Hedge accounting
An 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.
In plain language
A company hedges to reduce volatility. But accounting can put it right back. The default rule for derivatives is that they sit on the balance sheet at fair value, with every change in fair value hitting the profit and loss statement immediately. The hedged item — a future export receipt, say — may not be recognised until much later. So a perfectly sensible hedge can make reported profits swing wildly.
Hedge accounting fixes the timing mismatch. If a company designates a derivative as a hedging instrument and meets strict conditions, gains and losses on the hedge are recognised in step with the hedged item.
The workbook stresses that it is permitted but not required. An entity can use hedge accounting for some derivatives and not for others.
How it works
The framework in the workbook (Chapter 9, section 9.1):
| Entity | Governing guidance |
|---|---|
| Banks, NBFCs, HFCs, insurers | Their regulator's prescribed treatment (RBI, IRDAI), if any |
| Companies under Ind AS | Ind AS 109, Financial Instruments (based on IFRS 9) |
| Others | ICAI Guidance Note on Accounting for Derivative Contracts (Revised 2021) |
Minimum conditions under the Guidance Note: identify the risk management objective; show how the derivative meets it; specify how the derivative's fair value will be measured (including the hedge ratio); document all this at inception and every reporting period; for cash flow hedges, show the cash flows are highly probable; conclude the hedged risk could affect profit and loss; and disclose policies. Ind AS 109 adds an economic relationship, credit risk not dominant, and a consistent hedge ratio.
Three types:
| Type | Hedges | Effective gains and losses go to |
|---|---|---|
| Fair value hedge | Fair value changes of recognised assets / liabilities or unrecognised firm commitments | Profit and loss (alongside the hedged item) |
| 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, ineffective part to P&L; recycled on disposal |
Exchange-traded contracts need extra care. The workbook notes that instruments like currency futures do not come with these requirements built in, so compliance must be demonstrated before hedge accounting can be applied.
Hedge effectiveness — how far changes in the hedge offset changes in the hedged item — may be assessed by critical terms match, dollar offset or regression.
A worked example
Illustrative. The company, amounts and rates are hypothetical; the accounting treatment follows the workbook's description.
On 1 January, Nilgiri Tea expects a highly probable export receipt of USD 1,00,000 on 30 June. It sells 100 lots of USDINR futures at 83.50 and documents the hedge.
At its 31 March year-end, the futures price is 84.00.
Fair value loss on futures = (84.00 − 83.50) × 100 × 1,000 = Rs 50,000
Without hedge accounting: the Rs 50,000 loss goes to profit and loss for the year ending 31 March — while the matching gain on the higher rupee value of the export is not recognised until the sale next year. Reported profit falls by Rs 50,000 for a hedge that is working.
With cash flow hedge accounting: the effective Rs 50,000 loss goes to the cash flow hedge reserve in equity. When the export is recognised in the next year, it is released against the higher rupee revenue.
If only part is effective. Suppose a dollar-offset test shows the expected export value rose by only Rs 45,000. Then Rs 45,000 goes to equity and the Rs 5,000 ineffective portion goes to profit and loss immediately.
Why NISM asks about it
Chapter 9, section 9.1.1, summarises the ICAI Guidance Note: fair value on balance sheet, conditions for hedge accounting, the three types, presentation and disclosure, and hedge effectiveness. Sections 9.1.2 and 9.1.3 cover AS 30 and Ind AS 109, including FVTPL and embedded derivatives. The Chapter 9 sample question asks which hedge accounting models the Guidance Note recognises.
Common exam traps
- Hedge accounting is optional — "permitted but not required".
- Default treatment is fair value through profit and loss. Hedge accounting is the exception, and only with documentation from inception.
- Cash flow hedge → equity; fair value hedge → profit and loss. Net investment hedges go to equity, like cash flow hedges.
- The ineffective portion always goes to profit and loss immediately.
- AS 30 has been withdrawn and replaced by Ind AS 109 for Ind AS companies. The workbook still cites AS 30 in Chapter 2's definition of a derivative; treat that as historical.
- The Guidance Note does not prescribe one effectiveness method; critical terms match, dollar offset and regression are all acceptable.
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.
3.AS 30 defines a derivative as a financial instrument or contract with three characteristics. Which set is correct?
- a)It is traded on a stock exchange; it is cash settled; it has a maturity of up to one year
- b)Its value changes in response to a specified underlying variable; it requires no initial net investment, or one smaller than other contracts with a similar response to market factors; it is settled at a future date
- c)It is issued by a bank; it pays interest; it is transferable by endorsement
- d)It must be designated as a hedge; it must be highly effective; it must be documented at inception
Show the answer
Answer: (b) Its value changes in response to a specified underlying variable; it requires no initial net investment, or one smaller than other contracts with a similar response to market factors; it is settled at a future date
The workbook quotes AS 30: a derivative has "all three of the following characteristics:"
- (a) "its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable" — the 'underlying'
- (b) "it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors"
- (c) "it is settled at a future date."
AS 30 was eventually withdrawn and replaced by Ind AS 109 for entities under the Ind AS framework.
Why the others are wrong:
- Exchange-traded, cash settled, up to one year — forwards and swaps are OTC derivatives too. None of these features is in the definition.
- Bank-issued, interest-bearing, endorsable describes a debt instrument, not a derivative.
- Designation, effectiveness, documentation are conditions for hedge accounting, not part of what makes a contract a derivative.
Where this is taught
- Series IV · Chapter 9: Accounting and Taxation of IRDintroduced 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.
- Other Comprehensive IncomeGains and losses that Ind AS requires or permits to bypass the profit and loss account — they change shareholders' equity and never touch earnings per share.
- 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.
- Embedded derivativeA derivative component hidden inside a non-derivative contract, which Ind AS 109 requires to be pulled out and accounted for separately unless it is "closely related" to the host contract.
- Fair value hedgeA 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.
- 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.
- Speculative transactionUnder income tax, a transaction settled otherwise than by actual delivery. Exchange-traded currency derivatives are excluded by Section 43(5), so their gains and losses are non-speculative business income.
- Carry forward of business lossTaking an unabsorbed business loss — including a loss on exchange traded derivatives — into later years: up to 8 assessment years, against business income only, and only if the return was filed by the due date.