IFRS 9 Hedge Accounting Notes (Comprehensive)

IFRS 9 Hedge Accounting — Key Concepts and Examples

• IFRS 9 treats hedge accounting as an accounting policy choice that can be applied when strict criteria are met.
• Objective: offset timing/measurement differences between a hedging instrument and a hedged item to reduce profit or loss volatility.
• Hedge accounting is optional; an entity may apply it for qualifying hedges or choose not to.

Hedge accounting: criteria to apply (IFRS 9)

• The hedging relationship must involve:
  • An eligible hedged item
  • An eligible hedging instrument
• The hedging relationship must be formally designated and documented as a hedge at the inception (designation and documentation of:
  • The nature of the risk being hedged
  • The hedged item and hedging instrument
  • How hedge effectiveness will be assessed)
• Three effectiveness requirements must be met: 1) An economic relationship exists between the hedged item and the hedging instrument. 2) Credit risk does not dominate the change in value. 3) The hedge ratio is the same for:
  • The hedging relationship
  • The quantity of the hedged item actually hedged and the quantity of the hedging instrument used
    • Hedge ratio:\text{Hedge ratio} = \frac{\text{Fair value of hedging instrument}}{\text{Fair value of hedged item}}
• Qualifying hedged items (what can be hedged):
  • An existing asset or liability position (e.g., accounts receivable/payable)
  • An unrecognized firm commitment (e.g., ordered goods not yet shipped/received)
  • A highly probable future transaction (e.g., forecast revenue/expense)
  • A net investment in foreign operations (foreign currency investment in a foreign subsidiary)
• Qualifying hedging instruments:
  • Derivatives (e.g., forward contracts, interest rate swaps)
  • Non-derivatives such as monetary assets and liabilities (e.g., deposits, foreign currency-denominated debt)
• ASPE differences (for reference): hedge accounting allowed only when: 1) Hedge relationship is designated and documented. 2) Hedging instrument and hedged item have the same critical terms. 3) For anticipated transactions, the expected transaction is probable.
  • ASPE examples include use of forward contracts to hedge anticipated foreign currency cash flows or commodities, and the use of an interest rate swap to hedge interest rate risk on recognized loans.

Types of hedges under IFRS 9

• Fair value hedge: hedge of the exposure to changes in the fair value of a recognized asset or liability (or an unrecognized firm commitment) or a component thereof attributable to a particular risk.
  • Example: hedge FX risk on a foreign currency-denominated receivable.
• Cash flow hedge: hedge of the exposure to variability in cash flows that is attributable to a particular risk of a recognized asset/liability or a highly probable forecast transaction.
  • Example: hedging all or part of future interest payments on variable-rate debt or a forecast sales in foreign currency.
• Hedge of a net investment in a foreign operation: hedge of FX risk related to investment in foreign operation with different functional currencies.
  • Note: This is a variation of cash flow hedge; often complex and not covered in all introductory CPA material.

Qualifying hedged items and instruments (IFRS 9)

• Qualifying hedged item: any item entity wants to protect from FX rate variability.
  • Examples: existing asset/liability (receivable/payable), unrecognized firm commitment, highly probable forecast transaction, net investment in foreign operation.
• Qualifying hedging instrument: used to reduce/eliminate exposure to risk on the hedged item.
  • Examples: forwards (to buy/sell foreign currency), non-derivative monetary assets/liabilities in a foreign currency.
• Qualifying criteria (summary):
  1) Hedging relationship must consist of a qualifying hedged item and a qualifying hedging instrument.
  2) At inception, hedging relationship and risk management objective/strategy documented (nature of risk, items involved, how effectiveness will be assessed).
  3) Three effectiveness requirements met (economic relationship, credit risk not dominating, hedge ratio alignment).
• Hedge ratio definition (revisited):\text{Hedge ratio} = \frac{\text{Fair value of hedging instrument}}{\text{Fair value of hedged item}}

Forward contracts: basics and accounting (IFRS 9 context)

• A forward contract is an agreement to buy or sell an asset on a future date at a specified price.
• Common forwards include foreign currencies, commodities, and financial instruments.
• Key forward contract terms:
  • Forward contract date: when the contract is entered into.
  • Forward contract rate: rate specified for future delivery/sale.
  • Settlement date: date on which exchanges occur.
  • Spot rate: rate for immediate purchase/delivery.
  • Forward rate: rate for future purchase/delivery.
• For forwards to hedge, treat them as two-sided instruments: receivable from bank and payable to bank. Both are measured at fair value.
  • At inception: both sides recorded at the forward contract rate.
  • Throughout life: fixed side remains at forward rate; the variable side is updated to reflect changes in forward rates.
  • On settlement: update the variable side to spot rate; settle the contract.
• Net vs gross method for forwards:
  • Net method: record net difference as a forward contract asset/liability; no separate GL entries for the two sides.
  • Gross method: record each side separately; but presentation-netting in FS; both methods yield the same accounting outcome.
• Summary of forward contract accounting (timeline):
  • At inception: record receivable and payable at forward rate.
  • Throughout term: update variable side to forward rate; recognize FX gain/loss in profit or loss.
  • Settlement: update variable side to spot rate; recognize FX gain/loss in profit or loss; settle the contract.
• Speculation vs hedging:
  • If a forward contract is entered into without a hedged item, it is a speculative position (expecting asset value to move favorably).
  • If the purpose is hedging a forecasted or existing exposure, it qualifies for hedge accounting if criteria are met.

Example: 42.1a forward contract (illustrative)

• Scenario: ABC Corp. agrees to buy US$100,000 on Jan 31, Year 2, at a forward rate of C$1.22 per US$1; Year-end date is Dec 31.
• Rates:
  • Spot: Dec 1, Year 1 = US$1 = C$1.20
  • Spot: Dec 31, Year 1 = US$1 = C$1.18
  • Forward rate (delivery on Jan 31, Year 2): US$1 = C$1.22; forward for settlement date (Jan 31, Year 2) = C$1.19
• Journal entries (illustrative):
  • December 1, Year 1: DR Receivable from bank (US$100,000 × C$1.22) 122,000; CR Payable to bank 122,000.
  • Rationale: at inception, both sides translated at forward contract rate; payable is fixed by contract.
  • December 31, Year 1: DR Foreign exchange loss 3,000; CR Receivable from bank [US$100,000 × (1.19 − 1.22)] 3,000.
  • Rationale: year-end FX movement on the forward contract variable side recognized as FX loss.
• Notes: The forward rate beyond inception is used to measure the fixed side; the variable side moves with exchange rates.

Hedge accounting in practice: 42.2 and related concepts

• Hedge accounting concept: two separate transactions accounted as one linked item to offset temporary P&L volatility.
• It is based on IFRS 9 requirements; not mandatory.
• Three hedge types (recap):
  • Fair value hedge
  • Cash flow hedge
  • Hedge of a net investment in a foreign operation (variation of cash flow hedge)
• Qualifying hedged items (reiterate): existing asset/liability, unrecognized firm commitment, highly probable forecast transaction, net investment in foreign operation.
• Qualifying hedging instruments (reiterate): forwards (derivatives) and non-derivatives (monetary assets/liabilities in foreign currency).

42.2.1: Qualifying criteria for hedge accounting (IFRS 9)

• 1) The hedging relationship must consist of a qualifying hedged item and a qualifying hedging instrument.
• 2) At inception, hedging relationship must be formally designated and documented (risk, items, hedging instrument, and how effectiveness will be assessed).
• 3) The following three effectiveness requirements must be met:
  • An economic relationship exists between the hedged item and hedging instrument.
  • Credit risk does not dominate the change in value.
  • The hedge ratio is the same for both the hedging relationship and the hedged/hedging quantities; i.e., the hedge ratio equates the relative changes in FV:
    \text{Hedge ratio} = \frac{\text{Fair value of hedging instrument}}{\text{Fair value of hedged item}}

42.2a: Example – hedging a foreign currency receivable with a forward contract

• Facts: On Oct 1, Year 1, Hotel Software Inc. (HSI) sells software to a US hotel chain for US$80,000, due Jan 31, Year 2. HSI enters into a forward contract to sell US$80,000 on Jan 31, Year 2 to hedge the FX risk on the US$ receivable. HSI has a Dec 31 year end.
• Can HSI designate the forward as a hedge?
  • Step 1: Identify qualifying items and instruments.
  • Hedged item: US$ receivable (existing asset) → Qualifying hedged item.
  • Hedging instrument: forward contract to sell US$80,000 → Qualifying hedging instrument.
  • Step 2: Relationship of gains/losses offsetting hedge risk.
  • A fall in spot US$→C$ leads to FX loss on receivable; a fall in forward rate for the contract would lead to FX gain on the forward; offsetting effect minimizes net FX effect on P&L.
  • Hedge effectiveness is measured by how well changes in the forward contract offset changes in the US$ receivable; criterion MET.
  • Step 3: Economic relationship between hedged item and hedging instrument.
  • Both are measured relative to FX movements; spot rate vs forward rate movements generally in the same direction considering carrying costs and expected interest income; correlation exists; criterion MET.
  • Step 4: Hedge ratio at inception is 100% (the hedge is sized to cover the full US$80,000 of receivable); criterion MET.
• Conclusion: HSI can designate the forward contract as a hedge of the US$ receivable.

Practical implications and common considerations

• Hedging is not automatic; it requires formal designation and thorough documentation to qualify for hedge accounting.
• Hedge accounting changes where gains/losses are recognized in OCI (for cash flow hedges, in some cases) or in the income statement, depending on the hedge type and the timing of the hedged item’s impact on P&L.
• For cash flow hedges, the effective portion of the hedge (IFRS 9) is typically recorded in OCI and later reclassified to the income statement when the hedged item affects earnings.
• For fair value hedges, changes in the fair value of both the hedged item and the hedging instrument are recognized in profit or loss (with the hedged item's FV changes offset by changes in the instrument).

Real-world relevance and implications

• Hedge accounting provides a tool to manage exposure to FX, interest rate, and commodity risks, aligning accounting with risk management activities.
• It affects reported earnings volatility, balance sheet presentation, and risk management policies.
• Practitioners must weigh the benefits of hedge accounting (reduced earnings volatility) against the costs and complexities of documentation and ongoing effectiveness assessments.

Quick reference: key terms

• Hedged item: item exposed to variability in risk to be hedged (asset, liability, forecast transaction, or net investment).
• Hedging instrument: instrument used to mitigate that risk (derivative or non-derivative).
• Cash flow hedge: hedges variability in cash flows from a recognized asset/liability or forecast transaction.
• Fair value hedge: hedges exposure to changes in the fair value of a recognized asset/liability or firm commitment.
• Hedge ratio:\text{Hedge ratio} = \frac{\text{Fair value of hedging instrument}}{\text{Fair value of hedged item}}
• Net vs gross method: accounting approaches for presenting forwards; net method records net exposure, gross method records both sides separately (presentation can net in FS).
• Forward contract terms: forward date, forward rate, spot rate, settlement date.
• Speculation vs hedging: hedging requires an identified hedged item; speculation is without a hedged item and generally does not qualify for hedge accounting.

Summary takeaway

• Hedge accounting under IFRS 9 is a policy choice that can reduce P&L volatility if and only if the hedging relationship is properly designated, documented, and effective under all required criteria (economic relationship, no dominant credit risk, correct hedge ratio).
• Forward contracts are common hedging instruments; understanding which side is fixed (receivable/payable) and when to recognize FX gains/losses is essential for proper accounting.
• Real-world examples (e.g., 42.1a and 42.2a) illustrate how to determine qualifying items/instruments, assess effectiveness, and implement hedge accounting in practice.