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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: hedge ineffectiveness

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

Hedge ineffectiveness

CFM27070 explains how to assess the effectiveness of a hedge. In practice, few hedges are 100% efficient. Where the hedge is not fully effective, the ineffective portion is recognised in the income statement.

Regardless of whether a quantitative or qualitative analysis is used to assess hedge effectiveness, a quantitative analysis is used to determine the amount of ineffectiveness to be recognised in the income statement.

In the example at CFM27070, 100 of the loss on the hedging instrument could be offset against the 100 gain on the hedged item. But the remaining 20 of the loss would be recognised in the income statement as the ineffective portion.

The extent to which ineffectiveness causes income statement volatility depends on whether the hedge relationship is a cash-flow or fair-value hedge (see CFM27120 for a definition of these terms). For fair value hedges, the entire change in fair value of both the hedging instrument and the hedged item is recognised in the income statement, and where there is ineffectiveness these will not offset.

For cash-flow hedges, the amount recognised in equity is the lower of the cumulative gain or loss on the hedging instrument and the cumulative change in the fair value of the expected future cash-flows of the hedged item. Where the cumulative gains/losses on the hedging instrument exceed the cumulative change in the fair value of the hedged item, the difference is recognised in the income statement. Where there is a shortfall, there will be no ineffectiveness recognised.

Again using the example at CFM27070, if the hedging relationship was accounted for as a cash-flow hedge, the 100 cumulative gain on the hedged item is lower than the 120 cumulative loss on the hedging instrument, so 100 would be recognised in equity. As the 120 loss on the hedging instrument exceeds the 100 gain on the hedged item, the remaining 20 of the loss would be recognised in the income statement.

If, however, the loss on the hedging instrument had been only 90, only 90 would have been recognised in equity (being the lower of the cumulative loss on the hedging instrument and the cumulative gain on the hedged item), and no ineffectiveness would be recognised in the income statement.