Introduction

Publication date: 08 Dec 2017


6.8A.1 This chapter assumes the application of IAS 39 for both classification and hedge accounting and does not deal with issues that arise from the application of IFRS 9. The hedging chapter of IFRS 9 was issued in November 2013 and included in the final July 2014 standard. See chapter 46 for hedge accounting under IFRS 9, and chapters 42 and 45 for other aspects of IFRS 9.

Introduction - What is hedging?

Publication date: 08 Dec 2017


6.8A.2 Entities face many types of business risk. One of the most significant is financial risk. Different companies, however, are exposed to different risks. Some may be concerned about commodity prices, such as the price of copper or oil; others about interest rates or exchange rates. Successful entities manage risk by deciding to which risk, and to what extent, they should be exposed, by monitoring the actual exposure and taking steps to reduce risks to within agreed limits, often through the use of derivatives. However, hedging one risk may magnify another. Management has to decide for example whether it is cash flow risk averse, which will mean that it is not concerned with fair value risk.

6.8A.3 Entering into a derivative transaction with a counterparty in the expectation that the transaction will eliminate or reduce an entity’s exposure to a particular risk is referred to as hedging. Risk is reduced because the derivative’s value or cash flows are expected, wholly or partly, to move inversely and, therefore, offset changes in the value or cash flows of the ‘hedged position’ or item. The hedged position/item can include recognised assets and liabilities, a firm commitment or a forecast transaction. Sometimes an entity can arrange its affairs so as to be naturally hedged. For example, if an entity’s portfolio of fixed interest securities is financed by fixed rate borrowings of the same amount and duration, a rise in the general level of interest rates will decrease the value of both asset and liability positions by approximately the same amount, so the entity has no net exposure to interest rate risk. Hedging in an economic sense, therefore, concerns the reduction or elimination of different financial risks such as price risk, interest rate risk, currency risk, etc, associated with the hedged position. It is a risk management activity that is now commonplace in many entities.

Introduction - What is hedge accounting?

Publication date: 08 Dec 2017


6.8A.4 Once an entity has entered into a hedging transaction, it must be reflected in the financial statements of the entity. Accounting for the hedged position should be consistent with the objective of entering into the hedging transaction, which is to eliminate or reduce significantly specific risks that management considers can have an adverse effect on the entity’s financial position and results, whilst acknowledging that such strategies can increase other risks with which management is less concerned. This consistency can be achieved if both the hedging instrument and the hedged position are recognised and measured on symmetrical bases and offsetting gains and losses are reported in profit or loss in the same periods. Unfortunately, mismatches occur under existing recognition and measurement standards and practices. Hedge accounting practices have been developed to correct or mitigate these mis-matches.

6.8A.5 In simple terms ‘hedge accounting’ is a technique that modifies the normal basis for recognising gains and losses (or revenues and expenses) on associated hedging instruments and hedged items so that both are recognised in earnings in the same accounting period. Hedge accounting thus allows management to eliminate or reduce the income statement volatility that otherwise would arise if the hedged items and hedging instruments were accounted for under GAAP separately, without regard to the hedge’s business purpose.

Hedge accounting under IAS 39

Publication date: 08 Dec 2017


6.8A.6 IAS 39 provides a set of strict criteria that must be met before hedge accounting can be used. These require that the hedge relationship is designated and formally documented at inception. There are also requirements to demonstrate both at inception and throughout the life of the hedge that the hedge is ‘highly effective’. As a result, not all hedging activities undertaken by entities qualify for hedge accounting. Failure to meet any of the criteria whilst the hedge is in place results in the discontinuance of hedge accounting.

6.8A.7 The standard also specifies three methods of hedge accounting that were designed to reflect the standard’s requirement to measure all derivatives at fair value. As a result, hedge accounting in IAS 39 can be applied to three types of hedging relationships as indicated below:

Where the hedged risk is that the hedged item’s fair value will change in response to some variable, such as changes in interest rates, foreign exchange rates, or market prices, gains and losses on the hedging instrument and the offsetting losses and gains on the hedged item are both recognised in profit or loss. This is a fair value hedge.

Where the hedged risk is that the hedged item’s future cash flows will change in response to such variables, the gain or loss on the hedging instrument is initially recognised in other comprehensive income and subsequently recycled from equity to profit or loss as the hedged item affects profit or loss. This is a cash flow hedge.

Where the hedge risk is that the carrying amount of a net investment in a foreign operation will change in response to exchange rate movements, the gain or loss on the hedging instrument is initially recognised in other comprehensive income and subsequently recycled to profit or loss from equity on disposal of that foreign operation. This is a hedge of a net investment in a foreign operation.

6.8A.8 IAS 39 does not mandate the use of hedge accounting. It is a privilege not a right. Entities intending to use hedge accounting must have proper systems and procedures to monitor each hedging relationship. Many entities may find these requirements too onerous and decide not to try to hedge account. However, this approach generally comes at a cost – income statement volatility.

Amendment to IAS 39 – Novation of derivatives and continuation of hedge accounting

Publication date: 08 Dec 2017


6.8A.8.1 Widespread legislative changes have been introduced, such as the European Market Infrastructure Regulation (‘EMIR’) in Europe and the Dodd–Frank Wall Street Reform and Consumer Protection Act (‘Dodd-Frank’) in the US, to improve transparency and regulatory oversight of over-the-counter (OTC) derivatives. These regulations are likely to impact many companies not just those in the banking sector. One potential impact of the regulations on hedge accounting is that entities are novating derivative contracts to central counterparties (CCPs) in an effort to reduce counterparty credit risk. Usually under IAS 39, an entity is required to discontinue hedge accounting for a derivative that has been designated as a hedging instrument where the derivative is novated; this is because the original derivative no longer exists. A new derivative with the CCP is recognised at the time of the novation. The IASB, however, recognised concerns about the financial reporting effects of novations that are a consequence of laws or regulations. As a result, the IASB has amended IAS 39 to provide relief from discontinuing hedge accounting when novation of a hedging instrument to a CCP meets specified criteria.

6.8A.8.2 The amendments will not result in the expiration or termination of the hedging instrument if:
   
as a consequence of laws or regulations, the parties to the hedging instrument agree that a CCP, or an entity (or entities) acting as a counterparty in order to effect clearing by a CCP, replaces their original counterparty; and
other changes, if any, to the hedging instrument are limited to those that are necessary to effect such replacement of the counterparty. These changes include changes in the contractual collateral requirements, rights to offset receivables and payables balances, and charges levied.

Hedged items

Publication date: 08 Dec 2017


6.8A.9 Before the hedge accounting principles and methods set out in the standard can be appreciated, it is necessary to understand the basic definitions and concepts that underpin all hedging relationships.

Hedged items - Definition

Publication date: 08 Dec 2017


6.8A.10 A hedged item is an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that:

exposes the entity to risk of changes in fair value or future cash flows; and
is designated as being hedged.
[IAS 39 para 9].

6.8A.11 In particular, the hedged item can be:

a single asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation;
a group of assets, liabilities, firm commitments, highly probable forecast transactions or net investments in foreign operations with similar risk characteristics; or
in a portfolio hedge of interest rate risk only, a portion of the portfolio of financial assets or financial liabilities that share the risk being hedged.

[IAS 39 para 78].


6.8A.12 One of the key aspects of the above definition is that the hedged item must expose the entity to risk of changes in the fair value or future cash flows that could affect profit or loss. [IAS 39 para 86(a)-(b)]. This could be in the current or future periods. As a result, hedge accounting cannot apply to any items included in equity or transactions that directly affect equity (see further para 6.8A.46 below).

6.8A.13 The assets or liabilities referred to above are assets and liabilities that are recognised in the entity’s balance sheet. It could be a financial item or a non-financial item such as inventory. Unrecognised assets cannot qualify as a hedged item except for firm commitments. For example, internally generated core deposit intangibles (for a bank) are not recognised as intangible assets under IAS 38. Because they are not recognised, they cannot be designated as hedged items. [IAS 39 para IG F2.3].

6.8A.14 For hedge accounting purposes, only assets, liabilities, firm commitments or highly probable forecast transactions that involve a party external to the entity can be designated as hedged items. It follows that hedge accounting can be applied to transactions between entities in the same group only in the individual or separate financial statements of those entities and not in the consolidated financial statements of the group. [IAS 39 para 80]. However, there are some exceptions to this general rule, which are considered from paragraph 6.8A.39 below.

Hedged items - Designation of groups of items as hedged items

Publication date: 08 Dec 2017


6.8A.15 The definition of a hedged item in paragraph 6.8A.11 above permits similar assets, or similar liabilities to be grouped together and designated as a hedged item. Designating a group/portfolio of items as a hedge requires that:

the individual assets or individual liabilities in the group share the risk exposure that is designated as being hedged; and
the change in the fair value attributable to the hedged risk for each individual item in the group is expected to be approximately proportional to the overall change in fair value attributable to the hedged risk of the group of items.
[IAS 39 para 83].

6.8A.16 In grouping similar assets and liabilities in a portfolio, an entity should consider various factors, including:

The type of assets or liabilities.
The interest rate (fixed or variable) and, in the case of fixed rate assets or liabilities, the coupon rate.
The currency in which the assets or liabilities are denominated.
The scheduled maturity date and, in the case of prepayable assets, the prepayment terms, past prepayment history and expected future prepayment performance.

6.8A.17 With respect to the first bullet point in paragraph 6.8A.15 above, it is not necessary that each item in the group shares all of the same risks, as long as they all share a common risk characteristic that is the subject of the hedge. Sharing the same risk exposure means not only that the hedged items have a common risk (for example, foreign currency risk), but also that the exposure moves in the same direction. For example, forecast foreign currency sales and purchases do not share the same risk exposure, because the risks move in opposite directions.

6.8A.18 With respect to the second bullet point in paragraph 6.8A.15 above, the standard does not provide any guidance on the meaning of ‘approximately proportional’. FAS 133 provides some guidance in the context of US GAAP. It considers that a movement of the fair value of the individual items within a fairly narrow range, such as from 9% to 11%, when the fair value of the portfolio as a whole moves 10%, would be consistent with this requirement, but a move such as from 7% to 13% would not be consistent. A similar approach could be applied in IAS 39. The following two examples demonstrate applications of this second bullet point:

Example 1 – Designating a portfolio of bonds as the hedged item
 
An entity has a portfolio of fixed rate corporate bonds with different coupons. All the bonds mature within a period of 4-5 years. The entity designates an interest rate swap to hedge the entire portfolio’s risk-free interest rate.
 
The group of bonds may be designated as the hedged item as the risk free rate that is being hedged is common to all the bonds. However, the fair value movement of each individual bond that is attributable to the hedged interest-free rate should be approximately proportional to the portfolio’s fair value movement that is attributable to the hedged risk. The entity’s management should, therefore, model the changes in fair value of the portfolio relative to the fair values of individual bonds in response to the hedged risk.

Example 2 – Designating a portfolio of shares as the hedged item
 
Entity A acquires a portfolio of French CAC 40 shares, in the same proportions as are used to calculate the French CAC 40 index and classifies the investments as available-for-sale. At the same time, the entity purchases a put option on the CAC 40 index to hedge changes in the fair value of the portfolio. The option constitutes a near perfect hedge of decreases in the value of the portfolio, in economic terms. Any decline in the portfolio’s fair value below the option’s strike price will be offset by an increase in the put option’s intrinsic value.
 
The entity cannot designate the portfolio of shares as the hedged item in a hedge of equity price risk. The hedged risk is the total change in value of each share in the portfolio. Some share prices may increase and others may decrease. The relationship will not qualify for hedge accounting, because the change in the fair value attributable to the hedged risk for each individual item in the group (individual share prices) is not expected to be approximately proportional to the overall change in fair value attributable to the hedged risk of the group.

Hedged items - Designation of groups of items as hedged items - Hedging an overall net position

Publication date: 08 Dec 2017


6.8A.19 An entity cannot designate an overall net position as the hedged item. Hedging a common risk in a portfolio of similar assets and liabilities would mean allocating the overall gain or loss on the hedging instrument to the individual items in the portfolio. Furthermore, if some of the items in the portfolio were producing gains and others losses, the entity would have to impute both gains and losses to the single hedging instrument to offset both the gains and the losses on the hedged items. As such an allocation would be inherently arbitrary and produce significant ineffectiveness, designating the hedged item as a net position is not permitted. [IAS 39 para 84]

6.8A.20 However, almost the same effect on profit or loss can be achieved by designating some of the underlying gross items as the hedged item equal in amount to the net position. For example, an entity (C functional currency) with a firm commitment to make a purchase in a foreign currency of FC100 and a firm commitment to make a sale in the foreign currency of FC90 can hedge the net amount of FC10 by acquiring a derivative and designating it as a hedging instrument associated with FC10 of the firm purchase commitment of FC100. Similarly, an entity with C100 of fixed rate assets and C90 of fixed rate liabilities with terms of a similar nature could hedge the net C10 exposure by designating as the hedged item C10 of those assets. [IAS 39 para AG 101].

6.8A.21 An entity’s hedging strategy and risk management practices may assess cash flow risk on a net basis, but the net cash flow exposure cannot be designated as a hedged item for hedge accounting purposes. This is because, as explained above, it would not be possible to identify the net exposure arising from forecast sales and purchases as the exposure being hedged, because forecast sales and purchases are not similar items and the effectiveness test would fail. However, once again hedge accounting can be achieved by designating some of the forecast purchases or sales as the hedged item equal in amount to the net position, as illustrated in the example below.

Example 1 – Hedging a net FX position
 
Entity A, whose functional currency is the euro, has a global treasury centre that is responsible for collecting and assessing the group’s foreign currency risks and offsetting the net position using derivative instruments with an external party. For example, it forecasts sales of US$2.5m and purchases of US$1m in June and has, therefore, entered into a forward contract to sell US$1.5m against euros in that month.
 
As stated in paragraph 6.8A.19 above, the entity is prohibited from designating a net position as the hedged item. It is possible to achieve a similar effect by designating the hedged item as part of one of the gross positions that is equal in amount to the net position. Entity A can, therefore, designate the forward contract as a hedge of highly probable forecast sales of US$1.5m in June.

Example 2 – Hedging a net interest rate position
 
Entity B has a number of bank loans with different interest rates and terms. The entity also has loans receivable with different interest rates. Management proposes to hedge the net interest-rate risk position in a number of separate maturity bands through the use of interest-rate swaps for the net asset or liability in each maturity band.
 
Management may allocate the net exposure in each band to a specific asset or liability, so that the net position in each maturity band could qualify as a hedged item. This approach provides management with an interest-rate gap methodology to manage interest-rate risk. [IAS 39 para AG111]. Alternatively, management may choose to apply fair value hedge accounting for a portfolio hedge of interest rate risk and designate an amount of assets or liabilities in given time buckets as hedged items (see para 6.8A.104 onwards for definition and examples of fair value hedge accounting and para 6.8A.218 for details of portfolio hedging). [IAS 39 para 81A].

Hedged items - Designation of financial items as hedged items

Publication date: 08 Dec 2017


6.8A.22 When the hedged item is a financial instrument or a forecast transaction involving a financial instrument, examples of financial risk exposures that can be hedged (provided all the hedging criteria are met) are described below.

Examples of financial instrument risks that can be hedged
 

Market risk – the risk that a financial instrument’s fair value or cash flows will fluctuate because of changes in market prices. Market risk embodies not only the potential for loss but also the potential for gain. It comprises three types of risk as follows:

 

Interest rate risk – the risk that a financial instrument’s fair value or future cash flows will fluctuate because of changes in market interest rates.
  Currency risk – the risk that a financial instrument’s fair value or future cash flows will fluctuate because of changes in foreign exchange rates.
  Other price risk – the risk that a financial instrument’s fair value or future cash flows will fluctuate because of changes in market prices (other than those arising from interest rate risk or currency risk), whether those changes are caused by factors specific to the individual financial instrument or its issuer, or factors affecting all similar financial instruments traded in the market.
Other examples of risks that can be hedged in financial items include:
  Pre-payment risk in mortgages (provided not held-to-maturity investments – see para 6.8A.47).
  Those risks arising from closely related embedded derivatives that were not separated from the host financial contract (such as inflation).
 
Other financial instrument risks, such as credit risk (that is, the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation) or liquidity risk (that is, the risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities), would not normally be deemed to be a separately identifiable component for hedging purposes – see paragraphs 6.8A.23 to 6.8A.24 below regarding hedges of portions.
 
[Definitions taken from IFRS 7 App A].

Hedged items - Designation of financial items as hedged items - Hedges of portions of financial items

Publication date: 08 Dec 2017


6.8A.23 For hedges of financial assets and financial liabilities, IAS 39 does not restrict hedge accounting to hedges of the entire risk of change in the fair value or all of the cash flows of a financial instrument, or the entire exposure to interest rate risk, currency risk, credit risk or other risks of changes in a financial instrument’s fair value or cash flows. In June 2008 the IASB changed IAS 39 to clarify that provided that effectiveness can be measured, it is possible to designate the risks associated with only a portion of its cash flows or fair value, such as one or more selected contractual cash flows or portions of them or a percentage or a proportion of the fair value. For example :
   
(a) all of the cash flows of a financial instrument may be designated for cash flow or fair value changes attributable to some (but not all) risks; or
(b) some (but not all) of the cash flows of a financial instrument may be designated for cash flow or fair value changes attributable to all or only some risks (that is, a ‘portion’ of the cash flows of a financial instrument may be designated for changes attributable to all or only some risks).
[IAS 39 para AG99E].

6.8A.24 To be eligible for hedge accounting, the designated risks and portions must be separately identifiable components of the financial instrument, and changes in the cash flows or fair value of the entire financial instrument arising from changes in the designated risks and portions must be reliably measurable. For example:
   
(a) For a fixed rate financial instrument hedged for changes in fair value attributable to changes in a risk-free or benchmark interest rate, the risk-free or benchmark rate is normally regarded as both a separately identifiable component of the financial instrument and reliably measurable.
(b) Inflation is not separately identifiable and reliably measurable and cannot be designated as a risk or a portion of a financial instrument unless the requirements in (c) are met.
(c) A contractually specified inflation portion of the cash flows of a recognised inflation-linked bond (assuming there is no requirement to account for an embedded derivative separately) is separately identifiable and reliably measurable as long as other cash flows of the instrument are not affected by the inflation portion.  
[IAS 39 para AG99F].
 
Entities may also wish to hedge a residual risk. There is no specific prohibition on hedging a residual in IAS 39. However, IAS 39 does require portions to be separately identifiable and reliably measurable.
 
It should be noted that hedges of portions apply only to financial assets and liabilities and not to non-financial assets and liabilities (see para 6.8A.34 below).
 
The variety of different hedgeable risk exposures that may arise on a five year fixed rate bond classified as loans and receivables can be demonstrated in the following table:

 
Risk exposure
Contractual cash flows

 

All
Specific component
Principal
Interest
Hedge the fair value of all the cash flows for all risks (100% of fair value of the debt).
 
Hedge the fair value of all the cash flows for a specific risk, for example, interest rate (100% of fair value of the debt for a specific risk).  
Hedge a proportion of the fair value of all the cash flows for all risks (90% of fair value of the debt).
 
90%
90%
Hedge a proportion of the fair value of all the cash flows for a specific risk, for example, interest rate risk (90% of fair value of the debt for a specific risk).  
90%
90%
 
Hedge the fair value of a specifically identified cash flow for all risk.
 
or
Hedge the fair value of a specifically identified cash flow for a specific risk (for example, interest rate risk).  
or

 

Hedge the fair value of a portion of a specifically identified cash flow for all risk.
  90% or 90%
Hedge the fair value of a portion of a specifically identified cash flow for a specific risk, for example, interest rate risk.  
90% or 90%

6.8A.25 Consistent with paragraph 6.8A.23 above, financial assets or liabilities may be hedged with respect to a specific risk (a component of total risk), provided that the exposure to the specific risk component is identifiable and separately measurable, which is also a pre-requisite for measuring effectiveness. Some examples of situations where component of a risk may be hedged are given below. [IAS 39 para 81].

Example – Hedging a risk component of a fixed rate debt instrument
 
An entity issues 8% fixed rate debt instrument for C100 that is repayable at par at the end of year 2. At the time of issue the risk-free interest rate is 6%. Therefore, the credit spread on the new issue is 2%.
 
In this scenario, the entity can designate an identifiable and separately measurable portion of the interest rate exposure as the hedged risk. Such a portion may be a risk-free interest rate or benchmark interest rate component of the debt instrument’s total interest rate exposure, that is, the entity’s own credit spread of 2% may be excluded. This is subject to the proviso that effectiveness can be measured.
 
So if the entity intends to designate the benchmark LIBOR component of 6% as the hedged risk, it may take out a receive 6% fixed pay floating LIBOR interest rate swap to hedge the changes in the debt’s fair value due to changes in LIBOR. The hedge will be expected to be highly effective as the credit spread is not included in the net cash flows relating to the swap.
 
Note that it is not necessary for the pay leg of the swap to be the same as LIBOR (receive 6% pay LIBOR). The entity could take out a receive 8% pay floating LIBOR + 2% interest rate swap and still designate the benchmark LIBOR component as the hedged risk. This is because the fair value of the swap comprises the net of the present values of both the fixed and the floating legs. Therefore, increasing both sides of the swap by 2% (from receive 6% pay LIBOR to receive 8% pay LIBOR + 2%) will not change the fair value for a given change in interest rates. However, this is only true when the payment frequency of both legs is identical. If the fixed leg pays yearly and the variable leg pays quarterly, there would be a difference.

6.8A.26 If a portion of the cash flows of a financial asset or financial liability is designated as the hedged item, that designated portion must be less than the total cash flows of the asset or liability. As a designated portion of the cash flows cannot be greater than the whole, an entity that issues a debt instrument whose effective interest rate at issuance is below LIBOR (such an issuance of debt at below LIBOR rates may be possible by some entities with exceptionally strong credit rating), cannot designate the following components as hedges:

a portion of the liability equal to the principal amount plus interest at LIBOR; and
a negative residual portion.
[IAS 39 para AG 99C].
 
It should be noted, however, that the above prohibition does not feature in the EU carve-out version of IAS 39.

6.8A.27 However, the entity may designate all of the cash flows of the entire financial asset or financial liability as the hedged item and hedge them for only one particular risk (for example, only for changes that are attributable to changes in LIBOR) as illustrated in the example below:

Example – Designating a benchmark interest rate as the hedged risk on a fixed rate debt instrument issued at sub-LIBOR rate
 
An entity issues a 5% fixed rate debt instrument for C100 that is repayable at par at the end of year 2. At the time of issue, the benchmark LIBOR rate is 6%.
 
The entity can designate the entire financial liability as the hedged item (that is, principal + interest) and hedge the change in the fair value or cash flows of that entire liability that is attributable to changes in LIBOR. Some ineffectiveness will occur. However, the entity may choose a hedge ratio of other than one to one (a proportion of the total cash flow) in order to improve the effectiveness of the hedge. [IAS 39 para AG 99C].

6.8A.28 It is also possible to hedge the benchmark interest rate risk portion of a fixed rate financial instrument some time after its origination, by which time interest rates may have changed since the instrument’s origination. This is possible if the benchmark rate is higher than the contractual rate paid on the item as illustrated in the example below. [IAS 39 para AG 99D]. It should be noted that the restriction that the hedged benchmark rate is higher than the contractual rate does not feature in the EU carve-out version of IAS 39.

Example – Designating a benchmark interest rate as the hedged risk of a fixed rate debt instrument subsequent to its origination
 
On 1 April 20X1, an entity issues a 6% fixed rate debt instrument for C100 that is repayable at par at the end of year 5 (31 March 20X6). Interest is payable annually in arrears. At the time of issue, the benchmark LIBOR rate is 5%. On 1 July 20X2, the entity decides to hedge the interest rate risk on the debt instrument with an interest rate swap when LIBOR has increased to 7%. At that time, the fair value of the debt instrument is C93.
 
The entity calculates that if it had issued the debt instrument on 1 July 20X2 when it first designates it as the hedged item for its fair value of C93, the effective yield on the instrument would have been 8.1%. Because LIBOR on 1 July 20X2 is 7% and is less than this effective yield, the entity can designate a LIBOR portion of 7% that consists partly of the contractual interest cash flows and partly of the discount that is included in the difference between the current fair value of C93 and the amount repayable on maturity of C100.

6.8A.29 In the valuation of cross currency interest rate swaps and long term currency forwards, spreads are applied to cash flows in currencies with a perceived higher credit risk or lower liquidity. These spreads – commonly referred to as ‘currency basis spreads’ – are typically quoted in the market against a USD LIBOR benchmark. In the past, the effect of currency basis spreads was generally immaterial (2-3bp). However, since early 2008 these spreads have widened significantly. The question therefore arises as to whether the increased currency spreads lead to hedge ineffectiveness. It is generally accepted that in the case of a cash flow hedge where effectiveness is measured using a hypothetical derivatives method, currency basis spreads can be included in the hypothetical derivative and hence will not give rise to ineffectiveness. This reflects both that (a) the hedged risk is modelled as a derivative and hence includes all features that a stand-alone derivative would and (b) in a cash flow hedge it can be argued there is an implicit exchange of the foreign currency cash flow being hedged into the entity’s functional currency and currency basis is part of the cost the market charges for such an exchange.

6.8A.30 However, in a fair value hedge, the currency basis spread cannot be included in the fair value measurement of the hedged item. There is normally a single fair value measure for the hedged item with respect to the hedged risk. As the hedged item is a foreign currency asset or liability, it does not contain the currency basis risk, and hence the hedged risk should not include the currency basis adjustment. Furthermore, fair value is defined in terms of a price in a current transaction. If the hedged item is quoted, IAS 39 requires the quoted price to be used. This will be the price in the foreign currency and, when translated to the entity’s functional currency at the spot rate, will not include the currency basis. Finally, were the entity to sell/repay the hedged item and close out the hedge part way through its life (for example, by entering into an offsetting derivative), it would incur a gain or loss from changes in the currency basis. Thus, in a fair value hedge currency basis spreads will cause ineffectiveness.

6.8A.30.1 A number of alternative designations have been proposed with the aim of ‘removing’ the ineffectiveness that results from the currency basis spread in fair value hedges, such as the hedge of fixed rate foreign currency debt with a cross currency swap. These proposed alternatives typically involve designating only the fixed interest rate risk in a fair value hedge, with the remaining risks designated in cash flow hedges. However, such designations will not have the desired effect as it is unlikely the first fair value hedge will be effective, and the currency basis will still result in ineffectiveness that is no less than the ineffectiveness that would arise in the more usual designation of a fair value hedge.

6.8A.31 Under IAS 39, when a gain or loss on a non-monetary available-for-sale equity security is recognised in other comprehensive income, any exchange component of that gain or loss is also recognised directly in other comprehensive income. [IAS 39 para AG 83]. Normally, items taken to other comprehensive income/equity cannot be hedged, however, foreign currency exposure in such an equity security can be hedged provided there is a clear and identifiable exposure to changes in foreign exchange rates and all the other hedge accounting criteria are met. In the case of a fair value hedge, the changes in foreign currency exposure will be recognised in profit or loss. The implementation guidance explains that this would be possible only if:

the equity instrument is not traded on an exchange (or in another established marketplace) where trades are denominated in the same currency as the entity’s functional currency (investor); and
dividends to the investor are not denominated in the investor’s functional currency.
 
Thus, if a share is traded in multiple currencies and one of those currencies is the reporting entity’s functional currency, hedge accounting for the foreign currency component of the share price is not permitted.
[IAS 39 para IG F2.19].

Example – Hedging foreign currency risk of an available-for-sale investment
 
On 1 April 20X5, entity A, a Swiss company with Swiss Francs as its functional currency, buys equity shares in entity B located in the US. The shares are listed on the New York Stock Exchange and pay dividends in US$. The acquisition cost is US$1m. On that date US$ = CHF1.3 resulting in an investment of CHF1.3m. Entity A classifies the investment as available-for-sale.
 
At the same time, to protect itself from the exposure to changes in the foreign exchange rate associated with the shares, entity A enters into a forward contract to sell US$1m and buy CHF. Entity A intends to roll over the forward exchange contract for as long as it retains the shares. It is assumed that the hedge is effective and the other conditions for hedge accounting are met.
 
Entity A could designate the currency exposure relating to the shares’ fair value as the hedged risk, because it meets the two conditions set out in the above paragraph. Also, entity A could designate the forward contract as either a fair value hedge of the foreign exchange exposure of US$1m or as a cash flow hedge of a forecast sale of the shares, provided the future sale and its timing are highly probable. For the purposes of this example, it is assumed that the forward contract is designated as a fair value hedge.
 

At 31 March 20X6, the entity’s financial year end, shares increased in value to US$2m. At that date, US$ = CHF1.20.

   
The change in fair value is calculated as follows: CHF m
   
Value of investment at 31 March 20X6 – US$2m @ 1.2 = 2.4
Value of investment at 1 April 20X5 – US$1m @ 1.3 = 1.3

Fair value change 1.1
Exchange component of change – US 1m (@ 1.2 − @1.3) ( 0.1)

Recognised in other comprehensive income – change in fair value US$1m @ 1.2 1.2

   
In this situation, the gain arising from the changes in the forward contract’s fair value is recognised in the income statement. This includes both the spot component (which may be designated as part of the hedging relationship to improve effectiveness) and the forward points component (see further paragraph 6.8A.60 below). The entity also recognises the exchange loss of CHF100,000 in profit or loss to offset the gain on the forward contract. [IAS 39 para 89(b)]. The remaining portion of the change in fair value of CHF1.2m is deferred in equity in accordance with the subsequent measurement rules for available-for-sale investments.

Hedged items - Designation of financial items as hedged items - Partial term hedging

Publication date: 08 Dec 2017


6.8A.32 The ability to hedge a portion of one or more selected cash flows of a financial asset or liability means that an entity will be able to hedge exposures for a period that is less than the hedged item’s term – so called ‘partial term’ hedges. This is subject to the proviso that effectiveness can be measured and the other hedge accounting criteria are met. This will usually be so if the hedging derivative also has the same term as the selected cash flows, as illustrated in the example below. It should be noted that the notion of ‘partial term’ does not apply to a hedging instrument as stated in paragraph 6.8A.65 below. Note, where a forecasted transaction is designated with a foreign currency derivative of shorter duration, if the hedging relationship is designated on a ‘forward’ basis (that is, as a hedge of changes in forward exchange rates), it will not be fully effective. This is because a time portion of a forecasted transaction is not an eligible portion of a non-financial item and the hypothetical derivative must be based on the full term until the forecasted transaction is expected to occur. However, such a relationship may be designated on a ‘spot’ basis (that is, as a hedge of changes in spot exchange rates) with minimal ineffectiveness.

Example – Partial term hedging
 
Entity A acquires a 10% fixed rate government bond with a remaining term to maturity of ten years. Entity A classifies the bond as available for sale. On the same date, to hedge against fair value exposure on the bond associated with the first five year interest payments, the entity acquires a 5 year pay-fixed, receive-floating swap. The swap has a fair value of zero at the inception of the hedge relationship.
 
The swap may be designated as hedging the fair value exposure of the interest rate payments on the government bond until year 5 and the change in value of the principal payment due at maturity to the extent affected by changes in the yield curve relating to the 5 years of the swap. [IAS 39 para IG F2.17].
 
The same principle applies if the hedged item had been a financial liability instead of a financial asset with the same terms. In that situation, the entity could designate the fair value exposure of the first 5 years interest payments due to changes in interest rate only and hedge that exposure using a 5 year receive-fixed, pay-floating interest rate swap.
 
The entity is also able to achieve effective partial term cash flow hedges. For instance, assume an entity issues a 10 year floating rate debt and wish to hedge the variability in the first three year of interest payments. This could be easily done by using a 3 year receive-floating, pay-fixed interest rate swap.

Hedged items - Designation of financial items as hedged items - Loans and receivables

Publication date: 08 Dec 2017


6.8A.33 Under IAS 39, loans and receivables are carried at amortised cost. An entity may decide to hold such loans and receivables to maturity. Indeed, banking institutions in many countries hold the bulk of their loans and receivables until maturity. Therefore, it would appear that as changes in the fair value of such loans and receivables that are due to changes in market interest rates will not affect profit or loss, fair value hedge accounting for loans and receivables is precluded (see para 6.8A.12 above). However, it is always possible that such instruments will be disposed of or extinguished before then, in which case the change in fair values would affect profit or loss. Accordingly, fair value hedge accounting is permitted as such loans and receivables are not designated as held-to-maturity. Financial assets designated as held to maturity cannot be designated as hedged items for interest rate or pre-payment risk (see para 6.8A.47). [IAS 39 para IG F2.9].

Hedged items - Hedges of portions of non-financial items

Publication date: 08 Dec 2017

6.8A.35 The standard explains that changes in the price of an ingredient or component of a non-financial asset or non-financial liability generally do not have a predictable, separately measurable effect on the item’s price that is comparable to the effect of, say, a change in market interest rates on a bond’s price. Therefore, because of the difficulty of isolating and measuring the appropriate portion of the cash flows or fair value changes attributable to specific risks other than foreign currency risks, a non-financial asset or non-financial liability is a hedged item only in its entirety or for foreign exchange risk. [IAS 39 para AG 100]. Accordingly, when an entity chooses to hedge the fair value of inventory (a non-financial asset), the inventory cannot be separated into its commodity and other components, regardless of whether the inventory consists of a single commodity component and conversion or rework costs, or is a product comprised of multiple commodities. The standard makes no exception to this rule even though in some cases it may be possible to isolate the changes in cash flows or fair value attributable to a particular risk. In some cases, ineffectiveness can be minimized by designating multiple derivatives as a hedging instrument based on the expected ingredients of the non-financial item (for example, where a metal concentrate containing gold and copper is hedged using a combination of gold and copper forwards) or by designating the quantity of the hedged item expected to contain the quantity of the non-financial item contracted for in the hedging instrument.

Example 1 – Separation of risks in non-financial assets
 
An entity manufacturers aluminium cans from sheets of aluminium. The entity intends to use aluminium futures as a fair value hedge of the exposure to changes in the aluminium cans’ fair value held in inventory.
 
The entity cannot designate aluminium’s market price as the hedged risk, even though the price of aluminium is likely to account for a significant portion of the exposure to changes in the price of aluminium cans held in inventory. Permitting an entity to designate the market price of aluminium as the hedged risk would ignore other components of the price of the cans, such as protective coating materials, labour and production overheads.  
 
However, provided the requirement for effectiveness and other hedge accounting criteria are met (see para 6.8A.154 below), the derivative instrument (aluminium futures) could be designated as a hedge of the exposure to changes in the full fair value of the inventory. See also the fair value and cash flow examples in paragraphs 6.8A.110 and 6.8A.130 below for examples hedging the full fair value of silver inventory.

Example 2 – Forecast purchase of a non-monetary asset in foreign currency
 
Entity A is planning to buy a large piece of machinery from a foreign supplier. The forecast purchase will be denominated in a foreign currency, so the company enters into a forward contract to hedge the risk of movements in the relevant foreign exchange rate.
 
The forecast purchase can be designated as a hedged item in a cash flow hedge of foreign currency risk, provided that the forecast purchase is highly probable, the requirements for effectiveness and the other conditions for hedge accounting are met. The hedged risk (movements in exchange rates) will affect the amount paid for the machine and will, therefore, affect profit or loss as the machine is depreciated.

Example 3 – Hedge of foreign currency denominated commodity risk
 
Entity A plans to purchase a fixed quantity of a commodity in 12 months’ time in US dollars. The functional currency of entity A is the euro. Entity A wants to reduce the risk of price changes of the commodity and hedges its exposure to that price risk by entering into a twelve-month cash-settled forward contract for this commodity. The price in the forward contract is denominated in US dollars, reflecting that the underlying commodity is commonly traded in US dollars.
 
The purchase exposes entity A to two risks: price risk regarding the market price of the commodity; and foreign exchange risk of US dollars against the euro. Under IAS 39 it is possible to designate only the market price component as the hedged item. This designation is possible because the market price component is the difference between the total price risk and the foreign currency risk, both of which could be individually designated as the hedged risk as noted in paragraph 6.8A.34 above.

6.8A.36 As stated in paragraph 6.8A.34 above, a non-monetary item can be hedged for foreign currency risk only if it is separately measurable. As the hedged item is remeasured in a fair value hedge (see para 6.8A.106 below), a non-monetary financial asset that was purchased in a foreign currency and initially recorded, under IAS 21 in the purchaser’s functional currency, at the exchange rate at the date of the transaction cannot be classified as a fair value hedge for foreign currency risk. This is because it is not subsequently remeasured under IAS 21 and, therefore, does not contain any separately measurable foreign currency risk. Nevertheless, if all the hedge accounting conditions are met, an entity could designate as a cash flow hedge the anticipated sale of the non-monetary asset in a foreign currency. This is because, in a cash flow hedge, the non-monetary item is not remeasured. However, in practice, it would be rare for such a hedge to meet all the hedging accounting criteria as illustrated in the example below.

Example – Foreign currency borrowings hedging a ship
 
A shipping entity in Denmark has a US subsidiary that has the same functional currency (the Danish Krone). In its consolidated financial statements shipping entity measures its ships at historical cost less depreciation. In accordance with paragraph 23(b) of IAS 21, the ships are measured in Danish Krone using the historical exchange rate. To hedge, fully or partly, the potential currency risk on the ships at disposal in US dollars, the shipping entity normally finances its purchases of ships with loans denominated in US dollars.
 
US dollar borrowings cannot be classified as a fair value hedge of a ship, because ships do not contain any separately measurable foreign currency risk, even though the entity purchases and sells them in US dollars.
 
US dollar borrowing (or a portion of it) may, however, be designated as a cash flow hedge of the ship’s anticipated sale proceeds in US dollars financed by the borrowing provided all the hedging criteria are met. Those conditions are likely to be met if the sale is highly probable because it is expected to occur in the immediate future, the amount of the sales proceeds designated as being hedged is equal to the amount of the foreign currency borrowing designated as the hedging instrument and the timing of the future cash flows on the debt coincides with the timing on the future cash flow from the disposal. [IAS 39 para IG F6.5].

Hedged items - Firm commitments

Publication date: 08 Dec 2017


6.8A.37 A firm commitment is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates. [IAS 39 para 9]. Therefore, the key characteristic of a firm commitment is that it must have fixed terms, namely: fixed quantity, fixed price and fixed timing of the transaction. It follows from this definition that an agreement where the price paid is the market price at the date of settlement is not a firm commitment. A firm commitment must be with a party that is external to the entity (see para 6.8A.14 above). As the firm commitment is a binding agreement, it is usually legally enforceable. Firm commitments are discussed further in paragraph 6.8A.114 below.

Hedged items - Forecast transactions

Publication date: 08 Dec 2017


6.8A.38 In many cases, entities will not be hedging risk exposures arising from firm commitments but rather those arising from forecast transactions that they expect to happen, but for which there is not a binding contract. Therefore, the definition of a hedged item also includes a forecast transaction. A forecast transaction is an uncommitted but highly probable, anticipated future transaction. [IAS 39 para 9]. Concluding that an uncommitted but anticipated transaction is highly probable and will happen is more difficult than for transactions arising from firm commitments. The qualifying conditions for getting hedge accounting for forecast transactions are considered further from paragraph 6.8A.121 below.

Hedged items - Intra-group and intra-entity hedging transactions

Publication date: 08 Dec 2017


6.8A.39 It is common for entities in a group to transact with other group members or segments. These transactions may expose the entities to risks that they wish to hedge. The entity exposed to the risk can hedge it by entering into internal derivative contracts with, say, group treasury, or through external derivative contracts. However, as stated in paragraph 6.8A.14 above, only assets, liabilities, firm commitments or highly probable forecast transactions that involve a party external to the entity can be designated as hedged items. It follows that such intra group transactions can be designated as hedged items only in the individual or separate financial statements of those entities and not in the consolidated financial statements of the reporting group. This is because the intra-group transactions cancel out on consolidation and do not expose the consolidated group to any risk that affects consolidated profit or loss. There are, however, two exceptions to this general rule involving foreign currency exposures:
 
foreign exchange gains and losses on intra group monetary items; and
forecast intra group transactions.
 
These are considered in the paragraphs that follow.

6.8A.40 Under IAS 21, foreign exchange gains and losses on intra group monetary asset (or liability) between group entities with different functional currencies, whether short-term or long-term, do not fully eliminate in the consolidated profit or loss. This is because a foreign currency monetary item represents a commitment to convert one currency into another and exposes the reporting entity to a gain or loss through currency fluctuations. Accordingly, in the reporting entity’s consolidated financial statements, such exchange differences continue to be recognised in profit or loss. For this reason, the foreign currency exposure on such an intra group monetary item can be designated as a hedged item on consolidation. [IAS 39 para 80].

Example – Hedging intra group monetary items
 
Subsidiary A, whose functional currency is the euro, has an intra group receivable from subsidiary B, whose functional currency is the Swiss franc. The receivable is denominated in Swiss francs and subsidiary A enters into a €/CHF forward contract with an external party to hedge the resulting foreign currency risk.
 
In its separate financial statements, subsidiary A translates the receivable into euros using the spot rate at the balance sheet date and recognises a foreign currency gain or loss in accordance with IAS 21. Subsidiary B, in its separate financial statements, records the payable to subsidiary A in its own functional currency and does not recognise any gain or loss. On consolidation, the gain or loss recognised by subsidiary A is translated into the group’s presentation currency and is recognised in the group’s income statement. There is no offsetting loss or gain arising from subsidiary B.
 
Subsidiary A uses the €/CHF forward contract to hedge the foreign currency exchange risk on the receivable from subsidiary B in its individual financial statements. As the receivable gives rise to an exposure to foreign currency gains or losses that is not fully eliminated on consolidation, the foreign currency exposure on the intra group receivable can be designated as the hedged item in the consolidated financial statements. The group can designate the €/CHF forward contract in subsidiary A as the hedging instrument. The hedge accounting achieved by subsidiary A is reversed on consolidation and replaced with hedge accounting achieved by the group.
 
For group purposes, it is not necessary for the subsidiary to take out the forward contract for the foreign exchange exposure on the intra group receivable to qualify as a hedged item on consolidation. The parent entity could have taken out the same forward contract hedging the €/CHF exchange risk instead.

6.8A.41 IAS 39 permits the foreign currency risk of a highly probable forecast intra group transaction to be designated as a hedged item in the consolidated financial statements, provided the following two conditions are met:

the highly probable forecast intra group transaction is denominated in a currency other than the functional currency of the group member entering into that transaction; and
the foreign currency risk will affect the group’s consolidated profit or loss.
[IAS 39 para 80].

6.8A.42 The group member entering into the transaction can be a parent, subsidiary, associate, joint venture or branch. The first condition is necessary because, under IAS 21, a foreign currency exposure arises only when a transaction is denominated in a currency other than the functional currency of the entity entering into that transaction. The second condition is met if the forecast intra group transaction is related to an external transaction. An example is forecast sales or purchases of inventories between members of the same group if there is an onward sale of the inventory to a party external to the group (see example below). However, if there is no external related transaction, which will often be the case for royalty payments, interest payments or management charges between members of the same group, the foreign currency risk of those forecast intra group transactions would not affect consolidated profit or loss and, so, cannot qualify as hedged items. [IAS 39 para AG 99A]. Intra group foreign currency dividends can never qualify as hedged items (see para 6.8A.46 below).

6.8A.43 An entity cannot apply hedge accounting to only one part of the foreign currency risk arising on a highly probable forecast intra-group transaction.

Example – Hedging of inter-company transactions
 
Subsidiary A has a functional currency of euro (EUR); subsidiary B has a functional currency of Japanese Yen (JPY); both subsidiaries are part of a group with presentation currency of USD.
 
Subsidiary A sells goods to subsidiary B based on USD-denominated prices, invoicing takes place in USD. USD is used due to the group’s global transfer pricing strategy, whereby it has been agreed internally and with relevant tax authorities that all intra-group transactions are priced and invoiced in USD. Subsidiary B will sell the goods in the Japanese market in JPY.
 
Subsidiary B enters into a USD/JPY derivative to hedge the USD-risk on its purchases; subsidiary A does not enter into any hedge in relation to this transaction.
 
Paragraph 80 of IAS 39 requires that the foreign currency risk affects consolidated profit and loss to qualify as a hedged item. In the above example, hedge accounting cannot be applied as only part of the foreign currency risk arising on the highly probable forecast intra-group transaction is reflected in consolidate profit or loss. Since the overall profit and loss on this intra-group transaction is ultimately affected by the EUR/JPY exposure, rather than the USD/JPY exposure, hedge accounting cannot be applied.

6.8A.44 If a hedge of a forecast intra-group transaction qualifies for hedge accounting, any gain or loss that is recognised directly in equity should be reclassified into profit or loss in the same period or periods during which the foreign currency risk of the hedged transaction affects consolidated profit or loss (see further para 6.8A.131 below).

Example 1 – Hedging the foreign currency risk of an intra group forecast transaction
 
Group A (pound sterling presentation currency) includes entity B with euro functional currency and entity C with US dollar functional currency in the consolidation. Entity B manufactures tyres and incurs production costs in euros. It sells most of the tyres to entity C and those transactions are denominated in US dollars. Entity C markets and sells those tyres to external customers in the US, also in US dollars.
 
In June 20X6 entity B forecasts that it will sell tyres to entity C in October 20X6 amounting to US$ 10m. These sales are highly probable and all the other conditions in IAS 39 for hedge accounting are met. Entity C expects to sell this inventory to external customers in early 20X7. At the same time in June 20X6, entity B enters into a euro/US$ derivative (buy €/sell US$) to hedge the foreign currency risk of the forecast sale of US$10m to entity C in October 20X6.
 
Group A intends to designate the forward contract as hedging the foreign currency risk of the forecast intra group sales of US$10m by entity B in a cash flow hedging relationship in the consolidated financial statements. It is able to do so because all the following conditions are met
 
The intra group sales are highly probable and all the other conditions for using hedge accounting are met.
The intra group sales are denominated in a currency (US$) other than entity B’s functional currency (€).
The existence of the expected onwards sale of the inventory in US dollars to third parties outside the group results in the hedged exposure affecting the pound sterling consolidated profit or loss. This is because the intra group profit on sale recognised in entity B is € number that is fixed according to the €/$ rate when the sale takes place in October 20X6. This profit is eliminated on consolidation against the carrying value of tyre inventory in entity C and released to consolidated profit or loss when the onward sale of inventory to third parties take place in 20X7.
 
Gains/losses on the €/US$ derivative are recognised initially in consolidated equity to the extent the hedge is effective. These amounts are reclassified to consolidated profit or loss in 20X7 when the external sales occur.
 
The standard notes the difficulty in demonstrating that there is a related external transaction for intra-group royalty and interest payments, but does not preclude the use of hedge accounting for such transactions where a clear link to an external transaction can be demonstrated.

Example 2 – Linkage to an external transaction
 
A GBP parent obtains a GBP external loan and immediately lends the proceeds in USD to a subsidiary with a USD functional currency. The subsidiary uses the money to make external loans to customers in USD. In the consolidated financial statements including the parent and subsidiary the group proposes to hedge the GBP/USD risk of the loan to the subsidiary with a GBP/USD swap. In considering whether the hedge can be designated under IAS 39 it is necessary to evaluate the linkage between the loan by the parent and the external transaction by considering factors such as whether:
   
the stated purpose of the parent lending is to allow the subsidiary to on-lend to external parties;
there is a short time lag between lending by the parent an on-lending by the subsidiary (ideally simultaneous on-lending);
similar terms exist between the loan to the parent and the subsidiary. If the loan with the parent is longer in duration than the external loan the parent should demonstrate an intention to rollover the external loans;
if the loans were repaid early by the subsidiary’s external borrowers, there is a requirement to repay the loan to the parent company.

Hedged items - Items that do not qualify as hedged items

Publication date: 08 Dec 2017


6.8A.45 There are a number of items that, for various reasons, cannot qualify as a hedged item in a hedging relationship. For such items the normal measurement and recognition rules will apply. These items are considered below.

Hedged items - Items that do not qualify as hedged items - Own equity instruments

Publication date: 08 Dec 2017


6.8A.46 Hedge accounting cannot be applied for hedges of any items included in equity or transactions that directly affect equity. This is because the hedged item cannot create an exposure to risk that will affect profit or loss. Therefore, hedges of risks relating to the forecast sale, purchase or redemption of an entity’s own equity shares cannot qualify as hedged items. Similarly, distributions to holders of an equity instrument are debited by the issuer directly to equity. [IAS 32 para 25]. Therefore, such distributions cannot be designated as a hedged item. However, a dividend that has been approved in a general meeting of members and has not yet been paid and is recognised as a financial liability may qualify as a hedged item, for example, for foreign currency risk if it is denominated in a foreign currency as illustrated in the example below. [IAS 39 para IG F2.7].

Example – Inter-company dividends denominated in foreign currency
 
Entity A, whose functional currency is the pound sterling, has a subsidiary in the US, whose functional currency is the US dollar. On 1 January 20X6, entity A forecasts that it will receive a US$100m dividend from its US subsidiary in six months. The inter-company dividend was approved in general meeting of members (or equivalent) on 30 April 20X6, at which time both entity A and its subsidiary recognised the dividend as a receivable or payable in their respective financial statements.
 
The foreign currency dividend receivable in entity A’s balance sheet was re-translated at the reporting period end, 31 May 20X6, resulting in a foreign currency loss. The subsidiary paid the dividend on 30 June 20X6.
 
Entity A wanted to designate the foreign currency risk on highly probable inter-company dividend as the hedged item in its group financial statements in a cash flow hedge from 1 January 20X6 to 30 June 20X6, in order to hedge the exposure to changes in the £/US$ exchange rate. However, inter-company dividends are not foreign currency transactions that can be hedged, because they do not affect the consolidated income statement. They are distributions of earnings.
 
The foreign currency exposure arising from the receivable in US dollars recognised on 30 April 20X6 can be designated as a hedged item because it gives rise to foreign currency gains and losses that do not fully eliminate on consolidation and, therefore, affect the consolidated income statement (see para 6.8A.40 above). Entity A can, therefore, apply hedge accounting from that date until 30 June 20X6 when the cash is received in its group financial statements.

Hedged items - Items that do not qualify as hedged items - Held-to-maturity investments

Publication date: 08 Dec 2017


6.8A.47 Unlike loans and receivables (see para 6.8A.33 above), a held-to-maturity (HTM) investment (whether it pays fixed or floating interest) cannot be hedged for interest rate risk, because designation of an investment as held-to-maturity requires the holder’s positive intent and ability to hold the instrument to maturity. Held-to-maturity classification implies that the net changes in fair value stemming from changes in market interest rates from inception to maturity will not have an impact on profit or loss as the entity has committed itself to retaining the investment to maturity. Similarly, a held-to-maturity investment cannot be hedged for pre-payment risk – risk that an investment will be paid earlier or later than expected. As interest rates fall below rates on existing loans, borrowers may, and commonly do, pre-pay their existing loans and refinance at lower rates. Therefore, as pre-payment risk is primarily a function of interest rates, it is more akin to interest rate risk and, accordingly, cannot be designated as a hedged risk. However, a held-to-maturity investment can be a hedged item with respect to risks from changes in foreign currency exchange rates and credit risk. [IAS 39 para 79].

6.8A.48 Although hedge accounting is prohibited for hedging the interest rate risk of a held-to-maturity asset, the prohibition only applies to held-to-maturity assets that have already been recognised on the entity’s balance sheet. The prohibition does not apply to a forecast purchase of a held-to-maturity asset as illustrated in the example below.

Example – Forecast purchase of held-to-maturity investment
 
An entity has a forecast transaction to purchase a financial asset that it intends to classify as held-to-maturity when the forecast transaction occurs. It enters into a derivative contract to lock in the current interest rate and designates the derivative as a hedge of the forecast purchase of the financial asset.
 
Provided all the hedge accounting criteria are met, the entity can apply cash flow hedge accounting to the forecast purchase of a held-to-maturity security. This is because the investment is not classified as held-to-maturity until the transaction occurs. [IAS 39 para IG F2.10].

6.8A.49 The standard also permits cash flow hedge accounting for future interest receipts from a debt instrument that originated from the re-investment of interest receipts from an held-to-maturity investment as illustrated in the example below.

Example – Hedging reinvestment risk of funds obtained from held-to-maturity investments
 
An entity owns a variable rate asset that it has classified as held-to-maturity. The cash from variable interest receipts is re-invested in debt instruments. The entity enters into a derivative contract to lock in the current interest rate on the reinvestment of variable rate cash flows and designates the derivative as a cash flow hedge of the forecast future interest receipts on debt instruments.
 
Provided all the hedge accounting criteria are met, the hedging relationship will qualify for cash flow hedge accounting even though the cash from the interest receipts that are being reinvested come from an asset that is classified as held-to-maturity. The source of the funds used to purchase the debt instrument is not relevant in determining whether the reinvestment risk can be hedged. This answer applies also if the source of the funds used to purchase the debt instrument had been a fixed rate held-to-maturity investment. [IAS 39 para IG F2.11].

Hedged items - Items that do not qualify as hedged items - Equity method investment and investment in consolidated subsidiaries

Publication date: 08 Dec 2017


6.8A.50 An equity method investment, such as an associate or joint venture, cannot be a hedged item in a fair value hedge because the equity method recognises in profit or loss the investor’s share of the associate’s profit or loss, rather than changes in the investment’s fair value. [IAS 39 para AG 99]. Although this applies to consolidated financial statements, an entity may be able to designate an investment in an associate as a fair value hedge in its separate financial statements, provided that its fair value can be measured reliably.

6.8A.51 The ability of an entity to treat an associate as the hedged item in a cash flow hedge is considered in the following example.

Example – Forecast cash flows in associates
 
Entity A has a 25% investment in a foreign entity over which it has significant influence. It, therefore, accounts for the foreign entity as an associate using the equity method. The associate’s functional currency, in which most of its sales and costs are denominated, differs from entity A’s functional currency. In entity A’s consolidated financial statements its share of the associate’s net results will fluctuate with the changes in the exchange rate. The entity intends to designate a portion of the forecast cash flows in the associate as the hedged item in a hedge of foreign currency risk.
 
Under the functional currency concept in IAS 21, a cash flow that is denominated in an associate’s functional currency does not give rise to a foreign currency (transaction) exposure for the associate in its separate financial statements. The variability in entity A’s share of its associate’s net results arises only in its consolidated financial statements and arises from the translation of the associate’s financial statements into the group’s presentation currency. This is a translation rather than a transaction exposure. IAS 39 permits an entity to apply hedge accounting to a hedge of the translation risk on its existing net investment, but this does not extend to the investee’s forecast future cash flows or profits.

6.8A.52 An investment in a consolidated subsidiary cannot be a hedged item in a fair value hedge, because consolidation recognises in profit or loss the subsidiary’s profit or loss, rather than changes in the investment’s fair value. If a subsidiary was allowed to be designated as a hedged item, it would result in double counting, as both the income from the investment as well as changes in the fair value would be reported in profit or loss. A hedge of a net investment in a foreign operation is different because it is a hedge of the foreign currency exposure, not a fair value hedge of the change in the investment’s value. [IAS 39 para AG 99]. Another example of a transaction undertaken by a foreign subsidiary that cannot be hedged at the consolidation level is considered below.

Example 1 – Forecast foreign currency transaction undertaken by a foreign subsidiary
 
Entity A’s functional currency is the euro. It has a US subsidiary, subsidiary B, whose functional currency is the US dollar. Subsidiary B has highly probable forecast sales denominated in Japanese yen.
 
Entity A wishes to hedge subsidiary B’s forecast Japanese yen inflows back into euros (entity A’s functional currency) using external foreign currency forward contracts (¥/€). Entity A’s management intends to designate, in the consolidated financial statements, the forward contracts as hedging instruments in a cash flow hedge of the forecast transactions denominated in Japanese yen.
 
The ¥/€ forward contracts taken out by entity A do not qualify for cash flow hedge accounting on consolidation. This is because there is no ¥/€ cash flow exposure that affects consolidated profit or loss. The consolidated income statement will be exposed to ¥/US$ movements, as subsidiary B will translate its ¥ sales into its own functional currency (US$). The exposure to movements in US/€ constitutes a translation risk rather than a cash flow exposure and, therefore, cannot be the subject of a cash flow hedge.
 
However, it is possible for the subsidiary B to use a ¥/US$ forward contract to designate a cash flow hedge of its ¥/US$ transaction exposure. Alternatively, entity A could use a ¥/US$ forward contract to hedge the exposure since IAS 39 does not require that the operating unit that is exposed to the risk being hedged be a party to the hedging instrument. [IAS 39 para IG F2.14].
 
Entity A could also hedge its net investment in subsidiary B using a €/US$ forward (see para 6.8A.150 below). This would, however, not include the forecast transaction.

Example 2 – Parent hedging forecasted future revenues denominated in the functional currency of a subsidiary which is different from functional currency of the parent
 
Entity A, based in Germany, whose functional currency is euro, has a subsidiary in the UK, whose functional currency is GBP. The group’s presentation currency is also euro. The UK subsidiary sells gas within the UK for GBP to British customers. At the group level, the group’s treasury department enters into external GBP/euro forward contract to hedge against movements in GBP versus euro on behalf of the group. The group cannot obtain cash flow hedge accounting for the UK subsidiary sales. The sales of the UK subsidiary are made in its functional currency so it has no foreign currency exposure. The consolidated group has a foreign currency exposure, but it will not affect the group’s reported net profit or loss. At the consolidated level the foreign currency exposure will be deferred as part of cumulative translation adjustment in equity when the UK subsidiary’s financial statements are translated into the group’s presentation currency for consolidation [IAS 21 para 39(c)]. Group management may, therefore, consider the possibility of net investment hedge accounting under paragraph 102 of IAS 39. However, the group will not be able to obtain hedge accounting for hedges of forecasted sales – see last sentence of the example 1 above.

Example 3 – Hedging of foreign currency sales of a foreign subsidiary denominated in group’s presentation currency by the parent
 
A European parent entity whose functional currency is euro, has a Chinese subsidiary whose functional currency is RMB. The presentation currency of the group is euro. The Chinese entity has highly probable forecast sales in euro that its management has not hedged. The parent’s management enters into EUR/RMB forward contracts and designates these as cash flow hedges of the Chinese subsidiary forecast sales.
 
The forecast euro sales give rise to a currency risk that will affect the subsidiary’s profit or loss in its separate financial statements. This is because the RMB amount at which the sales are reported in the subsidiary’s separate financial statements will be affected by the EUR/RMB exchange rate at the time the sales occur.
 
However, in the consolidated financial statements the sales will be translated into euro using the exchange rates at the dates of the transactions (or an average rate when this approximates the rates at the dates of the transactions) in accordance with paragraph 39(b) of IAS 21. Hence, the amount at which the sales are reported in the group’s consolidated financial statements will not be affected by the EUR/RMB exchange rate at the time the sales occur. Even though the exchange rate may not have an impact on the sales expressed in euros, the consolidated profit or loss is affected by the realised margin in the Chinese subsidiary.
 
The forecast transaction meets the requirements of paragraph 88(c) of IAS 39. The reference in paragraph 88(c) of IAS 39 to ‘profit or loss’ refers to the subsidiary’s profit or loss where the exposure is located and not to the profit or loss of the consolidated entity. This is consistent with the functional currency framework in IAS 21 under which a foreign exchange exposure arises whenever a transaction is denominated in a currency other than the functional currency of the entity entering into the transaction. Paragraph IG F.2.14 of IAS 39 also permits the hedging instrument to be entered into by the parent and states that it need not be entered into by the subsidiary that has the exposure. Hence, provided all the other criteria in paragraph 88 of IAS 39R are met, the group may obtain cash flow hedge accounting in its consolidated financial statements.

Hedged items - Items that do not qualify as hedged items - Future earnings

Publication date: 08 Dec 2017


6.8A.53 Future earnings or future results cannot be designated as hedged items because they are the net effect of various transactions that do not share the same risk characteristic. However, future revenue or future expenditure may be separately designated as hedged items if the underlying risk exposure can be specifically identified and measured (see example in para 6.8A.121 below).

Hedged items - Items that do not qualify as hedged items - Derivative instruments

Publication date: 08 Dec 2017


6.8A.54 A derivative instrument (whether a stand-alone or separately recognised embedded derivative) cannot be designated as a hedged item, either individually or as part of a hedged group in a fair value or cash flow hedge. For instance, it is not possible to designate a pay-variable, receive-fixed forward rate agreement (FRA) as a cash flow hedge of a pay-fixed, receive-variable FRA. This is because derivative instruments are always deemed held for trading and measured at fair value with gains and losses recognised in profit or loss unless they are designated and effective hedging instruments. As an exception, IAS 39 permits the designation of a purchased option as the hedged item in a fair value hedge. [IAS 39 para AG 94]. [IAS 39 para IG F2.1]. A contract to buy or sell a non-financial asset that can be settled net in cash will be accounted for as a derivative under IAS 39, unless it meets the ‘own use’ exception discussed in chapter 40 and so cannot be a hedged item.

Hedged items - Items that do not qualify as hedged items - General business risk

Publication date: 08 Dec 2017


6.8A.55 To qualify for hedge accounting, the hedge must relate to a specific identified and designated risk and not merely to the entity’s general business risks and must ultimately affect the entity’s profit or loss. For example, a firm commitment to acquire a business in a business combination cannot be a hedged item, except for foreign exchange risk in respect of the purchase consideration, because the other risks being hedged cannot be specifically identified and measured. These other risks are general business risks. [IAS 39 para AG 98]. [IAS 39 para AG 110]. Similarly, the risk that a transaction will not occur such that it would result in less revenue than expected is an overall business risk that is not eligible as a hedged item. [IAS 39 para IG F2.8]. A hedge of the risk of obsolescence of a physical asset or the risk of expropriation of property by a government is also not eligible for hedge accounting; effectiveness cannot be measured because those risks are not measurable reliably.

Hedging instruments - Definition

Publication date: 08 Dec 2017


6.8A.56 A hedging instrument is a designated derivative or, for a hedge of the risk of changes in foreign currency exchange rates only, a designated non-derivative financial asset or non-derivative financial liability, whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. [IAS 39 para 9].

6.8A.57 Only instruments that involve a party external to the reporting entity (that is, external to the group, or individual entity that is being reported on) can be designated as hedging instruments. Therefore, if an entity wishes to achieve hedge accounting in the consolidated financial statements, it must designate a hedging relationship between a qualifying external hedging instrument and a qualifying hedged item. However, internal derivative contracts may qualify for hedge accounting in the individual or separate financial statements of individual entities within the group provided that they are external to the individual entity being reported on (see para 6.8A.86 below). [IAS 39 para 73].

Hedging instruments - Derivative financial instruments

Publication date: 08 Dec 2017


6.8A.58 IAS 39 does not restrict the circumstances in which a derivative may be designated as a hedging instrument provided the hedge accounting conditions are met (see para 6.8A.156 below), except for some written options. This means that derivative instruments such as forward exchange contracts, futures contracts, interest rate swaps, cross-currency and commodity swaps and purchased options can all be designated as hedging instruments. An embedded derivative that is accounted for separately from its host contract can be used as a hedging instrument. Also, those contracts for purchases or sales of non-financial assets that are accounted for as derivatives under IAS 39 (that is, can be settled net or by exchanging another financial instrument and that are not for own use) may be used as hedging instruments.

Example 1 – Hedging with a sales commitment
 
Entity J’s functional currency is the Japanese yen. It has issued a US$ fixed rate debt instrument with semi-annual interest payments that matures in 2 years with principal due at maturity of 5 million US dollars. It has also entered into a fixed price sales commitment for 5 million US dollars that matures in two years that is not accounted for as a derivative, because it meets the exemption for normal sales. Entity J intends to designate the sales commitment as a hedge of the fair value change of the maturity amount of the debt attributable to foreign currency risk.
 
In this scenario, the sales commitment is accounted for as a firm commitment and not as a derivative and, therefore, cannot be designated as a hedging instrument. However, if the foreign currency component of the sales commitment is required to be separated as an embedded derivative on the grounds that US dollar is not the customer’s functional currency and otherwise not closely related under IAS 39, it could be designated as a hedging instrument in a hedge of the exposure to changes in the fair value of the debt’s maturity amount attributable to foreign currency risk. [IAS 39 para IG F1.2]. However, as the exchange difference on the fixed rate debt would, in any event, be reported in profit or loss under IAS 21, a separate hedging relationship is not necessary.

Example 2 – Hedging with fixed to fixed cross currency swaps
 
Entity X, whose functional currency is the euro, has issued a US dollar fixed rate debt. Entity X’s management intends to hedge the foreign exchange cash flow exposure on the debt’s interest and principal by entering into a fixed to fixed euro/US dollar cross currency interest rate swap.
 
Entity X expects the cross currency interest rate swap to be a highly effective hedge of the cash flow exposure, since the critical terms of the hedging instrument and the hedged item match.
 
IAS 39 does not specify the methodology that should be used for effectiveness testing other than to require this to be consistent with the entity’s risk management strategy. One possible method would be to apply the hypothetical derivative method.
 
The hypothetical derivative method models the hedged item as a derivative (called the ‘hypothetical derivative’ as it does not exist) and then compares the change in the fair value of the hedging instrument with the change in the fair value of the hypothetical derivative. The USD leg of the hypothetical derivative will have terms that identically match those of the hedged item and the euro leg is set such that the fair value of the hypothetical derivative is zero at the inception of the hedge.
 
As mentioned in paragraph 6.8A.29, it is generally accepted that in the case of a cash flow hedge where effectiveness is measured using a hypothetical derivative method, currency basis spreads can be included in the hypothetical derivative and hence will not give rise to ineffectiveness.
 
If all the critical terms of the swap exactly match the terms of the underlying bond (as reflected in the hypothetical derivative), this test is likely to give rise to no ineffectiveness. If this is the case and, if all the remaining requirements of paragraph 88 of IAS 39 relating to documentation and designation are met, management could defer the entire change in the fair value of the swap in other comprehensive income.
 
At each reporting date, the underlying bond will be re-measured through profit or loss using the spot exchange rate in accordance with IAS 21. At the same time an equivalent offsetting portion of the fair value adjustment of the swap should be recycled to profit or loss. The remaining revaluation gain or loss deferred in equity relates to the forward points, that is, the difference between the spot rate and the forward rate. These forward points deferred in equity should be recognised in profit or loss over the period of the hedging relationship (this being the period(s) in which the hedged item affects profit or loss) using the effective interest rate method.

6.8A.59 It is not necessary for an entity to enter into a new derivative contract every time it enters into a new hedging relationship. Provided the hedge accounting criteria are met, a pre-existing derivative instrument that has been held for some time and classified as held-for-trading can be designated as a hedging instrument in a new hedging relationship, as can a derivative that has been designated previously as a hedging instrument in a hedge relationship that no longer qualifies for hedge accounting. Changing the designation of a derivative from a trading instrument to a hedging instrument occurs at inception of the new hedging relationship.

6.8A.59.1 However, an existing derivative will have a non-zero fair value because of its ‘off market terms’. Consequently, it cannot be assumed that the new relationship will be highly effective without performing the necessary analysis of the impact of the ‘off market’ nature of the derivative on the new relationship, particularly when compared to a new ‘on market’ hypothetical derivative where the hedge is a cash flow hedge (see para 6.8A.190 onwards below for more details of constructing a hypothetical derivative). For example, a derivative asset can be thought of as containing an ‘embedded loan receivable’ and a derivative liability as containing an ‘embedded loan payable’. This ‘embedded’ financing can be a source of ineffectiveness due to the fair value movements on the opening balance and the off market element of interest. The actual settlement of the original carrying value is not itself a fair value change and can be excluded from the effectiveness testing for the purposes of performing an 80%-120% test. However, it does not change the fact that the instrument is still a derivative and must be carried in its entirety at fair value, with all fair value movements recorded in profit or loss or other comprehensive income as appropriate.

Hedging instruments - Derivative financial instruments - Portions and proportions of a hedging instrument

Publication date: 08 Dec 2017


6.8A.60 There is normally a single fair value measure for a hedging instrument in its entirety and the factors that cause changes in fair value are co-dependent. Thus, a hedging relationship is designated by an entity for a hedging instrument in its entirety. It follows that a derivative instrument cannot be split into components representing different risks with only certain components designated as a hedging instrument. The only exceptions permitted are:

separating the interest element and the spot price of a forward contract; and
separating the intrinsic value and time value of an option contract and designating as the hedging instrument only the change in intrinsic value of an option.
   
These exceptions are permitted because the intrinsic value of the option and the premium or discount on the forward can generally be measured separately.
[IAS 39 para 74].

Example 1 – Definition of a forward contract 
 
For hedging purposes, entity A enters into the following derivative instruments:
   
A fixed to fixed cross-currency swap.
A floating to floating cross-currency swap.
A floating to fixed cross-currency swap.
   
Entity A’s management wishes to designate only the spot element of these derivatives as hedging instruments in separate hedging relationships.
 
Paragraph 74 of IAS 39 allows an entity to designate the spot element of a derivative as a hedging instrument provided the derivative is a forward contract. A simple forward contract is a contract to exchange a fixed amount of a financial or non-financial asset on a fixed future value date or dates beyond the spot value date. For the purposes of applying paragraph 74 of IAS 39, the term ‘forward contract’ should be interpreted as being any derivative instrument that is a simple forward contract or that may be constructed using only a series of simple forward contracts. Forward contracts may be settled by gross delivery of the financial asset in return for cash, or on a net basis at each settlement date.
 
The fixed to fixed cross-currency swap entered into by entity A constitutes a forward contract under paragraph 74 of IAS 39 provided that the settlements on each leg of the swap occur on the same dates in the future (that is, there is no timing mismatch between the two legs of the swap).
 
However, the other derivatives (the floating to floating cross-currency swap and the floating to fixed cross-currency swaps) are not forward contracts since they cannot be constructed using only simple forward contracts.

Example 2 – Splitting a written swaption into components
 
Entity A, whose functional currency is euro, issues 30-year fixed-rate debt. At the same time, entity A enters into an interest rate derivative with a third party with the following terms: entity A receives 7% fixed and pays 5% fixed for 7 years. After 7 years, the counterparty has the option to require entity A to enter into a pay fixed 5%, receive LIBOR interest rate swap with a maturity of 23 years. (Economically, entity A has sold the counterparty a swaption on a 23 year swap with 7 years until exercise date and with premium payments spread over 7 years).
 
Entity A proposes to split the derivative into separate components, one of which is an on-market receive fixed, pay variable interest rate swap. It would designate this component as a hedge of the first seven years of interest rate exposure under the fixed rate debt. The remaining component would be treated as a trading derivative.
 
Entity A cannot split the derivative into its components, because of the requirements of paragraph 74 of IAS 39 and paragraph IG F1.8 of IAS 39 so any attempt to designate it as a hedging instrument would be likely to fail the prospective effectiveness requirements.
 
In addition the combined instrument is a written option and cannot be designated as a hedging instrument under paragraph AG94 of IAS 39 (see para 6.8A.75).

6.8A.61 The fair value of a foreign exchange forward contract is affected by changes in the spot rate and by changes in the forward points. The latter derives from the interest rate differential between the currencies specified in the forward contract. Changes in the forward points may give rise to ineffectiveness if the hedged item is not similarly affected by interest rate differentials unless only the spot component of the forward is designated as the hedging instrument (see para 6.8A.208 below).

6.8A.62 The fair value of an option can be divided into two portions: the intrinsic value, which is determined in terms of the difference between the strike price and the current market price of the underlying (as described in more detail below); and the time value, which is the option’s remaining value and depends on the volatility of the price of the underlying, interest rates and the time remaining to maturity. When the option is used to hedge the one-sided risk on a non-optional position, changes in the option’s time value will not be offset by an equivalent change in the value or cash flows of the hedged item (for more details about hedging of portions see para 6.8A.23). IAS 39 does not specify how the intrinsic value of an option is determined. Intrinsic value can be defined based on the spot rate. For example, for an interest rate cap that is used to hedge the exposure to interest rates on floating rate debt, the intrinsic value may be deferred by projecting all future cash flows on the cap at the current spot rate and discounting the result using the zero-coupon curve. If the current spot rate is below the market rate, the cap is ‘out of the money’ in all periods. Alternatively, the intrinsic value could be defined using the forward rate curve. The projected cash flows would be calculated using the forward rates. In that case the cap may be in the money in some periods, even when the current spot rate is below the strike price.
 
The intrinsic value of a European option (that is, an option which is settled at the end of its term) may be defined as discounted where the difference between:
   
the strike price of the option’s underlying specified in the option; and
the market price of the underlying
 
is discounted to present value.
 
The intrinsic value may also be defined as undiscounted – that is, simply as the absolute difference between the strike price and market price of the underlying asset.
 
The intrinsic value of an American style option may be defined as the difference between the undiscounted spot price on the day when it is determined and the strike price specified in the option contract. This is because the American style option can be exercised at any time.

6.8A.63 Generally, it may be advantageous to exclude the forward points and the time value of an option to improve effectiveness. However, this comes at a price as it will most probably increase the volatility in the income statement. This is because as the forward points or time value are not subject to hedge accounting, any changes in their fair value will be recognised as gains or losses in the income statement as they occur. If forward points were included in the hedge relationship then they could generate ineffectiveness for example if the timing of the hedged forecast transaction changed and change in fair value of the forward was higher in absolute terms than change in fair value of the hedged cash flow (see para 6.8A.129). [IAS 39 para 96].

6.8A.64 A proportion of the entire hedging instrument, such as 50% of the notional amount, may be designated as the hedging instrument. [IAS 39 para 75]. The proportion that is not acting as a hedge is either treated as held-for-trading or designated as a hedging instrument in another hedge relationship.

Example – Proportions of derivatives as hedging instruments
 
Entity A, whose functional currency is the euro, enters into a US$10m forward contract on 1 June 20X1 to hedge forecast future US$-denominated sales in March 20X2. At the time of entering into the forward contract, only US$8m of forecast sales are considered to be highly probable of occurring in March 20X2.
 
In this situation, entity A can designated 80% of the forward contract as a hedge of the highly probable future sales of US$8m in March 20X2. The remaining US$2m of the forward contract (20%) may either be designated as trading or as a hedging instrument in another hedge relationship. In other words, 20% of the total change in the fair value of the forward contract would be reported in profit or loss, or used as an offset in another hedge relationship.

6.8A.65 A hedging relationship may not be designated for only a portion of the time period during which a hedging instrument remains outstanding as illustrated in the example below. [IAS 39 para 75].

Example – Portion of the outstanding life of a derivative as a hedging instrument
 
An entity enters into a pay-fixed, receive-variable interest rate swap to hedge the cash flow exposure of a floating rate debt instrument. Both the swap and the debt instrument are entered into on the same date. The floating rate debt instrument has a term of 5 years and the swap has a term of 7 years.
 
The entity cannot designate the cash flows arising in the first 5 years of the 7 year swap as a hedging instrument. The swap’s fair value derives from the present value of the net settlements over the entire 7 year period, not the first 5 years. Furthermore, the fair value of the swap cannot be time apportioned using linear interpolation, as the change in the swap’s fair value per unit of time is non-linear.
 
However, the entity can designate the entire 7 year swap as a hedge of the 5 year debt, but ineffectiveness will arise because of timing mismatches and is likely to be so large (that is, outside the 80%-125% range, see para 6.8A.165) as to prohibit hedge accounting.
 
On the other hand, if the swap’s terms and the debt are reversed so that they are 5 years and 7 years respectively, the 5 year swap can be designated as a hedge of the first 5 years of the debt instrument. This is referred to as ‘partial-term’ hedging and is discussed in paragraph 6.8A.32 above.

Hedging instruments - Derivative financial instruments - Hedging more than one risk with a single instrument

Publication date: 08 Dec 2017


6.8A.66 A derivative, such as a forward contract, swap or an option, is used as a hedging instrument to hedge a single risk (foreign currency, interest rate or equity price risk). However, entities may often use a single derivative such as a cross-currency swap (combined interest rate and currency swap) to convert a variable rate position in a foreign currency to a fixed rate position in the entity’s functional currency. IAS 39 permits a single hedging instrument to be designated as a hedge of more than one type of risk provided that:

The risks hedged can be identified clearly.
The effectiveness of the hedge can be demonstrated.
It is possible to ensure that there is specific designation of the hedging instrument and different risk positions.
[IAS 39 para 76].

6.8A.67 If a single hedging instrument is used to hedge different risk exposures and each of these risk exposures are accounted for using different forms of hedge accounting (fair value hedge for one, cash flow hedge for the other), IFRS 7 requires separate disclosures for each type of hedge (see chapter 47). [IAS 39 para IG F1.12].

Example 1 – Dual foreign currency forward exchange contract to hedge currency risk
 
Entity A’s functional currency is the Japanese yen. Entity A has a 5 year floating rate US dollar liability and a 10 year fixed rate pound sterling denominated bond (an asset). The principal amounts of the asset and liability when converted into the Japanese yen are the same. Entity A enters into a single foreign currency forward contract to hedge its foreign currency exposure on both instruments under which it receives US dollars and pays pound sterling at the end of 5 years.
 
Entity A designates the forward exchange contract as a hedging instrument in a cash flow hedge against the foreign currency exposure on the principal repayments of both instruments. Since entity A’s functional currency is Yen, it is exposed to US$/¥ foreign currency risk on the floating rate liability and ¥/£ foreign exchange risk on the fixed rate asset.
 
IAS 39 permits a single hedging instrument to be designated as a hedge of multiple types of risk if three conditions stated in paragraph 6.8A.66 above are met. In this example, the derivative hedging instrument satisfies all of these conditions, as follows:
   
The risks hedged can be identified clearly. The risks are the exposures to changes in the forward exchange rates between US dollars and yen and yen and pounds, respectively.
The effectiveness of the hedge can be demonstrated. For the pound sterling bond, the effectiveness is measured as the degree of offset between the fair value of the principal repayment in pounds sterling and the fair value of the pound sterling payment on the forward exchange contract. For the US dollar liability, the effectiveness is measured as the degree of offset between the fair value of the principal repayment in US dollars and the US dollar receipt on the forward exchange contract. Even though the receivable has a 10-year life and the forward protects it for only the first 5 years, hedge accounting is permitted for only a portion of the exposure as described in paragraph 6.8A.32 above.
It is possible to ensure that there is specific designation of the hedging instrument and different risk positions. The hedged exposures are identified as the principal amounts of the liability and the note receivable in their respective currency of denomination.
[IAS 39 para IG F1.13].
 
It should be noted that in respect of the second point above, the US $/£ forward is theoretically divided into two different derivatives. The Yen is imputed as the base currency for the two derivatives creating a synthetic US$/Yen (receive US dollar, pay Yen) foreign currency forward and a synthetic ¥/£ (receive Yen, pay sterling) foreign currency forward. The synthetic Yen leg is defined in such a manner that the fair value of each synthetic forward contract is nil at the hedge’s inception. This can be pictorially represented as follows:
 
25a631
 
Furthermore, it should be noted that the hedge accounting criteria must be satisfied for both the designated hedged risks. For instance, if effectiveness of the hedge can be demonstrated for US$/¥ risk only and not ¥/£ risk, hedge accounting is not permitted. Similarly, if one of the hedged risks no longer exists or a hedge effectiveness test is failed for that risk during the term of the hedge then both hedges must be discontinued. This is because a derivative instrument must be fair valued and used as a hedging instrument in its entirety apart from the specific exemptions discussed in paragraph 6.8A.60.

Example 2 – Hedging a floating rate foreign currency debt with a floating rate cross currency interest rate swap
 
Entity A’s functional currency is sterling. Entity A has issued a floating rate (3 month USD LIBOR) bond denominated in USD and on the same date entered into a cross currency swap to hedge the bond to floating rate (3 month Stg LIBOR) in sterling. So the swap (after the initial exchange of principal amounts) is to receive 3 month USD LIBOR plus USD principal, and to pay 3 month Stg LIBOR plus Stg principal.
 
Entity A wishes to designate the swap in its entirety as a cash flow hedge of the foreign exchange and interest rate risk on the bond so as to minimise ineffectiveness, including from currency basis. However, the swap can be designated as a cash flow hedge of spot foreign exchange risk only. All variability due to foreign exchange has been eliminated and the foreign exchange movements, including the effect of changes in currency basis, can be recognised in OCI.
 
As regards interest rate risk, this cannot be designated as being hedged as entity A’s exposure to cash flow variability associated with interest rate changes has not been reduced. Rather entity A has merely exchanged one exposure to variable rates (3 month USD LIBOR) for another (3 month Stg LIBOR).
 
Under paragraph IG F5.5 of IAS 39 the hypothetical derivatives method can be used to measure the effectiveness of cash flow hedges. In the circumstances described, the USD leg of the hypothetical derivative would mirror the hedged debt and hence have a receive leg of receive 3 month USD LIBOR plus USD principal. However the sterling leg should be to pay sterling overnight rates plus sterling principal (that is, with daily resets) to exclude any interest rate risk. As a result of the sterling leg of the hypothetical derivative resetting daily, some ineffectiveness will arise. Entity A will need to assess whether this is so big as to prevent the use of hedge accounting.

6.8A.68 It is also possible to use a single derivative instrument to hedge more than one risk in more than one hedged item. In order to do this, the entity should be able to identify the hedged risks in each of the hedged items and split the single derivative into its components in order to allocate those components to each hedged risk identified. As a derivative has only a single fair value, care should be taken in splitting a derivative so that it does not result in the recognition of cash flows in the single hedging instrument that do not contractually exist. Hedging multiple risks in multiple items in this way is complex and the desired effectiveness may not always be achieved. Therefore, expert guidance should always be sought.

Example 1 – Cross currency interest rate swap hedging multiple risks in multiple hedged items
 
Entity A’s functional currency is the euro. On the same date, entity A has issued a 10 year fixed-rate debt denominated in US dollar with an annual 5% coupon and has made a 10 year 6 months LIBOR + 80bp loan to a third party in sterling. Entity A has also entered into on the same date a cross-currency interest rate (CCIR) US$ fixed/£ floating swap. Under the terms of the swap. Entity A will receive fixed interest in US dollar at 4% and will pay variable 6-month LIBOR interest in sterling. The entity wishes to obtain hedge accounting for the swap.
 
With regard to the loan asset, entity A is exposed to a £/€ exchange risk, because the loan is denominated in sterling which is not entity A’s functional currency. It is also exposed to cash flow interest rate risk (sterling 6 months LIBOR) because entity A will pay variable coupon on the loan. Entity A is also exposed to a credit risk (change in the credit rating of the issuer of the loan).
 
With regard to the liability, entity A is exposed to a risk of changes in the fair value of the debt due to €/US$ exchange risk (both the notional amount and the interest on the loan are denominated in US dollars, which is not entity A’s functional currency). Entity A is also exposed to fair value interest rate risk (US$ 6 months LIBOR is defined as the benchmark risk), because it will pay fixed coupon in US$ on the debt.
 
Two ways in which entity A could use the CCIR swap as a hedging instrument are described below. A single swap (receive US$ 4% fixed, pay floating £) may be analysed into its separate risk components for hedging purposes by imputing a notional leg denominated in the entity’s functional currency. The additional leg may be either fixed or floating, provided the chosen alternative qualifies for hedge accounting for both of the exposures hedged and effectiveness can be reliably measured for both elements. Prospective and retrospective effectiveness testing must be performed on both elements of the hedge relationship. Both elements must be highly effective in order for the hedge relationship to qualify for hedge accounting.
 
Therefore, the entity could separate the swap by inserting a euro floating leg (6 month LIBOR) into the CCIR swap, creating a US$ fix/€ float swap and a € float/£ float swap. Entity A will end up with a fair value hedge of both the interest rate and currency risk on the US $ debt and a cash flow hedge of the foreign currency exposure on the sterling floating rate loan. This is shown in the diagram below.
 

25a632

 
Alternatively, entity A could separate the swap by inserting a € fixed leg into the CCIR swap, creating a US $ fixed/€ fixed swap and a € fixed/£ floating swap. Entity A will end up with a cash flow hedge of the currency risk on the US$ debt and a cash flow hedge of the interest rate and foreign currency risk on the sterling floating rate loan. This is shown in the diagram below.
 
25a6321
 
The risks hedged can be identified clearly.
 
Situation 1 (€ floating leg)
 
For the US$ denominated debt, the hedging relationship is a fair value hedge of the exposure to changes in the fair value attributable to both changes in the 6 months US LIBOR interest rate (benchmark rate) and US$/€ spot rate movements.
 
For the sterling floating loan, the hedging relationship is a cash flow hedge of the variability in cash flow attributable to the £/€ spot rate movements.
 
Situation 2 (€ fixed leg)
 
For the US$ denominated debt, the hedging relationship is a cash flow hedge of the variability in cash flow on the fixed rate US$-denominated debt attributable to the US$/€ spot rate movements.
 
For the sterling floating loan, the hedging relationship is a cash flow hedge of the variability in cash flow attributable to both the change in sterling 6 months LIBOR (benchmark rate) and £/€ spot rate movements.

Example 2 – Using a single FX forward to hedge forecast transactions in two different currencies
 
Entity J, whose functional currency is the euro, has highly probable forecast sales in US dollars and highly probable forecast purchases in Japanese yen. Entity J enters into an external foreign currency forward contract to sell US dollars and buy Japanese yen. Entity J’s management intends to designate the foreign currency forward contract as a hedge of both the US dollar/euro foreign currency risk associated with the forecast sales and the Japanese yen/euro foreign currency risk associated with the forecast purchases.
 
For hedge effectiveness testing the Japanese yen/US dollar forward contract is theoretically divided into two different derivatives. The euro is imputed as the base currency for the two derivatives creating a synthetic US dollar/euro foreign currency forward and a synthetic euro/Japanese yen foreign currency forward. The hedged item is designated as two risks:

■   The foreign currency cash flow risk associated with the forecast US dollar sales.
The foreign currency cash flow risk associated with the forecast Japanese yen purchases.
   
25a633
 
The Japanese yen/US dollar forward may be designated as a cash flow hedge of both the foreign currency cash flow risks associated with the forecast sales in US dollars and the forecasted purchases in Japanese yen, provided all of the conditions in paragraph 76 of IAS 39 are met.
 
This solution is consistent with paragraph IG F2.18 of IAS 39, which allows a Japanese yen functional currency entity to designate a US dollar/sterling swap as a hedge of both a US dollar liability and sterling asset. However, each hedging relationship must be tested for effectiveness separately and if one of the two hedging relationships becomes ineffective (either because an effectiveness test is failed or because one of the forecast transactions is no longer highly probable to occur), hedge accounting will be discontinued prospectively for both hedge relationships.

Hedging instruments - Derivative financial instruments - Combination of derivative instruments

Publication date: 08 Dec 2017


6.8A.69 A derivative may also be designated as the hedging instrument in combination with one or more other derivatives, or even, for a hedge of foreign exchange risk, in combination with groups of non-derivative assets or liabilities. Two or more derivatives or proportions of them may be viewed in combination and jointly designated as the hedging instrument, provided none of them is a written option or a net written option (see further para 6.8A.75 below). For hedges of currency risk, two or more non-derivatives, or proportions of them, may be designated as the hedging instrument. [IAS 39 para 77].

6.8A.70 Derivative instruments do not have to be similar to be combined, either together or with non-derivative instruments. Even when the risks arising from some derivatives offset(s) those arising from others, the combination can still be designated as a hedging instrument. [IAS 39 para 77].

6.8A.71 Multiple derivatives need not be acquired at the same time to be designated as a hedge of the same item. They could be acquired at different times. For instance, an entity can designate two purchased options as a hedge of the same hedged item. Multiple derivatives can be used to hedge the same risk or different risks, provided that all of the other hedge criteria have been met and there is no ‘duplicate’ hedging of the same risk. For example, assume that two derivatives are designated as a hedge of the risk of a change in the fair value of a foreign currency denominated bond. One derivative hedges interest rate risk and the other hedges currency risk. In assessing an expectation of offsetting changes in fair value that are attributable to the type of risk that is being hedged, an entity would consider the two hedges separately, since the derivatives are hedging two separate risks.

Example – Combination of derivatives designated as a hedging instrument
 
Entity A’s functional currency is pound sterling. On 1 January 20X5, the entity issues a 5 year 5% fixed-rate £100m debt with interest payable annually on 31 December. The debt is classified as other financial liabilities.

The risk management policy of entity A requires it to pay variable rate interest on debt except during the first 2 years. Accordingly, entity A enters into:
 
A 5-year £100m notional receive fixed 5%, pay floating (3 month LIBOR) interest swap (swap 1).
A 2-year £100m notional pay fixed 5%, receive floating (3 month LIBOR) interest swap (swap 2).
 
IAS 39 permits entity A to designate the combination of swap 1 and swap 2 as a hedge of the fair value exposure relating to interest rate movements in the debt instrument for the cash flows on the bond (principal plus interest) that will occur in period 1 January 20X7 to 31 December 20X9. This is because IAS 39 permits the designation of a portion of the fair value or cash flows of a financial instrument as a hedged item. Therefore, provided that all criteria for hedge accounting are met (in particular the hedge, as described, is expected to be highly effective and the new hedge relationship is consistent with entity A’s risk management policies), fair value hedge accounting can be applied.

As a result of combining the two swaps entity A will achieve its objective of paying fixed interest in the first two years and achieve fair value hedge of the interest rate risk in the remaining 3 years as shown below:
 
1067
 
Changes in the aggregate fair value of swap 1 and swap 2 will be recognised in profit or loss. Similarly changes in the fair value of the debt attributable to interest rate movements relating to the period 1 January 20X7 to 31 December 20X9 will be recognised in profit or loss (see para 6.8A.107 below). Some ineffectiveness is likely to arise because of the variable rate leg of swap 1 that is not mirrored in the hedged item. Also, the fair value of swap 2 is based on a different section of the yield curve from the section of the yield curve used for determining swap 1’s fair value of (2 year versus 5 years).

6.8A.72 IAS 39 also permits derivative instruments to be combined with non-derivative instruments, or proportions of them, and the combination designated as the hedging instrument, but only for hedges of foreign currency risk. For example, a Swedish kroner functional currency entity could hedge its net investment in Korea with debt denominated in US dollars combined with a pay Korean won receive US dollar swap (excluding forward points) in its consolidated financial statements. Alternatively, if the entity wanted to minimise ineffectiveness in the profit or loss account, the entity may impute two identical (but offsetting) Swedish kroner pay and receive legs and then designate the resulting pay Swedish kroner receive US dollar swap as a hedge of the US dollar debt and the receive Swedish kroner pay Korean won swap as a hedge of its foreign net investment in Korea. Similarly, an entity could use a combination of a foreign currency cash instrument and a derivative to hedge the foreign currency risk of a firm commitment, provided all the hedge accounting conditions are met. However, a combination of a non-derivative and derivative cannot be the hedged item.

Hedging instruments - Derivative financial instruments - Options as hedging instruments

Publication date: 08 Dec 2017


6.8A.73 Options, in contrast to forward and swaps, give the holder the right but not the obligation to exercise the instrument and exchange the underlyings. Generally, options that have the potential to reduce risk exposure can qualify as hedging instruments. For instance, a purchased option has potential gains equal to or greater than losses and, therefore, has the potential to reduce profit or loss exposure from changes in fair values or cash flows. Therefore, it can qualify as a hedging instrument. [IAS 39 para AG 94].

Example 1 – Purchased option as a hedging instrument in cash flow hedges
 
Entity A operates a mail-order business. Its functional currency is the euro, but it purchases approximately 20% of its merchandise from the USA.
 
Entity A issues the mail-order catalogue for the coming year, incorporating its price list, before entering into a firm purchase commitment with US suppliers. Entity A, therefore, sets the prices in the catalogue based on expected exchange rates of €1=US$1.25. It is highly probable that the entity will make purchases of at least €500,000 from the US in the first six months.
 
The entity’s documented risk management policy requires it to hedge the risk that exchange rates will be higher than expected by purchasing a call option to buy US dollars for euros with a strike price equal to the expected exchange rate. Entity A, therefore, purchased a call option at a rate of €1=US$1.25, for a maximum of €500,000 in six months’ time at a cost of €60,000.
 
The spot rate at the time of entering into the option contracts was €1= US$1.1.
 
Entity A can designate the intrinsic value of the purchased option as a hedge against the movements in the €/$ exchange rate. The exposure being hedged is the variability in cash flows that would arise if the US dollar exchange rate exceeds the expected level of €1 = US$1.25.

Example 2 – Purchased option as a hedging instrument in fair value hedges
 
Entity A has issued a 5 year €100m debt that bears interest at a fixed rate of 3%. It wishes to hedge the risk of increases in the fair value of the debt if interest rates decrease. It enters into a €100m 5 year floor on 3 month EURIBOR with a strike rate of 3%.
 
The purchased option (the interest rate floor) can be designated as a hedging instrument in a hedge of changes in the fair value of the 5 year debt as a result of changes in interest rates. IAS 39 states that a financial item may be hedged with respect to the risks associated with only a portion of its cash flow or fair value, provided that effectiveness can be measured (see para 6.8A.23 above). It is, therefore, possible to designate the hedge as the risk of changes in the fair value if interest rates fall below 3%. The effectiveness of the hedge will be improved if the entity designates only the intrinsic value of the floor as the hedging instrument. In this case, the floor’s time value is excluded from the hedge relationship and changes in time value are recognised in the income statement as they occur.

6.8A.74 In a hedge of one-sided risk, entities are permitted to designate the hedged risk as the intrinsic value of a purchased option that has the same principal terms as the hedged item, but may not include the time value of the option. For example, an entity can designate the variability of future cash flow outcomes resulting from a price increase of a forecast commodity purchase. [IAS 39 para AG99BA]. Only cash flow losses that result from an increase in the price above the specified level are designated. The inclusion of an option’s time value is prohibited in the designated one sided risk on a non-optional hedged item because time value is not a component of a forecast transaction that will affect profit or loss. [IAS 39 para 86(b)]. Greater hedge effectiveness is, therefore, likely to be achieved if the hedging instrument is designated in the same way – that is, to exclude time value. Since hedging a one-sided risk is not a hedge of a portion, this covers financial as well as non-financial items. An option may be in-the-money at the time of designation from an intrinsic value perspective. It may be possible to hedge account in these circumstances as long as only changes in the intrinsic value after the date of designation are deferred in OCI.

6.8A.75 A written option (as opposed to a purchased option) exposes its writer to the possibility of unlimited loss but limits the gain to the amount of premium received. A written option serves only to reduce the potential for gain in the hedged item or hedged transaction. It leaves the potential for loss on the hedged item or hedged transaction unchanged, except for the amount of the premium received. As a result, a written option generally increase risk exposure because the potential loss on an option that an entity writes could be significantly greater than the potential gain in value of a related hedged item. In other words, a written option is not effective in reducing the profit or loss exposure of a hedged item. Therefore, a written option does not qualify as a hedging instrument, either on its own or in combination with other derivatives, unless it is designated as an offset to a purchased option. In addition, a written option can be designated as an offset to a purchase option that is embedded in another financial instrument. For example, in a callable debt, a written option can be used as a hedging instrument to hedge the callable liability where the issuer can call the debt early. [IAS 39 para AG 94].

6.8A.76 An entity may enter into a hedging strategy that involves a written put option and a purchased call option combining to form a collar. The objective of such a hedging strategy is to protect the entity from loss below a certain value (the floor/written put) and also limit the upside potential for gain above a certain value (the cap/purchased call) so as to reduce the cost of the hedging strategy. A typical example is an interest rate collar. Such an interest rate collar or other derivative instrument that combines a written option and a purchased option does not qualify as a hedging instrument if it is, in effect, a net written option (for which a net premium is received). [IAS 39 para 77].

6.8A.77 However, an interest rate collar or other derivative instrument that includes a written option may be designated as a hedging instrument, if the combination is a net purchased option or zero cost collar (that is, it is neither a net written or a net purchased option). Such a combination is not a net written option and, therefore, can be designated as a hedging instrument provided all the following conditions are met:

No net premium is received either at inception or over the life of the combination of options. The distinguishing feature of a written option is the receipt of a premium to compensate the writer for the risk incurred.
Except for the strike prices, the critical terms and conditions of the written option component and the purchased option component are the same (including underlying variable or variables, currency denomination and maturity date).
The notional amount of the written option component is not greater than the notional amount of the purchased option component.
[IAS 39 para IG F1.3].

6.8A.78 Where a collar whose fair value was zero at inception is designated as a hedging instrument some time into its life, it may have some fair value on the date of designation. If its fair value on the date of designation is negative then the first criteria above would be failed and such a collar would not be allowed for designation as a hedging instrument. However, if the negative fair value is only due to the deferral of a premium, then the negative nature does not create an exposure linked to net written options, and therefore the instrument could be designated as a hedging instrument providing the other conditions are met. If the collar’s fair value is zero or positive then, subject to compliance with criteria two and three it could be designated as a hedging instrument.

6.8A.79 It should be noted that since a collar combines two options, it is subject to the 2008 amendment to IAS 39 described in paragraph 6.8A.74. Hence, it will not be fully effective if the net time value of the written and purchased options is included in the designation of the hedging instrument. That is, ineffectiveness is minimised where the collar is designated on an intrinsic value basis (see para 6.8A.207 onwards).

6.8A.80 If a combination of a written option and a purchased option (such as an interest rate collar) is transacted as a single instrument with one counterparty, an entity cannot split the derivative instrument into its written option component and purchased option component and designate the purchased option component as a hedging instrument. This is because a hedging relationship is designated by an entity for a hedging instrument in its entirety. The only exceptions permitted are splitting the time value and intrinsic value of an option and splitting the interest element and spot price on a forward (see para 6.8A.60 above). [IAS 39 para IG F1.8].

Example 1 – Combination of written and purchased options
 
Entity A purchases a call option from bank X and sells a put option to bank Y. Bank X and bank Y are not related. The contracts are entered into on the same day, with the purpose of creating a collar. The premium paid on the purchased call equals the premium received on the sold put; no net premium is, therefore, received.
 
The combination of these two instruments cannot be designated as a hedging instrument, as one of the options is a sold (written) option for which a premium is received. A collar can only be designated as a hedging instrument if the purchased and written option are combined in a single instrument and the collar is not a net written option (that is, no net premium is received).
 
If the two instruments have the same counterparty and are entered into simultaneously and in contemplation of one another with the intent of creating a collar, the two instruments should be viewed as one transaction.

Example 2 – Combination of written and purchased options
 
Entity A holds a variable interest rate debt and wishes to hedge the risk of the interest rate increasing above 3%. Entity A’s assessment of the risk of the interest rate increasing above 4% is remote and it is prepared to bear that excess risk. It, therefore, enters into a ‘cap spread’ structure, which is a single instrument, consisting of:
   
the purchase of an interest rate cap whose strike rate is 3% (purchased option); and
the sale of an interest rate cap whose strike rate is 4% (written option).
 
The cap spread is structured as a single contract entered into with the same counterparty.
 
Entity A can designate the hedged risk as the risk that the interest rate rises to between 3% and 4%, provided that the cap spread does not constitute a net written option (that is, the entity does not receive a net premium for the cap spread). In this case, the entity is permitted to apply hedge accounting if the strategy is in line with the company’s risk management strategy and all other conditions for hedge accounting are met.
 
If the entity had entered into two separate options (a purchased interest rate cap and a written interest rate cap), it could not designate both options as the hedging instrument. This is because two or more derivatives may be jointly designated as the hedging instrument only when none of them is a written option.

Example 3 – Designating a combination of several derivatives as a hedging instrument in a fair value hedge
 
Entity A has issued a 7%, 5 year fixed rate bond and at the same time entered into a receive-fixed (7%), pay-floating (LIBOR) 5 year interest rate swap to hedge the bond against changes in fair values resulting from changes in interest rates. The entity has also entered into a zero cost collar (a combination of written floor at 5% and purchased cap at 10%) to limit variability in cash flows arising from the combination of the fixed rate debt and interest rate swap. There is no net premium received for the cap and floor, therefore, there is no net written option.
 
Entity A’s management can designate the combination of the interest rate swap and the zero cost collar as a hedging instrument to hedge the changes in the bond’s fair value arising from changes in the risk-free rate, provided all other hedge accounting criteria required by paragraph 88 of IAS 39 are met. Although the zero cost collar contains a written option component, this is written as a single instrument and the combination is not a net written option as no premium is received by entity A at inception or over the contract’s life. The hedging documentation could specify that the hedged risk is the risk of changes in the bond’s fair value arising from changes in the risk-free rate within the range from 5% to 10%. Specifying the hedge in this way would improve hedge effectiveness.

Hedging instruments - Derivative financial instruments - Dynamic hedging strategies

Publication date: 08 Dec 2017


6.8A.81 IAS 39 states that a dynamic hedging strategy that assesses both an option contract’s intrinsic value and time value can qualify for hedge accounting. [IAS 39 para 74]. This allows an entity to apply hedge accounting for a ‘delta neutral’ hedging strategy and other dynamic hedging strategies under which the quantity of the hedging instrument is constantly adjusted in order to maintain a desired hedge ratio (for example, to achieve a delta neutral position insensitive to changes in the hedged item’s fair value). For example, a portfolio insurance strategy that seeks to ensure that the hedged item’s fair value item does not drop below a certain level, while allowing the fair value to increase, may qualify for hedge accounting. [IAS 39 para IG F1.9].

6.8A.82 To qualify for hedge accounting, the entity must document how it will monitor and update the hedge and measure hedge effectiveness, be able to track properly all terminations and redesignations of the hedging instrument and demonstrate that all other criteria for hedge accounting in IAS 39 are met. Also, it must be able to demonstrate an expectation that the hedge will be highly effective for a specified short period of time during which the hedge is not expected to be adjusted. [IAS 39 para IG F1.9].

Example – Dynamic hedging strategy
 
Entity A whose functional currency is the euro has an investment in a listed equity security denominated in US dollars. The fair value at acquisition was US$ 70 and entity A hedged it by entering into a sell US$ 70 buy €44 foreign currency forward. Entity A periodically re-assesses the fair value of the equity security and FX revaluation of it is based on such fair value. Entity A also re-assesses the amount of the exposure that should be hedged in accordance with its strategy. For instance, if the fair value of the security reduces from US$ 70 to US$ 40 then the nominal amount of the forward should be adjusted from sell US$ 70 to US$ 40.
 
When changing the amount of hedged exposure in US$, entity A first:
   
de-designates the existing hedge relationship between US$ 70 security vs. sell US$70/buy €44 forward;
enters into a new foreign currency forward contract (being buy US$ 30 sell €20) with the same maturity date to modify its position; and
re-designates the new combination of derivative instruments (the previous hedging instrument being buy US$ 70/sell €44 plus the new forward being sell US$ 30 / buy €20) as the hedging instrument.
   
Entity A is permitted to periodically de-designate and re-designate the cash flow hedge relationship. However the mechanism of de-designation and re-designation must be properly documented and consistent with its risk management policy. Assuming that the other hedge accounting criteria are met, the accounting treatment at the date of de-designation and re-designation is as follows:
   
Hedge accounting may be applied to the original hedge relationship until the date of its de-designation.
Hedge accounting may be applied to the second hedge relationship starting from the date of re-designation.
 
The strategy described will require a significant amount of documentation to support the de-designation/re-designation process and a detailed monitoring of the accounting entries. Entity A will have to disclose in its financial statements the objective of this hedging strategy and the corresponding policies, together with a discussion of the associated risks and the business objectives pursued.

6.8A.83 It follows from the above that there is no prohibition in IAS 39 against terminating one hedge and initiating another with the same hedging instrument. Furthermore, there is no limitation on the frequency of such terminations/designations and re-designations. Provided an entity can properly track all of the terminations and re-designations and demonstrate that all other qualifying criteria, such as high effectiveness, have been met, hedge accounting using the same instrument on a recurring basis is not prohibited. However, initiating new hedging relationships with existing derivatives may not qualify for hedge accounting if the ineffectiveness caused by the derivatives’ ‘non-zero’ fair value is too great to satisfy the 80%-125% range for effectiveness. As noted in paragraph 6.8A.59, settlement of the opening non-zero fair value is not itself a fair value change and can be excluded from the effectiveness calculations.

Example – Continuation of hedge accounting where the underlying reference risk is changed and additional hedging instruments are entered into
 
Entity A borrows money from a bank on 1 January 20X1 by entering into a 5 year floating rate bullet loan with a bank. The loan contract allows entity A to elect at each reset date whether the interest should be based on 3 month LIBOR or 1 month LIBOR. Entity A enters into a 5 year pay fixed (say 4%) receive floating interest rate swap, with the notional terms matching those of the loan. The swap’s floating leg prices off 3 month LIBOR, and entity A elects the loan to also price off 3 month LIBOR. The net effect economically is a synthetic fixed rate loan of 4%.
 
In January 20X3, entity A recognises an opportunity to save 10 bps based on the differential between 1 month LIBOR and 3 month LIBOR. It decides to elect that the loan should be priced off 1 month LIBOR for the next year. Simultaneously, it enters into a basis swap with a bank, paying 3 month LIBOR and receiving 1 month LIBOR (with spreads). The net effect amounts to a synthetic fixed rate loan of 3.9% for the next year, and a synthetic fixed rate loan of 4% for the remainder of the loan term, assuming that entity A will elect the loan interest as 3 month LIBOR for the remaining period. 
 
6883libor
 
Hedge accounting should be available at inception, and even if the new basis swap is not entered into, providing that the hedged risk is designated to allow for potential variability in the reference rate. That variability will result in some ineffectiveness each time the reference rate changes. Note that the hedging documentation must still document the hedged risk with enough specificity to identify the hedged transaction/risk when it occurs.
 
If the hedged risk is designated as “cash flow changes due to changes in the 3 month LIBOR rate” (being the initial pricing mechanism) and does not anticipate that the reference rate might change, then the hedging relationship would cease when management elect a new reference rate.
 
However, if a new basis swap is entered into in January 20X3 as proposed then only a partial de-designation of the hedge would be needed in the example where the documentation did not allow for flexibility in the reference rate (and no de-designation where potential variability was documented). The benchmark rate for year three cash flows would be re-assessed based on the 1 month LIBOR rates on the re-designation date. The remaining hedge relationship would continue and the combination of the two interest rate derivatives would be compared to the change in the fair value of the hedged item for effectiveness testing purposes.

Hedging instruments - Derivative financial instruments - All-in-one hedges

Publication date: 08 Dec 2017


6.8A.84 Under IAS 39, a derivative can be an instrument which is settled gross by delivery of the underlying asset and the payment of the price specified in the contract rather than by net settlement of the difference between the two legs. The implementation guidance states that such an instrument can be designated as a hedging instrument in a cash flow hedge of the variability of the consideration to be paid or received in the future transaction that will occur on gross settlement of the derivative contract itself, assuming the other cash flow hedge accounting criteria are met. Without the derivative, there would be an exposure to variability in the purchase or sale price. As the derivative eliminates the exposure, it qualifies as a hedging instrument. This applies to all fixed price contracts that are accounted for as derivatives under IAS 39.

Example – Gross settled derivative designated as an ‘all-in-one hedge’
 
An entity enters into a forward contract to purchase a bond that will be settled by delivery. The forward contract is a derivative, because its term exceeds the regular way delivery period in the marketplace.
 
The entity may designate the forward as a cash flow hedge of the variability of the consideration to be paid to acquire the bond (a future transaction), even though the derivative is the contract under which the bond will be acquired. [IAS 39 para IG F2.5].

6.8A.85 Such ‘all-in-one hedge’ accounting strategy can be beneficial to entities. For instance, if an entity enters into a fixed price contract to buy a commodity that falls to be accounted for as a derivative under IAS 39, the contract would be recognised at fair value with gains and losses recognised in profit or loss. By applying an all-in-one hedge accounting strategy, the entity is able to defer gains and losses on the hedging instrument in equity under cash flow hedge accounting until the hedged transaction occurs. In other words, the entity is able to keep gains and losses from being recognised in profit or loss on what is effectively a fixed price purchase or sale commitment.

6.8A.85.1 A question arises as to whether it is possible to achieve an all-in-one hedge when there is some variability in the contractual cash flows for the reporting entity. In our view, any variables that would have been closely related if the contract could have been accounted for as an executory contract outside the scope of IAS 39 should not prevent the otherwise fixed price contract being designated as an all-in-one hedge, provided that it can be documented that the hedge is expected to be highly effective. For example, a non-executory contract to purchase a commodity at a future date at a fixed price denominated in the counterparty’s functional currency could be eligible to be designated as an all-in-one hedge.

Hedging instruments - Derivative financial instruments - Internal hedging instruments

Publication date: 08 Dec 2017


6.8A.86 Entities with sophisticated central treasury functions often use internal hedging transactions to ‘transfer’ interest rate and currency risk to the group treasury. For instance, central treasury may enter into internal derivative contracts such as forward contracts and swaps with subsidiaries and various divisions of a consolidated group with the objective of ‘converting’ all financial assets and liabilities of those operating units to variable rate instruments in the reporting currency. Central treasury will assess its exposure to various currencies and to interest rate risk and enter into external forward contracts and swaps to manage those risks on a centralised basis, thereby generating economies of scale and pricing efficiency.

6.8A.87 Consistent with paragraph 6.8A.39 above, internal derivative contracts used to transfer risk exposures between different companies within a group or divisions within a single legal entity cannot be designated as hedging instruments if the derivative contracts are internal to the entity being reported on. It follows that internal derivative contracts cannot be designated as hedging instruments in the consolidated financial statements. Nor can they be designated as hedging instruments in the individual or separate financial statements of a legal entity for hedging transactions between divisions in the entity. IAS 39 makes it clear that only instruments that involve a party external to the reporting entity (that is, a group, or an individual entity that is being reported on) can qualify as designated hedging instruments.

6.8A.88 However, if an internal contract is offset with an external party, the external contract may be regarded as the hedging instrument and the hedging relationship may qualify for hedge accounting. [IAS 39 para IG F1.4]. In such situations, the hedging relationship consists of the external instrument and the item that was the subject of the internal hedge. The internal derivative is often used as a tracking mechanism to relate the external derivative to the hedged item. Indeed, many entities take advantage of this provision in IAS 39 that allows them to net risk through a central treasury centre and thereafter hedge the net exposure by entering into external contracts with third parties. This avoids the cost of each subsidiary entering into contracts with third parties, some of which may duplicate each other. The following example illustrates the situations described above.

Example – Internal derivative contracts
 
The banking division of Entity A enters into an internal interest rate swap with the trading division of the same entity. The purpose is to hedge the interest rate risk exposure of a loan (or group of similar loans) in the loan portfolio. Under the swap, the banking division pays fixed interest payments to the trading division and receives variable interest rate payments in return.
 
If a hedging instrument is not acquired from an external party, IAS 39 does not allow hedge accounting treatment for the hedging transaction undertaken by the banking and trading divisions. This is because only derivatives that involve a party external to the entity can be designated as hedging instruments. [IAS 39 para 73]. Furthermore, any gains or losses on intra-group or intra-entity transactions are eliminated on consolidation. Therefore, transactions between different divisions within entity A do not qualify for hedge accounting treatment in entity A’s financial statements. Similarly, transactions between different entities within a group do not qualify for hedge accounting treatment in entity A’s consolidated financial statements.
 
However, if in addition to the internal swap in the above example the trading division enters into an interest rate swap or other contract with an external party that offsets the exposure hedged in the internal swap, hedge accounting is permitted under IAS 39. For the purposes of IAS 39, the hedged item is the loan (or group of similar loans) in the banking division and the hedging instrument is the external interest rate swap or other contract.
 
The trading division may aggregate several internal swaps or portions of them that are not offsetting each other and enter into a single third party derivative contract that offsets the aggregate exposure. Under IAS 39, such external hedging transactions may qualify for hedge accounting treatment provided that the hedged items in the banking division are identified and the other conditions for hedge accounting are met. It should be noted, however, that hedge accounting is not permitted where the hedged items are held-to-maturity investments and the hedged risk is the exposure to interest rate changes. [IAS 39 para IG F1.4].

6.8A.89 IAS 39 provides a very useful summary of its application to internal hedging transactions that is reproduced below.

The standard does not preclude an entity from using internal derivative contracts for risk management purposes and it does not preclude internal derivatives from being accumulated at the treasury level or some other central location so that risk can be managed on an entity-wide basis or at some higher level than the separate legal entity or division.
Internal derivative contracts between two separate entities within a consolidated group can qualify for hedge accounting by those entities in their individual or separate financial statements, even though the internal contracts are not offset by derivative contracts with a party external to the consolidated group.
Internal derivative contracts between two separate divisions within the same legal entity can qualify for hedge accounting in that legal entity’s individual or separate financial statements only if those contracts are offset by derivative contracts with a party external to the legal entity.
Internal derivative contracts between separate divisions within the same legal entity and between separate entities within the consolidated group can qualify for hedge accounting in the consolidated financial statements only if the internal contracts are offset by derivative contracts with a party external to the consolidated group.
If the internal derivative contracts are not offset by derivative contracts with external parties, the use of hedge accounting by group entities and divisions using internal contracts must be reversed on consolidation.
[IAS 39 para IG F1.4].
 
For segment reporting purposes entities may present financial information including the effects of hedging as reported to management; for that purpose entities do not have to meet the IAS 39 criteria for hedge accounting. This was the subject of an amendment published in 2008 that removed reference to segments from paragraph 73 of IAS 39. Hence, internal derivatives between segments may be freely accounted for as hedges for the purpose of segment reporting if this is the information presented to the chief operating decision maker. Disclosure of intra-group hedging policies may be required.

Hedging instruments - Derivative financial instruments - Internal hedging instruments - Offsetting internal hedging instruments

Publication date: 08 Dec 2017


6.8A.90 As noted in the example in paragraph 6.8A.86 above, central treasury often, before laying off the risk, first nets off internal derivative contracts against each other and then enters into a single third party derivative contract that offsets the net exposure. The circumstances in which such a single external contract can be treated as a hedging instrument on consolidation is considered below in the context of interest rate risk and foreign currency risk management.

Example 1 – Offsetting internal derivative contracts used to manage interest rate risk
 
Entity A has a number of subsidiaries. All treasury activities of the group are undertaken by entity A. Individual subsidiaries intending to hedge their exposure to interest rate risk are required to enter into separate derivative contracts with entity A.
 
Entity A aggregates the internal derivative contracts and enters into a single external derivative contract that offsets the internal derivative contracts on a net basis. For instance, Entity A may enter into three internal receive-fixed, pay-variable interest rate swaps (total notional amount of say C100m) that lay off the exposure to variable interest cash flows on variable rate liabilities in the three subsidiaries and one internal receive-variable, pay-fixed interest rate swap (notional amount of C80m) that lays off the exposure to variable interest cash flows on variable rate assets in another subsidiary. It then enters into receive-variable, pay-fixed interest rate swap (notional amount of C20m) with an external counterparty that exactly offsets the four internal swaps. It is assumed that the hedge accounting criteria are met.
 
In entity A’s consolidated financial statements, the single offsetting external derivative would not qualify as a hedging instrument in a hedge of an overall net position, that is, it cannot be used to hedge all of the items that the four internal derivatives are hedging, as explained in paragraph 6.8A.31 above.
 
However, as explained in paragraph 6.8A.32 above, designating a part of the underlying items as the hedged position on a gross basis is permitted, that is, the external derivative can hedge C20m of variable rate liabilities totalling C100m. Therefore, even though the purpose of entering into the external derivative was to offset internal derivative contracts on a net basis, hedge accounting is permitted if the hedging relationship is defined and documented as a hedge of a part of the underlying cash inflows or cash outflows on a gross basis. [IAS 39 para IG F2.15].

Example 2 – Offsetting internal derivative contracts hedging foreign currency fair value risk
 
An entity has a number of subsidiaries. Subsidiary A has trade receivables in foreign currency (FC) of 100, due in 60 days, which it hedges using a forward contract with the treasury centre (TC) subsidiary. Subsidiary B has payables of FC50, also due in 60 days, which it hedges using a forward contact with TC. TC nets the two internal derivatives and enters into a net external forward contract to pay FC50 and receive LC in 60 days.
 
At the end of month 1, FC weakens against LC. Subsidiary A incurs a foreign exchange loss of LC10 on its receivables, offset by a gain of LC10 on its forward contract with TC. Subsidiary B makes a foreign exchange gain of LC5 on its payables offset by a loss of LC5 on its forward contract with TC. TC makes a loss of LC10 on its internal forward contract with subsidiary A, a gain of LC5 on its internal forward contract with subsidiary B, and a gain of LC5 on its external forward contract. At the end of month 1, the following entries are made in the individual or separate financial statements of subsidiary A, subsidiary B and TC.
 
  Dr (Cr)
Accounting entries Receivable Payable Derivative P&L

Subsidiary A        
Recognition of loss on receivable (10)     10
Recognition of gain on internal derivative     10 (10)
         
Subsidiary B        
Recognition of gain on payable   5   (5)
Recognition of loss on internal derivative     (5) 5
         
Central Treasury (TC)        
Recognition of loss on internal derivative with A     (10) 10
Recognition of gain on internal derivative with B     5 (5)
Recognition of gain on external derivative     5* (5)

* External derivative        
         
The above entries are recorded in the individual financial statements of the three entities. In this case, no hedge accounting is required because gains and losses on the internal derivatives and the offsetting losses and gains on the hedged receivables and payables are recognised immediately in the income statements of entity A and entity B without hedge accounting.
         
In the consolidated financial statements, the internal derivative transactions are eliminated. In economic terms, the payable in B hedges FC50 of the receivables in A. The external forward contract in TC hedges the remaining FC50 of the receivable in A. Hedge accounting is not necessary in the consolidated financial statements, because monetary items are measured at spot foreign exchange rates under IAS 21 irrespective of whether hedge accounting is applied.
 
The net balances before and after eliminating the accounting entries relating to the internal derivatives are the same, as set out below. Accordingly, there is no need to make any further accounting entries on consolidation to meet the requirements of IAS 39.

  Dr (Cr)
  Receivable Payable Derivative P&L

Consolidation        
Receivable in A (10)      
Payable in B   5    
External derivative     5  

[IAS 39 para IG F1.7].

Example 3 – Offsetting internal derivative contracts hedging foreign currency cash flow risk
 
An entity has a number of subsidiaries. Subsidiary A has highly probable future revenues of FC200 on which it expects to receive cash in 90 days. B has highly probable future expenses of FC500 (advertising cost), also to be paid for in 90 days. Entity A and entity B enter into separate forward contracts with TC to hedge these exposures and TC enters into an external forward contract to receive FC300 in 90 days.
 
FC weakens at the end of month 1.
 
A incurs a ‘loss’ of LC20 on its anticipated revenues because the LC value of these revenues decreases. This is offset by a ’gain’ of LC20 on its forward contract with TC.
 
B incurs a ‘gain’ of LC50 on its anticipated advertising cost because the LC value of the expense decreases. This is offset by a ’loss’ of LC50 on its transaction with TC.
 
TC incurs a ‘gain’ of LC50 on its internal transaction with B, a ‘loss’ of LC20 on its internal transaction with A and a loss of LC30 on its external forward contract.
 
Entity A and entity B complete the necessary documentation, the hedges are effective, and both entity A and entity B qualify for hedge accounting in their individual financial statements. A defers the gain of LC20 on its internal derivative transaction in a hedging reserve in equity and B defers the loss of LC50 in its hedging reserve in equity. TC does not claim hedge accounting, but measures both its internal and external derivative positions at fair value, which net to zero. At the end of month 1, the following entries are made in the individual or separate financial statements of A, B and TC.
   
  Dr (Cr)
Hedge accounting entries at end of month 1 Derivative Equity P&L

Subsidiary A      
Recognition of gain on internal derivative with TC 20 (20)  
       
Subsidiary B      
Recognition of loss on internal derivative with TC (50) 50  
       
Subsidiary TC      
Recognition of loss on internal derivative with A (20)   20
Recognition of gain on internal derivative with B 50   (50)
Recognition of loss on external derivative (30)*   30

* External derivative      
       
For the consolidated financial statements, TC’s external forward contract on FC300 is designated, at the beginning of month 1, as a hedging instrument of the first FC300 of B’s highly probable future expenses. IAS 39 requires that in the consolidated financial statements at the end of month 1, the accounting effects of the internal derivative transactions must be eliminated. However, the net balances before and after elimination of the accounting entries relating to the internal derivatives are the same, as set out below. Accordingly, there is no need to make any further accounting entries in order for the requirements of IAS 39 to be met.
 
Note that only FC300 in costs that were designated in hedge relationships are effectively reported at the hedged foreign currency rate in profit or loss. The revenue and cost of sales that were not designated in hedge relationships are reported at the currency rate ruling on the date of the respective transactions.
       
Consolidation Derivative Equity P&L

Recognition of loss on external derivative (30) 30  

[IAS 39 para IG F1.7].      

Example 4 – Offsetting internal derivative contracts hedging fair value and cash flow risks
 
Assume that the exposures and the internal derivative transactions are a combination of the transactions in examples 2 and 3 above. However, instead of entering into two external derivatives to hedge separately the fair value and cash flow exposures, TC enters into a single net external derivative to receive FC250 in exchange for LC in 90 days.
 
TC has four internal derivatives, two maturing in 60 days and two maturing in 90 days. These are offset by a net external derivative maturing in 90 days. The interest rate differential between FC and LC is minimal and, therefore, the ineffectiveness resulting from the mismatch in maturities is expected to have a minimal effect on profit or loss in TC.
 
As in examples 2 and 3, subsidiary A and subsidiary B apply hedge accounting for their cash flow hedges and TC measures its derivatives at fair value. Subsidiary A defers a gain of LC20 on its internal derivative transaction in equity and subsidiary B defers a loss of LC50 on its internal derivative transaction in equity.
 
At the end of month 1, the following entries are made in the individual or separate financial statements of subsidiary A, subsidiary B and TC.
   
  Dr (Cr)
Hedge accounting entries Receivable Payable Derivative Equity P&L

Subsidiary A          
Loss on receivable (10)       10
Gain on internal derivative with TC (FV)     10   (10)
Gain on internal derivative with TC (CF)     20 (20)  

  (10)   30 (20)

Subsidiary B          
Gain on payable   5     (5)
Loss on internal derivative with TC (FV)     (5)   5
Loss on internal derivative with TC (CF)     (50) 50  

    5 (55) 50

Subsidiary TC          
Loss on internal derivative with A (FV)     (10)   10
Loss on internal derivative with A (FV)     (20)   20
Gain on internal derivative with B (CF)     5   (5)
Gain on internal derivative with B (CF)     50   (50)

Loss on external contract (Net)     (25)*   25

* External derivative      

The gross amounts relating to fair value of monetary assets and liabilities and the forecast transactions in subsidiary A and subsidiary B are as follows:
  Dr (Cr) Dr (Cr)
  Monetary items Forecast transactions

Subsidiary A 100     200
Subsidiary B   50 500  


For the consolidated financial statements, the following designations are made at the beginning of month 1:
   
The payable of FC50 in entity B is designated as a hedge of the first FC50 of the highly probable future revenues in entity A (non-derivative financial liability designated as a hedging instrument hedging foreign exchange risk). Therefore, at the end of month 1, the following entries are made in the consolidated financial statements: Dr Payable LC5; Cr Other comprehensive income LC5.
The receivable of FC100 in entity A is designated as a hedge of the first FC100 of the highly probable future expenses in entity B (non-derivative financial asset designated as a hedging instrument in hedging foreign exchange risk). Therefore, at the end of month 1, the following entries are made in the consolidated financial statements: Dr Other comprehensive income LC10, Cr Receivable LC10.
The external forward contract on FC250 in TC is designated as a hedge of the next FC250 of highly probable future expenses in entity B. Therefore, at the end of month 1, the following entries are made in the consolidated financial statements: Dr Other comprehensive income LC25; Cr External forward contract LC25.
 
In the consolidated financial statements at the end of month 1, IAS 39 requires the accounting effects of the internal derivative transactions to be eliminated. The effect of the above entries are summarised below:

Consolidation Receivable Payable External derivative Other comprehensive income/equity

Hedge accounting entries (10) 5 (25) 30

         
As can be seen, the total net balances before and after elimination of the accounting entries relating to the internal derivatives are the same, as set out above. Accordingly, there is no need to make any further accounting entries to meet the requirements of IAS 39. [IAS 39 para IG F1.7].

6.8A.91 An entity’s risk management objectives and strategies may require an entity to enter into a master netting agreement with a counterparty under which the entity is required to settle all external derivative contracts with that counterparty on a net basis. Although netting arrangements imply that an entity is able to set off profitable and loss making contracts against each other, this, in itself, would not preclude the external derivative contracts from being designated as hedging instruments.

Example – External derivative contracts that are settled net
 
Entity A has a number of subsidiaries. All the group’s treasury activities are undertaken by entity A. Individual subsidiaries intending to hedge their exposure to interest rate risk are required to enter into separate derivative contracts with entity A, which in turn enters into a separate offsetting matching derivative contract with a single external counterparty B. For instance, if entity A enters into an intra-group receive 5% fixed, pay LIBOR or interest rate swap, then entity A would also enter into a separate offsetting pay 5% fixed, receive LIBOR interest swap with counterparty B.
 
Although each of the external derivative contracts is formally documented as a separate contract, only the net of the payments on all of the external derivative contracts is settled by entity A, as there is a netting agreement with the external counterparty B.
 
The individual external derivative contracts, such as the pay 5% fixed, receive-LIBOR interest rate swap above, can be designated as hedging instruments of underlying gross exposures, such as the exposure to changes in variable interest payments on the pay-LIBOR borrowing above, in the group’s consolidated financial statements, even though the external derivatives are settled on a net basis.
 
External derivative contracts that are legally separate contracts and serve a valid business purpose, such as laying off risk exposures on a gross basis, qualify as hedging instruments even if those external contracts are settled on a net basis with the same external counterparty, provided the hedge accounting criteria in IAS 39 are met. [IAS 39 para IG F2.16]. Note that it would not be considered a valid business purpose if the entity entered into the two transactions only to achieve hedge accounting for one of them (that is, if accounting treatment for one of them was the only reason for entering into two transactions and not one).
 
It may well be that by entering into the external offsetting contracts and including them in the centralised portfolio, entity A is no longer able to evaluate the exposures on a net basis. As a result, it may decide to manage the portfolio of offsetting external derivatives separately from the entity’s other exposures. Thus, it enters into an additional, single derivative to offset the portfolio’s risk.
 
In this situation, the individual external derivative contracts in the portfolio can still be designated as hedging instruments of underlying gross exposures. This is so even if the final external derivative is affected with the same counterparty under the same netting arrangement and, as a result, may net to zero.
 
The purpose of structuring the external derivative contracts in the above manner, which is consistent with the entity’s risk management objectives and strategies, constitutes a substantive business purpose. Therefore, external derivative contracts that are legally separate contracts and serve a valid business purpose qualify as hedging instruments. In other words, hedge accounting is not precluded simply because the entity has entered into a swap that mirrors exactly the terms of another swap with the same counterparty if there is a substantive business purpose for structuring the transactions separately. [IAS 39 para IG F2.16]. [IAS 39 para IG F1.14].

Hedging instruments - Non-derivative financial instruments

Publication date: 08 Dec 2017


6.8A.92 As stated in paragraph 6.8A.56 above, a non-derivative financial asset or liability may only be designated as a hedging instrument for foreign currency risk. This means that foreign currency cash deposits, loans and receivables, available-for-sale monetary items and held-to-maturity investments carried at amortised cost may be designated as a hedging instrument in a hedge of foreign currency risk. Similarly, a contract to purchase the non-controlling interest in a subsidiary which is required to be recognised as a liability under paragraph 23 of IAS 32 is not accounted for as a derivative and, accordingly, could be designated as a hedged item or a hedging instrument in a hedge of foreign currency risk only. The following examples illustrate the type of situations in which a non-derivative financial instrument can be designated as a hedging instrument.

Example 1 – Hedging with a non-derivative the fair value exposure of an available-for-sale bond
 
Entity J, whose functional currency is the Japanese yen, has issued US$5m 5 year fixed rate debt. It also owns a US$5m 5 year fixed rate bond that it has classified as available-for-sale. Entity J intends to designate its US dollar liability as a hedging instrument in a fair value hedge of the entire fair value exposure of its US dollar bond.
 
The total change in bond’s fair value is a function of interest rate risk, currency risk and credit risk. The debt instrument is a non-derivative that cannot be used to hedge the entire fair value exposure of the bond. However, the debt instrument can be designated as a hedge of the foreign currency component of the bond in either a fair value or cash flow hedge.
 
In this situation, hedge accounting is unnecessary since the amortised cost of the hedging instrument and the hedged item are both remeasured using closing rates with any differences arising in the period recognised in profit or loss in accordance with IAS 21. In other words, there is a natural offset regardless of whether entity J designates the relationship as a cash flow hedge or a fair value hedge. Any gain or loss on the non-derivative hedging instrument designated as a cash flow hedge is immediately recognised in profit or loss in accordance with paragraph 100 of IAS 39 to correspond with the recognition of the change in spot rate on the hedged item in profit or loss. [IAS 39 para IG F1.1].

Example 2 – Hedging a firm commitment with a non-derivative financial instrument
 
Entity J’s functional currency is the Japanese yen. It has issued a fixed rate debt instrument with semi-annual interest payments that matures in 2 years with principal due at maturity of US$5 million. It has also entered into a fixed price sales commitment for US$5 million that matures in 2 years and is not accounted for as a derivative because it meets the exemption for normal sales. Entity J intends to designate the fixed rate debt instrument as a hedge of the entire fair value change of the firm sales commitment.
 
The US dollar liability cannot be designated as a fair value hedge of the entire fair value exposure of its fixed price sales commitment and qualify for hedge accounting, because it is a non-derivative. However, as IAS 39 permits the designation of a non-derivative asset or liability as a hedging instrument in either a cash flow hedge or a fair value hedge of foreign exchange risk, entity J can designate its US dollar liability as a cash flow hedge of the foreign currency exposure associated with the future receipt of US dollars on the fixed price sales commitment.
 
Any gain or loss on the non-derivative hedging instrument that is recognised in equity during the period preceding the future sale is recognised in profit or loss when the sale takes place (see further para 6.8A.133 below). [IAS 39 para IG F1.2].

Example 3 – Hedging a foreign currency exposure in a net investment with a hedging instrument denominated in a different currency
 
An entity with a Sing$ functional currency has an investment in a subsidiary in Hong Kong with a HK$ functional currency. Since the HK$ is linked to the US$, management decides to designate a US dollar borrowing as the hedging instrument in a hedge of its net investment.
 
Management may use a US$ borrowing to hedge a net investment denominated in HK$ if it is highly correlated to that currency, there is qualitative evidence to support the relationship and actual results are in the range of 80-125%. It is possible to designate a borrowing in one foreign currency as a hedge of a net investment in another currency with any ineffectiveness recognised in profit or loss. However, the requirements of paragraph AG105 of IAS 39 – that the hedging instrument is expected to be highly effective – is likely to prevent the use of hedge accounting for most currency pairs. A high degree of correlation between the two currencies would be achieved if one of the currencies was formally pegged to the other, as in this case, but for hedge accounting to be possible, it must be reasonable to assume that this correlation will continue. Some ineffectiveness will arise as a result of inefficiencies in the linking mechanism.

6.8A.93 Consistent with paragraph 6.8A.64 above, a proportion of a non-derivative financial instrument, such as 50% of the carrying amount of a foreign currency liability, may be designated as the hedging instrument. However, as stated in paragraph 6.8A.65 above, an entity cannot treat the cash flows of only a proportion of the period during which a non-derivative instrument designated as a hedge against foreign currency risk remains outstanding and exclude the other cash flows from the designated hedging relationship. For example, the cash flows during the first three years of a ten – year borrowing denominated in a foreign currency cannot qualify as a hedging instrument in a cash flow hedge of the first three years of revenue in the same foreign currency.

Hedging instruments - Items that do not qualify as hedging instruments

Publication date: 08 Dec 2017


6.8A.94 Generally, financial assets and financial liabilities whose fair value cannot be reliably measured cannot be hedging instruments. This means that an investment in an unquoted equity instrument that is not carried at fair value because its fair value cannot be reliably measured, or a derivative that is linked to and must be settled by, delivery of such an unquoted equity instrument cannot be designated as a hedging instrument. [IAS 39 para AG 96].

6.8A.95 An entity’s own equity instruments are not financial assets or financial liabilities of the entity and, therefore, cannot be designated as hedging instruments. [IAS 39 para AG 97]. Similarly, minority interests in consolidated financial statements are treated as part of equity and, hence, cannot be designated as hedging instruments in the consolidated financial statements.

6.8A.96 Firm commitments and forecast transactions cannot be designated as hedging instruments since they are not normally recognised in the financial statements. However, if the foreign currency component of the sales commitment is required to be separated as an embedded derivative under paragraph 11 of IAS 39 and paragraph AG33(d) of IAS 39, it could be designated as a hedging instrument in a hedge of the exposure to changes in the fair value of the maturity amount of the debt attributable to foreign currency risk. [IAS 39 para IG F1.2].

6.8A.97 IFRS 3 requires an acquirer entity to re-assess “designation of a derivative instrument as a hedging instrument in accordance with IAS 39…on the basis of the pertinent conditions as they exist at the acquisition date”. [IFRS 3 para 16]. In other words the acquirer is required to re-designate all hedge relationships of the acquired entity as if they started at the date of acquisition.

6.8A.98 Corporates that are using derivatives for hedging normally take them out at market rate. If the derivatives do not contain option provisions they are expected, therefore, to have fair value of zero at inception. If such derivatives are designated as hedges at inception the underlying hedged risk (modelled as a hypothetical derivative – see para 6.8A.192) would be almost a mirror of the actual derivative and such hedge relationships are often highly effective.

6.8A.99 As market rates would be likely to have changed from the inception of acquiree’s hedges until the date of the business combination the requirement to re-assess designation of derivatives as hedges means that the underlying hypothetical derivative would have to be ‘re-set’ to the market rates current at the time of business combination and, hence, their fair value would then also be ‘re-set’ to zero.

6.8A.100 The ‘off-market’ nature of the hedging derivative at the date of acquisition could be described as an embedded financing within the derivative, representing the amount that would have to be paid to settle a derivative liability (or the amount that would be received to settle a derivative asset) at the date that the entity decides to re-designate the derivative in a new hedge relationship.

6.8A.101 The derivative itself will still be recorded at full fair value going forward and this embedded financing does not necessarily keep the new hedge relationship from being within the required range of effectiveness (80%-125%), but it could be a source of ineffectiveness. Specifically, it is the change in fair value of the financing element that represents the hedge ineffectiveness, not the eventual settlements of the embedded financing element. As a result more hedge relationships will be likely to fail, or at least there will be more ineffectiveness.

The hedge accounting models

Publication date: 08 Dec 2017


6.8A.102 Hedge accounting recognises the offsetting effects on profit or loss of changes in the fair values of the hedging instrument and the hedged item. Hedge accounting may be applied to three types of hedging relationships:

Fair value hedges (see para 6.8A.104 below).
Cash flow hedges (see para 6.8A.119 below).
Hedges of a net investment in a foreign operation (see para 6.8A.137 below).
[IAS 39 para 86].

The hedge accounting models - Risk reduction and hedge accounting

Publication date: 08 Dec 2017


6.8A.103 IAS 39 does not require risk reduction on an entity-wide basis as a condition for hedge accounting. Exposure is assessed on a transaction basis, focusing on the risks inherent in an individual item. For example, an entity may have a fixed rate asset and a fixed rate liability, each having the same principal amount. Under the instrument’s terms, interest payments on the asset and liability occur in the same period and the net cash flow is always positive, because the interest rate on the asset exceeds the interest rate on the liability. The entity may decide to enter into an interest rate swap to receive a floating interest rate and pay a fixed interest rate on a notional amount equal to the asset’s principal and designate the interest rate swap as a fair value hedge of the fixed rate asset. Although the effect of the interest rate swap on an entity-wide basis is to create an exposure to interest rate changes that did not previously exist, hedge accounting may be applied to this hedge relationship provided that the relevant hedge accounting criteria are met. [IAS 39 para IG F2.6].

The hedge accounting models - Fair value hedges - Definition

Publication date: 08 Dec 2017


6.8A.104 A ‘fair value hedge’ is a hedge of the exposure to changes in fair value of a recognised asset, liability or unrecognised firm commitment, or portion thereof, that is attributable to a particular risk and could affect profit or loss. [IAS 39 para 86(a)].

6.8A.105 Examples of fair value hedges that often occur in practice are shown below:

Hedges of market price risk exposure   Fair value exposure
An entity fixes the value of its commodity inventory by entering into a commodity futures contract. The entity is hedging the risk of changes in the inventory’s overall fair value.
   
An entity purchases a put option to protect the fall in value of its quoted equity investments. The entity is hedging the risk of fall in the fair value of the equity securities below the option’s strike price.
   
Hedges of interest rate exposures  
An entity with fixed rate debt converts the debt into a floating rate using an interest rate swap. The entity is hedging the risk of changes in the fair value of the debt due to changes in interest rate.
   
Hedges of foreign currency exposures  
An entity enters into a binding contract to purchase machinery for a fixed amount in foreign currency at a future date and hedges the amount in its functional currency by entering into a forward foreign exchange contract. The entity is hedging the risk of changes in the value of the contract to purchase machinery due to changes in foreign exchange rate.
   
An entity enters into a forward contract to hedge a foreign currency receivable or a payable due for settlement in six months’ time. The entity is hedging the risk of changes in the carrying amount of the receivable or payable due to changes in foreign exchange rate.

The hedge accounting models - Fair value hedges - Fair value hedge accounting

Publication date: 08 Dec 2017


6.8A.106 Under IAS 39, if a fair value hedge meets the hedge accounting conditions discussed in paragraph 6.8A.155 below during the period, it should be accounted for as follows:

the gain or loss from re-measuring the hedging instrument at fair value (for a derivative hedging instrument) or the foreign currency component of its carrying amount measured in accordance with IAS 21 (for a non-derivative hedging instrument) should be recognised in profit or loss; and
the gain or loss on the hedged item attributable to the hedged risk adjusts the carrying amount of the hedged item and is recognised in profit or loss. This applies even if the hedged item is an available-for-sale financial asset or if it is otherwise measured at cost.
[IAS 39 para 89].

6.8A.107 As stated in the second bullet point above, where the hedged item is an available-for-sale financial asset, the gain or loss attributable to the risk being hedged is recognised in profit or loss, rather than other comprehensive income, although the remainder of any fair value change is still recognised in other comprehensive income

6.8A.108 The standard explains that if only particular risks attributable to a hedged item are hedged, recognised changes in the hedged item’s fair value unrelated to the hedged risk are recognised in accordance with paragraph 55 of IAS 39 (see chapter 6.7). This means that changes in fair value of a hedged financial asset or financial liability that is not part of the hedging relationship would generally be accounted as follows:

For instruments measured at amortised cost, such changes would not be recognised.
For instruments measured at fair value through profit or loss, such changes would be recognised in profit or loss in any event.
For available-for-sale financial assets, such changes would be recognised in other comprehensive income as explained above. However, exceptions to this would include foreign currency gains and losses on monetary items and impairment losses, which would be recognised in profit or loss in any event.

6.8A.109 If the fair value hedge is fully effective, the gain or loss on the hedging instrument would exactly offset the loss or gain on the hedged item attributable to the risk being hedged and there would be no net effect in profit or loss. However, this would rarely be the case and often some difference would arise. The recognition of this difference in profit or loss is commonly referred to as hedge ineffectiveness. Hedge ineffectiveness is considered further from paragraph 6.8A.206 below.

6.8A.110 An in-depth application of fair value hedge accounting for a hedge of interest rate risk of a fixed rate debt instrument using an interest rate swap (including full prospective and retrospective hedge effectiveness testing) is illustrated in the comprehensive examples included at the end of this chapter.

Example – Fair value hedge of inventory (commodity)
 
On 1 October 20X5, a metal refining entity has 1m troy ounces of silver in its inventory. The silver is recorded at an average historical cost of C5.00 per ounce (C5m total value). To protect the inventory from a decline in silver prices, the entity hedges its position by selling 200 silver futures contracts on a specified commodity exchange. Each contract is for 5,000 troy ounces of silver priced at C5.55 per ounce. The futures contracts mature on 31 March 20X6, which is the date that the entity has scheduled delivery of the entire silver inventory to its customer at the spot price at that date.
 
The entity designates the futures contract as a fair value hedge of its silver inventory (that is, it is hedging changes in the inventory’s fair value). Based on historical data, the entity determines and documents that changes in the fair value of the silver futures contracts will be highly effective in offsetting all changes in the fair value of the silver inventory.
 
On 31 December 20X5 (the entity’s financial year end) and on 31 March 20X6, the entity determines that the fair value of its silver inventory has declined cumulatively by C160,000 and C320,000 respectively. The fair value of the silver inventory has declined by more than the spot price of silver, because the fair value of the inventory is influenced by other factors such as changes in expected labour and transport costs.
 
On 31 March 20X6, the entity closes out its futures. On the same day it also sells the entire silver inventory at the spot price of C5.25 per ounce.
 
The following data is relevant:
       
Date Spot price Futures price (for delivery on 31 March 20X6) Fair value of futures contract assuming yield curve is flat at 6% per year*
  C C C
1 Oct 20X5 5.40 5.55
31 Dec 20X5 5.30 5.40 147,830
31 Mar 20X6 5.25 5.25 300,000
*Fair value = (1m ounces × (5.55 – 5.40))/1.06¼ = C147,830
*Fair value = (1m ounces × (5.55 – 5.25)) = C300,000

The entity assesses hedge effectiveness by comparing the entire change in the fair value of the futures contract to the entire change in the fair value of the silver inventory, based on futures prices. A summary of the hedge’s effectiveness, calculated using the dollar offset method discussed in paragraph 6.8A.186, is shown below.
       
Date Change in full fair value of future contracts Change in full fair value of inventory Effectiveness ratio for the period
  Gain (loss) Gain (loss)  
  C C C
31 Dec 20X5 147,830 160,000 92.39
31 Mar 20X6 152,170 160,000 95.11
       

Ignoring any margin payments on the futures contract, the accounting entries from inception of the hedge to its termination following closure of the future contracts (which is settled daily) and delivery of inventory are as follows:
Dr (Cr)
Date Transaction Cash Futures contract Inventory Profit or loss
C C C C
31 Dec 20X5 Change in fair value of futures contract   147,830   (147.830)
31 Dec 20X5 Change in fair value of silver stock   (160,000) 160,000
31 Dec 20X5 Cumulative cash settlement for period* 147,830 (147,830)
   
  Entity A’s year end 147,830 (160,000) 12,170
31 Mar 20X6 Change in fair value of futures contract 152,170   (152,170)
31 Mar 20X6 Change in fair value of silver stock   (160,000) 160,000
31 Mar 20X6 Sale of silver @ 5.25 5,250,000     (5,250,000)
31 Mar 20X6 Cost of sale     (4,680,000) 4,680,000
31 Mar 20X6 Cumulative cash settlement for period* 152,170 (152,170)
   
    5,550,000 (5,000,000) (550,000)
   
 
* Futures contracts are settled daily. The entries summarises the daily journals for each day throughout the quarter.
 
The fair value hedge example illustrates that if the entity had not hedged the change in fair value of the silver stock, it would have made a gain of C250,000 (revenue of C5,250,000 less cost of sales of C5,000,000).  By entering into the hedge the company has ‘locked in’ a net profit of C550,000, that is, gross profit of C570,000 (revenue of C5,250,000 less cost of sales of C4,680,000) less loss of C20,000 on the hedging activity. In this example, the hedge was not 100% effective, which lead to some ineffectiveness being recognised in profit or loss.
 
At the entity’s year end, the derivative asset and the carrying value of the inventory amounted to C147,830 and C4,840,000. The carrying value of C4,840,000 is neither cost nor realisable value nor fair value. It is cost less a hedging adjustment. The gain on the derivative offsets the loss on the inventory in profit or loss, except for ineffectiveness of C12,170. This matching is achieved by accelerating the recognition in the profit or loss of part of the gain or loss on the silver inventory. In other words part of the gain or loss that would normally be recognised only on the sale of the inventory is recorded earlier. Therefore, in the case of a fair value hedge, hedge accounting accelerates income recognition on the hedged item to match the profit or loss effect of the hedging instrument.

The hedge accounting models - Fair value hedges - Adjustments to hedged items

Publication date: 08 Dec 2017


6.8A.111 The adjustment made to the carrying amount of a hedged asset or liability due to fair value changes that are attributable to a specific hedged risk, as stated in the second bullet point in paragraph 6.8A.106 above, are dealt with in accordance with the normal accounting treatment for that item. The adjustment is often referred to as a ‘basis adjustment’, because the hedging gain or loss adjusts the carrying value of the hedged item resulting in an amount that is neither cost nor fair value. Thus, in the above example, changes in fair value of silver are adjusted against the carrying value of silver inventory and the adjusted carrying amount becomes the cost basis for the purposes of applying the lower of cost and net realisable value test under IAS 2. In other words, the basis adjustment remains part of the carrying value of inventory and enters into the determination of earnings when the inventory is sold.

6.8A.112 When the hedged item is an interest bearing financial instrument for which the effective interest rate method of accounting is used, any adjustment to the carrying amount of the hedged financial instrument should be amortised to profit or loss. The adjustment should be based on a recalculated effective interest rate at the date the amortisation begins and should be fully amortised by maturity. Amortisation may begin as soon as an adjustment exists and should begin no later than when the hedged item ceases to be adjusted for changes in its fair value attributable to the risk being hedged. [IAS 39 para 92].

6.8A.113 The IASB decided to permit entities to defer amortisation of a basis adjustment until the hedged interest bearing financial instrument ceases to be basis adjusted in order to simplify the accounting and record keeping that an entity might otherwise have to undertake to track and properly account for such adjustments, as explained in the example below.

Example – Deferral of amortisation of basis adjustment
 
Entity A enters into an interest rate swap contract to hedge changes in the fair value of a fixed rate borrowing of C100m due for settlement in 5 years. The terms of the borrowing and the swap exactly match. Interest rates rise so that the borrowing’s fair value falls to C90m and the swap’s fair value changes from zero to – C10m.
 
Under fair value hedge accounting, the swap is carried as a liability of C10m (less any settlement paid). The carrying amount of the borrowing is reduced to C90m. Both the loss and the gain are recognised in the profit or loss. Under the amortised cost method, the C90m carrying amount of the liability would be amortised back up to C100m, giving rise to additional finance cost over the remaining period to maturity.
 
As explained above, the standard allows amortisation to be deferred until hedge accounting is discontinued. If the swap is in place until the borrowing’s maturity date, the debt’s carrying amount will be adjusted back to C100m through further hedge accounting adjustments. In other words, any fair value adjustments to the debt’s carrying value would be reversed by maturity as the fair value of the liability immediately before settlement must be C100m. Therefore, no amortisation will be necessary.
 
However, if only the first 2 years of the debt instrument is hedged for interest rate risk and the entity chooses to defer amortisation until end of year 2 when hedge accounting ceases, a significant income statement impact could result in later periods. This is because the entity would need to ‘catch up’ the basis of the hedged item to its settlement amount of C100m over the remaining 3 years.

The hedge accounting models - Fair value hedges - Hedges of firm commitments

Publication date: 08 Dec 2017


6.8A.114 Hedges of firm commitments are generally treated as fair value hedges except in one situation. If a firm commitment has a price fixed in foreign currency, the standard allows the hedge of the foreign currency risk in the firm commitment to be accounted for as a cash flow hedge of the foreign currency risk. [IAS 39 para 87]. If a firm commitment has a fixed price in the functional currency of the entity rather than a price fixed in a foreign currency, there would be no cash flow variability in the entity’s functional currency in the anticipated transaction and cash flow hedging would not be possible. For this reason, hedges of firm commitments, other than those denominated in a foreign currency, are accounted for as fair value hedges because the entity is exposed to changes in fair value of that commitment.

6.8A.115 When an unrecognised firm commitment to acquire an asset or assume a liability is designated as a hedged item in a fair value hedge, the accounting treatment is as follows:

The subsequent cumulative change in the fair value of the firm commitment attributable to the hedged risk since inception of the hedge is recognised as an asset or a liability with a corresponding gain or loss recognised in profit or loss.
The changes in the fair value of the hedging instrument are also recognised in profit or loss.
When the firm commitment is fulfilled, the initial carrying amount of the asset or liability is adjusted to include the cumulative change in the firm commitment that was recognised in the balance sheet under point one above.
[IAS 39 para 93]. [IAS 39 para 94].

Example – Measurement of the fair value of a firm commitment
 
On 1 January 20X6 entity A enters into a firm commitment to purchase 100,000 widgets for C5 each in 6 months’ time. On 31 March 20X6, the entity’s year end, the market price of the widgets has increased to C6.
 
The fair value of a firm commitment represents the amount that an entity would have to pay, or the amount that it would receive, upon terminating the commitment. On 1 January 20X6, the company has an obligation to pay C500,000 in 6 months’ time and a right to receive 100,000 widgets in 6 months. The initial value of the obligation and the right are generally equal, resulting in a net fair value of zero.
 
At 31 March 20X6 when the widget’s market price increases to C6, the right’s value to receive widgets increases. This is because the widget’s value received in three months would be C600,000, while the obligation to pay C500,000 in three months would remain the same, resulting in a fair value that reflects the C100,000 difference adjusted for the discount that is appropriate for the remaining three month duration of the commitment. The present value of the C100,000 represents the amount that the entity could reasonably expect to receive if the counterparty to the commitment were to terminate the commitment at 31 March 20X6.
 
Firm commitments represent rights and obligations that are assets and liabilities, even though they are generally not recorded. If entity A designates the firm commitment as a hedged item, it would account for the changes in the fair value of the hedged commitment due to changes in the market price of widgets in a manner similar to how that entity would account for any hedged asset or liability that it records. That is, changes in fair value (that are attributable to the risk that is being hedged) would be recognised in profit or loss and, on the balance sheet, recognised as an adjustment of the hedged item’s carrying amount.
 
Because firm commitments normally are not recorded, accounting for the initial change in the fair value of the firm commitment would result in the entity recognising the firm commitment on the balance sheet. Therefore, in this example, the entity would record the present value of C100,000 as an asset on the balance sheet with a corresponding gain in profit or loss. Recognition of subsequent changes in fair value would adjust that recognised firm-commitment amount. Assuming no further changes in fair value, the widgets would be recognised on the balance sheet on 30 June 20X6 at C600,000 (being C500,000 purchase price plus the C100,000 basis adjustment).

The hedge accounting models - Fair value hedges - Discontinuing fair value hedge accounting

Publication date: 08 Dec 2017


6.8A.116 Fair value hedge accounting should be discontinued prospectively if any of the following occurs:

The hedging instrument expires or is sold, terminated or exercised. For this purpose, the replacement or rollover of a hedging instrument into another hedging instrument is not an expiration or termination if such replacement or rollover is part of the entity’s documented hedging strategy.
The hedge no longer meets the criteria for hedge accounting discussed in paragraph 6.8A.155 below.
The entity revokes the designation.
[IAS 39 para 91].

6.8A.117 When an entity ceases to apply hedge accounting because the hedge does not meet hedge effectiveness criteria, it should discontinue hedge accounting from the last date on which compliance with hedge effectiveness was demonstrated. However, if the event or change in circumstances that caused the hedging relationship to fail the effectiveness criteria can be identified and it can be demonstrated that the hedge was effective before the event or change in circumstances occurred, the entity should discontinue hedge accounting from the date of the event or change in circumstances. [IAS 39 para AG 113].

6.8A.118 The table below sets out the accounting treatment to be applied when fair value hedge accounting is discontinued.

Discontinuance of fair value hedges (including firm commitments)
  Hedging instrument Hedged item
Hedge termination events Continue mark-to-market accounting De-recognise from the balance sheet De-recognise from the balance sheet Freeze basis adjustments
  Note 1 Note 2 Note 3
Hedging instrument no longer exists (that is, sold, terminated, extinguished, exercised or expired)    
The hedge no longer meets the criteria for hedge accounting (effectiveness)    
The entity revokes the hedge designation    
The hedged item is sold or extinguished    

Note 1 – The hedging instrument will continue to be marked to market, unless it is re-designated as a hedging instrument in a new hedge.
 
Note 2 – The de-recognition of the hedged item occurs through profit or loss (for example, the firm commitment asset or liability or the gain or loss on sale or extinguishment of the hedged item (inclusive of fair value basis adjustments) is recognised in profit or loss).
 
Note 3 – The hedged item ceases to be adjusted for changes in its fair value attributable to the risk being hedged and continues to be accounted for in a manner that was applicable prior to it being hedged. Once the basis adjustment on the hedged item is frozen, it either:
   
Continues as part of the carrying amount of the asset up to the date the carrying value is recovered through use or sale or the asset becomes impaired.
Is amortised through profit or loss (for interest bearing financial instruments). Amortisation should begin no later than when the hedged item ceases to be adjusted for changes in its fair value attributable to the risk being hedged (see para 6.8A.117 above).

Example 1 – Discontinuance of a fair value hedge of a bond
 
Two years ago, entity A issued at par a C4m, 5 year fixed interest rate bond. At the same time, it entered into a 5-year fixed-to-floating interest rate swap that it designated as a fair value hedge of the bond. After 2 years, the hedge fails a retrospective test and the entity determines it is no longer expected to be highly effective for the remaining 3 years of the hedge. At the date the hedge last passed an effectiveness test, the bond’s carrying value included a cumulative adjustment of C0.2m, reflecting the change in the fair value of the hedged risk.
 
Entity A discontinues hedge accounting prospectively (that is, previous accounting entries are not reversed). If the reason for discontinuance is that the hedge failed an effectiveness test, hedge accounting is discontinued from the last date when the hedge was demonstrated to be effective.
 
The adjustments to the carrying amount of the hedged item to reflect the changes in fair value that are attributable to the hedged risk remain as part of the item’s carrying value, but no further adjustments are made in future periods. When the hedged item is carried at amortised cost, these previous hedging adjustments are amortised over the item’s remaining life by recalculating its effective interest rate, or on a straight-line basis if this is not practicable.
 
The adjusted carrying value of C4.2m will be the basis for calculating a new effective interest rate, starting from the last date the hedge passed an effectiveness test. The hedging adjustment of C0.2m is, therefore, recognised in profit or loss over the bond’s remaining life.

Example 2 – Discontinuance of a fair value hedge of an available-for-sale investment
 
Entity A is a Swiss entity whose functional currency is the Swiss franc (CHF). Entity A buys an equity investment in entity X, which is classified as available-for-sale. Entity X’s shares are listed only in the US in US dollars and it pays dividends in US dollars. The fair value at the date of purchase including transaction costs is US$10m.
 
Entity A does not want to be exposed to the risk of future losses if the US$ weakens against the CHF. It intends to hold the investment for 2 years and enters into a forward contract to sell US$ and receive CHF in 2 years, with a notional amount of US$9m to hedge US$9m of the fair value of the investment in entity X.
 
Entity A designates the forward contract as a fair value hedge of the currency risk on US$9m of its investment in entity X. This designation allows entity A to take the foreign exchange movements on US$9m of the investment to the income statement to offset the fair value changes in the derivative. The rest of the fair value movements in CHF for the instrument are retained in equity until the instrument is sold.
 
One year later, entity A believes that the US dollar is not likely to decline further and decides to discontinue the hedge and revoke the hedge designation. The hedge is demonstrated to have been highly effective up to the time it is discontinued.
 
Entity A discontinues hedge accounting prospectively (that is, previous accounting entries are not reversed). When the hedged item is an equity instrument classified as available-for-sale, all future changes in the instrument’s fair value, including all changes related to exchange rate movements, are deferred in equity until the instrument is sold or impaired.

The hedge accounting models - Cash flow hedges - Definition

Publication date: 08 Dec 2017


6.8A.119 A ‘cash flow hedge’ is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability or a highly probable forecast transaction and could affect profit or loss. [IAS 39 para 86(b)].

6.8A.120 Examples of some cash flow hedges that often occur in practice are shown below:

Hedges of market price risk exposure   Cash flow exposure
     
An entity that has a highly probable sales of a commodity in the future at the then prevailing market price ‘fixes’ the selling price of the goods by entering into a futures contract.   The entity is hedging the risk of variability in the cash flows to be received on the sale due to changes in the good’s market price.
     
Hedges of interest rate exposures    
     
An entity with floating rate debt converts the rate on the debt to a fixed rate using an interest rate swap.   The entity is hedging the risk of variability in interest payments due to changes in the interest rate specified for the debt.
     
An entity that has a highly probable issuance of fixed rate debt in the future at the then coupon rate enters into a forward starting interest rate swap to protect itself from the effects of changes in a specified interest rate that may occur before the debt is issued.   The entity is hedging the variability in the expected interest payments from the issuance of a debt due to changes in a specified interest rate on a debt expected to be issued within a specified period.
     
Hedges of foreign currency exposures    
An entity that has a highly probable sale of goods in foreign currency takes out a forward exchange contract to ‘fix’ the local (functional) currency price of the goods.   The entity is hedging the risk of changes in local (functional) currency amount of the sale due to changes in foreign exchange rates.
     
An entity enters into a forward contract to hedge a foreign currency receivable or a payable due to be settled in six months’ time.   The entity is hedging the risk of changes in the amount receivable or payable on settlement in six months’ time due to changes in the foreign exchange rates.

The hedge accounting models - Cash flow hedges - Forecast transactions

Publication date: 08 Dec 2017


6.8A.121 A forecast transaction is an uncommitted but anticipated future transaction. [IAS 39 para 9]. To qualify for cash flow hedge accounting, the forecasted transaction should be specifically identifiable as a single transaction or a group of individual transactions. If the hedged transaction is a group of individual transactions, those individual transactions must share the same risk exposure for which they are designated as being hedged. Thus, a forecast purchase and a forecast sale cannot both be included in the same group of individual transactions that constitute the hedged transaction (see para 6.8A.21 above).

6.8A.122 The key criterion for hedge accounting purposes is that the forecast transaction that is the subject of a cash flow hedge must be ‘highly probable’. In IFRS terminology, probable means ‘more likely than not’. Therefore, in the context of forecast transaction, the term ‘highly probable’ is taken to indicate a much greater likelihood of happening than the term ‘more likely than not’. This is consistent with the IASB’s use of highly probable in IFRS 5, where ‘highly probable’ is regarded as implying a significantly higher probability than ‘more likely than not’. [IFRS 5 para BC81]. The other conditions are that the forecast transaction must be with a party that is external to the entity (see para 6.8A.14 above) and it presents an exposure to variations in cash flows for the hedged risk that could affect profit or loss (see para 6.8A.12 above).

6.8A.123 IAS 39’s implementation guidance explains that a transaction’s probability should be supported by observable facts and the attendant circumstances and should not be based solely on management’s intentions, because intentions are not verifiable. In assessing the likelihood that a transaction will occur, an entity should consider the following circumstances:

The frequency of similar past transactions.
The financial and operational ability of the entity to carry out the transaction.
Substantial commitments of resources to a particular activity (for example, a manufacturing facility that can be used in the short run only to process a particular type of commodity).
The extent of loss or disruption of operations that could result if the transaction does not occur.
The likelihood that transactions with substantially different characteristics might be used to achieve the same business purpose (for example, an entity that intends to raise cash may have several ways of doing so, ranging from a short-term bank loan to an offering of ordinary shares).
The entity’s business plan.
[IAS 39 para IG F3.7].

6.8A.124 The length of time until a forecast transaction is projected to occur is also a factor in determining probability. Other factors being equal, the more distant a forecast transaction is, the less likely it is that the transaction would be regarded as highly probable and the stronger the evidence that would be needed to support an assertion that it is highly probable. For example, a transaction forecast to occur in five years may be less likely to occur than a transaction forecast to occur in one year. However, forecast interest payments for the next 20 years on a plain vanilla variable rate debt would typically be highly probable if supported by an existing contractual obligation and it is expected that the debt will not be paid early.

6.8A.125 In addition, other factors being equal, the greater a forecast transaction’s physical quantity or future value in proportion to the entity’s transactions of the same nature, the less likely it is that the transaction would be regarded as highly probable and the stronger the evidence that would be required to support an assertion that it is highly probable. For example, less evidence generally would be needed to support forecast sales of 100,000 units in the next month than 950,000 units in that month when recent sales have averaged 800,000 units per month for the past three months. [IAS 39 para IG F3.7].

6.8A.126 A history of having designated hedges of forecast transactions and then determining that the forecast transactions are no longer expected to occur would call into question both an entity’s ability to predict forecast transactions accurately and the propriety of using hedge accounting in the future for similar forecast transactions. [IAS 39 para IG F3.7].

6.8A.127 The documentation that needs to be put in place before a forecast transaction can be designated as a hedged item is considered further from paragraph 6.8A.159 below.

The hedge accounting models - Cash flow hedges - Cash flow hedge accounting

Publication date: 08 Dec 2017


6.8A.128 Under IAS 39, if a cash flow hedge meets the hedge accounting conditions discussed in paragraph 6.8A.155 below during the period, it should be accounted for as follows:

the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge should be recognised directly in other comprehensive income; and
the ineffective portion of the gain or loss on the hedging instrument should be recognised in profit or loss.
[IAS 39 para 95].

6.8A.129 In particular:

the separate component of equity associated with the hedged item is adjusted to the lesser of the following (in absolute amounts):
the cumulative gain or loss on the hedging instrument from inception of the hedge; and
the cumulative change in fair value (present value) of the expected future cash flows on the hedged item from inception of the hedge;
any remaining gain or loss on the hedging instrument or designated component of it (that is not an effective hedge) is recognised in profit or loss; and
if an entity’s documented risk management strategy for a particular hedging relationship excludes from the assessment of hedge effectiveness a specific component of the gain or loss or related cash flows on the hedging instrument, that excluded component of gain or loss is recognised in accordance with the instrument’s normal classification. If the hedging instrument is a derivative, the excluded components can include the time value of an option or the interest element of a forward (see para 6.8A.60 above) or a proportion, such as 50% of a derivative (or non-derivative financial instrument for hedges of foreign currency risk) (see para 6.8A.64 above). Changes in the value of those excluded components are recognised in profit or loss (unless, in the case a proportion of a derivative, the remaining portion is designated as the hedging instrument in a different cash flow hedge or a net investment hedge).
[IAS 39 para 96].

6.8A.130 The way in which an entity accounts for cash flow hedges is illustrated in the examples below. In addition, another more in-depth application of cash flow hedge accounting for a hedge of a highly probable foreign currency purchase of raw materials using a forward contract (including full prospective and retrospective hedge effectiveness testing) is given in illustration 2 at paragraph 6.8A.224.

Example 1 – Cash flow hedge of commodity sale
 
The facts are the same as in the example in paragraph 6.8A.110 above, except that the entity decides to designate a silver forward contract as a cash flow hedge of the forecast sale of 1million troy ounces of silver to a customer that is expected to occur on 31 March 20X6. It is highly probable that the sale will occur based on its sales history with the customer. The entity is hedging its exposure to change in cash flows from the highly probable sales. The futures contract entered into on 1 October 20X5 on a specified commodity exchange for 1 million troy ounces of silver at a forward price of C5.55 per ounce matures on 31 March 20X6 and will be settled net in cash. This is the date the entity expects to deliver 1 million troy ounces of silver to its customer at the forward price.
 
The hedging relationship qualifies for cash flow hedge accounting. The entity determines and documents the entire change in the full fair value of the forward contract will be highly effective in offsetting all the variability in cash flow from the expected sale based on the forward prices.
 
The entity prepares its financial statements to 31 December each year. The accounting entries from inception of the hedge to its termination following closure of the forward contract (which is settled daily) and the inventory’s delivery are as follows:

    Dr (Cr)
Date Transaction Cash Forward contract Equity Silver stock Profit and loss
C’000 C’000 C’000 C’000 C’000
31 Dec 20X5 Change in fair value of fwd contract   147,830 (147,830)    
31 Mar 20X6 Change in fair value of fwd contract   152,170 (152,170)    
31 Mar 20X6 Sale of silver inventory 5,250,000       (5,250,000)
31 Mar 20X6 Cost of sale       (5,000,000) 5,000,000
31 Mar 20X6 Recycle of hedging gain from equity     300,000   (300,000)
31 Mar 20X6 Settlement of fwd contract 300,000 (300,000)      

    5,550,000 (5,000,000) (550,000)

             

As can be seen from the above, through the hedge transaction, the entity has locked in a cash flow of C5.55 per troy ounce of silver, that is, C5,550,000. This is equivalent to the sale at spot rate plus the gain on the derivative.

Example 2 – Cash flow hedge of a variable rate debt
 
Entity A has a floating rate liability of C10m with 5 years remaining to maturity. It enters into a 5 year pay-fixed, receive-floating interest rate swap in the same currency and with the same principal terms as the liability to hedge the exposure to variable cash flow payments on the floating rate liability attributable to interest rate risk.
 
At inception, the swap’s fair value is zero. Subsequently, there is an increase of C490,000 in the swap’s fair value. This increase consists of a change of C500,000 resulting from an increase in market interest rates and a change of minus C10,000 resulting from an increase in the credit risk of the swap counterparty. There is no change in the fair value of the floating rate liability as the interest rate regularly resets to market rates, but the fair value (present value) of the future cash flows needed to offset the change in variable interest cash flows on the liability increases by C500,000. The fair value movement in this hedged risk can be demonstrated using a hypothetical derivative – see paragraph 6.8A.190 for an explanation of how the hypothetical derivative method can be used to measure effectiveness.
 
Entity A determines that although the hedge is not fully effective, because part of the change in the derivative’s fair value is attributable to the counterparty’s credit risk that is not reflected in the floating rate liability, the hedge is still highly effective. Therefore, entity A credits the effective portion of the change in fair value of the swap, that is, the net change in fair value of C490,000 to other comprehensive income. There is no debit to profit or loss for the change in fair value of the swap attributable to the deterioration in the credit quality of the swap counterparty, because the cumulative change in the present value of the future cash flows needed to offset the exposure to variable interest cash flows on the hedged item, that is the hedged risk, C500,000, exceeds the cumulative change in value of the hedging instrument, C490,000 (see para 6.8A.129 above). If entity A concludes that the hedge is no longer highly effective, it discontinues hedge accounting prospectively as from the date the hedge ceased to be highly effective (see para 6.8A.134-135 below).
 
Alternatively, if the change in the fair value of the swap increased to C510,000 of which C500,000 results from the increase in market interest rates and C10,000 from a decrease in the credit risk of the swap counterparty, there would be a credit to profit or loss of C10,000 for the change in the swap’s fair value attributable to the improvement in the swap counterparty’s credit quality. This is because the cumulative change in the value of the hedging instrument, C510,000 exceeds the cumulative change in the present value of the future cash flows needed to offset the exposure to variable interest cash flows on the hedged item, C500,000. The difference of C10,000 represents the ineffectiveness attributable to the derivative hedging instrument, the swap and is recognised in profit or loss. [IAS 39 para IG F5.2].

The hedge accounting models - Cash flow hedges - Reclassifying gains and losses from equity

Publication date: 08 Dec 2017


6.8A.131 If a hedge of a forecast transaction subsequently results in the recognition of a financial asset or liability, the associated gains or losses that were recognised directly in equity (see para 6.8A.128 above) should be reclassified into profit or loss in the same period or periods during which the asset acquired or liability assumed affects profit or loss (such as in the periods when interest expense or income is recognised). However, if an entity expects that all or a portion of a loss recognised in other comprehensive income will not be recovered in one or more future periods, it should reclassify into profit or loss the amount that is not expected to be recovered. [IAS 39 para 97]. In addition, in the April 2009 ‘Improvements to IFRSs’, the IASB amended paragraph 97 of IAS 39 to clarify the case when an entity hedges some, but not all, of the cash flows of a forecast transaction that would result in the recognition of a financial asset or liability, for example, the first three years of a highly probable forecast five year fixed debt issuance in six months’ time. In such a case the associated gains or losses deferred in other comprehensive income should be reclassified from equity to profit or loss as a reclassification adjustment in the same period or periods during which the hedged forecast cash flows affect profit or loss (that is, over the first three years of the debt in the above example).

6.8A.132 If a hedge of a forecast transaction subsequently results in recognising a non-financial asset or liability (or a forecast transaction for a non-financial asset or liability becomes a firm commitment for which fair value hedge accounting is applied), then the entity should adopt either of the following approaches as its accounting policy and apply that policy consistently:

It should reclassify the associated gains and losses that were recognised directly in equity into profit or loss in the same period or periods during which the asset acquired or liability assumed affects profit or loss (such as in the periods that depreciation or cost of sales is recognised). However, if an entity expects that all or a portion of a loss recognised directly in equity will not be recovered in one or more future periods, it should reclassify into profit or loss the amount that is not expected to be recovered.
It should remove the associated gains and losses that were recognised directly in equity and include them in the initial cost or other carrying amount of the asset or liability (often referred to as ‘basis adjustment’).
[IAS 39 para 98]. [IAS 39 para 99].

6.8A.133 For cash flow hedges other than those covered by paragraphs 6.8A.131 and 6.8A.132 above, amounts that had been recognised directly in equity should be recognised in profit or loss in the same period or periods during which the hedged forecast transaction affects profit or loss (for example, when a forecast sale occurs). [IAS 39 para 100].

Example 1 – Reclassification of derivative loss recorded in equity
 
Entity A regularly purchases inventory from a foreign supplier and designates a forecast purchase of particular inventory as the hedged item in a cash-flow hedge. At the date the inventory is purchased, a loss on the hedging instrument of C30 has accumulated in equity. In a subsequent period, the purchased inventory has a carrying amount of C100 (without any basis adjustment) and a fair value of C110. The entity expects to sell the inventory at a price equivalent to its fair value.
 
In this example, the entity determines that the combined value of the loss deferred in equity and the carrying amount of the inventory (that is, C130) exceeds the inventory’s fair value of C110, such that a net loss of C20 on the hedged transaction will be recognised in a future period. Therefore, in accordance with the first bullet point in paragraph 6.8A.132 above, the loss of C20 should immediately be reclassified into profit or loss since the entity determines that the loss cannot be recovered. The remaining C10 will only be recognised in profit or loss when the inventory is sold or if there is a further decline in its fair value.
 
The same effect in profit or loss would result had the entity chosen to adjust the inventory’s carrying value by the amount of the loss deferred in equity of C30 as noted in the last bullet point in paragraph 6.8A.132 above. In that case, the carrying value of the inventory of C130 would be greater than fair value of C110 resulting in the recognition of an immediate loss of C20 in profit or loss in accordance with IAS 2.

Example 2 – Reclassification of derivative gain recorded in equity
 
Entity A regularly purchases inventory from a foreign supplier and designates a forecast future purchase of particular inventory as the hedged item in a cash-flow hedge. At the date that the inventory is purchased, a gain on the hedging instrument of C30 has accumulated in equity. In a subsequent period, the fair value of the purchased inventory, which has a carrying amount of C100 (no basis adjustment), declines to C80.
 
In accordance with IAS 2, the entity writes down the inventory to its net realisable value of C80 and recognises an impairment loss of C20. The entity should also reclassify from equity an equivalent amount of gain of C20 (that is, part of the total gain of C30 deferred in equity) to profit or loss. The effect of the above adjustments is that inventory is recorded at its net realisable value of C80, the gain deferred in equity is C10 and there is no net impact in profit or loss. The gain in equity of C10 would continue to be deferred until the hedged forecast transaction impacts profit or loss when the inventory is sold or there is a further reduction in fair value.
 
The same effect in profit or loss would result had the entity chosen to adjust the inventory’s carrying value by the amount of the gain deferred in equity of C30. In that situation, the carrying value of the inventory of C70 would be less than fair value of C80 and there will be no immediate impact on profit or loss. The hedging gain of C10 included in the carrying value will affect profit or loss when the inventory is sold.

Example 3 – Reclassification of derivative gains/losses hedging partial term of forecast debt issuance
 
Entity A took out a 5 year (pay fix, receive float) forward starting swap 6 months ago to hedge the first 5 years of cash flows on its highly probable forecast issuance of 15 year fixed rate debt. It is assumed that appropriate documentation was in place, that entity A demonstrated the issuance of debt was highly probable and effectiveness tests were passed prospectively and retrospectively. As anticipated at inception, on issuance of the debt, the forward starting swap is terminated. Interest rates have increased since the forward starting swap was transacted, which has resulted in a gain on the swap, but the debt being issued at a higher interest rate. In accordance with the amendment to paragraph 97 referred to in paragraph 6.8A.131 above, this gain will be released to the income statement over the first 5 years of the debt as the hedged cash flows affect the income statement.

The hedge accounting models - Cash flow hedges - Discontinuing cash flow hedge accounting

Publication date: 08 Dec 2017


6.8A.134 Cash flow hedge accounting should be discontinued prospectively if any of the following occurs:

The hedging instrument expires or is sold, terminated or exercised.
  For this purpose, the replacement or rollover of a hedging instrument into another hedging instrument is not an expiration or termination if such replacement or rollover is part of the entity’s documented hedging strategy.
  In this case, the cumulative gain or loss on the hedging instrument that remains recognised directly in equity from the period when the hedge was effective should remain in equity until the forecast transaction occurs. Thereafter, it should be dealt with in accordance with paragraphs 6.8A.131 to 6.8A.133 above.
   
The hedge no longer meets the criteria for hedge accounting discussed in paragraph 6.8A.155 below.
  In this case, unless the next bullet point is also met, the cumulative gain or loss on the hedging instrument that remains recognised directly in equity from the period when the hedge was effective should remain in equity until the forecast transaction occurs. Thereafter, it should be dealt with in accordance with paragraphs 6.8A.131 to 6.8A.133 above.
   
The forecast transaction is no longer expected to occur.
  In this case, the cumulative gain or loss on the hedging instrument that remains recognised directly in equity from the period when the hedge was effective should be recognised in profit or loss. However, a forecast transaction that is no longer highly probable (and, therefore, the hedge no longer meets the criteria for hedge accounting discussed in para 6.8A.154 below) may still be expected to occur, in which case, the cumulative gain or loss is treated in the same way as set out in the previous bullet point.
   
The entity revokes the designation.
  In this case, the cumulative gain or loss on the hedging instrument that remains recognised directly in equity from the period when the hedge was effective should remain in equity until the forecast transaction occurs. Thereafter, it should be dealt with in accordance with paragraphs 6.8A.131 to 6.8A.133 above. However, if the transaction is no longer expected to occur, the cumulative gain or loss in equity is dealt with in accordance with the third bullet point above.
[IAS 39 para 101].

6.8A.135 The above rules are summarised in the table below:

Discontinuance of cash flow hedges
     
  Hedging instrument Amount accumulated in equity
Hedge termination events Continue mark-to-market accounting De-recognise from the balance sheet Reclassify to profit or loss Retain amounts in equity
  Note 1     Note 2
Hedging instrument no longer exists (that is, sold, terminated, extinguished, exercised, or expired)    
The hedge no longer meets the effectiveness criteria for hedge accounting    
The entity revokes the hedge designation    
The forecast transaction is no longer highly probable, but is still expected to occur    
The forecast transaction is no longer expected to occur    
Variability of cash flow ceases (for example, the forecast transaction becomes a fixed price firm commitment)    
         
Note 1 – The hedging instrument will continue to be marked to market, unless it is re-designated as a hedging instrument in a new hedge.
 
Note 2 – The cumulative gain or loss on the hedging instrument previously recognised directly in other comprehensive income from the period when the hedge was effective remains recognised in equity and is reclassified to profit or loss when profit or loss is impacted by the hedged item.

6.8A.136 When an entity ceases to apply hedge accounting because the hedge does not meet hedge effectiveness criteria, it should discontinue hedge accounting from the last date on which compliance with hedge effectiveness was demonstrated. However, if the event or change in circumstances that caused the hedging relationship to fail the effectiveness criteria can be identified and it can be demonstrated that the hedge was effective before the event or change in circumstances occurred, the entity should discontinue hedge accounting from the date of the event or change in circumstances. [IAS 39 para AG113].

Example – Discontinuance of cash flow hedge
 
On 1 January 20X6, entity A has a highly probable sale that is expected to occur on 31 May 20X6. Entity A expects to collect the cash on 30 June 20X6. Entity A’s functional currency is pound sterling and the sale is denominated in US dollars. At the same time on 1 January 20X6, entity A takes out a £/US$ forward contract to hedge the future sale. This forward contract matures on 30 June 20X6. Entity A has put in place all the documentation required to achieve cash flow hedge accounting.
 
On 1 March 20X6, the transaction is no longer considered to be highly probable, but is still expected to occur. On 1 April 20X6, the transaction is no longer expected to occur. The entity does not close out the forward contract earlier than maturity.
 
The fair value of the forward contract at each date is as follows:
  Fair value of forward (maturity 30 June 20X6)
  £’000
31 January 20X6 35,000
28 February 20X6 30,000
31 March 20X6 25,000
30 April 20X6 27,000
31 May 20X6 28,000
30 June 20X6 32,000
   
The accounting entries from the inception of the hedge to settlement of the forward contract, assuming perfect effectiveness (that is, the hedged risk is the forward rate and no other mismatches occur), are as follows:

    Dr (Cr)
Date Transaction Cash Forward contract Equity Profit or loss
    £’000 £’000 £’000 £’000
31 Jan 20X6 Change in fair value of forward   35 (35)  
28 Feb 20X6 Change in fair value of forward   (5) 5  
  Hedge accounting ceases prospectively from 1 March 20X6. Gain deferred in equity remains in equity but the forward is now marked to market through profit or loss        
31 Mar 20X6 Change in fair value of forward   (5)   5
30 Apr 20X6 Change in fair value of forward   2   (2)
30 Apr 20X6 Recycling of gain as hedged transaction is no longer expected to occur     30 (30)
31 May 20X6 Change in fair value of forward   1   (1)
30 Jun 20X6 Change in fair value of forward   4   (4)
30 Jun 20X6 Settlement of forward 32 (32)

    32 (32)

 
Had the transaction continued to be highly probable, the movements on the forward contract to the extent that the hedge was effective would continue to be taken to equity until the sale occurred in May at which date the gain would be recycled from equity to the income statement. Management would then de-designate the forward contract as a hedge and the fair value movements would be recorded through the income statement between May and June and this should offset the gain or loss on the receivable (settlement due on 30 June 20X6) caused by currency fluctuations. There would be some income statement volatility as the interest element (forward points) included in the forward contract’s fair value is not present in the undiscounted trade receivable. Alternatively, the forward contract could be re-designated as a hedge of movements in the spot rate on the receivable, but this is not necessary because movements in the receivable and forward will approximately offset as the receivable is measured at spot exchange rates under IAS 21 irrespective of whether hedge accounting is applied.

The hedge accounting models - Net investment hedges - Background

Publication date: 08 Dec 2017


6.8A.137 A net investment in a foreign operation is defined as “the amount of the reporting entity’s interest in the net assets of that operation”. [IAS 21 para 8]. Such foreign operations may be subsidiaries, associates, joint ventures or branches. An entity may decide to hedge against the effects of changes in exchange rates in its net investment in a foreign operation. This may be done with non-derivative financial liabilities or with derivatives. Because the net assets of subsidiaries, associates and joint ventures are only reported in the reporting entity’s consolidated financial statements, hedge accounting for a net investment in such foreign operations can only be carried out at the consolidation level. The only exception is when an entity prepares separate financial statements in which investments in associates or joint ventures are accounted for using the equity method or that include a branch or a joint operation as defined in IFRS 11. Under IAS 21, the reporting entity’s share of the net assets of a foreign operation is translated into the group’s presentation currency at the closing exchange rate, and all resulting exchange differences are recognised as a separate component in equity until it disposes of the foreign operation. The hedge of a net investment in a foreign operation at the consolidated level is, therefore, a hedge of the translation foreign currency risk arising on the foreign operation, which is included in the reporting entity.

6.8A.138 The IFRS IC recognised that IAS 39 and IAS 21 provided limited guidance on the application of their requirements for hedges of net investments in foreign operations and therefore issued IFRIC 16 on 3 July 2008. IFRIC 16 applies only to hedges of net investments in foreign operations; it should not be applied by analogy to other types of hedge accounting such as fair value or cash flow hedge accounting.

The hedge accounting models - Net investment hedges - Hedged items

Publication date: 08 Dec 2017


6.8A.139 In a hedge of the foreign currency risks arising from a net investment in a foreign operation, the hedged item can be an amount of net assets equal to or less than the carrying amount of the net assets of the foreign operation in the consolidated financial statements of the parent entity. The amount of the net assets that may be designated as the hedged item in the consolidated financial statements of a parent depends on whether any lower level parent of the foreign operation has applied hedge accounting for all or part of the net assets of that foreign operation and that accounting has been maintained in the parent’s consolidated financial statements. The hedged risk may be designated as the foreign currency exposure arising between the functional currency of the foreign operation and the functional currency of any parent entity (the immediate, intermediate or ultimate parent entity) of that foreign operation. The fact that the net investment is held through an intermediate parent does not affect the nature of the economic risk arising from the foreign currency exposure to the ultimate parent entity.

6.8A.140 However, the hedged risk must relate to the functional currencies of the entities involved (that is, the foreign operation and any of its parents). IFRIC 16 does not permit an entity to hedge a foreign operation to the group’s presentation currency. This is because IAS 21 places no restrictions on what presentation currency a group can select, and therefore presentation currency risk is not viewed as a true economic exposure. In practice, this limitation is likely to have little effect as most entities either only hedge functional currency risk or choose a presentation currency that is also the functional currency of a relevant parent.

6.8A.141 If the same net assets of a foreign operation are hedged by more than one parent entity within the group (for example, both a direct and an indirect parent entity) for the same risk, only one hedging relationship will qualify for hedge accounting in the consolidated financial statements of the ultimate parent. A hedging relationship designated by one parent entity in its consolidated financial statements need not be maintained by another higher level parent entity. However, if it is not maintained by the higher level parent entity, the hedge accounting applied by the lower level parent should be reversed before the higher level parent’s hedge accounting is recognised.

Example – Options for hedge designation in a group situation
 
hedgingflowchart
 
For example, in the group depicted above the parent can hedge its net investment in each of subsidiaries A, B and C for the foreign exchange risk between their respective functional currencies (Japanese yen (JPY), pounds sterling and US dollars) and euro. In addition, parent can hedge the USD/GBP foreign exchange risk between the functional currencies of subsidiary B and subsidiary C. In its consolidated financial statements, subsidiary B can hedge its net investment in subsidiary C for the foreign exchange risk between their functional currencies of US dollars and pounds sterling.
 
Parent wishes to hedge the foreign exchange risk from its net investment in subsidiary C. Assume that subsidiary A has an external borrowing of US$300m. The net assets of subsidiary A at the start of the reporting period are ¥400,000m including the proceeds of the external borrowing of US$300m. The hedged item can be an amount of net assets equal to or less than the carrying amount of parent’s net investment in subsidiary C (US$300m) in its consolidated financial statements. In its consolidated financial statements parent can designate the US$300m external borrowing in subsidiary A as a hedge of the EUR/USD spot foreign exchange risk associated with its net investment in the US$300m net assets of subsidiary C. In this case, both the EUR/USD foreign exchange difference on the US$300m external borrowing in subsidiary A and the EUR/USD foreign exchange difference on the US$300m net investment in subsidiary C are included in the foreign currency translation reserve in parent’s consolidated financial statements after the application of hedge accounting.
 
In the absence of hedge accounting, the total USD/EUR foreign exchange difference on the US$300m external borrowing in subsidiary A would be recognised in parent’s consolidated financial statements as follows:
 
■  USD/JPY spot foreign exchange rate change, translated to euro, in profit or loss; and
■  JPY/EUR spot foreign exchange rate change in equity.
   
Instead of designating the US$300m external borrowing as a hedge of the EUR/USD spot foreign exchange risk on the investment in subsidiary C in its consolidated financial statements, the parent could designate the borrowing in subsidiary A as a hedge of the GBP/USD spot foreign exchange risk between subsidiary C and subsidiary B. In this case, the total USD/EUR foreign exchange difference on the US$300m external borrowing in subsidiary A is instead recognised in parent’s consolidated financial statements as follows:
   
■  the GBP/USD spot foreign exchange rate change in the foreign currency translation reserve relating to subsidiary C;
■  GBP/JPY spot foreign exchange rate change, translated to euro, in profit or loss; and
■  JPY/EUR spot foreign exchange rate change in equity.
   
Parent cannot designate the US$300m external borrowing in subsidiary A as a hedge of both the EUR/USD spot foreign exchange risk and the GBP/USD spot foreign exchange risk in its consolidated financial statements. A single hedging instrument can hedge the same designated risk only once. Subsidiary B cannot apply hedge accounting in its consolidated financial statements because the hedging instrument is held outside the group comprising subsidiary B and subsidiary C.

The hedge accounting models - Net investment hedges - Hedging instruments

Publication date: 08 Dec 2017


6.8A.142 A derivative or a non-derivative instrument (or a combination of derivative and non-derivative instruments) may be designated as a hedging instrument in a hedge of a net investment in a foreign operation. The hedging instrument(s) may be held by any entity or entities within the group, as long as the designation, documentation and effectiveness requirements of IAS 39 paragraph 88 that relate to a net investment hedge are satisfied. In particular, the hedging strategy of the group should be clearly documented because of the possibility of different designations at different levels of the group.

6.8A.143 The designated risk may be spot foreign exchange risk if the hedging instruments are not derivatives (for example, a debt instrument). If the hedging instruments are forward contracts, an entity can designate either the spot or the forward foreign exchange risk as the hedged risk. [IFRIC 16 para 14]. [IFRIC 16 para AG2].

The hedge accounting models - Net investment hedges - Effectiveness testing

Publication date: 08 Dec 2017

6.8A.144 When determining the effectiveness of a hedging instrument in the hedge of a net investment, an entity calculates the gain or loss on the hedging instrument by reference to the functional currency of the parent entity against whose functional currency the hedged risk is measured, in accordance with the hedge documentation. This is the same regardless of the type of hedging instrument used. This ensures that the effectiveness of the instrument is determined on the basis of changes in fair value or cash flows of the hedging instrument, compared with the changes in the net investment as documented. Any effectiveness test is not therefore dependent on the functional currency of the entity holding the instrument. In other words, the fact that some of the change in the hedging instrument is recognised in profit or loss by one entity within the group and some is recognised in other comprehensive income by another does not affect the assessment of hedge effectiveness.

6.8A.145 In our example above, the total change in value in respect of foreign exchange risk of the US$300 million external borrowing in subsidiary A is recorded in both profit or loss (USD/JPY spot risk) and equity (EUR/JPY spot risk) in parent’s consolidated financial statements in the absence of hedge accounting. Both amounts are included for the purpose of assessing the effectiveness of the hedge because the change in value of both the hedging instrument and the hedged item are calculated by reference to the euro functional currency of parent against the US dollar functional currency of subsidiary C, in accordance with the hedge documentation. The method of consolidation (that is, direct method or step-by-step method) does not affect the assessment of the effectiveness of the hedge. However, as explained in paragraph 6.8A.148 below, it may affect the amounts that are recycled when the hedged foreign operation is disposed of.

The hedge accounting models - Net investment hedges - Recycling on disposal of foreign operation

Publication date: 08 Dec 2017


6.8A.146 When a foreign operation that was hedged is entirely disposed of, the amount reclassified or ‘recycled’ to profit or loss from the foreign currency translation reserve in respect of the hedging instrument is the effective portion of the revaluation of the hedging instrument calculated in accordance with paragraph 102 of IAS 39. The amount reclassified to profit or loss from the foreign currency translation reserve in respect of the net investment in that foreign operation is the amount included in that parent’s foreign currency translation reserve in respect of that foreign operation. [IAS 21 para 48]. This latter amount may vary depending on what consolidation method (direct or step-by-step) the entity has chosen.

6.8A.147 The direct method of consolidation is the method of consolidation in which the financial statements of the foreign operation are translated directly into the functional currency of the ultimate parent. The step-by-step method is the method of consolidation in which the financial statements of the foreign operation are first translated into the functional currency of any intermediate parent(s) and then translated into the functional currency of the ultimate parent (or the presentation currency if different). IAS 21 does not prescribe which method of consolidation entities should use. In the ultimate parent’s consolidated financial statements, the aggregate net amount recognised in the foreign currency translation reserve in respect of all foreign operations is not affected by the consolidation method. However, whether the ultimate parent uses the direct or the step-by-step method of consolidation (see para 6.8A.141 above) may affect the amount included in its foreign currency translation reserve in respect of an individual foreign operation. The amount of foreign currency translation reserve for an individual foreign operation determined by the direct method of consolidation reflects the economic risk between the functional currency of the foreign operation and that of the ultimate parent (if the parent’s functional and presentation currencies are the same). The use of the step-by-step method of consolidation may result in the reclassification to profit or loss of an amount different from that used to determine hedge effectiveness. This difference may be eliminated by determining the amount relating to that foreign operation that would have been posted if the direct method of consolidation had been used. However, IAS 21 does not require this adjustment. It is, therefore, an accounting policy choice that should be followed consistently for all net investments. Entities with foreign currency net investments will have to disclose their choice of accounting policy for revaluation of the net investments in foreign operations.

6.8A.148 The IFRS IC noted that this issue arises also when the net investment disposed of was not hedged and, therefore, is not strictly within the scope of the interpretation. However, because it was a topic of considerable confusion and debate, the IFRS IC decided to include a brief example illustrating its conclusions, which are discussed below. [IFRIC 16 para 16]. [IFRIC 16 para 17]. [IFRIC 16 para BC38]. [IFRIC 16 para BC39].

Example – Choice of consolidation method and effect on recycling
 
Using the same facts as in the example of the group in paragraph 6.8A.141 above, parent used a USD borrowing in subsidiary A to hedge the EUR/USD risk of the net investment in subsidiary C in Parent’s consolidated financial statements. Parent uses the step-by-step method of consolidation. Assume the hedge was fully effective and the full USD/EUR accumulated change in the value of the hedging instrument before disposal of subsidiary C is €24m (gain). This is matched exactly by the fall in value of the net investment in subsidiary C, when measured against the functional currency of Parent (euro). If the direct method of consolidation is used, the fall in the value of parent’s net investment in subsidiary C of €24m is reflected totally in the foreign currency translation reserve relating to subsidiary C in parent’s consolidated financial statements. However, because parent uses the step-by-step method, this fall in the net investment value in subsidiary C of €24m is reflected both in subsidiary B’s foreign currency translation reserve relating to subsidiary C and in parent’s foreign currency translation reserve relating to subsidiary B. The aggregate amount recognised in the foreign currency translation reserve in respect of subsidiaries B and C is not affected by the consolidation method. Assume that using the direct method of consolidation, the foreign currency translation reserves for subsidiaries B and C in parent’s consolidated financial statements are €62m gain and €24m loss respectively; using the step-by-step method of consolidation those amounts are €49m gain and €11m loss respectively.
 
IAS 39 requires the full €24m gain on the hedging instrument to be reclassified to profit or loss when the investment in subsidiary C is disposed of. Using the step-by-step method, the amount to be reclassified to profit or loss in respect of the net investment in subsidiary C is only €11m loss. The parent could adjust the foreign currency translation reserves of both subsidiaries B and C by €13m in order to match the amounts reclassified in respect of the hedging instrument and the net investment as would have been the case if the direct method of consolidation had been used, if that was its accounting policy. An entity that had not hedged its net investment could make the same reclassification.

6.8A.148.1 Where a foreign operation is partially disposed of, the amount of the hedging reserves to reclassify to the income statement has changed under IAS 27 as compared to IAS 27 (superseded). In the table below hedging reserves refer to the cash flow hedge reserve in the subsidiary itself and the net investment hedge reserve in the consolidated financial statements. The table below illustrates common situations and the effect on hedging reserves:
 
Relationship of foreign operation before disposal Relationship of foreign operation after disposal Reclassification of hedging reserves
Subsidiary Subsidiary (with new NCI recognised) Re-attribute share of hedging reserves to non-controlling interest(s). No amount reclassified to profit and loss.
Subsidiary Associate Reclassify 100% of hedging reserves related to foreign operation to profit and loss as part of gain or loss on disposal of subsidiary.
Associate Associate Reclassify proportionate amount of share of hedging reserves to profit and loss as part of gain or loss on partial disposal of an associate.
Associate or subsidiary Financial asset (IAS 39) Reclassify 100% of share of hedging reserve related to foreign operation to profit and loss as above
 
If a foreign operation that is a subsidiary is contributed to a joint venture, the question of whether to recycle is based on the policy choice. See chapter 26.
 
It should be noted that reductions of the net investment in a foreign operation through payment of non-liquidating distributions or repayment of quasi-equity loans may no longer trigger reclassification of CTA. Whether such reductions trigger a reclassification of CTA is, in our view, an accounting policy choice as discussed in chapter 7. Where such a payment is made and a policy of reclassifying CTA adopted, then this may also trigger the reclassification of part of the net investment hedge reserve related to that foreign operation.

Example – Recycling of amounts in OCI due to return of capital
 
Entity A (pound sterling functional currency) owns a net investment of 30 billion USD in a foreign operation (entity B, wholly-owned, with functional currency USD). Entity A hedges the foreign currency risk with derivatives and designates them as hedging the first 15 billion USD of the net investment in entity B. After some time, there is a 20 billion USD return of capital, which represents two thirds of the net investment. In view of the return of capital, the entity de-designates the hedging relationship. The amount to be recycled from the hedging reserve because of the return of capital could be either two thirds, that is, proportionate reclassification based on a two thirds return of capital; or one third, based on the fact that only 5 billion USD of the first 15 billion USD net investment has been returned. This is a policy choice and should be adopted consistently by entity A in any further partial disposals of foreign operations.

The hedge accounting models - Net investment hedges - Hedging with derivatives

Publication date: 08 Dec 2017


6.8A.149 It is also possible to hedge a net investment with derivatives. A derivative that is commonly used is a forward contract. However, in this situation, it would be necessary for the entity to designate at inception whether effectiveness would be measured by reference to changes in spot exchange rates or changes in forward exchange rates. If the spot rate method is used, only the change in the fair value of the forward contract due to changes in spot rates would be reported in other comprehensive income and the balance of the fair value of the forward (due to the forward points) would be included in profit or loss at each reporting date. On the other hand, if the forward rate method is used, the full change in the fair value of the forward would be reported in other comprehensive income. This is explained further in paragraph 6.8A.207 below. If the notional amount of a currency forward that swaps the functional currency of the hedged net investment into the investor’s functional currency matches the portion of the net investment hedged, it is likely to be an effective hedging instrument.

6.8A.150 It is possible to designate a cross-currency interest rate swap as a hedge of a net investment in a foreign operation. However, such cross-currency interest rate swaps (CCIRS), having foreign exchange and interest rates as underlyings may not be effective hedging instruments since the hedged net investment is not affected by changes in interest rates. Nevertheless, cross-currency swaps could be designated as hedging instruments in a net investment hedge, provided both legs of the swap are either floating rates or fixed rates. This is because a cross-currency interest rate swap that has two floating legs has a fair value that is primarily driven by changes in foreign exchange rates rather than changes in interest rates. However, a cross-currency swap interest rate swap with one fixed-leg and one floating-rate leg is unlikely to be effective as a hedging instrument in a net investment hedge.

6.8A.151 To designate a fixed-fixed CCIRS as a hedge of net investment, management should bear in mind that hedges of a net investment in a foreign operation are accounted similarly to cash flow hedges. [IAS 39 para 102]. There is no other guidance within IAS 39 or the Basis for Conclusions, regarding the basis for this similarity. One interpretation of this statement could be that a net investment hedge is capable of being viewed as analogous to a cash flow hedge of the foreign currency cash flows that would arise from a sale of the net investment at a (or several) future date(s) for the cash flow variability arising due to foreign currency risk – see the example in paragraph 6.8A.151.1 below. This interpretation would give a rationale for accounting for net investment hedges in a similar manner to cash flow hedges and deconstructing a fixed:fixed cross currency interest rate swap into a series of forward contracts.

6.8A.151.1 An alternative acceptable view is that a cross-currency interest rate swap is similar in nature to a long dated forward. The key difference is that the forward points due to the interest differential on the two currencies are paid off over the period (via interest payments on the swap) rather than at the end. Under this view, the notional can be seen as an exchange of principal at spot at inception and at maturity. If the CCIRS is treated as a forward for hedge accounting purposes, it would be possible to use only the notional as a hedge of the spot exchange rate in a net investment hedge (as explained in para 6.8A.207). Fair value movements on the forward points should be recorded separately through the income statement.

Example – Net investment hedge with a cross-currency swap
 
An entity A, with Swiss francs as its functional currency, which has a net investment of US$ 120m. Entity A wishes to eliminate foreign exchange risk associated with the re-translation of part of this net investment into its functional currency and enters into a fixed-fixed CCIRS. The swap has a CHF100m receive leg receiving interest at 3% and US$80m pay leg paying interest at 5% (assume that CHF100m and US$80m are equivalent based on the spot rate at inception). The swap has annual interest settlements, a five year maturity and has a zero fair value at inception.
 
In applying paragraph 102 of IAS 39, the cash flow hedge method may be applied to the US dollar net investment by viewing the hedged net investment as a series of cash flows on various ‘deemed disposal’ dates in the future. In other words, the net investment hedge would be treated in a manner similar to a cash flow hedge of cash flows arising on a deemed sale of US$4m (that is, US$80m × 5%) of the net investment at the end of each of the next 4 years, and a deemed sale of US$84m at the end of year 5. The total net investment of US$ 120m exceeds the aggregate of the deemed disposals (US$4 + US$4 + US$4 + US$4 + US$84 = US$100m) and, hence, this designation is acceptable.
 
This net investment (series of deemed cash flows) is identical to the profile of cash flows in a US$80m foreign currency debt (which is an asset of entity A) that pays interest annually at 5%, and hence effectiveness may be measured in a manner similar to that used for a cash flow hedge of a fixed rate foreign currency debt.
 
In a cash flow hedge of a recognised foreign currency fixed rate liability, a fixed-fixed CCIRS can be used to hedge the foreign currency exposure. The most appropriate hypothetical derivative to test effectiveness is a fixed to fixed CCIRS which would ensure little-to-no ineffectiveness.
 
As hedges of a net investment in a foreign operation are accounted similarly to cash flow hedges, an at-market fixed-fixed CCIRS may be used as a hypothetical derivative to test effectiveness in a net investment hedge. This hypothetical derivative is a CCIRS that is equivalent (and opposite) to the actual hedging instrument. Ineffectiveness is likely to be minimal as the fair value changes in the hedging instrument and hypothetical derivative will offset.
 
However, this designation requires the net investment to equal or exceed the aggregate of notional principal and interest flows on the CCIRS, in this case US$100m. This approach cannot be adopted where the notional principal in the CCIRS is equal to the net investment balance.

The hedge accounting models - Net investment hedges - Hedging in individual or separate financial statements

Publication date: 08 Dec 2017


6.8A.152 IAS 27 states that in a parent’s separate financial statements, investments in subsidiaries, jointly controlled entities and associates that are included in the consolidated financial statements should be carried at cost or accounted for in accordance with IAS 39. This means that the equity investment can be designated as ‘available-for-sale’ or ‘at fair value through profit or loss’ (if permitted by IAS 39). However, in some jurisdictions, entities normally record their investments in subsidiaries, associates and joint ventures at cost in their separate financial statements. A question, therefore, arises as to whether a foreign currency borrowing can be designated as a hedge of the entity’s foreign equity investment in its separate financial statements where the foreign equity investment is recorded at historical cost.

6.8A.153 The answer is that it may be possible to construct a hedging relationship to achieve hedge accounting despite the apparent contradictions with IAS 21 and IAS 39. The rationale for achieving hedge accounting is set out in IG E3.4 of the implementation guidance of IAS 39. In summary, IG E3.4 states that, as an exception, if the financial asset or financial liability is designated as a hedged item in a fair value hedge of the exposure to changes in foreign currency rates under IAS 39, the hedged item is re-measured for changes in foreign currency rates even if it would otherwise have been recognised using a historical rate under IAS 21. This exception applies to non-monetary items that are carried in terms of historical cost in the foreign currency (such as equity investments in foreign subsidiaries) and are hedged against exposure to foreign currency rates. In effect, this exception allows an entity to hedge the change in the historical foreign currency cost of the foreign equity investment due to the movement in the relevant foreign currency rates. In these circumstances, the historical foreign currency cost of the foreign currency investment would be re-translated at each balance sheet date at the closing rate and the exchange difference arising on the re-translation will be recognised in profit or loss to offset the exchange difference recognised in profit or loss arising on the re-translation of the foreign currency borrowings (where these are used as the hedging instrument) or the change in the fair value of the foreign currency derivative, that is used as the hedging instrument. Although this treatment is an exception, nevertheless it is still classified as a fair value hedge. Accordingly, the hedging criteria set out in paragraph 6.8A.154 below must still be met in order to achieve fair value hedge accounting in the reporting entity’s separate financial statements. Whether, in practice, a parent entity would apply hedge accounting in its separate financial statements may depend on the tax treatment of undertaking such hedging activities. 

Example – Hedge of a foreign subsidiary in entity’s separate financial statements
 
Entity A whose functional currency is the pound sterling acquired a subsidiary B in France for €300m in 20X0 when the £/€ exchange rate on the day of the transaction was £1 = €1.50. Entity A, therefore, measures its investment on initial recognition at £200m (€300/1.50). Entity A borrowed €300m to make the purchase and designates the euro borrowing as a hedge of the exposure to the change in £/€ spot rate.
 
Assuming that the hedging criteria in paragraph 6.8A.154 below are met and using the exception discussed above, entity A will re-translate its investment in its French subsidiary at each balance sheet date using the closing £/€ spot rate. Therefore, if at the first balance sheet reporting date following the acquisition, the spot rate has moved to £1 = €1.75, entity A will re-measure the historical euro cost of its investment into £171.43m. The exchange difference of £28.57m is recognised as an exchange loss in profit or loss for the period. At the same time the €300m borrowing is re-translated at the closing rate and the exchange gain of £28.57m is also recognised in profit or loss. Therefore, in this case the net effect as a result of hedge accounting is £nil on profit or loss. This example ignores any tax consequences of such a strategy.

Criteria for obtaining hedge accounting

Publication date: 08 Dec 2017


6.8A.154 Hedge accounting is an exception to the normal accounting principles for financial instruments (and sometimes non-financial instruments). IAS 39, therefore, requires hedge relationships to meet certain criteria in order to qualifying for hedge accounting. The three types of hedging relationship set out in paragraph 6.8A.102 qualify for hedge accounting only if all of the following conditions are met:

At the inception of the hedge there is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge.
The hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk, consistently with the originally documented risk management strategy for that particular hedging relationship.
A forecast transaction that is the subject of a cash flow hedge must be highly probable and must present an exposure to variations in cash flows that could ultimately affect profit or loss.
The effectiveness of the hedge can be reliably measured, that is, the hedged item’s fair value or cash flows that are attributable to the hedged risk and the hedged instrument’s fair value can be reliably measured.
The hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the financial reporting periods for which the hedge was designated.
[IAS 39 para 88(a)-(e)].

6.8A.155 The criteria for hedge accounting are onerous and have systems implications for all entities. Hedge accounting is optional and management should consider the costs and benefits when deciding whether to use it. Much of the burden and cost associated with hedge accounting arises from the effectiveness testing requirement. These requirements are considered from paragraph 6.8A.164 below.

Criteria for obtaining hedge accounting - Documentation and designation

Publication date: 08 Dec 2017


6.8A.156 Formal hedge documentation in support of the hedge must be prepared at the inception of the hedge and should include the following:

The entity’s risk management objective and strategy for undertaking the hedge.
The nature of the risk being hedged.
The hedged item.
The hedging instrument.
How the entity will assess the hedging instrument’s effectiveness in offsetting the exposure to changes in the hedged item’s fair value or cash flows attributable to the hedged risk.
[IAS 39 para 88(a)].

6.8A.157 Since there must be formal designation and documentation of the hedging relationship at the inception of the hedge, a hedge relationship cannot be designated retrospectively. However, IAS 39 does not require a hedging relationship to be established at the time the hedging instrument is acquired. For instance, an entity is permitted to designate and formally document a derivative contract as a hedging instrument after entering into the derivative contract. Hedge accounting will apply prospectively from the date all hedge accounting criteria in paragraph 6.8A.154 above are met. [IAS 39 para IG F3.8]. [IAS 39 para F3.9].

6.8A.158 Risks associated with assets previously designated at fair value through profit and loss that were not previously designated as a hedged risk can be so designated from the date they are reclassified in accordance with the ‘Reclassification of financial assets’ amendment.

Criteria for obtaining hedge accounting - Documentation relating to forecast transaction

Publication date: 08 Dec 2017


6.8A.159 When the entity is hedging a forecast transaction, the hedge relationship documentation should also identify the date on, or time period in, which the forecast transaction is expected to occur. This is because to qualify for hedge accounting:

the hedge must relate to a specific identified and designated risk;
it must be possible to measure its effectiveness reliably; and
the hedged forecast transaction must be highly probable.
[IAS 39 para IG F3.11].

6.8A.160 To meet the above criteria, the hedged forecast transaction must be identified and documented with sufficient specificity so that when the transaction occurs, it is clear whether the transaction is or is not the hedged transaction. Therefore, a forecast transaction may be identified as the sale of the first 15,000 units of a specific product during a specified three-month period, but it could not be identified as the last 15,000 units of that product sold during a three-month period, because the last 15,000 units cannot be identified when they are sold. For the same reason, a forecast transaction cannot be specified solely as a percentage of sales or purchases during a period. [IAS 39 para IG F3.10].

6.8A.161 An entity is not required to predict and document the exact date a forecast transaction is expected to occur. However, it is required to identify and document the time period during which the forecast transaction is expected to occur within a reasonably specific and generally narrow range, as a basis for assessing hedge effectiveness. To determine that the hedge will be highly effective, it is necessary to ensure that changes in the expected cash flow’s fair value are offset by changes in the hedging instrument’s fair value and this test may be met only if the cash flows occur within close proximity of each other. [IAS 39 para IG F3.11].

6.8A.162 The change in timing of the forecast transaction within the specific and narrow time range does not affect the validity of the designation. For instance, if, subsequent to designating a derivative as a hedging instrument in a cash flow hedge of a forecast transaction such as a commodity sale, the entity expects the forecast sale to occur in an earlier period than originally anticipated, the original designation is not invalidated. Provided the hedging relationship met all the hedge accounting conditions, including the requirement to identify and document the period in which the sale was expected to occur within a reasonably specific and narrow range of time as explained above, the entity can conclude that this transaction is the same as the one that was designated as being hedged. However, this may well affect the assessment of the effectiveness of the hedging relationship since the derivative would need to be designated as a hedging instrument for the whole remaining period of its existence, which will include a period after the forecast sale. [IAS 39 para IG F 5.4].

Example – Hedging cash flows in specific time periods
 
Entity A manufactures and sells ice cream. Its functional currency is the euro, but 30% of its sales are made in the UK and denominated in pounds sterling. Entity A forecasts highly probable sales in the UK for the next summer season on a monthly basis. Using these forecasts, it enters into forward contracts to sell pounds sterling in exchange for Euros. Due to the nature of its business, entity A is not able to forecast or track individual sales transactions.
 
Although the forecast transaction should be specifically identifiable as a single transaction or a group of individual transactions in order to qualify for cash flow hedge accounting, Entity A can designate the forecast sales of ice cream as the hedged item. It should do this by designating the hedged item as the first £Xm of highly probable cash flows in specific time periods (for example, in each month). To qualify for hedge accounting, the designation must be sufficiently specific to ensure that when a forecast transaction occurs, it is possible to determine objectively whether that transaction is or is not the one that is hedged. If the forecasted cash flows are no longer expected to occur in the designated time period, management cannot continue with hedge accounting for the related hedging instruments. It should reclassify the amounts previously deferred in equity to profit or loss at that point.

Criteria for obtaining hedge accounting - Documentation relating to forecast transaction - Example documentation

Publication date: 08 Dec 2017


6.8A.163 IAS 39 does not mandate any standard format for documenting the hedging relationship and, therefore, in practice, the nature and style of the documentation may vary from entity to entity. The important thing to note is that the documentation must include all of the basic contents required by IAS 39 paragraph 88 (see para 6.8A.156 above) and must be in place at inception of the hedge. Examples of hedge designation and documentation are included in the three comprehensive examples illustrated from paragraph 6.8A.223 below.

Criteria for obtaining hedge accounting - Hedge effectiveness

Publication date: 08 Dec 2017


6.8A.164 The requirement to assess hedge effectiveness is critical for a hedge transaction to qualify for hedge accounting. But this requirement is also the most onerous of the hedge accounting criteria because of the time, cost and effort that it entails. Hedge effectiveness is defined as “the degree to which changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument”. [IAS 39 para 9]. Assessing the degree or the extent to which such offset will be effective for hedge accounting purposes is by no means an easy task. The difficulty is also exacerbated by the lack of practical guidance in the standard for undertaking the effectiveness exercise. Often, it will require the use of complex statistical techniques whose output will require careful interpretations. As a result, the approach taken by entities may vary: from electing not to adopt hedge accounting and managing the resulting volatility in the income statement through communications with the market, to putting hedge accounting systems and processes in place and thereby obtaining the benefits of hedge accounting. In practice, most entities are likely to adopt a mixed approach, undertaking hedge accounting only for large material hedges and not electing to adopt hedge accounting for immaterial ones.

Criteria for obtaining hedge accounting - Hedge effectiveness - Requirements for assessing effectiveness

Publication date: 08 Dec 2017


6.8A.165 To qualify for hedge accounting, IAS 39 requires a hedge to be highly effective. A hedge is regarded as highly effective if both of the following two conditions are met:

At the inception of the hedge and in subsequent periods, the hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated.
The actual results of the hedge are within a range of 80%-125%.
[IAS 39 para AG 105].

6.8A.166 In order to comply with the first condition above, an entity needs to perform a prospective hedge effectiveness assessment. This is a forward looking test that assesses whether the entity expects the hedging relationship to be highly effective in achieving offset in the future. An expectation that the hedging relationship will be highly effective can be demonstrated in various ways, including a comparison of the critical terms of the hedging instrument with those of the hedged item (see para 6.8A.182 below), or a comparison of past changes in the fair value or cash flows of the hedged item that are attributable to the hedged risk with past changes in the fair value or cash flows of the hedging instrument (see para 6.8A.186 below), or by demonstrating a high statistical correlation between the fair value or cash flows of the hedged item and those of the hedging instrument (see para 6.8A.195 below). The entity may choose a hedge ratio of other than one to one in order to improve the effectiveness of the hedge as described in paragraph 6.8A.206 below. [IAS 39 para AG 105(a)].

6.8A.167 In order to comply with the second condition above, an entity needs to perform a retrospective hedge effectiveness assessment. This is a backward looking test that assesses whether the hedging relationship actually has been highly effective in achieving offset. The objective is to demonstrate that the hedging relationship has been highly effective by showing that actual results of the hedge are within a range of 80%-125%. For example, if actual results are such that the loss on the hedging instrument is C120 and the gain on the hedged item is C100, offset can be measured by 120/100, which is 120%, or by 100/120, which is 83%. In this example, assuming the hedge meets the first condition above, the entity would conclude that the hedge has been highly effective. [IAS 39 para AG 105(b)].

6.8A.168 An entity is required to perform the prospective test at the inception of the hedging relationship and at the beginning of each assessment period to demonstrate that the hedge is expected to be highly effective in the future. If, at any point, the prospective consideration indicates that the hedging instrument is not expected to be highly effective in the future, hedge accounting must be discontinued from that point forward. An entity must also perform the retrospective test at the end of every period to demonstrate that the hedge has been highly effective through the date of the periodic assessment. If the retrospective test indicates that the hedging instrument has not been highly effective, hedge accounting must be discontinued from the point the hedging relationship ceased to be highly effective. Both tests must be met for a particular period of the hedge relationship for hedge accounting to be available. The requirements are illustrated as follows:
 
10149
 
Note: The diagram refers to tests being carried out at time T (the assessment date). It is assumed that the prospective test at inception of hedge at time T0 has been met.

6.8A.169 Given the nature of the two assessments, it is possible for an entity to pass the prospective test at the beginning of the period but fail the retrospective test at the end of the period (for example, due to unexpected market factors). In that situation, hedge accounting would be precluded for the current period in question. However, a new hedge relationship could be designated and hedge accounting applied in future periods for the same hedging instrument and hedged item, provided the prospective test is met for those periods. Similarly, if the entity passes the retrospective test at the end of one period, but fails the prospective test at the beginning of the next period, hedge accounting would be permitted for the period just ended, but could not be applied in the next period. To some degree, these results will be impacted by the manner in which an entity elects to assess hedge effectiveness, because the entity is not required to use the same method for both the prospective and the retrospective assessments.

Example – Failed retrospective test with a successful prospective test
 
A hedge relationship designated by entity A fails the retrospective test for a given period. Accordingly, entity A ceases to apply hedge accounting from the last date on which it demonstrated effectiveness. Entity A performs a successful prospective effectiveness test with the same hedging instrument and the same hedged item at the start of the following period. It should be noted that this prospective effectiveness testing will need to take account of the fact that the derivative now has a non-zero fair value as discussed in paragraph 6.8A.59 above.
 
In this scenario, entity A can designate a new hedge relationship for the remaining life of the instrument following a successful prospective effectiveness test. IAS 39 does not preclude an entity from designating the same derivative as a hedge of the same item in a subsequent period, provided the hedge relationship meets the criteria for hedge accounting (including effectiveness) in that subsequent period. [IFRIC Update April 2005].

6.8A.170 Effectiveness is assessed, at a minimum, at the time an entity prepares its annual or interim financial statements. [IAS 39 para AG 106]. However, the standard does not prevent an entity from undertaking an assessment more frequently. Indeed, an entity may wish to assess effectiveness more frequently say, at the end of each month or other applicable reporting period, in order to minimise the time period during which the hedge may fail due to ineffectiveness and to better manage the hedged risk exposure.

6.8A.171 IAS 39 does not specify a single method for assessing hedge effectiveness. The method an entity adopts for assessing hedge effectiveness depends on its risk management strategy. Also the appropriateness of a given method of assessing hedge effectiveness will depend on the nature of the risk being hedged and the type of hedging instrument used. IAS 39, however, does require an entity to document at the inception of the hedge how effectiveness will be assessed. The method of assessing effectiveness must be reasonable and consistent with other similar hedges, unless different methods can be explicitly justified. The defined and documented method should be used on a consistent basis throughout the hedge’s duration. [IAS 39 para 88]. [IAS 39 para IG F4.4]. There is nothing in the standard to prevent an entity from using one method for prospective testing and another different method for retrospective testing as long as the chosen methods are reasonable and properly documented upfront and used on a consistent basis throughout the hedge’s duration. Methods normally used for testing hedge effectiveness are considered in paragraph 6.8A.181 below.

6.8A.172 There is nothing in the standard to prevent an entity from changing its method of assessing hedge effectiveness. However, if an entity wishes to change its method of assessing hedge effectiveness, this will result in a new hedging relationship. Hence, the entity should de-designate the old hedging relationship and then immediately designate a new hedging relationship using the new method of assessing hedge effectiveness. As a result, new documentation would need to be prepared. It should be noted, however, that there is a danger in de-designating and re-designating the hedge relationship. This is because the hedging instrument will have a non-zero fair value and this may well impact the assessment of hedge ineffectiveness due to ineffectiveness caused by the non-zero fair values.

Criteria for obtaining hedge accounting - Hedge effectiveness - Assessment on a cumulative or a period-by-period basis

Publication date: 08 Dec 2017


6.8A.173 IAS 39 permits an entity to assess hedge effectiveness using either a period-by-period approach or a cumulative approach, provided the chosen approach is incorporated into the hedging documentation at inception of the hedge. [IAS 39 para IG F4.2]. The period-by-period approach involves comparing the changes in the hedging instrument’s fair values (or cash flows) that have occurred during the period being assessed to the changes in the hedged item’s fair value (or hedged transaction’s cash flows) attributable to the risk hedged that have occurred during the same period. The cumulative approach involves comparing the cumulative changes (to date from inception of the hedge) in the hedging instrument’s fair values (or cash flows) to the cumulative changes in the hedged item’s fair value (or hedged transaction’s cash flows) attributable to the risk hedged. The two methods can produce significantly different results as illustrated below:

  Cumulative basis Period-by-period basis
Assessment period Hedging instrument Hedged item Ratio (%) Hedging instrument Hedged item Ratio (%)
Quarter 1 50 (50) 100% 50 (50) 100%
Quarter 2 105 (107) 98% 55 (57) 96%
Quarter 3 129 (120) 108% 24 (13) 184%
Quarter 4 115 (116) 99% (14) 4 350%

6.8A.174 It is clear from the above table that the period-by-period approach of retrospective assessment results in the disqualification of hedge accounting in quarters 3 and 4. By contrast, had the cumulative method of retrospective assessment been applied, all periods would have been considered highly effective and qualified for hedge accounting. It is, therefore, important to ensure that the chosen method of assessment, in this instance, the cumulative method, is documented at the inception of the hedging relationship. Indeed, in most situations, the cumulative method would be adopted in practice as it results in less ineffectiveness. Another example of assessing expected hedge effectiveness on a cumulative basis is given below.

Example – Hedge effectiveness assessment on a cumulative basis
 
An entity designates a LIBOR-based interest rate swap as a hedge of a borrowing whose interest rate is a UK base rate plus a margin. The UK base rate changes, perhaps, once each quarter or less, in increments of 25-50 basis points, while LIBOR changes daily. Over a period of 1-2 years, the hedge is expected to be almost perfect. However, there will be quarters when the UK base rate does not change at all, while LIBOR has changed significantly.
 
Expected hedge effectiveness may be assessed on a cumulative basis if the hedge is so designated and that condition is incorporated into the appropriate hedging documentation. Therefore, even if a hedge is not expected to be highly effective in a particular period, hedge accounting is not precluded if effectiveness is expected to remain sufficiently high over the life of the hedging relationship. However, any ineffectiveness is required to be recognised in profit or loss as it occurs. [IAS 39 para IG F4.2].

Criteria for obtaining hedge accounting - Hedge effectiveness - Counterparty credit risk

Publication date: 08 Dec 2017


6.8A.175 An entity must consider the likelihood of default by the counterparty to the hedging instrument in assessing hedge effectiveness. This is because an entity cannot ignore whether it will be able to collect all amounts due under the contractual provisions of the hedging instrument. When assessing hedge effectiveness, both at the inception of the hedge and on an ongoing basis, the entity should consider the risk that the counterparty to the hedging instrument will default by failing to make any contractual payments to the entity when due (see chapter 6.7 for further guidance). For a cash flow hedge, the fair value of the underlying cash flow (hypothetical derivative) will not be affected by change in credit risk of the hedge counterparty. However, the fair value of the actual hedging instrument will be affected. This will lead to ineffectiveness and may even cause hedge relationship to fail if the effectiveness test result falls outside of the 80%-125% range. Furthermore if it becomes probable that the derivative counterparty bank will default, an entity would be unable to conclude that the hedging relationship is expected to be highly effective in achieving offsetting cash flows. As a result, hedge accounting would be discontinued. For a fair value hedge, if there is a change in the counterparty’s creditworthiness, the fair value of the hedging instrument will change, which affects the assessment of whether the hedge relationship is effective and whether it qualifies for continued hedge accounting. [IAS 39 para IG F4.3].

Criteria for obtaining hedge accounting - Hedge effectiveness - Entity credit risk

Publication date: 08 Dec 2017


6.8A.175.1 Entities are required to adopt IFRS 13 for accounting periods commencing after 1 January 2013. This has amended the definition of fair value in IAS 39. Derivative liabilities should now be recorded at a transfer price; this includes an adjustment for the entity’s own credit risk. Many entities previously used a counter-party settlement price approach to fair value measurement so the effect of own credit risk was often insignificant. Use of a transfer price will be a change in estimate for many entities. The updated valuations may affect hedge effectiveness testing in a similar way to the adjustments for counterparty credit risk. See chapter 5 for more details on fair value accounting under IFRS 13.

Criteria for obtaining hedge accounting - Hedge effectiveness - Transaction costs

Publication date: 08 Dec 2017


6.8A.176 Transaction costs are never part of a fair value movement under IAS 39 and, therefore, they should be excluded from hedge effectiveness tests.

Example Transaction costs
 
Entity A, whose functional currency is the pound sterling, granted a US$ denominated loan to entity B. Entity A measures the loan at amortised cost, which at initial recognition is the amount lent of US$1m plus transaction costs of US$ 5,000. Entity A designates the loan as a hedging instrument for the foreign exchange risk of a forecast purchase of US$1m. The repayment of the loan and the forecast purchase occur on the same date and all other requirements for hedge accounting are met. Since transaction costs of US$5,000 would not be included in the loan’s fair value if it had been carried at fair value, entity A’s management should exclude transaction costs of US$5,000 from the effectiveness test.

Criteria for obtaining hedge accounting - Hedge effectiveness - Pre-payment risk

Publication date: 08 Dec 2017


6.8A.177 Pre-payment risk will impact the effectiveness of fair value hedges of pre-payable assets, such as mortgage loans and, therefore, should be taken into account when an entity designates the hedge relationship. The hedged mortgage loans’ contractual terms include the pre-payment option (for the borrower), which cannot be ignored. Furthermore, pre-payment rates are primarily a function of interest rates and, hence, IAS 39 specifies that pre-payment risk is a component of interest rate risk. Therefore, if an entity intends to hedge a portfolio of mortgage loans for interest rate risk, pre-payment risk cannot be excluded. For instance, an entity may have a portfolio of C500 million of mortgage loans that may be pre-paid at par. The entity may wish to hedge the changes in fair value of this portfolio attributable to interest rate movements by entering into a simple receive-variable, pay-fixed interest rate swap. Such a swap, however, would not be a highly effective hedging instrument, because the hedged item contains a pre-payment option that is not present in the swap. However, if the entity can demonstrate (based on historical data) that C100 million of the portfolio would not pre-pay if interest rate were to decline, it could designate that specific portion of the mortgage portfolio as the hedged item.

6.8A.178 Cash flows after the pre-payment date may be designated as the hedged item to the extent it can be demonstrated that they are ‘highly probable’. For example, cash flows after the pre-payment date may qualify as highly probable if they result from a group or pool of similar assets (for example, mortgage loans) for which pre-payments can be estimated with a high degree of accuracy or if the pre-payment option is significantly out of the money. In addition, the cash flows after the pre-payment date may be designated as the hedged item if a comparable option exists in the hedging instrument. [IAS 39 para IG F2.12].

Criteria for obtaining hedge accounting - Hedge effectiveness - Discount rate

Publication date: 08 Dec 2017


6.8A.179 Historically, derivative valuations were based on a LIBOR discount rate applied to the derivative’s contractual cash flows. The LIBOR discount rate reflected the cost of funding for banks. The use of LIBOR as the standard discount rate, however, ignores the fact that some of derivative transactions are collateralised. Collateralised trades involve a funding rate based off the overnight indexed swap (OIS) curve rather than LIBOR. This discrepancy has always existed, however historically the difference between LIBOR and OIS has been small. This basis differential widened significantly in 2008 and the structural shift in credit pricing following 2008.

6.8A.180 As a result, valuing collateralised swaps has been shifting from using a discount rate of LIBOR to using an OIS rate. Companies should assess at each reporting date whether market practice has moved sufficiently that the use of LIBOR as the discount rate to value collateralised derivatives is no longer appropriate. They should also consider the impact on hedge effectiveness. In particular, in a cash flow hedge, it may be possible to avoid additional ineffectiveness by designating the hedge such that the hypothetical derivative is discounted using either LIBOR or OIS as appropriate, given both are used by the market to price swaps (as LIBOR continues to be used to price uncollateralised swaps). However, for a fair value hedge, ineffectiveness may arise where the hedging instrument is a collateralised swap and the appropriate discount rate used to value the swap is determined to be OIS, unless the appropriate benchmark rate for the hedged item is also deemed to be OIS.

Criteria for obtaining hedge accounting - Hedge effectiveness - Methods used to assess hedge effectiveness

Publication date: 08 Dec 2017


6.8A.181 IAS 39 does not specify a single method for assessing hedge effectiveness prospectively or retrospectively. The method an entity adopts for assessing hedge effectiveness depends on its risk management strategy and should be included in the documentation at the inception of the hedge. There are a number of methods that are used in practice ranging from the most simple (qualitative) to the more complex (highly quantitative). Although the particular method selected would depend on the nature and type of the hedging relationship, all of the methods attempt to gauge the relative change in value of the hedged item and the hedging instrument. The methods that are commonly used in practice to assess hedge effectiveness are described in the paragraphs that follow. It should be noted, however, that whatever method is used test the effectiveness of a hedge, a quantitative retrospective test must be performed to determine the amount of ineffectiveness that has occurred and that must be recognised in profit or loss (see para 6.8A.211 below).

Criteria for obtaining hedge accounting - Hedge effectiveness - Methods used to assess hedge effectiveness - Critical terms comparison

Publication date: 08 Dec 2017


6.8A.182 This method consists of comparing the principal terms of the hedging instrument with those of the hedged item. If the principal terms of the hedging instrument and of the hedged item are the same, the changes in fair value and cash flows attributable to the risk being hedged may be likely to offset each other fully, both when the hedge is entered into and afterwards. [IAS 39 para AG 108]. The principal terms of the hedging instrument and hedged items are those that are critical to the assessment of hedge effectiveness. Further, critical terms are the same if and only if the terms are exactly the same and there are no features (such as optionality) that would invalidate an assumption of perfect effectiveness. Therefore, this method may only be used in limited circumstances, but in such cases it is the simplest way to demonstrate that a hedge is expected to be highly effective on a prospective basis. This method does not require any calculation. For instance, an interest rate swap is likely to be an effective hedge if the notional and principal amounts, term, re-pricing dates, dates of interest and principal receipts and payments and basis for measuring interest rates are the same for the hedging instrument and the hedged item. [IAS 39 para AG 108]. A separate assessment is required for the retrospective effectiveness test, as ineffectiveness may arise even when critical terms match; for example, because of a change in the liquidity of a hedging derivative or in the creditworthiness of the derivative counterparty.

6.8A.183 Similarly, a hedge of a highly probable forecast purchase of a commodity with a forward contract is likely to be highly effective if:

the forward contract is for the purchase of the same quantity of the same commodity at the same time and location as the hedged forecast purchase;
the fair value of the forward contract at inception is zero; and
either the change in the discount or premium on the forward contract is excluded from the assessment of effectiveness and recognised in profit or loss or the change in expected cash flows on the highly probable forecast transaction is based on the commodity’s forward price. [IAS 39 para AG 108].
   
In these circumstances, the change in the derivative’s fair value can be viewed as a proxy for the present value of the change in cash flows attributable to the risk being hedged. The documentation that the critical terms of the hedging instrument and hedged item match must be performed at the inception of the hedging relationship and on an ongoing basis throughout the hedging period.

6.8A.184 It should be noted that the critical terms of the hedged item and hedging instrument listed in the above example all pertain to factors that could produce ineffectiveness in a hedging relationship. The fair value of the forward must be zero at the inception of the hedging relationship because forward contracts with a value of other than zero include a ‘financing’ element that is a source of ineffectiveness (see para 6.8A.59 above). Accordingly, the use of this method should be restricted to situations where an entity enters into the derivative at or very close to the same time it establishes the hedging relationship.

6.8A.185 Even if all of the critical terms of a hedging relationship match, an entity cannot assume perfect hedge effectiveness throughout the life of the hedge without further effectiveness testing. An entity still must assess retrospectively the effectiveness of the relationship, at a minimum, at the time it prepares its annual or interim financial statements. A separate quantitative assessment is required for the retrospective effectiveness test, as ineffectiveness may arise even when critical terms match as illustrated in the following example. [IAS 39 para IG F4.7].

Example – Testing effectiveness retrospectively when critical terms match
 
Entity A enters into a 5 year fixed-rate borrowing. On the same date, it enters into a receive-fixed/pay-floating interest rate swap on which the floating leg is reset every 3 months. The principal terms of the swap and the debt match (start date, end date, fixed payment dates, calendar basis, principal amount, fixed interest rate) and there are no features or conditions (such as optionality) that would invalidate an assumption of perfect effectiveness.
 
As the principal terms of the debt and the fixed leg of the swap match and entity A is able to demonstrate and document that the change in the fair value of the floating leg of the swap will not give rise to material ineffectiveness, this is sufficient that the hedge is expected to be highly effective on a prospective basis. Thus, a numerical test is not required to demonstrate prospective effectiveness.
 
However, even though the critical terms of the fixed rate borrowing and the swap match, hedge effectiveness cannot be assumed throughout the life of the hedge and a retrospective test must be performed. The objective of the retrospective effectiveness test is to determine that the hedge actually has been highly effective throughout the financial reporting period for which it was designated. If the principal terms of the hedging instrument match those of the hedged item, ineffectiveness may still arise, for example if in the case of a fair value hedge:
 
there is a change in the swap’s liquidity;
there is a change in the swap counterparty’s creditworthiness; or
the floating rate leg is not reset on the testing date.

Criteria for obtaining hedge accounting - Hedge effectiveness - Methods used to assess hedge effectiveness - Dollar offset method

Publication date: 08 Dec 2017


6.8A.186 This is a quantitative method that consists of comparing the change in fair value or cash flows of the hedging instrument with the change in fair value or cash flows of the hedged item attributable to the hedged risk. If this ratio falls within the range of 80%-125% as explained in paragraph 6.8A.169, the hedge is regarded as highly effective. Depending on the entity’s risk management policies, this test can be performed either on a cumulative basis or on a period-by-period basis as explained in paragraph 6.8A.173-6.8A.174 above. The formula for assessing hedge effectiveness on cumulative basis under the dollar-offset method can be expressed as follows:
 
 
0.8 <
|
|
|
|
n
Xi
i = 1
|
|
|
|
< 1.25  
 
 
  n
Yi
i = 1
 

where n
Xi
i = 1
is the cumulative sum of the periodic changes in the values of the hedging instrument and n
Yi
i = 1
is the cumulative sum of the periodic changes
in the values of the hedged item and n = number of periods since inception of the hedge. Since Xi and Yi are variables that offset each other, the minus sign has been introduced to ensure that the ratio is an absolute number.
 
For a perfect hedge, the change in the value of the hedging instrument exactly offsets the change in the value of the hedged item. Therefore, the above ratio of the cumulative sum of the periodic changes in value of the hedging instrument and the hedged item would equal one in a perfect hedge.

Example – Dollar-offset method
 
Entity A has a C1,000 debt at 10% fixed rate with a 2 year term. Interest payments are made annually In order to hedge against future changes in interest rates it enters into a 2 year C1,000 notional interest rate swap requiring interest payments at one year LIBOR in exchange for the receipt of fixed interest at 10% (fair value hedge of interest rate risk).
 
At inception, LIBOR is expected to be 10% for the following 2 years, but at the end of year 1 LIBOR is expected to be 5% for the second year. At the end of year 1, the retrospective test would be performed as follows:
    C
Hedged item (debt)  Fair value at inception = 1,000
  Fair value at end of year 1 = C1,000 × 1.10/1.05 1,048

  Change in fair value (48)

Hedging instrument Fair value at inception 0
  Fair value at end of year 1 = C50 */1.05 48

  Change in fair value 48

* Difference in anticipated swap cash flows = C1,000 × (10% – 5%)  

Dollar offset test at end of year 1  
   
Change in fair value of hedging instrument 48  

=
=
1
Change in fair value of hedged item (48)  

This hedge is, therefore, currently 100% effective.
     
If there had been a contractual difference or delay in the timing of the cash flows either on the debt or the swap, or if effectiveness is tested at a date other than the swap re-pricing date, then some ineffectiveness would most likely result. Also no account has been taken here of the credit risk in the swap payments, which could have introduced some ineffectiveness. Note that any credit risk on the debt was not designated as part of the hedging relationship and any impact of this would be booked to the income statement anyway over time, though not on a fair value basis.
     
Consider the example above, but the cash flows on the debt are anticipated to slip by one month at the end of year 2. The end of year 1 retrospective test would show:
    C
Hedged item (debt)  Fair value at inception = 1,000
  Fair value at end of year 1 = C1,000 × 1.10/(1.05)13/12 1,043

  Change in fair value (43)

Hedging instrument Fair value at inception 0
  Fair value at end of year 1 = C50 */1.05 48

  Change in fair value 48

* Difference in anticipated swap cash flows = C1m × (10% – 5%)  

Dollar offset test at end of year 1  
   
Change in fair value of hedging instrument 48  

  =
  =
1.12
Change in fair value of hedged item (43)  
     
Due to the cash flow slippage on the debt ineffectiveness of C5 has been introduced. This is still within the 80-125 % range so hedge accounting is still permitted, however, the C5 will need to be recognised in profit or loss as explained further in paragraph 6.8A.213 below.

6.8A.187 The above examples illustrate that the dollar-offset method has the advantage that the calculation is straightforward and does not rely on maintaining a large population of valuation data. When applied retrospectively to an assessment of actual effectiveness, the dollar-offset method can be applied either on a period-by-period basis or cumulatively from the date of the inception of the hedge as explained in paragraph 6.8A.173 above. However, the example in that paragraph also indicated that even though on a cumulative basis the hedge was highly effective, two test ratios were outside the critical range on a period-by-period basis. This is an unfortunate consequence of the 80/125 rule that during periods of market stability virtually any hedge is likely to fail as small changes in the values of either the hedged item or the hedging instrument can produce extreme ratios. This is a general shortcoming of the dollar-offset method and is likely to occur when there are short testing intervals. As a result, the dollar offset method can be unreliable, causing hedges that are, by other reasonable standards, highly effective, to fail the effectiveness test. In practice, however, this short coming is often overcome by performing a cumulative dollar-offset test.

6.8A.188 Notwithstanding the above, when the dollar offset method is used for assessing retrospectively the effectiveness of a hedge, it has the advantage of determining the amount of ineffectiveness that has occurred and of generating the numbers required for the accounting entries. For instance, to the extent that the sum of the changes in the value of the hedged item and the hedging instrument is not zero, there is an element of ineffectiveness in the hedge that is included in profit or loss. Thus, even when a hedge is determined to be highly effective, there is an impact on profit or loss when there is not an exact offset of the hedged risk as illustrated in the example in paragraph 6.8A.186 above.

6.8A.189 The dollar offset method can be performed using different approaches. Three approaches that are generally used in practice are:

■   The hypothetical derivative method (see para 6.8A.190 below).
■   The benchmark rate method (see para 6.8A.193 below).
■   The sensitivity analysis method (see para 6.8A.194 below).

Criteria for obtaining hedge accounting - Hedge effectiveness - Methods used to assess hedge effectiveness - Hypothetical derivative method

Publication date: 08 Dec 2017


6.8A.190 The hypothetical derivative method is used under dollar offset method to measure the effectiveness of cash flow hedges. Under the hypothetical derivative method, the hedged risk is modelled as a derivative called a ‘hypothetical derivative’ (as it does not exist). The hypothetical derivative approach compares the change in the fair value or cash flows of the hedging instrument with the change in the fair value or cash flows of the hypothetical derivative. The hypothetical derivative method is referred to as ‘method B’ in IAS 39 paragraph IGF5.5. The measurement of hedge ineffectiveness is based on a comparison of the change in fair value of the actual derivative designated as the hedging instrument and the change in fair value of a hypothetical derivative. That hypothetical derivative would have terms that identically match the critical terms of the hedged item. For example, for a cash flow hedge that involves either a variable rate asset or a liability, the hypothetical derivative would be a swap that must have the same notional amount and the same re-pricing dates. Also, the index on which the hypothetical swap’s variable rate is based should match the index on which the asset or liability’s variable rate is based, and must mirror any caps, floors or any other non-separated embedded derivative features of the hedged item. Thus, the hypothetical swap would be expected to perfectly offset the hedged cash flows. The change in fair value of the ‘perfect’ hypothetical swap is regarded as a proxy for the present value of the cumulative change in expected future cash flows on the hedged transaction. However, if the hedge starts part way through the life of the hedged item, the hypothetical swap (or benchmark rate in example 1 of para 6.8A.193) will not identically match the critical terms of the hedged item as the relevant rate for the fixed leg of the hypothetical derivative or benchmark rate will be the market rate at inception of the hedge, not the rate at inception of the hedged item or hedging instrument. This will give rise to ineffectiveness and may preclude the use of hedge accounting if rates have moved significantly since the hedged item was taken out.

6.8A.191 Accordingly, once an entity has determined the change in fair value of the hypothetical swap and the change in the fair value of the actual swap for particular periods, it would use this data to assess the hedging relationship’s effectiveness. The actual swap would be recorded at fair value on the balance sheet and the amount reported in equity would be adjusted to a balance that reflects the lesser of either the cumulative change in the actual swap’s fair value or the cumulative change in the ‘perfect’ hypothetical swap’s fair value. Determining the fair value of both the ‘perfect’ hypothetical swap and the actual swap should use discount rates based on the relevant swap curves. Thus, for the hypothetical swap the discount rates used are the spot rates implied by the current yield curve for hypothetical zero coupon bonds due on the date of each future net settlement of the swap. The amount of ineffectiveness, if any, recorded in profit or loss would then be equal to the excess of the cumulative change in the fair value of the actual swap over the cumulative change in the fair value of the ‘perfect’ hypothetical swap.

6.8A.192 The hypothetical derivative method often is useful in evaluating the effectiveness of cash flow hedging relationships involving other derivatives, such as cross-currency swaps, commodity swaps and forward exchange contracts.

Example – Hypothetical derivative method
 
Entity A hedges the foreign currency risk of highly probable forecast transactions using forward contracts. Entity A intends to measure the effectiveness of the hedge by modelling the hedged risk of the forecast transaction as a hypothetical derivative.
 
As explained above, this method is specifically mentioned in IAS 39. Entity A would construct a hypothetical derivative whose terms reflect the relevant terms of the hedged item. Since entity A hedges the foreign currency risk of highly probable sales, the relevant hypothetical derivative is a forward foreign currency contract for the hedged amount maturing at the date on which the cash flows are anticipated, at the relevant forward rate at inception of the hedge. The change in the fair value of the hypothetical derivative is then compared with the change in the fair value of the hedging instrument to determine effectiveness.

Criteria for obtaining hedge accounting - Hedge effectiveness - Methods used to assess hedge effectiveness - The benchmark rate method

Publication date: 08 Dec 2017


6.8A.193 The benchmark rate approach is used under the dollar offset method to measure the effectiveness of cash flow hedges. Although not specifically mentioned in IAS 39, it is a variant of the hypothetical derivative method that is permitted by the standard and discussed in paragraph 6.8A.192 above. Under this method, a ‘target’ rate is established as the benchmark rate for the hedge. For example, in an interest rate hedge of a variable rate debt instrument using an interest rate swap, the benchmark rate is usually the swap’s fixed rate at the inception of the hedge. The benchmark rate method first identifies the difference between the hedging item’s actual cash flows and the benchmark rate. It then compares the change in the amount or value of this difference with the change in the cash flow or fair value of the hedging instrument as illustrated in the example below.

Example 1 – Cash flow hedge effectiveness testing – ‘fixed benchmark method’
 
Entity A issues a variable rate bond. On the same date, it enters into an interest rate swap under which it will receive variable and pay a fixed rate of interest. An equivalent fixed rate debt instrument with the same maturity could have been issued at 8%. Entity A designates the swap as a cash flow hedge of the bond. All the criteria for hedge accounting in paragraph 6.8A.154 are met.
 
Entity A proposes to test effectiveness both prospectively and retrospectively by comparing:
 
the present value of the cumulative change in expected future cash flows on the swap; with
the present value of the cumulative change in the expected future interest cash flows on the variable leg less the fixed rate (8%).
 
In this situation, entity A can use the ‘fixed benchmark method’ in a cash flow hedge relationship for both prospective and retrospective effectiveness testing. This method reflects the risk management objective of the hedging relationship – that is, to swap a series of future variable cash flows to a fixed rate and is consistent with the requirements in IAS 39 that the method an entity adopts for assessing hedge effectiveness depends on its risk management strategy. [IAS 39 para AG 107].
 
Entity A should define the hedged risk as the change in the fair value of the variable cash flows, less the change in the fair value of a fixed rate of interest that could have been achieved at the inception of the underlying debt instrument (8%). It therefore measures the variability against a specified fixed rate. Effectiveness testing should be performed based on the ability of the hedging instrument to deliver that specified set of cash flows and should, therefore, measure variability from that fixed rate.

Example 2 – Cash flow hedge effectiveness testing – ‘Change in variable cash flow method’
 
Using the facts as set out in example 1 above, the entity’s management proposes to test effectiveness both prospectively and retrospectively by comparing the present value of the cumulative change in expected future cash flows on the swap’s floating rate leg and the present value of the cumulative change in the expected future interest cash flows on the floating rate liability.
 
This method is sometimes referred to as the ‘change in variable cash flow’ method. This method is an acceptable method for performing prospective effectiveness testing, but not for retrospective effectiveness testing.
 
The justification for using this approach for prospective effectiveness testing is that the change in variable cash flows method is consistent with the cash flow hedge objective of effectively offsetting the changes in the hedged cash flows attributable to the hedged risk and that only the floating rate leg of the swap provides the cash flow hedge protection.
 
With regards to retrospective effectiveness testing, the change in variable cash flow method is not permitted for retrospective effectiveness testing since only a portion of the derivative (the floating rate leg only) is used for the test. Paragraph 74 of IAS 39 states that a hedging relationship is designated by an entity for a hedging instrument in its entirety and that the only exceptions are for the split between time value and intrinsic value of an option and the spot and forward points on a foreign exchange forward. Neither of these exceptions applies when the hedging instrument is an interest rate swap. The entire fair value of the hedging instrument must be used in performing retrospective hedge effectiveness testing.
 
The last paragraph of IAS 39 IG F5.5 explicitly states that this method is not acceptable, as it has the effect of measuring ineffectiveness on only a portion of the derivative. IAS 39 does not permit the bifurcation of a derivative for the purposes of assessing effectiveness.

Criteria for obtaining hedge accounting - Hedge effectiveness - Methods used to assess hedge effectiveness - Sensitivity analysis method

Publication date: 08 Dec 2017


6.8A.194 This method is applied to assess the effectiveness of a hedge prospectively. The method consists of measuring the effect of a hypothetical shift in the underlying hedged risk (for example, a 10% shift in the foreign currency exchange rate being hedged) on both the hedging instrument and the hedged item.

Criteria for obtaining hedge accounting - Hedge effectiveness - Methods used to assess hedge effectiveness - Regression analysis

Publication date: 08 Dec 2017


6.8A.195 Regression analysis is a statistical technique used to analyse the relationship between one variable (the dependent variable) and one or more other variables (known as independent variables). A common application of regression analysis is to build a model using past information that can be used to predict, say, the value of the dependent variable (for example, current year revenue of a particular retail outlet) for a new observation of the independent variable (for example, local employment). However, in the context of hedge effectiveness test, the method investigates the extent to which changes in the hedged item (the independent variable) and the hedging instrument (the dependent variable) are highly and negatively correlated and, thus, supportive of the assertion that there will be a high degree of offset in fair values or cash flows achieved by the hedge.

6.8A.196 For purposes of the hedge accounting effectiveness test, the analysis usually involves a simple linear regression that involves determining a ‘line of best fit’ and then assessing the ‘goodness of fit’ of this line. Multiple linear regression analysis examines the relationship between a dependent variable and two or more independent variables. The linear equation estimated in a simple regression is commonly expressed as:
 
     Y = a + bX + e

Y: The dependent variable
X: The independent variable
a: The intercept, where the line crosses the Y axis
b: The gradient of the line
e: The random error term

 
The values of the X and Y variables are plotted and a ‘best fit’ line is drawn as illustrated below.
10174a

6.8A.197 There are three critical test statistics to determine an effective hedge relationship when using regression analysis. These are as follows:

Gradient of the line (b) must be negative and in the range -0.8 < b < -1.25.

The gradient that the regression analysis determines ‘best fits’ the data, is the ratio of the change in Y value over the change in X value (assuming the model is developed using the hedging derivative as Y or the dependent variable and the hedged item as X or the independent variable). The gradient is a very important component when developing a highly effective hedging relationship and represents the variance-minimising hedge ratio. A gradient of -1 means that for a C1 increase (decrease) in the hedged item, the derivative will generally decrease (increase) by C1, which represents a perfect hedge. The gradient should be negative because the derivative is expected to offset changes in the hedged item. Therefore, if the regression analysis is performed using equal units of the hedging instrument and the hedged item, the gradient b can be used to determine the optimal hedge ratio (that is, the optimal volume of derivative that should be transacted to maximise expected effectiveness). This ratio can then be used by the entity to determine how many units of the hedging instrument it should transact to best mitigate the risk for the particular position being hedged. For example, if the gradient = -0.95, a hedge ratio based on 95 units of the hedging instrument to 100 units of the hedged item will maximise expected effectiveness.

Once the hedge ratio has been determined and the hedge transacted, the regression analysis is re-performed using the actual quantities of the hedging instrument and the hedged item. The gradient is used when assessing the effectiveness of the actual hedge relationship. The gradient must be negative and fall within the range of -0.8 to -1.25. If the gradient is positive, there is no hedge relationship (that is, the hedging instrument does not mitigate the hedged risk). If the gradient is negative but outside of the range of -0.8 to -1.25, there is some hedge relationship, but it is not strong enough to pass the effectiveness test. Hedge accounting is not permitted in either case.

   

The co-efficient of determination (R2) > 0.96

The co-efficient of determination (R2) measures the degree of explanatory power or correlation between the dependent and independent variable. Best practice is that it should have a value greater than 0.96, since this is equivalent to a dollar offset of between 80% and 125%. R2 represents the proportion of variability in the hedging derivative (the dependent variable) that can be explained by variation in the hedged item (the independent variable). By way of illustration, an R2 of .98 indicates that 98% of the movement in the hedging instrument is ‘explained’ by variation in the hedged item. R2 values will always be positive (as it is a squared number) and can never exceed 1 (that is, it is not possible to explain more than 100% of the movement in the dependent variable). The square root of R2 or ‘r’ is called the co-efficient of correlation. The co-efficient of correlation can be either positive or negative depending on the underlying relationship between the dependent and independent variables. Whereas values of R2 are easily interpreted, ‘r’ does not have a clear-cut operational interpretation. It should be noted that although it is best practice to have a value of R2>0.96, a value of 0.8 (used under US GAAP) maybe acceptable, provided the other regression statistics are also met. In other words, R2>0.8 is not, on its own, sufficient.

   

The statistical validity of the overall regression model (the F-statistic) must be significant.

The F-statistic is a standard output from the statistical model. It is a measure of the statistical significance of the relationship between the dependent variable and the independent variable (that is, whether the derivative relationship, relative to the hedged risk, is a statistically valid relationship). A non-significant F-statistic indicates there is no statistically significant relationship between the dependent and independent variables. The F-statistic varies with the number of data points used. It can be obtained from statistical tables. To be significant, the result of the F-statistic should be less than 5% (sometimes expressed as a whole number, for example, 4.96) at a 95% or greater confidence level.


6.8A.198 It is important to note that in order to be deemed highly effective, a regression analysis of a hedging relationship must yield acceptable levels for all three factors as noted above. For example, a regression analysis may produce an R2 = 0.96, but an F-statistic that is not significant at the 95% threshold. In this situation, it is not possible to conclude that there is a statistically significant relationship between the hedged item and the hedging derivative and, therefore, the hedging relationship is not considered effective. Another example is where an entity establishes a 1 for 1 hedge and the regression analysis results in an R2 = 0.96, an F-statistic that is significant at the 95% threshold, but a gradient of only −0.7. In this situation, the hedge relationship would be ineffective, because, on average, it would achieve a dollar offset of only 70% of the hedged item. However, if the entity adjusted its hedge ratio from 1 to 1 to reflect the gradient of −0.7 in order to achieve a higher dollar offset, hedge accounting would be permitted.

6.8A.199 When using regression analysis to test the effectiveness of a hedge, it is important to use a sufficient number of matched paired data points to ensure a statistically valid analysis. Generally speaking, the higher the sample size, the more robust will be the analysis and more reliable the conclusion drawn from the model’s output. For statistically reliable results, hedge effectiveness should be based on more than 30 observations. However, as a rule of thumb, no less than 12 observations should be used.

6.8A.200 In using regression or other statistical analysis, it also will be necessary for an entity to determine the interval between data points – for example, whether to use daily, weekly, monthly, or quarterly changes in prices in assessing effectiveness. Generally, the selection frequency would depend on:

The nature of the hedged item.
The nature of the hedging derivative.
Whether certain data points will most appropriately represent the interaction of the hedged item versus the hedging instrument.
The availability of the data.

Ideally, the entity should try to incorporate as much relevant information as possible. Determining what is relevant requires considerable judgment. For instance, it would not be appropriate to use past data that is no longer representative of the current or future market conditions. In those circumstances, it may be appropriate to use a shorter more recent data set consisting of say, daily or weekly frequency period that more faithfully represents the current hedging relationship. On the other hand, too short a period might be equally problematic. If, say, interest rates remained stable over the past few months, a regression analysis based over this short time span would provide a poor indication of how the hedge will perform when interest rates become more volatile.

6.8A.201 When a regression analysis is first performed (at the inception of the hedging relationship), an entity may need to determine that the hedging relationship will be highly effective on a prospective basis. This analysis may use historical data to determine valuations for the proposed derivative and the hedged item. The historical data observation would typically (but not necessarily) cover the same period as the length of the hedging relationship. For example, assume an entity issues a three-year fixed rate debt instrument today and enters into an interest rate swap to hedge the fair value exposure to changes in interest rate. The entity should use last three year’s data as input for a regression analysis to test whether, at inception, given the terms of the loan and the swap, the hedge is likely to be highly effective on a prospective basis. Conversely, if the last three years’ data were not representative of the next three years’, use of regression analysis would not be appropriate.

6.8A.202 As the standard requires that effectiveness should be assessed at a minimum at the time an entity prepares its annual or interim financial statements, the entity would carry out both prospective and retrospective hedge effectiveness testing at the subsequent measurement date. If one method is being used for both prospective and retrospective analyses, the same number of data points should be used in the subsequent assessment. Assuming that the entity has chosen monthly data points, the regression analysis at the next annual reporting date would also include 36 data points (12 monthly actual data after inception and the 24 monthly data before inception). As such, 12 months of the oldest data is excluded from the regression analysis. Accordingly, the regression analysis will always contain the same number of data points. It should be noted that the method outlined is not the only acceptable method to determine inputs for regression analysis. Instead of using discrete monthly data, the entity could use a cumulative retrospective evaluation as long as the same number of data points is included in the analysis.

6.8A.203 From an accounting perspective, regression analysis proves whether or not the relationship is sufficiently effective to qualify for hedge accounting. It does not calculate the amount of any ineffectiveness, nor does it provide the numbers necessary for the accounting entries where the analysis demonstrates that the ‘highly effective’ test has been passed. The accounting entries are based on the dollar-offset method of measuring the changes in the fair values of the derivative and in the hedged risk of the hedged item, both calculated using actual rates at the test date as explained in paragraph 6.8A.211 below.

Criteria for obtaining hedge accounting - Hedge effectiveness - Methods used to assess hedge effectiveness - Comparison between regression analysis and dollar offset method

Publication date: 08 Dec 2017


6.8A.204 There may be circumstances where the results from regression analysis support the use of hedge accounting, but the dollar offset measurement indicate that the hedge would not be highly effective if the dollar offset method had been used. Indeed, it would not be unusual for this to happen, as the two methods are very different. Therefore, in a period where the dollar offset accounting measurement indicates that the accounting results are slightly outside of the 80%-125% range, hedge accounting would still be appropriate assuming that there was a sound statistical regression analysis supporting the use of hedge accounting for that period. However, if the dollar offset accounting measurements indicate that the hedging relationship was significantly outside of the 80%-125% range, then the validity and soundness of the regression analysis would be called into question. In that situation, the entity should seek to ascertain the causes for such differences. It may be that small changes in the values of either the hedged item or the hedging instrument cause the dollar offset method to be outside the range based on current hedge designation. In that situation, continuation of hedge accounting may be appropriate. However, continual failure to achieve high effectiveness under the dollar offset method for reasons other than small dollar differences may invalidate the use of regression analysis for the hedging relationship. In that situation, hedge accounting should be discontinued prospectively unless the entity is able to correct any known deficiencies in the prior model and demonstrate that the new model produces a sound statistical regression result that is representative of the hedging relationship.

Criteria for obtaining hedge accounting - Hedge ineffectiveness - Sources of hedge ineffectiveness

Publication date: 08 Dec 2017


6.8A.205 Hedge relationships are seldom perfect. Therefore, ineffectiveness will almost always arise with the result that changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk and the hedging instrument do not offset within a period. Examples of differences that can produce ineffectiveness include:

Basis differences – the fair value or cash flows of the hedged item depend on a variable that is different from the variable that causes the fair value or cash flows of the hedging instrument to change. For example, an entity designates the benchmark interest rate as the hedged risk when the hedged item uses a different index, such as the prime base rate. The basis difference between those indices would affect the assessment and measurement of hedge ineffectiveness.
Location differences – the fair value or cash flows of the hedged item and hedging instrument both depend on the price of the same commodity, but are based on the price at different locations. The price of a commodity will be different in different locations, because of factors such as regional supply and demand and transportation costs.
Timing differences – the hedged item and hedging instrument occur or are settled at different dates. For example, an entity hedges the forecast purchase of a commodity with a derivative that settles at an earlier or later date than the date of the forecast purchase. Another example is a floating rate debt whose variability is hedged with an interest rate swap where the interest rate reset dates on the two instruments are different.
Quantity or notional amount differences – the hedged item and hedging instrument are based on a different quantities or notional amounts.
Changes in the fair value or cash flows of a derivative hedging instrument or hedged item relating to risks other than the specific risk being hedged. For example, an entity hedges the variability in the price of a forecast purchase of a commodity with a derivative whose cash flows are based on the price of a different commodity and this is the only source of ineffectiveness in the relationship or there is a change in estimated future cash flows following impairment of the hedged item.
Use of off market derivatives – an off market derivative is an existing derivative that has a non-zero fair value. Hedge ineffectiveness can arise when using an off market derivative in a number of common place scenarios such as: documentation of a hedge not completed at inception, attempting to restart hedge accounting following a documentation deficiency, temporary interruption of a hedging strategy, change of method of assessing hedge effectiveness in the middle of a hedge period, hedges acquired in a business combination and renegotiation of terms of the derivative.
Currency basis – as discussed in paragraphs 6.8A.29-6.8A.30 the different treatment of currency basis in calculating changes in the fair value of the derivative hedging instrument and the hedged item will create ineffectiveness.

Criteria for obtaining hedge accounting - Hedge ineffectiveness - Minimising hedge ineffectiveness

Publication date: 08 Dec 2017


6.8A.206 The key to minimising hedge ineffectiveness lies in the hedge designation. In many cases, it will be possible to minimise the ineffectiveness in a hedging relationship by the way an entity designates the risk being hedged. This is because under IAS 39 financial assets or liabilities can be hedged with respect to specific risk only (a component of total risk), provided that the exposure to the specific risk component is identifiable and separately measurable (see para 6.8A.25 above). Also, it is possible to designate a hedged financial asset or a financial liability with respect to the risks associated with only a portion of its cash flows or fair value (see para 6.8A.23 above). For non-financial items only certain risks can be hedged and this is discussed from paragraph 6.8A.34. Therefore, considerable ineffectiveness can be eliminated when the risk designated as being hedged matches the risk of the hedging instrument. Consider the following example.

Example – Exclusion of credit risk from interest rate risk
 
On 1 October 20X5, entity A issues a fixed-interest note at 8% for C1,000. On the same day, entity A enters into an interest rate swap to pay LIBOR and receive interest at 7% based on the same payment terms and with a notional principal of C1,000. At inception entity A designates the swap as a hedge of the variability in fair value of the issued note.

  Fair values
  1 October 20X5 30 September 20X6 Change
       
Fixed interest note (1,000) (1,048) (48)
Interest rate swap 102 102
Difference     54
The effectiveness of the hedging relationship =   – 102/48 =   213%
 
Hedge accounting is not permitted, as the results of the effectiveness test are significantly below the minimum required effectiveness of 125%. The main reason for the difference in fair value movements leading to the ineffectiveness is entity A’s deteriorating creditworthiness.
 
IAS 39 permits an entity to designate any portion of risk in a financial asset or liability as the hedged item. Hedge effectiveness is generally significantly easier to achieve if the designated hedged risk matches the hedging instrument as closely as possible. In this case, entity A should re-designate the risk being hedged in order to improve the hedge effectiveness for future periods. As the entity’s deteriorating creditworthiness is the major cause of the hedge ineffectiveness, it should exclude this risk going forward and hedge only the changes in the bond’s fair value attributable to changes in the risk-free interest rate. The new designation to exclude the bond’s credit risk from the hedge relationship will improve hedge effectiveness, because the bond’s credit risk is not reflected in the hedge.

6.8A.207 There is normally a single fair value measure for a hedging derivative in its entirety. Therefore, a derivative cannot be split into components representing different risks and designating only certain components as the hedging instruments. However, as stated in paragraph 6.8A.60 above, the interest element of a forward contract and the time value of an option may be excluded from the fair value measurement of the hedging derivative for hedging purposes. These exclusions can often improve the hedge’s effectiveness as they allow the hedging derivative’s risk to match that of the hedged item. In that case, changes in the excluded component, for example, the interest element portion of the fair value of the forward exchange contract are recognised directly in profit or loss. However, where a balance sheet item is hedged with a forward contract and the interest element is not excluded, the forward points should be recycled, because the hedged item affects profit or loss. Note that this recycling is not equivalent to amortisation of the original premium. [IAS 39 para IG F6.4].

6.8A.208 Similarly, when the hedging instrument is an option rather than a forward contract, the option’s time value can be excluded from the option’s fair value and hedge effectiveness assessed based on the changes in the option’s intrinsic value. However, in such situations, the excluded time value, which is not part of the hedge relationship, will be recognised in profit or loss as explained in paragraph 6.8A.63 above and illustrated in the example below.

Example – Exclusion of time value of option from hedge effectiveness assessment
 
Entity A owns 100,000 equity shares in a quoted entity B, which it has classified as available-for-sale. The current price of the security is C25. To give itself partial protection against decreases in the share price of entity B, Entity A acquires an at-the-money put option on 100,000 shares of entity B at a strike price of C25 for C10,000. Entity A designates the change in the intrinsic value of the put as a hedging instrument in a fair value hedge of changes in the fair value of its share in entity B.
 
In this situation, IAS 39 permits entity A to designate changes in the intrinsic value of the put option as a hedge of its equity investment that is consistent with entity A’s hedging strategy. The hedge relationship is designated only for the price range when the put option is in-the-money (current market price ≤ strike price), that is, the option provides protection against the risk of variability in the fair value of entity B’s 100,000 shares below or equal to the strike price of the put of C25.
 
Effectiveness is measured by comparing the change in the investment’s fair value below the strike price of C25 with changes in the option’s intrinsic value. Therefore, when the option is out-of-the-money, no effectiveness measurement is necessary, but prospective assessment is still required. This means that gains and losses on entity B’s 100,000 shares for prices above C25 are not attributable to the hedged risk for the purposes of assessing hedge effectiveness and for recognising gains and losses on the hedged item. Therefore, entity A reports changes in the shares’ fair value in other comprehensive income if it is associated with variation in its price above C25. [IAS 39 para 55]. [IAS 39 para 90]. Changes in the fair value of the shares associated with price declines below C25 form part of the designated fair value hedge and are recognised in profit or loss. [IAS 39 para 89(b)]. Assuming the hedge is effective, those changes are offset by changes in the intrinsic value of the put, which are also recognised in profit or loss. [IAS 39 para 89(a)].
 
Since the option is at-the-money at inception, the premium paid of C10,000 is all attributable to the option’s time value. Changes in the put option’s time value are not included in the assessment of hedge effectiveness and are recognised in profit or loss. [IAS 39 para 55(a)]. The option’s fair value may change due to factors such as volatility of the share price, the passage of time and risk free rate. As such factors do not affect the option’s intrinsic value (current price – strike price), they form part of the time value component.

6.8A.209 Another issue in connection with ineffectiveness arises when assessing the effectiveness of hedging instruments such as interest rate swaps. In an interest rate swap, the payments are usually set at the beginning of a period and paid at the next interest reset date. Where hedge effectiveness assessments are undertaken between two re-pricing dates, the effect of interest accrual will affect the swap’s fair value. Accordingly, the corresponding changes in the swap’s fair value will not fully offset changes in the bond’s fair value. However, it is possible to improve the hedge’s effectiveness by using the swap’s ‘clean’ fair value rather than the ‘dirty’ fair value that includes the accrued interest. Using the clean fair value in effectiveness testing often decreases the ineffectiveness, as it excludes the accrued interest on the swap’s variable leg that will not have any offsetting component in the bond. The comparison between ‘clean’ and ‘dirty’ fair values and the impact on effectiveness of the hedge can be seen in illustration 1 of the comprehensive examples in paragraph 6.8A.223 and onwards.

Criteria for obtaining hedge accounting - Hedge ineffectiveness - Measuring hedge ineffectiveness

Publication date: 08 Dec 2017


6.8A.210 High effectiveness must be achieved initially and on an ongoing basis in order for a hedging relationship to qualify for hedge accounting. High effectiveness does not guarantee, however, that there will be no earnings volatility resulting from hedge ineffectiveness. Where the hedge is highly effective but not perfectly effective (that is, if a dollar-offset test is used the hedge is between 80% and 125% effective, but it is not 100% effective), there will be some volatility in earnings due to the ineffective portion of the hedge. Equally, the designation of the hedge may be very precise and thus achieves hedge accounting but volatility will be caused by that which has been excluded from the hedge relationship, although this is not ‘hedge ineffectiveness’.

6.8A.211 Regardless of whether dollar-offset or regression analysis is used to assess prospective and/or retrospective hedge effectiveness, the dollar offset measurements are used to determine the amount of ineffectiveness that has occurred and that must be recognised in profit or loss in each reporting period. Similarly, where hedge effectiveness is assessed using clean prices of an interest rate swap, the spot component of a forward contract, or the intrinsic value of an option to improve hedge effectiveness, the measurement of the hedging instrument for accounting purposes must still be based on the entire fair value of the derivative that will include accrued interest, forward points or time value.

6.8A.212 The extent to which hedge ineffectiveness is recognised in profit or loss will depend on whether the hedge is a fair value hedge or a cash flow hedge. In a fair value hedge, any hedge ineffectiveness directly affects profit or loss. This is because the entire change in the fair value of the hedged item (attributable to the hedged risk) and the entire change in the fair value of the hedging instrument are both reflected in profit or loss in each reporting period and the two changes may not perfectly offset each other.

6.8A.213 For cash flow hedges, the measurement of hedge effectiveness is different from a fair value hedge. As explained in paragraph 6.8A.129 above, the amount recognised in equity for a cash flow hedge is the lower of the cumulative gain or loss on the hedging instrument from inception of the hedge and the cumulative change in fair value (present value) of the expected future cash flows on the hedged item from inception of the hedge. To the extent that the cumulative gain or loss on the hedging instrument exceeds the cumulative change in fair value of the expected cash flows on the hedged item, the excess is recognised in profit or loss. However, if there is a shortfall, there will be no ineffectiveness recognised in profit or loss.

6.8A.214 The implementation guidance to IAS 39 provides a very comprehensive example of the dollar offset method for cash flow hedges. [IAS 39 IG F5.5]. The example sets out two practical methods for assessing effectiveness and measuring ineffectiveness for cash flow hedge of a forecast issuance of fixed rate debt. These two methods are known as ‘the hypothetical derivative method’ and the ‘change in fair value method’. Although the example is not reproduced here, the way in which the hypothetical derivative and the change in fair value methods work in practice is explained in paragraphs 6.8A.190 and 6.8A.215 respectively. Regardless of which method is used for the measurement of cash flow hedge effectiveness, an entity must meet the requirements of paragraph 6.8A.154 above for designation of a cash flow hedging relationship. That is, in designating a cash flow hedging relationship, an entity must have the expectation, both at inception of the hedge and ongoing, that the relationship will be highly effective at achieving offsetting changes in cash flows.

Criteria for obtaining hedge accounting - Hedge ineffectiveness - Measuring hedge ineffectiveness - Change in fair value method

Publication date: 08 Dec 2017


6.8A.215 The ‘change in fair value method’ is referred to as ‘method A’ in paragraph IG F5.5 of IAS 39. This is similar to the benchmark rate method (see para 6.8A.193). This method is applicable for determining hedge effectiveness for variable rate financial assets and liabilities and forecast issuance of fixed rate debt. Under this method, the measurement of hedge ineffectiveness is based on a calculation that compares the present value of the cumulative change in expected variable future interest cash flows that are designated as the hedged transactions and the cumulative change in the fair value of the swap designated as the hedging instrument. The discount rates applicable to determining the fair value of the swap designated as the hedging instrument should also be applied to the computation of present values of the cumulative changes in the hedged cash flows.

[The next paragraph is 6.8A.218.]

Portfolio (or macro) hedging

Publication date: 08 Dec 2017


6.8A.218 Portfolio or macro hedging is a technique used to reduce or eliminate the risk of a portfolio of assets and liabilities. Banks and similar financial institutions often use this technique to manage the interest rate risk of a portfolio of assets and liabilities. They do this by hedging the net position (for example, net of fixed rate assets and fixed rate liabilities).

6.8A.219 Prior to the issue of the amended version of IAS 39 (see below), the hedging techniques used by banks were not in accordance with the underlying core principles of IAS 39 of not permitting hedges of a net position of assets and liabilities to qualify for hedge accounting. In addition, many of the assets included in a portfolio are typically pre-payable fixed rate assets, that is, the counterparty has the right to pre-pay the item before its contractual maturity. When interest rates change, the resulting change in the fair value of the pre-payable asset differs from the change in fair value of the hedging derivative (which is not pre-payable), with the result that the hedge would often fail the IAS 39 hedge effectiveness test. Furthermore, many of the liabilities included in a portfolio are repayable on demand or after a notice period (often referred to as core deposits). Including them in a portfolio implies that their fair values change with movements in interest rates, which is against the notion in IAS 39 that the fair value of a demand deposit is not less than the amount repayable on demand, because that amount does not change with movements in interest rates.

6.8A.220 Therefore, when the exposure draft of proposed improvements to IAS 39 was published in June 2002, it did not contain any substantial changes to the requirements for hedge accounting as they applied to a portfolio hedge of interest rate risk. Banks were concerned that portfolio hedging strategies that they regarded as effective hedges would not qualify for fair value hedge accounting under IAS 39. They would either:

not qualify for hedge accounting at all, with the result that profit or loss would be volatile; or
qualify only for cash flow hedge accounting with the result that equity would be volatile. This is could potentially give rise to genuine problems for some banks because of capital adequacy requirements imposed by prudential regulators.

6.8A.221 The banks’ concerns found considerable political sympathy and the IASB was strongly encouraged to come to an agreement with them. As a result, after much deliberation, in March 2004, the IASB published an amendment to IAS 39. Unfortunately, not all of the banks’ concerns were addressed. In particular, significant restrictions for hedging deposits with a demand feature still remained. As a result, the version of IAS 39 that was endorsed by the EU had a carve-out that primarily allows banks to apply fair value hedge accounting to hedges of the interest rate risk in their portfolio of demand or core deposits for interest rate risk, which is prohibited by the full IAS 39 as noted in paragraph 6.8A.219 above. It also removed the need for banks to recognise ineffectiveness in the income statement as a result of under hedging that may arise in certain circumstances in fair value hedge accounting for a portfolio hedge of interest rate risk.

6.8A.222 IAS 39 sets out in paragraphs AG114-AG132 a series of procedures that an entity would need to comply with for achieving hedge accounting for a fair value hedge of interest rate risk associated with a portfolio of financial assets or financial liabilities. It should be noted, however, that in the EU carve-out version some of the above paragraphs were amended and some deleted. The implementation guidance to IAS 39 also sets out a series of issues that an entity should consider when applying cash flow hedge accounting to a portfolio hedge of interest rate risk. [IAS 39 para IG F6.2]. A very comprehensive example of applying the approach discussed in IG F6.2 is also included [IAS 39 para IG F6.3]. As the topic of macro hedging is of little interest to entities other than banks and other financial institutions, it is not dealt with in this chapter.

Comprehensive examples

Publication date: 08 Dec 2017


6.8A.223 Three detailed illustrations of how hedge accounting can be applied in practice are given below. The objective is to present the mechanics of applying IAS 39 requirements, starting with the entity’s risk management and effectiveness testing policies, working through the necessary designation and effectiveness testing and culminating with the accounting entries.

6.8A.224 The three examples illustrate some of the most common hedging strategies used in practice. They cover the three types of hedges recognised for accounting purposes by IAS 39 (fair value hedges, cash flow hedges and net investment hedges). The issues addressed are summarised in the table below:

 

Type of hedge and hedged risk Hedged item and hedging instrument Effectiveness testing Other key points of the illustration
Prospective Retrospective
Illustration 1          
‘Conversion’ of fixed rate debt into variable rate debt using an interest rate swap Fair value hedge – Interest rate risk Fixed rate debt – Interest rate swap Dollar offset using clean market values, sensitivity analysis approach Dollar offset on a cumulative basis using clean market values, benchmark approach Credit risk not hedged
Illustration 2          
Hedge of highly probable foreign currency forecast purchases Cash flow hedge – Foreign exchange risk Highly probable forecast transaction – Forward contract Dollar offset, sensitivity analysis approach Dollar offset on a cumulative basis, hypothetical derivative approach Spot/spot rate designation – Change in timing of cash flows – Basis adjustment
Illustration 3          
Foreign currency hedge of a net investment in a foreign operation Net investment hedge – Foreign exchange risk Net investment – Borrowing Dollar offset using dirty market values, sensitivity analysis approach Dollar offset on a cumulative basis using dirty market values, benchmark approach Credit risk in borrowing excluded – Effect of losses

6.8A.225 Despite the range of approaches covered, these illustrations do not set out all of the ways of complying with IAS 39’s hedging requirements. Other approaches to hedge accounting may meet IAS 39’s requirements. One issue not covered in the illustrations is the discontinuance of hedge accounting. This is covered earlier in the chapter. The underlying calculations in some of the illustrations have been performed using more decimal places for interest rates and discount factors than are presented. If the calculations are re-performed using the data presented, some minor differences in the numbers may arise. Finally, at various points ‘helpful hint’ boxes have been included. These highlight important issues, give additional guidance and contain tips relating to the illustrations.

Comprehensive examples - Fair value hedge of fixed rate debt

Publication date: 08 Dec 2017

Company A is a UK company with a £ functional currency. Company A’s reporting dates are 30 June and 31 December.
 
On 15 March 20X5, company A issues at par a £10m four year debt with the following characteristics:

Type  Issued debt
Principal amount £10m
Start date 15 March 20X5
Maturity date 15 March 20X9
Interest rate  7%
Settlement date 15 March, 15 June, 15 September and 15 December each year

No transaction costs are incurred relating to the debt issuance. On the date on which the debt was issued, consistent with its risk management policies, company A enters into a four year pay three month £ LIBOR receive 5% interest rate swap. The variable leg of the swap is pre-fixed/post-paid on 15 March, 15 June, 15 September and 15 December each year. The fixing of the variable leg for the first three-month period is 4.641%.
 

Helpful hint

A pre-fixed/post-paid interest rate swap is an interest rate swap in which the variable coupon is determined based on the market interest rate at the beginning of each period and is paid at the end. The variable coupon on the interest rate swap determined on 15 March is paid on 15 June, and so on.
6_8_225_m0afiex1

The cash flows on the debt and the swap can be represented as follows:
 
moafiex2
 
Three-month £ LIBOR rate at various dates when the swap is reset is as follows:

15 Mar 20X5 4.562%
15 Jun 20X5 5.080%
15 Sep 20X5 5.280%
15 Dec 20X5 5.790%

The forward rates derived from the £ LIBOR swap yield curve and the implied zero coupon rates at the dates of testing effectiveness are as follows:

  Forward rates for testing dates Zero coupon rates for testing dates
  15 Mar 20X5 (YC1) 30 Jun 20X5 (YC2) 31 Dec 20X5 (YC3) 15 Mar 20X5 (ZC1) 30 Jun 20X5 (ZC2) 31 Dec 20X5 (ZC3)
15 Jun 20X5 4.562% 4.641%
15 Sep 20X5 4.623% 5.069% 4.672% 5.172%
15 Dec 20X5 4.684% 5.130% 4.704% 5.204%
15 Mar 20X6 4.744% 5.191% 5.705% 4.735% 5.235% 5.835%
15 Jun 20X6 4.805% 5.251% 5.767% 4.766% 5.266% 5.866%
15 Sep 20X6 4.865% 5.311% 5.827% 4.798% 5.298% 5.898%
15 Dec 20X6 4.926% 5.371% 5.887% 4.829% 5.329% 5.929%
15 Mar 20X7 4.986% 5.432% 5.947% 4.860% 5.360% 5.960%
15 Jun 20X7 5.046% 5.492% 6.007% 4.892% 5.392% 5.992%
15 Sep 20X7 5.107% 5.552% 6.067% 4.923% 5.423% 6.023%
15 Dec 20X7 5.167% 5.612% 6.127% 4.954% 5.454% 6.054%
15 Mar 20X8 5.228% 5.673% 6.187% 4.986% 5.486% 6.086%
15 Jun 20X8 5.288% 5.733% 6.246% 5.017% 5.517% 6.117%
15 Sep 20X8 5.348% 5.793% 6.306% 5.048% 5.548% 6.148%
15 Dec 20X8 5.409% 5.853% 6.366% 5.080% 5.580% 6.180%
15 Mar 20X9 5.469% 5.913% 6.426% 5.111% 5.611% 6.211%

Helpful hint
The forward rates are used to calculate the projected cash flows. The zero-coupon rates are used to discount the projected cash flows to the testing date.

Extracts of risk management policies for interest rate risk
 
Company A is exposed to market risk, primarily related to foreign exchange, interest rates and the market value of the investments of liquid funds.
 
Company A manages its exposure to interest rate risk through the proportion of fixed and variable rate net debt in its total net debt portfolio. Such a proportion is determined twice a year by company A’s financial risk committee and approved by the board of directors. The benchmark duration for net debt is 12 months.
 
To manage this mix, company A may enter into a variety of derivative financial instruments, such as interest rate swap contracts.
 
Extracts of hedge effectiveness testing policies
 
Strategy 1A Hedges of interest rate risk using interest rate swaps for fair value hedges
 
Prospective effectiveness testing
Prospective effectiveness testing should be performed at the inception of the hedge and at each reporting date. The hedge relationship is highly effective if the changes in fair value or cash flow of the hedged item that are attributable to the hedged risk are expected to be offset by the changes in fair value or cash flows of the hedging instrument.
 
Prospective effectiveness testing should be performed by comparing the numerical effects of a shift in the hedged interest rate (£ LIBOR zero coupon curve) on both the fair value of the hedging instrument and the fair value of the hedged item.
 
This comparison should normally be based on at least three interest rate scenarios. However, for hedges where the critical terms of the hedging instrument perfectly match the critical terms, including reset dates of the hedged item, one scenario is sufficient.

Effectiveness = Change in clean fair value of hedging instrument when zero coupon curve is shifted

Change in clean fair value of hedged item when zero coupon curve is shifted

Change in the clean fair value of a swap is the difference between the clean fair value of the projected cash flows of the swap discounted using the zero coupon curve derived from the swap yield curve at the date of testing, and the clean fair value of the projected shifted cash flows discounted using the shifted zero-coupon rates.
 
Change in the clean fair value of a bond is the difference between the clean fair value of the cash flows on the bond excluding the credit spread discounted using the zero coupon curve derived from the swap yield curve at the date of testing, and the clean fair value of the same cash flows discounted using the shifted zero coupon rates.
 
The scenarios that should be used in the effectiveness test are:

(1) a parallel shift (upwards) of 100 basis points of the zero coupon curve;
   
(2) a change in the slope of the zero coupon curve of a 5% increase in the rate for one year cash flows, a 10% increase in the rate for two year cash flows, and a 15% increase in the rate for three and more year cash flows; and
   
(3) a change to a flat zero coupon curve at present three-month LIBOR.

Helpful hint
The number of scenarios needed to assess prospectively the effectiveness of a hedge when using the dollar offset method will vary depending on the terms of the hedge. When the critical terms of the hedging instrument (start date, end date, currency, fixed payment date, interest rate re-set date, fixed interest rate, principal amount) do not match those of the hedged item, or the hedged item contains a feature – such as optionality – that is likely to cause ineffectiveness, several scenarios should be used, including scenarios that reflect the mismatch in terms or optionality.
 
The pre-fixed/post-paid feature of the swap that is not present in the bond prevents the use of the critical terms method, as there will be some ineffectiveness. Three scenarios should be used to test effectiveness prospectively, consistent with the entity’s policy. The example below shows only the first of these three scenarios.
 
The dirty fair value is the fair value including accrued interest. The clean fair value excludes accrued interest. Using the clean fair value in effectiveness testing often decreases the ineffectiveness, as it excludes the accrued interest on the variable leg of the swap that will not have any offsetting component in the bond.

Retrospective effectiveness testing
 
Retrospective effectiveness testing should be performed at each reporting date using the dollar offset method on a cumulative basis. Hedge effectiveness is demonstrated by comparing the cumulative change in the clean fair value of the hedging instrument with the cumulative change in the clean fair value of the hedged item attributable to the hedged risk and showing that it falls within the required range of 80%-125%.

Effectiveness = Cumulative change in clean fair value of hedging instrument

Cumulative change in clean fair value of hedged item

Change in the clean fair value of a swap is the difference between:
   
(a) the clean fair value of the projected cash flows of the swap based on the original yield curve discounted using the zero coupon curve derived from the yield curve at the beginning of the hedge; and
   
(b) the clean fair value of the projected cash flows of the swap based on the yield curve at the date of testing discounted using the zero coupon curve derived from the yield curve at the date of testing.
   
Change in the clean fair value of a bond is the difference between:
   
(a) the clean fair value of the cash flows on the bond, excluding the credit spread discounted using the zero coupon curve derived from the yield curve at the beginning of the hedge; and
   
(b) the clean fair value of the same cash flows discounted using the zero coupon curve derived from the yield curve at the date of testing.

Helpful hint
In a fair value hedge, the carrying amount of the hedged item, in this case the debt, is adjusted for changes in value attributable to the hedged risk only. This might not be the same as the total changes in the fair value of the debt. Fair value changes attributable to credit or other risks that are not hedged are not included in the adjustment of the carrying amount of the hedged item.

Hedge designation
 
Company A’s hedge documentation is shown below.
 
1 Risk management objective and strategy
For the current period, company A’s approved strategy in accordance with its risk management policies is to maintain a ratio of fixed:floating rate net debt of between 40:60 and 50:50. In order to achieve this ratio, management has selected this debt to be swapped from fixed to floating.
 
2 Type of hedging relationship
Fair value hedge: swap of fixed to floating interest rates.
 
3 Nature of risk being hedged
Interest rate risk: change in the fair value of debt number C426 million attributable to movements in the £ LIBOR zero coupon curve. Credit risk on the debt is not designated as being hedged.
 
4 Identification of hedged item
Transaction number: reference number C426 million in the treasury management system.
 
The hedged item is a four-year, £10m, 7% fixed rate debt, which pays interest quarterly.
 
5 Identification of hedging instrument
Transaction number: reference number L1815E in the treasury management system.
 
The hedging instrument is a four-year interest rate swap, notional value £10m, under which fixed interest of 5% is received quarterly and actual three-month LIBOR is paid with a three-month reset.
 
Hedge designation: the fair value movements on the full notional £10m of the swap L1815E is designated as a hedge of fair value movements in the debt C426 million attributable to movements in £ LIBOR zero coupon curve (see point 3 above).
 
6 Effectiveness testing
Testing shall be performed using hedging effectiveness testing strategy 1A in the effectiveness testing policy.
 
Description of prospective test
Dollar offset method, being the ratio of the change in the clean fair value of the swap L1815E, divided by the change in clean fair value of the bond C426 million attributable to changes in £ LIBOR zero coupon curve.
 
The critical terms of the swap do not perfectly match the critical terms of the hedged debt. The prospective tests will therefore, as required by the risk management policies, be performed based on three scenarios. (Only scenario 1, the 100 basis point increase, is illustrated below; all three would be performed in practice.)
 
Frequency of testing: at inception of the hedge and at each reporting date (30 June and 31 December).
 
Description of retrospective test
Dollar offset method, being the ratio of the change in the clean fair value of swap L1815E, divided by the change in the clean fair value of the bond C426 million attributable to changes in the £ LIBOR zero coupon curve on a cumulative basis.
 
Frequency of testing: at every reporting date (30 June and 31 December) after inception of the hedge.
 
Effectiveness tests and accounting entries
 
1 Prospective effectiveness test on 15 March 20X5
Company A’s management should assess prospectively the effectiveness of the hedge, as required by IAS 39.
 
Based on the hedge documentation, the prospective effectiveness test consists of comparing the effects of a 100 basis points shift upwards of the zero coupon curve on the clean fair value of the swap and the clean fair value of the hedged item.
 
A coupon of 7% per annum is paid on the debt (that is, £175,000 per quarter), which can be split into an AA interest rate of 5% and a credit spread of 2%. For effectiveness testing purposes, only the cash flows relating to the AA interest rate (that is, £125,000 per quarter) are taken into account. The credit risk associated with the debt is not part of the hedge relationship; the credit spread of 2% in the coupon is, therefore, excluded from the tests.
 
Prospective effectiveness test on 15 March 20X5

  15 Jun 20X5 15 Sep 20X5 15 Dec 20X5 15 Dec 20X8 15 Mar 20X9 Total
Cash flows on the swap

Fixed leg 125,000 125,000 125,000 125,000 125,000  
Variable leg* (114,059) (115,573) (117,088) (135,221) (136,729)  

Net cash flows 10,941 9,427 7,912 (10,221) (11,729)  
Discounted CF @ ZC1 10,818 9,214 7,644 (8,488) (9,609) 0
Shifted zero coupon curve
Fixed leg 125,000 125,000 125,000 125,000 125,000  
Variable leg+1% (114,059) (139,640) (141,144) (159,148) (160,646)  

Net cash flows 10,941 (14,640) (16,144) (34,148) (35,646)  
Discounted CF @ ZC1+1% 10,792 (14,242) (15,486) (27,368) (28,117) (315,574)

(315,574)
Cash flows on the debt

Cash flows (125,000) (125,000) (125,000) (125,000) (10,125,000)  
Discounted CF at ZC1** (123,590) (122,178) (120,764) (103,804) (8,294,694) (10,000,000)
Discounted CF @ ZC1+1% (123,297) (121,599) (119,906) (100,182) (7,986,407) (9,660,676)

              339,324
Effectiveness             -93.0%

               
* The variable leg of the swap is the projected cash flow according to forward rates derived from the swap yield curve. As an example, the 15 Sep 20X5 projected cash flow is calculated as 10 million £* 4.623%/4 = 115,573, as the swap has quarterly reset and settlement.
 
** The discounted cash flows are calculated using the zero coupon rate for the relevant point on the implied zero coupon curve using the normal discounting formula cf/(1+r)^(d/360), where cf is the undiscounted cash flow, r is the relevant zero coupon rate and d is the number of days remaining to the cash flow (on 360 day basis). As an example, the discounted cash flow on 15 Sep 20X5 is calculated as 125,000/(1.0467)^(180/360)=122,178.

Conclusion: The hedge is expected to be highly effective.

Helpful hint
The ineffectiveness in the prospective test comes from the change in the fair value of the variable leg of the swap that occurs when projected cash flows are changed. The change in fair value of the fixed leg of the swap perfectly offsets changes in the fair value of the bond.

2 Accounting entries on 15 March 20X5
The debt is recognised at the proceeds received by company A, which represents its fair value on the issuance date. The debt is classified as other financial liabilities and will subsequently be measured at amortised cost.

    Dr Cr
Cash  10,000,000  
  Other financial liabilities – debt   10,000,000
Issuance at par of a £10m four-year debt with a fixed coupon of 7%    
       
The swap entered into by company A is recognised at fair value on the balance sheet. The fair value of the swap is nil at inception, as it is issued at market rate. The floating rate for the first period is set to 4.562%, which is the three-month swap rate.
       
    Dr Cr
Derivative instruments  nil  
  Cash   nil
Recognition of the interest rate swap at fair value (nil)    
       
3 Accounting entries on 15 June 20X5    
On 15 June, the first coupon on the loan is paid and the first period of the swap is settled.
       
Recognition of interest on the debt    
       
    Dr Cr
Finance costs – interest expense  175,000  
  Cash   175,000
Interest on the debt at 7% for three months    
       
Cash settlement of the swap    
       
    Dr Cr
Finance costs – interest expense  114,059  
  Finance costs – interest expense   125,000
  Cash 10,941  
Settlement of the swap: receive 5% and pay 4.562% for three months
 
These two transactions result in a total charge of £164,059 to finance cost, which is equivalent to 6.562% interest for the period (that is, the rate on the variable leg of the swap of 4.562% + 2% credit spread). The variable rate on the swap for the following quarter is set at the three-month swap rate of 5.080%.

Helpful hint
In order to increase clarity, we have chosen to show the entry gross (that is, with the effects of the pay and receive legs of the swap shown separately). This entry is often made on a net basis.
 
The charge to interest expense has been made without performing an effectiveness test, as no effectiveness test is required until 30 June. In the event that the next effectiveness test is failed, the entries will have to be reversed out of interest expense, as hedge accounting is not permitted for the period after the last successful test. The entries could be to ‘other operating income and expense’.

4 Retrospective effectiveness test on 30 June 20X5
 
IAS 39 requires the effectiveness of a hedging relationship to be assessed retrospectively as a minimum at each reporting date. Based on company A’s risk management policies, the effectiveness of the hedge must be assessed using the dollar offset method.
 
The dollar offset method consists of comparing the effects of the change in £ LIBOR swap yield curve between 15 March and 30 June (in this case, a parallel shift of 0.5%) on the clean fair values of the hedged item and the hedging instrument.
 
Retrospective effectiveness test on 30 June 20X5

  15 Sep 20X5 15 Dec 20X5 15 Mar 20X6 15 Dec 20X8 15 Mar 20X9 Total
Cash flows on the swap              

Fixed leg 104,167 125,000 125,000 125,000 125,000  
Variable leg at YC2 (105,833)* (128,257) (129,765) (146,327) (147,830)  

Net cash flows (1,667) (3,257) (4,765)  (21,327) (22,830)  
Discounted CF at ZC2 (1,649) (3,182) (4,596) (17,676) (18,646) (161,184)
Clean fair value at original yield curve             0

Change in clean fair value (cumulative)             (161,184)

Cash flows on the debt              

Cash flows (104,167)** (125,000) (125,000) (125,000) (10,125,000)  
Discounted CF at ZC2  (103,078) (122,127) (120,563) (103,600) (8,269,357) (9,839,030)
Clean fair value at original yield curve             (10,000,000)

              160,970
Effectiveness             -100.1%

             
* The variable rate for the first period is set to 5.08%. The rest of the variable cash flows are projected according to the forward rates derived from the current swap yield curve (YC2), as they have not yet been set.
 
** The effect of accruals needs to be removed, as the test is based on the clean fair value. 75 days of the next coupon have not yet been accrued; the amount of the first coupon included in the test is, therefore, the cash flow 125,000*75/90.
 
Conclusion: The hedge has been highly effective for the period ended 30 June 20X5.

Helpful hint
Based on company A’s risk management policies, the retrospective effectiveness test above uses the clean fair values of the swap and the debt. Accrued interest for the current period as well as the fair value changes due to the passage of time on the original swap yield curve are excluded from the tests.
 
The relationship is ineffective because the variable leg of the swap is pre-fixed/post-paid. As the interest on the variable leg of the swap is determined at the beginning of the period (15 June) it is fixed until the next re-pricing date and, therefore, has an exposure to changes in its fair value. If the variable leg of the swap had been post-fixed/post-paid, then the ineffectiveness would have been lower.

5 Accounting entries on 30 June 20X5
Recognition of accrued interest on the bond
 
Accrued interest for 15 days on the loan is recognised.

    Dr Cr
Finance costs – interest expense  29,167  
  Accrued interest   29,167
Interest on the debt at 7% for 15 days    
       
Recognition of fair value changes of the swap       
The recorded change in dirty fair value of the swap can be reconciled to the clean fair value of the swap as follows:
       
Clean fair value on 30 Jun 20X5   (161,184)
Accrued interest on receive fixed 5% for 15 days (discounted)   20,617
Accrued interest on pay variable 5.080% for 15 days (discounted)   (20,947)

Dirty fair value   (161,514)

       
The swap is recorded at the dirty fair value (that is, including the accrued interest).    
       
    Dr Cr
Other operating income and expense – ineffectiveness 161,184  
Finance costs – interest expense 330  
  Derivative instruments    161,514
Fair value hedge – change in fair value of the swap including accrued interest    
       
Fair value adjustment to the hedged item    
All the criteria for hedge accounting are met for the period ended 30 June 20X5, and fair value hedge accounting can be applied. The carrying amount of the debt is adjusted for the fair value change of the hedged risk (that is, the changes in the clean fair value of the debt attributable to changes in the zero coupon curve). The entry is as follows:
       
    Dr Cr
  Other operating income and expense – ineffectiveness    160,970
Other financial liabilities – debt  160,970  
Fair value hedge – change in fair value of the debt attributable to the hedged risk      
       
As the hedge is not 100% effective, the ineffectiveness of £214 (£161,184 – £160,970) is recognised in profit or loss. Best practice is to present the ineffectiveness in ‘other operating income and expense’, as illustrated above.
 
6 Prospective effectiveness test on 30 June 20X5
The same method is used as at the inception of the hedge.
 
Prospective effectiveness test on 30 June 20X5

  15 Sep 20X5 15 Dec 20X5 15 Mar 20X6 15 Dec 20X8 15 Mar 20X9 Total

Cash flows on the swap              
Fixed leg  104,167 125,000 125,000 125,000 125,000  
Variable leg @ YC2  (105,833) (128,257) (129,765) (146,327) (147,830)   

Net cash flows  (1,667)  (3,257) (4,765) (21,327) (22,830)  
Discounted CF @ ZC2 (1,649) (3,182) (4,596) (17,676) (18,646) (161,184)

Shifted zero coupon curve              
Fixed leg  104,167 125,000 125,000 125,000 125,000  
Variable leg @ YC2+1% (105,833) (152,234) (153,731) (170,177) (171,669)  

Net cash flows (1,667)  (27,234) (28,731) (45,177) (46,669)  
Discounted CF @ ZC2+1%  (1,646) (26,493) (27,526) (36,241) (36,807) (451,850)

              (290,666)
Cash flows on the debt              

Cash flows (104,167) (125,000) (125,000) (125,000) (10,125,000)  
Discounted CF @ ZC2 (103,078) (122,127) (120,563) (103,600) (8,269,357) (9,839,030)
Discounted CF @ ZC2+1% (102,875) (121,599) (119,758) (100,277) (7,985,352) (9,528,668)

              310,362
Effectiveness             -93.7%

               

Conclusion: The hedge is expected to be highly effective.


7 Accounting entries on 1 July 20X5

   

The accrual of the interest on the debt is reversed.

   
       
    Dr Cr
Finance costs – interest expense   29,167
  Accrued interest 29,167  
Interest on the debt reversed at 7% for 15 days    
       
The accrual on the swap is reversed.    
       
    Dr Cr
  Finance costs – interest expense   330
Other operating income and expense – ineffectiveness 330  
Accrued interest on the swap reversed for 15 days    
       
8 Accounting entries on 15 September 20X5    
On 15 September the coupon on the loan is paid and the second period of the swap is settled.
       
Recognition of interest on the debt    
       
    Dr Cr
Finance costs – interest expense  175,000  
  Cash   175,000
Interest on the debt at 7% for three months    
       
Cash settlement of the swap    
       
    Dr Cr
Finance costs – interest expense 127,000  
  Finance costs – interest expense    125,000
  Cash   2,000
Settlement of the swap: receive 5% and pay 5.080% for three months    
       
These two transactions result in a total charge of £177,000 to finance cost, which is equivalent to 7.08% interest for the period (that is, the variable rate of 5.08% plus 2% credit spread).
 
The floating rate on the swap for the following quarter is set at the three-month swap rate of 5.28%.
 
9 Accounting entries on 15 December 20X5
On 15 December the coupon on the loan is paid and the third period of the swap is settled.
 
Recognition of interest on the debt    
       
    Dr Cr
Finance costs – interest expense 175,000  
  Cash    175,000
Interest on the debt at 7% for three months    
       
Cash settlement of the swap    
       
    Dr Cr
Finance costs – interest expense 132,000  
  Finance costs – interest expense   125,000
  Cash    7,000
Settlement of the swap: receive 5% and pay 5.28% for three months    

These two transactions result in a total charge of £182,000 to finance cost, which is equivalent to 7.28% interest for the period (that is, the variable rate of 5.28% plus 2% credit spread).
 
The floating rate on the swap for the following quarter is set at the three-month swap rate of 5.79%.
 
10 Retrospective effectiveness test on 31 December 20X5
The same method for retrospective testing is used as on 30 June 20X5. As required in company A’s risk management policies, the effectiveness test is done using the dollar offset method on a cumulative basis.
 
Retrospective effectiveness test on 31 December 20X5

  15 Mar 20X6 15 Jun 20X6 15 Sep 20X6 15 Dec 20X8 15 Mar 20X9 Total
Cash flows on the swap              

Fixed leg 104,167 125,000 125,000 125,000 125,000  
Variable leg at YC3 (120,625) (144,165) (145,666) (159,157) (160,654)  

Net cash flows (16,458) (19,165) (20,666) (34,157) (35,654)  
Discounted CF at ZC3 (16,265) (18,671) (19,844) (28,605) (29,386) (308,922)
Clean fair value at original yield curve             0

Change in clean fair value (cumulative)             (308,922)
               
Cash flows on the debt              

Cash flows (104,167) (125,000) (125,000) (125,000) (10,125,000)  
Discounted CF at ZC3 (102,943) (121,776) (120,028) (104,681) (8,345,128) (9,692,833)
Clean fair value at original yield curve              (10,000,000)

Change in clean fair value (cumulative)             307,167
Effectiveness             -100.6%


Conclusion: The hedge has been highly effective for the period ended 31 December 20X5.

11 Accounting entries on 31 December 20X5
Recognition of accrued interest on the bond
Accrued interest for 15 days on the loan is recognised.

    Dr Cr
Finance costs – interest expense 29,167  
  Accrued interest   29,167
Interest on the debt at 7% for 15 days    
       
Recognition of fair value changes of the swap    
       
       
Clean fair value of the swap   (308,922)
Accrued interest on receive fix 5% for 15 days   20,589
Accrued interest on pay variable 5.79% for 15 days    (23,842)

Dirty fair value of the swap on 31 December 20X5   (312,175)
Dirty fair value of the swap on 30 June 20X5   (161,514)

Change in fair value to be recognised on 31 December 20X5   (150,661)

       
The swap is recorded at the dirty fair value (that is, including the accrued interest).
       
    Dr Cr
Other operating income and expense – ineffectiveness 147,408  
Finance costs – interest expense 3,253  
  Derivative instruments    150,661
Fair value hedge – change in fair value of the swap    
       
Fair value adjustment to the hedged item    
All the criteria for hedge accounting are met for the period ended 31 December 20X5, and fair value hedge accounting can be applied.
       
       
Fair value adjustment on debt on 30 June 20X5   160,970
Fair value adjustment on debt on 31 December 20X5   307,167

Change in the clean fair value of the debt    146,197

As the hedge is not 100% effective, the ineffectiveness of £1,211 (£147,408 – £146,197) is recognised in profit or loss. Best practice is to present the ineffectiveness in ‘other operating income and expense’, as illustrated above.
 
12 Prospective effectiveness test on 31 December 20X5
The same method is used as at the inception of the hedge.
Prospective effectiveness test on 31 December 20X5

  15 Mar 20X6 15 Jun 20X6 15 Sep 20X6 15 Dec 20X8 15 Mar 20X9 Total
Cash flows on the swap              

Fixed leg  104,167 125,000 125,000 125,000 125,000  
Variable leg at YC3 (120,625) (144,165) (145,666) (159,157) (160,654)  

Net cash flows (16,458) (19,165) (20,666) (34,157) (35,654)  
Discounted CF at ZC3 (16,265) (18,671) (19,844) (28,605) (29,386) (308,922)

Shifted zero coupon curve              
Fixed leg 104,167 125,000 125,000 125,000 125,000  
Variable leg at YC3+1% (120,625) (168,030) (169,520) (182,917) (184,403)  

Net cash flows (16,458) (43,030) (44,520) (57,917) (59,403)  
Discounted CF at ZC3+1% (16,233) (41,740) (42,466) (47,176) (47,511) (556,044)

              (247,122)
               
Cash flows on the debt              

Cash flows (104,167) (125,000) (125,000) (125,000) (10,125,000)  
Discounted CF at ZC3 (102,943) (121,776) (120,028) (104,681) (8,345,128) (9,692,833)
Discounted CF at ZC3+1% (102,742) (121,253) (119,231) (101,818) (8,097,959) (9,426,135)

              266,698
Effectiveness             -92.7%


Conclusion: The hedge is expected to be highly effective.
 
The testing and accounting entries are carried out in the same manner throughout the remaining life of the hedge relationship.

  Balance sheet Income statement
  Derivative instruments Accrued interest Other financial
liabilities – debt
Cash Finance cost –
interest expense
Other operating income and expense – ineffectiveness
15 Mar 20X5            
Debt     (10,000,000) 10,000,000    
Swap            
             
15 Jun 20X5            
Interest on debt       (175,000) 175,000  
Settlement of swap       10,941 114,059  
          (125,000)  
30 Jun 20X5            
Accrued interest on debt   (29,167)     29,167  
Fair value change of swap (161,514)       330 161,184
Hedge adjustment to debt     160,970     (160,970)
             
01 Jul 20X5            
Accruals reversed on debt   29,167     (29,167)  
Accruals reversed on swap         (330) 330
             
15 Sep 20X5            
Interest       (175,000) 175,000  
Settlement of swap       (2,000) 127,000  
          (125,000)  
15 Dec 20X5            
Interest       (175,000) 175,000  
Settlement of swap       (7,000) 132,000  
          (125,000)  
31 Dec 20X5            
Accrued interest on debt   (29,167)     29,167  
Fair value change of swap (150,661)       3,253 147,408
Hedge adjustment to debt     146,197     (146,197)

Comprehensive examples - Cash flow hedge of a highly probable forecast purchase in foreign currency

Publication date: 08 Dec 2017

Background and assumptions

Company C is a Swedish company with a SEK functional currency. Its reporting dates are 30 June and 31 December.

Company C produces and sells electronic components for the automotive industry and is planning to launch a new electronic component that it expects to be more reliable and cheaper than the existing alternatives.

Production is scheduled to start in June 20X6. Company C’s management expects to purchase a significant amount of raw material in May 20X6 for the start of production. An external company based in Spain will supply the raw material. Based on C’s production plans and the prices that the supplier is currently charging, Company C’s management forecasts that 500,000 units of raw material will be received and invoiced on 1 May 20X6 at a price of EUR 50 per unit. The invoice is expected to be paid on 31 August 20X6.

On 1 January 20X5, Company C’s management decides to hedge the foreign currency risk arising from its highly probable forecast purchase. C enters into a forward contract to buy EUR against SEK. On that date, the forecast purchase is considered as highly probable, as the board of directors has approved the purchase, and negotiations with the Spanish supplier are far advanced.

The foreign currency forward contract entered into as a hedge of the highly probable forecast purchase is as follows:

Type  European forward contract
Amount purchased EUR 25,000,000
Amount sold SEK 192,687,500
Forward rate EUR 1 = SEK 7.7075
Start date  1 January 20X5
Maturity date  31 August 20X6

Exchange rates on various dates during the hedge are as follows:

 
1 Jan 20X5
30 Jun 20X5
31/12/20X5 
30 Jun 20X6
31 Jul 20X6
31 Aug 20X6
31/10/20X6
SEK/EUR spot rate
7.6900
7.6500
7.7500
7.8100
7.9000
8.1500
8.0500
SEK/EUR forward rate*
7.7075
7.6622
7.7574
7.8118
7.9008
8.1500
 
Forward points
0.0175
0.0122
0.0074
0.0018
0.0008
0.0000
 

* For a forward maturing on 31 August 20X6.

Annualised interest rates applicable for discounting a cash flow on 31 August 20X6 at various dates during the hedge are as follows:

 
1 Jan 20X5
30 Jun 20X5
31/12/20X5
30 Jun 20X6
31 Jul 20X6
31 Aug 20X6
SEK interest rate
1.3550%
1.3850%
1.3670%
1.3850%
1.4240%
1.4030%
EUR interest rate
1.4916%
1.5213%
1.5100%
1.5200%
1.5470%
1.5170%

Extracts of risk management policies for foreign currency risk

Foreign currency risk

Company C’s functional and presentation currencies are the SEK (Swedish krona). Company C is exposed to foreign exchange risk because some of its purchases and sales are denominated in currencies other than SEK. It is therefore exposed to the risk that movements in exchange rates will affect both its net income and financial position, as expressed in SEK.

Company C’s foreign currency exposure arises from:

■   highly probable forecast transactions (sales/purchases) denominated in foreign currencies;
firm commitments denominated in foreign currencies; and
monetary items (mainly trade receivables, trade payables and borrowings) denominated in foreign currencies.

Company C is mainly exposed to EUR/SEK and GBP/SEK risks. Transactions denominated in foreign currencies other than EUR and GBP are not material.

Company C’s policy is to hedge all material foreign exchange risk associated with highly probable forecast transactions, firm commitments and monetary items denominated in foreign currencies.

Company C’s policy is to hedge the risk of changes in the relevant spot exchange rate.

Hedging instruments

Company C uses only forward contracts to hedge foreign exchange risk. All derivatives must be entered into with counterparties with a credit rating of AA or higher.

Extracts of effectiveness testing policies for interest rate risk

Strategy 2A: Cash flow hedges of foreign currency exposure in highly probable forecast transactions

Prospective effectiveness testing for cash flow hedges

Prospective effectiveness testing should be performed at the inception of the hedge and at each reporting date. The hedge relationship is highly effective if the changes in fair value or cash flow of the hedged item that are attributable to the hedged risk are expected to be offset by the changes in fair value or cash flows of the hedging instrument.

Prospective effectiveness testing should be performed by comparing the numerical effects of a shift in the exchange rate (for example, EUR/SEK rate) on: the fair value of the hedged cash flows measured using a hypothetical derivative; and the fair value of the hedging instrument. Consistent with Company C’s risk management policy, the hedged risk is defined as the risk of changes in the spot exchange rate. Changes in interest rates are excluded from the hedge relationship (for both the hedging instrument and the hedged forecast transaction) and do not affect the calculations of effectiveness. Only the spot component of the forward contract is included in the hedge relationship (that is, the forward points are excluded).

At least three scenarios should be assessed unless the critical terms of the hedging instrument perfectly match the critical terms of the hedged item, in which case one scenario is sufficient.

Retrospective effectiveness testing for cash flow hedges

Retrospective effectiveness testing must be performed at each reporting date using the dollar offset method on a cumulative basis. The hedge is demonstrated to be effective by comparing the cumulative change in the fair value of the hedged cash flows measured using a hypothetical derivative; and the fair value of the hedging instrument. A hedge is considered to be highly effective if the results of the retrospective effectiveness tests are within the range 80%-125%.

  Cumulative change in fair value of hedging instrument  
Effectiveness =
 
  Cumulative change in fair value of hedged item (hypothetical derivative)  


Change in the fair value of the spot component of the hedging instrument (the forward contract) is the difference between the fair value of the spot component at the inception of the hedge, and the end of the testing period based on translating the foreign exchange leg of the forward contract at the current spot rate and discounting the net cash flows on the derivative using the zero-coupon rates curve derived from the swap yield curve.

Change in fair value of the hedged cash flows of the hedged item (hypothetical derivative) is the difference between the value of the hypothetical derivative at the inception of the hedge, and the end of the testing period based on translating the foreign exchange leg of the hypothetical derivative at the current spot rate and discounting the net cash flows on the hypothetical derivative using the zero-coupon rates curve derived from the swap yield curve.

Helpful hint
The fair value of a foreign exchange forward contract is affected by changes in the spot rate and by changes in the forward points. The latter derives from the interest rate differential between the currencies specified in the forward contract. Changes in the forward points may give rise to ineffectiveness if the hedged item is not similarly affected by interest rate differentials.


Hedge designation

Company C’s hedge documentation is as follows:

1 Risk management objective and strategy
   
In order to comply with Company C’s foreign exchange risk management strategy, the foreign exchange risk arising from the highly probable forecast purchase detailed in 5 below is hedged.
   
2 Type of hedging relationship
   
Cash flow hedge: hedge of the foreign currency risk arising from highly probable forecast purchases.
   
3 Nature of risk being hedged
   
EUR/SEK spot exchange rate risk arising from a highly probable forecast purchase denominated in EUR that is expected to occur on 1 May 20X6 and to be settled on 31 August 20X6.
   
4 Identification of hedged item
   
Purchase of 500,000 units of raw material for EUR 50 per unit.
   
5 Forecast transactions
   

Hedged amount: EUR 25,000,000

Nature of forecast transaction: purchase of 500,000 units of raw material

Expected timescale for forecast transaction to take place:

   
■   delivery: 1 May 20X6
cash payment: 31 August 20X6
   
Expected price: EUR 50 per unit.
   
Rationale for forecast transaction being highly probable to occur:
   
production of electronic component is scheduled to start in June 20X6;
purchase has been approved by the board of directors; and
negotiations with supplier are far advanced.
   
Method of reclassifying into profit and loss amounts deferred through equity: in accordance with Company C’s chosen accounting policy, the gains or losses recognised in other comprehensive income will be included in the carrying amount of the inventory acquired (that is, basis adjustment).
   
6 Identification of hedging instrument
   

Transaction number: reference number K1121W in the treasury management system.

The hedging instrument is a forward contract to buy EUR 25,000,000 with the following characteristics:


Type European forward contract
Amount purchased EUR 25,000,000
Amount sold SEK 192,687,500
Forward rate  EUR 1 = SEK 7.7075
Spot rate at inception EUR 1 = SEK 7.6900
Spot component of notional amount SEK 192,250,000
Start date  1 January 20X5
Maturity date 31 August 20X6

Hedge designation: the spot component of forward contract K1121W is designated as a hedge of the change in the present value of the cash flows on the forecast purchase identified in 5 above that is attributable to movements in the EUR/SEK spot rate, measured as a hypothetical derivative.

7 Effectiveness testing

Hedge accounting strategy 2A should be applied (see hedge effectiveness testing policy). The hypothetical derivative that models the hedged cash flows is a forward contract to pay EUR 25,000,000 on 31 August 20X6 in return for SEK. The spot component of this hypothetical derivative is SEK 192,250,000 (that is, EUR 25,000,000 at the spot rate on 1 January 20X5 of 7.6900).

Description of prospective testing

Dollar offset method, being the ratio of the change in the fair value of the spot component of forward contract K1121W, divided by the change in present value of the hedged cash flows (hypothetical derivative) attributable to changes in spot EUR/SEK rate.

Frequency of testing: at inception of the hedge and then at each reporting date (30 June and 31 December).

Description of retrospective testing

Dollar offset method, being the ratio of the change in fair value of the spot component of the forward contract, divided by the change in present value of the hedged cash flows (hypothetical derivative) attributable to changes in spot EUR/SEK rate, on a cumulative basis.

Frequency of testing: at every reporting date (30 June and 31 December) after inception of the hedge.

Effectiveness tests and accounting entries

1 Prospective effectiveness test on 1 January 20X5

On 1 January 20X5, the forward EUR/SEK exchange rate is 7.7075. On that date, the spot EUR/SEK exchange rate is 7.6900. Company C’s management should assess prospectively the effectiveness of the hedge, as required in IAS 39.

Based on the hedge documentation, the prospective effectiveness test consists of comparing the effects of a 10% shift of the spot EUR/SEK exchange rate on both the fair value of the spot component of the hedging instrument and on the hedged cash flows (hypothetical derivative).

Hedged item and hedging instrument (spot components)

The EUR leg of both the hypothetical derivative (hedged item) and the forward contract (hedging instrument) are translated into SEK using the shifted spot exchange rate (8.459), then discounted back using the current SEK interest rate (1.3550%) for a cash flow due on 31 August 20X6. The SEK leg is discounted back using the current SEK interest rate. The difference between the present values of each leg represents the fair value of the spot component. As the fair value of this spot component is nil at inception, the change in fair value is equal to its fair value.

Hedged item
Hypothetical derivative – spot component
Hedging instrument
Spot component

Notional amount (25,000,000) EUR 25,000,000 EUR   Notional amount
             
Spot rate + 10% 8.4590   8.4590     Spot rate + 10%

Notional amount in SEK (211,475,000) SEK 211,475,000 SEK   Notional amount in SEK
             
Discount factor* 0.9776   0.9776     Discount factor

FV of the EUR leg (spot) (A) (206,729,957) EUR 206,729,957 SEK   FV of the EUR leg (spot) (A)
       
Spot component of notional 192,250,000 SEK (192,250,000)     Spot component of notional
Discount factor 0.9776   0.9776     Discount factor

FV of SEK leg (spot) (B) 187,936,324 SEK (187,936,324) SEK   FV of SEK leg (spot) (B)

(A-B) FV of the hypothetical derivative (spot) (18,793,632) SEK 18,793,632 SEK   (A-B) FV of the derivative (spot)
Effectiveness
-100%
         


* The discount factor has been derived from the annualised SEK interest rate on 1 January for cash flows on 31 August 20X6 and has been calculated as 1/(1.01355)^(607days/360).

Conclusion: the hedge is expected to be highly effective.

Helpful hint
As the critical terms of the forward perfectly match the critical terms of the forecast purchase, a quantitative test is not necessarily required. A qualitative test consisting of a comparison of the critical terms of the hedging instrument and the hedged item may be used as long as it is consistent with Company C’s risk management policies.

2 Accounting entries on 1 January 20X5

No entry, as the fair value of the forward contract is nil, as shown below:

Derivative
Notional amount in EUR 25,000,000 EUR
Forward rate 7.7075  

Notional amount in SEK 192,687,500 SEK
Discount factor 0.9776  

FV of the EUR leg 188,364,007 SEK
     
Notional amount in SEK (192,687,500) SEK
Discount factor 0.9776  

FV of the SEK leg (188,364,007) SEK

FV of the derivative 0 SEK


3 Retrospective effectiveness test on 30 June 20X5

IAS 39 requires the effectiveness of a hedging relationship to be assessed retrospectively as a minimum at each reporting date. Based on Company C’s risk management policies, the effectiveness of the hedge is assessed using the dollar offset method on a cumulative basis.

The dollar offset method consists of comparing the effects of the change in spot EUR/SEK exchange rate (from 7.69 to 7.65) on the fair value of the spot component of the hedging instrument and the hypothetical derivative (hedged cash flows).

Hedged item
Hypothetical derivative – spot component
Hedging instrument
Spot component

Notional amount (25,000,000) EUR 25,000,000 EUR   Notional amount
Spot rate at test date 7.6500   7.6500     Spot rate at test date

Notional amount in SEK (191,250,000) SEK 191,250,000 SEK   Notional amount in SEK
Discount factor 0.9838   0.9838     Discount factor
      (1/(1.01385)^(427days/360))

FV of the EUR leg (spot) (A) (188,155,087) EUR 188,155,087 SEK   FV of the EUR leg (spot) (A)
Spot comp of notional at inception 192,250,000 SEK (192,250,000)     Spot comp of notional at inception
Discount factor 0.9838   0.9838     Discount factor

FV of SEK leg (spot) (B) 189,138,905 SEK (189,138,905) SEK   FV of SEK leg (spot) (B)

(A-B) FV of the derivative (spot) 983,818 SEK (983,818) SEK   (B-A) FV of the derivative (spot)
Effectiveness -100%          


Conclusion:
the hedge has been highly effective for the period ended 30 June 20X5.

Helpful hint
Ineffectiveness can arise from a number of causes, including changes in the date of the forecast transaction and changes in the credit risk or liquidity of the forward contract.

4 Accounting entries on 30 June 20X5

All the criteria for hedge accounting are met for the period ended 30 June 20X5. Cash flow hedge accounting can therefore be applied. The hedge is 100% effective; the change in the fair value of the spot component of the hedging instrument is, therefore, recognised in other comprehensive income. The full fair value of the hedging instrument includes the forward points. The change in the fair value of the forward points component is recognised in the income statement.

Derivative
Notional amount in EUR 25,000,000 EUR
Forward rate 7.6622  

Notional amount in SEK 191,554,154 SEK
Discount factor 0.9838  

FV of the EUR leg 188,454,319 SEK
     
Notional amount in SEK (192,687,500) SEK
Discount factor 0.9838  

FV of the SEK leg (189,565,963) SEK

FV of the derivative (1,111,644) SEK


The entry is as follows:

 
Dr
Cr
Derivative (financial liability)   
1,111,644
Cash flow hedge reserve (via other comprehensive income)
983,818
 
Interest expense (income statement) 
127,826
 
Cash flow hedge – change in fair value of the forward contract    

Helpful hint
The forward points represent the interest rate differential between the currencies of the forward contract. It is common to recognise fair value movements on the forward points component as interest income or expense, although they could also be recognised as ‘operating income and expense’.

5 Prospective effectiveness test on 30 June 20X5

The same method is used as at the inception of the hedge.

Hedged item
Hypothetical derivative – spot component
Hedging instrument
Spot component

Notional amount (25,000,000) EUR 25,000,000 EUR   Notional amount
Spot rate + 10% 8.4150   8.4150     Spot rate + 10%

Notional amount in SEK (211,475,000) SEK 210,375,000 SEK   Notional amount in SEK
Discount factor 0.9838   0.9838     Discount factor

FV of the EUR leg (spot) (A) (206,970,596) EUR 206,970,596 SEK   FV of the EUR leg (spot) (A)
Spot component of notional 191,250,000 SEK (191,250,000)     Spot component of notional
Discount factor 0.9838   0.9838     Discount factor

FV of SEK leg (spot) (B) 188,155,087 SEK (188,155,087) SEK   FV of SEK leg (spot) (B)

(A-B) FV of the hypothetical derivative (spot) (18,815,509) SEK 18,815,509 SEK   (A-B) FV of the derivative (spot)
Effectiveness
-100%
         


Conclusion:
the hedge is expected to be highly effective.

6 Retrospective effectiveness test on 31 December 20X5


Change in timing of expected cash flow

In December 20X5, management decides to delay the start of production by two months, due to the late delivery of an essential machine. The production will now start in August 20X6, and the raw materials will be purchased in July. The invoice for the raw materials is expected to be paid on 31 October 20X6.

Annualised interest rates applicable for discounting a cash flow on 31 October 20X6 at various dates during the hedge are as follows:

 
31/12/20X5 
30 Jun 20X6
31 Jul 20X6
31 Aug 20X6
SEK interest rate
1.3920%
1.4060%
1.4420%
1.4030%

The dollar offset method consists of comparing the effects of the cumulative change in spot EUR/SEK exchange rate (from 7.69 to 7.75) on the fair value of the spot component of the hedging instrument and the hedged cash flow (hypothetical derivative). As the hedged cash flow has been delayed, it is discounted from the revised payment date. The payment date on the hedging instrument and the associated discount factor remain unchanged.

Hedged item
Hypothetical derivative – spot component
Hedging instrument
Spot component

Notional amount (25,000,000) EUR 25,000,000 EUR   Notional amount
Spot rate at test date 7.7500   7.7500     Spot rate at test date

Notional amount in SEK (193,750,000) SEK 193,750,000 SEK   Notional amount in SEK
Discount factor* 0.9884   0.9909     Discount factor**

FV of the EUR leg (spot) (A) (191,501,389) EUR 191,982,442 SEK   FV of the EUR leg (spot) (A)
Spot comp of notional at inception 192,250,000 SEK (192,250,000) SEK   Spot component of notional at inception
Discount factor* 0.9884   0.9909     Discount factor**

FV of SEK leg (spot) (B) 190,018,798 SEK (190,496,126) SEK   FV of SEK leg (spot) (B)

(A-B) FV of the derivative (spot) (1,482,591) SEK 1,486,316 SEK   (A-B) FV of the derivative (spot)
Effectiveness -100.25%          


* Discount factor calculated based on changed timing of cash flows - (1/(1.01392)^(304days/360)).
** Discount factor calculated based on original timing of cash flows - (1/(1.01367)^(243days/360)).

Conclusion: the hedge has been highly effective for the period ended 31 December 20X5.

7 Accounting entries on 31 December 20X5


The full fair value of the hedging instrument is as follows:

Derivative
Notional amount in EUR 25,000,000 EUR
Forward rate 7.7574  

Notional amount in SEK 193,935,000 SEK
Discount factor 0.9909  

FV of the EUR leg 192,165,754 SEK
     
Notional amount in SEK (192,687,500) SEK
Discount factor 0.9909  

FV of the SEK leg (190,929,635) SEK

FV of the derivative 1,236,119 SEK


All the criteria for hedge accounting are met for the period ended 31 December 20X5. Cash flow hedge accounting can therefore be applied. The hedge is not, however, 100% effective and, therefore, the amount recognised in other comprehensive income is adjusted to the lesser of (a) the cumulative change in the fair value of the spot component of the hedging instrument, and (b) the cumulative change in the fair value of the spot component of the hypothetical derivative.

  Derivative (full fair value) Hedging instrument (spot component) Hedged item hypothetical derivative (spot component) Effective portion Ineffective portion
30 Jun 20X5 (1,111,644) (983,818) 983,818 (983,818)
31 Dec 20X5 1,236,119 1,486,316 (1,482,591) 1,482,591 3,725

Change 2,347,763 2,470,134 (2,466,409) 2,466,409 3,725


The difference between the full fair value of the forward contract and the amount deferred in other comprehensive income is charged to the income statement. The portion relating to the forward points is recognised in ‘interest expense’ and the ineffectiveness (SEK 1,486,316 – SEK 1,482,591 = SEK 3,725) is recognised in ‘other operating income and expense’.

Helpful hint
The forward points reflect an interest element and can therefore be included in interest income and expense. Alternatively all fair value movements in excess of the effective portion may be recognised in ‘other operating income and expense’.


The entry is as follows:

   
Dr
Cr
Derivative (financial asset) 
2,347,763
 
  Cash flow hedge reserve (via other comprehensive income)  
2,466,409
Interest expense (income statement)
122,371
 
  Other operating income and expense  
3,725
Cash flow hedge – change in fair value of the forward contract    

8 Prospective effectiveness test on 31 December 20X5


The same method is used as at the inception of the hedge.

Hedged item
Hypothetical derivative – spot component
Hedging instrument
Spot component

Notional amount (25,000,000) EUR 25,000,000 EUR   Notional amount
Spot rate + 10% 8.5250   8.5250     Spot rate + 10%

Notional amount in SEK (213,125,000) SEK 213,125,000 SEK   Notional amount in SEK
Discount factor 0.9884   0.9909     Discount factor

FV of the EUR leg (spot) (A) (210,651,528) EUR 211,180,686 SEK   FV of the EUR leg (spot) (A)
Spot comp of notional at inception 193,750,000 SEK (193,750,000) SEK   Spot component of notional
Discount factor 0.9884   0.9909     Discount factor**

FV of SEK leg (spot) (B) 191,501,389 SEK (191,982,442) SEK   FV of SEK leg (spot) (B)

(A-B) FV of the derivative (spot) (19,150,139) SEK 19,198,244 SEK   (A-B) FV of the derivative (spot)
Effectiveness -100.25%          


Conclusion:
the hedge is expected to be highly effective.

9 Retrospective effectiveness test on 30 June 20X6


The dollar offset method consists of comparing the effects of the change in spot EUR/SEK exchange rate (from 7.69 to 7.81) on the fair value of the spot component of the hedging instrument, and the hypothetical derivative (hedged cash flows). As the hedged cash flow has been delayed, it is discounted from the revised payment date. The payment date on the hedging instrument and the associated discount factor remain unchanged.

Hedged item
Hypothetical derivative – spot component
Hedging instrument
Spot component

Notional amount (25,000,000) EUR 25,000,000 EUR   Notional amount
Spot rate at test date 7.8100   7.8100     Spot rate at test date

Notional amount in SEK (195,250,000) SEK 195,250,000 SEK   Notional amount in SEK
Discount factor* 0.9952   0.9976     Discount factor**

FV of the EUR leg (spot) (A) (194,320,802) EUR 194,788,017 SEK   FV of the EUR leg (spot) (A)
Spot comp of notional at inception 192,250,000 SEK (192,250,000) SEK   Spot component of notional at inception
Discount factor 0.9952   0.9976     Discount factor

FV of SEK leg (spot) (B) 191,335,079 SEK (191,795,116) SEK   FV of SEK leg (spot) (B)

(A-B) FV of the derivative (spot) (2,985,723) SEK 2,992,901 SEK   (A-B) FV of the derivative (spot)
Effectiveness -100.24%          


* Discount factor calculated based on changed timing of cash flows - (1/(1.014060)^(123days/360)).
** Discount factor calculated based on original timing of cash flows - (1/(1.01385)^(62days/360)).


Conclusion:
the hedge has been highly effective for the period ended 30 June 20X6.

10 Accounting entries on 30 June 20X6


The full fair value of the hedging instrument is as follows:

Derivative
Notional amount in EUR 25,000,000 EUR
Forward rate 7.8118  

Notional amount in SEK 195,293,907 SEK
Discount factor 0.9976  

FV of the EUR leg 194,831,821 SEK
     
Notional amount in SEK 192,687,500 SEK
Discount factor 0.9976  

FV of the SEK leg (192,231,581) SEK

FV of the derivative 2,601,240 SEK


All the criteria for hedge accounting are met for the year ended 30 June 20X6. Cash flow hedge accounting can therefore be applied. The hedge is not however 100% effective; the amount recognised in other comprehensive income is, therefore, adjusted to the lesser of (a) the cumulative change in the fair value of the spot component of the hedging instrument, and (b) the cumulative change in the fair value of the spot component of the hypothetical derivative.

  Derivative (full fair value) Hedging instrument (spot component) Hedged item hypothetical derivative (spot component) Effective portion Ineffective portion
31 Dec 20X5 1,236,119 1,486,316 (1,482,591) 1,482,591 3,725
30 Jun 20X6 2,601,240 2,992,901 (2,985,723) 2,985,723 7,178

Change 1,365,121 1,506,585 (1,503,132) 1,503,132 3,453


The difference between the full fair value of the forward contract and the amount deferred in equity is charged to the income statement. The portion relating to the forward points is recognised in ‘interest income’ and the ineffectiveness is recognised in ‘other operating income and expense’.

The entry is as follows:

   
Dr
Cr
Derivative (financial asset)
1,365,121
 
  Cash flow hedge reserve (via other comprehensive income)   
1,503,132
Interest expense (income statement)
141,464
 
  Other operating income and expense  
3,453
Cash flow hedge – change in fair value of the forward contract    

11 Prospective effectiveness test on 30 June 20X6

The same method is used as at the inception of the hedge.

Hedged item
Hypothetical derivative – spot component
Hedging instrument
Spot component

Notional amount (25,000,000) EUR 25,000,000 EUR   Notional amount
Spot rate + 10% 8.5910   8.5910     Spot rate + 10%

Notional amount in SEK (214,775,000) SEK 214,775,000 SEK   Notional amount in SEK
Discount factor 0.9952   0.9976     Discount factor

FV of the EUR leg (spot) (A) (213,752,882) EUR 214,266,819 SEK   FV of the EUR leg (spot) (A)
Spot comp of notional at inception 195,250,000 SEK (195,250,000) SEK   Spot component of notional
Discount factor 0.9952   0.9976     Discount factor

FV of SEK leg (spot) (B) 191,335,079 SEK (191,795,116) SEK   FV of SEK leg (spot) (B)

(A-B) FV of the derivative (spot) (22,417,803) SEK 22,471,703 SEK   (A-B) FV of the derivative (spot)
Effectiveness -100.24%          


Conclusion:
the hedge is expected to be highly effective.

12 Retrospective effectiveness test on 31 July 20X6


The dollar offset method consists of comparing the effects of the change in spot EUR/SEK exchange rate (from 7.69 to 7.90) on the fair value of the spot component of the hedging instrument, and the hedged cash flows (hypothetical derivative). As the hedged cash flow has been delayed, it is discounted from the revised payment date. The payment date on the hedging instrument and the associated discount factor remain unchanged.

Hedged item
Hypothetical derivative – spot component
Hedging instrument
Spot component

Notional amount (25,000,000) EUR 25,000,000 EUR   Notional amount
Spot rate at test date 7.9000   7.9000     Spot rate at test date

Notional amount in SEK (197,500,000) SEK 197,500,000 SEK   Notional amount in SEK
Discount factor* 0.9963   0.9988     Discount factor**

FV of the EUR leg (spot) (A) (196,778,708) EUR 197,259,676 SEK   FV of the EUR leg (spot) (A)
Spot comp of notional at inception 192,250,000 SEK (192,250,000) SEK   Spot component of notional
Discount factor 0.9963   0.9988     Discount factor

FV of SEK leg (spot) (B) 191,547,882 SEK (192,016,064) SEK   FV of SEK leg (spot) (B)

(A-B) FV of the derivative (spot) (5,230,826) SEK 5,243,612 SEK   (A-B) FV of the derivative (spot)
Effectiveness -100.24%          


* Discount factor calculated based on changed timing of cash flows - (1/(1.01442)^(92days/360)).
** Discount factor calculated based on original timing of cash flows - (1/(1.01424^(31days/360)).

Conclusion: the hedge has been highly effective for the period ended 31 July 20X6.

Helpful hint
Although IAS 39 does not explicitly require it, an effectiveness test is performed when the hedged highly probable forecast transaction occurs in order to determine the amount to be reclassified into the carrying amount of the hedged item.

13 Accounting entries on 31 July 20X6

Recognition of the purchase

   
Dr
Cr
Inventory
197,500,000
 
  Trade payable   
197,500,000
Purchase of EUR 25m at spot rate of 7.90    

As the trade payable is short-term and EUR interest rates are low, Company C has determined that the effect of discounting is not material. The trade payable is therefore recognised at its face value, as permitted in IAS 39.

Recognition of the change in the fair value of the derivative

The full fair value of the hedging instrument is as follows:

Derivative
Notional amount in EUR 25,000,000 EUR
Forward rate 7.9008  

Notional amount in SEK 197,520,232 SEK
Discount factor   0.99878  

FV of the EUR leg 197,279,883 SEK
     
Notional amount in SEK (192,687,500) SEK
Discount factor 0.99878  

FV of the SEK leg (192,453,032) SEK

FV of the derivative 4,826,851 SEK


All the criteria for hedge accounting are met as at 31 July 20X6. Cash flow hedge accounting can therefore be applied. The hedge is not however 100% effective; the amount recognised in other comprehensive income is, therefore, adjusted to the lesser of (a) the cumulative change in the fair value of the spot component of the hedging item, and (b) the cumulative change in the fair value of the spot component of the hypothetical derivative.

  Derivative (full fair value) Hedging instrument (spot component) Hedged item hypothetical derivative (spot component) Effective portion Ineffective portion
30 Jun 20X6 2,601,240 2,992,901 (2,985,723) 2,985,723 7,178
31 Jul 20X6 4,826,851 5,243,612 (5,230,826) 5,230,826 12,786

Change 2,225,611 2,250,711 (2,245,103) 2,245,103 5,608


The difference between the full fair value of the forward contract and the amount deferred in equity is charged to the income statement. The portion relating to the forward points is recognised in ‘interest expense’ and the ineffectiveness is recognised in ‘other operating income and expense’.

The entry is as follows:

   
Dr
Cr
Derivative (financial asset)
2,225,611
 
  Cash flow hedge reserve (via other comprehensive income)  
2,245,103
Interest expense (income statement) 
25,100
 
  Other operating income and expense  
5,608
Cash flow hedge – change in fair value of the forward contract    


Basis adjustment

Company C’s accounting policy is that the gain on the hedging derivative is included in the carrying amount of the inventory acquired. The gain is reclassified to profit or loss when the inventory affects profit or loss (that is, on sale of the goods containing the hedged components or impairment of the inventory).

   
Dr
Cr
Cash flow hedge reserve (via other comprehensive income)
5,230,826
 
  Inventory  
5,230,826
Reclassification of gains recognised in equity into the carrying amount of the inventory acquired by company C

Helpful hint
The ‘basis adjustment’ approach is not required. It can be used only if the hedged item is non-financial (for example, a forecast purchase of inventory) and only if its use is consistent with the Company’s chosen accounting policy. If company C’s management had chosen not to adjust the carrying amount of the inventory acquired, the amount accumulated in the cash flow hedge reserve would have remained in equity until the inventory affects the income statement (for example, when it is sold or impaired) and then been reclassified to profit or loss.

14 Retrospective effectiveness test on 31 August 20X6


The spot EUR/SEK exchange rate is 8.15. Company C’s management assesses the effectiveness of the hedge retrospectively. The same method is used as at 30 June 20X6. As required in Company C’s risk management policies, the effectiveness test uses the dollar offset method on a cumulative basis.

Hedged item
Hypothetical derivative – spot component
Hedging instrument
Spot component

Notional amount (25,000,000) EUR 25,000,000 EUR   Notional amount
Spot rate at test date 8.1500   8.1500     Spot rate at test date

Notional amount in SEK (203,750,000) SEK 203,750,000 SEK   Notional amount in SEK
Discount factor 0.9976   1.0000     Discount factor
(1/(1.0403)^(61days/360))      

FV of the EUR leg (spot) (A) (203,269,558) EUR 203,750,000 SEK   FV of the EUR leg (spot) (A)
Spot comp of notional at inception 192,250,000 SEK (192,250,000) SEK   Spot component of notional
Discount factor 0.9976   1.0000     Discount factor

FV of SEK leg (spot) (B) 191,796,675 SEK (192,250,000) SEK   FV of SEK leg (spot) (B)

(A-B) FV of the derivative (spot) (11,472,883) SEK 11,500,000 SEK   (A-B) FV of the derivative (spot)
Effectiveness -100.24%          


Conclusion:
the hedge has been highly effective for the period ended 31 August 20X6.

15 Accounting entries on 31 August 20X6


Translation of the trade payable at the spot rate

The trade payable is a monetary item denominated in a foreign currency that must be re-translated at the spot rate under IAS 21, with the resulting currency gain or loss recognised in profit or loss.

The calculation of the gain or loss is as follows:

   
Trade payable translated at 31 July at 7.90
197,500,000
Trade payable translated at 31 August at 8.15
203,750,000

Foreign exchange loss to be recognised in profit or loss 
6,250,000

The accounting entry is as follows:

   
Dr
Cr
Other operating income and expenses – foreign exchange loss
6,250,000
 
  Trade payable  
6,250,000
To recognise the foreign exchange loss on re-translating the trade payable    

All the criteria for hedge accounting are met as at 31 August 20X6. Cash flow hedge accounting can, therefore, be applied. The hedge is not however 100% effective; the amount recognised in other comprehensive income is therefore adjusted to the lesser of:

(a) the cumulative change in the fair value of the spot component of the hedging instrument less the basis adjustment recognised in the previous period; and
   
(b) the cumulative change in the fair value of the spot component of the hypothetical derivative (hedged item) less the basis adjustment recognised in the previous period.

  Derivative (full fair value) Hedging instrument (spot component) Hedged item hypothetical derivative (spot component) Effective portion (recognised as basis adjustment) Ineffective portion
31 Jul 20X6 4,826,851 5,243,612 (5,230,826) 5,230,826 12,786
31 Aug 20X6 11,062,500 11,500,000 (11,472,883) 11,472,883 27,117

Change 6,235,649 6,256,388 (6,242,057) 6,242,057 14,331


The dif