International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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figure denotes a reduction in the net present value of the payable and, therefore represents a gain to offset the
loss on the forward contract.
LC
LC
Forward – liability
2,400
Cash 2,400
To record the net settlement of the forward exchange contract.
Although this arrangement has been set up to be a ‘perfect hedge’, the loss on the forward in the last three months
is significantly different from the exchange gain recognised on retranslating the hedged payable. The principal
reason for this is that the change in the fair value of the forward contract includes changes in its interest element,
as well as its currency element, whereas the payable is translated at the spot foreign exchange rate. [IAS 21.23(a)].
Case 2: Changes in the spot element of the forward contract only are designated in the hedge
Ignoring ineffectiveness that may arise from other elements that have an impact on the fair value of the
hedging instrument, the hedge is expected to be fully effective because the critical terms of the forward
exchange contract and the purchase contract are the same and the change in the premium or discount on the
forward contract is excluded from the assessment of effectiveness.
30 June 2019
LC
LC
Forward
–
Cash
–
To record the forward exchange contract at its initial fair value, i.e. zero.
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31 December 2019
LC
LC
Profit or loss (interest element of forward)
1,165
Other comprehensive income (spot element)
777
Forward – liability
388
To recognise the change in the fair value of the forward contract between 30 June 2019 and 31 December 2019,
i.e. 388 – 0 = LC388. The change in the present value of spot settlement of the forward exchange contract is a
gain of LC777 = {([1.080 × 100,000] – 107,200) ÷ 1.06(6/12)} – {([1.072 × 100,000] – 107,200) ÷ 1.06}), which
is recognised in other comprehensive income. The change in the interest element of the forward exchange contract
(the residual change in fair value) is a loss of LC1,165 = 388 + 777, which is recognised in profit or loss. The
hedge is fully effective because the gain in the spot element of the forward contract, LC777, exactly offsets the
change in the purchase price at spot rates {([1.080 × 100,000] – 107,200) ÷ 1.06(6/12)} – {([1.072 × 100,000] –
107,200) ÷ 1.06} = LC777. The positive figure denotes an increase in the net present value of cash outflows and,
therefore, effectively represents a ‘loss’ to offset the gain on the forward in other comprehensive income.
31 March 2020
LC
LC
Other comprehensive income (spot element)
580
Profit or loss (interest element)
1,003
Forward – liability
1,583
To recognise the change in the fair value of the forward contract between 1 January 2020 and 31 March 2020,
i.e. 1,971 – 388 = LC1,583. The change in the present value of spot settlement of the forward exchange
contract is a loss of LC580 = {([1.074 × 100,000] – 107,200) ÷ 1.06(3/12)} – {([1.080 × 100,000] – 107,200)
÷ 1.06(6/12)}, which is recognised in other comprehensive income. The change in the interest element of the
forward contract (the residual change in fair value) is a loss of LC1,003 = 1,583 – 580), which is recognised
in profit or loss. The hedge is fully effective because the loss in the spot element of the forward contract,
LC580, exactly offsets the change in the purchase price at spot rates {([1.074 × 100,000] – 107,200) ÷
1.06(3/12)} – {([1.080 × 100,000] – 107,200) ÷ 1.06(6/12)} = –LC580. The negative figure denotes a reduction
in the net present value of cash outflows and, therefore, effectively represents a ‘gain’ to offset the loss on
the forward in other comprehensive income.
LC
LC
Paper (purchase price)
107,400
Other comprehensive income
197
Paper (hedging gain)
197
Payable 107,400
To recognise the purchase of the paper at the spot rate (1.074 × 100,000 = LC 107,400) and remove the
cumulative gain on the spot element of the forward contract that has been recognised in other comprehensive
income (777 – 580 = LC197) and include it in the initial measurement of the purchased paper. Accordingly,
the initial measurement of the purchased paper is LC107,203 consisting of a purchase consideration of
LC107,400 and a hedging gain of LC197.
30 June 2020
LC
LC
Payable 107,400
Cash 107,200
Profit or loss
200
To record the settlement of the payable at the spot rate (100,000 × 1.072 = LC107,200) and recognise the
associated exchange gain of LC200 (= – [1.072 – 1.074] × 100,000) in profit or loss.
Financial instruments: Hedge accounting 4103
LC
LC
Profit or loss (spot element)
197
Profit or loss (interest element)
232
Forward – liability
429
To recognise the change in the fair value of the forward between 1 April 2020 and 30 June 2020, i.e. 2,400 –
1,971 = LC429). The change in the present value of spot settlement of the forward exchange contract is a loss
of LC197 = {[1.072 × 100,000] – 107,200 – {([1.074 × 100,000] – 107,200) ÷ 1.06(3/12)}, which is recognised
in profit or loss. The change in the interest element of the forward contract (the residual change in fair value)
is a loss of LC232 = 429 – 197, which is recognised in profit or loss. The hedge is fully effective because the
loss in the spot element of the forward contract, LC197, exactly offsets the gain on the payable reported using
spot rates = {[1.072 × 100,000] – 107,200 – {([1.074 × 100,000] – 107,200) ÷ 1.06(3/12)} = –LC197. The
negative figure denotes a reduction in the net present value of the payable and, therefore represents a gain to
offset the loss on the forward contract.
LC
LC
Forward – liability
2,400
Cash 2,400
To record the net settlement of the forward exchange contract.
The following table provides an overview of the components of the change in fair value of the hedging
instrument over the term of the hedging relationship. It illustrates that the way in which a hedging relationship
is designated affects the subsequent accounting for that hedging relationship, including the assessment of
hedge effectiveness and the recognition of gains and losses. [IAS 39.F.5.6].
Fair value of
Fair value of
Fair value of
Change in
change in
Change in
change in
change in
spot
spot
forward
forward
interest
Period ending
settlement
settlement
settlement
settlement
element
LC
LC
LC
LC
LC
30 June 2019
–
–
–
– –
31 December 2019
800
777
(400)
(388)
(1,165)
31 March 2020
(600)
(580)
(1,600)
(1,583)
(1,003)
30 June 2020
(200)
(197)
(400)
(429)
(232)
Total
–
–
(2,400)
(2,400) (2,400)
Ignoring ineffectiveness that may arise from elements that affect the fair value of the
hedging instrument only or that may be different from the hedged item to the hedging
instrument (e.g. foreign currency basis spreads), both designations result in effective
hedges as a result of the way effectiveness is measured. The example also sets out how
a single hedge can initially be a cash flow hedge of the future sale and then become a
fair value hedge of the associated payable, provided it is documented as such.
The example also indicates that the time value of money is relevant for the assessment
of effectiveness even when the spot element is designated in a hedge relationship
(see 7.4.2 above). Although in many circumstances the effect of discounting the
revaluation of the spot element may not be material.
7.4.6
The impact of the hedging instrument’s credit quality
One of the key hedge effectiveness requirements in IFRS 9 is that the impact of
credit risk should not be of a magnitude such that it dominates the value changes
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(see 6.4.2 above). [IFRS 9.6.4.1(c)(ii)]. It is therefore clear that the credit quality of the
hedging instrument, and hedged item are both relevant in determining the ongoing
eligibility of a hedge relationship. However, the assessment of the effect of credit
risk on value changes for hedge effectiveness purposes, which often may be made
on a qualitative basis, should not be confused with the requirement to measure and
recognise the impact of credit risk on the hedging instrument and, where
appropriate, the designated hedged item, which will normally give rise to hedge
ineffectiveness recognised in profit or loss (see 7.4.1 and 7.4.4.C above).
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].
Although it is permissible to exclude some components from a designated hedging
instrument, and associated fair value changes, counterparty credit risk is not one of the
permitted exclusions (see 3.6 above). Accordingly, unless the hedged item attracts the
same credit risk as the hedging instrument, it will be a source of ineffectiveness (see 7.4.1
above). It is very unlikely to be the case that the hedged item and hedging instrument
both attract the same credit risk. In particular, they will often not share the same
counterparty, credit enhancement arrangements, term, exposure to credit risk and even
contractual status. In addition to changes in the hedging instrument’s counterparty
credit risk, changes in the reporting entity’s own credit risk may also affect the fair value
of the hedging instrument in ways that are not replicated in the hedged item (see
Chapter 14 at 11.3).
For a fair value hedge, the implications of this requirement are clear. If there is a change
in the hedging instrument’s credit risk, the hedging instrument’s fair value will change,
but there is unlikely to be an offsetting change in fair value for the hedged item. This
will affect its effectiveness as measured. In most cases, credit risk in the hedged item
does not form part of the designated hedged risk (see 2.2 above) and so changes in fair
value of the hedged item due to credit risk will not provide any offset to changes in the
fair value of the hedging instrument due to its credit risk. However, as noted above,
even if credit risk is not part of the designated risk, if changes in the fair value of the
hedged item due to credit risk dominate the value changes in the hedge relationship,
then the hedge must be discontinued (see 8.3 below).
For a cash flow hedge, the implications might not immediately be so obvious. It is
relatively common for the measurement of ineffectiveness in a cash flow hedge to be
calculated using a hypothetical derivative (see 7.4.4.A above). Hence, the effect of
changes in the hedging instrument’s credit risk on the measurement of ineffectiveness
might be best explained in the context of a hypothetical derivative. The application
guidance of IFRS 9 states that when applying the hypothetical derivative method, one
cannot include features in the value of the hedged item that only exist in the hedging
instrument, but not in the hedged item. [IFRS 9.B6.5.5]. Arguably, both the hedged item
and the hedging instrument include credit risk. However, the credit risk in the hedged
item is likely to be different from the credit risk in the hedging instrument. This is true
even when the specific credit risk that exists in the hedged item is not included in the
hedge relationship as a benchmark interest rate has been designated as the hedged
risk (see 2.2 above).
Financial instruments: Hedge accounting 4105
Given the prohibition on reflecting terms in the hypothetical derivative that do not exist
in the hedged item, it is clear that, when using a hypothetical derivative for measuring
ineffectiveness in a cash flow hedge, the counterparty credit risk on the hedging
instrument should not, as a matter of course be deemed to be equally present in the
hedged item. [IFRS 9.B6.5.5]. For example, if the hedged item is a highly probable forecast
transaction it may not involve any credit risk at all, so that there is no offset for any
credit risk affecting the fair value of the hedging instrument. This would give rise to
some ineffectiveness recorded in profit or loss.
The impact will be more pronounced where the hedging instrument is longer term, has
a significant fair value and there exist no other credit enhancements such as collateral
agreements or credit break clauses.
Nowadays, most over-the-counter derivative contracts between financial institutions are
cash collateralised. Furthermore, current initiatives in several jurisdictions, such as, the
European Market Infrastructure Regulation (EMIR) in the European Union or the Dodd-
Frank Act in the United States, have resulted in more derivative contracts being
collateralised by cash. Cash collateralisation significantly reduces the credit risk for both
parties involved (see 8.3.2.A below). Accordingly the residual credit risk to these cash
collateralised derivatives are much less likely to be a significant source of ineffectiveness.
7.4.7
Interest accruals and ‘clean’ versus ‘dirty’ values
When measuring ineffectiveness in hedge relationships for which the designated
hedging instruments is an interest rate swap or similar, fair value ‘noise’ is often
generated between the dates on which the variable leg is reset to market. The payments
on an interest rate swap are typically established at the beginning of a reset period and
paid at the end of that period. Betwee
n these two dates the swap is no longer a pure
pay-fixed receive-variable (or vice versa) instrument because both the next payment
and the next receipt are fixed. Accordingly, the corresponding changes in the fair value
of the hedged item (e.g. fixed rate debt) will not strictly mirror that of the swap. This
problem becomes more acute the less frequently variable interest rates are reset to
market rates.
This ‘noise’ is unlikely to be significant enough to influence whether there is an
economic relationship or not, especially where the interval between re-pricings is
frequent enough, e.g. quarterly rather than yearly, so as to minimise the changes in fair
value from the fixed net settlement or next interest payment (see 6.4.1 above). However,
ineffectiveness should always be measured and recognised in profit or loss (see 7.4
above). This ineffectiveness is likely to be more significant when interest rates are more
volatile, as experienced by a number of entities during the ‘credit crunch’ starting in the
second half of 2007.
7.4.8
Effectiveness of options
It was explained at 3.6.4 above that the time value of an option may be excluded from
the hedge relationship and, in many cases, this may make it easier to demonstrate an
expectation of offset from changes in the hedged item and the hedging instrument
(see 6.4.1 above). In such cases, if the documented hedged risk is appropriately
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customised there will, in many cases, be very little ineffectiveness to recognise (other
than that arising from changes in credit risk), as set out in the following example.
Example 49.70: Out of the money put option used to hedge forecast sales of
commodity
Company A expects highly probable forecast sales of 100 tonnes of commodity X in 6 months’ time. The
current unit price of commodity X is £100 per tonne. To partially protect itself against a decrease in the price
of the commodity, A acquires a put option, which gives it the right to sell 100 tonnes of commodity X at £90
per tonne. Company A’s objective is only to provide protection for price changes below £90 per tonne, and
such a strategy is often referred to as a hedge of a one-sided risk. [IFRS 9.B6.3.12].