Designated hedging instruments

Designated hedging instruments

Most derivative financial instruments can be designated as hedging instruments, provided they are entered into with an external party. Intra-group derivatives or other balances do not qualify as hedging instruments in consolidated financial statements irrespective of whether a proposed hedging instrument, such as an intercompany borrowing, will affect consolidated profit or loss. But they might qualify in the separate financial statements of individual entities in the group.

The main changes to hedging instruments in IFRS 9 are: how to account for the time value of options; the interest element of forward contracts; and the currency basis of cross-currency swaps when used as hedging instruments.

Derivative financial instruments

IFRS 9 contains no restrictions regarding the circumstances in which a derivative can be designated as a hedging instrument (provided the hedge accounting criteria are met), except for some written options.

– Non-derivative financial instruments measured at fair value through P&L

Under IFRS 9, non-derivative financial instruments are allowed as hedging instruments of foreign currency risk provided that such non-derivative financial instruments are not investments in equity instruments for which the entity has elected to present the changes in fair value in OCI.

In addition, IFRS 9 also allows non-derivative financial instruments as hedging instruments to hedge other risks if measured at fair value through P&L. The only exception is for financial liabilities accounted for at fair value for which the changes in the liability’s own credit risk are presented in OCI – these are not eligible for designation as hedging instruments.

For financial instruments that an entity has originally elected to designate at inception at fair value through P&L to mitigate an accounting mismatch (commonly referred as the ‘fair value option’), a designation as hedging instruments is allowed only if such designation mitigates an accounting mismatch, without recreating another one (that is, no conflict should exist between the purpose of the fair value option and the purpose of hedge accounting).

Embedded derivatives

Under IFRS 9’s requirements for the classification and measurement of financial instruments, embedded derivatives in financial assets are not accounted for separately. Instead an embedded derivative in a financial asset is (in most cases) carried at fair value through P&L for the whole instrument.

As a result, embedded derivatives in financial assets are not eligible as hedging instruments on their own. As an alternative, entities could designate the instrument in its entirety (or a proportion of it) at fair value through P&L as a hedging instrument, as noted above. However, entities should note that designation at fair value through P&L is allowed only at inception; therefore, they can do this only for new financial instruments.

Derivatives embedded in financial liabilities are separated in some circumstances. If an embedded derivative is separated from the host instrument and accounted for separately, it continues to be eligible as a hedging instrument.

Purchased options

The fair value of an option can be divided into two portions: the intrinsic value (which is determined in terms of the difference between the strike price and the current market price of the underlying) and the time value (that is, the remaining value of the option which reflects the volatility of the price of the underlying, interest rates and the time remaining to maturity).

IAS 39 permits designation of either the entire fair value or only the intrinsic value of the option. However, designating only the intrinsic value usually increases the volatility in P&L, due to the fact that changes in the time value of the option are recognised in P&L.

IFRS 9 changed the accounting requirements on using purchased options as hedging instruments. It views a purchased option as similar to purchasing insurance cover with the time value being the associated cost. If an entity elects to designate only the intrinsic value of the option as the hedging instrument, it must account for the changes in the time value in OCI.

This amount will be removed from OCI and recognised in P&L, either over the period of the hedge if the hedge is time related (for example, six-month fair value hedge of inventory), or when the hedged transaction affects P&L if the hedge is transaction related (for example, a forecast sale). This is known as the ‘cost of hedging’ approach and should result in less volatility in P&L for these option-based hedges, and it removes an obstacle to sensible risk management practice.

An entity needs to take into consideration that, once it designates the intrinsic value of the option, the accounting introduced by IFRS 9 is not optional, but mandatory. In addition, the aforementioned accounting for the initial time value of purchased options applies only to the extent that the time value relates to the hedged item. This is called the ‘aligned time value’.

Where the hedging instrument and hedged item are not fully aligned, entities need to determine the aligned time value – that is, how much of the time value included in the premium paid (actual time value) relates to the hedged item – and apply this accounting treatment to that portion. This can be determined using the valuation of the option that would have critical terms that perfectly match the hedged item. The residual amount is recognised in P&L.

Forward contracts

A forward is a contract to exchange a fixed amount of a financial or non-financial asset on a fixed future date at a fixed price. The fair value of a forward contract is affected by changes in the spot rate and changes in the forward points (in the case of an FX forward contract, the forward points arise from the interest rate differential between currencies specified in a forward contract).

Under IFRS 9, the ability to designate the forward or the spot rate is not restricted to foreign currency risk and an entity has a choice of whether to hedge using either the forward rate or the spot rate:

• If the forward rate is used, the entity is hedging with the full fair value of the forward contract. Changes in the fair value of the forward are accounted for in accordance with the type of hedge (such as fair value hedge or cash flow hedge). In this type of designation, some ineffectiveness would generally arise if the hedged item is not similarly affected by interest rate differentials for example if the timing of the hedged item differs from the maturity of the forward contract designated as the hedging instrument.
• Where an entity designates only the change in the value of the spot element as the hedging instrument, the entity is only concerned about movements in the spot rate (and not changes due to interest rates, which is the forward element). Changes in the spot rate are part of the hedge relationship, and so they are accounted for in accordance with the type of hedge, whereas the changes in fair value due to the forward points are immediately recognised in P&L.

However, where an entity designates only the change in the spot element as the hedging instrument an additional accounting approach exists for the forward element of the forward contracts. Even though a forward contract can be considered to be related to a time period, IFRS 9 states that the relevant aspect for its accounting is the characteristic of the hedged item and how it affects profit or loss.

An entity must assess the type of hedge on the basis of the nature of the hedged item, regardless of whether the hedging relationship is a cash flow hedge or a fair value hedge. An entity assesses whether the hedge is transaction related (for example, the hedge of a forecast purchase of inventory in foreign currency) or whether it is time- period related (for example, a hedge of the fair value of commodity inventory for the next six months using a commodity forward contract).

The accounting treatment to be applied to the forward element of a forward contract is the same as for the time value of hedging with options (described in Purchased options above). However, unlike the accounting for options, this ‘cost of hedging’ accounting treatment is optional rather than mandatory. This additional approach helps to reduce volatility in P&L accounting from previous standard.

Accounting for currency basis spreads

IAS 39 did not prescribe specific accounting criteria for currency basis spreads (that is, the liquidity charge for exchanging different currencies that is inherent in a foreign exchange contract). Many entities included this spread when applying the hypothetical derivative method for assessing hedge effectiveness for cash flow hedges. The hypothetical derivative is an accepted mathematical expedient used by entities to calculate the value of the hedged item in cash flow hedges.

IFRS 9 states that a hypothetical derivative cannot include features that do not exist in the hedged item. It clarifies that a hypothetical derivative cannot simply impute a charge for exchanging different currencies (that is, the currency basis spread), even though actual derivatives under which different currencies are exchanged might include such a charge (for example, cross-currency interest rate swaps).

Under IFRS 9, where an entity separates the foreign currency basis spread from a financial instrument and excludes it from the designation of that financial instrument as the hedging instrument, the entity can account for the changes in the currency basis spread in the same manner (that is, transaction related or time-period related) as applied to the forward element of a forward contract, as noted in Forward contracts above.

Entities might want to use the cost of hedging approach for the currency basis spread to avoid ineffectiveness that would otherwise arise, particularly for longer dated swaps or forwards or where hedging less common or more volatile currencies, where the spread is likely to be larger.

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