ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 11.

189
11.189

UNIT 6:
HEDGE ACCOUNTING

6.1 INTRODUCTION
The objective of hedge accounting is to represent, in the financial statements, the effect of an
entity's risk management activities that use financial instruments to manage exposures
arising from particular risks that could affect profit or loss (or other comprehensive income, in the
case of investments in equity instruments for which an entity has elected to present changes in fair
value in other comprehensive income).
An entity may choose to designate a hedging relationship between a hedging instrument and a
hedged item, i.e, hedge accounting is an option provided qualifying criteria are met. In such a case,
accounting for gain / loss arising on the hedging relationship, ie, including hedging instrument and
hedged item shall be accounted in a specific manner as detailed further in the unit in order to avoid
measurement and recognition inconsistencies which may arise otherwise if the hedging instrument
and hedged item were accounted separately.
A step wise analysis has been presented using the following diagrammatic presentation –

Step 1 Identify the hedged item [ie, exposed to one or

more risks]

Identify the hedging instrument [ie, a derivative or

Step 2 non-derivative to off-set risks in cash flow/ fair
value of hedged item]

Evaluate if hedging relationship meets the

Step 3
requisite criteria for hedge accounting

If hedge is effective, establish type of hedge –

(A) Fair value hedge
Step 4
(B) Cash flow hedge
(C) Hedge of net investment in foreign operation

Step 6 Account for the hedging relationship basis

guidance in Ind AS 109

© The Institute of Chartered Accountants of India

 11.190 2.190
FINANCIAL REPORTING

A hedge relationship can be evaluated for a single hedged item or group of items and the hedging
instrument can also be a single instrument or multiple instruments hedging specific risk associated
with the hedged item.

6.2 IDENTIFYING THE HEDGED ITEM AND DESIGNATION

OF HEDGED ITEMS
♦ A hedged item can be a recognised asset or liability, an unrecognised firm commitment, a
forecast transaction or a net investment in a foreign operation. The hedged item can be:
(a) a single item; or

(b) a group of items.

A hedged item can also be a component of such an item or group of items.
♦ The hedged item must be reliably measurable.

♦ If a hedged item is a forecast transaction (or a component thereof), that transaction must be
highly probable.
♦ An entity may designate an item in its entirety or a component of an item as the hedged
item in a hedging relationship.
 An entire item comprises all changes in cash flows or fair value of an item.
 A component comprises less than the entire fair value change or cash flow variability
of an item. In that case, an entity may designate only the following types of
components (including combinations) as hedged items:
(a) only changes in the cash flows or fair value of an item attributable to a specific
risk or risks (risk component), provided that, based on an assessment within
the context of the particular market structure, the risk component is separately
identifiable and reliably measurable. Risk components include a designation of
only changes in the cash flows or the fair value of a hedged item above or below
a specified price or other variable (a one-sided risk).
(b) one or more selected contractual cash flows.
(c) components of a nominal amount, ie a specified part of the amount of an item

© The Institute of Chartered Accountants of India

 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 11.191
11.191

6.3 QUALIFYING INSTRUMENTS FOR HEDGE

ACCOUNTING AND DESIGNATION OF HEDGING
INSTRUMENTS

Derivative measured at fair value through profit

or loss (except for written options)
Hedging
instrument
Non-Derivative financial asset or financial
liability measured at fair value through profit or
loss

♦ Exceptions to designating non-derivative financial asset or non-derivative financial

liability as hedging instrument:
 A financial liability designated as at fair value through profit or loss for which the
amount of its change in fair value that is attributable to changes in the credit risk of
that liability is presented in other comprehensive income.
 For a hedge of foreign currency risk, the foreign currency risk component of a non-
derivative financial asset or a non-derivative financial liability may be designated as a
hedging instrument provided that it is not an investment in an equity instrument for
which an entity has elected to present changes in fair value in other comprehensive
income.
♦ For hedge accounting purposes, only contracts with a party external to the reporting entity
(ie external to the group or individual entity that is being reported on) can be designated as
hedging instruments.
♦ A qualifying instrument must be designated in its entirety as a hedging instrument.
The only exceptions permitted are:

(a) separating the intrinsic value and time value of an option contract and designating as
the hedging instrument only the change in intrinsic value of an option and not the
change in its time value;
(b) separating the forward element and the spot element of a forward contract and
designating as the hedging instrument only the change in the value of the spot element
of a forward contract and not the forward element; and

© The Institute of Chartered Accountants of India

 11.192 2.192
FINANCIAL REPORTING

(c) a proportion of the entire hedging instrument, such as 50 per cent of the nominal
amount, may be designated as the hedging instrument in a hedging relationship.
However, a hedging instrument may not be designated for a part of its change in fair
value that results from only a portion of the time period during which the hedging
instrument remains outstanding.
♦ Written options are not hedging instruments: A derivative instrument that combines a
written option and a purchased option (for example, an interest rate collar) does not qualify
as a hedging instrument if it is, in effect, a net written option at the date of designation.

The decision tree to determining if an instrument can be designated as a hedging instrument

is as follows:

Whether the hedging instrument is a

derivative or non-derivative?

Non-derivative financial
Derivative asset or non-derivative
financial liability

Whether a net written (a) Non-derivative FL

option? No
whose FV changes
attributable to credit risk
are recognized in OCI?
Yes or
(b) Investment in equity
instrument designated
Cannot be a hedging Can be a hedging as FVOCI?
instrument instrument

Yes

© The Institute of Chartered Accountants of India

 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 11.193
11.193

6.4 QUALIFYING CRITERIA FOR HEDGE ACCOUNTING

A hedging relationship qualifies for hedge accounting only if all of the following criteria are met:
(a) Hedging relationship consists only of eligible hedging instruments and eligible hedged
items.
(b) At the inception of the hedging relationship, there is formal designation and documentation
of the hedging relationship and the entity's risk management objective and strategy for
undertaking the hedge. That documentation shall include identification of the hedging
instrument, the hedged item, the nature of the risk being hedged and how the entity will
assess whether the hedging relationship meets the hedge effectiveness requirements
(including its analysis of the sources of hedge ineffectiveness and how it determines the
hedge ratio)
(c) Hedging relationship meets all of the following hedge effectiveness requirements:
i. there is an economic relationship between the hedged item and the hedging
instrument;
ii. the effect of credit risk does not dominate the value changes that result from that
economic relationship; and
iii. the hedge ratio of the hedging relationship is the same as that resulting from the
quantity of the hedged item that the entity actually hedges and the quantity of the
hedging instrument that the entity actually uses to hedge that quantity of hedged
item. However, that designation shall not reflect an imbalance between the
weightings of the hedged item and the hedging instrument that would create hedge
ineffectiveness (irrespective of whether recognised or not) that could result in an
accounting outcome that would be inconsistent with the purpose of hedge
accounting.

© The Institute of Chartered Accountants of India

 11.194 2.194
FINANCIAL REPORTING

6.5 ACCOUNTING FOR QUALIFYING HEDGING

RELATIONSHIPS
♦ An entity applies hedge accounting to hedging relationships that meet the qualifying
criteria.
♦ Types of hedging relationships:

Fair value hedge

Three types of
hedging Cash flow hedge
relationships

Hedge of net investment in

foreign operation

♦ Fair value hedge

A fair value hedge is a hedge of the exposure to changes in fair value of a recognised asset
or liability or an unrecognised firm commitment, or a component of any such item, that is
attributable to a particular risk and could affect profit or loss.
Where a fair value hedge meets the qualifying criteria, fair value hedge shall be accounted
as follows:

Fair value hedge

Is the hedged Hedging gain/

item an equity Gain/ loss*
recognized in loss on hedged
instrument Yes
item
designated as OCI
FVOCI
Gain/ loss Adjusted in
No recognized in carrying amount
P&L of hedged item

© The Institute of Chartered Accountants of India

 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 11.195
11.195

*Gain/ loss comprises both hedging instrument and hedged item

 If the hedged item is a financial asset (or a component thereof) that is measured at
fair value through other comprehensive income (FVOCI) other than equity instrument
designated as FVOCI in accordance with Ind AS 109, the hedging gain or loss on the
hedged item shall be recognised in profit or loss.

 When a hedged item is an unrecognised firm commitment (or a component thereof),

the cumulative change in the fair value of the hedged item subsequent to its
designation is recognised as an asset or a liability with a corresponding gain or loss
recognised in profit or loss.
♦ Cash flow hedge
A 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 recognised asset or liability (such
as all or some future interest payments on variable debt), or a highly probable forecast
transaction, and could affect profit or loss.

Where a cash flow hedge meets the qualifying criteria, it shall be accounted as follows:
(a) the separate component of equity associated with the hedged item (cash flow hedge
reserve) is adjusted to the lower of the following (in absolute amounts):
(i) the cumulative gain or loss on the hedging instrument from inception of the
hedge; and
(ii) the cumulative change in fair value (present value) of the hedged item (ie the
present value of the cumulative change in the hedged expected future cash
flows) from inception of the hedge.
(b) the portion of the gain or loss on the hedging instrument that is determined to be an
effective hedge (ie the portion that is offset by the change in the cash flow hedge
reserve calculated in accordance with (a)) shall be recognised in other comprehensive
income.
(c) any remaining gain or loss on the hedging instrument (or any gain or loss required to
balance the change in the cash flow hedge reserve calculated in accordance with (a))
is hedge ineffectiveness that shall be recognised in profit or loss

(d) the amount that has been accumulated in the cash flow hedge reserve in accordance
with (a) shall be accounted for as follows:

© The Institute of Chartered Accountants of India

 11.196 2.196
FINANCIAL REPORTING

(i) If a hedged forecast transaction subsequently results in the recognition of a

non-financial asset or non-financial liability, or a hedged forecast transaction
for a non-financial asset or a non-financial liability becomes a firm commitment
for which fair value hedge accounting is applied, the entity shall remove that
amount from the cash flow hedge reserve and include it directly in the initial
cost or other carrying amount of the asset or the liability. This is not a
reclassification adjustment as defined in IAS 1 and hence it does not affect
other comprehensive income.

(ii) For cash flow hedges other than those covered by (i), that amount shall be
reclassified from the cash flow hedge reserve to profit or loss as a
reclassification adjustment in the same period or periods during which the
hedged expected future cash flows affect profit or loss (for example, in the
periods that interest income or interest expense is recognised or when a
forecast sale occurs).
(iii) However, if that amount is a loss and an entity expects that all or a portion of
that loss will not be recovered in one or more future periods, it shall immediately
reclassify the amount that is not expected to be recovered into profit or loss as
a reclassification adjustment.
♦ Hedge of net investment in foreign operation
Hedge of a net investment in foreign operation, including a hedge of a monetary item that
is accounted for as part of the net investment, shall be accounted for similarly to cash flow
hedges:
Hedge of net investment in foreign operation

Portion of gain/loss on hedging instrument Ineffective portion

that is determined to be effective hedge

Gain/ loss recognized in OCI (Foreign Gain/ loss recognized in

currency translation reserve) P&L

The cumulative gain or loss on the hedging instrument relating to the effective portion of the hedge
that has been accumulated in the foreign currency translation reserve shall be reclassified from
equity to profit or loss as a reclassification adjustment on the disposal or partial disposal of the
foreign operation.

© The Institute of Chartered Accountants of India