Example 49.51:
Common proxy hedging designations ........................................... 4057
Example 49.52:
Hedge documentation ...................................................................... 4058
Example 49.53:
Economic relationship between HKD and USD ......................... 4064
Example 49.54:
Designating interest rate hedges of loan assets when credit
risk is expected .................................................................................. 4068
Example 49.55:
Setting the hedge ratio ...................................................................... 4069
Example 49.56:
Deliberate under-hedging in a cash flow hedge to avoid
recognition of ineffectiveness ......................................................... 4069
Example 49.57:
Deliberate under-hedging in a fair value hedge to create
fair value accounting ......................................................................... 4070
Financial instruments: Hedge accounting 3971
Example 49.58:
Fair value hedge ................................................................................. 4072
Example 49.59:
Hedge of a firm commitment to acquire equipment .................. 4074
Example 49.60:
Cash flow hedge of anticipated commodity sale ........................ 4076
Example 49.61:
Cash flow hedge of a floating rate liability .................................... 4077
Example 49.62:
Hedge of a firm commitment to acquire equipment .................. 4078
Example 49.63:
Identification of the effective portion in a net investment
hedge (1) ............................................................................................... 4082
Example 49.64:
Identification of the effective portion in a net investment
hedge (2) .............................................................................................. 4082
Example 49.65:
Impact of time value of money when measuring
ineffectiveness .................................................................................... 4088
Example 49.66:
Calculation of ineffectiveness ......................................................... 4089
Example 49.67:
Impact on ineffectiveness of changes in credit risk in the
hedged item when the hedged risk is a benchmark
component .......................................................................................... 4090
Example 49.68:
Measuring effectiveness for a hedge of a forecast
transaction in a debt instrument ..................................................... 4093
Example 49.69:
Cash flow hedge of firm commitment to purchase
inventory in a foreign currency ...................................................... 4099
Example 49.70:
Out of the money put option used to hedge forecast sales
of commodity ..................................................................................... 4106
Example 49.71:
Amortisation of time value of an option hedging a time
related hedged item ............................................................................ 4110
Example 49.72:
Hedging the purchase of equipment (transaction related) ......... 4110
Example 49.73:
Hedging interest rate risk of a bond (time period
related) (1) ............................................................................................. 4110
Example 49.74:
Hedging interest rate risk of a bond (time period
related) (2) ............................................................................................ 4112
Example 49.75:
Funding swaps – designating the spot risk only ........................... 4114
Example 49.76:
Calculation of the value of foreign currency basis spread .......... 4117
Example 49.77:
Hedge of a foreign exchange risk in rollover cash flow
hedging strategy .................................................................................. 4121
Example 49.78:
Rebalancing .......................................................................................... 4124
Example 49.79:
Rebalancing the hedge ratio by decreasing the volume of
the hedging instrument ...................................................................... 4127
Example 49.80:
Rebalancing the hedge ratio by decreasing the volume of
hedged item ......................................................................................... 4128
Example 49.81:
Partial discontinuation as a result of a change in risk
management objective ....................................................................... 4130
Example 49.82:
Partial discontinuation of an interest margin hedge .................... 4131
Example 49.83:
Change in risk management objective for an open
portfolio of debt instruments ........................................................... 4133
Example 49.84:
Disposal of foreign operation ........................................................... 4138
3972 Chapter 49
Example 49.85:
Illustrative disclosure of risk management strategy for
commodity price risk ......................................................................... 4143
Example 49.86:
Illustrative disclosure of timing, nominal amount and
average price of coffee futures contracts ...................................... 4144
Example 49.87:
Illustrative disclosure of the effects of hedge accounting
on the financial position and performance ................................... 4145
Example 49.88:
Processing and brokerage of soybeans and sunflowers .............. 4152
Example 49.89:
Retrospective application of accounting for time value of
option .................................................................................................... 4155
3973
Chapter 49
Financial instruments:
Hedge accounting
1 INTRODUCTION
1.1 Background
Chapter 40 provides a general background to the development of accounting for
financial instruments and notes the fundamental changes that have been experienced in
international financial markets. The markets for derivatives, especially, have seen
remarkable and continued growth over the past two to three decades. This reflects the
increasing use of such instruments by businesses, commonly to ‘hedge’ their financial
risks. Accordingly, the accounting treatment for derivatives and hedging activities has
taken on a high degree of importance.
‘Hedging’ itself is a much wider topic than hedge accounting and is not the primary
subject of this chapter. It is an imprecise term although standard setters frequently
describe hedging in terms of designating a hedging instrument that has a value that is
expected, wholly or partly, to offset changes in the value or cash flows of a ‘hedged
position’.1 In this context, hedged positions normally include those arising from
recognised assets and liabilities, contractual
commitments and expected, but
uncontracted, future transactions. Whilst this may be an appropriate description for
many hedges, it does not necessarily capture the essence of all risk management
activities involving financial instruments. Nevertheless, it forms the basis for the hedge
accounting requirements under IFRS.
1.2
What is hedge accounting?
Every entity is exposed to business risks from its daily operations. Many of those risks
have an impact on the cash flows or the value of assets and liabilities, and therefore,
ultimately affect profit or loss. In order to manage these risk exposures, companies often
enter into derivative contracts (or, less commonly, other financial instruments) to hedge
them. Hedging can therefore be seen as a risk management activity in order to change
an entity’s risk profile.
3974 Chapter 49
Applying the default IFRS accounting requirements to those risk management activities can
result in accounting mismatches, when the gains or losses on a hedging instrument are not
recognised in the same period(s) and/or in the same place in the financial statements as gains
or losses on the hedged exposure. Many believe that the resulting accounting mismatches
are not a good representation of those risk management activities. Hedge accounting is often
seen as ‘correcting’ deficiencies in the accounting requirements that would otherwise apply
to each leg of the hedge relationship. These deficiencies are an inevitable consequence of
using a mixed-measurement model of accounting. Typically, hedge accounting involves
recognising gains and losses on a hedging instrument in the same period(s) and/or in the
same place in the financial statements as gains or losses on the hedged position. It may be
used in a number of situations, for example to adjust (or correct) for:
• Measurement differences
These might arise where the hedge is of a recognised asset or liability that is
measured on a different basis to the hedging instrument. An example might be
inventory that is recorded in the financial statements at cost, but whose value is
hedged by a forward contract that enables inventory of the same nature to be sold
at a predetermined price. In this case, both the hedging instrument and the hedged
position exist and are recognised in the financial statements, but they are likely to
be measured on different bases.
Avoiding the measurement difference could in this situation theoretically be achieved
in a number of ways. One alternative would be not to recognise unrealised gains or
losses on the forward contract, and realised gains or losses could be deferred (e.g.
separately as assets or liabilities or by including them within the carrying amount of
the inventory) until the inventory is sold. On the other hand, if unrealised gains or
losses on the forward contract were recognised in profit or loss, the measurement basis
of the inventory could be changed to reflect changes in its fair value in profit or loss.
• Performance reporting differences
Even if the measurement bases of the hedging instrument and hedged item are the
same, performance reporting differences might arise if gains and losses are
reported in a different place in the financial statements. An example might be
where an investment in shares is classified as fair value through other
comprehensive income (FVOCI) (see Chapter 44 at 8) and whose value is hedged
by a put option. The investment and the put option are both measured at fair value.
However, gains or losses on the investment are recognised in other comprehensive
income whilst those on the put option are recognised in profit or loss, therefore
resulting in a mismatch in the income statement (or statement of comprehensive
income). Similarly, gains or losses on retranslating the net assets of a foreign
operation are recorded in other comprehensive income whilst retranslation gains
or losses on a foreign currency borrowing used to hedge that net investment are,
absent any form of hedge accounting, recorded in profit or loss.
In the case of the FVOCI investment and the put option, hedge accounting might
involve reporting gains and losses on the investment in profit or loss, or gains and
losses on the put option in other comprehensive income. For the foreign operation,
hedge accounting normally involves reporting the retranslation gains and losses on
both the borrowing and the foreign operation in other comprehensive income.
Financial instruments: Hedge accounting 3975
• Recognition differences
These might arise where the hedge is of contractual rights or obligations that are
not recognised in the financial statements. An example is a foreign currency
denominated operating lease held by the lessor, where the unrecognised future
contractual lease rentals to be received in another currency are hedged by a series
of forward currency contracts (i.e. each receipt is effectively ‘fixed’ in functional
currency terms).
In this case, one solution might be to treat the lease as a ‘synthetic’ functional
currency denominated lease. A similar outcome would be obtained if unrealised
gains and losses on each forward contract remained unrecognised until the accrual
of the lease receivables it was hedging.
• Existence differences
These might arise where the hedge is of cash flows arising from an uncontracted
future transaction, i.e. a transaction that does not yet exist. An example is a foreign
currency denominated sale expected next year that is hedged by a forward
currency contract.
Again, a solution to this issue might involve treating the future sale as a ‘synthetic’
functional currency sale or it might involve deferring the gain or loss on the
forward contract until the sale is recognised in profit or loss.
1.3
Development of hedge accounting standards
The first comprehensive hedge accounting requirements issued by the IASB were
contained in IAS 39 – Financial Instruments: Recognition and Measurement. Hedge
accounting under IAS 39 was often criticised as being complex and rules-based, and
thus, ultimately not reflecting an entity’s risk management activities. This was unhelpful
for preparers and users of the financial statements alike. The IASB took this concern as
the starting point of its project for a new hedge accounting model. Consequently, the
objective of IFRS 9 – Financial Instruments – is to reflect the effect of an entity’s risk
management activities in the financial statements. [IFRS 9.6.1.1].
In addition, the financial crisis resulted in a significant amount of political pressure being
brought to bear on standard setters in general and the IASB specifically. Responding to
this pressure, in April 2009 the IASB announced a detailed six-month timetable for
publishing a proposal to replace IAS 39.2 In order to expedite the replacement of IAS 39,
the IASB divided the project into three phases: classification and measurement;
amortised cost and impairment of financial assets; and hedge accounting.
In December 2010, the IASB issued the Exposure Draft (‘ED’ or the exposure draft)
Hedge Accounting, being the proposals for the third part of IFRS 9. After redeliberating
the
proposals in 2011, in September 2012 the Board published a draft of Chapter 6 –
Hedge Accounting – of IFRS 9, together with consequential changes to other parts of
IFRS 9 and other IFRSs (the draft standard). The idea of the draft standard was to enable
constituents to familiarise themselves with the new requirements.3
Although the IASB did not ask for comments, a number of constituents asked the IASB
to clarify certain elements of the draft standard. As a result, the IASB redeliberated some
3976 Chapter 49
elements of the IFRS 9 hedge accounting requirements in its January 2013 and
April 2013 meetings.
This resulted in the third version of IFRS 9, issued in November 2013, which included
the new hedge accounting requirements. Finally, in July 2014 the IASB issued the all-
encompassing final version of IFRS 9 that includes the new impairment requirements
(see Chapter 47) and some amendments to the classification and measurement
requirements (see Chapter 44). This also involved some minor consequential
amendments to the hedge accounting requirements in IFRS 9, mainly because of the
introduction of a new category for debt instruments measured at fair value through
other comprehensive income with subsequent reclassification adjustments.
IFRS 9 does not provide any particular solutions for so-called ‘macro hedge’ accounting,
the term used to describe the more complex risk management practices used by entities
such as banks to manage risk in dynamic portfolios. In May 2012 the Board decided to
decouple accounting for macro hedging from IFRS 9, and a separate project was set up
to develop an accounting solution for dynamic risk management – the project name
adopted by the IASB for an accounting solution for macro hedging. Work is still ongoing
for the Dynamic Risk Management project. A discussion paper – Accounting for
Dynamic Risk Management: a Portfolio Revaluation Approach to Macro Hedging – was
published in April 2014. No consensus was reached as a result of the discussion paper
and so a second discussion paper is now expected in the first half of 2019. See 11.1 below
for more details.
IFRS 9 is effective for periods beginning on or after 1 January 2018 and replaces
substantially all of IAS 39, including the hedge accounting requirements. However,
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 786
