Corporate Reporting & Group Accounting: Hedge Accounting

Financial instruments that derive their value from an underlying asset, interest rate, or exchange rate. Their value fluctuates with changes in the underlying asset.

A strategy where a financial instrument (hedge instrument) is used to offset the risk of fluctuations in the value or cash flows of another asset (hedged item).

Financial Instruments (derivatives) are always measured at Fair Value through Profit and Loss (FVPL).

Derivatives are subsequently measured at Fair Value through Profit and Loss (FVPL) or Fair Value through Other Comprehensive Income (FVOCI).

A hedge accounting strategy where the objective is to manage the exposure to changes in cash flows, such as interest rate risk on a debt security.

A hedge accounting strategy where the objective is to manage the exposure to changes in the fair value of an asset or liability, such as a foreign currency exposure.

The asset or liability that is being hedged against risk.

A financial instrument used to manage the risk of changes in the value or cash flows of the hedged item.

The relationship between the hedging instrument and the hedged item must be formally designed and documented.

The application of hedge accounting is optional. Companies can choose to use it or not.

A financial instrument that is used to reduce the risk of changes in interest rates.

The accounting treatment for transactions where the goal is to hedge against the risk of changes in the fair value of a financial asset or liability.

The method of accounting for financial instruments that are measured at amortized cost, where the interest income is recognized over time, but there is no adjustment to the carrying amount of the loan to reflect changes in fair value.

The risk of losing money due to changes in interest rates.

The process of recognizing the economic effects of an asset or liability in the same period as the derivative instrument used to hedge the risk.

The accounting treatment for the change in fair value of the derivative instrument used in a FV hedge, where the gain or loss is recognized in the same period as the related asset or liability is recognized.

The accounting treatment for a financial instrument used to hedge against changes in the cash flows of an asset or liability.

The method of accounting for changes in fair value of a derivative instrument that is not designated as a hedge, where the gain or loss is recognized immediately in the income statement.

The accounting treatment for a financial instrument where the gain or loss is recognized immediately in the income statement, resulting in earnings volatility.

The portion of the hedging instrument's changes in value that's directly related to the risk being hedged. The effective portion is recognized in OCI (Other Comprehensive Income) to balance out the hedged item's exposure to that risk.

The portion of hedging instrument's value changes that are NOT related to the hedged risk. This portion is recognized in P&L immediately because it doesn't directly offset the risk being hedged.

A reserve account in OCI (Other Comprehensive Income) that balances out the changes in value of the effective portion of the hedging instrument. The hedge reserve is meant to avoid premature recognition of changes in value related to the hedged risk.

When a company uses a CF hedge, the gains or losses arising from the hedging instrument are deferred in OCI. This means the changes in value are not immediately recognized in P&L, but instead, held in the reserve account.

The treatment of the CF hedge reserve depends on the nature of the hedged item. If the hedged item results in a non-financial asset or liability, the reserve is removed and included in the initial cost of that asset or liability.

In a CF hedge, the changes in value of the hedging instrument are recognized in P&L when the related cash flows are recognized.

CF hedges are used to manage the risk associated with changes in cash flows. This helps to minimize the impact of unexpected events on a company's profitability and financial stability.

The value of the IRS asset is revalued based on its fair value at the end of year 2. This revaluation results in a loss, which is recognized in the income statement.

The interest expense is calculated at 10% on the outstanding debt balance. This expense is recognized in the income statement.

The debt is adjusted to reflect the difference between the interest expense and the cash interest paid. This adjustment is recorded in the balance sheet.

The interest charge on the IRS asset is calculated at 10% of its fair value. This expense is recognized in the income statement.

Firm A is required to pay an additional 2% on the IRS contract as a penalty. This expense is recognized in the income statement.

The principal amount of the debt is repaid, and the IRS asset is closed out of the balance sheet. This action finalizes the hedge transaction.

The IRS asset represents a financial derivative that is used to offset the risk of the hedged item, which is the debt. The asset's value fluctuates in a way that is intended to cancel out changes in the debt's value.

The value of the bond is adjusted to its fair value at the end of each period, reflecting changes in interest rates.

A journal entry is made to record the difference between the bond's carrying value and its fair value at the end of each period.

This entry is made to adjust the bond's value to its fair value. The difference is either a debit (FV loss) or credit (FV gain) depending on the direction of interest rate changes.

The interest expense is calculated based on the effective interest rate, which is the rate that equates the discounted present value of the bond's remaining cash flows to its carrying value.

The interest revenue is recorded based on the change in the fair value of the interest rate swap (IRS). This change reflects the differences between the fixed rate on the bond and the prevailing market interest rate.

The IRS is revalued to reflect its fair value at the end of each period. This adjustment represents the change in the present value of the future cash flows from the IRS.

A hedging strategy that aims to mitigate the impact of changes in fair value (FV) on a recognized asset or liability or an unrecognized firm commitment.

The accounting treatment for an FV hedge involves recognizing the FV change of the hedged item in the current period to offset the change in the hedging instrument, such as a derivative.

The accounting treatment for an FV hedge when a firm commitment to acquire an asset or assume a liability exists. The FV change of the commitment is recognized during the hedge life as an asset or liability in the balance sheet, and a corresponding entry is made in the profit and loss statement. When the commitment is fulfilled, the accumulated FV change is incorporated into the carrying amount of the recognized asset or liability.

When a financial instrument is measured at amortized cost, the FV change is included in the carrying amount and amortized into the profit and loss through recalculation of the effective interest rate. Amortization can begin as soon as an adjustment exists.

When a debt instrument is measured at fair value through other comprehensive income (FVOCI), the FV change is included in the carrying amount and amortized into the profit and loss. Amortization only applies to the portion of the debt instrument representing the cumulative gain or loss recognized in the profit and loss previously.

A financial instrument that is used to hedge against changes in fair value. This is typically a derivative, which is a contract whose value depends on the value of an underlying asset.

A common example of an FV hedge is using an interest rate swap (IRS) to convert a fixed-rate debt instrument into a variable-rate one. The IRS acts as the hedge instrument, while the debt instrument is the hedged item.

The goal of an FV hedge is to minimize the impact of changes in fair value on the profit and loss of a company, by offsetting the change in the value of the hedged item with the change in the value of the hedging instrument.