US$300 million borrowing issued by A because the hedging instrument is held outside
of the group headed by B. [IFRIC 16.AG6].
6 QUALIFYING
CRITERIA
6.1 General
requirements
In order to qualify for hedge accounting as set out at 7 below, all of the following criteria
must be met:
• the hedging relationship consists only of eligible hedging instruments and eligible
hedged items (see 2 and 3 above);
• at inception of the hedging relationship, there is formal designation and
documentation of the hedging relationship and entity’s risk management objective
and strategy for undertaking the hedge (see 6.2 below). That documentation shall
include an identification of the hedging instrument, the hedged item, the nature of
the risk being hedged and how the entity will assess the effectiveness requirements
(including its analysis of the sources of hedge ineffectiveness and how it
determines the hedge ratio (see 6.3 below); and
• the hedging relationship meets all the following hedge effectiveness requirements
(see 6.4 below):
• there is ‘an economic relationship’ between the hedged item and the hedging
instrument;
• the effect of credit risk does not ‘dominate the value changes’ that result from
that economic relationship; and
• ‘the hedge ratio of the hedging relationship is the same as that resulting from
the quantity of the hedged item that the entity actually hedges and the
quantity of the hedging instrument that the entity actually uses to hedge that
quantity of the hedged item. However, that designation shall not reflect an
imbalance between the weightings of the hedged item and the hedging
instrument that would create hedge ineffectiveness (irrespective of whether
recognised or not) that could result in an accounting outcome that would be
inconsistent with the purpose of hedge accounting’. The second part of this
requirement is an anti-abuse clause that is explained in more detail in at 6.4.3
below. [IFRS 9.6.4.1].
The required steps for designating a hedging relationship can be summarised in a flow
chart as follows:
Financial instruments: Hedge accounting 4055
Figure 49.2:
How to achieve hedge accounting
Define risk management (RM) strategy
and objective
Identify eligible hedged item(s) and
eligible hedging instrument(s)
No
Is there an economic relationship between
hedged item and hedging instrument?
Yes
Yes Does the effect of credit risk dominate the
fair value changes?
No
Base hedge ratio on the actual quantities
used for risk management
Yes Does the hedge ratio reflect an imbalance
To avoid
that would create hedge ineffectiveness?
ineffectiveness, the
ratio may have to
No
differ from the one
used in RM
Formal designation and documentation
The initial effectiveness requirements also form the basis for the subsequent effectiveness
assessment in order to continue to achieve hedge accounting, which is discussed at 8 below.
6.2
Risk management strategy versus risk management objective
Linking hedge accounting with an entity’s risk management activities requires an
understanding of what those risk management activities are. IFRS 9 distinguishes
between the risk management strategy and the risk management objective. One of the
qualifying criteria for hedge accounting is that the risk management objective and
strategy are documented. [IFRS 9.6.4.1(b)].
The risk management strategy is established at the highest level of an entity and
identifies the risks to which the entity is exposed, and whether and how the risk
management activities should address those risks. For example, a risk management
strategy could identify changes in interest rates of loans as a risk and define a specific
target range for the fixed to floating rate ratio for those loans. The strategy is typically
maintained for a relatively long period of time. However, it may include some flexibility
to react to changes in circumstances. [IFRS 9.B6.5.24].
4056 Chapter 49
IFRS 9 refers to the risk management strategy as normally being set out in ‘a general
document that is cascaded down through an entity through policies containing more
specific guidelines.’ [IFRS 9.B6.5.24]. However, in our view, this does not need to be a formal
written risk management strategy document in all circumstances. Small and medium-sized
entities with limited risk management activities that use financial instruments may not have
a formal written document outlining their overall risk management strategy that they have
in place. In some instances, there might be an informal risk management strategy
empowering an individual within the entity to decide on what is done for risk management
purposes. In such situations entities do not have the benefit of being able to incorporate
the risk management strategy in their hedge documentation by reference to a formal policy
document, but instead have to include a description of their risk management strategy
directly in their hedge documentation. Also, there are disclosure requirements for the risk
management strategy that apply irrespective of whether an entity uses a formal written
policy document as part of its risk management activities. Consequently, a more informal
risk management strategy should be both reflected in the disclosures and ‘compensated’ by
a more detailed documentation of the hedging relationships.
The risk management strategy is an important cornerstone of the hedge accounting
requirements in IFRS
9. Consequently, the Board added specific disclosure
requirements so that should allow users of the financial statements to understand the
risk management activities of an entity and how they affect the financial statements
(see 10.2 below). [IFRS 7.21A(a)].
The risk management objective, on the contrary, is set at the level of an individual hedging
relationship. It defines how a particular hedging instrument is designated to hedge a particular
hedged item, and how that hedging instrument is used to achieve the risk management
strategy. For example, this would define how a specific interest rate swap is used to ‘convert’
a specific fixed rate liability into a floating rate liability. Hence, a risk management strategy
would usually be supported by many risk management objectives. [IFRS 9.B6.5.24].
Example 49.50: Risk management strategies with related risk management objectives
The table below shows two examples of a risk management strategy with a related risk management objective.
Risk management strategy
Risk management objective
Maintain 40% of financial debt at floating interest rate
Designate an interest rate swap as a fair value hedge of a
GBP 100m fixed rate liability
Hedge foreign currency risk of up to 70% of
Designate a foreign exchange forward contract to hedge
forecast sales in USD up to 12 months in advance
the foreign exchange risk o
f the first USD 100 sales in
March 2018
It is essential to understand the difference between the risk management strategy and
the risk management objective. In particular, a change in a risk management objective,
is likely to affect the entity’s ability to continue applying hedge accounting.
Furthermore, voluntary discontinuation of a hedging relationship without a respective
change in the risk management objective is not allowed. This is described at 8.3 below.
There is no need to demonstrate the documented risk management strategy and/or risk
management objective reduce risk at an entity-wide level. For example, if an entity has
a fixed rate asset and a fixed rate liability, each with the same principal terms, it may
enter into a pay-fixed, receive-variable interest rate swap to hedge the fair value of the
Financial instruments: Hedge accounting 4057
asset even though the effect of the swap is to create an interest rate exposure for the
entity that previously did not exist. However, such a hedge designation would of course
only make sense when the hedge is offsetting an economic risk. For example, in the
situation described above, the hedge designation might only be a proxy for a hedge of a
cash flow risk that does not qualify for hedge accounting (see 6.2.1 below).
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.7 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]. The examples below are common proxy hedging designations:
Example 49.51: Common proxy hedging designations
Net position cash flow hedging
IFRS 9 limits the designation of net positions in cash flow hedges to hedges of foreign exchange risk
(see 2.5.3 above). However, in practice, entities often hedge other types of risk on a net cash flow basis. Such
entities could still designate the net position as a gross designation. [IFRS 9.BC6.100(a)].
For example, an entity holds Australian Dollar (AUD) 2m of variable rate loan assets and AUD 10m of
variable rate borrowings. The treasurer is hedging the cash flow risk exposure on the net position of AUD 8m,
by entering into a pay fixed/receive variable interest rate swap (IRS) with a nominal amount of AUD 8m.
Rather than designate the net AUD 8m as the hedged item, the entity could designate the IRS in a hedge of
variable rate interest payments on a portion of AUD 8m of its AUD 10m borrowing.
The same approach could be applied when hedging the net foreign exchange risk from forecast purchases and sales.
Risk components
An entity that hedges on a risk component basis in accordance with its risk management view might not meet
the criteria for designating the hedged item as a risk component. This does not mean that the entity is
prohibited from applying hedge accounting altogether. The entity could designate the item in its entirety as
the hedged item and apply hedge accounting, if all the qualifying criteria are met. [IFRS 9.BC6.100(b)].
Macro hedging strategies
Permitting proxy hedging is of particular relevance for banks wishing to apply macro cash flow hedging strategies
(see 11 below). Typically, banks manage the interest margin risk resulting from fixed-floating mismatches of
financial assets and financial liabilities held at amortised cost on their banking books. Assume the assets are floating
rate and the liabilities are fixed rate. The fixed-floating mismatches are offset by entering into receive fixed/pay
variable interest rate swaps. There is no hedge accounting model that perfectly accommodates such hedges of the
interest margin. Consequently, banks are forced to use either fair value hedge accounting for the liabilities or cash
flow hedge accounting for the assets, although the actual risk management activity is neither to hedge fair values nor
cash flows, but to hedge the interest margin. Both cash flow hedge accounting and fair value hedge accounting would
be directionally consistent with the risk management activity and so acceptable as proxy hedging designations.
4058 Chapter 49
6.3 Documentation
and
designation
An entity may choose to designate a hedging relationship between a hedging instrument
and a hedged item in order to achieve hedge accounting. [IFRS 9.6.1.2]. At inception of the
hedging relationship the documentation supporting the hedge should include the
identification of:
• the hedging relationship and entity’s risk management objective and strategy for
undertaking the hedge (see 6.2 above);
• the hedging instrument (see 3 above);
• the hedged item (see 2 above);
• the nature of the risk being hedge (see 2.2 above); and
• how the entity will assess the effectiveness requirements (including its analysis of the
sources of hedge ineffectiveness and how it determines the hedge ratio (see 6.4 below);
All of the criteria at 6.1 above, including the documentation requirements, must be met
in order to achieve hedge accounting. [IFRS 9.6.4.1]. Accordingly hedge accounting can be
applied only from the date all of the necessary documentation is completed, designation
of a hedge relationship takes effect prospectively from that date. In particular, hedge
relationships cannot be designated retrospectively.
Example 49.52: Hedge documentation
In order to meet the above documentation requirements, the hedge documentation should include definitive
information on the following, where relevant:
IFRS 9.6.4.1 requirement
Detailed documentation required
Risk management objective
• Risk management strategy (Could reference a formal policy document)
and strategy
• Risk management objective (specific to the hedge relationship)
Hedging instrument
• Specific identification of hedging instrument(s).
• Specified proportion
• Exclusion of time value, forward element or cross currency basis
• Whether part of a rollover strategy (see 7.7 below)
• Whether part of a dynamic strategy (see 6.3.2 below)
Hedged item
• Identification of hedged item(s) with sufficient specificity to determine
whethe
r/when the hedged item has occurred
• Specified proportion or layer
• Specified risk component
• Which contractual cash flows (if not all)
• Timing of and rationale for forecast transactions being highly probable
Risk being hedged
• Hedge type (e.g. fair value, cash flow or net investment hedge)
• Specific identification of hedged risk
• Designation of a one side risk
Approach to effectiveness
• Rationale for existence of an economic relationship
assessment
• Hedge ratio and how determined
• The effects of credit risk and how determined
• Method for assessing the effectiveness qualification criteria
• Sources of hedge ineffectiveness
• Frequency of assessment
Date of designation
• Date of designation
• Approval signature
Financial instruments: Hedge accounting 4059
Hedge effectiveness is the extent to which changes in the fair value or the cash flows of
the hedging instrument offset changes in the fair value or the cash flows of the hedged
item (for example, when the hedged item is a risk component, the relevant change in
fair value or cash flow of an item is the one that is attributable to the hedged risk).
[IFRS 9.B6.4.1]. If there are changes in circumstances that affect the hedge effectiveness,
an entity may have to change the method for assessing whether a hedge relationship
meets the hedge effectiveness requirements, in order to ensure that the relevant
characteristics of the hedging relationship, including the sources of ineffectiveness are
still captured. The hedge documentation shall be updated to reflect any such change.
[IFRS 9.B6.4.2, B6.4.17, B6.4.19].
An entity can designate a new hedging relationship that involves the hedging
instrument or hedged item of a previous hedging relationship, for which hedge
accounting was (in part or in its entirety) discontinued. This does not constitute a
continuation, but is a restart and requires redesignation. [IFRS 9.B6.5.28]. Hedge
accounting will apply prospectively from redesignation, provided all other qualifying
criteria are met. Even where the qualifying criteria are met, a hedge relationship in
which an existing hedging instrument is designated, is likely to result in higher levels
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 803