
Accounting for Derivatives: Why Hedge Accounting?
Hedging:
Hedging of an open risk position by building an offsetting position, so that Hedging of an open risk position by building an offsetting position, so that gains and losses from the open underlying transaction (hedged item) and the gains and losses from the open underlying transaction (hedged item) and the hedging transaction cancel each other out hedging transaction cancel each other out
Problem prior to IAS 39/FAS 133:
If derivatives are off-balance sheet items, the earnings risk - for non-hedging If derivatives are off-balance sheet items, the earnings risk - for non-hedging derivatives or not effectively hedging derivatives - is not measured. derivatives or not effectively hedging derivatives - is not measured.
Solution
Derivatives have to be accounted on the balance sheet. Derivatives have to be accounted on the balance sheet. Special hedge accounting allowed if criterias like effectiveness are met Special hedge accounting allowed if criterias like effectiveness are met
Hedge Exposures
- Forecasted transactions are expected future cash flows that are not recorded in the balance sheet and are not related to a certain contract. Example: forecasted sale.
- Unrecognized firm commitmentsare contractual obligations or liabilities to third parties. All important parameters such as quantity and price are fixed. Example: sales order/sales contract.
- Recognized assets and liabilities - Financial assets and liabilities, e.g. bonds. As of FAS 138 receivables and payables can also be designated as hedged items.
Hedge Categories I
Fair value hedge:
Hedging of balance sheet exposures, or of unrecognized firm commitments, against fluctuations in their fair value
Cash flow hedge:
Hedging of balance sheet exposures, or of forecasted transactions, against fluctuations in future cash flows Hedge of a net investment:
Hedging of net investments
recorded on the balance sheet against value fluctuations due to exchange rate fluctuations
Fair value hedge
Transaction/Exposure:
- Fair value of a recognized asset/liab. fair value of an unrecognized firm commitment
Risk factors :
- Price interest rate exchange rate risk
Accounting Treatment:
- Recognize the change in fair value of derivatives in balance sheet against earnings recognize the change in fair value of the hedged item against earnings effective portion is offset and any ineffectiveness is recorded in earnings (net effect on earnings)
Cash flow hedge
Transaction/Exposure:
- variability in future cash flows of recogn. asset/liab.
- variability in future cash flows of forecasted transact.
Risk factors :
- price
- interest rate
- exchange rate risk
Accounting Treatment:
- effective portion is recorded on a cumulative basis in Other Comprehensive Income (OCI) or equity
- the ineffective portion is recorded in current P/L
- no adjustments of the hedged item is recorded
- OCI-balance is reclassified as hedged item affects earnings
Net investment in a foreign subsidiary
Exposure:
- Investment in a foreign subsidiary (different functional currency)
Risk factors :
Accounting Treatment:
- effective portion is recorded on a cumulative basis in CTA or equity
- the ineffective portion is recorded in current P/L
- no adjustments of the hedged item is recorded
- OCI-balance is reclassified as hedged item affects earnings
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