Hedge accounting
Principi contabili e informativa
finanziaria
Prof.ssa Pucci Sabrina
a.a.2013-2014
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Risk definition
• Risk is an abstract term (we are all faced with risk in
our everyday lives)
• Risk is the chance of injury, damage or loss. It is the
event probability multiplied by consequences effects
• Pure and speculative risk
• Risk is often related to the volatility of future value of a
position due to changes in creditworthiness, market
behaviour or uncertain events, unexpected happenings
and other outliers
• Risk lies in the variability of costs and revenues
• The measure of variance around an expected value is
the quantitative expression of risk
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Risk definition - continued
• Type of risk:
– traditional risk (such as credit risk, liquidity risk
and market risk)
– non-traditional risk (such as stategic and business
risk, event risk and legal risk, reputational risk)
• All risks concerning an entity must be
identified, measured, evaluated and managed
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Risk definition - continued
• measuring. monitoring and controlling risks
are key activities in accounting and in auditing
• innovation, leverage, volatility, liquidity and
their lack combine to increase the risk of
major exposure, which has the potential to
destroy a financial institution or any other
entity
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Risk control
• Various approaches in risk evaluation: insurance
approach, managerial approach, financial
approach
• Techniques of risk control:
– Physical control (elusion, prevention, protection);
– Financial control (retention, insurance, non-insurance
transfer)
–
• Evaluation of convenient retention level
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Risk management
• “the science of risk management, if not
practised beforehand, cannot be gained when
it becomes necessary. Nor indeed can the
athlete bring high spirit to the contest, who
never has been trained to practise it” (Roger of
Hourden)
• “Risk management and risk taking are not
opposites, but two sides of the same coin”
(M.Crouhy, D.Galai, R. Mark, 2005)
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Thinking out of the box
It is necessary that:
• accountants improve their ability to calculate
additional risk factors that exist outside the
immediate trading and back office functions;
• boards of directors improve their understanding
of risk management;
• firms introduce continuous effective risk control
based on: rigorous auditing, better performance
measurement, appropriate capital allocation and
realistic pricing of financial products.
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What accountants should do:
• learn risk management
• calibrate tools to retain risk and to register risk
exposures;
• apply value differentiation provided by
traders, loans officers, risk managers, senior
executives;
• use accounting practices that respond to the
need to focus on every signal connected to
exposure.
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The accountant’s mission in risk
control
• to develop risk accounting and cost accounting
based on both qualitative and quantitative
criteria, for which metrics must be provided
• to develop appropriate standards to analyze risk
exposure and to present this information
• to develop comprehensive internal controls with
authorization procedures, compliance checks and
follow-ups of non compliance clearly defined at
every level of activity.
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The accountant’s mission in risk
control - continued
• To develop systems and procedures that:
–
–
–
–
clearly delineate risk elements
allow efficient management of the limits system,
monitor conterparty and financial market risks,
manage assets and liabilities in a consistent and
secure manner
– apply stress testing (as a defensive weapon) in
risk accounting to help identify what is wrong and
what may happen in future if some fundamental
variables change.
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Situations that must be analyzed by
accountants
• Uncertainty
(frequency and impact of
expected and unexpected events)
• Volatility (and correlation between markets
and instruments)
• Liquidity (of market and firms)
• Solvency (also default point characteristics)
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Economic and accounting hedging
• Economic hedging
– Use of appropriate instruments to neutralize
unfavourable trends of variables like: interest
rates, exchange rates, …
– The economic effect of the variation of value of
the hedged financial instrument and of the
hedging instrument is equal to zero;
• Accounting hedging
– How is a hedging operation recognised in financial
statements?
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Hedge accounting
This is a technique that modifies the normal basis for
recognising gains and losses (revenues and expenses)
associated with a hedged item or a hedging instrument.
This enables gains and losses on the hedging instrument
to be recognised in the P&L in the same period as
offsetting losses and gains on the hedged item.
Hedge accounting takes three forms under IAS – IFRS:
- fair value hedge
- cash flow hedge
- net investment hedge (IAS 21)
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Hedge accounting: requirements
To be able to apply hedge accounting, very strict criteria must
be met at inception and throughout the life of the hedging
relationship:
• the hedging relationship must be documented in detail,
• the hedge must be expected to be highly effective at
inception,
• for cash flow hedging, the forecast transaction must be
highly probable,
• hedge effectiveness must be measured reliably,
• the effectiveness of the hedging relationship must be
assessed on an ongoing basis, and the relationship must be
deemed to be highly effective throughout the entire hedge
relationship term.
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Hedge accounting – example of the
impacts
In year x, the entity acquires a derivative to
hedge risk exposure of an item that is already
recognised in the balance sheet. The derivative
matures in x+1 and the hedged item settles in
x+2.
It can be observed that only the fair value hedge
provides perfect synchronisation between the
hedging instrument and the hedged item
recognition.
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Hedge accounting: example
x+1
x+2
total
Without hedging
Hedging instrument
1.000
Hedged item (realized gain)
Net profit/(loss)
1.000
1.000
(1.000)
(1.000)
(1.000)
0
With fair value hedge
Hedging instrument
1.000
1.000
Hedged item (unrealized gain)
(1.000)
(1.000)
Net profit/(loss)
0
0
0
Hedging instrument (after deferral
in equity)
1.000
1.000
Hedged item (realized gain)
(1.000)
(1.000)
0
0
With cash flow hedge
Net profit/(loss)
0
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Hedge accounting: types
 fair value hedge
 the objective is to reduce exposure to changes in the fair value of an
asset or liability already recognised in the balance sheet that is
attributable to a particular risk and could affect reported P&L. The aim is
to offset the change in fair value of the hedged item with the change in
fair value of the derivative;
 cash flow hedge
 the portion of gain or loss on the hedging instrument that is
determined to be an effective hedge is recognised directly in a separate
reserve in equity. Any ineffective portion of the fair value movement on
the hedging instrument is recorded immediately in the P&L;
 net investment hedge
 is a hedge of foreign currency exposure arising from the reporting
entity’s interest in the net assets of a foreign operation. The effective
portion of the gain or loss is recognised in equity. Any ineffective portion
of the fair value movement on the hedging instrument is recorded
immediately in the P&L.
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Hedge relationship documentation
• risk management objective and hedging strategy
• type of hedge
• risk being hedged
• hedging instrument
• hedged item
• assessment of effectiveness testing (by comparing
changes in the fair value of the hedging instrument
to changes in the fair value of the expected cash
flow. (prospective test and retrospective test)
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Hedge accounting: effectiveness tests
o prospective test
o the objective is to prove that the hedge is expected to be
highly effective in future. This test must be performed at
inception and at least at each balance-sheet date
o retrospective test
o the objective is to prove whether the actual hedging
relationship was effective in the last period (since the last test
was performed). This test must be completed at each
reporting date. In order to pass the test, the hedging
instrument must be within the range of 80 - 125 per cent in
the terms of effectively offsetting the changes in value of the
hedged item. IAS 39 does not specify a single method for
assessing retrospective hedge effectiveness. In general the
ratio analysis method is used.
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