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What is hedge accounting?
In this method, companies are allowed to recognize their gains and losses on hedging instruments against exposure of derivative instruments to reduce income volatility, if both are accounted separately.
The main purpose of hedge accounting is to match the derivative gain/loss with underlying investment gain/loss. Its main advantage is that it can recognize both the transactions in the same accounting period.
Hedge accounting International Financial Reporting Standards (IFRS) 9 contains the following −
- Classification and measurement of financial instruments.
- Impairment of financial assets.
Types
The types of hedge accounting are as follows −
Fair value hedge − Change in fair value of asset/liability/unrecognised firm commitment.
Cash flow hedge − Exposure of firm variability in cash flow, currency risk unrecognised from commitment.
Net investment hedge − Risk arises due to translation of net assets of foreign operations to their parent company functional currency
Criteria
Given below is the criterion required for the hedge accounting −
Both hedge items and hedge instruments are identified and designated.
Hedge relationships should be documented formally
Hedge relationships should be highly effective.
Effectiveness of hedge relationships should be tested periodically.
Calculation Methods
Commonly used calculation methods (International Accounting Standard IAS 39) to calculate the hedge effectiveness are as follows −
Critical terms comparison − Comparison of hedge instruments (term, currency, notation, rate etc.) to hedged items.
Dollar offset method − Comparison of change in fair value between hedge instruments and hedge item.
Regression analysis − Investigates statistical strength between hedge instruments and hedge items.
Termination process
The termination process of hedge relationship includes −
Fails an effectiveness test.
Hedge item sold/settled.
Hedge instrument sold/terminated/exercised.
Management decision.
Forecast transaction is not highly probable.
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