Generally hedging instruments are financial instruments used by investors to offset potential changes in fair value of their hedged items.
For example, if a company is selling and buying their products in international markets they are subject to foreign exchange risk, as the exchange rate (foreign currency to domestic currency) always fluctuates and sometimes it has a negative impact on the company’s profits.
To minimise that risk, companies may purchase financial products to secure a specific exchange rate at a future date. Contracts of this type are known hedging instruments.
Sometimes, a group/entity carries their hedging transactions using their central treasury function instead of an external group. This central treasury aggregates all internal positions and enters into external transactions to offset internal on net basis.
It is also cost efficient. In this, the intragroup derivatives are not considered as hedging instruments and on consolidation they are eliminated.
International accounting standards 39 (IAS 39) was released by the International Accounting Standards Board (IASB) in 2003. IAS 39 outlines financial assets, financial liabilities requirements for recognition and measurement. It also outlines about come contracts (non-financial items) to buy or sell.
In 2004, European Union adopted these standards and in 2005, European Union introduced the fair value and hedging provision of the amended version of international accounting standards 39.
This version was changed in 2008 due to the financial crisis. In response to the financial crisis, the Financial Accounting Standards Board (FASB) issued a staff position statement in 2008 October.
Held to maturity investments, loans and receivables, financial liabilities (not carried through fair values) are measured at amortised cost.
Financial assets and liabilities (held for trading), financial assets (available for sale) are measured at fair value.
According to Indian accounting standards 39 (IAS 39), hedging instruments are designated as follows−
For currency basis spreads, no particular accounting treatment is prescribed.