statements of that legal entity only if those contracts are offset by derivative
contracts with a party external to the legal entity.
• Internal derivative contracts between separate divisions within the same legal
entity and between separate legal entities within the consolidated group can
qualify for hedge accounting in the legal entity or consolidated financial statements
only if the internal contracts are offset by derivative contracts with a party external
to the legal entity or consolidated group.
• If the internal derivative contracts are not offset by derivative contracts with
external parties, the use of hedge accounting by group entities and divisions using
internal contracts must be reversed on consolidation. [IAS 39.F.1.4].
The premise on which the restriction on internal hedging instruments is based does not
always hold. Foreign currency intragroup balances may well give rise to gains and losses
in profit or loss under IAS 21 that are not fully eliminated on consolidation. To address
this, such intra-group monetary items, as well as forecast intragroup transactions, may
qualify as a hedged item in the consolidated financial statements if the other conditions
for hedge accounting are met (see 4.3.2 below).
However, although internal transactions are sometimes permitted to be hedged items,
even those internal transactions that affect consolidated profit or loss cannot be used in
consolidated financial statements as hedging instruments. This is somewhat surprising as
one might consider the same arguments that led to the exception permitting intragroup
monetary items and forecast intragroup transactions to be hedged items to support
allowing intragroup monetary items to be hedging instruments. However, during its
Financial instruments: Hedge accounting 4035
deliberations of the hedge accounting model under IFRS 9 the IASB decided to retain this
restriction, and so the guidance is equally relevant in applying IFRS 9. [IFRS 9.BC6.142-147].
IFRS 8 – Operating Segments – requires disclosure of segment information that is
reported to the chief operating decision maker even if this is on a non-GAAP basis (see
Chapter 32 at 3.1). Consequently, for a hedge to qualify for hedge accounting in segment
reporting, it is not always necessary for the hedging instrument to involve a party
external to the segment.
4.1.1
Central clearing parties and ring fencing of banks
Following the introduction of legal or regulatory requirements requiring over-the-
counter (OTC) derivatives to be novated to a central clearing party (CCP) or
incentivising financial institutions to do so (see 8.3.2.A below) coupled with additional
legislation in various jurisdictions for banks to separate core retail banking activities
from investment banking activities, additional focus has arisen on ‘internal derivatives’
within a banking group.
When derivatives transacted between the retail banking and investment banking legal
entities within a banking group are novated to a CCP, the CCP becomes the
counterparty to the derivative. This does not automatically mean that the external
derivatives with the CCP are eligible for hedge accounting, judgement will be required
as to whether the offsetting external derivatives should be considered in substance as a
single contract (see 3.2.1 above).
4.2
Offsetting internal hedging instruments
As noted at 4.1 above, if an internal contract used in a hedging relationship is offset with
an external party, the external contract may be regarded as a hedging instrument and
the hedge may qualify for hedge accounting. The IAS 39 implementation guidance
elaborates on this further in the context of both interest rate and foreign currency risk
management, particularly in the situation where the exposure from internal derivatives
are offset before being laid off with a third party.
4.2.1
Interest rate risk
Sometimes, central treasury functions enter into internal derivative contracts with
subsidiaries and, perhaps, divisions within the consolidated group to manage interest
rate risk on a centralised basis. If, before laying off the risk, the internal contracts are
first netted against each other and only the net exposure is offset in the marketplace
with external derivative contracts, the internal contracts cannot qualify for hedge
accounting in the consolidated financial statements.
Where two or more internal derivatives used to manage interest rate risk on assets
or liabilities at the subsidiary or division level are offset at the treasury level, the
effect of designating the internal derivatives as hedging instruments is that the
hedged non-derivative exposures at the subsidiary or division levels would be used
to offset each other on consolidation. Accordingly, since IAS 39 did not permit
designating non-derivatives as hedging instruments (except for foreign currency
exposures), the results of hedge accounting from the use of internal derivatives at
the subsidiary or division level that are not laid off with external parties must be
4036 Chapter 49
reversed on consolidation. [IAS 39.F.1.5]. Although IFRS 9 does permit designation of
non-derivative instruments as hedging instruments, this is only for financial
instruments measured at fair value through profit or loss, which is unlikely to be the
case in this scenario (see 3.3 above).
It should be noted, however, that if internal derivatives that offset each other at the
consolidation level if they are used in the same type of hedging relationship at the
subsidiary or division level; and (in the case of cash flow hedges) if the hedged items
affect profit or loss in the same period and if the hedges are perfectly effective at the
subsidiary level, then there will be no effect on profit or loss and equity of reversing the
effect of hedge accounting on consolidation. Just as the internal derivatives offset at the
treasury level, their use as fair value hedges by two separate entities or divisions within
the consolidated group will also result in the offset of the fair value amounts recognised
in profit or loss. Similarly, their use as cash flow hedges by two separate entities or
divisions within the consolidated group will also result in the fair value amounts being
offset against each other in other comprehensive income. [IAS 39.F.1.5].
However, reversal of subsidiary hedge accounting on consolidation may have an effect
on individual line items in both the consolidated income statement (or statement of
comprehensive income) and the consolidated statement of financial position. This will
be the case, for example, when internal derivatives that hedge assets (or liabilities) in a
fair value hedge are offset by internal derivatives that are used as a fair value hedge of
other assets (or liabilities) that are recognised in a different line item in the statement of
financial position or income statement (or statement of comprehensive income). In
addition, to the extent that one of the internal contracts is used as a cash flow hedge and
the other is used in a fair value hedge, the effect on profit or loss and equity would not
offset since the gain (or loss) on the internal derivative used as a fair value hedge would
be recognised in
profit or loss and the corresponding loss (or gain) on the internal
derivative used as a cash flow hedge would be recognised in other comprehensive
income. [IAS 39.F.1.5].
Notwithstanding this, under the principles set out at 4.1 above, it may be possible to
designate the external derivative as a hedge of some of the underlying exposures as
illustrated in the following example.
Example 49.40: Single external derivative offsets internal contracts on a net basis
Company A uses internal derivative contracts to transfer interest rate risk exposures from individual divisions
to a central treasury function. The central treasury function aggregates the internal derivative contracts and
enters into a single external derivative contract that offsets the internal derivative contracts on a net basis.
On one particular day the central treasury function enters into three internal receive-fixed, pay-variable
interest rate swaps that lay off the exposure to variable interest cash flows on variable rate liabilities in other
divisions and one internal receive-variable, pay-fixed interest rate swap that lays off the exposure to variable
interest cash flows on variable rate assets in another division. It enters into an interest rate swap with an
external counterparty that exactly offsets the four internal swaps.
Financial instruments: Hedge accounting 4037
A cash flow hedge of an overall net position for interest rate risk does not qualify for hedge accounting under
IFRS 9 (see 2.5.3 above). However, designating a part of the variable rate assets or liabilities as the hedged
position on a gross basis is permitted if the designation is directionally consistent with the actual risk
management activities (see 6.2.1 below). Therefore, even though the purpose of entering into the external
derivative was to offset internal derivative contracts on a net basis, hedge accounting is permitted if the
hedging relationship is defined and documented as a hedge of a part of the underlying cash inflows or cash
outflows on a gross basis and assuming that the hedge accounting criteria are met. [IAS 39.F.2.15].
4.2.2
Foreign exchange risk
Although much of the discussion at 4.2.1 above applies equally to hedges of foreign
currency risk, there is one important distinction between the two situations. Non-
derivative financial instruments are permitted to be used as the hedging instrument in
the hedge of foreign currency risk. Therefore, in this case, internal derivatives may be
used as a basis for identifying non-derivative external transactions that could qualify as
hedging instruments or hedged items, provided that the internal derivatives represent
the transfer of foreign currency risk on underlying non-derivative financial assets or
liabilities (see Case 3 in Example 49.41 below). However, for consolidated financial
statements, it is necessary to designate the hedging relationship so that it involves only
external transactions.
Forecast transactions and unrecognised firm commitments cannot qualify as hedging
instruments. Accordingly, to the extent that two or more offsetting internal derivatives
represent the transfer of foreign currency risk on such items, hedge accounting cannot
be applied. As a result, if any cumulative net gain or loss on an internal derivative has
been included in the initial carrying amount of an asset or liability (a ‘basis adjustment’)
(see 7.2.1 below), it would have to be reversed on consolidation if it cannot be
demonstrated that the offsetting internal derivative represented the transfer of a foreign
currency risk on a financial asset or liability to an external hedging instrument.
[IAS 39.F.1.6].
The following example illustrates this principle – it also illustrates the mechanics of
accounting for fair value hedges and cash flow hedges, which are discussed in more
detail at 7.1 and 7.2 below. [IAS 39.F.1.7].
Example 49.41: Using internal derivatives to hedge foreign currency risk
In each of the following cases, ‘FC’ represents a foreign currency, ‘LC’ represents the local currency (which
is the entity’s functional currency) and ‘TC’ the group’s treasury centre.
Case 1: Offset of fair value hedges
Subsidiary A has trade receivables of FC100, due in 60 days, which it hedges using a forward contract
with TC. Subsidiary B has payables of FC50, also due in 60 days, which it hedges using a forward
contact with TC.
TC nets the two internal derivatives and enters into a net external forward contract to pay FC50 and receive
LC in 60 days.
4038 Chapter 49
At the end of month 1, FC weakens against LC. A incurs a foreign exchange loss of LC10 on its receivables, offset
by a gain of LC10 on its forward contract with TC. B makes a foreign exchange gain of LC5 on its payables, offset
by a loss of LC5 on its forward contract with TC. TC makes a loss of LC10 on its internal forward contract with
A, a gain of LC5 on its internal forward contract with B and a gain of LC5 on its external forward contract.
Accordingly, the following entries are made in the individual or separate financial statements of A, B and TC
at the end of month 1 (assuming that forward foreign exchange and spot exchange rates are exactly the same,
which is unlikely in reality). Entries reflecting intra-group transactions or events are shown in italics.
A’s entries
LC
LC
Foreign exchange loss
10
Receivables 10
Internal contract (TC)
10
Internal gain (TC)
10
B’s entries
LC
LC
Payables 5
Foreign exchange gain
5
Internal loss (TC)
5
Internal contract (TC)
5
TC’s entries
LC
LC
Internal loss (A)
10
Internal contract (A)
10
Internal contract (B)
5
Internal gain (B)
5
External forward contract
5
Foreign exchange gain
5
Both A and B could apply hedge accounting in their individual financial statements provided all the necessary
conditions were met. However, because gains and losses on the internal derivatives and the offsetting losses
and gains on the hedged receivables and payables are recognised immediately in profit or loss without hedge
accounting (as required by IAS 21), hedge accounting is unnecessary (see 7.1.1 below for further information
on hedges of foreign currency denominated monetary items).
In the consolidated financial statements, the internal derivative transactions are eliminated. In economic terms, B’s
payable hedges FC50 of A’s receivables. The external forward in TC hedges the remaining FC50 of A’s receivable.
In the consolidated financial statements, hedge accounting is again unnecessary because monetary items are
measured at spot foreign exchange rates under IAS 21 irrespective of whether hedge accounting is applied.
The net balances, before and after elimination of the accounting entries relating to the internal derivatives,
are the same, as set out below. Accordingly, there is no need to make any further accounting entries to meet
the requirements of IAS 39.
LC
LC
Receivables
–
10
Payables 5
–
External forward contract
5
–
Gains and losses
–
–
Internal contracts
–
–
Case 2: Offset of cash flow hedges
To extend the example, A also has highly probable future revenues of FC200 on which it expects to receive
cash in 90 days. B has highly probable future expenses of FC500 (advertising cost), also to be paid for
Financial instruments: Hedge accounting 4039
in 90 days. A and B enter into separate forward contracts with TC to hedge these exposures and TC enters
into an external forward contract to receive FC300 in 90 days.
As before, FC weakens at the end of month 1. A incurs a ‘loss’ of LC20 on its anticipated revenues because
the LC value of these revenues decreases and this is offset by a gain of LC20 on its forward contract with TC.
Similarly, B incurs a ‘gain’ of LC50 on its anticipated advertising cost because the LC value of the expense
decreases and this is offset by a loss of LC50 on its transaction with TC.
TC incurs a gain of LC50 on its internal transaction with B, a loss of LC20 on its internal transaction with A
and a loss of LC30 on its external forward contract.
Both A and B satisfy the hedge accounting criteria and qualify for hedge accounting in their individual
financial statements. A recognises the gain of LC20 on its internal derivative transaction in other
comprehensive income and B does the same with its loss of LC50. TC does not claim hedge accounting, but
measures both its internal and external derivative positions at fair value, which net to zero.
Accordingly, the following entries are made in the individual or separate financial statements of A, B and TC
at the end of month 1. Entries reflecting intra-group transactions or events are shown in italics.
A’s entries
LC
LC
Internal contract (TC)
20
Other comprehensive income
20
B’s entries
LC
LC
Other comprehensive income
50
Internal contract (TC)
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 799
