What’s the issue?
If a company applies hedge accounting as part of its risk management strategy under IAS 39 Financial Instruments: Recognition and Measurement or IFRS 9 Financial Instruments, then in times of economic uncertainty it may need to consider whether:
- the hedge accounting criteria in IFRS® Standards continue to be met;
- there is hedge ineffectiveness to recognise in profit or loss; and
- amounts accumulated in a cash flow hedge reserve need to be reclassified to profit or loss.
Economic uncertainty may affect when and how a company applies hedge accounting.
Getting into more detail
Companies frequently enter into cash flow hedges of forecast transactions, such as purchases and sales of raw materials, and inventories. A forecast transaction can be designated as a hedged item only if it is highly probable to occur. This assessment needs to reflect the expectations at the reporting date. External events – e.g. a natural disaster, geopolitical event or pandemic – may cause economic uncertainty resulting in supply chain disruption and a significant impact on the growth of the global economy.
If such events reduce the probability of a hedged forecast transaction occurring or they affect its timing, then the hedge accounting relationship may need to be terminated or there may be hedge ineffectiveness. Similarly, a reduction in the volume of highly probable forecast transactions may lead to partial termination under IFRS 9. [IAS 39.101(b), IFRS 188.8.131.52, B6.5.25, B6.5.27(b), BC6.317]
When a hedging relationship is discontinued because a forecast transaction is no longer highly probable, a company needs to determine whether the transaction is still expected to occur. If the transaction is:
- still expected to occur, then gains or losses on the hedging instrument previously accumulated in the cash flow reserve would generally remain there until the future cash flows occur; or
- no longer expected to occur, then the accumulated gains or losses on the hedging instrument need to be immediately reclassified to profit or loss. [IAS 39.101(b)–(c), IFRS 184.108.40.206(a)–(b)]
In addition, any changes to the contractual terms of a financial instrument, resulting from the economic and/or geopolitical uncertainty, may affect the instrument’s eligibility as a hedged item. For example, a bank may be applying fair value hedge accounting to term deposits whose terms and conditions include significant penalties in the case of early withdrawals. If a bank waives its right to penalties to allow customers to withdraw deposits early, then the contracts could be viewed as demand deposits. This could mean that the hedging relationship is discontinued because there would be no fair value exposure to hedge. [IAS 39.AG118(b), BC87(d), IFRS 13.47]
Hedge effectiveness and ineffectiveness
A company considers the effect of changes in both counterparty credit risk and own credit risk when assessing hedge effectiveness and measuring hedge ineffectiveness. The increased credit risk, arising from economic and/or geopolitical uncertainty, could therefore affect both hedge effectiveness testing and the measurement of hedge ineffectiveness. [IAS 39.AG109, IFRS 9.B6.4.7]
For example, if a hedged financial asset becomes credit-impaired due to the failure of a Russian counterparty, then the current hedging relationship is discontinued if the hedge no longer meets the applicable effectiveness requirements.
In addition, if there is an increase in the credit risk of a hedging instrument, then fair value changes due to the increased credit risk are not generally offset by changes in the value of the hedged item attributable to the hedged risk. This may lead to increased ineffectiveness or even failure of the effectiveness requirements.
Irrecoverability of losses in the cash flow hedge reserve
If the amount accumulated in the cash flow hedge reserve for a particular cash flow hedge is a loss and the company expects that all or a portion of that loss will not be recovered in future periods, then it immediately reclassifies to profit or loss the amount that is not expected to be recovered. The consequences of economic turbulence may increase the risk of this occurring. For example:
- a company is hedging future purchases of inventory and may not recover a loss on the hedging instrument through expected sales of those items; or
- a company hedged the purchase of a fixed-rate financial asset and may not recover a loss on the hedging instrument because the financial asset has become credit-impaired. [IAS 39.97–98, IFRS 220.127.116.11(d)(iii)]
When a company applies hedge accounting, it is required to disclose how it applies its risk management strategy and the effects on its financial performance and future cash flows. It is possible that economic and/or geopolitical uncertainty could affect these disclosures and a company will need to use judgement to determine the specific disclosures that are relevant and necessary for its business. [IFRS 7.21A]
Examples of specific disclosures include:
- changes in how the company manages risks;
- impacts on hedge ineffectiveness;
- forecast transactions that were subject to hedge accounting but are no longer expected to occur, and the related reclassifications to profit or loss; and
- reclassifications of irrecoverable losses from the cash flow hedge reserve to profit or loss. [IFRS 7.21A, 23E–23F, 24C(b)]
Actions for management
- Evaluate whether forecast transactions designated as hedged items in cash flow hedges continue to be highly probable. If a transaction is not highly probable, then consider whether it is still expected to occur.
- Determine whether any changes in the contractual terms of a hedged financial instrument resulting from the economic and/or geopolitical uncertainty affect the instrument’s eligibility to be a hedged item.
- Evaluate whether changes in the credit risk of hedging instruments and hedged items arising from economic and/or geopolitical uncertainty affect the assessment of hedge effectiveness and the measurement of hedge ineffectiveness.
- Evaluate whether accumulated losses in the cash flow hedge reserve will be recovered in future periods.
Our annual Guides to financial statements, which help you to prepare financial statements in accordance with IFRS Standards, include a COVID-19 supplement illustrating additional disclosures that entities may need to provide on accounting issues arising from the pandemic.
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