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 t0
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 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 7.4.9 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 44 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
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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 IFRS 9.B6.5.2
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].
Accordingly, not all instruments measured at fair value through profit or loss will be
eligible hedged items, as it will depend on the reason why the instrument is measured
at fair value through profit or loss. 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 44 at 2). We discuss the eligibility of such instruments
measured at fair value through profit or loss in the paragraphs below.
2.6.2.A
Hedged items managed on a fair value basis
For a portfolio of financial assets that is managed and whose performance is evaluated
on a fair value basis, an entity is primarily focused on fair value information and uses
that information to assess the assets’ performance and to make decisions. [IFRS 9.B4.1.6].
In our view if the hedging instrument is also part of the same portfolio (or business
model), and the entity has by definition determined that fair value is the most
appropriate measure for that portfolio, then this would be inconsistent with the idea of
cash flow hedging, whereby part of the fair value movements would be recorded in
other comprehensive income, separately from the remaining fair values movements that
would be recorded in profit or loss. We therefore believe cash flow hedge accounting
would not ordinarily be appropriate in this scenario.
However there may be some situations where the cash flow interest rate risk on an asset
that is part of a portfolio managed on a fair value basis, may be managed outside of the
portfolio (or business model). In such cases any instrument hedging the interest rate risk
would also be held separately from the managed portfolio. In such a scenario, cash flow
Financial instruments: Hedge accounting 4007
hedge accounting is not necessarily inconsistent with the hedged asset being held at fair
value through profit or loss. Such a situation is shown in the following example:
Example 49.21: Interest rate risk managed separately from a credit risk portfolio
managed on a fair value basis
Entity A has excess funds to invest and spreads these across various investment portfolios for which the credit
risk is managed by individual portfolio managers on a fair value basis. The individual managers are likely to
manage the fair value of the portfolio using credit risk derivatives such as credit default swaps. The entity
however, wishes to retain the management of interest rate risk centrally where it is aggregated with other
interest rate exposures across the entity, e.g. from issue debt, and therefore instructs each portfolio manager
to invest in order to achieve a 3m LIBOR based rate of return. Accordingly the majority of assets within each
investment portfolio will attract a floating rate and hence most of the portfolio’s fair value volatility will arise
from changes in credit risk. The interest rate risk is managed centrally and so any interest rate swaps used to
fix some of the variability in the future cash flows from changes in interest rate risk are transacted centrally
and not part of any investment portfolio, nor are they considered when reportin
g or assessing the performance
of the individual investment portfolios. Each investment portfolio is managed based on its fair value, has
discreet fair value financial information and each portfolio manager is assessed on the fair value performance
of their portfolio. The entity concludes that the business model test should be applied at the portfolio level
and as such each investment portfolio is measured at fair value through profit or loss.
It is possible that in these circumstances the decision to enter into interest rate swaps
and apply cash flow hedge accounting to an asset within the investment portfolios is not
inconsistent with the fact the instrument is held at fair value through profit or loss, since
that designation is driven by management of the fair value of credit and not the interest
rate element.
2.6.2.B
Hedged items held for trading
A portfolio that is held for trading is one where assets and liabilities are acquired or
incurred principally for the purpose of selling or repurchasing or short-term profit-
taking. An entity achieves those objectives by either selling or repurchasing the financial
instruments or by entering into an opposite trade to lock-in a gain. We believe in this
case cash flow hedging will not be appropriate for the reasons set out below:
• a trading portfolio is likely to be managed on a fair value basis and so a number of the
considerations above will also apply. Furthermore, it is unlikely that any of the risks
within the trading portfolio will be managed separately outside of the trading portfolio;
• in a trading portfolio where an entity plans to sell an asset in the near team, the
asset will not be eligible for cash flow hedging as the future cash flows will not be
highly probable; and
• in a trading portfolio where an entity plans to enter into an offsetting position to
lock in the gain, there will be no net position remaining to economically hedge or
to be managed separately outside of the portfolio.
Derivatives are deemed to be held for trading (see Chapter 44 at 4) and so are ineligible
as hedged items on their own. However, derivatives can be designated as hedged items
in combination with a non-derivative item as part of an aggregated exposure if certain
criteria are met. This allows hedge accounting to be applied to many common risk
management strategies, such as where an entity initially only hedges the price risk of a
highly probable forecast purchase of a raw material denominated in a foreign currency,
then later hedges the foreign exchange risk too (see 2.7 below).
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2.6.2.C
Hedged items that have failed the contractual cash flows test
Where instruments are classified as fair value through profit or loss because they fail the
contractual cash flow characteristics test (see Chapter 44 at 6), the above arguments do
not apply and so it appears that such instruments may be designated as the hedged item
in a cash flow hedge.
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 44
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 44 at 2.2). Consequently, the same also applies for any accumulated fair
value changes on the hedging instrument, including any ineffectiveness.
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 exchange risk, because the other risks being hedged cannot be
specifically identified and measured. These other risks are also said to be general
business risks. [IFRS 9.B6.3.1]. 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). This 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 exchange rates prior to acquisition or issuance of a monetary
item denominated in a foreign currency do not impact profit or loss. Therefore an
Financial instruments: Hedge accounting 4009
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 forecast acquisition or
issuance of a foreign currency monetary item and an associated 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 43) 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 divid
end 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 exchange 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.4
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
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the first date that the amount could be required to be paid. [IFRS 13.47]. Therefore the fair
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