What are the circumstances that permit hedge accounting?

Hedge accounting allows entities to match the timing of gains and losses on hedging instruments with the recognition of gains and losses on the hedged items, which can lead to more accurate financial reporting. One of the primary requirements for applying hedge accounting is the formal designation and documentation of the hedging relationship. This means that the entity must clearly identify the hedging instrument, the hedged item, the nature of the risk being hedged, and how the hedging relationship will be assessed for effectiveness.

Formal designation and documentation establish a framework for the hedge accounting treatment and ensure that the entity has a coherent risk management strategy in place. This is essential for maintaining transparency and accountability in financial reporting.

In contrast, the other options do not align with the stringent requirements for hedge accounting. For instance, hedge accounting is not restricted to cash instruments alone, nor can it be established without formal documents outlining the relationship and its strategy. Furthermore, if the entity's risk management objective is unrelated to the hedged item, it would not meet the necessary criteria for hedge accounting, as the effectiveness of the hedge would be undermined. Thus, the requirement for formal designation and documentation stands as a critical element in determining eligibility for hedge accounting.