Financial instruments: hedge accounting Flashcards
Objective of hedging
Many entities which are exposed to financial or other risks use derivatives or other
instruments to mitigate or reduce the impact of risks to profits, assets, liabilities or the
value of the firm as a whole. This is known as ‘hedging’.
Hedging is therefore a risk management strategy to reduce fluctuations in the value
of specific assets and liabilities or the entity as a whole.
When a company has used, for example, a derivative to hedge against the losses it
potentially faces there can be an accounting mismatch in that the gains and losses
on the derivative do not affect the profit or loss of the company in the same period as
the gains and losses that are being hedged against. Hedge accounting is a particular
set of rules laid out in IFRS 9 Financial Instruments that seeks to overcome this
mismatch.
IFRS 9 Financial Instruments has specific rules on how to account for a hedge,
although these are optional and are only allowed if the hedging arrangement
complies with certain criteria.
Components of a hedge
There are 3 elements to a hedge:
The hedged item
The hedging instrument
The hedged risk.
Components of a hedge 2.1 The hedged item (&3 types)
As per IFRS 9 Financial Instruments, the hedged item is the item that generates the
risk and what the entity is trying to protect. There are 3 types of hedged item:
A recognised asset or liability – this already exists in the statement of financial
position and the entity is trying to protect its value.
An unrecognised firm commitment – a transaction that is not yet recognised in
the statement of financial position but for which there is a binding agreement for
the exchange of a specified quantity of resources at a specified price on a
specified future date or dates.
A highly probable forecast transaction – the transaction has not yet happened
but it is highly probable that it will take place at some future point. The entity is
trying to protect itself from movements in the future cash flows.
Other points
A group of assets can be hedged if they have similar risk characteristics, and
are managed together.
Components of a hedge 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
(see later) e.g. an overseas investment which is financed by an overseas loan – the
overseas loan is not a derivative but can be deemed to be a hedging instrument.
Components of a hedge 2.3 The hedged risk
The following are all types of risk the entity may choose to hedge against:
Currency risk e.g. movements in exchange rates
Market risk e.g. movements in commodity prices
Interest rate risk e.g. movements in interest rate
Credit risk e.g. risk of a customer bad debt
Liquidity risk e.g. risk of an entity being unable to pay suppliers.
Criteria for hedging
Hedge accounting is a choice, but to be able to hedge account, certain criteria need to be met:
‘The hedging relationship consists only of eligible hedging instruments and eligible hedged items.’ (IFRS 9, para 6.4.1)
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’. (IFRS 9, para 6.4.1)
Hedge accounting
How an entity accounts for hedging depends upon the type of hedge.
There are 3 types of hedge:
How an entity accounts for hedging depends upon the type of hedge.
There are 3 types of hedge:
‘Fair value hedge: a hedge of the exposure to changes in fair
value of a recognised asset or liability or an unrecognised
firm commitment …’ (IFRS 9, para 6.5.2)
‘Cash flow hedge: a hedge of the exposure to variability in
cash flows that is attributable to a particular risk associated
with … a recognised asset or liability (such as all or some
future interest payments on variable rate debt) or a highly
probable forecast transaction and could affect profit or loss.’
(IFRS 9, para 6.5.2)
‘Hedge of a net investment in a foreign operation …’ (IFRS 9,
para 6.5.2)
Note: ‘A hedge of the foreign currency risk of a firm
commitment may be accounted for as a fair value hedge
or a cash flow hedge.’ (IFRS 9, para 6.5.4)
Hedge accounting 4.1 Fair value hedge
At the reporting date, an entity must assess whether the fair value hedge has met the
hedge accounting criteria. If so, then normal accounting rules are over-ridden and fair
value hedge accounting rules are applied instead.
Under a fair value hedge, both the hedged item and the hedging instrument are
adjusted for the changes in fair value that have arisen since the inception of the
hedge.
Any gains and losses are recognised:
in profit or loss in most cases, but
in 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 that volatility is reduced.
Hedge accounting Using options as hedging instruments
Unlike other types of derivative, options do require a significant upfront payment
(premium). This means when we assess effectiveness on movements in fair value,
the options would be unlikely to qualify for hedge accounting.
IFRS 9 Financial Instruments recognises this problem and allows us to overcome it
by designating only the intrinsic value of the option as the hedging instrument.
(Note: Fair value of an 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 other
comprehensive income
Hedge accounting 4.3 Cash flow hedge
At the reporting date, an entity must assess whether the cash flow hedge meets the
hedge accounting criteria. If so, then normal accounting rules are over-ridden and
cash flow hedge accounting rules are applied instead.
Under a cash flow hedge, the hedging instrument is adjusted for the changes in fair
value that have arisen since the inception of the hedge. No entries are posted in
respect of the hedged item (as the cash flow has not yet occurred).
The gain or loss arising on the hedging instrument will be recorded in other
comprehensive income and taken to reserves.
However, if the gain or loss on the hedging instrument since inception
of the hedge is greater than the loss or gain on the hedged item, then
the excess gain or loss on the hedging 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
profit or loss for a financial asset.
Hedge accounting 4.2 Fair value hedges of unrecognised firm commitments
The movement in the fair value of the item (unrecognised firm commitment) must be
recognised in profit or loss. This results in either an:
unrecognised firm commitment payable if the movement is
unfavourable, or
unrecognised firm commitment receivable if the movement is
favourable.
Hedge accounting 4.4 Ineffectiveness of a cash flow hedge
As detailed above, the ineffective portion of the hedge must be recognised in profit or
loss.
If the gain or loss on the hedging instrument is larger than the change in fair value of
the hedged item, it is ‘over-hedged’ and the ineffective element has to go to the
statement of profit or loss.
If the change in fair value on the hedged item is larger than the gain or loss on the
instrument, it is ‘under-hedged’ and the whole movement goes to reserves.
Hedge accounting 4.5 Net investment hedge
A net investment hedge is only used in group accounting. It usually
arises when a parent company buys a foreign subsidiary and is
concerned about exchange rate risk. To hedge against this risk, the
parent takes out a foreign loan of the same currency, so that
movements in the loan will offset the movements in the investment.
The hedged item is the amount of the reporting entity’s interest in
the opening net assets of the operation at the commencement of
the hedging period plus goodwill.
The hedging instrument is usually, but does not have to be, a
foreign loan taken out to buy the investment.
IFRS 9 Financial Instruments states that net investment hedges should
be ‘accounted for similarly to cash flow hedges:
(a) the portion of the gain or loss on the hedging instrument that
is determined to be an effective hedge shall be recognised in
other comprehensive income, and
(b) the ineffective portion shall be recognised in profit or loss.’
(IFRS 9, para 6.5.13)
The gain or loss held in equity is reclassified to profit or loss
on disposal of the subsidiary.
Swaps and hedge accounting 5.1 What is a swap?
An agreement whereby two parties agree to swap a floating stream of interest
payments for a fixed stream of interest payments and vice versa. There is no
exchange of principal. The companies involved are termed ‘counterparties’.
The scenario
One company (A) wants to borrow at a fixed rate, but has been offered a relatively
good deal on a variable loan. Another company (B) wants to borrow at a variable
rate, but has been offered a relatively good deal on a fixed rate loan. Instead of the
companies borrowing as they would prefer:
A will borrow at a variable rate and B will borrow at a fixed rate.
B will make a variable interest payment to A and A will make a fixed interest
payment to B – thereby the companies effectively swap interest payments.
5.2 Hedge accounting scenarios for the CR exam interest rate swaps
Swapping from fixed to variable (FV hedge)
Hedged item
The fair value of the fixed rate loan.
Hedged risk
If variable interest rates decrease, then the FV of a fixed rate loan increases.
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.
Swapping from variable to fixed (Cash flow hedge)
Hedged item
The future interest payments on the loan.
Hedged risk
If variable interest rates increase then the future interest payments will rise.
Hedging instrument
Swap – if interest rates rise, then the swap will have a gain as the entity will have benefitted from swapping into a fixed rate.
