IFRS 9 hedge accounting is the optional set of rules that lets a company match the gain or loss on a currency hedge to the transaction it is protecting, so that the two land in the same period and reported profit is not distorted by timing. Without it, a forward contract used to protect a future foreign currency cash flow is still measured at fair value, and the swings in that value can hit the profit and loss account before the underlying sale or purchase is recognised. This guide explains, in plain language, what IFRS 9 hedge accounting is, the conditions a company must meet, the main types of hedge, and what corporate treasurers need to have in place. Medlock & Thames is a currency broker, not an accountant or auditor, so this is general information and not accounting or audit advice. The treatment of any specific hedge should be agreed with your auditors.
What is hedge accounting?
Hedge accounting is a way of presenting a hedge and the item it protects together in the financial statements. By default, a derivative such as a currency forward is measured at fair value, and the change in that value each period goes through profit and loss. The problem is one of timing. A business might sell currency forward today to protect a sale it will not recognise for six months, so the fair value swings on the forward would otherwise appear in profit long before the sale they relate to. Hedge accounting realigns the two, so the protection and the protected item affect reported profit in the same period. It does not change the cash, the rate or the economics of the hedge. It changes only how and when the gains and losses are reported.
Which standard applies, IFRS 9 or FRS 102?
It depends on the framework a company reports under. IFRS 9, issued by the International Accounting Standards Board, applies to companies reporting under UK adopted international accounting standards, which includes listed groups and others that choose IFRS. It replaced the older standard, IAS 39, for accounting periods beginning on or after 1 January 2018, and it brought hedge accounting closer to how businesses actually manage risk. Many private UK companies instead report under UK GAAP and apply Section 12 of FRS 102, set by the Financial Reporting Council. The principles are similar, but the detail differs, so the first step is always to confirm which framework governs your accounts.
What conditions must a hedge meet?
Hedge accounting is not automatic. To apply it, a company must meet several conditions at the start of the hedge. There must be formal designation and written documentation at inception, setting out the risk management objective, the hedged item, the hedging instrument and how effectiveness will be assessed. The hedged item and the hedging instrument must both be eligible. There must be an economic relationship between them, meaning their values are expected to move in opposite directions for the risk being hedged. The effect of credit risk must not dominate that relationship. And the hedge ratio used for accounting must match the ratio the business actually uses to manage the risk. IFRS 9 removed the strict 80 to 125 per cent effectiveness test that IAS 39 required, replacing it with this more principles based, forward looking assessment. The single most important practical point is that the documentation has to exist at inception. It cannot be written after the event.
What are the main types of hedge?
IFRS 9 recognises three types of hedging relationship, and the type determines where the gains and losses are reported.
A cash flow hedge protects against variability in future cash flows, such as a forecast foreign currency sale or purchase. The effective portion of the gain or loss on the hedging instrument is recognised in other comprehensive income, in a cash flow hedge reserve, and is later reclassified to profit and loss when the hedged transaction itself affects profit. Any ineffective portion goes straight to profit and loss. This is the most common treatment for a forward used to hedge a forecast transaction.
A fair value hedge protects against changes in the value of a recognised asset or liability, or a firm commitment, such as a fixed price foreign currency order already placed. Here the change in the fair value of the hedging instrument and the change in the value of the hedged item, for the risk being hedged, are both recognised in profit and loss, where they largely offset.
A net investment hedge protects the currency exposure on a net investment in a foreign operation, for example a euro denominated subsidiary. Like a cash flow hedge, the effective portion is held in other comprehensive income, in the translation reserve, and is reclassified to profit and loss only when the foreign operation is disposed of.
How does a cash flow hedge work in practice?
Take a UK exporter that expects to receive 1,000,000 US dollars in six months from forecast sales. The treasurer sells the dollars forward to fix the sterling amount, and designates the forward as a cash flow hedge of the forecast sale, with the documentation in place from day one. Over the next six months, as the exchange rate moves, the effective change in the value of the forward is recorded in other comprehensive income rather than profit, so it does not whipsaw the reported result. When the sale is recognised, the amount built up in the cash flow hedge reserve is reclassified, so the revenue is effectively recorded at the rate the treasurer locked in. The economic outcome is the same as the underlying forward contract; hedge accounting simply stops the timing of the fair value movements from distorting profit along the way.
How is hedge effectiveness assessed under IFRS 9?
IFRS 9 assesses effectiveness on a forward looking basis. Rather than a numerical pass or fail test each period, a company must show that an economic relationship exists, that credit risk does not dominate the value changes, and that the hedge ratio reflects the actual quantities hedged. If the relationship still meets the risk objective but the ratio has drifted, the standard may require rebalancing, which means adjusting the quantities so the ratio stays appropriate. Even where a hedge qualifies, any ineffectiveness must still be measured and recognised in profit and loss, so accurate fair value measurement each period remains essential.
What is the cost of hedging under IFRS 9?
When a company hedges with a forward, the forward rate differs slightly from the spot rate because of the interest rate difference between the two currencies, known as the forward points. IFRS 9 lets a company separate this forward element and account for it as a cost of hedging, recognising it in other comprehensive income and releasing it over the life of the hedge, rather than letting it add noise to profit. The same option applies to the currency basis. It is an accounting policy choice that can further reduce volatility in reported profit, and it is worth discussing with your auditors when you set up a programme.
What do treasurers need to have in place?
In practice, qualifying for hedge accounting is as much about process as about standards. A treasurer needs a documented risk management objective and strategy, usually set out in a currency hedging policy; designation documentation prepared at the inception of each hedge; a way to measure the fair value of each instrument and any ineffectiveness every reporting period; and clear records tying each contract to a specific, named exposure. Early coordination with the auditors matters, because the treatment is agreed with them, and forecast transactions need to be described precisely enough to support the hedge. Good contract confirmations from your currency provider make that record keeping much easier.
According to Medlock & Thames
In our experience, the practical failures around hedge accounting are rarely about the calculations. They are about timing and paperwork: the designation documentation that was never written at inception, or the forecast transaction described too vaguely to support the hedge. The treasurers who decide the accounting treatment at the same moment they place the hedge, and who keep the contract notes that tie each trade to a named exposure, tend to have a far smoother audit.
Frequently asked questions
Is hedge accounting compulsory?
No. Hedge accounting is optional. A company can hedge its currency risk without applying it, in which case the derivatives are simply measured at fair value through profit and loss. Companies apply hedge accounting when they want to reduce the resulting volatility in reported profit.
Can a smaller company use hedge accounting?
Yes. Companies reporting under FRS 102 can apply hedge accounting under Section 12 if the conditions are met. Some smaller companies choose not to, because the documentation and measurement requirements add work, and weigh that against the benefit of smoother reported profit.
Does hedge accounting change the exchange rate we get?
No. It changes only how and when gains and losses are reported in the accounts. The rate, the cash flows and the economic protection of the hedge are exactly the same whether or not hedge accounting is applied.
What happens if a forecast transaction no longer occurs?
For a cash flow hedge, if the forecast transaction is no longer expected to occur, the cumulative gain or loss held in other comprehensive income is reclassified to profit and loss immediately. This is one reason forecasts need to be realistic and well documented.
Does Medlock & Thames prepare the accounting entries?
No. Medlock & Thames is a currency broker. We provide the contracts, rates and confirmations that support your records, but the accounting entries and the hedge accounting treatment are for your finance team and auditors to prepare and agree.
Related articles
This guide is part of our FX Hedging and Treasury series. For the wider picture, read FX hedging for finance directors. To compare the instruments behind a hedge, see forward contracts and currency options, and for the mechanics, how a forward contract works. To discuss a corporate exposure, visit corporate currency, and for how your money is protected, see our regulation and compliance guide.
For how hedging sits alongside a funding requirement, see business finance and currency.
