After modifications witnessed in IFRS concerning hedge accounting a couple of years ago, many company audit experts in Dubai, UAE, remained confused. The standard came with a prospective test of the hedge effectiveness. So, does this mean audit firms in Dubai and other entities don’t need to recalculate anything from the past and focus on the future as far as hedge effectiveness? The answer is no.
Here is a brief thought:
According to IFRS 9, financial audit specialists must test the hedge effectiveness prospectively. They can leverage qualitative techniques, for instance, critical terms matching. So for many individuals and companies in Dubai, UAE, the question has always been, is there a need for a quantitative retrospective test of the hedge effectiveness?
Remember that we are discussing cash flow hedge of forecast transaction and all the fundamentals of hedged products, hedging instrument match, and its recognition on the first day. If all terms match, the hedge is 100% reliable, and there is no reason to test.
With the new changes in the IFRS 9 standard, audit services should evaluate whether it is expected that the hedge will be viable in the future. That’s the reason why it’s prospective since it’s looking to the future. This, however, does not mean you will not review the past now and then.
When a Dubai firm enters into the hedging relationship and wants to apply hedge accounting, there are two things associated with hedge effectiveness that is important to consider:
- Evaluating the hedge effectiveness
- Measuring the hedge effectiveness
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Analyzing the Hedge Effectiveness
This is also known as a prospective test since the audit specialist needs to evaluate whether a company expects a hedge to be effective in the future. In other words, internal auditors for the company are analyzing three areas of hedge effectiveness:
- There is an economic association between the hedging instrument and the hedged item.
- The appropriate hedge ratio is maintained.
- The effect of credit risk doesn’t control the value changes from that economic association.
Auditors should do this:
- At each reporting date.
- At the inception of the hedge.
- Whenever there is a change in the hedge.
How this could be done
There are several techniques that internal auditors and external auditors in Dubai can leverage:
Simple Scenario Analysis Approach
This is a quantitative technique. Auditors simulate different scenarios and assess how the hedged item’s fair value and hedging instruments change while other variables fluctuate.
Critical Terms Matching
The qualitative technique. In this approach, financial audit specialists don’t conduct any calculations. They need to compare the hedged instrument and hedged item terms, such as interest rates, maturity dates, notional amounts, currencies, etc. This technique is ideal for simple transactions.
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Calculating The Hedge Ineffectiveness
You can do this retrospectively. Not at the beginning of the inception of the hedging relationship. In most cases, you will apply the dollar offset method. Therefore, Dubai financial audit pros should calculate how the fair value of the hedged item changed in a given period, the movement of the hedging instrument’s fair value. According to these movements, it’s easy to calculate its ineffectiveness.
So, in the cash flow hedge, the Dubai auditors will recognize:
- The ineffective section in profit/loss
- The effective section in other income as cash flow hedge reserve.
An Example: Measuring Hedge Ineffectiveness Versus Assessing Hedge Effectiveness
Suppose you’re planning to make a sale in foreign currency in 6 months. Still, you want to minimize the risk of foreign exchange fluctuations. You then enter into the forward contract for exactly how much you assume you will sell the currency.
Here is a cash flow hedge – a typical hedge of forecast transactions.
The prospective hedge effectiveness assessment must be performed at inception.
- Are the sale and forward contracts of the forecast transaction in line?
- What is the maturity date of the forward? Does the assumed date of the sale match the maturity date of the forward?
- Do the notional forward and assumed sale amounts match up?
The hedge ineffectiveness can’t be measured at the start since there is no data yet. Assume that the date of reporting is 3 months from now.
By analyzing the fair value of the forecast transaction and the hedging instrument, you conclude that the forecast transaction increased by 100 and the hedging instrument decreased by 110.
As you have just measured, the hedge ineffectiveness is 10. This is because the fair value change of the forward amount was ten times that of the forecast sale amount. In other comprehensive income, you record 10 in profit or loss.
Furthermore, you must assess the hedge effectiveness prospectively by comparing the critical terms or by performing any other method you may choose.
Let us ultimately address one more point from your question: in the case of matching binding terms, why is the hedge ineffective? Notional amounts are the same; maturities are the same. Most often, the answer resides in different credit risks.
Due to the lack of counterparties, your forecast transaction or sale – your hedged item – does not have credit risk. A forward contract has credit risk since you need a counterparty – usually another bank – to enter it.
There will be some ineffectiveness within your hedging relationship because the fair values of your hedged item and hedging instrument will be different because of the difference in credit risk.
To know more about IFRS9 contact Audit Firms in Dubai
Theshani is a Senior auditor and has experience of 4+ years in providing audit assurance and advisory services to a wide range of industry clients. She continues to stay on top of ever-changing industry dynamics by continuously learning and developing expertise.