International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards

by International GAAP 2019 (pdf)

  potential impact of credit risk on the global derivatives markets. In response to this,

  several jurisdictions have introduced, legal or regulatory requirements that require or

  incentivise over-the-counter (OTC) derivatives to be novated to a central clearing party

  (CCP). The CCP would usually require the derivatives to be collateralised, thereby

  reducing (potentially significantly) the counterparty credit risk.

  Financial instruments: Hedge accounting 4135

  Following an urgent request, the IFRS Interpretation Committee concluded in

  January 2013 that an entity is required to discontinue hedge accounting where an

  OTC derivative that is designated as hedging instrument in a hedging relationship is

  novated to a CCP (unless, very unusually, the novation represented a replacement

  or rollover of the hedging instrument as part of a documented hedging strategy). This

  is because the novated derivative is derecognised and the new derivative contract,

  with the CCP as a counterparty, is recognised at the time of the novation. However,

  if the new derivative was designated in a cash flow hedge relationship accounting

  ineffectiveness would likely arise if the derivative is off market (see 7.4.4.B above).

  Consequently, the Interpretations Committee decided to recommend that the IASB

  make a narrow-scope amendment to IAS 39 to permit continuation of hedge

  accounting in such narrow circumstances.19 In July 2013 the IASB amended IAS 39

  after the publication of an exposure draft in February 2013 and the changes were

  also incorporated in IFRS 9 when the hedge accounting chapter was added

  in Novemeber 2013.

  The relevant guidance in IFRS 9 states that an expiration or termination of the hedging

  instrument does not require discontinuation of the hedge relationship if:

  • as a consequence of changes in laws or regulations, the original counterparty to the

  hedging instrument is replaced by a clearing counterparty (sometimes called a

  ‘clearing organisation’ or ‘clearing agency’) or a clearing member of a clearing

  organisation or a client of a clearing member of a clearing organisation, that are

  acting as counterparty in order to effect clearing by a central counterparty, and

  • each of the original counterparties to the hedging instrument effects clearing with

  the same central counterparty; and

  • other changes, if any, to the hedging instrument are limited to those that are

  necessary to effect such a replacement of the counterparty. Such changes are

  limited to those that are consistent with the terms that would be expected if the

  hedging instrument were originally cleared with the clearing counterparty. These

  changes include changes in the collateral requirements, rights to offset receivables

  and payables balances, and charges levied. [IFRS 9.6.5.6].

  It can be seen from the guidance e that the exception applies to some, but not all,

  voluntary novations to a CCP. In order for hedge accounting to continue, a voluntary

  novation should at least be associated with laws or regulations that are relevant to

  central clearing of derivatives. For example, a voluntary novation could be in

  anticipation of regulatory changes. However, the mere possibility of laws or regulations

  being introduced is not, in the view of the IASB, a sufficient basis for continuation of

  hedge accounting. [IAS 39.BC220O-BC220Q].

  Further, the exception applies to so-called ‘indirect clearing’ arrangements whereby a

  clearing member of a CCP provides an indirect clearing service to its client or where a

  group entity is clearing on behalf of another entity within the same group since they are

  consistent with the objective of the amendments. [IAS 39.BC220R, BC220S].

  4136 Chapter 49

  The other criteria for achieving hedge accounting will still need to be met in order to

  continue hedge accounting (see at 6 above).

  8.3.2.B

  The impact of the introduction of settle to market derivatives on cash

  flow hedges

  In December 2015, the London Clearing House (LCH) changed its rule book to

  introduce a new type of settled-to-market (STM) interest rate swap in addition to the

  previously existing collateralized-to-market (CTM) swaps.

  In the existing CTM model, transactions cleared through LCH are subject to daily

  cash variation margining. This means that the replacement value of the trade is in

  effect paid or received as cash each day and there is no ability to recover any of

  the variation margin unless the fair value of the interest rate swap changes. In

  addition, the variation margin is also used to settle the periodic swaps payments,

  and, in case of early settlement, the variation margin is used to settle the

  outstanding derivative position. Interest is paid on the variation margin based on a

  risk free overnight rate.

  In the new STM model, transactions have the same economic exposure and overall

  cash flows as in the CTM model, except that the previous daily variation margin is

  now treated as a settlement of the interest rate swap’s outstanding fair value. While

  the swap is gradually settled, it remains the same swap with the same original terms

  (e.g. the fixed rate, maturity date etc.). In order to maintain the same economics, a new

  feature of the STM swap pricing is the Price Alignment Interest (PAI) that essentially

  replicates what would have been the interest on the collateral for a CTM swap into

  the STM swap pricing.

  The introduction of the new STM swaps was primarily driven by the potentially

  different regulatory treatment they attract and at first sight it may appear that the

  accounting impact is limited since the existing CTM swap replacement values and

  related cash collateral are already normally offset in the statement of financial position.

  There are however some important accounting considerations if swaps designated in

  on-going hedging relationships are migrated from the CTM model to the STM model.

  The first question that arises is whether the change results in the de-designation of the

  existing hedge relationship and hence the need to re-designate a new hedging

  relationship with a derivative that is now likely to have a non-zero fair value (and so

  give rise to ineffectiveness if designated in a cash flow hedge). We consider that the

  amendment of each swap from being CTM to STM is not a substantial modification and

  so does not result in derecognition of one swap and the recognition of another.

  Accordingly, we believe that there is no requirement to de-designate the existing

  hedging relationship. The second question that arises is how the PAI should be

  considered in the hedge effectiveness measurement and whether any hypothetical

  derivative can be assumed to reflect these new terms (see 7.4.4.A above). No consistent

  interpretation of the accounting requirements has yet emerged with respect to the

  measurement of ineffectiveness from the PAI. This is an area where we expect practice

  to continue to evolve.

  Financial instruments: Hedge accounting 4137

  8.3.2.C

  The replacement of IBOR benchmark interest rates

  Due to various regulatory changes and political events such as the probable end of IBOR

  benchmark interest rates, the departure of the UK from the European Union (‘Brexit’) and

 
; the ‘ring fencing’ of certain activities of banks, how these might all affect cash flow hedge

  accounting has been the subject of discussion. Entities could find that the counterparty to

  some of their existing hedging derivatives may change to a different legal entity within an

  existing banking group, as banks make their preparations for Brexit or compliance with

  ring fencing regulations. In these circumstances, the entity will need to conclude whether

  such a change in counterparty would require discontinuation of the existing hedge

  relationship and its replacement with a new one.

  As a result of the reforms mandated by the Financial Stability Board following the Financial

  Crisis, regulators are pushing for IBOR to be replaced by new ‘official’ benchmark rates,

  known as Risk Free Rates (RFRs). For instance, in the UK, the new official benchmark will

  be the reformed Sterling Overnight Interest Average (SONIA) and banks will no longer be

  required to quote LIBOR beyond the end of 2021. Such a change will necessarily affect

  future cash flows in both contractual floating rate financial instruments currently

  referenced to IBOR, and highly probably forecast transactions for which IBOR is

  designated as the hedged risk. This raises a number of accounting questions, many of which

  relate to hedge accounting. A key question is whether such future IBOR cash flows remain

  highly probable if it is know that IBOR will not exist in its current form beyond the end of

  2021 (or the equivalent date for other jurisdictions) (see 2.6.1 above).

  On 20 June 2018, the IASB, noting the urgency, decided to add a research project to its

  active research programme.20 However, this is unlikely to result in any amendments to

  the standards, if any are made, for the best part of a year.

  We believe that, as at the date of writing, it is possible to consider that IBOR is still a

  component of variable interest rates in the context of the market structure and that IBOR

  and RFR interest rates are equivalent for the purposes of cash flow hedge accounting.

  8.3.3

  Disposal of a hedged net investment

  When a foreign operation that was hedged is disposed of, the amount reclassified from

  the foreign currency translation reserve to profit or loss is as follows:

  • in respect of the hedging instrument in the consolidated financial statements, the

  cumulative gain or loss on the hedging instrument that was determined to be an

  effective hedge (see 7.3.1 above). [IFRIC 16.16].

  • in respect of the net investment, the cumulative amount of exchange differences

  relating to that foreign operation. [IAS 21.48, IFRIC 16.17].

  If an intermediate parent exists within the ultimate consolidation group, there is a choice

  of applying either the direct or step-by-step method of consolidation (see Chapter 15

  at 6.1.5 and at 6.6). If the step by step method of consolidation is used, the cumulative

  amount of exchange differences relating to that foreign operation accumulated in the

  foreign currency transaction reserve could be different to the equivalent amount had the

  direct method of consolidation been applied. This potential difference in the accounting

  outcome on disposal of a foreign operation is illustrated in Example 49.84 below.

  4138 Chapter 49

  This difference in accounting treatment could be eliminated, but there is no

  requirement to do so. An accounting policy choice must be taken as to whether the

  difference is eliminated or not, and such a choice must be applied consistently on

  disposal of all net investments. [IFRIC 16.17].

  Example 49.84: Disposal of foreign operation

  Based on the same facts as in Examples 49.46 and 49.47 at 5.3.1 and 5.3.2 above, the group has designated

  US$300 million of the US dollar borrowings of A as a hedge of the net investment in C with the risk being

  the spot foreign exchange exposure (€/US$) between P and C. If C were disposed of, the amounts reclassified

  to profit or loss in P’s consolidated financial statements from its foreign currency translation reserve would

  be: [IFRIC 16.17, AG8]

  • in respect of A’s borrowing (the hedging instrument), the total change in value in respect of foreign

  exchange risk that was recognised in other comprehensive income as the effective portion of the hedge

  (i.e. the retranslation effect on the US$300 million borrowing with respect to the EUR/USD foreign

  exchange rate since initial designation); and

  • in respect of the net investment in C, the amount determined by the entity’s consolidation method:

  • If P uses the direct method, its foreign currency translation reserve (‘FCTR’) in respect of C will

  be determined directly by the EUR/USD foreign exchange rate.

  • If P uses the step-by-step method, its FCTR in respect of C will be determined by the FCTR

  recognised by B reflecting the GBP/USD foreign exchange rate, translated to P’s functional

  currency using the EUR/GBP foreign exchange rate.

  P’s use of the step-by-step method for consolidation in prior periods does not require it to or preclude it

  from determining the amount of FCTR to be reclassified when it disposes of C to be the amount that it

  would have recognised if it had always used the direct method. However, it is an accounting policy

  choice which should be followed consistently on disposal of all net investments.

  9 PRESENTATION

  For a comprehensive overview of the financial instruments related presentation

  requirements of IFRS 7 – Financial Instruments: Disclosures – see Chapter 50. We

  present below only some of the key requirements for hedge accounting.

  IFRS 9 includes plenty of guidance as to when gains and losses from hedge accounting

  should be recognised in the profit or loss. The standard is much more imprecise as to

  where in the profit or loss such gains and losses should be presented. However it can be

  inferred that gains and losses from hedging instruments in hedging relationships would

  be presented in the same line item that is affected by the hedged item (at least to the

  extent the hedge is effective) rather than being shown separately, although this is not

  explicitly stated in IFRS 9 (see Chapter 50 at 7.1.3).

  The IFRS Interpretations Committee clarified in March 2018 that only interest on

  financial assets measured at amortised cost or on debt instruments measured at fair

  value through other comprehensive income should be included in the amount of

  interest revenue presented separately for items calculated using the effective interest

  method (see Chapter 50 at 7.1.1). [IAS 1.82(a)]. At this meeting it was also concluded that

  the separate interest revenue line would encompass any effect of a qualifying hedging

  relationship applying the hedge accounting requirements. 21

  Financial instruments: Hedge accounting 4139

  9.1 Cash

  flow

  hedges

  IFRS 9 requires that those amounts accumulated in the cash flow hedging reserve shall

  be reclassified from the cash flow hedge reserve as a reclassification adjustment in the

  same period or periods during which the hedged future cash flows affect profit or loss.

  The guidance provides as an example of the period over such a reclassification should

  occur as the ‘periods that interest income or interest expense is recognised’ (see 7.2.2

  above). [IFRS 9.6.5.11(d)(ii)]. This clarifies
that entities cannot simply account for the net

  interest payment on an interest rate swap straight into profit or loss but would have to

  present this as a reclassification adjustment between OCI and profit or loss. There is a

  requirement to disclose reclassification adjustments in the statement of comprehensive

  income (see Chapter 50 at 7.2). [IAS 1.92].

  If the hedged transaction subsequently results in the recognition of a non-financial item,

  the amount accumulated in equity is removed from the separate component of equity

  and included in the initial cost or other carrying amount of the hedged asset or liability.

  This accounting entry, sometimes referred to as ‘basis adjustment’, does not affect OCI

  of the period.

  A similar approach would equally apply to situations where the hedged forecast

  transaction of a non-financial asset or non-financial liability subsequently becomes a

  firm commitment for which fair value hedge accounting is applied.

  For any other cash flow hedges, the amount accumulated in equity is reclassified to profit

  or loss as a reclassification adjustment in the same period or periods during which the

  hedged cash flows affect profit or loss. This accounting entry does affect OCI of the period

  and should be disclosed as a reclassification adjustment in OCI. [IFRS 9.6.5.11(d), IAS 1.92].

  9.2

  Fair value hedges

  Entities recognise the gain or loss on the hedging instrument in profit or loss and adjust

  the carrying amount of the hedged item for the hedging gain or loss with the adjustment

  being recognised in profit or loss (see 7.1.1 above).

  For hedged items that are debt instruments measured at fair value through OCI in

  accordance with paragraph 4.1.2A of IFRS 9 (see Chapter 46 at 2.3), the gain or loss on

  the hedged item results in recognition of that amount in profit or loss rather than

  accumulating in OCI. This means fair value hedge accounting changes the presentation

  of gains or loss on the hedged item, but the measurement of the debt instrument at fair

  value remains unaffected. [IFRS 9.6.5.8(b)].

  For hedged items that are equity instruments for which an entity has elected to present

  fair value changes in OCI without subsequent reclassification to profit or loss, the

  accounting for a fair value hedge is different because it does not affect profit or loss but,