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1. Changes in fair value of the hedged item are recognized in the current period to offset the recognition of changes in the fair value of the hedging instrument.
This is the accounting treatment for fair value hedges.
2. Changes in fair value of the hedging instrument are recognized in other comprehensive income to the extent that the hedge is effective and released to profit or
loss in the time periods in which the hedged item impacts profit or loss. This is the accounting treatment for cash flow hedges and hedges of net investments in
foreign operations.
PRACTICAL INSIGHT
Hedge accounting is not always necessary to reflect the effect of hedging activities in the financial statements. When consistent accounting principles apply
to offsetting positions (e.g., when both the hedging instrument and the hedged item are accounted for at fair value or at amortized cost), there is no need for
an entity to apply hedge accounting to achieve consistent accounting for the offsetting positions.
Hedge Accounting Conditions
As discussed, hedge accounting is optional and allows entities to defer or accelerate the recognition of gains and losses under otherwise applicable accounting
requirements. To prevent abuse, therefore, IAS 39 limits the use of hedge accounting to situations where special hedge accounting conditions are met. To qualify for
hedge accounting, the hedging relationship should meet three conditions related to the designation, documentation, measurement, and effectiveness of the hedging
relationships. These three conditions are
1. There is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge.
Hedge accounting is permitted only from the date such designation and documentation is in place.
2. The hedging relationship is effective, which means
a. The hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk (“prospective”
effectiveness).
b. The effectiveness of the hedge can be measured reliably.
c. The hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the financial reporting periods for which
the hedge was designated (“retrospective” effectiveness).
3. For cash flow hedges of forecast transactions, the hedged forecast transaction must be highly probable and must present an exposure to variations in cash flows
that could ultimately affect profit or loss.
Example
The designation and documentation of a hedging relationship should include identification of
• The hedging instrument(s)
• The hedged item(s) or transaction(s)
• The nature of the risk(s) being hedged
• How the entity will assess the hedging instrument’s effectiveness in offsetting the exposure to changes in the hedged item’s fair value or the hedged
transaction’s cash flows attributable to the hedged risk
This case considers the reasons and conditions for hedge accounting.
Required
CASE STUDY 14
1. Describe the three types of hedging relationships specified by IAS 39.
2. Discuss in what circumstances entities may want to apply hedge accounting.
3. Discuss the conditions for hedge accounting.
Solution
1. IAS 39 identifies three types of hedging relationships:
a . Fair value hedges are hedges of the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm
commitment that is attributable to a particular risk and that could affect profit or loss. Under fair value hedge accounting, if the hedged
item is otherwise measured at cost or amortized cost, the measurement of the hedged item is adjusted for changes in its fair value
attributable to the hedged risk. These changes are recognized in profit or loss. If the hedged item is an available-for-sale financial asset,
changes in fair value that would otherwise have been included in other comprehensive income are recognized in profit or loss.
b . Cash flow hedges are hedges of the exposure to variability in cash flows that is attributable to a particular risk associated with a
recognized asset or liability or a highly probable forecast transaction and could affect profit or loss. Under cash flow hedge accounting,
changes in the fair value of the hedging instrument attributable to the hedged risk are recognized in other comprehensive income to the
extent the hedge is effective (rather than being recognized immediately in profit or loss).
c. Hedges of net investments in foreign operations are accounted for like cash flow hedges.
2. Entities may want to use hedge accounting to avoid mismatches in the recognition of gains and losses on related transactions. When an entity uses a
derivative (or other instrument measured at fair value) to hedge the value of an asset or liability measured at cost or amortized cost or not recognized
at all, accounting that is not reflective of the entity’s financial position and financial performance may result because of the different measurement
bases used for the hedging instrument and the hedged item. The normally applicable accounting requirements would include the changes in fair
value of a derivative in profit or loss but not the changes in fair value of the hedged item in profit or loss. In addition, when an entity uses a
derivative (or other instrument measured at fair value) to hedge a future expected transaction, the entity would like to defer the recognition of the