Objective of hedge accounting provides the introduction a a few narratives to obtain an understanding of hedge accounting under IFRS 9. All hedge accounting narratives are listed here. Every entity is exposed to business risks from its daily operations. Many of those risks have an impact on the cash flows or the value of assets and liabilities, and therefore, ultimately affect profit or loss. In order to manage these risk exposures, companies often enter into derivative contracts (or, less commonly, other financial instruments) to hedge them.
Hedging can, therefore, be seen as a risk management activity in order to change an entity’s risk profile. Objective of hedge accounting
Applying the normal IFRS accounting requirements to those risk management activities can then result in accounting mismatches when the gains or losses on a hedging instrument are not recognised in the same period(s) and/or in the same place in the financial statements as gains or losses on the hedged exposure. The idea of hedge accounting is to reduce this mismatch by changing either the measurement or (in the case of certain firm commitments) recognition of the hedged exposure, or the accounting for the hedging instrument. Objective of hedge accounting
Although the hedge accounting requirements in IAS 39 resolve many of the above-mentioned accounting mismatches, they do not accommodate some risk management activities that are commonly applied in practice. Furthermore, some of the requirements in IAS 39 are arguably arbitrary, such as the 80% – 125% effectiveness requirement, and may lead to economic risk management activities not or no longer qualifying for hedge accounting. Objective of hedge accounting
As a result, the financial statements of many entities do not necessarily reflect what is done for risk management purposes, which is unhelpful for preparers and users alike. The IASB took this as the cornerstone of its project for a new hedge accounting model.
Consequently, the objective of the hedge accounting requirements brought by IFRS 9 is to ‘represent, in the financial statements, the effect of an entity’s risk management activities.’ This is a rather broad objective that focuses on an entity’s risk management activities and reflects what the Board wanted to achieve with the new accounting requirements. However, this broad objective does not override any of the hedge accounting requirements, which is why the Board noted that hedge accounting is only permitted if all the new qualifying criteria are met (see ‘Qualifying criteria‘) Objective of hedge accounting
Linking hedge accounting with an entity’s risk management activities requires an understanding of what those risk management activities are. IFRS 9 distinguishes between the risk management strategy and the risk management objective: Objective of hedge accounting
The risk management strategy is established at the highest level of an entity and identifies the risks to which the entity is exposed and whether and how the risk management activities should address those risks. For example, a risk management strategy could identify changes in interest rates of loans as a risk and define a specific target range for the fixed to floating rate ratio for those loans. The strategy is typically maintained for a relatively long period of time. However, it may include some flexibility to react to changes in circumstances.
IFRS 9 refers to the risk management strategy as normally being set out in ‘a general document that is cascaded down through an entity through policies containing more specific guidelines.’
The Board added specific disclosure requirements to IFRS 7 Financial Instruments: Disclosures that should allow users of the financial statements to understand the risk management activities of an entity and how they affect the financial statements (see ‘Disclosures – Risk management strategy‘): Objective of hedge accounting
The risk management objective, on the contrary, is set at the level of an individual hedging relationship and defines how a particular hedging instrument is designated to hedge a particular hedged item. would define how a specific interest rate swap is used to ‘convert’ a specific fixed rate liability into a floating rate liability. Hence, a risk management strategy would usually be supported by many risk management objectives.
Small and medium-sized entities with limited risk management activities that use financial instruments, may not have a formal written document outlining their overall risk management strategy in place. Those entities do not have the benefit of being able to incorporate the risk management strategy in their hedge documention by reference to a formal policy document but instead have to include a description of their risk management strategy directly in their hedge documentation. Also, there are disclosure requirements for the risk management strategy that apply irrespectively of whether an entity uses a formal written policy document as part of its risk management activities.
Two examples of a risk management strategy with a related risk management objective are illustrated below:
Understanding the difference between the risk management strategy and the risk management objective is critical, as a change in a risk management objective, or a specific action without a corresponding change in the risk management objective, may affect the ability to continue applying hedge accounting. This is illustrated in Discontinuation of hedge accounting.
See also: The IFRS Foundation