Hedge accounting can bring a number of advantages over traditional accounting methods. The core benefit is that by addressing the timings mismatch associated with standard derivative accounting, hedge accounting removes temporary volatility from the P&L. As a result, the financial statements will better reflect the company’s true economic performance.
Reducing the volatility in earnings results in a number of additional benefits:
- Enterprise value. Earnings volatility is negatively perceived by investors.
- Creditworthiness. Predictability in future earnings is a positive factor in creditworthiness.
- Risk management. Statements reflect better and more accurately how FX-risk is managed.
- Executive compensation. Compensation tied to performance, for example measured based on quarterly earnings, can incur unintended impacts from earnings volatility.
But it can also go very wrong, see this article from Reuters: Dutch housing coop Vestia seeks damages from Deutsche Bank for derivatives.
The three types of hedging relationships in IFRS 9 Financial instruments – Hedge accounting are as follows:
- fair value hedge : a hedge of the exposure to changes in fair value of a recognised asset or liability or an off-balance firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss.
- cash flow hedge : a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction, and could affect profit or loss.
- hedge of a net investment in a foreign operation as defined in IAS 21 The effects of changes in Foreign Exchange Rates.
Cash flow hedge
A hedge of the exposure to variability in cash flows that is associated with a particular risk of the hedged item and could affect profit or loss. For example, hedging against proceeds from future sales in a foreign currency by entering into a foreign exchange forward contract.
A cash flow hedge that meets the qualifying criteria (outlined below) shall be accounted for as follows:
- The portion of the gain or loss on the hedging instrument that is determined to be effective is recognised in other comprehensive income
- The ineffective portion (if any) of the gain or loss shall be recognised in profit or loss
- The amount recognised in other comprehensive income is the lower of:
- The cumulative gain or loss on the hedging instrument from the inception of the hedge, and
- The cumulative change in fair value (present value of the expected future cash flows) of the hedged item from the inception of the hedge
- The portion of gain or loss recorded in other comprehensive income is recorded as a separate component in equity, the cash flow hedge reserve.
The amount in other comprehensive income shall be reclassified to profit or loss in the same period the hedged expected cash flows occur and affect the profit or loss (reclassification through the equity component – the cash flow hedge reserve).
However if there is a cumulative loss which the entity expects will not be recovered, the loss shall be immediately recognised in profit or loss.
If a hedged forecast transaction results in the recognition of a non-financial asset or liability, or the hedged forecast transaction becomes a firm commitment (fair value hedge), then the entity shall remove the amount from other comprehensive income and include it in the carrying amount of the asset or liability. This is not considered a reclassification adjustment under IAS 1, Presentation of Financial Statements.
Hedge accounting can only be applied if ALL of the hedging criteria, as outlined below, are met:
- The hedging relationship consists of eligible hedged item(s) and eligible hedging instrument(s)
- Formal designation and documentation at the inception of the hedge exists for the hedging relationship and the entity’s risk management objective and strategy. This should include the nature of the risk, how it will be assessed and how the hedge will be tested for effectiveness
- The hedging relationship is anticipated to be effective throughout the life of the hedge by meeting all the following requirements:
- There is an economic relationship between the hedged item and the hedging instrument
- Credit risk does not dominate the value changes
- The hedge ratio is effective.
The necessity for an effective economic relationship now is anticipated by an entity in entering into the hedging relationship knowing that the gains or losses will offset.
The requirement that credit risk should not dominate the change in value may prohibit, for example, some financial assets from being eligible hedged items, eg bonds with high credit risk.
The hedge ratio is the relationship between the quantity of the hedging instrument and the quantity of the hedged item in terms of their relative weighting. This will be based on an entity’s risk management objective and strategy.
The 80% to 125% range prescribed in IAS 39 has been replaced by a more objective test based on internal risk strategies.
Testing hedge effectiveness
In order to qualify to use the hedge accounting rules the hedging relationship must be effective and in line with the documentation prepared at inception. IFRS 9 does not specify a method for assessing whether the hedging relationship meets the effectiveness requirements documented. However examples may include:
- Critical terms analysis cash flow hedge reserve
- Dollar offset test cash flow hedge reserve
- Regression analysis. cash flow hedge reserve
The testing of the effectiveness shall be performed at least annually at the reporting date, but on a quarterly basis is considered the most appropriate approach.
Example and journal entries
On 1 December 2015, Platform, Inc. entered into a 1-year contract with a multinational financial services giant to provide air transport to its executives. Under the contract, Platform will be paid EUR 1,000 per kilometer for 12,000 minimum guaranteed kilometers per annum. Payment shall be made at the end of each quarter.
Platform obtained an aircraft on a wet lease (i.e. a lease of aircraft together with crew and maintenance, etc.). Since almost all of Platform’s costs are denominated in USD, it enters into a 3-month forward contract to sell EUR 3,000,000 forward at USD1.5/EUR.
At its financial year end, i.e. 31 December 2015, USD had appreciated to 1.45/EUR and the company had operated a total of 1,000 kilometers over the one-month period.
By end of February 2016, i.e. at the end of first quarter, the company had provided services for 3,100 kilometers. Exchange rate at the quarter end was USD1.44/EUR.
This is a cash flow hedge because Platform is looking to hedge the risk of variability of its cash flows i.e. revenue. The hedging instrument is the forward contract while the hedged instrument is the cash flows from services contract. cash flow hedge reserve
Based on 1,000 kilometers operated in the first month i.e. December 2015, Platform expects to operates 3,000 kilometers in the first quarter and earn EUR 3,000,000 (3,000 * EU1,000). USD value of the expected kilometers @ the year-end exchange rate of USD1.45/EUR amounts to $4,350,000 against initial forecast of $4,500,000 (EUR 3,000,00*1.5).
The adverse movement in the cash flows due to currency fluctuation amounts to USD $150,000 ($4,500,000 – $4,350,000). This loss in future cash flows from foreign exchange movement is offset by the gain on hedging instrument. The hedging instrument entitles Platform to convert EUR 3,000,000 at USD1.5/EUR even though EUR depreciated over the one month.
The gain on forward contract is $150,000 (EUR3,000,000 * (1.5 – 1.45)). The hedging instrument exactly offsets the movement of the cash flows expectation and is totally effective, hence, it should be recognized in other comprehensive income.
Platform shall make the following journal entry as at 31 December 2015: cash flow hedge reserve
Dr Derivative position – Asset
Cr Other comprehensive income (and allocation in equity to cash flow hedge reserve)
At the end of the first quarter, since the actual kilometers for the quarter were 3,100, the cash flows exposure which required hedging increased to EUR 3,100,000 (=3,100*1,000). The value of forward contract at the end of February would be $180,000 (EUR 3,000,000 * (1.5 – 1.44)). This represents a gain of $30,000 ($180,000 minus $150,000) over the last reporting period.
Actual adverse foreign exchange movement in the revenue transaction was $186,000 (EUR 3,100,000 *(1.5 – 1.44)) which is higher than the favorable movement of $180,000 in the associated hedging instrument. This means the hedging arrangement has been ineffective to the extent of $6,000 (=$186,000 – $180,000). cash flow hedge reserve
Accounting standards require recognition of the lower of cumulative gain or loss in the hedging instrument or in the fair value of the hedged item separately in the other comprehensive income as reserve. The $30,000 favorable movement in the hedging instrument shall be recognized as follows: cash flow hedge reserve
Cr Other comprehensive income (and allocation in equity to cash flow hedge reserve)
At settlement, the whole arrangement is wrapped up as follows: cash flow hedge reserve
Dr Other comprehensive income (and reclassification in equity from cash flow hedge reserve to retained earnings)
Dr Cash 3,000,000 x 1.5 + $100,000 x 1.44 =
Cr Derivative (asset)
Please note that the $6,000 ineffective part of the hedge is reflected in profit and loss through a reduction in revenue, i.e. revenue is calculated by applying the 1.5USD/EUR hedged relationship to only first EUR 3,000,000 chunk and the additional EUR 100,000 are exchanged at USD 1.44/EUR i.e. the prevailing exchange rate. cash flow hedge reserve
See also: The IFRS Foundation