IFRS Hedging of Elements of Financial Statements of Credit Institutions

IFRS Hedging of Elements of Financial Statements of Credit Institutions

IFRS Hedging of Elements of Financial Statements of Credit Institutions: The fundamental principle is that the hedged item creates an exposure to risk that could affect the income statement.

The hedged item can be:

  • A single asset, liability, firm commitment or highly probable forecast
  • A group of assets, liabilities, firm commitments or highly probable forecast transactions with similar risk
  • A non-financial asset or liability (such as inventory) for either foreign currency risk or the risk of changes in the fair value of the entire
  • A held-to-maturity investment for foreign currency risk or credit risk (but not interest rate risk);
  • A portion of the risk or cash flows of any financial asset or liability (however, for one-sided risk, only the intrinsic value can be hedged).
  • A net investment in a foreign

Hedge accounting is prohibited for hedges of net positions, but it is possible to track back from the  net position to a gross position and to designate a portion of the latter as the hedged item if it meets the other criteria for hedge accounting.

IFRS Hedging of Elements of Financial Statements of Credit Institutions

Categories of hedges

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Hedge accounting may be applied to three types of hedging relationships: fair value hedges, cash flow hedges and hedges of a net investment in a foreign operation.

Fair value hedges

A fair value hedge is a hedge of the exposure to changes in the fair value of a recognised asset or liability or a previously unrecognised firm commitment to buy or sell an asset at a fixed price, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect reported profit or  loss.

In a fair value hedge, the gain or loss from remeasuring the hedging instrument at fair value (derivative) or the foreign currency component of its carrying amount (non-derivative) is recognised immediately in the income statement. At the same time, the carrying amount of the hedged item is adjusted for the gain or loss attributable to the hedged risk; the change is also recognised immediately in the income statement to offset the value change on the derivative.

Entities are also permitted to apply fair value hedge accounting to be applied to a portfolio hedge of interest rate risk (sometimes referred to as a ‘macro hedge’). Special requirements apply to this type of hedge.

IFRS Hedging of Elements of Financial Statements of Credit Institutions

Cash flow hedges

A cash flow hedge is a hedge of the exposure to variability in cash flows that: (a) is attributable to a particular risk associated with a recognised asset or liability or a forecast transaction; and (b) could affect reported profit or loss. Hedges of the foreign currency risk associated with firm commitments may be designated as cash flow hedges. The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge is recognised directly in  equity.

The gain or loss deferred in equity is recycled to the income statement when the hedged cash flows affect income. If the hedged cash flows result in the recognition of a non-financial asset or liability on the balance sheet, the entity can choose to adjust the basis of the asset or liability by the amount deferred in equity. This choice has to be applied consistently to all such hedges. However, such basis adjustment is prohibited if a financial asset or liability results from the hedged cash  flows.

Hedges of a net investment in a foreign operation

Under IAS 21, ‘The effects of changes in foreign operations’, the net investment in a foreign operation is the amount of the reporting entity’s interest in the net assets of that operation. If a derivative or non-derivative is designated as a hedge of that interest, the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge is recognised directly in equity.

Hedge effectiveness/ineffectiveness

IAS 39 requires the hedge to be highly effective if it is to qualify for hedge accounting. There are separate tests to be applied prospectively and retrospectively and these tests are  mandatory:

  • Prospective effectiveness testing is performed at inception of the hedge and at each subsequent reporting date during the life of the hedge. This testing consists of demonstrating that the entity expects changes in the fair value or cash flows of the hedged item to be almost fully offset (that is, nearly 100 per cent) by the changes in the fair value or cash flows of the hedging
  • Retrospective effectiveness testing is performed at each reporting date throughout the life of the hedge in accordance with a methodology set out in the hedge documentation. The objective is to demonstrate that the hedging relationship has been highly effective by showing that actual results of the hedge are within the range of 80-125 per

Hedge ineffectiveness is systematically and immediately reported in the income  statement.

IFRS Hedging of Elements of Financial Statements of Credit Institutions

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Discontinuing hedge accounting

Hedge accounting is discontinued prospectively if any of the following   occurs:

  • A hedge fails the effectiveness
  • The hedging instrument is sold, terminated or
  • The hedged position is
  • Management decides to revoke the hedge
  • In a cash flow hedge, the forecast transaction that is hedged is no longer expected to take place.

When a debt instrument (a non-derivative liability) has been adjusted for changes in fair value under a hedging relationship, the adjusted carrying amount becomes amortised cost. Any ‘premium’ or ‘discount’ is then amortised through the income statement over the remaining period to maturity of the liability.

If a cash flow hedge relationship ceases, the amounts accumulated in equity is maintained in equity until the hedged item affects profit or loss. However, if the hedge accounting ceases because the forecast transaction that was hedged is no longer expected to take place, gains and losses deferred in equity have to be recognised in the income statement immediately. Any amounts accumulated in equity while a hedge of net investment was effective remain in equity until the disposal of the related net investment.

IFRS Hedging of Elements of Financial Statements of Credit Institutions

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