Impairment and hedge accounting (ifrs 9) - Hedge relationshi...

Learning Outcomes

After reading this article, you should be able to recognise the types of hedge relationships under IFRS 9, understand the qualifying criteria for hedge accounting, and explain the requirements for hedge effectiveness. You will know how to account for fair value, cash flow, and net investment hedges, assess hedge effectiveness, and apply the correct accounting treatment for gains, losses, and ineffectiveness. You will also become alert to common errors tested in ACCA SBR.

ACCA Strategic Business Reporting (SBR) Syllabus

For ACCA Strategic Business Reporting (SBR), you are required to understand when and how hedge accounting can be applied, the different types of hedges available under IFRS 9, and the conditions required for hedge effectiveness. Focus your revision on the following syllabus points:

• Explain and apply the qualifying criteria for hedge accounting under IFRS 9
• Identify, distinguish, and account for fair value hedges, cash flow hedges, and net investment hedges
• Assess and explain the hedge effectiveness requirements, including documentation and economic relationship
• Account for gains and losses arising from both the hedged item and hedging instrument
• Recognise when hedge accounting must be discontinued and the implications for the financial statements

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is not a type of hedge relationship permitted under IFRS 9?
   1. Fair value hedge
   2. Cash flow hedge
   3. Net investment hedge
   4. Hedged purchase hedge

2. True or false? Hedge effectiveness under IFRS 9 requires that gains and losses on the hedging instrument and hedged item are always exactly equal.

3. Name two formal documentation requirements that must be established at the inception of a hedge relationship under IFRS 9.

4. In a cash flow hedge, what happens if the gain on the hedging instrument exceeds the loss on the hedged item at the reporting date?

5. Briefly explain what is meant by “hedge ineffectiveness” and how it is accounted for under IFRS 9.

Introduction

IFRS 9 Financial Instruments allows entities to use hedge accounting to reduce volatility in profit or loss by aligning the recognition of gains and losses on hedging instruments with those on hedged items. Correctly applying hedge accounting requires understanding the types of hedge relationships, meeting strict qualifying criteria, and continually assessing hedge effectiveness. Exam success depends on knowing the detailed accounting for each type of hedge and how to address ineffectiveness.

Key Term: Hedge accounting
The process of matching the timing of recognition of gains or losses on a hedging instrument with those on the hedged item, in accordance with IFRS 9.

Hedge Relationships under IFRS 9

Entities use hedge accounting when managing exposure to risks such as interest rate, foreign currency, or commodity price fluctuations. A hedging relationship formally designates a specific hedged item and a specific hedging instrument.

Types of Hedge Relationships

IFRS 9 permits three main types:

Fair Value Hedge

A fair value hedge offsets risk of changes in the fair value of a recognised asset, liability, or firm commitment attributable to a specified risk.

Key Term: Fair value hedge
A hedge of the exposure to changes in the fair value of a recognised asset, liability, or firm commitment due to a particular risk.

Key Term: Hedged item
An asset, liability, firm commitment, or forecast transaction whose risk exposure is designated within a hedge relationship.

Key Term: Hedging instrument
A derivative or qualifying non-derivative financial instrument used to offset risk in a designated hedge relationship.

Cash Flow Hedge

A cash flow hedge addresses exposure to variability in cash flows of a recognised asset, liability, or forecast transaction.

Key Term: Cash flow hedge
A hedge of the exposure to variability in cash flows from a recognised asset, liability or forecast future transaction due to a specific risk.

Net Investment Hedge

A net investment hedge manages foreign exchange risk associated with investments in foreign subsidiaries, branches, or associates.

Key Term: Net investment hedge
A hedge of the foreign currency risk arising from an entity's net investment in a foreign operation.

Worked Example 1.1

A company has $10 million of fixed-rate bonds outstanding. It worries that if market rates rise, the fair value of the bonds will fall. It enters into an interest rate swap, paying floating and receiving fixed.

Question:
What type of hedge relationship is this? How are fair value changes of the bond and swap accounted for?

Answer:
This is a fair value hedge. Both the gain or loss on the swap (hedging instrument) and the loss or gain on the bond’s fair value (hedged item) are recognised in profit or loss, offsetting each other.

Qualifying Criteria for Hedge Accounting

IFRS 9 sets out strict rules:

• Only eligible hedged items and qualifying hedging instruments can be designated.
• The hedging relationship must be formally documented at inception.
• The hedge must meet all “hedge effectiveness” requirements: there must be an economic relationship, the effect of credit risk is not dominant, and the hedge ratio reflects actual risk management.

Poor or missing documentation means hedge accounting cannot be applied.

Key Term: Hedge effectiveness
The extent to which changes in the hedging instrument offset changes in the hedged item attributable to the hedged risk.

Documentation at Inception

Effective documentation must specify:

• The risk management objective and strategy
• The identification of both the hedged item and the hedging instrument
• The exact nature of the risk being hedged
• How hedge effectiveness will be assessed (both prospectively and retrospectively)

Hedge Effectiveness Assessment

IFRS 9 requires that:

• There is an economic relationship between the hedged item and instrument (i.e. values move in response to the same risk).
• The impact of credit risk does not dominate either fair value change.
• The hedge ratio must reflect the quantities actually used for risk management.

Quantitative tests (e.g. 80–125% band) once required by IAS 39 are no longer mandatory. Instead, the assessment is principles-based but must be robust and supportable.

Worked Example 1.2

A UK exporter expects to receive €1 million in 4 months. To hedge currency fluctuations, it enters into a forward contract to sell euros for pounds at a fixed rate.

Question:
What must be documented to permit hedge accounting for this relationship?

Answer:
The company must document the hedged item (forecast euro receipt), hedging instrument (forward contract), the risk being hedged (currency risk), and describe the method for measuring effectiveness. There must be an economic relationship, and credit risk must not overwhelm the results.

Key Term: Hedge ratio
The proportion of the hedged item to the hedging instrument, reflecting the quantities designated as a hedge relationship.

Accounting for Types of Hedges

• Fair value hedge: Gains and losses on both hedged item (related to the hedged risk) and hedging instrument are recognised in profit or loss.
• Cash flow hedge: The effective portion of the gain or loss on the instrument goes to other comprehensive income (OCI) and is reclassified to profit or loss when the hedged item affects profit or loss. Any ineffective portion is recognised immediately in profit or loss.
• Net investment hedge: The effective portion of any foreign exchange gain/loss is recognised in OCI and reclassified to profit or loss on disposal of the foreign operation.

Worked Example 1.3

A company expects to purchase 100,000 litres of jet fuel in six months. To hedge price risk, it enters into a futures contract. At the reporting date:

• Futures contract shows a gain of $200,000.
• Expected future cash flow risk has resulted in $150,000 of loss on the hedged forecast purchase (relative to original expectation).

Question:
How do you account for the hedge in the financial statements?

Answer:
The effective portion ($150,000) is recognised in OCI. The excess $50,000 (ineffective portion) is recognised in profit or loss.

Exam Warning

A common mistake is to assume all gains or losses on the hedging instrument always go to OCI for cash flow hedges. Only the effective portion does, with the excess (ineffectiveness) going to profit or loss. Clearly show your calculations and allocations in exam answers.

Ongoing Assessment, Rebalancing and Discontinuation

Hedge effectiveness must be reassessed at each reporting date. If a hedging relationship becomes ineffective, you must rebalance (adjust the hedge ratio) if possible. If effectiveness cannot be restored, hedge accounting must be discontinued prospectively—no previous entries are reversed.

Discontinuation is also required if:

• The hedging instrument expires, is sold, is terminated, or exercised
• The entity revokes the designated hedge relationship
• The forecast hedged transaction is no longer highly probable (for cash flow hedges)

Revision Tip

Label all relevant parts in scenario answers: hedged item, hedging instrument, hedge type, accounting entries for effective and ineffective portions. This reduces errors and demonstrates structured thinking.

Summary

Hedge accounting under IFRS 9 permits three hedge types—fair value, cash flow, and net investment—each with distinct accounting. Qualification requires strict documentation and ongoing effectiveness assessment. Ineffectiveness must be measured and recognised in profit or loss as required. Proper application reduces profit or loss volatility and aligns reported results with actual risk management.

Key Point Checklist

This article has covered the following key knowledge points:

• Distinguish between fair value, cash flow, and net investment hedges under IFRS 9
• Document and assess qualifying criteria for hedge accounting, including risk designation and effectiveness
• Apply the correct accounting treatment for each type of hedge relationship
• Recognise and account for hedge ineffectiveness and rebalancing
• Identify when and how to discontinue hedge accounting

Key Terms and Concepts

• Hedge accounting
• Fair value hedge
• Hedged item
• Hedging instrument
• Cash flow hedge
• Net investment hedge
• Hedge effectiveness
• Hedge ratio