1. Definition, regulation and business approach
Definition of hedge accounting
A hedge accounting means designating one or more hedging instruments so that their change in fair value offsets the change in fair value or the change in cash flows of a hedged item.
Regulations on hedge accounting in Germany
HGB §254 Bildung von Bewertungseinheiten; Bilanzrechtsmodernisierungsgesetz (BilMoG)
International financial reporting standard (IFRS) 9 Financial Instruments.
Normal approach in the market
Many institutions use IRS as an interest rate risk management tool to explain the hedge accounting approach with SAP Bank. IRS is the main interest rate risk management tool for big/huge and medium-sized banks in Germany, Austria, etc. Regarding institution numbers / trading volumes, over 95% percent players in the market with IRS as the hedging instrumnet. For so-called “small” institution projects, people do not implement this instrument. To simulate the case in the real-world, we define following scenario settings:
The hedged item: a corporation loan with fixed interest rate. The bank collects fixed interest rate. Amortized cost measured, accrued interest daily adjustment, straight-line approach.
The hedging instrument: OTC IRS contract, pays fixed interest rate. Fair value P/L, daily valuation. The dilemma: profit and loss of the bank fluctuates greatly.
The purpose and the economic effect of the hedge tool: hedging interest rate risk and reducing profit and loss fluctuation; accounting effect is contradictory: it magnifies the volatility.
Regulation environment: the bank needs a solution to meet both German GAAP and IFRS.
2. Scenario replicates the real business approach
Case study with two scenarios
Initial condition: At the Start Date, December 31, 20X7, Bank A issued a loan of 100 million Euros at face value, with a loan interest rate of 1.3%, interest paid quarterly, with a Maturity Date of December 31, 20X8. The loan at amortized cost. Start Date, Bank A and its counterparty signed a one-year interest rate swap contract with a nominal amount of 100 million Euros, with a value date of Start Date. Bank A paid a fixed interest rate of 1.3% on a quarterly basis, and charged and reset the floating interest rate of Euro LIBOR 6M on a quarterly basis. The first interest rate determination date was December 30, 20X7. Both the loan and interest rate swap contract bear interest at Actual/Actual. The cash flow of IRS contracts and changes in fair value are based on Euro LIBOR 6M.
To clarify the solution, this case defines scenario 1 and 2.
Scenario one: The initial fair value of the IRS contract is zero. Bank A designated the interest rate swap contract as a hedging instrument on Start Date, and hedged the risk of fair value changes of 100 million Euros due to changes in market interest rates. At the Maturity Date both contracts terminated.
Scenario two: On July 1, 20X8, risk management targets of Bank A changed, causing the hedging relationship no longer meet the conditions for applying hedging accounting. Bank A terminated the use of hedging accounting for the aforementioned designation on the same day.
Scenario 1 is a more common approach in the real world. Scenario 2 has already exceeded the complexity of business approach of certain financial institutions.
3. Step by step solution
Scenario One: Designation of an Effective Hedging Relationship.
Step one: Valuation before Hedging Relationship, on Start Date, loan designated as hedged item.
DR: Hedged item – Loan
CR: Bank deposit
In the SAP customization, need to assign types for valuation for IRS as hedging instrument, types for position outflows for the loan as hedged item. Assign types for derived business transactions relation of hedged and hedging.
Step two: Valuations during the Hedging Relationship, on key date valuation of March 31, 20X8, loan interest income was recognized and loan interest was received, hedging relationship is effective on key date, as well on June 30, 20X8. The result of the valuation can only be posted if effectiveness is given.
DR: Interest Receivable
CR: Interest income
And
DR: Bank deposit
CR: Interest receivable
Settlement interest rate swap contract interest
DR: Bank deposit
CR: Interest income
Step three. Posting item is used to write the effective write-up/write-down amount to the position component hedging instrument. Confirmation of changes in fair value of hedging instruments
DR: Hedging instrument – IRS
CR: Hedging profit and loss
The ineffective write-up/write-down amount is written to the position component Loan, Recognize changes in fair value of hedged items due to interest rate risk. The update type is determined on the basis of the settings made in the Customizing activity Assign Update Types for Valuation.
DR: Hedging profit and loss
CR: Hedged item – Loan
Scenario Two: Manual Dedesignation of an Ineffective Hedging Relationship
Step four (continue with step 3): In the case of ineffectiveness, the hedging relationship has to be dedesignated manually. Valuations as part of derived business transactions also affect business transactions in the future. On Key Date July 1, 20X8, the hedging relationship was terminated. Then:
Amortizations are assigned to the position component Loan.
DR: Loan – principal
CR: Hedged item – loan
DR: Hedged item – IRS
CR: Derivatives – IRS
Step five: On September 30, 20X8, recognized loan interest income and received loan interest
DR: Interest receivable
CR: Interest income
DR: Bank deposit
CR: Interest receivable
Write-ups and write-downs in the Loan are divided into an effective part and an ineffective part. Settle interest rate swap contract interest:
DR: Investment income
CR: Bank deposit
Step six: Value change of the hedging instrument is classified with the value change of the hedged item. Recognize changes in the fair value of IRS contract
DR: Derivatives - interest rate swap contracts
CR: gains or losses from changes in fair value
Step seven: On December 31, 20X8, the recognition of interest income to the principal and interest of Loan. Transfer postings are made from the hedged subpositions or to the subpositions to be hedged to the free-standing subpositions.
DR: Interest receivable
CR: Interest income
DR: Bank deposit
CR: Interest receivable
CR: Loan – principal
The hedged subpositions or the subpositions to be hedged are valuated as part of derived business transactions. Settlement of interest on IRS:
DR: Investment income
CR: Bank deposit
For the hedging instrument, valuation at the end of the hedging relationship corresponds to valuation before the start of the hedging relationship. Recognize changes in fair value of IRS.
DR: Derivatives - Interest Rate Swap Contracts
CR: Profit and loss from changes in fair value
4. Relevant SAP products
1. Product: Smart Accounting (Version: 9.0 SP12)/Accounting Process Model and Book Value Components/Financial Instruments/Product Scope/ Hedge Accounting, Sep 2019
2. Product: SAP S/4HANA/ Treasury and Risk Management (Version: 1809/1909)/Hedge Management and Accounting/Hedge Accounting for Positions (P-HA), Sep 2018/Sep 2019
Scenario: 720 CFH: Loan Hedged with Interest Rate Swap
Accounting Rule: 500 Hedge Adjustment OCI / Write-Up and Write-Down P&L
3. Product: banking services from SAP/Bank Analyzer (FS-BA Version: 8.0 SP27)/Analytics (FS-BA-AN)/Merge Scenario (Balance Analyzer)/Accounting/Hedge Accounting, Sep 2019.
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