How to Make Hedging Documentation
If your company enters into some derivatives or other contracts to protect against any (potentially adverse) changes in cash flows or fair values, then it’s probably beneficial to apply hedge accounting.
I wrote a few articles about hedge accounting, therefore if you need to refresh your memory, here they are:
- Hedge accounting: IAS 39 vs. IFRS 9
- Difference Between Fair Value Hedge and Cash Flow Hedge
- Hedge Accounting Under IFRS 9: Rebalancing – What Is This New Concept?
I need to stress that hedge accounting is OPTIONAL.
No, you do NOT have to apply it.
Instead, you can book all profits or losses resulting from your derivatives straight in profit or loss statement.
However, this approach is not very beneficial for two reasons:
- You are NOT showing the true character and substance of your derivatives (or other instruments) and it can look you are speculating on the market;
- Profits and losses that you report in your financial statements can look like an electrocardiogram of a heart attack – lots of bumps, ups and downs, with great volatility.
I’m convinced that YES, once you take some derivatives or something else to protect your assets/liabilities/cash flows, you DO WANT to apply hedge accounting.
It’s not a free ride.
You need to meet three conditions before you can apply the hedge accounting.
If you don’t meet them, then sorry, no hedge accounting.
These conditions are described in IFRS 9 Financial Instruments par. 6.4.1 and one of them is to have a hedging documentation ready.
In today’s article, I tried to explain how you should prepare your hedging documentation in order to be acceptable.
I never planned to write it, because frankly speaking – hedge accounting is not my favorite topic, but I got so many requests from you, guys, that persuaded me to go into these deep waters again. I really hope you enjoy!
What is hedging documentation?
It’s a document that describes your hedging.
While the term “hedging documentation” is not defined in IFRS, IFRS 9 specifies (par. 6.4.1) what you need to write in your documentation:
- What your risk management objective is and why you undertake the hedge
- What your hedging instrument is(e.g. derivative)
- What your hedged item is (Receivables? Forecast sales?)
- What risk you’re protecting against (Foreign exchange risk? Interest rate risk? Commodity price risk? Etc.).
- You should state the type of the hedge here (Fair value? Cash flow?)
- How you assess the hedge effectiveness
One of the biggest mistakes that accountants do is that they try to apply hedge accounting, yet they don’t have the sufficient hedging documentation and as a result, they do not meet the hedge accounting criteria.
I’ve seen so many sad examples while working with my clients that I included this mistake in my report “Top 7 IFRS Mistakes That You Should Avoid” (by the way, you’ll receive it on your e-mail if you subscribe to my free newsletter here).
What your auditor would NOT accept as a hedging documentation
Here are few examples of totally unacceptable hedging documentation:
- Few sentences in the accounting manual
The common practice is that bigger groups or holdings elaborate their own group accounting manual with all accounting policies so that all subsidiaries can apply the same accounting rules.
Within this accounting manual, there’s a few sentences stating something like:
“ABC Group enters into interest rate swaps in order to hedge the interest rate risk. By swapping the floating rate for fixed rate, the interest payments are fixed and cash flow risk is eliminated.”
Pardon me, but this is NOT the hedging documentation.
It’s merely a description of the hedging strategy, and I doubt it’s sufficient even for this purpose.
Your auditor should definitely NOT accept it.
- A hedging documentation with insufficient details
One of my clients elaborated a 5-page document titled “Hedging documentation”.
I was so happy to hold it in my hands… well, until I started reading it.
The company’s accountants loosely described their transactions. They wrote something like:Special For You! Have you already checked out the IFRS Kit ? It’s a full IFRS learning package with more than 40 hours of private video tutorials, more than 140 IFRS case studies solved in Excel, more than 180 pages of handouts and many bonuses included. If you take action today and subscribe to the IFRS Kit, you’ll get it at discount! Click here to check it out!
“ABC Ltd. partially finances its research activities with the bank loans and pays floating interest rate. In order to minimize the volatility of cash flows risk, ABC enters into interest rate swaps and uses them as the hedging instruments.”
Then, on the remaining 4.5 pages, individual paragraphs from IFRS 9 were copied.
This is also unacceptable, because it does NOT describe ABC’s hedging relationship at all.
- Hedging documentation worked out subsequently
Some companies were even not aware of the fact that they needed a hedging documentation, so they had none.
But, they still wanted to apply hedge accounting and therefore, they quickly prepared some document with description of what’s happening.
OK, I will be silent about the question whether the auditor can or cannot accept the hedging documentation prepared well after the hedged item and hedging instruments have already been in place for some while.
Just let me remind you that you need to think UPFRONT.
You should work out your hedging documentation AT THE INCEPTION of the hedging relationship and not when it has already started.
- Too general hedging documentation
I have also experienced the companies who prepared their hedging documentation for all hedges they have, without precise identification of individual hedged items and hedging instruments.
Hedging documentation contained other necessities, such as the type of the hedge, the nature of the risk hedged, methods for effectiveness testing, etc.
However, their hedging documentation was still NOT sufficient, because it is necessary to identify precisely WHAT specifically the hedged item is and WHAT specifically the hedging instrument is.
Writing: “The hedged item are all loans with floating interest rate and the hedged instruments are interest rate swaps pay fixed receive floating” is not enough.
You should precisely give details of each loan and each swap that you use.
How to make your hedging documentation
If you read this far, please don’t be scared.
The hedging documentation does NOT need to be very complex or lengthy document.
If it contains all necessary information as I listed above, just 1 or 2 pages will be sufficient.
IFRS 9 does NOT prescribe the format, so it’s up to you to decide.
Just don’t forget to include everything it needs and don’t forget to make it AT THE INCEPTION of your hedging relationship.
Example – hedging documentation
EUtec, a producer of technical equipment operating in Germany with the functional currency of EUR, enters into a contract to produce and sell technical equipment for USlab, an American R&D company.
The contract was signed on 1 February 20X1 with the total contract price of USD 25 million. The equipment will be delivered on 31 July 20X1 and the payment terms are as follows:
- USD 5 million: upon contract signature
- USD 20 million: within 30 days after delivery
EUtec is worried about the adverse movement in foreign exchange rates and their negative effect on EUtec’s cash flows (that is, EUtec is afraid that the USD will weaken against EUR and EUtec will receive less EUR for 20 mil. USD than it would have received at the inception).
Therefore, in order to hedge foreign exchange exposure, EUtec enters into a foreign currency forward contract with BigBank under the following terms:
- Start date: 1 February 20X1
- End date: 30 August 20X1 (30 days after delivery)
- EUtec pays 20 million USD and receives 18 million EUR
Note: here, I am not going to show you how to calculate the fair value changes of the forward contract, or journal entries, or measuring the hedge effectiveness. I solve these questions in the IFRS Kit. Here, we are solving only the hedge documentation.
Before EUtec can apply the hedge accounting, it must prepare the hedge documentation on 1 February 20X1, that is on the inception of the hedging relationship.
It can look as follows:
EUtec: Hedging documentation #01/20X1
Risk management objective:
To protect the cash flows resulting from the future sale of equipment produced for USlab denominated in USD and the subsequent conversion of USD to the functional currency of EUR.
Strategy for undertaking the hedge:
EUtec is exposed to foreign exchange risk when selling to clients overseas in currencies different from EUR. Therefore, its strategy is to minimize the risk of adverse impact of foreign exchange rate movements on EUtec’s cash flows by entering into offsetting foreign currency forward contracts.
Type of the hedge:
Cash flow hedge
Nature of the risk being hedged:
Foreign currency risk
Cash flows in USD resulting from the future sale of technical equipment to USlab, American R&D company, based on the contract signed on 1 February 20X1.
Exposed cash flows amount to USD 20 million and EUtec expects to receive them on 30 August 20X1.
Foreign currency forward contract #346/20X1. The counterparty is BigBank.
The forward contract starts on 1 February 20X1, matures on 30 August 20X1, EUtec pays 20 million USD and BigBank pays 18 million EUR.
Method of assessing the hedge effectiveness:
EUtec uses both qualitative and quantitative methods for assessing the hedge effectiveness. Hedge is assessed at the inception:
- An economic relationship between the hedged item (cash flows of 20 million EUR) and hedging instrument (foreign currency forward contract) was tested by:
- The qualitative analysis: comparing the critical terms of both items and concluding that they are offsetting.
- The quantitative analysis: simple scenario analysis method was used.
EUtec simulated a few scenarios. EUtec examined how the fair value of the hedging instrument moved when the fair value of the hedged item was shifted in various directions.
The conclusion is that the changes in fair values of the hedged item and the hedging instrument are moving in the opposing directions and the change in fair value of hedging instrument highly offsets the change in fair value of the hedged item (note – it would be perfect if you could prepare this analysis and document it).
- Credit ratings of both EUtec and BigBank are solid, therefore credit risk does not affect any value changes in the hedging relationship.
- The hedge ratio is 1:1, which is exactly 20 million USD (quantity of hedged item) to 20 million USD (quantity of notional amount in foreign currency forward).
EUtec assessed that based on these 3 criteria, the hedge is highly effective and hedge accounting can be applied.
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