fair value start to dominate the interest rate risk-related changes, the hedging
relationship would have to be discontinued.
Financial instruments: Hedge accounting 4069
6.4.3
The hedge ratio
The hedge ratio is the ratio between the amount of hedged item and the amount of
hedging instrument. For many hedging relationships, the hedge ratio would be 1:1 as the
underlying of the hedging instrument perfectly matches the designated hedged risk.
Some hedging relationships may include basis risk such that the fair value changes of
the hedged item and the hedging instrument do not have a simple 1:1 relationship. In
such cases, risk managers will generally set the hedge ratio so as to be other than 1:1, in
order to improve the effectiveness of the hedge. Consequently, the third effectiveness
requirement is that the hedge ratio used for accounting should ordinarily be the same
as that used for risk management purposes. [IFRS 9.6.4.1(c)(iii)].
Example 49.55: Setting the hedge ratio
An entity purchases a raw material whose price is at a discount to the commodity benchmark price, reflecting
that the raw material is not yet processed to the same extent as the benchmark commodity, as well as quality
differences. The entity runs a rolling 12-month regression analysis at each month end to ascertain that the
price of the commodity in the futures market and the price of the raw material remain highly correlated. The
slopes of the regression analyses (commodity benchmark price to raw material price) over recent months
varied between 1.237 and 1.276.
The entity considers that the pattern of its regression analyses is consistent with its longer term view that the
raw material trades at an approximately 20% discount to the commodity benchmark price and does not
indicate a change in trend but fluctuations around that discount. Therefore, the entity uses a notional amount
of 1 tonne of a forward contract for the benchmark commodity to hedge highly probable forecast purchases
of 1.25 tonnes of the raw material. Note that this is not exactly the same as the particular slope of the most
recent monthly regression, which is not required because the standard requires only that the entity uses the
hedge ratio that it actually uses for risk management purposes, and not that it is required to minimise
ineffectiveness. The example also illustrates what the standard acknowledges: there is no ‘right’ answer, as
different entities would run different regression analyses (e.g. in terms of frequency and data inputs used,
which means there is no one hedge ratio that could be required). The fluctuation of the actual discount around
the particular hedge ratio chosen for designating the hedging relationship will give rise to some
ineffectiveness that will need to be recorded.
However, the standard requires the hedge ratio for accounting purposes to be different
from the hedge ratio used for risk management if the latter hedge ratio reflects an
imbalance that would create hedge ineffectiveness ‘that could result in an accounting
outcome that would be inconsistent with the purpose of hedge accounting.’
[IFRS 9.6.4.1(c)(iii), B6.4.10]. This complex language was introduced because the Board is
specifically concerned with deliberate ‘under-hedging’, either to minimise recognition
of ineffectiveness in cash flow hedges or the creation of additional fair value
adjustments to the hedged item in fair value hedges. [IFRS 9.B6.4.11(a)].
Example 49.56: Deliberate under-hedging in a cash flow hedge to avoid
recognition of ineffectiveness
IFRS 9 requires the cash flow hedge reserve to be adjusted for the lower of (a) the cumulative gain or loss on
the hedging instrument or (b) the cumulative change in fair value of the hedged item (see 7.2 below).
[IFRS 9.6.5.11(a)]. If (a) exceeds (b), the difference is recognised in profit or loss as ineffectiveness. On the
other hand, no ineffectiveness is recognised if (b) exceeds (a).
4070 Chapter 49
An entity has highly probable forecast purchases of a raw material used in its manufacturing process. The
average volume of raw material purchases is expected to be Russian Rouble (RUB) 200 million per month.
The entity wishes to hedge the commodity price risk on those forecast purchases. The only derivative
available does not have an underlying risk exactly matching the one from the actual raw material hedged. The
slope of a linear regression analysis is 0.93, indicating the ideal hedge ratio.
To seek to avoid recognition of accounting ineffectiveness, the entity ensures (b) will exceed (a), applying
the accounting requirement discussed above. It enters into derivatives with a notional amount of only
RUB 150m per month and designates the RUB 150 million of derivatives as hedging instruments in cash flow
hedges of highly probable forecast purchases of RUB 200 million (thereby setting the hedge ratio at 0.75:1).
In this scenario, the hedge ratio would be considered unbalanced and only entered into to avoid recognition
of accounting ineffectiveness. For hedge accounting purposes, the hedge ratio would have to be based on the
expected sensitivity between the hedged item and the hedging instrument (in this example possibly around
the 0.93:1 based on the linear regression analysis, which would give a hedged volume of RUB 161m). As a
result, if the relative change in the fair value of the hedging instrument is greater than that on the hedged item
because the relationship between the underlyings changes, some ineffectiveness will have to be recognised.
Example 49.57: Deliberate under-hedging in a fair value hedge to create fair value
accounting
An entity acquires a CU 50 million portfolio of debt instruments. The debt instruments fail the ‘cash flow
characteristics test’ of IFRS 9 (i.e. the contractual cash flows do not solely represent payments of principal
and interest on the principal amount outstanding) and are therefore accounted for at fair value through profit
or loss (see Chapter 44 at 6). [IFRS 9.4.1.2(b), 4.1.2A(b), 4.1.4].
The treasurer dislikes the profit or loss volatility resulting from the fair value accounting. He realises that
one of the entity’s fixed rate bank borrowings has a similar term structure and that fair value changes on
the liability would more or less offset the fair value changes on the asset portfolio. However, at the time
of entering into the bank borrowing, the entity did not apply the fair value option to this liability (see
Chapter 44 at 7).
The treasurer enters into a CU 1 million receive fixed/pay variable interest rate swap (IRS) and designates
the IRS in a fair value hedge of CU 50 million of fixed rate liability (thereby setting the hedge ratio at 0.02:1).
As a result, the entire CU 50 million of liability would be adjusted for changes in the hedged interest rate risk.
In this scenario, the hedge ratio is unbalanced as the real purpose of the hedging relationship is to achieve fair
value accounting (related to changes in interest rate risk) for CU 49 million of the liability. The hedge ratio
used for hedge accounting purposes would have to be different (likely close to 1:1).
Alternatively the entity could consider designating the CU 50 million portfolio of debt instruments as the
hedging instrument in a fair value hedge of the fixed rate bank borrowings for interest rate risk (see 3.3
above), in that case a 1:1 hedge ratio may also be required.
hedge designations are likely to be rare; IFRS 9 does not however require an entity to
designate a ‘perfect hedge’. For instance, if the hedging instrument is only available in
multiples of 25 metric tonnes as the standard contract size, an imbalance due to using,
say, 400 metric tonnes nominal value of hedging instrument to hedge 409 metric tonnes
of forecast purchases, would not be regarded as resulting in an outcome ‘that would be
inconsistent with the purpose of hedge accounting’ and so would meet the qualifying
criteria. [IFRS 9.B6.4.11(b)].
The subsequent prospective effectiveness assessment requires consideration as to
whether the accounting hedge ratio is still appropriate, or indeed whether a change is
required. This ‘rebalancing’ of a live hedge relationship is further discussed at 8.2 below.
Financial instruments: Hedge accounting 4071
7
ACCOUNTING FOR EFFECTIVE HEDGES
If any entity chooses to designate a hedging relationship of a type described at 5 above,
between a hedging instrument and a hedged item as described at 2 and 3 above and it
meets the qualifying criteria set out at 6 above, the accounting for the gain or loss on the
hedging instrument and the hedged item will be as set out in the remainder of this
section. [IFRS 9.6.1.2, 6.5.1].
7.1
Fair value hedges
7.1.1
Ongoing fair value hedge accounting
If a fair value hedge (see 5.1 above) meets the qualifying conditions set out at 6 above
during the period, it should be accounted for as follows:
• the gain or loss on the hedging instrument shall be recognised in profit or loss (or
OCI if the hedging instrument hedges an equity instrument for which an entity has
elected to present changes in fair value in OCI in accordance with paragraph 5.7.5
of IFRS 9 (see Chapter 44 at 2.2)); and
• the hedging gain or loss on the hedged item shall adjust the carrying amount of the
hedged item (if applicable) and be recognised in profit or loss.
If the hedged item is a debt instrument (or a component thereof) that is measured
at fair value through OCI in accordance with paragraph 4.1.2.A of IFRS 9 (see
Chapter 44 at 2.1) the hedging gain or loss on the hedged item shall be recognised
in profit or loss.
If the hedged item is an equity instrument for which an entity has elected to present
changes in fair value in OCI, those amounts shall remain in OCI.
Where a hedge item is an unrecognised firm commitment (or a component
thereof), the cumulative change in the fair value of the hedged item subsequent to
its designation is recognised as an asset or liability with a corresponding gain or
loss recognised in profit or loss. [IFRS 9.6.5.8].
The hedging gain or loss on the hedged item is not necessarily the full fair value change
in the hedged item, but reflects the change in value since designation of the designated
portion or component of the hedged item (see 2.2 and 2.3 above) attributable to the
hedged risk. Any changes in the fair value of the hedged item that are unrelated to the
hedged risk should only be recognised in compliance with normal IFRS requirements.
[IFRS 9.B6.3.11].
The gain or loss on the hedging instrument for the purposes of accounting for a fair
value hedge, refers to all changes in fair value of the hedging instrument since
designation in the hedge relationship. Only fair value changes with respect to the time
value of an option, forward element of a forward contract or foreign currency basis
spreads if excluded from the hedge designation (see 3.6.4 and 3.6.5 above), or a
documented excluded proportion of the instrument (see 3.6.1 above) are not included
within the gain or loss on the hedging instrument.
Hedge ineffectiveness is the extent to which the changes in the fair value or the cash
flow of the hedging instrument are greater or less that those on the hedged item.
[IFRS 9.B6.4.1, B6.3.11]. Where hedge ineffectiveness arises in a fair value hedge, a net
4072 Chapter 49
amount will be recognised in profit or loss, (unless the hedged item is an equity
instrument for which an entity has elected to present changes in fair value in OCI in
accordance with paragraph 5.7.5 of IFRS 9, in which case it will be recognised in OCI).
Hedge ineffectiveness is an important concept with IFRS 9, and measurement of it is
considered more fully at 7.4 below.
Although not clearly evident from the standard, we believe the gain or loss on the
hedging instrument and the hedging gain or loss on the hedged item should be
recognised in the same line item in profit or loss to reflect the offsetting effect of hedge
accounting (see Chapter 50 at 7.1.3).
The following simple example illustrates how the treatment above might apply to a
hedge of fair value interest rate risk on an investment in fixed rate debt.
Example 49.58: Fair value hedge
At the beginning of Year 1 an investor purchases a fixed rate debt security for £100 and classifies it as measured
at fair value thorough OCI in accordance with paragraph 4.1.2A of IFRS 9. At the end of Year 1, the fair value
of the asset is £110. To protect this value, the investor enters into a hedge by acquiring an interest rate derivative
with a nil fair value and designates it in fair value hedge of interest rate risk. By the end of Year 2, the derivative
has a fair value of £5 and the debt security has a corresponding decline in fair value. Fair value changes in both
the fixed rate security and the derivative have only occurred due to interest rates.
The investor would record the following accounting entries:
Year 1
Beginning of year
£
£
Debt security
100
Cash 100
To reflect the acquisition of the security.
End of year
£
£
Debt security
10
Other comprehensive income
10
To record the increase in the security’s fair value in other comprehensive income.
Year 2
Beginning of year
£
£
Derivative
–
Cash
–
To record the acquisition of the derivative at its fair value of nil.
End of year
£
£
Derivative 5
Profit or loss
5
To recognise the increase in the derivative’s fair value in profit or loss.
£
£
Profit or loss
5
Debt security
5
To recognise the decrease in the security’s fair value in profit or loss.
Financial instruments: Hedge accounting 4073
The £5 credit to the carrying amount of the debt security in Example 49.58 above,
reflects application of the usual accounting for instruments measured at fair value
thorough OCI in accordance with paragraph 4.1.2A of IFRS 9 (see Chapter 46 at 2.3).
The effect of fair value hedge accounting in this example, is just that the reduction in
fair value is recognised in profit or loss, rather than OCI. For hedged items not held at
<
br /> fair value, the adjustment to both the carrying amount of the hedged item and profit or
loss would only occur as a result of application of fair value hedge accounting.
Conversely, when hedging the foreign exchange risk on a foreign currency monetary
item, IAS 21 retranslation gains or losses would be recognised in profit or loss in any
event, accordingly any incremental adjustment to the carrying amount as part of fair
value hedge accounting should not include the retranslation effect again.
Example 49.58 above also includes an assumption that fair value changes only occurred
as a result of changes in interest rates. No ineffectiveness was recorded as the effect of
changes in interest rates on both the hedged item and hedging instrument offset
perfectly, however this is a simplified example and is unlikely to be the case.
The basic hedge accounting treatment above applies equally to fair value hedges of
unrecognised firm commitments. Therefore, where an unrecognised firm commitment
is designated as a hedged item in a fair value hedge, the subsequent cumulative change
in its fair value attributable to the hedged risk should be recognised as an asset or liability
with a corresponding gain or loss recognised in profit or loss. Thereafter, the firm
commitment would be a recognised asset or liability (albeit that its carrying amount will
not represent either its cost or, necessarily, its fair value). The changes in the fair value
of the hedging instrument would also be recognised in profit or loss. [IFRS 9.6.5.8(b)].
It can be seen that applying fair value hedge accounting adjustments does not change
the accounting for the hedging instrument (unless it hedges an equity instrument for
which an entity has elected to present changes in fair value in OCI or if the time value
of an option, forward element of a forward contract or foreign currency basis spreads
are excluded from the hedge (see 7.5 below)). This is true whether the hedging
instrument is a derivative or non-derivative instrument. For example, if a foreign
currency cash instrument was designated as the hedging instrument in a fair value hedge
(see 3.3.1 above), the foreign currency component of its carrying amount would
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 806
