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To hedge its net investment in a foreign operation that has the Japanese yen as its functional currency, Entity A borrows ¥100,000,000. Assuming all hedge
accounting conditions are met, Entity A may designate its borrowing as a hedging instrument in a hedge of the net investment. As a result, foreign currency
gains and losses on the borrowing that would otherwise have been included in profit or loss under IAS 21 would instead be recognized in other comprehensive
income to the extent that the hedge is effective until the disposal of the net investment.
As mentioned, two of the conditions for hedge accounting are that the hedge is
Hedge Effectiveness Assessment and Measurement
• Expected to be highly effective in achieving offsetting changes in fair value or cash flows during the period for which the hedge is designated (prospective
effectiveness)
• Determined actually to have been highly effective throughout the reporting period for which the hedge was designated (retrospective effectiveness)
Generally, a hedge is viewed as being highly effective if actual results are within a range of 80% and 125%.
Example
If actual results are such that the gain on the hedging instrument is $90 and the loss on the hedged item is $100, the degree of offset is 90% (= 90/100), or
111% (= 100/90). The hedge would be considered to be highly effective because the degree of offset is between 80% and 125%.
Hedge effectiveness is important not only as a condition for hedge accounting, but also because the measurement of hedge effectiveness determines how much
ineffectiveness will be reflected in profit or loss. To the extent that the changes do not fully offset, such differences reflect ineffectiveness that generally should be
included in profit or loss. Such ineffectiveness may exist even though a hedge is determined to be highly effective based on the prospective or retrospective hedge
effectiveness assessment for purposes of continued qualification for hedge accounting.
Example
If, for a fair value hedge, the gain on the hedging instrument is $90 and the loss on the hedged item is $100, a net loss of $10 would be included in profit or
loss.
For a qualifying cash flow hedge, ineffectiveness is included in profit or loss only to the extent that the cumulative gain or loss on the hedging instrument exceeds
the cumulative gain or loss on the hedged item since the inception of the hedging relationship (overhedging). If the cumulative gain or loss on the hedged item exceeds
the cumulative gain or loss on the hedging instrument (underhedging), no ineffectiveness is reported. This is because—for a cash flow hedge—the hedged item is a
future transaction that does not qualify for accounting recognition.
Example
If, for a cash flow hedge, the gain on the hedging instrument in the first period after designation is $490 and the loss on the hedged item is $100, no
ineffectiveness is included in profit or loss, because the cumulative gain or loss on the hedged item exceeds the cumulative gain or loss on the hedging
instrument (“underhedging”).
If instead the loss on the hedging instrument in the first period after designation is $100 and the gain on the hedged item is $90, a loss of $10 is included in
profit or loss due to ineffectiveness, because the cumulative gain or loss on the hedging instrument exceeds the cumulative gain or loss on the hedged item
(“overhedging”).
Discontinuation of Hedge Accounting
In any of these circumstances, an entity should discontinue hedge accounting prospectively:
• The hedging instrument expires or is sold, terminated, or exercised.
• The hedge no longer meets the hedge accounting conditions.
• The entity revokes the hedge designation.
• A hedged forecasted transaction is no longer expected to occur.
For discontinued fair value hedges, any previous hedge accounting adjustment to the carrying amount of hedged interest-bearing assets or liabilities, are amortized
over the remaining maturity of those assets and liabilities. Other hedge accounting adjustments to the carrying amount of hedged items remain in the carrying amount.
For discontinued cash flow hedges, hedging gains and losses that have been recognized in other comprehensive income remain in equity until the hedged item
affects profit or loss unless
• A forecast transaction is no longer expected to occur, in which case the deferred gain or loss is recognized immediately in profit or loss.
• A forecast transaction results in the recognition of a nonfinancial asset or nonfinancial liability and the entity has made an accounting policy choice to include
those deferred gains and losses in the initial carrying amount of the nonfinancial asset or nonfinancial liability.
Macrohedging
One issue that has been the subject of considerable debate is the hedge accounting treatment of derivatives that are used to manage interest rate risk on a net,
portfolio basis (“macrohedging”). For instance, banks, as part of their asset-liability management activities, for risk management purposes may wish to offset risk
exposures on a net basis. However, IAS 39 does not permit an entity to designate a net position (i.e., a net amount of assets less liabilities or a net amount of cash
inflows less cash outflows) as a hedged item because of difficulties associated with assigning hedge accounting adjustments to individual hedged assets or liabilities
and measuring effectiveness.