SAP Treasury Hedge Accounting , Matching concept and Accounting treatment

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SAP TRM Hedge Accounting postings from Balance Sheet item first then posting to profit and loss on reclassification.

This document seeks to explain in detail the various account postings that will happen with the hedged item; hedging item and the transfer from balance sheet to Profit and Loss in SAP Treasury and Risk Management.  In this example the hedging instrument in use is forex forward (60A 101(forex forward). NB The process may vary depending on the company. Figure 1 below will be the pictorial reference point to point the stage in the process with the four lines depicting the different stages in SAP Treasury and Risk Management (TRM).

Background

When certain criteria are met, IFRS 9 “Financial instruments: Recognition and Measurement” permits entities to apply special accounting treatment, so-called ‘hedge accounting ‘. The result is that both hedging instruments and hedged items are reported differently from the normal accounting principles required. The aim of hedge accounting is to match the accounting effect of the hedged item and of the hedging instrument in profit or loss. This is a matching concept that eliminates or reduces the volatility in the statement of comprehensive income that otherwise would arise if the hedged item and the hedging instrument were accounted for separately under IFRS.

Key terms and definitions

Hedged items must meet the following conditions: (1) they expose the entity to the risk of fair value changes or future cash flows variability; and (2) they are designated.

as hedged.

Hedging instruments can be especially derivatives, only if they meet certain conditions: (1) formal designation and documentation of hedging relationship at the

inception of hedge; (2) hedge is expected to be highly effective; (3) effectiveness of hedge can be reliably measured; (4) hedge is assessed and determined to have been highly effective; and (5) for cash flow hedges, a forecast transaction is highly probable and

presents an exposure to variations in cash flows.

Hedge transactions are required to be qualified for hedge accounting, based on the following criteria:

(1) Both the hedged item and the hedging instrument should be clearly identified and documented. Management must document exactly what is the hedged risk and how it will assess the effectiveness of the hedge.

(2) The hedge must be expected to be effective: the impact of the hedged risk on the hedged and on the hedging item must ‘fully offset; subsequently, effectiveness must be evaluated regularly throughout its life, considering that a hedging relationship is defined for the entire life of the hedging instrument.

(3) Hedge effectiveness must be capable of being reliably measured on an ongoing basis; hedge ineffectiveness is required to be identified and reported in profit or loss, and, if ineffectiveness exceeds a certain limit, the use of hedge accounting is precluded.

(4) When hedging future variability in cash flows, there must be a high probability of those cash flows occurring and affecting profit or loss.

Effectiveness tests must be prospective and retrospective. To be classified as effective, the hedge does not have to be perfect. The constraint is that the hedge is expected to be: (I) highly effective at inception, i.e. changes in fair values should ‘almost fully’ offset; and (ii) effective in practice throughout the life of the hedging relationship, i.e. The ratio of the change in fair value of the hedged item and the hedging item must remain within a range of 80% to 125%. If during its life the hedging relationship fails to remain within the pre-set range, the derivative will be accounted for at its mark-to-market whereas the assets or liabilities at historical cost.

Figure 1

Red Line in Figure 1

Cash Flow Hedge

A cash flow hedge used from the red line until the yellow line. It is a hedge of the exposure to variability in the cash flows of a specific asset or liability, of a forecasted transaction, that is attributable to a particular risk. Cashflow hedges can help to mitigate the risks that are associated with sudden changes in cash flows of assets or liabilities, rate than the asset or liability itself (Which is the sale or purchase).

The following Activities happen at Red Line

Release of designated Hedging Relationship (TPM120), which happens on the contract day of the trade. The release of the hedging relationship is a separate step because market data is needed for this function and the market data may not be imported until later in the day.

• Hedging relationship changes from Planned Designation Hedge Relationship to Designated
• Hypothetical derivative is created
• Hedge documentation created
• Effectiveness test executed (The hedge must be expected to be effective: the impact of the hedged risk on the hedged and on the hedging item must ‘almost fully ‘offset; subsequently, effectiveness must be tested regularly throughout its life, considering that a hedging relationship is defined for the entire life of the hedging instrument).
• Hedging relationship is now ready for upcoming period-end activities Hint: In certain hedging scenarios, the hypothetical derivative is required for performing the effectiveness test (except for the critical term match method). During the effectiveness test, the hypothetical derivative represents the hedged item.

Cash flow hedges are accounted for as follows when a month end valuation is done after net present valuation is done. This valuation results in computation of effectiveness and ineffectiveness of the hedging and may result in the below adjustment.

• The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge (i.e. the portion that is offset by the change in the cash flow hedge reserve calculated in accordance with (a)) shall be recognized in other comprehensive income (OCI).
• Any remaining gain or loss on the hedging instrument (or any gain or loss required to balance the change in the cash flow hedge reserve … is hedge ineffectiveness that shall be recognized in profit or loss. (Please note we account only for Hedging instrument)

Description	Debit	Credit
Loss on the hedging instrument – effective portion	OCI – Cash flow hedge reserve ((Balance sheet item)	FP – Financial liabilities from hedging instruments
Loss on the hedging instrument – ineffective portion	P/L – Ineffective portion of loss on hedging instrument	FP – Financial liabilities from hedging instruments
OR
Gain on the hedging instrument – effective portion	FP – Financial assets from hedging instruments	OCI – Cash flow hedge reserve (Balance sheet item)
Gain on the hedging instrument – ineffective portion	FP – Financial assets from hedging instruments	P/L – Ineffective portion of gain on hedging instrument

Note: P/L = profit or loss, FP = statement of financial position, OCI = other comprehensive income.

Hedging of forecasted transactions. Between the Red Line and the sky-blue line, all items are(can) hedged as cash flow hedges as they are not balance sheet items but still forecasts captured in exposure management 2.0. For matching concept reasons and to avoid comprehensive income volatility, the hedge item postings associated with this hedge should post to balance sheet account. These amounts will be taken to a ‘cashflow hedging reserve’, as a separate component of equity. The ineffective portion of the gain or loss on the hedging instrument is recognised in the statement of profit or loss.

• At the date of creation of FX Spot as hedging instrument no accounting postings happen (except bank charges)

The hypothetical derivative is created during the release of designation (matching of hedged exposure with hedging instrument) for all hedging scenarios of the Hedge Accounting for Exposure Items process. The hypothetical derivative is needed for the calculation of the hedge accounting key figures and during effectiveness testing. During the effectiveness test, the hypothetical derivative represents the hedged item.

Month end before Sky Blue Line (Valuation of Net present valuation determine effectiveness of Hedge TPM1)

The key date valuation of the FX hedging instrument is executed: Postings of the Hedging

Reserve and Cost of Hedging Reserve amounts are created on Exposure Subitem level and ineffective amounts on Financial Transaction level.

The postings executed are driven by the Valuation Category selected on the Run Valuation (TPM1) app. The supported procedures are with reset and without reset. (Reset is book and reverse versus an incremental (difference) posting.)

The period-end close process of designated FX Transactions consists of the following steps:

1. Calculation of NPV, Forward, CCBS, CVA/DVA key figures (TPM60CVA)
2. Valuation of FX Transaction (TPM1)
3. Classification of Hedging Relationship (TPM101)

• Hedging Reserve (aka OCI I)
• Cost of Hedging Reserve (aka OCI II) amounts are created on Exposure Subitem level
• P/L ineffective amounts on Financial Transaction level

The newly processed and posted valuation and measurement results can be reported in Position and Flow Reporting as well as Posting Journal. OCI = Other Comprehensive Income, which is a balance sheet account

Process Reclassification for Hedging Business Transaction at Balance Sheet Recognition Date (Release Hedging Business Transactions (TPM120)) at Balance sheet recognition.

Between a cash flow hedge and a fair value hedge, there is a step taken to take items previously accounted for in Other Comprehensive Income to profit and loss. This is done at the yellow line in figure 1 and sometime before fair value hedge.  This step uses TRM technical clearing account. It helps zerorise the balance sheet account and transfers items to profit and loss.  The items are now in our books as purchases/sales and any movement not as forecast transaction but as actual postings. This changes the hedging reason from Cash flow hedge to Fair Value Hedge (in some instances).  Other Comprehensive Income (OCI)items in balance sheet are supposed to be transferred to profit and loss account by reclassification.

In SAP TRM the following activities are done by the Release Hedging Business Transactions (TPM120) app:

• Calculation and saving of NPV of FX Transaction
• Calculation and saving of NPV component values for FX Transaction and Hypothetical Derivative
• Posting of key date valuation of the designated portion of the FX Transaction with actual NPV values
• Posting of classification of the selected Hedging Relationship with actual NPV component values
• Update amounts of Reclassification Update Types
• Fix scheduled Reclassification Updated Types

Fair Value Hedge

A fair value hedge is a position taken by a company to protect the fair value of a specific asset, liability or unrecognized company commitment from risks that can affect their profit and loss accounts. The underlying asset is the asset being protected. There is an unrecognized firm commitment that have not been sitting in your accounts yet, but they will be in the future. The business concern here is that in the future, you will be paying or receiving a different amount than the market or fair value will be.  With a cash flow hedge, you're hedging the changes in cash inflow and outflow from assets and liabilities, whereas fair value hedges help to mitigate your exposure to changes in the value of assets or liabilities. This starts on Sky Blue line in Figure 1, depending on the company policy.

Fair value hedges are accounted for as follows:

• The gain or loss on the hedging instrument is recognized in profit or loss.
• ● The hedging gain or loss on the hedged item shall adjust the carrying amount of the hedged item (if applicable) and be recognized in profit or loss.
• Exception: If the hedging instrument hedges an equity instrument for which an entity has elected to present changes in fair value in other comprehensive income: both are posted to other comprehensive income (OCI). ● When a hedged item is a recognized firm commitment (or a component thereof), the cumulative change in the fair value of the hedged item after its designation is recognized as an asset or a liability with a corresponding gain or loss recognized in profit or loss.

Description	Debit	Credit
Hedging instrument:
Loss on the hedging instrument	P/L – FV loss on hedging instrument	FP – Financial liabilities from hedging instruments
OR
Gain on the hedging instrument	FP – Financial assets from hedging instruments	P/L – FV gain on hedging instrument
Hedged item:
Gain on the hedged item	FP – Hedged item (e.g. inventories)	P/L – Gain on the hedged item
OR
Loss on the hedged item	P/L – Loss on the hedged item	FP – Hedged item (e.g. inventories)

Note: P/L = profit or loss, FP = statement of financial position.

At contract end Navy Blue line in Figure 1

• Process Payment Request Optional Process the payment run procedure for payment request and create posting for outgoing payment via app Automatic Payment Transactions for Payment Requests (F111).
• Post to General Ledger Mandatory Post the relevant flows (incoming or outgoing payment) at value date of FX transaction in valuation area US0 (local GAAP) via app Post Flows (TBB1)
• Process Business Transactions (TPM10).
• Post Realized Profit and Loss Mandatory Post realized profit or loss at value date of FX transaction in your valuation area Post Derived Business Transactions (TPM18)