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Criteria to achieve hedge accounting
Hedge accounting is an exception to the usual rules
for financial instruments. Therefore there are strict
criteria that must be met before it can be used.
Management must identify, document and test the
effectiveness of those transactions for which it
wishes to use hedge accounting. The specific requirements
are [IAS39R.88]:
| a) |
The hedged item and the hedging instrument are
specifically identified;
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| b) |
The hedging relationship is formally documented;
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| c) |
The documentation of the hedged relationship must
identify the hedged risk and how the effectiveness
of the hedge will be assessed;
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| d) |
At the inception of the hedge, the hedge must be
expected to be highly effective;
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| e) |
The effectiveness of the hedge must be tested regularly
throughout its life. Effectiveness must fall within
a range of 80 to 125% over the life of the hedge.
This leaves some scope for short-term ineffectiveness,
provided that overall effectiveness falls within
this range;
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| f) |
One to one designation is normally required between
a single external asset, liability or forecast transaction
and a single external derivative instrument; and
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| g) |
In the case of a hedge of a forecast transaction,
the forecast transaction must be 'highly probable'
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The criteria to achieve hedge accounting are onerous
and will have systems implications for all entities.
Hedge accounting is optional and management should
always consider the costs and benefits when deciding
whether to use it .
Hedged items
Hedge accounting can be applied to qualifying hedged
items. A hedged item must create an exposure to risk
that could affect the income statement, currently
or in future periods. The usual types of risks that
are hedged include foreign currency risk, interest-rate
risk, equity-price risk, commodity price risk and
credit risk. Portfolio hedging, that is, hedging the
open position arising from a number of similar hedged
items, is difficult to achieve [IAS39R.76] [IAS39R.83]
. Designating a net open position
as a hedged item is not permitted [IAS39R.84] [IAS39R.IG.F.2.21].
Any financial asset or liability that creates exposure
to risk can be a hedged item with two specific exclusions.
First, held-to-maturity investments cannot be hedged
items for interest-rate risk [IAS39R.79]. Second,
investments in subsidiaries or associates that are
consolidated or measured using the equity method
cannot be a hedged item in a fair value hedge [IAS39R.AG99].
However, the net investment in a foreign entity
can be hedged. Additionally, if the hedged item
is a financial asset or financial liability, it
may be a hedged item with respect to 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 of the fair
value) provided that effectiveness can be measured.
[IAS 39R.81].
Some examples of common hedged items are:
| a) |
foreign currency monetary item (risk of
changes in foreign exchange rate); |
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| b) |
fixed interest debt security classified
as available for sale (risk of changes in interest
rates or credit risk); |
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| c) |
highly probable forecast sale or purchase
in a foreign currency; and |
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| d) |
originated loans (risk of changes in interest
rates). |
An exposure to general business risks cannot be
hedged, including risk of obsolescence of plant
or risk of unseasonable weather, because these risks
cannot be reliably measured. For similar reasons,
a commitment to acquire another entity in a business
combination cannot be a hedged item, other than
for foreign exchange risk [IAS39R.AG98].
Large groups use treasury centres to manage and
hedge risks on a group-wide basis. Economically,
the treasury centre may seek to hedge the net principal
amount of all assets, liabilities and derivative
instruments denominated in a particular currency.
This might provide a reasonable economic hedge of
the group's exposure to that currency. But the net
position may not be designated as the hedged item
under IFRS. There are ways to achieve hedge accounting,
but they may require major systems changes [IAS39R.84]
[IAS39R.AG101] [IAS39R.AG111] [IAS39R.IG.F.6.1]
[IAS39R.IG.F.6.2] .
Hedging instruments
Only an external derivative instrument can be used
as a hedging instrument in most cases [IAS39R.73].
An external non-derivative financial instrument
can be used as a hedging instrument only for foreign
currency risk [IAS39R.72]. A foreign currency borrowing,
for example, could be designated as a hedge of the
currency risk of a net investment in a foreign entity.
Multinational groups with complex treasury operations
will often use intra-group derivatives to manage
currency and interest-rate risk across the group.
Intra-group derivatives are not external derivative
instruments, do not qualify as hedging instruments
and are eliminated on consolidation [IAS39R.73].
A group treasury centre might net all of the foreign
currency positions and enter into a single external
derivative transaction. This would qualify for hedge
accounting provided all the other criteria in the
standard are met [IAS39R.IG.F.1.6] .
Similarly, the net of internal positions relating
to interest-rate risk cannot be designated as the
hedged item [IAS39R.F.1.5]. If a net position is
hedged with a single external derivative instrument
the external derivative may be designated as hedging
a part of the underlying gross position, similar
in amount and timing to the net position [IAS39R.AG101] .
A single derivative with several elements, such
as a cross-currency interest-rate swap, can be designated
as a hedge of more than one type of risk (for example
interest rate and foreign currency risk) provided
the separate risks are clearly identifiable and
effectiveness can be measured [IAS39R.76] [IAS39R.IG.F.2.18]
.
Generally a hedging instrument is designated in
its entirety in a hedge relationship. The only exceptions
permitted are separating the intrinsic value and
time value of an option; and separating the interest
element and the spot price of a forward contract
[IAS39R.74] .
Hedge accounting models
There are three types of hedge accounting recognised
by IFRS, fair value hedges, cash flow hedges and
hedges of the net investment in a foreign operation
[IAS39R.86]. Each has specific requirements on accounting
for the fair value changes.
Fair value hedges
The risk being hedged in a fair value hedge is a
change in the fair value of an asset or liability
or unrecognised firm commitment that will affect
the income statement [IAS39R.86(a)]. Changes in
fair value might arise through changes in interest
rates (for fixed-rate loans), foreign exchange rates,
equity prices or commodity prices .
The impact on the income statement can be immediate
or expected to happen in future periods. A foreign
currency borrowing that is translated at the closing
rate would have immediate impact on the income statement.
An available-for-sale equity security, where gains
and losses are deferred in equity, would affect
the income statement when sold or impaired.
The hedged asset or liability is adjusted for fair
value changes attributable to the risk being hedged,
and those fair value changes are recognised in the
income statement [IAS39R.89(b)] . The hedging
instrument is measured at fair value with changes
in fair value also recognised in the income statement
[IAS39R.89(a)] . Examples of fair
value hedges might be equity securities classified
as available-for-sale denominated in a foreign currency
that are hedged with foreign currency forward contracts
; a fixed-rate
loan that is 'converted' to floating rates with
an interest-rate swap ; and a foreign currency receivable hedged
using a foreign currency option .
Fair value hedge accounting for a portfolio
hedge of interest rate risk
For banks, there is another type of fair value
hedge accounting that may be applied for a portfolio
hedge of interest rate risk. The requirements of
IAS 39R are met if the following procedures are
complied with:
| (a) |
As part of its risk management process the
bank identifies a portfolio of items whose interest
rate risk it wishes to hedge. The portfolio
may comprise only assets, only liabilities or
both assets and liabilities. |
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| (b) |
The bank analyses the portfolio into repricing
time periods based on expected, rather than
contractual, repricing dates. The analysis into
repricing time periods may be performed in various
ways including scheduling cash flows into the
periods in which they are expected to occur,
or scheduling notional principal amounts into
all periods until repricing is expected to occur. |
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| (c) |
On the basis of this analysis, the bank decides
the amount it wishes to hedge. The bank designates
as the hedged item an amount of assets or liabilities
(but not a net amount) from the identified portfolio
equal to the amount it wishes to designate as
being hedged. |
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| (d) |
The bank designates the interest rate risk
it is hedging. This risk could be a portion
of the interest rate risk in each of the items
in the hedged position, such as a benchmark
interest rate (e.g. LIBOR). |
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| (e) |
The bank designates one or more hedging instruments
for each repricing time period. |
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| (f) |
Using the designations made in (c)-(e) above,
the bank assesses at inception and in subsequent
periods, whether the hedge is expected to be
highly effective during the period for which
the hedge is designated. |
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| (g) |
Periodically, the bank measures the change
in the fair value of the hedged item (as designated
in (c)) that is attributable to the hedged risk
(as designated in (d)), on the basis of the
expected repricing dates determined in (b).
Provided that the hedge is determined actually
to have been highly effective when assessed
using the bank's documented method of assessing
effectiveness, the bank recognises the change
in fair value of the hedged item as a gain or
loss in profit or loss and in one of two line
items in the balance sheet as described in paragraph
89A of IAS 39R. The change in fair value need
not be allocated to individual assets or liabilities. |
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| (h) |
The bank measures the change in fair value
of the hedging instrument(s) (as designated
in (e)) and recognises it as a gain or loss
in profit or loss. The fair value of the hedging
instrument(s) is recognised as an asset or liability
in the balance sheet. |
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| (i) |
Any ineffectiveness will be recognised in
profit or loss as the difference between the
change in fair value referred to in (g) and
that referred to in (h) |
Cash flow hedges
The risk being hedged is the potential volatility
in future cash flows that will affect the income
statement. Future cash flows might relate to existing
assets and liabilities such as future interest payments
or receipts on floating rate debt. Future cash flows
can also relate to future transactions such as forecast
sales or purchases in a foreign currency [IAS39R.86]
or the foreign currency exposure in an unrecognised
firm commitment [IAS39R.87]. Potential volatility
in future cash flows might also result from changes
in interest rates, changes in exchange rates or
changes in commodity prices. Many fair value hedges
can also be designated as cash flow hedges, but
to qualify they must include an exposure to variability
in cash flows as a result of the item being hedged
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Changes in the fair value of the hedging instrument,
to the extent the hedge is effective, are deferred
in a 'hedging reserve' in equity [IAS39R.95(a)]
and recycled to the income statement when the hedged
transaction affects the income statement [IAS39R.100].
Fair value changes from cash flow hedges that relate
to highly probable forecast transactions and result
in the recognition of non-financial assets or liabilities
may be included in the initial measurement of those
assets or liabilities if the entity chooses this
option as its accounting policy [IAS39R.97-98].
Examples of common cash flow hedges are an interest-rate
swap converting a floating-rate loan to fixed-rate
and a forward foreign exchange
contract hedging forecast future revenue or a forecast
future purchase of equipment .
Hedge of net investment in a foreign operation
An entity may have subsidiaries that meet the tests
and qualify for treatment as foreign operations
of the parent. Exchange differences arising on consolidation
are deferred in equity until the subsidiary is disposed
of [IAS21R.32]. On disposal or liquidation they
are recognised in the income statement as part of
the gain or loss on disposal [IAS21R.48-49] . The net investment in a subsidiary including
any related goodwill can be hedged with a foreign
currency borrowing or a derivative .
The fair value changes of the hedging instrument,
if effective, are deferred in equity until the subsidiary
is disposed of, when they become part of the gain
or loss on disposal [IAS39R.102] .
The hedging instrument for a net investment hedge,
in order to be effective, will almost always be
denominated in the foreign operation's local currency
.
Hedge effectiveness
A hedge is regarded as highly effective only if
both of the following conditions are met:
| (a) |
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 and |
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| (b) |
The actual results of the hedge are within
a range of 80-125 per cent [IAS39R.AG105]. |
When a hedge fails the effectiveness test, hedge
accounting is discontinued prospectively
[IAS39R.91] [IAS39R.101].
Hedges are seldom, if ever, perfectly effective.
Any hedge ineffectiveness, even if the hedge continues
to be considered effective overall, must be recognised
in income in the current period. Hedge ineffectiveness
can arise for a number of reasons. For example,
the hedged item and the hedging instrument may:
a) Be in different currencies;
b) Have different maturities;
c) Use different underlying interest or equity indices;
d) Use commodity prices in different markets; or
e) Be subject to different counter-party risks.
Careful definition of the hedged risk and the components
of the hedging instrument are the best ways to improve
hedge effectiveness .
Discontinuing hedge accounting
Hedge accounting shall cease prospectively when
any of the following occurs [IAS39R.91] [IAS39R.101]:
a) A hedge fails the effectiveness tests;
b) The hedged item is settled;
c) The hedging instrument is sold, terminated or
exercised;
d) Management decides to revoke the designation;
or
e) For a cash flow hedge, the forecast transaction
is no longer highly probable.
Hedge accounting ceases prospectively from the
beginning of the period in which the hedge fails
the effectiveness test. All further fair value changes
in a derivative hedging instrument are recognised
in the income statement. Future changes in the fair
value of the hedged item, and any non-derivative
hedging instruments, are accounted for as they would
be without hedge accounting .
Gains or losses arising in the effective period
of a cash flow hedge will have been recognised in
equity. These gains remain in equity until the related
cash flows occur. Where a forecast transaction is
no longer highly probable but still expected to
take place, previous gains continue to be deferred.
However, once a forecast transaction is no longer
expected to occur, any gain or loss is released
immediately to the income statement [IAS39R.101].
Presentation and disclosure
The presentation and disclosure requirements for
financial instruments, including hedging, are extensive
and detailed. Some of the specific and significant
disclosures for hedging are [IAS32R.56-59]:
| a) |
a description of the entity's financial
risk management policies and objectives, including
its policy for hedging each major type of forecast
transaction; |
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| b) |
for each category of hedge (fair value,
cash flow and net investment):
- a description of the hedge;
- the hedging instruments used;
- the risks being hedged;
- the fair values of the hedging instruments
at the balance sheet date;
- the periods in which forecast transactions
are expected to occur and when they are expected
to impact on the income statement; and
- a description of any forecast transaction
which is no longer expected to occur but for
which hedge accounting had previously been used.
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| c) |
If gains or losses on hedging instruments
have been recognised in equity, the following
disclosures are required in the statement of
changes in equity:
- the amount that was recognised in equity in
the current period;
- the amount removed from equity and recognised
in the income statement in the current period;
and
- the amount removed from equity and included
in the initial carrying amount of assets or
liabilities in the current period.
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