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HMRC internal manual

Corporate Finance Manual

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HM Revenue & Customs
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Accounting for corporate finance: hedging: designating a hedging instrument

This guidance applies to companies which apply IFRS, New UK GAAP or FRS 26.

What can be designated as a hedging instrument?

A proportion (such as 50% of the notional value) of a hedging instrument can be designated in a hedging relationship. For example, part of an interest rate swap may be designated as a cash flow hedge of the interest rate risk from a company’s borrowing. Gains and losses on the designated portion of the swap would be taken to equity (see CFM27160), while fair value changes on the remainder of the swap would be taken to profit and loss.

However, a hedging relationship cannot be designated as a hedge for only part of the time for which the hedging instrument remains outstanding. Nor, generally, can a company choose to designate specific components of a derivative as a hedge, but not others. The only exceptions permitted are:

  • Separating the interest element and spot price of a forward contract; and
  • Separating the intrinsic value and time value of an option and designating the hedging instrument as the only change in intrinsic value.

Two or more derivatives, or proportions of them, can jointly be designated as the hedging instrument. For currency risk only, this is extended to two or more non-derivatives, or combinations of derivatives and non-derivatives or proportions of them. However, a company cannot use this to circumvent the rule that a written option cannot normally qualify as a hedging instrument.

Generally, financial assets and liabilities whose fair value cannot be reliably measured cannot be hedging instruments. For example, unquoted shares that are not carried at fair value because their value cannot reliably be measured cannot be designated as a hedging instrument. Nor can a company’s own equity instruments, which are neither financial assets nor financial liabilities. Firm commitments and forecast transactions cannot be designated as hedge instruments as they are not normally recognised in the financial statements. However, if (for example) the foreign currency components of a sales commitment is required to be separated as an embedded derivative, it could be designated as a hedging instrument in a fair value hedge of foreign currency risk.