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HMRC internal manual

Corporate Finance Manual

HM Revenue & Customs
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Accounting for corporate finance: hedging: qualifying hedged items

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

Hedged items

A hedged item is an asset, liability, firm commitment, highly probable forecast transaction, or net investment in a foreign operation that:

  • Exposes the entity to risk of changes in fair values or future cash-flows; and
  • Is designated as being hedged.

A key aspect of the above definition is that the hedged item must expose the entity to the risk of changes in fair values or cash-flows, which could impact upon profit or loss in current or future periods.

A hedged item can be:

  • a single recognised asset or liability, firm commitment, highly probable transaction, or a net investment in a foreign operation;
  • a group of assets, liabilities, firm commitments, highly probable forecast transactions, or net investments in foreign operations with similar risk characteristics; or

Designating a group or portfolio of items as hedged items requires that:

  • the individual assets or liabilities in the group share the risk exposure that is designated as being hedged; and
  • the change in the fair value attributable to the hedged risk for each individual item in the group is expected to be approximately proportional to the overall change in fair value attributable to the hedged risk of the group of items.

CFM27180 provides further details of ‘macro hedges’.

Designation of portions of financial items

For financial assets and financial liabilities, it is possible to hedge the risks associated with only a portion of its cash-flows or fair values. For example, all of the cash-flows may be designated for cash-flow or fair value changes related only to certain, but not all risks, while some (but not all) the cash-flows may be designated for all, or only certain risks. Equally, the ability to designate only a portion of the cash-flows means than an instrument may be designated as a hedged items for a period which is less than the term of the instrument.

To qualify as a hedged item, the designated portion or risks of the instrument must be capable of being separately identified and reliably measured.

Designation of non-financial items

If the hedged item is non-financial, it can only be designated as a hedged instrument for foreign currency risks, or in its entirety for all risks. This is because the standard does not consider that changes in fair values or cash-flows can be accurately apportioned to specific risks other than foreign currency risks.

Examples of hedged items: example 1

A company has borrowed money at a variable rate of interest. It enters into an interest rate swap under which it pays fixed and receives floating. This arrangement is designed to hedge the risk that cash-flows will vary in the future if the interest rate changes. In this case the loan is designated the hedged item and the interest rate swap the hedging instrument.

Examples of hedged items: example 2

A company has a contractual commitment to purchase a fixed quantity of fuel oil at a fixed price and on a fixed date. The fair value of this firm commitment will vary as fuel oil prices change. The company can designate its firm commitment as a hedged item, and enter into a commodity forward contract (the hedging instrument) that will offset the fair value changes.