International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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a cash flow hedge, as variability in cash flows with respect to foreign currency has
been reduced (or eliminated). The fact that variability in cash flows with respect to
interest rate risk remains, does not preclude hedge accounting for foreign currency
risk (see 2.2 above).
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3.3
Non-derivative financial instruments
Under IFRS 9, entities are permitted to designate, as hedging instruments, non-
derivative financial assets or non-derivative financial liabilities that are accounted for at
fair value through profit or loss. [IFRS 9.6.2.2]. This is meant in a strict sense. Consequently:
• A liability designated as at fair value through profit or loss (for which the amount
of its change in fair value that is attributable to changes in the credit risk of that
liability is presented in other comprehensive income (OCI)) does not qualify as a
hedging instrument. [IFRS 9.6.2.2]. This is because the entire fair value change is not
recognised in profit or loss, which would in effect allow the entity to ignore its own
credit risk when assessing and measuring hedge ineffectiveness and thus conflict
with the concepts of hedge accounting.
Example 49.32: Hedge of a forecast commodity purchase with an investment in a
commodity fund or an exchange traded commodity
An entity is exposed to variability in cash flows from highly probable forecast purchases of crude oil that are
indexed to Brent crude oil. The entity wants to hedge its cash flow risk from changes in the price of Brent
crude oil. Instead of using derivative contracts, the entity purchases exchange traded investments that replicate
the performance of Brent futures contracts such as commodity funds or exchange traded commodities (ETCs).
ETCs have the legal form of bonds that are coupled to the price development of a commodity (either directly
at the spot price or with a commodity futures contract). They can be traded like exchange traded funds but,
because they are legally debt securities, they involve credit risk of the issuer (which is usually mitigated by
collateralisation through physically deposited commodities or other suitable collateral).
These investments are financial instruments that (under IFRS 9) would be accounted for at fair value through
profit or loss. Consequently, they could qualify as hedging instruments if all other qualifying criteria for
hedge accounting are met. In particular, the effectiveness assessment would have to consider that the fair
value change of the investments will differ from the present value of the cumulative change in the cash flows
for the forecast purchases of crude oil. This is because of aspects such as ‘tracking errors’ (i.e. that the
investments do not perfectly replicate the performance of futures contracts) and that the investments are fully
funded cash-instruments whereas the cash flows on the forecast transactions will only occur in the future.
The ability to designate non-derivative hedging instruments can be helpful if an entity
does not have access to derivatives markets (e.g. because of local regulations that
prohibit the entity from holding such instruments), or if an entity does not want to be
subject to margining requirements nor enter into uncollateralised over-the-counter
derivatives. Purchasing and selling financial investments in such cases can be
operationally easier for entities than transacting derivatives.
For hedges other than of foreign exchange risk, when an entity designates a non-
derivative financial asset or liability measured at fair value through profit or loss as a
hedging instrument, it may only designate the non-derivative financial instrument in its
entirety or a proportion of it. [IFRS 9.B6.2.5].
3.3.1
Hedge of foreign currency risk by a non-derivative financial instrument
For a hedge of foreign currency risk, the foreign currency component of a non-derivative
financial asset or liability may be designated, as a hedging instrument. However, an equity
instrument for which an entity has elected to present changes in fair value in OCI does not
qualify as a hedging instrument in a hedge of foreign currency risk. [IFRS 9.6.2.2]. This reflects
that fair value changes (including from foreign currency risk) are not recognised in profit or
loss, which is incompatible with the mechanics of fair value hedges and cash flow hedges.
4026 Chapter 49
For hedges of foreign currency risk, the foreign currency risk component of a non-
derivative financial instrument is determined in accordance with IAS 21. [IFRS 9.B6.2.3].
This means that an entity could, for example, hedge the spot risk of highly probable
forecast sales in 12 months’ time that are denominated in a foreign currency with a 7-
year financial liability in the same foreign currency. However, when measuring
ineffectiveness, IFRS 9 is explicit that the revaluation of the forecast sales for foreign
currency risk would have to be on a discounted basis (i.e. a present value calculation of
the spot revaluation, reflecting the time between the reporting date and the future cash
flow date), whereas the hedging instrument (i.e. the IAS 21-based foreign currency
component of the financial liability) would not. This would result in some
ineffectiveness (see 7.4.5 below). [IFRS 9.B6.5.4].
The following two examples illustrate the types of permitted hedge relationships for foreign
currency risk where the hedging instrument is a non-derivative financial instrument.
Example 49.33: Hedging with a non-derivative liability
Company J, which has GBP as its functional currency, has issued a fixed rate debt instrument with a principal
due at maturity in two years of US$5 million. The debt is accounted for at amortised cost. J had also entered
into a fixed price sales commitment, accounted for as an executory contract, for US$5 million that matures
in two years as well.
J could not designate the debt instrument as a hedge of the exposure to all fair value changes of the fixed
price sales commitment because the hedging instrument is a non-derivative liability that is not measured at
fair value through profit or loss (and it would not be a good economic hedge anyway). However, J could
designate the fixed rate debt instrument as a hedge of the foreign currency exposure associated with the future
receipt of US dollars on the fixed price sales commitment.
Example 49.34: Hedge of foreign currency bond
Company J has also issued US$5 million five year fixed rate debt and owns a US$5 million five year fixed
rate bond, both measured at amortised cost.
J’s bond has exposure to changes in both foreign currency and interest rates, as does the liability. However,
the liability can only be designated as a hedge of the bond’s foreign currency, not interest rate, risk because
it is a non-derivative instrument.
In Example 49.34 above, hedge accounting is unnecessary because the amortised cost
of the hedging instrument and the hedged item are both remeasured using closing rates
with differences recognised in profit or loss as required by IAS 21.
In principle, there is no reason why a non-derivative financial instrument cannot be a
hedging instrument in one hedge (of foreign currency risk) and a hedged item in another
hedge (for example in a hedge of interest rate risk).
3.4
Own equity instruments
An entity’s own equity instruments are not financial assets or liabilities of the entity and
therefore cannot be designated as hedging instruments. [IFRS 9.B6.2.2].
This prohibition would also apply to instruments that give rise to non-controlling
interests in consolidated financial statements – under IFRS it is clear that non-
controlling interests are part of a reporting entity’s equity.
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3.5
Combinations of instruments
An entity may view in combination, and jointly designate as the hedging instrument, any
combination of the following (including those circumstances in which the risk or risks
arising from some hedging instruments offset those arising from others):
• derivatives (or a proportion of them); and
• non-derivatives (or a proportion of them). [IFRS 9.6.2.5].
Further discussion on designation of proportions is provided in 3.6 below. There is a
requirement that any combination can only be designated as a hedged item if the
combination is not a net written option (see 3.2.2 above).
Example 49.35: Hedging with a combination of a derivative and non-derivative
instrument
Entity J with the euro as its functional currency has issued a yen denominated floating rate borrowing and entered
into a matching receive-yen floating (plus principal at maturity), pay-US dollar floating (plus principal at
maturity) cross-currency interest rate swap. These instruments, which effectively synthesise a US dollar floating
rate borrowing, contain offsetting terms, i.e. the whole of the borrowing and the yen leg of the swap.
Entity J could designate the combination of these two instruments in a hedge of the entity’s foreign currency
risk arising from, say, an asset with an identifiable exposure to US dollar exchange rates.
Designation of a combination of instruments as the hedging instrument does not change
the unit of accounting for the instruments within the designated combination. The
incremental hedge accounting entries are applied (see 7 below) to the usual
classification and measurement requirements for the individual instruments included
within the combination.
3.6
Portions and proportions of hedging instruments
In contrast to the position for hedged items (see 2 above), there are significant
restrictions on what components of an individual financial instrument can be carved out
and designated as a hedging instrument. A qualifying instrument must be designated in
its entirety as a hedging instrument, with only the following exceptions:
• a proportion of a hedging instrument (see 3.6.1 below);
• the time value of options may be separated (see 3.6.4 below);
• forward elements of forwards may be separated (see 3.6.5 below);
• foreign currency basis spread may be separated (see 3.6.5 below);
• the spot rate retranslation risk of a foreign currency non-derivative financial
instrument may be separated (see 3.3.1 above); and
• a derivative may be separated into notional component parts when each part is
designated as a hedge and qualifies for hedge accounting (see 3.6.2 below).
The hedge accounting guidance is applied only to the designated portion or proportion of
the hedging instrument. However, should an entity choose to separate the time value of an
option, the forward element of a forward contract or the cross currency basis spread from
a hedge relationship, the costs of hedging guidance should also be applied (see 7.5 below).
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3.6.1 Proportions
of
instruments
It is possible to designate a proportion of the entire hedging instrument, such as 50% of
the notional amount, in a hedging relationship. [IFRS 9.6.2.4(c)]. The proportion that is not
designated is available for designation within other hedge relationships, such that a
maximum of 100% of the notional is designated as a hedging instrument. Any
proportions of an instrument not designated within hedge relationships are accounted
under the usual IFRS 9 classification and measurement guidance.
3.6.2 Notional
decomposition
A single hedging instrument may be designated as a hedging instrument of more than
one type of risk, provided that there is specific designation of:
• the hedging instrument; and
• the different risk positions.
Those hedged items can be in different hedging relationships. [IFRS 9.B6.2.6]. Designation
of a single derivative in more than one hedged relationship is discussed in more detail
at 3.7 below.
3.6.3
Restructuring of derivatives
An entity may exchange a derivative that does not qualify as a hedging instrument (say,
the knock-out swap in Example 49.30 above) for two separate derivatives that, together,
have the same fair value as the original instrument (say, a conventional interest rate
swap and a written swaption). Such an exchange is likely to be motivated by a desire to
obtain hedge accounting for one of these new instruments.
In order to determine whether the new arrangement can be treated as two separate
derivatives, rather than a continuation of the original derivative, we believe it is
necessary to determine whether the exchange transaction has any substance, which is
clearly a matter of judgement. If the exchange has no substance then hedge accounting
would still be precluded as the two ‘separate’ derivatives would in substance be a
continuation of the original derivative (see 3.2.1 above and Chapter 42 at 3.2).
In the case of the knock-out swap, if the two new contracts had the same counterparty
and, in aggregate, the same terms as the original contract this would not necessarily lead
to the conclusion that the exchange lacked substance. However if, in addition, the
swaption would be settled by delivery of the conventional interest rate swap in the event
that it was exercised, this is a strong indicator that the exchange does lack substance.
3.6.4
Time value of options
An entity may choose to hedge for risk management purposes the variability of future
cash flow outcomes resulting from a price increase (but not a decrease) of a forecast
commodity purchase. This hedge of a ‘one-sided risk’ could be achieved by transacting
a purchased option as the hedging instrument. In such a situation, it is permitted that
only cash flow losses in the hedged item that result from an increase in the price above
the specified level are designated within a hedge relationship. However, only the
intrinsic value of a purchased option hedging instrument, not its time value, reflects this
one-sided risk in the hedged item (assuming that it has the same principal terms as the
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designated risk). The hedged risk for a one-sided risk does not include the time value of
a purchased option, because the time value is not a component of the forecast
transactions that affects profit or loss (see 7.4.9 below). [IFRS 9.B6.3.12]. As a result changes
in the time value of the option would give rise to hedge ineffectiveness.
To address this problem, an entity is permitted to designate as the hedging instrument
only the change in the intrinsic value of an
option and not the change in its time value.
[IFRS 9.6.2.4(a)].
If it does so, the entity accounts for the time value of the option as a cost of hedging
(see 7.5 below). [IFRS 9.6.5.15].
Excluding the time value may make it administratively easier to process the hedges and
it can certainly improve a hedge’s effectiveness from an accounting perspective.
However, accounting for the option time value as a cost of hedging does involve some
complexity, in particular where the terms of the hedged item and hedging option are
what is described in the standard as not ‘closely aligned’ (see 7.5.1.A below).
The use of this exception is not mandatory. For example, a dynamic hedging strategy that
assesses both the intrinsic value and time value of an option contract can qualify for hedge
accounting (see 6.3.2 below), although the time value is still likely to result in some
ineffectiveness. In addition, an entity may use an option to hedge an exposure that itself
contains optionality – see 7.4.9 below for the challenges that arise with such a designation.
3.6.5
Forward element of a forward contract and foreign currency basis spread
IFRS 9 also permits (but does not require) an entity to separate the forward element and
the spot element of a forward contract and designate only the change in the value of the
spot element of a forward contract and not the forward element as the hedging
instrument. In addition, the foreign currency basis spread may be separated and
excluded from the designation of a financial instrument as the hedging instrument.
[IFRS 9.6.2.4(b)].
Where the forward element or foreign currency basis are excluded from the designation
as a hedging instrument, IFRS 9 permits a choice as to whether to account for the
excluded portion as a cost of hedging (see 7.5 below) or to continue measurement at fair
value through profit or loss. This is, however, not an accounting policy choice, but an
election for each designation. [IFRS 9.6.5.16].
3.6.6
Hedges of a portion of a time period
A hedging instrument may not be designated for a part of its change in fair value that
results from only a portion of the time period during which the hedging instrument
remains outstanding. This clarifies that an entity cannot designate a ‘partial-term’