Fair Value Hedges

In short – A fair value hedge is a hedge of the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment, or components of any such item, that is attributable to a particular risk and could affect profit or loss.

Fair value hedges recognize the change in fair value of the hedged item in the current reporting period to offset the change in the related hedging instrument. Therefore, there is earlier recognition of the fair value change in the hedged item than if hedge accounting was not applied.

For example, inventory is ordinarily measured at the lower of net realizable value and cost. A farming company with cattle inventory could seek to hedge its commodity price risk with a forward contract for the sale of its cattle. This derivative would be measured at FVPL. Any increase in the market price of the cattle would result in a loss on the derivative.

However, without applying hedge accounting, the increase in the fair value of the cattle inventory would not be recognized until the physical inventory is sold. Conversely, designation of a fair value hedging relationship would allow the Company to record the impact of the change in market prices for the cattle in profit or loss on both the derivative and its physical inventory to accurately reflect the company’s risk management practices.

The following table summarizes fair value hedge accounting which applies if the hedge meets the qualifying criteria:

Hedging relationship Component	Accounting Treatment at the End of Each Reporting Period
Hedging Instrument	Recognize the change in fair value in profit or loss (which is the typical treatment for a derivative).
Hedged Item	Recognize the change in fair value attributable to the hedged risk in profit or loss* and recognize a corresponding adjustment to the carrying value of the hedged item on the balance sheet (if applicable).

* When the hedged item is a financial asset (e.g. debt investment), or component thereof, that is measured at FVOCI, the hedging gain or loss on the hedged item is recognized in profit or loss. However, there is one exception to this rule. Where the hedged item is an equity instrument for which changes in fair value are recognized in OCI, the gain or loss on the hedging instrument and hedged item is recognized in OCI.

In a fair value hedge, hedge ineffectiveness is recognized automatically through any differences between the amount by which the hedging instrument and the hedged item are adjusted.

Something else – Excellent Study IFRS 9 Eligible Hedged items

As can be seen in the following table, the accounting for the change in fair value relating to the hedged item depends on the item being hedged.

Hedged Item	Accounting Treatment
A firm commitment (or a component thereof) to acquire assets or assume liabilities	The change in fair value of the firm commitment is recognized during the life of the hedging relationship in the statement of financial position as an asset or liability with a corresponding entry to profit or loss. When the firm commitment is met, the cumulative fair value change of the firm commitment previously recognized is included in the initial carrying amount of the recognized asset or liability.
A financial instrument (or component thereof) measured at amortized cost	The change in fair value of the financial instrument is included in the carrying amount of the asset or liability and amortized into profit or loss through recalculation of the effective interest rate at the date amortization begins. Amortization may begin as soon as an adjustment exists, but must begin no later than when the hedged item ceases to be adjusted for hedging gains and losses.
A debt instrument measured at FVOCI	The change in fair value of the financial instrument is included in the carrying amount of the asset or liability. Amortization applies in the same manner as for a financial instrument measured at amortized cost, as described above. However, such amortization only applies to the amount of the debt instrument that represents the cumulative gain or loss previously recognized through profit or loss.

Something else – Measuring ineffectiveness in hedging

When a fair value hedge is discontinued, any remaining fair value adjustments previously recognized to the hedged item are amortized as described in the table above.

Example of the Accounting for a Fair Value Hedge of a Fixed Rate Loan

Part I:

On January 1, 20×1, ABC Credit Union entered into a 3-years interest rate swap paying 4% interest in exchange for Fair Value Hedges the Bank of Canada prime interest rate plus 1%. The swap’s notional amount is $3 million and the prime interest rate at inception of the swap is 3% (i.e., the swap is on-market). The Credit Union designated the swap as the hedging instrument on the origination date of a $3 million fixed-rate loan asset bearing interest at 6% with a 3-years term. It encounters some hedge ineffectiveness due to the variations in maturity dates and payment options.

During 20×1, the Bank of Canada increases the prime interest rate to 3.5%.

Assessment: Using quoted prices, the Credit Union determines that the gain on the interest rate swap is $42,500. The credit union reviews its loan portfolio using an updated discount rate and determines that the loss on the fair value of its loan portfolio would be $37,500 if it was accounted for at FVTPL.

At the reporting date, the Credit Union records the following journal entries:

December 31, 20×1 – To recognize the fair value adjustment on the hedging instrument during 20×1.

Derivative asset	$42,500
Profit or loss – Hedging gain		$42,500

To recognize the fair value adjustment on the hedged item during 20×1.

Profit or loss – Hedging loss	$37,500
Loan Assets		$37,500

Part II:

The Credit Union decides to begin amortization of the fair value hedge adjustment of $37,500 immediately after its recognition on December 31, 20×1. Assume that the coupon payments on the loan asset are made annually on December 31, 20×1, 20×2 and 20×3, and that the principal will be repaid on December 31, 20×3.

Assessment: On December 31, 20×1, an adjustment to the carrying amount was made of $37,500 as a result of hedge accounting; thus, the loan assets’ revised carrying amount is $2,962,500 ($3 million – $37,500).

Accordingly, the entity uses the following amounts to recalculate the effective interest rate once it decides to begin amortization of the hedging adjustment:

Carrying value at December 31, 20×1	$2,962,500
Coupon payment receivable at end of 20×2	$180,000
Coupon payment and repayment of principal receivable at end of 20×3	$3,180,000

The revised effective interest rate based on the above cash flows is $6.69% and should be used to calculate the amortized cost of the loan assets until the effective interest rate must be recalculated to reflect any subsequent hedging adjustment.

Something else – Firm commitment

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Something else – Disclosure Financial risk management

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