An overview of Hedge Accounting
Derivatives are often used to mitigate or offset risks (such as interest or currency risk) that arise from corporate activities. The standard accounting treatment for hedge instruments is that changes in fair value will have to be recorded in Profit and Loss (P&L). As opposed to the hedge instruments, the hedged assets or liabilities are often measured at (amortized) cost or fair value through equity, or are forecasted items which are not recognized in the Balance Sheet. This results in a (temporary) valuation and or timing mismatch between the hedged item and the hedge instrument. The objective of hedge accounting is to avoid temporary undesired volatility in P&L as a result of these valuation and timing differences. However, entities can practice hedge accounting only if they meet the numerous and complex requirements set out in IAS 39. What are these requirements and how Zanders can help you in the different steps?
What is hedging?
The aim of hedging is to mitigate the impact of non-controllable risks on the performance of an entity. Common risks are foreign exchange risk, interest rate risk, equity price risk, commodity price risk and credit risk.
The hedge can be executed through financial transactions. Examples in which hedging is used include:
- an entity that has a liability in a foreign currency and wants to protect itself against the change in the foreign exchange rate
- a company entering into an interest rate swap so that the floating rate of a loan becomes a fixed rate
Types of hedge accounting
There are three types of hedge accounting: fair value hedges, cash flow hedges and hedges of the net investment in a foreign operation.
- Fair Value Hedges
The risk being hedged in a fair value hedge is a change in the fair value of an asset or a liability. For examples, changes in fair value may arise through changes in interest rates (for fixed-rate loans), foreign exchange rates, equity prices or commodity prices.
- Cash Flows Hedges
The risk being hedged in a cash flow hedge is the exposure to variability in cash flows that is attributable to a particular risk and could affect the income statement. Volatility in future cash flows will result from changes in interest rates, exchange rates, equity prices or commodity prices.
- Hedges of net investment in a foreign operation
An entity may have overseas subsidiaries, associates, joint ventures or branches (‘foreign operations’). It may hedge the currency risk associated with the translation of the net assets of these foreign operations into the group’s currency. IAS 39 permits hedge accounting for such a hedge of a net investment in a foreign operation.
The mismatch in the income statement recognition
Under the accounting standard IAS 39, all derivatives are recorded at fair value in the income statement. However these derivatives are often used to hedge recognized assets and liabilities, which are recorded at amortized cost or forecasted transactions that are not yet recognized on the Balance Sheet yet. The difference between the fair value measurement for the derivative and the amortized cost for the asset/liability leads to a mismatch in the timing of income statement recognition.
Hedge accounting seeks to correct this mismatch by changing the timing recognition in the income statement.
Fair value hedge accounting treatment will accelerate the recognition of gains or losses on the hedged item into the P&L, whereas cash flow hedge accounting and net investment hedge accounting will defer the gains or losses on the hedge instrument.
The hedge relation
The hedge relation consists of a hedged item and a hedge instrument. A hedged item exposes the entity to the risk of changes in fair value or future cash flows that could affect the income statement currently or in the future. For example, a hedged item could be a loan in which the entity is paying a floating rate (e.g., Euribor 6 month + spread) to a counterparty.
If the hedge instrument is a derivative, it can be designated entirely or as a proportion as a hedging instrument. Even a portfolio of derivatives can be jointly designated as a hedge instrument. The hedge instrument can be a swap in which the entity is receiving a floating rate and paying a fixed rate. With this relation the entity is offsetting the floating rate payments and will only pay the fixed rate.
Criteria to qualify for hedge accounting
Hedge accounting is an exception to the usual accounting principles, thus it has to meet several criteria:
- At the start of the hedge, the hedged item and the hedging instrument has to be identified and designated.
- At the start of the hedge, the hedge relationship must be formally documented.
- At the start of the hedge, the hedge relationship must be highly effective.
- The effectiveness of the hedge relationship must be tested periodically. Ineffectiveness is allowed, provided that the hedge relationship achieves an effectiveness ratio between 80% and 125%.
Complying with IAS 39 requires two types of effectiveness tests:
- A prospective (forward-looking) test to see whether the hedging relationship is expected to be highly effective in future periods
- A retrospective (backward-looking) test to assess whether the hedging relationship has actually been highly effective in past periods
Both tests need to be highly effective at the start of the hedge. A prospective test is highly effective if, at the inception of the hedge relation and during the period for which the hedge relation is designated, the expected changes in fair value of cash flows are offset. Meaning that during the life of the hedge relation, the change in fair value (due to change in the market conditions) of the hedged item should be offset by the change in fair value of the hedged instrument.
A retrospective test is highly effective if the actual results of the hedge are within the range 80%-125%.
IAS 39 does not specify a single method for the calculation of the effectiveness of the hedge. The method used depends on the risk management strategy. The most common methods are:
- Critical terms comparison - this method consists of comparing the critical terms (notional, term, timing, currency, and rate) of the hedging instrument with those from the hedged item. This method does not require any calculation.
- Dollar offset method - this is a quantitative method that consists of comparing the change in fair value between the hedging instrument and the hedged item. Depending on the entity risk policies, this method can be performed on a cumulative basis (from inception) or on a period-by-period basis (between two specific dates). A hedge is considered highly effective if the results are within the range 80%-125%.
- Regression analysis - this statistical method investigates the strength of the statistical relationship between the hedged item and the hedge instrument. From an accounting perspective this method proves whether or not the relationship is sufficiently effective to qualify for hedge accounting. It does not calculate the amount of ineffectiveness.
Termination of the hedge relation
A hedge relation has to be terminated going forward when any of the following occur:
- A hedge fails an effectiveness test
- The hedged item is sold or settled
- The hedging instruments are sold, terminated or exercised
- Management decides to terminate the relation
- For a hedge of a forecast transaction; the forecast transaction is no longer highly probable.
Please note that these requirements described previously may change as the IASB is currently working to replace IAS39 by IFRS9 (new qualification of hedging instruments, hedged items, hedge effectiveness…)
Hedge accounting is a complex process involving numerous and technical requirements with the objective to avoid temporary undesired volatility in P&L. This volatility is the result of valuation and or timing mismatch between the hedged item and the hedge instrument. If you are considering hedge accounting, Zanders has a dedicated team on the valuation desk. They can offer advices on the calculation of the market values of the underlying risks and the hedge instruments, as well as setting up the hedge relation, preparing documentation and helping on the accounting treatment of the results.