Discontinuation hedge accounting

Discontinuation hedge accounting is not a simple as one would think, three choices are available, no discontinuation (i.e. continue the hedge), full discontinuation of the hedge or partial discontinuation of the hedge. An entity would have to discontinue hedge accounting if the qualification criteria are no longer met. As also mentioned at ‘Assessment of effectiveness‘, this includes if the risk management objective for the hedging relationship has changed. In short the qualification criteria are: Discontinuation hedge accounting

  1. Only eligible hedging instruments and eligible hedged items,
  2. From inception through discontinuation – existence of formal designation and documentation, and
  3. Meet the hedge effectiveness criteria: Discontinuation hedge accounting
    1. existence of an economic relationship,
    2. existence of no dominant credit risk,
    3. existence of a hedge ratio consistent with the risk management policies.

In an important change to IAS 39, IFRS 9 now introduces ‘partial discontinuation’ of hedge accounting, which means that hedge accounting continues for the remaining part of the hedging relationship. Discontinuation hedge accounting

The table below summarises the main scenarios resulting in either full or partial discontinuation.

Scenario

Discontinuation

The risk management objective has changed

Full or partial

There is no longer an economic relationship between the hedged item and the hedging instrument

Full Discontinuation hedge accounting

The effect of credit risk dominates the value changes of the hedging relationship

Full Discontinuation hedge accounting

As part of rebalancing, the volume of the hedged item or the hedging instrument is reduced

Partial Discontinuation hedge accounting

The hedging instrument expires

Full

The hedging instrument is (in full or in part) sold, terminated or exercised

Full or partial

The hedged item (or part of it) no longer exists or is no longer expected to occur

Full or partial

The application guidance in IFRS 9 provides three examples elaborating on what constitutes a change in risk management objective. We believe that a change in risk management objective has to be a matter of fact that can be observed in the entity’s actual risk management.

The examples below, the first of which is derived from the application guidance to IFRS 9, demonstrate how this could be assessed in practice.

Worked example – Partial discontinuation as a result of a change in risk management objective 
ABC Ltd is currently fully financed with variable rate borrowings (the tables show nominal amounts):

Discontinuation hedge accounting

Risk management strategy

To maintain between 20% and 40% of borrowings at a fixed rate.

Risk management activity

The treasurer of ABC enters into a pay fixed/receive variable IRS and designates the IRS in a hedging relationship.

Risk management objective

Use a pay fixed/receive floating interest rate swap with a notional amount of CU30 m in a cash flow hedge to hedge the interest payments on CU30m of the variable rate borrowings in order to maintain 30% of the borrowings at fixed rate.

Discontinuation hedge accounting

On 31 March 20×2, the entity needs further funding and takes advantage of lower interest rates by issuing a CU50m fixed rate bond. At the same time, the entity decides to set its fixed rate exposure at 40% of total borrowings, still being within the risk management strategy.

Discontinuation hedge accounting

It becomes evident that ABC is no longer within the target range of its risk management strategy. In order to execute the risk management strategy, ABC no longer needs part of its interest rate swap. In other words, the risk management objective for the hedging relationship has changed. Consequently, ABC discontinues CU20m of the hedging relationship (a partial discontinuation).

Going forward, ABC’s debt financing and risk profile will be, as follows:

Discontinuation hedge accounting

Something else -   Hedge accounting requirements

The above example only illustrates the outcome of one particular course of action. The entity could also have adjusted its interest rate exposure in a different way in order to remain in the target range for its fixed-rate funding, for instance by swapping CU20m of the new fixed-rate bond into variable-rate funding. In that case, instead of discontinuing a part of the already existing cash flow hedge the entity would have designated a new fair value hedge.

The example in the application guidance of the standard is obviously a simplified one. In practice, entities tend to have staggered maturities for different parts of their financing. In such situations, it would often be obvious from the maturity of the new interest rate swaps if they are a fair value hedge of the debt or a reduction of the already existing cash flow hedge volume.

For example, if the new CU50m fixed rate bond is for a longer period than the existing debt and the new interest rate swap is for the same longer period, it would suggest that it is a fair value hedge of the new fixed rate bond instead of a reduction of the cash flow hedge for the already existing debt. Conversely, a reduction of the cash flow hedge volume would be consistent with entering into a new interest rate swap that has the same remaining maturity as the existing interest rate swap and offsets it partially.

Worked example – Partial discontinuation of an interest margin hedge

XYZ Bank is holding a combination of fixed and variable rate assets and liabilities on its banking book. For risk management purposes, the bank allocates all the assets and liabilities to time buckets based on their contractual maturity. As of 1 January 20×1, the bank holds the following instruments in the 5-year time bucket (the table show nominal amounts in CU millions):

Discontinuation hedge accounting

The fixed-variable mismatch results in interest margin risk due to changes in interest rates.

Risk management strategy

To eliminate the interest margin risk resulting from fixed-variable interest mismatches.

Risk management activity

In order to achieve the risk management strategy, XYZ Bank enters into a pay fixed/receive variable IRS with a notional amount of CU30m. For accounting purposes, the bank could either designate the IRS in a cash flow hedge of CU30m of specific variable rate liabilities or in a fair value hedge of CU30m of specific fixed rate assets. Under the local regulatory requirements, fair value hedges are more favourable for the bank’s regulatory capital.

Risk management objective

Using a CU30m pay fixed/receive variable IRS in a fair value hedge of CU30m of fixed rate retail loans to hedge a fixed-variable interest mismatch on fixed and variable rate assets and liabilities in the 5-year time bucket of XYZ Bank’s banking book.

At the beginning of year 20×3, XYZ Bank attracts CU10m of client term deposits as a result of a successful marketing campaign. The new term deposits all have a fixed interest rate for a maturity of three years, therefore, matching the (remaining) maturity of the instruments in the above time bucket. The XYZ Bank uses the proceeds from the new term deposits to buy back CU10m of variable rate bonds that it has issued. The new situation in the (now) 3-year time bucket is:

Discontinuation hedge accounting

As a result of the change in funding, the risk management objective of the hedging relationship has changed. XYZ Bank is over-hedged and needs to discontinue CU10m of its hedging relationship.

Something else -   Hedge Risk components General requirements

A consequence of linking the discontinuation to the risk management objective is that voluntary discontinuations just for accounting purposes are no longer permitted. This change, introduced in the Exposure Draft leading up to the final published amendments, gave rise to concern among some constituents who argued that, given hedge accounting is optional, voluntary discontinuation should be retained.

Entities have often voluntarily discontinued hedge accounting to adjust, for instance:

  • The hedge ratio for a change in the expected relationship between the hedged item and the hedging instrument
  • The volume of hedged forecast transactions if part of the volume is no longer highly probable

Each of the scenarios mentioned above is addressed in IFRS 9 by introducing a new effectiveness assessment, rebalancing and partial discontinuation. Hence, voluntary discontinuation is no longer needed in such situations.

In its redeliberations, the IASB noted that hedge accounting is an exception to the general accounting principles in IFRS to present in the financial statements a particular risk management objective of a risk management activity. If that risk management objective is unchanged and the qualifying criteria for hedge accounting are still met, a voluntary discontinuation would jeopardise the original reason for applying hedge accounting. The Board believes that hedge accounting, including its discontinuation, should have a meaning and should not be a mere accounting exercise. Based on this, the IASB decided not to allow voluntary discontinuation for hedges with unchanged risk management objectives.

Discontinuation hedge accounting

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Something else -   Foreign currency basis spreads
Something else -   Hedged items General requirements

Discontinuation hedge accounting Discontinuation hedge accounting Discontinuation hedge accounting Discontinuation hedge accounting Discontinuation hedge accounting Discontinuation hedge accounting Discontinuation hedge accounting Discontinuation hedge accounting Discontinuation hedge accounting Discontinuation hedge accounting Discontinuation hedge accounting Discontinuation hedge accounting

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