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Practical Challenges Relating to Hedge Accounting

by V. Venkataramanan, Executive Director - Accounting Advisory Services, KPMG

Companies in India are moving towards IFRS convergence from April 1 2011. The build-up towards IFRS convergence has been both challenging and tricky, with regulatory clarity on the timelines and the exact nature of revised accounting standards being difficult to obtain. In addition, given the recent global developments relating to the replacement of IAS 39 and the issuance of IFRS 9, another layer of uncertainty appears to have been introduced into the mix. Amid all this uncertainty, there are a number of practical issues that have become more evident as companies have sought to apply IAS 39 (AS 30 in the Indian context). A significant contributor to why this change in accounting for derivative and hedging transactions is critical in India has to do with the fact that traditional accounting for derivatives in India has been based on an off-balance sheet / accrual based model and neither required on-balance sheet recognition of derivatives nor even, for that matter, disclosure of  the fair values of these instruments.

Conflicts between economic choices and accounting volatility

Indian companies have realised that there are a number of current risk management practices that would not qualify for hedge accounting under the new accounting standards. This realisation is causing a number of companies to review the structures and transaction components used. The conflict between the objective of ensuring a less volatile income statement and of managing the economic exposures of an entity has been brought sharply into focus.

For instance, a number of organizations in India have traditionally used leveraged option structures to hedge foreign exchange exposures. For example, an Indian exporter buys a USD/INR put option for USD 1m and to finance this option writes two options for USD 1m each. This structure is used often as the strike price for this structure (all options have the same strike) is more favourable than the available forward rate. This structure does not qualify for hedge accounting (as it is determined to be a net written option), and while it may have been possible to mitigate the effects of this accounting conclusion by transacting a synthetic forward separately from a portion of the written option component, in the Indian context, regulatory restrictions do not permit this to happen. 

A key area of concern for companies has been the requirement to apply the 80/125% rule relating to the ‘highly effective’ criteria for applying hedge accounting. Many Indian companies have been vocal in supporting proposals to amend the hedge accounting norms under IAS 39 and to do away with the effectiveness testing criteria whilst continuing to measure ineffectiveness. Most Indian companies do not currently use regression as a tool to test effectiveness and hence are often faced with ‘small dollar change’ effects that often preclude hedge accounting.

Another common area of consideration is the hedging time horizon that they consider while conducting their risk management activities. Many Indian entities have traditionally hedged for time periods longer than what would qualify for the purpose of determining ‘highly probable forecast transactions’. These risk management interventions have benefited entities in recent times of currency volatility but also potentially expose companies to considerably larger accounting volatility than what they have an appetite for.

Many Indian entities are therefore being forced to reconsider if they should continue with such structures given the level of accounting volatility that would ensue if they retained their current risk management activities.

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