Accounting for corporate finance: hedging: conditions for hedging
This guidance applies to companies which apply IFRS, New UK GAAP or FRS 26.
Conditions for hedging
The accounting standards set out various criteria, all of which must be met, for a hedging relationship to qualify for hedge accounting.
Formal documentation of hedging relationship
At the start of the hedge, there must be formal documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge. The documentation should include identification of the hedging instrument, the hedged item or transaction, and the nature of the risk being hedged.
Hedge ineffectiveness is immediately recognised in the income statement, along with all other fair value changes in derivatives that do not function as hedges.
High probability of occurrence
For cash flow hedges, a forecast transaction that is the subject of the hedge must be highly probable, and must present an exposure to variations in cash flows that could ultimately affect profit and loss.
It must be possible to measure reliably the effectiveness of the hedge, which in turn means that it must be possible to reliably measure both the fair value or cash flows of the hedged item attributable to the hedged risk and the fair value of the hedging instrument.
Ongoing assessment of hedge effectiveness and actual effect (IAS 39 and FRS 26 only)
IAS 39/FRS 26 contain more specific requirements on assessing hedge effectiveness on an ongoing basis. It is necessary for the hedge to be determined to have been highly effective. These more detailed rules are set out in CFM27070. These specific rules are not applicable to those applying hedge accounting under IFRS 9 or FRS 102.