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Companies will often try to reduce or mitigate the financial effects from risks that could impact upon the companys core business. The company will often enter into derivative contracts which will be structured to minimise these risks. The hedged item is the asset, liability or future transaction whose risk is being mitigated. The hedging instrument is the instrument used to mitigate the risk associated with the hedged item. A hedging relationship is where a company has a hedging instrument to mitigate the risk from the hedged item.
Financial Reporting Standard (FRS) 102 identifies 3 main types of hedging relationships:
fair value hedges are intended to hedge the exposure to variations in the fair value of the hedged item and which could affect profit or loss
cash flow hedges are intended to hedge the exposure to variations in cash flows that are attributable to a risk associated with the hedged item and which could affect profit or loss
net investment hedges are intended to hedge movements in the assets and liabilities held in a foreign investment with foreign exchange movements on the related financing
Not all hedging arrangements qualify for hedge accounting and the following conditions must apply.
a recognised asset or liability – or a component of such an item
an unrecognised firm commitment – or a component of such an item
a highly probable forecast transaction – or a component of such an item
be a financial instrument measured at fair value through profit or loss – unless as a hedge of foreign currency risk
be a contract with a party external to the group or individual entity that is being reported on
not be a written option – unless is an offset to or is combined with a purchased option
consistent with companys risk management objectives
documented by the entity as a hedging relationship so that the risk being hedged, the hedged item and the hedging instrument are clearly identifiable
assessed and documented for causes of hedge ineffectiveness
The effect is to adjust the accounting of the hedging instrument by taking the fair value movements on the hedging instrument attributable to the hedged risk to a cash flow hedging reserve (shown within other comprehensive income). These amounts are then recycled from the cash flow hedging reserve to either the income statement or the carrying value of the asset/liability in line with the hedged risk.
The effect is to adjust the accounting of the hedged item by making an adjustment to the carrying value of the hedged item for the fair value risk being hedged. A corresponding amount in respect of this adjustment is recognised in the income statement.
The accounting similar to a designated cash flow hedge. However, amounts are not subsequently recycled from other comprehensive income.
The commentary above is based on the requirements of Section 12 ofFRS102. Companies which adoptFRS102 have the option of applying the recognition and measurement requirements of International Accounting Standards (IAS) 39 or International Financial Reporting Standard (IFRS) 9. The requirements of these standards do contain certain differences to those contained in Section 12.
Further guidance can be found in the Corporate Finance Manual atCFM27000onwards.
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