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accounting regulations as set out in IAS 39, Financial Instruments: Recognition and
Measurement(IAS 39). The article concludes by considering the
weaknesses of IAS 39 and how those weaknesses are addressed by
the proposed changes issued by the IASB in September 2012.
BASIC PRINCIPLES OF HEDGING
Are you risk adverse? I think I am. For example, as a property owner I
have an insurance policy to protect me from the risk of incurring a loss
if my house were to burn down. Companies will face many risks and if
they seek to cover these risks then they are said to be hedging.
Hedging therefore is a risk management process whereby risk adverse
companies firstly identify and quantify that they have a risk and
secondly seek to cover that risk.
THE HEDGED ITEM
Risks come in many forms for companies. For example there is a risk
that the fair value of assets and liabilities that they hold might increase
or decrease, that in future the price of the goods they buy or sell might
change, that interest rates on their borrowings or deposits might
change, and that foreign exchange rates may move. A hedged item is
defined as an item that exposes the entity to risk of changes in fair
value or future cash flows and is designated as being hedged.
THE HEDGING INSTRUMENT
an investment for foreign currency or credit risk (but not for interest risk or prepayment risk)
a portion of the cash flows or fair value of a financial asset or financial liability
a non-financial item for foreign currency risk only for all risks of the entire item
a portion of the portfolio of financial assets or financial liabilities that share the risk being hedged.
formally designated and documented at inception, including the entity's risk management objective and
strategy for undertaking the hedge, identification of the hedging instrument, the hedged item, the nature of
the risk being hedged, and how the entity will assess the hedging instrument's effectiveness, and
expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to
the hedged risk as designated and documented, and effectiveness can be reliably measured, and
loss (or gain) with respect to the hedged risk, which is also recognised
immediately in the statement of profit or loss. This is instant hedge
accounting as the gains and losses offset in the statement of profit or
loss. A fair value hedge is taken to the statement of profit or loss.
EXAMPLE OF A FAIR VALUE HEDGE
gains and losses which may or may not be recycled to the statement of
profit or loss in future periods.
If the asset is a non-financial asset for example, inventory that is sold
in the accounting period then the previously recognised gain of $19m
on the hedging instrument can be recycled from its reserve in equity
and recognised in the statement of profit or loss. However, if the asset
is property, plant and equipment, then the reserve would be recycled
over the useful life of the property, plant and equipment.
ISSUES WITH IAS 39 AND HOW THE PROPOSALS ADDRESS THEM
there should be an economic relationship between the hedging instrument and the hedged item
the effect of credit risk should not dominate the value changes that result from that economic
relationship, and
the hedge ratio should reflect the actual quantity of hedging instrument used to hedge the actual quantity
of hedge item.
the cash flow hedge the gain or loss on the hedging instrument is
initially recognised in the other comprehensive income with the
potential for it being recycled to the statement of profit or loss at a later
date. Accordingly similar items are being treated in an inconsistent
manner, which is not ideal. Further it can be difficult to distinguish
between a fair value hedge and a cash flow hedge.
IAS 39 allows hedge accounting to be optional. Therefore, even if a
company does actually hedge and complies with the current rules they
do not need to apply hedge accounting. The rules-based approach to
hedge accounting also results in some companies who do hedge not
being able to apply hedge accounting because they fall foul of the
rules. An example of this is the inability to apply hedge accounting for
specific components of non-financial items. For example an airline
wishing to protect itself from changes in aircraft fuel prices can in
reality do so by entering into forward crude oil contracts. This is
because crude oil is a major component of aircraft fuel and the price of
aircraft fuel will be closely correlated to crude oil prices. However, this
is not considered a valid hedge under IAS 39 as the company can only
account for a hedge of either the foreign currency risk, or the entire
non-financial item (the purchase price of the aircraft fuel).
Under the new proposals hedging by risk components will be
permitted for both financial and non-financial items, if separately
identifiable and measurable. In addition, hedging instruments can
include non-derivatives and there are significant new disclosure
requirements.
CONCLUSION