The benefits and challenges of hedge accounting under IFRS 9: What you need to know

Hedge accounting is a method of accounting that allows an entity to reduce the volatility in its profit or loss or other comprehensive income caused by changes in the fair value or cash flows of certain financial instruments. Under IFRS 9, hedge accounting is an option, and management can decide whether to use it after fulfilling the criteria for recognizing the hedge.

There are three types of hedge relationships under IFRS 9:

(i) 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 a component of any such item, that is attributable to a particular risk and could affect profit or loss.

(ii) A cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all or a component of a recognized asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction, and could affect profit or loss.

(iii) A hedge of a net investment in a foreign operation is a hedge of a monetary item that is accounted for as an equity instrument or a hedge of a non-monetary item that is accounted for at fair value through other comprehensive income, and that forms part of the net investment in a foreign operation.

To apply hedge accounting, an entity must document the hedge relationship at the inception of the hedge, including the following information:

? The hedging instrument and the hedged item or net investment in a foreign operation.

??The nature of the risk being hedged.

??How the entity will assess whether the hedging relationship meets the hedge effectiveness requirements, including the hedge ratio and the sources of hedge ineffectiveness.

The hedge effectiveness requirements under IFRS 9 are based on the principle of an economic relationship between the hedging instrument and the hedged item, and the effect of credit risk on that relationship. The hedge ratio must reflect the actual quantity of the hedging instrument and the hedged item that the entity uses for hedging. The hedge effectiveness must be assessed prospectively and retrospectively, and the hedge relationship must be discontinued if it ceases to meet the qualifying criteria.

The disclosure requirements for hedge accounting under IFRS 9 are intended to provide information about the effect of hedge accounting on an entity's financial position, financial performance, and cash flows. Some of the disclosures include:

??The risk management strategy and how it is applied to manage risk.

??How the entity's hedging activities may affect the amount, timing and uncertainty of its future cash flows.

??The effect of hedge accounting on each line item in the statement of financial position, the statement of profit or loss and the statement of other comprehensive income.

??The sources of hedge ineffectiveness and the amount of hedge ineffectiveness recognized in profit or loss.

Hedge accounting is a complex and sophisticated method of accounting that requires careful planning, documentation, and monitoring, but it can also provide significant benefits for entities that want to reduce the volatility in their financial statements caused by changes in the fair value or cash flows of certain financial instruments.