Chapter 12 Financial instruments: hedge accounting Flashcards
1.1 Objective of hedging
Hedging is a risk management strategy to reduce fluctuations in the value of specific assets and liability or the entity as a whole. Mismatches can occur, so IFRS 9 Financial instruments seek to overcome this.
2.1 The hedged item
There are three elements to a hedge: hedged item, hedging instrument and the hedged risk.
The hedged item is the item that generates the risk, there are three types:
- A recognised asset/liability: recognised on SFP and the entity protecting its value
- Unrecognised firm commitment: transaction not yet recognised in the SFP but there is a binding agreement for the exchange of resources at a price at a future date
- Highly probable forecast transaction: highly probable a transaction will take place. Entity is trying to protect itself from movements in the future cash flows
2.2 The hedging instrument
Hedging instruments are usually derivatives entered into in order to offset the risk generated by a hedged item. Non-derivatives can be used if the conditions for hedge accounting are still satisfied.
2.3 The hedged risk
An entity can hedge against the following risks: currency risks, market risk, interest rate risk, credit risk and liquidity risk.
3.1 Criteria for hedging
In order to hedge account certain criteria needs to be met. The hedging relationship consists only of eligible hedging instruments and eligible hedged items. An entity that chooses to hedge account must document the following at inception:
- The hedged item: the asset, liability, commitment or highly probable forecast transaction that exposes the entity to fair value or cash flow changes
- The hedging instrument: the derivative whose fair value or cash flow changes are expected to offset those of the hedged item
- The risk that the entity is hedging against
Hedge accounting can only be used if the hedging relationship meets all effectiveness requirements. According to IFRS 9 a hedge is effective if:
- There is an economic relationship between the hedged item and the hedging instrument
- Credit risk does not dominate the value changes that result from the relationship between the hedged item and the hedging instrument
- The hedge ratio is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item
4.1 Hedge accounting
There are three types of hedge:
- Fair value hedge: hedging the exposure to change in FV of a recognised asset/liability
- Cash flow hedge: hedging exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset/liability or a highly probable forecast transaction which could affect profit/loss
- Hedge of a net investment in a foreign operation
4.2 Fair value hedge
At reporting, an entity must assess whether the FV hedge has met the hedge criteria. If so, normal accounting rules are over-ridden and FV hedge accounting rules are applied. Both the hedged item and instrument are adjusted for changes in FV that have arisen since the inception of the hedge. Any gains and losses are recognised in profit/loss in most cases. But OCI if the hedged item is an investment in equity measured at FVOCI.
Any gain on the hedged item and any loss on the hedging instrument (or vice-versa) will largely be offset in either profit or loss or OCI meaning volatility is reduced.
Using options are hedging instruments: options require upfront payment in a premium. This means the options would be unlikely to qualify for hedge accounting. IFRS 9 allows us to overcome this, by designating only the intrinsic value of the option as the hedging instrument (FV of option = intrinsic value + time value). This is accounted for as follows:
- The change in the intrinsic value of the option is treated as the hedging instrument and accounted for using the hedging rules
- The change in the time-value of the option is recognised in OCI
4.3 Fair value of unrecognised firm commitments
The movement in the FV of the item must be recognised in profit or loss. This results in either:
- Unrecognised firm commitment payable if the movement is unfavourable, or
- Unrecognised firm commitment receivable if the movement is favourable
4.4 Cash flow hedge
At reporting, an entity must assess whether the cash flow hedge meets the hedge accounting criteria. If so, normal accounting rules are over-ridden and cash flow hedge accounting rules apply.
Under a cash flow hedge, the hedging instrument is adjusted for changes in FV that have arisen since the inception of the hedge. No entries are posted in respect of the hedged item (cash flow not occurred yet). The gain or loss arising on the hedging instrument will be recorded in OCI and taken to reserves.
However if the gain or loss is of the hedge is greater than the gain/loss on the hedged item, then the excess gain or loss on the instrument is recognised in profit or loss. The balance in reserves is released and set-off against the cash flow when it occurs. Either against the cost of a non-financial asset or to the profit/loss for a financial asset.
4.5 Ineffectiveness of a cash flow hedge
The ineffective portion of the hedge must be recognised in profit or loss. If the gain or loss of the instrument is larger than the change in fair value of the hedged item, it is over-hedged and the ineffective element goes to the SPL. If the change in FV of the hedged item is larger than the gain or loss on the instrument, it is under-hedged and the whole movement goes to reserves.
4.6 Net investment hedge
Only used in group accounting. It usually arises when a parent company buys a foreign subsidiary and is concerned with exchange rate risk. The parent takes out a foreign loan of the same currency, so movements in the loan offset the movements in the investment. The hedged item is the amount of the entity’s interest in the opening assets of the operation plus goodwill. The instrument is usually a foreign loan.
IFRS 9 states that net investment hedges should be accounted for similarly to cash flow hedges. The portion of the gain or loss on the instrument that is an effective hedge is recognised in OCI and the ineffective element recognised in SPL.
5.1 Swaps and hedge accounting
A swap is an agreement whereby two parties agree to swap a floating system of interest payments for a fixed stream of interest payments and vice versa. There is no exchange of principal.
Swapping from fixed
variable (FV hedge)
Swapping from variable to fixed (cash
flow hedge) Hedged item: The fair value of the
fixed rate loan
The future payments on the loan Hedged risk: If variable interest rates
decrease, then the FV of a fixed
rate loan increases
If variable interest rates increase
then the future interest
payments will rise Hedging instrument: Swap – if interest rates
fall, then the swap will have
a gain as the entity will have benefitted
from swapping into a variable rate
Swap – if interest rates rise, then
the swap will have a gain as the
entity will have benefitted from
swapping into a fixed rate
7.1 Discontinuing hedge accounting
An entity shall discontinue hedge accounting prospectively only when the hedging relationship ceases to meet the qualifying criteria. This includes instances when the hedging instrument expires or is sold, terminated or exercised.
8.1 Audit and assurance implications of hedging financial instruments
Risks Tests/procedures
Inherently complex, could lead to a lack of management understanding Confirm audit team have adequate experience and skill with IFRS 9 Financial Instruments. Increase level of review of audit work. Assess the risks associated with these transactions as part of the risk procedures of the audit and ensure there is a strong control environment in place at the entity. Perform a test of controls in this area. Discuss with management the company’s hedging strategy
Hedge accounting may be used when criteria not satisfied. For future cash flows assessed as highly probable: consider previous transactions and likelihood of repetition, obtain a management representation regarding future intentions, confirm to post year-end cash flows where cash flow was forecast before completion of audit.
At interim and final audits inspect documentation to confirm hedge was documented at inception.
Use analytical procedures to identify whether any patterns suggest manipulation. For any documented hedge, review the nature of the hedged item and instrument to determine whether there is a relationship between them and that the hedge is expected to be effective.
Hedge may be misclassified Review classification of hedges to ensure it is appropriate to the nature of the hedged item.
Incorrect accounting treatment Review entity’s working papers and recalculate. Agree fair values to quoted prices. Check movements on instruments have been recognised and classified correctly in the financial statements.
Incorrect disclosures Ensure disclosures comply with IFRS 7 Financial Instruments: Disclosures.
