What types of hedges do we have?Although I clearly explain a hedge accounting in details inmy IFRS Kit, let me shortly explain what type of hedges we have:1. Fair Value Hedge;2. Cash Flow Hedge, and3. Hedge of a Net Investment in a Foreign Operation but we will not deal with this one here, as its almost the same mechanics as a cash flow hedge.

First, lets explain the basics.What is a Fair Value Hedge?Fair value hedgeis a hedge of the exposure tochanges in fair valueof a recognized asset or liability or unrecognized firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss.Special For You!Have you already checked out theIFRS Kit? Its a full IFRS learning package with more than 30 hours of private video tutorials, more than 100 IFRS case studies solved in Excel, more than 120 pages of handouts and many bonuses included. If you take action today and subscribe to the IFRS Kit, youll get it at discount!Click here to check it out!Thats the definition inIFRS 9andIAS 39.So here, you have some fixed itemand youre worried that its value will fluctuate with the market. Ill come back to this later.How to Account for a Fair Value Hedge?OK, lets not go into details and lets just assume that your fair value hedge meets all criteria for hedge accounting.In such a case, you need to make the following steps: Step 1:Determine the fair value of both your hedged item and hedging instrument at the reporting date; Step 2:Recognize any change in fair value (gain or loss) on the hedging instrument in profit or loss (in most cases).You need to do the same in most cases even if you dont apply the hedge accounting, because you need to measure all derivatives (your hedging instruments) at fair value anyway. Step 3:Recognize the hedging gain or loss on the hedged item in its carrying amount.To sum up theaccounting entries for a fair value hedge:DescriptionDebitCredit

Hedging instrument:

Loss on the hedging instrumentP/L FV loss on hedging instrumentFP Financial liabilities from hedging instruments

OR

Gain on the hedging instrumentFP Financial assets from hedging instrumentsP/L FV gain on hedging instrument

Hedged item:

Gain on the hedged itemFP Hedged item (e.g. inventories)P/L Gain on the hedged item

OR

Loss on the hedged itemP/L Loss on the hedged itemFP Hedged item (e.g. inventories)

Note: P/L = profit or loss, FP = statement of financial position.What is a Cash Flow Hedge?Cash flow hedgeis a hedge of the exposure tovariability in cash flowsthat is attributable to a particular risk associated with all or a component of a recognized asset or liability or a highly probable forecast transaction, and could affect profit or loss.Again, thats the definition inIAS 39andIFRS 9.Here, you have some variable item and youre worried that you might get less money or have to pay more money in the future than now.Equally, you can have a highly probable forecast transaction that hasnt been recognized in your accounts yet.How to Account for a Cash Flow Hedge?Assuming your cash flow hedge meets all hedge accounting criteria, youll need to make the following steps: Step 1:Determine the gain or loss on your hedging instrument and hedge item at the reporting date; Step 2:Calculate the effective and ineffective portions of the gain or loss on the hedging instrument; Step 3:Recognize the effective portion of the gain or loss on the hedging instrument in other comprehensive income (OCI). This item in OCI will be calledCash flow hedge reservein OCI. Step 4:Recognize the ineffective portion of the gain or loss on the hedging instrument in profit or loss. Step 5:Deal with a cash flow hedge reserve when necessary. You would do this step basically when the hedged expected future cash flows affect profit or loss, or when a hedged forecast transaction occurs but lets not go in details here, as its all covered inthe IFRS Kit.To sum up theaccounting entries for a cash flow hedge:DescriptionDebitCredit

Loss on the hedging instrument effective portionOCI Cash flow hedge reserveFP Financial liabilities from hedging instruments

Loss on the hedging instrument ineffective portionP/L Ineffective portion of loss on hedging instrumentFP Financial liabilities from hedging instruments

OR

Gain on the hedging instrument effective portionFP Financial assets from hedging instrumentsOCI Cash flow hedge reserve

Gain on the hedging instrument ineffective portionFP Financial assets from hedging instrumentsP/L Ineffective portion of gain on hedging instrument

Note: P/L = profit or loss, FP = statement of financial position, OCI = other comprehensive income.As you can see,you dont even touch the hedged itemhere and you only deal with the hedging instrument. So thats completely different from fair value hedge accounting.How to Distinguish Fair Value Hedge and Cash Flow Hedge?What Im going to explain right now is my own logic of looking at this issue. Its not covered in any book.Itshow I look at most hedging transactionsand this is avery simplifiedview. But maybe it opens up your mind to logical thinking about hedges.Please, ask first:What kind of item are we hedging?Basically, you can hedge a fixed item or a variable item.

Hedging a Fixed ItemAfixed itemmeans that the item has afixed value in your accountsand it may provide or require fixed amount of cash in the future.The same applies forunrecognized firm commitmentsthat have not been sitting in your accounts yet, but they will be in the future.And when it comes tohedging fixed items, then youre practically dealing withthe fair value hedge.Why is that?Well, here, you are worried, that in the future, you would be paying or receiving a different amount than the market or fair value will be. So you dont want to FIX the amount, you want toGET or PAYexactly in line with the market.Im referring to GET or PAY only for the sake of simplicity. In fact, you dont even need to get or pay anything in the future youre just worried that the item will have a different carrying amount in your books that its fair value.Fair Value Hedge ExampleYou issued some bonds with coupon 2% p.a.Its nice that you always know how much youll pay in the future.BUT you are worried that in the future, market interest rate will be much lower than 2% and you will be overpaying (in other words, you could get the loan at much lower interest in the future than you will be paying at the fixed rate of 2%).Therefore, you enter into interest rate swap to receive 2% fixed / pay LIBOR12M + 0.5%. This is a fair value hedge you tied the fair value of your interest payments to market rates.Hedging a Variable ItemAvariable itemmeans that theexpected future cash flows from this item changeas a result of certain risk exposure, for example, variable interest rates or foreign currencies.When it comes to hedging variable items, youre practically speaking ofa cash flow hedge.Why is that?Here, you are worried that you will get or pay adifferent amount of moneyin certain currency in the future that you would get now.In fact, in a cash flow hedge, you want to FIX the amount of money youll get or pay so that this amount would be the same NOW and IN THE FUTURE.Cash Flow Hedge ExampleYou issued some bonds with coupon LIBOR 12M+0.5%.It means that in the future, you will pay interest in line with the market, because LIBOR reflects the market conditions.BUT you dont want to pay in line with market. You want to know how much you will pay in the future, as you need to make some budget, etc.Therefore you enter into interest rate swap to receive LIBOR 12 M + 0.5% / pay 2% fixed. This is cash flow hedge you fixed your cash flows and you will always pay 2%.To Sum This All UpNow you can see that the same derivative interest rate swap can be a hedging instrument in a cash flow hedge as well as in a fair value hedge.The key to differentiate isWHAT RISK you hedge. Always ask yourself, why you undertake the hedging instrument.But its not that simple as it seems because there are some exceptions in IAS 39 and IFRS 9.For example, even when you have a fixed item, you can still hedge it under cash flow hedge and protect it against foreign currency risk.Equally, you can hedge a variable rate debt against fair value changes and thats the fair value hedge.Therefore, please refer to the followingtable summarizing the types of hedgesaccording to risks and items hedged:Item hedgedRisk hedgedType of hedge

Fixed-rate assets and liabilitiesInterest rates, Fair value, Termination OptionsFair value hedge

Fixed-rate assets and liabilitiesForeign currency, credit riskFair value hedge or cash flow hedge

Unrecognized firm commitmentsInterest rates, Fair value, Credit riskFair value hedge

Unrecognized firm commitmentsForeign currencyFair value hedge or cash flow hedge

Variable-rate assets and liabilitiesFair value, termination optionsFair value hedge

Variable-rate assets and liabilitiesInterest rates, foreign currencies, credit riskCash flow hedge (most cases)

Highly probable forecast transactionsFair value, interest rates, credit risk, foreign currencyCash flow hedge

Now, Id like to hear from you. Please leave me a comment and let me know whether you have dealt with some hedge accounting in practice, what issues you faced and how you solved them. Thank you!