Fair value hedge
A hedge of the exposure to changes in fair value of a recognised asset or liability, or an unrecognised firm commitment, attributable to a particular risk that could affect profit and loss.
In plain language
Some risks do not threaten a future cash flow; they threaten the value of something the company already has. A fixed-rate bond loses value when interest rates rise. Inventory loses value when its market price falls. Nothing has been sold, but the balance sheet is worth less.
A fair value hedge uses a derivative to offset that change in value. The ICAI Guidance Note on Accounting for Derivative Contracts (Revised 2021), summarised in Chapter 9, defines it as a hedge of the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect the statement of profit and loss.
It is one of the three types of hedge accounting the Guidance Note recognises, alongside the cash flow hedge and the hedge of a net investment in a foreign operation. The distinction that matters is what is being protected: a fair value hedge protects a value, a cash flow hedge protects a future cash flow.
How it works
The two workbook examples (Chapter 9, section 9.1.1):
| Hedged item | Risk | Hedging instrument |
|---|---|---|
| Fixed rate bond | Interest rates change its fair value | Interest rate swap, changing the rate from fixed to floating |
| Inventory | Its price changes | Commodity futures |
Where the gains and losses go. Under Ind AS 109 (section 9.1.3), a fair value hedge hedges changes in the fair value of recognized items or unrecognised firm commitments, with gains/losses recognized in profit and loss. That is the contrast with the other two types:
| Type | Protects | Effective gains and losses |
|---|---|---|
| Fair value hedge | Value of a recognised item or unrecognised firm commitment | Profit and loss |
| Cash flow hedge | Variability of highly probable future cash flows | Equity (cash flow hedge reserve / OCI); ineffective part to P&L |
| Net investment hedge | FX risk on a net investment in a foreign operation | Equity, like a cash flow hedge |
Conditions before any hedge accounting. The entity must identify its risk management objective, show how the derivative meets it, specify how the derivative's fair value will be measured (including the hedge ratio), document this at inception and every reporting period, conclude the hedged risk could affect profit and loss, and disclose policies. For exchange-traded contracts such as currency futures, the workbook stresses that compliance with these criteria must be demonstrated before hedge accounting is applied.
A worked example
Illustrative. The company, quantities and prices are hypothetical; the classification and the destination of gains and losses follow the workbook.
Tamra Metals holds copper inventory worth Rs 5,00,00,000 at today's market price. It fears a price fall before it sells, so it sells commodity futures — the workbook's own inventory example — and designates them as a fair value hedge of the inventory's price risk, documenting the relationship at inception.
By the reporting date the copper price has fallen 4 per cent:
Fall in fair value of inventory = 5,00,00,000 × 4% = Rs 20,00,000
Gain on short futures = Rs 19,00,000
Net effect in profit and loss = 19,00,000 − 20,00,000 = −Rs 1,00,000
| Recognised in profit and loss | Rs |
|---|---|
| Loss attributable to the hedged risk on inventory | (20,00,000) |
| Gain on the hedging futures | 19,00,000 |
| Net | (1,00,000) |
Both sides go through profit and loss in the same period, so a Rs 20 lakh swing shows up as a Rs 1 lakh net. That residual is the part of the hedge that did not offset — its ineffectiveness.
Contrast a cash flow hedge of a future copper purchase: there, the effective gain would sit in equity until the purchase affected profit.
Why NISM asks about it
Chapter 9 (Accounting and Taxation), section 9.1.1, lists the three types of hedge accounting under the ICAI Guidance Note and defines the fair value hedge with the swap and inventory examples; section 9.1.3 restates it under Ind AS 109 with gains and losses in profit and loss. The Chapter 9 sample question asks which hedge accounting models the Guidance Note recognises — answer: all three. Expect a classification question: given a hedged item, which model applies.
Common exam traps
- Fair value hedge → profit and loss; cash flow hedge and net investment hedge → equity for the effective portion.
- It covers recognised assets and liabilities and unrecognised firm commitments, or an identified portion of them.
- Workbook examples: fixed rate bond hedged with an interest rate swap (fixed to floating); inventory hedged with commodity futures.
- A firm commitment appears in two places. The Guidance Note's summary puts an unrecognised firm commitment under the fair value model, and also says the cash flow model applies to a firm commitment in a foreign currency. Read which risk the question describes.
- Hedge accounting is optional, and needs documentation from inception. Without it the derivative is simply at fair value through profit and loss.
- Three types, not two. Forgetting the net investment hedge is the usual slip in the sample question.
Check yourself
1.The ICAI Guidance Note on Accounting for Derivatives Contract recognises which types of hedging for hedge accounting?
- a)All of the above
- b)The fair value hedge accounting model
- c)The cash flow hedge accounting model
- d)The hedge of a net investment in a foreign operation
Show the answer
Answer: (a) All of the above
This Guidance Note recognises the following three types of hedging:
The fair value hedge accounting model is applied when hedging the risk of a fair value change of assets and liabilities already recognized in the balance sheet, or a firm commitment that is not yet recognized.
The cash flow hedge accounting model is applied when hedging the risk of changes in highly probable future cash flows or a firm commitment in a foreign currency.
The hedge of a net investment in a foreign operation.
Ind AS 109 recognises the same three: Fair Value Hedge · Cash Flow Hedge · Net Investment Hedge.
Where the effective gains go differs by model. For a fair value hedge, to the statement of profit and loss. For a cash flow hedge, any gain or loss that is determined to be an effective hedge is recognized in equity, for e.g. cash flow hedge reserves — because this is intended to avoid volatility in the statement of profit and loss in a period when the gains and losses on the hedge item are not recognized therein. For a net investment hedge, directly in equity to the extent that the hedge is considered to be effective.
And in every case: the ineffective portion of the gains and losses on the hedging instruments is recognised in the statement of profit and loss immediately.
Designation is a choice: an entity is permitted but not required to designate a derivatives contract as a hedging instrument.
If it does not: it will be measured at fair value and changes in fair value will be recognized immediately in the statement of profit and loss.
2.Under a cash flow hedge, where is the effective portion of the gain or loss on the hedging instrument recognised, and why?
- a)In the statement of profit and loss, matching the hedged item
- b)In equity, such as cash flow hedge reserves, to avoid volatility in profit and loss in a period when the hedged item's gains and losses are not recognised there
- c)Not recognised at all until settlement
- d)Split equally between equity and profit and loss
Show the answer
Answer: (b) In equity, such as cash flow hedge reserves, to avoid volatility in profit and loss in a period when the hedged item's gains and losses are not recognised there
Under the cash flow hedge, the hedging instrument is measured at fair value, but any gain or loss that is determined to be an effective hedge is recognized in equity, for e.g. cash flow hedge reserves.
And the reason is given explicitly: this is intended to avoid volatility in the statement of profit and loss in a period when the gains and losses on the hedge item are not recognized therein.
The mismatch it solves: a highly probable future receivable is not yet in the accounts, so booking the hedge's gain alone would show a profit with no offsetting loss.
Option A describes the fair value hedge instead. A fair value hedge seeks to offset the risk of changes in the fair value of an existing asset or liability or an unrecognised firm commitment that may give rise to a gain or loss being recognized in the statement of profit and loss — there both sides are already in P&L, so they offset naturally.
Option C is wrong: the hedging instrument is measured at fair value from the outset, and all derivative contracts should be recognized on the balance sheet and measured at fair value.
Option D confuses effective with ineffective. The split is by effectiveness, not proportion: the ineffective portion of the gains and losses on the hedging instruments is recognised in the statement of profit and loss immediately.
Ind AS 109 says the same in newer language: for a Cash Flow Hedge, effective portions of gains/losses go to Other Comprehensive Income (OCI), ineffective portions to profit or loss.
When this model applies: the cash flow hedge accounting model is applied when hedging the risk of changes in highly probable future cash flows or a firm commitment in a foreign currency.
And one documentation requirement is specific to it: the entity must demonstrate in cases of hedging a future cash flow that the cash flows are highly probable of occurring.
Where this is taught
- Series IV · Chapter 9: Accounting and Taxation of IRDintroduced here
- Series XVI · Chapter 9: Accounting and Taxationintroduced here
- Series I · Chapter 9: Accounting and Taxation of ETCDintroduced here
Related terms
- HedgingTaking a derivative position that moves opposite to an exposure you already have, so gains on one offset losses on the other and the future rate is locked in at a known level.
- Cash flow hedgeA hedge of the variability of future cash flows — such as a highly probable foreign currency receipt — whose effective gains and losses are held in equity until the hedged cash flow hits profit and loss.
- Hedge accountingAn optional accounting treatment that matches the timing of gains and losses on a designated hedging derivative with the item it hedges, instead of taking the derivative's fair value changes straight to profit and loss.
- Hedge effectivenessThe degree to which changes in the fair value or cash flows of a hedged item, attributable to the hedged risk, are offset by changes in the fair value or cash flows of the hedging instrument.
- Net investment hedgeA hedge of the foreign exchange risk on a net investment in a non-integral foreign operation, with the effective gains and losses on the hedging instrument recognised directly in equity.
- Fair Value Through Profit or LossThe default Ind AS 109 measurement for a derivative not in a qualifying hedging relationship — recognised at fair value on the balance sheet, with every gain or loss taken straight to profit and loss.
- Hedged itemThe asset, liability, cash flow or firm commitment that carries the risk being protected — the exposure a hedging instrument is designated against, and without which there is no hedge at all.
- ICAI Guidance NoteICAI's revised 2021 note on accounting for derivative contracts, effective for accounting periods beginning on or after 1 April 2021, requiring every derivative on the balance sheet at fair value.
- Inventory hedge accounting adjustmentA separate basis adjustment carrying the fair value change of hedged inventory, kept apart from the AS 2 valuation, and released to cost of goods sold when the inventory is finally sold.