Overview hedge accounting

Every entity faces risks from its business environment that can impact expected cash flows or the fair value of its assets and liabilities and, accordingly, have an effect on its earnings. An entity may face risks such as changes in the price or exchange rate for inputs required for its operations (e.g. labour or commodities), or changes in the costs of financing arising from changes in market interest rates. Consequently, it might undertake activities or transactions to manage the effect of these risks on its operations which is known as hedging.

For example, an entity may enter into contracts to purchase the commodities necessary for its operations far in advance, locking in current prices and shielding itself from potential increases in commodity prices. Or an entity with variable rate debt could arrange to pay a fixed interest rate on a notional amount that coincides with its debt, in exchange for receiving variable interest on the same notional amount. Hence, it has insulated itself from the impacts that changes in market interest rates would have on payments towards its borrowings.

Objective

As per IFRS 9 6.1.1, “the objective of hedge accounting under IFRS 9 is to represent, in the financial statements, the effect of an entity’s risk management activities that use financial instruments to manage exposures arising from particular risks that could affect profit or loss”1. In other words, the goal is to ensure that offsetting gains, losses, revenues and expenses, including the effects of changes in cash flows, are recognized in profit or loss in the same period(s).

The following examples demonstrate how hedge accounting achieves this objective.


Example of the Effect of Hedging the Variability in Cash Flows

Lender A holds a portfolio of loan assets on which they receive interest based on the Bank of Canada prime rate. To hedge the cash flow risk from fluctuations in the prime rate over the next 3 years, Lender A purchases a 3 years pay-variable receive-fixed interest rate swap with a notional amount equal to that of the loan portfolio being hedged. On December 31, 20×1, the Bank of Canada increases the prime rate by 0.25%.

Assessment: The interest rate swap is a derivative liability accounted for at FVPL. Therefore, the entire amount of the fair value loss on the derivative is recorded immediately in income. If Lender A does not apply hedge accounting, the impact of a higher interest rate on its portfolio of variable rate loan assets is only recognized as interest payments are received over future periods. Because the loss on the interest rate swap is recognized in the current year but the corresponding increase in earnings is recognized over future periods, this creates volatility in profit or loss for both current and future periods that the hedging strategy aims to avoid. As a result, this accounting treatment does not accurately reflect the entity’s risk management activities. To prevent this accounting mismatch, Lender A can adopt hedge accounting to defer the loss on the derivative in the current period to the periods where the variable interest rates affect profit or loss. This is referred to as a cash flow hedge.


Example of the Effect of Hedging Changes in Fair Value

Lender B holds a portfolio of loan assets bearing interest at a fixed rate of 5% which is accounted for at amortized cost. To hedge the risk of fair value changes due to fluctuations in the prime rate over the next 5 years, Lender B purchases a 5 years pay-fixed receive-variable interest rate swap with a notional amount equal to that of the loan portfolio being hedged. On December 31, 20×1, the Bank of Canada decreases the prime rate by 0.25%.

Assessment: The interest rate swap is a derivative liability accounted for at FVTPL. Therefore, the entire amount of the fair value loss on the derivative is recorded immediately in income. If Lender B does not apply hedge accounting, because the loan portfolio is accounted for at amortized cost, there is no change in the value of the loans and no impact on earnings. This creates volatility in Lender B’s earnings as the change in the fair value of the interest rate swap is recognized in the current year but not for the loan portfolio. As a result, this accounting treatment does not accurately reflect the entity’s risk management activities.

To prevent this accounting mismatch, Lender B can adopt hedge accounting to recognize the change in fair value of the loan portfolio in the same period as the derivative affects profit or loss. This is referred to as a fair value hedge.


Hedge accounting is optional and in order to apply it an entity is required to meet certain conditions, including the preparation of hedge documentation. Some entities find hedge accounting and the qualifying conditions too cumbersome. Consequently, entities may engage in hedging activities (i.e., acquire a financial instrument whose performance cancels that of a different financial instrument) but not necessarily apply hedge accounting.

Types of Hedging Relationships

IFRS 9 provides for three different types of hedges (the first two already presented above).

IFRS 9 Term

Defintion

High-level Summary of Accounting

Fair value hedge

(see IFRS 9.6.5.8 –10)

A hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that is attributable to a particular risk and could affect profit or loss.

The change in the fair value of the hedged item that is attributable to the hedged risk is recognized in the current period as the change in the fair value of the hedging instrument. This results in earlier recognition of the fair value change in the hedged item than if hedge accounting was not applied.

Cash flow hedge

(see IFRS 9.6.5.11 – 12)

A hedge of the exposure to variability in the future cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk.

The effective portion of the change in the fair value of the hedging instrument is recognized in an equity reserve until the hedged item is recognized or affects profit or loss. This delays the recognition of the change in cash flows related to the hedging instrument. The ineffective portion of the change in the fair value of the hedging instrument is immediately recognized in profit or loss.

Net investment hedge2

(see IFRS 6.5.13 – 14)

A hedge of the exposure to foreign currency risk of a net investment in a foreign operation.

Accounted for similarly to a cash flow hedge.

Qualifying Criteria for Hedge Accounting


Step 1: Eligibility of hedged items or transactions

Step 2: Eligibility of hedged risk(s)

Step 3: Eligibility of hedging instruments

Step 4: Hedge effectiveness

  • Methods for demonstrating an economic relationship
  • The effect of credit risk on an economic relationship

Document the designated hedging relationship (as evidence of formally approved management decision(s))

Other topics

effect of risk management and use of financial instruments  effect of risk management and use of financial instruments  

effect of risk management and use of financial instruments effect of risk management and use of financial instruments effect of risk management and use of financial instruments effect of risk management and use of financial instruments

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