Resources (This includes links to the latest standards, drafts, PwC interpretations, tools and practice aids for this topic)
The final version of IFRS 9 was issued in July 2014, overhauling hedge accounting so entities can better reflect their risk management activities in the financial statements. The standard mandatory effective date is periods commencing 1 January 2018.
IFRS 9 provides an accounting policy choice: entities can either continue to apply the hedge accounting requirements of IAS 39, or they can apply IFRS 9 (with the scope exception only for fair value macro hedges of interest rate risk). This accounting policy choice will apply to all hedge accounting and cannot be made on a hedge-by-hedge basis.
The IASB is also working on a macro hedging project. They issued a discussion paper on ‘Accounting for dynamic risk management: a portfolio revaluation approach to macro hedging’ in April 2014. Following review of comments received, the IASB has decided to reconsider its approach and to prioritise consideration of interest rate risk and address other risks (such as commodity risk) at a later stage. In the meantime, entities applying macro hedging for a fair value hedge of the interest rate exposure of a portfolio of financial assets or financial liabilities are allowed to continue to use IAS 39 for such hedges. Alternatively they could continue to apply IAS 39 to all hedges as referred to above.
'Hedging’ is a risk management activity. More specifically, it is the process of using a financial instrument (usually a derivative) to mitigate all or some of the risk of a hedged item. 'Hedge accounting' changes the timing of recognition of gains and losses on either the hedged item or the hedging instrument so that both are recognised in profit or loss in the same accounting period in order to record the economic substance of the combination of the hedged item and hedging instrument. On transition to IFRS 9 entities may also continue to apply IAS 39 hedge accounting.
To qualify for hedge accounting IFRS 9 includes the following requirements:
- An entity should formally designate and document the hedging relationship at the inception of the hedge. This includes identifying the hedging instrument, the hedged item or transaction, the nature of the risk being hedged and how the entity will assess hedge effectiveness, identification of sources of ineffectiveness, how the hedge ratio will be determined, and the entity’s risk management objective and strategy for undertaking the hedge.
- There must be an economic relationship between the hedging instrument and the hedged item. There must be an expectation that the value of the hedging instrument and the value of the hedged item will move in the opposite direction as a result of the common underlying or hedged risk.
- Credit risk should not dominate value changes. Even if there is an economic relationship, a change in the credit risk of the hedging instrument or the hedged item must not be of such magnitude that it dominates the value changes that result from that economic relationship.
- Designated hedge ratio which is consistent with risk management strategy. The hedge ratio is defined as the relationship between the quantity of the hedging instrument and the quantity of the hedged item in terms of their relative weighting.
There is no 80-125% effectiveness ‘bright line’. As such a retrospective effectiveness test is no longer required to prove the effectiveness was between 80-125%. However, all ineffectiveness should still be calculated and recorded in the income statement.
There are three types of hedge relationships:
- Fair value hedge – a hedge of the exposure to changes in the fair value of a recognised asset or liability, or a firm commitment.
- Cash flow hedge – a hedge of the exposure to variability in cash flows of a recognised asset or liability, a firm commitment or a highly probable forecast transaction.
- Net investment hedge – a hedge of the foreign currency risk on a net investment in a foreign operation.
For a fair value hedge, the hedged item is adjusted for the gain or loss attributable to the hedged risk. That element is included in the income statement where it will offset the gain or loss on the hedging instrument.
For a cash flow hedge, gains and losses on the hedging instrument are initially included in other comprehensive income. The amount included in other comprehensive income is the lower of the fair value change of the hedging instrument and that of the hedged item. Where the hedging instrument has a fair value change greater than the hedged item, the excess is recorded within the profit or loss as ineffectiveness. Gains or losses deferred in other comprehensive income are reclassified to profit or loss when the hedged item affects the income statement. If the hedged item is the forecast acquisition of a non-financial asset or liability, the carrying amount of the non-financial asset or liability is adjusted for the hedging gain or loss at initial recognition.
Hedges of a net investment in a foreign operation are accounted for similarly to cash flow hedges.