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Hedge accountingis anaccountancypractice, the aim of which is to provide an offset to themark-to-marketmovement of thederivativein theprofit and loss account. There are two types ofhedgerecognized. For a fair value hedge, the offset is achieved either by marking-to-market an asset or a liability which offsets the P&L movement of the derivative. For a cash flow hedge, some of the derivative volatility is placed into a separate component of the entitys equity called thecash flowhedge reserve. Where ahedge relationshipis effective (meets the 80%125% rule), most of the mark-to-market derivative volatility will be offset in the profit and loss account. Hedge accounting entails much compliance – involving documenting the hedge relationship and both prospectively and retrospectively proving that the hedge relationship is effective.

All entities are exposed to some form of market risk. For example, gold mines are exposed to the price of gold, airlines to the price of jet fuel, borrowers to interest rates, and importers and exporters to exchange rate risks.

Manyfinancial institutionsand corporate businesses (entities) useto hedge their exposure to different risks (for exampleinterest rate riskforeign exchange riskcommodity risk, etc.).

Accounting for derivative financial instruments underInternational Accounting Standardsis covered by IAS39 (Financial Instrument: Recognition and Measurement).1

IAS39 requires that all derivatives are marked-to-market with changes in the mark-to-market being taken to theprofitand loss account. For many entities this would result in a significant amount of profit and loss volatility arising from the use of derivatives.

An entity can mitigate the profit and loss effect arising from derivatives used for hedging, through an optional part of IAS39 relating to hedge accounting.

A specific type of hedging transaction that entities can engage in aims to manage foreign currency exposure. These hedges are undertaken for the economic aim of reducing potential loss from fluctuations in foreign exchange rates. However, not all hedges are designated for special accounting treatment. Accounting standards enable hedge accounting for three different designated forex hedges:

Acash flow hedgemay be designated for a highly probable forecasted transaction, a firm commitment (not recorded on the balance sheet), foreign currency cash flows of a recognized asset or liability, or a forecasted intercompany transaction.

A fair value hedge may be designated for a firm commitment (not recorded) or foreign currency cash flows of a recognized asset or liability.

A net investment hedge may be designated for the net investment in a foreign operation.

Financial Instruments (replacement of IAS 39)

, of theInternational Accounting Standards Board

Financial Instruments: Recognition and Measurement

, of theInternational Accounting Standards Board

IAS 39 Financial Instruments: Recognition and Measurement

A summary of the IAS39 by Deloitte Touche Tohmatsu.

IAS 39 summary as provided by Deloittes IAS Plus website

Basic Fixed Income Derivative Hedging- Article on .

[1]Comparing Hedge Accounting Under GAAP and IFRS 9

Articles needing additional references from February 2012

This page was last edited on 30 May 2019, at 23:02

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