IAS 39 provides for special hedge accounting under defined circumstances. The standard defines three types of hedging relationships: (1) fair value hedges; (2) cash flow hedges; and (3) hedges of net investment in a foreign entity. The most contentious issue regarding hedging has been the decision to apply special hedge accounting to such transactions. If all financial instruments were marked to market (fair) values, there would be no need for special accounting except, perhaps, for hedges of unrecognized firm commitments and forecasted transactions.
However, given that fair value accounting has yet to be fully accepted for financial instruments held as assets, and is even less widely accepted for financial instruments classed as liabilities, the topic of hedge accounting must be addressed.
Five Conditions to Be Met for Special Hedge Accounting Presentation
Under the provisions of IAS 39, a hedging relationship will qualify for special hedge accounting presentation if all of the following conditions are met:
1. At the inception of the hedge there is formal documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge. That documentation should include identification of the hedging instrument, the related hedged item or transaction, the nature of the risk being hedged, and how the entity will assess the hedging instrument’s effectiveness if offsetting the exposure to changes in the hedged item’s fair value or the hedged transaction’s cash flows that is attributable to the hedged risk.
2. The hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk, consistent with the originally documented risk management strategy for that particular hedging relationship.
3. For cash flow hedges, a forecasted transaction that is the subject of the hedge must be probable and present an exposure to price risk that could produce variation in cash flows that will affect reported income.
4. The effectiveness of the hedge can be reliably measured, that is, the fair value or cash flows of the hedged item and the fair value of the hedging instrument can be reliably measured.
5. The hedge was assessed and determined actually to have been effective throughout the financial reporting period. Under IAS 39, a hedging relationship could be designated for a hedging instrument taken as a whole, or, in certain specified instances, for a component of a hedging instrument. Thus, an entity could designate the change in the intrinsic value of an option as the hedge, while the remaining component of the option (its time value) is excluded.
As noted, to qualify for hedge accounting, the effectiveness of a hedge would have to be subject to effectiveness testing. The method an entity adopts for this would depend on its risk management strategy, and this could vary for different types of hedges. If the principal terms of the hedging instrument and of the entire hedged asset or liability or hedged forecasted transaction are the same, the changes in fair value and cash flows attributable to the risk being hedged offset fully, both when the hedge is entered into and thereafter until completion.
An interest rate swap is likely to be an effective hedge if the notional and principal amounts, term, re-pricing dates, dates of interest or principal receipts and payments, and basis for measuring interest rates are the same for the hedging instrument and the hedged item.
Also, to qualify for special hedge accounting under IAS 39’s provisions, the hedge would have to relate to a specific identified and designated risk, and not merely to overall entity business risks, and must ultimately affect the entity’s net profit or loss, not just its equity.
The standard provides that a hedge can be judged to be highly effective if, both at inception and throughout its life, the reporting entity can expect that changes in the fair value or cash flows (depending on the type of hedge) of the hedged item will be virtually fully offset by changes in the fair value or cash flows of the underlying or hedged item, and that actual results are within a range of 80% to 125% of full offset.
While there is flexibility in terms of how an entity measures and monitors effectiveness (and this may even vary within an entity regarding different types of hedges), the fact that IAS 39 provides quantified upper and lower effectiveness thresholds underlines the importance of making such a determination. The documentation of the entity’s hedging strategy must stipulate how this will be achieved, and hedging effectiveness must be assessed at least as often as financial reports are prepared.
Next, let’s see how each of the three types of hedging relationships prescribed by the IAS 39.
1. Fair Value Hedges
A hedge, using a derivative or other financial instrument, of the exposure to changes in the fair value of a recognized asset or liability, or an identified portion of such an asset or liability, that is attributable to a particular risk and will affect reported net income. With specific regard to fair value hedges, IAS 39 prescribes the following special hedge accounting:
- The gain or loss from remeasuring the hedging instrument at fair value is to be recognized currently in net profit or loss; and
- The gain or loss on the hedged item attributable to the hedged risk should adjust the carrying amount of the hedged item and be recognized currently in net profit or loss.
These requirements apply even if a hedged item is otherwise measured at fair value with changes in fair value recognized in other comprehensive income. Hedge accounting must be discontinued, however, when the hedging instrument expires or is sold, terminated, or exercised, or when the hedge no longer meets the criteria for qualification for hedge accounting.
When there has been an adjustment made to the carrying amount of a hedged, interest bearing instrument, it should be reclassified from equity to profit or loss as a reclassification adjustment, beginning no later than when it ceases to be adjusted for changes in fair value attributable to the risk being hedged.
What is Macrohedging? What is The Rule?
Historically, it was required that specific assets or liabilities be identified as the hedged items, but many financial managers have argued that actual fair value hedging is often conducted by acquiring a hedging position to protect against the effect of the value changes of the net asset or liability position maintained. This is known as “macrohedging” or hedging a portfolio of interest rate risks. Such an action, while sound from a management perspective, did not qualify for hedge accounting treatment under the original IAS 39.
In response to this perceived failure to address the accounting implications of common risk management strategies, IASB amended IAS 39 to permit hedge accounting for such macrohedge situations. As amended, IAS 39 permits the following rules to apply for purposes of accounting for a fair value hedge of a portfolio of interest rate risk:
1. The reporting entity identifies a portfolio of items whose interest rate risk it wishes to hedge. The portfolio may include both assets and liabilities, or could include only assets or only liabilities.
2. The reporting entity analyzes the portfolio into repricing time periods based on expected, rather than contractual, repricing dates.
3. The reporting entity then designates the hedged item as a percentage of the amount of assets (or liabilities) in each time period. All of the assets from which the hedged amount are drawn have to be items (a) whose fair value changes in response to the risk being hedged and (b) that could have qualified for fair value hedge accounting under the original IAS 39 had they been hedged individually.
4. The reporting entity designates what interest rate risk it is hedging. This risk may be a portion of the interest rate risk in each of the items in the portfolio, such as a benchmark interest rate like LIBOR or US Prime.
5. The reporting entity designates a hedging instrument for each time period. The hedging instrument may be a portfolio of derivatives (for instance, interest rate swaps) containing offsetting risk positions.
6. The reporting entity measures the change in the fair value of the hedged item that is attributable to the hedged risk. The result is then recognized in profit or loss and in one of two separate line items in the statement of financial position.
7. The reporting entity measures the change in the fair value of the hedging instrument and recognized this as a gain or loss in profit or loss. It recognizes the fair value of the hedging instrument as an asset or liability in the statement of financial position.
8. Ineffectiveness will be given as the difference in profit or loss between the amounts determined in steps 6 and 7.
A change in the amounts that are expected to be repaid or mature in a time period will result in ineffectiveness, measured as the difference between (a) the initial hedge ratio applied to the initially estimated amount in a time period and (b) that same ratio applied to the revised estimate of the amount.
2. Cash Flow Hedges
A hedge, using a derivative or other financial instrument, of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognized asset or liability (such as all or a portion of future interest payments on variable-rate debt) or forecasted transaction (such as an anticipated purchase or sale) that will affect reported income or loss.
Gain or loss relating to the portion of a cash flow hedge that is determined to be effective is to be recognized in other comprehensive income. The ineffective portion, if any, must be recognized currently in profit or loss.
Per IAS 39, the amount that has been recognized in other comprehensive income associated with the hedged item is to be adjusted to the lesser of two amounts: (1) the cumulative gain or loss on the hedging instrument needed to offset the cumulative change in expected future cash flows on the hedged item from inception of the hedge, less the portion associated with the ineffective component, or (2) the fair value of the cumulative change in expected future cash flows on the hedged item from inception of the hedge.
Any remaining gain or loss (the ineffective portion) is recognized in profit or loss, or other comprehensive income as described above.
Revised IAS 39 requires that when a hedged forecast transaction occurs and results in the recognition of a financial asset or a financial liability, the cumulative gain or loss deferred in equity does not adjust the initial carrying amount of the asset or liability (thus, the formerly acceptable method of basis adjustment has been prohibited). This remains as a separate component of equity until subsequent de-recognition or impairment, when that cumulative gain or loss should be reclassified from equity to profit or loss as a reclassification adjustment, consistent with the recognition of gains and losses on the asset or liability.
On the other hand, for hedges of forecast transactions that result in the recognition of a nonfinancial asset or a nonfinancial liability, the entity may elect whether to apply basis adjustment or retain the hedging gain or loss in equity and reclassify that gain or loss from equity to profit or loss when the asset or liability affects profit or loss.
In the case of other cash flow hedges (i.e., those not resulting in recognition of assets or liabilities), amounts reflected in other comprehensive income should be reclassified from equity to profit or loss in the period or periods when the hedged firm commitment or forecasted transaction also affects profit or loss.
Hedge accounting is to be discontinued when the hedging instrument is sold, expires, is terminated or exercised. If the gain or loss was accumulated in equity, it should remain there until such time as the forecasted transaction occurs, when it is added to the asset or liability recorded or is reclassified from equity to profit or loss when the transaction impacts profit or loss.
Hedge accounting is also discontinued prospectively when the hedge ceases meeting the criteria for qualification of hedge accounting. The accumulated gain or loss remains in equity until the committed or forecasted transaction occurs, whereupon it will be handled as discussed above.
Finally, if the forecasted or committed transaction is no longer expected to occur, hedge accounting is prospectively discontinued. In this case, the accumulated gain or loss included in equity must be immediately reclassified from equity to profit or loss.
3. Hedges of a Net Investment In a Foreign Entity
Hedges of a net investment in a foreign entity are accounted for similarly to those of cash flows. To the extent it is determined to be effective, accumulated gains or losses are reflected in other comprehensive income and in equity. The ineffective portion is reported in profit or loss.
In terms of financial reporting, the gain or loss on the effective portion of these hedges should be classified in the same manner as the foreign currency translation gain or loss.
According to IAS 21, translation gains and losses are not reported in profit or loss but instead are reported in other comprehensive income and the cumulative amounts in equity, with allocation being made to minority interest when the foreign entity is not wholly owned by the reporting entity.
Likewise, any hedging gain or loss would be reported in other comprehensive income. When the foreign entity is disposed of, the cumulative translation gain or loss would be reclassified from equity to profit or loss, as would any related deferred hedging gain or loss.
When a hedge does not qualify for special hedge accounting (due to failure to properly document, ineffectiveness, etc.), any gains or losses are to be accounted for based on the nature of the hedging instrument. If a derivative financial instrument, the gains or losses must be reported in profit or loss.
Hedges of interest rate risk on a portfolio basis (also called macrohedging). As discussed above, revised IAS 39 permits fair value hedge accounting to be used more readily for a portfolio hedge of interest rate risk than previously was the case. In particular, for such a hedge, it allows:
- The hedged item to be designated as an amount of a currency (e.g., an amount of dollars, euros, pounds, or rands) rather than as individual assets (or liabilities)
- The gain or loss attributable to the hedged item to be presented either: (a) In a single separate line item within assets, for those repricing time periods for which the hedged item is an asset; or (b) In a single separate line item within liabilities, for those repricing time periods for which the hedged item is a liability.
- Prepayment risk to be incorporated by scheduling prepayable items into repricing time periods based on expected, rather than contractual, repricing dates. However, when the portion hedged is based on expected repricing dates, the effect that changes in the hedged interest rate have on those expected repricing dates are included when determining the change in the fair value of the hedged item. Consequently, if a portfolio that contains prepayable items is hedged with a non-prepayable derivative, ineffectiveness arises if the dates on which items in the hedged portfolio are expected to prepay are revised, or actual prepayment dates differ from those expected.
Assessing Hedge Effectiveness
Under the provisions of IAS 39, assuming other conditions are also met, hedge accounting may be applied as long as, and to the extent that, the hedge is effective. By effective, the standard is alluding to the degree to which offsetting changes in fair values or cash flows attributable to the hedged risk are achieved by the hedging instrument. A hedge is generally deemed effective if, at inception and throughout the period of the hedge, the ratio of changes in value of the underlying to changes in value of the hedging instrument are in a range of 80 to 125%.
Hedge effectiveness will be heavily impacted by the nature of the instruments used for hedging. For example, interest rate swaps will be almost completely effective if the notional and principal amounts match, and the terms, repricing dates, interest and principal payment dates, and basis for measurement are the same. On the other hand, if the hedged and hedging instruments are denominated in different currencies, effectiveness will not be 100% in most instances. Also, if the rate change is partially due to changes in perceived credit risk, there will be a lack of perfect correlation as well.
Hedges must be defined in terms of specific identified and designated risks. Overall (entity) risk cannot be the basis for hedging. Also, it must be possible to precisely measure the risk being hedged; thus, threat of expropriation (which may be an insurable risk) is not a risk that can be hedged, as that term is used in IAS 39. Similarly, investments accounted for by the equity method cannot be hedged, since that would be inconsistent with the equity method of accounting. In contrast, a net investment in a foreign subsidiary can be hedged, since this is a function of currency exchange rates alone.
If a hedge does not qualify for special hedge accounting because it is not effective, any gains or losses arising from changes in the fair value of a hedged item measured at fair value, subsequent to initial recognition, are reported as otherwise prescribed by IAS 39. That is, if an item is held for trading, changes in value are reported in profit or loss; if available for sale, the changes are reported in other comprehensive income.