to hedge its foreign currency risk on the firm commitment. The following options exist
and the entity may choose the most appropriate accounting treatment:
• because the hedge is a purchase of US dollars, it is, arguably, not a fair value
hedge of the acquisition, since the acquisition is itself naturally hedged for
changes in the fair value in the US dollar – that is, the entity is committed to buy
a group of US dollar denominated assets and liabilities for a price denominated
in US dollars. Nevertheless, the entity may still designate the transaction as the
hedged item in a fair value hedge relationship, although this may not make
intuitive sense; [IFRS 9.B6.5.3]
• the entity could instead designate the forward contract as a hedge of the cash flows
associated with the committed purchase, which is a cash flow hedge; [IFRS 9.B6.3.1] or
• if the anticipated business combination in this example is only a highly probable
forecast transaction and not a firm commitment, then the entity can only apply
cash flow hedging.
If the transaction is a fair value hedge, then the carrying amount of the hedged item is
adjusted for the gain or loss attributable to the hedged risk. Since separately identifiable
assets acquired and liabilities assumed must be recognised on initial consolidation at fair
value in the consolidated financial statements of the acquirer, it follows that the gain or
loss attributable to the hedged risk must be included in the consideration paid. In other
words, the impact of the hedge affects the calculation of goodwill that is otherwise
determined by the application of IFRS 3 see Chapter 9 at 6.18
During the hedging period, the effective portion of the gain or loss on a hedging
instrument in a cash flow hedge is recognised in other comprehensive income. Upon
initial recognition of the acquisition, gains or losses recognised in other comprehensive
income are included in the consideration paid for the business combination that is
designated as the hedged item. [IFRS 9.6.5.11(d)(i)].
The adjusted carrying amount of goodwill, including the gain or loss from hedge
accounting, will then be subject to the normal requirements to test for annual
impairment (see Chapter 20 at 5).
Once the purchase price is paid and the transaction is completed, the entity is ‘long’
US dollars as a result of recognising the US dollar net assets of the acquired entity. Those
net assets would then be eligible for net investment hedging which would require selling
US dollars to create an eligible hedging instrument, for example by entering into a
foreign currency forward (see 5.3 and 7.3 above).
Financial instruments: Hedge accounting 4121
7.7
Hedge accounting for a documented rollover hedging strategy
The standard is clear that the replacement or rollover of a hedging instrument into another
hedging instrument is not an expiration or termination of a hedge relationship if such
replacement or rollover is part of the entity’s documented hedging strategy (see 8.3
below). [IFRS 9.6.5.6]. However, there is minimal additional specific guidance provided on
what is meant by, or the accounting for, a documented rollover hedging strategy. We
believe that a rollover hedging strategy refers to a strategy whereby the maturity of the
hedging instrument is intentionally shorter than the maturity of the hedged item, and there
is an expectation that on expiry of the original hedging instrument it will be replaced by a
new hedging instrument. The replacement hedging instrument is likely to have similar
characteristics to the instrument being replaced. Whether the risk management strategy
is to be achieved through a rollover strategy is a matter of fact, and must have been
documented as such at inception of the initial hedge and the usual qualifying conditions
for hedge accounting should be met (see 6 below). An alternative risk management
strategy would be a partial term hedge, i.e. for a specified portion of the life of the hedged
item (see 2.2.4 above), which is not the same as a rollover strategy.
An entity’s risk management strategy is the main source of information to perform an
assessment of whether a hedging relationship meets the effectiveness requirements, for
example whether an economic relationship exists between the hedged item and the
hedging instrument. [IFRS 9.B6.3.18]. Therefore, when making this assessment for a
rollover hedging strategy, it will be necessary to consider whether the risk management
strategy does envisage rolling over the hedging instrument. [IFRS 9.B6.4.6].
The standard is clear that the measurement of hedge ineffectiveness is undertaken is on a
cumulative basis (see 7.1.1 and 7.2.1 above). [IFRS 9.6.5.8, 6.5.11]. ‘Cumulative’ is generally
understood to mean over the life of the hedge relationship. This will include historic gains
and losses from previous periods in which the hedging instruments were rolled over, for as
long as the hedge continues to remain live. The cumulative period is not reset just because
a new rollover hedging instrument is transacted, if it is part of a documented rollover
strategy. This is particularly relevant for a cash flow hedge in the identification of the
hypothetical derivative, as demonstrated in Example 49.76 below (see also 7.4.4.A above).
Example 49.77: Hedge of a foreign exchange risk in rollover cash flow hedging
strategy
Company A has sterling as its functional currency. Company A expects highly probable foreign currency sales
resulting in a forecast cash inflow of €2m in 9 months’ time. Company A chooses to hedge the foreign currency risk
and transacts an FX forward to sell €2m and receive GBP in 3 months’ time. This is with an expectation that as the
initial contract matures another 3 month contract will be transacted and then again a third contract on maturity of the
second contract. As part of the usual hedge documentation Company A has identified this as being a rollover strategy
for foreign currency risk. Company A has determined that the effectiveness criteria are met on initial designation.
The hedge relationship is not discontinued when the second and third FX contracts are transacted. The
effectiveness requirements are assessed throughout the life of the hedge relationship, including consideration
of the expected roll-over of the hedging instruments (see 6.4 above). The amount of ineffectiveness recorded
is determined by a comparison of the change in fair value of the hedging instruments (the aggregate of the
changes in fair value of the 3 month FX contracts) and the change in value of the hedged item (the highly
probable cash flow in 9 months’ time) for changes in foreign currency risk. This cumulative approach means
the calculation would include fair value changes since designation of the hedge relationship, which would
include the realised changes in fair value of the matured 3 month FX forwards.
4122 Chapter 49
If the hypothetical derivative method (see 7.4.4.A above) is adopted to calculate the change in value of the
hedged item, a single hypothetical derivative would be used based on the expected timing of the forecast
transaction (i.e. a 9 month FX contract).
Amortisation of any fair value adjustment made to the hedged item under a fair value
hedge of a documented roll-over strategy need not commence until the
rollover hedge
strategy is discontinued (see 7.1.2 above).
8
SUBSEQUENT ASSESSMENT OF EFFECTIVENESS,
REBALANCING AND DISCONTINUATION
8.1
Assessment of effectiveness
A prospective effectiveness assessment is required on an ongoing basis, in a similar
manner as at the inception of the hedging relationship (see 6 above) and, as a minimum,
at each reporting date in order to continue to apply hedge accounting. [IFRS 9.B6.4.12]. The
flow chart below illustrates the assessment life cycle.
Figure 49.3:
Effectiveness assessment and rebalancing
Effective hedge
Retrospectively measure ineffectiveness
and recognise in P&L
Has the risk management objective for
Yes
designated hedging relationship changed?
No
Is there still an economic relationship
between hedged item and hedging
No
instrument?
Yes
Does the effect of credit risk dominate
value changes that result from the
Yes
economic relationship?
No
Has the hedge ratio been adjusted for
No
risk management purposes or is there an
imbalance in the hedge ratio that would
create ineffectiveness?
Yes
Rebalancing
Discontinuation
Each accounting period an entity first has to assess whether the risk management
objective for the hedging relationship has changed. A change in risk management
Financial instruments: Hedge accounting 4123
objective is a matter of fact that triggers discontinuation. Discontinuation of hedging
relationships is discussed at 8.3 below.
An entity would also have to discontinue hedge accounting if it turns out that there is
no longer an economic relationship (see 6.4.1 above). This makes sense as whether there
is an economic relationship is a matter of fact that cannot be altered by adjusting the
hedge ratio (see 6.4.3 above). The same is true for the impact of credit risk; if credit risk
is now dominating the hedging relationship, then the entity has to discontinue hedge
accounting (see 6.4.2 above). [IFRS 9.6.5.6].
The hedge ratio may need to be adjusted if it turns out that the hedged item and hedging
instrument do not move in relation to each other as expected, or if the ratio has changed for
risk management purposes. This is referred to as ‘rebalancing’ and is discussed at 8.2 below.
It can be seen from the above flow chart that hedge accounting can only continue
prospectively if the risk management objective has not changed, and the effectiveness
requirements continue to be met. Otherwise the hedge relationship must be
discontinued (see 8.3 below).
8.2 Rebalancing
8.2.1 Definition
An entity is required to ‘rebalance’ the hedge ratio to reflect a change in the relationship
between the hedged item and hedging instrument if it expects the new relationship to
continue going forward. Rebalancing refers to the adjustments made to the designated
quantities of the hedged item or hedging instrument of an already existing hedging
relationship for the purpose of maintaining a hedge ratio that complies with the hedge
effectiveness requirements. Changes to the designated quantities of either the hedged
item or hedging instrument for other purpose is not rebalancing within the context of
IFRS 9. [IFRS 9.B6.5.7].
Rebalancing allows entities to refine their hedge ratio without discontinuation and
redesignation, so reducing the need for designation of ‘late hedges’ and the associated
accounting issues that can arise with such a hedge (see 2.4.1 and 7.4.4.B above).
The concept of rebalancing only comprises prospective changes to the hedge ratio (i.e. the
quantity of hedged item compared to the quantity of hedging instrument) in response to
changes in the economic relationship between the hedged item and hedging instrument,
when the risk management otherwise continues as originally designated. [IFRS 9.BC6.303]. For
instance, an entity may have designated a hedging relationship in which the hedging
instrument and the hedged item have different but related underlying reference indices,
rates or prices. If the relationship or correlation between those two underlyings change,
the hedge ratio may need to change to better reflect the revised correlation. [IFRS 9.B6.5.9].
By way of an example; an entity hedges an exposure to Foreign Currency A using a
currency derivative that references Foreign Currency B. Foreign Currency A and B are
pegged (i.e. their exchange rate is maintained within a band or at an exchange rate set by
a central bank or other authority). If the exchange rate between Foreign Currency A and
Foreign Currency B were changed (i.e. a new band or rate was set), rebalancing the
4124 Chapter 49
hedging ratio to reflect the new exchange rate would ensure that the hedging relationship
would continue to meet the hedge effectiveness requirements. [IFRS 9.B6.5.10].
Any other changes made to the quantities of the hedged item or hedging instrument, for
instance, a reduction in the quantity of the hedged item because some cash flows are no
longer highly probable, would not be rebalancing. Such other changes to the designated
quantities would need to be treated as a partial discontinuation if the entity reduces the
extent to which it hedges, and a new designation of a hedging relationship if the entity
increases it. [IFRS 9.B6.5.7].
Changes that risk managers may make to improve hedge effectiveness but that do not
alter the quantities of the hedged item or the hedging instrument are not rebalancing
either. An example of such a change is the transaction of derivatives related to a risk
that was not considered in the original hedge relationship.
Therefore, rebalancing is only relevant if there is basis risk between the hedged item
and the hedging instrument. Basis risk, in the context of hedge accounting, refers to any
difference in price sensitivity of the underlyings of the hedging instrument and the
hedged item. The existence of basis risk in a hedge relationship usually results in a
degree of hedge ineffectiveness. For example, hedging a cotton purchase in India with
NYMEX cotton futures contracts is likely to result in some ineffectiveness, as the
hedged item and the hedging instrument do not share exactly the same underlying price.
Rebalancing only affects the expected relative sensitivity between the hedged item and
the hedging instrument going forward, as ineffectiveness from past changes in the
sensitivity will have already been recognised in profit or loss.
The following example provides some indications as to how to distinguish rebalancing
from other changes to a hedge relationship:
Example 49.78: Rebalancing
Fact pattern 1
An entity is exposed to price changes in commodity A which is not widely traded as a derivative. The entity has
proven that there is an economic relationship between commodity A and B and commodity B is widely traded
as a derivative. In that case, the entity may use commodity B derivatives to hedge the price risk in commodity
A. An initial hedge ratio of 1:1.1 is ba
sed on the expected relationship between the prices of commodity A and
commodity B. The relationship subsequently changes such that a ratio of 1:1.15 is expected to be more effective.
The entity can account for the changes in the hedging relationship as rebalancing because the difference
between the prices is caused by basis risk.
Fact pattern 2
An entity swaps a base rate floating rate loan into a fixed interest rate using a pay LIBOR receive fixed swap.
At inception, the entity is able to prove that there is an economic relationship between the base rate and
LIBOR and designates the swap and the loan in a cash flow hedge, although it expects some level of
ineffectiveness. Similar to fact pattern 1, the entity may use rebalancing to account for changes in the basis
spread between the base rate and LIBOR.
However, the entity subsequently transacts a LIBOR versus base rate swap in order to eliminate the basis risk.
The accounting consequences would depend on the reason for doing so and here we consider two scenarios:
a) The entity can no longer prove that there is an economic relationship between the base rate and LIBOR
(although this is unlikely in practice).
b) The entity can still prove that there is an economic relationship between the base rate and LIBOR, but
no longer wishes to suffer the resultant ineffectiveness arising from the basis risk.
Financial instruments: Hedge accounting 4125
In scenario a), the hedging relationship no longer meets the eligibility criteria and needs to be discontinued, as
there is no longer an economic relationship between the hedged item and the hedging instrument. The entity
cannot use rebalancing to avoid discontinuation because the hedge no longer meets the qualifying criteria.
In scenario b), the entity tries to avoid ineffectiveness by contracting another hedging instrument. Arguably,
the entity could continue with the original designation and account for the LIBOR versus base rate swap as a
derivative measured at fair value through profit or loss. However, given that the entity seeks to avoid
ineffectiveness, it might want to apply hedge accounting to the base rate swap as well. If the entity wants to
include the LIBOR versus base rate swap in the original hedging relationship, it would represent a change in
the documented risk management objective which requires discontinuation of the existing and re-designation
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 817