Hedge New Rules

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  • OPENING COMMENTS The following are applicable only if presented as stand-alone module Welcome participants Introduce yourself with special emphasis on practical experience If necessary - use introduction as an ice-breaker Introduce content map and objectives (details on next slide) Set learning environment guidelines (questions any time) Emphasise peer learning opportunities (working in pairs, sharing problems) Introduce Module Learning Objectives Understanding the rationale and conceptual logic of the Standards The impact of new requirements on financial instruments for both banks and non-banking entities Module opening comments In various jurisdiction, the Standards will change the practices of accounting for financial instruments dramatically. It adopts a prescriptive approach. It is preferable that participants have already followed a basic presentation of IAS 32 and IAS 39 (see 2 to 3 hour course) This module aims to provide a Level 2 knowledge of the IAS requirements on financial instruments. In some cases, the module provides further discussions, particularly applicable to financial institutions. These latter discussions are identified as Level 3. This module introduces the proposed changes to IAS 32 and IAS 39 that were published in June 2002. Date of review of module and approval by technical specialist: Date: 08/02
  • Hedge New Rules

    1. 1. IAS 39 Financial Instruments : Recognition and Measurement John Kidd Partner Financial Services Group
    2. 2. Foreign Currency Transaction - Example <ul><li>2 Jan 2004, Tinman Ltd expects to sell of 100 tonnes of Tin </li></ul><ul><li>Receipt from sale = USD 550,000 </li></ul><ul><li>Tinman hedges the foreign currency risk </li></ul><ul><li>Estimated Settlement Date = 10 April 2004 </li></ul><ul><li>Tinman enters into a forward foreign exchange contract </li></ul><ul><ul><li>sell USD 550,000 </li></ul></ul><ul><ul><li>value date 10 April 2004 </li></ul></ul><ul><ul><li>forward rate .60 </li></ul></ul><ul><ul><li>spot rate at transaction date .61 </li></ul></ul>
    3. 3. Foreign Currency Transaction – Hedge Steps <ul><li>Determine your functional currency </li></ul><ul><li>Determine the type of hedge </li></ul><ul><li>Document, Document, Document </li></ul><ul><ul><ul><li>Policy document supported by </li></ul></ul></ul><ul><ul><ul><li>Individual hedge documentation </li></ul></ul></ul><ul><li>Value the derivative </li></ul><ul><li>Quantify the degree of ineffectiveness </li></ul><ul><li>Prepare the journal entries </li></ul>
    4. 4. Impact on Hedging <ul><li>Situation – Sales in USD, Cost in AUD </li></ul><ul><li>Functional Currency – USD or AUD? </li></ul><ul><li>Impact on hedging – Functional currency will determine source of foreign currency risk. Hence impacts your risk management approach </li></ul><ul><li>E.g. If FC = AUD - then hedge FX exposure on USD Sales </li></ul><ul><li>If FC = USD – then hedge FX exposure on AUD Costs </li></ul><ul><li>Functional Currency decision is subjective and the consequences of the decision must be considered re hedging impact </li></ul>
    5. 5. Factors re Functional Currency <ul><li>Factors to consider re the Currency </li></ul><ul><ul><li>That mainly influences sales prices </li></ul></ul><ul><ul><li>Of the country whose competitive forces and regulations – mainly determine the sales prices </li></ul></ul><ul><ul><li>That mainly influences labour, material and other costs </li></ul></ul><ul><li>When indicators are mixed and the functional currency is not obvious, management uses judgement to determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions. </li></ul>
    6. 6. Foreign Currency Transaction – Hedge Steps <ul><li>Determine your functional currency </li></ul><ul><li>Determine the type of hedge </li></ul><ul><li>Document, Document, Document </li></ul><ul><ul><ul><li>Policy document supported by </li></ul></ul></ul><ul><ul><ul><li>Individual hedge documentation </li></ul></ul></ul><ul><li>Value the derivative </li></ul><ul><li>Quantify the degree of ineffectiveness </li></ul><ul><li>Prepare the journal entries </li></ul>
    7. 7. Overview - Hedge Relationship <ul><ul><li>hedging instrument </li></ul></ul><ul><ul><li>hedged item </li></ul></ul><ul><ul><li>AND </li></ul></ul><ul><ul><li>formal documentation of the hedging relationship </li></ul></ul><ul><ul><li>hedge is highly effective </li></ul></ul><ul><ul><li>any forecasted transactions (underlying) must be highly probable (Cash Flow Hedges) </li></ul></ul><ul><ul><li>effectiveness can be reliably measured </li></ul></ul><ul><ul><li>effectiveness assessed on an on-going basis and shown to be effective </li></ul></ul>
    8. 8. <ul><li>Derivative </li></ul><ul><ul><li>Must be designated in its entirety (IAS 39.74) </li></ul></ul><ul><ul><ul><li>Including embedded derivatives </li></ul></ul></ul><ul><ul><li>&quot;Proportion&quot; is allowed (IAS 39.75) </li></ul></ul><ul><ul><li>not permitted for certain written options (IAS 39.77 & AG92) </li></ul></ul><ul><ul><li>time value can be excluded (IAS 39.74) </li></ul></ul><ul><ul><li>cannot split the derivative on a time basis (IAS 39.75) </li></ul></ul><ul><ul><li>combinations are permitted (IAS 39.77) </li></ul></ul><ul><ul><li>must be external to the group in consolidate accounts (IAS 39.73) </li></ul></ul><ul><li>Other financial instruments (IAS 39.72) </li></ul><ul><ul><li>Foreign currency risk only </li></ul></ul><ul><ul><li>Entity’s own securities are not financial assets/liabilities </li></ul></ul>Overview – Hedging Instrument
    9. 9. <ul><li>Recognised Asset </li></ul><ul><li>Recognised Liability </li></ul><ul><li>Unrecognised Firm Commitment </li></ul><ul><li>Highly Probable Forecast Transaction </li></ul><ul><li>Net Investment in a Foreign Operation </li></ul>Overview - Hedged Item (1 of 2)
    10. 10. Foreign Currency Transaction – Example, Sequence 2/1/2004 Expected Sale Enter into sell USD buy AUD forward fx contract Recognition Date 10/4/2004 Record Sale Spot Rate plus gain/loss on fx contact Record Receivable Spot Rate Settle the USD forward Settle the USD receivable
    11. 11. Overview – Exposures Net investment in a foreign entity Cash flow Fair Value Exposure ?
    12. 12. <ul><li>Firm Commitment </li></ul><ul><ul><li>Fixed volume </li></ul></ul><ul><ul><li>Fixed price </li></ul></ul><ul><ul><li>Fixed maturity date </li></ul></ul><ul><ul><li>Can be Fair Value or Cash Flow </li></ul></ul><ul><li>Highly probable forecast transaction </li></ul><ul><ul><li>Always Cash Flow </li></ul></ul>Type of Hedge
    13. 13. Foreign Currency Transaction – Hedge Steps <ul><li>Determine your functional currency </li></ul><ul><li>Determine the type of hedge </li></ul><ul><li>Document, Document, Document </li></ul><ul><ul><ul><li>Policy document supported by </li></ul></ul></ul><ul><ul><ul><li>Individual hedge documentation </li></ul></ul></ul><ul><li>Value the derivative </li></ul><ul><li>Quantify the degree of ineffectiveness </li></ul><ul><li>Prepare the journal entries </li></ul>
    14. 14. Example of Documentation <ul><li>Policy Document </li></ul><ul><li>Summarises key aspects of IAS 39 for your business / hedge arrangements </li></ul><ul><li>Individual Hedge Documentation </li></ul><ul><li>Documents hedge relationship for each derivative </li></ul>
    15. 15. Hedge Documentation Checklist <ul><li>Identification of: </li></ul><ul><ul><ul><li>the hedging instrument </li></ul></ul></ul><ul><ul><ul><li>and the hedged item </li></ul></ul></ul><ul><li>The nature of the risk being hedged </li></ul><ul><li>Type of Hedge </li></ul><ul><li>Time value included or excluded </li></ul><ul><li>The risk management strategy </li></ul><ul><li>The risk management objective </li></ul><ul><li>How effectiveness will be assessed </li></ul><ul><li>Effectiveness assessment </li></ul>
    16. 16. Nature of the Risk to be Hedged <ul><li>Commodity </li></ul><ul><ul><li>FX Risk or </li></ul></ul><ul><ul><li>Overall Risk </li></ul></ul><ul><li>Financial Asset or Liability </li></ul><ul><ul><li>Overall Risk </li></ul></ul><ul><ul><li>Credit Risk </li></ul></ul><ul><ul><li>Benchmark Interest Rate Risk </li></ul></ul><ul><ul><li>FX Risk </li></ul></ul>
    17. 17. Strategy / Objective <ul><li>Strategy </li></ul><ul><li>Board policy has set a strategy of hedging 100% of firm commitments to minimise foreign currency risk </li></ul><ul><li>Objective </li></ul><ul><li>The objective of the hedge is to offset cash flows of the hedged item from foreign exchange risk, such that when the hedge item and the hedge are combined the AUD cash flow associated with the purchase is fixed. </li></ul>
    18. 18. Assessing Effectiveness <ul><li>IAS 39 AG 105. </li></ul><ul><li>A hedge is highly effective if: </li></ul><ul><ul><li>Prospective </li></ul></ul><ul><ul><li>at inception and throughout the life of the hedge, the entity can expect changes in the fair value or cash flows of the hedged item that are attributable to the hedged risk to be almost fully offset by the changes in the fair value or cash flows of the hedging instrument </li></ul></ul><ul><ul><li>Retrospective </li></ul></ul><ul><ul><li>and actual results are within a range of 80%-125% </li></ul></ul><ul><ul><li>For example, if actual results are such that the loss on the hedging instrument is CU 120 and the gain on the cash instrument is CU 100, offset can be measured by 120/100 which is 120%, or by 100/120 which is 83%. In this example, the entity would conclude that the hedge is highly effective. </li></ul></ul>
    19. 19. Assessing Effectiveness: How? <ul><li>Regression analysis </li></ul><ul><li>Ratio dollar offset (period-to-period or cumulative) </li></ul><ul><li>Volatility Reduction Method </li></ul><ul><li>Matched terms </li></ul><ul><li>Treatment of time value </li></ul>
    20. 20. Ratio Dollar Offset <ul><li>Ratio of 80% to 125% considered highly effective </li></ul><ul><li>Ratio = Change in FV of derivative </li></ul><ul><li> Change in FV of hedged item </li></ul><ul><li>Period-to-Period </li></ul><ul><ul><li>Compare prices over distinct intervals (Q1 v. Q2) </li></ul></ul><ul><li>Cumulative </li></ul><ul><ul><li>Compare prices at two different points in time (beginning of hedge v. today) </li></ul></ul><ul><li>Issues </li></ul><ul><ul><li>Small dollar changes </li></ul></ul><ul><ul><li>Point-in-time measurement </li></ul></ul><ul><ul><li>Non-statistical </li></ul></ul>
    21. 21. Example – Ratio Dollar Offset <ul><li>Entity has firm commitment to purchase copper in January 2006 </li></ul><ul><li>Use derivative to hedge against price risk </li></ul>
    22. 22. Matched Terms Method <ul><li>If critical terms of the hedging instrument and of the entire hedged asset or liability or hedged forecasted transaction are the same, conclude no ineffectiveness </li></ul><ul><ul><li>Same quantity </li></ul></ul><ul><ul><li>Same underlying (including grade, if a commodity) </li></ul></ul><ul><ul><li>Same time </li></ul></ul><ul><ul><li>Same location </li></ul></ul><ul><ul><li>Fair value of the hedging instrument at inception = zero </li></ul></ul><ul><li>Need to consider credit risk and liquidity </li></ul><ul><li>Subsequent assessments of effectiveness: </li></ul><ul><ul><li>Verify and document whether the critical terms of the hedge and the underlying risk have changed during the period in review </li></ul></ul><ul><ul><li>Consider risk of default of counterparty </li></ul></ul>
    23. 23. Highly Probable – FX Exposure <ul><li>Considerations </li></ul><ul><ul><li>consistency with planned or budgeted production </li></ul></ul><ul><ul><li>capacity </li></ul></ul><ul><ul><li>frequency of past transactions </li></ul></ul><ul><li>Hedged Item </li></ul><ul><ul><li>Project ID expected to occur in a month </li></ul></ul><ul><ul><ul><li>If project schedule rolls than potentially hedge rolls </li></ul></ul></ul><ul><ul><ul><ul><li>Not unlimited </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Depends on documented hedge strategy </li></ul></ul></ul></ul><ul><ul><ul><ul><li>No project / roll limits breached, P&L recognition </li></ul></ul></ul></ul><ul><li>Forecasts </li></ul><ul><ul><li>incentive not to change expected dates for future accounting periods </li></ul></ul><ul><ul><li>changes to expected dates within current account period will have same profit and loss impact </li></ul></ul>
    24. 24. Forecast Foreign Currency Transaction – Example Settle the USD forward Settle the USD receivable 1/2/2004 Forecast Sale Recognition Date 10/4/2004 Recognise Sale Recognise Accounts Receivable Hedged risk is FX cash flow exposure on receivable to be settled in 10 April. What is the accounting?
    25. 25. Foreign Currency Transaction – Hedge Steps <ul><li>Determine your functional currency </li></ul><ul><li>Determine the type of hedge </li></ul><ul><li>Document, Document, Document </li></ul><ul><ul><ul><li>Policy document supported by </li></ul></ul></ul><ul><ul><ul><li>Individual hedge documentation </li></ul></ul></ul><ul><li>Value the derivative </li></ul><ul><li>Quantify the degree of ineffectiveness </li></ul><ul><li>Prepare the journal entries </li></ul>
    26. 26. Forecasted Foreign Currency Transaction – Example, Information <ul><li>Spot rates </li></ul><ul><ul><li>Recognition date – sale (or purchase) </li></ul></ul><ul><ul><li>At each receivable (or payable) remeasurement date </li></ul></ul><ul><li>Forward rates </li></ul><ul><ul><li>At inception </li></ul></ul><ul><ul><li>At each remeasurement date </li></ul></ul><ul><li>Risk-free Interest Rates </li></ul><ul><ul><li>Discount cash flows on forward / forecasted transaction* </li></ul></ul><ul><li>* For purposes of this illustration, using notional resulting from change in forward rates, but typically must discount using applicable risk free interest rates </li></ul>
    27. 27. Forecasted Foreign Currency Transaction – Example, fair Value
    28. 28. Foreign Currency Transaction – Hedge Steps <ul><li>Determine your functional currency </li></ul><ul><li>Determine the type of hedge </li></ul><ul><li>Document, Document, Document </li></ul><ul><ul><ul><li>Policy document supported by </li></ul></ul></ul><ul><ul><ul><li>Individual hedge documentation </li></ul></ul></ul><ul><li>Value the derivative </li></ul><ul><li>Quantify the degree of ineffectiveness </li></ul><ul><li>Prepare the journal entries </li></ul>
    29. 29. Where does ineffectiveness come from? <ul><li>If all terms are matched the relationship between the hedging instrument and hedged item should be 100% effective </li></ul><ul><li>Ineffectiveness arise when terms are not matched </li></ul><ul><li>Examples </li></ul><ul><ul><li>Different reference rate </li></ul></ul><ul><ul><li>Different currency </li></ul></ul><ul><ul><li>Different grade commodity </li></ul></ul><ul><ul><li>Different delivery location </li></ul></ul>
    30. 30. Effectiveness Assessment and Measurement of Ineffectiveness <ul><li>Expectation (assessment) of high effectiveness differs from the measurement of ineffectiveness </li></ul><ul><li>2 Step Process </li></ul><ul><ul><li>Assessment of effectiveness: </li></ul></ul><ul><ul><ul><li>Can hedge accounting be applied? </li></ul></ul></ul><ul><ul><ul><li>Prospective and Retrospective </li></ul></ul></ul><ul><ul><li>Measurement of ineffectiveness: </li></ul></ul><ul><ul><ul><li>Net profit impact </li></ul></ul></ul><ul><ul><ul><li>Based on actual results </li></ul></ul></ul><ul><ul><ul><li>Ineffectiveness is not used to determine whether hedge accounting should be applied </li></ul></ul></ul><ul><ul><ul><li>But it may indicate that high effectiveness can no longer be expected </li></ul></ul></ul>
    31. 31. Measuring Ineffectiveness: Cash Flow <ul><li>Need to calculate ineffectiveness separately </li></ul><ul><li>Amounts recognised in equity are limited to the lesser of: </li></ul><ul><ul><li>Fair value change of the derivative OR </li></ul></ul><ul><ul><li>Expected future cash flows of the hedged transaction </li></ul></ul>
    32. 32. Measuring Ineffectiveness: Cash Flow <ul><li>Limits in Equity: </li></ul><ul><ul><li>Derivative fair value changes by more than the change in cash flows of the hedged item </li></ul></ul><ul><ul><ul><li>Derivative increases by $100; expected future cash flows decrease by $90 </li></ul></ul></ul><ul><ul><ul><li>$10 would be recorded in earnings as ineffectiveness while $90 would go to equity as the effective portion of the hedge </li></ul></ul></ul><ul><ul><li>Derivative fair value changes by less than the change in cash flows of the hedged item </li></ul></ul><ul><ul><ul><li>Derivative increases by $90; expected future cash flows decrease by $100 </li></ul></ul></ul><ul><ul><ul><li>$0 would be recorded in earnings as ineffectiveness and entire $90 would go to equity as the effective portion of the hedge </li></ul></ul></ul>
    33. 33. Foreign Currency Transaction – Hedge Steps <ul><li>Determine your functional currency </li></ul><ul><li>Determine the type of hedge </li></ul><ul><li>Document, Document, Document </li></ul><ul><ul><ul><li>Policy document supported by </li></ul></ul></ul><ul><ul><ul><li>Individual hedge documentation </li></ul></ul></ul><ul><li>Value the derivative </li></ul><ul><li>Quantify the degree of ineffectiveness </li></ul><ul><li>Prepare the journal entries </li></ul>
    34. 34. Overview - Fair Value Hedge Accounting Hedging instrument Changes in fair value go to Net Profit Hedged item Fair value the hedged item due to the hedged risk and recognise changes in fair value in Net Profit Net Profit (net impact = ineffectiveness)
    35. 35. Overview - Cash Flow Hedge – Accounting (Method 1) Changes in Fair Value of Hedging Instrument Net Profit Separate component of Equity (reserve) Effective portion Ineffective portion Recognised with hedged item IAS 39.95
    36. 36. Overview - Cash Flow Hedge – Accounting ( Method 2 – Amendment ) Changes in Fair Value of Hedging Instrument Net Profit Separate component of Equity (reserve) Effective portion Ineffective portion Basis Adjustment to Hedged Item IAS 39.98(b)
    37. 37. Forecasted Foreign Currency Transaction – Example, High Level 1/2/2004 Forecast Sale Recognition Date 10/4/2004 Revalue fx contract to fair value through equity Record Sale. Revalue Accounts Receivable at spot through Net Profit Revalue fx contract to fair value through net profit Transfer equity to sales (net profit)
    38. 38. Implementation - Plan <ul><li>Form implementation team </li></ul><ul><li>Review risk management policies </li></ul><ul><li>Compile inventory of derivatives & related exposures </li></ul><ul><li>Categorise inventory & exposures </li></ul><ul><li>Assess processes/technology and implement changes </li></ul><ul><li>Develop and test hedge effectiveness / valuation models </li></ul><ul><li>Determine tax impact / transition adjustments </li></ul><ul><li>Evaluation of disclosures </li></ul><ul><li>Develop ongoing monitoring process </li></ul><ul><li>Inform stakeholders </li></ul>
    39. 39. <ul><li>Timeline for companies with June year-end: </li></ul>Timetable 2005 31st December 31st December 2004 1st January Present first report Manage Investor Relations 2005 2004 Full Year Comparatives Due 2004 System and documentation requirements implemented 2006 31st December 2006 Opening balance sheet under IFRS For Nylex, the first presentation of fully compliant financial statements will be for the year ended 30 June 2006 First consolidation and comparatives Scope the impact Identify business issues Plan the implementation Design and implement systems Train staff Implement business decisions Parallel run and test system INTRODUCTION OF IFRS STANDARDS First Full Year IFRS Compliant Financial Statements Due
    40. 40. Other Issues and further Questions

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