In: Accounting
1) (a) What is the purpose of hedge accounting?
(b) Paragraph 86 of AASB 139 ‘Financial Instruments: Recognition and Measurement’ identifies three types of hedging relationships. Identify and explain those relationships.
1.Purpose of Hedge Accounting:
Hedge accounting is a method of accounting where entries for the ownership of a security and the opposing hedge are treated as one. Hedge accounting attempts to reduce the volatility created by the repeated adjustment of a financial instrument's value, known as marking to market.
This reduced volatility is done by combining the instrument and the hedge as one entry, which offsets the opposing movements.
The point of hedging a position is to reduce the volatility of the overall portfolio.
Hedge accounting has the same effect except that it's used on financial statements.
For example, when accounting for complex financial instruments, such as derivatives, the value is adjusted by marking to market; this creates large swings in the profit and loss account.
Hedge accounting treats the reciprocal hedge and the derivative as one entry so that large swings are balanced out.
Hedge accounting is used in corporate bookkeeping as it relates to derivatives.
In order to lessen overall risk, hedging is often used to offset the risks associated with the derivatives. Hedge accounting uses the information from the derivative and the associated hedge as a single item, lessening the appearance of volatility when compared to reporting each individually.
Hedge accounting is an alternative to more traditional accounting methods for recording gains and losses.
When treating the items individually, such as a derivative and its associated hedge fund, the gains or losses of each would be displayed individually.
Since the purpose of the hedge fund is to offset the risks associated with the derivative, hedge accounting treats the two line items as one.
Instead of listing one transaction of a gain and one of a loss, the two are examined to determine if there was an overall gain or loss between the two and just that amount if recorded.
This approach can make financial statements simpler, as they will have fewer line items, but some potential for deception exists since the details are not recorded individually.
2.Hedging Relation
Ships:
Hedging relationships are of three types:
(a) fair value hedge: a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss.
(b) cash flow hedge: a hedge of the exposure to variability in cash flows that (i) is attributable to a particular risk associated with a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction and (ii) could affect profit or loss.
(c) hedge of a net investment in a foreign operation as defined in AASB 121.
Fair Value Hedges:
If a fair value hedge meets the conditions in paragraph 88 during the period, it shall be accounted for as follows:
(a) the gain or loss from remeasuring the hedging instrument at fair value (for a derivative hedging instrument) or the foreign currency component of its carrying amount measured in accordance with AASB 121 (for a non-derivative hedging instrument) shall be recognised in profit or loss; and
(b) the gain or loss on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognised in profit or loss. This applies if the hedged item is otherwise measured at cost. Recognition of the gain or loss attributable to the hedged risk in profit or loss applies if the hedged item is a financial asset measured at fair value through other comprehensive income.
Cash Flow Hedge:
If a cash flow hedge meets the conditions in paragraph 88 during the period, it shall be accounted for as follows:
(a) the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge (see paragraph 88) shall be recognised in other comprehensive income; and
(b) the ineffective portion of the gain or loss on the hedging instrument shall be recognised in profit or loss.
Hedge Relation shi[p Conditions:
A hedging relationship qualifies for hedge accounting under paragraphs 89–102 if, and only if, all of the following conditions are met.
(a) At the inception of the hedge there is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge. That documentation shall include identification of the hedging instrument, the hedged item or transaction, the nature of the risk being hedged and how the entity will assess the hedging instrument’s effectiveness in offsetting the exposure to changes in the hedged item’s fair value or cash flows attributable to the hedged risk.
(b) The hedge is expected to be highly effective (see Appendix A paragraphs AG105–AG113A) in achieving offsetting changes in fair value or cash flows attributable to the hedged risk, consistently with the originally documented risk management strategy for that particular hedging relationship.
(c) For cash flow hedges, a forecast transaction that is the subject of the hedge must be highly probable and must present an exposure to variations in cash flows that could ultimately affect profit or loss.
(d) The effectiveness of the hedge can be reliably measured, ie the fair value or cash flows of the hedged item that are attributable to the hedged risk and the fair value of the hedging instrument can be reliably measured.
(e) The hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the financial reporting periods for which the hedge was designated.
Hedges of a net investment :
102 Hedges of a net investment in a foreign operation, including a hedge of a monetary item that is accounted for as part of the net investment (see AASB 121), shall be accounted for similarly to cash flow hedges: Federal Register of Legislative Instruments F2015L01609 AASB 139 12 STANDARD
(a) the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge (see paragraph 88) shall be recognised in other comprehensive income; and
(b) the ineffective portion shall be recognised in profit or loss. The gain or loss on the hedging instrument relating to the effective portion of the hedge that has been recognised in other comprehensive income shall be reclassified from equity to profit or loss as a reclassification adjustment (see AASB 101) in accordance with paragraphs 48–49 of AASB 121 on the disposal or partial disposal of the foreign operation.