8.2 Hedge accounting

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

Top images from around the web for Firm commitments as hedged items

• 

  Effectiveness of Financial Risk Management Framework: An Analysis of the Mauritian Banking Sector View original

  Is this image relevant?

• 

  Financial Risk Management in Dutch SMEs: An Empirical Analysis View original

  Is this image relevant?

• 

  Accounting Information | Boundless Business View original

  Is this image relevant?

• 

  Effectiveness of Financial Risk Management Framework: An Analysis of the Mauritian Banking Sector View original

  Is this image relevant?

• 

  Financial Risk Management in Dutch SMEs: An Empirical Analysis View original

  Is this image relevant?

1 of 3

Top images from around the web for Firm commitments as hedged items

• 

  Effectiveness of Financial Risk Management Framework: An Analysis of the Mauritian Banking Sector View original

  Is this image relevant?

• 

  Financial Risk Management in Dutch SMEs: An Empirical Analysis View original

  Is this image relevant?

• 

  Accounting Information | Boundless Business View original

  Is this image relevant?

• 

  Effectiveness of Financial Risk Management Framework: An Analysis of the Mauritian Banking Sector View original

  Is this image relevant?

• 

  Financial Risk Management in Dutch SMEs: An Empirical Analysis View original

  Is this image relevant?

1 of 3

• 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 hedged item
• Hedging instruments are typically derivative instruments, but non-derivative financial instruments may also qualify in certain circumstances
• The value of the hedging instrument 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 effective portion of the change in fair value of the hedging instrument is initially recorded in other comprehensive income (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 ineffective portion 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:
  1. The hedged item or transaction
  2. The hedging instrument
  3. The nature of the risk being hedged
  4. How the company will assess hedge effectiveness
• The documentation should demonstrate that the hedging relationship is expected to be highly effective in achieving offsetting 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 ineffectiveness 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 (cash flow hedge)

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 risk management objectives 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