IFRS vs US GAAP Derivatives and hedging – Derivatives and hedging represent some of the more complex and nuanced topical areas within both US GAAP and IFRS. While IFRS generally is viewed as less rules-laden than US GAAP, the difference is less dramatic in relation to derivatives and hedging, wherein both frameworks embody a significant volume of detailed and complex guidance.
Derivatives and embedded derivatives
The definition of derivatives is broader under IFRS than under US GAAP; therefore, more instruments may be required to be accounted for as derivatives at fair value through the income statement under IFRS. There are also differences in the identification of embedded derivatives within both financial and nonfinancial host contracts that should be carefully considered. In terms of measurement of derivatives, day one gains or losses cannot be recognized under IFRS unless the fair value (1) is evidenced by comparison to other observable current market transactions of the same instrument or (2) is based on a valuation technique whose variables include only data from observable markets.
Under US GAAP, day one gains or losses are recognized, even if the fair value is based on unobservable inputs.
Hedge accounting models
Both the IASB and the FASB have issued recent hedge accounting guidance.
The FASB updated its hedge accounting guidance when it issued ASU 2017-12 in August 2017. The IASB’s hedge accounting guidance, IFRS 9, Financial Instruments, was effective for annual periods beginning on or after January 1, 2018. Under IFRS, entities have an accounting policy choice to apply the IFRS 9 hedge accounting guidance or to continue applying the IAS 39 hedge accounting guidance. This policy choice is applied to all of the entity’s hedges.
The IASB is planning to propose a macro hedge accounting model in a separate project, which is still ongoing. In the meantime, if an entity adopts IFRS 9 for hedge accounting, it may apply the “macro hedging” provisions of IAS 39 for a fair value hedge of the interest rate exposure of a portfolio of financial assets and/or financial liabilities (and only for such hedges) rather than the new IFRS 9 requirements.
If an entity chooses not to adopt IFRS 9 for hedge accounting when it adopts the other parts of IFRS 9, it continues to apply the IAS 39 hedging guidance, and it can still choose to adopt IFRS 9’s hedging provisions at a later date. However, once an entity has adopted IFRS 9 for hedge accounting, it cannot revert back to IAS 39.
Although both IFRS 9 and the amended ASC 815 guidance permit more hedging strategies to qualify for hedge accounting, the frameworks retain complex (though different) requirements for hedge accounting. Both the criteria to qualify for hedge accounting and the accounting for qualifying hedges are different. IFRS 9 has made it easier to qualify for hedge accounting than under IAS 39 by permitting hedging of more components of items, and eliminating the 80-125% effectiveness requirement.
US GAAP maintained more stringent qualifying criteria as compared to IFRS 9, including a requirement to perform rigorous assessments of effectiveness in many cases. But the amendments to US GAAP simplified subsequent reporting as compared to the previous ASC 815 guidance by eliminating the requirement to separately measure ineffectiveness for cash flow and net investment hedging relationships in earnings in each reporting period.
This chapter compares the IFRS 9 hedge accounting model and the ASC 815 hedge accounting model (after adoption of ASU 2017-12, but prior to the adoption of ASU 2019-04).
The following discussion captures a number of the more significant differences between ASC 815 (after adoption of ASU 2017-12) and IFRS 9. It summarizes the differences between IFRS and US GAAP that we generally consider to be the most significant or pervasive, and should be read in combination with the authoritative literature and a thorough analysis of all the facts and circumstances.
Derivative definition—net settlement provisions
More instruments will qualify as derivatives under IFRS.
Some instruments, such as option and forward agreements to buy unlisted equity investments, are accounted for as derivatives under IFRS but not under US GAAP.
IFRS vs US GAAP Derivatives and hedging IFRS vs US GAAP Derivatives and hedging IFRS vs US GAAP Derivatives and hedging
To meet the definition of a derivative, a financial instrument or other contract must require or permit net settlement.
The scope of ASC 815 excludes instruments linked to unlisted equity securities when such instruments fail the net settlement requirement and are, therefore, not accounted for as derivatives.
IFRS does not include a requirement for net settlement within the definition of a derivative. It only requires settlement at a future date.
Under IFRS, instruments linked to unlisted equity securities are required to be recorded at fair value.
An option contract between an acquirer and a seller to buy or sell stock of an acquiree at a future date that results in a business combination may not meet the definition of a derivative as it may fail the net settlement requirement (e.g., the acquiree’s shares are not listed so the shares may not be readily convertible to cash).
An option contract between an acquirer and a seller to buy or sell stock of an acquiree at a future date that results in a business combination would be considered a derivative under IFRS 9 for the acquirer (a similar forward contract is scoped out of IFRS 9); however, the option may be classified as equity from the seller’s perspective.
Own use versus normal purchase normal sale
Under IFRS, contracts that meet the “own use” criteria are scoped out of derivative accounting. However, a fair value option is available if it eliminates or significantly reduces an accounting mismatch. Under US GAAP, these contracts are accounted for as derivatives unless an entity elects the “normal purchase normal sale” (NPNS) exception.
IFRS vs US GAAP Derivatives and hedging IFRS vs US GAAP Derivatives and hedging IFRS vs US GAAP Derivatives and hedging
There are many factors to consider in determining whether a contract related to nonfinancial items can qualify for the NPNS exception.
If a contract meets the requirements of the NPNS exception, the reporting entity must document that it qualifies in order to apply the exception—otherwise, it will be considered a derivative.
Similar to US GAAP, there are many factors to consider in determining whether a contract related to nonfinancial items qualifies for the “own use” exception.
While US GAAP requires documentation to apply the NPNS exception, IFRS requires a contract to be accounted for as own use (i.e., not accounted for as a derivative) if the own use criteria are satisfied.
However, IFRS 9 provides a fair value option for own use contracts in situations in which the use of the option would eliminate or significantly reduce an accounting mismatch.
For example, an entity in the utility industry that hedges its physically settled contracts with energy derivatives could use the option for the physically settled contracts to reduce the measurement inconsistency between these contracts and the energy derivatives, and thus achieve offsetting effects without the need to apply hedge accounting.
This fair value option is irrevocable and only available at inception.
Embedded derivatives: hosts and reassessment
Under IFRS, embedded derivatives are not bifurcated from hybrid financial assets, and instead are part of the classification assessment of the entire financial asset (see Embedded derivatives in financial assets (in IFRS vs US GAAP Assets—financial assets) for further information on financial assets).
In addition, differences with respect to the reassessment of embedded derivatives may result in significantly different outcomes under the two frameworks. Generally, reassessment is more frequent under US GAAP.
IFRS vs US GAAP Derivatives and hedging IFRS vs US GAAP Derivatives and hedging IFRS vs US GAAP Derivatives and hedging
If a hybrid instrument (such as financial asset or liability, insurance or lease) contains an embedded derivative that is not clearly and closely related at inception, and it is not bifurcated (because it does not meet the definition of a derivative), it must be continually reassessed to determine whether bifurcation is required at a later date.
Once it meets the definition of a derivative, the embedded derivative is bifurcated and measured at fair value with changes in fair value recognized in earnings.
Similarly, the embedded derivative in a hybrid instrument that is not clearly and closely related at inception and is bifurcated must also be continually reassessed to determine whether it subsequently fails to meet the definition of a derivative. Such an embedded derivative should cease to be bifurcated at the point at which it fails to meet the requirements for bifurcation.
An embedded derivative that is clearly and closely related is not reassessed subsequent to inception for the “clearly and closely related” criterion. For nonfinancial host contracts, the assessment of whether an embedded foreign currency derivative is clearly and closely related to the host contract should be performed only at inception of the contract.
A financial asset that is within the scope of IFRS 9 is not assessed for embedded derivatives because the solely payment of principal and interest (SPPI) test is applied to the entire hybrid contract to determine the appropriate measurement category.
IFRS precludes reassessment of embedded derivatives after inception of the contract unless there is a change in the terms of the contract that significantly modifies the cash flows that would otherwise be required under the contract.
Calls and puts in debt instruments
IFRS and US GAAP have fundamentally different approaches to assessing whether calls and puts embedded in debt host instruments require bifurcation. Additionally, under IFRS, the embedded derivative analysis is only performed for the issuer of the debt instrument and not the holder, since there is no assessment of embedded derivatives for financial assets (see Embedded derivatives in financial assets (in IFRS vs US GAAP Assets—financial assets).
Multiple tests are required to evaluate whether an embedded call or put (i.e., a feature that can accelerate repayment of principal of a debt instrument) is clearly and closely related to the debt host. If any of the conditions outlined in the following tests occurs, the call or put is not clearly and closely related to the debt host and bifurcation is generally required.
Test 1—Upon exercise of the call or put, a debt instrument’s settlement amount changes based on anything other than interest rates or credit risk.
Test 2—A debt instrument involves a substantial premium or discount and the call or put that can accelerate repayment of principal is contingently exercisable.
Test 3—If the only underlying is an interest rate or interest rate index and either (a) there is a substantial premium or discount (but the put or call is not contingently exercisable), or (b) there is no substantial premium or discount, an additional test is required.
If the debt instrument can either (a) be settled in such a way that the holder would not recover substantially all of its recorded investment or (b) the embedded derivative would both (1) at least double the holder’s initial rate of return and (2) the resulting rate of return would be double the then current market rate of return, then the call or put is not clearly and closely related. However, certain exceptions are provided for this test.
Calls, puts, or prepayment options embedded in a hybrid debt instrument are closely related to the debt host instrument if either (1) the exercise price approximates the amortized cost on each exercise date or (2) the exercise price of a prepayment option reimburses the lender for an amount up to the approximate present value of the lost interest for the remaining term of the host contract. Once determined to be closely related as outlined above, these features do not require bifurcation.
Nonfinancial host contracts—currencies commonly used
Although IFRS and US GAAP have similar guidance in determining when to separate foreign currency embedded derivatives in a nonfinancial host, there is more flexibility under IFRS in determining that the currency is closely related.
US GAAP requires bifurcation of a foreign currency embedded derivative from a nonfinancial host unless the payment is denominated in (1) the functional currency of a substantial party to the contract, (2) the currency in which the price of the good or service is routinely denominated in international commerce (e.g., US dollar for crude oil transactions), (3) the local currency of a substantial party to the contract, or (4) a foreign currency used because a substantial party to the contract uses the currency as if it were the functional currency because it operates in a highly inflationary environment.
Criteria (1) and (2) cited for US GAAP also apply under IFRS. However, bifurcation of a foreign currency embedded derivative from a nonfinancial host is not required under IFRS if payments are denominated in a currency that is commonly used in contracts to purchase or sell such nonfinancial items in the economic environment in which the transaction takes place, provided the host contract is not leveraged and does not contain an option feature.
For example, Company X, in Russia (functional currency and local currency is Russian ruble), sells timber to another Russian company (with a ruble functional currency) in euros. If the company determines that the euro is a currency commonly used in Russia, bifurcation of a foreign currency embedded derivative from the nonfinancial host contract would not be required under IFRS.
Measurement—Day one gains and losses
Day one gains and losses occur when the entity uses a model to measure the fair value of the instrument and the model price at initial recognition is different from the transaction price.
The ability to recognize day one gains and losses is different under both frameworks, with gain/loss recognition more common under US GAAP.
In some circumstances, the transaction price is not equal to fair value, usually when the market in which the transaction occurs differs from the market in which the reporting entity could transact. For example, banks can access wholesale and retail markets; the wholesale price may result in a day one gain compared to the transaction price in the retail market.
In these cases, entities must recognize day one gains and losses even if some inputs to the measurement model are not observable.
Day one gains and losses are recognized only when the fair value is evidenced by a quoted price in an active market for the same instrument or is based on a valuation technique that only uses data from observable markets.
Hedge effectiveness criterion
Both US GAAP and IFRS permit application of hedge accounting to only certain eligible hedging instruments and hedged items and require formal designation and documentation of a hedging relationship at the beginning of the relationship and an assessment of effectiveness. However, the detailed requirements for hedge effectiveness vary between the two frameworks. Unlike US GAAP, there is no high effectiveness criterion to qualify for hedge accounting under IFRS. Instead, IFRS 9 requires an economic relationship between the hedged item and the hedging instrument, which is a less restrictive test.
Hedging relationships are required to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk.
The term “highly effective” has been interpreted in practice to mean that the change in fair value/cash flows of the designated component of the hedging instrument is within 80 to 125% of the change in fair value/cash flows of the designated proportion of the hedged item attributable to the risk being hedged.
hedging relationship needs to meet the following effectiveness requirements:
– Nature and timing of effectiveness assessments
Both US GAAP and IFRS require initial and ongoing assessments of effectiveness. However, the nature and timing of these effectiveness assessments vary between the two frameworks.
In certain cases, an initial quantitative assessment is required. In addition, periodic effectiveness assessments need to be performed on both a prospective basis (to reconfirm forward-looking expectations) and a retrospective basis (to determine whether the hedge was highly effective).
Effectiveness assessments are required at hedge inception and periodically thereafter, with an assessment required whenever financial statements or earnings are reported, and at least every three months. The initial assessment may be completed by the end of the quarter. Additionally, simplified approaches exist for non-public non-financial institutions.
When assessing effectiveness of hedges of forecasted transactions, entities can ignore timing differences between the hedged transactions and the maturity date of the hedging instrument within 31 days or a fiscal month (when that is the only difference between the derivative and the hedged forecasted transactions).
A retrospective effectiveness assessment is not required. However, an entity must make an ongoing assessment of whether the hedge continues to meet the three hedge effectiveness criteria described in Hedge effectiveness criterion (in Derivatives and hedging).
There is no requirement to perform effectiveness assessments every three months. The ongoing effectiveness assessment needs to be performed at each reporting date (which may only be semi-annually or annually) or upon a significant change in circumstances. It is only a forward-looking test.
The hedge ratio must be rebalanced to maintain the hedge ratio that the entity actually uses to achieve its economic hedging strategy. Entities should not need to rebalance very often if they have a good risk management strategy in place and the economic relationship is stable.
– Recognition of ineffectiveness
IFRS requires measurement and recognition of ineffectiveness in a hedging relationship even though the hedge meets the effectiveness criteria. US GAAP no longer has a concept of ineffectiveness that is separately measured and disclosed, although there may still be an income statement impact for certain hedges.
Both IFRS and US GAAP permit an entity to exclude certain components from the assessment of effectiveness and separately account for them, which may improve hedge effectiveness, as discussed in Amounts excluded from effectiveness assessment (in Hedge effectiveness criterion (in Derivatives and hedging)).
For cash flow and net investment hedges, hedge ineffectiveness is not separately measured and recognized in income each reporting period. If the hedge is highly effective, all changes in the fair value of the derivative hedging instrument will be recorded in other comprehensive income (OCI) (in cumulative translation adjustment (CTA) for net investment hedges), unless different recognition is prescribed/elected for any excluded components.
Any difference between the gain or loss on the hedged item and the derivative (except for the excluded component) is recognized when the hedged item affects earnings, at which time the amount deferred in AOCI from the hedging instrument is released to earnings.
On the other hand, for fair value hedges, because the change in fair value of the hedged item attributable to the hedged risk and the derivative hedging instrument are both recorded in current earnings, if the hedge is not perfectly effective, there will be an income statement impact.
While not identified as ineffectiveness, a reporting entity is required to disclose the change in fair value of the hedged item attributable to the hedged risk and the change in fair value of the derivative.
For cash flow hedges, the effective portion of the change in the fair value of the hedging instrument is recognized in OCI.
The amount recognized in OCI should be the lower of (1) the cumulative gain or loss on the hedging instrument from the inception of the hedge, and (2) the cumulative change in the fair value (present value) of the expected cash flows on the hedged item from the inception of the hedge.
The remaining ineffective portion of the change in the fair value of the hedging instrument (if any) is recognized in profit or loss.
For hedges of a net investment in a foreign operation, the effective portion of the change in the fair value of the hedging instrument is recognized in OCI and the ineffective portion of the hedging relationship is recognized in profit or loss.
For fair value hedges, both the effective and ineffective portions of the hedge relationship are recorded in profit or loss.
IFRS 7 requires disclosure of ineffectiveness.
– Amounts excluded from effectiveness assessment
Both US GAAP and IFRS permit an entity to exclude certain components of the change in the fair value of a hedging instrument from the assessment of effectiveness. However, the standards diverge in certain respects on what is permitted to be excluded.
An entity may elect to exclude certain components of the change in value of the derivative from the assessment of effectiveness for fair value and cash flow hedges:
For derivatives designated as net investment hedges, an entity is only permitted to use either (1) the spot method in which the entire difference between the spot price and the forward or futures price is excluded or (2) the full fair value method. Further, an entity is not permitted to exclude only part of the spot-forward difference when using the spot method.
US GAAP prohibits the exclusion of any other components of the hedging instrument.
IFRS 9 only permits three components to be excluded from the effectiveness assessment:
IFRS 9 does not prescribe a specific methodology for calculating the value of the excluded components.
However, a discounted calculation (such as discounted spot or discounted intrinsic value) is generally required since IFRS requires an entity to consider the time value of money when measuring hedge effectiveness.
Additionally, entities can elect to exclude only the foreign currency basis spread component of the spot-forward difference for forward contracts, which is not permitted under US GAAP.
– Accounting for amounts excluded from effectiveness assessment
US GAAP and IFRS diverge regarding how to account for a component excluded from the assessment of effectiveness.
For cash flow, fair value, and net investment hedges, an entity may choose between two methods to account for an excluded component:
The initial value of the excluded component is recognized in earnings using a systematic and rational method over the life of the hedging instrument, with any difference between the change in fair value of the excluded component and the amount in earnings recognized in OCI (CTA for net investment hedges).
The changes in fair value of the excluded component are recognized in current earnings.
Unlike IFRS, US GAAP does not have a specific concept of aligned time value (i.e., time value that only relates to the hedged item) or aligned forward element.
When using the spot method, discounting of the spot rate is not required (and in the case of a net investment hedge, discounting is not permitted).
IFRS 9 has specific guidance by type of derivative.
For cash flow, fair value, and net investment hedges, 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 “aligned time value” (i.e., when the critical terms of the option and hedged item are aligned) in OCI and hold those changes in a hedging reserve in equity.
Recognition of the aligned time value in profit or loss will depend on whether the hedge is transaction-related (and recorded in profit or loss at the same time as the hedged item) or time period-related (and recorded in profit or loss using a systematic and rational basis over the period of the hedge).
Forwards points and currency basis spread
An entity may recognize changes in value due to changes in forward points or foreign currency basis spread in profit or loss immediately or defer them using the recognition guidance for options.
Recognition of the excluded component applies to the aligned portion, i.e., the portion for which the critical terms such as notional, price, term and underlying of the derivative and the hedged item are aligned. This is called the “aligned time value” or “aligned forward element.”
IFRS 9 specifies a particular calculation methodology that can be complex to apply when the actual time value or forward element is lower than the aligned time value or forward element at inception of the hedge.
When the change in spot rate is the designated hedged risk, entities still need to consider the time value of money and, when appropriate, measure the hedged item using the discounted spot rate. However, for a net investment hedge, we believe that an entity can choose not to impute a time period into the hedging relationship and designate the hedged risk without discounting.
Eligible hedged items
Several differences exist between the two frameworks as it relates to the eligibility of the hedged item.
– Hedging components of nonfinancial items
Under both US GAAP and IFRS, an entity is permitted to hedge a component of a nonfinancial item. However, IFRS 9 permits more nonfinancial components to qualify as hedged items.
US GAAP permits cash flow hedges of the variability in cash flows attributable to changes in contractually specified components of forecasted purchases or sales of nonfinancial items, subject to specific criteria.
IFRS 9 permits entities to hedge risk components for nonfinancial items, provided such components are separately identifiable and reliably measurable. They do not have to be contractually specified, as under US GAAP.
A contractually specified component is an index or price explicitly stated in the contract or governing agreements to purchase or sell the nonfinancial item that is not solely linked to the entity’s own operations.
In assessing whether a risk component of a nonfinancial item is eligible for designation as a hedged risk, an entity should take into consideration factors such as:
– Hedging groups of items
Both US GAAP and IFRS permit an entity to hedge groups of items, but IFRS permits more groups of items to qualify as the hedged item. In particular, IFRS 9 permits hedging groups of offsetting exposures, while US GAAP specifically prohibits it.
If an entity wishes to designate a group of individual items as the hedged item in a hedging relationship, the individual items or transactions must share the same risk exposure for which they are designated as being hedged.
A quantitative evaluation, known as the “similar assets/liabilities test,” of whether a portfolio of assets or liabilities share the same risk exposure is generally required.
IFRS 9 allows hedges of:
IFRS 9 stipulates additional qualifying criteria. These include:
See Presentation of hedging instrument gains or losses (in Derivatives and hedging) on presentation of gains and losses on hedging instruments for a discussion of grouping items with offsetting disclosures.
– Hedging prepayable financial assets
Both US GAAP and IFRS permit an entity to hedge layers of items, provided that certain criteria are met. However, US GAAP and IFRS differ in the application of the guidance to interest rate fair value hedges of layers of prepayable financial assets not expected to be prepaid during the hedge period.
A “last-of-layer approach” permits the designation of a portion of a closed pool of prepayable assets, beneficial interests secured by prepayable assets, or a combination that is not expected to be prepaid during the hedge period as the hedged item in a fair value hedge of the benchmark interest rate.
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. If a layer component is designated in a fair value hedge, an entity must specify it from a defined nominal amount.
When an entity executes a partial-term hedge of the benchmark interest rate, the entity is able to ignore the impact of prepayment and credit risk by assuming that prepayments and defaults relate to the portion of the portfolio that is not part of the designated hedged item (the “last of layer”). For this strategy, a similar assets test may be performed qualitatively and only at inception.
A layer of a contract that includes a prepayment option that 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 other words, the prepayment option cannot be ignored. 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.
For macro hedges of interest rate risk, IFRS 9 permits an entity to elect to apply the requirements in IAS 39 for fair value portfolio hedges instead of applying IFRS 9 in full. Under IAS 39’s portfolio hedge model, it may apply fair value hedge accounting in a portfolio of dissimilar items (i.e., macro hedging) whereby the hedged portion may be designated as an amount of currency of a prepayable item, rather than individual assets or liabilities.
Further, under this approach in IAS 39, an entity is able to incorporate changes in prepayment risk by using a simplified method set out in the guidance, rather than specifically calculating the fair value of the prepayment option on a prepayable item by item basis.
Expected rather than contractual repricing dates may be used. In such a strategy, the change in fair value of the hedged item is presented as a separate line item in the balance sheet and is not allocated to individual assets or liabilities.
– Hedging aggregated exposures
IFRS permits an entity to combine a derivative and non-derivative exposure together and to designate them together as the hedged item in a hedging relationship. This is not permitted under US GAAP.
US GAAP does not permit hedge accounting for hedged items that are remeasured for changes in fair value through earnings (or a forecasted acquisition of an asset or incurrence of a liability that subsequently will be similarly remeasured at fair value).
Therefore, items meeting the definition of a derivative are not permitted to be the hedged item in a hedging relationship either by themselves or when combined with other non-derivatives.
Aggregated exposures can be designated as hedged items. An aggregated exposure is a combination of (1) an exposure that qualifies as a hedged item and (2) a derivative. This includes a forecasted transaction of an aggregated exposure (i.e., uncommitted but anticipated future transactions that would give rise to an exposure and a derivative) as long as the aggregated exposure is highly probable and, once it has occurred, would be eligible as a hedged item.
For example, an entity could hedge the forecasted issuance of variable-rate debt even if the currency of issuance is not yet known. If the debt is not issued in the entity’s functional currency, but the entity plans to enter into a cross-currency swap to convert the exposure back into its functional currency, it can designate as the hedged item highly probable variable interest payments arising from either (1) debt denominated in the functional currency or (2) a combination of foreign currency debt and a cross-currency swap that will swap the foreign currency debt to functional currency debt.
– Partial term hedging
Both US GAAP and IFRS permit partial-term hedging of a financial instrument. However, US GAAP is more prescriptive about the timing of the assumed beginning and maturity of the hedged item.
US GAAP allows a partial-term fair value hedge of interest rate risk in which the hedged item is designated as selected consecutive contractual interest payments. For example, entities can hedge the interest rate payments in the first two years, the last two years, or in years two through four in debt with a five-year term.
Or, for hedges of a single financial instrument, an entity could simultaneously enter into a hedge of year 1 with a swap in one hedging relationship and years 3 and 4 with another swap in a different hedging relationship.
Partial-term hedging is achieved by assuming that (1) the term begins when the first hedged cash flow begins to accrue, and (2) the maturity of the hedged item is the same date as the last hedged cash flow. To achieve #2, the payments made at the contractual maturity of the hedged item are assumed to be made at the conclusion of the hedged term.
In a cash flow hedge of interest rate risk, the hedged forecasted transactions are future interest payments. An entity may choose to hedge only certain selected interest payments to be paid under the terms of a debt agreement.
IFRS similarly permits designation of a derivative as hedging a financial instrument (the hedged item) for only a portion of its cash flows or fair value, if effectiveness can be measured and the other hedge accounting criteria are met.
Under IFRS 9, partial-term hedging of forecasted transactions of nonfinancial items, such as purchases and sales, is not permitted. However, the terms of the hedged item and hedging instrument do not need to match exactly to achieve hedge accounting.
If the mismatch is not so long as to invalidate the economic relationship, an entity can designate the hedge for the full period. However, the difference in terms will result in ineffectiveness.
Ineffectiveness arises regardless of whether the designated hedged risk is the forward or the spot foreign currency rate because the requirement in IFRS 9 to consider the time value of money is applicable in both circumstances
– Hedging variable-rate financial assets and liabilities
Both US GAAP and IFRS permit designation of the contractually specified interest rate as the hedged risk in a cash flow hedge of interest rate risk of a variable-rate financial instrument. Under IFRS 9, the interest rate does not need to be contractually specified; it only needs to be separately identifiable and reliably measurable. However, IFRS 9 does not permit the designated interest rate component to exceed the contractual cash flows.
US GAAP allows hedging the interest rate risk associated with the contractually specified index rate of an existing or forecasted issuance/purchase of a variable rate financial instrument. The rate does not need to be a benchmark interest rate.
If an entity desires to hedge interest payments from a forecasted issuance/purchase and does not know whether it will be variable rate or fixed rate, the entity must designate a rate that would qualify both as a contractually specified rate and a benchmark interest rate.
IFRS similarly allows a portion of specific interest payments to qualify as a hedged risk, provided it is separately identifiable and reliably measurable. It does not have to be contractually specified.
However, under IFRS 9, a designated portion of the cash flows cannot be greater than the cash flows of the whole financial asset or financial liability. Consequently, an entity that issues a debt instrument whose effective interest rate at designation is below the designated interest rate component cannot designate a component of the liability equal to the benchmark interest rate.
For example, if an entity issues debt that pays a rate of LIBOR minus 1%, it cannot designate the hedged item as only the LIBOR component of the cash flows. However, IFRS permits the entity to designate as a hedged item the change in cash flows of the entire liability (LIBOR minus 1%) that is attributable to changes in LIBOR. In practice, this may have a similar result, unless the debt contains a floor or contractually permits other variability besides the referenced interest rate.
– Hedging fixed-rate financial assets and liabilities
Both US GAAP and IFRS permit the designation of the entire contractual cash flows or a component of the contractual cash flows in a fair value hedge of interest rate risk of a fixed-rate financial instrument. US GAAP also permits a hedge of the benchmark component for fair value hedges of other risks, regardless of whether the coupon or yield is more or less than the benchmark rate.
The interest rate risk that can be hedged in a fixed-rate financial asset or liability is explicitly limited to benchmark interest rates. In each financial market, generally only the most widely used and quoted rates are considered benchmark interest rates.
In the United States, the benchmark rates currently allowed to be hedged under US GAAP are:
In calculating the change in value of the hedged item for interest rate changes, an entity can use either the full contractual coupon cash flows or the benchmark rate component as determined at hedge inception.
A hedge of the benchmark component of coupons is permitted for all fair value hedges, regardless of whether the coupon or yield is more or less than the benchmark rate. In other words, sub-benchmark hedging is allowed.
Under US GAAP, an entity should consider the effect of a prepayment option that is exercisable during the hedged term when hedging interest rate risk of a prepayable item. In evaluating the impact to the prepayment option, an entity is explicitly permitted to consider either (1) all factors that would cause a borrower to prepay, or (2) only how changes in the benchmark interest rate affect prepayments.
Similar to US GAAP, IFRS 9 permits an entity to hedge the full contractual coupon or just the interest rate component of the contractual coupon. IFRS allows a portion of a specific risk in a fixed-rate financial asset or liability to be designated as a hedged item, provided it is separately identifiable and reliably measurable. In certain circumstances, an inflation risk component could be considered separately identifiable and reliably measurable even if not contractually specified.
Unlike US GAAP, IFRS 9 does not contain a list of acceptable benchmark rates. Additionally, IFRS 9 does not permit use of a designated component of the cash flows that exceeds the total fair value or cash flows of a hedged item.
For a fixed rate sub-LIBOR debt, an entity would designate changes in fair value of all the cash flows attributable to changes in LIBOR. If a fixed-rate financial instrument is hedged after its origination/issuance and interest rates have risen, the entity can designate a risk component equal to a benchmark rate that is higher than the contractual rate paid on the item as long as LIBOR is less than the effective interest rate based on the hedged item’s fair value at designation.
In that case, the cash flows used for the hedged item would consist of the contractual interest and the difference between the hedged item’s fair value at designation and the amount repayable at maturity (discount).
While IFRS 9 allows an entity to designate the interest rate component as the hedged risk, it does not specifically provide the approach laid out under US GAAP when considering the impact of a prepayment option. However, in practice, changes in fair value attributable to the referenced interest rate may be designated as the hedged risk, which has the same effect.
– Hedging more than one risk
IFRS provides greater flexibility than US GAAP with respect to utilizing a single hedging instrument to hedge more than one risk in two or more hedged items. This allows entities to adopt new and sometimes more complex strategies to achieve hedge accounting while managing certain risks under IFRS.
US GAAP does not allow a single hedging instrument to hedge more than one risk in two or more hedged items and does not permit creation of a hypothetical component in a hedging relationship of more than one risk with a single hedging instrument. An exception is a basis swap designated as a cash flow hedge of both a floating rate asset and a floating rate liability.
IFRS 9 permits designation of a single hedging instrument to hedge more than one risk in two or more hedged items. A single hedging instrument may be designated as a hedge of more than one type of risk, provided that there is a specific designation of the hedging instrument and of the different risk positions as hedged items.
Those hedged items can be in different hedging relationships. In the application of this guidance, a single derivative may be separated by inserting an additional (hypothetical) leg if each portion of the contract is designated as a hedging instrument in a qualifying and effective hedge relationship.
For example, an entity whose functional currency is the Japanese yen (JPY) that has a fixed-rate loan receivable denominated in British pounds (GBP) and a variable-rate liability denominated in US dollars (USD) with the same principal amount can enter into a single foreign currency forward contract to hedge the FX exposure on the principal payments of the liability and the note receivable.
This would be achieved by splitting a GBP / USD forward into two forwards by imputing two JPY legs into the contract.
– Hedging business combinations
IFRS permits hedging foreign currency risk in a business combination, but US GAAP does not.
US GAAP specifically prohibits a firm commitment to enter into a business combination, or acquire or dispose of a subsidiary, minority interest, or equity method investee from qualifying as a hedged item for hedge accounting purposes (even if it is with respect to foreign currency risk). Additionally, US GAAP does not permit cash flow hedges of forecasted transactions involving business combinations.
An entity is permitted to hedge foreign exchange risk in a firm commitment to acquire a business or a forecasted business combination if the transaction is highly probable.
Eligible hedging instruments
Several differences exist between the two frameworks as it relates to the eligibility of the hedging instruments.
– Eligible hedging instruments – non-derivatives
Both US GAAP and IFRS permit nonderivatives to be designated as hedging instruments in certain cases. IFRS generally permits nonderivatives to be designated as hedging instruments in more instances than US GAAP. Nonderivative financial instruments are most commonly used as hedges in hedge relationships involving foreign currency risk, which is permitted under both frameworks. In this way, US GAAP and IFRS are similar. As a result, there is not a substantive difference in practice in most cases.
Generally, a nonderivative may not be used as a hedging instrument. However, certain nonderivative financial instruments that may give rise to a foreign currency transaction gain or loss may be designated in a hedge of foreign currency risk in fair value hedges of firm commitments and net investment hedges.
Non derivative financial instruments classified at fair value through profit or loss are permitted to be used as hedging instruments for all types of risks (except for financial liabilities when changes in fair value as a result of credit risk are presented in OCI).
The foreign currency component of non derivative financial instruments can be designated as a hedge of FX risk (except for equity instruments for which changes in fair value are recorded in OCI).
– Foreign currency risk – location of hedging instrument
IFRS permits a parent company to hedge exposures of an indirect subsidiary regardless of the functional currency of intervening entities within the organizational structure. The rules under US GAAP for hedges of foreign exchange risk for forecasted transactions (cash flow hedges) or net investments in foreign operations are prescriptive regarding the functional currency and structure of the entities involved.
Either the operating unit that has the foreign currency exposure or another member of the consolidated group that has the same functional currency as that operating unit must be a party to the hedging instrument.
However, for another member of the consolidated group to enter into the hedging instrument, there cannot be an intervening entity with a different functional currency. Instead, entities may designate intercompany derivatives between the subsidiary with the exposure and the entity that is a party to an offsetting external derivative if certain criteria are met.
IFRS does not require the entity with the hedging instrument to have the same functional currency as the entity with the hedged item or the operating unit exposed to the risk being hedged within the consolidated group to be a party to the hedging instrument.
For example, IFRS allows a parent company with a functional currency different from that of a subsidiary to achieve cash flow hedge accounting for the subsidiary’s transactional foreign currency exposure (i.e., an exposure in a currency other than the subsidiary’s functional currency).
The same flexibility regarding location of the hedging instrument applies to net investment hedges.
Cash flow hedging and basis adjustments
For hedges of a forecasted purchase of a nonfinancial item, US GAAP and IFRS differ with regards to the accounting (at the time of acquisition of the nonfinancial item) for the fair value changes of the hedging instrument that were deferred in AOCI. This results in different amounts in AOCI and different carrying amounts of the nonfinancial items between US GAAP and IFRS. However, the ultimate effect on earnings is the same.
US GAAP prohibits adjusting the basis of the hedged item in a cash flow hedge, and requires the fair value changes deferred in AOCI to be released out of AOCI into earnings when the hedged forecasted transaction impacts earnings.
IFRS 9 requires mandatory basis adjustment of the nonfinancial hedged item once it is recognized. Accordingly, fair value changes in the hedging instrument that are deferred in AOCI (referred to as the “cash flow hedge reserve”) are included in the value of the hedged item on its initial recognition.
The basis adjustment does not flow back through OCI. It is a direct transfer from equity to the hedged item.
Similar accounting is required if a hedged forecasted transaction for a nonfinancial asset or a nonfinancial liability becomes a firm commitment for which fair value hedge accounting is applied.
Presentation of hedging instrument gains or losses
US GAAP is more prescriptive regarding the presentation of gains and losses from hedges than IFRS.
For fair value hedges, the entire change in the fair value of the hedging instrument is presented in the same income statement line item as the earnings effect of the hedged item.
For cash flow hedges, the entire change in fair value of the hedging instrument (except for excluded components) should be recorded in other comprehensive income (OCI) and reclassified to earnings in the same income statement line item used to present the earnings effect of the hedged item when the hedged item impacts earnings.
Splitting gains and losses into more than one income statement line item is generally not appropriate. However, if the hedging instrument offsets changes in fair value or cash flows that are reported in more than one income statement line item, the changes in fair value of the hedging instrument is split among the line items that include the earnings effect of the hedged item.
For cash flow and fair value hedges, amounts excluded from the assessment of effectiveness are presented in the same income statement line item that is used for the hedged item.
For net investment hedges, the entire change in fair value of the hedging instrument included in the hedge effectiveness assessment is recorded in CTA and reclassified to earnings in the same income statement line item used to present the earnings effect of the hedged item (when the subsidiary is sold or substantially liquidated).
US GAAP is silent on the income statement geography for excluded components for net investment hedges.
IFRS 9 generally has no requirements regarding the income statement presentation of gains and losses from a hedging instrument. However, in practice, we believe most entities present gains and losses from a hedging instrument in the same income statement line item as the hedged transaction.
We believe ineffectiveness should be presented in a manner consistent with the entity’s policy for trading derivatives. This might mean that the results of hedge ineffectiveness are included in the same line item as the impact of the related hedged item or in “other operating income and expense” or a separate line item if the amount is significant.
For cash flow hedges of a group of items with no offsetting risk position, the presentation of gains and losses should be apportioned to the line items affected by the hedged items on a systematic and rational basis.
The net gains or losses arising from a single hedging instrument should not be presented as gross amounts in different line items.
For a hedge of a group of items with offsetting risk positions whose hedged risk affects different line items in the statement of profit or loss and OCI, any hedging gains or losses in that statement must be presented in a separate line from those affected by the hedged items.
Consequently, the amount in the line item that relates to the hedged item itself (e.g., revenue or cost of sales) remains unaffected. In practice, this makes hedges of a group of items less attractive, and we expect many entities to designate just a part of one of the gross positions (rather than the net position).
Voluntary dedesignation of a hedging relationship
Under both US GAAP and IFRS, an entity is required to discontinue a hedging relationship if the respective qualifying criteria are no longer met. However, voluntary dedesignation is not allowed under IFRS 9. In practice, this may have a limited impact because IFRS requires discontinuance of the hedging relationship when the risk management objective is no longer met. Hence, when an entity no longer pursues a specific risk management objective, the hedging relationship should be discontinued prospectively. This likely includes most instances when an entity would have chosen to dedesignate a hedging relationship.
An entity is permitted to dedesignate a hedging relationship voluntarily at any time.
Under IFRS 9, an entity cannot voluntarily dedesignate a hedging relationship that:
Novations, rollovers, and replacements
Both US GAAP and IFRS permit continuance of a designated hedging relationship when a contract is modified in certain circumstances. However, the circumstances under which the hedge relationship can continue after a modification differ under the two frameworks.
A change in the counterparty to a derivative that has been designated as the hedging instrument does not, in and of itself, require dedesignation of that hedging relationship, provided that all other hedge accounting criteria continue to be met.
However, US GAAP requires an entity to dedesignate a hedging relationship upon expiration of the derivative or a change to the critical terms of the derivative or hedging relationship.
IFRS explicitly permits the continuation of hedge accounting when the counterparty to a derivative changes through novation to a clearing counterparty (such as a central clearing party) as a consequence of laws or regulations. However, in practice, there may be other scenarios when a novation, in and of itself, would not require a dedesignation of the hedging relationship.
IFRS permits the continuation of hedge accounting upon the replacement or rollover of a hedging instrument into another hedging instrument if it is part of the entity’s documented hedging strategy.
See also: The IFRS Foundation