foreign exchange forward contracts, but applies equally to forward contracts with
respect to other risks, such as commodity or interest rate. [IFRS 9.BC6.416]. We would also
expect the treatment to apply to a fixed-for-fixed currency swap as arguably that is no
more than a series of forward contracts applying a blended rate.
Just like for the accounting for the time value of an option, the accounting for the
forward element as a cost of hedging applies only to the extent of the so-called ‘aligned’
forward element (i.e. only to the extent that the forward element relates to the hedged
item – see 7.1.2 above). [IFRS 9.B6.5.37]. We believe it is acceptable for the type of aligned
instrument to match that of the actual instrument where that makes sense, for example
if a fixed-for-fixed cross currency swap is the hedging instrument it is likely to be
acceptable for the aligned instrument to also be a fixed-for-fixed cross currency swap.
The above discussion focuses on the costs of hedging accounting where the forward
element is excluded from the hedging instrument. It should be noted that most foreign
exchange instruments also include foreign currency basis spreads which can also be
excluded from hedging instruments (see 7.5.3 below).
7.5.2.A
Forward element of forward contracts in a net investment hedge
It is possible to designate the forward rate as the hedged risk in a net investment hedge
(see 7.3.3 above), but for some entities it may be preferable to designate only the spot
rate, so a question arises as to the accounting treatment of the excluded forward element
in a net investment hedge. The costs of hedging guidance (see 7.5 above) is not specific
to a particular type of hedge relationship, accordingly it can be applied to fair value,
cash flow and net investment hedges (see 5 above). In fact, the application guidance to
IFRS 9, includes a net investment hedge as an example of a fact pattern for which the
costs of hedging accounting could be applied. The example given is of a time-related
hedge: a net investment that is hedged for 18 months using a foreign-exchange option,
which would result in allocating the time value of the option over that 18 month period.
[IFRS 9.B6.5.29(b)]. This guidance also confirms that for the purposes of accounting for the
costs of hedging, a hedge of a net investment would ordinarily be treated as time-period
related hedge, in particular as in most cases there is no expectation of a hedged
transaction (see 7.5.1 above).
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The application of the costs of hedging guidance to the excluded forward element of a
forward contract is not an accounting policy choice, but an election for each
designation. [IFRS 9.6.5.16]. If the costs of hedging guidance is not applied, designating the
spot element of a forward contract in a net investment hedge results in the forward
element being accounted for at fair value through profit or loss (see 3.6.5 above).
The costs of hedging accounting can only be applied to the extent that it relates to the
hedged item, this is achieved by comparison with an ‘aligned hedging instrument’
(see 7.5.1.A above). [IFRS 9.6.5.15]. The aligned hedging instrument should match the
critical terms of the hedged item. [IFRS 9.B6.5.36]. Where the hedged item is a financial
instrument or a forecast transaction for which specific terms exist, determining the
aligned hedging instrument is relatively straight forward. However given that a net
investment hedge is largely an accounting concept, identifying appropriate terms for an
aligned hedging instrument is more judgemental. Given that it is possible to designate
the forward rate as the hedged risk in a net investment hedge and assess effectiveness
using a hypothetical forward contract (see 7.3.3.A above), it is relatively easy to conclude
that an aligned hedging instrument for a net investment hedge could similarly be a
simple forward. It is harder to conclude that a cross currency swap for which there are
periodic settlements is an aligned instrument that matches the critical terms of the
hedged net investment (see 7.3.3.B above).
Although the above analysis focuses on accounting for any excluded forward element in a
net investment hedge, it is also relevant to foreign currency basis spreads (see 7.5.3 below).
7.5.3
Foreign currency basis spreads in financial instruments
The foreign currency basis spread, a phenomenon that became very significant during
the financial crisis, is a charge embedded in financial instruments that compensates for
aspects such as country and liquidity risk as well as demand and supply factors. This
charge only applies to transactions involving the exchange of foreign currencies at a
future point in time (as, for example, in currency forward contracts or cross currency
interest rate swaps (CCIRS)).
Historically, the difference between the spot and forward prices of currency forward
contracts and CCIRS represented the differential between the interest rates of the two
currencies involved. However, basis spreads increased significantly during the financial
crisis and during the subsequent sovereign debt crisis, and have become a significant
and volatile component of the pricing of longer term forward contracts and CCIRS.
The standard cites currency basis spread as an example of an element that is only
present in the hedging instrument, but not in a hedged item that is a single currency
instrument. Consequently, this would result in some ineffectiveness even when using a
hypothetical derivative for measuring ineffectiveness (see 7.4.4.A above). [IFRS 9.B6.5.5].
When using a foreign currency forward contract or a CCIRS in a hedge, the foreign currency
basis spread is an unavoidable ‘cost’ of the hedging instrument. Hence IFRS 9 permits the
accounting for foreign currency basis spreads as a ‘cost of hedging’, similar to the time value
of options and the forward element of forward contracts.17 This means that, when
designating a hedging instrument, an entity may exclude the foreign currency basis spread
and account for it separately in the same way as the accounting for time value of options or
the forward element of the forward rate, as described in 7.5.1 and 7.5.2 above. [IFRS 9.6.5.16].
Financial instruments: Hedge accounting 4117
Consistent with the approach to designation of the forward element as a cost of hedging,
designation of foreign currency basis as a cost of hedging is not an accounting policy
choice, but an election for each designation. However, if an entity designates the entire
hedging instrument, fair value changes due to changes in the foreign currency basis
spread would result in some ineffectiveness.
It may be the case for some hedging instruments that contain both a forward element
and foreign currency basis that it is more operationally efficient to designate only the
spot risk and calculate the combined cost of hedging, rather than the forward element
and foreign currency basis individually or designating the forward rate and excluding
only the foreign currency basis spread. The standard does not explicitly permit a
combined treatment, but for many scenarios the aggregate of the individual costs of
hedging accounting will equate to the costs of hedging accounting calculated on a
/> combined basis.
7.5.3.A
Measurement of the costs of hedging for foreign currency basis spread
Although the standard is clear that the ‘costs of hedging’ accounting method can be applied
to the foreign currency basis spread within hedging instruments, it is less clear as to how to
identify the foreign currency basis spread for this purpose. This is an area where we expect
practice to evolve. We outline below two possible approaches for the identification of the
foreign currency basis spread; other acceptable approaches may exist:
Approach 1: Based on the difference between the fair value of the actual foreign
currency hedging instrument and the value of a hypothetical instrument derived and
valued using market data excluding foreign currency basis spread.
Approach 2: Based on the difference between the fair value of the actual foreign
currency hedging instrument and its value calculated using market data excluding
foreign currency basis spread.
Example 49.76: Calculation of the value of foreign currency basis spread
Entity A has functional currency of GBP and issued three year USD100m fixed rate debt on 31/12/19, paying
a semi-annual coupon of 3.75%. In order to eliminate variability in the fair value of the debt with respect to
interest rate and foreign currency risk, Entity A transacted a foreign currency swap (Swap A) on the same
day as follows:
Pay leg – GBP 64.2m paying 6m LIBOR +2.757% (semi-annual) maturing on 31/12/22
Receive leg – USD100m paying 3.75% (semi-annual) maturing on 31/12/22
The spread of 2.757% on the GBP floating leg includes an amount of –0.103% that represents the foreign
currency basis spread priced into the swap contract. (Quoted prices for foreign currency basis spreads for
many currency pairs are widely available.)
Entity A designates the debt and Swap A in a fair value hedge of foreign currency and interest rate risk, and
wishes to apply the costs of hedging approach to the foreign currency basis spread. The hedge appears to be
a time-period related hedge (see 7.5.1 above).
The receive leg of Swap A matches the cash flows from the debt exactly. As the critical terms of the foreign
currency basis swap are aligned with the hedged debt, there is no need to create an aligned foreign currency
basis swap (see 7.5.1.A above). For the purposes of this example no other valuation sources of ineffectiveness
arise, although this is unlikely to be the case in practice.
Below are two possible approaches to calculating the value of the foreign currency basis spread to be
recognised in other comprehensive income as part of the costs of hedging:
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Approach 1 – Swap B
Entity A creates hypothetical Swap B. The receive leg of Swap B should exactly match the receive leg of
Swap A (which also matches the debt). The pay leg of Swap B should be derived to achieve an overall zero
fair value for Swap B on designation, based on market curves, excluding foreign currency basis spread.
Accordingly, Swap B might look like the following:
Pay leg – GBP 64.2m paying 6m LIBOR +2.86% (semi-annual) maturing on 31/12/22
Receive leg – USD100m paying 3.75% (semi-annual) maturing on 31/12/22
(The spread of 2.86% on the GBP floating leg does not include an amount representing foreign currency basis spread.)
The accounting for the hedge relationship would be as follows:
Instrument
Fair value on Accounting
designation
Debt
nil
Value changes due to foreign currency and interest rate risk (using
discount curves that do not reflect foreign currency basis spread) are
recognised in profit or loss, and adjust the carrying value of the debt.
(The recognised changes in value of the debt will be offset by changes
in the fair value of Swap B’s receive leg.)
Swap B
nil
Changes in fair value due to foreign currency and interest rate risk
(hypothetical
(using discount curves that do not reflect foreign currency basis
swap)
spread) are recognised in profit or loss.
Swap A
nil
Changes in fair value of Swap A (i.e. using discount curves that
(actual swap)
reflect foreign currency basis spreads) LESS the calculated changes
in the fair value of Swap B, are recognised in other comprehensive
income as the costs of hedging.
In the statement of financial position, Swap A is recognised at its fair
value at all times.
Other
As the fair value of the foreign currency basis spread is zero at
comprehensive
inception, there is no requirement for a systematic and rational
income
amortisation of the costs of hedging from other comprehensive
income into profit or loss. [IFRS 9.6.5.15(c)].
The value of the foreign currency basis spreads at inception (nil)
equals the initial fair value of Swap A (nil) less the initial fair value
of Swap B (nil).
Approach 2 – Swap C
Entity A creates hypothetical Swap C. The terms of Swap C exactly match the terms of Swap A, but Swap C
would be fair valued based on market curves excluding foreign currency basis spread. (It should be noted that
the receive leg of Swap C in this example also matches the debt). Swap C will have a fair value on designation
which is equal to the net present value of the foreign currency basis spread included within the GBP pay leg
(e.g. a negative spread of 0.103% in this example). Accordingly Swap C will look like the following:
Pay leg – GBP 64.2m paying 6m LIBOR +2.757% (semi-annual) maturing on 31/12/22.
Receive leg – USD100m paying 3.75% (semi-annual) maturing on 31/12/22
The fair value of Swap C on designation is an asset of £132k, this is calculated using market curves excluding
foreign currency basis spread.
Financial instruments: Hedge accounting 4119
The accounting for the hedge relationship would be as follows:
Instrument
Fair value on Accounting
designation
Debt
nil
Value changes due to foreign currency and interest rate risk (using
discount curves that do not reflect foreign currency basis spread) are
recognised in profit or loss, and adjust the carrying value of the debt.
(The recognised changes in value of the debt will be offset by
changes in the fair value of Swap C’s receive leg.)
Swap C
£132k DR
Changes in fair value due to foreign currency and interest rate risk
(hypothetical
(using discount curves that do not reflect foreign currency basis
swap)
spread) are recognised in profit or loss.
Swap A
nil
Changes in fair value of Swap A (i.e. using discount curves that
(actual swap)
reflect foreign currency basis spreads) LESS the calculated changes
in the fair value of Swap C, are recognised in other comprehensive
income as the costs of hedging.
In the statement of financial position, Swap A is recognised at its fair
value at all times.
Other
The value of the foreign currency basis spread at inception must be
comprehensive
&
nbsp; amortised from other comprehensive income into profit or loss on a
income
systematic and rational basis. [IFRS 9.6.5.15(c)].
The value of the foreign currency basis spread at inception (GBP
132k CR) is the initial fair value of Swap A (nil) less the initial fair
value of Swap C (GBP 132k DR).
Over the life of the hedge relationship the cumulative amortisation
will result in the following:
DR other comprehensive income GBP 132k
CR profit or loss GBP 132k
The above fact pattern assumes that there are no sources of ineffectiveness and that the
hedging derivative exactly matches the critical terms of the hedged item. In reality this
is unlikely to always be the case, therefore additional complexity may need to be
incorporated into the chosen approach for identifying the foreign currency basis spread.
In particular where the critical terms of the hedging derivative do not match those of
the hedged item, it is the aligned foreign currency basis spread which is eligible for the
costs of hedging treatment. In that case swap A, B and C (above) should be based on an
aligned foreign currency derivative, i.e. one that would perfectly match the hedged item.
Differences in fair value changes between the actual foreign currency derivative and the
aligned foreign currency derivative will be an additional source of ineffectiveness
(see 7.5.2 above). [IFRS 9.B6.5.37].
Although quoted prices for foreign currency basis spreads for many currency pairs are
widely available, entities should not underestimate the complexities involved in
eliminating the effect of foreign currency basis spreads from market forward foreign
currency rates which generally do reflect foreign currency basis spreads.
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7.6
Hedges of a firm commitment to acquire a business
A firm commitment to acquire a business in a business combination cannot be a hedged
item, except for foreign exchange risk (see 2.6.4 above).
Consider the situation where an entity with euro as its functional currency enters into a
binding agreement to purchase a subsidiary in six months. The subsidiary’s functional
currency is the US dollar. The consideration is denominated in US dollars and is payable
in cash. The entity decides to enter into a forward contract to buy US dollars for euros
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