International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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component of a financial instrument as the hedging instrument, but only the entire
instrument for its remaining life (notwithstanding that an entity may exclude from
designation the time value of an option, the forward element of a forward contract or
the foreign currency basis spread, see 3.6.4 and 3.6.5 above). [IFRS 9.6.2.4]. This does not
mean that the hedge relationship must necessarily continue for the entire remaining
life of the hedging instrument – the usual hedge discontinuation requirements apply
(see 8.3 below).
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Example 49.36: Designation of hedging instrument with longer life than hedged item
Entity T has an interest rate swap with a remaining maturity of five years and 6 months. Entity T wishes to
designate the swap as the hedging instrument with respect to interest rate risk in issued debt that matures in
five years
It would not be possible for Entity T to designate only payments and receipts from the swap that occur over
the next five years (i.e. ignoring those after year five) as the hedging instrument. Instead, the whole derivative
(i.e. including payments and receipts after year five) could be designated as the hedging instrument, although
the hedging relationship may itself last for only five years.
However, hedge accounting can only be applied if the hedge effectiveness criteria are met (see 6.4 below),
which may not necessarily be immediately obvious from a qualitative assessment if there are significant
mismatches in maturity between the hedged item and the hedging instrument.
3.7
Hedging different risks with one instrument
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 as the hedged items.
Those hedged items can be in different hedging relationships. [IFRS 9.B6.2.6].
A common example where a single hedging derivative is used to hedge more than one
risk is the use of a foreign currency forward to eliminate the resulting foreign currency
risk from payables and receivables in two different foreign currencies, see
Example 49.37 below, which is based on an example given in IAS 39. [IAS 39.F1.13].
Example 49.37: Foreign currency forward hedging position arising from two
hedged items with different foreign currencies
Company J, which has Japanese yen as its functional currency, issues five year floating rate US dollar debt
and acquires a ten year fixed rate sterling bond. The principal amounts of the asset and liability, when
converted into Japanese yen, are the same. J enters into a single foreign currency forward contract to hedge
its foreign currency exposure on both instruments under which it receives US dollars and pays sterling at the
end of five years.
Company J designates the foreign currency forward as the hedging instrument in a cash flow hedge of foreign
currency risk of both the sterling bond and the US dollar debt.
Designating a single hedging instrument as a hedge of multiple types of risk is permitted if there is specific
designation of the hedging instrument and the different risk positions.
Company J has Japanese yen as its functional currency, hence it is exposed to JPY/GBP and USD/JPY foreign
currency risk from the sterling bond and the US dollar debt respectively. Separation of these different risk
positions can be achieved by documentation of the principal repayment of the bond and debt in their
respective currency of denomination as the hedged items in the separate cash flow hedge relationships.
In order to achieve specific designation of the hedging instrument, it is effectively decomposed and viewed
as two forward contracts, each with an offsetting position in yen, i.e. J’s functional currency. Each of the
decomposed forward contracts is then designated in an eligible hedge accounting relationship.
Even though the bond has a ten year life and the foreign currency forward only protects it for the first five
years, hedge accounting is permitted for only a portion of the exposure (see 3.6.6 above).
Accordingly hedge accounting may be achieved, but only if all the hedge accounting qualification criteria
continue to be met (see 6 below).
In the above example a single hedging instrument is designated in a hedge of foreign
currency risk arising from two separate hedged items. The hedges in the example could
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both be designated as either cash flow fair value hedges (see 5.1.2 and 5.2.3 below).
However, there is no reason why a single hedging instrument may not be designated in
both a cash flow hedge and a fair value hedge for different risks, provided the usual
conditions for achieving hedge accounting are met.
Example 49.38: Cross-currency interest rate swap hedging two foreign currency
exchange rate exposures and fair value interest rate exposure
Applying the same fact pattern as Example 49.37 above, but in this case Company J wishes to hedge the
foreign currency exposure on both the bond and the debt as well as the fair value interest rate exposure on the
bond. To do this it enters into a matching cross-currency interest rate swap to receive floating rate US dollars,
pay fixed rate sterling and exchange the US dollars for sterling at the end of five years.
Similar to Example 49.37 above, the cross-currency interest rate swap is effectively decomposed and viewed
as two cross-currency swaps, each with an offsetting leg in yen, i.e. J’s functional currency, as follows:
• Decomposed swap 1: receive floating rate yen, pay fixed rate sterling and exchange the sterling for yen
at the end of five years; and
• Decomposed swap 2: receive floating rate US dollars, pay floating rate yen and exchange the US dollars
for yen at the end of five years.
Therefore, the swap may be designated as a hedging instrument in separate hedges of the sterling bond and
the US dollar liability as follows:
• Decomposed swap 1 designated as the hedging instrument against exposure to changes in fair value of
the sterling bond associated with the interest rate payments on the bond until year five and the change in
value of the principal payment due at maturity to the extent affected by changes in the yield curve relating
to the five years of the swap (see Example 49.5 at 2.2.4 above) as well as the exchange rate between
sterling and yen.
• Decomposed swap 2 designated as the hedging instrument against changes in all cash flows on the US
dollar liability associated with forward USD/JPY foreign currency risk.
Accordingly hedge accounting may be achieved, but only if all the hedge accounting qualification criteria
continue to be met (see 6 below).
As can be seen in Examples 49.37 and 49.38 above, decomposition of a derivative
hedging instrument by imputing notional legs is an acceptable means of splitting the fair
value of a derivative hedging instrument into multiple components in order to achieve
hedge accounting, as long as:
• the split does not result in the recognition of cash flows that do not exist in the
contractual terms of the derivative instrument;
• the notional legs introduced must be offsetting; and
• all decomposed elements of the derivative instrument are included within an
el
igible hedge relationship.
The IFRS Interpretations Committee previously confirmed that it considered such an
approach to be acceptable under IAS 39 and there is no reason to believe that this
would not also be the case under IFRS 9.5 Consideration of the hedge accounting
qualifying criteria for all relationships that include decomposed elements of a
derivative instrument should be captured in the hedge documentation on designation,
as normal.
The qualifying criteria assessment may be carried out for the total hedged position,
i.e. incorporating all risks identified if these risks are inextricably linked, or for the
decomposed parts separately, i.e. individually for each hedge relationship that
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includes a decomposed part of the derivative. However, if the assessment is
undertaken separately, each hedge relationship that includes a decomposed part
would need to meet the qualifying criteria. Otherwise the derivative would not qualify
for hedge accounting as part of it would not be included within an eligible hedge
relationship. This restriction is necessary as a financial instrument can only be
designated as a hedging instrument in its entirety (see 3.6 above). For example, the
‘knock-out swap’ in Example 49.30 above could not be split into, on the one hand, a
conventional interest rate swap, to be used as a hedging instrument and, on the other
hand, the knock-out feature (a written swaption, i.e. an option for the counterparty to
enter into an offsetting interest rate swap with the same terms as the conventional
swap). This is because the knock out feature is unlikely to be designated and qualify
for hedge accounting at all.
If a similar interpretation was applied to a basis swap as a hedge of appropriate asset
and liability positions, hedge accounting may also be possible. For example, an entity
may have made a $1m loan that earns LIBOR based interest and incurred a $1m liability
that pays interest based on the central bank rate. In this case it may use as a hedging
instrument a basis swap under which it pays LIBOR based interest and receives interest
based on the central bank rate on a notional amount of $1m. In this case, the basis swap
could be decomposed into two interest rate swaps, both with an offsetting $1m fixed
rate leg, to facilitate hedge designations for each of the LIBOR loan and central bank
deposit within separate cash flow hedges.
The guidance above discussed various combinations of cash flow and fair value hedge
relationships. However, there appears to be no reason why a single instrument could
not, in theory, be designated in other combinations of hedges, for example a cash flow
hedge and a hedge of a net investment.
4
INTERNAL HEDGES AND OTHER GROUP ACCOUNTING
ISSUES
One of the most pervasive impacts that hedge accounting can have on groups, especially
those operating centralised treasury functions, is the need to reassess hedging strategies
that involve intra-group transactions. To a layman this might come as something of a
surprise because the standard does little more than reinforce the general principle that
transactions between different entities within a group should be eliminated in the
consolidated financial statements of that group. Nevertheless, where risk is centrally
managed the requirement to identify eligible hedged items and hedging instruments
with counterparties that are external to the reporting group, and to ensure the qualifying
criteria are met, can be a challenge.
IAS 39 included a significant volume of implementation guidance devoted to the subject
of internal hedges. The requirements in IFRS 9 for hedged items and hedging
instruments to be with a party external to the reporting group (and the associated
exemptions to this rule) are unchanged from the requirements in IAS 39. Therefore,
much of the IAS 39 guidance is still relevant under IFRS 9, and is frequently referred to
within this section.
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4.1
Internal hedging instruments
The starting point for this guidance is the principle of preparing consolidated financial
statements in IFRS 10 – Consolidated Financial Statements – that requires ‘intragroup
assets and liabilities, equity, income, expenses and cash flows to be eliminated in full’.
[IFRS 10.B86].
Although individual entities within a consolidated group (or divisions within a single
legal entity) may enter into hedging transactions with other entities within the group (or
divisions within the entity), such as internal derivative contracts to transfer risk
exposures between different companies (or divisions), any such intragroup (or intra-
entity) transactions are eliminated on consolidation. Therefore, such hedging
transactions do not qualify for hedge accounting in the consolidated financial statements
of the group, [IFRS 9.6.3.5, IAS 39.F.1.4], (or in the individual or separate financial statements
of an entity for hedging transactions between divisions of the entity). Effectively, this is
because they do not exist in an accounting sense.
Accordingly, IFRS 9 is very clear that for hedge accounting purposes only instruments that
involve a party external to the reporting entity (i.e. external to the group or individual
entity that is being reported on) can be designated as hedging instruments. [IFRS 9.6.2.3].
The implementation guidance of IAS 39 explains that the standard does not specify how
an entity should manage its risk. Accordingly, where an internal contract is offset with
an external contract, the external contract may be regarded as the hedging instrument.
In such cases, the hedging relationship (which is between the external transaction and
the item that is the subject of the internal hedge) may qualify for hedge accounting, as
long as such a representation is directionally consistent with the actual risk management
activities. Where the hedge designation does not exactly mirror an entity’s risk
management activities it is commonly referred to as ‘proxy hedging’. The eligibly of
proxy hedging designations was discussed by the IASB in their deliberations in
developing IFRS 9 (see 6.2.1 below).
The following example illustrates the proposed approach.
Example 49.39: Internal derivatives
The banking division of Bank A enters into an internal interest rate swap with A’s trading division. The
purpose is to hedge the interest rate risk exposure of a loan (or group of similar loans) in the banking division’s
loan portfolio. Under the swap, the banking division pays fixed interest payments to the trading division and
receives variable interest rate payments in return.
Assuming a hedging instrument is not acquired from an external party, hedge accounting treatment for the
hedging transaction undertaken by the banking and trading divisions is not allowed, because only derivatives
that involve a party external to the entity can be designated as hedging instruments. Further, any gains or
losses on intragroup or intra-entity transactions should be eliminated on consolidation. Therefore, transactions
between different divisions within A cannot qualify for hedge accounting treatment in Bank A’s financial
statements. Similarly, transactions between dif
ferent entities within a group cannot qualify for hedge
accounting treatment in A’s consolidated financial statements.
However, if, in addition to the internal swap in the above example, the trading division entered into an interest rate
swap or other contract with an external party that offset the exposure hedged in the internal swap, hedge accounting
would be permitted. For the purposes of hedge accounting, the hedged item is the loan (or group of similar loans)
in the banking division and the hedging instrument is the external interest rate swap or other contract.
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The trading division may aggregate several internal swaps or portions of them that are not offsetting each
other (see 4.2 below) and enter into a single third party derivative contract that offsets the aggregate exposure.
Such external hedging transactions may qualify for hedge accounting treatment provided that the hedged
items in the banking division are identified and the other conditions for hedge accounting are met.
[IAS 39.F.1.4].
It follows that internal hedges may qualify for hedge accounting in the individual or
separate financial statements of individual entities within the group, provided they are
external to the individual entity that is being reported on. [IFRS 9.6.2.3].
The IAS 39 implementation guidance contains the following summary of the application
of IAS 39 to internal hedging transactions:
• IAS 39 does not preclude an entity from using internal derivative contracts for risk
management purposes and it does not preclude internal derivatives from being
accumulated at the treasury level or some other central location so that risk can be
managed on an entity-wide basis or at some higher level than the separate legal
entity or division.
• Internal derivative contracts between two separate entities within a consolidated
group can qualify for hedge accounting by those entities in their individual or
separate financial statements, even though the internal contracts are not offset by
derivative contracts with a party external to the consolidated group.
• Internal derivative contracts between two separate divisions within the same legal
entity can qualify for hedge accounting in the individual or separate financial