IFRS9 Financial Instruments

Introduction

The IASB project on hedge accounting seeks to align the accounting treatment with the economics of risk management.

Key Initiatives

Hedged items

Component exposures (portions of non-financial items): allow hedging non-financial items for a commodity price risk that is only a component of the overall price risk of the item (i.e. components can be designated in hedge accounting relationships) provided the risk component is separately identifiable and reliably measurable.
Synthetic exposures (derivatives hedging derivatives): lift a restriction that the hedged exposure cannot include a derivative (e.g. an entity wishing to hedge the domestic interest rate risk on a forecast debt issuance could not hedge account for that exposure if the risk arose on a combination of foreign debt and a cross-currency interest rate swap that together created synthetic domestic debt). This change will allow a number of economic hedge strategies that utilise multiple derivatives to get hedge accounting where previously they could not.
Groups and net positions of exposures: permits groups of individually eligible hedged items to be hedged collectively as a group, provided the group of items is managed together for risk management purposes. Such groups may be net positions. However, for a cash flow hedge of a net position, the offsetting cash flows exposed to the hedged risk, must affect profit or loss in the same, and only in that, reporting period. This reduces the need to designate the hedge for accounting purposes in a way that is not equivalent to the way it is being hedged from a risk management perspective. When an entity hedges a net position that affects different line items in the income statement, any hedging instrument gains or losses recognised in profit or loss must be presented in a separate line item from the items that are hedged.

Hedging instruments

Accounting for the time value of options: currently, entities have the choice to: (a) designate an option as a hedging instrument in its entirety; or (b) separate the time value of the option and designate as the hedging instrument only (the change in) its intrinsic value. It is usual to apply choice (b), in which case, the time value of the option has to be recorded at fair value through profit or loss (volatility). A change to the accounting for the time value of an option when only the intrinsic value of the option is designated in a hedge is proposed by making a distinction between two types of hedged items:

  • Transaction related (e.g. the forecast purchase of a commodity)
  • Time period related (e.g. hedging price changes affecting commodity inventory).

For both transaction-related and time period-related hedged items, the cumulative change in fair value of the option’s time value would initially be accumulated in Other Comprehensive Income (OCI). In the former case, the amount is removed from OCI and included in the initial cost or other carrying amount of the hedged item. In the latter case, the amount is recycled from OCI to profit or loss, in order to amortise the original time value of the option over the term of the hedging relationship.

Hedge effectiveness

Effectiveness threshold: other than accidental offset (removal of 80-125% bright line test): The focus will be to ensure that the hedging relationship results in an unbiased or neutral hedge (e.g. is not intentionally designed to over or under hedge), and minimise expected hedge ineffectiveness. It is also necessary to demonstrate that any expected offsetting between changes in the fair value or cash flows of the hedging instrument and the hedged items is not accidental. This is done by analysing the economic relationship between the hedged item and hedging instrument. The assessment will be prospective and needs to be performed at inception on an ongoing basis (a backward looking retrospective test is no longer required to determine whether hedge accounting can be applied). The type of assessment — quantitative or qualitative — will depend on the relevant characteristics of the hedging relationship and the potential sources of ineffectiveness.
Measurement of hedge ineffectiveness: An entity would still be required to calculate fair value changes of both the hedged item and hedging instrument in order to post the necessary accounting journals to record the actual effectiveness of the hedge.

Changes to a hedging relationship

Concept of re-balancing: In cases where there is a change in expectation of hedge effectiveness, a change in the weightings of the hedged item and hedging instrument (re-balancing) may be required in order to continue to comply with “the objective of hedge effectiveness assessment”. The proposal removes the formal de-designation and re-designation of a hedging relationship when only part of the relationship changes.
De-designation of existing hedges: When there has been no change to a designated hedging relationship, and the risk management objective for the hedge remains the same, an entity would not be permitted to discontinue voluntarily hedge accounting.

Transition

Effective date of annual periods beginning on or after 1 January 2018. For further information contact the Author.

Ian Gordon
ian.gordon@cnstreasury.com

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