Financial instruments – the devil is not so black? Part 4

Katarzyna STENCEL
Audit Supervisor at RSM Poland

After the introduction to financial instruments under Polish and international law, exploring the subject of classification and measurements of debentures, analysing the initial recognition of financial instruments in the account books and their classification in compliance with the new IFRS 9 guideline, it is time to discuss hedge accounting.

Hedge accounting under IFRSF 9 – theory and practice

As we have probably already convinced you, financial instruments are an inseparable element of any business activity. Due to their character, financial instruments are often related to the interest rate, or foreign exchange risk which are directly reflected in the financial standings of a business entity. The management is responsible for identifying, measuring and monitoring the risk as well as protecting the company against any potential implications. Any company oriented towards maximising financial results should be aware of the importance of having a risk management policy.

When to use hedge accounting?

How does this apply to financial instruments? Can the impact of e.g. volatility of interest rates or FX due to market turmoil be completely or partly eliminated? The answer to these questions is hedging, which allows to offset the impact of the volatility  of the hedged instrument on the financial result by the impact of changes in the hedging instrument’s fair value thanks to their parallel recognition. Using hedge accounting is optional and is only possible if the hedge relationship is clearly defined, measurable and effective, as will be discussed later in the article.  

It should be noted that the entering of IFRS 9 into force was accompanied by changes concerning hedge accounting. They relate primarily to those balance sheet items or future transactions which are exposed to more than one risk. This could be for example a foreign currency loan,
exposed both to the interest rate risk as well as  foreign exchange risk, or a transaction being a combination of the risk of changing commodity prices and foreign exchange risk. A certain novelty in comparison to IAS 39 is the current possibility to establish a hedging relationship both on the primary exposition, and the derivative instrument, which together constitute an aggregate position. This solution is similar to market practices, as two types of risk do not have to be hedged on the same day.

How to hedge risk?

Returning to the issue of risk management, it should be noted that the risk management strategy and the purpose of risk management are two separate terms.

Risk management strategy is superior to the purpose, as it determines the manner in which the company manages risk and stands for the identification of risks to which the company is exposed as well as ways of reacting to them. The strategy may stipulate that a debt with a variable interest rate should be maintained at a level no higher than assumed.

Risk management objectives apply to a specific hedging relationship, i.e. way of applying a given hedging instrument to hedge against a certain exposure to the risk of a hedging position. It may be a designation of a forward currency contract as a hedge for the exchange rate risk in a sales transaction effected in the near future.

A hedging instrument can be a derivative, with the exception of some options, but also another financial asset or financial liability not being a derivative. Its fair value or resulting cash flows are aimed at offsetting the changes in fair value or cash flows of the hedged position.

A hedged item is a recognised asset or liability, unrecognised probable future liability, highly probable planned transaction or shares in assets of foreign entities.

Types of hedging relationships

Under IFRS 9, para. 6.5.2, there are 3 types of hedging relationships:

• fair value hedge,
• cash flow hedge,
• hedge of a net investment in a foreign operation  (see: IAS 21: The Effects of Changes in Foreign Exchange Rates).

Under MSSF 9, para. 6.4.1, hedging relationships should meet all the following criteria to qualify for hedge accounting:

• 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 of the following hedge effectiveness requirements:
  
  • there is an economic relationship between the hedged item and the hedging instrument, which means that  they must change in opposite directions due to the change of hedged risk, which is the same (however, IFRS 9 fails to determine the method of assessing if such an economic relationship exists),
  • 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 resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item.

It has to be remembered that in hedge accounting it is the hedging relationship documentation that  is of key importance and it should specify:

• the hedging instrument,
• the hedging item,
• the character of the hedged risk and
• the method of determining if the hedging relationship meets the effectiveness  requirements (this includes the analysis of the sources of ineffectiveness of the hedge conducted by the company as well as the manner of determining the hedge ratio).

Also, under IFRS 9, effective hedging should be defined in the documentation , as it results in different recognition of the measurement of the hedging item in the account books. Before the implementation of IFRS 9, IAS 39 defined effective hedge as a hedge that exceeds 80%. If the hedge is not deemed effective, hedge accounting cannot be applied and thus any changes in the fair value of the hedging instrument should be recognised in profit and loss.

Coming back to types of hedges, we can list the following methods of their recognition in the financial statements:

• for fair value (under MSSF 9, para. 6.5.8) of an asset or liability hedged against changes in market prices, as their price or cash flow is constant, the recognition is a s follows:

• the gain or loss on the hedging instrument shall be recognised in profit or loss,
• the hedging gain or loss on the hedged item shall adjust the carrying amount of the hedged item and be recognised in profit or loss.

It is important for the valuation presentation results to know what is actually hedged.

• for cash flow hedged (under IFRS 9, para. 6.5.11) against the volatility  associated with certain risk related to the recognised asset or liability, as cash flows may not be constant e.g. due to fluctuant interest rate, the recognition is as follows:

• the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge, shall be recognised in other comprehensive income,
• the portion of the gain or loss that is determined to be ineffective, shall be recognised in profit and loss.

When the acquired asset or incurred liability affects the profit or loss, the measurement of a financial instrument that has been recognised in other comprehensive income is reclassified to profit or loss.

• Net investment hedge is recognised similarly to the cash flow hedge, i.e.:

• the effective portion of the hedging instrument shall be recognised in other comprehensive income,
• the portion deemed ineffective shall be recognised in profit and loss.

It should be highlighted that a company ceases to use the hedge accounting when the relevant requirements are no longer met. It is not possible to cease to use it voluntarily as it would interfere with the very essence of hedge accounting, taking into account the predetermined goals and applied criteria.

The impact of hedging on the financial result

Although implementing hedge accounting is time-consuming – especially due to restrictions related to keeping statutory records – and they have significant impact on company’s financial ratios, and thus also on covenants in the event of concluding loan agreements –  it allows to eliminate the fluctuation of the financial result, ensuring greater transparency of financial statements for stakeholders. Hedge accounting also allows to present hedging relationships in accordance with the business nature of transactions based on derivatives.

If you would like to know more about the correct recognition of financial instruments in financial statements, remember to read our following posts.