Application Guidance of ASBE No. 24 - Hedging

(1) Derivatives can generally be used as hedging instruments under Article 5 of this standard. Derivatives include forward contracts, futures contracts, swaps and options, as well as instruments with one or more of the characteristics of forward contracts, futures contracts, swaps and options. For example, in order to avoid the risk of a fall in the price of copper inventory, enterprises can be realized by selling a certain amount of copper futures contracts, in which the sale of copper futures contracts is a hedging instrument.

Derivatives that do not effectively reduce the risk of the hedged item cannot be used as hedging instruments. For example, an interest rate call option or an option consisting of an option issued and an option purchased, which in essence is equivalent to the issuance of an option (i.e., the enterprise receives a net option fee), cannot be designated as a hedging instrument.

(2) In accordance with Article 6 of the Guidelines, a derivative that qualifies as a hedging instrument should normally be designated as a hedging instrument in its entirety or in a proportion thereof at the inception of the hedge. Under Article 7 of this Standard, a single derivative instrument is generally designated as a hedge of one risk. Derivatives with multiple exposures may also be designated as hedges of more than one exposure, provided that the hedged exposures are clearly identifiable, the effectiveness of the hedge can be demonstrated, and the specific designation of the derivative with respect to the different exposures can be ensured. For example, an enterprise whose local currency is RMB issues a 5-year US dollar-denominated floating rate bond. In order to hedge the foreign exchange risk and interest rate risk of this financial liability, the enterprise enters into a cross-currency swap contract with a financial institution and designates it as the hedging instrument and the US dollar floating rate bond as the hedged item. Upon execution of the contract, the enterprise will receive periodic floating-rate US dollar interest payments from the financial enterprise to pay the bondholders and RMB interest payments at a fixed rate to the financial enterprise. In this example, the enterprise converts the floating-rate US dollar interest into fixed-rate RMB interest, thus avoiding the risk of changes in the exchange rate of the US dollar to the RMB and the risk of changes in the interest rate of the US dollar.

According to Article 9 of the Guidelines, inventory, held-to-maturity investments, available-for-sale financial assets, loans, long-term borrowings, expected sales of commodities, expected purchases of commodities, and net investment in foreign operations that expose the enterprise to changes in fair value or cash flow risk can be designated as hedged items.

According to Article 16 of this standard, when hedging a portfolio of assets or liabilities with similar risk characteristics (i.e., the hedged item), the individual assets or liabilities in the portfolio should ***share the hedged risk, and the change in the fair value of the individual assets or liabilities in the portfolio due to the hedged risk should be expected to be substantially proportional to the overall change in the fair value of the portfolio due to the hedged risk. The change in fair value of each individual asset or liability in the portfolio attributable to the hedged risk should be expected to be substantially proportionate to the overall change in fair value of the portfolio attributable to the hedged risk. For example, when the change in fair value attributable to the hedged risk for the portfolio as a whole is 10%, the change in fair value attributable to the hedged risk for each individual financial asset or liability in the portfolio should generally be limited to a lesser range of 9% to 11%.

According to Article 4 of this standard, hedge accounting refers to the method of recognizing the offsetting result of the changes in the fair value of the hedging instrument and the hedged item in profit or loss in the same accounting period. For example, a company intends to hedge the cash flow of a sale of a precious metal that is likely to occur six months from now. In order to hedge the risk of a decline in the price of the underlying precious metal, the company may sell the same number of futures contracts for the precious metal now and designate them as the hedging instrument, and designate the expected sale of the precious metal as the hedged item. At the balance sheet date (assuming the expected precious metal sale has not yet occurred), the fair value of the futures contract increases by $1 million, and the corresponding present value of the expected sale price of the precious metal decreases by $1 million. Assuming that the above hedge qualifies for hedge accounting, the company should recognize the change in the fair value of the futures contract in equity (capital surplus) and transfer it out to adjust the sales revenue when the expected sales transaction actually occurs.

Fourth, the evaluation of hedge effectiveness According to Article 17 of this standard, an enterprise should evaluate the effectiveness of a hedge on an ongoing basis and ensure that the hedge relationship is highly effective in the accounting period to which it is assigned. Common methods of evaluating hedge effectiveness include: (1) comparison of key terms; (2) ratio analysis; and (3) regression analysis.