International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
Page 812
Original forward periods
1 2 3 4 5
Remaining periods
1 2 3 4
€
€
€
€
€
Cash flows:
Fixed interest at 6.86% 1,716
1,716
1,716
1,716
Principal
100,000
Fair value:
New discount rate (spot)
5.75%
6.50%
7.50% 8.00%
Interest 6,562
1,692
1,662
1,623
1,585
Principal 92,385
*92,385
Total 98,947
Fair value at inception
100,000
Difference (1,053)
* €100,000 ÷ (1 + [0.08 ÷ 4])4
Under Method A, a computation is made of the fair value in the new interest rate environment of debt that carries
interest that is equal to the coupon interest rate that existed at the inception of the hedging relationship (6.86%).
This fair value is compared with the expected fair value as of the beginning of Period 2 that was calculated on
the basis of the term structure of interest rates that existed at the inception of the hedging relationship, as
illustrated above, to determine the change in the fair value. Note that the difference between the change in the
fair value of the swap and the change in the expected fair value of the debt (€1,053) exactly offset in this example,
since the terms of the swap and the forecast transaction match each other.
Method B – Compute change in fair value of cash flows
Total
Original forward periods
1
2
3
4
5
Remaining periods
1
2
3
4
Market rate at inception
6.86%
6.86%
6.86%
6.86%
Current forward rate
5.75%
7.25%
9.51%
9.50%
Rate difference
1.11%
(0.39%)
(2.64%)
(2.64%)
Cash flow difference (principal × rate)
€279
(€97)
(€661) (€660)
Discount rate (spot)
5.75%
6.50%
7.50% 8.00%
Fair value of difference
(€1,053)
€275
(€93)
(€625) (€610)
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Under Method B, the present value of the change in cash flows is computed on the basis of the difference
between the forward interest rates for the applicable periods at the effectiveness measurement date and the
interest rate that would have been obtained if the debt had been issued at the market rate that existed at the
inception of the hedge. The market rate that existed at the inception of the hedge is the one-year forward
coupon rate in three months. The present value of the change in cash flows is computed on the basis of the
current spot rates that exist at the effectiveness measurement date for the applicable periods in which the cash
flows are expected to occur. This method also could be referred to as the ‘theoretical swap’ method (or
‘hypothetical derivative’ method) because the comparison is between the hedged fixed rate on the debt and
the current variable rate, which is the same as comparing cash flows on the fixed and variable rate legs of an
interest rate swap.
As before, the difference between the change in the fair value of the swap and the change in the present value
of the cash flows exactly offset in this example.
Other considerations
There is an additional computation that should be performed to compute ineffectiveness before the expected
date of the forecast transaction that has not been considered for the purpose of this illustration. The fair value
difference has been determined in each of the illustrations as of the expected date of the forecast transaction
immediately before the forecast transaction, i.e. at the beginning of Period 2. If the assessment of hedge
effectiveness is performed before the forecast transaction occurs, the difference should be discounted to the
current date to arrive at the actual amount of ineffectiveness. For example, if the measurement date were one
month after the hedging relationship was established and the forecast transaction is now expected to occur in
two months, the amount would have to be discounted for the remaining two months before the forecast
transaction is expected to occur to arrive at the actual fair value. This step would not be necessary in the
examples provided above because there was no ineffectiveness. Therefore, additional discounting of the
amounts, which net to zero, would not have changed the result.
Under Method B, ineffectiveness is computed on the basis of the difference between the forward coupon
interest rates for the applicable periods at the effectiveness measurement date and the interest rate that
would have been obtained if the debt had been issued at the market rate that existed at the inception of
the hedge. Computing the change in cash flows based on the difference between the forward interest rates
that existed at the inception of the hedge and the forward rates that exist at the effectiveness measurement
date is inappropriate if the objective of the hedge is to establish a single fixed rate for a series of forecast
interest payments. This objective is met by hedging the exposures with an interest rate swap as illustrated
in the above example. The fixed interest rate on the swap is a blended interest rate composed of the
forward rates over the life of the swap. Unless the yield curve is flat, the comparison between the forward
interest rate exposures over the life of the swap and the fixed rate on the swap will produce different cash
flows whose fair values are equal only at the inception of the hedging relationship. This difference is
shown in the table below.
Total
Original forward periods
1
2
3
4
5
Remaining periods
1
2
3
4
Forward rate at inception
5.25%
7.51%
7.50%
7.25%
Current forward rate
5.75%
7.25%
9.51%
9.50%
Rate difference
(0.50%)
0.26%
(2.00%)
(2.25%)
Cash flow difference
(principal × rate)
(€125)
€64
(€501) (€563)
Discount rate (spot)
5.75%
6.50%
7.50% 8.00%
Fair value of difference
€1,055
(€123)
€62
(€474) (€520)
Fair value of interest rate swap
€1,053
Ineffectiveness (€2)
If the objective of the hedge is to obtain the forward rates that existed at the inception of the hedge, the interest
rate swap is ineffective because the swap has a single blended fixed coupon rate that does not offset a series
Financial instruments: Hedge accounti
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of different forward interest rates. However, if the objective of the hedge is to obtain the forward coupon rate
that existed at the inception of the hedge, the swap is effective, and the comparison based on differences in
forward interest rates suggests ineffectiveness when none may exist. Computing ineffectiveness based on the
difference between the forward interest rates that existed at the inception of the hedge and the forward rates
that exist at the effectiveness measurement date would be an appropriate measurement of ineffectiveness if
the hedging objective is to lock in those forward interest rates. In that case, the appropriate hedging instrument
would be a series of forward contracts each of which matures on a repricing date that corresponds with the
date of the forecast transactions.
It also should be noted that it would be inappropriate to compare only the variable cash flows on the interest
rate swap with the interest cash flows in the debt that would be generated by the forward interest rates. That
methodology has the effect of measuring ineffectiveness only on a portion of the derivative, and IAS 39 does
not permit the bifurcation of a derivative for the purposes of assessing effectiveness in this situation16 – see 3.6
above. It is recognised, however, that if the fixed interest rate on the interest rate swap is equal to the fixed
rate that would have been obtained on the debt at inception, there will be no ineffectiveness assuming that
there are no differences in terms and no change in credit risk or it is not designated in the hedging relationship.
[IAS 39.F.5.5].
7.4.5
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 7.4.3 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.
Example 49.69: Cash flow hedge of firm commitment to purchase inventory in a
foreign currency
Company A has the Local Currency (LC) as its functional and presentation currency. A’s accounting policy
is to apply basis adjustments to non-financial assets that result from hedged forecast transactions and it
chooses to treat hedges of the foreign currency risk of a firm commitment as cash flow hedges.
On 30 June 2019, A enters into a forward exchange contract to receive Foreign Currency (FC) 100,000 and
deliver LC109,600 on 30 June 2020 at an initial cost and fair value of zero. On inception, it designates the
forward exchange contract as a hedging instrument in a cash flow hedge of a firm commitment to purchase a
certain quantity of paper for FC100,000 on 31 March 2020 and, thereafter, as a fair value hedge of the
resulting payable of FC100,000, which is to be paid on 30 June 2020. It is assumed that all hedge accounting
conditions in IFRS 9 are met.
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The relevant foreign exchange rates and associated fair values for the forward exchange contract are provided
in the following table:
Forward rate to
Fair value of
Date Spot
rate
30 June 2020
forward contract
30 June 2019
1.072
1.096
–
31 December 2019
1.080
1.092
(388)
31 March 2020
1.074
1.076
(1,971)
30 June 2020
1.072
–
(2,400)
The applicable yield curve in the local currency is flat at 6% per annum throughout the period. The fair value
of the forward exchange contract is negative LC388 on 31 December 2019 ({[1.092 × 100,000] – 109,600}
÷ 1.06(6/12)), negative LC1,971 on 31 March 20120 ({[1.076 × 100,000] – 109,600} ÷ 1.06(3/12)), and negative
LC2,400 on 30 June 2020 (1.072 × 100,000 – 109,600).
Case 1: Changes in the fair value of the forward contract are designated in the hedge
Ignoring ineffectiveness that may arise from other elements that have an impact on the fair value of the
hedging instrument, the hedge is expected to be fully effective because the critical terms of the forward
exchange contract and the purchase contract are otherwise the same. The assessments of hedge effectiveness
are based on the forward price.
The accounting entries are as follows.
30 June 2019
LC
LC
Forward
–
Cash
–
To record the forward exchange contract at its initial fair value, i.e. zero.
31 December 2019
LC
LC
Other comprehensive income
388
Forward – liability
388
To recognise the change in the fair value of the forward contract between 30 June 2019 and 31 December
2019, i.e. 388 – 0 = LC388, in other comprehensive income. The hedge is fully effective because the loss
on the forward exchange contract, LC388, exactly offsets the change in cash flows associated with the
purchase contract based on the forward price {([1.092 × 100,000] – 109,600) ÷ 1.06(6/12)} – {([1.096 ×
100,000] – 109,600) ÷ 1.06} = –LC388. The negative figure denotes a reduction in the net present value
of cash outflows and, therefore, effectively represents a ‘gain’ to offset the loss on the forward in other
comprehensive income.
31 March 2020
LC
LC
Other comprehensive income
1,583
Forward – liability
1,583
To recognise the change in the fair value of the forward contract between 1 January 2020 and 31 March
2020, i.e. 1,971 – 388 = LC1,583, in other comprehensive income. The hedge is fully effective because
the loss on the forward exchange contract, LC1,583, exactly offsets the change in cash flows associated
with the purchase contract based on the forward price {([1.076 × 100,000] – 109,600) ÷ 1.06(3/12)} –
{([1.092 × 100,000] – 109,600) ÷ 1.06(6/12)} = –LC1,583. The negative figur
e denotes a reduction in the
net present value of cash outflows and, therefore, effectively represents a ‘gain’ to offset the loss on the
forward in other comprehensive income.
Financial instruments: Hedge accounting 4101
LC
LC
Paper (purchase price)
107,400
Paper (hedging loss)
1,971
Other comprehensive income
1,971
Payable 107,400
To record the purchase of the paper at the spot rate (1.074 × 100,000 = LC 107,400) and remove the cumulative
loss on the forward recognised in other comprehensive income from equity, LC1,971, and include it in the initial
measurement of the purchased paper. Accordingly, the initial measurement of the purchased paper is LC 109,371
consisting of a purchase consideration of LC 107,400 and a hedging loss of LC 1,971. The payable is recorded as
a foreign currency monetary item of FC100,000, equivalent to LC107,400 (100,000 × 1.074) on initial recognition.
30 June 2020
LC
LC
Payable 107,400
Cash 107,200
Profit or loss
200
To record the settlement of the payable at the spot rate (100,000 × 1.072 = LC107,200) and recognise the associated
exchange gain of LC200 = 107,400 – 107,200 in profit or loss.
LC
LC
Profit or loss
429
Forward – liability
429
To recognise the loss on the forward exchange contract between 1 April 2020 and 30 June 2020, i.e. 2,400 –
1,971 = LC429) in profit or loss. The hedge is considered to be fully effective because the loss on the forward
exchange contract, LC429, exactly offsets the change in the fair value of the payable based on the forward
price [1.072 × 100,000] – 109,600 – {([1.076 × 100,000] – 109,600) ÷ 1.06(3/12)} = –LC429. The negative