HedgeAccounting

Hedge accounting refers to a set of accounting rules that align the recognition of gains and losses on a hedging instrument with the accounting for the hedged risk, in order to reduce unwanted volatility in reported earnings. It is applied when an entity designates a hedging relationship and documents how the hedge will mitigate specific risks, such as changes in fair value, cash flows, or net investments in foreign operations.

The main hedging relationships are fair value hedges, cash flow hedges, and net investment hedges. In a fair value hedge, both the hedging instrument and the hedged item are adjusted through earnings to reflect changes in the hedged risk. In a cash flow hedge, the effective portion of the gain or loss on the hedging instrument is reported in other comprehensive income (OCI) and subsequently reclassified to earnings when the hedged item affects earnings. In a net investment hedge, gains and losses are recognized in OCI as part of translation adjustments. The accounting treatment is designed to reflect the economic intent of the hedge and the timing of the hedged exposure.

Eligibility requires formal designation and comprehensive documentation at inception, including the hedging objective, the hedged risk, the hedging instrument, and the method for assessing effectiveness. Effectiveness testing is performed to determine whether the hedge is highly effective in offsetting changes in the hedged risk, with certain regimes allowing some tolerance for ineffectiveness.

IFRS 9 (IFRS) and US GAAP (ASC 815) govern hedge accounting, with IFRS emphasizing a unified model and US GAAP maintaining specific eligibility criteria and effectiveness requirements. Differences exist in measurement and presentation, but both aim to reflect economic hedging activity in financial statements.

Examples include using interest rate swaps to hedge floating-rate debt, commodity futures to hedge purchase commitments, and foreign currency borrowings to hedge net investments in subsidiaries. Limitations include potential ineffectiveness, the need for ongoing documentation, and possible discontinuation if criteria fail.