2.2.1 General requirements

Instead of hedging the total changes in fair values or cash flows, risk managers often enter into derivatives to hedge only specific risk components. Managing a specific risk component reflects that hedging all risks is often not economical and hence not desirable, or even not possible (because of a lack of suitable hedging instruments).

If designated, the usual hedge accounting requirement apply to a risk component in the same way as they apply to other hedged items that are not risk components. For example, the qualifying criteria apply, including that the hedging relationship must meet the hedge effectiveness requirements, and any hedge ineffectiveness must be measured and recognised, albeit only with respect to the hedged risk, and not the full item. [IFRS 9.B6.3.11, B6.4.1].

IFRS 9 permits an entity to designate a risk component of a financial or non-financial item as the hedged item in a hedging relationship. Designation of a risk component means that only changes in the cash flows or fair value of the hedged item with respect to the designated risk are subject to the hedge accounting requirements. So instead of considering value changes in the hedged item with respect to all risks that are value drivers, only value changes in the hedged item with respect to the designated risk component are considered for hedge accounting purposes. This is valuable as it is common for entities to economically hedge a specific risk within a hedged item rather than its full price risk. The ability to designate risk components in a hedge relationship is an important step in enabling entities to achieve the IASB's objective for hedge accounting, which is to ‘represent, in the financial statements, the effect of an entity's risk management activities’. [IFRS 9.6.1.1].

It should be noted, however, that only eligible risk components can be designated in hedge relationships. IFRS 9 provides guidance on this topic which is discussed in the sections below.

The key requirements for designating a risk component are that risk component is less than the entire item (see 2.4 below), it must be a separately identifiable component of the item and the changes in the cash flows or fair value of the item attributable to the changes in that risk component must be reliably measurable. [IFRS 9.B6.3.7, B6.3.8]. A risk component can be contractually specified in the contract (see 2.2.2 below) but non-contractually specified risk components may also be eligible (see 2.2.3 below). [IFRS 9.B6.3.10].

When identifying what risk components qualify for designation as a hedged item, in particular whether they are separately identifiable and reliably measurable, an entity assesses such risk components within the context of the particular market structure to which the risk(s) relate and in which the hedging activity takes place. [IFRS 9.B6.3.9]. This assessment has increased relevance for non-contractual risk components for which is it important to undertake a careful analysis of the specific facts and circumstances of the relevant markets. [IFRS 9.BC6.176].

As noted above, a risk component may be contractually specified or it may be implicit in the fair value or the cash flows of the item to which the component belongs. [IFRS 9.B6.3.10]. However, the mere fact that a physical component is part of the make-up of the whole item does not mean that the component necessarily qualifies as a risk component for hedge accounting purposes. A physical component is neither required nor by itself sufficient to meet the criteria for risk components that are eligible as a hedged item. However, depending on relevant market structure, a physical component can help meet those criteria. The example of an eligible risk component that is often quoted is that of the crude oil component of refined products such as jet fuel. However, just because rubber is a physical component of car tyres that does not mean that an entity can automatically designate rubber as a risk component in a hedge of forecast tyre purchases or sales, since the price of tyres may be related only indirectly to the price of rubber. Further analysis of the pricing structure of the whole car tyre would be required.

The determination of eligible non-contractually specified risk components is a judgemental area where we expect practice to continue to evolve (see 2.2.3 below).

It was reaffirmed by the IASB in developing IFRS 9 that it is not considered possible to determine that credit risk is an eligible risk component of a debt instrument. It was explained that a portion cannot be a residual; i.e. an entity is not permitted to designate as a portion the residual fair value or cash flows of a hedged item or transaction if that residual does not have a separately measurable effect on the hedged item or transaction. [IFRS 9.BC6.470, BC6.517]. However, IFRS 9 does introduce an alternative accounting solution for entities undertaking economic credit risk hedging activity (see 11.1 below).

2.2.2 Contractually specified risk components

Potential hedged items such as financial instruments, purchase or sales agreements may contain clauses that link the contractual cash flows via a specified formula to a benchmark rate or price. The examples below all include a contractually specified risk component:

• the interest rate on a financial instrument contractually linked to a benchmark interest rate plus a fixed incremental spread;
• the coupon on a financial instrument contractually linked to an inflation or other financial index plus a determinable incremental spread;
• the price of natural gas contractually linked in part to a gas oil benchmark price and in part to a fuel oil benchmark price;
• the price of electricity contractually linked in part to a coal benchmark price and in part to transmission charges that include an inflation indexation;
• the price of wires contractually linked in part to a copper benchmark price and in part to a variable tolling charge reflecting energy costs; and
• the price of coffee contractually linked in part to a benchmark price of Arabica coffee and in part to transportation charges that include a diesel price indexation.

In each of the above examples, for items other than financial assets, it is assumed that the contractual pricing component would not require separation as an embedded derivative (see Chapter 46 at 4 and 5). The example below provides a fuller illustration of the circumstances under which a contractually specified risk component might usefully be designated in a hedge relationship.

In this case the risk component is contractually specified by the pricing formula in the supply contract. This means it is separately identifiable, because the entity knows exactly which part of the change in the future purchase price of coal under its particular supply contract results from changes in the benchmark price for coal and what part of the price change results from changes in the Baltic Dry Index. The risk component can also be reliably measured using the price in the futures market for the relevant delivery months as inputs for calculating the present value of the cumulative change in the hedged cash flows. An entity could also decide to hedge only its exposure to variability in the coal price that is related to transportation costs. For example, the entity could enter into forward freight agreements and designate them as hedging instruments, with the hedged item being only the variability in the coal price under its supply contract that results from the indexation to the Baltic Dry Index.

Although it is generally easier to determine that a contractually specified risk component is separately identifiable and reliably measurable, than one that is non-contractual, the requirement must still be met. When contractually specified, a risk component would usually be considered separately identifiable. [IFRS 9.BC6.174]. Further, the risk component element of an index/price formula would usually be referenced to observable data, such as a published index/price index. Therefore, the risk component would most likely also be considered reliably measurable.

Nevertheless, difficulties can still arise where a contractual negative spread exists in the hedged item, as a risk component must be less than the entire item. [IFRS 9.B6.3.7]. A negative spread arises when the formula for the contractual coupon/price includes a spread that is subtracted from the hedged risk component, so that the full contractual coupon/price is lower than the identified risk component. This has become termed the ‘sub-LIBOR issue’ (discussed at 2.4 below).

2.2.3 Non-contractually specified risk components

Not all contracts define the various pricing elements and, therefore, specify risk components. In fact, we expect most risk components of financial and non-financial items not to be contractually specified. While it is certainly easier to determine that a risk component is separately identifiable and reliably measurable if it is specified in the contract, IFRS 9 is clear that there is no need for a component to be contractually specified in order to be eligible for hedge accounting. The assessment of whether a risk component qualifies for hedge accounting (i.e. whether it is separately identifiable and reliably measurable) has to be made ‘within the context of the particular market structure to which the risk or risks relate and in which the hedging activity takes place’. [IFRS 9.B6.3.9]. We understand ‘market structure’ here to mean the basis upon which market prices are established or the market conventions that are in evidence. Prices are typically established through a number of ‘building blocks’. So, for instance, a benchmark interest rate such as LIBOR may form the first building block in the valuation of a debt instrument, while a benchmark price, such as the LME price for copper, may form the first building block for the pricing of a non-financial item. The ‘sub-LIBOR’ issue, (see 2.4 below) will arise from negative spread building blocks, if as a result the identified non-contractually specified risk component is larger than the full contract itself.

2.2.4 Partial term hedging

A common risk management technique is to hedge a risk for only a partial term for which it is outstanding, as illustrated in Example 53.5 below. The example, which is based on the Implementation Guidance of IAS 39, illustrates that a time portion of interest rate risk can be a separately identifiable and reliably measurable risk component of a financial instrument, and remains relevant under IFRS 9. Accordingly, it is possible to designate a financial instrument as a hedged item for the portion of risk that represents only part of the term that a hedged item remains outstanding.

Whilst the above implementation guidance uses the example of a financial instrument, the same conclusion could be reached for hedging a partial term of a non-financial instrument. For example, an entity might wish to hedge the foreign currency risk for the next three months from a highly probable forecast purchase cash flow in six months' time. The six month forward foreign currency rate is driven by the relationship between spot rates and forward rates for any given yield curve. Furthermore, the market is built on the premise that a six-month forward rate is a combination of the three-month forward rate (i.e. the market rate for months one to three), plus the three month forward rate (i.e. the market rate for months four to six). This market structure would appear to support being able to hedge a partial risk component of a highly probable forecast purchase cash flow.

An alternative risk management strategy would be a roll over strategy, i.e. when the maturity of the hedging instrument is intentionally shorter than the maturity of the hedged item, and there is an expectation that on expiry of the original hedging instrument it will be replaced by a new hedging instrument (see 7.7 below), which is not the same as for a partial term hedge.

2.2.5 Foreign currency as a risk component

One risk component that is frequently designated as an eligible risk component is foreign currency risk. [IFRS 9.BC6.176]. It is relatively easy to determine that foreign currency risk is a separately identifiable component of a financial instrument denominated in a foreign currency, and that the changes in the cash flows or fair value of the instrument attributable to changes in foreign currency risk are reliably measurable – at least for most frequently traded currency pairs.

Similarly, for highly probable forecast foreign currency cashflows in a cash flow hedge, it may be relatively easy to conclude that variation in foreign currency rates does have a distinguishable effect on the hedged cash flows. (See 5.2 below for more discussion on cash flow hedges.)

It is less straight forward, however, to reach a similar conclusion for non-financial items purchased or sold in a foreign currency that are designated in a fair value hedge (see 5.1 below for more discussion on fair value hedges). In June 2019, the Interpretations Committee discussed whether foreign currency risk can be a separately identifiable and reliably measurable risk component of a non-financial asset held for consumption that an entity can designate as the hedged item in a fair value hedge accounting relationship.

As part of the discussion, the Committee considered that if an entity has exposure to foreign currency risk on a non-financial asset, whether it is a separately identifiable and reliably measurable risk component. The Committee tentatively concluded that this can be the case, depending on an assessment of the particular facts and circumstances within the context of the particular market structure. A key consideration would be whether, at a global level, changes in fair value of the non-financial asset are determined only in one particular currency and that currency is not the entity's functional currency. For example, as purchases and sales of wide-bodied aircraft are routinely globally determined in US dollars, it might be possible for an entity with a functional currency other than US dollars to identify an eligible foreign currency risk component in a wide-bodied aircraft that it owns.

As noted above, the Interpretations Committee discussion as to whether foreign currency risk is a separately identifiable and reliably measurable risk component of a non-financial asset held for consumption was part of a wider debate on the eligibility of designating such a risk component in a valid hedge relationship. In order to achieve hedge accounting for such a risk component, consideration should also be given to all the qualifying criteria for hedge accounting (see 6 below) and in particular those discussed by the Interpretations Committee in June 2019⁴. These include the requirement that the changes in fair value could affect profit or loss (see 2.6.8, 5.1 and 6.2.1 below).

Prior to designation of foreign currency risk in a non-financial instrument in a fair value hedge, careful analysis and judgement will likely be required to determine that foreign currency risk is a separately identifiable component of a non-financial instrument for which the changes in the cash flows or fair value of the non-financial asset attributable to changes in that foreign currency risk are reliably measurable.

The Committee also noted, that the fact that market transactions are commonly settled in a particular currency does not necessarily mean that this is the currency in which the non-financial asset is priced – and thus the currency in which its fair value is determined. The currency may be purely a ‘settlement currency’. A ‘settlement currency’ might arise where the price is determined in one foreign currency, but settled in another (i.e. the settlement currency) at the prevailing foreign currency rate on settlement. In that instance it is difficult to argue that changes in the foreign currency risk between an entity's functional currency and the settlement currency have a reliably measurable impact on the cash flows or fair value of the hedged item. In fact, it is the foreign currency risk between an entity's functional currency and the currency that drives the pricing of the hedged item that is more likely to be an eligible risk component.

Although the IFRIC discussion was limited to foreign currency risk in a non-financial instrument in a fair value hedge, the guidance on a settlement currency is also relevant for highly probable forecast foreign currency cash flows.

Accordingly, consideration is required to determine that any ‘foreign currency risk’ is an eligible risk component in a non-financial instrument or highly probable forecast foreign currency cash flow, and is not merely due to the use of a settlement currency. However, when the prices of forecast foreign currency purchases or sales are determined in the local environment in which the foreign currency is used, it is likely that the foreign currency is more than just a settlement currency and foreign currency risk is a separately identifiable component of the foreign currency purchases or sales.

Furthermore, although it is not explicit in the standard, it seems reasonable that an entity may identify a risk component of an exposure for risk(s) excluding foreign currency risk. The designation of a foreign currency risk component, and a risk component excluding foreign currency risk are both illustrated in the following example.

2.2.6 Inflation as a risk component

A contractually specified inflation risk component of the cash flows of a recognised inflation-linked bond liability (assuming that there is no requirement to account for an embedded derivative separately – see Chapter 46 at 4) is separately identifiable and reliably measurable, as long as other cash flows of the instrument are not affected by the inflation risk component. [IFRS 9.B6.3.15].

However, IFRS 9 includes a rebuttable presumption that for financial instruments, unless contractually specified, inflation is not separately identifiable and reliably measurable. This means that there are limited cases under which it is possible to identify inflation as a non-contractually specified risk component of a financial instrument and designate that inflation component in a hedging relationship. Similar to other non-contractually specified risk components, the analysis would have to be based on the particular circumstances in the respective market, which is, in this case, the debt market. [IFRS 9.B6.3.13].

The example below, derived from the application guidance of IFRS 9, explains a situation in which the presumption that inflation does not qualify as a risk component of a financial instrument can be rebutted.

There are not many currencies with a liquid market for inflation-linked debt instruments, therefore limiting the availability of designating non-contractually specified inflation risk components of financial instruments. Of course, even where the presumption is successfully rebutted, the other qualifying criteria must be met in order to apply hedge accounting, as described at 6 below. In particular, demonstrating that the hedged item and the hedging instrument have values that are generally expected to move in opposite directions may prove challenging. [IFRS 9.B6.4.4].

While IFRS 9 defines in what circumstances inflation can be a risk component for a financial instrument, inflation can be treated as a risk component for non-financial items under IFRS 9 in the same manner as any other risk component (as described at 2.2.2 and 2.2.3 above), i.e. the rebuttable presumption described in this section applies only to financial instruments. For example, linkage to a consumer price index in a sales contract would normally qualify as a hedged item.

2.2.7 Interest rate risk component in an insurance contract

Entities that write insurance contracts often use derivatives to manage the interest rate risk they associate with those insurance liabilities. On application of IFRS 17 – Insurance Contracts – (see Chapter 56) insurance entities may have more inclination to apply hedge accounting to their interest rate risk management derivatives in order to avoid an accounting mismatch and better represent risk management in their financial statements.

IFRS 9 is silent on the application of hedge accounting to insurance liabilities, hence the standard IFRS 9 hedge accounting criteria must be applied. In particular, a key question will be whether there is a risk component of an insurance contract representing the risk-free interest rate risk that could be eligible as a hedged item in a fair value hedge.

In order for a risk component to be eligible, the risk component must be separately identifiable and reliably measurable. This assessment should be made within the context of a particular market structure (see 2.2.3 above). [IFRS 9.B6.3.8, B6.3.9].

Given the wide variety of insurance contracts, such an assessment will need to be undertaken for the particular facts and circumstances. Consideration as to what is the ‘particular market structure’ will also be important. Often there is a lack of a clear primary and, possibly, even a secondary market for insurance contracts (i.e. evidence suggests that in many markets, very few sales of insurance contracts occur post origination). Therefore, in some circumstances, it has been suggested that it may be appropriate to interpret ‘market structure’ as meaning the basis upon which market origination prices are established or the market conventions for fair value determination – if such common market practices exist. This is an area in which we expect practice to evolve.

2.3.1 General requirement

A component of a nominal amount is a specified part of the amount of an item. [IFRS 9.6.3.7(c)]. This could be a proportion of an entire item (such as, 60% of a fixed rate loan of EUR 100 million) or a layer component (for example, the ‘bottom layer’ of EUR 60 million of a EUR 100 million fixed rate loan that can be prepaid at fair value. ‘Bottom layer’ here refers to the portion of the loan that will be prepaid last). The type of component changes the accounting outcome. An entity must designate the component for accounting purposes consistently with its risk management objective (see 6.2 below). [IFRS 9.B6.3.16].

A component must be less than the entire item, [IFRS 9.B6.3.7], and must be defined in such a way that it is possible to determine whether the usual effectiveness criteria are met and ongoing ineffectiveness can be measured. (See 6.4 and 7.4 respectively below).

An example of a component that is a proportion is 50 per cent of the contractual cash flows of a loan. [IFRS 9.B6.3.17].

Nominal layer components are frequently used in risk management activities in practice. For hedge accounting purposes it is possible to designate a layer in a defined, but open, population (see examples i) and iii) below), or from a defined nominal amount (see examples ii) and iv) below). An open population is one where the items within the population are not restricted to items that already exist. Examples of layers that could be eligible for hedge designation include:

1. part of a monetary transaction volume, for example, the first USD 1 million cash flows from sales to customers in a given period;
2. part of a physical volume, for example, the 50 tonnes bottom layer of 200 tonnes of coal inventory in a particular location (i.e. the portion that will be used last);
3. a part of a physical or other transaction volume, for example, the sale of the first 15,000 units of widgets during January 2021; and
4. a layer from the nominal amount of the hedged item, for example, the top layer of a CHF 100 million fixed rate liability that can be prepaid at fair value. ‘Top layer’ refers to the portion of the liability that will be prepaid first. [IFRS 9.B6.3.18].

The ability to designate a ‘bottom layer’ nominal component for a group of forecast cash flows, such as the sale of the first 15,000 units of widgets, used in example iii) above, accommodates the fact that there may be a level of uncertainty as to the quantity of the hedged item. The bottom layer designation means that any uncertainty in forecast cash flows ‘above’ the bottom layer does not negatively impact the assessment as to whether the bottom layer itself is eligible as a hedged item (i.e. meets the highly probable requirement) (see 2.6.1 above). However, it would not be possible to designate a ‘top layer’ nominal component for a group of forecast cash flows, as it is not possible to determine when that top layer occurs, as more forecast cash flows could always follow (see 6.3.3 below).

Further analysis is however required on the ability to designate layers within a fair value hedge (see 2.3.2 below).

2.3.2 Layer component for fair value hedges

Although IFRS 9 allows the designation of layer components from a defined nominal amount or a defined, but open, population as long as it is consistent with an entity's risk management objective (see 2.3.1 above), there are some additional restrictions for fair value hedges. [IFRS 9.B6.3.18, B6.3.16].

If a layer component is designated in a fair value hedge, an entity must specify it from a nominal amount, e.g. the top CHF 20 million layer of a CHF 100 million fixed rate liability. Accounting for a fair value hedge requires remeasurement of the hedged item for fair value changes attributable to the hedged risk (see 7.1.1 below). In addition, that fair value hedge adjustment must be recognised in profit or loss no later than when the hedged item is derecognised (see 7.1.2 below). Accordingly, it is necessary to track the designated hedged item so it can be determined when the hedged item has been derecognised. Applying this requirement to the example of a top CHF 20 million layer of a CHF 100 million fixed rate liability, the total defined nominal amount of CHF 100 million fixed rate liability must be tracked in order to identify when the specified CHF 20 million top layer is derecognised. [IFRS 9.B6.3.19].

Further, a layer component that includes a prepayment option does not qualify as a hedged item in a fair value hedge if the fair value of the prepayment option is affected by changes in the hedged risk (unless the changes in fair value of the prepayment option as a result of changes in the hedged risk are included when measuring the change in fair value of the hedged item (see Example 53.9 below). [IFRS 9.B6.3.20]. However, if the prepayment option with a layer component is prepayable at fair value, the fair value of the option is not affected by changes in the hedged risk, and hence it would be possible to designate a layer component in a fair value hedge (see Example 53.8 below).

The situation illustrated by Example 53.8 above, of a hedge of a top layer of a loan, would not often be found in practice as most prepayment options in loan agreements allow, in our experience, for prepayment at the nominal amount (instead of at fair value). Moreover, if a financial asset included an option that allowed prepayment at fair value, that would affect the assessment of the characteristics of the contractual cash flows. That assessment is a part of the classification of financial assets and such a prepayment option may not be consistent with payments that are solely principal and interest (see Chapter 48 at 6.4.5). However, the ability to designate a top layer in a fair value hedge could be helpful when hedging a group of fixed rate readily transferable financial instruments, see 2.5.2 below.

As already mentioned above, IFRS 9 does not preclude hedge accounting for layers including a prepayment option that are affected by changes in the hedged risk. However, in order to achieve hedge accounting for such a designation, changes in fair value of the prepayment option as a result of changes in the hedged risk have to be included in the assessment of whether the effectiveness requirements are met and when measuring the change in fair value of the hedged item. Example 53.9 illustrates what this means in practice:

When deciding on which instruments to transact in order to manage the interest rate risk in a prepayable portfolio, an entity will usually consider the likelihood of prepayment in a bottom layer. In particular it will consider whether the risk of prepayment is sufficient to justify the added expense of transacting a hedging instrument that can also be cancelled (e.g. an interest rate swap cancellable at zero cost or an offsetting swaption as described in Example 53.9 above). As part of these considerations it is relatively common that from an economic perspective, an entity might view a bottom layer as having no prepayment risk attached at all and transact a non-cancellable hedging instrument accordingly. Despite this economic view, the hedge accounting guidance requires consideration of the fair value changes of that bottom layer based on the contractual terms of the hedged item, which would include the prepayment option. Hence, for many economic hedges of bottom layers of prepayable hedged items, the changes in the fair values of the hedging instrument and the hedged item will not normally be the same, at least from an accounting perspective. The consequence is that there is likely to be a level of ineffectiveness in the accounting hedge relationship, to be measured and recognised (see 7.4 below).

‘Bottom layer’ hedging strategies that avoid this source of ineffectiveness can only be applied if the hedged layer is not affected by the prepayment risk. This is best demonstrated by an example (see Example 53.10 below).

Therefore while IFRS 9 provides an effective solution for portfolios that feature a bottom layer that is not prepayable, as explained in Example 53.10 above, it does not provide an answer for portfolios that are fully prepayable (for example, a residential fixed rate mortgage portfolio). The IASB decided to address hedging of such portfolios in its separate macro hedging project. Until that project is finalised, entities are allowed to apply the portfolio fair value hedging guidance in IAS 39 (see 10 below).

Given the current lack of an effective hedge accounting solution within IFRS 9 for portfolios that feature a bottom layer that is prepayable, it is not uncommon for entities to consider alternative ‘proxy’ hedge accounting designations (see 6.2.1 below). For example, an entity wishing to hedge an economic bottom layer within a group of items prepayable at par within a fair value hedge could identify specific items within the group (and designate those items only) or designate a percentage of the total as the hedged item. Both these approaches are still likely to result in ineffectiveness. If specific items within the group were designated in a fair value hedge, and those specific items prepaid, then the designated hedged item would no longer exist, even if there was sufficient ‘non-designated’ items within the group to cover the amount designated. The issues arising from designation of a proportion are best explained with an example (see Example 53.11 below).

2.4.1 Late hedges of benchmark portions of fixed rate instruments

There is no requirement in IFRS 9 for hedge accounting to be designated on initial recognition of either the hedged item or the hedging instrument. [IFRS 9.B6.5.28]. In particular, it is not uncommon for risk management and/or hedge accounting to be applied sometime after initial recognition of the hedged item. This is often referred to as a ‘late hedge’. There is no additional guidance in IFRS 9 on how to apply hedge accounting to ‘late hedges’ over and above the usual criteria. However the identification of eligible risk components in fixed rate hedged items in late hedges can be problematic.

An example of the difficulties of such a designation is discussed in the application guidance to IFRS 9 with respect to a fixed rate financial instrument that is hedged sometime after its origination, and interest rates have changed in the meantime, such that the fixed rate on the instrument is now below LIBOR. In this case it may be possible for the entity to designate a risk component equal to the benchmark rate that is higher than the contractual rate paid on the item. This is provided that the benchmark rate is still less than the effective interest rate calculated as if the instrument had been purchased on the day it was first designated as the hedged item. [IFRS 9.B6.3.23]. This is illustrated below.

The guidance illustrated in Example 53.13 above will assist entities in designating hedges in a way that significantly reduces ineffectiveness.

2.4.2 Negative interest rates

The negative interest rate environment in some countries, mainly Switzerland and certain countries in the Eurozone, has further implications on the designation of risk components in connection with the sub-LIBOR issue. The following example illustrates this.

Notwithstanding the above, in both cases, the banks can designate all the cash flows in the financial asset for changes in the benchmark rate, although this is likely to result in some ineffectiveness. [IFRS 9.B6.3.21].

2.5.1 General requirements

Under IFRS 9, hedge accounting may be applied to a group of items if:

• the group consists of items or components of items that would individually qualify for hedge accounting; and
• for risk management purposes, the items in the group are managed together on a group basis. [IFRS 9.6.6.1].

Whether the items in the group are managed together on a group basis is a matter of fact, i.e. it depends on an entity's behaviour and cannot be achieved by mere documentation.

The IFRS 9 eligibly criteria for groups of items for hedge accounting also permits designation of net positions, however some restrictions for cash flow hedges of net positions are retained (see 2.5.3 below). [IFRS 9.BC6.435, BC6.436]. Net hedged positions are permitted as eligible hedged items under IFRS 9 only if an entity hedges on a net basis for risk management purposes. Whether an entity hedges in this way is a matter of fact (not merely of assertion or documentation). Hence an entity cannot apply hedge accounting on a net basis solely to achieve a particular accounting outcome, if that would not reflect its risk management approach. [IFRS 9.B6.6.1].

IFRS 9 also contains special presentation requirements when hedging net positions, which are discussed at 9.3 below.

2.5.2 Hedging a component of a group

A group designation can also consist of a component of a group of items, such as a layer component of a group. A component could also be a proportion of a group of items, such as 50% of a fixed rate bond series with a total volume of CU 100 million. Whether an entity designates a layer component or a proportionate component depends on the entity's risk management objective. [IFRS 9.6.6.1, 6.6.2].

The benefits of identifying a layer component, as discussed at 2.3 above, are relevant when applied to a group of items. In fact, the bottom layer hedging strategy discussed in Example 53.10 above is, in fact, a designation of a component of a group. The following example provides a different example of designating a component of a group, this time a top layer.

If it was not permitted to designate a layer of a group of items, entities would in such cases either have to identify individual items within the group and designate them on a standalone basis, or prorate the fair value hedge gain or loss to the entire bond issue volume, as discussed in 2.3.2 above. The IASB believes this would result in arbitrary accounting results and decided to allow a layer component designation for a group of items. [IFRS 9.BC6.438, BC6.439].

A layer component of a group of items only qualifies for hedge accounting if:

• the layer is separately identifiable and reliably measurable;
• the risk management objective is to hedge a layer component;
• the items in the group from which the layer is identified are exposed to the same hedged risk (so that measurement of the hedged layer is not significantly affected by which particular items from the overall group form part of the hedged layer);
• for a hedge of existing items, the items in the group can be identified and tracked; and
• any items in the group containing prepayment options meet the requirements for components of a nominal amount (see 2.3.2 above). [IFRS 9.6.6.3].

Based on the information provided, the top layer in Example 53.16 above would meet the criteria in order for a top layer to be designated.

A hedging relationship can include layers from several different groups of items. For example, in a hedge of a net position of a group of assets and a group of liabilities (see 2.5.1 above), the hedging relationship can comprise, in combination, a layer component of the group of assets and a layer component of the group of liabilities. [IFRS 9.B6.6.12].

2.5.3 Cash flow hedge of a net position

Many entities are exposed to foreign currency risk arising from purchases and sales of goods or services denominated in foreign currencies. Cash inflows and outflows occurring on forecast transactions in the same foreign currency are often economically hedged on a net basis, as illustrated in the below example.

In the case of a cash flow hedge of a group of items whose variabilities in cash flows are not expected to be approximately proportional to the overall variability in cash flows of the group so that offsetting or net risk positions arise, designation is only permitted for a hedge of foreign currency risk. [IFRS 9.6.6.1(c), B6.6.7, BC6.455]. Said differently, designation of a net position in a cash flow hedge is limited to hedges of foreign currency risk under IFRS 9.

The standard mechanics for hedged items is as follows: of cash flow hedge accounting cannot accommodate a hedged net position whose gross cash flows affect profit or loss in different periods (see 7.2 below). Applying standard cash flow hedge accounting to Example 53.17, the gain or loss accumulated in other comprehensive income (OCI) on the USD 20 of hedging instrument would be reclassified to profit or loss when the revenue transaction occurs. However, this will only offset the gain or loss on USD 20 of the USD 100 hedged revenue while the remaining revenue of FC 80 and the fixed asset purchase of USD 80 (i.e. the economic hedge) would still be measured at the spot rate. This would result in the bottom line profit for the period(s) not reflecting the economic hedge.

IFRS 9 amends the standard cash flow hedge accounting for such a net position in that the foreign currency gain or loss on the USD 80 revenue cash flows that affect profit or loss in the earlier period must be carried forward to offset the foreign currency gain or loss on the fixed asset purchase cash flows that will affect profit or loss in later periods. This is achieved by deferring the gain or loss on the natural hedge in OCI, with a reclassification to profit or loss once the offsetting cash flows affect profit or loss (see 9.3.1 and Example 53.18 below).

However, the gross transactions that make up the net position are recognised when they arise and will be measured at the spot foreign currency rate ruling at that time. They are not adjusted to reflect the result of the hedge. The whole impact of hedge accounting must be presented in a separate line item in profit or loss. [IFRS 9.6.6.4].

This separate line item includes:

• the reclassification adjustment for gains or losses on the hedge of the net position;
• the gain or loss on the natural hedge, with the counter-entry being recognised in OCI; and
• the later reclassification adjustment of the gain or loss on the natural hedge from OCI to profit or loss.

The rather complicated accounting described above is best illustrated using an example:

The transactions within a net position still must be measured at their spot rates, while the effect of the hedge is presented in a separate line item. [IFRS 9.B6.6.15]. In other words, although an entity may be economically hedged from a bottom line (or net) perspective, volatility will still arise in the amounts reported for the individual hedged transactions (on a gross basis), and it is only the bottom line of profit or loss that will reflect the benefits of the hedge.

For a net position to qualify for cash flow hedge accounting the hedge documentation has to include, for each type of item within the net position, its amount and nature as well as the reporting period in which it is expected to affect profit or loss. This is expected to be a relatively detailed record of what makes up the net position and how it will impact profit or loss, including the depreciation profile, if relevant. [IFRS 9.6.6.1(c)(ii), B6.6.7, B6.6.8].

2.5.4 Nil net positions

IFRS 9 also addresses hedges of nil net positions. This refers to when entities hedge a group of items where the hedged items themselves fully offset the risk that is managed. An example would be similar to the scenario illustrated by Example 53.17 above but where the entity anticipates sales of GBP 100m in 12 months and also plans a major capital expenditure of GBP 100m in 12 months. An entity is allowed to designate such a nil net position in a hedging relationship, provided that:

• the hedge is part of a rolling net risk hedging strategy, whereby the entity routinely hedges new positions of the same type over the course of time (for example when transactions move into the time horizon for which the entity hedges);
• hedging instruments are used to hedge the net risk when the hedged net position changes in size over the life of the rolling hedging strategy and is not a nil net position;
• the entity would normally apply hedge accounting to such net positions when the net position is not nil; and
• not applying hedge accounting to the nil net position would result in inconsistent accounting outcomes over time (because in a period in which the net position is nil, hedge accounting would not be available for what is otherwise the same type of exposure). [IFRS 9.6.6.6].

2.6.1 Highly probable

Forecast transactions (or a component thereof) may only be eligible hedged items if they are highly probable of occurring (see 2.1 above). [IFRS 9.6.3.3]. The term ‘highly probable’ is not defined in IFRS 9, but is often interpreted to have a much greater likelihood of happening than ‘more likely than not’. The implementation guidance within IAS 39 contained some guidance as to how the term highly probable should be applied within the context of hedge accounting and, this guidance can be considered relevant for IFRS 9 hedge accounting. The IAS 39 guidance indicates that an assessment of the likelihood that a forecast transaction will take place is not based solely on management's intention, it should be supported by observable facts and the attendant circumstances. In such an assessment, an entity should consider the following:

• the frequency of similar past transactions;
• the financial and operational ability of the entity to carry out the transaction;
• whether substantial commitments of resources have been made to a particular activity;
• the extent of loss of disruption of operations that could result if the transaction does not occur;
• the likelihood that transactions with substantially different characteristics might be used to achieve the same business purpose; and
• the entity's business plan.

In March 2019, the Interpretations Committee discussed the application of the highly probable requirement with respect to a specific derivative (a load following swap) designated as a hedging instrument. In a load following swap the notional amount of the derivative designated as a hedging instrument varies depending on the outcome of the hedged item (e.g. forecast energy sales). As part of that specific discussion, the IFRIC observed more generally that the terms of the hedging instrument do not affect the highly probable assessment because the highly probable requirement is applicable to the hedged item (see 6.3.3 below). For example, an entity that wishes to hedge the foreign currency risk of a future business combination, can only achieve hedge accounting once the business combination itself is highly probable (see 2.6.4 below). This is the case even if the hedging instrument is a deal contingent foreign currency contract, such that if the business combination does not go ahead, the foreign currency contract is terminated with no cash settlement.

An entity may also need to consider the impact of wider industry and business drivers as to whether cash flows are highly probable or not. For example:

• whether forecast cash flows in a subsidiary that is due to be sold can be considered highly probable in the parent's consolidated financial statements (see 7.2.4 below); or
• if a designated benchmark interest rate is no longer expected to exist, whether forecast cash flows linked to that benchmark can be highly probable (see 8.3.5 below).

The length of time until a forecast transaction is projected to occur is also a factor. Other factors being equal, the more distant a forecast transaction is, the less likely it is that it would be considered highly probable and the stronger the evidence required to determine that it is highly probable.

For example, a transaction forecast to occur in 5 years will often be less likely to occur than a transaction forecast to occur in one year. However, forecast interest payments for the next 20 years on variable rate debt would typically be highly probable if supported by an existing contractual obligation.

An entity may also need to consider the credit risk associated with the counterparty to a forecast transaction. Even though a forecast transaction does not involve credit risk, depending on the possible counterparties for the anticipated transaction, the credit risk that affects them can indirectly affect the assessment of whether the forecast transaction is highly probable or not (see 6.4.2.B below).

In addition, other factors being equal, the greater the physical quantity or future value of the forecast transaction, in proportion to the entity's total transactions of the same nature, the less likely it is that the transaction would be considered highly probable. For example, less evidence generally would be needed to support forecast highly probable sales of 100,000 units in the next month than 950,000 units in that month, when recent sales have averaged 950,000 for the past 3 months.

A history of having designated hedges of forecast transactions and then determining that they are no longer expected to occur would call into question both an entity's ability to predict forecast transactions accurately and the propriety of using hedge accounting in the future for similar transactions. [IAS 39 IG F.3.7]. This is clearly makes common sense, however the standard contains no prescriptive ‘tainting’ provisions in this area. Therefore, entities are not automatically prohibited from using cash flow hedge accounting if a forecast transaction fails to occur. Instead, whenever such a situation arises the particular facts, circumstances and evidence should be assessed to determine whether doubt has, in fact, been cast on an entity's ongoing hedging strategies.

It is also explained in the IAS 39 implementation guidance that cash flows arising after the prepayment date on an instrument that is prepayable at the issuer's option may be highly probable for a group or pool of similar assets for which prepayments can be estimated with a high degree of accuracy, e.g. mortgage loans, or if the prepayment option is significantly out of the money. In addition, the cash flows after the prepayment date may be designated as the hedged item if a comparable option exists in the hedging instrument (see 7.4.12 below). [IAS 39.F.2.12].

Further discussion on the hedge documentation requirements for designated highly probable forecast transactions is given at 6.3.3 below.

2.6.2 Hedged items held at fair value through profit or loss

It does not immediately appear that it would be useful to designate a hedged item that is measured at fair value through profit or loss in a hedge relationship. However, because IFRS 9 may require certain variable rate assets to be measured at fair value through profit or loss (see Chapter 48 at 6), designation as the hedged item in a cash flow hedge relationship may be desirable. Although the variable hedged item would be measured at fair value through profit or loss, an entity may still seek to hedge the variability of cash flows by entering into a hedging derivative. Because of the variable nature of the hedged item, such instruments may not be significantly exposed to changes in fair value caused by movements in the hedged risk whereas the hedging derivative will be. In this instance, application of cash flow hedge accounting facilitates deferral of fair value changes in the hedging derivative to the cash flow hedge reserve, which may better reflect the risk management strategy.

IFRS 9 provides confirmation that cash flow hedge accounting is not prohibited for all hedged items measured at fair value through profit or loss. It gives as an example of an eligible cash flow hedge where an entity uses a swap to change floating rate debt to fixed-rate, even if the debt is measured at fair value. This is because there is a systematic way in which the cash flow hedge reserve can be reclassified, i.e. in the same way interest payments occur on the hedged instrument. A further example is given of a forecast purchase of an equity instrument that, once acquired, will be accounted for at fair value through profit or loss. This is mentioned as an example of an item that cannot be the hedged item in a cash flow hedge, because any gain or loss on the hedging instrument that would be deferred could not be appropriately reclassified to profit or loss during a period in which it would achieve offset. [IFRS 9.B6.5.2].

As well as providing confirmation that cash flow hedge accounting is not precluded for hedged items measured at fair value through profit or loss, the guidance in paragraph B6.5.2 of IFRS 9 also appears to introduce an additional requirement that there is a systematic way in which the cash flow hedge reserve can be reclassified for such a hedge. [IFRS 9.B6.5.2].

In addition, the reason why the instrument is measured at fair value through profit or loss will also be a factor in determining whether an instrument measured at fair value through profit or loss will be an eligible hedged item or not. Classification of an item at fair value through profit or loss could be because such an item is held for trading, managed on a fair value basis, designated as measured at fair value through profit or loss using the fair value option or because the contractual terms of the financial asset give rise on specified dates to cash flows that are not solely payments of principal and interest on the principal amount outstanding (see Chapter 48 at 2). We discuss the eligibility of such instruments measured at fair value through profit or loss in the paragraphs below.

2.6.3 Hedges of exposures affecting other comprehensive income

Only hedges of exposures that could affect profit or loss qualify for hedge accounting. [IFRS 9.6.5.2]. This would include hedged debt instruments measured at fair value through other comprehensive income (OCI) as they are held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets. [IFRS 9.4.1.2A]. Although changes in fair value are initially recognised in OCI, on derecognition of such items and gains or losses held in OCI will be reclassified to profit or loss.

The sole exception to the requirement that hedges could affect profit or loss is when an entity is hedging an investment in equity instruments for which it has elected to present changes in fair value in OCI, as permitted by IFRS 9. Using that election, gains or losses on the equity investments will never be recognised in profit or loss (see Chapter 48 at 2.2). [IFRS 9.6.5.3].

For such a hedge, the fair value change of the hedging instrument is recognised in OCI. [IFRS 9.6.5.8]. Any hedge ineffectiveness is also recognised in OCI. [IFRS 9.6.5.3]. On sale of the investment, gains or losses accumulated in OCI are not reclassified to profit or loss (see Chapter 48 at 2.2). Consequently, the same also applies for any accumulated fair value changes on the hedging instrument, including any ineffectiveness (see 7.8 below).

2.6.4 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 currency risk, because the other risks being hedged cannot be specifically identified and measured. [IFRS 9.B6.3.1]. It also follows that a forecast business combination could be a hedged item for foreign currency risk in a cash flow hedge, as long as the highly probable criterion is met (see 2.6.1 above). The other risks – i.e. other than foreign currency risk, are also said to be general business risks. IAS 39 provided additional guidance on hedging general business risks that appears relevant also to IFRS 9. A hedge of the risk of obsolescence of a physical asset or the risk of expropriation of property by a government is not eligible for hedge accounting (effectiveness cannot be measured because those risks are not reliably measurable). [IAS 39.AG110]. Similarly, the risk that a transaction will not occur is an overall business risk that is not eligible as a hedged item. [IAS 39.F.2.8].

Nevertheless, transactions of the business to be acquired (for example floating rate interest payments on its borrowings) may potentially qualify as hedged items. For this to be the case it would need to be demonstrated that, from the perspective of the acquirer, those hedged transactions are highly probable (see 2.6.1 above) and could impact the post-acquisition profit or loss of the acquirer (see 5.1 and 5.2 below). Determining that the hedged transaction is highly probable may not be straightforward, as this requirement applies to both the business combination and the hedged transactions themselves.

2.6.5 Forecast acquisition or issuance of foreign currency monetary items

Changes in foreign currency rates prior to the acquisition or issuance of a monetary item denominated in a foreign currency do not impact profit or loss. Therefore an entity cannot hedge the foreign currency risk associated with the forecast acquisition or issuance of a monetary item denominated in a foreign currency, such as the expected issuance for cash of borrowings denominated in a currency other than the entity's functional currency. This is because there is a need for the hedged risk to have the potential to impact profit or loss in order to achieve hedge accounting. [IFRS 9.6.5.2].

However, it may be possible to designate a combination of the highly probable forecast acquisition or issuance of a foreign currency monetary item and an associated highly probable forecast foreign currency derivative as an aggregated exposure within a hedge accounting relationship (see 2.7 below).

2.6.6 Own equity instruments

Transactions in an entity's own equity instruments (including distributions to holders of such instruments) are generally recognised directly in equity by the issuer (see Chapter 47) and do not affect profit or loss. Therefore, such instruments cannot be designated as a hedged item. [IFRS 9.6.5.2]. Similarly, a forecast transaction in an entity's own equity instruments (e.g. a forecast dividend payment) cannot qualify as a hedged item. However, a declared dividend that qualifies for recognition as a financial liability, e.g. because the entity has become legally obliged to make the payment, may qualify as a hedged item. For example, a recognised liability to pay a dividend in a foreign currency would give rise to foreign currency risk.

2.6.7 Core deposits

Financial institutions often receive a significant proportion of their funding from demand deposits, such as current account balances, savings accounts and other accounts that behave in a similar manner. Even though the total balance from all such customer deposits may vary, a financial institution typically determines a level of core deposits that it believes will be maintained for a particular time frame. These customer deposits or accounts usually pay a zero or low, stable interest rate which is generally insensitive to changes in market interest rates, and hence will behave like a fixed interest rate exposure from an interest rate risk perspective for the time frame over which they are expected to remain.

Both existing and new deposits are generally considered fungible for interest rate risk management purposes, as new deposits will usually be on the same terms as any withdrawn deposits that they replace. Financial institutions cannot determine which individual customer deposits will make up the core deposits. While these deposits can be withdrawn at little or short notice, typically they are left as a deposit for a long and generally predictable time despite the low interest paid.

Risk management of the ‘deemed’ fixed rate interest rate risk exposure that financial institutions attribute to core deposits will often result in the need to transact interest rate derivatives, although achieving hedge accounting for these derivatives can be difficult.⁵

In order for items to be eligible hedged items in a fair value hedge, the fair value of the hedged items must vary with the hedged risk. However, IFRS 13 – Fair Value Measurement – states that the fair value of a financial liability with a demand feature (e.g. a demand deposit) is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid. [IFRS 13.47]. Therefore, the fair value of demand deposits will not vary with the hedged risk and fair value hedge accounting is precluded.

An alternative consideration is whether it is possible to designate a core deposit intangible (representing the value of this source of funding to the financial institution) as an eligible hedged item. The term ‘core deposit intangible’ could be used to represent the difference between:

1. the fair value of a portfolio of core deposits; and
2. the aggregate of the individual fair values of the liabilities within the portfolio, normally calculated in accordance with the requirements of IFRS 13.

Generally, an internally-generated core deposit intangible cannot be a hedged item because it is not a recognised asset. However, if a core deposit intangible is acquired together with a related portfolio of deposits, it is required to be recognised separately as an intangible asset (or as part of the related acquired portfolio of deposits) if it meets the recognition criteria in IAS 38 – Intangible Assets, which it normally will (see Chapter 9 at 5.5.2).

Theoretically, therefore, a recognised purchased core deposit intangible asset could be designated as a hedged item. However this will only be the case if it meets the conditions for hedge accounting, including the requirement that the effectiveness of the hedge can be measured reliably. The implementation guidance of IAS 39 explains that because it is often difficult to measure reliably the fair value of a core deposit intangible asset other than on initial recognition, it is unlikely that this requirement will be met. [IAS 39.F.2.3]. In fact, this probably understates the difficulty.

For the reasons set out above, financial institutions are rarely, if ever, able to designate core deposits with the associated hedging instruments in hedge accounting relationships, despite the economic validity of these risk management activities. Accordingly, many financial institutions apply the special portfolio or macro hedge accounting guidance (see 10 below).

2.6.8 Leases and associated right of use assets

Following the introduction of IFRS 16 – Leases (see Chapter 23), most entities that previously hedged and designated the full foreign currency risk from future operating lease payments will no longer need to apply hedge accounting. This is because the foreign currency risk in the hedging instrument will naturally offset part of the IAS 21 retranslation of the lease liability. However, the foreign currency risk from future operating lease payments that are not economically hedged will have a previously unrecognised impact on profit or loss. As there is no hedging instrument providing offset to the IAS 21 retranslation of the lease liability, the full foreign currency risk arising from future operating lease payments will be recognised in profit or loss. Accordingly, there may be an additional incentive either to start economically hedging the foreign currency risk in the lease liability and achieve hedge accounting, or to try to achieve hedge accounting using existing foreign currency exposures. In each case, this would be subject to meeting the normal hedge accounting qualifying criteria.

Lease liabilities could be either eligible hedged items or hedging instruments (see 2.1 above and 3.3.1 below respectively). However, achieving hedge accounting for unhedged foreign currency risk in lease liabilities is likely to be problematic. For example, it may be tempting to consider designating the lease liability as the hedging instrument in a fair value hedge of foreign currency risk in the associated right of use asset. A related fact pattern was discussed in June 2019 by the Interpretations Committee when a number of difficulties were identified.⁶

The Committee considered whether foreign currency risk can be a separately identifiable and reliably measurable risk component of a non-financial asset held for consumption that an entity can designate as the hedged item in a fair value hedge accounting relationship. The Committee concluded that, although in theory such a hedge may be possible, the particular facts and circumstances would need to be considered to ensure the hedge accounting criteria were met. The Committee assessed the following key questions as part of their considerations:

Can an entity have exposure to foreign currency risk on a non-financial asset held for consumption that could affect profit or loss? IFRS 9 does not require changes in fair value to be expected to affect profit or loss but, rather, that those changes could affect profit or loss. The Committee observed that changes in fair value of a non-financial asset held for consumption could affect profit or loss if, for example, the entity were to sell the asset before the end of the asset's economic life (see 5.1 below).

If an entity has exposure to foreign currency risk on a non-financial asset, is it a separately identifiable and reliably measurable risk component? The Committee observed that foreign currency risk is separately identifiable and reliably measurable when the risk being hedged relates to changes in fair value arising from translation into an entity's functional currency of fair value that, based on an assessment within the context of the particular market structure, is determined globally only in one particular currency and that currency is not the entity's functional currency (see 2.2.5 above).

Can the designation of foreign currency risk on a non-financial asset held for consumption be consistent with an entity's risk management activities? The Committee observed that, in applying IFRS 9, an entity can apply hedge accounting only if it is consistent with the entity's risk management objective and strategy for managing its exposure (see 6.2.1 below).

In order to achieve fair value hedge accounting for a foreign currency risk component of a non-financial asset held for consumption, all three questions must be answered satisfactorily. It is unlikely that this will be the case for a fair value hedge of the foreign currency risk in a right of use asset with the associated foreign currency lease liability as the hedging instrument. In most cases, there is not an exposure to foreign currency risk in the right of use asset that will affect profit or loss, the fair value of the right of use asset is unlikely to be determined globally only in one particular currency and such a hedge is often not consistent with the entity's risk management objective.

2.7.1 Introduction

IFRS 9 introduced a new hedge accounting concept known as ‘an aggregated exposure’; the purpose of which was to facilitate hedge accounting that reflects the effect of risk management undertaken for a hedged position that includes a derivative. An aggregated exposure is described as a combination of an exposure that could qualify as a hedged item, and a derivative together designated as a hedged item. [IFRS 9.6.3.4]. The guidance does not change the unit of account for instruments making up the aggregated exposure, specifically it is not accounted for as a ‘synthetic’ single item. Instead, an entity should consider the combined effect of the aggregated exposure for the purpose of assessing hedge effectiveness and measuring hedge ineffectiveness.

Whilst the ability to designate an aggregated exposure as a hedged item in a hedge relationship should allow an entity to reflect better the effect of its risk management in the financial statements, the steps required to achieve this hedge accounting are quite complex. Furthermore, although some detailed examples of hedge accounting for aggregated exposures are provided in the implementation guidance in the standard, there are still some areas of uncertainty. [IFRS 9.IE115‑147]. We outline below the general requirements for hedge accounting for aggregated exposures.

2.7.2 Background

Entities often purchase or sell items (in particular commodities) that expose them to more than one type of risk (e.g. commodity and foreign currency risk). When hedging those risk exposures, entities do not always hedge each risk for the same time period. This is best explained with an example:

In the above example it would be possible for the entity to initially designate the copper futures contract as hedging variations in the copper purchase price in a cash flow hedge relationship. This is on the assumption that the relevant hedge accounting eligibility criteria are met. (See 6 below). However, when the entity transacts the foreign currency forward contract three months later the general hedge accounting guidance would provide the entity with two choices (see 8.3 below):

• discontinue the first hedging relationship (i.e. the copper price risk hedge) and re-designate a new relationship with joint designation of the copper futures contract and the foreign currency forward contract as the hedging instrument. This is likely to lead to some ‘accounting’ hedge ineffectiveness as the copper futures contract will now have a non-zero (i.e. off market) fair value on designation of the new relationship (see 7.4.3 below); or
• maintain the copper price risk hedge and designate the foreign currency forward contract in a second relationship as a hedge of the variable USD copper purchase price. Even if the other hedge accounting requirements could be met, this means that the volume of hedged item is constantly changing as it is the variable copper purchase price that is now hedged for foreign currency risk, (i.e. without consideration of the effect of the copper futures). This will likely have an impact on the effectiveness of the hedging relationship, in particular if the variable USD copper price falls, as there may not be sufficient volume of USD cash flows from the designated hedged item in order to match the foreign currency forward contract.

As mentioned above, IFRS 9 includes an additional accounting choice for such a strategy which is to permit designation as hedged items the aggregated exposures that are a combination of an exposure that could qualify as a hedged item and a derivative. [IFRS 9.6.3.4].

Consequently, in the scenario described in Example 53.20 above, the entity could designate the foreign currency forward contract in a cash flow hedge of the combination of the original exposure and the copper futures contract (i.e. the aggregated exposure) without affecting the first hedging relationship. In other words, it would not be necessary to discontinue and re-designate the first hedging relationship, as summarised in the table below:

It is important to keep in mind that the individual items in the aggregated exposure are accounted for separately, applying the normal requirements of hedge accounting (i.e. there is no change in the unit of account; the aggregated exposure is not treated as a ‘synthetic’ single item). For example, when hedging a combination of a variable rate loan and a pay fixed/receive variable interest rate swap (IRS), the loan would still be accounted for at amortised cost with the IRS accounted for at fair value through profit or loss, and presented separately in the statement of financial position. An entity would not be allowed to present the IRS and the loan (i.e. the aggregated exposure) together in one line item (i.e. as if it was one single fixed rate loan). [IFRS 9.B6.3.4].

However, when assessing the effectiveness and measuring the ineffectiveness of a hedge of an aggregated exposure, the combined effect of the items in the aggregated exposure must be taken into consideration. [IFRS 9.B6.3.4]. (See 6.4 and 7.4 below respectively). This is of particular relevance if the terms of the hedged item and the hedging instrument in the first hedging relationship do not perfectly match, e.g. if there is basis risk. Any ineffectiveness in the first level relationship would automatically also lead to some ineffectiveness in the second level relationship. However, this does not mean that the same ineffectiveness is recognised twice. The accounting for aggregated exposures is explained using a series of examples, below.

2.7.3 Accounting for aggregated exposures

The following three examples, partly derived from illustrative examples in the implementation guidance of IFRS 9, help explain the concept of a hedge of an aggregated exposure. We have not repeated the detailed calculations provided in the illustrative examples, but have focused instead on explaining the required approach:

As noted above, the accounting for aggregated exposures can be complex. In this example the complexity lies in the calculation of the present value (PV) of the variability of cash flows of the aggregated exposure. This calculation is necessary in order to calculate the ineffectiveness in the second level relationship, in line with the usual hedge accounting requirements for cash flow hedges. [IFRS 9.6.5.11(a)(ii)].

Example 17 in the implementation guidance demonstrates that the variability of the cash flows of the aggregated exposure can be calculated by creating a ‘synthetic’ aggregated exposure for calculation purposes only. [IFRS 9.IE.134(a)]. This is similar to creating what is often referred to as a ‘hypothetical derivative’ for hedge relationships that do not include aggregated exposures. (See 7.4.4 below).

One leg of the synthetic aggregated exposure is based on the gross cash flows from the aggregated exposure, and the other leg is ‘fixed at a blended rate’ such that the present value of the whole synthetic aggregated exposure is nil on initial hedge designation. Similar to the role of the fixed leg in a hypothetical derivative, the fixed leg in the synthetic aggregated exposure is designed to reflect the level at which the hedged risk in the aggregated exposure could be locked in on initial designation of the second level relationship. The purpose of this is to capture the present value of the variability of cash flows of the aggregated exposure from that point onwards.

In this particular fact pattern, the leg in the synthetic aggregated exposure that represents the cash flows of the aggregated exposure is a combination of the future foreign currency cash outflows on the liability and the local and foreign currency cash outflows and inflows on the CCIRS. The ‘blended’ rate for the fixed leg of the synthetic aggregated exposure is calibrated so that the present value of the synthetic aggregated exposure in total is nil on designation of the second level relationship.

In the example in the implementation guidance, all the cash flows contributing to the leg that represents the cash flows of the aggregated exposure, are recorded and valued on a gross basis. It follows that if the cash flows from the foreign currency fixed rate liability and those from the receive fixed foreign currency leg of the CCIRS do not exactly offset, then the resultant ‘net cash flow’ will contribute to the synthetic aggregated exposure leg that represents the cash flows of the aggregated exposure. However, the need to consider gross cash flows could also indicate that the valuation techniques used to calculate the local currency present value for each cash flow making up the leg that reflects the aggregated exposure, must be appropriate for the instrument from which the cash flows arise. Consequently, even if the cash flows from the foreign currency liability and the foreign currency leg of the CCIRS offset completely, the local currency present value of each may not. This could be due to valuation differences such as foreign currency basis spreads or the credit risk of the CCIRS. Accordingly, gross cash flows must be considered without any netting of cash flows from separate instruments. [IFRS 9.IE134(a)].

The diagram below illustrates the methodology described above. The grey field identifies the output from the calculation, which is the calibrated fixed leg of the synthetic aggregated exposure that results in a zero present value for the overall synthetic aggregated exposure on initial designation of the second level relationship.

While, as stated above, the implementation guidance indicates that valuation techniques used to calculate the present value for each gross cash flow making up the leg that represents the aggregated exposure, must be appropriate for the instrument from which the cash flows arise, it is not entirely clear which valuation basis should be used when calibrating the synthetic fixed rate leg such that the overall synthetic aggregated exposure has a zero present value on designation.

In each subsequent period, the present values are updated for the changes in the cash flows representing the aggregated exposure and associated discount rates, while holding the previously calibrated blended fixed rate on the synthetic aggregated exposure constant, similar to a hypothetical derivative (see 7.4.4 below). The sum of the resulting present values of cash flows, i.e. the present value of the overall synthetic aggregated exposure (which previously was calibrated to be nil as at designation), represents the present value of the cash flow variability of the aggregated exposure which is used for measurement of ineffectiveness. [IFRS 9.IE134].

This is illustrated in the diagram below. The grey field represents the output from this calculation which is the current present value of the cash flow variability of the aggregated exposure.

Ineffectiveness is then determined by comparing the change in calculated present value of the cash flow variability of the aggregated exposure and the fair value of the hedging instrument, (i.e. the local currency IRS). The normal ongoing cash flow hedge accounting treatment is applied to the change in fair value of the hedging instrument (see 7.2 below). The accounting for the first level relationship in Example 53.21 above continues unaffected by the second level relationship.

The concept of economically hedging aggregated exposures as such is straightforward. However, the accounting for such relationships includes some complexity. As for any hedge accounting relationship, there is a need to calculate the cumulative change in present value of the aggregated exposure, in order to measure ineffectiveness in the second level hedge relationship. Paragraph IE144 in the IFRS 9 implementation guidance provides some direction as to how this should be achieved: similar to Example 53.21 above, this can be calculated as the change in present value of the gross cash flows from the instruments making up the aggregated exposures. However, in this example there is no requirement to create a synthetic blended fixed leg, as the aggregated exposure itself is essentially fixed – it is simply the change in present value of the aggregated exposure cash flows.

An additional complexity in Example 53.22 above, is that it is a cash flow hedge in the first-level relationship that is then designated as the hedged item in a fair value hedge. This means that the cross-currency interest rate swap is both a hedging instrument (first level cash flow hedge relationship) and part of a hedged item (second level fair value relationship) at the same time. Accordingly, its fair value changes are initially recognised in other comprehensive income (OCI) through the first level cash flow hedge accounting, but at the same time, should also offset the fair value changes in profit or loss of the hedging IRS in the second-level fair value relationship. This requires a reclassification of the amounts recognised in OCI to profit or loss (to the extent they relate to the second-level relationship) to achieve the offset in the second-level fair value hedge relationship. Consequently, applying fair value hedge accounting to a cross currency interest rate swap designated as the hedged item as part of an aggregated exposure affects where the hedging gains or losses from the first level cash flow hedge relationship are recognised (i.e. reclassification from the cash flow hedge reserve to profit or loss. [IFRS 9.IE143].

As explained in the illustrative examples in the implementation guidance, the application of hedge accounting to an aggregated exposure gets even more complicated when basis risk is involved in one of the hedging relationships, in particular if basis risk is present in the first-level relationship. This is shown in Example 53.23 below.

Illustrative example 16 in the implementation guidance of IFRS 9 demonstrates the accounting effort required in order to achieve hedge accounting for the aggregated exposure. First, the entity calculates the change in fair value of the hedged item and hedging instrument in the first level cash flow hedge relationship in foreign currency and translates them into local currency, using spot rates. Using these local currency equivalents, the entity calculates the ineffectiveness in the first level hedging relationship in the usual way. Second, the entity calculates the change in fair value of the aggregated exposure and the hedging instrument in the second-level cash flow hedge relationship in local currency. This results in the second level ineffectiveness.

The existence of basis risk within the first level relationship complicates the measurement of ineffectiveness in the second level relationship described above. The aggregated exposure is a combination of the foreign currency cash flows expected from the highly probable coffee purchases and the gain or loss on the commodity hedging contract. If the first level relationship was a ‘perfect hedge’, the resultant foreign currency cash flow to be hedged in the second level relationship would be known. However, as commodity basis risk exists in the first level relationship, the hedged amount of foreign currency in the second level relationship will vary, as the basis spread between the price of the forecast coffee purchases and the underlying coffee price in the hedging contract varies. The hedging instrument in the second level relationship is just a foreign currency forward contract, and so its fair value changes are insensitive to commodity basis risk. Accordingly, additional ineffectiveness may arise in the second level relationship, due to the commodity basis risk that exists in the first level relationship. [IFRS 9.IE119(b)].

For example, at inception of the second level relationship, an entity might have expected a hedged aggregated cash flow of FC 990 based on the price achieved in the commodity hedging contract and the level of basis risk that then existed. However, at the date when the entity calculates the ineffectiveness, the expected aggregated cash flow might be FC 1,000 due to changes in the commodity basis risk in the first level relationship. The expected aggregated hedged cash flow is calculated as follows:

Designated volume of hedged coffee purchases × prevailing forward coffee price for actual coffee purchases

Plus

Change in market value of designated hedging coffee benchmark forward contracts

If the expected hedged cash flow has changed since inception of the second level relationship, an entity would need to measure effectiveness as if the current expected hedged cash flow from the aggregated exposure was always the expectation at inception (i.e. FC 1,000 in the example given above). [IFRS 9.IE122, IE123]. As is usual for cash flow hedges (see 7.2 below), ineffectiveness to be reported in the profit or loss is the change in fair value of the actual hedging instrument less the effective portion taken to OCI. Specifically, for the second level relationship in this scenario the effective portion taken to OCI would be calculated as the lower of the following amounts: [IFRS 9.6.5.11(a)]

Change in fair value of the current expected hedged cash flows as if they had existed since inception.

(e.g. based on a hedged cash flow of FC 1,000)

And

Change in fair value of the actual hedging instrument

(e.g. based on original assumption of hedged flow of FC 990)

For hedge effectiveness measurement purposes, not only is the change in fair value of the hedged cash flows affected by variations in the second level relationship hedged risk, but also by ineffectiveness in the first level relationship. This second driver of fair value change can be seen in the example above as, although the hedging instrument has a notional of FC 990, the hedged cash flow is updated to FC 1,000, to reflect ineffectiveness in the first level relationship. This is likely to result in incremental ineffectiveness in the second level relationship.

The illustrative example in the standard demonstrates that to reduce the basis risk the entity may chose a hedge ratio other than 1:1 for the first level relationship (see 6.4.3 below). In the example the entity selects the volume of foreign currency forward contract for the hedging instrument in the second level relationship based on the implied coffee forward price at the time the first level relationship was designated. This assumes the entity's original long-term expectations of the basis spread have not changed since the coffee forward was transacted, which may not always be the case. Alternatively, when identifying the optimal volume of the hedging instrument, an entity may conclude that the appropriate basis spread is the prevailing basis spread at the time of designation of the second level relationship. However, of course, the actual basis spread the entity will suffer is unknown.

Another layer of complexity would be added if the entity subsequently needed to rebalance the hedge relationship because of changes in the expected basis. The example, however, does not include this. Although the accounting for the second level relationship may be complex, the accounting for the first level hedge relationship in this example would continue to be unaffected by the existence of the second level relationship.

The definition of an aggregated exposure also includes a forecast transaction of an aggregated exposure. [IFRS 9.6.3.4]. An example, where this might be helpful, is when pre-hedging the interest rate risk in a forecast foreign currency debt issue:

In this example the first level relationship does not exist yet, as both the hedged item (fixed rate foreign currency debt) and the hedging instrument (CCIRS) are forecast transactions. Hedge accounting for the ‘second level hedge relationship’ of the forecast aggregated exposure is still permitted though, on the condition that when the aggregated exposure occurs and is no longer forecast, it would be eligible as a hedged item. [IFRS 9.6.3.4].

As an aggregated exposure is a combination of an exposure and a derivative, the aggregated exposure is often a hedging relationship itself (the first-level relationship). In order for the aggregated exposure to qualify for hedge accounting, IFRS 9 only requires that the first-level relationship could qualify for hedge accounting and not that hedge accounting is actually applied. However, applying hedge accounting to the aggregated exposure gets even more complex when hedge accounting is not applied to the first-level relationship, and the entity is also unlikely to achieve its desired accounting result. [IFRS 9.BC6.167]. Therefore, in many cases we expect entities to apply hedge accounting to the first-level relationship, even if not required.

However, just because an entity enters into an additional derivative transaction that relates to an existing hedging relationship it does not mean that this relationship qualifies as an aggregated exposure. This is demonstrated by the following example.

3.2.1 Offsetting external derivatives

Where two offsetting derivatives are transacted at the same time, it is generally not permitted to designate one of them as a hedging instrument in a hedge when the derivatives are viewed as one unit. [IFRS 9.6.2.4]. Indicators that the two derivatives should be accounted for as one unit are as follows:

• the second derivative was entered into at the same time and in contemplation of the first;
• there is a no apparent economic need or substantive business purpose for structuring the transactions separately, that could not also have been accomplished in a single transaction;
• they relate to the same risk; and
• the derivatives are with the same counterparty. [IFRS 9.IG B.6].

This issue is also discussed in Chapter 46 at 3.2 and 8. It is emphasised that judgement should be applied in determining what a substantive business purpose is. For example, a centralised treasury entity may enter into third party derivative contracts on behalf of other subsidiaries to hedge their interest rate exposures and, to track those exposures within the group, enter into internal derivative transactions with those subsidiaries. It may also enter into a derivative contract with the same counterparty during the same business day with substantially the same terms as a contract entered into as a hedging instrument on behalf of another subsidiary as part of its trading operations, or because it wishes to rebalance its overall portfolio risk. In this case, there is a valid business purpose for entering into each contract. However, a desire to achieve hedge accounting for the hedged item is deemed not to be a substantive business purpose. [IAS 39.F.1.14].

3.2.2 Net written options

It was explained in IAS 39 that an option an entity writes is not effective in reducing the profit or loss exposure of a hedged item. In other words, the potential loss on a written option could be significantly greater than the potential gain in value of a related hedged item. [IAS 39.AG94]. This is the rationale for prohibiting a written option from qualifying as a hedging instrument unless it is designated as an offset to a purchased option, including one that is embedded in another financial instrument and not required to be accounted for separately (see Chapter 46 at 4). An example of this might be a written call option that is used to hedge a callable liability. [IFRS 9.B6.2.4]. In contrast, a purchased option has potential gains equal to or greater than losses and therefore has the potential to reduce profit or loss exposure from changes in fair values or cash flows. Accordingly, a purchased option can qualify as a hedging instrument.

It follows that a derivative such as an interest rate collar that includes a written option cannot be designated as a hedging instrument if it is a net written option. However, if the interest rate collar was deemed to be a net purchased option or zero cost collar then it would be an eligible hedging instrument.

Accordingly, determining whether an option contract or a combination of options (see 3.5 below) constitutes a net written option is an important step in hedge designation, and can require judgement. The following factors, taken together, indicate that an instrument or combination of instruments is not a net written option:

• no net premium is received, either at inception or over the life of the combination of options – the distinguishing feature of a written option is the receipt of a premium to compensate for the risk incurred;
• except for the strike prices, the critical terms and conditions of the written and purchased option components are the same, including underlying variable(s), currency denomination and maturity date; and
• the notional amount of the written option component is not greater than that of the purchased option component. [IFRS 9.BC6.153, IAS 39.F.1.3(b)].

The application of these requirements is illustrated in the following two examples.

See 3.6.4, 7.4.11 and 7.5.1 below for further discussion of the implications of using options as hedging instruments.

3.2.3 Embedded derivatives

Only derivatives that are measured at fair value through profit or loss are eligible hedging instruments. [IFRS 9.6.2.1]. Derivatives that are embedded in hybrid contracts, but that are not separately accounted for, cannot be designated as separate hedging instruments. [IFRS 9.B6.2.1]. Given that embedded derivatives in financial assets are not accounted for separately under IFRS 9 (see Chapter 48 at 6), this guidance precludes designation of embedded derivatives in financial assets as separate hedging instruments. [IFRS 9.BC6.117‑122].

However, an embedded derivative that is accounted for separately from its host contract (either a financial liability or non-financial host) (see Chapter 46 at 4), is measured at fair value through profit or loss, and therefore could be an eligible hedging instrument.

3.2.4 Credit break clauses

It is not uncommon for certain derivatives (e.g. long-term interest rate swaps) to contain terms that allow the counterparties to settle the instrument at a so-called ‘fair value’ in certain circumstances. The ‘fair value’ is usually not a true fair value as it excludes changes in credit risk. Such terms, often called ‘credit break clauses’, enable the counterparties to manage their credit risk in markets where collateral or margin accounts and master netting agreements are not used. They are particularly common where a long-duration derivative is transacted between a financial and non-financial institution. For example, the terms of a twenty-year interest rate swap may allow either party to settle the instrument at fair value on the fifth, tenth and fifteenth anniversary of its inception.

These terms can be seen as options on counterparty credit risk. However, provided the two parties have equivalent rights to settle the instrument at ‘fair value’, the credit break clause will generally not prevent the derivative from qualifying as a hedging instrument. Particularly, in assessing whether a premium is received for agreeing to the incorporation of such terms into an instrument, care needs to be exercised. For example, marginally better underlying terms offered by one potential counterparty (as a result of market imperfections) should not be mistaken for a very small option premium.

3.2.5 Basis swaps

A derivative which does not reduce risk at the transaction level cannot be a hedging instrument. Consider a ‘basis swap’ that effectively converts one variable interest rate index (say a central bank base rate) on a liability to another (say LIBOR). A relationship of this nature would not normally qualify for hedge accounting because the hedging instrument does not reduce or eliminate risk in any meaningful way – it simply converts one risk to another similar risk.⁷ For this reason, such an economic strategy would not qualify as either a fair value or cash flow hedge relationship (see 5.1 and 5.2 below).

A basis swap or similar instrument may qualify as a hedging instrument when considered in combination with another instrument (see 3.5 below). For example, the basis swap described above and a pay-fixed, receive-LIBOR interest rate swap may qualify as a hedging instrument in a cash flow hedge of a borrowing that pays interest based on a central bank rate. It may also be notionally decomposed and designated in hedges of offsetting gross asset and liability positions (see Example 53.37 at 3.6.2 below).

However, a currency basis swap that converts foreign currency variable rate interest and principal cash flows from a financial liability into variable rate interest and principal cash flows in functional currency may be eligible as a hedging instrument in a cash flow hedge, as variability in cash flows with respect to foreign currency has been reduced (or eliminated). The fact that variability in cash flows with respect to interest rate risk remains, does not preclude hedge accounting for foreign currency risk (see 2.2 above).

3.3.1 Hedge of foreign currency risk by a non-derivative financial instrument

For a hedge of foreign currency risk, the foreign currency component of a non-derivative financial asset or liability may be designated, as a hedging instrument. However, an equity instrument for which an entity has elected to present changes in fair value in OCI does not qualify as a hedging instrument in a hedge of foreign currency risk. [IFRS 9.6.2.2]. This reflects that fair value changes (including from foreign currency risk) are not recognised in profit or loss, which is incompatible with the mechanics of fair value hedges and cash flow hedges.

For hedges of foreign currency risk, the foreign currency risk component of a non-derivative financial instrument is determined in accordance with IAS 21. [IFRS 9.B6.2.3]. This means that an entity could, for example, hedge the spot risk of highly probable forecast sales in 12 months' time that are denominated in a foreign currency with a 7‑year financial liability in the same foreign currency. However, when measuring ineffectiveness, IFRS 9 is explicit that the revaluation of the forecast sales for foreign currency risk would have to be on a discounted basis (i.e. a present value calculation of the spot revaluation, reflecting the time between the reporting date and the future cash flow date), whereas the hedging instrument (i.e. the IAS 21-based foreign currency component of the financial liability) would not. This would result in some ineffectiveness (see 7.4.7 below). [IFRS 9.B6.5.4].

The following two examples illustrate the types of permitted hedge relationships for foreign currency risk where the hedging instrument is a non-derivative financial instrument.

In Example 53.33 above, hedge accounting is unnecessary because the amortised cost of the hedging instrument and the hedged item are both remeasured using closing rates with differences recognised in profit or loss as required by IAS 21.

In principle, there is no reason why a non-derivative financial instrument cannot be a hedging instrument in one hedge (of foreign currency risk) and a hedged item in another hedge (for example in a hedge of interest rate risk).

3.6.1 Proportions of instruments

It is possible to designate a proportion of the entire hedging instrument, such as 50% of the notional amount, in a hedging relationship. [IFRS 9.6.2.4(c)]. The proportion that is not designated is available for designation within other hedge relationships, such that a maximum of 100% of the notional is designated as a hedging instrument. Any proportions of an instrument not designated within hedge relationships are accounted under the usual IFRS 9 classification and measurement guidance.

3.6.2 Hedging different risks with one instrument

A single hedging instrument may be designated as a hedging instrument of more than one type of risk, provided that there is specific designation of:

• the hedging instrument; and
• the different risk positions.

Those hedged items can be in different hedging relationships. [IFRS 9.B6.2.6]. A single hedging instrument can also be used to hedge different risks within the same hedge relationship; one such frequent designation is of a single cross currency swap used to hedge both foreign exchange and interest rate risk in foreign currency debt.

An example where a single hedging derivative is used to hedge more than one risk in different hedging relationships is the use of a foreign currency forward to eliminate the resulting foreign currency risk from payables and receivables in two different foreign currencies, see Example 53.35 below, which is based on an example given in IAS 39. [IAS 39.F1.13].

In the above example a single hedging instrument is designated in a hedge of foreign currency risk arising from two separate hedged items. The hedges in the example could both be designated as either cash flow or fair value hedges (see 5.1.2 and 5.2.3 below). There is no reason why a single hedging instrument may not be designated in both a cash flow hedge and a fair value hedge for different risks, provided the usual conditions for achieving hedge accounting are met.

As can be seen in Examples 53.35 and 53.36 above, decomposition of a derivative hedging instrument by imputing notional legs is an acceptable means of splitting the fair value of a derivative hedging instrument into multiple components in order to achieve hedge accounting, as long as:

• the split does not result in the recognition of cash flows that are not evident from contractual terms of the derivative instrument;
• the notional legs introduced must be offsetting;
• all decomposed elements of the derivative instrument are included within an eligible hedge relationship; and
• the designation is consistent with risk management (see 6.2 below).

The IFRS Interpretations Committee confirmed such an approach to be acceptable under IAS 39 and there is no reason to believe that this would not also be the case under IFRS 9.⁸ Consideration of the hedge accounting qualifying criteria for all relationships that include decomposed elements of a derivative instrument should be captured in the hedge documentation on designation, as normal.

The qualifying criteria assessment may be carried out for the total hedged position, i.e. incorporating all risks identified if these risks are inextricably linked, or for the decomposed parts separately, i.e. individually for each hedge relationship that includes a decomposed part of the derivative. However, if the assessment is undertaken separately, each hedge relationship that includes a decomposed part would need to meet the qualifying criteria. Otherwise the derivative would not qualify for hedge accounting as part of it would not be included within an eligible hedge relationship. This restriction is necessary as a financial instrument can only be designated as a hedging instrument in its entirety (see 3.6 above). For example, the ‘knock-out swap’ in Example 53.28 above could not be split into, on the one hand, a conventional interest rate swap, to be used as a hedging instrument and, on the other hand, the knock-out feature (a written swaption, i.e. an option for the counterparty to enter into an offsetting interest rate swap with the same terms as the conventional swap). This is because the knock out feature is unlikely to be designated and qualify for hedge accounting at all.

If the IFRIC analysis of the decomposition of derivatives is applied to a basis swap, hedge accounting for that swap may be possible. The swap would be designated as a hedge of appropriate asset and liability positions.

The guidance above discussed various combinations of cash flow and fair value hedge relationships. However, there appears to be no reason why a single instrument could not, in theory, be designated in other combinations of hedges, for example a cash flow hedge and a hedge of a net investment.

3.6.3 Restructuring of derivatives

An entity may exchange a derivative that does not qualify as a hedging instrument (say, the knock-out swap in Example 53.28 above) for two separate derivatives that, together, have the same fair value as the original instrument (say, a conventional interest rate swap and a written swaption). Such an exchange is likely to be motivated by a desire to obtain hedge accounting for one of these new instruments.

In order to determine whether the new arrangement can be treated as two separate derivatives, rather than a continuation of the original derivative, we believe it is necessary to determine whether the exchange transaction has any substance, which is clearly a matter of judgement. If the exchange has no substance, then hedge accounting would still be precluded as the two ‘separate’ derivatives would in substance be a continuation of the original derivative (see 3.2.1 above and Chapter 46 at 3.2).

In the case of the knock-out swap, if the two new contracts had the same counterparty and, in aggregate, the same terms as the original contract this would not necessarily lead to the conclusion that the exchange lacked substance. However if, in addition, the swaption would be settled by delivery of the conventional interest rate swap in the event that it was exercised, this is a strong indicator that the exchange does lack substance.

3.6.4 Time value of options

An entity may choose to hedge for risk management purposes the variability of future cash flow outcomes resulting from a price increase (but not a decrease) of a forecast commodity purchase. This hedge of a ‘one-sided risk’ could be achieved by transacting a purchased option as the hedging instrument (see 3.2.2 above). In such a situation, it is permitted that only cash flow losses in the hedged item that result from an increase in the price above the specified level are designated within a hedge relationship. However, only the intrinsic value of a purchased option hedging instrument, not its time value, reflects this one-sided risk in the hedged item (assuming that it has the same principal terms as the designated risk). The hedged risk for a one-sided risk does not include the time value of a purchased option, because the time value is not a component of the forecast transactions that affects profit or loss (see 7.4.12 below). [IFRS 9.B6.3.12]. As a result, changes in the time value of the option would give rise to hedge ineffectiveness.

To address this problem, an entity is permitted to designate as the hedging instrument only the change in the intrinsic value of an option and not the change in its time value. [IFRS 9.6.2.4(a)].

If it does so, the entity accounts for the time value of the option as a cost of hedging (see 7.5 below). [IFRS 9.6.5.15].

Excluding the time value may make it administratively easier to process the hedges and it can certainly improve a hedge's effectiveness from an accounting perspective. However, accounting for the option time value as a cost of hedging does involve some complexity, in particular where the terms of the hedged item and hedging option are what is described in the standard as not ‘closely aligned’ (see 7.5.1.A below).

The use of this exception is not mandatory. For example, a dynamic hedging strategy that assesses both the intrinsic value and time value of an option contract can qualify for hedge accounting (see 6.3.2 below), although the time value is still likely to result in some ineffectiveness. In addition, an entity may use an option to hedge an exposure that itself contains optionality – see 7.4.12 below for the challenges that arise with such a designation.

3.6.5 Forward element of a forward contract and foreign currency basis spread

IFRS 9 also permits (but does not require) an entity to separate the forward element and the spot element of a forward contract and designate only the change in the value of the spot element of a forward contract and not the forward element as the hedging instrument. In addition, the foreign currency basis spread may be separated and excluded from the designation of a financial instrument as the hedging instrument. [IFRS 9.6.2.4(b)].

Where the forward element or foreign currency basis are excluded from the designation as a hedging instrument, IFRS 9 permits a choice as to whether to account for the excluded portion as a cost of hedging (see 7.5 below) or to continue measurement at fair value through profit or loss. This is, however, not an accounting policy choice, but an election for each designation. [IFRS 9.6.5.16].

3.6.6 Hedges of a portion of a time period

A hedging instrument may not be designated for a part of its change in fair value that results from only a portion of the time period during which the hedging instrument remains outstanding. This clarifies that an entity cannot designate a ‘partial-term’ component of a financial instrument as the hedging instrument, but only the entire instrument for its remaining life (notwithstanding that an entity may exclude from designation the time value of an option, the forward element of a forward contract or the foreign currency basis spread, see 3.6.4 and 3.6.5 above). [IFRS 9.6.2.4]. This does not mean that the hedge relationship must necessarily continue for the entire remaining life of the hedging instrument – the usual hedge discontinuation requirements apply (see 8.3 below).

4.1.1 Central clearing parties and ring fencing of banks

Following the introduction of legal or regulatory requirements requiring over-the-counter (OTC) derivatives to be novated to a central clearing party (CCP) or incentivising financial institutions to do so (see 8.3.3 below) coupled with additional legislation in various jurisdictions for banks to separate core retail banking activities from investment banking activities, additional focus has arisen on ‘internal derivatives’ within a banking group.

When derivatives transacted between the retail banking and investment banking legal entities within a banking group are novated to a CCP, the CCP becomes the counterparty to the derivatives. This does not automatically mean that the external derivatives with the CCP are eligible for hedge accounting, judgement will be required as to whether the offsetting external derivatives should be considered in substance as a single contract in the consolidated financial statements. As part of this judgement, consideration should be given to the substantive business purpose for the practice of transacting derivatives between the retail banking and investment banking legal entities and, in particular, novating derivatives to a CCP – other than to achieve hedge accounting (see 3.2.1 above). The assessment as to whether such a substantive business purpose exists or not must be made based on the particular facts and circumstances, including consideration of the regulatory environment, and the judgement documented accordingly.

4.2.1 Interest rate risk

Sometimes, central treasury functions enter into internal derivative contracts with subsidiaries and, perhaps, divisions within the consolidated group to manage interest rate risk on a centralised basis. If, before laying off the risk, the internal contracts are first netted against each other and only the net exposure is offset in the marketplace with external derivative contracts, the internal contracts cannot qualify for hedge accounting in the consolidated financial statements.

Where two or more internal derivatives used to manage interest rate risk on assets or liabilities at the subsidiary or division level are offset at the treasury level, the effect of designating the internal derivatives as hedging instruments is that the hedged non-derivative exposures at the subsidiary or division levels would be used to offset each other on consolidation. Accordingly, since IAS 39 did not permit designating non-derivatives as hedging instruments (except for foreign currency exposures), the results of hedge accounting from the use of internal derivatives at the subsidiary or division level that are not laid off with external parties must be reversed on consolidation. [IAS 39.F.1.5]. Although IFRS 9 does permit designation of non-derivative instruments as hedging instruments, this is only for financial instruments measured at fair value through profit or loss, which is unlikely to be the case in this scenario (see 3.3 above).

It should be noted, however, that if internal derivatives offset each other on consolidation; are used in the same type of hedging relationship at the subsidiary or division level; if the hedged items affect profit or loss in the same period (in the case of cash flow hedges); and if the hedges are perfectly effective at the subsidiary level; then there will be no effect on profit or loss and equity of reversing the effect of hedge accounting on consolidation. Just as the internal derivatives offset at the treasury level, their use as fair value hedges by two separate entities or divisions within the consolidated group will also result in the offset of the fair value amounts recognised in profit or loss. Similarly, their use as cash flow hedges by two separate entities or divisions within the consolidated group will also result in the fair value amounts being offset against each other in other comprehensive income. [IAS 39.F.1.5].

However, reversal of subsidiary hedge accounting on consolidation may affect individual line items in both the consolidated income statement (or statement of comprehensive income) and the consolidated statement of financial position. This will be the case, for example, when internal derivatives that hedge assets (or liabilities) in a fair value hedge are offset by internal derivatives that are used as a fair value hedge of other assets (or liabilities) that are recognised in a different line item in the statement of financial position or income statement (or statement of comprehensive income). In addition, to the extent that one of the internal contracts is used as a cash flow hedge and the other is used in a fair value hedge, the effect on profit or loss and equity would not offset since the gain (or loss) on the internal derivative used as a fair value hedge would be recognised in profit or loss and the corresponding loss (or gain) on the internal derivative used as a cash flow hedge would be recognised in other comprehensive income. [IAS 39.F.1.5].

Notwithstanding this, under the principles set out at 4.1 above, it may be possible to designate the external derivative as a hedge of some of the underlying exposures as illustrated in the following example.

4.2.2 Foreign currency risk

Although much of the discussion at 4.2.1 above applies equally to hedges of foreign currency risk, there is one important distinction between the two situations. Non-derivative financial instruments are permitted to be used as the hedging instrument in the hedge of foreign currency risk. Therefore, in this case, internal derivatives may be used as a basis for identifying non-derivative external transactions that could qualify as hedging instruments or hedged items, provided that the internal derivatives represent the transfer of foreign currency risk on underlying non-derivative financial assets or liabilities (see Case 3 in Example 53.39 above). However, for consolidated financial statements, it is necessary to designate the hedging relationship so that it involves only external transactions.

Forecast transactions and unrecognised firm commitments cannot qualify as hedging instruments. Accordingly, to the extent that two or more offsetting internal derivatives represent the transfer of foreign currency risk on such items, hedge accounting cannot be applied. As a result, if any cumulative net gain or loss on an internal derivative has been included in the initial carrying amount of an asset or liability (a ‘basis adjustment’) (see 7.2.2 below), it would have to be reversed on consolidation if it cannot be demonstrated that the offsetting internal derivative represented the transfer of a foreign currency risk on a financial asset or liability to an external hedging instrument. [IAS 39.F.1.6].

The following example illustrates this principle – it also illustrates the mechanics of accounting for fair value hedges and cash flow hedges, which are discussed in more detail at 7.1 and 7.2 below. [IAS 39.F.1.7].

It is apparent that extending the principles set out in this relatively simple example to the more complex and higher volume situations that are likely to be encountered in practice is not going to be straightforward.

4.3.1 Intragroup monetary items

IFRS 9 allows the foreign currency risk of an intra-group monetary item (e.g. a payable or receivable between two subsidiaries) to qualify as a hedged item in the consolidated financial statements if it results in an exposure to foreign exchange rate gains or losses under IAS 21 that are not fully eliminated on consolidation. Foreign exchange gains and losses on such items are not fully eliminated on consolidation when they are transacted between two group entities that have different functional currencies (see Chapter 15 at 6.3), [IFRS 9.6.3.6], as illustrated in the following example.

4.3.2 Forecast intragroup transactions

IFRS 9 also contains a second exception allowing the foreign currency risk of a highly probable forecast intragroup transaction to qualify as a hedged item in a cash flow hedge in consolidated financial statements in certain circumstances. The transaction must be denominated in a currency other than the functional currency of the entity entering into that transaction (e.g. parent, subsidiary, associate, joint venture or branch) and the foreign currency risk must affect consolidated profit or loss (otherwise it cannot qualify as a hedged item). [IFRS 9.6.3.6].

Normally, royalty payments, interest payments and management charges between members of the same group will not affect consolidated profit or loss unless there is a related external transaction. However, by way of example, a forecast sale or purchase of inventory between members of the same group will affect profit or loss if there is an onward sale of the inventory to a party external to the group. Similarly, a forecast intragroup sale of plant and equipment from the group entity that manufactured it to a group entity that will use it in its operations may affect consolidated profit or loss. This could occur, for example, because the plant and equipment will be depreciated by the purchasing entity and the amount initially recognised for the plant and equipment may change if the forecast intragroup transaction is denominated in a currency other than the functional currency of the purchasing entity. [IFRS 9.B6.3.5].

Therefore, in order that a forecast intragroup transaction to be eligible as a hedged item, a related external transaction must also exist. It is clear that the designated hedged item is the forecast intragroup transaction, which is therefore subjected to the usual eligibility criteria for hedge accounting (see 2 above). However, the highly probable criterion (see 2.6.1 above) is also relevant for the external transaction in order to meet the requirement that the forecast foreign currency risk will affect consolidated profit or loss. The related external transaction also drives the timing of recycling of the effective portion of the hedge relationship (see 7.2.2 below).

Although the standard refers exclusively to forecast intragroup transactions, we believe there is no reason why these provisions should not also apply to intragroup firm commitments.

5.1.1 Hedges of firm commitments

A hedge of a firm commitment (e.g. a hedge of the change in fuel price relating to an unrecognised contractual commitment by an electricity utility to purchase fuel at a fixed price) is considered a hedge of an exposure to a change in fair value. Accordingly, such a hedge is a fair value hedge. However, a hedge of the foreign currency risk of a firm commitment may be accounted for as either a fair value hedge or a cash flow hedge (this is discussed further at 5.2.2 below). [IFRS 9.B6.5.3].

5.1.2 Hedges of foreign currency monetary items

A foreign currency monetary asset or liability that is hedged using a forward exchange contract may be treated as a fair value hedge because its fair value will change as foreign currency rates change (see 7.1 below). Alternatively, it may be treated as a cash flow hedge because changes in exchange rates will affect the amount of cash required to settle the item (as measured by reference to the entity's functional currency) (see 7.2 below).

5.2.1 All-in-one hedges

The implementation guidance of IAS 39 made specific reference to an ‘all in one hedge’, although none of the IAS 39 implementation guidance on hedge accounting was carried forward into IFRS 9, much of it remains relevant under IFRS 9 (see 1.3 above). [IFRS 9.BC6.94‑97]. Accordingly the IAS 39 guidance on an ‘all in one hedge’ is discussed below with respect to application within IFRS 9.

There are situations where an instrument that is accounted for as a derivative is expected to be settled gross by delivery of the underlying asset in exchange for the payment of a fixed price. The IAS 39 implementation guidance states that such an instrument can be designated as the hedging instrument in a cash flow hedge of the variability of the consideration to be paid or received in the future transaction that will occur on gross settlement of the derivative contract itself. It is explained that this is acceptable because there would be an exposure to variability in the purchase or sale price without the derivative. It is important to note that, in order to qualify for a hedge of a highly probable forecast transaction, the hedging entity must have the intention (and the ability) to gross settle the derivative. For example, consider an entity that enters into a fixed price contract to sell a commodity and that contract is accounted for as a derivative under IFRS 9 (see Chapter 45 at 4). This might be because the entity has a practice of settling such contracts net in cash or of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer's margin. In this case, the fixed price contract may be designated as a cash flow hedge of the variability of the consideration to be received on the sale of the asset (a future transaction) even though the fixed price contract is the contract under which the asset will be sold. [IAS 39.F.2.5].

Similarly, an entity may enter into a forward contract to purchase a debt instrument (which will not be classified at fair value through profit or loss) that will be settled by delivery of the debt instrument, but the forward contract is a derivative. This will be the case if its term exceeds the regular way delivery period in the marketplace (see Chapter 49 at 2.2). In this case the forward may be designated as a cash flow hedge of the variability of the consideration to be paid to acquire the debt instrument (a future transaction), even though the derivative is the contract under which the debt instrument will be acquired. [IAS 39.F.2.5]. If the forecast debt instrument was to be classified at fair value through profit or loss, the all-in-one hedge strategy could not be applied. This is because cash flow hedging of a forecast transaction that will be accounted for at fair value through profit or loss on initial recognition is precluded, since any gain or loss on the hedging instrument that would be deferred could not be appropriately reclassified to profit (see 2.6.2 above).

5.2.2 Hedges of firm commitments

A hedge of the foreign currency risk of a firm commitment may be accounted for as a cash flow hedge or a fair value hedge (see 5.1.1 above). [IFRS 9.B6.5.3]. This is because foreign currency risk affects both the cash flows and the fair value of the hedged item. Accordingly, a foreign currency cash flow hedge of a forecast transaction need not be redesignated as a fair value hedge when the forecast transaction becomes a firm commitment.

5.2.3 Hedges of foreign currency monetary items

A foreign currency monetary asset or liability that is hedged using a forward exchange contract may be treated as a fair value hedge because its fair value will change as foreign currency rates change. Alternatively, it may be treated as a cash flow hedge because changes in exchange rates will affect the amount of cash required to settle the item (as measured by reference to the entity's functional currency) (see 7.2.3 below).

5.3.1 Nature of the hedged risk

Perhaps the most important decision made by the Interpretations Committee was that hedge accounting may be applied only to the foreign exchange differences arising between the functional currency of the foreign operation and the parent entity's functional currency. [IFRIC 16.10]. Furthermore, the hedged risk may be designated as the foreign currency exposure arising between the functional currency of the foreign operation and the functional currency of any parent entity (the immediate, intermediate or ultimate parent entity) of that foreign operation. The fact that the net investment may be held through an intermediate parent does not affect the nature of the economic risk arising from the foreign currency exposure to the ultimate parent entity. [IFRIC 16.12]. This principle is illustrated in the following example.

5.3.2 Amount of the hedged item for which a hedging relationship may be designated

The hedged item can be an amount of net assets equal to or less than the carrying amount of the net assets of the foreign operation in the consolidated financial statements of the parent entity. [IFRIC 16.11].

The carrying amount of the net investment takes account of monetary items receivable from or payable to a foreign operation for which settlement is neither planned nor likely to occur in the future. These balances are considered to be, in substance, part of the reporting entity's net investment in the foreign operation. [IAS 21.15]. A loan made to the foreign operation, for which settlement is neither planned nor likely to occur in the future, will increase the amount that can be hedged; if a loan is made by the foreign operation, the amount that can be hedged will be reduced. [IFRIC 16.AG14].

In many cases the full economic value of a net investment will not be recognised in the financial statements. The most common reason will be the existence of, say, goodwill or intangible assets that are either not recognised or measured at an amount below their current value. In these situations, if an investor hedges the entire economic value of its net investment it will not be able to obtain hedge accounting for the proportion of the hedging instrument that exceeds the recognised net assets.

A single hedging instrument can hedge the same designated risk only once. Consequently, in Examples 453.47 and 53.48 above, P could not in its consolidated financial statements designate A's external borrowing in a hedge of both the €/US$ spot foreign exchange risk and the £/US$ spot foreign exchange risk in respect of its net investment in C. [IFRIC 16.AG6].

The carrying amount of the net assets of a foreign operation that may be designated as the hedged item in the consolidated financial statements of a parent depends on whether any lower level parent of the foreign operation has applied hedge accounting for all or part of the net assets of that foreign operation and whether that accounting has been maintained in the parent's consolidated financial statements. [IFRIC 16.11]. An exposure to foreign currency risk arising from a net investment in a foreign operation may qualify for hedge accounting only once in the consolidated financial statements. Therefore, if the same net assets of a foreign operation are hedged by more than one parent entity within the group (for example, both a direct and an indirect parent entity) for the same risk, only one hedging relationship will qualify for hedge accounting in the consolidated financial statements of the ultimate parent. [IFRIC 16.13]. This is illustrated in the following example.

A hedging relationship designated by one parent entity in its consolidated financial statements need not be maintained by another higher level parent entity. However, if it is not maintained by the higher level parent entity, the hedge accounting applied by the lower level parent must be reversed before the higher level parent's hedge accounting is recognised. [IFRIC 16.13]. This is illustrated in the following example.

5.3.3 Where the hedging instrument can be held

The hedging instrument(s) may be held by any entity or entities within the group, including the foreign operation being hedged, provided the designation, documentation and qualification criteria of IFRS 9 are satisfied. The hedging strategy of the group should be clearly documented because of the possibility of different designations at different levels of the group (see 5.3.2 above). [IFRIC 16.14, BC24A, BC24B].

Where the entity holding the hedging instrument has a functional currency that is not the same as the parent by which the hedged risk is defined, this could result in some of the foreign exchange difference on the hedging instrument remaining in profit or loss – this is discussed further at 7.3.1 below.

Clearly the reporting entity (which, in the case of consolidated financial statements, includes any subsidiary consolidated by the parent) must be a party to the hedging instrument. In Examples 53.47 and 539.48 above, therefore, B could not apply hedge accounting in its consolidated financial statements in respect of a hedge involving the US$300 million borrowing issued by A because the hedging instrument is held outside of the group headed by B. [IFRIC 16.AG6].

6.2.1 Designating ‘proxy hedges’

The objective of the standard is ‘to represent, in the financial statements, the effect of an entity's risk management activities’. [IFRS 9.6.1.1]. However, this does not mean that an entity can only designate hedging relationships that exactly mirror its risk management activities. The Basis for Conclusions notes that, in some circumstances, the designation for hedge accounting purposes is inevitably not the same as an entity's risk management view of its hedging, but that the designation reflects risk management in that it relates to the same type of risk that is being managed and the instruments used for this purpose. The IASB refer to this situation as ‘proxy hedging’ (i.e. designations that do not exactly represent the actual risk management). In redeliberating the September 2012 draft standard, the Board decided that proxy hedging is permitted, provided the designation is directionally consistent with the actual risk management activities.¹⁰ Furthermore, where there is a choice of accounting hedge designation, there is no apparent requirement for an entity to select the designation that most closely matches the risk management view of hedging as long as the chosen approach is still directionally consistent with actual risk management. [IFRS 9.BC6.97‑101].

In June 2019, within the context of a fair value hedge of foreign currency risk of a non-financial asset held for consumption, the IFRS Interpretations Committee discussed the extent to which a designated hedge relationship should be consistent with an entity's risk management activities.¹¹

Paragraph 6.4.1(b) of IFRS 9 requires that, at the inception of a hedging relationship, ‘there is formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge’. Accordingly, the Committee observed that, in applying IFRS 9, an entity can apply hedge accounting only if it is consistent with the entity's risk management objective and strategy for managing its exposure. An entity therefore cannot apply hedge accounting solely on the basis that it identifies items in its statement of financial position that are measured differently but are subject to the same type of risk.

The Committee observed that to the extent that an entity intends to consume a non-financial asset (rather than to sell it), changes in the fair value of the non-financial asset may be of limited significance to the entity. In such cases, an entity may not be economically managing or hedging risk exposures on the non-financial asset and, in that case, it cannot apply hedge accounting.

However, although the Interpretations Committee has reiterated the importance of consistency between designation of a hedge relationship and the entity's risk management objective, proxy hedging is still permitted, as long as the hedge designation is still directionally consistent with actual risk management. The examples below are common proxy hedging designations:

6.3.1 Business combinations

In a business combination accounted for using the purchase method of accounting where the acquiree has designated hedging relationships, the question arises of whether the acquirer should:

• be permitted to continue to apply the hedge accounting model to hedge relationships designated previously by the acquiree, assuming it is consistent with the acquirer's strategies and policies; or
• be required to re-designate hedge relationships at the acquisition date.¹²

IFRS 3 – Business Combinations – provides guidance that in order to obtain hedge accounting in their consolidated financial statements, acquirers are required to redesignate the acquiree's hedges. [IFRS 3.15, 16(b)]. Further, the acquirer should not recognise in its consolidated financial statements any amounts in equity in respect of any cash flow hedges of the acquiree relating to the period prior to acquisition.

Redesignating the hedge relationships at the acquisition date means that if the hedging instrument has a fair value other than zero (see 7.4.3 below), it is likely that ineffectiveness will be introduced in a hedge that may have been nearly 100% effective prior to the acquisition, particularly for cash flow hedges. To mitigate this, the acquirer may, subsequent to the combination, choose to settle the existing hedging instruments and replace them with similar ‘on market’ contracts with a zero fair value. Furthermore, the existence of this source of ineffectiveness may influence the chosen methodology used to demonstrate the existence of an economic relationship in order to qualify for hedge accounting in the acquirer's consolidated financial statements (see 6.4 1 below). [IFRS 9.B6.4.15].

For business combinations under common control, for which IFRS 3 is not applicable, see further discussion in Chapter 10 at 3.3.3.

6.3.2 Dynamic hedging strategies

A dynamic risk management strategy is one where the entity uses a dynamic process in which the exposure and the hedging instruments used to manage the exposure do not remain the same for long. [IFRS 9.B6.5.24(b), IFRS 7.23C].

One such dynamic hedging strategy is where an entity assesses both the intrinsic value and time value of option contracts when hedging a risk exposure. Consider, as an example, a delta-neutral option hedging strategy (i.e. a strategy that is designed to create a net risk position (including the full option value) that is unlikely to be affected by small movements in the price of the underlying). In this situation it is helpful that there is no requirement to exclude the time value of hedging option contracts from the hedge relationship. IFRS 9 permits, but does not require, separation of the intrinsic and time value of an option contract and designation only of the intrinsic value as the hedging instrument (see 3.6.4 above). [IFRS 9.6.2.4(a)]. Accordingly, for a delta-neutral option hedging strategy, it is possible to achieve hedge accounting without excluding the option time value, as long as the other qualifying criteria are met (see 6.1 above).

Similarly, other dynamic hedging strategies under which the quantity of the hedging instrument is constantly adjusted in line with the risk management strategy in order to maintain a desired hedge ratio (e.g. to achieve a delta-neutral position, insensitive to changes in the fair value of the hedged item), may qualify for hedge accounting.

For a dynamic hedging strategy to qualify for hedge accounting, the documentation must specify how the hedge will be monitored and updated and how the effectiveness criteria will be assessed. Consideration must also be made as to whether the periodic changes made as part of dynamic hedging strategy should be treated as a rebalancing of the hedge relationship (see 8.2 below) or a discontinuation and redesignation of the hedge relationship (see 8.3 below). Such a determination is not a choice but based on facts and circumstances; for example, treatment as rebalancing is only permitted where changes to the hedge ratio are made (i.e. the quantity of hedged item compared to the quantity of hedging instrument). In contrast, the introduction of new types of hedging instruments would most likely be treated as a discontinuation and redesignation.

The guidance on rebalancing is applicable when the quantity of the hedging instrument is constantly adjusted in order to maintain a desired hedge ratio for the existing hedged item(s), often referred to as a closed portfolio (see 8.2 below). Accounting for dynamic risk management of the associated risk in an open portfolio, to which new exposures are frequently added, existing exposures mature, where frequent changes also occur to the hedged item(s) is the subject of a live project for the IASB (see 10.1 below).

For any designated dynamic hedging strategies that do meet the IFRS 9 hedge accounting requirements, additional disclosures are required (see Chapter 54 at 4.3.2). [IFRS 7.23C].

6.3.3 Forecast transactions

In the case of a hedge of a forecast transaction, the documentation should identify the date on, or time period in which, the forecast transaction is expected to occur. This is because, in order to qualify for hedge accounting:

• the hedge must relate to a specific identified and designated risk;
• it must be possible to measure its effectiveness reliably; and
• the hedged forecast transaction must be highly probable (see 2.6.1 above).

To meet these criteria, entities are not required to predict and document the exact date a forecast transaction is expected to occur. However, the time period in which the forecast transaction is expected to occur should be identified and documented within a reasonably specific and generally narrow range of time from a most probable date, as a basis for measuring hedge ineffectiveness. Consideration of the effectiveness criteria would need to reflect differences in timing of the hedged and hedging cash flows in a manner consistent with the designated hedged risk (see 6.4.1 and 7.4.2 below).

If a forecast transaction such as a commodity sale is properly designated in a cash flow hedge relationship and, subsequently, its expected timing changes to an earlier (or later) period, this does not affect the validity of the original designation. If the entity can conclude that this transaction is the same as the one designated as being hedged, then hedge accounting may be able to continue. However, ineffectiveness may arise due to the change in timing, as the calculation would be based on the up to date expectation of the timing of the hedged forecast transaction. For example, if the forecast transaction was now expected earlier than originally thought, the hedging instrument will be designated for the remaining period of its existence, which will exceed the period to the forecast sale.

Further, hedged forecast transactions must be identified and documented with sufficient specificity so that when the transaction occurs, it is clear whether the transaction is, or is not, the hedged transaction. Therefore, a forecast transaction may be identified as the sale of the first 15,000 units of a specific product during a specified three-month period (see 2.3.1 above), but it could not be identified as the last 15,000 units of that product sold because they cannot be identified when they occur. For the same reason, a forecast transaction cannot be specified solely as a percentage of sales or purchases during a period. The need for documented specificity of the hedged item was reiterated by the Interpretations Committee in March 2019 in a discussion within the context of the Application of the Highly Probable Requirement when a Specific Derivative is Designated as a Hedging Instrument (IFRS 9 Financial Instruments and IAS 39 Financial instruments: Recognition and Measurement)¹³ (see 2.6.1 above).

6.4.1 Economic relationship

The first effectiveness requirement means that the hedging instrument and the hedged item must generally be expected to move in opposite directions as a result of a change in the hedged risk. This is within the context of how the hedged item and hedging instrument have been designated as described at 2 and 3 above. [IFRS 9.B6.4.1]. The guidance does not require that the value changes of the hedging instrument and the hedged item move in the opposite direction for the hedged risk in all circumstances, but that generally there is an expectation that they will systematically move in opposite directions. It is clear therefore, that there can be instances where the value changes in the hedged item and hedging instrument move in the same direction, although they should typically be expected to move in opposite directions.

The standard discusses an example where the price of the hedged instrument is based on the West Texas Intermediate (WTI) price of oil whereas the price of the hedged item is based on the Brent crude oil price. The values of the hedging instrument and the hedged item can both move in the same direction if, for example, there is only a minor change in the relative underlyings of each of the hedged item and hedging instrument (i.e. the WTI and Brent oil prices) but there is a change in the price differential between the two. However, no guidance is provided as to how frequently this would have to happen so as to lead us to reject the expectation that they would ‘generally’ move in opposite directions. One possibility might be to use correlation analysis to demonstrate that there is, over time, a reliable and systematic price relationship. We expect practice to evolve in this area. [IFRS 9.B6.4.4, B6.4.5, BC6.238].

The assessment of whether there is an economic relationship should be based on an economic rationale rather than it just arising by chance, as could be the case if the relationship is based only on a statistical correlation. That is, causality cannot be assumed purely from correlation or, to quote the IASB, ‘the mere existence of a statistical correlation between two variables does not, by itself, support a valid conclusion that an economic relationship exists’. [IFRS 9.B6.4.6].

Conversely, a statistical correlation may provide corroboration of an economic rationale. For example, if it can be seen that value drivers exist such that there is an expectation that the value of the hedged item and hedging instrument would generally move in opposite directions, but that significant sources of ineffectiveness exist within a relationship that may counteract the offset, then quantitative analysis may assist in determining whether an economic relationship exists or not. For example, in the case of a fair value hedge of an inflation risk component in a fixed rate bond (assuming it is determined that an eligible risk component exists (see 2.2.6 above)), quantitative analysis may provide additional evidence as to whether an economic relationship exists or not. In summary, a quantitative assessment alone is not enough to establish an economic relationship, but it may be useful in a small number of cases to support a qualitative analysis that an economic relationship exists.

The requirement of an economic relationship will automatically be fulfilled for many hedging relationships, as the underlying of the hedging instrument often matches, or is closely aligned with, the hedged risk. [IFRS 9.B6.4.14]. Even though it is not sufficient to focus solely on changes in value due to the hedged risk, the economic relationship will often still be capable of being demonstrated using a qualitative assessment. However, value drivers of fair value movements that are excluded from the hedge relationship (e.g. a change in credit risk on a hedged bond, if the designated risk is the benchmark rate), can be ignored for the purposes of the assessment of whether there is an economic relationship.

A qualitative assessment may also be used to determine that an economic relationship does not exist. For example, a hedge of one-sided risk in forecast purchases is designated as being hedged by an out-of-the-money call option. If the main driver of value change in the option is expected to be the time value of the option, (perhaps as the option is expected to remain out of the money) then it can easily be seen the hedged item and hedging instrument are generally not expected to move in opposite directions with respect to the hedged risk. Of course, in this example, if the time value of the option were to be excluded from the hedge relationship (see 3.6.4 above), then it would be easier to demonstrate that there is an economic relationship.

When the critical terms of the hedging instrument and hedged item are not closely aligned, and there is increased uncertainty about the extent of offset, such that hedge effectiveness is more difficult to predict, as noted above, IFRS 9 suggests that ‘it might only be possible for an entity to conclude [that there is an economic relationship] on the basis of a quantitative assessment.’ [IFRS 9.B6.4.16, BC6.269]. The standard does not provide any further guidance on when a quantitative assessment might be required or how it would be made. However, it would seem to be most relevant when the hedged item and the hedging instrument are each based on prices derived from different markets, as in the example of WTI and Brent crude oil, cited earlier, where there is a reasonable chance that the value changes of the hedging instrument and the hedged item will frequently move in the same direction. This is an area where practice will develop, but we expect the need for a quantitative assessment over and above what is already undertaken for risk management purposes, to be relatively infrequent. [IFRS 9.B6.4.18].

The standard also mentions hedging relationships where a derivative with a non-zero fair value is designated as the hedging instrument, as an example of a situation where a quantitative assessment might be required to establish an economic relationship. It depends on the particular circumstances as to whether hedge effectiveness arising from the non-zero fair value could potentially have a magnitude that a qualitative assessment would not adequately capture. [IFRS 9.B6.4.15]. However, as noted above, the standard does not provide guidance on how large the non-zero fair value would have to be for a quantitative assessment to be required, or for an economic relationship to be considered not to exist.

The assessment of the economic relationship, whether qualitative or quantitative, would need to consider, amongst other possible sources of mismatch between the designated hedged item and the hedging instrument, the following:

• maturity;
• volume or nominal amount;
• cash flow dates;
• interest rate basis, or quality and location basis differences;
• day count methods;
• features that arise only in either the designated hedged item or hedging instrument;
• differences in valuation methods and inputs such as discount rates or credit risk; and
• the extent that the hedging instrument is already ‘in the money’, or ‘out of the money’ when designated.

The assessment should also include an analysis of the possible behaviour of the hedging relationship during its term to ascertain whether it can be expected to meet the risk management objective. [IFRS 9.B6.4.6]. The assessment must be forward looking at all times, without solely relying on actual retrospective offset. This does not mean that retrospective offset is never relevant, but it should only be relied upon if there is a reasonable expectation that it is representative of the future.

IFRS 9 does not specify a method for assessing whether an economic relationship exists. An entity should use a method capturing all the relevant characteristics of the hedging relationship including the sources of ineffectiveness. [IFRS 9.B6.4.13]. Which methods, including statistical methods such as regression or sensitivity analysis, as well as the thresholds attached to them, is an area where we expect that best practice will emerge over time. No ‘bright lines’ are mandated by the guidance, nor is there a requirement for an entity to determine their own bright lines. Instead, judgement is required in determining whether an economic relationship exists or not. However, it follows from the objective of the hedge accounting requirements to represent the effect of an entity's risk management activities, that the main source of information to perform the assessment would be an entity's risk management activities. [IFRS 9.6.1.1, B6.4.18]. In practice, an entity will normally have assessed the economic relationship for risk management purposes and, in most cases, assuming sound risk management, we would expect that this assessment to be appropriate for accounting purposes as well. However, in some cases, existing risk management techniques might not adequately consider all sources of ineffectiveness, such that additional quantitative analysis may be required, although this is likely to be rare. The chosen quantitative technique should depend on the complexity of the relationship, availability of data, the time value of money and the level of uncertainty of offset in the hedge relationship. If there are changes in circumstances that affect hedge effectiveness, an entity may have to change the method for assessing whether an economic relationship exists. [IFRS 9.B6.4.17].

The standard also mentions that a quantitative method, (e.g. regression analysis), might help demonstrate a suitable hedge ratio (see 6.4.3 below). [IFRS 9.B6.4.16].

The following example illustrates an approach that uses a qualitative assessment.

When using a statistical method such as regression analysis, either to corroborate an economic relationship or to determine a suitable hedging ratio, an entity is required to consider its expectations of future developments. A prominent recent example is negative interest rates in some European countries. Many variable debt instruments such as mortgages include an explicit or implicit floor while the interest rates swaps used to hedge the variability of cash flows of those exposures usually do not. Although the interest cash flows of the hedged item and the variable leg of the hedging instrument may well have been highly correlated in the past, in an environment where interest rates are expected to be negative in the foreseeable future, this may no longer be expected because of the floor in the hedged item. This means that an entity needs to incorporate changes in expectations and re-calibrate its regression analysis accordingly.

6.4.2 Credit risk and the effectiveness assessment

IFRS 9 requires that, to achieve hedge accounting, the impact of credit risk should not be of a magnitude such that it dominates the value changes, even if there is an economic relationship between the hedged item and hedging instrument. Credit risk can arise on both the hedging instrument and the hedged item in the form of counterparty credit risk or the entity's own credit risk.

Judgement must be used in determining when the impact of credit risk is ‘dominating’ the value changes. But clearly, to ‘dominate’ would mean that there would have to be a very significant effect on the fair value of the hedged item or the hedging instrument (i.e. ‘the loss (or gain) from credit risk frustrating the effect of changes in the underlyings on the value of the hedging instrument or hedged item, even if those changes were significant’). [IFRS 9.B6.4.7]. The standard provides guidance that small effects should be ignored even when, in a particular period, they affect the fair values more than changes in the hedged risk. An example of credit risk dominating a hedging relationship would be when an entity hedges an exposure to commodity price risk with an uncollateralised derivative and the credit standing of the counterparty to that derivative deteriorates severely, such that the effect of the changes in the counterparty's credit standing might outweigh the effect of changes in the commodity price on the fair value of the hedging instrument. [IFRS 9.B6.4.8].

The assessment of the effect of credit risk on value changes for hedge effectiveness purposes, which often may be made on a qualitative basis, should not be confused with the requirement to measure and recognise the impact of credit risk on the hedging instrument and, where appropriate, the designated hedged item, which will normally give rise to hedge ineffectiveness recognised in profit or loss (see 7.4.9 below).

6.4.3 The hedge ratio

The hedge ratio is the ratio between the amount of hedged item and the amount of hedging instrument. For many hedging relationships, the hedge ratio would be 1:1 as the underlying of the hedging instrument perfectly matches the designated hedged risk.

Some hedging relationships may include basis risk such that the fair value changes of the hedged item and the hedging instrument do not have a simple 1:1 relationship. In such cases, risk managers will generally set the hedge ratio so as to be other than 1:1, in order to improve the effectiveness of the hedge. Consequently, the third effectiveness requirement is that the hedge ratio used for accounting should ordinarily be the same as that used for risk management purposes. [IFRS 9.6.4.1(c)(iii)].

However, the standard requires the hedge ratio for accounting purposes to be different from the hedge ratio used for risk management if the latter hedge ratio reflects an imbalance that would create hedge ineffectiveness ‘that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting.’ [IFRS 9.6.4.1(c)(iii), B6.4.10]. This complex language was introduced because the Board is specifically concerned with deliberate ‘under-hedging’, either to minimise recognition of ineffectiveness in cash flow hedges or the creation of additional fair value adjustments to the hedged item in fair value hedges. [IFRS 9.B6.4.11(a)].

The above examples are of course extreme scenarios and instances of unbalanced hedge designations are likely to be rare; IFRS 9 does not however require an entity to designate a ‘perfect hedge’. For instance, if the hedging instrument is only available in multiples of 25 metric tonnes as the standard contract size, an imbalance due to using, say, 400 metric tonnes nominal value of hedging instrument to hedge 409 metric tonnes of forecast purchases, would not be regarded as resulting in an outcome ‘that would be inconsistent with the purpose of hedge accounting’ and so would meet the qualifying criteria. [IFRS 9.B6.4.11(b)].

The subsequent prospective effectiveness assessment requires consideration as to whether the accounting hedge ratio is still appropriate, or indeed whether a change is required. This ‘rebalancing’ of a live hedge relationship is further discussed at 8.2 below.

7.1.1 Ongoing fair value hedge accounting

If a fair value hedge (see 5.1 above) meets the qualifying conditions set out at 6 above during the period, it should be accounted for as follows:

• the gain or loss on the hedging instrument shall be recognised in profit or loss (or OCI if the hedging instrument hedges an equity instrument for which an entity has elected to present changes in fair value in OCI in accordance with paragraph 5.7.5 of IFRS 9 (see Chapter 48 at 2.2)); and
• the hedging gain or loss on the hedged item shall adjust the carrying amount of the hedged item (if applicable) and be recognised in profit or loss.

  If the hedged item is a debt instrument (or a component thereof) that is measured at fair value through OCI in accordance with paragraph 4.1.2.A of IFRS 9 (see Chapter 48 at 2.1) the hedging gain or loss on the hedged item shall be recognised in profit or loss.

  If the hedged item is an equity instrument for which an entity has elected to present changes in fair value in OCI, those amounts shall remain in OCI.

  Where a hedge item is an unrecognised firm commitment (or a component thereof), the cumulative change in the fair value of the hedged item subsequent to its designation is recognised as an asset or liability with a corresponding gain or loss recognised in profit or loss. [IFRS 9.6.5.8].

The hedging gain or loss on the hedged item is not necessarily the full fair value change in the hedged item, but reflects the change in value since designation of the designated portion or component of the hedged item (see 2.2 and 2.3 above) attributable to the hedged risk. Any changes in the fair value of the hedged item that are unrelated to the hedged risk (or occurred prior to the hedge designation) should only be recognised in compliance with normal IFRS requirements. [IFRS 9.B6.3.11].

The gain or loss on the hedging instrument for the purposes of accounting for a fair value hedge, refers to all changes in fair value of the hedging instrument since designation in the hedge relationship. Only fair value changes with respect to the time value of an option, forward element of a forward contract or foreign currency basis spreads if excluded from the hedge designation (see 3.6.4 and 3.6.5 above), or a documented excluded proportion of the instrument (see 3.6.1 above) are not included within the gain or loss on the hedging instrument.

Hedge ineffectiveness is the extent to which the changes in the fair value or the cash flow of the hedging instrument are greater or less that those on the hedged item. [IFRS 9.B6.4.1, B6.3.11]. Where hedge ineffectiveness arises in a fair value hedge, a net amount will be recognised in profit or loss, (unless the hedged item is an equity instrument for which an entity has elected to present changes in fair value in OCI in accordance with paragraph 5.7.5 of IFRS 9, in which case it will be recognised in OCI). Hedge ineffectiveness is an important concept with IFRS 9, and measurement of it is considered more fully at 7.4 below.

Although not clearly evident from the standard, we believe the gain or loss on the hedging instrument and the hedging gain or loss on the hedged item should be recognised in the same line item in profit or loss to reflect the offsetting effect of hedge accounting (see Chapter 54 at 7.1.3).

The following simple example illustrates how the treatment above might apply to a hedge of fair value interest rate risk on an investment in fixed rate debt.

The £5 credit to the carrying amount of the debt security in Example 53.59 above, reflects application of the usual accounting for instruments measured at fair value thorough OCI in accordance with paragraph 4.1.2A of IFRS 9 (see Chapter 50 at 2.3). The effect of fair value hedge accounting in this example, is just that the reduction in fair value is recognised in profit or loss, rather than OCI. For hedged items not held at fair value, the adjustment to both the carrying amount of the hedged item and profit or loss would only occur as a result of the application of fair value hedge accounting. Conversely, when hedging the foreign currency risk on a foreign currency monetary item, IAS 21 retranslation gains or losses would be recognised in profit or loss in any event, accordingly any incremental adjustment to the carrying amount as part of fair value hedge accounting should not include the retranslation effect again.

Example 53.59 above also includes an assumption that fair value changes only occurred as a result of changes in interest rates. No ineffectiveness was recorded as the effect of changes in interest rates on both the hedged item and hedging instrument offset perfectly, however this is a simplified example and is unlikely to be the case.

The basic hedge accounting treatment above applies equally to fair value hedges of unrecognised firm commitments. Therefore, where an unrecognised firm commitment is designated as a hedged item in a fair value hedge, the subsequent cumulative change in its fair value attributable to the hedged risk should be recognised as an asset or liability with a corresponding gain or loss recognised in profit or loss. Thereafter, the firm commitment would be a recognised asset or liability (albeit that its carrying amount will not represent either its cost or, necessarily, its fair value). The changes in the fair value of the hedging instrument would also be recognised in profit or loss. [IFRS 9.6.5.8(b)].

It can be seen that applying fair value hedge accounting adjustments does not change the accounting for the hedging instrument (unless it hedges an equity instrument for which an entity has elected to present changes in fair value in OCI, or if the time value of an option, forward element of a forward contract or foreign currency basis spreads are excluded from the hedge and accounting for the costs of hedging is applied (see 7.5 below)). This is true whether the hedging instrument is a derivative or non-derivative instrument. For example, if a foreign currency cash instrument was designated as the hedging instrument in a fair value hedge (see 3.3.1 above), the foreign currency component of its carrying amount would continue to be measured in accordance with IAS 21.

7.1.2 Dealing with adjustments to the hedged item

In general, adjustments to the hedged asset or liability arising from the application of hedge accounting as described at 7.1.1 above are dealt with in accordance with the normal accounting treatment for that item. For example, copper inventory might be the hedged item in a fair value hedge of the exposure to changes in the copper price. In this case, the adjusted carrying amount of the copper inventory becomes the cost basis for the purpose of applying the lower of cost and net realisable value test under IAS 2 – Inventories (see Chapter 22 at 3). [IAS 39.F.3.6].

Where the hedged item is a financial instrument (or component thereof) for which the effective interest method of accounting is used, the adjustment should be amortised to profit or loss. Amortisation may begin as soon as the adjustment exists and should begin no later than when the hedged item ceases to be adjusted for hedging gains and losses. The adjustment should be based on a recalculated effective interest rate at the date amortisation begins and should be fully amortised by maturity. If the hedged item is measured at fair value through OCI in accordance with paragraph 4.1.2A of IFRS 9, it is the cumulative gain or loss previously recognised in OCI that is adjusted, not the carrying amount. [IFRS 9.6.5.10]. See Chapter 51 at 7.5 for details on how the recalculated effective interest rate interacts with the IFRS 9 expected credit loss calculation.

When a hedged item in a fair value hedge is a firm commitment (or component thereof) to acquire an asset or assume a liability, the initial carrying amount of the asset or liability that results from the entity meeting the firm commitment is adjusted to include the cumulative change in the fair value of the hedged item that was recognised in the statement of financial position. [IFRS 9.6.5.9].

7.2.1 Ongoing cash flow hedge accounting

If a cash flow hedge (see 5.2 above) meets the qualifying conditions set out at 6 above during the period, it should be accounted for as follows:

1. the separate component of equity associated with the hedged item (cash flow hedge reserve) is adjusted to the lesser of the following (in absolute amounts):
   1. the cumulative gain or loss on the hedging instrument from inception of the hedge; and
   2. the cumulative change in fair value (present value) of the hedged item (i.e. the present value of the cumulative change in the hedged expected future cash flows) from inception of the hedge;
2. the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge (i.e. the portion that is offset by the change in the cash flow hedge reserve calculated in accordance with (a) shall be recognised in other comprehensive income;
3. any remaining gain or loss on the hedging instrument (or any gain or loss required to balance the change in cash flow hedge reserve in accordance with (a)) is hedge ineffectiveness and shall be recognised in profit or loss; and
4. if the amount accumulated in the cash flow hedge reserve is a loss and an entity expects that all or a portion of that loss will not be recovered in one or more future periods, it shall immediately reclassify the amount that is not expected to be received into profit or loss as a reclassification adjustment. [IFRS 9.6.5.11, IAS 1.92].

Unlike fair value hedge accounting (see 7.1.1 above), the application of cash flow hedge accounting does not amend the accounting for the hedged items, it is the accounting for the hedging instrument that is changed. However, cash flow hedge accounting only changes the accounting for the designated portion of the hedging instrument. For example, if the time value of an option, forward element of a forward contract or foreign currency basis spreads are excluded from the hedge (see 7.5 below) or a proportion of the instrument is not designated (see 3.6.1 above), the accounting for those excluded elements remains unchanged by cash flow hedge accounting.

The requirements set out in (a) above are often referred to as the ‘lower of’ requirements. This accounting treatment is illustrated in the following examples.

The above example illustrates that measurement of hedge ineffectiveness differs for a cash flow hedge when compared to a fair value hedge. In a cash flow hedge, if the fair value of the derivative increases by €10 and the present value of the hedged expected cash flows change by only €8, the €2 difference is recognised in profit or loss (as would be the case for a fair value hedge). However, in a cash flow hedge, if the present value of the hedged expected cash flows changes by €10, but the fair value of the derivative changes by only €8, this €2 of hedge ineffectiveness is not recognised in profit or loss (which would not be the case for a fair value hedge).

Because of this, an entity might consider deliberately under-hedging an exposure in a cash flow hedge. It might do this by targeting an offset of, say, 85% to 90%, however, whilst it still might be possible to demonstrate the existence of an economic relationship for such a designation (see 6.4.1 above), it is unlikely to meet the hedge ratio requirements (as it seems the hedge ratio was established to avoid recognising ineffectiveness in a cash flow hedge) and so would most likely be precluded (see 6.4.3 above). [IFRS 9.B6.4.11(a)].

7.2.2 Reclassification of gains and losses recognised in cash flow hedge reserve from OCI to profit or loss

The amount that has been accumulated in the cash flow hedge reserve in accordance with 7.2.1 above shall be accounted for as follows:

1. if a hedged forecast transaction subsequently results in the recognition of a non-financial asset or liability, or a hedged forecast transaction for a non-financial asset or liability becomes a firm commitment for which fair value hedge accounting is applied, the entity shall remove that amount from the cash flow hedge reserve and include it directly in the initial cost or other carrying amount of the asset or liability, this is often referred to as a ‘basis adjustment’. This is not a reclassification adjustment and hence it does not affect OCI; and
2. for a hedged transaction in a cash flow hedge other than those covered in (a) above, that amount shall be reclassified from the cash flow hedge reserve to profit or loss as a reclassification adjustment in the same period(s) during which the hedged expected future cash flows affect profit or loss, e.g. in the periods that interest income or interest expense is recognised or when a forecast sale occurs. [IFRS 9.6.5.11(d)].

The treatments for (a) above is illustrated in the following example.

In applying treatment (b) above to hedged items that are not forecast transactions that subsequently result in the recognition of a non-financial asset or liability, or a hedged forecast transaction for a non-financial asset or liability becomes a firm commitment for which fair value hedge accounting is applied, an appropriate reclassification method must be applied. When instruments such as conventional interest rate swaps are used as a hedging instrument in a cash flow hedge, it is common for entities to recognise net interest income or expense on the hedging instrument directly in profit or loss on an accruals basis. Other changes in fair value of the hedging instrument (i.e. the ‘clean value’ – excluding accrued interest) are recognised in other comprehensive income, subject to the ‘lower of’ requirements (see 7.2.1 above). Such an approach avoids the need to reclassify from cash flow hedge reserve to profit or loss the net interest as the hedged item impacts profit or loss. However, care must be taken to ensure the portion of the gain or loss on the hedging instrument that is recognised in the cash flow hedge reserve appropriately excludes ineffectiveness, which should be recognised in profit or loss. The hedging derivative would still be recognised in the statement of financial position at the full fair value.

Although not clearly evident from the standard, we believe the reclassification from cash flow hedge reserve to profit or loss should be recognised in the same line item in profit or loss as the hedged transaction to reflect the offsetting effect of hedge accounting (see Chapter 54 at 7.1.3).

If a hedge of a foreign currency forecast intragroup transaction qualifies for hedge accounting (see 4.3.2 above), any gain or loss that is recognised in other comprehensive income should be reclassified from cash flow hedge reserve to profit or loss in the same period(s) during which the foreign currency risk of the hedged transaction affects consolidated profit or loss. [IFRS 9.B6.3.6]. In order for the consolidated profit or loss to be affected by a foreign currency forecast intragroup transaction, an associated external forecast transaction must also exist. Accordingly, that external transaction also drives the timing of recycling of the effective portion of the hedge relationship.

7.2.3 Recycling for a hedge of foreign currency monetary items

It was stated at 5.2.3 above that using a forward exchange contract to hedge a foreign currency payable or receivable could be treated either as a fair value hedge, or a cash flow hedge. In a fair value hedge, the gain or loss on remeasurement of both the forward contract and the hedged item are recognised immediately in profit or loss. Even if the forward foreign currency risk was the designated hedged risk, then ineffectiveness would arise from changes in the forward points, as the retranslation of the foreign currency payable or receivable is restricted to the IAS 21 spot revaluation (see 7.4.7 below).

However, in a cash flow hedge of the forward foreign currency risk, the cumulative gain or loss on remeasuring the forward contract is recognised in the cash flow hedge reserve (assuming no sources of ineffectiveness) and reclassified from the cash flow hedge reserve to profit or loss when the payable or receivable affects profit or loss (see 7.2.2 above). Because the payable or receivable is remeasured continuously in respect of changes in foreign currency rates per IAS 21, there is a requirement for the gain or loss on the forward contract to be reclassified from the cash flow hedge reserve to profit or loss as the payable or receivable is remeasured, not when the payment occurs. There is variation in practice as to the method used to facilitate the reclassification over the period the payable or receivable affects profit or loss.

The forward element of a forward contract may be excluded from the designated hedge relationship (designation of the spot exchange risk only – see 3.6.5 above). In that case any fair value changes attributable to the forward element may be recognised in other comprehensive income if accounted for as costs of hedging (see 7.5.2 below). [IFRS 9.6.5.16].

Designating the forward exchange rate or the spot exchange rate as the hedged risk could result in different results as illustrated in Example 53.69 at 7.4.6 below.

7.2.4 Cash flow hedges within subsidiaries on acquisition or disposal

Where a reporting entity acquires a subsidiary that is applying cash flow hedge accounting, additional considerations arise. In applying the purchase method of accounting in its consolidated financial statements, the reporting entity does not inherit the subsidiary's existing cash flow hedge reserve, since this clearly represents cumulative pre-acquisition gains and losses.¹⁴ This has implications for the assessment of hedge effectiveness and the measurement of ineffectiveness because, so far as the group is concerned, it has effectively started a new hedge relationship with a hedging instrument that is likely to have a non-zero fair value (see 6.3.1 above and 7.4.3 below).

The standard does not address the situation when a subsidiary is disposed of. In November 2016, the Interpretations Committee discussed the issue of whether a group should discontinue hedge accounting in the consolidated financial statements where the group applies cash flow hedge accounting to forecast transactions that are anticipated in a subsidiary after the expected date of disposal of that subsidiary. The Interpretations Committee were of the tentative view that the assessment of a qualifying hedging relationship should be performed from the group's perspective based on whether the transaction is highly probable and could affect the group's profit or loss. Given that the forecast transactions are expected to occur only after the expected date of disposal of the subsidiary, these transactions are no longer expected to occur from the group's perspective as soon as the subsidiary is classified as held for sale. According to the Interpretation Committee's tentative view the forecast transactions would no longer be eligible hedged items and the group would discontinue hedge accounting from the date the subsidiary is classified as held for sale.¹⁵ The Interpretations Committee suggested that outreach would be helpful to understand if diverse accounting is currently applied in practice. If the Interpretation Committee's view is confirmed, existing accounting policies may need to be changed retrospectively, although this has still not happened at the time of writing.

7.3.1 Identifying the effective portion in a net investment hedge

In accounting for a hedge of a net investment, IFRS 9 requires that the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge should be recognised in other comprehensive income. [IFRS 9.6.5.13]. IFRIC 16 provides some helpful guidance in calculating the effective portion of the gain or loss on the hedging instrument.

As set out at 5.3.1 above, IFRIC 16 explains that the hedged risk in a net investment hedge is defined by reference to the functional currency of a parent of the foreign operation that is the subject of the hedge. The cumulative gain or loss on the hedging instrument that is determined to be effective is the change in value of the hedging instrument in respect of foreign exchange risk, this should be computed by reference to the functional currency of this parent entity. [IFRIC 16.15, 16].

Depending on where the hedging instrument is held, in the absence of hedge accounting the total change in its value might be recognised in profit or loss, in other comprehensive income, or both. The interpretation states that the calculation of the effective portion should not be affected by where the change in value of the hedging instrument would be recognised. In applying hedge accounting, the total effective portion of the change should be included in other comprehensive income. [IFRIC 16.15, 16].

The calculation of the effective portion is not affected by whether the hedging instrument is a derivative or a non-derivative instrument or by the method of consolidation. [IFRIC 16.15, AG7].

7.3.2 Non-derivative liabilities hedging a net investment

A foreign currency denominated non-derivative financial liability, such as a borrowing, can be used as the hedging instrument in a hedge of a net investment in a foreign operation (see 3.3.1 above). [IFRIC 16.14]. This can be seen as purely an ‘accounting’ hedge, i.e. the retranslation gain or loss on the borrowing (an accounting entry representing a part of its change in fair value that is accounted for on a continuous basis) can offset the retranslation gain or loss on the net investment (another accounting entry). In fact, if the liability is:

• denominated in the same currency as the functional currency of the hedged net investment;
• held by an entity with the same functional currency as the parent by which the hedged risk is defined;
• has an amortised cost that is lower than the net investment in the foreign operation; and
• is designated appropriately,

the hedge is likely to be perfectly effective in terms of the offsetting retranslation gains and losses on the liability and the hedged proportion of the net investment.

If a borrowing or similar liability is denominated in a different currency to the functional currency of the net investment, it may still be possible to designate it as the hedging instrument. However, it will need to be demonstrated that the two currencies are sufficiently correlated so that the hedging instrument is expected to result in offsetting gains and losses over the period that the hedge is designated, i.e. an economic relationship exists (see 6.4.1 above). This might be the case if the two currencies are formally pegged or otherwise linked to one another or if the relevant exchange rates move in tandem because of, say, similarities in the underlying economies.

Even if such a hedge meets the hedge effectiveness requirements (see 6.4 above), it is likely to result in some ineffectiveness. Under US GAAP it is suggested that the retranslation gains and losses on the actual instrument should be compared to those on a hypothetical non-derivative (e.g. a borrowing in the correct currency) with any difference recognised in profit or loss.¹⁸ This approach should normally be acceptable under IFRS 9, if applied in conjunction with the accounting requirements for net investment hedges (see 7.3 above).

For hedges of foreign currency risk, the foreign currency risk component of a non-derivative financial instrument is determined in accordance with IAS 21. [IFRS 9.B6.2.3]. Therefore, when designating a foreign currency denominated non-derivative financial liability as the hedging instrument in a hedge of a net investment, it is only possible to designate the spot foreign exchange risk, and not a forward foreign exchange risk. [IFRIC 16.AG2].

7.3.3 Derivatives hedging a net investment

It is clear that a derivative instrument may be designated as the hedging instrument in a hedge of a net investment. [IFRIC 16.14]. What is harder to determine is how various types of derivative may be designated in a hedge of a net investment in order that the hedge relationship meets the usual hedge accounting criteria, and how the relationship should be accounted for. For example:

• Is it possible to designate the forward foreign currency risk as the hedged risk in a net investment hedge?
• How should the hedged risk in the net investment be represented for ineffectiveness measurement purposes when the hedging instrument is a derivative?
• What is the accounting treatment for any excluded portions of a derivative hedging instrument in a net investment hedge?

These questions will be considered in the remainder of this section.

In the application guidance to IFRIC 16, it is noted that if the hedging instrument is a forward contract, then it is possible to designate a forward foreign currency risk as the hedged risk in a hedge of a net investment (see 3.6.5 above). [IFRIC 16.AG2]. Forward foreign currency risk must therefore be deemed to exist within the net investment. If the forward foreign currency risk is designated for a net investment hedge, then the entire change in fair value of the hedging instrument, (including changes in the forward element) should be included in the calculation of the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge. [IFRS 9.6.5.13]. This could be achieved by using a hypothetical derivative that is also a forward foreign contract (see 7.4.4 below).

Like forward contracts, cross-currency interest rate swaps are sometimes used as hedging instruments in net investment hedges. It is often said that cross currency swaps are essentially a series of forward contracts and so arguably the treatment for forwards should be equally applicable to cross-currency swaps. However, it is difficult to rationalise why a cross-currency swap, for which there are periodic gross settlements is a good representation of the forward foreign currency risk within the retranslation of a net investment, and therefore an appropriate hypothetical derivative (see 7.3.3.B and 7.4.4 below).

There is no reason why an option contract, that is not a written option, cannot be designated as the hedging instrument in a hedge of a net investment (see 3.2.2 above). In fact such a hedge is included as an example in the IFRS 9 application guidance. [IFRS 9.B6.5.29(b)].

A qualifying instrument may be designated with the following portions excluded: time value of options, forward elements of forwards, and/or foreign currency basis spread (see 3.6 above). Where such portions are excluded they may be treated as a cost of hedging (see 7.5 below), or, alternatively, the excluded forward elements of forwards and/or foreign currency basis spread may remain at fair value through profit or loss. This treatment for hedges of a net investment is discussed in more detail in 7.5.2.A below. It is worth noting that unless the foreign currency basis spread is excluded from the derivative hedging instrument in a net investment hedge, ineffectiveness will occur as foreign currency basis spread cannot be assumed to exist in a non-derivative hedged item (see 7.4.8 below).

7.3.4 Combinations of derivative and non-derivative instruments hedging a net investment

It is not uncommon for entities to hedge their net investments using synthetic foreign currency debt instruments. For example, consider a parent with the euro as its functional currency that has a net investment in a Japanese subsidiary with yen as its functional currency. The parent might borrow in US dollars and enter into a pay-Japanese yen, receive-US dollar cross-currency interest rate swap. In this way the two instruments might be considered a synthetic Japanese yen borrowing, although they are required to be accounted for separately (see Chapter 46 at 8).

As noted at 3.5 above, a combination of derivatives and non-derivatives may be viewed in combination and jointly designated as a hedging instrument. [IFRS 9.6.2.5]. However, all the hedging instruments must be clearly identified in the hedge documentation (see 6.3 above). [IFRS 9.6.4.1(b)].

The European parent in the above fact pattern may wish to designate the spot rate only when hedging a net investment with a combination of derivatives and non-derivatives. Designation of the combination as hedging a forward rate is more problematic as the foreign currency risk component of a non-derivative financial instrument is restricted to the spot rate, in accordance with IAS 21 (see 3.3.1 above). [IFRS 9.B6.2.3].

Another alternative may be to notionally decompose the cross currency swap by introducing an interest bearing functional currency denominated leg and designating one part as a hedge of the borrowing and the other as a hedge of the net investment (see 3.6.2 above).

7.3.5 Individual or separate financial statements

The discussion so far has concentrated on the accounting for a hedge of the foreign currency risk in a foreign operation in the parent's consolidated financial statements. However, in the parent's individual or separate financial statements, the investment in the foreign operation will generally be accounted for as an asset measured at cost or as a financial asset in accordance with IFRS 9. [IAS 27.10]. In other words, it will not be accounted for by way of consolidation.

Accordingly, from the perspective of the individual or separate financial statements, the reporting entity will not have a net investment in a foreign operation. Therefore, the borrowing could not be designated as the hedging instrument in a net investment hedge for the purposes of the separate financial statements. However, if hedge accounting is desirable, it may be possible to designate the borrowing as the hedging instrument in another type of hedge. Typically, this would be a fair value hedge of the foreign currency risk arising from the investment. This will be an independent hedge relationship, separate from the net investment hedge in the consolidated financial statements. Therefore, all of the other hedge accounting criteria (including the documentation requirements) will need to be met for this hedge too. Of course, the effects of this hedge accounting will need to be reversed when preparing the group's consolidated financial statements (otherwise those financial statements will reflect as an asset or liability certain changes in the fair value of a parent's investment in its subsidiary which would be contrary to the general principles of IFRS 10 – see Chapter 7).

7.4.1 General requirements

Hedge ineffectiveness is the extent to which the changes in the fair value or cash flows of the hedging instrument are greater or less than those on the hedged item. [IFRS 9.B6.4.1].

All hedge ineffectiveness is recognised in the profit or loss for fair value hedges (except where the hedged item is an equity instrument measured at fair value through OCI) (see 7.1.1 above). For cash flow and net investment hedges ineffectiveness is recognised in the profit or loss to the extent that the cumulative change in the fair value or cash flows of the hedging instrument are greater than those on the hedged item (see 7.2.1 and 7.3 above). Accordingly the measurement of ineffectiveness is an important aspect of IFRS 9.

Although, for many hedge relationships, it will be acceptable to undertake a qualitative assessment as to whether the hedge effectiveness requirements are met (see 6.4 above) there is still a requirement to measure and record ineffectiveness appropriately within the financial statements.

In determining the ineffectiveness of a hedge relationship, it is important to closely follow the hedge designation. In particular it is necessary to determine the hedged risk, and whether any portions or proportions have been excluded from hedged item (see 2.2 and 2.3 above) and/or the hedging instrument (see 3.6 above). Hedge ineffectiveness only relates to those elements not excluded from the hedge relationship, and for the hedged item only, with respect to changes in the hedged risk, not the full price risk. [IFRS 9.B6.3.11, B6.4.1]. The initial designation of a hedge relationship is therefore very important and can in some cases significantly reduce the expected ineffectiveness levels from hedge relationships. However, it should be noted that not all sources of ineffectiveness can be eliminated via clever hedge designation. All sources of ineffectiveness must be documented as part of the hedged documentation. [IFRS 9.6.4.1(b)].

The calculation of ineffectiveness compares the monetary amount of the change in fair value of the hedging instrument with the monetary amount of the change in fair value or cash flows of the hedged item or transactions attributable to the hedged risk, over the assessment period. This is illustrated by the following simplified example:

Whilst it may be relatively obvious how to calculate the change in fair value or cash flows of a hedged item with fixed flows for changes in the hedged risk since designation (typically a fair value hedge) (see 5.1 above), it is less obvious how this might be achieved where the hedged flows are not fixed, in particular, as hedged items with variable flows do not tend to attract fair value risk. This is discussed in more detail at 7.4.4 and 7.4.6 below.

7.4.2 The time value of money

Entities must consider the time value of money when measuring hedge ineffectiveness. This means that an entity must determine the value of the hedged item on a present value basis (thereby including the effect of the time value of money). [IFRS 9.B6.5.4]. The inclusion of the words ‘the changes in the fair value or cash flows’ in the definition of ineffectiveness is unhelpful (see 7.4.1 above), but the need for consideration of the time value of money is clear based on the noted application guidance of IFRS 9. In valuation practice, the effect of the time value of money is also included when measuring the fair value of financial instruments. Consequently, it is logical to apply the same principle to the hedged item as well.

It is possible to designate a spot element of a hedged item if it can be determined to be an eligible risk component (see 2.2 above). Whilst a spot designation is relatively common place for both foreign currency and commodity risk, the need to consider the time value of money for effectiveness purposes for spot designations has been a matter of some debate. The IAS 39 Implementation Guidance contains an example in which an entity designates changes in the spot element only (see 7.4.7 below). The example indicates that the time value of money is still relevant for the measurement of ineffectiveness even when the spot element is designated in a hedge relationship. See Example 53.71 below for the detailed example in the IAS 39 Implementation Guidance, but Example 53.68 immediately below more simply demonstrates how ineffectiveness can arise when there are differences in the timing of hedged and hedging cash flows.

The requirement to calculate ineffectiveness on a present value basis intuitively makes sense in cases where the cash flows of the hedged item and hedging instrument are not aligned. It would seem inappropriate to have no ineffectiveness under a spot designation, for example in the situation described at 3.3.1 above, where a 7-year financial liability denominated in a foreign currency is used as the hedging instrument for a 12 month forecast sale in that foreign currency.

7.4.3 Hedging using instruments with a non-zero fair value

There is no requirement for hedge accounting to be designated on initial recognition of either the hedged item or the hedging instrument. [IFRS 9.B6.5.28]. However, there is often a hidden danger when designating a derivative as a hedging instrument subsequent to its inception. For non-option derivatives, such as forwards or interest rate swaps, any fair value is likely to create ‘noise’ in measuring hedge ineffectiveness that may not be fully offset by changes in the hedged item, especially in the case of a cash flow hedge. This is because the derivative contains a ‘financing’ element (the initial fair value), gains and losses on which will not be replicated in the hedged item and therefore the hedge contains an inherent source of ineffectiveness. For example, if applying the hypothetical derivative method for measurement of ineffectiveness (see 7.4.4 below) this financing element will be evident as the hypothetical derivative will be based on the prevailing market rates on designation, which will result in cash flows that differ from those of the actual now ‘off market’ derivative.

Consequently, there is likely to be more ineffectiveness recognised and, in extremis, a quantitative assessment may be needed to demonstrate the existence of an economic relationship It depends on the circumstances whether hedge ineffectiveness arising from the financing element on designation could have a magnitude that a qualitative assessment would not adequately capture. [IFRS 9.B6.4.15]. Only by coincidence will a derivative that was entered into previously still have a fair value that is zero, or close to zero, on the date of designation which would minimise this problem.

This situation can not only arise when a derivative is designated or redesignated in a hedging relationship subsequent to its initial recognition, but also in a business combination (see 6.3.1 above).

This same issue does not arise for hedged items that are designated after initial recognition, however difficulties can occur identifying eligible risk components (see 2.4.1 above).

7.4.4 Hypothetical derivatives

A method commonly used in practice to calculate ineffectiveness of cash flow hedges (and net investment hedges) is the use of a so-called ‘hypothetical derivative’. The method involves establishing a notional derivative that has terms that match the critical terms of the hedged exposure (normally an interest rate swap or forward contract with no unusual terms) and a zero fair value at inception of the hedging relationship. The fair value of the hypothetical derivative is then used as a proxy to measure the change in the value of the hedged item against which changes in value of the actual hedging instrument are compared to calculate ineffectiveness. The use of a hypothetical derivative is one possible way of determining the change in the value of the hedged item when measuring ineffectiveness. [IFRS 9.B6.5.5].

IFRS 9 is clear that a hypothetical derivative has to be a replication of the hedged item and not the ‘perfect hedge’. Also the standard makes clear that any different method for determining the change in the value of the hedged item would have to give the same outcome. Consequently, an entity cannot include features in the hypothetical derivative that only exist in the hedging instrument, but not in the hedged item. [IFRS 9.B6.5.5]. Whilst this appears to be a logical requirement, it may have wider implications for cash flow hedges than many would have expected. An entity cannot simply assume no ineffectiveness for a cash flow hedge because the principal terms of the hedging instrument exactly match the principal terms of a hedged item, if there are differences in other features of the hedging instrument and the hedged item. For example, IFRS 13 requires an entity to reflect both the counterparty's credit risk and the entity's own credit risk when determining the fair value of a derivative. The same credit risk cannot be assumed in the hypothetical derivative. This difference in credit risk would result in some ineffectiveness (see 7.4.5 and 7.4.9 below).

It is possible to exclude the credit risk in the hedged item from the hedge relationship, for example by designating interest rate risk as the hedged risk (see 2.2 above). This does not eliminate ineffectiveness from changes in the credit risk of the hedging derivative, but prevents additional ineffectiveness from changes in the credit risk of the hedged item. (This assumes that credit risk is not of a magnitude such that it dominates the value changes of the hedged item (see 6.4.2 above)).

Examples 53.69 and 53.70 below provide simple illustrations of how an entity might establish and apply a hypothetical derivative for the calculation of ineffectiveness in a hedge relationship.

One other example of when the features of the hedging instrument and the hedging item are likely to differ is when an entity hedges a debt instrument denominated in a foreign currency in a cash flow hedge (irrespective of whether it is fixed-rate or variable-rate debt). IFRS 9 is explicit that when using a hypothetical derivative to calculate ineffectiveness, the hypothetical derivative cannot simply impute a charge for exchanging different currencies (i.e. the foreign currency basis spread) even though actual derivatives (for example, cross currency interest rate swaps) under which different currencies are exchanged might include such a charge. [IFRS 9.B6.5.5]. Although cross currency interest rate swaps are used to highlight the fact that foreign currency basis spreads should not be replicated in hypothetical derivatives, this issue is also likely to arise in other foreign currency contacts settled in the future. To address this, IFRS 9 includes the ability to account for the foreign currency basis spread as a cost of hedging (see 7.5 below).

In many cases where the critical terms of the hedged item are closely matched by a hedging instrument which had a zero fair value on designation, the hypothetical derivative is likely to have similar terms to the actual hedging derivative – subject to the known differences mentioned above (e.g. foreign currency basis spreads and credit risk).

Example 53.71 (see 7.4.6 below) contains a very comprehensive illustration of the calculation of infectiveness based on implementation guidance in IAS 39, which remains relevant under IFRS 9.

7.4.5 Discount rates for calculating the change in value of the hedged item

The standard is clear that entities must consider the time value of money when measuring hedge ineffectiveness. This means that an entity must determine the value of the hedged item on a present value basis (thereby including the effect of the time value of money) (see 7.4.2 above). [IFRS 9.B6.5.4]. Although capturing the effect of the time value of money is a key aspect of the application of hedge accounting, little guidance is provided on how to calculate the time value in the hedged item. By contrast, guidance is given on how to calculate the fair value changes for hedging instruments in various places: in IFRS 13 for those held at fair value through profit or loss (see Chapter 14), and in IAS 21 for non-derivative hedging instruments of foreign currency risk (see 3.3.1 above).

For example, a key consideration for market participants in calculating the fair value of derivatives is the selection of an appropriate discount rate. Historically, the fair values of interest rate swaps (IRS) have been calculated using LIBOR-based discount rates. As per its definition, LIBOR is the average rate at which the reference banks can fund unsecured cash in the interbank market for a given currency and maturity.¹⁹ However, the use of LIBOR as the standard discount rate ignores the fact that many derivative transactions are now collateralised and have therefore a lower credit risk than LIBOR would suggest. For cash-collateralised trades, a more relevant discount rate is an overnight rate rather than LIBOR. Overnight index swaps (OIS) are interest rate swaps where the floating leg is linked to a benchmark interest rate for overnight unsecured lending. OIS rates much better reflect the credit risk of cash collateralised IRS. So although an IRS might be referenced to one benchmark rate (e.g. LIBOR) the appropriate discount rates for calculating fair value in line with IFRS 13 guidance, may be derived from a different benchmark rate (e.g. OIS) if that is how market participants would calculate the fair value.

The way in which the time value of a hedged item is captured can have a significant impact on the measurement of ineffectiveness. This is illustrated in the following two examples.

Consider firstly the example of a fair value hedge of a fixed rate bond for changes in an eligible benchmark interest rate risk component (see 2.2.3.A above). It is clear that in order to capture the change in value of the hedged fixed cash flows attributable to changes in the benchmark interest rate, the discounting curve would have to be based on the designated benchmark interest rate. For a fair value hedge of a specified interest rate, to choose any other discounting curve would reflect a risk other than the designated hedged risk. For such hedges, in order to reflect the hedged risk, that choice of hedged risk predetermines the discounting rate to be applied to the hedged item. Hence for a fair value hedge, unless the benchmark rate designated as the hedged risk is the same as the discounting curve applied to the hedging instrument, ineffectiveness will arise. This is the case even if the hedged fixed cash flows match exactly the fixed cash flows of the hedging instrument.

Now contrast this with the example of a LIBOR floating rate debt, swapped into a fixed rate of interest using a receive-LIBOR, pay-fixed interest rate swap, designated in a cash flow hedge for changes in LIBOR. For the purposes of calculating the change in the value of the hedged item due to the hedged risk, the entity may use a hypothetical derivative (see 7.4.4 above). When measuring the fair value of the actual and hypothetical interest rate swaps, the entity would start by using the specified benchmark forward curve to forecast the future floating cash flows. However potentially the discount rate applied to those future cash flows may not be the same as that used for forecasting. In the case of a collateralised swap (for which the relevant discount rate is likely to be an overnight rate (e.g. OIS), unless the value of the hypothetical derivative is also calculated using an OIS discounting curve, even though the future cash flows might be the same, changes in value of the hypothetical derivative and the fair value of the actual swap will not be same – resulting in ineffectiveness.

For those hedge relationships where the discounting curve is not predetermined by the hedged risk (e.g. a cash flow hedge of a benchmark interest rate) the standard is not prescriptive, and practice has evolved such that there appears to be an element of choice as to which benchmark interest rate is used as the basis for discounting in the calculation of changes in value of the hedged item. We believe this choice is limited to a benchmark interest rate. For example, it is not permissible to use a discount rate that exactly mirrors the ongoing specific credit risk inherent in the hedging instrument, as this would reflect a feature in the hedging instrument that is unlikely to exist in the hedged item (see 7.4.4 above). [IFRS 9.B6.5.5]. Put differently, although it may be possible to choose the discounting benchmark rate for the hedged item to be that which is used for discounting purposes for the actual derivative, no such choice exists to reflect elements of the valuation of the actual derivative such as the credit valuation adjustment (CVA) in determining value changes in the hedged item (see Chapter 14 at 11.3.2). Hence changes in the specific credit risk inherent in the hedging instrument will still result in ineffectiveness. However, if the hedging derivative is collateralised, the use of an OIS curve for discounting the hedged item may result in very little ineffectiveness.

Similarly, the ability to choose a benchmark rate curve for discounting purposes when calculating a change in value of the hedged item, does not permit the inclusion of cross currency spreads within such a curve – unless cross currency basis occurs in the hedged item (see 7.4.4 above).

Any choice of discounting benchmark rate should be documented at the inception of the hedge relationship (see 6.3 above).

As a result of the reforms mandated by the Financial Stability Board following the financial crisis, regulators are pushing for IBOR (including LIBOR) to be replaced by new ‘official’ benchmark rates, known as Risk Free Rates (RFRs). Such a change will necessarily affect both forecasting and discounting curves for financial instruments, and may reduce the instances of where there is a difference between discounting curves for the valuation of hedging derivatives and hedged items. However, this change in benchmark rates raises a number of hedge accounting questions. In May 2019, the IASB published an Exposure Draft: Interest Rate Benchmark Reform – proposed amendments to IFRS 9 and IAS 39 to address some of these issues (see 8.3.5 below).

7.4.6 Detailed example of calculation of measuring ineffectiveness for a cash flow hedge of a forecast transaction in a debt instrument

Example 53.71 below contains a very comprehensive illustration of the calculation of ineffectiveness for a cash flow hedge that is based on the implementation guidance to IAS 39. Method B describes, but is not explicitly named as the hypothetical derivative method. Method A in the example is also an acceptable of calculating ineffectiveness for a cash flow hedge, but is not widely applied.

Although the example is somewhat esoteric, and many accountants will find the calculations difficult to follow, it is an important example that remains relevant under IFRS 9.

7.4.7 Comparison of spot rate and forward rate methods

It was explained at 3.6.5 above that the spot and forward elements of a forward contract may be treated separately for the purposes of hedge designation. The next example, based on the implementation guidance of IAS 39, contrasts calculation of ineffectiveness for two hedge relationships using the same hedging instrument, but designated in different ways (see 7.4.1 above). Case 1 can be used when the whole of a forward contract is treated as the hedging instrument and the hedged risk is identified by reference to changes attributable to the forward rate (the forward rate method). Case 2 can be used when the forward element is excluded and the hedged risk is identified by reference to changes attributable to the spot rate (the spot rate method).

To demonstrate these methods, the IAS 39 implementation guidance uses a type of hedge that is very common in practice, the hedging of foreign currency risk associated with future purchases using a forward exchange contract. The example also illustrates the difference in the accounting for such hedges depending on whether the spot and forward elements of a forward contract are treated separately for the purposes of hedge designation.

Although the example is based on IAS 39 implementation guidance it is still relevant under IFRS 9 if we assume that the entity has chosen not to apply the costs of hedging guidance in Case 2. There is also an assumption that there is no impact from changes in foreign currency basis spreads.

Ignoring ineffectiveness that may arise from elements that affect the fair value of the hedging instrument only or that may be different from the hedged item to the hedging instrument (e.g. foreign currency basis spreads), both designations result in effective hedges as a result of the way effectiveness is measured. The example also sets out how a single hedge can initially be a cash flow hedge of the future purchase and then become a fair value hedge of the associated payable, provided it is documented as such.

The example also indicates that the time value of money is relevant for the assessment of effectiveness even when the spot element is designated in a hedge relationship (see 7.4.2 above). Although in many circumstances the effect of discounting the revaluation of the spot element may not be material.

7.4.8 Foreign currency basis spreads

One phenomenon of the financial crisis was the increase in foreign currency basis spreads. The foreign currency basis is the charge above the risk-free rate in a foreign country to compensate for country and liquidity risk. Historically, basis spreads had been low, but increased significantly after the financial crisis and the following sovereign debt crisis. Volatility in foreign currency basis can create hedge ineffectiveness when using a cross currency interest rate swap (CCIRS) to hedge the foreign currency and interest rate risk of a debt instrument issued in a foreign currency.

When designating the CCIRS in a fair value hedge, the gain or loss on the hedged item attributable to changes in the hedged interest rate risk is determined based on the foreign currency interest rate curve, therefore excluding currency basis. IAS 21 then requires such a monetary item in a foreign currency to be translated to the functional currency using the spot exchange rate. [IAS 21.23]. Conversely, the fair value of the CCIRS incorporates the foreign currency basis spread which results in ineffectiveness.

For a cash flow hedge, IFRS 9 is explicit that when using a hypothetical derivative to calculate ineffectiveness, the hypothetical derivative cannot simply impute a charge for exchanging different currencies (i.e. the foreign currency basis spread) even though actual derivatives (for example, cross-currency interest rate swaps) under which different currencies are exchanged might include such a charge (see 7.4.4 above). [IFRS 9.B6.5.5].

Although cross currency interest rate swaps are used to highlight the fact that foreign currency basis spreads should not be replicated in hypothetical derivatives, this issue is also likely to arise in other foreign currency contacts settled in the future. This is also an issue for net investment hedges for which the hedging instrument is a derivative (see 7.5.2.A below).

To address this, IFRS 9 identifies foreign currency basis spread as a ‘cost of hedging’. Application of the costs of hedging accounting permits an appropriate portion of the change in the fair value of foreign currency basis spread to be taken to OCI rather than immediately recognised in profit or loss, see 7.5.3 below.

7.4.9 The impact of the hedging instrument's credit quality

One of the key hedge effectiveness requirements in IFRS 9 is that the impact of credit risk should not be of a magnitude such that it dominates the value changes (see 6.4.2 above). [IFRS 9.6.4.1(c)(ii)]. It is therefore clear that the credit quality of the hedging instrument, and hedged item are both relevant in determining the ongoing eligibility of a hedge relationship. However, the assessment of the effect of credit risk on value changes for hedge effectiveness purposes, which often may be made on a qualitative basis, should not be confused with the requirement to measure and recognise the impact of credit risk on the hedging instrument and, where appropriate, the designated hedged item, which will normally give rise to hedge ineffectiveness recognised in profit or loss (see 7.4.1 and 7.4.5 above).

Hedge ineffectiveness is the extent to which the changes in the fair value or cash flows of the hedging instrument are greater or less than those on the hedged item. [IFRS 9.B6.4.1]. Although it is permissible to exclude some components from a designated hedging instrument, and associated fair value changes, counterparty credit risk is not one of the permitted exclusions (see 3.6 above). Accordingly, unless the hedged item attracts the same credit risk as the hedging instrument, it will be a source of ineffectiveness (see 7.4.1 above). It is very unlikely to be the case that the hedged item and hedging instrument both attract the same credit risk. In particular, they will often not share the same counterparty, credit enhancement arrangements, term, exposure to credit risk and even contractual status. In addition to changes in the hedging instrument's counterparty credit risk, changes in the reporting entity's own credit risk may also affect the fair value of the hedging instrument in ways that are not replicated in the hedged item (see Chapter 14 at 11.3.2).

For a fair value hedge, the implications of this requirement are clear. If there is a change in the hedging instrument's credit risk, the hedging instrument's fair value will change, but there is unlikely to be an offsetting change in fair value for the hedged item. This will affect its effectiveness as measured. In most cases, credit risk in the hedged item does not form part of the designated hedged risk (see 2.2 above) and so changes in fair value of the hedged item due to credit risk will not provide any offset to changes in the fair value of the hedging instrument due to its credit risk. However, as noted above, even if credit risk is not part of the designated risk, if changes in the fair value of the hedged item due to credit risk dominate the value changes in the hedge relationship, then the hedge must be discontinued (see 8.3 below).

For a cash flow hedge, the implications might not immediately be so obvious. It is relatively common for the measurement of ineffectiveness in a cash flow hedge to be calculated using a hypothetical derivative (see 7.4.4 above). Hence, the effect of changes in the hedging instrument's credit risk on the measurement of ineffectiveness might be best explained in the context of a hypothetical derivative. The application guidance of IFRS 9 states that when applying the hypothetical derivative method, one cannot include features in the value of the hedged item that only exist in the hedging instrument, but not in the hedged item. [IFRS 9.B6.5.5]. Arguably, both the hedged item and the hedging instrument include credit risk. However, the credit risk in the hedged item is likely to be different from the credit risk in the hedging instrument. This is true even when the specific credit risk that exists in the hedged item is not included in the hedge relationship as a benchmark interest rate has been designated as the hedged risk (see 2.2 above).

Given the prohibition on reflecting terms in the hypothetical derivative that do not exist in the hedged item, it is clear that, when using a hypothetical derivative for measuring ineffectiveness in a cash flow hedge, the counterparty credit risk on the hedging instrument should not, as a matter of course be deemed to be equally present in the hedged item (see 7.4.5 above). [IFRS 9.B6.5.5]. For example, if the hedged item is a highly probable forecast transaction it may not involve any credit risk at all, so that there is no offset for the specific credit risk affecting the fair value of the hedging instrument. This would give rise to some ineffectiveness recorded in profit or loss.

The impact will be more pronounced where the hedging instrument is longer term, has a significant fair value and there exist no other credit enhancements such as collateral agreements or credit break clauses.

Nowadays, most over-the-counter derivative contracts between financial institutions are cash collateralised. Furthermore, current initiatives in several jurisdictions, such as, the European Market Infrastructure Regulation (EMIR) in the European Union or the Dodd-Frank Act in the United States, have resulted in more derivative contracts being collateralised by cash. Cash collateralisation significantly reduces the credit risk for both parties involved (see 8.3.3 below). Similarly, since December 2015, when the London Clearing House (LCH) changed its rule book to introduce a new type of settled-to-market (STM) interest rate swap, in which the daily variation margin is used to settle the interest rate swap's outstanding fair value derivative position, more transactions are settled in this way (see 8.3.4 below).

Accordingly the residual credit risk to these cash collateralised and STM derivatives are much less likely to be a significant source of ineffectiveness.

7.4.10 Interest accruals and ‘clean’ versus ‘dirty’ values

When measuring ineffectiveness in hedge relationships for which the designated hedging instruments is an interest rate swap or similar, fair value ‘noise’ is often generated between the dates on which the variable leg is reset to market, in particular for a fair value hedge. Currently the payments on an interest rate swap are typically established at the beginning of a reset period and paid at the end of that period. Between these two dates the swap is no longer a pure pay-fixed receive-variable (or vice versa) instrument because both the next payment and the next receipt are fixed. Accordingly, the corresponding changes in the fair value of the hedged item (e.g. fixed rate debt) will not strictly mirror that of the swap. This problem becomes more acute the less frequently variable interest rates are re-fixed to market rates.

This ‘noise’ is unlikely to be significant enough to influence whether there is an economic relationship or not, especially where the interval between re-pricings is frequent enough, e.g. quarterly rather than yearly, in order to minimise the changes in fair value from the fixed net settlement or next interest payment (see 6.4.1 above). However, ineffectiveness should always be measured and recognised in profit or loss (see 7.4 above). This ineffectiveness is likely to be more significant when interest rates are more volatile, as experienced by a number of entities during the ‘credit crunch’ starting in the second half of 2007.

However, as a result of the reforms mandated by the Financial Stability Board following the Financial Crisis, regulators are pushing for IBORs to be replaced by new ‘official’ benchmark rates, known as Risk Free Rates (RFRs) (see 8.3.5 below). In many jurisdictions, the nature of term structures for RFRs remains an area of development at the time of writing. In particular it is unclear whether a ‘term RFR’ will exist at all (e.g. a 3 month RFR rate set in advance, similar to existing 3 month LIBOR) or if there will only be a compounded RFR rate with regular settlements (e.g. a rate equal to daily cumulative accrual at the overnight RFR rate, settled every 3 months). It is also possible that term RFRs will develop in some currencies and not others. Where a cumulative accrual RFR is applied this will reduce or fully eliminate the ‘noise’ from the revaluation of the floating leg, as the floating rate never becomes ‘fixed’ given the ongoing cumulative accrual at the prevailing overnight rate.

7.4.11 Effectiveness of options

It was explained at 3.6.4 above that the time value of an option may be excluded from the hedge relationship and, in many cases, this may make it easier to demonstrate an expectation of offset from changes in the hedged item and the hedging instrument (see 6.4.1 above). In such cases, if the documented hedged risk is appropriately customised there will, in many cases, be very little ineffectiveness to recognise (other than that arising from changes in credit risk), as set out in the following example.

When hedging a one-sided risk, the hedged risk cannot include the time value of a purchased option, because the time value is not a component of the forecast transaction. [IFRS 9.B6.3.12]. Hence if, a purchased option is designated in its entirety as the hedging instrument of a one-sided risk arising from a forecast transaction, additional ineffectiveness will arise, as changes in the fair value of the hedged item will not provide any offset to changes in time value of the hedging instrument. This is consistent with the implementation guidance on hypothetical derivatives in IFRS 9 that prohibits the inclusion of features in the value of the hedged item that only exist in the hedging instrument (see 7.4.4 above). [IFRS 9.B6.5.5].

7.4.12 Hedged items with embedded optionality

As described at 3.6.4 above, an entity can exclude the time value of the hedging instrument from the hedging relationship when hedging with options. Changes in value of the excluded time value must then be treated as a cost of hedging (see 7.5 below). Such a strategy is sometimes applied when hedging highly probable forecast cash flows, in which case excluding the time value of the hedging option would most likely achieve a lower level of ineffectiveness from an accounting perspective (see 7.4.11 above).

However, if the hedged item contains embedded optionality, which is matched by optionality within the hedging instrument, including the time value from both the hedged item and hedging instrument in the hedge relationship may result in a highly effective hedge. This is because there will be a level of offset from changes in time value of the hedging option and changes in the embedded time value in the hedged item. The following fact patterns provide examples of where there may be offsetting changes in time value:

• Entity A has purchased 10-year fixed rate debt. At the end of years five and seven, the issuer has the option to prepay the debt at par. Entity A may choose to eliminate variability in the fair value of the fixed rate debt by transacting a pay fixed receive floating interest rate swap, with matching prepayment options at five and seven years.
• Entity B has issued floating rate debt which includes an embedded floor (e.g. interest is floored at 0%). Entity B could choose to eliminate the variability in the cash flows above the floor (and lock in current low rates), by transacting a pay fixed swap with an embedded floor.

In the case of Entity A above, it is relatively easy to conclude that the change in value of the embedded prepayment option should form part of the effectiveness assessment and measurement of ineffectiveness, as a fair value hedge. However, it is less clear in the case of Entity B since the arrangement would be a cash flow hedge.

IFRS 9 provides guidance on hedge accounting for purchased options hedging a one-sided risk in a forecast transaction. The guidance explains that the hedged risk cannot include option time value because time value is not a component of the forecast transaction that affects profit or loss. Therefore, if an entity designates a purchased option in its entirety, as the hedging instrument of a one-sided risk arising from a forecast transaction, the hedging relationship will not be perfectly effective. In this situation, there will be no offset between the cash flows relating to the time value of the option premium paid and the designated hedged risk. [IFRS 9.B6.3.12].

This might indicate that including the change in the time value of the embedded option in the hedged item as part of the change in value of the hedged item when measuring ineffectiveness is also not permitted. However, the above guidance was written specifically for forecast transactions that do not include time value, whereas hedged items with embedded optionality do include time value. Therefore, we believe that the guidance referred to above is not relevant for hedged items that do include optionality.

IFRS 9 defines a cash flow hedge as a hedge of an exposure to variability in cash flows that could affect profit or loss. [IFRS 9.6.5.2(b)]. Arguably, a change in the time value of an embedded option within the hedged item does not affect profit or loss, nor does it result in cash flow variability. However, we believe that cash flow variability and the potential to affect profit or loss must be demonstrated for the designated hedged risk, which in this case is the underlying of the host hedged item and the embedded option. The measurement of ineffectiveness should incorporate the cumulative change in fair value (present value) of the expected future cash flows of the entire hedged item, with respect to the designated hedged risk. [IFRS 9.6.5.11(a)(ii)]. The fair value of the hedged cash flows, which include the embedded optionality, includes the time value and not just the intrinsic value.

Furthermore, when calculating ineffectiveness, it is not acceptable only to compare cash flows, since it is also necessary to consider the time value of money by discounting the cash flows. [IFRS 9.B6.5.4]. This is despite the fact that the time value of money does not affect profit or loss or cause variability in the cash flows in a cash flow hedge, but is considered a factor in the cumulative fair value (present value) of the future cash flows (consistent with paragraph 6.5.11(a)(ii) of IFRS 9). This is also consistent with the requirement that the time value of any embedded optionality within the hedged item with respect to the hedged risk should be considered when measuring ineffectiveness, irrespective of whether the associated hedging instrument also has optionality.

7.5.1 Time value of options

The fair value of an option consists of its intrinsic value and its time value. An entity can either designate an option as a hedging instrument in its entirety, or it can separate the intrinsic value and the time value and designate only the intrinsic value (see 3.6.4 above). [IFRS 9.6.2.4(a)].

If the option is designated in its entirety as a hedge of a non-option item, changes in the portion of the fair value attributable to the option time value result in ineffectiveness (see 7.4.11 above). This is because only changes in the intrinsic value of the option will provide offset to the fair value changes attributable to the hedged risk (the situation is different if the hedged item also includes optionality, see 7.4.12 above, or if a delta-neutral hedging strategy is applied, see 6.3.2 above). Depending on the level of ineffectiveness from changes in the time value, an entity may have difficulty determining that an economic relationship existed between the hedged item and the hedging option (see 6.4.1 above).

If an entity chooses to exclude the time value from the designated hedging instrument it must apply the costs of hedging guidance, such that changes in the fair value of the time value of options to the extent that they relate to the hedged item, are first recognised in other comprehensive income (OCI). [IFRS 9.6.5.15]. It is worth noting that this treatment is not an accounting policy choice, as the treatment must be applied for all hedge relationships for which only the intrinsic value of the hedging instrument is designated within the hedge relationship. The subsequent treatment depends on the nature of the hedged transaction.

The standard differentiates between transaction related hedged items and time-period related hedged items: [IFRS 9.6.5.15, B6.5.29]

• Transaction related hedged items: the time value of an option used to hedge such an item has the character of part of the cost of the transaction. Examples would be a hedge of forecast purchases of inventory or property, plant and equipment, and forecast sales or purchases, as well as purchases or sales resulting from firm commitments.

  The amount that is accumulated in OCI is removed similarly to amounts accumulated in the cash flow hedge reserve (see 7.2.2 above). I.e. if the hedged transaction subsequently results in the recognition of a non-financial item (e.g. purchase of inventory or property, plant and equipment) the amount becomes a ‘basis adjustment’, otherwise the amount is reclassified to profit or loss in the same period or periods during which the hedged cash flows affect profit or loss (e.g. forecast sales);

• Time-period related hedged items: the time value of an option used to hedge such an item has the character of the cost of protection against a risk over a particular period of time (rather than a hedge of a transaction for which the transactions costs are accounted for as part of a one-off event).

  The amount that will be accumulated in OCI is amortised on a systematic and rational basis to profit or loss as a reclassification adjustment. The amortisation period is the period during which the hedge adjustment for the option's intrinsic value could affect profit or loss (or other comprehensive income if the option is designated as a hedge of an equity instrument accounted for at fair value through other comprehensive income). The appropriate amortisation period is illustrated in Example 53.74 below.

  Examples are hedges of interest expense or income in particular periods, already existing inventory hedged for fair value changes or a hedge of a net investment in a foreign operation. In the case of a forward starting interest rate option, the time value would be amortised over the interest periods that the option covers (i.e. the amortisation period would exclude the initial part of the option's life).

By default, the time value will be zero at expiry of an option contract. For a transaction related hedged item, recognising the fair value changes of the time value in OCI means that on expiry, the aligned time value that existed at designation will have accumulated in OCI (see 7.5.1.A below). Once the hedged transaction happens, the accounting for the accumulated time value follows the accounting for any changes in fair value of the intrinsic value of the option recorded in the cash flow hedge reserve. [IFRS 9.6.5.15]. Example 53.75 below illustrates how the costs of hedging accounting might be applied for a transaction related hedged item.

As noted above, by default, the time value will be zero at expiry of an option contract. For a time-period related hedged item, recognising the fair value changes of the time value in OCI means that on expiry, the time value that existed at designation will have accumulated in OCI. For time-period related hedged items, the amount accumulated in OCI is amortised on a ‘systematic and rational basis’ to profit or loss, however the standard does not prescribe what ‘on a systematic and rational basis’ means in this context. We believe a straight-line amortisation to be appropriate in most cases.

The standard is, however, not wholly prescriptive as to where in profit or loss the costs of hedging accumulated in OCI should be recycled. The distinction between transaction related hedged items and time-period related hedged items reflects that the accounting for the time value of the option should follow general IFRS principles for how to account for payments that are akin to insurance premiums (the ‘insurance premium view’ mentioned above). So, in making the distinction, an entity needs to consider how the accounting for the hedged item will eventually affect profit or loss. This would be an accounting policy choice since the standard is not clear. However, when hedging forecast sales or purchases, one an acceptable treatment would be presentation within the financial expense/income line item.

If hedge accounting is discontinued for a time-period related hedge relationship for which the costs of hedging treatment has been applied to the time value of the hedging option, the net amount (i.e. including cumulative amortisation) that has been accumulated in OCI must be immediately reclassified to profit or loss. This appears to be the case whether or not the hedged item is still expected to occur. [IFRS 9.6.5.15(c), BC6.399]. In contrast there is no equivalent guidance for discontinuation of transaction related hedges when the transaction is still expected to take place, and so there does not seem to be a need to reclassify the net amount accumulated in OCI immediately to profit or loss in that scenario, although this is an area of uncertainty given the standard as drafted.

The accounting for the time value of options would also apply to combinations of options, for example, when hedging a highly probable forecast transaction with a zero-cost collar. When designating the intrinsic value only, the volatility resulting from changes in the time values of the two options would be recognised in other comprehensive income. However, the amortisation (in the case of time-period related hedged items) or the transaction costs deferred at the end of the life of the hedging relationship (for transaction related hedged items) would be nil when using a zero-cost collar, as the cumulative change in time value over the period would be nil. [IFRS 9.B6.5.31].

7.5.2 Forward element of forward contracts

Entities using foreign currency forward contracts in hedging relationships can designate the instrument in their entirety or exclude the forward element by designating the spot element only. When only the spot element is designated, an entity has a choice to apply costs of hedging accounting to the excluded forward element. This is, however, 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 results in the forward points (often also called the ‘forward element’) being accounted for at fair value through profit or loss (see 3.6.5 above).

When designating the entire hedging instrument, it is usually desirable for the hedged item also to be measured at the forward rate instead of the spot rate in order to enhance effectiveness. For example, when hedging a highly probable forecast transaction, the hedged item, once transacted, could be measured with respect to the forward rate if the ‘forward rate method’ is designated (see 7.4.7 above). However, IAS 21 requires monetary financial assets and liabilities denominated in a foreign currency to be measured at the spot rate. As a result, the forward rate method does not provide a similar solution for hedges of such monetary items because of the IAS 21 requirement for such assets and liabilities to be measured at the spot rate. [IFRS 9.BC6.422]. Some assistance is provided in the implementation guidance of IAS 39 as to how the spot and forward elements of a simple forward contract can be identified (see also Example 53.72 at 7.4.7 above). [IAS 39.F.5.6]. This guidance remains relevant under IFRS 9.

When designating the spot element and applying the costs of hedging to the forward element, the change in fair value of the forward element is recognised in other comprehensive income (OCI) and accumulated in a separate component of equity. The accounting for the forward element that exists at inception also follows the distinction between transaction related hedged items and time-period related hedged items that is made when accounting for the time value of an option (see at 7.5.1 above). This means, in the case of a transaction related hedged item, that the change in the fair value of the forward element is deferred in OCI and included, like transaction costs, in the measurement of the hedged item (or it is reclassified to profit or loss when a hedged sale occurs). In case of a time-period related hedged item, the forward element that exists at inception is amortised from the separate component of equity to profit or loss on a rational basis. [IFRS 9.6.5.16, B6.5.34‑36].

As a result of the above accounting, fluctuations in the fair value of the forward element over time will affect other comprehensive income, and the amount accumulated in OCI will be recognised in profit or loss when the hedged item affects profit or loss (in case of a transaction related hedged item), or be amortised to profit or loss (in case of a time-period related hedged item). The following example is designed to demonstrate the accounting for the forward element of a hedging derivative, as a cost of hedging. The fact pattern is intentionally simplified in order to isolate the costs of hedging accounting.

The forward element costs of hedging treatment is not solely applicable for simple foreign currency 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 7.5.1.A 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 currency instruments also include foreign currency basis spreads which can also be excluded from hedging instruments (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 7.4.8 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.²¹ 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].

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.

8.2.1 Definition

An entity is required to ‘rebalance’ the hedge ratio to reflect a change in the relationship between the hedged item and hedging instrument if it expects the new relationship to continue going forward. Rebalancing refers to the adjustments made to the designated quantities of the hedged item or hedging instrument of an already existing hedging relationship for the purpose of maintaining a hedge ratio that complies with the hedge effectiveness requirements. Changes to the designated quantities of either the hedged item or hedging instrument for other purpose is not rebalancing within the context of IFRS 9. [IFRS 9.B6.5.7].

Rebalancing allows entities to refine their hedge ratio without discontinuation and redesignation, so reducing the need for designation of ‘late hedges’ and the associated accounting issues that can arise with such a hedge (see 2.4.1 and 7.4.4.B above).

The concept of rebalancing only comprises prospective changes to the hedge ratio (i.e. the quantity of hedged item compared to the quantity of hedging instrument) in response to changes in the economic relationship between the hedged item and hedging instrument, when the risk management otherwise continues as originally designated. [IFRS 9.BC6.303]. For instance, an entity may have designated a hedging relationship in which the hedging instrument and the hedged item have different but related underlying reference indices, rates or prices. If the relationship or correlation between those two underlyings change, the hedge ratio may need to change to better reflect the revised correlation. [IFRS 9.B6.5.9].

By way of an example; an entity hedges an exposure to Foreign Currency A using a currency derivative that references Foreign Currency B. Foreign Currency A and B are pegged (i.e. their exchange rate is maintained within a band or at an exchange rate set by a central bank or other authority). If the exchange rate between Foreign Currency A and Foreign Currency B were changed (i.e. a new band or rate was set), rebalancing the hedging ratio to reflect the new exchange rate would ensure that the hedging relationship would continue to meet the hedge effectiveness requirements. [IFRS 9.B6.5.10].

Any other changes made to the quantities of the hedged item or hedging instrument, for instance, a reduction in the quantity of the hedged item because some cash flows are no longer highly probable, would not be rebalancing. Such other changes to the designated quantities would need to be treated as a partial discontinuation if the entity reduces the extent to which it hedges, and a new designation of a hedging relationship if the entity increases it. [IFRS 9.B6.5.7].

Changes that risk managers may make to improve hedge effectiveness but that do not alter the quantities of the hedged item or the hedging instrument are not rebalancing either. An example of such a change is the transaction of derivatives related to a risk that was not considered in the original hedge relationship.

Therefore, rebalancing is only relevant if there is basis risk between the hedged item and the hedging instrument. Basis risk, in the context of hedge accounting, refers to any difference in price sensitivity of the underlyings of the hedging instrument and the hedged item. The existence of basis risk in a hedge relationship usually results in a degree of hedge ineffectiveness. For example, hedging a cotton purchase in India with NYMEX cotton futures contracts is likely to result in some ineffectiveness, as the hedged item and the hedging instrument do not share exactly the same underlying price. Rebalancing only affects the expected relative sensitivity between the hedged item and the hedging instrument going forward, as ineffectiveness from past changes in the sensitivity will have already been recognised in profit or loss.

The following example provides some indications as to how to distinguish rebalancing from other changes to a hedge relationship:

8.2.2 Requirement to rebalance

Whether an entity is required to rebalance a hedging relationship is first and foremost a matter of fact, which is, whether the hedge ratio has changed for risk management purposes. An entity must rebalance a hedging relationship if that relationship has an unchanged risk management objective but no longer meets the hedge effectiveness requirements regarding the hedge ratio. This will, in effect, be the case if the hedge ratio is no longer the one that is actually used for risk management (see 6.4.3 above). [IFRS 9.6.5.5].

However, consistent with initial designation, the hedge ratio used for hedge accounting purposes may have to differ from the hedge ratio used for risk management if the latter would result in ineffectiveness that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting (see 6.4.3 above). [IFRS 9.B6.5.14]. The guidance in IFRS 9 clarifies that an accounting outcome that would be inconsistent with the purpose of hedge accounting as the result of failing to adjust the hedge ratio for risk management purposes, would not meet the qualifying criteria for hedge accounting. This simply means that the qualifying criteria treat inappropriate hedge ratios in the same way, irrespective of whether they were achieved by acting (inappropriate designation) or failure to act (by not adjusting a designation that has become inappropriate). [IFRS 9.B6.5.13].

IFRS 9 also clarifies that not every change in the extent of offset between the hedging instrument and the hedged item constitutes a change in the relationship that requires rebalancing. For example, hedge ineffectiveness arising from a fluctuation around an otherwise valid hedge ratio cannot be reduced by adjusting the hedge ratio. [IFRS 9.B6.5.11, B6.5.12]. A trend in the amount of ineffectiveness on the other hand might suggest that retaining the hedge ratio would result in increased ineffectiveness going forward.

Accordingly, in order to continue to apply hedge accounting, an entity must rebalance the hedge ratio if required for accounting purposes as part of the prospective effectiveness assessment. IFRS 9 acknowledges that such an assessment is usually inherent in effective risk management monitoring, and so in many cases existing risk management process may be sufficient to determine whether accounting rebalancing is required or not. [IFRS 9.BC6.301].

IFRS 9 does not specify the nature of the assessment to determine if rebalancing is required. Therefore, the nature of the assessment requires judgement based on the facts and circumstances of the hedge relationship. For example, a hedge involving two underlyings with correlation that has been historically volatile would likely require more robust analysis than two underlyings that have shown consistent correlation over many years. As another example, a relationship that has been under-hedging for four consecutive quarters would likely require more robust analysis than a relationship constantly moving to and from an over- and under-hedge position.

Regardless of the chosen assessment methodology, it is clear that rebalancing is not a mathematical optimization exercise. [IFRS 9.BC6.310]. Accordingly hedges are not required to be perfectly effective, but judgement will be required to determine if rebalancing is necessary or not. Therefore at each reporting date entities should document the work performed to determine whether rebalancing is necessary or not, and any judgements made.

8.2.3 Mechanics of rebalancing

Rebalancing is accounted for as a continuation of the hedging relationship. On rebalancing, any hedge ineffectiveness arising from the hedging relationship is determined and recognised immediately before adjusting the hedging relationship. [IFRS 9.B6.5.8].

Once any hedge ineffectiveness has been recognised, rebalancing can be achieved by:

• increasing the volume of the hedged item;
• increasing the volume of the hedging instrument;
• decreasing the volume of the hedged item; or
• decreasing the volume of the hedging instrument. [IFRS 9.B6.5.16].

Decreasing the volume of the hedging instrument or hedged item does not mean that the respective transactions or items no longer exist or are no longer expected to occur. As demonstrated in Examples 53.82 and 53.83 below, rebalancing only changes what is designated in the particular hedging relationship.

In Example 53.82 above, the entity no longer needs to hold this portion of the derivative any longer for hedging purposes and could, therefore, close it out. If the entity chooses to keep that portion of the derivative it will of course continue to result in volatility in the profit or loss, although it would no longer be presented as hedge ineffectiveness. As mentioned, the entity could have also rebalanced by designating more WTI exposure (assuming that the higher level of exposure is highly probable of occurring). In that case, there would not be any immediate accounting entries; the entity would simply designate more WTI exposure. However, the ongoing accounting can be more complex, which is discussed in more detail below. The same would be true when rebalancing by increasing the volume of hedging instrument, in which case the entity would simply designate more of the same hedging instruments within the hedge relationship. This could be achieved either by entering into additional hedging instruments via a market transaction, or designating existing derivatives that are not currently designated within a hedge relationship. [IFRS 9.B6.5.16‑20].

Even though the standard allows adjusting either the quantity of hedging instrument or the quantity of the hedged item, when rebalancing, entities should consider that adjusting the hedged item will be operationally more complex than adjusting the hedging instrument because of the need to track the history of different quantities that were designated during the term of the hedging relationship. For example, if a quantity of 10 tonnes of a hedged item were added to increase the quantity of hedged item and later deducted to decrease it, those 10 tonnes would have been part of the hedged item for only a part of the life of the hedging relationship. However, the amount accumulated in the cash flow hedge reserve, would still, in part, relate to that quantity, even though it is not currently part of a cash flow hedge. Therefore ongoing tracking of the 10 tonnes is required to ensure appropriate recycling of the amounts previously taken to the cash flow hedge reserve (see 7.2.2 above). This can get more complex in situations in which the hedging relationship needs frequent rebalancing, if not all hedged transactions occur at the same time, or in conjunction with the cost formulas used for the measurement of the cost of inventory (for example a first in first out formula) (see Chapter 22 at 3.2). In addition, risk management would normally adjust the quantity of the designated hedging instruments when rebalancing, since the hedged exposure is normally the ‘given’ and drives what hedges are needed.

When rebalancing a hedging relationship, an entity must update its analysis of the sources of ineffectiveness in the hedge documentation. [IFRS 9.B6.5.21].

8.3.1 Accounting for discontinuation of fair value hedge accounting

On discontinuation of a hedge relationship for which the hedged item is a financial instrument (or component thereof) measured at amortised cost, any adjustment arising from a hedging gain or loss on the hedged item must be amortised to profit or loss. The amortisation is based on a recalculated effective interest rate at the date the amortisation begins. The treatment of any fair value hedge adjustments on discontinuation should also be applied to partial discontinuations. [IFRS 9.6.5.10].

In the case of a debt instrument (or component thereof) that is a hedged item measured at fair value through other comprehensive income (see 7.1.1 above), the amortisation is applied in the same manner as for financial instruments measured at amortised cost, but to other comprehensive income instead of by adjusting the carrying amount. [IFRS 9.6.5.10].

On discontinuation of a fair value hedge, no further guidance is provided for hedge relationships for which the hedged item is not a financial instrument. Therefore, on discontinuation of such a hedge relationship, the entity ceases to make any further adjustment arising from a hedging gain or loss on the hedged item, and any previous adjustment from fair value hedge accounting becomes part of the carrying amount of the hedged item. [IFRS 9.6.5.8(b)].

8.3.2 Accounting for discontinuation of cash flow hedge accounting

When an entity discontinues hedge accounting for a cash flow hedge, it must account for the amount that has been accumulated in the cash flow hedge reserve as follows:

• the amount remains in accumulated OCI if the hedged future cash flows are still expected to occur; or
• the amount is immediately reclassified to profit or loss as a reclassification adjustment if the hedged future cash flows are no longer expected to occur. [IFRS 9.6.5.12].

After discontinuation, once the previously expected hedged cash flow occurs, any amount remaining in accumulated OCI must be accounted for depending on the nature of the underlying transaction consistent with the accounting for cash flow hedge relationships that are not discontinued (see 7.2.2 above). [IFRS 9.6.5.12]. The treatment of the cash flow hedge reserve on discontinuation should also be applied to partial discontinuations.

8.3.3 Impact of novation to central clearing parties on cash flow hedges

The collapse of some financial institutions during the financial crisis highlighted the 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.

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 7.4.3 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.²³ 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 November 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;
• 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 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 also 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].

A further impact of novating derivatives to a CCP is that the derivatives are likely to become collateralised by cash. The July 2013 amendments to IFRS 9 acknowledged this and provided clarity that such a change on novation to a CCP would not result in derecognition if 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. [IFRS 9.6.5.6].

Cash collateralisation significantly reduces the credit risk for both parties involved, which will influence the fair value of derivatives novated. The application guidance clarifies that the change in the fair value of the hedging instrument that results from the changes to the contract in connection with the novation (e.g. a change in the collateral arrangements) must be included in the measurement of hedge ineffectiveness. [IFRS 9.B6.4.3].

The other criteria for achieving hedge accounting will still need to be met in order to continue hedge accounting (see at 6 above).

8.3.4 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 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.

8.3.5 The replacement of IBOR benchmark interest rates

As a result of the reforms mandated by the Financial Stability Board following the financial crisis, regulators are pushing for benchmark interbank offered rates (IBORs) such as LIBOR 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 panel banks will no longer be required to submit the quotes used to build 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 known 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).

In 2018, the IASB noted the increasing level of uncertainty about the long-term viability of some interest rate benchmarks and decided to add a project to its agenda to consider the financial reporting implications of the reform. The IASB identified two groups of accounting issues that could have financial reporting implications. These are:

• Phase 1: pre-replacement issues – issues affecting financial reporting in the period before the replacement of an existing interest rate benchmark with an alternative RFR; and
• Phase 2: replacement issues – issues that might affect financial reporting when an existing interest rate benchmark is replaced with an alternative RFR.

The IASB decided to prioritise the Phase 1 issues because they are more urgent, and in May 2019 the IASB issued an Exposure Draft: Interest Rate Benchmark Reform (the ED) to address them. Following responses by constituents to the ED, the Board met in August 2019 to confirm its proposals and agree some additional amendments. The Board agreed not to re-expose the amendments and gave permission to make the amendments to the standards, with the expectation that the final amendments will be issued in September 2019.

A combination of the amendments in the ED and the additional amendments agreed in August 2019 propose a number of temporary exceptions from applying specific hedge accounting requirements of both IAS 39 and IFRS 9.

The proposed reliefs apply to all hedging relationships that are directly affected by uncertainties due to IBOR reform about the timing or amount of interest rate benchmark-based cash flows of the hedged item or hedging instrument. However, if the hedged item or hedging instrument is designated for risks other than just interest rate risk, the proposed exceptions only apply to the interest rate benchmark-based cash flows. The relief will therefore not apply to net investment hedges as the hedged item must have interest-based cashflows to be eligible.

Application of the reliefs will be mandatory. The first three reliefs for IFRS 9 provide for:

1. The assessment of whether a forecast transaction (or component thereof) is highly probable;
2. Assessing when to reclassify the amount in the cash flow hedge reserve to profit and loss; and
3. The assessment of the economic relationship between the hedged item and the hedging instrument.

For each of these reliefs, it is assumed that the benchmark on which the hedged cash flows are based (whether or not contractually specified) and/or, for relief three, the benchmark on which the cash flows of the hedging instrument are based, are not altered as a result of IBOR reform.

The fourth relief provides that, for a benchmark component of interest rate risk that is affected by IBOR reform, the requirement that the risk component is separately identifiable need be met only at the inception of the hedging relationship. For ‘macro’ hedging strategies (i.e. where hedging instruments and hedged items may be added to or removed from an open portfolio in a continuous hedging strategy resulting in frequent de-designations and re-designations) the entity need only satisfy the separately identifiable requirement when hedged items are initially designated within the hedging relationship. The entity would not subsequently need to reassess this requirement for any hedged items that have been re-designated.

The reliefs are intended to be narrow in their effect. The Basis for Conclusions in the ED contains an example of where relief will not be available: benchmark-based cash flows cannot be assumed to still be highly probable if a liability is repaid early due to the uncertainties arising from IBOR reform. Also, to the extent that a hedging instrument is altered so that its cash flows are based on an RFR, but the hedged item is still based on IBOR (or vice versa), there is no relief from measuring and recording any ineffectiveness that arises due to differences in their changes in fair value.

Reliefs one and two above will cease to apply at the earlier of when the uncertainty arising from IBOR reform is no longer present with respect to the timing and amount of the benchmark-based cash flows of the hedged item, and:

• for relief one, when the hedging relationship that the hedged item is part of is discontinued; and
• for relief two, when the entire amount accumulated in the cash flow hedge reserve has been reclassified to profit and loss.

Relief three will cease:

• for a hedged item when the uncertainty arising from IBOR reform is no longer present with respect to the timing and amount of benchmark-based cash flows of the hedged item;
• for a hedging instrument, when the uncertainty arising from IBOR reform is no longer present with respect to the timing and amount of benchmark-based cash flows of the hedging instrument; and
• if the hedging relationship is discontinued before either of the two above events occur, at the date of discontinuation.

When an entity designates a group of items as the hedged item, the end of relief requirements would be applied to each individual item within the designated group of items.

The reliefs will continue indefinitely in the absence of any of the events described above. The Basis for Conclusions to the ED sets out a number of different fact patterns, which could arise as contracts are amended in anticipation of IBOR reform, to illustrate when uncertainties due to IBOR reform will end. The key message appears to be that, in most cases, relief will only end when a contract is amended to specify both what the new benchmark will be and when it will take effect.

The proposed amendments exempt entities from the disclosure requirements on changes in accounting estimates and errors upon the initial application of the amendments, as required by paragraph 28 of IAS 8 – Accounting Policies, Changes in Accounting Estimates and Errors (see Chapter 3 at 5.1.2.B). This avoids the need for entities to describe the nature of the change in accounting policy and to disclose the amount of any adjustment on adoption of the policy.

In addition, disclosures will be mandated to enable users to understand the extent to which an entity's hedging relationships are within the scope of the exceptions as well as qualitative disclosures about significant assumptions and judgments and how the uncertainties are affecting the entity's risk management strategies.

The effective date of the amendments is for annual periods beginning on or after 1 January 2020, with early application permitted. The requirements must be applied retrospectively, however, the reliefs would only apply to hedging relationships in existence as of the date of first application.

As many entities remain under the hedge accounting requirements of IAS 39 (see 1.3 above), amendments are also proposed to IAS 39. The corresponding amendments to IAS 39 are consistent with those for IFRS 9, but with the following differences:

• For the retrospective assessment of effectiveness, an entity would continue to apply hedge accounting to a hedging relationship for which effectiveness is outside of the 80–125% range during the period of uncertainty arising from the reform. All other hedge accounting requirements, including the amended prospective assessment requirements, would need to be met and any actual ineffectiveness would need to be measured and recognised in the financial statements. This should be calculated based on how market participants would value the hedged items and hedging instruments. This would include the effect of any increase in discount rates that the market would require due to the uncertainties arising from IBOR reform.
• For the prospective assessment of hedge effectiveness, it is assumed that the benchmark on which the hedged cash flows are based (whether or not it is contractually specified) and/or the benchmark on which the cash flows of the hedging instrument are based, are not altered as a result of IBOR reform.
• For a hedge of a benchmark portion (rather than a risk component under IFRS 9) of interest rate risk that is affected by IBOR reform, the requirement that the portion is separately identifiable need be met only at the inception of the hedge.

As noted above, the proposed amendments only cover pre-replacement issues (i.e. Phase 1). The replacement issues (i.e. Phase 2) of the IASB's project remains in progress at the time of writing. We believe the following replacement issues should be considered by the IASB

• the impact of transition to RFRs on hedge designation, specifically once a hedging relationship is amended to refer to an RFR rather than an IBOR, whether a de-designation and re-designation will be required;
• the basis on which amounts deferred in the cash flow hedge reserve should be recycled to profit or loss, as the originally designated IBOR cash flows will no longer occur;
• how (and when) any fair value measurement difference on transition should be accounted for;
• whether the existing guidance to determine if derecognition or modification of a financial asset or liability has occurred on transition (i.e. following an amendment to refer to an RFR rather than an IBOR) is appropriate for this circumstance (see Chapter 52 at 8.3);
• assuming that a financial asset or liability has not been derecognised following the amendment to refer to an RFR, how the changes in cash flow should affect the effective interest rate (see Chapter 50 at 3); and
• the impact on assets and liabilities outside the scope of IFRS 9, for example leases and insurance contracts.

8.3.6 Change of hedging counterparty within the same consolidated group

An entity may be required to, or choose to, novate a hedging instrument from one entity within a consolidated group, to another entity within the same group. For example, following the vote by the United Kingdom to leave the European Union in June 2016, commonly known as ‘Brexit’, Corporate A (the hedging entity) might plan to novate existing hedging derivatives with Bank UK (the hedging counterparty entity), to Bank EU, both Bank UK and Bank EU are subsidiaries of the same global banking group. Alternatively, a banking group may undertake an internal reorganisation such that a portfolio of derivatives (or a whole business) is transferred into a different entity within the same banking group. In both instances a question arises as to whether such a change in hedging derivative counterparty will result in the discontinuation of a hedge relationship.

We set out below the accounting requirement from the perspective of the various parties in the fact pattern – on the assumption that all parties designate the novated derivative in an eligible hedge relationship, consistent with their risk management objective.

• In the standalone financial statements of the original hedging counterparty, (i.e. Bank UK in the Brexit example above), it is clear that a hedge relationship would be discontinued, as an eligible hedging instrument no longer exists within that hedging counterparty legal entity.
• In the standalone financial statements of the new hedging counterparty (i.e. Bank EU in the Brexit example above), it is clear that a new hedge relationship would need to be designated (including identification of an eligible hedged item), as this entity is not party to the instruments designated in the previous hedge relationship (unless the derivative and designated hedged item were both included in a business transferred as part of the common control transaction (see Chapter 8 at 4.4.2)).
• In the consolidated financial statements of a parent that consolidates both the original hedging counterparty (i.e. Bank UK) and the new hedging counterparty (i.e. Bank EU), (i.e. the global banking group in the Brexit example above) the hedge relationship will continue. This is because an entity first consolidates all subsidiaries and then applies the derecognition guidance to financial instruments. [IFRS 9.3.2.1]. Accordingly, the hedging derivative still exists within the consolidated financial statement, hence there is no requirement to discontinue the hedge relationship.
• From the perspective of the hedging entity (i.e. Corporate A), the transfer of a derivative from one counterparty to another would ordinarily result in derecognition and hence a de-designation and re-designation of a hedge relationship. However, the appropriate treatment will depend on the specific facts and circumstances.

8.3.7 Disposal of a hedged net investment

The amount relating to a net investment hedge that has been accumulated in the foreign currency translation reserve must be reclassified from equity to profit or loss as a reclassification adjustment on disposal or, in certain circumstances, partial disposal of the foreign operation in accordance with IAS 21 (see Chapter 15 at 6.6 and 7.3 above). [IFRS 9.6.5.14].

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); and [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 53.87 below.

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].

9.3.1 Cash flow hedges

The designation of a group of items within a cash flow hedge, has no effect on the presentation in profit or loss of those designated hedged items. However, the presentation of the related hedging gains or losses in the statement of profit or loss depends on the nature of the group position. [IFRS 9.B6.6.13‑15]. The required presentation for hedges of groups of items is discussed in more detail in Chapter 54 at 7.1.3, and is summarised in the table below.

Note that the designation of a net position cash flow hedge is only permitted when hedging foreign currency risk (see 2.5.3 above).

For net position cash flow hedges, as the hedging gains and losses will be presented in a different line to that which the hedged items are presented in profit or loss, such a hedge designation might not seem very attractive, as the presentation of the hedged transactions will not reflect the effect of the hedge. However, the Board was concerned that grossing-up the hedging gain or loss would result in non-existing gains or losses being recognised in the statement of profit or loss, which would be in conflict with general accounting principles. [IFRS 9.BC6.457]. The Board also considered that such a presentation makes it transparent that an entity is hedging on a net basis and would clearly present the effect of those hedges of net positions on the face of the statement of profit or loss. [IFRS 9.BC6.461]. However, because of this presentation, in practice some entities may choose to continue to designate a proportion of a gross position rather than a net designation. Such a ‘proxy designation’ would be permitted provided the designation is directionally consistent with the actual risk management activities. [IFRS 9.BC6.98, BC6.100(a)]. (See 6.2.1 above).

9.3.2 Fair value hedges

A special presentation in the income statement is prescribed for fair value hedges of groups of items with offsetting risk positions (i.e. hedges of a net position), whose hedged risk affects different profit or loss line items. Entities must present the hedging gains or losses of such a hedge in a separate line item in the income statement in order to avoid grossing up the hedging gain or loss on a single instrument into multiple line items. Hence in that situation the amount in the line item that relates to the hedged item itself remains unaffected. [IFRS 9.6.6.4, B6.6.16].

However, the treatment in the statement of financial position is different, in that the individual items in the group are separately adjusted for the change in fair value due to changes in the hedged risk. [IFRS 9.6.6.5].

12.3.1 Accounting for the time value of options

Entities must apply the new accounting treatment for the time value of options retrospectively, if in accordance with IAS 39, only the hedging option's intrinsic value was designated as part of the hedge relationship (see 13 below). However, retrospective treatment is only applied to hedging relationships that existed at the beginning of the earliest comparative period and hedging relationships designated thereafter. [IFRS 9.7.2.26(a)]. There is also the restriction that IFRS 9 shall only be applied to items that have not been derecognised by the date of application, which would preclude any retrospective application to hedge relationships for which either of the hedging instrument or hedged item have been derecognised prior to that date. [IFRS 9.7.2.1].

For those foreign entities registered with and reporting to the United States Securities and Exchange Commission and required to present two comparative years of income statements, this means they would have a longer period to adjust for the retrospective application of the new requirements.

Applying the new accounting requirement retrospectively may have a much wider impact on comparative periods than is at first apparent. Depending on the type of hedging relationship, many line items in the primary statements and many disclosures in the notes may be affected.

12.3.2 Accounting for the forward element of forward contracts

Different to the accounting for the time value of options, entities have a choice of whether to apply retrospectively the new accounting for the forward element of forward contracts or not (see at 7.5.2 above). This is exclusively relevant for hedge relationships where, in accordance with IAS 39, only changes in the spot element of a hedging forward contract were designated within the hedge relationship. The choice applies on an all or nothing basis (i.e. if an entity elects to apply the accounting retrospectively, it must be applied to all hedging relationships that qualify for the election). The retrospective application would also only apply to those hedging relationships that ‘existed’ at the beginning of the earliest comparative period or that were designated thereafter. [IFRS 9.7.2.26(b), BC7.49]. We believe that in order for a hedge relationship to ‘exist’ as at the beginning of the earliest comparative period, it must have met all the hedge accounting conditions in paragraph 88 of IAS 39 on that date, including demonstration of effectiveness (see 13 below). Assets and liabilities cannot be adjusted to reflect hedges that had already finished at the start of the comparative period. Furthermore, if under IAS 39 a forward designation was made, yet on application of IFRS 9 a spot designation is deemed preferable, we believe that such a change to the designation should be treated as discontinuation of the original relationship and the re-designation of a new relationship, hence this retrospective application will not apply in that case, see 12.3.4 below.

12.3.3 Accounting for foreign currency basis spread

Similar to the retrospective transition guidance for the accounting for the forward element of forward contracts, it is also possible to apply retrospectively the accounting for foreign currency basis spreads (see at 7.5.3 above) on transition to IFRS 9 hedge accounting. However, in contrast to the transition requirements for the forward element of forward contracts, the decision to apply retrospectively the costs of hedging guidance on foreign currency basis spreads can be made on a hedge by hedge basis, without a requirement that foreign currency basis had been excluded from the designation under IAS 39. This is owing to the differences in circumstances: IAS 39 did not have an exception for excluding a foreign currency basis spread from the designation of a financial instrument as a hedging instrument. The hedge by hedge choice can be made for those hedging relationships that ‘existed’ at the beginning of the earliest comparative period or that were designated thereafter. [IFRS 9.7.2.26(b), BC7.49].

12.3.4 Re-designation of hedge relationships for non-financial risk components

IFRS 9 permits the designation of eligible risk components in non-financial hedged items (see 2.2 above). Such a designation was not possible under IAS 39. This means, even if entities were economically hedging a risk component, they were obliged to designate the change in the entire hedged item as the hedged risk in order to achieve hedge accounting. Such a designation was likely to result in the recognition of ineffectiveness in profit or loss and in some cases failure of the effectiveness requirements.

On transition to IFRS 9 hedge accounting, entities may wish to amend hedge accounting relationships such that the hedged risk is an eligible risk component for non-financial hedged items. The question is whether that change in the documented hedged risk must result in the discontinuation of the original hedge relationship and the start of a new hedge relationship, or whether it can be treated as an amendment to the original designation such that the original hedge relationship continues. This question is particularly relevant for cash flow hedges, as on re-designation the non-zero fair value of the hedging instrument can result in subsequent ineffectiveness recorded in profit or loss (see 7.4.3 above).

We believe that such a change in the documented hedged risk should be treated as a discontinuation of the original hedge relationship and the re-designation of a new hedge relationship because it can be seen as either a change in the hedged item or a change in the documented risk management objective which both require discontinuation of a hedging relationship. [IFRS 9.B6.5.26(a)].

The IASB was nervous of permitting any retrospective application of the IFRS 9 hedge accounting requirements, as such an application could involve the use of hindsight, for example as to whether it is beneficial or not to change the hedged risk to be an eligible risk component. The specific scenarios where retrospective application is permitted are those that either do not involve the use of hindsight as IFRS 9 application relied on particular choices that had already been made under IAS 39 (e.g. the designation of the intrinsic value of an option or the spot element of a forward) or where retrospective application was already permitted in IAS 39 (novation of a derivative through a central counterparty). [IFRS 9.BC7.44‑51]. Due to the absence of a specific respective transition relief, it follows that a hedge relationship cannot continue if an eligible risk component under IFRS 9 is introduced into an existing IAS 39 hedge relationship.

The question has been asked as to whether this transition issue could be resolved by ‘dual-designating’ the hedge relationship, at the inception of the hedge, under both IAS 39 and IFRS 9. The IAS 39 designation would be for the full price risk, while the IFRS 9 designation would be of just the eligible risk component. Unfortunately this does not work, because the switch from the IAS 39 hedge designation to the IFRS 9 hedge designation would reflect a change in risk management objective, which would result in discontinuation of the first hedge relationship (see 8.3 above).

The logical follow-on question is whether an entity can continue with the original IAS 39 designation although it does not exactly represent the entity's risk management objective. We note that although the objective of hedge accounting under IFRS 9 is to represent an entity's risk management activities, [IFRS 9.6.1.1], it does not require that it is an exact match. The Basis for Conclusions notes that, in some circumstances, the designation for hedge accounting purposes is inevitably not the same as an entity's risk management view of its hedging, but that the designation reflects risk management in that it relates to the same type of risk that is being managed and the instruments used for this purpose. The IASB refer to this situation as ‘proxy hedging’, which is an eligible way of designating the hedged item under IFRS 9 provided that it still reflects risk management (see 6.2.1 above). One example of proxy hedging mentioned is those instances where the risk management objective is to hedge a risk component but the accounting hedge designation is for the full price risk. Where there is a choice of accounting hedge designation, there is no requirement for an entity to select the designation that most closely matches the risk management view of hedging as long as the chosen approach still reflects risk management. [IFRS 9.BC6.97, BC6.98, BC6.100(b)]. Consequently, we believe that it is permitted, on transition, to continue with an accounting designation of the full price risk even if the management objective was always to hedge a component of risk.

Both questions above were debated by the IFRS Interpretations Committee in September 2015 and January 2016. The final agenda decision reached by the Interpretations Committee is consistent with the analysis presented above.²⁸