Australian Hedge Accounting - Case Study Example

Hedge Accounting Name: Course: College: Tutor: Date: Introduction Business organizations operating in both domestic and international markets often utilize hedge accounting in order to minimize or eliminate business risk brought about by the changes of foreign exchange rates. However, in Australia business organizations are supposed to meet some conditions in order to apply the hedge accounting. Hedge accounting is stipulated in AASB 139. AASB 139 is an Australian accounting standard which generally gives guidance on recognition and measurement of financial instruments. Hedging includes actions taken by business organizations through entering into a contract pertaining foreign currency. The major objective of such relationships between organizations is to mitigate possible negative financial effects brought by changes in foreign exchange rates. Business organizations or rather the parties involved in such relationships are required to meet various conditions which prescribed in AASB 139 (Australian Accounting Standards Board). Which items can be hedged? According to AASB 139, items to be hedged can be divided into various categories. To start with, a hedged item can be a single asset, firm commitment or liability. Moreover, I n this category of single items, net foreign investment operation and highly probable forecast transaction can also be hedged. Secondly, a group of items such assets, liabilities, net foreign investment operations and groups of other items as described in single item category can also be hedged to enable a business organization minimize or fully eliminate the risk of foreign exchange rate changes. However, it must be noted that in order for business organizations to hedge a group of items, the items must possess similar risk characteristics. Items which don’t possess similar characteristics should not be grouped for hedging purposes. Thirdly, a hedged item can be in a portfolio hedge regarding risk of interest rate only. Besides, a portion of portfolio of financial liabilities or assets with a common risk can be subjected to hedging accounting (Australian Accounting Standards Board). In the 78th paragraph of the AASB 139, firms or entities are prohibited from hedging an item which results from the firms’ commitment to acquire a business entity in a business combination. However, the standard allows an exception for the business organizations to recognize such items as hedged items the purpose of reducing the risk of foreign exchange. The reason behind this is that the other risks can not be specifically measured or even identified. Moreover, paragraph 80 of the AASB 139, states that in financial statements which are consolidated, the foreign currency risk of a high possible forecast intra-group proceedings or transactions qualifies for hedging purposes in a cash flow hedging category. However, the AASB provides further condition that such a transaction can only qualify for hedging if it is denominated in a different currency from the functional currency of the party entering into such a transaction (Australian Accounting Standards Board). What are the qualifications for hedging? Australian Accounting Standard Board has established various accounting policies which need to be adhered to by all business organizations operating in the region. Qualification for business organizations to practice hedging is one of critical standard which was established by the board. Various conditions have been laid down to ensure that business organizations do not engage in unethical or fraudulent acts in the name of hedging their assets or liabilities. The first major condition as described in AASB 139 is that, for hedging of assets or liabilities to take place, there must be involvement of external party to the entity. In other words, a business organization which is interested in hedging its assets or liabilities must have an agreement with an external organization or any other external party wishing to take the benefits and the risks associated with the hedging process (CPA Australia). According to AASB 139, the hedging relationship between the hedging instrument and the hedged item are supposed to satisfy specific conditions which include an official designation and documentation of the relationship at inception. In this case, the two parties engaging in hedging relationship must agree concerning the terms and conditions of the hedging exercise before the hedging period or process begins. As a result, the two parties or organizations engaging into ac hedging agreement must document their agreement in order to help in solving issues which may arise in future. Such a formal documentation acts as evidence in case one of the parties fails to honor his obligations in future. Bearing in mind that business organizations mainly aim at making high profits, it is likely that certain may be reluctant in honoring their obligations in case the hedging agreement turns out to be disadvantageous on their sides. In this regard, the formal designation and documentation of the hedging agreement is supposed to be used to solve such issues in the most effective manner. Besides, clear designation and documentation of the hedging agreement has been put forward by AASB as a condition in order to provide reference materials in future. Need to refer to terms and conditions of the hedging agreement must prevail in future especially for business organizations which accommodate managerial changes often. In this regard, having a well designated and documented agreement will help the agreement to remain effective in future regardless of changes in organizational structure of parties involved (CPA Australia). According to paragraph 72 of the AASB 139, a written option can not by itself authorize a party to reduce the loss or profit exposure of the item hedged. The reason behind this is that the probable loss on the option that a party writes could be substantially higher than the potential gain in value of a related item hedged. In this regard, a written option fails to qualify as a hedging instrument unless if it is designated to a purchased option as an offset inclusive of one which is embedded in other financial instrument. However, a purchased option possesses potential gains which are equivalent or greater than the losses thus having the potential to minimize loss or profit exposure from the variances in cash flow or fair value. In this regard, a purchased option is in a position to qualify as a hedging instrument thus business organizations or parties involved in hedging transactions must include such effects on their profit and loss account (CPA Australia). For business organizations to qualify to carry out asset and liability hedging, the outcome of the hedging process must be highly effective in attaining offsetting variances in cash flow or fair value. The major aim of hedging is to offset variance in value of cash flows in order to prevent business organizations from making unnecessary losses which might be harmful to their operations. As a result, the Australian Accounting Standard Board requires that business organizations carry out critical analysis on the effectiveness of the hedging process before implementing it. Parties engaging into hedging process are required to come with a reliable measure of the effectiveness of the hedging process. This is one of the conditions prescribed by Australian Accounting Standard Board in its 139 standard. Moreover, parties engaging into hedging process must carry out an ongoing assessment to demonstrate that the instruments are highly effective. The effectiveness of the financial instruments seems to be of great significance to the Australian Accounting Standard Board (CPA Australia). Instruments such as unquoted equity that are not carried at their fair value due inability to measure their value can not be designated as hedging instruments as per according to AASB 139 paragraph 46. Besides, derivatives that is related to or need to be settled by delivery of the equity instrument which is unquoted, should not be designated as hedging instruments as per AASB 139. In addition, on the 73rd paragraph of the AASB 139, organization’s equity instruments are not the organization’s financial liabilities or financial assets thus they must not be designated as hedging instruments (CPA Australia). What are the hedging relationship types which are authorized by the AASB? Generally, there are three categories of hedging relationships which are supposed to be adopted by parties willing to engage into hedging relationships. The three categories of hedging relationships include fair value, cash flow and net investment hedge in a foreign operation. Parties need to adopt one of these categories of hedging relationship in order for the relationship to be effective. Any relationship fails to meet the requirements of one of the categories, is not recognized by the Australian Accounting Standard Board as a hedging relationship thus parties are not supposed to apply hedging accounting in reporting such transactions (CPA Australia). The fair value hedge is whereby the exposure to variances in fair value of a recognized liability or asset that is attributable to certain risk and could affect gain or loss of the party involved. This type of hedging also includes exposure to variances in fair value of unrecognized commitment of a firm or recognized portion of unrecognized commitment that is likely to have impact on the profitability of the parties involved. The profit or losses made from re-measuring the instruments subjected to hedging at fair value must be recognized in income statement of the parties involved in the relationship. Any value change o f the hedged item due to the hedged risk has impact on the carrying amount of the item thus must be recognized as profit or loss of the party involved (Australian Accounting Standards Board). Cash flow category involves hedging relationship whereby the exposure to changes in cash flows related to item hedged is attributed to a certain risk related to a recognized liability or asset or highly probable forecast transaction that could have impact on the profitability of the parties involved. However, in cash flow hedging, losses and gains identified directly in equity are supposed to be reclassified into loss or profit on the period on which the liability assumed or asset acquired affects loss or profit. In other words, gains and losses are recognized in income statements of parties involved in the hedging relationship when there is recognition of interest expense. Besides, the accounting treatment of the foreign operation net investment hedging is similar to that of cash flow hedge. In this regard, loss and profits arising from the variability of the value of the hedged item are recognized when gain or loss of liability assumed or assets acquired affects profit or loss of parties involved in the hedging relationship (Australian Accounting Standards Board). Works Cited Australian Accounting Standards Board. Financial Instruments: Recognition and Measurement. 7 November 2008. 14 April 2009. . CPA Australia. AASB 139 Financial Instruments: Recognition and measurement. 31 December 2007. 14 April 2009. Read More