Hedge accounting

Hedge accounting – What is this all about?

If investors purchase a security that comprises a high level of risk, they may accompany the purchase with an opposing item (usually a derivative, such as an option or future contract) referred to as a hedge.

This hedge experiences gains in value when the corresponding security (or ‘underlying asset’) sustains losses.

Under traditional accounting practices, a security and its hedge are treated as separate components when priced. Hedge accounting treats them as a single accounting entry that reflects the combined market values of the security and the hedge.

For example, suppose an investor, Jane, holds 10 shares of stock ABC priced at $10 each, worth a total of $100. Hedge accounting

To hedge against the stock’s price falling, she buys a put option contract priced at $1 per share for 10 shares of stock ABC with a strike price of $8. Under traditional methods, these items and their prices would be recorded independently. Under hedge accounting, they would be recorded as one item. The value of the item under hedge accounting would be the price of the shares plus the market value of the options contract, $100 + $1(10) = $110.

So, the accounting for derivative instruments at fair value creates a common issue for organizations that hedge risks using such instruments. Specifically, such organizations may face an accounting mismatch between the derivative instrument which is measured at fair value, and the underlying exposure being hedged, as typically underlying exposures are recognized assets or liabilities that are accounted for on a cost or an amortized cost basis, or future transactions that have yet to be recognized. This accounting mismatch results in volatility in profit or loss reporting as there is no offset to the change in the fair value of the derivative instrument. Companies try to remove (or hedge) the volatility in profit or loss reporting as a result of this mismatch by using hedge accounting contracts.

Hedge accounting provides this offset by effectively eliminating/reducing the accounting mismatch through one of three ways:

  1. through a Fair Value Hedge, which is achieved by accounting for the underlying exposure, asset or liability (typically referred to as the hedged item) by adjusting the carrying value for changes in the hedged risk, which would then offset, to the extent effective, the change in the fair value of the derivative instrument, or
  2. through a Cash Flow Hedge which is achieved by ‘insuring’ a highly probable forecast transaction, where changes in the fair value of the derivative instrument are deferred in shareholders equity, to the extent effective, until the underlying exposure impacts the income statement in the future (netting the risk exposure in the forecast transaction), or
  3. through a Net Investment Hedge, which is a variation on a cash flow hedge, used to hedge foreign exchange risk associated with net investments in foreign currency denominated operations.

Overview hedge accounting

Hedge accounting is permitted only if all applicable criteria are met. There are five general criteria that apply to fair value hedges and cash flow hedges, some of which also apply to net investment hedges.

There are also specific qualifying criteria based on the type of hedge and the type of risk(s) being hedged. IFRS 9 also specifically prohibits certain items and transactions from hedge accounting.
If any eligibility criteria cease to be met, the hedging relationship must be discontinued – i.e. hedge dedesignation.

Short explanations and links to detailed explanations

1. A hedged item is an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that

  1. exposes the entity to risk of changes in fair value or future cash flows; and
  2. is designated as being hedged.

2. Hedged risks

The risks eligible to be designated in a fair value hedge are different for financial and nonfinancial items.

  • Interest rate risk Hedge accounting
    • Financial items – Changes in the benchmark interest rate for recognized fixed-rate financial instruments.
    • Non-financial items – Not applicable Hedge accounting
  • Credit risk Hedge accounting
    • Financial items – Includes: — changes in the obligor’s creditworthiness; and — changes in the credit spread over the benchmark interest rate.
    • Non-financial items – Not applicable Hedge accounting
  • Foreign currency risk Hedge accounting
    • Financial items – Changes in the related foreign currency exchange rates.
    • Non-financial items – Changes in the related foreign currency exchange rates if the firm commitment is denominated in a foreign currency.
  • Price risk Hedge accounting
    • Financial items – Total change in the fair value. Hedge accounting
    • Non-financial items -Total change in the fair value. Hedge accounting

The risks eligible to be designated in a cash flow hedge are different for financial and nonfinancial items.

  • Interest rate risk Hedge accounting
    • Financial items – Either: — changes in a contractually specified interest rate for variable-rate financial instruments or forecasted issuances or purchases of variable-rate financial instruments; or — changes in the benchmark interest rate for forecasted issuances or purchases of fixed-rate financial instruments.
    • Non-financial items – Not applicable Hedge accounting
  • Credit risk Hedge accounting
    • Financial items – Includes: — risk of default; — changes in the obligor’s creditworthiness; and — changes in the credit spread over the contractually specified interest rate or the benchmark interest rate. Hedge accounting
    • Non-financial items – Not applicable Hedge accounting
  • Foreign currency risk Hedge accounting
    • Financial items – Changes in the related foreign currency exchange rates. Hedge accounting
    • Non-financial items – Changes in the related foreign currency exchange rates of foreign currency denominated forecasted transactions or firm commitments.
  • Price risk
    • Financial items – Total change in the cash flows related to the asset or liability – e.g. all changes in the purchase price or sales price.
    • Non-financial items -Either: – all changes in the purchase price or sales price of the asset – i.e. price risk; or – changes in a contractually specified component – i.e. a component of price risk.

3. A hedging instrument is a designated derivative or (for a hedge of the risk of changes in foreign currency exchange rates only) a designated non-derivative financial asset or non-derivative financial liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item.

Net position – Under IFRS 9, groups of items (e.g. a group of assets) and a net position (e.g. the net of assets and liabilities, or net of forecast sales and purchases) may be hedged collectively as a group, provided the group consists of individually eligible hedged items and the risks of those items are managed together.

For a cash flow hedge of a group of items, where the variabilities in cash flows are not expected to be approximately proportional to the overall variability of cash flows of the group, only a hedge of foreign currency risk is permitted.

For such hedges the designation of that net position should specify the reporting period in which the forecast transactions are expected to affect profit or loss, as well as their nature and volume.

4. Hedge effectiveness is the degree to which changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument, this calculated ratio is the hedge ratio. The perfect hedge would be 1 : 1 or 100%. The acceptable deviation from the perfect hedge ratio (or the accepted hedge ratio range) is included in the formal hedging documentation.

Hedge ratio – The relationship between the quantity of the hedging instrument and the quantity of the hedged item in terms of their relative weighting.

5. Formal documentation

Hedge accounting

There are general documentation requirements that must be met for all types of hedges. In addition, there are incremental documentation requirements specific to fair value hedges and cash flow hedges.

The initial hedge set-up, including results of the initial effectiveness assessment, has to be strictly documented, in order to avoid subsequent management of hedging results by rebalancing of the hedging relationship.

There are certain exceptions for some SMEs adopting the simplified hedge accounting approach and for private companies not adopting the simplified hedge accounting approach.

General model of measurement of insurance contracts

Hedge accounting

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