1 Perfect Subsequent assessment of effectiveness

Subsequent assessment of effectiveness

Under IFRS 9 derivative financial instruments are always (by definition) classified as instruments at fair value through other comprehensive income. As a result, an accounting mismatch can occur when an entity uses derivatives (hedging items or hedging instruments) to hedge against business exposures to a market risk arising from an underlying asset or liability that is not measured at fair value through profit or loss (hedged items).

Hedge accounting is intended to deal with this accounting mismatch. By adjusting the basis (hedged risk) for the hedged item in case of fair value hedges or the hedging item in respect of cash flow hedges entities can effectively use hedge accounting to reduce income statement volatility.

The accounting mismatch is calculated in a ration called the hedge ratio. The hedge ratio is required to be designated based on actual quantities of the hedged item and hedging instrument (unless doing so would create deliberate hedge ineffectiveness) – i.e. the hedge ratio applied for hedge accounting purposes should be the same as the hedge ratio used for risk management purposes.

For example, an entity hedges 90% of the foreign exchange exposure of a financial instrument. The hedging relationship should be designated using a hedge ratio resulting from 90% of the foreign currency exposure and the quantity of the hedging instrument that the entity actually uses to hedge the 90%. The accounting mismatch is calculated in a ration called the hedge ratio that is:

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Generic formula

Example

Cash flow hedge

Fair value hedge

=

Value of the Hedge Position

90

Hedging instrument

Hedging instrument1

Value of the Total Exposure

100

Hedged item2

Hedged item

Hedge effectiveness is the degree to which changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument.

Prospective assessment hedge effectivenessHedge effectiveness testing at inception

At inception of the hedge relationship (date of designation) an entity is required to assess a prospective hedge effectiveness test to demonstrate an expectation of effectiveness in order to qualify for hedge accounting.

Subsequent assessment of effectiveness

The subsequent assessment of effectiveness has become less burdensome, but 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 theSubsequent assessment of effectiveness hedging relationship during its term.

Depending on those factors, entities can perform either a qualitative or 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.

Entities no longer need to perform a retrospective quantitative effectiveness assessment using the 80% – 125% bright lines. However, this does not mean that hedge accounting continues irrespective of how effective the hedge is.

Prospective assessment in lifetimeA prospective effectiveness assessment is still required, in a similar manner as at the inception of the hedging relationship (see ‘Designation‘) and on an ongoing basis, as a minimum at each reporting date. Subsequent assessment of effectiveness

Decision tree: Effectiveness assessment and rebalancing Subsequent assessment of effectiveness

Subsequent assessment of effectiveness

An entity first has to assess whether the risk management objective for the hedging relationship has changed. A change in risk management objective is a matter of fact that triggers discontinuation. Discontinuation of hedging relationships is discussed in ‘Discontinuation‘. Subsequent assessment of effectiveness

An entity would also have to discontinue hedge accounting if it turns out that there is no longer an economic relationship. This makes sense as whether there is an economic relationship is a matter of fact that cannot be altered by adjusting the hedge ratio. The same is true for the impact of credit risk; if credit risk is now dominating the hedging relationship, then the entity has to discontinue hedge accounting.

But the hedge ratio may need to be adjusted if it turns out that the hedged item and hedging instrument do not move in relation to each other as expected. The entity has to assess whether it expects this to continue to be the case going forward. If so, the entity is likely to rebalance the hedge ratio to reflect the change in the relationship between the underlyings.

Currently, under IAS 39, when a hedge ratio is revised, entities have to discontinue the hedging relationship in its entirety and restart a new hedging relationship. For a cash flow hedge this is likely to lead to a degree of recognised ineffectiveness, as the hedging instrument will likely now have changed in fair value since it was originally designated (colloquially known as the ‘late hedge’ issue). Subsequent assessment of effectiveness

Rebalancing under IFRS 9 allows entities to refine their hedge ratio without discontinuation and so reducing this source of recorded ineffectiveness.

Rebalancing of hedged item or hedging instrument

IFRS 9 introduces the concept of ‘rebalancing’. Rebalancing refers to adjustments to the designated quantities of either the hedged item or the hedging instrument of an existing hedging relationship for the purpose of maintaining a hedge ratio that complies with the hedge effectiveness requirements. This allows entities to respond to changes that arise from the underlying or risk variables. As a result, rebalancing does not lead to de-designation and re-designation of a hedge, but it is accounted for as a continuation of the hedging relationship. However, on rebalancing, hedge ineffectiveness is determined and recognised immediately before adjusting the hedge relationship.

Rebalancing is consistent with the requirement of avoiding an imbalance in weightings at inception of the hedge, but also at each reporting date and on a significant change in circumstances, whichever comes first. Subsequent assessment of effectiveness

When rebalancing a hedging relationship, an entity must update its documentation of the analysis of the sources of hedge ineffectiveness that are expected to affect the hedging relationship during its remaining term. Subsequent assessment of effectiveness

In some circumstances, rebalancing is not applicable (for example, where the changes in the hedge relationship – which might arise from changes in the derivative counterparty credit risk – cannot be compensated by adjusting the hedge ratio). In addition, if the risk management objective has changed, rebalancing is not allowed, and hedge accounting should be discontinued.

Rebalancing assessment

Example 1 – Rebalancing not required

An entity with a EUR functional currency has a forecast purchase in HKD in six months’ time amounting to HKD7.8 million. In order to hedge its future exposure, the entity wants to purchase foreign currency (that is, enter into foreign currency forward contracts) to effectively fix the purchase price in EUR.

HKD is pegged to the USD (which means that the exchange rate is maintained within a band or at an exchange rate set by the Hong Kong Monetary Authority).

The entity could enter into a forward contract to buy HKD and pay EUR. However, entering into a forward contract to buy HKD and pay EUR is more expensive than entering into an agreement to buy USD and pay EUR (as there is a smaller market and less liquidity in HKD compared with USD). The entity decides instead to enter into a USD:EUR forward. As long as the HKD remains pegged to the USD, using a USD derivative as a hedging instrument will provide an economic hedge of the forecast HKD purchase.

The peg ratio is HKD7.8:USD1. However, even though it is pegged, it is not completely fixed (as the HKD is allowed to trade within the narrow range of HKD7.75 to 7.85). Since the range is very small, the entity is willing to accept this risk, so it enters into a forward contract for USD1 million (HKD7.8 million).

Rebalancing is not required where ineffectiveness arises merely because of fluctuations in exchange rates within the narrow trading range around the hedge ratio.

Example 2 – Rebalancing required

Consider the facts of the previous example, but assume that the exchange rate HKD:USD is re-pegged to, say, HKD7.2:USD1. If the derivative continues to be for USD1 million, the hedge ratio will no longer reflect the relationship between the hedging instrument and hedged item, and so will result in mandatory rebalancing.

Rebalancing should reflect the entity’s risk management strategy, which could either be reducing the hedged item to HKD7.2 million of the forecast purchase of HKD7.8 million, or increasing its hedging instrument by buying another derivative to cover the remaining HKD600,000 of the hedged item.

Example 3 – Rebalancing not applicable

Continuing the above example, assume that sometime after the inception of the hedge, the peg between HKD and USD is removed, such that the currency exchange rate is floating (instead of pegged) within a very broad range such that now it is not possible to demonstrate that an economic correlation exists between the two currencies. In this situation, a change in the hedge ratio would not be applicable, since this may not ensure that the hedging relationship continues to meet that hedge effectiveness requirement. Accordingly, the hedge cannot be rebalanced but may need to be discontinued.

Originally, the requirement to rebalance was seen as onerous, but it might actually be a pragmatic solution that avoids discontinuing hedging relationships that would have failed the effectiveness test in the past. In practice, entities will not need to rebalance very often if they have a good risk management strategy in place and the economic relationship is stable. There is always some volatility in any hedging relationship but, if the initial hedge ratio is appropriate and in line with the risk management strategy, rebalancing should only be necessary if the ‘ideal’ hedge ratio changes significantly. Entities should document their tolerance to such variations. Subsequent assessment of effectiveness

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Subsequent assessment of effectiveness

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