Hedges of exposures affecting other comprehensive income Hedges of exposures affecting OCI
Only hedges of exposures that could affect profit or loss qualify for hedge accounting. The sole exception to this rule is when an entity is hedging an investment in equity instruments for which it has elected to present changes in fair value in OCI, as permitted by IFRS 9. Using that election, gains or losses on the equity investments will never be recognised in profit or loss.
For such a hedge, the fair value change of the hedging instrument is recognised in OCI. Ineffectiveness is also recognised in OCI. On sale of the investment, gains or losses accumulated in OCI are not reclassified to profit or loss.
Consequently, the same also applies for any accumulated fair value changes on the hedging instrument, including any ineffectiveness.
Entities often purchase or sell items (in particular, commodities) that expose them to more than one type of risk. When hedging those risk exposures, entities do not always hedge each risk for the same time period. This is best explained with an example:
2. In this example, we assume there is no ‘basis risk’ between the copper price exposures in the expected purchase and the futures contract, such as the effect of quality and the location of delivery.
IAS 39 precludes derivatives from being designated as part of a hedged item for accounting purposes. Applying IAS 39 to the scenario in Example 2 above, an entity would have two choices:
Discontinue the first hedging relationship (i.e., the copper price risk hedge) and re-designate a new relationship with joint designation of the copper futures contract and the foreign exchange forward contract as the hedging instrument. This is likely to lead to some ‘accounting’ hedge ineffectiveness as the copper futures contract will now have a non-zero fair value on designation of the new relationship.
Maintain the copper price risk hedge and designate the foreign exchange forward contract in a second relationship as a hedge of the variable USD copper price. Even if the other IAS 39 requirements could be met, this means that the volume of hedged item is constantly changing as the variable copper price is hedged for foreign exchange risk, which will likely have an impact on the effectiveness of the hedging relationship.
IFRS 9 expands the range of eligible hedged items by including aggregated exposures that are a combination of an exposure that could qualify as a hedged item and a derivative.
Consequently, in the scenario described in the example provided above, the entity could designate the foreign exchange forward contract in a cash flow hedge of the combination of the original exposure and the copper futures contract (i.e., the aggregated exposure) without affecting the first hedging relationship. In other words, it would no longer be necessary to discontinue and re-designate the first hedging relationship.
The individual items in the aggregated exposure are accounted for separately, applying the normal requirements of hedge accounting (i.e., there is no change in the unit of accounting; the aggregated exposure is not treated as a ‘synthetic’ single item). For example, when hedging a combination of a variable rate loan and a pay fixed/receive variable interest rate swap (IRS), the loan would still be accounted for at amortised cost with the IRS presented separately in the statement of financial position. An entity would not be allowed to present the IRS and the loan (i.e., the aggregated exposure) together in one line item (i.e., as if it were one single fixed rate loan). Hedges of exposures affecting OCI
However, when assessing the effectiveness and measuring the ineffectiveness of a hedge of an aggregated exposure, the combined effect of the items in the aggregated exposure has to be taken into consideration. This is of particular relevance if the terms of the hedged item and the hedging instrument in the first hedging relationship do not perfectly match, e.g., if there is basis risk. Any ineffectiveness in the first level relationship would automatically also lead to ineffectiveness in the second level relationship.
Basis risk, in the context of hedge accounting, refers to any difference in the underlyings of the hedging instrument and the hedged item. Basis risk usually results in a degree of hedge ineffectiveness. For example, hedging a cotton purchase in India with NYMEX cotton futures contracts is likely to result in some ineffectiveness, as the hedged item and the hedging instrument do not share exactly the same underlying price. Hedges of exposures affecting OCI
The following examples, partly derived from illustrative examples in the implementation guidance of IFRS 9, help to further explain the concept of a hedge of an aggregated exposure:
The concept of hedging aggregated exposures as such is straightforward. However, the accounting for such relationships includes some (necessary) complexity. The accounting mechanics are explained in detail in the illustrative examples in paragraphs IE7-IE39 of the implementation guidance of IFRS 9. In the last example above, where an entity has a cash flow hedge in the first-level relationship that is then designated as the hedged item in a fair value hedge, the cross-currency interest rate swap is both a hedging instrument and part of a hedged item at the same time but in different hedging relationships. Its fair value changes are recognised in OCI, but at the same time, should also offset the fair value changes in profit or loss of the interest rate swap in the second-level relationship. This requires a reclassification of the amounts recognised in OCI to profit or loss (to the extent they relate to the second-level relationship) to achieve the offset in the fair value hedging relationship. Hedges of exposures affecting OCI
As explained in the illustrative examples in the implementation guidance, the application of hedge accounting to an aggregated exposure gets even more complicated when basis risk is involved in one of the hedging relationships, in particular if basis risk is present in the first-level relationship. Hedges of exposures affecting OCI
The definition of an aggregated exposure includes a forecast transaction of an aggregated exposure. An example, where this might be helpful is when pre-hedging the interest rate risk in a forecast foreign currency debt issue: Hedges of exposures affecting OCI
As an aggregated exposure is a combination of an exposure and a derivative, the aggregated exposure is often a hedging relationship itself (the first-level relationship). IFRS 9 only requires the first-level relationship to be one that could qualify for hedge accounting. The application of hedge accounting for the first-level relationship is not required in order to qualify for hedge accounting for the aggregated exposure. However, applying hedge accounting to the aggregated exposure is more complex when hedge accounting is not applied to the first-level relationship.