Fair Value Hedge Accounting under Ind AS 109: Mechanics and Example

A fair value hedge is designed for exposure to changes in the fair value of an eligible hedged item attributable to a specific risk. A common example is a fixed-rate borrowing whose fair value changes when market interest rates change. The entity may use an interest-rate swap to transform the economic exposure from fixed to floating. Fair value hedge accounting helps the financial statements reflect that relationship.

The central accounting idea is matching. The change in fair value of the hedging instrument and the change in the hedged item's fair value attributable to the designated risk are recognised in the same reporting period. The difference between those amounts is hedge ineffectiveness.

When is a fair value hedge relevant?

A fair value hedge may involve a recognised asset or liability, an unrecognised firm commitment, or an eligible component of such an item. The designated fair-value exposure must be attributable to a risk that could affect profit or loss, subject to the specific treatment for certain equity instruments for which the entity has elected presentation of fair-value changes in other comprehensive income.

Examples include interest-rate risk in fixed-rate debt, foreign-exchange risk in a firm commitment, or an eligible commodity-price component where the identification and measurement requirements are met.

The risk should be clearly designated. Saying "the borrowing is hedged" is incomplete. The documentation might instead specify that the entity is hedging changes in the fair value of a particular fixed-rate borrowing attributable to a benchmark interest-rate risk over a defined period.

Core accounting mechanics

For a qualifying fair value hedge, the gain or loss on the hedging instrument is generally recognised in profit or loss. At the same time, the gain or loss on the hedged item attributable to the hedged risk adjusts the carrying amount of the hedged item and is also recognised in profit or loss.

This treatment is unusual because an item that would otherwise remain at amortised cost can receive a carrying-amount adjustment for the designated risk during the hedge relationship. The adjustment is not a full remeasurement of every risk in the item. It is limited to the fair-value change attributable to the hedged risk.

Where the hedged item is an equity instrument for which the entity elected to present fair-value changes in other comprehensive income, the standard contains a corresponding OCI presentation for the relevant hedge effects. That is a specific exception and should not be generalised to ordinary fair value hedges.

A simplified example

Assume an entity has a fixed-rate borrowing with a carrying amount of ₹100 crore and designates benchmark interest-rate risk in a fair value hedge using a pay-floating, receive-fixed interest-rate swap.

During the reporting period, assume the swap produces a fair-value gain of ₹4.8 crore attributable to the designated relationship. The borrowing's fair value attributable to the hedged benchmark risk decreases by ₹4.6 crore. Ignoring other complexities, the entity recognises the ₹4.8 crore gain on the swap in profit or loss and recognises a ₹4.6 crore loss on the hedged item in profit or loss, while increasing or decreasing the borrowing's carrying amount as required by the direction of the hedged-risk adjustment.

The net ₹0.2 crore difference represents hedge ineffectiveness for the period. The exact signs and entries depend on the facts, instrument direction and valuation convention, but the conceptual point is stable: both sides of the designated risk are brought into the same period.

What happens to interest income or expense?

The carrying-amount adjustment affects subsequent accounting. For a hedged item measured at amortised cost, the fair value hedge adjustment ultimately needs to be amortised to profit or loss based on a recalculated effective interest rate, as applicable. When hedge accounting is discontinued, the remaining adjustment does not simply disappear.

For a fixed-rate debt instrument, the entity generally begins amortising the hedge adjustment no later than when the item ceases to be adjusted for hedge gains and losses. The objective is to unwind the adjustment over the remaining life of the item in a systematic manner.

Firm commitments are different

An unrecognised firm commitment can also be designated in a fair value hedge. In that case, the cumulative change in the fair value of the commitment attributable to the hedged risk is recognised as an asset or liability, with a corresponding gain or loss. When the firm commitment results in recognition of an asset or liability, the initial carrying amount of that asset or liability is adjusted to include the cumulative fair-value change previously recognised for the hedged risk.

This is an area where clear transaction tracking is essential because the accounting crosses from an unrecognised commitment to a recognised balance-sheet item.

Common sources of ineffectiveness

Even a well-designed fixed-to-floating hedge may not offset perfectly. Differences can arise from reset dates, payment dates, benchmark curves, day-count conventions, floors or caps, credit adjustments, changes in liquidity, or a mismatch between the designated term of the item and the derivative.

The accounting team should identify these sources at inception and monitor whether they change. A near-perfect result should not be assumed merely because the nominal amounts are equal.

Control points for a fair value hedge file

A review-ready file should contain the original debt or exposure terms, derivative confirmation, formal designation, risk-management objective, valuation methodology, market-data sources, effectiveness assessment, the hedged-item fair-value calculation, journal entries and a roll-forward of the carrying-amount adjustment.

It should also explain any rebalancing or discontinuation and show how the hedge adjustment will be amortised after discontinuation where required.

Fair value hedge accounting is therefore more than booking a derivative. It temporarily changes how the designated risk in the hedged item is measured and presented. When the documentation, valuation and amortisation schedules are connected, the result provides a clear accounting picture of a genuine fair-value risk management strategy.