Unchanged from IAS 39, to qualify for hedge accounting, a hedging relationship has to consist of eligible hedging instruments and eligible hedged items. Also, at inception of the hedging relationship, there still has to be a formal designation and documentation. This would include the entity’s risk management objective underlying the hedging relationship and how that fits within the overall risk management strategy. The documentation has to include an identification of the hedging instrument, the hedged item, the nature of the risk being hedged and how the entity will assess whether the hedging relationship meets the hedge effectiveness requirements. Qualifying criteria Designation
However, compared to IAS 39, the entity’s risk management strategy and objective are more important under IFRS 9 because of the effect on discontinuation of hedge accounting and the hedge accounting related disclosures. IFRS 9 also requires documentation of the hedge ratio and potential sources of ineffectiveness (that may have to be updated as part of a continuing hedging relationship). Qualifying criteria Designation
Like IAS 39, entities can still only designate one of three types of hedging relationships: a fair value hedge, a cash flow hedge or a hedge of a net investment in a foreign operation. For hedges of the foreign currency risk of a firm commitment, an entity may designate either a fair value hedge or a cash flow hedge. Qualifying criteria Designation
Unlike IAS 39, entities are no longer required to perform an onerous quantitative effectiveness assessment to demonstrate that the hedge in any period was highly effective, using the 80 -125% bright line. Instead, IFRS 9 uses a new approach to the effectiveness assessment that is only prospective, does not involve any bright lines and, depending on the circumstances, may also be qualitative. This approach can also require that the method for assessing effectiveness is changed in response to changes in circumstances, in which case the hedge documentation is updated but without resulting in discontinuation of the hedging relationship.Qualifying criteria Designation
Under IFRS 9, a hedging relationship qualifies for hedge accounting if it meets all of the following effectiveness requirements: Qualifying criteria Designation
- There is ‘an economic relationship’ between the hedged item and the hedging instrument. Qualifying criteria Designation
- The effect of credit risk does not ‘dominate the value changes’ that result from that economic relationship. Qualifying criteria Designation
- The hedge ratio of the hedging relationship is the same as that resulting from the quantity of hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. However, that designation shall not reflect an imbalance between the weightings of the hedged item and the hedging instrument that would create hedge ineffectiveness (irrespective of whether recognised or not) that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting.Qualifying criteria Designation
The required steps for designating a hedging relationship can be summarised in a flow chart, as follows: Qualifying criteria Designation
Qualifying criteria designation
The individual steps in the effectiveness assessment are summarised below, with links to more detailed pages.
The first requirement means that the hedging instrument and the hedged item must be expected to move in opposite directions as a result of a change in the hedged risk. This should be based on an economic rationale rather than just by chance, as could be the case if the relationship is based only on a statistical correlation. However, a statistical correlation may provide corroboration of an economic rationale.
IFRS 9 requires that, to achieve hedge accounting, the impact of changes in credit risk should not be of a magnitude such that it dominates the value changes, even if there is an economic relationship between the hedged item and hedging instrument. Credit risk can arise on both the hedging instrument and the hedged item in the form of counterparty’s credit risk or the entity’s own credit risk.
The hedge ratio is the ratio between the amount of hedged item and the amount of hedging instrument. For many hedging relationships, the hedge ratio would be 1:1 as the underlying of the hedging instrument perfectly matches the designated hedged risk.
For a hedging relationship with a correlation between the hedged item and the hedging instrument that is not a simple 1:1 relationship, risk managers will generally set the hedge ratio so as to adjust for the type of relation in order to improve the effectiveness (i.e., the hedged ratio may be different to 1:1).
The objective of IFRS 9 Hedge accounting is to represent, in the financial statements, the effect of an entity’s risk management activities. However, this does not mean that an entity can only designate hedging relationships that exactly mirror its risk management activities. In fact, in many cases entities will designate so called proxy hedges (i.e., designations that do not exactly represent the actual risk management). During the re-deliberations leading to the final standard, the Board decided that proxy hedging is permitted, provided the designation is ‘directionally consistent’ with the actual risk management activities.
See also: The IFRS Foundationing Qualifying criteria – Designation