Discontinuation

Definition

Discontinuation refers to the cessation of hedge accounting for a financial instrument or a hedging relationship. This usually occurs when the hedged item no longer qualifies for hedge accounting treatment, whether due to changes in the underlying exposure or failure to meet the effectiveness criteria. The process involves reclassifying gains and losses that were previously deferred in other comprehensive income back to profit and loss, which can significantly impact financial statements.

5 Must Know Facts For Your Next Test

1. Discontinuation can occur when the hedging instrument expires, is sold, terminated, or when the underlying exposure is no longer present.
2. If a hedging relationship is discontinued, any previously recognized gains or losses must be reclassified from other comprehensive income into profit and loss.
3. The effectiveness of a hedging relationship must be consistently assessed; failure to maintain effectiveness can trigger discontinuation.
4. Discontinuation does not affect the actual cash flows related to the hedging instruments or the underlying exposure but impacts how they are reported.
5. Entities must document the reasons for discontinuation and adjust their accounting practices accordingly, following the relevant accounting standards.

Review Questions

• How does discontinuation affect the financial reporting of an entity's hedging relationships?
  • Discontinuation impacts financial reporting by requiring any previously deferred gains or losses related to hedge accounting to be recognized in profit and loss. This shift can lead to volatility in earnings as these amounts that were kept out of net income are suddenly included. Additionally, the entity must ensure its financial statements accurately reflect these changes, which may also necessitate additional disclosures regarding the reasons for discontinuation.
• What criteria must be met for a hedging relationship to avoid discontinuation, and what might lead to a loss of effectiveness?
  • To avoid discontinuation, a hedging relationship must demonstrate consistent effectiveness in offsetting changes in fair value or cash flows of the hedged item. If there are significant changes in market conditions that affect either the underlying exposure or the hedging instrument's performance—such as reduced correlation between them—this can lead to a loss of effectiveness. Regular assessment and documentation of effectiveness are crucial for maintaining hedge accounting.
• Evaluate how an entity should manage its accounting practices upon deciding to discontinue hedge accounting and what implications this might have on future financial strategies.
  • Upon deciding to discontinue hedge accounting, an entity should reassess its accounting policies and ensure compliance with relevant standards regarding reclassifying deferred gains or losses. This may require updating internal controls and reporting processes to capture these changes effectively. The implications on future financial strategies may involve reconsidering risk management approaches since reliance on hedge accounting could change how risk exposures are viewed, potentially leading to adjustments in investment strategies or increased focus on alternative risk mitigation techniques.

Related terms

Hedging:

Hedging is a risk management strategy that involves taking a position in a financial instrument to offset potential losses in another investment, aiming to reduce volatility in earnings.

Effective Hedge: An effective hedge is a hedging relationship where changes in the value of the hedged item and the hedging instrument offset each other to a significant degree, typically assessed using specific effectiveness tests.

Fair Value Hedge: A fair value hedge is used to mitigate the risk of changes in the fair value of an asset or liability due to market fluctuations, affecting the profit and loss directly.