Accounting for derivatives transactions is a vital component of hedging strategy, yet many companies find the compilation of the vast documentation necessary to justify accounting treatment a daunting task.

“When organizations elect to comply with hedge accounting standards, one of the most important considerations is documentation,” said Gurpreet Banwait, senior product manager of web systems at Fincad, a financial analytics provider. “Given its importance, many companies find putting together adequate documentation to be their biggest challenge. It is important that formal documentation is in place to support the hedge relationship.”

Accounting for derivative financial instruments under the International Accounting Standards is covered by IAS39 (Financial Instrument: Recognition and Measurement).

IAS39 requires that all derivatives are marked to market, with changes in the mark-to-market being taken to the profit and loss account.

For many entities, this would result in a significant amount of profit and loss volatility arising from the use of derivatives.

An entity can mitigate the profit and loss effect arising from derivatives used for hedging, through the process of hedge accounting.

“Genuine derivatives transactions may at times increase earnings volatility as they are marked to market at each reporting date without necessarily being referenced to the underlying transaction being hedged,” said Neville Dumasia, advisory partner and risk leader at accountancy firm Ernst & Young. “This challenge can be addressed by adopting the principles of hedge accounting.”

To achieve the benefits of hedge accounting, however, requires a large amount of compliance work involving documenting the hedge relationship, and both prospectively and retrospectively proving that the hedge relationship is effective.

“Solutions do exist that can simplify some or all of the processes required for compliance,” Banwait at Fincad said. “Although new accounting standards may make complying with hedge accounting standards even easier, the requirement for adequate and detailed documentation will not go away.”

The issue of hedge accounting has also figured prominently in the Greek debt crisis.

In July, the European Securities and Markets Authority (Esma), the pan-European regulator, issued a comment letter to the International Financial Reporting Standards’ (IFRS) Interpretations Committee regarding its decision to deny Esma’s previous request to clarify the accounting for different aspects of restructuring Greek government bonds under IAS 39.

“Esma does not agree with the committee’s conclusion not to add the subject to its active agenda nor to recommend the board to perform further work,” according to the comment letter.

In April, Esma had submitted a request to the IFRS Interpretations Committee, asking to clarify the accounting of the exposure to Greek sovereign debt, arguing that IAS 39 does not offer enough guidance in this respect.

“European enforcers of IFRS note varying accounting practices for debt restructurings by lenders due to the lack of clear guidance which leads in turn to decreased comparability between financial statements,” Esma said in April.

There are three basic requirements that must be satisfied in order for hedge accounting to be applied to any eligible hedge relationship, according to Banwait.

First, formal documentation of the hedge relationship should exist at the time of designation (inception of the hedge).

Second, at inception and each period thereafter, an entity must demonstrate that the relationship is expected to be highly effective on a go-forward basis (prospectively) and has actually been effective since the date of designation (retrospectively).

Third, during each period an entity must recognize any ineffectiveness in profit or loss.