IFRS 9, Financial Instruments

This is the second of two articles on the topic of financial instruments. This article covers:

• derivatives
• hedge accounting

Derivatives

According to IFRS 9, Financial Instruments, a derivative is a contract that:

• will be settled at a future date
• requires no (or a low) initial investment, and
• changes value in response to movements in an underlying item (such as commodity prices or interest rates).

Derivatives can be used by companies to manage risk. For example, a company that manufactures bread may reduce its exposure to changes in the price of wheat by entering into futures contracts to buy wheat for a fixed price in six months’ time. These contracts will be settled net in cash: if wheat prices rise, the company will make a gain on the contracts; if wheat prices fall, the company will make a loss.

All derivatives are measured at fair value. Changes in fair value are recognised in profit or loss (unless the entity has elected to apply hedge accounting by designating the derivative as a hedging instrument in an eligible hedging relationship.)

Note that a contract that otherwise meets the definition of a derivative would not be accounted for as a financial instrument if the company entered into it for the purpose of receiving a non-financial item (such as wheat) in accordance with its expected usage requirements.
 

Hedge accounting

Background
As noted above, derivatives are used by companies to manage risk. In the financial statements, they are remeasured to fair value at each reporting date, with the gain or loss recognised in profit or loss. However, the item that was generating the risk may not be recognised in the financial statements (such as a future purchase of wheat), or it may be accounted for in a different way (such as inventories of wheat, which are measured at the lower of cost and net realisable value). This gives rise to an accounting mismatch. This causes volatility in profit or loss that can make the company look like a riskier investment to its shareholders, even though the company has taken proactive steps to manage its risk. This outcome is at odds with the purpose of hedging and can be reduced or eliminated if the company chooses to apply hedge accounting.

Requirements
The hedge accounting requirements in IFRS 9 are optional. If certain eligibility and qualification criteria are met, hedge accounting allows an entity to reflect risk management activities in the financial statements by matching gains or losses on financial hedging instruments (derivatives) with losses or gains on the risk exposures they hedge.

Hedge accounting can be applied to the following examinable types of hedging relationships:

• Fair value hedge: a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, that is attributable to a particular risk and could affect profit or loss.
• Cash flow hedge: a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability or a highly probable forecast transaction, and could affect profit or loss.

A hedging relationship qualifies for hedge accounting only if all of the following criteria are met:

• The hedging relationship consists only of eligible hedging instruments and eligible hedged items.
• At the inception of the hedging relationship there is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge.
• The hedging relationship meets all the hedge effectiveness requirements.

In order to qualify for hedge accounting, the hedge relationship must meet the following effectiveness criteria at the beginning of each hedged period:

• There is an economic relationship between the hedged item and the hedging instrument.
• The effect of credit risk does not dominate the value changes that result from that economic relationship.
• The hedge ratio of the hedging relationship is the same as that actually used in the economic hedge.

Fair value hedge accounting
If the fair value hedge meets the qualifying criteria, the hedging instrument is re-measured at fair value. The gain or loss is recognised in profit or loss. The carrying amount of the hedged item is adjusted for the gain or loss attributable to the hedged risk only and is also recognised in profit or loss. Thus, all gains and losses attributed to the hedged risk are recognised in the statement of profit or loss, with the result that there is no net profit and loss effect, other than any hedge ineffectiveness.

Note that if the hedged item is an equity instrument designated to be measured at FVOCI, then the gains and losses on the hedged item and hedging instrument are both reported in other comprehensive income.

Cash flow hedge accounting
If the cash flow hedge meets the qualifying criteria, the hedging instrument is re-measured at fair value. Gains or losses on the effective portion of the hedging instrument are recognised in OCI. These amounts will be taken to a ‘cashflow hedging reserve’ as a separate component of equity. The ineffective portion of the gain or loss on the hedging instrument is recognised in the statement of profit or loss.

When cash flows relating to the hedged item are reported in profit and loss, amounts in OCI are reclassified (‘recycled’) to the statement of profit or loss.

Where a hedge of a forecast transaction results in the recognition of a financial asset or liability, the gains or losses on the hedging instrument that have previously been recognised in OCI are reclassified (‘recycled’) in the same period as the asset or liability affects profit or loss (for example, in the periods when interest expense or income is recognised). If a hedged forecast transaction subsequently results in the recognition of a non-financial asset or non-financial liability, the company removes that amount from the cash flow hedge reserve and includes it directly in the initial cost or other carrying amount of the asset or the liability. This is not a reclassification adjustment and hence it does not affect other comprehensive income. However, if a company expects that any of a loss recognised in OCI will not be recovered in future periods, it should reclassify to profit or loss the amount that is not expected to be recovered.
 

Written by a member of the DipIFR examining team