Corporate Financial Reporting · Accounting of Financial Instruments

Derivatives and Hedge Accounting under Ind AS 109

Updated 11 October 2026 · Fact-checked

A derivative is a contract whose value depends on an underlying, such as a rate or price. Ind AS 109 measures derivatives at fair value. Hedge accounting is optional and matches the gain or loss on the hedging instrument with the hedged item. Fair value hedges go to profit or loss; the effective part of cash flow hedges goes to OCI.

Understand Derivatives and Hedge Accounting

A derivative is a financial instrument whose value changes with an underlying variable (an exchange rate, interest rate or commodity price), needs little or no initial investment, and is settled at a future date. Forwards, futures, options and swaps are the common forms. Under Ind AS 109, derivatives are normally measured at fair value through profit or loss (FVTPL).

The problem is a mismatch. Suppose you hold an inventory or a forecast sale, and you take a forward contract to cover the risk. The forward's gain or loss hits profit or loss now. The item it protects may hit profit or loss later, or may not be fair valued at all. Hedge accounting fixes this by matching the timing of the two.

There are three types of hedge. In a fair value hedge, you hedge exposure to changes in fair value of a recognised asset, liability or firm commitment. The hedging gain or loss and the hedged item's gain or loss on the hedged risk both go to profit or loss. The hedged item's carrying amount is adjusted. In a cash flow hedge, you hedge variability in cash flows, such as a forecast sale or floating-rate interest. The effective part of the hedging gain or loss goes to OCI (cash flow hedge reserve). The ineffective part goes to profit or loss. In a hedge of a net investment in a foreign operation, the effective part goes to OCI (foreign currency translation reserve) and moves to profit or loss on disposal of the operation.

Hedge accounting is allowed only if the hedging relationship is formally designated and documented at inception, and meets the effectiveness requirements: there is an economic relationship between hedged item and hedging instrument, credit risk does not dominate the value changes, and the hedge ratio reflects the quantities actually used for risk management. Ind AS 109 has no 80-125% bright-line test.

An embedded derivative is a component of a hybrid contract that makes some cash flows behave like a stand-alone derivative. If the host is a financial asset within Ind AS 109, the whole hybrid is classified as one instrument and nothing is separated. If the host is not such an asset (for example, a financial liability or a lease), the embedded derivative is separated and measured at FVTPL when its economic characteristics and risks are not closely related to the host, a separate instrument with the same terms would be a derivative, and the hybrid is not itself at FVTPL. For a puttable instrument redeemable at net asset value (such as open-ended mutual fund units), separating the derivative has the effect of measuring the hybrid at the redemption amount payable at the reporting date (para B4.3.7).

Disclosure is covered in Ind AS 107. Paras 24A to 24C require tabular disclosure, by risk category and type of hedge, of hedging instruments, hedged items and the effect on profit or loss and OCI. Para 24E requires a reconciliation of each equity component and an OCI analysis.

Key rules to remember

Fair value hedge entry: Dr/Cr Hedging instrument (derivative) and Cr/Dr P&L; Dr/Cr Hedged item carrying amount and Cr/Dr P&L; Both changes go to P&L. Net P&L effect is the ineffectiveness.
Cash flow hedge reserve: OCI = lower of (cumulative gain/loss on hedging instrument) and (cumulative change in PV of expected future cash flows of hedged item), in absolute amounts; Any excess on the hedging instrument is ineffectiveness, recognised in P&L.
Hedge ineffectiveness: Ineffectiveness = change in hedging instrument value − change in hedged item value (on the hedged risk); Para 24C(a)(i) of Ind AS 107 describes it as the difference between the hedging gains or losses of the instrument and the hedged item.
Net position hedge: Net position = FC120 purchase commitments − FC100 sale commitments = FC20 net purchase position, hedged by a forward exchange contract for FC20; Para B6.6.5: compare (a) the forward's fair value change together with the foreign currency risk related changes in the FC100 sale commitments, against (b) the foreign currency risk related changes in the FC120 purchase commitments. For a cash flow hedge of highly probable forecast items, para B6.6.9 uses the same comparison. The changes in the forecast sales are recognised only once the sales are recognised; until then only amounts related to the forward are recognised.
Forward element: Transaction-related item: forward element is part of the cost of the transaction. Time-period-related item: forward element is amortised over the hedge period; Applies when the forward element is excluded from designation and its changes go to OCI (paras 6.5.16, B6.5.34).
Effectiveness criteria (para 6.4.1(c)): Economic relationship + credit risk not dominant + hedge ratio matches actual quantities; Plus formal designation and documentation at inception.

How to solve Derivatives and Hedge Accounting questions

Use this order for any derivative or hedge question. It stops you mixing up the two main hedge types.

1Identify the instrument and the exposure. Name the hedged item, the hedged risk and the hedging instrument.
2Check whether hedge accounting is allowed: designation, documentation and the three effectiveness conditions. If not met, the derivative goes to FVTPL.
3Classify the hedge. Recognised item or firm commitment with fair value exposure: fair value hedge. Forecast transaction or variable cash flows: cash flow hedge. Foreign operation's net assets: net investment hedge.
4Compute the fair value change of the derivative and the change in the hedged item (or in PV of expected cash flows) for the hedged risk only.
5Apply the recognition rule. Fair value hedge: both to P&L, adjust the hedged item. Cash flow hedge: lower-of test, effective part to OCI, rest to P&L.
6Pass the journal entries in date order, including settlement and the later transfer from the reserve (to P&L, or to the cost of a non-financial asset when the forecast transaction results in one).
7State the net P&L effect and the closing balances, and note the Ind AS 107 disclosures if asked.

Quickest way: Two-line test for hedge type and entry

When to use it: Use in MCQs and when you have under ten minutes for a hedge problem.

Ask: is the item already on the balance sheet (or a firm commitment) with a fair value risk? Yes means fair value hedge, both gains and losses to P&L, so net P&L is only the ineffectiveness.
If the item is a forecast transaction or floating cash flow, it is a cash flow hedge. Take the lower of the two cumulative amounts, put that to OCI, and the balance to P&L.
Compute only cumulative changes and subtract what was booked earlier to get the current period entry.

Common mistakes in Derivatives and Hedge Accounting

Taking the whole gain on a cash flow hedging instrument to OCI.
Students remember 'cash flow hedge means OCI' and skip the lower-of test.
Fix: Compare cumulative changes. OCI gets the lower in absolute terms. Any excess is ineffectiveness in P&L.
Using the 80-125% test as the Ind AS 109 criterion.
It comes from the old Ind AS 39 / AS 30 approach.
Fix: State the three criteria: economic relationship, credit risk not dominating, and a hedge ratio consistent with risk management. Effectiveness is forward-looking.
Not adjusting the carrying amount of the hedged item in a fair value hedge.
Students book only the derivative.
Fix: Adjust the hedged item for the change in fair value on the hedged risk, with the other side to P&L.
Separating an embedded derivative from a financial asset host.
Students apply the liability rule to every hybrid.
Fix: If the host is a financial asset in Ind AS 109's scope, classify the whole hybrid by the business model and cash flow tests. Separate only for non-asset hosts.
Treating hedge accounting as compulsory.
It is mixed up with fair valuing derivatives, which is compulsory.
Fix: Hedge accounting is optional and applies only when the entity designates and documents the relationship and the criteria are met.
Ignoring the forward element treatment and disclosure effects.
Students stop at the spot change.
Fix: If the forward element is excluded from the designation, its changes go to OCI and are accounted for as a transaction cost or amortised, depending on the hedged item.

Worked examples

Example 1

On 1 January 2027, Kaveri Metals Ltd holds copper inventory carried at cost of ₹70,00,000. The company hedges the fair value risk with a forward sale contract (fair value nil at inception). At 31 March 2027, the fall in the inventory's fair value due to the hedged risk is ₹4,00,000. The forward shows a gain of ₹3,60,000 (a derivative asset). Assume all hedge accounting criteria are met and that the separate Ind AS 2 test of lower of cost and net realisable value does not require any further write-down. Give the entries, the net P&L effect and the closing balances.

Show the solution

This is a fair value hedge: a recognised asset with fair value exposure.
Change in the hedged item, for the hedged risk only = fall of ₹4,00,000. This amount is used to adjust the carrying amount of the inventory.
Change in the forward = gain of ₹3,60,000, shown as a derivative asset. A forward sale gains when prices fall.
Entry 1: Derivative asset Dr ₹3,60,000; To Gain on hedging instrument (P&L) ₹3,60,000.
Entry 2: Loss on hedged item (P&L) Dr ₹4,00,000; To Inventory (hedge adjustment) ₹4,00,000.
Net P&L = 3,60,000 − 4,00,000 = ₹40,000 loss, which is the hedge ineffectiveness.
Closing inventory carrying amount = 70,00,000 − 4,00,000 = ₹66,00,000.

Answer: Net P&L loss of ₹40,000 (hedge ineffectiveness). Inventory carrying amount is ₹66,00,000 after the ₹4,00,000 adjustment, and the derivative asset is ₹3,60,000.

Example 2

Arjun Exports Ltd forecasts a highly probable sale of US$1,00,000 on 30 June 2027. On 1 April 2027 it enters a forward to sell US$1,00,000, designated as a cash flow hedge. At 30 April 2027 the forward has gained ₹1,50,000 (cumulative). The present value of the forecast sale's cash flows has fallen by ₹1,20,000 (cumulative, due to the hedged risk). Show the entry at 30 April 2027.

Show the solution

This is a cash flow hedge of a forecast transaction.
Cumulative gain on the hedging instrument = ₹1,50,000.
Cumulative change in PV of expected cash flows = ₹1,20,000 (absolute).
OCI = lower of the two = ₹1,20,000.
Ineffectiveness = 1,50,000 − 1,20,000 = ₹30,000 to P&L.
Entry: Derivative asset Dr ₹1,50,000; To Cash flow hedge reserve (OCI) ₹1,20,000; To Gain on derivative (P&L) ₹30,000.

Answer: Cash flow hedge reserve (OCI) ₹1,20,000 and P&L gain of ₹30,000 for ineffectiveness. The reserve is reclassified to P&L when the sale affects profit or loss.

Exam tips

In case-scenario MCQs, first decide the hedge type from the hedged item, not from the instrument. A forward can be used in either type.
Write the hedge accounting criteria as three bullets plus designation and documentation. Examiners reward the exact conditions.
In numerical questions, show cumulative figures and the lower-of test. Marks go for each entry and the net P&L.
For disclosure questions, quote Ind AS 107 paras 24A to 24C and 24E by what they require: hedging instruments, hedged items, P&L and OCI effects, and the equity reconciliation.
For net position hedges, use the FC100/FC120/FC20 pattern. Effectiveness considers the forward together with the items of similar effect.

Practice questions from Accounting of Financial Instruments

Derivatives and Hedge Accounting in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CA FinalHedge Accounting Objective and Scope

Derivatives and Hedge Accounting: frequently asked questions

What is the difference between a fair value hedge and a cash flow hedge?

A fair value hedge covers changes in fair value of a recognised asset, liability or firm commitment, and both sides go to profit or loss. A cash flow hedge covers variability in cash flows of a forecast transaction or variable-rate item. The effective part goes to OCI and the rest to profit or loss.

What are the hedge effectiveness criteria in Ind AS 109?

There must be an economic relationship between the hedged item and the hedging instrument. Credit risk must not dominate the value changes. The hedge ratio must match the quantities the entity actually hedges and uses. The relationship must also be formally designated and documented at inception.

When is an embedded derivative separated?

Only when the host is not a financial asset within Ind AS 109. It is separated if its risks are not closely related to the host, a separate instrument with the same terms would be a derivative, and the hybrid is not measured at FVTPL. It is then measured at FVTPL.

Is hedge accounting mandatory under Ind AS 109?

No. It is optional. If you do not apply it, derivatives are measured at FVTPL. If you apply it, you must designate and document the relationship and meet the effectiveness requirements.