Difference Between Fair Value Hedge and Cash Flow Hedge
The first thing 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.
Why?
Because: the type of hedge determines your accounting entries. Make no mistake here. If you incorrectly identify the type of the hedge, then your hedge accounting will go totally wrong.
But here’s the thing:
Although all types of hedges are neatly defined in IAS 39/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. Most of them were audit managers and seniors – so not really freshmen, but experienced and highly qualified people.
Yet after about 5 or 10 minutes of speaking about different types of hedges, one audit manager interrupted me with the question:
“Silvia, I get the definitions. 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?”
Of course.
What types of hedges do we have?
Although I clearly explain a hedge accounting in details in my IFRS Kit, let me shortly explain what type of hedges we have:
- Fair Value Hedge;
- Cash Flow Hedge, and
- Hedge of a Net Investment in a Foreign Operation – but we will not deal with this one here, as it’s almost the same mechanics as a cash flow hedge.
First, let’s explain the basics.
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.
That’s the definition in IFRS 9 and IAS 39.
So here, you have some “fixed item” and you’re worried that its value will fluctuate with the market. 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.
In such a case, you need to make the following steps:
- Step 1:
Determine the fair value of both your hedged item and hedging instrument at the reporting date; - Step 2:
Recognize any change in fair value (gain or loss) on the hedging instrument in profit or loss (in most cases).
You need to do the same in most cases even if you don’t apply the hedge accounting, because you need to measure all derivatives (your hedging instruments) at fair value anyway. - Step 3:
Recognize the hedging gain or loss on the hedged item in its carrying amount.
To sum up the accounting entries for a fair value hedge:
| Description | Debit | Credit |
| Hedging instrument: | ||
| Loss on the hedging instrument | P/L – FV loss on hedging instrument | FP – Financial liabilities from hedging instruments |
| OR | ||
| Gain on the hedging instrument | FP – Financial assets from hedging instruments | P/L – FV gain on hedging instrument |
| Hedged item: | ||
| Gain on the hedged item | FP – Hedged item (e.g. inventories) | P/L – Gain on the hedged item |
| OR | ||
| Loss on the hedged item | P/L – Loss on the hedged item | FP – Hedged item (e.g. inventories) |
Note: P/L = profit or loss, FP = statement of financial position.
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.
Here, you have some ”variable item” and you’re worried that you might get less money or have to pay more money in the future than now.
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?
Assuming your cash flow hedge meets all hedge accounting criteria, you’ll need to make the following steps:
- Step 1:
Determine the gain or loss on your hedging instrument and hedge item at the reporting date; - Step 2:
Calculate the effective and ineffective portions of the gain or loss on the hedging instrument; - Step 3:
Recognize the effective portion of the gain or loss on the hedging instrument in other comprehensive income (OCI). This item in OCI will be called “Cash flow hedge reserve” in OCI. - Step 4:
Recognize the ineffective portion of the gain or loss on the hedging instrument in profit or loss. - Step 5:
Deal with a cash flow hedge reserve when necessary. You would do this step basically when the hedged expected future cash flows affect profit or loss, or when a hedged forecast transaction occurs – but let’s not go in details here, as it’s all covered in the IFRS Kit.
To sum up the accounting entries for a cash flow hedge:
| Description | Debit | Credit |
| Loss on the hedging instrument – effective portion | OCI – Cash flow hedge reserve | FP – Financial liabilities from hedging instruments |
| Loss on the hedging instrument – ineffective portion | P/L – Ineffective portion of loss on hedging instrument | FP – Financial liabilities from hedging instruments |
| OR | ||
| Gain on the hedging instrument – effective portion | FP – Financial assets from hedging instruments | OCI – Cash flow hedge reserve |
| Gain on the hedging instrument – ineffective portion | FP – Financial assets from hedging instruments | P/L – Ineffective portion of gain on hedging instrument |
Note: P/L = profit or loss, FP = statement of financial position, OCI = other comprehensive income.
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.
Please, ask first:
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.
Why is that?
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.
I’m referring to “GET” or “PAY” only for the sake of simplicity. In fact, you don’t even need to get or pay anything in the future – you’re just worried that the item will have a different carrying amount in your books that its’ fair value.
Fair Value Hedge Example
You issued some bonds with coupon 2% p.a.
It’s nice that you always know how much you’ll pay in the future.
BUT you are worried that in the future, market interest rate will be much lower than 2% and you will be overpaying (in other words, you could get the loan at much lower interest in the future than you will be paying at the fixed rate of 2%).
Therefore, you enter into interest rate swap to receive 2% fixed / pay LIBOR12M + 0.5%. This is a fair value hedge – you tied the fair value of your interest payments to market rates.
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.
Why is that?
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.
In fact, in a cash flow hedge, you want to FIX the amount of money you’ll get or pay – so that this amount would be the same NOW and IN THE FUTURE.
Cash Flow Hedge Example
You issued some bonds with coupon LIBOR 12M+0.5%.
It means that in the future, you will pay interest in line with the market, because LIBOR reflects the market conditions.
BUT – you don’t want to pay in line with market. You want to know how much you will pay in the future, as you need to make some budget, etc.
Therefore you enter into interest rate swap to receive LIBOR 12 M + 0.5% / pay 2% fixed. This is cash flow hedge – you fixed your cash flows and you will always pay 2%.
To Sum This All Up
Now you can see that the same derivative – interest rate swap – can be a hedging instrument in a cash flow hedge as well as in a fair value hedge.
The key to differentiate is WHAT RISK you hedge. Always ask yourself, why you undertake the hedging instrument.
But it’s not that simple as it seems because there are some exceptions in IAS 39 and IFRS 9.
For example, even when you have a fixed item, you can still hedge it under cash flow hedge and protect it against foreign currency risk.
Equally, you can hedge a variable rate debt against fair value changes – and that’s the fair value hedge.
Therefore, please refer to the following table summarizing the types of hedges according to risks and items hedged:
| Item hedged | Risk hedged | Type of hedge |
| Fixed-rate assets and liabilities | Interest rates, Fair value, Termination Options | Fair value hedge |
| Fixed-rate assets and liabilities | Foreign currency, credit risk | Fair value hedge or cash flow hedge |
| Unrecognized firm commitments | Interest rates, Fair value, Credit risk | Fair value hedge |
| Unrecognized firm commitments | Foreign currency | Fair value hedge or cash flow hedge |
| Variable-rate assets and liabilities | Fair value, termination options | Fair value hedge |
| Variable-rate assets and liabilities | Interest rates, foreign currencies, credit risk | Cash flow hedge (most cases) |
| Highly probable forecast transactions | Fair value, interest rates, credit risk, foreign currency | Cash flow hedge |
Now, I’d like to hear from you. Please leave me a comment and let me know whether you have dealt with some hedge accounting in practice, what issues you faced and how you solved them. Thank you!
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239 Comments
Leave a Reply
thank you for this. we do foreign currency forwards at the year-end, cause we buy in usd. but they are short-term and we don’t book them as hedges. is it wrong?
Hi Anilla, no, it’s OK. Hedge accounting is OPTIONAL, not obligatory. So if you prefer to keep it simple, it’s OK to revalue your forwards to fair value and that’s it. Mainly when the forwards expire within some short term. S.
hi silvia, is the posting of the ineffective portion a balancing figure ? oomesh from mauritius
Hi, Oomesh, yes, basically it is. The gain or loss from change in FV of hedging instrument = effective portion (to OCI) + ineffective portion (to P/L). Take care! S.
Hi Madam,
Just wanted to ask what is the specific difference in hedge accounting between Cash flow hedge and Fair value Hedge.
Mayur, please revise the 2 tables above where you can see the tables with journal entries for both hedges. But the main difference is, that at CF hedge you don’t touch the hedged item and you revalue only hedging instrument + you need to split the gain/loss to effective and ineffective portion+effective goes to OCI and ineffective to P/L.
At FV hedge, you revalue both hedging instrument and hedged item and if the hedge is effective, you put gain/loss from both elements to P/L.
S.
Hi silvia
m c.a finalist n m finding it quite difficult to learn about how derivatives and hedging work and about their definition and accounting treatments in the light of ifrs. please help me out if u have easy to understand easy material on mentioned topics.
Hi Anjum,
yes, I have an easy-to-understand material about hedging, however, it is included in the IFRS Kit http://www.cpdbox.com/ifrs-kit.
Kind regards, S.
Hi silvia,
Hope you are doing well.
I have quesgion regarding IAS 20 with IFRS 9.
If an entity receives loan from Government @ LIBOR -1% and entity is not subject to IFRS 9 application Would it still account for it as Government grant?
Reference; kindly you may refer to Para 10A of IAS 20.
Thank you.
Hi Silvia,
in this case with short term forward agreements classified as CF hedge what will be the accounting entries? I will go for a forward agreement for 21 days to buy a fixed amount of USD (functional currency is RSD) in order to pay for the acquisition of a PPE (I know the exact amount of this order). How can I record the loss calculated for this agreement as being the difference between spot rate and the actual exchange rate at the settlement date? Many thanks
Hi Silvia,
I am doing an audit for an oil refinery, where they purchase crude and process it and sell the final product.
Please tell me that hedging performed for purchase of crude in order to tackle the risk of price movement of crude, will it be classified under cash flow or fair value hedge??
hi Silvia, thnks , I did P2 in 2012 in quite forgotten some bits , thanks once again . this is a very challenging IFRS ! BEST REGARDS . OOMESH .
Thanks Sylvia. . Difficult subject matter well explained.
Kind regards
Raj..
Thank you very much Silvia. When are you going to take us through Hedge of net investment in a foreign operation in this manner?
Hi James, well, I did not want to cover it here, because once you see this type of a hedge, you can clearly identify it – there’s no doubt about the type of the hedge 🙂 But I’ll do it. The thing is that not many people are interested in this topic, because that type of hedge is taken mostly by bigger companies or corporations and some IFRS expert solves it for them 🙂 S.
Hi Silvia,
Kindly explain the meaning of effective and ineffective portion as I m unable to understand it.
Rajesh,
Effectiveness is the measure that how successfully hedging instrument has covered the fluctuation in hedged item.
OK! how we determine that it effective or not
Hello Madam,
Have a following doubt.
If company has issued foreign currency fixed interest rate bond than and to hedge currency risk and interest rate risk it has undertaken cross currency interest rate swap than can this hedge be qualified for both fair value hedge (for interest rate movements) and cash flow hedge (for cross currency movements).
If yes than this hedge will be subject to cashflow hedge accounting treatment for currency movements and fair value hedge accounting treatment for interest rate movements.
Hello, Mayur, this is a great and interesting question.
The answer depends on the construction of the hedging relationship, but to make it short: what you described is totally doable. If your CCIRS (cross-currency interest rate swap) is constructed in a way that currency risk element is separable from interest rate risk element, and if these two elements can be separated and measured separately also for your fixed interest rate bond, then you can do it. You just need to designate it in your hedging strategy that way.
I have seen that CCIRS can be used in various types of hedges, for example, pure cash flow hedge (if swap is fixed for fixed, just in a different currency), also pure FV hedge (fixed for floating). By the way, if you want to keep your life easier, you can designate your hedge as CF or FV only, depending on the type and conditions of CCIRS. Have a nice day! S.
Thank you Silvia for the explanations above , i have one question , can we have a fair value hedge against a Fixed rate bond classified At Amortized cost” to hedge the interest rate risk ?
Yes, you can. In that case, any hedge adjustment is amortised to profit or loss based on a recalculated effective interest rate – so not right away to P/L. S.
Hi Silvia,
when fair value adjustments are amortized to p/l, isn’t there still the problem that financial statements do not represent the effect of an entity’s risk management? (when only the amortized volume is recognized in p/l for a period?)
Thanks in advance and kind regards, Janni
Hi Janni,
I don’t think so. When you keep an asset at FVTPL, then you put all the difference from revaluation in P/L at once, you do NOT “amortize it” over time. S.
Thank you very much Silvia,
Bank A (Subsidiary) in 2006 started to use Interest Rate Swaps- The Bank A pays fix and
receives variable interest rates from Bank B (Parent). The main purpose of these instruments is to mitigate the interest rate risk associated to the fixed rate lending (difference between loans –deposits)
For two years (2006&2007) Bank A recognized in Income Statement: Expenses in IRS SWAP and Income from SWAP
In 2008 Bank A recognized Negative fair value financial derivative instruments through profit or loss.
Please can you help in question below:
• According IFRS is allowed Subsidiary to use Interest Rate Swaps with Parent (Related Party)
• Is correct to recognized Negative fair value financial derivative instruments through profit or loss
• Can you help how to calculate fair value for Interest Rate Swaps
Thank you very much,
Hi Visar,
OK, let me go straight to your questions:
1) Yes, IRS can be arranged between 2 related parties. But in this case you need to make appropriate disclosures and also, you need to be careful because IRS between related parties are not necessarily arranged at market conditions (=fair values) and as a result, you would need to make appropriate adjustment to bring it to the fair value. Maybe it’s not your case though.
2) Of course. Is it officially designated and treated as a cash flow hedge? Because if not, then you don’t have any other choice but to recognize all gains or losses from derivative in profit or loss.
3) This is much more complex topic. I have covered it in my IFRS Kit where I show how to calculate the fair value of plain vanilla interest rate swap (same currency, fixed for floating). However, the calculation of IRS’s fair value depends on HOW exactly it is constructed and may require complex modelling.
Have a nice day!
Silvia
Thank you very much Silvia,
Just to clarify,
How should Bank A classify type of hedge in this scenario?
(Bank A (Subsidiary) use Interest Rate Swaps- The Bank A pays fix and
receives variable interest rates from Bank B (Parent).)
Cash flow hedge or
Fair value hedge
I sincerely appreciate the time you spent in my issue
Best regards,
Visar
That would be a cash flow hedge for the bank A. If the swap is opposite (A pays floating, receives fixed), then it’s a fair value hedge. S.
Hi Silvia
Wrt your reply to Visar, wont it be a FV hedge if Bank A is paying fixed as per your initial examples as the Swap is the hedging instrument in this case.
Regards
Amit
Yes, Amit, that’s what I wrote above.
Hi Silvia
Sorry, but I think I didn’t frame my question correctly earlier. If bank A is paying fixed that means it has a variable rate liability which it is hedging. So as per the example given under CF hedge above this should qualify under CF hedge for Bank A.
Regards
Amit
Hi Amit, my head turns around now 😀
You see, it’s usually not that easy to realize what risk we’re hedging.
So once again:
Hedged item = variable-rate loan
Hedging instrument = IRS with pay fixed, receive variable => then pay variable receive variable cancel out, so we’re left with pay fixed. Which is CF hedge as we’re fixing the amount of cash to pay. Hope it’s clear now 🙂
Thank you very much Silvia,
Kind regards
Visar
Can you tell me how many types of risks are there for which hedging can be done. As per me there are four risks– market price risk, interest rate risk, credit risk and foreign currency risk.
Regds
Sambhav
Hi Sambhav
In my view hedging for FX Risk, Interest Rate Risk and Credit Risk (limited) can be done by hedging. Other components of Market Risk due to macroeconomic scenarios can be managed by diversification.
Regards
Amit
Hi Silvia,
Very helpful article and thanks for explaining such a complex area in a very simple manner.
I understand that when a company goes for fair value hedge accounting, they take the accounting priviledge on the hedged item unlike a cash flow hedge where the same is taken on the hedging instrument.
I have couple of questions;
1. Can a fair value hedge be applied to Available for Sale securities? If yes then do we take the FV changes to P/L instead of OCI?
2. When I am entering into a FV hedge for a fixed rate debt (as mentioned in your example), I understand we do a fair valuation of the interest component for the debt (since FV of debt might also include other variable factors like credit risk, liquidity risk etc). In such case do I split the FV component and show them separately from the host debt contract?
Many thanks in advance
Regards,
Manish
Dear Silvia,
I have an ACCA P2 exam in December 2014 and I’m a bit confused with all these changes lately, so my q is: which standard we should refer to when dealing with financial instruments in our exams, IFRS 9 or IAS 39?
Thank you in advance
Hi Nena, don’t worry about this, you will be told in the question what to use. If not, and the accounting treatment in IAS 39 is different from IFRS 9, then simply make your choice and don’t forget to write it clearly in your answer. Remember that ACCA examiners give marks for stating the obvious, so do it 🙂 S.
Thanks silvia, the topic is explained in a perfect manner. Was very helpful and interesting.
Silvia. I am doing a college assignment. in notes of a financial statement by a company i saw this statement
“Hedging reserve we have relates to the effective portion of the cumulative net change in the fair value of cash flow hedges related to hedged transactions that have not yet occurred”.
Can you please tell me what type of hedging reserve this is? i find it a bit confusing. it would be highly appreciated if you could give me an answer today or tomorrow as my assignment is due tomorrow
Thank you in advance
Well, when you account for cash flow hedges, then you calculate effective and ineffective portion of FV change in your hedging instrument. The ineffective portion is recognized in P/L and the effective portion in OCI. This effective portion in OCI is then called “hedging reserve” – hope that’s clearer. S.
Thanks a lot Silvia
it really helped. can you tell me the difference between hedging reserve and share premium… i know its different but still need some point
Thanks Again
Silvia,
For a fair value hedge using an interest rate swap to hedge corporate bonds, do the notional values of the swap and the bond(s) have to be the same? Do the terms of the swap and the corporate bonds have to be the same?
Thank you!
Gail
Hi Gail,
IAS 39/IFRS 9 do not state this requirement. Notional values can be different, but in such a case, you’ll have a harder time to prove that your hedge is effective and qualifies for hedge accounting (as the terms in your hedged item and hedging instruments do not match). But I don’t say it’s impossible. S.
Hi Silvia
Lucid explanations to explain the hedge treatment. Thank you.
However am not sure what type of hedge would i classify a currency forward to hedge a payment for acquiring a fixed asset in future (the currency in which the payment is made is different from the functional currency). The purchase of fixed asset is committed hence I could call this unrecognized firm committment (hedged item) and the risk hedged is the foreign currency. Looking at your table where you have summarized the types of hedges it looks like we could use both Cashflow hedges or Fair value hedges which seems to be a bit confusing. Can you please clarify this.
Thank you
Harry
Hi Harry,
it depends on what you hedge. For example:
1) If you know your machine will cost the exact amount in the foreign currency in the future, and you want to protect just against foreign currency rate movements, then you can treat as a cash flow hedge.
2) If you’re not sure about the future price of your machine and you’re afraid of the price increase in the foreign currency, then it’s basically fair value hedge.
And there are lots of combinations, too. Hope it’s clearer! S.
Hi Silvia
Thanks for the clarifications. Yes the purchase price payable is fixed in foreign currency. Since the amount payable is fixed in foreign currency, since we are dealing with fixed item i pretty much concluded that we are dealing with the fair value hedge. Shouldnt this be the case? Are we talking about exceptions here? Please let me know
Thank you
Warm Regards
Harry
Dear Harry,
the thing with unrecognized firm commitments is that IAS 39 permits to hedge foreign currency risk under both fair value and cash flow hedge.
Above, I suggested to treat it as a cash flow hedge, because in your case, the amount to pay in the foreign currency is fixed – that’s true, but in fact, the amount to pay in your own currency is variable as it fluctuates with the changes in the foreign exchange rates. It’s very similar to typical receivable or payable.
But as I wrote, IAS 39 allows you to account for hedge of unrecognized firm commitment under both types of hedges.
Silvia, thank you for the excellent write up and question responses. However I am confused by your answer to Harry’s question. In the detailed article at the top of the page you explained that a fixed value item will be hedged using a fair value hedge. As the price of that item fluctuates in your local currency, your hedge PnL will offset the item’s PnL (in local currency). However, in your response to Harry’s question you’re saying that a cash flow hedge should be used. What am I missing?
Thank you.
Hi George, if I read my answer correctly. I suggested both hedges in this case, based on what risk Harry is hedging.
Silvia,
With reasons can you explain whether hedging reserve is a distributable reserve or non distributable reserve?
it would be highly appreciated if you could give me an answer today
Thank you in advance
Non-distributable. At some point in the future, it will reverse in P/L. S.
Dear Silvia
Thanks for the clarifications. I understand this much better now. I assume in such cases that there are no advantages in using a particular type of hedge accounting. If you think there is there an advantage in using a particular type of hedge accounting, can you explain with the reasons.
Regards
Harry
We are an European country (EUR) and we have a contract in Middle East (AED) for the next 5 years (long term), so our risk is a foreign currency risk, thus, Should we do a cash flow hedge better than fair valur hedge?
Are there some “clues” to identify the choice (FV hedge or CF hedge) in this kind of situations? For example:
-> Contracts > 1 year or
-> Hedges > EUR 500k
etc.
You recommend to work with CF hedge btter than FV hedge…
Thank you.
How to determine the effective and ineffective portion of cash flow hedge.
Thanks
I have same question
OK, let me reply, although it’s not really a topic to cover in 1 comment:
You simply need to compare the change in FV of your hedged item and the change in FV of your hedging instrument (in CF hedges).
Let’s say change in FV of hedging instrument is +100, and change in FV of hedged item is -90. It means that this hedge is not perfectly effective (in such a case, change in FV of hedging instrument would be 90 and there would be 100% offset). However, percentage of offsetting is 111% (100/90) which is very effective.
Now, the effective part of change in FV of hedging instrument is then 90, and ineffective part is 10 (100-90).
Is it clear, guys? 😉
Thanks a lot Silvia, really appreciate it. I guess its more clear now. But what if it was the other way round? Change in FV of Hedging instrument was +90, and change in FV of Hedge item was -100.. Then what will we do?
Thanks again for your help 🙂
Hi Anas,
above, I described “over-hedge”. Here, you described “under-hedge”.
In CF hedges, if there’s under-hedge, then there’s no ineffective portion and you should take all the change in FV of hedging instrument to OCI.
If there’s over-hedge in CF hedge, then you split change in FV of hedging instrument to effective and ineffective portion just as I described above.
Hope it’s clearer now. S.
Hi Silvia,
Very helpful article and thanks for explaining such a complex area in a very simple manner. It would be great if you can clear my dobut. I had asked this before and guess it was missed.
I understand that when a company goes for fair value hedge accounting, they take the accounting priviledge on the hedged item unlike a cash flow hedge where the same is taken on the hedging instrument.
I have couple of questions;
1. Can a fair value hedge be applied to Available for Sale securities? If yes then do we take the FV changes to P/L instead of OCI?
2. When I am entering into a FV hedge for a fixed rate debt (as mentioned in your example), I understand we do a fair valuation of the interest component for the debt (since FV of debt might also include other variable factors like credit risk, liquidity risk etc). In such case do I split the FV component and show them separately from the host debt contract?
Many thanks in advance
Regards,
Manish
Hi Silvia, thanks for being helpful and so clear! In the case of a variable rate bond, why would a fair value hedge be needed? Since by its very nature, a variable rate bond would be at fair value.
Hi Silvia,
Good day!
Would appreciate your insights on this…
We’re an importer of raw materials and pay the same in USD. We use FOB Shipping point terms. To hedge against the volatility of Forex we entered into a Forward contract to ensure that we already have a fixed amount of local currency equivalent to pay for the obligation. How should be clasifty this transaction? What are our proposed entries to record this transaction? Should we recognize the RM at the forward rate amount or the FOB date forex.
Thanks in advance and hope you can help us.
Hi Silvia. Your explanation is great. However, there’s one thing I’d like to ask. If the an entity’s commitment fixed only the quantity and date of the purchase while the price is fixed on a certain benchmark, is it still considered as firm commitment and should apply fair value hedge?
I have a question regarding the hedge relationships, from a banks perspective,
lets say a bank provides a interest rate gurantee on a mortgage for a period of 6 months. To reduce the risk that the bank is exposed to, the bank begins to economically hedge the risk via derivatives.
Based on this information – would this be a fair value hedge relationship? the hedge item is the fixed interest rate? or would the hedge item be the potential variable interest rate to be received when the customer funds their mortgage?
thanks
For me it seems like it is a fair value hedge, meaning that the hedged item is a “fixed-rate” interest rate.
hi Silvi,
What about commodity price hedge this i suppose also can be either cash flow or fair value hedge. In this case the FV of the hedged instrument will be the unrealised gain or loss as per the broker statement but what about the gain or loss of the hedged item? Will this be the same?
Eg customer wants to buy aluminium for USD 2K on 7th Jan and so supplier hedged the same quantity of aluminium at USD 2K on same date on 7th Jan. Broker statement will be USD 10 loss, so will this also represent the gain or loss on the hedged item and hence no entry will be passed? Thanx in advance
Dear Rima,
it really depends on the type of the hedge.
If you have a fair value hedge, then you book both FV gain/loss on hedging instrument and FV loss/gain on hedged item.
In a cash flow hedge, you need to measure effective/ineffective portion of the loss/gain on hedging instrument and if the hedge is still effective, you book ineffective part in P/L and effective part in OCI.
If I understand it correctly, the supplier holds aluminium for its client and contract’s price is fixed, so is supplier hedging the fair value of its inventories of aluminium? If yes, then it’s FV hedge.
hi Silvia,
i found some materials that the change in fair value of hedge instrument was discounted. i.e. discount period from closing date till settlement date.
my question is: when and/or what type of hedge do we use discounting the changes of FV?
thanks. would be very helpful.
Awesome explanation – thanks so much. Wonder if the predictability of the expected future cash flow is a required for the hedge accounting at inception. Say I am buying Foreign inventory payable in their currency and then If I as a practice keep taking different maturities of hedges to settle that due. My question is only after i purchase that inventory should I take that hedge can I use the hedge accounting or is it just the predictability of the forecasted purchase to offset my currency exposure (variable here). I am assuming that this is cash flow hedge
Thank you – I stumbled upon your resource – its brilliant
Hi Aparna,
thank you!
You can hedge highly probable forecast transactions – this would be your case. You don’t have to purchase the inventory in order to hedge, but the transaction must be highly probable. And yes, that would be a cash flow hedge.
S.
Hi Silvia. In relation to an investment in a foreign currency, does the hedge term have to meet the expected life of the investment. If so, what would occur if you cannot get a hedge to match the expected life of the asset, or if there was no defined term for the life of the asset, eg if you were buying property.
Hi Tony, not necessarily. If you can demonstrate that the hedge will still be effective and meets its objective, then OK. But in this case, it is very probable that there will be some ineffectiveness in the hedge, caused by different “maturity periods” of hedging instrument and hedged item. S.
Hi Silva,
Nice reading about Hedge Accounting, please help me to have better understanding, i want to ask you that:
1.how to calculate hedge effectiveness at the first cut off reporting period, because we just start to calculate the fair value and there is no changes in fair value movement?
2.how to calculate the ineffective portion? For example when the calculation set at 130%,is it only the portion amount of 130%-120% will be charge at Profit and Loss?
3.for fair value hedge at the perfectly match of Hedge Items versus Hedge Instruments, is it always perfectly offsetting in Profit and Loss between changes in Fair value of Hedge Instruments and Hedge Items?
4.in a very fluctuative exchange rate conditions, our company set several CCIRS transactions where our Hedge items is bank loan, the main problem is that our on balance sheet hedge items revaluated at each reporting period and then the net settlement from CCIRS also resulting a foreign exchange exposure due to different between book rate compare to spot rate when we receive or pay the CCIRS, is it my accounting treatment is not proper?
5. For a perfectly match condition of Hedge Items versus Hedge Instruments, can we only applied for critical match method for hedge accounting?
I would like to thanks in advance for your favourable reply.
Rgrds,
Ferry
Hi Silvia,
Needed a clarification:-
In case a Co whose reporting currency is INR & has fx risk on account of export receivables in USD, has a fixed rate debt issued in INR in its books.
The Co intends to swap this INR debt with a CCIRS where it receives fixed rate INR Interest & pays floating libor USD. On the final prinicipal exchange it receives INR & pays USD.
Through this the Co intends to naturally offset USD payment against its forecast receivables in USD.
Can this CCIRS be put into a cash flow hedge against highly probable forecast exports? The following issues may arise:-
1)Through the swap I am converting a fixed liability into floating which will require fair value hedge accounting.
2) The risk being hedged is fx risk for forecast trnsaction which will require cash flow hedge accounting.
3) At the time of taking the swap, the INR debt in the books has no risk involved.
Your guidance on the same would be appreciated.
Thanks So Much Silvia. This Is “Hedge Accounting Made Easy”.
Please i really néed to get your IFRS KITS, but i need You to confirm to me the pricé and the last edition
Specifically, does the newest édition of the IFRS KIT covers the completed version of IFRS 9- Financial Instruments.(i.e Released July 2014).
Please i need a response as urgent as possible.
thanks.
Hi Oluwaseun, I’ve just responded by e-mail, but to answer: YES, the IFRS Kit does include the newest version of IFRS 9. S.
i want to know about use of cash flow at risk in intelligence hedging decision?can u help me plz
Hi Silvia, thanks for such great explanation. I have been reading IAS 39, IFRS 7 and 9 and I still did not had an clear understanding between Fair Value and Cash Flow Hedge. I knew that I have to identify the risk, the hedge item, hedge instrument, strategy, economic relationship, effective and inefective portion and many other issues.
I work in treasury and am responsible for the follow up of financial instruments and their accounting/financial treatment. My industry is Coffee, a well known Commodity. So I will make up the context to you.
Hedge item: Arabica Coffee inventory bought at a fixed price.
Hedge instrument: Arabica Coffee Futures Contracts traded in Intercontinental Exchange (ICE, NY).
Economic relationship: the item is arabica coffee and the instrument is Arabica coffee futures. So the economic principle is very clear for me.
Strategy: Short Hedging for selling commodities.
Risk: possible decline price
Action: when we buy the coffee in the cash market, we hedge the inventory doing the oposite in the futures market (Sell) and buying futures later (buy) when is time to sell.
We do not have risk on the buying side of coffee in cash market since, we buy on spot price always. We never buy on a forward or time in advance later. In the same day we make a purchase contract of coffee(1 lot 375 bags of 46 kg), we fix a buying price, and that is the entry price for us to enter the futures market and start the Short hedge by selling (1 lot 375 bags of 46kg) futures Arabica coffee contracts in the futures market. Giving us a short position on the futures market, and long position on the cash market.
Now, on the sell side, we do make forward contracts to deliver an exact amount of coffee (e.g. 5 lots) at an exact quality(High Grown European Preparation HG EP), exact time (shipment on May N15 July expiration month), and exact place (Port FOB). But we do not fix a price, so we call these forward contracts Price to be fix (PTBF).
Now, that I have explain you the context, I will get you to the big deal I have.
Our company is implementing IFRS Full for the first time on FY14. Our Auditors are Deloitte. On the previous year we have been using Local GAAP. (Which does not even know or recognize financial instruments accounting treatment other than ordinary Assets and Liabilities.
We have these Derivaties (Financial Instruments) and we use them as hedging instruments, both item and instrument are well defined as I have mentioned before. Now let´s try to find out if the hedge item is a Fix or Variable item.
You mentioned that inventories are Fix item. That is ok for inventories of items that are not listed on Exchanges. For example, cars, iPads, beds, shoes, etc. But for coffee, we have an active market (Level 1). The information of these prices are available for everyone and they are a common ordinary item. Nonetheless, commodity prices are very volatile, and prices can vary more than 100% in less than one year.
We can say we have a fix item on the buy side, but as I mentioned before we do not make commitments to buy on forward prices just spot prices. And we sell on PTBF that means our value of our sales are unknown, and so are the cash flows related to the income of our physical inventory of coffee.
My boss financial controller says that the inventories are an asset an therefore should be treated as a fair value hedge. The auditos initially wanted to treat the inventory with IAS 2, and Net realizable Value NRV. I do not agree. I have change auditors mind that commodity inventories should not be treated as NRV since the IAS 2 clear states it should be treated as Fair Value. That is ok if the inventories were not hedge. And since we do not like risk, and we want to offset market price risk, we use coffee futures to mitigate that risk.
If we had firm commitments or contracts that represent the sale of our inventory we could treat them as Fair value less cost to sell. But since we do not have a fix price, and we are hedging them, I think, understand and belief they should be treated as a Cash Flow Hedge.
To add more context, we do have the practice of making the mark-to-market valuation approach, which in other words represent fair value of inventories.
As we are hedging the inventory that Is ready for sale but with a PTBF contract, there should be an account that records the variation on fair value of the hedge item (lets call PNL of the inventorie) and should be recorded against a reserve of equity, called (Reserve of PNL of coffee inventory) although they are called PNL that does not mean I am saying the effects should be taken to P/L statement.
On the financial instrument (derivative)[by the way I read commodity contracts are not financial instruments how is that possible or when is it????] And this should have an impact on its fair value depending on the market price. If prices goes down I will have an unrealized gain, and if prices go higher I will have an unrealized loss, ok? Because the futures market position is Short Hedge.
MY approach is the following.
Any variation of the hedge item and hedge instrument should be taken to :
Price Hedge item Dr. Cr.
Higher Gain Asset (Gain inventorie) Cash flow Reserve (Gain)
Lower Loss Cash Flow Reserve (Loss) Liabilitie (Loss)
Hedge instrument
Higher Loss OCI (Loss) Liabilitie (Loss)
Lower Gain Asset (Derivatie gain) OCI (Gain)
If the hedge is 100% effective, any ineffectiveness should be taken to Income statement for the FY of the change in price as the date of the FP.
We then arrive to the time to make the sell, and we have a known sell price.
Cash market (offset gain or loss on Cash Flow reserve Equity)
Future market (reclassify gain or loss to income statement when the price is know, and we buy the futures contract we had initially sold. That exit price will be my new fix price for the sale and the PTBF expires so I do not need any hedge since the market price risk have disappeared.
The main reason for these treatment I recall again, is the condition that I have a variable item hedge and not a fix variable hedge (coffee inventory).
Who makes more sense, me or my boss? Or the auditors?
Dear Jacinto,
thank you for your comment, and really let me thank you for your trust you placed in me and for posting me this question. However, to answer this question properly, I would need to dedicate more time than I currently can afford. I believe quick response would not give you the quality and diligence that everybody (also you) expect from my work.
Hence I leave it to other readers to go through your questions and tell you their opinion. When I have more time, I may eventually come back to it.
Hope you understand. S.
Hi Silvia, thanks for you explanation, very useful. Assuming a perfect hedge lets say either in the form of a cash flow hedge or fair value hedge. A fair value hedge will have zero FX impact because underlying is at same spot rate as hedge and they both mature at same rate. For cash flow hedges the spot will be taken in advance of the underlying being on your balance sheet so although they mature on the same date the initial value will be different and so FX gain/loss will be recognised. Is that a fair synopsis?
Hi Silvia, also as you mentioned “For example, even when you have a fixed item, you can still hedge it under cash flow hedge and protect it against foreign currency risk.
Equally, you can hedge a variable rate debt against fair value changes – and that’s the fair value hedge.”
In this example you said, we can hedge a variable debt against fair value changes and thats fair value hedge. This is exceptional, right. Can you please explain how are we hedging this?
Hello Silvia. I have one question. Is effectiveness or ineffectiveness only calculated in relation to cash flow hedging relationships or is it also applicable to fair value hedging relationship? Thank you for your time.
Every hedge must meet hedge effectiveness criteria in IFRS 9 in order to apply hedge accounting. If these are met, then you can apply hedge accounting, if not – then no hedge accounting.
However, hedge can me effective, but not perfectly effective.
Measuring “how much ineffectiveness” is applicable for cash flow hedge as you recognize ineffective portion in P/L and effective portion in OCI. For fair value hedges, you only need to determine whether your hedge is effective or not, but once your hedge meets effectiveness criteria, you do not measure effective and ineffective portion separately.
Hi Silvia, with regards to your answer to Xavier’s question, is it correct that for Fair Value hedges we only record the effective portion of the hedging instrument to P/L and no journal entry for the ineffective portion?
No, not this way. Once your hedge is effective, then you record the full change in fair value (hence both parts) in profit or loss, on both hedged item and hedging instrument (at cash flow hedges, you are recording only the changes in fair value of hedging instrument split to effective and ineffective part).
By the way, here’s the article with podcast on measuring the hedge effectiveness, it will shed some light on the topic. S.
What is effective and ineffective portion, Please give a suitable example. |?
Dear Raj,
please revise the above comments, there’s a mention above. Also, I talk about these issues fully in my IFRS Kit. However, maybe in 1 of my future articles, I’ll bring simple illustration,too. Have a nice day! S.
Iam still very confused when you still talk of IAS 39 yet my tutor told me that it was replaced long time ago by IFRS 9
Hi Julius,
it’s just a partial truth. Today, there are 2 valid standards: IAS 39 and IFRS 9 and the companies can make a choice which one to apply. IAS 39 stops being valid after 1 January 2018 only, so from 2018, there will be only IFRS 9.
Hi Sylvia
I also came across this ifrs box nd wow! You’re good at what you do.
Just a quick 1 though, hedge accounting for a basic FV hedge is exactly the same as normal accounting treatment of the hedging instrument and item. Cos I really don’t c the difference between when we apply hedge accounting and when we don’t?
Only difference comes with CF hedges.
Am I right in this!
Hi Glen,
thank you!
Well, not really. FV hedge is a bit different from “normal” accounting treatment. Yes, it’s true, that for hedging instrument, you use some derivative in most cases and its fair value change is recognised in P/L anyway. But for the hedged item no. For example, if you hedge your inventories at FV, then you also recognise a change in FV of your hedge item (inventories), while normally, you keep your inventories at lower of cost or NRV (IAS 2).
Have a nice day!
Silvia
Crystal clear – thanks!
What difference does it make whether you designate a fair value hedge or not, as far as I can see the movements in the values of the hedging instrument and the underlying item both go through the P&L irrespective of whether you designate or not.
Dear Doug,
that’s not true, please refer to my above comment. Some “hedged items” are not revalued through P/L without FV hedge (e.g. inventories). S.
Dear Silvia,
Thank you for a very very useful web site. I would like to kindly ask a question.
What if the hedged item is already recognised receivable which is denominated in Dollar, where functional currency is Euro (FX forward is enterred). The movement in receivables due to FX rate change is already booked on P&L at reporting date. If FV hedge is applied, hedged item (in this case $ denominated receivables) fair value change will be booked twice in P%L (one for usual accounting entry, two for FV hedge accounting)?
Dear Dora,
if you designate your receivable for FV hedge (but I guess that it’s not what you want to do, because most of the time, you designate it for cash flow hedge really), then you do not book the change twice. As soon as you revalue receivable to the current year-end FX rate, it’s in its fair value, so there’s nothing to be booked within FV hedge. S.
Thank you so much Silvia for your very helpful and quick response.
Then, if you designate FX forward as CFH (assume 100% efficiency), net income will fluctuate until settlement of FX forward as change in fair value of FX forward will be booked to OCI under CFH accounting. And the revaluation of receivable/payable will be booked in P&L (they will not offset each other in the P&L until settlement).
After settlement of FX forward, amount in OCI will be reclassified to P&L and offset with the revaluation gain/loss from receivable/payable. Am I right thinking like that?
If this is the case, why would we want to apply Cash Flow Hedge for recorded assets/liabilities denominated in FX (receivables, payables, etc) which are revalued at period-ends? We can simply apply Economic Hedge (as change in fair value goes to P&L, it will offset with revaluation of hedged item) instead of Hedge Accounting, given that hedge accounting requires upfront documentation and testing?
Best regards
Hello Silvia,
I wanted to inquire whether I can hedge my Loan payable in USD with my Revenue which I will receive in USD?
Is that possible under IAS 39 and IFRS 9?
Hi Silvia,
Wondering if you could clarify something…
My company have taken out CCIRS in GBP/USD and GBP/JPY.
We revalue these items (at fair value) every period in the STRGL (performing retrospective testing each period) and posting the changes accordingly in STGL. I presume this is correct methodology using IAS39?
How will the accounting change following IFR9 implementation? I presume no retrospective testing will be required and the change in fair value will need to be recognised in OCI?
Many thanks for clarifying
Hi Bob,
you haven’t written whether your CCIRS is a designated hedging instrument or it’s just a derivative without any hedging relationship. You mentioned some retrospective testing, however, it’s not clear what you hedge, what the type of the hedge is etc.
If it’s not a part of some hedge, then of course, you’re right and IFRS 9 implementation won’t change it’s treatment.
If it’s a hedging instrument, then there are some differences in relation to testing the effectiveness, but the mechanics of accounting for a hedge itself does not change.
Hi Silvia, thanks for replying to questions like this. I wanted to know if the following is correct. A company has FX denominated loans and entered into forward contracts to cover the interest and principal payments. The accounting treatment: book and carry the loan in functional currency translated at the hedge contract rate/forward rate. The mark-to-market on the hedge contract sits on the balance sheet. When loan and hedge contract matures, the gain/loss on the hedge contract goes to update the Loan Payable account on the balance sheet. Not hitting P&L at all.. rationale is that once forward contract was entered into, this effectively turned the loan into functional currency….does this make sense? I’m used to traditional fair value hedge where remeasurement gain/loss is offset by hedge gain/loss on the P&L.
Hi Silvia, my client currently enter into future commodities contract to ‘short’ (sell) it purchases of commodities on the purchase date of the commodities and at the same time ‘Long’ (buy) the commodities when a sales contract is sign between the seller on the sales contract date. Then follow by the prompt date as dated by the future contract. The client will either settle earlier or at the prompt and make a gain / loss .
For example, purchase 100mts @ $1/mt of zinc on 1/1/2015 , buyer not finalised yet hence short(sell) it by entering into future contract at $1.10/mt and at a later date when a sales contract with customer A to sell zinc at $1.30/mts is signed with a customer on 3/1/2015, the client entered into a long (buy) future contract 100mts of zinc @ $1.20 with the future broker.
Hence the company made a future contract loss of ($1.20 x 100 – $1.10 x 100 = $10).
while in actual purchases and sales, the company made a profit of ($1.30 x 100 – $1 x 100 = $30).
The company will recognised the $10/- as hedging loss and this amount will be recognised directly into PL. The amount due to or due from the future brokers should be recognised into the FP as derivative financial assets / derivative financial liabilties. Is this the right way to account for hedging??
The future contract could also work in the opposite way such as entering in ‘Long’ (buy) future contract in regards to the sales contract signed and subsequently enter into ‘Short’ purchase contract.
The sales and purchases is only recognised when the goods is delivered and onto the FP and PL.
This should be designated as fair value hedge?
Dear Silvia
Wonder how you explain such complicated topics at ease. really appreciate
Thanks 🙂 I just don’t like to be “lost in translation” 🙂
Can we get cash flow hedge for an interest rate swap agreement to manage 75% the risk of a variable debt. Meaning the notional amount on interest rate agreement is 75% of the value of the debt outstanding at the date interest rate swap agreement. Also can we get cash flow hedge for interest rate swap if the debt agreement was entered into on July 29, 2014 where as the interest date swap agreement was entered into on November 20, 2014. Does few months variance in the commencement matters?
Hi Silvia,
“irrespective of the hedge type, hedge accounting essentially involves measurement of the hedging instrument at fair value, regardless of the accounting method used on the underlying hedged item.”
Is this statement correct?
thanks
Ahamed
In banking, we offer fixed rate loans to borrowers and offset the interest rate risk by entering into an interest rate swap or fair value hedge. With the hedge, we pay a fixed rate payment and get a variable rate payment in return. With regards to reporting the change in fair value of the hedging instrument (the loan in this case), does this amount get added to the book balance of the loan or is it reported separately on the Balance Sheet as part of Other Assets. I understand the change in fair value of the hedge is reported as its own item on the Balance Sheet, just not sure if the fair value of the hedging instrument receives the same treatment.
Hi Silvia
how to Calculate the effective and ineffective portions of the gain or loss on the hedging instrument?
regards,
Tom
Hello Silvia!
I would like to humbly ask you for your kind help since I have read most of articles here and didnt find the answer. 🙂
If inventory is hedged through FV hedge and the FV increases during the perioid till reporting date, is the value of inventory changed (increased) accordingly? Im just confused by IAS 2 and its “lower of cost or NRV” rule. Does it not apply here?
I will be forever grateful for your reply, this question is kind of preventing me from further understanding of whole hedge accounting.
Thank you1 Have a great day!
Hi Silvia,
How to identify the ineffective portion of a hedging instrument practically. Can you give a short example to clarify the same under IFRS 9.
Good afternoon Silvia!
I have been searching internet for 2 months in a row and still didnt find answer for this:
What lines in P/L statement are affected by the change of the value of hedge item/instrument? Up till now, I have found 3 different ways in different books: to Financial income, operating income and to revenues.
Is it different for each hedging relationship? Or e.g. hedge of fair value of commodity inventory is always affects operating income.
Please help me! <3 My head is going to blow up soon.
Hi Wen,
it strongly depends on what your hedged item is 🙂 Then the change of fair value goes to the same line as the main expenses related to the hedged item. S.
Hi Silvia, Thanks a lot for the explanation. In our company we have hedged the foreign currency risk with forward contracts. Is this falling under fair value hedge? Can u please explain on this?
Hi Shafras,
in most cases, it’s a cash flow risk when it comes to foreign currencies (e.g. you protect your receivables/payables in foreign currencies). But sometimes, it can be a fair value hedge, too. S.
Hi Silvia, Need a clarification.
We have a long term loan in USD and intend to re pay with the foreign exchange earning in the future. Could please let me know, which one is the hedge item, hedge instrument and the impact on the OCI when the settlement is made. Thanking you
I think the difference is the certainty of cash flows. In cash flow hedge u r certain to receive or pay and u just protect from variation in that receipt or payment. In fair value hedge, there is no certainty in cash flow yet as the decision to hold or to sell and when to sell are still undecided. Is my logic right?…:)
How do you present cash hedging in the cash flow statements (investment or financing)? Is there a specific lingo I should use to add a line in the cash flow?
am also interested in knowing how to Calculate the effective and ineffective portions of the gain or loss on the hedging instrument?
Hi Naomi,
I replied somewhere above in the comment. Plus, I noted you subscribed to the IFRS Kit – so you’ll find a clear explanation there. S.
In the search of how to write up a significant matter for my client’s new fair value hedge and came to this website.
Have to say, very helpful! Thanks a lot!
And, I have a laugh when reading your “Top 3 Biggest Dilemma with your auditors”
I experienced all of what you mentioned there before. Lol!
Hi Silivia,
I am looking for material/subscription covering the following topics/Questions
1)If I have a bond that is classified under Amortized cost, could I do hedging accounting i.e the bond to be hedged item (with examples)
2)examples for Method of hedge effectiveness calculating
3)examples for hedging accounting under IFRS 9
Thanks
Sami
Hi selvia
I am looking for material /subscription covering the Hengyang accounting with Examples especially for
1)the treatment for hedging a bond that is classified under amortized cost (IFRS 9) or held to maturity (IAS 39)
2) examples for IAS 39
Method of hedge effectiveness calculating
1)dollar offset method
2)volatility reduction method
3)regression analysis
4)hypothetical derivatives method(for only cash flow)
Or rebalancing under IFRS 9
Hi Silvia,
Assume a scenario where I agree a fixed price for a defined quantity of crude oil, say USD90 for 10,000bbl of crude. The price of crude in the market is USD30 and I agreed to pay the Buyer USD3.50 for each barrel of crude lifted so as to guarantee the price. How do I treat this type of hedge? In my view this is as good as a cash and carry transaction. Do I need to recognize any gain from this type of forward contract since I have basically agreed to sell the crude at a fixed price?
Hi Silvia,
The difference between Fair value & cash Flow Hedge is explained beautifully. I have one doubt in case of Cash Flow Hedge what will happen to Mark to Market(MTM) gain/Loss of an Investment (Hedged Item). Because as explained earlier, in cash flow hedge we do not touch Hedged Item in accounting??
Regards,
Vikash
Hi Silvia,
I enter into a forward to hedge an expenses in future in one year and the invoices will be come in at that point of time.
I recorded it as cash flow hedge. Just when the forward contract is expire but the invoices haven’t come in and it sit under my accrual, is this call ineffective potion? need to charge out to PL?
I wonder i well i would have understood that area of Financial Instruments without your presentation Silvia. Guess what ? It was succinct and simply simplified.Under how to account for a cash flow hedge you clearly stated “As you can see,you don’t even touch the hedged iten hear” Hahahahh…….That was pam. Thanks and keep it up.
🙂 I wish everyone would read my stuff so carefully 🙂 S.
Hi silvia
Say I’m going to receive $10million GBP as royalty payment from my subsidiary. However, as i’m a US company i would want to hedge this against a variable foreign exchange currency. Does this justifies to be a Cash flow hedge ?
I would say a cash flow hedge. S.
Hi Silvia
Another question is that, since i have entered into a forward contract (signed and sealed). Do I have to record it down as a transaction (E.g a Receivable) or should it be included in the notes of the financial statements?
Thanks
Dear Philip, since this is a derivative, it should be recognized in the financial statements at fair value (although initially, the fair value usually comes close to zero). S.
Hi. Sivia
I want to ask from you about Cash Flow Hedge reclassification to earnings.
we are in Travel industry and we sell out tour package to our subsidiary companies in other countries..we have forward contract with bank..
Initially, we recognize gain from hedging in other comprehensive income..
my question is,
1. can we reclassify the gain from Hedging into earnings again ?
2.When we can make the reclassification.
Hi Silvia, thanks for the explanations. I just get confused on how to account for interest rate swaps with regards to hedging. Bank A is exposed to variable rate payments on their loan liabilities. They enter into a IRS with Bank B to pay fixed and receive variable.
1) This would be a CF hedge right?
2) What would be the difference if we apply hedge accounting and if we do not apply hedge accounting because I can’t see a difference – i.e under hedge accounting, the net amount between what we pay and what we receive will go to P+L (basically the non-effective portion). under normal accounting, we would still affect P+L with the net amount. So how does hedge accounting change this?
Thank you!
Dear Kalpesh,
1) Yes
2) There are 2 things to take care about:
– The interest paid: Sure, what you pay, is a part of the effective interest method and goes in profit or loss. I would say this is what happened in the past.
– Interest rate swap itself: You shall recognize the derivative too. This is what will happen in the future (its fair value is calculated as present value of future cash flows). Initially, its fair value is close to zero, but in the subsequent reporting periods, it will have some fair value and you need to account also for fair value change. Here the hedge accounting comes.
If you do not apply a hedge accounting, then the full change in derivative’s fair value goes to profit or loss.
If you do apply a hedge accounting, then only ineffective portion of change in FV goes to profit or loss and the effective portion is recognized in OCI.
Hope this helps. S.
hi Silvia,
i want to know ,in case we have hedged most of the payments which we have to pay to supplier with bank .further to explain ,bank first pay to supplier & then we pay to bank after 3 to 6 month of on forward contract rate ,so is it necessary to calculate the unrealise gain/loss for loan from bank in foreign currency
Shipra, I am a little lost in your question. You should calculate any unrealized gain/loss on any loan in foreign currencies stated in your financial statements. On top of that, if you enterred into a derivative (whether for hedge or not), then you should determine its fair value at the end of reporting period and recognize it. S.
Hi Sylvia
I have an interest in the impact of FX movement for reporting purposes.
In most (if not all) of the examples you gave above, they would be deemed to be monetary items. A company that held such items in a foreign subsidiary may consider cashflow or fair value hedges depending on the item.
Would it be fair to say that a company wouldn’t need to worry about FX movements for non-monetary items such as plant and equipment in a foreign subsidiary, as they would be converted to reporting currency at an historic rate?
Many thanks
Dear Steve,
in fact, when you translate foreign subsidiary’s accounts to a presentation currency for the reporting purposes, then you do NOT use historical rate, but the closing rate. You use historical rate for non-monetary assets only when you translate individual transactions to your functional currency (careful about what you translate: to a presentation currency? to a functional currency?). Of course, when you translate subsidiary’s functional currency accounts to parent’s functional currency (i.e. to a presentation currency), there are many exchange differences and their cumulative effect is recognized in other comprehensive income.
And then, about hedging of non-monetary items – maybe it would be great if you specify further what you have in mind. Do you own some fixed asset and you’d like to hedge its value? Or would you like to hedge investor’s interest in net assets of foreign subsidiary?
If the last is the case, then you can hedge the net assets and apply a cash flow hedge, but only to the foreign exchange differences arising between parent’s functional currency and subsidiary’s functional currency. You can apply cash flow hedge accounting, but only in the consolidated financial statements.
It’s quite a difficult topic and I plan to write some article about it. S.
Thanks for the explanation. If we purchase your material will it have examples on effectiveness testing on cash flow hedges as per AASB139.
Regards
Roland
Hi Sylvia
I have some questions regarding the designation and treatment of cash flow hedge for FX swap (funding swap) under IAS 39.
My Case:
FX swap is a swap transaction exchange of principals of different currencies at the beginning and at maturity (i.e. convert USD to AUD at the beginning (near leg) and convert AUD to USD at the maturity (far leg)).
Initially, I would raise USD by issuing discounted bill and the USD received would be swapped to AUD to fund an asset. At the maturity, the AUD asset would be converted back to USD by swap for repayment of liabilities.
Between the value date of near leg and maturity date, I would have a USD Liability and a AUD asset in my balance sheet while the far leg of swap would be a derivative asset or liabilities like a forward fx contract.
Because the Asset and Liabilities would be revalued using spot FX rate and the far leg of FX swap would be remeasured based on forward FX rate, the non-parallel shifts of spot rate and swap rate would cause fluctuation of FX Profit. Therefore, I would like to use cash flow hedging to offset such fluctuation. (Namely, designate the discounted bill in USD as hedged item and the far leg of swap as hedging instrument and hedge on forward rate method)
My Questions
For cash flow designation:
1. Should be hedged item be defined as a “Forecast” transaction or recognised liabilities?
2. Given the liability is a discounted bill, should the value of hedged item equal to the notional value to be paid at the end or the discounted value I received at beginning?
Treatment Afterward:
3. By using forward method Cash Flow Hedge, the value of far leg would be all transferred into OCI. Should I recycle the amount of realised FX Profit and Loss of hedged item (asset and liability) out of OCI and return back to P&L during the life of swap? If the answer is yes, which section in IAS 39 would require/allow me to do so?
Many Thanks
We hedge our foreign currency receivable on forecasted sales/future sales against the creditors, here hedged item is forecasted sales and hedged instrument is creditor. Please note we dont enter into an any forward contract or future contract.
i.e. any foreign currency receivables in future is hedged against the amount payable to creditors in foreign currency.
We treat this as Cash Flow hedge. This example (we are actually doing this) not covered in any book. Is this correct?
Hi Please I need clarification. I am having difficult establishing if a transaction I am working on is an hedging relationship.
My case,
I am currently reviewing the financials of a company which has an account designated as cashflow hedge reserve.
Now the entity buys raw material from foreign supplier and agrees times of payment which could be in 3 months. So my client sets aside some foreign currency amount in the bank( Eg EURO 15Million for the payment which will be due in say 3 months at an exchange rate of for example NGN250 per Euro on that day. So on the payment date the Euro I5 million is translated at the exchange rate of say NGN 300 per Euro and the exchange difference will now be recognized as cashflow hedge reserve.
My concern is that I am unable to identify a third party in this transaction. No one really bears the loss or reward of the transactions. Seems to me like is mere translation of foreign denominated monetary assets using the spot rate on the balance sheet date as required by IFRS.
Please assist to provide me with guidance on this as I am so confused
Hi Sylvia,
Should we classify a foreign currency denominated fixed rate bond as a fair value hedge or cash flow hedge?
S
Ah got it both!
But if I expect it to be effective, I’d rather choose to do fair value?
It would go straight to benefit P&L.
Dear Silvia,
Would like to check with you. If the Company is entered into Cross Currency Swap (applying hedge accounting, cash flow hedge and the hedge is effective). The loan which entered into the swap is different from the functional currency. Understand that the Fair Value of the derivative is taken up in Other Comprehensive Income, how about the spot rate translation of the loan itself? Should recognised in P&L or OCI?
Thanks.
Hi Silvia,
thanks for all the detailed explanations!
I had a question which is more specific to commodity hedges – is the accounting at all affected if there is an asset lien? I am looking at a gas hedge for a power plant.
Also, does the US GAAP differ on this topic?
Many thanks!
Visan
Hi Silvia, how does one think about hedging inventory that comprises gold jewellery, for example. Would this be a fixed hedge…and consequently, one has to adopt the Fair Value method?
Hi Silvia,
Excellent Post! Thank you for making it so simple.
I have two questions:
1. We do cash flow forecast of our foreign currency purchases. Example: we forecast purchase of 10 million EUR of raw material in May. 2017. Functional currency is USD.
If I want to hedge the future purchase with a FX forward contract in order to fix my margins (P/L), is this Cash Flow Hedge?
2. In May 2017 when I purchase this raw material, this 10 million EUR is A/P on my Balance Sheet with 45 days payment term.
I want to fix my A/P in USD so I hedge it with FX forward contract – Is this FV hedge?
Is there a major difference between GAAP and IFRS on hedge accounting?
Hi KHF,
thank you!
1) Yes
2) No, it’s a cash flow hedge.
There are some differences, but probably not major. S.
Hi Silvia,
If I take out a forward exchange contract to secure my exchange rate on a forecast transaction (for the purchase of inventory), I can obviously apply cash flow hedging.
However, once I receipt this inventory, I stop applying cash flow hedging. Does the hedge then become a fair value hedge or do I simply now account for this as a derivative instrument. I know the accounting treatment of a derivative and fair value hedge is the same, but want to understand the principle).
Thank you
Dear Jonathan,
I think that by the forward contract, you are hedging the planned cash flows and the receipt of inventories is not an event that would force you to discontinue the hedge accounting. Instead, you keep your hedge accounting until you pay for the inventories and exercise the forward contract. In fact, you are not hedging the inventories themselves, but the payment for these inventories.
Also, let me stress that fair value hedge accounting and the accounting treatment of a derivative are NOT the same. Yes, in both cases, you recognize the fair value change of a derivative in profit or loss, but in the case of fair value hedge, you also recognize the fair value change of the hedged item in profit or loss. S.
Dear Silva!
Thanks a million for sharing such a fantastic explanation about the differentiation both of these hedge’s type. Please define & explain the followings:
1. Define Effective & Ineffective portion of Gain or Loss on Derivatives;
2. What is the basis, criteria or parameters for splitting of Gain or Loss into Effective & Ineffective portions of Hedging Instruments?
Profound regards
Atif
Dear Muhammad,
hmmm, this is really a complex question and I think I need to write some article about it. In short: when the change in fair value (FV) of hedging instrument is greater than the change in FV of hedged item, you have an “overhedge”. If it falls within the range of 80-125%, then the effective part is the FV change equals to FV change on hedged item, and ineffective part is the difference between FV change of hedging instrument and FV change on hedged item. It looks very complicated, but it’s not really possible to explain it easily in the comment. And also, it’s only the example of dollar-offset method, applied under IAS 39. S.
Dear Silvia,
Firstly I thank you for replying my question. I made a flow chart presentation according to your comment still found very complicated. I would really appreciate if you write an article on this complex matter with numerical example for better understanding.
Profound regards
Muhammad,
may your wish come true. I’lll write something up within 1-2 months. S.
Hi,
Can you please also explain how to account for cross currency interest rate swaps (CCRIS).
I understand that fixed to fixed CCRIS are fixed interest payments in future and can be treated similar to forward contracts.
But how to account for floating to fixed CCIRS and vice versa and floating to floating CCRIS.
DO we apply hedge accounting these ?
Dear Mirza,
that’s the topic for a separate article itself. Let me just mention that yes, it’s possible to apply hedge accounting to CCIRS, based on what the hedge relationship is. What is your hedged item? What precisely is your hedging instrument – is it the full CCIRS? Or a part of it? Also, can you measure hedge effectiveness somehow?
If you hold your CCIRS outside any hedging relationship, then no, you do not apply hedge accounting, but you should account for all fair value changes of that derivative in profit or loss. S.
Hi silvia
The article is very helpful.Thanks for explaining complex topic in a simple way.
I have a doubt ;if I have two types of fixed debt instruments one I have amortised using EIR & the other I havenot amortised. Now I have entered in to fixed rate prinicipal & interest swap in foreign currency, whether the same will be cash flow hedge or fair value hedge ?
Regards
Dear Priya,
it depends on what risk you hedge. You need to specify that precisely. Are you protecting against foreign currency movements? Then it’s a cash flow hedge. Are you protecting against fair value movement (i.e. are you swapping fixed rate to get floating market rate)? Then it’s a fair value hedge.S.
Hi Sylvia,
Great article, thanks very much! I think I now am clear about fair value vs cash flow hedges. But now I see people speaking about balance sheet hedging vs cash flow hedging, and then things get muddled again. Is “balance sheet hedging” simply another way of referring to fair value hedging? Thanks very much!
Hi Dan,
IFRS do not define the term “balance sheet hedging”, but in most cases it refers to protecting against the risk associated with foreign currency movements, related to your assets or liabilities denominated in foreign currency. In most cases, it’s a cash flow hedge. S.
Thank you for the explanation, Sylvia!
Hello Sylvia,
Can you tell me how to account for hedging for a portion of assets classified at Amortised cost.
The hedging insturment is as usual but noit sure how MTM is treated on the balance sheet and the P&L.(IFRS 9)
Sorry, what is MTM?
MTM is Mark to market
It depends on what you are hedging. Is it the fair value hedge or a cash flow hedge?
Fair value hedge for Securities at Amortised cost(IFRS 9)
Hi Silvia,
Would it be possible to designate a USD denominated loan as the “hedging instrument” to hedge highly probable forecast sales also denominated in USD. As far as I know, the answer is yes, as I am trying to hedge the FX exposure.
Trick here is, this loan has already been designated as the “hedged item” to be able to hedge the interest rate risk with an IRS earlier & the relationship is still ongoing.
Therefore, technically, I am trying to use the same loan as the “hedged item” in my first designation & “hedging instrument” in my second designation. I was wondering if this is a possible scenario.
Many thanks!
Hi Silvia,
Appreciated for this great article which helps me a lot to understand for about the topic. As I am a bit confused with the concept of hedge as I think to qualify as hedge the gain/loss on hedging instruments and on hedged items must be opposite (i.e. gain on hedging instrument vs loss on hedged item). Just wondering for a cash flow hedge, whether it is correct to deem the hedge as effective when there are gains on both hedging instrument and hedged items and the effectiveness is within the range of 80-125%, because for cash flow hedge we are just looking to hedge the variability of the cash flows. Many thanks Silvia.
Hi Silvia,
I have a question.
Why the Gain/Loss on Fair value hedges booked in P&L, however in case of Cash flow hedges effective goes to OCI and ineffective goes to P&L.
Why this is happening if purpose of both is hedging ?
Regards,
Safiq
Safiq,
you forgot to add that at fair value hedge, also the gain/loss on the hedged item is booked (not in cash flow hedge). And it answers your question. It is happening to offset the fluctuations in fair value of the hedged item that are also recognized in P/L. S.
Hi Silvia,
I have a question. If an entity is applying hedge accounting on a cash flow hedge and has hedged for sales of say 100,000 units of x commodity and then has forecasted sales of 90,000, are they required to recognised the g/l on the additional 10,000 units (over hedged?) in the P&L as opposed to the OCI?
Thanks and regards,
Daniel
Daniel,
you should hedge only 90 000 of sales, not 100 000 units. The hedging instrument to hedge additional 10 000 units (that do not exist) should not be accounted for as a hedge accounting, but as a regular derivative. S.
Madam Silvia
In the example of accounting for fair value hedge given above, no hedge effectiveness testing has been included. Is it not compulsory to test hedge effectiveness for fair value hedges? If so, what could be the logic of keeping it mandatory for only cash flow hedges and not for fair value hedges? As far as I know, under US GAAP, hedge effectiveness testing is done for both fair value and cash flow hedges.
Thank you in advance for the clarification.
Hi Juhi,
you should test the fair value hedge for the effectiveness. If it’s not effective, then under IAS 39 you need to discontinue the hedge accounting and under IFRS 9, you need to rebalance the hedge ration. If it’s effective, you account for it as written in the article – you don’t split the effective and ineffective part though. S.
hello Md. Silvia I watch your video a lot and you are very helpful.
please how come was the Variable-rate assets and liabilities classified under fair value in your text above.
What are the hedges we can use on securities (equities)FVH OR CFH OR BOTH…AND what should be our hedging instruments for this.
Madam
In case of fair value hedge, why there is no requirement for a reserve like that in cash flow hedge? Also, Why there is no distinction between effective / in-effective portion of hedge and separate accounting treatment in fair value hedge like that in cash-flow hedge? Request to clarify the logic.
Thank you.
Juhi,
it’s because in FV hedge, you revalue not only hedging instrument, but also a hedged item (this is not the case at CF hedge). Both items are revalued to their fair value, hence there’s no sense to apportion effective/ineffective part. S.
Hi Madam,
Thanks for explaining such a difficult topic so clearly.
But what happens if the swap is based on two floating interest,
for example: A bank pays 3M LIBOR and receives 1M LIBOR, which type of hedge it will be?
Currency swaps can be both cash flow hedge and fair value hedge
Hi,
I am not asking for a currency swap.
It is a basis swap, in which we swap the base on which the floating rates depends.
Hi Silvia,
I have the same query as Neal.
Kindly answer this. TIA 🙂
It depends on what the hedged item is – for me, it’s very unclear from what Neal wrote. S.
Hi Silvia,
Suppose X borrows @3M LIBOR and hedges it by an interest rate swap in which it receives 3M LIBOR and pays 1M LIBOR. So hedged item here is the 3M LIBOR. Is it the cash flow hegde or fair value hedge?
Cheers 🙂 !!
OK, nice but I understood that 🙂 Fine, let me tell you that this basis swap that exchanges one variability for another type of variability does not qualify for neither type of the hedge. So I’m afraid you could not account for a hedge accounting if you just took this type of a derivative. But, if you combine this swap with another derivative, well then, it could be possible to designate this combined item in either fair value hedge or cash flow hedge, depending on the specific circumstances. Cheers!! 🙂
He Madam,
I have been studying theory but still I am not clear with the distinction of the two hedges. I got lost on the cash Flow hedge. What do you mean by effective portion and ineffective portion, Please help
Hi Silvia
Thanks for your time and effort in all this.
I feel this ‘fixed’ and ‘variable’ rule does not always work. Like if an entity X has 100 Tons of cotton in its inventory and its enters into futures contract to sell this cotton in 3 months time @ 50$ per Ton. The way I see it that company has converted something variable into fixed, so it is cash flow hedge. Am I right? And if it is fair value hedge, what am I doing wrong? Thanks
Pardon me, Tahir, but what’s the hedging here? I see only 1 contract – that is to sell the inventory in 3 months at fixed price. What’s the hedged item? And also, there’s also the question whether the delivery is physical, because if yes, then you don’t even have a derivative here, but the regular trading contract. S.
Hi Silvia, Entity entered into the contract to guard against the future fluctuations in the price of cotton (so that the value of its inventory does not fall), so inventory is hedged item. And lets assume contract can be net-settled. And thanks a lot
Hi Silvia, waiting for your guidance.
Hedge of inventory in hand through a forward contract is accounted for as cash flow hedge of fair value hedge? Thanks for your time.
Fair value. In your books, it’s a fixed item.
Hi Tahir,
I also think the fixed and variable method can’t be used to explain every case of fair value hedge and cash flow hedge. For the inventory example, I think can go back to the basics of the definition of fair value hedge and cash flow hedge. For example, Company A obtained a short term borrowing with a bank secured by Company A’s inventory of 1,000 tons of copper which it bought at $5 million. According to this borrowing contract, Company A has to provide additional collateral if the copper value falls below $4.8 million in future. So company A worries about the change in fair value of the copper and hedges it by a copper forward contract at price of $5,200 per ton. This is a fair value hedge. On the other hand, if company A worries about the change in cash flow from the copper in future then it can create a cash flow hedge. I think there are many ways to interpret a classification of fair value hedge or cash flow hedge. And the fixed and variable method is one of them and no one method can explain every classification. So sometimes we can apply the traditional method and sometimes we can apply this method.
If fair value hedge accounting requires adjustment of hedge item , particularly when fair value of hedge item increases , does this mean IAS 2 has no application when company uses fair value hedge accounting?
Hi silvia, so my question is :-
what would be the financial impact (if u had to sum it up) if the other comprehensive income/loss arising from cash flow hedges is to be reclassified to profit or loss account in the subsequent period. Hope to hear back soon as its very urgent! Thank you 🙂
Thanks for the great article. If a hypothetical derivative is used to check effectiveness, should the hedged item still be used to calculate to ineffective portion that goes to P&L?
If it’s a cash flow hedge, yes. The hedge can be effective, but not 100% effective and it means that it will have some ineffective portion.
Great, thanks Silvia. Yes, it is a cashflow hedge. So I’ll check effectiveness using a hypothetical derivative and the hedging instrument. Then I’ll calculate the cumulative change of the hedging instrument and if it is more than the cumulative change of the hedging item, that excess portion is the ineffective portion that will go to P&L. Does this sound correct?
good afternoon, I’m working for an oil and service company and I have the following example:
we got an advance from a client(contract in dollar) in NAIRA equivalent at fix exchange rate. During 2016 NAIRA has been drastically devaluated and the equivalent amount of naira that we are getting from client against the advance is giving us a huge loss on the current year.
is it a sample where a cash flow edge have suppose to be applicable in order to minimize the impact on P&L?
regards
Sabino
Hi Silvia,
I’m interested on the CVA/DVA impact on the cash flow hedge portion especially on recognizing the accounting entries that should goes to OCI. Would you be able to provide some insight and sample affecting this matter.
Thank you.
Rgds/Zed
Hey Silvia,
So here is my question, Suppose i have taken forward cover against my foreign currency receivable, so is it a cash flow hedge or fair value hedge?
Also if i have taken forward cover for an amount which is more than/less than my foreign currency receivable, then what will be the treatment of excess/short position taken?
Hi Silvia,
Thank you for this useful link on hedge accounting.
I have a question I would like to ask you.
Do you think it is possible to achieve hedge accounting if we forward hedge against forecast debt, i.e. the underlying debt is not yet drawn, but anticipated to be drawn, so there is a risk of being overhedged, could we still achieve hedge accounting?
Hi Silvia,
I saw you double entries for hedge item only for fair value hedge. For effective cashflow hedge, means there is not necessary to retranslate hedge item at closing rate and difference posted to P&L?
Hello Silvia,
Thank you in advance for your all supports.
I am still having difficulty for distingushing the difference of cash flow and fair value hedge.
I live in Turkey and as you know our currency is TL. My company, that I work in, services in operational fleet car leasing industry. We take borrowing to purchase the car by EUR currency because it is cheaper then TL funding. Due to this we make the rental contract by EUR with our customers which are not recognized in asset.
When the currency rate increase we book foreign exchange loss which is calculated through our borrowings. Avoid of the fx loss in our statements we started to use fair value hedging. In our case, we use our borrowing as a hedging instrument and we hedged our firm commitments which is hedge item.
After starting fair value hedge, although we book fx loss for our borrowings if the currency rate increase, at the same time we book fx gain for our firm commitment which is calculated according to the difference between reporting dates currency rate and contracts starting dates currency rate.
As a result, we do hedging avoid of fx loss coming from our borrowings, because most of time fx rate increases in Turkey.
Everything that I explained above was confirmed by our audit company which is one of big four.
I kindly ask you that if our hedging methodology, which is fair value, correct or not or can we use either cash flow or fair value?
Thank you in advance.
Hi Gurcan,
that’s OK. As you can see from the table in the article, you can hedge foreign currency risk in both cash flow and fair value hedge. S.
Sylvia, hope you are well! My question resides on the presentation of the hedging instrument’s gain or loss when it is ultimately reflected in the P&L. If I have a cash flow hedge to protect exchange variations on the income tax payable account, it appears that the hedge instrument’s gain or loss would impact the income tax expense account. However, this creates some confusion in my mind because what is generally a pre-tax item (the outcome from the hedging item) would be impacting tax expense.
Thanks in advance for your thoughts, and thank you for all the teachings!
Hi Juan,
frankly speaking, I’ve never come across similar situation when you are hedging the income tax. Anyway – if it is a cash flow hedge, you need to know the exact amount that you are hedging and if your real income tax expense is different, then the remaining part would be just unhedged. Also, you are right, the outcome of hedging instrument is presented together with the outcome of the hedged item and yes, if it affects the income tax, then of course, there will not be perfect match. S.
Hi Silvia
I work for an Australian Listed entity and we have entered into a number of Fixed Rate USD bonds, we have entered into CCIRS that take that debt from Fixed USD to Fixed AUD as we want to protect against FX Risk and Interest Rate Risk, by understanding is this is a cashflow hedge as we are protecting against movements in the USD/AUD exchange rate and also the AUD interest rate by locking in a fixed interest rate. Is my assessment correct?
We also issued AUD debt fixed rate debt, do I need to fair value this debt at each reporting period and record the movement through PL? I don’t believe I have to if I have classified this as a Loan under AASB139
Hi Silvia,
Does OCI is a part of Cash flow? If yes then which items of OCI should be considered while preparing Cash flow statement?
Hi, do you mean cash flow hedge reserve in OCI? Yes, you have to take it into account, but careful – the change in cash flow hedge reserve should be treated as a non-cash item in the operating part. Please see more here. S.
HI Silvia,
I have trouble identifying the correct hedge accounting method for the following:
– A lends B an amount of USD 5,000, B pays 4% fixed interest to A
– A measures its loan to B at amortised cost
– A enters into a pay-fixed/receive variable swap contract with Z
– SWAP: A pays 4% fixed and Z pays variable market interest
Do I need to use CF or FV hedge?
Many thanks in advance!
Regards,
Jay
Well, A exchanges fixed to variable, hence it is a fair value hedge as A effectively ties the cash flows from this hedge to market, and gives up certainty of fixed cash flows.
Hi, Silvia,
This is a very good article.
I would have a different type of question under IFRS – knowing that in a bank there could be many dormant accounts with long dormancy periods and assuming there is no eschatement law and the statutes of limitation never start (so the bank is forever liable to pay back these accounts to its customers) could use as hedged item a pool of dormant deposits due to customers (in a bank, liabilities, not valued at fair value but at nominal value) and hedge against the risk that these deposits are claimed (knowing that there is a chance that maybe 20 out of 100 are claimed in the future, based on history and actuarial models)? The hedging item would be a swap (derivative) with an external party. Would this arrangement qualify for hedge accounting? Thank you so much.
Thank you for the wonderful article.
When I enter into an interest rate swap for 4 quarters (receive fixed 5%, pay variable LIBOR+2%) offsetting my variable income elsewhere, at end of each quarter, two things happen
a) my fair value of this swap on FS changes (let’s say it increases from 0 to 40 in end of q1)
b) i receive fixed cash flows ( I receive 5%, pay 4% thereby making 1% offsetting my variable pay of 4% elsewhere) fully effective because my net inflow = 4 (revenue) +5-4 (cash flow based on hedging) = 5
So, as per your definition
“OCI should recognize ineffective portion in P&L” because hedge the swap is a hedge right?
why not that means 39 in P&L and 1 in oci?
I am not quite sure whether I am correct or not, but I fill that you must have mentioned about spot rate and forward rate in relation to cash flow hedging. Am I right?
Well, I was just describing the differences between the different types of hedge relationships and you don’t really have to mention spot and forward rates, since I was not calculating fair values. S.
Hi Silvia,
You have a really amazing article right here!
I was just wondering if I wish to hedge an investment in a local subsidiary where I’ve purchased shares in, would I be able to apply hedge accounting for such an investment if the investment is a) recognised at cost and b) equity accounted for (an associate company)
Stay blessed you helped me a lot in understanding difference between fair value and cash flow hedge.
Hi,
A clarification. If a forward contract is booked for cashflows (basically for receipt of dividend, receivables etc) by a manufacturing company. year end falls on 31st March and the company follows cash flow hedging. When will the reclassification happen if the company is booked the forward as a single contract based on approximate value for dividend and receivables ?
What reclassification do you mean? In general, it depends on how you designate the hedging instrument. At the year-end it is necessary to fair-value your hedging instrument and any gain/loss on this derivative is split to effective part (in OCI) and ineffective part (P/L).
Is it possible to take out forward cover on a dividend for which the timing and amount is uncertain and then designate the FEC contract as a cash flow hedge?
Assume the FEC is taken out in March. The dividend is declared in May and will be paid in June. Based on budgets, management can estimate the amount of dividend to be paid March and take out an FEC at this point.
My understanding is that a parent entity cannot designate the foreign currency risk on a highly probable inter-company dividend as a hedged item in its group financial statements in a cash flow hedge. Inter-company dividends are not foreign currency transactions that can be hedged, because they do not affect the consolidated income statement. They are distributions of earnings.
hi Silva,
thanks for your nice and simple explanations for the treatment of derivative transactions.
i have one query:
we have commodity swap contracts entered with some broker and we follow cash flow hedge accounting and the settlements payments/receipts are accounted in inventory but out of these some contracts are terminated by mutual agreement and for that we need to pay say usd 3/MT for 10000 MT.
we we should take this termination cost directly taken to P&L or can i inventorise it. pl clarify
Hi Silvia,
The steps for accounting a Net Investment hedge will be the same as per the Cash Flow Hedge right?
Thanks, amazing support you have provide!
Hi Michael, yes, almost the same. Anyway, I am working on an article with the example on net investment hedge, so I’ll keep you posted (if you are subscribed to my newsletter). S.
Hi Silvia, what happens when swap is early terminated but hedge item still live. How to deal with MTM. Thanks
HI Silvia – in the above it says that the you account (In most cases) for fair value changes in a fair value hedge through P&L _ yet we go to the importance of hedge accounting in the guest article – and the first example – a fair value hedge of the AFS – it would seem only the ineffective portion is going to the P&L. Can you please clarify?
Well, the second treatment (ineffective portion in P/L) relates to the cash flow hedge; you first sentence relates to fair value hedge.
Dear Silvia,
My company is applying the layer approach while hedging future probable sales forecast.
I tried to find out if IFRS 9 can offer a guidance related to de designation. If the hedge is outside the range defined in the company(over hedged) am I forced to de designated full last layer or I can use partially de designation? Thank you a lot for your guidance.
Ana Maria
Hi Silvia, Could you please answer my question. If Swap is sold (terminated) but Bond (hedge item) is still live what will be the treatment of MTM realization from Swap, as of now there is no MTM taken to P&L apart from Ineffectiveness portion.
Hi Akanksha, you need to take everything to P/L, including accumulated cash flow hedge reserve in other comprehensive income. So even if you do not realize any profit or loss at the date of swap termination, you will still need to derecognize this reserve (accumulated in OCI) and recognize it in P/L.
Hi Silvia, I would like to ask what the impacts on the balance sheet for both hedging methods? Will they lead to no balance sheet volatility if it is a 100% effect hedge?
Also, if I have a FVOCI asset that is hedged using a put option, will I need to do amortisation?
if you cash flow hedge account for a future cash flow from a signed sales contract, once that sale contract is invoiced to the customer it appears in the GL as an account recieable which is revalued monthly as part of the ERP’s reval process but we are still hedge account for this transacton, do we need to discontinue the reval process as the AR is included in our hedge account amounts.
Is it appropriate to recognise the fair value of a hedge contract before the effective date of the contract due to a prepayment of the hedging premium?
Hi Silvia
I have a question regarding the fair value hedge.
Normally, inventories (e.g. Oil..) are measured at lower of cost and NRV. Do we measure inventories at fair value in case of fair value hedge accounting?
Thanks in advance!
Hi Movsar, if they are hedged item, yes.
Hi Silvia,
Thank you for your explanations, very helpful indeed. One question related to presentation & disclosure in the F/S: Let’s assume I want to hedge a future sales transaction which will happen in a foreign currency – and I want to secure it against FX rate changes (not applying hedge accounting). In what PNL line item would I record the hedge revaluation effects in my financials until the underlying sales transaction will happen somewhere in the future?
Thx a lot in advance.
Hi Daniel, if you do not apply hedge accounting, then all change in FV of your derivative goes in profit or loss. Now, the standard does not tell you the exact classification and it will depend on your policy choice, but I would recommend grouping it somewhere after sales/cost of sales since it relates to this main business, but of course there are many factors affecting the policy choices.
Hi Silvia
Thank you for great insights on this comlicated subject . I have a question if you may .
i have entered into an irs where i recieve floating rate ( euribor 3m flat ) and pay fix ( + spread ) .
this spread on the fix side is composed of credit exposure + funding cost & ext .
obviously , the irs is not nill at inception ( because the spread added to the fix side )
my question to you is how do i treat that irs from accounting point of view ( my main problem from now on is to check effectiness’ and how do i enter this not nill irs into the books ) . my primary objective in entering this irs in 1st place was to hedge afloating loan i took , so it was cash flow hedge .
many thanks , looking forward for your insights on that subject
Adiv