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change in fair value of the derivative until the future transaction affects profit or loss. Otherwise, the changes in fair value of a derivative hedging
instrument would be recognized in profit or loss without a corresponding offset associated with the hedged item.
3. The hedge accounting conditions are
a. 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.
b. The hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk.
c. The effectiveness of the hedge can be measured reliably.
d. 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.
e. For cash flow hedges, a hedged forecast transaction must be highly probable and must present an exposure to variations in cash flows
that could ultimately affect profit or loss.
Fair Value Hedge
A fair value hedge is a hedge 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. (A firm commitment is a binding agreement for the exchange of a specified quantity of resources at a specified price
on a specified future date or dates.)
Fair value hedge accounting involves this accounting:
• The hedging instrument is measured at fair value with changes in fair value recognized in profit or loss.
• If the hedged item is otherwise measured at cost or amortized cost (e.g., because it is classified as a loan or receivable), 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 recognized in other comprehensive income are
recognized in profit or loss.
Under fair value hedge accounting, changes in the fair value of the hedging instrument and of the hedged item are recognized in profit or loss at the same time. The
result is that there will be no (net) impact on profit or loss of the hedging instrument and the hedged item if the hedge is fully effective, because changes in fair value
will offset each other. If the hedge is not 100% effective (i.e., the changes in fair value do not fully offset), such ineffectiveness is automatically reflected in profit or
loss.
Example
Fair value hedges include
• A hedge of the exposure to changes in the fair value of a fixed interest rate loan due to changes in market interest rates. Such a hedge could be entered
into by either the borrower or the lender.
• A hedge of the exposure to changes in the fair value of an available-for-sale investment.
• A hedge of the exposure to changes in the fair value of a nonfinancial asset (e.g., inventory).
• A hedge of the exposure to changes in the fair value of a firm commitment to purchase or sell a nonfinancial item (e.g., a contract to purchase or sell
gold for a fixed price on a future date).
Example
On January 1, 20X5, Entity A purchases a five-year bond that has a principal amount of $100,000 and pays annually a fixed interest rate of 5% per year (i.e.,
$5,000 per year). Entity A classifies the bond as an available-for-sale financial asset. Current market interest rates for similar five-year bonds are also 5% such
that the fair value of the bond and the carrying amount of the bond on the acquisition date is equal to its principal amount of $100,000.
Because the interest rate is fixed, Entity A is exposed to the risk of declines in fair value of the bond. If market interest rates increase above 5%, for example,
the fair value of the bond will decrease below $100,000. This is because the bond would pay a lower fixed interest rate than equivalent alternative investments
available in the market (i.e., the present value of the principal and interest cash flows discounted using market interest rates would be less than the principal
amount of the bond).
To eliminate the risk of declines in fair value due to increases in market interest rates, Entity A enters into a derivative to hedge (offset) this risk. More
specifically, on January 1, 20X5, Entity A enters into an interest rate swap to exchange the fixed interest rate payments it receives on the bond for floating
interest rate payments. If the derivative hedging instrument is effective, any declines in the fair value of the bond should be offset by opposite increases in the
fair value of the derivative instrument. Entity A designates and documents the swap as a hedging instrument of the bond.
On entering into the swap on January 1, 20X5, the swap has a net fair value of zero. (In practice, swaps usually are entered into at a zero fair value. This is
achieved by setting the interest payments that will be paid and received such that the present value of the expected floating interest payments Entity A will
receive exactly equals the present value of the fixed interest payments Entity A will pay because of the swap agreement.) Therefore, no journal entry is
required on this date.
At the end of 20X5, the bond has accrued interest of $5,000. Entity A makes this journal entry:
Interest receivable 5,000
Interest income 5,000