Clear IFRS 9 Fair value hedge accounting

Clear IFRS 9 Fair value hedge accounting – The fair value hedge is one of three hedges defined in IFRS 9, the others are the cash flow hedge and the hedge of a net investment.

Hedge accounting can bring a number of advantages over traditional accounting methods. The core benefit is that by addressing the timings mismatch associated with standard derivative accounting, hedge accounting removes temporary volatility from the P&L. As a result, the financial statements will better reflect the company’s true economic performance.

Reducing the volatility in earnings results in a number of additional benefits:

• Enterprise value. Earnings volatility is negatively perceived by investors.
• Creditworthiness. Predictability in future earnings is a positive factor in creditworthiness.
• Risk management. Statements reflect better and more accurately how FX-risk is managed.
• Executive compensation. Compensation tied to performance, for example measured based on quarterly earnings, can incur unintended impacts from earnings volatility.

But it can also go very wrong, see this article from Reuters: Dutch housing coop Vestia seeks damages from Deutsche Bank for derivatives.

The three types of hedging relationships in IFRS 9 Financial instruments – Hedge accounting are as follows:

1. fair value hedge : a hedge of the exposure to changes in fair value of a recognised asset or liability or an off-balance firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss. Clear IFRS 9 Fair value hedge accounting
2. cash flow hedge : a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction, and could affect profit or loss.
3. hedge of a net investment in a foreign operation as defined in IAS 21 The effects of changes in Foreign Exchange Rates.

Fair value hedge

The risk being hedged in a fair value hedge is a change in the fair value of an asset or liability or an unrecognised firm commitment that is attributable to a particular risk and could affect P&L. Changes in fair value might arise through changes in interest rates (for fixed-rate loans), foreign exchange rates, equity prices or commodity prices.

The carrying value of the hedged item is adjusted for fair value changes attributable to the risk being hedged, and those fair value changes are recognised in P&L. The hedging instrument is measured at fair value, with changes in fair value also recognised in P&L.

The exception  Clear IFRS 9 Fair value hedge accounting
For fair value hedges of an equity instrument accounted for at fair value through other comprehensive income (FVOCI) (here is the link) – under IFRS 9, gains/losses of equity instruments are never recycled to P&L – changes in the fair value of the hedging instrument are also recorded in OCI without recycling to P&L.

Hedging with purchased options

IFRS 9 changed the accounting requirements on using purchased options as hedging instruments. It views a purchased option as similar to purchasing insurance cover with the time value being the associated cost. If an entity elects to designate only the intrinsic value of the option as the hedging instrument, it must account for the changes in the time value in OCI.

This amount will be removed from OCI and recognised in P&L, either over the period of the hedge if the hedge is time related (for example, six-month fair value hedge of inventory), or when the hedged transaction affects P&L if the hedge is transaction related (for example, a forecast sale). This should result in less volatility in P&L for these option-based hedges, and it removes an obstacle to sensible risk management practice. Clear IFRS 9 Fair value hedge accounting

An entity needs to take into consideration that, once it designates the intrinsic value of the option, the accounting introduced by IFRS 9 is not optional, but mandatory. In addition, the aforementioned accounting for the initial time value of purchased options applies only to the extent that the time value relates to the hedged item. This is called the ‘aligned time value’.

Where the hedging instrument and hedged item are not fully aligned, entities need to determine the aligned time value – that is, how much of the time value included in the premium paid (actual time value) relates to the hedged item – and apply this accounting treatment to that portion. This can be determined using the valuation of the option that would have critical terms that perfectly match the hedged item. The residual amount is recognised in P&L.

Hedging layers of a group

IFRS 9 allows a layer of a group to be designated as the hedged item. A layer component can be specified from a defined, but open, population or from a defined nominal amount. Examples include: Clear IFRS 9 Fair value hedge accounting Clear IFRS 9 Fair value hedge accounting

• A part of a monetary transaction volume (such as the next CU10 cash flows from sales denominated in a foreign currency after the first CU20 in March 201X);
• A part of a physical or other transaction volume (such as the first 100 barrels of the oil purchases in June 201X, or the first 100 MWh of electricity sales in June 201X); or
• A layer of the nominal amount of the hedged item (such as the last CU80 million of a CU100 million firm commitment, or the bottom layer of CU20 million of a CU100 million fixed rate bond, where the defined nominal amount is CU100 million). Clear IFRS 9 Fair value hedge accounting

If a layer component is designated in a fair value hedge, an entity must specify it from a defined nominal amount. To comply with the requirements for qualifying fair value hedges, an entity must remeasure the hedged item for fair value changes attributable to the hedged risk. The fair value adjustment must be recognised in P&L no later than when the item is derecognised. Therefore, it is necessary to track the item to which the fair value hedge adjustment relates. Clear IFRS 9 Fair value hedge accounting

Entities are required to track the nominal amount from which the layer is defined in order to track the designated layer (for example, the total defined amount of CU100 million sales must be tracked in order to track the bottom layer of CU20 million sales or the top layer of CU30 million sales). Clear IFRS 9 Fair value hedge accounting

A layer of a contract that includes a prepayment option (if the fair value of the prepayment option is affected by changes in the hedged risk) is only eligible as a hedged item in a fair value hedge if the layer includes the effect of the prepayment option when determining the change in fair value of the hedged item. In this situation, if an entity hedges with a hedging instrument that does not have option features that mirror the layer’s prepayment option, hedge ineffectiveness would arise. Clear IFRS 9 Fair value hedge accounting

Hedged item in a fair value hedge

When hedge accounting is discontinued, or at any earlier date, the carrying amount of the instrument and the total payments to be made over the remaining term of the instrument are used to calculate a revised effective interest rate for the instrument. [IFRS 9 3.2.18] Clear IFRS 9 Fair value hedge accounting

Firm commitment hedge

For a hedge of a firm commitment, fair value hedge accounting results in the change in fair value of the firm commitment attributable to the hedged risk during the period of the hedging relationship being recognised as an asset or a liability in the statement of financial position. Clear IFRS 9 Fair value hedge accounting

When the hedged transaction is recognised, the amount previously recognised in the statement of financial position adjusts the initial measurement of the underlying transaction (basis adjustment). [IFRS 9 6.5.8(b), IFRS 6.5.9, IAS 39 93–94]] Clear IFRS 9 Fair value hedge accounting

For forecast transaction of a non-financial asset or a non-financial liability under a cash flow hedge that becomes a firm commitment for which fair value hedge accounting is subsequently applied, the entity shall remove that amount from the cash flow hedge reserve and include it directly in the initial cost or other carrying amount of the asset or the liability.

This is not a reclassification adjustment (see IAS 1) and hence it does not affect other comprehensive income. [IFRS 9 6.5.11(d)(i)]

Fair value hedge accounting

As long as a fair value hedge meets the qualifying criteria, the hedging relationship shall be accounted for as follows: Clear IFRS 9 Fair value hedge accounting

1. the gain or loss on the hedging instrument shall be recognised in profit or loss (or elects other comprehensive income, if the hedging instrument hedges an equity instrument).
2. the hedging gain or loss on the hedged item shall adjust the carrying amount of the hedged item (if applicable) and be recognised in profit or loss but
   1. If the hedged item is a financial asset (or a component thereof), measured at FVOCI, the hedging gain or loss on the hedged item shall be recognised in profit or loss,
   2. if the hedged item is an equity instrument elected to present changes in FVOCI, those amounts shall remain in OCI,
   3. when a hedged item is an unrecognised firm commitment (or a component thereof), the cumulative change in the fair value of the hedged item subsequent to its designation is recognised as an asset or a liability with a corresponding gain or loss recognised in profit or loss. Clear IFRS 9 Fair value hedge accounting

Example – Risk management strategy

Strategy – Deliberate under-hedging in a fair value hedge to create fair value accounting Clear IFRS 9 Fair value hedge accounting

An entity acquires a CU50m portfolio of debt instruments. The debt instruments fail the ‘Solely Payment of Principal and Interest Test’ in IFRS 9 4.1.2(b) and 4.1.3 (i.e., the contractual cash flows do not solely represent payments of principal and interest on the principal amount outstanding) and are therefore accounted for at fair value through profit or loss.

The treasurer dislikes the profit or loss volatility resulting from the fair value accounting. He realises that one of the entity’s fixed rate bank borrowings has a similar term structure and that fair value changes on the liability would more or less offset the fair value changes on the asset portfolio. However, at the time of entering into the bank borrowing, the entity did not apply the fair value option to this liability. Clear IFRS 9 Fair value hedge accounting

The treasurer enters into a CU1m receive fixed/pay variable interest rate risk (IRS) and designates the IRS in a fair value hedge of CU50m of fixed rate liability (thereby setting the hedge ratio at 0.02:1). As a result, the entire CU50m of liability would be adjusted for changes in the hedged interest rate risk.

In this scenario, the hedge ratio is unbalanced as the real purpose of the hedging relationship is to achieve fair value accounting (related to changes in interest rate risk) for CU49m of the liability.

The hedge ratio used for hedge accounting purposes would have to be different (likely close to 1:1). Clear IFRS 9 Fair value hedge accounting

The above example is of course an extreme scenario and instances of unbalanced hedge designations are likely to be rare; IFRS 9 does not require an entity to designate a ‘perfect hedge’. For instance, if the hedging instrument is only available in multiples of 25 metric tonnes as the standard contract size, an imbalance due to using, say, 400 metric tonnes nominal value of hedging instrument to hedge 409 metric tonnes of forecast purchases, would not be regarded as resulting in an outcome ‘that would be inconsistent with the purpose of hedge accounting’ and so would meet the qualifying criteria. Clear IFRS 9 Fair value hedge accounting

Example – Fair value hedge journal entries

A company purchases a debt instrument that has a principal amount of £1 million at a fixed interest rate of 6% per year. The instrument is classified at amortized cost. The fair value of the instrument is £1 million. Clear IFRS 9 Fair value hedge accounting

The company is exposed to a risk of the decline in the fair value of the instrument if the market interest rate increases because of the fixed interest rate.

The company enters into an interest rate swap. It exchanges the fixed interest rate payments it receives on the bond for floating interest rate payments, in order to offset the risk of a decline in fair value. If the derivative hedging instrument is effective, any decline in the fair value of the bond should be offset by opposite increases in the fair value of the derivative instrument. The company designates and documents the swap as a hedging instrument. On entering into the swap, the swap has a fair value of zero. As a result the debt instrument is now in a hedge and valued at fair value through profit or loss rather than at amortised cost.

Assuming market interest rates have increased to 7%, the fair value of the bond will have decreased to £960,000. The Swap has a fair value of £39,000 at the same date.

What are the necessary journal entries?  Clear IFRS 9 Fair value hedge accounting

Debt instrument at amortised costs Clear IFRS 9 Fair value hedge accounting	1,000,000
Cash Clear IFRS 9 Fair value hedge accounting		1,000,000

Recording of the purchase Clear IFRS 9 Fair value hedge accounting

Debt instrument at fair value through profit or loss Clear IFRS 9 Fair value hedge accounting	1,000,000
Debt instrument at amortised costs Clear IFRS 9 Fair value hedge accounting		1,000,000

Reclassification to fair value through profit or loss Clear IFRS 9 Fair value hedge accounting

Swap asset identified at nil value, but recorded in the contractual commitments

– Adjustment of fair value at month/quarter/year-end financial close

Fair value accounting debt instruments in profit or loss Clear IFRS 9 Fair value hedge accounting	40,000
Debt instrument at fair value through profit or loss Clear IFRS 9 Fair value hedge accounting		40,000

Recording the change in fair value of the debt instrument as a result of the change in market interest

SWAP asset Clear IFRS 9 Fair value hedge accounting	39,000
Fair value accounting SWAP instruments in profit or loss Clear IFRS 9 Fair value hedge accounting		39,000

Recording the change in fair value of SWAP instrument as a result of the change in market interest

Other journal entries that are not shown here are the accrual of interest receivable each month and the recording of the interest receipt on the bank account on a periodical basis.

Disclosure example from Total S.A. – Financial Statements 2018

Note 15 Financial structure and financial costs

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Clear IFRS 9 Fair value hedge accounting

Clear IFRS 9 Fair value hedge accounting Clear IFRS 9 Fair value hedge accounting Clear IFRS 9 Fair value hedge accounting Clear IFRS 9 Fair value hedge accounting