Guidance

Overview of hedge accounting

Published 27 March 2015

Hedging

Companies will often try to reduce or mitigate the financial effects from risks that could impact upon the company’s core business. The company will often enter into derivative contracts which will be structured to minimise these risks. The hedged item is the asset, liability or future transaction whose risk is being mitigated. The hedging instrument is the instrument used to mitigate the risk associated with the hedged item. A hedging relationship is where a company has a hedging instrument to mitigate the risk from the hedged item.

Types of hedge

Financial Reporting Standard (FRS) 102 identifies 3 main types of hedging relationships:

• fair value hedges are intended to hedge the exposure to variations in the fair value of the hedged item and which could affect profit or loss
• cash flow hedges are intended to hedge the exposure to variations in cash flows that are attributable to a risk associated with the hedged item and which could affect profit or loss
• net investment hedges are intended to hedge movements in the assets and liabilities held in a foreign investment with foreign exchange movements on the related financing

Conditions for hedge accounting under FRS 102

Not all hedging arrangements qualify for hedge accounting and the following conditions must apply.

Hedged items must be:

• a recognised asset or liability - or a component of such an item
• an unrecognised firm commitment - or a component of such an item
• a highly probable forecast transaction - or a component of such an item
• a net investment in a foreign operation

Hedging instruments must:

• be a financial instrument measured at fair value through profit or loss - unless as a hedge of foreign currency risk
• be a contract with a party external to the group or individual entity that is being reported on
• not be a written option - unless is an offset to or is combined with a purchased option

Hedging relationships must be:

• consistent with company’s risk management objectives
• an economic hedge
• documented by the entity as a hedging relationship so that the risk being hedged, the hedged item and the hedging instrument are clearly identifiable
• assessed and documented for causes of hedge ineffectiveness

Mechanics of hedge accounting under FRS 102

Designated cash flow hedges

The effect is to adjust the accounting of the hedging instrument by taking the fair value movements on the hedging instrument attributable to the hedged risk to a cash flow hedging reserve (shown within other comprehensive income). These amounts are then recycled from the cash flow hedging reserve to either the income statement or the carrying value of the asset/liability in line with the hedged risk.

Designated fair value hedges

The effect is to adjust the accounting of the hedged item by making an adjustment to the carrying value of the hedged item for the fair value risk being hedged. A corresponding amount in respect of this adjustment is recognised in the income statement.

Designated net investment hedge

The accounting similar to a designated cash flow hedge. However, amounts are not subsequently recycled from other comprehensive income.

Further guidance

The commentary above is based on the requirements of Section 12 of FRS 102. Companies which adopt FRS 102 have the option of applying the recognition and measurement requirements of International Accounting Standards (IAS) 39 or International Financial Reporting Standard (IFRS) 9. The requirements of these standards do contain certain differences to those contained in Section 12.

Further guidance can be found in the Corporate Finance Manual at CFM27000 onwards.