Qualifying for Hedge Accounting

Qualifying for Hedge Accounting – Before being able to qualify for hedge accounting it has to be determined whether a hedge relationship is eligible. This means:

The hedging relationship should consist only of eligible hedging instruments and hedged items. There are changes to what is eligible for both hedged items and hedging instruments, which are discussed in detail here.

Formal designation and documentation

There are three basic requirements that must be satisfied in order for hedge accounting to be applied to any eligible hedge relationship:

  1. formal documentation of the hedge relationship should exist at the time of designation;
  2. at inception and each period thereafter an entity must demonstrate that the relationship is expected to be highly effective on a go-forward basis (prospectively) and has actually been effective since the date of designation (retrospectively);
  3. each period an entity must recognize any ineffectiveness in profit or loss.

Formal documentation of the hedge relationship needs to exist at the date of designation that details:

  1. the entity’s risk management objective and strategy for undertaking the hedge; Qualifying for Hedge Accounting
  2. the nature of the risk being hedged; Qualifying for Hedge Accounting
  3. clear identification of the hedged item and hedging derivative including the key terms; and Qualifying for Hedge Accounting
  4. the methods through which the effectiveness of the relationship will be assessed on both a prospective and retrospective basis, and how any ineffectiveness will be measured.

The methodologies used to assess and measure effectiveness need to be described in sufficient detail that would allow a reasonably knowledgeable individual to be able to understand and consistently reproduce the results of the assessment. This effectiveness assessment and measurement aspect of the requirements can get particularly complicated requiring specialized resources in certain instances for the more complex types of relationships. Qualifying for Hedge Accounting

Formal designation and documentation must be in place at the inception of the hedge relationship. As a result, from the documentation point of view, there is not much relief from the administrative work necessary to start hedge accounting. Qualifying for Hedge Accounting

Entities should also take into consideration that, as a result of the new hedge accounting requirements under IFRS 9, documentation will no longer be static but must be updated from time to time. Examples of situations where modification of the hedge documentation would be required are where the hedge ratio is rebalanced (see below) or where the analysis of sources of hedge ineffectiveness is updated. Qualifying for Hedge Accounting

Hedge effectiveness Qualifying for Hedge Accounting

Hedge effectiveness is defined as the extent to which changes in the fair value or cash flows of the hedging instrument offset changes in the fair value or cash flows of the hedged item. IFRS 9 introduces three hedge effectiveness requirements: Qualifying for Hedge Accounting

  1. Economic relationship – IFRS 9 requires the existence of an economic relationship between the hedged item and the hedging instrument. So there must be an expectation that the value of the hedging instrument and the value of the hedged item would move in the opposite direction as a result of the common underlying or hedged risk.For example, this is the case for forecast fixed interest payments and an interest rate swap that receives fixed interest payments and pays variable interest. An on-going analysis of the possible behaviour of the hedging relationship during its term is required in order to ascertain whether it can be expected to meet the risk management objective.
  2. Credit risk – Even if there is an economic relationship, a change in the credit risk of the hedging instrument or the hedged item must not be of such magnitude that it dominates the value changes that result from that economic relationship. Because the hedge accounting model is based on a general notion of there being an offset between the changes of the hedging instrument and those of the hedged item, the effect of credit risk must not dominate the value changes associated with the hedged risk; otherwise, the level of offset might become erratic.For example, where an entity wants to hedge its forecast inventory purchases for commodity price risk, it enters into a derivative contract with Bank X to purchase a commodity at a fixed price and at a future date.If the derivative contract is uncollateralised and Bank X experiences a severe deterioration in its credit standing, the effect arising from changes in credit risk might have a disproportionate effect on the change in the fair value of the derivative contract arising from changes in commodity prices; whereas the changes in the value of the hedged item (forecast inventory purchases) would depend largely on the commodity price changes and would not be affected by the changes in the credit risk of Bank X.
  3. Hedge ratio – The hedge ratio is defined as the relationship between the quantity of the hedging instrument and the quantity of the hedged item in terms of their relative weighting. IFRS 9 requires that the hedge ratio used for hedge accounting purposes should be the same as that used for risk management purposes.One of the key objectives in IFRS 9 is to align hedge accounting with risk management objectives. There is no retrospective effectiveness testing required under IFRS 9, but there is a requirement to make an on-going assessment of whether the hedge continues to meet the hedge effectiveness criteria, including that the hedge ratio remains appropriate.This means that entities will have to ensure that the hedge ratio is aligned with that required by their economic hedging strategy (or risk management strategy). A deliberate imbalance is not permitted. This requirement is to ensure that entities do not introduce a mismatch of weightings between the hedged item and the hedging instrument to achieve an accounting outcome that is inconsistent with the purpose of hedge accounting.

    This does not imply that the hedge relationship must be perfect, but only that the weightings of the hedging instruments and hedged item actually used are not selected to introduce or to avoid accounting ineffectiveness. In some cases, there are commercial reasons for particular weightings of the hedged item and the hedging instrument even though they create hedge ineffectiveness.

    This is the case, for example when using standardised contracts that have a defined contract size (for instance, 1 standard aluminium future contract in the LME has a contract size of 25 tonnes). When an entity wants to hedge 90 tonnes of aluminium purchases with standard aluminium future contracts, due to the standard contract size, the entity could use either 3 or 4 future contracts (equivalent to a total of 75 or 100 tonnes respectively).

    Such designation would result in a hedge ratio of either 0.83:1 or 1.11:1. In that situation the entity designates the hedge ratio that it actually uses, because the hedge ineffectiveness resulting from the mismatch would not result in an accounting outcome that is inconsistent with the purpose of hedge accounting. Hedge ineffectiveness is still required to be measured and accounted for in P&L.

Hedge effectiveness assessment Qualifying for Hedge Accounting

IFRS 9 does not prescribe a specific method for assessing whether a hedging relationship meets the hedge effectiveness requirements. An entity must use a method that captures the relevant characteristics of the hedging relationship, including the sources of hedge ineffectiveness that are expected to affect the hedging relationship during its term.

A qualitative assessment is always necessary and, depending on the characteristics of the hedge relationship, entities might also need to perform a quantitative assessment. For example, in a simple hedge where all the critical terms match (or are only slightly different), a qualitative test might be sufficient. On the other hand, in highly complex hedging strategies, some type of quantitative analysis would likely need to be performed. Qualifying for Hedge Accounting

The assessment relates to expectations about hedge effectiveness, and so is only forward looking. Such an assessment should be performed at inception and on an on-going basis at each reporting date or on a significant change in circumstances, whichever comes first. The intention behind these requirements is to ensure that only economically viable hedging strategies (that is, those reflecting the underlying economic relationship and aligned to the risk management strategy) qualify for hedge accounting purposes.

Here is a practical hedge documentation template under IFRS 9. Qualifying for Hedge Accounting

Qualifying for Hedge Accounting

Qualifying for Hedge Accounting

Qualifying for Hedge Accounting

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