In principle, but only in principle, hedging aims to reduce the risk on a hedged instrument by combining it with a hedginginstrument. In reality there are risks inherent in both hedged and hedging instruments depending, to a large extent, on the way the market turns. The hedging instrument may be an option, forward, future or swap.
● Theoretically, through hedging, value changes in one instrument are offset by value changes in the other instrument.
● Practically, this is never the case, because the behaviour of the hedged and hedging instruments is quite often asymmetric.
Moreover, if different accounting valuation methods are used for the different instru- ments, for instance historical cost and accruals for the hedged item and marking to market for the hedging, this will result in volatility in the profit and loss account.
Hence the use of a specific accounting treatment, known as hedge accounting.
The process of hedge accounting is fairly sophisticated and one must pay atten- tion to it. For this reason project management for IFRS conversion, in Chapter 6, singles out hedge accounting as a major sub-project. The Introduction made ref- erence to hedge accounting under IAS 39, saying that it provides two key methods companies can choose from:
● 1. Fair value hedges, which aim at controlling exposure(s) to changes in fair value of a recognized asset or liability.
Under IAS 39, fair value hedging is permitted only for micro-hedges.
● 2. Cash flow hedges, for which evidence must be furnished of a sufficient volume of variable future cash flows for the hedging relationship.
There exist specific circumstances under which cash flow hedges, whose objec- tive is that of controlling exposure to variability in future cash flows from the hedged item, may not be the best way (more on this later).
As should be expected, for both methods IAS 39 requires a high degree of effec- tiveness as well as comprehensive formal documentation of the hedging rela- tionship. Hedge accounting is permitted, if specific conditions prevail, and the process focuses on the hedging relationship which should be expected to be:
● Effective in achieving offsetting changes in fair value or cash flows attri- butable to hedged risk, and
● Formally designated and documented, including the company’s risk man- agement objective(s) and strategy for undertaking the hedge.
In terms of its mechanics, hedge accounting works in two ways. It either defers the recognition of losses, or brings forward the recognition of gains in the profit and loss statement. In this manner, gain or loss from the hedged instrument is recog- nized at the same time as the offsetting gain or loss from the hedging instrument.
According to many experts, full fair value accounting does away with hedge accounting practice. But others think that hedge accounting has a role to play in the modern firm. To avoid situations where hedging relationships are identified ex post to deliberately massage profits and losses, the International Accounting Standards Board laid down a number of specific requirements to qualify for hedge accounting. The most important are:
● A hedging relationship is clearly identified and documented at inception
● Such relationships must be conceived in an effective manner, and
● The after-effect of the hedge must be highly probable, if this is a forecasted transaction.
The message conveyed by these three bullets points is that a hedge can only qualify for hedge accounting if it passes identification, effectiveness and after-effect tests.
For instance, in terms of effectiveness changes in the value of the hedged and the hedging instruments should almost fully offset each other at designation. That is:
● Relatively easy to do when planning a hedge
● But very difficult to realize at the end, where it really counts.
Asymmetries between hedged and hedging instruments can turn the hedge on its head. In addition, according to IAS 39, actual results realized over the life of the hedge must remain within a narrow margin in order for it to continue to be con- sidered effective. This is a precondition for hedge accounting. Benefits from hedge accounting can be achieved if and when countervailing changes in value cancel each other in terms of amount. This will depend greatly on:
● The quality of the hedge
● The way in which it is implemented, and
● Market(s) behavior, which is beyond the control of the entity making the hedge.
Moreover, it is important to notice that not all instruments qualify for hedge accounting. IAS 39 clearly states that a hedge item can be a single recognized asset or liability, firm commitment, highly likely forecast transactions, or net investment in a foreign operation. A hedge might also be a group of assets, liabilities under the same conditions outlined in the preceding sentence – or a held-to-maturity invest- ment for foreign currency or credit risk, but not for interest risk or prepayment risk.
Also qualifying for a hedge is a portion of cash flows of a financial asset or finan- cial liability at fair value; or a non-financial item for hedging foreign currency risk as well as a macro-hedge. Hedging may also concern a portion of the port- folio of financial assets, or financial liabilities, that share the risk being hedged.
These are the items to be most carefully studied for hedge accounting in an IFRS implementation project, like the one discussed in Chapter 6.
IAS 39 does not permit strategies based on hedging entire portfolios, and this is for a good reason. Such strategies could easily degenerate into king-size gambles.
Additionally, under IFRS only hedging transactions with third parties are elig- ible for recognition. Internal contracts within a company or group do not qualify for hedge accounting.
Even with these constraints, hedge accounting is important to banks because it permits them to defer putting gains and losses on derivatives through their income statements. The problem, however, is that many ‘hedges’ through deriv- atives are nothing more than risky gambles. Regulators are aware of this; that is why many countries already have in place, since the late 1990s, legislation requiring banks to report on recognized but not yet realized gains and losses.
● The United States did so through the Statement of Financial Accounting Standards 133.
● The UK through the Statement of Recognized Gains and Losses (STRGL).
● Switzerland, by obliging banks to report ‘other assets’ and ‘other liabili- ties’, which is essentially recognized gains and losses from derivatives contracts.
It is also appropriate to take notice that IAS 39 provides rules for discontinua- tionof hedge accounting. Hedge accounting must be discontinued if the hedging instrument expires or is sold, terminated, or exercised; the hedge no longer meets the outlined hedge accounting criteria.
For cash flow hedges, hedge accounting must be discontinued if the projected transaction is no longer expected to occur; or the company revokes the hedge’s designation. Also, there is no sense in doing hedge accounting when the item to be hedged is one that would normally not be recorded at fair value, because the rules allow that it is held at cost less impairment.
Keeping all these issues in mind, one can make the statement that IAS 39 hedge accountingpermits a company to mitigate some risks ifit succeeds in being fully compliant with specified hedge criteria. The better managed banks chose to apply hedge accounting whenever they meet these criteria, so that their financial statements clearly reflect the economic hedge effect obtained from the use of hedging instruments which should normally be accounted for at fair value.
Differences and discrepancies between fair values of hedged and hedging instru- ments will affect P&L even if, over the whole life of the instrument, they might be expected to balance out. Therefore, senior management should appreciate that applying hedge accounting means that changes in fair values of designated hedging instruments do affect reported profit and loss in a given period. This can happen not only to the extent that a hedge is ineffective, but also because of market reasons.