Page 1 23 August 2021 Presentation title

Classification and accounting of financial instruments

Classification and measurement of financial instruments under Ind AS 109

Financial assets Financial liabilities Business model Contractual cashflows

Classification
test assessment
▪ Amortised cost ▪ Amortised cost
Solely payment of
▪ Fair value through OCI ▪ Fair value through PL Hold to collect Amortised cost
principal and interest
(FVOCI) (FVTPL)
Hold to collect Solely payment of Fair value through
▪ Fair value through PL and sell principal and interest OCI
(FVTPL)
Fair value through
Other
PL

Business model test Contractual cashflows

assessment
1) Hold to collect
Contractual cashflows are solely
Are derivatives financial assets or
2) Hold to collect and sell payments of principal and liabilities?
interest on the principal amount
3) Others
outstanding
How are they classified?
Classification and accounting of financial instruments

Measurement and accounting at Fair Value through PL (FVTPL)

Ind AS 109, Para 5.7.1:

Inception Ongoing
“A gain or loss on a
Measurement Fair value Fair value
financial asset or financial
liability that is
measured at fair value shall
Changes in fair value Profit and loss account
be recognised in profit or
loss unless… ”

Lets understand with the help of an example:

Classification and accounting of derivative instruments

Illustration: When hedge accounting is not adopted

Background:
Company ABC is a leading global technology service provider in India having functional currency as INR. The ABC earns revenue in
USD and is exposed to fluctuation in USDINR exchange rates. The Company enters into foreign exchange forward contracts.

Risk Management Strategy and Objective:

The Company’s foreign currency exposure arises from highly probable forecast transactions denominated in foreign currency and
the company’s policy is to hedge material foreign exchange risk associated with this using forward contracts.

Details of the hedging instrument

Trade date : 01 April 2019
Type of deal : Sell USD and Buy INR forward contracts
Notional Amount : USD 1 Mn
Maturity date : 31 May 2020
Spot rate : 69.1650
Forward premium : 2.9447
Hedged Forward rate : 72.1097

Accounting of foreign exchange forward contract

Derivatives may be financial assets or financial liabilities depending on its mark-to-market (MTM) valuation at a given point in time.
Derivatives are classified as FVTPL as per Ind AS 109 and the change in the MTM is reported in profit and loss statement.
Classification and accounting of derivative instruments

SNo. Reporting Date 1-Apr-19 30-Jun-19 30-Sep-19 31-Dec-19 31-Mar-20 31-May-20

a. Notional 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000

b. Spot rate 69.1650 69.0275 70.8688 71.3800 75.6650 75.6200

c. Forward rate for residual maturity 72.1097 72.0175 72.9038 72.6350 76.1101 75.6200

d. Hedged Forward Rate 72.1097 72.1097 72.1097 72.1097 72.1097 72.1097

e. D.F for residual maturity 0.932537 0.942933 0.959448 0.975036 0.992536 1.000000

f. Fair value (INR) [ (d) – (c) ] * (a) * (e) - 86,938 -761,850 -512,186 -3,970,540 -3,510,300

g. Incremental movement from QoQ - 86,938 -848,788 249,663 -3,458,354 460,240

QoQ impact on PL (in INR)

May’20
10,00,000
86,938.38 2,49,663.45 4,60,240.07
5,00,000
The incremental Quarter-on-Quarter (QoQ) movement - 0
Jun’19 Dec’19
(5,00,000) Mar’19
will impact the profit and loss statement at each
(10,00,000) Sept’19
reporting date causing volatility in the profit and loss (15,00,000)
(8,48,787.99)
(20,00,000)
statement as shown in the chart alongside. (25,00,000)
(30,00,000)
(35,00,000)
Mar’20
(40,00,000) (34,58,353.91)

Incremental movement from QoQ

Impairment

As asset is said to be impaired when the asset has a market price that is lower than the value recognised in books of accounts.
Under accounting guidelines, assets should be tested for impairment to ensure that it is accurately reflected in the balance sheet

The accounting standard establishes a three-stage approach based on the credit risk of a financial asset, which ultimately quantifies the
impairment loss to be recognised

Measurement of ECL
POD = Probability of default: It is an estimate of the likelihood of a default over a specific time
horizon. It is defined as the probability of whether the borrowers will default on their obligations
in future.

LGD = Loss given default: It is an estimate of loss resulting from a transaction given that default
occurs. In other words, in the event of default, LGD is the amount that is not expected to be
recovered.

EAD = Exposure at default: It is the amount of exposure, that is, the financial asset on which ECL
is calculated.
Page 7 23 August 2021 Presentation title
Need for application of hedge accounting

The objective of hedge accounting is to represent, in the financial statements, the effect of risk management activities that use
financial instruments.

Better reflects the risk management Brings in transparency

strategy
Disclosures required by the Standard
Principal based approach to align the allow users of financial statement to
representation of the risk management better understand the risk management
strategy in the financial statements strategy of the Company and how it
achieves its risk management objectives

Benefits
Reduces volatility in the Profit and Treatment for Cost of hedging
Loss statement (PL)
Hedge accounting allows better
Minimises the timing mismatch of representation of cost of hedging in the
recording hedging instrument movements PL
and hedged item movements in the PL
Types of hedging relationships

Hedge of exposure to variability in cash flows that is Example:

attributable to a particular risk associated with 1) Foreign currency risk/ Commodity price
▪ a recognised asset or liability or risk hedge of highly probable forecast
Cash flow ▪ foreign currency risk of firm commitment (unrecognised) purchase/ sales transaction
hedge ▪ or a highly probable forecast transaction (also an inter- 2) Interest rate risk hedge of floating rate
company one) borrowing
and could affect profit or loss.

Example:
Hedge of exposure to changes in fair value of a recognised 1) Foreign currency risk of recognised
Fair value asset or liability; an unrecognised firm commitment; or an debtors/ creditors
2) Foreign currency risk of an ECB
hedge identified portion of any of the above two, that is
attributable to a particular risk

Example:
Net Hedge of a net investment in a foreign operation (including
1) Foreign currency risk on restatement of
foreign currency net assets of
investment a hedge of a monetary item that is accounted for as part of subsidiaries in consolidated books of
hedge the net investment) parent company
Types of hedging relationships

Bharti Airtel Annual report: 2019-2020

Tata Steel Annual report: 2018-2019 Ultratech Cement Limited Annual report: 2019-2020
 Benefits for cash flow hedges

Hedge accounting allows an entity to align its risk management strategy with accounting.

Accounting benefit
The fair value change on the hedging instrument can be held in Other Comprehensive income (‘OCI’)
(Component of Equity) till the time the hedged item impacts the Profit and Loss Account (‘PL’). This
For Cash flow hedges is permissible only to the extent the hedge is effective.
The amount held in OCI shall be recycled to PL when the hedged transaction impacts the PL

Example: Intermediate periods upto May 2020 At maturity in May 2020

On Dec 2019, an Indian
company has a forecast Hedged item Hedging instrument Hedged item Hedging instrument
USD denominated sale (forecast sale transaction) (Forward contract) (forecast sale transaction (Forward contract)
Not yet recorded in now to be recognised)
transaction expected to Settlement gain/loss recorded
financial statements. MTM gain/loss to be recorded
occur in May 2020. The Recorded in PL at prevailing in PL providing an offset to
Hence, does not impact PL in financial statements with
company enters into a impact to PL spot rate hedged item impact
forward contract to
hedge the foreign
No impact to PL One sided impact to PL Impact offset in PL
currency risk on the
forecast sale
transaction. Hedge accounting allows Settlement gain/loss recorded
parking of this impact in OCI in OCI recycled to PL at the
instead of PL, thus avoiding time of recognition of sale
one sided impact thus providing an offset
 Benefits for fair value hedges

Hedge accounting allows an entity to align its risk management strategy with accounting.

Accounting benefit
The fair value change in the hedging instrument can offset the change in value of the hedged item in
PL. Allows reducing the mismatch in impact to PL.
For Fair value hedges

Example: Up to sale of inventory On sale

On Mar 2020, an Indian
company holds Hedged item Hedging instrument Hedged item Hedging instrument
aluminum inventory for (Inventory) (Commodity futures contract) (Inventory) (Commodity futures contract)
sale. Currently, it hedges Settlement gain/loss recorded
Recorded at lower of cost MTM gain/loss to be recorded Sale recorded in PL at
the price of the prevailing commodity spot in PL providing an offset to
or NRV*. Not valued at in financial statements with
inventory using mark to market impact to PL price hedged item impact
commodity future
contracts. Impact to PL only if
One sided impact to PL Impact offset in PL
The company adopts a NRV< Cost
rollover strategy till the
time it sells its inventory. Fair value hedge accounting allows revaluing of the hedged
item. Changes in fair value to impact PL providing an offset
to hedging instrument impact to PL.
*NRV = Net realisable value
 Benefits for net investment hedges

Hedge accounting allows an entity to align its risk management strategy with accounting.

Accounting benefit
The fair value change on the hedging instrument can be taken to Foreign currency translation
For Net Investment reserve (‘FCTR’) (Component of Equity) till disposal of the net investment. This is permissible only to
hedges the extent the hedge is effective.
The amount held in OCI shall be recycled to PL on partial/ complete disposal of the investment.

Example: Up to disposal of subsidiary On disposal of subsidiary

An Indian parent Company
(INR functional currency) Hedged item Hedging instrument Hedged item Hedging instrument
has an investment in a US (Net investment in (Forward contract) (Net investment in (Forward contract)
subsidiary (US functional subsidiary) subsidiary)
currency). At each Net assets recorded in INR MTM gain/loss to be recorded Exchange gain/loss Settlement gain/loss recorded
reporting date, the and change in value taken in financial statements with recorded in FCTR recycled in PL providing an offset to
to FCTR impact to PL to PL hedged item impact
Company reports the net
assets of the subsidiaries
in INR. No impact to PL One sided impact to PL Impact offset in PL
The company has taken a
USD/INR forward contract Hedge accounting allows Hedging instrument
to hedge FX fluctuation parking of this impact in settlement gain/loss recorded
risk on its net investment FCTR instead of PL, thus in FCTR, recycled to PL at the
in subsidiary. avoiding one sided impact time of disposal of subsidiary
Qualifying criteria for adopting hedge accounting

1) Eligibility
Eligibility
• Only eligible hedging instruments and hedged items as per the requirements of Ind AS 109

2) Documentation

Hedge • At inception, formal designation and documentation of the hedging relationship and the entity’s risk
management objective and strategy
documentation
• Include identification of hedging instrument, hedged item, nature of risk being hedged, method of
assessing effectiveness, etc.

3) Hedge effectiveness
➢ Economic relationship
• Between hedged item and hedging instrument
• Systematic change (opposite direction) in response to same or economically related underlying
Hedge ➢ Credit risk does not dominate
effectiveness • Credit risk does not frustrate economic relationship
• Credit risk can arise from both - hedging instrument and hedged item
➢ Hedge ratio
• Consistent with actual ratio used by entity
• Different ratio only if accounting outcome would be inconsistent with purpose of hedge accounting
 Eligible hedging instruments

Qualifying hedging instruments Designation of hedging instruments Examples

1 ➢ Derivative should be designated as Foreign Currency forward contracts

Derivatives measured at FVTPL
3
2
(except for some written option) hedging instrument in its entirety 1 for hedge of foreign exchange risk on
except for: associated with Highly probable sales
• Intrinsic value of Options
1 Non-Derivative financial assets/ • Spot price element of forwards Interest rate Swap (Floating to Fix) for
2
2
3 liabilities measured at FVTPL hedge of Interest rate risk on floating
(except for hedge of foreign ➢ Derivative may not be designated for rate borrowing
exchange risk) only a portion of its remaining time to
maturity Price adjustment clause of trade
payable (linked to future commodity
1
2
Only contracts with a party
external to the reporting ➢ Written options may be designated only 3 price) as a hedge against inventory
3
entity can be designated as to offset purchased options price movements
hedging instruments.
Currency component of foreign
➢ A proportion of a financial instrument
currency borrowing can be used as a
may be designated as hedging 4 hedging instrument against forecast
instrument
sale transaction
➢ Separable embedded derivatives 50% of the notional of a derivative
5 contract may be designated as a
hedging instrument in a relationship
 Eligible hedged items

A single (or a group of items if they share Risk Components Examples

the same risk):
Risk component of a component of the
Foreign currency loans, Investments,
1 A recognised Asset or Liability financial or the non-financial item can be
designated as hedged Item if it’s
1 Payables, Receivables etc.

An unrecognised firm ▪ a separately identifiable component

2 ▪ the changes in the cash flows or the
commitment A binding agreement for purchase/sale
fair value of the item attributable to
A highly probable forecast
changes in that risk component must be 2 of a specified quantity of resources at a
specified price and at a specified date
3 reliably measurable.
transaction

A net investment in a foreign Forecasted sales/purchases, Forecasted

4
operation 3 receivables/payables etc.

Forex risk arising on account of

Aggregated exposure: Combination of derivative and hedged item translation of net assets of the foreign
4 operation in the functional currency of
Highly probable Commodity swap to the entity
forecast purchase of hedge price risk in
crude denominated in USD
USD

Aggregated exposure exposed to USD INR risk

Qualifying criteria for adopting hedge accounting

1) Eligibility
Eligibility
➢ Only eligible hedging instruments and hedged items as per the requirements of Ind AS 109

2) Documentation

Hedge ➢ At inception, formal designation and documentation of the hedging relationship and the entity’s risk
management objective and strategy
documentation
➢ Include identification of hedging instrument, hedged item, nature of risk being hedged, method of
assessing effectiveness, etc.

3) Hedge effectiveness
➢ Economic relationship
• Between hedged item and hedging instrument
• Systematic change (opposite direction) in response to same or economically related underlying
Hedge ➢ Credit risk does not dominate
effectiveness • Credit risk does not frustrate economic relationship
• Credit risk can arise from both - hedging instrument and hedged item
➢ Hedge ratio
• Consistent with actual ratio used by entity
• Different ratio only if accounting outcome would be inconsistent with purpose of hedge accounting
Hedge documentation

At inception, there should be formal designation and documentation of the hedging relationship

Illustrative extract of hedge documentation

1 Risk management strategy and objective Strategy and objective of how the company manages its risk

The risk that is being hedged (currency, interest rate), spot/ intrinsic component, nature and
2 Risk being hedged
timing of impact of the risk

3 Identification of hedging instrument Reference number, notional, maturity, buy/sell position, fixed rate

Nature of hedged item, Reference number (if available), maturity/ timing of impact, risk
4 Identification of hedged item
component, layer component
Assessment of economic relationship, credit risk and hedge ratio
5 Assessment of effectiveness requirements
Methods that will be used consistently to assess hedge effectiveness
Potential sources of ineffectiveness over the life of the hedging relationship (eg. Change in
6 Sources of ineffectiveness
timing of occurrence of forecast transaction, effect of credit risk)

7 Assessment of highly probable forecasts Rationale for company’s assessment of highly probable forecasts

In case of use of hypothetical derivative for effectiveness testing, definition and valuation of
8 Definition of hypothetical derivative
the hypothetical derivative
Accounting treatment adopted by the company at inception and at each reporting date.
9 Accounting treatment adopted
Treatment for cost of hedging

10 Frequency of effectiveness testing Frequency at which company will assess hedge effectiveness
Defined risk management strategy and objective

Risk management strategy Vs Risk management objective

▪ Established at the highest level at which an entity ▪ Applies at the level of a particular hedging relationship
determines how it manages its risk
▪ Relates to how the particular hedging instrument that has
▪ Identify the risks to which the entity is exposed and set out been designated is used to hedge the particular exposure
how the entity responds to them that has been designated as the hedged item

▪ In place for a longer period and may include some flexibility

to react to changes in circumstances that occur while that
strategy is in place (for example, different interest rate or
commodity price levels that result in a different extent of
hedging)
Defined risk management strategy and objective

Example:
An entity has a strategy of managing its interest rate exposure on debt funding that sets ranges for the overall entity for the mix
between variable-rate and fixed-rate funding.

Strategy: Fixed rate debt = 20% to 40%

Execution of the strategy:

Particulars Fixed rate Variable rate Total debt Fixed debt (%)

Current position: Rs.100 of variable-rate debt of which Rs.30 is swapped into a fixed-rate 30 70 100 30%

Entity takes advantage of low interest rate and issues additional Rs. 50 fixed rate bond.
60 90
Entity decides to set its fixed interest-rate exposure to 40 per cent of the total debt by 150 40%
(30+50-20) (70+20)
reducing by Rs.20 the extent to which it previously hedged its variable-rate exposure
Qualifying criteria for adopting hedge accounting

1) Eligibility
Eligibility
➢ Only eligible hedging instruments and hedged items as per the requirements of Ind AS 109

2) Documentation

Hedge ➢ At inception, formal designation and documentation of the hedging relationship and the entity’s risk
management objective and strategy
documentation
➢ Include identification of hedging instrument, hedged item, nature of risk being hedged, method of
assessing effectiveness, etc.

3) Hedge effectiveness
➢ Economic relationship
• Between hedged item and hedging instrument
• Systematic change (opposite direction) in response to same or economically related underlying
Hedge ➢ Credit risk does not dominate
effectiveness • Credit risk does not frustrate economic relationship
• Credit risk can arise from both - hedging instrument and hedged item
➢ Hedge ratio
• Consistent with actual ratio used by entity
• Different ratio only if accounting outcome would be inconsistent with purpose of hedge accounting
 Hedge effectiveness testing

An entity should assess whether the hedging relationship meets the hedge effectiveness requirements at inception and on an ongoing basis

Credit risk does not

Economic relationship Hedge ratio
dominate
▪ A hedging instrument and hedged item Does the effect of credit risk Does the hedge ratio reflect an
are said to be economically related if dominate the economic imbalance resulting in an
they generally move in opposite
relationship? accounting outcome inconsistent
directions due to same underlying risk
with the purpose of hedge
▪ The assessment should be prospective accounting?
or forward looking

▪ Different methods to assess economic Consider the following: For example:

relationship ▪ A company uses a forward contract to Deliberate under-hedging to avoid
➢ Critical terms hedge foreign currency risk on forecast recognising hedge ineffectiveness in a cash
➢ Scenario analysis sales. The critical terms match and an flow hedge
➢ Regression analysis economic relationship exists.
▪ The USD/INR rate is lower than the Deliberate under-hedging to achieve fair
▪ Use of hypothetical derivative hedged rate and the company has a value accounting in a fair value hedge
receivable position on the derivative.
▪ Determination of ineffectiveness ▪ The counterparty bank has defaulted on
its obligations, and the company is not Is the hedge ratio consistent with the
likely to receive the settlement on the risk management strategy and
derivative. objective?
Is it still an effective hedge?
Page 25 23 August 2021 Draft- For discussion purposes only