IND-AS: Derivatives & Hedge Accounting!

By: Pankaj Chadha, Partner, member firm of EY Global

The accounting landscape for Indian companies is undergoing a fundamental shift. Multiple regulatory changes like the Companies Act 2013, IND-AS and Income Computation & Disclosure Standards have been introduced that are either applicable immediately or will be applicable in the next two 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. Various Indian regulatory bodies, including Institute of Chartered Accountants of India (ICAI) and Reserve Bank of India (RBI) had issued disparate guidance on certain areas of accounting for financial instruments. Notified Accounting Standard (AS) 11 “The Effects of Changes in Foreign Exchange Rates” provided limited guidance only to account for exchange difference on forward contracts. The ICAI announcement issued in March 2008 recommended accounting for derivatives other than forwards, by providing all marked to market (MTM) losses in the income statement and ignoring all gains keeping in view the principle of prudence as enunciated in AS 1 “Disclosure of Accounting Policies”. ICAI had also issued AS 30 “Financial Instruments: Recognition and Measurement” in 2008 which had detailed guidance on derivatives and hedge accounting but this AS was never notified by the Ministry of Corporate Affairs (MCA). Due to this disparity in guidance, varied practices were applied by different companies for derivative and hedge accounting based on AS 11, AS 1 and AS 30.Indian Accounting Standard 109: Financial Instruments (‘IND-AS 109’) provides comprehensive guidance for accounting for financial instruments and is much wider in scope covering financial assets, financial liabilities and impairment of financial assets in addition to derivatives and hedge accounting. However, as per the IND-AS roadmap issued by the Ministry of Corporate Affairs (‘MCA’), IND-AS will currently not be applicable to Banks, NBFCs, Insurance companies and unlisted companies with a net-worth of INR 250 crores. 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 with its earlier application is encouraged. 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 move to IND-AS. This guidance note covers all derivative contracts that are not covered by an existing notified Accounting Standard. Hence, it does not apply to foreign exchange forward contracts covered by AS 11: The Effects of Changes in Foreign Exchange Rates, embedded derivatives and derivatives that are covered by regulations specific to a sector or specified set of entities. The guidance note also provides guidance on accounting of assets like inventories, fixed assets and investments which are designated as hedged items, since the notified Accounting Standards for these items are silent on hedge accounting using derivative instruments for these items.  For example, while doing fair value hedge accounting in relation to inventory/investment being a hedge item, separate hedge accounting adjustments are recorded distinguished from the valuation of inventories/investments under AS 2/ AS 13 respectively. Accounting for embedded derivative contracts is not part of the scope of this Guidance Note since there are potential conflicts with the requirements of certain other notified Accounting Standards such as AS 2, AS 13 etc. Further this Guidance Note does not deal with macro-hedging and accounting for non-derivative financial assets/liabilities which are designated as hedging instruments.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. The extent and availability of collateral should be factored in while arriving at the fair value of a derivative contract. If any entity decides not to use Hedge Accounting as described in this 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 treatment for hedging prescribed in the guidance note is in line with IND-AS 109. It permits but does not require designation of a derivative contract as a hedging instrument. It gives the management the flexibility to specify their hedge ratio which is effective in meeting their risk management objective and retaining its focus on hedge documentation which can demonstrate how derivatives help meet those objectives. There is no reference to testing hedge effectiveness quantitatively. But some open issues remain with respect to how to monitor the hedge ratio and ability to judge an imbalance between the weighing of the hedged item and the hedging instrument that would create hedge ineffectiveness. Similarities as compared to IND-AS 109 on Financial Instruments.    Types of hedge accounting.    Formal documentation at inception.    Hedge effectiveness testing and concept of rebalancing the hedge ratio.    Risk component of a non-financial item can be designated as hedged item if it is Separately identifiable and reliably measurable.    Where the Company assess the time value of option to be “cost of hedging”, the changes in fair value are first recognised in Other Comprehensive Income (OCI).    Termination of hedge accounting/reclassification of hedge reservesDis-similarities as compared to IND-AS 109 on Financial Instruments.    The Guidance Note does not deal with macro-hedging and accounting for non-derivative financial assets/liabilities which are designated as hedging instruments..    The Guidance Note does not cover foreign exchange forward contracts which are within the scope of AS 11.

This Guidance Note applies to all derivative contracts covered by it and are outstanding on the date this Guidance Note becomes effective. Any cumulative impact (net of taxes) should be recognised in reserves as a transition adjustment and disclosed separately. An entity is not permitted to follow hedge accounting as recommended in this Guidance Note retrospectively.Though, the guidance note is step in the right direction in order to bring parity in accounting for derivative contracts and hedging for all Indian entities not transitioning to IND AS, it still does not address the entire gamut of financial instruments accounting – namely, classification and measurement and loan loss provisioning using the expected credit loss model. Nonetheless, the guidance note, albeit conceived as a temporary measure, seeks to bring uniformity in practice for entities in India: even those that are currently out of the IND AS ambit. It may also increase transparency in the area of derivatives and hedge accounting. Entities that are currently not impacted by IND AS should analyze the impact of the guidance note on their current accounting practices in the areas of derivatives and hedge accounting. For many businesses that are it could significantly impact its financial reporting and have consequential considerations for review of business model, practices and related processes.