8.2 Hedge accounting
9 min read•august 19, 2024
Hedge accounting is a crucial tool for managing financial risks in complex business environments. It allows companies to match gains and losses on hedged items with those of hedging instruments, reducing income statement volatility.
This topic is essential for understanding how companies use financial instruments to mitigate risks. It covers the types of hedging relationships, qualifying criteria, and accounting treatments for fair value and cash flow hedges.
Overview of hedge accounting
- Hedge accounting is a special accounting treatment used to manage and reflect the risk management activities of a company in its financial statements
- It aims to match the timing of recognition of gains and losses on hedged items with those of the hedging instruments, reducing income statement volatility
- Hedge accounting is relevant to the course on Accounting for Mergers, Acquisitions, and Complex Financial Structures as it deals with complex financial instruments and their impact on financial reporting
Hedged items
- Hedged items are the assets, liabilities, firm commitments, highly probable forecasted transactions, or net investments in foreign operations that are subject to a hedged risk
- The value of hedged items is expected to change in response to the movement of a specified risk variable (interest rates, foreign exchange rates, commodity prices)
- Hedged items must be specifically identified and documented at the inception of the hedge relationship
Firm commitments as hedged items
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- Firm commitments are binding agreements to buy or sell a specified quantity of an asset at a specified price on a specified future date
- Examples include contracts to purchase raw materials at a fixed price or to sell finished goods at a predetermined price
- Firm commitments expose the company to the risk of changes in fair value due to movements in the hedged risk variable (commodity prices)
Forecasted transactions as hedged items
- Forecasted transactions are anticipated future transactions that are expected to occur but are not yet committed
- Examples include projected sales denominated in a foreign currency or expected purchases of raw materials at market prices
- Forecasted transactions must be highly probable to occur and present an exposure to variations in cash flows that could ultimately affect profit or loss
Recognized assets or liabilities as hedged items
- Recognized assets or liabilities are those that are already recorded on the balance sheet
- Examples include inventory, fixed assets, accounts receivable, or issued debt
- Recognized assets or liabilities can be designated as hedged items if they expose the company to changes in fair value or cash flows attributable to a particular risk
Hedging instruments
- Hedging instruments are the financial instruments designated by the company to offset changes in the fair value or cash flows of a
- Hedging instruments are typically derivative instruments, but non-derivative financial instruments may also qualify in certain circumstances
- The value of the is expected to move in the opposite direction of the hedged item's value when exposed to the same risk variable
Derivative instruments as hedging instruments
- Derivative instruments are financial contracts whose value is derived from an underlying asset, rate, or index
- Common derivative instruments used as hedging instruments include forward contracts, futures, options, and swaps
- Derivative instruments do not require an initial net investment and their value changes in response to the movement of a specified underlying variable
Nonderivative instruments as hedging instruments
- Non-derivative financial instruments, such as foreign currency-denominated debt, can be designated as hedging instruments in certain cases
- The use of non-derivative instruments is limited to hedges of foreign exchange risk on firm commitments, highly probable forecasted transactions, or net investments in foreign operations
- The foreign currency-denominated non-derivative instrument must be designated in its entirety or a proportion of it
Types of hedging relationships
- There are three types of hedging relationships recognized under hedge accounting: fair value hedges, cash flow hedges, and hedges of net investments in foreign operations
- Each type of hedge addresses a different risk exposure and has specific accounting treatments
- The type of hedging relationship determines how the changes in fair value or cash flows of the hedged item and hedging instrument are recognized in the financial statements
Fair value hedges
- Fair value hedges are used to mitigate the risk of changes in the fair value of a recognized asset, liability, or firm commitment
- The hedging instrument is recorded at fair value on the balance sheet, with changes in fair value recognized in profit or loss
- The carrying amount of the hedged item is adjusted for the hedged risk, with the change in fair value also recognized in profit or loss
Cash flow hedges
- Cash flow hedges are used to mitigate the risk of variability in cash flows associated with a recognized asset or liability or a highly probable forecasted transaction
- The of the change in fair value of the hedging instrument is initially recorded in other (OCI)
- The accumulated OCI is reclassified to profit or loss when the hedged transaction affects earnings
Hedges of net investments
- Hedges of net investments are used to mitigate the foreign exchange risk associated with a company's net investment in a foreign operation
- The effective portion of the change in fair value of the hedging instrument is recorded in OCI as part of the foreign currency translation adjustment
- The is recognized immediately in profit or loss
Qualifying criteria for hedge accounting
- To apply hedge accounting, a hedging relationship must meet certain qualifying criteria at inception and throughout the life of the hedge
- These criteria ensure that the hedging relationship is properly documented, effective, and aligned with the company's risk management strategy
- Failure to meet these criteria may result in the discontinuation of hedge accounting and potential volatility in the income statement
Formal documentation at inception
- At the inception of the hedging relationship, formal documentation must be prepared to clearly identify:
- The hedged item or transaction
- The hedging instrument
- The nature of the risk being hedged
- How the company will assess hedge effectiveness
- The documentation should demonstrate that the hedging relationship is expected to be highly effective in achieving changes in fair value or cash flows
Hedge effectiveness requirements
- Hedge effectiveness refers to the degree to which changes in the fair value or cash flows of the hedging instrument offset changes in the fair value or cash flows of the hedged item
- The hedge relationship must be highly effective both prospectively and retrospectively
- Prospective effectiveness: At inception and on an ongoing basis, the company must expect the hedge to be highly effective
- Retrospective effectiveness: The actual results of the hedge must be within a range of 80-125% of the intended offset
- Effectiveness must be assessed at least quarterly or at each reporting date, whichever is more frequent
Accounting for fair value hedges
- The accounting for fair value hedges involves measuring the changes in fair value of both the hedged item and the hedging instrument and recognizing the gains or losses in profit or loss
- The objective is to offset the changes in fair value of the hedged item attributable to the hedged risk with the changes in fair value of the hedging instrument
- Any in the hedging relationship is immediately recognized in profit or loss
Measuring changes in fair value
- The hedging instrument is measured at fair value on the balance sheet, with changes in fair value recognized in profit or loss
- The carrying amount of the hedged item is adjusted for the change in fair value attributable to the hedged risk
- The change in fair value of the hedged item is calculated as the difference between its carrying amount and what its carrying amount would have been had no hedging relationship existed
Recognizing gains and losses
- The change in fair value of the hedging instrument and the change in the adjusted carrying amount of the hedged item are both recognized in profit or loss
- If the hedge is perfectly effective, the gains and losses on the hedging instrument and hedged item will offset each other
- Any difference between the change in fair value of the hedging instrument and the change in the adjusted carrying amount of the hedged item is recognized as ineffectiveness in profit or loss
Accounting for cash flow hedges
- The accounting for cash flow hedges involves initially recording the effective portion of the change in fair value of the hedging instrument in OCI and subsequently reclassifying it to profit or loss when the hedged transaction affects earnings
- The objective is to defer the recognition of gains and losses on the hedging instrument until the hedged transaction occurs
- Any ineffectiveness in the hedging relationship is immediately recognized in profit or loss
Recording effective vs ineffective portions
- The change in fair value of the hedging instrument is split into an effective portion and an ineffective portion
- Effective portion: The change in fair value of the hedging instrument that offsets the change in expected future cash flows of the hedged item
- Ineffective portion: The change in fair value of the hedging instrument that does not offset the change in expected future cash flows of the hedged item
- The effective portion is initially recorded in OCI, while the ineffective portion is immediately recognized in profit or loss
Reclassifying gains and losses
- The accumulated gains or losses on the hedging instrument recorded in OCI are reclassified to profit or loss in the same period(s) during which the hedged forecasted transaction affects earnings
- If the hedged transaction results in the recognition of a non-financial asset or liability, the accumulated OCI is removed and included in the initial cost or carrying amount of the asset or liability
- If the forecasted transaction is no longer expected to occur, any related accumulated gains or losses in OCI are immediately reclassified to profit or loss
Discontinuing hedge accounting
- Hedge accounting must be discontinued prospectively when the hedging relationship no longer meets the qualifying criteria or when the company voluntarily terminates the hedge designation
- The accounting treatment after discontinuation depends on the reason for discontinuation and the type of hedging relationship
- Discontinuing hedge accounting may result in increased volatility in the income statement as the gains and losses on the hedging instrument are no longer deferred or offset
Reasons for discontinuation
- The hedging relationship no longer meets the qualifying criteria, such as:
- The hedging instrument expires, is sold, terminated, or exercised
- The hedged item is sold, settled, or otherwise disposed of
- The hedge is no longer highly effective
- The company voluntarily discontinues the hedge designation
- The forecasted transaction is no longer expected to occur ()
Accounting treatment after discontinuation
- For fair value hedges:
- The adjustment to the carrying amount of the hedged item is amortized to profit or loss over the remaining life of the hedged item
- If the hedged item is derecognized, the unamortized adjustment is immediately recognized in profit or loss
- For cash flow hedges:
- The accumulated gains or losses in OCI remain in equity until the forecasted transaction affects earnings, at which point they are reclassified to profit or loss
- If the forecasted transaction is no longer expected to occur, the accumulated gains or losses in OCI are immediately reclassified to profit or loss
Disclosures for hedging activities
- Companies are required to provide extensive disclosures about their hedging activities in the notes to the financial statements
- These disclosures provide users of financial statements with information about the company's risk management strategies, the impact of hedging on the financial statements, and the effectiveness of the hedging relationships
- Disclosures are critical for understanding the company's use of hedging and its effect on financial performance and risk exposure
Objectives and strategies
- Companies must disclose their and strategies for undertaking hedging activities
- This includes a description of the risks being hedged, the hedging instruments used, and how the hedging instruments are expected to mitigate the hedged risks
- The disclosure should also include a description of how the company determines hedge effectiveness and measures ineffectiveness
Effects on financial statements
- Companies must disclose the impact of hedging activities on each line item in the balance sheet, income statement, and statement of comprehensive income
- For fair value hedges, this includes the carrying amount of the hedged items, the accumulated adjustment to the carrying amount, and the change in fair value of the hedged items and hedging instruments
- For cash flow hedges, this includes the amount of gains or losses recognized in OCI during the period, the amount reclassified from OCI to profit or loss, and the amount of ineffectiveness recognized in profit or loss
- The disclosure should also include a reconciliation of the components of accumulated OCI related to hedging activities
Key Terms to Review (18)
ASC 815: ASC 815 refers to the Accounting Standards Codification Topic 815, which focuses on derivatives and hedging activities. It outlines the requirements for recognizing, measuring, and disclosing derivatives and hedging instruments, ensuring that companies provide transparency about their risk management strategies and the impact of these financial instruments on their financial statements.
Cash flow hedge: A cash flow hedge is a financial strategy used to manage the risk of fluctuations in future cash flows associated with a specific asset or liability. This technique aims to protect against the variability in cash flows that may arise from changes in interest rates, foreign exchange rates, or commodity prices. By using derivatives like options or swaps, companies can stabilize their cash flows, ensuring they have a clearer financial outlook and more predictable earnings.
Comprehensive income: Comprehensive income refers to the total change in equity of a company during a specific period from all non-owner sources. This includes not just net income from regular business operations but also other comprehensive income items, such as unrealized gains and losses on certain investments and foreign currency translation adjustments. This broader measure gives a fuller picture of a company's financial performance, particularly when considering the impact of hedge accounting, which can affect how these components are recognized.
Derivatives: Derivatives are financial contracts whose value is derived from the performance of an underlying asset, index, or interest rate. They are used primarily for hedging risks, speculating on price movements, and enhancing financial leverage. Derivatives can take various forms, including options, futures, and swaps, and are important tools in risk management and investment strategies.
Effective Portion: The effective portion refers to the part of a hedging relationship that offsets changes in the fair value or cash flows of the hedged item, demonstrating the effectiveness of the hedge. It is crucial for recognizing gains and losses in financial statements, ensuring that only the effective part of the hedge is accounted for, while any ineffective portion is recognized immediately in profit or loss.
Fair value hedge: A fair value hedge is a risk management strategy used to offset the risk of changes in the fair value of an asset or liability. It typically involves the use of derivative financial instruments, like options or swaps, to mitigate potential losses from fluctuations in market conditions. This strategy allows organizations to stabilize cash flows and protect the value of their investments against market volatility.
Forwards: Forwards are customized financial contracts that obligate the buyer to purchase, and the seller to sell, an asset at a predetermined price on a specific future date. They are often used to hedge against price fluctuations in various markets, allowing parties to lock in prices and manage risk associated with future transactions. Forwards are not standardized and are typically traded over-the-counter (OTC), which can lead to increased counterparty risk.
Hedge documentation: Hedge documentation refers to the formal records and agreements that outline the terms and conditions of hedging transactions, ensuring compliance with accounting standards and regulations. It serves as a crucial tool in achieving hedge accounting, which allows companies to match the timing of gains and losses on hedges with the underlying exposures they are intended to mitigate. This documentation provides evidence of the effectiveness of hedging relationships, which is necessary for financial reporting purposes.
Hedged item: A hedged item refers to an asset, liability, or forecasted transaction that is exposed to risks, such as changes in market prices, interest rates, or foreign exchange rates, which a company seeks to mitigate through hedging. The connection to hedge accounting lies in the treatment and recognition of these items in financial statements, particularly when establishing a hedging relationship with a derivative. When it comes to cash flow hedges, the hedged item is typically a forecasted transaction that may impact future cash flows and requires careful accounting to ensure that the effects of the hedge are accurately reflected.
Hedging instrument: A hedging instrument is a financial asset or liability used to reduce the risk of adverse price movements in an asset or liability. By entering into these instruments, businesses and investors can manage exposure to various financial risks such as currency fluctuations, interest rate changes, or commodity price volatility. Hedging instruments can take various forms, including derivatives like options, forwards, and swaps, which help stabilize cash flows and protect against unpredictable market conditions.
IFRS 9: IFRS 9 is an International Financial Reporting Standard that addresses the classification, measurement, and impairment of financial instruments. It introduced a forward-looking approach for recognizing impairment losses and enhanced guidance for hedge accounting, linking financial reporting more closely to risk management practices.
Ineffective portion: The ineffective portion refers to the part of a hedging instrument’s gain or loss that does not offset the change in fair value or cash flows of the hedged item. This concept is critical in understanding how hedge accounting works, as it helps in determining which portions of gains and losses can be recognized in earnings and which should be deferred in other comprehensive income. Recognizing this distinction ensures that financial statements accurately reflect the economic reality of hedging activities.
Ineffectiveness: Ineffectiveness refers to the extent to which a hedging instrument fails to offset changes in the fair value or cash flows of a hedged item. In financial contexts, this concept is crucial as it determines how well a hedge performs in mitigating risks, particularly in hedge accounting, foreign currency risk management, and cash flow hedges. Understanding ineffectiveness helps in assessing the reliability and impact of hedging strategies on financial statements.
Oci - other comprehensive income: Other comprehensive income (OCI) refers to revenues, expenses, gains, and losses that are not included in net income but affect a company's equity. OCI typically includes items such as unrealized gains and losses on certain investments, foreign currency translation adjustments, and pension plan gains or losses. This concept is particularly relevant when discussing financial reporting standards, which provide guidance on how to recognize and present these items in financial statements.
Offsetting: Offsetting refers to the practice of balancing or neutralizing gains and losses in financial transactions, particularly in the context of hedging strategies. It is used to reduce risk exposure by creating positions that counteract each other, ensuring that adverse market movements do not significantly impact overall financial performance. This method is crucial for effective risk management, especially when dealing with complex financial instruments and uncertain market conditions.
Prospective effectiveness testing: Prospective effectiveness testing is a method used to evaluate the expected effectiveness of a hedging relationship before it takes place. This process involves forecasting future cash flows and assessing whether the hedging instrument will effectively offset the changes in fair value or cash flows of the hedged item. The goal is to ensure that the hedge is likely to be effective at mitigating risks associated with fluctuations in interest rates, foreign exchange rates, or other market variables.
Quantitative disclosures: Quantitative disclosures are numerical data provided in financial statements that reveal significant information about a company's financial performance and position. These disclosures play a crucial role in understanding the impact of financial instruments and entities, especially in contexts like risk management and transparency. By presenting numerical figures, these disclosures help stakeholders make informed decisions based on the financial health and operational risks associated with the company.
Risk management objectives: Risk management objectives are specific goals set by an organization to identify, assess, and mitigate risks that may affect its financial stability and operational effectiveness. These objectives are crucial in guiding the organization's risk management strategies and ensuring that risks are managed in a way that aligns with overall business goals. Establishing clear risk management objectives helps organizations prioritize risk exposure and allocate resources efficiently to protect their assets and achieve long-term success.