Accounting for Derivatives - Ramirez Juan

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recognised in the balance sheet. The derivative matures in 20X1 and the hedged item settles in 20X2. It can be observed that only the fair value hedge provided a perfect synchronisation between the hedging instrument and hedged item recognitions.

      To be able to apply hedge accounting, the hedge must meet remarkably strict criteria at inception and throughout the life of the hedging relationship, which I will cover below.

2.1.3 Accounting for Derivatives

      I mentioned earlier that all derivatives are recognised at fair value on the balance sheet, no matter whether or not they are part of a hedge accounting relationship. Fluctuations in the derivative's fair value can be recognised in different ways, depending on the type of hedging relationship:

      • undesignated or speculative;

      • fair value hedge;

      • cash flow hedge;

      • net investment hedge.

2.1.4 Undesignated or Speculative

      Some derivatives are termed “undesignated” or “speculative”. They include derivatives that do not qualify for hedge accounting. They also include derivatives that the entity may decide to treat as undesignated even though they could qualify for hedge accounting. These derivatives are recognised as assets or liabilities for trading. The gain or loss arising from their fair value fluctuation is recognised directly in profit or loss.

      2.2 TYPES OF HEDGES

      Under IFRS 9 there are three types of hedging relationships: fair value, cash flow and net investment hedges. This section describes the main accounting mechanics of each type of hedge.

2.2.1 Fair Value Hedge

The objective of the fair value hedge is to reduce the exposure to changes in the fair value of an asset or liability already recognised in the balance sheet, or a previously unrecognised firm commitment (or a component of any such item), that is attributable to a particular risk and could affect reported profit or loss. Therefore, the aim of the fair value hedge is to offset in profit or loss the change in fair value of the hedged item with the change in fair value of the hedging instrument (e.g., a derivative). See Figure 2.1.

Figure 2.1 Accounting for fair value hedges.

      If the hedged item is an equity instrument designated at FVOCI, the hedged exposure must be one that could affect OCI.

      The recognition of the hedging instrument is as follows:

      • Losses or gains from remeasuring the hedging instrument at fair value are recognised in profit or loss (or in OCI, including hedge ineffectiveness, if the hedged item is an equity instrument classified at FVOCI).

      • If the hedging instrument is a non-derivative hedging the foreign currency risk component of a hedged item, the amount recognised in profit or loss related to the hedging instrument is the gain or loss from remeasuring, in accordance with IAS 21, the foreign currency component of its carrying amount.

      The recognition of the hedged item is as follows:

      • If the hedged item is measured at amortised cost or a debt instrument at FVOCI, the hedging gain or loss on the hedged item adjusts the carrying amount of the hedged item (if applicable) and is recognised in profit or loss. The adjustment of the carrying amount is amortised to profit or loss. Amortisation may begin as soon as an adjustment exists and shall begin no later than when the hedged item ceases to be adjusted for hedging gains and losses. In theory the amortisation is based on a recalculation of the effective interest rate for the hedged item. In practice, to ease the administrative burden of amortising the adjustment while the hedged item continues to be adjusted for changes in fair value attributable to the hedged risk, it may be easier to defer amortising the adjustment until the hedged item ceases to be adjusted for the designated hedged risk. An entity must apply the same amortisation policy for all of its debt instruments. In other words, an entity cannot defer amortising on some items and not on others.

      • If the hedged item is an equity instrument at FVOCI, the hedging gain or loss on the hedged item shall remain in OCI.

      • If the hedged item is an unrecognised firm commitment (or a component thereof), the subsequent cumulative change in the fair value of the unrecognised firm commitment attributable to the hedged risk is recognised as an asset or a liability with a corresponding gain or loss recognised in profit or loss. If the firm commitment is to acquire an asset or assume a liability, the initial carrying amount of the asset or liability that results from the entity meeting the firm commitment is adjusted to include the cumulative change in the fair value of the commitment attributable to the hedged risk that was recognised in the statement of financial position.

      A hedge of the FX risk of a firm commitment may be accounted for as a fair value hedge or a cash flow hedge.

2.2.2 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 rate debt), or a highly probable forecast transaction; and

      • could affect reported profit or loss.

      A hedge of the FX risk of a firm commitment may be accounted for as a fair value hedge or as a cash flow hedge.

      Effective and Ineffective Parts

The change in the hedging instrument fair value is split into two components (see Figure 2.2): an effective and an ineffective part.

Figure 2.2 Recognition of effective and ineffective parts of the change in fair value of a hedging instrument.

      The effective part represents the portion that is offset by a change in fair value of the hedged item and is calculated as the lower of the following (in absolute amounts):

      • the cumulative gain or loss on the hedging instrument from inception of the hedge; and

      • the cumulative change in fair value (present value) of the hedged item (i.e., the present value of the cumulative change in the hedged expected future cash flows) from inception of the hedge.

      The ineffective part represents the hedge ineffectiveness, or in other words, the portion of the change in fair value of the hedging instrument that has not been offset by a change in fair value of the hedged item. It is calculated as the difference between the cumulative change in fair value of the hedging instrument and its effective part.

      The ineffective part includes specific components excluded, as documented in the entity's risk management strategy, from the assessment of hedge effectiveness. Common sources of ineffectiveness for a cash flow hedge are (i) the time value of an option or the forward points of a forward or the foreign currency basis spread included in the hedging relationship (this situation is quite unusual as commonly these elements are excluded from the hedging relationship), (ii) structured derivative features embedded in the hedging instrument, (iii) changes in timing of the highly probable forecast transaction, (iv) credit/debit valuation adjustments and (v) differences between the risk being hedged and the underlying of the hedging instrument.

      Accounting Recognition of the Effective and Ineffective Parts

      The recognition of the change in fair value of the hedging instrument is as follows:

      • The effective portion of the gain or loss on the hedging instrument is recognised directly in a separate reserve in OCI –the “cash flow hedge reserve”.

      • The ineffective portion of the fair value movement on the hedging instrument is recorded immediately in profit or loss.

      THE TEMPTATION TO UNDERHEDGE

      An

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