|
Criteria to achieve hedge accounting
Hedge accounting is an exception to the usual rules
for financial instruments. Therefore there are strict
criteria that must be met before it can be used.
Management must identify, document and test the
effectiveness of those transactions for which it
wishes to use hedge accounting. The specific requirements
are [IAS39R.88]:
| a) |
The hedged item
and the hedging instrument are specifically
identified; |
|
| b) |
The hedging relationship is formally documented; |
|
| c) |
The documentation of the hedged
relationship must identify the hedged risk and
how the effectiveness of the hedge will be assessed; |
|
| d) |
At the inception of the hedge,
the hedge must be expected to be highly effective; |
|
| e) |
The effectiveness of the hedge
must be tested regularly throughout its life.
Effectiveness must fall within a range of 80
to 125% over the life of the hedge. This leaves
some scope for short-term ineffectiveness, provided
that overall effectiveness falls within this
range; |
|
| f) |
One to one designation is normally
required between a single external asset, liability
or forecast transaction and a single external
derivative instrument; and |
|
| g) |
In the case of a hedge of a
forecast transaction, the forecast transaction
must be 'highly probable' |
The criteria to achieve hedge accounting are onerous
and will have systems implications for all entities.
Hedge accounting is optional and management should
always consider the costs and benefits when deciding
whether to use it.
Hedged items
Hedge accounting can be applied to qualifying hedged
items. A hedged item must create an exposure to
risk that could affect the income statement, currently
or in future periods. The usual types of risks that
are hedged include foreign currency risk, interest-rate
risk, equity-price risk, commodity price risk and
credit risk. Portfolio hedging, that is, hedging
the open position arising from a number of similar
hedged items, is difficult to achieve [IAS39R.76]
[IAS39R.83] . Designating a net open
position as a hedged item is not permitted [IAS39R.84]
[IAS39R.IG.F.2.21].
Any financial asset or liability that creates exposure
to risk can be a hedged item with two specific exclusions.
First, held-to-maturity investments cannot be hedged
items for interest-rate risk [IAS39R.79]. Second,
investments in subsidiaries or associates that are
consolidated or measured using the equity method
cannot be a hedged item in a fair value hedge [IAS39R.AG99].
However, the net investment in a foreign entity
can be hedged.
Some examples of common hedged items are:
| a) |
foreign currency
monetary item (risk of changes in foreign exchange
rate); |
|
| b) |
fixed interest debt security classified
as available for sale (risk of changes in
interest rates or credit risk); |
|
| c) |
highly probable forecast sale
or purchase in a foreign currency; and |
|
| d) |
originated loans (risk of changes
in interest rates). |
An exposure to general business risks cannot be
hedged, including risk of obsolescence of plant
or risk of unseasonable weather, because these risks
cannot be reliably measured. For similar reasons,
a commitment to acquire another entity in a business
combination cannot be a hedged item, other than
for foreign exchange risk [IAS39R.AG98].
Large groups use treasury centres to manage and
hedge risks on a group-wide basis. Economically,
the treasury centre may seek to hedge the net principal
amount of all assets, liabilities and derivative
instruments denominated in a particular currency.
This might provide a reasonable economic hedge of
the group's exposure to that currency. But the net
position may not be designated as the hedged item
under IFRS. There are ways to achieve hedge accounting,
but they may require major systems changes [IAS39R.84]
[IAS39R.AG101] [IAS39R.AG111] [IAS39R.IG.F.6.1,
2] .
Hedging instruments
Only an external derivative instrument can be used
as a hedging instrument in most cases [IAS39R.73].
An external non-derivative financial instrument
can be used as a hedging instrument only for foreign
currency risk [IAS39R.72]. A foreign currency borrowing,
for example, could be designated as a hedge of the
currency risk of a net investment in a foreign entity.
Multinational groups with complex treasury operations
will often use intra-group derivatives to manage
currency and interest-rate risk across the group.
Intra-group derivatives are not external derivative
instruments, do not qualify as hedging instruments
and are eliminated on consolidation [IAS39R.73].
A group treasury centre might net all of the foreign
currency positions and enter into a single external
derivative transaction. This would qualify for hedge
accounting provided all the other criteria in the
standard are met [IAS39R.IG.F.1.6]
.
Similarly, the net of internal positions relating
to interest-rate risk cannot be designated as the
hedged item [IAS39R.F.1.5]. If a net position is
hedged with a single external derivative instrument
the external derivative may be designated as hedging
a part of the underlying gross position, similar
in amount and timing to the net position [IAS39R.AG101]
.
A single derivative with several elements, such
as a cross-currency interest-rate swap, can be designated
as a hedge of more than one type of risk (for example
interest rate and foreign currency risk) provided
the separate risks are clearly identifiable and
effectiveness can be measured [IAS39R.76] [IAS39R.IG.F.2.18]
.
Generally a hedging instrument is designated in
its entirety in a hedge relationship. The only exceptions
permitted are separating the intrinsic value and
time value of an option; and separating the interest
element and the spot price of a forward contract
[IAS39R.74] .
Hedge accounting models
There are three types of hedge accounting recognised
by IFRS, fair value hedges, cash flow hedges and
hedges of the net investment in a foreign operation
[IAS39R.86]. Each has specific requirements on accounting
for the fair value changes.
Fair value hedges
The risk being hedged in a fair value hedge is a
change in the fair value of an asset or liability
or unrecognised firm commitment that will affect
the income statement [IAS39R.86(a)]. Changes in
fair value might arise through changes in interest
rates (for fixed-rate loans), foreign exchange rates,
equity prices or commodity prices .
The impact on the income statement can be immediate
or expected to happen in future periods. A foreign
currency borrowing that is translated at the closing
rate would have immediate impact on the income statement.
An available-for-sale equity security, where gains
and losses are deferred in equity, would affect
the income statement when sold or impaired.
The hedged asset or liability is adjusted for fair
value changes attributable to the risk being hedged,
and those fair value changes are recognised in the
income statement [IAS39R.89(b)] .
The hedging instrument is measured at fair value
with changes in fair value also recognised in the
income statement [IAS39R.89(a)] .
Examples of fair value hedges might be equity securities
classified as available-for-sale denominated in
a foreign currency that are hedged with foreign
currency forward contracts ; a fixed-rate loan that is 'converted' to
floating rates with an interest-rate swap ; and a foreign currency receivable hedged
using a foreign currency option .
Cash flow hedges
The risk being hedged is the potential volatility
in future cash flows that will affect the income
statement. Future cash flows might relate to existing
assets and liabilities such as future interest payments
or receipts on floating rate debt. Future cash flows
can also relate to future transactions such as forecast
sales or purchases in a foreign currency [IAS39R.86]
or the foreign
currency exposure in an unrecognised firm commitment
[IAS39R.87]. Potential volatility in future cash
flows might also result from changes in interest
rates, changes in exchange rates or changes in commodity
prices . Many fair
value hedges can also be designated as cash flow
hedges, but to qualify they must include an exposure
to variability in cash flows as a result of the
item being hedged .
Changes in the fair value of the hedging instrument,
to the extent the hedge is effective, are deferred
in a 'hedging reserve' in equity [IAS39R.95(a)]
and recycled to the income statement when the hedged
transaction affects the income statement [IAS39R.100].
Fair value changes from cash flow hedges that relate
to highly probable forecast transactions and result
in the recognition of non-financial assets or liabilities
may be included in the initial measurement of those
assets or liabilities if the entity chooses this
option as its accounting policy [IAS39R.97-98].
Examples of common cash flow hedges are an interest-rate
swap converting a floating-rate loan to fixed-rate
and a forward foreign exchange
contract hedging forecast future revenue or a forecast
future purchase of equipment .
Hedge of net investment in a foreign operation
An entity may have subsidiaries that meet the tests
and qualify for treatment as foreign operations
of the parent. Exchange differences arising on consolidation
are deferred in equity until the subsidiary is disposed
of [IAS21R.32]. On disposal or liquidation they
are recognised in the income statement as part of
the gain or loss on disposal [IAS21R.48-49] . The net investment in a subsidiary including
any related goodwill can be hedged with a foreign
currency borrowing or a derivative .
The fair value changes of the hedging instrument,
if effective, are deferred in equity until the subsidiary
is disposed of, when they become part of the gain
or loss on disposal [IAS 39R.102] .
The hedging instrument for a net investment hedge,
in order to be effective, will almost always be
denominated in the foreign operation's local currency
.
Hedge effectiveness
A hedge is regarded as highly effective only if
both of the following conditions are met:
| a) |
At the inception of
the hedge and in subsequent periods, the hedge
is expected to be highly effective in achieving
offsetting changes in fair value or cash flows
attributable to the hedged risk during the period
for which the hedge is designated and |
|
| b) |
The actual results of the hedge are within
a range of 80-125 per cent [IAS39R.AG105]
.
|
When a hedge fails the effectiveness test, hedge
accounting is discontinued prospectively [IAS39R.91]
[IAS39R.101].
Hedges are seldom, if ever, perfectly effective.
Any hedge ineffectiveness, even if the hedge continues
to be considered effective overall, must be recognised
in income in the current period. Hedge ineffectiveness
can arise for a number of reasons. For example,
the hedged item and the hedging instrument may:
| a) |
Be in different currencies; |
|
| b) |
Have different maturities; |
|
| c) |
Use different underlying
interest or equity indices; |
|
| d) |
Use commodity prices
in different markets; or |
|
| e) |
Be subject to different
counter-party risks. |
Careful definition of the hedged risk and the components
of the hedging instrument are the best ways to improve
hedge effectiveness
.
Discontinuing hedge accounting
Hedge accounting shall cease prospectively when
any of the following occurs [IAS39R.91] [IAS39R.101]:
| a) |
A hedge fails the
effectiveness tests; |
|
| b) |
The hedged item is settled; |
|
| c) |
The hedging instrument
is sold, terminated or exercised; |
|
| d) |
Management decides
to revoke the designation; or |
|
| e) |
For a cash flow
hedge, the forecast transaction is no longer
highly probable. |
Hedge accounting ceases prospectively from the
beginning of the period in which the hedge fails
the effectiveness test. All further fair value changes
in a derivative hedging instrument are recognised
in the income statement. Future changes in the fair
value of the hedged item, and any non-derivative
hedging instruments, are accounted for as they would
be without hedge accounting .
Gains or losses arising in the effective period
of a cash flow hedge will have been recognised in
equity. These gains remain in equity until the related
cash flows occur. Where a forecast transaction is
no longer highly probable but still expected to
take place, previous gains continue to be deferred
. However, once a forecast transaction
is no longer expected to occur, any gain or loss
is released immediately to the income statement
[IAS39R.101] .
Presentation and disclosure
The presentation and disclosure requirements for
financial instruments, including hedging, are extensive
and detailed. Some of the specific and significant
disclosures for hedging are [IAS32R.56-59]:
| a) |
a description of
the entity's financial risk management policies
and objectives, including its policy for hedging
each major type of forecast transaction; |
|
| b) |
for each category of hedge (fair value,
cash flow and net investment): |
| - |
a description of
the hedge; |
| - |
the hedging instruments
used; |
| - |
the risks being hedged; |
| - |
the fair values
of the hedging instruments at the balance sheet
date; |
| - |
the periods in which
forecast transactions are expected to occur
and when they are expected to impact on the
income statement; and |
| - |
a description of
any forecast transaction which is no longer
expected to occur but for which hedge accounting
had previously been used. |
|
| c) |
If gains or losses
on hedging instruments have been recognised
in equity, the following disclosures are required
in the statement of changes in equity: |
| - |
the amount that was
recognised in equity in the current period; |
| - |
the amount removed
from equity and recognised in the income statement
in the current period; and |
| - |
the amount removed
from equity and included in the initial carrying
amount of assets or liabilities in the current
period. |
|
