8.3 Fair value hedges
6 min read•august 19, 2024
Fair value hedges protect companies from changes in the fair value of assets, liabilities, or firm commitments. They're crucial in mergers and acquisitions to manage risks between deal announcement and closing. Companies use derivatives like swaps or forwards to offset value changes in hedged items.
Accounting for fair value hedges involves recognizing changes in both the hedged item and 's fair value in the income statement. This offsetting approach aims to mitigate the impact of fair value changes on financial results. Proper designation, documentation, and effectiveness assessment are key to qualifying for hedge accounting.
Fair value hedge overview
- Fair value hedges are a type of hedge accounting that aims to mitigate the risk of changes in the fair value of a recognized asset, liability, or firm commitment
- Entities use fair value hedges to protect against exposure to changes in fair value that are attributable to a particular risk and could impact the income statement
- Fair value hedges are commonly used in mergers and acquisitions to manage the risk associated with changes in the value of assets or liabilities between the announcement and closing of the transaction
Hedged items in fair value hedges
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- Hedged items in fair value hedges can be recognized assets or liabilities, or an unrecognized firm commitment
- Examples of hedged items include fixed-rate debt instruments (bonds), equity investments, and commodity inventories
- The hedged item must have a reliably measurable fair value and be exposed to changes in fair value due to a specific risk (interest rate risk, foreign exchange risk)
- The designated risk being hedged should be specifically identified (benchmark interest rate risk, foreign currency risk)
Hedging instruments for fair value hedges
- Hedging instruments in fair value hedges are typically instruments, such as interest rate swaps, forward contracts, or options
- The hedging instrument should have a fair value that moves in the opposite direction of the hedged item's fair value when exposed to the designated risk
- Examples of hedging instruments include interest rate swaps used to hedge fixed-rate debt and foreign currency forward contracts used to hedge firm commitments denominated in a foreign currency
- The hedging instrument's critical terms (notional amount, maturity, underlying) should match or closely align with those of the hedged item
Qualifying criteria for fair value hedges
- The hedging relationship must be formally designated and documented at inception, including the risk management objective, the hedged item, the hedging instrument, and the nature of the risk being hedged
- The hedge is expected to be highly effective in achieving offsetting changes in fair value attributable to the hedged risk
- must be assessed both prospectively and retrospectively
- The hedged item and hedging instrument should not be with the same counterparty to avoid counterparty credit risk
Accounting for fair value hedges
- accounting involves recognizing the changes in fair value of both the hedged item and the hedging instrument in the income statement
- The goal is to offset the impact of changes in the hedged item's fair value with the changes in the hedging instrument's fair value
Initial recognition of fair value hedges
- At the inception of the hedge, the hedged item is recognized at its fair value, and the hedging instrument is recognized at its fair value with any difference recorded in the income statement
- If the hedged item is a firm commitment, it is not recognized on the balance sheet until the commitment is fulfilled
Ongoing measurement of hedged items
- The carrying amount of the hedged item is adjusted for changes in its fair value attributable to the hedged risk
- The adjustment to the hedged item's carrying amount is recognized in the income statement
- If the hedged item is an available-for-sale debt security, the changes in fair value attributable to the hedged risk are recognized in the income statement, while other changes in fair value are recorded in other comprehensive income
Ongoing measurement of hedging instruments
- The hedging instrument is measured at fair value at each reporting date
- Changes in the fair value of the hedging instrument are recognized in the income statement
- If the hedging instrument is a derivative, it is typically measured at fair value through profit or loss (FVTPL)
Hedge effectiveness assessment
- Hedge effectiveness must be assessed at the inception of the hedge and on an ongoing basis, at least at each reporting date
- The assessment can be qualitative or quantitative, depending on the complexity of the hedge and the nature of the hedged risk
- Common methods for assessing hedge effectiveness include critical terms comparison, dollar-offset method, and regression analysis
- Hedge ineffectiveness arises when the changes in fair value of the hedging instrument do not perfectly offset the changes in fair value of the hedged item
Ineffectiveness in fair value hedges
- Hedge ineffectiveness is the extent to which the changes in fair value of the hedging instrument do not offset the changes in fair value of the hedged item
- Ineffectiveness can arise due to differences in the critical terms of the hedged item and hedging instrument (basis risk) or changes in counterparty credit risk
- Ineffectiveness is recognized immediately in the income statement
- If the hedge becomes ineffective and no longer qualifies for hedge accounting, the entity must discontinue hedge accounting prospectively
Presentation and disclosure
- The presentation and disclosure requirements for fair value hedges aim to provide users of financial statements with relevant information about the entity's risk management activities and the impact of hedging on the financial statements
Balance sheet presentation of fair value hedges
- The hedged item is presented on the balance sheet at its adjusted carrying amount, which includes the cumulative fair value adjustment attributable to the hedged risk
- The hedging instrument is presented as either an asset or liability on the balance sheet, depending on its fair value
Income statement impact of fair value hedges
- The change in fair value of the hedged item attributable to the hedged risk and the change in fair value of the hedging instrument are both recognized in the income statement
- The ineffective portion of the hedge is reported separately in the income statement
- Interest income or expense related to the hedged item and hedging instrument is recognized using the effective interest method
Footnote disclosures for fair value hedges
- Entities must disclose information about the nature and extent of their fair value hedges, including a description of the hedging instruments, hedged items, and risks being hedged
- The disclosure should include the amount of hedge ineffectiveness recognized in the income statement
- Entities should also disclose the impact of hedging on the balance sheet, income statement, and statement of comprehensive income
Special considerations
- Fair value hedges can involve complex transactions and require careful consideration of various factors to ensure proper accounting treatment and effectiveness
Partial-term hedging with fair value hedges
- Partial-term hedging occurs when the term of the hedging instrument is shorter than the term of the hedged item
- In such cases, the entity must assess hedge effectiveness and measure ineffectiveness based on the change in fair value of the hedged item attributable to the hedged risk during the designated hedge period
- The unhedged portion of the hedged item's fair value change is recognized in the income statement
Fair value hedges vs cash flow hedges
- Fair value hedges protect against changes in the fair value of a recognized asset or liability, while cash flow hedges protect against variability in future cash flows
- Fair value hedges impact the income statement, whereas the effective portion of cash flow hedges is initially recorded in other comprehensive income and later reclassified to the income statement when the hedged transaction affects profit or loss
- The accounting treatment, effectiveness assessment, and disclosure requirements differ between fair value hedges and cash flow hedges
Discontinuation of fair value hedge accounting
- An entity must discontinue fair value hedge accounting when the hedging relationship no longer qualifies for hedge accounting or the hedging instrument expires, is sold, terminated, or exercised
- Upon discontinuation, the cumulative adjustment to the carrying amount of the hedged item is amortized to the income statement over the remaining life of the hedged item using the effective interest method
- If the hedged item is derecognized, the unamortized fair value adjustment is immediately recognized in the income statement
Key Terms to Review (16)
ASC 815: ASC 815 refers to the Accounting Standards Codification Topic 815, which focuses on derivatives and hedging activities. It outlines the requirements for recognizing, measuring, and disclosing derivatives and hedging instruments, ensuring that companies provide transparency about their risk management strategies and the impact of these financial instruments on their financial statements.
Cash flow hedge: A cash flow hedge is a financial strategy used to manage the risk of fluctuations in future cash flows associated with a specific asset or liability. This technique aims to protect against the variability in cash flows that may arise from changes in interest rates, foreign exchange rates, or commodity prices. By using derivatives like options or swaps, companies can stabilize their cash flows, ensuring they have a clearer financial outlook and more predictable earnings.
Deferred gains: Deferred gains refer to profits that have been recognized for accounting purposes but are not yet realized in cash or other assets. These gains arise from specific transactions or events, such as the revaluation of assets, that will impact the financial statements but may not result in immediate cash flow. In the context of fair value hedges, deferred gains play a critical role in matching the timing of revenue recognition with the underlying risk management strategies employed by companies to protect against market fluctuations.
Derivative: A derivative is a financial instrument whose value is derived from the performance of an underlying asset, index, or rate. These instruments can be used for various purposes, such as hedging against risk, speculation, or arbitrage. In finance, derivatives include options, futures, and swaps, and they play a significant role in managing the risks associated with price fluctuations in assets.
Discounted Cash Flow: Discounted cash flow (DCF) is a financial valuation method used to estimate the value of an investment based on its expected future cash flows, which are adjusted to their present value using a specific discount rate. This approach is crucial for making informed financial decisions, especially when analyzing mergers, acquisitions, and other complex financial structures, as it provides a comprehensive view of the investment's profitability over time.
Fair value hedge: A fair value hedge is a risk management strategy used to offset the risk of changes in the fair value of an asset or liability. It typically involves the use of derivative financial instruments, like options or swaps, to mitigate potential losses from fluctuations in market conditions. This strategy allows organizations to stabilize cash flows and protect the value of their investments against market volatility.
Hedge effectiveness: Hedge effectiveness refers to the extent to which a hedge instrument offsets the changes in fair value or cash flows of the hedged item. It’s an important measure that ensures that hedges are functioning as intended, minimizing risks associated with market fluctuations. This concept is crucial for understanding how well hedges protect against risk, particularly in the contexts of fair value and net investment hedges, where precise alignment is necessary for proper accounting treatment and financial reporting.
Hedging instrument: A hedging instrument is a financial asset or liability used to reduce the risk of adverse price movements in an asset or liability. By entering into these instruments, businesses and investors can manage exposure to various financial risks such as currency fluctuations, interest rate changes, or commodity price volatility. Hedging instruments can take various forms, including derivatives like options, forwards, and swaps, which help stabilize cash flows and protect against unpredictable market conditions.
IFRS 9: IFRS 9 is an International Financial Reporting Standard that addresses the classification, measurement, and impairment of financial instruments. It introduced a forward-looking approach for recognizing impairment losses and enhanced guidance for hedge accounting, linking financial reporting more closely to risk management practices.
Ineffectiveness assessment: An ineffectiveness assessment is a process used to evaluate the extent to which a hedging relationship is effective in offsetting changes in the fair value of the hedged item. This assessment ensures that the financial reporting reflects the actual economic hedging strategy and its results, focusing on how well the hedge performs in mitigating risk associated with fluctuations in fair value.
Mark-to-market adjustment: Mark-to-market adjustment is an accounting practice that involves updating the value of an asset or liability to reflect its current market value instead of its book value. This process is essential for providing a more accurate picture of an entity's financial health, especially when dealing with financial instruments that can fluctuate in value due to market conditions. It helps in recognizing unrealized gains and losses, ensuring that financial statements provide relevant and timely information to stakeholders.
Market approach: The market approach is a valuation method that estimates the fair value of an asset based on the prices of similar assets in the marketplace. This approach relies on the principle of substitution, which suggests that a knowledgeable buyer would not pay more for an asset than the price of a comparable asset in a similar condition and location. It is particularly useful for assessing the value of identifiable intangible assets and plays a critical role in fair value measurements, bargain purchase gains, hedges, and corporate reorganizations.
Market price: Market price refers to the current price at which an asset, security, or commodity can be bought or sold in a marketplace. This price is determined by the forces of supply and demand and reflects what buyers are willing to pay and sellers are willing to accept at any given time. It plays a critical role in investment decisions and financial reporting, particularly in relation to fair value measurements.
Observable inputs: Observable inputs are inputs used in the valuation of assets or liabilities that are derived from market data, providing a reliable basis for measuring fair value. These inputs include quoted prices for identical or similar assets or liabilities in active markets, as well as other observable market data such as interest rates, yield curves, and credit spreads. Because they rely on actual market transactions, observable inputs are considered more reliable than unobservable inputs.
Underlying asset: An underlying asset is a financial instrument or asset that underpins a derivative contract, such as options or futures. The value of the derivative is derived from the performance of this asset, which can include stocks, bonds, commodities, or currencies. Understanding the underlying asset is crucial as it influences pricing, risk assessment, and hedging strategies in financial transactions.
Unrealized losses: Unrealized losses are declines in the value of an asset that have not yet been sold, meaning the loss has not been actualized through a transaction. These losses reflect the difference between the current market value of an asset and its purchase price, showcasing potential economic impacts on an entity's financial statements. Unrealized losses are particularly relevant in accounting for investments and can affect reported earnings, cash flow statements, and overall financial health.