Accounting

5 Qualifying Conditions For Hedge Accounting

Highly effective and highly probable in the context of IAS 39 : There are 5 Qualifying Conditions For Hedge Accounting. All conditions are given below.

Five Qualifying Conditions for hedge accounting which all must be met  :

  1. At the inception of the hedge there must be formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge. That documentation must include identification of:
  • the hedging instrument
  • the hedged item
  • the nature of the risk being hedged
  • how the entity will assess hedge effectiveness (‘Hedge effectiveness’ is defined in IAS 39 paragraph 9 as:

“the degree to which changes in the fair value or cash flows attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument.”

  1. The hedge must be expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk. “Highly effective” is elaborated on in AG105 which explains that changes must almost fully offset each other and actual results are within a range of 80%-125%. For example if actual results are that the loss on a hedging instrument is $120 and the corresponding gain on the hedged item is $100, offset can be measured by 100/120 which is 83% or by 120/100 which is 120%.
  2. 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 affect profit or loss. ‘Highly probable’ means there is a much greater likelihood of occurrence than ‘more likely than not’.
  3. The effectiveness of the hedge can be reliably measured.
  4. The hedge is assessed on an on-going basis and must be determined actually to have been highly effective throughout the financial reporting periods for which the hedge was designated.

Highly effective – thus relates to the assessment of hedge effectiveness of the hedging relationship as a whole whereas ‘highly probable’ relates to whether or not the underlying transaction (that is, the hedged item) will occur.

Highly effective and highly probable is well discussed in IAS 39

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