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
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 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. 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 effectiveand 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
- Dollar offset test
- Regression analysis.
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.
Cash flow hedge
Cash flow hedge
Cash flow hedge Cash flow hedge Cash flow hedge Cash flow hedge Cash flow hedge