Implementing IAS 39 Hedge Accounting with Fairmat

Posted by Fairmat Srl on 27 December 2012 | 0 Comments

Tags: Hedge Acconting

The IAS 39 accounting rules disciplines the representation and the valuation of financial instruments on the balance sheet. A fundamental principle in IAS is that all derivatives are measured at fair value. Besides innovation in the valuation process, the IAS 39 principle introduces relevant advances in the hedging instruments accounting (Hedge Accounting).

Hedge accounting seeks to reflect the results of hedging activities, in particular hedging using derivatives, by reporting the effects of the derivative and the risk being hedged in the same period. These rules allows you to evaluate at the same time the effects at income statement level derived by hedging instrument and hedged item fair values changes. Hedge accounting is an exception with respect to the standard accounting principles: it allows entities to override the normal accounting treatment for derivatives (fair value through profit or loss) or to adjust the carrying value of assets and liabilities. Therefore, in order to apply hedge accounting, IAS 39 requires hedging instruments that satisfy given criteria.

• The hedging relationship must be formally designated and documented at the inception of the hedge. This must include identifying and documenting the risk management objective, the hedged item, the hedging instrument, the nature of the risk being hedged and how the effectiveness of the hedge will be assessed;
• The hedge must be expected to be highly effective at the inception of the hedge;
• The effectiveness of the hedge must be tested regularly throughout its life and hedge accounting must terminate if the hedging instrument loses its efficacy.

In particular, a hedge is regarded as highly effective only if both of the following tests are passed:

• Prospective Effectiveness Test: from the beginning of the derivatives (and for all the length of the hedging operation), the company can expect that changes to the fair value or of the subsequent cash flows given by the hedged activity “hedged item'' will be almost compensated by changes of the fair value or cash flows of the hedging instrument. It is required, at a minimum, at the inception of the hedge and at each reporting date.
• Retrospective Effectiveness Test: the recorded relative changes must fall in the 80-125\% interval.

It is required, at a minimum, at each reporting date. %at the time an entity prepares its interim or annual financial statements.

Therefore, the possibility of implementing hedge accounting depends on the satisfying of the prospective and retrospective tests which are designed to guarantee that the hedging objectives are met.  A minimum requirement, at the inception of the hedge and at the time an entity prepares its interim or annual financial statements the company must perform both the tests.

We published a new plug-in called IAS-39 Hedge Accounting which allows to perform IAS 39 prospective and retrospective tests on Fairmat projects. The IAS-39 plug-in makes IAS-39 implementation straightforward: IAS 39 Test can be performed on Fairmat projects where the hedged item represented by the hypothetical derivative and hedging instruments is defined using Fairmat option map scenarios (see image below), thus allowing extreme flexibility on the definition of the hedge item and the hedging instrument (in Fairmat, the first scenario represents the hedging instrument cash flows, while the second the hedged item).