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What is a fair value hedge?
It is an investment position taken by an investor or by a company to protect fair value of their specific asset/liability/unrecognised commitment from risk which can affect their profit and loss account.
In other words, it is a derivative instrument to balance their risk in other investments to offset potential losses in fair value of their assets/liability/unrecognised commitments.
Accounting for fair value of hedge
- For derivatives of hedging instruments loss or gain is measured according to IAS 21 and for non-derivative hedging instruments is recognized as immediate loss or gain.
- Carrying amount of the hedged item is adjusted through gain or loss on the hedged item attributable to hedged risk (also for AFS financial assets recognized in other comprehensive income). This applies to hedged items measured at cost
Discontinuation of fair value of accounting
- Hedging instrument sold/expires/terminated/exercised.
- Fail to meet hedging accounting criteria.
- Hedge relationship is de-designated.
Advantages of fair value hedge are as follows −
- Provides more accurate current valuations.
- Opportunity to manipulate accounting data in this hedge is less.
- Provides measurement of true income.
- Most agreed standard of accounting.
- Tracks fair value accounting of all asset types accurately.
- Provides a cumbersome financial burden in difficult economic times.
Disadvantages of fair value hedge are as follows −
- Not suitable for assets which fluctuate frequently with large amounts.
- Some Investor dissatisfaction.
- Loss in historical perspective.
Example
Assets and liabilities which are commonly fair value hedged are as follows −
- Fixed rate liabilities
- Fixed rate assets
- Investments in equity securities (classified as ASF under IAS 39)
- Buying or selling of non-financial items at fixed price
Understanding the fair value of hedge by example
Let’s say the company has an asset of $500000 and they may be concerned due to fair value hedge asset value may decrease up $10000.
To offset this, the company may enter a derivative contract of $15000. As companies enter derivative contracts now fair value moves opposite the direction of hedged items. Thus the company covers their assets and liabilities to potential changes to fair market value.
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