A group designation can also consist of hedging a component of a group of items, such as a layer component of a group. A component could also be a proportion of a group of items, such as 50% of a fixed rate bond series with a total volume of CU 100m. Whether an entity designates a layer component or a proportionate component depends on the entity’s risk management objective.
The benefits of identifying a layer component, discussed at ‘Hedge accounting requirements in IFRS 9‘, may be even more relevant when applied to a group of items. A bottom layer hedging strategy is, in fact, a designation of a component of a group.
Examples are as follows:
- A bond issue of CU 50m that is made up of 50,000 fixed rate bonds with a face value of CU 1,000 each. If the issuer expects that it might repurchase up to CU 10m of the issue volume before maturity it could hedge the benchmark component of the fair value interest rate risk with a receive fixed/pay variable interest rate swap that has a notional amount of CU10m. From an economic perspective, that hedge would allow repurchases of up to CU 10m total face value for which the gain or loss from changes in the benchmark interest rate would be compensated by the gain or loss on the swap. However, this can only be reflected in the accounting if the entity can designate a CU 10m top layer (i.e., for the first CU 10m of face value that are repurchased, the entity would include a fair value hedge gain or loss on the full face value when determining the gain or loss on derecognition of the bonds). If it was not permitted to designate a layer of a group of items, entities would in such cases either have to identify individual items within the group and designate them on a standalone basis or prorate the fair value hedge gain or loss to the entire bond issue volume. The IASB believes this would result in arbitrary accounting results and decided to allow layer component designations for group of items.
- A part of a monetary transaction volume (such as the next CU10 cash flows from sales denominated in a foreign currency after the first CU20 in March 201X);
- A part of a physical or other transaction volume (such as the first 100 barrels of the oil purchases in June 201X, or the first 100 MWh of electricity sales in June 201X); or
- A layer of the nominal amount of the hedged item (such as the last CU80 million of a CU100 million firm commitment, or the bottom layer of CU20 million of a CU100 million fixed rate bond, where the defined nominal amount is CU100 million).
A layer component of a group of items only qualifies for hedge accounting if:
- The layer is separately identifiable and reliably measurable.
- The risk management objective is to hedge a layer component.
- The items in the group from which the layer is identified all share the same risk.
- For a hedge of existing items, the items in the group can be identified and tracked.
- Any items in the group containing prepayment options meet the requirements for components of a nominal amount (see ‘Hedge accounting requirements in IFRS 9‘).
If a layer component is designated in a fair value hedge, an entity must specify it from a defined nominal amount. To comply with the requirements for qualifying fair value hedges, an entity must remeasure the hedged item for fair value changes attributable to the hedged risk. The fair value adjustment must be recognised in P&L no later than when the item is derecognised. Therefore, it is necessary to track the item to which the fair value hedge adjustment relates. Entities are required to track the nominal amount from which the layer is defined in order to track the designated layer (for example, the total defined amount of CU 100 million sales must be tracked in order to track the bottom layer of CU 20 million sales or the top layer of CU 30 million sales).
A layer of a contract that includes a prepayment option (if the fair value of the prepayment option 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 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.
Hedging a component of a group
See also: The IFRS Foundation