IAS 39 places several restrictions on the types of instruments that can qualify as hedging instruments for hedge accounting purposes. This is to reflect that hedge accounting was mainly intended to address accounting mismatches that resulted from requiring derivatives to be accounted for at fair value through profit or loss. IFRS 9 takes a different approach that focuses on which instruments are used for hedging. As a result, entities are also now permitted to designate, as hedging instruments, non-derivative financial assets or non-derivative financial liabilities that are accounted for at fair value through profit or loss1. Consequently:
- A liability designated as at fair value through profit or loss (for which the amount of its change in fair value that is attributable to changes in the credit risk of that liability is presented in OCI) does not qualify as a hedging instrument. This is because the entire fair value change is not recognised in profit or loss, which would in effect allow the entity to ignore its own credit risk when assessing and measuring hedge ineffectiveness and thus conflict with the concepts of hedge accounting.
- An equity instrument for which an entity has elected to present changes in fair value in OCI does not qualify as a hedging instrument in a hedge of foreign currency risk. Again, this reflects that fair value changes are not recognised in profit or loss, which is incompatible with the mechanics of fair value hedges and cash flow hedges.
The ability to designate non-derivative hedging instruments can be helpful if an entity does not have access to derivatives markets (e.g., because of local regulations that prohibit the entity from holding such instruments); does not want to be subject to margin requirements, nor enter into uncollateralised over-the-counter derivatives. Purchasing and selling financial investments in such cases can be operationally easier for entities than transacting derivatives.
IAS 39 contains a restriction that a hedging relationship cannot be designated for only a portion of the time period during which a hedging instrument remains outstanding. In essence, this restriction remains, however, it is now formulated more precisely, in that a hedging instrument may not be designated for a part of its change in fair value that results from only a portion of the time period during which the hedging instrument remains outstanding. This clarifies that an entity cannot designate a ‘partial-term’ component of a financial instrument as the hedging instrument, but only the entire instrument for its remaining life (notwithstanding that an entity may exclude from designation the time value of an option, the forward element of a forward contract or the foreign currency basis spread, see ‘Time value of options‘ and ‘Forward element of forward contracts and foreign currency basis spread of financial instruments‘ ).
For hedges of foreign currency risk, the foreign currency risk component of a non-derivative financial instrument is determined in accordance with IAS 21 The Effects of Changes in Foreign Exchange Rates. This means that an entity could, for example, hedge the spot risk of highly probable foreign currency forecast sales in 12 months’ time that with a seven-year financial liability denominated in the same foreign currency. However, when measuring ineffectiveness, the foreign currency revaluation of the forecast sales would have to be discounted, whereas the hedging instrument (i.e., the IAS 21-based foreign currency component of the financial liability) would not. This would result in some ineffectiveness (see ‘The effect of the time value of money‘).
Also unchanged from IAS 39, derivatives measured at fair value through profit or loss still qualify as hedging instruments. The sole exception to this rule continues to be written options, unless the written option is designated to offset a purchased option. This would also include hedges of purchased options embedded in another financial instrument.
Two or more financial instruments can be jointly designated as hedging instruments. This was already permitted under IAS 39. Also unchanged is the requirement that a single instrument combining a written option and a purchased option, such as an interest rate collar, cannot be a hedging instrument if it is a net written option at the date of the designation.
In practice, many zero cost collars are transacted as legally separate written and purchased options. On the face of it, therefore, it could be argued that such transactions cannot be treated as a combined hedging instrument. In what we believe to be a clarification, IFRS 9 specifically permits such jointly designated hedging instruments if the combined instrument is not a net written option at the date of designation.
The requirement that the hedging instrument has to be a contract with a party external to the reporting entity remains.