Deferral Hedge Accounting under Japanese GAAP

Deferral hedge accounting under Japanese GAAP is a hedge accounting method in which a company defers gains, losses, or valuation differences on a hedging derivative in net assets until gains or losses on the hedged item are recognized, so that the two fall in the same period. Japanese GAAP also has the special treatment for qualifying interest rate swaps and the assignment method for FX forwards and similar instruments.

Under Japanese GAAP, accounting staff decide whether to apply hedge accounting to a derivative. They also handle deferred hedge gains or losses, from the inception of the hedge through the closing. Of the requirements, documented confirmation is done at inception, and effectiveness is evaluated at the closing date.

Why it exists

When a company uses derivatives for hedging, the gains and losses on the hedged item and on the hedging instrument can fall in different periods. Suppose, for example, that a company holds an interest rate swap that fixes the interest payments on a floating-rate loan. If it does not use hedge accounting, the swap is valued at fair value under the basic principle¹. Hedge accounting is an accounting treatment that matches the two gains or losses to the same period and shows the effect of the hedge in the financial statements².

The standard for hedge accounting under Japanese GAAP is the Accounting Standards Board of Japan (ASBJ)'s ASBJ Statement No. 10, "Accounting Standard for Financial Instruments". The Japanese Institute of Certified Public Accountants (JICPA)'s Accounting Systems Committee Statement No. 14, "Practical Guidelines on Accounting for Financial Instruments", set out how to apply the standard³. As that Statement was abolished, the paragraph numbers below are those of its last version before the abolition (the 2019 revision)⁴.

The idea of hedge accounting and its three types (fair value hedges, cash flow hedges, and others) are covered in Hedge Accounting Basics.

Deferral hedge accounting and the fair value hedging method

The basic hedge accounting method under Japanese GAAP is deferral hedge accounting. As an exception, the fair value hedging method is also allowed⁵.

Deferral hedge accounting defers the gains, losses, or valuation differences on the hedging instrument until the gain or loss on the hedged item is recognized in net profit or loss. The deferred amount is called deferred hedge gains or losses⁶⁷. The fair value hedging method reflects market changes in the hedged item in profit or loss, so that the gain or loss on the hedged item and the gain or loss on the hedging instrument are recognized in the same accounting period⁵.

The fair value hedging method can be used only where the hedged item can be carried at fair value on the balance sheet. The practical guidelines as of the 2019 revision read this, in light of their relationship with the accounting standard for financial instruments, as covering only other securities⁵. When other securities are the hedged item, the company chooses either deferral hedge accounting or the fair value hedging method⁶.

Requirements for using hedge accounting

To use hedge accounting, a company must meet requirements at the inception of the hedge and requirements from then on⁸.

When the hedge begins, the company makes clear in a formal document the hedging instrument, the hedged item, and the method for evaluating hedge effectiveness⁹.
The company shows objectively that the hedge follows its own risk management policy. To do so, it must be confirmable in a document that the hedge follows the policy, or there must be clear internal rules and an internal control organization, and the transaction must be expected to be processed in line with them¹⁰.
After the hedge begins, the company also checks that high effectiveness is kept throughout the designated hedge period. It evaluates effectiveness at every closing date, and at least about once every six months¹¹.

In principle, the effectiveness test compares the cumulative changes in the hedged item and the hedging instrument from the start of the hedge to the date of the test. If the ratio of the changes is roughly within the range of 80% to 125%, a high correlation is recognized¹². For example, if the loss on the hedging instrument is 80 and the gain on the hedged item is 100, the ratio is 80%. If the gain on the hedging instrument is 100 and the loss on the hedged item is 80, it is 125%. Both are within the range¹².

Treatment under deferral hedge accounting and deferred hedge gains or losses

Under deferral hedge accounting, the company marks the hedging instrument to fair value and records the valuation difference in deferred hedge gains or losses. Deferred hedge gains or losses are recorded in the net assets section. They are recorded net of the amount of deferred tax assets or deferred tax liabilities, and in consolidated financial statements the change for the period is presented as other comprehensive income¹⁷.

Consider a hypothetical example in which a company enters into an interest rate swap to fix the interest payments on a floating-rate loan of 1 billion yen. Assume the swap meets the requirements for hedge accounting but not the conditions for the special treatment. Ignore tax effects.

Fair value of the swap at period-end	Content of the journal entry	Deferred hedge gains or losses
Plus 30 million yen (favorable to the receiving side)	Record the interest rate swap (asset) of 30 million yen and record deferred hedge gains or losses on the credit side	Credit 30 million yen
Minus 20 million yen (unfavorable to the paying side)	Record the interest rate swap (liability) of 20 million yen and record deferred hedge gains or losses on the debit side	Debit 20 million yen

In either case, the valuation difference does not appear in profit or loss for the period. An entry of the same form appears in Example 24 of the practical guidelines (a loan of 100 million yen, three years)¹⁸.

Figure 1 shows the flow from when deferred hedge gains or losses are recorded until they return to profit or loss.

Figure 1From recording deferred hedge gains or losses to returning them to profit or loss

Figure description

The figure is a timeline of deferral hedge accounting in chronological order. At the inception of the hedge, the company makes clear in a formal document the hedging instrument, the hedged item, and the method for evaluating effectiveness. At each closing date, it marks the hedging instrument to fair value and records the valuation difference, whether a gain or a loss, in deferred hedge gains or losses, so that it does not appear in profit or loss for the period. Deferred hedge gains or losses sit in the net assets section, net of tax effects. When the gain or loss on the hedged item arises, the company returns deferred hedge gains or losses to profit or loss and, in principle, presents them in the same category as the hedged item. The spacing in the figure does not represent the length of time. The filled circle marks the point at which the amount returns to profit or loss.

The timing at which deferred hedge gains or losses return to profit or loss is set by the hedged item. If the hedged item is goods, it goes to cost of sales; if it is shares, to gains or losses on sales of securities; and if it is an interest-bearing asset or liability, it goes to an adjustment of interest¹⁹. For the hedge of a forecast transaction, the treatment is as follows²⁰.

Forecast transaction	Treatment of deferred hedge gains or losses
A transaction whose net profit or loss arises immediately, such as a sale or interest	Taken into net profit or loss for the period when the transaction is executed
Purchase of inventory or property, plant and equipment	Added to or deducted from the acquisition cost of the asset and reflected in profit or loss in the period in which the asset becomes an expense
Incurrence of an interest-bearing liability, such as a bond or a loan	Kept in net assets and allocated to each period under the amortized cost method, in line with the interest expense

Special treatment for interest rate swaps

Interest rate swaps are used to convert the payment and receipt terms of interest on an asset or a liability. Suppose the requirements for hedge accounting are met. Suppose also that the notional amount, the interest payment and receipt terms, and the contract period are almost the same as those of the hedged item. The company then need not mark the swap to fair value. Instead, it adds the net cash settlement to, or deducts it from, the interest on the hedged asset or liability. This is called the special treatment²¹.

All of the following conditions must be met for the special treatment²².

The notional amount of the swap and the principal of the hedged asset or liability almost match.
The contract period of the swap almost matches the maturity of the hedged item.
If the hedged item has a floating rate, its underlying index almost matches the floating-rate index of the swap.
The interval and dates of the interest rate resets on the swap almost match those of the hedged item.
The payment and receipt terms of the swap are constant throughout the period.
If the swap has an early termination option, a floor on the interest paid, or a cap on the interest received, it is there to offset an equivalent condition included in the hedged item.

Figure 2 shows the order of the judgment on whether the special treatment can be used. The "conditions for the special treatment" in the figure are the six conditions above.

Figure 2Whether the special treatment can be used for an interest rate swap

Figure description

The figure is a decision flow that checks, in order, whether the special treatment can be used for an interest rate swap, through three questions. The first asks whether the hedging instrument is an interest rate swap. If the answer is no, the case is outside the figure, and the treatment of FX forwards and similar instruments is in the next section (even apart from interest rate swaps, caps and floors may be eligible for the special treatment, as a later paragraph explains). The second asks whether the requirements for hedge accounting are met, and if not, hedge accounting cannot be used. The third asks whether all six conditions above are met. If not, deferral hedge accounting applies in principle, and if so, the special treatment can in principle be used. Because a company that meets the requirements for hedge accounting can use deferral hedge accounting even when the conditions for the special treatment are not met, not qualifying for the special treatment does not mean giving up hedge accounting. However, if the hedged items are trading securities or other securities, the special treatment is outside its scope.

The notional amount and the principal are treated as almost the same if they differ by no more than 5% of either²². If it can be determined that the conditions for the special treatment are met, that determination can replace the effectiveness test²³.

Consider a hypothetical example in which a company enters into a swap with the same principal, term, and payment dates to fix the interest payments on a floating-rate loan of 1 billion yen, paying a fixed rate of 1.5% and receiving the floating rate. Interest is paid once a year in arrears, for simplicity.

Year	Floating rate	Interest on the loan	Net swap settlement	Interest burden
Year 1	1.0%	10 million yen	Pay 5 million yen	15 million yen
Year 2	2.0%	20 million yen	Receive 5 million yen	15 million yen

Because the net swap settlement is added to or deducted from the interest on the loan, the interest burden is fixed at 1.5% of 1 billion yen, which is 15 million yen, in both years. In a year when the floating rate falls, the swap settlement is a payment, and in a year when it rises, it is a receipt. Compared with not fixing the rate, the interest burden is heavier in a year when the floating rate falls (15 million yen against 10 million yen in Year 1) and lighter in a year when it rises (15 million yen against 20 million yen in Year 2). An example of the same form appears in Example 23 of the practical guidelines²⁴.

A cap on the interest paid and a floor on the interest received can also be given the special treatment, in line with interest rate swaps, if they meet the same conditions²⁵.

Assignment method for FX forwards and similar instruments

When foreign-currency monetary claims and obligations are hedged with an FX forward or a similar instrument, the company uses one of the following²⁶.

Mark the FX forward or similar instrument to fair value under the accounting standard for financial instruments, and translate the foreign-currency claim or obligation at the closing-date rate.
Assign the FX forward or similar instrument to the foreign-currency claim or obligation (the assignment method).

Method 1 simply applies the ordinary treatment to the hedging instrument and the hedged item, and the timing at which the effect of the hedge appears in profit or loss is already matched. It is therefore not hedge accounting, and there is no need to test whether the requirements are met²⁷. The assignment method in 2 is allowed "for the time being", and meeting the requirements for hedge accounting is a condition of applying it²⁶.

Under the assignment method, the hedged item is translated at the forward rate, and the valuation difference and translation difference on the hedging instrument and the hedged item are not recorded. The difference between the forward rate and the spot rate is allocated over the period, so it is generally considered that there is no material difference in the calculation of net profit or loss from the case where the FX forward or similar instrument is marked to fair value²⁸.

Consider a hypothetical example in which a company sells a foreign-currency receivable of USD 1 million under an FX forward at 150 yen per dollar. The receivable is translated at 150 million yen. If the spot rate at the time of the transaction is 148 yen per dollar, the difference of 2 yen per dollar, or 2 million yen for USD 1 million, is what is allocated over the period. If the forward rate is 146 yen per dollar, it is 2 yen per dollar lower than the spot rate, and the difference of 2 million yen for USD 1 million, unfavorable to the selling side, is likewise what is allocated over the period.

When hedge accounting ends

A company discontinues hedge accounting when the hedging relationship no longer meets the company's criteria for evaluating effectiveness, or when the hedging instrument disappears through maturity, sale, termination, or exercise⁷.

The gains and losses on the hedging instrument up to the point of discontinuation stay deferred until the gain or loss on the hedged item is recognized in net profit or loss⁷. When hedge accounting is discontinued because the effectiveness criteria are no longer met, the gains and losses on the hedging instrument after the discontinuation go to net profit or loss for the period in which they arise⁷.

When the hedging instrument was hedging the interest rate risk of an interest-bearing financial instrument, the deferred gains and losses are allocated as an adjustment of interest over the period up to the maturity of the hedged item⁷.

When the hedged item disappears, or when it becomes clear that a forecast transaction will not be executed, the deferred gains and losses go to net profit or loss for the period²⁹. If, after hedge accounting is discontinued, the unrealized gain on the hedged item shrinks and a material loss may arise, the company estimates the loss and takes it as a loss for the period³⁰.

Notes

Accounting Systems Committee Statement No. 14, paragraph 346 (Basis for conclusions: the statement that the basic principle of the accounting standard for financial instruments is fair value measurement of derivatives and that the special treatment for interest rate swaps is an exception to it) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 338 (Basis for conclusions: hedge accounting is an accounting treatment that recognizes the gains and losses on the hedged item and on the hedging instrument in the same accounting period, so that the effect of the hedge is reflected in the calculation of net profit or loss for the period) (in Japanese). ↩
Japanese Institute of Certified Public Accountants (JICPA), Accounting Systems Committee Statement No. 14, "金融商品会計に関する実務指針" (Practical Guidelines on Accounting for Financial Instruments, our translation), last revised July 4, 2019, paragraph 1 (ASBJ Statement No. 10 "Accounting Standard for Financial Instruments" is referred to as the "accounting standard for financial instruments") and the revision history on the cover (in Japanese). ↩
Japanese Institute of Certified Public Accountants, "移管に伴う会計制度委員会が公表した実務指針等の廃止について" (Abolition of the practical guidelines published by the Accounting Systems Committee on their transfer, our translation). Accounting Systems Committee Statement No. 14 was abolished as of July 1, 2024 and transferred to the guidance of the Accounting Standards Board of Japan (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 185 (the method in the proviso to paragraph 32 of the accounting standard for financial instruments. As of the 2019 revision, it is read as applying only to other securities) (in Japanese). ↩ ↩² ↩³
Accounting Systems Committee Statement No. 14, paragraph 160 (in a hedge of other securities, either deferral hedge accounting or the fair value hedging method can be chosen) (in Japanese). ↩ ↩²
Accounting Systems Committee Statement No. 14, paragraph 180 (gains, losses, or valuation differences on the hedging instrument are deferred until the gain or loss on the hedged item is recognized in net profit or loss) (in Japanese). ↩ ↩² ↩³ ↩⁴ ↩⁵
Accounting Systems Committee Statement No. 14, paragraph 142 (requirements for hedge accounting: requirements at the inception of the hedge and requirements from then on) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 143 (matters to be made clear in a formal document when the hedge begins) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 144 (the requirement at the inception of the hedge in paragraph 31 of the accounting standard for financial instruments) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 146 (confirming effectiveness after the hedge begins: at every closing date and at least about once every six months) (in Japanese). ↩ ↩²
Accounting Systems Committee Statement No. 14, paragraph 156 (criteria for the effectiveness test: roughly within 80% to 125%, with the example of 80 and 100) (in Japanese). ↩ ↩²
Accounting Systems Committee Statement No. 14, paragraph 147 (matters to be stated in the risk management policy document) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 155 (when the method for evaluating effectiveness is changed) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 150 (matters to be confirmable in the hedge designation) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 153 (linking the hedge transaction to the hedged item, and separate management) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 174 (deferred hedge gains or losses are recorded in the net assets section, net of the amount of deferred tax assets or deferred tax liabilities; in consolidated statements they are presented as other comprehensive income) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, Example 24 "金利スワップによるヘッジ会計の適用" (Application of hedge accounting with an interest rate swap, our translation) (PDF pages 149 to 150. The entries recording the interest rate swap and deferred hedge gains or losses at the closing date for a floating-rate loan of 100,000,000 yen over three years) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 176 (the account used when deferred hedge gains or losses are taken into net profit or loss) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 170 (treatment when a forecast transaction is executed) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 177 (the special treatment in Note 14 to the accounting standard for financial instruments) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 178 (conditions for the special treatment, the difference within 5%, the excluded securities, and hedge accounting through deferral hedge accounting) (in Japanese). ↩ ↩²
Accounting Systems Committee Statement No. 14, end of paragraph 158 (where the requirements for the special treatment are met, that determination can replace the effectiveness test) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, Example 23 "金利スワップの特例処理の対象" (Hedged items for the special treatment of interest rate swaps, our translation) (PDF pages 148 to 149. A loan of 100,000 over five years, the entries under the special treatment, and the conclusion that the total interest is fixed at the fixed rate) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 179 (the special treatment for caps and floors) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 167 (hedging foreign-currency monetary claims and obligations. The assignment method is "for the time being", and meeting the requirements for hedge accounting is a condition) (in Japanese). ↩ ↩²
Accounting Systems Committee Statement No. 14, paragraph 168 (the basic treatment is outside hedge accounting) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 336(4) (Basis for conclusions: treatment of the assignment method. The allocation over the period of the difference between the forward rate and the spot rate is in Note 7 to the Accounting Standard for Foreign Currency Transactions; our translation of the title) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraph 181 (the end of hedge accounting) (in Japanese). ↩
Accounting Systems Committee Statement No. 14, paragraphs 182 and 183 (estimating the loss at the point hedge accounting ends; paragraph 33 of the accounting standard for financial instruments) (in Japanese). ↩

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