The first xavier pages forex market you need to do before you even start to play with hedge accounting is to determine the TYPE of hedge relationship that you’re dealing with. Because: the type of hedge determines your accounting entries.
If you incorrectly identify the type of the hedge, then your hedge accounting will go totally wrong. IFRS 9, we all struggle with understanding the differences and distinguishing one type from the other one. A few weeks ago I was giving a lecture about hedge accounting to the group of auditors. I just don’t get the difference. I mean the real substance of a difference between fair value hedge and cash flow hedge. It looks the same in many cases.
Can you shed some light there? What types of hedges do we have? What is a Fair Value Hedge? Fair value hedge is a hedge of the exposure to changes in fair value of a recognized asset or liability or unrecognized firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss. Have you already checked out the IFRS Kit? It’s a full IFRS learning package with more than 30 hours of private video tutorials, more than 100 IFRS case studies solved in Excel, more than 120 pages of handouts and many bonuses included. If you take action today and subscribe to the IFRS Kit, you’ll get it at discount!
Click here to check it out! That’s the definition in IFRS 9 and IAS 39. I’ll come back to this later. How to Account for a Fair Value Hedge?
OK, let’s not go into details and let’s just assume that your fair value hedge meets all criteria for hedge accounting. Recognize the hedging gain or loss on the hedged item in its carrying amount. What is a Cash Flow Hedge? Cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all or a component of a recognized asset or liability or a highly probable forecast transaction, and could affect profit or loss. Again, that’s the definition in IAS 39 and IFRS 9. Equally, you can have a highly probable forecast transaction that hasn’t been recognized in your accounts yet. How to Account for a Cash Flow Hedge?
Recognize the ineffective portion of the gain or loss on the hedging instrument in profit or loss. Deal with a cash flow hedge reserve when necessary. As you can see, you don’t even touch the hedged item here and you only deal with the hedging instrument. So that’s completely different from fair value hedge accounting. How to Distinguish Fair Value Hedge and Cash Flow Hedge? What I’m going to explain right now is my own logic of looking at this issue.
It’s not covered in any book. It’s how I look at most hedging transactions and this is a very simplified view. But maybe it opens up your mind to logical thinking about hedges. What kind of item are we hedging? Basically, you can hedge a fixed item or a variable item. Hedging a Fixed Item A fixed item means that the item has a fixed value in your accounts and it may provide or require fixed amount of cash in the future.
The same applies for unrecognized firm commitments that have not been sitting in your accounts yet, but they will be in the future. And when it comes to hedging fixed items, then you’re practically dealing with the fair value hedge. Well, here, you are worried, that in the future, you would be paying or receiving a different amount than the market or fair value will be. So you don’t want to FIX the amount, you want to GET or PAY exactly in line with the market. It’s nice that you always know how much you’ll pay in the future. Hedging a Variable Item A variable item means that the expected future cash flows from this item change as a result of certain risk exposure, for example, variable interest rates or foreign currencies.
When it comes to hedging variable items, you’re practically speaking of a cash flow hedge. Here, you are worried that you will get or pay a different amount of moneyin certain currency in the future that you would get now. It means that in the future, you will pay interest in line with the market, because LIBOR reflects the market conditions. You want to know how much you will pay in the future, as you need to make some budget, etc. The key to differentiate is WHAT RISK you hedge. Always ask yourself, why you undertake the hedging instrument.