The objective of hedge accounting is to represent the effect of an entitys risk management activities that use financial instruments to manage exposures arising from particular risks that could affect P/L or OCI (IFRS 22.214.171.124). If there were no specific requirements for hedge accounting, many risk management strategies could result in an accounting mismatch as different accounting rules may apply to assets/liabilities that form a hedging relationship (e.g. inventory carried at cost and derivatives carried at fair value).
Application of hedge accounting is voluntary (IFRS 126.96.36.199).
The IASB allows to continue applying hedge accounting as set out in IAS 39 until it finalises its project for so-called macro hedging, officially referred to as Accounting for Dynamic Risk Management (IFRS 188.8.131.52).
IFRS 9 distinguishes between risk management strategy and risk management objectives. Risk management strategy is established at the highest level at which an entity determines how it manages its risk and it typically identifies the risks to which the entity is exposed and sets out how the entity responds to them. In contrast, the risk management objective for a hedging relationship applies at the level of a particular hedging relationship. It relates to how the particular hedging instrument that has been designated is used to hedge the particular exposure that has been designated as the hedged item (IFRS 9.B6.5.24). The significance of this distinction is that certain hedge accounting eligibility is based on risk management strategy, which also needs to be disclosed in financial statements (IFRS 7.21A(a)).
The following are qualifying instruments, i.e. can be designated as hedging instruments (IFRS 184.108.40.206-2):
derivatives measured at FVTPL except most written options (see IFRS 9.B6.2.4),
non-derivative financial assets or liabilities measured at FVTPL (this excludes financial liabilities designated at FVTPL or assets measured at FVOCI).
A qualifying instrument must be designated in its entirety as a hedging instrument with the exceptions listed in paragraph IFRS 220.127.116.11 and discussed below.
It is allowed to designate only the intrinsic value of an option as a hedging instrument (IFRS 18.104.22.168(a)). Time value of an option is often the only composite of a premium paid and is considered by risk managers as a cost of hedging (IFRS 9.BC6.387). When only the intrinsic value of an option is designated as a hedging instrument, the changes in fair value of the time value of an option are recognised in OCI and subsequent accounting depends on whether the hedged item is transaction related or time-period related (IFRS 22.214.171.124).
The time value of an option relates to a transaction related hedged item if the nature of the hedged item is a transaction for which the time value has the character of costs of that transaction. IFRS 9 gives an example of a commodity purchase where initial measurement includes transaction costs (IFRS 9.B6.5.29(a)). Subsequent accounting for amounts accumulated in OCI is set out in IFRS 126.96.36.199(b) and is very similar toaccounting for cash flow hedge reserves.
On 1 January Entity A decides to purchase a piece of equipment and the transaction is expected to take place on 30 June the same year. Entity A has EUR as its functional currency, equipment will cost USD 300k. Entity A purchases a call option for USD 300k to hedge the downside risk only. The premium paid amounts to EUR 10k and represents time value of the option. Entity A designates only the intrinsic value of the option as a hedging instrument in a cash flow hedge. The entries below illustrate the accounting for the time value of an option.
1/ Entity A purchases the option on 1 January and pays a premium of EUR 10k:
2/ Entity A prepares financial statements on 31 March and recognises changes in the fair value of a time-value of an option:
3/ On 30 June, the fair value of a time value of the option drops to zero:
4/ Entity A purchases the equipment for USD 300k which equals EUR 280k:
5/ Entity A recognises the time value accumulated in OCI as a basis adjustment that increases the cost of equipment:
The time value of an option relates to a time-period related hedged item if the nature of the hedged item is such that the time value has the character of a cost for obtaining protection against a risk over a particular period of time, but the hedged item does not result in a transaction that involves the notion of a transaction cost as for transaction related hedged items covered above. IFRS 9 gives an example of commodity inventory that is hedged against a fair value decrease for six months using a commodity option with a corresponding life (IFRS 9.B6.5.29(b)). Amounts accumulated in OCI should be subsequently amortised (as a reclassification adjustment) on a systematic and rational basis over the period during which the hedge adjustment for the options intrinsic value could affect P/L (IFRS 188.8.131.52(c)).
On 1 January 20X1 Entity A issues a 2-year floating rate bond and purchases an interest rate cap for the same period to protect itself against increases in interest rates. The premium paid amounts to $100k. Only the intrinsic value of this cap is designated as a hedging instrument in a cash flow hedge. Entity A considers that straight-line method will be a systematic and rational basis of amortisation to P/L of the time value of the interest rate cap. Accounting entries relating to the time value of the interest rate cap are as follows:
1/ Entity A purchases the interest rate cap on 1 January 20X1 and pays a premium of $100k:
2/ At 31 December 20X1, Entity A amortises to P/L the part relating to first year:
3/ At 31 December 20X1, Entity A determines that the fair value of the time value of interest rate cap amounts to $60k, it therefore need to be increased by $10k as a result of the amortisation in point 2:
4/ At 31 December 20X2, Entity A amortises to P/L the part relating to second year:
5/ At 31 December 20X2, the fair value of the time value of interest rate cap is nil, therefore the entry 3/ is reversed:
The accounting for the time value of options set out above applies only to the extent that the time value of the option and hedged item are aligned. If the actual time value and the aligned time value differ, provisions set out in paragraph IFRS 9.B6.5.33 apply.
Similarly to intrinsic value of an option, an entity can designate only the spot element of a forward contract as a hedging instrument (IFRS 184.108.40.206(b)). If this is the case, the general accounting requirements for the forward element and foreign currency basis spread are the same as for the intrinsic value of an option (IFRS 220.127.116.11, B6.5.34B6.5.39).
Any of the following can be a hedged item provided they are reliably measurable (IFRS 18.104.22.168-2):
An aggregated exposure that is a combination of an exposure that could qualify as a hedged item under general rules and a derivative may be designated as a hedged item (IFRS 22.214.171.124). This is a huge difference when compared to IAS 39 which did not allow derivatives to be designated as hedged items. More discussion with examples is given in paragraphs IFRS 9.B6.3.3-4 and Illustrative examples 16-18 accompanying IFRS 9.
It is allowed to designate only a component of an item as the hedged item, namely the following components (IFRS 126.96.36.199):
a/ only changes in the cash flows or fair value of an item attributable to a specific risk or risks (risk component),
b/ one or more selected contractual cash flows,
c/ components of a nominal amount, i.e. a specified part of the amount of an item.
Risk component of a financial or non-financial item must be separately identifiable and reliably measurable in order to be eligible for designation as a hedged item. However, it need not be contractually specified. See more discussion and examples in paragraphs IFRS 9.B6.3.8-10.
When designating a risk component as a hedged item, the hedge accounting requirements apply to that risk component in the same way as they apply to other hedged items (IFRS 9.B6.3.11).
An entity can also designate only changes in the cash flows or fair value of a hedged item above or below a specified price or other variable, so-called a one-sided risk (IFRS 9.B6.3.12).
There are two types of components of nominal amounts that can be designated as the hedged item (IFRS 9.B6.3.16):
a proportion of an entire item (e.g. 50 per cent of the contractual cash flows of a loan)
a layer component (examples are given in paragraph IFRS 9.B6.3.18)
Relationship between components and the total cash flows of an item
A component of the cash flows designated as hedged item cannot exceed total cash flows of the entire item. See paragraphs IFRS 9.B6.3.21-25 for more discussion and examples.
Forecast transactions with owners (e.g. share issuance, share buy-back, declaration of dividend) cannot be hedged items because the transaction will not affect P/L nor OCI which is a necessary ingredient of a cash flow hedge (IFRS 188.8.131.52).
General business risks cannot be hedged items as they cannot be specifically identified and measured (IFRS 9.B6.3.1). Examples of such general business risks include a risk that a transaction will not occur or obsolescence of a physical asset.
A firm commitment to acquire a business in abusiness combinationcannot be a hedged item, except for foreign currency risk. Risks other than foreign currency risk cannot be specifically identified and measured and are considered to be general business risks (IFRS 9.B6.3.1).
It may happen that the transactions of a business to be acquired will qualify as hedged item, provided that they can be considered a highly probable forecast transaction from the perspective of the acquirer. Assessment of the probability needs to take into account not only the transaction itself, but also the business combination actually occurring.
IFRS 9 does not give any guidance on what is meant by a highly probable forecast transaction. IAS 39 did include such a guidance, which can be considered to be still valid and can be found in paragraph IAS 39.F.3.7.
IFRS 9 allows a group of items, including a group of items that constitute a net position, to be an eligible hedged item if the criteria set out in paragraph IFRS 184.108.40.206 are met.
See paragraphs IFRS 9.B6.6.1-6 for more discussion.
Similarly to individual items, components of a group of items can also be designated as hedged items provided the criteria in paragraphs IFRS 220.127.116.11-3 are met.
For a hedge of a net position whose hedged risk affects different line items in P/L or OCI, any hedging gains or losses should be presented in a separate line from those affected by the hedged items (IFRS 18.104.22.168).
Nil net position is a situation where hedged items among themselves fully offset the risk that is managed on a group basis. Nil net position can be designated in a hedging relationship that does not include a hedging instrument if the criteria set out in paragraph IFRS 22.214.171.124 are met.
A hedging relationship qualifies for hedge accounting only if all of the following criteria are met (IFRS 126.96.36.199):
a/ the hedging relationship consists only of eligible hedging instruments and eligible hedged items (discussed in previous sections)
b/ at the inception of the hedging relationship, there is formal designation and documentation of the hedging relationship and the entitys risk management objective and strategy for undertaking the hedge
c/ the hedging relationship meets the hedge effectiveness requirements:
there is an economic relationship between the hedged item and the hedging instrument
the hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item
At the inception of the hedging relationship, there must be a formal designation and documentation of the hedging relationship and the entitys risk management objective and strategy for undertaking the hedge. That documentation should include (IFRS 188.8.131.52(b)):
identification of the hedging instrument,
description of how the entity will assess whether the hedging relationship meets the hedge effectiveness requirements (including its analysis of the sources of hedge ineffectiveness and how it determines the hedge ratio) see below.
There must be an economic relationship between the hedged item and the hedging instrument in order for the hedging relationship to meet the hedge effectiveness criterion. This means that the hedging instrument and the hedged item have values that generally move in the opposite direction because of the same risk, which is the hedged risk. However, this does not mean that the values of the hedging instrument and the hedged item must always and without exceptions move in opposite directions. See paragraphs IFRS 9.B6.4.4-6; B6.4.14 for more discussion.
There is no objective-based assessment or bright line set that would indicate whether the hedging relationship qualifies for hedge accounting in terms of its effectiveness, as was the case with the 80%-125% threshold in IAS 39 (IFRS 9.BC6.238). Often, it will be obvious that the hedging instrument and the hedged item have values that will generally move in the opposite direction and only qualitative assessment will be sufficient. In some cases, however, the hedge effectiveness will be more difficult to predict and a quantitative assessment will be necessary (IFRS 9.B6.4.13-16).
At least at each reporting date, or when significant change in the circumstances occurs, an entity must assess whether a hedging relationship meets the hedge effectiveness requirements described above. The assessment relates to expectations about hedge effectiveness and is therefore only forward-looking (IFRS 9.B6.4.12).
Changes in credit risk impact fair value of a financial instrument but they hardly ever be opposite changes in credit risk for hedged item and hedging instrument, which will cause some hedge ineffectiveness. Paragraph IFRS 184.108.40.206(c)(ii) states that the effect of credit risk cannot dominate the value changes that result from economic relationship determined for the hedge effectiveness criterion. This condition will be met for the most common hedging instruments as they are contracted with respectable financial institutions and/or are cash collateralised. For hedged items, it is possible that, at some point, the credit risk will dominate their value changes. It is generally accepted that movement to a Stage 3 in impairment model (see above) does not imply that the credit risk dominates value changes of a financial asset.
See paragraphs IFRS 9.B6.4.7-8 for more discussion.
As noted earlier, the hedge documentation should include the description of how the entity will assess whether the hedging relationship meets the hedge effectiveness requirements and its analysis of the sources of hedge ineffectiveness and how it determines the hedge ratio. Hedge ineffectiveness is the extent to which the changes in the fair value or the cash flows of the hedging instrument are greater or less than those on the hedged item and is immediately recognised in P/L (IFRS 9.B6.4.1).
IFRS 9 does not prescribe how to measure hedge ineffectiveness, but a ratio analysis can be used in simple arrangements. Ratio analysis is the comparison of hedging gains and losses with the corresponding gains and losses on the hedged item at a point in time. This method was explicitly mentioned in IAS 39.F.4.4.
IFRS 9 mentions a hypothetical derivative method as one of possible ways to measure hedge effectiveness in more complex arrangements. The hypothetical derivative method compares the change in fair value or cash flows of the hedging instrument with the change in fair value or cash flows of a hypothetical derivative that represents the hedged risk. The ineffectiveness recognised in P/L is based on comparing the actual hedging instrument with hypothetical derivative (IFRS 9.B6.5.5).
An illustrative example is included in paragraph IAS 39.F.5.5.
Hedge ratio is the relation of hedging instruments to hedged items and IFRS 9 requires the hedge ratio used for accounting purposes to be the same as used for risk management purposes (see IFRS 9. B6.4.9). However, paragraph IFRS 220.127.116.11(c)(iii) contains an anti-abuse rules against setting this ratio too low to avoid recognising hedge ineffectiveness for cash flow hedges or to achieve fair value hedge adjustments for more hedged items with the aim of increasing the use of fair value accounting (see IFRS 9.B6.4.11).
There are three types of hedging relationships (IFRS 18.104.22.168):
Fair value hedge is a hedge of the exposure to changes in fair value of a 1/ recognised asset or liability or 2/ an unrecognised firm commitment, or a component of any such item, that is attributable to a particular risk and could affect P/L (IFRS 22.214.171.124(a)). Examples of fair value hedges are:
interest rate swaps used to hedge exposure to fair value changes of a fixed-rate debt (by issuer or holder) even if the debt instrument is accounted for at amortised cost (IFRS 9.B6.5.1, see also IAS 39.F.2.13)
a forecast purchase of an equity instrument that, once acquired, will be accounted for at FVTPL or FVOCI
hedges of exposure to changes in fair value of variable rate debt due to credit risk or movements in the market interest rate in periods between which the variable interest rate is reset (IAS 39.F.3.5)
hedges of foreign currency risk in a monetary asset or liability (which could also be treated as cash flow hedges, see IAS 39.F.3.34)
forward contract for inventory to hedge exposure to changes in the price of the inventories (even though inventories are measured at the lower of cost and net realisable value, this is because the change in fair value of inventories will affect P/L when the inventories are sold or their carrying amount is written down, see IAS 39.F.3.6)
a hedge of a price risk or a currency risk in a firm commitment to purchase an inventory (IFRS 9.B6.5.3)
The accounting for fair value hedges can be summarised as follows (IFRS 126.96.36.199):
hedging instruments are measured at fair value with gains or losses recognised in P&L (or OCI if the hedged item is an equity instrument at FVOCI without recycling)
the fair value changes of the risk being hedged are recognised in the carrying value of the hedged item and in P/L (or OCI if the hedged item is an equity instrument at FVOCI without recycling)
when a hedged item is an unrecognised firm commitment, the change in the fair value of the hedged item subsequent to its designation is recognised as an asset or a liability with a corresponding gain or loss recognised in P/L. When the firm commitment becomes an asset or a liability, its carrying amount includes the amount recognised as a basis adjustment (IFRS 188.8.131.52)
The adjustment to the carrying value of a hedged item if often referred to as a basis adjustment.
Basis adjustment made to the carrying amount of a debt instrument measured at amortised cost should be amortised to P/L as an adjustment to effective interest rate (EIR). However, in order to relieve entities from making constant adjustments to EIR, it is allowed to begin amortisation when the hedged instrument ceases to be adjusted for hedging gains and losses (IFRS 184.108.40.206).
Cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, 1/ a recognised asset or liability, 2/ a highly probable forecast transaction or 3/ a firm commitment (foreign currency risk only IFRS 220.127.116.11) , and could affect P/L (IFRS 18.104.22.168(b)). The purpose of a cash flow hedge is to defer the gain or loss on the hedging instrument to a period or periods in which the hedged expected future cash flows affect profit or loss. Examples of cash flow hedges are:
interest rate swaps used to change floating rate debt (whether measured at amortised cost or fair value) to fixed-rate debt (i.e. a hedge of future cash flows being the future interest payments) (IFRS 9.B6.5.2)
hedges against changes in interest rate risk in a planned debt issuance (IAS 39.F.2.2)
forward contract for inventory to hedge exposure to cash flows resulting from future sale of inventory (IAS 39.F.3.6)
hedge of the foreign currency risk of a firm commitment (this is the only risk of a firm commitment that can be classified as a cash flow hedge) (IFRS 22.214.171.124)
hedges of foreign currency risk in a monetary asset or liability (which could also be treated as fair value hedges, see IAS 39.F.3.34)
The accounting for cash flow hedges can be summarised as follows (IFRS 126.96.36.199):
changes in fair value of hedging instruments are recognised in OCI and are accumulated in a cash flow reserve within equity
the cumulative gain or loss on the hedging instrument from inception of the hedge and
the cumulative change in the fair value (present value) of hedged expected future cash flows from inception of the hedge (i.e. over-hedge ineffectiveness not accumulated in OCI)
as a result of the above, over-hedge ineffectiveness is recognised in P&L, under-hedge ineffectiveness is not recognised
for hedges other than covered in the point below, gains/ losses accumulated in a cash flow reserve are reclassified to P/L as a reclassification adjustment or recycling (which should be disclosed under IAS 1.92) in the same period or periods during which the hedged expected future cash flows affect profit or loss; for example, in the periods that interest income/ expense or foreign exchange gain/loss is recognised or when a forecast sale occurs (see IAS 39.F.3.3-4)
for: 1/ hedges of a forecast transaction that result in the recognition of a non-financial asset/liability (e.g. inventory) or 2/ when a hedged forecast transaction for a non-financial asset /liability becomes a firm commitment for which fair value hedge accounting is applied gains/ losses accumulated in a cash flow reserve are included directly in the carrying amount of the asset or liability, and this is not a reclassification adjustment and hence does impact OCI (see also IFRS 9.BC6.380) (so called basis adjustment, see example below)
accumulated loss on a hedging instrument that is not expected to be recovered should be immediately reclassified to P/L as a reclassification adjustment
Example: basis adjustment in a forecast acquisition of inventory
Entity A has EUR as its functional currency and on 1 January contracts for a purchase of inventory on 30 September for USD 1 million. Entity A decides to hedge the foreign currency exposure and enters into a forward contract with a bank to purchase USD 1 million for EUR 1 million. The forward contract is treated as a cash flow hedge. Entity A prepares its interim financial statements on 30 June when the forward contract has a positive fair value of EUR 0.1 million. On 30 September, the forward contract has a positive fair value of EUR 0.15 million. The accounting entries are as follows:
2/ Change in fair value between 30 June and 30 September:
The utilisation of cash flow reserve in entry no.5 is not treated as a reclassification adjustment and hence does not impact OCI (IFRS 188.8.131.52(d)(i); BC6.380). It does however impact total equity and therefore it should be included in the statement of changes in equity as a distinct movement.
See also thediscussionon presentation in OCI (items that will not be reclassified subsequently to profit or loss vs will be reclassified).
Hedges of a net investment in a foreign operation work essentially the same as cash flow hedges, with the hedged item being the net investment in a foreign operation (IFRS 184.108.40.206-14). Details can be found in IFRIC 16.
Rebalancing is a term used in IFRS 9 that refers to the adjustments made to the designated quantities of the hedged item or the hedging instrument of an already existing hedging relationship for the purpose of maintaining a hedge ratio that complies with the hedge effectiveness requirements. Rebalancing is accounted for as a continuation of the hedging relationship with immediate recognition of hedge ineffectiveness. Rebalancing does not apply if the risk management objective for a hedging relationship has changed. Instead, hedge accounting for that hedging relationship should be discontinued. See further discussion and examples in paragraphs IFRS 9.B6.5.7-21.
Hedge accounting should be discontinued prospectively when the hedging relationship ceases to meet the qualifying criteria discussed above. Discontinuation can relate to only a part of a hedging relationship. The replacement or rollover of a hedging instrument into another hedging instrument is not an expiration or termination if such a replacement or rollover is part of, and consistent with, the entitys documented risk management objective (IFRS 220.127.116.11). See more discussion and examples in paragraphs IFRS 9.B6.5.22-28.
On discontinuation of a fair value hedge, the basis adjustment is amortised to P/L under IFRS 18.104.22.168 (IFRS 22.214.171.124).
When hedge accounting for cash flow hedge is discontinued, the accounting depends on whether the hedged cash flows are expected to occur. If they are, the accumulated cash flow reserve remains as it is until the hedged cash flows occur. If they are no longer expected to occur, the amount accumulated in the cash flow hedge reserve is recycled to P&L (IFRS 126.96.36.199).
As a rule, intragroup items cannot be considered to be hedged items in the consolidated financial statements (IFRS 188.8.131.52). As an exception to this general rule, the foreign currency risk of an intragroup monetary item (e.g. receivables and payables) can be a hedged item if those subsidiaries have different functional currencies. It is so because exchange rate gains and losses on such items affect consolidated P/L (see IAS 21).
Similarly, the foreign currency risk of a highly probable forecast intragroup transaction may qualify as a hedged item in consolidated financial statements provided that the transaction is denominated in a currency other than the functional currency of the entity entering into that transaction and the foreign currency risk will affect consolidated P/L (IFRS 184.108.40.206). See paragraph IFRS 9.B6.3.5 for more discussion.
It is quite common for large corporation to have centralised treasury function. It may happen then that one entity contracts a derivative whose purpose is to hedge a risk that another group entity is exposed to. There is nothing in IFRS 9 that would preclude such an arrangement from being accounted for using hedge accounting principles in consolidated financial statements, and this was explicitly allowed in IAS 39 (IAS 39.F.2.14).
If the group of hedged items does not have any offsetting risk positions, the gains or losses on hedging instrument are presented in the financial statement line items affected by the hedged items. When there is more than a one line affected, the allocation of gains/losses on hedging instrument should be done on a systematic and rational basis. If the group of hedged items does have offsetting risk positions (e.g. net position of forecast sales and expenses), the gains or losses on hedging instrument are presented in a separate line item (IFRS 9.B6.6.13-16).
Disclosure requirements for hedge accounting are set out in paragraphs IFRS 7.21A-24G.
IFRS 9 Financial Instruments: Scope and Initial Recognition
IFRS 9 Financial Instruments: Classification of Financial Assets and Financial Liabilities
IFRS 9 Financial Instruments: Derivatives and Embedded Derivatives: Definitions and Characteristics
IFRS 9 Financial Instruments: Derecognition of Financial Assets and Financial Liabilities
Excerpts from IFRS Standards come from the Official Journal of the European Union (© European Union, information provided on this website does not constitute professional advice and should not be used as a substitute for consultation with a certified accountant.
Introduction to hedge accounting under IFRS 9
Risk management strategy and risk management objectives
Forward element and foreign currency basis spread of a forward contract
Overview of the criteria for designating a component of an item as hedged item
Relationship between components and the total cash flows of an item
Overview of the criteria for designating group of items as hedged item
Overview of the criteria for hedge accounting
Overview of IFRS 9 approach to hedge effectiveness
Overview of requirements for measurement of hedge ineffectiveness
Basis adjustment to debt instruments measured at amortised cost
Hedges of a net investment in a foreign operation
Overview of requirements relating to discontinuation of hedge accounting
Overview of hedging in the context of intragroup transactions
Hedged item and hedging instrument held by different group entities
Presentation of gains or losses on hedging instruments
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