Explained: Derivatives and Hedge Accounting

Tom, shaking hands with a former student.
Tom with a former student

What are derivatives?

Derivatives are complex financial instruments that are entered into at little or no cost and are designed to be settled at a future date. They are called derivatives because their value will derive from the price of an underlying item. Thus, a forward contract to buy foreign currency or a commodity at a fixed price in the future will vary in value as the exchange rate or price of the commodity varies in the meantime. Other examples of derivatives are futures, swaps, and options.

How are derivatives accounted for?

Because derivatives have no cost but will change in value then they are required to be re-measured at fair value every year. The default is to assume that the derivative has been entered into for speculation purposes and so the gain or loss is recognised in profit or loss. In other words, the default is that derivatives are accounted at FVTPL.

What about hedge accounting?

If a derivative is designated a hedging instrument, it means it is intended to cover / offset / counterbalance a loss that might arise on a risk that the company faces. The objective of hedge accounting is to match the loss on the risk with the gain that will be generated by the derivative.

Fair Value Hedge

If the risk being hedged relates to changes in the carrying value of assets or liabilities such that the loss on the risk is recognised in either profit or loss or equity (OCI), then hedge accounting looks to offset that loss on the risk with the gain on the derivative. Thus, with a fair value hedge there is an instant match.

Cash Flow Hedge

But if the risk being hedged is a highly probable future transaction – then there is no recognition of any loss on this in the financial statements (as it is a future transaction). In these circumstances there cannot be an immediate offset with any gain on the derivative. With a cash flow hedge the gain on the derivative is taken to equity (OCI) to the extent that is effective. It will subsequently be recycled back to profit or loss when the future cash flow arises and throws up a loss. In this way the substance of hedge accounting to match the loss on the risk and the gain on the derivative (the hedging instrument) is eventually achieved.

If you want to know more about this topic, why not listen to my podcast on this issue.

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