With respect to the effectiveness assessment, it is important to note that in practice, often in association with the elimination of the retrospective effectiveness test previously required under IAS 39, it can be concluded that calculation of retrospective ineffectiveness is no longer required. This perspective can only be accepted in very restrictive cases, as a quantitative measurement of changes in the value of hedged items and hedging instruments to generate accounting entries is generally still required (cf. IFRS 184.108.40.206). In this sense, while the retrospective effectiveness test including the 80 – 125% range has been eliminated (cf. IAS 39.88(d); IFRS 9.BC6.237), the quantitative measurement of changes in value remains indispensable. In general the discussions on extended application options for hedge accounting under IFRS 9 are mostly restricted to the application of cash flow hedges and further options to hedge commodity risks. The application criteria and designation options for hedge accounting are not, however, based on the different classifications of hedge accounting, but apply across the board. In this respect, the newly introduced designation options and concepts are also relevant for fair value hedges and should not be disregarded. A summary of the significant new features of the complex topic of hedge accounting with effects on fair value hedges under IFRS 9 is given below.
A significant new feature under IFRS 9 is the further specification of changes in value of hedged items in respect of hedge effectiveness. As a result, changes in value that are solely included in the hedging instrument and not in the hedged item, such as foreign currency basis spreads for foreign currency risks, may no longer be ascribed to the hedged item. (cf. IFRS 9.B6.5.5). To that extent, the forward-to-forward designation for the application of hedge accounting (also full fair value) frequently practised under IAS 39 needs to be scrutinised further and no longer appears to be possible without change, especially for foreign currency risks.
In addition to specifying changes in value of the hedged item, an alternative option has been created to present unavoidable components of changes in value of hedging instruments in accordance with the (economic) risk management. In conformity with an option price (mostly equivalent to the time value), which is viewed by entities as a type of insurance premium (cost of hedging) of a risk exposure, IFRS 9 allows treatment of the time value as a type of insurance premium or cost of hedging in the statement of financial position (cost of hedging approach; cf. IFRS 9.B6.5.29 et seqq).
The concept of the cost of hedging specifies that the time value of an option or the forward element of a forward contract and/or any foreign currency basis spreads is exempt from designation as a hedging instrument and is recognised separately as cost of hedging (cf. IFRS 220.127.116.11 et seqq). To this extent, the undesignated component of the derivative does not constitute a non-derivative component of the designated hedging instrument and has no further impact on the effectiveness of the hedging relationship.1
Application of the cost of hedging approach is mandatory for designation of the intrinsic value of an option (cf. IFRS 18.104.22.168). By contrast, there is the option to recognise the forward element and/or the foreign currency basis spread as cost of hedging when designating the spot element of a forward contract (cf. IFRS 22.214.171.124). As already noted, the requirements for the cost of hedging generally do not make a distinction between the different hedge accounting classifications, meaning that it is also possible to apply the cost of hedging to fair value hedges.
Use of the cost of hedging approach is mostly discussed only in the context of designating cash flow hedges and hedges of a net investment in a foreign operation, not in the context of fair value hedges. The reason why the discussion is restricted to cash flow hedges and hedges of a net investment in a foreign operation is that the measurement concept involving the recognition of changes in value of the hedging instrument out of profit or loss in applying the cost of hedging approach is retained and here too the respective changes in value of the forward element/time value component are recognised outside of profit or loss in a separate reserve in equity (cost of hedging reserve). As a result, in applying the cost of hedging approach for fair value hedges (for instance spot-to-spot designation) to the situation, changes in the value of hedging instruments are recognised according to two different measurement concepts. The designated changes in value of the hedging instrument are to be recognised in profit or loss in accordance with the requirements of fair value hedge accounting. Remember: for fair value hedge accounting, generally the measurement concept of the hedged item – and not that of the hedging instrument – is discontinued and no effects on profit or loss arise overall in the case of full effectiveness based on synchronous recognition of offsetting changes in the value of the hedged item and hedging instrument (cf. IFRS 126.96.36.199). By contrast, under the cost of hedging approach, the measurement concept for the undesignated changes in value of the hedging instrument is discontinued, resulting in (the possibility of) the initial recognition of changes in value in equity in the cost of hedging reserve.
Time-period related hedged items affect profit or loss over a specific time period; the cumulative amount in the cost of hedging reserve is regarded as part of the Reclassification of the cumulative changes in value in the cost of hedging reserve is dependent on the hedged item, with a distinction being made between time-period related hedged items and transaction related hedged items (cf. IFRS 188.8.131.52 et seq.; IFRS 9.B6.5.29; IFRS 9.B6.5.34).
- costs for hedging a risk exposure and reclassified over the period of the hedged item's effect on profit or loss. An example is the hedging of a commodity inventory asset over a period of nine months.
- Transaction-related hedged items affect profit or loss at a defined point in time; the cumulative amount in the cost of hedging reserve is regarded as part of the costs of the transaction and reclassified at the date of the hedged item's effect on profit or loss. An example of this is the expected purchase of commodities.
Implementation of the cost of hedging approach for fair value hedges enables a reassessment of designated hedging strategies not previously recognised in the statement of financial position, such as the (statement of financial position) hedging of inventory assets in the area of commodities. While IAS 39 in each case requires that unpredictable volatility arising from the forward element of the hedging instrument be recognised in profit or loss, changes in value of the forward element under IFRS 9 can be allocated over the period of the hedging relationship and thus unpredicted volatility can be avoided.2
Other new developments relating to the application requirements also need to be observed. In general, the same methods that were applied under IAS 39 can be used for the assessment of effectiveness and the economic relationship. In respect of fair value hedge accounting under IFRS 9, the following expedients for the assessment of effectiveness are apparent:
- For the critical terms match, a full match of significant measurement parameters is no longer required; instead it is sufficient if they are closely aligned (cf. IFRS 9.B6.4.14).
- In recent times, the hypothetical derivative method can also be used as an assessment of hedge effectiveness for fair value hedges, whereas this method had been considered questionable under IAS 39 (cf. KPMG Insights 16th ed. (2019/2020) 7I.7.630.50).
With respect to the effectiveness assessment, it is important to note that in practice, often in association with the elimination of the retrospective effectiveness test previously required under IAS 39, it can be concluded that calculation of retrospective ineffectiveness is no longer required. This perspective can only be accepted in very restrictive cases, as a quantitative measurement of changes in the value of hedged items and hedging instruments to generate accounting entries is generally still required (cf. IFRS 184.108.40.206). In this sense, while the retrospective effectiveness test including the 80 – 125% range has been eliminated (cf. IAS 39.88(d); IFRS 9.BC6.237), the quantitative measurement of changes in value remains indispensable.
Our accounting experts in the Finance and Treasury Management Team are available to answer your questions and would be happy to present you the different options for the balance sheet presentation of hedging relationships for your business environment.
Source: KPMG Corporate Treasury News, Edition 104, September 2020
1 Effectiveness of the hedging relationship refers to the opposite movements in value of the designated hedged item and hedging instrument, with changes in value of the forward element, foreign currency basis spread or time value not being considered. Regardless of this, discontinuation of the hedging relationship, meaning no matching of significant measurement parameters, results in corresponding effects on the statement of profit or loss.
2 It should however be noted that the cost of hedging approach can only be applied to the aligned forward element or the aligned time value component. For consistency of the parameters relevant to measurement, measurement of an adjusted aligned forward element or aligned time value component is not necessary. If there is no consistency of the significant measurement parameters of the hedged item and the hedging instrument, measurement of the aligned forward element or aligned time value component is required. Depending on whether the values differ and whether a contingent or unconditional hedging instrument is involved, different accounting routines need to be implemented (cf. IFRS 9.B6.5.33, IFRS 9.B6.5.38).