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New UK GAAP and IFRS

Under new UK GAAP and IFRS, derivative contracts must be shown on the balance sheet at their fair value and changes in the market value reflected in the income statement, unless hedge accounting is adopted.

Market value movements in interest rate hedges reflect changes in market interest rates and counter-party risk. The former risk in particular can fluctuate considerably. Although the fluctuations typically reverse over the life of a contract, such movements can cause volatility in the annual financing expense. Hedge accounting is designed to reduce this volatility.

See Example 1.

Hedge accounting ― cash flow hedges

Corporate treasurers will typically use a hedging instrument, such as an interest