A new decree in Italy enables more openness from legislators to recognise derivative instruments in the financial statements of ITA Gaap entities. These had previously been omitted due to concerns they would impact companies’ assets in periods of instability.
The recognition of derivative instruments took on fundamental importance with the approval of Legislative Decree no. 139/2015; while in the financial statements for previous years they were only disclosed in the notes, the new rules require them also to be recognised in the financial statements of ITA GAAP entities, that are measured at fair value, along with the hedging relationship. Such instruments are now accepted as instruments for hedging risk.
The following items have been added to accommodate values relating to financial instruments.
- Assets III. Long-term investments 4) Derivative instrument assets
- Liabilities and Owner’s Equity A) Shareholders' equity VII – Reserve for transactions to hedge expected cash flows B) Provisions for liabilities and charges 3) Derivative instrument liabilities
D) Adjustments to financial assets and liabilities 18) Revaluations d) of derivative instruments 19) Write-downs d) of derivative instruments
Recognition of a derivative to hedge the risk of cash flow variability must comply with a set of characteristics established by OIC 32 and must be demonstrated in the hedging relationship: in the preliminary valuation, it is crucial to determine whether the fair value assumed by a derivative is intended to hedge a cash flow risk (i.e. a risk deriving from changes in the value of cash flows). This valuation determines whether such changes in fair value will affect the income statement and therefore also tax, or not during the hedging.
Recording of the fair value hedge
The principle is established in Art. 2426 of the Italian Civil Code: changes in the fair value to hedge cash flow risk are recognised in the dedicated equity reserve, with the recognition of both positive and negative values as a contra-entry to the provision for risk for derivatives. If there is no hedging relationship, any changes in fair value will affect the income statement as they do not have a closely-correlated hedging relationship or because the derivative has been acquired for speculative purposes.
Usually, the risk of interest rate fluctuations is hedged by an interest rate swap, where a company that has taken out a variable-rate loan intends to hedge the risk of variability in cash outflows. In the hedging relationship, all the information about the loan and the derivative should be reported, indicating the notional amount on which the flows swapped to hedge the risk will be determined and the relative due dates for the payment of interest. The correlation between all this information must be described, as well as the reliability of the method used to determine the fair value of the derivative.
If, at the end of the period, the fair value of the derivative has changed, it will be recognised under long-term investments if positive, and in the provision for risk if negative; a contra-entry will again be made in the equity reserve for hedging transactions, which will move up or down accordingly.
Effectiveness of hedging relationship
Contractual changes in the loan or derivative, or if the entity that issued the derivative experiences financial difficulties, the effectiveness of the hedging relationship may be reduced, thus redirecting the recognition of changes in fair value to the income statement and affecting the result on which taxes are calculated.
For hedging purposes, the fair value of the derivative must be entirely destined for hedging and may not be broken down. There are two exceptions to this general rule, which are recognised in both IAS/IFRS and OIC 32 (point 58):
- The options (put or call) may be designated as a hedge for the intrinsic value only: it represents a component that, added to the time value, allows the total fair value to be obtained
- For forward contracts, only the spot element - i.e. the current price or rate of the underlying - may be designated for risk hedging.
For example, a company that obtains a variable-rate loan may want to place a limit on the risk of a rise in interest rates at maturity; it therefore enters into an interest rate cap, which is a tool similar to a “call option”, as the counterparty is obliged to pay the company a flow equal to the product between a notional principal and the positive difference between the variable rate and a strike rate established in the contract.
When the option is “in the money” (the variable rate exceeds strike), the company will receive from the counterparty an amount equal to the notional value multiplied by that difference. If, on the other hand, the difference between the variable rate and the strike is negative (strike exceeds variable rate), nothing will be owed to the company and it will continue to pay the interest rate calculated at the variable rate. The advantage of this contract is that it hedges against increases in variable interest rates on a fixed initial premium, but at the same time provides the benefits of any reduction in variable rates below the strike where the cap does not take effect.
By contrast, in an interest rate swap (IRS), hedging takes place through a “swap” of values: with a loan, the company pays the lender a variable rate (plus a spread), while with an IRS it receives the variable rate from the counterparty. The result is a fixed and pre-determinable charge.
Intrinsic value and Time value
The value designated to hedge cash flow risk is only the intrinsic value, represented by the “in the money” value assumed by the option. This means that it can have a minimum value of zero when the value of the underlying (the variable rate of the loan) is less than the strike value set in the option (the upper limit set for hedging purposes); when the underlying has a higher strike value, the intrinsic value is the positive difference between the two.
The time value, on the other hand, represents the probability that it will be expedient to exercise the option in the future; in other words, the option is currently “out of the money” and it is assumed that it will become “in the money”.
For hedging purposes, only the intrinsic value will be recognised in the cash flow hedge reserve, while the time value will always be recognised in the income statement, precisely because it has no relationship to the hedge and cannot be designated as a value relating to the hedge.