IFRS 9 Hedge Accounting APPLIES to all hedge relationships, with the EXCEPTION of fair value hedges of the interest rate exposure of a portfolio of financial assets or financial liabilities.
There are various effective hedging strategies under to REDUCE ‘Market Risk’, depending on the asset or portfolio of assets being hedged. Three popular ones are Portfolio construction, Options, and Volatility indicators.
Table of Contents
IFRS 9 Hedge Accounting – Key Definitions
1. Hedging
Hedging being the process of entering into a transaction in order to reduce risk. Companies use derivatives to ESTABLISH positions so that ‘gains or losses from holding the position in derivatives’ will offset losses or gains on the related item that is being hedged.
2. Hedge Accounting
IFRS 9 provides SPECIAL rules that allow the Matching of the gain or loss on the derivatives position with the loss or gain on the hedged item.
This reduces the volatility in the ‘Statement of Financial Position‘ and the ‘Statement of Profit or Loss‘.
[It is Optional, NOT Obligatory.]
Under IFRS 9 rules can only be applied if the hedging relationship meets the following criteria:
| (a) Hedging relationship includes: – Eligible Hedged Item(s); AND – Eligible Hedging Instrument(s) |
| (b) At inception of the hedge there should be a formal designation and documentation identifying; – Risk Management Objective and Strategy – Eligible Hedged Item – Eligible Hedging Instrument – Nature of the Risk being Hedged – How Hedge Effectiveness will be Assessed |
| (c) Hedging relationship should Meet ‘hedge effectiveness requirement‘. |
3. Eligible Hedge Item
| A hedged item is: |
|---|
| Asset; |
| Liability; |
| Firm Commitment; |
| Highly Probable Forecast Transaction; OR |
| Net Investment in a Foreign Operation exposes the entity to the risk of changes in fair value or future cash flows and is designated as being hedged. |
4. Eligible Hedge Instrument
It is a designated derivative or a designated non-derivative financial asset or designated non-derivative financial liability Measured at FVPL whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item.
5. Hedge Effectiveness Criteria
An ‘Entity’ should assess at inception and at each reporting date whether the hedge meets all of the following hedge effectiveness criteria:
- Economic Relationship – There must be an ‘Economic Relationship’ between the hedged item and & the hedging instrument meaning that the hedging instrument and the hedged item must be expected to have offsetting changes in fair value.
- Credit Risk – The effect of credit risk does not dominate the change in value from that economic relationship i.e. the fair value changes due to ‘Credit Risk’ should not be a significant driver of the changes in fair value of either the hedging instrument or the hedged item.
- Hedge Ratio – ‘Hedge Ratio’ is the same for BOTH the:
| Hedging relationship. |
| Quantity of the hedged item actually hedged, and the quantity of the hedging instrument used to hedge it. |
[‘Hedge Effectiveness’ relates to expectations and therefore the assessment of effectiveness must be forward-looking i.e. Prospective.]
IFRS 9 Hedge Accounting – Types
Where the conditions for using ‘Hedge Accounting’ are fulfilled, the method to be used depends on the type of hedge.
There are THREE types of hedging relationships:
(a) Fair Value Hedge;
(b) Cash Flow Hedge; AND
(c) Hedge of a Net Investment in a Foreign Entity (accounted for as a ‘Cash Flow Hedge’).
Fair Value Hedge
It is ‘a hedge of the exposure to changes in the fair value of a recognized asset or liability or firm commitment’ attributable to a risk that could affect P&L.
1. Practical Example
For Instance, oil held in inventory could be hedged with an ‘oil forward contract‘ to hedge the exposure to a risk of a fall in oil sales prices or the risk of a change in the fair value of a fixed-rate debt owed by a company could be hedged using an interest rate swap.
2. Accounting (As Per IFRS 9)
| At the reporting date, the ‘Hedging Instrument’ and the ‘Hedged Item’ will be Measured at fair value. |
| Gain/loss on hedge instrument and Loss/gain on hedge item will be recorded in: – P&L in most cases, but – OCI if the hedged item is an investment in equity at FVOCI. |
Cash Flow Hedge
It is ‘a hedge of the exposure to variability in cash flows’ that is attributable to a particular risk associated with a recognized asset or liability or a highly probable forecast transaction.
1. Practical Example
For Instance, floating-rate debt issued by a company might be hedged using an ‘interest rate swap’ to manage increases in interest rates or future US dollar sales of airline seats by a Pakistani company might be hedged by a US$/Rs. forward contracts to protect against changes in exchange rates.
2. Accounting (As Per IFRS 9)
| At the reporting date, the hedge instrument will be Re-Measured to fair value. |
| ‘Effective Portion‘ of Gain/loss on hedge instrument is recognized in OCI (Cash flow Hedge Reserve). [Effective portion is the Gain/loss on the hedge instrument to the EXTENT of Loss/gain on the hedged item.] |
| ‘Ineffective Portion‘ of Gain/loss on the hedge instrument is recognized in P&L. [Effective portion is the Gain/loss on the hedge instrument in EXCESS of Loss/gain on the hedged item.] |
| Gain/loss on hedging instrument recognized in OCI will be reclassified to P&L when the hedged transaction affects P&L. However, in the case of forecast transactions that result in a non-financial asset/liability, ‘Cash flow Hedge Reserve’ is removed and included in the initial cost of the non-financial asset/liability. |
| If hedge accounting ceases for a Cash flow hedge because the forecast transaction is no longer expected to occur Gain/loss deferred in OCI must be taken to P&L immediately. |
| If the transaction is still expected to occur but the hedge relationship ceases, amounts accumulated in equity will be retained in equity until the hedged transaction occurs. |
3. Discontinuation of Hedge Accounting
[It is accounted for prospectively.]
| ‘Hedge Accounting’ should be discontinued if: – Hedging relationship no longer meets the qualifying criteria; AND – Hedging instrument is expired, sold, terminated, or exercised. |
Synopsis
IFRS 9 Hedge Accounting a Concept allowing entities to better reflect the economic substance of their hedging relationships. It INCLUDES criteria for ‘Hedge Effectiveness’ and permits the use of various hedging instruments. IFRS 9 also introduced the concept of ‘Qualifying Criteria’, providing entities with more flexibility in applying hedge accounting principles.
Chartered Accountant – ICAP
Bachelor of Accounting (Honours) – AeU, Malaysia