and discount factors (using 8% discount rate) on various dates during the hedge period have been presented in the table on the next page: 4. Illustrative solution Exhibit Illustrative Board s resolution (click icon to retrieve attachment) Exhibit 2 Illustrative risk management policy (click icon to retrieve attachment) Note Board resolution and risk management policy is not a specific requirement of the standard. However, these documents have been included here in order that entities may consider the same in their documentation to meet the overall objectives of hedge accounting and for setting up necessary processes and approvals for hedge accounting. Further, for conditions for hedge accounting refer to risk management strategy, which assumes that the entities adopting hedge accounting have a documented risk management policy. The illustrative exhibits included here will assist in understating the overall documentation requirements. Tracking IFRS Hedging made simple: Part 5 3

4 Exchange rates and discount factors Particulars -Apr- 30-Jun- 30-Sep- 3-Dec- 3-Mar-2 Spot rate Discount factor (rate 8%) for cash flows on 3 March (+8%) ^ (+8%) ^ (+8%) ^ (+8%) ^ (+8%) ^ 0 Exhibit 3 Illustrative hedge accounting policy (click icon to retrieve attachment) Exhibit 4 Illustrative hedge documentation (click icon to retrieve attachment) Additional facts For the purpose of illustrative solution, the schedule of the value of purchased forex call option determined using the Black-Scholes method has been assumed as follows. However, in practice, the same will be required to be computed using the help of valuation experts and a careful evaluation of the variables input in the valuation method will be required. Exhibit 5 Illustrative effectiveness testing and journal entries for cash flow hedging of highly probable forecast transaction using purchased forex call option (continued on next page) Date of measurement Option value -Apr- `0, Jun- `75, Sep- `85,000 3-Dec- `300,000 3-Mar-2 `500,000 4

5 Exhibit 5: Illustrative effectiveness testing and journal entries Hedge accounting in the books of accounts of XYZ India Limited April 20 (inception of hedge). Computation of intrinsic value Particulars Hedging instrument purchased call option Notional amount (N),000,000 Notional amount (N),000,000 Spot price on the date of testing 45 Spot price on the date of testing 45 Greater of zero, or [spot price - 0 Lower of zero, or [strike price - 0 strike price] (V) spot price] (V) Discount factor (D) Discount factor (D) Intrinsic value (N x V x D) 0 Intrinsic value (N x V x D) 0 2. Prospective hedge effectiveness testing sensitivity analysis Particulars Hedging instrument purchased call option Notional amount (N),000,000 Notional amount (N),000,000 Spot price on the date of testing 45 Spot price on the date of testing 45 Shifted spot price (spot price Shifted spot price (spot price %) 0%) Greater of zero, or [shifted spot price - strike price] (V) 4.45 Lower of zero, or [strike price - shifted spot price] (V) Discount factor (D) Discount factor (D) Intrinsic value (N x V x D) 4,20,255 Intrinsic value (N x V x D) (4,20,255) (4.45) Prospective hedge effectiveness = Change in the intrinsic value of the purchased forex call option due to sensitivity analysis Change in the intrinsic value of the hypothetical derivative due to sensitivity analysis = 4,20,255-0 = 00% (sign ignored) (4,20,255) - 0 At the inception of the hedge, the hedge is expected to be highly effective as the result is within the range 80-25%. 3. Accounting entries Derivative asset Dr. `0,000 Bank Cr. `0,000 (being premium paid for purchasing forex call option, transaction number DR ) No other accounting entry is required to be passed. Tracking IFRS Hedging made simple: Part 5 5

6 Hedge accounting in the books of accounts of XYZ India Limited 30 June 20 (interim reporting date during hedge period). Computation of intrinsic value Particulars Hedging instrument purchased call option Notional amount (N),000,000 Notional amount (N),000,000 Spot price on the date of testing Spot price on the date of testing Greater of zero, or [spot price - 0 Lower of zero, or [strike price - 0 strike price] (V) spot price] (V) Discount factor (D) Discount factor (D) Intrinsic value (N x V x D) 0 Intrinsic value (N x V x D) 0 2. Retrospective hedge effectiveness testing Retrospective hedge effectiveness (cumulative basis) = Change in the intrinsic value of the purchased forex call option from inception Change in the intrinsic value of the hypothetical derivative from inception = No change = 00% (sign ignored); the hedge was fully effective during the period. No change 3. Prospective hedge effectiveness testing sensitivity analysis Particulars Hedging instrument purchased call option Notional amount (N),000,000 Notional amount (N),000,000 Spot price on the date of testing Spot price on the date of testing Shifted spot price (spot price Shifted spot price (spot price %) 0%) Greater of zero, or [shifted spot price - strike price] (V) Lower of zero, or [strike price - shifted spot price] (V) (4.505) Discount factor (D) Discount factor (D) Intrinsic value (N x V x D) 4,25,369 Intrinsic value (N x V x D) (4,25,369) Prospective testing = Change in the intrinsic value of the purchased forex call option due to sensitivity analysis Change in the intrinsic value of the hypothetical derivative due to sensitivity analysis = 4,25,369-0 = 00% (sign ignored) (4,25,369) - 0 The hedge is expected to be highly effective as the result is within the range 80-25%. 6

7 Hedge accounting in the books of accounts of XYZ India Limited 30 June 20 (interim reporting date during hedge period) (contd.) 4. Accounting entries All the criteria for hedge accounting are met for the period ended 30 June 20, and cash flow hedge accounting therefore can be applied. The hedge is 00% effective, and, therefore, the amount recognised in appropriate equity account/ other comprehensive income is equal to the effective portion of cumulative change in the intrinsic value of the purchased forex call option. This can also be determined as lower of (a) the cumulative change in the intrinsic value of the purchased forex call option, and (b) the cumulative change in the intrinsic value of the hypothetical derivative. Particulars Hedging instrument - A Hedged item (hypothetical derivative) - B Effective portion - C (lower of A and B in absolute terms) Ineffective portion - (difference between A and C in absolute terms) Change from inception of hedge Change in the period There is no change in the intrinsic value of the purchased forex call option (and the hypothetical derivative) in the current period. Following entry shall be passed to record the change in the time value, not designated as hedged, of the purchased call option. Derivative asset Dr. `65,000 Profit or loss Cr. `65,000 (being change in the time value of the purchased call option during the period recorded in profit or loss as the same has not been designated as hedged). The same has been computed as follows: Date of measurement Option value (A) Intrinsic value (B) Time value (A - B) -Apr- `0,000 `0 `0, Jun- `75,000 `0 `75,000 Change during the period `65,000 Tracking IFRS Hedging made simple: Part 5 7

8 Hedge accounting in the books of accounts of XYZ India Limited 30 September 20 (interim reporting date during hedge period). Computation of intrinsic value Particulars Hedging instrument purchased call option Notional amount (N),000,000 Notional amount (N),000,000 Spot price on the date of testing 45.5 Spot price on the date of testing 45.5 Greater of zero, or [spot price - 0. Lower of zero, or [strike price - (0.) strike price] (V) spot price] (V) Discount factor (D) Discount factor (D) Intrinsic value (N x V x D) 96,20 Intrinsic value (N x V x D) (96,20) 2. Retrospective hedge effectiveness testing Retrospective hedge effectiveness (cumulative basis) = Change in the intrinsic value of the purchased forex call option from inception Change in the intrinsic value of the hypothetical derivative from inception = 96,20-0 = 00% (sign ignored); the hedge was fully effective during the period. (96,20) Prospective hedge effectiveness testing sensitivity analysis Particulars Hedging instrument purchased call option Notional amount (N),000,000 Notional amount (N),000,000 Spot price on the date of testing 45.5 Spot price on the date of testing 45.5 Shifted spot price (spot price Shifted spot price (spot price %) 0%) Greater of zero, or [shifted spot price - strike price] (V) 4.65 Lower of zero, or [strike price - shifted spot price] (V) (4.65) Discount factor (D) Discount factor (D) Intrinsic value (N x V x D) 4,440,092 Intrinsic value (N x V x D) (4,440,092) Prospective testing = Change in the intrinsic value of the purchased forex call option due to sensitivity analysis Change in the intrinsic value of the hypothetical derivative due to sensitivity analysis = 4,440,092-96,20 = 00% (sign ignored) (4,440,092) - (96,20) The hedge is expected to be highly effective as the result is within the range 80-25%. 8

9 Hedge accounting in the books of accounts of XYZ India Limited 30 September 20 (interim reporting date during hedge period) (contd.) 4. Accounting entries All the criteria for hedge accounting are met for the period ended 30 September 20, and cash flow hedge accounting therefore can be applied. The hedge is 00% effective, and, therefore, the amount recognised in appropriate equity account/ other comprehensive income is equal to the effective portion of cumulative change in the intrinsic value of the purchased forex call option. This can also be determined as lower of (a) the cumulative change in the intrinsic value of the purchased forex call option, and (b) the cumulative change in the intrinsic value of the hypothetical derivative. Particulars Hedging instrument - A Hedged item (hypothetical derivative) - B Effective portion - C (lower of A and B in absolute terms) Ineffective portion - (difference between A and C in absolute terms) Change from inception of 96,20 (96,20) 96,20 0 hedge Change in the period 96,20 (96,20) 96,20 0 Derivative asset Dr. `96,20 Hedging reserve Cr. `96,20 (being effective portion change in the intrinsic value of the purchased forex call option designated as hedged recognised in equity; thereby, reducing volatility in profit or loss to that extent) Following entry shall be passed to record the change in the time value, not designated as hedged, of the purchased call option. Derivative asset Dr. `3,790 Profit or loss Cr. `3,790 (being change in the time value of the purchased call option during the period recorded in profit or loss as the same has not been designated as hedged). The same has been computed as follows: Date of measurement Option value (A) Intrinsic value (B) Time value (A - B) 30-Jun- `75,000 `0 `75, Sep- `85,000 `96,20 `88,790 Change during the period `3,790 Tracking IFRS Hedging made simple: Part 5 9

10 Hedge accounting in the books of accounts of XYZ India Limited 3 December 20 (interim reporting date during hedge period). Computation of intrinsic value Particulars Hedging instrument purchased call option Notional amount (N),000,000 Notional amount (N),000,000 Spot price on the date of testing Spot price on the date of testing Greater of zero, or [spot price Lower of zero, or [strike price - (0.25) strike price] (V) spot price] (V) Discount factor (D) Discount factor (D) Intrinsic value (N x V x D) 245,250 Intrinsic value (N x V x D) (245,250) 2. Retrospective hedge effectiveness testing Retrospective hedge effectiveness (cumulative basis) = Change in the intrinsic value of the purchased forex call option from inception Change in the intrinsic value of the hypothetical derivative from inception = 245,250-0 = 00% (sign ignored); the hedge was fully effective during the period. (245,250) Prospective hedge effectiveness testing sensitivity analysis Particulars Hedging instrument purchased call option Notional amount (N),000,000 Notional amount (N),000,000 Spot price on the date of testing Spot price on the date of testing Shifted spot price (spot price Shifted spot price (spot price %) 0%) Greater of zero, or [shifted spot price - strike price] (V) 4.78 Lower of zero, or [strike price - shifted spot price] (V) Discount factor (D) Discount factor (D) Intrinsic value (N x V x D) 4,689,80 Intrinsic value (N x V x D) (4,689,80) (4.78) Prospective testing = Change in the intrinsic value of the purchased forex call option due to sensitivity analysis Change in the intrinsic value of the hypothetical derivative due to sensitivity analysis = 4,689,80-245,250 = 00% (sign ignored) (4,689,80) - (245,250) The hedge is expected to be highly effective as the result is within the range 80-25%. 0

11 Hedge accounting in the books of accounts of XYZ India Limited 3 December 20 (interim reporting date during hedge period) (contd.) 4. Accounting entries All the criteria for hedge accounting are met for the period ended 3 December 20, and cash flow hedge accounting therefore can be applied. The hedge is 00% effective, and, therefore, the amount recognised in appropriate equity account/ other comprehensive income is equal to the effective portion of cumulative change in the intrinsic value of the purchased forex call option. This can also be determined as lower of (a) the cumulative change in the intrinsic value of the purchased forex call option, and (b) the cumulative change in the intrinsic value of the hypothetical derivative. Particulars Hedging instrument - A Hedged item (hypothetical derivative) - B Effective portion - C (lower of A and B in absolute terms) Ineffective portion - (difference between A and C in absolute terms) Change from inception of 245,250 (245,250) 245,250 0 hedge Change in the period 49,040 (49,040) 49,040 0 Derivative asset Dr. `49,040 Hedging reserve Cr. `49,040 (being effective portion change in the intrinsic value of the purchased forex call option designated as hedged recognised in equity; thereby, reducing volatility in profit or loss to that extent) Following entry shall be passed to record the change in the time value, not designated as hedged, of the purchased call option. Profit or loss Dr. `34,040 Derivative asset Cr. `34,040 (being change in the time value of the purchased call option during the period recorded in profit or loss as the same has not been designated as hedged). The same has been computed as follows: Date of measurement Option value (A) Intrinsic value (B) Time value (A - B) 30-Sep- `85,000 `96,20 `88,790 3-Dec- `300,000 `245,250 `54,750 Change during the period `(34,040) Tracking IFRS Hedging made simple: Part 5

12 Hedge accounting in the books of accounts of XYZ India Limited 3 March 202 (end of the hedge period). Computation of intrinsic value Particulars Hedging instrument purchased call option Notional amount (N),000,000 Notional amount (N),000,000 Spot price on the date of testing Spot price on the date of testing Greater of zero, or [spot price Lower of zero, or [strike price - (0.50) strike price] (V) spot price] (V) Discount factor (D).0000 Discount factor (D).0000 Intrinsic value (N x V x D) 500,000 Intrinsic value (N x V x D) (500,000) 2. Retrospective hedge effectiveness testing Retrospective hedge effectiveness (cumulative basis) = Change in the intrinsic value of the purchased forex call option from inception Change in the intrinsic value of the hypothetical derivative from inception = 500,000-0 = 00% (sign ignored); the hedge was fully effective during the period. (500,000) Prospective hedge effectiveness testing sensitivity analysis No prospective effectiveness testing is required as it is the end of the hedge period. 4. Accounting entries All the criteria for hedge accounting are met for the period ended 3 March 202, and cash flow hedge accounting therefore can be applied. The hedge is 00% effective, and, therefore, the amount recognised in appropriate equity account/ other comprehensive income is equal to the effective portion of cumulative change in the intrinsic value of the purchased forex call option. This can also be determined as lower of (a) the cumulative change in the intrinsic value of the purchased forex call option, and (b) the cumulative change in the intrinsic value of the hypothetical derivative. Particulars Hedging instrument - A Hedged item (hypothetical derivative) - B Effective portion - C (lower of A and B in absolute terms) Ineffective portion - (difference between A and C in absolute terms) Change from inception of 500,000 (500,000) 500,000 0 hedge Change in the period 254,750 (254,750) 254,750 0 Derivative asset Dr. `254,750 Hedging reserve Cr. `254,750 (being effective portion change in the intrinsic value of the purchased forex call option designated as hedged recognised in equity; thereby, reducing volatility in profit or loss to that extent) 2

13 Hedge accounting in the books of accounts of XYZ India Limited 3 March 202 (end of the hedge period) (contd.) Following entry shall be passed to record the change in the time value, not designated as hedged, of the purchased call option: Profit or loss Dr. `54,750 Derivative asset Cr. `54,750 (being change in the time value of the purchased call option during the period recorded in profit or loss as the same has not been designated as hedged. The same has been computed as follows: Date of measurement Option value (A) Intrinsic value (B) Time value (A - B) 3-Dec- `300,000 `245,250 `54,750 3-Mar-2 `500,000 `500,000 `0 Change during the period `(54,750) Following entry shall be passed to record the settlement of purchased forex call option with the bank: Bank Dr. `500,000 Derivative asset Cr. `500,000 (being realisation of gain on purchased forex call option on maturity) Following entry shall be passed to record the occurrence of the forecast purchase transaction: Inventory Dr. `45,550,000 Accounts payable Cr. `45,550,000 (being recording of purchase of inventory and related payable at spot rate) Following entry shall be passed to reclassify the amounts recognised in hedging reserve as the hedged item has occurred: Hedging reserve Dr. `500,000 Inventory Cr. `500,000 (being the amount of hedging reserve of `500,000 transferred to the cost of asset resulting from the hedged forecast transaction; this is also called basis adjustment) Tracking IFRS Hedging made simple: Part 5 3

14 Summary A summary of the result of hedge accounting may be observed as follows: Date Derivative asset Bank Profit or loss Hedging reserve Inventory Trade payable -Apr-20 0,000 (0,000) Jun-20 65,000 - (65,000) Sep-20 0,000 - (3,790) (96,20) Dec-20 5,000-34,040 (49,040) Mar-20 (300,000) 500,000 54,750 (254,750) 45,550,000 (45,550,000) Basis adjustment ,000 (500,000) - Summary - 490,000 0,000-45,050,000 (45,550,000) Thus, it can be observed that by following hedge accounting, XYZ has been able to record its inventory at the hedged price i.e. the strike price of the purchased forex call option of `

15 Exhibit 6 Illustrative ineffectiveness scenario and journal entries For the purpose of illustrating ineffectiveness scenario in case of cash flow hedging using option, consider the following additional facts: On 25 September 20, XYZ is intimated by the state government that due to the hosting of an international games event in Bangalore in February 202, the phase 3 will be taken up after March 202 and the new delivery schedule will be March 203 instead of March 202. On 30 Sep 20, the management of XYZ highly anticipates the execution of phase 3 and considers the forecasted USD purchase from the US supplier to be highly probable. Relevant exchange rates and discount factors (using 8% discount rate) on various dates during the hedge period are as follows: Particulars -Apr- 30-Jun- 30-Sep- 3-Dec- 3-Mar-2 Spot rate Discount factor (rate 8%) for cash flows on 3 March 202 i.e. hedging instrument Discount factor (rate 8%) for cash flows on 3 March 203 i.e. hedged item (+8%) ^ (+8%) ^ (+8%) ^ (+8%) ^ (+8%) ^ (+8%) ^ (+8%) ^ (+8%) ^ If, with the changed facts, management still decides to continue to use the same hedging instrument, the hedge relationship will have some ineffectiveness as the critical terms of the hedging instrument and the hedged item do not match. The same has been illustrated in the next page (only for the period ended 30 September 20). It may be noted that there will be no change in the accounting for the earlier periods as the forecast transaction continues to be highly probable and shall remain in equity until the forecast transaction occurs. Where a forecast transaction is no longer highly probable but still expected to occur, hedging gains and losses previously deferred in equity remain in equity until the transaction affects profit or loss. Once a forecast transaction is no longer expected to occur, any gain or loss is recognised immediately in the income statement. Tracking IFRS Hedging made simple: Part 5 5

16 Exhibit 6: Illustrative ineffectiveness scenario and journal entries Hedge accounting in the books of accounts of XYZ India Limited 30 September 20 (interim reporting date during hedge period, change in forecast). Computation of intrinsic value Particulars Hedging instrument purchased call option Notional amount (N),000,000 Notional amount (N),000,000 Spot price on the date of testing 45.5 Spot price on the date of 45.5 testing Greater of zero, or [spot price - 0. Lower of zero, or [strike price (0.) strike price] (V) - spot price] (V) Discount factor (D) Discount factor (D) * Intrinsic value (N x V x D) 96,20 Intrinsic value (N x V x D) (89,090) * Due to a change in the estimate of forecast transaction, the cash flow is now expected to occur in March 203. Hence the discount factor considered for the hypothetical derivative has been adjusted accordingly. 2. Retrospective hedge effectiveness testing Retrospective hedge effectiveness (cumulative basis) = Change in the intrinsic value of the purchased forex call option from inception Change in the intrinsic value of the hypothetical derivative from inception = 96,20-0 = 08% (sign ignored); the hedge was highly effective during the period. (89,090) Prospective hedge effectiveness testing sensitivity analysis Particulars Hedging instrument purchased call option Notional amount (N),000,000 Notional amount (N),000,000 Spot price on the date of testing 45.5 Spot price on the date of 45.5 testing Shifted spot price (spot price Shifted spot price (spot price %) + 0%) Greater of zero, or [shifted spot price - strike price] (V) 4.65 Lower of zero, or [strike price - shifted spot price] (V) (4.65) Discount factor (D) Discount factor (D) * Intrinsic value (N x V x D) 4,440,092 Intrinsic value (N x V x D) (4,,504) * Due to a change in the estimate of forecast transaction, the cash flow is now expected to occur in March 203. Hence the discount factor considered for the hypothetical derivative has been adjusted accordingly. 6

17 30 September 20 (interim reporting date during hedge period, change in forecast) (contd.) Prospective testing = Change in the intrinsic value of the purchased forex call option due to sensitivity analysis Change in the intrinsic value of the hypothetical derivative due to sensitivity analysis = 4,440,092-96,20 = 08% (sign ignored) (4,,504) - (96,20) The hedge is expected to be highly effective as the result is within the range 80-25%. 4. Accounting entries All the criteria for hedge accounting are met for the period ended 30 September 20, and cash flow hedge accounting therefore can be applied. The hedge is not 00% effective, and, therefore, the amount recognised in appropriate equity account/ other comprehensive income is equal to the effective portion of cumulative change in the intrinsic value of the purchased forex call option. This can also be determined as lower of (a) the cumulative change in the intrinsic value of the purchased forex call option, and (b) the cumulative change in the intrinsic value of the hypothetical derivative. Particulars Hedging instrument - A Hedged item (hypothetical derivative) - B Effective portion - C (lower of A and B in absolute terms) Ineffective portion - (difference between A and C in absolute terms) Change from inception of 96,20 (89,090) 89,090 7,20 hedge Change in the period 96,20 (89,090) 89,090 7,20 Derivative asset Dr. `96,20 Hedging reserve Cr. `89,090 Profit or loss Cr. `7,20 (being effective portion change in the intrinsic value of the purchased forex call option designated as hedged recognised in equity, and ineffective portion recognised in profit or loss) Following entry shall be passed to record the change in the time value, not designated as hedged, of the purchased call option. Derivative asset Dr. `3,790 Profit or loss Cr. `3,790 (being change in the time value of the purchased call option during the period recorded in profit or loss as the same has not been designated as hedged). The same has been computed as follows: Date of measurement Option value (A) Intrinsic value (B) Time value (A - B) 30-Jun- `75,000 `0 `75, Sep- `85,000 `96,20 `88,790 Change during the period `3,790 It may be observed by comparing the accounting entry in the corresponding period in Exhibit 5, the Company has been exposed to additional volatility in its profit or loss to the extent of ineffective portion of the hedge. Similarly, effectiveness calculations for periods ended 3 December 20 and 3 March 202 will be made using the revised discount factors for the hedged item. Tracking IFRS Hedging made simple: Part 5 7

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