Hedge accounting comes up when a company that hedges with derivatives decides how the effect of the hedge shows in its period-end profit or loss. It involves the reason gains and losses fall in different periods, three types of hedge, designation documents, and the situations in which it ends.

The timing gap that hedge accounting resolves

A hedging instrument such as a derivative is, in principle, measured at fair value at the end of each period, and the valuation gain or loss goes to the income statement. A hedged item is not always treated this way1. For example, if a loan at a floating rate is measured at amortised cost, its future interest is not valued at period end and recognized in profit or loss like a hedging instrument. It is allocated to the periods by the effective interest method2.

Left as it is, two gains or losses that are meant to offset each other appear in different periods. The gap is called an "accounting mismatch." Hedge accounting reflects the effect of hedging in the accounts by recognizing the gain or loss on the hedging instrument and the gain or loss on the hedged item in the same period1. Under IFRS 9, the objective of hedge accounting is to represent in the financial statements the effect of risk management activities that use financial instruments3. ASC 815 of US generally accepted accounting principles (US GAAP) likewise provides special accounting to deal with the difference in accounting between the hedging instrument and the hedged item4.

The idea of measuring derivatives at fair value is covered in Fair Value Measurement: IFRS 13, ASC 820 and the Fair Value Hierarchy.

The three types and the names each standard uses

IFRS 9 divides hedging relationships into three types5. ASC 815 also distinguishes three: fair value hedges, cash flow hedges, and net investment hedges6.

Type (IFRS 9) What is hedged Treatment of the gain or loss on the hedging instrument
Fair value hedge Changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment Recognized in profit or loss. The hedged item also has a gain or loss from the hedged risk, which adjusts its carrying amount and is recognized in profit or loss
Cash flow hedge Variability in the cash flows of a recognized asset or liability, and of a highly probable forecast transaction The effective portion is held in other comprehensive income and reclassified to profit or loss in the period in which the hedged cash flows affect profit or loss. The ineffective portion is recognized in profit or loss
Hedge of a net investment in a foreign operation A net investment in a foreign operation Treated like a cash flow hedge. The accumulated amount of the effective portion is reclassified to profit or loss when the foreign operation is disposed of

The treatment differs from the table when the hedged item is an equity instrument for which the company elected to present fair value changes in other comprehensive income5.

The 2017 amendment to ASC 815 (ASU 2017-12) requires the change in the fair value of the hedging instrument in a fair value hedge to be presented in the same income statement line as the gain or loss on the hedged item. For cash flow hedges and net investment hedges, the change is recorded in other comprehensive income (in the translation adjustment category for a net investment hedge) and reclassified to profit or loss when the hedged item affects profit or loss7.

The description of Japanese generally accepted accounting principles (Japanese GAAP)8 rests on an audit firm's commentary. The commentary describes the Japanese GAAP hedge accounting methods by the names of the treatments. They are deferral hedge accounting, the fair value hedging method, the assignment method, and the special treatment1. Deferral hedge accounting (the principle) is a method in which the gain, loss, or valuation difference on the hedging instrument stays on the balance sheet until the gain or loss on the hedged item is recognized. Under deferral hedge accounting, the valuation difference on the hedging instrument at the fiscal year-end is recorded in the net assets section as deferred hedge gains or losses, not in profit or loss9. The fair value hedging method (the exception) is a method in which the change in the market value of the hedged item is also included in profit or loss, so the gains and losses on the hedged item and the hedging instrument fall in the same period. It is the name of a Japanese GAAP method, separate from the "fair value hedge" type of IFRS 9 and ASC 8159. The exceptions also include the special treatment for interest rate swaps and the assignment method for FX forwards1.

In short, the names in IFRS 9 and ASC 815 refer to the kind of thing being hedged, and the names in Japanese GAAP refer to the method of treatment. Deferral hedge accounting and cash flow hedges both defer the gain or loss on the hedging instrument, but they are treatments set by different standards and cannot be treated as the same. The Japanese GAAP treatment is covered in Deferral Hedge Accounting under Japanese GAAP.

A numerical example: fixing the interest on a loan

Consider a hypothetical example in which a non-financial company has a floating-rate loan of 1 billion yen (repayable in 2 years, with interest paid once a year). The company enters into an interest rate swap to fix the interest. The floating rate is set at the start of each year. Discounting, tax, and the ineffective portion are ignored. The example is written as a cash flow hedge under IFRS 9. The amount held in other comprehensive income accumulates in the net assets section.

  • The swap has a notional amount of 1 billion yen. The company pays a fixed rate of 1.5% and receives the floating rate. With discounting ignored, the fixed rate equals the average of the 2-year floating rates (1.0% and 2.0%), so the fair value at inception is 0.
  • The floating rate is 1.0% in year 1 and 2.0% in year 2. It moves as the market expected when the swap was entered into.
  • The hedged item is the future floating-rate interest on the loan. The swap in this example is one example of a cash flow hedge that converts a floating-rate loan to a fixed rate10.
Item (in million yen) Year 1 Year 2
Interest on the loan (hedged item) −10 −20
Swap settlement (pay fixed, receive floating) −5 +5
Change in the swap's fair value +5 −5
Swap's fair value at year-end +5 0
Profit or loss (with the swap, without hedge accounting) −10 −20
Profit or loss (with hedge accounting) −15 −15
Year-end balance in other comprehensive income (with hedge accounting) +5 0

Profit or loss with the swap but without hedge accounting is the sum of the interest, the swap settlement, and the change in the swap's fair value. In year 1 it is −10 + (−5) + 5 = −10, and in year 2 it is −20 + 5 + (−5) = −20. Profit or loss follows the floating rate, and the effect of fixing the rate does not show.

With hedge accounting, the change in the swap's fair value is held in other comprehensive income until the interest on the hedged item reaches profit or loss. Only the interest and the swap settlement enter profit or loss. In year 1 it is −10 + (−5) = −15, and in year 2 it is −20 + 5 = −15. A burden of 1.5% × 1 billion yen = 15 million yen appears in both years11.

↑ Gain　↓ LossYearly profit or loss, not paymentsYear 1Year 2−10 million yenNo hedge acctg−15 million yenHedge acctg−20 million yenNo hedge acctg−15 million yenHedge acctg
Figure 1Profit or loss each year, with and without hedge accounting
Figure description

The figure shows profit or loss each year, not payments. Both cases have the swap. In the labels, "No hedge acctg" and "Hedge acctg" mean not using and using hedge accounting. With the swap but without hedge accounting, the loss is 10 million yen in year 1 and 20 million yen in year 2, following the floating rate. With hedge accounting, the loss is 15 million yen in both years. The length of each arrow is a rough guide to the size of the amount. The total over the 2 years is a loss of 30 million yen in both cases, and only how it falls across the years changes.

In this example, the swap is a payment of 5 million yen (a loss) in year 1 and a receipt of 5 million yen (a gain) in year 2. The total profit or loss over the 2 years is −30 million yen with or without hedge accounting. Hedge accounting does not change the total. It changes how the total falls across the periods.

Designation documents and the effectiveness assessment

To use hedge accounting, you designate the hedging relationship in advance and document it when the hedge begins. To keep using it, you keep confirming that the hedge is effective.

Item IFRS 9 ASC 815 Japanese GAAP (audit firm's commentary)
Documentation at inception Document the hedging relationship and the risk management objective and strategy. Identify the hedging instrument, the hedged item, the risk being hedged, and the method of assessing effectiveness12 Document the same items as IFRS 9 at inception6 Confirm objectively, through documents or through clear internal rules and an internal control organization, that the hedge transaction follows the company's risk management policy13
Effectiveness requirements An economic relationship exists between the hedged item and the hedging instrument, the effect of credit risk does not dominate, and the hedge ratio equals the ratio actually used. No numerical range is given14 The assessment at inception is quantitative, except in certain cases. Later assessments can be qualitative if conditions are met615 If the ratio of the cumulative changes is roughly within 80% to 125%, a high correlation is recognized13

The hedge ratio is the proportion of the hedging instrument used against the quantity of the hedged item. IFRS 9 requires you to designate a ratio that results from the quantities you actually use14.

Under Japanese GAAP, effectiveness is assessed at each closing date and at least about once every 6 months13.

When hedge accounting ends

Under IFRS 9, hedge accounting ends prospectively only when the hedging relationship no longer meets the criteria. This includes cases where the hedging instrument matures, is sold, is terminated, or is exercised16.

However, replacing a hedging instrument with another one, or rolling it over, does not count as expiry or termination if it is consistent with the documented risk management objective. Agreeing to novation to a central counterparty because of laws or regulations also does not count as expiry or termination if certain conditions are met16.

A relationship whose risk management objective has not changed and that still meets the other criteria cannot be revoked at the company's discretion16. If the ratio no longer fits but the objective is the same, you adjust the hedge ratio and continue17.

When a cash flow hedge ends, the treatment of the amount accumulated in other comprehensive income depends on whether the future cash flows of the hedged item are still expected to occur. If they are, the amount stays where it is until the cash flows occur. If they are no longer expected, the amount is reclassified to profit or loss immediately18.

For a fair value hedge under ASC 815, hedge accounting ends prospectively when the criteria are no longer met, when the hedging instrument expires, is sold, is terminated, or is exercised, or when the company removes the designation19. A hedging relationship can be dedesignated at any time20. This differs from IFRS 9.

Under Japanese GAAP, there are two ways for hedge accounting to end, "discontinuation" and "termination". Discontinuation occurs in two cases. One is when the hedging relationship no longer meets the criteria for assessing effectiveness. The other is when the hedging instrument ceases to exist through maturity, sale, termination, or exercise. The gain, loss, or valuation difference on the hedging instrument up to that point stays deferred until the gain or loss on the hedged item is recognized. Termination occurs when the hedged item ceases to exist, or when it becomes clear that the forecast transaction that is the hedged item will not take place. The deferred gain or loss is then recognized in profit or loss for that period21.

Notes

  1. EY ShinNihon LLC, "わかりやすい解説シリーズ「ヘッジ会計」 第1回：ヘッジ取引とヘッジ会計の必要性" (Easy-to-understand commentary series "Hedge Accounting," part 1: why hedge transactions and hedge accounting are needed; in Japanese; English title added by this site) (April 19, 2018). It covers the fair value measurement of the hedging instrument and the treatment of the hedged item, the effect reflected by recognition in the same period, and the Japanese GAAP methods (deferral hedge accounting, the fair value hedging method, the assignment method, and the special treatment). ↩ ↩2 ↩3 ↩4

  2. IFRS Foundation, "IFRS 9 Financial Instruments," paragraph 4.2.1 (a financial liability is measured at amortised cost using the effective interest method, except for items such as those at fair value through profit or loss). The Appendix A definition describes the effective interest method as the method for calculating amortised cost and for allocating interest expense to profit or loss over the relevant periods. ↩

  3. IFRS Foundation, "IFRS 9 Financial Instruments," paragraph 6.1.1. ↩

  4. FASB, "Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, In Focus" (August 2017), page 1. ↩

  5. IFRS Foundation, "IFRS 9 Financial Instruments," paragraphs 6.5.2, 6.5.8, 6.5.11, and 6.5.13 to 6.5.14. The terms "firm commitment" and "highly probable forecast transaction" in the table are the terms used in paragraph 6.5.2. The exception for equity instruments is in paragraphs 6.5.3 and 6.5.8. ↩ ↩2

  6. FASB, "Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815)," 815-20-25-3 (pages 33 to 34). It covers the documentation requirement at inception, the principle that the assessment at inception is quantitative (with exceptions), and the simultaneous designation and documentation. ↩ ↩2 ↩3 ↩4

  7. FASB, "Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815)," Summary (page 4). ↩

  8. Among Japanese GAAP, the standard that sets the accounting for financial instruments is ASBJ, Statement No. 10 "Accounting Standard for Financial Instruments." The EY commentary also cites paragraphs of the practical guidance. ↩

  9. EY ShinNihon LLC, "わかりやすい解説シリーズ「ヘッジ会計」 第2回：ヘッジ会計の方法①" (Easy-to-understand commentary series "Hedge Accounting," part 2: methods of hedge accounting, 1; in Japanese; English title added by this site) (April 19, 2018). It gives the definitions of deferral hedge accounting and the fair value hedging method and where deferred hedge gains or losses are recorded. The positioning of deferral hedge accounting as the principle and the fair value hedging method as the exception is from part 1 of the same series. ↩ ↩2

  10. IFRS Foundation, "IFRS 9 Financial Instruments," B6.5.2. It gives a swap that converts a floating-rate debt to a fixed rate as an example of a cash flow hedge. ↩

  11. IFRS Foundation, "IFRS 9 Financial Instruments," paragraph 6.5.11. The paragraph says that the effective portion of the gain or loss on the hedging instrument is held in other comprehensive income and reclassified to profit or loss in the period in which the hedged cash flows affect profit or loss. The table shows annual totals and is a simplified presentation in which the swap settlement goes to profit or loss. It does not show the details of the reclassification entries. ↩

  12. IFRS Foundation, "IFRS 9 Financial Instruments," paragraph 6.4.1(b) (formal designation and documentation at inception). The method of assessing effectiveness also includes the analysis of the sources of ineffectiveness and how the hedge ratio is determined. ↩ ↩2

  13. EY ShinNihon LLC, "わかりやすい解説シリーズ「ヘッジ会計」 第4回：ヘッジ会計の適用要件" (Easy-to-understand commentary series "Hedge Accounting," part 4: criteria for applying hedge accounting; in Japanese; English title added by this site) (April 26, 2018). It covers the ex ante test (consistency with the risk management policy) and the ex post test (frequency of assessment, the range of 80% to 125%). ↩ ↩2 ↩3

  14. IFRS Foundation, "IFRS 9 Financial Instruments," paragraph 6.4.1(c)(i) to (iii). ↩ ↩2

  15. FASB, "Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, In Focus" (August 2017), page 3 (simplified effectiveness assessment). ↩

  16. IFRS Foundation, "IFRS 9 Financial Instruments," paragraph 6.5.6 and B6.5.23. The exceptions for replacement and for novation to a central counterparty are in the body of paragraph 6.5.6 and in (a) and (b). ↩ ↩2 ↩3

  17. IFRS Foundation, "IFRS 9 Financial Instruments," paragraph 6.5.5 (rebalancing the hedge ratio). ↩ ↩2

  18. IFRS Foundation, "IFRS 9 Financial Instruments," paragraph 6.5.12. ↩

  19. FASB, "Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815)," 815-25-40-1 (page 194). This is the paragraph for fair value hedges. ↩

  20. FASB, "Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815)," 815-20-55-56 (page 120). ↩ ↩2

  21. EY ShinNihon LLC, "ヘッジ会計の中止と終了" (Discontinuation and termination of hedge accounting; in Japanese; English title added by this site) (May 31, 2022). It is explained as corresponding to paragraphs 33 and 34 of the standard and paragraphs 180 and 181 of the practical guidance. ↩