Key Points
- The hedged item's carrying amount is adjusted for fair value changes attributable to the hedged risk, even if it is otherwise measured at amortised cost.
- Fair value hedges are most common for fixed-rate debt and inventory held at cost where the entity wants to neutralise interest rate or commodity price exposure.
- Hedge ineffectiveness flows through profit or loss immediately; there is no OCI parking mechanism as in a cash flow hedge.
- Incomplete hedge designation documentation at inception is the single most frequent audit finding on fair value hedge relationships.
What is Fair Value Hedge?
IFRS 9.6.5.2(a) requires the entity to recognise the gain or loss on the hedging instrument in profit or loss (or in OCI if the instrument is an equity investment designated at FVOCI). Simultaneously, IFRS 9.6.5.8(a) adjusts the carrying amount of the hedged item for the gain or loss attributable to the hedged risk, with that adjustment also going to profit or loss. The two entries offset each other to the extent the hedge is effective.
This carrying-amount adjustment is what distinguishes a fair value hedge from a cash flow hedge. Under a cash flow hedge, the effective portion of the hedging instrument's gain or loss sits in OCI until the hedged cash flow affects profit or loss. A fair value hedge skips OCI entirely and puts both sides straight into the income statement.
The auditor's focus falls on two points: whether the designation documentation satisfies IFRS 9.6.4.1 at inception, and whether the basis adjustment to the hedged item is correctly computed at each reporting date. ISA 540.13(a) directs the auditor to evaluate the entity's method for producing that basis adjustment, which includes verifying that the risk being hedged (and only that risk) drives the carrying-amount change. Where the hedged item is a financial instrument measured at amortised cost, the basis adjustment creates an accounting hybrid that requires careful tracking through to derecognition.
Worked example: Fernández Distribución S.L.
Client: Spanish wholesale distributor, FY2025, revenue €34M, IFRS reporter. Fernández holds a €10M fixed-rate bond (4.2% annual coupon, maturing December 2029) classified at amortised cost. To hedge the fair value exposure to interest rate movements, Fernández enters a pay-fixed, receive-variable interest rate swap on 1 January 2025 with a notional of €10M and a fixed leg of 4.2%.
Step 1 — Designation at inception
On 1 January 2025 the treasury function designates the swap as a fair value hedge of the interest rate risk on the bond. The hedge documentation identifies the hedged item (€10M bond), hedged risk (benchmark interest rate), hedging instrument (the swap), hedge ratio (1:1), and the method for measuring ineffectiveness (comparison of fair value changes attributable to the benchmark rate).
Step 2 — Fair value movements at reporting date
By 31 December 2025, market interest rates have risen by 75 basis points. The bond's fair value has fallen by €285,000 attributable to the benchmark interest rate component. The swap has a positive fair value of €291,000 to Fernández.
Step 3 — Journal entries at 31 December 2025
Fernández records the swap gain in profit or loss (Dr: Derivative asset €291,000 / Cr: Gain on hedging instrument €291,000). The bond's carrying amount is reduced by €285,000 (Dr: Loss on hedged item €285,000 / Cr: Bond carrying amount €285,000). Net P&L effect: a gain of €6,000 representing hedge ineffectiveness.
Step 4 — Amortisation of the basis adjustment
The €285,000 basis adjustment begins amortising from 31 December 2025 over the bond's remaining life (four years) using the effective interest rate method. IFRS 9.6.5.10 requires amortisation to begin no later than when the hedged item ceases to be adjusted for hedging gains and losses.
Conclusion: the net P&L impact of €6,000 (rather than a €285,000 loss on the bond or a standalone €291,000 swap gain) demonstrates the volatility reduction that fair value hedge accounting achieves, and the approach is defensible because the designation memo predates inception and the basis adjustment tracks only the hedged risk.
Why it matters in practice
Teams apply the basis adjustment to the full fair value change of the hedged item rather than isolating the component attributable to the hedged risk. IFRS 9.6.5.8(a) requires adjustment only for the designated risk (for example, benchmark interest rate risk, not credit spread movements). Over-adjusting the carrying amount creates a measurement error that compounds across reporting periods.
When a fair value hedge is discontinued, the cumulative basis adjustment on the hedged item must be amortised to profit or loss under IFRS 9.6.5.10. Entities frequently leave the adjustment frozen in the carrying amount without commencing amortisation, which misstates interest income or expense for every subsequent period until maturity.
Fair value hedge vs. cash flow hedge
| Dimension | Fair value hedge | Cash flow hedge |
|---|---|---|
| What it protects against | Changes in the fair value of a recognised item or firm commitment | Variability in future cash flows from a forecast transaction or recognised item |
| Where hedging gains/losses land | Profit or loss immediately | OCI (effective portion), reclassified to P&L when the hedged item affects earnings |
| Hedged item adjustment | Carrying amount adjusted for the hedged risk (basis adjustment) | No adjustment to the hedged item's carrying amount |
| Typical use case | Fixed-rate debt exposed to interest rate changes; inventory with commodity price risk | Forecast purchases in foreign currency; variable-rate debt |
| On discontinuation | Basis adjustment amortised to P&L over remaining life | OCI balance reclassified to P&L when the forecast transaction occurs (or immediately if no longer expected) |
The choice between the two depends on whether the entity is hedging an existing balance sheet item's value or a future cash flow's variability. Misclassifying one as the other changes where gains and losses appear and can trigger restatement if detected after issuance.
Related terms
Frequently asked questions
Can I apply fair value hedge accounting to inventory?
IFRS 9.6.3.3 permits a non-financial item (such as inventory) to be designated as a hedged item for the risk component that is separately identifiable and reliably measurable. A commodity trader holding physical copper stock can designate the LME copper price component as the hedged risk and apply fair value hedge accounting to it. The basis adjustment then sits in the inventory's carrying amount and flows to cost of goods sold upon sale (IFRS 9.B6.3.10).
What happens to the basis adjustment if I derecognise the hedged item?
If the hedged item is sold or otherwise derecognised, the entire remaining basis adjustment is released to profit or loss at that point (IFRS 9.6.5.10). The auditor should verify that the entity did not continue amortising the adjustment over the original remaining term after derecognition occurred, which would defer recognition of a gain or loss that IFRS 9 requires immediately.
Does a fair value hedge affect other comprehensive income?
For most fair value hedges the answer is no. Both the hedging instrument's gain or loss and the hedged item's basis adjustment go to profit or loss under IFRS 9.6.5.2(a) and IFRS 9.6.5.8(a). The single exception is when the hedging instrument is an equity investment that the entity has irrevocably designated at FVOCI under IFRS 9.5.7.5; in that case the hedging gain or loss stays in OCI permanently.