potential impact of credit risk on the global derivatives markets. In response to this,
several jurisdictions have introduced, legal or regulatory requirements that require or
incentivise over-the-counter (OTC) derivatives to be novated to a central clearing party
(CCP). The CCP would usually require the derivatives to be collateralised, thereby
reducing (potentially significantly) the counterparty credit risk.
Financial instruments: Hedge accounting 4135
Following an urgent request, the IFRS Interpretation Committee concluded in
January 2013 that an entity is required to discontinue hedge accounting where an
OTC derivative that is designated as hedging instrument in a hedging relationship is
novated to a CCP (unless, very unusually, the novation represented a replacement
or rollover of the hedging instrument as part of a documented hedging strategy). This
is because the novated derivative is derecognised and the new derivative contract,
with the CCP as a counterparty, is recognised at the time of the novation. However,
if the new derivative was designated in a cash flow hedge relationship accounting
ineffectiveness would likely arise if the derivative is off market (see 7.4.4.B above).
Consequently, the Interpretations Committee decided to recommend that the IASB
make a narrow-scope amendment to IAS 39 to permit continuation of hedge
accounting in such narrow circumstances.19 In July 2013 the IASB amended IAS 39
after the publication of an exposure draft in February 2013 and the changes were
also incorporated in IFRS 9 when the hedge accounting chapter was added
in Novemeber 2013.
The relevant guidance in IFRS 9 states that an expiration or termination of the hedging
instrument does not require discontinuation of the hedge relationship if:
• as a consequence of changes in laws or regulations, the original counterparty to the
hedging instrument is replaced by a clearing counterparty (sometimes called a
‘clearing organisation’ or ‘clearing agency’) or a clearing member of a clearing
organisation or a client of a clearing member of a clearing organisation, that are
acting as counterparty in order to effect clearing by a central counterparty, and
• each of the original counterparties to the hedging instrument effects clearing with
the same central counterparty; and
• other changes, if any, to the hedging instrument are limited to those that are
necessary to effect such a replacement of the counterparty. Such changes are
limited to those that are consistent with the terms that would be expected if the
hedging instrument were originally cleared with the clearing counterparty. These
changes include changes in the collateral requirements, rights to offset receivables
and payables balances, and charges levied. [IFRS 9.6.5.6].
It can be seen from the guidance e that the exception applies to some, but not all,
voluntary novations to a CCP. In order for hedge accounting to continue, a voluntary
novation should at least be associated with laws or regulations that are relevant to
central clearing of derivatives. For example, a voluntary novation could be in
anticipation of regulatory changes. However, the mere possibility of laws or regulations
being introduced is not, in the view of the IASB, a sufficient basis for continuation of
hedge accounting. [IAS 39.BC220O-BC220Q].
Further, the exception applies to so-called ‘indirect clearing’ arrangements whereby a
clearing member of a CCP provides an indirect clearing service to its client or where a
group entity is clearing on behalf of another entity within the same group since they are
consistent with the objective of the amendments. [IAS 39.BC220R, BC220S].
4136 Chapter 49
The other criteria for achieving hedge accounting will still need to be met in order to
continue hedge accounting (see at 6 above).
8.3.2.B
The impact of the introduction of settle to market derivatives on cash
flow hedges
In December 2015, the London Clearing House (LCH) changed its rule book to
introduce a new type of settled-to-market (STM) interest rate swap in addition to the
previously existing collateralized-to-market (CTM) swaps.
In the existing CTM model, transactions cleared through LCH are subject to daily
cash variation margining. This means that the replacement value of the trade is in
effect paid or received as cash each day and there is no ability to recover any of
the variation margin unless the fair value of the interest rate swap changes. In
addition, the variation margin is also used to settle the periodic swaps payments,
and, in case of early settlement, the variation margin is used to settle the
outstanding derivative position. Interest is paid on the variation margin based on a
risk free overnight rate.
In the new STM model, transactions have the same economic exposure and overall
cash flows as in the CTM model, except that the previous daily variation margin is
now treated as a settlement of the interest rate swap’s outstanding fair value. While
the swap is gradually settled, it remains the same swap with the same original terms
(e.g. the fixed rate, maturity date etc.). In order to maintain the same economics, a new
feature of the STM swap pricing is the Price Alignment Interest (PAI) that essentially
replicates what would have been the interest on the collateral for a CTM swap into
the STM swap pricing.
The introduction of the new STM swaps was primarily driven by the potentially
different regulatory treatment they attract and at first sight it may appear that the
accounting impact is limited since the existing CTM swap replacement values and
related cash collateral are already normally offset in the statement of financial position.
There are however some important accounting considerations if swaps designated in
on-going hedging relationships are migrated from the CTM model to the STM model.
The first question that arises is whether the change results in the de-designation of the
existing hedge relationship and hence the need to re-designate a new hedging
relationship with a derivative that is now likely to have a non-zero fair value (and so
give rise to ineffectiveness if designated in a cash flow hedge). We consider that the
amendment of each swap from being CTM to STM is not a substantial modification and
so does not result in derecognition of one swap and the recognition of another.
Accordingly, we believe that there is no requirement to de-designate the existing
hedging relationship. The second question that arises is how the PAI should be
considered in the hedge effectiveness measurement and whether any hypothetical
derivative can be assumed to reflect these new terms (see 7.4.4.A above). No consistent
interpretation of the accounting requirements has yet emerged with respect to the
measurement of ineffectiveness from the PAI. This is an area where we expect practice
to continue to evolve.
Financial instruments: Hedge accounting 4137
8.3.2.C
The replacement of IBOR benchmark interest rates
Due to various regulatory changes and political events such as the probable end of IBOR
benchmark interest rates, the departure of the UK from the European Union (‘Brexit’) and
; the ‘ring fencing’ of certain activities of banks, how these might all affect cash flow hedge
accounting has been the subject of discussion. Entities could find that the counterparty to
some of their existing hedging derivatives may change to a different legal entity within an
existing banking group, as banks make their preparations for Brexit or compliance with
ring fencing regulations. In these circumstances, the entity will need to conclude whether
such a change in counterparty would require discontinuation of the existing hedge
relationship and its replacement with a new one.
As a result of the reforms mandated by the Financial Stability Board following the Financial
Crisis, regulators are pushing for IBOR to be replaced by new ‘official’ benchmark rates,
known as Risk Free Rates (RFRs). For instance, in the UK, the new official benchmark will
be the reformed Sterling Overnight Interest Average (SONIA) and banks will no longer be
required to quote LIBOR beyond the end of 2021. Such a change will necessarily affect
future cash flows in both contractual floating rate financial instruments currently
referenced to IBOR, and highly probably forecast transactions for which IBOR is
designated as the hedged risk. This raises a number of accounting questions, many of which
relate to hedge accounting. A key question is whether such future IBOR cash flows remain
highly probable if it is know that IBOR will not exist in its current form beyond the end of
2021 (or the equivalent date for other jurisdictions) (see 2.6.1 above).
On 20 June 2018, the IASB, noting the urgency, decided to add a research project to its
active research programme.20 However, this is unlikely to result in any amendments to
the standards, if any are made, for the best part of a year.
We believe that, as at the date of writing, it is possible to consider that IBOR is still a
component of variable interest rates in the context of the market structure and that IBOR
and RFR interest rates are equivalent for the purposes of cash flow hedge accounting.
8.3.3
Disposal of a hedged net investment
When a foreign operation that was hedged is disposed of, the amount reclassified from
the foreign currency translation reserve to profit or loss is as follows:
• in respect of the hedging instrument in the consolidated financial statements, the
cumulative gain or loss on the hedging instrument that was determined to be an
effective hedge (see 7.3.1 above). [IFRIC 16.16].
• in respect of the net investment, the cumulative amount of exchange differences
relating to that foreign operation. [IAS 21.48, IFRIC 16.17].
If an intermediate parent exists within the ultimate consolidation group, there is a choice
of applying either the direct or step-by-step method of consolidation (see Chapter 15
at 6.1.5 and at 6.6). If the step by step method of consolidation is used, the cumulative
amount of exchange differences relating to that foreign operation accumulated in the
foreign currency transaction reserve could be different to the equivalent amount had the
direct method of consolidation been applied. This potential difference in the accounting
outcome on disposal of a foreign operation is illustrated in Example 49.84 below.
4138 Chapter 49
This difference in accounting treatment could be eliminated, but there is no
requirement to do so. An accounting policy choice must be taken as to whether the
difference is eliminated or not, and such a choice must be applied consistently on
disposal of all net investments. [IFRIC 16.17].
Example 49.84: Disposal of foreign operation
Based on the same facts as in Examples 49.46 and 49.47 at 5.3.1 and 5.3.2 above, the group has designated
US$300 million of the US dollar borrowings of A as a hedge of the net investment in C with the risk being
the spot foreign exchange exposure (€/US$) between P and C. If C were disposed of, the amounts reclassified
to profit or loss in P’s consolidated financial statements from its foreign currency translation reserve would
be: [IFRIC 16.17, AG8]
• in respect of A’s borrowing (the hedging instrument), the total change in value in respect of foreign
exchange risk that was recognised in other comprehensive income as the effective portion of the hedge
(i.e. the retranslation effect on the US$300 million borrowing with respect to the EUR/USD foreign
exchange rate since initial designation); and
• in respect of the net investment in C, the amount determined by the entity’s consolidation method:
• If P uses the direct method, its foreign currency translation reserve (‘FCTR’) in respect of C will
be determined directly by the EUR/USD foreign exchange rate.
• If P uses the step-by-step method, its FCTR in respect of C will be determined by the FCTR
recognised by B reflecting the GBP/USD foreign exchange rate, translated to P’s functional
currency using the EUR/GBP foreign exchange rate.
P’s use of the step-by-step method for consolidation in prior periods does not require it to or preclude it
from determining the amount of FCTR to be reclassified when it disposes of C to be the amount that it
would have recognised if it had always used the direct method. However, it is an accounting policy
choice which should be followed consistently on disposal of all net investments.
9 PRESENTATION
For a comprehensive overview of the financial instruments related presentation
requirements of IFRS 7 – Financial Instruments: Disclosures – see Chapter 50. We
present below only some of the key requirements for hedge accounting.
IFRS 9 includes plenty of guidance as to when gains and losses from hedge accounting
should be recognised in the profit or loss. The standard is much more imprecise as to
where in the profit or loss such gains and losses should be presented. However it can be
inferred that gains and losses from hedging instruments in hedging relationships would
be presented in the same line item that is affected by the hedged item (at least to the
extent the hedge is effective) rather than being shown separately, although this is not
explicitly stated in IFRS 9 (see Chapter 50 at 7.1.3).
The IFRS Interpretations Committee clarified in March 2018 that only interest on
financial assets measured at amortised cost or on debt instruments measured at fair
value through other comprehensive income should be included in the amount of
interest revenue presented separately for items calculated using the effective interest
method (see Chapter 50 at 7.1.1). [IAS 1.82(a)]. At this meeting it was also concluded that
the separate interest revenue line would encompass any effect of a qualifying hedging
relationship applying the hedge accounting requirements. 21
Financial instruments: Hedge accounting 4139
9.1 Cash
flow
hedges
IFRS 9 requires that those amounts accumulated in the cash flow hedging reserve shall
be reclassified from the cash flow hedge reserve as a reclassification adjustment in the
same period or periods during which the hedged future cash flows affect profit or loss.
The guidance provides as an example of the period over such a reclassification should
occur as the ‘periods that interest income or interest expense is recognised’ (see 7.2.2
above). [IFRS 9.6.5.11(d)(ii)]. This clarifies
that entities cannot simply account for the net
interest payment on an interest rate swap straight into profit or loss but would have to
present this as a reclassification adjustment between OCI and profit or loss. There is a
requirement to disclose reclassification adjustments in the statement of comprehensive
income (see Chapter 50 at 7.2). [IAS 1.92].
If the hedged transaction subsequently results in the recognition of a non-financial item,
the amount accumulated in equity is removed from the separate component of equity
and included in the initial cost or other carrying amount of the hedged asset or liability.
This accounting entry, sometimes referred to as ‘basis adjustment’, does not affect OCI
of the period.
A similar approach would equally apply to situations where the hedged forecast
transaction of a non-financial asset or non-financial liability subsequently becomes a
firm commitment for which fair value hedge accounting is applied.
For any other cash flow hedges, the amount accumulated in equity is reclassified to profit
or loss as a reclassification adjustment in the same period or periods during which the
hedged cash flows affect profit or loss. This accounting entry does affect OCI of the period
and should be disclosed as a reclassification adjustment in OCI. [IFRS 9.6.5.11(d), IAS 1.92].
9.2
Fair value hedges
Entities recognise the gain or loss on the hedging instrument in profit or loss and adjust
the carrying amount of the hedged item for the hedging gain or loss with the adjustment
being recognised in profit or loss (see 7.1.1 above).
For hedged items that are debt instruments measured at fair value through OCI in
accordance with paragraph 4.1.2A of IFRS 9 (see Chapter 46 at 2.3), the gain or loss on
the hedged item results in recognition of that amount in profit or loss rather than
accumulating in OCI. This means fair value hedge accounting changes the presentation
of gains or loss on the hedged item, but the measurement of the debt instrument at fair
value remains unaffected. [IFRS 9.6.5.8(b)].
For hedged items that are equity instruments for which an entity has elected to present
fair value changes in OCI without subsequent reclassification to profit or loss, the
accounting for a fair value hedge is different because it does not affect profit or loss but,
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 820