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Atila Salsabilla

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Accounting for Derivatives and Hedging Activities


Hedge Accounting : accounting designed to record changes in the value of the
hedged item, and in the value of the hedging instrument in the same accounting
period

Characteristics for a Derivative :


1. It has one or more underlyings and one or more notional amounts or payment
provisions, or both.
2. 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.
3. Its terms require or permit net settlement, so it can readily be settled net by a
means outside the contract, or it provides for delivery of an asset that puts the
recipient in a position not substantially different from net settlement.

Formal Documentation to Qualify for Hedge Accounting


The relationship between the hedged item and the derivative instrument
The risk-management objective and the strategy that the company is
achieving through this hedging relationship, including identification of:
- The hedging instrument
- The hedged item
- The nature of the risk being hedged
- For fair value hedges, how the hedging instruments effectiveness in
offsetting the exposure to changes in the hedged items fair value will be
assessed
- For cash flow hedges, how the hedging instruments effectiveness in
hedging the hedged transactions variability in cash flows attributable to the
hedged risk will be assessed
Management must demonstrate that the derivative is considered highly
effective in mitigating an identified risk (offsetting gains or losses in the
item being hedged).
Assessing Hedge Effectiveness
Critical Term Analysis

Examining the nature of the underlying variable, the notional amount of the
derivative and the item being hedged, the delivery date for the derivative, and
the settlement date for the item being hedged.
If the critical terms of the derivative and the hedged item are identical, then an
effective hedge is assumed.

Statistical Analysis
If critical terms of item to be hedged and hedge instrument do not match,
statistical analysis can determine effectiveness
Regression analysis
Correlation analysis
Example
Using derivatives based on heating oil or crude oil to hedge jet fuel
costs
There is no a specific benchmark correlation coefficient or an adjusted R2.
However, cash flow offsets of between 80 percent and 125 percent are
considered to reflect highly-effective hedges.

Assess Ongoing Hedge Effectiveness


Cumulative dollar-offset method
A ratio is computed by dividing the cumulative change in the derivative
value by the cumulative change in the hedged items fair value
No benchmark ratio has been officially mandated, but a ratio in the range
of 80 percent to 125 percent is generally considered to indicate a highly
effective hedge
Derivative Does Not Qualify As A Highly-effective Hedge
The derivative is marked to market at the end of each year regardless of
when the gain or loss on the item that management is attempting to
hedge is recognized
No offsetting changes in the fair value of the item being hedged are
recorded until they are realized

Types of Hedge Accounting


Cash flow hedge accounting
A Cash Flow Hedge is used for anticipated or forecasted transactions
where there is risk of variability in future cash flows
Forward Contract
- At inception date: No entry
- The fair value of forward contract adjusted quarterly until the contract is
settled (by using Present Value (PV)); the fair value adjusted by comparing to
the initial value
Future Contract
- At inception date: Journal entries for margin payment
- The fair value of future contract adjusted quarterly until the contract is
settled (not adjusted to PV); the fair value adjusted by comparing to the
adjusted value before
Options
- At inception date: Journal entries for contract cost payment
- The fair value of options adjusted quarterly until the contract is settled
(by using Present Value (PV)); the fair value adjusted by comparing to the
initial value

Fair value hedge accounting


A Fair Value Hedge is used for an asset or liability position, or firm
purchase or sale commitment, where there is a risk of variability in the
value of the position
Both the item being hedged and the derivative are
adjusted to fair value at each reporting date
accounted for immediately in income with offsetting gains or losses

Hedge of net investment in a foreign subsidiary