two currencies are formally pegged or otherwise linked to one another or if the relevant
exchange rates move in tandem because of, say, similarities in the underlying economies.
Even if such a hedge is meets the hedge effectiveness requirements, it is likely to result in
some ineffectiveness. Under US GAAP it is suggested that the retranslation gains and
losses on the actual instrument should be compared to those on a hypothetical non-
derivative (e.g. a borrowing in the correct currency) with any difference recognised in
profit or loss.13 This approach should normally be acceptable under IFRS 9, if applied in
conjunction with the accounting requirements for net investment hedges (see 7.3 above).
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]. Therefore, when
designating a foreign currency denominated non-derivative financial liability as the hedging
instrument in a hedge of a net investment, it is only possible to designate the spot foreign
exchange risk, and not a forward foreign exchange risk. [IFRIC 16.AG2].
7.3.3
Derivatives hedging a net investment
It is clear that a derivative instrument may be designated as the hedging instrument in a
hedge of a net investment. [IFRIC 16.14]. What is harder to determine is how various types
of derivative may be designated in a hedge of a net investment in order that the hedge
relationship meets the usual hedge accounting criteria, and how the relationship should
be accounted for. For example:
• Is it possible to designate the forward foreign currency risk as the hedged risk in a
net investment hedge?
• How should the hedged risk in the net investment be represented for ineffectiveness
measurement purposes when the hedging instrument is a derivative?
• What is the accounting treatment for any excluded portions of a derivative hedging
instrument in a net investment hedge?
These questions will be considered in the remainder of this section.
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In the application guidance to IFRIC 16, it is noted that if the hedging instrument is a
forward contract, then it is possible to designate a forward foreign currency risk as the
hedged risk in a hedge of a net investment (see 3.6.5 above). [IFRIC 16.AG2]. Forward
foreign currency risk must therefore be deemed to exist within the net investment. If
the forward foreign currency risk is designated for a net investment hedge, then the
entire change in fair value of the hedging instrument, (including changes in the forward
element) should be included in the calculation of the portion of the gain or loss on the
hedging instrument that is determined to be an effective hedge. [IFRS 9.6.5.13]. This could
be achieved by using a hypothetical derivative that is also a forward foreign contract
(see 7.4.4.A below).
Like forward contracts, cross-currency interest rate swaps are sometimes used as
hedging instruments in net investment hedges. It is often said that cross currency swaps
are essentially a series of forward contracts and so arguably the treatment for forwards
should be equally applicable to cross-currency swaps. However, it is difficult to
rationalise why a cross-currency swap, for which there are periodic gross settlements is
a good representation of the forward foreign currency risk within the retranslation of a
net investment, and therefore an appropriate hypothetical derivative (see 7.3.3.B and
7.4.4.A below).
There is no reason why an option contract, that is not a written option, cannot be
designated as the hedging instrument in a hedge of a net investment (see 3.2.2 above).
In fact such a hedge is included as an example in the IFRS 9 application guidance.
[IFRS 9.B6.5.29(b)].
A qualifying instrument may be designated with the following portions excluded: time
value of options, forward elements of forwards, and/or foreign currency basis spread
(see 3.6 above). Where such portions are excluded they may be treated as a cost of
hedging (see 7.5 below), or, alternatively, the excluded forward elements of forwards
and/or foreign currency basis spread may remain at fair value through profit or loss. This
treatment for hedges of a net investment is discussed in more detail in 7.5.2.A below. It
is worth noting that unless the foreign currency basis spread is excluded from the
derivative hedging instrument in a net investment hedge, ineffectiveness will occur as
foreign currency basis spread cannot be assumed to exist in a non-derivative hedged
item (see 7.4.4.D below).
7.3.3.A
Forward currency contracts hedging a net investment
It is very common for forward currency contracts to be used as the hedging instrument
in a hedge of a net investment, and it is acknowledged in the IFRIC 16 application
guidance that it is possible to designate a forward foreign currency risk for such a hedge
(see 7.3.3 above). Therefore, permitting the hedged foreign currency risk in the net
investment hedge to be represented by a hypothetical forward foreign currency
contract seems relatively uncontroversial and has effectively been endorsed in
IFRIC 16. [IFRIC 16.15, AG2].
If on the other hand the spot risk is designated, the costs of hedging guidance may be
applied to the excluded portion rather than fair value changes in the excluded portion
being recognised immediately profit or loss (see 7.5 below).
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It is clear under IFRS 9 that foreign currency basis spread cannot be assumed to exist in
a non-derivative hedged item, hence this will be an additional source of ineffectiveness,
unless foreign currency basis spread is excluded from the hedging instrument.
[IFRS 9.6.B6.5.5].
7.3.3.B
Cross currency interest rate swaps hedging a net investment
Like forward contracts, cross currency interest rate swap instruments are commonly
used as hedging instruments in net investment hedges. As noted above, it is often said
that cross currency swaps are essentially a series of forward contracts. However what
the appropriate hypothetical derivative would be for measuring ineffectiveness when
hedging with a cross currency interest rate swap depends very much on the type of cross
currency interest rate swaps.
At a conceptual level, it is easy to see that the changes in value of a cross-currency swap
with two floating-rate legs are likely to offset the spot retranslation gains and losses of
a net investment, provided the floating rate resets sufficiently frequently. Hence such a
designation will most probably meet the requirement to demonstrate that an economic
relationship exists, although some residual ineffectiveness is likely to occur from the
floating rate legs of the cross-currency swap.
It is also reasonably easy to see that a swap with one floating-rate leg and one fixed-rate
leg could result in levels of ineffectiveness that contradict the existence of an economic
relationship between the hedged item and hedging instrument, which would preclude
hedge accounting (see 6.4.1 above). This is because the fair value of a swap with one
floating-rate leg and one fixed-rate leg will change due to factors unrelated to changes<
br />
in forward exchange rates.
It is less easy to see how hedge accounting will be applied using a swap with two fixed-
rate legs as a hedge of the retranslation gains and losses in a net investment (since again
the fixed-rate legs will give rise to changes in the swap’s value that are unrelated to
changes in forward exchange rates). As noted above, such an instrument is often viewed
as a combination of a series of forward contracts, (i.e. each interest and principal fixed
foreign currency cash flow and associated fixed functional currency cash flow is a
forward contract, albeit based on a blended forward rate across the life of instrument).
Applying this perspective, combined with the guidance that net investment hedges
should be accounted for similarly as cash flow hedges, [IFRS 9.6.5.13], we believe it is
possible to designate a fixed-for-fixed currency swap in a net investment hedge,
whereby the amount of the hedged item would be equal to the sum of the undiscounted
foreign currency interest and principal payments, (i.e. an amount higher than just the
notional amount of the swap). For example, a 2 year fixed-for-fixed cross currency
swap with a foreign currency notional amount of FC100 million paying 3% annually,
could be designated as hedging the forward foreign currency risk in a net investment of
FC106 million. The foreign currency risk for such a designated hedged item could be
represented by a fixed-for-fixed cross currency swap (this would be for both the
hypothetical derivative used to measure the effective portion and the aligned hedging
derivative if the costs of hedging guidance is applied) (see 7.4.4.A and 7.5.2 below).
If a fixed-for-fixed cross currency swap with a foreign currency notional amount of
FC100m is designated as a hedge of the forward foreign currency risk in a net investment
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of only FC100m, it is harder to argue that the hedged risk could be represented by fixed-
for-fixed cross currency swap also with a foreign currency notional amount of FC100m.
Given that there are no periodic settlements in the hedged item, it might be argued that
the forward foreign currency risk in the hedged item would be better represented by a
simple forward contract with notional amount of FC100m, for both measurement of
ineffectiveness and application of the costs of hedging guidance.
It would of course be possible to designate only the spot element of a cross currency
swap as a hedging instrument in a hedge of a net investment (see 3.6.5 above). For
example, a cross currency swap with a foreign currency notional amount of FC100m
could be designated as hedging the spot foreign currency risk in FC100m of a net
investment. Changes in the undesignated component of the cross currency swap would
remain in profit or loss, to the extent that costs of hedging guidance was not applied
(see 7.5 below).
7.3.3.C
Purchased options hedging a net investment
It is possible to designate the intrinsic value of a purchased option as the hedging
instrument (i.e. its time value is excluded from the hedge relationship) (see 3.6.4 above).
Such a designation would require the costs of hedging treatment to be applied. The costs
of hedging accounting would require changes in fair value of the excluded time value to
be initially recorded in other comprehensive income (see 7.5.1 below).
As discussed at 3.6.4 above, designating the entire purchased option as the hedging
instrument is likely to result in high levels of ineffectiveness and could challenge the
existence of an economic relationship (see 6.4.1 above). This is because no offset will
arise for changes in the time value of the purchased option, as the time value is not a
component of the hedged net investment. [IFRS 9.B6.3.12].
7.3.4
Combinations of derivative and non-derivative instruments hedging a
net investment
It is not uncommon for entities to hedge their net investments using synthetic foreign
currency debt instruments. For example, consider a parent with the euro as its
functional currency that has a net investment in a Japanese subsidiary with yen as its
functional currency. The parent might borrow in US dollars and enter into a pay-
Japanese yen, receive-US dollar cross-currency interest rate swap. In this way the two
instruments might be considered a synthetic Japanese yen borrowing, although they are
required to be accounted for separately (see Chapter 42 at 8).
As noted at 3.5 above, a combination of derivatives and non-derivatives may be viewed
in combination and jointly designated as a hedging instrument. [IFRS 9.6.2.5]. However, all
the hedging instruments must be clearly identified in the hedge documentation (see 6.3
above). [IFRS 9.6.4.1(b)].
The Japanese parent in the above fact pattern may wish to designate the spot rate only
when hedging a net investment with a combination of derivatives and non-derivatives.
Designation of the combination as hedging a forward rate is more problematic as the
foreign currency risk component of a non-derivative financial instrument is restricted
to the spot rate, in accordance with IAS 21. [IFRS 9.B6.2.3].
Financial instruments: Hedge accounting 4087
Another alternative may be to notionally decompose the cross currency swap by
introducing an interest bearing functional currency denominated leg and designating
one part as a hedge of the borrowing and the other as a hedge of the net investment
(see 3.7 above).
7.3.5
Individual or separate financial statements
The discussion so far has concentrated on the accounting for a hedge of the foreign
currency risk in a foreign operation in the parent’s consolidated financial statements.
However, in the parent’s individual or separate financial statements, the investment in
the foreign operation will generally be accounted for as an asset measured at cost or as
a financial asset in accordance with IFRS 9. [IAS 27.10]. In other words, it will not be
accounted for by way of consolidation.
Accordingly, from the perspective of the individual or separate financial statements, the
reporting entity will not have a net investment in a foreign operation. Therefore, the
borrowing could not be designated as the hedging instrument in a net investment hedge
for the purposes of the separate financial statements. However, if hedge accounting is
desirable, it may be possible to designate the borrowing as the hedging instrument in
another type of hedge. Typically, this would be a fair value hedge of the foreign
currency risk arising from the investment. This will be an independent hedge
relationship, separate from the net investment hedge in the consolidated financial
statements. Therefore, all of the other hedge accounting criteria (including the
documentation requirements) will need to be met for this hedge too. Of course, the
effects of this hedge accounting will need to be reversed when preparing the group’s
consolidated financial statements (otherwise those financial statements will reflect as an
asset or liability certain changes in the fair value of a parent’s investment in its subsidiary
which would be contrary to the general principles of IFRS 10).
7.4 Measuring
ineffectiveness
7.4
.1 General
requirements
Hedge ineffectiveness is the extent to which the changes in the fair value or cash flows
of the hedging instrument are greater or less than those on the hedged item. [IFRS 9.B6.4.1].
All hedge ineffectiveness is recognised in the profit or loss for fair value hedges (except
where the hedged item is an equity instrument measured at fair value through OCI)
(see 7.1.1). For cash flow and net investment hedges ineffectiveness is recognised in the
profit or loss to the extent that the cumulative change in the fair value or cash flows of
the hedging instrument are greater than those on the hedged item (see 7.2.1 and 7.3.1).
Accordingly the measurement of ineffectiveness is an important aspect of IFRS 9.
Although, for many hedge relationships, it will be acceptable to undertake a qualitative
assessment as to whether the hedge effectiveness requirements are met (see 8.1 below)
there is still a requirement to measure and record ineffectiveness appropriately within
the financial statements.
In determining the ineffectiveness of a hedge relationship, it is important to closely
follow the hedge designation. In particular it is necessary to determine the hedged risk,
and whether any portions or proportions have been excluded from hedged item (see 2.2
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and 2.3 above) and/or the hedging instrument (see 3.6 above). Hedge ineffectiveness
only relates to those elements not excluded from the hedge relationship, and for the
hedged item only, with respect to changes in the hedged risk, not the full price risk. The
initial designation of a hedge relationship is therefore very important and can in some
cases significantly reduce the expected ineffectiveness levels from hedge relationships.
However, it should be noted that not all sources of ineffectiveness can be eliminated via
clever hedge designation. All sources of ineffectiveness must be documented as part of
the hedged documentation. [IFRS 9.6.4.1(b)].
7.4.2
The time value of money
Entities have to consider the time value of money when measuring hedge
ineffectiveness. This means that an entity has to determine the value of the hedged item
on a present value basis (thereby including the effect of the time value of money).
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 809
