Accounting concepts and applications

¶ … IFRS No.39 hedge accounting requirements, accounting for investments in derivative financial instruments, criteria for hedge accounting recognition, and deferral of recognition of periodic unrealized fair value changes.

IFRS No.39 hedge accounting requirements

IFRS 39 permits hedge accounting under certain circumstances as long as the hedging relationship is:

Thoroughly and fully spelled out and defined as well as the circumstances in which it will be used, the objective, the nature of the risk, and how the entity will assess the hedging instrument's effectiveness

It is regularly assessed and determined to be effective

It is determined to be effective in achieving changes in fair value or cash flows attributable to the hedged risk as is written, and that this effectiveness can be reliably measured (Deloitte IAS 39)

Accounting for investments in derivative financial instruments,

If an embedded derivative is separated, the host contract is accounted for under the appropriate standard. If the entity is however unable to measure the embedded derivative separately, the entire combined contract is considered separately as an asset.

Criteria for hedge accounting recognition,

Criteria for hedging instruments include the following:

This is an instrument whose cash flows are expected to offset changes in the cash flows of a certain specified hedged item.

Hedging instruments are also only those that are external to the entity being measured

There are also criteria to hedging items. (Deloitte IAS 39)

Deferral of recognition of periodic unrealized fair value changes.

IAS 39 requires recognition of a financial asset or a financial liability only when the entity becomes part of the contractual provisions of the instrument. There are also various conditions outlined as per its requirements (see for instance Deloitte IAS 39)

Identify and describe financial instruments used by firms for hedging activities and their distinctive characteristics.

Some of the financial instruments are stocks (where investors have a share in the company), exchange-traded funds (where stocks of company are exchanged), insurance (such s life or business insurance), forward contracts (an agreement between two parties to buy or sell an asset at a certain time), swaps (exchange of stocks), options (a contract which gives the owner the right to buy or sell an asset), many types of over-the-counter and derivative products, and futures contracts ( making a contract to buy / sell something at a future time). (Jorion, 2009)

Identify and describe financial activities for which hedging behavior is appropriate and some of the activities for which companies commonly engage in hedging.

A commercial farmer is a typical hedger since the fluctuation of the growth and price as well as supply and demand of his crop is unpredictable. The farmer therefore may decide to hedge his bet for wheat (for instance) at the start of the season so that if the price drops, the farmer is locked into a certain profitable index. However, this also has its downturn in that if the price rises, the farmer is unable to make a profit (Jorion, 2009).