Hedge Management

Below I try to explain the basic principles in Hedge Accounting and the process in SAP. Please note that Hedge Accounting and Financial Instruments under IFRS are undergoing changes including replacement of IAS39 and changes to Hedge Accounting and Disclosure requirements. Hence, this write-up may be read in this context. For further information on the changes and the timetable for implementation of these changes, please look up the IASB website. The work plan for IFRS can be found at the following link – IFRS Work Plan

---

Why Hedge?

Hedging is carried out normally to mitigate a financial risk position (interest rate risk, currency risk, equity price risk, Commodity price risk) of an entity by use of a countering transaction, usually a derivative

For example, the risk of fluctuations in exchange rates of a foreign currency sales order maybe countered by entering into a forward ‘sell’ foreign currency contract which will offset the risk due to exchange rate fluctuation when Cash is finally received from the Customer

Accounting Guidelines

– Prior to Accounting Guidelines on Derivatives

Derivatives were off-balance sheet items

Hence, ‘earnings risk’ for non hedging derivatives and not effectively hedging derivatives were not measured leading to enormous ‘Surprise Factor’

– FAS 133 in the US and IAS 39 under IFRS (International Financial Reporting Standards) specifies the guidelines concerning derivative instruments and hedging activities

This requires all Derivatives to be accounted in the Balance Sheet

Special hedge accounting allowed if criteria like effectiveness are met

Differences

#	IAS 39 – IFRS	FAS 133 – USGAAP
1	Principle based – looks at the economics of the transaction than the form	Form based
2	Requires hedged forecasts to be highly probable and provides detailed guidance	Requires hedged forecasts to be probable and provides little guidance. This may result in some probable hedges under FAS 133 not being allowed under IAS 39
3	Critical Terms Match – allowed for prospective effectiveness but not for retrospective effectiveness	Critical Terms Match – allowed for both prospective effectiveness and retrospective effectiveness
4	Shortcut Method – allowed for prospective effectiveness but not for retrospective effectiveness	Shortcut Method – allowed for both prospective effectiveness and retrospective effectiveness
5	Basis Adjustment allowed for Cash Flow Hedges	No Basis Adjustment allowed for Cash Flow Hedges
6	Hedging allowed in the Group company	Requires entity with the FX exposure to do the hedging

Hedge Item

Can be an Asset, Liability, Firm Commitment, a highly probable forecast transaction or a net investment in a foreign operation

The Hedge Item must expose the entity to risk of changes in fair value or future cash flows that could affect the income statement, currently or in future periods

FAS 133 / IAS39 sets out restrictions on what may be designated as a hedged item

Examples of Hedge Item:

– Receivables, Payables, Borrowings & Investments (Foreign currency risk);

– Firm Commitments (Sales Orders, Purchase Orders) in a foreign currency (Foreign currency risk);

– Highly probable forecast sales or purchases in a foreign currency (Foreign currency risk);

– Highly probable forecast purchase or sale of commodities (commodity price risk);

– Available-for-sale equity instruments (equity price risk);

– Loans and receivables (interest rate risk);

– Fixed or floating rate borrowings (interest rate risk)

Hedge Instrument

Can be either Derivatives or Non-derivatives

Most derivatives can be designated as hedging Instruments

A written option cannot be designated as a hedging instrument. However a purchased option can be designated as a hedging instrument

A derivative need not be designated as a hedging instrument at the time it was first entered into. However, designating a derivative other than at its inception may give rise to some ineffectiveness.

A non-derivative instrument can be designated as hedging instruments only for foreign currency risk

For example, a foreign currency borrowing may be designated as a hedge of the currency risk of a net investment in a foreign entity

An entity’s own equity instruments are not financials assets or financial liabilities and therefore cannot be designated as hedging instruments

Why Hedge Accounting?

Under FAS133 / IAS 39 all Derivatives are carried at Fair Value with gains and losses accounted in the Income Statement.

These Derivatives may be used to hedge:

– Assets and Liabilities that are measured:

>at cost;

>amortized costs;

>or at fair value with the gains /losses on them recognized in the Equity;

-Forecasted Transaction or Firm Commitment not recognized in the financial statement   at all

This creates a mismatch in the timing of the impact of the Gain/Loss in the Income Statement:

as the recognition of the gain/loss of the derivative in the Income Statement might be in a different reporting period as compared to the recognition in Income Statement of the gain/loss of the Hedged Item

This mismatch will create volatilities in the Income Statement

Hedge Accounting tries to avoid this volatility by changing the timing of the recognition of the gain/loss in the Income Statement of either the Hedged item or the Hedging Instrument

That is, to recognize the gain/loss on the hedging instrument in the same period as the offsetting gain/losses in the hedged item

Hedge Categories

Fair Value Hedge

Cash Flow Hedge

Hedge of Net Investment in a Foreign Operation

Hedge Categories: Fair Value Hedge

is a hedge of the risk of changes in the fair value that is attributable to a particular risk and which could affect the Income statement, associated with a fair value change in:

– a recognized asset , liability

– or an unrecognized firm commitment (eg; Sales Order, Purchase Order),

– or an identified portion of the above

Hedge of Firm commitments are treated as fair value hedges

– However, the hedge of a foreign currency risk of a firm commitment can be treated as either a cash flow hedge or a fair value hedge.

Accounting Treatment

> Hedging Instrument : the gain or loss on re-measuring the hedging instrument at fair value is recognized in the Income Statement

> Hedged Item: the gain or loss on re-measuring the hedged item attributable to the hedged risk shall also be recognized in the Income statement

In the case of hedge of an unrecognized firm commitment (hedged Item), the subsequent cumulative change in the fair value of the firm commitment attributable to the hedged risk is recognized as an asset or liability with the corresponding gain or loss recognized in the Income Statement

Hedge Categories: Cash Flow Hedge

is a hedge of the variability in cash flows that is attributable to a particular risk that could affect the Income statement and associated with

> a recognized asset or liability (such as all or some future interest payments on variable rate debt),

> an unrecognized firm commitment (Currency risk only)

> or a highly probable forecast transaction

Hedge of forecasted future foreign currency sales of inventory or forecasted purchase of Inventory or Equipment using foreign currency forward contract can qualify for Cash Flow Hedge Accounting

Accounting Treatment

>Hedging Instrument : The portion of the gain or loss on re-measuring the hedging instrument that is attributable to the hedged risk and determined to be an effective hedge is recognized in other comprehensive income (OCI). The ineffective portion of the gain or loss is immediately recognized in the Income Statement

> Hedged Item: no adjustments of the hedged item is recorded

> OCI-balance is reclassified as hedged item affects earnings

Hedge Categories: Hedge of Net Investment in a Foreign Operation

is the hedge of the amount of the reporting entity’s interest in the net assets in a Foreign operation (Functional Currency is different) including any recognized goodwill

These include monetary items like long-term receivables or loans but do not include trade receivables or trade payables

The hedging instrument needs to be denominated in the functional currency of the foreign operation to be effective

Accounting Treatment

> Hedging Instrument : The portion of the gain or loss on re-measuring the hedging instrument that is attributable to the hedged risk and determined to be an effective hedge is recognized in other comprehensive income (OCI). The ineffective portion of the gain or loss is immediately recognized in the Income Statement

> Hedged Item: no adjustments of the hedged item is recorded

> OCI-balance is reclassified as hedged item affects earnings

Example 1 – Differing Accounting Treatment

Type of Hedge	Item subject to different accounting	Normal Accounting Treatment	Accounting Treatment when Hedge Accounting is applied
Fair Value Hedge	Hedge Item – Currency Risk of an Equity Instrument held under the category ‘Available-for-Sale’	As per IAS39 – all future changes in the fair value of a financial asset held as ‘ Available-for-Sale’ are deferred in equity until the instrument is sold or impaired	As per IAS39 – when Hedge Accounting is applied, the fair value changes (in this example, the currency risk) are taken to the Income statement (and not deferred in equity) to offset the fair value changes of the derivative which is the hedging instrument (fair value changes in the derivative is also taken to the Income statement) When Hedge Accounting is discontinued prospectively, the previous entries are not reversed but the changes in the fair value of the Hedge item subsequent to the discontinuance of the hedging relationship is deferred in equity.

Example 2 – Differing Accounting Treatment

Type of Hedge	Item subject to different accounting	Normal Accounting Treatment	Accounting Treatment when Hedge Accounting is applied
Cash Flow Hedge	Hedging Instrument – a forward contract (Derivative) used to hedge the currency risk of a highly probable forecasted purchase of raw materials in foreign currency.	As per IAS39 – all future changes in the fair value of the ‘Derivative’ should be recognized in the Income Statement except for those instruments which are designated as part of a qualifying hedging relationship.	When Hedge Accounting is applicable, the fair value changes in the derivative is deferred in equity under ‘Other Comprehensive Income’ and reclassified into the Income statement when the effects of the Hedge item affect the Income Statement.

When does Hedge Relationship end?

The various events which can trigger an end to a hedging relationship are:

> The hedging Instrument (eg: Foreign currency forward contract) has reached its due date or has been exercised

> The hedged item (exposure – for eg: sales order) no longer exits due to its sales, settlement or cancellation

> In the case of a hedge of a forecasted transaction (eg: forecasted sales), the forecasted transaction is no longer highly probable

> The hedge fails a prospective effectiveness test

> The hedge fails a retrospective effectiveness test

> The hedging relationship is manually dissolved by the management

Criteria to be met to qualify for Hedge Accounting

The qualifying Hedging Instrument (Eg: a forward contract Foreign Currency contract) is formally designated as an offset to changes in either the Fair value or the Cash Flows of a Hedged Item (Exposure – say Sales Order)

The hedge Relationship should be effective both at inception and throughout the life of the Hedging Relationship

The method used for the effectiveness test (Eg; Critical Terms Comparison, Dollar Offset Method, Regression Analysis) should be stated and the logs of each of the calculations documented

Formal detailed Documentation on the Hedge including identification and the risk management objective, details of the hedge item, the hedge instrument, the nature of risk being hedged and how the effectiveness of the hedge will be assessed should be maintained for each Hedge Relationship

What happens if criteria is not met subsequently?

If any of the criteria is not met, then Hedge Accounting needs to be discontinued prospectively

Any amounts lying in Equity needs to be reclassified to P/L

The hedging Instrument is accounted as a ‘Held-for-Trading’ instrument with changes in value reported in the Income Statement

Effectiveness Testing – Fundamentals

The effectiveness of a hedging relationship is a measure of how well a derivative protects against the underlying risk (exposure)

Effectiveness is measured through the ‘effectiveness ratio’. This ratio has to fall within a certain range (80% to 125%) in order for the hedging relationship to be considered highly effective

An effectiveness test has to be carried out at every balance sheet date, and at least every 3 months

Kinds of Effectiveness Tests

There are two kinds of effectiveness tests:

> Prospective (tests whether the hedging relationship is likely to be effective in the future)

> Retrospective (tests whether the hedge relationship was effective in the past)

What causes Hedge ineffectiveness?

Hedge ineffectiveness can be caused by different factors including:

> When the hedged item and the hedging transaction are in different currencies;

> Where the fair value of the hedging instrument is not equal to zero at inception;

> Where the hedged item and the hedging transaction have different maturities;

> In case of hedge of commodities, prices from different commodity markets are used for the hedged item and the hedging instrument

Presentation in the income statement of gains and losses from derivatives

The standards are not prescriptive about where gains and losses from derivatives should be shown in the income statement. However, they do set out some guiding principles. IAS 1 describes the line items required to be included, as a minimum, on the face of the income statement. Additional line items may be presented to comply with other standards or to present fairly an entity’s financial performance. The income statement presentation of gains and losses from hedging instruments should be consistent with the entity’s risk management strategy and accounting policies. Best practice is that:

> Gains and losses from designated and effective hedging instruments are presented in the same line item as the gains and losses from hedged items. Ineffectiveness is presented separately, for example, in other operating income and expense.

> Gains and losses on derivatives held for trading (including both derivatives that are not designated as hedging instruments and those that do not qualify for hedge accounting, for example because they fail an effectiveness test) are not presented as part of the entity’s revenue, cost of sales or specific operating expenses. They are usually presented either in a separate line item in the income statement (if significant) or within other operating income and expense.

---

Hedge Accounting in SAP

Process overview in SAP

The Hedge related activities in SAP can be roughly classified into the following areas:

Exposure Management

In Exposure Management, the exposures are created either manually created or automatically created from the other areas like Materials Management or Sales & Distribution (eg: Sales Orders and Purchase orders in foreign currency) or uploaded from excel worksheets (eg: forecasted sales details). These are then analyzed by the users with regard to the decision to hedge and then transferred to Hedge Management.

Hedge Management

In Hedge Management, the ‘Hedge Items’ are created from the exposures transferred from exposure management (exposures can also be created manually in hedge management also, but use of exposure management is recommended as it gives a very robust solution for exposure management). Hedge relationship between the derivative and the Hedge items are created here and the hedge strategy identified. The detailed documentation required is maintained here. The Hedge effectiveness tests are done here. The accounting of distribution of change in derivatives on key dates based on the effectiveness assessment is done here (i.e. distribution of effective, ineffective, freestanding parts). The accounting on dissolution of cash flow hedges (eg: reclassification of amounts lying in OCI to P&L) is also done here. All accounting entries are posted in GL automatically by the system.

Transaction Management

In Transaction Management, the Foreign Exchange Forward Contracts / Derivatives are created, settled and accounted. Accounting includes the valuation of the derivative on key dates and the accounting of cash flows and the realized gains /losses on the contract date. All the accounting entries are posted in the GL automatically. Considerable savings can be achieved both in terms of time and money by executing transactions company code wise thereby ensuring accounting of all entries pertaining to a company code at one go.

Figure 1-1 & 1-2 below gives a diagrammatic process flow of the hedge management process in SAP of a cash flow hedge:

Please note that the example is not based on Exposure Management 2 in EHP4 but on the earlier Exposure Management module. However, even after EHP4, both the Exposure management modules are available in SAP.

The details of the example transaction is given below:

Hedge Item
Exposure Details	:	Highly probable Forecast of purchase of Raw Material – payment expected to be paid to the Vendor in 75 days. Current Date April 1, 2009.
Exposure Date	:	15-Jun-09
Expected period when the Finished Goods are expected to be sold	:	Between June 20, 2009 and August 31, 2009
Other Assumptions	:	the raw material purchased is used in many products and the effective portions of the hedge which is lying in OCI is not reclassified to profit and loss immediately on ending the hedging relationship but reclassified gradually on a time based pro-rata basis ( no ‘basis’ adjustment is made where the balance in OCI is adjusted against the carrying amount of the Inventory). This is a suitable approximation to satisfy IAS39 which allows entities to reclassify the balance in OCI to profit and loss once the product made from that raw material has been sold(in case of cash flow hedge of forecasted purchase of raw materials).
Derivative
Derivative	:	FX Forward Contract
Contract Conclusion Date	:	01-Apr-09
Contract Value Date	:	05-Jun-09

You can click on the images for a larger resolution picture

---

Example: Calculation of Hedge Effectiveness and distribution of NPV

Below is a working on how the effectiveness is calculated and how SAP distributes the NPV (Net Present value) of the derivative. The information used for the calculation is given below and the working follows thereafter. An explanation of each element in the working is also there. Please note that all figures are taken just for example purposes.

Notes:

The date of the derivative is June 5, 2008 which is the value date of the FX contract, while the date of the Exposure – the Hedge Item – is June 15, 2008. The date of exposure has been made different from the date of the derivative as this cause some ineffectiveness;

It is assumed that the annualized interest rate for USD is 2.5% and INR is 5%. These rates are used for discounting. Please note that the rates are not indicative of actual rates and are purely for our example purposes. The SAP system uses Zero Coupon Yield Curves to arrive at the interest rates;

The number of days to be considered for discounting is the difference between the ‘Key date’ (which in this calculation is  April 30, 2008) and the value date of the derivative (which in our example is June 5, 2008) / Hedge Item (exposure date in our example is June 15, 2008);

The SAP system calculates the discounting factor by the following three methods:

> If continuous compounding factor has not been set while customizing and the term of the cash flow is up to one year, then the linear interest calculation method is used:

Discounting Factor = 1/(1+Interest Rate X Term)

> If continuous compounding factor has not been set while customizing and the term of the cash flow is one year or more, then the exponential interest calculation method is used:-

Discounting Factor = 1/(1+Interest Rate)^Term

> If continuous compounding factor has been set, the system uses the constant interest calculation method, regardless of the terms of the cash flow:

Discounting Factor = Exp(-Interest Rate X Term)

In our example, the continuous compounding factor has not been set and since the cash flow is less than one year, the discounting factor is calculated by:

Derivative Discounting Factor for USD= 1/(1+(2.5%/360 Days)X 36 Days)= 0.997506234

Since the interest rate is annualized interest rate, it is divided by 360 to arrive at one day rate.

The Present value in the respective currencies is arrived at by multiplying the discounting rate with the amount in the respective currencies

The Net present value of the Derivative / Hedge Item is the sum of the present values of the USD and INR legs

The designated ratio of the derivative and the hedge item is calculated by:

a. Derivative – 90,000(Amount Designated )/ 125,000 (Amount of Derivative) = 0.72

b. Hedge Item – 90,000 (Amount Hedged) / 100,000 (Amount of Exposure) = 0.90

The previous value is the value as per the last posted valuation. Generally if the start date of the Derivative and the start date of the hedge item are the same, the Net Present value of the derivative will be zero at inception. Hence, in our example this value is zero

The Hedge Ratio is calculated by Delta Derivative divided by Delta Hedge item without the signs, which is 42,922.54 / 39,874.56 = 1.0764395. Since this value lies between the allowed range of 0.80 and 1.25, we can say that the relationship is prospectively effective

We shall now look at the distribution of the NPV. The NPV is distributed the following way:

> The freestanding portion is that portion of the NPV of the derivative which is not covered by any designation. In our example it is 59,614.64 – 42,922.54 = 16,692.10. This is posted to P/L

> The effective portion is that part of the NPV of the derivative which covers the hedged item (the designated part of the hedge item NPV), which in our example is 39,874.56. This is posted to OCI

> The ineffective portion is the designated portion of the NPV of the derivative which is not covered by the designated hedge items NPV. In our example it is 42,922.54 – 39,874.56 = 3,047.98. This is posted to P/L

---

Example: Accounting

Below are two examples of the accounting postings in case of a cash flow hedge and a fair value hedge. These examples are based on a working from PwC. It has been modified a bit. The scenario is given for each example followed by the postings.

Cash Flow Hedge

A company whose functional currency is INR is expecting the sale of a particular equipment which it manufactures several months from now. It has entered into a firm contract with a buyer in India for this. However, it forecasts purchase of a raw material from US which it expects to purchase in USD after some months. However, the company plans to hedge the currency risk of this highly probable forecasted purchase today itself. Hence, the company enters into a purchase USD / Sale INR forward exchange contract to hedge the currency risk. This forward contract is designated as a cash flow hedge of the highly probable forecasted purchase IAS 39 requires the fair value of the derivative to be brought into the balance sheet. However, the loss/gain (which is actually the fair value of the derivative) is not taken to the Income statement, but taken to the equity. The amount in the equity is reclassified in the period when the Inventory purchased hits the Income statement. This normally will be, when the Product made out of the inventory is sold. Hedge Instrument = FX Derivative Hedge Item = Forecasted Purchase

Fair Value Hedge

A company whose functional currency is INR has entered into a contract to supply a product to a customer in the US in a few months time. The Company decides to hedge the currency risk on this firm commitment when they actually receive the USD from the buyer. Hence, the company enters into a sale USD / purchase INR forward exchange contract to hedge the currency risk. This forward contract is designated as a fair value hedge of the form commitment for sales. Note that in the case of a hedge of a firm commitment for currency risk, the hedge can either be a cash flow hedge or a fair value hedge as the both the cash flows and the fair value are affected by the currency risk. IAS 39 requires the fair value of the derivative to be brought into the balance sheet with the corresponding entry to the Income statement. Correspondingly, the firm commitment also needs to be brought into the balance sheet by charge to the Income statement. By this, if the hedge is very effective, the entry from the firm commitment and the derivative in the Income statement should cancel each other out.

Bringing into Books the Fair value of Firm Commitments in SAP

> Transaction code THM56 is used to see the fair value change in the Firm commitments. That is, to bring into books the fair value of the firm commitments;

> Using this information user have to post the necessary journal entries in the system manually

> After posting these documents, then come back to THM56 and enter the document numbers against the fair value changes shown by the system. This will then be marked by system and it will not be shown again as those for which entry needs to be passed.

> In practice, THM56 should be run only after running the valuation using TPM1 as THM56 will only pick and show only hedge relationships for which the valuation exist on that key date and it is a firm commitment.

Hedge Accounting – Changes in EHP 3 & 4

> Commodities can be Hedged using Commodity Futures / Options / Forward Transactions

> Securities can be Hedged using Forward Securities Transaction (new product category is available now to create forward transactions for Stocks, Investment Certificates, Bonds, Shareholding)

> Security Positions can be split up into sub positions which will allow the differentiation between hedged portions of a security and the freestanding portions

> Hedge Documentation is now available