HSBC 2007 Annual Report Download - page 356

HSBC HOLDINGS PLC
Notes on the Financial Statements (continued)
Note 2
354
with the same counterparty, a legal right of offset exists, and the parties intend to settle the cash flows on a net
basis.
The method of recognising fair value gains and losses depends on whether derivatives are held for trading or are
designated as hedging instruments, and if the latter, the nature of the risks being hedged. All gains and losses
from changes in the fair value of derivatives held for trading are recognised in the income statement. When
derivatives are designated as hedges, HSBC classifies them as either: (i) hedges of the change in fair value of
recognised assets or liabilities or firm commitments (‘fair value hedges’); (ii) hedges of the variability in highly
probable future cash flows attributable to a recognised asset or liability, or a forecast transaction (‘cash flow
hedges’); or (iii) a hedge of a net investment in a foreign operation (‘net investment hedges’). Hedge accounting
is applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge
provided certain criteria are met.
Hedge accounting
At the inception of a hedging relationship, HSBC documents the relationship between the hedging instruments
and the hedged items, its risk management objective and its strategy for undertaking the hedge. HSBC also
requires a documented assessment, both at hedge inception and on an ongoing basis, of whether or not the
hedging instruments, primarily derivatives, that are used in hedging transactions are highly effective in offsetting
the changes attributable to the hedged risks in the fair values or cash flows of the hedged items. Interest on
designated qualifying hedges is included in ‘Net interest income’.
Fair value hedge
Changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are
recorded in the income statement, along with changes in the fair value of the hedged assets, liabilities or group
thereof that are attributable to the hedged risk.
If a hedging relationship no longer meets the criteria for hedge accounting, the cumulative adjustment to the
carrying amount of the hedged item is amortised to the income statement based on a recalculated effective
interest rate over the residual period to maturity, unless the hedged item has been derecognised, in which case, it
is released to the income statement immediately.
Cash flow hedge
The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow
hedges is recognised in equity within the cash flow hedging reserve. Any gain or loss in fair value relating to an
ineffective portion is recognised immediately in the income statement.
Amounts accumulated in equity are recycled to the income statement in the periods in which the hedged item
will affect profit or loss. However, when the forecast transaction that is hedged results in the recognition of a
non-financial asset or a non-financial liability, the gains and losses previously deferred in equity are transferred
from equity and included in the initial measurement of the cost of the asset or liability.
When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting,
any cumulative gain or loss existing in equity at that time remains in equity until the forecast transaction is
eventually recognised in the income statement. When a forecast transaction is no longer expected to occur, the
cumulative gain or loss that was reported in equity is immediately transferred to the income statement.
Net investment hedge
Hedges of net investments in foreign operations are accounted for in a similar way to cash flow hedges. A gain
or loss on the effective portion of the hedging instrument is recognised in equity; a gain or loss on the ineffective
portion is recognised immediately in the income statement. Gains and losses accumulated in equity are included
in the income statement on the disposal of the foreign operation.
Hedge effectiveness testing
To qualify for hedge accounting, HSBC requires that at the inception of the hedge and throughout its life, each
hedge must be expected to be highly effective (prospective effectiveness), and demonstrate actual effectiveness
(retrospective effectiveness) on an ongoing basis.