Accounting for Hedges according to CIMA F3

Accounting for Hedges according to CIMA F3

Hedging is all about what we can do to try and remove or reduce the risk, that exposure to that global price movement. In accounting for hedges there are three types of hedges that you need to be aware of. 

Hedging is all about creating a counterbalance and there are various different types of hedges that are examinable. 

This vlog is going to uncover all 3 of them, so after watching this short lecture, you can be sure you will know how to distinguish forward contracts, futures contract, options, swaps. 

You'll also understand what is a fair value hedge, a cash flow hedge, and the overseas investment. 


In CIMA, hedges are covered in F3 and in P3.

F3 covers the accounting side, P3 covers the mechanics. This video is only about the F3 side. 


For more lectures on F3, you can check our free F3 package with a sample lecture on the objectives of the financial strategy, covered in F3 chapter 1 (according to CIMA F3 Kaplan study book). 

Also, have a look at our highly rated video F3 course here: CIMA F3 Complete Course.

 

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Transcription

All you need to know about HEDGES [00:08]

Hello and welcome to this short video, looking at the topic of hedging from a CIMA F3 perspective with Practice Test Academy.

Hedging - where is it mentioned? [00:20]

Hedging is covered in two places in the CIMA syllabus, is it some in F3 and then some in P3.

The P3 side of things is the mechanics of actually undertaking a hedge.

So, it's when the cash flows, uh, working out the profits or losses and the net position, those kinds of things, the numbers themselves all come up in P3.

F3, which is what this video is about, is more to do with the accounting side of things.

So, it's looking at the accounting standards, as to how we reflect hedging transactions in the financial statements.

That's what we're going to be focusing on here.

What is hedging? [01:01]

Now, hedging is about removing or reducing your exposure to some kind of an externally imposed price.

Whether that price is interest rates or exchange rates, which are the two main ones that feature on the syllabus.

But, it could be the price of anything that's set globally, the price of oil, the price of gold, share prices.

So, for example, if you deal in gold as a business, then you'll be very exposed to what happens to the global price of gold.

And, if we buy gold today with a view to selling it later, we'll be very exposed to whether the price of gold moves in between times.

So, hedging is all about what we can do to try and remove or reduce that risk, that exposure to that global price movement.

On our exam though, in our exam, we focus on the interest rate risk.

So, the fact that our profits might be affected by interest rates going up or down, for example, if we're a borrower or if we're a saver, an exchange rate, so if we trade overseas for example, we sell something to an overseas company then when they pay us, if we sell to them on credit.

When they pay us, we don't know how much domestic currency that's going to be worth if we're exposed to that movement in the spot rate from one minute to the next.

Types: forward, future, options, swaps [02:17]

So hedging is all about essentially creating a counterbalance.

And there are various different types of hedges that are examinable.

We've got forward contracts which are a fix.

So, you agree a rate, typically with a bank but doesn't have to be with a bank.

Agree a rate for a future transaction today whether that's alone or whether that's selling some foreign currency or buying some foreign currency.

It's for a specific amount on a specific date.

You're a named party in the contract and the banks are named party in the contract.

So, it's tailored to your needs and it's a fix.

That's as opposed to a futures, contract a futures contract is essentially a standardised forward contract for a standard amount of something, whether it's currency or debt on a standard date and because they're at the standard nature of these things they can be traded, so there are active exchanges these things are bought and sold all the time.

Options as the name suggests give you the right but not the obligation to do something.

So rather than insisting on you buying or selling say some foreign exchange on a certain date, an option is giving you the right to buy or sell some foreign exchange a certain rate on a certain date.

The good thing with options is that you only have to go ahead with them if it's beneficial to you, if you get a better rate under the option that you would otherwise get.

But, there is a price to pay for that.

You have to pay a premium upfront non-negotiable, non-refundable whether you exercise that option or not.

And just in terms of option terminology, a put option is an option to sell something, put it into the market you want to get rid of it.

A call option is an option to buy something.

So you want to call it out of the market, you want to buy it.

So for example a put option on EUR is an option to sell EUR at a certain rate.

Then finally we have swaps.

This is more particularly to do with interest rate hedging.

Although, it can help with foreign exchange in the context of a foreign investment.

But, the simplest type of swap is changing a fixed interest rate for a variable interest rate by swapping interest payments with somebody else and usually through an intermediary like a bank.

So, they're the various different types of hedges you could use.

The mechanics of those you'll see in paper P3 as we said earlier.

Now let's have a look at how a hedge works.

Now on the right hand side of these scales, we've got what would happen if we were unhedged.

So, here we've sold something to an overseas customer on credit and in the future they're going to give us a certain amount of foreign currency and we're now thinking: well, the amount of domestic currency that foreign currencies worth will depend on the exchange rate when the money comes in.

So, if we just sit and wait then we might for example make a loss of $50,000, if the exchange rate moves against us.

What we're going to do is at the time we make the sale to the customer, set up an agreement with somebody else and this is what's known as the hedge transaction and that acts as a counter balance.

So, create a situation where if we make a loss of 50k, when the money comes in from our customer, we'll get a counterbalancing gain of 50k and coming through from the from the hedge transaction.

There is usually a pretty quick pro quo for that though that if it goes the other way, once the hedge transaction set up and it turns out we make a gain on the receipt from the customer.

So, actually the spot rate of exchange has gone in our favor, we've got more of our domestic currency as a result of that favorable movement.

Unfortunately, the hedge transaction will take that gain away.

But the whole idea is the hedge transaction is taking away the gains and taking away the losses.

So, it's just taking away the risk ultimately.

You have to think of the big picture here and think what we're trying to get some certainty in the rate that we're going to get and that means trying to remove the gains and losses.

There is one small exception to that though.

Number four, on the screen there, that if it's an option and you only have to go ahead with an option if you're going to make money out of it.

So, the good thing with an option is you would not have to accept that loss on the hedge transaction.

You would just abandon the option or walk away from it and you could just then live with your nice $30,000 gain on the underlying transaction.

But, of course, remember that's not free, you have to pay a premium up front right back at the start to get the right to be able to do that.

Accounting for hedges [07:01]

Now, coming on to accounting for hedges there are three types of hedges that you need to be aware of and let's cover the three types of hedges first and then we'll talk about how we, how we account for them.

First of all there's a hedge on an existing asset or liability.

So, if you've already sold something to an overseas customer for example and you have a receivable denominated in foreign exchange and then you take out say a forward contract or a futures contract to protect your position there.

That's what's known as a fair value hedge.

So, the key word here is existing, as an existing asset or liability like a receivable.

If it's a probable future transaction, so it's something that hasn't happened yet like a sale next year and you're worried about what's going to happen to the exchange rate between now and when you make the sale next year, then you might take out a hedge now, you might take out a forward contract or futures now to protect your position.

But, the underlying transaction the sale is not yet happened then that's something slightly different and that's known as a cash flow hedge.

Then finally something a little bit different is if you invest overseas, so you've got overseas denominated asset like a business or a factory or something like that and, and you take out an overseas loan, so that if the value of the asset shrinks so does the value of the liability of the loan and that type of a hedge is known as a net investment in overseas operation.

Now before hedging was ever even sort of featured in accounting standards, the standard approach was what's known as FVPL: fair value to the profit and loss.

So, if you had an asset that was like a receivable that was denominated in a foreign currency, you would just restate its value at the spot rate at the end of the year for the reporting date.

And, if you had a separate hedging instrument except he wasn't accounted for as a hedge if it was just a forward or a future, you would also do the same there fair value profit and loss.

Now, a fair value hedge sticks very closely to that.

So, the idea here comes very much back to those scales we saw earlier on that if you have a receivable, you fair value to profit and loss that so you might get a 50k profit let's say on the receivable.

On the hedging instrument, the future or the forward, you had fair value profit or loss that as well.

So what you would typically end up with if the hedge is a nice close match to the size of the underlying transaction, the profits and losses both cancel out, so the profits on one are more or less the same as the losses on the other, which is what you wanted.

This is why you've done this, to sort of act as a counterbalance, to take the pain away, take the pleasure away.

So, that's a fair value hedge.

Now you might say well why do we even give that a name because that's no different to what you would have done before.

Well, say for example if that asset was inventory.

Now, normally if the value of inventory goes up, you wouldn't normally revalue it upwards, but with fair value hedging and if you've got a hedge in place to protect the value of say gold that you have in inventory and the value of gold goes up, you would increase the value of that gold on your balance sheet.

But, because you've made a gain there, you would also be increasing the loss you make on the corresponding hedge instrument.

So again, your profit and loss account is cushioned.

So, enables you to value things like inventory upwards when it's done as part of a hedge.

That's a fair value hedge.

A cash-flow hedge, this is really trying to deal with a timing issue.

If I take out some futures contracts today to protect my position against a sale, I'm going to be making next year.

Then unfortunately, the fair value profit or lost default would suggest that when I get to a reporting deadline at the end of this year and I've got my futures in place, but I haven't made the sale yet, I'm actually going to be ending up making profits or losses as I revalue that term, that hedging instrument.

And, that doesn't seem to make sense because the whole reason we took the hedge out was to avoid fluctuations in the profit or loss account.

So, to try and get around that and to say well look this is a hedge, it shouldn't be affecting our profit and loss account, when we have the hedging instrument in place, but the probable future transaction is not yet happened.

When we restate the value of that hedging instrument, we don't put it to the profit and loss account, we sort of put it in this temporary parking spot: the OCI - the statement of other comprehensive income, which keeps it away from the face of the profit or loss account.

So, if you make profits or losses on the hedging instrument, we park those temporarily in the OCI until we get to the year or the period where the sale actually happens, then as that sale happens, we will then and the technical term for this is recycle those entries from the OCI to the P&L on the hedging instrument.

So, what you should see happen is let's say the exchange rate is moving against is gradually on a sale that we're making next year, okay? While the time we get to the end of this year, the fact the exchange rates moved against us on the future sale should mean it's moved in our favour on the hedging transaction, the hedging instrument.

So, what you'd see is a profit made there.

Now rather than recognising that profit in the P&L account, we temporarily park that profit in the OCI.

Now, next year, when we make the sale and that sale will be it sadly a lower amount because the exchange rate has been moving against us on the sale, but not to worry we recognise that sale at the lower amount but we then recycle that profit that we parked temporarily in the OCI to bump it back up.

So, in a net effect what you're doing there is keeping the profit figure relatively stable.

So, in summary then, until the transaction happens, you revalue the hedging instrument at the reporting period end and put that entry to the OCI then when the actual sale happens for example the underlying transaction happens, then you take the entry out of the OCI put it into the P&L.

Then finally, we have net investments in overseas operations.

In these situations, you never let any entries go near the profit and loss account.

So every period end, you revalue both the loan and the overseas investment and put both entries to the OCI and in theory, they should be pretty much netting out anyway, otherwise it wouldn't be a very effective hedge.

So, that are three types of hedge.

The first thing you need to do is to decide what type of hedge it is and to distinguish between the top two there: a fair value hedge relates to an existing asset or liability, a cash-flow hedge relates to a probable future transaction.

And once you've done that, then you follow the accounting rules.

IFRS 9 changes - per your exam [14:35]

Now there have been some admittedly relatively small changes as far as affects our exam is concerned anyway.

The old accounting standard IAS 39 said that for a hedge to be accounted for as a hedge, the hedge had to be deemed to be effective and by effective, we mean, the profits on one more or less the same as the losses on the other.

And the way we used to calculate that is we take the profits on one and divide it by the losses on the other and times that by a hundred to get as a hedge effectiveness.

Now, with an ideal hedge the profits are going to equal the losses.

That's going to come out it's smack all the 100%.

But there was a little bit of variation allowed in IAS 39 and a percentage effectiveness of between 80 and 125 % was deemed to be effective.

If it fell outside of that, then you couldn't really say you had a hedge in place.

IFRS 9, which is now replaced IAS 39, is not so prescriptive on the percentages.

It still needs to be assessed and justified as a hedge transaction, but it's not so prescriptive on that 80 to 125 %, so that that's been removed in effect.

Now, IFRS 9 is on the syllabus now you still need to be aware of IAS 39 because it may affect things like comparatives that you're looking at in the case study for example.

That's everything you need to know then about hedging for F3.

Hedging for P3 is an entirely different matter and that looks at the mechanics of how you calculate the profits and losses, etc.

I hope that was useful, I'll speak to you in a future presentation.

Thanks very much for listening.