IFRS rules differentiate
3 types of derivatives, e.g. hedge derivatives, non-hedge
derivatives, and embedded derivatives.
Hedge derivatives
Hedge accounting rules
apply under 4 cumulative conditions:
- Upon inception, the entity assigns and documents the hedging relationship and its risk management objective.
- It expects the hedge to be highly efficient (= capacity to offset changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designed + actual results of the hedge within the range of 80-125 % + assessment of the effectiveness at least at the time an entity prepares its annual or interim financial statements).
- The company can measure the hedge's effectiveness reliably.
- The firm assesses the hedge on an ongoing basis.
In addition, the hedge of
an overall net position, rather than of a specific item, does not
qualify for hedge accounting.
Once the hedging nature
of a financial instrument established, the accountant differentiates
3 hedging relationships:
- A fair value hedge counters an exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment. The fair value hedge might also target a portion of such asset, liability or commitment if the company runs a particular risk that could affect its profit or loss.
- A cash flow hedge matches the exposure to variability in cash flows that is linked to a particular risk of a recognized asset, liability, or highly probable forecast transaction.
- Hedge of a net investment in a foreign operation
Accounting for a fair
value hedge
The gain or loss from
remeasuring the hedging instrument at fair value is recognized in
profit or loss, thereby adjusting the carrying amount of the hedged
item.
Accounting for a cash
flow hedge
The portion of the gain
or loss on the hedging instrument that constitutes an effective hedge
shall be recognized on the company's balance sheet as other
comprehensive income. The ineffective portion of the gain or loss on
the hedging instrument shall be recognized in profit or loss.
Accounting for the
hedge of a net investment in a foreign operation
Again, the portion of the
gain or loss on the hedging instrument that constitutes an effective
hedge shall be recognized in other comprehensive income. The
ineffective portion of the gain or loss on the hedging instrument
shall be recognized in profit or loss.
Non-hedge
Derivatives
Non-hedge derivatives are
always recognized at fair value.
Embedded
Derivatives
An embedded derivative is
a component of a hybrid contract that combines a derivative with a
non-derivative host. In this context, “embedded” means that the
derivative part is not independently transferable by way of contract.
Accounting for embedded
derivatives is subject to the following rules:
The above mentioned
derivative accounting rules shall apply to the hybrid contract as a
whole if the underlying is an IFRS financial asset (See my December
15, 2012 post).
By contrast, if the host
is not an IFRS financial asset, the embedded derivative is separated
from the host. It is then recognized as a derivative if
- the embedded derivative's economic and risk characteristics are not closely related to those of the host; or
- the company has chosen to account the entire hybrid contract at fair value through profit or loss.
Resources:
- IFRS 9 – Financial Instruments
- IFRS 32 – Financial Instruments: Presentation
- IAS 39 – Financial Instruments: Recognition and Measurement
