by Assume a company has issued fixed-rate debt, but the majority of their interest-earning assets earn interest based on variable interest rates. The company is exposed to interest rate risk because if interest rates decline substantially, the income earned on their interest earning assets will be less, while the interest payable on their debt remains constant at the fixed rate.
To mitigate this risk, a pay-variable, receive-fixed interest rate swap could be used to “free” themselves from this fixed position. If the hedge qualifies for fair value hedge accounting, then the derivative unlocks the fixed-rate debt, protecting against exposure to changes in fair value of the debt.
Under fair value hedge accounting, the derivative must be recorded at fair value with changes in fair value presented in the same income statement line item as the earnings effect of the hedged item.
Additionally, the change in fair value of the hedged item due to the risk being hedged is recorded as an adjustment to the hedged item through the income statement in the same account line item that normally would be used for that underlying asset or liability.
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.
Cash flow hedges are used when hedging the variability of cash flows. For example, assume a company issues variable rate debt while the majority of their interest-earning assets are in the form of fixed interest receivables. They are at risk of changes in interest rates because if interest rates increase substantially, the income being earned on their interest earning assets will be constant or fixed, while the interest payable on their debt will fluctuate with the changes in rates.
To mitigate this risk, a receive-variable, pay-fixed interest rate swap could be used to protect against future cash flow uncertainty. If the hedge qualifies for cash flow hedge accounting, then the derivative fixes or locks-in the debt interest payments, protecting against changes in cash flows due to changes in interest rates.
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.
Accounting treatment:
| 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) |
Cash flow hedge
Cash flow hedges can help to mitigate the risks that are associated with sudden changes in cash flows of assets or liabilities, rather than the asset or liability itself. There are many different factors that can bring about these sorts of changes, such as increases/decreases in foreign exchange rates, changes in interest rates, changes in asset prices, and so on.
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.
Steps:
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
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 |
Fair Value Hedge vs Cash Flow Hedge
- Fair value hedge is hedging against the risk on the fair value of an asset which is expected to impact the financial statement whereas as a cash flow hedge aims at mitigating the risk associated with the cash flows.
- The cash flow hedge mitigates the vulnerability of a cash flow related to an asset, liability or a transaction that is related to a particular risk. A cash flow hedge is formulated in a way that it minimizes the risk that a company might end up paying more for a raw material than what it expects.
