CFM16040 - Accounting for financial instruments: IAS 32 and IAS 39: meaning of hedge accounting terms

Key definitions and terms: hedging

IAS 39 defines a number of terms in relation to hedge accounting (see CFM16265 onwards). International Accounting Standards do not specifically define hedge, or hedging, but for accounting purposes "hedging" refers to designating a derivative (or, for hedges of foreign currency risk only, a non-derivative financial instrument) as a complete or partial offset in profit and loss to the change in fair value or cash flows of a hedged item.

The commercial concept of hedging is discussed at CFM11200 onwards.

Firm commitment

A firm commitment is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

For example, a company that has signed a contract to buy or sell trading stock or some other asset, will have a firm commitment.

Forecast transaction

A forecast transaction is an uncommitted but anticipated future transaction.

Suppose, for example, that a company has a multi-currency borrowing facility with a bank: it expects in September 2006 to draw down $50 million under the facility, but is not committed to doing so. The draw-down would be a forecast transaction.

Hedging instrument

A hedging instrument is a designated derivative or (for a hedge of the risk of changes in foreign currency exchange rates only) a designated non-derivative financial asset or non-derivative financial liability, whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item.

Hedged item

A hedged item is an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that (a) exposes the entity to the risk of changes in fair value or future cash flows and (b) is designated as being hedged.

CFM16295 - 16305 tells you about fair value hedges and cash flow hedges, and CFM16280 explains what is meant by "designated as being hedged". "Net investment in a foreign operation" is defined at CFM16045.

Hedge effectiveness

Hedge effectiveness is the degree to which changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument.

For example, suppose that a company has a foreign currency borrowing, and has hedged the foreign exchange risk by entering into a forward currency contract. If, in a particular reporting period, the fair value of the liability decreases by £100,000 because of exchange movements, and the fair value of the currency contract increases by £100,000, the hedge is 100% efficient. If the fair value of the currency contract increases by only £90,000, the hedge effectiveness is 90%. You can, with equal validity, look at it the other way round and say the hedge effectiveness is 100/90 x 100% = 111%.